Analysis Of Louise Leasing And Manchester Plc Finance Essay

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"Manchester" Plc is a telecommunications company. The consolidated income

statement and balance sheet for the year ended 31st March 2008 are shown below with
comparative figures for 2007.

Note
The market share price of "Manchester" plc is:
31st March 2008 - 10 per share
31st March 2007 - 12 per share

Required
a) Using accounting ratios, evaluate the overall performance of "Manchester" plc for the
years ended 31st March 2008 and 2007.

(30 marks)
b) Discuss the main principles of financial management.

(5 marks)
c) Discuss the means of effective working capital management.

(5 marks)
(Total 40 marks)
Question 2

At the beginning of its accounting year Alice plc leases a machine from Louise Leasing
plc. The following information relates to the lease agreement:
The term of the lease is 5 years, and the lease agreement is non-cancellable, requiring
equal rental payments of 9,276 at the beginning of each year;
The machine has a fair value at the inception of the lease of 40,000, an estimated
economic life of 5 years, and no residual value;

Alice plc's incremental borrowing rate is 10% per year;

Alice plc depreciates similar equipment that it owns on a straight-line basis;
Louise Leasing plc has set the annual rental to earn a rate of return on its investment of
8% per year; this fact is known to Alice plc.

Required:
Should the above lease agreement be accounted for as a finance or an operating lease?
Give reasons to justify your answer.

(5 marks)
Prepare the journal entries for Alice plc that relate to the above lease agreement during
years 1 and 2 for each of the following assumptions:
The lease is classified as a finance lease;
The actuarial method should be used to allocate finance charges to accounting periods
during the lease term.
(ii) The lease is classified as an operating lease.

(25 marks)

With reference to (b) discuss the extent to which the distinction between a finance lease
and an operating lease is important for financial reporting and analysis.

(10 marks)
(Total 40 marks)
Answers
Let us describe the following criteria to see whether the agreement is a finance or
operating lease

Criteria
Yes/No
Comments
Transfer of ownership at end of lease
No
Bargain purchase option
No
Lease term is 75 % or more of the economic life
Yes
100 % of estimated economic life
Present value of the minimum lease payment (MLP) is 90% or more of fair value
Yes
46,380/40,000 = 115,95 % > 90 %

The two criteria above are met and we conclude that the agreement should be accounted
for as a finance (capital) lease. And in addition, this agreement is non cancellable.
(i) As a finance lease:
Lease payment schedule: we shall use the rate of return of the lesser since the lessee
knows it, that is 8 %

Year
Lease payment
Interest
Reduction Liability
Lease liability
0
40,000
1
9,276
3,200
6,076
33,924
2
9,276
2,714
6,562

27,362
3
9,276
2,189
7,087
20,275
4
9,276
1,622
7,654
12,621
5
9,276
1,010
8,266
4,355

Journal entries for Year 1 and Year 2

Year 1
Machine lease
40,000

Lease Obligation
40,000
Depreciation expense
8,000
Accumulated depreciation
8,000
Lease Obligation
9,276
Interest revenue
3,200
Lease Liability
6,076
Year 2
Lease Obligation
9,276
Interest revenue
2,714
Lease Liability
6,562
Depreciation expense

8,000
Accumulated depreciation
8,000
(ii) Now the lease is classified as the operating lease, we shall record each lease payment
as rent expense.
Year 1
Rent expense
9,276
Cash
9,276
Year 2
9,276
9,276
Knowing whether the agreement is either the finance or the operating lease is very
important given accounting and financial implications that are incurred for each type of
lease.
In the finance lease, since the lease offers all of benefits and risks of ownership to the
lessee, this leads to more complicated accounting recording that needs particular
attention for both lessee and lessor. The finance leases are included on the balance sheet
of the lessee while the operating leases are off-balance-sheet financing for the lessee (it
is included only in the notes to the financial statements).
From (b) above, we can notice the following:
In the finance lease, the lease is considered as an asset and as a liability on balance
sheet. And the lessee will claim depreciation each year on the asset and will discount the

interest expense of the lease payment. We can notice at overall view that there are lower
current ratios, higher debt and leverage ratios and lower asset turnover and lower
profitability in the early years on the lease term. The net income is lower in the early
years and higher in the later years of the lease term.
In the operating lease, the lease expense is treated as an operating expense in the
income statement and has no effect on the balance sheet.
Here, the net income is higher in the early years and lower in the later years of the lease
term. In the contrast of the finance lease, the current ratios are higher, debt and
leverage ratios are lower and asset turnover and profitability ratios become higher
especially in the early years of the asset life.

Question 3
a) The table below presents information about the Treasury bill I and securities A, B and
C. The data presented refer to five states of economy: recession, below average, average,
above average and boom.
Economy
Probability
T-Bill
Security A
Security B
Recession
0.1
8%
-22%
28%

Below average

0.2
8%
-2%
14.7%
Average
0.4
8%
20%
0%
Above average
0.2
8%
35%
-10%
Boom
0.1
8%
50%

-20%

Required
a1) Calculate the expected return of the Treasury bill and securities A and B.
a2) Calculate the standard deviation of the Treasury bill and securities A and B.
a3) Calculate the coefficient of variation of the Treasury bill and securities A and B.
a4) Calculate the expected return and standard deviation of a portfolio consisting of
60% of security A and 40% of security B (assuming the correlation between A and B is
0.2).
a5) Briefly interpret the correlation coefficient that is given above.

(25 marks)
b) Describe the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory
(APT).

(10 marks)
c) Define the terms "business risk" and "financial risk".

(5 marks)
(Total 40 marks)
Answers
We shall be using the following formula:
Expected value or mean () = (v x P)
Where,
= mean or the expected value

v = possible value
P = probability
Standard deviation ()= P (v- )2
Coefficient of variation (CV) = /
Expected rate of return, E(Rp), of two assets, A and B is
E (Rp)= [Wa + E(Ra)] + [Wb + E(Rb)], where,
Wa = the weight
E (Ra) = Expected rate of return
The standard deviation of two securities ( or assets) is
AB=W2Ax 2A+W2Bx 2B+2WAWBrAB A B, where,
WA is the weighted average of the expected return of the Security A
WB is the weighted average of the expected return of the Security B
A is the standard deviation of the security A
B is the standard deviation of the security B
and rAB is the correlation coefficient between A and B

a1) Expected returns of the three securities are

calculated below:
Probability
T Bill
Security A

Security B
0.1
8%x0.1=0.8%
-22%x0.1=-2.2%
28%x0.1=2.8%
0.2
8%x0.2=1.6%
-2%x0.2=-0.4%
14.7%x0.2=2.94%
0.4
8%x0.4=3.2%
20%x0.4=8%
0%x0.4=0%
0.2
8%x0.2=1.6%
35%x0.2=7%
-10%x0.2=-2%
0.1
8%x0.1=0.8%
50%x0.1=5%

-20%x0.1=-2%

Total/Expected return
8%
17.4%
1.74%
a2) Calculation of the standard deviation
Standard deviation of the T- Bill = 0.1 (8-8)2 + 0.2(8-8)2 +0.4(8-8)2+0.2(88)2+0.1(8-8)2=0
Standard deviation of the Security A = 0.1 (-22-17.4)2 + 0.2(-2-17.4)2+0.4(2017.4)2+
0.2(35-17.4)2+0.1(50-17.4)2
The standard deviation for the Security A = 22.035%
Standard Deviation of the Security B = 0.1 (28-1.74)2+0.2(14.7-1.74)2+0.4(0-1.74)2
+0.2(-10-1.74)2+0.1(-20-1.74)2
= 0.1x26.262+0.2x12.962+0.4x3.0276+0.2x11.742+0.1x21.742
= 0.1x689.5876+0.2x167.9616+1.21104+0.2x137.8276+0.1x472.6276
= 68.95876+33.59232+1.21104+27.56552+47.26276
= 178.5904
= 13.36.

a3) Calculation of the coefficient of variation (CV)

CV of the T- Bill = 0/8 = 0 %

CV of the Security A = 22.035/17.4=1.26%

CV of the security B = 13.36/1.74=7.67%

a4) Calculation of the expected return and

standard deviation of a portfolio of two securities
A and B are:
The expected return in a portfolio containing 60 %
Security A and 40% Security B is
= 0.60x0.174 + 0.40x0.0174
= 0.1044+0.00696

= 0.11136= 11.136%
The standard deviation of the two securities A and
B is
= 0.62x22.035+0.42x13.36+2x0.6x22.035x0.4x13.36x0.2
= 0.36x22.035+0.16x13.36+28.2612096
= 7.9326+2.1376+28.2612096
= 38.3314096

= 6.19%
a5) The correlation coefficient values vary between -1 and +1. This correlation indicates
the degree to which one variable is linearly related to another.
If the correlation coefficient is negative, this indicates the negative correlation while if
positive, it indicates the positive correlation.
The correlation between A and B is here 0.2, positive, this means that A and B change
their values proportionately in the same direction at the same time at 0.2 degree. And

since +0.2 is less than +1.0, this falls in with the statement that any time the correlation
coefficient of the returns of two assets is less than +1.0 (here +0.2) then the standard
deviation of their portfolio - here is 6.19 % - will be less than the weighted average of the
individual assets' standard deviations (22.035% for A and 13.36% for B).
We can assume also that the cash flows of each A or B may be due to different and even
unrelated factors.

b1) Capital asset Pricing Model:

Developed by the financial theorists William F. Sharpe (1964), John Lintner (1965) and
Jan Mossin, the capital asset pricing model (CAPM) is the powerful tool to measure risk
and the relation between expected return and risk. This model stipulates that the
equilibrium rates of return on all risky assets are a linear function of their covariances
and with the market portfolio.
The use of the CAPM over the last decades had led several financial experts to qualify it
as the "Birth of the asset pricing models". This model draws its assets to the portfolio
theory developed by Harry Markowitz who, in 1959, says that an investor selects a
portfolio at a time that produces a stochastic return at another time.
In fact, the Markowitz's model as an algebraic condition which that CAPM has turned
into the testable prediction about the relation between risk and expected return. This is
made possible by identification of the portfolio that must be efficient if asset prices are
to clear the market of all assets.

The CAPM formula below allows calculating the appropriate required rate of return for
an investment project given its degree of risk.
The CAPM formula kp = kRF+ (kM - kRF) x , where,
kp is the required rate of return appropriate for the investment project
kRF is the risk-free rate of return
kM is the required rate of return on the overall market

 is the project's beta that allows to measure the degree of non diversifiable risk
kM - kRF is the risk premium
As above stated, the CAPM uses variance as a measure of risk and specifies that only the
portion of variance that is not diversifiable is rewarded. It measures the non
diversifiable risk with beta, which is standardized around one:
If = 1, average risk investment
> 1, above risk investment
< 1, below risk investment
= 0, riskless investment
The CAPM properties are:
Total risk = systematic risk + unsystematic risk
The systematic risk measures how the asset co-varies with the entire economy (cannot
be diversified away without cost): e.g. interest rate, business cycle, etc
The unsystematic risk measures the idiosyncratic shocks specific to the asset (can be
diversified away with no cost): e.g. death of the financial manager, etc.
Every asset, in equilibrium, must be priced so that its risk-adjusted required rate of
return falls exactly on the security market line;
CAPM quantifies the systematic risk of any asset at its beta
Expected return of any risky asset depends linearly on its exposure to the market
(systematic) risk, measured by beta;
Assets with higher beta require a higher risk-adjusted rate of return. In other words, in
market equilibrium, investors are only rewarded for bearing the market risk.
The practical applications of the Market Asset Pricing Model (CAPM) are the valuation
of risky assets, the estimation of required rate of return of risky projects.

b2) The Arbitrage Pricing Theory (APT)

The APT is an alternative of CAPM because they both use the linear relation between
assets' expected returns and their co-variances with other random variables.
Developed by Ross in 1976, Ross says that if equilibrium prices offer no arbitrage
opportunities over static portfolios of the assets, then the expected returns on the assets
are approximately linearly related to the factor loadings ( or betas), which in return are
proportional to the returns' co variances with factors.
APT has the following principles:
Two items that are the same cannot sell at different prices;
If they sell at different prices, arbitrage will take place in which arbitrageurs buy the
good which cheap and sell the one which is higher till all prices for the goods are equal.
The assumption of investors utilizing a mean-variance framework is replaced by an
assumption of the process of generating security returns;
It requires that the returns on any stocks be linearly related to a set of indices;
APT is a generalization of the CAPM: multiple factors have an impact on the returns of
an asset in contrast with CAPM that suggests that return is related to only one factor
(beta), the systematic risk: e.g. inflation, political instability, changes of interest rates,
etc.
The assumptions of the Arbitrage Pricing Theory are:
Capital markets are perfectly competitive;
Investors always prefer more wealth to less wealth with certainty.
Its formula is
r = rf + 1f1+ 22f2+... where,
r = expected return

rf = risk free rate

f = a separate factor
= a measure of relationship between the price and that factor.

Business risk and financial risk

Business risk refers to the uncertainty a company has with regard to its operating
income (or EBIT = Income Before Interest and Taxes).
Measuring the business risk leads to measuring the degree of this uncertainty about the
company's operating income; in other words, this means measuring the variability of its
EBIT. We do it by calculating the standard deviation of the EBIT forecast:
If the standard deviation is small, there is little variability and little uncertainty of the
EBIT
If the standard deviation is large, there is great uncertainty about the operating income.
The standard deviation depends on the sales volatility, fixed operating costs and is
associated with its operations. The business risk is affected by the company's
investment decisions.
Financial risk refers to the additional volatility of a company's net income caused by the
presence of fixed interest expenses. The financial risk is measured by noting the
difference between the volatility of net income in two scenarios: there is and there is not
interest expense. This is done by subtracting their coefficients of variation.
Companies that operate primarily on debt are exposed to a higher degree of financial
risk while those operating on equity financing have no financial risk.
The financial risk is also called the financial leverage and is associated with the company
capital structure and is affected by its financing decisions.

PART B

Question 4
a) Describe the factors that should be taken into consideration by firms when forming
their capital structure.

(10 marks)
Answer:
The capital structure of the firm refers to the mix of debt and equity the firm uses to
finance its long term operations.
The firm should plan its capital structure to maximize the use of these funds and to be
able to adapt more easily to the changing conditions and circumstances. Therefore,
when forming its capital structure, the firm must take into consideration the following
general factors:
Profitability: The capital structure should be the most advantageous: the maximum use
of leverage at a minimum cost;
Solvency: A debt that adds significant risk should be avoided;
Capacity: The capital structure should be determined within the debt capacity of the
firm that should have enough cash to pay creditors' fixed charges and principal sum.
Flexibility: the firm should be flexible to the changing conditions and should be able to
provide funds whenever needed to finance its profitable activities;
Control: the capital structure should involve the minimum risk of loss of control of the
firm.
And these external and internal factors related to the size and other features should be
considered:
Internal factors including
the size of business,

nature of business,
regularity and certainty of income,
age of the firm,
desire to certain control,
future plans,
trading on equity where debt and preference shares are main sources of finance,
period and purpose of financing;
External factors including
capital market conditions,
nature of investors,
statutory requirements,
taxation policy,
policies of financial institutions,
cost of financing,
seasonal variations,
economic fluctuations and the nature of competition.
Different theories were developed to try to define the interchangeability and
interdependence of these factors.
b) Describe the "Efficient Market Hypothesis" (EMH). Explain how the "Efficient
Market Hypothesis" is used to explain the stock market behaviour.

(10 marks)

(Total 20 marks)
Answer:
The EMH states that there is perfect information in the stock market, i.e. whatever
information about a stock is available to one investor is available to other investors.
In other words, in an efficient financial market, an asset's price should be the best
possible estimate of its economic values.
And a financial market is informationally efficient when market prices reflect all
available information about value.
All available information includes past prices, public and inside information (news, past
prices).
All this information available has a great impact on the market behaviour because when
data gathered from different stock markets can show any correlation between their
returns and prices. The latter in turn react to news quickly.
However, in such a context, we cannot assume we have exhaustively all available
information about the stock markets and confirm absolutely that the prices are low or
high.
With the EMH, it is not necessary to spend a lot of time to pick stocks that may become
winners but instead looking to match the market's performance though we cannot
consistently outperform.