Monitoring Test MT2AFinancialManagement F9FM-MT2A-Z08-A Answers & Marking Scheme Accountancy Tuition Centre Ltd ATC INTERNATIONAL WATER SUPPLY SERVICES PLC (a) Rental costs based on projected sales Sales growth at 15% per annum Period: Units: Existing capacity: Extra capacity required: Number of machines required: Rental costs ($): 110,000 126,500 145,475 167,296 192,391 80,000 80,000 80,000 80,000 80,000 30,000 46,500 65,475 87,296 112,391 2 22,000 44,000 44,000 44,000 66,000 Unit variable costs $/unit 109.00 23.85 62.25 10.00 Labour (45+64) Material A costs Material B costs (5 × 12.45) Variable overheads 2.00 × 5kg Unit variable costs 205.10 Incremental cash flow schedule: Year: Units: Incremental Units: $ 000 Variable Costs: Fixed Costs: Machine Rentals: Allowable Costs Incremental Revenue Capital Costs: Working Capital Net cash flow DF at 20% PV NPV 110,000 126,500 145,475 167,296 192,391 30,000 46,500 65,475 87,296 112,391 $ 000 (6,153) $ $ $ $ 000 000 000 000 (9,537) (13,429) (17,904) (23,051) (50) (50) (22) (44) (44) (44) (66) (6,175) 7,719 (9,581) (13,473) (17,998) (23,167) 11,976 16,841 22,498 28,959 (7,500) (30) (1,158) (639) (729) (849) (969) 4,344 (8,658) (8,658) 474 905 0·833 754 Decision: project is worthwhile Accountancy Tuition Centre (International Holdings) Ltd 2008 1,666 0·694 1,156 2,519 0·579 1,459 3,501 0·482 1,688 10,136 0·402 4,075 (b) Report to the Board of Directors (Forecasting) December 2008 Prepared by the Senior Accountant Limitations of the five year period of analysis A number of limitations to the analysis potentially arise: The approach does not take account of future benefits/costs after five years either continuing or new; No information on contract length from the Water Authorities which may be longer than five years; Other, cheaper, resources may be available over a longer period e.g it may be cheaper to buy machines rather than rent them; Analysis does not take account of the potential for physical site capacity increases that may become available after five years Problems and difficulties associated with forecasting We have relied to a great extent on the forecasting of data in order to provide an evaluation of the proposal Not all the components are forecast: for example, we will know that we are able to recover agreed costs However, to the extent that components are forecast, there exists the potential for error in our evaluation which, of course, leads to uncertainty in our conclusions In particular, the following problems are evident at this stage: uncertainty increases with the length of time forecast That is, the further into the future, the less able we are to predict with accuracy because our initial assumptions may be wrong and small errors at the beginning magnify subsequently as the forecast becomes increasingly irrelevant to what is actually happening to the key variable in question For example, we may have not predicted general inflation rates correctly which could have a large impact on our labour costs project complexity: the more variables we have to forecast, the less likely we are to be accurate This problem has an unknowable outcome if there are a large number of variables to forecast, the uncertainty concerning the two components can have two effects: the larger the number of components to forecast, the greater the difficulty in determining project outcome Forecasting so many components can lead to errors because the scale of the problem is large by forecasting many components we assume a relationship between the components which is also a forecast This relationship may change For example, the relationship of production variable overheads to units produced may change Currently, they are related to the amount of materials used If we use forecasts based on these assumptions, then we also assume that the relationship between materials used and overheads absorbed is constant This may not be the situation if the type of materials change Accountancy Tuition Centre (International Holdings) Ltd 2008 the background information may change What happens, for example, if a new competitor enters the market? This effect will be alleviated to the extent that we have an agreed contract There are other factors which could have a significant effect given enough time to materialise For example, technological change could have an impact on our industry In particular, social change may be relevant if consumers begin to demand even higher quality water supplies which would inevitably affect our costs there is always the random component that could distort our forecasts However, an alternative view would suggest that such random components are really an admission of lack of skill in forecasting The best forecasters attempt to anticipate all eventualities Choice of an appropriate discount rate The difficulty with choosing a discount rate rests on whether the correct rate for the risk/return has been derived A number of factors are relevant here the position of the Water Authorities as single customer The business is potentially at risk if the Water Authorities choose to look elsewhere for their water supplies This may mean that a higher discount rate is more appropriate the financing of the capacity expansion This may have an impact on the discount rate if the debt/equity mix of the company is significantly altered A number of factors are relevant here: (a) higher gearing is likely to induce higher costs of equity; (b) higher equity financing may reduce the cost of equity, but increase the overall WACC if we move off our minimum WACC a lower discount rate may be more appropriate to the extent that a long term contract implies secure income streams different components of the cash flows may have different variability and it may therefore not be appropriate to discount them all at the same rate Any non-quantifiable factors you feel might influence the decision to accept the proposal Net present value methods are only assessments of factors that we can quantify There may be non-quantifiable factors that may also have an impact on any decision we make Some of these may be: It is important to keep our only customer happy and therefore a high standard of general service is important Future contracts are likely to depend on agreeing to the proposal Hence, future benefits may emerge which are currently hard to quantify The continuance of the existing business relationship with the Water Authorities may position the company to expand and provide water to other sectors of the economy Accountancy Tuition Centre (International Holdings) Ltd 2008 The existing and proposed contracts secure continued employment for personnel This is important in a labour market that may be experiencing shortages and where key personnel are difficult to replace DEBENTURES (a) (i) The market price of Hammer’s debentures will be largely determined by their essential debenture characteristics because conversion does not appear to be an attractive proposition At present, the value of 20 shares is only $70, considerably less than the redemption value of $100 Although there is over a year to go until redemption, the share price would have to rise more than $1.50 (over 40%) over this period to make conversion the better alternative Consequently, Hammer’s debt will be valued as debentures, based on the future interest payments plus the redemption consideration There will still, however, be some (probably small) option premium to add to this (ii) In the case of Nail’s debt, the share conversion value (25 × $4.10 = $102.50) already exceeds the stock redemption value of $100 Conversion is not due for another three years, and although share prices could fall, there is the prospect of further capital gains at conversion These convertibles will be valued based on the remaining interest payments and the expected ordinary share price at conversion The critical factors in valuation are thus the actual and expected share price and the length of time to conversion, especially if the share price is volatile (b) There are three main ways in which a company can “come to the market” (i) Offer for sale by prospectus - shares are offered at a fixed price to the public, including both institutions and private individuals Application forms and a prospectus, setting out all relevant details of the company’s past performance and future prospects, as stipulated by Stock Exchange regulations laid down in “The Yellow Book”, must be published in the national press A variant on this method is the offer for sale by tender, where no prior issue price is announced, but prospective investors are invited to bid for shares at a price of their choosing The eventual “striking price” at which shares are sold is determined by the weight of applications at various prices Essentially, the final price is set by supply and demand (ii) A placing occurs when shares are “placed” or sold to institutional investors, such as pension funds and insurance companies, selected by the investment bank advising the company, and the company’s stockbroker In a placing, the general public have to wait until official dealing in the shares begins before they, too, can buy the shares An intermediaries’ offer is a placing with financial intermediaries, which allows brokers to apply for shares These brokers are allocated shares that they can subsequently distribute to their clients Accountancy Tuition Centre (International Holdings) Ltd 2008 (iii) Introduction In some cases, the proportion of shares held by the public (25% for a full listing) may already meet Stock Exchange requirements, and the company is seeking a listing merely to open up a wider market for its shares rather than seeking new capital With an Introduction no new shares are issued, and new investors can only participate if some of the existing shareholders decide to liquidate their holdings after the listing (c) (i) A scrip dividend is where the company offers it shareholders a choice of cash dividend, or new shares in lieu of cash From the company’s point of view, the scrip alternative preserves liquidity, which may be important at a time of cash shortage and/or high borrowing costs, although it may become committed to a higher level of cash outflows in the future if shareholders revert to a preference for cash dividend However, having issued more shares, the company’s reported financial gearing may be lowered, possibly enhancing borrowing capacity In this respect, the scrip dividend resembles a rights issue (ii) For shareholders wishing to increase their holdings, the scrip is a cheap way as it avoids dealing fees The conversion price used to calculate the number of shares receivable is based on the average share price for several trading days after the “ex dividend day” Should the market price rise above the conversion price before the date at which shareholders have to declare their choice; there is the prospect of a capital gain A scrip dividend has no tax advantages for shareholders as it is treated as income for tax purposes If the capital market is efficient, there is no depressing effect on the share price by the scrip dividend through earnings dilution This is because the scrip simply replaces a cash dividend that would have caused share price to fall anyway due to the “ex dividend” effect In other words, shareholder wealth is unchanged However, if the additional capital retained is invested wisely, then share price may be maintained or even rise (d) Operating gearing – Fixed operating costs Variable operating costs – a measure of the sensitivity of earnings to a change in the level of sales Accountancy Tuition Centre (International Holdings) Ltd 2008 Financial gearing – – Fixed return capital Equity capital and reserves a measure of the sensitivity of returns to ordinary shareholders to a change in the level of earnings and to changes in the cost of debt Companies with high operating gearing have potentially very variable earnings and should therefore generally avoid high financial gearing, e.g professional services firms, highly mechanised manufacturing companies Companies with low operating gearing have potentially more stable earnings and could therefore have high financial gearing, e.g leasing companies (e) Deep discount bonds are issued at a large discount to their par value To achieve this low selling price they must be issued with a low coupon rate This means that much of the gain to any investor is a capital gain rather than interest income This will appeal to some investors (probably for tax reasons; although in the UK, some of the capital gain may be taxed as income) Companies also save having to pay large amounts of interest each year Some companies will prefer this if they expect to be short of cash in the near future Accountancy Tuition Centre (International Holdings) Ltd 2008 Marking Scheme Marks WATER SUPPLY SERVICES PLC (a) Forecast increase in capacity Machines required Variable cost per unit Forecast variables costs Incremental fixed costs Rental expense Revenue Capital costs Working capital Calculation of NPV Conclusion Marks 2 2 2 1 17 (b) marks per (i) – (iv) 25 DEBENTURES (a) (i) Conversion unlikely Interest Redemption value (ii) Conversion likely Interest Likely share value (b) ½ 1 ½ ––– marks per well explained method max (c) (i) Liquidity Gearing (ii) Easy way to increase holding Impact on share price (d) 1 ––– per formulae Interaction per example Definition Liquidity Return largely capital gain Accountancy Tuition Centre (International Holdings) Ltd 2008 2 ––– (e) 1½ 1½ ––– 5 ––– 25 ––– ... physical site capacity increases that may become available after five years Problems and difficulties associated with forecasting We have relied to a great extent on the forecasting of data in order... forecast, the greater the difficulty in determining project outcome Forecasting so many components can lead to errors because the scale of the problem is large by forecasting many components we assume... Currently, they are related to the amount of materials used If we use forecasts based on these assumptions, then we also assume that the relationship between materials used and overheads absorbed