Ratios and Strategy 1 / 7

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MC Question 14

Peach Co’s latest results are as follows:

$000
Profit before interest and taxation 2,500
Profit before taxation 2,250
Profit after tax 1,400
In addition, extracts from its latest statement of financial position are as follows:
$000
Equity 10,000
Non-current liabilities 2,500

What is Peach Co’s return on capital employed (ROCE)?

A. 14%
B. 18%
C. 20%
D. 25%

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MC Question 27

The following information relates to an investment project which is being evaluated by the directors of Fence Co, a listed company. The initial investment, payable at the start of the first year of operation, is $3·9 million.

Year 1 2 3 4
Net operating cash flow ($000) 1,200 1,500 1,600 1,580
Scrap value ($000) 100

The directors believe that this investment project will increase shareholder wealth if it achieves a return on capital employed greater than 15%. As a matter of policy, the directors require all investment projects to be evaluated using both the payback and return on capital employed methods. Shareholders have recently criticised the directors for using these investment appraisal methods, claiming that Fence Co ought to be using the academically-preferred net present value method.

The directors have a remuneration package which includes a financial reward for achieving an annual return on capital employed greater than 15%. The remuneration package does not include a share option scheme.

Based on the average investment method, what is the return on capital employed of the investment project?

A. 13·3%
B. 26·0%
C. 52·0%
D. 73·5%

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Question 1a

Gemlo Co is a company listed on a large stock market. Extracts from its current statement of financial position are as follows:
$m $m
Equity
Ordinary shares ($1 nominal) 15
Reserves 153
168
Non-current liabilities
6% Irredeemable loan notes 10
7% Loan notes 12
22

190

Gemlo Co is planning an expansion of existing business operations costing $10 million in the near future and is assessing its current financial position as part of preparing a business case in support of seeking new finance.

The business expansion is expected to increase the profit before interest and tax of Gemlo Co by 20% in the first year.

The planned business expansion by Gemlo Co has already been announced to the stock market. Information on the expected increase in profit before interest and tax has not yet been announced and the company has not decided on how the expansion is to be financed.

The ordinary shares of the company are currently trading at $3·75 per share on an ex dividend basis. The irredeemable loan notes have a cost of debt of 7%.

The 7% loan notes have a cost of debt of 6% and will be redeemed at a 5% premium to nominal value after seven years. The interest cover of Gemlo Co is 6 times.

Companies operating in the same business sector as Gemlo Co have an average debt/equity ratio of 40% on a market value basis and an average interest cover of 9 times.

Required:
(a) Calculate the debt/equity ratio of Gemlo Co based on market values and comment on your findings. (4 marks)

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MC Question 20

The following financial information relates to QK Co, whose ordinary shares have a nominal value of $0·50 per share:
$m $m
Non-current assets 120
Current assets
Inventory 8
Trade receivables 12
20
Total assets 140
Equity
Ordinary shares 25
Reserves 80
105
Non-current liabilities 20
Current liabilities 15
Total equity and liabilities
140

On an historic basis, what is the net asset value per share of QK Co?

A. $2·10 per share
B. $2·50 per share
C. $2·80 per share
D. $4·20 per share

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MC Question 17

The following are extracts from the statement of financial position of a company:
$000 $000
Equity
Ordinary shares 8,000
Reserves 20,000
28,000
Non-current liabilities
Bonds 4,000
Bank loans 6,200
Preference shares 2,000
12,200
Current liabilities
Overdraft 1,000
Trade payables 1,500
2,500
Total equity and liabilities
42,700
The ordinary shares have a nominal value of 50 cents per share and are trading at $5·00 per share. The preference shares have a nominal value of $1·00 per share and are trading at 80 cents per share. The bonds have a nominal value of $100 and are trading at $105 per bond.

What is the market value based gearing of the company, defined as prior charge capital/equity?

A. 15·0%
B. 13·0%
C. 11·8%
D. 7·3%

Specimen
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MC Question 11

The following are extracts from the statement of profit or loss of CQB Co:

$000
Sales income 60,000
Cost of sales 50,000

Profit before interest and tax 10,000
Interest 4,000

Profit before tax 6,000
Tax 4,500
Profit after tax
1,500

60% of the cost of sales is variable costs.

What is the operational gearing of CQB Co?

A. 5·0 times
B. 2·0 times
C. 0·5 times
D. 3·0 times

Specimen
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Question 5a ii

DD Co has a dividend payout ratio of 40% and has maintained this payout ratio for several years. The current dividend per share of the company is 50c per share and it expects that its next dividend per share, payable in one year’s time, will be 52c per share.

The capital structure of the company is as follows:

$m $m
Equity
Ordinary shares (par value $1 per share) 25
Reserves 35
60
Debt
Bond A (par value $100) 20
Bond B (par value $100) 10
30

90

Bond A will be redeemed at par in ten years’ time and pays annual interest of 9%. The cost of debt of this bond is 9·83% per year. The current ex interest market price of the bond is $95·08.

Bond B will be redeemed at par in four years’ time and pays annual interest of 8%. The cost of debt of this bond is 7·82% per year. The current ex interest market price of the bond is $102·01.

DD Co has a cost of equity of 12·4%. Ignore taxation.

Required:
(a) Calculate the following values for DD Co:
(ii) capital gearing (debt divided by debt plus equity) using market values; and (2 marks)

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Question 2b

The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:

$000$000
Inventory5,700
Trade recievables6,57512,275
Trade payables2,137
Overdraft4,6826,819
Net current asstes5,456

For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers.

For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the company’s overdraft.

CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015:

Inventory days:60 days
Trade receivables:75 days
Trade payables:5 days
Current Ratio:1.4

Required:
(b)Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working capital of CSZ Co at the end of March 2015. (5 marks)

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Question 4a

The following financial information relates to MFZ Co, a listed company:

Year201420132012
profit before interest tax ($m)18.317.717.1
profit after tax ($m)12.812.412.0
dividends ($m)5.15.14.8
equity market value ($m)56.455.254.0

MFZ Co has 12 million ordinary shares in issue and has not issued any new shares in the period under review. The company is financed entirely by equity, and is considering investing $9•2 million of new finance in order to expand existing business operations. This new finance could be either long-term debt finance or new equity via a rights issue. The rights issue price would be at a 20% discount to the current share price. Issue costs of $200,000 would have to be met from the cash raised, whether the new finance was equity or debt.

The annual report of MFZ Co states that the company has three financial objectives:

Objective 1: to achieve growth before interest and tax of 4% per year.
Objective 2: to achieve growth in earnings per share of 3.5% per year .
Objective 3: to achieve total shareholder return of 5% per year.
MFZ Co has a cost of equity of 12% per year.

Required:

Analyse and discuss the extent to which MFZ Co has achieved each of its stated objectives. (7 marks)

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Question 4b c

GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company needs to raise $3,200,000 for research and development and is considering three financing options.

Option 1
GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown by 3% per year.

Option 2
GXG Co could seek a stock market listing, raising $3·2 million after issue costs of $100,000 by issuing new shares to new shareholders at a price of $2·50 per share.

Option 3
GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable after ten years at par.

Recent financial information relating to GXG Co is as follows:

Under options 2 and 3, the funds invested would earn a before-tax return of 18% per year.

The profit tax rate paid by the company is 20% per year.

GXG Co has a cost of equity of 9% per year, which is expected to remain constant.

(b) Calculate the effect on earnings per share of the proposal to raise finance by a stock market listing  (option 2), and comment on the acceptability of the proposal to existing shareholders.

(5 marks)

(c) Calculate the effect on earnings per share and interest cover of the proposal to raise finance by issuing new debt (option 3), and comment on your findings.

(5 marks)

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