# Financial Decision Making Sample paper

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2 To produce a schedule of cash flows, the operating cash flows should first be calculated. These are as follows: m Sales (9,000 x 2,500) 22.5 Manufacturing, marketing and distribution costs [ 25.5m ( 2.0m + 4.5m)*] * The annual depreciation charge is 11.5m - 3.5m/4 = 2.0m per year. This must be deducted, along with the general apportionment for head office costs of 4.5m, to derive the net operating cash outflows. To calculate the relevant discount factor, the weighted average cost of capital must be calculated. The cost of equity (K o ) can be calculated using the formula for the capital asset pricing model (CAPM), which is: K 0 = K RF + b(k m - K RF ) = 2% (7.0% - 2.0%) = 10% The cost of irredeemable debt (K d ) can be calculated as follows: I K d = P d = (6/120) x 100% = 5.0% The weighted average cost of capital is therefore: [(0.60 x 10%) + (0.40 x 5.0%)] = 8.0% The schedule of net relevant cash flows will take account of the initial cost of the equipment and its residual value as well as the net operating cash flows. The net present value (NPV) of the proposal is as follows: The NPV of the project is: Year m m m m m Net cash flows (11.5) Discount rate (8%) Present value (11.5) NPV 2.6 ICSA, 2010 Page 2 of 14

3 (b) Prepare a briefing paper for a non-executive director on the benefits of sensitivity analysis in the current turbulent economic climate. As part of your briefing, undertake sensitivity analysis to show by how much each of the following would have to change before it becomes no longer worthwhile to produce the new camera: (i) (ii) The cost of the equipment. The net annual operating cash flows. (9 marks) To: Non-executive director From: A Candidate Benefits of sensitivity analysis The current turbulent economic climate has added greatly to the risk and uncertainty associated with investment decisions. This, in turn, has given added impetus to the need to employ techniques that take account of these factors when evaluating investment decisions. Sensitivity analysis involves taking a single variable in the investment appraisal calculations and examining the effect of changes to this variable on the final outcomes. Thus, a common form of sensitivity analysis examines the change required before the investment results in a zero net present value. The aim is to help managers to gain a better feel for the effect of forecast inaccuracies on the results. However, sensitivity analysis only considers one variable at a time. In practice, it is possible that changes to a number of variables will occur simultaneously. The point at which a change will result in a zero NPV for the proposal is calculated below: (i) (ii) The equipment cost would have to rise by 2.6m, which is the amount of the NPV. This would represent a rise of almost 23% ( 2.6m/ 11.5m) in the equipment cost. The decrease in net annual operating cash flows (N) needed to make the project no longer worthwhile is calculated as follows: (N x annuity factor for a four-year period) - NPV = 0 (N x 3.312) - 2.6m = 0 N = 2.6m/3.312 N = 0.79m This represents a decrease of approximately 23% ( 0.79m/ 3.5m) in the estimated figure. (c) Comment on the findings contained in your answers to (a) and (b), above, and identify any further information which may be useful before a final decision is made. (6 marks) The calculations in (a) and (b), above, ignore two costs that have already been incurred: research and development costs and market survey costs. As these represent sunk costs, they are not relevant to the decision. However, if the calculations had been made before these costs were incurred, the NPV outcome would have been significantly different. The calculations above show that producing the new camera will yield a positive NPV. This means that, by accepting the proposal, it is estimated that shareholder wealth will be enhanced. This is normally assumed to be the key objective of a company and so the decision rule is that the proposal should go ahead where there is a positive NPV. ICSA, 2010 Page 3 of 14

4 The calculations in (b), above, indicate that the two variables examined are not sensitive to change. Net operating cash flows would require a fall of almost 23% and the cost of the equipment would require a rise of nearly 23% before a zero NPV is produced. Sensitivity analysis does not provide an insight to the probability of these changes occurring and it would be useful to discover this information before a final decision is made. It may also be useful to examine the sensitivity of other key variables, such as the life of the project and the discount rate. This may reveal more sensitive variables that require further investigation. 2. Trafford plc ( Trafford ) operates a large chain of pizza restaurants. In recent years, the company has expanded its operations and is seeking opportunities to expand further through a policy of acquisition. To this end, the directors of Trafford have identified Stamford plc ( Stamford ), which owns a chain of hamburger restaurants. The directors of Trafford believe that this restaurant chain would fit well within their existing business. Abridged financial statements for both companies appear below. Statement of financial position as at 30 April 2010 Trafford Stamford ASSETS m m Non-current assets Current assets Total assets EQUITY AND LIABILITIES 1 Ordinary shares Retained earnings Non-current liabilities Current liabilities Total equity and liabilities Income statement for the year ended 30 April 2010 Trafford Stamford m m Revenue Operating profit Interest payable (0.6) (0.8) Profit before taxation Tax (4.1) (2.5) Profit for the period The directors of Trafford wish to acquire Stamford using a share-for-share exchange. They have offered 2 shares in Trafford for every 3 shares held in Stamford. The price/earnings ratio of Trafford is 16 times and for Stamford it is 9 times. The directors of Trafford believe that it is possible to achieve a price/earnings ratio of 15 times in the enlarged company by ensuring that the restaurants formerly owned by Stamford adopt more efficient practices and better marketing techniques. Annual, aftertax cost savings of 2.5 million per year are expected from the acquisition of Stamford. ICSA, 2010 Page 4 of 14

5 Required (a) Calculate the total value of the proposed bid by Trafford and the expected earnings per share following a successful takeover of Stamford. (7 marks) The number of shares offered as bid consideration are: 2/3 x 15m = 10m The earnings per share of Trafford is: 16.5m/50m = 33p The value of each share is = P/E ratio x EPS = 16 x 33p = 5.28 The total value of the proposed bid is, therefore = 5.28 x 10m = 52.8m The after-tax earnings following takeover are expected to be: m Earnings of Trafford 16.5 Earnings of Stamford 9.2 Cost savings Shares in issue following takeover = 50m + 10m = 60m EPS following takeover = 28.2m/60m = 47p (b) Assess the likely implications of a successful bid for the wealth of shareholders in Trafford and in Stamford and discuss any issues that are critical to this assessment. (10 marks) Share price following takeover = P/E Ratio x EPS = 15 x 47p = 7.05 From the perspective of shareholders in Trafford, the proposed bid appears to be worthwhile. Shares are currently trading at 5.28 and are expected to rise to 7.05 following the takeover. This represents a rise of approximately 34%. Shareholders of Stamford, on the other hand, have little to celebrate. The value of a share in Stamford is currently worth 5.52 ( x 9). A 2-for-3 offer would involve exchanging shares worth (3 x 5.52) for shares worth (2 x 7.05). This represents a fall of approximately 15%. Unless the benefits from the proposed takeover are more evenly shared between the two groups of shareholders, there is little incentive for the shareholders in Stamford to accept the bid. The above calculations are dependent on the company achieving the cost savings mentioned. In practice, this may be difficult to achieve. It is also dependent on maintaining the price/earnings (P/E) ratio of Trafford at 15 times. If the market does not share the confidence of the Trafford ICSA, 2010 Page 5 of 14

6 directors concerning the benefits of the takeover, the P/E ratio may fall further, which would make the bid much less attractive for both groups of shareholders. The basis for assuming that the P/E ratio will be maintained at 15 times should, therefore, be carefully examined. (c) Explain, for a new non-executive director, the use of a share-for-share exchange as a means of bid consideration from the perspective of shareholders in both Trafford and in Stamford. (8 marks) The new non-executive director should be made aware that the real benefit of a share-for-share exchange, from the perspective of Trafford shareholders, is that it will provide the opportunity to acquire Stamford without incurring any strain on liquidity. However, this benefit must be weighed against the costs. A share-for-share exchange will lead to a dilution of control. In this case, 20% more shares would be in issue following a takeover. It may also add to the uncertainty of the proposed takeover. Share prices fluctuate over time and there is always a risk that a fall in share prices could undermine the chances of acceptance. It should also be borne in mind that equity shares are an expensive form of long-term funding as they represent the risk capital of the business. Future service costs are, therefore, likely to be high. For the shareholders of Stamford, the receipt of shares would mean that their investment portfolio would retain an equity element, which may be desirable. The shareholders would also avoid any liability to capital gains tax, which may arise where cash is offered in exchange for shares. However, the shares received may not have the same risk/return profile as those exchanged. Thus, they may not fit the particular investment portfolio that is required. Shareholders may also find it more difficult to evaluate a bid offer in the form of shares, rather than cash, as share prices tend to fluctuate. 3. The efficiency of stock markets has important implications for managers. Where stock markets are efficient, managers must learn important lessons on how to manage their business. Required (a) Explain what is meant by the term efficient markets and outline the three major forms of market efficiency. (7 marks) The term efficient markets refers to the manner in which information provided to stock market participants is processed. In an efficient stock market, participants will process information quickly and accurately so that share prices are adjusted to represent all relevant information that is available. This means that share prices will provide the best estimate of the intrinsic value of a share. Three forms of market efficiency have been identified. These are: Weak form efficiency This form of efficiency occurs when past information, such as the trend of share prices and rates of return, are quickly and accurately incorporated within the current share price. The consequence of this is that past information has no influence on future share prices. In other words, future share price movements are not linked to past share price movements. This means that any attempt to detect underlying share price patterns will fail. ICSA, 2010 Page 6 of 14

7 Semi-strong efficiency This extends the notion of efficiency by stating that all publiclyavailable information, such as published financial statements and company announcements, is quickly and accurately incorporated within the current share price. This means that studying publicly-available reports and other information will not enable investors to make abnormal gains on a consistent basis. Strong-form efficiency This extends the notion of efficiency even further by stating that all information, whether or not it is in the public domain, will be fully incorporated within the current share price. This means that even those with inside information will be unable to make abnormal gains on a consistent basis. Each level of efficiency incorporates the features of the level(s) below it. Thus, the strong-form efficiency incorporates the features of both the weak form and the semi-strong form. Although the evidence concerning the efficiency of stock markets is, almost inevitably, mixed, there is persuasive evidence that leading stock markets are efficient, at least in the semi-strong form. (b) Identify and discuss six important implications of market efficiency for managers. (18 marks) The notion of stock market efficiency has the following important implications for managers. (i) (ii) (iii) (iv) (v) (vi) The first implication is that managers should be wary of trying to identify takeover targets by seeking out companies with undervalued shares. If the market reflects strong-form efficiency, share prices will already reflect the best estimate of the true worth of a company. If the market reflects semi-strong form efficiency, managers would need information not available to the market to make such a strategy worthwhile. The second implication is that substance is more important than form when releasing new information to investors. Some managers may believe that, by presenting information in a certain way, investors will view the company in a better light. For example, a decision may be made to change accounting policies in order to boost profits. However, the evidence shows that investors will see through any attempts at window dressing and will price shares according to the underlying economic substance. The third implication is that any investment plans and decisions made by managers will be assessed by investors and this will be reflected in the share price. Thus, a fall in share price following an important investment decision will provide managers with the market s judgement, which is objective and informed. Managers may, therefore, wish to review their decisions following this judgement. The fourth implication is that the timing of new share issues may not be of critical importance. If the market is efficient, there is no optimal point for an issue. Even when share prices are low, it will still reflect the market s view of future share returns and there are no grounds for assuming future improvement. However, if the market was efficient in the semi-strong form, managers may have inside information which, when released to the market, would result in an upward revision in the share price. The fifth implication is that stock market investors determine the level of risk associated with a particular investment and, therefore, the required level of return. This cannot be changed by managers and will apply to whichever business undertakes the investment. The final implication is that, where managers adopt policies that seek to maximise shareholder wealth, this will be reflected in the share price. Not only should this benefit shareholders, but it may also benefit managers. ICSA, 2010 Page 7 of 14

11 The value of the rights per existing share is calculated as follows: m Theoretical ex-rights value per share 7.82 Cost of 1 rights share 5.10 Rights value 2.72 Rights value per existing share ( 2.72/4) 0.68 (b) With regard to the rights issue, evaluate each of the options available to a shareholder owning 10,000 shares in Maine plc. (6 marks) The following options are available to the investor: To take up the rights shares Value of holding after the rights issue [(10, ,500) x ,750 Cost of rights shares (2,500 x 5.10) 12,750 85,000 To sell the rights shares Value of holdings after the rights issue (10,000 x 7.82) 78,200 Proceeds from the sale of rights shares (2,500 x 2.72) 6,800 85,000 To let the rights offer lapse Value of holdings after the rights issue (10,000 x 7.82) 78,200 The calculations above reveal that the shareholder would have the same total wealth under the first two options but would be worse off if the rights offer was allowed to lapse. However, in practice a company would normally sell the rights shares not taken up and pass the proceeds on to the shareholders. The shareholder would then be in the same position as that shown in the second option. (c) Calculate the market value per share following the rights issue, if the expansion strategy leads to an increase in after-tax profits of 4.6 million and to an increase in the price/earnings ratio of 20%. (6 marks) The market value per share resulting from the expansion strategy can be calculated as follows: Current earnings per share ( 42.0m/80m) 52.5p Current P/E ratio ( 8.50/52.5p) times Post-expansion earnings per share ( m/100m) 46.6p Post-expansion P/E ratio [ (20% x 16.19)] times New market value per share (19.43 x 46.6p) 9.05 ICSA, 2010 Page 11 of 14

14 Loan covenants Where a business has loan capital, conditions may be contained within the loan agreement that restrict the amount of dividend to be paid during the period of the loan. Such restrictions are designed to protect the interests of the lenders. The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental. ICSA, 2010 Page 14 of 14

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