Financial Management NPV Analysis

STUDY QUESTION BANK FINANCIAL MANAGEMENT (F9)
1
Question 1 PRIVATE V PUBLIC SECTOR OBJECTIVES
Assume that you are a financial manager in a state owned enterprise that is about to have its majority
ownership transferred from the government to the private sector and to become a listed company on the
Stock Exchange.
Required:
Discuss the differences in financial objectives that you are likely to face and the changes in
emphasis that are likely to occur in your strategic and operational decisions as a finance
manager.
(10 marks)
Question 2 CAPITAL MARKET EFFICIENCY
The following statement contains several errors with reference to the three levels of market efficiency.
According to the efficient market hypothesis all share prices are correct at all times. This is
achieved by prices moving randomly when new information is publicly announced. New
information from published accounts is the only determinant of the random movements in
share price.
Fundamental and technical analysis of the capital market serves no function in making the
market efficient and cannot predict future share prices. Corporate financial managers are also
unable to predict future share prices.
Required:
Explain the errors in the above statement.
(10 marks)
Question 3 BASIC DISCOUNTING
(a) What are the present values of the following cash flows at a discount rate of 10%?

t
0
t
1
t
2
t
3
t
4
t
5

$ $ $ $ $ $
(i) 30 40 50 60 70
(ii) 30 30 50 50 50
(iii) 50 60 70 80

(b) What is the present value of $500 per annum receivable for ten years if the first payment is
due

(i) in a years time
(ii) in two years time
(iii) immediately?

The discount rate is 15%.

FINANCIAL MANAGEMENT (F9) STUDY QUESTION BANK
2
(c) What annual income over five years could be purchased for a capital sum of $15,000 if the
appropriate interest rate were 5% and the first of the five payments were due

(i) in one years time
(ii) in two years time
(iii) immediately?

(d) What is the present value of $1,500 per annum due in perpetuity at a 10% discount rate if
the first payment is due

(i) in one years time
(ii) in five years time?

(e) A payment of $500 is due immediately.

How much would you be prepared to pay four years from now if it were possible to defer
payment until then and the appropriate discount rate were 20%?

(f) What would be the market value of an 8% debenture with a nominal value of $100 due for
redemption at par in five years time, if the required return for that category of debt were
10%?

Ignore taxation.
(15 marks)

Question 4 ELVIRA CO PLC
The Elvira Co plc is contemplating three available investment opportunities, the cash flows of which
are given below.
Initial Cash flow
investment Year 1 Year 2 Year 3 Year 4 Year 5
$000 $000 $000 $000 $000 $000
Project Adina 100 40 40 40 40
Project Belcore 120 10 10 10 10 200
Project Calisto 150 100 80

In each case the initial investment represents the purchase of plant and machinery, whose realisable
value will be 10% of initial cost, receivable in addition to the above flow at the end of the life of the
project.
Required:
Advise the company on which project it should prefer, taking as your investment criterion the
following alternative measures.

(a) Payback period. (3 marks)
(b) Accounting rate of return (based on average investment). (3 marks)
(c) Net present value at 15%. (3 marks)
(d) Internal rate of return. (3 marks)

(12 marks)

3
Question 5 KHAN LTD
Khan Ltd is an importer of novelty products. The directors are considering whether to introduce a
new product, expected to have a very short economic life. Two alternative methods of promoting
the new product are available, details of which are as follows.

Alternative 1 would involve heavy initial advertising and the employment of a large number of
agents. The directors expect that an immediate cash outflow of $100,000 would be required (the
cost of advertising) which would produce a net cash inflow of $255,000 after one year. Agents
commission, amounting to $157,500, would have to be paid at the end of year 2.

Alternative 2 would involve a lower outlay on advertising ($50,000 payable immediately) and no use
of agents. It would produce net cash flows of zero after one year and $42,000 at the end of each of
the subsequent two years.

Mr Court, a director of Khan Ltd, comments: I generally favour the payback method for choosing
between investment alternatives such as these. However, I am worried that the advertising
expenditure under the second alternative will reduce our reported profit next year by an amount not
compensated by any net revenues from sale of the product that year. For that reason I do not think
we should even consider the second alternative.

The discount rate of Khan Ltd is 20% per annum.

Required:
(a) Calculate the net present values and estimate the internal rates of return of the two
methods of promoting the new product. (6 marks)

(b) Advise the directors of Khan Ltd which, if either, method of promotion they should
adopt, explaining the reasons for your advice and noting any additional information
you think would be helpful in making the decision. (6 marks)

(c) Comment on the views expressed by Mr Court. (6 marks)

(18 marks)
Question 6 FIORDILIGI PLC
Fiordiligi plc is evaluating a potential new product, the ottavio, in which the following costs are
involved.

(a) Labour

Each ottavio requires hour of skilled labour and 2 hours of unskilled labour. During the
next year Fiordiligi expects to have a surplus of skilled labour, retained on contracts under
which the minimum wage is guaranteed. This surplus is sufficient to complete the
budgeted quantity of ottavios in the first year, but there will be no surplus thereafter. All
unskilled labour will be taken on as required.

The wage rates are $4.00 per hour for skilled labour and $2.50 per hour for unskilled.

4
(b) Materials

(i) Material Ping is used in the ottavios, 2 kgs per unit. No inventory of Ping is
held by the company.
(ii) Material Pang contributes 0.5 kg per unit. Sufficient of this material to meet
the entire budgeted production is already held in inventory; it has no other use.
(iii) Material Pong is also used; 1.5 kgs are required per unit. Some inventory is
already held, further supplies may readily be purchased. Pong is used in the
manufacture of another product, the masetto, which contributes $0.85 per kg of
Pong, net of the cost of Pong, and depreciation at an estimated $0.06 per kg.

The value of the various materials may be summarised as follows.

Ping Pang Pong
$/kg $/kg $/kg
Cost of material in inventory 2.00 0.70
Current replacement cost 1.40 2.20 0.80
Current realisable value 1.10 1.80 0.65

Any materials requiring purchase will be bought in advance of the year for which they are
needed.

(c) Overheads

(i) Variable overheads are expected to be incurred at the rate of $1.40 per skilled
labour hour. This represents extra cash cost expended.

(ii) Fixed overheads will be affected by the project as follows.

(1) A new factory will be leased at an annual rental of $2,000 in
advance for the life of the project.

(2) Rates on the factory (payable in arrears) will be $1,000 per annum.

(3) The equipment (see below) will be written down to its realisable
value over the life of the project.

(4) The central management accounting department will absorb
administration costs into production on the basis of $0.50 per
unskilled labour hour. Direct administration of the project will be
carried out by management without any increase in overtime or
staffing levels.

It is expected that ottavios will be produced for three years at the rate of 10,000 units per annum, and
then for a further two years at the rate of 8,000 units per annum. The selling price will be $18 per
unit in the first three years and $14 thereafter.

Special machinery will be purchased at the start of the project for $60,000. It will be sold at the end
of the fifth year for $6,000.

5
Required:
Calculate the net present value of the projected production of ottavios and hence advise the
directors whether or not to proceed. The companys cost of capital for investments of this
nature is 15%.

Ignore taxation.
(15 marks)

Question 7 HULME LTD
Hulme Ltd is considering the manufacture of a new product, the Champ, to add to its existing range.
Manufacture would commence on 1 January 19.00 and 100,000 Champs would be produced and sold
each year for three years. The directors of Hulme Ltd expect to be able to charge a price of $6 per
Champ during 19.00 and to increase the price during 19.01 and 19.02 in line with increases in the
Consumer Price Index. The Index is expected to increase in the future at an annual compound rate of
10%.

The following costs are involved in producing Champs.

Labour
Each Champ requires hour of skilled labour and
1
/2 hour of unskilled labour. Current (1
January 19.00) wage rates are $3 per hour for skilled labour and $2 per hour for unskilled
labour. For 19.00 only Hulme Ltd expects to have 100,000 surplus hours of unskilled
labour. Whether or not Champs are manufactured, the employees concerned will be
retained and paid by the company. All labour costs are expected to increase at an annual
compound rate of 20%.

Materials
Each Champ requires 2 kgs of Alpha and 1 kg of Beta. Hulme Ltd currently holds in
inventory 200,000 kgs of Alpha and 100,000 kgs of Beta. The inventory of Alpha
originally cost $0.40 per kg and has a current realisable value of $0.30 per kg. The current
buying price is $0.50 per kg. The inventory of Beta originally cost $0.80 per kg and has a
current realisable value of $0.90 per kg. The current buying price is $1.10 per kg. Alpha is
used regularly by the company on many products. Beta is used rarely and the only use for
the existing inventory, if it is not applied to the manufacture of Champs, is to sell it
immediately.

Materials required to manufacture Champs must be purchased and paid for annually in
advance. Replacement costs and realisable values of Alpha and Beta are expected to
increase at an annual compound rate of 10%.

Overheads
It is the policy of the company to allocate all overhead costs to its various products. The
calculated overhead cost per unit for Champs, at current prices, is as follows.

$
Allocated head office fixed costs (rent, rates, administration, etc) 0.70
Depreciation $30,000 100,000 0.30
Variable overheads 0.50

1.50

6
Head office costs and variable overheads are expected to increase in line with the Consumer Price
Index. The machine required to manufacture Champs was bought some years ago. Its current book
value is $90,000, and the above depreciation charge is based on a remaining life of three years at the
end of which the machine will have no scrap or re-sale value. If it is not used to produce Champs,
the machine will be sold immediately for $150,000.

Hulme Ltd has a cost of capital of 20% per annum in money terms.

Assume that all receipts and payments (except costs of materials and machine sale proceeds) will
arise on the last day of the year to which they relate.

Assume also that input prices will change annually on 31 December.

Required:
(a) Prepare calculations showing whether Hulme Ltd should undertake production of the
Champ. (8 marks)

(b) Provide brief explanations of the figures you have used. (5 marks)

(c) Comment on factors which are not included in your calculations but which may affect
the decision. (7 marks)

Ignore taxation
(20 marks)
Question 8 BAILEY PLC
Bailey plc is developing a new product, the Oakman, to replace an established product, the Shepard,
which the company has marketed successfully for a number of years. Production of the Shepard will
cease in one year whether or not the Oakman is manufactured. Bailey plc has recently spent $75,000
on research and development relating to the Oakman. Production of the Oakman can start in one
years time.

Demand for the Oakman is expected to be 5,000 units per annum for the first three years of
production and 2,500 units per annum for the subsequent two years. The products total life is
expected to be five years.

Estimated unit revenues and costs for the Oakman, at current prices, are as follows.

$ $
Selling price per unit 35.00
Costs per unit
Materials and other consumables 8.00
Labour (see (1) below) 6.00
Machine depreciation and overhaul (see (2) below) 12.50
Other overheads (see (3) below) 9.00
(35.50)

Loss per unit (0.50)

7
(1) Each Oakman requires two hours of labour, paid $3 per hour at current prices. The labour
force required to produce Oakmans comprises six employees, who are at present employed
to produce Shepards. If the Oakman is not produced, these employees will be made
redundant when production of the Shepard ceases. If the Oakman is produced, three of the
employees will be made redundant at the end of the third year of its life, when demand
halves, but the company expects to be able to find work for the remaining three employees
at the end of the Oakmans five year life. Any employee who is made redundant will
receive a redundancy payment equivalent to 1,000 hours wages, based on the most recent
wage rate at the time of the redundancy.

(2) A special machine will be required to produce the Oakman. It will be purchased in one
years time (just before production begins). The current price of the machine is $190,000.
It is expected to last for five years and to have no scrap or resale value at the end of that
time. A major overhaul of the machine will be necessary at the end of the second year of
its life. At current prices the overhaul will cost $60,000. As the machine will not produce
the same quantity of Oakmans each year, the directors of Bailey plc have decided to spread
its original cost and the cost of the overhaul equally between all Oakmans expected to be
produced (i.e. 20,000 units). Hence the combined charge per unit for depreciation and
overhaul is $12.50 [$(190,000 + 60,000) 20,000 units].

(3) Other overheads at current prices comprise variable overheads of $4.00 per unit and head
office fixed costs of $5.00 per unit, recovered on the basis of labour time.

All wage rates are expected to increase at an annual compound rate of 15%. The selling price per
unit and all costs other than labour are expected to increase in line with the Consumer Price Index.
The Index is expected to increase in the future at an annual compound rate of 10%.

Corporation tax at 35% on net cash income is payable in full one year after the income arises. 25%
writing down tax allowances are available on the machine. Bailey plc has a money cost of capital,
net of corporation tax, of 20% per annum.

Assume that all receipts and payments will arise on the last day of the year to which they relate.
Assume also that all current prices given above have been operative for one year and are due to
change shortly. Subsequently all prices will change annually.

Required:
(a) Prepare calculations, with explanations, showing whether Bailey plc should
undertake production of the Oakman. (15 marks)

(b) Discuss the particular investment appraisal problems created by the existence of high
rates of inflation. (5 marks)

(20 marks)

8
Question 9 STAN BELDARK
Stan Beldark is a wholesaler of lightweight travelling aids. His company employs a large number of
sales representatives, each of whom is supplied with a company car. Each sales representative
travels approximately 40,000 miles per annum visiting customers. Stan wishes to continue his
present policy of always buying new cars for the sales representatives but wonders whether the
present policy of replacing the cars every three years is optimal. He believes that keeping the cars
longer than three years would result in unacceptable unreliability, and wishes to consider whether a
replacement period of either one year or two years would be better than the present three year period.
The companys fleet of cars is due for replacement in the near future.

The cost of a new car at current prices is $5,500. Resale values of used cars, which have travelled
similar mileages to those of Stans firm, are $3,500 for a one-year-old car, $2,100 for a two-year-old
car and $900 for a three-year-old car, all at current prices. Running costs at current prices, excluding
depreciation, are as follows.
Road fund licence Fuel, maintenance
and insurance repairs, etc
$ $
During first year of cars life 300 3,000
During second year of cars life 300 3,500
During third year of cars life 300 4,300

Stan uses a discount rate of 10% when making such decisions as this.

Running costs and resale proceeds are paid or received on the last day of the year to which they
relate. New cars acquired for use from the start of year 1 are purchased on the last day of the
previous year.

Required:
(a) Prepare calculations for Stan Beldark showing whether he should replace the cars of
sales representatives every one, two or three years. (7 marks)

(b) Discuss how investment appraisal procedures are affected by the existence of high
rates of inflation. (3 marks)

Ignore taxation.
(10 marks)
9
Question 10 TALEB LTD
Taleb Ltd is a manufacturing company which makes a wide range of products. One of these, the
Bat, requires the use of a special Dot machine. The companys present policy is to replace each Dot
machine at the end of its physical productive life of four years. The directors are now considering
whether to replace the machine more frequently than once every four years, in view of the fact that
its productive capacity declines as it gets older and potential sales of Bats are lost. There is
insufficient demand for the companys Bats to justify the purchase of a second Dot machine.

Taleb Ltd charges a selling price of $0.12 per Bat, at which price it is able to sell up to 500,000 per
annum. Variable costs, excluding machine depreciation and running costs, amount to $0.04 per Bat.
Details of productive capacities and running costs (including maintenance) of the Dot machine are as
follows.

Year of machines life Productive capacity Running costs
(Bats) $
First 500,000 6,000
Second 500,000 6,500
Third 400,000 7,500
Fourth 400,000 9,000

Annual running costs are independent of the number of Bats manufactured.

The directors wish to continue their present policy of always buying new Dot machines, at a price of
$60,000 each. Resale values of Dot machines are $40,000 for one-year-old machines, $25,000 for
two-year-old machines, $10,000 for three-year-old machines and zero for four-year-old machines.
The company provides depreciation on all its fixed assets using the straight-line method.

All costs and revenues are paid or received in cash at the end of the year to which they relate, with
the exception of the initial price of the Dot machine which is paid immediately on purchase. Taleb
Ltd has an annual cost of capital of 10%.

Required:
Prepare calculations for the directors of Taleb Ltd showing whether they should replace the
Dot machine every one, two, three or four years.

Ignore inflation and taxation. (10 marks)

Question 11 STICKY FINGERS PLC
After paying $15,000 for a preliminary investigation, the costing department of Sticky Fingers plc
was able to calculate the cash flows for the following investment projects.

Net cash flows t
0
t
1
t
2
t
3
t
4

Immediate
outlay
$000 $000 $000 $000 $000
Project A (1,500) (500) 1,200 600 300
Project B (2,000) (1,000) 2,500 2,500 2,500
Project C (1,750) 500 1,100 1,400 1,000
Project D (2,500) 700 900 1,300 300
Project E (1,600) (500) 200 2,800 2,300
Note that all cash flows take place at the end of the year.
10

You have only just taken up the appointment of financial analyst. The cash flows from the various
projects, as shown above, have been given to you with a memorandum from the managing director
outlining your first task.

Required:
Advise the company in the following circumstances.

(a) The companys cost of capital has been calculated as 15%. Cash is freely available, and all
projects are independent and divisible.

Prepare calculations showing which projects should be accepted. (3 marks)

(b) The amount of cash available for investment at time 0 has been limited to $3 million.
None of the projects can be delayed.

Which projects should be accepted? (3 marks)

(c) The amount of cash available for investment at time 1 has been limited to $200,000. None
of the projects can be delayed. There is now no rationing at time 0.

Which projects should be accepted? (5 marks)

(d) The situation is as in part (b) except that now all projects are independent but indivisible,
and $3.5 million is available.

Which projects should now be accepted? (2 marks)

(e) Now there is capital rationing at both t
1
($200,000) and t
0
($3,000,000). Formulate a
linear programming model to maximise NPV.
(7 marks)

(20 marks)

Question 12 ARMSTRONG
Armstrong plc manufactures a range of electric kitchen gadgets from its own factory in East Anglia.
In recent years sales of product ZP28, an egg-blower for the use of senior citizens, have been
decreasing and the directors are considering whether or not to substitute an alternative product.

The most likely replacement is a top-secret gadget, the XK72, reputed to involve an electric toaster
specially adapted for left-handed users. This could be produced in that part of the factory currently
devoted to ZP28 (which has no other use or rental value), but would need to be burnished in a new
plant. This plant could be constructed on land adjacent to the existing factory, already owned by
Armstrong plc. The land cannot be used for any other purpose, but has a current resale value of
$120,000. In five years time (when demand for the XK72 will have expired), its resale value is
estimated to be $160,000; no tax consequences will attach to the sale of the land. The cost of the
new building would be $30,000, and this expenditure would qualify for writing down allowances of
4% per annum on a straight line basis. The resale value of the building is estimated at $25,000 in
five years time, when production of the new product would cease.

11
The sales directors estimates of the maximum possible sales of ZP28 are as follows.

Year 1 2 3 4 5
Demand (000) 20 15 3 3

This product has yielded a contribution of $1.50 per unit in recent years. This should continue until
the end of year 3, but the sales price will need to be reduced by $1 for year 4 if any sales are to be
made.

The best estimates of sales of the new XK72 are as follows.

Year 1 2 3 4 5
Demand (000) 15 25 30 35 35

Initially its contribution will be $2 per unit, but an aggressive advertising campaign in year 3 (which
will cost $14,200 payable at the end of that year) will mean that the price can be raised by $1.50
thereafter).

The new machinery required for the burnishing department has a cost of $100,000. This machinery
is expected to have no salvage value in year 5.

Purchase of the machinery entitles the owner to claim writing down allowances at the rate of 25%
per annum for tax purposes. There is the possibility of entering into a non-cancellable finance lease
to obtain the use of this machinery. Such a lease would require an initial payment of $21,800 at the
start of the lease, followed by four similar payments made at strictly yearly intervals. Such
payments are tax-deductible expenses. The alternative to leasing is to finance the purchase of the
machinery by borrowing at an after-tax interest rate of 10% per annum, the current competitive
market interest rate for debt.

Armstrong plc is a profitable company and can utilise in full all tax allowances at the earliest
opportunity. The tax rate is 35% (for the whole life of the project) and the tax delay is one year. If
the project is accepted it will commence at the end of a tax year, and the initial payments and any
lease rentals will be included in that tax year. All cash flows not associated with the commencement
of the project will arise at the end of the year to which they relate.

The company uses 15% as an estimate of its cost of capital, as it believes that this rate reflects the
level of risk attaching to its activities.

Required:
(a) Advise Armstrong plc whether or not the proposed change of products is worthwhile.
(12 marks)

(b) Determine whether purchase or leasing, on the terms specified, would be the better
alternative for the new machinery. (8 marks)

(20 marks)

12
Question 13 COMPOUNDING AND DISCOUNTING
(a) Assume a 10% time value of money. Compute the sum to which $1 will accumulate at
compound interest at the end of:
(i) one year
(ii) two years
(iii) three years
(iv) ten years.
(b) Compute the sum which must be invested today at 10% to accumulate to $1 at the end of one
year, two years, three years and ten years respectively.
(c) Using the present value tables, find the present value of the following stream of cash flows at
10%.
Time (end of year) 1 2 3 4
Cash flow ($) 2,000 1,500 3,000 1,000
(d) Using the present value tables, compute the present value of the following stream of cash
flows at 10%.
Time (end of year) 1 2 3 4
Cash flow ($) 1,000 1,000 1,000 4,000
(e) $1.00 is to be invested at the end of each year for the next four years. Calculate the amount to
which the fund will accumulate by the end of year four if the interest rate is 10%.
(f) How much would be in the fund by the end of year 4 in (e) above, if the cash deposits
occurred at the beginning of each year?
(g) Calculate the terminal value at the end of year 5 of the following stream of cash flows at 8%.
Year end 1 2 3 4 5
$ $ $ $ $
Cash flow 450 525 500 425 350
(h) Calculate the effective annual interest rate of
(i) 12% per annum nominal compounded twice yearly
(ii) 12% per annum nominal compounded quarterly
(iii) 24% per annum nominal compounded monthly.
(i) $600 is invested half yearly in a fund earning 8% per annum nominal. If the first investment
of $600 is made on 30 June 19X1, how much will be on deposit by 31 December 19X3?
(j) A project requires an initial investment of $23,000 and produces the following stream of cash
inflows.
End of year 1 2 3
$ $ $
Cash flow 10,000 15,000 5,000
13
Required:
(i) Calculate the net present value of the project at 10%
(ii) Calculate the net present value of the project at 20%
(iii) Determine the internal rate of return for the project.
(k) Find the NPV at 10% of a project with the following cash flows.
End of year 0 1 2 3
$000 $000 $000 $000
Cash flows (50) 10 20 30
(l) If $50,000 were borrowed to finance the project in (k) above and the loan repaid by the cash
flows of the project, what balance would be outstanding at the end of year 3 and how is this
figure related to the NPV previously calculated?
(m) A project requires an initial investment of $33,000 and is expected to generate the following
stream of cash flows.
End of year 1 2 3
$ $ $
Cash flows 10,000 20,000 10,000
Required:
(i) Calculate the net present value of the project at 8%
(ii) Calculate the net present value of the project at 12%
(iii) Determine the internal rate of return of the project.
(n) By solving a quadratic equation, calculate the internal rate of return of a project requiring an
initial investment of $1,440 and generating cash flows of $700 at the end of year 1 and $900
at the end of year 2.
(o) SCR Ltd is considering launching a new product. An initial investment in equipment of
$30,000 is required.
The project life will be four years. Market research has indicated a 75% chance of demand
for the new product being high and a 25% chance of it being low. Cash inflows are forecast
as follows:
Year High demand Low demand
$000 $000
1 12 10
2 13 10
3 13 9
4 14 8
Assume that all cash flows occur at year ends. The cost of capital is 14%.
The equipment can be sold at the end of the project for $2,000.
Required:
Calculate the net present value of the project.
(45 marks)
14
Question 14 DESPATCH CO
Despatch Co is considering a project involving a capital outlay of $12,000 and producing annual cash
inflows of $2,000 for ten years. At the end of that period the asset initially purchased will have a scrap
value of $500. Despatch Co uses a discount rate of 14% in all investment appraisals.
Required:
Determine whether or not the project is worthwhile.
(4 marks)
Question 15 DISCOUNTED CASH FLOW
(a) Two alternative machines are being considered for purchase, one at a cost of $10,000 and the
other at a cost of $9,000. The revenue cash flows resulting from their operation over their
expected lives have been estimated as follows:
Net cash flows at year end
Year Machine 1 Machine 2
1 1,000 1,200
2 1,600 1,500
3 2,500 3,500
4 2,500 2,000
5 2,500 2,000
6 1,500 1,000
7 1,000 Life over
The listed cash flows do not include salvage values at the end of the machines useful lives of
$1,500 and $1,000 respectively.
Required:
(i) If a company can borrow money at 8%, determine which machine you would
recommend for purchase.
(ii) Comment on your results. (12 marks)
(b) An electrical firm is planning to produce a device. Development of the device would cost
$40,000 payable at the end of the first year and thereafter would produce net receipts of
$2,000 for an estimated 28 years.
Required:
If the firms cost of capital is 7% determine whether the device should be produced.
(5 marks)
(c) A company is considering investing in a crusher costing $6,000 and producing net cash
savings of $1,200 per annum in perpetuity. However, the first saving will only be receivable
three years from now. The companys cost of capital is 12%.
Required:
Determine whether the crusher should be purchased. (4 marks)
15
(d) J can invest in a scheme which requires a capital expenditure of $5,000 and will produce
annual returns of $475 in perpetuity.
Required:
Calculate the internal rate of return of the scheme. If J can earn 8.96% in a building
society should he invest in the scheme? (3 marks)
(e) A demolition firm is considering investing in a new ball and crane costing $20,000 payable in
two equal annual instalments on 1 January 19X3 and 1 January 19X4 with no scrap value. It
is hoped that the plant will produce additional annual income of $4,000 for the first two years of
operation (first income receivable on 1 January 19X5) and $3,000 for the next eight years.
The firm requires a rate of return in excess of 10%.
Required:
(i) Calculate the IRR to see if investment is worthwhile.
(ii) How else could one evaluate the viability of the project? (6 marks)
(30 marks)
Question 16 GERRARD
Gerrard runs a small printing business with rather limited resources. He plans to ask his bank manager
to increase his overdraft facilities to enable him to buy one more printing machine, a collator and
machine for perfect binding. Gerrards discount rate, which reflects the cost of borrowing from the
bank, is 12%.
He has drawn up a cash budget for the next five years which shows that the machinery has to be paid
for in two instalments: $50,000 now and $25,000 in a years time. Over the next five years sales will
increase, pushing up receipts by $30,000 per annum (receivable in arrears). This will result in annual
paper purchases (payable in advance) increasing by $8,000 and a small increase in annual wages
(assumed payable in arrears) of $500.
Required:
(a) Calculate the NPV at 12%. (4 marks)
(b) Calculate the NPV at 14%. (4 marks)
(c) Find the IRR and determine whether the expansion is worthwhile. (4 marks)
(12 marks)
Question 17 CARTER LTD
Carter Ltd is considering whether to invest in a machine which will enable a process, at present carried
out manually, to be performed more efficiently. The machine will cost $35,000.
It is estimated that the new machine will save $6,500 per annum in labour costs at an additional annual
cost of $1,500. The machine has an expected life of 15 years at the end of which it will have zero scrap
value. The mechanisation will involve the scrapping of some loose tools and equipment which have
zero book value but a scrap value of $3,000. In 15 years time these would be worthless.
The company can borrow at 10%. Assume all annual cash flows occur at the end of each year.
16
Required:
(a) Calculate the following to decide whether project should be accepted.
(i) Net present value
(ii) Internal rate of return. (6 marks)
(b) Determine how your answer to (a)(i) above would alter if:
(i) existing equipment had a book value of $2,000
(ii) the new equipment had a life of only ten years
(iii) fixed overheads were reapportioned and an extra $1,000 allocated to this process
(iv) the existing equipment had a scrap value of $2,000 in 15 years time.
(7 marks)
(13 marks)

Question 18 ABC
A company wishes to use a five-year time scale over which to appraise the following projects, with no
allowance for scrap values. Its required rate of return is 17%.
Project A
Capital investment in additional equipment to produce a de-luxe version of one of its existing
products. The equipment will cost $285,000, payable in three equal annual instalments, the first to be
paid immediately.
The de-luxe version has an estimated annual demand of 10,000 in the first two years after which it is
expected to increase at a rate of 10% pa. The net cash flow per unit is estimated at $8.
The existing product was expected to be sold at a rate of 25,000 units pa at a net cash contribution of $5
per unit. If the new version is introduced, however, it is expected that this demand will be reduced by
15% of the volume of new product sold in the corresponding year.
Project B
Purchase of patent rights to a new process at an initial cost of $320,000 payable immediately.
The new process will enable the company to reduce its labour force, at present incurring a total wages
bill of $280,000, by a quarter; and will allow an increased production capacity of 5,000 units pa of
another existing product which at present is sold at $12 per unit with direct costs of $6. There is an
80% chance that the extra potential production could all be sold, with a 20% chance of demand only
taking up an extra 3,000 units pa. Production would be adjusted to match demand. This product is
made with hardly any labour.
Project C
Installation of a mini-computer to deal with the accounting functions at an annual rental charge of
$50,000, paid in advance. At present the company uses an IT service bureau at a cost of approximately
$90,000 pa payable in arrears. This will be run in parallel for the first year. The installation will
result in staff being sent on a training course during the first year which is expected to cost $10,000, and
the employment of a consultant for the first year, to whom $5,000 will be payable in six months time
and another $5,000 in twelve months time.
17
Required:
Determine which (if any) of the projects are worth further consideration based upon the
information given, assuming all cash flows arise at the end of the year to which they relate unless
otherwise stated.
(20 marks)
Question 19 MOORGATE COMPANY
The Moorgate Company has issued 100,000 $1 par ordinary shares which are at present selling for $3
per share. The company has plans to issue rights to purchase one new share at a price of $2 per share
for every four existing shares.
Required:
(a) Calculate the theoretical ex-rights price of Moorgates shares. (5 marks)
(b) Calculate the theoretical value of a Moorgate right. (5 marks)
(c) The chairman of the company receives a telephone call from an angry shareholder who
owns 1,000 shares. The shareholder argues that he will suffer a loss in his personal
wealth due to this rights issue, because the new shares are being offered at a price lower
than the current market value.
The chairman assures him that his wealth will not be reduced because of the rights
issue, as long as the shareholder takes appropriate action.
(i) Is the chairman correct?
(ii) What should the shareholder do?
Prepare a statement showing the effect of the rights issue on this particular
shareholders wealth, assuming
(i) he sells all the rights
(ii) he exercises half the rights and sells the other half
(iii) he does nothing at all. (10 marks)
(d) Are there any real circumstances which might lend support to the shareholders claim?
Explain. (5 marks)
(25 marks)
Question 20 GREINER LTD
Greiner Ltd, a company dealing exclusively in antique furniture, was set up in July 19.00 and has
shown a steady growth in after-tax profits from $120,000 in the year ended 30 June 19.01 to $2.75m in
the year ended 30 June 19.06. Mr and Mrs Greiner, the directors and sole shareholders, wish to engage
in a major expansion of the business, which would require additional funds of $2m, and wish also to
realise a proportion of their investment in the company. To do so they are considering obtaining a
quotation on the Stock Exchange, and are prepared to allow up to 25% of the enlarged equity in the
company to be traded. Mr and Mrs Greiner are unsure about what is entailed in obtaining a quotation
and have asked for your advice.
18
Required:
Write a report to Mr and Mrs Greiner which deals with the following issues.
(i) The steps to be taken prior to obtaining a quotation.
(ii) An evaluation of the two main methods (placing and offer for sale) of raising equity
capital on the Stock Exchange.
(iii) Which of the two methods better meets the requirements of Mr and Mrs Greiner.
(12 marks)
Question 21 MR FIDELIO
Mr Fidelio has recently been made redundant. He intends to start his own business as a manufacturer of
electronic components and estimates that he will require $250,000 to purchase fixed assets and to
provide working capital. He has $50,000 available from his own savings and redundancy payments,
and is seeking advice as to how to raise the remaining $200,000.
Aida Ltd is a long-established private limited company which operates a chain of ten discount furniture
stores. The directors of Aida wish to expand the companys activities by opening a new store in a
location not presently served by the company. They estimate that the proposed expansion will cost $2
million, and they need advice as to how to raise the necessary finance.
Required:
Describe briefly the characteristics of the sources of finance available to Mr Fidelio and to Aida
Ltd, identifying sources which are likely to be available only to Mr Fidelio, those which are likely
to be available only to Aida Ltd, and those which are likely to be available to both Mr Fidelio and
Aida Ltd.
(10 marks)
Question 22 COST OF CAPITAL
(a) Calculate the current pre-tax cost of the following loans.
(i) A 10% coupon irredeemable debenture issued at par.
(ii) A 10% irredeemable debenture trading at $85 per cent.
(iii) A 10% redeemable debenture trading at $74 per cent with three years until
redemption at par.
(iv) A 10% redeemable debenture trading at par, with three years until redemption at
par.
(v) A 5% irredeemable $1 preference share trading at 65c.
(4 marks)
(b) Calculate the current post-tax cost with a corporation tax rate of 35% of the loans in (a)
above. (3 marks)
19
(c) Given the following data about share prices, compute the cost of equity in each case.
(i) Market price per share $1.50 ex-dividend. Dividend just paid 7.5c, which is
expected to remain constant.
(ii) Market price per share $1.65 cum-dividend. Dividend about to be paid 15c, which
is expected to remain constant.
(iii) Market price per share $1.20 ex-dividend. Dividend just paid 24c, with expected
annual growth rate of 5%.
(iv) Market capitalisation of equity $10 million. Dividends just paid $1.5 million, which
are expected to remain constant.
(4 marks)
(d) Compute the market price of the following equities.
(i) W has 50,000 $1 ordinary shares in issue, current dividends 10c per share expected
to remain constant; cost of equity 10%.
(ii) X has 1,000 $1 ordinary shares in issue, total dividend $500, no growth expected;
cost of equity 15%.
(iii) Y has 1 million ordinary shares, the dividend just paid was 10c and it is expected to
grow at 5% per annum; cost of equity 15%.
(iv) Z has 10,000 shares in issue, dividends for the next five years are expected to be
constant at 10c per share and then grow at 5% per annum to perpetuity; cost of
equity 15%.
(4 marks)
(15 marks)
Question 23 KELLY PLC
On 1 July 19X5 Kelly plc had the following three classes of debenture, all of which had been in issue
for some years and have $100 par value.
Coupon Year(s) of Date of Dates of Market price
rate redemption redemption interest payments at 1 July 19X5
14% 19X9 31 December 1 July, 31 December $110.43 ex-interest
14% 19X819X10 1 July 1 July, 31 December $110.15 ex-interest
6% 19X10 1 April 1 April, 1 October Unlisted
All the companys debentures will be redeemed at par. Market evidence suggests that the 6% 19X10
debentures should have a six-monthly gross redemption yield (i.e. internal rate of return to maturity) of
6%. The prevailing level of market interest rates can be assumed to remain unchanged over the next six
years.
Required:
(a) Calculate the six-monthly gross redemption yield of the 14% 19X9 debenture. (3 marks)
(b) Determine when investors are likely to assume that Kelly plc will redeem the 14%
19X819X10 debentures, and hence calculate their effective annual gross redemption
yield. (4 marks)
20
(c) Estimate the price on 1 July 19X5 that an investor should be prepared to pay for the 6%
19X10 debentures. (5 marks)
(d) Discuss the factors that will influence the market price of issued corporate debentures.
(8 marks)
Ignore taxation in parts (a), (b) and (c), but not (d).
(20 marks)
Question 24 REDSKINS PLC
Redskins plc is a holding company owning shares in various subsidiary companies. Its directors are
currently considering several projects to increase the range of the business activities undertaken by
Redskins plc and its subsidiaries. The directors would like to use discounted cash flow techniques in
their evaluation of these projects but as yet no weighted average cost of capital has been calculated.
Redskins plc has an authorised share capital of 10 million 25c ordinary shares, of which 8 million have
been issued. The current ex-dividend market price per ordinary share is $1.10. A dividend of 10c per
share has been paid recently. The companys project analyst has calculated that 18% is the most
appropriate cost of equity capital. Extracts from the latest balance sheets for both the group and the
holding company are given below.
Redskins and Subs Redskins
$000 $000
Issued Share Capital 2,000 2,000
Share Premium 1,960 1,960
Reserves 3,745 708
_____ _____
Shareholders funds 7,705 4,668
_____ _____
Redskins and Subs Redskins
Minority interests 895
_____ _____
3% Irredeemable 1,400
9% Debentures 1,500 1,500
6% Bonds 2,000 2,000
Bank Loans 1,540 600
_____ _____
6,440 4,100
_____ _____
All debt interest is payable annually and all the current years payments will be made shortly. The
current cum-interest market prices for $100 nominal value are $31.60 and $103.26 for the 3% and 9%
debentures respectively. Both the 9% debentures and the 6% bonds are redeemable at par in ten years
time. The 6% bonds are not traded on the open market but the analyst estimates that its actual pre-tax
cost is 10% per annum. The bank loans bear interest at 2% above base rate (which is currently 11%)
and are repayable in six years. The effective corporation tax rate of Redskins plc is 30%.
Required:
(a) Calculate the effective after-tax weighted average cost of capital as required by the
directors. (8 marks)
21
(b) Discuss the problems that are encountered in the estimation of a companys weighted
average cost of capital when
(i) bank overdrafts, and
(ii) convertible bonds
are used as sources of long-term finance. (6 marks)
(c) Outline the fundamental assumptions that are made whenever the weighted average cost
of capital of a company is used as the discount rate in net present value calculations.
(6 marks)
Ignore personal taxation. (20 marks)
Question 25 BERLAN
(a) Berlan plc has annual earnings before interest and tax of $15 million. These earnings are
expected to remain constant. The market price of the companys ordinary shares is 86 cents
per share cum-div and of debentures $105.50 per debenture ex-interest. An interim dividend
of six cents per share has been declared. Corporate tax is at the rate of 35% and all available
earnings are distributed as dividends.
Berlans long-term capital structure is shown below:
$000
Ordinary shares (25 cents par value) 12,500
Reserves 24,300
______
36,800
16% debenture 31 December 19X4 ($100 par value) 23,697
______
60,497
______
Required:
Calculate the weighted average cost of capital of Berlan plc according to the traditional
theory of capital structure. Assume that it is now 31 December 19Xl. (8 marks)
(b) Canalot plc is an all equity company with an equilibrium market value of $32.5 million and a
cost of capital of 18% per year.
The company proposes to repurchase $5 million of equity and to replace it with 13%
irredeemable bonds.
Canalots earnings before interest and tax are expected to be constant for the foreseeable
future. Corporate tax is at the rate of 35%. All profits are paid out as dividends.
Required:
Use the assumptions of Modigliani and Miller to explain and demonstrate how this
change in the capital structure of Canalot plc will affect:
the market value
the cost of equity
the cost of capital (7 marks)
(15 marks)
22
Question 26 WEMERE
The managing director of Wemere, a medium-sized private company, wishes to improve the companys
investment decision-making process by using discounted cash flow techniques. He is disappointed to
learn that estimates of a companys cost of capital usually require information on share prices which,
for a private company, are not available. His deputy suggests that the cost of equity can be estimated
by using data for Folten plc, a similar sized company in the same industry whose shares are listed on
the AIM, and he has produced two suggested discount rates for use in Wemeres future investment
appraisal. Both of these estimates are in excess of 17% per year which the managing director believes
to be very high, especially as the company has just agreed a fixed rate bank loan at 13% per year to
finance a small expansion of existing operations. He has checked the calculations, which are
numerically correct, but wonders if there are any errors of principle.
Estimate 1: capital asset pricing model
Data has been purchased from a leading business school:
Equity beta of Folten 1.4
Market return 18%
Treasury bill yield 12%

The cost of capital is 18% + (18% 12%) 1.4 = 26.4%.
This rate must be adjusted to include inflation at the current level of 6%. The recommended
discount rate is 32.4%.
Estimate 2: dividend valuation model
Year Folten plc
Average share price Dividend per share
(cents) (cents)
19X5 193 9.23
19X6 109 10.06
19X7 96 10.97
19X8 116 11.95
19X9 130 13.03
D1 14.20
The cost of capital is 11.01%
P 138
G 9%
where D1 = expected dividend
P = market price
g = growth rate of dividends (%)
When inflation is included the discount rate is 17.01%.
23
Other financial information on the two companies is presented below:
Wemere Folten
$000 $000
Fixed assets 7,200 7,600
Current assets 7,600 7,800
Less: Current liabilities 3,900 3,700
______ ______
10,900 11,700
______ ______
Financed by:
Ordinary shares (25 cents) 2,000 1,800
Reserves 6,500 5,500
Term loans 2,400 4,400
______ ______
10,900 11,700
______ ______
Notes:
(1) The current ex-div share price of Folten plc is 138 cents.
(2) Wemeres board of directors has recently rejected a take-over bid of $10.6 million.
(3) Corporate tax is at the rate of 35%.
Required:
(a) Explain any errors of principle that have been made in the two estimates of the cost of
capital and produce revised estimates using both of the methods.
State clearly any assumptions that you make. (14 marks)
(b) Discuss which of your revised estimates Wemere should use as the discount rate for
capital investment appraisal. (4 marks)
(c) Discuss whether discounted cash flow techniques, including discounted payback, are
useful to small unlisted companies. (7 marks)
(25 marks)
Question 27 CRESTLEE
Crestlee plc is evaluating two projects. The first involves a $4.725 million expenditure on new
machinery to expand the companys existing operations in the textile industry. The second is a
diversification into the packaging industry, and will cost $9.275 million.
Crestlees summarised balance sheet, and those of Canall plc and Sealalot plc two quoted companies in
the packaging industry, are shown below (20X2) :
Crestlee plc Canall plc Sealalot plc
$m $m $m
Fixed assets 96 42 76
Current assets 95 82 65
Less: Current liabilities (70) (72) (48)
___ __ __
121 52 93
___ __ __
24
Financed by:
Ordinary shares
1
15 10 30
Reserves 50 27 50
Medium and long-term loans
2
56 15 13
___ __ __
121 52 93
___ __ __
Ordinary share price (cents) 380 180 230
Debenture price ($) 104 112
Equity beta 1.2 1.3 1.2
1
Crestlee and Sealalot 50 cents par value, Canall 25 cents par value. Debentures $100 par
2
Crestlee 12% debentures 20X820Y0, Canall 14% debentures 20Y3, Sealalot medium-term bank
loan.
Crestlee proposes to finance the expansion of textile operations with a $4.725 million 11% bond issue,
and the packaging investment with a $9.275 million rights issue at a discount of 10% on the current
market price. Issue costs may be ignored.
Crestlees managers are proposing to use a discount rate of 15% per year to evaluate each of these
projects.
The risk free rate of interest is estimated to be 6% per year and the market return 14% per year.
Corporate tax is at a rate of 33% per year.
Required:
(a) Determine whether 15% per year is an appropriate discount rate to use for each of these
projects. Explain your answer and state clearly any assumptions that you make.
(19 marks)
(b) Crestlees marketing director suggests that it is incorrect to use the same discount rate
each year for the investment in packaging as the early stages of the investment are more
risky, and should be discounted at a higher rate. Another board member disagrees
saying that more distant cash flows are riskier and should be discounted at a higher
rate. Discuss the validity of the views of each of the directors. (6 marks)
(25 marks)
Question 28 MUGWUMP LTD
The following data relate to Mugwump Ltd, a manufacturing company.

Turnover for year $1,500,000

Costs as percentage of sales
Direct materials 30%
Direct labour 25%
Variable overheads 10%
Fixed overheads 15%
Selling and distribution 5%

25
On average

(a) customers take 2 months credit

(b) raw materials are in inventory for 3 months

(c) work in progress represents 2 months half-produced goods

(d) finished goods represent 1 months production

(e) credit is taken as follows

(i) materials 2 months
(ii) direct labour 1 week
(iii) variable overheads 1 month
(iv) fixed overheads 1 month
(v) selling and distribution month

Work in progress and finished goods are valued at materials, labour and variable overhead cost.

Required:
Compute the working capital requirement of Mugwump Ltd, assuming that the labour force is
paid for 50 working weeks.
(10 marks)

Question 29 DYER LTD
Dyer Ltd manufactures a variety of products using a standardised process which takes one month to
complete. Each production batch is started at the beginning of a month and is transferred to finished
goods at the beginning of the next month. The cost structure, based on current selling prices, is as
follows.
% $
Sales price 100
Variable costs
Raw materials 30
Other variable costs 40

Total variable costs used for inventory valuation (70)

Contribution 30

Activity levels are constant throughout the year and annual sales, all of which are made on credit, are
$2.4 million. Dyer is now planning to increase sales volume by 50% and unit sales price by 10%. Such
expansion would not alter the fixed costs of $50,000 per month, which includes monthly depreciation of
plant at $10,000. Similarly, raw materials and other variable costs per unit would not alter as a result of
the price rise.
26
In order to facilitate the envisaged increases, several changes would be required in the long term. The
relevant points are as follows.
(1) The average credit period allowed to customers will increase to 70 days.
(2) Suppliers will continue to be paid on strictly monthly terms.
(3) Raw material inventory held will continue to be sufficient for one months production.
(4) Inventory of finished goods held will increase to one months output or sales volume.
(5) There will be no change in the production period and other variable costs will continue to
be paid for in the month of production.
(6) The current end of month working capital position is as follows.
$000 $000
Raw materials 60
Work in progress 140
Finished goods 70
270
Accounts receivable 200

470
Accounts payable (60)

Net working capital excluding cash 410

Compliance with the long-term changes required by the expansion will be spread over several months.
The relevant points concerning the transitional arrangements are as follows.
(i) The cash balance anticipated for the end of May is $80,000.
(ii) Up to and including June all sales will be made on one months credit. From July all sales
will be on the transitional credit terms which will mean
60% of sales will take two months credit
40% of sales will take three months credit.

(iii) The sales price increase will occur with effect from the sales in August.
(iv) Production will increase by 50% with effect from production in July; raw material purchases
made in June will reflect this.
(v) Sales volume will increase by 50% from sales in October.
Required:
(a) Show the long-term increase in annual profit and long-term working capital
requirements as a result of the plans for expansion and the price increase. (Costs of
financing the extra working capital requirements may be ignored.) (6 marks)
(b) Produce a monthly cash forecast for June to December, the first seven months of the
transitional period. (10 marks)
27
(c) Using your findings from (a) and (b) above, make brief comments to the management of
Dyer Ltd on the major factors concerning the financial aspects of the expansion which
should be brought to their attention. (4 marks)
Assume that there are 360 days in a year and that each month contains 30 days.
(20 marks)
Question 30 PUNTER BOOKMAKERS LTD
Punter Bookmakers Ltd runs a chain of betting shops in the Midlands. There are no fixed assets subject
to depreciation. The companys finance director has prepared budgets for the companys overall annual
performance about which he is fairly confident. As a result he has provided that funds should be set
aside week-by-week for investment in short-term securities sufficient not only to meet tax liabilities but
also to cover expected dividend payments, which it is intended should absorb after-tax net profits.
However, because of the nature of the business he feels he is unable to forecast daily cash inflows and
outflows with any accuracy. Nevertheless he takes the view that the company is in danger of carrying
too high a liquid cash balance. He would prefer to invest some of the money, although this would mean
the company would incur transaction costs if it had to liquidate securities to meet unforeseen demands.
The finance director approaches you for advice. He explains that a major problem in the betting shop
business is that cash flows are uncertain but, unlike those of firms in most other industries, they are
only affected to a limited extent by general economic events. He then describes the main features of the
betting shop business as follows.
A bookmaker taking bets on horse races will attempt to calculate the odds so that the size of the bets
placed and the probability of horses wining and losing will, on a particular race or over a short period,
balance out, after leaving him with a margin to cover overheads and profit. If he finds himself
particularly exposed, he will generally reinsure himself by laying off bets with other bookmakers. It
follows, therefore, that if his predictions of outcomes are on average correct, the cash flow over a
reasonable period of time should equal the planned margin. However, for day-to-day purposes the
incidence of cash inflows and outflows may be largely unpredictable, since the race results themselves
can be viewed as random variables. Moreover, this is true even though the bookmaker knows that
certain events (e.g. the Grand National or the Derby) generate more business than others; he may take
more in bets on such occasions, but he will have to pay out more, particularly if the favourite wins and
the odds offered do not quite balance the books. More generally, a bookmaker will have to ensure that
he has a reasonable amount of liquid cash in hand at each betting shop to cover the claims that might
arise or at least he should have ready access to cash (on deposit, etc) should exceptionally large
claims have to be met.
Required:
(a) Advise the finance director on how, given the uncertain environment described, he
might best try to manage the cash position of the business without for general day-to-
day purposes carrying too high a liquid cash balance. (10 marks)
(b) Comment briefly on the nature of the securities in which the finance director might
invest any potentially surplus funds. (6 marks)
(16 marks)
28
Question 31 MR COLORADO
Mr Colorado is a map retailer. His business has operated at a constant level for many years; sales have
been $14,500 per month, purchases have represented 60% of sales and overhead costs have been $4,000
per month, all directly variable with the amount of sales. The business has no fixed assets.
One half of sales are paid for as they are made. The remainder are on credit. Mr Colorado offers no
cash discount for early payment and credit customers pay, on average, two months after the date of sale.
All purchases are on credit. Mr Colorados suppliers each offer 2.5% cash discount for payment within
one month, and at present Mr Colorado takes advantage of the cash discount offered for all purchases.
Overhead costs are paid in the month in which they arise.
Mr Colorado estimates that his bank overdraft at 31 December 19.01 will amount to $14,800 and that
his inventory at the same date will be $18,500.
The present limit on Mr Colorados overdraft is $15,000. He is now expecting a steady expansion of
his business from 1 January 19.02 and is concerned that he might exceed his overdraft limit if he does
not change his present policy for giving and taking credit. Mr Colorado expects his sales in January
19.02 and in subsequent months to increase at a monthly compound rate of 2% indefinitely.
Mr Colorado is considering whether to offer his credit customers 2.5% cash discount for payment
within one month of sale. If he does so, he expects that all credit customers will take advantage of the
discount, which will be available in respect of all credit sales made on or after 1 January 19.02. He is
also considering whether to delay paying his suppliers until two months after the date of purchase for
purchases made on or after 1 January 19.02. In addition, he wishes to increase his inventory level so
that he always has sufficient inventory to meet sales requirements for three months at predicted levels.
Mr Colorado currently pays 2.5% interest per month on his bank overdraft, calculated on the balance at
the beginning of each month. This rate of interest is expected to continue indefinitely.
You may assume that all receipts and payments are made on the last day of the month and that, but for
the possibility of maintaining three months inventory, Mr Colorado would have held inventory at the
$18,500 level.
Required:
(a) Predict Mr Colorados bank balance or overdraft at 31 March 19.02 under both his
present and proposed policies for giving and taking credit. (10 marks)
(b) Comment on the figures you have calculated in (a), and describe and justify how you
would evaluate the long-term effects of the alternative credit policies on Mr Colorados
business. (You are not required to calculate the long-term effects.) (10 marks)
Ignore taxation.
(20 marks)
29
Question 32 WORRAL LTD
Worral Ltd is a wholly-owned subsidiary of Grandus plc. Grandus has always allowed its subsidiaries
considerable freedom of action, but the board of directors of Grandus are concerned about Worrals
recent performance and working capital management. As a result Grandus board of directors has
given the managers of Worral one year in which to increase the companys current ratio to at least the
industry average, without adversely affecting other aspects of the companys performance.
Worrals managers are considering three possible alternative courses of action.
(1) Increase long-term loans by $300,000 and use the proceeds to reduce the companys
overdraft.
(2) Offer a cash discount of 3% for payment in 14 days. The normal terms of sale allow 60 days
credit. All sales are on a credit basis. If the cash discount is offered, 50% of customers are
expected to take it, and bad debts are expected to be halved. The annual cost of administering
the cash discount scheme would be $30,000.
(3) Use the services of a non-recourse factoring company at a commission of 2.5% of turnover
and finance charges of 3% over bank base rate on funds advanced immediately. Worral
would take the full finance facility available on all credit sales, and would use the proceeds to
reduce current liabilities. The use of a factor is expected to result in credit management cost
savings of $135,000 per year.
Bank base rate is 11%. Worral pays 2% above bank base rate for its overdraft.
Summarised financial details of Worral Ltd
19.04 19.05 19.06 19.07 Industry
average
$000 $000 $000 $000 19.07
Turnover 8,234 8,782 8,646 9,182
Profit after tax 486 492 448 465

Current ratio 1.84 1.61 1.52 1.48 1.60
Acid test 0.97 0.93 0.90 0.84 0.95
Gearing 75.4% 74.6% 79.2% 85.8% 75%
Bad debts/sales 0.5% 0.9% 1.2% 1.5% 0.5%
Collection period 60 days 73 days 92 days 107 days 60 days
30
Summarised balance sheet as at 31 December 19.07
$000 $000
Fixed assets 3,200
Current assets
Inventory 2,100
Accounts receivable 2,684
Cash 90

4,874
Less Current liabilities
Overdraft 1,650
Other 1,643

(3,293)

4,781

Financed by
Shareholders funds 3,461
12% long-term loan 1,320

4,781

The long-term loan is from Grandus plc. Long-term loans to subsidiaries are charged at their current
cost to Grandus. Grandus 12% $100 debentures are currently trading at $82.75 and can be redeemed
between 11-15 years from now.
Required:
(a) Critically evaluate the three suggestions and recommend which should be selected. (All
relevant calculations must be shown. The effects of taxation may be ignored.) (15 marks)
(b) Briefly describe three ways, other than factoring, that a company might obtain finance
by using accounts receivable as security. (5 marks)
(20 marks)
Question 33 DIRE PLC
At 31 December 19.01 Dire plc has an overdraft of $1m. Interest at a rate of 10% per annum is being
charged on the overdraft.
The directors are concerned at the size of the overdraft and ask the finance manager to take steps to
reduce the figure. Additionally, the directors suspect that improvements could be made within the
working capital cycle.
Sales during 19.01 were $5m, with cost of sales at $3m. The following working capital ratios at 31
December 19.01 had been calculated.
Accounts receivable collection period 3 months
Inventory holding period 4 months
Accounts payable period 2 months

31
At present cash sales represent 10% of turnover, and 20% of all trade purchases were cash on delivery
(COD).
The finance manager feels that the working capital ratios could be improved to
Accounts receivable collection period 2 months
Inventory holding period 3 months
Accounts payable period 2 months

Additionally, no further COD purchases will be made. Cash sales will continue to represent 10% of
sales.
After negotiations with the bank it was agreed that $200,000 of the overdraft could be converted to a
fixed loan on which 7% interest would be charged per year. The loan comes into effect on 1 January
19.02.
Required:
Assuming that the 19.01 levels of sales and cost of sales are repeated in 19.02 and that any
improvements in working capital will give rise to a whole year of interest charge saved, calculate
the total amount of interest saved solely as a result of the financial managers proposed
improvements.
(6 marks)
Question 34 MOORE LTD
Moore Ltd, a small retailing business, has been trading for many years. Figures for next year are
predicted to be
Sales $10,000 per calendar month (pcm)
Purchases $6,000 pcm, a constant gross profit margin of 40% being made
Administration costs $1,000 pcm

Customers pay as follows.
20% one month after invoice
78% two months after invoice
2% go bad

All sales are invoiced at the end of the month.
Two months inventory are held. Suppliers are paid after one month. This will result in a bank balance
of $20,000 at the end of the year.
The directors are considering offering a 2% discount for payment after the first month.
Estimates
Sales volume will increase by 10%
Administration will increase by 15%

32
New payment pattern
60% take discount and pay after one month
37% pay after two months
3% go bad

Cost of capital is 1% per month)
Required:
(a) Use DCF to appraise the discount scheme (5 marks)
(b) Calculate profits for next year under the old and new schemes (4 marks)
(c) Calculate the cash operating cycle under the old and new schemes (3 marks)
(d) Calculate both the quick ratio and current ratio in one years time under the old and
new schemes. (5 marks)
(17 marks)
Question 35 WAGTAIL LTD
Wagtail Ltd uses the economic order quantity formula to determine optimal levels of raw materials
inventory. Material B is consumed at a steady rate of 4,000 units per annum. The costs of ordering B
are independent of order size; clerical costs of ordering have been calculated at $30 per order. Each
order is checked by an employee who is engaged in using B in production and who earns $5 per hour
irrespective of his output. The employee generates a contribution of $4 per hour when not involved in
materials checks; the inventory check takes five hours. Holding costs amount to $15 per unit per
annum.
The supplier of material B has very recently offered Wagtail Ltd a quantity discount of 24p a unit on
the current price of $24 for all orders of 400 or more units.
Required:
(a) Calculate the optimal batch size for material B, ignoring the quantity discount.
(b) Evaluate whether the quantity discount offered should be taken up by Wagtail Ltd.
(10 marks)
33
Question 36 TIPEX LTD
Tipex Ltd carries on business as a supplier of office equipment, one of its lines being typewriters.
The lead time for obtaining further supplies from the manufacturers is one month.
Analysis of past data suggests that the probability of monthly demand is as follows.
Demand Probability
Less than 3 0.00
3 0.01
4 0.03
5 0.10
6 0.20
7 0.32
8 0.20
9 0.10
10 0.03
11 0.01
Greater than 11 0.00

The cost of each typewriter is $280. Annual inventory-holding costs are estimated at 20% of average
inventory value. Delivery cost is estimated at $15 for each order placed. Stock-out costs are estimated
at $40 per typewriter.
Required:
Calculate the re-order level and order quantity which will minimise the total cost to the company
of supplying the typewriters.
(10 marks)
Question 37 ORION PLC
Orion plc is a company operating a nation-wide chain of superstores. All purchasing is undertaken by a
head office buying department, the goods then being stored in a central warehouse from which they are
despatched to individual stores as ordered by the store managers. This buying department is currently
reviewing its ordering and inventory policy relating to all the companys major inventory lines.
The following information has been obtained in relation to one such item.
(1) The daily demand from the individual stores is normally distributed, averaging 2,800 items
per day with a standard deviation of 400 items. The companys warehouse and stores are
open 250 days per annum.
(2) The supplier charges a basic purchase price of $1.19 per item but offers to reduce this to
$1.18 if the company orders at least 20,000 items at a time. The lead time on orders is always
exactly 2 days.
(3) Regression analysis of historic warehousing costs indicates that directly variable warehousing
costs amount to $0.1715 per annum for each item stored.
(4) The buying department estimates that variable ordering costs are $12.25 per order, excluding
any allowance for the time of the buyer. Buyers are paid annual salaries of $15,000, which is
equivalent to $7.50 per hour, and each order is estimated to require hour of a buyers time.
34
(5) The companys cost of capital is 15% pa and it is company policy to provide a service level of
98% on all major line items.
(6) Normal distribution tables indicate that 2% of observations lie 2.05 standard deviations above
the mean.
Required:
(a) Calculate the optimal order size, ignoring the discount opportunity offered by the
supplier. (3 marks)
(b) Determine the optimal order size, allowing for the discount opportunity. (4 marks)
(c) Calculate the minimum discount which the supplier must offer on orders for 20,000 or
more items at a time to make it attractive to the company. (5 marks)
(d) Calculate the re-order level required. (3 marks)
(15 marks)
Question 38 3 SMALL COMPANIES
The managers of three small UK companies are discussing their strategies towards foreign exchange
risk.
Company one exports to several countries in Europe, Africa and the Americas. Company two exports
to and imports from Europe. Company three is not engaged in any form of foreign trade. All three
companies believe themselves to be risk averse.
All three have decided that there is no need to take any action due to foreign exchange risk. Their
reasons for no action are:
Company one: Foreign exchange markets are efficient, and on balance my company is as likely to gain
from foreign exchange movements as to lose from them. There is, therefore, no point in paying for
hedging foreign exchange risk as overall the company will not gain by using such hedges.
Company two: My company only trades with Europe and the existence of the European Single
Currency prevents foreign exchange losses.
Company three: As my company is not engaged in any form of foreign trade, foreign exchange rates
are irrelevant to me.
Required:
Discuss the validity of-the views of each of the three managers. Assume that exports are
denominated in the foreign currency concerned, and that imports are denominated in sterling.
(12 marks)
35
Question 39 FOURX LTD
Fourx Ltd is a small brewing firm located in the UK. It finds that the most suitable supplier of
replacement equipment is based in the south of Freeland. The Freeland firm has offered to supply the
equipment for Ff 150,000 in three months time (Ff = Freeland franc)
In order to settle the deal, Fourx Ltds managing director plans to go to Freeland immediately and
anticipates another trip in three months time. He will buy Ff 2,000 for the first trip and wishes to enter
a three month forward contract to buy 200 of Freeland francs.
The managing director is contemplating two ways of eliminating the foreign exchange exposure
associated with the venture: forward market cover and money market cover. The following forward
market and borrowing and lending rates apply.
Spot rate (Ff/) 9.725 9.735
Three months premium 0.015 0.014
Franc Sterling
Borrowing rate 10.5% 11%
Lending rate 10% 10.25%
Required:
(a) Calculate how much the managing directors Ff 2,000 will cost him and how much he
will get back if he returns with Ff 100. (2 marks)
(b) Calculate how many francs he will get in three months time for his 200.
(2 marks)
(c) Show how much Fourx will have to pay for the equipment in three months time if it
hedges in the forward market. (2 marks)
(d) Perform the same calculations in respect of money market cover and explain briefly how
risk has been removed by the exercises in (c) and (d). (4 marks)
(10 marks)
Question 40 STORACE PLC
Storace plc is UK based and has recently finalised a contract with a US company, Jacquin Inc, for the
sale of a machine. The selling price is 100,000. As this is the first export sale made by Storace plc,
the currency settlement details were not discussed at the meeting when the sale of the machine was
agreed. The management of Storace plc believes that Jacquin Inc will agree to whatever currency
settlement is suggested, since Jacquin Inc is very anxious that the machine contract be finalised quickly.
Delivery of the machine will take place in three months time when the amount will be settled
immediately by Jacquin Inc.
The management of Storace plc is considering three possible methods of invoicing Jacquin Inc for the
machine.
(i) Prepare the invoice in sterling (i.e. 100,000) and request payment in sterling on the
settlement date.
(ii) Convert the sterling price at the current sterling/dollar spot rate and invoice Jacquin Inc in
dollars. Buy sterling at the spot rate in three months time when the dollar settlement is made
by Jacquin Inc.
36
(iii) Invoice Jacquin Inc in dollars, converting the sterling price at the spot rate (as in (ii)). Storace
plc will then immediately cover the position in the forward exchange market, by selling the
dollars receivable forward at the three month forward exchange rate.
The current spot rate between sterling and dollars in London is 1 = $1.11. The premium for the dollar
for three month forward exchange contracts is quoted as 1.20 1.15 cents (the buying/ selling range).
The management of Storace plc believes that the sterling/dollar spot rate will be somewhere in the
range of 1 = $1.20 to 1 = $1.09 in three months time.
Required:
(a) Calculate the amount of sterling to be received by Storace plc under each of the three
methods. (4 marks)
(b) Prepare a report to the management of Storace plc which sets out the advantages and
disadvantages of each method, and which contains your recommendation as to choice of
method. (8 marks)
(c) Outline the implications for corporate financial management of undertaking a major
export sales drive. (4 marks)
Ignore taxation.
(16 marks)
Question 41 OMNIOWN
It is now 31 December 19X1 and the corporate treasurer of Omniown plc is concerned about the
volatility of interest rates. In three months time his company needs to borrow $5 million for a six
month period. Current interest rates are 14% per year for the type of loan Omniown would use, and the
treasurer does not wish to pay more than this.
He is considering using:
(i) a forward rate agreement (FRA); or
(ii) interest rate futures; or
(iii) an interest rate guarantee (short-term cap).
Required:
To explain briefly how each of these three alternatives might be useful to Omniown plc
(10 marks)
Question 42 BRITISH INDUSTRIAL GROUP
The British Industrial Group plc (BIG), a large conglomerate, is considering acquiring an interest in
Bertram Ltd, a private company. You have been asked by the directors of BIG to advise them on the
value of Bertram Ltds shares.
Bertram Ltd has manufactured domestic appliances since its incorporation in the 1940s. In recent years
its management have adopted a policy of maintaining dividend growth at approximately 10% pa.
Bertram Ltds summarised accounts for the years ended 31 December 19X9, 19X10 and 19X11 are as
follows:
37
Profit and loss account for the year ended 31 December
19X9 19X10 19X11
$m $m $m
Profit on ordinary activities after tax 14.60 18.72 20.30
Extraordinary items (2.60) (4.80) (5.00)
_____ _____ _____
12.00 13.92 15.30
Dividends 4.00 4.40 5.00
_____ _____ _____
Profit retained 8.00 9.52 10.30
_____ _____ _____
Balance sheet as at 31 December
19X9 19X10 19X11
$m $m $m
Fixed assets 46.39 48.83 50.67
Net current assets 77.21 84.29 92.75
______ ______ ______
123.60 133.12 143.42
______ ______ ______
Issued share capital (shares of 5c) 2.00 2.00 2.00
Share premium account 6.00 6.00 6.00
Reserves 85.60 95.12 105.42
14% debentures (19X15) 30.00 30.00 30.00
______ ______ ______
123.60 133.12 143.42

At 31 December 19X11 fixed assets were as follows:
Net book value Estimated
market value
$m $m
Freehold land and buildings 19.67 25.00
Plant and equipment 31.00 31.00

50.67 56.00

Freehold land and buildings include a warehouse with a net book value of $3 million and an estimated
market value of $5 million. It has remained unused since 19X7.
The debenture of Bertram Ltd, on which interest is payable annually on 31 December, is redeemable at
par on 31 December 19X15. Debentures of a similar risk class to those of Bertram Ltd are currently
offering a yield of 10%.
The cost of equity of listed companies in the same industry as Bertram Ltd and which are similarly
geared is estimated at 16%. The average price earnings ratio of such companies is 8.0.
Corporation tax at the rate of 33% is payable at the end of the accounting period to which it relates.
The directors of BIG have not yet decided what proportion of the share capital of Bertram Ltd they
wish BIG to acquire and you have been asked to consider the possibility of acquiring either a minority
or a majority stake.
38
Required:
Produce a report for the directors of BIG which uses three different techniques to value the
shares in Bertram Ltd which are to be acquired. In each case describe the circumstances in
which the technique is appropriate and state any additional information that you would require.
(30 marks)
Question 43 TWELLO
A four year summary of the financial accounts of Twello plc is shown below:
Consolidated profit and loss accounts for the years
19X5 19X6 19X7 19X8
$m $m $m $m
Sales 742 859 961 1,028
Operating profit 22 25 40 54
Interest receivable
less-payable (2) (5) (6)
Profit on ordinary
activities before tax 20 25 35 48
Taxation (7) (8) (12) (17)
___ ___ ___ ___
13 17 23 31
Extraordinary items (4) (2)
Dividends (4) (5) (7) (9)
___ ___ ___ ___
Profit retained 5 12 14 22
___ ___ ___ ___
39
Consolidated end of year balance sheets
19X5 19X6 19X7 19X8
$m $m $m $m
Fixed assets
Tangible assets 142 168 189 225
Long-term investments 4 6 7 8
___ ___ ___ ___
146 174 196 233
___ ___ ___ ___
Current assets
Inventory 43 46 49 52
Accounts receivable 18 24 26 31
Money market investments 11 20 20 12
Cash 4 4 8 6
___ ___ ___ ___
76 94 103 101
___ ___ ___ ___
Less: Current liabilities
Bank loans and overdrafts 8 8 20 18
Trade accounts payable 66 60 84 89
Taxation 7 7 8 12
Proposed dividend 2 2 3 4
Other accounts payable 21 26 35 40
___ ___ ___ ___
104 103 150 163
___ ___ ___ ___
Total assets less
current liabilities 118 165 149 171
___ ___ ___ ___

Long-term liabilities
11 % convertible debenture
19X20/-24 (note 1) 17 17 17 17
4% deep discount bonds (note 2) 30 30
___ ___ ___ ___
17 17 47 47
___ ___ ___ ___
Shareholders funds
Called up share capital (50c) 25 30 30 30
Share premium 30 60
Profit and loss account 46 58 72 94
___ ___ ___ ___
118 165 149 171
___ ___ ___ ___

40
Note 1 Each $100 debenture is convertible into 12.6 ordinary shares in any year up to 19X20. The
conversion rate has been adjusted for a rights issue in 19X6.
Note 2 Redeemable at a total cost of $60 million in 19X14 (at face value $100).
19X5 19X6 19X7 19X8
Average share price (cents) 300 350 440 520
Average earnings yield of the industry 12% 11% 14% 12.5%
Additional notes:
(i) The companys activities (except for import/export) are entirely within the UK
(ii) A 1 for 5 rights issue was made in 19X6.
(iii) The company made an acquisition in 19X7 costing $80 million. The book value of the
tangible assets acquired was $20 million.
(iv) The directors estimate that the current market value of tangible fixed assets is $315 million.
Required:
(a) Appraise the financial health of Twello plc, commenting upon any possible financial
weaknesses. (13 marks)
(b) What other information would be useful in your assessment of the companys financial
health? (5 marks)
(c) What are the advantages of deep discount bonds?
If ordinary debentures have a redemption yield of 12% per year evaluate whether a
second deep discount bond on the same terms as Twellos existing deep discount bond is
likely to be attractive to investors. Assume that interest is payable annually. Taxation
may be ignored in your evaluation. (7 marks)
(25 marks)

Financial Management NPV Analysis

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Management NPV Analysis

Uploaded by

Copyright:

Available Formats

STUDY QUESTION BANK FINANCIAL MANAGEMENT (F9)

You might also like