Guidelines
For all parts, you are advised to show all your workings. If the answer is Excel based, your answer should make it clear to the reader how any calculations have been made. There is no word count limit for TMA 01.
Part 1
In this question, apply your knowledge of how changes to supply and demand affect resource prices.
Part 2
In the first part, you are required to draw a decision tree based on the information provided. You are not required to analyse it. Your tree should include all relevant information (costs or probabilities, for example).
In the second part, you are given a decision tree to analyse. Note that the figures provided in the right-hand terminal boxes have not had earlier costs deducted. Value each node (referring to the node label as appropriate) and then advise, using these values, what the company should do.
Part 3
This question asks you to read a paper on behavioural aspects of finance as it relates to forecasting. You are asked to consider how taking account of such biases may affect organisations and how they mitigate those biases.
Part 4
This is an investment appraisal. As in Part 1, marks will be available for both the calculation and the quality of Excel model design. Ensure that the model is easily understood by another user and that it may be sensitised without changing any equations. Remember that discursive answers should be shown in your Word document and not in Excel.
PRESENTATION
ACTUAL PAPER QUESTIONS
Part 1
You have been asked to forecast next year’s income statement for a UK-based business in the logistics and distribution sector. The business undertakes wholesale distribution (using large and, if needed, chilled trucks) and consumer deliveries (using vans and mini-vans). As part of this, you will need to make some high-level assumptions, based on macroeconomic conditions, for the coming years. Consider the following statements:
- a.As a combined result of Brexit and Covid-19, a large number of your European workers have left the UK. The workers in question were largely employed in unskilled, relatively low-paid jobs.
- b.Until recently, there has been a dispute between Russia and OPEC, whereby Russia produced more oil than agreed with OPEC. However, that dispute has now been resolved. Russia and OPEC will not immediately reduce production. Instead, they plan to start raising oil production in three months’ time. However, analysts believe the rate of increase will not be as high as the rate of economic growth as the world emerges from Covid restrictions.
- c.Interest rates are at historical lows, with some countries reporting negative rates.
- d.The government is planning on introducing a tax on petrol and diesel vehicles.
Explain how these statements might affect future profits of the business. (Note: you are not being asked to provide any quantitative assumptions.) You are encouraged to research material beyond that included in the module material. Reference where appropriate. You may assume all other economic conditions are as of May 2022.
Part 2
- a) A company is contemplating purchasing a new manufacturing machine. There are two models under consideration. Model Alpha costs £10m but has relatively low capacity. This can be upgraded to increase capacity after a year, if needed, at a cost of £15m. The other model, Beta, has higher capacity, equal to the upgraded Alpha. Beta costs £18m.
Demand can either be high or low. First year demand has a 0.6 probability of being low, with value £20m. If demand is high, due to the reduced capacity, Alpha would have a value of £30m and Beta £40m. The company will only upgrade model Alpha at this point if first year demand is high.
The demand for the second year has a 0.4 probability of being low, with value £27m. High demand in the second year is worth £52m for the upgraded Alpha and Beta, and £40m for the low capacity Alpha.
Draw the decision tree that reflects this scenario. Your tree should include all relevant information. Note: you are not required to value any of the nodes nor arrive at a strategy. (10 marks)
- b.) A company, WeBuyItAll Inc (WBIA), is assessing whether to acquire a rival company. If it does not bid, then its share will not move from its current price. If, however, it decides to launch a bid, there will be consequences (either positive or negative depending on the outcome of the bid), as well as taking account of the bid costs.
Just launching the bid is likely to immediately reduce the share price by $2. This reflects the costs of the bid and the general market view that bids often destroy value for bidders’ shareholders. The company will be able to make up to 2 bids. Once a bid is deemed successful, the process comes to an end.
For the first bid (in one month’s time), the company must decide whether to make a high or low bid. A high bid has a 0.45 probability of succeeding. If it does, it will add $7 to the current share price (so the net effect would be $5: the $2 cost of launching plus the $7 for success). If it makes the low bid, it has a 0.25 chance of being successful. If successful, the share price would rise by $9, reflecting the good deal.
In both cases, if the bid fails, WBIA may launch a second bid a month later. If it decides against a second bid, then its share price will fall by $1, reflecting the market’s view that time and resources will have been wasted launching a failed bid.
If the company does launch a second bid, it will reduce the share price by $1.25, reflecting further bid costs. Again, WBIA can make a high or low bid. A high bid has a 0.85 probability of being accepted and would add $8 to the share price if successful. A low bid has a 0.65 probability of succeeding and would add $10 to the share price if successful.
Non-acceptance of either second bid would cause the share price to fall by $1.50. For the purposes of this question, ignore the time value of money.
The decision tree for this situation is provided below. For example, if WBIA launches the bid (-$2) and makes a first high offer that is then successful (+$7), the total impact on share price will be =$5.
i.Calculate the values of nodes A to H, showing all workings. (16 marks)
- ii.Based on your answer to part i., what strategy should the company follow and why? (4 marks)
Part 3
Access the article ‘The Overconfident Investor’ in Resources. The article discusses cognitive biases in the context of investment. However, similar biases would occur in budget forecasting and investment appraisals.
- a.Discuss how these biases might affect either budget forecasting or investment appraisals. (10 marks)
- b.Explain what steps an organisation might take to avoid mistakes in forecasts that might arise from such biases. You are encouraged to draw both on your own experience as well as research beyond the module material. (10 marks)
Part 4
A company is considering launching a new product. The following data is from a report the company commissioned, costing £2m.
Initially, it will manufacture the product for a period of 4 years. The company will need to invest in equipment costing £25m, which attracts capital allowance of 25% of cost for the first 4 years. The equipment is depreciated in equal amounts over 10 years. It will also use a factory that it owns, which it would otherwise rent out for £5m per annum, before tax. There will need to be a working capital investment at the start of £7m, which will be recouped when production is finished.
Revenue in the first year is estimated to be £24m, and it will grow at an annual rate of 6% over the 4-year period. Costs are estimated to be 48% of revenues.
The tax rate is 19% per annum, paid in arrears. The required return for a project like this is 7.5%.
- a.In an Excel spreadsheet, create an investment appraisal calculating the net present value (NPV) and internal rate of return (IRR) for this project. (7 marks)
- b.Based on your answer to part a., give a recommendation, with explanation, as to whether the company should proceed with the launch. (5 marks)
- c.Insert into your spreadsheet a data table showing the effect on NPV of changing both the tax rate and revenue growth. Your table should vary the tax rate from 16% to 22%, showing results at each percentage point (that is, 7 figures) and the revenue growth from 3% to 9%, also showing 7 figures. (5 marks)
- d.A client tells you that payback is the best method for appraising investments. Explain to your client the shortcomings of payback compared with the net present value method. (5 marks)
