Financial statements, Principle accounting ratios, Risk and returns – Case Study Answers

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Alexandra Buchanan, aged 56, is a new investment client introduced to you by a mutual friend. Alexandra is a widow and is retiring from her job in the City next month. She has recently inherited £100,000 from her late uncle’s estate.

Alexandra has an existing portfolio, which contains both direct and collective investments. It has been managed by her previous investment manager on an advisory basis.

Alexandra has expressed concern over the previous management of her portfolio, especially the risk and return of two UK shares held. She has asked you to review her portfolio with a more detailed analysis of them. Information regarding the shares is contained in Table 1 below. Alexandra is also interested in investing her £100,000 inheritance into the portfolio.

Table 1

Safebury plc Morrisco plc
Variance of returns 843 258
Expected net dividend per share 10p 18p
Dividend growth per annum 5% 6%
Expected return on share 8% 8%
Earnings per share 17p 46p
Current assets £200,000,000 £327,000,000
Current liabilities (£230,000,000) £208,000,000
Stock (inventory) £10,000,000 £15,000,000

Questions:

a) Alexandra is concerned over the investment risk of Safebury plc and Morrisco plc.

i) List the steps required to calculate the standard deviation of a share’s returns. (5)

ii) Using Table 1, calculate the standard deviation for Safebury plc and Morrisco plc. (2)

iii) Comment on the range of returns on each share within one standard deviation. (3)

Answer

a)

i) Where probability factors provided:

Step 1: Calculate the difference between the actual return and expected return.
Step 2: Square the difference to eliminate the minuses.
Step 3: Multiply the squared answer by the probability.
Step 4: Sum the result (variance).
Step 5: Find the square root of the variance.
Alternative answers excluding probability whereby sum of variance figures is added together and then divided by n (or n-1 with sample results) would gain full marks.

ii)

Safebury plc – variance = 843

Square root of variance (standard deviation) = 29.034%

Morrisco plc – variance = 258

Square root of variance (standard deviation) = 16.062%

iii)

Safebury plc has an expected return of 8%, but the range of returns from one standard deviation will be -21.03% to +37.03%.

Morrisco plc also has an expected return of 8% but the range of returns within one standard deviation will be from -8.06% to +24.06%, which will occur about 68% of the time.

Morrisco plc has a lower risk of losing value and Safebury plc has a higher risk of capital loss.

b)

i) State the formula and calculate the share price of Safebury plc and Morrisco plc using Gordon’s Growth Model. (6)

ii) State the dividend cover formula and calculate this for Safebury plc and Morrisco plc. (3)

iii) Comment on the level of dividend cover for Safebury plc and Morrisco plc. (3)

Answers

i) Gordon’s Growth Model: Price = Expected net dividend per share / Expected return – Dividend growth

Safebury plc: 10/0.08 – 0.05 = £3.33

Morrisco plc: 18/0.08 – 0.06 = £9.00

ii) Dividend cover: Earnings per share / Net dividend per share

Safebury plc 17/10 = 1.70

Morrisco plc 46/18 = 2.55

iii) Safebury plc has a low level of dividend cover as a level of 2 is considered satisfactory in the UK. Morrisco plc therefore, has a satisfactory dividend cover.

c)

i) State three of the main measures of company performance in addition to liquidity that can be obtained from their accounts. (3)

ii) State the formula and calculate the liquidity ratio for Safebury plc and Morrisco plc. (5)

iii) Comment on the level of liquidity ratio for Safebury plc and Morrisco plc. (3)

iv) Briefly explain to Alexandra the characteristics of prospective data and historic data when calculating measure of share value. (4)

Answers

i) Profitability, profit volatility, operational efficiency. (others would have gained candidate marks).

ii) Liquidity ratio:

Current ratio = current assets / current liabilities

Safebury plc: 200 / 230 = 0.87

Morrisco plc 327 / 208 = 1.57

Quick assets ratio / acid test = Current assets – stock / Current liabilities

Safebury plc: 200 – 10 / 230 = 0.83

Morrisco plc 327 – 15 / 208 = 1.5

iii) Safebury plc has a liquidiy ratio of below the generally accepted minimum of 1. Some companies are able to run at a lower level if they have a high turnover of stock. Morrisco plc has an acceptable level of liquidity ratio.

iv) Prospective data is usually made up to date and enables a forward projection of the company’s value. Historical data is exact and most people can agree with it. It is also more readily available, such as from published accounts and statutory filings.

d Alexandra’s previous investment manager had indicated to her that the likely future total returns on UK Equities was anticipated to be 7% per annum over the next few years. She is considering investing her £100,000 inheritance in the UK Equity market.

i) Assuming the anticipated return from UK Equities to be correct, state
the formula and calculate the future value of Alexandra’s £100,000 investment in five years time. (4)

ii) Based on an assumed increase in the consumer prices index (CPI) of 2.25%
per annum over the next five years, calculate the real return that would
be achieved on Alexandra’s investment of £100,000. (4)

Answer

i)

FV = PV (1+i)n
FV = £100,000 (1+0.07)5

FV = £100,000 (1.402552) FV = £140,255 (rounded to nearest pound).

ii)

Real value of portfolio after 5 years: 1.07% / 1.0225% = 1.04645%

£100,000 (1.04645)5
£100,000 (1.25485) = £125,485 (rounded to nearest pound). (£125,488 if all the calculation is held in the calculator)

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