Description

University of Sunderland (London)

PGBM142 CORPORATE FINANCIAL MANAGEMENT

LEVEL                                    :               6

MODULE                              :                Financial Management

ASSIGNMENT CODE        :               PGBM 142

Submission Date              :               23^rd Nov 2021

Assessment weight        :               100% of module

 

This assessment is in two parts, please answer all elements.

Part A carries a weighting of 30% and students should write 1,500 words (+10%). It is recommended that this section of the assignment be completed using Microsoft PowerPoint.

Part B carries a weighting of 70% and students should write 3,500 words (+10%). As the weightings for the tasks are not identical this should be considered in word allocation. It is recommended that this section of the assignment be completed using Microsoft Word.

Part A

Requirements

It has been three months since your promotion to assistant financial manager at fashion company RR Ltd. RR Ltd is a fashion retailer listed on the AIM market. The firm was founded 10 years ago, after a short and successful period as a partnership between Rebecca and Roy Race. The company has grown rapidly and has two successful own brand labels, ‘RR’ catering for the middle-income woman’s market and ‘Racey’ aimed at younger women.

RR Ltd distributes its two major seasonal lines (spring/summer and autumn/winter) under the ‘RR’ label and its young women’s label ‘Racey’ through major high street retailers in the UK and United States. Sales are also generated through exhibits of new collections at clothing exhibitions and through a fledgling, but not dynamic online presence, and very occasional webcast fashion shows.

The company’s investment priorities are to maintain its existing competitive position and identify Value creating growth opportunities. The current low interest rates have incentivised RR Ltd management team to consider raising debt finance to fund their investment priorities.

• You have been asked to produce a PowerPoint presentation together with notes to the slides which critically examines the benefits and risks to a company of incorporating corporate debt into an existing portfolio of equity and debt. Please note you will not be required to present the PowerPoint presentation (30%).

 

 

Part B

Task 1

RR Ltd has recently established a private pension scheme for its employees and the financial manager has asked you to provide a short report on why diversification generally leads to a reduction in risk relative to return. This report will be made available on the company website to inform employees on how the pension scheme manages both risk and return when selecting investable assets (including reference to forms of risk, covariance and CAPM). (20%)

In this section students should demonstrate understanding, knowledge, and an ability to critically evaluate the differing theoretical viewpoints associated with the topic. The response should attempt to incorporate a critical perspective through relevant academic referencing, rather than overly describing the topic. Attempting to evaluate within a practical, real-life business context through investigation of academic empirical findings will assist in developing the response.

Task 2

Currently, the management at RR Ltd are in preliminary decisions on a horizontal acquisition of ‘Sporty PLC’. Sporty PLC has an established men’s fashion brand; however, it is seen as a ‘Problem Child’ evidenced by relatively low market share in an industry segment that is experiencing growth. Industry analysts believe declining sales is principally due to not anticipating current tastes/trends and the financial manager has approached you for information on what value to place on Sporty PLC.

If the acquisition tales place, Sporty PLC will operate as a separate entity within RR Ltd. Existing designers at RR Ltd are very knowledgeable on the female market and believe they can transfer these skills to men’s fashion. Also, Roy Race is an ex-professional footballer and is passionate about men’s sport/casual wear. Both Rebecca and Roy are confident that synergies will improve economies of scale and scope, quality and in the medium-term, key performance ratios for Sporty PLC will be comparable to RR Ltd. RR Ltd’s share price is currently £6.00, and the company’s earnings per share stand at 17p. RR Ltd’s weighted average cost of capital is 9%

The board estimates that annual after-synergy benefits resulting from the takeover will be £7m, that Sporty’s distributable earnings will grow at an annual rate of 4% and that duplication will allow the sale of £20m of assets, net of corporate tax (currently standing at 30%), in a year’s time. Information relating to Sporty PLC:

Financial Position Statement of Sporty PLC.

£m

Non-Current Assets                                                        40

Current Assets                                                                  78

118

Equity:

Ordinary Shares (£1)                                                       40

Reserves                                                                             3

43

Long-Term Debt                                                               10

Current Liabilities                                                             65

Total Liabilities                                                                   118

 

Statement of Profit or Loss Extracts

£m

Profit before interest and tax                                     8

Interest payments                                                          2

Profit before tax                                                              6

Taxation                                                                               1.8

Distributable Earnings                                                    4.2

Other Information:

Current ex-dividend share price                                                £2.00

Latest dividend payment                                              9p

Past four years’ dividend payment                          6p, 7p, 8p, 8.5p

Sporty’s Equity Beta                                                       1.15

Treasury bill yield                                                             5%

Return of the market                                                     12%

 

Required:

1) Given the information above, calculate the value of Sporty PLC using the following valuation methods:

1. a) Price / Earnings Ratio. (using RR Ltd’s P/E ratio)
2. b) Dividend valuation method.
3. c) Discounted cash flow method. (15%)

2) Based on your calculations, justify the value of Sporty PLC and the stated motives for this acquisition.

(10%)

Task 3

Designs for RR Ltd’s fashion lines are created in house and manufacturing takes place across numerous locations in Birmingham, however the company is keen to expand into Asian-Pacific markets and is considering a small manufacturing base in Vietnam.

The project will have an initial outlay of £2m has a 0.55 probability of producing a return of £1.7m in Year 1 and a 0.45 probability of delivering a return of £1m in Year 1. If the £1.7m results occurs, then the second year could return either £2.8m (probability of 0.6) or £1.9m (probability of 0.4). If the £1m result for Year 1 occurs, then either £1.1m (probability 0.5) or £600,000 (probability of 0.5) could be received in the second year. All cash flows occur on anniversary dates. The discount rate for this project is 15%.

Required:

1) Calculate:

1. a) The expected NPV.
2. b) The standard deviation of NPV.
3. c) The probability of the NPV being less than zero assuming a normal distribution of return – (bell shaped and symmetrical about the mean). (10%)

 

Based on your analysis of the macroeconomic risk factors, you believe that if the project was delayed by a year, RR Ltd would be able to improve the accuracy of the Year 1 probability estimates, which could lead to a reduced initial outlay and discount rate.

2) Upon finishing your calculations, a colleague states that the ‘traditional NPV method is just as effective as an NPV method incorporating probabilities and real option perspectives’. Critically evaluate this statement.  (15%)

In this section students should demonstrate understanding, knowledge, and an ability to critically evaluate the differing theoretical viewpoints associated with the topic. The response should attempt to incorporate a critical perspective through relevant academic referencing, rather than overly describing the topic. Attempting to evaluate within a practical, real-life business context through investigation of academic empirical findings will assist in developing the response.

 

Solution

1. Task 1: Critical evaluation of diversification and how RR Ltd’s pension scheme manages both risk and return

Executive summary

Diversification is a one of the most adopted risk management strategy, which entails mixing a variety of investments within a portfolio. Thus, a portfolio that is diversified contains a mix of particular asset types and investment vehicles with the aim of limiting exposure to any single asset or risk. In light of this, this report aimed to critically evaluate diversification as a way of reducing risk in relation to return and thus inform employees of RR Ltd how the pension scheme established by the company manages both risk and return when selecting investable assets. The report established that diversification could help reduce risk since by owning various assets performing differently; the overall risk of a portfolio is reduced. Moreover, diversification can reduce unsystematic risk from a portfolio since it is unlikely that events such as strikes, slumping sales and fires would happen in every company at the same time. However, it was established that diversification cannot help reduce systematic risk. Further, it was established that the pension scheme could adopt frameworks such as MPT, covariance, and CAPM to help reduce risk in its portfolio.

1.1. Introduction

The idea behind diversification is that a portfolio made up of various types of assets will, on average, result to higher returns in the long-term and lower the risk of any individual asset. Further, due to importance of diversification in reducing risks, pension schemes have increasingly adopted this strategy to manage both risk and return when selecting investable assets (Bernard & Kwak, 2016). Nonetheless, various drawbacks prevent diversification from being implemented successfully, and there are certain types of risks that cannot be eliminated through diversification.  Against this backdrop, this report will critically discuss how diversification can help reduce risks and how the pension scheme established by RR Ltd can manage both risk and return when selecting investable assets.

1.2 Diversification as a way of reducing risk

1.2.1 Arguments for

As explained by Le (2019) diversification can help a company increase its overall return without demanding the company to sacrifice anything in exchange. In other words, diversification can help reduce risk without costing a company’s returns. In this regard, RR Ltd’s pension scheme (the pension scheme or the scheme) can use diversification as a strategy to improve its potential returns and stabilise the pension scheme results. Thus, by owning various assets performing differently, the overall risk of the portfolio is reduced, therby making sure that there is no single investment that can hurt the pension scheme. This assertion is supported by Setianto (2020) who put forth that diversification smoothens a firm’s returns because different assets perform differently in different economic scenarios. For instance, while bonds may be zigging, stocks may be zagging (negatively correlated assets). This combination of assets, in turn, will more than average cancel out each asset’s fluctuations, thereby reducing risk………………………….

 

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