Mock Examination, Jun 2005 CAT T10 Managing Finance Suggested Answers Answer to Question 1 a) Year 0 1 2 3 Investment (380) 100 Sales 750 750 750 Variable cost (450) (450) (450) Material cost (160) (160) (160) _____ ______ ______ ______ Net cashflow (380) 140 140 240 ( 10 marks ) b) Initial Investment 380 1st year (140) ____ 240 2nd year (140) _____ 100 Payback period = 2 years 100/240 = 2.42 years ( 4 marks ) c) Net cashflow (380) 140 140 240 12% Discount factor 1.000 0.893 0.797 0.712 ______ ______ ______ ______ Present value (380) 125 116 171 Net present value = $32,000 ( 5 marks ) d) Net cashflow (380) 140 140 240 20% Discount factor 1.000 0.833 0.694 0.579 ______ ______ ______ ______ Present value (380) 116 97 139 Net present value = ($28,000) ( 5 marks ) Internal rate of return = 12% + 32/60 x 8% = 16.3% e) Initial feasibility study. Before a detailed evaluation of a capital investment proposal can be carried out, a brief initial investigation should generally be carried out to establish in broad terms whether the project is feasible. This initial investigation should take into account such factors as the availability of the required resources, the risks of the project, its technical and commercial feasibility, its risks, and the place of the project in the context of the strategic objectives of the enterprise. Detailed evaluation. If the project is feasible, a detailed evaluation should be undertaken. This investigation will take into account all the relevant expected cash flows deriving from the project. Net present value (NPV), internal rate of return, or other appraisal techniques, may be employed. The project should be appraised alongside any alternative projects which are also being considered. The NPV method is to be preferred because it is consistent with the objective of maximising shareholder wealth. An assessment of the sources of finance available for the project, and their relative costs, should be incorporated in the detailed appraisal. Any non-financial factors arising from the project should also be considered. The degree of risk in the project may be assessed with the help of sensitivity analysis. Approval of the project. Except for minor projects which are within the specified authorisation limits of other staff, senior management and possibly the Board of Directors, will make the final decision about whether to go ahead with the project. Those making the decision must be satisfied that an appropriately detailed evaluation has been carried out, that the proposal meets the necessary criteria to contribute to profitability, and that it is consistent with the overall strategy of the enterprise. Implementation. Once the decision has been made that the project will be undertaken, responsibility for the project should be assigned to a project manager or other responsible person. The required resources will need to be made available to this manager, who should be given specific targets to achieve. Project monitoring. After commencement of the project, progress should be of monitored and senior management should be informed on the progress of the project regularly. The project can be monitored more effectively if the costs and benefits originally expected are reassessed in the light of unforeseen events happening in the course of the project. ( 8 marks ) f) Companies can raise funds from the public as well as the bank, sources of finances can be from: Bank • In the form of bank loans • Fluctuating interest rate • Regardless of company’s financial performance, interest must be paid • No voting rights in the management of the company • Restrictive loan covenants • Interest paid is tax deductible, as it is considered as an expense • Secured by some fixed assets, mortgage, collateral, guarantee. In the form of debentures • Sometimes known as bonds, loan stock • Fixed interest rate, expressed as a percentage of the nominal value • No voting rights • Regardless of company’s financial performance, interest must be paid • Interest paid is tax deductible, as it is considered as an expense • Usually secured by some fixed assets, can be unsecured, obviously, investor will demand higher return on unsecured debentures. • Debentures are redeemable at a future definite date, usually debentures are issued for 3, 5, 7 or 10 years • If issued by PLC or the government, the debenture can be traded in the market. • It is possible to issue convertible loan stock, giving the investor the choice of converting the loan stock to a certain number of ordinary shares on maturity • The debenture issued by a PLC is a security. In the form of preference shares • Can be cumulative or non cumulative in nature • Preference shares are generally irredeemable • Enjoys preference to dividend if the company makes profit • Preference dividend must be paid before any ordinary dividend • No preference dividend if the company suffers losses • No voting rights, unless dividend is in arrear or in matters that will affect their legal rights • Preference dividend is paid at the fixed rate, lower if the company makes insufficient profit • Dividend paid by company to the shareholders are not tax deductible In the form of ordinary shares • Also known as equity shares, common shares • Ordinary shares are not redeemable • Ordinary shareholders are owners of the company • Can be issued to shareholders by initial public offer or subsequent placements • Further equity can be raised from existing shareholders through rights issue • Each share comes with voting rights • Exercise the rights during the annual general meeting • Board of directors and auditors are appointed by the shareholders • Board of directors are accountable to shareholders • No rights to ordinary dividend, unless provided in the memorandum and articles of association • Ordinary dividend will only be paid if recommended by the board of directors and accepted by the shareholders in the ACM. • Dividend paid by company to the shareholders are not tax deductible ( 8 marks ) Answer to Question 2 a) If the customer accepts the cash discount, and pays in full after 7 days, the implied cost in interest per annum would be approximately: 1 x 365 99 x 53 = 6.96% per annum ( 6 marks ) b) Working capital required : 60/365 x 3,000,000x 70% = 345,205 7/365 x 3,000,000 x30% = 17,260 _______ Working capital required $362,465 ________ ( 6 marks ) c) Increase the discount Reduce the credit period Tighter credit control Extend the qualifying period for the discount ( 3 marks ) d) Trade credit granted by suppliers certainly represent a very attractive source of short term finance as it is: i) Easily available and flexible ii) No need for suitable securities iii) Can does not impose restrictions like other facilities provided by bank Although a company may delay payment beyond the final due date, thereby obtaining even longer credit from its suppliers, such a policy would generally be inadvisable. i) Unacceptable delays in payment will worsen the company’s credit rating. and additional credit may become difficult to obtain. ii) The company may also be charged interest on overdue amounts and iii) have to spend significant administration time dealing with unpaid suppliers. ( 5 marks ) Answer to Question 3 a) Working capital required: Stock: Raw material ( 2.5/12x 40% x 12,000,000) 1,000,000 WIP Material ( 1/12 x 40% x 12,000,000) 400,000 Labour ( 1/12 x 30% x 12,000,000 x 60% ) 180,000 Overheads ( 1/12 x 10% x 12,000,000 x 60% ) 60,000 ______ 640,000 Finished goods ( 0.5/12x 12,000,000 x 70% ) 350,000 __________ 1,990,000 Debtor ( 12,000,000 x 1.5/12 ) 1,500,000 __________ 3,490,000 Creditor Direct material ( 3/12 x 12,000,000 x 40%) (1,200,000) Direct labour ( 1/12 x 12,000,000x30% ) (300,000) Overheads ( 1/12 x 12,000,000x10%) (100,000) Selling and distribution ( 2/12x12,000,000x5%) (100,000 ) __________ Net working capital required 1,790,000 __________ ( 12 marks ) b) Reduce the raw material, example Just in time ordering Reduce the work in progress time Reduce the finished goods stock Reduce the credit period to customers Re-negotiate to increase the credit period with suppliers ( 4 marks ) c) The working capital calculated is only an average, there will inevitably be seasonal fluctuation in sales and production, so, the working capital required will be higher in certain months and lower in some months. Other working capital element are ignored, items like taxation, dividend, the need to place deposits, advance payments were ignored. ( 4 marks ) Answer to Question 4 To: Managing Director From : Assistant Accountant Date: 29 Mar 2005 The following sources of short term finance to fund temporary shortage in working capital, can be considered: Trade creditors By delaying payments to the creditors, although, this is the most flexible and simple source of short term finance, it may usually resulted in some detrimental effects as creditors may withdraw future support or threaten legal actions Bank overdraft Usually bank will grant an overdraft facility based on past working relationship, the interest and administration fees charged on an overdraft account is usually very expensive. By issuing short term debt, such as commercial papers These are promissory notes issued to secure loans to the business, usually short term like 3 months, at a discount to the amount payable. Factoring of debts The company may arrange with a factor to advance certain amount of money as working capital, whenever a sales is made, using the debtors as securities on such cash advances. Typically, factors are able to advance up to 80% of the value of debts. Such arrangement is to allow a business to finance it’s working capital requirement due to rapid increase in sales. The factor will charge interest on the cash advanced, as well as administration fees for taking over the function of debt collection and management, however, the factoring arrangement will provide some credit protection as the factor will take over the risk of bad debts, this is sometimes known as “debt underwriting”. Invoice discounting This is the purchase of a selection of invoices by the factor. The invoice discounter does not take over the administration of the client’s sales ledger, and the arrangement is purely for the advance of cash. A business many only want to have some invoices discounted when it has a temporary cash shortage, and so invoice discounting tends to be a “one off deal” ( 20 marks )