Apply knowledge to decide appropriate financing plan and dividend policy
In this assignment, you are expected to:
Compute and interpret financial ratios
Evaluate investment proposals
Apply knowledge to decide appropriate financing plan and dividend policy
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Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2.
Exhibit 1 Income Statement for the year ending December 31, 2016
Sales Revenue
6,000,000
Cost of goods sold
-1,800,000
Gross Profit
4,200,000
Operating expenses
-2,000,000
Depreciation
-200,000
EBIT
2,000,000
Interest
-120,000
Earnings before tax
1,880,000
Tax (20%)
-376000
Net income
1,504,000
Dividend payment
-601600
Addition to retained earnings
902,400
Exhibit 2 Balance Sheet as at December 31, 2016
Assets
Cash and Cash Equivalents
Receivables
1,200,000
560,000
Inventory
500,000
Total current assets
2,260,000
Gross Fixed assets
1,350,000
Accumulated Depreciation
-550,000
Net fixed assets
800,000
Total assets
3,060,000
Assignment 1
Assignment 1 – Page 3 of 5
Liabilities and Shareholder equity
Payables
400,000
Short-term debt
150,000
Current Liabilities
550,000
Long-term debt
1,000,000
Total Liabilities
1,550,000
Paid up capital
1,000,000
Retained Earnings
510,000
Total equity
1,510,000
Equity + Liabilities
3,060,000
The number of shares outstanding is 1,000,000.
The company expects that its dividend will grow at 6% every year indefinitely. The long-term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 8%
The beta of furniture industry is 1.2; the risk free rate is 4% and the expected market risk premium is 7%.
The current credit terms offered by Modern Furnitures is 2/15 net 45. Under these terms, 30% of the customers take the discount and the expected bad debt is 2% of total sales.
Question 1
(a) Calculate the market price per share using dividend growth model.
(10 marks)
(b) Compute the market value of bonds.
(10 marks)
Question 2
Typically, most companies use line of credit with a bank to finance its working capital needs as opposed to taking out a bank loan. Line of credit costs 8% per annum while term loan for 6 months costs 6% per annum. Modern Furnitures has worked out the working capital for the next 6 months as follows:
Month
Working Capital
1
60,000
2
70,000
3
100,000
4
80,000
5
60,000
6
40,000
Assignment 1
Assignment 1 – Page 4 of 5
(a) Explain how line of credit will work for Modern Furnitures, indicating the amount of line of credit that will be taken from the bank.
(4 marks)
(b) Calculate the amount of interest that the company will pay if line of credit is taken up.
(6 marks)
(c) Calculate the amount of interest that the company will pay if term loan is taken up.
(6 marks)
(d) Compare the two (2) financing methods and discuss which of these alternatives will be good for the company.
(4 marks)
Question 3
Modern Furnitures is considering a change in credit policy to 2/10 net 30. Under these terms, sales are expected to decrease by 10%; bad debt is expected to reduce to 1%; 20% of the customers are expected to take credit. This will lead to an increase in receivables turnover to 12. The opportunity cost of investing in receivables is the cost of equity.
Analyse the change in credit policy.
(20 marks)
Question 4
Cash conversion cycle is an important concept in working capital management. Analyse the importance of cash conversion cycle and explain the strategies to manage the cash conversion cycle.
(10 marks)
Question 5
Analyse why Modern Furnitures’ ROE is different from that of the industry using Du Pont Identity and other ratios. The relevant ratios are shown in Exhibit 3.
(30 marks)
Exhibit 3 Relevant Ratios
Ratios
Modern
Industry average
Current ratio
4.11
5.20
Quick ratio
3.20
3.80
Total asset turnover
Fixed asset turnover
1.96
7.50
1.75
7.00
Working capital turnover
9.09
10.45
Inventory turnover
3.60
4.50
Assignment 1
Assignment 1 – Page 5 of 5
Ratios
Modern
Industry average
Receivables turnover
10.71
12.42
Payables turnover
4.50
3.90
Gross profit margin
70.00%
60.00%
Operating profit margin
33.33%
38.00%
Net profit margin
25.07%
28.00%
Return on assets
49.15%
50.00%
Return on equity
99.60%
85.00%
Total debt/Total assets
37.58%
32.00%
LTD/Total assets
32.68%
28.00%
LTD/(LTD+Equity)
39.84%
35.00%
Equity multiplier
2.03
1.735
Interest Coverage
16.67
22.10
