Posted: June 17th, 2015

Using your results from (a) where appropriate, explain what is meant by the term ‘weighted average cost of capital

 

 

Question 1                                                                                                                  (50 marks)

 

Maple plc is financed by a mixture of ordinary share and loan capital. The following information is available concerning the business for the year to 30 November Year 200X:

 

Maple plc

Profit for the year                                                                     £2.0m

Gross dividends                                                                         £1m

Market value per ordinary share                                         £4.00

Number or ordinary shares                                                   5m

Gross interest yield on loan capital                                     8%

Market value of loan capital                                                 £10m

 

 

The annual growth rate in dividends is 2% for Maple plc. Assume a 25% tax rate. The book value and the market value of the loan capital are the same.

 

Required:

• Calculate the weighted average cost of capital (WACC) for Maple plc. (20 marks)
• Using your results from (a) where appropriate, explain what is meant by the term ‘weighted average cost of capital’. (10 marks)
• Assess the arguments for and against whether a company should use their weighted average cost of capital as the discount rate when assessing the acceptability of a new project? (10 marks)
• Marple plc wishes to pursue a large scale expansion programme. Critically discuss the major factors that should be taken into account when deciding on the appropriate mix of long term and short term borrowing necessary to finance an expansion programme. (10 marks)

 

 

Total 50 marks

End of Question 1

Question 2                                                                                                                  (50 marks)

 

Oak Ltd operates a marketing agency. It has annual turnover of £20 million before taking into account bad debts of £0.1 million. All sales are on credit and, on average; the settlement period for trade debtors is 70 days. The company is currently reviewing its credit policies. To encourage prompt payment the credit control department has proposed that customers should be given a 1% discount if they pay within 30 days. For those who do not pay within this period a maximum of 50 days’ credit should be given.

The credit department believes that 40 per cent of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. The credit department believes that bad debts can be eliminated by adopting the above policies and by employing stricter credit investigation procedures which will cost an additional £10,000 per year. The credit department is confident that these new policies will not result in any reduction in sales. The business uses an overdraft facility to fund its credit sales, on which it pays annual interest of 10%.

Required:

• Explain the meaning of the term ‘working capital’. (5 marks)
• Calculate the net annual cost or benefit to the company of abandoning its existing credit policy and adopting the proposal of the credit control department. (18 marks)
• Which credit policy would you recommend and why? (2marks)

 

The Board of Oak Ltd has found out that a competitor company, Ash Plc, is experiencing liquidity problems due to overtrading. Here is some further information about Ash Plc:

EXTRACT FROM BALANCE SHEET	Ash plc £000
Inventories	1,500
Trade receivables	600
Trade payables	(100)
EXTRACTS FROM INCOME STATEMENT
Sales	15,000
Cost of sales	12,000
Purchases of goods for resale	10,000

 

• Explain the term ‘overtrading’ and state how overtrading might occur. (5 marks)
• Discuss the kinds of problems that overtrading can create for a business. (10 marks)
• Calculate the cash conversion cycle for Oak Ltd. (4 marks)
• State the ways in which Oak Ltd business may overcome the problem of overtrading. (6 marks)

 

 

Total 50 marks

End of Question 2

 

Question 3                                                                                                              (50 marks)

 

Part A. The capital structure debate has two major schools of thought.

Required: Critically discuss the “traditionalist” and “modernist” views on capital structure.   (10 marks)

 

Part B. The following summarised balance sheet information is available for two UK companies, which operate in the same sector, with the same total capital employed:

EXTRACT FROM BALANCE SHEET	Rose plc £000	Acer plc £000
Non-current assets	3,200	3,200
Current assets less current liabilities	400	400
Total net assets	3,600	3,600
LESS: Creditors due after one year – 10% debentures	(1,600)	(800)
	2,000	2,800
Financed by
Ordinary Shares	200	2,800
12% preference shares	1,800	0
	2,000	2,800

 

No interest was receivable by either of the companies, and the profit before interest and tax (PBIT) for both companies was £200,000.

Part B Required:

1. Calculate the gearing for both companies. (4 marks)
2. Calculate the interest cover for both companies. (4 marks)
3. Evaluate on a comparative basis the current financing of both companies as far as the information available allows. (12 marks)

Part C. Acer plc has provided you with the following additional information about its inventory. Acer plc uses 20,000 units per year of a particular item of inventory. It costs £28 for each order placed with the supplier and the annual cost of holding each of the units is £1.20. The lead time on orders is two weeks. Demand for the inventory is steady throughout the year. The business maintains a buffer inventory of 100 units.

Part C Required:

1. Calculate the reorder point for Acer plc. (4 marks)
2. Calculate economic order quantity (EOQ) and the total annual cost of managing inventories for this business assuming costs are minimised. (10 marks)

Part D. Vasililis plc’s (another company in the sector) cost of ordinary shares (15%) was estimated using the dividend growth model. A dividend has just been paid (5 pence) and the share price of 61 pence is based on the assumption that this will increase at a fixed rate each year in the future.

 

Required: What growth rate has been assumed for the business’s ordinary share dividend? (6 marks)

Total 50 marks

End of Question 3

 

FORMULA SHEET

 

 

COST OF CAPITAL
Description	Formula
For Ordinary Shares   Where: K0 = Cost of ordinary shares to the business D1 = Annual dividend per share in year 1 g = Growth rate of dividends Po = Current market value of the share
For Preference Shares   Where: Kp = Cost of preference shares to the business Dp = Annual Dividend Payment Pp = Current Market Price of the preference shares
Irredeemable Loan Capital   Where: Kd = Cost of Loan Capital to the Business I = Annual Rate of Interest on the Loan Capital t = Rate of Corporation Tax Pd = Current Market Value of the Loan Capital

 

 

GEARING Gearing ratio (%) = x 100%     Degree of financial gearing =                                                   Where: EPS   = earnings per share PBIT = profit before interest and tax

 

 

 

INTEREST COVER Interest cover ratio =   Where: PBIT = Profit Before Interest and Tax

 

 

WORKING CAPITAL MANAGEMENT

 

Economic Order Quantity =

 

EOQ =

 

Total annual cost of managing inventory =                                          DC     +   EOQ*H

                                                                                                                EOQ             2

 

 

 

Where:

EOQ= Economic Order Quantity

D=the annual demand for the inventories items

C= the cost of placing an order

H=the cost of holding one unit of inventory item for one year

 

Cash or Operating Conversion Cycle (CCC or OCC) =

Inventory days + Accounts Receivable Days– Accounts Payable Days

Where:

Inventory days = Inventories/Cost Of Goods Sold (COGS) x 365

Accounts (Trade) receivable days = Trade receivables/turnover x 365

Accounts (Trade) payable days = Trade payables/purchases x 365