F3 Financial Strategy. Examiner s Answers

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1 F3 Financial Strategy September 2012 examination Examiner s Answers Question One Rationale This question begins by testing candidates ability to evaluate the working capital requirements of a retail operation and the possible implications of adopting an aggressive strategy for the management of working capital. It then moves on to require an investment appraisal of the proposed retail development on a discounted cash flow basis, incorporating changing working capital requirements and considering sensitivities to changes in key variables and the additional risks of setting up a new business in a foreign country. Question One examines syllabus sections A2 (c), B1(a) and (e), C1(a) and (b). Financial Strategy 1 September 2012

2 Suggested Approach The first requirement requires description of two possible reasons (other than the use of an aggressive strategy for the management of working capital) for differences between the working capital days of the proposed project and B as a whole. Answers should specifically focus on issues such as the difference in maximum payment terms due to the different locations and the differences in the nature of the products sold by B as a whole and by the project. The second requirement then takes this further and asks for discussion on the benefits and drawbacks of an aggressive strategy for the management of working capital. Answers here should focus on the management of working capital rather than the financing of working capital. The third element of the requirement asks for the calculation of forecast accounts payable and inventory balances for the four years of the project. This should be set out in Excel with both calculations using purchases as a base (as requested in the question). The next element requires the calculation of the net present value (NPV) for the proposed project. Candidates should schedule out the relevant cash flows within Excel, convert the cash flows at an appropriate exchange rate and then discount them at a cost of capital of 11%. Particular care needs to be taken in quantifying the tax related cash flows and the working capital cash flows required (which should show the opening and closing balances at the beginning and end of the project with only the movement adjusted during the project). Finally the question requires advice as to whether to proceed with the project paying particular attention to three specific areas. Candidates should ensure that all three areas identified in the requirement are covered in their answer. Examiner s note: Answers provided throughout are direct extracts from EXCEL spreadsheets and so rounding differences will arise when compared to the results obtained using a calculator (a) Briefing paper To: The main board of B From: Mr X, Project team for USA convenience store project Date: 1 September 2012 Investment appraisal as at 1 September 2012 Purpose: To provide a progress report and initial investment appraisal for the above project and an initial assessment on whether or not to proceed. Working capital strategy (a)(i) USA stores B group Difference Accounts receivables Nil Nil Nil Accounts payable 100 days 139 days - 39 days Inventory 30 days 53 days - 23 days September Financial Strategy

3 The US convenience stores are likely to carry a different profile of goods than the average store operated by the B group. In particular: (a)(ii) Inventory in the convenience stores will include a greater predominance of fresh foods, which are perishable and therefore require a fast turnover. Inventory days for the convenience stores can therefore be expected to be lower than the average figure for the B group - where a wider range of both perishable and non-perishable products are held in inventory. The most likely explanation for the lower accounts payable days estimate for the US stores is that US suppliers are able to demand more favourable payment terms than B is used to being able to negotiate elsewhere. Shorter credit periods may also reflect the higher service level required in order to maintain inventory levels at all times in convenience stores. An aggressive strategy with regard to the management of working capital levels will mean that inventory will be kept to a minimum and accounts payable maximised to the extent that the particular market will accept (NB: it is presumed for the purposes of this analysis that 100 days is the maximum credit available in the US). The US convenience stores are not expected to have any accounts receivable, so we do not need to consider the benefits and potential drawbacks of an aggressive strategy for managing accounts receivable. Benefits of an aggressive strategy: Cash flow advantages arising from having low investments in inventory in the first place and from paying suppliers as late as possible. This has the benefit of reducing the level of finance needed to support the working capital investment which then leads to lower borrowing costs. Reduced costs of holding inventory, although this might be mitigated by additional delivery costs. Potential drawbacks of an aggressive strategy: Higher risk of stock outs from holding low levels of inventory leading to customer dissatisfaction and possible loss of customers both in the short term and the longer term. Dissatisfied suppliers facing payment delays - leading to a higher risk of loss of supply or lowering of quality, especially in times of shortages. Attempts by suppliers to charge higher prices in order to compensate for later payment. (a)(iii) Working capital values Year Base data USD '000 USD '000 USD '000 USD '000 USD '000 Purchases, growth: 12% 35, , , , Accts payable 100 days (9,589.04) (10,739.73) (12,028.49) (13,471.91) Inventory 30 days 2, , , , Net balance (for (b)(i)) (6,712.33) (7,517.81) (8,419.95) (9,430.34) 0.00 Movement (for (b)(i)) (6,712.33) (805.48) (902.14) (1,010.39) 9, Financial Strategy 3 September 2012

4 (b)(i) Investment Workings: tax depreciation Year Base data USD '000 USD '000 USD '000 USD '000 USD '000 Capex and b/f balance 10,000 10, , , , , Tax depreciation 25% (2,500.00) (1,875.00) (1,406.25) (218.75) C/f balance 4,000 7, , , , Tax relief at 33% DCF calculations Year Base data USD '000 USD '000 USD '000 USD '000 USD '000 Buy properties 30,000 (30,000.00) Residual value of properties 36,000 36, Refit (10,000.00) 4, Tax depreciation relief Subtotal (40,000.00) , Net operating cash, growing at 12% 15, , , , Tax at 33% (4,950.00) (5,544.00) (6,209.28) (6,954.39) Working capital movement (a)(iii) 6, , (9,430.34) Total in USD '000 (33,287.67) 11, , , , Exchange rate EUR/USD EUR '000 EUR '000 EUR '000 EUR '000 EUR '000 Total in EUR '000 (30,261.52) 10, , , , NPV at 11% in EUR '000 (using EXCEL NPV function) 21,850 September Financial Strategy

5 (b)(ii) Change in NPV resulting from change in final property value The cash flow in respect of the value of the properties at time 4 would change from USD 36 million to USD 24 million (ie: USD 30 million x 80%) a difference of USD 12 million Incremental approach: Reduce NPV by USD 12million/ x = EUR 6,657,000 Giving a revised NPV value of EUR 15,193,000 (= EUR 21,850,000 - EUR 6,657,000) As this exam is being sat on PC, we demonstrate below an alternative approach that can be achieved simply using EXCEL by saving a 2 nd copy of the EXCEL sheet and then changing a single cell representing the residual value of the properties. This gives a slightly different result due to rounding differences. Year Base data USD '000 USD '000 USD '000 USD '000 USD '000 Buy properties 30,000 (30,000.00) Residual value of properties 24,000 24, Refit (10,000.00) 4, Tax depreciation relief Subtotal (40,000.00) , Net operating cash growing at 12% 15, , , , Tax at 33% (4,950.00) (5,544.00) (6,209.28) (6,954.39) Working capital movement (see (a)(iii)) 6, , (9,430.34) Total in USD '000 (33,287.67) 11, , , Exchange rate EUR/USD Total in EUR '000 (30,261.52) 10, , , , NPV at 11% in EUR '000 15,196 Financial Strategy 5 September 2012

6 (c) Financial implications The project is expected to generate a significant return with a net present value of EUR 21,850,000. Purely on this basis the project to set up 50 new convenience stores in the USA should be undertaken. However, the DCF results depend heavily on the reliability of the input variables, as is demonstrated by the results of the sensitivity analysis in (b)(ii). Just by changing the assumption relating to the value of the properties on 31 December 2016 from a 20% increase to a 20% decrease, the NPV would fall by EUR 6,657,000 to EUR 15,193,000 (using the result obtained from the incremental approach), a fall of 30%. Given that property prices are volatile and past experience shows that values can fall significantly, then it could be argued that an evaluation based on a 20% drop in value would be more prudent for decision making purposes. Other input variables that may prove to be unreliable estimates include: The Growth rate (which appears to be highly optimistic at 12%, although this is, presumably, a money rate, including any inflationary expectations, but may well be unsustainable at that level). Revenue (which depends heavily on having the correct business model to meet customer preferences). Costs (which depend on correct estimates of required staffing levels and salary costs). Exchange rates (see below). The cost of capital used of 11% is the rate applicable to B as a whole and may not be appropriate for this investment, especially as the project is overseas. It would also be more prudent to assume that annual working capital investment/cash release occurs at the end rather than at the beginning of each year since cash is released from working capital rather than absorbed in each financial year until the final year. Expanding in a foreign country carries additional risks in terms of the following (key issues only listed below but these would be expected to be developed in a candidate s answer): Foreign exchange risk Understanding customer preferences especially given that this is a different type of store than previously operated in the USA. Local regulatory environment including taxation and reporting, plus health and safety etc. Managing the business and the people from a distance and/or relocating UK staff to help set up and manage the business, at least at the start. Adapting the culture of the business to fit with B s culture while being sensitive to local differences in culture that need to be retained and working within these. Local resistance from customers to foreign ownership. Communication difficulties across different time zones. Understanding the demands of government and any steps required to avoid government intervention. Integrating different systems. Conducting business in a different business environment understanding local protocol and business practices. Financial management in a different environment (eg working round the absence of credit interest on bank accounts in the US). September Financial Strategy

7 Foreign exchange risks may be significant. The investment appraisal has been based on forecast exchange rates derived from the interest rate differential. These are likely to be highly unreliable predictors of future exchange rates. The outturn result could therefore differ significantly from that shown. This may not be a problem, however, if, as is likely, shareholders have invested in B group with full knowledge of its major exposure to the US and, indeed, many other regions of the world. Investors may have deliberately chosen to invest in B group in order to obtain exposure to a diverse range of currencies and expect results to reflect exchange rate movements in the year. Conclusion On basis of this analysis, the project appears to be worthwhile pursuing on a trial basis. The greatest risk to success is probably the business plan itself in terms of whether the convenience store concept will be successful in the USA. Opening a few stores may be the only way of confirming that such stores will be welcomed and have the potential to be run on a profitable basis. Financial Strategy 7 September 2012

8 Question Two Rationale This question tests understanding of the distinction between the overall objective of for profit and not for profit organisations and how this might affect the choice of financial and nonfinancial objectives. It also tests understanding of the risks and benefits of the current trend for not for profit organisations to adopt more aggressive financial strategies that are more commonly found in for profit organisations. Question Two examines syllabus sections A1(a) and (d). Suggested Approach The first part of the question requires a simple description of the differences between the overall objectives of for profit and not for profit organisations. Answers should focus on the differences and reasons for those differences rather than just state what the objectives of such organisations are. The second part of the question asks for advice on whether the 6 specific objectives identified can be adapted for use by the charity in question. Answers here should address each objective in turn and focus on its suitability and suggest how it might be adapted. The next part of the question then asks for additional objectives that may be suitable (these should be additional objectives and not simply a repeat of previous suggestions. The last part of the question asks for advice again on the appropriateness of a charity using a bond issue to raise funds to support expansion. Answers here should make reference to the FD s comment that charities should be run on commercial grounds and should focus on the risks and the impact of a bond issue on the main beneficiaries of the charity. (a) For profit organisations are generally principally run for the benefit of the shareholders who as the owners of the organisation are major stakeholders. The overall objective is therefore likely to be the maximisation of shareholder wealth, measured in terms of returns to shareholders through dividend payments and an increasing share price. In a not for profit organisation, the overall objectives will be different because the organisation does not have shareholders and so a profit objective is not appropriate. The main purpose is normally some charitable or other non-profit objective such as improvements in the welfare of a certain part of society or the environment at home or abroad and so the key objective will be based on the benefits provided. Not for profit organisations tend to measure their objectives in terms of efficiency, economy and effectiveness rather than profit. September Financial Strategy

9 (b)(i) Financial objectives: Growth in earnings per share Clearly, a target based on earnings per share is not appropriate for an organisation such as SPORT which does not have shareholders. However, the principle of increasing revenue and decreasing costs (that underpins growth in earnings) is relevant to SPORT. The commercial activities of SPORT should operate along sound commercial lines in order to maximise the surplus that can be used to subsidise equipment. SPORT might consider adapting the earnings target and redefining it in terms of, for example: Increasing donations. Reducing costs/increasing income from stores. Growth in dividends This is a measure of the benefit derived by shareholders in a commercial context and is therefore not appropriate for SPORT. However, this could be redefined in the context of SPORT in terms of a growth in subsidies provided or, if a fixed subsidy %, a growth in value of subsidised equipment provided. Gearing target Gearing level is essentially a measure of risk and applies equally to a for profit and not for profit organisation such as SPORT. SPORT could apply the gearing target to its lease obligations and, if pursued in future, to the bond as well. Non-financial objectives To a certain extent the objectives identified could apply equally to a not for profit and for profit organisation. The customer satisfaction target could equally apply to SPORT in terms of both successful stores and appropriate special equipment supplied. The objective of retaining market position probably doesn t apply so directly to SPORT, although it is important for SPORT to maintain and grow its profile in the charity sector to ensure a continued stream of donations and support. An alternative might be to achieve the highest level of donations compared to other similar charities (although this level of competiveness might actually be against the ethos of SPORT as ultimately all charity is worthwhile). The last objective of reducing the carbon footprint is an important objective for all organisations in these times and should be encouraged. Financial Strategy 9 September 2012

10 (b)(ii) Additional objectives As with commercial organisations, SPORT will have other stakeholders such as employees, customers, suppliers and the communities in which the stores operate. As a charity, SPORT should be very aware of the social dimension of business and needs to address the requirement to take account of all stakeholders. Additional objectives that could be considered by SPORT include: Providing employees with fair salaries and treating volunteers fairly. Providing equal treatment for all employees. Providing recipients of reduced cost sports equipment with quality service and ensuring that recipients receive products which are safe and fit for purpose. Ensure a high level of service is provided to customers of the charity stores. Ensuring that goods sold in the charity stores are of high quality and meet safety regulations. Fair treatment of workers in the organisation s supply chain. Aiming to expand the range of sporting equipment supplied and/or expanding the range of recipients. (b)(iii) There is some merit in the FD s comment, certainly in terms of the commercial aspects of the organisation. The concept of what constitutes a charitable organisation needs to encompass social enterprise organisations run for social benefit, which operate on a commercial basis. There is nothing inherently wrong with trying to operate the stores at a profit and hence maximise funds available for pursuing a charity s main charitable objectives. However, a charity should not be seen to take excessive risks in order to realise profit that can be used for charitable purposes. It is not unknown for the trading arm of a charity to prove to be unprofitable and, in extreme cases, to fail and pull the charity down with it. Commercial operations need to be conducted in a professional manner there is an even higher duty of care in the use of donated funds than in the use of shareholders funds and so the Trustees need to be absolutely sure that the return on investment of the funds will more than cover the cost of servicing the bond and that sufficient investments can be realised or other provision made to ensure that there is no problem repaying the bond on maturity. Conclusion: If the trustees are confident that the proceeds from the bond can be used to successfully develop the stores and that the expansion would be successful and lead to an increase in net income without undue risk, then the bond issue and store development should be considered further. Careful risk assessment is required. For example, to determine the maximum extent of loss possible if the project proves to be unsuccessful and therefore new stores need to be closed and the bond repaid, possibly at a time when market rates are unfavourable. September Financial Strategy

11 Question Three Rationale Question Three focuses on the choice of financing between buy/borrow and leasing for an approved project to acquire a capital asset. It tests understanding that the incremental cost of leasing rather than bank borrowing can be found by discounting future cash flows under each alternative financing approach using the post-tax cost of debt. The question also tests understanding of what other factors might affect the financing decision in the context of this scenario. Question Three examines syllabus sections B1(b) and (d). Suggested Approach The first part of this question is a straightforward buy/borrow vs leasing NPV exercise. Firstly the cash flows appropriate for the borrowing option should be identified (being the purchase of the asset and its residual value at the end of the lease term, the associated tax impacts from owning the asset and the maintenance costs to be borne, net of tax). These should then be discounted at the post tax cost of debt for the company to arrive at the present value cost of the buy/borrow option. Secondly, the cash flows appropriate for the leasing option (being the lease payments and associated tax relief) should be identified and the same post tax cost of debt used to arrive at the present value of the cost of leasing. The next part of the question asks for advice on the impact of each option on the statement of financial position. The key point here is that the operating lease will in effect be off-balance sheet. Extra marks are available for candidates who indicate that they are aware of possible future changes to the accounting treatment of operating leases that are under consideration at the present time. The final part of the question asks for advice on which option to choose and should comment on the findings from the first two parts of the question as well as other relevant factors such as the certainty of cash flows, the variability of the interest rate and the position at the end of the contract period. Financial Strategy 11 September 2012

12 (a) Buy/borrow L$ million Time 4% PV Initial purchase (50.0) (50.0) Tax relief Maintenance (1.5) 1 to (12.2) Tax relief on maintenance to Residual value Tax charge on residual value (7.3) (4.7) Versus operating lease Initial lease payment saved Tax relief lost (1.9) (1.8) Subsequent lease payments saved to Tax relief lost (1.9) 2 to (14.8) PV of buy/borrow versus leasing 3.3 Showing a net benefit of buy/borrow. Workings: The DF of 4% is calculated as: Gross interest of 6.0% (= 2.5% + 3.5%) Giving cost of debt net of tax of 4.0% ( = 6.0% x (1-0.33)) (Or, more accurately, taking into account the year time delay in receiving the tax relief on interest: 4.08% = 6% - 2%/1.04, which could be rounded to 4%.) The discount factor of is calculated as = / 1.04 Or, alternatively, it is acceptable to use = or a discount factor obtained using an appropriate EXCEL function. (b) The operating lease does not have the same 'grossing up' effect on the financial statements as the buy/borrow alternative, since neither the asset value nor accrued lease payments are shown in the statement of financial position. Whereas both the value of the rolling stock and the value of matching debt will be included if the company were to buy the rolling stock outright and finance the purchase using a bank borrowing. Using an operating lease therefore has the beneficial effect on the financial statements of lower gearing and lower bank borrowings, which potentially could make it easier for LL to raise finance in the future. Note that the IASB is currently looking at bringing operating lease commitments onto a company s statement of financial position. September Financial Strategy

13 (c) From a financial point of view and based on current interest rates and estimated future values, the buy/borrowing approach appears to be slightly less expensive than the operating lease approach. However, the buy/borrow approach has the disadvantage of grossing up the statement of financial position with both the total borrowing and the value of the asset. This could be an important consideration if LL is close to breaching a borrowing covenant. Other relevant factors affecting the decision include: The risk due to the variable rate basis for the interest cost of the bank loan. The actual interest cost is therefore unknown at the beginning of the project and could change the balance of costs between the bank loan and lease. Maintenance costs are included in the lease payment and so the lease also provides certainty as to these costs whereas, under the buy/borrow approach, LL will need to retain additional liquidity (eg bank facilities) to meet any unforeseen large maintenance payments. Any follow on real option might have a major impact on the choice of approach. With the buy/borrow approach, the company already holds the asset and is in a position to carry ontrading and follow up new custom. Leasing for an additional period of time could prove to be much more costly. Under the lease, the lessor can simply remove the asset if lease payments are not made. The asset may or may not be secured against the bank loan and so the same risk may not arise. However, securing the loan against the assets is likely to reduce the cost of the bank loan. Under the buy/borrow approach, the appraisal relies heavily on the residual value of the asset and the ability of the company to sell the asset at the year end for the value expected. Overall recommendation: The operating lease approach has major advantages in terms of certainty of future cash flows and improved statement of financial position structure. However, it is slightly more expensive based on these estimated figures, although these are probably not large enough to outweigh the advantage of certainty provided by the lease. However, if there is a high probability of lucrative follow on options, this might swing the decision in favour of the bank borrowing. Financial Strategy 13 September 2012

14 Question Four Rationale Question Four tests understanding of capital rationing in the context of selecting investment projects. Candidates are required to rank projects according to each of three different evaluation measures and advise on the optimum combination. The question then moves on to consider the difference between hard and soft capital rationing and whether the decision would have been different if soft rather than hard capital rationing had been applied. Question Four examines syllabus sections A1(c) and C1(d). Suggested Approach In answering the first part of this question, candidates should firstly calculate the payback period and profitability index for each of the 4 projects and then rank the projects on each of the bases requested. The second part of the question then requires an explanation of the strengths and weaknesses of each of these prioritisation methods in the situation of capital rationing with nondivisible projects. Answers here should focus on capital rationing rather than just discussing the overall strengths and weaknesses of each method. The third part of the question asks for the optimum combination of projects in this situation of non-divisible projects. A trial and error approach of different combinations of projects should be used selecting the combination with the highest overall NPV. The final element of the question asks for explanation of how the optimal combination might be impacted if soft capital rationing applied and if capital rationing applied in future years. In terms of the soft capital rationing candidates should identify that potentially all projects could be undertaken if the funds could be found because they are all worthwhile. Other possible combinations of projects and the additional amount of funding needed should be identified and commented upon. In the future capital rationing situation candidates should identify that the payback of projects becomes more important, although without more sophisticated techniques assessing which projects to choose would be difficult. (a)(i) Base data workings (all figures are in F$ million) Project Year 0 PV of cash flows Year 1+ NPV PI Annual cash flows Term (Years) Payback (Years) A % B % C % D % Ranking of individual projects according to: Project NPV PI Payback A (4) (4) (1) B (3) (1) (3) September Financial Strategy

15 C (2) (3) (2) D (1) (2) (4) (a)(ii) NPV gives an indication of the increase in shareholders funds as a result of investing in each project. However, if capital is limited, it is also important to look at how much of the limited capital resource is required by each project when deciding which projects to invest in. The profitability index is most appropriate when choosing between projects that are divisible but is less reliable when projects are non-divisible. However, it can also be helpful when ranking nondivisible projects. Indeed, it often indicates the optimum combination and, if not, a combination of projects that is very close to the optimum combination. However, in this case it has not identified the optimal combination of projects and, indeed, the simpler approach of ranking by NPV result has produced a better result. Payback places a greater emphasis on the timing of the cash flows. It therefore gives project A the highest priority because the initial investment is paid back within the year. This is very useful information for multi-period scenario situations as it indicates that the funds can be reinvested in new projects in the following year. If there are even more lucrative projects planned next year, this could be an important advantage. However, this is not so useful if we are only concerned with immediate capital restrictions in the current year. Uncertainty as to the realisation of cash flows generally increases with time, so the payback can also give a helpful indication of the riskiness of the project. A project with a low payback will often carry lower risk and therefore be more attractive. However, all three methods have major drawbacks in practice. In the majority of cases, a capital rationing decision is much more complicated than purely the choice of projects indicated by such measures as NPV, PI or payback. For example: If capital rationing applies in the current year, it will almost certainly also apply in subsequent years. A multi-period model is therefore required. The projects are unlikely to have the same other characteristics. For example, some may provide follow on opportunities and others may be of more strategic significance than others. Some projects may be once only opportunities and need to be pursued in the current year whereas it may be possible to delay others to the following year. In conclusion, none of the three methods listed is likely to provide the best solution in isolation. Each contributes some useful information that can be used in the decision making process, but each only provides part of the picture. Financial Strategy 15 September 2012

16 (b)(i) Combination of projects based on rankings of individual projects and subject to $700m initial investment Combination F$ million Initial investment F$ million NPV F$ million NPV D C PI B D Payback A C B BEST A B D Conclusion: The optimal combination is provided by projects A, B and D. This leaves F$ 100 million unspent. (b)(ii) Soft versus hard capital rationing Soft capital rationing is where the restriction is internally imposed by the company for budgetary purposes and, for example, to allocate capital investment provision between different operating units. The limits are targets only and can be adjusted according to circumstances. Hard capital rationing is where the restriction cannot be moved where, for example, capital is limited by covenant restrictions on borrowings. If WIDGET were to apply soft capital rationing, it is likely to prefer to undertake the projects with the highest PIs if it were possible to increase the limit on the total value of the initial investment from F$700 million to F$800 million. That is, carry out projects B, C and D at a total initial investment of F$800 million and a much higher NPV of F$370 million. This compares to an NPV of F$295 million in part (b)(i). The NPV has increased by F$75 million (F$ 370million F$295million), an increase of 25%, as a result of increasing the capital investment by just 14% (F$100million/F$700million). Indeed, it would be of benefit to shareholders to undertake all 4 projects if there funding is available to cover all 4. Capital rationing in the following year The optimal combination of projects is likely to be quite different when assumptions are added regarding capital rationing in the following year. Indeed, Project A becomes much more attractive since it provides a payback of less than one year and so the capital is available for re-investment again in the second year. Assuming that this amount can be added to the F$700 million new capital available in a year s time, this would greatly enhance WIDGET s investment capability at that time. Where multi-period capital rationing is involved, an alternative technique such as linear programming is required. However, this is outside the scope of the F3 syllabus. September Financial Strategy