Financial Management

DT310 ACCT9023 27073 TECHNOLOGICAL UNIVERSITY DUBLIN AUNGIER ST CAMPUS DT310 - Postgraduate Diploma in Accounting Year 1 SEMESTER 2 EXAMINATIONS 2018/19 Financial Management Internal Examiner: Dr. James Fitzgerald External Examiner: Michael Farrell Exam Duration: 3 hours Instructions: Answer Question 1 and any three other questions of your choice. Answer all parts of your chosen questions. Total marks for the exam is 100 marks. Non-programmable calculators are allowed. Special Instructions/Handouts: Formula Sheet Wed 22nd May 9.30 - 12.30 Carmelites DT310 Financial Management 26 Question 1 (compulsory) Part a Formacon Plc is an electronics manufacturer based in Ireland. The firm is considering purchasing new equipment that will enable it to produce new products and compete more effectively in the marketplace. As the Financial Manager of Formacon Plc, you have been asked to estimate the firm's weighted average cost of capital (WACC), which will be used as the discount rate when appraising any potential investment. You have gathered the following information about the firm's financing from its balance sheet: Financed By: €'000 Ordinary Share Capital @ 25c each 30,000 Preference Share Capital @ €1.00 each 8,000 Coupon Bonds (6.5%) 25,000 • The ordinary shares are currently trading at €1.50. The risk-free rate is 3%, the beta of the firm's shares is 1.5, and the return on the market is 10%. • The preference shares have a market value of €1.20 and a dividend rate of 10% • The coupon bonds are currently trading at a price of €1,030 per bond with a face value of €1,000. The bonds have 9 years left to maturity and will be redeemed at face value. • The firm's marginal tax rate is 30% Required: Calculate the after-tax weighted average cost of capital (WACC) for Formacon Plc. (15 marks) Part b Outline the assumptions upon which Modigliani and Miller’s Capital Structure Irrelevancy Theory is based, and explain how the Trade-Off Theory emerges when two of these assumptions are dropped. (10 marks) Page 2 of 9 Part c SafeHome Ltd manufactures and installs home security systems. It is currently considering producing a new security system, the SleepTight system. The firm recently carried out market research costing €50,000 and there appears to be significant demand for this new product. To produce the new product, SafeHome Ltd will need to purchase a new machine at a cost of €2,000,000 payable immediately. The purchase is being financed by a four year loan with an annual interest cost of €150,000. The machine is expected to have a useful life of four years, after which it will be scrapped at a zero net cost. The total cost of the machine can be written off for tax purposes over four years using the straight line basis. Investment in working capital will increase immediately by €250,000, 30% of which is recovered in year 3 and the remaining 70% in year 4. The selling and installation price will be €500 per unit. Sales are estimated to be 5,000 units in year 1, and are expected to increase by 800 units each year. The costs of producing the SleepTight system are as follows: Labour: Each system produced will cost €100 in direct labour. Direct labour costs are expected to remain constant over the next five years. Materials: The cost of materials per system produced will be €150 in year 1, and will increase at the same rate as expected inflation (2%) in each subsequent year. Overheads: The firm's fixed overheads are currently €1,000,000 per annum. This will increase by 10% as a result of the new project and will stay at this new level for four years. In addition to increased expenditure, the firm also anticipates that the sales of existing products will be adversely affected. The effect of this is estimated to be a €260,000 drop in after tax net cash flow each year for four years. The firm pays tax at a rate of 30% per annum. Tax is payable 1 year in arrears. Required: If the firm's after tax cost of capital is 15%, calculate the NPV of the proposed project. (15 marks) Total 40 Marks Page 3 of 9 Question 2 Part a FastTech currently extends credit to risk classes 1 and 2, but is evaluating the profitability of offering credit to risk class 3. The relevant data relating to each risk class is as follows: | Credit Risk Class | Credit Sales | Average Collection Period(days) | Bad Debt Loss Ratio (%) | |--------------------|--------------|----------------------------------|------------------------| | 1 | €2,100,000 | 44 | 3.0 | | 2 | €1,900,000 | 55 | 6.0 | | 3 | €1,700,000 | 71 | 12.0 | FastTech also estimates that its variable costs are 75% of total sales. Required: Based on an estimated pre-tax required return of 20% on its investment in receivables, determine with workings whether or not FastTech should extend credit to risk class 3. (6 marks) Part b In relation to working capital management, discuss what is meant by the cash conversion cycle (CCC) and describe how you would measure a firm's CCC. How would you expect the CCC of a manufacturing firm that sells goods on credit to differ to the CCC of a retail chain that predominantly sells perishable goods for cash? Which of these two CCCs would you, as a financial manager, rather have to manage? Explain your answer. (14 marks) Total 20 Marks Page 4 of 9 Question 3 The management of SafeBet Plc is trying to decide on the dividend per share to pay out at the end of the year (in 6 months' time). Historically the firm has maintained a dividend pay-out ratio of 50% of net income, but recent feedback from some of its shareholders suggests there is concern that the firm is building up cash reserves that could be sub-optimally used by management. The firm is intending to raise additional equity financing next year to fund a major project, and in order to alleviate shareholders worries, management is considering paying out 90% of the year's free cash flow to equity (FCFE). As such, they have estimated the following year end figures: £m Net Income 8,500 Depreciation 1,200 Debtors 950 Stock 675 Other current assets 1,380 Creditors 790 Other current liabilities 1,540 Debt 10,750 Capital Expenditure 1,860 Acquisitions 1,020 In addition, the last annual report shows that the level of working capital was €750m and the firm had €11,500m debt. The firm currently has 500m shares in issue. Required: i. Calculate the dividend per share the firm should pay if is to pay out 90% of FCFE. What will the firm’s new pay-out ratio be? (8 marks) ii. Prepare a report for the directors of SafeBet Plc that discusses other factors that should be considered before it changes its pay-out ratio. (12 marks) Total 20 Marks Page 5 of 9 Question 4 The following figures (in €'000) have been extracted from a firm's annual reporting archives: | | 2016 | 2017 | 2018 | |-----------------|-------|-------|-------| | Current Assets | 50,000| 60,000| 65,000| | Current Liabilities| 30,000| 35,000| 38,000| | Closing Stock | 25,000| 37,000| 45,000| | Long-term Debt | 100,000| 130,000| 170,000| | Shareholders' Funds| 300,000| 340,000| 400,000| | Operating Profit| 60,000| 62,000| 65,000| | Interest Expense| 9,000 | 12,000| 17,000| | Net Income | 35,000| 33,000| 34,000| | Dividends | 17,500| 11,000| 20,000| In addition, the following average ratios have been calculated for the firm's closest competitors over the past 3 years: | | 2016 | 2017 | 2018 | |------------------|------|------|-------| | Current Ratio | 1.5:1| 1.45:1| 1.55:1| | Acid Test Ratio | 1.2:1| 1.2:1| 1.3:1 | | Gearing Ratio | 20% | 16% | 12% | | Interest Cover | 8 times| 8.4 | 9.2 | | Dividend Payout | 40% | 39.5%| 39.7% | Required: Using ratio analysis, analyse the firm's performance in the most recent year from the perspectives of its liquidity, gearing and investment potential. Total 20 Marks Page 6 of 9