Analysis Of Louise Leasing And Manchester Plc Finance Essay

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"Manchester" Plc is a telecommunications company. The consolidated

income statement and balance sheet for the year ended 31st March 2008

are shown below with comparative figures for 2007.

Note

The market share price of "Manchester" plc is:

31st March 2008 - £10 per share

31st March 2007 - £12 per share

Required

a) Using accounting ratios, evaluate the overall performance of

"Manchester" plc for the years ended 31st March 2008 and 2007.

(30 marks)

b) Discuss the main principles of financial management.

(5 marks)

c) Discuss the means of effective working capital management.

(5 marks)

(Total 40 marks)

Question 2

At the beginning of its accounting year Alice plc leases a machine from

Louise Leasing plc. The following information relates to the lease

agreement:

The term of the lease is 5 years, and the lease agreement is non-cancellable,

requiring equal rental payments of £9,276 at the beginning of each year;

The machine has a fair value at the inception of the lease of £40,000, an

estimated economic life of 5 years, and no residual value;

Alice plc's incremental borrowing rate is 10% per year;

Alice plc depreciates similar equipment that it owns on a straight-line basis;

Louise Leasing plc has set the annual rental to earn a rate of return on its

investment of 8% per year; this fact is known to Alice plc.

Required:

Should the above lease agreement be accounted for as a finance or an

operating lease? Give reasons to justify your answer.

(5 marks)

Prepare the journal entries for Alice plc that relate to the above lease

agreement during years 1 and 2 for each of the following assumptions:

The lease is classified as a finance lease;

The actuarial method should be used to allocate finance charges to

accounting periods during the lease term.

(ii) The lease is classified as an operating lease.

(25 marks)

With reference to (b) discuss the extent to which the distinction between a

finance lease and an operating lease is important for financial reporting and

analysis.

(10 marks)

(Total 40 marks)

Answers

Let us describe the following criteria to see whether the agreement is a

finance or operating lease

Criteria

Yes/No

Comments

Transfer of ownership at end of lease

No

Bargain purchase option

No

Lease term is 75 % or more of the economic life

Yes

100 % of estimated economic life

Present value of the minimum lease payment (MLP) is 90% or more of fair

value

Yes

£46,380/£40,000 = 115,95 % > 90 %

The two criteria above are met and we conclude that the agreement should

be accounted for as a finance (capital) lease. And in addition, this

agreement is non cancellable.

(i) As a finance lease:

Lease payment schedule: we shall use the rate of return of the lesser since

the lessee knows it, that is 8 %

Year

Lease payment

Interest

Reduction Liability

Lease liability

0

£40,000

1

£9,276

£3,200

£6,076

£33,924

2

£9,276

£2,714

£6,562

£27,362

3

£9,276

£2,189

£7,087

£20,275

4

£9,276

£1,622

£7,654

£12,621

5

£9,276

£1,010

£8,266

£ 4,355

Journal entries for Year 1 and Year 2

Year 1

Machine lease

40,000

Lease Obligation

40,000

Depreciation expense

8,000

Accumulated depreciation

8,000

Lease Obligation

9,276

Interest revenue

3,200

Lease Liability

6,076

Year 2

Lease Obligation

9,276

Interest revenue

2,714

Lease Liability

6,562

Depreciation expense

8,000

Accumulated depreciation

8,000

(ii) Now the lease is classified as the operating lease, we shall record each

lease payment as rent expense.

Year 1

Rent expense

9,276

Cash

9,276

Year 2

9,276

9,276

Knowing whether the agreement is either the finance or the operating lease

is very important given accounting and financial implications that are

incurred for each type of lease.

In the finance lease, since the lease offers all of benefits and risks of

ownership to the lessee, this leads to more complicated accounting

recording that needs particular attention for both lessee and lessor. The

finance leases are included on the balance sheet of the lessee while the

operating leases are off-balance-sheet financing for the lessee (it is included

only in the notes to the financial statements).

From (b) above, we can notice the following:

In the finance lease, the lease is considered as an asset and as a liability on

balance sheet. And the lessee will claim depreciation each year on the asset

and will discount the interest expense of the lease payment. We can notice

at overall view that there are lower current ratios, higher debt and leverage

ratios and lower asset turnover and lower profitability in the early years on

the lease term. The net income is lower in the early years and higher in the

later years of the lease term.

In the operating lease, the lease expense is treated as an operating expense

in the income statement and has no effect on the balance sheet.

Here, the net income is higher in the early years and lower in the later

years of the lease term. In the contrast of the finance lease, the current

ratios are higher, debt and leverage ratios are lower and asset turnover and

profitability ratios become higher especially in the early years of the asset

life.

Question 3

a) The table below presents information about the Treasury bill I and

securities A, B and C. The data presented refer to five states of economy:

recession, below average, average, above average and boom.

Economy

Probability

T-Bill

Security A

Security B

Recession

0.1

8%

-22%

28%

Below average

0.2

8%

-2%

14.7%

Average

0.4

8%

20%

0%

Above average

0.2

8%

35%

-10%

Boom

0.1

8%

50%

-20%

Required

a1) Calculate the expected return of the Treasury bill and securities A and

B.

a2) Calculate the standard deviation of the Treasury bill and securities A

and B.

a3) Calculate the coefficient of variation of the Treasury bill and securities A

and B.

a4) Calculate the expected return and standard deviation of a portfolio

consisting of 60% of security A and 40% of security B (assuming the

correlation between A and B is 0.2).

a5) Briefly interpret the correlation coefficient that is given above.

(25 marks)

b) Describe the Capital Asset Pricing Model (CAPM) and the Arbitrage

Pricing Theory (APT).

(10 marks)

c) Define the terms "business risk" and "financial risk".

(5 marks)

(Total 40 marks)

Answers

We shall be using the following formula:

Expected value or mean (μ) = ∑ (v x P)

Where,

μ = mean or the expected value

v = possible value

P = probability

Standard deviation (σ)= √∑ P (v- μ)2

Coefficient of variation (CV) = σ/ μ

Expected rate of return, E(Rp), of two assets, A and B is

E (Rp)= [Wa + E(Ra)] + [Wb + E(Rb)], where,

Wa = the weight

E (Ra) = Expected rate of return

The standard deviation of two securities ( or assets) is

σ AB=√W2Ax σ2A+W2Bx σ2B+2WAWBrAB σA σB, where,

WA is the weighted average of the expected return of the Security A

WB is the weighted average of the expected return of the Security B

σA is the standard deviation of the security A

σB is the standard deviation of the security B

and rAB is the correlation coefficient between A and B

a1) Expected returns of the three securities are calculated below:

Probability

T Bill

Security A

Security B

0.1

8%x0.1=0.8%

-22%x0.1=-2.2%

28%x0.1=2.8%

0.2

8%x0.2=1.6%

-2%x0.2=-0.4%

14.7%x0.2=2.94%

0.4

8%x0.4=3.2%

20%x0.4=8%

0%x0.4=0%

0.2

8%x0.2=1.6%

35%x0.2=7%

-10%x0.2=-2%

0.1

8%x0.1=0.8%

50%x0.1=5%

-20%x0.1=-2%

Total/Expected return

8%

17.4%

1.74%

a2) Calculation of the standard deviation

Standard deviation of the T- Bill = √0.1 (8-8)2 + 0.2(8-8)2 +0.4(8-

8)2+0.2(8-8)2+0.1(8-8)2=0

Standard deviation of the Security A = √0.1 (-22-17.4)2 + 0.2(-2-

17.4)2+0.4(20-17.4)2+

0.2(35-17.4)2+0.1(50-17.4)2

The standard deviation for the Security A = 22.035%

Standard Deviation of the Security B = √0.1 (28-1.74)2+0.2(14.7-

1.74)2+0.4(0-1.74)2

+0.2(-10-1.74)2+0.1(-20-1.74)2

= √0.1x26.262+0.2x12.962+0.4x3.0276+0.2x11.742+0.1x21.742

= √0.1x689.5876+0.2x167.9616+1.21104+0.2x137.8276+0.1x472.6276

= √68.95876+33.59232+1.21104+27.56552+47.26276

= √178.5904

= 13.36.

a3) Calculation of the coefficient of variation (CV)

CV of the T- Bill = 0/8 = 0 %

CV of the Security A = 22.035/17.4=1.26%

CV of the security B = 13.36/1.74=7.67%

a4) Calculation of the expected return and standard deviation of a portfolio of two securities A and B are:

The expected return in a portfolio containing 60 % Security A and 40% Security B is

= 0.60x0.174 + 0.40x0.0174

= 0.1044+0.00696

= 0.11136= 11.136%

The standard deviation of the two securities A and B is

= √0.62x22.035+0.42x13.36+2x0.6x22.035x0.4x13.36x0.2

= √0.36x22.035+0.16x13.36+28.2612096

= √7.9326+2.1376+28.2612096

= √38.3314096

= 6.19%

a5) The correlation coefficient values vary between -1 and +1. This

correlation indicates the degree to which one variable is linearly related to

another.

If the correlation coefficient is negative, this indicates the negative

correlation while if positive, it indicates the positive correlation.

The correlation between A and B is here 0.2, positive, this means that A and

B change their values proportionately in the same direction at the same

time at 0.2 degree. And since +0.2 is less than +1.0, this falls in with the

statement that any time the correlation coefficient of the returns of two

assets is less than +1.0 (here +0.2) then the standard deviation of their

portfolio - here is 6.19 % - will be less than the weighted average of the

individual assets' standard deviations (22.035% for A and 13.36% for B).

We can assume also that the cash flows of each A or B may be due to

different and even unrelated factors.

b1) Capital asset Pricing Model:

Developed by the financial theorists William F. Sharpe (1964), John Lintner

(1965) and Jan Mossin, the capital asset pricing model (CAPM) is the

powerful tool to measure risk and the relation between expected return and

risk. This model stipulates that the equilibrium rates of return on all risky

assets are a linear function of their covariances and with the market

portfolio.

The use of the CAPM over the last decades had led several financial experts

to qualify it as the "Birth of the asset pricing models". This model draws its

assets to the portfolio theory developed by Harry Markowitz who, in 1959,

says that an investor selects a portfolio at a time that produces a stochastic

return at another time.

In fact, the Markowitz's model as an algebraic condition which that CAPM

has turned into the testable prediction about the relation between risk and

expected return. This is made possible by identification of the portfolio that

must be efficient if asset prices are to clear the market of all assets.

The CAPM formula below allows calculating the appropriate required rate

of return for an investment project given its degree of risk.

The CAPM formula kp = kRF+ (kM - kRF) x ß, where,

kp is the required rate of return appropriate for the investment project

kRF is the risk-free rate of return

kM is the required rate of return on the overall market

ß is the project's beta that allows to measure the degree of non diversifiable

risk

kM - kRF is the risk premium

As above stated, the CAPM uses variance as a measure of risk and specifies

that only the portion of variance that is not diversifiable is rewarded. It

measures the non diversifiable risk with beta, which is standardized around

one:

If ß = 1, average risk investment

ß > 1, above risk investment

ß< 1, below risk investment

ß = 0, riskless investment

The CAPM properties are:

Total risk = systematic risk + unsystematic risk

The systematic risk measures how the asset co-varies with the entire

economy (cannot be diversified away without cost): e.g. interest rate,

business cycle, etc

The unsystematic risk measures the idiosyncratic shocks specific to the

asset (can be diversified away with no cost): e.g. death of the financial

manager, etc.

Every asset, in equilibrium, must be priced so that its risk-adjusted required

rate of return falls exactly on the security market line;

CAPM quantifies the systematic risk of any asset at its beta

Expected return of any risky asset depends linearly on its exposure to the

market (systematic) risk, measured by beta;

Assets with higher beta require a higher risk-adjusted rate of return. In

other words, in market equilibrium, investors are only rewarded for bearing

the market risk.

The practical applications of the Market Asset Pricing Model (CAPM) are

the valuation of risky assets, the estimation of required rate of return of

risky projects.

b2) The Arbitrage Pricing Theory (APT)

The APT is an alternative of CAPM because they both use the linear relation

between assets' expected returns and their co-variances with other random

variables.

Developed by Ross in 1976, Ross says that if equilibrium prices offer no

arbitrage opportunities over static portfolios of the assets, then the

expected returns on the assets are approximately linearly related to the

factor loadings ( or betas), which in return are proportional to the returns'

co variances with factors.

APT has the following principles:

Two items that are the same cannot sell at different prices;

If they sell at different prices, arbitrage will take place in which

arbitrageurs buy the good which cheap and sell the one which is higher till

all prices for the goods are equal.

The assumption of investors utilizing a mean-variance framework is

replaced by an assumption of the process of generating security returns;

It requires that the returns on any stocks be linearly related to a set of

indices;

APT is a generalization of the CAPM: multiple factors have an impact on the

returns of an asset in contrast with CAPM that suggests that return is

related to only one factor (beta), the systematic risk: e.g. inflation, political

instability, changes of interest rates, etc.

The assumptions of the Arbitrage Pricing Theory are:

Capital markets are perfectly competitive;

Investors always prefer more wealth to less wealth with certainty.

Its formula is

r = rf + ß1f1+ ß22f2+…... where,

r = expected return

rf = risk free rate

f = a separate factor

ß = a measure of relationship between the price and that factor.

Business risk and financial risk

Business risk refers to the uncertainty a company has with regard to its

operating income (or EBIT = Income Before Interest and Taxes).

Measuring the business risk leads to measuring the degree of this

uncertainty about the company's operating income; in other words, this

means measuring the variability of its EBIT. We do it by calculating the

standard deviation of the EBIT forecast:

If the standard deviation is small, there is little variability and little

uncertainty of the EBIT

If the standard deviation is large, there is great uncertainty about the

operating income.

The standard deviation depends on the sales volatility, fixed operating costs

and is

associated with its operations. The business risk is affected by the

company's

investment decisions.

Financial risk refers to the additional volatility of a company's net income

caused by the presence of fixed interest expenses. The financial risk is

measured by noting the difference between the volatility of net income in

two scenarios: there is and there is not interest expense. This is done by

subtracting their coefficients of variation.

Companies that operate primarily on debt are exposed to a higher degree of

financial risk while those operating on equity financing have no financial

risk.

The financial risk is also called the financial leverage and is associated with

the company capital structure and is affected by its financing decisions.

PART B

Question 4

a) Describe the factors that should be taken into consideration by firms

when forming their capital structure.

(10 marks)

Answer:

The capital structure of the firm refers to the mix of debt and equity the

firm uses to finance its long term operations.

The firm should plan its capital structure to maximize the use of these funds

and to be able to adapt more easily to the changing conditions and

circumstances. Therefore, when forming its capital structure, the firm must

take into consideration the following general factors:

Profitability: The capital structure should be the most advantageous: the

maximum use of leverage at a minimum cost;

Solvency: A debt that adds significant risk should be avoided;

Capacity: The capital structure should be determined within the debt

capacity of the firm that should have enough cash to pay creditors' fixed

charges and principal sum.

Flexibility: the firm should be flexible to the changing conditions and should

be able to provide funds whenever needed to finance its profitable activities;

Control: the capital structure should involve the minimum risk of loss of

control of the firm.

And these external and internal factors related to the size and other

features should be considered:

Internal factors including

the size of business,

nature of business,

regularity and certainty of income,

age of the firm,

desire to certain control,

future plans,

trading on equity where debt and preference shares are main sources of

finance,

period and purpose of financing;

External factors including

capital market conditions,

nature of investors,

statutory requirements,

taxation policy,

policies of financial institutions,

cost of financing,

seasonal variations,

economic fluctuations and the nature of competition.

Different theories were developed to try to define the interchangeability and

interdependence of these factors.

b) Describe the "Efficient Market Hypothesis" (EMH). Explain how the

"Efficient Market Hypothesis" is used to explain the stock market behaviour.

(10 marks)

(Total 20 marks)

Answer:

The EMH states that there is perfect information in the stock market, i.e.

whatever information about a stock is available to one investor is available

to other investors.

In other words, in an efficient financial market, an asset's price should be

the best possible estimate of its economic values.

And a financial market is informationally efficient when market prices

reflect all available information about value.

All available information includes past prices, public and inside information

(news, past prices).

All this information available has a great impact on the market behaviour

because when data gathered from different stock markets can show any

correlation between their returns and prices. The latter in turn react to

news quickly.

However, in such a context, we cannot assume we have exhaustively all

available information about the stock markets and confirm absolutely that

the prices are low or high.

With the EMH, it is not necessary to spend a lot of time to pick stocks that

may become winners but instead looking to match the market's

performance though we cannot consistently outperform.