Dear jd2005,
I have worked out the exercises below. If you feel that any part of my
answer requires correction or elaboration, please let me know through
a Clarification Request so that I may fully meet your needs before you
assign a rating.
Regards,
leapinglizard
Ex. 1
(a)
i.
Based on the credit department's forecast, 60% of the annual accounts
receivable of $50 million will be collected with a 2.5% discount. We
can calculate the annual loss due to the discount as follows.
.60 * $50 million * 0.025 = $30 million * 0.025
= $750,000
Credit investigation procedures will cost an additional $100,000 annually,
but there will be savings of $120,000 in administrative costs. We also
project savings of $500,000 in bad debts.
$750,000 + $100,000 - $120,000 - $500,000 = $230,000
The new policies would therefore result in a net annual cost of $230,000.
ii.
The factoring company charges as its fee 2% of the accounts receivable.
.02 * $50 million = $1 million
A further cost is the 12% interest on 80% of the debt for an average of
40 days.
.80 * $50 million * 40/365*0.12 = $40 million * 0.01315 = $526,000
Offsetting these costs are administrative savings of $260,000 and
eliminated defaults of $500,000.
$1 million + $526,000 - $260,000 - $500,000 = $766,000.
The net annual cost of factoring would therefore be $766,000.
(b)
The net annual cost of factoring is $536,000 greater than that of adopting
the proposals of the credit control department. However, factoring makes
customer payments available sooner.
The average settlement period is currently 60 days, a period that would
drop to 40 days with factoring. Yet the 40-day period would apply to only
20% of customer payments, with the remaining 80% advanced immediately by
the factoring company. Let us suppose that the company takes advantage
of these advances by applying them toward the overdraft for 60 days or
20 days, respectively. Recall that the overdraft interest is 14% annually.
0.8 * $50 million * 60/365*0.14 = $40 million * 0.02301
= $921,000
0.2 * $50 million * 20/365*0.14 = $10 million * 0.00767
= $77,000
$766,000 - $921,000 - $77,000 = -$232,000
Taking into account interest savings on the overdraft, the company would
save $232,000 in the first year by factoring its trade debts.
Let us perform a similar calculation for the proposals of the credit
control department, which would result in a 30-day advance in 60% of
cases and 10 days in the remaining 40%.
0.6 * $50 million * 30/365*0.14 = $30 million * 0.01151
= $345,000
0.4 * $50 million * 10/365*0.14 = $20 million * 0.00384
= $77,000
$230,000 - $345,000 - $77,000 = -$192,000
By applying the advanced cash toward the overdraft, the company aould
save $192,000 in the first year by factoring its trade debts.
Although factoring results in only $40,000 greater overall savings in
the first year, and smaller savings in subsequent years as the overdraft
diminishes, it is still the better choice. If the overdraft does shrink
dramatically due to other causes, the company can always switch over to
the credit control department's proposals. But for the time being, given
the urgency of reducing the overdraft, factoring is the superior option.
Ex. 3
(a)
1) Net assets
We know that there are 3 million Sp shares outstanding and that the net
assets of the company are stated as $33 million in 2003, the most recent
year for which we have a financial statement.
$33 million / 3 million = $11
On the basis of net assets, the value of one Sp share is $11.
Shares are easily calculated on the basis of net assets because the
requisite figures are made available by the company in its annual
financial statement, which is subject to audit. However, the value
of fixed assets is easily manipulated, and asset valuations can
fluctuate so rapidly that the most recent annual figures are generally
outdated. Company valuations calculated on this basis therefore tend
to be inaccurate, except in cases where asset valuation can be done
rapidly and precisely. This is true if a company's primary holdings
are financial instruments or properties traded on an open market. If
a company's value resides in its personnel or intellectual property,
net assets are not at all a good basis for share valuation.
2) Prospective price earnings ratio
The after-tax net income of the company is $5.8 million. It has 3 million
shares outstanding.
$5.8 million / 3 million = $1.93
Thus, earnings per share amount to $1.93. Under a prospective price
earnings ratio of 17, we can calculate the share price as follows.
17 = P / $1.93
P = 17 * $1.93
= $33
The price earning ratio is a mixed model that reflects figures from
the company's financial statement as well as subjective information
from the market's pricing of the company stock. If the price earnings
ratio of similar firms is used as a basis for valuing a given company,
the resulting estimate may not take into account strengths and weaknesses
that are unique to that company. Even if it is currently viewed as being
comparable to other firms within its sectors, the company may fall out of
favor with analysts in the near future, which would skew its prospective
price earning ratio away from the current value. On this basis, then,
market turbulence can cause the company's estimated value to fluctuate
more rapidly than is warranted by changes in its sales or assets.
3) Dividend yield
The latest annual dividend was $0.6 million, distributed over 3 million
shares.
$0.6 million / 3 million = $0.20
Hence, the dividend per share is $0.20. Let us employ in our share
valuation the dividend yield of similar hotel groups, which is 4%.
0.04 = $0.20 / P
P = $0.20 / 0.04
= $5
On the basis of dividend yield, each share has a value of $5.
The chief advantage of valuing shares on this basis is that it uses
a readily available figure, namely the company's annual dividend. The
dividend yield, however, is obtained by comparison with other firms, which
has the pitfalls we have noted above. Furthermore, the dividend itself
is generally not a good reflection of the company's value, since it is
highly subject to the whims of management. Often, a firm with a strong
market position and steady cash flow will adopt a policy of paying small
or no dividends for reasons of fiscal policy. This is true, for example,
at Microsoft, which recently made a large one-time dividend payment but
otherwise eschews dividends. Thus, the dividend yield is a good basis
for company valuation only from the perspective of those buyers whose
chief interest in holding a company stock is the prospect of future
dividends. Most investors have other reasons for purchasing shares.
4) Free cash flow
The free cash flow of a company is composed of its earnings before
interest, taxes, depreciation, and amortization. For the most recent
reported year, this amounts to $17.2 million.
$17.2 million / 3 million = $5.73
On this basis, the company is worth $5.73 per share.
Cash flow analysis is a valuation method that overlooks secondary costs
such as taxation and depreciation in favor of the earning power of the
company. It provides a good estimate of a company's ability to produce and
sell its products at a profit, even though taxation and capital costs may
end up taking a large bite out of the earnings pie. Thus, although free
cash flow is not the best indicator of a company's financial prospects, it
offers potential investors a good sense of its core production power. In
the case of a firm whose worth resides mostly in financial instruments
or property holdings rather than the sale of goods or service, it is
not an accurate basis for company valuation.
(b) Select the share price from the above calculations at which the
company shares should be issued, with your reasons for selection.
Net assets are the most accurate basis for calculating the value of
this company's shares. We therefore value its shares at $11 each. This
is because the hotel group's worth is concentrated in its physical
assets, namely the hotels themselves. The location and condition of
these holdings are accurately appraised by the real-estate market,
which is a better source of valuation than any fiscal measure. It is
true that real estate markets are subject to volatility, but this makes
it all the more sensible to base the share value on net assets. This is
because the hotel group's value to a buyer is inextricably linked to
its real-estate valuation. Even though hotel patrons are not directly
affected by this market, the real-estate value of the hotel property
is a reflection of its desirability to guests. Net assets do not take
into account the quality of a hotel's management and service, but these
are difficult to measure and are subject to fluctuations that are not
immediately reflected in market share.
(c) Calculate how many shares need to be issued to reduce the company's
gearings so that it has the same amount of long-term debt as equity.
The hotel group currently owes $62.4 million in long-term loans. Let us
value its equity on the basis of net assets.
3 million * $11 = $33 million
Equity is currently worth $33 million.
$62.4 million - $33 million = $29.4 million
In order to equalize long-term debt and equity, we must make up a
shortfall of $29.4 million.
$29.4 million / $11 = 2.67 million
This will entail issuing 2.67 million Sp shares at $11 each.
Ex. 3
(a)
Because collections are delayed by one month but payments to suppliers
may also be delayed by one month without penalty, we shall assume that
all monthly transactions are performed at the end of each month.
All figures below are in thousands.
Jan Feb Mar Apr May Jun
Revenue $41 $122 $122 $163 $163 $204
Costs
collection fees 1 2 2 3 3 4
rent and rates 40 40
others 36 36 36 36 36 36
total 77 38 38 79 39 40
Cash Flow -36 78 78 78 118 158
(b)
The profit/loss account is very similar to the cash flow projection,
with the difference that it includes depreciation.
With a salvage value of zero, the full $120,000 in new goods is to be
depreciated over 36 months.
$120,000 / 36 = $3333
The goods will therefore depreciate at the rate of $3333 a month. All
figures below are in thousands.
Jan Feb Mar Apr May Jun
Revenue $41 $122 $122 $163 $163 $204
Costs
collection fees 1 2 2 3 3 4
rent and rates 40 40
others 36 36 36 36 36 36
depreciation 3 3 3 3 3 3
total 80 41 41 82 42 43
Profit (Loss) (39) 81 81 81 121 161
(c)
All we know is that the company has $100,000 in equity and $232,000
in assets.
30 June 2000
Assets $232,000
Equity $100,000
(d)
This company has favorable financial prospects. Its sales are forecast
to reach a level comparable with its assets, which means it will
have high liquidity. The steadily increasing sales also indicate high
profitability. We therefore conclude that the company's finances are in
good order. |
