Section 1: Financial strategies and accounts Understanding financial objectives

Transcription

1 Section 1: Financial strategies and accounts Understanding financial objectives BUSINESS IN FOCUS 1 2 Questions: What was Toyota s profit target? Its profit target was $12 billion/6 10 $20 billion. What other financial targets might the company have set itself? In the current market the company might set itself a cash-flow target (e.g. avoiding high stock levels). The company may react to declining profits by adopting an objective of cost minimisation. The directors may decide to pursue a ROCE target in an attempt to improve profitability and satisfy their shareholders. PROGRESS QUESTIONS 1. Define, with the use of examples, the term financial objective. () A goal or target pursued by the finance department (or function) within an organisation, e.g. a specific return on capital employed (ROCE) figure or cost minimisation. 2. Distinguish between cash flow and profit. (6 marks) Profit: the surplus of revenues over total costs at the end of a trading period relates to a trading period. Cash flow: the movement of cash into and out of a business over a period of time considers the timing of payments and receipts. A profitable business can run short of cash. 3. Explain two reasons why a public limited company might use ROCE as a basis for a financial objective. (8 marks) Using ROCE as a target might help the company to attract shareholders. It is a financial objective that is easy to measure and publicise if the company is successful. It measures the financial performance of a company in a comparable way, which is likely to be of interest to shareholders.

2 1 4. What types of businesses might use cash-flow targets as a financial objective? Why? (5 marks) Businesses that face long cash cycles, such as house builders. Businesses that have experienced cash-flow problems in the past. Businesses that are likely to require large long-term loans in the near future. 5. Explain why a business entering an established market might choose to operate cost minimisation as a financial target. (6 marks) It will help the business to ensure that it makes a profit during a difficult period of trading. It will help the business to be more price competitive against larger and established rivals. The business may be able to use price competitiveness as a USP to help establish customer loyalty. 6. What is meant by the term shareholders returns? () The current share price and any associated dividends that are due in the near future, or a combination of short-term returns (both share prices and dividends) as well as future share prices and dividends. 7. Explain why a business s finance department should not set its objectives without consulting the other functions of the business. (6 marks) Primarily because it will affect the spending decision of other functions, such as HR and marketing. All the functions should set objectives following communication to ensure that they are integrated. The finance function s objectives must assist the other functions in contributing to the achievement of corporate objectives. 8. JHG plc builds oil rigs for use in locations across the globe. Explain how the nature of the company s product might influence its corporate objectives. (8 marks) A long cash cycle might mean that the company opts for cash-flow targets to reassure creditors. However, the business might set a ROCE target or opt to pursue shareholder returns if it requires increases in share capital to finance its activities. Demand for oil rigs may not be highly price elastic as buyers are more likely to be concerned about quality (and thus safety) and also meeting their precise specifications. Hence cost minimisation may not be a vital financial objective. 9. Why might the business s corporate objectives be considered the most important influence on its financial objectives? (6 marks) The finance function operates to help the business achieve its overall objectives, not for its own reasons. Corporate objectives are set first and then functional objectives are decided, to dovetail with corporate objectives. Finance is only one aspect of a business s operations. 10. Outline how the state of the market in which a business is selling might influence the financial objectives that it chooses. (6 marks)

3 1 In a growing market, with the possibility of excess demand, a business might set itself a ROCE target as trading is profitable. Equally, in such a market shareholders returns might be vital as a financial objective if the business needs to raise share capital on a regular basis. In a highly competitive market a business might decide to operate with cost minimisation as a financial target to allow more freedom in pricing decisions. ANALYSIS AND EVALUATION QUESTIONS 1. (a) Analyse the potential advantages to this company of pursuing a financial objective of cost minimisation. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of It entails seeking to reduce to the lowest possible level all the costs of production that a business incurs as part of its trading activities. The company is a new entrant and cost minimisation will help it to overcome possible absence of economies of scale. It will give the company a little more flexibility in its pricing decisions. The company may use cost minimisation as the basis for lower prices, a USP and also a focus for its marketing campaigns. (b) Discuss the likely consequences for the entire business of the adoption of the financial objective of cost minimisation. (15 marks)

4 1 Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. It entails seeking to reduce to the lowest possible level all the costs of production that a business incurs as part of its trading activities. It will mean that the HR department will seek to keep wage costs to their lowest through negotiating tough pay settlements and achieving high levels of productivity. The operations department may seek to minimise running costs, e.g. through keeping employee breaks to a minimum and operating with cheaper models and specifications of coaches. The marketing department will have to operate with a relatively small budget but may also stress the business s competitive prices in its marketing. The consequences will depend on the degree of price elasticity for coach travel (which is likely to be high). 2. (a) Analyse the likely impact on its choice of financial objectives of the changes in the market. (10 marks)

5 1 Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of A financial objective is a goal or target pursued by the finance department (or function) within an organisation. The retirement of the chief executive may mean that she expects shareholders returns to be the key financial target, especially if her pension depends on the company s share price. However, ROCE might be the most important financial objective if her retirement package is determined by the level of profits. Falling sales might mean that cost minimisation becomes more important as a target it might be vital for the company to have the flexibility to reduce prices if necessary. (b) Do you think that external influences are more important as an influence on its financial objectives than internal factors? Justify your answer. (15 marks)

6 1 Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A financial objective is a goal or target pursued by the finance department (or function) within an organisation. The fall in sales is likely to be a key influence on the company s decisions about financial objectives. This will affect its existing customers. The new entrant will have an impact, but whether it has a major influence on financial objectives may depend on its size and competitiveness. The retirement of the chief executive could have a significant influence and make the company look for more short-term financial targets, such as profits, over the next two years. The importance of the two groups of factors depends on a range of factors, including the power and influence of the retiring chief executive and the extent and expected duration of the fall in sales. Questions CASE STUDY 1. Explain what is meant by shareholders returns. (5 marks) A short-term view defines it as the current share price and any associated dividends that are due in the near future.

7 1 A longer-term view defines it as a combination of short-term returns (both share prices and dividends) as well as future share prices and dividends. In any event, shareholders returns focuses on generating profits and increasing the value of the company as reflected in its share price. 2. Analyse the possible financial objectives that Cadbury may pursue following this announcement. (8 marks) Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of A financial objective is a goal or target pursued by the finance department (or function) within an organisation. The company may pursue cost minimisation in order to become more efficient. This means using fewer resources, and cost minimisation will assist in this aim. The company also states that it intends to improve its returns to shareholders, so this will become an important financial objective. The company may need to achieve a specified (and quite high) return on capital if it is to fund the product and market development strategies that it is proposing.

8 1 3. Evaluate the likely influences on Cadbury s decision to establish a financial objective of reducing its costs. (1) Evaluation Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. It entails seeking to reduce to the lowest possible level all the costs of production that a business incurs as part of its trading activities. The threat of a takeover by a private equity business is a key factor influencing the company s decisions making itself more competitive is a way of preventing this happening. If the business increases its shareholders returns as a consequence of reducing costs it will make the business more valuable and less vulnerable to a takeover. Reducing costs will help the company to raise the funds necessary to enter new markets and develop new products. It is almost certainly a combination of these factors, with the threat of a takeover being the most pressing short-term influence.

9 1 4. To what extent is Cadbury s decision likely to please all of its stakeholders? (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A stakeholder is any person or group with an interest in a business. Shareholders might be pleased by the proposed reduction in costs and focus on shareholders returns, as this is likely to increase dividends and possibly share prices. Employees (and their representatives) will be concerned by the proposed loss of 7,500 jobs, although their reaction will depend on how these jobs are to be lost. Existing customers may be pleased by the commitment to new products and potential customers by the proposal to enter new markets. Managers (if they retain their jobs) could be excited by the prospect of new products and markets and perhaps higher bonuses. It is unlikely that the company can please all of its stakeholders by this or any other major decision.

10 Using financial data to measure and assess performance 2 Question: BUSINESS IN FOCUS What other actions might the two companies take to improve the cash position as shown on the balance sheet? The companies may seek to increase sales of cars (using a variety of marketing techniques) to create cash inflows. The two businesses might choose to sell fixed assets that are no longer needed (e.g. some land). Alternatively, the firms could sell and lease back other fixed assets such as factories. The companies might attempt to negotiate loans with banks. Given the importance of these two businesses to the American economy, the two management teams may approach the American government for grants or loans. Questions: BUSINESS IN FOCUS Do you think that Mothercare s rise in profits is good quality? The rise in profits is the result of the company s expansion this is good quality as it is likely to continue in the future. Which of the company s stakeholders might be pleased about this news? Why? Employees may respond well to this news as it increases job security and offers more opportunities of promotion. For shareholders the rise in Mothercare s profits is good news in the short term in terms of dividends, and for share prices in the longer Customers may be satisfied by the rise in profits as it has come about from an increase in online retailing, making it easier for customers to buy the company s products.

11 2 Question: BUSINESS IN FOCUS Would this slump in profits have been predicted from looking at the company s most recent balance sheet and income statement? Both documents are historical and do not necessarily indicate future developments. The fall in profits is principally due to rising fuel costs, which neither the income statement nor balance sheet would indicate. These changes are due to alterations in market conditions which are not likely to be revealed by financial statements (though a trend of falling sales might be shown on income statements). PROGRESS QUESTIONS 1. Merrills Industries manufactures biscuits and other convenience foodstuffs. Identify three stakeholder groups who may have an interest in the company s balance sheet. Outline the likely nature of their interest. (9 marks) Shareholders future dividends and trends in the company s share price. Employees to inform negotiations about wages and salaries. Suppliers to help to make decisions about offering trade credit. Competitors to make decisions on pricing strategies and tactics. Revenue and Customs to check the company s liability for taxation. 2. Explain two factors that lead to a business s balance sheet always balancing. (6 marks) The dual effect of the balance sheet means that transactions always balance each other, e.g. borrowing to purchase a non-current asset has the same effect on assets and liabilities. Reserves (the profit accumulated over previous years) is also a mechanism to ensure this financial statement always balances. Thus, if the business grows in value, so will reserves (which are a liability). 3. Outline how the information recorded on a business s balance sheet can be used to assess the cash or liquidity position of the business. (7 marks) The business s current assets can be compared with its current liabilities. The same comparison, but excluding inventories, may be carried out to give a better measure of liquidity (as inventories can be illiquid in certain circumstances). The firm s holdings of cash give a clear indication of its immediate ability to meet commitments.

12 2 4. Explain the difference between the net current assets and the net assets of a public limited company. (6 marks) Net current assets (also known as working capital) are a business s current assets less its current liabilities. Net assets are non-current assets plus non-current or fixed assets. 5. The net assets of Gujarati Products plc is 540 million. The company s non-current liabilities total 339 million. What are the possible implications of this position? (7 marks) The company has borrowed a high proportion of its capital employed (high gearing), so it is vulnerable to a rise in interest rates. May put off potential shareholders as they fear profits may be reduced due to possibile high interest charges. 6. Smith and Whyte s reserves rose by 54 million last year. Outline the possible causes of this. (5 marks) The company may have made a handsome profit on its trading activities. Its non-current assets may have increased in value. It may have revalued its intangible assets, e.g. brands. 7. Explain two possible consequences of a retailer having too much working capital. (6 marks) The business may be less profitable than it could be if it invested these funds in assets that generated high returns. Shareholders may be dissatisfied with the business s financial performance. The business would experience no difficulty in meeting its current liabilities. 8. Explain why a manufacturing business that is expanding rapidly might face problems with its working capital. (8 marks) The business will be increasing purchases of stock and paying for labour before it has received payment from its customers. This problem will be serious if the business has a long cash cycle. The business may use new suppliers who may be unwilling to grant trade credit initially. It may have taken out long-term loans to finance the purchase of non-current assets, placing further pressure on its working capital. 9. Explain why a road haulage company will have to depreciate its non-current assets each year. (8 marks) The assets may lose value because of obsolescence or wear and tear. They will be used over a period of several years and the purchase cost should be spread over the same number of years. 10. Outline why it is important to value non-current assets as accurately as possible. (6 marks) The value of non-current assets is an important component of the valuation of the entire business.

13 2 Valuation of non-current assets affects the profits and hence the amount of corporation tax paid by a company. HM Revenue and Customs has strict rules on depreciating assets. 11. Explain what is meant by high-quality profit. () High-quality profit is expected to continue into the future. Thus: Profit arising from the sale of an asset is low quality since it is unlikely to be repeated. Profit arising from sales of a newly introduced product is likely to be high quality. 12. Explain why an extraordinary item should be listed separately in a company s income statement. (5 marks) It not part of the business s normal trading activities and so should be distinct. Accounting regulations insist that such transactions should be included separately within the income statement. 13. Outline two aspects of a supermarket s income statement that might be of particular interest to a shareholder considering buying a large quantity of the company s shares. (8 marks) The revenue of the business, especially when compared with previous years. A comparison of gross and net profit (allowing a judgement to be made of the effectiveness of the control of overheads). The overall profitability of the business after tax. The amount of profit retained within the business (giving an indication of future growth). The dividends paid to its shareholders. 14. Explain two reasons why a balance sheet can be considered a valuable document for stakeholders. (6 marks) It shows the liquidity position of the business to any actual or potential suppliers. It shows the value of a business and how this has changed since the previous balance sheet. It shows from where the business raised its finance and how it has been used. It shows the amount that the business has borrowed and allows stakeholders to decide whether or not this is excessive. 15. Outline three sources of information, other than its balance sheet and income statement, that might help an investor to assess the future prospects of a computer manufacturer. (8 marks) The financial statements of close competitors. The business s cash-flow statement.

14 2 Market data for those markets in which the business trades. Information about the business s workforce, such as absenteeism, productivity and labour turnover. ANALYSIS AND EVALUATION QUESTIONS 1. (a) Analyse what is meant by the phrase a strong balance sheet. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period. A strong balance sheet may mean that the business has raised a large amount of its funds through share issues rather than borrowing and therefore has a favourable gearing ratio. It may also refer to the business s cash position: holding sufficient cash, but not so much as to be regarded as wasteful of profitable assets. The balance sheet may have a large figure for reserves, indicating that the business has been profitable in recent years, increasing the value of the owners stakes in the business. The term may refer to the value of non-current assets held by the business, possibly in the form of oil not yet recovered.

15 2 (b) Discuss the value of Benson plc s balance sheets and income statements in assessing its future performance. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. An income statement shows a firm s sales revenue over a trading period, and all the relevant costs generated to earn that revenue. The balance sheet will show the value of the company s assets and some indication of the value of its reserves of oil. The balance sheet will show whether the company has borrowed excessively in discovering new oil fields. The income statement shows the level of net and gross profit achieved by the business, and also the profit that is available for reinvestment in future oil exploration. The income statement and balance sheet will show how much finance is available to the business for reinvestment. There are many factors that are not shown by these financial statements a critical one for this company is the future price of oil.

16 2 2. (a) Analyse the possible reasons why Marine Ltd might experience problems in managing its working capital. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of Working capital measures the amount of money available to a business to pay its day-to-day expenses, such as bills for fuel and raw materials, wages and business rates. The company is expanding and is a manufacturing business. This means that it has to purchase stocks before it can sell them to customers and receive payment. When it is growing it is in danger of overtrading. The company s products are popular, which may result in rapid growth, stretching cash reserves. Marine has had to grant Tesco 45 days credit, which will add to its difficulties.

17 2 (b) Discuss the possible implications of the cash-flow problems for Marine Ltd. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3- judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Cash flow is the money flowing into and out of a business over time. The business may not be able to pay its suppliers, e.g. of bottles and flavourings, and may be forced to cease trading. If the business is unable to buy sufficiently large quantities of supplies, it may lose its contract with Tesco which would be a major blow. The company has been growing for some time and presumably will have planned its cash flow and prepared for some problems, e.g. by arranging an overdraft. The implications depend on the size of the cash-flow problems and the attitude of the company s bankers. Questions CASE STUDY 1. Identify two stakeholders who may have an interest in the balance sheet of Ollington. In each case explain the possible reasons for their interest. (6 marks)

18 2 Candidate identifies two stakeholders. Candidate identifies single stakeholder. 4 Candidate explains interest effectively in relation 2 s Candidate attempts to explain interest in relation Employees interested in security of jobs, particularly if they sense Paul is about to sell the business. Suppliers provide expensive photographic equipment and will want to ensure the business is sufficiently liquid to meet its debts, or face substantial bad debts. Rivals if there is takeover talk in the air, Ollington & Smart s balance sheet will be of great interest to provide an indication of the worth of the business. 2. Analyse the benefits that Ollington s Photographers may gain from taking action to window dress its balance sheet. (8 marks) Good analysis of two or more relevant points or shows good term or a combination. Candidate applies knowledge effectively 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period. An improved liquidity position may make the business more attractive to potential purchasers and attract higher bids. Sales could be improved by bringing forward invoices, which could improve profitability.

19 2 Profits may also be improved by altering the business s depreciation policy to reduce the value of fixed assets more slowly and enhance profits. May be able to negotiate a higher price for the business if it looks more profitable. 3. Smith Photographic plc is considering the purchase of Ollington & Smart. Consider the disadvantages of using a balance sheet as the basis of such a decision. (1) Evaluation Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period. It only relates to a single point in time, which may not be representative of the true position of the business. It excludes any information relating to costs, revenues or profits, which must be a crucial part of the evaluation of any business prior to making a bid. It only really includes financial information: much non-financial information would play an important part in such a decision. It would not provide Smith Photographic with any information about the market in which Ollington & Smart trades. 4. Paul s accountant has commented that there are strong reasons why he should sell the business at this time. Discuss the case for and against this view. (1)

20 2 Evaluation Candidate identifies two or more relevant points. Candidate applies knowledge effectively Good analysis of 4 judgement plus full justification. two or more relevant points. Candidate makes reasonable attempt 3 Reasonable analysis of judgement plus limited justification. single relevant point. Candidate attempts Limited analysis of undeveloped judgement based on evidence. The value of fixed assets has declined over the past year possibly due to leases on property nearing expiry. Ollington & Smart probably incurred a loss in the previous year reserves declined by 20,000 between 2007 and Its liquidity position declined between 2007 and 2008, as shown by its position with regard to working capital. The owners stake in the business is still substantial and they are not under pressure to reach a decision. The company has faced a downturn in the local economy over the past couple of years and has been affected as a seller of income-elastic products; in spite of this, sales figures have held up. There is insufficient evidence in the balance sheet on which to make this type of judgement. Questions CASE STUDY 1. Explain what is meant by a consolidated balance sheet. () A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period. A consolidated balance sheet brings together the balance sheets of a number of companies that are owned by the same parent company. Rolls-Royce plc operates in four global markets civil aerospace, defence aerospace, marine and energy and may have different companies or divisions trading in these markets, with different balance sheets.

21 2 2. Analyse the key trends in the company s income statements for 2006 and (9 marks) Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt An income statement shows a firm s sales revenue over a trading period and all the relevant costs generated to earn that revenue. Revenue has risen but gross profit has fallen. This suggests that the company has not been successful in controlling its cost of sales. Expenses have risen, but not in line with revenue, so the company has been more successful in controlling this aspect of its operations. There has been a substantial fall in the company s finance income (from 1,196 million to 718 million. The company may have sold assets that were generating an income for it. Profit for the year has fallen considerably, mainly due to rising cost of sales and falling finance income.

22 2 3. Discuss the strengths and weakness of Rolls-Royce s balance sheet in (1) Evaluation Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A balance sheet is a financial statement recording the assets (possessions) and liabilities (debts) of a business on a particular day at the end of an accounting period. There was a substantial increase in the value of the company, which was reflected in the value of its non-current assets across the two years. The working capital position remained strong over the two years the company had over 2,000 million available on the date of the 2007 balance sheet. Non-current liabilities decreased while the value of the business rose. This will have reduced the gearing level substantially. Inventories are high and increased further in The strengths of the balance sheet appear to outweigh its weaknesses. These figures are for two specific days across two years of trading they may have been window dressed.

23 2 4. To what extent could an investor base a decision to purchase 1 million of the Rolls-Royce group s shares on the basis of this information? (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points. Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point. Candidate attempts Limited analysis of undeveloped judgement based on evidence. The balance sheet provides the investor with valuable information about the company s liquidity position and also its gearing position, which is essential to make such a decision. The income statement shows profitability and dividends essential detail for a potential investor. There are two years of figures available in this data, giving some indication of the trend on financial performance. There is no information about the company s position in relation to the various markets in which it trades and how these markets are performing. Rolls-Royce is an engineering company what patents does it have and what is its position in relation to the development of new products? Skilled employees are essential to the long-term performance of a high-technology engineering company and the balance sheet provides no information on labour turnover or similar data. A decision to spend such a large sum of money will require more than financial information about the company and this information may have been massaged.

24 Interpreting published accounts AQA Business Studies for A2 3 Questions: BUSINESS IN FOCUS What are the implications of this news for companies with high rates of gearing (over 50 per cent)? The rise in effective interest rates (if not the Bank of England s base rate) will increase the interest charges faced by businesses. For highly geared businesses these costs could become high and possibly unmanageable depending on the extent of the rise and level of gearing. What actions might they take in response? Business may respond by selling assets to reduce gearing levels. Business may lower dividend payments to allow more of profits to be used to repay loans. A further option could be to renegotiate loans to reduce monthly payments(perhaps by extending the term). Question: BUSINESS IN FOCUS Why might a small business be reluctant to claim interest from a large customer that buys a high proportion of its output and regularly delays payment? It may be afraid of losing sales (and a large amount of revenue). Question: BUSINESS IN FOCUS Why might a supermarket in a highly competitive industry be happy to achieve a net profit margin on sales of less than 3 per cent? This may be acceptable if other businesses in the same market are achieving similar profit margins. This figure may be acceptable if the company achieves high sales figures allowing it to generate sufficient profits even with a low margin. If the figure is in line with the company s financial forecasts then the management team may find it acceptable in this case the figure was better than forecasts. It may depend on whether this is a gross or a net margin as a gross margin it would be unacceptable.

25 3 Question: BUSINESS IN FOCUS Why might some of Debenham s shareholders be satisfied to see the company reduce its dividend per share? This allows the company to reduce its debts and may result in higher profits in the future. This action of reducing indebtedness may increase the company s share price. The company may be able to finance investment in the business (in this case refurbishing stores), improving the company s future financial performance. PROGRESS QUESTIONS 1. Explain, with the aid of an example, why a ratio might provide more detail on a firm s performance than a single piece of financial information. (7 marks) A ratio allows a comparison with some other piece of information, allowing a more informed judgement, e.g. expressing profits as a percentage of capital employed. Ratios give a figure that can be compared with industry standard figures or with those of rivals. Ratios make trend analysis easier, assessing the performance of a company over time. Ratios allow stakeholders to place key figures (profits, sales etc.) in some context. 2. Distinguish between efficiency ratios and profitability ratios. (6 marks) Efficiency ratios measure the effectiveness with which managers control the internal operation of a business. How well are stocks managed, and are creditors chased up promptly? Profitability ratios assess the amount of gross or net profit made in relation to the business s turnover or the capital available to it. 3. Outline two sources of information that might be important when conducting ratio analysis. (6 marks) The balance sheet and the profit and loss account over recent years provide vital information. Norms or benchmarks for the industry in question these assist in making a judgement about the results of ratio analysis. The economic and market environment. Improvements in profitability might be due to an upswing in the business cycle rather than improved management of the business. 4. Marsham Trading has current liabilities amounting to 2.8m. Its current assets are: receivables 1.1m, inventories 2.0m and cash 0.9m. Calculate the business s current and acid test ratios. (8 marks) current assets 4.0 million Current ratio = 1.43:1 current liabilities 2.8 million

26 3 liquid assets 2.0 million Acid test = 0.71:1 current liabilities 2.8 million 5. Explain two reasons why the results of liquidity ratios might be treated with caution. (6 marks) In recent years firms have operated successfully with lower liquidity figures than in the past: the view of norms is changing. The expected figure for acid test or current ratio varies according to the type of business retailing runs with very low liquidity ratios. The current and acid test ratios are susceptible to massaging by use of window dressing, especially selling non-current assets for cash immediately prior to the drawing up of the balance sheet. 6. Pelennor Products is a rapidly growing business providing IT services. The company s receivables (debtors ) days ratio has increased from 33.2 days to 41.7 days over the past year. Outline the possible implications of this for the business. (10 marks) This could be the consequence of a period of expansion during which the firm has offered more favourable credit terms to win new customers and therefore heralds a period of prosperity. It could be due to the firm s inefficiency in chasing up slow payers, in which case some remedial action on the part of senior managers may be required. It could be the result of an economic downturn, with many firms seeking to strengthen their liquidity position by delaying payments, in which case the firm may have to review its trade credit arrangements. 7. Fangorn plc has seen an improvement in its gross profit margin over the financial year. At the same time its net profit margin has deteriorated. Explain the implications of this for the business and outline possible actions that the management team might take. (10 marks) The business may be selling more products or enjoying the fruits of efficiencies that have lowered its direct costs of production, boosting gross profits. It may face rising overheads, possibly due to a slackening of managers control over this type of cost. This scenario might come about because of a perfectly justifiable increase in indirect costs, e.g. as a result of purchasing new and larger premises. Remedial actions should centre on reducing overheads (or reversing recent increases). 8. Explain why the return on capital employed (ROCE) is such an important ratio for stakeholders. (6 marks) It is termed the primary efficiency ratio because by comparing profits and capital employed it measures the effectiveness with which the firm has used its resources. A fundamental comparison can be made between the prevailing rate of interest and the ROCE achieved by a particular firm. It is a simple but effective method of comparing the performance of diverse businesses. 9. Why might the dividend yield ratio provide a better indication of a company s performance than the dividend per share ratio? (5 marks)

27 3 The dividend per share does not take into account the price of the share in question. It is possible and worthwhile to compare the dividend yield with the rate of interest. The dividend yield makes inter-firm comparisons possible. 10. Outline two possible external factors that need to be taken into account when conducting ratio analysis. (6 marks) The trends observed in the market in which the firm is trading. A period of growth may produce vastly different results from those achieved in a declining market. The quality of the management team and the workforce will not be shown directly through the application of ratio analysis. The position of the firm will also be important: a market leader would be expected to perform better than a relatively small new entrant. ANALYSIS AND EVALUATION QUESTIONS 1. (a) Analyse whether the company s director is right to be worried about the company s liquidity position. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of The company s acid test ratio has declined to a situation where it has little more than 1 available to pay each 1 of current liabilities. It has a long cash cycle as a house builder. However, it has just completed a housing estate and the sale of houses is just starting, so this may alleviate the position.

28 3 (b) The company s chief executive believes that financial ratios are of little use to analyse Steeple plc s current position. Justify your decision. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Financial ratios are the result of the comparison of two figures, e.g. profits and capital employed. The company is expecting a major cash inflow from the sale of the houses in Dorset, so liquidity ratios may be misleading. Dividend per share does not tell investors what is happening to the company s share prices and this might be more significant financially for the investors. The ratios are historical and do not necessarily predict the future. However, it appears that the company has borrowed more this year (perhaps to buy the land in Birmingham) and gearing would be a significant ratio for any creditors. Suppliers to the company would be interested in the company s acid test ratio as an indicator of its ability to pay on time. The value of ratios varies according to the stakeholder that is involved and the reason for their interest.

29 3 2. (a) Analyse how ratio analysis might help the company to make this decision. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of Ratio analysis is a technique for analysing a business s financial performance by comparing one piece of accounting information with another. The acid test or current ratio will allow the company to assess its ability to finance this plan in the short Calculating gearing will assist the company in assessing its long-term ability to repay the loan. Its gearing figure will rise above 50 per cent if it goes ahead with this decision, which may be an important factor. The company s directors will be able to compare the forecast ROCE from the new project with that achieved elsewhere in the business (21 per cent) and use this comparison to inform their decision. (b) To what extent do you agree with the view that information on the market in which the company trades is the most important information needed to supplement the ratio analysis? (15 marks)

30 3 Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. It will help with the company s decisions on pricing and will determine profitability to some degree. The market that Penhaligon plc is entering is highly competitive and this will be a major influence on the company s decision. In particular the likely reaction of competitors must be taken into account. The workforce will be an important influence, so an HR plan will be needed. This project is forecast to improve the company s cost efficiency. Operations will be vital. Will the company have the necessary capacity and can the new production methods meet quality standards? The results of ratio analysis need to be supplemented by a range of information from across the other functions of the business as well as the market. Theimportanceof themarketinsuchadecisionwilldependonthemarketpowerof thebusinessconcerned. Questions CASE STUDY 1. Explain what is meant by net assets. () Net assets are an indication of the net worth of a business. They are calculated by totalling non-current assets and net current assets (that is, current assets less current liabilities) and then deducting non-current liabilities.

31 3 2. Analyse the possible implications for Rohan s shareholders of the announcement of the proposed takeover of Breckland Stores. (8 marks) Candidate applies knowledge effectively Good analysis of two or more relevant points. Candidate makes reasonable attempt Reasonable analysis of single relevant point. Candidate makes limited attempt Limited analysis of Shareholders may be impressed by the long-term possibilities of this deal in terms of profitability and hence higher dividends. In the long term this takeover may result in higher share prices, allowing for a capital gain if the company is successful. Some analysts believe that Rohan paid too much for Breckland Stores this may result in a fall in the share price. If Rohan plc struggles to pay for the loans it has taken out for this deal (non-current liabilities have risen significantly) then future profits (and dividends) may be lower. The short-term reaction of shareholders was to sell shares the share price fell by 13.4 per cent in a single day.

32 3 3. Using ratios to support your arguments, assess the case for and against the Rohan Group spending 229 million on a takeover of Breckland Stores. (1) Evaluation Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points. Candidate makes reasonable attempt Reasonable analysis of 3 judgement plus limited justification. single relevant point. Candidate attempts Limited analysis of undeveloped judgement based on evidence. The takeover improves the company s geographical coverage of the UK. The company is committed to a period of rapid growth and this takeover is a central part of its ambitious expansion programme. The company could be considered to be overstretched, e.g. its gearing ratio is very high. Expenses are rising rapidly, suggesting that it is not controlling its costs effectively. The key point might be that Rohan is paying a price for Breckland that analysts regard as too high.

33 3 4. Discuss the value of ratio analysis in assessing the financial performance of the Rohan Group. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Ratio analysis is a technique for analysing a business s financial performance by comparing one piece of accounting information with another. Ratios provide an effective basis for the comparison of the performances of the business with other, larger, rivals. Ratio analysis puts financial investigation into a context Rohan s profits will be smaller than its competitors, but what about its ROCE figure? Ratio analysis ignores an enormous range of non-financial factors that may be critical determinants of the future performance of the business, e.g. the company s need to have a broader geographical coverage. Ratio analysis is historical and may, particularly in view of Rohan s expansion plans, be of limited relevance. Ratio analysis is just one tool for financial analysis and should be used cautiously and in conjunction with other types of analysis.

34 Selecting financial strategies AQA Business Studies for A2 4 Question: BUSINESS IN FOCUS Why might a professional football club welcome an increase in retained profit? The profits can be invested in the business, e.g. improving facilities at the stadium or buying new players. The retention of increased profits may improve the club s cash position. Higher retained profits may strengthen the club s financial position and enable it to cope more effectively with an uncertain future (one that depends to some degree on results). The club may be able to reduce its borrowing levels in the future. Question: BUSINESS IN FOCUS In what ways might Seat s ability to raise capital by selling shares be affected by its high debt levels? The company may find it difficult to sell shares as potential investors may believe that it has excessive interest payments and is unlikely to be profitable. If Seat is sufficiently profitable, potential investors may be interested and see the sale of shares as a logical way for the company to reduce its gearing. The revenue from selling the shares may be used to reduce the company s debt levels and this may lead to higher profits in the long Question: BUSINESS IN FOCUS Why do you think that J Sainsbury plc has chosen to raise 566 million to finance its investments by using this method of raising capital? This approach does not commit the company to future interest payments, which may be variable. Sale and leaseback do not involve borrowing, so will not affect the company s gearing ratio.

35 4 Sainsbury s may already have a high gearing level. The investments may generate a greater return than the supermarket generates on its property portfolio. Question: BUSINESS IN FOCUS How might Volkswagen intend to finance its expansion plans? The company might use retained profits for at least part of the investment, given its increased sales. The company s financial success will mean that it is able to negotiate loans at favourable terms with banks. Shareholders may be willing to buy shares, given Volkswagen s positive recent financial performance. What would be the possible implications for other functions within the business of raising finance to build a factory in the United States? The company s HR function will need to recruit new employees to staff the US factory. There will be considerable implications for operations, e.g. managing production lines for new models to be manufactured in the United States. Marketing will be a key element in this expansion. This represents market development and Volkswagen will need to develop a new marketing strategy. BUSINESS IN FOCUS Question: What disadvantages might HSBC experience as a result of operating profit centres? Centres may only consider local issues when making decisions. The regions are quite different and it is not reasonable to make direct comparisons.

36 4 Question: BUSINESS IN FOCUS In what ways might the policy of offshoring IT jobs add to the costs of UK businesses in the long run? The move may mean that IT businesses have to pay higher wages to attract people into an industry that appears to lack prospects. IT companies may face increased recruitment costs to attract high-calibre candidates. IT companies may suffer from high levels of labour turnover, given the lack of prospects in the industry. This may add to recruitment and training costs. Question: BUSINESS IN FOCUS Why might a fashionable clothing brand decide to allocate its capital in this way? The company s corporate aims are based on expansion, and this method of allocating capital expenditure will assist in achieving this aim. Fashion markets are becoming global, making this an obvious financial strategy. Consumer spending in America has fallen, and moving into new markets may help to offset this. Presumably the new stores in Canada and the United States have been successful, encouraging this further stage of development. PROGRESS QUESTIONS 1. Outline two reasons why a car manufacturer may need to raise large sums of finance. (6 marks) It may need to invest in new production line equipment to improve productivity. It will have to invest regularly in new models of cars, possibly developing technology to reduce pollution. It may need to take over smaller rivals to acquire brands such as Jaguar. It may extend its production capacity to allow it to enter new markets. 2. Explain the benefits a business may receive from using retained profits to finance a major investment programme. (6 marks) The business will not have to pay interest on this source of finance.

37 4 It will not have a negative impact on the company s gearing ratio. It will not dilute the existing shareholders control of the business. It will not dilute the value of shares 3. Explain why raising finance might be an appropriate financial strategy for a business aiming to sell in a global market. (8 marks) Operating in a global market might mean that the company needs to increase its productive capacity, requiring substantial investment. It might be essential to improve productivity and competitiveness to allow the business to operate successfully in the global market. The business may need to develop new products to meet the needs of global consumers. A strategy of market development will require finance to establish distribution networks, for example. 4. Why might a business with a corporate objective of growth seek to raise finance through a mixture of selling shares and negotiating bank loans? (8 marks) A growth objective may require large amounts of finance and thus a single source may not suffice. The sale of shares will not commit the company to fixed interest payments in the future. Raising finance through loans will not dilute shareholders control or the value of shares. 5. Why have many retailers with large numbers of stores chosen to raise finance through sale and leaseback? (8 marks) These are assets which have increased substantially in value over recent years, providing a major source of finance. The company avoids any interest charges (which may vary). There is no impact on share prices. The company avoids paying to maintain assets,which could require substantial sums to be spent regularly. 6. Explain why implementing profit centres is a common financial strategy for large businesses with diverse product ranges. (8 marks) A business s senior managers are not always able to control the diverse elements of the business as closely or effectively as they would wish profit centres allow some delegation of authority. Businesses can compare the financial performance of the areas which comprise the business. This can be an important motivational and training strategy for middle managers in a large organisation. 7. Why might the implementation of profit centres as a financial strategy have significant implications for a business s HR department? (7 marks) The HR department may have to implement a training programme for its employees to operate the profit centres successfully. It may need to recruit employees with financial skills if this strategy is put in place. The strategy may have a positive impact on motivation of certain employees, which may influence other motivational policies that the HR department uses.

38 4 8. In what ways might a large business manufacturing non-branded T-shirts implement a financial strategy of cost minimisation? (8 marks) It may seek to produce much of its product range in less developed countries, thereby benefiting from reduced labour costs. It could provide a limited range of products,seeking to benefit as fully as possible from economies of scale. It could use a flexible workforce to assist in minimising costs. 9. Why might a UK manufacturer choose to allocate finance to investing in technology? (5 marks) To reduce wage costs, hence cutting the overall cost of production. It should increase the business s levels of productivity. More technology on the production line may enable a company to reduce its unit costs of production in the long run. Quality may improve as defects are likely to be reduced. 10. Which types of business might opt to allocate large sums of capital expenditure to the purchase of property? Explain your answer. (6 marks) Retailers frequently invest in high street locations, to be alongside other, similar, businesses. Banks require high street locations and secure, expensive properties to conduct their business successfully. Hotels, especially luxury hotels, will depend upon having suitable properties, often in expensive city locations. ANALYSIS AND EVALUATION QUESTIONS 1. (a) Analyse the possible reasons why Prestige Hotels has selected a financial strategy of allocating capital expenditure. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of

39 4 Capital expenditure is spending on new non-current assets such as property, machinery or vehicles. The company s image and reputation are based on the provision of a luxury service, and purchasing expensive property is an essential element of this. Customers expect the hotels to be equipped with expensive furniture and fittings, requiring substantial investment. The company has been highly profitable (its ROCE exceeded 30 per cent last year) and therefore it has funds available or can afford to finance further loans. It is planning to expand into some European cities, so further investment will be required. (b) Discuss the likely consequences for the other functions within Prestige Hotels of the operation of this financial strategy. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A financial strategy is a medium- to long-term plan designed to achieve the objectives of the finance function or department of a business. The HR department will need to recruit suitable and sufficient employees to staff the new hotels. This may also require an extensive training programme to ensure that the new employees meet the standards expected by customers. The marketing department will need to promote the extended product range and to reflect the strategy in its promotional activities. The marketing department may need to research the best locations for the company s new hotels.

40 4 2. (a) Analyse two reasons why Top Pizzas may have decided upon a financial strategy of implementing profit centres. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of A profit centre is an area, department, division or branch of an organisation that is allowed to control itself separately from the larger organisation. The company operates 59 similar mini businesses and it is advantageous to be able to assess which are the most efficient and profitable. Tony has found it more difficult to control the growing business in a hands on way. The company s profit margins have fallen, perhaps because of diseconomies of scale. Implementing profit centres can have a positive effect on the levels of motivation in the business. (b) Tony is convinced that this is the right financial strategy for his business. Do you agree with him? Justify your decision. (15 marks)

41 4 Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A financial strategy is a medium- to long-term plan designed to achieve the objectives of the finance function or department of a business. The business comprises 59 small elements, which can operate with a degree of financial independence. As it is growing, some type of decentralisation is probably essential. Tony is keen to take most of the decisions, which may not fit in with the strategy of implementing profit centres. It might not fit smoothly with Tony s desire to keep costs to a minimum if branch managers take decisions which increase the business s costs. Whether this is the right strategy depends on a number of factors, such as the amount of training Tony intends to offer and the degree of support he has from other managers. Questions CASE STUDY 1. Explain what is meant by cost minimisation. () A business operates a strategy of cost minimisation where it reduces its level of expenditure as far as is possible to allow it to provide goods or services of acceptable quality to its customers. This strategy has received much publicity as a result of its use by budget airlines such as easyjet.

42 4 2. Examine the ways in which easyjet has implemented its financial strategy of cost minimisation. (9 marks) Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of Cost minimisation occurs when a business reduces its level of expenditure as far as is possible to allow it to provide goods or services of acceptable quality to its customers. It minimises the amount of time that its aircraft spend on the ground 20 minutes rather than one and a half hours. It sells 90 per cent of its tickets online, reducing staffing costs. It does not offer free meals and drinks to passengers. The biggest cost saving is that easyjet does not need to pay commission to travel agents.

43 4 3. Discuss whether a financial strategy of implementing cost centres might become a necessity if easyjet continues to grow rapidly. (1) Evaluation two or more relevant points and shows Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Acost centre is an area, department, division or branch of an organisation for which it is possible to calculate costs (but not revenues). Using cost centres could help to control costs if easyjet s employees are set tough budgets. Some relatively junior employees might have good ideas on ways to reduce costs if given some authority in the area of finance. Central control of costs will become much more difficult if the airline continues to grow. Surely the airline should continue to focus on cost minimisation, taking decisions centrally to achieve this. It might make more sense for the company to operate profit centres, as this will focus on revenues as well as costs. Implementing cost centres might become desirable, but not a necessity.

44 4 4. To what extent is the company s operations function most affected by its decision to minimise costs? (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. A company s operation s function manages the production process, converting inputs into goods and services. It will be responsible for turning the planes around as quickly as possible It will shape operation s tasks, e.g. not providing free meals and drinks is likely to reduce this aspect of its work. However, marketing s role will be heavily dependent on the strategy of costs minimisation, affecting its promotion and the way it communicates with customers (electronically). HR will be affected by the need to minimise wage costs. This will require minimal staffing and the use of technology (as in sales of tickets) wherever possible. All of the functions within easyjet will have to contribute to the company s corporate strategy of growth through providing a low-price product.

45 Making investment decisions AQA Business Studies for A2 5 Question: BUSINESS IN FOCUS Why does Nokia, with the resources to carry out extensive market research, have such difficulty in forecasting its sales accurately? The company operates in a highly competitive market and it is difficult to predict the actions of rivals. The market is strongly influenced by technological change Nokia may have fallen behind on occasions. Nokia trades in a global market this is comprised of many different markets where trends may differ. Mobile phones are luxury products and may be subject to wide variations in demand. Question: BUSINESS IN FOCUS What criterion (or criteria) might Coca-Cola have used to judge the value of this investment? Coca-Cola may have calculated a return on this investment and compared it with the rate of interest. The level of profit that the company expects to receive on this investment is likely to have been a key criterion. Coca-Cola would have considered a number of bottled water companies as takeover targets. Abbey Well may have offered the highest figure. Question: BUSINESS IN FOCUS What effect might the dramatic fall in oil prices have had on Southwest Airlines hedging strategy in the second half of 2008? The company may have paid a higher price for its fuel by basing its decisions on earlier and higher prices on world oil markets. The company may have forecast the fall in prices and have negotiated a lower price, which may have reflected (or been below) world prices.

46 5 Southwest Airlines may have decided not to engage in hedging if it believed that global oil prices were going to fall. Questions: BUSINESS IN FOCUS What financial methods of investment appraisal might Dell have used before deciding to invest funds in these ways? It may have calculated the ARR on its green project and not making a change and compared the two levels of profits. The company may have taken a similar approach with NPV possibly a better option, given the longterm nature of this investment. What qualitative factors might have influenced its decision? Going green might improve Dell s corporate image. This strategy might assist Dell in achieving its corporate objectives (it is challenging to be the global market leader in computer hardware). PROGRESS QUESTIONS 1. Outline three business decisions that may require the application of investment appraisal techniques. (9 marks) The development of new products. The purchase of production equipment. The takeover of another business. Investment in training and development. The acquisition of additional capacity. 2. Explain why forecasts of sales revenues arising from an investment may prove to be inaccurate. (7 marks) Actions (and reactions) of competitors. Unexpected changes in the state of the economy. Insufficient market research.

47 5 Further technological development rendering products or processes obsolete. 3. Why might investment appraisal be easier to conduct in a stable economic environment? (7 marks) Costs are less vulnerable to sudden fluctuation, e.g. due to the effects of inflation. Demand for a new product (and hence expected revenues) will be more predictable. Interest rates are less likely to be adjusted as part of the government s counter-cyclical policy. The degree of risk will be lower, making judgements easier. 4. Thames Radio is contemplating investing in new broadcasting equipment. The cost of the investment is forecast to be 150,000. The expected additional revenue from being able to broadcast to a larger area is 40,000 per annum. What is the payback period of this investment? (5 marks) Revenue is 40,000 per annum and over a period of 3.75 years would be sufficient to cover the initial investment. Thus payback is three years and nine months. 5. Explain one disadvantage of using payback in the circumstances in question 4. () It ignores any income received after the payback period is complete. No account is made of the timing of payment within the payback period. Changes in the cost of borrowing, as reflected in the rate of interest, are not taken into account. 6. Outline the stages that have to be completed to carry out an average rate of return calculation. (6 marks) Establish the costs and revenues associated with the project(s). Calculate the total earnings from the project. Deduct the cost of the project from its total earnings to calculate the overall profit. Divide the total profit by the duration of the project (in years) to give the annual average profit. Express the annual average profit as a percentage of the initial investment to show the annual rate of return. 7. Wessex Leisure is considering the purchase of a pleasure cruiser for use on the Solent. The Meriden is available at a cost of 900,000 and would cost 100,000 each year to operate. Over its ten-year life the cruiser would generate 280,000 in revenue each year. Calculate the average rate of return on this investment. (7 marks) Costs equal 900,000 ( 100,000 10) 1,900,000. Revenues ,000 2,800,000. Overall profit 2,800,000 1,900, ,000 Average annual profit 900,000/10 90,000 Average rate of return 90,000/ 900, %.

48 5 8. Explain what is meant by the present value of a stream of earnings from an investment. (5 marks) The value of the income generated by an investment, expressed in terms of its current worth. Future earnings are converted into their present-day values through the process of discounting. This process uses the expected rate of interest as the basis for reducing the value of future earnings to represent their current worth. The longer the wait for income, the less it is worth in present-day terms. This is because a smaller amount could be invested and earn interest to equal the value of the future earnings. 9. Chedgrave Printers Ltd is appraising the costs of and benefits from a new piece of machinery. The equipment costs 300,000 and has a working life of four years. The company expects to generate revenue of 120,000 each year if it purchases the machine. Calculate the net present value of this project assuming an interest rate of 10 per cent. (7 marks) CAM Year Annual cash flows s Discounting factors at 10% Present value s 0 (300,000) 1 (300,000) 1 120, , , , , , , ,960 Net present value 80, Outline two qualitative factors that an oil company may consider as part of the appraisal of a proposed investment to extract oil from the seabed under the English Channel. (6 marks) The possible environmental damage. The impact upon the corporate image. The extent to which the project would assist the business in meeting its corporate objectives. ANALYSIS AND EVALUATION QUESTIONS 1. (a) Analyse the benefits to the business of using net present value to compare the two pieces of machinery. (10 marks)

49 5 Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of Net present value (NPV) is the value today of the estimated cash flows resulting from an investment decision. NPV will take into account the profitability of the business as well as the timings of cash flows this is a benefit over other techniques. It gives numerical data as a basis for a decision and is a more scientific approach. The business will benefit from a careful consideration of the costs and revenues involved in the purchase of the two pieces of machinery.

50 5 (b) Discuss whether the business should give greater emphasis to quantitative or qualitative influences when taking this decision. (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Net present value (NPV) is the value today of the estimated cash flows resulting from an investment decision. The company s profits were low last year ( 245,000) and this is a major investment, so quantitative factors should rule this decision. The business has a duty to its shareholders to make the maximum possible profits, so quantitative factors should take precedence. Burrows Ltd is located in an area of high unemployment a major reason why qualitative factors should be considered. Shouldn t this business be considering all its stakeholders and taking both factors into account as part of the decision?

51 5 2. (a) Explain why the finance director might think that investing in copper mining in Africa is a more attractive project in terms of profits. (10 marks) Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of single relevant point or shows some Candidate makes limited attempt Limited analysis of Profits are the surplus of revenue over total costs for a specified period of trading. The average rate of return for the African project is substantially higher. Item African project UK opencast coal Initial investment 70 million 40 million Average annual profits over five years 36 million 10 million Average rate of return (ARR) 51.43% 25.0% The directors judgement is based on current prices for copper and coal.

52 5 (b) To what extent does the risk involved in this decision mean that the use of financial techniques of investment appraisal is of little value? (15 marks) Evaluation 5 marks Candidate identifies two or more relevant points and shows Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. Investment appraisal is a series of techniques designed to assist businesses in judging the desirability of investing in particular projects. The African country is a risky area to work: there was an armed uprising only three years ago. A future government in the African country may not honour any agreement made with the current one. The financial director s forecasts for the UK are based on a rising price for coal, which may not continue and may be reversed. Financial techniques can build in a margin for risk. The company aims to make a profit for its shareholders. How can it assess any investment without considering financial aspects? The appraisal of any project requires the consideration of quantitative and qualitative factors, so financial techniques must play a part. The company s directors may give less weight to quantitative factors than normal, given the extent of the risk, especially in the African project.

53 5 Questions CASE STUDY 1. Explain what is meant by net cash flow. () Cash flow is the money that flows into and out of a business over some period of time. Net cash flow deducts cash outflows from cash inflows to give overall cash flow for a period. It can be positive or negative depending on the relative sizes of the cash inflows and cash outflows. 2. Calculate the average rate of return for the two investment projects and state which one the managers of Transit should select on the basis of your calculations. (9 marks) Candidate demonstrates good knowledge of ARR using formula or definition and makes correct decision. Candidate demonstrates good knowledge of ARR using formula or definition. Candidate demonstrates some knowledge of ARR using formula or definition. 6 marks 6 5 marks Candidate calculates answer correctly. 4 Candidate makes reasonable attempt at relevant calculation. 2 s Candidate makes limited attempt at relevant calculation. The calculation of average rate of return: West Coast Trains ( m) HK Transport ( m) Initial investment (240) (250) Income Year Year Year Year Total income Total profit Average annual profit 36 4 Average rate of return Investment in HK Transport offers a more attractive average rate of return and the managers should select this on the basis of financial data.

54 5 3. Discuss whether the average rate of return was the best financial method of investment appraisal to use in these circumstances. (1) Evaluation two or more relevant points and shows good understanding of the Candidate applies knowledge effectively Good analysis of judgement plus full justification. two or more relevant points or shows good term or a combination. Candidate makes reasonable attempt Reasonable analysis of 3 judgement plus limited justification. single relevant point or shows some Candidate attempts Limited analysis of undeveloped judgement based on evidence. The average rate of return (ARR) calculates the percentage rate of return on each possible investment. ARR calculates the profit on the investment as a percentage of the cost of the investment. The company will seek to make the maximum possible profit for its shareholders. However, this measure does not take into account the timings of cash flows, and this is an important element of such a decision, especially for a business that is suffering financial problems. Any effective method of investment appraisal should include an assessment of qualitative factors too. NPV might have been a preferable financial technique as it accounts for the timings of cash flows as well as profitability.

55 5 4. Some directors said that the company should not invest in either of the projects. Do you agree with them? Justify your view. (15 marks) Evaluation 5 marks three or more relevant points. Candidate applies knowledge effectively Good analysis of 5 judgement plus full justification. two relevant points. Candidate makes reasonable attempt 3 Reasonable analysis of 3 judgement plus limited justification. single relevant point. Candidate attempts Limited analysis of undeveloped judgement based on evidence. The company is not in a strong financial position and these projects entail a degree of financial risk. The threat of recession and fluctuations in the value of the pound may alter the costs and returns from the HK project, rendering it less profitable the managers should seek a safer investment. The company s performance on its existing businesses is declining and this may require attention and funds to repair. The directors (other than Craig) have severe doubts about the wisdom of a strategy of expansion at this time. Profits have declined significantly (as well as the company s reputation), meaning that it may not be able to raise the finance required for either project. More information is needed to make this decision, particularly about the precise financial position of Transit plc.