CONTENT

Question Answer

Section – 1 NPV
1. Corter 1 41
2. Calvic 1 42
3. Capital Rationing 2 44
4. Rainbow 2 45
5. Chromex 2 46
6. Trecor 3 48
7. Duo Co 4 50
8. SC Co 4 53
9. PV Co 5 56
10. Basril 6 60
11. ZSC 6 61
12. ASOP 7 62
13. BRT 8 64
14. OKM 9 65

Section – 2 Cost of Capital

15. AMH Co 10 67
16. IML Co 11 69
17. Droxfol 11 71
18. Burse Co 12 73

Section – 3 Sources of Finance

19. AQR 13 74
20. DD Co 14 76
21. BKB 14 78
22. Echo Beach 15 80
23. Terwin 16 82
24. Li Co 17 83
25. Bar Co 17 84
Section – 4 Ratios
26. YGV 19 85
27. TFR 20 86
28. ARWIN 21 87

Section – 5 Business Valuation

29. Close Co 22 89
30. Phobis (1) 23 90
31. Phobis (2) 23 91
32. THP 23 94
33. Dartig 24 97
34. KFP 25 100
35. QSX 26 103
36. Corhig 27 103

Section – 6 Working Capital

37. Edwin 28 104
38. Cash Budget 30 104
39. Velm Co 31 104
40. Special Gift supplier 32 106
41. Ulnad 33 109
42. PKA 34 111
43. FLG 35 113
44. HRG 36 116
45. APX 37 119
46. WQZ 38 120
47. Plot Co 39 121
48. PNP Co 40 121
QUESTIONS

Section – 1 NET PRESENT VALUE

1 CORTER

Corter Co plans to buy a machine costing $250,000 which will last for four years and then
be sold for $5,000. Net cash flows before tax are expected to be as follows.
T1 T2 T3 T4

Net cash flow $ 122,000 143,000 187,000 78,000

Corter Co has a target return on capital employed of 20%. Depreciation is charged on a
straight-line basis over the life of an asset.
(a) Calculate the before-tax return on capital employed (accounting rate of return)
based on the average investment and comment on your findings. (5 marks)
(b) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments.
(5 marks)

(Total = 10 marks)

2 CALVIC

Calvic Co services custom cars and provides its clients with a courtesy car while servicing is taking
place. It has a fleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy
car will cost $15,000. The trade-in value of each new car declines over time as follows:

Age of courtesy car (years) 1 2 3

Trade-in value ($/car) 11,250 9,000 6,200

Servicing and parts will cost $1,000 per courtesy car in the first year and this cost is expected to
increase by 40% per year as each vehicle grows older. Cleaning the interior and exterior of each
courtesy car to keep it up to the standard required by Calvic's clients will cost $500 per car in the first
year and this cost is expected to increase by 25% per year.

Calvic Co has a cost of capital of 10%. Ignore taxation and inflation.

Required

(a) Using the equivalent annual cost method, calculate whether Cavic Co should replace its fleet after one
year, two years, or three years. (10 marks)
(b) Discuss the causes of capital rationing for investment purposes. (5 marks) (Total = 15 marks)

1
3 CAPITAL RATIONING

(a) Explain how cash shortages can restrict the investment opportunities of a business.

(5 marks)
(b) Distinguish between 'hard' and 'soft' capital rationing, explaining why acompany may
deliberately chooseto restrict its capital expenditure. (5 marks)
(Total = 10 marks)

4 RAINBOWS

Rainbow Co, a medium-sized company specialising in the manufacture and distribution of equipment for
babies and small children, is evaluating a new capital expenditure project. In a joint venture with another
separate company, it has invented a remote controlled pushchair, one of the first of its kind on the market. It
has been unable to obtain a patent for the invention, but is sure that it will monopolise the market for the first
three years. After this, it expects to be faced with stiff competition.
The details are set out below.
The project has an immediate cost of $2,100,000.
Sales are expected to be $1,550,000 per annum for years 1 to 3, falling to $650,000 per annum for the two
years after that. No further sales of the product are expected after the end of this five- year period.
Cost of sales is 40% of sales.
Distribution costs represent 10% of sales.
20% of net profits are payable to the joint venture partner the year after the profits are earned.
The company's cost of capital is 5%.
Required
(A) Calculate the net present value of the project at the company's required rate of return.
Assume that all cash flows arise annually in arrears unless otherwise stated. Conclude whether the project
is financially viable.
(B) Calculate the project's internal rate of return (IRR) to the nearest percent.
(C) Calculate the project's simple payback period. Assume all cash flows arise at the end of the year apart
from the immediate investment costs.

5 CHROMEX

It is now June 20X8. Chromex Co manufactures bicycles for the UK and European markets, and has made a bid
of $150 million to take over Bexell Co, their main UK competitor, which is also active in the German market.
Chromex currently supplies 24% of the UK market and Bexell has a 10% share of the same market.

Chromex anticipates labour savings of $700,000 per year, created by more efficient production and
distribution facilities, if the takeover is completed. In addition, the company intends to sell off surplus land and
buildings with a balance sheet value of $15 million, acquired in the course of the takeover.

Total UK bicycle sales for 20X7 were $400 million. For the year ended 31 December 20X7, Bexell reported an
operating profit of $10 million, compared with a figure of $55 million for Chromex. In calculating profits, Bexell
included a depreciation charge of $0.5 million.

Note. The takeover is regarded by Chromex in the same way as any other investment, and is appraised
accordingly.

2
Required

(a) 'Despite the theoretical limitations of the payback method of investment appraisal, it is the method
most used in practice.' Discuss this statement briefly. (5 marks)
(b) Assuming that the bid is accepted by Bexell, calculate the payback period (pre-tax) for the investment,
if the land and buildings are immediately sold for $5 million less than the balance sheet valuation and
Bexell's sales figures remain static. (3 marks)

6 TRECOR

Trecor Co plans to buy a new machine to meet expected demand for a new product, Product T. This machine
will cost $250,000 and last for four years, at the end of which time it will be sold for $5,000. Trecor Co expects
demand for Product T to be as follows:

Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 25,000

The selling price for Product T is expected to be $12.00 per unit and the variable cost of production is expected
to be $7.80 per unit. Incremental annual fixed production overheads of $25,000 per year will be incurred.
Selling price and costs are all in current price terms. Selling

price and costs are expected to increase as follows:

Increase

Selling price of Product T: 3% per year

Variable cost of production: 4% per year

Fixed production overheads: 6% per year

Other information

Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears. It can
claim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year.

Trecor Co has a target return on capital employed of 20%. Depreciation is charged on a straight-line basis over
the life of an asset.

Required

(A) Calculate the net present value of buying the new machine and comment on your findings (work to
the nearest $1,000). (13 marks)
(B) Calculate the before-tax return on capital employed (accounting rate of return) based on the average
investment and comment on your findings. (5 marks)
(C) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments.
(7 marks)

(Total = 25 marks)

3
7 DUO CO

Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’,
which is used in food processing. A new machine, with a useful life of four years and a maximum output of
600,000 kg of Quago per year, could be bought for $800,000, payable immediately. The scrap value of the
machine after four years would be $30,000. Forecast demand and production of Quago over the next four
years is as follows:

Year 1 2 3 4
Demand (kg) 1.4 million 1.5 million 1.6 million 1.7 million

Existing production capacity for Quago is limited to one million kilograms per year and the new machine would
only be used for demand additional to this. The current selling price of Quago is $8.00 per kilogram and the
variable cost of materials is $5.00 per kilogram. Other variable costs of production are $1.90 per kilogram.
Fixed costs of production associated with the new machine would be $240,000 in the first year of production,
increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowable
depreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of
operation.Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It
has a cost of
equity of 11% and a before-tax cost of debt of 8.6%. The long-term finance of the company, on a market-value
basis, consists of 80% equity and 20% debt.

Required

(a) Calculate the net present value of buying the new machine and advise on the acceptability of the
proposed purchase (work to the nearest $1,000). (13 marks)
(b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of the
proposed purchase (work to the nearest $1,000). (4 marks)
(c) Explain the difference between risk and uncertainty in the context of investment appraisal, and
describe how sensitivity analysis and probability analysis can be used to incorporate risk into the
investment appraisal process. (8 marks)

8 SC CO

SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle
due to rapidly changing technology. The machine is expected to cost $1 million. Production and sales of
product P are forecast to be as follows:

Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the
product (in current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and
variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co
has spare capacity in both space and labour terms.
Producing and selling product P will call for increased investment in working capital. Analysis of historical levels
of working capital within SC Co indicates that at the start of each year, investment in working capital for
product P will need to be 7% of sales revenue for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by
capital allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis
over the four year life of the proposed investment. The new machine is expected to have no scrap value at the
end of the four year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

4
 Required

(a) Calculate the net present value of the proposed investment in product P. (12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)
(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of the
evaluations you have carried out. (5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards the objective
of maximising the wealth of shareholders. (5 marks)

9 PV CO

PV Co is evaluating an investment proposal to manufacture Product W33, which has performed well in test
marketing trials conducted recently by the company’s research and development division. The following
information relating to this investment proposal has now been prepared.

Initial investment $2 million

Selling price (current price terms) $20 per unit
Expected selling price inflation 3% per year Variable operating costs (current price terms) $8 per unit
Fixed operating costs (current price terms) $170,000 per year Expected operating cost inflation 4% per year

The research and development division has prepared the following demand forecast as a result of its test
marketing trials. The forecast reflects expected technological change and its effect on the anticipated life-cycle
of Product W33.

Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000

It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keeping
no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four
years, when production of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a
nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year.
Ignore taxation.

Required

(A) Identify and explain the key stages in the capital investment decision-making process, and the role of
investment appraisal in this process. (7 marks)
(B) Calculate the following values for the investment proposal:
I. net present value;
II. internal rate of return;
III. return on capital employed (accounting rate of return) based on average investment; and
discounted payback period. (13 marks)
(C) Discuss your findings in each section of (b) above and advise whether the investment proposal is
financially acceptable. (5 marks)

5
10 BASRIL

Basril Co is reviewing investment proposals that have been submitted by divisional managers. The investment
funds of the company are limited to $800,000 in the current year. Details of three possible investments, none
of which can be delayed, are given below.

Project 1
An investment of $300,000 in work station assessments. Each assessment would be on an individual employee
basis and would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to
work-related illness. Savings in labour costs from these assessments in money terms are expected to be as
follows:
Year 1 2 3 4 5
Cash flows ($'000) 85 90 95 100 95
Project 2
An investment of $450,000 in individual workstations for staff that is expected to reduce administration costs
by $140,800 per annum in money terms for the next five years.
Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000 per annum are expected in
current price terms and these are expected to increase by 3.6% per annum due to inflation during the five-year
life of the machines.

Basril Co has a money cost of capital of 12% and taxation should be ignored.

Required
(A) Determine the best way for Basril Co to invest the available funds and calculate the resultant NPV:
on the assumption that each of the three projects is divisible;
on the assumption that none of the projects are divisible. (10 marks)
(B) Explain how the NPV investment appraisal method is applied in situations where capital is rationed.
(3 marks)
(C) Discuss the reasons why capital rationing may arise. (7 marks)
(D) Discuss the meaning of the term 'relevant cash flows' in the context of investment appraisal, giving
examples to illustrate your discussion. (5 marks)

11 ZSC CO

ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two periods. It has been
experiencing considerable volatility in cash flows in recent periods because of trading difficulties experienced
by its customers, who have often settled their accounts after the agreed credit period of 60 days. ZSE has also
experienced an increase in bad debts due to a small number of customers going into liquidation.
The company has prepared the following forecasts of net cash flows for the next two periods, together with
their associated probabilities, in an attempt to anticipate liquidity and financing problems. These probabilities
have been produced by a computer model
which simulates a number of possible future economic scenarios. The computer model has been built with the
aid of a firm of financial consultants.

Period 1 cash flow Probability Period 2 cash flow Probability

$000 $000
8,000 10% 7,000 30%
4,000 60% 3,000 50%
(2,000) 30% (9,000) 20%

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.

6
Required:
(A) Calculate the following:
I. the expected value of the period 1 closing balance;
II. the expected value of the period 2 closing balance;
III. the probability of a negative cash balance at the end of period2;
IV. the probability of exceeding the overdraft limit at the end of period2.
Discuss whether the above analysis can assist the company in managing its cash flows.
(13 marks)
(B) Identify and discuss the factors to be considered in formulating a trade receivables management
policy for ZSE Co. (8 marks)

12 ASOP

ASOP Co is considering an investment in new technology that will reduce operating

costs through increasing energy efficiency and decreasing pollution. The new technology will cost $1 million
and have a four-year life, at the end of which it will have a scrap value of $100,000.
A licence fee of $104,000 is payable at the end of the first year. This licence fee will increase by 4% per year in
each subsequent year.
The new technology is expected to reduce operating costs by $5.80 per unit in current price terms. This
reduction in operating costs is before taking account of expected inflation of 5% per year.
Forecast production volumes over the life of the new technology are expected to be as follows:

Year 1 2 3 4
Production (units per year) 60,000 75,000 95,000 80,000

If ASOP Co bought the new technology, it would finance the purchase through a four- year loan paying interest
at an annual before-tax rate of 8.6% per year.
Alternatively, ASOP Co could lease the new technology. The company would pay four annual lease rentals of
$380,000 per year, payable in advance at the start of each year. The annual lease rentals include the cost of
the licence fee.
If ASOP Co buys the new technology it can claim capital allowances on the investment on a 25% reducing
balance basis. The company pays taxation one year in arrears at an annual rate of 30%. ASOP Co has an after-
tax weighted average cost of capital of 11% per year.

Required
(a) Based on financing cash flows only, calculate and determine whether ASOP Co should lease or buy the
new technology. (11 marks)
(b) Using a nominal terms approach, calculate the net present value of buying the new technology and
advise whether ASOP Co should undertake the proposed investment. (6 marks)
(c) Discuss and illustrate how ASOP Co can use equivalent annual cost or equivalent annual benefit to
choose between new technologies with different expected lives.
(3 marks)
(d) Discuss how an optimal investment schedule can be formulated when capital is rationed and
investment projects are either:
I. Divisible; or
II. Non-divisible. (5 marks)

7
13 BRT

BRT Co has developed a new confectionery line that can be sold for $5.00 per box and that is expected to have
continuing popularity for many years. The Finance Director has proposed that investment in the new product
should be evaluated over a four-year time- horizon, even though sales would continue after the fourth year,
on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable
and fixed costs (both in current price terms) will depend on sales volume, as follows.

Sales volume (boxes) less than 1 million 1–1.9 million 2–2.9 million 3–3.9 million
Variable cost ($ per box) 2.80 3.00 3.00 3.05
Total fixed costs ($) 1 million 1.8 million 2.8 million 3.8 million

Forecast sales volumes are as follows.

Year 1 2 3 4
Demand (boxes) 0.7 million 1.6 million 2.1 million 3.0 million

The production equipment for the new confectionery line would cost $2 million and an additional initial
investment of $750,000 would be needed for working capital. Capital allowances (tax-allowable depreciation)
on a 25% reducing balance basis could be claimed on the cost of equipment. Profit tax of 30% per year will be
payable one year in arrears. A balancing allowance would be claimed in the fourth year of operation.
The average general level of inflation is expected to be 3% per year and selling price, variable costs, fixed costs
and working capital would all experience inflation of this level. BRT Co uses a nominal after-tax cost of capital
of 12% to appraise new investment projects

Required:

(A) Assuming that production only lasts for four years, calculate the net present value of investing in the
new product using a nominal terms approach and advise on its financial acceptability (work to the
nearest $1,000). (13 marks)
(B) Comment briefly on the proposal to use a four-year time horizon, and calculate and discuss a value
that could be placed on after-tax cash flows arising after the fourth year of operation, using a
perpetuity approach. Assume, for this part of the question only, that before-tax cash flows and profit
tax are constant from year five onwards, and that capital allowances and working capital can be
ignored. (5 marks)
(C) Discuss THREE ways of incorporating risk into the investment appraisal process. (7 marks)
(Total = 25 marks)

8
14 OKM

The following information was included with the draft investment appraisal:
The initial investment is $2 million
Selling price: $12/unit (current price terms), selling price inflation is 5% per year
Variable cost: $7/unit (current price terms), variable cost inflation is 4% per year
Fixed overhead costs: $500,000/year (current price terms), fixed cost inflation is 6% per year
$200,000/year of the fixed costs are development costs that have already been incurred and are being
recovered by an annual charge to the project
Investment financing is by a $2 million loan at a fixed interest rate of 10% per year
OKM Co can claim 25% reducing balance capital allowances on this investment and pays taxation one year in
arrears at a rate of 30% per year
The scrap value of machinery at the end of the four-year project is $250,000
The real weighted average cost of capital of OKM Co is 7% per year
The general rate of inflation is expected to be 4.7% per year

Required

(A) Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(5 marks)
(B) Prepare a revised calculation of the net present value of the proposed investment project and
comment on the project’s acceptability. (12 marks)
(C) Discuss the problems faced when undertaking investment appraisal in the following areas and
comment on how these problems can be overcome:
1. assets with replacement cycles of different lengths;
2. an investment project has several internal rates of return;
3. the business risk of an investment project is significantly different from the business risk of current
operations. (8 marks)
(Total = 25 marks)

9
 SECTION – 2 COST OF CAPITAL

15 AMH CO

10
16 IML CO
IML Co is an all equity financed listed company. It develops customised software for clients which are mainly large
civil engineering companies. Nearly all its shares are held by financial institutions.
IML Co's chairman has been dissatisfied with the company's performance for some time. Some directors were
also concerned about the way in which the company is perceived by financial markets. In response, the
company recently appointed a new finance director who advocated using the capital asset pricing model as a
means of evaluating risk and interpretingthestockmarket's reaction tothecompany.
Thefollowinginitialinformation was putforward by thefinance director fortworival companies operating in the
same industry:
Equity Beta
AZT Co 0.7
BOR Co 1.4
The finance director notes that the risk-free rate is 5% each year and the expected rate of return on the market
portfolio is 15% each year.
The chairman set out his concerns at a meeting of the board of directors: 'I fail to understand these calculations.
AZT Co operates largely in overseas markets with all the risk which that involves, yet you seem to be arguing that it
is a lower risk company than BOR Co, whose income is mainly derived from long-term contracts in our domestic
building industry. I am very concerned that we can take too much notice of the stock market. Take last year for
instance, we had to announce a loss and the share price went up.'

Required

(A) Calculate, usingthecapital asset pricingmodel, therequired rate ofreturn on equity of:
I. AZT Co
II. BOR Co (4 marks)
(B) Calculate the equity beta of IML Co, assuming its required annual rate of return on equity is 17% and
the stock market uses the capital asset pricing model to calculate the equity beta, and explain the
significance of
the beta factor. (5 marks)
(C) Explain the assumptions and limitations of the capital asset pricing model. (6 marks)
(Total = 15 marks)

17 DROXFOL
Current financial information on Droxfol Co is as follows.
Statement of profit or loss information for the last year
$000
Profit before interest and tax 7,000
Interest (500)
Profit before tax 6,500
Tax (1,950)
Profit for the period 4,550

Statement of financial position for the last year $000 $000

Non-current assets 20,000
Current assets 20,000
Total assets 40,000
Equity and liabilities
Ordinary shares, nominal value $1 5,000
Retained earnings 22,500
Total equity 27,500
10% loan notes 5,000
9% preference shares, nominal value $1 2,500
Total non-current liabilities 7,500
Current liabilities 5,000
Total equity and liabilities 40,000

11
 The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per
share has just been paid and dividends are expected to increase by 4% per year for the
foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are
secured on the existing non-current assets of Droxfol Co and are redeemable at nominal
value in eight years’ time. They have a current ex interest market price of $105 per $100
loan note. Droxfol Co pays tax on profits at an annual rate of 30%.
Required

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)
(b) Discuss whether financial management theory suggests that Droxfol Co can reduce
its weighted average cost of capital to a minimum level. (6 marks)

(Total = 15 marks)
18 BURSE CO

Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the
company at the current time:
Number ofordinary shares20 million
Book value of 7% convertible debt $29 million
Book value of 8% bank loan $2 million
Market price of ordinary shares $5.50 pershare
Marketvalue ofconvertibledebt $107.11 per $100 bond
Equity beta of Burse Co 1.2
Risk-free rate of return 4.7%
Equity risk premium 6.5%
Rate of taxation 30%
Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be
redeemed at nominal value in eight years’ time, or converted in six years’ time into 15 shares of Burse Co per $100
bond.

Required

Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions that
you make. (10 marks)

12
 SECTION – 3 SOURCES OF FINANCE

19 AQR

The finance director of AQR Co has heard that the market value of the company will increase if
the weighted average cost of capital of the company is decreased. The company, which is
listed on a stock exchange, has 100 million shares in issue and the current ex div ordinary
share price is $2.50 per share. AQR Co also has in issue bonds with a book value of $60 million
and their current ex interest market price is $104 per $100 bond. The current after-tax cost of
debt of AQR Co is 7% and the tax rate is 30%.
The recent dividends per share of the company are as follows.
Year 20X0 20X1 20X2 20X3 20X4
Dividend per share (cents) 19.38 20.20 20.41 21.02 21.80
The finance director proposes to decrease the weighted average cost of capital of AQR Co, and
hence increase its market value, by issuing $40 million of bonds at their nominal value of $100
per bond. These bonds would pay annual interest of 8% before tax and would be redeemed at
a 5% premium to par after 10 years.
Required

(a) Calculate the market value after-tax weighted average costofcapitalof

AQR Co in the following circumstances:
(i) before the new issue of bonds takes place;
(ii) after the new issue of bonds takes place.
Comment on your findings. (10 marks)

(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks)
(Total = 15 marks)

13
 20 DD CO

Required

(a) Calculate the cost of debt of Bond A. (3 marks)

(b) Discuss the reasons why different bonds of the same company might have different costs of debt.
(6 marks)
(c) Discuss whether a change in dividend policy will affect the share price of DD Co. (6 marks)
(Total = 15 marks)
21 BKB CO
The statement of financial position of BKB Co provides the following ation:
information:
$m $m
Equity finance
Ordinary shares ($1 nominal value) 25
Reserves 15 40
Non-current liabilities
7% Convertible bonds ($100 nominal value) 20
5% Preference shares ($1 nominal value) 10 30
Current liabilities
Trade payables 10
Overdraft 15 25
Total liabilities 95

14
BKB Co has an equity beta of 1.2 and the ex-dividend market value of the company’s equity is $125 million. The
ex- interest market value of the convertible bonds is $21 million and the ex-dividend market value of the
preference shares is $6.25 million.
The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date and
redemption date are both on the same date in five years’ time. The current ordinary share price of BKB Co is
expected toincreaseby 4% peryear fortheforeseeable future.
The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in the
near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft
interest rate was 4% per year. The company’s bank will not allow the overdraft to increase from its current level.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an
annual rate of 30% per year.

Required

(a) Calculate the market value after-tax weighted average cost of capital of BKB Co, explaining clearly any
assumptions you make. (11 marks)
(b) Discuss why market value weighted average cost of capital is preferred to book value weighted average
cost of capital when making investment decisions. (4 marks) (Total = 15 marks)

22 ECHO BEACH

The following financial information relates to Echo Beach Co:

Statement of profit or loss information for the last year

$m
Profit before interest and tax 12
Interest 3
Profit before tax 9
Income tax expense 3
Profit for the period 6
Dividends 2
Retained profit for the period 4
Statement of financial position information as at the end of the last year

$m $m
Ordinary shares, nominal value 50c 5
Retained earnings 15
Total equity 20
8% loan notes, redeemable in three years’ time 30
Total equity and non-current liabilities 50
Average data on companies similar to Echo Beach Co:
Interest coverage ratio 8 times
Long-term debt/equity (book value basis) 80%
The board of Echo Beach Co is considering a proposal made by its finance director.
Proposal
A 1 for 4 rights issue should be made at a 20% discount to the current share price of $2.30 per share in order to
reduce gearing and the financial risk of the company.

Required
(A) Calculate thetheoretical ex rightspricepershare and the amount of finance that would beraised under
the proposal.
Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk. (8 marks)
(B) Discuss the attractions of operating leasing as a source of finance. (7 marks) (Total = 15 marks)

15
23 TERWIN

Tirwen Co is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15%
discount to the current market price of $4.00 per share. Issue costs are expected to be $220,000 and these costs
will be paid out of the funds raised. It is proposed that the rights issue funds raised will be used to redeem some
of the existing loan stock at nominal value. Financial information relating to Tirwen Co is as follows:
Current statement of financial position
$'000 $'00
Non-current assets 0
Current
assets 2,000
Receivables 1,500
Cash 300
3,800
Total assets 10,350
Ordinary shares (nominal value 50c) 2,000
Reserves 1,500
12% loan notes 4,500
2X12 Current
liabilities 1,100
Overdraft 1,250
2,350
Total equity and liabilities 10,350

Other information:
Price/earnings ratio of Tirwen Co: 15.24
Overdraft interest rate: 7%
Tax rate: 30%
Sector averages: debt/equity ratio (book value): 100%
interest cover: 6 times
Required

(A) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:
I. thetheoretical ex rightspricepershare;
II. the value of rights per existing share. (3 marks)

(B) What alternative actions are open to the owner of 1,000 shares in Tirwen Co as
regards the rights issue? Determine the effect of each of these actions on the wealth of
the investor. (6 marks)

(C) Calculate the current earnings per share and the revised earnings per share if the rights
issue funds are used to redeem some of the existing loan notes. (6 marks) (Total =
15 marks)

16
24 Li CO

The following is an extract from the statement of financial position of Li Co at 31 December 20X9.
$'000 5,200
Ordinary shares of 50c each
Reserves 4,850
9% preference shares of $1 each 4,500
14% loan notes 5,000
Total long-term funds 19,550
The ordinary shares are quoted at 80c. Assume the market estimate of the next ordinary dividend is 4c, growing
thereafter at 12% per annum indefinitely. Thepreferenceshares which are irredeemable are quotedat 72c and the
loan notes are quoted at nominal value. Tax on profits is 33%.

Required
(A) Use the relevant data above to calculate the company's weighted average cost of capital (WACC), ie
the return required by the providers of the three types of capital, using the respective market values
as weighting factors. (5 marks)
(B) Assume that the loan notes have recently been issued specifically to fund the company's expansion
programme under which a number of projects are being considered. It has been suggested at a
project appraisal meetingthat becausetheseprojects are tobefinanced by theloan notes, thecutoffrate
forproject acceptance should be the after-tax interest rate on the loan notes rather than the WACC.
Discuss this suggestion. (5 marks) (Total = 10 marks)

25 BAR CO
Bar Co is a stock exchange listed company that is concerned by its current level of debt
finance. It plans to make a rights issue and to use the funds raised to pay off some of its debt.
The rights issue will be at a 20% discount to its current ex-dividend share price of $7.50 per
share and Bar Co plans to raise $90 million. Bar Co believes that paying off some of its debt
will not affect its price/earnings ratio, which is expected to remain constant.
Statement of profit or loss information
$m
Turnover 472
Cost of sales 423
Profit before interest and tax 49
Interest 10
Profit before tax 39
Tax 12
Profit after tax 27

Statement of financial position information

$m
Equity
Ordinary shares ($1 nominal) 60
80
140
Long-term liabilities
8% bonds ($100 nominal) 125
265
The 8% bonds are currently trading at $112.50 per $100 bond and bondholders have agreed
that they will allow Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate
of 30% per year

17
Required

(a) Calculate the theoretical ex rights price per share of Bar Co following the rights issue. (3 marks)
(b) Calculate and discuss whether using the cash raised by the rights issue to buy back
bonds is likely to be financially acceptable to the shareholders of Bar Co,
commenting in your answer on the belief that the current price/earnings ratio will
remain constant. (7 marks)
(Total = 10 marks)

18
 SECTION – 4 RATIOS

26 YGV

19
27 TFR

20
28 ARWIN

21
 SECTION – 5 BUSINESS VALUATION
29 CLOSE CO

Recent financial information relating to Close Co, a stock market listed company, is as follows.
$m
Profit after tax (earnings) 66.6
Dividends 40.0

22
30 PHOBIS
Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss the
significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong
form efficient. (10 marks)

31 PHOBIS (2)
Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time.
Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The current
ordinary share price of Phobis Co is $4.45 and this is expected to grow at a rate of 6.5% per year for the
foreseeable future. Phobis Co has a cost of debt of 7% per year.

Required
(A) Calculate the following current values for each $100 convertible bond:
I. market value;
II. floor value;
III. Conversion premium. (6 marks)

(B) Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss the
significance to a listed company if the stock market on which its shares are traded is shown to be semi strong form
efficient. (8 marks)

32 THP CO

23
33 DARTIG

24
34 KFP CO

25
35 QSX

26
36 CORHIG

27
 SECTION – 6 WORKING CAPITAL
37 EDWIN

Ewden plc is a medium-sized company producing a range of engineering products which it sells to wholesale
distributors. Recently, its sales have begun to rise rapidly following a general recovery in the economy as a whole.
However, it is concerned about its liquidity position and is contemplating ways of improving its cash flow. Ewden’s
accounts for the past two years are summarised below.

Profit and loss account for the year ended 31 December

20X2 20X3
$000 $000
Sales 12,000 16,000
Cost of sales 7,000 9,150
Operating profit 5,000 6,850
Interest 200 250
Profit before tax 4,800 6,600
Taxation (after capital allowances) 1,000 1,600
Profit after tax 3,800 5,000

28
29
38 Cash Budget

In the near future a company will purchase a manufacturing business for $315,000, this price to include goodwill
($150,000), equipment and fittings ($120,000), and stock of raw materials and finished goods ($45,000).
A delivery van will be purchased for $15,000 as soon as the business purchase is completed. The delivery van will
be paid for in the second month of operations.
The following forecasts have been made for the business following purchase:
Sales (before discounts) of the business's single product, at a mark-up of 60% on production cost will be:
Month 1 2 3 4 5 6
($000) 96 96 92 96 100 104

30
39 VELM Co

Velm Co sells stationery and office supplies on a wholesale basis and has an annual turnover of $4,000,000. The
company employs four people in its sales ledger and credit control department at an annual salary of $12,000
each. All sales are on 40 days' credit with no discount for early payment. Bad debts represent 3% of turnover
and Velm Co pays annual interest of 9% on its overdraft. The most recent accounts of the company offer the
following financial information:

Velm Co is considering offering a discount of 1% to customers paying within 14 days, which it believes will reduce
bad debts to 2.4% of turnover. The company also expects that offering a discount for early payment will reduce the
average credit period taken by its customers to 26 days. The consequent reduction in the time spent chasing
customers where payments are overdue will allow one member of the credit control team to take early
retirement. Two-thirds of customers are expected to take advantage of the discount.

Required

(a) Using the information provided, determine whether a discount for early payment of 1 per cent will lead to
an increase in profitability for Velm Co. (5marks)

(b) Discuss the relative merits of short-term and long-term debt sources for the financing of working capital.
(6 marks)

(c) Discuss the different policies that may be adopted by a company towards the financing of working capital
needs and indicate which policy has been adopted by Velm Co. (7 marks)

(d) Outline the advantages to a company of taking steps to improve its workingcapital management, giving
examples of steps that might be taken. (7 marks)

31
40 SPECIAL GIFT SUPPLIER

Special Gift Suppliers Co is a wholesale distributor of a variety of imported goods to a range of retail outlets. The
company specialises in supplying ornaments, small works of art, high value furnishing (rugs, etc) and other items
that the chief buyer for the company feels would have a market. In seeking to improve working capital
management, the financial controller has gathered the following information.
Months
Average period for which items are held in inventory 3.5
Average receivables collection period 2.5
Average payables payment period 2.0
Required

(a) Calculate Special Gift Suppliers' funding requirement for working capital measured in terms of months. (2
marks)
In looking to reduce the working capital funding requirement, the financial controller of Special Gift Suppliers is
considering factoring credit sales. The company's annual turnover is $2.5m of which 90% are credit sales. Bad
debts are typically 3% of credit sales. The offer from the factor is conditional on the following.

1. The factor will take over the sales ledger of Special Gift Suppliers completely.

2. 80% of the value of credit sales will be advanced immediately (as soon as salesare made to the customer)
to Special Gift Suppliers, the remaining 20% will be paid to the company one month later. The factor
charges 15% per annum on credit sales for advancing funds in the manner suggested. The factor is
normally able to reduce the receivables' collection period to one month.

3. The factor offers a 'no recourse' facility whereby they take on the responsibility for dealing with bad
debts.The factor is normally able to reduce bad debts to 2% ofcredit sales.

4. A charge for factoring services of 4% of credit sales will be made.

5. A one-off payment of $25,000 is payable to thefactor.

The salary of the Sales Ledger Administrator ($12,500) would be saved under the proposals and overhead costs of
the credit control department, amounting to $2,000 per annum, would have to be reallocated. Special Gift
Suppliers' cost of overdraft finance is 12% per annum. Special Gift Suppliers pays its sales force on a commission
only basis. The cost of this is 5% of credit sales and is payable immediately the sales are made.
There is no intention to alter this arrangement under the factoring proposals.

Required

(b) Evaluate the proposal to factor the sales ledger by comparing Special Gift Suppliers' existing receivable
collection costs with those that would result from using the factor (assuming that the factor can reduce
the receivables collection period to one month). (8 marks)

(c) As an adviser to Special Gift Suppliers Co, write a report to the financial controller that outlines:
(i) How a credit control department might function
(ii) The benefits of factoring
(iii) How the financing of working capital can be arranged in terms of short and long term
sources of finance
In particular, make reference to:

32
 (1) The financing of working capital or net current assets when short term sources of
finance are
exhausted
(2) The distinction between fluctuating and permanent current assets. (15 marks)
(Total = 25 marks)

41 ULNAD CO
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 turnover. 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 theprofitability 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. (6 marks)

(C) Identify and explain the key areas of accounts receivable management. (6 marks)

(D) Discuss the key factors to be considered when formulating a working capital funding policy.(7 marks)
(Total = 25 marks)

33
42 PKA
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%.

Accounts payable management

PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time.
The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to
hedge the currency risk of this account payable. The following information has been provided by the company’s
bank:

Spot rate (per €1): $1.998 ± 0.002

Six months forward rate (per €1): $1.979 ± 0.004
Money market rates available to PKA Co:
Borrowing Deposit
One year euro interest rates: 6.1% 5.4%
One year dollar interest rates: 4.0% 3.5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

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. (7 marks)
(C) Discuss ways in which PKA Co could improve the management ofdomestic accounts receivable. (7 marks)
(D) Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to
hedge the foreign account payable. (8 marks) (Total = 25 marks)

34
43 FLG CO

(ii) Determine whether accepting the discount offered by the supplier will minimise the total
cost of inventory for the raw material. (3 marks) (Total = 25 marks)

35
44 HRG CO

Required:

(a) Discuss the working capital financing strategy of HGR Co. (7 marks)

(b) For HGR Co, calculate:

1. the bank balance in three months’ time if no action is taken; and
2. the bank balance in three months’ time if the finance director’s proposals are implemented.
Comment on the forecast cash flow position of HGR Co and recommend a suitable course of action.(10 marks)

(c) Discuss how risks arising from granting credit to foreign customers can be managed and reduced.
(8 marks)

36
45 APX Co

APX Co achieved a turnover of $16 million in the year that has just ended and expects turnover 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:

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
Bank loan interest 8%
Tax rate 30%

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.

Required
(a) Discuss the role of financial intermediaries in providing short-term finance for use by business
organizations. (4 marks)

(b) Prepare the following forecast financial statements for APX Co using the information provided:

(i) An income statement for the next year; and

(ii) A statement of financial position at the end of the next year. (9 marks)

37
 (c) Analyse and discuss the working capital financing policy of APX Co. (6 marks)

(d) Analyse and discuss the forecast financial performance of APX Co in terms of working capital
management.(6 marks)

(Total = 25 marks)

46 WQZ

WQZ Co is considering making the following changes in the area of working capital management:

Inventory management
It has been suggested that the order size for Product KN5 should be determined using the economic order
quantity model (EOQ).
WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionally
ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding
cost is expected to be $5.12 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be
maintained, whether orders are made by the traditional method or using the economic ordering quantity model.

Receivables management
WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the
same time, through improved operational procedures, maintain a maximum average payment period of 60 days
for credit customers who do not take the discount. It is expected that 25% of credit customers will take the
discountif it were offered.
It is expected that administration and operating cost savings of $753,000 per year will be made after
improving operational procedures and introducing the early settlement discount.

Credit sales of WQZ Co are currently $87.6 million per year and trade receivables are currently $18 million. Credit
sales are not expected to change as a result of the changes in receivables management. The company has a cost
of short-term finance of 5.5% per year.

Required:
(a) Calculate the cost of the current ordering policy and the change in the costs of inventory management
that will arise if the economic order quantity is used to determine the optimum order size for Product
KN5. (6 marks)

(b) Briefly describe the benefits of a just-in-time (JIT) procurement policy. (5marks)

(c) Calculate and comment on whether the proposed changes in receivables management will be acceptable.
Assuming that only 25% of customers take the early settlement discount, what is the maximum early
settlement discount that could be offered? (6 marks)

(d) Discuss the factors that should be considered in formulating working capital policy on the management of
trade receivables. (8 marks)
(Total = 25 marks)

38
47 PLOT CO

Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the year.

Product P
The annual demand for Product P is 300,000 units and an order for new inventory is placed each month. Each
order costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year. Buffer inventory
equal to 40% of one month’s sales is maintained.

Product Q
The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on 60
days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days.

Other information
Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365 days in
each year.

Required:

(a) Calculate the following values for Product P:

1. The total cost of the current ordering policy; (3 marks)
2. The total cost of an ordering policy using the economic order quantity; (3 marks)
3. The net cost or saving of introducing an ordering policy using the economic order quantity. (1 mark)

(b) Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q.
(5 marks)
(c) Discuss how invoice discounting and factoring can aid the management of trade receivables. (6 marks)
(d) Identify the objectives of working capital management and discuss the central role of working capital
Management in financial management. (7 marks)
(25 marks)

39
48 PNP CO

40
ANSWERS
1. CORTER

41
2. Calvic

42
43
3. Capital rationing

44
4. Rainbow

45
5. Chromex

46
47
6. Trecor

48
49
7. Duo CO

50
51
52
8. SC CO

53
54
55
9. PV CO

56
57
58
59
10. Basril

60
11. ZSC Co – To be attempted in class.

61
12. ASOP

62
63
13. BRT

64
14 OKM

65
66
Section – 2 COST OF CAPITAL

15. AMH Co

67
68
16. IML Co

69
70
17. Droxfol

71
72
18. Burse Co

73
Section – 3 Sources of Finance

19. AQR

74
75
20. DD Co

76
77
21. BKB CO

78
79
22. Echo Beach

80
81
23. TERWIN

82
24. LI CO

83
25. BAR CO

84
SECTION – 4 RATIOS

26. YGV CO

85
27. TFR

86
28. ARWIN

87
88
SECTION – 5 BUSINESS VALUATION

29. CLOSE CO

89
30. PHOBIS

90
31. PHOBIS (2)

91
92
93
32. THP

94
95
96
33. DARTIG

97
98
99
34. KFP CO

100
101
102
35. QSX – To be attempted in class!

36. CORHIG

103
SECTION – 6 WORKING CAPITAL

37. Edwen – To be attempted in class.

38. CASH BUDGET – To be attempted in class.

39. Velm co

104
105
40. SPECIAL GIFT SUPPLIER

106
107
108
41. ULNAD

109
110
42. PKA

111
112
113
43. FLG

114
115
116
44. HRG CO

117
118
119
45. APX CO

120
46. WQZ

120
47. PLOT CO – To be attempted in class.

48. PNP CO – To be attempted in class.

121