Question

Mr. Preprah is the chairman of PALOO company and has become concerned about the accumulation of cash in hand and in the deposit accounts shown in the company's statement of financial position. The company is in the manufacturing sector, supplying engines to the auto markets in the Ghana and Africa. For the last 30 years the company has grown predominantly by acquisition and has not invested significantly in research and development on its own account. The acquisitions have given the company the technology that it has required and have all tended to be small, relative to the company's total market capitalisation.

The company has a healthy current asset ratio of 1.3, although its working capital cycle has an average of 24 unfunded days. The company has not systematically embraced new manufacturing technologies nor has it sought to reduce costs as a way of rebuilding profitability. Managerial and structural problems within divisions have led to a number of substantial projects overrunning and losses being incurred as a result. It has also proven difficult to ensure the accountability of managers promoting projects – many of which have not subsequently earned the cash flows originally promised. At the corporate level, much of the company's accounting is on a contracts basis and over the years it has tended to be cautious in its revenue recognition practices. This has meant that earnings growth
has lagged behind cash flow.

Over the last year the company has come under strong competitive pressure on the dominant defence side of its business which, coupled with the slow-down in spending in this area across the major African economies, has slowed the rate of growth of its earnings. The company's gearing ratio is very low at 12% of total market capitalisation and borrowing has invariably been obtained in the European fixed interest market and used to support capital investment in its Africa production facility. In the current year, investment plans are at the lowest they have been in real terms since the company was founded in the 1930s.

In discussion, the chairman comments upon the poor nature of the company's buildings and its poor levels of pay which could, in his view, be improved to reflect standards across the industry. Directors' pay, he reminds you, is some 15% below industry benchmarks and there is very little equity participation by the board of directors. He also points out that the company's environmental performance has not been good. Last year the company was fined for an untreated discharge into a local river. There are, he says, many useful things the company could do with the money to help improve the long-term health of the business. However, he does admit some pessimism that
business opportunities will ever again be the same as in previous years and he would like a free and frank discussion at the next board meeting about the options for the company. The company has a very open culture where ideas are encouraged and freely debated.

Mr. Preprah asks if you, as the newly appointed Finance Director, would lead the discussion at the next board.

(a) In preparation for a board paper entitled 'Agenda for Change', write brief notes which identify the strategic financial issues the company faces and the alternatives it might pursue.

(b) Identify and discuss any ethical issues you believe are in the above case and how the various alternatives you have identified in (a) may lead to their resolution.

Answer 1

Ans a).

Agenda for Change

Board Paper on Strategic Financial Issues that may be discussed in the Board Meeting .

To,

Mr Preprah,

Chairman to PALOO,

Consequent to the discusiions and deliberation reagrding the strategic finacial issues, the following points are presented for your consideration and review during the Board Meeting.

1. Reviewing the Revenue recognition principles. As the Cash pile up suggests, the cash flow is effectivley exceeding the revenue recognitions done in books of accounts. As the company is following a considerabley conservative approach but the cash flow is exceeding the earning growth , the company needs to review and reconsider the revenue recogfnition approach to become more practical and not unnecessarily conservative. This will improve the earning reported and definitely increase the share price and market capitalization.

2. Investment in R&D : As the competion is becoming stiff , the company needs to consider in investing in R&D projects to improve the quality and reduce cost of its products. Imroved and cost effective products can improve the market share and also help in finding new market segments to make up for the losses in the existing markets. The cash reserve can be used for this.

3. It is important to reveiew the pay to Directors and employees which are 15% below the industry benchmark. Increased pay using the cash reserve can be linked to the accountability and performance of the Projects to which the Directors and employees are responsible for. Higher pay link to performance will improve the project completion and cash flow situations and a sense of ownership will develop in the long run.

4. Improvement of company building : As the buidling condition is poor, the company may consider repairing it with the cash available.

5. Agrreessive acquisition and Market development: As the company has cash reserves, it can take decisions of aggressive expansion into new markets and geographical regions ( considering the loss of market in Africa) . It should aim for new and improved cost effective product through R&D, better project execution by the employees encouraged by better pay, and expansion by penetrating new market and acquiring new companies using its cash reserve. As its geraing ratio is very less (%) it can decide to go for additional borrowing to fund for the additional capital needed for any protential expansion or acquisition.

Ans b)

The company has some ethical issues. It has been fined for environmental issues last year when it used to discharge untreated effluents into Local rivers. This is clearly an act of environmental degradation and the company must take measure to avoid such happenings.

The company must install effluent treatment plant to proerly treat it effluent before discharging into rivers. The cash reserve can be utilized for any investment for such plants.

Also the R&D Team can take up projects that can enhance the use of environmentally safe raw materials, reduce in process polluting material production and focus on reusing and recycling of materials.