Homework answers / question archive / FINANCIAL DECISION MAKING SECTION I Mini-scenario 1 Seconds Ticking Limited (‘STL’) is based in Hong Kong and designs and manufactures lowend stopwatches for sale worldwide

FINANCIAL DECISION MAKING SECTION I Mini-scenario 1 Seconds Ticking Limited (‘STL’) is based in Hong Kong and designs and manufactures lowend stopwatches for sale worldwide

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FINANCIAL DECISION MAKING

SECTION I Mini-scenario 1

Seconds Ticking Limited (‘STL’) is based in Hong Kong and designs and manufactures lowend stopwatches for sale worldwide. The monthly sales are one million stopwatches. The selling price and variable cost of a stopwatch are HK$225 and HK$175, respectively. Currently, STL makes all of its sales to distributors on credit, with an average collection period of three months. After attending a recent seminar on receivables management, the CEO Michael Yung has asked his CFO Linda Li to look into how STL might alter its credit management policy. He has suggested that STL shorten its current credit period offered to distributors to two months and offering a 4% cash discount for payment before the end of first month. This is similar to the terms that many of STL’s competitors offer their customers. The CEO estimates that the discount could boost existing sales by as much as 20% per month and that 90% of STL’s distributors would take advantage of the discount. The Sales Director (Allan Ho), however, is not as optimistic as the CEO on the additional revenue that this new policy could bring in. STL has a weighted average cost of capital equivalent to 0.75% monthly and discount factors for this are: Month 1 0.993 Month 2 0.986 Month 3 0.979 Required: 1. What is the three-month net present value of the return from one month’s sales under the existing policy? Show all workings. (2 marks) 2. What is the expected three-month net present value of the return from one month’s sales under the new credit management policy? Show all workings. (2 marks) 3. Demonstrate financially in HK$ whether the proposed new credit management policy would be acceptable to STL. Show all workings. (2 marks) 4. Taking the Sales Manager’s concern into consideration, what is the minimum monthly sales that STL has to achieve under the new policy so that it will not be made worse off by the change of credit management policy? (2 marks)

5. List four basic factors that STL should consider when deciding what credit terms to offer new customers. (2 marks) Total 10 marks

Mini-scenario 2 Carlito Manolito SpA (CMS) is a business based in the south of Italy that manufactures and distributes extra virgin olive oil throughout Europe. Its capital structure as reported in its statement of financial position at 31 December 2020 is as follows: €m 24m ordinary shares (50c) 12 Retained profits 6 Total equity shareholders’ funds 18 10% irredeemable bond 8 The current market prices for CMS shares is €3.00. The bond is trading currently at 120%. CMS pays corporate tax at a rate of 25%. The cost of the CMS’s equity has been estimated at 10% pa. The Board of Directors is considering a major new investment, but the CEO and CFO disagree over the best method of financing this. • The CEO argues that the funds should be raised using a 1 for 4 rights issue priced at a 20% discount on the current market price • The CFO suggests that a bank loan would be more appropriate as debt is cheaper and, in her opinion, CMS’s share price currently undervalues the business Question 1 1. What is CMS’s cost of debt to two decimal places? Show all workings. (2 marks) 2. What is CMS’s weighted average cost of capital to two decimal places for investment appraisal purposes? Show all workings. (2 marks) 3. What is CMS’s financial gearing ratio using market values to two decimal places? Show all workings. (2 marks) 4. Assuming CMS goes ahead with the rights issue, what is the theoretical ex-rights price per share? Show all workings. (2 marks) 5. If the government of Italy lowers the rate of corporate taxation to 24% would the cost of debt go up or down? No calculations are required. (2 marks) Total 10 marks

Section II Case Studies Case Study 1

You are a financial analyst working for Turnbull Statistics Inc (TSI), a consultancy business based in Edinburgh. TSI specialises in advising corporate clients about the financial health of businesses by examining their financial statements (the income statement, the statement of financial position and the cash flow statement). Two of TSI’s corporate clients have come to you with two different scenarios. Client 1: Motor Component Manufacturers (‘MCM’) MCM manufactures parts for the car industry. The Board of Directors of MCM have asked you to perform a financial analysis on a potential new supplier. This new supplier is replacing a long-standing supplier and will supply critical components for MCM. Required: 1. Using only the financial statements of the potential new supplier, what financial ratios, maximum of 4 and relevant to this scenario, would you select to help assess the financial health of the potential new supplier? Explain your selection with reference to the scenario. Please note – no calculations are required as there are no numbers available. In addition to the financial ratios you have selected, what other information from the financial statements would you regard as critical in this scenario. (10 marks – maximum word count 500 words) Client 2: Superscents Toiletries (‘ST’) ST makes and supplies toiletries and other bathroom consumables to the hotel industry. It has a wide variety of customers, all based in the UK, from small boutique hotels to large chains. The Board of Directors is considering bidding for a contract to supply a chain of hotels that ST has never dealt with and has asked you to perform a financial analysis on this potential new customer. Required: 2. Using only the financial statements of the potential new customer, what financial ratios, maximum of 4 and relevant to this scenario, would you select to help assess the financial health of the potential new customer? Explain your selection with reference to the scenario. Please note – no calculations are required as there are no numbers available. In addition to the financial ratios you have selected, what other information from the financial statements would you regard as critical in this scenario. (10 marks – maximum word count 500 words) Total 20 marks

Case Study 2 Roggee Limited (’Roggee’) makes three types of lemonade – Skoosh (S), Ginger (G) and Pop (P) at its production plant in southern Scotland. The lemonade is produced in 10-litre packs. Roggee has always used a traditional product costing system using machine hours to allocate production overheads to the three types of lemonade. The Board of Directors, as advised by the CFO, is now considering the introduction of an activity-based costing (‘abc’) system. Some of the directors, however, have concerns about the implementation problems of such a new system. Details of the three types of lemonade for a typical month are: Labour Machine Material cost (£) 10 litre packs hours hours per 10 litres produced Skoosh 0.10 0.30 2.00 3,100 Ginger 0.30 0.20 3.00 6,000 Pop 0.25 0.60 5.00 16,450 Direct labour costs £11 per hour and production overheads are allocated to the 10-litre packs of lemonade on a machine hour basis. The overhead allocation rate for the month is £30 per machine hour. Total production overheads are £360,000 and further analysis shows that they can be divided up as follows: Analysis: % Inventory costs 10% Set-up costs 25% Costs relating to machinery 15% Product testing costs 30% Quality control costs 20% Total production overhead 100% The activity volumes associated with each 10-litre pack of lemonade for the month are: Number of Number of Number of Number of inventory machine product quality movements set ups tests inspections Skoosh 30 26 350 75 Ginger 10 74 200 90 Pop 45 90 150 200 85 190 700 365

Required: 1. Calculate the cost per 10-litre pack for each lemonade type using traditional methods, allocating overheads on the basis of machine hours. Show all workings. (3 marks) 2. Calculate the cost per 10-litre pack for each lemonade type using ‘abc’ principles (to two decimal places). Show all workings. (10 marks) 3. Explain why costs per unit calculated under ‘abc’ are often very different to costs per unit calculated under more traditional methods, illustrating your answer with reference to the 10-litre packs produced by Roggee Limited (7 marks – maximum word count 300 words) 4. Discuss the implications for Roggee Limited of a switch to ‘abc’ on its pricing strategy and profitability. (6 marks – maximum word count 300 words) 5. Explain the implementation problems that Roggee might experience when ‘abc’ is first introduced. (4 marks – maximum word count 200 words) Total 30 marks

Case Study 3 It is 01 January 2021. A group of three individuals have formed a company, Orraway Adventures Limited (‘OAL’), and have subscribed a total of £240,000 in equity share capital (£80,000 for each individual). The group of individuals make up the Board of Directors. The corporate strategy is to purchase a small property with adjoining land to set up an outdoor adventure venue for corporate team-building events. The purchase of the property and adjoining land has already taken place on 01 January at an agreed cost of £270,000 and conversion work required at an agreed cost of £25,000 per month will take place over the first three months of 2021. To fund this, the company has negotiated a four-year £108,000 loan with Bluebell Bank. Interest at 6% on this loan is to be paid monthly, starting in January 2021 but there will be no capital repayments required in the first year. Repayment commences in January 2022 over three years at £3,000 per month. The adventure centre will open for business on 01 April 2021, meaning that there will be no customers for the first three months. OAL plans to offer ‘away days’ comprising a series of outdoor games and challenges for groups of participants. Between the directors, they have researched the costs involved and potential income and have compiled the following information: Customer base is large corporate companies that wish to send employees on team building days out; all customers will be given one month’s credit. Directors’ assumptions: Income: • £1,500 per group, 20 groups per month from April to June inclusive and 30 for each month thereafter. • Customers will pay one month in arrears. Direct costs: • Single use equipment and consumables will amount to 25% of the revenue for that month and are paid in the month incurred. • Food and other costs related to days out are estimated to be 10% of the revenue for that month and are paid in the month incurred. Overheads: • Staff costs: o January to March: £2,000 per month. o April to June inclusive: £4,000 per month. o July to December inclusive: £6,000 per month. • Directors salaries: £9,000 per month, starting in July. • Utility bills of £1,000 per month are expected April to September inclusive and £1,300 for the remainder of the year. • Advertising and marketing are planned at a cost of £750 per month throughout the year, starting in January. • Other indirect costs will amount to £500 per month, starting in January. • Depreciation will be charged over 50 years for the property/land.

Required: 1. Prepare a monthly cash flow projection for 2021 (12 marks) 2. Prepare an annual profit forecast for 2021 (8 marks) 3. What impact do you think the Covid-19 pandemic might have on each of the assumptions made by the OAL Board of Directors? (10 marks – maximum word count 500 words) Total 30 marks