THE ASSOCIATION OF BUSINESS EXECUTIVES

ADVANCED DIPLOMA
FM

Corporate Finance

afternoon 8 December 2005

1 Time allowed: 3 hours.

2 Answer any FOUR questions.

3 All questions carry 25 marks. Marks for subdivisions of questions are

shown in brackets.

4 Present value and annuity tables are included with the question paper
on pages 12 and 13.

5 No books, dictionaries, notes or any other written materials are

allowed in this examination.

6 Calculators are allowed providing they are not programmable and

cannot store or recall information. Electronic dictionaries and
personal organisers are NOT allowed. All workings should be
shown.

7 Candidates who break ABE regulations, or commit any misconduct,

will be disqualified from the examinations.

8 Question papers must not be removed from the Examination Hall.

 Answer any FOUR questions

Q1 Staveley PLC is a listed company which manufactures and

distributes footwear. It made sales of 12 million units
world-wide at an average wholesale price of £12 per unit
during its last financial year ended 30 September 2005. In
2005/6 it is planning to introduce a new brand which will
be sold at a lower unit price. After allowing for any
negative effects on its current brands, Staveley PLC has
estimated that the introduction of the new brand is
expected to raise total sales value by 15%.

To support greater sales activity, it is expected that

additional financing, both capital and working capital, will
be required. Staveley PLC’s estimate of capital
expenditure in 2005/6 is £28 million, partly to replace
worn-out equipment but largely to support sales
expansion. You may assume that, except for taxation
(which is not to be included as part of working capital) all
current assets and current liabilities will vary directly in
line with sales.

Staveley PLC’s summarised balance sheet for the financial

year ended 30 September 2005 shows the following:
£’m £’m £’m
Assets employed
Fixed (net) 100
Current
– stocks 26
– debtors 33
– cash 8 67
–––
Current liabilities
– Corporation Tax 7
– Trade creditors 22 (29)
––– –––
Net current assets 38
Long-term debt at 12% (20)
––––
Net assets 118
––––
Financed by:
Ordinary shares 60
(50p par value)
Reserves 58
––––
Shareholders’ funds 118
––––
Staveley PLC’s profit before interest and tax in 2004/5
was 20% of sales after deducting depreciation of
£4 million. The depreciation charge for 2005/6 is
expected to rise to £7 million. Corporation tax is payable
with a one year delay, and has been estimated at
£8.72 million for 2004/5.

Staveley PLC has a distribution policy of raising dividends

by 10% per annum and in 2004/5 it paid dividends of
£14 million net.

You have been approached to advise on the additional

financing required to support the sales expansion.
Company policy is to avoid cash balances falling below 8%
of sales.

Required:

(a) By projecting the financial statements, calculate for

2005/6:

(i) the TOTAL additional funding requirement; (10 marks)

(ii) the additional EXTERNAL finance Staveley PLC

must raise. (10 marks)

Note: you may assume that all depreciation

provisions qualify for tax relief.

(b) Name five external options that Staveley PLC might

use to finance their sales expansion. (5 marks)
(Total 25 marks)
Q2 Three alternative methods of valuing unquoted companies
are:

– Net Asset Value

– Price Earnings (P:E) Ratio
– Discounted Cash Flow (DCF)

Required:

(a) What are the main problems associated with each of

the above three methods? (10 marks)

(b) North West Computing Ltd is a manufacturer of

computer peripherals which it sells to personal
computer users. It was formed 10 years ago and has
grown its sales by an average of 12% per annum since
its formation, largely financed by a policy of earnings
retention. In the year ended 30 September 2005 its
sales were £48 million. Its original founders are
contemplating a quotation on the Alternative
Investment Market (AIM), partly to raise further
capital for diversification into other products and
partly to realise some of their own equity stake.

As merchant bankers to North West Computing Ltd,

you have been asked to advise on the above issue.

The most recent balance sheet (as at 30 September

2005) shows the following details:

£’m £’m £’m

Assets employed:
Fixed assets (net)
Tangible 30
Intangible 30 60
–––
Current assets
Stock 15
Debtors 10
Cash 5 30
–––
Current liabilities
Trade creditors (20)
Bank overdraft (5) (25)
–––
Net current assets 5
–––
Net assets 65
–––
 £’m £’m £’m
Financed by:
Issued share capital
(par value 25p) 5
Revaluation reserve 10
Profit and loss reserve 50
–––
Shareholders’ funds 65
–––

The following information is also available:

– Profits after interest but before tax were £4m, and

capital allowances of £1.015m were available. The
rate of Corporation Tax is 33%.
– The dividend was covered three times by profits
after tax.
– Depreciation provisions, which coincided with
replacement investment, were £5m.
– Stocks have been revalued to £7.5m.
– North West Computing has a policy of capitalising
research and development work. About half of
intangible assets are accounted for by this
category.
– Tangible fixed assets were revalued during
November 2005 at £38m.
– The P:E ratio for North East Computing which is
North West Computing’s main competitor in
several of its markets, is 18:1, although the sector
average is 11:1
– North West Computing shareholders require a
return of 14% pa. after all taxes.

Required:

What price would you place on North West Computing

ordinary shares using the following different valuation
methods:

– valuation of net assets based on the accounts

– using a P:E ratio approach
– using a free cash flow approach? (15 marks)
(Total 25 marks)
Q3 Following a merger or takeover there has sometimes been
a fragmentation process, with the decentralisation of
individual companies and often the promotion of
competition between them. There will always be a certain
level of risk with a merger or takeover but adequate
research and preparation should help to minimise such
risk.

Required:

(a) Identify the key features of the target company that

will improve the chance of success in a merger or
takeover. (8 marks)

(b) What savings might be achieved and what problems

might be faced with mergers or acquisitions? (7 marks)

(c) Consider the following situation:

Copper plc and Tin plc have entered into negotiations

to merge and form Bronze plc. Details of the
companies are as follows:

Copper Tin
£1 ordinary share capital £800,000 £600,000
Estimated maintainable
future earnings £300,000 £186,540
Agreed P:E ratio
for amalgamation 17 5

Suggest a suitable scheme for a merger between the

two companies. (10 marks)
(Total 25 marks)
 BLANK PAGE

TURN OVER FOR THE NEXT QUESTION

Q4 The final accounts for Dixon for the last three financial
periods are given as follows:

Profit and Loss Account

30 Sept 2005 30 Sept 2004 30 Sept 2003

£’000 £’000 £’000 £’000 £’000 £’000
Sales (all
credit) 23,860 22,800 22,000
Opening
Stock 1,200 1,100 1,100
Purchases
(all credit) 12,700 11,750 11,000
Closing
Stock 1,400 1,200 1,100
Cost of
sales 12,500 11,650 11,000
––––––– ––––––– –––––––
Gross
Profit 11,360 11,150 11,000
Operating
and
Financial
Expenses 7,800 6,500 4,400
––––––– ––––––– –––––––
Net Profit 3,560 4,650 6,600
––––––– ––––––– –––––––
 Balance Sheet

30 Sept 2005 30 Sept 2004 30 Sept 2003

£,000 £,000 £,000 £,000 £,000 £,000
Fixed
Assets 1,312 800 600
Current Assets:
Stock 1,400 1,200 1,100
Debtors 1,220 1,200 1,450
Cash 10 2,630 2 2,402 30 2,580
–––––– –––––– ––––––
Current Liabilities:
Creditors 1,350 1,100 1,000
Bank
Overdraft 1,580 (2,930) 1,150 (2,250) 150 (1,150)
–––––– –––––– –––––– –––––– –––––– ––––––
Total Assets
less Current
Liabilities 1,012 952 2,030
Long-Term Liabilities:
Bank Loan (250) (250) (225)
–––––– –––––– ––––––
Net Assets 762 702 1,805
––––––
–––––– ––––––
–––––– ––––––
––––––
Financed by:
–––––– –––––– ––––––
Owners’ Capital 762 702 1,805
––––––
–––––– ––––––
–––––– ––––––
––––––

Required:

Dixon is concerned about its management of working

capital.

(a) Explain the changes in the cash operating cycle for

this firm over the years indicated. (15 marks)

(b) Do you think the firm is overtrading? Suggest possible

future action based on your analysis. (10 marks)
(Total 25 marks)
Q5 Ross Plc specialises in the manufacture of footwear. Sales
in the current year have been £6.2 million. The terms of
sale are 2% discount 14 days, net 28 days, although those
customers not taking the discount actually take longer
than 28 days to pay on average. The current level of
debtors is £600,000, included in which are the one half of
Ross’s customers who take advantage of the cash
discount. 2% of credit sales become bad debts. The net
operating margin (excluding bad debts and discounts) for
Ross is 25% of sales. The average time taken for debtors
to pay is currently 8 weeks.

The company is considering a change in its credit policy

to 4% discount 14 days, net 28 days. It anticipates the
following effects of this change:

– Sales to increase by 10% pa

– 75% of customers to take advantage of the discount
– The period of time before payment by the customers
not taking the discount to increase by 7 days
– Bad debts to fall to 1.5% of sales

Ross’s cost of finance is 8%.

Required:

(a) Calculate the financial implications of this change in

credit policy and give your advice on the proposed
change. (15 marks)

(b) Debtors and credit control are, of course, only one

aspect of working capital management. What policies
may produce savings in other items of working
capital? Discuss some of the potential difficulties
attached to the management of working capital. (10 marks)
(Total 25 marks)
Q6 A company Keswick Ltd has estimated the expected cash
flows for four possible projects as follows:

Project Year
0 1 2 3 4 5
1 (500) 200 200 300 200 200
2 (400) 100 100 100 100 500
3 (150) 40 50 60 70 100
4 (1,000) 500 400 300 200 100

Note that all figures are in £000s.

Required:

(a) Calculate and rank these projects in order of

acceptability using:

(i) Payback; (2 marks)

(ii) Net present value at 20% cost of capital; (4 marks)

(iii) Internal rate of return. (4 marks)

(b) Explain which project should be accepted if the

projects were mutually exclusive and there was no
capital rationing. (2 marks)

(c) Explain which project(s) should be accepted if the

projects were independent and indivisible, and the
company had £1 million to invest. (4 marks)

(d) Explain which project(s) should be accepted if the

projects were independent and divisible, and the
company had up to £1.1 million to invest. (4 marks)

(e) Explain briefly the relative advantages and

disadvantages of the appraisal methods used in (a)
above. (5 marks)
(Total 25 marks)
 Present Value Table

Present value of 1 i.e. (1 + r )–n

where r = discount rate
where n = number of periods until payment

Discount Rates (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

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

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
 Annuity Table

1 – (1 + r )–n
Present value of an annuity of 1 i.e. ––––––––––
r
where r = interest rate
where n = years

Interest Rates (r)

Years
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

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

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 3·748 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
 Advanced Diploma

Corporate Finance

Examiner’s Suggested Answers

Question 1

(a) (i) Staveley PLC needs additional finance to fund both working and fixed
capital needs. As sales are expected to increase by 15% and since
working capital needs are expected to rise in line with sales, the
predicted working capital needs will be 15% above the existing
working capital level i.e.:

Stock + debtors + cash – trade creditors

= 26 + 33 + 8 – 22
= 45 x 1.15% = 51.75, an increase of £6.75m

Together with the additional capital expenditure of £28million, the

total funding requirement = £6.75m + £28m i.e. £34.75 million

(ii) This funding requirement can be met partly by internal finance and
partly by new external capital. The internal finance available will
derive from depreciation provisions and retained earnings after
accounting for anticipated liabilities such as taxation, that is from
cash flow.

Note that the profit margin on sales of £144million (£12 x 12 million

units) before interest and tax in 2004/5 was 20%. If depreciation of
£4million for 2004/5 is added back, this yields a “cash flow” margin of
22.78% (ignoring movements in current assets/liabilities).

Using the same margin, and making a simple cash flow projection
based on the accounts and other information provided, you would get
the following results:

Inflows £’m
Sales in 2005/6 = (£12 x 12 m) + 15% 165.60
cost of sales before depreciation (i.e. 77.22%) (127.88)
–––––––
operating cash flow 37.72

Outflows
Tax liability for 2004/5 (8.72)
Interest payments (£28m x 12%) (3.36)
Dividends (1.1 x £14m) (15.40)
–––––––
Net internal finance generated 10.24
Total funding requirement 34.75
Net additional external finance required £24.51 million
–––––––
(b) • Some new equipment could be leased if Staveley PLC’s assets are of
sufficient quality i.e. easily saleable and it may be possible to raise a
mortgage secured on these assets
• Staveley PLC could make a debenture issue
• An alternative to a debt (e.g. debenture) issue could be a rights issue
of ordinary shares
• Venture capital
• Utilise official sources of aid, such as a regional development agency
or perhaps an organisation such as the European Investment Bank.

Question 2

(a) The main purpose usually for valuing unquoted companies is with a view to
either making a bid for the business or attempting to sell the business.

Net Asset Value

There are problems both on the asset and liability side:

Assets

Fixed asset values are usually based on historic cost less depreciation.
Different depreciation methods result in different values of fixed assets.
Whatever the method of depreciation, the book values are unlikely to
correspond to market values. Although companies do re-value their assets
periodically, this is a subjective exercise, often undertaken by the directors
themselves.

Values of stock may not be reliable, especially if the accounts were

prepared some time ago. (They could be up to a year old.) Companies often
“window-dress” their accounts at year end, and stock values in high
technology and fashion industries are often soon outdated.

Some accounts may be uncollectable. Provision should have been made for
bad and doubtful debts but the valuer should be wary of the extent of this
allowance.

Liabilities

Some liabilities are “off-balance sheet” such as guarantees to other

companies, e.g. in a joint venture, warranty obligations and operating lease
commitments. Inspection of the notes to the accounts should reveal these.

Some other provisions may be inadequate for the purpose intended. A

provision is a reduction in retained earnings to allow for some anticipated
contingency, such as replacement of assets or redundancy payment in the
event of closure of a factory.

However, although these factors can be adjusted for, the fundamental

problem with the NAV method is that it views the company merely as a set
of assets rather than as an income-generating activity, i.e. the NAV ignores
the company’s earning power, which is what really drives value. The NAV is
really only valid when a company is making losses, or has a collection of
assets which have a much greater value when put to some alternative use,
e.g. farming land converted to a housing estate.

Price Earnings Ratio (P/E ratio)

Problems with this approach include the following:

The earnings figure can be distorted by accounting policies, e.g.

organisations may adopt different depreciation policies.

The current earnings may be atypically high or low. It may be more

appropriate to take an average over the past few years (how many though?)

We should consider likely growth in earnings, especially as one

organisation could maybe exploit its assets more effectively. This depends
from whose perspective we perform the valuation!

It is difficult in reality to find close substitutes, i.e. companies that produce

the same product lines, serve the same markets and have similar
management capabilities. In short, companies have different potential for
growth (which is what the P/E ratio is supposed to reflect).

Two companies might not be comparable in some important respect. One

might be a large company and with a stock market quotation. Investors are
usually prepared to pay a premium for size and, especially, marketability
i.e. the ability to easily buy one’s share holding. For this reason, it is usual
to reduce the P/E ratio applied to the unquoted company’s earnings. But
by how much is a question of judgement – and ultimately depends on what
the seller will accept.

Discounted Cash Flow (DCF)

Problems with the DCF approach centre on specification of the key

variables involved.

Can the future investment be accurately projected? Most approaches of this

type (i.e. DCF investment exercises) only project cash flows over 5–10 years
for this reason, but build in a “residual value” to indicate the likely value of
the company at the end of the period. This is very largely guesswork,
although errors are minimised by the discounting process.

How can we measure the discount rate? If valuing the equity stock, we
need to know what rate of return is required by shareholders. If we are
dealing with an acquisition, the valuation is effectively an investment
appraisal and the return required by the bidders’ shareholders should be
used. However, if the project operates in a different line of business
activity, adjustment should be made for the risk differential.

Over what time period should we assess value? This partly depends on the
size of company – small companies are more exposed to risk and are more
likely to have short lives. Market-positioning factors are also relevant. All
companies have life cycles corresponding to their project life cycles and the
period over which they enjoy competitive advantages.
(b) Net asset valuation

The simplistic answer is to read off the value of the net assets from the
accounts (i.e. £65m). However, fixed assets have been revalued (yielding a
surplus of £8m). Against this, the value of the capitalised pure research
must be doubtful and North West Computing carries a high level of stocks
in what is a fast-moving technology business. Discounting the value of pure
research and applying a 50% discount to stocks yields a valuation of:

£65m – (£30m/2) – (50% x £15m) + 8m = £50.5m

On a share basis, this is

£50.5m/(£5m * 4 ) = £2.53

Price Earnings Ratio

Taxable profits are

(£4m – capital allowance)

= (£4m – £1.015m) = £2.98m
Tax bill = £0.98m

Profit after tax

£4m – £0.98m = £3.02m

Applying the North East Company P/E ratio yields a value of

(18 x £3.02m) = £54.36m, or £2.72 per share

but applying the sector average P/E ratio yields

(11 x £3.02m) = £33.22m, or £1.66 per share although this may be

depressed by current generally low profitability. Against this, North West
Computing is a newcomer to the market, and its shares have to be
attractively priced to stimulate interest in the sale and encourage an
aftermarket.

Using a free cash flow approach.

Cash flow = PAT (profit after tax) + depreciation provisions

= £3.02m + £5m = £8.02m
But deducting ongoing investment requirements

Free Cash Flow

= (£8.02m – £5m) = £3.02m

Assuming perpetual life for North West Computing, its value is:
£3.02m/0.14 = £21.6m or £1.08 per share

Restricting the lifetime assumption to 10 years, the value is

£3.02m x (5.216*) = £15.75m, or 79p per share.

*5.216 = the annuity value of 14% over 10 years

Question 3

(a) The key features are:

A well-defined market niche

A balanced customer portfolio
A growth industry
Seasonal, fashion and economic cycle stability
A stable and motivated workforce
High added value
Good technical know-how
A short production cycle
Located near the acquisitor’s business
Matches the corporate strategic plan
Provides something the firm does not have for itself.

The early months will be critical in settling down the enlarged business and
gradually bringing about new working practices to improve the efficiency of
the operation. It requires commitment from all levels of the organisation.
Mergers and acquisitions have often been found to fail because senior
management are more concerned with future expansion , especially via
further acquisitions, rather than with integrating the organisation’s current
units. There is a particular problem if the cultures of the merging
organisations are very different.

A further point for you to note is that mergers have often been criticised as
being implemented to reduce competition and thus to create a more
comfortable environment for further business development, rather than
due to a desire for increased operating efficiency.

(b) Savings might include

• Economies of scale e.g. one head office with less staff than exists in
the two companies currently
• Additional expertise from staff between the two companies possibly
reducing training and development costs
• Lack of competition should result in operating economies e.g. the
advertising budget may be reduced
• Tax advantages may occur on merger or acquisition

Problems might include

• Economies of scale are often difficult to achieve in practice.

• Additional expenditure may be required to integrate the different
systems (e.g. computer systems) of the two companies.
• Staff redundancies may be necessary.
• New management contracts (particularly senior management
contracts) may have to be negotiated.
• If the operational units of the two companies are geographically
separate, additional transport costs may arise.
(c) Value of shares for merger

Copper PLC Tin PLC

EPS 300 186.54
–––– = 37.5p –––––––– = 31.1p
800 600

EPS x = 37.5p x 17 31.1p x 5

P/E ratio

Therefore
Market Value = £6.375 = £1.555

If Bronze PLC is to have ordinary share capital of £800,000 + £600,000 (i.e.

£1,400,000) the holdings of ordinary shares in the new company could be
divided between the former companies’ shareholders in the following
proportions:

Copper 800,000 x £6.375 = £5,100,000

Tin 600,000 x £1.555 = £933,000
(i.e. in the proportion 5,100:933)

or £
Copper 1,183,490
Tin 216,510
––––––––––
Total 1,400,000

This would mean that Bronze would have an EPS of:

486,540
–––––––––– = 34.753 pence per share
1,400,000

and that the proportions attributable to Copper and Tin are:

£
Copper 1,183,490 x 34.753p = 411,298
Tin 216,510 x 34.753p = 75,242
––––––––
Total 486,540
––––––––

In this scheme, Copper gains some earnings from Tin and Tin loses
earnings to Copper.

As an alternative to the above, the shares in Bronze could be apportioned

on the basis of input of earnings without heeding the market price
situation. This would penalise Copper in the sense that the market appears
to favour its development and growth potential more highly than it does
Tin’s. A straight proportional split would not acknowledge the apparent
difference in market rating.
Question 4

(a) The cash operating cycle is the period between the payment of cash to
creditors and the receipt of cash from debtors. We need to calculate
appropriate ratios:

(1) Trade debtors

Debtors’ payment period = ––––––––––––– x 365 days
Credit sales

Year ended 30 Sept 2005 1,220

––––––– x 365 = 18.7 days
23,860

Year ended 30 Sept 2004 1,200

––––––– x 365 = 19.2 days
22,800

Year ended 30 Sept 2003 1,450

––––––– x 365 = 24.1 days
22,000

(2) Creditors
Creditors’ payment period = –––––––––– x 365 days
Purchases

Year ended 30 Sept 2005 1,350

–––––––– x 365 = 38.8 days
12 ,700

Year ended 30 Sept 2004 1,100

–––––––– x 365 = 34.2 days
11,750

Year ended 30 Sept 2003 1,000

––––––– x 365 = 33.2 days
11,000

(3) Average stock

Stock turnover ratio = ––––––––––––– x 365 days
Cost of sales

Year ended 30 Sept 2005 (1,200 + 1,400)/2

––––––––––––––––– x 365 = 38.0 days
12,500

Year ended 30 Sept 2004 (1,100 + 1,200)/2

––––––––––––––––– x 365 = 36.00 days
11,650

Year ended 30 Sept 2003 (1,100 + 1,100)/2

–––––––––––––––––– x 365 = 36.5 days
11,000

Cash Operating cycle

Year ended 30 Sept 2003

Average days before receipt of cash on sales = 36.5 + 24.1 = 60.6 days
Average days before payment of creditors = 33.2 days
Operating cycle = 27.4 days
 Year ended 30 Sept 2004
Average days before receipt of cash on sales = 36.0 + 19.2 = 55.2 days
Average days before payment of creditors = 34.2 days
Operating cycle = 21 days

Year ended 30 Sept 2005

Average days before receipt of cash on sales = 38.0 + 18.7 = 56.7 days
Average days before payment of creditors = 38.8 days
Operating cycle = 17.9 days

Over the period it appears that the company has continued to improve the
cash operating period from 27.4 days to 17.9 days. However, a closer look
at the ratios reveals some potential problems.

Although the company has improved its debt collection procedures and has
reduced the payment period from 24.1 days to 18.7 days, the stock
turnover ratio in the year ended 30 Sept 2005 is longer, indicating that it is
taking longer to convert stock purchases into actual sales.

The creditors’ payment period in the year ended 30 Sept 2005 is longer
than previous years, indicating that the company is making more use of
creditors as a source of short-term finance. This can be dangerous in the
long term as liquidity problems can arise.

(b) To consider whether the firm is overtrading we need to look at some ratios:

Year ended Year ended Year ended

30 Sept 2005 30 Sept 2004 30 Sept 2003
Turnover £23,860 £22,800 £22,000
Gross Profit Ratio 11,360 11,150 11,000
––––––– x 100 ––––––– x 100 ––––––– x 100
23,860 22,800 22,000
= 47.6% = 48.9% = 50.0%
Net Profit Ratio 3,560 4,650 6,600
––––––– x 100 ––––––– x 100 ––––––– x 100
23,860 22,800 22,000
= 14.9% = 20.4% = 30%
Current Asset Ratio 2,630 2,402 2,580
––––––– ––––––– –––––––
2,930 2,250 1,150
= 0.9:1 = 1.07:1 = 2.24:1
Acid Test Ratio 1,230 1,202 1,480
––––––– ––––––– –––––––
2,930 2,250 1,150
= 0.42:1 = 0.53:1 = 1.29:1

The company shows significant signs of overtrading:

An increase in turnover over the period.

A decrease in gross profit and net profit ratios over the same period.
A deterioration in stock turnover ratios.
Increasing liquidity problems shown by current asset and acid test
ratios.
Increasing reliance on short-term finance e.g. increase in bank
overdraft and creditors’ payment period.
 Future action may include:

Efforts to increase stock turnover e.g. advertising campaign

Reduction in expenses to improve net profit percentage.
Seeking of alternative methods of finance to fund any expansion.

Question 5

(a) The financial implications are:

(1) Increase in net operating profit

Current level of sales = 25% x £6.2m = £1.55m

After change in policy = 25% x £6.82m = £1.705m

(2) Increase in discount allowed

Current level = £6.2m x 2% x 50% = £0.062m

After change in policy = £6.82m x 4% x 75% = £0.2046m

(3) Savings on debtors

New situation (taking one week longer to pay)

£6.82m £6.82m
Total debtors = (75% x ––––––– x 2) + (25% x ––––––– x 9) = £491,827
52 52

Reduction on debtors = £600,000 – £491,827 = £108,173

Savings = 8% x £108,173 = £0.0087m

(4) Reduction in bad debts

Current level = 2% x £6.2m = £0.124m

After change in policy = 1.5% x £6.82m = £0.1023m

Summary of changes: Saving Increased cost

£m £m
(1) Increase in net operating profit 0.155
(2) Increase in discount allowed £0.1426
(3) Savings due to reduced debtors 0.0087
(4) Reduction in bad debts 0.0217
––––––– –––––––
0.1854 0.1426
––––––– –––––––
Overall benefit = £0.0428m

This is a relatively small benefit given quite favourable assumptions have

been made, e.g. a 10% rise in sales and a 25% reduction of bad debts. The
cost of discount allowed is high and it is debatable whether the proposed
change is actually viable.
(b) You could base your answer on the following points:

(1) Stock control – improvements using computerised systems and

techniques such as economic order quantity and just-in-time stock
control. Achieving faster stock turnover can reduce costs of
stockholding.
(2) Cash control – use of cash flow forecasts can help identify likely
surpluses and deficits of cash. Surpluses can be invested and
short–term overdrafts arranged to cover deficits.
(3) Creditors – it may be possible to delay payments to creditors but this
can have adverse effects on relationships with suppliers and the
company could incur interest payments on overdue accounts.

There are a number of practical difficulties that often affect the

management of working capital such as the following:

• liquidity risk
• interest rate risk
• currency risk
• deciding whether it is better to borrow short-term or long-term
• business risk
• insurable risk
• costs and benefits of working capital

Question 6

(a) (i) Payback method

Project 1
The £500,000 initial outlay is returned as follows:
(200,000 + 200,000 + 1/3 [300,000]) = 2.3 years

Project 2
The £400,000 initial outlay is returned as follows:
(100,000 + 100,000 + 100,000 + 100,000) = 4 years

Project 3
The £150,000 initial outlay is returned
(40,000 + 50,000 + 60,000) = 3 years

Project 4
The £1,000,000 initial outlay is returned as follows:
(500,000 + 400,000 + 1/3 [300,000]) = 2.3 years

So the ranking is:

1st equal – Project 1 and Project 4

3rd – Project 3
4th – Project 2
(ii) With NPV at 20%

Project 1 Year Cash Flow Factor NPV

£000 £000
0 (500) 1.000 (500.0)
1 200 0.833 166.6
2 200 0.694 138.8
3 300 0.579 173.7
4 200 0.482 96.4
5 200 0.402 80.4
155.9

Project 2 Year Cash Flow Factor NPV

£000 £000
0 (400) 1.000 (400.0)
1 100 0.833 83.3
2 100 0.694 69.4
3 100 0.579 57.9
4 100 0.482 48.2
5 500 0.402 201.0
59.8

Project 3 Year Cash Flow Factor NPV

£000 £000
0 (150) 1.000 (150.0)
1 40 0.833 33.32
2 50 0.694 34.70
3 60 0.579 34.74
4 70 0.482 33.74
5 100 0.402 40.20
26.70

Project 4 Year Cash Flow Factor NPV

£000 £000
0 (1,000) 1,000 (1,000.0)
1 500 0.833 416.50
2 400 0.694 277.60
3 300 0.579 173.70
4 200 0.482 96.40
5 100 0.402 40.20
4.40

The ranking from project 1 to 4 runs also from 1 to 4 in order.

(iii) IRR method
An NPV rate of 30% has been used for illustrative purposes; in reality,
any two NPV rates can be used, and a straight line graph can be used
to predict the relevant IRR, rather than by formula.

NPV at 30%, when combined with the NPV at 20%, can be used to
determine the IRR by use of a formula:

Project 1 Year Cash Flow Factor NPV

£000 £000
0 (500) 1.0000 (500.00)
1 200 0.7692 153.80
2 200 0.5917 118.30
3 300 0.4552 136.60
4 200 0.3501 70.00
5 200 0.2693 53.90
32.60

Project 2 Year Cash Flow Factor NPV

£000 £000
0 (400) 1.0000 (400.00)
1 100 0.7692 76.90
2 100 0.5917 59.20
3 100 0.4552 45.50
4 100 0.3501 35.00
5 500 0.2693 134.70
(48.70)

Project 3 Year Cash Flow Factor NPV

£000 £000
0 (150) 1.0000 (150.00)
1 40 0.7692 30.80
2 50 0.5917 29.60
3 60 0.4552 27.30
4 70 0.3501 24.50
5 100 0.2693 26.90
(10.90)

Project 4 Year Cash Flow Factor NPV

£000 £000
0 (1,000) 1.0000 (1,000.00)
1 500 0.7692 384.60
2 400 0.5917 236.70
3 300 0.4552 136.60
4 200 0.3501 70.00
5 100 0.2693 26.90
(145.20)
 To determine the internal rate of return for each project we can apply
the formula:

X + ((a/a + b * (Y – X))

where: X = the lower rate of interest used

Y = the higher rate of interest used
a = the difference between the present values of the outflow
and the inflows at X%
b = the difference between the present values of the Y%.

If one NPV is positive (i.e. a) and the other negative (i.e. b), the formula
is:
X + ((a/a – b * (Y – X))

So to take each project in turn:

Project 1: IRR = 20 + ((155.99/188.59 x (30 – 20)) = 28.3%

Project 2: IRR = 20 + ((59.82/108.52 x (30 – 20)) = 25.5%

Project 3: IRR =20 + ((26.72/37.62 x (30 – 20)) = 27.1%

Project 4: IRR = 20 + ((4.8/150.0 x (30 – 20)) = 20.3%

This then ranks the projects in the order:

1st – Project 1
2nd – Project 3
3rd – Project 2
4th – Project 4

(b) With mutually exclusive projects and no capital rationing, the company
should select the one with the highest NPV, this being Project 1.

(c) In the situation of independent, indivisible projects where the company had
£1 million to invest, the best approach would be to maximise the NPV
obtainable. In this case, Projects 1 and 2 should be accepted.

(d) Looking at the situation of divisible, independent projects where the

company had up to £1.1 million to invest, we would need to consider the
highest profitability index, being:

Project 1 2 3 4
P/V – Inflows 655.99 459.82 176.72 1,004.8
––––––––––––––––– ––––––– –––––– –––––– ––––––
Initial investment 500 400 150 1,000
= 1.31 1.15 1.18 1.00
 We would allocate our money to the most profitable first, which would
provide the following portfolio;

Project 1 – investment of £500,000

Project 3 – investment of £150,000
Project 2 – investment of £400,000
–––––––––––
£1,050,000
–––––––––––

(e) Payback is useful in that it has the advantage of showing when the initial
investment has been repaid. However, it also has the disadvantage of:

(1) Ignoring income after the payback period; and

(2) Ignoring interest.

Net present value provides the advantage of considering both cash flows
and interest over the project life but the disadvantage of ignoring risk.

Internal rate of return provides the advantage of an appraisal as a single

percentage figure and thereby indicates a project yielding the highest
return on investment. However, by the use of such a rate the cash flow
effects can be hidden and the risk aspects ignored.