the board of paper Co. has decided to. limit investment funds to sh. 10 million for the next year and is preparing it's capital budget. the company is considering five projects as follows: 1. initial investment. net present value project A. sh. 2,500,000. sh. 1,000,000 project B. sh. 2,200,000. sh. 1,550,000 project C sh. 2,600,000. sh. 1,350,000 project D. sh. 1,900,000. sh. 1,500,000 project E. sh. 5,000,000. to be calculated

all five projects have a project life of four years. project A, B, C, and D are divisible and projects B and D are mutually exclusive. All net present values are in nominal after tax terms. project E This is a strategically important project which the board if Paper Co. have decided must be undertaken in order for the company to remain competitive, regardless of its financial acceptability. information relating to the future cash flows of this project is as follows. year. 1. 2. 3. 4 sales vol (units) 12,000. 13,000 10,000 10,000 s. p (sh/unit) 450. 475. 500. 570 variable cost. 260. 280. 295. 320 fixed costs. 750. 750. 750. 750

These forecasts are before taking account of selling price inflation of 5.0% per year, variable cost inflation of 6.0% per year and fixed cost inflation of 3.5% per year. the fixed costs are incremental fixed costs which are associated with project E. At the end of four years, machinery from the project will be sold for scrap with a value of sh. 400,000. Tax allowable depreciation on the initial investment cost of the project E is available on a 25% reducing balance basis and OAP Co. pays corporation tax of 28% per year, one yaer DFI 501 FINANCIAL MANAGEMENTASSIGNMENT The Question One should be handed in as assignment in two weeks time QUESTION ONE (Assignment) The Board of OAP Co has decided to limit investment funds to Sh.10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows: I Initial investment Net present value Project A Sh.2,500,000 Sh.1,000,000 Project B Sh.2,200,000 Sh.1,550,000 Project C Sh.2,600,000 Sh.1,350,000 Project D Sh.1,900,000 Sh.1,500,000 Project E Sh.5,000,000 To be calculated All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms. Project E This is a strategically important project which the Board of OAP Co have decided must be undertaken in order for the company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows: Year 1 2 3 4 Sales volume (units) 12,000 13,000 10,000 10,000 Selling price (Sh./unit) 450 475 500 570 Variable cost (Sh./unit) 260 280 295 320 Fixed costs (Sh.000) 750 750 750 750 These forecasts are before taking account of selling price inflation of 50% per year, variable cost inflation of 60% per year and fixed cost inflation of 35% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of Sh.400,000. Tax allowable depreciation on the initial investment cost of Project E is available on a 25% reducing balance basis and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available at the end of the fourth year of operation. OAP Co has a nominal after-tax cost of capital of 13% per year. Required: (a) Calculate the nominal after-tax net present value of Project E and comment on the financial acceptability of this project. (14 marks) (b) Calculate the maximum net present value which can be obtained from investing the fund of Sh.10 million, assuming here that the nominal after-tax NPV of Project E is zero. (5 marks) (c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds for the next year.(6 marks) (25 marks) QUESTION TWO (Illustration) The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows: Sh.000 Sh.000 Inventory 5,700 Trade receivables 6,575 12,275 Trade payables 2,137 Overdraft 4,682 6,819 Net current assets 5,456 For the year to end of March 2014, CSZ Co had domestic and foreign sales of Sh.40 million, all on credit, while cost of sales was Sh.26 million. Trade payables related to both domestic and foreign suppliers. For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at Sh.40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the companys overdraft. CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015: Inventory days: 60 days Trade receivables days: 75 days Trade payables days: 55 days Current ratio: 14 times Required: (a) Calculate the operating and the cash collection cycles of CSZ Co at the end of March 2014 and discuss whether a cash conversion cycle should be positive or negative. (6 marks) (b) Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working capital of CSZ Co at the end of March 2015. (5 marks) (c) Analyse and compare the current asset and current liability positions for March 2014 and March 2015, and discuss how the working capital financing policy of CSZ Co would have changed. (8 marks) (d) Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign currency transaction risk arising from its continuing business activities. (6 marks) (25 marks) ANSWER TO QUESTION TWO (a) Inventory days = 365 x (5,700/26,000) = 80 days Trade receivables days = 365 x (6,575/40,000) = 60 days Trade payables days = 365 x (2,137/26,000) = 30 days The Operating cycle is = 80 +60 =140 days Cash conversion cycle of CSZ Co = 80 + 60 30 = 110 days The cash conversion cycle of CSZ Co is positive and the company pays its trade suppliers 110 days (on average) before it receives cash from its customers. This represents a financing need as far as CSZ Co is concerned, which could be funded from a short-term or long-term source. If the CCC had been negative, CSZ Co would have been receiving cash from its customers before it needed to pay its trade suppliers. A company which does not give credit to its customers, such as a supermarket chain, can have a negative CC cycle. Even if companies might generally prefer to be paid by customers before they have to pay their suppliers, the question of whether the CC cycle should be positive or negative implies that companies are able to make such a choice, but this is not usually the case. This is because the length of the CC cycle depends on its elements, which are inventory days, trade receivables days and trade payables, and these elements usually depend on the nature of the business undertaken by a company and the way that business is conducted by its competitors. The length of the CC cycle is usually therefore similar between companies in the same business sector, but can differ between business sectors. (b) At the end of March 2015: Cost of sales = 40,000,000 x 06 = Sh.24,000,000 Inventory using target inventory days = 24,000,000 x 60/365 = Sh.3,945,206 Trade receivables using target trade receivables days = 40,000,000 x 75/365 = Sh.8,219,178 Current assets = 3,945,206 + 8,219,178 = Sh.12,164,384 If the target current ratio is 14 times, current liabilities = 12,164,384/14 = Sh.8,688,846 The target quick ratio (acid test ratio) = 8,219,178/8,688,846 = 095 times Net current assets at the end of March 2015 = 12,164,384 8,688,846 = Sh.3,475,538 Target sales/net working capital ratio = 40,000,000/3,475,538 = 115 times (c) The current liabilities at the end of March 2015, calculated in part (b), can be divided into trade payables and the forecast overdraft balance. Trade payables using target trade payables days = 24,000,000 x 55/365 = Sh.3,616,438. The overdraft (balancing figure) = 8,688,846 3,616,438 = Sh.5,072,408 Comparing current assets and current liability ies: March 2014 March 2015 Sh.000 Sh.000 Sh.000 Sh.000 Inventory 5,700 3,945 Trade receivables 6,575 12,275 8,219 12,164 Trade payables 2,137 3,616 Overdraft 4,682 6,819 5,072 8,688 Net current assets 5,456 3,476 The overdraft as a percentage of current liabilities will fall from 69% (4,682/6,819) to 58% (5,072/8,688). Even though the overdraft is expected to increase by 83%, current liabilities are expected to increase by 274% (8,688/6,819). Most of this increase is expected to be carried by trade payables, which will rise by 692% (3,616/2,137), with trade payables days increasing from 30 days to 55 days. At the end of March 2014, current liabilities were 56% of current assets (100 x 6,819/12,275), suggesting that 44% of current assets were financed from a long-term source. At the end of March 2015, current liabilities are expected to be 71% of current assets (100 x 8,688/12,164), suggesting that 29% of current assets are financed from a long-term source. This increasing reliance on short-term finance implies an aggressive change in the working capital financing policy of CSZ Co. (d) Transaction risk relates to foreign currency transactions which are short-term in nature, such as payments expected by a company from foreign trade receivables, payments made by a company in settling foreign trade payables, and interest payments made by a company on foreign currency-denominated debt. Transaction risk can be managed by several internal methods. Currency of invoice One internal hedging method is for a company to invoice foreign customers in its domestic currency, thereby transferring the foreign currency risk to the foreign customers. This method is usually not commercially viable, however, as foreign customers will transfer their business to competitors who do invoice in the foreign currency, thereby avoiding the foreign currency risk. Matching The risk arising from foreign currency receipts and payments can be managed by matching. Receipts and payments in the same foreign currency can be matched, for example, by using a foreign currency bank account, so that there is no need to buy the foreign currency. Taking a longer-term view, assets and liabilities can be matched in order to hedge foreign currency risk. For example, a company expecting regular foreign currency income can use debt in the same currency to meet a financing need, so that the foreign currency interest on the debt can be met from the foreign currency income. Leading and lagging Transaction risk can be managed by leadi7ng and lagging, where foreign currency payments could be made in advance (leading) or in arrears (lagging), depending on the view of the paying company as to whether the currency of payment was expected to appreciate or depreciate against the domestic currency. Lagged payments to accounts payable should not exceed the credit period agreed with the supplier, however. Sharing and diversifying FX risk The risk may be shared between the counterparties, or could be diversified by invoicing in a basket of currencies such as SDR