Working Capital Management and Investment Appraisal: Two Case Studies

Case Study 1: Fruit Confectionery Limited

Fruit Confectionery Limited (FCL) is a small-medium sized enterprise based in Scotland. The company manufactures and sells confectionery made from fruit to a range of wholesalers and retailers in the UK. The company has only been in existence for three years but already has made its first revenue from sales to mainland Europe but suffered an exchange rate loss due to a decrease in the value of the €.

The rapid expansion concerns the Board of Directors as financial systems have grown on an ad hoc basis to date. One of the major concerns the Board has is its management of working capital, in particular the credit control function. Despite its best credit control efforts, including analysing customers into slow, medium and fast payers and chasing them accordingly, FCL still incurred some significant bad debts in its first three years.

FCL offers its customers a 1% discount for settlement in 30 days but less than a third of the customers take advantage of this. Revenue for the year just ended was £4,065,694 with variable cost of sales of £3,862,410.

The following working capital financial information is available for the year just ended:

Analysis of the outstanding trade receivables at the end of the year just ended and forecast bad debts incidence (based on historical actuals) as a percentage of the balance shows the following:

It has been proposed that the discount for early payment be increased from 1% to 2% for settlement within 25 days. Other plans to improve working capital management have led the Board of directors to forecast the following:

• Revenues to increase by £750,000, split 70%/20%/5%/5% between the categories of receivables above

• Gross margin to continue at the existing level

• Inventory will increase to £275,000 to support the new revenues and trade payables are expected to increase to £230,000

• Bad debts are forecast to fall as follows: medium category receivables to fall from 4% to 2.5%; slow category receivables to fall from 10% to 5% and European receivables to fall from 12% to 7.5%.

Other information:

• FCL finances its receivables using overdraft facilities at an annual cost of 5%

• The current spot rate is £1/€1.15 and the 3-month forward rate is £1/€1/1.17

1. Calculate the net benefit or cost of increasing the discount to 2% for early payment in 25 days and conclude on the acceptability of the proposal. Show all workings.(8 marks)

2. Calculate and comment on the change in the operating cycle resultant from the forecast changes to working capital. Show all workings.(3 marks)

3. Critically evaluate three appropriate methods that FCL might use to hedge its foreign exchange rate risk on its European revenues.(7 marks – 400 maximum word limit)

4. Advise on the essential elements of a system of credit control appropriate for FCL.(7 marks – 400 maximum word limit)(Total 25 marks)

Hazel Tree Hotels (HTH) is a Scottish company that operates tourist hotels throughout the UK and Europe. The Board of Directors has decided that strategically the company requires to diversify into running bus tours in order to build greater value for its shareholders. As this is an entirely new venture for HTH, it was decided by the Board to evaluate it over a four-year period initially.

The previous CFO left the company recently and the financial controller was asked to undertake a financial investment appraisal of the proposed ‘Beech Tree Buses (BBB)’ project. The Board has been given the following net present value (NPV) estimate and recommendation by the financial controller:

Net present value is negative £0.13 million, and therefore the recommendation is that the ‘BBB’ project should be rejected.

A new CFO has since joined the company and has indicated that there may be a problem with the above analysis. She is concerned that there are a few errors in the calculations and indeed that the wrong approach has been taken. She believes that an adjusted present value (APV) approach should have been taken, as the ‘Beech Tree Buses (BBB)’ project is quite different from operating tourist hotels.

Jimmy Jalopy (‘JJ’) is a quoted company that operates in the bus tour business. JJ is financed by 22 million shares trading at £2.50 each and £10 million debt trading at £89 per £100. JJ’s equity beta is estimated at 1·70. The current yield on government treasury bills is 1% and it is estimated that the average return on the market is 7%. JJ pays corporate taxation at a rate of 18%.

The new CFO has found the working notes and assumptions used by the financial controller to compile his NPV assessment:

• Initial investment is £6 million; of this, £5.7 million relates to the purchase of tour buses, which are expected to be sold for £0.5 million when the project ceases.
• Tax allowable depreciation at 25% is available on the buses on a reducing balance basis. A balancing adjustment is available in the year the buses are sold. No tax allowable depreciation is available on the £0.3 million remaining investment and it will have a £nil value at the end of the project.

• Incremental fixed costs of £0.5 million per annum have been ignored. These have not been accounted for as the financial controller believes them to be irrelevant.
• HTH uses either a nominal cost of capital of 9% or a real cost of capital of 6% to discount all projects, given that the general rate of inflation has been stable at 3% for several years. As the real cost of capital has been used to discount the cash flows, neither the revenue nor the direct costs have been inflated.

• It is estimated that the inflation rate applicable to sales revenue is 5% per annum, to direct costs is 3% per annum and to fixed costs is 1% per annum.
• At the beginning of each year, HTH will require to invest working capital equivalent to 10% of the anticipated revenue for the year. Any remaining working capital will be released at the end of the project. As the net movement in working capital is zero, it has been ignored in the net present value calculation.

• The Board plans to finance the BBB project by loan finance at a rate of 4% above the current yield on government treasury bills. This loan will be repaid in four equal annual instalments. Issue costs are estimated at 0.5% of the gross loan required and will be paid out of cash reserves.
• HTH pays corporate taxation on profits at a rate of 20%. Corporate taxation is payable in the same year as profits are earned.

1. Critically assess the work undertaken by the financial controller and the recommendation he made.(12 marks – 750 maximum word limit)

2. Undertake an APV analysis, clearly explaining each step of the APV approach and provide a recommendation based on this. Show all workings(13 marks – 500 maximum word limit, excluding calculations)