Questions and Answers of Financial Management

Why might calculating working capital as a fixed percentage of sales provide a reasonable simplifying assumption?
Calculate the margin of safety for the higher geared option and interpret its significance.
If a business is overtrading, do you think the following ratios would be higher or lower than normally expected?1. Current ratio 2. Average inventories turnover period 3. Average settlement period
Let us assume that research indicates that a particular ratio is shown to be a good predictor of failure. Can you think of a practical problem that may arise when using this ratio to predict
Bernese plc develops and manufactures drills for businesses operating in the oil and gas industry. Although it is committed to maximising the wealth of its shareholders, the business has incurred
When managers of a business are making a decision involving capital investments, what should the decision seek to achieve?
A business assesses potential investment projects on the basis of their IRRs. Why does the business need to know its cost of capital and why would it be helpful to calculate by how much a particular
Chesterfield Wanderers is a professional football club that has enjoyed some success in recent years. As a result, the club has accumulated £10 million to spend on its further development. The board
Can you identify the kinds of risks that the business may face?
The directors of Tocantins Co. are considering whether to invest in two separate projects: one is small while the other is large. They are also trying to decide between two other competing projects.
A garage has an old car that it bought several months ago for £3,000. The car needs a replacement engine before it can be sold. It is possible to buy a reconditioned engine for £300. This would
Can you think of any drawbacks to the use of a post-completion audit? Could it have an adverse effect on management behaviour?
What does the profitability index calculated in Example5.1 suggest about the relative profitability of the projects? What would be the NPV of the £12 million invested, assuming the profitability
Davos plc is considering four possible investment projects for the current year but has only a limited amount to invest. As a result, it will not be able to undertake in full all of the projects
Should objective probabilities be preferred to subjective ones? Discuss the advantages of each.
Khan Engineering Ltd has the opportunity to invest in two competing machines. Details of each machine are as follows:The business has a cost of capital of 10 per cent.State which of the two machines,
Recommend a solution for Unicorn Engineering Ltd in Example5.1 above if the investment projects were not divisible (that is, it was not possible to undertake part of a project).Assume the finance
In what way is the term ‘expected value’ a misnomer?
S. Saluja (Property Developers) Ltd intends to bid at an auction, to be held today, for a large town house that has fallen into disrepair. The auctioneer believes that the house will be sold for
Helena Chocolate Products Ltd is considering the introduction of a new chocolate bar into its range of chocolate products. The new chocolate bar will require the purchase of a new piece of equipment
Explain why the standard deviation may be useful in measuring risk. Under what circumstances might the standard deviation fail to be a reliable measure of risk?
Patel Properties Ltd has the opportunity to acquire a lease on a block of apartments that has only two years remaining before it expires. The cost of the lease would be £1,000,000. The occupancy
What is the NPV for Machine B over the six-year period? Which machine is the better buy?
Devonia (Laboratories) Ltd has recently carried out successful clinical trials on a new type of skin cream, which has been developed to reduce the effects of ageing. Research and development costs
Use the table provided in Appendix B to calculate the equivalent annual annuity for each machine referred to in Example5.2. Which machine is the better buy?Data from Example5.2Khan Engineering
Zeta Computing Services Ltd has recently produced some software for a client organisation. The software has a life of two years and will then become obsolete. The cost of developing the software was
Frank N. Stein plc has the opportunity to invest in two investment projects in Transylvania. The possible outcomes from each project will depend on whether the ruling party of the country wins or
What are the possible benefits of delaying an investment decision?
Plato Pharmaceuticals Ltd has invested £500,000 to date in developing a new type of insect repellent. The repellent is now ready for production and sale, and the marketing director estimates that
Why is inflation likely to have a differing effect on the various items making up the net cash flow of a business?
A business has the opportunity to invest £12 million immediately in new plant and equipment in order to produce a new product. The product will sell at £80 per unit and it is estimated that 200,000
Try to draw a graph that plots the utility of wealth against wealth for an individual who is indifferent to risk. Explain the shape of the graph line.
Kernow Ltd provides street-cleaning services for a small town. The work is currently labour intensive and few machines are employed. However, the business has recently been considering the purchase
Ukon Ltd is considering two competing projects. Details of each project are as follows:Project A has a 0.8 probability of producing a negative NPV of £500,000, a 0.1 probability of producing a
Draw a graph plotting the utility of wealth against wealth for an individual who is risk seeking, and explain the shape of the graph line.
Suppose the returns from Project Y had a perfect negative correlation with those of ProjectX. Draw a graph depicting the relationship between the two projects.
Should the managers of a business seek project diversification as their main objective?
Bellona Ltd is a small business that produces a single product – a thermostat that is used in a range of kitchen appliances. Information relating to the thermostat is as follows:All sales are made
Why might a business decide to repay long-term loan capital earlier than the specified repayment date?
Balliol Ltd produces a tracking device that can be attached to bicycles. The device is designed to help locate the whereabouts of stolen bicycles and is sold to wholesalers and retailers throughout
Under what circumstances might a business wish to avoid paying a dividend?
‘Convertible loan notes are really a form of delayed equity.’ Do you agree? Discuss.
Abyss plc intends to make a 1 for 4 bonus issue of ordinary shares. What will be the effect of this issue on the business’s:(i) Financial gearing, (ii) Earnings per share, (iii) Liquidity, and
Would you expect the market price of ordinary shares, or of preference shares, to be the more volatile? Why?
Telford Engineers plc, a medium-sized manufacturer of automobile components, has decided to modernise its factory by introducing a number of robots. These will cost £20million and will reduce
Rashford plc intends to raise £45 million to launch an advertising campaign for a new product. To raise this amount, its senior management team has decided that a loan for a one-year period should
Can you think of a reason why a business may prefer a floating charge rather than a fixed charge on its assets?
Would you expect the returns from loans to be higher or lower than those from preference shares?
What factors might a business take into account when deciding between preference shares and loans as a means of raising new finance? Try to think of at least two.
Does it really matter if the loan notes of a business are downgraded to a lower category?
Why do you think the value of fixed-interest loan notes will rise and fall with rises and falls in interest rates?
Under what circumstances will the holders of share warrants exercise their option to buy?
What action might managers have to take in order to meet the borrowing commitments?
Can you think of circumstances where managers may welcome the opportunity to take on higher gearing?
Some high-street retailers may well regret sale-and-leaseback arrangements made in earlier years. Can you think why?
What advantages do you see, from both a buyer and supplier perspective, of drawing up a bill of exchange?
Why do you think the service charge for factoring is higher than for invoice discounting?
Rusli Ltd provides a car valet service for car-hire businesses when their cars are returned from hire. Details of the service costs are as follows:Sales revenue is £10 million a year and is all on
Why shouldn’t the managers simply release any inside information to the market to allow the share price to rise and so make it possible to issue shares at a fair price? Try to think of one reason.
Comment on each of the following statements.(a) A stock market that is efficient in the strong form is one in which investors cannot make any gains from their investment.(b) Private-equity firms
Could listed businesses also benefit by the Stock Exchange making it easier for investors to sell their securities? If so, how?
UK private-equity firms have been criticised for the low level of funding invested in business start-ups by comparison with the levels invested by their US counterparts. Can you think of possible
Consider each of the following.1. An investor expects to make abnormal gains on her stock market investments by analysing published annual reports, relevant newspaper articles, industry reports and
How would you define the ‘true worth’ of a share?
Explain the role that investment analysts and investors play in creating an efficient stock market. Can you see a paradox in their behaviour?
Provide two reasons why:(a) Tax incentives may have only limited value in stimulating greater investment by business angels.(b) Business angels can be an attractive source of finance to
Can you explain why the relationship between the various forms of market efficiency described above should be the case?
The board of directors of Beton Ltd are considering the use of private equity finance to help fund the next stage of development. What should the board take into consideration before going down this
Thermia Ltd is a family-owned business that produces packaged foods for supermarkets. The family has recently lost interest in the business and has indicated a willingness to sell. The senior
Dornier plc is a large civil engineering business that is listed on the Stock Exchange. On 1 May it received a confidential letter stating that it had won a large building contract from an overseas
If share prices follow a random pattern, does this not mean that the market is acting in an irrational (and inefficient) manner?
Why might managers who accept that the market is efficient, at least in the semi-strong form, be justified in delaying the issue of new shares until what they believe will be a more appropriate time?
Can you suggest why, in the UK, April may provide better returns than other months of the year?
What consequences may arise from investors displaying irrational behaviour when buying and selling shares?
Can you think of at least two advantages of syndication for a business angel?
What other motive may a business angel have for contributing to the business?
Riphean plc and Silurian plc are two businesses operating in different industries. They are both financed by a mixture of ordinary share and loan capital and both are seeking to derive the cost of
What adverse consequences might result from incorrectly calculating the cost of capital?
Hackney Wholesalers plc is about to embark on an expansion programme that will have a significant impact on the size and nature of the business in forthcoming years. As at 31 July Year 6, the
Portby Potassium plc began issuing a dividend at the end of the first year of trading. The first dividend paid was 10 pence per share. Dividends grew steadily each year and, by the end of the fifth
The valuation approach above takes into account the expected dividend stream over the whole life of the business. Is this relevant for an investor who holds a share for a particular period of time
Celtor plc is a property development business operating in the London area. The business has the following capital structure as at 30 November Year 9:The ordinary shares have a current market value
How might excessively high levels of borrowing adversely affect the ability of managers to run the business?
Lim Associates plc issues £20 million loan capital on which it pays an annual rate of interest of 10 per cent on the nominal value. The issue price of the loan capital is £88 per £100 nominal
Kowloon Investments plc has ordinary shares in issue with a current market value of £2.20. The annual dividend per share in future years is expected to be 40p. What is the cost of the ordinary
One study mentioned in the chapter found, amongst other things, that businesses often based their target capital structures on statement of financial position values rather than on market values.
Danton plc has 10 million ordinary shares in issue with a current market value of £2.00 per share. The expected dividend for next year is 16p per share and this is expected to grow each year at a
Avalon plc has ordinary shares in issue that have a current market price of £1.50. The dividend expected for next year is 20p per share and future dividends are expected to grow at a constant rate
Consider each of the following:Mallard plc issues loan capital with a nominal value of 100 million at a price of 90 per 100 nominal value. The annual interest rate is 10 per cent of the nominal
Can you think why returns from government bonds can be used as an approximation for the risk-free rate?
Averna plc is a research-based engineering business that has recently developed an electric scooter operated by solar batteries. The technology employed is highly sophisticated and so the scooter is
Can you recall the difference between the two types of risk?
Ndovu plc is considering investing in a new project and, in the past, it would have used a cost of capital of 10 per cent as the discount rate to assess new projects. This rate had been calculated by
Would it be better to hold shares with a beta value of more than 1.0 or less than 1.0 when stock market prices are generally:(a) Rising(b) Falling?
Lansbury plc has recently obtained a measure of its beta from a business information agency. The beta value obtained is 1.2. The expected returns to the market for the next period is 10 per cent and
Tan and Co plc has irredeemable loan capital outstanding on which it pays an annual rate of interest of 10 per cent. The current market value of the loan capital is £88 per £100 nominal value and
Iordanova plc has 12 per cent irredeemable preference shares in issue with a nominal (par) value of £1. The shares have a current market price of £0.90 (excluding dividends). What is the cost of
Under what circumstances would the use of WACC still be suitable? Try to think of at least one.
Sandarajan plc has recently obtained a listing on the Stock Exchange. The business operates a chain of supermarkets and was the subject of a management buyout five years ago.Since the buyout, the
Why might investors interpret an announcement to increase borrowing as an indication of managers’ confidence in the future?

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