Advanced Financial Analysis BA (Hons) Business Accounting & Finance

Revision Session Year 4 Semester 1

Question 1:

ABC Construction Company Ltd plans to build 95 houses on a development site over the next four years.
The cost of the development site acquired for the construction of houses is $ 3,500,000, payable at the start
of the first year of construction. Annual sales of house expected to be as follows:

Year 1 2 3 4
Number of houses sold: 20 25 30 20

Houses are built in the year of sale. Financial information relating to each type of house is as follows:

$
Selling price: 210,000
Variable cost of construction: 90,000

Selling prices and variable cost of construction are in current price terms, before allowing for selling price
inflation of 3% per year and variable cost of construction inflation of 4·5% per year.

Fixed infrastructure costs of $1,200,000 per year in current price terms would be incurred. These would not
relate to any specific house, but would be for the provision of new roads, gardens and utilities. Infrastructure
cost inflation is expected to be 2% per year.

ABC Construction Company Ltd pays half-tax current year and half one year in arrears at an annual rate of
15%. The company can claim capital allowances of 25% on the purchase cost of the development site on a
straight-line basis.

ABC Construction Company Ltd has a real after-tax cost of capital of 7% per year and a nominal after-tax
cost of capital of 10% per year.

Required:
Calculate the net present value of the proposed investment and comment on its financial acceptability.

Answer:
Tax allowable
depreciation/capital
allowance

Year $'000
0
1 25% of cost 875
2 25% of cost 875
3 25% of cost 875
4 25% of cost 875
0 1 2 3 4 5
No of units 20 25 30 20
Inflated SP (Previous SP *1.03) 210 216 223 229 236
Inflated VC (Previous VC * 1.045) 90 94 98 103 107

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1

Year 0 1 2 3 4 5
$'000 $'000 $'000 $'000 $'000 $'000
Taxable items:
Revenue 4,326 5,570 6,884 4,727
Variable costs (1,881) (2,457) (3,081) (2,147)
Contribution 2,445 3,113 3,803 2,581
Fixed costs (Previous FC *1.02) (1,224) (1,248) (1,273) (1,299)
Before tax cash flow (A) 1,221 1,864 2,530 1,282
Tax allowable depreciation (875) (875) (875) (875)
Taxable profit - 346 989 1,655 407 -

Tax @ 15% - 52 148 248 61 -

Taxation (B) - 26 100 198 155 31

(1/2 (Current Year + Previous Year)
After tax cash flow (A-B) - 1,195 1,764 2,331 1,127 (31)

Non-taxable items
Cost (3,500)
Net cash flows (3,500) 1,195 1,764 2,331 1,127 (31)

Discount factor @ 10% 1 0.9091 0.8264 0.7513 0.6830 0.6209

Present values (3,500) 1,086 1,458 1,752 770 (19)

NPV 1,547

Since the proposed investment has a positive NPV, it is financially acceptable.

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
Question 2:
SL is considering whether to purchase a dredger for Rs 1,000,000 now. It will have a life of 5 years, after
which it will be sold Rs 100,000. The machine would create revenues of Rs 250,000 per annum. The machine
will attract tax-allowable depreciation of 20% which will start now and for the next 5 years. The tax rate is
15% and tax is half-payable in the current year and half one year in arrears. The after-tax cost of capital is
6%. Calculate the NPV.
Source: Lecture notes Unit 2 - Question 5
Reducing
Tax allowable balance/ Tax
depreciation/capital written down
allowance value
Year 1,000,000
0 20% of cost 200,000 800,000
1 20% of RB 160,000 640,000
2 20% of RB 128,000 512,000
3 20% of RB 102,400 409,600
4 20% of RB 81,920 327,680
5 20% of RB 65,536 262,144

Sale proceeds, end of fifth year 100,000

Less reducing balance, end of fifth year - 262,144
Balancing allowance - 162,144

Year 0 1 2 3 4 5 6
Taxable items:
Revenue 250,000 250,000 250,000 250,000 250,000
Tax allowable depreciation - 200,000 - 160,000 - 128,000 - 102,400 - 81,920 - 227,680
Taxable profit - 200,000 90,000 122,000 147,600 168,080 22,320

Tax @ 15% - 30,000 13,500 18,300 22,140 25,212 3,348

Taxation - 15,000 - 8,250 15,900 20,220 23,676 14,280 1,674

After tax cash flow 15,000 258,250 234,100 229,780 226,324 235,720 - 1,674

Non-taxable items
Cost - 1,000,000
Proceeds 100,000
Net cash flows - 985,000 258,250 234,100 229,780 226,324 335,720 - 1,674

Discount factor @ 6% 1 0.9434 0.8900 0.8396 0.7921 0.7473 0.7050

Present values - 985,000 243,632 208,348 192,928 179,270 250,870 - 1,180

NPV 88,867

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
Question 3
Suppose an investor is considering to buy share in CDE Ltd and ABC Ltd, which has a market price Rs 250
and Rs 300 today respectively.
CDE Ltd ABC Ltd
Economic Conditions Probability Share Price Dividend Share Price Dividend
% Rs Rs
Scenario 1 25 306 4 355 3
Scenario 2 75 287 5 345 2
The investor want to hold 60% of share in CDE Ltd and 40% in ABC Ltd’s shares for one year. Calculate
the following:
(i) Individual expected return for each company
(ii) Individual standard deviation for each company
(iii) Expected return of portfolio based on the choice of the investor
(iv) Standard deviation of portfolio based on the choice of the investor

A. Rate of return = Dividend yield + Capital gain yield

𝐷𝐼𝑉1 𝑃1 − 𝑃𝑂
𝑅1 = +
𝑃0 𝑃𝑂
B. 𝐸(𝑅) = ∑𝑛𝑖=1 𝑅𝑖 𝑃𝑖
C. 𝜎 2 = ∑𝑛𝑖=1[ 𝑅𝑖 − 𝐸(𝑅)]2 𝑃𝑖
D. 𝐸 (𝑅)𝑝 = (𝑊𝑥 𝑋 𝐸 (𝑅)𝑥 ) + (𝑊𝑦 𝑋 𝐸 (𝑅)𝑦 )
E. 𝐶𝑂𝑉𝐴𝐵 = ∑𝑛𝑖=1[ 𝑅𝐴 − 𝐸 (𝑅𝐴 )] [ 𝑅𝐵 − 𝐸 (𝑅𝐵 ]𝑋 𝑃𝑖
F. 𝜎𝑝2 = 𝜎𝐴2 𝑊𝐴2 + 𝜎𝐵2 𝑊𝐵2 + 2 𝑊𝐴 𝑊𝐵 𝐶𝑜𝑣𝐴𝐵

250 CDE Ltd

Economic Conditions Probability Share Price Dividend D.Yield Capital Gain Total Return
% Rs
Scenario 1 25% 306 4 4/250 1.6% (306-250)/250 22.4% 24.0%
Scenario 2 75% 287 5 5/250 2.0% (287-250)/250 14.8% 16.8%

300 ABC Ltd

Economic Conditions Probability Share Price Dividend D.Yield Capital Gain Total Return
% Rs
Scenario 1 25% 355 3 3/300 1.0% (355-300)/300 18.3% 19.3%
Scenario 2 75% 345 2 2/300 0.7% (345-300)/300 15.0% 15.7%

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1

(i) E (R- CDE) = (0.25*24)+(0.75*16.8) = 18.6%

E (R- ABC) = (0.25*19.3)+(0.75*15.7) = 16.6%

(ii)

Var - CDE = (24-18.6)^2*0.25 + (16.8-18.6)^2*.75 = 9.7

Std Dev. - CDE = (9.7)^0.5 = 3.1%

Var - ABC = (19.3-16.6)^2*0.25 + (15.7-16.6)^2*.75 = 2.4

Std Dev. - ABC = (2.4)^0.5 = 1.4%

(iii)

E(Rp) = (0.6*18.6)+(0.4*16.6)=17.8%

(iv)

COV = (24-18.6)(19.3-16.6)*0.25+(16.8-18.62)(15.7-16.6)*.75 = 4.9

Var p = (9.7*0.6^2)+(2.4*0.4^2)+(2*0.6*0.4*4.9) = 6.2

Std Dev. P = (6.2)^0.5 = 2.5%

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
Question 4:
A company XYZ Ltd, based in United Kingdom, bought raw materials from France for € 100,000 which is
payable in three month’s time. XYZ Ltd has just made sales amounting to € 135,000 on 3 months credit to a
company based in France.

Given that the payments and receipts will occur on the same date, what is the amount XYZ Ltd need to
hedge?
Answer:
Amount to hedge: € 135,000 – € 100,000 = € 35,000 (Net receipt)

Question 5:
T Plc, a UK company, has bought goods from a US supplier, and must pay USD 800,000 to them in three
months’ time. The company treasury manager wishes to hedge against the foreign exchange risk and the three
methods which the company usually considers are:
 Leading payments
 Using forward exchange contracts
 Using currency options

The annual interest rates in UK is as follows:

Sterling
Time Deposit rate Borrowing rate
1 month 5% 6%
3 months 8% 9%
6 months 10 11%

The forward rate is as follows:

($/ 1 £)
Spot 1.9655 - 1.9845
1 month forward 1.8744 - 1.8812
3 months forward 1.8545 - 1.8678
6 months forward 1.8249 - 1.8369

The details of the currency options listed in the Chicago Mercantile Exchange ($/ 1 £) options, Contract
size $ 100,000 available at a strike price USD 1.9. Premium is in £ cents per $.
Contract size: $ 100,000 Calls (£ cents per $) Puts (cents per $)
Exercise price/strike price ($/1 £) 1 month 3 months 6 months 1 month 3 months 6 months
1.90 2.25 3.35 4.35 5.25 5.75 6.25

The treasury manager has requested to recommend the best hedging strategy for the US $ payment it is due

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
to pay in 3 months’ time based on the information provided above.
Answer:
Two methods of quotation:
IQ: 1 Domestic currency = ____ FCY
DQ: 1 FCY = ____ DCY
IQ: The bid rate is the rate at which the bank in UK will sell $ and the offer rate at which the bank in UK
will buy $.
Choice 1: Lead payments
The cost of a lead payment ( paying $ 800,00 now) would be:
=800,000/1.9655
407,021 £
The cost in three months time is the cost of lost interest (opportunity cost):
=407021*(1+(0.08*3/12))
415,161 £

Choice 2: Forward exchange market

T Plc must buy US$ in order to pay the US supplier. The exchange rate in a forward
exchange contract to buy USD 800k in three months time (bank sell) is £1 = USD 1.8545.
The cost of the USD 800k to T Plc in three months time will be:
=800000/1.8545
431,383 £
Choice 3: Currency options
Choose the contract period - 3 months
Decide whether a put or call option is required - We need USD to pay the US Company, contract denominated in $;
we will provide the exchange market £ and in return the exchange market will supply us USD, therefore buy a CALL
option therefore buy a CALL option
Strike price $ 1.90
Number of contract ($8000,000/100,000) = 8
Calculate premium
=(3.35*.01)*100000*8
26,800 £
£
Options position (800/1.90) 421,053
Premium 26,800
Total cost 447,853

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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1

The present value of the costs are as follows:

£
Lead payment 415,161
Forward exchange contract 431,383
Currecy options 447,853
Lowest of the above; thus lead payment 415,161

The cheapest method for T Plc is leading the payment . Therefore the company should use
this hedging technique to hedge against transaction risk for this transaction

Question 6:

(a) What is capital rationing?

Capital rationing: a situation in which a company has a limited amount of capital to invest in potential
projects, such that the different possible investments need to be compared with one another in order to
allocate the capital available most effectively.
Capital rationing may occur due to internal factors (soft capital rationing) or external factors (hard capital
rationing).
(b) What are the two different types of capital rationing?
Soft capital rationing is brought about by internal factors.
Hard capital rationing is brought about by external factors.
(c) Why soft capital rationing may arise?
Soft capital rationing may arise for one of the following reasons.
i. Management may be reluctant to issue additional share capital because of concern that this may
lead to outsiders gaining control of the business.
ii. Management may be unwilling to issue additional share capital if it will lead to a dilution of
earnings per share.
iii. Management may not want to raise additional debt capital because they do not wish to be
committed to large fixed interest payments.
iv. Management may wish to limit investment to a level that can be financed solely from retained
earnings.
(d) Why hard capital rationing may arise?
i. Raising money through the stock market may not be possible if share prices are depressed.
ii. There may be restrictions on bank lending due to government control.
iii. Lending institutions may consider an organisation to be too risky to be granted further loan
facilities.
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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
iv. The costs associated with making small issues of capital may be too great.
(e) Why Profitability Index is better to the NPV model when there is capital rationing?
Ranking in terms of absolute NPVs will normally give incorrect results. This method leads to the selection
of large projects, each of which has a high individual NPV but which have, in total, a lower NPV than a
large number of smaller projects with lower individual NPVs. Ranking is therefore in terms of what is called
the profitability index.

(f) Ranked the projects using the NPV model and Profitability Index model. Calculate the resulting
NPV under the PI model. (Adapted from past exam paper November/ December 2020)
Capital available: $ 3,000 million
Initial outlay Present Value of cash Net Present
Project
($ million) flows ($ million) Value ($ million)
A 380 600 220
B 570 800 230
C 1,280 1,350 70
D 830 1,100 270

Answer:
Present Value of
Initial outlay Ranking as PI (PV/ Initial Ranking as
Project cash flows ($ NPV($ million)
($ million) per NPV outlay) per PI
million)
A 380 600 220 3 1.58 1
B 570 800 230 2 1.40 2
C 1280 1350 70 4 1.05 4
D 830 1100 270 1 1.33 3

NPV as per PI ranking

Initial outlay
Project NPV($ million)
($ million)
A 380 220
B 570 230
D 830 270
C 1,220 67
(3000-1280); (1220/1280*70)
3,000 787

(g) What are the problems associated with profitability index model?
Problems with the Profitability Index method
i. The approach can only be used if projects are divisible. If the projects are not divisible a decision
has to be made by examining the absolute NPVs of all possible combinations of complete projects
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Advanced Financial Analysis BA (Hons) Business Accounting & Finance
Revision Session Year 4 Semester 1
that can be undertaken within the constraints of the capital available. The combination of projects
which remains at or under the limit of available capital without any of them being divided, and which
maximises the total NPV, should be chosen.
ii. The selection criterion is fairly simplistic, taking no account of the possible strategic value of
individual investments in the context of the overall objectives of the organisation.
iii. The method is of limited use when projects have differing cash flow patterns. These patterns may
be important to the company since they will affect the timing and availability of funds. With
multiperiod capital rationing, it is possible that the project with the highest Profitability Index is the
slowest in generating returns.
iv. The Profitability Index ignores the absolute size of individual

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