FINANCIAL STRATEGY AND DECISION MAKING I

FINAL EXAM – SAMPLE PAPER 3 – Solutions

Number of Questions: 2, Total Marks: 100
Time Allowed: 2 hours and 10 minutes reading time

NOTE: ATTEMPT ALL THE FOLLOWING QUESTIONS.

QUESTION 1
(a) What is meant by "the operating cycle"? Highlights its importance in the management
of cash for a business. [Marks = 10]

(b) The following information is extracted from the financial statements of ABC plc.
Calculate the length of the operating cycle. [Marks = 10]

2024 ($) 2023 ($)

Stock 127,000 119,550
Debtors 95,500 93,750
Creditors 89,950 85,500
Cost of sales 709,600 685,500
Turnover 965,500 929,600

(c) In addition to the credit ratings and references, how can the information in the length
of the operating cycle help a credit analyst in performing the credit analysis of a
potential customer? [Marks = 10]

(d) Consider the following financial data of ABC plc. To evaluate the financial position of
the company, please calculate quick ratio, market capitalization, earnings per share,
price-earnings ratio, and gearing. [Marks = 10]
2024 ($000) 2023 ($000)
Stock 1100 1500
Total current assets 2400 2900
Total current liabilities 1500 2800
Loans 580 720
Total equity 2400 2100
Ordinary share capital ($1 each) 1800 1600
Net profit for the year 500 500
Share price 12 11
(e) Technology Inc is planning to lease a machine which would involve making annual
lease payments of $4,000 to the lessor at the end of each of the next five years. The
machine is projected to generate additional cash flows of $2,000 annually over its
five-year lifespan, and it would be depreciated over its estimated useful life on a
straight-line basis. After-tax interest rate is 7% and the company pays 30%
corporation tax. Calculate the net present value of this lease contract. [Marks = 10]

SOLUTION
(a)
Businesses need to understand how long it takes them to turn their inventory into cash. This
period is called the "operating cycle." Therefore, the length of the business’s operating cycle
is the average length of time that elapses between the acquisition of inventory and the
receipt of cash for its eventual sale.

A long operating cycle indicates high working capital and a high requirement for cash,
whereas a short operating cycle indicates the opposite. Businesses aim to shorten their
operating cycle. This helps them manage their cash more efficiently. A shorter cycle means
they need less cash tied up in inventory. In essence, the operating cycle is a key indicator of
a business's cash flow health. By understanding and optimizing this cycle, businesses can
improve their financial stability.

(b)
As we know that,
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑦𝑐𝑙𝑒 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 + 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 − 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠
2024 2023
𝑠𝑡𝑜𝑐𝑘 127,000 119,550
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑑𝑎𝑦𝑠 = 365 × = 365 × = 65 𝑑𝑎𝑦𝑠 = 365 × = 64 𝑑𝑎𝑦𝑠
𝐶𝑂𝐺𝑆 709,600 685,500
Inventory days = Stock turnover days
𝑑𝑒𝑏𝑡𝑜𝑟𝑠 95,500 93,750
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 365 × = 365 × = 36 𝑑𝑎𝑦𝑠 = 365 × = 37 𝑑𝑎𝑦𝑠
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 965,500 929,600

𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 89,950 85,500

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 365 × = 365 × = 46 𝑑𝑎𝑦𝑠 = 365 × = 46 𝑑𝑎𝑦𝑠
𝐶𝑂𝐺𝑆 709,600 685,500

𝐿𝑒𝑛𝑔𝑡ℎ 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑦𝑐𝑙𝑒 65 + 36 − 46 = 55 𝑑𝑎𝑦𝑠 64 + 37 − 46 = 55 𝑑𝑎𝑦𝑠

The length of operating cycle remains the same in 2023 and 2024.

(c)
To perform the credit analysis of a potential customer,
▪ References from other businesses can be consulted to assess the customer's
creditworthiness.
 ▪ The customer’s credit rating over the years can be reviewed.

In addition to these, the information in the length of the operating cycle helps a credit analyst
in performing the credit analysis. For example, the length of operating cycle highlights the
requirement of cash for the business of the customer. It also gives information on how many
days the customer takes to pay its creditors, as well as, in how many days the customer
receives payment from its debtors.

(d)
2024 2023
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 2400,000 − 1100,000 2900,000 − 1500,000
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = = 0.87 = 0.5
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 1500,000 2800,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝 = 𝑝𝑟𝑖𝑐𝑒 × 𝑛𝑜. 𝑠ℎ𝑎𝑟𝑒𝑠 12 × 1800,000 = $21,600,000 11 × 1600,000 = $17,600,000
𝑖𝑛𝑐𝑜𝑚𝑒 500,000 500,000
𝐸𝑃𝑆 = = $0.28 = 28𝑝 = $0.31 = 31𝑝
𝑛𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 1800,000 1600,000

𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 12 11
𝑃𝐸 𝑟𝑎𝑡𝑖𝑜 = = 42.86 = 35.48
𝐸𝑃𝑆 0.28 0.31
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 580,000 720,000
𝐺𝑒𝑎𝑟𝑖𝑛𝑔 = = 19.46% = 25.53%
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 + 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 580,000 + 2400,000 720,000 + 2100,000

(e)
Year 0 1 2 3 4 5 6
Lease payments –4,000 –4,000 –4,000 –4,000 –4,000
Tax shield 1,200 1,200 1,200 1,200 1,200
Net cash flow –4,000 –2,800 –2,800 –2,800 –2,800 1,200
Present value –3738 –2446 –2286 –2136 –1996 800
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑃𝑉) = $ − 11,802

QUESTION 2
(a) ABC plc is planning to purchase a new machine using funds obtained through a bank
loan at an after-tax interest rate of 8% per year. The machine has a cost of $60,000
and is expected to have a useful life of five years with a disposal value of $10,000 at
the end of this period. The machine is projected to generate additional cash flows of
$10,000 annually over its five-year lifespan, and it would be depreciated over its
estimated useful life on a straight-line basis. ABC plc pays 30% corporation tax and
can claim capital allowance on a 25% reducing balance basis. Calculate the net
present value of this purchase through the bank loan. [Marks = 15]
(b) Presently, ABC Plc offers a 3% discount to customers who pay within 30 days, with
40% of customers taking advantage of this discount. The remaining 60% of
customers pay, on average, in 70 days. Bad debts are currently at 4% of sales. With
sales forecasts for the upcoming year estimated at $12,000,000 based on existing
credit arrangements, the company is considering an alternative credit policy. The
company is now considering introducing a 6% discount for payment within 15 days.
This plan anticipates 50% of customers expected to utilize the new discount facility.
However, the average payment period for the remaining customers is expected to
extend to 80 days, and bad debts are projected to rise to 5.5%. The company finances
working capital from an overdraft at a cost of 12%. Is the proposed change in policy
worth implementing? [Marks = 15]

(c) The new credit policy presented in part (b) resulted in an increment in sales by 25%.
Variable costs make up 70% of the selling price, and the proposed policy did not
change the fixed costs. Calculate the net effect of the proposed policy. [Marks = 10]

(d) The CEO of Tyco, Dennis Kozlowski, threw a $2 million birthday bash for his wife and
charged half of the cost to the company. This of course was an extreme conflict of
interest. But more subtle and moderate agency problems arise whenever managers
think just a little less hard about spending money when it is not their own (Principles
of Corporate Finance by Brealey, Myers and Allen). Identify five areas where the
interests of shareholders and directors may conflict, leading the directors to pursue
objectives other than maximizing shareholders’ wealth. [Marks = 10]

SOLUTION
(a)
Capital Allowance Calculations
Year Allowance Remaining Balance
Year 1 15,000 45,000
Year 2 11,250 33,750
Year 3 8,438 25,312
Year 4 6,328 18,984
Year 5 4,746 (Last allowance) 14,238
Total Allowance 45,762
Cost = 60,000 Disposal value = 10,000
Value consumed = 60,000 – 10,000 = 50,000
Closing Allowance = Last Allowance + Value Consumed – Total Allowance
= 4,746 + 50,000 – 45,762
 = 8,984

Year 0 1 2 3 4 5 6
Cost –60,000
Disposal 10,000
Allowance 15,000 11,250 8,438 6,328 4,746 8,984
Tax shield 4,500 3,375 2,531 1,898 2,695
Net cash –60,000 0 4,500 3,375 2,531 11,898 2,695
PV –60000 0 3,858 2,679 1,861 8,098 1,699
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑃𝑉) = $ − 41,806

(b)
Current Policy
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 0.4 × 30 + 0.6 × 70 = 54 𝑑𝑎𝑦𝑠
54
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 ($) = 12,000,000 × = $1,775,342
365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 1,775,342 × 0.12 = $213,041
𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 12,000,000 × 0.04 = $480,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 12,000,000 × 0.03 × 0.4 = $144,000
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 213,041 + 480,000 + 144,000 = $837,041

Proposed Policy
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 0.5 × 15 + 0.5 × 80 = 47.5
47.5
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 ($) = 12,000,000 × = $1,561,644
365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 1,561,644 × 0.12 = $187,397
𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 12,000,000 × 0.055 = $660,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 12,000,000 × 0.06 × 0.5 = $360,000
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 187,397 + 660,000 + 360,000 = $1,207,397

𝑁𝑒𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 = 1,207,397 − 837,041 = $370,356

The proposed policy increases the cost by $370,356. Therefore, the new policy is NOT
financially attractive.

(c)
Proposed Policy
𝑁𝑒𝑤 𝑠𝑎𝑙𝑒𝑠 = 12,000,000 × 1.25 = 15,000,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = 0.5 × 15 + 0.5 × 80 = 47.5
 47.5
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠 ($) = 15,000,000 × = $1,952,055
365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 1,952,055 × 0.12 = $234,247
𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 15,000,000 × 0.055 = $825,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 15,000,000 × 0.06 × 0.5 = $450,000
NOTE: Now, compare with current policy in part (b).
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 = 234,247 − 213,041 = $21,206
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠 = 825,000 − 480,000 = $345,000
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 = 450,000 − 144,000 = $306,000
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 12,000,000 × 0.25 × 0.3 = $900,000
𝑁𝑒𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 = 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 + 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐵𝑎𝑑 𝑑𝑒𝑏𝑡𝑠
+ 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑁𝑒𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 = 21,206 + 345,000 + 306,000 − 900,000 = $ − 227,794
The proposed policy reduces the cost by $227,794. Therefore, the new policy is financially
attractive. Or the incremental contribution of $900,000 is greater than the increment in the
cost of $672,206. Therefore, the new policy is financially attractive.

(d)
▪ Corporate expenditures benefit management, but costs stockholders. For example,
a company buying an unneeded corporate jet.
▪ Directors’ performance is usually judged on their short-term achievements.
Therefore, directors may make decisions that are in their own best interest over a
short period of time.
▪ Directors may provide themselves with high executive compensation that may
reduce the net profit available for distribution to shareholders.
▪ Directors might take a high-profile initiative to enhance their personal legacy which
might not necessarily provide the highest financial return.
▪ Directors might often throw ultra-luxury parties on shareholders' expenses.
▪ At the time of stock compensation grants, directors might try to manipulate the stock
price to get extra grants.