1. Contrast the appropriateness of the different sources of finance to a business.

FIN4001 Introduction to Finance

Learning Outcomes:

After completing the module, you should be able to:

• Contrast the appropriateness of the different sources of finance to a business.
• Explain the implications of finance as a resource within a business.
• Produce simple financial statements in accordance with accepted principles.
• Use financial information for decision making purposes.
• Demonstrate a confident use of the financial terminology and conventions in communicating results.

Question 1 You are the Chief Financial Officer at Touchdown Sports Inc., a leading manufacturer of protective equipment for use in contact sports. The company manufactures a range of products, including shoulder pads for use by players of American football. These pads comprise a hard plastic shell with foam padding underneath, metal rivets and elastic straps. Touchdown Sports Inc. sells all of its products to retailers on a credit basis. Estimated annual usage of hard plastic in Touchdown Sports Inc’s manufacturing process is 27,000 kilograms. This is used evenly throughout the year other than during July and August, when production increases to meet demand due to the start of the American football season in September, and during November, when production increases to meet demand prior to the Christmas holiday in December. Inventory holding costs for hard plastic are estimated to be $1.75 per kilogram per year. The estimated cost of placing and processing each order of hard plastic is $14. Throughout the year, it is estimated that hard plastic will cost an average of $0.90 per kilogram. However, forecast fluctuations in demand mean that the cost of hard plastic could vary from a maximum of $1.90 per kilogram and a minimum of $0.75 during the year. Touchdown Sports Inc. imports hard plastic from Guangzhou Productions plc, China. Recent disputes with this supplier have led Touchdown Sports Inc. to maintain a ‘buffer’ inventory to manage the risk of disruption to this supply. Guangzhou Productions plc offers a 7.5% bulk purchase discount on orders of hard plastic of 10,000 kilograms or more. The company’s approach to inventory management was discussed at a recent meeting of Touchdown Sports Inc’s senior executive team. Grace Rodriguez, Chief Executive at Touchdown Sports Inc., is an advocate of just-in-time (JIT) inventories management. Grace has questioned the company’s current approach to the management of its inventory of hard plastic and has commented: Holding inventories results in costs for the company. We could avoid these costs if we introduce a JIT approach to the management of our inventory of hard plastic. Inventories management models and information technology are available to help us. Maria Cousins, Chief Operating Officer at Touchdown Sports Inc., has pointed out that the successful management of inventories involves a number of practical issues. Maria has commented: Inventories management models and information technology are useful, but I am sure that there are other issues that we need to consider. I would like to know more about the practical implications of managing inventories.

Required:

(a) Calculate the economic order quantity (EOQ) for hard plastic. (5 marks)

(b) Calculate the total annual cost of hard plastic. (4 marks)

(c) Critically evaluate Touchdown Sports Inc’s decision to use the EOQ model as part of its approach to the management of inventories. (5 marks)

(d) Advise Touchdown Sports Inc’s senior executive team on the comments made by Grace Rodriquez and Maria Cousins. Your advice should include an explanation of the costs of holding inventories, the costs of failing to manage inventories properly and the practical implications of managing inventories.

 

Question 2

You are a Senior Analyst at Eagles LLP, a major advisory and professional services firm. One of your clients is Touchdown Trips Inc., a company that provides luxury package tours to watch sports events in North America. Touchdown Trips Inc. uses a luxury private jet aeroplane to carry clients to their destination. The company is planning to invest in a new luxury jet. Two possible investment options have been identified: the Gulfstream G650ER (option A) and the Boeing BBJ Max 7 (option B). Each option has an expected life of five years, after which the selected aeroplane will be replaced by a new luxury private jet aeroplane. Sufficient funding is available to finance only one of the options. Option A Option B USD ($000 USD ($000) Initial cost (year 0) 51,000 76,500 Scrap value (year 5) 40,110 60,120 Forecast net cash inflows Year 1 3,200 3,900 Year 2 3.300 3,600 Year 3 3,100 3,300 Year 4 3,000 3,100 Year 5 2,900 2,600 Assume that all cash flows occur at the end of the respective year. Touchdown Trips Inc. has a cost of capital of 12 per cent. Touchdown Trips Inc. have requested that the payback period and accounting rate of return techniques be used to support this capital investment decision. The company’s approach to investment appraisal was discussed at a recent meeting of Eagles LLP’s senior executive team. Bill Brady, Senior Partner at Eagles LLP is keen for the managers of Touchdown Trips Inc. to understand the characteristics of capital investment decisions: Bill has commented: We need to ensure that the managers at Touchdown Trips Inc. understand the characteristics of capital investment decisions. This might lead them to accept the use of capital investment appraisal techniques other than payback and accounting rate of return. Xiaolin Peng, Head of Asset Management at Eagles LLP, has highlighted that the internal rate of return technique may be suitable in this case. Xiaolin has commented: Internal rate of return is the rate of return that an investment project yields, taking account of the fact that cash may be flowing in and out of the project at various points in its life. If we explain the advantages and disadvantages of internal rate of return to the managers at Touchdown Trips Inc., this might encourage them to accept the use of this technique.

Required:

(a) Calculate the payback period for both option A and option B. (4 marks)

(b) Calculate the accounting rate of return for both option A and option B. Assume that the only difference between cash flow and profit is the depreciation charge. (6 marks)

(c) Critically evaluate the accounting rate of return technique. (8 marks)

(d) Advise the senior executive team on the comments made by Bill Brady and Xiaolin Peng. Your advice should include an explanation of the characteristics of investment appraisal decisions and the advantages and disadvantages of the internal rate of return technique.