Professional Documents
Culture Documents
BUSINESS FINANCE
CONTENTS
2 Investment Appraisal 13
7 Leasing 127
1
Business Finance
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
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Business Finance
ANNUITY TABLE
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
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Business Finance
Study Unit 1
A. Introduction
B. Agency Theory
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Business Finance
A. INTRODUCTION
Or
In reality, firms have multiple, and often conflicting, objectives and will seek to optimise among
those. The modern corporation is a complex entity which is responsible not only to shareholders but
to all stakeholders. The main stakeholders are:
1. Shareholders
2. Lenders – seek security, repayment of loan interest and principal.
3. Employees – seek fair wages, promotional opportunities, welfare & social facilities =>
improved motivation.
4. Management - job security; fair reward; job satisfaction.
5. Suppliers - payment within credit terms.
6. Community - sponsorship; charities; install environmental measures.
7. Government - payment of taxes, rates, provide employment.
8. Customers - provision of service/goods at fair price; quality; on time etc.
The relative importance of the various groups may differ, possibly depending on company size and
management style.
Management will be concerned with the value of the firm as it satisfies one of the important
stakeholders (the shareholders). A low valuation may increase the possibility of an unwanted takeover
bid. Also, finance must be adequately rewarded and its market value maintained, so that further
finance is obtainable when required.
Non-financial objectives may conflict with financial objectives – e.g. provision of staff recreational
facilities; modern, safe working environment etc.
B. AGENCY THEORY
The managers/directors act as agents for the shareholders (owners) in running the company. This
separation of ownership from control may lead to certain problems if managers are not monitored or
constrained - e.g. management working inefficiently; adopting risk averse policies such as ‘safe’
short-term investments and low gearing; empire building for power/status; rewarding themselves with
high salaries and fringe benefits; increased leisure time etc.
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Business Finance
Managers’ and shareholders’ interests can be aligned by a number of measures - introducing profit-
related remuneration for management; offering bonus shares; share option schemes; scrutiny of
performance by the board of directors and banks who provide finance etc. However, care must be
taken to ensure that management does not take action to boost performance in the short-term to the
detriment of the long-term wealth of the shareholders (‘short-termism’).
C. NOT-FOR-PROFIT ORGANISATIONS
The objectives of Not-For-Profit organisations are likely to be strongly influenced by the government
and not primarily financial. These organisations exist to provide a service (e.g. Postal Services,
Health Services, House the Homeless etc.) and to ensure that social needs are satisfied and financial
requirements may be seen as constraints and not objectives. They are not usually profit maximising,
although subsidiary objectives may be concerned with earning an acceptable return on capital
employed.
In the private sector the effects of investments (and associated financing and dividend decisions) on
share price and shareholder wealth will be important. As there are no share prices in Not-For-Profit
organisations and investor wealth maximisation is not the assumed objective, some private sector
investment appraisal techniques will not be appropriate.
However, some private sector financial management techniques can be used in the Not-For-Profit
sector - e.g. discounted cash flow is often used.
The theory of business finance is that the prime objective of management of a listed
company is to maximise the wealth of its ordinary shareholders. Agency theory
dictates that management, as agents of the company’s owners, must act in their best
interests and, thus, strive to maximise shareholder wealth at all times. In their
attempt to achieve this prime objective management will set financial objectives,
including:
• profit levels
• sales and profit growth
• margin improvement
• cost releasing efficiency savings
• Earnings Per Share (EPS) growth
Management will also set non-financial objectives, which should complement and
support the financial objectives. These may include:
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Business Finance
Likewise, companies have been alleged to have acted in a less than socially
responsible manner. Examples include clothing and sports goods companies using
sub-contractors who employ child labour practices.
The extent to which organisations subscribe to CSR varies greatly both ideologically
and in practice. Research has shown that 90% of companies believed that CSR should be part of a
company’s makeup, yet only 30% actually did anything about it.
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Business Finance
However, there are many writers who vigorously oppose the notion that private organisations should
embrace social responsibility. Some of the main arguments against CSR are:
• market capitalism is the most equitable form of society that has ever appeared
• the ethics of doing business are not those of wider society
• governments are responsible for the well being of society
• an organisation’s maximum requirement is to remain within the law, no more than this is
required.
Ultimately, they argue that business organisations are created and run in order to
maximise returns for their owners and that CSR detracts from the profit maximisation
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Business Finance
1. You have been summoned to a meeting with your new managing director. He states that as
maximisation of the company’s share price depends upon the level of earnings per share that is
achieved, it is vital to improve profits next year. He gives you a list of suggested ways to achieve this.
The list includes:
(i) Minimise capital investment to reduce depreciation charges.
(ii) Increase wages and salaries by less than the level of inflation and sell the land that is
currently used as a staff sports field.
(iii) Reduce overdraft charges by delaying payments to creditors.
(iv) Delay expenditure on new equipment that will reduce pollution levels from the
company’s factory.
Prepare a memo to the managing director discussing the possible effects on relevant stakeholders of
the managing director’s suggestions and whether or not they are likely to result in an increased share
price.
2. ‘During the recent turbulent times the key objective of the executive directors of companies that
are listed on the Stock Exchange is to ensure that their company survives so that they may keep their
jobs.’
Discuss the validity of this statement and explain what financial or other factors are likely to influence
executive directors’ objectives.
3. Discuss whether or not the objectives of directors of a quoted company are likely to conflict with
those of the company’s shareholders.
4. Discuss the importance and limitations of ESOP’s (executive share option plans) to the
achievement of goal congruence within an organisation
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Business Finance
1. Whilst I agree that it is important to ensure that our share price is maximised, share price
maximisation is dependent upon maximising the present value of future cash flows, not on
maximising earnings per share (EPS) or profits. There is, of course, a correlation between EPS, profit
and share price, but, as long as the stock market is efficient, short-term accounting measures are not
the most important influence on share price. If the stock market is not efficient then short-term
accounting measures might influence the company’s share price. In an efficient market, in order to
maximise share price the company should concentrate on undertaking capital investments with a
positive net present value. Some of your suggestions might upset stakeholders and result in a
reduction in share price. For example:
(i) Minimising capital investment to produce a short-term increase in accounting profit takes a short-
term perspective and could mean ignoring excellent investment projects which would increase the
value of the organisation. Shareholder wealth could be reduced as a result of such actions and
employee remuneration could be lower than would be achievable with further investment.
(ii) Increasing wages and salaries by less than inflation could increase profits, but the detremental
effect on workforce morale might produce the opposite effect because of reduced efficiency. Conflict
with trade unions could occur and some employees might seek employment elsewhere.
Disposal of the sports field could produce a very hostile response from staff.
(iii) There might be some scope for delaying payment to creditors but if this delay is significant,
relations with creditors might be harmed and the company might face more stringent credit terms
from suppliers when new orders are placed. Additionally, such a move could result in a lower credit
rating and possibly higher costs of finance.
(iv) The company might have some flexibility to delay expenditure on pollution control equipment
but we must ensure that we can still meet all government standards for pollution. There might be
significant social costs. Delay might harm our reputation in the local community and with
environmental pressure groups. The effect of adverse publicity could outweigh any savings from
delaying expenditure.
2. Many countries have experienced economic recession, with high levels of corporate failure.
Executive directors will normally strive to ensure that their company survives, and that they keep their
jobs but this should not be their prime objective. In most listed companies the executive directors
only own a small minority of the company’s shares. Directors, as agents of the owners of the
companies (primarily non-director shareholders -NDS), should act in the best interest of such
shareholders. There may be conflicts of objectives between NDS and directors. NDS will normally
seek to maximise their wealth, often subject to satisfying secondary objectives such as environmental
standards and social provision. Executive directors may have many objectives, including keeping
their jobs, maximising salary or ‘perks,’maximising prestige, pensions or compensation agreements
should they lose their positions.
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Business Finance
Ensuring corporate survival may satisfy the majority of shareholders of companies that are in
financial distress, but for profitable going concerns it might mean that relatively safe decisions are
taken, which although maintaining corporate survival, do not maximise expected net present value or
shareholder wealth. Remuneration schemes may be devised that reward directors according to
corporate performance, especially share price linked performance. This is an attempt to ensure that
goal congruence (goals consistent with the maximisation of shareholders’ wealth) exists between
directors and NDS. If directors are going to personally benefit from good share price performance,
e.g. through share option schemes, they are likely to be motivated to take decisions that will maximise
share price. There have, however, been criticisms that many recent share option schemes have been
too generous to directors.
If the market is efficient, or almost efficient, the decisions of directors, including investment decisions
will be known to the market and share prices will move according to how market analysts and NDS
regard the decisions. A decision that is sub-optimal, and is not using the the company’s resources in
the most efficient way is likely to result in a fall in share price. This may increase the probability of
takeover by a company that is perceived to have more efficient directors and managers. The fear of
takeover is believed to be an incentive for managers to try and take the decisions that maximise
shareholder wealth.
3. The main objective of shareholders is often assumed to be to seek the maximisation of their
wealth, subject to taking an acceptable amount of risk. In practice shareholders may have multiple
objectives which include social and environmental issues.
The objectives of directors do not automatically correspond with those of the shareholders. Directors
may seek to maximise their own income and/or wealth, which could be at the expense of
shareholders, to increase work related benefits such as cars and pension schemes, to increase power
and prestige, or to generate job security. The amount of risk that directors are prepared to take may
significantly differ from the desired risk of shareholders, especially shareholders who own a well
diversified portfolio.
To some extent the actions of directors should correspond to the objectives of shareholders who, at
least in theory, have the right to replace directors if they are not satisfied with the directors’
performance. In practice, unless major shareholders act in unison the removal of directors may not be
easy. Directors may, however, be influenced by market forces to take actions that result in a high
quality performance of the company. If they do not, and if the market in which they operate is at least
semi-strong form efficient, the share price of the company will fall and the company will be more
exposed to takeover bids, which could result in the directors losing their positions. If the market is
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Business Finance
not efficient, poor or self-motivated decision-making by directors may not feed quickly and accurately
into changes in market price.
Shareholders may try to encourage the objectives of directors to correspond to their own through a
variety of incentive schemes, such as performance related remuneration, or share option schemes.
The idea is that the directors will benefit from the same positive corporate performance as the
shareholders and, thus, have the incentive to take decisions which lead to the best possible
performance.
4. Goal congruence refers to the situation where the goals of different groups coincide. In many
companies there are potential conflicts of objectives between the owners of the company, the
shareholders, and their agents, the managers of the company. Other interest groups such as creditors,
the government, employees and the local community might also have conflicting objectives to the
company’s shareholders. One way by which managers, and sometimes employees in general, might
be motivated to take decisions/engage in actions which are consistent with the goals of the
shareholders is through Executive Share Option Plans (ESOP). ESOP’s, however, will not assist in
encouraging goal congruence between other interest groups and the shareholders and managers.
ESOP’s allow managers to purchase a company’s shares at a fixed price during a specified period of
time in the future, usually a period of years. They are aimed at encouraging managers to take
decisions which will result in high NPV projects, which will lead to an increase in share price and
shareholder wealth. The managers are believed to seek high NPV investments as they, as
shareholders, will participate in the benefits as share prices increase.
There is, however, little evidence of a positive correlation between share option schemes and the
creation of extra share value. There is no guarantee that ESOP’s will achieve goal congruence. Share
options will only be part of the total remuneration package and may not be the major influence on
managerial decisions. If share prices fall managers do not have to purchase the shares and the value
of the option to buy shares becomes worthless or very small. This means that managers face less risk
than shareholders as they have an option which may be exercised if things go well but may be ignored
if things go badly. Shareholders have to face both circumstances.
Managers may be rewarded when share prices increase due to factors that have nothing to do with
their managerial skills. Additionally, ESOP schemes often base reward in part upon earnings per
share, an accounting ratio which, at least in the short term, is subject to manipulation by managers to
their advantage.
Although ESOP’s may assist in the achievement of goal congruence they are by no means a perfect
solution.
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Business Finance
Study Unit 2
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Business Finance
Nature
• Replacement Investment – Purchase new machinery
• Investment for Expansion – Build new factory
• Product Improvement/Cost Reduction – Introduce new product to existing range
• New Ventures – Acquire another company
• Strategic Investment – may satisfy overall objectives but might not satisfy normal financial
criteria.
Stages
1. Identification.
Ideas may generate from all levels of the organisation. Initial screening may reject those that
are unsuitable – too technical/too risky/large cost/incompatible with company objectives etc.
The remainder are investigated in greater depth - assumptions made regarding sales, costs
etc./collect relevant data. Also consider alternative methods of completing projects.
2. Evaluation
Identification of expected incremental cash flows. Measure against some agreed criteria -
Payback/Accounting Rate of Return/Net Present Value/Internal Rate of Return. Consultation
with other interested parties (particularly if great organisational and/or technological change)
- accountants/production staff/marketing & sales staff/trade unions etc.
3. Authorisation
Submit to appropriate management level for approval/rejection/modification. The larger the
expenditure, the higher the management level. Reappraise investment - reassess assumptions
and cash flows (e.g. check for any "bias" in estimates)/evaluate how investment fits within
corporate strategy and capital constraints (if any). If budgetary or other constraints exist rank
as to how essential (financial and non-financial considerations).
There are many techniques for evaluating investment proposals. These can be broadly classified as:
Non-Discounting
Payback Period
Accounting Rate of Return (ARR)
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Business Finance
PAYBACK PERIOD
Definition: The time taken in years for the project to recover the initial investment.
Example
An initial investment of €50,000 in a project is expected to yield the following cash flows:
Cash Flow
Year 1 €20,000
Year 2 €15,000
Year 3 €10,000
Year 4 €10,000
Year 5 €8,000
Year 6 €5,000
The Payback Period is 3 1/2 years - the cash inflows for that period equal the initial outlay of €50,000.
Is 3 1/2 years acceptable ? - it must be compared to the target which management has set. For
example, if all projects are required to payback within, say, 4 years this project is acceptable; if the
target payback is 3 years then it is not acceptable.
Advantages
• Calculation is simple.
• It is easily understood
• It gives an indication of liquidity.
• It gives a measure of risk - later cash flows are more uncertain.
• It considers cash flow rather than profit – profit is more easily manipulated.
Disadvantages
• Cash flows after the Payback Period are ignored.
• It ignores the timing of the cash flows (“Time Value of Money”).
• No clear decision is given in an accept/reject situation.
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Business Finance
Definition:
Average Annual Accounting Profits
ARR = -------------------------------------------- = %
Initial Investment
(Alternative definitions may be used occasionally - e.g. ‘Average Investment’ may replace ‘Initial
Investment’).
The Accounting Rate of Return is based upon accounting profits, not cash flows.
Example
A company is considering an investment of €100,000 in a project which is expected to last for 4 years.
Scrap value of €20,000 is estimated to be available at the end of the project. Profits (before
depreciation) are estimated at:
Year 1 €50,000
Year 2 €50,000
Year 3 €30,000
Year 4 €10,000
€60,000
Average Annual Profits (4 years) ---------- = €15,000
4
€15,000
ARR = ------------ = 15%
€100,000
To ascertain if the project is acceptable the ARR must be compared to the target rate which
management has set. If this target is less than 15% the project is acceptable; if greater than 15% the
project is unacceptable.
Advantages
• Calculation is simple.
• It is based upon profits, which is what the shareholders see reported in the annual accounts.
• It provides a % measure, which is more easily understood by some people.
• It looks at the entire life of the project.
Disadvantages
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Business Finance
Discounted Cash Flow addresses these shortcomings, by allowing for the “time-value of money” and
looking at all cash flows. So what is discounting? Discounting can be regarded as Compound
Interest in reverse. To understand Compound Interest let us take a simple example.
Example
If you invest €100 and are guaranteed a return of 10% per annum we can work out how much your
investment is worth at the end of each year.
We are starting with a Present Value (€100) and depending on the rate of interest used (10%) and the
duration of the investment (n) we can find the Future Value, using Compound Interest.
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Business Finance
As mentioned above, Discounting is Compound Interest in reverse. Thus, using the statement
n
PV (1 + i) = FV we can turn it around to get
FV 1
--------- = PV or FV x ------- = PV
n n
(1 + i) (1 + i)
Again, taking the example above, if you are given the Future Value and asked to find the Present
Value
1
End of Year 2 €121.00 x --------- = €100
2
(1.10)
1
End of Year 3 €133.10 x -------- = €100
3
(1.10)
In effect, what you are doing is ascertaining the amount which must be invested now at 10% per
annum to accumulate to €110 in a year’s time (or €121.00 in two years; or €133.10 in three years).
In converting the Future Value to a Present Value it is multiplied by a factor (Discount Factor), which
varies depending on the discount rate (i) selected and the number of years/periods (n) into the future.
Fortunately, it is not necessary to individually calculate each factor - these can be easily obtained from
DISCOUNTING TABLES (page 1). These tables supply a factor for all % rates and periods.
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Business Finance
The compounding and discounting features shown above relate to single payments or receipts at
different points in time. Similar calculations can be done for a series of cash flows, where a single
present value can be calculated by aggregating the present value of several future cash flows.
ANNUITIES
An annuity is where there is a series of cash flows of the same amount over a number of years.
The present value of an annuity can be found by discounting the cash flows individually (as above).
Example
Using a discount rate of 10% find the present value of an annuity of €2,000 per annum for the next
four years, with the first payment due at the end of the first year.
However, a much quicker approach is to multiply the annual cash flow by an annuity factor. The
annuity factor is simply the sum of the discount factors for each year of the annuity. In this example
the annuity factor is 3.17 (0.909 + 0.826 + 0.751 + 0.683). If you multiply the €2,000 by the annuity
factor of 3.17 you get €6,340, which is the same Net Present Value as the longer approach adopted in
the example. Annuity factors are available for all % rates and periods in Annuity Tables (attached)
and you will see the factor of 3.17 at period 4 under the 10% column.
In the above example the first receipt arose at the end of the first year. If this is not the case you can
still use the Annuity Tables but you must modify your approach. The present value can be found by
multiplying the annual cash flow by the annuity factor for the last date of the annuity less the annuity
factor for the year before the first payment.
Example
Using a discount rate of 10% find the present value of an annuity of €5,000 per annum, which starts in
year 5 and ends in year 10.
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Business Finance
The NPV figure represents the change in shareholders' wealth from accepting the project. It produces
an absolute value (€) and therefore, the impact of the project is identified.
For mutually exclusive projects (where it is only possible to select one of many choices) - calculate
the NPV of each project and select the one with the highest NPV.
In calculating the NPV, the selection of a discount rate is vitally important. It is generally taken as the
cost to the business of long-term funds used to fund the project.
The project should be accepted as it produces a positive NPV. This indicates that the project provides
a return in excess of 10% (the discount rate used).
Which project should the company select if its cost of capital is 10%
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Business Finance
Advantages
• Correctly accounts for the time value of money.
• Uses all cash flows.
• Is an absolute measure (€) of the increase in wealth
• Consistent with the idea of maximising shareholder wealth i.e. telling managers to maximise
NPV is equivalent to telling them to maximise shareholder wealth.
Disadvantages
• Difficult to estimate cost of capital.
• Not easily interpreted by management i.e. managers untrained in finance often have difficulty
in understanding the meaning of a NPV.
The IRR is another discounted cash flow technique. It produces a percentage return or yield, rather
than an absolute value. It determines the discount rate at which the NPV would be zero -where the
present value of the outflows = present value of the inflows. It can, therefore, be regarded as the
expected earning rate of the investment.
If the IRR exceeds the company's target rate of return it should be accepted. If less than the target rate
of return it should be rejected.
The IRR can be estimated by a technique called 'Linear Interpolation’. This requires the following
steps:
1. Calculate two NPV's, using two different discount rates.
2. Any two rates can be used but, ideally, one calculation will produce a positive NPV and the
other a negative NPV.
21
Business Finance
3. Choosing the discount rate is a 'shot in the dark.' However, if the first attempt produces a
positive NPV, generally a higher discount rate will be required to produce a negative NPV
and vice versa.
We now know that the real rate of return is > 10% (+ NPV) but < 15% (- NPV). The IRR is
calculated by 'Linear Interpolation.' It will only be an approximation of the actual rate as it assumes
that the NPV falls in a straight line (linear) from + €755 at 10% to - €1,245 at 15%. The NPV, in fact,
falls in a curved line but nevertheless the interpolation method is accurate. In this example the IRR is:
755 + 1,245
Advantages
• Generally gives the same decision rule as NPV.
• More easily understood than NPV.
• Doesn’t require an exact definition of discount rate in advance.
• Considers the time value of money.
• Considers all relevant cash flows over a project’s life.
Disadvantages
• Relative, not absolute return -> ignores the relative size of investments.
• If a change in the sign of the cash flow pattern, one can have multiple IRR’s.
• It cannot cope with interest rate changes.
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Business Finance
To calculate the IRR it is not necessary to know in advance the required rate of return or discount
rate, as it would be to calculate the NPV.
It always gives only one solution. The IRR can give multiple answers for projects with non-
conventional cash flows (a number of outflows occur at different times).
It always gives the correct ranking for mutually exclusive projects, whereas the IRR technique may
give conflicting rankings.
Changes in interest rates over time can easily be incorporated into NPV calculations but not IRR
calculations.
In an examination question you will be given much information regarding the impact on the
organisation of a new investment proposal etc. Some of the information may not be relevant to the
decision and it is important that you are able to figure out which flows are relevant and should be
included in an investment appraisal calculation.
For example, in a previous examination question where you were asked to evaluate whether an Irish
organisation should establish a subsidiary in the USA, the following paragraph appeared halfway
through the question:
‘...The company currently exports to the USA, yielding an after-tax net cash flow of €100,000. No
production will be exported to the USA if the subsidiary is established. It is expected that new export
markets of a similar worth in Southern Europe could replace exports to the USA. Home production is
at full capacity and there are no plans for further expansion in capacity’.
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Business Finance
This lengthy paragraph is, obviously, designed to confuse you. If we analyse it further we find that it
is merely saying that the organisation currently exports €100,000 worth of goods to the USA which
will be replaced by €100,000 of new exports to Southern Europe, if we establish the subsidiary. Thus,
it has a neutral impact on our decision and can be omitted from the appraisal.
The following pointers and simple examples should assist in coping with the various items which are
presented to you in an examination:
Example
A company is considering investing in a new project which requires the expenditure of €12m.
immediately on plant. The project will last for 5 years and at the end of the project the plant is
expected to have a scrap value of €2m. The company normally depreciates plant over 5 years using
the straight-line method.
In this simple illustration the last sentence concerning depreciation can be ignored completely as it
does not affect the cash flows. It would be incorrect to show an outflow of €2m. p.a.for depreciation.
The relevant cash flows are the outflow of €12m. on plant in year 0 and the inflow of €2m. as scrap in
year 5.
Example
A company is considering a proposal which would require (amongst other cash flows) the purchase of
a new machine for €100,000. If it proceeds with the proposal it could dispose of an existing machine
which has a value of €30,000 in the company’s accounts. This machine could be sold immediately for
€20,000 instead of waiting for 5 years as planned and selling it for scrap value of €5,000.
Should the existing machine be taken into account in evaluating the new proposal ?
Undertaking the new proposal requires the purchase of a new machine which, in turn, enables the
existing machine to be sold, thereby generating an inflow for the organisation. Thus, the cash flows
associated with the existing machine are relevant in evaluating the new proposal. The present written-
down value of €30,000 is not relevant as it is merely an accounting book entry. The sale proceeds of
€20,000 is obviously relevant as is the loss of €5,000 scrap value which the company would have
received in year 5 if the new proposal was not undertaken.
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Business Finance
Year New Machine Sale - Existing Machine Scrap Foregone Net Cash Flows
Existing Machine
0 (100,000) 20,000 (80,000)
1
2
3
4
5 (5,000) (5,000)
3. OVERHEADS
Variable overheads will always be relevant in decision making. However, depending on the situation
fixed overheads may or may not be relevant. If fixed overheads are allocated on some arbitrary basis
(e.g. on the basis of machine or labour hours) they are not usually relevant. However, if the total
fixed costs of the organisation are affected by the proposal then they are relevant and should be
incorporated as a cash flow.
Example 1
A company is considering the introduction of a new product to its existing range. Each product will
take two hours labour to manufacture. Fixed overheads are allocated within the company on the basis
of €1 per labour hour. Sales of the new product are estimated at 12,000 units per annum. If the new
product is manufactured the company will have to employ an additional supervisor at a salary of
€20,000 per annum.
The allocation of fixed overheads at the rate of €2 per unit has no effect on cash flows and is not
relevant. It is merely an accounting entry for costing or control purposes.
The additional supervisory salary of €20,000 per annum is relevant, as it is incurred solely as a result
of the new proposal and must be taken into account.
Example 2
A company is considering the introduction of a new product to its existing range. It currently rents a
factory at an annual rental of €100,000. Only three-quarters of the factory is used on production of its
existing range of products and the remaining quarter of the factory would be adequate in which to
produce the new product. However, it will be necessary to rent additional warehouse space at
€20,000 per annum in order to store the new production.
To produce the new product the organisation can utilise factory space which is currently idle. No
additional factory rental costs will be incurred by the company and it would be incorrect to show an
annual cash outflow of €25,000 (one-quarter) in respect of rent when evaluating the new proposal.
On the other hand, the additional warehouse rent of €20,000 per annum is incurred solely as a result
of the new proposal and must be taken into account in the evaluation process.
4. SUNK COSTS
Sunk costs (or past costs) are costs which have already been incurred. When making an investment
decision sunk costs can be ignored and you need only consider future incremental cash flows.
Example
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Business Finance
A company is considering the introduction of a new type of widget. Over the past two years it has
spent €100,000 on research and development work.
The €100,000 spent on research and development is a sunk cost and can be ignored when evaluating
the future inflows and outflows of the proposal. One way of looking at it is that whether you decide
to go ahead with the new proposal or not this will not alter the position of the €100,000 - it has
already been incurred.
Example
A company uses a special raw material, named Zylon, in production. It currently has 5,000 tons in
stock. The company is considering a once-off project which would use 2,000 tons of Zylon. The
original cost of the Zylon in stock was €20 per ton; the current purchase price is €17 per ton and its
resale value is €10 per ton.
What is the relevant cost of the Zylon for the project if :
(a) it is regularly used by the company ?
(b) it is no longer used and any remaining stock will be sold off immediately ?
(a) The original cost of €20 per ton is not relevant. The 2,000 tons used on this project are taken
out of stock and must be replaced at the current purchase price, as the Zylon is regularly used by the
company. Thus, current purchase price is the relevant cost - 2,000 tons @ €17 = €34,000.
(b) Again, the original cost of €20 per ton is not relevant. If the company does not use the
existing stock in the new project the next best use is to dispose of it at €10 per ton, as it is no longer
used in production. Thus, current resale value is the relevant cost - 2,000 tons @ €10 = €20,000.
5. OPPORTUNITY COSTS
The use of resources for a new project may divert them from existing projects, thereby causing
opportunity costs. These opportunity costs must be taken into account in evaluating any new project.
Example
A company is considering the introduction of a new range of advanced personal computer, which will
be very competitively priced. While accepting that the new machine is vital to remain competitive,
the marketing manager has estimated that sales of existing models will be reduced by 100 units per
annum for the next three years as a consequence. The existing model sells for €3,000 and variable
costs are €1,750 per unit.
In evaluating the introduction of the new advanced machine, the lost contribution from reduced sales
of existing models must be included as an opportunity cost. In this case the opportunity cost is
€125,000 [100 units x (€3,000 - €1,750)] per annum for the next three years.
6. INTEREST COSTS
In examination questions you will be presented with all the costs of the proposed project. These may
be presented in the form of a standard Profit & Loss Account. One of these costs may be ‘Interest.’
The figure for interest should not be included as a relevant cost because the cost of finance, no matter
what its source, is encompassed within the discount rate. Therefore, to include the annual interest
charge as a relevant cost and to also discount the cash flows would result in double counting.
7. WORKING CAPITAL
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Business Finance
Where the project requires an investment of, say €50,000, for working capital it should be
remembered that working capital revolves around continuously in the project (e.g. purchase of raw
materials, which are used to manufacture goods, sold and eventually generate cash to enable the
purchase of more raw materials etc.. and continuously repeat the cycle). Thus, the €50,000 flows
back into the organisation once the project ceases. In this example, if the project has a life of five
years the cash flows relating to working capital are:
5 50,000
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Business Finance
1. The management of Easy Limited are reviewing the company’s capital investment options for the
coming year, and are considering four projects.
Project A would cost €29,000 now, and would earn the following cash profits:
1st Year €8,000 3rd Year €10,000
nd
2 Year €12,000 4th Year €6,000
The capital equipment purchased at the start of the project could be resold for €5,000 scrap value at
the start of year 5.
Project B would involve a current outlay of €44,000 on capital equipment and €20,000 on working
capital. The profits from the project would be as follows:
Fixed costs include an annual charge of €4,000 for depreciation. At the end of year 3 the equipment
would be sold for €5,000.
Project C would involve a current outlay of €50,000 on equipment and €15,000 on working capital.
The investment in working capital would be increased to €21,000 at the end of the first year. Annual
cash profits would be €18,000 per annum for 5 years.
Project D would involve an outlay of €20,000 now and a further outlay of €20,000 after one year.
Cash profits thereafter would be as follows:
Required:
(a) Calculate the NPV of each project and determine which should be undertaken.
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Business Finance
2. Silicon Limited over the past 4 years has spent €2 million on developing a new silicon chip and is
faced with three mutually exclusive choices:
(1) It can manufacture the chip itself in which case the plant will cost €5 million. This will be
spent at the end of December 19X7. Additional working capital of €2.1 million will be
required when production commences at the start of 19X8. Sales and selling prices are
expected to be as follows:
19X8 19X9 19Y0 19Y1 19Y2
Number Sold – (000’s) 100 100 100 80 80
Sales Prices ( € per unit) 120 120 120 100 90
Silicon usually depreciates plant of this type over 5 years using the straight line method and
assumes a zero scrap value. Variable costs are expected to be €65 per unit and additional
fixed costs, including depreciation, €3 million per year. Production will take place in a
quarter of the existing factory which is currently unused. The annual rent payable on the
factory is €400,000
(2) Sell the know-how to a major international firm for a single payment of €3.1 million,
receivable at the end of December 19X7.
(3) Sell the know-how for a royalty of €10 per unit. Anticipated sales of chips would be as
shown above.
If choices (2) or (3) are taken then the company will not manufacture the chips itself. Silicon
estimates that its cost of capital is 12%. You should assume that sales revenue and costs occur
at the end of the year in which they arise. Ignore taxation.
Required:
(a) Calculate the cash flows relevant to a decision whether or not to manufacture the chips. You
can ignore choices 2 and 3 for this part of the answer.
(b) Calculate the net present value of each option.
(c) What other factors should be taken into account before a decision is made? What would your
decision be?
3. Bling plc is a new company which is planning to establish an internet business. The company will
operate a website inviting individuals to subscribe for membership which will provide members with
substantial discounts on travel and accommodation.
You have been asked to evaluate the proposal and you have ascertained the following:
1. Market research has been carried out at a cost of €300,000. This indicates that the number of
new members joining each year will be 6,000. Research also shows that of the new members
only 40% will renew their membership in the second year and that none will continue
membership beyond their second year. It is estimated that the business will have a life of four
years.
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Business Finance
2. Membership fees will initially be set at €100 and it is expected that this can be increased to
€120 in year three.
3. The costs of setting up the website are:
Design €0.4m.
Implementation €0.6m.
Legal Fees €0.2m.
Testing €0.5m.
€1m. of these costs will be paid immediately and the remainder in one year’s time. Bling plc
will depreciate this capital cost over four years on a straight-line basis.
4. A contract for technical support of the website has been arranged. The cost in the first year is
€200,000 and this will increase by 10% per annum.
5. Staffing costs for the administration team to manage the business are estimated at €120,000 in
the first year. Salary increases of 5% per annum will be provided.
6. Members will receive a Gold Card as proof of membership which must be used when booking
flights or accommodation. The cost of manufacturing and processing each card is €10 and
new members will be issued with a card on registration. Members renewing their
membership will not be issued with a new card.
7. When members book flights or accommodation using their Gold Card the suppliers will pay
5% commission to Bling plc. This will be paid at the end of each year. Bookings in the first
year are estimated at €2m.and this will grow by €1m per annum.
8. Bling plc has arranged a bank loan from its bank at a fixed rate of 10% per annum to cover
the €1.7m. capital cost of setting up the website.
10. Assume that all cash flows occur at the end of each year, unless otherwise stated.
Required
(i) Calculate the Net Present Value of the proposal
(iii) Without performing any calculations, briefly explain one other technique which could be
used to evaluate the proposal.
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4. Max-oil plc. is exploring for oil in Pakistan. The Pakistani government is prepared to grant a
licence for a five-year period for a fee of €300,000 per annum. The option to acquire the rights must
be taken immediately or it will be offered to a competitor. However, Max-oil plc. is not in a position
to commence operations immediately and exploration will not start until the beginning of the second
year. The company will require specialist equipment costing €10.4m., half payable immediately and
the balance when the equipment has been built and tested. It is expected that the second instalment
will be paid at the end of the first year. The company commissioned a geological survey and the
results indicate that the oilfield will produce relatively small amounts of high quality crude oil. The
survey cost €0.25m and is now due for payment.
An assistant has produced the following for years 2 – 5, when the oilfield is operational:
Projected profit & Loss Accounts (€’000)
2 3 4 5
Sales 7,400 8,300 9,800 5,800
8. Ignore taxation.
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Required
Prepare calculations which will help the company to evaluate further the profitability of the proposed
project and state, with reasons, whether you would recommend acceptance.
5. Roadrunner Ltd has recently been offered a contract to produce a specialised lubricant for a large
multinational company. The contract will involve producing 15,000 tonnes of the lubricant at a sale
price of €70.00 per tonne each year over a four year contract period. The management of the company
are interested in taking the contract as they believe that it may open the way to further contract work
in the multinational sector. Apart from these operational considerations however, the management of
Roadrunner Limited are uncertain as to the financial benefits of the contract.
They have therefore invited you, as an investment analyst, to review this proposal. Following a
preliminary meeting you sought some additional information about the company and its production
process which has now been provided as follows:
(i) Overheads relating to the contract are estimated to be €140,000 per annum, of which
40% represents a reallocation of existing fixed overhead to the contract.
(ii) New capital equipment costing €260,000 will be required immediately. At the end of the
contract period, it is expected that the equipment can be sold for an estimated €30,000.
(iii) Five additional workers will be required to work on the new contract. Additional labour costs
are therefore estimated at €100,000 in the first year of the contract. A pay rise of 1.5% will
take effect at the end of the first year, with a further rise of 2% at the end of year three.
Recruitment costs in hiring these workers are estimated at €30,000 at the start of the contract
and it is expected that each of the five additional workers will be let go at the end of the
contract, and that they will receive a redundancy payment of €10,000 each.
(iv) Production of the new lubricant will require 9000 tonnes of a certain chemical each year .
Roadrunner already has 5000 tonnes of this chemical in stock at an original cost of €20 per
tonne. If Roadrunner does not accept the contract, it will have no alternative use for the
chemical and it will therefore dispose of it at a cost of €3.50 per tonne. The replacement cost
of the chemical is €28 per tonne.
Production of the new lubricant will also require 11000 tonnes of heavy fuel oil each year,
which is also widely used across Roadrunner’s other product ranges. At present Roadrunner
has 6000 tonnes of heavy fuel oil in stock. The original cost of this stock was €44 per tonne,
and the replacement cost is €50 per tonne .
Required:
(a) Prepare a Report for Roadrunner Ltd setting out the NPV and IRR of the project and make
recommendations as you consider appropriate. Ignore taxation.
(b) Outline the principles governing your assessment of how costs and benefits relevant to the
proposal should be identified.
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6. Spring plc has developed a new product which it will shortly launch. It has carried out some
market research which indicates that demand for the product will be very strong. The cost of this
market research was €150,000.
You have been provided with the following information for the product over its estimated four-year
life:
YEAR 1 2 3 4
Direct material cost is estimated at €5.50 and other variable production costs at €6.00 per unit.
An advertising campaign will be undertaken in conjunction with the launch of the new product. It is
agreed that €500,000 will be spent in the first year and €200,000 will be spent in the second year. No
advertising will be carried out in years three and four.
New equipment will be required at an initial cost of €1m. This will have a scrap value of €100,000 at
the end of the project. Spring plc has a policy of depreciating equipment over four years on a straight-
line basis.
Spring plc will manufacture the new product in a factory building which is currently not fully
occupied. One-quarter of the building is unoccupied and it is expected that this will remain
unoccupied over the life of the project. This is adequate for production of the new product. The
annual rent on the total factory building is €100,000 and it will remain at this level for the next four
years.
Spring plc uses a discount rate of 10% when evaluating new capital investments.
Required
(i) Ignoring taxation and inflation, calculate the Net Present Value of the proposed
investment. Calculations to be made to the nearest €’000 (15 marks)
(ii) Ignoring taxation and inflation, calculate the Internal Rate of Return of the proposed
investment (5 marks)
(iii) Based on your calculations above write a brief report to management outlining your
recommendations with supporting reasons. (5 marks)
Total 25 marks
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7. Innovate currently has one product on the market, which has been extremely successful. The
company is developing a new advanced model - the Lexus
To date €120,000 has been spent on developing the product. The company has also incurred
€250,000 of market research costs, although the invoice for these costs has only just been received
and will be paid in January.A final decision now needs to be made as to whether it is viable to
manufacture and sell ‘Lexus’.
1. A new factory, to be used solely for the production of ‘Lexus’, will need to be built. This will take
nearly a year to build and is expected to cost €10·75 million in total, payable in two instalments - €5m
will be paid at the start of the building work and the remainder will be paid when the building work is
completed at the end of the first year.
2. Innovate will immediately enter into a one-year contract with a project management company, who
will oversee the building of the factory. The cost of €250,000 will be paid when building is
completed. Two production lines will need to be installed in the factory at a further cost of €1.5m.
payable in one year’s time.
3. Machinery also needs to be built-to-order and is expected to cost €2·5m, payable in one year’s
time. Its terminal value is nil. Depreciation will be charged as soon as production commences (in one
year’s time) at 10% per annum on a straight-line basis.
Maintenance costs for the machinery are estimated at €250,000 per annum.
4. Production and Sales will commence in the year following the build. Sales quantities and prices are
expected to be as follows:
Years 1 2 3 4
Sales volume (’000 units) 5 10 30 50
Sales price (€) 1,000 800 700 500
It is anticipated that there will be no further sales after these dates.
7. Fixed production overheads on the new factory are estimated at €240,000 per annum. Variable
production overheads are expected to be €50 per unit.
8. Head office costs of €2·5m per annum will be allocated to ‘Lexus’ when production commences.
Of these costs, only €1·7m is incremental and relates directly to the Lexus project.
10. Assume that all cash flows occur at the end of the year, unless stated otherwise.
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Required
(a) Calculate the net present value (NPV) of the project at the company’s
cost of capital. Conclude as to whether Innovate should proceed with the project.
(20 marks)
(b) Explain the main principles to differentiate between relevant and irrelevant costs for
investment appraisal. Using the costs of the “Lexus” project above refer to three examples
in your answer. (5 marks)
(Total 25 marks)
8. Zyher has developed a new process to convert waste oil into a lubricant which is used in
the motor industry. It is expected that the process will have a life of four years before its
patent runs out when large-scale operators will enter the market and make it uneconomical
for Zyher to operate.
Zyher retained a firm of market consultants to carry out some research at a cost of
€250,000. They have estimated sales of the lubricant at €4m. for each of the first two
years, reducing to €3m. per annum for the last two years.
‘Other expenses’ are incurred by the proposed project and are paid in the years
shown. Purchases of additional materials are for cash.
Storage of materials will utilise warehouse space which would otherwise have been
rented out by Zyher for €520,000 per year (receivable end of each year).
It may be assumed that all cash flows relating to Zyher’s activities which occur
during, but not at the start of a year, actually occur at the year-end.
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(b) Calculate the Internal Rate of Return of the proposed venture (5 marks)
(c) Based on your calculations at (a) and (b) advise Zyher whether it should proceed with the
venture. In your report quote three other factors which Zyher should consider, apart from
those mentioned above, before making a final decision.
(8 marks)
(Total 25 Marks)
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(ii) Project B
Year Equipment Working Cash Net Cash Discount Present
Capital Profit Flow Factor Value
€ € € € 12% €
0 (44,000) (20,000) (64,000) 1.000 (64,000)
1 19,000 19,000 0.893 16,967
2 24,000 24,000 0.797 19,128
3 5,000 20,000 10,000 35,000 0.712 24,920
Net Present Value (2,985)
(iii) Project C
Year Equipment Working Cash Net Cash Discount Present
Capital Profit Flow Factor Value
€ € € € 12% €
0 (50,000) (15,000) (65,000) 1.000 (65,000)
1 (6,000) (6,000) 0.893 (5,358)
1–5 18,000 18,000 3.605 64,890
5 21,000 21,000 0.567 11,907
Net Present Value + 6,439
(iv) Project D
Year Cash Flow Discount Factor Present Value
€ 12% €
0 (20,000) 1.000 (20,000)
1 (20,000) 0.893 (17,860)
2 15,000 0.797 11,958
3 12,000 0.712 8,544
4–8 8,000 2.566 20,528
Net Present Value + 3,170
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Business Finance
Projects A,C and D have positive Net Present Values and should be undertaken. Project B should not
be undertaken.
(b)(i) The IRR of project A is above 12% (see (a) above where the NPV is €1,826). We will
calculate the NPV at 15%.
The IRR is between 12% and 15%. By interpolation, we can estimate the IRR as:
1,826
12% + -------------- x (15% – 12%)
1,826 + 96
= 14.85 %
(ii) The IRR of project C is above 12%, where the NPV is €6,439. Try 20%.
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(b) Net Cash Flow (7,100) 3,500 3,500 3,500 800 2,100
Discount Factor 1.00 0.89 0.80 0.71 0.64 0.57
Present Value (7,100) 3,115 2,800 2,485 512 1,197
Single Payment
Net present value - € 000 3,100
Royalty
Royalty - € per unit 10 10 10 10 10
No. sold 000’s 100 100 100 80 80
Total Royalty – € 000’s 1,000 1,000 1,000 800 800
Discount Factor 0.89 0.80 0.71 0.64 0.57
Present value - € 000’s 890 800 710 512 456
Net present value - € 000 3,368
(c) There are a number of other factors which should be considered before a choice between the
three alternatives is made. Firstly the company should consider its overall strategy. Has it a
policy to licence its know-how rather than to use it in its own production? Secondly, it should
carefully consider the impact of any decision to sell its know-how on the employment
prospects within the firm and on the morale of its employees. Thirdly it should assess any
other financial factors which have not been included in the analysis. For example no
allowance has been made in the question for taxation or inflation.
From a purely financial viewpoint the royalty option has the highest net present value of just
over €3.3 million. However it is more risky that the down-payment whose net present value
is €3.1 million The manufacture option with virtually the same net present value of just over
€3m does not look particularly attractive in view of its risks. Probably the best option would
be for Silicon to try to negotiate a minimum royalty payment. If this is not possible, the
down-payment option appears to be marginally the most attractive choice.
3. Bling plc
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(i)
0 1 2 3 4
Sales Revenue 600 840 1,008 1,008
Set-up (1,000) (700)
Tech Supp (200) (220) (242) (266)
Staff (120) (126) (132) (139)
Cards (60) (60) (60) (60)
Commission 100 150 200 250
---------------------------------------------------------------------------------
Net (1,000) (380) 584 774 793
D.F. 12% 1.0 .893 .797 .712 .636
Pres. Value (1,000) (339) 465 551 504
4. Max-oil plc
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0 1 2 3 4 5
Sales 7,400 8,300 9,800 5,800
Equipment (5,200) (5,200) 2,000
Working capital (650) 650
Wages (550) (580) (620) (520)
Materials (340) (360) (410) (370)
Licence fee (300) (300) (300) (300) (300)
Overheads (100) (100) (100) (100)
Hire – cutting tool - - (150) - - -
Net cash flow (5,200) (6,150) 5,960 6,960 8,370 7,160
Discount factor – 10% 1.00 .909 .826 .751 .683 .621
Present value (5,200) (5,590) 4,923 5,227 5,717 4,446
The above calculations indicate that the project will have a positive net present value.
Acceptance would, therefore, increase shareholder wealth.
5. Roadrunner Ltd.
Following our preliminary meeting last week, and the further information which you have forwarded
to me since then, I now submit my report and recommendations on this matter. I would draw your
attention in particular to the calculation of Net Present Value (NPV) and Internal Rate of Return
(IRR) which are set out as follows:
Year 0 1 2 3 4
Sales 1050 1050 1050 1050
Equipment (260) 30
Overheads (84) (84) (84) (84)
Wages (100) (101.5) (101.5) (103.5)
Recruitment (30)
Redundancy (50)
Disposal 17.5
Chemical Cost (112) (252) (252) (252)
Fuel Oil (550) (550) (550) (550)
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= 19.2 %
Given the strong positive NPV of €49,400 and that fact that the Internal Rate of Return at 19.2% is
well above Roadrunner’s cost of capital (8%), I would recommend that the company should proceed
with the contract on the terms indicated.
(b) The following principles should influence the assessment of how costs and benefits are treated:
(i) Incremental cost and benefits only should be taken into account. That is, only those costs and
benefits which arise as a direct consequence of a decision to proceed with the proposal should be
considered relevant. Costs which would exist irrespective of the decision taken (i.e. the 40% of
reallocated overhead) should be ignored.
(ii) Past costs are irrelevant to the decision. For example, the cost of fuel oil already purchased and
widely used elsewhere is irrelevant. The replacement cost of the fuel oil is the relevant factor for
costing and analysis purposes.
(iii) Only actual costs and benefits which can be expressed in cash terms should be taken into the
analysis. For example, no immediate cash significance can be attributed to the fact that Roadrunner
might gain further business in the multinational sector if it accepts the contract.
6. Spring plc
YEAR 0 1 2 3 4
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(iii) As the project has a positive NPV of €60,000 when the cash flows are discounted at the
company’s cost of capital and the IRR of 14.61% is greater than the company’s cost of capital
I would recommend acceptance of the project.
7. Innovate
(a) NPV
0 1 2 3 4 5
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8. Zyher
(a)
Year 0 Year 1 Year 2 Year 3 Year 4
€’000
Machinery (3,000) 600
Sales 4,000 4,000 3,000 3,000
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(c) As the project has a positive NPV, when discounted at the company’s cost of
capital (12%) and also produces an IRR of 19.56% the project should be
progressed.
However, Zyher might consider some other factors before a final decision is made:
Has Zyher got the necessary “know-how”
Safety aspects of storage
Impact of taxation
Impact of inflation
Risk & Uncertainty
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Study Unit 3
A. Introduction
B. Corporation Tax
C. Capital Allowances
E. Worked Examples
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A. INTRODUCTION
To fully appraise an investment management must take account of the impact of taxation, as it is the
after-tax cash flows that are relevant to decision making.
As a result of accepting a project tax payments or savings will, generally, be made by the company.
These relate to:
B. CORPORATION TAX
Annual cash inflows from a project will cause an increase in taxable profits and, hence, a tax
payment. Annual cash outflows (e.g. cost of materials, labour etc.) will reduce taxable profits and
yield tax savings. However, tax payments or savings can be based upon the net cash inflows or
outflows each year.
One can assume that an annual cash flow (inflow or outflow) will produce a similar change in taxable
profits, unless the exam question specifically indicates otherwise. For example, you may be told that
a particular item of expenditure (say, a contract termination payment of €100,000) is not allowable for
tax purposes. In this instance, the €100,000 must be shown as an outflow of the project but it is
ignored when calculating the taxation effect.
It is important to appreciate that the taxation payment or saving is the cash flow multiplied by the rate
of Corporation Tax. For example, if the net cash inflow in a particular year is €50,000 and the rate of
Corporation Tax is 40% an outflow of €20,000 (€50,000 x 40%) is shown in the taxation column.
C. CAPITAL ALLOWANCES
The Revenue does not allow depreciation charges as a deduction in calculating the tax payable.
However, it does grant capital allowances, which can be quite generous. These allowances on capital
items can be set-off against taxable profits to produce tax savings (i.e. cash inflows).
The capital allowances can take various forms. The most common are:
1. 100% initial allowance, whereby an allowance equivalent to the full cost of the item is
available up-front.
2. A writing-down allowance of, say, 25% per annum on a straight line basis. This means
that the benefit of the allowance is spread equally over 4 years.
3. A writing-down allowance of, say, 25% per annum on a reducing balance basis. This
means that the allowance is spread over a number of years but on a reducing basis. 25%
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of the expenditure is allowable in the first year (as under number 2) and a reducing
allowance thereafter.
Again, it is important to appreciate that the cash flow effect is the capital allowance multiplied by the
rate of Corporation Tax. For example, if the capital expenditure (which qualifies for 100%
allowances) in a particular year is €50,000 and the rate of Corporation Tax is 40% then a saving of
€20,000 (€50,000 x 40%) is shown in the taxation column.
The eventual sale of capital items will usually cause a balancing charge or a balancing allowance,
which must also be taken into account in the project appraisal.
Unless specifically advised to the contrary in an examination, assume that there is a time lag of one
year between a cash flow and the corresponding taxation effect. Thus, expenditure on a capital item
in year 0 will usually be accompanied by a tax saving in year 1.
E. WORKED EXAMPLES
EXAMPLE 1
A company is considering a new project. It must purchase plant and machinery for €48,000, which
qualifies for 100% initial allowance. The project will generate net cash inflows of €20,000 per
annum before tax for three years. Corporation Tax is 40% and the company makes large taxable
profits from its existing operations. The after-tax cost of capital is 10%.
The phrase ‘...the company makes large taxable profits from its existing operations’ is very significant
as it is an indicator that the taxation advantage of the capital allowance can be utilised at the earliest
opportunity, by reducing the existing tax liability.
YEAR PLANT PROFITS TAXATION NET C. FLOWS D.F.- 10% PRES. VALUE
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Using the same data as Example 1 but now due to the nature of the expenditure assume that the
company can only claim a 25% per annum writing down allowance on a straight line basis.
YEAR PLANT PROFITS TAXATION NET C.FLOWS D.F.- 10% PRES. VALUE
0 (48,000) (48,000) 1.00 (48,000)
1 20,000 4,800 24,800 0.909 22,543
2 20,000 (3,200) 16,800 0.826 13,877
3 20,000 (3,200) 16,800 0.751 12,617
4 (3,200) (3,200) 0.683 (2,186)
----------
(1,149)
======
Note: The year 1 figure under the Taxation column is the first year’s capital allowance (€48,000 x
25% = €12,000) at the tax rate of 40% = €4,800. The figure for years 2-4 consists of profits of
€20,000 less capital allowance (€12,000) multiplied by the tax rate of 40% = €3,200 payment.
Now due to the delay in receiving the benefit of the capital allowances they are not as valuable (“Time
Value of Money”) as in Example 1 and the project produces a negative NPV.
It should, therefore, be rejected.
EXAMPLE 3
In Examples 1 and 2 we have assumed that the company is in a tax paying position and can utilise the
allowances as early as possible. However, if the company has tax losses or only limited taxable
profits from its existing operations this will affect the timing of the tax savings.
A company is considering a project which will last for four years and produce annual net cash inflows
of €20,000. It must purchase a new machine for €45,000. The machine qualifies for a 100% initial
allowance and will have a scrap value of €8,000 at the end of the project. Working capital of €12,000
is required. Corporation Tax is 40% and the company earns no profits or losses from its other
operations. The after-tax cost of capital is 10%.
While the machine qualifies for 100% allowances the company is unable to utilise this initially as it is
not currently in a tax paying position. As a result, it will have to spread the advantage of the
allowance by setting them off against the profits of the new project.
Note: The capital allowances are set-off against the cash inflows of years 1 - 3.
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As capital allowances are claimed in full over years 1-3, when the machine is sold for €8,000 scrap in
year 4 this generates a balancing charge.
The tax payments can now be incorporated in the main cash flow schedule.
YEAR MACHINE W. CAP PROFITS TAXATION NET C. FLOW D.F. 10% PRES. VAL
0 (45,000) (12,000) (57,000) 1.00 (57,000)
1 20,000 20,000 0.909 18,180
2 20,000 20,000 0.826 16,520
3 20,000 20,000 0.751 15,020
4 8,000 12,000 20,000 (6,000) 34,000 0.683 23,222
5 (11,200) (11,200) 0.621 (6,955)
-----------
8,987
======
As the project produces a positive NPV it should be accepted.
EXAMPLE 4
A company is considering a new project. It must purchase equipment for €80,000. Due to the nature
of the equipment it qualifies for a writing down allowance of 25% per annum on a reducing balance
basis. The project will generate net cash inflows of €35,000 per annum for four years. Corporation
Tax is 40% and the after-tax cost of capital is 10%. The equipment will have no scrap value at the end
of the project. Working capital of €10,000 is required.
Year 1
Plant 80,000
Capital Allowance (80,000 x 25%) 20,000
--------
Written Down Value 60,000
=====
Year 2
Written Down Value 60,000
Capital Allowance (60,000 x 25%) 15,000
--------
Written Down Value 45,000
=====
Year 3
Written Down Value 45,000
Capital Allowance (45,000 x 25%) 11,250
--------
Written Down Value 33,750
=====
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Year 4
As the plant is disposed of in year 4 for zero value there is a Balancing Allowance of €33,750
(written down value for tax purposes) available. Thus, over the four years, allowances
totalling €80,000 have been claimed.
Note
A quick method of calculating the capital allowances on a reducing balance basis is to take the
previous year’s capital allowance and multiply it by 75% (100% minus the rate at which the
allowance is available). Thus, in this example:
Thirdly, incorporate the tax payments in the main cash flow schedule:
YEAR MACHINE W. CAP PROFITS TAXATION NET C. FLOW D.F. 10% PRES. VAL
0 (80,000) (10,000) (90,000) 1.00 (90,000)
1 35,000 35,000 0.909 31,815
2 35,000 (6,000) 29,000 0.826 23,954
3 35,000 (8,000) 27,000 0.751 20,277
4 10,000 35,000 (9,500) 35,500 0.683 24,247
5 (500) (500) 0.621 (310)
-----------
9,983
======
As the project produces a positive NPV it should be accepted.
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1. The management team of Bryher plc is considering the purchase of equipment to enable the
corrosive waste produced by one of its existing manufacturing processes to be converted into a
marketable product. At present the corrosive waste is removed by a firm and the contractual
arrangements for the safe disposal of the waste will cost Bryher €100,000 per year for each of the next
four years. Early termination of the contract, which will be required if the waste is used for
production, will cost €60,000 immediately and this contract termination penalty will not be allowed as
a tax deductible expense.
The machinery will cost €400,000, financed entirely by a fixed interest 10% loan. At the end of year
4 the equipment will be sold for €40,000; the dismantling, cleaning and selling costs will amount to
€30,000.
Availability of the waste product would restrict sales of the marketable product, all made on a cash
basis, to €450,000 for each of years 1 and 2 and to €700,000 for each of years 3 and 4. The operating
and other costs of the proposal are estimated at:
All ‘Other expenses’ are caused by the proposed project and are paid in the years shown.
Similarly, ‘Labour costs’ are incremental cash costs except that part of the costs for each of years 1
and 2 relate to persons currently employed by Bryher who are not fully utilised in productive work.
The transfer of these employees to the proposed project is expected to save Bryher €30,000 and
€20,000 for years 1 and 2 respectively.
Purchases of additional materials are for cash. Storage of materials will utilise space which would
otherwise have been rented out for €20,000 per year for years 2 and 3 only. Included in ‘Additional
materials used’ are 1,000 units per year of material X at a cost of €15 per unit; this is the price which
Bryher has contracted to pay for each unit of the material. However, until the end of year 3 material X
will be in short supply and any available quantities could be used elsewhere in Bryher to earn a
contribution before tax of €10 per unit in excess of cost. From year 4 material will not be in short
supply. No stocks of material X are ever held at year-ends.
‘Factory overhead’ is an apportionment of general factory overheads which, as a result of this venture,
will increase in total only by €60,000 per year for the additional insurance premiums relating to the
hazards of handling the corrosive material.
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It may be assumed that all cash flows relating to Bryher’s activities which occur during, but not at the
start of a year, actually occur at the year-end.
Bryher is subject to tax at a rate of 50% with a one-year delay. Capital expenditure is eligible for
100% first year allowances and sales proceeds of assets are subject to tax.
Bryher is a very profitable firm and can utilise all first year allowances in full at the earliest
opportunity.
Required
Using 15% as the appropriate after-tax discount rate within a net present value calculation, to advise
Bryher on the desirability of converting the corrosive waste into a marketable product.
2. Charm plc, a software company, has developed a new game, ‘Fingo’, which it plans to launch in
the near future. Sales of the new game are expected to be very strong and sales volumes, production
volumes and selling prices for ‘Fingo’ over its four-year life are expected to be as follows.
YEAR 1 2 3 4
Advertising costs to stimulate demand are expected to be €650,000 in the first year of production and
€100,000 in the second year of production. No advertising costs are expected in the third and fourth
years of production. Fixed costs represent incremental cash fixed production overheads. ‘Fingo’ will
be produced on a new production machine costing €800,000. Charm plc can claim capital allowances
on a straight-line basis over four years.
Charm plc pays tax on profit at a rate of 30% per year in the year in which they arise.
Charm plc uses an after-tax discount rate of 10% when appraising new capital investments.
Required:
(a) Calculate the net present value of the proposed investment and comment on your findings.
(b) Calculate the internal rate of return of the proposed investment and comment on your findings.
(c) Discuss the reasons why the net present value investment appraisal method is preferred to other
investment appraisal methods such as payback, return on capital employed and internal rate of return.
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Notes:
(1) Labour costs are reduced by €30,000 and €20,000 in each of years 1 and 2. These amounts
will be paid by Bryher whether or not the project is undertaken and are therefore not
incremental costs of the project.
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The net present value is €63,820 and the project is worthwhile. Therefore, Bryher should convert the
corrosive waste into a marketable product.
€000
Present value of future benefits 865·2
Initial investment 800·0
––––––
Net present value 65·2
––––––
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Workings
Fixed costs in year 1 = 150,000 x 4 = €600,000 and since these represent a one-off increase in fixed
production overheads, these are the fixed costs in subsequent years as well.
Annual capital allowance (CA) tax benefits = (800,000/4) x 0·3 = €60,000 per year
Comment
The net present value of €65,200 is positive and the investment can therefore be recommended on
financial grounds. However, it should be noted that the positive net present value depends heavily on
sales in the first year. In fact, sensitivity analysis shows that a decrease of 5% in first year sales will
result in a zero net present value.
€000
Present value of future benefits 754·9
Initial investment 800·0
––––––
Net present value (45·1)
––––––
Since the internal rate of return is greater than the discount rate used to appraise new investments, the
proposed investment is financially acceptable.
(c) There are many reasons that could be discussed in support of the view that net present value
(NPV) is superior to other investment appraisal methods:
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57
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Study Unit 4
B. Cash Management
Cash Budget
Bank Overdraft
Term Loan
Cash Lodgement
Centralised Cash Management
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Good working capital management achieves a balance between the objectives of profitability and
liquidity. Profitability supports the primary financial management objective of shareholder wealth
maximization. Liquidity ensures the company can meet its liabilities as they fall due and remain in
business.
Obviously, the levels of Working Capital required depend to a large extent on the type of industry
within which the company is operating.
Contrast service industries (no inventory) with manufacturing industries (large investment in
inventory).
Matching Concept
Long-term assets should be financed by long-term funds (debt/equity). Short-term assets can be
financed with short-term funds (e.g. overdraft, payables) but it may be prudent to finance partly with
long-term funds. Working capital policies can be identified as conservative, aggressive or moderate:
2. Aggressive – short-term finance used for all fluctuating and most of the permanent current
assets. This will reduce interest costs and increase profitability but at the expense of an
increase in the amount of higher-risk finance used.
3. Moderate (or matching approach) – short-term finance used for fluctuating current assets
and long-term finance used for permanent current assets.
Short-term finance is usually cheaper and more flexible than long-term finance. However, the trade-
off between the relative cheapness of short-term debt and its risks must be considered. For example,
it may need to be continually renegotiated as various facilities expire and due to changed
circumstances (e.g. a credit squeeze) the facility may not be renewed. Also, the company will be
exposed to fluctuations in short-term interest rates (variable rate).
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Overtrading/Undercapitalisation
This occurs where a company is attempting to expand rapidly but doesn’t have sufficient long-term
capital to finance the expansion. Through overtrading, a potentially profitable business can quite
easily go bankrupt because of insufficient cash.
Output increases are often obtained by more intensive use of existing fixed assets and growth is
financed by more intensive use of working capital. Overtrading can lead to liquidity problems that
can cause serious difficulties if they are not dealt with promptly.
Overtrading companies are often unable/unwilling to raise long-term capital and rely more heavily on
short-term sources (e.g. payables/overdraft). Receivables usually increase sharply as credit is relaxed
to win sales, while inventories increase as the company attempts to produce at a faster rate ahead of
increases in demand.
Symptoms of Overtrading
• Turnover increases rapidly
• The volume of current assets increases faster than sales (fixed assets may also
increase)
• Increase in inventory days and receivables days
• The increase in assets is financed by increases in short-term funds such as payables
and bank overdrafts
• The current and quick ratios decline dramatically and Current Assets will be far
lower than Current Liabilities
• The cash flow position is heading in a disastrous direction.
Causes of Overtrading
• Turnover is increased too rapidly without an adequate capital base (management may
be overly ambitious)
• The long-term sources of finance are reduced
• Management may be completely unaware of the absolute importance of cash flow
planning and so may get carried away with profitability to the detriment of this aspect
of their financial planning.
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Undertrading/Overcapitalisation
Here the organisation operates at a lower level than that for which it is structured. As a result capital
is inadequately rewarded. This can normally be identified by poor accounting ratios (e.g. liquidity
ratios too high or inventory turnover periods too long).
Current Assets
Current Ratio = ------------------------
Current Liabilities
Receivables
Receivables Days (Collection Period) = --------------- x 365 Days
Sales
Payables
Payables Days (Payment Period) = ------------- x 365 Days
Purchases
Inventory
Inventory Period = ------------------ x 365 Days
Cost of Sales
Benchmarks often quoted are a Current Ratio of 2 : 1 and a Quick Ratio of 1 : 1 but these should not
be adopted rigidly as organisations have vastly different circumstances (operating in different
industries, seasonal trade etc.).
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(2) (5)
PAYABLES RECEIVABLES
(6)
CASH
The Working Capital Cycle can also be expressed as a period of time, by computing various ratios:
Inventory
Inventory ---------------- x 365 = x days
Cost of Sales
Receivables
Receivables --------------------- x 365 = x days
Sales
Payables
Less: Payables ------------------------ x 365 = (x days)
Purchases
----------
WORKING CAPITAL CYCLE (days) x days
======
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It is difficult to determine the optimum cycle. Attention will probably be focussed more on individual
components rather than on the total length of the cycle.
Comparison with previous periods or other organisations in the same industry may reveal areas for
improvement.
B. CASH MANAGEMENT
Cash is an idle asset and the company should try to hold the minimum sufficient for its needs.
Three motives are suggested for holding liquid funds (cash, bank deposits, short-term investments):
Transaction Motive - to meet payments in the ordinary course of business – pay employees,
suppliers etc. Depends upon the type of business, seasonality of trade etc. Can usually be
identified by preparing a Cash Budget.
Precautionary Motive - to provide for unforeseen events e.g. fire at premises. Depends upon
management’s attitude to risk and availability of credit at short notice.
Speculative Motive - to keep funds available to take advantage of any unexpected “bargain”
purchases which may arise - e.g. acquisitions, bulk-buying etc.
Cash Budget
This is a very important aid in cash management. Most organisations, whether small unsophisticated
or large multinationals, will prepare a Cash Budget at least once a year. It is usually prepared on a
monthly/quarterly basis to predict cash surpluses/shortages.
Example
A company’s sales are €100,000 for November and these are expected to grow at the rate of 10% per
month. All sales are on credit and it is estimated that 60% of customers will pay in the month
following sale; the remainder will pay two months after sale but on average 10% of sales will turn out
to be bad debts. The company has some investments on which income of €20,000 will be received in
February.
Materials must be purchased two months in advance of sale so that demand can be met. Materials
cost 50% of sales value. The supplier of the materials grants one month’s credit. Wages and
overheads are €30,000 and €15,000 respectively per month.
A new machine costing €48,000 will be purchased in February for cash. The estimated life of the
machine is 4 years and there will be no scrap value at the end of its life. Depreciation will be at the
rate of €12,000 per annum and this will be charged in the monthly management accounts at €1,000
per month.
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Rent on the company’s factory is charged in the monthly management accounts at €5,000. This is
paid half-yearly in March and September.
At the 31st December the company expects to have a cash balance of €50,000.
The opening cash surplus of €50,000 turns into a negative figure from end of January onwards,
mainly due to capital expenditure, and peaks at (€96,000) in March. Thus, the company will have to
arrange an overdraft in advance to cover the shortfalls. Alternatively, the company could take action
to avoid the potential negative results. Some possibilities are:
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Bank Overdraft
This is one of the most important sources of short-term finance. It is a very useful tool in cash
management, particularly for companies involved in seasonal trades.
Term Loan
Finance is made available for a fixed term and usually, at a fixed rate of interest. Repayments are in
equal instalments over the term of the loan. Early repayment may result in penalties.
Cash Lodgement
It is important that cash is lodged as quickly as possible so that the organisation gets the benefit
through an increase in investments or a reduction in overdraft. However, apart from the security risk
of cash lying idle there are costs of making lodgements (bank, clerical, transportation etc.) It becomes
a “Balancing Act” to minimise costs and maximise benefits (interest).
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Example
A company always works off an overdraft which currently costs 15% p.a. Sales are €600,000 per
week (5 working days). Half the cash is received on Monday and Tuesday, split equally between the
two days. The remaining sales are split equally over the other three days. At present all lodgements
are made on Friday afternoon.
It is now proposed to lodge on Monday, Wednesday and Friday but this will increase administration
and bank costs by €200 per week. Should the company change policy?
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Receivables are often one of the largest items in a company’s Balance Sheet and also one of the most
unreliable assets, largely because company policies concerning them are often inadequate or poorly
defined and in the hands of untrained staff. Typically, a company could have 20% - 25% of total
assets as receivables.
Credit management is a problem of balancing profitability and liquidity. Credit terms are a sales
attraction but higher receivables put a strain on liquidity. Management will be concerned with
achieving the optimum level of investment. This requires finding the correct balance between:
• the cost of investment in receivables (cost of finance, administration, bad debts etc.)
By setting the “terms of sale” the company can, to some extent, control the level of receivables.
However, the relative strengths of the credit-giver and the credit-taker are important.
Consideration must also be given to the industry norm.
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• Other Credit Controllers - trade associations where controllers meet regularly to exchange
information about the state of the industry generally and slow/bad payers in particular.
• Own Information - check old customer files to see if you have done business in the past.
• Trial Period - on a "cash -only" basis.
• Credit Limit - fix at low level initially and only increase if payment record warrants.
• Site Visits - an opinion on the operations can be formed by visiting the premises.
• Credit Scoring - evaluate potential customer using credit scoring or other quantitative
techniques. Credit scores are risk indicators - the higher the score, the lower the risk. Scores
will be allocated based on the characteristics of the new customer (e.g. age, occupation,
length of service, married/single, home owner, size of family, income, commitments etc.).
Credit scoring is particularly suited to financial institutions and the amount of credit offered,
if any, will depend on whether the credit score is above a predetermined cut-off level.
Computerised systems (“expert systems”) are especially useful for this purpose.
Although terms and settlement discounts are often influenced by custom and practice within an
industry it is still possible to change them. Once defined, ensure that the customers are aware of them
- ideally, they should be informed when they order, when they are invoiced and when they receive
statements. Always try to enforce the specified discount policy.
Discounts
As extended credit facilities may be expensive to finance the firm may offer customers a discount
(cash/settlement discount) to encourage them to pay early. As with extended credit discounts may
also be used as a marketing tool in an effort to increase sales. To evaluate whether it is financially
worthwhile the cost of the discount should be compared with the benefit of the reduced investment in
receivables.
Example
A company offers its customers 40 days credit. On average they take 60 days to pay. To
encourage early payment the company now proposes to offer a 2 % discount for payment
within 10 days.
For each €100 of sales the cost is €2 and the company only receives a net €98. In return the
company receives payment 50 days earlier (day 60 - day 10).
The annualised cost of the discount is:
2 365
---- x ----- = 14.9% p.a.
98 50
The cost of 14.9% should be compared with other sources of finance. If, for example, the cost of the
company’s overdraft is 16% p.a. the discount would seem to be worthwhile. If, on the other hand, the
cost of the overdraft is only 10% p.a. the discount should not be offered as it would be better to leave
the debts outstanding and finance through the overdraft.
In industries that deal with both trade and retail customers (e.g. building supplies) it is usual to offer
trade discounts. This may reflect the economies of scale which derive from larger orders and the
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greater bargaining power of the customer. Trade discounts are frequently much larger than
cash/settlement discounts and may be for as much as 20% of the quoted price.
Debt Control
Good debt control can be summed up as:
ensuring that all sales are paid for within an agreed period, without alienating customers,
at the minimum cost to the company.
The company itself can take steps to “assist” the customers to pay promptly:
1. Issue invoices and statements promptly.
2. Deal with customer queries/disputes immediately.
3. Issue credit notes as agreed.
4. Be flexible in billing arrangements to accommodate customers.
There is no debt collection policy that is applicable to all companies. Policies will differ according to
the nature of the product and the degree of competition. Debt control system will probably include:
1. Well trained credit personnel.
2. Measures to ensure that credit limits are not exceeded.
3. Formal set procedures for collecting overdue debts, which should be known by all staff and
applied according to an agreed time schedule. Care must be taken that the cost of the debt
collection does not exceed the amount of the debt, except where used as a deterrent. Also
over-zealous collection techniques may damage goodwill and lose future sales.
4. Computerised monitoring systems to identify overdue accounts as early as possible. For
example, ratios, compared with the previous period to highlight trends in credit levels and the
incidence of overdue and bad debts; statistical data to identify causes of default and the
incidence of bad debts among different classes of customer and types of trade.
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Debt collection policies must not be regarded as completely inflexible and systems should be
modified as circumstances change.
Among the many debt collection techniques that can be used are:
1. Invoices - issued promptly following delivery of goods/service.
2. Statements - at monthly/other intervals to draw attention to unpaid debts.
3. Overdue Letters - carefully drafted to provoke an immediate response; individual rather
than computer-produced; series of letters of varying degrees of severity.
4. Telephone Calls – these ensure that customer has received the letter(s) and gives him an
opportunity to raise any queries or advise of any difficulties which may cause a change of
approach to help him out.
5. Mail or Email Reminders.
6. Visits by Sales Staff.
7. Visits by Credit Control Staff.
8. Use of External Agencies - debt collection agency; factoring company etc.
9. Threaten Withdrawal of Credit Facilities/Discounts.
10. Threaten To Withold Future Supplies.
11. Solicitor’s Letter.
12. Legal Action - beware cost of action does not exceed debt.
In most cases some extra spending on debt collection will reduce the overall cost of the investment in
receivables (e.g. reduction in bad debts/average collection period etc.). However, beyond a certain
level extra spending is not usually cost effective.
Credit Policy
Example 1
Current sales are €500,000 p.a. - all on credit. On average customers take 60 days credit. Bad debts
are 1% of sales.
Marketing manager suggests that if credit is relaxed to 90 days sales will increase by 20%. However,
bad debts will increase to 2%. It is estimated that 75% of existing customers will take the 90 days.
Variable costs are 90% of sales value and the company uses an overdraft costing 10% p.a.
Should the new proposal be adopted?
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Business Finance
Example 2
Current sales are €500,000 p.a. - all on credit. 60 days credit allowed but on average 90 days taken.
New credit terms of a 4% discount for payment by day 10 are being considered. It is estimated that
60% of the customers will take the discount. The new terms will increase sales by 20%. Variable
costs are 85% of sales value and the company uses an overdraft costing 11% per annum.
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Factoring
This involves the sale of trade debts for immediate cash to a “factor” who charges commission.
Factoring companies are financial institutions often linked with banks. Unlike an overdraft the level
of funding is dependent, not upon the fixed assets of the company, but on its success for as the
company grows and sales increase the facility offered by the factor grows, secured against the
outstanding invoices due to the company. Three basic services are offered, although a company need
not use all of them:
2. Sales Ledger Management - the factor takes the place of the client’s accounts department.
Duplicate invoices are sent to the factor who maintains a full sales ledger for each client,
handles invoices, chases outstanding payments etc. Commission of 1% - 2% is charged.
3. Credit Insurance - in return for a commission the factor provides a guarantee against bad
debts.
Recourse Factoring - the factor will reclaim the money advanced on any uncollected debt so the
business will retain the risk of non-recovery and, depending on the contract terms, perhaps the
administration burden as well.
Non-Recourse (Full) Factoring - the factor runs credit checks on the company’s customers and agrees
limits dependent on their creditworthiness. These can be adjusted in the light of experience, once a
pattern has been established. The factor will protect the client against bad debts on approved sales
and will also take on all the administration burden. The balance over the 80% advance is paid to the
client an agreed number of days after the initial advance.
Recourse v Non-Recourse Factoring - with non-recourse factoring the business knows that it will get
paid, no matter what happens but protection only applies to credit-approved debts and it is not
always easy to get this approval for doubtful ones. Recourse factoring allows more funding to be
made available against less credit-worthy debtors and the business is in control of when and how
individual debts are to be pursued and collected.
The cost of finance through factoring is usually slightly above overdraft rates. The administration
charges vary between 0.6% and 2.5% approx.
Advantages of Factoring
1. It is an alternative source of finance if other sources are fully utilised, particularly for a
company with a high level of receivables.
2. It is especially useful for growth companies where receivables are rising rapidly and funds
available from the factor will rise in tandem.
3. Security for the finance is the company’s receivables, leaving other assets free for
alternative forms of debt finance.
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4. The factor may be able to manage the company’s sales ledger more efficiently by
employing specialist staff, leading to lower costs for the company and freeing management to
concentrate on growing the business.
5. Bad debts will be reduced or guaranteed by credit insurance.
6. Due to the greater guarantee of cashflow the company will have a better opportunity for
taking up cash discounts from suppliers.
7. The factor will be more efficient in collecting monies. Evidence suggests that, on average,
it takes over 75 days for an invoice to be paid, whereas the average debt turn of companies
using factoring is 60 days.
8. The company replaces a great many clients with one - the factor - who is a prompt payer.
Disadvantages of Factoring
1. It may be more expensive than other sources.
2. When fixing credit terms and limits the factor will be concerned with minimising risk and,
therefore, certain risky but potentially profitable business may be rejected.
3. The factor may be “pushy” when collecting debts. This may lead to ill-feeling by
customers.
4. Use of a factor might reflect adversely on a company’s financial stability in the eyes of
some ill-informed people. Factoring is more acceptable nowadays but this problem could be
overcome by undisclosed factoring, which leaves the company to collect payment as agent for
the factor.
Invoice Discounting
This is similar to factoring but only the finance service is used. Invoices are discounted (like Bills
Receivable) and immediate payment, less a charge, is received. The company still collects the debt as
agent for the financial institution and is also liable for bad debts. The service tends to be used on an
ad hoc basis and is provided by factors for clients who need finance but not the administrative service
or protection. Invoice Discounting is confidential and solely a matter between the lender and
borrower, unlike Factoring where the bank assumes a direct and visible role between the company and
its receivables. Also, the company retains full control over the management of its receivables’ ledger,
including credit control.
The credit is mistakenly believed to be cost-free. The costs include the following:
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Business Finance
1. Loss of Supplier’s Goodwill - this is difficult to quantify. If the credit period is regularly
overdone suppliers may put a low priority on the quality of service given; further orders may
be refused; cash on delivery or payment in advance demanded.
2. Higher Unit Costs - the supplier may try to recoup the cost of longer credit by charging
increased prices.
3. Loss of Cash Discounts - if the credit period is used then discounts are not being taken.
Thus, the cost of credit is the cost of not taking the discount.
Example
Your company normally pays within 45 days. The supplier offers a 2% discount for payment
within 10 days. If the company refuses the discount the implied cost of not taking the
discount is:
2 365
----- x ----- = 21.3% p.a.
98 35
The cost of not taking the discount (opportunity cost) is 21.3% p.a.
Despite the above costs trade credit is the largest source of short-term funds for companies. Among
the advantages are:
1. Obtaining credit is informal.
2. It is a flexible source of finance - but payment should not be delayed regularly.
3. It is a relatively stable source of finance - it is available continuously.
4. No security is required - unlike other forms of credit.
Ordering costs relate to those which are incurred each time an order is placed (e.g. administration,
authorisation, receiving goods, checking etc.)
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Business Finance
High levels of inventory can only be achieved at a cost. The Holding cost of inventory has many
elements:
Cost of financing (bank interest)
Storage (warehousing)
Handling
Insurance
Administration
Obsolescence
Deterioration
Theft
Overall, reducing inventory is likely to increase profitability rather than decrease it.
Reducing inventory is almost totally within the control of management - unlike reducing receivables
or increasing payables, it does not rely on the co-operation of third parties.
2cd
EOQ = -------
h
Example:
A company has annual demand for 2,000 units. Each unit can be purchased for €20. The cost
of placing each order is €20 and the annual cost of holding an item in stock is €2. Calculate
the Economic Order Quantity.
2 x 20 x 2,000
EOQ = ----------------- = 200 units
2
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Business Finance
Discounts
If the supplier offers a discount for larger orders this may alter the position. The discount will offer
two savings - a reduced purchase price and lower ordering costs because fewer orders are placed.
Using the above example, suppose that a discount of 2% is offered on orders of 400 or more.
Calculate the total costs with and without the discount. Total costs will now consist of ordering costs
+ holding costs + purchase price.
200 Units
2,000
Ordering: €20 x ------- €200
200
200
Holding: €2 x ------ €200
2
400 Units
2,000
Ordering: €20 x ------- €100
400
400
Holding: €2 x ------ €400
2
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Business Finance
unloading bay to the production line. There may also be benefits from bulk-purchasing discounts or
lower purchase costs.
With a JIT system there is little room for manoeuvre in the event of unforeseen delays – e.g. on
delivery times. The buyer is also dependent on the supplier for the quality of materials as expensive
downtime or a production standstill may arise, although guarantees and penalties may be included in
the contract as protection.
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Business Finance
1. At present Williams requires payment from its customers one month after delivery but on average
it takes them 70 days to pay. Sales are €4m. per annum and bad debts €20,000 per annum.
It is planned to offer customers a cash discount of 2% for payment within 30 days. Williams
estimates that 50% of customers will accept this facility but that the remaining customers, who tend to
be slow payers, will not pay until 80 days after the sale. The company has a partly used overdraft
facility costing 13% per annum. If the plan goes ahead bad debts will be reduced to €10,000 per
annum and there will be savings in credit administration expenses of €6,000 per annum.
Required:
(a) Calculate the approximate equivalent annual percentage cost of a 2% cash discount which
reduces debtors from 70 to 30 days sales outstanding. You need not refer to the data above to
answer this part of the question.
(b) Should Williams offer the new credit terms to customers ? You should support your answer
with any calculations and explanations which you consider necessary.
2. The customers of Jerum plc take, on average, 90 days credit before paying. New credit terms are
being considered which would allow a 5% discount for payment within 30 days with the alternative of
full payment due after 60 days.
It is expected that 60% of all customers will take advantage of the discount terms. Customers not
taking the discount would be equally split between those paying after 60 days and those taking 90
days credit. The new policy would increase sales by 20% from the current level of €100,000 per
annum, but bad debts would rise from 1% to 2% of total sales. The company's products have variable
costs amounting to 80% of sales value.
Jerum plc finances all trade credit with readily available overdrafts at a cost of 12% per annum.
Required:
Advise Jerum plc on the merits of the new credit terms after considering their effect on sales levels,
bad debts etc.
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Business Finance
3. Barton Limited manufactures specialist components for a wide range of customers. In the recent
year turnover amounted to €20m. and no growth in this figure is anticipated for the next year. Bad
debts currently stand at 0.5% of turnover and the average collection period for debtors is 70 days.
Barton Limited is concerned about its liquidity and is considering using a factoring company. The
service will be on a non-recourse basis, the factoring company administering and collecting payment
from Barton’s customers. As a result, Barton will achieve administrative savings of €150,000 per
annum. The factor is confident that it can lower the average collection period by 15 days. The factor
will make a service charge of 1% of turnover.
Barton Limited finances its working capital by means of an overdraft which costs 12% per annum.
Required
(a) Advise Barton Limited if it should accept the offer from the factoring company.
(b) Apart from the collection of payments on behalf of Barton Limited, what other services
might the factoring company provide which would be attractive to Barton Limited ?
4. Bradley is a retailer of fashion goods. Turnover is €700,000 per week and the current
policy is to lodge this to its bank twice a week on Wednesday and Friday.
A new Finance Manager has been appointed and he is reviewing this approach to cash lodging. He is
investigating the possibility of switching to making lodgements on a daily basis. He estimates that the
various costs associated with each lodgement total €30.
Bradley is open for business Monday to Friday of each week. Tuesday and Thursday are the busiest
days when Bradley opens late and turnover on each of these two days is twice that of the other three
days.
Bradley finances all working capital requirements by means of an overdraft which costs 10% per
annum.
Required:
(a) Prepare calculations to show the impact on annual profits of switching to daily bank
lodgements and advise Bradley which policy to adopt.
(b) Before extending credit to new customers there are a number of steps that a company can
take to evaluate the credit risk. Outline briefly, four methods of doing this.
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Business Finance
5. Your client Mrs. Moneybags proposes to start her own business commencing 1st July 2010.She
has asked you to help her to produce a cash forecast for the six months July to December 2010.
She provides you with the following list of actions that she intends to take.
1: The new business will commence with € 65,000 in the bank made up of her personal savings.
She will immediately pay a deposit of € 30,000 on a building for conversion into a workshop,
and (commencing 15th July) a € 250 per month mortgage repayment. She will also purchase
plant in July valued at € 18,000 and a motor van valued at € 8,000.Other immediate
payments include € 2,000 and she expects to pay € 150 per month on miscellaneous items
from August onwards.
2: Four staff will be employed, each paid € 500 per month on the last day of the month.
3: Purchases of raw materials on credit and paid one month after receipt will be as follows:
July Aug. Sept. Oct. Nov. Dec.
18,000 13,000 16,000 16,000 16,000 18,000
50% of units will be sold for €10 each and cash received in the month following sale.50%
will sell at €12 each, receivable two months after sale.
6: Mrs. Moneybags will draw € 600 every month for personal spending.
7: Advertising will be € 2,000 per month for the first three months and € 100 per month
thereafter, paid for in the month incurred.
Required
(a) Construct a cash budget showing clearly the cash at bank position
at the end of each month. (15 Marks)
(b) Comment on the closing cash balances each month and indicate if
she might be better off arranging some payments differently and
if she needs to discuss the position with the bank manager.
(5 Marks)
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Business Finance
6. The board of directors of Cashcall have been recently reviewing the company’s performance
for 2011. The discussion then moved on to 2012 and one director expressed concern about the
liquidity position of the company. As a result, it has been agreed to immediately produce a Cash
Budget for the first four months of 2012 and to have it available for discussion at the next board
meeting.
You have been asked to prepare the Cash Budget and have been supplied with the following
information:
o Sales have been static at €500,000 per month in the last quarter of 2011. However it is
expected that this will increase by €100,000 per month for the next six months as a result
of a recent marketing campaign. Twenty per cent of sales are on a cash basis. Ten per
cent of total sales turn out to be bad debts The remainder are on credit and pay in the
month following sale. The cost of the marketing campaign is €60,000 and this will be
paid to the agency in February.
o In order to satisfy demand materials are purchased two months in advance of sale.
Materials cost 60% of the sales value and the supplier operates a strict one month credit
policy.
o Wages are estimated at €120,000 per month and a 5% increase is due to be paid from
March onwards
o Cashcall has an outstanding loan of €100,000 with its bank. Interest is charged at the rate
of 10% per annum and is paid half-yearly in March and September
o Cashcall will purchase some additional machinery in January for €96,000. The supplier
will allow 60 days credit. Cashcall normally depreciates machinery over four years so it
will charge depreciation of €24,000 each year or €2,000 in each month’s accounts.
o Cashcall charges rent of €10,000 in its monthly management accounts. It pays the rent
quarterly in February, May, August and November.
Required
(i) Prepare a Cash Budget for the first four months of 2012 for Cashcall. You should show
your answer in €’000’s (17 marks)
(ii) Having prepared a Cash Budget for Cashcall, if the cash position proves to be
unacceptable to Cashcall’s management suggest four measures that it could adopt to
improve the position. (8 marks)
Total 25 marks
7. (i) Newdeal has recently had some difficulties with its liquidity and has been looking at ways of
speeding up collection from its debtors. Sales in the recent year have been €16m.and debtors average
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€2.6m. It is considering the offer of a 2% discount to customers who pay within 10 days of despatch
of invoices rather than the normal 30 days offered. Newdeal estimates that 50% of its customers
would take advantage of this offer. It is not expected that the discount scheme will impact on sales
volume.
Required
(i) Advise whether Newdeal should proceed with the offer of the discount. (11 marks)
(ii) As an alternative to the discount scheme mentioned in (i) Newdeal has been approached by a
factoring company. The factor will operate on a service-only basis, administering and collecting
payment from Newdeal’s customers. This is expected to generate savings of €100,000 per annum
and should also shorten the debtor days to an average of 45. The factor will impose a service
charge of 1.5% of Newdeal’s turnover.
Required
Advise whether the offer from the factor is beneficial. In light of your answer to (i) above advise
Newdeal whether it should proceed with the discount scheme or the offer from the factor, if any.
(14 marks)
Total 25 marks
8. Devoy plc has annual sales of €5m. Ten per cent of sales are on a cash basis. Devoy plc offers
thirty days credit but on average customers take sixty days to pay.
It is now considering offering a 2% discount for payment within ten days and it has estimated that
50% of its customers will take the discount. The remaining customers will continue to take the
current sixty days period. At present bad debts are 1% of credit sales and it is expected that this rate
can be reduced to 0.50%
Devoy plc finances all short-term assets with an overdraft costing 10% per annum.
Required
Prepare calculations to decide if Devoy plc should proceed with the offer of this discount scheme.
9. Silver stocks a number of different items of jewellery. Details of one product are as follows:
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Business Finance
10. Vero is a new company which will commence business from 1st January 2009 and wishes to
prepare a Cash Budget for its bank for the first four months of operations. It is now December 2008.
The promoters of the company will invest €300,000 in initial share capital on 1st January 2009.
Sales for January are estimated at €400,000. It is forecast that sales can be increased by 20% each
month thereafter. 25% of sales are on a cash basis. The remaining sales are on credit - of these half
will pay in the month following sale and the other half will take two months to pay. It is not expected
that there will be any bad debts.
Purchases represent 40% of gross sales revenue and purchases are made in the same month as the
sales occur. The suppliers allow one month’s credit.
Packaging costs 10% of sales value and is paid in the same month as the sale.
A machine costing €144,000 will be purchased in January. The machine has a life of three years and
will be depreciated in the company’s accounts at the rate of €4,000 per month. The machine supplier
will grant two month’s credit.
Premises have been rented for €5,000 per month from 10th December 2008 . The lease provides for
the rent to be paid quarterly in arrears.
Staff costs are estimated at €20,000 per month and are paid each month.
Distribution costs represent 15% of sales revenue and are incurred in the month of sale.
Required
(a) Outline three main reasons why a company prepares a Cash Budget (6 marks)
(b) Prepare a Cash Budget for Vero for the first four months of 2009, showing the closing cash
balance at the end of each month. (Workings to be calculated in €’000’s)
(13 marks)
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(c) Suggest three ways by which Vero could improve the cash position for the period as
calculated in part (b) (6 marks)
(Total 25 marks)
11. Despite introducing a generous discount to customers, Flight plc has found that very few
customers have paid early and taken the discount. In fact, receivables days have increased
significantly, as has the company’s overdraft. Flight plc is, therefore, considering factoring its debts
in the coming year.
Credit sales for the last year totalled €12 million, with average receivables of €2 million. Next year,
sales are expected to increase by 10%. Debtors days are expected to increase to 70 days if the
factoring arrangement is NOT entered into.
A factoring company has put forward the following proposal to Flight plc:
(i) Debtors days will be reduced to 28 days as a result of stricter credit control.
(ii) The factor will charge interest of 13% per annum on the advances.
(iii) The factor will charge an administration fee of 1·5% of turnover for the service.
(iv) The factor will advance 80% of the value of sales invoices.
Should Flight plc enter into the agreement, it will make its credit controller redundant. She earns a
salary of €38,000 per annum.
Current bank overdraft rates have remained the same at 12% per annum.
Required
(a) Evaluate whether it is financially viable for Flight Co to factor its debts in the coming year.
(18 marks)
(Total 25 marks)
12. The management of Tradeco are reviewing the year-end accounts which have just been prepared.
They are concerned about the liquidity aspects of the company and have obtained some key financial
indicators for the industry in which they operate. Details of the accounts and the industry indicators
are as follows:
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Business Finance
Profit & Loss Account for Year Ended 31st December 20X8 (€m)
Sales 50.00
Cost of Sales (43.00)
Operating Profit 7.00
Interest Charges (2.00)
Pre-Tax Profit 5.00
Corporation Tax (1.00)
Profits attributable to Ordinary Shareholders 4.00
Dividends (1.00)
Retained Earnings 3.00
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Financed by:
Issued Share Capital
Ordinary Shares 4.00
Revenue Reserves 17.00
--------
Shareholders’ Funds 21.00
=====
The following are key financial indicators from Tradeco’s industry:
Current Ratio 1.7
Quick Ratio 1.2
Receivables (Collection) Period 45 days
Payables Period 40 days
Inventory Days 35 days
Required
(i) Calculate similar ratios for Tradeco to those identified for the industry.
(15 marks)
(ii) Using the ratios calculated at (i) above, write a report to management which
compares the performance of Tradeco to that of the industry and make appropriate
recommendations. (10 marks)
(Total 25 marks)
13. Frigid is a skiwear retailer operating through its website shop. Its busiest months of the year are
December, January, February and March, with sales for the rest of the year being relatively
insignificant.
In December the company prepares a cash budget for January, February and March. The following
figures from its profit forecast for December 2008 through to March 2009 are currently available.
1. The company does not provide any credit to customers. However, customers who join the
company’s members’ club are given a 5% discount on all of their purchases. Half of customers are
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club members. The sales revenue forecasts above have been calculated before any discounts have
been taken into account.
2. Purchases represent 40% of gross sales revenue. Sales revenue in November was €95,000.
3. Suppliers allow two months’ credit.
4 All staff are paid at the beginning of the month for the previous month’s work.
5. Packaging costs are paid one month after they are incurred.
6. Distribution costs are paid in the month in which they are incurred.
7. Other costs include depreciation of €12,000 per month. They also include rental costs of €30,000
per month, which are paid quarterly in December, March, June and September. The remainder of
‘other costs’ are paid in the month in which they are incurred.
8. The overdraft on Frigid’s bank account at 31 December 2008 is expected to be €500,000.
9. All workings should be in €’000, to the nearest €’000.
Required
(a) Prepare a monthly cash budget for each of the three months to 31 March 2009, showing the cash
balance at the end of each month. (17 marks)
(b) Frigid wishes to expand its business by branching out into the manufacture of its own brand of
skiwear, and then expand its customer base to include wholesale customers. The three
owners/directors have produced a business plan and are considering approaching a venture capital
organisation for finance. Identify four factors that a venture capital organisation would take into
account when deciding whether or not to invest in Frigid (8 marks)
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1. (a) 2 365
---- x ---- = 18.6% p.a.
98 40
Revised Debtors:
€4m. x 50% x 30/365 164,000
€4m. x 50% x 80/365 438,000
----------
602,000
----------
Reduction in Debtors 165,000
======
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The new credit terms are marginally profitable. There is a high level of
discount and if this could be reduced to, say, 3% without reducing sales then
the overall increase in profit would be more worthwhile.
4. (a)
€700,000
------------ = €100,000 (Monday, Wednesday, Friday)
7
€200,000 (Tuesday & Thursday)
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Banking Costs
Currently 2 x €30 = €60
Revised 5 x €30 = €150
-------
(€90)
--------
Net Saving – per week €75
=====
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Payments
Deposit on building 30000 30000
Mortgage 250 250 250 250 250
1500 250
Plant Purchase 18000 18000
MV Purchase 8000 8000
Other 2000 150 150 150 150 150 2750
Staff 2000 2000 2000 2000 2000 2000 12000
Credit Purchases 18000 13000 16000 16000 16000 79000
Machine(second) 14000 14000
Drawings 600 600 600 600 600 600 3600
Advertising 2000 2000 2000 100 100 100 6300
Total Payments 62850 23000 18000 33100 19100 19100 175150
Working – Sales
July Aug Sept Oct Nov Dec Total
Units 2000 2500 2500 2000 3000 3000 15000
6. Cashcall
(€’000) Jan Feb Mar April
Inflows
Cash Sales (20%) 120 140 160 180
Cr. Sales (70%) 350 420 490 560
Inv. Income 52
-------------------------------------------------------------------
470 560 650 792
=======================================
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Outflows
Materials (60%) 420 480 540 600
Wages 120 120 126 126
Marketing 60
Interest 5
Machinery 96
Rent 30
-------------------------------------------------------------------
540 690 767 726
=======================================
7. Newdeal
Current Debtors €2,600,000
Revised
€16m. x 50% x 10/365 €219,178
€16m. x 50% x 59/365 €1,293,151
--------------
€1,512,329
Reduction in Debtors €1,087,671
========
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8. Devoy plc
Credit sales €5m. x 90% = €4.5m.
9. Silver
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3,000
-------- x €450 = €4,500
300
300 units
------------ x €30 = €4,500
2
10. Vero
(a) Planning
Identify surpluses/deficits
Take action in advance
(b)
January February March April
INFLOWS
Sales Revenue
Jan – 400 100 150 150
Feb – 480 120 180 180
Mar – 576 144 216
Apr – 691 173
Share Capital 300
---------------------------------------------------------------------
400 270 474 569
========================================
OUTFLOWS
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-------------------------------------------------------------------
120 300 515 423
=======================================
Cost of Factoring
Sales 13,200,000
Debtors reduced to 28 days:
€13,200,000 x 28/365 = 1,012,603
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Conclusion
It is financially viable for Flight plc to factor its debts as a saving of €14,168 will arise.
(b) Recourse Factoring – client bears the loss from any irrecoverable debt and must reimburse
the factor for any money it has already received for the debt.
Non-Recourse Factoring – factor provides protection for the client against irrecoverable
debts and thus, the client is guaranteed the money from the debt.
12. Tradeco
(i) Industry Average Tradeco
Current Ratio 1.7 13/11 1.18
Quick Ratio 1.2 9/11 0.82
Receivable Days 45 days 8/50 x 365 58 days
Payable Days 40 days 9/43 x 365 76 days
Inventory Days 35 days 4/43 x 365 34 days
(ii) Report
The working capital ratios need some attention. Both the Current Ratio and the Quick Ratio are
substantially below the industry average. While not disasterous they should be improved by better
management to nearer the industry levels.
The Receivables period at 58 days is reasonable but if brought down to the norm of 45 days this could
improve profitability.
The Payables period must be sorted out – the period of 76 days is extreme and is almost double the
industry average. This may be due to the lack of liquidity in the company and if this level continues
creditors may cut off the credit facilities.
The Inventory Days at 34 days is marginally below the industry average and show that Tradeco seems
to be managing its inventory levels very efficiently. This is not an area where savings could be made.
13. Frigid
(a) Jan Feb Mar
Cash inflows
Sales revenue: non-members 325 375 175
Sales revenue: members (5% discount) 309 356 166
–––– –––– ––––
Cash inflows 634 731 341
–––– –––– ––––
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Cash outflows
Purchases (40% x sales + 2 months) 38 180 260
Staff costs (+ 1 month) 45 60 70
Packaging costs (+ 1 month) 7 10 12
Distribution costs 50 58 28
Other costs (excl. deprec +rent) 33 43 13
Rent (3 x €30k ) 90
–––– –––– ––––
Cash outflows 173 351 473
–––– –––– ––––
(b)
(i) Level of expertise/commitment of Frigid’s management
(ii) Level of expertise in the area of service
(iii) The nature of Frigid’s product
(iv) The market and competition
(v) Future prospects
(vi) Exit routes
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Study Unit 5
A. Introduction
B. Share Capital
C. Loan Capital
E. Bank Lending
F. Case Studies
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A. INTRODUCTION
Organisations use many different types of finance to fund their operations. Much will depend on the
size and complexity of the company and whether it is a quoted or unquoted company.
Example:
€’000 AVERAGE POOR EXCELLENT
Profits 100 20 300
(i) Interest (200 x 10%) 20 20 20
----- ----- -----
80 0 280
Corporation Tax (20%) 16 0 56
----- ----- -----
Profits After Tax 64 0 224
(ii) Preference Dividend 10 0 10
----- ----- -----
(iii) Available for Equity 54 0 214
=== === ===
Note: Comparing the Average with the Excellent performance it should be noted that while Profits
increase by 200%, the amount Available [at number (iii)] to Equity increases by almost
300%.
No matter what the level of performance, a fixed amount is paid to the Lenders and the
Preference Shareholders.
The Ordinary Shareholders (equity) are entitled to the “residue” after all others have been
rewarded.
B. SHARE CAPITAL
ORDINARY SHARES
The main features are:
• Issued to the owners of the company (equity).
• Nominal or “face” value (e.g. 50c.).
• Market value moves with market’s view of the company’s performance/prospects.
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• Shareholders are not liable for the company’s debts on a winding-up (limited liability).
• Carry voting rights
• Ordinary shareholders are entitled to the residue after other parties are rewarded. This applies
to both annual profits and return of capital on a winding-up of the company.
• Shareholders may be rewarded by dividends (income), or retained profits (capital gain).
PREFERENCE SHARES
The main features are:
• Holders are entitled to a fixed maximum dividend.
• Dividends are only paid if sufficient profits are available.
• Rank prior to ordinary shares (both dividends and capital on a winding-up).
• If Cumulative Preference Shares the right to any arrears of dividend is carried forward and
must be paid before any dividend is paid to the ordinary shareholders. Preference Shares are
cumulative, unless expressly stated to be non-cumulative.
• Restricted voting rights - usually only available in a situation where the rights attaching to the
shares are being amended or if dividends are in arrears.
• Some companies have different classes of preference shares. For example,
Convertible Preference Shares - right to convert to ordinary shares as the terms of the issue.
C. LOAN CAPITAL
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• Convertibles are often not secured and have less restrictive covenants than straight
debentures.
DEBT EQUITY
Cheaper than equity More expensive than debt
Interest allowable – tax relief Dividends not allowable – tax relief
No control issues May impact on control
Increases gearing Reduces gearing
Commitment to pay interest No obligation to pay dividends
Capital repaid on maturity Capital not repaid
Security may be required No security required
Lower issue costs Higher issue costs
Restrictive covenants No restrictive covenants
Ranks before equity Ranks after debt
Quicker to raise funds Longer time to raise funds
Generally reduces Interest Cover Generally raises Interest Cover
Fixed v Floating rate of interest ?
Possibly, convertible debt ?
Choose term to suit requirements
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PLACING
Shares "Placed" with Target Audience – generally institutions
RIGHTS ISSUE
Shares Issued to Existing Shareholders
Pro-rata to Existing Shareholding (e.g. One for Five Issue)
Company Shareholder
10 m. shares 1 m. shares (10% holding)
2 m. new shares 0.2m. new shares
------- -------
12 m. 1.2m. (10% holding)
==== ====
Possible Choices:
Subscribe for new shares (exercise rights)
Sell "rights" to new shares
Exercise rights (part) & sell rights (part)
Do nothing
E. BANK LENDING
The main considerations by the bank before advancing a loan can be summarized by the mnemonic
PARTS.
P URPOSE
A MOUNT
R EPAYMENT
T ERM
S ECURITY
F. CASE STUDIES
1. Bord Gais Raises €500m. In Bond Sale
State-owned energy group Bord Gais will use the €500m. it raised through yesterday’s bond issue to
refinance part of its existing debt. The company yesterday borrowed €500m. from more than 400
European financial institutions through a bond sale.
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The company will pay a rate of 3.625% on the bonds, which will be repaid in five years. The rate is
far below the 5.75% at which its last bond sale in 2009 was priced. The company raised €550m. at
that point.
Bord Gais received €6.5 billion worth of orders within an hour of beginning the bond sale yesterday
morning. The offer was thirteen times oversubscribed, which is unusual – normally its four or five
times. The positive response, coming quickly after similar moves by the National Treasury
Management Agency, ESB and Bank of Ireland demonstrated that international markets were
regaining confidence in Irish companies and the Republic.
The money will be used to repay the 2009 issue, which is due to mature in 2014. The board had
calculated that the exercise would reduce its interest burden by one to two basis points. The groups
total debt is €2.2 billion.
Irish Times
The US-based Export-Import Bank (Ex-Im) has long offered to guarantee bank loans to finance
overseas buyers' purchases of American-made products and services ranging from bulldozers to
engineering work to jetliners. After credit markets froze, the Washington agency agreed to back
bonds issued by airlines to refinance loans. In May, Ex-Im eased rules so airlines could raise the
money for planes directly from the bond market with debt guaranteed by the bank. The notes are
called "pre-funded," because airlines can now sell them before taking delivery of their aircraft.
Ryanair has issued $597m of the debt. On September 5, the carrier sold $194.3m of 1.741pc notes due
in October 2024. The carrier is due to receive delivery early next year of the final stage of what was a
record aircraft order it made with Boeing a number of years ago. Ryanair currently has no other
aircraft on order.
Interest rates at record lows and the relaxation of Ex-Im Bank rules are making it easier for non-US
airlines to access capital markets even as private-sector lending becomes more expensive and difficult
to obtain.
Boeing, the biggest US exporter has a jet order book backlog valued at $302bn. "We're using a
fraction of the market's capacity for this type of product," said Kostya Zolotusky, managing director
of leasing and capital markets for Boeing Capital, the Chicago-based planemaker's finance arm.
Selling the bonds now lets airlines beat a change in international trade rules taking effect in 2013 that
will make it costlier to tap financing such as the bonds and loans backed by the Ex-Im Bank, Mr
Zolotusky said.
Fixed-income investors are snapping up the bonds because they yield more than treasuries while still
carrying US government backing, Mr Zolotusky added. "When you're buying a long-lived asset like
aircraft and you have the opportunity to lock in a coupon like the last couple of deals at less than 2pc,
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you'd sleep a lot better knowing you'd locked that in," said Robert Morin, vice president of Ex-Im
Bank's transportation division.
Independent.ie 12th September 2012
Borrowings
The Group’s sources of borrowing for funding and liquidity purposes come from a range of
committed bank facilities and through short-term and long-term issuances in the capital markets. Our
key borrowings at 31st March 2013 consist of bond and commercial paper issues and bank loans.
We manage the basis on which we incur interest on debt between fixed interest rates and floating
interest rates, depending on market conditions using interest rate derivatives. Hedges are designed for
some of the Group’s bonds where interest rate swaps have been entered to convert the basis of future
cash flows to floating interest rates. The Group enters into foreign exchange contracts to mitigate the
impact of exchange rate movements on certain monetary items.
Borrowings – Carrying
Value
Short-term (£m.) Long-term (£m.) Total (£m.)
Bank Loans 2,929 4,281 7,210
Bank Overdrafts 25 ---- 25
Redeemable Preference ---- 1,355 1,355
Shares
Commercial Paper 4,054 ---- 4,054
Bonds 2,133 15,698 17,831
Other Liabilities 3,148 753 3,901
Bonds in Hedge ---- 7,021 7,021
Relationships
Total 12,289 29,108 41,397
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Total 12,289
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Commentary
You will note from the above that Vodafone Group plc uses a variety of short and long term
borrowings to fund its operations. These consist mainly of Bank Loans and Overdrafts, Redeemable
Preference Shares, Commercial Paper and Bonds.
Borrowings are arranged in different currencies (Euro, Sterling, US$, Japanese Yen, Czech Koruna)
to reflect the international nature of the company’s operations.
While mostly fixed-rate (ranging from 0.90% - 8.125%), there are a number of Floating Rate Notes
outstanding.
The maturity profile indicates debt maturing from as early as June 2013 to as late as February 2043
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1. Bestsource plc is planning to build production facilities to introduce a major new product
at a cost of €12m. The board has approved the project on the basis that it will yield a positive
NPV, when discounted over a ten-year period at the company’s cost of capital. The
investment is expected to increase profit before interest and tax by approximately 25%.
No internally generated funds are available and the finance director has suggested:
1. A five year €12m. floating rate term loan from a bank, at an initial interest rate of
10%.
2. A share issue at a discount of 10% on the current market price.
The company’s share price is €1.70. The current summarised financial statements are shown
below:
Balance Sheet
€’000
Fixed Assets 57,194
Current Assets 18,286
Current Liabilities (16,914)
Net Current Assets 1,372
---------
58,566
=====
Financed by:
Ordinary Shares (25c. each) 7,200
Reserves 38,200
11% Loan Stock 13,166
---------
58,566
=====
Required:
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2. Shortfall plc is considering investing in a new project which is expected to last for ten years. The
capital cost of the project is €20m. It is considering two methods of raising the funds:
(i) an issue of 7% Loan Stock which is redeemable in ten years
(ii) an issue of Ordinary Shares at a price of €8 each
Shortfall’s recent Profit Before Tax was €10m. and this is expected to increase by 25% next year
as a result of the new project. Shortfall pays Corporation Tax at the rate of 20%.
Required
(i) Calculate the current Earnings Per Share and Gearing (Debt/Equity) of Shortfall plc
(8 marks)
(ii) Calculate the expected Earnings Per Share and Gearing of Shortfall plc for next year as a
result of undertaking the new project and financing it by means of
(a) the issue of 7% Loan Stock
(b) the issue of Ordinary Shares. (12 marks)
(iii) Briefly, comment on the results of your calculations at (i) and (ii) above.
(5 marks)
Total 25 marks
3. Laker needs to raise €5 million to finance new projects. The proposed investment of the
€5 million is expected to yield pre-tax profits of €2 million per annum. Earnings on existing
investments are expected to remain at their current level. Data is supplied below:
€ 000
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The 50c ordinary shares are currently quoted at €2.25 per share. The company’s tax rate is
33%. The average gearing percentage for the industry in which the company operates is 35%
(computed as debt as a percentage of debt plus equity, based on book values, and excluding
bank overdrafts).
Required
(i) Calculate and comment briefly on the company’s current capital gearing.
(ii) Discuss briefly the effect on gearing and EPS at the end of the first full year following
the new investment if the €5 million new finance is raised in each of the following
ways:
(a) By issuing ordinary shares at €2 each.
(b) By issuing 5% convertible loan stock, convertible in 20X4. The conversion
ratio is 40 shares per €100 of loan stock.
(c) By issuing 7.5% undated debentures.
4. Your firm has several different issues of long-term debt as well as a portfolio of short and
medium term loans at a variety of interest rates, including some variable rates.
Required:
Briefly discuss the main advantages and disadvantages of including fixed interest debt
finance
in the firm’s financial structure.
5. The Nevel Co. Ltd which is still effectively controlled by the Nevel family although they
now own only a minority of shares, is to undertake a substantial new project which requires
external finance of about €4 million, a 40% increase in gross assets. The project is to develop
and market a new product and is fairly risky. About 70% of the funds required will be spent
on land and buildings. The resale value of the land and buildings is expected to remain
about, or above, the initial purchase price. Expenditure during the development period of 4 –
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7 years will be financed from Nevel’s other revenues with a consequent strain on the firm’s
overall liquidity.
If, after the development stage, the project proves unsuccessful then the project will be
terminated and its assets sold. If, as is likely, the development is successful the project’s
assets will be utilised in production and Nevel’s profits will rise considerably. However, if
the project proves to be extremely successful then additional finance may be required to
further expand production facilities.
The Financial Manager is uncertain whether he should seek funds from a financial institution
in the form of an equity interest, a loan (long or short term) or convertible debentures.
Clearly state and justify the type of finance recommended for Nevel.
6. Newfunds is reviewing the acquisition of a smaller competitor company in its industry. The
board estimates that the cost of the acquisition will be €30m and it is examining a number of methods
of raising the funds. You have been asked to evaluate the impact on the borrowing capacity of
Newfunds of each of the following:
(i) an issue of 6% Loan Stock
(ii) an issue of Ordinary Shares at a price of €5 each
Newfunds’ recent Profit Before Interest and Tax was €12m. and this is expected to increase by 20%
next year as a result of the new acquisition. Newfunds pays Corporation Tax at the rate of 20% and
has a policy of paying all earnings as dividends to shareholders.
Required
(a) Calculate the current Interest Cover and Gearing (Debt/Equity) of Newfunds
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(b) Calculate the expected Interest Cover and Gearing of Newfunds for next year as a result of the
proposed acquisition and financing it by means of
(i) the issue of 6% Loan Stock
(ii) the issue of Ordinary Shares.
(c) Briefly, comment on the results of your calculations at (i) and (ii) above.
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Debt = 13,166
--------- = 29%
Equity (7,200 + 38,200) = 45,400
New EPS:
PBIT (+ 25%) 9,680
Debenture Interest (+ 1.2m.) 2,648
-------
Profit Before Tax 7,032
Taxation (50%) 3,516
-------
Available to Ordinary Shareholders 3,516
====
Share Issue
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The current share price is €1.70. As the new issue could be made at a 10% discount
€12m.would require the issue of 7.85m. (€12m./€1.53 ) new shares.
Gearing will be reduced, although with the existing gearing at only 29% a reduction may be
unnecessary. The revised Gearing will be:
Debt = 13,166
--------- = 23%
Equity (45,400 + 12,000) = 57,400
This is only a 2.7% increase over the current EPS and may not prove satisfactory to
shareholders.
All of this information has ignored issue costs which may be significant and is based upon
only an estimate of profit for the next year. Forecasts for further years are desirable for
decision making purposes.
Perhaps consideration should be given to using a mixture of new debt and equity finance.
2. Shortfall plc
€’000
(i) Profit Before Tax 10,000
Corporation Tax - 20% (2,000)
---------
Available to Equity 8,000
=====
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Commentry
Current EPS is 80c. and current Gearing is 40%.
If the project is financed by Loan Stock EPS is expected to increase to 88.8c. but Gearing will
increase to 80%, indicating a substantial increase in financial risk for shareholders, which may not be
acceptable. This increase in risk may not be compensated by the uplift in EPS.
If the project is financed by a share issue the Gearing is reduced to 29% but there is no uplift in EPS
which remains at 80c.
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Much will depend on the shareholders’ attitude to risk but the substantial increase in Gearing from the
Loan Stock issue may not be acceptable.
€2,000
€8,500 = 23.53%
The current gearing position is on the low side, particularly when compared with the industry
average of 35%. This provides an indication that the company still has the scope and
capacity to attract more debt.
There is however, a large secured overdraft, and it is more likely that quite a high proportion
of it represents hard-core debt. It is also most unlikely that the bankers would call in such a
large overdraft at short notice. If the overdraft were included in the gearing calculation, and
treated as debt the gearing ratio of 38.1% is a little above the industry average.
€3,000
EPS 5,000 = 60c. per share
€5,000,000
Number of new shares = €2 = 2,500,000 shares
Earnings € 000
Current net profit after interest and tax 3,000
€ 000
Additional earnings 2,000
Less tax at 33% 660 1,340
Available to Equity 4,340
€4,340
EPS 7,500 = 58c per share
€2,000
Gearing €13,500 = 14.81%
More equity would reduce the gearing further. The gearing in the future would also tend to
fall due to increases in reserves via retained earnings.
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The scheme would reduce the EPS by 2c. per share when compared with current earnings.
Other considerations which should be looked at are:
the control factor i.e. those shareholders who currently control the company could lose
control unless they buy some of the shares being offered.
€4,172
Undiluted EPS 5,000 = 83c per share
The gearing at the time of issuing the convertible loan stock would be:
This figure would be expected to decrease in future years as a result of ‘ploughing back’
profits by way of retained earnings - i.e. increasing the equity. On conversion the gearing
percentage should fall quite significantly. This would be affected by the retained earnings,
new loans taken out and old loans paid off.
If conversion occurs:
Earnings €4,340 as per scheme (i)
€4,340 .
EPS 7,000 shares = 62c per share
For the period in which the holders cannot or do not convert the undiluted EPS, (provided
earnings remain at this level and tax rates do not change), is much greater, at 83p per share as
indicated above.
If and when the holders convert a dilution of earnings will take place and the control of the
company may be affected. If the interest rate is fixed, the company would appear to have
locked in to quite a low rate compared with the 7½ % Debentures i.e. the convertibles have a
low service cost. The gearing would be well above the current industry average, but on
conversion would fall well below it.
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(iv) 7½ % Debentures
Earnings € 000 € 000
Current (as above) 3,000
Add Additional 2,000
Less Interest at 7½% 375
1,625
Less Tax at 33% 536 1,089
Available to Equity €4,089
€4,089
EPS 5,000 = 82c per share
The EPS again illustrates that using more debt i.e. becoming more highly geared, can
increase the earnings of the Ordinary Shareholders i.e. EPS 82c per share compared with
current earnings of 60c per share. However, the increase in gearing which would be higher
than the industry average does place the increased risk of insolvency on the company. If
trading conditions are bad, the company still has to pay interest on the debentures.
Disadvantages include:
(i) The interest charge and agreed principal repayments are obligations which must be
met irrespective of the firm’s level of success thereby increasing the firm’s insolvency
risk.
(ii) From (i), the need to service the debt may make the financial management of the firm
more difficult.
(iii) Makes the return to equity more risky and will cause greater fall in share price in
times of poor performance than would be the case if the firm had less gearing.
(iv) The restrictive covenants often imposed may reduce the firm’s flexibility of
operations.
(v) Can be an expensive source of finance if the firm does not have sufficient taxable
profits to obtain tax relief on interest payments.
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(iii) Convertible Debentures – Provide the security of a loan with the possibility of
favourable (but not unfavourable) equity participation. However, in order to obtain
this protected position the interest received is usually lower than a normal loan and
the conversion terms result in fewer shares than would be obtained by an initial
investment in equity.
In the circumstances of Nevel the use of Convertible Debentures is recommended as they will
utilise debt capacity and provide medium term or long term finance as required by the
outcome of the project. The Debentures should be convertible into equity from about year 4
onwards at the holder’s option unless previously repaid by Nevel. Nevel should arrange a
repayment option during the period of about 4 – 7 years. The Debenture could be secured on
the land and buildings to be purchased.
6. Newfunds
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---------
Available to Equity 9,920
=====
(c ) Commentry
Current Interest Cover is 6 times and current Gearing is 30.8%.
If the project is financed by Loan Stock, interest Cover is expected to fall to 3.8 times and Gearing
will increase to 76.9%, indicating a substantial increase in financial risk, which may not be
acceptable to lenders and shareholders. This increase in risk may not be compensated by an uplift in
EPS.
If the project is financed by a share issue the Interest Cover is increased to 7.2 times and Gearing is
reduced to 21%.
Much will depend on the shareholders’ and lenders’ attitude to risk and the impact on EPS but the
substantial deterioration in both Interest Cover and Gearing from the Loan Stock issue may not be
acceptable. It would also be important to check Newfunds’ ratios against the industry averages.
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Study Unit 6
Venture Capital
A. Introduction
B. Stages of Investment
C. Specialist Areas
D. Business Plan
G. Case Study
H. Business Angels
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A. INTRODUCTION
Many new business ventures are considered too risky for traditional bank lending (term loans,
overdrafts etc.) and it is this gap that Venture Capital usually fills.
Venture Capital could be described as a means of financing the start-up, expansion or purchase of a
company, whereby the venture capitalist acquires an agreed proportion of the share capital (equity) of
the company in return for providing the requisite funding. To look after its interests the venture
capitalist will usually want to have a representative appointed to the board of the company.
The venture capitalist’s financing is not secured – he takes the risk of failure just like other
shareholders. Thus, there is a high risk in providing capital in these circumstances and the possibility
of losing the entire investment is much greater than with other forms of lending. The venture
capitalist also participates in the success of the company by selling his investment and realising a
capital gain, or by the company achieving a flotation on the Stock Market in usually five to seven
years from making his investment. As a result, it will generally take a long time before a return is
received from the investment but to compensate there is the prospect of a substantial return.
B. STAGES OF INVESTMENT
• Start-Up – finance for product development and initial marketing. Companies may be in the
process of being set up or may have been in business for a short time but have not sold their
product commercially.
• Expansion – capital provided for the growth of a company which is breaking even or
possibly, trading profitably. Funds may be used to finance increased production capacity,
market or product development and/or provide additional working capital. Capital for
“turnaround” situations is also included in this category.
• Management Buy Out (MBO) – funds provided to enable current operating management
and investors to acquire an existing business.
C. SPECIALIST AREAS
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Venture Capitalists may specialise in areas in which they will invest. These may relate to:
• Preferred Business Sectors – e.g. consumer services, Information Technology, property etc.
• Stage of Investment – many venture capitalists will finance expansions, MBO’s and MBI’s
but far fewer are interested in financing “Seed Capital,” start-ups and other early stage
companies, due to the additional risks and time/costs involved in refinancing smaller deals as
compared with the benefits.
• Amount of Investment – varies with the stage of the investment. Start-up and other early
stage investments are usually lesser in amount than expansion and MBO/MBI investments.
Few investments of less than €250,000 are made unless there is a good opportunity for a
second round of financing.
D. BUSINESS PLAN
Before deciding whether an investment is worth backing the venture capitalist will expect to see a
Business Plan. This should cover the following:
• Product/Service – what is unique about the business idea? What are the strengths compared
to the competitors?
• Management Team – can the team run and grow a business successfully? What are their
ages, relevant experience, qualifications, track record and motivation? How much is invested
in the company by the management team? Are there any non-executive directors? Details of
other key employees.
• Industry – what are the issues, concerns and risks affecting the business area?
• Financial Projections – are the assumptions realistic (sales, costs, cash flow etc.)?
Generally, a three year period should be covered. Alternative scenarios, using different
economic assumptions. Also state how much finance is required, what it will be used for and
how and when the venture capitalist can expect to recover his investment?
• Executive Summary – should be included at the beginning of the Business Plan. This is
most important as it may well determine the amount of consideration the proposal will
receive.
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The various means by which an investment may be withdrawn after a number of years include:
G. CASE STUDY
Balderton Capital Management, with $19bn. in assets under management is one of Europe’s largest.
In March 2008 it made more than nine times its initial investment when it sold a 15.7% stake in Bebo
to Time Warner for $140m. It had made the investment less than two years earlier.
Balderton sold a stake in MySQL, a software company, to Sun Microsystems for a hefty multiple and
last month made ten times its original stake when Cisco Systems bought Scansafe, an online security
business. Yoox, an online fashion retailer and another Balderton investment, will be the first IPO on
the Milan bourse for 18 months. Next year Balderton could yield one of its biggest ever paydays
when the online betting exchange Betfair debuts on London’s Stock Market.
Balderton’s model is “labour intensive” investing in early-stage companies with a view to big returns.
The goal for every investment is nine or ten times return. Of ten investments we would expect three
or four to lose money and three or four to return twice or three times our money. Then we would
expect two of the ten to make a return of eight, nine or ten times. Its not a fool-proof formula,
however. In the past two years Balderton had two spectacular blowouts Payzone and Setanta Sports.
Payzone is still a live investment but the company is so burdened with debt that equity holders are
likely to be wiped out in an upcoming restructuring. A $75m - $80m. loss at Setanta Sports is
balanced by an earlier $50m. gain that Balderton made from NASN, the sports network that Setanta
sold to ESPN. The risk did not pay off but that’s par for the Venture Capital course – if you are not
prepared to take risk, you shouldn’t be in the game.
Balderton has 67 investments, many of them in the “new economy” – wonga.com, a loans company;
Bling Nation, a mobile payments company; figleaves.com, which sells lingerie and LoveFilm, a
movie rentals business. It has backed a disproportionately high number of Irish companies, with
almost a quarter of its total funds ($450m) invested in them.
H. BUSINESS ANGELS
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The greatest source of seed and start-up capital comes from successful entrepreneurs who have
achieved wealth from their gains in previous investments. These are known as Business Angels.
Business Angel usually refers to a wealthy individual, or group of individuals, who are willing to
invest in smaller businesses. Like venture capital organisations they would normally take a
significant equity stake. Business Angels, however, tend to be prepared to invest at an earlier stage
than venture capital organisations and are often prepared to invest for a longer period of time. In
addition, they can offer valuable expertise and guidance as they tend to invest in areas in which they
have expertise. Angels usually seek active participation in the company in which they invest.
The average initial investment by Business Angels ranges between €50,000 and €250,000individually
or through partnerships with other Business Angels up to €500,000 and beyond.
The lending of money to individuals or businesses through online services (intermediaries) that match
lenders with borrowers.
Companies operating the services operate online with less costs than traditional financial institutions
and therefore, lenders can earn higher returns compared to savings and investment products offered by
banks. Likewise borrowers can borrow at lower interest rates.
Most loans are unsecured and are not protected by government guarantee schemes, as with traditional
bank products. Thus, there are additional risks of default for lenders.
Interest rates can be set by lenders/borrowers competing for the funds or fixed by the intermediary
company, following a credit assessment of the borrower.
The intermediary company will generally charge the borrower a fee for the credit assessment and the
lender an ongoing account administration fee.
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Study Unit 7
Leasing
A. Introduction
C. Advantages of Leasing
E. Hire Purchase
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A. INTRODUCTION
A lease is a contract between a lessor (bank/finance house) and a lessee (person/company to whom
the asset is leased) for the hire of a specific asset. The lessor retains ownership but gives the lessee
the right to use the asset for an agreed period in return for the payment of specified rentals.
OPERATING LEASE
The lessee hires the asset for a period which is normally substantially less than its useful economic
life. The lessor retains most of the risks and rewards of ownership. Generally, there will be more than
one lessee over the life of the asset. An operating lease is “Off Balance Sheet” finance.
FINANCE LEASE
This transfers substantially all the risks and rewards of ownership, other than legal title, to the lessee.
It usually involves payment to the lessor over the lease term of the full cost of the asset plus a
commercial return on the finance provided by the lessor.
Both the leased asset and the corresponding stream of rental liabilities must be shown on the lessee’s
Balance Sheet. Other features include:
• The lessee is responsible for the upkeep, maintenance etc. of the asset.
• The lease has a primary period, covering the whole or most of the economic life of the asset.
The asset will be almost worn out at the end of the primary period, so the lessor will ensure
that the cost of the asset and a commercial return on the investment will be recouped within
the primary period.
• At the end of the primary period the lessee has the option to continue to lease at a very small
rent (“peppercorn rent”). Alternatively, he can sell the asset and retain about 95% of the
proceeds.
C. ADVANTAGES OF LEASING
1. The lessee’s capital is not tied up in fixed assets, so a cash flow advantage accrues.
2. Liquidity is improved as no down-payment is required.
3. The lessor can obtain capital allowances and pass the benefit to the lessee in the form of
lower lease rentals. This is especially important for a company with insufficient taxable
profits.
4. The whole of the rental payment is tax deductible.
5. Security is usually the asset concerned. Other assets are free for other forms of borrowing.
6. Traditional forms of borrowing often impose restrictive covenants.
7. The cost of other forms of borrowing may exceed the cost of leasing.
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This is an arrangement whereby a firm sells an asset, usually land or a building, to a financial
institution and simultaneously enters an agreement to lease the property back from the purchaser. The
seller receives funds immediately and retains use of the asset but is committed to a series of rental
payments over an agreed period. This arrangement is useful when a company needs to unlock the
cash invested in an asset for other investments, but the asset is still needed in order to operate. Thus,
it is suited to capital-rationed companies who are eager to finance expansion programmes before the
opportunity is lost.
The lessor benefits as they will receive stable rental payments for a specified period of time.
The main disadvantages are the loss of participation in any capital appreciation, the loss of a valuable
asset which could have been used as security for future borrowing (thereby reducing the future
borrowing capacity of the company ) and commitment to future rental payments.
The user pays a periodic hire charge to a finance house which purchases the asset. The charge
includes both interest and capital. Generally, the hirer must pay a deposit up-front. Ownership of the
asset passes to the user at the end of the contract period, unless he defaults on repayments when the
finance house will repossess the asset. The user can claim capital allowances on the cost of the asset
and the interest element of the periodic charge is tax deductible.
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Study Unit 8
Performance Appraisal
A. Introduction
B. Categories of Ratios
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A. INTRODUCTION
To judge the performance of a company or group of companies the analysis of financial statements is
normally based largely on ratio analysis.
You may be expected to carry out a performance analysis on a set of company accounts. Generally,
this will require you to extract the relevant figures from financial statements and notes to the
statements. Having done this you must then calculate suitable trends and ratios. Finally, and most
importantly, you must be able to analyse and interprete the figures, trends and ratios. This may
require you to draft a report with supporting appendices.
You should be familiar with many of the important ratios from your other studies. This note is
intended to pull all the ratios together and to comment on their usefulness.
A ratio expresses the relationship of one figure to another. A change in the ratio represents a change
in the relationship. Ratios once computed should then be subjected to comparison. The two broad
areas of comparison are:
• Internal - present performance is compared with past performance and with budgets.
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• External - present performance is compared with similar firms in the same industry or with
industry averages.
Ratio analysis has many limitations and care must be exercised in their use. Among the limitations
are:
1. Ratios are only a guide, they cannot be used to make absolute statements. For example, if the
Debtors Collection Period is lengthening it might be concluded that there is poor credit
control with additional costs incurred by the company. However, if other aspects of
performance are checked it may become apparent that longer credit has been used as a
marketing tool, which in turn has led to increased sales and profitability. Thus, ratios should
be used to provide support for other information.
2. A ratio represents the relationship between figures. Thus, both figures can alter the ratio and
this should be taken into account when indicating the reason for change. Also, note that
proportionate changes in both figures will leave the ratio unaltered. For example:
10 100
----- = 10% as is ------- = 10%
100 1,000
3. For ratios to be fully comparable the figures used must be computed in like manner from year
to year or from firm to firm. Changes in accounting policies or firms adopting different
accounting policies will render the ratios uncomparable.
4. A Balance Sheet represents a company’s financial position at one particular point in time. A
Balance Sheet drawn up one month earlier or later might reveal a sharply contrasting
situation, particularly for current assets and liabilities.
B. CATEGORIES OF RATIOS
1. Profitability
3. Liquidity
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1. Profitability
To properly assess a company’s profits or profit growth it is necessary to relate them to the capital
employed in producing them. The most important profitability ratio is, therefore, the Return on
Capital Employed (ROCE), which shows the profit as a percentage of the amount of capital
employed.
PBIT
ROCE = ---------------------- x 100%
Capital Employed
Capital Employed = Total Assets - Current Liabilities (Looking at the Liability side of the
Balance Sheet this is the same as Shareholders Funds + Long Term Debt).
ROCE is a measure of the efficiency with which the company is using its funds.
To look more deeply into the ROCE it can be divided into two secondary ratios:
PBIT
(1) Profit Margin = -------------- x 100%
Sales
Sales
(2) Asset Turnover = ------------------------- = x times
Capital Employed
Example
A company with net assets of €10m. earns profits before interest and tax of €2.5m. on a turnover of
€40m.
2.5m.
ROCE = ---------- = 25%
10m.
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2.5m.
Profit Margin = ---------- = 6.25%
40m.
40m
Asset Turnover = ----------- = 4 times
10m.
A low profit margin can be caused by relatively low selling prices, high costs or both. Asset Turnover
indicates the efficiency with which the business is using its assets. A low turnover shows that the
volume of business is too low relative to the value of the assets used.
Gross Profit
(1) Gross Profit Margin = ----------------- x 100%
Sales
Gives an indication of the total margin available to cover operating expenses and yield a
profit.
Net Profit
(2) Net Profit Margin = --------------- x 100%
Sales
This shows the after-tax profits per € of sales. Low profit margins indicate that the sales
prices are relatively low or that costs are relatively high or both.
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Gearing Ratio
This is concerned with a company’s long-term capital structure. There is no absolute limit to what the
gearing ratio ought to be. Many companies are highly geared but if such companies wish to borrow
further they may have difficulties unless they can also boost shareholders’ capital, either with retained
profits or a new share issue.
or
* Prior Charge Capital refers to long-term debt and includes Preference Shares but does not normally
include Bank Overdraft.
Interest Cover
This shows the financial risk in terms of profit rather than capital values. It demonstrates whether a
company is earning enough profits before interest and tax to pay its interest costs comfortably.
PBIT
Interest Cover = --------------------
Interest Charges
As a general guide, an interest cover of less than 3 times is considered low, indicating that profitability
is too low given the gearing of the company.
3. Liquidity
A company requires liquid assets in order to meet its debts as they fall due. Liquidity is the amount of
cash a company can put its hands on quickly to settle its debts and possibly meet other unforeseen
demands.
Current Ratio
Indicates the extent to which the claims of short-term creditors are covered by assets that are expected
to be converted to cash in a period which corresponds roughly to the maturity of the liabilities.
Current Assets
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A benchmark of 2 : 1 is often quoted but this should not be adopted rigidly as organisations
have vastly different circumstances (e.g. operating in different industries, seasonal trade etc.).
A benchmark of 1 : 1 is often quoted but, again, this should not be adopted rigidly.
Receivables Period
This is a measure of the average length of time it takes for a company’s receivables to pay what they
owe. The credit period allowed may depend on the industry in which the company operates.
Receivables
Receivables Period = ---------------- x 365 days
Sales
Payables Period
This is a measure of the average credit period that a company takes before paying its suppliers.
Payables
Payables Period = ------------- x 365 days
Purchases
Inventory Period
This shows the number of times the stock is turned over during the year and indicates how vigorously
a business is trading.
Cost of Sales
Inventory Turnover Period = ------------------ = x times
Stock
Alternatively:
Inventory
Inventory Period = ------------------- x 365 days
Cost of Sales
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These ratios help equity shareholders and other investors to assess the value and quality of an
investment in the ordinary shares of the company.
EPS on its own does not tell us too much but it is widely used to measure a company’s performance
and to compare the results over a number of years.
All quoted companies have a P/E Ratio. It is equal to the number of years earnings needed to cover
the current market price. The value of the P/E Ratio reflects the market’s appraisal of the share’s
future prospects. A high P/E Ratio indicates strong shareholder confidence in the company and its
future (e.g. profit growth etc.), and a lower P/E Ratio indicates lower confidence.
The P/E Ratio of one company can be compared with the P/E Ratio of other companies in the same
business sector or other companies generally.
Dividend Cover
This is the number of times the actual dividend could be paid out of current earnings. A high rate of
dividend cover means that a high proportion of earnings are being retained.
Dividend Yield
The Dividend Yield is used so that investors can make a direct comparison with interest yields from
loan stock and Government Stocks (gilts).
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Current Liabilities:
Payables 15.00
Bank Overdraft 5.00
--------
(20.00)
----------
Net Current Assets 3.00
--------
Total Assets less Current Liabilities 33.00
14% Debentures (5.00)
--------
Net Assets 28.00
=====
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Financed by:
Issued Share Capital
Ordinary Shares (50c. par value) 4.00
Revenue Reserves 24.00
--------
Shareholders’ Funds 28.00
=====
Profit & Loss Account for Year Ended 31st December 20X6 (€m)
Turnover 80.00
Cost of Sales (70.00)
----------
Operating Profit 10.00
Interest Charges (3.00)
-----------
Pre-Tax Profit 7.00
Corporation Tax (1.00)
----------
Profits attributable to Ordinary Shareholders 6.00
Dividends (0.50)
----------
Retained Earnings 5.50
=====
The following are key financial indicators from Collie’s industry:
Return on Capital Employed 22%
Return on Equity 14%
Operating Profit Margin 10%
Current Ratio 1.8
Acid Test 1.1
Gearing (Total Debt/Equity) 18%
Interest Cover 5.2
Dividend Cover 2.6
Required:
Discuss the performance and financial health of Collie plc in relation to that of the industry.
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2. The following information has been extracted from the accounts of Hopeless Ltd:
20X5 20X6
€’000 €’000
Turnover (all credit sales) 7,650 15,500
Less: Cost of sales (5,800) (9,430)
Gross profit 1,850 6,070
Other expenses (150) (170)
Loan interest (50) (350)
10,900 15,600
Capital and reserves
Share Capital 5,900 5,900
Reserves 5,000 9,700
10,900 15,600
Required:
(a) Calculate the following accounting ratios for each of the two years
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3. Cool plc has recorded strong growth over the past ten years. The accounting statements for the
last financial year are summarised below:
Profit & Loss Account for Year Ended 31st December 20X7 (€m)
Turnover 100.00
Cost of Sales (87.00)
----------
Operating Profit 13.00
Interest Charges (4.00)
-----------
Pre-Tax Profit 9.00
Corporation Tax (after Capital Allowances) (1.00)
----------
Profits attributable to Ordinary Shareholders 8.00
Dividends (1.00)
----------
Retained Earnings 7.00
=====
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Fixed Assets:
Land & Premises 15.00
Machinery 20.00
--------
35.00
Current Assets:
Inventory 8.00
Receivables 15.00
Cash 1.00
--------
24.00
Current Liabilities:
Payables 18.00
Bank Overdraft 2.00
--------
(20.00)
----------
Net Current Assets 4.00
--------
Total Assets less Current Liabilities 39.00
10% Loan Stock (8.00)
--------
Net Assets 31.00
=====
Financed by:
Issued Share Capital
Ordinary Shares (25c par value) 4.00
Reserves 27.00
--------
Shareholders’ Funds 31.00
=====
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Required
(iii)Calculate similar ratios for Cool plc to those identified for Cool plc’s industry.
(18 marks)
(iv) Using the ratios calculated at (i) above, write a report to management which discusses
the performance and financial health of Cool plc in relation to that of the industry
as a whole (7 marks)
Total 25 marks
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Collie’s profitability, expressed both in terms of Return On Capital Employed and Return on Equity,
compares favourably with the industry average and the company appears attractive to its peers. The
Net Profit Margin of 12.5% is above that of the overall industry, suggesting a cost advantage either in
production or in operating a flat administrative structure. Alternatively, it may operate in a market
niche where it is still exploiting first-comer advantages.
Set against the apparently strong profitability is the poor level of liquidity. Both the Current and Acid
Test ratios are well below the industry average and suggest that the company should be demonstrating
tighter working capital management. However, the inventory turnover of (10/70 x 365) = 52 days and
the receivables days of (10/80 x 365) = 46 days do not appear excessive, although industry averages
are not given. It is possible that Collie has recently been utilising liquid resources to finance fixed
investment or to repay past borrowings.
Present borrowings are split equally between short-term and long-term, although the level of gearing
is well above the market average. The Debenture is due for repayment shortly which will exert
further strains on liquidity, unless it can be refinanced. Should interest rates increase in the near
future Collie is exposed to the risk of having to lock-in higher rates on a subsequent long-term loan or
pay (perhaps temporarily) a higher interest rate on an overdraft. The high gearing is reflected also in
low interest cover, markedly below the industry average.
In view of the high gearing and poor liquidity it is not surprising that the payout ratio is below 10%
(0.5/6.0), although Collie’s managers would presumably prefer to link high retentions to the need to
finance ongoing investment and growth rather than to protect liquidity.
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2. Hopeless Ltd.
(a) Ratios 2005 2006
(b) Comments:
Rise in Profit
Dramatic Increase in Sales
Overtrading
Increase in Loans & Interest charges
Decrease in Cash
Receivables Days dramatic increase
Other points
3. Cool plc
INDUSTRY AVERAGE COOL PLC
(ii) Both ROCE and Operating Profit Margin are above the industry averages and are very
positive signs. The ROCE is substantially above the industry average and may be due to
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efficient operations and the above average margin. The Operating Profit Margin is 1% higher
than the industry and may be due to a cost advantage or the charging of premium prices.
The working capital ratios need some attention. Both the Current Ratio and the Quick Ratio
are below the industry average. While not disasterous they should be improved to nearer the
industry levels. The Receivables period at 55 days is reasonable but if brought down to the
norm of 50 days this could improve profitability. The Payables period must be sorted out –
the period of 76 days is extreme and is more than double the industry. This may be due to the
lack of liquidity in the company and if this level continues creditors may cut off the credit
facilities.
Both Gearing and Interest Cover are marginally worse than the industry and should be
improved. There is no major cause for concern but an injection of equity would improve the
position.
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