Questions

1. Sludgewater

Sludgewater, a furniture manufacturer, has been reported to theanti-pollution authorities on several occasions in recent years, andfined substantial amounts for making excessive toxic discharges into theair. Both the environmental lobby and Sludgewater's shareholders havedemanded that it clean up its operations.

If no clean up takes place, Sludgewater estimates that the totalfines it would incur over the next three years can be summarised by thefollowing probability distribution (all figures are expressed in presentvalues).

A firm of environmental consultants has advised that spray paintingequipment can be installed at a cost of $4m to virtually eliminatedischarges. Unlike fines, expenditure on pollution control equipment istax-allowable via a 25% writing-down allowance (reducing balance, basedon gross expenditure).

The rate of corporation tax is 30%, paid with a one-year delay. Theequipment will have no scrap or resale value after its expected threeyear working life. The equipment can be in place ready for Sludgewater'snext financial year.

A European Union grant of 25% of gross expenditure is available,but with payment delayed by a year. The consultant's charge is $200,000and the new equipment will raise annual production costs by 2% of salesrevenue. Current sales are $15 million per annum, and are expected togrow by 5% per annum compound. No change in working capital isenvisaged.

Sludgewater applies a discount rate of 10% after tax on investmentprojects of this nature. All cash inflows and outflows occur at yearends.

Required:

(a)Calculate the expected net present value of the investment. Briefly comment on your results.

(b)Outline the main limitations of using expected values when making investment decisions.

(c)What financial and non-financial criteria will need to be considered when deciding whether the investment should be made.

2. Pheonix

Pheonix is considering the purchase of a new machine to makewood-burning stoves. They have had a market research survey conducted ata cost of $200,000. This predicts demand of 4,000 stoves per annum at aselling price of $750 per stove for 10 years.

The machine will cost $2,000,000, payable in two instalments as follows.

Depreciation of $180,000 per annum over the next 10 years will be provided to write down the machine to its scrap value.

Use will also be made of some existing equipment which originallycost $150,000, has a book value of $75,000 and would cost $200,000 toreplace.

Pheonix is currently negotiating the sale of this machine for $100,000.

Variable cost per stove will be $600, and in accordance with thenormal policy $250,000 of fixed overheads will be apportioned to the newproduct line per annum.

The machine will require its first service one year after purchase,and from then on will be serviced every year. Each service costs$50,000.

The machine will be brought into use immediately to build upinventory, but the first revenues will not be received until 31 December20X2. Variable costs are payable annually at the same time as therevenues are received.

Required:

Calculate the following:

(a)Return on capital employed on an initial investment basis.

(b)Return on capital employed on an average investment basis.

(c)Payback period.

(d)NPV at the company's cost of capital of 15%.

(e)Internal rate of return of the project.

(f)The sensitivity of your advice based on the NPV computed in (d) to errors in the estimates of

(i)the required rate of return

(ii) the selling price per unit

(iii)the level of demand.

Your answer should also include a comment on the sensitivities calculated.

3. Cloud Co

The following financial information related to Cloud Co:

Other information

(1)Sales for the year to 30 April20X0 were $89m, yielding an operating profit of $8.7m and a profitbefore tax (after finance costs) of $8.2m.

(2)At the beginning of the year to30 April 20X1 the company bought some new manufacturing equipment andrecruited six more sales staff.

(3)Sales for the year to 30 April 20X1 were $131m, with an operating profit of $8.5m, and a profit before tax of $7m.

Required:

(a)Explain the cash conversion cycle (operating cycle) and its significance in determining the working capital needed by a company.

(b)Calculate the cash operating cycle of Cloud Co for the years ending 30 April 20X0 and 20X1.

(c)Using additional calculations, together with your results to part (b) discuss whether or not Cloud Co is overtrading.

(d)Explain the different strategies a firm may follow in order to finance its working capital requirements.

(e)Suggest ways in which Cloud Comight seek to resolve its current funding problems, and avoid the risksassociated with overtrading.

4. Hexicon

(a)Hexicon Inc manufactures andmarkets automatic washing machines. Among the many hundreds ofcomponents which it purchases each year from external suppliers forassembling into the finished article are drive belts, of which it uses40,000 units pa. It is considering converting its purchasing, deliveryand inventory control of this item to a just-in-time system. This willraise the number of orders placed but lower the administrative and othercosts of placing and receiving orders. If successful, this will providethe model for switching most of its inwards supplies on to this system.Details of actual and expected ordering and carrying costs are given inthe table below.

To implement the new arrangements will require 'one-off'reorganisation costs estimated at $4,000 which will be treated as arevenue item for tax purposes. The rate of corporation tax is 33% andHexicon can obtain finance at 12%. The effective life span of the newsystem can be assumed to be eight years.

Required:

(i)Determine the effect of the new system on the economic order quantity (EOQ).

(ii) Determine whether the new system is worthwhile in financial terms.

(b)You are required to brieflyexplain the nature and objectives of JIT purchasing agreements concludedbetween components users and suppliers.

6. Marton

Marton Co produces a range of specialised components, supplying awide range of customers, all on credit terms. 20% of revenue is sold toone firm. Having used generous credit policies to encourage past growth,Marton Co now has to finance a substantial overdraft and is concernedabout its liquidity.

Marton Co borrows from its bank at 13% pa interest. No furthersales growth in volume or value terms is planned for the next year.

In order to speed up collection from customers, Marton Co is considering two alternative policies:

Option one

Factoring on a non-recourse basis, the factor administering andcollecting payment from Marton Co's customers. This is expected togenerate administrative savings of $200,000 pa and to lower the averagereceivable collection period by 15 days. The factor will make a servicecharge of 1% of Marton Co's revenue and also provide credit insurancefacilities for an annual premium of $80,000.

Option two

Offering discounts to customers who settle their accounts early.The amount of the discount will depend on speed of payment as follows.

Payment within 10 days of despatch of invoices 3%

Payment within 20 days of despatch of invoices 1.5%

It is estimated that customers representing 20% and 30% of MartonCo's sales respectively will take up these offers, the remaindercontinuing to take their present credit period.

Extracts from Marton Co's most recent accounts are given below:

Required:

(a)Calculate the net benefit to the company of taking option 1, the non-recourse factoring arrangement.

(8 marks)

(b)Calculate the net benefit to the company of taking option 2, offering a prompt payment discount to customers.

(10 marks)

(c)Recommend which option is the most financially advantageous policy. Comment on your results.