Solutionstocasestudies

SolutiontoCase1:PaceLeisurewearLtd(1)
(Note: There is no single correct solution tothis casestudy.Variousapproaches could have been adopted. The plan of action proposed should flow logically from the initial analysisoftheproblemsfacedbythecompany.) Whenanalysingtheproblemsfacedbythecompany,thefollowingpointsmay havebeenraised: The lack of financial expertise within the boardroom and the apparent lack of financialcontrolsoperatingwithinthebusiness(e.g.thefactthatthebusinesshad breachedtheoverdraftlimitonseveraloccasions). The lack of proper businessplanning.Thegrowth inthe company appears to be uncontrolledandunpredicted.Thereisnoevidencethatthecompanyhastriedto ensure that there is capital available to finance the growth of the business. The companyappearstoreacttothedevelopmentsinthebusinessastheyariserather thantoanticipateproblemsbeforetheyarise. The relatively high dividends being paid despite the liquidity problems of the business.

Tableofratios Thefollowingratiosprovideausefulinsighttothefinancialhealthofthebusiness: Year beforelast Returnoncapitalemployed(netassets) Netprofitbeforeinterestandtax 100% Sharecapital + Reserves + Longtermloans 2,100 100% 10,474 4, 618 100% 15,600 Returnonequity(shareholdersfunds) Netprofitafterlongterminterestandtax 100% Sharecapitalandreserves 20.0%

Lastyear

29.6%

1248 , 100% 6,874 2, 926 100% 9,000 Grossprofitmargin Grossprofit 100% Sales 6,510 100% 14,006 10, 792 100% 22,410 Netprofitmargin Netprofitbeforeinterestandtax 100% Sales 2, 100 100% 14,006 4, 618 100% 22,410 Stockholdingperiod Stockheld 365 days Costofsales 2, 418 365 7,496 5, 820 365 11618 , *basedonyearendstocklevels Debtorcollectionperiod(Daysdebtors)

18.2%

32.5%

46.5%

48.2%

15.0%

20.6%

118days

183days

Tradedebtors 365days Creditsales 1614 , 365 14,006 3, 744 365 22,410 Salestocapitalemployedratio Sales Totalassetsemployed 14, 006 8, 600+ 4,356 22, 410 14, 470+ 9,974 Currentratio Currentassets Currentliabilities 4, 356 2, 482 9, 974 8, 844 Quickassets(liquidoracidtest)ratio Currentassets, excludingstock Creditorsfallingduewithinoneyear 4, 356- 2, 418 2,482 9, 974- 5, 820 8,844 Debttoequityratio 0.78:1 1.76:1 1.08times 42days

61days

0.92times

1.12:1

0.40:1

Longtermliabilities 100% Sharecapital + Reserves + Longtermloans 3, 600 100 10,474 7, 600 100 15,600 Commentsonthefinancialresults Thefollowingpointsaresignificantfromtheresultstohand: PaceLeisurewearhasexperiencedamajorexpansionofactivities.Saleslastyear increased by 37.5% compared to the previous year. Net profits after tax have increasedby134.5%overthesameperiod. There has been an increase in the ROCE ratio, but a ROCE in excess of the interest rate had caused an even greater increase in ROE, an effective use of gearing.However,thelevelofgearingisnowveryhigh. The gross profit ratio increased significantly, accompanied by an increase in the netprofitmargin. The liquidity position has weakened considerably from what was probably a healthy position to one that looks distinctly unhealthy. It is quite clear why the continuingsupportofthebankisimportant. Stockisnowturningoverratherslowlycomparedwithlastyear.However,thisratio willbeaffectedbytheneedtoincreasestocksinanticipationofhighersaleslevels inthefuture. The debtors collection period has increased significantly over the period. Once again,however,thisratiowillbeaffectedbyanyincreaseinsalestowardstheend oftheyear. 34.4%

42.3%

Cashflowstatementfortheyearended31Decemberlastyear 000 Netcashinflowsfromoperatingactivities (seeNote1below) Returnsfrominvestmentandservicingoffinance Interestpaid Dividendspaid Netcashoutflowfromreturnsoninvestment andservicingoffinance Taxation 000 3,304

(912) (600) (1,512)

Corporationtaxpaid Taxpaid Investingactivities Paymentstoacquiretangiblefixedassets (Seenote) Netcashoutflowfrominvestingactivities Netcashoutflowbeforefinancing Financing Bankloan Netcashinflowfromfinancing Netdecreaseincashandcashequivalents

(420) (420)

(8,670) (8,670) (7,298)

3,000) 3,000) (4,298)

To see how this relates to the cash of the company at the beginningand end ofthe year,itisusefultoshowareconciliationasfollows: Analysisofcashandcashequivalentsduringtheyearended31Decemberlastyear 000 56) (4,298) (4,242)

Balanceat1Januarylastyear Netcashoutflow Balanceat31Decemberlastyear

Toexplainwheretheopeningandclosingbalancescamefrom,anotherreconciliation canbeshown,asfollows: Analysisofbalancesofcashandcashequivalentsasshowninthebalancesheet start 000 56) ) (17) end 000 8) (4,250) (4,242) Changeinyear 000 (48) (4,250) (4,298)

Cashatbankandinhand Bankoverdrafts

Note: Calculationofnetcashinflowfromoperatingactivities 000 Netoperatingprofit(fromtheprofitandlossaccount) Add: Depreciation Add: Increaseintradecreditors(2,6121,214) Increaseinothercreditors(402248) 1,398 154 3,402 2,130 134 000 4,618 2,800 7,418 1,552 8,970

Less: Increaseinstocks(5,8202,418) Increaseintradedebtors(3,7441,614) Increaseinotherdebtors(402268)

5,666 3,304

Sincetherewerenodisposals,theadditionsmustbethedifferencebetweenthestart andendoftheyearfixedassetvalues,adjustedbythedepreciationcharge,e.g.: Fixedassets,atbookvalue,atthestartoftheyear Add:additions(balancingfigure) Less:depreciation Fixedassets,atbookvalue,attheendoftheyear Planofaction Inproducingaplanofaction,thefollowingpointsmaybemade: Thecompanyshouldensurethatsomeonewithfinancialexpertiseisbroughtonto theboardofdirectorstotakeafirmcontrolofthefinancingandinvestingactivities ofthe business. The cashflowstatementshown aboverevealsthatthecompany investednearly8.7minfixedassetsduringlastyearbutonlyraised4minloans tofundthebusiness.Theresultwasinevitablyadeteriorationinthecashposition ofthebusiness. Thecompanymayfinditdifficulttofindpotentialinvestors.Althoughthecompany ishighlyprofitable,thelevelofgearingishighandthecompanyisfacingaliquidity crisis.Nevertheless,therearecertaininvestors(e.g.venturecapitalists)whomay still find the company attractive. They may be prepared to take on such risks in exchangeforpotentialhighreturns.However,theKeeblebrothersarenotkeenon havinganotherlarge shareholderinthecompanywhichcouldpreventthisoption frombeingfeasible.Itmaybepossibletoapproachcustomersandsupplierstosee whether they would be prepared to make small investments in the business. However,theremaybedisadvantagesinthisapproach.Customersandsuppliers may wish to use their shares to influence future policy of the business in a way whichunderminesitsautonomy. In the absence of a large injection of funds from outside the business, it is necessary to ensure that the level of operations is more closely aligned to the 8,600 8,670 17,270 2,800 14,470

finance available. This means that the company must take a more controlled approach to expanding the business. In the short term, it may be necessary to reducethelevelofactivity,oratleastreducetherateofgrowthinordertoensure that orders can be fulfilled. Although this policy may involve losing sales, the alternativemaybethatthebusinesscollapsesthroughlackofliquidity. The company must also find ways of generating finance from within the firm in ordertoensurethatthebanksdemandsaremetandtheliquidityofthebusiness is improved. If customers and suppliers become concerned with the liquidity of PaceLeisurewear, it couldprecipitatethecollapseofthebusiness.Thefollowing stepsshouldbeconsidered: canceltheproposeddividendfortheyear selloffanyunderutilisedassets reducestocklevels reducethedebtorscollectionperiod leaseratherthanbuyfixedassetsinthefuture.

Byholdingsalesatlastyearslevelandreducingstocklevelsanddaysdebtorsto thelevelsofthepreviousyear,thefollowinginternalfundscanbegenerated:

Reductioninstocklevel Currentinvestmentinstocks Revisedinvestmentinstocks 11,618118/365 Reductionindebtorslevels Currentinvestmentindebtors Revisedinvestmentinstocks 22,41042/365 5820 3756

2064

3744 2579 1165 3229

Theabovefiguressuggestthatthereductionintheoverdraftasrequiredbythebankis possible,providingthebusinessispreparedtoholdbackitsgrowthintheshortterm.

SolutiontoCase2:Carpetrightplc
The following ratios can be used in assessing the performance and position of the business: 2001 Profitability Returnonownersequity(ROE) (31,715/47,609)100 (25,613/35,578)100 2000

66.6% 71.2%

Returnoncapitalemployed(ROCE)* [(44,552*)/(52,640)100] 84.6% [(36,557*)/(38,363)100] *Interestpayableignored(assumedtobeallshortterminterestpayments) Netprofitmargin (44,452)/322,917)100 (36,557)/304,818)100 Grossprofitmargin (184,642/322,917)100 (164,208/304,818)100 Efficiency Stockturnoverperiod* (28,453/138,275)365 (22,268/140,610)365 *Usingyearendfigures Averagesettlementperiodfordebtors* (11,144/322,917)365 (11,783/304,818)365 *Usingyearendfigures

95.3%

13.8% 12.0%

57.2% 53.9%

75days 58days

13days 14days

Averagesettlementperiodforcreditors* (42,962/138,725)365 113days (38,399/140,610)365 *Usingyearendfiguresandcostofsalesratherthancreditpurchases Salestocapitalemployed* (322,917/52,640) (304,818/38,363) *Usingyearendfigures

100days

6.1times 7.9times

Liquidity Currentratio (55,817/93,474) (42,616/75,239) Acidtestratio [(55,81728,453)/93,474] [(42,61622,268)/75,239] Gearing Gearingratio (5,031/52,640)100 (2,785/38,363)100 Investment Dividendpayoutratio (20,428/31,715)100 (17,927/25,613)100 Earningspershare* *peraccounts

0.6:1 0.6:1

0.3:1 0.3:1

9.6% 7.3%

64.4% 70.0% 42.0p 33.3p

The following information concerning changes in the size of the company is also revealing: Turnover %increase Netprofitaftertax %increase Netassets %increase 322,917 5.9% 31,715 23.8% 47,609 33.8% 304,818

25,613

35,578

In some respects, Carpetright plc has grown significantly over the year. Note the percentagechangeintheprofitaftertaxandnetassetsfiguresovertheperiod.However, theincreaseinturnoverduringtheperiodwasmoremodest. TheratiosrevealthatCarpetrightplcisanextremelyprofitablebusiness.TheROEand ROCEofthebusinessareveryhighalthoughtherehasbeensomedeclineinbothover the period under review. This decline results from a decrease in the sales to capital employed ratio as the net profit margin has increased over the period. (Although sales haveincreased,theincreaseinnetassetshasbeenproportionatelygreater.) Therehasbeenanincreaseinboththegrossprofitmarginandnetprofitmarginofthe businessovertheperiod.Thegrossprofitmarginhasincreasedrathermorethanthenet

profit margin, which suggests that the increased profitability from buying and selling carpets has been partly consumed by increased operating expenses. (Note that the distributioncostsincreasedbymuchmorethantheincreaseinturnover.) The average settlement period for debtors has remained much the same over the period (the very low settlement period suggests a high proportion of cash sales). However,therehasbeenanincreaseintheaveragesettlementperiodforcreditorsand the stockholding period. These three ratios reveal that during the year, the business receivedcashfromcustomers88days(i.e.13.0+75)afterreceivingthegoodsandpaid the creditors 113 days after receiving the invoice for the goods. Thus, trade creditors weremorethanfinancingthestocksanddebtorsofthebusiness. Theliquidityofthebusinessislowbuthasbeenstableovertheperiodunderreview. The acidtest ratio in the most recent year seems very low indeed and might provide causeforconcern.However,thisratiomaywellreflecttightfinancialmanagementbythe business. An examination of the cash flow statement reveals that although there has beenalargeoutlayontheacquisitionoffixedassets,dividendsandtaxduringtheyear, the operating cash flows were able to cover these. In any event, the business is very profitableandhaslittlegearingandsothereshouldbefewproblemsinraisingfundsto improve the liquidity of the business if it was felt that this was a serious, or long term, problem.Thebusinesscould,ofcourseconsiderreducingthelevelofdividendsinorder toconservecash.Atpresentthedividendpayoutratioisveryhigheventhoughtherewas adecreasecomparedtothepreviousyear. An investor should have reason to be satisfied with the performance ofthe business overtheperiod.ThebusinessisgrowingandismaintainingveryhighlevelsofROEand ROCE.Theimprovementinprofitsovertheperiodhasledtoasignificantimprovementin earningspershareandthedividendpayoutratioishigh.However,theexpansionofthe businesscombinedwithhighdividendpayoutshasplacedastrainontheliquidityofthe business andit may be necessaryforthebusinesstoconsideradditionalfundinginthe futureifthisrateofexpansionistocontinue.Thiswouldmeanhigherlevelsofgearingor requiring further funds from equity investors. However, if the business continues to generatestrongoperatingcashflows,externalfundingmaybeunnecessary. A carpet manufacturer may feel it has much to gain from association with such a successful andgrowingbusiness. However, Carpetright islikelyto be demanding onits suppliers.ItisinterestingtonotethatCarpetrightimproveditsgrossprofitmarginduring theperiod.Thismaybeduetothesaleofhigherprice/highermarginitemsbutitmayalso may be due tosqueezing thesuppliersmargins. The carpetmanufacturermayfeelthis issueisworthfurtherinvestigation.Theaveragesettlementperiodforcreditorsisnearly four months, which seems fairly long. There was a slight decrease in theperiodduring the most recent year and given the liquidity problem referred to earlier, suppliers are unlikelytobepaidmuchquickerinthefuture. ThiscasestudyisreproducedwithpermissionofCarpetrightplc.

10

SolutiontoCase3:GadaboutTravelLtd
Cashbudgetfornextyear Jan CashReceipts Bookings:WS B 220,500 40,500 261,000 Payments Airlines: T+LC* EC* Hotels: T+LC* EC* Salaries Electricity Rates Repairs Travel Feb 233,100 264,600 497,700 Mar 37,800 232,200 270,000 Apr 12,600 178,200 190,800 May June

121,500 121,500

27,000) 27,000)

56,000 1,200 84,000 1,800 20,600 1,500 100 3,500 168,700

54,500 1,500 81,750 2,250 20,600

82,500 2,100 123,750 3,150 20,600

24,000 600 36,000 900 20,600 1,500 1,000 100 3,500 88,200 102,600 583,900

21,000 600 26,250 750 20,600

38,500) 900) 48,125) 1,125) 20,600)

100 3,500 164,200 333,500 447,000

100 3,500 235,700 34,300 481,300

100 3,500

100) 3,500)

72,800 112,850) 48,700 (85,850) 632,600 546,750)

Surplus/(deficit)for themonth Cumulativebalance

92,300 113,500

11

Cashbudgetfornextyear(continued) July CashReceipts Bookings:WS B Aug Sept 22,050 13,500 35,500 Oct 34,650 Nov 113,400 Dec 126,000

21,600 21,600

21,600 21,600

34,650

113,400

126,000

Payments Airlines: T+LC* EC** Hotels T+LC* EC** Salaries Electricity Rates Repairs Travel

93,000 2,400 116,250 3,000 20,600 1,500 100 3,500 240,350 (218,750) 328,000

111,500 2,700 139,375 3,375 20,600

63,000 1,800 78,750 2,250 20,600

100 3,500 281,150

100 3,500 170,000

20,600 1,500 1,000 100 500 23,700 10,950

20,600

20,600

100 500 21,200 92,200 37,150

100 500 21,200 104,800 141,950

Surplus/(deficit) forthemonth Cumulative balance

(259,550) (134,450) 68,450

(66,000) (55,050)

*T+LCistheholidaystakenplusthelatecancellations,allofwhichmustbepaidinfull. ** EC is the early cancellations (50 per cent of the total cancellations), 60 per cent of whichmustbepaid.

12

BudgetedProfitandLossAccountfortheyearending31December nextyear Sales:Holidayssold(netofagents commission) Wintersports(2,080+180)315 Beach(3,130+280)270 Hotelcharges: Wintersports(2,080+90)150 9090 Beach(3,130+140)125 14075 Airlinecharges: Wintersports(2,080+90)100 9060 Beach(3,130+140)100 14060 Salaries Electricity Rates Repairs Travel Depreciation Budgetednetprofitfortheyear

711,900 920,700 1,632,600 325,500 8,100 408,750 10,500 217,000 5,400 327,000 8,400

752,850

557,800 247,200 6,000 2,000 1,200 33,000 11,400 1,611,450 21,150

13

BudgetedOutlineBalanceSheetasat31Decembernextyear Fixedassets Freeholdlandandbuilding Equipmentandfurniture(57,00011,400) Currentassets Prepaidrates Cash Currentliabilities Accruedelectricity Tradecreditors(940wintersports(35010%)) 210,000) 45,600) 255,600) 500 141,950 142,450 1,500 296,100 297,600 (155,150) 100,450) Sharecapitalandreserves(79,300+21,150) Commentsontheresults Thefollowingfivepointsareworthnoting: A2025percentreturnonequitymayormaynotbeconsideredadequateforthe levelofriskinvolved. Theprofit/contributionmarginisrelativelysmall. Thereisrelativelyhighsensitivitytochangesindemand,sellingpriceandcosts. During much of the year there are major cash surpluses. These need to be carefully managed to gain the maximum benefit from interest receipts, without placingthefundsatseriousrisk. DuringSeptemberandOctoberthereareoverdraftsscheduled.Stepsneedtobe taken to deal with this. An overdraft could be negotiated in advance. Perhaps better, steps could be taken to reschedule some of the payments so as to avoid thesecashdeficits. 100,450)

Accountingpolicywithreferencetorealisationofprofit Thegenerallyacceptedaccountingtreatmentofrevenuesistorecognisethemwhenthe periodinwhichtheworktoearnthemhassubstantiallybeencompleted,theyarecapable ofobjectivemeasurementanditseemsprobablethatthecashwillbereceived. Itcouldbearguedthatthispositionisestablishedintheperiodinwhichthebookingis made.Duringthatperiod,thebookingswiththeairlinesandhotelswillbeplaced,leaving onlythepaymenttothemoutstanding.Thusitcouldbecontendedthattheworktoearn the revenue has been substantially completed. Since the price is fixed, the revenue is capable of objective measurement. Also, cash is received at the time of the customer makingthebooking.

14

Ontheotherhand,itisnotuntilthecustomeractuallytakestheholidaythattheworkis fullycompleted.Theprocesscouldgowronginthemeantime,leadingtoextraworkand toextracost.Itcouldbearguedthataprudentviewshouldbeadoptedsothatprofitisnot recognised until the holiday is actually taken. This is probably the view that would be takeninpractice. Ultimately, a major factor in the decision must be the usefulness of the information provided. If it is feltthat one approach givesthe morevaluable information,then thisis the approach that would probably be taken. This is particularly the case here because there are quite good arguments, based on accounting conventions, for adopting either policy.

15

SolutiontoCase4:PaceLeisurewear(2)
TheQuarterto31stMarch
ThisperiodseesthestartoftheturnaroundinthefortunesofPaceLeisurewear. NoticeableisthelargeLoss,mainlyduetoatotalof1.9millionbeingwrittenoffstock anddebtors.Itisreasonabletoacceptwriteoffsonsuchhighlevelsofstockinafashion industrywithrapidobsolescence,anddebtorwriteoffsarenotunexpectedgiventhe natureoftheindustry.ThemanagementandshareholdersofPacewouldwishtobe confidentthatadequate,butnotexcessive,prudencewasusedtodeterminethelevelof writeoffs.Itiscommonfornewmanagementtobeultraprudentinitially,knowingthatany excessiveprovisionsmayberelaxedatalaterdatetomaketheirownperformances appearmoreimpressive. Operatingprofits(beforewriteoffs)remainhealthy,althoughitcanbeseenthatthegross profithasdroppedto42.9%(previously48.2%),duelargelytotheimpactoftherecently acceptedorderfromArena,forwhomPacestartedmaking"ownbrand"itemswhich wouldbelowerpricethanthePacebrandeditemsotherwisesold. Thereisnowanetlossof22.3%,comparedwithnetprofitslastyearof20.6% Interestexpensehasincreasedduetothehighlevelofoverdraftexpense. Theoverdrafthasreducedto2.536million,whichdemonstratesthefundamental strengthofthebusiness,whichgeneratessubstantialamountsofcash.Thecashposition isaidedbythenonadoptionoftheproposed800,000dividendpayments,whichwould havebeenunwiseinthecircumstances,inparticularassuchapaymentwouldmerely confirmaviewoffinancialincompetenceintheeyesofthebank.

16

TheQuarterto30thJune
Manyofthefiguresareunchangedfromthepreviousquarter,notablyTurnover,Costof salesandOperatingexpenses(exceptfortheadditionalsalaryexpenseofPeterDrake, whichisatanannualrateof300,000). Significantlybothaprofitandapositivecashbalanceareexpectedbytheendofthis quarterareflectionontheessentialstrengthofthebusinessandcoremanagement team.However,thecompanywillnotyetbeinapositionwhereitcanpaydividendstoits shareholders,andthemanagementmayconsiderwhetherdividendsshouldbepaidas soonaspossible,orwhetheritwouldbemoreprudenttouseanysurpluscashtoreduce thelevelofthebankloanbeforepayingdividends.Thedebttoequityratioremainsabove theleveloftwoyearsago,whenitwas34.4%.Itisnowexpectedtobe42.8%byJune. Itremainstobeseenifitisrealistictodisposeofanyofthefixedassets,orwhethera saleandleasebackispossibleforanybuildings. Thechallengeforthecompanytothefuturewillbetoincreasetheprofitabilityratios, notablythegrossmargin,whichhasdroppedby5%fromlastyear.Themanagementwill needtoconsidercostreductionsand/orimprovementsinthesalespricesachieved:for example,whetherlowermargincontractssuchasthatfromArenashouldbeacceptedor not. Jill Dempsey will be pressing for the removal of Peter Drake on the grounds of incompetence,butitislikelythatsuchanattackwouldberejectedbytheBoard,notleast becauseJillappearstoberunningoutofallies.PeterDrakemightbeabletoleavesoon, butmoreasaresultofhavingsuccessfullyturnedthecompanyaroundandpreventedits liquidation than any failure on his part. Itwouldstill be essential toemploysomeonein Peter's role, and a direct replacement would be required for Peter when he comes to leave.Itislikelythatsuchareplacementwouldcostthecompanylessthanthe300,000 ayearthatPeterwouldcharge.

17

Tableofratios Lastyear Quarter Quarter toMarch toJune Grossprofitmargin 10,792*100% 22,410 2,700*100% 6,300 Netprofitmargin 4,618*100% 22,410 (1,404)*100% 6,300 418*100% 6,300 Stockholdingperiod 5,820*365 11,618 3,720*91 3,600 2,280*91 3,600 (basedonperiodendstocklevels* numberofdaysinperiod) Averagesettlementperiodfordebtors 3,744*365 22,410 3,640*91 6,300 3,140*91 6,300 CurrentRatio 9,974 8,844 7,790 6,340 48.2%

42.9%

42.9%

20.6%

(22.3%)

6.6%

183days

58days

58days

61days

53days

46days

1.12:1

1.23:1

18

6,606 3,854 Acidtestratio 9,9745,820 8,844 7,7703,720 6,340 6,6062,280 3,854

1.71:1

0.40:1

0.64:1

1.12:1

19

SolutiontoCase5:Landlord:investmentappraisal
Thereisnosolutionforthiscasestudyasitistooopenended.

20

SolutiontoCase6:BlueHillsCountryParkLimited
NetPresentValuecalculation
Capitalinvestment[W1] Opportunitycost(barn) (30,000) Extracontribution[W2] 89,775 184,039 283,015 386,940 Extrarunningcosts[W3] (120,080) (123,283) (126,615) (130,079) Taxrebate/(payable)[W4] 15,000 18,826 (6,752) (32,772) TotalCashFlow (240,000) (45,305) 79,582 149,648 224,089 7%factor 1.000 0.935 0.873 0.816 0.763 PresentValues (240,000) (42,341) 69,510 122,159 170,957 NetPresentValue Yr5 (240,000) Yr6 Yr7 Yr8 Yr9 Yr10

(45,231) (45,231) 0.713 (32,249)

48,036 (Note:youmayspotsomeslightdifferenceswithyourPV calculations.Thisisduetotherounding,tothreedecimalplaces,of thediscountingfactor.)

TheprojectgeneratesarepositiveNetPresentValue(NPV)andshouldthereforebeconsideredfavourably bytheBlueHills'management.However,itisnotaclearcutdecisionastheNPVisreasonablycloseto zero.Managementshouldbeawareofthelikelihoodofnotachievingtheforecastresults.Thesensitivity analysesareworthlookingatinthisregard.

Workings [W1]Capitalinvestment
ThefollowingcapitalexpenditurewouldbeincurredinAutumnYr5andisthereforeeligibleforCapital Allowances(seeWorking5)fromtradingyearYr5: Landscapingof"TopField" 30,000 Aluminiumtrack 90,000 Costof60plastictoboggans 60,000 Conversionofbarnin"TopField" 25,000 Costofwinchingequipmentforthetoboggans 35,000 Totalassets 240,000

[W2]Extracontribution
Firstlyconsidertheextravisitors: Yr6 378,000 396,900 18,900 Yr7 378,000 416,745 38,745 Yr8 378,000 437,582 59,582 Yr9 Yr69 378,000 1,512,000 459,461 1,710,688 81,461 198,688

Totalvisitorsperannum(atpresent) Visitors(if5%compoundgrowth) Extravisitors

21

Youcannowcalculatetheadditionalcontributionthattheseextravisitorswillgenerateeachyear. Contributionpervisitorisshownhere: Entrancefee 4.00 less:Variablecostpervisitor (0.25) 3.75 plus:Profitmadefromextravisitorstotheshop(21) 1.00 Totalcontributionpervisitor 4.75 Sothetotalextracontributionperannumcannowbecalculatedbymultiplyingtheextravisitorsbythe contributionpervisitor:

Extravisitors Extracontribution(@4.75/head)

Yr6 18,900

Yr7 38,745

Yr8 59,582

Yr9 81,461

Yr69 198,688

89,775 184,039 283,015 386,940 943,769

[W3]Extrarunningcosts
Yr6 Extracosts(inc.4%inflation) Newstaff(4x8,000) Maintenance/electricity/insurance plus:Patentfee(inflationproof) Total 33,280 46,800 80,080 40,000 120,080 Yr7 34,611 48,672 83,283 40,000 123,283 Yr8 35,996 50,619 86,615 40,000 126,615 Yr9 37,435 52,644 90,079 40,000 130,079

[W4]Taxcalculations
Yr6 Yr7 Yr8 Yr9 89,775 184,039 283,015 386,940 (120,080) (123,283) (126,615) (130,079) (60,000) (45,000) (33,750) (25,313) (75,937) (60,000) (75,305) 27,006 131,087 180,924 (15,000) (18,826) 6,752 32,772 45,231 Yr5

Extracontribution Extrarunningcosts CapitalAllowances[W5]

Tax(rebate)/payable@25%

Thecashflowforthesetaxfigureswilloccurattheendofthefollowingyear,i.e.Yr5'sinYr6,Yr6'sinYr 7andsoon.

[W5]CapitalAllowances
Yr5 240,000 (60,000) 180,000 Yr6 180,000 (45,000) 135,000 Yr7 135,000 (33,750) 101,250 Yr8 101,250 (25,313) 75,937 75,937 Yr9 75,937 (0)

Expenditure/WDVb/f WritingDownAllowance(at25%) Scrapvalue WrittenDownValue(WDV)c/f BalancingAllowance

22

SensitivityAnalysis TheNetPresentValues(seethespreadsheetfortheworkings)forthethreeothersituationssuggestedare shownbelow: NPV() Originalforecast 48,036 3%visitorgrowth 195,049 7%costinflation 31,948 10%moneycostofcapital 21,989 ClearlythealterationtothevisitorgrowthratehashadadramaticeffectontheNPVoftheprojectanditis thereforeverysensitivetochangesincustomerdemand.Thechangestocostinflationandcostofcapital havehadfarlesseffectandinbothcasestheproject,withapositiveNPV,isstillworthwhile.

23

SolutiontoCase7:Homelandplc
(a) Trends 2002 Sales(000s) Trend Costofsales(000s) Trend Grossprofit(000s) Trend Netprofit(000s) Trend Capitalemployed(000s) Trend Ratios Profitability GPmargin NPmargin(aftertax) ROSF Efficiency Sales/Capitalemployed Averagereceivables(days) Inventoriesturnover(days) Liquidity Currentratio Acidtest Gearing Gearingratio Investment Dividendpayout Earningspershare 2003 14,945 100 10,460 100 4,485 100 1,260 100 11,870 100 2004 16,650 111 12,050 115 4,600 103 960 76 12,030 101 2005 18,900 126 14,175 136 4,725 105 896 71 12,726 107

22,700 152 17,800 170 4,900 109 800 63 12,726 107

30.0% 8.4% 10.6%

27.6% 5.8% 8.0%

25.0% 4.7% 7.4%

21.6% 3.5% 6.6%

1.3T 33 61

1.4T 39 65

1.6T 45 70

1.9T 48 70

4.0 2.1

3.1 1.5

2.8 1.3

2.5 1.2

4.7%

4.7%

63.0% 0.63

83.3% 0.48

89.3% 0.45

100.0% 0.40

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Keypoints

Since2002,salesrevenuehasincreasedby52%butcostofsaleshasincreased by70%.

Theeffecthasbeenarelativelysmallincreaseinoverallgrossprofitanda significantdeclineinthegrossprofitmargin.

Bothoverallnetprofitandthenetprofitmarginhavedeclinedeachyearoverthe threeyearperiod.BotharenowsignificantlylowerthanwhenJackBennettwasat thehelm.

Theincreaseincapitalemployedissmallinrelationtotheincreaseinsales.This hasledtoanincreaseinthesalestocapitalemployedratioandraisesthe questionastowhetherthebusinessisovertrading.

Therehasbeenasignificantincreaseintheaveragetradereceivablesperiod (poorcontrolsoraliberalisationofcredittoachievegreatersales?)

Therehasalsobeenanincreaseintheinventoryturnoverperiod(poorcontrolsor expectationsofgreaterfuturesales?)

Theliquidityratiosshowasharpdeclinethatmustbeaddressed. Despitethedecliningliquidityandincreasingbankoverdraft,thedividendpayout ratioremainedhighandswallowedupthewholeoftheprofitin2005.

1

Inadditiontotheoverdraftrepaymentof337,000( /2 of674,000),thebusiness mustrepayaloanof600,000in2006.

Gearinglevelsremainlowandthebusinesshasconsiderabledebtcapacity.It appearsthatthefreeholdlandisunsecuredandmaybeusedassecurityforaloan ifrequired.

Overall,thepursuitofmarketshareappearstohavebeenachievedattheexpenseof profitabilityandliquidity.Unlessthereissomeattempttoreversethisdeclinein profitabilityandliquidity,thebusinessmaysoonbeinserioustrouble.Thebusinesshas notinvestedsufficientlyintheadditionalresourcesrequiredtosustainthegrowththatit

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wishestoachieve.Theabilityofthebusinesstomeetthechallengesofthenew competitiveenvironmenthasbeenweakenedratherthanstrengthenedasaresultofthe dashforgrowth.Nevertheless,thebusinessisnotinveryseriousdifficultiesattheend of2005.Theworryingtrendsthathaveemergedmaybereversed,ifappropriateactionis taken.

TherealquestioniswhetherDanielBennett,whodoesnotseemtobeawareofthe problems,willtakesuchaction.Eveniftheadditionalfundsareforthcoming,theamount toberaisedisnotverysubstantial(800,000)andwillonlycovertheannualdividend payment.ItwillnotbeenoughtounderwritetheambitiousgrowthplansofDanielBennett. Althoughheiscorrectinseekingadditionalresources,itisnotclearwhetherhehas identifiedthecorrectsumthatisrequiredorthemostappropriateformoffinance. Furthermore,thepurposeforwhichthefinanceisbeingraisedisquestionable.Priority shouldbegiventohelpingtorestoretheviabilityofthebusiness.

(b)Keypoints VulturusLtdwouldbeinvestinginabusinesswhereprofitability,includingROSF, hasexperiencedsignificantdecline.Unlessthereareplanstoaddressthis problem,thebusinessappearstoofferlittleforanequityinvestor. Homelandplchas2msharesinissueanditstotalequityattheendof2005is 12.126m,whichamountstoaround6ashare. Atafigureof8ashare,thenewsharesappeartohavegoodassetbacking, particularlyifthefreeholdlandhasahighermarketvaluethanthefigureshownin thefinancialstatements UsingaP/Eratioof22times,thesharesofHomelandplcwouldbevaluedat 8.80(thatis22x0.40)attheendof2005.However,itisnotclearfromthecase studywhetherthelistedbusinessmentionedisreallysimilartoHomelandplc. Furthermore,thesharesoflistedbusinessesenjoyasignificantpremiumover thoseofunlistedonesbecauseoftheirmarketability.Thereisnoevidencefrom thiscomparison,therefore,thatthesharesarecheap.

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(c)Advice VariousapproachestoHomelandplcsproblemsmaybefeasible,includingthefollowing: Reversethetrendinliquiditybyrestrictingdividendpaymentsandtighteningcredit andinventorypolicies. Improveprofitmarginsbyraisingprices,evenifthisisattheexpenseoflostsales. Investigateotherapproachestoincreasingthescaleofoperations(suchasa mergerortakeover). Considerdebtasanalternativetoequity,particularlyifequityinvestorsare unconvincedbythefuturedirectionofthebusiness.

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