FEEDBACK TUTORIAL LETTER ASSIGNMENT 1 SEMESTER 1 2018 MANAGERIAL FINANCE 4B [MAF412S] 1
Question 1 (20 Marks) The following are the statements of comprehensive income of Checkers Ltd and Choppies Ltd, two companies operating in the food and beverages industries. Checkers Choppies N$m N$m Revenue 290 290 Variable costs 58 145 Contribution 232 145 Fixed costs 120 75 Earnings before interest and tax 112 70 Interest expense 60 18 Net income 52 52 Required: (a) Calculate the degree of operating leverage. 4 marks (b) Calculate the degree of financial leverage. 4 marks (c) Calculate the degree of combined leverage 4 marks (d) Find the break-even points in dollars 4 marks (e) Discuss the riskiness of the two companies based on the leverage factors calculated. 4 marks Question 2 (26 Marks) Supreme industries forecasts cash outlays of N$1 800 000 for its next fiscal year. To minimize investment in cash account, management intends to apply the Baumol model. A financial analyst for the company has estimated the conversion cost of converting marketable securities to cash or cash to marketable securities to be N$45 per conversion transaction, and the annual opportunity cost of holding cash instead of marketable securities to be 8%. Required a) Calculate the optimal amount of cash to transfer from marketable securities to cash. 3 marks b) What will be the average cash balance? 3 marks c) How many transactions will be required per year? 3 marks d) Determine the total cost of holding cash. 6 marks e) If the management makes 12 equal conversions, calculate 1
(i) The total conversion cost. 3 marks (ii) The total opportunity cost. 3 marks (iii) The total cost. 1 mark Question 3 (38 marks) 1. Meatcan Canning Company Ltd is considering expansion of its facilities. Its current income statement is as follows: N$ Sales 5,000,000 Variable expenses (2,500,000) Fixed expenses (1,800,000) EBIT 700,000 Interest at 10% (200,000) Earnings before tax (EBT) 500,000 Income tax at 30% (150,000) Earnings after tax 350,000 Shares of common stock outstanding 200,000 Earnings per share (EPS) 1.75 The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of N$10). In order to expand the facilities, the director of the company, estimates a need for N$2 million in additional funds. The company s investment banker has laid out three alternatives to be considered. 1. Sell N$2 million of debt at 13 percent interest 2. Sell N$2 million of common stock at N$20 per share. 3. Sell N$1 million of debt at 12 percent interest and N$1 million of common stock at N$25 per share. Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to N$2 300 000 per year. The director is not sure how much this expansion will add to sales, but he estimates that sales will rise by N$1 million per year for the next five years. 2
The director is interested in the thorough analysis of the company s expansion plans and methods of financing and consults you to help him. Required a) Determine the break-even point before and after expansion in sales dollars (4 marks) b) Calculate the degree of operating leverage before expansion (2 marks) c) Calculate the degree of operating leverage after expansion at sales of N$6 million (2 marks) d) Calculate the degree of financial leverage before expansion (2 marks) e) Calculate the degree of financial leverage after expansion for all three alternative financing plans at sales of N$6 million (12 marks) f) Calculate EPS under all three financing plans after expansion at N$6 million in sales (12 marks) Question 4 (30 marks) Semi Ltd produces one product, a small calculator. Last year, 50 000 calculators were sold at N$20 each. Semi s income statement for the year ended December 31 st, 2007 is as follows: Semi Ltd Income statement for the year ended December 31 st, 2007 N$ N$ Sales 1,000,000 Less variable costs (400,000) Fixed costs (200,000) (600,000) EBIT 400,000 Less interest (125,000) Net income before tax 275,000 Income tax at 40% (110,000) Net income 165,000 Earnings per share (100 000 shares) 1.65 Required a) Calculate the following for Semi s Ltd 2007 level of sales 3
i. The degree of operating leverage (3 marks) ii. The degree of financial leverage (3 marks) iii. The combined leverage effect (2 marks) b) Semi Ltd is considering changing to a new production process from manufacturing the calculators. Highly automated and capital intensive, the new process will double fixed costs to N$400 000 but will decrease variable costs to N$4 per unit. If the new equipment is financed with bonds, interest will increase by N$70 000; if it is financed by common stock, total stock outstanding will increase by 20 000 shares. Assuming that sales remain constant, calculate for each financing method i. Earnings per share (10 marks) ii. The combined leverage effect (8 marks) c) If sales are expected to increase, which alternative will have the greatest impact on EPS? Illustrate with an example. (4 marks) Question 3 (28 marks) Mango Company Ltd is a wholesale furniture seller that provides furniture to small and medium-size retail businesses. The following is the most recent financial statements of the business: Mango Company Ltd Balance sheet as on September 30 th, 2009 Assets N$ N$ Non-current assets Freehold land and buildings at cost 840 000 Less accumulated depreciation (110 000) 730 000 Fixtures and fittings at cost 62 000 Less accumulated depreciation (24 000) 38 000 Motor vans at cost 360 000 Less accumulated depreciation (150 000) 210 000 4
Current assets Inventory 780 000 Trade receivables 460 000 1 240 000 Total assets 2 218 000 Equity and liabilities Share capital and reserves Ordinary shares of N$1 each 100 000 Accumulated profit 678 000 Current liabilities Trade payables 780 000 Proposed dividends 120 000 Taxation 210 000 Bank overdraft 330 000 2 218 000 Mango Company Income statement for the year ended September 30 th, 2009 N$ 5
Sales 4 850 000 Cost of sales Opening inventory (820 000) Purchases (2 590 000) (3 410 000) Less closing inventory 780 000 Cost of sales (2 630 000) Gross profit 2 220 000 Expenses (1 240 000) Net profit before tax 980 000 Income tax (210 000) Net profit for the year 770 000 Proposed dividends (120 000) Retained profit for the year 650 000 Additional information: 1. All purchases and sales were on credit and the trade receivables and trade payables outstanding at the beginning of the year were lower by 10 percent and 20 percent respectively than those at the end of the year. 2. The directors of Mango Company Ltd are being pressed by the bank to significantly reduce the overdraft. Some of the directors wish to do this by reducing the cash conversion cycle of the company. However, other directors would prefer to use an external source of shortterm finance. Required a) Explain what is meant by the term cash conversion cycle and very briefly discuss the importance of this concept to the financial management of the company. (8 marks) b) State alternative ways of reducing cash conversion cycle and indicate what problems the firm may encounter in using those ways. (10 marks) c) Calculate the cash conversion cycle of Mango Company Ltd for the year ended September 30 th, 2009. (Use 360 days) (10 marks) 6
SOLUTIONS Question 1 (20 Marks) Checkers Choppies a) DOL = (S - VC)/(S - VC F) = 232/112 145/70 = 2.07 2.07 b) DFL = (EBIT)/(EBIT - I) = 112/52 70/52 = 2.15 1.35 c) DTL = DOL x DFL = 2.07 x 2.15 2.07 x 1.35 = 4.45 2.79 d) CPU = Total Contribution/Total Sales = 232/290 145/290 = 0.8 0.5 Break even = FC/C.P.U. = 120/0.8 75/0.5 = N$150 N$150 e) Both companies achieve the same net income with sales of N$290m. The companies have the same degree of operating leverage at sales of N$290m, which is confirmed by breakeven sales of N$150m. Checkers is, however, financed by more debt and is thus more risky than Choppies with regard to returns to shareholders. Question 2 26 marks (a) ECQ = = N$45 000 2 x 1 800 000 x 45 0.08 (b) Average cash balance = 45 000/2 = N$22 500 (c) Transactions per year =1 800 000/45 000 = 40 transactions 7
(d) Opportunity costs =45 000/2 x 8% = N$1 800 Conversion cost: = 40 transactions x 45 =N$1 800 Total cost = N$3 600 4 marks (e) With 12 equal conversions: (i) Conversion cost = 12 conversions x N$45 =N$540 (ii) Opportunity cost = 12/40 x 45 000 = 13 500 =13 500/2 x 8% =N$540 (f) (iii) Total cost of holding cash = Conversion cost + opportunity cost =540 + 540 = N$1 080 i) Cost as annual rate = 2/98 x 365/20 = 37.24% ii) Cost as annual rate = 3/97 x 365/20 = 56.54% iii) Cost as annual rate = 3/97 x 365/50 = 22.58% iv) Cost as annual rate = 3/97 x 365/110 = 10.26% Question 3 a) Break-even point before and after expansion Before expansion Break-even point in N$ = Fixed costs Contribution margin ratio = N$1 800 000 8
50% = N$3 600 000 After expansion Break-even point in N$ = N$2 300 000 50% = N$4 600 000 b) Degree of operating leverage before expansion DOL = Contribution margin Contribution margin fixed costs = N$2 500 000 N$2 500 000 N$1 800 000 = 3.57 c) Degree of operating leverage after expansion at sales of N$6 000 000 = N$3 000 000 N$3 000 000 N$2 300 000 = 4.25 9
d) Degree of financial leverage before expansion DFL = EBIT EBIT Interest = N$700 000 N$700 000 N$200 000 = 1.40 e) Degree of financial leverage after expansion for all financing plans Sell debt Sell common Sell debt and stock common stock N$ N$ N$ Sales 6,000,000 6,000,000 6,000,000 Variable expenses (3,000,000) (3,000,000) (3,000,000) Fixed expenses (2,300,000) (2,300,000) (2,300,000) EBIT 700,000 700,000 700,000 Interest (460,000) (200,000) (320,000) Earnings before tax 240,000 500,000 380,000 Income tax at 30% (72,000) (150,000) (114,000) Earnings after tax 168,000 350,000 266,000 No of share outstanding 200,000 300,000 240,000 DFL = N$700 N$700 N$700 700 460 700 200 700 320 10
= 2.92 1.40 1.84 f) EPS after expansion for all three financing plans Earnings after tax N$168 000 N$350 000 N$266 000 No. of shares outstanding 200 000 300 000 240 000 EPS N$0.84 N$1.17 N$1.11 2. The value of Milton Company Ltd a) Without leverage Value = N$6 000 000 15% = N$40 000 000 b) With leverage Value = N$40 000 000 + N$19 500 000 x 35% (tax shield) = N$46 825 000 11