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XYZ is carefully reviewing all aspects of its business and is currently focusing on working capital management in its publishing division. On-demand printing is where books are only printed when orders are received. The cur- rent method is to print for the estimated demand over the following 12 months. At a recent Board Meeting the following comments were made on how to maximise the use of working capital: Director of Publishing: Inventory control has been a big problem.
We have been particularly badly hit in by a large number of changes in syllabi for the various professional bodies. This has made it dif- ficult to predict demand when setting print quantities. Changing syllabi has also resulted in a large number of books needing to be re-printed at higher per unit costs while other books were substantially overprinted, requiring large quantities of books to be thrown away. Sales Director: I think our receivables position needs some attention. I would recommend extra staff- ing in credit control to reduce receivable days and the use of aggressive legal action in an attempt to reduce our bad debt levels.
By putting this resource in place, I estimate that our receivable days would fall to the industry average. The Finance Director has asked you to produce a draft response to the following memoran- dum received from the Chief Executive. I would like a report on the following: a Compare the inventory control, 9 marks receivable control and gross margin [5 marks of which are record for our Publishing Division with for calculations] the industry average and interpret your results.
Use data and assume [4 marks of which that all sales are on credit. Its sales have risen sharply over the past 6 months as a result of an improvement in the economy and a strong hous- ing market. The entity is 1 month from its year end. Estimated figures for the full 12 months of the current year and forecasts for next year, on present cash management policies, are shown below. Cost of sales includes depreciation of Ms Smith is considering methods of improving the cash position. Official terms of sale at present require payment within 30 days. Interest is not charged on late payments.
In both cases, assume a full month period, that is the changes will be effective from day 1 of next year. Include comments on the factors, financial and non-financial, that the entity should take into account before implementing the new policies. REPORT To: Finance Director From: Management Accountant Date: x of xx Working capital management This report discusses the main aspects of working capital management, calculates the return on assets and current ratio under the different proposals and recommends a course of action.
A conservative policy would have high inventory levels to ensure that demand can always be met instantly, and high cash levels in order to meet any unforeseen liabilities. A conservative policy would normally mean playing safe and not offering extended credit, while an aggres- sive policy would try to boost sales by tactics such as giving better credit terms. ZX has included a reduction in credit terms offered, or at least an improvement in collec- tion, as an aggressive policy; this might be described as an aggressive cash manage- ment policy as it will collect cash more quickly.
The financing of working capital can also be described as conservative or aggressive. Using only trade payables, by increasing the credit period taken, can be viewed as an aggressive approach, while reducing payables and using long-term finance would be safer and more conservative. Short-term finance is often less expensive in the case of trade payables almost costless if there is no impact on the trading relationship but is more risky for ZX as the facility can be withdrawn at short notice.
The receivables days are currently and would fall to 89 mod- erate or 77 aggressive. Whether this will be acceptable to the customers will depend on whether our competitors can supply a comparable product on better terms. ZX has a highly mechanised process and uses modern techniques and equipment which would suggest a shorter production process.
However, before applying this policy we need to look at the impact this will have on our relationship with our customers and our suppliers. This will depend to a large extent on the terms offered by our competitors as an attempt to reduce our credit period could adversely affect our sales. To this extent, as a small company ZX has less leeway in adjusting its policies than it might appear as it will probably have to follow the industry practices. In addition, cutting inventory levels and reducing the current account cash could incur costs if demand exceeds the inventory held lost contribution and reputation or more funds are required finance costs or bank charges for transferring between accounts.
In the light of this, I recommend that we look closely at the industry norms in this area and go for the more cautious approach of the moderate policy. This will allow an increase in the return on net assets, but give sufficient liquidity to compete on an equal basis with the rest of the industry. Because of uncertainty, companies must hold some inventory and cash based on the forecasts made as well as some surplus.
The amount of excess inventory and cash held will be a compromise between the risk of running out, and causing commercial problems, and holding too much, which is a waste of money. An aggressive policy would hold lower safety inventories, a conservative one would hold higher levels. An aggressive policy is therefore more risky. In a similar way, a conservative policy would not want to take as much risk of customers not paying and so is likely to extend less generous payment terms than under an aggressive policy, which would be prepared to take the risk of non-payment in order to increase sales.
Whilst trade payables are not an investment, by taking credit a company can reduce the overall net investment required. An aggressive policy would take as long as possible to pay as long as it did not undermine the commercial relationship with the supplier. This effec- tively means funding much of the current assets through short-term finance which is inher- ently more risky than using long-term finance. Problems of an aggressive policy UR might have encountered a number of commercial problems in operating its aggressive policies.
Key elements to consider in change UR needs to look closely at the impact on its relations with customers and sales, and to review carefully the projections made if the change is implemented. Unless UR has a product which is so different that no customer would dream of going to a com- petitor, any terms which are much worse than the industry average could lead to lost sales. This would suggest that current assets are under-utilised.
Detailed cash-flow projections should be prepared and excess funds invested else- where. It might be more sensible to review management procedures for each component of working capital. A more rapid invoicing of customers, a tighter and more efficient credit control department or a better inventory control system may do more than this suggested change in policy.
External changes in policy will have an impact on the commercial rela- tionships with customers and suppliers, leading to loss of business, while tightening up internal processes will have less impact. Question 4 — ML a Share price movements The stock market seems in practice to be closest to the semi-strong form of efficiency which states that the share price reflects all publicly available information.
Thus it appears to feel profits will recover as they did. Additionally, the market may have already built in the expectation of a loss, and a smaller loss than expected had a favourable impact on the price. The results are only comparable if the number of shares is constant; in this case the rights issue means that a holder of 2 shares in would now hold 3 shares in This gives an indication of future expectations, and incorporates growth estimates and an allowance for risk. A higher ratio suggests higher expectations compared with current performance. This may mean the market expects higher growth or lower risk than envisaged in , but may also mean that current earnings are not as good as the long-term trend expected.
Dividend cover indicates the ease with which dividends can be covered by profits generated in the year. This will tend to fluctuate, as profits are more volatile than the steady dividend policies usually followed, and therefore needs to be analysed as a long-term trend. A cover of 5 is fairly safe, but does not mean that the company will always have the cash available to maintain the dividend. In order to finance these investments, cash will be needed and this can be from raising new finance or by using cash the company already has. The former is more expen- sive in that it will incur issue costs, while the latter reduces the cash available for divi- dends.
In most markets, information is less than perfect and a reduction in dividends may cause the market to reduce its future expectations, and hence the share price, unless it understands the future benefits to be obtained by withholding the cash. There is therefore a compromise to be reached between the dividend policy and the financ- ing decision. This accesses outside finance in the cheapest way, but ML reduces the risk to shareholders engendered in a high gearing level by periodically raising more equity to lower the debt level.
This has higher issue costs and is unlikely to be popular with shareholders on an annual basis, so is kept to a larger issue every few years. This may well lead to further write-offs if demand turns out to be lower than expected. It is also possible that growing overseas sales have led to inventories being held overseas as well.
In addition bad debts are now nearly ten times the industry level and have risen from last year. The receivables collection and bad debts need urgent attention. It is possible these are linked to the expansion overseas, but care needs to be taken before offering credit. It is possible that the results have been distorted by a major customer going into liquidation. The gross margin has fallen from its position above the industry average to below it.
This has been caused in part by the printing costs associated with the change in syllabuses. In addition, the lower inventories may mean a saving in storage costs, which have not been quantified. However, it will need careful management to ensure that large orders can be met on time and that peak demand periods can be managed. Despite these concerns, the financial case for moving to on-demand printing is compelling.
While this suggests we should implement both, it is important to consider other alter- natives such as factoring our debts, undertaking stricter credit checks before granting credit and reviewing our terms of trade. It is also important to consider the impact on our relationship with customers if we tighten our credit periods or pursue aggressive legal action.
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It is likely that this analysis would benefit from looking at each type of receivable, by nature of business and location, separately so that the key areas of concern can be high- lighted and appropriate action taken. While covering the key points required by the question, it should not be considered an ideal solution, either in terms of its presentation or content.
Perversely, ratio looks to improve even if company takes no action and causes an overdraft. This is because of high debtors and stock levels. Moral: high current assets do not mean high cash. Cash ratio is perhaps a better measure.
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Company could perhaps look to improve its credit control before offering discounts. Are discounts being ignored? Are relationships with suppliers being threatened? If change implemented, inventory will still be 67 days. Percentage will fall to Equity is the risk, and permanent, capital of an entity. In balance sheet terms it is repre- sented by ordinary share capital and reserves.
The difference between book values, market values, and nominal values of equity needs to be fully understood. Bank borrowing has historically been the most popular form of debt to be raised. Preference shares are a hybrid between debt and equity and account for a small proportion of corporate finance. Sources of capital also need to be discussed in relation to the use to which that finance will be put and the duration of the investment.
Matching the maturity of the investment to the maturity of the finance is often considered to be the preferred approach. Issue of shares to new shareholders a Offer for sale by prospectus: shares are offered at a fixed price to the public and are presented in a prospectus. The issuing house then ranks the bids to determine which applicants are at the top of the list, and who therefore become shareholders.
This tends to be the cheapest way to issue new shares. Rights issues This is an issue of shares to existing shareholders in proportion to their current holding.
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Considerations when issuing debt Security — fixed and floating charge Gearing and interest cover Impact on EPS Interest rates Duration of the loan Risk Size of the loan Yield curve A financial manager must consider the likely movement in interest rates when choosing the type of finance, for example whether to borrow short or long term.
It shows the market expectation of interest rates and should be reviewed before making large borrowing decisions. Lease or buy decision There are two main types of lease: finance leases and operating leases. In both cases the lessor is the legal owner. In a finance lease the terms will allow for full recovery of the cost to the lessor. In an operating lease the costs may not be recovered as the lease may be can- cellable before full recovery is assured. The risk of a lease is therefore with the lessee in a finance lease and with the lessor in an operating lease.
The discount rate to use in a lease or buy decision is usually assumed to be the rate for secured bank borrowing, as finance leases are usually considered to be equivalent to secured bank borrowing. Venture Capital entities, such as 3i, and some banks provide equity finance to SMEs. Venture Capitalists retain an interest in an entity for a number of years, before looking for an exit route. However, as they are accepting a high level of risk, they will require a very high return. This is usually in the form of a capital gain over 5—7 years.
Business Angels are often business people who provide relatively small capital amounts for an equity stake sometimes called the informal venture capital market. They may also offer their management expertise. The entity is concerned about the relatively high coupon rate it is committed to pay on the debentures, which still have several years to maturity. Comment upon your results. It manufactures a variety of concrete and clay building materials. It has decided to replace of its grinding machines with of a new type of machine that has just been launched. The entity is unable to issue any further equity and is therefore considering alternative methods of financing the new machines.
After this time, the entity expects to scrap the machines, but it has no idea what proceeds would be generated from the sale. If XYZ plc issues debt, it would do so on 31 December for the full purchase price in order to finance the investment. The debt would be secured by fixed and floating charges. Sources of Long-term Finance 53 Option 2 — Long-term lease The machines can be leased with equal annual rentals payable in arrears. The lease term would be 8 years, but this can be extended indefinitely at the option of the entity at a nom- inal rent. The lease cannot be cancelled within the minimum lease term of 8 years.
The entity would need to pay its own maintenance costs. Option 3 — Short-term leases The machines can be leased using a series of separate annual contracts. Maintenance costs would be paid by the lessor under these contracts but, even so, the average lease rentals would be much higher than under Option 2. There is no obligation on either party to sign a new annual contract on the termination of the previous lease contract. Requirements a Calculate the after tax cost of debt at 31 December to be used in Option 1.
The company manufactures soft furnishings such as curtains and drapes for theatres, exhibitions and concert halls in the United Kingdom. It has been trading for 20 years. There are also 25 other shareholders with holdings of various sizes. These sales and earnings levels are expected to continue unless new investment is undertaken. The Board is considering two alternative methods of financing this expansion: 1 A rights issue to vexisting shareholders plus a new issue of shares to employees and trading partners. The company at present has no long-term debt.
It has an overdraft facility that is used for short-term financing needs. Requirements Write a report to Mrs Henry that advises on: a the factors that need to be considered by the Board when deciding to raise new equity. You only need provide some simple calculations here to support your arguments.
You do not have enough information to do a detailed valuation. It makes and distrib- utes videos, both for the general market and to customer specifications.
CIMA Strategic – Exam Practice Kits
Its common stock shares have been listed on a US stock exchange for the past 8 years. However, there are relatively few stockholders and the stock is not traded in large volumes. VID Inc. This new business will involve joint ventures with UK partners and much of the filming will be done in the UK or Spain. The new investment is not expected to have a significant effect on profits for at least 18 months. Summary financial statistics for the last financial year for VID Inc. Evaluate the three methods of finance being considered at the present time and advise the directors of VID Inc.
Support your advice with any calculations you consider appropriate. Make only other simplifying assumptions you think neces- sary and appropriate. A report structure is not required for this question. Question 5 — Rump Rump plc is an all-equity financed, listed company which operates in the food processing industry. The company has just finalised a long-term contract to supply a large chain of restaurants with a variety of food products.
This machinery would become operational on 1 January , and payment would be made on the same date. Sales would commence immediately thereafter. Requirements a Calculate the issue and ex-rights share prices of Rump plc assuming a 2-for-5 rights issue is used to finance the new project at 1 January Ignore taxation. Cash flows beyond 5 years are ignored by RZ in all its investment decisions.
RZ at present has no debt in its capital structure. The directors, who are the major share- holders, would be prepared to finance the purchase of the new machinery via a rights issue but believe an all-equity capital structure fails to take advantage of the tax benefits of debt. Interest payments would be made at the end of each year. Assume the whole amount of each annual payment is tax deductible. No cost details are available at present.
Tax is payable in the year in which the liability arises. Requirements a Discuss the advisability of the investment and the advantages and disadvantages of financing with either i undated debt, ii a finance lease or iii an operat- ing lease compared with new equity raised via a rights issue and comment on whether the choice of method of finance should affect the investment decision. Provide appropriate and relevant calculations and assumptions to support your discussion. It is going through a period of rapid expansion and requires additional funds to finance the long-term working capital needs of the business.
Two major institutional share- holders have indicated that they are not prepared to invest further in EFG at the present time and so a rights issue is unlikely to succeed. The directors are, therefore, considering various forms of debt finance. There have been lengthy boardroom discussions on the relative merits of each instrument and you, as Finance Director, have been asked to address the following queries: Sr. Is this actually the case? A, Sr. B and Sr.
Ignore tax. It wishes to acquire a further new ferry due to high demand for its services from passengers. At a Board meeting, proposals were put forward for three different methods of financing the new ferry. It was made clear at the meeting that the company is unable to raise any fur- ther equity finance.
The ferry being acquired is identical under all three methods of financing. After this time, the terms of the operating licence given by the Translavian government require that the ferry should be scrapped for health and safety reasons. The net proceeds are expected to be zero. The lease term would be 5 years, but this can be extended indefinitely, at the option of the entity, at a nominal rent.
The lease cannot be cancelled within the minimum lease term of 5 years. Method 2 — Short-term lease The ferry can be leased using a series of separate annual contracts. Maintenance costs would be paid in full by the lessor. There is no obliga- tion on either party to sign a new annual contract on the termination of the previous lease contract. These payments are to be made at the end of each of the four years. Taxation Taxation payments are made one year after the relevant transaction occurs. All lease payments, interest payments and maintenance charges are allowable in full for tax.
Similarly, the purchase price of the ferry is allowable in full as a tax deduction in the year in which the expenditure is incurred. The company has sufficient profits from the existing ferries to ensure that tax allowances can be offset immediately. Yet we can obtain just about enough cash to fund the new ferry from our own resources, even though we may need to sell some of our short-term invest- ments. Why should we pay interest and other finance charges to outsiders when we can fund the new ferry for free ourselves? Shareholders who do not wish to take up the rights can sell them on a nil-paid basis.
A rights issue can be made at any time. A VCP, on the other hand, is made specifically in connection with acquisitions. Thus, although the acquisition is effected by exchange of equity shares, the vendors still receive payment in cash. Pre-emption rights do not, therefore, apply. Provide information about company, and state the purpose for which new funds are required. If for acquisition, information regarding the company to be acquired is to be furnished. Disclosure of material contracts entered into in the preceding year, and any legal or arbitration proceedings, etc.
Provisional allotment letter. For rights issues, a provisional allotment letter not a sub- scription form is required. Each letter is to be addressed to an individual shareholder, specifying the exact number of shares that have been provisionally allotted. The com- pany effectively purchases a put option which guarantees take-up of all the issue, par- ticularly if the equity market falls significantly between the time of setting the issue price and the closure of the offer.
Underwriting is essential when the uncertainty costs of an undersubscribed issue are considerably greater than the costs of underwriting. It is possible to dispense with underwriting in respect of deeply discounted rights issues, which are unlikely to fail. However, it is relatively rare for underwriting to be dispensed with, as the presence of underwriters is a favourable signal to the market. If the project merely earned a sufficient return to cover the interest payments, it would fail to recognise the overall impact on existing providers of finance, and that they would be likely to demand a higher return in response to additional financial risk.
This is because the borrowing of additional funds to finance the grinding machines will increase the gearing of the business, possibly significantly. Also, in the event of corporate failure, they would rank behind a higher level of debt in a distribution from the receiver. Given that most investors are risk averse, then shareholders are likely to demand a higher return in response to this additional risk. The exception to this would be if the new project were lease financed, and there was no penalty arising from termination of the contract, other than the return of the asset.
In this case, there is no additional exposure to existing shareholders. The lessor would, however, be taking most of the risk and would thus require a significant risk premium. As an alternative to the cost of debt, the WACC may be an appropriate discount rate. It would first be necessary, however, to calculate the cost of equity. It would be nec- essary, however, to carry out detailed calculations of the present values of the cash fl ows for each of the three options before a final decision was taken. Notwithstanding this, some of the broader issues that would need to be considered are as follows.
Cash flow Given that the long-term lease is payable in arrears, a short-term cash fl ow advantage is given. The long-term lease is, however, payable equally over 8 years. In contrast, only the interest on the loan is payable over the next 10 years and the capital is not repayable until the end of this period.
This gives a significant cash flow advantage to debt financing which may be relevant if capital is constrained. Risk The risk of the underlying operations is identical in each case, as the physical assets are the same. This can thus be ignored as a common factor.
Given this is some way into the future, it may be regarded as extremely uncertain, particularly if there is a thin market for this type of asset. Also, the payment terms of the purchase and long-term finance arrangements are fixed, but those of the short lease may vary. Lease rentals may rise with infl ation or a change in market conditions.
Alternatively, they may fall if the rate of technological change is greater than expected. In the extreme, it is possible that the lessor company may collapse and there may be other claims over the asset from creditors arising from this. The fi nancial risk implications have already been discussed in requirement b above. Depending on the terms of the lease contract, the lessor may only have the right to reclaim the asset, perhaps with a penalty. At best, the balance would be an unsecured creditor against XYZ.
This relatively higher risk position of the les- sor is likely to be reflected in the return demanded in the form of higher lease rentals. Maintenance The maintenance contract is included in the short-term lease, but not the other options, although the cost is clearly built into the short-term lease rentals. Financial reporting considerations For financial reporting purposes, the long-term lease is probably a finance lease, while the short-term lease is probably an operating lease. From a finance perspective, these definitions are not of themselves signifi cant.
Indirectly, however, the operating lease could probably be kept off the balance sheet, while purchase and finance lease options are on balance sheet. This should not make any difference from an information perspective, as stock markets are reasonably efficient and are not normally deceived by changes in disclosed accounting procedures. However, there may be debt covenants e. Other forms offinance There may be other forms of finance which may be preferable to those specified. One exam- ple may be hire purchase, but also other forms of lease or debt contract may be available.
Signed: Management Accountant. The decision is very marginal. Question 3 — PJH REPORT To: Mrs Henry From: Management Accountant Date: xx of x Expansion finance, valuations and objectives This report will consider the factors to be considered when raising new equity, the impact of the method of financing on the valuation of the business and appropriate long-term financial objectives.
However, issuing shares to others will dilute the control of the family, and may mean that decisions are made which are not in their best interests. Ultimately, if the family ends up with a minority stake the company could be sold.
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One possibility is to calculate the number of shares the family would have to buy to maintain control. However, the sums required from existing shareholders may be too much, particularly as the above calculations look at averages - in reality some of the family members will have to find more if they have greater shareholdings than the average. However, this bid was not evaluated and may not have been a realistic value and it takes no account of what has happened over the last two years.
The second calculation assumes a very efficient market and that debt is effectively risk- free, while both assume that there is no change in the operating risk of the company. However, other stakeholders set constraints on this objective which will need to be observed if the company is going to thrive in the long term. These include commitments to staff, customers and suppliers. In addition, the intentions of the family members in the medium term might influence the objectives decided upon. Generally, the company does not appear to be particularly highly geared based on mar- ket values , although it would be useful to know the average for the industry.
The interest cover is also reasonable even if new debt is issued. The project will not produce profits for 18 months; the market needs to be aware of this or the disappointment will depress the share price in the short term. In addition there may be restrictions on the operations of the business in order to maintain certain gearing ratios or interest cover. They will probably require security over assets, or compensate for the addi- tional risk of less than full security by applying a higher interest charge. However, the issue costs associated with the debentures are likely to be lower than those incurred on a rights issue.
In addition, the fixed income and asset security will lead to a cheaper cost than the equity which is enhanced by the tax relief available on debt interest. The calculations in b have assumed the cost of equity and hence the total market value would stay the same under a debenture issue.
However, the risk to the share- holders would increase as the financial risk of the interest being paid out of prof- its increases the fluctuation in returns and so the return required would increase. It therefore may not be as beneficial to shareholders as it appears, as the share value may drop from the price calculated. Finally, it is possible that not all shareholders will want to take up their rights, which will involve the company selling the rights to other shareholders or the general public if possible.
The family would see its shareholding reduced if it could not finance its share of the rights issue. A placing is where an issuing house places shares with clients, and is likely to have relatively low costs as it avoids underwriting and much of the advertising. An offer for sale is when an issuing house buys the shares and then offers them to the public, at a fixed price or via a tender, by circulating a prospectus. The costs are likely to be higher as the fees effectively incorporate underwriting of the issue. A public offer for subscription means that Rump plc itself would issue the prospectus and invite subscription at a fixed price.
Costs are likely to be high, as they will have to cover underwriting, publicity and specialist advice. Further analysis may alter the result. This may not be a problem for a currently all-equity pri- vate company. Response to Sr. This capital gain is equivalent to a compound yield of 3. This is in addition to the 4. Recommendation For a rapidly expanding entity such as EFG, the convertible bond may be the most appro- priate. The convertible bond provides low cost finance for five years and may result in the desired equity base at the end of the five year period.