AFIN 253: Financial Management - Finance - Assessment Answer

Finance Assignment

Assignment Task

The Chief Investment Officer (CIO) of Rammstein Holdings, one of Germany’s largest hedge funds, Mr Till Lindemann has contracted your company, Accept Consulting to investigate Breville Group Ltd (Breville) and GUD Holdings Ltd (GUD). Both these companies are leaders in the small appliance market in Australia and Mr Lindemann believes that his clients would benefit from the diversification these companies would bring to an international share portfolio. With this in mind, Rammstein is considering investing substantial amounts in either company but is being cautious given the current state of the Australian economy. Lindemann is interested to understand what the cashflow degree of operating leverage (DOL) is for these companies for 2014 and 2015. A copy of these reports has been provided on Ilearn.

They have requested that you prepare a report for them that detail the following information.

1. The Cashflow DOL for 2014 and 2015 for GUD and Breville using information contained in their 2015 Annual Reports. (Any calculations and assumptions must be detailed in an appendix and not appear in the body of the report).
2. Where there are significant differences in the DOL between the companiesthe reason for this should be explained.
3. Where there are significant differences between years for either companythe reason for the difference should be explained.
4. A short summary of the reasons that analysis of the accounting and cash flow DOL is useful for a prospective investor. This should be supported by appropriate academic research.You will be assessed on the following criteria:
5. Accuracy of calculations presented. (2 marks)
6. Explanation/analysis of relevant changes in DOL. (4 Marks)
7. Analysis of reasons why analysis of accounting and cashflow DOL may beuseful for a prospective investor (5 marks)
8. Depth and Quality of research undertaken to support your answers. (2marks)
9. Grammar, spelling and referencing style (2 Marks)
10. Assignments should be succinct in their language and arguments.

Academic Honesty Policy https://www.mq.edu.au/policy/docs/academic_honesty/policy.html

You are required to submit the following:

1. You are required to submit an assignment of no more than 1000 words inilearn by the due date. Any words beyond this limit will not be marked.
2. You are required to display the word count at the top of your assignment.
3. You are expected to submit using 12-point double spaced Arial font.
4. You will be required to copy and paste it into the submission box.
5. You are encouraged to research this topic well in advance of preparing towrite your submission.
6. You are required to reference using the Harvard Referencing style.
7. References should be from credible sources (Note: Wikipedia andInvestopedia are not acceptable).

Analysis

2 The significant differences in the DOL calculations for both the companies reflects the sensitive nature of the pre-tax operating cash flows in response to changes in revenue. It also signifies that the risk of uncertainty on the forecasts for these companies depending on the computed DOL in both cases.

Gud holdings has a DOL of 2.69 while Breville DOL is 1.91 implying that the cash flows of Gud will vary by 2.69% and for Breville by 1.91 % with a 1% change in revenue in 2015. Gud holdings has a DOL of 3.86 while Breville DOL is 1.89 implying that the cash flows of Gud will vary by 3.86 % and for Breville by 1.89 % with a 1% change in revenue in 2014. (Details in Appendicle). To be noted that the DOL is dropping with increase in revenue in both cases. The EBITDA response to the change in revenue (fixed costs are unlikely to change) could also be the reason for the difference. The DOL for both the companies is different for both the years depending on the revenue change as well as the increase and decrease of the fixed costs (Parrino and Kidwell, 2009)

3 The significant differences in the DOL for the two years for both the companies are attributed to the fact that Gud’s fixed costs were lower compared to Breville. By implication Gud made more profit comparatively on additional sales. The EBITDA for Gud increased while the fixed costs reduced from 2014 to 2015 causing the DOL to fall in 2015. The EBITDA for Breville fell minor while the fixed costs increased minor from 2014 to 2015 causing the DOL to rise minor in 2015. Since the change in Breville case in respect of fixed costs and EBITA was not profound, a significant change in DOL was not noted.

4 A prospective investor would benefit with the knowledge of the Accounting and Cash flow DOL as he will be able to get an idea of the certainty of the cash flow and revenue predictions depending on the sensitivity of the EBITDA and EBIT with operating cash flows to changes in revenue. The forecasting risk would be higher where these two computations are on the higher side signifying that even a small change in in sales would impact the cash flow projections in a big way.

The analysis would also aid the investor in the contribution and breakeven analysis of the companies where he intends to invest. Companies with higher DOL represent higher risks as their revenues are more prone to changes in demand, competitors marketing strategies and other factors. They also get a clear idea on the best choice between two companies in the same industry for investment purposes.

The analysis also aids high fixed costs industries like aviation and heavy machinery. Increase in the profits of the company would imply greater recovery if fixed costs thereby making it even more important to discern the degree of operating leverage so as to make an informed best judgement on the best investment option available. This is due to the fact that two similar companies with similar or equal revenue and operating profits may have different degree of operating leverage due to the presence of different fixed costs which would impact their risk profile in a big way. In case of high fixed cost industries profits tend to decline with increasing revenues due to the allocation of the contribution margin towards the recovery of the huge fixed cost component. (Gahlon and Gentry, 1982)

So the investor’s interpretation of the accounting and cash flow DOL is simply that the company with greater DOL has more possibility of riskier and fluctuating revenue and profits while the company with low DOL is a safe proposition comparatively. This happens due to uncertain operating cash flows and volatile revenue and profits. The investor will select a company based on his risk profile at a given point of time. (Lev,1974) Hedge funds select portfolios on the basis of minimum risk parameters for the portfolio taken as a whole. Preference ranking is assigned to each potential security comprising the portfolio on the basis of the degree of risk. Conservative investors will opt for low DOL companies, while aggressive investors will opt for high DOL companies in a hope for huge profits. (Nitin D Sharma, 2015)

Conclusion

The significant differences in the DOL calculations for both the companies reflects the sensitive nature of the pre-tax operating cash flows in response to changes in revenue. The significant differences in the DOL for the two years for both the companies are attributed to the fact that Gud’s fixed costs were lower compared to Breville.

The investor’s interpretation of the accounting and cash flow DOL is simply that the company with greater DOL has more possibility of riskier and fluctuating revenue and profits while the company with low DOL is a safe proposition comparatively. This happens due to uncertain operating cash flows and volatile revenue and profits. The investor will select a company based on his risk profile at a given point of time. Hedge funds select portfolios on the basis of minimum risk parameters for the portfolio taken as a whole.