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.
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