KC 2 CORPORATE FINANCE With Trevin Hannibal CIMA

KC 2 CORPORATE FINANCE With Trevin Hannibal (CIMA Passed Finalist , Pg. Dip in BA, MBA Cardiff Metropolitan University)

Scheme of Work • Question based theory discussions • Analysis of questions • Advice on answer planning • Discussion of model questions

Question 1 - Requirement – a) • Discuss the role of the treasury department when determining financing or refinancing strategies • in the context of the economic environment described in the scenario • Explain how these might impact on the determination of corporate objectives.

Answer plan • Introduction sentence - economic environment • Inflation zero, fall in interest rate • On financing a re-financing options to the treasury department • What is the current situation at CD • Can they increase debt ? if so the implications • Can they increase equity? if so the implications • Implications to the corporate objectives • Can we re-finance? if so implications • What will happen to share holders wealth

Question 1 - Requirement – b) • Evaluate the appropriateness of CD's current objective and of the two new objectives being considered. • Discuss alternative objectives that might be appropriate for CD • Conclude with a recommendation.

Answer plan • Evaluation of the current objective- increase divided • Benefits of the current objective • Drawbacks • Proposed objectives • Shareholder wealth max? implications • Increasing PAT and ROI? Implications • Recommendation • Highlight the issues on the proposed objectives • Suggest – balance score card

Question 2 –Requirement • Prepare a report to the Finance Director of MAT advising on whether the entity could be classified as “overtrading” • Recommending financial strategies that could be used to address the situation. • Points to consider • Recommendations should be based on analysis of the forecast financial position • making whatever assumptions that are necessary • Should include brief reference to any additional information that would be useful to MAT at this time

Relevant ratio to be calculated • • • • Increase in sales Increase in cost of goods sold Increase in profit margin Current ratio Quick ratio Sales to net current assets Inventory to revenue Debt Ratio : Debt Equity Gearing – Debt : Debt + Equity Days accounts receivable Days accounts payable Days inventory Capital turnover Revenue: Non-current assets

Ratios

Ratios

Operating cycle

Answer plan • Report format • Introduction • Purpose • Sections of the report üDiscussion of the calculations as symptoms of overtrading; üAdvice on financial strategies; üOther information

Symptoms of over-trading • There is a fall in liquidity, as measured here by the current ratio=2⋅83 to 1⋅55. • The sales to net-current assets ratio will rise from 5⋅5 to 10 indicating a potential overtrading situation. • There is expected to be a sharp rise in receivables as measured by days outstanding. Last year, on average, debtors were 44⋅6 days. The forecast is 60⋅3 days • either a change in collection policy • an expectation that sales will be extended to customers with poorer credit or payment history • A dramatic increase in WC Cycle is not to be seen.

Symptoms of over-trading • MAT is demonstrating some signs of overtrading • (current ratio and the ratio of sales to net current assets and days accounts receivable) • The entity is forecasting an increase in its non-current assets but no increase in long term debt. • This suggests these purchases are likely to be financed by overdraft • Overtrading can have serious consequences for any organization; liquidity problems can result in bankruptcy or financial distress.

Financial strategies • Use more trade credit • Reduce credit to customers • Consider invoicing customers in their own currency • More aggressive debt collection

Additional information • Breakdown of inventory into raw materials, WIP and finished goods; • Cash flow forecast by month; • Details of the non-current assets purchases and depreciation policy; • Information on level of bad debts incurred and expected.

Questions-3 a) Construct a forecast income statement, including dividends and retentions for the years ended 31 December 2016 and 2017. b) Section b) • Construct a cash flow forecast for each of the years 2016 and 2017 • Discuss, briefly, how the company might finance any cash deficit.

Financing the cash deficit • There is need to finance a cash shortfall of £ 1, 680, 000 by the end of 2016. • As the shortfall is caused by the purchase of new assets, there should be no problem increasing the overdraft limit given the size of the entity. • It could be argued that as these are long term assets they should be funded by long-term finance but the amount is relatively small compared to the value of the entity.

Requirement c) • Using your results in (a) and (b) above, Evaluate whether EF is likely to meet its stated objectives. • EVALUATE • As part of your evaluation, discuss whether the assumption regarding overdraft interest is reasonable • Explain how a more accurate calculation of overdraft interest could be obtained.

Requirement – c)- answer plan • Return on shareholders’ funds: • Achieved in 2015 and unsuccessful in 2016 and 2017 • The new assets might begin to contribute to an improvement but they are clearly replacement assets for an existing facility and as such are unlikely to have a significant impact. • Increasing's earnings? • The increase in earnings is well below EF’s target for 2016 and 2017 but is moving in the right direction.

OD interest • The removal of the simplifying assumption regarding overdraft interest can be expected to have a significant effect on forecast cash flows after tax. • the increase in earnings that is observed above is so small that an increase in overdraft interest in 2016 could reduce earnings to the point at which earnings actually decline in 2016 from 2015 levels. • Recommended to calculate an Average OD interest based on average cash balances.

Question 4 • (a) • Calculate which payment method is expected to be cheaper for AB and recommend which should be chosen based solely on the present value of the two alternatives as at 1 January 2016 • Explain the reasons for your choice of discount factor in the present value calculations. • Discuss other factors that AB should consider before deciding on the method of financing the acquisition of the system

a ii) discount rate • The discount rate that should be used in financing decisions is the opportunity cost. • Finance leases are considered a direct substitute for borrowing, the opportunity cost of leasing is the after-tax cost of borrowing

a iii) other factors to consider • Consideration must be given as to how or when the borrowings are to be repaid if alternative 1 is chosen. • Tax benefits appear to have a significant influence on the decision; a sensitivity analysis should be carried out to determine the impact on the decision if tax rates or regulations change.

b) • Advise the Directors of AB on the following: • The main purpose and content of a post completion audit (PCA). • The limitations of a PCA to AB in the context of the POS system.

Answer plan for b) • Importance of PCA • It enables a check to be made on whether the performance of the system corresponds with the expected results. • It generates information, which allows an appraisal to be made of the managers who took the decision to upgrade the system. • It can provide for better project planning in the future. • Limitation if PCA • Sufficient resources are often not allocated • They can be time consuming • They are sometimes seen as tools for apportioning blame,

Q 5 Requirement • a) Calculate and recommend which payment method is expected to be cheaper for BEN in NPV terms. • b) Evaluate the benefits that might result from the introduction of the new TMS. • Include in your evaluation some reference to the control factors that need to be considered during the implementation stage.

Answer plan for b) • Benefits of TMS • The primary benefit is that one integrated system will replace a number of apparently disparate legacy systems • Greater security of data • More flexibility of operations • Takes advantage of technological developments. • Control mechanism • The PCA should provide a source of information • This should improve project control and governance • Enable changes to be introduced to put the project back on track in a timely manner

Requirement c) • Advise the Directors of BEN on the following: • The main purpose of a post-completion audit (PCA): • What should be covered in a PCA of the TMS project; • The importance and limitations of a PCA to BEN in the context of the TMS project.

c) With reference to BEN • Purpose • Project control; • Improving the investment process; • Assisting the assessment of performance of future projects

c) With reference to BEN • What is covered • It enables a check to be made on whether the performance of the TMS corresponds with the expected results • It generates information, which allows an appraisal to be made of the managers who took the decision to upgrade the system • It can provide for better project planning in the future

c) With reference to BEN • Limitations • Sufficient resources are often not allocated to the task of completing PCAs so often are not undertaken • They can be time consuming and costly to complete • If undertaken by the managers of the project, they may claim credit for all that went well and blame external factors for everything that didn’t

Capital structure -Theory in a nutshell • Calculation of Ke • DVM • DGM • CAPM – deal with • Risk free • Risk premium • The risk premium could be categorized into • Diversifiable/Firm Specific/Unsystamatic Risk • Non Diversifiable/Market/Systamatic Risk

Capital structure -Theory in a nutshell • Calculation of Kd • If the debt is irredeemable • Interest yield is considered • If the debt is redeemable • Yeild to maturity is considered • A combination of Ke and Kd is embedded in the WACC

Calculation of project specific COC • Approach 1 • Calculation of beta ungeared through the beta asset formula using the proxy companies geared beta ( Removing the financial risk) • Re-gear to the companies capital structure • The new beta is incorporated to the CAPM formula to compute the Keg • The Keg is substituted to the WACC to compute the Project specific COC

Calculation of project specific COC • Approach 2 • Calculation of beta ungeared through the beta asset formula using the proxy companies geared beta ( Removing the financial risk) • The beta ungeared is incorporated to the CAPM formula to compute Keu. • The Keu is substituted to the M&M Kadj formula to compute the Project specific COC

Question 6 –a) • Discuss the appropriateness of the two Directors’ suggestions about the discount rate when evaluating the proposed investment • Recommend an appropriate rate to use. • You should support your discussion and recommendation • with calculations of two separate discount rates – • one for each Director’s suggestion. • Show all your workings

Answer plan a) • Director A • Comment on the gearing • COC of 10. 06 or 10. 74 toward the NPV • Arguments against using WACC? • Proposed project is a major diversification • Hence WACC does not capture the risk of the new venture • Arguments against for using WACC • The project is marginal, that is, it is small relative to the size of the entity • Gearing doesn’t change drastically

Answer plan a) • Director B • The theoretically correct approach • Gearings are significantly different from ABC. • However, the equity beta is influenced by the level of financial risk (gearing). • Unless the market-weighted gearing of XYZ is the same as ABC, it is necessary to “ungear” the equity of XYZ. • Regear to take account of ABC’s financial risk: • Prior or post capital structures can be used for regearing

Requirement b) • Discuss how ABC’s market capitalisation might change during the week • the proposed investment becomes public knowledge. • No calculations are required for this part of the question.

Answer plan • EMH – 3 forms and how the price will react if semi-strong form exists • In theory, if the market agrees with ABC’s figures and confidence in its ability to handle the diversification, the market capitalisation will increase by the NPV of the venture; • Change in price depends on how the market receives the information – major diversification could be seen as a positive or negative; • Market capitalization will increase if the public perceives its successful • There will be external factors that affect the price/value as well as what is happening at ABC.

Question 7 - requirement a) • Discuss the meaning of the terms “systematic” and “unsystematic” risk • Their relationship to a company’s equity beta. • Include in your answer an appropriate diagram to demonstrate the difference between the two types of risk.

Answer plan a) • Risk that cannot be diversified away is called systematic risk • Risk that can be reduced by diversifying the securities in a portfolio is unsystematic risk. • Beta is the measurement of systematic risk estimated by considering the volatility of an individual share price movement against the movement in the market as a whole • An entity with an equity beta greater than 1 would be expected to have systematic risk proportionately greater than the risk of the market( vice versa)

Diagram

Requirement b) • Using the CAPM and the information given in the scenario about CIP and Companies A and B, calculate for each of CIP’s proposed investments: • An asset beta. • An appropriate discount rate to be used in the evaluation of the investment

Requirement c) • Evaluate • The benefits • Limitations • Of using each of the following in CIP’s appraisal of the two investments: • CIP’s WACC. • An adjusted WACC as suggested by the Managing Director. • CAPM-derived rates that use proxy (or surrogate) companies’ betas.

Pros and cons of the discounts rates • WACC • Easy to understand • Theory does not support using WACC for investment appraisal • Discrepancies in capital structure • Adjusted WACC • suffer from the same problems as the basic WACC • easily understood by non-finance people • CAPM-derived rates • It is based on historical data • Comparisons with proxy companies are difficult as they assume close similarity of activities and business risk

CAPM derived rates • CAPM is a single period model, The risk of the investments could well change over their lives. • It is based on historical data and the variance surrounding beta is large; using the CAPM at all can only provide a rough estimate. It also assumes that past variability with the market will continue. • CAPM assumes only systematic risk needs to be captured as unsystematic risk has been diversified away. • This might not be true in a single, relatively small private company with few shareholders, whereas the proxies are listed companies with, presumably, a large number of unconnected shareholders. • Comparisons with proxy companies are difficult as they assume close similarity of activities and business risk. No two companies are exactly alike and even if the activities seem similar their operations could be quite different in terms of business risk.

Requirement d) • Discuss, briefly, how an asset beta differs from an equity beta • And why the former is more appropriate to CIP’s investment decision. • Include in your discussion some reference to how the use of the CAPM can assist CIP to achieve its financial objective.

Answer plan • Distinguish asset and equity beta • Refer to the case • Use of CAPM • Comparison with the current rate

Explanation of asset and equity betas, investment appraisal and objectives • An equity beta is the beta that attaches to a company’s shares • An asset beta reflects business risk assuming a company is ungeared • An asset beta is more useful than an equity beta in Proxy companies A and B because it incorporates the total business risk inherent in those companies • stripping out the impact of the financing structures of the individual companies.

Explanation of asset and equity betas, investment appraisal and objectives • Companies A and B have been selected as proxy companies primarily because they have the same business risk. • The asset beta does not take into account the financing structure of the investments, Therefore, the asset beta needs to be adjusted. This is achieved by re-gearing the asset • After re-gearing the beta comprises of both Biz and Fin. Risk.

Explanation of asset and equity betas, investment appraisal and objectives • The CAPM- derived rates calculated in part (b) suggest that for the investments under consideration lower rates would be more appropriate than 12%. • CIP would have rejected investment opportunities that would have been profitable and therefore contributed to the achievement of its objective. • On the other hand if the CAPM had suggested rates above 12% then CIP would not be fully compensating shareholders for the risks inherent in its investments

Question 8 • a) • Calculate the current WACC of Claudia (before taking the project into account). • b) • Evaluate the project using the current WACC calculated in part (a

Question 8 c) • Calculate the post-project WACC for Claudia after adjusting for the NPV of the project and the increased debt, • Discuss your results. • Discuss and advise whether the pre-project WACC was an appropriate discount rate for Claudia to use in this scenario.

Answer plan for c) • Suitability of the current WACC in project appraisal: • The WACC has fallen slightly from 5. 13% to 4. 95% but there is insufficient change to invalidate the use of the current WACC in the evaluation of the project. • Risk. • There is no indication that the project has a different risk profile to that of the business as a whole. • Upgrading IT systems is in line with normal business practice for this company and this business sector.

Answer plan for c) • Conclusion • Therefore the current WACC is considered to be a suitable discount rate with which to evaluate this project. However any other non financial factors should be also taken into consideration.

Requirement d) • Discuss the key factors that Claudia should take into account in respect of this project when: • assessing customer requirements • drawing up an implementation plan

Answer plan d) • Assessing customer requirements • essential stage to the success of the project • requires careful market research amongst customers and also a review of competitors’ systems • include review of language, security, ease of use, speed of internet access of customers • use market survey at order point – ask customers for feedback when they place an order through the website • Drawing up an implementation plan • timetable key processes and dates • key tasks allocated to project manager and team members • frequent review of progress against the plan to ensure no overrun on timing • project manager to monitor actual costs and revenues against budget and take remedial action to address any problems arising • train staff • careful testing of the system and trial run before live running • parallel running of the new system before closing the old system (if possible)

Question 9 -a) • Calculate the weighted average cost of capital of JKL. • Advise on the appropriateness of using the WACC of JKL as the discount rate in GOH’s project appraisal, • Including reference to the differences in the financial and non- financial objectives between the public sector and private sector.

Answer plan ii) • A private sector organisation is likely to have very different financial and non-financial objectives than a public sector organisation. • A private sector organisation will focus on maximising shareholder wealth by maximising profits • A public sector organisation will usually have a greater focus on non-financial objectives such as: • value for money; • social benefits (including education and health); • environmental benefits (of growing concern);

Answer plan ii) • A lower discount rate is appropriate for a public sector organisation such as GOH because it is not necessary to make the large returns that shareholders expect in a private sector organisation. • The 4% rate is often set to reflect ‘time preference’, that is, the preference of society as a whole to receive goods and services sooner rather than later. • Inputs are also different. A public sector organisation measures returns and benefits of a project in a nonfinancial nature (such as improvements in public health) and so it is appropriate to include estimates of these nonfinancial benefits in an appraisal exercise.

Answer plan ii) • In addition, the funding structure of JKL and GOH are completely different. JKL’s WACC will reflect both the high returns demanded by equity holders and also the cost of debt whereas GOH will effectively only be funded by debt. • Based on the above, using the WACC of JKL as a discount rate for GOH’s project appraisal is not appropriate. However other non financial factors should be considered.

Requirement b) (i) Calculate the project NPV following government’s guidelines (ii) Advise GOH on other issues that need to be taken into account before deciding whether or not to proceed with the proposed project

Answer plan (b) ii) • Sensitivity analysis to ascertain the critical variables. • In particular, the social benefits of the health centre should be considered in depth. These appear to have been factored into the cash inflows in terms of “perceived social benefits” of inflows but these are extremely difficult to quantify unless the government has some established basis of quantification. • The relationship of the investment to GOH’s objectives should be examined. • This is a very long term investment that has obvious follow on expenditure in 15 years time. In this case, 15 years might not be long enough for the evaluation.

Answer plan (b) ii) • The availability of government funding both for the initial investment and the on-going running costs of the centre. • Prioritising the use of government funds – what would they be used for if not used for the health centre – where is the greatest need. • Alternative strategic approaches could be examined such as: • co-operating with other government agencies • provision of the service by the private sector • refurbishing existing facilities rather than building new

Adjustment of FOREX to Investment decisions. • Eg: -A Sri Lanka Based company is looking for options for an investment in US. The expected incremental CF are as follows • Y 0 – ($50 m) • Y 1 - $20 m • Y 2 - $25 m • Y 3 - $30 m • DCF = 12% • Current Spot Rate US $1= LKR 140 • The LKR is expected to weaken by 2% per annum

Question 10 a) i. • Calculate the profitability index and equivalent annual annuities for all three projects; • Explain the usefulness of these methods of evaluation in the circumstances here • Recommend which project(s) should be undertaken.

Answer plan a) i. • PI • The profitability index is the NPV expressed as a percentage of the initial investment • PI is most appropriate when projects are divisible. • Indeed, in many cases a PI analysis will identify the optimum combination of projects. • Annual equivalent method • This is found by dividing the project’s NPV by the relevant annuity discount factor. • Determines the constant annual cash flow that offers the same present value as the project’s NPV

Answer plan a) i. • Recommendation • Since the projects are not divisible a trial and error method is recommended to arrive at the best combination • The combination of projects B&C gives the highest NPV and PI, but this would exceed the entity’s investment limit

Answer plan a) i. • The combination of B&C is only marginally above the investment limit and it might be possible to borrow such a small amount, relative to the size of the investments • If the entity does not wish to exceed the $30 m limit under any circumstances, the only option is to invest in A&C, even though this is sub-optimal in terms of NPV and, to a lesser extent, PI. • It also leaves balance of $1⋅8 m to invest elsewhere, or borrow less.

Question 10 a) ii. • Explain the differences between “hard” and “soft” capital rationing • Which type is evident in the scenario here. • Discuss, briefly, the advisability of the directors of HIJ limiting their capital expenditure in this way.

Answer plan a) ii. • Hard capital rationing occurs when external limitations are applied to the entity, as when additional borrowed funds cannot be obtained. • This might be because there is an economy-wide squeeze on the availability of new capital. • Soft capital rationing is the result of an internal budget ceiling being imposed on capital expenditure by management. • The type in evidence here is mainly “soft” rationing, although the high interest rate that might be applied on additional borrowing suggests an element of “hard” rationing.

Advise • This is a private entity and the Directors may have their own reasons for sub-optimal investment. Also, the assumption that funds will be forthcoming for all projects that offer an adequate return are subject to various qualifications, such as: • Differences of opinion on return between lender and borrower; • Potential loss of control; • Shortage of skills to undertake projects; • Conflicting evidence of various ranking methods.

Question 10 a) iii. • You later discover that the discount rate used was nominal, but the cash flows have been calculated in real terms. • Explain, briefly, how the calculation for NPV should be adjusted • What effect the changes might have and on your recommendation. • You are not required to do any calculations for this section of the question

Answer plan a) iii. • If the cash flows are in real terms and the discount rate is nominal then either the cash flows have to be adjusted for year on year inflation or the discount rate has to be converted to a real rate using the formula • 1 + nominal rate = [(1 + real rate) x (1 + inflation rate)] • Whichever approach is taken, and the former is the most common, the result will be to increase the NPVs. • If the cash flows of all three projects are affected by the same rates of inflation in the same proportions then the ranking of the projects NPVs willnot change. • However, if the pattern and type of cash flow within each project is affected by significantly different levels of inflation, then the ranking may well change.

Question 10 b) • Discuss, with supporting calculations, whether this new information would change your recommendation using an APV approach incorporating the NPV in the scenario as the “base case”.

Answer plan b) i Revise Rankings

Question 11 - Requirement a) i. • Calculate the NPV and PI of each of the THREE projects based on the LKR cash flows. ii. • Evaluate your results • Advise PEI which project or combination of projects to accept.

Answer plan for requirement a ii) • The profitability index (PI) shown above is the NPV expressed as a percentage of the initial investment, this is the “net” method. • PI is most appropriate when projects are divisible. However, it is technically acceptable to apply the profitability index alongside other analysis when determining the best combination of non-divisible projects in a capital rationing situation. • In many cases a PI analysis will identify the optimum combination of projects.

Answer plan for requirement a ii) • As all three projects cannot be undertaken given the entity’s capital expenditure limit of Rs. 25 million, it is necessary to look at combinations of any two projects. • The combination of projects A&C gives the highest NPV, B&C has the highest ranking using PI, and is well within the company’s investment limit, leaving just over Rs. 5 million to invest elsewhere. • A&B breaches the limit of capital available. This combination also ranks last so PEI might not wish to even consider sourcing the additional Rs. 700, 000 required to make both investments

Answer plan for requirement a ii) • PI should only really be used if the projects being considered are of equal duration and equal risk. • Here we are comparing A + C with B + C. we can be fairly confident that the top ranking PI combination of B + C is superior to the highest ranking NPV combination of A + C assuming that we can make constructive use of the unused capital. • Conclusion: The best investment appears to be a combination of Projects B and C. however non financial factors should be taken into consideration.

Requirement b) • Explain the alternative method of evaluating Project C using an A$ discount rate • illustrating your answer with a calculation of an appropriate A$ discount rate.

Answer plan for requirement b) • The alternative method involves working with A$ cash flows and an A$ discount rate. • • The expected movements in the LKR /A$ exchange rate are taken into account in the adjusted discount rate. The A$NPV result is then converted into LKR at the spot rate. • The DCF as per this scenario amounts to 7. 39%

Requirement c) • Discuss the key financial factors, other than the NPV decision, that should be considered before investing in a project located in a foreign country rather than the home country.

Key factors to consider include: • Foreign exchange exposure arising on Project C. • Availability of suitable finance. PEI has cash available but this might not be the most appropriate type of finance in a foreign investment. Borrowing in A$, if available, would provide a natural hedge by matching (to a greater or lesser extent) income streams with interest payments and A$ denominated assets with liabilities. • Risk appetite of shareholders. This is a private company and the profile of shareholdings is not known but it is likely that at least some of the shareholders are also directors or employees of the company.

Key factors to consider include: • Political risks – the foreign country in which Project C will be invested is not specified but investment in any foreign jurisdiction carries some risk. • Tax implications – these might have been accounted for in the net operating cash flows but PEI needs to assess the impact of differential tax rates and/or whether a double taxation treaty exists between the two countries. • Appropriateness of the discount rate – no indication was given as to how the 9% was determined.

Question 12 • (a) • Calculate the net present value (NPV), internal rate of return (IRR) and (approximate) modified internal rate of return (MIRR) as at 01 January 2017 for the proposed project. • Discuss the advantages and limitations of MIRR in comparison with NPV and IRR.

Answer plan for requirement a) • MIRR Vs IRR • MIRR is intended to address some of the deficiencies of IRR; notably that it eliminates the possibility of multiple rates of return and seeks to adjust the IRR so that it has the same reinvestment assumption as NPV • (ie: that the cash inflows of a project are reinvested at the company’s cost of capital).

Answer plan for requirement a) • MIRR vs NPV • The MIRR, like IRR, is biased towards projects with short payback periods which is not the case with NPV. • It could be argued that this bias is advantageous as a short payback means that funds are available earlier for reinvestment . • However, MIRR (again like IRR) gives a rate and as such gives no indication of the size of a project, whilst NPV does. • Ultimately despite its advantages, MIRR does not appear to be understood or used as extensively in practice as NPV and IRR.

Requirement b) • Evaluate the likely impact of the project on MR’s ability to meet its financial objectives assuming the project goes ahead.

Answer plan for requirement b) • Project’s contribution to achievement of financial objectives • The proposed investment demonstrates a positive NPV at a discount rate that reflects the specific risk of the project. As we would expect with a positive NPV, the project’s IRR and MIRR show returns greater than this risk adjusted cost of capital. • It should therefore contribute to MR’s main financial objective to achieve a return on shareholder’s funds of 11%. • Borrowing Rs. 23 million will however take the company dangerously close to its objective of a maximum gearing ratio of 35%.

Answer plan for requirement b) • At present its gearing is: 350/ (760+350) = 31. 5%, • Assuming market value is increased by the NPV of the proposed project and 50% of the cost is borrowed, gearing becomes: • (350+23)/(760+7+350+23) = 32. 7%

Other factors • Gearing based on market values changes day to day and the market value of securities is affected by external factors as well as those internal to the company. • A financial objective based on such volatile variables is difficult to monitor or achieve on a regular basis. Gearing based on book values might be a useful supplementary objective. • The NPV of the project will be evaluated by the market once information is released and this value might be more or less than MR has calculated. • The NPV is heavily influenced by the end-of-project residual value of the non-current assets and the value of current assets. Also, three years is a very short time over which to evaluate such a project. The evaluation should extend over a much longer period, at least 10 years for a project such as this.

Question 12 • a) Calculate, as at 1 January 2017: (i) The NPV of the project at CIP’s existing WACC of 10%. (ii) The NPV of the project at a risk adjusted WACC using PPP as a proxy company in respect of business risk. (iii) The APV of the project.

Points to note • Base–case discount rate • Under APV to discount the project cash flows we need a discount rate that assumes that the project is fully funded by equity. • Therefore the discount rate should be the cost of equity for an all equity financed company. To establish this we need an asset beta appropriate to the project, which we have already calculated above as 1. 66. • This then needs to be applied to the CAPM formula to establish the ungeared cost of equity

Points to note • We will round this to the nearest whole number – therefore a rate of 12% should be applied to the cash flows to establish the base case. • Given that this is the same discount rate as above the base case NPV is therefore negative at Rs. (485, 300).

Requirement b) • b) Evaluate the potential financial benefits of the project. Your answer should include discussion on the appropriateness of each of the methods used in part (a) to appraise the project

Answer plan b) • Based on considering only the financial benefits, the project would be rejected under the two NPV methods but accepted under the APV method. • Therefore before making a recommendation we need to consider the appropriateness of each of the methods in turn.

Answer plan b) • NPV at existing WACC • The company’s existing WACC is not appropriate here as both the business risk and financial gearing of the project are different from those of the company itself prior to the project. • The proposed project carries a higher level of risk than CIP’s current business activities. In addition, the benefit to the company of the subsidy on the government borrowing and access to higher levels of debt (leading to higher tax relief) is project-specific have not been taken into account.

Answer plan b) • NPV at risk adjusted WACC • The risk adjusted WACC is superior to the existing WACC in that it provides an adjustment to reflect the business risk specific to the project. A proxy company’s beta is used for this purpose. • However, this method does not solve the financing issues identified previously in the discussion of the use of the existing WACC.

Answer plan b) • APV can be used in situations where a project has special financing features such as providing access to subsidised financing or where the financing structure of the project is more relevant to the project appraisal than the financing structure of the company itself • Where the project represents a new area of business for the company where a different capital structure is appropriate).

Answer plan b) • For CIP, the APV approach has the advantage of taking into account: • The NPV of the subsidy on the government borrowing (net of issue costs). • Greater tax benefit due to the higher level of debt funding supported by the project. • By using the ungeared cost of equity derived from the proxy company, APV is correctly based on the project risk rather than CIP’s current business risk.

Requirement c) • Advise the directors of CIP whether they should proceed with the project.

Answer plan c) • Advise on whether to proceed with the project • Based on APV we should accept this project. • We should, however, recognise that this decision relies on the underlying assumptions of APV analysis, including the important assumption that it is appropriate to use the actual gearing level for the project where different projects support different levels of debt, as appears to be the case here.

Specific investment decisions • Mergers and acquisitions: reasons • Increase market share • To yield combine economies of scale • To gain tax reliefs • In order to reduce risk • Divestment/ Exit • Sell off • MBO • Spin off

Investment decisions and valuations Asset based • Earnings based Approaches Book value, realizable values Dividend based P/E or Market Based PV of FCF Cash flow based SH value analysis Economic value added

Question 14 • (a) • Calculate a range of values, in total and per share, for SB. • Advise the directors of SB on the relevance and limitations of each method of valuation to an entity such as theirs, and in the circumstances of the two alternative disposal strategies being considered. • Recommend a suitable valuation figure that could be used for a trade sale or an IPO.

Requirement a • The following three valuation models are considered • Asset based • Earnings based • Cash flow based

Asset based • The net book value of SB 's net assets is Rs, 22⋅5 million at the last balance sheet date. • This value has little relevance except in specific circumstances such as a liquidation or disposal of parts of a business. • In SB’s situation, it has even less relevance than in an entity with a high level of tangible assets as much of its value is in employees' expertise, or intellectual capital. • It is therefore unnecessary to consider the book value of assets further. It is sometimes claimed that net asset value provides a "floor" level valuation, but in the circumstances here this is unrealistic.

Earnings based • The P/E ratio can be viewed as indicative of expected growth. • A relatively high P/E would suggest that investors are prepared to pay a premium for the entity's shares, based upon present earnings, because they anticipate growth in future earnings beyond growth rates expected in comparable entities.

Limitations of PE • Market capitalisation is not necessarily the true value of an entity as it can be affected by a variety of extraneous factors • In the case of an unlisted entity, using the P/E ratios of similar quoted entities take no real account of SB’s specific circumstances and potential • Establishing a level of earnings for SB that is sustainable is very subjective especially in such a high risk business.

Cash flow based • DCF/NPV analysis is theoretically correct method of valuation as it recognises future cash flows and discounts them at a rate that recognises their specific risk. • Limitations • It is based on an entity’s own estimation; • In the case here, it is necessary to use an industry cost of capital, which could be wildly inaccurate for SB; • Using perpetuity to value cash flows from 2020 onwards is a serious over-simplification (although justified in an examination situation).

Summary • As discussed, the asset value is largely irrelevant. • The P/E basis is a useful benchmark, but is highly unreliable because of difficulties in comparing SB with the industry. • The DCF method is the most likely to be reliable and is remarkably close to the value provided at the middle of the P/E range. However, the DCF is heavily influenced by the use of a perpetuity. • Both methods are flawed, but an estimated valuation of around Rs. 300 million or Rs. 60 per existing share could be considered

Requirement b) • Advise the directors of SB on the advantages and disadvantages of a trade sale compared with a stock market flotation at the present time • Recommend a course of action

Trade sale versus IPO- advantages • The main advantages of a trade sale are that the administrative costs are likely to be relatively low (although legal fees could be high) and the directors will make a “clean” exit from the entity, even if they are retained as advisors. • The sales value will be known and not subject to the vagaries of the stock market, which is a major consideration at the present time, and environmental issues might have a negative effect on the acceptance of SB’s entry to the market.

Trade sale versus IPO- disadvantages • A trade buyer is likely to try to value the entity lower than a sale on an open market as they will no doubt question growth rates and so on. • However, the value of the NPV of the cash flows is very likely to increase once they value the cash flows as part of their own operations, for example economies of scale might reduce the operating costs • The directors might be subject to a hefty capital gains tax unless they enter into a phased payment deal, possibly linked to share options in the buying entity.

Trade sale versus IPO- disadvantages • The directors may forgo the benefits of the future growth of the entity, which could be substantial given the impending developments. • If the directors not unanimous in their decision, a trade sale is unlikely to succeed.

Recommendation • The directors should decide on their own personal objectives for the future. • If they are not unanimous in their wish to exit SB, an IPO might give them more flexibility. A starting point should be an independent valuation exercise that provides a bargaining position with potential trade buyers. • If they try for an IPO that fails, they might have lost their opportunity for a trade sale. If they fail to reach agreement on a trade sale, the option of an IPO is still available.

Question 15 - requirement a) a) Assuming synergistic benefits are realized, evaluate bid offer A and bid offer B from the viewpoint of: • MMM’s existing shareholders. • JJJ’s shareholders. • Up to 7 marks are available for calculations

Answer plan for a) • MMM shareholders can expect to make a higher financial gain under the cash offer than under the share offer. • Under the cash offer, the share price is expected to increase from Rs. 6. 90 to Rs. 7. 06, a gain of Rs. 0. 16 per share and Rs. 4. 7 million in total. • Under the share offer, a lower rise in the share price is expected, from Rs. 6. 90 to Rs. 6. 98 per share, a total of Rs. 2. 4 million.

Answer plan for a) • JJJ shareholders can expect to benefit from an immediate and certain financial gain of Rs. 3. 3 million (Rs. 67. 5 million - Rs. 64. 2 million) under the cash offer. • They need to weigh this up against a theoretical gain of Rs. 5. 6 million (Rs. 69. 8 million - Rs. 64. 2 million) from the share offer. • However the share offer carries greater risk for the shareholders of JJJ because they are exposed to the risk of a fall in the share price of MMM if the market fails to respond to the merger favourably and/or the potential synergistic benefits are not realised. • They are also accepting a shareholding in a company with lower growth prospects than JJJ and lower growth in value could wipe out any short term gains.

Answer plan for a) • The value of JJJ assumes a growth rate of 9% which is considerably higher than MMM’s growth rate of 6%. • It is important that MMM’s management is able to manage business activities acquired from JJJ efficiently in order to protect the higher growth rate associated with these activities. • If JJJ’s activities are simply merged into MMM’s business structure, there is a danger of the growth rate associated with JJJ’s business area dropping to something closer to MMM’s previous growth rate of 6%. That would clearly have a serious impact on shareholder value.

Answer plan for a) • The cash offer has the advantage of protecting the proportionate ownership of the current shareholders of MMM. • After the share offer there would be 40 million shares on issue, including 10 million held by the previous shareholders of JJJ. • However, the cash offer has the problem of accessing the required funds. Rs. 67. 50 million is a material value to raise for a company that has a market capitalisation of just Rs. 207 million.

Answer plan for a) • MMM would need to consider the impact on gearing levels and earnings per share of the new borrowings. The share offer also has cash flow implications in paying future dividends on a larger number of shares. • This could have an even greater call on cash over time but has a delayed impact on cash flow.

Requirement b) • Advise the directors of MMM on: (i) The potential impact on the shareholders of both MMM and JJJ of not successfully realising the potential synergistic benefits after the takeover. • Up to 5 marks are available for calculations

Answer plan for b) • MMM’s shareholders can expect to see a fall in share price under both the share offer and the cash offer (in the order of Rs. 3. 6 million for the share offer and Rs. 3. 3 million for the cash bid). • The acquisition will therefore only be attractive to MMM’s shareholders if additional benefits can be realised such as the synergistic benefits arising from improved IT/IS systems or enhanced future growth throughout the business.

Answer plan for b) • JJJs shareholders would expect to benefit from an immediate and certain financial gain of Rs. 3. 3 million (Rs. 67. 5 million - Rs. 64. 2 million) under the cash offer and a higher theoretical gain of Rs. 3. 6 million (Rs. 67. 8 million - Rs. 64. 2 million) under the share offer. • However, the share offer carries greater risk for the shareholders of JJJ because they are exposed to the risk of a fall in the share price of MMM if the market fails to respond to the merger favourably and are also accepting a shareholding in a company with lower growth prospects than JJJ.

Requirement b) ii) • The steps that could be taken to minimise the risk of failing to realise the potential synergistic benefits arising from the adoption of JJJ’s information technology and information system

Answer plan for b) ii • The realisation of synergistic benefits will depend upon a smooth and efficient integration process. Key issues to discuss: • Careful planning – detailed timetable, allocated responsibilities, interim targets. • Retention of key personnel (programmers and operators) possibly by offering enhanced packages and by keeping these personnel fully informed. • Building good relationships between staff transferring from JJJ to MMM.

Answer plan for b) II) • Training of key personnel on how to operate the system. • Parallel running of the systems and possible test data before going live. • Looking at post completion audit reports of any such projects that have happened before to see if any lessons can be learnt. • Proper management control via regular meetings and involvement of key personnel throughout

Question 16 a) • Discuss and advise the directors on the likely success of the bid based on the current offer and current market data. • Recommend, if necessary, revised terms for the share exchange

Answer plan • The terms of the bid are 2 LP shares for 1 MQ share. On today's share prices, the market appears to be expecting a substantially increased bid; 2 LP shares are worth Rs. 6. 10 whereas 1 MQ share is worth Rs. 6. 80. • On this ratio the bid could not possibly succeed. LP would need to raise the bid to at least 2· 3 shares for 1 MQ share for MQ’s shareholders to be no better off than if they sold in the market. • To ensure, as far as possible, acceptance by MQ’s shareholders a revised bid would probably have to be at least Rs. 8. 16 or around 2· 7 for 1 (any sensible ratio is acceptable here but it should show a premium on MQ’s pre-bid share price.

Key points to consider: • The bid is taking place in a dynamic market and there are other, external influences that might affect share prices. • Over the last month the share price of LP has fallen, while that of MQ has increased. This is not untypical in bid situations and reflects uncertainty of the market of the likely success of LP’s bid and increased interest in the shares of the target. Studies have shown that in hostile bid situations bidders typically pay too much to acquire their target.

Key points to consider: • The share prices of the two entities will react to any revised bid based on market perceptions of the benefits to be gained by the shareholders of the two entities. If the market thinks LP is paying too much, its own share price will fall, thus making the terms less attractive to MQ. • Evidence has shown that in a hostile bid it is usually the target entity's shareholders who obtain all the gains from a merger

Conclusion • Advice should be that the bidder must make a realistic assessment of what MQ is really worth to it. MQ’s earnings last year were Rs. 156 million. • If LP applies its cost of equity to MQ’s earnings in perpetuity, this would give a value for the entity of Rs. 1· 56 billion. • Its current market capitalisation is Rs. 884 million. This suggests there is substantial potential for growth although valuing earnings as a perpetuity is a very crude method

Question 16 b) • Discuss the advantages and disadvantages of offering a cash alternative to a share exchange. You should include the following calculations in your answer: • The amount of cash that would be needed based on your recommendation of revised terms in part (a) above; • The impact of the proposed finance on the combined entity's gearing (debt to debt plus equity).

Answer plan • The main advantage of offering cash as an alternative to a share exchange is that the future gains from the merger are obtained by a proportionately larger number of the bidding entity's shareholders

Disadavantages • That cash has to be raised, most probably by the issue of a long-term debt instrument. • There might also be taxation implications for individual shareholders, although as the offer is optional, this should not be a problem. • It is necessary to recognise that as some of both LP’s and MQ’s existing debt matures within the next three to four years, refinancing needs to be considered. LP will, of course, obtain MQ’s cash balances post-merger, but the cost of the acquisition process is likely to be high and will require a considerable amount of cash-generating capacity in the short-term. Also, the cash available at the balance sheet date (six months’ ago) might not be available now.

Effect on gearing • This is difficult to do without more information and it is almost impossible to forecast the value of the equity post-merger. • Current gearing: • D/D+E = 350/350 + 1, 464 = 19· 3% • Approximate gearing for enlarged group if a full share exchange • D/D+E • * = 455/455 + (1, 464 + 1071) = 15· 2%

Requirement b) ii) • Recommend how the cash alternative might be financed

Answer plan • A rights issue is a possibility but this would take considerable time to organise and in the circumstances here is very unlikely. • The most likely form of finance is a long-term debt instrument as noted above. Secured debt with a maturity of 10 to 15 years would be the most obvious, but alternatives that could be considered and that have cost advantages are convertible debt or debt with warrants.

Answer plan • A discussion of the features and benefits of these types of debt is not required, but the key feature is that they tend to offer lower rates of interest because of the opportunity of buying into the entity's equity "cheaply" at some future date. • Debt with warrants also has the advantage that additional money will be raised at some time in the future, subject of course to the holders exercising their warrants. Convertible debt does not raise additional money, but has the advantage of being self-liquidating if all holders convert into equity on or before the final maturity date.

Question 17 • (a) (i) Describe two possible reasons, other than the use of an aggressive strategy to manage working capital levels, for the differences in working capital days between those expected for the project and historical data for RPS. (3 marks)

Answer plan • Report structure is expected • To: The main board of RPS • From: Mr X • Date: 1 st June 2016. • Subject : Project team for “A” country convenience store project

Working capital strategy Working Project RPS Difference capital days Accounts Nil Nil receivable Accounts 100 days 139 days -39 days 30 days -23 days payable Inventory 53 days

Two reasons • The A convenience stores are likely to carry a different profile of goods than the average store operated by RPS 1. Inventory in the convenience stores will include a greater predominance of fresh foods, which are perishable and therefore require a fast turnover. Inventory days for the convenience stores can therefore be expected to be lower than the average figure for the RPS - where a wider range of both perishable and nonperishable products are held in inventory

Two reasons • The most likely explanation for the lower accounts payable days estimate for the A stores is that A suppliers are able to demand more favourable payment terms than RPS is used to being able to negotiate elsewhere. Shorter credit periods may also reflect the higher service level required in order to maintain inventory levels at all times in convenience stores.

Question 17 • (ii) Discuss the benefits and potential drawbacks of the proposed aggressive strategy for managing working capital for the project. (6 marks)

Answer plan • An aggressive strategy with regard to the management of working capital levels will mean that inventory will be kept to a minimum and accounts payable maximised to the extent that the particular market will accept. • The A convenience stores are not expected to have any accounts receivable, so we do not need to consider the benefits and potential drawbacks of an aggressive strategy for managing accounts receivable

Benefits of an aggressive strategy • • Cash flow advantages arising from having low investments in inventory in the first place and from paying suppliers as late as possible. This has the benefit of reducing the level of finance needed to support the working capital investment which then leads to lower borrowing costs. • • Reduced costs of holding inventory, although this might be mitigated by additional delivery costs.

Potential drawbacks of an aggressive strategy • • Higher risk of stock outs from holding low levels of inventory – leading to customer dissatisfaction and possible loss of customers both in the short term and the longer term. • • Dissatisfied suppliers facing payment delays - leading to a higher risk of loss of supply or lowering of quality, especially in times of shortages. • • Attempts by suppliers to charge higher prices in order to compensate for later payment.

Question 17 • (iii) Calculate the forecast accounts payable and inventory balances for each year of the project. (5 marks) • (b) (i) Calculate the forecast project net present value (NPV), in LKR, as at 1 January 2017. (14 marks) • (ii) Calculate the change in the project NPV if the value of the properties, excluding fittings, on 31 December 2020 is 20% lower than the original purchase cost of A$ 30 million. (3 marks)

Question 17 • (c) Advise whether or not to proceed with the project, taking into account: • • Your results in (b)(i) and (b)(ii) above. • • The reasonableness of the key input variables used in the NPV appraisal. • • The potential risks to RPS of establishing a new business in a foreign country. (16 marks) • Additional marks available for structure and presentation: (3 marks)

Answer plan • The project is expected to generate a significant return with a net present value of LKR 29, 987. Purely on this basis the project to set up 50 new convenience stores in the A should be undertaken. However non financial factors should be taken into consideration • However, the DCF results depend heavily on the reliability of the input variables, as is demonstrated by the results of the sensitivity analysis in (b)(ii) • Just by changing the assumption relating to the value of the properties on 31 December 2020 from a 20% increase to a 20% decrease, the NPV would fall by LKR 8087 to LKR 21900(using the result obtained from the incremental approach), a fall of 27%

Answer plan • Given that property prices are volatile and past experience shows that values can fall significantly, then it could be argued that an evaluation based on a 20% drop in value would be more prudent for decision making purposes.

• The cost of capital used of 11% is the rate applicable to RPS as a whole and may not be appropriate for this investment, especially as the project is overseas. • It would also be more prudent to assume that annual working capital investment/cash release occurs at the end rather than at the beginning of each year since cash is released from working capital rather than absorbed in each financial year until the final year.

Other input variables that may prove to be unreliable estimates • The Growth rate (which appears to be highly optimistic at 12%, although this is, presumably, a money rate, including any inflationary expectations, but may well be unsustainable at that level). • Revenue (which depends heavily on having the correct business model to meet customer preferences). • Costs (which depend on correct estimates of required staffing levels and salary costs).

Additional risk • Foreign exchange risk • Understanding customer preferences – especially given that this is a different type of store than previously operated in the A. • Local regulatory environment including taxation and reporting, plus health and safety etc. • Adapting the culture of the business to fit with RPS’s culture while being sensitive to local differences in culture that need to be retained and working within these.

Additional Forex risk • Local resistance from customers to foreign ownership. • Communication difficulties across different time zones. • Understanding the demands of government and any steps required to avoid government intervention. • Integrating different systems. • Conducting business in a different business environment – understanding local protocol and business practices. • Financial management in a different environment (eg working round the absence of credit interest on bank accounts in the US)

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