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Z04_ATRI3622_06_SE_APP4.QXD 508 APPENDIX D 5/29/09 10:43 AM Page 508 SOLUTIONS TO SELECTED EXERCISES (c) The ground improvement option provides the higher NPV and is therefore the preferable option, based on the objective of shareholder wealth maximisation. (d) A professional football club may not wish to pursue an objective of shareholder wealth enhancement. It may prefer to invest in quality players in an attempt to enjoy future sporting success. If this is the case, the NPV approach will be less appropriate because the club is not pursuing a strict wealth-related objective. 8.7 Simtex Ltd (a) Net operating cash flows each year will be: £000 Sales revenue (160 × £6) Less Variable costs (160 × £4) Relevant fixed costs 640 170 £000 960 810 150 The estimated NPV of the new product can then be calculated: Annual cash flows (150 × 3.038*) Residual value of equipment (100 × 0.636) Less Initial outlay Net present value £000 456 64 520 480 40 * This is the sum of the 12 per cent discount factors over four years. Where the cash flows are constant, it is a quicker procedure than working out the present value of cash flows for each year and then adding them together. (b) (i) Assume the discount rate is 18%. The net present value of the project would be: Annual cash flows (150 × 2.690) Residual value of equipment (100 × 0.516) Less Initial outlay NPV £000 404 52 456 480 (24) Thus an increase of 6%, from 12% to 18%, in the discount rate causes a fall from +40 to −24 in the NPV, a fall of 64 or 10.67 (that is, 64/6) for each 1% rise in the discount rate. So a zero NPV will occur with a discount rate approximately equal to 12 + (40/11.67) = 15.4%. (This is, of course, the IRR.) This higher discount rate represents an increase of about 28% on the existing cost of capital figure. (ii) The initial outlay on equipment is already expressed in present-value terms and so, to make the project no longer viable, the outlay will have to increase by an amount equal to the NPV of the project (that is, £40,000) – an increase of 8.3% on the stated initial outlay. (iii) The change necessary in the annual net cash flows to make the project no longer profitable can be calculated as follows: Let Y = change in the annual operating cash flows. Then (Y × cumulative discount rates for a four-year period) − NPV = 0 Z04_ATRI3622_06_SE_APP4.QXD 5/29/09 10:43 AM Page 509 SOLUTIONS TO SELECTED EXERCISES This can be rearranged as Y × cumulative discount factors for a four-year period = NPV Y × 3.038 = £40,000 Y = £40,000/3.038 Y = £13,167 In percentage terms, this is a decrease of 8.8% on the estimated cash flows. (iv) The change in the residual value required to make the new product no longer profitable can be calculated as follows: Let V = change in the residual value: (V × discount factor at end of four years) − NPV of product = 0 This can be rearranged as follows: V × discount factor at end of four years = NPV of product V × 0.636 = £40,000 V = £40,000/0.636 V = £62,893 This is a decrease of 63.9% in the residual value of the equipment. (c) The NPV of the product is positive and so it will increase shareholder wealth. Thus, it should be produced. The sensitivity analysis suggests that the initial outlay and the annual cash flows are the most sensitive variables for managers to consider. 8.8 Kernow Cleaning Services Ltd (a) The first step is to calculate the expected annual cash flows: Year 1 £ 80,000 × 0.3 £160,000 × 0.5 £200,000 × 0.2 £ 24,000 80,000 40,000 144,000 Year 2 £140,000 × 0.4 £220,000 × 0.4 £250,000 × 0.2 £ 56,000 88,000 50,000 194,000 Year 3 £140,000 × 0.4 £200,000 × 0.3 £230,000 × 0.3 £ 56,000 60,000 69,000 185,000 Year 4 £100,000 × 0.3 £170,000 × 0.6 £200,000 × 0.1 £ 30,000 102,000 20,000 152,000 509 Z04_ATRI3622_06_SE_APP4.QXD 510 APPENDIX D 5/29/09 10:43 AM Page 510 SOLUTIONS TO SELECTED EXERCISES The expected net present value (ENPV) can now be calculated as follows: Period Expected cash flow £ (540,000) 144,000 194,000 185,000 152,000 0 1 2 3 4 ENPV Discount rate 10% 1.000 0.909 0.826 0.751 0.683 Expected PV £ (540,000) 130,896 160,244 138,935 103,816 (6,109) (b) The worst possible outcome can be calculated by taking the lowest values of savings each year, as follows: Period Cash flow £ (540,000) 80,000 140,000 140,000 100,000 0 1 2 3 4 NPV Discount rate 10% 1.000 0.909 0.826 0.751 0.683 PV £ (540,000) 72,720 115,640 105,140 68,300 (178,200) The probability of occurrence can be obtained by multiplying together the probability of each of the worst outcomes above, that is 0.3 × 0.4 × 0.4 × 0.3 = 0.014. Thus, the probability of occurrence is 1.4%, which is very low. Chapter 9 9.1 Aires plc (a) The SVA determination of shareholder value will be as follows: Year 1 2 3 4 FCF £m 28.0* 28.0 28.0 28.0 Total business value Less Loan notes Shareholder value Discount rate 12% 0.893 0.797 0.712 0.636 Present value £m 25.0 22.3 19.9 17.8 85.0 24.0 61.0 * The free cash flows will be the operating profit after tax plus the lease depreciation charge (that is, £12.0m + £16m). (b) The EVA® determination of shareholder value will be as follows: Year 1 2 3 4 Opening capital invested (C) £m 64.0 48.0 32.0 16.0 Capital charge (12% × C) £m 7.7 5.8 3.8 1.9 Operating profit after tax £m 12.0 12.0 12.0 12.0 Opening capital Less Loan notes Shareholder value EVA® £m 4.3 6.2 8.2 10.1 Discount rate 12% 0.893 0.797 0.712 0.636 PV of EVA® £m 3.8 4.9 5.8 6.4 20.9 64.0 84.9 24.0 60.9 Z04_ATRI3622_06_SE_APP4.QXD 5/29/09 10:43 AM Page 511 SOLUTIONS TO SELECTED EXERCISES 9.3 Sharma plc Analysis of trading with Lopez Ltd during last year Gross sales revenue Discount allowed Manufacturing cost Sales order handling Delivery costs Customer sales visits Credit costs Profit from the customer for the year 9.4 (40,000 × £20) (£800,000 × 5%) (40,000 × £12) (22 × £75) (22 × 120 × £1.50) (30 × £230) [(£800,000 − £40,000) × 2/12 × 2%] £ 800,000 (40,000) (480,000) (1,650) (3,960) (6,900) (2,533) (535,043) 264,957 Shareholder value and EVA® (a) It is difficult for these different approaches to co-exist in a highly competitive economy. The pursuit of shareholder value may be necessary in order to secure funds and for managers to secure their jobs. A stakeholder approach, which is committed to satisfying the needs of a broad group of constituents, may be difficult to sustain in such an environment. It has been suggested that other stakeholders have been seriously adversely affected by the pursuit of shareholder value. It is claimed that the application of various techniques to improve shareholder value such as hostile takeovers, cost cutting and large management incentive bonuses have badly damaged the interests of certain stakeholders such as employees and local communities. However, a commitment to shareholder value must take account of the needs of other stakeholders if it is to deliver long-term benefits. (b) If businesses are overcapitalised it is probably because insufficient attention is given to the amount of capital that is required. Management incentive schemes that are geared towards generating a particular level of profits or achieving a particular market share without specifying the level of capital invested can help create such a problem. EVA® can help by highlighting the cost of capital, through the capital charge. 9.5 Virgo plc There is no single correct answer to this problem. The suggestions set out below are based on experiences that some businesses have had in implementing a management bonus system based on EVA® performance. In order to get the divisional managers to think and act like the owners of the business, it is recommended that divisional performance, as measured by EVA®, should form a significant part of their total rewards. Thus, around 50 per cent of the total rewards paid to managers could be related to the EVA® that has been generated for a period. (In the case of very senior managers it could be more, and for junior managers less.) The target for managers to achieve could be a particular level of improvement in EVA® for their division over a year. A target bonus can then be set for achievement of the target level of improvement. If this target level of improvement is achieved, 100 per cent of the bonus should be paid. If the target is not achieved, an agreed percentage (below 100 per cent) could be paid according to the amount of shortfall. If, on the other hand, the target is exceeded, an agreed percentage (with no upper limits) may be paid. The timing of the payment of management bonuses is important. In the question it was mentioned that Virgo plc wishes to encourage a longer-term view among its managers. One approach is to use a ‘bonus bank’ system whereby the bonus for a period is placed in a ‘bank’ and a certain proportion (usually one-third) can be drawn in the period in which it is earned. If the target for the following period is not met, there can be a charge against the 511 Z04_ATRI3622_06_SE_APP4.QXD 512 APPENDIX D 5/29/09 10:43 AM Page 512 SOLUTIONS TO SELECTED EXERCISES bonus bank so that the total amount available for withdrawal is reduced. This will ensure that the managers try to maintain improvements in EVA® consistently over the years. In some cases, the amount of bonus is determined by three factors: the performance of the business as a whole (as measured by EVA®), the performance of the division (as measured by EVA®) and the performance of the particular manager (using agreed indicators of performance). The performance for the business as a whole is often given the most weighting, and individual performance the least weighting. Thus, 50 per cent of the bonus may be for corporate performance, 30 per cent for divisional performance and 20 per cent for individual performance. 9.6 Leo plc Free cash flows Sales revenue Operating profit (20%) Less Cash tax (25%) Operating profit less cash tax Less ANCAI (15%) AWCI (10%) Free cash flows 12% discount factor Present value Year 1 £m 30.0 6.0 Year 2 £m 36.0 7.2 Year 3 £m 40.0 8.0 Year 4 £m 48.0 9.6 Year 5 £m 60.0 12.0 After Year 5 £m 60.0 12.0 1.5 4.5 1.8 5.4 2.0 6.0 2.4 7.2 3.0 9.0 3.0 9.0 (0.9) (0.6) 3.9 0.797 3.1 (0.6) (0.4) 5.0 0.712 3.6 (1.2) (0.8) 5.2 0.636 3.3 (1.8) (1.2) 6.0 0.567 3.4 (4.5)* (3.0)* (3.0) 0.893 (2.7) 53.2 – – 9.0 0.567 42.5† * In the first year, the additional sales revenue will be £30m and so the calculations for non-current (fixed) assets and working capital must be based on this figure. † The terminal value is (9.0/0.12 × 0.567) = 42.5. Total business value will increase by £53.2m. As there has been no change to the level of borrowing, shareholder value should increase by this amount. Chapter 10 10.1 Divisionalised organisations (a) A divisionalised organisation is one that divides itself into operating units in order to deliver its range of products or services. Divisionalisation is, in essence, an attempt to deal with the problems of size and complexity. Autonomy of action relates to the amount of discretion the managers of divisions have been given by central management over the operations of the division. Two popular forms of autonomy are profit centres and investment centres. Though divisionalisation usually leads to decentralisation of decision making, this need not necessarily be the case. (b) The benefits of allowing divisional managers autonomy include: l l l l l l Better use of market information. Increase in management motivation. Providing opportunities for management development. Making full use of specialist knowledge. Giving central managers time to focus on strategic issues. Permitting a more rapid response to changes in market conditions. Z04_ATRI3622_06_SE_APP4.QXD 5/29/09 10:43 AM Page 513 SOLUTIONS TO SELECTED EXERCISES (c) There are certain problems with this approach which include: l l l l Goal conflict between divisions or between divisions and central management. Risk avoidance on the part of divisional managers. The growth of management ‘perks’. Increasing costs due to inability to benefit from economies of scale. Transfers between divisions can create problems for a business. Managers of the selling division may wish to obtain a high price for the transfers in an attempt to achieve certain profit objectives. However, the managers of the purchasing division may wish to buy as cheaply as possible in order to achieve their own profit objectives. This can create conflict, and central managers may find that they are spending time arbitrating disputes. It may be necessary for central managers to impose a solution on the divisions where agreement cannot be reached, which will, of course, undermine the divisions’ autonomy. 10.2 Financial performance measures (a) Contribution represents the difference between the total sales revenue of the division and the variable expenses incurred. This is a useful measure for understanding the relationship between costs, output and profit. However, it ignores any fixed expenses incurred and so not all aspects of operating performance are considered. The controllable profit deducts all expenses (variable and fixed) within the control of the divisional manager when arriving at a measure of performance. This is viewed by many as the best measure of performance for divisional managers as they will be in a position to determine the level of expenses incurred. However, in practice, it may be difficult to categorise expenses as being either controllable or non-controllable. This measure also ignores the investment made in assets. For example, a manager may decide to hold very high levels of inventories, which may be an inefficient use of resources. Return on investment (ROI) is a widely used method of evaluating the profitability of divisions. The ratio is calculated in the following way: ROI = Division profit Divisional investment (assets employed) × 100% The ratio is seen as capturing many of the dimensions of running a division. When defining divisional profit for this ratio, the purpose for which the ratio is to be used must be considered. When evaluating the performance of a divisional manager, the controllable contribution is likely to be the most appropriate, whereas for evaluating the performance of a division, the divisional contribution is likely to be more appropriate. Different definitions can be employed for divisional investment. The net assets or total assets figure may be used. In addition, assets may be shown at original cost or some other basis such as current replacement cost. (b) There are several non-financial measures available to evaluate a division’s performance. Examples of these measures have been cited in the chapter. Further examples include: l l l l Plant capacity utilised. Percentage of rejects in production runs. Ratio of customer visits to customer orders. Number of customers visited. If a broad range of financial and non-financial measures covering different time horizons are used, there is a better chance that all of the major dimensions of management and divisional performance will be properly assessed. Focusing on a few short-term financial objectives incurs the danger that managers will strive to achieve these at the expense of the longer-term objectives. Clearly, ROI can be increased in the short term 513 Z04_ATRI3622_06_SE_APP4.QXD 514 APPENDIX D 5/29/09 10:43 AM Page 514 SOLUTIONS TO SELECTED EXERCISES by cutting back on discretionary expenditure such as staff training and research and development and by not replacing heavily depreciated assets. 10.4 ABC Corporation (a) (1) Residual income calculation – original plan: Sales revenue Variable costs Contribution Fixed costs Divisional profit Capital charge (£500,000 × 20%) Residual income £000 1,200 (800) 400 (250) 150 (100) 50 (2) Residual income calculation – original plan and Option X: Sales revenue [(100,000 × £12) + (20,000 × £11)] Variable costs (120,000 × £8) Contribution Fixed costs [250,000 + (80,000/4)] Divisional profit Capital charge (£580,000 × 20%) Residual income £000 1,420 ( 960) 460 ( 270) 190 (116) 74 (3) Residual income calculation – original plan and Option Y: Sales revenue [(80,000 × £12) (20,000 × £10)] Variable costs Contribution Fixed costs Divisional profit Capital charge (£500,000 × 20%) Residual income £000 1,160 (800) 360 (250) 110 (100) 10 We can see that the highest residual income for Division A arises when only Option X is added to the original plan and that the lowest residual income arises when only Option Y is added to the original plan. (b) Division A is unlikely to find the price reduction for Division B attractive. Division B, on the other hand, will benefit by £40,000 (20,000 × £2) from the price reduction. However, overall, the total profits of the business will be unaffected as the increase in Division B’s profits will be cancelled out by the decrease in Division A’s profit. If an outside supplier is used, the profits of the business overall will fall by the amount of the lost contribution (20,000 × (£10 − £8) = £40,000). Another option would be to allow the outsiders to supply Division B and to use the released production capacity to sell outside customers 20,000 units at £11 per unit. In this way, additional equipment costs would be avoided. 10.5 Telling Company (a) (1) ROI = = Divisional profit Divisional investment (assets employed) 25,000 150,000 = 16.7% × 100% × 100% Z04_ATRI3622_06_SE_APP4.QXD 5/29/09 10:43 AM Page 515 SOLUTIONS TO SELECTED EXERCISES (2) £ 25,000 (30,000) (5,000) Divisional profit Required return (20% × £150,000) Residual income (loss) (3) The results show that the ROI is less than the required return of 20 per cent and the residual income is negative. The results must therefore be considered unsatisfactory. (b) Increase Increase Increase Increase Increase Increase Increase in in in in in in in £ 75,000 (60,000) 15,000 (5,000) 10,000 (4,000) 6,000 sales revenue (£7.50 × 10,000) variable costs (£6 × 10,000) contribution fixed costs divisional profit cost of capital (20% × £20,000) RI (c) (1) Though the divisional profits of Goodman and Sharp will each be affected by a change in the transfer price, the total profits of Telling Co. will be unaffected. The increase in profit occurring in one division will be cancelled out by the decrease in profit in the other division and so the overall effect will be nil. (2) If the work goes outside, Goodman would lose £20,000 in contribution (that is, 10,000 × £2) and Sharp would gain £8,000 by the reduction in the buying-in price (that is, 10,000 × (£8 − £7.20)). The net effect on the business as a whole will therefore be a loss of £12,000 (that is, £20,000 − £8,000). 10.6 Glasnost plc (a) West £000 Residual income: 300 − (2,500 × 10%) 100 − (500 × 10%) Return on investment (ROI): Based on net profit (250/2,500) × 100% (80/500) × 100% Based on divisional profit (300/2,500) × 100% (100/500) × 100% Expenses to sales revenue ratio: Direct manufacturing Indirect manufacturing Selling and distribution Central overhead East £000 50 50 10% 16% 12% 20% 30% 22% 18% 5% 53% 12% 10% 5% (b) The ROI ratios indicate that East is the better performing division. However, we are told in the question that East has older plant than West, which has recently modernised its production lines. This difference in the age of the plant is likely to mean that the ROI of East is higher due, at least in part, to the fact that the plant has been substantially written down. Some common base is required for comparison purposes (for example, unadjusted historical cost). 515 Z04_ATRI3622_06_SE_APP4.QXD 516 APPENDIX D 5/29/09 10:43 AM Page 516 SOLUTIONS TO SELECTED EXERCISES We are told that ROI is used as the basis for evaluating performance. We can see that, whichever measure of ROI is used, the two divisions meet the minimum returns required. If ROI is being used to assess managerial performance then the divisional profit rather than net profit figure should be used in the calculation. This is because the net profit figure is calculated after non-controllable central overheads have been deducted. The business should consider the use of RI as another measure of divisional performance. This measure reveals the same level of performance for the current year from each division. The expenses to sales revenue ratios are revealing. West has a lower direct manufacturing cost to sales revenue ratio but a higher indirect manufacturing cost to sales revenue ratio than East. This is consistent with the introduction of modern laboursaving plant. West has a higher selling expenses to sales revenue ratio than East. This is probably due to the fact that inter-business transfers are minimal whereas for East they represent 50 per cent of total sales revenue. Chapter 11 11.1 Hercules Wholesalers Ltd (a) The business is probably concerned about its liquidity position because: l it has a substantial overdraft, which together with its non-current borrowings means that it has borrowed an amount roughly equal to its equity (according to values in the statement of financial position); l it has increased its investment in inventories during the past year (as shown by the income statement); and l it has a low current ratio (ratio of current assets to current liabilities). (b) The operating cash cycle can be calculated as follows: Number of days Average inventories holding period: [(Opening inventories + Closing inventories)/2] × 360 Cost of inventories = [(125 + 143/2)] × 360 323 = 149 Add Average settlement period for receivables: Trade receivables × 360 Credit sales revenue 163 = 452 × 360 = 130 279 Less Average settlement period for payables: Trade payables × 360 Credit purchases Operating cash cycle = 145 341 × 360 = 153 126 (c) The business can reduce the operating cash cycle in a number of ways. The average inventories holding period seems quite long. At present, average inventories held represent almost five months’ sales. Reducing the level of inventories held can reduce this period. Similarly, the average settlement period for receivables seems long at more than four months’ sales revenue. Imposing tighter credit control, offering discounts, charging interest on overdue accounts, and so on, may reduce this. However, any policy Z04_ATRI3622_06_SE_APP4.QXD 5/29/09 10:43 AM Page 517 SOLUTIONS TO SELECTED EXERCISES decisions concerning inventories and receivables must take account of current trading conditions. Extending the period of credit taken to pay suppliers would also reduce the operating cash cycle. However, for the reasons mentioned in the chapter, this option must be considered carefully. 11.5 Mayo Computers Ltd New proposals from credit control department £000 Current level of investment in receivables (£20m × (60/365)) Proposed level of investment in receivables ((£20m × 60%) × (30/365)) (986) ((£20m × 40%) × (50/365)) (1,096) Reduction in level of investment £000 3,288 (2,082) 1,206 The reduction in overdraft interest as a result of the reduction in the level of investment will be £1,206,000 × 14% = £169,000. £000 Cost of cash discounts offered (£20m × 60% × 2.5%) Additional cost of credit administration Bad debt savings Interest charge savings (see above) Net cost of policy each year (100) (169) £000 300 20 320 (269) 51 These calculations show that the business would incur additional annual costs if it implemented this proposal. It would therefore be cheaper to stay with the existing credit policy. 11.6 Boswell Enterprises Ltd (a) (i) Current policy £000 Receivables [(£3m × 1/12 × 30%) + (£3m × 2/12 × 70%)] [(£3.15m × 1/12 × 60%) + (£3.15m × 2/12 × 40%)] Inventories {[£3m − (£3m × 20%)] × 3/12} {[£3.15m − (£3.15m × 20%)] × 3/12} Cash (fixed) Payables {[£3m − (£3m × 20%)] × 2/12} {[£3.15m − (£3.15m × 20%)] × 2/12} Accrued variable expenses [£3m × 1/12 × 10%] [£3.15m × 1/12 × 10%] Accrued fixed expenses Investment in working capital £000 (ii) New policy £000 £000 425.0 367.5 600.0 630.0 140.0 1,137.5 140.0 1,165.0 (400.0) (420.0) (25.0) (15.0) (440.0) 725.0 (26.3) (15.0) (461.3) 676.2 517