FAM nov 14 Practice questions - Answers

Investment Appraisal
Project B
Year
0
1
2
3
NPV(10%
NPV(20%)
IRR

cashflows ('000)
A
B
(100)
(100)
10
95
50
25
90
10
$17.98
($4.86)
17.87%

14.52
$2.27
21.86%

According to the IRR rule projects can be undertaken as long as the discount rate is less than the
IRR. The above calculations show that the NPV of Project B is positive both at 10% and 20%
and therefore it can be undertaken at either of these rates. On the other hand, Project A could be
undertaken at 10% discount rate, but not at 20%, as its IRR falls between these rates (17.87%). If
capital (upto 200,000 for investment) is available, both projects can be undertaken at 10%
discount rate, but if the required return is 20% only B can be undertaken.
Which project should be undertaken if only one of them can be undertaken ie only 100,000 is
available for investment? The following plot shows the answer:

17.98
A
14.52

2.26

10%

17.87%

20%

21.86%

NPV
-4.86
If the required rate of return is 10%, then Project A is preferred.
If the required rate of return is 20%, then Project B is preferred.
1

Tadlet

Tadlet Enterprises has to make a decision between the following three

investments:
(All figures in $000 )
Year Project A

Project B

Project C

0
1
2

-$ 100
+ $32
+ $123

-$100
+$115
+$21

-$100
+140

28%

31%

40%

IRR

The Managing Director of the company prefers Project C. Which project would
you recommend to him if the cost of capital is (a) 10% (b) 20%? Your answer
should include a full explanation.
Answer
Year

IRR
NPV(10%
NPV(20%)

Project A
Project B Project C
0
($100)
($100)
($100)
1
$32
$115
$140
2
$123
$21
28%
40%
31%
$30.69
$12.02

$21.88
$10.37

$27.26
$16.62

If required rate =10%, accept A, as it has the highest NPV

If required rate =20%, accept C, as it has the highest NPV
Even though C has the highest IRR, student to explain that the decision using the
NPV rule is superior as it covers the wealth maximisation principle.

BPQ
BPQ Ltd. is considering a project requiring an investment of 200,000. Net cash flows from the
investment are 60,000 per annum for the first four years, 100,000 for year 5. The companys
weighted average cost of capital is 10 %.
Required:
a) Calculate the projects net present value (NPV).
b) Calculate the projects internal rate of return (IRR).
c) Calculate the payback and
d) Calculate the profitability index for the project.

Answer

BPQ
Year
DF@10%
DF @20%

0
-200
1
1

NPV(10%)
NPV(20%)
IRR %
pi=
payback

52.24
-4.52
19.20
1.26
3.33

1
60
0.909

2
60
0.826

3
60
0.751

4
60
0.683

5
100
0.621

0.833

0.694

0.579

0.482

0.402

(b) Ratio Analysis : Morland plc 2013

(a) Profitability Ratios

(i) Return on capital
employed

=Net profit before tax and loan interest/

average capital employed

(ii) Gross Profit Ratio
= Gross profit/Sales
(iii) Net Profit Ratio
=Net profit before tax/Sales
Conclude the company is profitable and performimg better than industry
(b) Efficiency Ratios
(i) Debtors' Collection
= average debtors/credit sales per day
period
(ii) Creditors' Collection
= average creditors/credit purchase per
period
day
(iii) Stock Turnover Ratio
= Cost of sales/average stock
(iv) Asset turnover ratio
= Sales/Total Assets
are somewhat less than those of industry; discuss with management the
strategy it is pursuing
(c) Liquidity Ratios
(i) Current ratio
= current assets/current liabilities
(ii) Quick ratio
= (current assets-stock)/current liabilities
The company is liquid
(d) Gearing ratio

=Long term borrowings/total long term

capital
The gearing is higher than the industry; more risky for shareholders
(e) investor ratios
(i) Dividend yield
(ii) Dividend cover

=(150+10)/520

30.77%

Industry
Average
18%

=600/3000
=150/3000

20.00%
5.00%

20%
4%

=130/(3000/s65)

15.82

10

=140/(2400/365)

21.29

15

=2400/150
=3000/(660)

16.00
4.55

20
5

=310/140
=(310-150)/140

2.21
1.14

2
1

= (200+50)/520

0.48

0.4

2.78%
2.00

5%

= dividend per share/ share price

=50/1800
= profit after tax and pref
=(105-5)/50
dividend/ordinary dividend
(iii) Earnings/share (p)
= profit after tax and pref dividend/no of
=(105-5)*100/100
ordinary shares
(iv) Price Earnings ratio
= share price /earnings per share
=(1800/100)
(v) Interest cover
= PBT and loan interest/loan interest
=(150+10)/10
div yield is lower; pe ratio is higher, seems to have higher growth prospects than industry

100.00
18.00
16.00

15
20

Carcom plc
Carcom Plc manufactures a Popular brand caravan which it sells at 30,000/unit. Fixed
overheads are 550,000 in a year. Budgeted sales for the next year and variable costs for the
popular brand are given below:
Budgeted sales for next year
Material 000/unit
Labour 000/unit
Variable OH/unit 000

35 units
4.00
1.20
3.00

(a) Calculate
(i) the contribution/unit = 30-(4+1.2+3)= 21,800/unit
(ii) breakeven point in units and value = 550,000/21,800 =25.229 units
(iii) Profit Volume Ratio = 21800/30000=0.727
BEP by value= 25.229 x 30,000= 756,870; 550,000/0.727= 756,534
(iv) Margin of safety = (35-25.229)/35 = 0.2792= 27.92%
(v) Units to be sold for a minimum profit target of 100,000
= (550000+100000)/21800= 29,816 units, 30 units

(b) The Marketing department has identified the possibility of selling 5 units next year of a
premium model at 47,000/unit, and 10 units of a Budget model at 20,000 each. These models
can be manufactured without any additional fixed costs. The accountant of the company has redrawn the draft profit budget with both the models as below, after ascertaining the direct
(material, labour) and variable costs associated with each of the additional products under
consideration and allocating the fixed overheads between all three products as below:
Popular
Units to be sold
Budgeted values
('000)
Revenue

Premium Budget Total

35

10

1050

235

200

1485

140

35

50

225

42

20

20

82

Variable overhead

105

30

150

285

Fixed overhead

300

200

50

Profit/(loss)

463

-50

-70

550
343

Material
Labour

As an MBA employed by the company you are required to advise the company on its production
plan for the next year: specifically whether the Premium model and Budget models should be
undertaken or not.

As fixed overheads are incurred irrespective of which product is produced, the same data above
can be represented as below: ie entirely on the existing product firstly and then afterwards on the
new products under considerationPopular
Units to be sold
Budgeted values
('000)
Revenue

Premium Budget Total

35

10

1050

235

200

1485

140

35

50

225

42

20

20

82

Variable overhead

105

30

150

CONTRIBUTION

763

150

-20

285
893

Fixed overhead

550

Profit/(loss)

213

-20

550
343

Material
Labour

150

000

Above table shows that if Popular alone is produced, profits would be 213,000.
Undertaking Premium in addition to the Popular Model, increases profit from 213,000 to
363,000 (213,000+150,000); if model Bufdget is additionally taken, profit is reduced by
20,000 to 343,000.
This gives a clear decision rule in the above problem, products with a positive contribution must
be undertaken (Popular, Premium) as they increase profits but products with a negative
contribution must be rejected as they reduce overall profits.

The Regulatory framework

Do companies need regulations for responsible operation?
How important are the following?
-

(1) Company Law- Companies Act (UK)

(2) Accounting standards (IAAS, GAAP, USGAAP, IFRS
(3) Type of Companies: Proprietorship, Limited Liability (Private/Public, Plc )
(4) Stock Market Listing procedures
(5) Corporate Governance codes: US Sorbanes-Oxley Act// UK Combined Code

(d) Capital Structure

Lemon plc
The following information relates to Lemon plcs capital structure:

1 Ordinary shares
Reserves
10% 1 Pref shares
9% debentures (100 face value)
Capital Employed

m
20
10
8
5
43

Additional relevant
information:
Share price (p)
Dividend (p)
Ex div market price of preference shares (p)
the ex-interest price of debenture ()
Tax rate

300
40
95
110
30%

Required:
(a) Assuming the preference shares and debentures are irredeemable, calculate the wacc of
Lemon plc if:
(i) dividends are not expected to grow in the future.
(ii) if dividends are expected to grow at 6% per year in the future.
(b) Suppose the debentures or preference shares were redeemable, would your answers be
different?

Answer overleaf

Lemon plc
Cost of equity= Ke= D/Ps=40/300=0.1333, 13.33%
Market value of equity =Vs= ns x Ps= 20m x 3 = 60m
Cost of preference share = Dp/Pp= 10p/95p = 0.1053= 10.53%
Market value of pref shares = np x Pp = 8m x 0.95= 7.6m
Cost of debentures = Kd(1-t)/Pd = 9(0.7)/110= 0.0573 =5.73%
Market value of bonds = B= nb x Pb = 50,000 x 110= 5.5m
Nb= 5m on balance sheet/100 = 50,000
WACC= Ke Vs/Vg + Kp Vp/ Vg + Kd (1-T). B/ Vg.
Vg= 60m +7.6m+5.5= 73.1
type of cap
equity
preference
debenture
Total

Cost
13.33%
10.53%
5.73%

Market value
60m
7.6m
5.5m
Vg= 73.1m

%Total
=60/73.1= 0.821
=7.6/73.1=0.104
=5.5/73.1=0.075
1.00 (100%)

WACC = 12.47%
WACC = Ke Vs/Vg + Kp Vp/ Vg + Kd (1-T). B/ Vg

= 13.33 (60/73.1) +10.53(7.6/73.1) + 5.73 (5.5/73.1) =12.47%

summary
no growth
ke
Kp=
Kd

= (D1/P)
= Dp/Pp
=rd()1-t)/Dd

K
MV
13.33% =Ps*ns
10.53% =Pp*np
5.73% =Pd*n
V=
Wacc=

K
MV
20.13% =Ps*ns
10.53% =Pp*np
5.73% =Pd*n
V=
Wacc=

60
7.6
5.5
73.1
0.1247
12.47%

growth
ke
Kp=
Kd

= (D1/P) +g
= Dp/Pp
=rd()1-t)/Dd

60
7.6
5.5
73.1
0.1805
18.05%

If the debentures or preference shares were redeemable, it would be necessary to calculate the
IRR of the respective casflows on the bond/preference capital