MANAGEMENT ACCOUNTING III

RAFFLES EDUCATION GROUPKuala Lumpur w Petaling Jaya w Penang w Singapore w Jakarta w Bangkok w Beijing w London w New-York

OLYMPIA BUSINESS SCHOOL

SCHOOL OF ACCOUNTING & FINANCE

ADVANCED DIPLOMA IN ACCOUNTING

FILO-TEXT

MANAGEMENT ACCOUNTING IIIMay, 1999

School Of Accounting & Finance Management Accounting III

Olympia Business School SoAF PJ/CI//1999

TABLE OF CONTENTS

TABLE OF CONTENTS............................................................................................................................... 2

ASSESSMENT............................................................................................................................................... 4

INDIVIDUAL ASSIGNMENT ............................................................................................................................ 4MID-TERM EXAMINATION ............................................................................................................................ 4TEAM PROJECT ............................................................................................................................................ 4FINAL EXAMINATION ................................................................................................................................... 5

ATTENDANCE ............................................................................................................................................. 5

FEES .............................................................................................................................................................. 5

CONTACT-TIME ......................................................................................................................................... 6

FULL-TIME................................................................................................................................................... 6PART-TIME................................................................................................................................................... 6

THE ACADEMIC TEAM ............................................................................................................................. 7

THE ACADEMIC PLANNER ...................................................................................................................... 8

INTRODUCTION ......................................................................................................................................... 9

THE SUBJECT CORPORATE FINANCE ............................................................................................................ 9

WEEK 1 ....................................................................................................................................................... 10

WEEK 2 ....................................................................................................................................................... 13

WEEK 3 ....................................................................................................................................................... 18

WEEK 4 ....................................................................................................................................................... 21

WEEK 5 ....................................................................................................................................................... 24

WEEK 6 ....................................................................................................................................................... 29

WEEK 7 ....................................................................................................................................................... 32

WEEK 8 ...................................................................................................................................................... 35

WEEK 9 ....................................................................................................................................................... 36

WEEK 10 ..................................................................................................................................................... 39

WEEK 11 ..................................................................................................................................................... 42

WEEK 12 ..................................................................................................................................................... 45



The Filo-text is a tool to assist you in your study at Olympia Business School. It providesgeneral information on the course structure and also details on the syllabus that you will becovering throughout your course.

The general information, provided at the beginning of this document, includes informationon the following:

• Assessment

• Attendance

• Fees

• Contact time

• The academic team

• The academic planner

To assist you in your classes and revision, this filo-text also provides information on thetopics you will be covering in each of the classes you will be attending. This informationincludes the following:

• The topic

• The objective(s) of the lecture

• The textbook, the chapter(s) and page(s) related to the given topic

• Other reference books available on the topic

• Additional reference material for your own research

• The objective(s) of the tutorial

• Questions to prepare for discussion during the tutorial

• Questions for your personal research and self-assessment

Use the Filo-text to prepare yourself prior to the lecture, between the lecture and the tutorialand after the tutorial.

HOW TO USE THE FILO TEXT ?



ASSESSMENT

Student assessment will be evaluated based on the following:

1) Individual Assignment 15 %

2) Mid-Term Examination 15 %

3) Team Project 20 %

4) Final Examination 50 %

Total 100 %

INDIVIDUAL ASSIGNMENT

An individual assignment will be given to the student on the first week and will have to bereturned no later than on the 8th week. The marked assignment will be returned to the student nolater than on week 10.

The assignment will be related to the topics covered between week 1 and week 6 inclusive.It will comprise a written report of approximately 500 words.

Should the student fail to submit his/her assignment on week 8, the result will automaticallybe zero.

MID-TERM EXAMINATION

A mid-term examination will be conducted during the lecture session of week 10. It willassess the students’ knowledge and understanding of the topics covered up to week 8.

The results, together with the answer scripts, will be returned to the students no later than onweek 12.

Should a student be absent without a valid apology, the result will automatically be zero.

TEAM PROJECT

A team project will be assigned to students during the first week. The team will comprise of4 to 6 students.

The report of the team project will have to be submitted to the subject lecturer by no laterthan week 12 and will be presented on week 13. Late submission won’t be entertained and willautomatically result in no marks being awarded.



FINAL EXAMINATION

The final examination will be conducted two weeks after you have completed your syllabus.The examination will take 3 hours.

Registration for the examination is open from week 5 and closes on week 8. Make sure youregister on time. No late registration will be entertained.

The format of the examination is as follows:

• Section A - Short Questions 5 * 4 Points

• Section C - Essay-type Questions Any 4 out of 6 * 20 Points

• Total 100 Points

ATTENDANCE

Attendance for both the lectures and the tutorials is compulsory. Any student not attending aclass should provide a medical certificate or a written justification (signed by a parent orguardian in the case of a full-time student). Should a student fail to do so, he / she will beconsidered truant.

If a student’s attendance for a given subject is lower then 70%, he / she will not be allowedto sit for the final examination.

Punctuality is equally important. The lecturer is entitled to refuse entry into the classroom toany student coming late for classes.

FEES

The registration fee is to be paid upon registration.

The course fee is paid either in full, per semester or by instalments. For payments made infull, the payment is due before the first lecture. For payments made by semester, the paymentper semester is due on the first day of the semester. For monthly instalments, the first paymentis due on the first day of class while subsequent payments are due on the first day of eachsubsequent month.

Should any student have difficulty to pay his / her fees on time, he / she must meet with the(Deputy) Principal to arrange an alternative. Any student who has not settled his / her fees andhas not met with the (Deputy) Principal will not be allowed to attend classes or sit for anexamination.



CONTACT-TIME

FULL-TIME

Classes are conducted over a period of 12 weeks. Contact time consists of 1 1/2 hours oflecture and 1 1/2 hours of tutorial per week.

PART-TIME

Classes are conducted over a period of 12 weeks. Contact time consists of 1 ½ hours oflecture per week.

For each hour of contact, the student is expected to spend at least 2 hours of unsupervisedwork, either individually or in groups.



THE ACADEMIC TEAM

At the beginning of the first lecture, please fill-in the following:

Day Time Room

Starting Finishing

Lecture

Lecturer

Consultation

Tutorial

Tutor

Consultation

Class Lecturer

Consultation

Lecturer-in-Charge

Consultation

Principal

Consultation

Head of Department

Consultation

Subject Representative



THE ACADEMIC PLANNER

This is an outline of the topics you will cover for this subject. Please ensure you fill-in thedates of the respective lectures during the first lecture.

Week Date Lecture Topic

1 The Finance Function

2 Capital Markets, Market Efficiency and Ratio Analysis

3 Investment Appraisal: Application & risk (1 )

4 Investment Appraisal: Application & risk (2 )

5 Sources Of Long-term Finance: Equity Finance

6 Sources Of Long-term Finance: Debt Finance, HybridFinance, And Leasing

7 Sources Of Long-term Finance: Debt Finance, HybridFinance, And Leasing

8 Mid-term Exam

9 The Cost Of Capital And Capital Structure ( 1 )

10 The Cost Of Capital And Capital Structure (2 )

11 Working Capital Management ( 1 )

12 Working Capital Management ( 2 )

13/14 Final Examination



INTRODUCTION

THE SUBJECT CORPORATE FINANCE

Welcome to Corporate Finance

Corporate finance is concerned with the financing and investment decisions made by themanagement of companies in pursuit of corporate goals. As a subject, corporate finance has atheoretical base which has evolved over many years and which continues to evolve. It has apractical side too, concerned with the study of how companies actually make financing andinvestment decisions, and it is often the case that theory and practice disagree.

The value of an option depends upon the extent to which it contributes towards theachievement of corporate goals. In corporate finance, the fundamental goal is usually taken tobe to increase the wealth of shareholders.



WEEK 1

Lecture Subject: THE FINANCE FUNCTION

Lecture Objectives:

On completion of this lecture, the student will be able to understand:

• The role of the financial manager

• Corporate objectives

• How is shareholders’ wealth maximized?

• Agency theory

• Corporate governance

Textbook:

Chapter(s) Pages

“Corporate Finance”, Denzil Watson & Tony Head, PitmanPublishing, 1998

1 1 to 17

Reference Books:

Chapter(s) Pages

Investment Appraisal & Financial decisions 3rd Edition

By Stephen Lumby

Capital Budgeting and Long –term financial Decisions 2nd

Edition By Neil Seitz

Additional Reference Material:

1) Weston, J. Fred, ‘New Theme in Finance,” Journal of Finance , March, 1974.

2) Myers, S. C. “ Finance Theory and Financial Strategy,” Midland corporation

Finance Journal, Spring, 1987.



Tutorial Subject: THE FINANCE FUNCTION

Tutorial Objectives:

On completion of this tutorial, the student will have:

• The role of the financial manager

• Corporate objectives

• How is shareholders’ wealth maximized?

• Agency theory

• Corporate governance

Questions to prepare for discussion during the tutorial:

1) What are the functions and areas of responsibility that fall under the control of the financialmanager?

2) Give examples to illustrate the high level of interdependence existing between the differentdecision areas of corporate finance.

3) Given the following possible corporate objectives, provide a rational argument explainingwhich of them should be the main goal of the financial manager:

(a) profit maximisation(b) sales maximisation

(c) maximisation of benefit to employees and the local community

(d) maximisation of shareholder wealth

4) Explain how a financial manager can, in practice, maximise the wealth of shareholders.

5) Give some examples of good financial management.

6) Which of the following will not lead to a reduction of agency problems experienced byshareholders?

(a) increased monitoring by shareholders(b) salary bonuses for management based on financial performance

(c) the granting of share options to management

(d) the use of restrictive covenants in bond deeds

(e) the use of shorter contracts for management

7) What is meant by the ‘agency problem’ in the context of a public limited company?

8) How is it possible for the agency problem to be reduced in a company?

9) What goals might be pursued by managers instead of maximisation of shareholder wealth?

10) Do you consider the agency problem to be of particular relevance to UK public limitedcompanies?



Questions available for self-assessment:

1) The primary financial objective of a company is stated by corporate finance theory to bethe maximisation of the wealth of its shareholders, but this objective is usually replaced bythe surrogate objective of maximisation of the company’s share price. Discuss the ways inwhich this substitution can be justified.

2) Explain why maximisation of a company’s share price is preferred as a financial objectiveto the maximisation of its sales.

3) Discuss the ways in which the concepts of agency theory can be used to explain therelationships that exist between the managers of a listed company and the providers of itsequity finance. Your answer should include an explanation of the following terms:

(a) asymmetry of information

(b) agency costs

(c) the free-rider problem

4) Discuss ways in which the shareholders of a company can encourage its managers to act ina way which is consistent with the objective of maximisation of shareholder wealth.

5) The primary financial objective of financial management is usually taken to be themaximisation of shareholder wealth. Discuss what other objectives may be important to a publiclimited company and whether such objectives are consistent with the primary objective ofshareholder wealth maximisation.

6) Discuss the significance of the Cadbury Report in the context of corporate governance inthe UK. Have its recommendations led to improvements?



WEEK 2

Lecture Subject: CAPITAL MARKETS, MARKET EFFICIENCY AND RATIOANALYSIS

Lecture Objectives:

On completion of this lecture, the student will be able to:

• Sources of business finance

• The capital markets

• Ratio analysis

Textbook:

Chapter(s) Pages

Corporate Finance”, Denzil Watson & Tony Head, PitmanPublishing, 1998

2 23 to 44

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: CAPITAL MARKETS, MARKET EFFICIENCY ANDRATIO ANALYSIS



• Sources of business finance

• The capital markets

• Ratio analysis


1) Explain the difference between retained earnings and retained profit.

2) Describe the factors that influence the relative proportions of internal and external financeused in capital investment.

3) What is the relevance of the efficient market hypothesis for corporate financial managers?

4) Which of the following statements about the efficient market hypothesis is not correct?

(a) if the stock market shows weak form efficiency, then chartists cannot make consistentlysuperior returns;

(b) if the market is strong form efficient, only people with insider information can beat themarket;

(c) if the market is semi-strong form efficient, then fundamental analysis will not bringabnormal returns to analysts;

(d) if the market is semi-strong form efficient, all past and current publicly availableinformation is reflected in the share price;

(e) if the market is weak form efficient, then all historic information about a share isembodied in its current market price.

5) Describe the features of a perfect capital market.

6) Explain the difference between allocational efficiency, pricing efficiency and operationalefficiency.

7) Why is it difficult to test for strong form efficiency?

8) Describe the different benchmarks that can be used for ratio analysis.

9) Describe the five categories of ratios and list and define the ratios in each category. In eachcase, without referring to the calculations in the text, calculate the relevant ratio for Boater plc.



10) What are the potential problems associated with using ratio analysis to analyse thefinancial health and performance of companies?

11) Questions available for self-assessment:

1) Distinguish between the primary and secondary capital markets in the UK and discuss therole played by these markets in financial management. What are the desirable characteristics ofprimary and secondary capital markets?

2) While there is a large body of evidence in support of the efficient market hypothesis, it hasbeen suggested that this evidence only shows that it is not possible to prove that markets areinefficient. Recent research has explored ‘anomalies’ in the behaviour of prices of securities.Briefly describe these anomalies and suggest possible explanations.

3) The following financial statements are extracts from the accounts of Hoult plc.

Profit and loss accounts for years ending 31 December

1995 1996 1997

$000 $000 $000

Sales 960 1080 1220

Cost of sales 670 780 885

Gross profit 290 300 335

Administration expenses 260 270 302

Operating profit 30 30 33

Interest 13 14 18

Profit before taxation 17 16 15

Taxation 2 1 1

Profit after taxation 15 15 14

Dividends 0 0 4

Retained profit 15 15 10



Balance sheets for years to 31 December

1995 1996 1997

$000 $000 $000 $000 $000 $000

Net fixed assets 160 120 100

Current assets:

Stock 200 210 225

Debtors 160 180 250

Cash 0 0 0

360 390 475

Current liabilities:

Trade creditors 75 80 145

Overdraft 70 80 110

145 160 255

Net current assets 215 230 220

Total assets less

current liabilities 375 350 320

8% debentures 120 80 40255 270 280

Capital and reserves:

Ordinary shares 160 160 160

Profit and loss 95 110 120

255 270 280

The 8% debentures are redeemable in installments and the final installment is due to be paid in1998.



The finance director is concerned about the poor liquidity of Hoult plc. and has asked you toreport on the company’s recent performance. After calculating appropriate ratios, comment onthe performance and financial health of Hoult plc.

4) You have been approached by Mr. Dayton, who is seeking advice about his investmentportfolio. He is considering purchasing shares in companies listed on either the Unlisted SecuritiesMarket or the Alternative Investment Market. Mr. Green, a friend of Mr. Dayton, has told him thathe should invest only in shares that are listed on markets that are efficient, since otherwise he cannotbe sure that he is paying a fair price for them. Mr. Dayton has explained to you that he is not surewhat an ‘efficient’ market is.

5) Critically discuss the following statements about stock market efficiency.

(a) The weak form of the efficient market hypothesis implies that it is possible for aninvestor to generate abnormal returns by analysing changes in past share prices.

(b) The semi-strong form of the efficient market hypothesis implies that it is possible for aninvestor to earn superior returns by studying company accounts, newspapers andinvestment journals, or by purchasing reports from market analysts.

(c) The strong form of the efficient market hypothesis implies that since security pricesreflect all available information, there is no way that investors can achieve abnormalreturns.

6) Discuss the importance of the efficient market hypothesis to the following parties:

(a) shareholders concerned about the maximisation of their wealth;

(b) corporate financial managers making capital investment decisions; and

(c) investors analysing the annual reports of listed companies.



WEEK 3

Lecture Subject: INVESTMENT APPRAISAL: APPLICATION & RISK (1)

Lecture Objectives:


• Relevant project cash flows

• Taxation and capital investment decisions

• Inflation and capital investment decisions

• Investment appraisal and risk

Textbook: Chapter(s) Pages

Corporate Finance”, Denzil Watson & Tony Head, PitmanPublishing, 1998

4 83 to100

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: INVESTMENT APPRAISAL : APPLICATION & RISK



• Relevant project cash flows

• Taxation and capital investment decisions

• Inflation and capital investment decisions

• Investment appraisal and risk


1) A machine is to be purchased by Blake Ltd for $100 000. The expected life of the machineis four years, at the end of which it will have zero value and will be scrapped. Blake Ltd. payscorporation tax at a rate of 33% and its discount rate for investment purposes is 8%. What are thepresent values of the tax benefits arising to Blake Ltd from the purchase of the machine in thefollowing circumstances:

(a) first year capital allowances of 100% are available;

(b) capital allowances are available on a straight-line basis over the asset’s life;

(c) capital allowances are available on a 25% reducing balance basis?

1) Discuss which cash flows are relevant to investment appraisal calculations.

2) Explain, with the aid of a short example, how 25% reducing balance capital allowances are

calculated.

3) Explain the difference between the nominal (or money) terms approach and the real terms

approach to dealing with inflation in the context of investment appraisal.




1) Explain whether general or specific inflation should be taken into account in investmentappraisal.

2) Explain the difference between risk and uncertainty.

3) Critically discuss the use of the following techniques as methods of dealing with risk inthe appraisal of capital investment projects:

a) Sensitivity analysis

b) Risk-adjusted discount rate

c) Adjusted payback

d) Monte Carlo methods.



WEEK 4

Lecture Subject: AN OVERVIEW OF INVESTMENT APPRAISAL METHODS (2)

Lecture Objectives:


• The problem of unequal project lives

• Empirical investigation of investment appraisal

• Calculation of an optimum replacement cycle

Textbook:

Chapter(s) Pages

“Corporate Finance” Co, Denzil Watson & Tony Head,Pitman Publishing, 1998

4 100 to 112

Reference Books: Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: INVESTMENT APPRAISAL: APPLICATION & RISK (2)



• The problem of unequal project lives

• Empirical investigation of investment appraisal

• Calculation of an optimum replacement cycle


1) The financial manger of Logar plc is considering the purchase of a finishing machine which willimprove the appearance of the company’s range of decorated fudges. She expects that theimproved output will lead to increased sales of $110 000 per year for a period of five years. Atthe end of the five-year period, the machine will be scrapped. Two machines are beingconsidered and the relevant financial information on the capital investment proposal form is asfollows:

Machine A Machine B

Initial cost ($) 200 000 250 000

Labour cost ($ per year) 10 000 7 000

Power cost ($ per year) 9 000 4 000

Scrap value ($) Nil 25 000

The following forecasts of average annual rates of inflation have been prepared by theplanning department of Logar plc:

Sales prices: 6% per year

Labour costs: 5% per year

Power costs: 3% per year

Logar plc pays corporation tax of 31% one year in arrears and has a nominal after-tax cost ofcapital of 15%. Capital allowances are available on a 25% reducing balance basis.

Advise the financial manager of Logar plc on her choice of machine.



2) Discuss how sensitivity analysis can help management to assess the risk of aninvestment project.

3) Why is payback commonly used as a way of dealing with risk in investment projects?

4) Discuss the use of risk-adjusted discount rates in the evaluation of investment projects.


1) Explain the meaning of the term ‘Monte Carlo simulation’.

2) Explain the difference between the lowest common multiple (LCM) and the equivalentannual cost (EAC) methods of deciding when to replace identical assets.

3) Nodil Ltd wishes to determine the optimal replacement cycle for its capping machine. Thefinance department has estimated the following costs and resale values for the next four years.

Year 0 1 2 3 4

Initialinvestment($)

(50 000)

Operatingcosts ($)

(14 000) (17 000) (20 000) (24 000)

Maintenancecosts ($)

(3 000) (4 500) (7 000)

Scrap value($)

(30 000) (18 000) (11 000) (6 000)

If the cost of capital of Notodil Ltd is 12%, determine the optimum replacement cycle using:

(a) the equivalent annual cost method;

(b) the lowest common multiple method.



WEEK 5

Lecture Subject: SOURCES OF LONG-TERM FINANCE: EQUITY FINANCE

Lecture Objectives:


• Equity finance

• The new issues market

• Rights issues

• Scrip issues, stock splits, scrip dividends and share repurchases

• Preference shares

Textbook:

Chapter(s) Pages

“Corporate Finance” Co, Denzil Watson & Tony Head,Pitman Publishing, 1998

5 122 to 136

Reference Books:

Chapter(s) Pages


By Stephen Lumby






Finance Journal, Spring, 1987



Tutorial Subject: SOURCES OF LONG-TERM FINANCE: EQUITY FINANCE



• Equity finance

• The new issues market

• Rights issues

• Scrip issues, stock splits, scrip dividends and share repurchases

• Preference shares


1) Explain the reason why the return required by ordinary shareholders is different from thereturn required by debenture holders.

2) Briefly outline some of the important rights of shareholders.

3) Briefly explain the various ways in which a company may obtain a quotation for itsordinary shares on the London Stock Exchange.

4) Outline the advantages and disadvantages which should be considered by a currently unquotedcompany which is considering obtaining a listing on a recognised stock exchange.

5) What are pre-emptive rights and why are they important to shareholders?

6) Discuss the advantages and disadvantages of a rights issue to a company.

7) XTC is planning a 1 for 4 rights issue at a 20% discount to the current market price of $2.50. Ifan investor is to sell their ‘rights per share’ how much should they sell it for?

(a) 10 cents (b) 20 cents (c) 30 cents (d) 40 cents (e) 50 cents

8) ‘A conversion of existing capital reserves into ordinary shares, which are then distributed prorata to existing shareholders’. This statement best defines:

(a) scrip dividends

(b) a rights issue

(c) bonus bonds

(d) scrip issues

(e) stock splits



9) Explain why preference shares do not enjoy great popularity as a source of finance forcompanies.

2) Which one of the following statements best describes a cumulative preference share?

(a) It has the right to be converted into ordinary shares at a future date.

(b) It entitles the shareholder to a share of residual profits.

(c) It carries forward the right to receive unpaid dividends to the next year.

(d) It entitles the shareholder to a fixed rate of dividend.

(e) It gives its holder voting rights at a company’s annual general meeting.




1) Brand plc. generates profit after taxation of 15% on shareholders’ funds. Its current capitalstructure is as follows:

$

Ordinary shares of 50 cents each 200 000

Share premium 87 500

Reserves 312 500

600 000

The board of Brand plc. wishes to raise $160 000 from a rights issue in order to expandexisting operations. Its return on shareholders’ funds will be unchanged. The current ex-difmarket price of Brand plc. is $1.90. Three different rights issue prices have been suggested bythe finance director: $1.80, $1.60 and $1.40.

Determine the number of shares to be issued, the theoretical ex-rights price, the expectedearnings per share and the form of the issue for each rights issue price. Comment on yourresults.

2) Maltby plc., a company quoted on the London Stock Exchange, has been making regularannual after-tax profits of $7 000 000 for some years and has the following long-term capitalstructure.

$000

Ordinary shares, 50 cents each 4 000

16% debentures 9 000

13 000

The debenture issue is not due to be redeemed for some time and the company has becomeincreasingly concerned about the need to continue paying interest at 16% when the interest rateon newly issued government stock of a similar maturity is only 7%.

A proposal has been made to issue 2 000 000 new shares in a rights issue, at a discount of20% to the current share price of Maltby plc, and to use the funds raised to pay off part of thedebenture issue. The current share price of Maltby plc is $3.50 and the current market price ofthe debentures is $112 per $100 block.



Alternatively, the funds raised by the rights issue could be invested in a new project givingan annual after-tax return of 20%. Whichever option is undertaken, the stock market view of thecompany’s prospects will be unchanged and its P/E ratio will remain unchanged. Maltby plc.pays corporation tax at a rate of 31%.

By considering the effect on the share price of the two alternative proposals, discuss whetherthe proposed rights issue can be recommended as being in the best interests of the ordinaryshareholders of Maltby plc. Your answer should include all relevant calculations.

3) It has become increasingly common for companies to offer their shareholders a choicebetween a cash dividend or an equivalent scrip issue of shares. Briefly consider theadvantages of scrip dividends from the point of view of:

(a) the company

(b) the shareholders



WEEK 6

Lecture Subject: SOURCES OF LONG-TERM FINANCE: DEBT FINANCE, HYBRIDFINANCE, AND LEASING ( 1)

Lecture Objectives:


• Loan Stock and debentures

• Bank and institutional debt

• International debt finance

• Hybrid finance

Textbook:

Chapter(s) Pages

Corporate Finance” Co, Denzil Watson & Tony Head,Pitman Publishing, 1998

6 145 to 150

Reference Books:

Chapter(s) Pages


By Stephen Lumby






FinanceJournal,Spring,1987



Tutorial Subject: SOURCES OF LONG-TERM FINANCE: DEBT FINANCE,HYBRID FINANCE, AND LEASING



• Loan Stock and debentures

• Bank and institutional debt

• International debt finance

• Hybrid finance


1) Discuss briefly the key features of debentures and ordinary loan stock.

2) Briefly explain what is meant by the following terms that refer to fixed interest debtsecurities:

(a) restrictive covenant

(b) debenture sinking fund

(c) redemption window

3) Explain the meaning of the following terms and state the circumstances under which theirissue would be beneficial to lenders and borrowers:

(a) deep discount bonds

(b) zero coupon bonds

(c) warrants

(d) convertible loan stock

4) What are the advantages and disadvantages of raising finance by issuing Eurobonds?

5) Explain the difference between a conversion premium and a rights premium with respect toa convertible debenture.




1) Bugle plc has some surplus funds that it wishes to invest in corporate bonds. The companyrequires a return of 15% on such bonds, and you have been asked to advise on whether it shouldinvest in either of the following stocks which have been offered to it:

(a) Stock 1: 12% debentures redeemable at par at the end of 2 more years, current marketvalue per $100 block is $95.

(b) Stock 2: 8% debentures redeemable at $110 at the end of 2 more years, current marketvalue per $100 block is also $95.

2) Discuss, with the aid of a diagram, the relationship between the conversion premium, therights premium and the market value of a convertible debenture.

3) Discuss the reasons for the growth in popularity of leasing during the last 15 years. Whatsignificant changes affecting leasing occurred in 1984?



WEEK 7

Lecture Subject: SOURCES OF LONG-TERM FINANCE: DEBT FINANCE,HYBRID FINANCE, AND LEASING ( 2 )

Lecture Objectives:


• The valuation of fixed interest debt securities

• The valuation of convertible loan stock

• Leasing

Textbook:

Chapter(s) Pages


6 153 to157

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: SOURCES OF LONG-TERM FINANCE: DEBT FINANCE,HYBRID FINANCE, AND LEASING



• The valuation of fixed interest debt securities

• The valuation of convertible loan stock

• Leasing


1) A company has in issue a 10% debenture, redeemable at the option of the company betweenone and five years from now. What factors do you think will be considered by the company inreducing a decision on when to redeem the debenture?

2) Briefly outline the advantages and disadvantages to a company of issuing convertible loanstock?

3) What is the gearing effect of warrants?

4) A company has in issue some 9% debentures, which are redeemable at par in 3 years

time. Investors now require an interest yield of 10%. What will be the current ex-interestmarket value of $100 worth of debentures? What would the current ex-interest market value beif the issue had been one of irredeemable loan stock?




1 ) Discuss the reasons for the growth in popularity of leasing during the last 15 years. What

significant changes affecting leasing occurred in 1984?

2 ) Explain the difference between a finance lease and an operating lease, and discuss the

importance of the distinction for corporate finance?



WEEK 8

MID-TERM EXAMINATION



WEEK 9

Lecture Subject: THE COST OF CAPITAL AND CAPITAL STRUCTURE (1)

Lecture Objectives:


• Calculating the cost of individual sources of finance

• Calculating the weighted average cost of capital

• Average vs marginal cost of capital

• The practical application of WACC

• Gearing: its measurement and implications

• The concept of an optimal capital structure

• The traditional approach to capital structure

Textbook:

Chapter(s) Pages


8 198 to 213

Reference Books: Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: THE COST OF CAPITAL AND CAPITAL STRUCTURE



• Calculating the cost of individual sources of finance

• Calculating the weighted average cost of capital

• Average vs marginal cost of capital

• The practical application of WACC

• Gearing: its measurement and implications

• The concept of an optimal capital structure

• The traditional approach to capital structure


1) Gorky plc has in issue 500 000 $1 ordinary shares whose current ex-dividend market priceis $1.50 per share. The company has just paid a dividend of 27 cents per share, and dividends areexpected to continue at this level for some time. If the company has no debt capital, what is theweighted average cost of capital?

2) Five years ago, Eranio plc issued 12% irredeemable debentures at $103, a $3 premium totheir par value of $100. The current market price of these debentures is $94. If the company payscorporation tax at a rate of 35 % what is its current cost of debenture capital?

3) Pollock plc has a capital structure consisting of 1 million ordinary shares, par value 25cents and $100 000 of 10% irredeemable debentures. The current ex-dividend market price of theordinary shares is 49 cents per share, and the current ex-interest market price of the debentures is$72 per $100 block. The company has just paid a dividend of 9 cents per share and dividends areexpected to continue at this level indefinitely. If the company pays corporation tax at a rate of 33 %,what is its weighted average cost of capital?

4) Should companies use their weighted average cost of capital as the discount rate whenassessing the acceptability of new projects?

5) A company incorporates increasing amounts of debt finance into its capital structure whileleaving its operating risk unchanged. Assuming that a perfect capital market exists with no taxation,will the company’s weighted average cost of capital:

(a) fall slowly

(b) fall quickly

(c) remain the same



(d) fall to a minimum and then rise

(e) rise steadily


1) Smith plc, a quoted company, has the following long-term capital structure:

$000

Ordinary shares, 50 cents each 4000

16% debentures 9000

13000

The current share price of Smith plc is $3.50 and the current market price of the debenturesis $112 per $100 block. Smith plc pays corporation tax at a rate of 33%.

Calculate the capital gearing of Smith plc based on (a) market values, and (b) book values,and discuss why a market-based estimate of capital gearing is generally considered to besuperior.

2) The calculation of WACC is straightforward in theory, but in practice is not an easy task.Outline any possible difficulties that might be experienced when trying to calculate WACC.



WEEK 10

Lecture Subject: THE COST OF CAPITAL AND CAPITAL STRUCTURE (2)

Lecture Objectives:


• Miller & Modigliani (I) – net income approach

• Miller & Modigliani (II) and market imperfections

• Miller and personal taxation

• Peeking order theory

• Does an optimal capital structure exist?

Textbook: Chapter(s) Pages


8 214 to 222

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: THE COST OF CAPITAL AND CAPITAL STRUCTURE



• Miller & Modigliani (I) – net income approach

• Miller & Modigliani (II) and market imperfections

• Miller and personal taxation

• Peeking order theory

• Does an optimal capital structure exist?


1) One-third of the total market value of Johnson plc consists of loan stock, which has a costof 10%. Another company, York, is identical in every aspect to Johnson plc, except that itscapital structure is all-equity, and its cost of equity is 16%. According to Modigliani andMiller, if we ignored taxation and tax relief on debt capital, what would be the cost of equity ofJohnson plc?

2) Which of the following statements concerning capital structure is incorrect?

(a) Bankruptcy risk is ignored in Miller and Modigliani”s first model.

(b) Debt holders are not subject to the effects of financial risk.

(c) The traditional approach assumes that capital markets are perfect.

(d) Miller and Modigliani’s second paper takes into account the effects of corporate taxation.

(e) Miller and Modigliani’s first model argues that no optimal capital structure exists andsupports this proposition with arbitrage theory.

3) If a company finds that its cost of capital has changed does this affect the profitability

of the company?

4) What is the significance of the arbitrage proof for Miller and Modigliani’s first paper

on the cost of capital?




1) Critically discuss whether you consider that companies, by integrating a sensible level of

gearing into their capital structure, can minimise their weighted average cost of capital.

2) Briefly explain the traditional view that an optimal capital structure exists.



WEEK 11

Lecture Subject: WORKING CAPITAL MANAGEMENT (1)

Lecture Objectives:


• The objectives of working capital management

• Working capital policies

• Working capital and the cash conversion cycle

• Over trading

Textbook:

Chapter(s) Pages


10 267 to 275

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: WORKING CAPITAL MANAGEMENT



• The objectives of working capital management

• Working capital policies

• Working capital and the cash conversion cycle

• Over trading


1) Explain the different strategies a firm may follow in order to finance its cumulative

capital requirements.

2) Describe the cash conversion cycle and explain its significance in determining the

working capital needed by a company.

3) Describe the strategies that could be followed by a company seeking to deal with the

problem of over trading.

4) Explain the difference between factoring and invoice discounting.

5) Discuss the possible reasons why a company might experience cash flow problems and

suggest ways in which such problems might be alleviated.

6) Explain why a company may choose to have reserves of cash.

7) Discuss ways in which a company might invest its short-term cash surpluses, explaining

8) briefly the factors which it should consider in making its selection.

9) How might the creditworthiness of a new customer be checked?

10) Is it worth offering discounts to debtors to encourage prompt payment?

11) Suggest ways in which companies can exercise control over their levels of working

capital.




1) Sec plc. uses a large quantity of salt in its production process. Annual consumption is 60000 tonnes over a 50-week working year. It costs $100 to initiate and process an order and deliveryfollows 2 weeks later. Storage costs for the salt are estimated at 10 cents per tonne per annum. Thecurrent practice is to order twice a year when the stock falls to 10 000 tonnes. Recommend anappropriate ordering policy for Sec plc, and contrast it with the cost of the current policy.

2) MW Ltd has budgeted its sales to be $700 000 per annum. Its costs as a percentage of salesare as follows:

%

Raw materials 20

Direct labour 35

Overheads 15

Raw materials are carried in stock for two weeks and finished goods are held in stock beforesale for three weeks. Production takes 4 weeks. MW Ltd takes 4 weeks credit from suppliersand gives 8 weeks credit to its customers. If both overheads and production are incurred evenlythroughout the year, what is MW Ltd’s total working capital requirement?

3) A company is considering offering a discount for payment within 10 days to its customers,who currently pay after 45 days. Only 40% of credit customers would take the discount, althoughadministrative cost savings of $4450 per year would be gained. If sales, which are unaffected by thediscount, are $1 600 000 per year and the cost of short-term finance is 11%, what is the maximumdiscount that could be offered?



WEEK 12

Lecture Subject: WORKING CAPITAL MANAGEMENT (2)

Lecture Objectives:


• The management of stock

• The management of cash

• The management of debtors

Textbook:

Chapter(s) Pages


10 276 to 284

Reference Books:

Chapter(s) Pages


By Stephen Lumby









Tutorial Subject: WORKING CAPITAL MANAGEMENT



• The management of stock

• The management of cash

• The management of debtors

•


1) Explain why a company may choose to have reserves of cash.

2) Discuss ways in which a company might invest its short-term cash surpluses, explaining

briefly the factors which it should consider in making its selection.

3) How might the creditworthiness of a new customer be checked?

4) Is it worth offering discounts to debtors to encourage prompt payment?

5) Suggest ways in which companies can exercise control over their levels of working

capital.


1) A company is considering offering a discount for payment within 10 days to its

customers, who currently pay after 45 days. Only 40% of credit customers would take the

discount, although administrative cost savings of $4450 per year would be gained. If sales,

which are unaffected by the discount, are $1 600 000 per year and the cost of short-term

finance is 11%, what is the maximum discount that could be offered?

MANAGEMENT ACCOUNTING III

Business

Transcript of MANAGEMENT ACCOUNTING III