1. A senior management team at Railcam, a supplier to the railway industry, is trying to prepare a cash flow forecast for the year s 20X1-20X5. The estimated sales are: Year 20X1 20X2 20X3 2

1. A senior management team at Railcam, a supplier to the railway industry, is trying to prepare a cash flow forecast for the year’s 20X1-20X5. The estimated sales are:

Year 20X1 20X2 20X3 20X4 20X5

Sales (£) 20m 22m 24m 21m 25m

These sales will be made on three months’ credit and there will be no bad debts. There are only three cost elements. First, wages amounting to £6m p.a. Second, raw materials costing one-half of sales of the year. Raw material supplier grants three months of credit, third, direct overhead at £5m per year. Calculate the net operating cash flow for the year’s 20X2-20X4. Start date: 1.1.20X1.

2. (Examination level) Pine Ltd have spent £20,000 researching the prospects for a new range of products. If it were decided that production is to go ahead an investment of £240,000 in capital equipment on 1 January 20X1 would be required. The accounts department has produced budgeted profit and loss statements for each of the next five years for the project. At the end of the fifth year, the capital equipment will be sold and production will cease. The capital equipment is expected to be sold for scrap on 31.12.20X5 for £40,000.

Year end Year end Year end Year end Year end

31.12.20X1 31.12.20X 2 31.12.20X3 31.12.20X4 31.12.20X5

Sales 400 400 400 320 200

Materials 240 240 240 192 120

Other variable costs 40 40 40 32 20

Fixed overheads 20 20 24 24 24

Depreciation 40 40 40 40 40

Net profit (loss) 60 60 56 32 (4)

When production is started, it will be necessary to raise material stock levels by £30,000 and other working capital by £20,000. It may be assumed that payment for materials, other variable costs and fixed overheads are made at the end of each year. Both the additional stock and other working capital increases will be released at the end of the project. Customers receive one years credit from the firm. The fixed overhead figures in the budgeted accounts have two elements – 60 percent is due to a reallocation of existing overheads, 40 percent is directly incurred because of the take-up of the project. For the purpose of this appraisal, you may regard all receipts and payments as occurring at the year-end to which they relate, unless otherwise stated. The company’s cost of capital is 12 percent. Assume no inflation or tax.

Required:

a. Use the net present value method of project appraisal to advise the company on whether to go ahead with the proposed project.

b. Explain to a management team unfamiliar with discounted cash flow appraisal techniques the signifance and value of the NPV method.

3. For the following cash flows, calculate the payback and the discounted payback

Point in time 0 1 2 3 4 5 6 7

(Yearly intervals) £ £ £ £ £ £ £ £

A -3,000 500 500 500 500 500 500 500

B -10,000 2,000 5,000 3,000 2,000 – – –

C -15,000 5,000 4,000 4,000 5,000 10,000 – –

D – 4,000 1,000 1,000 1,000 1,000 7,000 7,000 7,000

E – 8,000 500 500 500 2,000 5,000 10,000 –

The cost of capital is 12 percent.

4. The Washer division of Plumber plc is permitted to spend £5m on investment projects at time zero. The cash flows for five proposed projects are:

Points in time (yearly intervals)

0 1 2 3 4

Projects £m £m £m £m £m

A -1.5 0.5 0.5 1.0 1.0

B -2.0 0 0 0 4.2

C -1.8 0 1.2 1.2 1.2

D -3.0 1.2 1.2 1.2 1.2

E -0.5 0.3 0.3 0.3 0.3

The cost of capital is 12 percent, all projects are divisible and none may be repeated. The projects are not mutually exclusive.

a. Which projects should be undertaken to maximize NPV in the presence of the capital constraint?

b. If the division was able to undertake all positive NPV projects, what level of NPV could be achieved?

c. If you now assume that these projects are indivisible, how would you allocate the available £5m?

5. (Examination level) A company is trying to decide whether to make a £400,000 investments in a new product are. The project will last 10 years and the £400,000 of machinery will have a zero scrap value. Other best estimate forecasts are”

– Sales volume of 22,000 units per year;

– Sales price £21 unit;

– Variable direct cost £16 per unit.

There are no other costs and inflation and tax are not relevant.

a. The senior management team have asked you to calculate the internal rate of return (IRR) of this project based on these estimates.

b. To gain a broader picture they also want you to recalculate IRR on the assumption that each of the following variables changes adversely by 5 percent in turn:

– sales volume;

– sales price;

– Variable direct costs.

c. Explain to the management team how this analysis can help to direct attention and further work to improve the likelihood of a successful project implementation.

6. (Examination level) RJW plc is a quoted firm, which operates ten lignite mines in Wales. It has total assets of £50m and the value of its shares is £90m. RJW plc’s directors perceive a great opportunity in the UK governments privatization drive. They have held preliminary discussions with the government about the purchase of the 25 lignite mines in England. The purchase price suggested by the Treasury is £900m.

For two months, the directors have been engaged in a fund raising campaign to persuade City financial institutions to provide £500m of new equity capital for RJW and £400m of fixed interest rate debt capital in the form of bank loans. You are a senior analyst with the fund management arm of Klein-Ben wesons and last week you listened attentively to RJW’s presentation. You were impressed by their determination; acumen and track record but have some concerns about their figures for the new project.

RJW’s projections are as follows, excluding the cost purchasing the mines:

Table 1: Cash flows for the English lignite mines: RJW’s estimate

Time t 0 1 2 3 4 5 and all

Subsequent

Years

Sales (£m) cash inflows) 1,200 1,250 1,300 1,320 1,350

Less operating costs

(£m) (Cash flows) 1,070 1,105 1,150 1,190 1,200

Net cash flows (£m) 130 145 150 130 150

You believe the probability of RJW’s projection being correct to be 50 percent (or 0.5). You also estimate that there is a chance that RJW’s estimates are over-cautious. There is a 30 percent probability of the cash flows being as shown in Table 2 (excluding the cost of purchasing the mines).

Table 2: A more optimistic forecast

Time t 0 1 2 3 4 5 and all

Subsequent

Years

Sales (£m) cash inflows) 1,360 1,416.7 1,473.33 1,496 1,530

Less operating costs

(£m) (Cash out flows) 1,100 1,140 1,190 1,225 1,250

Net cash flows ((£m) 260 276.7 283.33 271 280

On the other hand, events may not run out as well as RJW’s estimates. There is 20 percent probability that the cash flows will be shown in Table 3.

Table 3: A more pessimistic scenario (excluding purchase cost of mines)

Time t 0 1 2 3 4 5 and all

Subsequent

Years

Sales (£m) cash inflows) 1,166.67 1,216.7 1,266.67 1, 44 1, 70

Less operating costs

(£m) (Cash out flows) 1,070 1,105 1,150 1,165 1,150

Net cash flows ((£m) 96.67 111.7 116.67 -21 20

Assume:

1. The cost of capital can be taken to be 14 percent

2. Cash flow will arise at year-ends except the initial payment to the government, which occurs at Time 0.

Required

a. Calculate the expected net present value (NPV) and the standard deviation of the NPV for the project to buy the English lignite mines if £900m is taken to be the initial cash outflow.

b. There is a chance that events will turn out to be much worse than RJW would like. If the net present value of the English operation turns out to be worse than negative £550m, RJW will be liquidated. What is the probability of avoiding liquidations?

c. If the NPV is greater than positive £100m then the share price of RJW will start to rise rapidly in tow or three years after the purchase. What is the provability of this occurring?

7. (Examination level) Extracted data from Penguin plc’s last accounts are as follows:

£m

Annual sales 21

Profits before interest and tax 2

Interest 0.5

Shareholder funds 5

Long-term debt 4

Debtors 2.5

Stocks 2

Trade creditors 5

Bank overdraft 4

A major supplier to Penguin offers a discount of 2 percent on all future supplies if payment is made on the seventh day following delivery rather than the present 70th day. Monthly purchases from this supplier amount to a regular £0.8m. Penguin pays 15 percent annual percentage rate on its overdraft.

Required:

a. Consider what Penguin should do with respect to this supplier

b. Suggest steps that Penguin could take to improve the balance sheet, profit and loss and cash flow position.

8. (Examination level) you have been asked to prepare a cash budget for Whitborrow plc for the next three months, October, November and December. The Managers are concerned that they may not have sufficient cash to pay for a £150,000 investment in equipment in December. The overdraft has reached its limit £70,000 at the present time – the end of September. Sales during September were a total of £400,000 of which £55,000 was received in cash. £165,000 is expected to be paid on October, with the remainder likely to flow in during November. Sales for the next three months are as follows:

Total sales Cash sales Credit sales

October 450,000 90,000 360,000

November 550,000 110,000 440,000

December 700,000 140,000 560,000

There is a gross profit margin of 40 percent on sales. All cost (materials, labour and other) are paid for on receipt. Only 20 percent of customer sales are expected to be paid for in the month f delivery. A further 70 percent will be paid after one month and the remainder after two months. Labour and other costs amount to 10 percent of sales. Debtor levels at the end of September are £400,000 and the investment in stock is £350,000

Required:

a. Prepare a cash budget for October, November and December, and state if the firm will be able to purchase the new equipment.

b. Recommend action that could be taken to improve the working capital position of Whitborrow.

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