SOLENT UNIVERSITY

School of Business, Law & Communications

ACC314 BUSINESS FINANCE MANAGEMENT Sept 2020 (Solution)

QUESTION ONE:

a) Project NPV

Project “A” £627,000

Project “B” £1,152,000
See schedule on page 8 for workings.

b) Payback period

Project “A” 1 year 6 months

Project “B” 2 years 0 months
See schedule on page 8 for workings.

c) Recommended action, and basis of recommendation

The NPV decision rule states that projects with a positive NPV should be
accepted, because they produce a rate of return higher than the cost of
financing, and so create wealth for shareholders.

Both projects have a positive NPV, and so both meet the acceptance
criteria.

Project “B” is preferred, because it has the higher NPV, and so generates
the higher increase to shareholders’ wealth.

The significance of sensitivity and risk should be recognised. Project “B”

has higher risk with a longer payback period and higher sales in the final
year. If the project life could be extended, then “B” becomes even more
attractive.

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d) Critically evaluate the advantages and limitations of using the Net
Present Value technique, in preference to other investment appraisal
methods.

A coherent rational evaluation is required, incorporating some of the

points identified below:

• NPV:
o Cash flow based – therefore objective unlike profit
o Take account of time value of money
o NPV > 0 acceptance criteria
o NPV is consistent with shareholders’ wealth maximisation
objective. NPV is superior to IRR which maximises return not
absolute value.
o Limitations of year end cash assumption and subject to quality
of forecast – need sensitivity analysis
• Payback:
o Cash flow based – therefore objective unlike profit
o Does not take account of time value of money
o Ignores cash flows after payback
o Simple to calculate
o Useful screening technique, particularly when funds are
limited
• Potential of other techniques:
o IRR is also DCF based, and IRR > Hurdle rate is equivalent to
NPV>0. However, weaknesses include: Multiple IRR; Assumes
funds reinvested at IRR; Complex to calculate
o ARR should be rejected because it is subjective – being based
on profit (not cash), and has no accepted standard definition
(alternative definitions / calculations)

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QUESTION TWO:

a) Ratio analysis

Inputs & workings:

INPUTS:
2019 2018
Current assets:
Inventory 153 120
Trade receivables 334 355
Bank & cash 43 5
530 480
Current liabilities:
Trade payables (252) (324)

Non-current assets 80 62

Non-current liabilities:
Bank loan (100) 0

Net assets / shareholders funds 258 218

2019 2018

Sales 1,668 1,558

Cost of sales (1,507) (1,414)
Gross profit 161 144

Expenses (114) (107)

Operating profit 47 37

Interest (7) 0
Profit for year 40 37

WORKINGS:

Capital employed:
Equity 258 218
Borrowing 100 0
Bank & cash (43) (5)
315 213

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 Ratios:

RATIOS:

Return on capital employed 14.9% 17.4%

Return on equity 15.5% 17.0%

Gross profit margin 9.7% 9.2%

Operating profit margin 2.8% 2.4%

Asset turnover 5.30 7.31

Inventory days 37.1 31.0

Receivable days 73.1 83.2
Payables days (COS proxy for purchases) (61.0) (83.6)
Operating cycle 49.1 30.5

Current ratio 2.10 1.48

Quick ratio 1.50 1.11

Interest cover 6.71 #DIV/0!

Gearing (D/(D+E)) 18.10% -2.35%

b) Assess financial success and operating efficiency

Comments should be structured around the twin themes of ‘financial

success’ and ‘efficiency’. Success could include: sales growth;
profitability; adequacy of liquidity, and risk associated with borrowing.
Efficiency could include asset turnover and operating cycle.

Students are expected to present reasoned arguments supported by

quantified evidence drawn from the ratio analysis and financial
statements. Better answers will attempt to relate the ratios to possible
causes. I.e. demonstrate application to the specific business in the case.

Financial success:

Sales increasing.

Profitability (ROCE) has declined sharply. Operating profit margins are

up, but asset turnover (efficiency) is down.

Liquidity (current & quick ratios) improving and adequate at 2.1.

Gearing increasing, but modest at 18%.
No major financial risks being taken.

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 Conclusion: Achieving absolute profit without excessive risk exposure
constitutes success. However, there are concerns regarding declining
ROCE.

Efficiency:

Asset turnover down.

Operating cycle has lengthened. Sharp increase in inventory days but

reductions in receivables and payables.

Is growth causing operating difficulties?

c) Comment on the validity of the exercise and any further work which
could usefully be carried out to support a discussion for further
expansion.

A useful starting point is to recognise that the information provided is all

financial and is restricted to 2 years. A more informed view can be taken
by analysing trends over longer periods, and comparing to other
companies in the same industry. The company’s business plan should
provide information on the market, and company strategy, which will
help place the financial information in context.

Ratio analysis is based on historic data, and is therefore backward

looking. It has identified that the business is consuming cash, and that
the operating cycle is lengthening. Further work is need to identify why
this is happening. Does it indicate a loss of control, or a decline in the
quality of new customers / sales? Budgeting and cash flow projections
are going to be needed to determine whether further expansion is likely
to be successful.

A reasoned argument is expected.

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QUESTION THREE:

a) WACC calculation.

Scenario: 1 2 3

Data:
Equity % 70.00% 60.00% 50.00%
Debt % 30.00% 40.00% 50.00%
Cost of equity (%) 13.00% 14.50% 16.50%
Cost of debt (%) 5.50% 6.00% 6.75%
Corporation tax rate 20.00% 20.00% 20.00%

Calculation of WACC:
Equity proportion x cost of equity 9.10% 8.70% 8.25%
Debt proportion x cost of debt 1.65% 2.40% 3.38%
Tax shield -0.33% -0.48% -0.68%
WACC 10.42% 10.62% 10.95%

b) Discuss results and recommend level of gearing to be adopted in

target capital structure.

70:30 is the preferred gearing level, as this has the lowest WACC. The
optimal position could be less than 30% but the question does not provide
sufficient information for this to be confirmed.

This should provide the highest return in terms of share price for
shareholders but this does not need to be proved. Mention of the
traditional theory of optimal capital structure is expected.

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 c) Investor ratios.

Enterprise value 400.00

Operating profit 40.00
Dividend 8.00

Capital structure:
Value of equity 280.00
Value of debt 120.00
400.00

Income statement:
Operating profit 40.00
Interest (6.60)
Profit before tax 33.40
Tax (6.68)
Net profit 26.72

Dividend yield 2.86% Dividend / Value of equity

Interest cover 6.06 Operating profit / Interest

Price Earnings ratio 10.48 Value of equity / Net profit

d) The directors of Lulworth plc have arranged to see their bankers to discuss a
new bank loan. What aspects will the bank wish to consider before agreeing a
new loan facility?

The CAMPARI & ICE (Character; Ability; Means; Purpose; Amount;

Repayment; Insurance; & Interest; Commission; Expenses) or 5Cs bank
lending models could be used to draw out the elements of an appropriate
answer.

This is a 20-mark question, so it needs to be more than just a listing. A

reasoned argument is required.

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QUESTION ONE Parts a) & b) (Workings)

Project cash flows

Project A Project B
Per unit T0 T1 T2 T3 Per unit T0 T1 T2 T3

Sales volume (000) 450 450 50 300 450 500

Cash flows:
Sales £ 15.00 6,750 6,750 750 £ 12.50 4,500 6,750 7,500
Variable cost £ 10.00 (4,500) (4,500) (500) £ 8.00 (3,000) (4,500) (5,000)
Variable marketing costs £ 0.50 (225) (225) (25) £ 0.50 (150) (225) (250)
Contribution £ 4.50 2,025 2,025 225 £ 4.00 1,350 2,025 2,250

Fixed overheads (200) (200) 0 (200) (200) 0

Trading cash flow 0 1,825 1,825 225 0 1,150 1,825 2,250

Equipment purchase (2,500) (2,750)

Equipment disposal 100 100
Working capital (300) 300 (300) 300

Net cash flow (2,800) 1,825 1,825 625 (3,050) 1,150 1,825 2,650

Net Present Value

T0 T1 T2 T3 Total T0 T1 T2 T3 Total
Net cash flow (2,800) 1,825 1,825 625 (3,050) 1,150 1,825 2,650
Discount factor 14% 1.0000 0.8772 0.7695 0.6750 14% 1.0000 0.8772 0.7695 0.6750

Present value (2,800) 1,601 1,404 422 627 (3,050) 1,009 1,404 1,789 1,152

Net Present Value = £627,000 Net Present Value = £1,152,000

Payback
T0 T1 T2 T3 T0 T1 T2 T3

Cash flow (2,800) 1,825 1,825 625 (3,050) 1,150 1,825 2,650
Cumulative cash flow (2,800) (975) 850 1,475 (3,050) (1,900) (75) 2,575

Payback 1 year 2 years

Plus 975/1,825 =0.53 years or 6.4 months Plus 75/2,650 =0.02 years or 0.3 months
Payback = 1 year 6 months (apprx) Payback = 2 year 0 months (apprx)