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The Board of Directors disapproved reinvesting the £100 million free cash flow from closing the existing five brands. Instead, they want to keep this fund reserve for future uncertainty

Introduction

 Put yourself in the following situation as a member of the Financial Services Team of XYZ plc, which is a UK conglomerate. It owns companies across different industries, such as – car manufacturing, consumer goods, leisure etc.

You have been requested to provide meaningful financial analysis and information for decision making concerning financing, performance, capital investment, constrain in production, budgeting, and sensitivity analysis. Accordingly, you are required to write a report (3,000 words in total) providing information about these areas.

You must submit the report online via the Turnitin link by 15:00 pm (UK time) on 12th May 2022 (Thursday). Please use the Harvard referencing where relevant, do not use lecture slides or any Pedia (such as Wikipedia or Investopedia) as reference. You should report your calculations and supplementary information in Appendix. Don’t forget to mention your assumptions and the limitations of your analysis.

Financial analysis related to Investment Strategy:

Because of the climate change target of the UK (the road to net-zero target), the company’s newly appointed investment manager Ms Madison came up with a new investment strategy – closing five of the company’s existing brand and focusing more on the company’s most popular electronic vehicle brand in the UK. According to her assessment, this closing decision will generate around £100 million free cash flow, which the company could reinvest to expand its popular brand – ‘eXi Drive’. Madison suggests that the market survey indicates this is one of the most popular brands in England, and demand is increasing. The year-to-year sales of the ‘eXi Drive’ brand have gone up by 25% (5,000 units in 2021 compared to 2020), which was higher than all of those five brands together.

Moreover, she has indicated that the expansion decision will reduce the overall cost while improving quality. This cost-quality dynamic will help the company face competition and achieve a larger market share. However, this expansion will cost £150 million for the company, which require rigorous strategic assessment, including financial viability. Now, she has approached you to evaluate this possible restructuring decision, whether it is a financially viable strategy or not. She also has suggested that this expansion project will run for the next five years, and after that, the company will enter into a new strategic cycle.

You have collected the following information from her to do the financial analysis for meaningful decisions.

The expansion is expected to increase the sales of ‘eXi Drive’ by the following units.

8,000 units in 2022

8,000 units in 2023

10,000 units in 2024

11,000 units in 2025

12,000 units in 2026

In 2021 the market price of this brand was £45,000, but the company wants to reduce it by £5,000 in 2022 and then will increase/decrease with the pace of the economy and purchasing power of the consumers. KPMG has projected that the Bank of England’s bank rate will remain 0.50 per cent for the next couple of years, which will allow the post-Brexit-and-Covid expansion of the economy. In line with this economic assessment, your company has decided not to increase the price for the next three years (i.e., till 2024), but from the fourth year, a contingency plan is in place to increase the unit price by £2,000.

The production cost is £20,000 per unit, which will increase in the line of inflation and other materials cost over the project’s life at a rate of 10% each year starting from year two. The production involves fixed overhead expenditure of £20 million in 2022 and 2023, £15 million in 2024 and £10 million in 2025 and 2026. The project requires a working capital investment of £850,000 at the beginning, 50 per cent of which the company will recover at the end of project life. The cost of promotion and R&D will be £5 million, respectively, over the five years. Assume that there is no other cost involved in this investment. The company is currently following the straight-line depreciation method, and historically 10% of the cost price of such investment is recovered in the final year.

Financing choices: (the Board of Directors have agreed)

The Board of Directors disapproved reinvesting the £100 million free cash flow from closing the existing five brands. Instead, they want to keep this fund reserve for future uncertainty. For this expansion project recommended by Ms Madison, the Board has recommended raising capital from alternatives financing from external sources.

The company has three choices for financing this expansion: issuing new equity, issuing a bond, or issuing preference shares.

The equity of XYZ plc is currently trading in London Stock Exchange (LSE) with a face value of £10. The market price of each share is as follows:

Date Closing Price
04.11.20 £34.50
03.12.20 £36.20
06.01.21 £33.55
03.02.21 £35.10
To date £ 34.80

In the last fiscal year, the company had declared a £1.2 per share dividend (DPS). The company’s investment banker KPMG always charges an issuing (i.e. flotation) cost of 20% on the face value to issue new common stock in the market. Historically, the company’s earnings per share are as follows:

Year EPS (Earning Per Share
2017 22p
2018 26p
2019 17p
2020 22p
2021 25p

The company has also assessed the possibility of issuing a bond in the market. Currently, bonds of similar companies are selling at £110, slightly over the face value (i.e. £100) with a coupon rate of 10% and maturity of 5 years. The company’s third financing option is to issue preferred stock in the LSE. The industry average preferred dividend and the current market price of preference shares of similar companies are £10 and £108, respectively.

You have also collected additional data on the UK financial market and the company. Currently, the yield of the 3-month UK Gilt is 3.0%, the FTSE 100 index has an average yearly return of 10%, and the average corporate tax rate in the UK is 30%. In addition, the beta of XYZ plc is 1.5, which is slightly higher than the market beta of 1.

The company wants to maintain its existing capital structure policy of 50% debt, 10% preferred equity and 40% common equity for this new investment.

Ms Madison has requested you to make a report based on the following queries so that she can present it at the next board meeting.

  1. What will be the cost for each source of financing? Consider both DDM (i.e. Dividend Discount Model) and CAPM (i.e. Capital Asset Pricing Model) method for common equity. Please provide your comments on the assumptions of each approach and their merits and limitations.
  2. Determine the optimum cost of capital using the Weighted Average Cost of Capital (WACC) approach for target capital structure. (Hints: Ms Madison would prefer to use CAPM over DDM).
  3. Evaluate the total value addition (i.e. total NPV) and breakeven rate (i.e. IRR) of this possible restructuring decision. (Hints: Use the WACC as your discount rate to evaluate the investment projects)                                                            
  4. Assume that the product lifecycle of five years is viewed as a safe bet, but the scale of demand for the product is highly uncertain, mainly due to possible BREXIT and COVID-19. Analyse the sensitivity of the projected NPV to the unit sales and the cost of capital.
  5. Explain how the BREXIT could affect the UK automobile manufacturing sector and the possible strategic changes required in this industry to cope with the risk?                                                                         (Total 30 marks)

[Following profit statement is just for your reference to calculate the net cash benefit given by your investment manager Ms Madison]

Income Statement          
  2017 2018 2019 2020 2021
  £m £m £m £m £m
           
Sales 1,622 1,800 2,730 2,654 2,703
Cost of Sales (908) (1,056) (1,855) (1,897) (1,754)
Gross Profit (Loss) 714 744 875 757 949
           
Overheads          
Fixed Overheads 120 156 165 154 146
Stock Upkeep Cost 0 1 0 17 31
Promotion 50 60 149 149 409
Research and Development 0 194 20 27 16
Market Research 15 15 15 15 15
Depreciation 68 80 78 72 65
  (253) (506) (427) (433) (682)
           
Operating Profit (Loss) 461 238 448 323 267
           
Investment Disposal Income 0 8 11 0 0
Interest on Current Account 0 7 8 8 10
Interest on Loans (34) (45) (33) (11) (12)
  (34) (30) (14) (3) (2)
           
Pre-Tax Profit (Loss) 427 208 434 320 265
           
Tax (85) (27) (126) (137) (78)
Post Tax Profit (Loss) 342 181 308 183 187
           
Cost of Dividends (20) (40) (36) (40) (28)
           
Year Retained Profit (Loss) 322 141 272 143 159

Financial Analysis for internal management:

The management accounting team of XYZ plc also came up with some questions and requested you to explain/answer them for the upcoming board meeting:

  1. A chain of XYZ plc, BHealthy Ltd is a wholesale manufacturer of healthy foodstuffs. Because of a series of machine-related accidents at one of its factories, working practices have been revised and altered. It has resulted in a reduction in the number of labour hours available next period to 60,000. Four ready-made meals are produced in this factory and estimated data for the next accounting period are as follows:
Product S1 S2 S3 S4
Maximum Demand (units) 8,000 6,500 4,800 3,200

Selling and costing information (per unit)

  £ £ £ £
Selling price 80 110 145 170
Direct materials 12 30 35 40
Direct labours (Labour rate = £5/hr) 16 20 15 20
Variable overhead 8 10 14 16
Selling overhead 4 4 4 4

 

The team wants to know about the limiting factor and requested you to help calculate the maximum profit which can be achieved in the period?

They also asked to provide TWO alternatives BHealthy Ltd has to overcome the limiting factor?

(10 marks)

  1. Another chain, Phase3 Sports Club, is opening an exquisite new gym with a luxury spa within the city centre of Leeds as part of its growth strategy, but it needs to attract new members to make sure it survives. Over the last few years, demand for sports facilities has been rising as more and more consumers become health conscious, resulting in a significant increase in the number of sports clubs within the city of Leeds. Phase3 club has to come up with the right pricing strategy to attract and retain customers to achieve their financial objectives.

The budgeted fixed costs (for the rental of the building and sports equipment) for the first month are £7,500, and they are expected to be 27.27% of the total overheads at breakeven. The managers estimate that each member will use about £200 in resources over a year. In addition, each club member will be charged a £275 annual membership fee.

The management accounting team has the following questions for you:

  1. How many members will the club need to have to break even?
  2. Calculate the margin of safety percentage if Phase3 attracts 200 or 300 members in the first month.
  3. If Phase3 wishes to make a profit of £2,400, how many members should it target?
  4. The managers decide that a £275 fee is too high. What would happen if they reduced the membership fee to £245? Make the adjustment and recalculate the contribution, breakeven point, and margin of safety percentages at output levels stated in b) and advise management of the feasibility of a price reduction.
  5. Explain the limitations of Cost Volume Profit (CVP) analysis.                                                                                                                         (15marks)
  6. Budget planning is an essential process for an organisation, with many advantages. However, there can be negative aspects to the budgeting process. The management accounting team of XYZ plc wants you to discuss and provide examples of both of these aspects of budgeting.                                                                                                                                                                                                             (5 marks)

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