Financial Management

ASSIGNMENT

The questions in this assignment require some quantitative work and some interpretation. When answering the discussion questions you should try to make full use of the relevant theoretical propositions and concepts.

Question 1: Clyach Plc: A Capital Expenditure Decision Clyach plc has grown rapidly in recent years, to a large extent by expanding its product range. It is now necessary to evaluate another new product investment. The latest of these products has just completed the final stages of its trials and a decision must now be taken whether or not to proceed to the manufacture of the product. The product’s development has already cost £400,000 and the manufacture of the product will require an outlay of £1,500,000 on production facilities. This expenditure will have to be depreciated for tax purposes on a straight line basis over a ten year period, but the anticipated commercial life of product, given the level of product innovation in the industry, is only five years. The residual (re-sale) value of the production line is expected to be £250,000. The production line would be located in one of the company’s existing factories with unused capacity. Based on the space occupied a cost of £40,000 will be allocated to be product by the company’s management accounting system. The product is expected to sell for £35.00 per unit and sales of 80,000 units are anticipated for the first year. For years two to five 90,000 units are expected to be sold. The estimated variable cost per unit is £27.00 per unit, made up of 50 per cent raw material costs and 50 per cent labour costs. The fixed costs of production directly related to the product are expected to £100,000 per annum. Each product is also allocated an overhead charge of 8 per cent of lower costs through the management accounting system to allow for the recovery of R&D expenditure and head office expenses. It will be necessary to hold the equivalent of 15 per cent of expected sales in stocks of the finished product. Promotion and marketing expenditure prior to the introduction of the product will cost £70,000 and a further expenditure of £20,000 per annum will be required for each of the next five years. The company requires an expected return of 14 per cent on investments and pays tax at 30 per cent.

- a) Determine the net present value of the investment. Set out your calculations clearly and specify the critical assumptions. (13 MARKS) b) Explain that is meant by sensitivity analysis, determine and discuss the sensitivity of the investment’s NPV to deviations in the expected price from the assumed value of £35 per unit. (5 MARKS) c) Explain the principles underlying the treatment of net working capital in investment appraisal and comment on the approach you adopted in the evaluation of Clyach’s proposed investment. (2 MARKS) (TOTAL 20 MARKS)

Question 2: Valuation of a Company’s Shares

Collect the price earnings ratios for three companies in the same country for the years 2009 to 2018. You can use the data set provided for the London Stock Exchange or pick your own companies. The data set has a sample of companies from the FTSE 100, and the P/E ratios are for the end of each year from 2009 to 2018. The data also gives the P/E ratios for the FTSE 100 index.

Discuss the factors that might explain the differences in the price earnings ratios of the three companies you have chosen and the changes that have occurred in their price earnings ratios over the period. (Choose companies with a range of P/E ratios, to give you one with a relatively low value, one with a relatively high value, and another with a middling value. Although not necessary, firms from the same industry helps for comparison reasons)

You should use the insights provided by valuation models on the determinants of the priceearnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chose (20 MARKS)

Question 3: Portfolio Analysis

The attached file gives monthly returns for securities drawn from the FT ALL Share Index for the period January 2009 and December 2018.

- a) Create four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx)) the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 120 months of returns data in the calculations and use the Excel functions identified as Variance.P and Standard Deviation P.)

Next determine the monthly returns on the four portfolios along with the standard deviation of these returns. The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio.

Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of portfolio’s returns. Comment on the difference between the outcomes.

Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification. (8 MARKS)

Determine the variance of each security and the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Employ this information to calculate the standard deviation of the portfolio returns using the equally weighted portfolio risk equation. Compare your results to those obtained for the portfolio in part i above. (4 MARKS)

- b) Determine the betas for BP, an oil and gas company, and Ferguson, a distributor of plumbing and heating products, by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spreadsheet). i. Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies. Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companies

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