Monitoring Test MT2A

Financial
Management

F9FM-MT2A-Z08-A

Answers & Marking Scheme


Accountancy Tuition Centre Ltd

ATC
INTERNATIONAL

Accountancy Tuition Centre (International Holdings) Ltd 2008 2
1 WATER SUPPLY SERVICES PLC
(a) Rental costs based on projected sales. Sales growth at 15% per annum.
Period: 1 2 3 4 5
Units: 110,000 126,500 145,475 167,296 192,391
Existing capacity: 80,000 80,000 80,000 80,000 80,000
Extra capacity required: 30,000 46,500 65,475 87,296 112,391
Number of machines required: 1 2 2 2 3
Rental costs ($): 22,000 44,000 44,000 44,000 66,000

Unit variable costs
$/unit
Labour (45+64) 109.00
Material A costs 23.85
Material B costs (5 12.45) 62.25
Variable overheads 2.00 5kg 10.00
______
Unit variable costs 205.10

Incremental cash flow schedule:
Year: 0 1 2 3 4 5
Units: 110,000 126,500 145,475 167,296 192,391
Incremental Units: 30,000 46,500 65,475 87,296 112,391

$ $ $ $ $ $
000 000 000 000 000 000
Variable Costs: (6,153) (9,537) (13,429) (17,904) (23,051)
Fixed Costs: (50) (50)
Machine Rentals: (22) (44) (44) (44) (66)
______ ______ ______ ______ ______
Allowable Costs (6,175) (9,581) (13,473) (17,998) (23,167)
Incremental Revenue 7,719 11,976 16,841 22,498 28,959
Capital Costs: (7,500) (30)
Working Capital (1,158) (639) (729) (849) (969) 4,344
______ ______ ______ ______ ______ ______
Net cash flow (8,658) 905 1,666 2,519 3,501 10,136
DF at 20% 0833 0694 0579 0482 0402
PV (8,658) 754 1,156 1,459 1,688 4,075
NPV 474

Decision: project is worthwhile

Accountancy Tuition Centre (International Holdings) Ltd 2008 3
(b) Report to the Board of Directors
(Forecasting)
December 2008
Prepared by the Senior Accountant
Limitations of the five year period of analysis
A number of limitations to the analysis potentially arise:
The approach does not take account of future benefits/costs after five years either
continuing or new;
No information on contract length from the Water Authorities which may be longer
than five years;
Other, cheaper, resources may be available over a longer period e.g. it may be
cheaper to buy machines rather than rent them;
Analysis does not take account of the potential for physical site capacity increases
that may become available after five years.
Problems and difficulties associated with forecasting
We have relied to a great extent on the forecasting of data in order to provide an evaluation of
the proposal. Not all the components are forecast: for example, we will know that we are able
to recover agreed costs. However, to the extent that components are forecast, there exists the
potential for error in our evaluation which, of course, leads to uncertainty in our conclusions.
In particular, the following problems are evident at this stage:
uncertainty increases with the length of time forecast. That is, the further into the
future, the less able we are to predict with accuracy because our initial assumptions
may be wrong and small errors at the beginning magnify subsequently as the
forecast becomes increasingly irrelevant to what is actually happening to the key
variable in question. For example, we may have not predicted general inflation rates
correctly which could have a large impact on our labour costs.
project complexity: the more variables we have to forecast, the less likely we are to
be accurate. This problem has an unknowable outcome if there are a large number
of variables to forecast, the uncertainty concerning the two components can have
two effects:
the larger the number of components to forecast, the greater the difficulty
in determining project outcome. Forecasting so many components can
lead to errors because the scale of the problem is large.
by forecasting many components we assume a relationship between the
components which is also a forecast. This relationship may change. For
example, the relationship of production variable overheads to units
produced may change. Currently, they are related to the amount of
materials used. If we use forecasts based on these assumptions, then we
also assume that the relationship between materials used and overheads
absorbed is constant. This may not be the situation if the type of materials
change.

Accountancy Tuition Centre (International Holdings) Ltd 2008 4
the background information may change. What happens, for example, if a new
competitor enters the market? This effect will be alleviated to the extent that we
have an agreed contract. There are other factors which could have a significant
effect given enough time to materialise. For example, technological change could
have an impact on our industry. In particular, social change may be relevant if
consumers begin to demand even higher quality water supplies which would
inevitably affect our costs.
there is always the random component that could distort our forecasts. However, an
alternative view would suggest that such random components are really an
admission of lack of skill in forecasting. The best forecasters attempt to anticipate
all eventualities.
Choice of an appropriate discount rate
The difficulty with choosing a discount rate rests on whether the correct rate for the
risk/return has been derived. A number of factors are relevant here
the position of the Water Authorities as single customer. The business is potentially
at risk if the Water Authorities choose to look elsewhere for their water supplies.
This may mean that a higher discount rate is more appropriate
the financing of the capacity expansion. This may have an impact on the discount
rate if the debt/equity mix of the company is significantly altered. A number of
factors are relevant here:
(a) higher gearing is likely to induce higher costs of equity;
(b) higher equity financing may reduce the cost of equity, but increase the
overall WACC if we move off our minimum WACC.
a lower discount rate may be more appropriate to the extent that a long term
contract implies secure income streams
different components of the cash flows may have different variability and it may
therefore not be appropriate to discount them all at the same rate.
Any non-quantifiable factors you feel might influence the decision to accept the
proposal.
Net present value methods are only assessments of factors that we can quantify. There may be
non-quantifiable factors that may also have an impact on any decision we make. Some of
these may be:
It is important to keep our only customer happy and therefore a high standard of
general service is important.
Future contracts are likely to depend on agreeing to the proposal. Hence, future
benefits may emerge which are currently hard to quantify.
The continuance of the existing business relationship with the Water Authorities
may position the company to expand and provide water to other sectors of the
economy.

Accountancy Tuition Centre (International Holdings) Ltd 2008 5
The existing and proposed contracts secure continued employment for personnel.
This is important in a labour market that may be experiencing shortages and where
key personnel are difficult to replace.
2 DEBENTURES
(a)
(i)
The market price of Hammers debentures will be largely determined by their essential
debenture characteristics because conversion does not appear to be an attractive proposition.
At present, the value of 20 shares is only $70, considerably less than the redemption value of
$100. Although there is over a year to go until redemption, the share price would have to rise
more than $1.50 (over 40%) over this period to make conversion the better alternative.
Consequently, Hammers debt will be valued as debentures, based on the future interest
payments plus the redemption consideration. There will still, however, be some (probably
small) option premium to add to this.
(ii)
In the case of Nails debt, the share conversion value (25 $4.10 = $102.50) already exceeds
the stock redemption value of $100. Conversion is not due for another three years, and
although share prices could fall, there is the prospect of further capital gains at conversion.
These convertibles will be valued based on the remaining interest payments and the expected
ordinary share price at conversion. The critical factors in valuation are thus the actual and
expected share price and the length of time to conversion, especially if the share price is
volatile.
(b) There are three main ways in which a company can come to the market.
(i)
Offer for sale by prospectus - shares are offered at a fixed price to the public, including both
institutions and private individuals. Application forms and a prospectus, setting out all
relevant details of the companys past performance and future prospects, as stipulated by
Stock Exchange regulations laid down in The Yellow Book, must be published in the
national press.
A variant on this method is the offer for sale by tender, where no prior issue price is
announced, but prospective investors are invited to bid for shares at a price of their choosing.
The eventual striking price at which shares are sold is determined by the weight of
applications at various prices. Essentially, the final price is set by supply and demand.
(ii)
A placing occurs when shares are placed or sold to institutional investors, such as pension
funds and insurance companies, selected by the investment bank advising the company, and
the companys stockbroker. In a placing, the general public have to wait until official dealing
in the shares begins before they, too, can buy the shares.
An intermediaries offer is a placing with financial intermediaries, which allows brokers to
apply for shares. These brokers are allocated shares that they can subsequently distribute to
their clients.

Accountancy Tuition Centre (International Holdings) Ltd 2008 6
(iii)
Introduction. In some cases, the proportion of shares held by the public (25% for a full
listing) may already meet Stock Exchange requirements, and the company is seeking a listing
merely to open up a wider market for its shares rather than seeking new capital. With an
Introduction no new shares are issued, and new investors can only participate if some of the
existing shareholders decide to liquidate their holdings after the listing.
(c)
(i)
A scrip dividend is where the company offers it shareholders a choice of cash dividend, or
new shares in lieu of cash.
From the companys point of view, the scrip alternative preserves liquidity, which may be
important at a time of cash shortage and/or high borrowing costs, although it may become
committed to a higher level of cash outflows in the future if shareholders revert to a
preference for cash dividend. However, having issued more shares, the companys reported
financial gearing may be lowered, possibly enhancing borrowing capacity. In this respect, the
scrip dividend resembles a rights issue.
(ii)
For shareholders wishing to increase their holdings, the scrip is a cheap way as it avoids
dealing fees. The conversion price used to calculate the number of shares receivable is based
on the average share price for several trading days after the ex dividend day. Should the
market price rise above the conversion price before the date at which shareholders have to
declare their choice; there is the prospect of a capital gain.
A scrip dividend has no tax advantages for shareholders as it is treated as income for tax
purposes.
If the capital market is efficient, there is no depressing effect on the share price by the scrip
dividend through earnings dilution. This is because the scrip simply replaces a cash dividend
that would have caused share price to fall anyway due to the ex dividend effect. In other
words, shareholder wealth is unchanged.
However, if the additional capital retained is invested wisely, then share price may be
maintained or even rise.
(d) Operating gearing

costs operating Variable
costs operating Fixed

a measure of the sensitivity of earnings to a change in the level of sales

Accountancy Tuition Centre (International Holdings) Ltd 2008 7
Financial gearing

Fixed return capital
Equity capital and reserves

a measure of the sensitivity of returns to ordinary shareholders to a change in the
level of earnings and to changes in the cost of debt
Companies with high operating gearing have potentially very variable earnings and should
therefore generally avoid high financial gearing, e.g. professional services firms, highly
mechanised manufacturing companies.
Companies with low operating gearing have potentially more stable earnings and could
therefore have high financial gearing, e.g. leasing companies.
(e) Deep discount bonds are issued at a large discount to their par value. To achieve this low
selling price they must be issued with a low coupon rate. This means that much of the gain to
any investor is a capital gain rather than interest income. This will appeal to some investors
(probably for tax reasons; although in the UK, some of the capital gain may be taxed as
income). Companies also save having to pay large amounts of interest each year. Some
companies will prefer this if they expect to be short of cash in the near future.




Accountancy Tuition Centre (International Holdings) Ltd 2008 8
Marking Scheme
Marks Marks
1 WATER SUPPLY SERVICES PLC
(a) Forecast increase in capacity 2
Machines required 1
Variable cost per unit 2
Forecast variables costs 1
Incremental fixed costs 2
Rental expense 1
Revenue 2
Capital costs 2
Working capital 2
Calculation of NPV 1
Conclusion 1

__

17
(b) 2 marks per (i) (iv) 8


__

25

__
2 DEBENTURES
(a) (i) Conversion unlikely 1
Interest
Redemption value 1
(ii) Conversion likely 1
Interest
Likely share value 1
5

(b) 2 marks per well explained method 5 max

(c) (i) Liquidity 1
Gearing 1
(ii) Easy way to increase holding 1
Impact on share price 2
5

(d) 1 per formulae 2
Interaction 1
1 per example 2

5

(e) Definition 2
Liquidity 1
Return largely capital gain 1
5

25