Financial Management - Calculation and Analysis

Capital Appraisal for New Product Launch

AAA plc is considering launching a new product. It bought the patent to manufacture the item a year ago for £20,000 and could now sell it for £10,000. (The taxation effects of the purchase or sale of a patent should be ignored).

Preliminary market research, costing £5,000, has added to the optimism about the product and a full capital appraisal is now to be undertaken. It is anticipated that sales in the first year would be 10,000 units, 20,000 in year 2, rising to 30,000 per annum in years 3 to 8 before dropping to 20,000 in year 9 and 10,000 in year 10. The company plans to stop production at that point. The patent would have no residual value.

The sales price would be £2.20 per unit in the first year and it is anticipated that it would then rise by 4% per annum for the life of the product. The current price of the relevant materials for the first year’s sales is 50p per unit and this cost is expected to rise by 2% per annum.

Current salaries’ estimates are £15,000 per annum and wage inflation is expected to be 3% per annum for the life of the project. Other costs are budgeted to be 30p per unit in today’s money and will rise by the general level of inflation estimated at 2.5% per annum.

A new machine would have to be purchased to manufacture the product. It would cost £100,000 and could be purchased immediately. It would last the ten years of the product’s expected life and could then be sold for £10,000 at today’s money. The price of machinery is expected to rise in line with the general rate of inflation. The machine would qualify for the standard 25% reducing balance writing down allowances and would be subject to a balancing allowance or balancing charge, if applicable, on sale.

AAA plc pays corporation tax at a rate of 30% and will have sufficient income from other activities to ensure it will be paying tax for the foreseeable future.

You may assume that the tax payments will occur in the year the related profits are made and that cash flows will occur at the end of the relevant year. There would be no other alteration to the cost structure of the firm. The market determined cost of capital for this project is 11%.

Required:

Advise AAA plc whether it should go ahead with production on financial grounds. (Support your answer with all the necessary calculations. You must show all your workings.)

Working Capital Management - Customer Credit Extension and Factoring

a) Bricks plc’s sales for 2019 were £8m. Costs of sales were 80% of sales. Bad debts were 2% of sales. The variable portion of the cost of sales was 90% of the total cost of sales, while the fixed portion of the cost of sales was 10% of the total cost of sales. Bricks plc’s cost of finance is 10% per annum. Bricks plc allows its customer 60 days’ credit, but is now considering increasing this to 90 days’ credit because it believes that this will increase sales. Bricks plc’s sales manager estimated that if customers were granted 90 days’ credit, sales may be increased by 20%, but that bad debts would increase from 2% to 3%. The finance director calculated that such a change in policy would not increase fixed costs, and neither would it result in changes to trade payables and inventory.

Would you recommend that Bricks plc increase customer credit to 90 days? (Support your answer with all the necessary calculations. You must show all your workings.)  (10 Marks)

b) Nert plc has annual sales of £160,000,000. Its current receivables are £41,000,000. All sales are on credit. The company currently pays interest on its overdraft at an annual rate of 4%. The finance director decided to improve company’s working capital management and asked a factoring firm to provide a quotation for non-recourse factoring. The factor has indicated that it would require an annual fee of 0.5% of sales. It would advance Nert plc 80% of the face value of sales at an interest rate 1% above the current overdraft rate. It expects the average time taken by receivables to pay to fall immediately to 75 days. The finance director has also been assured that irrecoverable debts, currently standing at £500,000 per year, would fall by 80%. Savings in current administration costs of Nert plc of £100,000 per year would be achieved as a result of factoring.

a) The returns on shares X and Y vary depending on the state of economic growth.

Calculate:

i) The expected return and standard deviation for share X;

ii) The expected return and standard deviation for share Y;

iii) The covariance and the correlation coefficient between returns on X and returns on Y;

iv) Determine a portfolio’s expected return and standard deviation if two-thirds of a fund is devoted to X and one-third devoted to Y.

(Support your answer with all the necessary calculations. You must show all your workings.) (14 marks)

 b) The choice of working capital policy inevitably presents a conflict between the goals of profitability and liquidity.

Critically discuss how a company’s choice of working capital policy can address such a conflict.   

a) Two companies, A and B, are considering entering into a swap agreement. Their borrowing rates are as follows.

Company A needs a floating rate loan, while company B needs a fixed rate loan.

Required:

i) Which company has a comparative advantage in floating rate debt, and which company has a comparative advantage in fixed rate debt.

ii) At what rate will company A be able to obtain floating rate debt and company B be able to obtain fixed rate debt if the two companies agree a swap and the benefits of the swap are split equally between them?

(Ignore bank charges. Support all your answers with all the necessary step by step calculations. You must show all your workings.)

Critically discuss the inverse correlation between financial risk and business risk, and explain how a company may use this to develop an appropriate financial strategy, during each stage of its life cycle.