1 UUL CO
UUL Co is a public water supply company which was privatised a number of years ago. As the deputy Finance Director you are reviewing the draft financial statements which contain the following statement by the chairman:
‘This company has delivered above average performance in fulfilment of our objective of maximising shareholder wealth. Earnings, dividends and the share price have all shown good growth. It is our intention to continue to deliver strong performance in the future’.
Required:
(a) Identify three key stakeholders, other than the shareholders, in a company such as UUL Co. Identify what financial and other objectives the company should aim to follow in order to satisfy each of these stakeholders. (6 marks) (b) Identify what government intervention and other regulation UUL Co may suffer and
how this will impact upon the company. (4 marks)
(Total: 10 marks)
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2 CCC
CCC is a local government entity. It is financed almost equally by a combination of central government funding and local taxation. The funding from central government is determined largely on a per capita (per head of population) basis, adjusted to reflect the scale of deprivation (or special needs) deemed to exist in CCC’s region. A small percentage of its finance comes from the private sector, for example from renting out City Hall for private functions.
CCC’s main objectives are:
to make the region economically prosperous and an attractive place to live and work
to provide service excellence in health and education for the local community.
DDD is a large listed entity with widespread commercial and geographical interests. For historic reasons, its headquarters are in CCC’s region. This is something of an anomaly as most entities of DDD’s size would have their HQ in a capital city, or at least a city much larger than where it is.
DDD has one financial objective: To increase shareholder wealth by an average 10% per annum. It also has a series of non‐financial objectives that deal with how the entity treats other stakeholders, including the local communities where it operates.
DDD has total net assets of $1.5 billion and a gearing ratio of 45% (debt to debt plus equity), which is typical for its industry. It is currently considering raising a substantial amount of capital to finance an acquisition.
Required:
Discuss the criteria that the two very different entities described above have to consider when setting objectives, recognising the needs of each of their main stakeholder groups.
Make some reference in your answer to the consequences of each of them failing to meet
its declared objectives. (10 marks)
3 NEIGHBOURING COUNTRIES
Two neighbouring countries have chosen to organise their electricity supply industries in different ways.
In Country A, electricity supplies are provided by a nationalised industry. In Country B, electricity supplies are provided by a number of private sector companies.
Required:
(a) Explain how the objectives of the nationalised industry in Country A might differ from those of the private sector companies in Country B. (5 marks) (b) Briefly discuss whether investment planning and appraisal techniques are likely to differ in the nationalised industry and private sector companies. (5 marks) (Total: 10 marks)
4 RZP CO
As assistant to the Finance Director of RZP Co, a company that has been listed on the London Stock Market for several years, you are reviewing the draft Annual Report of the company, which contains the following statement made by the chairman:
‘This company has consistently delivered above‐average performance in fulfilment of our declared objective of creating value for our shareholders. Apart from 20X2, when our overall performance was hampered by a general market downturn, this company has delivered growth in dividends, earnings and ordinary share price. Our shareholders can rest assured that my directors and I will continue to deliver this performance in the future’.
The five‐year summary in the draft Annual Report contains the following information:
Year 20X4 20X3 20X2 20X1 20X0
Dividend per share 2.8¢ 2.3¢ 2.2¢ 2.2¢ 1.7¢
Earnings per share 19.04¢ 14.95¢ 11.22¢ 15.84¢ 13.43¢
Price/earnings ratio 22.0 33.5 25.5 17.2 15.2
A recent article in the financial press reported the following information for the last five years for the business sector within which RZP Co‐operates:
Share price growth average increase per year of 20%
Earnings growth average increase per year of 10%
You may assume that the number of shares issued by RZP Co has been constant over the five‐year period.
Required:
Discuss the factors that should be considered when deciding on a management remuneration package that will encourage the directors of RZP Co to maximise the wealth of shareholders, giving examples of management remuneration packages that
might be appropriate for RZP Co. (10 marks)
5 DAZZLE CO (DEC 2008 MODIFIED)
Dazzle Co is a stock‐market listed company that manufactures personal protection equipment. At a recent board meeting of Dazzle Co, a non‐executive director suggested that the company’s remuneration committee should consider scrapping the company’s current share option scheme, since executive directors could be rewarded by the scheme even when they did not perform well.
A second non‐executive director disagreed, saying the problem was that even when directors acted in ways which decreased the agency problem, they might not be rewarded by the share option scheme if the stock market were in decline.
Required:
(a) Explain the nature of the agency problem (5 marks) (b) Discuss the use of share option schemes as a way of reducing the agency problem in a stock‐market listed company such as Dazzle Co. (5 marks) (Total: 10 marks) 6 JJG CO (JUNE 09 MODIFIED)
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JJG Co is planning to raise $15 million of new finance for a major expansion of existing business and is considering a rights issue, a placing or an issue of bonds. The corporate objectives of JJG Co, as stated in its Annual Report, are to maximise the wealth of its shareholders and to achieve continuous growth in earnings per share. Recent financial information on JJG Co is as follows:
20X8 20X7 20X6 20X5
Revenue ($m) 28.0 24.0 19.1 16.8
Profit before interest and tax ($m) 9.8 8.5 7.5 6.8
Earnings ($m) 5.5 4.7 4.1 3.6
Dividends ($m) 2.2 1.9 1.6 1.6
Ordinary shares ($m) 5.5 5.5 5.5 5.5
Reserves ($m) 13.7 10.4 7.6 5.1
8% Bonds, redeemable 2015 ($m) 20.0 20.0 20.0 20.0
Share price ($) 8.64 5.74 3.35 2.67
The nominal value of the shares of JJG Co is $1.00 per share. The general level of inflation has averaged 4% per year in the period under consideration. The bonds of JJG Co are currently trading at their nominal value of $100. The following values for the business sector of JJG Co are available:
Average return on capital employed 25%
Average return on shareholders’ funds 20%
Average debt/equity ratio (market value basis) 50%
Return predicted by the capital asset pricing model 14%
Required:
Evaluate the financial performance of JJG Co, and analyse and discuss the extent to which the company has achieved its stated corporate objectives of:
(i) Maximising the wealth of its shareholders;
(ii) Achieving continuous growth in earnings per share.
Note: up to 6 marks are available for financial analysis (Total: 10 marks)
Calculate your allowed time, allocate the time to the separate parts
7 NEWS FOR YOU
News For You operates a chain of newsagents and confectioner’s shops in the south of a Northern European country, and are considering the possibility of expanding their business across a wider geographical area. The business was started in 20X2 and annual revenue grew to $10 million by the end of 20X6. Between 20X6 and 20X9 revenue grew at an average rate of 2% per year.
The business still remains under family control, but the high cost of expansion via the purchase or building of new outlets would mean that the family would need to raise at least
$2 million in equity or debt finance. One of the possible risks of expansion lies in the fact that both tobacco and newspaper sales are falling. New income is being generated by expanding the product range stocked by the stores, to include basic foodstuffs such as bread and milk. News For You purchases all of its products from a large wholesale distributor which is convenient, but the wholesale prices leave News For You with a relatively small gross margin. The key to profit growth for News For You lies in the ability to generate sales growth, but the company recognises that it faces stiff competition from large food retailers in respect of the prices that it charges for several of its products.
In planning its future, News For You was advised to look carefully at a number of external factors which may affect the business, including government economic policy and, in recent months, the following information has been published in respect of key economic data:
(i) Bank base rate has been reduced from 5% to 4.5%, and the forecast is for a further 0.5% reduction within six months.
(ii) The annual rate of inflation is now 1.2%, down from 1.3% in the previous quarter, and 1.7% 12 months ago. The rate is now at its lowest for 25 years, and no further falls in the rate are expected over the medium/long term.
(iii) Personal and corporation tax rates are expected to remain unchanged for at least 12 months.
(iv) Taxes on tobacco have been increased by 10% over the last 12 months, although no further increases are anticipated.
(v) The government has initiated an investigation into the food retail sector focusing on the problems of ‘excessive’ profits on certain foodstuffs created by the high prices being charged for these goods by the large retail food stores.
Required:
Explain the relevance of each of the items of economic data listed above to News For
You. (10 marks)
WORKING CAPITAL MANAGEMENT
8 GORWA CO (DEC 08 MODIFIED)
The following financial information relates to Gorwa Co:
2007 2006
$000 $000
Sales (all on credit) 37,400 26,720
Cost of sales 34,408 23,781
–––––– ––––––
Operating profit 2,992 2,939
Finance costs (interest payments) 355 274
–––––– ––––––
Profit before taxation 2,637 2,665
2007 2006
$000 $000 $000 $000
Non‐current assets 13,632 12,750
Current assets
Inventory 4,600 2,400
Trade receivables 4,600 2,200
–––––– ––––––
9,200 4,600
Current liabilities
Trade payables 4,750 2,000
Overdraft 3,225 1,600
–––––– ––––––
7,975 3,600
Net current assets 1,225 1,000
–––––– ––––––
14,857 13,750
8% Bonds 2,425 2,425
–––––– ––––––
12,432 11,325
–––––– ––––––
Capital and reserves
Share capital 6,000 6,000
Reserves 6,432 5,325
–––––– ––––––
12,432 11,325
–––––– ––––––
The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years’ time.
A factor has offered to take over the administration of trade receivables on a non‐recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%.
Required:
(a) Use the above financial information to discuss, with supporting calculations, whether or not Gorwa Co is overtrading. (9 marks) (b) Evaluate whether the proposal to factor trade receivables is financially acceptable.
Assume an average cost of short‐term finance in this part of the question only.
(6 marks)
(Total: 15 marks)
9 FLIT CO (DEC 14)
Flit Co is preparing a cash flow forecast for the three‐month period from January to the end of March. The following sales volumes have been forecast:
December January February March April
Sales (units) 1,200 1,250 1,300 1,400 1,500
Notes:
(1) The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales are all on one month’s credit.
(2) Production of goods for sale takes place one month before sales.
(3) Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials inventory is held. Raw material purchases are on one months’ credit.
(4) Variable overheads and wages equal to $100 per unit are incurred during production, and paid in the month of production.
(5) The opening cash balance at 1 January is expected to be $40,000.
(6) A long‐term loan of $300,000 will be received at the beginning of March.
(7) A machine costing $400,000 will be purchased for cash in March.
Required:
(a) Calculate the cash balance at the end of each month in the three‐month period.
(5 marks)
(b) Calculate the forecast current ratio at the end of the three‐month period. (2 marks) (c) Assuming that Flit Co expects to have a short‐term cash surplus during the three‐
month period, discuss whether this should be invested in shares listed on a large
stock market. (3 marks)
(Total: 10 marks)
10 WOBNIG CO (JUNE 12 MODIFIED)
Wobnig Co is in the process of reviewing its working capital investment strategy, in particular the cash management of the company.
Wobnig Co is considering using the Miller‐Orr model to manage its cash flows. The minimum cash balance would be $200,000 and the spread is expected to be $75,000.
Required:
(a) Critically discuss the similarities and differences between working capital policies in the following areas:
(i) Working capital investment;
(ii) Working capital financing. (10 marks)
(b) Calculate the Miller‐Orr model upper limit and return point, and explain how these would be used to manage the cash balances of Wobnig Co. (5 marks) (Total: 15 marks)
11 FLG CO (JUNE 08 MODIFIED)
FLG Co has annual credit sales of $4.2 million and cost of sales of $1.89 million. Current assets consist of inventory and accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rate of 7% per year. The company gives two months’ credit to its customers and is allowed, on average, one month’s credit by trade suppliers. It has an operating cycle of three months.
Other relevant information:
Current ratio of FLG Co 1.4 Cost of long‐term finance of FLG Co 11%
Required:
(a) Discuss the key factors which determine the level of investment in current assets.
(4 marks)
(b) Discuss the ways in which factoring and invoice discounting can assist in the
management of accounts receivable. (5 marks)
(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost of financing its current assets. (6 marks) (Total: 15 marks)
12 PKA CO (DEC 07 MODIFIED) Walk in the footsteps of a top tutor
PKA Co is a European company that sells goods solely within Europe. The recently‐
appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units.
Forecast demand to meet production requirements during the next year is 625,000 units.
The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0.50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50‐week year and that demand is constant throughout the year.
Accounts receivable management
Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.
Required:
(a) Identify the objectives of working capital management and discuss the conflict that
may arise between them. (3 marks)
(b) Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model. (6 marks) (c) Discuss ways in which PKA Co could improve the management of domestic
accounts receivable. (6 marks)
(Total: 15 marks)
13 KXP CO (DEC 12 MODIFIED)
KXP Co is an e‐business which trades solely over the internet. In the last year the company had sales of $15 million. All sales were on 30 days’ credit to commercial customers.
Extracts from the company’s most recent statement of financial position relating to working capital are as follows:
$000
Trade receivables 2,466
Trade payables 2,220
Overdraft 3,000
In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement discount of 1% for payment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50% of customers will take the discount and pay within 30 days, 30% of customers will pay after 45 days, and 20% of customers will not change their current paying behaviour.
KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant.
There is only one supplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and the holding cost is 24 cents per unit per year.
KXP Co has an overdraft facility charging interest of 6% per year.
Required:
(a) Calculate the net benefit or cost of the proposed changes in trade receivables
policy and comment on your findings. (6 marks)
(b) Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and comment on the assumptions made by your calculation. (6 marks) (c) Identify and discuss the factors to be considered in determining the optimum level
of cash to be held by a company. (3 marks)
(Total: 15 marks)
14 ULNAD
Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of sales revenue. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay.
Required:
(a) Evaluate whether the proposed changes in credit policy will increase the
profitability of Ulnad Co. (6 marks)
(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of
$7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%.
Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller‐Orr model and explain the relevance of these values for
the cash management of the company. (5 marks)
(c) Identify and explain the key areas of accounts receivable management. (4 marks) (Total: 15 marks)
15 APX CO (DEC 09 MODIFIED)
APX Co achieved revenue of $16 million in the year that has just ended and expects revenue growth of 8.4% in the next year. Cost of sales in the year that has just ended was
$10.88 million and other expenses were $1.44 million.
The financial statements of APX Co for the year that has just ended contain the following statement of financial position:
$m $m
Non‐current assets 22.0
Current assets
Inventory 2.4
Trade receivables 2.2
–––
4.6
––––
Total assets 26.6
––––
Equity finance:
$m $m
Ordinary shares 5.0
Reserves 7.5
–––
12.5
Long‐term bank loan 10.0
––––
22.5
Current liabilities
Trade payables 1.9
Overdraft 2.2
–––
4.1
––––
Total liabilities 26.6
––––
The long‐term bank loan has a fixed annual interest rate of 8% per year. APX Co pays taxation at an annual rate of 30% per year.
The following accounting ratios have been forecast for the next year:
Gross profit margin: 30%
Operating profit margin: 20%
Dividend payout ratio: 50%
Inventory turnover period: 110 days Trade receivables period: 65 days
Trade payables period: 75 days
Overdraft interest in the next year is forecast to be $140,000. No change is expected in the level of non‐current assets and depreciation should be ignored.