1.

VADENER PLC (JUN 06 ADAPTED)

(a) Group performance can be analysed by using financial ratios, growth trends and comparative market
data. Alternative definitions exist for some ratios, and other ratios are equally valid.

Operating and profitability ratios:

20X3 20X4 20X5
Return of capital EBIT 410 540 560
=27.6 % =32.4 % =29.9 %
employed: Capital employed 1,486 1,665 1,876
Assets turnover: Sales 1,120 1,410 1,490
=0.81 =0.85 =0.79
Capital employed 1,486 1,665 1,876
Profit margin: EBIT 410 540 560
=33.9 % =38.3 .% =37.6 %
Sales 1,210 1,410 1,490

Liquidity ratios:
20X3 20X4 20X5
Current Current assets 728 863 1,015
=1.29 =1.19 =1.27
ratio: Current liabilities 565 728 799
Acid test: Current assets – Inventory 388 453 525
=0.69 =0.62 =0.66
Current liabilities 565 728 799

Market ratios:
Dividend Dividend per share 48.7 56.7 61.7
=4.0 % =4.0 % =4.0 %
yield: Market price 1,220 1,417 1,542
Earnings per Earnings after tax 259 339 346
=86.3 =113.0 =115.3
share Number of shares 300 300 300
(pence):
PE ratio Market price 1,220 1,417 1,542
=14.1 =12.5 =13.4
Earnings per share 86.3 113 115.3
Gearing: Total borrowing 535 580 671
=33 % =32% =32 %
Borrowing+ Equity 1,621 1,835 2,077
It is difficult to reach conclusions about the performance of Vadener without more comparative data
from similar companies.

Return on capital at around 30% is dominated by the effect of high profit margins, but the split between
divisions is not provided. Asset utilisation is well below 1, which implies relatively inefficient utilisation of
assets. Vadener might investigate whether this could be improved.

Liquidity has improved during the last year, and although below some commonly used benchmarks
might be satisfactory for the sectors that Vadener is involved with. However, some aspects of working
capital require attention. Stock levels have increased from 28% of revenue in 20X3 to 33% in 20X5, and
the collection period for debtors has similarly increased from 114 days to 125 days. Creditors have also
increased more than proportionately to revenue. Vadener should take action to improve the efficiency
of its working capital management.
In contrast operating costs have fallen over the three years from 66% to 62% of revenue, indicating
greater efficiency. Gearing appears to be relatively low at around 32%, but comparative data is needed,
and interest cover is high at more than eight times in 20X5.

Investors do not appear to be entirely satisfied with group performance. The FT market index has
increased by 34% between 20X3 and 20X5, whereas Vadener’s share price has only increased by 26%.
With an equity beta of 1.1 Vadener’s share price would be expected to increase by more than the
market index. Vadener’s PE ratios are also lower than those of similar companies, suggesting that
investors do not value the company’s future prospects as highly as those of its competitors.

The required return from Vadener’s shares may be estimated using the capital asset pricing model
(CAPM).

Required return = 5% + (12% – 5%) 1.1 = 12.7%

An approximation of the actual return from Vadener’s shares is the 12% average annual increase in
share price plus 4% annual dividend yield, or 16%. The total return is higher than expected for the
systematic risk. Given this, Vadener should investigate the reasons why its share price has performed
relatively poorly. One possibility is the company’s dividend policy.

Dividends have consistently been more than 50% of available after tax earnings, which might not be
popular with investors.

Divisional performance

The information on the individual divisions is very sparse. All divisions are profitable, but the return from
the pharmaceutical division is relatively low for its systematic risk.

Using CAPM to approximate required returns:

Required return Actual return

Construction 5% + (12% – 5%) 0.75 = 10.25% 13%
Leisure 5% + (12% – 5%) 1.1 = 12.7% 16%
1
Pharmaceuticals 5% + (12% – 5%) 1.40 = 14.8% 14%
1
It is assumed that the same market parameters are valid for the US based division.

The construction and leisure divisions appear to have greater than expected returns (a positive alpha)
and the pharmaceutical division slightly less than expected for the risk of the division. The
pharmaceutical division has recently suffered a translation loss due to the weakness of the US dollar,
and the potential economic exposure from changes in the value of the dollar should be investigated.

From a financial perspective it would appear that the company should not devote equal resources to the
divisions, and should focus its efforts on construction and leisure. However, the future prospects of the
sectors are not known, nor the long term strategy of Vadener, which might be to expand international
operations in the USA or elsewhere. The strategic use of resources should not be decided on the basis of
the limited financial information that is available.
(b) Other information that would be useful includes:

(i) Cash flow forecasts for the group and the individual divisions.

(ii) Full product and market information for each of the divisions.

(iii) Details of recent investments in each of the divisions and the expected impact of such investment on
future performance.

(iv) Detailed historic performance data of the divisions over at least three years, and similar data for
companies in the relevant sectors.

(v) Competitors and potential growth rates in each of the sectors.

(vi) The economic exposure of the US division

(vii) The future strategic plans of Vadener. Are there any other proposed initiatives?

(viii) How the company’s equal resource strategy will be viewed by investors. The company has
performed worse than the market in recent years despite having a higher beta than the market.

(c) A translation loss of £10 million is not necessarily a problem for Vadener plc.

Translation exposure, sometimes known as accounting exposure, often does not reflect any real cash
flow changes. It is changes in cash flow that, in an efficient market, will impact on the share price and
value of a company. For example, a translation loss might in part reflect a lower home currency value of
an overseas factory, but the factory will still be the same and will still be producing goods. It is the
impact on the home currency cash flows from the continuing operations of the factory that will affect
share price.

However, if the market is not efficient, investors might not understand that there are no real cash flow
implications from the exposure, and might be worried about the effect of the translation loss on
Vadener, and possibly sell their shares. If this is the case Vadener might consider internal hedges to
reduce translation exposure. In most cases this would not be recommended, and companies must also
be careful that hedges to manage translation exposure do not adversely affect the efficient operations
of the business, or be contrary to hedges that are being undertaken to protect against other forms of
currency exposure such as transaction exposure.

(d) Income may be increased by writing (selling) options, as the writer of the option receives the option
premium.

However, unless the option is hedged, writing options exposes the writer to a theoretically unlimited
loss.

Uncovered writing of options is effectively speculating, involves very high risk, and is not normally
recommended as a strategy to companies such as Vadener.