Understanding Role of Financial Management in Business Entities

Knowledge

• Discuss and briefly analyse the key strategic decisions that a business may have to make and appreciated how accounting and finance can assist in making and evaluating those decisions.
• A brief evaluation of specific analytical skills in key decision areas within strategy and finance at local and international level
• A brief understanding of the limitations of the current state of financial theory in making strategic business finance decisions

Skills

• Use the key valuation concepts and methodologies of financial decision making in order to contribute to the wider decision making of the organisation 

Answer any TWO questions. Each question that is attempted will carry a maximum mark of 50%

Question 1: Cost of capital and Capital structure 

The capital structure of company is currently being reviewed by the finance director of Kadlex plc.  She is convinced that the company is not financing itself in a way that the cost of capital (WACC) is minimised. The company’s financing as at 31 December 2017 is as follows:

£000

Ordinary shares, £1each                                              20000

Reserves                                                                        5000

7% preference shares, £1each                                     10000

10% bonds (irredeemable 31 December2017)            15000

Total capital                                                                  50000

 Other information from stock market (as at 31December2017):

Ordinary shareprice (ex-div)                       £2.65

Preference shareprice (ex-div)                     75p

Bond price for10% bonds                            £107 per £100

Last 5 years’ dividends (most recent last) 21p, 23p, 25p 27p,28p

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The finance director assumes that by issuing more debt the company will be able to reduce its cost of capital. She proposes the issue of £15m of 11 per cent bonds. These bonds will be sold at a 5 per cent premium to their par value and will mature after seven years. It will be able to repurchase ordinary shares by raising funds which the company will then cancel. She expects the repurchase will cause the company’s share price to rise to £2.85 and the future dividend growth rate to increase by 20 per cent (in relative terms). She expects the price of the 10 per cent bonds to be not affected, but the price of the preference shares to fall to 68p. Corporate tax stands at 30 percent.

 (a) Evaluate the book value and market value cost of capital (WACC) for Kadlex plc. (10 marks)

 (b) Analyse the company’s cost of capital to reflect these changes and comment on the finance director’s projections with the proposed changes to Kadlex’s capital structure. (10 marks)

(c) Briefly evaluate whether you consider that companies, by integrating a sensible level of gearing into their capital structure, can minimise their weighted average cost of capital, ensuring the response integrates relevant empirical research within this area of study.

(d) Briefly analyse the effects of short-termism on bankruptcy and the agency problem in a company, ensuring the response is supported with relevant academic research.

Question 2 – Long term finance: Equity finance 

(a) Lexbel plc generates earnings after tax (PAT) of 20 per cent on shareholders’ funds. Its current capital structure is as follows:

£

Ordinary shares of50p each                 300,000

Reserves                                              400,000

Total                                                     700,000

The board of Lexbel plc wants to increase £180,000 from a right issue in order to extend existing operations. Its return on shareholders’ funds will be unchanged. The present ex-dividend market price of Lexbel plc is £1.90. The finance director has issued three different rights where prices have been suggested by: £1.80, £1.60 and£1.40.

 (b) Determine the:

• number of shares to be issued.
• theoretical ex-rights price.
• expected earnings per share and
• form of the issue for each rights issue price, and
• Give your results in a tabular form and critically evaluate the best option among the three right issues.

(c) It is very common for companies to offer their shareholders a choice between a cash dividend and an equivalent scrip dividend. Briefly analyse the advantages of scrip dividends from the point of view of the company and the shareholders, ensuring the response draws upon relevant academic research within this highly topical area of financial management.

Question 3 Investment Appraisal Techniques 

Lovewell Limited a food manufacturer which is considering to purchase a new machine for £275,000. The organisation is expecting an annual cash inflow of £85,000 from the sale of products and an annual cash outflow of £12,500 for each of the six years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using the straight –line method. The machine is expected to last for six years, with a residual value estimated to be at the rate of 15% of the original cost of the machine. The cost of capital for Lovewell Limited is 12%.

 You are required to:

(a) Discuss using the following investment appraisal techniques, and give brief suggestions as to the economic feasibility of acquiring the machine:

• The Payback Period.
• The Accounting Rate of Return.
• The Net Present Value.
• The Internal Rate of Return (to two decimal places)

(b) Briefly analyse the benefits and limitations of each of the differing investment appraisal techniques, ensuring the response is supported with relevant academic research.

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