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Financial Management
SECTION A
Answer four questions from this section.
Question 1
Stellar plc reviews its credit policy at regular intervals. Its current policy offers customers a 60 days credit period with a discount of 2% for all payments settled within 30 days. 30% of its customers take advantage of the discounting facility and the remaining customers pay on average in 70 days. Bad debts currently stand at 4% of annual sales. Sales forecast for next year is £1,250,000, assuming this credit policy is maintained.
Two new policy proposals have been put forward by the senior management team. They are as follows:
Proposal 1
The finance director has called for the policy to be tightened. He believes customers should be offered a discount of 2% on pay settlement within 10 days and the remaining customers not taking advantage of the discount should be offered a credit period of 30 days. It is expected that only 15% of customers would take advantage of the discounting facility and the remaining customers would pay on average in 45 days. Bad debt will fall to 2% and annual sales forecast is not expected to change under this policy. To tighten the policy, the company would incur costs of £30,000.
Proposal 2
The marketing director takes an opposing view and she suggests that the policy should be relaxed to attract more customers. She proposes that customers be offered a 3% discount for all payments settled within 30 days. It is expected that 40% of customers would take advantage of the discounting facility. Policy for the remaining customers will be lax and they are likely to pay on average in 90 days. This proposal is likely to be attractive to the market and the marketing team forecast sales will rise by 25% if this policy is introduced. They accept it may attract high risk customers and propose that provision for bad debt be set to 6% of annual sales.
Stellar plc earns a contribution of 25% on sales revenue and its cost of capital has been estimated at 10% per annum.
Assume that 1 year comprises 365 days.
REQUIRED:
Advise Stellar plc, about which of the two proposals, if any, to adopt. (20 Marks)
[Total: 20 Marks]
Question 2
Supernova plc is in the process of determining its dividend policy for the next four years. Two different proposals have been made to the senior management team: (i) a residual policy, which the company currently follows and (ii) a fixed dividend policy with a growth element.
Below are the details relating to the company’s forecast profit levels (based on current assets, i.e. excluding those from planned reinvested profits) and plans for reinvestment.
|
0 |
1E |
2E |
3E |
4E |
Net profit (£m) |
120 |
120 |
140 |
140 |
160 |
Plans for reinvestment (£m) |
60 |
60 |
80 |
60 |
60 |
Return on the investment levels above are expected to be 10% per annum.
We are currently at the end of year 0, the end of the last financial year for which profits have just been reported and the first period for which the new dividend policy will be operational.
With the first dividend policy, annual dividend payments will be made from the residual income left after all funds required for reinvestment have been taken from the profits earned. At the end of year 4, the forecast PE ratio (ex div) under this strategy is expected to be 14.
The second dividend policy which has been proposed by the finance director requires the company to increase its dividends by a fixed percentage of 5% annually, regardless of the profit level. The starting dividend payment for year 0 has been proposed at £60 million. Any earnings not distributed by the firm as a dividend payment will be retained. These retained earnings will not earn any return. These funds can however be drawn upon to make up for any shortfall in reinvestment that may arise in future years.
Shareholders in Supernova plc require a return of 10% on their investment. Ignore taxation.
REQUIRED:
a) Given the information above and assuming that all the forecasts above come true, calculate the company’s equity value using the first dividend policy. (7 Marks)
b) Similarly, calculate the company’s equity value using the second dividend policy assuming that the forecast PE ratio (ex div) at the end of year 4 is expected to be 14.5. (7 Marks)
c) Discuss whether or not you believe the PE ratio in part b) above can be higher than that associated with the residual dividend policy in part a). (4 Marks)
d) Briefly explain any other factor that you would encourage the company to consider before finalising its dividend policy. (2 Marks)
[Total: 20 Marks]
Question 3
The Power Shipping Company is a bulk-carrier shipping business registered in Ruritania, the currency of which is the Ruritarian euro (R€). It has noticed the increasing international demand for wheat and wishes to exploit this feature. It has agreed to buy a British bulk-carrier for £40million. Certain specification changes will be necessary first, and delivery and full payment will be made in six months time.
The Power Shipping Company is considering the following possibilites in order to deal with the foreign exchange risk associated with the payment:
(i) A purchase of a euros forward contract and at present the six months
forward rate is at a discount of R€0.0197 per £.
(ii) An over-the-counter option contract with a six month maturity and an exercise price of R€1.34. The premium on the contract is R€0.015 per £1.
(iii) A money market hedge through the use of banks in Ruritania and the UK. At present the interest rates for six months are 3% and 1.5% in Ruritania and the UK, respectively. The company will have to pay a 0.1% administration charge on the sterling value to the bank.
The current spot rate is R€1.33 per £1 and the actual spot rate in six months time materialises to be R€1.3550 per £1.
REQUIRED:
a) Calculate the total cost in R€ terms of using each of the three options under consideration by the Power Shipping Company. (10 marks)
b) Comparing your outcomes in part a) with an unhedged position, calculate the hedge gain/loss for each of the three options above. (5 marks)
c) Describe the main features of each of the three methods used above to hedge the currency risk. Evaluate the three alternatives and recommend, in your view, the best method the Power Shipping Company should use to make its payment. (5 marks)
[Total: 20 Marks]
Question 4
Andromeda plc is a UK based company that operates in two industries: vaping, which makes up 60% of the company, and tobacco, which makes up the remaining 40% of the company. The company is an all-equity company financed by a share capital of 50
million £1 ordinary shares, currently priced at £3.00 each.
The company pays out an annual dividend on its ordinary shares. The dividend payment forecast for next year is £0.42 per share which represents a growth of 1.8% on the current year’s dividend payment. Management plans to maintain this growth rate in dividend levels for the foreseeable future.