The Examiner's Answers. Financial Strategy 1

Transcription

1 The Examiner's Answers F3 - Financial Strategy Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike. SECTION A Answer to Question One (a) See Appendix A The on-site car parking business has made a positive impact on the forecast results for Without this business: Forecast net operating loss for 2011 would increase from D$ 2.1 million to D$ 2.9 million see A.1. Operating profit before charging depreciation would decline from D$ 2.9 million to D$ 1.9 million (that is, a reduction of 34%) see A.2. Assuming that cash flows are reflected by operating profit before depreciation, the on-site car parking business generates one third of the cash flows from operations from just 15% of the revenues. Conclusion This analysis shows the importance of the on-site car parking business to DEF as a whole, both in terms of profitability and cash generation. (b) See Appendix B The present value of the net cash flows generated by DEF s car parking business is estimated to be: D$ 0.74 million assuming no investment is made - see B.1 D$ 1.46 million assuming the proposed upgrade is made by DEF see B.2 Financial Strategy 1

2 REPORT To: The Board of Directors From: Mr X, Financial Controller Date: 4 REPORT ON THE PROPOSED DEVELOPMENT OF THE ON-SITE CAR PARKING BUSINESS PURPOSE The purpose of this report is to present the results of an evaluation of the two proposed schemes for operating the on-site car parking facilities. This will include: Advice on whether to proceed with the proposed investment in on-site car parking facilities. (c) A comparison of the alternative Schemes A and B. Advice on an appropriate annual lease payment by ABC under Scheme B and on whether or not to adopt Scheme B in preference to Scheme A. Advise whether or not to proceed with the proposed investment The investment in the car parking business is expected to result in an increase in shareholder value of D$ 0.72 million, being the difference in the value of the business in the calculations in B.1 and B.2 in Appendix B, when measured over a 10 year period. In practice, the benefit is likely to continue beyond the 10 year period and so be considerably higher. The car parking business is also a major contributor to the overall profits of the business (see Appendix A). Without the car parking business, the net operating loss would have increased from D$ 2.1million to D$ 2.9million. Other benefits arising directly from the investment include enhancing the attractiveness of the airport for passengers wishing to use on-site car parking facilities. In conclusion, there is a clear case for proceeding with the proposed investment in on-site car parking facilities as the project has a significant positive NPV and therefore would be expected to increase shareholder value. (d)(i) Advice on an appropriate annual lease payment by ABC under Scheme B and whether or not to adopt Scheme B rather than Scheme A Annual lease payment under Scheme B A maximum annual payment can be calculated from the perceived value of the cash stream to ABC of the car parking business. The value of the cash stream is D$ 4.39 million after tax (being D$ 1.46 million plus the after tax cost of the investment of D$ 2.93 million, where D$ 2.93 million is D$ 4 million less D$ 1.2 million x 0.893). D$ 4.39 million is equivalent to approximately D$ 6.27 million before tax (where D$ 6.27 million = D$ 4.39 million / 0.7). 2 Financial Strategy

3 D$ 6.27 million can then be converted to an annual annuity at a discount rate of 12% over 10 years. That is, an annual payment of D$ 1.1 million (where D$1.1 million = D$ 6.27 million/5.650). Note that this is the maximum payment and does not provide compensation to ABC for the risks that it is acquiring,nor enables ABC to make a profit on the deal. (d)(ii) Compare and contrast Schemes A and B with reference to DEF s financial and strategic objectives. Financial objectives DEF has the following three financial objectives: 1. The airport should not run at a loss. 2. All creditors are paid on time. 3. Gearing levels must not exceed 20%. Objective 1 Scheme A Only under Scheme A are annual profits from the car parking business retained in full by DEF. The payment received from ABC is likely to be lower than the profit that could be generated by DEF managing the business directly. Scheme B Income generated under Scheme B will inevitably be lower than the profit that would have been generated by the car parking business had it been retained. The annual payment will need to be low enough to enable ABC to make a profit from the deal and also to provide it with compensation for the risks that it is taking on. One major advantage to DEF is, indeed, the lower risk associated with Scheme B. Profits generated under Scheme A are less reliable, whilst the revenues from Scheme B will be known with certainty. Objective 2 There should be little impact here and no difference between the two proposed schemes. Objective 3 Current gearing, based on book values, is D$ million 22.7/( ) = 14.8% If Scheme A were implemented and additional funds of D$ 4 million borrowed to fund the upgrade, gearing levels would be expected to rise to 17.0%. (where 17.0% = ( )/( ) x 100%) This is getting dangerously close to the maximum level of 20%. Under Scheme B, it may be possible to capitalise the contracted payments and so the increase in assets would help to lower gearing to compensate for the additional debt. Strategic objectives The strategic objectives of DEF include: 1. To create a planning framework which enables DEF Airport to meet the demands of the forecast passenger numbers. 4. To improve land based access to the airport. 6. Maintain/increase employment opportunities for people living close to the airport. Financial Strategy 3

4 The greatest degree of flexibility to fulfil those objectives is provided by Scheme A as the car parking business remains wholly under DEF s control. Under Scheme B, the car parking facilities will still be upgraded and this will still be organised by DEF, so quality of the facilities themselves should be identical under both schemes. Differences may arise in the way the car parks are managed over the 10 year period. ABC may not agree to employ local staff or redeploy the current workforce and so Scheme B could be detrimental to the achievement of objective 6. There is also a risk that ABC might underinvest in the staffing and maintenance of the car parking facilities. Standards of service need to be fully documented in a service agreement but it would be difficult to ensure that this agreement allows sufficient flexibility to meet changing passenger demands. Real options Scheme A provides the greatest range of real options, including: Delay development until the company is in a better position to secure funding. Abandon plans to upgrade the facilities and adopt an alternative business strategy such as lowering car park fees instead to encourage more customers. Follow on with a subsequent change of use or further redevelopment of the car parking business. Under Scheme B, some of this flexibility is removed, namely the delay and abandon options. However, Scheme B still protects the follow on option as it gives DEF the opportunity to take back the management of the car parking at the end of the 10 year period. This is a valuable option, giving DEF the ability to be able to change the use of the land or the nature of the business after 10 years. Advice on whether or not to adopt Scheme B rather than Scheme A Cash flow/borrowing capacity Under Scheme B, DEF may be able to access funds more easily to finance the upgrade by using the guaranteed future income stream as collateral for the loan. This could be critically important if the bank refuses to lend the funds required if DEF were to retain the business rather than outsource it to ABC. Shareholder wealth The impact on shareholder wealth will depend on the price agreed under Scheme B and on the success of Scheme A if that is chosen. Scheme B should not lead to any loss in shareholder value if an annual payment of D$ 1.1 million is agreed. However, in reality, a lower payment is likely to be agreed, as previously discussed, and this could lead to a loss of shareholder value compared toscheme A. Scheme A gives the greatest flexibility and retains this highly profitable and cash generative business within DEF. Ultimately, Scheme A is likely to provide the greatest return and also the greatest flexibility and ability to adjust the car parking facilities to meet the changing needs of passengers. DEF may prefer to retain this highly profitable part of the business and enhance the in-house car parking management team to ensure that it is managed effectively. However, Scheme A may not be possible due to a lack of the availability of finance. In addition, we should consider risk appetite. Scheme A may provide a higher return than Scheme B but it also carries higher risk. If DEF Airport is highly risk averse, it may prefer Scheme B as this scheme guarantees income levels for the next 10 year period. So adopt Scheme B if: funds are not available for Scheme A and/or DEF is risk averse (as, indeed, the shareholder LSGs are likely to be) and prefers the guaranteed income provided by Scheme B. 4 Financial Strategy

5 Otherwise adopt Scheme A. APPENDIX A A.1 Analysis of net operating profit or loss for the year ended 30 June 2011 Total Car Airport Workings parking excluding car parking D$m D$m D$m Revenue = 15% x 23.4 Operating costs (or 0.7 x 5) Net A.2 Analysis of net operating profit after adding back depreciation for the year ended 30 June 2011 Total Car Airport Workings parking excluding car parking D$m D$m D$m Revenue = 15% x 23.4 Operating costs (or 0.7 x 5) Add back depreciation Net Financial Strategy 5

6 Question One part (b) APPENDIX B B.1 Valuation of car parking business assuming no investment Year ending 30 June: Base data and workings Cars using airport parking (million) 2 year growth at 6% Market share (% of cars) As given 50% 40% 35% 35% 35% 35% 35% 35% 35% 35% 35% Cars using on-site car parks (million) Cars x Market share D$ D$ D$ D$ D$ D$ D$ D$ D$ D$ D$ Average fee per car Growing at 3% D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 Income Cars x Average fee 3, , , , , , , , , , Costs Growing at 4% (2,600.00) (2,704.00) (2,812.16) (2,924.65) (3,041.63) (3,163.30) (3,289.83) (3,421.42) (3,558.28) (3,700.61) Net income (1.05) Tax at 30% (137.11) (64.94) (58.78) (52.10) (44.89) (37.11) (28.74) (19.73) (10.06) 0.32 After tax (0.74) Discount factor at 12% PV at 01 July (0.24) TOTAL NPV (D$000) B.2 Valuation of car parking business after investment Year ending 30 June: Base data and workings Cars using airport parking (million) 2 year growth at 6% Market share (% of cars) As given 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% Cars using on-site car parks (million) Cars x Market share D$ D$ D$ D$ D$ D$ D$ D$ D$ D$ D$ Average fee per car Growing at 4% D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 D$ 000 Income Cars x Average fee 3, , , , , , , , , , Costs Growing at 4% (3,100.00) (3,224.00) (3,352.96) (3,487.08) (3,626.56) (3,771.62) (3,922.49) (4,079.39) (4,242.56) (4,412.27) Net income , , , , , , , , , Tax at 30% (227.52) (308.85) (321.20) (334.05) (347.41) (361.31) (375.76) (390.79) (406.43) (422.68) After tax Investment (4,000.00) Tax relief on investment 30% 1, (4,000.00) 1, Discount factor at 12% PV at 01 July 2011 (4,000.00) 1, TOTAL NPV (D$000) 1, Financial Strategy

7 SECTION B Answer to Question Two (a) Export sales in the first quarter of 2011 are forecast at A$ 1,725,000 (= 30% x A$ 5,750,000). This is equivalent to EUR 690,000 (= A$ 1,725,000 x ). Export sales in the second quarter of 2011 are expected to be one-third higher, that is, EUR 920,000 (= EUR 690,000 x 4/3). Sales of EUR 920,000 are worth: A$2,300,000 at A$/EUR (920,000 / ) A$2,000,000 at A$/EUR (920,000 / ). The difference in revenue due solely to exchange rate movements is therefore A$300,000 (which equates to 4.7% of the total revenue of A$ million). Given that credit terms would now be 90 days this means that all of this change in revenue would impact on accounts receivable. (b)(i) Calculation of operating cycle Days Inventory of raw materials: Raw materials/purchases x 63.7 (1500/2150x4) x Less finance from suppliers: Accounts payable/ Purchases x (1800/2150x4) x Days Production time Work-in-progress/Cost of Goods 21.3 (740/3163x4) x Soldx Finished goods/cost of Goods Sold x 12.1 (420/3163x4) x Days credit given to customers Accounts Receivable/Revenue on 79.3 (5000/5750x4) x creditx Total operating cycle (Days) Examiner s note: Other relevant ratios and calculations were given credit as appropriate (1700/2350x4) x (2600/2350x4) x 22.2 (860/3529x4) x 12.9 (500/3529x4) x (7000/6325x4) x If the A$/EUR exchange rate were to move to , revenue would be A$ 300,000 less at A$ 6,025,000. Accounts receivable would also be A$ 300,000 less at A$ 6,700,000. Receivables days would therefore be only marginally higher at (6,700/ (6,025 x 4) x ). There would there be no significant change to the operating cycle which would change from days to days. Financial Strategy 7

8 (b)(ii) The operating cycle s total days has not changed as dramatically as might be expected; from a forecast of days in the first quarter to a forecast of days in the second quarter. However, two components have changed substantially and more or less cancel each other out. We would expect accounts receivable days to increase given the change in terms for export sales. We know that the change in terms means that export customers will have an extra 30 days to pay and hence given that for the second quarter of 2011 export sales are expected to account for approximately 36% of total sales, then we would only expect an increase of approximately 11 days overall. However, accounts receivable days are being forecast to increase from 79.3 to days, a rise of approximately 22 days, thus indicating that a potential worsening in customers ability to pay is being forecast. The other component to change considerably is accounts payable days which have increased from 76.4 to 101.0, indicating that the increase in accounts receivable days is being financed almost entirely by TM s suppliers. This might be by agreement with suppliers but is unlikely. In any case, it might mean TM foregoing discounts and supplier goodwill. Credit policy in general should be reviewed in an attempt to prevent customers taking longer to pay than agreed. TM could consider early payment discounts or charging interest on overdue accounts, although both these methods can be difficult to implement, administer and enforce. All components of days production time have increased, although not substantially. However, the increases should be investigated. Given the concerns noted above, efforts should be made to reduce all three components for example by reviewing production methods, suppliers and suppliers terms of trade. (c) The operating cycle is only the time span between production costs and cash returns; it says nothing in itself about the amount of net current assets that will be needed over this period. TM seems to be following an aggressive financing policy, financing all of its net current assets (including permanent and fluctuating elements) with short term debt in the form of an overdraft. This policy generally provides the highest expected return (because short-term debt costs are typically less than long-term costs) but it is very risky. TM should consider a more moderate policy by financing part of its net current assets with medium or long term debt. As the need for more finance is caused by an increase in export sales, TM might consider arranging a medium term borrowing denominated in euro. There would be no need to raise such a borrowing in a foreign country in the euro zone as euro finance is likely to be readily available in TM s home country. The main benefit of financing overseas investment or expansion with finance raised in the same country is currency matching. A loan in a major world currency such as the euro should not be difficult to raise as there will be an active and ready market in the currency. With euro borrowings, some of the receipts from sales in euro can be used to service the debt. However, aspects to consider are: Borrowing in euro is a relatively inflexible approach to hedging currency exposure arising on accounts receivable as it cannot be readily adjusted (without incurring costs) to reflect constantly changing levels of euro denominated accounts receivables. Using euro finance only hedges exposure on accounts receivable. The impact on operating profit is likely to be of more importance to TM. Forward contracts are a more appropriate tool to hedge euro cash inflows. If these are used to cover the period up to expected settlement of the amount due, the translation exposure arising on euro accounts receivables will already have been hedged within this approach and 8 Financial Strategy

9 euro denominated finance for a portion of net current assets would no longer be appropriate. Answer to Question Three (a)(i) JKL s pre-tax cost of debt is estimated as: 5.79% = 5.5% x 100/95 As a private sector organisation, JKL will be subject to taxation and therefore it is necessary to calculate a post tax cost of debt: 5.79% x 0.7 = 4.05% Note that this is an estimation only a yield to maturity calculation would take into account the discount of 5% on the price. However, no information is provided about the maturity of the bonds other than that they are long dated and therefore the annual effect of the discount is likely to be insignificant and has been ignored for the purposes of arriving at this estimate. JKL s WACC is calculated as: Type of security Market Value Rate of return Proportion Weighted G$ million % of total % return % Equity Long term debt Total (that is, approximately 8%) (a)(ii) A private sector organisation is likely to have very different financial and non-financial objectives than a public sector organisation. A private sector organisation will focus on maximising shareholder wealth by maximising profits. Shareholder wealth can be measured by the return that shareholders receive from their investment, represented partly by the dividend received each year and partly by the capital gain from the increase in the value of the shares over that period. The value of the shares should increase when the entity is expected to make additional profits that will be paid out as dividends or reinvested for future growth. The focus will be on financial targets. Shareholders expect higher returns than lenders in order to compensate for the greater risks that they take. A public sector organisation will usually have a greater focus on non-financial objectives such as: value for money; social benefits (including education and health); environmental benefits (of growing concern); within pre-determined financial budgets. A lower discount rate is appropriate for a public sector organisation such as GOH because it is not necessary to make the large returns that shareholders expect in a private sector organisation. The 4% rate is often set to reflect time preference, that is, the preference of society as a whole to receive goods and services sooner rather than later. Financial Strategy 9

10 Inputs are also different. A public sector organisation measures returns and benefits of a project in a non-financial nature (such as improvements in public health) and so it is appropriate to include estimates of these non-financial benefits in an appraisal exercise. In addition, the funding structure of JKL and GOH are completely different. JKL s WACC will reflect both the high returns demanded by equity holders and also the cost of debt whereas GOH will effectively only be funded by debt. The debt itself will be at different rates. Debt investors in JKL will expect a higher return then investors in government debt in order to reflect the credit risk involved in investing in JKL. Based on the above, using the WACC of JKL as a discount rate for GOH s project appraisal is not appropriate. Requirement (b)(i) Year G$ million G$ million G$ million G$ million G$ million G$ million Initial investment Land (950.00) (250.00) Net future benefits DF at 4% (Gohland rate) x Total DCF (1,200.00) , Total NPV of G$ million (b)(ii) On the basis of the return on investment the project should clearly go ahead. However, a number of important factors need to be taken into account before a final decision can be reached. These include: Sensitivity analysis to ascertain the critical variables. In particular, the social benefits of the health centre should be considered in depth. These appear to have been factored into the cash inflows in terms of perceived social benefits of inflows but these are extremely difficult to quantify unless the Gohland government has some established basis of quantification (as in the UK s NHS). The relationship of the investment to GOH s objectives should be examined. This is a very long term investment that has obvious follow on expenditure in 15 years time. In this case, 15 years might not be long enough for the evaluation. The availability of government funding both for the initial investment and the on-going running costs of the centre. Prioritising the use of government funds what would they be used for if not used for the health centre where is the greatest need. Alternative strategic approaches could be examined such as: o co-operating with other government agencies o co-locating or sharing health facilities with other agencies o engaging the voluntary sector o transferring service provision to another body o provision of the service by the private sector o refurbishing existing facilities rather than building new o changing location or scale. 10 Financial Strategy

11 Answer to Question Four (a) Private placing Under a private placing the bond units would not be offered to the public. Instead an issuing house typically a stockbroker will arrange for the bonds to be placed at an agreed price with institutional clients. A private placing of bonds is quicker and cheaper to arrange than an offer for sale and to some extent less risky as usually the issuing house will be fairly certain its clients will subscribe to the issue before agreeing to a placing. Public issue In a public issue, an issuing house typically a merchant bank will acquire the bonds and offer them to the public, usually at a fixed price (as compared with tender offers). The offers are usually announced by way of an abbreviated prospectus in a financial newspaper or journal. The main issuing house may involve underwriters if they are unsure of the success rate of the offer. Other features of offers for sale/public issue are: Offers that are oversubscribed may be scaled down on a pre-determined basis. Some subscribers may buy simply to re-sell quickly and make a short-term profit, although this is more likely with ordinary shares than bonds. Advantages of a private placing for RED Marketability. A key difference is whether RED and its advisors think there is a ready market for the bonds. Being a private company, the company may not be well enough known for a public issue to succeed in attracting sufficient investors. Cost. Private placing is almost certain to be cheaper as there will be no costs of underwriting and this method also largely avoids the cost of extensive road shows to publicise the issue. Speed. A private placing is also likely to be completed faster than a public issue for the same reason. Advantages of a public issue for RED Publicity ahead of the IPO. A public issue and accompanying road show would raise the company in the public awareness and therefore help prepare for a successful IPO later in the year. Conclusion I would advise that a private placing is used by RED for the issue of the bonds as this is likely to be more successful for an unlisted company than a public issue and would also be a useful first step in helping to raise the market profile of the company in the run up to the planned IPO. Financial Strategy 11

12 (b)(i) Explanation of the weak, semi-strong and strong forms of the EMH: Weak form EMH in its weak form states that the current share price reflects all the information that could be gleaned from a study of past share prices. Therefore no investor can earn above-average returns by developing trading rules based on historical price or return information. Semi-strong form The semi-strong form of the EMH says that the current share price will not only reflect all historical information, but will also reflect all other published information. Therefore no investor can be expected to earn above-average returns from trading rules based on any publicly available information. Strong form The strong form of the EMH says that the current share price incorporates all information, including non-published information. This would include insider information and views held by the directors of the entity. Therefore people with inside knowledge of the company could not make a profit by using this information; however, this is insider trading and is illegal in many countries and so this form of the theory is difficult to test. The academic consensus is that the semi-strong form is the most likely to occur in practice. (b)(ii) The success of the IPO can be improved by: An appropriate choice of issue price. To be attractive, this should be slightly below the perceived market value, although there is a risk of under-pricing the offer as current shareholders would then lose out. Underwriting (at a significant cost). Careful choice of timing in terms of the new product development cycle (ie: to ensure that the new product is developed sufficiently, patents obtained, market research available etc). Choice of timing in terms of market conditions (to help ensure there is sufficient interest in equity investments in general at the time of the issue). Careful/planned communication to prospective investors. A high share price after issue can be assured by: Positive financial performance. Publicising that positive financial performance to the market by careful management of share information released to the public (eg profit forecasts, quarterly and annual financial statements, information provided in press releases) so that the market can respond in an appropriate manner to this information and, under the semi-strong form of the efficient market, reflect this information in the share price of the company. 12 Financial Strategy