f9 past years

Financial Management

Time allowed Reading and planning: 15 minutesWriting: 3 hours

ALL FOUR questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

This question paper must not be removed from the examination hall.

Fundamentals Pilot Paper – Skills module

Pape

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The Association of Chartered Certified Accountants

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ALL FOUR questions are compulsory and MUST be attempted

1 Droxfol Co is a listed company that plans to spend $10m on expanding its existing business. It has been suggested

that the money could be raised by issuing 9% loan notes redeemable in ten years’ time. Current financial information on Droxfol Co is as follows.

Incomestatementinformationforthelastyear $000 Profit before interest and tax 7,000 Interest (500) Profit before tax 6,500 Tax (1,950) Profit for the period 4,550

Balancesheetforthelastyear $000 $000 Non-current assets 20,000 Current assets 20,000 Total assets 40,000 Equityandliabilities Ordinary shares, par value $1 5,000 Retained earnings 22,500 Total equity 27,500 10% loan notes 5,000 9% preference shares, par value $1 2,500 Total non-current liabilities 7,500 Current liabilities 5,000 Total equity and liabilities 40,000

The current ex div ordinary share price is $4.50 per share. An ordinary dividend of 35 cents per share has just been paid and dividends are expected to increase by 4% per year for the foreseeable future. The current ex div preference share price is 76.2 cents. The loan notes are secured on the existing non-current assets of Droxfol Co and are redeemable at par in eight years’ time. They have a current ex interest market price of $105 per $100 loan note. Droxfol Co pays tax on profits at an annual rate of 30%.

The expansion of business is expected to increase profit before interest and tax by 12% in the first year. Droxfol Co has no overdraft.

Averagesectorratios: Financial gearing: 45% (prior charge capital divided by equity capital on a book value basis) Interest coverage ratio: 12 times

Required:

(a) Calculate the current weighted average cost of capital of Droxfol Co. (9 marks)

(b) Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted average cost of capital to a minimum level. (8 marks)

(c) Evaluate and comment on the effects, after one year, of the loan note issue and the expansion of business on the following ratios:

(i) interest coverage ratio; (ii) financial gearing; (iii) earnings per share.

Assume that the dividend growth rate of 4% is unchanged. (8 marks)

(25 marks)



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2 Nedwen Co is a UK-based company which has the following expected transactions..

One month: Expected receipt of $240,000 One month: Expected payment of $140,000 Three months: Expected receipts of $300,000

The finance manager has collected the following information:

Spot rate ($ per £): 1.7820 ± 0.0002 One month forward rate ($ per £): 1.7829 ± 0.0003 Three months forward rate ($ per £): 1.7846 ± 0.0004

Money market rates for Nedwen Co: Borrowing Deposit One year sterling interest rate: 4.9% 4.6 One year dollar interest rate: 5.4% 5.1

Assume that it is now 1 April.

Required:

(a) Discuss the differences between transaction risk, translation risk and economic risk. (6 marks)

(b) Explain how inflation rates can be used to forecast exchange rates. (6 marks)

(c) Calculate the expected sterling receipts in one month and in three months using the forward market. (3 marks)

(d) Calculate the expected sterling receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used. (5 marks)

(e) Discuss how sterling currency futures contracts could be used to hedge the three-month dollar receipt. (5 marks)

(25 marks)

3 Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.

Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay.

Required:

(a) Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co. (6 marks)

(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%.

Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller-Orr model and explain the relevance of these values for the cash management of the company. (6 marks)

(c) Identify and explain the key areas of accounts receivable management. (6 marks)

(d) Discuss the key factors to be considered when formulating a working capital funding policy. (7 marks)

(25 marks)



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4 Trecor Co plans to buy a new machine to meet expected demand for a new product, Product T. This machine will cost $250,000 and last for four years, at the end of which time it will be sold for $5,000. Trecor Co expects demand for Product T to be as follows:

Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000

The selling price for Product T is expected to be $12.00 per unit and the variable cost of production is expected to be $7.80 per unit. Incremental annual fixed production overheads of $25,000 per year will be incurred. Selling price and costs are all in current price terms.

Selling price and costs are expected to increase as follows:

Increase Selling price of Product T: 3% per year Variable cost of production: 4% per year Fixed production overheads: 6% per year

Other information

Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is expected to be 5% per year.

Trecor Co has a target return on capital employed of 20%. Depreciation is charged on a straight-line basis over the life of an asset.

Required:

(a) Calculate the net present value of buying the new machine and comment on your findings (work to the nearest $1,000). (13 marks)

(b) Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment and comment on your findings. (5 marks)

(c) Discuss the strengths and weaknesses of internal rate of return in appraising capital investments. (7 marks)

(25 marks)



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Formulae Sheet

Economicorderquantity

Miller–OrrModel

TheCapitalAssetPricingModel

Theassetbetaformula

TheGrowthModel

Gordon’sgrowthapproximation

Theweightedaveragecostofcapital

TheFisherformula

Purchasingpowerparityandinterestrateparity

Economic order quantity = 2C DC

Miller – Or

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H

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Return point = Lower limit + (13

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Spread = 3 x transaction cost x va3

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9

Answers



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Pilot Paper F9 AnswersFinancial Management

1 (a) Calculation of weighted average cost of capital (WACC)

Market values Market value of equity = 5m x 4.50 = $22.5 million Market value of preference shares = 2.5m x .0762 = $1.905 million Market value of 10% loan notes = 5m x (105/ 100) = $5.25 million Total market value = 22.5m + 1.905m + 5.25m = $29.655 million

Cost of equity using dividend growth model = [(35 x 1.04)/ 450] + 0.04 = 12.08%

Cost of preference shares = 100 x 9/ 76.2 = 11.81%

Annual after-tax interest payment = 10 x 0.7 = $7

Year Cashflow $ 10%DFPV($)5%DFPV($) 0 market value (105) 1.000 (105) 1.000 (105) 1–8 interest 7 5.335 37.34 6.463 45.24 8 redemption 100 0.467 46.70 0.677 67.70 (20.96) 7.94

Using interpolation, after-tax cost of loan notes = 5 + [(5 x 7.94)/ (7.94 + 20.96)] = 6.37%

WACC = [(12.08 x 22.5) + (11.81 x 1.905) + (6.37 x 5.25)]/ 29.655 = 11.05%

(b) Droxfol Co has long-term finance provided by ordinary shares, preference shares and loan notes. The rate of return required by each source of finance depends on its risk from an investor point of view, with equity (ordinary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Ignoring taxation, the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is replaced by debt, since debt is cheaper than equity, i.e. the cost of debt is less than the cost of equity.

However, financial risk increases as equity is replaced by debt and so the cost of equity will increase as a company gears up, offsetting the effect of cheaper debt. At low and moderate levels of gearing, the before-tax cost of debt will be constant, but it will increase at high levels of gearing due to the possibility of bankruptcy. At high levels of gearing, the cost of equity will increase to reflect bankruptcy risk in addition to financial risk.

In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at higher levels of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view, therefore, Droxfol Co can gear up using debt and reduce its WACC to a minimum, at which point its market value (the present value of future corporate cash flows) will be maximised.

In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital market, Miller and Modigliani demonstrated that the WACC remained constant as a company geared up, with the increase in the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital market the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani showed, therefore, that the market value of a company depends on its business risk alone, and not on its financial risk. On this view, therefore, Droxfol Co cannot reduce its WACC to a minimum.

When corporate tax was admitted into the analysis of Miller and Modigliani, a different picture emerged. The interest payments on debt reduced tax liability, which meant that the WACC fell as gearing increased, due to the tax shield given to profits. On this view, Droxfol Co could reduce its WACC to a minimum by taking on as much debt as possible.

However, a perfect capital market is not available in the real world and at high levels of gearing the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk and other costs associated with the need to service large amounts of debt. Droxfol Co should therefore be able to reduce its WACC by gearing up, although it may be difficult to determine whether it has reached a capital structure giving a minimum WACC.

(c) (i) Interest coverage ratio Current interest coverage ratio = 7,000/ 500 = 14 times Increased profit before interest and tax = 7,000 x 1.12 = $7.84m Increased interest payment = (10m x 0.09) + 0.5m = $1.4m Interest coverage ratio after one year = 7.84/ 1.4 = 5.6 times

The current interest coverage of Droxfol Co is higher than the sector average and can be regarded as quiet safe. Following the new loan note issue, however, interest coverage is less than half of the sector average, perhaps indicating that Droxfol Co may not find it easy to meet its interest payments.



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(ii) Financial gearing This ratio is defined here as prior charge capital/equity share capital on a book value basis Current financial gearing = 100 x (5,000 + 2,500)/ (5,000 + 22,500) = 27% Ordinary dividend after one year = 0.35 x 5m x 1.04 = $1.82 million Total preference dividend = 2,500 x 0.09 = $225,000

Incomestatementafteroneyear $000 $000 Profit before interest and tax 7,840 Interest (1,400) Profit before tax 6,440 Income tax expense (1,932) Profit for the period 4,508 Preference dividends 225 Ordinary dividends 1,820 (2,045) Retained earnings 2,463

Financial gearing after one year = 100 x (15,000 + 2,500)/ (5,000 + 22,500 + 2,463) = 58%

The current financial gearing of Droxfol Co is 40% less (in relative terms) than the sector average and after the new loan note issue it is 29% more (in relative terms). This level of financial gearing may be a cause of concern for investors and the stock market. Continued annual growth of 12%, however, will reduce financial gearing over time.

(iii) Earnings per share Current earnings per share = 100 x (4,550 – 225)/ 5,000 = 86.5 cents Earnings per share after one year = 100 x (4,508 - 225)/ 5,000 = 85.7 cents

Earnings per share is seen as a key accounting ratio by investors and the stock market, and the decrease will not be welcomed. However, the decrease is quiet small and future growth in earnings should quickly eliminate it.

The analysis indicates that an issue of new debt has a negative effect on the company’s financial position, at least initially. There are further difficulties in considering a new issue of debt. The existing non-current assets are security for the existing 10% loan notes and may not available for securing new debt, which would then need to be secured on any new non-current assets purchased. These are likely to be lower in value than the new debt and so there may be insufficient security for a new loan note issue. Redemption or refinancing would also pose a problem, with Droxfol Co needing to redeem or refinance $10 million of debt after both eight years and ten years. Ten years may therefore be too short a maturity for the new debt issue.

An equity issue should be considered and compared to an issue of debt. This could be in the form of a rights issue or an issue to new equity investors.

2 (a) Transaction risk This is the risk arising on short-term foreign currency transactions that the actual income or cost may be different from the

income or cost expected when the transaction was agreed. For example, a sale worth $10,000 when the exchange rate is $1.79 per £ has an expected sterling value is $5,587. If the dollar has depreciated against sterling to $1.84 per £ when the transaction is settled, the sterling receipt will have fallen to $5,435. Transaction risk therefore affects cash flows and for this reason most companies choose to hedge or protect themselves against transaction risk.

Translationrisk This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known as

accounting exposure. Consider an asset worth €14 million, acquired when the exchange rate was €1.4 per $. One year later, when financial statements are being prepared, the exchange rate has moved to €1.5 per $ and the balance sheet value of the asset has changed from $10 million to $9.3 million, resulting an unrealised (paper) loss of $0.7 million. Translation risk does not involve cash flows and so does not directly affect shareholder wealth. However, investor perception may be affected by the changing values of assets and liabilities, and so a company may choose to hedge translation risk through, for example, matching the currency of assets and liabilities (eg a euro-denominated asset financed by a euro-denominated loan).

Economicrisk Transaction risk is seen as the short-term manifestation of economic risk, which could be defined as the risk of the present

value of a company’s expected future cash flows being affected by exchange rate movements over time. It is difficult to measure economic risk, although its effects can be described, and it is also difficult to hedge against it.

(b) The law of one price suggests that identical goods selling in different countries should sell at the same price, and that exchange rates relate these identical values. This leads on to purchasing power parity theory, which suggests that changes in exchange rates over time must reflect relative changes in inflation between two countries. If purchasing power parity holds true, the expected spot rate (Sf) can be forecast from the current spot rate (S0) by multiplying by the ratio of expected inflation rates ((1 + if)/ (1 + iUK)) in the two counties being considered. In formula form: Sf = S0 (1 + if)/ (1 + iUK).



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This relationship has been found to hold in the longer-term rather than the shorter-term and so tends to be used for forecasting exchange rates several years in the future, rather than for periods of less than one year. For shorter periods, forward rates can be calculated using interest rate parity theory, which suggests that changes in exchange rates reflect differences between interest rates between countries.

(c) Forward market evaluation

Net receipt in 1 month = 240,000 – 140,000 = $100,000 Nedwen Co needs to sell dollars at an exchange rate of 1.7829 + 0.003 = $1.7832 per £ Sterling value of net receipt = 100,000/ 1.7832 = $56,079

Receipt in 3 months = $300,000 Nedwen Co needs to sell dollars at an exchange rate of 1.7846 + 0.004 = $1.7850 per £ Sterling value of receipt in 3 months = 300,000/ 1.7850 = $168,067

(d) Evaluation of money-market hedge

Expected receipt after 3 months = $300,000 Dollar interest rate over three months = 5.4/ 4 = 1.35% Dollars to borrow now to have $300,000 liability after 3 months = 300,000/ 1.0135 = $296,004 Spot rate for selling dollars = 1.7820 + 0.0002 = $1.7822 per £ Sterling deposit from borrowed dollars at spot = 296,004/ 1.7822 = $166,089 Sterling interest rate over three months = 4.6/ 4 = 1.15% Value in 3 months of sterling deposit = 166,089 x 1.0115 = $167,999

The forward market is marginally preferable to the money market hedge for the dollar receipt expected after 3 months.

(e) A currency futures contract is a standardised contract for the buying or selling of a specified quantity of foreign currency. It is traded on a futures exchange and settlement takes place in three-monthly cycles ending in March, June, September and December, ie a company can buy or sell September futures, December futures and so on. The price of a currency futures contract is the exchange rate for the currencies specified in the contract.

When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Nedwen Co expects to receive $300,000 in three months’ time and so is concerned that sterling may appreciate (strengthen) against the dollar, since this would result in a lower sterling receipt. The company can hedge the receipt by buying sterling currency futures contracts in the US and since it is 1 April, would buy June futures contracts. In June, Nedwen Co could sell the same number of US sterling currency futures it bought in April and sell the $300,000 it received on the currency market.

3 (a) Evaluation of change in credit policy

Current average collection period = 30 + 10 = 40 days Current accounts receivable = 6m x 40/ 365 = $657,534 Average collection period under new policy = (0.3 x 15) + (0.7 x 60) = 46.5 days New level of credit sales = $6.3 million Accounts receivable after policy change = 6.3 x 46.5/ 365 = $802,603 Increase in financing cost = (802,603 – 657,534) x 0.07 = $10,155

$ Increase in financing cost 10,155 Incremental costs = 6.3m x 0.005 = 31,500 Cost of discount = 6.3m x 0.015 x 0.3 = 28,350 Increase in costs 70,005 Contribution from increased sales = 6m x 0.05 x 0.6 = 180,000 Net benefit of policy change 109,995

The proposed policy change will increase the profitability of Ulnad Co

(b) Determination of spread: Daily interest rate = 5.11/ 365 = 0.014% per day Variance of cash flows = 1,000 x 1,000 = $1,000,000 per day Transaction cost = $18 per transaction

Spread = 3 x ((0.75 x transaction cost x variance)/interest rate)1/3

= 3 x ((0.75 x 18 x 1,000,000)/ 0.00014)1/3 = 3 x 4,585.7 = $13,757



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Lower limit (set by Renpec Co) = $7,500 Upper limit = 7,500 + 13,757 =$21,257 Return point = 7,500 + (13,757/ 3) = $12,086

The Miller-Orr model takes account of uncertainty in relation to receipts and payment. The cash balance of Renpec Co is allowed to vary between the lower and upper limits calculated by the model. If the lower limit is reached, an amount of cash equal to the difference between the return point and the lower limit is raised by selling short-term investments. If the upper limit is reached an amount of cash equal to the difference between the upper limit and the return point is used to buy short-term investments. The model therefore helps Renpec Co to decrease the risk of running out of cash, while avoiding the loss of profit caused by having unnecessarily high cash balances.

(c) There are four key areas of accounts receivable management: policy formulation, credit analysis, credit control and collection of amounts due.

Policyformulation This is concerned with establishing the framework within which management of accounts receivable in an individual company

takes place. The elements to be considered include establishing terms of trade, such as period of credit offered and early settlement discounts: deciding whether to charge interest on overdue accounts; determining procedures to be followed when granting credit to new customers; establishing procedures to be followed when accounts become overdue, and so on.

Creditanalysis Assessment of creditworthiness depends on the analysis of information relating to the new customer. This information is often

generated by a third party and includes bank references, trade references and credit reference agency reports. The depth of credit analysis depends on the amount of credit being granted, as well as the possibility of repeat business.

Creditcontrol Once credit has been granted, it is important to review outstanding accounts on a regular basis so overdue accounts can be

identified. This can be done, for example, by an aged receivables analysis. It is also important to ensure that administrative procedures are timely and robust, for example sending out invoices and statements of account, communicating with customers by telephone or e-mail, and maintaining account records.

Collectionofamountsdue Ideally, all customers will settle within the agreed terms of trade. If this does not happen, a company needs to have in place

agreed procedures for dealing with overdue accounts. These could cover logged telephone calls, personal visits, charging interest on outstanding amounts, refusing to grant further credit and, as a last resort, legal action. With any action, potential benefit should always exceed expected cost.

(d) When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent current assets and fluctuating current assets. Permanent current assets represent the core level of working capital investment needed to support a given level of sales. As sales increase, this core level of working capital also increases. Fluctuating current assets represent the changes in working capital that arise in the normal course of business operations, for example when some accounts receivable are settled later than expected, or when inventory moves more slowly than planned.

The matching principle suggests that long-term finance should be used for long-term assets. Under a matching working capital funding policy, therefore, long-term finance is used for both permanent current assets and non-current assets. Short-term finance is used to cover the short-term changes in current assets represented by fluctuating current assets.

Long-term debt has a higher cost than short-term debt in normal circumstances, for example because lenders require higher compensation for lending for longer periods, or because the risk of default increases with longer lending periods. However, long-term debt is more secure from a company point of view than short-term debt since, provided interest payments are made when due and the requirements of restrictive covenants are met, terms are fixed to maturity. Short-term debt is riskier than long-term debt because, for example, an overdraft is repayable on demand and short-term debt may be renewed on less favourable terms.

A conservative working capital funding policy will use a higher proportion of long-term finance than a matching policy, thereby financing some of the fluctuating current assets from a long-term source. This will be less risky and less profitable than a matching policy, and will give rise to occasional short-term cash surpluses.

An aggressive working capital funding policy will use a lower proportion of long-term finance than a matching policy, financing some of the permanent current assets from a short-term source such as an overdraft. This will be more risky and more profitable than a matching policy.

Other factors that influence a working capital funding policy include management attitudes to risk, previous funding decisions, and organisation size. Management attitudes to risk will determine whether there is a preference for a conservative, an aggressive or a matching approach. Previous funding decisions will determine the current position being considered in policy formulation. The size of the organisation will influence its ability to access different sources of finance. A small company, for example, may be forced to adopt an aggressive working capital funding policy because it is unable to raise additional long-term finance, whether equity of debt.



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4 (a) Calculation of NPV

Nominal discount rate using Fisher effect: 1.057 x 1.05 = 1.1098 ie 11%

Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales (W1) 433 509 656 338 Variable cost (W2) 284 338 439 228 Contribution 149 171 217 110 Fixed production overheads 27 28 30 32 Net cash flow 122 143 187 78 Tax (37) (43) (56) (23) CA tax benefits (W3) 19 14 11 30 After-tax cash flow 122 125 158 33 7 Disposal 5 After-tax cash flow 122 125 158 38 7 Discount factors 0.901 0.812 0.731 0.659 0.593 Present values 110 102 115 25 4

$ PV of benefits 356,000 Investment 250,000 NPV 106,000

Since the NPV is positive, the purchase of the machine is acceptable on financial grounds.

Workings

(W1)Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000 Selling price ($/unit) 12.36 12.73 13.11 13.51 Sales ($/year) 432,600 509,200 655,500 337,750

(W2)Year 1 2 3 4 Demand (units) 35,000 40,000 50,000 25,000 Variable cost ($/unit) 8.11 8.44 8.77 9.12 Variable cost ($/year) 283,850 337,600 438,500 228,000

(W3)Year Capitalallowances Taxbenefits 1 250,000 x 0.25 = 62,500 62,500 x 0.3 = 18,750 2 62,500 x 0.75 = 46,875 46,875 x 0.3 = 14,063 3 46,875 x 0.75 = 35,156 25,156 x 0.3 = 10,547 4 By difference 100,469 100,469 x 0.3 = 30,141 250,000 – 5.000 = 245,000 73,501

(b) Calculation of before-tax return on capital employed

Total net before-tax cash flow = 122 + 143 + 187 + 78 = $530,000 Total depreciation = 250,000 – 5,000 = $245,000 Average annual accounting profit = (530 – 245)/ 4 = $71,250

Average investment = (250,000 + 5,000)/ 2 = $127,500

Return on capital employed = 100 x 71,250/ 127,500 = 56%

Given the target return on capital employed of Trecor Co is 20% and the ROCE of the investment is 56%, the purchase of the machine is recommended.

(c) One of the strengths of internal rate of return (IRR) as a method of appraising capital investments is that it is a discounted cash flow (DCF) method and so takes account of the time value of money. It also considers cash flows over the whole of the project life and is sensitive to both the amount and the timing of cash flows. It is preferred by some as it offers a relative measure of the value of a proposed investment, ie the method calculates a percentage that can be compared with the company’s cost of capital, and with economic variables such as inflation rates and interest rates.

IRR has several weaknesses as a method of appraising capital investments. Since it is a relative measurement of investment worth, it does not measure the absolute increase in company value (and therefore shareholder wealth), which can be found using the net present value (NPV) method. A further problem arises when evaluating non-conventional projects (where cash



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flows change from positive to negative during the life of the project). IRR may offer as many IRR values as there are changes in the value of cash flows, giving rise to evaluation difficulties. There is a potential conflict between IRR and NPV in the evaluation of mutually exclusive projects, where the two methods can offer conflicting advice as which of two projects is preferable. Where there is conflict, NPV always offers the correct investment advice: IRR does not, although the advice offered can be amended by considering the IRR of the incremental project. There are therefore a number of reasons why IRR can be seen as an inferior investment appraisal method compared to its DCF alternative, NPV.



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Pilot Paper F9 Marking SchemeFinancial Management

Marks Marks1 (a) Calculation of market values 2 Calculation of cost of equity 2 Calculation of cost of preference shares 1 Calculation of cost of debt 2 Calculation of WACC 2 9

(b) Relative costs of equity and debt 1 Discussion of theories of capital structure 7–8 Conclusion 1 Maximum 8

(c) Analysis of interest coverage ratio 2–3 Analysis of financial gearing 2–3 Analysis of earnings per share 2–3 Comment 2–3 Maximum 8 25

2 (a) Transaction risk 2 Translation risk 2 Economic risk 2 6

(b) Discussion of purchasing power parity 4–5 Discussion of interest rate parity 1–2 Maximum 6

(c) Netting 1 Sterling value of 3-month receipt 1 Sterling value of 1-year receipt 1 3

(d) Evaluation of money market hedge 4 Comment 1 5

(e) Definition of currency futures contract 1–2 Initial margin and variation margin 1–2 Buying and selling of contracts 1–2 Hedging the three-month receipt 1–2 Maximum 5 25



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Marks Marks3 (a) Increase in financing cost 2 Incremental costs 1 Cost of discount 1 Contribution from increased sales 1 Conclusion 1 6

(b) Calculation of spread 2 Calculation of upper limit 1 Calculation of return point 1 Explanation of findings 2 6

(c) Policy formulation 1–2 Credit analysis 1–2 Credit control 1–2 Collection of amounts due 1–2 Maximum 6

(d) Analysis of assets 1–2 Short-term and long-term debt 2–3 Discussion of policies 2–3 Other factors 1–2 Maximum 7 25

4 (a) Discount rate 1 Inflated sales revenue 2 Inflated variable cost 1 Inflated fixed production overheads 1 Taxation 2 Capital allowance tax benefits 3 Discount factors 1 Net present value 1 Comment 1 13

(b) Calculation of average annual accounting profit 2 Calculation of average investment 2 Calculation of return on capital employed 1 5

(c) Strengths of IRR 2–3 Weaknesses of IRR 5–6 Maximum 7 25



FinancialManagement andControl

PART 2

WEDNESDAY 11 DECEMBER 2002

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST beanswered

Section B TWO questions ONLY to be answered

Formulae sheet, present value and annuity tables are on pages 10 and 11

Pape

r 2.4



Section A – This ONE question is compulsory and MUST be attempted

1 Jack Geep will set up a new business as a sole trader on 1 January 2003 making decorative glassware. Jack is inthe process of planning the initial cash flows of the business. He estimates that there will not be any sales demandin January 2003 so production in that month will be used to build up stocks to satisfy the expected demand inFebruary 2003. Thereafter it is intended to schedule production in order to build up sufficient finished goods stock atthe end of each month to satisfy demand during the following month. Production will, however, need to be 5% higherthan sales due to expected defects that will have to be scrapped. Defects are only discovered after the goods havebeen completed. The company will not hold stocks of raw materials or work in progress.

As the business is new, demand is uncertain, but Jack has estimated three possible levels of demand in 2003 asfollows:

High Medium Lowdemand demand demand

£ £ £February 22,000 20,000 19,000March 26,000 24,000 23,000April 30,000 28,000 27,000May 29,000 27,000 26,000June 35,000 33,000 32,000

Demand for July 2003 onwards is expected to be the same as June 2003. The probability of each level of demandoccurring each month is as follows:

High 0·05; Medium 0·85; Low 0·10.

It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making smallpurchases. The remaining 90% of sales will be made on two months’ credit. A 2·5% discount will, however, beoffered to credit customers settling within one month. It is estimated that customers, representing half of credit salesby value, will take advantage of the discount while the remainder will take the full two months to pay.

Variable production costs (excluding costs of rejects) per £1,000 of sales are as follows:

£Labour 300Materials 200Variable overhead 100

Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears and variableoverheads are paid two months in arrears. Fixed production and administration overheads, excluding depreciation, are£7,000 per month and are payable in the same month as the expenditure is incurred.

Jack employed a firm of consultants to give him initial business advice. Their fee of £12,000 will be paid in February2003. Smelting machinery will be purchased on 1 January 2003 for £200,000 payable in February 2003. Furthermachinery will be purchased for £50,000 in March 2003 payable in April 2003. This machinery is highly specialisedand will have a low net realisable value after purchase.

Jack has redundancy money from his previous employment and savings totalling £150,000, which he intends to payinto his bank account on 1 January 2003 as the initial capital of the business. He realises that this will be insufficientfor his business plans, so he is intending to approach his bank for finance in the form of both a fixed term loan andan overdraft. The only asset Jack has is his house that is valued at £200,000, but he has an outstanding mortgageof £80,000 on this property.

The consultants advising Jack have recommended that rather than accumulating sufficient stock to satisfy thefollowing month’s demand he should not maintain any stock levels but merely produce sufficient in each month tomeet the expected demand for that month.

2



Jack’s production manager objected: ‘I need to set up my production schedule based on the expected average demandfor the month. I will reduce production in the month if it seems demand is low. However, there is no way productioncan be increased during the month to accommodate demand if it happens to be at the higher level that month. As aresult, under this new system, there would be no stocks to fall back on and the extra sales, when monthly demandis high, would be lost, as customers require immediate delivery.’ In respect of this, an assessment of the impact ofthe introduction of just-in-time stock management on cash flows has been made that showed the following:

January February March April May JuneNet cash 143,000 (223,279) (7,587) (50,667) 1,843 1,704flow (£)Month-end 143,000 (80,279) (87,866) (138,533) (136,690) (134,986)balance (£)

Required:

(a) Prepare a monthly cash budget for Jack Geep’s business for the six month period ending 30 June 2003.Calculations should be made on the basis of the expected values of sales. The cash budget should show thenet cash inflow or outflow in each month and the cumulative cash surplus or deficit at the end of each month.

For this purpose ignore bank finance and the suggested use of just-in-time stock management. (17 marks)

(b) Assume now that just-in-time stock management is used in accordance with the recommendations of theconsultants. Calculate for EACH of the six months ending 30 June 2003:

(i) receipts from sales; and

(ii) payments to labour. (6 marks)

(c) Evaluate the impact for Jack Geep of introducing just-in-time stock management. This should include anassessment of the wider implications of just-in-time stock management in the particular circumstances ofJack Geep’s business. (10 marks)

(d) Write a report to Jack Geep which identifies the financing needs of the company. It should consider thefollowing:

(i) the extent of financing required;

(ii) the factors that should be considered in determining the most appropriate mix of short-term financing(e.g. overdraft) and long-term financing (e.g. fixed term bank loan); and

(iii) the extent to which improved working capital management (other than just-in-time stock management)might reduce the company’s financing needs and describe how this might be achieved.

Where appropriate, show supporting calculations. (17 marks)

(50 marks)

3 [P.T.O.



Section B – TWO questions ONLY to be attempted

2 Private sector companies have multiple stakeholders who are likely to have divergent interests.

Required:

(a) Identify five stakeholder groups and briefly discuss their financial and other objectives. (12 marks)

(b) Examine the extent to which good corporate governance procedures can help manage the problems arisingfrom the divergent interests of multiple stakeholder groups in private sector companies in the UK.

(13 marks)

(25 marks)

4



3 Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been disappointing inrecent years and a new managing director, Peter Beech, was appointed to raise production volumes. After an initialassessment Peter Beech considered that budgets had been set at levels which made it easy for employees to achieve.He argued that employees would be better motivated by setting budgets which challenged them more in terms ofhigher expected output.

Other than changing the overall budgeted output, Mr Beech has not yet altered any part of the standard cost card.Thus, the budgeted output and sales for November 2002 was 4,000 benches and the standard cost card below wascalculated on this basis:

£Wood 25 kg at £3·20 per kg 80·00Labour 4 hours at £8 per hour 32·00Variable overheads 4 hours at £4 per hour 16·00Fixed overhead 4 hours at £16 per hour 64·00

–––––––192·00

Selling price 220·00–––––––

Standard profit 28·00–––––––

Overheads are absorbed on the basis of labour hours and the company uses an absorption costing system. There wereno stocks at the beginning of November 2002. Stocks are valued at standard cost.

Actual results for November 2002 were as follows:

£Wood 80,000 kg at £3·50 280,000Labour 16,000 hours at £7 112,000Variable overhead 60,000Fixed overhead 196,000

––––––––Total production cost (3,600 benches) 648,000Closing stock (400 benches at £192) 76,800

––––––––Cost of sales 571,200Sales (3,200 benches) 720,000

––––––––Actual profit 148,800

––––––––

The average monthly production and sales for some years prior to November 2002 had been 3,400 units and budgetshad previously been set at this level. Very few operating variances had historically been generated by the standardcosts used.

Mr Beech has made some significant changes to the operations of the company. However, the other directors are nowconcerned that Mr Beech has been too ambitious in raising production targets. Mr Beech had also changed suppliersof raw materials to improve quality, increased selling prices, begun to introduce less skilled labour, and significantlyreduced fixed overheads.

The finance director suggested that an absorption costing system is misleading and that a marginal costing systemshould be considered at some stage in the future to guide decision-making.

Required:

(a) Prepare an operating statement for November 2002. This should show all operating variances and shouldreconcile budgeted and actual profit for the month for Woodeezer Ltd. (14 marks)

(b) In so far as the information permits, examine the impact of the operational changes made by Mr Beech onthe profitability of the company. In your answer, consider each of the following:

(i) motivation and budget setting; and

(ii) possible causes of variances. (6 marks)

(c) Re-assess the impact of your comments in part (b), using a marginal costing approach to evaluating theimpact of the operational changes made by Mr Beech.

Show any relevant additional calculations to support your arguments. (5 marks)

(25 marks)

5 [P.T.O.



4 Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The machine is essentialto the operations of the company. The company is, however, considering whether to purchase the machine outrightor to use lease financing.

Purchasing the machine outrightThe machine is expected to cost £360,000 if it is purchased outright, payable on 31 December 2002. After fouryears the company expects new technology to make the machine redundant and it will be sold on 31 December 2006generating proceeds of £20,000. Capital allowances for tax purposes are available on the cost of the machine at therate of 25% per annum reducing balance. A full year’s allowance is given in the year of acquisition but no writingdown allowance is available in the year of disposal. The difference between the proceeds and the tax written downvalue in the year of disposal is allowable or chargeable for tax as appropriate.

LeasingThe company has approached its bank with a view to arranging a lease to finance the machine acquisition. The bankhas offered two options with respect to leasing which are as follows:

Finance OperatingLease Lease

Contract length (years) 4 1Annual rental £135,000 £140,000First rent payable 31 December 2003 31 December 2002

GeneralFor both the purchasing and the finance lease option, maintenance costs of £15,000 per year are payable at the endof each year. All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposesin full in the year of payment. Assume that tax is payable one year after the end of the accounting year in which thetransaction occurs. For the operating lease only, contracts are renewable annually at the discretion of either party.Leaminger plc has adequate taxable profits to relieve all its costs. The rate of corporation tax can be assumed to be30%. The company’s accounting year-end is 31 December. The company’s annual after tax cost of capital is 10%.

Required:

(a) Calculate the net present value at 31 December 2002, using the after tax cost of capital, for

(i) purchasing the machine outright;

(ii) using the finance lease to acquire the machine; and

(iii) using the operating lease to acquire the machine.

Recommend the optimal method. (12 marks)

(b) Assume now that the company is facing capital rationing up until 30 December 2003 when it expects to makea share issue. During this time the most marginal investment project, which is perfectly divisible, requires anoutlay of £500,000 and would generate a net present value of £100,000. Investment in the turbine wouldreduce funds available for this project. Investments cannot be delayed.

Calculate the revised net present values of the three options for the turbine given capital rationing. Advisewhether your recommendation in (a) would change. (5 marks)

(c) As their business advisor, prepare a report for the directors of Leaminger plc that assesses the issues thatneed to be considered in acquiring the turbine with respect to capital rationing. (8 marks)

(25 marks)

6



This is a blank page.

Question 5 begins on page 8.

7 [P.T.O.



8

5 Abkaber plc assembles three types of motorcycle at the same factory: the 50cc Sunshine; the 250cc Roadster andthe 1000cc Fireball. It sells the motorcycles throughout the world. In response to market pressures Abkaber plc hasinvested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the sizeof its workforce.

Historically, the company has allocated all overhead costs using total direct labour hours, but is now consideringintroducing Activity Based Costing (ABC). Abkaber plc’s accountant has produced the following analysis.

AnnualAnnual Direct RawOutput Labour Selling material(units) Hours Price cost

(£ per unit) (£ per unit)Sunshine 2,000 200,000 4,000 400Roadster 1,600 220,000 6,000 600Fireball 400 80,000 8,000 900

The three cost drivers that generate overheads are:

Deliveries to retailers – the number of deliveries of motorcycles to retail showroomsSet-ups – the number of times the assembly line process is re-set to accommodate a production run of

a different type of motorcyclePurchase orders – the number of purchase orders.

The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:

Number of Number of Number ofdeliveries set-ups purchase to retailers orders

Sunshine 100 35 400Roadster 80 40 300Fireball 70 25 100

The annual overhead costs relating to these activities are as follows:

£Deliveries to retailers 2,400,000Set-up costs 6,000,000Purchase orders 3,600,000

All direct labour is paid at £5 per hour. The company holds no stocks.

At a board meeting there was some concern over the introduction of activity based costing.

The finance director argued: ‘I very much doubt whether selling the Fireball is viable but I am not convinced thatactivity based costing would tell us any more than the use of labour hours in assessing the viability of each product.’

The marketing director argued: ‘I am in the process of negotiating a major new contract with a motorcycle rentalcompany for the Sunshine model. For such a big order they will not pay our normal prices but we need to at leastcover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averagescosts for our entire production’.

The managing director argued: ‘I believe that activity based costing would be an improvement but it still has itsproblems. For instance if we carry out an activity many times surely we get better at it and costs fall rather than remainconstant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.’

The chairman argued: ‘I cannot see the problem. The overall profit for the company is the same no matter whichmethod of allocating overheads we use. It seems to make no difference to me.’



Required:

(a) Calculate the total profit on each of Abkaber plc’s three types of product using each of the following methodsto attribute overheads:

(i) the existing method based upon labour hours; and

(ii) activity based costing. (13 marks)

(b) Write a report to the directors of Abkaber plc, as its management accountant. The report should:

(i) evaluate the labour hours and the activity based costing methods in the circumstances of Abkaber plc; and

(ii) examine the implications of activity based costing for Abkaber plc, and in so doing evaluate the issuesraised by each of the directors.

Refer to your calculations in requirement (a) above where appropriate. (12 marks)

(25 marks)

9 [P.T.O.



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15

Part 2 Examination – Paper 2.4Financial Management and Control December 2002 Answers

1 (a) Jack Geep

High Medium Low Expecteddemand demand demand demand

£ £ £ £February 22,000 x 0·05 20,000 x 0·85 19,000 x 0·1 20,000March 26,000 x 0·05 24,000 x 0·85 23,000 x 0·1 24,000April 30,000 x 0·05 28,000 x 0·85 27,000 x 0·1 28,000May 29,000 x 0·05 27,000 x 0·85 26,000 x 0·1 27,000June 35,000 x 0·05 33,000 x 0·85 32,000 x 0·1 33,000

January February March April May JuneReceipts £ £ £ £ £ £Capital 150,000Cash sales (W1) 2,000 2,400 2,800 2,700 3,300 Credit sales (W1) 8,775 10,530 12,285 11,846Credit sales (W1) 9,000 10,800 12,600

PaymentsFixed assets 200,000 50,000Labour (W2) 6,300 7,560 8,820 8,505 10,395 10,395Materials (W2) 4,200 5,040 5,880 5,670 6,930Overheads (W2) 2,100 2,520 2,940 2,835Fixed costs 7,000 7,000 7,000 7,000 7,000 7,000Consultant 12,000

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––Net cash flow 136,700 (228,760) (11,785) (51,575) (220) 586Bal b/d 0 136,700 (92,060) (103,845) (155,420) (155,640)

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––Bal c/d 136,700 (92,060) (103,845) (155,420) (155,640) (155,054)

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––

Workings(W1) Sales:

January February March April May JuneCash (10%) 2,000 2,400 2,800 2,700 3,300Credit(90% x 0·5 x 0·975) 8,775 10,530 12,285 11,846(90% x 0·5) 9,000 10,800 12,600

(W2) Production cash flows (see working 3):

January February March April May JuneLabour (3/6) 6,300 7,560 8,820 8,505 10,395 10,395Materials (2/6) 4,200 5,040 5,880 5,670 6,930Overheads (1/6) 2,100 2,520 2,940 2,835

(W3) Production costs:

January February March April May JuneCost of sales 12,000 14,400 16,800 16,200 19,800 19,800Defects 600 720 840 810 990 990

––––––– ––––––– ––––––– ––––––– ––––––– –––––––Total 12,600 15,120 17,640 17,010 20,790 20,790

––––––– ––––––– ––––––– ––––––– ––––––– –––––––



16

(b) NoteOnly the cash flows for sales and labour are required. The remainder of the cash budget is provided to prove the figuressupplied in the question.

The basic point is that high demand cannot be satisfied with a just-in-time stock management system.

Medium Low Expecteddemand demand sales

£ £ £February 20,000 x 0·9 19,000 x 0·1 19,900March 24,000 x 0·9 23,000 x 0·1 23,900April 28,000 x 0·9 27,000 x 0·1 27,900May 27,000 x 0·9 26,000 x 0·1 26,900June 33,000 x 0·9 32,000 x 0·1 32,900

January February March April May JuneReceipts £ £ £ £ £ £Capital 150,000Cash sales (W4) 1,990 2,390 2,790 2,690 3,290 Credit sales (W4) 8,731 10,486 12,241 11,802Credit sales (W4) 8,955 10,755 12,555

PaymentsFixed assets 200,000 50,000Labour (W5) 6,269 7,529 8,789 8,474 10,364Materials (W5) 4,179 5,019 5,859 5,649Overheads (W5) 2,090 2,510 2,930Fixed costs 7,000 7,000 7,000 7,000 7,000 7,000Consultant 12,000

–––––––– ––––––––– –––––––– –––––––– ––––––––– –––––––––Net cash flow 143,000 (223,279) (7,587) (50,667) 1,843 1,704Bal b/d 0 143,000 (80,279) (87,866) (138,533) (136,690)

–––––––– ––––––––– –––––––– –––––––– ––––––––– –––––––––Bal c/d 143,000 (80,279) (87,866) (138,533) (136,690) (134,986)

–––––––– ––––––––– –––––––– –––––––– ––––––––– –––––––––

Workings(W4) Sales:

January February March April May JuneCash (10%) 1,990 2,390 2,790 2,690 3,290Credit(90% x 0·5 x 0·975) 8,731 10,486 12,241 11,802(90% x 0·5) 8,955 10,755 12,555

(W5) Production cash flows (see working 6):

February March April May JuneLabour (3/6) 6,269 7,529 8,789 8,474 10,364Materials (2/6) 4,179 5,019 5,859 5,649Overheads (1/6) 2,090 2,510 2,930

(W6) Production costs:

February March April May JuneCost of sales 11,940 14,340 16,740 16,140 19,740Defects 597 717 837 807 987

––––––– ––––––– ––––––– ––––––– –––––––Total 12,537 15,057 17,577 16,947 20,727

NB a quicker method is merely to deduct 63 from each of the totals in requirement (a) as the loss of sales is constant.



17

(c) The introduction of just-in-time stock management for finished goods has a number of benefits:

(1) It significantly improves the short-term liquidity of the business with a maximum financing requirement of £138,533rather than £155,640. There is also a more rapidly improving deficit thereafter, with the balance falling to £134,986by the end of June. In the longer term, however, there is continued loss of profitability due to lost sales when demandis high.

The primary reason for this is the reduced investment in stock that is tying up cash. Under the original proposal thereis surplus stock amounting to the next month’s sales which means production is necessary at an earlier stage therebyusing up cash resources.

(2) Interest costs and stock holding costs are saved by reduced stock levels, thereby adding to profit.

(3) There already appears to be a just-in-time stock management policy with respect to raw materials and work in progressand such a policy for finished goods would be consistent with this.

There are, however, a number of problems with just-in-time stock management in these circumstances:

(1) When demand is higher than expected the additional sales are lost as there is insufficient production to accommodatedemand above the mean expected level as no stock is carried. This, however, amounts to only £100 per month of saleson average, which may be a price worth paying in return for improved liquidity in terms of a reduced cash deficit.

(2) In addition to losing contribution there may be a loss of goodwill and reputation if customers cannot be supplied. Theymay go elsewhere not just for the current sale but also for future sales if Mr Geep is seen as an unreliable supplier. Thisresults from the fact that customers demand immediate delivery of orders.

(3) Just-in-time management of stock relies upon not just reliable timing and quantities but also reliable quality. The numberof defects can be planned if it is constant but if they occur irregularly this presents an additional problem.

(4) If production in each month is to supply demand each month this relies on the fact that demand parallels productionwithin the month. If the majority of demand is at the beginning of each month this would cause problems without alevel of safety stock given that prompt delivery is expected by customers.

A number of compromises between the two positions would be possible:

(1) Stock could be held sufficient to accommodate demand when it was high. This amounts to only an extra £2,000 atselling values thus an extra £1,200 at variable cost. This is significantly lower than a whole month’s production butwould accommodate peak demand.

(2) Liquidity is very important initially as the business attempts to become established. Minimal stocks could be held in theearly months therefore, with perhaps slightly increased stocks once the business and its cash flows become established.

(d) REPORTTo: Mr J GeepFrom: An AccountantDate December 2002Subject: Liquidity and financing

(i) The Extent of Financing Required

It is clear that sales are uncertain with high, low and medium estimates of demand. This of itself gives some uncertaintybut the reliability and probability of these estimates will need to be established by appropriate market research. If salesare lower than expected then any bank finance will take longer to repay, thus increasing the amount of finance neededand the proportion of longer-term finance.

Assuming that just-in-time stock management is not implemented then the maximum finance requirement is £155,640.

After July 2003 the expected net cash inflow will be constant (ignoring any further purchases of fixed assets) as follows:

Sales 33,000Discounts (33,000 x ·45 x ·025) (371)Labour (9,900)Material (6,600)Variable overheads (3,300)

–––––––(19,800) x 1·05 (20,790)

Fixed costs (7,000)–––––––

4,839–––––––

Thus, to pay off a loan of £155,054 it would mean payments over 32 months (155,054/4,839) would have to takeplace, excluding interest charges. Any variation in these estimates would, however, affect the amount of the financingneeded.



18

In addition to uncertain trading results affecting the amount of future financing, there is an additional requirement tofinance future capital investment as the business expands. This is likely to be a major financing need in the futuredepending on the rate of expansion.

The levels of the drawings, taxation and interest charges will also extend the amount of finance needed, as these itemswere not included in the cash budget presented.

(ii) Short- and long-term financing mix

In forming a new business there is no business history to present to the bank, thus there is additional uncertainty, whichwill need to be considered before any finance is likely to be forthcoming, either of a short-term or a long-term nature.

If, however, there is a good relationship with the bank an overdraft might be possible for the entire financing requirement,but this runs the risk of being payable immediately on demand and thus if planned cash flows did not turn out asexpected then the bank may get nervous and possibly withdraw credit facilities.

A medium-term loan would also be possible to meet the entire financing requirement. This has the advantage of securityin that it cannot be recalled unless there is a breach in the terms. Most likely it would come from a bank, the issue ofdebentures being entirely out of the question on the grounds of scale. Other considerations would be the term of theloan, security required, fixed or variable interest rates, other conditions (e.g. accounts, covenants, reviews).

Other forms of finance include leasing which can be regarded as a quasi loan if entering into a long-term contract,although other considerations may apply such as variability of rental terms, transfer of risk, residual value of asset,cancellation rights, amount of rentals, period of agreement.

A further option would be for Mr Geep to put in more ownership capital, perhaps secured on the equity in his house.

A mixture of these various forms of finance would be most likely.

The precise mix will depend upon a number of factors (although some of these may also influence the total amount offinance needed):

(1) The ability and willingness of Mr Geep to supply funds initially and additionally if plans do not turn out as expected.

(2) A loan would require some security. The company has few assets to use as security as there does not appear tobe any property, the machinery has a low net realisable value and there is little stock, which is normally poorsecurity anyway. An overdraft may also require security but may place increased emphasis on the cash generatingpotential of the business to make appropriate repayments. Ultimately, however, this is an unlimited business andMr Geep’s personal assets, and particularly the equity in his house, will act as security.

(3) Other costs are necessary including: the drawings of the owner Mr Geep and interest charges. These will reducethe ability of the business to repay any loan and thus extend the period of repayments in excess of the aboveestimate of 35 months.

(4) There may be more restrictive covenants in a loan agreement than an overdraft as an overdraft is repayable ondemand, and thus the bank needs less protection from other clauses in the contact. There are, however, likely tobe restrictive covenants in overdraft agreements.

(5) Overdraft interest is only payable on the balance outstanding, thus if major inflows occur this will reduce interestcosts.

(6) The difference between short- and long-term interest rates may influence the relative charges on an overdraft or amedium-term loan.

(7) The purpose of the finance is also likely to affect the form of finance. For example, if funds are required to financefixed assets then it might be appropriate to use long-term finance to match the long-term usage of the asset.

(iii) Working Capital ManagementIt has already been seen (in requirement (b)) that a reduction in stock due to the introduction of just-in-time stockmanagement can improve liquidity by improving cash flows and reducing any cash deficit. The same principle can beapplied to other types of working capital.

Some of the same arguments also apply, however, in that while liquidity may be improved there could be offsettingdisadvantages in terms of lost profitability or increased risk.

Debtors. Giving two months’ credit makes a significant level of debtors that needs financing.

In steady state of sales of £33,000 per month then debtors will be:

One month’s credit (£33,000 x 90% x 50% x 0·975) 14,479Two months’ credit (£33,000 x 90% x 50% x 2m) 29,700

–––––––Total debtors 44,179

–––––––

This is a significant proportion of the maximum financing requirement.



19

Whether the credit terms themselves can be changed may depend upon the credit terms of competitors when setalongside the other conditions of sale. If the business is out of line with competitors then lost sales may result and abalance between liquidity and profitability may need to be struck.

In terms of debt collection it would appear that all debtors are expected to pay on time so there is little that can be donein this area given the current credit terms.

Accelerated payment could be encouraged by a higher cash discount but this is expensive, particularly as customerswho would pay within one month anyway would also receive a greater reduction in price without any benefit to thebusiness.

Invoice discounting and debt factoring may be alternatives but these are expensive and in the particular circumstancesof the business, where there are expected to be no late payers or bad debts, it might seem inappropriate to use outsideassistance.

CreditorsIt may be possible to delay payment to creditors in respect of materials and variable overheads. This may, however,damage relationships with suppliers and this might be significant for a new business.

2 (a) The range of stakeholders may include: shareholders, directors/managers, lenders, employees, suppliers and customers.These groups are likely to share in the wealth and risk generated by a company in different ways and thus conflicts of interestare likely to exist. Conflicts also exist not just between groups but within stakeholder groups. This might be because subgroups exist e.g. preference shareholders and equity shareholders. Alternatively it might be that individuals have differentpreferences (e.g. to risk and return, short term and long term returns) within a group. Good corporate governance is partlyabout the resolution of such conflicts. Stakeholder financial and other objectives may be identified as follows:

ShareholdersShareholders are normally assumed to be interested in wealth maximisation. This, however, involves consideration of potentialreturn and risk. Where a company is listed this can be viewed in terms of the share price returns and other market-basedratios using share price (e.g. price earnings ratio, dividend yield, earnings yield).

Where a company is not listed, financial objectives need to be set in terms of accounting and other related financial measures.These may include: return of capital employed, earnings per share, gearing, growth, profit margin, asset utilisation, marketshare. Many other measures also exist which may collectively capture the objectives of return and risk.

Shareholders may have other objectives for the company and these can be identified in terms of the interests of otherstakeholder groups. Thus, shareholders, as a group, might be interested in profit maximisation; they may also be interestedin the welfare of their employees, or the environmental impact of the company’s operations.

Directors and managersWhile directors and managers are in essence attempting to promote and balance the interests of shareholders and otherstakeholders it has been argued that they also promote their own interests as a separate stakeholder group.

This arises from the divorce between ownership and control where the behaviour of managers cannot be fully observed givingthem the capacity to take decisions which are consistent with their own reward structures and risk preferences. Directors maythus be interested in their own remuneration package. In a non-financial sense, they may be interested in building empires,exercising greater control, or positioning themselves for their next promotion. Non-financial objectives are sometimes difficultto separate from their financial impact.

LendersLenders are concerned to receive payment of interest and ultimate re-payment of capital. They do not share in the upside ofvery successful organisational strategies as the shareholders do. They are thus likely to be more risk averse than shareholders,with an emphasis on financial objectives that promote liquidity and solvency with low risk (e.g. gearing, interest cover,security, cash flow).

EmployeesThe primary interest of employees is their salary/wage and security of employment. To an extent there is a direct conflictbetween employees and shareholders as wages are a cost to the company and a revenue to employees.

Performance related pay based upon financial or other quantitative objectives may, however, go some way toward drawingthe divergent interests together.

Suppliers and customersSuppliers and customers are external stakeholders with their own set of objectives (profit for the supplier and, possibly,customer satisfaction with the good or service from the customer) that, within a portfolio of businesses, are only partlydependent upon the company in question. Nevertheless it is important to consider and measure the relationship in term offinancial objectives relating to quality, lead times, volume of business, price and a range of other variables in considering anyorganisational strategy.



20

(b) Corporate governance is the system by which organisations are directed and controlled.

Where the power to direct and control an organisation is given, then a duty of accountability exists to those who have devolvedthat power. Part of that duty of accountability is discharged by disclosure both of performance in the normal financialstatements but also of the governance procedures themselves.

The governance codes in the UK have mainly been limited to disclosure requirements. Thus, any requirements have been todisclose governance procedures in relation to best practice, rather than comply with best practice.

In deciding on which of the divergent interests should be promoted, the directors have a key role. Much of the corporategovernance regulation in the UK (including Cadbury, Greenbury and Hampel) has therefore focused on the control of thisgroup and disclosure of its activities. This is to assist in controlling their ability to promote their own interests and make morevisible the incentives to promote the interest of other stakeholder groups.

A particular feature of the UK is that Boards of Directors are unitary (i.e. executive and non-executive directors sit on a singleboard). This contrasts to Germany for instance where there is more independence between the groups in the form of two tierboards.

Particular Corporate Governance proposals in the UK which have resulted in the Combined Code include:

(1) Independence of the board with no covert financial reward

(2) Adequate quality and quantity of non-executive directors to act as a counterbalance to the power of executive directors.

(3) Remuneration committee controlled by non-executives.

(4) Appointments committee controlled by non-executives.

(5) Audit committee controlled by non-executives.

(6) Separation of the roles of chairman and chief executive to prevent concentration of power.

(7) Full disclosure of all forms of director remuneration including shares and share options.

(8) The Hampel report has an emphasis not just on whether compliance with best practice has been achieved, but on howit has been achieved.

Overall, the visibility given by corporate governance procedures goes some way toward discharging the directors’ duty ofaccountability to stakeholders and makes more transparent the underlying incentive systems of directors.

3 Woodeezer

(a) Operating statement£

Budgeted profit (4,000 x £28) 112,000Sales Volume Profit Variance (3,200 – 4,000) £28 (22,400) A

––––––––Standard profit on actual sales 89,600Selling Price Variance (220 – 225) 3,200 16,000 F

––––––––105,600

Cost variancesFav Adv

Material Usage [(3,600 x 25) – 80,000] £3·2 32,000Material Price (3·2 – 3.5) 80,000 24,000Labour efficiency [(4 x 3,600) – 16,000)] £8 12,800Labour rate (8 – 7) 16,000 16,000Var O/H eff [(4 x 3,600) – 16,000)] £4 6,400Var O/H exp (£4 x 16,000) – 60,000 4,000Fixed O/H exp (256,000 – 196,000) 60,000Fixed O/H eff [(4 x 3,600) – 16,000)] £16 25,600Fixed O/H capacity [16,000 – (4 x 4,000)] £16 nil

–––––––– ––––––––112,000 68,800 43,200–––––––– –––––––– ––––––––

Actual profit 148,800––––––––

(b) Motivation and budget settingAbsorption costing profit has increased by £53,600 from £95,200 (28 × 3,400) to £148,800.

It would appear that in the past an expectations budget has been set whereby the target output was set at the level thatemployees were expected to achieve.

Mr Beech appears to have considered the evidence that suggests that the best budget for motivating employees to maximiseachievement (in this case output) is one which is difficult but credible (an aspirations budget). In maximising actualperformance, however, it is normally expected that production will fall short of the budget target. This means that there is anexpectation of adverse planning variances.



21

Explanations of VariancesThe sales volume variance and the sales price variance may be inter-related as an increase in price is likely to reduce demand,thus an adverse SVV is consistent with a favourable SPV given the price increase.

Better quality materials are being purchased by Mr Beech and, given this was not foreseen at the time of the budget, then itmay explain a higher price resulting in an adverse MPV. Conversely, however, with better materials there may be less wasteand thus it may have contributed to the favourable MUV.

The lower skilled labour may account for the favourable LRV but may also account for the adverse LEV as less skilled labourmay take longer to complete a given task. Also if new labour is introduced there may be an initial learning effect.

The impact of the LEV is magnified by the variable and fixed overhead efficiency variances as they are merely linear functionsof the LEV. Their meaning is questionable however, as variable overheads seldom vary proportionately to labour hours. Bydefinition fixed overheads do not vary with labour hours and this variance merely ‘balances the books’ in an absorption costingsystem.

The fixed overhead expenditure variance is significant and requires further consideration. This is particularly the case if itinvolves discretionary expenditure which has been reduced but which may have a long-term impact on the business.

(c) Marginal costingMarginal cost statement (this could be in summarised form by candidates)

£Budgeted contribution (4,000 x £92) 368,000SVV (3,200 – 4,000) £92 (73,600) A

––––––––Standard contribution on actual sales 294,400SPV (220 – 225) 3,200 16,000 F

––––––––310,400

Cost variancesFav Adv

MUV [(3,600 x 25) – 80,000] £3·2 32,000MPV (3·2 – 3·5) 80,000 24,000LEV [(4 x 3,600) – 16,000)] £8 12,800LRV (8 – 7) 16,000 16,000Var O/H eff [(4 x 3,600) – 16,000)] £4 6,400Var O/H exp (£4 x 16,000) – 60,000 4,000

–––––––– ––––––––52,000 43,200 8,800

––––––––Actual contribution 319,200Fixed overheads

Budgeted 256,000Expenditure variance 60,000

––––––––(196,000)––––––––

Actual profit 123,200––––––––

ReconciliationAbsorption costing profit 148,800Fixed costs in stock [400 x £64]

(stock is now restated to variable cost) (25,600)––––––––

Variable costing profit 123,200––––––––

Thus some of the ‘success’ of Mr Beech in increasing profit arises from the fact that fixed overheads of £25,600 are not beingwritten off in the current month but are being carried forward as part of closing stock, notwithstanding that they are periodcosts and are thus sunk. Unless sales can be increased this position is unsustainable.

Nevertheless, some improvement has been made as the previous contribution was, taking the budget as the historic norm,£312,800 [3,400 x (£220 – 128)], which is lower than the £319,200 achieved by Mr Beech. The difference is, however,much lower than would be implied by the absorption costing statement.



22

4 Leaminger plc

(a) Purchase outright

2002 2003 2004 2005 2006 2007Outlay/NRV (360,000) 20,000Maintenance (15,000) (15,000) (15,000) (15,000)Taxation 4,500 4,500 4,500 4,500WDA Tax Effect (W1) 27,000 20,250 15,188 11,391Bal Allowance (W2) 28,172

–––––––– ––––––– –––––– –––––– ––––––– –––––––Cash flow (360,000) 12,000 9,750 4,688 20,891 32,672DF 1·0 0·909 0·826 0·751 0·683 0·621

–––––––– ––––––– –––––– –––––– ––––––– –––––––DCF (360,000) 10,908 8,054 3,521 14,269 20,289

–––––––– ––––––– –––––– –––––– ––––––– –––––––

Net Present Cost = £(302,959)––––––––––

(W1) Writing Down Allowances

Year TWDV WDA Tax Effectb/d 25% 30%

2002 360,000 90,000 27,0002003 270,000 67,500 20,2502004 202,500 50,625 15,1882005 151,875 37,969 11,3912006 113,906

(W2) Balancing allowance

TWDV 113,906Proceeds 20,000

––––––––Bal Allow 93,906

––––––––Tax effect = 93,906 x 30% = 28,172

Finance leaseAnnuity Factor (AF) at 10% for 4 years is 3·17Thus PV outflows = (135,000 + 15,000)3·17 = (475,500)PV tax relief = [(150,000 x 0·3)3·17]/1·1 = 129,682Net Present Cost = £(345,818)

––––––––––

Operating leaseAnnuity Factor (AF) at 10% for 3 years is 2·487Thus PV outflows = (140,000)(2·487 +1) = (488,180)PV tax relief = (140,000 x 0·3)(2·487 +1)/1·1 = 133,140Net Present Cost = £(355,040)

––––––––––

On the basis of net present value, purchasing outright appears to be the least cost method.



23

(b) Each £1 of outlay before 31 December 2003 would mean a loss in NPV on the alternative project of £0·20. There is thusan opportunity cost of using funds in 2002.

PurchasingNet Present Cost (302,959)Opportunity cost (0·2 x 360,000) (72,000)

–––––––––Total (374,959)

–––––––––

Finance leaseNet Present Cost = £(345,818)

There is no cash flow before 31 December 2003 in this case and thus no opportunity cost.

Operating leaseNet Present Cost = (355,040)Opportunity cost (0·2 x 140,000) (28,000)

–––––––––Total (383,040)

–––––––––

Thus the finance lease is now the lowest cost option.

All the above assume that the alternative project cannot be delayed.

(c) REPORTTo: The Directors of Leaminger plcFrom: A business advisorDate: December 2002Subject: Acquiring the turbine machine

Introduction

In financial terms, and without capital rationing, the purchasing outright method is the preferred method of financing as ithas the lowest negative NPV. With capital rationing, a finance lease becomes the preferred method. There are, however, anumber of other factors to be considered before a final decision is taken.

(1) If capital rationing persists into further periods the value of cash used in leasing becomes more significant and thuspurchasing becomes relatively more attractive.

(2) Even without capital rationing, leasing has a short-term cash flow advantage over purchasing which may be significantfor liquidity.

(3) The use of a 10% cost of capital may be inappropriate as these are financing issues and are unlikely to be subject tothe average business risk. Also they may alter the capital structure and thus the financial risk of the business and thusthe cost of capital itself. This may alter the optimal decision in the face of capital rationing.

(4) The actual cash inflows generated by the turbine are constant for all options, except that under an operating lease thelessor may refuse to lease the turbine at the end of any annual contract thus making it unavailable from this particularsource. On top of capital rationing, we need to consider the availability of finance as a continuing source under theoperating lease.

(5) Conversely, however, with the operating lease Leaminger plc can cancel if business conditions change (e.g. atechnologically improved asset may become available). This is not the case with the other options. On the other hand,if the market is buoyant then the lessor may raise lease rentals, whereas the cost is fixed under the other options andhence capital rationing might be more severe.

(6) On the issue of maintenance costs of £15,000 per annum, this is included in the operating lease if the machinebecomes unreliable, but there is greater risk beyond any warranty period under the other two options.

(7) It is worth investigating if some interim measure can be put in place which would assist in lengthening the turbine’s lifesuch as sub-contracting work outside or overhauling the machine.



5 Abkaber plc

(a) (i) Labour hoursTotal overhead cost = £12,000,000Total labour hours = 500,000 hoursOverhead per labour hour = £12,000,000/500,000 = £24

Sunshine Roadster Fireball£ £ £

Direct labour (£5 p.h.) 1,000,000 1,100,000 400,000Materials (at £400/600/900) 800,000 960,000 360,000Overheads (at £24) 4,800,000 5,280,000 1,920,000

–––––––––– –––––––––– ––––––––––Total Costs 6,600,000 7,340,000 2,680,000

–––––––––– –––––––––– ––––––––––

Output (Units) 2,000 1,600 400Cost per unit £3,300 £4,587·5 £6,700Selling price £4,000 £6,000 £8,000

–––––––––– –––––––––– ––––––––––Profit/(loss) per unit £700 £1,412·5 £1,300

–––––––––– –––––––––– ––––––––––

Total Profit/(loss) £1,400,000 £2,260,000 £520,000

Total Profit £4,180,000–––––––––––

(ii) Activity Based CostingDeliveries to retailers £2,400,000/250 = £9,600Set-ups £6,000,000/100 = £60,000Deliveries inwards £3,600,000/800 = £4,500

Sunshine Roadster Fireball£ £ £

Direct labour (£5 p.h.) 1,000,000 1,100,000 400,000Materials (at £400/600/900) 800,000 960,000 360,000

Overheads:Deliveries at £9,600 960,000 768,000 672,000Set-ups at £60,000 2,100,000 2,400,000 1,500,000Purchase orders at £4,500 1,800,000 1,350,000 450,000

–––––––––– –––––––––– ––––––––––6,660,000 6,578,000 3,382,000–––––––––– –––––––––– ––––––––––

Output (Units) 2,000 1,600 400Cost per unit £3,330 £4,111·25 £8,455Selling price £4,000 £6,000 £8,000

–––––––––– –––––––––– ––––––––––Profit/(loss) per unit £670 £1,888·75 (£455)

–––––––––– –––––––––– ––––––––––

Total Profit/(loss) £1,340,000 £3,022,000 (£182,000 )

Total Profit £4,180,000–––––––––––

24



25

(b) REPORT – ABKABER PLC

To: Directors of Abkaber plcFrom: Management AccountantSubject: The Introduction of Activity Based CostingDate: December 2002

(i) Direct costsThe direct costs of labour and materials are unaffected by the use of ABC as they are directly attributable to units ofoutput.

Notwithstanding the fact that labour is a relatively minor cost, however, the use of labour hours to allocate overheadsmagnifies its importance.

The labour hours allocation basisAs labour appears to be paid at a constant rate an allocation using labour cost or labour hours gives the same result.

The central concern is, however, whether there is a cause and effect relationship between overheads and labourhours. Moreover for this allocation base to be correct overheads would need to be linearly variable with labour hours.This seems unlikely on the basis of the information available.

ABC and labour hours cost allocationABC attempts to allocate overheads using a number of cost drivers rather than just one as with labour hours. It thusattempts to identify a series of cause and effect relationships. Moreover, those in favour of ABC argue that it isactivities that generate costs, not labour hours.

While costs are likely to be caused by multiple factors, the accuracy of any ABC system will depend on both thenumber of factors selected and the appropriateness of each of these activities as a driver for costs. Each cost drivershould be appropriate to the pool of overheads to which it relates. As noted already there should ideally be a directcause and effect relationship between the cost driver and the relevant overhead cost pool, but this should also be alinear relationship (i.e. costs increase proportionately with the number of activities operated).

The contrast between the labour hours costing system and ABC can be seen in requirement (a). These differencescan be brought out by reviewing the comments of the directors.

(ii) The Finance DirectorUsing the labour hours method of allocation the Fireball makes an overall profit of £520,000 but using ABC it makesa loss of £182,000. There is thus a significant difference in the levels of cost allocated and in profitability betweenthe two methods, to the extent it affects the conclusions on the Fireball’s viability.

The major reason for the difference appears to be that while labour hours are not all that significant for Fireballproduction, the low volumes of Fireball sales cause a relatively high amount of set-ups, deliveries and purchaseprocesses, and this is recognised by ABC.

If the Fireball model is to continue, a review of the assembly and distribution systems may be needed in order toreduce costs.

There may, however, be other non-financial reasons to maintain the Fireball, e.g. maintaining a wide product rangeand raising the reputation of the motorcycles, which may increase sales of other models.

The Marketing DirectorThe marketing director suggests that ABC may have a number of problems and its conclusions should not be believedunquestioningly. These problems include:

(1) For decisions such as the closure of Fireball production or the pricing of the new motorbike rental contract, whatis really needed is the incremental cost to determine a break-even position. While ABC may be closer to thisconcept than a labour hours allocation basis, its accuracy depends upon identifying appropriate cost drivers.

(2) The use of ABC for one-off decisions can be distinguished from its use in normal, ongoing costing procedures.It is perfectly possible that while labour hours may have been used for normal costing, an incremental costinganalysis would be undertaken for important one-off decisions such as the closure of Fireball production or thepricing of the new motorbike rental contract. In these circumstances the introduction of ABC in normal costingprocedures may have restricted benefits.

(3) There may be interdependencies between both costs and revenues that ABC is unlikely to capture. Where costsare truly common to more than one product then this may be difficult to capture by any given single activity.

(4) As with labour hours allocations it is the future that matters. Any relationship between costs and activities basedupon historic experience and observation may be unreliable as a guide to the future.



The Managing Director(1) ABC normally assumes that the cost per activity is constant as the number of times the activity is repeated

increases. In practice there may be a learning curve, such that costs per activity are non linear. As a result, themarginal cost of increasing the number of activities is not the same as the average.

(2) Also, in this case, fixed costs are included which would also mean that the marginal cost does not equal theaverage cost.

(3) The MD is correct in stating that some costs do not vary with either labour hours or any cost driver, and thus donot fall easily under ABC as a method of cost attribution as there is no cause and effect relationship. Depreciationon the factory building might be one example.

The ChairmanFrom a narrow perspective of reporting profit it is true that the two methods give the same overall profit as is illustratedin requirement (a) at £4,180,000. There are, however, a number of qualifications to this statement:

(1) If the company carried stock then the method of cost allocation would, in the short term at least, affect stock valuesand thus would influence profit.

(2) If the ABC information can be relied upon, notwithstanding the above qualifications, then a decision could be takento cease Fireball production as it generates a negative contribution of £182,000. This was not apparent from theuse of labour hours; thus by the introduction of ABC and the subsequent closure decision profits would, all otherthings being equal, improve by £182,000.

Further IssuesThe following should also be considered in evaluating ABC:

– The need to develop new data capture systems, and the relevant costs of doing so.

– Increased and on-going analysis work

– Continued evaluation of cause and effect relationships between cost drivers and cost pools.

26



27

Part 2 Examination – Paper 2.4Financial Management and Control December 2002 Marking Scheme

Marks Marks1 (a) Demand forecasts 2

Production cash flows 5Sales cash flows 4Fixed cost cash flows 1Consultant cost cash flows 1Capital investment cash flows 1Purchase of machinery 1Bank balances 2

17

(b) Sales 4 Labour 2

6

(c) 2 marks for each explained point 10

(d) Up to 2 marks for each explained point 18Report format 2

Available 20Maximum 17

Total 50

2 (a) Explanation of financial and other objectives(3 marks for each explained point) 15


(b) Outline of good corporate governance practices withappropriate references to elements of Combined CodeUp to 2 marks for each point 13

Total 25



28

Marks Marks3 (a) 1 mark for each variance (including Fixed O/H capacity nil variance) 11

Budgeted profit 1Standard profit 1Reconciliation to actual profit 1

14

(b) Effect on profitability 1Comments on motivation (1 mark for each explained point) 4Comments on explaining variances (1 mark for each explained point) 4


(c) 1 mark for each of correct calculations relating to budgeted contribution, SVV, standard contribution on actual sales, actual contribution, appropriate inclusion of fixed overheads(max 3) 3 Reconciliation 1Comments on marginal costing (2 marks for each explained point) 4


Total 25

4 (a) PurchaseCapital allowances 3Maintenance 1Taxation 1NPV 1

Finance leasePV outflows 1PV tax relief 1NPV 1

Operating leasePV outflows 1PV tax relief 1NPV 1

Recommendation 1


(b) Opportunity cost 1Revised NPV for each option (1 mark each) 3Evaluation 1

5(c) 2 marks for each explained point 8

Total 25



Marks Marks5 (a) Labour hours

Overhead per labour hour 1Labour costs for each product 1Materials 1Total profits 1

ABCCosts per activity 3Labour 1Materials 1Overheads 3Total profits 1

13

(b) Report format 12 marks for each detailed point 12


Total 25

29




PART 2

WEDNESDAY 11 JUNE 2003

QUESTION PAPER





Formulae Sheet, Present Value and Annuity Tables are on pages8 and 9. Pa

per

2.4




1 Springbank plc is a medium-sized manufacturing company that plans to increase capacity by purchasing newmachinery at an initial cost of £3m. The following are the most recent financial statements of the company:

Profit and Loss Accounts for years ending 31 December2002 2001£000 £000

Sales 5,000 5,000Cost of Sales 3,100 3,000

–––––– ––––––Gross Profit 1,900 2,000Administration and Distribution Expenses 400 250

–––––– ––––––Profit before Interest and Tax 1,500 1,750Interest 400 380

–––––– ––––––Profit before Tax 1,100 1,370Tax 330 400

–––––– ––––––Profit after Tax 770 970Dividends 390 390

–––––– ––––––Retained Earnings 380 580

–––––– ––––––Balance Sheets as at 31 December

2002 2001£000 £000 £000 £000

Fixed Assets 6,500 6,400Current Assets

Stock 1,170 1,000Debtors 850 900Cash 130 100

–––––– ––––––2,150 2,000

Current Liabilities 1,150 1,280–––––– ––––––

1,000 720–––––– ––––––7,500 7,120

10% Debentures 2007 3,500 3,500–––––– ––––––4,000 3,620

–––––– ––––––

Capital and Reserves 4,000 3,620–––––– ––––––

The investment is expected to increase annual sales by 5,500 units. Investment in replacement machinery would beneeded after five years. Financial data on the additional units to be sold is as follows:

£Selling price per unit 500Production costs per unit 200

Variable administration and distribution expenses are expected to increase by £220,000 per year as a result of theincrease in capacity. In addition to the initial investment in new machinery, £400,000 would need to be invested inworking capital. The full amount of the initial investment in new machinery of £3 million will give rise to capitalallowances on a 25% per year reducing balance basis. The scrap value of the machinery after five years is expectedto be negligible. Tax liabilities are paid in the year in which they arise and Springbank plc pays tax at 30% of annualprofits.

The Finance Director of Springbank plc has proposed that the £3·4 million investment should be financed by an issueof debentures at a fixed rate of 8% per year.

Springbank plc uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its financialstatements, Springbank plc uses straight-line depreciation over the expected life of fixed assets.

2



Average data for the business sector in which Springbank operates is as follows:

Gearing (book value of debt/book value of equity) 100%Interest Cover 4 timesCurrent Ratio 2:1Stock Days 90 daysReturn before Interest and Tax/Capital Employed 25%

Required:

(a) Calculate the net present value of the proposed investment in increased capacity of Springbank plc, clearlystating any assumptions that you make in your calculations. (11 marks)

(b) Calculate the increase in sales (in units) that would produce a zero net present value for the proposedinvestment. (4 marks)

(c) (i) Calculate the effect on the gearing and interest cover of Springbank plc of financing the proposedinvestment with an issue of debentures and compare your results with the sector averages. (6 marks)

(ii) Analyse and comment on the recent financial performance of the company. (13 marks)

(iii) On the basis of your previous calculations and analysis, comment on the acceptability of the proposedinvestment and discuss whether the proposed method of financing can be recommended. (10 marks)

(d) Briefly discuss the possible advantages to Springbank plc of using an issue of ordinary shares to finance theinvestment. (6 marks)

(50 marks)

3 [P.T.O.




2 It is mid-June and the new managing director of Storrs plc is reviewing sales forecasts for Quarter 3 of 2003, whichbegins on 1 July, and for Quarter 4. The company manufactures garden furniture and experiences seasonal variationsin sales, which has made forecasting difficult in the past. Sales for the last two calendar years were as follows:

Year Quarter 1 Quarter 2 Quarter 3 Quarter 42001 £2,700,000 £3,500,000 £3,400,000 £3,000,0002002 £3,100,000 £3,900,000 £3,600,000 £3,400,000

Sales in Quarter 1 of 2003 were £3,600,000. There is two weeks to go until the end of Quarter 2 and the managingdirector of Storrs plc is confident that it will achieve sales of £4,400,000 in this quarter.

The existing sales forecasts for the two remaining quarters of the year were made by the sales director (who has beenwith the company for several years) during last year’s budget-setting process. These forecasts are £3,800,000 forQuarter 3 and £3,600,000 for Quarter 4. Budgets within Storrs plc have traditionally been prepared and agreed bythe directors of the company before being implemented by junior managers.

As a basis for revising the sales forecasts for the two remaining quarters of 2003, the management accountant ofStorrs plc has begun to apply time series analysis in order to identify the seasonal variations in sales. He has so farcalculated the following centred moving averages, using a base period of four quarters.

Year Quarter 1 Quarter 2 Quarter 3 Quarter 42001 £3,200,000 £3,300,0002002 £3,375,000 £3,450,000 £3,562,500 £3,687,500

Required:

(a) Using the sales information and centred moving averages provided, and assuming an additive model, forecastthe sales of Storrs plc for Quarter 3 and Quarter 4 of 2003, and comment on the sales forecasts made bythe sales director.(Note that you are NOT required to use regression analysis) (8 marks)

(b) Discuss the limitations of the sales forecasting method used in part (a). (5 marks)

(c) Discuss the relative merits of top-down and bottom-up approaches to budget setting. (12 marks)

(25 marks)

4



3 Velm plc sells stationery and office supplies on a wholesale basis and has an annual turnover of £4,000,000. Thecompany employs four people in its sales ledger and credit control department at an annual salary of £12,000 each.All sales are on 40 days’ credit with no discount for early payment. Bad debts represent 3% of turnover and Velm plcpays annual interest of 9% on its overdraft. The most recent accounts of the company offer the following financialinformation:

Velm plc: Balance Sheet as at 31 December 2002£000 £000 £000

Fixed assets 17,500Current assets

Stock of goods for resale 900Debtors 550Cash 120

–––––1,570

Creditors: amounts falling due within one yearTrade creditors 330Overdraft 1,200

–––––1,530–––––

40–––––––17,540

Creditors: amounts falling due after more than one year12% Debenture due 2010 2,400

–––––––15,140–––––––

Ordinary shares 3,500Reserves 11,640

–––––––15,140–––––––

Velm plc is considering offering a discount of 1% to customers paying within 14 days, which it believes will reducebad debts to 2·4% of turnover. The company also expects that offering a discount for early payment will reduce theaverage credit period taken by its customers to 26 days. The consequent reduction in the time spent chasingcustomers where payments are overdue will allow one member of the credit control team to take early retirement.Two-thirds of customers are expected to take advantage of the discount.

Required:

(a) Using the information provided, determine whether a discount for early payment of 1 per cent will lead toan increase in profitability for Velm plc. (5 marks)

(b) Discuss the relative merits of short-term and long-term debt sources for the financing of working capital.(6 marks)

(c) Discuss the different policies that may be adopted by a company towards the financing of working capitalneeds and indicate which policy has been adopted by Velm plc. (7 marks)

(d) Outline the advantages to a company of taking steps to improve its working capital management, givingexamples of steps that might be taken. (7 marks)

(25 marks)

5 [P.T.O.



4 Tagna is a medium-sized company that manufactures luxury goods for several well-known chain stores. In real terms,the company has experienced only a small growth in turnover in recent years, but it has managed to maintain aconstant, if low, level of reported profits by careful control of costs. It has paid a constant nominal (money terms)dividend for several years and its managing director has publicly stated that the primary objective of the company isto increase the wealth of shareholders. Tagna is financed as follows:

£mOverdraft 1·010 year fixed interest bank loan 2·0Share capital and reserves 4·5

–––7·5–––

Tagna has the agreement of its existing shareholders to make a new issue of shares on the stock market but has beeninformed by its bank that current circumstances are unsuitable. The bank has stated that if new shares were to beissued now they would be significantly under-priced by the stock market, causing Tagna to issue many more sharesthan necessary in order to raise the amount of finance it requires. The bank recommends that the company waits forat least six months before issuing new shares, by which time it expects the stock market to have become strong-formefficient.

The financial press has reported that it expects the Central Bank to make a substantial increase in interest rate in thenear future in response to rapidly increasing consumer demand and a sharp rise in inflation. The financial press hasalso reported that the rapid increase in consumer demand has been associated with an increase in consumer creditto record levels.

Required:

(a) Discuss the meaning and significance of the different forms of market efficiency (weak, semi-strong andstrong) and comment on the recommendation of the bank that Tagna waits for six months before issuing newshares on the stock market. (9 marks)

(b) On the assumption that the Central Bank makes a substantial interest rate increase, discuss the possibleconsequences for Tagna in the following areas:

(i) sales;(ii) operating costs; and,(iii) earnings (profit after tax). (10 marks)

(c) Explain and compare the public sector objective of ‘value for money’ and the private sector objective of‘maximisation of shareholder wealth’. (6 marks)

(25 marks)

6



5 The managers of Albion plc are reviewing the operations of the company with a view to making operational decisionsfor the next month. Details of some of the products manufactured by the company are given below.

Product AR2 GL3 HT4 XY5Selling price (£/unit) 21·00 28·50 27·30Material R2 (kg/unit) 2·0 3·0 3·0Material R3 (kg/unit) 2·0 2·2 1·6 3·0Direct labour (hours/unit) 0·6 1·2 1·5 1·7Variable production overheads (£/unit) 1·10 1·30 1·10 1·40Fixed production overheads (£/unit) 1·50 1·60 1·70 1·40Expected demand for next month (units) 950 1,000 900

Products AR2, GL3 and HT4 are sold to customers of Albion plc, while Product XY5 is a component that is used inthe manufacture of other products. Albion plc manufactures a wide range of products in addition to those detailedabove.

Material R2, which is not used in any other of Albion’s products, is expected to be in short supply in the next monthbecause of industrial action at a major producer of the material. Albion plc has just received a delivery of 5,500 kgof Material R2 and this is expected to be the amount held in stock at the start of the next month. The company doesnot expect to be able to obtain further supplies of Material R2 unless it pays a premium price. The normal marketprice is £2·50 per kg.

Material R3 is available at a price of £2·00 per kg and Albion plc does not expect any problems in securing suppliesof this material. Direct labour is paid at a rate of £4·00 per hour.

Folam Limited has recently approached Albion plc with an offer to supply a substitute for Product XY5 at a price of£10·20 per unit. Albion plc would need to pay an annual fee of £50,000 for the right to use this patented substitute.

Required:

(a) Determine the optimum production schedule for Products AR2, GL3 and HT4 for the next month, on theassumption that additional supplies of Material R2 are not purchased. (8 marks)

(b) If Albion plc decides to purchase further supplies of Material R2 to meet demand for Products AR2, GL3 andHT4, what should be the maximum price per kg that the company is prepared to pay? (3 marks)

(c) Discuss whether Albion plc should manufacture Product XY5 or buy the substitute offered by Folam Limited.Your answer must be supported by appropriate calculations. (7 marks)

(d) Discuss the limitations of marginal costing (variable costing) as a basis for making short-term decisions.(7 marks)

(25 marks)

7 [P.T.O.



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Answers



Part 2 Examination – Paper 2.4Financial Management and Control June 2003 Answers

1 (a) Calculation of tax benefits of capital allowances

Year 1 2 3 4 5£000 £000 £000 £000 £000

Capital allowance 750 563 422 316 949Tax benefits 225 169 127 95 284

Calculation of NPV of proposed investment:

Year 0 1 2 3 4 5£000 £000 £000 £000 £000 £000

Sales 2,750 2,750 2,750 2,750 2,750Production costs (1,100) (1,100) (1,100) (1,100) (1,100)Admin expenses (220) (220) (220) (220) (220)

–––––– –––––– –––––– –––––– ––––––Net revenue 1,430 1,430 1,430 1,430 1,430Tax payable (429) (429) (429) (429) (429)Tax benefits 225 169 127 95 284

–––––– –––––– –––––– –––––– ––––––1,226 1,170 1,128 1,096 1,285

Working capital (400) 400Investment (3,000) – – – – –

–––––– –––––– –––––– –––––– –––––– ––––––Project cash flows (3,400) 1,226 1,170 1,128 1,096 1,685Discount factors 1·000 0·893 0·797 0·712 0·636 0·567Present values (3,400) 1,095 932·5 803 697 955·5

The net present value is approximately £1,083,000

An alternative answer using annuity factors is as follows.£000

PV of tax benefits = (225 x 0·893) + (169 x 0·797)+ (127 x 0·712) + (95 x 0·636) + (284 x 0·567) = 647·5PV of working capital recovered = 400 x 0·567 = 226·8PV of revenue after tax = 1,430 x 0·7 x 3·605 = 3,608·6Investment in working capital = (400)Investment in new machinery = (3,000)

––––––––Net present value = 1,083·0

––––––––

The net present value is approximately £1,083,000

This analysis makes the following assumptions:(1) The first tax benefit occurs in Year 1, the last tax benefit occurs in Year 5(2) Cash flows occur at the end of each year.(3) Inflation can be ignored.(4) The increase in capacity does not lead to any increase in fixed production overheads.(5) Working capital is all released at the end of Year 5

(b) Administration and distribution expenses per unit = 220,000/5,500 = £40 per unitNet revenue from additional units sold = 500 – 200 – 40 = £260 per unitPresent value of tax benefits = £647,500Incremental working capital per unit = 400,000/5,500 = £72·73 per unit

Let annual sales volume be SV unitsNPV = [SV x 260 x (1 – 0·3) x 3·605] + 647,500 – [72·73 x SV x (1 – 0·567)] – 3,000,000 = 0

Hence SV =(3,000,000 – 647,500)

=2,352,500

= 3,766 units–––––––––––––––––––––– ––––––––––(656·11 – 31·49) 624·62

Annual increase in sales volume of 3,766 units will produce a zero NPVThis is 31% (100 x 1,734/5,500) less than the expected increase in sales volume.(Note: working capital is assumed to depend on sales volume)

(c) (i) The current gearing of Springbank plc = 100 x (3·5m/4m) = 87·5%Total debt after issuing £3·4m of debt = 3·5m + 3·4m = £6·9mNew level of gearing = 100 x (6·9m/4m) = 172·5%

Current annual debenture interest = £350,000 (3·5m x 0·1)Current interest on overdraft = 400,000 – 350,000 = £50,000

13



Annual interest on new debt = £272,000 (3·4m x 0·08)Expected annual interest = 400,000 + 272,000 = £672,000

Current profit before interest and tax = £1·5mCurrent interest cover = 3·75 (1·5m/0·4m)Assuming straight line depreciation, additional depreciation = £600,000 per yearExpected profit before interest and tax = 1·5 + 1·43 – 0·6 = £2·33mExpected interest cover = 3·47 (2·33/0·672)

This is lower than the current interest cover and also assumes no change in overdraft interest.

Thus, Springbank’s gearing is expected to rise from slightly below the sector average of 100% to significantly more thanthe sector average. Springbank’s interest cover is likely to remain at a level lower than the sector average of four times,and will be slightly reduced assuming no change in overdraft interest.

(ii) Ratio calculations

2001 2002ROCE 1,750/7,120 24·6% 1,500/7,500 20%Net profit margin 1,750/5,000 35% 1,500/5,000 30%Asset turnover 5,000/7,120 0·70 5,000/7,500 0·67Current ratio 2,000/1,280 1·56 2,150/1,150 1·87Quick ratio 1,000/1,280 0·78 980/1,150 0·85Stock days 365 x 1,000/3,000 122 days 365 x 1,170/3,100 138 daysDebtors ratio 12 x 900/5,000 2·2 months 12 x 850/5,000 2 monthsSales/working capital 5,000/720 6·9 5,000/1,000 5Debt/equity 3,500/3,620 96·7% 3,500/4,000 87·5%Interest cover 1,750/380 4·6 1,500/400 3·75

The return on capital employed of Springbank has declined as a result of both falling net profit margin and falling assetturnover: while comparable with the sector average of 25% in 2001, it is well below the sector average in 2002. Theproblem here is that turnover has remained static while both cost of sales and investment in assets have increased.

Despite the fall in profitability, both current ratio and quick ratio have improved, in the main due to the increase in stocklevels and the decline in current liabilities, the composition of which is unknown. The current ratio remains below thesector average, however. The increase in both stock levels and stock days, together with the fact that stock days is now53% above the sector average, may indicate that current products are becoming harder to sell, a conclusion supportedby the failure to increase turnover and the reduced profit margin. The expected increase in sales volume is thereforelikely to be associated with a new product launch, since it is unlikely that an increase in capacity alone will be able togenerate increased sales. There is also the possibility that the static sales of existing products may herald a decline insales in the future.

The decrease in the debtors’ ratio is an encouraging sign, but the interpretation of the decreased sales/working capitalratio is uncertain. While the decrease could indicate less aggressive working capital management, it could also indicatethat trade creditors are less willing to extend credit to Springbank, or that stock management is poor.

The gearing of the company has fallen, but only because reserves have been increased by retained profit. The interestcover has declined since interest has increased and operating profit has fallen. Given the constant long-term debt, theincrease in interest, although small, could indicate an increase in overdraft finance.

Ratio analysis offers evidence that the financial performance of Springbank plc has been disappointing in terms of sales,profitability and stock management. It may be that the management of Springbank see the increase in capacity as acure for the company’s declining performance.

(iii) Since the investment has a positive NPV it is acceptable in financial terms. The danger highlighted by the analysis ofrecent financial performance is that existing sales may generate a declining contribution towards meeting interestpayments in the future. However, sensitivity analysis shows the proposed expansion is robust in terms of sales volume,since a 31% reduction in forecast sales is needed to eliminate the positive NPV. The proposed expansion is thereforeacceptable, but the choice of financing is critical.

Springbank should be able to meet future interest payments if the cashflow forecasts for the increase in capacity aresound. However, no account has been taken of expected inflation, and both sales prices and costs will be expected tochange. There is also an underlying assumption of constant sales volumes, when changing economic circumstancesand the actions of competitors make this assumption unlikely to be true. More detailed financial forecasts are needed togive a clearer indication of whether Springbank can meet the additional interest payments arising from the newdebentures. There is also a danger that managers may focus more on the short-term need to meet the increased interestpayments, or on the longer-term need to replace the machinery and redeem the debentures, rather than on increasingthe wealth of shareholders.

Financial risk has increased from a balance sheet point of view and this is likely to have a negative effect on howfinancial markets view the company. The cost of raising additional finance is likely to rise, while the increased financialrisk may lead to downward pressure on the company’s share price. The current debentures represent 54% of fixed assetsand after the new issue of debentures, this will rise to 73% of fixed assets. The assets available for offering as securityagainst new debt issues will therefore decrease, and continue to decrease as fixed assets depreciate.

14



No information has been offered as to the maturity of the new debenture issue. If the matching principle is applied, amedium term maturity of five to six years is indicated. However, the 10% debentures are due for redemption in 2007and it would be unwise to have two significant redemption calls so close to each other.

On the basis of the above discussion, careful thought needs to be given to the maturity of any new issue of debenturesand it may be advisable to use debt finance to meet only part of the financing need of the proposed capacity expansion.Alternative sources of finance such as equity and leasing should be considered.

(d) Financing the investment by an issue of ordinary shares could offer several advantages to Springbank plc. Gearing would fallto 47% (3·5/7·4), less than half of the sector average of 100%, rather than increasing to significantly more than the sectoraverage. Interest cover would increase to 5·8 (2·33/0·4) from 3·75, compared to a sector average of 4. The financial riskfaced by the company would thus be reduced, making it a more attractive investment prospect on the stock market. Thiscould have a positive effect on the company’s share price.

Ordinary shares do not carry a commitment to make regular payments such as interest on debt, giving Springbank plc adegree of flexibility in rewarding shareholders in financial terms. This must be balanced against the common desire ofshareholders for a regular and increasing dividend.

Ordinary shares are permanent capital since they do not need to be repaid. Springbank plc would thus avoid the need to findfunds for redemption that would arise if it issued debentures.

Because the fixed assets of the company would increase but its burden of long-tem debt would be unchanged, Springbankwould find it easier to raise additional debt in the future. This could be useful when the need arises to redeem the existingdebentures in 2007.

2 (a) The centred moving averages can be compared with actual sales for each quarter in order to determine the seasonalvariations.

Quarter actual sales centred moving average seasonal variation£000 £000 £000

2001Q3 3,400 3,200 200Q4 3,000 3,300 (300)2002Q1 3,100 3,375 (275)Q2 3,900 3,450 450Q3 3,600 3,562·5 37·5Q4 3,400 3,687·5 (287·5)

The average seasonal variations and the residual error term can now be calculated.

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total£0000 £000 £000 £000 £000

2001 200 (300)2002 (275) 450 37·5 (287·5)Average (275) 450 118·75 (293·75) nil

Since the residual error term is nil, there is no need to net this off against the average seasonal variations. The average trendof the centred moving averages is (3,687·5 – 3,200)/5 = £97,500

The sales for Quarter 3 of 2003 can now be forecast.

Forecast centred moving average = 3,687·5 + (3 x 97·5) = £3,980,000Forecast sales for Quarter 3 = 3,980,000 + 118,750 = £4,098,750

The sales for Quarter 4 of 2003 can now be forecast.

Forecast centred moving average = 3,687·5 + (4 x 97·5) = £4,077,500Forecast sales for Quarter 4 = 4,077,500 – 293,750 = £3,783,750

Both forecasts are higher than those made by the Sales Director (7·9% more for the Quarter 3 forecast and 5·1% for theQuarter 4 forecast). This may be because the Sales Director built some slack into his forecasts, or because the forecasts weremade using data prior to the current year (although applying the additive model to earlier sales data does not support this).

(b) The additive model assumes that the trend and seasonal variations are independent of each other, and that an increasingtrend is not linked to increasing seasonal variations. There is no evidence of an increasing trend in the sales of Storrs plc, andin such circumstances use of the additive model may be acceptable.

The model assumes that the historic pattern of the trend and the seasonal variations will continue in the future. This may nothappen for a number of reasons, for example because of the occurrence of unexpected events or because of changes inconsumer preferences. The forecast sales figures should be compared with the expectations and opinions of sales staff, whomay have a more detailed knowledge of likely sales and market factors.

15



The reliability of the forecasting method is linked to the amount and accuracy of the data analysed. Since only two years ofdata has been considered, the forecast is unlikely to be reliable. The reliability of the forecast will also decrease as theforecasting period increases, but the forecast period here is only six months.

(c) The top-down approach to budget setting implies that budgets are imposed by senior management. This has the advantagethat budgets are more likely to support the strategic objectives of the company, and the operations of different divisions aremore likely to be co-ordinated. It may be an appropriate form of budget setting in small organisations, where senior managersare likely to have a detailed knowledge of all aspects of the business, or in situations where close control of planned costs iscalled for, such as business start up or difficult economic conditions. It also has the advantage of decreasing the amount oftime taken, and the resources consumed, by budget preparation.

There are number of difficulties with the top-down approach that make it likely that it will not regularly be used in isolation.Staff may be demotivated if they have not been involved in the formulation of budgets that produce targets they are expectedto achieve, especially if their rewards and incentives are linked to their performance against budget. This reduction inmotivation could result in strategic objectives and organisational goals being less than fully supported at the operational level,with company performance and profitability suffering as a result. Initiative and innovation could also be lost as staff simply‘work to budget’, rather than making creative suggestions for improving performance that they feel are unlikely to be rewarded,or form part of future plans.

The bottom-up approach to budget setting implies that functional and other junior managers participate in the preparation ofbudgets. This approach is likely to lead to more realistic and more co-ordinated budgets than the top-down approach if thesemanagers have a more detailed knowledge of the operations and markets of the organisation. It is also likely to be useful inlarge, established companies where the complexity of the budget-setting process calls for detailed input from lower levels ofthe organisation. This approach will also lead to higher levels of motivation and commitment, since managers will havecontributed towards the targets against which their performance will be measured.

There are a number of difficulties with the bottom-up approach. For example, it can be more time-consuming than the top-down approach because of the larger number of participants in the budget-setting process. Participants may becomedissatisfied if their budget proposals are subsequently amended by senior managers. Managers may introduce an element ofbudgetary slack into their budget estimates, giving them a ‘zone of comfort’ in reaching budget targets. Any variances betweenplanned and actual performance are then likely to be favourable ones. The bottom-up approach also requires detailedplanning and co-ordination of the budget-setting process, perhaps supported by a budget manual.

The top-down and bottom-up approaches represent two extremes of the budget-setting process. In practice, a compromise ornegotiated approach is likely to be used, with senior management reviewing and amending the budget proposals of junior oroperational managers in the light of the organisation’s strategic plan, and junior or operational managers negotiatingamendments to aspects of the budget they find unacceptable.

3 (a) The benefits of the proposed policy change are as follows.

Trade terms are 40 days, but debtors are taking 365 x 0·550/4 = 50 daysCurrent level of debtors = £550,000Cost of 1% discount = 0·01 x 4m x 2/3 = £26,667Proposed level of debtors = (4,000,000 – 26,667) x (26/365) = £283,000Reduction in debtors = 550,000 – 283,000 = £267,000

Debtors appear to be financed by the overdraft at an annual rate of 9%Reduction in financing cost = 267,000 x 0·09 = £24,030

Reduction of 0·6% in bad debts = £4m x 0·006 = £24,000Salary saving from early retirement = £12,000

Total benefits = 24,030 + 24,000 + 12,000 = £60,030

Net benefit of discount = 60,030 – 26,667 = £33,363

A discount for early payment of 1 per cent will therefore lead to an increase in profitability for Velm plc.

(b) Short-term sources of debt finance include overdrafts and short-term loans. An overdraft offers flexibility but since it istechnically repayable on demand, it is a relatively risky source of finance and a company could experience liquidity problemsif an overdraft were called in, until an alternative source of finance were found. The danger with a short-term loan as a sourceof finance is that it may be renewed on less favourable terms if economic circumstances have deteriorated at its maturity,leaving the company vulnerable to short-term interest rate changes.

Short-term finance will be cheaper than long-term finance, although this is based on the assumption of a normal shape tothe yield curve. Economic circumstances could invert the yield curve, for example if short-term interest rates have beenincreased in order to curb economic growth or to dampen inflationary pressures.

Long-term sources of debt finance include loan stock, debentures and long-term loans. These are relatively secure forms offinance: for example, if a company meets its contractual obligations on debentures in terms of interest payments and loancovenants it will not have to repay the finance until maturity. The risk for the company is therefore lower if it finances workingcapital from a long-term source.

16



However, long-term finance is more expensive than short-term finance. The shape of the normal yield curve, for example,indicates that providers of debt finance will expect compensation for deferred consumption and default risk, as well asprotection against expected inflation.

The choice between short-term and long-term debt for the financing of working capital is hence a choice between cheaperbut riskier short-term finance and more expensive but less risky long-term debt.

(c) Working capital policies on the method of financing working capital can be characterised as conservative, moderate andaggressive. A conservative financing policy would involve financing working capital needs predominantly from long-termsources of finance. If current assets are analysed into permanent and fluctuating current assets, a conservative policy woulduse long-term finance for permanent current assets and some of the fluctuating current assets. Such a policy would increasethe amount of lower-risk finance used by the company, at the expense of increased interest payments and lower profitability.

Velm plc is clearly not pursuing a conservative financing policy, since long-term debt only accounts for 2·75% (40/1,450) ofnon-cash current assets. Rather, it seems to be following an aggressive financing policy, characterised by short-term financebeing used for all of fluctuating current assets and most of the permanent current assets as well. Such a policy will decreaseinterest costs and increase profitability, but at the expense of an increase in the amount of higher-risk finance used by thecompany.

Between these two extremes in policy terms lies a moderate or matching approach, where short-term finance is used forfluctuating current assets and long-term finance is used for permanent current assets. This is an expression of the matchingprinciple, which holds that the maturity of the finance should match the maturity of the assets.

(d) The objectives of working capital management are often stated to be profitability and liquidity. These objectives are often inconflict, since liquid assets earn the lowest return and so liquidity is achieved at the expense of profitability. However, liquidityis needed in the sense that a company must meet its liabilities as they fall due if it is to remain in business. For this reasoncash is often called the lifeblood of the company, since without cash a company would quickly fail. Good working capitalmanagement is therefore necessary if the company is to survive and remain profitable.

The fundamental objective of the company is to maximise the wealth of its shareholders and good working capitalmanagement helps to achieve this by minimising the cost of investing in current assets. Good credit management, forexample, aims to minimise the risk of bad debts and expedite the prompt payment of money due from debtors in accordancewith agreed terms of trade. Taking steps to optimise the level and age of debtors will minimise the cost of financing them,leading to an increase in the returns available to shareholders.

A similar case can be made for the management of stock. It is likely that Velm plc will need to have a good range of stationeryand office supplies on its premises if customers’ needs are to be quickly met and their custom retained. Good stockmanagement, for example using techniques such as the economic order quantity model, ABC analysis, stock rotation andbuffer stock management can minimise the costs of holding and ordering stock. The application of just-in-time methods ofstock procurement and manufacture can reduce the cost of investing in stock. Taking steps to improve stock managementcan therefore reduce costs and increase shareholder wealth.

Cash budgets can help to determine the transactions need for cash in each budget control period, although the optimum cashposition will also depend on the precautionary and speculative need for cash. Cash management models such as the Baumolmodel and the Miller-Orr model can help to maintain cash balances close to optimum levels.

The different elements of good working capital management therefore combine to help the company to achieve its primaryfinancial objective.

4 (a) Market efficiency is commonly discussed in terms of pricing efficiency.

A stock market is described as efficient when share prices fully and fairly reflect relevant information.

Weak form efficiency occurs when share prices fully and fairly reflect all past information, such as share price movements inpreceding periods. If a stock market is weak form efficient, investors cannot make abnormal gains by studying and actingupon past information.

Semi-strong form efficiency occurs when share prices fully and fairly reflect not only past information, but all publicly availableinformation as well, such as the information provided by the published financial statements of companies or by reports in thefinancial press. If a stock market is semi-strong form efficient, investors cannot make abnormal gains by studying and actingupon publicly available information.

Strong form efficiency occurs when share prices fully and fairly reflect not only all past and publicly available information, butall relevant private information as well, such as confidential minutes of board meetings. If a stock market is strong formefficient, investors cannot make abnormal gains by acting upon any information, whether publicly available or not.

There is no empirical evidence supporting the proposition that stock markets are strong form efficient and so the bank isincorrect in suggesting that in six months the stock market will be strong form efficient. However, there is a great deal ofevidence suggesting that stock markets are semi-strong form efficient and so Tagna’s share are unlikely to be under-priced.

17



(b) A substantial interest rate increase may have several consequences for Tagna in the areas indicated.

(i) As a manufacturer and supplier of luxury goods, it is likely that Tagna will experience a sharp decrease in sales as aresult of the increase in interest rates. One reason for this is that sales of luxury goods will be more sensitive to changesin disposable income than sales of basic necessities, and disposable income is likely to fall as a result of the interestrate increase. Another reason is the likely effect of the interest rate increase on consumer demand. If the increase indemand has been supported, even in part, by the increase in consumer credit, the substantial interest rate increase willhave a negative effect on demand as the cost of consumer credit increases. It is also likely that many chain storecustomers will buy Tagna’s goods by using credit.

(ii) Tagna may experience an increase in operating costs as a result of the substantial interest rate increase, although thisis likely to be a smaller effect and one that occurs more slowly than a decrease in sales. As the higher cost of borrowingmoves through the various supply chains in the economy, producer prices may increase and material and other inputcosts for Tagna may rise by more than the current rate of inflation. Labour costs may also increase sharply if the recentsharp rise in inflation leads to high inflationary expectations being built into wage demands. Acting against this will bethe deflationary effect on consumer demand of the interest rate increase. If the Central Bank has made an accurateassessment of the economic situation when determining the interest rate increase, both the growth in consumer demandand the rate of inflation may fall to more acceptable levels, leading to a lower increase in operating costs.

(iii) The earnings (profit after tax) of Tagna are likely to fall as a result of the interest rate increase. In addition to the decreasein sales and the possible increase in operating costs discussed above, Tagna will experience an increase in interest costsarising from its overdraft. The combination of these effects is likely to result in a sharp fall in earnings. The level ofreported profits has been low in recent years and so Tagna may be faced with insufficient profits to maintain its dividend,or even a reported loss.

(c) The objectives of public sector organisations are often difficult to define. Even though the cost of resources used can bemeasured, the benefits gained from the consumption of those resources can be difficult, if not impossible, to quantify. Becauseof this difficulty, public sector organisations often have financial targets imposed on them, such as a target rate of return oncapital employed. Furthermore, they will tend to focus on maximising the return on resources consumed by producing thebest possible combination of services for the lowest possible cost. This is the meaning of ‘value for money’, often referred toas the pursuit of economy, efficiency and effectiveness.

Economy refers to seeking the lowest level of input costs for a given level of output. Efficiency refers to seeking the highestlevel of output for a given level of input resources. Effectiveness refers to the extent to which output produced meets thespecified objectives, for example in terms of provision of a required range of services.

In contrast, private sector organisations have to compete for funds in the capital markets and must offer an adequate returnto investors. The objective of maximisation of shareholder wealth equates to the view that the primary financial objective ofcompanies is to reward their owners. If this objective is not followed, the directors may be replaced or a company may findit difficult to obtain funds in the market, since investors will prefer companies that increase their wealth. However, shareholderwealth cannot be maximised if companies do not seek both economy and efficiency in their business operations.

5 (a) The optimum production schedule is found using limiting factor analysis.

AR2 GL3 HT4Material R2 (£/unit) 2·5 x 2 = 5·00 2·5 x 3 = 7·50 2·5 x 3 = 7·50Material R3 (£/unit) 2 x 2 = 4·00 2 x 2·2 = 4·40 2 x 1·6 = 3·20Labour (£/unit) 4 x 0·6 = 2·40 4 x 1·2 = 4·80 4 x 1·5 = 6·00Variable o/h (£/unit) 1·10 1·30 1·10

––––– ––––– –––––Variable costs (£/unit) 12·50 18·00 17·80Selling price (£/unit) 21·00 28·50 27·30

––––– ––––– –––––Contribution (£/unit) 8·50 10·50 9·50

––––– ––––– –––––

Material R2 (kg/unit) 2 3 3Contribution (£/kg of R2) 8·5/2 = 4·25 10·5/3 = 3·50 9·5/3 = 3·17Ranking 1 2 3

Product Demand (units) R2 used (kg) Production (units) Contribution (£)AR2 950 1,900 950 8,075GL3 1,000 3,000 1,000 10,500HT4 900 600 200 1,900

–––––– –––––––5,500 20,475

–––––– –––––––

The optimum production schedule is 950 units of Product AR2, 1,000 units of GL3 and 200 units of HT4, giving a totalcontribution of £20,475. The fixed production overheads are ignored in this analysis because they are assumed not to varywith changes in the level of production.

18



(b) Further supplies of Material R2 will be used to produce additional units of Product HT4. The contribution per kg of MaterialR2 of Product HT4 is £3·17 and so if Albion pays 3·17 + 2·50 = £5·67 per kg for Material R2, the additional units ofProduct HT4 produced will make a zero contribution towards fixed costs. £5·67 is therefore the maximum price.

(c) The variable cost of Product XY5:

£/unitMaterial R3: 3 x 2 = 6·00Labour: 1·7 x 4 = 6·80Variable overhead: 1·40

–––––14·20–––––

The substitute offered by Folam gives a saving of £4 per unit. However, Albion plc would also pay an annual fee of £50,000for the right to use the substitute. The company would need to manufacture more than 50,000/4 = 12,500 units per yearof Product XY5, or 1,042 units per month, in order for the offered substitute to be financially acceptable. If it needed lessthan 12,500 units of Product XY5 per year, it would be cheaper to manufacture the product in house. This evaluation is froma short-term perspective: in the longer term, buying in may lead to fixed cost savings and lower investment, increasing thebenefits of buying in and lowering the break-even point.

Albion plc would also need to assure itself that the quality of the substitute was acceptable and that this quality could bemaintained: the lower price offered by Folam might be associated with poorer quality than that deemed necessary by Albion plc. Orders for the substitute product would also need to be delivered promptly in order to avoid production hold-ups.Albion plc could also become dependent on Folam Limited for supplies of the substitute product and might be vulnerable tofuture price increases by the supplier. Such price increases might reduce or even eliminate the cost saving of buying in.

(d) Marginal costing (variable costing) treats fixed costs as a period cost, on the assumption that fixed costs do not change in theshort term. The difference between selling price and variable costs is the variable contribution made by units sold towardsmeeting fixed costs and generating profit.

Marginal costing has traditionally been used for short-term decisions such as whether to cease production of a product,whether to make a product or buy it from a supplier, and how to allocate scarce resources in order to maximise contribution.

A major limitation with using marginal costing as the basis for making short-term decisions is the assumption that fixed costsare irrelevant to short-term decisions. In the longer term, fixed costs will change: for example, rent is usually regarded as afixed cost and in the longer term rent might be expected to increase due to inflation. However, a change in fixed costs maybe the result of a short-term decision: for example, if a product is discontinued and as a result the work of the marketingdepartment decreases, in the longer term marketing costs would be expected to decrease.

This points to the danger of relying on a simplistic analysis of costs into fixed costs and variable costs, and of assuming thatonly variable costs are relevant for decision-making purposes. It is possible for a fixed cost to be a relevant cost. It is alsopossible for a variable cost to be irrelevant, for example in the case where a variable cost is common to two decisionalternatives. If fuel costs are incurred whether a machine is leased or bought, for example, these costs are not relevant to thedecision on whether to lease or buy.

Reliance on marginal costing as a basis for making short-term decisions may therefore lead to sub-optimal decisions overallfor a company, as the analysis may fail to consider all relevant costs. A relevant cost is an incremental or differential cost atthe whole company level. If a cost changes or is incurred, now or in the future, as a result of a decision, it is a relevant costand should be considered when making a decision. When making short-term decisions, therefore, it is essential to adopt awhole company perspective in determining relevant costs.

When making short-term decisions, a detailed analysis of cost behaviour is therefore needed in order to determine not onlyvariable costs and fixed costs, but relevant costs as well.

19



Part 2 Examination – Paper 2.4Financial Management and Control June 2003 Marking Scheme

Marks Marks1 (a) Calculation of capital allowances 2

Calculation of tax benefits 1Calculation of net revenue 1Calculation of tax on net revenue 1Inclusion of tax benefits 1Treatment of working capital 1Capital investment 1Calculation of project cash flows 1Use of correct discount factors 1Calculation of NPV 1

–––11

(b) Formulation of solution 1Calculation of sales volume giving zero NPV 2Expression of volume change in relative terms 1

–––4

(c) (i) Calculation of current gearing 1Calculation of expected gearing 1Calculation of current interest cover 1Calculation/discussion of expected interest cover 2Comparison with sector averages 1

–––6

(ii) Calculation of relevant ratios 8Comment on recent financial performance 5

–––13

(iii) Comment on acceptability of expansion 2Ability to meet future interest payments 2Maturity of new debentures 2Financial risk and asset backing 2Comment on acceptability of proposed financing 2

–––10

(d) Up to 2 marks for each detailed advantage 6–––50

2 (a) Calculation of seasonal variations 2Calculation of average seasonal variations 1Consideration of residual error term 1Sales forecasts for quarter 3 and quarter 4 2Discussion and explanation 2

–––8

(b) Discussion of trend and seasonal variations 2Historic pattern may not be repeated 2Amount of data used in the analysis 1

–––5

(c) Discussion of top-down budgeting 6Discussion of bottom-up budgeting 6

–––12

–––25

21



Marks Marks3 (a) Reduction in debtors 1

Cost of discount 1Reduction in financing cost 1Reduction in bad debts and salary saving 1Calculation of net benefit and conclusion 1

–––5

(b) Risks of short-term finance 2Cost of short-term finance 1Risks of long-term finance 1Cost of long-term finance 1Discussion and conclusion 1

–––6

(c) Permanent and fluctuating current assets 2Explanation of financing policies 4Discussion and link to Velm plc 1

–––7

(d) Advantages of working capital management 2Credit management 2Stock management 2Discussion and link to Velm plc 1

–––7

–––25

4 (a) Pricing efficiency 1Meaning and significance of weak form 2Meaning and significance of semi-strong form 2Meaning and significance of strong form 2Comment on bank’s recommendation 2

–––9

(b) Up to 2 marks for each detailed consequence 10

(c) Value for money 3Maximisation of shareholder wealth 3

–––6

–––25

5 (a) Calculation of contribution per unit 2Calculation of contribution per kg of R2 2Optimum production schedule 4

–––8

(b) Calculation of a maximum price 1Discussion 2

–––3

(c) Calculation of cost saving 1Calculation of break-even point 1Discussion of relevant issues 5

–––7

(d) Up to 2 marks for each detailed point made 7–––25

22




PART 2


QUESTION PAPER





Formulae Sheet, Present Value and Annuity Tables are on pages7 and 8.

Pape

r 2.4




1 At a recent meeting of the Board of Doe Ltd, a supplier of industrial and commercial clothing, it was suggested thatthe company might be suffering liquidity problems as a result of overtrading, despite encouraging growth in turnover.The Finance Director was instructed to report to the next Board meeting on this matter.

Extracts from the financial statements of Doe Ltd for 2002, and from the forecast financial statements for 2003, aregiven below.

Profit and Loss Account extracts for years ending 31 December

2003 2002£000 £000

Turnover 8,300 6,638Cost of sales 4,900 3,720

–––––– ––––––Gross profit 3,400 2,918Administration and distribution expenses 2,700 2,318

–––––– ––––––Operating profit 700 600Interest 125 100

–-–––– –-––––Profit before tax 575 500

––––– ––––––

Balance Sheet extracts as at 31 December2003 2002

£000 £000 £000 £000 £000 £000Fixed assets 1,650 1,500Current assetsStocks 3,200 2,700Debtors 2,750 2,000

–––––– ––––––5,950 4,700

Creditors: amounts due within 1 yearTrade creditors 2,550 1,800Bank overdraft 2,750 2,300Other liabilities 500 400

––––– –––––5,800 4,500

–––––– ––––––Net current assets 150 200

–––––– ––––––Total assets less current liabilities 1,800 1,700

–––––– ––––––Capital and reservesOrdinary shares 400 400Reserves 1,400 1,300

–––––– ––––––1,800 1,700

–––––– ––––––

The Finance Director had reported to the recent board meeting that the bank was insisting the company reduce itsoverdraft as a matter of urgency. It was suggested that the company could consider factor finance as an alternativesource of funds for working capital investment. The Production Director insisted that a new machine would be neededto maintain growth in turnover and the Finance Director agreed to investigate how this might be financed.

2



FactoringThe Finance Director has found a factor who would take over administration of the company’s debtors on a non-recourse basis for an annual fee of 1·0% of turnover. The factor would advance 80% of the book value of debtorsat an annual interest rate 2% above the company’s current overdraft rate. The factor expects to reduce the averagedebtor period to 90 days. The company estimates that Doe Ltd could save £15,000 per year in administration costs.No redundancy costs are expected.

The New MachineThe new machine wanted by the Production Director would cost £365,000 if purchased. The Finance Director isconfident this purchase could be financed by a medium-term bank loan at an annual interest cost of 10% before tax.

Alternatively, the machine could be leased for £77,250 per annum, payable annually in advance. The machine hasan expected life of five years, at the end of which it would have zero scrap value.

Sales and Costs of New Machine OutputThe Finance Director has commissioned research that shows growth in sales of the output produced by the newmachine depends on the sales price, as follows:

Sales price New sales in year 1 Expected annual growth in sales£70 per unit 10,000 units 20%£67 per unit 11,000 units 23%

Variable costs of production are £42 per unit and incremental fixed production overheads arising from the use of themachine are expected to be £85,000 per annum. The maximum capacity of the new machine is 20,000 units perannum.

Other InformationDoe Ltd pays tax one year in arrears at a rate of 30% and can claim annual writing down allowances (tax-allowabledepreciation) on a 25% reducing balance basis. The company pays interest on its overdraft at approximately 6% perannum before tax.

Average ratios for the business sector in which Doe Ltd operates are as follows:

Stock days 210 days Current ratio 1·35Debtor days 100 days Quick ratio 0·55Creditor days 120 days

Required:

(a) Write a report to the board of Doe Ltd that analyses and discusses the suggestion that the company isovertrading. (12 marks)

(b) (i) Determine whether Doe Ltd should accept the factor’s offer. (7 marks)

(ii) What are the advantages to Doe Ltd of factoring its debtors? (8 marks)

(c) Discuss three ways (other than factoring) by which Doe Ltd might improve the management of its debtors.(8 marks)

(d) Evaluate whether Doe Ltd should buy or lease the new machine, using an after tax discount rate of 7%.(Assume that payment for the purchase, or the first lease payment, would take place on 1 January 2004.)

(9 marks)

(e) Calculate the optimum sales price for the output from the new machine. (Taxation and the time value ofmoney should be ignored.) (6 marks)

(50 marks)

3 [P.T.O.




2 Acred Ltd manufactures a single product. It is preparing monthly budgets for the six months from July to December2004. The following standard revenue and cost data is available:

Selling price £12·00 per unitMaterials 2 kg per unit at £2·40 per kgLabour £1·80 per unitDirect expenses £1·20 per unit

Sales in June 2004 and July 2004 are forecast to be 10,000 units in each month. As a direct result of marketingexpenditure of £95,000 in August 2004, sales are expected to be 11,000 units in August 2004 and to increase by1,000 units in each month from September to December. Sales after December 2004 are expected to remain at theDecember 2004 level.

25% of sales are paid for when they occur and 75% of sales are paid for in the month following sale. Stocks offinished goods at the end of each month are required to be 20% of the expected sales for the following month. Stocksof materials at the end of each month are required to be 50% of the materials required for the following month’sproduction.

Materials are paid for in the month following purchase. Labour and direct expenses are paid for in the month in whichthey occur. Overheads for production, administration and distribution will be £34,000 per month, includingdepreciation of £12,000 per month. These overheads are payable in the month in which they occur. Acred Ltd hasa £750,000 bank loan at 8% per annum on which it pays interest twice per year, in March and September.

The cash balance at the end of June 2004 is expected to be £50,000.

Required:

(a) Prepare the following budgets for Acred Ltd on a month by month basis for the six month period from Julyto December 2004:

(i) production budget (units);

(ii) cash budget. (13 marks)

(b) Critically discuss the relative merits of periodic budgeting and continuous budgeting. (7 marks)

(c) Discuss the consequences of budget bias (budgetary slack) for cost control. (5 marks)

(25 marks)

4



3 Basril plc is reviewing investment proposals that have been submitted by divisional managers. The investment fundsof the company are limited to £800,000 in the current year. Details of three possible investments, none of which canbe delayed, are given below.

Project 1An investment of £300,000 in work station assessments. Each assessment would be on an individual employee basisand would lead to savings in labour costs from increased efficiency and from reduced absenteeism due to work-relatedillness. Savings in labour costs from these assessments in money terms are expected to be as follows:

Year 1 2 3 4 5Cash flows (£000) 85 90 95 100 95

Project 2An investment of £450,000 in individual workstations for staff that is expected to reduce administration costs by£140,800 per annum in money terms for the next five years.

Project 3An investment of £400,000 in new ticket machines. Net cash savings of £120,000 per annum are expected incurrent price terms and these are expected to increase by 3·6% per annum due to inflation during the five-year lifeof the machines.

Basril plc has a money cost of capital of 12% and taxation should be ignored.

Required:

(a) Determine the best way for Basril plc to invest the available funds and calculate the resultant NPV:

(i) on the assumption that each of the three projects is divisible;

(ii) on the assumption that none of the projects are divisible. (10 marks)

(b) Explain how the NPV investment appraisal method is applied in situations where capital is rationed.(3 marks)

(c) Discuss the reasons why capital rationing may arise. (7 marks)

(d) Discuss the meaning of the term ‘relevant cash flows’ in the context of investment appraisal, giving examplesto illustrate your discussion. (5 marks)

(25 marks)

4 Two important elements in the economic and financial management environment of companies are the regulation ofmarkets to discourage monopoly and the availability of finance to fund growth and development.

Required:

(a) Outline the economic problems caused by monopoly and explain the role of government in maintainingcompetition between companies. (9 marks)

(b) Describe the methods of raising new equity finance that can be used by an unlisted company. (8 marks)

(c) Discuss the factors to be considered by a listed company when choosing between an issue of debt and anissue of equity finance. (8 marks)

(25 marks)

5 [P.T.O.



5 Carat plc, a premium food manufacturer, is reviewing operations for a three-month period of 2003. The companyoperates a standard marginal costing system and manufactures one product, ZP, for which the following standardrevenue and cost data per unit of product is available:

Selling price £12·00Direct material A 2·5 kg at £1·70 per kgDirect material B 1·5 kg at £1·20 per kgDirect labour 0·45 hrs at £6·00 per hour

Fixed production overheads for the three-month period were expected to be £62,500.

Actual data for the three-month period was as follows:

Sales and production 48,000 units of ZP were produced and sold for £580,800Direct material A 121,951 kg were used at a cost of £200,000Direct material B 67,200 kg were used at a cost of £84,000Direct labour Employees worked for 18,900 hours, but 19,200 hours were paid at a

cost of £117,120Fixed production overheads £64,000

Budgeted sales for the three-month period were 50,000 units of Product ZP.

Required:

(a) Calculate the following variances:

(i) sales volume contribution and sales price variances;

(ii) price, mix and yield variances for each material;

(iii) labour rate, labour efficiency and idle time variances. (8 marks)

(b) Prepare an operating statement that reconciles budgeted gross profit to actual gross profit with each varianceclearly shown. (5 marks)

(c) Suggest possible explanations for the following variances:

(i) material price, mix and yield variances for material A;

(ii) labour rate, labour efficiency and idle time variances. (5 marks)

(d) Critically discuss the types of standard used in standard costing and their effect on employee motivation.(7 marks)

(25 marks)

6



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Answers




1 (a) To: The Board of Doe LtdSubject: Overtrading SuggestionDate: December 2003

1. IntroductionThis report presents my findings regarding the suggestion made at the last board meeting that our company is overtrading.Overtrading is also known as undercapitalisation, and occurs when the volume of trade is not supported by an adequatesupply of capital. Overtrading can lead to liquidity problems that can cause serious difficulties if they are not dealt withpromptly.

2. Signs of OvertradingThere are a number of generally recognised signs that a company may be overtrading. These are considered, together withrelevant financial data from Appendix 1, in the following paragraphs.

Rapid increase in turnoverThe forecast financial statements for 2003 show that our turnover is expected to increase by 25% during the year.

Rapid increase in current assetsCurrent assets are expected to rise by 27%, slightly more than the increase in turnover.

Increase in stock days and debtor daysDebtor days are expected to increase from 110 to 121 days, with a 38% increase in total debtors, but stock days are notexpected to increase, but to fall from 265 days to 238 days. Nevertheless, a 19% increase in stocks is anticipated.

Increased reliance on short term financeReserves are expected to increase by £100,000 whereas total assets are expected to increase by £1,400,000. The expansionof our business activity is therefore based primarily on an expansion of short-term finance (trade creditors and overdraft).Creditor days will increase from 177 to 190 days, while in relative terms creditors will increase by 42% – more than theexpected rise in turnover (25%) and in our overdraft (20%).

Decrease in current ratio and quick ratioThe current ratio is expected to fall very slightly from 1·04 to 1·03, but the quick ratio is not expected to fall, but to increasefrom 0·44 to 0·47.

However, any interpretation of these ratios should reflect the fact that different industries have different working capital needs.Sector average data can be useful here.

3. Comparison with Sector AveragesAny conclusion concerning the signs of overtrading needs to be put in the context of the normal values of accounting ratiosindicated by the sector averages. However, it should be recognised that averages exist because no two companies areidentical, even when in the same business sector, and the following discussion should be read with this in mind.

The increasing trend of debtor days away from the sector average of 100 days is clearly a cause for concern. If our level ofdebtors was brought into line with the sector average our financing need would fall by £477,000 (£2·75m x 21/121), whichis equivalent to 17% of our forecast overdraft. The decrease in stock days is encouraging, although forecast stock days remain13% higher than the sector average, indicating the possibility of further improvement.

There is clear evidence of an increased reliance on short-term finance. The trend of creditor days is increasing away from thesector average of 120 days and the forecast of 190 days is a very worrying 58% more than the average. This represents£940,000 (£2·55m x 70/190) more in trade finance that our company is carrying compared to a similar company in ourbusiness sector. On this evidence, it is likely that our suppliers will begin to press for earlier settlement in the near future andthis will add to the pressure already being exerted by our bank.

The quick ratio is expected to increase but will still be 15% below the sector average, while the current ratio is expected tobe 25% lower than the average. The low current and quick ratios reflect the increased reliance of our company in comparativeterms on short-term sources of finance.

4. Conclusion on OvertradingMost of the evidence suggests that our company is moving into an overtrading situation, although the evidence is notconclusive. Current pressure from our bank to reduce our overdraft serves to highlight the fact that our company needs toreduce its reliance on short-term finance, whether trade finance or overdraft finance. Improved working capital managementcould reduce the level of investment in debtors, and to a lesser extent perhaps in stocks, which would ease our financialdifficulties. However, more drastic measures than this will be needed to deal with our reliance on short-term finance. Althoughthe size of the reduction in the overdraft required by the bank is not known at present, simply reducing trade credit to anaverage level would need £1m of additional finance. Factoring of debtors has been suggested as a source of working capitalfinance and it is certainly true that this would produce an immediate injection of cash that could decrease our overdraft andlower our average trade credit period. A further consideration is that our company has no long-term debt and given ourcontinuing growth, this source of finance also deserves serious consideration.

11



12

Appendix 1: Financial AnalysisGrowth in turnover = 100 x (8,300 – 6,638)/6,638 = 25%Growth in current assets = 100 x (5,950 – 4,700)/4,700 = 27%Increase in overdraft = 100 x (2,750 – 2,300)/2,300 = 20%Increase in trade creditors = 100 x (2,550 – 1,800)/1,800 = 42%

2003 2002Stock days 365 x 3,200/4,900 238 days 365 x 2,700/3,720 265 daysDebtor days 365 x 2,750/8,300 121 days 365 x 2,000/6,638 110 daysCreditor days 365 x 2,550/4,900 190 days 365 x 1,800/3,720 177 daysCurrent ratio 5,950/5,800 1·03 4,700/4,500 1·04Quick ratio 2,750/5,800 0·47 2,000/4,500 0·44

(b) (i) Evaluation of factor’s offer using overdraft interest rate of 6%£000

Forecast level of debtors 2,750New level of debtors = 8,300 x 90/365 = 2,047

––––––Reduction in level of debtors 703

––––––

£Saving in financing cost = 703,000 x 0·06 = 42,180Saving in administration costs 15,000

––––––––57,180

Increased financing cost = 2·047m x 80% x 2% = (32,752)Factor’s fee = 8·3m x 0·01 = (83,000)

––––––––Net cost of factoring (58,572)

––––––––

On this analysis, the factor’s offer is not financially acceptable. The offer was on a non-recourse basis, however, and theinformation given does not refer to any reduction of bad debts. If bad debts are currently more than 0·7% of turnover(58,572/8·3m), the factor’s offer might become financially attractive.

Evaluation of factor’s offer using medium-term bank loan rate of 10%As the overdraft must be reduced anyway, the 10% interest cost of the medium-term bank loan could be seen as theopportunity cost of not accepting the factor’s offer. An alternative evaluation of the factor’s offer could be as follows:

£Current financing cost = £2·75m x 0·10 = 275,000Revised financing cost:£2·047m x 0·8 x 0·08 = 131,000£2·047 x 0·2 x 0·10 = 40,940

–––––––– 171,940––––––––

Saving in financing cost 103,060Saving in administration costs 15,000Factor’s fee (83,000)

––––––––Net benefit of factoring 35,060

––––––––

On this analysis, the factor’s offer is financially acceptable, even before considering any reduction in bad debts.

(ii) The following benefits of factoring are commonly identified.

Factor financeThe factoring company will advance up to 80% of the face value of invoices raised. This would allow Doe Ltd to pay itstrade creditors promptly and perhaps take advantage of any early payment discounts available. It would also allow Doe Ltd to finance its growth from sales rather than by seeking external finance.

Reduces administration costsThe factor would take over the administration of Doe Ltd’s sales ledger, allowing a reduction in administration costs inthe longer term.

Factor expertiseIn the areas of credit analysis and debtor collection, the expertise of the factor is likely to be higher than Doe Ltd’s,leading to lower bad debts and more efficient collection of amounts owed by debtors.



13

Credit protectionIf the factoring is without recourse, Doe Ltd will be effectively insured against the possibility of bad debts, although thiswill be included in the factor’s fee.

(c) No information has been provided on the current methods used by Doe Ltd to manage its debtors and so this answer is ingeneral terms. The question asked for three methods to be discussed.

Credit AnalysisPotential credit customers should be carefully screened using such methods as trade references, bank references, creditreports from credit reference agencies, and analysis of financial statements. The extent of the credit analysis should dependon the size of the initial order as well as the potential for repeat business. Credit analysis can improve debtor managementby reducing the incidence of bad debts, slow payers and troublesome customers.

Terms of TradeDoe Ltd should negotiate agreed terms of trade with its customers in order to encourage prompter payment. These terms oftrade may offer discounts for early payment, which apart from cash flow benefits will reduce the likelihood of late paymentsand bad debts.

Credit ControlOnce credit has been extended it is important to ensure that customers abide by agreed terms of trade. Regular checks oncustomer accounts, for example using an aged debtor analysis, can direct attention to overdue accounts or those close to theircredit limit. Statements of account should be mailed to debtors on a regular basis in order to remind them of their outstandingdebts. Late payers should be contacted by telephone to enquire after the reason for the delay in settling their accounts. Apolicy of charging interest on overdue accounts might be considered in order to encourage prompt payment.

Debtor CollectionThe company should have an agreed policy or procedure for dealing with accounts in default. This policy should be includedin the terms of trade so that customers are aware of the steps the company is likely to take if payment is not made on time.The company could decide, for example, to take legal action to recover debts more than one month old. However, the benefitof such action must always exceed the cost incurred.

Factoring and Invoice DiscountingThe cash flow and other benefits of factoring were discussed earlier. Invoice discounting also offers cash flow advantages.Here, selected invoices of good quality are sold in exchange for an advance of up to 80% of face value. The balance, less afee charged by the invoice discounter, is received when the invoices are settled.

(d) It is appropriate to use the after-tax cost of borrowing as the discount rate since Doe Ltd is clearly in a tax-paying situationand hence is in a position to claim the tax benefits of lease payments and capital allowances.

Care must be taken when determining the timing of cash flows, since financial evaluation models seek to represent the realworld. As lease payments are made on the first day of Doe Ltd’s accounting period, it is appropriate to treat them fordiscounting purposes as though they occur at the end of the previous accounting period. However, the tax benefits of leasepayments will occur in the accounting period following that in which payment is made. Similarly, it is appropriate to treat thepurchase cost on 1 January of the first year of use as being made at year 0 for discounting purposes, even though the taxbenefit from the first capital allowance will arise in year 2, i.e. in the accounting period following the one in which paymentis made.

Capital allowances and associated tax benefits:year capital allowance tax benefit

1 365,000 x 0·25 = £91,250 £27,3752 91,250 x 0·75 = £68,437 £20,5313 68,437 x 0·75 = £51,328 £15,3984 51,328 x 0·75 = £38,496 £11,5495 balancing allowance £115,489 £34,647

Evaluation of borrowing to buy:year capital (£) tax savings net cash discount present value

(£) flow (£) factor (7%) (£)0 (365,000) (365,000) 1·000 (365,000)2 27,375 27,375 0·873 23,8983 20,531 20,531 0·816 16,7534 15,398 15,398 0·763 11,7495 11,549 11,549 0·713 8,2346 34,647 34,647 0·666 23,075

–––––––––)(281,291)–––––––––)

The cost of borrowing to buy is £281,291.



14

Evaluation of leasingyear cash flow £ annuity factor (7%) present value (£)0-4 lease rentals (77,250) 4·387 (338,896)2-6 tax benefits 23,175 3·832 88,807

––––––––)(250,089)–––––––––)

The cost of leasing is £250,089Leasing has the lower cost by £31,202 and is therefore preferred to borrowing.

(e) The optimum price will be the one that optimises total contribution over the five-year life of the new machine.

Sales price of £70 per unitContribution per unit = 70 – 42 = £28 per unitSales growth is 20% per annum

Year 1 2 3 4 5Sales volume (units) 10,000 12,000 14,400 17,280 20,000Contribution (£/unit) 28 28 28 28 28Total contribution (£) 280,000 336,000 403,200 483,840 560,000

Year 5 sales volume is limited to the maximum capacity of the new machineTotal contribution over the five years is £2,063,040

Sales price of £67 per unitContribution per unit = 67 – 42 = £25 per unitSales growth is 23% per annum

Year 1 2 3 4 5Sales volume (units) 11,000 13,530 16,640 20,000 20,000Contribution (£/unit) 25 25 25 25 25Total contribution (£) 275,000 338,250 416,050 500,000 500,000

Sales volume is restricted in years 4 and 5Total contribution over the five years is £2,029,300

The sales price of £70 per unit appears to be marginally preferable on the basis of total contribution. The incremental fixedproduction overheads will be the same irrespective of which sales price is selected and so may be omitted from the analysis.

2 (a) Acred Ltd: Production budget for 6 months to end of December 2004

July Aug Sept Oct Nov DecSales (units) 10,000 11,000 12,000 13,000 14,000 15,000Stock increase (units) 10,200 10,200 10,200 10,200 10,200 nil

––––––– ––––––– ––––––– ––––––– ––––––– –––––––Production (units) 10,200 11,200 12,200 13,200 14,200 15,000

Acred Ltd: Cash Budget for 6 months to end of December 2004

Receipts July August September October November DecemberCash sales (£) 130,000 133,000 136,000 139,000 142,000 145,000Credit sales (£) 190,000 190,000 199,000 108,000 117,000 126,000

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––Total receipts 120,000 123,000 135,000 147,000 159,000 171,000

PaymentsMaterials 148,480 151,360 156,160 160,960 165,760 170,080Labour 118,360 120,160 121,960 123,760 125,560 127,000Direct expenses 112,240 113,440 114,640 115,840 117,040 118,000Fixed overheads 122,000 122,000 122,000 122,000 122,000 122,000Advertising 195,000Interest – – 130,000 – – –

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––Total payments 101,080 201,960 144,760 122,560 130,360 137,080

Opening balance 150,000 168,920 1(10,040) 1(19,800) 114,640 133,280Net cash in/out 118,920 1(78,960) 11(9,760) 124,440 128,640 133,920

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––Closing balance 168,920 1(10,040) 1(19,800) 114,640 133,280 167,200

–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––



15

Workings:Sales budget for 6 months to end of December 2004

July Aug Sept Oct Nov DecSales (units) 110,000 111,000 112,000 113,000 114,000 115,000Sales price (£) 12 12 12 12 12 12Sales revenue 120,000 132,000 144,000 156,000 168,000 180,000

Calculation of sales receiptsJuly Aug Sept Oct Nov Dec

Sales revenue 120,000 132,000 144,000 156,000 168,000 180,000Cash sales (25%) (£) 130,000 133,000 136,000 139,000 142,000 145,000Credit sales (75%) (£) 190,000 199,000 108,000 117,000 126,000 135,000

Calculation of material purchases:June July Aug Sept Oct Nov Dec

Production (units) 10,000 10,200 11,200 12,200 13,200 14,200 15,000Materials for production (kg) 20,000 20,400 22,400 24,400 26,400 28,400 30,000Materials for production (£) 48,000 48,960 53,760 58,560 63,360 68,160 72,000Half delivered in month (£) 24,000 24,480 26,880 29,280 31,680 34,080Closing stock delivered (£) 24,480 26,880 29,280 31,680 34,080 36,000

––––––– –––––––– ––––––– ––––––– ––––––– –––––––Total purchases in month (£) 48,480 51,360 56,160 60,960 65,760 70,080

––––––– –––––––– ––––––– ––––––– ––––––– –––––––Payable in: July Aug Sept Oct Nov Dec

Calculation of labour cost: production units x £1·80 per unitCalculation of direct expenses: production units x £1·20 per unitCalculation of cash fixed overheads: 34,000 – 12,000 = £22,000 per monthDepreciation is excluded as a non-cash item.

(b) A periodic budget is one that is drawn up for a full budget period such as one year. A new budget will not be introduced untilthe start of the next budget period, although the existing budget may be revised if circumstances deviate markedly from thoseassumed during the budget preparation period.

A continuous or rolling budget is one that is revised at regular intervals by adding a new budget period to the full budget aseach budget period expires. A budget for one year, for example, could have a new quarter added to it as each quarter expires.In this way, the budget will continue to look one year forward. Cash budgets are often prepared on a continuous basis.

The advantages of periodic budgeting are that it involves less time, money and effort than continuous budgeting. For example,frequent revisions of standards could be avoided and the budget-setting process would require managerial attention only onan annual basis.

A major advantage of continuous budgeting is that the budget remains both relevant and up to date. As it takes account ofsignificant changes in economic activity and other key elements of the organisation’s environment, it will be a realistic budgetand hence is likely to be more motivating to responsible staff. Another major advantage is that there will always be a budgetavailable that shows the expected financial performance for several future budget periods.

It has been suggested that if a periodic budget is updated whenever significant change is expected, a continuous budgetwould not be necessary. Continuous budgeting could be used where regular change is expected, or where forward planningand control are essential, such as in a cash budget.

(c) Budget bias (budgetary slack) occurs when managers aim to give themselves easier budget targets by understating budgetedsales revenue or overstating budgeted costs.

Cost control using budgets is achieved by comparing actual costs for a budget period with budgeted or planned costs.Significant differences between planned and actual costs can then be investigated and corrective action taken whereappropriate.

Budget bias will lead to more favourable results when actual and budgeted costs are compared. Corrective action may not betaken in cases where costs could have been reduced and in consequence inefficiency will be perpetuated and overallprofitability reduced.

Managers may incur unnecessary expenditure in order to protect existing budget bias with the aim of making their jobs easierin future periods, since if the bias were detected and removed, future budget targets would be more difficult to achieve.Unnecessary costs will reduce the effectiveness of cost control in supporting the achievement of financial objectives such asvalue for money or profitability.

Where budget bias exists, managers will be less motivated to look for ways of reducing costs and inefficiency in those partsof the organisation for which they bear responsibility. The organisation’s costs will consequently be higher than necessary forthe level of performance being budgeted for.



3 (a) (i) Analysis of projects assuming they are divisible.Project 1 PV at 12% Project 3 PV at 12%

£ £ £ £Initial investment (300,000) (300,000) (400,000) (400,000)Year 1 185,000 175,905 124,320 111,018Year 2 190,000 171,730 128,795 102,650Year 3 195,000 167,640 133,432 195,004Year 4 100,000 163,600 138,236 187,918Year 5 195,000 153,865 143,212 181,201

–––––––– ––––––––NPV 132,740 177,791

–––––––– ––––––––

Profitability index 332,740/300,000 = 1·11 477,791/400,000 = 1·19

Project 2 NPV at 12% = (140,800 x 3·605) – 450,000 = £57,584Project 2 profitability index = 507,584/450,000 = 1·13

The optimum investment schedule involves investment in projects 3 and 2:

Project Profitability Index Ranking Investment NPV (£)3 1·19 1 400 177,7912 1·13 2 400 151,186 (57,584 x 400/450)

–––– ––––––––800 128,977–––– ––––––––

(ii) If the projects are assumed to be indivisible, the total NPV of combinations of projects must be considered.

Projects Investment NPV (£)1+2 750,000 190,324 (32,740 + 57,584)1+3 700,000 110,531 (32,740 + 77,791)

The optimum combination is now projects 1 and 3.

(b) The NPV decision rule requires that a company invest in all projects that have a positive net present value. This assumes thatsufficient funds are available for all incremental projects, which is only true in a perfect capital market. When insufficientfunds are available, that is when capital is rationed, projects cannot be selected by ranking by absolute NPV. Choosing aproject with a large NPV may mean not choosing smaller projects that, in combination, give a higher NPV. Instead, if projectsare divisible, they can be ranked using the profitability index in order make the optimum selection. If projects are not divisible,different combinations of available projects must be evaluated to select the combination with the highest NPV.

(c) The NPV decision rule, to accept all projects with a positive net present value, requires the existence of a perfect capitalmarket where access to funds for capital investment is not restricted. In practice, companies are likely to find that fundsavailable for capital investment are restricted or rationed.

Hard capital rationing is the term applied when the restrictions on raising funds are due to causes external to the company.For example, potential providers of debt finance may refuse to provide further funding because they regard a company as toorisky. This may be in terms of financial risk, for example if the company’s gearing is too high or its interest cover is too low,or in terms of business risk if they see the company’s business prospects as poor or its operating cash flows as too variable.In practice, large established companies seeking long-term finance for capital investment are usually able to find it, but smalland medium-sized enterprises will find raising such funds more difficult.

Soft capital rationing refers to restrictions on the availability of funds that arise within a company and are imposed bymanagers. There are several reasons why managers might restrict available funds for capital investment. Managers may preferslower organic growth to a sudden increase in size arising from accepting several large investment projects. This reason mightapply in a family-owned business that wishes to avoid hiring new managers. Managers may wish to avoid raising furtherequity finance if this will dilute the control of existing shareholders. Managers may wish to avoid issuing new debt if theirexpectations of future economic conditions are such as to suggest that an increased commitment to fixed interest paymentswould be unwise.

One of the main reasons suggested for soft capital rationing is that managers wish to create an internal market for investmentfunds. It is suggested that requiring investment projects to compete for funds means that weaker or marginal projects, withonly a small chance of success, are avoided. This allows a company to focus on more robust investment projects where thechance of success is higher1. This cause of soft capital rationing can be seen as a way of reducing the risk and uncertaintyassociated with investment projects, as it leads to accepting projects with greater margins of safety.

–––––––––––––––––––––––1 Watson, D. and Head, A. (2001) Corporate Finance: Principles and Practice, 2nd edition, FT Prentice Hall, p.73.

16



(d) When undertaking the appraisal of an investment project, it is essential that only relevant cash flows are included in theanalysis. If non-relevant cash flows are included, the result of the appraisal will be misleading and incorrect decisions will bemade. A relevant cash flow is a differential (incremental) cash flow, one that changes as a direct result of an investmentdecision2.

If current fixed production overheads are expected to increase, for example, the additional fixed production overheads are arelevant cost and should be included in the investment appraisal. Existing fixed production overheads should not be included.

A new cash flow arising as the result of an investment decision is a relevant cash flow. For example, the purchase of rawmaterials for a new production process and the net cash flows arising from the production process are both relevant cashflows.

The incremental tax effects arising from an investment decision are also relevant cash flows, providing that a company is ina tax-paying position. Direct labour costs, for example, are an allowable deduction in calculating taxable profit and so giverise to tax benefits: tax liabilities arising on incremental taxable profits are also a relevant cash flow.

One area where caution is required is interest payments on new debt used to finance an investment project. They are adifferential cash flow and hence relevant, but the effect of the cost of the debt is incorporated into the discount rate used todetermine the net present value. Interest payments should not therefore be included as a cash flow in an investment appraisal.

Market research undertaken to determine whether a new product will sell is often undertaken prior to the investment decisionon whether to proceed with production of the new product. This is an example of a sunk cost. These are costs already incurredas a result of past decisions, and so are not relevant cash flows.

4 (a) Many governments consider it necessary to prevent or control monopolies.

A pure monopoly exists when one organisation controls the production or supply of a good that has no close substitute. Inpractice, legislation may consider a monopoly situation to occur when there is limited competition in a particular market. Forexample, UK legislation considers a monopoly to occur if an organisation controls 25% or more of a particular market.

Governments consider it necessary to act against an existing or potential monopoly because of the economic problems thatcan arise through the abuse of a dominant market position. Monopoly can lead to economic inefficiency in the use ofresources, so that output is at a higher cost than necessary. Further inefficiency can arise as a monopoly may lack theincentive to innovate, to research technological improvements, or to eliminate unnecessary managers, since it can always besure of passing on the cost of its inefficiencies to its customers. Inefficiencies such as these have been seen as major problemsin state-owned monopolies and have fuelled the movement towards privatisation in recent years. It has been expected thatthe competition arising following privatisation will lead to the elimination of these kinds of inefficiency.

Monopoly can also result in high prices being charged for output, so that the cost to customers is higher than would be thecase if significant competition existed, allowing monopolies to generate monopoly profits.

The government can prevent monopolies occurring by monitoring proposed takeovers and mergers, and acting when it decidesthat a monopoly situation may occur. This monitoring is carried out in the UK by the Office of Fair Trading, which can refertakeovers and mergers that are potentially against the public interest to the Competition Commission for detailed investigation.The Competition Commission has the power to prevent a proposed takeover or merger, or to allow it to proceed with conditionsattached, such as disposal of a portion of the business in order to preserve competition.

(b) A company is required by law to offer an issue of new equity finance on a pro-rata basis to its existing shareholders. Thisensures that the existing pattern of ownership and control will not be affected if all shareholders take up the new sharesoffered. Because the right to be offered new equity is a legal one, such an issue is called a rights issue.

If an unlisted company decides that it needs to raise a large amount of equity finance and provided existing shareholders haveagreed, it can offer ordinary shares to new investors (the public at large) via an offer for sale. Such an offer is usually part ofthe process of seeking a stock exchange listing, as it leads to the wider spread of ownership that is needed to meet stockexchange listing regulations. An offer for sale may be either at fixed price, where the offer price is set in advance by the issuingcompany, or by tender, where investors are invited to submit bids for shares. An offer for sale will result in a significant changeto the shareholder structure of the company, for example by bringing in institutional investors. In order to ensure that therequired amount of finance is raised, offers for sale are underwritten by institutional investors who guarantee to buy anyunwanted shares.

A placing is cheaper than an offer for sale. In a placing, large blocks of shares are placed with institutional investors, so thatthe spread of new ownership is not as wide as with an offer for sale. While a placing may be part of seeking a listing on astock exchange (for example, it is very popular with companies wanting to float on markets for smaller companies such asthe Alternative Investment Market in the UK), it can also provide equity finance for a company that wishes to remain unlisted.

New shares can also be sold by an unlisted company to individual investors by private negotiation. While the amount of equityfinance raised by this method is small, it has been supported in recent years by government initiatives such as the EnterpriseInvestment Scheme and Venture Capital Trusts in the UK.

–––––––––––––––––––––––2 Drury, C. (2000), Management and Cost Accounting, 5th edition, Thomson Business Press, p.280

17



(c) The factors that should be considered by a company when choosing between an issue of debt and issue of equity financecould include the following:

Risk and ReturnRaising debt finance will increase the gearing and the financial risk of the company, while raising equity finance will lowergearing and financial risk.

Financial risk arises since raising debt brings a commitment to meet regular interest payments, whether fixed or variable.Failure to meet these interest payments gives debt holders the right to appoint a receiver to recover their investment. Incontrast, there is no right to receive dividends on ordinary shares, only a right to participate in any dividend (share of profit)declared by the directors of a company. If profits are low, then dividends can be passed, but interest must be paid regardlessof the level of profits. Furthermore, increasing the level of interest payments will increase the volatility of returns toshareholders, since only returns in excess of the cost of debt accrue to shareholders.

CostDebt is cheaper than equity because debt is less risky from an investor point of view. This is because it is often secured byeither a fixed or floating charge on company assets and ranks above equity on liquidation, and because of the statutoryrequirement to pay interest. Debt is also cheaper than equity because interest is an allowable deduction in calculating taxableprofit. This is referred to as the tax efficiency of debt.

Ownership and ControlIssuing equity can have ownership implications for a company, particularly if the finance is raised by a placing or offer forsale. Shareholders also have the right to appoint directors and auditors, and the right to attend general meetings of thecompany. While issuing debt has no such ownership implications, an issue of debt can place restrictions on the activities ofa company by means of restrictive covenants included in issue documents such as debenture trust deeds. For example, arestrictive covenant may specify a maximum level of gearing or a minimum level of interest cover, or may forbid the securingof further debt on particular assets.

RedemptionEquity finance is permanent capital that does not need to be redeemed, while debt finance will need to be redeemed at somefuture date. Redeeming a large amount of debt can place a severe strain on the cash flow of a company, although this canbe addressed by refinancing or by using convertible debt.

FlexibilityDebt finance is more flexible than equity, in that various amounts can be borrowed, at a fixed or floating interest rate and fora range of maturities, to suit the financing need of a company. If debt finance is no longer required, it can more easily berepaid (depending on the issue terms).

AvailabilityA new issue of equity finance may not be readily available to a listed company or may be available on terms that areunacceptable with regards to issue price or issue quantity, if the stock market is depressed (a bear market). Currentshareholders may be unwilling to subscribe to a rights issue, for example if they have made other investment plans or if theyhave urgent calls on their existing finances. A new issue of debt finance may not be available to a listed company, or availableat a cost considered to be unacceptable, if it has a poor credit rating, or if it faces trading difficulties.

5 (a) Calculation of variances£/unit £/unit

Standard sales price 12·00Material A = £1·70 x 2·5 = 4·25Material B = £1·20 x 1·5 = 1·80Labour = £6·00 x 0·45 = 2·70

––––– 18·75–––––

Standard contribution 13·25–––––

Sales variancesSales volume contribution variance = 3·25 x (50,000 – 48,000) = £6,500 (A)Sales price variance = 580,800 – (12·00 x 48,000) = £4,800 (F)

Direct material price variancesMaterial A price variance = (1·70 x 121,951) – 200,000 = £7,317 (F)Material B price variance = (1·20 x 67,200) – 84,000 = £3,360 (A)

Direct material mix and yield variancesActual quantity in actual proportions at standard price:Material A = 121,951 x 1·70 = £207,317Material B = 67,200 x 1·20 = £80,640

Actual quantity in standard proportions at standard price:Actual quantity of materials A and B = 121,951 + 67,200 = 189,151 kgMaterial A = 189,151 x (2·5/4) x 1·70 = £200,973Material B = 189,151 x (1·5/4) x 1·20 = £85,118

18



Standard quantity in standard proportions at standard price:Standard quantity of materials A and B = 48,000 x 4 = 192,000 kgMaterial A = 192,000 x (2·5/4) x 1·70 = £204,000Material B = 192,000 x (1·5/4) x 1·20 = £86,400

Material A mix variance = 200,973 – 207,317 = £6,344 (A)Material B mix variance = 85,118 – 80,640 = £4,478 (F)Material A yield variance = 204,000 – 200,973 = £3,027 (F)Material B yield variance = 86,400 – 85,118 = £1,282 (F)

Direct labour variancesLabour rate variance = (6·00 x 19,200) – 117,120 = £1,920 (A)Idle time variance = 6·00 x (19,200 – 18,900) = £1,800 (A)Labour efficiency variance = 6·00 x ((0·45 x 48,000) – 18,900) = £16,200 (F)

(b) £ £ £Budgeted gross profit 100,000Budgeted fixed production overhead 62,500

––––––––Budgeted contribution (50,000 x 3·25) 162,500Sales volume contribution variance 6,500 (A)Sales price variance 4,800 (F) 1,700 (A)

–––––– ––––––––Actual sales (£580,800) less standard variable cost of sales 160,800

Variable cost variances (F) (A)Material A price 7,317Material B price 3,360Material A mix 6,344Material B mix 4,478Material A yield 3,027Material B yield 1,282Labour rate 1,920Idle time 1,800Labour efficiency 16,200

––––––– –––––––32,304 13,424 18,880 (F)––––––– ––––––– ––––––––

Actual contribution 179,680Budgeted fixed production overhead 62,500Fixed production overhead expenditure variance 1,500 (A)

–––––––Actual fixed production overhead 64,000

––––––––Actual gross profit 115,680

––––––––

(c) The favourable material A price variance indicates that the actual price per kilogram was less than standard. Possibleexplanations include buying lower quality material, buying larger quantities of material A and thereby gaining bulk purchasediscounts, a change of supplier, and using an out-of-date standard.

The adverse material A mix variance indicates that more of this material was used in the actual input than indicated by thestandard mix. The favourable material price variance suggests this may be due to the use of poorer quality material (hencemore was needed than in the standard mix), or it might be that more material A was used because it was cheaper thanexpected.

The favourable material A yield variance indicates that more output was produced from the quantity of material used thanexpected by the standard. This increase in yield is unlikely to be due to the use of poorer quality material: it is more likely tobe the result of employing more skilled labour, or introducing more efficient working practices.

It is only appropriate to calculate and interpret material mix and yield variances if quantities in the standard mix can be varied.It has also been argued that calculating yield variances for each material is not useful, as yield is related to output overallrather than to particular materials in the input mix. A further complication is that mix variances for individual materials areinter-related and so an explanation of the increased use of one material cannot be separated from an explanation of thedecreased use of another.

19



The unfavourable labour rate variance indicates that the actual hourly rate paid was higher than standard. Possibleexplanations for this include hiring staff with more experience and paying them more (this is consistent with the favourableoverall direct material variance), or implementing an unexpected pay increase. The favourable labour efficiency varianceshows that fewer hours were worked than standard. Possible explanations include the effect of staff training, the use of betterquality material (possibly on Material B rather than on Material A), employees gaining experience of the production process,and introducing more efficient production methods. The adverse idle time variance may be due to machine breakdowns; ora higher rate of production arising from more efficient working (assuming employees are paid a fixed number of hours perweek).

(d) The theory of motivation suggests that having a clearly defined target results in better performance than having no target atall, that targets need to be accepted by the staff involved, and that more demanding targets increase motivation provided theyremain accepted3. It is against this background that basic, ideal, current and attainable standards can be discussed.

A basic standard is one that remains unchanged for several years and is used to show trends over time. Basic standards maybecome increasingly easy to achieve as time passes and hence, being undemanding, may have a negative impact onmotivation. Standards that are easy to achieve will give employees little to aim at.

Ideal standards represent the outcome that can be achieved under perfect operating conditions, with no wastage, inefficiencyor machine breakdowns. Since perfect operating conditions are unlikely to occur for any significant period, ideal standardswill be very demanding and are unlikely to be accepted as targets by the staff involved as they are unlikely to be achieved.Using ideal standards as targets is therefore likely to have a negative effect on employee motivation.

Current standards are based on current operating conditions and incorporate current levels of wastage, inefficiency andmachine breakdown. If used as targets, current standards will not improve performance beyond its current level and theirimpact on motivation will be a neutral one.

Attainable standards are those that can be achieved if operating conditions conform to the best that can be practicallyachieved in terms of material use, efficiency and machine performance. Attainable standards are likely to be more demandingthan current standards and so will have a positive effect on employee motivation, provided that employees accept them asachievable.

–––––––––––––––––––––––3 Otley, D. (1987), Accounting Control and Organizational Behaviour, CIMA, pp.40-44

20




Marks Marks1 (a) Explanation of overtrading 1

Symptoms of overtrading 2Calculation of relevant ratios 4Discussion of evidence for overtrading 3Conclusion 1Format 1

––– 12

(b) (i) Change in level of debtors 1Reduction in cost of financing 1Cost of advance by factor 1Administration savings 1Factor’s fee 1Net cost of factor’s offer 1Discussion 1

––– 7

(ii) Up to 2 marks for each detailed advantage 8

(c) Up to 3 marks for each way discussed 8

(d) Capital allowances 2Tax effects of capital allowances 1Evaluation of cost of borrowing to buy 2Lease payments 1Tax effects of lease payments 1Evaluation of cost of leasing 1Evaluation of leasing versus borrowing to buy 1

––– 9

(e) Sales volumes 2Annual contributions 2Total contributions 1Conclusion 1

––– 6–––50

2 (a) (i) Sales budget 1Stock increase 1Production budget 1

(ii) Cash sales 1Credit sales 1Material costs 3Labour costs and direct expenses 1Overheads 1Marketing expenditure 1Interest payment 1Closing balance 1

––– 13

(b) Discussion of periodic budgeting 3Discussion of continuous budgeting 4

––– 7

(c) Meaning of budget bias 1Cost control 1Consequences of budget bias 3

––– 5–––25

21



Marks Marks3 (a) (i) NPV of project 1 1

NPV of project 2 1NPV of project 3 2Calculation of profitability indices 2Optimum investment schedule 2

(ii) Selection of optimum combination 2––– 10

(b) NPV decision rule 1Link to perfect capital markets 1Explanation of ranking problem and solution 1

––– 3

(c) Hard capital rationing 3Soft capital rationing 4

––– 7

(d) Explanation of relevant cash flows 2Examples of relevant cash flows 3

––– 5–––25

4 (a) Meaning of monopoly 1Discussion of economic problems of monopoly 5Discussion of role of government 3

––– 9

(b) Rights issue 2Offer for sale 2Placing 2Private sale to individuals or institutions 2

––– 8

(c) Up to 2 marks for each well discussed factor 8–––25

22



Marks Marks5 (a) Sales volume contribution variance 1

Sales price variance 1Material price variances 1Material mix variances 2Material yield variances 2Labour rate and efficiency variances 1Idle time variance 1

–––Available 9Maximum 8

(b) Budgeted gross profit 1Budgeted contribution 1Fixed production overhead expenditure variance 1Actual gross profit 1Format of operating statement 1

––– 5

(c) Material price, mix and yield variances 3Labour rate, efficiency and idle time variances 2

––– 5

(d) Basic standard 1Ideal standard 2Current standard 2Attainable standard 2

––– 7–––25

23




PART 2


QUESTION PAPER





Formulae Sheet, Present Value and Annuity Tables are on pages10 and 11.

Pape

r 2.4





1 Nespa is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three years.Although the company has an overdraft, it has no long-term debt and its current interest cover is high compared tosimilar companies. Its return on capital employed, however, is close to the average for its business sector. One of itsmachines is leased under an operating lease, but the company has no other leasing or hire purchase commitments.The company owns two factories and the land on which they are built, as well as a small fleet of delivery vehicles.The company does not own any retail outlets through which to distribute its manufactured output.

Nespa is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in orderto manufacture a new toy. Market research undertaken for the company indicated a link between selling price anddemand, and the research agency involved has suggested two sales strategies that could be implemented, as follows:

Strategy 1 Strategy 2Selling price (in current price terms) £8·00 per unit £7·00 per unitSales volume in first year 100,000 units 110,000 unitsAnnual increase in sales volume after first year 5% 15%

The services of the market research agency have cost £75,000 and this amount has yet to be paid.

Nespa expects economies of scale to reduce the variable cost per unit as the level of production increases. When100,000 units are produced in a year, the variable cost per unit is expected to be £3·00 (in current price terms). Foreach additional 10,000 units produced in excess of 100,000 units, a reduction in average variable cost per unit of£0·05 is expected to occur. The average variable cost per unit when production is between 110,000 units and119,999 units, for example, is expected to be £2·95 (in current price terms); and the average variable cost per unitwhen production is between 120,000 units and 129,999 units is expected to be £2·90 (in current price terms), andso on.

The new machine would cost £1,500,000 and would not be expected to have any resale value at the end of its life.Capital allowances would be available on the investment on a 25% reducing balance basis. Although the machinemay have a longer useful economic life, Nespa uses a five-year planning period for all investment projects. Thecompany pays tax at an annual rate of 30% and settles tax liabilities in the year in which they arise.

Operation of the new machine will cause fixed costs to increase by £110,000 (in current price terms). Inflation isexpected to increase these costs by 4% per year. Annual inflation on the selling price and unit variable costs isexpected to be 3% per year. For profit reporting purposes Nespa depreciates machinery on a straight-line basis overits planning period.

Nespa applies three investment appraisal methods to new projects because it believes that a single investmentappraisal method is unable to capture the true value of a proposed investment. The methods it uses are net presentvalue, internal rate of return and return on capital employed (accounting rate of return). The company believes thatnet present value measures the potential increase in company value of an investment project: that a high internal rateof return offers a margin of safety for risky projects; and that a project’s before-tax return on capital employed shouldbe greater than the company’s before-tax return on capital employed, which is 20%. Nespa does not use any explicitmethod of assessing project risk and has an average cost of capital of 10% in money (nominal) terms.

The company has not yet decided on a method of financing the purchase of the new machine, although the financedirector believes that a new issue of equity finance is appropriate given the amount of finance required.

2



Required:

(a) Determine the sales strategy which maximizes the present value of total contribution. Ignore taxation in thispart of the question. (9 marks)

(b) Evaluate the investment in the new machine using internal rate of return. (12 marks)

(c) Evaluate the investment in the new machine using return on capital employed (accouting rate of return)based on the average investment. (5 marks)

(d) Critically discuss the relative advantages and disadvantages of internal rate of return and return on capitalemployed (accounting rate of return), and comment on Nespa’s views on investment appraisal methods.

(8 marks)

(e) Discuss TWO methods that could be used to assess the risk or level of uncertainty associated with aninvestment project. (8 marks)

(f) Discuss the factors that Nespa should consider when selecting an appropriate source of finance for the newmachine. (8 marks)

(50 marks)

3 [P.T.O.




2 Blin is a company listed on a European stock exchange, with a market capitalisation of €6m, which manufactureshousehold cleaning chemicals. The company has expanded sales quite significantly over the last year and has beenfollowing an aggressive approach to working capital financing. As a result, Blin has come to rely heavily on overdraftfinance for its short-term needs. On the advice of its finance director, the company intends to take out a long-termbank loan, part of which would be used to repay its overdraft.

Required:

(a) Discuss the factors that will influence the rate of interest charged on the new bank loan, making referencein your answer to the yield curve. (9 marks)

(b) Explain and discuss the approaches that Blin could adopt regarding the relative proportions of long- andshort-term finance to meet its working capital needs, and comment on the proposed repayment of theoverdraft. (9 marks)

(c) Explain the meaning of the term ‘cash operating cycle’ and discuss its significance in determining the levelof investment in working capital. Your answer should refer to the working capital needs of different businesssectors. (7 marks)

(25 marks)

4



3 Admer owns several home furnishing stores. In each store, consultations, if needed, are undertaken by specialists,who also visit potential customers in their homes, using specialist software to help customers realise their designobjectives. Customers visit the store to make their selections from the wide range of goods offered, after which salesstaff collect payment and raise a purchase order. Customers then collect their self-assembly goods from thewarehouse, using the purchase order as authority to collect. Administration staff process purchase orders and alsoarrange consultations.

Each store operates an absorption costing system and costs other than the cost of goods sold are apportioned on thebasis of sales floor area.

Results for one of Admer’s stores for the last three months are as follows:

Department Kitchens Bathrooms Dining Rooms Total£ £ £ £

Sales 210,000 112,500) 440,000 762,500Cost of goods sold 163,000 137,500) 176,000 276,500Other costs 130,250 181,406) 113,968 325,624

––––––– ––––––– ––––––– ––––––––Profit 116,750 1(6,406) 150,032 160,376

––––––– ––––––– ––––––– ––––––––

The management accountant of Admer is concerned that the bathrooms department of the store has been showing aloss for some time, and is considering a proposal to close the bathrooms department in order to concentrate on themore profitable kitchens and dining rooms departments. He has found that other costs for this store for the last threemonths are made up of:

£ EmployeesSales staff wages 164,800 12Consultation staff wages 124,960 4Warehouse staff wages 130,240 6Administration staff wages 130,624 4General overheads (light, heat, rates, etc.) 175,000

––––––––325,624––––––––

1 He has also collected the following information for the last three months:

Department Kitchens Bathrooms Dining RoomsNumber of items sold 1,000 1,500 4,000Purchase orders 1,000 900 2,500Floor area (square metres) 16,000 10,000 14,000Number of consultations 798 200 250

The management accountant believes that he can use this information to review the store’s performance in the lastthree months from an activity-based costing (ABC) perspective.

Required:

(a) Discuss the management accountant’s belief that the information provided can be used in an activity-basedcosting analysis. (4 marks)

(b) Explain and illustrate, using supporting calculations, how an ABC profit statement might be produced fromthe information provided. Clearly explain the reasons behind your choice of cost drivers. (8 marks)

(c) Evaluate and discuss the proposal to close the bathrooms department. (6 marks)

(d) Discuss the advantages and disadvantages that may arise for Admer from introducing activity-based costingin its stores. (7 marks)

(25 marks)

5 [P.T.O.



4 Arwin plans to raise £5m in order to expand its existing chain of retail outlets. It can raise the finance by issuing 10%debentures redeemable in 2015, or by a rights issue at £4·00 per share. The current financial statements of Arwinare as follows.

Profit and loss account for the last year £000Sales 50,000Cost of sales 30,000

–––––––Gross profit 20,000Administration costs 14,000

–––––––Profit before interest and tax 6,000Interest 300

–––––––Profit before tax 5,700Taxation at 30% 1,710

–––––––Profit after tax 3,990Dividends 2,394

–––––––Retained earnings 1,596

–––––––

Balance sheet £000Net fixed assets 20,100Net current assets 4,96012% debentures 2010 2,500

–––––––22,560–––––––

Ordinary shares, par value 25p 2,500Retained profit 20,060

–––––––22,560–––––––

The expansion of business is expected to increase sales revenue by 12% in the first year. Variable cost of sales makesup 85% of cost of sales. Administration costs will increase by 5% due to new staff appointments. Arwin has a policyof paying out 60% of profit after tax as dividends and has no overdraft.

Required:

(a) For each financing proposal, prepare the forecast profit and loss account after one additional year ofoperation. (5 marks)

(b) Evaluate and comment on the effects of each financing proposal on the following:

(i) Financial gearing;

(ii) Operational gearing;

(iii) Interest cover;

(iv) Earnings per share. (12 marks)

(c) Discuss the dangers to a company of a high level of gearing, including in your answer an explanation of thefollowing terms:

(i) Business risk;

(ii) Financial risk. (8 marks)

(25 marks)

6



This is a blank page.Question 5 begins on page 8.

7 [P.T.O.



8

5 Linsil has produced the following operating statement reconciling budgeted and actual gross profit for the last threemonths, based on actual sales of 122,000 units of its single product:

Operating statement £ £ £Budgeted gross profit 800,000Budgeted fixed production overhead 352,000

––––––––––Budgeted contribution 1,152,000Sales volume contribution variance 19,200Sales price variance (61,000)

––––––––(41,800)

––––––––––Actual sales less standard variable cost of sales 1,110,200

Planning variancesVariable cost variances Favourable AdverseDirect material price 23,570Direct material usage 42,090Direct labour rate 76,128Direct labour efficiency 203,333

––––––– ––––––––42,090 303,031 (260,941)––––––– ––––––––

Operational variancesVariable cost variances Favourable AdverseDirect material price 31,086Direct material usage 14,030Direct labour rate 19,032Direct labour efficiency 130,133

–––––––– ––––––––144,163 50,118 94,045–––––––– –––––––– ––––––––

Actual contribution 943,304Budgeted fixed production overhead (352,000)Fixed production overhead expenditure variance 27,000

––––––––Actual fixed production overhead (325,000)

–––––––––Actual gross profit 618,304

–––––––––

The standard direct costs and selling price applied during the three-month period and the actual direct costs andselling price for the period were as follows:

Standard ActualSelling price (£/unit) 31·50 31·00Direct material usage (kg/unit) 13·00 12·80Direct material price (£/kg) 12·30 12·46Direct labour efficiency (hrs/unit) 11·25 11·30Direct labour rate (£/hr) 12·00 12·60



After the end of the three-month period and prior to the preparation of the above operating statement, it was decidedto revise the standard costs retrospectively to take account of the following:

1. A 3% increase in the direct material price per kilogram;

2. A labour rate increase of 4%;

3. The standard for labour efficiency had anticipated buying a new machine leading to a 10% decrease in labourhours; instead of buying a new machine, existing machines had been improved, giving an expected 5% savingin material usage.

Required:

(a) Using the information provided, demonstrate how each planning and operational variance in the operatingstatement has been calculated. (11 marks)

(b) Calculate direct labour and direct material variances based on the standard cost data applied during thethree-month period. (4 marks)

(c) Explain the significance of separating variances into planning and operational elements, using the operatingstatement above to illustrate your answer. (5 marks)

(d) Discuss the factors to be considered in deciding whether a variance should be investigated. (5 marks)

(25 marks)

9 [P.T.O.



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1 (a) Strategy 1Year 1 2 3 4 5Demand (units) 100,000 105,000 110,250 115,762 121,551Selling price (£/unit) 8·00 8·00 8·00 8·00 8·00Variable cost (£/unit) 3·00 3·00 2·95 2·95 2·90Contribution (£/unit) 5·00 5·00 5·05 5·05 5·10Inflated contribution (£/unit) 5·15 5·30 5·52 5·68 5·91Total contribution (£) 515,000 556,500 608,580 657,528 718,36610% discount factors 0·909 0·826 0·751 0·683 0·621PV of contribution (£) 468,135 459,669 457,044 449,092 446,105

Total PV of strategy 1 contributions = £2,280,045 or approximately £2,280,000

Strategy 2Year 1 2 3 4 5Demand (units) 110,000 126,500 145,475 167,296 192,391Selling price (£/unit) 7·00 7·00 7·00 7·00 7·00Variable cost (£/unit) 2·95 2·90 2·80 2·70 2·55Contribution (£/unit) 4·05 4·10 4·20 4·30 4·45Inflated contribution (£/unit) 4·17 4·35 4·59 4·84 5·16Total contribution (£) 458,700 550,275 667,730 809,713 992,73810% discount factors 0·909 0·826 0·751 0·683 0·621PV of contribution (£) 416,958 454,527 501,465 553,034 616,490

Total PV of strategy 2 contributions = £2,542,474 or approximately £2,542,000

Strategy 2 is preferred as it has the higher present value of contributions.

(b) Evaluating the investment in the new machine using internal rate of return:

Year 0 1 2 3 4 5£ £ £ £ £ £

Contribution 458,700 550,275 667,730 809,713 992,738Fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)

–––––––– –––––––– –––––––– –––––––– ––––––––Taxable profit 344,300 431,299 543,995 681,029 858,906Taxation at 30% (103,290) (129,390) (163,199) (204,309) (257,672)

–––––––– –––––––– –––––––– –––––––– ––––––––241,010 301,909 380,796 476,720 601,234

CA tax benefits 112,500 84,375 63,281 47,461 142,383–––––––– –––––––– –––––––– –––––––– ––––––––

Profit after tax 353,510 386,284 444,077 524,181 743,617–––––––– –––––––– –––––––– –––––––– ––––––––

Cash flows (1,500,000) 353,510 386,284 444,077 524,181 743,61710% discount factors 1·000 0·909 0·826 0·751 0·683 0·621

Present values (1,500,000) 321,341 319,071 333,502 358,016 461,786NPV at 10% = £293,716

Cash flows (1,500,000) 353,510 386,284 444,077 524,181 743,61720% discount factors 1·000 0·833 0·694 0·579 0·482 0·402

Present values (1,500,000) 294,474 268,081 257,121 252,655 298,934NPV at 20% = (£128,735)

IRR = 10 + [(10 x 293,716) / (293,716 + 128,735)] = 17%

Since the internal rate of return is greater than the company’s cost of capital of 10%, the investment is financially acceptable.



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(c) Evaluating the investment using return on capital employed:Annual depreciation charge = 1,500,000/5 = £300,000

Year 1 2 3 4 5Inflated contribution 458,700 550,275 667,730 809,713 992,738Inflated fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)Depreciation (300,000) (300,000) (300,000) (300,000) (300,000)

–––––––– –––––––– –––––––– –––––––– –––––––––Annual PBIT 44,300 131,299 243,995 381,029 558,906

–––––––– –––––––– –––––––- –––––––– ––––––––

Average investment = 1,500,000/2 = £750,000

Average annual accounting profit = 1,359,529/5 = £271,906

Return on capital employed = 100 x (271,906/ 750,000) = 36%

Since the return on capital employed is greater than the hurdle rate of 20%, the investment is financially acceptable

(d) Internal rate of return (IRR) is a discounted cash flow investment appraisal method that calculates the discount rate whichcauses the net present value of an investment to become zero. An investment project is acceptable if it has an IRR greaterthan the cost of capital of the investing company. It uses cash flows rather than accounting profits in the evaluation of aninvestment project. It also takes account of the time value of money, the concept that the value of a given sum of moneydecreases over time due to the opportunity cost of selecting one investment rather than the best available alternative. IRRconsiders all cash flows over the life of an investment project and always gives correct advice, provided that investmentprojects being compared are not mutually exclusive.

Return on capital employed (ROCE) is also called accounting rate of return. Unlike IRR, ROCE uses average annual accountingprofit before interest and tax in the evaluation of investment projects, expressing this as a percentage of the amount of capitalinvested. The decision as to whether a project is acceptable is made by comparing project ROCE with a target ROCE, suchas a company’s current ROCE.

The problem with using accounting profit rather than cash flow is that only cash flow is linked directly to an increase incompany value. ROCE also ignores the time value of money. Because it averages accounting profit over the life of the project,the amount of profit in a given year is irrelevant; ROCE therefore ignores the timing of accounting profits.

ROCE also suffers from definition problems as there are several definitions in common use and so care must be taken toensure comparisons are made using identical definitions. Capital invested can be defined as initial capital invested or averagecapital invested, but other definitions are met in practice.

Both IRR and ROCE offer a relative measure of return in percentage terms, a feature that is seen as attractive to managerswho may have difficulty in interpreting the absolute measure of value offered by net present value. A relative measure of returnignores the size of the initial investment, however, and so should not be relied on as a sole measure of investment worth.

Academically, IRR is preferred to ROCE because it takes account of the time value of money, uses cash flows, and comparesthe return on investment projects with the cost of capital of a company.

Nespa’s use of several investment appraisal methods is, however, common in practice as few companies rely on a singleinvestment appraisal method. In fact, one survey reported that 67% of companies employed three or more methods1.

The company is correct in its belief that NPV measures the potential increase in company value of an investment project,since theoretically the stock market value of a company increases by the total NPV of projects undertaken. This is correct aslong as the capital market is efficient and information about new investment projects is made available to it.

It is possible that a high IRR offers a margin of safety for risky projects and it can be interpreted in this way. However,calculation of IRR is not a substitute for an assessment of project risk.

Nespa’s decision rule for ROCE is flawed, in that if used continually it could eventually run out of investment projects thatmeet its hurdle rate (its existing before-tax ROCE). This hurdle rate could increase with each successive project accepted,causing the company to reject projects that would have been acceptable in a previous period. However, it is important torecognise that not all costs associated with the capital budgeting process are included in investment appraisal and that suchcosts will reduce the existing ROCE. The sunk cost of Nespa’s market research is one example, and another would beinfrastructure costs that increase on a stepped basis as a result of cumulative project investment. The existence of such costsoffers a partial justification for Nespa’s ROCE decision rule.

(e) In assessing project risk it is important to be clear about the meaning of risk. From an academic perspective, risk refers to aset of circumstances regarding a given decision which can be assigned probabilities2. This distinguishes risk from uncertainty,which implies that it is not possible to assign probabilities to future events. In practice, the two terms are often usedinterchangeably, but the distinction is a useful one for the purposes of analysis and discussion.

There are several methods commonly considered to assess project risk and uncertainty, such as sensitivity analysis,probability analysis, risk-adjusted discount rates, certainty equivalents and range estimates. This question required studentsto discuss two methods.

––––––––––––––––––––––1 Arnold, G.C. (2002) Corporate Financial Management, 2nd edition, FT Prentice Hall, p.1372 Watson, H.D. and Head, A.M. (2004) Corporate Finance: Principles and Practice, 3rd edition, FT Prentice Hall, p.102



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Sensitivity AnalysisThis method measures the change in project NPV arising from a fixed change in each project variable, or measures the changein each project variable required to make the NPV zero. Only one project variable is changed at one time. The key or criticalproject variables are the ones to which the NPV is most sensitive, or the ones where the smallest change results in a zeroNPV.

Knowledge of the key project variables allows managers to confirm the strength of their underlying assumptions, therebyincreasing their confidence that the forecast NPV will be achieved. It also allows managers to monitor these variables closelywhen the project is implemented as a way of ensuring success. However, sensitivity analysis does not indicate the likelihoodof a change occurring in a given project variable and so, strictly speaking, does not assess project risk at all.

Probability AnalysisThis involves the assessment of the probabilities of future events linked to an investment project. If these events are generalcircumstances, the technique is called scenario analysis. For example, an assessment might be made of the outcome of aninvestment project under poor, moderate and good economic conditions, and the probability of each economic state arisingassessed.

An alternative approach is to assess the likelihood of particular values of project variables occurring, so that a probabilitydistribution for each variable can be determined. This leads to the technique called simulation or the Monte Carlo method,which results in a probability distribution for the project NPV.

With both approaches it is therefore possible to determine the expected net present value (ENPV) based on all possibleoutcomes, and the probability of a negative or zero NPV. The problem with probability analysis is that in practice it is difficultto determine the probabilities to be attached to future events. An inescapable element of subjectivity is likely to exist inprobability estimates.

Risk-adjusted discount ratesOne technique under this heading is the assignment of investment projects to one of a set of risk classes, each of which hasa different discount rate. The assessment of risk depends here on the classification of the project: for example, assetreplacements projects are considered to be low risk, while new product launches may be placed in a high risk category. Thediscount rate applied then increases with the risk class to which a project is assigned. One problem with this technique isthat there may be no academic justification for the discount rate assigned to each risk class, so that there is no explicit linkbetween risk and required rate of return.

An alternative approach is to increase the discount rate by an amount that reflects the perceived risk of an investment project,i.e. to add a risk premium reflecting project risk. While this can be done on a rule of thumb basis, so that a different discountrate is used for each project, it would be preferable to use a technique that assesses project risk and derives a required rateof return based on that assessment. Such techniques are outside our syllabus.

Students could also discuss certainty equivalents and range estimates.

(f) Since Nespa has been listed on a stock exchange for some time, it will be able to access the capital market for new financeif it wishes. It can therefore consider issuing debt securities, such as debentures or loan stock, issuing shares to existingshareholders via a rights issue, issuing shares to new investors, a bank loan, and leasing. Nespa should consider the followingfactors.

Amount of Finance NeededAlthough the director suggests that equity finance is appropriate given the amount of finance needed, the amount alone doesnot rule out other financing methods. It would be sensible to review the effect of the new finance on the company’s capitalstructure and cost of capital, to consider the relative issue costs of different sources of finance, and to assess the effect on thecompany of any change in financial risk.

Cost of CapitalIf Nespa can reduce its average cost of capital, this will increase its overall value. The information that its interest cover ishigher than similar companies points to its competitors having proportionately more debt in their capital structures, a viewsupported by Nespa’s return on capital employed being close to the sector average.

It is also worth noting that, since Nespa’s average cost of capital (and hence its cost of equity) is 10%, and since equity ismore expensive than debt, the cost of debt finance is certain to be less than 10%. The tax efficiency of debt will reduce theeffective cost to Nespa even further, implying that debt finance at a cost of 6% or less is available; the cost will be even lowerfor secured debt. From this discussion it may be concluded that an issue of debt may well be in the best interests of Nespa’sshareholders.

SecurityNespa appears to have an adequate supply of fixed assets to offer as security for an issue of new debt.

Interest CoverNespa should also consider the volatility of its profit before interest and tax. Debt finance would not be as attractive if thisvolatility is high: the existence of similar companies with higher interest cover indicates that competitors may be comfortablewith higher levels of debt than Nespa.

MaturityNespa should match the maturity of the finance with the life of the purchased asset, although no indication of the usefuleconomic life of the new machine is provided.



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LeasingClear advice cannot be given because we lack detailed financial information on the company. It may be worth consideringleasing as an alternative to outright purchase, but this decision would depend on an assessment of relevant costs and benefits.For example, under an operating lease the lessor would be responsible for maintenance and servicing, but the cost of thiswould be reflected in the annual lease payments.

The least likely alternative in the circumstances described appears to be equity finance. While this financing choice keepsfinancial risk low, it does not appear to offer any other advantages to shareholders.

2 (a) The following factors will influence the rate of interest charged on the new bank loan.

Risk of defaultThe bank providing the loan to Blin will make an assessment of the risk that the company might default on its loancommitments and charge an interest rate that reflects this risk. Since Blin is listed on a stock exchange it will be seen as lessrisky than an unlisted company and will pay a lower interest rate as a result. The period of time that the company has beenlisted may also be an influential factor.

Since Blin has expanded sales significantly and relies heavily on overdraft finance, it may be in an overtrading situation. Thiscould increase the risk of default and so increase the rate of interest charged on the loan. The bank would need to beconvinced through financial information supporting the loan application, such as cash flow forecasts, that Blin would be ableto meet future interest payments and repayments of principal.

Security offeredThe rate of interest charged on the loan will be lower if the debt is secured against an asset or assets of the company. It islikely in Blin’s case that the loan will carry a fixed charge on particular assets, such as land or buildings. In the event of defaultby the company, the bank can recover its loan by selling the secured assets.

Duration of loanThe longer the period of the loan taken out by Blin, the higher the interest rate that will be charged. This reflects the shapeof the normal yield curve.

Yield curveThe normal yield curve shows that the yield required on debt increases in line with the term to maturity. One reason for thisis that loan providers require compensation for deferring their use of the cash they have lent, and the longer the period forwhich they are deprived of their cash, the more compensation they require. This is described as the liquidity preferenceexplanation for the shape of the normal yield curve.

Other explanations for the shape of the normal yield curve are expectations theory and market segmentation theory.Expectations theory suggests that interest rates rise with maturity because rates of interest are expected to rise in the future,for example due to an expected increase in inflation. Market segmentation theory suggests that the market for long-term debtdiffers from the market for short-term debt.

Amount borrowedThe rate of interest charged on the new loan could be lower if the amount borrowed is not a small sum. It is more convenientfrom an administrative point of view for a bank to lend a large sum rather than several small amounts.

(b) The approaches that Blin could adopt regarding the relative proportions of long- and short-term finance to meet its workingcapital needs have been described as conservative, moderate and aggressive.

The assets of a business can be divided into current assets and fixed assets, where current assets are used up on a regularbasis within a single accounting period and fixed assets benefit a business for several accounting periods. Current assets canbe further divided into permanent current assets and fluctuating current assets. Permanent current assets represent the corelevel of investment in current assets needed for a given level of business activity, and arise from the need for businesses tocarry stock and to extend credit. Fluctuating current assets represent a variable need for investment in current assets, arisingfrom either seasonal or unpredictable variations in business activity.

A conservative approach to the financing mix would emphasize long-term finance as the main source of working capital funds.This approach would use long-term finance for fixed assets, permanent current assets and some fluctuating current assets.

Long-term debt finance is less risky to a company than short-term debt finance, since once in place it is not subjected to thedangers of renewal or immediate repayment, but is more expensive in that the rate of interest charged normally increaseswith maturity. A conservative approach would therefore increase the amount of lower-risk long-term debt finance used by thecompany, but would also incur higher total interest payments than an approach emphasizing the use of short-term debt, andso would lead to relatively lower profitability. A similar argument can be made with reference to equity finance, which requiresa higher return than long-term debt finance.

An aggressive approach to the financing mix would emphasize short-term finance as the main source of working capitalfunds. This approach, which is currently being used by Blin, uses short-term finance for fluctuating current assets and somepermanent current assets, with long-term finance being used for the balance of permanent current assets and fixed assets.This increases the relative amount of higher-risk short-term finance used by the company, but will also incur lower totalinterest payments than the conservative approach discussed above, leading to relatively higher profitability.



19

Between these two approaches lies a moderate or matching approach. This approach applies the matching principle, wherebythe maturity of the funding is matched with life of the assets financed. Here, long-term finance is used for permanent currentassets and fixed assets, while short-term finance is used for fluctuating current assets.

The repayment of the overdraft will result in Blin adopting a conservative approach to the mix of long- and short-term finance.This will resolve an overtrading situation, if it exists, but may reduce profitability more than necessary. If Blin continues toexpand sales, or reintroduces overdraft finance, the conservative position will only be temporary and a moderate position mayarise in the future. The speed with which this happens will depend on the size of the loan taken out, and whether a moderateposition is desirable will depend on the company’s attitude to risk and return. It may be preferable to reduce the overdraft toa lower level rather than repaying it completely. A clearer picture would emerge if we knew the intended use for, and theamount of, the balance of the loan not being used to repay the overdraft.

(c) The cash operating cycle is the length of time between paying trade creditors and receiving cash from debtors. It can becalculated by adding together the average stock holding period and the average debtors’ deferral period, and then subtractingthe average creditors’ deferral period. The stock holding period may be subdivided into the holding periods for raw materials,work-in-progress and finished goods. In terms of accounting ratios, the cash operating cycle can be approximated by addingtogether stock days and debtor days (debtors’ ratio) and subtracting creditor days (creditors’ ratio). If creditors are paid beforecash is received from debtors, the cash operating cycle is positive; if debtors pay before trade creditors are paid, the cycle isnegative.

The significance of the cash operating cycle in determining the level of investment in working capital is that the longer thecash operating cycle, the higher the investment in working capital. The length of the cash operating cycle varies betweenindustries: for example, a service organization may have no stock holding period, a retail organization will have a stock holdingperiod based almost entirely on finished goods and a very low level of debtors, and a manufacturing organization will have astock holding period based on raw materials, work-in-progress and finished goods. The level of investment in working capitalwill therefore depend on the nature of business operations.

The cash operating cycle and the resulting level of investment in working capital does not depend only on the nature of thebusiness, however. Companies within the same business sector may have different levels of investment in working capital,measured for example by the accounting ratio of sales/net working capital, as a result of adopting different working capitalpolicies. A relatively aggressive policy on the level of investment in working capital is characterized by lower levels of stockand debtors: this lower level of investment increases profitability but also increases the risk of running out of stock, or of losingpotential customers due to better credit terms being offered by competitors. A relatively conservative policy on the level ofinvestment in working capital has higher levels of investment in stock and debtors: profitability is therefore reduced, but therisk of stock-outs is lower and new credit customers may be attracted by more generous terms.

It is also possible to reduce the level of investment in working capital by reducing the length of the cash operating cycle. Thisis achieved by reducing the stock holding period (for example by using JIT methods), by reducing the debtor deferral period(for example by improving debtor management), or by increasing the creditor deferral period (for example by settling invoicesas late as possible). In this way an understanding of the cash operating cycle can assist in taking steps to improve workingcapital management and profitability.

3 (a) Activity-based costing is based on identifying the activities that give rise to costs and this identification does not seem to havehappened in this case. Simply collecting information on different activities is not enough. A detailed analysis of businessoperations is needed in order to identify relationships between costs and cost drivers. There should ideally be a one-to-onerelationship between cost and cost driver. To the extent that this is not so, activity-based costing provides less usefulinformation on product cost and for cost control.

The management accountant believes that he can use the information provided to review the store’s performance from anactivity-based costing perspective, but the relationship between ‘other costs’ for the three-month period and the proposed costdrivers (number of items sold, purchase orders, etc) is unclear.

If sales staff, warehouse staff, consultation staff and administration staff are on fixed salaries, their wage costs will not belinked to items sold, purchase orders or consultations. If wage costs are apportioned on to product cost using the proposedcost drivers, it is likely that better product cost information will arise, simply because the apportionment bases being used arelikely to be more appropriate to retailing than floor area. But at what point does a more sophisticated absorption costingsystem become an activity-based costing system?

The information provided can be used in an activity-based costing analysis if wage costs do depend to some extent on theproposed cost drivers, for example if sales staff wages include a commission for each purchase order raised. The managementaccountant needs to eliminate confusion by undertaking an investigation to establish and clarify the links between costs andactivities if he wishes to use activity-based costing.



20

(b) Proposed cost drivers:Total number of items sold = 1,000 + 1,500 + 4,000 = 6,500Total number of purchase orders = 1,000 + 900 + 2,500 = 4,400Total floor area = 16,000 + 10,000 + 14,000 = 40,000Total number of consultations = 798 + 200 + 250 = 1,248

Are sales staff wages linked to items sold or to purchase orders? If sales staff wages are linked to items sold:Sales staff wages recovery rate = £64,800/6,500 = £9·97/item soldIf sales staff wages are linked to purchase orders:Sales staff wages recovery rate = £64,800/4,400 = £14·727/purchase order

It seems reasonable to link consultation staff wages to the number of consultations:Consultation staff wages recovery rate = £24,960/1,248 = £20·00/consultation

Warehouse staff wages could be linked to either purchase orders fulfilled or to items sold: if each item needs to be handled,items sold might be preferred;Warehouse staff wages recovery rate = £30,240/6,500 = £4·652/ item soldIf warehouse staff wages are linked to purchase orders fulfilled:Warehouse staff wages recovery rate = £30,240/4,400 = £6·873/purchase order

Administration staff process purchase orders and organize consultations, but no indication is given as to whether these tasksare equally weighted. If they are, the total number of tasks = 4,400 + 1,248 = 5,648 and:

Administration staff wages recovery rate = £30,624/5,648 = £5·422/task

General overheads appear to be related to floor space, but there will be other overheads that are not space costs; these willneed to be apportioned on a different basis, or even not apportioned at all. Using the information provided:

General overheads absorption rate = £175,000/40,000 = £4·375/square metre

Possible activity-based costing profit statement:

Department Kitchens Bathrooms Dining Rooms Total£ £ £ £

Sales 210,000 112,500 440,000 762,500Cost of goods sold (63,000) (37,500) (176,000) (276,500)

–––––––– –––––––– –––––––– ––––––––Variable contribution 147,000 75,000 264,000 486,000Sales staff wages (14,727) (13,255) (36,818) (64,800)Consultation staff wages (15,960) (4,000) (5,000) (24,960)Warehouse staff wages (4,652) (6,978) (18,610) (30,240)Admin staff wages (9,749) (5,964) (14,911) (30,624)General overheads (70,000) (43,750) (61,250) (175,000)

–––––––– –––––––– –––––––– ––––––––Profit 31,912 1,053 127,411 160,376

–––––––– –––––––– –––––––– –––––––

Note: sales staff wages are apportioned using purchase orders: warehouse staff wages are apportioned using items sold; otherchoices are possible.

(c) From the perspective of the absorption costing system currently used by the company, the bathrooms department does appearto make a loss.

When viewed from an activity-based costing perspective, however, it may make a small profit. The department makes acontribution towards other costs and overheads of £75,000 and a profit before general overheads of £44,803. Thereforefinancial grounds for closure do not appear to be compelling, although there may be a need to investigate the departmentwith a view to improving profitability.

A more detailed profitability analysis of bathroom sales might lead to greater understanding of which products were relativelyprofitable, which products were slow-moving and which products might be removed from sale without adversely affectingsales of other lines. Less drastic alternatives than closure might be suggested by such an analysis.

If the department were closed, it could be argued that general overheads would still need to be met and so overall profit wouldfall by about £45,000 in each three-month period. Overall profit could fall by more than this if some of the other costsallocated to the bathroom department remained after the closure. For example, the number of staff laid off would notcorrespond exactly to allocated wage costs.

However, it is unlikely the space vacated by the bathrooms department would remain unused. The remaining departmentsmight be expanded to fill it, or it might be used for a new venture (selling carpets, for example). The key question is whethera better use exists for the space. If an alternative use is found, staff redundancies might be reduced or eliminated entirely.

A further problem is that closure of the bathrooms department could affect sales of the other departments. The store mightbe seen as no longer offering an adequate range of products and potential customers might prefer other stores with a greaterrange of home furnishings. The potential for satisfied customers to return with further business would also be reduced if thestore offered a more limited range of products.



21

It is also unlikely that the closure decision would be made at the level of an individual store, since it carries consequencesfor the company as a whole. The image of the company might suffer if it were seen to be changing its product range, or if itwere seen as being unable to compete with other stores selling bathrooms.

(d) Activity-based costing could help Admer understand more clearly the origin of its costs. The nature of Admer’s business meansthat only a small number of cost drivers is likely to exist, but even given the limited information provided, the revised profitstatement is likely to be more useful than treating all overhead costs as being related to floor area.

Activity-based costing can help Admer to control costs by highlighting the activities that generate them. For example,consultation staff wages are high compared to sales staff wages in the kitchen department in this store. Perhaps sales staffcould be trained to provide in-store consultations and the number of home visits reduced; this could lower administrationcosts and reduce the cost of consultations.

It is clear that general overheads are the most significant cost other than cost of sales and existing information does notsuggest ways of reducing these. However, a more detailed analysis of overheads might reveal activity-based costs that arecurrently aggregated. Once disaggregated, they become more amenable to understanding and control.

It is argued that activity-based costing leads to more accurate product costs, and in order to achieve this Admer needs a moredetailed analysis of sales revenue and cost based on the nature of the products sold. For example, the company might beable to classify kitchens as basic, intermediate and deluxe, and collect sales and cost data accordingly.

A key advantage claimed for activity-based costing is that it can provide better information to aid decision-making. In thiscase, it could provide more appropriate information to aid managers in reaching a decision on whether to close the bathroomsdepartment. With better or more detailed information on product cost, managers are likely to make better decisions in keyareas such as product pricing and cost control.

Even after introducing activity-based costing, however, Admer will still face the problem that some arbitrary apportionment ofcosts may still be required when pooling costs. The general overheads of light, heat and rates, for example, are likely to needto be treated in this way, along with the wages of administration staff. A related problem is that not all costs are generated byactivities that can be measured in quantitative terms.

The management accountant of Admer should also be aware that the costs of introducing and maintaining an activity-basedcosting system may exceed the benefits that such a costing system may generate. Appropriate cost drivers will need to bedetermined and the required information may not be available. The existing management accounting information system maytherefore need to be modified to generate the required information, and perhaps new accounting software purchased ordeveloped.

4 (a) The forecast profit and loss accounts are as follows:Debt finance Equity finance

£000 £000Sales 56,000 56,000Variable cost of sales 28,560 28,560Fixed cost of sales 14,500 14,500

–––––– ––––––Gross profit 22,940 22,940Administration costs 14,700 14,700

–––––– ––––––Profit before interest and tax 18,240 18,240Interest 1,1800 11,300

–––––– ––––––Profit before tax 17,440 17,940Taxation at 30% 12,232 12,382

–––––– ––––––Profit after tax 15,208 15,558Dividends paid at 60% 13,125 13,335

–––––– ––––––Retained earnings 12,083 12,223

–––––– ––––––

Workings:Sales = 50,000 x 1·12 = £56,000,000Variable cost of sales = 30,000 x 1·12 x 0·85 = £28,560,000Fixed cost of sales = 30,000 x 0·15 = £4,500,000 (assumed to be constant)Administration costs = 14,000 x 1·05 = £14,700,000Interest under debt financing = 300 + (5,000 x 0·1) = 300 + 500 = £800,000



22

(b) Financial gearingTwo ratios commonly used to measure financial gearing are the debt/equity ratio (or equity gearing) and capital (or total)gearing. Students need only calculate one measure of financial gearing.

Using debt/equity ratio: Current Debt finance Equity financeDebt 2,500 7,500 2,500Share capital and reserves 22,560 24,643 29,783Debt/equity ratio (%) 11·1 30·4 8·4

Workings:Share capital and reserves (debt finance) = 22,560 + 2,083 = £24,643Share capital and reserves (equity finance) = 22,560 + 5,000 + 2,223 = £29,783

Using capital (total) gearing: Current Debt finance Equity financeDebt 2,500 7,500 2,500Total long-term capital 25,060 32,143 32,283Capital (total) gearing (%) 10·0 23·3 7·7

Operational gearing:There are several measures of operational (or operating) gearing. Students were only expected to calculate one measure ofoperational gearing.

Using fixed costs/total costs Current Debt finance Equity financeFixed costs 18,500 19,200 19,200Total costs 44,000 47,760 47,760Operational gearing (%) 42·0% 40·2% 40·2%

Total costs are assumed to consist of cost of sales plus administration costs.

Using fixed costs/variable costs Current Debt finance Equity financeFixed costs 18,500 19,200 19,200Variable costs 25,500 28,560 28,560Operational gearing 0·73 0·67 0·67

Using contribution/PBIT Current Debt finance Equity financeContribution 24,500 27,440 27,440PBIT 6,000 8,240 8,240Operational gearing 4·1 3·3 3·3

Contribution is defined here as sales revenue minus variable cost of sales.

Interest cover:Current Debt finance Equity finance

Profit before interest and tax 6,000 8,240 8,240Debt interest 300 800 300Interest cover 20 10·3 27·5

Earnings per share:Current Debt finance Equity finance

Profit after tax 3,990 5,208 5,558Number of shares 10,000 10,000 11,250Earnings per share (pence) 39·9 52·1 49·4

New number of shares using equity finance = (2,500 x 4) + (5,000/4) = 11·25m

Comment:The debt finance proposal leads to the largest increase in earnings per share, but results in an increase in financial gearingand a decrease in interest cover. Whether these changes in financial gearing and interest cover are acceptable depends onthe attitude of both investors and managers to the new level of financial risk; a comparison with sector averages would behelpful in this context. The equity finance proposal leads to a decrease in financial gearing and an increase in interest cover.The expansion leads to a decrease in operational gearing, whichever measure of operational gearing is used, indicating thatfixed costs have decreased as a proportion of total costs.

(c) Business risk is the possibility of a company experiencing changes in the level of its profit before interest as a result of changesin turnover or operating costs. For this reason it is also referred to as operating risk. Business risk relates to the nature of thebusiness operations undertaken by a company. For example, we would expect profit before interest to be more volatile for aluxury goods manufacturer than for a food retailer, since sales of luxury goods will be more closely linked to varying economicactivity than sales of a necessity good such as food.

The nature of business operations influences the proportion of fixed costs to total costs. Capital intensive business operations,for example, will have a high proportion of fixed costs to total costs. From this perspective, operational gearing is a measureof business risk. As operational gearing increases, a business becomes more sensitive to changes in turnover and the generallevel of economic activity, and profit before interest becomes more volatile. A rise in operational gearing may therefore leadto a business experiencing difficulty in meeting interest payments. Managers of businesses with high operational risk willtherefore be keen to keep fixed costs under control.



23

Financial risk is the possibility of a company experiencing changes in the level of its distributable earnings as a result of theneed to make interest payments on debt finance or prior charge capital. The earnings volatility of companies in the samebusiness will therefore depend not only on business risk, but also on the proportion of debt finance each company has in itscapital structure. Since the relative amount of debt finance employed by a company is measured by gearing, financial risk isalso referred to as gearing risk.

As financial gearing increases, the burden of interest payments increases and earnings become more volatile. Since interestpayments must be met, shareholders may be faced with a reduction in dividends; at very high levels of gearing, a companymay cease to pay dividends altogether as it struggles to find the cash to meet interest payments.

The pressure to meet interest payments at high levels of gearing can lead to a liquidity crisis, where the company experiencesdifficulty in meeting operating liabilities as they fall due. In severe cases, liquidation may occur.

The focus on meeting interest payments at high levels of financial gearing can cause managers to lose sight of the primaryobjective of maximizing shareholder wealth. Their main objective becomes survival and their decisions become focused onthis, rather than on the longer-term prosperity of the company. Necessary investment in fixed asset renewal may be deferredor neglected.

A further danger of high financial gearing is that a company may move into a loss-making position as a result of high interestpayments. It will therefore become difficult to raise additional finance, whether debt or equity, and the company may need toundertake a capital reconstruction.

It is likely that a business with high operational gearing will have low financial gearing, and a business with high financialgearing will have low operational gearing. This is because managers will be concerned to avoid excessive levels of total risk,i.e. the sum of business risk and financial risk. A business with a combination of high operational gearing and high financialgearing clearly runs an increased risk of experiencing liquidity problems, making losses and becoming insolvent.

5 (a) Revised standard costs:After 3% price increase, direct material price = 2·30 x 1·03 = 2.369 £/kgAfter savings of 5%, direct material usage = 3·00 x 0·95 = 2·85 kg/unitAdding 4% wage increase, direct labour rate = 12·00 x 1·04 = 12·48 £/hrAdding back 10% decrease, direct labour hours = 1·25/0·9 = 1·388 hrs/unit

Planning variancesThese variances compare original standard costs with revised standard costs

Direct material price variance = (2·30 – 2·369) x 122,000 x 2·80 = £23,570 (A)Direct material usage variance = (3·00 – 2·85) x 122,000 x 2·30= £42,090 (F)Direct labour rate variance = (12·00 – 12·48) x 122,000 x 1·30 = £76,128 (A)Direct labour efficiency variance = (1·25 – (1·25/0·9)) x 122,000 x 12·00= £203,333 (A)

Operational variancesThese variances compare actual cost with revised standard cost.

Direct material price variance = (2·369 – 2·46) x (122,000 x 2·80) = £31,086 (A)Direct material usage variance = 2·30 x (2·85 – 2·80) x 122,000 = £14,030 (F)Direct labour rate variance = (12·48 – 12·60) x (122,000 x 1·30) = £19,032 (A)Direct labour efficiency variance = 12·00 x ((1·25/0·9) – 1·30) x 122,000 = £130,133 (F)

(b) The direct material and direct cost variances based on the standard cost data applied during the three-month period can befound by adding the relevant planning and operational variances.

Direct material price variance = 23,570 + 31,086 = £54,656 (A)Direct material usage variance = 42,090 + 14,030 = 56,120 (F)Direct labour rate variance = 76,128 + 19,032 = £95,160 (A)Direct labour efficiency variance = 203,333 – 130,133 = £73,200 (A)

(c) If an operating statement had been prepared which did not take into account the changes that were needed to keep thestandard cost data relevant, it would have reported the direct material and direct labour variances calculated in part (b). Thesevariances contain both controllable and uncontrollable elements. For the variances to be more useful, these elements can bereported separately.

Each variance was separated into a planning (uncontrollable) variance and an operational (controllable) variance3. Managerscannot be held responsible for variances over which they have no control and so their attention is focused on operationalvariances. For example, the operating statement shows that the labour efficiency variance consists of an adverse planningvariance of £203,333 but a favourable operational variance of £130,133. If the controllable and uncontrollable elementshad not been separated, an adverse variance of £73,200 would have been reported.

The planning variances indicate where investigation may result in an improvement in the planning and budgeting process.For example, if it could reasonably have been expected that a wage increase would be agreed at the start of the budget period,the anticipated increase should have been incorporated. The reason for the omission of the 3% increase in direct materialprice should be investigated: was it a case of forgetfulness or were budget figures not checked before the budgets were sentfor approval?

–––––––––––––––––––3Drury, C. (2000) Management and Cost Accounting, 5th edition, Thomson Learning, p.747



24

(d) The following factors could be discussed.

SizeLarger cost savings are likely to arise from taking action to correct large variances and a policy could be established ofinvestigating all variances above a given size. Size can be linked to the underlying variable in percentage terms as a test ofsignificance: for example, a policy could be established to investigate all variances of 5% or more.

Adverse or favourableIt is natural to concentrate on adverse variances in order to bring business operations back in line with budget. However,whether a variance is adverse or favourable should not influence the decision to investigate. The reasons for favourablevariances should also be sought, since they may indicate the presence of budgetary slack or suggest ways in which thebudgeting process could be improved. Favourable variances may also indicate areas where the budget is easy to achieve,suggesting that the motivational effect of a budget could be improved by introducing more demanding targets.

Cost versus benefitsIf the expected cost of investigating a variance is likely to exceed any benefits expected to arise from its correction, it may bedecided not to investigate.

Historic pattern of variancesA variance which is unusual when compared to historic patterns of variances may be considered worthy of investigation.Statistical tests of significance may be used to highlight such variances.

Reliability and quality of dataIf data is aggregated or if the quality of the measuring and recording system is not as high as would be liked, there may beuncertainty about the benefits to arise from investigation of variances.



25


Marks1 (a) Variable costs 2

Contribution 2Inflated contribution 2Present value of overall contribution 2Selection of contribution-maximizing strategy 1

–––9

(b) Inflated fixed costs 1Taxable profit 1Tax liabilities 1Capital allowance tax benefits 3Net present values 2Calculation of internal rate of return 2Omission of cost of market research 1Recommendation 1

–––12

(c) Annual depreciation 1Average accounting profit 1Average investment 1Return on capital employed 1Recommendation 1

–––5

(d) Discussion of IRR 3Discussion of ROCE 3Discussion of company’s views 2

–––8

(e) Discussion of risk and uncertainty 1Discussion of risk assessment methods 7

–––8

(f) Effect of listed company status 1Discussion of debt finance 4Discussion of other forms of finance 3

–––8

–––50–––



Marks2 (a) Risk of default 2

Security 2Duration 1Yield curve 3Amount borrowed 1

–––9

(b) Relative risk of long- and short-term finance 1Discussion of aggressive approach 2Discussion of conservative approach 2Discussion of moderate/matching approach 2Comment on repayment of overdraft 2

–––9

(c) Meaning of cash operating cycle 2Significance re level of working capital investment 5

–––7

–––25–––

3 (a) Costs and cost drivers 2Limitations of information provided 2

–––4

(b) Analysis and discussion 4Activity-based profit statement 5

–––max 8

(c) Evaluation and discussion of closure proposal 6

(d) Up to 2 marks for each detailed advantage 6Up to 2 marks for each detailed disadvantage 4

–––max 7

–––25–––

26



Marks4 (a) Sales and administration cost 1

Cost of sales 1Interest 1Profit after tax 1Retained earnings 1

–––5

(b) Revised share capital and reserves 1Financial gearing 2Operational gearing 2Interest cover 2Earnings per share 2Calculation of current values 1Discussion 2

–––12

(c) Explanation of business risk 1Explanation of financial risk 1Up to 2 marks for each danger of high gearing 6

–––8

–––25–––

5 (a) Revised standard costs 3Calculation of planning variances 4Calculation of operational variances 4

–––11

(b) Direct material price variance 1Direct material usage variance 1Direct labour rate variance 1Direct labour efficiency variance 1

–––4

(c) Controllable and uncontrollable variances 2Discussion of calculated variances 3

–––5

(d) Up to 2 marks for each factor discussed 5–––25–––

27




PART 2


QUESTION PAPER





Formulae Sheet, Present Value and Annuity Tables are on pages 7, 8 and 9.

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examinationhall


Pape

r 2.4




1 Sassone plc is a medium-sized profitable company that manufactures engineering products. Its stated objectives areto maximise shareholder wealth and to maintain an ethical approach to the production and distribution of engineeringproducts. It has in issue two million ordinary shares, held as follows:

Number of sharesPension funds 550,000Insurance companies 250,000Investment trusts 200,000Unit trusts 100,000Directors of Sassone 350,000Other shareholders 550,000

––––––––––2,000,000––––––––––

The Managing Director of Sassone plc is considering three items that have been placed on the agenda of the nextBoard Meeting:

1. Complaint by institutional investorsA number of institutional investors complained at the recent Annual General Meeting of the company thatexpenditure on environmentally-friendly and socially responsible projects was at too high a level, resulting in aless than acceptable increase in annual dividend payments. They had warned that they would vote against there-appointment of directors if matters had not improved by the next Annual General Meeting.

2. Proposal to change variance reporting procedureThe Production Director has asked that the company amend its current variance reporting procedures in order toreport planning and operational variances rather than variances based only on start-of-period standard costinginformation. In support of his request he has highlighted a £33,000 adverse direct material usage variance forthe last period for Product Z, which he claims is not the responsibility of his staff since he believes that most ofthis variance is due to the use of an out-of-date standard.

The Production Director states that the standard cost of materials of Product Z at the start of the period was 5 kgper unit at £7·50 per kg, and that budgeted production and sales of Product Z for the period were 11,000 units.During the period, actual production and sales of Product Z were 10,000 units and 54,400 kg of materials wereused at a cost of £408,000. The Production Director believes that, due to the age of the machinery used to makeProduct Z, the standard usage of materials should be revised to 5·3 kg per unit.

3. Proposal to increase manufacturing capacityThe directors of Sassone plc need to increase capacity in order to meet expected demand for a new product,Product G, which is to be used in the manufacture of new-generation personal computers. Product G cannot bemanufactured on existing machines. The directors have identified two machines which can manufacture Product G, each with a capacity of 60,000 units per year, as follows:

Machine OneThis machine will cost £238,850 and last for five years, at the end of which time it will have zero scrap value.Maintenance costs will be £10,000 in the first year of operation, increasing by £3,000 per year for each year ofoperation.

Machine TwoThis machine will cost £215,000 and last for four years, at the end of which time it will have zero scrap value.Maintenance costs will be £10,000 in the first year of operation, increasing by £5,000 per year for each year ofoperation.

2



Sassone plc expects demand for Product G to be 30,000 units per year in the first year, and to increase by afurther 10,000 units per year in each subsequent year. Selling price is expected to be £10·00 per unit and themarginal cost of production is expected to be £7·80 per unit. Incremental fixed production overheads of £10,000per year will be incurred. Selling price and costs are all in current price terms.

Annual inflation rates are expected to be as follows:

Selling price of Product G: 4% per yearMarginal cost of production: 4% per yearMaintenance costs: 5% per yearFixed production overheads: 6% per year

Other informationSassone plc has a real cost of capital of 8% and uses a nominal (money) cost of capital of 11% in investmentappraisal. The company pays tax one year in arrears at an annual rate of 30% and can claim capital allowances ona 25% reducing balance basis, with a balancing allowance at the end of the life of the machines. The companydepreciates fixed assets on a straight-line basis over the life of the asset and has a target before-tax return on capitalemployed (accounting rate of return) of 25%.

Required:

(a) Calculate the planning and operational direct material usage variances for Product Z and comment on theviews of the Production Director. (4 marks)

(b) Using equivalent annual cost and considering machine purchase prices and maintenance costs only,determine which machine should be purchased by Sassone. Ignore inflation and taxation in this part of thequestion only. (6 marks)

(c) Calculate the net present value of the incremental cash flows arising from purchasing Machine Two andadvise on its acquisition. (18 marks)

(d) Calculate the before-tax return on capital employed (accounting rate of return) of the incremental cash flowsarising from purchasing Machine Two based on the average investment and comment on your findings.

(4 marks)

(e) Discuss the conflict that may arise between corporate objectives, using the information provided on Sassoneplc to illustrate your answer. (10 marks)

(f) Discuss how lifecycle costing and target costing may assist Sassone plc in controlling costs and pricingengineering products. (8 marks)

(50 marks)

3 [P.T.O.




2 Mermus plc is comparing budget and actual data for the last three months.

Budget Actual£ £ £ £

Sales 950,000 922,500Cost of sales

Raw materials 133,000 130,500Direct labour 152,000 153,000Variable production overheads 100,700 96,300Fixed production overheads 125,400 115,300

–––––––– ––––––––511,100 495,100–––––––– ––––––––438,900 427,400–––––––– ––––––––

The budget was prepared on the basis of 95,000 units produced and sold, but actual production and sales for thethree-month period were 90,000 units.

Mermus uses standard costing and absorbs fixed production overheads on a machine hour basis. A total of 28,500standard machine hours were budgeted. A total of 27,200 machine hours were actually used in the three-monthperiod.

Required:

(a) Prepare a revised budget at the new level of activity using a flexible budgeting approach. (4 marks)

(b) Calculate the following:

(i) raw material total cost variance;(ii) direct labour total cost variance;(iii) fixed overhead efficiency variance;(iv) fixed overhead capacity variance;(v) fixed overhead expenditure variance. (8 marks)

(c) Suggest possible explanations for the following variances:

(i) raw materials total cost variance;(ii) fixed overhead efficiency variance;(iii) fixed overhead expenditure variance. (6 marks)

(d) Explain three key purposes of a budgeting system. (7 marks)

(25 marks)

4



3 Tirwen plc is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15% discountto the current market price of £4·00 per share. Issue costs are expected to be £220,000 and these costs will be paidout of the funds raised. It is proposed that the rights issue funds raised will be used to redeem some of the existingdebentures at par. Financial information relating to Tirwen plc is as follows:

Current Balance Sheet£000 £000 £000

Fixed assets 6,550Current assets

Stock 2,000Debtors 1,500Cash 300

––––––3,800

Current liabilitiesTrade creditors 1,100Overdraft 1,250

––––––2,350

––––––Net current assets 1,450

––––––Total assets less current liabilities 8,00012% debentures 2012 4,500

––––––3,500

––––––

Ordinary shares (par value 50p) 2,000Reserves 1,500

––––––3,500

––––––

Other information:Price/earnings ratio of Tirwen plc: 15·24Overdraft interest rate: 7%Corporation tax rate: 30%Sector averages: debt/equity ratio (book value): 100%

interest cover: 6 times

Required:

(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:

(i) the theoretical ex rights price per share;(ii) the value of rights per existing share. (3 marks)

(b) What alternative actions are open to the owner of 1,000 shares in Tirwen plc as regards the rights issue?Determine the effect of each of these actions on the wealth of the investor. (6 marks)

(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are usedto redeem some of the existing debentures. (6 marks)

(d) Evaluate whether the proposal to redeem some of the debentures would increase the wealth of theshareholders of Tirwen plc. Assume that the price/earnings ratio of Tirwen plc remains constant.

(3 marks)

(e) Discuss the reasons why a rights issue could be an attractive source of finance for Tirwen plc. Your discussionshould include an evaluation of the effect of the rights issue on the debt/equity ratio and interest cover.

(7 marks)

(25 marks)

5 [P.T.O.



4 At a recent board meeting of Spring plc, there was a heated discussion on the need to improve financial performance.The Production Director argued that financial performance could be improved if the company replaced its existingabsorption costing approach with an activity-based costing system. He argued that this would lead to better costcontrol and increased profit margins. The Managing Director agreed that better cost control could lead to increasedprofitability, but informed the meeting that he believed that performance needed to be monitored in both financial andnon-financial terms. He pointed out that sales could be lost due to poor product quality or a lack of after-sales servicejust as easily as by asking too high a price for Spring plc’s products. He suggested that while the board should considerintroducing activity-based costing, it should also consider ways in which the company could monitor and assessperformance on a wide basis.

Required:

(a) Describe the key features of activity-based costing and discuss the advantages and disadvantages of adoptingan activity-based approach to cost accumulation. (14 marks)

(b) Explain the need for the measurement of organisational and managerial performance, giving examples of therange of financial and non-financial performance measures that might be used. (11 marks)

(25 marks)

5 Umunat plc is considering investing £50,000 in a new machine with an expected life of five years. The machine willhave no scrap value at the end of five years. It is expected that 20,000 units will be sold each year at a selling priceof £3·00 per unit. Variable production costs are expected to be £1·65 per unit, while incremental fixed costs, mainlythe wages of a maintenance engineer, are expected to be £10,000 per year. Umunat plc uses a discount rate of 12%for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

Required:

(a) Explain why risk and uncertainty should be considered in the investment appraisal process. (5 marks)

(b) Calculate and comment on the payback period of the project. (4 marks)

(c) Evaluate the sensitivity of the project’s net present value to a change in the following project variables:

(i) sales volume;(ii) sales price;(iii) variable cost;

and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)

(d) Upon further investigation it is found that there is a significant chance that the expected sales volume of 20,000 units per year will not be achieved. The sales manager of Umunat plc suggests that sales volumes coulddepend on expected economic states that could be assigned the following probabilities:

Economic state Poor Normal GoodProbability 0·3 0·6 0·1Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (6 marks)

(25 marks)

6



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Answers




1 (a) Planning direct material usage variance:10,000 x (5·0 – 5·3) x 7·50 = £22,500 (A)

Operational direct material usage variance:[(10,000 x 5·3) – 54,400] x 7·50 = £10,500 (A)

If the Production Director is correct in his claim that the standard material usage needs to be revised to 5·3 kg/unit, then 68%of the direct material variance of £33,000 is due to the use of an out-of-date standard. The Production Director is thereforecorrect in stating that most of the variance is due to an out-of-date standard, but he cannot avoid responsibility for theoperational usage variance of £10,500.

Standards need to be revised regularly in order that they remain relevant for costing and control purposes. The ProductionDirector’s claim must be investigated and the material usage standard revised if the claim is found to be true and a revisionis deemed to be necessary.

Providing planning and operational variances as a result of ex post variance analysis will enable more accurate assessmentof managerial performance by identifying controllable and uncontrollable variances. Managers cannot be held responsible foruncontrollable variances, whether positive or negative in nature. Providing planning and operational variances will also reducethe frequency of revisions to standards.

(b) Machine One

Year 0 1 2 3 4 5£ £ £ £ £ £

Initial Investment (238,850)Maintenance (10,000) (13,000) (16,000) (19,000) (22,000)11% discount factors 1·000 0·901 0·812 0·731 0·659 0·593

––––––––– ––––––– –––––––– –––––––– –––––––– ––––––––(238,850) (9,010) (10,556) (11,696) (12,521) (13,046)––––––––– ––––––– –––––––– –––––––– –––––––– ––––––––

Present value of costs = £295,679Annuity factor for five years at 11% = 3·696Equivalent annual cost = 295,679/3·696 = £80,000 per year

Machine Two

Year 0 1 2 3 4£ £ £ £ £

Initial Investment (215,000)Maintenance (10,000) (15,000) (20,000) (25,000)11% discount factors 1·000 0·901 0·812 0·731 0·659

––––––––– ––––––– –––––––– –––––––– ––––––––(215,000) (9,010) (12,180) (14,620) (16,475)––––––––– ––––––– –––––––– –––––––– ––––––––

Present value of costs = £267,285Annuity factor for four years at 11% = 3·102Equivalent annual cost = 267,285/3·102 = £86,165 per year

Machine One should be bought as it has the lowest equivalent annual cost.

13



(c) Sales volume reaches the maximum capacity of the new machine in Year 4.

Year 1 2 3 4 5£ £ £ £ £

Sales revenue 312,000 432,800 562,500 702,000Marginal cost (243,300) (337,600) (438,500) (547,200)Maintenance (10,600) (11,236) (11,910) (12,625)Fixed cost (10,000) (15,750) (22,050) (28,941)

––––––––– ––––––– –––––––– ––––––––Taxable cash flow 48,100 68,214 90,040 113,234Taxation (14,430) (20,464) (27,012) (33,970)WDA tax benefit 16,125 12,094 9,070 27,211

–––––––– –––––––– –––––––– –––––––– ––––––––Net cash flow 48,100 69,909 81,670 95,292 (6,759)Discount factors 0·901 0·812 0·731 0·659 0·593

––––––––– –––––––– –––––––– –––––––– ––––––––Present values 43,338 56,766 59,701 62,797 (4,008)

––––––––– –––––––– –––––––– –––––––– ––––––––

£Sum of present values 218,594Initial investment 215,000

––––––––Net present value 113,594

––––––––

The positive NPV indicates that the investment in Machine Two is financially acceptable, although the NPV is so small thatthere is likely to be a significant possibility of a negative NPV.

WorkingsYear 1 2 3 4Selling price (£/unit) 1110·40 1110·82 1111·25 1111·70Sales (units/yr) 130,000 140,000 150,000 160,000Sales revenue (£/yr) 312,000 432,800 562,500 702,000

Year 1 2 3 4Marginal cost (£/unit) 11,8·11 1118·44 1118·77 1119·12Sales (units/yr) 130,000 140,000 150,000 160,000Marginal cost (£/yr) 243,300 337,600 438,500 547,200

Year 1 2 3 4Maintenance (£/yr) 110,000 115,000 120,000 125,000Inflated cost (14/yr) 110,000 115,750 122,050 128,941

Writing down allowances and tax benefits

Allowances Benefits£ £

Year 1: 215,000 x 0·25 = 53,750 16,125Year 2: 161,250 x 0·25 = 40,312 12,094Year 3: 120,938 x 0·25 = 30,234 9,070

––––––––124,296

Year 4: (215,000 – 124,296) = 90,704 27,211––––––––215,000––––––––

(d) Total taxable cash flow = (48,100 + 68,214 + 90,040 + 113,234) = £319,588Total depreciation = £215,000Total accounting profit = 319,588 – 215,000 = £104,588Average annual accounting profit = 104,588/4 = £26,147Average investment = 215,000/2 = £107,500Return on capital employed = 100 x 26,147/107,500 = 24·3%

ROCE of 24·3% is slightly less than the target ROCE of 25%, indicating that buying the machine is not acceptable withrespect to this criterion. However, evaluation using the net present value approach is preferred for investment advice.

(e) The objectives to which organisational strategy relates depend on the relative power of different stakeholders associated withthe company, and on whether objectives are imposed on the organisation by, for example, government or other legislation.Since it is unlikely that the objectives of different stakeholders will coincide, conflict will arise between corporate objectivesand management must decide on the extent to which conflicting objectives can be met. In this case, 55% of the company’sshares are in the hands of institutional investors and so this shareholder group, if it acts in concert, can wield considerablepower over the organisational strategy of Sassone plc. In practice shareholder groups are likely to be fragmented and thisfragmentation will reduce the power of Sassone plc’s institutional investors.

14



The primary financial objective of a company is usually stated to be the maximisation of shareholder wealth and Sassone plchas declared publicly that this is one of its objectives. Returns to shareholders can be measured in terms of dividend yieldand capital growth, reflecting the attention paid by investors to dividends and increasing share prices. Both dividend yield andcapital growth can be measured over a standardised holding period in order to assess shareholder returns.

Some of the institutional shareholders of Sassone have complained that annual dividend payments have not increased at anacceptable rate due to expenditure on environmentally-friendly and socially acceptable projects. This represents a conflictbetween a financial objective (shareholder wealth maximisation) and a non-financial objective (social welfare). The claim isthat unnecessary expenditure has reduced the amount of profits paid out as dividends. It is important for Sassone plc to findthe extent to which this view is shared by other institutional shareholders, given the relative size of this shareholder grouping.

This conflict between objectives cannot be resolved by rational argument. It is possible that Sassone plc’s support forenvironmentally-friendly and socially acceptable projects has generated a positive image in the minds of its customers,resulting in increased sales, but this effect cannot be quantified readily. Alternatively, it is possible that sales would be lowerif Sassone plc did not support environmentally-friendly and socially acceptable projects, since such behaviour may beexpected by its customers. The institutional investors’ complaint may therefore be short-sighted, although a comparisonbetween Sassone plc and its competitors may show that its expenditure on socially acceptable and environmentally-friendlyprojects is larger than necessary. However, the benefit of such projects may arise only in the long term, whereas the complaintby institutional investors indicates a short-term focus.

One of the roles of company managers is therefore to seek to resolve or reduce any conflict between corporate objectives. Thefact that institutional investors have threatened to vote against the re-appointment of directors at the next Annual GeneralMeeting signifies that they are resolved to seek change, although in practice they may be unable to gather sufficient votes toachieve their objective. However, company managers must maintain a good relationship with institutional investors, if onlybecause they may wish to seek investor support for a rights issue in the future, and it is likely the complaint will beinvestigated and an amicable solution found. The key task of management may be to persuade institutional investors to adopta longer-term view.

(f) When considering the incremental increase in sales arising from the purchase of the new machine, it was assumed thatproduct costs remained constant in real terms over the life cycle of the product. In fact, the life cycle of the product wasignored and all of the engineering products produced were treated as being identical. In reality, each kind of engineeringproduct is likely to go through the stages of the product life cycle: introduction, growth, maturity and decline. Higher costsare likely to be incurred at the start of the product life cycle due to product development, marketing and promotion. Duringthe growth stage, sales volumes increase and unit cost consequently decreases. During the maturity stage, unit cost initiallycontinues to fall as developmental and promotional costs are recovered and scale economies continue to grow, but eventuallycompetition on price and product differentiation begin to reduce profitability. In the decline stage, sales volumes fall and unitcost increases, further reducing profitability and leading to abandonment or replacement of the product concerned.

Most costing systems report product costs on a periodic basis (e.g. monthly or annually) and fail to track product profitabilityover the product life cycle. Life cycle costing accumulates actual costs over the product life cycle and allocates research,development, promotion and marketing costs to specific products rather than treating them as general overhead costs. In thisway, a clearer picture of estimated life cycle costs and product profitability is gained, and actual life cycle costs can bemonitored and compared to budgeted life cycle costs for cost control purposes.

Product pricing should reflect the need to recover costs over the product life cycle. Initially, prices may be set at a level thatreflects the captive nature of the initial market (since competitors may not exist), while also considering the need to persuadepotential customers to substitute the new product for existing products. During the maturity stage, product prices will declineas companies struggle to maintain market share in the face of increasingly fierce competition. Product prices will continue tofall in the decline stage as the product becomes obsolete and replacements are developed. Sassone plc could incorporatethese considerations into the pricing of the engineering components it sells, particularly the need to keep prices competitiveduring the maturity and decline stages.

Target costing considers the price that ought to be charged in order to achieve a desired market share for a given product anduses this, together with the desired profit margin, as the basis for determining product cost. Target costing can therefore takeaccount of the life cycle of the product rather than just production costs. For new products, the product development teamcan use this product cost as a target to be met when the product is launched. If the target cost differs from the expected actualcost, the product development team can seek ways to achieve the desired target cost, for example by product and processdesign. This approach could be useful to Sassone plc since it would discover what product price was needed to achieve thedesired market share for a given engineering component, rather than simply adding a mark-up to expected actual cost, andit could use the derived target cost as a way of controlling costs and increasing profitability.

15



16

2 (a) The flexed budget will be based on the actual activity level of 90,000 units.

£ £Sales: £950,000 x 90/95 = 900,000Cost of sales

Raw materials: 133,000 x 90/95 = 126,000Direct labour: 152,000 x 90/95 = 144,000Variable production overheads: 100,700 x 90/95 = 95,400Fixed production overheads: 125,400

––––––––490,800––––––––409,200––––––––

(b) Raw materials cost total variance = 126,000 – 130,500 = £4,500 (Adverse)Direct labour cost total variance = 144,000 – 153,000 = £9,000 (Adverse)

Fixed overhead absorption rate = 125,400/28,500 = £4·40 per machine hourStandard machine hours for actual production = 28,500 x 90/95 = 27,000 hrs

Standard fixed overhead (actual production) = 27,000 x 4·4 = £118,800Fixed overhead absorbed on actual hours = 27,200 x 4·4 = £119,680Fixed overhead efficiency variance = 118,800 – 119,680 = 880 (Adverse)

Fixed overhead absorbed on actual hours = 27,200 x 4·4 = £119,680Fixed overhead absorbed on budgeted hours = 28,500 x 4·4 = £125,400Fixed overhead capacity variance = 119,680 – 125,400 = £5,720 (Adverse)

Budgeted overhead expenditure = £125,400Actual overhead expenditure = £115,300Fixed overhead expenditure variance = 125,400 – 115,300 = £10,100 (Favourable)

(c) Raw materials cost varianceThe budgeted raw material cost for production of 95,000 units was £1·40 per unit (133,000/95,000) but the actual rawmaterial cost for production of 90,000 units was £1·45 per unit (130,500/90,000). The raw material cost per unit may haveincreased either because more raw material per unit was used than budgeted, or because the price per unit of raw materialwas higher than budgeted. Calculation of the raw material price and usage sub-variances would indicate where furtherexplanation should be sought.

Fixed overhead efficiency varianceThe fixed overhead efficiency variance measures the extent to which more or less standard hours were used for the actualproduction than budgeted. In this case, a total of 27,200 machine hours were actually used, when only 27,000 standardmachine hours should have been used. The difference may be due to poorer production planning than expected or to machinebreakdowns.

Fixed overhead expenditure varianceThe fixed overhead expenditure variance measures the extent to which budgeted fixed overhead differs from actual fixedoverhead. Here, actual fixed overhead is £10,100 less than budgeted. This could be due to an error in forecasting fixedproduction overheads such as rent and power costs, or to a decrease in fixed production overheads, such as changing to acheaper cleaning contractor.

(d) Key purposes of a budgeting system that could be discussed include planning, co-ordination, communication, control,motivation and performance evaluation1. Students were required only to discuss three key purposes.

PlanningOne of the key purposes of a budgeting system is to require planning to occur. Strategic planning covers several years but abudget represents a financial plan covering a shorter period, i.e. a budget is an operational plan. Planning helps anorganisation to anticipate key changes in the business environment that could potentially impact on business activities andto prepare appropriate responses. Planning also ensures that the budgeted activities of the organisation will support theachievement of the organisation’s objectives.

Co-ordinationMany organisations undertake a number of activities which need to be co-ordinated if the organisation is to meet itsobjectives. The budgeting system facilitates this co-ordination since organisational activities and the links between them arethoroughly investigated during budget preparation, and the overall coherence between the budgeted activities is reviewedbefore the master budget is agreed by senior managers. Without the framework of the budgeting system, individual managersmay be tempted to make decisions that are not optimal in terms of achieving organisational objectives.

–––––––––––––––––––––––––––1 Drury, C. (2000) Management and Cost Accounting, 5th Edition, Thomson Business Press, pp.549–51



17

CommunicationThe budgeting system facilitates communication within the organisation both vertically (for example between senior and juniormanagers) and horizontally (for example between different organisational functions). Vertical communication enables seniormanagers to ensure that organisational objectives are understood by employees at all levels. Communication also occurs atall stages of the budgetary control process, for example during budget preparation and during investigation of end-of-periodvariances.

ControlOne of the most important purposes of a budgeting system is to facilitate cost control through the comparison of budgetedcosts and actual costs. Variances between budgeted and actual costs can be investigated in order to determine the reasonwhy actual performance has differed from what was planned. Corrective action can be introduced if necessary in order toensure that organisational objectives are achieved. A budgeting system also facilitates management by exception, wherebyonly significant differences between planned and actual activity are investigated.

MotivationThe budgeting system can influence the behaviour of managers and employees, and may motivate them to improve theirperformance if the target represented by the budget is set at an appropriate level. An inappropriate target has the potential tobe demotivating, however, and a key factor here is the degree of participation in the budget-setting process. It has been shownthat an appropriate degree of participation can have a positive motivational effect.

Performance evaluationManagerial performance is often evaluated by the extent to which budgetary targets for which individual managers areresponsible have been achieved. Managerial rewards such as bonuses or performance-related pay can also be linked toachievement of budgetary targets. Managers can also use the budget to evaluate their own performance and clarify how closethey are to meeting agreed performance targets.

3 (a) Rights issue price = 4·00 x 0·85 = £3·40Theoretical ex rights price = ((5 x 4·00) + 3·40)/6 = £3·90Value of rights per existing share = (3·90 – 3·40)/5 = 10p

(b) Value of 1,200 shares after rights issue = 1,200 x 3·90 =£4,680Value of 1,000 shares before rights issue = 1,000 x 4·00 =£4,000Value of 1,000 shares after rights issue = 1,000 x 3·90 = £3,900Cash subscribed for new shares = 200 x 3·40 = £680Cash raised from sale of rights = 1,000 x 0·1 = £100

The investor could do nothing, take up the offered rights, sell the rights into the rights market, or any combination of theseactions. The effect of the rights issue on the wealth of the investor depends on which action is taken.

The rights issue has a neutral effect if the rights attached to the 1,000 shares are exercised to purchase an additional 200shares, since the value of 1,200 shares after the rights issue (£4,680) is equal to the sum of the value of 1,000 sharesbefore the rights issue (£4,000) and the cash subscribed for new shares (£680). Part of the investor’s wealth has changedfrom cash into shares, but no wealth has been gained or lost. The theoretical ex rights per share therefore acts as a benchmarkfollowing the rights issue against which other ex rights share prices can be compared.

The rights issue also has a neutral effect on the wealth of the investor if the rights attached to existing shares are sold. Thevalue of 1,000 shares after the rights issue (£3,900) plus the cash received from the sale of rights (£100) is equal to thevalue of 1,000 shares before the rights issue (£4,000). In this case, part of the investor’s wealth has changed from sharesinto cash.

If the investor neither subscribes for the new shares offered nor sells the rights attached to the shares already held, a loss ofwealth of £100 will occur, due to the difference between the value of 1,000 shares before the rights issue (£4,000) and thevalue of 1,000 shares after the rights issue (£3,900).

The theoretical ex rights price is simply a weighted average of the cum rights price and the rights issue price, ignoring anyuse made of the funds raised. The actual ex rights price will depend on the use made of the funds raised by the rights issue,as well as the expectations of investors and the stock market.



18

(c) Current share price = £4·00Earnings per share = 100 x (4·00/15·24) = 26·25pNumber of ordinary shares = 2m/0·5 = 4m sharesEarnings of Tirwen = 4m x 0·2625 = £1·05m

Funds raised from rights issue = 800,000 x £4·00 x 0·85 = £2,720,000Funds raised less issue costs = 2,720,000 – 220,000 = £2,500,000Debenture interest saved = 2,500,000 x 0·12 = £300,000

Profit before tax of Tirwen = 1,050,000/(1 – 0·3) = £1,500,000Current debenture interest paid = 4,500,000 x 0·12 = £540,000Current overdraft interest = 1,250,000 x 0·07 = £87,500Total interest = 540,000 + 87,500 = £627,500Current profit before interest and tax = 1,500,000 + 627,500 = £2,127,500Revised total interest = 627,500 – 300,000 = £327,500Revised profit after tax = (2,127,500 – 327,500) x 0·7 = £1,260,000

(Or revised profit after tax = 1,050,000 + (300,000 x 0·7) = £1,260,000)

New shares issued = 4m/5 = 800,000Shares in issue = 4,000,000 + 800,000 = 4,800,000Revised earnings per share = 100 x (1,260,000/4,800,000) = 26·25p

(d) As the price/earnings ratio is constant, the share price expected after redeeming part of the debentures will remain unchangedat £4·00 per share (26·25 x 15·24). Since this is greater than the theoretical ex rights share price of £3·90, using the fundsraised by the rights issue to redeem part of the debentures results in a capital gain of 10p per share. The proposal to use therights issue funds to redeem part of the debentures therefore results in an increase in shareholder wealth.

(e) A rights issue will be an attractive source of finance to Tirwen plc as it will reduce the gearing of the company. The currentdebt/equity ratio using book values is:

Debt/equity ratio = 100 x 4,500/3,500 = 129%Including the overdraft, debt/equity ratio = 100 x 5,750/3,500 = 164%

Both values are above the sector average of 100% and issuing new debt will not be attractive in this situation. A substantialreduction in gearing will occur, however, if the rights issue is used to redeem £2·5m of debentures:


If the rights issue is not used to redeem the debenture issue, the decrease in gearing is less dramatic:


In both cases, the debt/equity ratio falls to less than the sector average, signalling a decrease in financial risk. The debt/equityratio would fall further if increased retained profits were included in the calculation, but the absence of information on Tirwen’sdividend policy makes retained profits uncertain.

If the rights issue is used to redeem £2·5m of debentures, there will be an improvement in interest cover from 3·4 times(2,127,500/627,500), which is below the sector average of 6 times, to 6·5 times (2,127,500/327,500), which ismarginally better than the sector average. Interest cover might also increase if the funds raised are invested in profitableprojects.

A rights issue will also be attractive to Tirwen plc since it will make it more likely that the company can raise further debtfinance in the future, possibly at a lower interest rate due to its lower financial risk.

It should be noted that a decrease in gearing is likely to increase the average cost of the finance used by Tirwen plc, since agreater proportion of relatively more expensive equity finance will be used compared to relatively cheaper debt. This willincrease the discount rate used by the company and decrease the net present value of any expected future cash flows.



19

4 (a) Activity-based costing is based on the insight that activities create costs, while products consume activities. It is claimed thatactivity-based costing attaches overheads to product cost in a more meaningful way than traditional absorption costing.

A key feature of activity-based costing is that overhead costs are collected in cost pools, which correspond to a particularactivity or group of activities that generate costs. A classic example of a cost pool is set-up costs for a production line. Thecost of each set-up is included in the cost pool reflecting the recognition that it is set-ups that incur costs, rather than thevolume of production on the production line. Set-up costs are an example of an indirect cost, and both traditional absorptioncosting and activity-based costing are concerned with the allocation of indirect costs onto product cost. Traditional absorptioncosting assigns indirect costs or overheads to production departments and service departments and then reallocates servicedepartment overheads to production centres. Activity-based costing is likely to use, or has the potential to use, considerablymore cost pools than traditional absorption costing uses production centres.

In activity-based costing, the link between cost pools and product cost is called a cost driver. A cost driver represents theextent to which a particular activity has been used by a particular product in its production. Continuing our example, anappropriate cost driver would be number of set-ups. A product which is produced in frequent short production runs wouldtherefore incur a greater share of set-up costs than a product produced in a single production run. In traditional absorptioncosting, overheads are linked to product cost through overhead absorption rates such as cost per machine hour or cost perlabour hour. Activity-based costing is likely to use considerably more cost drivers than traditional absorption costing usesoverhead absorption rates.

The key steps in introducing an activity-based costing system are as follows:

1. Identify the main activities that generate costs through activity analysis2. Assign costs to cost pools 3. Select appropriate cost drivers for assigning cost pool costs to products4. Calculate activity-based charge rates to assign the cost of activities to products

The following benefits have been claimed for an activity-based costing:

1. Product costs are more accurate due to the more sophisticated analysis and assignment of overhead costs. Overheadcosts are assigned on a cause-and-effect basis rather than on an ad hoc or subjective basis.

2. Cost behaviour is better understood due to the analysis of activities.3. Cost control is facilitated through the identification and management of cost-generating activities. For example, in order

to reduce set-up costs, production planning could be used to eliminate short production runs and hence reduce thenumber of set-ups.

4. Poor decisions due to inadequate cost information are less likely to occur.

As for disadvantages, identifying the main activities that generate costs in an organisation is expensive. Careful thought mustalso be given to the ability of existing management accounting information systems to provide the detailed activity and costinformation required by an activity-based costing system: upgrading or replacement may be needed. A further expense is thecost of training staff to use the new costing system. Once introduced, an activity-based costing system can be significantlymore expensive than a traditional absorption costing system. It is possible, therefore, that in some organisations the cost ofintroducing and maintaining an activity-based costing system may exceed the benefits gained.

Activity-based costing may be most appropriate in an organisation where indirect costs are a significant proportion of totalcost, or where a wide product range is maintained with a variety of different activity consumption patterns. Spring plc shouldconsider the significance of indirect costs to its product costs and undertake a cost-benefit analysis before making a decisionto implement an activity-based costing system. Spring plc should also consider that further developments can flow from theintroduction of an activity-based costing system, for example in budgeting (activity-based budgeting) and managementphilosophy (activity-based management).

(b) Managerial performance and organisational performance are inextricably linked, since managers are the key decision makersin an organisation and their decisions therefore determine organisational performance.

Managerial and organisational performance needs to be measured as part of the control process within an organisation. Thethree elements of the control process are recording or measuring actual performance or output, comparing performance withplanned performance or some benchmark, and taking action to correct or modify continuing performance in order to achieveplanned performance. Managerial and organisational performance can be measured in a wide variety of ways, depending onwhich aspect of performance, financial or non-financial, is the object of interest.

A wide variety of financial (or money) performance measures can be used to assess managerial and organisationalperformance. Financial performance is of interest to internal and external stakeholders who are concerned to monitor theprogress and risk of their investment, the security of their employment, and so on. Examples of financial performancemeasures include:

ProfitProfit before interest and tax or profit after tax are usually expected to increase on an annual basis and the financial mediaoften refer to profit when discussing managerial and organisational performance. Managers are expected to deliver increasingprofits and organisations are expected to produce profit increases equal to or greater than their competitors.

Earnings per shareEarnings per share is a profit measure of interest to shareholders and the financial market, since it represents the maximumdividend per share that a company could pay. Managerial rewards could be linked in part to meeting performance targetsbased on earnings per share.



Cash flowBecause profit may be affected by arbitrary adjustments linked to accounting policies and because profit does not measuredirectly the ability to generate returns for investors, many shareholders and providers of debt finance prefer to concentrate onchanges in cash flow as a means of assessing managerial and organisational performance.

CostsA focus on managerial and organisational performance in terms of cost control or cost reduction may be especially appropriatefor organisations in the public sector. Here, profitability is an inappropriate performance measure and a key objective is valuefor money, in terms of the drive for economy, efficiency and effectiveness.

Share priceSince one of the ways in which shareholders receive a return from their investment in a company is through capital growth,they will be interested in assessing managerial and organisational performance in terms of share price growth. If managersinvest in projects with a positive net present value then, theoretically, the share price should increase to reflect the rise incorporate net present value. Conversely, organisations in which managers are believed to be poor performers will experiencea share price decrease.

Measuring financial performance alone is not sufficient, since financial performance results from a range of organisationalactivities which must also therefore be monitored. Non-financial performance measures may be quantitative or qualitative.An example of a quantitative performance measure is the number of complaints received from customers. An example of aqualitative performance measure is feedback from a sales representative to the effect that most customers are very happy withthe after-sales service provided by the organisation.

An attempt is usually made to replace qualitative performance measures with a substitute measure that can be quantified.For example, the number of customer complaints can be used as a substitute measure of product quality or customersatisfaction. Similarly, the number of warranty claims can be used as a substitute measure of product reliability.

Modern organisations compete in terms of product quality, flexibility and reliability, customer satisfaction, and productdimensions such as after-sales care and customer loyalty. These features are captured by non-financial indicators such asnumber of customer complaints, number of warranty claims, and quality ratings (such as the star ratings of hotels orrestaurants, or the position of an organisation in a league table).

A more balanced assessment of organisational and managerial performance will consider both financial and non-financialperformance. For example, Kaplan and Norton’s Balanced Scorecard considers the customer perspective, the innovationperspective, the internal process perspective and the financial perspective, and requires the identification of quantitative andnon-quantitative goals and performance measures.

5 (a) The investment appraisal process is concerned with assessing the value of future cash flows compared to the cost ofinvestment.

Since future cash flows cannot be predicted with certainty, managers must consider how much confidence can be placed inthe results of the investment appraisal process. They must therefore be concerned with the risk and uncertainty of a project.Uncertainty refers to the situation where probabilities cannot be assigned to future cash flows. Uncertainty cannot thereforebe quantified and increases with project life: it is usually true to say that the more distant is a cash flow, the more uncertainis its value. Risk refers to the situation where probabilities can be assigned to future cash flows, for example as a result ofmanagerial experience and judgement or scenario analysis. Where such probabilities can be assigned, it is possible to quantifythe risk associated with project variables and hence of the project as a whole.

If risk and uncertainty were not considered in the investment appraisal process, managers might make the mistake of placingtoo much confidence in the results of investment appraisal, or they may fail to monitor investment projects in order to ensurethat expected results are in fact being achieved. Assessment of project risk can also indicate projects that might be rejectedas being too risky compared with existing business operations, or projects that might be worthy of reconsideration if ways ofreducing project risk could be found in order to make project outcomes more acceptable.

(b) Contribution per unit = 3·00 – 1·65 = £1·35 per unitTotal annual contribution = 20,000 x 1·35 = £27,000 per yearAnnual cash flow after fixed costs = 27,000 – 10,000 = £17,000 per yearPayback period = 50,000/17,000 = 2·9 years(assuming that cash flows occur evenly throughout the year)

The payback period calculated is greater than the maximum payback period used by Umunat plc of two years and on thisbasis should be rejected. Use of payback period as an investment appraisal method cannot be recommended, however,because payback period does not consider all the cash flows arising from an investment project, as it ignores cash flowsoutside of the payback period. Furthermore, payback period ignores the time value of money.

The fact that the payback period is 2·9 years should not therefore be a reason for rejecting the project. The project should beassessed using a discounted cash flow method such as net present value or internal rate of return, since the project as awhole may generate an acceptable return on investment.

20



(c) Calculation of project net present valueAnnual cash flow = ((20,000 x (3 – 1·65)) – 10,000 = £17,000 per yearNet present value = (17,000 x 3·605) – 50,000 = 61,285 – 50,000 = £11,285

Alternatively: PV (£)Sales revenue: 20,000 x 3·00 x 3·605 = 216,300Variable costs: 20,000 x 1·65 x 3·605 = (118,965)

––––––––Contribution 97,335Initial investment (50,000)Fixed costs: 10,000 x 3·605 = (36,050)

––––––––Net present value: 11,285

––––––––

Sensitivity of NPV to sales volumeSales volume giving zero NPV = ((50,000/3·605) + 10,000)/1·35 = 17,681 unitsThis is a decrease of 2,319 units or 11·6%

Alternatively, sales volume decrease = 100 x 11,285/97,335= 11·6%

Sensitivity of NPV to sales priceSales price for zero NPV = (((50,000/3·605) + 10,000)/20,000) + 1·65 = £2·843This is a decrease of 15·7p or 5·2%

Alternatively, sales price decrease = 100 x 11,285/216,300 = 5·2%

Sensitivity of NPV to variable costVariable cost must increase by 15·7p or 9·5% to £1·81 to make the NPV zero.

Alternatively, variable cost increase = 100 x 11,285/118,965 = 9·5%

Sensitivity analysis evaluates the effect on project net present value of changes in project variables. The objective is todetermine the key or critical project variables, which are those where the smallest change produces the biggest change inproject NPV. It is limited in that only one project variable at a time may be changed, whereas in reality several project variablesmay change simultaneously. For example, an increase in inflation could result in increases in sales price, variable costs andfixed costs.

Sensitivity analysis is not a way of evaluating project risk, since although it may identify the key or critical variables, it cannotassess the likelihood of a change in these variables. In other words, sensitivity analysis does not assign probabilities to projectvariables. Where sensitivity analysis is useful is in drawing the attention of management to project variables that need carefulmonitoring if a particular investment project is to meet expectations. Sensitivity analysis can also highlight the need to checkthe assumptions underlying the key or critical variables.

(d) Expected value of sales volume:(17,500 x 0·3) + (20,000 x 0·6) + (22,500 x 0·1) = 19,500 units

Expected NPV = (((19,500 x 1·35) – 10,000) x 3·605) – 50,000 = £8,852

Since the expected net present value is positive, the project appears to be acceptable. From earlier analysis we know that theNPV is positive at 20,000 per year, and the NPV will therefore also be positive at 22,500 units per year. The NPV of theworst case is:

(((17,500 x 1·35) – 10,000) x 3·605) – 50,000 = (£882)

The NPV of the best case is:

(((22,500 x 1·35) – 10,000) x 3·605) – 50,000 = £23,452

There is thus a 30% chance that the project will produce a negative NPV, a fact not revealed by considering the expected netpresent value alone.

The expected net present value is not a value that is likely to occur in practice: it is perhaps more useful to know that thereis a 30% chance that the project will produce a negative NPV (or a 70% chance of a positive NPV), since this may representan unacceptable level of risk as far as the managers of Umunat plc are concerned. It can therefore be argued that assigningprobabilities to expected economic states or sales volumes has produced useful information that can help the managers ofUmunat to make better investment decisions. The difficulty with this approach is that probability estimates of project variablesor future economic states are likely to carry a high degree of uncertainty and subjectivity.

21




Marks Marks1 (a) Planning variance 1

Operational variance 1Discussion of Production Director’s views 2

––––4

(b) Equivalent annual cost of machine 1 3Equivalent annual cost of machine 2 2Selection of lowest equivalent annual cost 1

––––6

(c) Sales volume 1Sales revenue 2Marginal costs 2Maintenance costs 1Incremental fixed costs 1Taxation 2Capital allowances and tax benefits 4Net cash flow 1Discount factors 1Net present value 1Comment 2

––––18

(d) Average annual accounting profit 1Average investment 1Return on capital employed 1Comment on findings 1

––––4

(e) Discussion of stakeholders and objectives 3–4Discussion of conflict between objectives 4–5Discussion relating to Sassone plc 2–3

––––Maximum 10

(f) Discussion of life cycle costing 3–4Discussion of target costing 3–4Link to Sassone plc 1


––––50

––––

23



Marks Marks2 (a) Sales and raw materials 1

Direct labour and variable overheads 1Fixed overheads 1Flexed budget 1

––––4

(b) Raw material total cost variance 1Direct labour total cost variance 1Fixed overhead absorption rate 1Fixed overhead efficiency variance 2Fixed overhead capacity variance 2Fixed overhead expenditure variance 1

––––8

(c) Raw material total cost variance 2Fixed overhead efficiency variance 2Fixed overhead expenditure variance 2

––––6

(d) Up to 3 marks per key purpose discussed 9––––

Maximum 7––––25

––––

3 (a) Theoretical ex rights price per share 2Value of rights per existing share 1

––––3

(b) Effect on wealth of exercising rights 2Effect on wealth of sale of rights 2Discussion of rights issue and shareholder wealth 2

––––6

(c) Current earnings per share 1Current earnings 1Funds raised via rights issue 1Interest saved by redeeming debentures 1Revised earnings 1Revised earnings per share 1

––––6

(d) Expected share price after redeeming debentures 1Comparison with theoretical ex rights price 1Discussion and conclusion 1

––––3

(e) Effect of rights issue on debt/equity ratio 2Effect of rights issue on interest cover 2Discussion and link to Tirwen plc 3

––––7

––––25

––––

24



Marks Marks4 (a) Key features of activity-based costing 5–6

Advantages of activity-based costing 5–6Disadvantages of activity-based costing 4–5


(b) Need for measurement of performance 3–4Examples of financial performance measures 4–5Examples of non-financial performance measures 4–5


––––25

––––

5 (a) Discussion of risk 2Discussion of uncertainty 1Value of considering risk and uncertainty 2

––––5

(b) Calculation of payback period 2Discussion of payback period 2

––––4

(c) Calculation of net present value 2Sensitivity of NPV to sales volume 2Sensitivity of NPV to sales price 2Sensitivity of NPV to variable cost 1Discussion of sensitivity analysis 3

––––10

(d) Calculation of expected value of sales 1Calculation of expected net present value 1Discussion of expected net present value 4

––––6

––––25

––––

25




PART 2


QUESTION PAPER





Formulae Sheet, Present Value and Annuity Tables are on pages8, 9 and 10.




Pape

r 2.4




1 ARG Co is a leisure company that is recovering from a loss-making venture into magazine publication three years ago.Recent financial statements of the company are as follows.

Profit and loss account for year ending 30 June 2005£000

Turnover 140,400Cost of sales 112,840

––––––––Gross profit 27,560Administration costs 23,000

––––––––Profit before interest and tax 4,560Interest 900

––––––––Profit before tax 3,660Taxation 1,098

––––––––Profit after taxation 2,562Dividends 400

––––––––Retained profit 2,162

––––––––

Balance sheet as at 30 June 2005£000 £000

Fixed assets 50,000Current assetsStock 2,400Debtors 20,000Cash 1,500

–––––––23,900

Current liabilities 33,000–––––––

(9,100)–––––––40,900

9% Debentures 2014 10,000–––––––30,900–––––––

Financed by:Ordinary shares, £1 par value 2,000Reserves 27,000Profit and loss 1,900

–––––––30,900–––––––

The company plans to launch two new products, Alpha and Beta, at the start of July 2005, which it believes willeach have a life-cycle of four years. Alpha is the deluxe version of Beta. The sales mix is assumed to be constant.Expected sales volumes for the two products are as follows.

Year 1 2 3 4Alpha 60,000 110,000 100,000 30,000Beta 75,000 137,500 125,000 37,500

2



The standard selling price and standard costs for each product in the first year will be as follows.

Product Alpha Beta£/unit £/unit

Direct material costs 12·00 9·00Incremental fixed production costs 8·64 6·42

–––––– ––––––Total absorption cost 20·64 15·42Standard mark-up 10·36 7·58

–––––– ––––––Selling price 31·00 23·00

–––––– ––––––

ARG traditionally operates a cost-plus approach to product pricing.

Incremental fixed production costs are expected to be £1 million in the first year of operation and are apportioned onthe basis of sales value. Advertising costs will be £500,000 in the first year of operation and then £200,000 per yearfor the following two years. There are no incremental non-production fixed costs other than advertising costs.

In order to produce the two products, investment of £1 million in premises, £1 million in machinery and £1 millionin working capital will be needed, payable at the start of July 2005. The investment will be financed by the issue of £3 million of 9% debentures, each £100 debenture being convertible into 20 ordinary shares of ARG Co after 8 yearsor redeemable at par after 12 years.

Selling price per unit, direct material cost per unit and incremental fixed production costs are expected to increaseafter the first year of operation due to inflation:

Selling price inflation 3·0% per yearDirect material cost inflation 3·0% per yearFixed production cost inflation 5·0% per year

These inflation rates are applied to the standard selling price and standard cost data provided above. Working capitalwill be recovered at the end of the fourth year of operation, at which time production will cease and ARG Co expectsto be able to recover £1·2 million from the sale of premises and machinery. All staff involved in the production andsale of Alpha and Beta will be redeployed elsewhere in the company.

ARG Co pays tax in the year in which the taxable profit occurs at an annual rate of 25%. Investment in machineryattracts a first-year capital allowance of 100%. ARG Co has sufficient profits to take the full benefit of this allowancein the first year. For the purpose of reporting accounting profit, ARG Co depreciates machinery on a straight line basisover four years. ARG Co uses an after-tax discount rate of 13% for investment appraisal.

Other informationAssume that it is now 30 June 2005The ordinary share price of ARG Co is currently £4·00Average interest cover for ARG Co’s sector is 7Average gearing for ARG Co’s sector is 45% (long-term debt/equity using book values)

3 [P.T.O.



Required:

(a) Calculate the net present value of the proposed investment in products Alpha and Beta. (17 marks)

(b) Identify and discuss any likely limitations in the evaluation of the proposed investment in Alpha and Beta.(6 marks)

(c) Evaluate and discuss the proposal to finance the investment with a £3 million 9% convertible debentureissue. (8 marks)

(d) A detailed evaluation of the incremental fixed costs for the first year of producing Alpha and Beta reveals thefollowing information on the composition of the fixed costs and their associated cost drivers.

Fixed cost £ Cost driver Alpha BetaPower, heating, etc. 505,000 Floor area 3,500 m2 6,500 m2

Salaries 300,000 Labour hours 10,000 15,000Inspection costs 67,500 Inspections 3,000 3,750Order processing 67,500 Orders 3,000 1,500Maintenance 26,000 Maintenance hours 625 1,875Set-up costs 34,000 Set-ups 120 50

––––––––––1,000,000

Calculate activity-based recovery rates for each fixed cost and calculate the total standard cost per unit foreach product using an activity-based approach. Comment on the implications of your findings for productpricing. (11 marks)

(e) Included in the debtors of ARG Co is an expected receipt of $500,000 payable in three months’ time. Thefollowing exchange rates are available:

$/£Spot 1·7642 – 1·7962Three months forward 1·7855 – 1·8174

Explain why ARG Co might wish to hedge its expected three-month dollar receipt using the forward marketand calculate the sterling value arising from a forward market hedge. (4 marks)

(f) Discuss how bills of exchange can be used to reduce the risk associated with the overseas debtors of ARG Co. (4 marks)

(50 marks)

4




2 Required:

(a) Discuss how costing information and principles may be applied in a not-for-profit organisation in the followingareas:

(i) the selection of cost units;(ii) the use of performance measures to measure output and quality;(iii) the comparison of planned and actual performance. (10 marks)

(b) Discuss the key features of zero-based budgeting and explain how it may be applied in a not-for-profitorganisation. (8 marks)

(c) Briefly discuss how activity-based budgeting might be introduced into a manufacturing organisation and theadvantages that might arise from the use of activity-based budgeting in such an organisation. (7 marks)

(25 marks)

3 BRK Co operates an absorption costing system and sells three products, B, R and K which are substitutes for eachother. The following standard selling price and cost data relate to these three products:

Product Selling price per unit Direct material per unit Direct labour per unitB £14·00 3·00 kg at £1·80 per kg 0·5 hrs at £6·50 per hourR £15·00 1·25 kg at £3·28 per kg 0·8 hrs at £6·50 per hourK £18·00 1·94 kg at £2·50 per kg 0·7 hrs at £6·50 per hour

Budgeted fixed production overhead for the last period was £81,000. This was absorbed on a machine hour basis.The standard machine hours for each product and the budgeted levels of production and sales for each product forthe last period are as follows:

Product B R KStandard machine hours per unit 0·3 hrs 0·6 hrs 0·8 hrsBudgeted production and sales (units) 10,000 13,000 9,000

Actual volumes and selling prices for the three products in the last period were as follows:

Product B R KActual selling price per unit £14·50 £15·50 £19·00Actual production and sales (units) 9,500 13,500 8,500

Required:

(a) Calculate the following variances for overall sales for the last period:

(i) sales price variance;(ii) sales volume profit variance;(iii) sales mix profit variance;(iv) sales quantity profit variance

and reconcile budgeted profit for the period to actual sales less standard cost. (13 marks)

(b) Discuss the significance of the sales mix profit variance and comment on whether useful information wouldbe obtained by calculating mix variances for each of these three products. (4 marks)

(c) Describe the essential elements of a standard costing system and explain how quantitative analysis can assistin the preparation of standard costs. (8 marks)

(25 marks)

5 [P.T.O.



4 As assistant to the Finance Director of RZP Co, a company that has been listed on the London Stock Market for severalyears, you are reviewing the draft Annual Report of the company, which contains the following statement made bythe chairman:

‘This company has consistently delivered above-average performance in fulfilment of our declared objective of creatingvalue for our shareholders. Apart from 2002, when our overall performance was hampered by a general marketdownturn, this company has delivered growth in dividends, earnings and ordinary share price. Our shareholders canrest assured that my directors and I will continue to deliver this performance in the future’.

The five-year summary in the draft Annual Report contains the following information:

Year 2004 2003 2002 2001 2000Dividend per share 2·8p 2·3p 2·2p 2·2p 1·7pEarnings per share 19·04p 14·95p 11·22p 15·84p 13·43pPrice/earnings ratio 22·0 33·5 25·5 17·2 15·2General price index 117 113 110 105 100

A recent article in the financial press reported the following information for the last five years for the business sectorwithin which RZP Co operates:

Share price growth average increase per year of 20%Earnings growth average increase per year of 10%Nominal dividend growth average increase per year of 10%Real dividend growth average increase per year of 9%

You may assume that the number of shares issued by RZP Co has been constant over the five-year period. Allprice/earnings ratios are based on end-of-year share prices.

Required:

(a) Analyse the information provided and comment on the views expressed by the chairman in terms of:

(i) growth in dividends per share;(ii) share price growth;(iii) growth in earnings per share.

Your analysis should consider both arithmetic mean and equivalent annual growth rates. (13 marks)

(b) Calculate the total shareholder return (dividend yield plus capital growth) for 2004 and comment on yourfindings. (3 marks)

(c) Discuss the factors that should be considered when deciding on a management remuneration package thatwill encourage the directors of RZP Co to maximise the wealth of shareholders, giving examples ofmanagement remuneration packages that might be appropriate for RZP Co. (9 marks)

(25 marks)

6



5 TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling price of £19 per unit andis purchased for £11 per unit from a supplier, MKR Co. TNG places an order for 50,000 units of product X at regularintervals throughout the year. Because the demand for product X is to some degree uncertain, TNG maintains a safety(buffer) stock of product X which is sufficient to meet demand for 28 working days. The cost of placing an order is£25 and the storage cost for Product X is 10 pence per unit per year.

TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for cash settlement within20 days.

TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365 days.

Required:

(a) Calculate the annual cost of the current ordering policy. Ignore financing costs in this part of the question.(4 marks)

(b) Calculate the annual saving if the economic order quantity model is used to determine an optimal orderingpolicy. Ignore financing costs in this part of the question. (5 marks)

(c) Determine whether the discount offered by the supplier is financially acceptable to TNG Co. (4 marks)

(d) Critically discuss the limitations of the economic order quantity model as a way of managing stock.(4 marks)

(e) Discuss the advantages and disadvantages of using just-in-time stock management methods. (8 marks)

(25 marks)

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Answers



13


1 (a) NPV calculation for Alpha and Beta

Year 1 2 3 4£ £ £ £

Sales revenue 3,585,000 6,769,675 6,339,000 1,958,775Material cost (1,395,000) (2,634,225) (2,466,750) (761,925)Fixed costs (1,000,000) (1,050,000) (1,102,500) (1,157,625)Advertising (500,000) (200,000) (200,000)

–––––––––– –––––––––– –––––––––– ––––––––––Taxable profit 690,000 2,885,450 2,569,750 39,225Taxation (172,500) (721,362) (642,438) (9,806)WDA tax benefit 250,000Fixed asset sale 1,200,000WC recovery 1,000,000

–––––––––– –––––––––– –––––––––– ––––––––––Net cash flow 767,500 2,164,088 1,927,312 2,229,419Discount factors 0·885 0·783 0·693 0·613

–––––––––– –––––––––– –––––––––– ––––––––––Present values 679,237 1,694,481 1,335,626 1,366,634

£Sum of present values 5,075,978Initial investment 3,000,000

–––––––––––Net present value 2,075,978

–––––––––––

The positive NPV indicates that the investment is financially acceptable.

Workings

Alpha sales revenueYear 1 2 3 4Selling price (£/unit) 31·00 31·93 32·89 33·88Sales (units/yr) 60,000 110,000 100,000 30,000Sales revenue (£/yr) 1,860,000 3,512,300 3,289,000 1,016,400

Beta sales revenueYear 1 2 3 4Selling price (£/unit) 23·00 23·69 24·40 25·13Sales (units/yr) 75,000 137,500 125,000 37,500Sales revenue (£/yr) 1,725,000 3,257,375 3,050,000 942,375

Year 1 2 3 4Sales revenue (£/yr) 3,585,000 6,769,675 6,339,000 1,958,775

Alpha direct material costYear 1 2 3 4Material cost (£/unit) 12·00 12·36 12·73 13·11Sales (units/yr) 60,000 110,000 100,000 30,000Material cost (£/yr) 720,000 1,359,600 1,273,000 393,300

Beta direct material costYear 1 2 3 4Material cost (£/unit) 9·00 9·27 9·55 9·83Sales (units/yr) 75,000 137,500 125,000 37,500Material cost (£/yr) 675,000 1,274,625 1,193,750 368,625

Year 1 2 3 4Material cost (£/yr) 1,395,000 2,634,225 2,466,750 761,925

(b) The evaluation assumes that several key variables will remain constant, such as the discount rate, inflation rates and thetaxation rate. In practice this is unlikely. The taxation rate is a matter of government policy and so may change due to politicalor economic necessity.

Specific inflation rates are difficult to predict for more than a short distance into the future and in practice are found to beconstantly changing. The range of inflation rates used in the evaluation is questionable, since over time one would expect therates to converge. Given the uncertainty of future inflation rates, using a single average inflation rate might well be preferableto using specific inflation rates.



The discount rate is likely to change as the company’s capital structure changes. For example, issuing debentures with aninterest rate of 9% is likely to decrease the average cost of capital.

Looking at the incremental fixed production costs, it seems odd that nominal fixed production costs continue to increase evenwhen sales are falling. It also seems odd that incremental fixed production costs remain constant in real terms whenproduction volumes are changing. It is possible that some of these fixed production costs are stepped, in which case theyshould decrease.

The forecasts of sales volume seem to be too precise, predicting as they do the growth, maturity and decline phases of theproduct life-cycle. In practice it is likely that improvements or redesign could extend the life of the two products beyond fiveyears. The assumption of constant product mix seems unrealistic, as the products are substitutes and it is possible that onewill be relatively more successful. The sales price has been raised in line with inflation, but a lower sales price could be usedin the decline stage to encourage sales.

Net working capital is to remain constant in nominal terms. In practice, the level of working capital will depend on the workingcapital policies of the company, the value of goods, the credit offered to customers, the credit taken from suppliers and so on.It is unlikely that the constant real value will be maintained.

The net present value is heavily dependent on the terminal value derived from the sale of fixed assets after five years. It isunlikely that this value will be achieved in practice. It is also possible that the machinery can be used to produce otherproducts, rather than be used solely to produce Alpha and Beta.

(c) ARG Co currently has £50m of fixed assets and long-term debt of £10m. The issue of £3m of 9% debentures will increasefixed assets by £2m of buildings and machinery. There seems to be ample security for the new issue.

Interest cover is currently 5·1 (4,560/900) which is less than the sector average, and this will fall to 3·9 (4,560/(900 + 3mx 9%)) following the debenture issue. The new products will increase profit by £440,000 (£690,000 – £250,000 ofdepreciation), increasing interest cover to 4·3 (5,000/1,170). Although on the low side and less than the sector average, thisevaluation ignores any increase in profits from current activities. Interest cover may not be a cause for concern.

Current gearing using debt/equity based on book values of 32% (10,000/30,900) will rise to 42% (13,000/30,900) afterthe debenture issue. Both values are less than the sector average and ignore any increase in reserves due to next year’s profits.Financial risk appears to be at an acceptable level and gearing does not appear to be a problem.

The debentures are convertible after eight years into 20 ordinary shares per £100 debenture. The current share price is£4·00, giving a conversion value of £80. For conversion to be likely, a minimum annual growth rate of only 2·83% is needed((5·00/4·00)0·125 – 1). This growth rate could well be exceeded, making conversion after eight years a likely prospect. Thisanalysis assumes that the floor value on the conversion date is the par value of £100: the actual floor value could well bedifferent in eight years’ time, depending on the prevailing cost of debt.

Conversion of the debentures into ordinary shares will eliminate the need to redeem them, as well as reducing the company’sgearing.

The current share price may be depressed by the ongoing recovery from the loss-making magazine publication venture.Annual share price growth may therefore be substantially in excess of 2·83%, making the conversion terms too generous(assuming a floor value equal to par value on the conversion date). On conversion, 600,000 new shares will be issued,representing 23% (100 x 0·6m/2·6m) of share capital. The company must seek the views and approval of existingshareholders regarding this potential dilution of ownership and control.

The maturity of the debentures (12 years) does not match the product life-cycle (four years). This may be caution on the partof the company’s managers, but a shorter period could be used.

It has been proposed that £1 million of the debenture issue would be used to finance the working capital needs of the project.Financing all working capital from a long-term source is a very conservative approach to working capital financing. ARG Cocould consider financing fluctuating current assets from a short-term source such as an overdraft. By linking the maturity ofthe finance to the maturity of the assets being financed, ARG Co would be applying the matching principle.

(d) Calculation of ABC recovery rates

Cost driver Alpha Beta Total Cost Recovery rateFloor area (m2) 3,500 6,500 10,000 £505,000 £50·50/m2

Labour hours 10,000 15,000 25,000 £300,000 £12/hrInspections 3,000 3,750 6,750 £67,500 £10/testOrders 3,000 1,500 4,500 £67,500 £15/orderMaintenance hours 625 1,875 2,500 £26,000 £10·40/hrSet-ups 120 50 170 £34,000 £200/set-up

14



Activity-based cost apportionmentFixed cost £ Alpha BetaPower, heating, etc. 505,000 176,750 328,250Salaries 300,000 120,000 180,000Inspection costs 67,500 30,000 37,500Order processing 67,500 45,000 22,500Maintenance 26,000 6,500 19,500Set-up costs 34,000 24,000 10,000

––––––––– –––––––– ––––––––1,000,000 402,250 597,750––––––––– –––––––– ––––––––

Fixed costs for Alpha = 402,250/60,000 = £6·70Fixed costs for Beta = 597,750/75,000 = £7·97

ARG Co uses a cost plus pricing system and appears from the information provided to use a mark-up of 50% on total cost.The revised total costs for Alpha and Beta are £18·70 and £16·97. Applying a 50% mark-up gives selling prices of £28·05and £25·45 respectively. On this basis Alpha is over-priced and Beta is under-priced. However, the selling price should alsoreflect the best price obtainable in the market. This might be higher or lower than any of the prices based on total cost.

(e) ARG Co will be concerned to protect the sterling value of its expected dollar receipt. The quoted forward rates show that thedollar is weakening against sterling, so that the sterling value of $500,000 dollars will have fallen in three months. ARG Cocan enter into a contract now with a bank to exchange its expected dollar receipt in three months time at the current forwardrate. Such a contract is called a forward exchange contract and is binding on both the bank and ARG Co. By agreeing to anexchange at the current forward rate, the company will be protected against any further deterioration in the sterling-dollarexchange rate. The sterling value arising from the contract will be $500,000/1·8174 = £275,118.

(f) A bill of exchange is a means of payment initiated by an exporter. It is signed (accepted) by an importer, signifying agreementto pay the amount on the face of the bill. This payment may either be on demand (sight bill) or on a mutually agreed futuredate (term bill).

The risk associated with overseas debtors is reduced by bills of exchange since these bills are a liquid short-term financialasset. They can be discounted (sold at less than face value) to a bank in order to provide advance payment of the amountdue to be received from overseas debtors. A smaller discount will be charged if the bill of exchange is confirmed(countersigned) by the importer’s bank.

Bills of exchange can be also used in conjunction with documentary letters of credit (also known as documentary credits) toreduce export credit risk even further.

2 (a) Not-for-profit (NFP) organisations such as charities deliver services that are usually limited by the resources available to them.It may be possible neither to express their objectives in quantifiable or measurable terms, nor to measure their output in termsof the services they deliver. The financial focus in NFP organisations is therefore placed on the control of costs.

Selection of cost unitsA cost unit for a NFP organisation is a unit of service for which costs are ascertained. These cost units will be used to assessthe efficiency and effectiveness of the organisation. The problem for a NFP organisation is that it may not have easilyidentifiable cost units, and it may not be possible to identify costs with specific outputs. Once appropriate cost units havebeen identified, however, they can be used to provide cost control information. Examples of costs units used by an NFPorganisation are patients, wards, drug treatment programmes, bed-nights and operations, which are all used by a hospital.

The use of performance measures to measure output and qualityWhere output for a NFP organisation can be quantified, targets can be set and performance against these targets can bemeasured. In a university, for example, targets could be set in terms of the number of students graduating with a first-classdegree, the number of students in a tutorial group, and the percentage of students who complete a degree course havingstarted it. Information could easily be gathered to enable an assessment of the University’s performance compared to agreed,budgeted or imposed targets.

Measuring performance in terms of quality is not so easy. It may be possible to use a surrogate or substitute performancemeasure if a quality cannot be directly measured. For example, the efficiency of hospital outpatient treatment could bemeasured by the average length of the queue for treatment. The quality of a University course could be assessed by acomposite weighting of responses to individual student questionnaires.

Comparison of planned and actual performanceIt is likely that a NFP organisation will have a budget that details expected levels of income (for example from donations andinvestments) and expenditure (for example on staff wages, continuing programmes, fixed overheads and planned purchases).The use and application of costing principles and information here is no different than in a profit-making organisation. Plannedperformance can be compared to actual performance, income and cost variances calculated and investigated, and correctiveaction taken to remedy under-performance.

Where objectives cannot be specified in terms of quantifiable targets, costing information will serve no purpose andassessment of actual performance with planned performance will need to be undertaken from a more subjective perspective.

15



(b) Zero-based budgeting requires that activities be re-evaluated as part of the budget process so that each activity, and eachlevel of activity, can justify its consumption of the economic resources available. This is in contrast to incremental budgeting,where the current budget is increased to allow for expected future conditions. Zero-based budgeting prevents the carryingforward of past inefficiencies that can be a feature of incremental budgeting and focuses on activities rather than departmentsor programmes. Each activity is treated as though it was being undertaken for the first time and is required to justify itsinclusion in the budget in terms of the benefit expected to be derived from its adoption.

The first step in zero-based budgeting is the formulation of decision packages. These are documents which identify anddescribe a given activity or group of activities in detail. The base package represents the minimum level of activity that isconsistent with the achievement of organisational objectives. Incremental packages describe higher levels of activity whichmay be delivered if they are acceptable from a cost-benefit perspective.

Following the formulation of decision packages, they are evaluated by senior management and ranked by decreasing benefitto the budgeting organisation. Resources should then be allocated, theoretically at least, to decision packages in order ofdecreasing marginal utility until all resources have been allocated.

Advantages claimed for zero-based budgeting are that it eliminates the inefficiencies that can arise with incrementalbudgeting, that it fosters a questioning attitude towards current activities and that it focuses attention on the need to obtainvalue for money from the consumption of organisational resources.

Value for money is important in not-for-profit (NFP) organisations, where the profit motive found in the private sector isreplaced by the need to derive the maximum benefits from limited resources available. Providers of funds to NFP organisationsexpect to see their cash being used wisely, with as much as possible being devoted to the achievement of organisational aims.For this reason, NFP organisations emphasise cost control and the need for economy in the selection of resources, efficiencyin the consumption of resources and effectiveness in the use of resources to achieve organisational objectives (i.e. value formoney).

Zero-based budgeting can therefore be applied in a NFP organisation to analyse its activities and the services it provides intodecision packages, with a view to ranking them on a cost-benefit basis relative to organisational aims and objectives. In hasbeen noted that zero-based budgeting can be applied more effectively in service-based rather than manufacturingorganisations and so it may be ideally suited to a NFP organisation such as a charity.

(c) Activity-based budgeting (ABB) would need a detailed analysis of costs and cost drivers so as to determine which cost driversand cost pools were to be used in the activity-based costing system. However, whereas activity-based costing uses activity-based recovery rates to assign costs to cost objects, ABB begins with budgeted cost-objects and works back to the resourcesneeded to achieve the budget.

Once the budgeted activity levels have been determined, the demand for resource-consuming activities is assessed from anorganisational perspective. The resources needed to provide for these activities are then assessed and action taken to ensurethat these resources are available when needed in the budget period.

The budgeted activity levels are determined in the same way as for conventional budgeting in that a sales budget and aproduction budget are drawn up. ABB then determines the quantity of activity cost drivers (e.g. number of purchase orders,number of set-ups) needed to support the planned sales and production. Standard cost data would be compiled that includeddetails of the activity cost drivers required to produce a product or number of products.

The resources needed to support the budgeted quantity of activity cost drivers would then be determined (e.g. number oflabour hours to process purchase orders, number of maintenance hours needed to complete set-ups). This resource needwould then be matched against the available capacity (i.e. number of purchase clerks to process purchase orders) to seewhether any capacity adjustment were needed.

One advantage suggested for ABB is that organisational resources are allocated more efficiently due to the detailed cost andactivity information obtained by implementing an ABB system. Another advantage of ABB is that it avoids the pitfalls ofincremental budgeting due to its detailed assessment of the activities and resources needed to support planned sales andproduction. In ABB the costs of support activities are not seen as fixed costs to be increased by annual increments, but asdepending to a large extent on the planned level of activity.

3 (a) Calculation of standard profit

Budgeted machine hours = (10,000 x 0·3) + (13,000 x 0·6) + (9,000 x 0·8) = 18,000 hoursOverhead absorption rate = 81,000/18,000 = £4·50 per machine hour

Product B(£) R(£) K(£)Direct material 5·40 (3 x 1·80) 4·10 (1·25 x 3·28) 4·85 (1·94 x 2·50)Direct labour 3·25 (0·5 x 6·50) 5·20 (0·8 x 6·50) 4·55 (0·7 x 6·50)Fixed production overhead 1·35 (0·3 x 4·50) 2·70 (0·6 x 4·50) 3·60 (0·8 x 4·50)

–––––– –––––– ––––––Standard cost 10·00 12·00 13·00Selling price 14·00 15·00 18·00

–––––– –––––– ––––––Standard profit 4·00 3·00 5·00

–––––– –––––– ––––––

16



17

Budgeted sales quantity in standard mix at standard profit:Product Quantity Standard profit £B 10,000 £4 40,000R 13,000 £3 39,000K 9,000 £5 45,000

––––––– ––––––––32,000 124,000––––––– ––––––––

Average standard profit per unit = 124,000/32,000 = £3·875 per unit

Actual sales quantity in actual mix at actual selling price less standard cost:Actual selling price

Product Quantity less standard cost £B 9,500 (14·5 – 10·0) 42,750R 13,500 (15·5 – 12·0) 47,250K 8,500 (19·0 – 13·0) 51,000

––––––– ––––––––31,500 141,000––––––– ––––––––

Actual sales quantity in actual mix at standard profit:Product Quantity Standard profit £B 9,500 £4 38,000R 13,500 £3 40,500K 8,500 £5 42,500

––––––– ––––––––31,500 121,000––––––– ––––––––

Actual sales quantity in standard mix at standard profit:Using the average standard profit per unit calculated earlier: 31,500 x 3·875 = £122,062

Sales price variance = 141,000 – 121,000 = £20,000 (F)Sales volume profit variance = 121,000 – 124,000 = £3,000 (A)Sales mix profit variance = 121,000 – 122,062 = £1,062 (A)Sales quantity profit variance = 122,062 – 124,000 = £1,938 (A)

Reconciliation £ £ £Budgeted sales at standard profit 124,000Sales price variance 20,000 (F)Sales mix profit variance 1,062 (A)Sales quantity profit variance 1,938 (A)

––––––Sales volume profit variance 3,000 (A)

–––––––17,000 (F)

––––––––Actual sales at actual price less standard cost 141,000

––––––––

(b) The sales mix profit variance explains how the change in sales mix contributed to the sales volume profit variance. It comparesthe actual sales quantity in the actual mix with the actual sales quantity in the standard mix, valued at the standard profit perunit.

The adverse variance calculated in part (a) using the average standard profit per unit was £1,062, indicating that the actualsales mix contained more lower-margin products and fewer higher-margin products. The changes in the sales mix can beshown in tabular form, as follows.

Product Standard mix Actual mix Difference Standard profit £B 9,844 9,500 (344) £4 1,376(A)R 12,797 13,500 703 £3 2,109(F)K 8,859 8,500 (359) £5 1,795(A)

––––––– ––––––– ––––––31,500 31,500 1,062(A)––––––– ––––––– ––––––

The difference column shows that more of Product R, with the lowest standard profit of £3 per unit, was sold than wasbudgeted for. Less of Products B and K, with the higher standard profits per unit, were sold than budgeted for. Calculation ofthe individual mix variances for Products B, R and K does not offer information which is any more useful than that containedin the ‘difference’ column.

Sales mix profit variance has significance only when products are inter-related and these relationships are taken into accountat the planning stage. If the products sold are not inter-related, the mix variance offers no useful information, since itincorrectly implies that a possible cause of the sales volume profit variance is a change in the mix1. In fact, only deviationsfrom the planned volumes for individual products need to be investigated if products are not inter-related. In this case theproducts are substitutes and so are inter-related. The individual sales mix profit variances may therefore be useful.

–––––––––––––––––––––1 Drury, C. (2000), Management and Cost Accounting, 5th edition, Thomson Learning, pp.734–8



(c) A standard costing system requires preparation of standard costs, comparison of standard costs with actual costs, investigationof variances and instigation of corrective action if needed, and review of standard costs on a regular basis. Standard costs arepredetermined unit costs arising under efficient operating conditions. Standard costing can be applied to repetitive or commonoperations where the input to produce a required output can be clearly specified.

Preparation of standard costsStandards are required for amount of materials, labour and services required to perform a particular operation, and coststandards are compiled from the standard costs of the individual operations needed to produce a given product. The quantitiesand costs needed for each standard can be derived using the engineering approach or through the analysis of historicalrecords.

The engineering approach requires a detailed study of each operation so that the materials, labour and equipment used inthe operation can be verified by observation, for example by using time and motion studies.

Analysis of historical records can be carried out using quantitative analysis, including the high-low method, scattergraphs andregression analysis. Standards are set by these methods by averaging historical data and so there is a danger that pastinefficiencies may be perpetuated. This approach to standard setting is widely used in practice2.

Variance analysisVariances obtained by comparing standard costs with actual costs form the basis of cost control and support the use ofresponsibility accounting. A wide range of variances can be calculated, depending in part on the costing system employed.The causes of individual variances can be investigated if a variance is deemed to be significant, in order to inform theinstigation of appropriate corrective action where necessary. Both favourable and adverse variances should be investigated,since useful information can be derived from both.

Review of standard costsStandard costs must be reviewed and updated if they are to retain their relevance to an organisation. The review shouldconsider changes in the prices of inputs such as labour and materials as well as changes in working practices and productionmethods. The exception to this is the basic standard, which is left unchanged for long periods of time so that trends over timecan be established. However, basic standards are not commonly used. It is more usual to find ideal, current and attainablestandards being used and these all need regular review.

4 (a) Analysis of data provided

Year 2004 2003 2002 2001 2000Dividend per share 2·8p 2·3p 2·2p 2·2p 1·7pAnnual dividend growth 21·7% 4·5% nil 29·4%

Earnings per share 19·04p 14·95p 11·22p 15·84p 13·43Annual earnings growth 27·3% 33·2% –29·2% 17·9%

Price/earnings ratio 22·0 33·5 25·5 17·2 15·2Share price 418·9p 500·8p 286·1p 272·4p 204·1pAnnual share price growth –16·3% 75·0% 5·0% 33·5%

Dividend per share 2·8p 2·3p 2·2p 2·2p 1·7pGeneral price index 117 113 110 105 100Real dividend per share 2·4p 2·0p 2·0p 2·1p 1·7pAnnual dividend growth 20·0% nil –4·8% 23·5%

Average dividend growth:Arithmetic mean = (21·7 + 4·5 + 0 + 29·4)/4 = 55·6/4 = 13·9%Equivalent annual growth rate = [(2·8/1·7)0·25 – 1] x 100 = 13·3%

Average earnings per share growth:Arithmetic mean = (27·3 + 33·2 – 29·2 + 17·9)/4 = 49·2/4 =12·3%Equivalent annual growth rate = [(19·04/13·43)0·25 – 1] x 100 = 9·1%

Average share price growth:Arithmetic mean = (–16·3 + 75·0 + 5·0 + 33·5)/4 = 97·2/4 = 24·3%Equivalent annual growth rate = [(418·9/204·1)0·25 – 1] x 100 = 19·7%

Average real dividend growth:Arithmetic mean = (20·0 + 0 – 4·8 + 23·5)/4 = 38·7/4 = 9·7%Equivalent annual growth rate = [(2·4/1·7)0·25 – 1] x 100 = 9·0%


18



Discussion of analysis and views expressed by chairmanThe chairman’s statement claims that RZP Co has delivered growth in every year in dividends, earnings and ordinary shareprice, apart from 2002. Analysis shows that the chairman is correct in excluding 2002, when no growth occurred individends, earnings fell by 29·2%, and real dividends fell by 4·8%. Analysis also shows that no growth in real dividendsoccurred in 2003 and that the company’s share price fell by 16·3% in 2004. It is possible the chairman may not have beenreferring to real dividend growth, in which case his statement could be amended. However, shareholders will be aware of thedecline in share price in 2004 or could calculate the decline from the information provided, so the chairman cannot claimthat RZP Co has delivered share price growth in 2004. In fact, the statement could explain the reasons for the decline inshare price in order to reassure shareholders. It also possible for the five-year summary to be extended to include annualshare price data, such as maximum, minimum and average share price, so that shareholders have this information readilyavailable.

The chairman’s statement claims that RZP Co has consistently delivered above-average performance. The company may havedelivered above- or below-average performance in individual years but without further information in the form of sectoraverages for individual years, it is not possible to reach a conclusion on this point. The average growth rates for the sectorcannot therefore be used to comment on the performance of RZP Co in individual years. If the company has consistentlydelivered above-average performance, however, the company’s average annual growth rates should be greater than the sectoraverages.

The growth rates can be compared as follows:

Arithmetic mean Equivalent annual rate SectorNominal dividends 13·9% 13·3% 10%Real dividends 9·7% 9·0% 9%Earnings per share 12·3% 9·1% 10%Share price 24·3% 19·7% 20%

It can be seen that if the sector average growth rates are arithmetic mean growth rates, the chairman’s statement is correct.If the sector average growth rates are equivalent annual growth rates, however, only the nominal dividend growth rate isgreater than the sector average. The basis on which the sector average growth rates have been prepared should therefore beclarified in order to determine whether the chairman’s statement is correct.

(b) The dividend yield and capital growth for 2004 must be calculated with reference to the 2003 end-of-year share price. Thedividend yield is 0·56% (100 x 2·8/500·8) and the capital growth is –16·35% (100 x (418·9 – 500·8)/500·8), so the totalshareholder return is –15·79% or –15·8% (0·56 – 16·35). A negative return of 15·8% looks even worse when it is notedthat annual inflation for 2004 was 3·5% (117/113).

While the negative total shareholder return is at odds with the chairman’s claim to have delivered growth in dividends andshare price in 2004, a different view might have emerged if average share prices had been used, since the return calculationignores share price volatility. The chairman should also be aware that share prices may be affected by other factors thancorporate activity, so a good performance in share price terms may not be due to managerial excellence. It also possible thatthe negative return may represent a good performance when compared to the sector as a whole in 2004: further informationis needed to assess this.

Note that total shareholder return can also be found as (100 x (2·8 + 418·9 – 500·8)/500·8).

(c) The objectives of managers may conflict with the objectives of shareholders, particularly with the objective of maximisationof shareholder wealth. Management remuneration package are one way in which goal congruence between managers andshareholders may be increased. Such packages should motivate managers while supporting the achievement of shareholderwealth maximisation. The following factors should be considered when deciding on a remuneration package intended toencourage directors to act in ways that maximise shareholder wealth.

Clarity and transparencyThe terms of the remuneration package should be clear and transparent so that directors and shareholders are in no doubtas to when rewards have been earned or the basis on which rewards have been calculated.

Appropriate performance measureThe managerial performance measure selected for use in the remuneration package should support the achievement ofshareholder wealth maximisation. It is therefore likely that the performance measure could be linked to share price changes.

Quantitative performance measureThe managerial performance measure should be quantitative and the manner in which it is to be calculated should bespecified. The managerial performance measure should ideally be linked to a benchmark comparing the company’sperformance with that of its peers. The managerial performance measure should not be open to manipulation bymanagement.

Time horizonThe remuneration package should have a time horizon that is linked to that of shareholders. If shareholders desire long-termcapital growth, for example, the remuneration package should discourage decisions whose objective is to maximise short-term profits at the expense of long-term growth.

19



20

ImpartialityIn recent years there has been an increased emphasis on decisions about managerial remuneration packages being removedfrom the control of managers who benefit from them. The use of remuneration committees in listed companies is an exampleof this. The impartial decisions of non-executive directors, it is believed, will eliminate or reduce managerial self-interest andencourage remuneration packages that support the achievement of shareholder rather than managerial goals.

Appropriate management remuneration packages for RZP CoRemuneration packages may be based on a performance measure linked to values in the profit and loss account. A bonuscould be awarded, for example, based on growth in turnover, profit before tax, or earnings (earnings per share). Suchperformance measures could lead to maximisation of profit in the short-term rather than in the long-term, for example bydeferring capital expenditure required to reduce environmental pollution, and may encourage managers to manipulatereported financial information in order to achieve bonus targets. They could also lead to sub-optimal managerial performanceif managers do enough to earn their bonus, but then reduce their efforts once their target has been achieved.

RZP Co has achieved earnings growth of more than 20% in both 2003 and 2004, but this is likely to reflect in part a recoveryfrom the negative earnings growth in 2001, since over the five-year period its earnings growth is not very different from itssector’s (it may be worse). If annual earnings growth were to be part of a remuneration package for RZP Co, earnings growthcould perhaps be compared to the sector and any bonus made conditional upon ongoing performance in order to discouragea short-term focus.

Remuneration packages may be based on a performance measure linked to relative stock market performance, e.g. shareprice growth over the year compared to average share price growth for the company’s sector, or compared to growth in a stockmarket index, such as the FTSE 100. This would have the advantage that managers would be encouraged to make decisionsthat had a positive effect on the company’s share price and hence are likely to be consistent with shareholder wealthmaximisation. However, as noted earlier, other factors than managerial decisions can have a continuing effect on share pricesand so managers may fail to be rewarded for good performance due to general economic changes or market conditions.

RZP Co recorded negative share price growth in 2004 and the reasons for this should be investigated. In the circumstances,a remuneration package linked to benchmarked share price growth could focus the attention of RZP managers on decisionslikely to increase shareholder wealth. The effect of such a remuneration package could be enhanced if the reward receivedby managers were partly or wholly in the form of shares or share options. Apart from emphasising the focus on share pricegrowth, such a reward scheme would encourage goal congruence between shareholders and managers by turning managersinto shareholders.

5 (a) TNG has a current order size of 50,000 unitsAverage number of orders per year = demand/order size = 255,380/50,000 = 5·11 ordersAnnual ordering cost = 5·11 x 25 = £127·75

Buffer stock held = 255,380 x 28/365 = 19,591 unitsAverage stock held = 19,591 + (50,000/2) = 44,591 unitsAnnual holding cost = 44,591 x 0·1 = £4,459·10

Annual cost of current ordering policy = 4,459·10 + 127·75 = £4,587

(b) We need to calculate the economic order quantity:EOQ = ((2 x 255,380 x 25)/0·1)0·5 = 11,300 units

Average number of orders per year = 255,380/11,300 = 22·6 ordersAnnual ordering cost = 22·6 x 25 = £565·00

Average stock held = 19,591 + (11,300/2) = 25,241 unitsAnnual holding cost = 25,241 x 0·1 = £2,524·10

Annual cost of EOQ ordering policy = 2,524·10 + 565·00 = £3,089

Saving compared to current policy = 4,587 – 3,089 = £1,498

(c) Annual credit purchases = 255,380 x 11 = £2,809,180Current creditors = 2,809,180 x 60/365 = £461,783Creditors if discount is taken = 2,809,180 x 20/365 = £153,928Reduction in creditors = 461,783 – 153,928 = £307,855Finance cost increase = 307,855 x 0·08 = £24,628

Discount gained = 2,809,180 x 0·01 = £28,091Net benefit of taking discount = 28,091 – 24,628 = £3,463The discount is financially acceptable.

An alternative approach is to calculate the annual percentage benefit of the discount.This can be done on a simple interest basis:

(1/(100 – 1)) x (365/40) = 9·2%



21

Alternatively, the equivalent annual rate can be calculated:

(100/(100 – 1))365/40 – 1 = 9·6%

Both methods indicate that the annual percentage benefit is greater than the current cost of short-term debt (8%) of TNGand hence can be recommended on financial grounds.

(d) The economic order quantity (EOQ) model is based on a cost function for holding stock which has two terms: holding costsand ordering costs. With the EOQ, the total cost of having stock is minimised when holding cost is equal to ordering cost.The EOQ model assumes certain knowledge of the variables on which it depends and for this reason is called a deterministicmodel. Demand for stock, holding cost per unit per year and order cost are assumed to be certain and constant for the periodunder consideration. In practice, demand is likely to be variable or irregular and costs will not remain constant. The EOQmodel also ignores the cost of running out of stock (stockouts). This has caused some to suggest that the EOQ model haslittle to recommend it as a practical model for the management of stock.

The model was developed on the basis of zero lead time and no buffer stock, but these are not difficulties that prevent thepractical application of the EOQ model. As our earlier analysis has shown, the EOQ model can be used in circumstanceswhere buffer stock exists and provided that lead time is known with certainty it can be ignored.

The EOQ model also serves a useful purpose in directing attention towards the costs that arise from holding stock. If thesecosts can be reduced, working capital tied up in stock can be reduced and overall profitability can be increased.

If uncertainty exists in terms of demand or lead time, a more complex stock management model using probabilities (astochastic model) such as the Miller-Orr model can be used. This model calculates control limits that give guidance as towhen an order should be placed.

(e) Just-in-time (JIT) stock management methods seek to eliminate any waste that arises in the manufacturing process as a resultof using stock. JIT purchasing methods apply the JIT principle to deliveries of material from suppliers. With JIT productionmethods, stock levels of raw materials, work-in-progress and finished goods are reduced to a minimum or eliminatedaltogether by improved work-flow planning and closer relationships with suppliers.

AdvantagesJIT stock management methods seek to eliminate waste at all stages of the manufacturing process by minimising oreliminating stock, defects, breakdowns and production delays3. This is achieved by improved workflow planning, anemphasis on quality control and firm contracts between buyer and supplier.

One advantage of JIT stock management methods is a stronger relationship between buyer and supplier. This offers securityto the supplier, who benefits from regular orders, continuing future business and more certain production planning. The buyerbenefits from lower stock holding costs, lower investment in stock and work in progress, and the transfer of stock managementproblems to the supplier. The buyer may also benefit from bulk purchase discounts or lower purchase costs.

The emphasis on quality control in the production process reduces scrap, reworking and set-up costs, while improvedproduction design can reduce or even eliminate unnecessary material movements. The result is a smooth flow of materialand work through the production system, with no queues or idle time.

DisadvantagesA JIT stock management system may not run as smoothly in practice as theory may predict, since there may be little roomfor manoeuvre in the event of unforeseen delays. There is little room for error, for example, on delivery times.

The buyer is also dependent on the supplier for maintaining the quality of delivered materials and components. If deliveredquality is not up to the required standard, expensive downtime or a production standstill may arise, although the buyer canprotect against this eventuality by including guarantees and penalties in to the supplier’s contract. If the supplier increasesprices, the buyer may find that it is not easy to find an alternative supplier who is able, at short notice, to meet his needs.




22




Marks Marks1 (a) Sales revenue 4

Material costs 4Fixed costs 1Advertising 1Taxation 2Capital allowance tax benefit 1Fixed asset sale 1Working capital recovery 1Present values 1Net present value 1

–––17

(b) Assumptions regarding economic variables 2Fixed costs 1Sales volume 1Working capital 1Terminal value 1

–––6

(c) Evaluation and discussion should consider:Security availableInterest coverGearingConvertibilityMaturity 8

(d) ABC recovery rates 3Fixed costs using ABC 4Total costs, selling prices and discussion 4

–––11

(e) Explanation of need to hedge receipt 2–3Sterling value of forward hedge 2

–––Maximum 4

(f) Bills of exchange and risk reduction 2Discounting bills of exchange 2

–––4

–––50

23



Marks Marks2 (a) Features of a not-for-profit organisation 1

Selection of cost units 3–4Use of performance measures 3–4Comparison of planned and actual performance 3–4

–––Maximum 10

(b) Zero-based budgeting and incremental budgeting 1Decision packages 2Ranking decision packages 2Allocating resources 1Zero-based budgeting and NFP organisations 2

–––8

(c) Explanation of activity-based budgeting 2Need for detailed analysis of costs and activities 1Stages in activity-based budgeting 2–3Advantages of activity-based budgeting 2–3

–––Maximum 7

–––25

3 (a) Overhead absorption rate 1Standard costs and standard profits 3Sales price variance 2Sales volume profit variance 2Sales mix profit variance 2Sales quantity profit variance 2Profit reconciliation 1

–––13

(b) Significance of sales mix profit variance 3Comment on individual mix variances 1

–––4

(c) Elements of a standard costing system 2–3Quantitative analysis and preparation of standard costs 2–3Variance analysis 2–3Review of standards 2–3

–––Maximum 8

–––25

4 (a) Growth in dividends per share: analysis/discussion 4–5Share price growth: analysis/discussion 4–5Growth in earnings per share: analysis/discussion 4–5

–––Maximum 13

(b) Calculation of total shareholder return 2Comment 1

–––3

(c) Discussion of factors 5–6Examples of appropriate remuneration packages 4–5

–––Maximum 9

–––25

24



Marks Marks5 (a) Annual ordering cost 1

Annual holding cost 2Annual cost of current policy 1

–––4

(b) Calculation of economic order quantity 1Annual ordering cost 1Annual holding cost 1Annual cost of EOQ policy 1Saving from using EOQ policy or discussion 1

–––5

(c) Analysis 2–3Discussion 1–2

–––Maximum 4

(d) Discussion of limitations of EOQ model 4

(e) Advantages of JIT stock management methods 4–5Disadvantages of JIT stock management methods 4–5

–––Maximum 8

–––25

25




PART 2


QUESTION PAPER









Pape

r 2.4




1 BFD Co is a private company formed three years ago by four brothers who, as directors, retain sole ownership of itsordinary share capital. One quarter of the initial share capital was provided by each brother. The company hasreturned a profit in each year of operation as shown by the following financial statements.

Profit and Loss Accounts for years ending 30 November2005 2004 2003£000 £000 £000

Turnover 5,200 3,400 2,600Cost of sales 4,570 2,806 2,104

–––––– –––––– ––––––Profit before interest and tax 630 594 496Interest 70 34 3

–––––– –––––– ––––––Profit before tax 560 560 493Tax 140 140 123

–––––– –––––– ––––––Profit after tax 420 420 370Dividends 20 20 20

–––––– –––––– ––––––Retained profit 400 400 350

–––––– –––––– ––––––

Balance Sheets as at 30 November2005 2004 2003

£000 £000 £000 £000 £000 £000Fixed assets 1,600 1,200 800Current assetsStock 1,450 1,000 600Debtors 1,400 850 400

–––––– –––––– ––––––2,850 1,850 1,000

Current liabilities 2,300 1,300 450–––––– –––––– ––––––

Net current assets 550 550 550–––––– –––––– ––––––2,150 1,750 1,350

–––––– –––––– ––––––

Ordinary shares (£1 par) 1,000 1,000 1,000Reserves 1,150 750 350

–––––– –––––– ––––––2,150 1,750 1,350

–––––– –––––– ––––––

BFD Co has an overdraft limit of £1·25 million and pays interest on its overdraft at a rate of 6% per year. Currentliabilities consist of trade creditors and overdraft finance in each of the three years.

The directors are delighted with the rapid growth of BFD Co and are considering further expansion through buyingnew premises and machinery to manufacture Product FT7. This new product has only just been developed andpatented by BFD Co. Test marketing has indicated considerable demand for the product, as shown by the followingresearch data.

Year of operation 1 2 3 4Accounting year 2005/6 2006/7 2007/8 2008/9Sales volume (units) 100,000 120,000 130,000 140,000

Sales after 2008/9 (the fourth year of operation) are expected to continue at the 2008/9 level in perpetuity.

Initial investment of £3,000,000 would be required in new premises and machinery, as well as an additional£200,000 of working capital. The directors have no further financial resources to offer and are consideringapproaching their bank for a loan to meet their investment needs. Selling price and standard cost data for ProductFT7, based on an annual budgeted volume of 100,000 units, are as follows.

2



£ per unitSelling price 18·00Direct material 7·00Direct labour 1·50Fixed production overhead 4·50

The fixed production overhead is incurred exclusively in the production of Product FT7 and excludes depreciation.Selling price and standard unit variable cost data for Product FT7 are expected to remain constant.

BFD Co expects to be able to claim writing down allowances on the initial investment of £3,000,000 on a straight-line basis over 10 years. The company pays tax on profit at an annual rate of 25% in the year in which the liabilityarises and has an after-tax cost of capital of 12%.

Average data for companies similar to BFD CoNet profit margin: 9% Creditor days: 70 daysInterest cover: 15 times Current ratio: 2·1 timesStock days: 85 days Quick ratio: 0·8 timesDebtor days: 75 days Debt/equity ratio: 40% (using book values)

Required:

(a) Calculate the net present value of the proposed investment in Product FT7. Assume that it is now 1 December 2005. (16 marks)

(b) Comment on the acceptability of the proposed investment in Product FT7 and discuss what additionalinformation might improve the decision-making process. (7 marks)

(c) BFD Co has received an offer from a rival company of £300,000 per year for 10 years for the manufacturingrights for Product FT7. If BFD Co accepts this offer, it would not be able to manufacture Product FT7 for theduration of the agreement.

Required:

Determine whether BFD Co should accept the offer for the manufacturing rights to Product FT7. In this partof the question only, ignore cash flows occurring after the ten-year period of the offer. Assume that it is 1 December 2005. (6 marks)

(d) As the newly-appointed finance director of BFD Co, write a report to the board which discusses whether thecompany is likely to be successful if it approaches its bank for a loan. Your discussion should include ananalysis of the current financial position and recent financial performance of the company. (16 marks)

(e) On the basis that BFD Co decided to invest and manufacture Product FT7, the actual data for the first year ofoperation (2005/6) is now available and is as follows:

Number of units produced and sold 110,000Selling price (£ per unit) 18·20Direct material (£ per unit) 7·10Direct labour (£ per unit) 1·70Fixed production overhead (£ per unit) 4·50

Required:

Calculate the following variances using marginal costing and absorption costing:

(i) sales price variance;(ii) sales volume profit variance;

and comment on the relative values obtained. (5 marks)

(50 marks)

3 [P.T.O.




2 Required:

(a) Identify the types of responsibility centres used in responsibility accounting and discuss how the performanceof each responsibility centre type might be measured, including in your discussion examples of controllableand non-controllable factors. (12 marks)

(b) Critically discuss whether return on investment or residual income should be used to assess managerialperformance in an investment centre. (13 marks)

(25 marks)

3 Linacre Co operates an activity-based costing system and has forecast the following information for next year.

Cost Pool Cost Cost Driver Number of DriversProduction set-ups £105,000 Set-ups 300Product testing £300,000 Tests 1,500Component supply and storage £25,000 Component orders 500Customer orders and delivery £112,500 Customer orders 1,000

General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are expected tobe £900,000 and these overheads are absorbed on a direct labour hour basis. Total direct labour hours for next yearare expected to be 300,000 hours.

Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders of 50 unitsper order. The company holds no stocks of Product ZT3 and will need to produce the order requirement in productionruns of 900 units. One order for components is placed prior to each production run. Four tests are made during eachproduction run to ensure that quality standards are maintained. The following additional cost and profit informationrelates to product ZT3:

Component cost: £1·00 per unitDirect labour: 10 minutes per unit at £7·80 per hourProfit mark up: 40% of total unit cost

Required:

(a) Calculate the activity-based recovery rates for each cost pool. (4 marks)

(b) Calculate the total unit cost and selling price of Product ZT3. (9 marks)

(c) Discuss the reasons why activity-based costing may be preferred to traditional absorption costing in themodern manufacturing environment. (12 marks)

(25 marks)

4



4 AGD Co is a profitable company which is considering the purchase of a machine costing £320,000. If purchased,AGD Co would incur annual maintenance costs of £25,000. The machine would be used for three years and at theend of this period would be sold for £50,000. Alternatively, the machine could be obtained under an operating leasefor an annual lease rental of £120,000 per year, payable in advance.

AGD Co can claim capital allowances on a 25% reducing balance basis. The company pays tax on profits at an annualrate of 30% and all tax liabilities are paid one year in arrears. AGD Co has an accounting year that ends on 31 December. If the machine is purchased, payment will be made in January of the first year of operation. If leased,annual lease rentals will be paid in January of each year of operation.

Required:

(a) Using an after-tax borrowing rate of 7%, evaluate whether AGD Co should purchase or lease the newmachine. (12 marks)

(b) Explain and discuss the key differences between an operating lease and a finance lease. (8 marks)

(c) The after-tax borrowing rate of 7% was used in the evaluation because a bank had offered to lend AGD Co£320,000 for a period of five years at a before-tax rate of 10% per year with interest payable every six months.

Required:

(i) Calculate the annual percentage rate (APR) implied by the bank’s offer to lend at 10% per year withinterest payable every six months. (2 marks)

(ii) Calculate the amount to be repaid at the end of each six-month period if the offered loan is to be repaidin equal instalments. (3 marks)

(25 marks)

5 [P.T.O.



5 Thorne Co values, advertises and sells residential property on behalf of its customers. The company has been inbusiness for only a short time and is preparing a cash budget for the first four months of 2006. Expected sales ofresidential properties are as follows.

2005 2006 2006 2006 2006Month December January February March AprilUnits sold 10 10 15 25 30

The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the value of each propertysold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after sale. The company hasnine employees who are paid on a monthly basis. The average salary per employee is £35,000 per year. If more than20 properties are sold in a given month, each employee is paid in that month a bonus of £140 for each additionalproperty sold.

Variable expenses are incurred at the rate of 0·5% of the value of each property sold and these expenses are paid inthe month of sale. Fixed overheads of £4,300 per month are paid in the month in which they arise. Thorne Co paysinterest every three months on a loan of £200,000 at a rate of 6% per year. The last interest payment in each yearis paid in December.

An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne Co intends to disposeof surplus vehicles, with a net book value of £15,000, for £20,000. The cash balance at the start of January 2006is expected to be a deficit of £40,000.

Required:

(a) Prepare a monthly cash budget for the period from January to April 2006. Your budget must clearly indicateeach item of income and expenditure, and the opening and closing monthly cash balances. (10 marks)

(b) Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecastby its cash budgets. (5 marks)

(c) Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cashshortages forecast by its cash budgets. (5 marks)

(d) Explain how the Baumol model can be employed to reduce the costs of cash management and discusswhether the Baumol cash management model may be of assistance to Thorne Co for this purpose.

(5 marks)

(25 marks)

6



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Answers




1 (a) Net present value evaluation of proposed investment:

2005/6 2006/7 2007/8 2008/9£000 £000 £000 £000

Sales revenue 1,800 2,160 2,340 2,520Variable costs 850 1,020 1,105 1,190

––––– –––––– –––––– ––––––Contribution 950 1,140 1,235 1,330Fixed costs 450 450 450 450

––––– –––––– –––––– ––––––Net cash flow 500 690 785 880Taxation 125 173 196 220

––––– –––––– –––––– ––––––After-tax cash flow 375 517 589 66012% discount factors 0·893 0·797 0·712 0·636

––––– –––––– –––––– ––––––Present values 335 412 419 419

––––– –––––– –––––– ––––––

£Sum of present values 1,585,000PV of tax benefits 423,750PV of cash flows after Year 4 = 3,498,000

––––––––––5,506,750

Less initial investment 3,200,000––––––––––

Net present value 2,306,750––––––––––

Workings2005/6 2006/7 2007/8 2008/9

Sales volume (units) 100,000 120,000 130,000 140,000Selling price (£/unit) 18·00 18·00 18·00 18·00Sales revenue (£) 1,800,000 2,160,000 2,340,000 2,520,000

Variable costs (£/unit) 8·50 8·50 8·50 8·50Variable costs (£) 850,000 1,020,000 1,105,000 1,190,000

Fixed costs = 4·50 x 100,000 = £450,000 per year

Annual writing down allowance = 3,000,000/10 = £300,000Annual writing down allowance tax benefits = 25% x 300,000 = £75,000Ten-year annuity factor at 12% = 5·650Present value of writing down allowance tax benefits = 75,000 x 5·650 = £423,750

Year 4 value of year 5 after-tax cash flows in perpetuity = 660,000/0·12 = £5,500,000Present value of these cash flows = 5,500,000 x 0·636 = £3,498,000

(b) From a net present value perspective the proposed investment is acceptable, since the net present value (NPV) is large andpositive. However, a large part of the present value of benefits (63%) derives from the assumption that cash flows willcontinue indefinitely after Year 4. This is very unlikely to occur in practice and excluding these cash flows will result in anegative net present value of approximately £1·2m. In fact the proposed investment will not show a positive NPV until morethan seven years have passed.

Before rejecting the proposal, steps should be taken to address some of the limitations of the analysis performed.

InflationForecasts of future inflation of sales prices and variable costs should be prepared, so that a nominal NPV evaluation can beundertaken. This evaluation should employ a nominal after-tax cost of capital: it is not stated whether the 12% after-tax costof capital is in nominal or real terms. Sales price is assumed to be constant in real terms, but in practice substitute productsare likely to arise, leading to downward pressure on sales price and sales volumes.

Constant fixed costsThe assumption of constant fixed costs should be verified as being acceptable. Sales volumes are forecast to increase by 40%and this increase may result in an increase in incremental fixed costs.

Constant working capitalThe assumption of constant working capital should be investigated. Net working capital is likely to increase in line with salesand so additional investment in working capital may be needed in future years. Inflation will increase required incrementalworking capital investment.

Taxation and capital allowancesThe assumptions made regarding taxation should be investigated. The tax rate has been assumed to be constant, when theremay be different rates of profit tax applied to companies of different size. The method available for claiming capital allowances

13



should be confirmed, since it is usual to find a different method being applied to buildings compared to that applied tomachinery, whereas in this case they are the same.

Machine replacementThe purchase of replacement machinery has been ignored, which seems unreasonable. Future reinvestment in newmachinery will be needed and this will reduce the net present value of the proposed investment.

Changes in technologyTechnological change is also possible, bringing perhaps new manufacturing methods and improved or substitute products,and these may affect the size of future cash flows.

FinancingThe method of financing the proposed investment should be considered. It may be that leasing will be cheaper than borrowingto buy, increasing the net present value and making the project more attractive. The amount of the investment is largecompared to the current long-term capital employed by BFD Co and the after-tax cost of capital is likely to change as a result.A lower cost of capital would increase the NPV.

(c) The offer for the manufacturing rights is for a ten-year period.

Annual after-tax cash flow after Year 4 = £660,000Present value of this cash flow over six years at 12% = 660,000 x 4·111 = £2,713,260Present value of post Year 4 cash flows = 2,713,260 x 0·636 = £1,725,633

Sum of present values over 4 years 1,585,000PV of tax benefits 423,750PV of cash flows from Year 5 to Year 10 = 1,725,633

––––––––––3,734,383

Less initial investment 3,200,000––––––––––

Net present value 534,383––––––––––

This net present value is equivalent to an annual benefit of 534,383/ 5·650 = £94,581The after-tax value of the offer of £300,000 per year for 10 years = 300,000 x 0·75 = £225,000In the absence of other information, the offer should be accepted.

An alternative approach is to calculate the present value of the offer:300,000 x 0·75 x 5·650 = £1,271,250Since this is greater than the NPV of investing by £736,867, the offer should be accepted.

(d) To: The Board of BFD CoFrom: Finance DirectorDate:Subject: Proposal to seek £3·2 million of Debt Finance

1. IntroductionThis report considers whether seeking £3·2 million of debt finance is likely to be successful in the light of our currentfinancial position and recent financial performance.

2. Sector DataI have obtained some benchmark data relating to companies active in our business sector. The sector data applies tothe current year and may not be applicable in previous years.

3. Analysis of Financial DataAnalysis of our financial statements gives the following results.

2002/3 2003/4 2004/5 Sector valueTurnover growth 31% 53%Cost of sales growth 33% 63%Net profit margin 19% 17% 12% 9%Interest cover 165 17 9 15Sales/net working capital 4·7 6·2 9·5Stock days 104 130 116 85Debtor days 56 91 98 75Creditor days 69 95 90 70Current ratio 2·2 1·4 1·2 2·1Quick ratio 0·9 0·7 0·6 0·8Gearing (debt/equity ratio) 4% 33% 54% 40%

Note: Gearing calculations are based on our average overdraft, as our company has no long-term debt. This seems areasonable approach to calculating gearing, since our overdraft is a large and increasing one.

14



Workings2002/3 2003/4 2004/5

Annual interest at 6% (£) 3,000 34,000 70,000Overdraft (£) 50,000 567,000 1,167,000Trade creditors (£) 400,000 733,000 1,133,000

4. Comment on Financial Position and PerformanceBFD Co has experienced rapid growth in turnover since its formation three years ago, but it has been unable to maintainnet profit margin, which has fallen from 19% in 2002 to 12% in 2004. On a positive note, our net profit margin ishigher than the sector average, but this may also indicate that a further decrease may arise.

Our growth in turnover has not been matched by growth in long-term finance. Apart from the original equity investmentmade by the founder directors, growth in long-term finance has been through retained earnings alone. Our company hasincreasingly relied on short-term finance and over the three-year period the overdraft has grown from £50,000 to£1,167,000. From a financial risk point of view, gearing has increased from 4% to 54% and interest cover has declinedfrom 165 times to nine times. Both ratios are currently worse than the comparable sector average. The average periodof time in which we settle with trade creditors has grown from 69 days to 90 days compared to a sector average of 70 days.

The average amount of credit extended by the sector is 75 days but our debtors’ ratio has grown from 56 days to 98 days. This has increased the amount of working capital finance we need, as has the growth in stock days from 104 days to 116 days compared to a sector average of 85 days. Funds which are tied up in stocks and debtors decreaseprofitability.

There is further bad news in the area of working capital management since both our current ratio and quick ratio areless than the current sector average, having declined in each of the past two years.

5. Effect of Additional Debt Finance on Current Financial PositionDebt finance of £3·2m would increase gearing on a book value basis from 54% to 203% ((1,167 + 3,200)/2,150),which is five times the sector average. If the overdraft is ignored in calculating gearing it would still be four times thesector average at 148% (3,200/2,150). Assuming interest at a fixed rate of 8%, our interest cover would fall from 9 times to 1·9 times (630/(272 + 70)). This is a dangerously low level of interest cover. We would need to assesswhether we could offer security for a loan of this size.

6. Chances of Success in Application for Debt FinanceI must advise you that there are signs of overtrading in our recent financial statements and our company is approachingits overdraft limit of £1·25 million. We will need to obtain further long-term finance regardless of whether our applicationfor a £3·2 million bank loan is successful.

I note that no further equity investment is available from the current directors. It may be in our best interests to addressour overall long-term financing needs rather than seeking finance only for the proposed investment in Product FT7manufacture. Our overall long-term financing need is greater than £3·2 million.

It is my opinion, based on our recent financial performance, our current financial position, and the effect of such a largeamount of debt on our capital structure, that an application for a £3·2 million bank loan would not be successful andthat alternative sources of finance should be sought. I would be pleased to advise on these if the Board requested.

Yours sincerely,A.N. Accountant

(e) Calculation of standard contribution and standard profit£

Selling price 18·00Direct material 7·00Direct labour 1·50 8·50

––––– –––––Standard contribution 9·50

–––––

Selling price 18·00Direct material 7·00Direct labour 1·50Fixed production overhead 4·50 13·00

––––– –––––Standard profit 5·00

–––––

Sales price variance (marginal costing) = ((18·20 – 8·50) – 9·50) x 110,000= (9·70 – 9·50) x 110,000 = £22,000 (F)

Sales price variance (absorption costing) = ((18·20 – 13·00) – 5·00) x 110,000= (5·20 – 5·00) x 110,000 = £22,000 (F)

There is no difference between the two sales price variances because this variance depends upon the difference betweenactual selling price and standard selling price and not on the costing system employed in calculating it.

15



Sales volume profit variance (marginal costing) = (110,000 – 100,000) x 9·50 = £95,000 (F)Sales volume profit variance (absorption costing) = (110,000 – 100,000) x 5·00 = £50,000 (F)

The sales volume profit variances are different, even though the volume difference is the same, because standard contribution(marginal costing) has a different value to standard profit (absorption costing), since marginal costing excludes productionoverheads from product cost while absorption costing includes them.

2 (a) A responsibility centre is part of an organisation for whose activities a manager is deemed to be responsible. The type ofresponsibility centre depends on the type of activities for which responsibility is carried.

Cost CentreA cost centre or expense centre can be defined as a responsibility centre where a manager is accountable only for costs whichare under his control. It is a production or service location for which costs can be identified or accumulated prior to allocationto cost units. Cost centres may be either standard cost centres, where output can be measured and the input needed for agiven output can be specified, or discretionary cost centres, where output cannot be measured easily and the relationshipbetween inputs and outputs cannot be specified1. An example of a standard cost centre is a production unit within a factory,while an example of a discretionary cost centre is a health and safety department within a university. A cost centre manageris responsible for the cost of inputs to the organisation. The performance of the manager of a cost centre can be assessed bycomparing actual performance with budgeted targets for price, usage and efficiency.

Revenue CentreA revenue centre is a responsibility centre where a manager is accountable solely for the revenue generation that is under hiscontrol. An example would be a sales team with a target geographical area which is under the control of a sales manager.The manager would have no responsibility for the production cost of the items his team is selling, but has responsibility formeeting sales targets in terms of sales volume, sales revenue or market share. A revenue centre manager has responsibilityfor the revenue generated by outputs from the organisation. The performance of the manager of a revenue centre can beassessed by comparing actual performance with budgeted targets for price, mix and volume.

Profit CentreA profit centre is a combination of a cost centre and a revenue centre where a manager has responsibility for both productioncosts and revenue generation. The degree of responsibility carried by a manager can be higher with a profit centre than witha cost centre or a revenue centre, and the manager may be responsible for purchasing, production planning, product mix andpricing decisions. The performance of the manager of a profit centre is unlikely to be assessed on the fine detail of cost andrevenue data but by the extent to which agreed targets for overall cost, revenue and profit have been achieved.

Investment CentreWith an investment centre, the manager of a profit centre is given additional responsibility for investment decisions regardingworking capital and the purchase and replacement of fixed assets. The manager of an investment centre is likely to beassessed with an aggregate measure that links periodic profit to the assets employed in the period to generate that profit. Anexample of such an aggregate measure is return on capital employed.

Controllable and Non-controllable FactorsIt is a cardinal principle of responsibility accounting that managers can only be assessed on the cash flows that are undertheir control. If a manager has no control over a cash flow he cannot influence its size or timing and so cannot be heldresponsible if either of these values changes. The performance of the manager of a cost centre can thus only be assessed onthe controllable costs over which he exercises control. In the case of a production cost centre, the manager may be able tocontrol material usage but could have no influence over the price at which materials are bought by the purchasingdepartment. For the production cost centre manager, material usage is a controllable factor whereas material purchase priceis not.

With a revenue centre, a sales manager can be held responsible for generating revenue against agreed sales volume targetsbut may have no control over the selling price of his products as this is determined by market conditions. In this case salesvolume is a controllable factor whereas selling price is not.

The manager of a profit centre will have control of operating costs but will not be able to influence the financing costs arisingfrom investment decisions. The manager may thus have responsibility for operating profit but his performance should not beassessed on profit before tax since interest charges are outside of his control.

The manager of an investment centre could have his performance assessed on profit before tax, but the profit on which heis assessed should exclude non-controllable elements such as overhead costs that he cannot influence, for example allocatedhead office charges.

(b) While it is possible to assess the performance of an investment centre such as a division within a company on the basis ofthe profit it generates, considering profit alone and taking no account of the assets used to generate the profit will provide anincomplete picture of performance. Comparing profit between profit centres is also misleading if assets employed are ignored.Assessment of the performance of an investment centre will usually therefore include a performance measure that relatesprofit to assets employed. Two such measures are return on investment (ROI) and residual income (RI).

1Drury, C. (2004) Management and Cost Accounting, 6th edition, pp.653–4

16



Return on investment expresses controllable profit as a percentage of capital employed. It is thus a relative, rather than anabsolute, performance measure and is both widely used and understood. Controllable profit means that non-controllablefactors are excluded as far as possible from the profit used in calculating ROI since these will diminish the usefulness of thecalculated measure in assessing managerial performance.

Because ROI is a relative measure, it can be used to compare performance between investment centres. ROI also offers away of assessing the past investment decisions made by an investment centre, since it is measured after these investmentdecisions have been made. It can thus be used to check that the performance predicted by investment appraisal decisions isin fact being achieved post implementation.

Since ROI assesses investment centre managerial performance on the basis of controllable profit generated, managers will bekeen to maximise this as far as possible. The desire to maximise controllable profit can be assisted by the use of performance-related pay and similar incentive schemes. But if performance is assessed using ROI, investment centre managers will be askeen to minimise capital employed as they will be to maximise controllable profit. While this can encourage managers todispose of obsolete equipment and minimise working capital, it can also lead to sub-optimal decisions for the company as awhole.

If managers are assessed using ROI, there will be a disincentive to invest in projects with a ROI that is less than the currentROI of the investment centre. However, these projects should be accepted if the project ROI is greater than the company’scost of capital. In this case, the decision not to invest will not be consistent with the overall objective of maximisingshareholder wealth.

A similar problem arises with asset disposal decisions. Here, a manager assessed using ROI may choose to retain assets witha low written down value since these assets will generate a higher ROI than new, more expensive assets that could be moreeconomical and efficient. This problem highlights the way in which short-term concerns can outweigh longer-term interestswhen ROI is used to assess managerial performance. It should be noted that ROI can simply increase due to ageing assetsrather than from the actions of managers charged with increasing it.

Residual income has been suggested as a way of overcoming some of the perceived shortcomings of ROI as a managerialperformance measure. Residual income (RI) is defined as controllable profit less a cost of capital charge on controllableinvestment. RI is therefore an absolute, rather than a relative, performance measure, which means that comparisons betweeninvestment centres cannot be made directly.

The advantage of RI as a performance measure is that the cost of capital charge (or imputed interest charge) is made byreference to the company’s cost of capital, so that a positive residual income arises if an existing or proposed investmentgenerates a return greater than the required minimum. Investment centre managers assessed on the basis of RI will thereforechoose to accept all projects with a positive RI, increasing the company’s overall return. Sub-optimal investment decisionsshould therefore be reduced or eliminated using RI. Investment centre managers will also be discouraged from retainingageing and inefficient assets, since replacing such assets by more efficient ones is likely to lead to an increase in residualincome.

Overall, it is felt that return on investment is an unsatisfactory way of assessing managerial performance as far as aninvestment centre is concerned, and that residual income should be used instead. Despite this, ROI appears in practice to bepreferred to RI2.

3 (a) Activity-based recovery rates are found by dividing the expected cost in each cost pool by the number of cost drivertransactions expected during the coming year.

Cost Pool Cost Number of Drivers ABC Recovery RateProduction set-ups £105,000 300 set-ups £350·00 per set-upProduct testing £300,000 1,500 tests £200·00 per testComponent supply/storage £25,000 500 component orders £50·00 per orderCustomer orders/delivery £112,500 1,000 customer orders £112·50 per order

(b) Production of product ZT3 = (100 x 60) + (60 x 50) = 9,000 units per yearNumber of production runs = number of set-ups = 9,000/900 = 10 set-upsNumber of product tests = 10 x 4 = 40 testsNumber of component orders = number of production runs = 10 ordersNumber of customer orders = 100 + 60 = 160 orders

General overheads absorption rate = 900,000/300,000 = £3·00 per direct labour hourAnnual direct labour hours for Product ZT3 = 9,000 x 10/60 = 1,500 hours

2Drury, C. (2004) Management and Cost Accounting, 6th edition, p.847

17



Activity ABC recovery rate Number of Drivers Annual cost (£)Setting up £350·00 per set-up 10 set-ups 3,500Product testing £200·00 per test 40 tests 8,000Component supply £50·00 per order 10 orders 500Customer supply £112·50 per order 160 orders 18,000

–––––––30,000

General overheads = 1,500 x £3·00 per hour = 4,500–––––––

Total annual overhead cost 34,500–––––––

Total unit cost £Components 1·00Direct labour = 7·80 x 10/60 = 1·30Overheads = 34,500/9,000 = 3·83

–––––6·13

Profit mark up 2·45–––––

Selling price 8·58–––––

(c) Traditional absorption costing allocates a proportion of fixed overheads (indirect costs) to product cost through an overheadabsorption rate, usually based on labour hours, machine hours, or some other volume-related measure of activity. Theseoverhead absorption rates may be factory-wide absorption rates (blanket rates) or, for increased accuracy in determiningproduct cost, departmental absorption rates. In the traditional manufacturing environment, indirect costs constituted arelatively small proportion of total product cost compared to direct costs such as direct material cost, direct labour cost anddirect expenses (collectively referred to as prime cost).

The modern manufacturing environmentIn the modern manufacturing environment, indirect costs constitute a relatively high proportion of total product cost. Thereare several reasons for this.

Modern manufacturing is characterised by shorter and more frequent production runs rather than continuous or high volumeproduction runs. This increases the frequency of production line set-ups and therefore the total cost arising from set-upactivity.

Widespread use of computer control and automation has decreased the importance and use of direct labour. Direct labourcost as a proportion of total cost has therefore declined. This decline has been accelerated by the use of salaried employeesrather than staff whose wages depend on production output, transferring labour costs from a direct cost to an indirect cost.

Increased use of just-in-time production methods and customer-led manufacture has led to quality control costs andproduction planning costs forming a higher proportion of total cost. These costs relate to particular production runs rather thanto manufacture as a whole.

Activities and costsTraditional absorption costing, by employing volume-related overhead absorption rates, failed to take account of therelationship between costs, activities and products. The insight at the heart of activity-based costing is that it is activities thatincur costs and products that consume activities. Analysis of the way in which products consume activities allows theoverhead costs incurred by those activities to be related to product cost using cost drivers derived from those activities ratherthan using production volume-related overhead absorption rates.

For example, set-up costs under traditional absorption costing could have been allocated to product cost using an overheadabsorption rate based on machine hours. This would transfer a disproportionate amount of set-up costs to high volumeproducts, which in fact gave rise to fewer set-ups because of their longer production runs. If set-up costs were transferredusing number of set-ups as the cost driver, a fairer allocation of set-up costs would be achieved and products with longerproduction runs would not be penalised with a disproportionate share of their indirect costs.

Improved cost controlActivity-based costing can lead to more detailed product cost information because a larger number of ABC cost drivers arelikely to be identified in a given manufacturing organisation. An average of fifteen ABC cost drivers tends to be used, comparedwith one or two overhead absorption rates in traditional absorption costing. This more detailed product cost information canlead to improved cost control, since managers can seek to control costs by controlling the activities that cause the costs to beincurred. Production scheduling, for example, can optimise the number of production runs in order to minimise set-up costs.

Better information on product profitabilitySince product cost information is more accurate, managers have more accurate information on the relative profitability ofindividual products. This can lead to better decisions on product promotion and pricing, since managers can promote highermargin products while seeking to improve margins on products where margins are lower.

18



Activity-based budgetingBudget planning and formulation can use an activity-based approach to determining the required level of support activities,rather than an incremental approach based on prior year figures. With activity-based budgeting, the required level ofproduction is used to determine the required number of cost driver transactions (e.g. number of set-ups), which in turn areused to determine the level of support activity that must be budgeted for (e.g. number of set-up engineers). In this waymanagers can seek to identify and eliminate any unnecessary slack in support activities, thereby improving efficiency andprofitability.

4 (a) Evaluation of purchase versus leasing compares the net cost of each financing alternative using the after-tax cost of borrowing.

Borrowing to buy evaluationYear 0 Year 1 Year 2 Year 3 Year 4£000 £000 £000 £000 £000

Purchase and sale (320) 50Capital allowance tax benefits 24 18 39Maintenance costs (25) (25) (25)Maintenance cost tax benefits 8 8 8

–––––– –––––– –––––– –––––– ––––––Net cash flow (320) (25) 7 51 47Discount factors (7%) 1·000 0·935 0·873 0·816 0·763

–––––– –––––– –––––– –––––– ––––––Present values (320) (23) 6 42 36

–––––– –––––– –––––– –––––– ––––––

PV of borrowing to buy = –£259,000

Workings: Capital allowance tax benefitsYear Capital allowance Tax benefit Taken in year1 320,000 x 0·25 = 80,000 80,000 x 0·3 = 24,000 22 80,000 x 0·75 = 60,000 60,000 x 0·3 = 18,000 33 Balancing allowance =130,000 130,000 x 0·3 = 39,000 4

Balancing allowance = (320,000 – 50,000) – (80,000 + 60,000) = £130,000

Leasing evaluationYear 0 Year 1 Year 2 Year 3 Year 4£000 £000 £000 £000 £000

Lease rentals (120) (120) (120)Lease rental tax benefits 36 36 36

–––––– –––––– –––––– –––––– ––––––Net cash flow (120) (120) (84) 36 36Discount factors (7%) 1·000 0·935 0·873 0·816 0·763

–––––– –––––– –––––– –––––– ––––––Present values (120) (112) (73) 29 27

–––––– –––––– –––––– –––––– ––––––

PV of leasing = –£249,000

On financial grounds, leasing is to be preferred as it is cheaper by £10,000. Note that the first lease rental is taken as beingpaid at year 0 as it is paid in the first month of the first year of operation.

An alternative form of evaluation combines the cash flows of the above two evaluations. Because this evaluation is morecomplex, it is more likely to lead to computational errors.

Combined evaluationYear 0 Year 1 Year 2 Year 3 Year 4£000 £000 £000 £000 £000

Purchase and sale (320) 50Capital allowance tax benefits 24 18 39Maintenance costs (25) (25) (25)Maintenance cost tax benefits 8 8 8Lease rentals saved 120 120 120Lease rental tax benefits lost (36) (36) (36)

–––––– –––––– –––––– –––––– ––––––Net cash flow (200) 95 91 15 11Discount factors (7%) 1·000 0·935 0·873 0·816 0·763

–––––– –––––– –––––– –––––– ––––––Present values (200) 89 79 12 8

–––––– –––––– –––––– –––––– ––––––

The PV of –£12,000 indicates that leasing would be £12,000 cheaper than borrowing. The difference between this and theprevious evaluation is due to rounding.

19



(b) A finance lease exists when the substance of the lease is that the lessee enjoys substantially all of the risks and rewards ofownership, even though legal title to the leased asset does not pass from lessor to lessee. A finance lease is thereforecharacterised by one lessee for most, if not all, of its useful economic life, with the lessee meeting maintenance and similarregular costs. A finance lease cannot be cancelled, once entered into, without incurring severe financial penalties. A financelease therefore acts as a kind of medium- to long-term source of debt finance which, in substance, allows the lessee topurchase the desired asset. This ownership dimension is recognised in the balance sheet, where a finance-leased asset mustbe capitalised (as a fixed asset), together with the amount of the obligations to make lease payments in future periods (as aliability).

In contrast, an operating lease is a rental agreement where several lessees are expected to use the leased asset and so thelease period is much shorter than the asset’s useful economic life. Maintenance and similar costs are borne by the lessor,with this cost being reflected in the lease rentals charged. An operating lease can usually be cancelled without penalty at shortnotice. This allows the lessee to ensure that only up-to-date assets are leased for use in business operations, avoiding theobsolescence problem associated with the rapid pace of technological change in assets such as personal computers andphotocopiers. Because the substance of an operating lease is that of a short-term rental agreement, operating leases do notrequire to be capitalised in the balance sheet, allowing companies to take advantage of this form of ‘off-balance sheetfinancing’ 3.

(c) (i) The offer of 10% per year with interest payable every six months means that the bank will require 5% every six months.This is equivalent to an annual percentage rate of 10·25% (100 x (1·052 – 1)) before tax.

(ii) Using annuity tables:

A = 320,000/7·722 = £41,440

An alternative solution can be found using the formula for the present value of an annuity given in the formula sheet, asix-monthly interest rate of 5% and 10 periods of six months over the 5-year period of the loan:

320,000 = (A/r) x (1 – 1/(1 + r)n) = (A/0·05) x (1 – 1/1·0510)

Hence the amount to be paid at the end of each six-month period = A = £41,441

The difference between the two values is due to rounding in the annuity tables.

5 (a) Cash Budget for Thorne Co:

January February March AprilReceipts £ £ £ £Cash fees 18,000 27,000 45,000 54,000Credit fees 36,000 36,000 54,000 90,000Sale of assets 20,000

––––––– ––––––– ––––––– ––––––––Total receipts 54,000 63,000 99,000 164,000

––––––– ––––––– ––––––– ––––––––

PaymentsSalaries 26,250 26,250 26,250 26,250Bonus 6,300 12,600Expenses 9,000 13,500 22,500 27,000Fixed overheads 4,300 4,300 4,300 4,300Taxation 95,800Interest 3,000

––––––– ––––––– ––––––– ––––––––Total payments 39,550 44,050 62,350 165,950

––––––– ––––––– ––––––– ––––––––

Net cash flow 14,450 18,950 36,650 (1,950)Opening balance (40,000) (25,550) (6,600) 30,050

––––––– ––––––– ––––––– ––––––––Closing balance (25,550) (6,600) 30,050 28,100

––––––– ––––––– ––––––– ––––––––

Workings

Month December January February March AprilUnits sold 10 10 15 25 30Sales value (£000) 1,800 1,800 2,700 4,500 5,400

Cash fees at 1% (£) 18,000 18,000 27,000 45,000 54,000Credit fees at 2% (£) 36,000 36,000 54,000 90,000 108,000

Variable costs at 0·5% (£) 9,000 13,500 22,500 27,000

Monthly salary cost = (35,000 x 9)/12 = £26,250Bonus for March = (25 – 20) x 140 x 9 = £6,300Bonus for April = (30 – 20) x 140 x 9 = £12,600

3Watson and Head (2004) Corporate Finance: Principles and Practice, 3rd edition, pp.161–2

20



(b) The number of properties sold each month indicates that Thorne Co experiences seasonal trends in its business. There is anindication that property sales are at a low level in winter and increase as spring approaches. A proportion of any cash surplusis therefore likely to be short-term in nature, since some cash will be required when sales are at a low level. Even though netcash flow is forecast to be positive in the January, the month with the lowest level of property sales, the negative openingcash balance indicates that there may be months prior to December when sales are even lower.

Short-term cash surpluses should be invested with no risk of capital loss. This limitation means that appropriate investmentsinclude treasury bills, short-dated gilts, public authority bonds, certificates of deposit and bank deposits. When choosingbetween these instruments Thorne Co will consider the length of time the surplus is available for, the size of the surplus (someinstruments have minimum investment levels), the yield offered, the risk associated with each instrument, and any penaltiesfor early withdrawal4. A small company like Thorne Co, with an annual turnover slightly in excess of £1m per year, is likelyto find bank deposits the most convenient method for investing short-term cash surpluses.

Since the company appears to generate a cash surplus of approximately £250,000 per year, the company must also considerhow to invest this longer-term surplus. As a new company Thorne Co is likely to want to invest surplus funds in expandingits business, but as a small company it is likely to find few sources of funds other than bank debt and retained earnings.There is therefore a need to guard against capital loss when investing cash that is intended to fund expansion at a later date.As the retail property market is highly competitive, investment opportunities must be selected with care and retained earningsmust be invested on a short- to medium-term basis until an appropriate investment opportunity can be found.

(c) In two of the four months of the cash budget Thorne Co has a cash deficit, with the highest cash deficit being the openingbalance of £40,000. This cash deficit, which has occurred even though the company has a loan of £200,000, is likely tobe financed by an overdraft. An advantage of an overdraft is that it is a flexible source of finance, since it can be used as andwhen required, provided that the overdraft limit is not exceeded. In addition, Thorne Co will only have to pay interest on theamount of the overdraft facility used, with the interest being charged at a variable rate linked to bank base rate. In contrast,interest is paid on the full £200,000 of the company’s bank loan whether the money is used or not. The interest rate on theoverdraft is likely to be lower than that on long-term debt.

A disadvantage of an overdraft is that it is repayable on demand, although in practice notice is given of the intention towithdraw the facility. The interest payment may also increase, since the company is exposed to the risk of an interest ratesincrease. Banks usually ask for some form of security, such as a floating charge on the company’s assets or a personalguarantee from a company’s owners, in order to reduce the risk associated with their lending.

(d) The Baumol model is derived from the EOQ model and can be applied in situations where there is a constant demand forcash or cash disbursements. Regular transfers are made from interest-bearing short-term investments or cash deposits into acurrent account. The Baumol model considers the annual demand for cash (D), the cost of each cash transfer (C), and theinterest difference between the rate paid on short-term investments (r1) and the rate paid on a current account (r2), in orderto calculate the optimum amount of funds to transfer (F). The model is as follows.

F = ((2 x D x C)/(r1 – r2))0·5

By optimising the amount of funds to transfer, the Baumol model minimises the opportunity cost of holding cash in the currentaccount, thereby reducing the costs of cash management.

However, the Baumol model is unlikely to be of assistance to Thorne Co because of the assumptions underlying itsformulation. Constant annual demand for cash is assumed, whereas its cash budget suggests that Thorne Co has a varyingneed for cash. The model assumes that each interest rate and the cost of each cash transfer are constant and known withcertainty. In reality interest rates and transactions costs are not constant and interest rates, in particular, can changefrequently. A cash management model which can accommodate a variable demand for cash, such as the Miller-Orr model,may be more suited to the needs of the company.

4Watson and Head (2004) Corporate Finance: Principles and Practice, 3rd edition, pp.291–2

21





Direct material cost 1Direct labour cost 1Fixed costs 2Taxation of operating cash flows 2Present value of income 1Present value of capital allowance tax benefits 3Present value of cash flows after year 4 3Initial investment and working capital 1Net present value 1

–––16

(b) Acceptability of proposed investment 2–3Discussion of additional information 4–5

–––Maximum 7

(c) PV of post Year 4 after-tax cash flows 2NPV of investing over ten years 1Present value comparison of offer with investing 2Discussion and conclusion 1

–––6

(d) Financial analysis 7–8Discussion 8–9Report format 1

–––Maximum 16

(e) Sales price variances 1Sales volume variances 2Discussion 2

–––5

–––50

2 (a) Responsibility centres 5–6Performance measurement 4–5Controllable and non-controllable factors 2–3

–––Maximum 12

(b) Return on capital employed 7–8Residual income 5–6Conclusion 1

–––Maximum 13

–––25

23



Marks Marks3 (a) ABC recovery rates 4

(b) Cost drivers for Product ZT3 2ABC overheads for Product ZT3 2General overheads for Product ZT3 2Direct labour cost 1Standard total unit cost 1Standard selling price 1

–––9

(c) Discussion of relevant issues 12–––25

4 (a) Purchase price 1Sale proceeds 1Capital allowances 1Balancing allowance 1Capital allowance tax benefits 1Maintenance costs 1Maintenance cost tax benefits 1NPV of borrowing to buy 1Lease rentals 1Lease rental tax benefits 1NPV of leasing 1Selection of cheapest option 1

–––12

(b) Explanation and discussionFinance lease 4–5Operating lease 4–5

–––Maximum 8

(c) Annual percentage rate 2Amount of equal instalments 3

–––5

–––25

5 (a) Credit sales 2Cash sales 1Proceeds from asset disposal 1Salaries 1Bonus 1Expenses 1Fixed overheads 1Taxation and interest 1Closing balances 1

–––10

(b) Discussion of factors 5

(c) Discussion of advantages and disadvantages 5

(d) Discussion of Baumol model 2–3Discussion of applicability in this case 2–3

–––Maximum 5

–––25

24




PART 2


QUESTION PAPER









Pape

r 2.4




1 The following financial information relates to Merton plc, a supplier of photographic equipment and film services tothe film industry.

Profit and loss accounts for years ended 30 April2006 2005 2004£m £m £m

Turnover 160·0 145·0 132·0Cost of sales 120·0 105·3 95·7

––––– ––––– –––––40·0 39·7 36·3

Operating expenses 30·0 26·0 23·5––––– ––––– –––––

Operating profit 10·0 13·7 12·8Interest 3·6 3·3 3·3

––––– ––––– –––––Profit before tax 6·4 10·4 9·5Taxation 1·9 3·1 2·8

––––– ––––– –––––Profit after tax 4·5 7·3 6·7Dividends 1·5 1·7 1·6

––––– ––––– –––––3·0 5·6 5·1

––––– ––––– –––––

Share price at 30 April: £2·70 £5·11 £4·69

Balance sheets as at 30 April2006 2005

£m £m £m £m £m £mFixed assets 45 35Current assets

Stock 36 32Debtors 41 24Cash 1 16

––– –––78 72

Current liabilitiesTrade creditors 17 11Overdraft 8 1

––– –––25 12

––– –––Net current assets 53 60

––– –––Total assets less current liabilities 98 95Long-term liabilities10% debentures 2008 13 138% debentures 2013 25 25

––– –––38 38

––– –––60 57

––– –––

Capital and reservesOrdinary shares (50 pence par) 10 10Reserves 50 47

––– –––60 57

––– –––

Notes: All sales are on credit. Merton currently pays interest on its overdraft at an annual rate of 4%, although thisrate is variable.

2



Shareholders of Merton plc have been alarmed by the company’s recent announcement that it intends to cut the totaldividend for the year. The announcement, which was released on 1 June 2006, also said that Merton plc isconsidering expanding into the retail camera market, as a result of which it expects future share price growth anddividend growth to be at least 8% per year. Following the announcement, the company’s share price fell from £2·70to £2·45 (on an ex dividend basis) where it has remained.

The Board of Merton plc has not announced how it plans to finance the proposed expansion into the retail cameramarket, but it believes that the additional capital needed would be at least £19 million. It also believes that theexpansion will generate an after-tax return of 9% per year. The newly-appointed Finance Director has suggested arights issue to finance the proposed expansion, but he is concerned that the recent fall in the company’s share pricemay cause many shareholders to decide against taking up their rights. Merton plc has not issued any new shares forthe last three years.

The Finance Director believes that a rights issue would be a 1 for 2 rights issue at a 20% discount to the currentshare price. The rights issue would be underwritten by the issuing house for a fee of £300,000.

The Finance Director decided when taking up his appointment that substantial improvement was needed in the areaof working capital management and asked the factoring subsidiary of a major bank to provide a quotation for non-recourse factoring. The factor has indicated that it would require an annual fee of 0·5% of sales. It would advanceMerton plc 80% of the face value of sales at an interest rate 1% above the current overdraft rate. It expects the averagetime taken by debtors to pay to fall immediately to 75 days, with a reduction to no more than the average for thesector within two years.

The Finance Director has also been assured that bad debts, currently standing at £500,000 per year, would fall by80%. Savings in current administration costs of Merton plc of £100,000 per year would be achieved as a result offactoring.

The Finance Director has collected the following average data for the media sector:

Return on capital employed 12% Stock days 100 daysGross profit margin 25% Debtor days 60 daysNet profit margin 8% Creditor days 50 daysInterest cover 8 times Current ratio 3·5 timesGearing (debt/equity using book values) 50% Quick ratio 2·5 times

Required:

(a) Using appropriate ratios and financial analysis, comment on:

(i) the view of the Finance Director that substantial improvement is needed in the area of working capitalmanagement of Merton plc; (10 marks)

(ii) the recent financial performance of Merton plc from a shareholder perspective. Clearly identify anyissues that you consider should be brought to the attention of the ordinary shareholders. (15 marks)

(b) Determine whether the factoring company’s offer can be recommended on financial grounds. Assume aworking year of 365 days and base your analysis on financial information for 2006. (8 marks)

(c) Calculate the theoretical ex rights price per share and the net funds to be raised by the rights issue, anddetermine and discuss the likely effect of the proposed expansion on:

(i) the current share price of Merton plc;(ii) the gearing of the company.

Assume that the price–earnings ratio of Merton plc remains unchanged at 12 times. (11 marks)

(d) Calculate the ex dividend share price predicted by the dividend growth model and discuss the company’sview that share price growth of at least 8% per year would result from expanding into the retail cameramarket. Assume a cost of equity capital of 11% per year. (6 marks)

(50 marks)

3 [P.T.O.




2 (a) Discuss the nature of the financial objectives that may be set in a not-for-profit organisation such as a charityor a hospital. (8 marks)

(b) Explain the meaning of the term ‘Efficient Market Hypothesis’ and discuss the implications for a company ifthe stock market on which it is listed has been found to be semi-strong form efficient. (9 marks)

(c) Discuss the difficulties that may be experienced by a small company which is seeking to obtain additionalfunding to finance an expansion of business operations. (8 marks)

(25 marks)

3 Ash plc recorded the following actual results for Product RS8 for the last month:

Product RS8 2,100 units produced and sold for £14·50 per unitDirect material M3 1,050 kg costing £1,680Direct material M7 1,470 kg costing £2,793Direct labour 525 hours costing £3,675Variable production overhead £1,260Fixed production overhead £4,725

Standard selling price and cost data for one unit of Product RS8 is as follows.

Selling price £15·00Direct material M3 0·6 kg at £1·55 per kgDirect material M7 0·68 kg at £1·75 per kgDirect labour 14 minutes at £7·20 per direct labour hourVariable production overhead £2·10 per direct labour hourFixed production overhead £9·00 per direct labour hour

At the start of the last month, 497 standard labour hours were budgeted for production of Product RS8. No stocks ofraw materials are held. All production of Product RS8 is sold immediately to a single customer under a just-in-timeagreement.

Required:

(a) Prepare an operating statement that reconciles budgeted profit with actual profit for Product RS8 for the lastmonth. You should calculate variances in as much detail as allowed by the information provided.

(17 marks)

(b) Discuss how the operating statement you have produced can assist managers in:

(i) controlling variable costs;(ii) controlling fixed production overhead costs. (8 marks)

(25 marks)

4



4 Sine Ltd produces a single product, Product DG, and is preparing budgets for the next three-month period, July toSeptember. The current cost data for Product DG is as follows.

£Direct Material X 1·5 kg at 3·50 per kg 5·25Direct Material P 2·0 kg at 4·50 per kg 9·00Direct labour 12 minutes at £8·00 per hour 1·60Variable production overhead £1·00 per unit 1·00Fixed production overhead £3·00 per direct labour hour 0·60

––––––17·45

––––––

Sine Ltd experiences seasonal changes in sales volumes and forecast sales for the next four months are expected tobe as follows.

Month July August September OctoberSales (units) 30,000 35,000 60,000 20,000

It has been decided that opening stocks of finished goods in August and September must be 20% of the expectedsales for the coming month. Closing stocks of finished goods in September must be 10% of the expected sales inOctober. Stocks of finished goods at the start of July are expected to be 4,000 units. Opening stocks of finished goodsin July are valued at £69,800.

There will be 30,000 kg of Material X and 40,400 kg of Material P in stock at the start of July. These stocks will bebought in June at the current prices per kilogram for each material. Further supplies of Material X and Material P willneed to be purchased for the higher prices of £3·80 per kg for Material X and £4·80 per kg for Material P due tosupplier price increases. Opening stocks of each material will remain at the same level as the start of July.

In any given month, any hours worked in excess of 8,000 hours are paid at an overtime rate of £12·00 per hour.

Sine Ltd operates a FIFO (first in, first out) stock valuation system.

Required:

(a) Prepare the following budgets for July, August and September and in total for the three-month period:

(i) Production budget, in units;(ii) Material usage budget, in kilograms;(iii) Production budget, in money terms. (10 marks)

(b) Calculate the value of the closing stocks of finished goods at the end of the three-month period, and the valueof cost of sales for the period. (3 marks)

(c) Discuss the ways in which budgets and the budgeting process can be used to motivate managers toendeavour to meet the objectives of the company. Your answer should refer to:

(i) setting targets for financial performance;(ii) participation in the budget-setting process. (12 marks)

(25 marks)

5 [P.T.O.



5 Charm plc, a software company, has developed a new game, ‘Fingo’, which it plans to launch in the near future. Salesof the new game are expected to be very strong, following a favourable review by a popular PC magazine. Charm plchas been informed that the review will give the game a ‘Best Buy’ recommendation. Sales volumes, productionvolumes and selling prices for ‘Fingo’ over its four-year life are expected to be as follows.

Year 1 2 3 4Sales and production (units) 150,000 70,000 60,000 60,000Selling price (£ per game) £25 £24 £23 £22

Financial information on ‘Fingo’ for the first year of production is as follows:

Direct material cost £5·40 per gameOther variable production cost £6·00 per gameFixed costs £4·00 per game

Advertising costs to stimulate demand are expected to be £650,000 in the first year of production and £100,000 inthe second year of production. No advertising costs are expected in the third and fourth years of production. Fixedcosts represent incremental cash fixed production overheads. ‘Fingo’ will be produced on a new production machinecosting £800,000. Although this production machine is expected to have a useful life of up to ten years, governmentlegislation allows Charm plc to claim the capital cost of the machine against the manufacture of a single product.Capital allowances will therefore be claimed on a straight-line basis over four years.

Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise.Charm plc uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your findings. (11 marks)

(b) Calculate the internal rate of return of the proposed investment and comment on your findings. (5 marks)

(c) Discuss the reasons why the net present value investment appraisal method is preferred to other investmentappraisal methods such as payback, return on capital employed and internal rate of return. (9 marks)

(25 marks)

6



7 [P.T.O.

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Answers



Part 2 Examination -– Paper 2.4Financial Management and Control June 2006 Answers

1 (a) (i) Discussion of working capital management

The Finance Director believes that substantial improvement in the area of working capital is needed. It should be notedthat turnover increased by 10·3% in 2006 and 9·8% in 2005, so an increase in working capital to support this growthis to be expected. This discussion will focus on the year ending 31 April 2006, but balance sheets for earlier periodswould allow a more complete analysis.

Stock managementThe average stock days for the sector are 100 days and Merton plc has marginally improved stock days from 111 daysin 2005 to 110 days in 2006. The increase in stock (12·5%) is similar to the increase in cost of sales (14%) andtherefore greater than the increase in turnover (10·3%). The reasons why the stock days are higher than the sector, andthe reason why stock has increased at a greater rate than turnover, should be investigated. There may be no cause forconcern in the area of stock management.

Debtor managementThe increase in debtors of 71% is much greater than the increase in turnover (10·3%) and it is therefore not surprisingto find that debtor days have deteriorated from 61 days in 2005 to 94 days in 2006. This compares unfavourably withthe sector average of 60 days, which the factoring company believes is achievable for Merton plc. It is possible that theincrease in turnover has been achieved in part by relaxing credit terms, but poor management of debtors is also apossibility.

Cash managementThe cash balance has declined from £16m to £1m due to financing an increase in current and fixed assets. Theoptimum level of cash needs to be found from cash flow forecasts and the expected transactions demand for cash. Theincreased reliance on overdraft finance is unwelcome, since the company is now carrying a total of £46m of debt andincurring annual interest of £3·6m: it is not clear how this debt is going to be repaid. Comments on the cashmanagement of Merton plc are not very useful in the absence of benchmark data.

Creditor managementMerton plc is just over the sector average creditors ratio of 50 days, having experienced an increase in creditor days from38 days to 52 days. This is not a cause for alarm, unless the increasing trend continues due to the company’s increasingreliance on short-term financing. In fact, taking full advantage of offered trade credit is good working capitalmanagement, in the absence of any incentives for early settlement.

Operating cycle and other ratiosThe operating cycle of Merton plc has lengthened from 134 days to 152 days and remains greater than the operatingcycle for the sector, which is 110 days (100 + 60 – 50). If the debtor days were reduced from 94 days to 60 days,the current operating cycle would fall to 118 days, which is similar to the sector average.

The current ratio of 3·1 times is less than the sector average of 3·5 times, but in 2005 it was almost twice the sectoraverage at 6 times. This could indicate that in 2005 the company was holding too much cash (£16m), but cashreserves might have been built up in preparation for the purchase of fixed assets, which have increased substantially.

The movement from a substantial cash surplus to a substantial overdraft has been the main factor causing the quickratio to decline from 3·3 times to 1·7 times, substantially below the sector average of 2·5 times.

Working capital financingMerton plc is increasingly relying on short-term finance from trade credit and a large overdraft. An increase in long-termfinance to support working capital is needed. It would be interesting to know what limit has been placed on the overdraftby the lending bank.

ConclusionOnly in the area of debtor management is there clear evidence to support the Finance Director’s view that substantialimprovement was needed in the area of working capital management. It is possible that this could be achieved byaccepting the factor’s offer. Attention also needs to be directed toward the company’s financing strategy, which from aworking capital perspective has become increasingly aggressive.

Analysis of key ratios and financial information

2006 2005Stock days (365 x 36/120) = 110 days (365 x 32/105·3) = 111 daysDebtor days (365 x 41/160) = 94 days (365 x 24/145) = 61 daysCreditor days (365 x 17/120) = 52 days (365 x 11/105·3) = 38 daysCurrent ratio (78/25) = 3·1 times (72/12) = 6·0 timesQuick ratio (42/25) = 1·7 times (40/12) = 3·3 timesOperating cycle (110 + 94 – 52) 152 days (111 + 61 – 38) 134 daysTurnover/NWC 160/53 = 3·0 times 145/60 = 2·4 times

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Growth rates: 2006 2005Turnover 160/145 = 10·3% 145/132 = 9·8%Cost of sales 120/105·3 = 14·0% 105·3/95·7 = 10·0%Operating expenses 30/26·0 = 15·4% 26·0/23·5 = 10·6%Stock 36/32 = 12·5%Debtors 41/24 = 71%

(ii) Discussion of financial performance

It is clear that 2006 has been a difficult year for Merton plc. There are very few areas of interest to shareholders whereanything positive can be found to say.

ProfitabilityReturn on capital employed has declined from 14·4% in 2005, which compared favourably with the sector average of12%, to 10·2% in 2006. Since asset turnover has improved from 1·5 to 1·6 in the same period, the cause of the declineis falling profitability. Gross profit margin has fallen each year from 27·5% in 2004 to 25% in 2006, equal to the sectoraverage, despite an overall increase in turnover during the period of 10% per year. Merton plc has been unable to keepcost of sales increases (14% in 2006 and 10% in 2005) below the increases in turnover. Net profit margin has declinedover the same period from 9·7% to 6·2%, compared to the sector average of 8%, because of substantial increases inoperating expenses (15·4% in 2006 and 10·6% in 2005). There is a pressing need here for Merton plc to bring costof sales and operating costs under control in order to improve profitability.

Gearing and financial riskGearing as measured by debt/equity has fallen from 67% (2005) to 63% (2006) because of an increase inshareholders’ funds through retained profits. Over the same period the overdraft has increased from £1m to £8m andcash balances have fallen from £16m to £1m. This is a net movement of £22m. If the overdraft is included, gearinghas increased to 77% rather than falling to 63%.

None of these gearing levels compare favourably with the average gearing for the sector of 50%. If we consider the largeincrease in the overdraft, financial risk has clearly increased during the period. This is also evidenced by the decline ininterest cover from 4·1 (2005) to 2·8 (2006) as operating profit has fallen and interest paid has increased. In each yearinterest cover has been below the sector average of eight and the current level of 2·8 is dangerously low.

Share priceAs the return required by equity investors increases with increasing financial risk, continued increases in the overdraftwill exert downward pressure on the company’s share price and further reductions may be expected.

Investor ratiosEarnings per share, dividend per share and dividend cover have all declined from 2005 to 2006. The cut in the dividendper share from 8·5 pence per share to 7·5 pence per share is especially worrying. Although in its announcement thecompany claimed that dividend growth and share price growth was expected, it could have chosen to maintain thedividend, if it felt that the current poor performance was only temporary. By cutting the dividend it could be signallingthat it expects the poor performance to continue. Shareholders have no guarantee as to the level of future dividends.This view could be shared by the market, which might explain why the price-earnings ratio has fallen from 14 times to12 times.

Financing strategyMerton plc has experienced an increase in fixed assets over the last period of £10m and an increase in stocks anddebtors of £21m. These increases have been financed by a decline in cash (£15m), an increase in the overdraft (£7m)and an increase in trade credit (£6m). The company is following an aggressive strategy of financing long-terminvestment from short-term sources. This is very risky, since if the overdraft needed to be repaid, the company wouldhave great difficulty in raising the funds required.

A further financing issue relates to redemption of the existing debentures. The 10% debentures are due to be redeemedin two years’ time and Merton plc will need to find £13m in order to do this. It does not appear that this sum can beraised internally. While it is possible that refinancing with debt paying a lower rate of interest may be possible, the lowlevel of interest cover may cause concern to potential providers of debt finance, resulting in a higher rate of interest. TheFinance Director of Merton plc needs to consider the redemption problem now, as thought is currently being given toraising a substantial amount of new equity finance. This financing choice may not be available again in the near future,forcing the company to look to debt finance as a way of effecting redemption.

OvertradingThe evidence produced by the financial analysis above is that Merton plc is showing some symptoms of overtrading(undercapitalisation). The board are suggesting a rights issue as a way of financing an expansion of business, but it ispossible that a rights issue will be needed to deal with the overtrading problem. This is a further financing issue requiringconsideration in addition to the redemption of debentures mentioned earlier.

ConclusionOrdinary shareholders need to be aware of the following issues.

1. Profitability has fallen over the last year due to poor cost control2. A substantial increase in the overdraft over the last year has caused gearing to increase

14



3. It is possible that the share price will continue to fall4. The dividend cut may warn of continuing poor performance in the future5. A total of £13m of debentures need redeeming in two year’s time6. A large amount of new finance is needed for working capital and debenture redemption

Appendix: Analysis of key ratios and financial information

2006 2005 2004Gross profit margin (%) (40·0/160) 25·0 (39·7/145·0) 27·4 (36·3/132) 27·5Net profit margin (%) (10·0/160) 6·2 (13·7/145) 9·4 (12·8/132) 9·7%Interest cover (times) (10/3·6) 2·8 (13·7/3·3) 4·1 (12·8/3·3) 3·9Earnings per share (pence) (4·5/20) 22·5 (7·3/20) 36·5 (6·7/20) 33·5Dividend per share (pence) (1·5/20) 7·5 (1·7/20) 8·5 (1·6/20) 8·0Dividend cover (times) (4·5/1·5) 3 (7·3/1·7) 4·3 (6·7/1·6) 4·2Price-earnings ratio (times) (270/22·5) 12 (511/36·5) 14 (469/33·5) 14

2006 2005ROCE (%) (10/98) 10·2 (13·7/95) 14·4Asset turnover (times) (160/98) 1·6 (145/95) 1·5Gearing (%) (38/60) 63 (38/57) 67Gearing (with overdraft, %) (46/60) 77 (39/57) 68

Growth rates:Cost of sales 120/105·3 = 14·0% 105·3/95·7 = 10·0%Operating expenses 30/26·0 = 15·4% 26·0/23·5 = 10·6%

(b) Evaluation of the offer made by the factoring company, assuming a reduction in bad debts of 80% (assuming that bad debtsare eliminated is also possible as the offer is for non-recourse factoring):

£ £Current level of debtors 41,000,000Proposed level of debtors = £160m x 75/365 = 32,876,712

–––––––––––Decrease in debtors 8,123,288

–––––––––––

Saving in overdraft interest = £8,123,288 x 0·04 = 324,931Reduction in bad debts = £500,000 x 0·8 = 400,000Reduction in administration costs 100,000

–––––––––––824,931

Interest cost of advance = £32,876,712 x 0·8 x 0·01 = 263,014Annual fee of factor = 0·005 x £160m = 800,000

–––––––––––1,063,014––––––––––

Net cost of factoring 238,083––––––––––

The factor’s offer is not financially acceptable on the basis of this analysis.

However, the factor believes that debtors’ days can be reduced to the sector average of 60 days over two years, so the analysiscan be repeated using this lower value.

£ £Current level of debtors 41,000,000Proposed level of debtors = £160m x 60/365 = 26,301,370

–––––––––––Decrease in debtors 14,698,630

–––––––––––

Saving in overdraft interest = £14,698,630 x 0·04 = 587,945Reduction in bad debts = £500,000 x 0·8 = 400,000Reduction in administration costs 100,000

–––––––––––1,087,945

Interest cost of advance = £26,301,370 x 0·8 x 0·01 = 210,411Annual fee of factor = 0·005 x £160m = 800,000

–––––––––––1,010,411––––––––––

Net benefit of factoring 77,534––––––––––

On this basis, the factor’s offer is marginally acceptable, but benefits will accrue over a longer time period. A more accurateanalysis, using expected levels of turnover and forecast interest rates, should be carried out.

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(c) Rights issue price = 2·45 x 0·8 = £1·96

Theoretical ex rights price = ((2 x 2·45) + (1 x 1·96))/3 = 6·86/3 = £2·29New shares issued = 20m x 1/2 = 10 million

Funds raised = 1·96 x 10m = £19·6 millionAfter issue costs of £300,000 funds raised will be £19·3 million

Annual after-tax return generated by these funds = 19·3 x 0·09 = £1,737,000New earnings of Merton plc = 1,737,000 + 4,500,000 = £6,237,000New number of shares = 20m + 10m = 30 millionNew earnings per share = 100 x 6,237,000/30,000,000 = 20·79 pence

New share price = 20·79 x 12 = £2·49

The weaknesses in this estimate are that the predicted return on investment of 9% may or may not be achieved: the price-earnings ratio depends on the post investment share price, rather than the post investment share price depending on theprice-earnings ratio; the current earnings seem to be declining and this share price estimate assumes they remain constant;in fact current earnings are likely to decline because the overdraft and annual interest are increasing but operating profit isfalling.

Expected gearing = 38/(60 + 19·3) = 47·9% compared to current gearing of 63%.Including the overdraft, expected gearing = 46/(60 + 19·3) = 58% compared to 77%.

The gearing is predictably lower, but if the overdraft is included in the calculation the gearing of the company is still higherthan the sector average. The positive effect on financial risk could have a positive effect on the company’s share price, butthis is by no means certain.

(d) The dividend growth model calculates the ex div share price from knowledge of the cost of equity capital, the expected growthrate in dividends and the current dividend per share (or next year’s dividend per share). Using the formula given in theformulae sheet, the dividend growth rate expected by the company of 8% per year and the decreased dividend of 7·5p pershare:

Share price = (7·5 x 1·08)/(0·11 – 0·08) = 270p or £2·70

This is the same as the share price prior to the announcement (£2·70) and so if dividend growth of 8% per year is achieved,the dividend growth model forecasts zero share price growth. The share price growth claim made by the company regardingexpansion into the retail camera market cannot therefore be substantiated.

In fact, a lower future share price of £2·49 was predicted by applying the current price-earnings ratio to the earnings pershare resulting from the proposed expansion. If this estimate is correct, a fall in share price of 7% can be expected.

The share price predicted by the dividend growth model of £2·70 would require an after-tax return on the proposed expansionof 11·66%, which is more than the 9% predicted by the Board. The current return on shareholders’ funds is 7·5% (4·5/60),but in 2005 it was 12·8% (7·3/57), so 11·66% may be achievable, but looks unlikely.

Since the market price fell from £2·70 to £2·45 following the announcement, it appears that the market does not believethat the forecast dividend growth can be achieved.

2 (a) In the case of a not-for-profit (NFP) organisation, the limit on the services that can be provided is the amount of funds thatare available in a given period. A key financial objective for an NFP organisation such as a charity is therefore to raise asmuch funds as possible. The fund-raising efforts of a charity may be directed towards the public or to grant-making bodies.In addition, a charity may have income from investments made from surplus funds from previous periods. In any period,however, a charity is likely to know from previous experience the amount and timing of the funds available for use. The sameis true for an NFP organisation funded by the government, such as a hospital, since such an organisation will operate underbudget constraints or cash limits. Whether funded by the government or not, NFP organisations will therefore have thefinancial objective of keeping spending within budget, and budgets will play an important role in controlling spending and inspecifying the level of services or programmes it is planned to provide.

Since the amount of funding available is limited, NFP organisations will seek to generate the maximum benefit from availablefunds. They will obtain resources for use by the organisation as economically as possible: they will employ these resourcesefficiently, minimising waste and cutting back on any activities that do not assist in achieving the organisation’s non-financialobjectives; and they will ensure that their operations are directed as effectively as possible towards meeting their objectives.The goals of economy, efficiency and effectiveness are collectively referred to as value for money (VFM). Economy isconcerned with minimising the input costs for a given level of output. Efficiency is concerned with maximising the outputsobtained from a given level of input resources, i.e. with the process of transforming economic resources into desires services.Effectiveness is concerned with the extent to which non-financial organisational goals are achieved.

Measuring the achievement of the financial objective of VFM is difficult because the non-financial goals of NFP organisationsare not quantifiable and so not directly measurable. However, current performance can be compared to historic performanceto ascertain the extent to which positive change has occurred. The availability of the healthcare provided by a hospital, forexample, can be measured by the time that patients have to wait for treatment or for an operation, and waiting times can becompared year on year to determine the extent to which improvements have been achieved or publicised targets have beenmet.

16



Lacking a profit motive, NFP organisations will have financial objectives that relate to the effective use of resources, such asachieving a target return on capital employed. In an organisation funded by the government from finance raised throughtaxation or public sector borrowing, this financial objective will be centrally imposed.

(b) The term ‘Efficient Market Hypothesis’ (EMH) refers to the view that share prices fully and fairly reflect all relevant availableinformation1. There are other kinds of capital market efficiency, such as operational efficiency (meaning that transaction costsare low enough not to discourage investors from buying and selling shares), but it is pricing efficiency that is especiallyimportant in financial management.

Research has been carried out to discover whether capital markets are weak form efficient (share prices reflect all past orhistoric information), semi-strong form efficient (share prices reflect all publicly available information, including pastinformation), or strong form efficient (share prices reflect all information, whether publicly available or not). This research hasshown that well-developed capital markets are weak form efficient, so that it is not possible to generate abnormal profits bystudying and analysing past information, such as historic share price movements. This research has also shown that well-developed capital markets are semi-strong form efficient, so that it is not possible to generate abnormal profits by studyingpublicly available information such as company financial statements or press releases. Capital markets are not strong formefficient, since it is possible to use insider information to buy and sell shares for profit.

If a stock market has been found to be semi-strong form efficient, it means that research has shown that share prices on themarket respond quickly and accurately to new information as it arrives on the market. The share price of a company quicklyresponds if new information relating to that company is released. The share prices quoted on a stock exchange are thereforealways fair prices, reflecting all information about a company that is relevant to buying and selling. The share price will factorin past company performance, expected company performance, the quality of the management team, the way the companymight respond to changes in the economic environment such as a rise in interest rate, and so on.

There are a number of implications for a company of its stock market being semi-strong form efficient. If it is thinking aboutacquiring another company, the market value of the potential target company will be a fair one, since there are no bargainsto be found in an efficient market as a result of shares being undervalued. The managers of the company should focus onmaking decisions that increase shareholder wealth, since the market will recognise the good decisions they are making andthe share price will increase accordingly. Manipulating accounting information, such as ‘window dressing’ annual financialstatements, will not be effective, as the share price will reflect the underlying ‘fundamentals’ of the company’s businessoperations and will be unresponsive to cosmetic changes. It has also been argued that, if a stock market is efficient, the timingof new issues of equity will be immaterial, as the price paid for the new equity will always be a fair one.

(c) Small businesses face a number of well-documented problems when seeking to raise additional finance. These problems havebeen extensively discussed and governments regularly make initiatives seeking to address these problems.

Risk and securityInvestors are less willing to offer finance to small companies as they are seen as inherently more risky than large companies.Small companies obtaining debt finance usually use overdrafts or loans from banks, which require security to reduce the levelof risk associated with the debt finance. Since small companies are likely to possess little by way of assets to offer as security,banks usually require a personal guarantee instead, and this limits the amount of finance available.

Marketability of ordinary sharesThe equity issued by small companies is difficult to buy and sell, and sales are usually on a matched bargain basis, whichmeans that a shareholder wishing to sell has to wait until an investor wishes to buy. There is no financial intermediary willingto buy the shares and hold them until a buyer comes along, so selling shares in a small company can potentially take a longtime. This lack of marketability reduces the price that a buyer is willing to pay for the shares. Investors in small companyshares have traditionally looked to a flotation, for example on the UK Alternative Investment Market, as a way of realising theirinvestment, but this has become increasingly expensive. Small companies are likely to be very limited in their ability to offernew equity to anyone other than family and friends.

Tax considerationsIndividuals with cash to invest may be encouraged by the tax system to invest in large institutional investors rather than smallcompanies, for example by tax incentives offered on contributions to pension funds. These institutional investors themselvesusually invest in larger companies, such as stock-exchange listed companies, in order to maintain what they see as anacceptable risk profile, and in order to ensure a steady stream of income to meet ongoing liabilities. This tax effect reducesthe potential flow of funds to small companies.

CostSince small companies are seen as riskier than large companies, the cost of the finance they are offered is proportionatelyhigher. Overdrafts and bank loans will be offered to them on less favourable terms and at more demanding interest rates thandebt offered to larger companies. Equity investors will expect higher returns, if not in the form of dividends then in the formof capital appreciation over the life of their investment.

1 Watson, D. and Head, A. (2004) Corporate Finance: Principles and Practice, 3rd edition, FT Prentice Hall, p.35

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3 (a) Operating statement for Product RS8 for the last month£

Budgeted gross profit (W1) 18,339·3Sales volume profit variance (W2) 258·3 (A)

–––––––––Actual sales at standard profit 18,081·0Sales price variance (W3) 1,050·0 (A)

–––––––––Actual sales less standard cost 17,031·0

Cost variances £ £Favourable Adverse

Direct material M3Price variance (W4) 52·5Usage variance (W5) 325·5

Direct material M7Price variance (W6) 220·5Usage variance (W7) 73·5

Direct labourRate variance (W8) 105·0Efficiency variance (W9) 252·0

Variable production overheadExpenditure variance (W10) 157·5Efficiency variance (W11) 73·5

Fixed production overheadExpenditure variance (W12) 252·0Volume variance (W13) 63·0

–––––– ––––––––430·5 1,144·5 714·0 (A)

–––––––––Actual gross profit (W14) 16,317·0

–––––––––

WorkingsNumber of units of RS8 budgeted to be produced in period = 497 x 60/14 = 2,130 units

Calculation of standard profit per unit: £Direct material M3 = 0·6 x 1·55 = 0·93Direct material M7 = 0·68 x 1·75 = 1·19Direct labour = 7·20 x 14/60 = 1·68Variable production overhead = 2·10 x 14/60 = 0·49Fixed production overhead = 9·00 x 14/60 = 2·10

––––––Total cost 6·39Selling price 15·00

––––––Standard gross profit per unit 8·61

––––––

(W1) Budgeted gross profit = 2,130 x 8·61 = £18,339·3

(W2) Sales volume profit variance = (2,130 – 2,100) x 8·61 = £258·3 (A)(W3) Sales price variance = (15.0 – 14·5) x 2,100 = £1,050·0 (A)

(W4) Material M3 price variance = (1·55 x 1,050) – 1,680 = £52·5 (A)(W5) Material M3 usage variance = ((2,100 x 0·6) – 1,050) x 1·55 = £325·5 (F)

(W6) Material M7 price variance = (1·75 x 1,470) – 2,793 = £220·5 (A)(W7) Material M7 usage variance = ((2,100 x 0·68) – 1,470) x 1·75 = £73·5 (A)

Mix and yield variances may be offered instead of usage variances:Actual quantity in actual proportions = (1,050 x 1·55) + (1,470 x 1·75) = £4,200Actual quantity in standard mix = (1,181.25 x 1·55) + (1,338·75 x 1·75) = £4,173·75Standard mix for actual yield = (1,260 x 1·55) + (1,428 x 1·75) = £4,452

Direct material mix variance = £4,173·75 – 4,200 = £26·25 (A)Direct material yield variance = 4,452 – 4,173·75 = £278·25 (F)

The sum of the mix and yield variances is the same as the sum of the usage variances

(W8) Direct labour rate variance = (7·2 x 525) – 3,675 = £105·0 (F)(W9) Direct labour efficiency variance = ((2,100 x 14/60) – 525) x 7·2 = £252·0 (A)

(W10) Variable overhead expenditure variance = (2·1 x 525) – 1,260 = £157·5 (A)(W11) Variable overhead efficiency variance = ((2,100 x 14/60) – 525) x 2·1 = £73·5 (A)

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Budgeted fixed production overhead = 497 x 9 = £4,473(W12) Fixed production overhead expenditure variance = 4,473 – 4,725 = £252·0 (A)

Standard hours for actual production = 2,100 x 14/60 = 490 hours(W13) Fixed production overhead volume variance = (490 – 497) x 9 = £63·0 (A)

Fixed production overhead efficiency and capacity variances may be offered:Budgeted standard labour hours = 497 hoursActual labour hours = 525 hoursStandard labour hours for actual production = 2,100 x 14/60 = 490 hours

Fixed production overhead efficiency variance = (490 – 525) x 9 = £315 (A)Fixed production overhead capacity variance = (497 – 525) x 9 = £252 (F)

The efficiency and capacity variances sum to the fixed production overhead volume variance

(W14) Actual gross profit calculation £Direct material M3 1,680Direct material M7 2,793Direct labour 3,675Variable production overhead 1,260Fixed production overhead 4,725

–––––––14,133

Sales revenue = 2,100 x 14·50 = 30,450–––––––16,317–––––––

(b) Controlling variable costsThe first step in the process of controlling costs is to measure actual costs. The second step is to calculate variances that showthe difference between actual costs and budgeted or standard costs. These variances then need to be reported to thosemanagers who have responsibility for them. These managers can then decide whether action needs to be taken to bring actualcosts back into line with budgeted or standard costs. The operating statement therefore has a role to play in reportinginformation to management in a way that assists in the decision-making process.

The operating statement quantifies the effect of the volume difference between budgeted and actual sales so that the actualcost of the actual output can be compared with the standard (or budgeted) cost of the actual output. The statement clearlydifferentiates between adverse and favourable variances so that managers can identify areas where there is a significantdifference between actual results and planned performance. This supports management by exception, since managers canfocus their efforts on these significant areas in order to obtain the most impact in terms of getting actual operations back inline with planned activity.

In control terms, variable costs can be affected in the short term and so an operating statement for the last month showingvariable cost variances will highlight those areas where management action may be effective. In the short term, for example,managers may be able to improve labour efficiency through training, or through reducing or eliminating staff actions whichdo not assist the production process. In this way the adverse direct labour efficiency variance of £252, which is 7·3% of thestandard direct labour cost of the actual output, could be reduced.

Controlling fixed production overhead costsIn the short term, it is unlikely that fixed production overhead costs can be controlled. An operating statement from last monthshowing fixed production overhead variances may not therefore assist in controlling fixed costs. Managers will not be able totake any action to correct the adverse fixed production overhead expenditure variance, for example, which may in fact simplyshow the need for improvement in the area of budget planning. Investigation of the component parts of fixed productionoverhead will show, however, whether any of these are controllable. In general, this is not the case2.

Absorption costing gives rise to a fixed production overhead volume variance, which shows the effect of actual productionbeing different from planned production. Since fixed production overheads are a sunk cost, the volume variance shows littlemore than that the standard hours for actual production were different from budgeted standard hours3. Similarly, the fixedproduction overhead efficiency variance offers little more in information terms than the direct labour efficiency variance. Whilefixed production overhead variances assist in reconciling budgeted profit with actual profit, therefore, their reporting in anoperating statement is unlikely to assist in controlling fixed costs.

2 Drury, C. (2004) Management and Cost Accounting, 6th edition, p.745–63 Drury, C. (2004) Management and Cost Accounting, 6th edition, p.751

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4 (a) Production budget (units)

Month July August September TotalSales (units) 30,000 35,000 60,000 125,000Closing stock (units) 7,000 12,000 2,000 2,000

––––––– ––––––– ––––––– ––––––––37,000 47,000 62,000 127,000

Opening stock (units) 4,000 7,000 12,000 4,000––––––– ––––––– ––––––– ––––––––

Production (units) 33,000 40,000 50,000 123,000––––––– ––––––– ––––––– ––––––––

Material usage budget (kg)Month July August September TotalMaterial X (kg) 49,500 60,000 75,000 184,500Material P (kg) 66,000 80,000 100,000 246,000

Production Budget (money terms)£ £ £ Total (£)

Material X 179,100 228,000 285,000 692,100Material P 304,680 384,000 480,000 1,168,680Labour 52,800 64,000 88,000 204,800Variable production overhead 33,000 40,000 50,000 123,000Fixed production overhead 19,800 24,000 30,000 73,800

–––––––– –––––––– –––––––– ––––––––––589,380 740,000 933,000 2,262,380–––––––– –––––––– –––––––– ––––––––––

Cost per unit £17·86 £18·50 £18·66

WorkingsMaterial X used in July = (30,000 x 3·50) + (19,500 x 3·80) = £179,100Material X used in August = 60,000 x 3·80 = £228,000Material X used in September = 75,000 x 3·80 = £285,000

Material P used in July = (40,400 x 4·50) + (25,600 x 4·80) = £304,800Material P used in August = 80,000 x 4·80 = £384,000Material P used in September = 100,000 x 4·80 = £480,000

Labour paid in July = 33,000 x (12/60) = 6,600 x 8·00 = £52,800Labour paid in August = 40,000 x (12/60) = 8,000 x 8·00 = £64,000Labour hours in September = 50,000 x (12/60) = 10,000 hoursLabour paid in September = (8,000 x 8·00) + (2,000 x 12·00) = £88,000

(b) Opening stock of finished goods = £69,800Closing stock of finished goods = 2,000 x 18·66 = £37,320Cost of sales for three-month period = 69,800 + 2,262,380 – 37,320 = £2,294,860

(c) Examiner’s Note:The topic of managerial motivation and budgeting has been a subject of discussion for a number of years. There are linkshere to the topics of performance measurement and responsibility accounting. Discussion should be focused on the area ofbudgets and the budgeting process, as specified in the question.

Setting targets for financial performanceIt has been reasonably established that managers respond better in motivation and performance terms to a clearly defined,quantitative target than to the absence of such targets. However, budget targets must be accepted by the responsiblemanagers if they are to have any motivational effect. Acceptance of budget targets will depend on several factors, includingthe personality of an individual manager and the quality of communication in the budgeting process.

The level of difficulty of the budget target will also influence the level of motivation and performance. Budget targets that areseen as average or above average will increase motivation and performance up to the point where such targets are seen asimpossible to achieve. Beyond this point, personal desire to achieve a particular level of performance falls off sharply. Carefulthought must therefore go into establishing budget targets, since the best results in motivation and performance terms willarise from the most difficult goals that individual managers are prepared to accept4.

While budget targets that are seen as too difficult will fail to motivate managers to improve their performance, the same istrue of budget targets that are seen as being too easy. When budget targets are easy, managers are likely to outperform thebudget but will fail to reach the level of performance that might be expected in the absence of a budget.

One consequence of the need for demanding or difficult budget targets is the frequent reporting of adverse variances. It isimportant that these are not used to lay blame in the budgetary control process, since they have a motivational (or planning)origin rather than an operational origin. Managerial reward systems may need to reward almost achieving, rather thanachieving, budget targets if managers are to be encouraged by receiving financial incentives.

4 Otley, D. (1987) Accounting Control and Organizational Behaviour, Heinemann, p.43

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Participation in the budget-setting processA ‘top-down’ approach to budget setting leads to budgets that are imposed on managers. Where managers within anorganisation are believed to behave in a way that is consistent with McGregor’s Theory X perspective, imposed budgets mayimprove performance, since accepting the budget is consistent with reduced responsibility and avoiding work.

It is also possible that acceptance of imposed budgets by managers who are responsible for their implementation andachievement is diminished because they feel they have not been able to influence budget targets. Such a view is consistentwith McGregor’s Theory Y perspective, which holds that managers naturally seek responsibility and do not need to be tightlycontrolled. According to this view, managers respond well to participation in the budget-setting process, since being able toinfluence the budget targets for which they will be responsible encourages their acceptance. A participative approach tobudget-setting is also referred to as a ‘bottom-up’ approach.

In practice, many organisations adopt a budget-setting process that contains elements of both approaches, with seniormanagement providing strategic leadership of the budget-setting process and other management tiers providing input in termsof identifying what is practical and offering detailed knowledge of their area of the organisation.

5 (a) Calculation of NPV of ‘Fingo’ investment project

Year 1 2 3 4£000 £000 £000 £000

Sales revenue 3,750 1,680 1,380 1,320Direct materials (810) (378) (324) (324)Variable production (900) (420) (360) (360)Advertising (650) (100)Fixed costs (600) (600) (600) (600)

–––––– ––––– ––––– –––––Taxable cash flow 790 182 96 36Taxation (237) (55) (29) (11)

–––––– ––––– ––––– –––––553 127 67 25

CA tax benefits 60 60 60 60–––––– ––––– ––––– –––––

Net cash flow 613 187 127 85Discount at 10% 0·909 0·826 0·751 0·683

–––––– ––––– ––––– –––––Present values 557·2 154·5 95·4 58·1

–––––– ––––– ––––– –––––

£000Present value of future benefits 865·2Initial investment 800·0

––––––Net present value 65·2

––––––

WorkingsFixed costs in year 1 = 150,000 x 4 = £600,000 and since these represent a one-off increase in fixed production overheads,these are the fixed costs in subsequent years as well.

Annual capital allowance (CA) tax benefits = (800,000/4) x 0·3 = £60,000 per year

CommentThe net present value of £65,200 is positive and the investment can therefore be recommended on financial grounds.However, it should be noted that the positive net present value depends heavily on sales in the first year. In fact, sensitivityanalysis shows that a decrease of 5% in first year sales will result in a zero net present value. (Note: candidates are notexpected to conduct a sensitivity analysis)

(b) Calculation of IRR of ‘Fingo’ investment project

Year 1 2 3 4£000 £000 £000 £000

Net cash flow 613 187 127 85Discount at 20% 0·833 0·694 0·579 0·482

–––––– ––––– ––––– –––––Present values 510·6 129·8 73·5 41·0

–––––– ––––– ––––– –––––

£000Present value of future benefits 754·9Initial investment 800·0

––––––Net present value (45·1)

––––––

Internal rate of return = 10 + [((20 – 10) x 65·2)/(65·2 + 45·1)] = 16%

Since the internal rate of return is greater than the discount rate used to appraise new investments, the proposed investmentis financially acceptable.

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(c) There are many reasons that could be discussed in support of the view that net present value (NPV) is superior to otherinvestment appraisal methods.

NPV considers cash flowsThis is the reason why NPV is preferred to return on capital employed (ROCE), since ROCE compares average annualaccounting profit with initial or average capital invested. Financial management always prefers cash flows to accounting profit,since profit is seen as being open to manipulation. Furthermore, only cash flows are capable of adding to the wealth ofshareholders in the form of increased dividends. Both internal rate of return (IRR) and Payback also consider cash flows.

NPV considers the whole of an investment projectIn this respect NPV is superior to Payback, which measures the time it takes for an investment project to repay the initialcapital invested. Payback therefore considers cash flows within the payback period and ignores cash flows outside of thepayback period. If Payback is used as an investment appraisal method, projects yielding high returns outside of the paybackperiod will be wrongly rejected. In practice, however, it is unlikely that Payback will be used alone as an investment appraisalmethod.

NPV considers the time value of moneyNPV and IRR are both discounted cash flow (DCF) models which consider the time value of money, whereas ROCE andPayback do not. Although Discounted Payback can be used to appraise investment projects, this method still suffers from thecriticism that it ignores cash flows outside of the payback period. Considering the time value of money is essential, sinceotherwise cash flows occurring at different times cannot be distinguished from each other in terms of value from theperspective of the present time.

NPV is an absolute measure of returnNPV is seen as being superior to investment appraisal methods that offer a relative measure of return, such as IRR and ROCE,and which therefore fail to reflect the amount of the initial investment or the absolute increase in corporate value. Defendersof IRR and ROCE respond that these methods offer a measure of return that is understandable by managers and which canbe intuitively compared with economic variables such as interest rates and inflation rates.

NPV links directly to the objective of maximising shareholders’ wealthThe NPV of an investment project represents the change in total market value that will occur if the investment project isaccepted. The increase in wealth of each shareholder can therefore be measured by the increase in the value of theirshareholding as a percentage of the overall issued share capital of the company. Other investment appraisal methods do nothave this direct link with the primary financial management objective of the company.

NPV always offers the correct investment adviceWith respect to mutually exclusive projects, NPV always indicates which project should be selected in order to achieve themaximum increase on corporate value. This is not true of IRR, which offers incorrect advice at discount rates which are lessthan the internal rate of return of the incremental cash flows. This problem can be overcome by using the incremental yieldapproach.

NPV can accommodate changes in the discount rateWhile NPV can easily accommodate changes in the discount rate, IRR simply ignores them, since the calculated internal rateof return is independent of the cost of capital in all time periods.

NPV has a sensible re-investment assumptionNPV assumes that intermediate cash flows are re-invested at the company’s cost of capital, which is a reasonable assumptionas the company’s cost of capital represents the average opportunity cost of the company’s providers of finance, i.e. itrepresents a rate of return which exists in the real world. By contrast, IRR assumes that intermediate cash flows are re-invested at the internal rate of return, which is not an investment rate available in practice,

NPV can accommodate non-conventional cash flowsNon-conventional cash flows exist when negative cash flows arise during the life of the project. For each change in sign thereis potentially one additional internal rate of return. With non-conventional cash flows, therefore, IRR can suffer from thetechnical problem of giving multiple internal rates of return.

22




Marks Marks1 (a) (i) Ratio calculations and financial analysis 5–6

Discussion of working capital management 5–6–––

Maximum 10

(ii) Ratio calculations and financial analysis 8–9Discussion of financial performance 7–8

–––Maximum 15

(b) Reduction in debtors and overdraft interest 2Decrease in bad debts and administration costs 1Interest cost of advance 1Factor’s fee 1Net cost of factoring and comment 1Analysis and comment on further reduction in debtors’ days 3

–––Maximum 8

(c) Rights issue price 1Theoretical ex rights price per share 1Net funds raised 1New earnings 1New earnings per share 1New share price 1Discussion of predicted share price 2Expected gearing 1Discussion 2

–––11

(d) Calculation of ex div share price 2Comparison with pre-announcement share price 1Comparison with earnings-based prediction 2Discussion 1

–––6

–––50

2 (a) Financial objectives related to funding 2–3Value for money 3–4Other financial objectives 2–3

–––Maximum 8

(b) Explanation of Efficient Market Hypothesis 2Discussion of forms of market efficiency 3–4Implications of Efficient Market Hypothesis 3–4

–––Maximum 9

(c) Risk 2Marketability of ordinary shares 2Tax considerations 2Cost 2

–––8

–––25

23



Marks Marks3 (a) Standard gross profit per unit 1

Budgeted production 1Budgeted gross profit 1Sales volume profit variance 1Sales price variance 1Material price variances 2Material usage. mix and yield variances 2–3Labour rate variance 1Labour efficiency variance 1Variable overhead expenditure variance 1Variable overhead efficiency variance 1Fixed overhead expenditure variance 1Fixed overhead volume, efficiency and capacity variances 2–3Actual gross profit 1Operating statement format 1

–––Maximum 17

(b) Controlling variable costs 5-6Controlling fixed costs 3-4

–––Maximum 8

–––25

4 (a) Production budget (units) 2Material usage budget 1Material X costs 1Material P costs 1Direct labour costs 2Variable production overhead cost 1Fixed production overhead cost 1Total budgets 1

–––10

(b) Closing stock of finished goods 1Cost of sales 2

–––3

(c) Up to 3 marks for each detailed point made 12–––25

24




Material costs 1Variable production costs 1Advertising 1Incremental fixed costs 2Taxation 1Capital allowance tax benefits 1Discount factors 1Net present value 1Comment 1

–––11

(b) Net present value 1IRR 3Comment 1

–––5


25




PART 2


QUESTION PAPER









Pape

r 2.4




1 Hendil plc, a manufacturer of electronic equipment, has prepared the following draft financial statements for the yearthat has just ended. These financial statements have not yet been made public.

Profit and loss account £000Turnover 9,600Cost of sales 5,568

––––––Gross profit 4,032Operating expenses 3,408

––––––Profit before interest and tax 624Interest 156

––––––Profit before tax 468Taxation 140

––––––Profit after tax 328Dividends 300

––––––Retained profit 28

––––––

Balance Sheet £000 £000 £000Fixed assets 2,250Current assets

Stocks 1,660Debtors 2,110Cash 780

––––––4,550

Current liabilitiesTrade creditors 750Dividends 300Overdraft 450

––––––1,500

––––––Net current assets 3,050

––––––Total assets less current liabilities 5,30010% debenture, repayable 2015 1,200

––––––4,100

––––––

Capital and reservesOrdinary shares, par value 50p 1,000Profit and loss 3,100

––––––4,100

––––––

Hendil plc pays interest on its overdraft at an annual rate of 6%. The 10% debenture is secured on fixed assets ofthe company.

Hendil plc plans to invest £1 million in a new product range and has forecast the following financial information:

Year 1 2 3 4Sales volume (units) 70,000 90,000 100,000 75,000Average selling price (£/unit) 40 45 51 51Average variable costs (£/unit) 30 28 27 27Incremental cash fixed costs (£/year) 500,000 500,000 500,000 500,000

The above cost forecasts have been prepared on the basis of current prices and no account has been taken of inflationof 4% per year on variable costs and 3% per year on fixed costs. Working capital investment accounts for £200,000

2



of the proposed £1 million investment and machinery for £800,000. Hendil uses a four-year evaluation period forcapital investment purposes, but expects the new product range to continue to sell for several years after the end ofthis period. Capital investments are expected to pay back within two years on an undiscounted basis, and within threeyears on a discounted basis. The company pays tax on profits in the year in which liabilities arise at an annual rateof 30% and claims capital allowances on machinery on a 25% reducing balance basis. Balancing allowances orcharges are claimed only on the disposal of assets.

Average data on companies similar to Hendil plc:Interest cover 6 timesLong-term debt/ equity (book value basis) 50%Long-term debt/ equity (market value basis) 25%

The ordinary shareholders of Hendil plc require an annual return of 12%. Its ordinary shares are currently trading onthe stock market at £1·80 per share. The dividend paid by the company has increased at a constant rate of 5% peryear in recent years and, in the absence of further investment, the directors expect this dividend growth rate tocontinue for the foreseeable future.

Required:

(a) (i) Calculate the ordinary share price of Hendil plc, predicted by the dividend growth model. (4 marks)

(ii) Explain the concept of market efficiency and distinguish between strong form efficiency and semi-strongform efficiency. (6 marks)

(iii) Discuss why the share price predicted by the dividend growth model is different from the current marketprice. (4 marks)

(b) (i) Using Hendil plc’s current average cost of capital of 11%, calculate the net present value of theproposed investment. (14 marks)

(ii) Calculate, to the nearest month, the payback period and the discounted payback period of the proposedinvestment. (4 marks)

(iii) Discuss the acceptability of the proposed investment and explain ways in which your net present valuecalculation could be improved. (6 marks)

(c) It has been suggested that the proposed £1 million investment could be financed by a new issue of debentureswith an interest rate of 8%, redeemable after 15 years and secured on existing assets of Hendil plc. The existingdebentures of the company are trading at £113 per £100 nominal value.

Required:

Evaluate and discuss the suggestion to finance the proposed investment with the new debenture issuedescribed above. Your answer should consider, but not be limited to, the effect of the new issue on:

(i) interest cover;(ii) gearing;(iii) ordinary share price. (12 marks)

(50 marks)

3 [P.T.O.




2 Cavic Ltd services custom cars and provides its clients with a courtesy car while servicing is taking place. It has afleet of 10 courtesy cars which it plans to replace in the near future. Each new courtesy car will cost £15,000. Thetrade-in value of each new car declines over time as follows:

Age of courtesy car (years) 1 2 3Trade-in value (£/car) 11,250 9,000 6,200

Servicing and parts will cost £1,000 per courtesy car in the first year and this cost is expected to increase by 40%per year as each vehicle grows older. Cleaning the interior and exterior of each courtesy car to keep it up to thestandard required by Cavic’s clients will cost £500 per car in the first year and this cost is expected to increase by25% per year.

Cavic Ltd has a cost of capital of 10%. Ignore taxation and inflation.

Required:

(a) Using the equivalent annual cost method, calculate whether Cavic Ltd should replace its fleet after one year,two years, or three years. (12 marks)

(b) Discuss the causes of capital rationing for investment purposes. (4 marks)

(c) Explain how an organisation can determine the best way to invest available capital under capital rationing.Your answer should refer to the following issues:

(i) single-period capital rationing;(ii) multi-period capital rationing;(iii) project divisibility;(iv) the investment of surplus funds. (9 marks)

(25 marks)

4



3 Extracts from the recent financial statements of Anjo plc are as follows:

Profit and loss accounts 2006 2005£000 £000

Turnover 15,600 11,100Cost of sales 9,300 6,600

––––––– –––––––Gross profit 6,300 4,500Administration expenses 1,000 750

––––––– –––––––Profit before interest and tax 5,300 3,750Interest 100 15

––––––– –––––––Profit before tax 5,200 3,735

––––––– –––––––

Balance sheets 2006 2005£000 £000 £000 £000

Fixed assets 5,750 5,400Current assets

Stocks 3,000 1,300Debtors 3,800 1,850Cash 120 900

–––––– ––––––6,920 4,050

Current liabilitiesTrade creditors 2,870 1,600Overdraft 1,000 150

–––––– ––––––(3,870) (1,750)–––––– ––––––

Total assets less current liabilities 8,800 7,700–––––– ––––––

All sales were on credit. Anjo plc has no long-term debt. Credit purchases in each year were 95% of cost of sales.Anjo plc pays interest on its overdraft at an annual rate of 8%. Current sector averages are as follows:

Stock days: 90 days Debtor days: 60 days Creditor days: 80 days

Required:

(a) Calculate the following ratios for each year and comment on your findings.

(i) stock days(ii) debtor days(iii) creditor days (6 marks)

(b) Calculate the length of the cash operating cycle (working capital cycle) for each year and explain itssignificance. (4 marks)

(c) Discuss the relationship between working capital management and business solvency, and explain the factorsthat influence the optimum cash level for a business. (7 marks)

(d) A factor has offered to take over sales ledger administration and debt collection for an annual fee of 0·5% of creditsales. A condition of the offer is that the factor will advance Anjo plc 80% of the face value of its debtors at aninterest rate 1% above the current overdraft rate. The factor claims that it would reduce outstanding debtors by30% and reduce administration expenses by 2% per year if its offer were accepted.

Required:

Evaluate whether the factor’s offer is financially acceptable, basing your answer on the financial informationrelating to 2006. (8 marks)

(25 marks)

5 [P.T.O.



4 (a) Explain three different types of standard that may be used in a standard costing system. (6 marks)

(b) Discuss the key elements of a standard costing system, illustrating your answer with examples whereappropriate. Your answer should include a discussion of:

(i) the preparation of standard costs;(ii) the use of standard costs;(iii) the review of standard costs. (13 marks)

(c) Discuss the circumstances under which variances arising in a standard costing system should beinvestigated. (6 marks)

(25 marks)

5 The following information relates to budget period 1 for Leysel Co:

Budget Budget Actual for period(60,000 units) (90,000 units)

Sales £900,000 £1,350,000 £1,240,000Raw materials £450,000 £675,000 £632,400Labour £155,000 £207,500 £165,200Production overheads £190,000 £235,000 £238,000

Actual production and sales in budget period 1 were 80,000 units. Actual labour costs for the period included£50,000 of fixed labour costs. Actual production overheads for the period included £110,000 of fixed productionoverheads.

Required:

(a) Using a marginal costing approach, prepare a flexed budget for the period and calculate appropriatevariances in as much detail as allowed by the information provided above. (10 marks)

(b) In budget period 2, Leysel Co planned to absorb fixed production overheads of £112,500 on a standard labourhour basis. A total of 22,500 standard labour hours were budgeted but only 16,000 labour hours were actuallyworked in the period. Standard labour hours for actual production were 22,000 hours.

Required:

Calculate the fixed production overhead efficiency variance for period 2 and explain its meaning.(4 marks)

(c) Explain how budgeting can help organisations to achieve their objectives. (11 marks)

(25 marks)

6



7 [P.T.O.

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Answers




1 (a) (i) Number of ordinary shares = 1,000,000/0·5 = 2 millionCurrent dividend per share = 100 x (300,000/2,000,000) = 15pShare price predicted by dividend growth model = (15 x 1·05)/(0·12 – 0·05) = 225p

(ii) Market efficiency is usually taken to refer to the way in which ordinary share prices reflect information. Fama definedan efficient market as one in which share prices fully and fairly reflect all available information.

A semi-strong form efficient market is one where share prices reflect all publicly available information, such as past shareprice movements, published company annual reports and analysts’ reports in the financial press.

A strong form efficient market is one where share prices reflect all information, whether publicly available or not. Shareprices would reflect, for example, takeover decisions made at private board meetings.

(iii) The share price predicted by the dividend growth model is 45p greater than the current share price of the company.However, the dividend growth model has used the proposed dividend of the company (15p), which may not yet havebeen made public. If the stock market is semi-strong form efficient and therefore unaware of the proposed dividend, thecompany’s ordinary share price could be different to that predicted by the dividend growth model because the marketexpects a dividend which is different from the proposed dividend used in the model. Working backwards using thedividend growth model suggests that the market expects a dividend of 12p per share (180 x (0·12 – 0·05)/1·05).

In a strong form efficient market, the information about the proposed dividend will be known. The difference betweenthe share price predicted by the dividend growth model and the current share price of the company may therefore beexplained by different views of the expected dividend growth rate or the return required by ordinary shareholders. Themarket might expect a lower growth rate than the 5% expected by the directors, for example, or the return required byordinary shareholders might have increased due to economic expectations or changing perceptions of risk. An increasein the required return to 13·75% would give a share price of £1·80 (15 x 1·05/(0·1375 – 0·05)). Another explanationis that the market may not be fully efficient.

(b) (i) Calculation of NPV

Year 1 2 3 4£000 £000 £000 £000

Sales revenue 2,800 4,050 5,100 3,825Variable costs 2,184 2,727 3,040 2,370

–––––– –––––– –––––– ––––––Contribution 616 1,323 2,060 1,455Fixed costs 515 530 546 563

–––––– –––––– –––––– ––––––Taxable cash flow 101 793 1,514 892Taxation 30 238 454 268

–––––– –––––– –––––– ––––––71 555 1,060 624

Capital allowance tax benefits 60 45 34 25–––––– –––––– –––––– ––––––

After-tax cash flow 131 600 1,094 64911% discount factors 0·901 0·812 0·731 0·659

–––––– –––––– –––––– ––––––Present values 118 487 800 428

–––––– –––––– –––––– ––––––

£000Sum of present values of future benefits 1,833Less initial investment 1,000

–––––Net present value 833

–––––

Because the investment continues in operation after the four-year period, working capital is not recovered in the abovecalculation. It is possible to make an assumption concerning incremental investment in working capital to accommodateinflation, but no specific inflation rate for working capital is provided. An assumption of 3–4% inflation in working capitalwould be reasonable given the expected inflation in variable and fixed costs.

The NPV calculation uses the company’s four-year evaluation period, but the terminal value of the investment at the endof this period could sensibly be considered. The remaining capital allowance tax benefit of £76,000 (800 x 30% – 60– 45 – 34 – 25) could be taken at the end of year 5 (other assumptions are possible) giving a present value of 76 x0·593 = £45,100. The after-tax cash flow (before capital allowance tax benefits) of £624,000 in year 4 could beassumed to continue for another four years (other assumptions are possible) giving a present value of 624 x 3·102 x0·659 = £1,276,000. These considerations would increase the net present value of the investment by 158% to£2,154,100.

13



Workings

Sales RevenueYear 1 2 3 4Sales volume (units) 70,000 90,000 100,000 75,000Selling price (£/unit) 40 45 51 51Sales revenue (£000/yr) 2,800 4,050 5,100 3,825

Variable costsYear 1 2 3 4Variable costs (£/unit) 30 28 27 27Inflated cost (£/unit) 31·2 30·3 30·4 31·6Sales volume (units) 70,000 90,000 100,000 75,000Variable costs (£000/yr) 2,184 2,727 3,040 2,370

Fixed costsFixed costs (£/year) 500,000 500,000 500,000 500,000Inflated cost (£/yr) 515,000 530,000 546,000 563,000

Capital allowance tax benefitsYear Capital allowance Tax benefit1 £800,000 x 0·25 = £200,000 £200,000 x 0·3 = £60,0002 £600,000 x 0·25 = £150,000 £150,000 x 0·3 = 45,0003 £450,000 x 0·25 = £112,500 £112,500 x 0·3 = £33,7504 £337,500 x 0·25 = £84,375 £84,375 x 0·3 = £25,312

(ii) Calculation of payback

Year Cash flow Cumulative cash flow£000 £000

0 (1,000) (1,000)1 131 (869)2 600 (269)3 1,094 8254 649 1,474

Payback period = 2 + (269/1,094) = 2 years 3 months

Calculation of discounted payback

Year Discounted cash flow Cumulative cash flow£000 £000

0 (1,000) (1,000)1 118 (882)2 487 (395)3 800 4054 428 833

Discounted payback period = 2 + (395/800) = 2 years 6 months

(iii) The proposed investment has a positive net present value of £833,000 over four years of operation compared with aninitial investment of £1 million and so is financially acceptable. The company has payback and discounted paybacktargets, but these are not a guide to project acceptability because of the shortcomings of payback as an investmentappraisal method. The proposed investment fails to meet the payback target of two years, but meets the discountedpayback target of three years. While discounted payback counters the criticism that payback ignores the time value ofmoney, it still ignores cash flows outside of the discounted payback period and so cannot be recommended to evaluateother than conventional investments.

The net present value calculation could be improved in several ways. One obvious improvement would be theconsideration of project cash flows beyond the four-year evaluation period used by Hendil plc. The company expects thenew product range to sell for several years after the end of the evaluation period and if these sales are at a profit, thenet present value would be higher than calculated. Another improvement would be more detailed information about thenew product range, for which only average selling price and average variable cost data are provided. The basis for theseaverages is not stated and it is not known whether the products in the new range are substitutes or alternatives, orwhether a constant product mix is being assumed. The basis for the changing annual sales volumes should also beexplained.

The assumption of constant annual inflation for variable and fixed costs is questionable. The information providedimplies that inflation may have been taken into account in forecasting selling prices, but the selling price growth ratesare sequentially 12·5%, 13·3% and zero, and so some factor other than inflation has also been used in the selling priceforecast. The net present value evaluation could be improved if the basis for the forecast was known and could beverified as reasonable.

14



(c) Interest coverAverage interest cover of similar companies = 6 timesCurrent interest cover = 624/156 = 4 timesAnnual interest on new debentures = £1m x 0·08 = £80,000Assuming no change to existing interest, increased annual interest = 80 + 156 = £236,000Interest cover after new debenture issue = 624/236 = 2·6 timesThis would not change significantly if profit before interest and tax were increased by the profit (after accounting depreciation)from the first year’s sales of the proposed investment.

The current interest cover of Hendil plc (four times) is less than the average interest cover of similar companies (six times),suggesting that the financial risk of the company is higher than that of similar companies even before the new debt is issued.After the new issue, interest cover would fall to 2·6 times, a level that would be regarded with concern by both lenders andinvestors. Although the interest on the new debt might be overstated in our interest cover calculation (debt in the balancesheet accounts for only part of the interest in the profit and loss account, implying that the overdraft may have decreasedsubstantially in the last year), it is likely that a new debt issue might be unwise.

Gearing (long-term debt/equity)Average gearing (book value basis) of similar companies = 50%Current gearing (book value basis) = 29%Revised gearing (book value basis) = 54%

Average gearing (market value basis) of similar companies = 25%Current gearing (market value basis) = 38%Revised gearing (market value basis) = 65%

Two conclusions can be drawn from these gearing values. Firstly, the current gearing of Hendil plc is below the averagegearing of similar companies on a book value basis, but higher than the average gearing of similar companies on a marketvalue basis. Secondly, the revised gearing of Hendil plc after the new issue is slightly above the average gearing of similarcompanies on a book value basis, and more than double the average gearing of similar companies on a market value basis.Gearing based on market values is preferred in financial management.

WorkingsCurrent gearing (book value basis) = 100 x (1,200/4,100) = 29%

Revised book value of long-term debt = 1·2m + 1m = £2·2 millionRevised gearing (book value basis) = 100 x (2,200/4,100) = 54%

Market value of debt = £1.2m x 113/ 100 = £1,356,000Number of ordinary shares = 1,000,000/0·5 = 2 millionMarket value of ordinary shares = 2m x 1·80 = £3·6 millionCurrent gearing (market value basis) = 100 x (1,356/3,600) = 38%

Market value of new debt issue = £1 millionTotal market value of debt = 1,356 + 1,000 = £2,356,000Market value of ordinary shares = 2m x 1·80 = £3·6 millionRevised gearing (market value basis) = 100 x (2,356/3,600) = 65%

The calculation of the revised gearing (market value basis) assumes that the ordinary share price and the market value ofexisting debt are unchanged. An alternative calculation could use a revised share price, for example £2·22 per share (seebelow), giving a lower gearing on a market value basis of 100 x (2,356/ (2m x 2·22)) = 53%.

Ordinary share priceCurrent ordinary share price = £1·80 per shareCurrent market value of company = 1·80 x 2m = £3·6 millionNet present value of investment = £832,000If the market is efficient, the value of the company will increase by the NPV of the investment, although this assumes thatthe current average cost of capital of Hendil plc, which was used as the discount rate in the NPV analysis, would remainunchanged by the new debenture issue. This may not be true.Revised market value = 3,600 + 832 = £4,432 millionRevised ordinary share price = 4,432,000/2,000,000 = £2·22 per share

MaturityThe proposed debenture has a maturity of 15 years but the life of the proposed investment is not clear. We know that it ismore than four years, but we do not know how much more. We also do not know whether the new machinery can be usedto produce other products, whether at the same time as the new product range or when the new product range is in thedecline phase of its product life-cycle. The matching principle holds that maturity of finance should match the expected lifeof the assets financed.

SecurityIt has been suggested that the new debenture could be secured on existing assets of Hendil plc. This would be on fixed assetsrather than current assets. Since the existing £1·2 million debenture is secured on fixed assets of the company, the most thatmight be available is £1·05 million of fixed assets. However, since debentures are secured on particular assets rather thanon a given value of assets, there may be insufficient existing fixed assets to offer as security for the new debentures issue.The new machinery may be suitable to offer as security in order to make up the deficit.

15



2 (a) Calculation of Equivalent Annual Cost

Year 1 2 3Servicing costs 10,000 14,000 19,600Cleaning costs 5,000 6,250 7,813

––––––– ––––––– –––––––Total costs 15,000 20,250 27,413Discount factors 0·909 0·826 0·751

––––––– ––––––– –––––––Present values of costs 13,635 16,727 20,587

––––––– ––––––– –––––––

Replacement cycle (years) 1 2 3Cost of new vehicles 150,000 150,000 150,000PV of Year 1 costs 13,635 13,635 13,635PV of Year 2 costs 16,727 16,727PV of Year 3 costs 20,587

––––––– ––––––– –––––––Sum of PV of costs 163,635 180,362 200,949Less PV of trade-in value 102,263 74,340 46,562

––––––– ––––––– –––––––Net PV of cost of cycle 61,372 106,022 154,387Annuity factor 0·909 1·736 2·487

––––––– ––––––– –––––––Equivalent annual cost 67,516 61,073 62,078

––––––– ––––––– –––––––

Replacement after two years is recommended, since this replacement cycle has the lowest equivalent annual cost.

Examiner’s NoteThe above evaluation could have been carried out on a per car basis rather than on a fleet basis with the same conclusionbeing made.

Workings

Servicing costsYear 1: 1,000 x 10 = £10,000Year 2: 10,000 x 1·4 = £14,000Year 3: 14,000 x 1·4 = £19,600

Cleaning costsYear 1: 500 x 10 = £5,000Year 2: 5,000 x 1·25 = £6,250Year 3: 6,250 x 1·25 = £7,813

PV of trade-in valuesYear 1: 11,250 x 10 x 0·909 = £102,263Year 2 9,000 x 10 x 0·826 = £74,340Year 3: 6,200 x 10 x 0·751 = £46,562

(b) In order to invest in all projects with a positive net present value a company must be able to raise funds as and when it needsthem: this is only possible in a perfect capital market. In practice capital markets are not perfect and the capital available forinvestment is likely to be limited or rationed. The causes of capital rationing may be external (hard capital rationing) or internal(soft capital rationing). Soft capital rationing is more common than hard capital rationing.

When a company cannot raise external finance even though it wishes to do so, this may be because providers of debt financesee the company as being too risky. In terms of financial risk, the company’s gearing may be seen as too high, or its interestcover may be seen as too low. From a business risk point of view, lenders may be uncertain whether a company’s futureprofits will be sufficient to meet increased future interest payments because its trading prospects are poor, or because theyare seen as too variable.

When managers impose restrictions on the funds they are prepared to make available for capital investment, soft capitalrationing is said to occur. One reason for soft capital rationing is that managers may not want to raise new external finance.For example, they may not wish to raise new debt finance because they believe it would be unwise to commit the companyto meeting future interest payments given the current economic outlook. They may not wish to issue new equity because thefinance needed is insufficient to justify the transaction costs of a new issue, or because they wish to avoid dilution of control.Another reason for soft capital rationing is that managers may prefer slower organic growth, where they can remain in controlof the growth process, to the sudden growth arising from taking on one or more large investment projects.

A key reason for soft capital rationing is the desire by managers to make capital investments compete for funds, i.e. to createan internal market for investment funds. This competition for funds is likely to weed out weaker or marginal projects, therebychannelling funds to more robust investment projects with better chances of success and larger margins of safety, andreducing the risk and uncertainty associated with capital investment.

(c) The net present value decision rule is to invest in all projects that have a positive net present value. By following this decisionrule, managers will maximise the value of a company and therefore maximise the wealth of ordinary shareholders, which is

16



a primary objective of financial management. Even when capital is rationed, it is still essential to be able to offer advice onwhich capital investment projects should be selected in order to secure the maximum return for the investing company, i.e.the maximum overall net present value.

Single-period and multi-period capital rationingCapital may be rationed in more than one period, i.e. not only in the current period at the start of an investment project(single-period rationing), but in future periods as well (multi-period capital rationing). Selecting the best projects forinvestment in order to maximise overall net present value when faced with multi-period capital rationing calls for the use oflinear programming. Here, the available capital investments are expressed as an objective function, subject to a series ofconstraints. Only simple linear programming problems can be solved by hand, for example using the simplex method. Morecomplex linear programming problems require the use of computers.

Project divisibilityThe approach to solving single-period capital rationing problems depends on whether projects are divisible or not. A divisibleproject is one where a partial investment can be made in order to gain a pro rata net present value. For example, investingin a forest is a divisible project, since the amount of land purchased can be varied according to the funds available forinvestment (providing the seller agrees to a partial sale, of course). A non-divisible project is one where it is not possible toinvest less than the full amount of capital. When building an oil refinery, for example, it is not possible to build only one partof the overall facility.

Where projects are divisible, the objective of maximising the net present value arising from invested funds can be achievedby ranking projects according to their profitability index and investing sequentially in order of decreasing profitability index,beginning with the highest, assuming that each project can be invested in only once, i.e. is non-repeatable. The profitabilityindex can be defined as net present value divided by initial investment. Ranking projects by profitability index is an exampleof limiting factor analysis. Because projects are divisible, there will be no investment funds left over: when investment fundsare insufficient to for the next ranked project, part of the project can be taken on because it is divisible.

When projects are non-divisible, the objective of maximising the net present value arising from invested funds can be achievedby calculating the net present value arising from different combinations of projects. With this approach, there will usually besome surplus funds remaining from the funds initially available.

The investment of surplus fundsWhen investigating combinations of non-divisible projects in order to find the combination giving rise to the highest netpresent value, any return from investing surplus funds is ignored. The net present value analysis has been based on thecompany’s average cost of capital and it is unlikely that surplus funds can be invested in order to earn a return as high asthis. Investment of surplus funds in, for example, the money markets would therefore be an investment project that would berejected as having a negative net present value, or an internal rate of return less than the company’s average cost of capitalif using IRR to assess investments projects. However, it is good working capital management to ensure that liquid funds areinvested to earn the highest available return, subject to any risk constraints, in order to increase overall profitability.

3 (a) Calculation of ratios

Stock days 2006: (3,000/9,300) x 365 = 118 days2005: (1,300/6,600) x 365 = 72 daysSector average: 90 days

Debtor days 2006: (3,800/15,600) x 365 = 89 days2005: (1,850/11,100) x 365 = 61 daysSector average: 60 days

Creditor days 2006: (2,870/9,300 x 0·95) x 365 = 119 days2005: (1,600/6,600 x 0·95) x 365 = 93 daysSector average: 80 days

In each case, the ratio in 2006 is higher than the ratio in 2005, indicating that deterioration has occurred in the managementof stock, debtors and creditors in 2006.

Stock days have increased by 46 days or 64%, moving from below the sector average to 28 days – one month – more thanit. Given the rapid increase in turnover (40%) in 2006, Anjo plc may be expecting a continuing increase in the future andmay have built up stocks in preparation for this, i.e. stock levels reflect future sales rather than past sales. Accountingstatements from several previous years and sales forecasts for the next period would help to clarify this point.

Debtor days have increased by 28 days or 46% in 2006 and are now 29 days above the sector average. It is possible thatmore generous credit terms have been offered in order to stimulate sales. The increased turnover does not appear to be dueto offering lower prices, since both gross profit margin (40%) and net profit margin (34%) are unchanged.

In 2005, only management of creditors was a cause for concern, with Anjo plc taking 13 more days on average to settleliabilities with trade creditors than the sector. This has increased to 39 days more than the sector in 2006. This could leadto difficulties between the company and its suppliers if it is exceeding the credit periods they have specified. Anjo plc has nolong-term debt and the balance sheet indicates an increased reliance on short-term finance, since cash has reduced by£780,000 or 87% and the overdraft has increased by £850,000 to £1 million.

17



Perhaps the company should investigate whether it is undercapitalised (overtrading). It is unusual for a company of this sizeto have no long-term debt.

(b) Cash operating cycle (2005) = 72 + 61 – 93 = 40 daysCash operating cycle (2006) = 118 + 89 – 119 = 88 daysThe cash operating cycle or working capital cycle gives the average time it takes for the company to receive payment fromdebtors after it has paid its trade creditors. This represents the period of time for which debtors require financing. The cashoperating cycle of Anjo plc has lengthened by 48 days in 2006 compared with 2005. This represents an increase in workingcapital requirement of approximately £15,600,000 x 48/365 = £2·05 million.

(c) The objectives of working capital management are liquidity and profitability, but there is a tension between these twoobjectives. Liquid funds, for example cash, earn no return and so will not increase profitability. Near-liquid funds, with shortinvestment periods, earn a lower return than funds invested for a long period. Profitability is therefore decreased to the extentthat liquid funds are needed.

The main reason that companies fail, though, is because they run out of cash and so good cash management is an essentialpart of good working capital management. Business solvency cannot be maintained if working capital management in theform of cash management is of a poor standard.

In order to balance the twin objectives of liquidity and profitability in terms of cash management, a company needs to decideon the optimum amount of cash to hold at any given time. There are several factors that can aid in determining the optimumcash balance.

First, it is important to note that cash management is a forward-looking activity, in that the optimum cash balance must reflectthe expected need for cash in the next budget period, for example in the next month. The cash budget will indicate expectedcash receipts over the next period, expected payments that need to be made, and any shortfall that is expected to arise dueto the difference between receipts and payments. This is the transactions need for cash, since it is based on the amount ofcash needed to meet future business transactions.

However, there may be a degree of uncertainty as to the timing of expected receipts. Debtors, for example, may not all payon time and some may take extended credit, whether authorised or not. In order to guard against a possible shortfall of cashto meet future transactions, companies may keep a ‘buffer stock’ of cash by holding a cash reserve greater than called for bythe transactions demand. This is the precautionary demand for cash and the optimum cash balance will reflect management’sassessment of this demand.

Beyond this, a company may decide to hold additional cash in order to take advantage of any business opportunities thatmay arise, for example the possibility of taking over a rival company that has fallen on hard times. This is the speculativedemand for cash and it may contribute to the optimum cash level for a given company, depending on that company’s strategicplan.

(d) £000Current debtors = 3,800Debtors under factor = 3,800 x 0·7 = 2,660

––––––Reduction in debtors = 1,140

––––––

£000Finance cost saving = 1,140 x 0·08 = 91·2Administration cost saving = 1,000 x 0·02 = 20·0Interest on advance = 2,660 x 0·8 x 0·01 = (21·3)Factor’s annual fee = 15,600 x 0·005 = (78·0)

––––––Net benefit of accepting factor’s offer 11·9

––––––

Although the terms of the factor’s offer are financially acceptable, suggesting a net financial benefit of £11,900, this benefitis small compared with annual turnover of £15·6 million. Other benefits, such as the application of the factor’s expertise tothe debtor management of Anjo plc, might also be influential in the decision on whether to accept the offer.

4 (a) There are four types of standard cost, as follows.

Basic standardThis is a standard that remains unchanged for long periods of time. Because it remains unchanged, it allows efficiency trendsover time to be identified. Because basic standards do not reflect current conditions, they are of limited use if currentconditions differ significantly from those existing when the standard was set. They are therefore seldom used.

Ideal standardThis is a standard that reflects perfect performance and is the minimum cost that is possible under ideal operating conditions.Because ideal standards are unattainable, they are unlikely to be used in practice, since inability to achieve them is likely tohave a demotivating effect on managers and employees.

18



Attainable standardThis standard allows for normal levels of wastage and operation, and represents a cost level achievable under reasonablyefficient working. Attainable standards may be difficult to achieve, but they do not represent impossible targets for employees.An attainable standard is considered to represent the best target against which to compare current activity and is the preferredstandard to use in planning, budgeting and cost control.

Current standardThis standard is one established for use over a short period of time and relates to current conditions. Drury does not considerthis standard to be different from an attainable standard1.

Ex ante and ex post standardsEx ante standards are based on anticipated conditions and performance and are prepared prior to the operating period towhich they relate. If operating conditions have changed significantly compared to the assumptions underlying ex antestandards, calculated variance may be less relevant and useful than desired. To combat this weakness, standards may berevised (ex post standards) to take account of changed operating conditions. The differences between ex ante and ex poststandards are taken into account by calculating planning variances, while operational variances are prepared using ex poststandards, leading to ex post variance analysis2.

Students were only required to discuss three standards.

(b) The preparation of standard costsA standard cost has two elements, namely a physical measure of a resource and a price per unit of resource. A standard costfor material, for example, consists of a specification of the kilograms of material required per unit of product, and aspecification of the price paid per kilogram. When setting standards, both elements need to be determined.

Standard costing is best suited to operations which are repetitive, where the quantity of resource needed to produce a givenquantity of output can be specified. It is therefore suited to manufacturing processes and the provision of repetitive services,such as the processing of loan applications in a financial institution.

Standard costs can be developed through the application of quantitative analysis, such as the engineering approach, whichuses technical specifications or time and motion study, and the accounts analysis approach, which analyses past accountinginformation. Quantitative analysis of past accounting information through techniques such as the high-low method andregression analysis can provide a cost function that can be used in the preparation of a standard cost3.

The use of standard costsStandard costs have many uses. They can be used to predict and forecast future costs for use in decision-making andbudgeting. They can be used as a basis for controlling costs arising in actual operations through detailed variance analysis,that is, the comparison of actual results with standard costs. They can be used as a basis for measuring and assessing theperformance of managers and employees. They can provide targets for motivating managers and employees to improveperformance and meet organisational objectives. They can be used as a basis for profit measurement and stock valuation.

The review of standard costsCurrently attainable standards only remain relevant if they continue to relate to current circumstances, that is, if they areregularly reviewed to take account of any changes in operating methods and any changes in the economic and businessenvironment. If changes are small and not significant, the standard may be left unchanged. If changes are more significant,management may consider using ex post variance analysis (see part (a) above) and reporting planning and operationalvariances to highlight differences that have arisen and to keep reported variances useful from a responsibility accountingperspective.

(c) When deciding whether to investigate a variance, the following factors should be considered.

The size of the varianceInvestigating large variances is likely to lead to large cost savings. Since ‘large variance’ is an imprecise term, a company canrequire that all variances above a given size should be investigated. This size threshold could be specified in percentage termsrelative to the underlying cost, i.e. all variances of 5% or more should be investigated.

Whether the variance is favourable or adverseThis should not influence whether a variance is investigated. While it is natural to focus on adverse variances in order to bringactual profitability back into line with planned profitability, investigation of favourable variances can provide usefulinformation. Budgetary slack may be discovered, or the budget may not be demanding enough to be motivating, orimprovements in operating practices may have arisen.

Whether the cost is greater than the benefitThe expected cost of investigating a variance should not normally exceed the benefit arising from its explanation or correction,since this goes against the drive to increase profitability.

1 Drury, C (2004) Management and Cost Accounting, sixth edition, pp.732–7332 Drury, C (2004) Management and Cost Accounting, sixth edition, p.7953 Drury, C (2004) Management and Cost Accounting, sixth edition, pp.1038–1046

19



What has happened in the pastThe historic pattern of variances should be considered and variances identified which are unusual compared to variancesrecorded in previous periods. Statistical control charts may be used for this purpose. Here, variations about the arithmeticmean are recorded and compared to control limits, set for example at plus and minus two standard deviations from the mean.Variances outside of the control limits are investigated. Statistical analysis of performance in previous periods can be used todetermine the expected mean value and the standard deviation.

5 (a) Flexed Budget Actual for period Variances(80,000 units) (80,000 units) for period

£000 £000 £000 £000 £000Sales 1,200 1,240·0 40·0 (F)Variable costsRaw materials 600 632·4 32·4 (A)Labour 140 115·2 24·8 (F)Production overheads 120 128·0 8·0 (A)

–––– –––––860 875·6–––– ––––––

Contribution 340 364·4Fixed costsLabour 50 50.0 nilProduction overheads 100 110.0 10·0 (A)

–––– –––––150 160·0–––– –––––– ––––

Gross profit 190 204·4 14·4 (F)–––– –––––– ––––

WorkingsSales:Selling price per unit = 1,350,000/90,000 = £15·00 per unitSales revenue at 80,000 units = 80,000 x 15·00 = £1,200,000

Raw materials:Variable cost per unit = (675,000 – 450,000)/(90,000 – 60,000) = £7·50 per unitAlternatively, 675,000/90,000 = £7·50 per unitRaw material cost at 80,000 units = 80,000 x 7·50 = £600,000

Labour:Variable cost per unit = (207,500 – 155,000)/(90,000 – 60,000) = £1·75 per unitFixed cost = 207,500 – (90,000 x 1·75) = 207,500 – 157,500 = £50,000Variable labour cost at 80,000 units = 80,000 x 1·75 = £140,000

Production overhead:Variable cost per unit = (235,000 – 190,000)/(90,000 – 60,000) = £1·50 per unitFixed cost = 235,000 – (90,000 x 1·50) = £100,000Variable production overhead cost at 80,000 units = 80,000 x 1·50 = £120,000

(b) Overhead absorption rate = 112,500/22,500 = £5 per labour hourOverhead efficiency variance = 5 x (16,000 – 22,000) = £30,000 (F)

The fixed production overhead efficiency variance measures the difference between the standard fixed production overheadcost of the actual output and the fixed production overhead absorbed on the actual hours worked. It arises because of theefficiency or inefficiency of workers in producing the actual output, as measured by the difference between the standard labourhours and the actual labour hours for the actual output. Here, the efficiency of the workforce was higher than expected.

(c) Organisations formulate plans in order to achieve their objectives. Corporate or strategic planning is concerned withdetermining the direction in which the organisation is expected to move and with setting objectives to support this.Achievement of longer-term objectives is supported in the shorter term by the budgetary planning process, which gives riseto the short-term financial plan known as a budget. Annual budgets, therefore, are the means by which organisationsimplement their long-term or strategic plan.

Budgetary planning requires the identification of the principal budget factor, which is the limiting factor as far as theorganisation’s activities are concerned. This limiting factor is usually sales volume in commercial organisations and so budgetpreparation would begin with formulating the sales budget. Where some other factor is limiting the organisation’s activities,such as production capacity, achievement of strategic plans may call for financial investment in new machinery in order toremove this limiting factor.

Once the principal budget factor and its associated budget have been prepared, functional budgets and the master budgetcan be prepared. In a large organisation the preparation of these budgets will require planning and co-ordination betweendifferent aspects or areas of the business, since otherwise the budget might contain elements that are unrealistic or notachievable.

20



In supporting planning and co-ordination, the budgetary planning process also supports communication between differentareas of the organisation. Each area will become aware of the long-term objectives of the organisation, the role that it isexpected to play in achieving those objectives in the short-term through the annual budget, and the way in which differentareas of the organisation need to work together during the budget period.

While annual budgets give structure and direction to organisational activity, regular monitoring of actual performance isneeded in order to determine whether planned performance is being achieved. The detailed comparison of planned withactual performance can indicate where the organisation needs to take action in order to ensure that the annual budget isachieved. By achieving the annual budget, the organisation will be meeting its long-term objectives. Although it is possiblethat changes in the environment of the organisation may mean that some elements of the budget are no longer appropriate,the budgetary control process can accommodate these environmental changes by amending the budget in order to supportthe continuing achievement of organisational objectives.

Another way in which budgetary planning and control can help organisations to achieve their objectives is by motivatingemployees to achieve those objectives. This motivation can arise through participation in the budgetary planning process,through setting budget targets which have a motivational effect on employees, through employee satisfaction at meetingperiodic budget targets, and by using performance against budget as the basis for employee rewards. An organisation willalso expect that managers do not perform poorly in the organisational areas for which they are responsible, since thisundermines the achievement of both short-term and long-term organisational objectives, and managerial performance can beevaluated against agreed budget targets in order to identify such managers.

21




Marks Marks1 (a) (i) Number of ordinary shares 1

Proposed dividend per share 1Share price predicted by dividend growth model 2

–––4

(ii) Explanation of market efficiency 2Explanation of semi-strong form efficiency 2Explanation of strong form efficiency 2

–––6

(iii) Discussion of share prices 4

(b) (i) Sales revenue 1Inflated variable costs per unit 1Total annual variable costs 1Inflated annual fixed costs 2Omission of accounting depreciation 1Tax liability 1Timing of tax liability 1Capital allowance tax benefits 2Working capital 1–2Discount factors 1Present values 1Net present value 1Consideration of terminal value 2

–––Maximum 14

(ii) Calculation of payback 2Calculation of discounted payback 2

–––4

(iii) Acceptability of proposed investment 2Ways to improve NPV calculation 4

–––6

(c) Calculation of current interest cover 1Calculation of revised interest cover 2Calculation of current gearing 2Calculation of revised gearing 2Calculation of revised ordinary share price 1–2Relevant discussion 6–8

–––Maximum 12

–––50

23



Marks Marks2 (a) Servicing costs 1

Cleaning costs 1Present values of total costs 1Present values of trade-in values 2Net present values of costs of each cycle 3Annuity factors 1Equivalent annual costs 2Recommendation 1

–––12

(b) Causes of capital rationing 4

(c) Single-period and multi-period capital rationing 3–4Project divisibility 3–4Investment of surplus funds 2–3

–––Maximum 9

–––25

3 (a) Ratio calculations 3Comment 3

–––6

(b) Calculation of cash operating cycle 2Significance of cash operating cycle 2

–––4

(c) Working capital and business solvency 3–4Factors influencing optimum cash level 4–5

–––Maximum 7

(d) New level of debtors 1Finance saving 1Administration cost savings 1Interest on advance from factor 2Factor annual fee 1Net benefit of factor’s offer 1Conclusion and discussion 1

–––8

–––25

4 (a) Basic standard 1Ideal standard 2Attainable standard 2Current standard 1

–––6

(b) The preparation of standard costs 4–5The use of standard costs 4–5The review of standard costs 4–5

–––13


24



Marks Marks5 (a) Flexed sales revenue 1

Flexed variable raw material costs 1Flexed variable labour costs 1Budgeted fixed labour costs 1Flexed production overhead costs 1Budgeted fixed production overhead costs 1Contribution 1Variances 3

–––10

(b) Calculation of overhead absorption rate 1Calculation of fixed overhead efficiency variance 2Explanation of efficiency variance 1

–––4


25




PART 2


QUESTION PAPER









Pape

r 2.4




1 The finance director of GTK plc is preparing its capital budget for the forthcoming period and is examining a numberof capital investment proposals that have been received from its subsidiaries. Details of these proposals are as follows:

Proposal 1Division A has requested that it be allowed to invest £500,000 in solar panels, which would be fitted to the roof ofits production facility, in order to reduce its dependency on oil as an energy source. The solar panels would saveenergy costs of £700 per day but only on sunny days. The Division has estimated the following probabilities of sunnydays in each year.

Number of sunny days ProbabilityScenario 1 100 0·3Scenario 2 125 0·6Scenario 3 150 0·1

Each scenario is expected to persist indefinitely, i.e. if there are 100 sunny days in the first year, there will be 100sunny days in every subsequent year. Maintenance costs for the solar panels are expected to be £2,000 per monthfor labour and replacement parts, irrespective of the number of sunny days per year. The solar panels are expected tobe used indefinitely.

Proposal 2Division B has asked for permission to buy a computer-controlled machine with a production capacity of 60,000 unitsper year. The machine would cost £221,000 and have a useful life of four years, after which it would be sold for£50,000 and replaced with a more up-to-date model. Demand in the first year for the machine’s output would be30,000 units and this demand is expected to grow by 30% per year in each subsequent year of production. Standardcost and selling price information for these units, in current price terms, is as follows:

£/unit Annual inflationSelling price 12 4%Variable production cost 4 5%Fixed production overhead cost 6 3%

Fixed production overhead cost is based on expected first-year demand.

Proposal 3Division C has requested approval and funding for a new product which it has been secretly developing, Product RPG.Product development and market research costs of £350,000 have already been incurred and are now due forpayment. £300,000 is needed for new machinery, which will be a full scale version of the current pilot plant.Advertising takes place in the first year only and would cost £100,000. Annual cash inflow of £100,000, net of allproduction costs but before taking account of advertising costs, is expected to be generated for a five-year period. Afterfive years Product RPG would be retired and replaced with a more technologically advanced model. The machineryused for producing Product RPG would be sold for £30,000 at that time.

Other informationGTK plc is a profitable, listed company with several million pounds of shareholders’ funds, a small overdraft and nolong-term debt. For profit calculation purposes, GTK plc depreciates assets on a straight-line basis over their usefuleconomic life. The company can claim writing down allowances on machinery on a 25% reducing balance basis andpays tax on profit at an annual rate of 30% in the year in which the liability arises. GTK plc has a before-tax cost ofcapital of 10%, an after-tax cost of capital of 8% and a target return on capital employed of 15%.

2



Required:

(a) For the proposed investment in solar panels (Proposal 1), calculate:

(i) the net present value for each expected number of sunny days;(ii) the overall expected net present value of the proposal;

and comment on your findings. Ignore taxation in this part of the question. (9 marks)

(b) Calculate the net present value of the proposed investment in the computer-controlled machine (Proposal 2)and advise whether the proposal is financially acceptable. Assume in this part of the question that tax ispayable and that writing down allowances can be claimed. (15 marks)

(c) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investmentin Product RPG (Proposal 3), using the average investment method, and advise on its acceptability.

(6 marks)

(d) Discuss how equity finance or traded debt (bonds) might be raised in order to meet the capital investmentneeds of GTK plc, clearly indicating which source of finance you recommend and the reasons for yourrecommendation. (12 marks)

(e) At the end of the first year of production after implementation of Proposal 2, the finance director noted that amistake had been made in forecasting selling price inflation, which should have been 1·5% instead of 4%. Hehas gathered the following information regarding selling price and sales volume.

Forecast standard selling price (4% inflation) £12·48Actual selling price £12·36Forecast and actual standard variable cost £4·20Forecast sales volume 30,000 unitsActual sales volume 32,000 units

Required:

(i) Using a marginal costing approach and ignoring the mistake in forecasting selling price inflation,calculate the selling price variance and the sales volume contribution variance, and reconcile budgetedcontribution to actual contribution. (4 marks)

(ii) Using a marginal costing approach, evaluate the selling price variance from an operational and planningperspective and discuss briefly whether your evaluation provides the finance director with usefulinformation. (4 marks)

(50 marks)

3 [P.T.O.




2 Required:

(a) Outline the key stages in the planning process that links long-term objectives and budgetary control.(10 marks)

(b) Explain the meaning of the terms ‘fixed budget’, ‘rolling budget’ and ‘zero-based budget’, and discuss thecircumstances under which each budget might be used. (10 marks)

(c) Discuss whether time series analysis may be preferred to linear regression as a way of forecasting salesvolume. (5 marks)

(25 marks)

3 Woodside is a local charity dedicated to helping homeless people in a large city. The charity owns and manages ashelter that provides free overnight accommodation for up to 30 people, offers free meals each and every night of theyear to homeless people who are unable to buy food, and runs a free advice centre to help homeless people findsuitable housing and gain financial aid. Woodside depends entirely on public donations to finance its activities andhad a fundraising target for the last year of £700,000. The budget for the last year was based on the following forecastactivity levels and expected costs:

Free meals provision: 18,250 meals at £5 per mealOvernight shelter: 10,000 bed-nights at £30 per nightAdvice centre: 3,000 sessions at £20 per sessionCampaigning and advertising: £150,000

The budgeted surplus (budgeted fundraising target less budgeted costs) was expected to be used to meet anyunexpected costs. Included in the above figures are fixed costs of £5 per night for providing shelter and £5 per advicesession representing fixed costs expected to be incurred by administration and maintaining the shelter. The numberof free meals provided and the number of beds occupied each night depends on both the weather and the season ofthe year. The Woodside charity has three full-time staff and a large number of voluntary helpers.

The actual costs for the last year were as follows:

Free meals provision: 20,000 meals at a variable cost of £104,000Overnight shelter: 8,760 bed-nights at a variable cost of £223,380Advice centre: 3,500 sessions at a variable cost of £61,600Campaigning and advertising: £165,000

The actual costs of the overnight shelter and the advice centre exclude the fixed costs of administration andmaintenance, which were £83,000.

The actual amount of funds raised in the last year was £620,000.

Required:

(a) Prepare an operating statement, reconciling budgeted surplus and actual shortfall and discuss the charity’sperformance over the last year. (13 marks)

(b) Discuss problems that may arise in the financial management and control of a not-for-profit organisation suchas the Woodside charity. (12 marks)

(25 marks)

4



4 TFR Ltd is a small, profitable, owner-managed company which is seeking finance for a planned expansion. A localbank has indicated that it may be prepared to offer a loan of £100,000 at a fixed annual rate of 9%. TFR Ltd wouldrepay £25,000 of the capital each year for the next four years. Annual interest would be calculated on the openingbalance at the start of each year. Current financial information on TFR Ltd is as follows:

Current turnover: £210,000Net profit margin: 20%Annual taxation rate: 25%Average overdraft: £20,000Average interest on overdraft: 10% per yearDividend payout ratio: 50%Shareholders funds: £200,000Market value of fixed assets £180,000

As a result of the expansion, turnover would increase by £45,000 per year for each of the next four years, while netprofit margin would remain unchanged. No capital allowances would arise from investment of the amount borrowed.

TFR Ltd currently has no other debt than the existing and continuing overdraft and has no cash or near-cashinvestments. The fixed assets consist largely of the building from which the company conducts its business. Thecurrent dividend payout ratio has been maintained for several years.

Required:

(a) Assuming that TFR is granted the loan, calculate the following ratios for TFR Ltd for each of the next fouryears:

(i) interest cover;(ii) medium to long-term debt/equity ratio;(iii) return on equity;(iv) return on capital employed. (10 marks)

(b) Comment on the financial implications for TFR Ltd of accepting the bank loan on the terms indicated above.(8 marks)

(c) Discuss the difficulties commonly faced by small firms such as TFR Ltd when seeking additional finance.(7 marks)

(25 marks)

5 [P.T.O.



5 The following financial information relates to PNP plc for the year just ended:

£000Turnover 5,242·0Variable cost of sales 3,145·0Stock 603·0Debtors 744·5Creditors 574·5

Segmental analysis of debtorsBalance Average payment period Discount Bad debts

Class 1 £200,000 30 days 1·0% noneClass 2 £252,000 60 days nil £12,600Class 3 £110,000 75 days nil £11,000Overseas debtors £182,500 90 days nil £21,900

––––––––– ––––––––£744,500 £45,500––––––––– ––––––––

The debtor balances given are before taking account of bad debts. All sales are on credit. Production and sales takeplace evenly throughout the year. Current sales for each class of debtors are in proportion to their relative year-endbalances before bad debts. The overseas debtors arise from regular export sales by PNP to the USA. The current spotrate is $1·7348/£ and the three-month forward rate is $1·7367/£.

It has been proposed that the discount for early payment be increased from 1·0% to 1·5% for settlement within 30 days. It is expected that this will lead to 50% of existing Class 2 debtors becoming Class 1 debtors, as well asattracting new business worth £500,000 in turnover. The new business would be divided equally between Class 1and Class 2 debtors. Fixed costs would not increase as a result of introducing the discount or by attracting newbusiness. PNP finances debtors from an overdraft at an annual interest rate of 8%.

Required:

(a) Calculate the net benefit or cost of increasing the discount for early payment and comment on theacceptability of the proposal. (9 marks)

(b) Calculate the current cash operating cycle and the revised cash operating cycle caused by increasing thediscount for early payment. (4 marks)

(c) Determine the effect of using a forward market hedge to manage the exchange rate risk of the outstandingoverseas debtors. (2 marks)

(d) Identify and explain the key elements of a debtor management system suitable for PNP plc. (10 marks)

(25 marks)

6



7 [P.T.O.

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Answers




1 (a) Expected net present value of Proposed 1

Scenario 1 Scenario 2 Scenario 3Number of sunny days 100 125 150Saving (£/day) 700 700 700Annual saving (£) 70,000 87,500 105,000Costs (24,000) (24,000) (24,000)

–––––––– ––––––––– ––––––––Net annual savings 46,000 63,500 81,000

–––––––– ––––––––– ––––––––

Present value of net savings at 10% 460,000 635,000 810,000Investment 500,000 500,000 500,000

–––––––– ––––––––– ––––––––Net present value (40,000) 135,000 310,000

–––––––– ––––––––– ––––––––

Probability 30% 60% 10%

Expected net present value = (–40,000 x 0·3) + (135,000 x 0·6) + (310,000 x 0·1) = £100,000

The ENPV is £100,000 so if the investment is evaluated on this basis, it is financially acceptable. In reaching a decision,however, the company should consider that there is a 30% chance of making a loss. This may be seen as an unacceptablyhigh risk. Furthermore, the number of sunny days each year will not be constant, as assumed here, and may or may not beexactly 100, 125 or 150 days. It is possible the net present values of Scenarios 1 and 3 represent extremes in terms ofexpectations, and that the net present value of Scenario 2 may be most useful as representing the most likely outcome, evenon a joint probability basis. It is also worth noting that inflation has not been taken into account and that the ever-increasingcost of energy may make the proposed investment much more financially attractive if it were factored into the analysis.

WorkingsPresent values must be calculated with the before-tax cost of capital of 10%, since before-tax cash flows are being evaluatedhere. The present value of a perpetuity is found by dividing the constant annual cash flow by the cost of capital.

Present value of net savings, Scenario 1 = 46,000/0·10 = £460,000Present value of net savings, Scenario 2 = 63,500/0·10 = £635,000Present value of net savings, Scenario 3 = 81,000/0·10 = £810,000

(b) Net present value of Proposal 2

Year 1 2 3 4£ £ £ £

Contribution (W1) 248,400 334,230 449,709 550,800Fixed costs (W2) (185,400) (190,962) (196,691) (202,592)

––––––––– ––––––––– ––––––––– –––––––––63,000 143,268 253,018 348,208

Taxation (30%) (18,900) (42,980) (75,905) (104,462)––––––––– ––––––––– ––––––––– –––––––––

44,100 100,288 177,113 243,746Tax benefits (W3) 16,575 12,431 9,323 12,970

––––––––– ––––––––– ––––––––– –––––––––After-tax cash flows 60,675 112,719 186,436 256,7168% discount factors 0·926 0·857 0·794 0·735

––––––––– ––––––––– ––––––––– –––––––––Present values 56,185 96,600 148,030 188,686

––––––––– ––––––––– ––––––––– –––––––––

£Sum of present values 489,501PV of scrap value (W4) 36,750

––––––––526,251

Initial investment 221,000––––––––

Net present value 305,251––––––––

The net present value is positive and so Proposal 2 is acceptable. Note that the after-tax cost of capital of 8% is used todiscount after-tax cash flows in evaluating this investment proposal.

13



Workings

(W1) Year 1 2 3 4Selling price (£/unit) 12·48 12·98 13·50 14·04Variable cost (£/unit) 4·20 4·41 4·63 4·86

–––––––– –––––––– –––––––– ––––––––Contribution (£/unit) 8·28 8·57 8·87 9·18Sales volume (units/yr) 30,000 39,000 50,700 60,000

–––––––– –––––––– –––––––– ––––––––Total contribution (£/yr) 248,400 334,230 449,709 550,800

–––––––– –––––––– –––––––– ––––––––

(W2) Total fixed production overhead cost in current price terms = 6 x 30,000 = £180,000Inflating this current cost at 3% per year:

Year 1 2 3 4Fixed costs (£/yr) 185,400 190,962 196,691 202,592

(W3) Year Capital allowances Tax benefits1 221,000 x 0·25 = 55,250 55,250 x 0·3 = 16,5752 55,250 x 0·75 = 41,438 41,438 x 0·3 = 12,4313 41,438 x 0·75 = 31,078 31,078 x 0·3 = 9,3234 By difference 43,234 43,234 x 0·3 = 12,970

–––––––– –––––––221,000 – 50,000 = 171,000 51,299

–––––––– –––––––

(W4) Present value of scrap value = 50,000 x 0·735 = £36,750

(c) Before-tax return on capital employed of Project 3

Total cash flow over five years before advertising and depreciation = £500,000Total depreciation over five years = 300,000 – 30,000 = £270,000Total accounting profit over five years = 500,000 – 100,000 – 270,000 = £130,000Average annual accounting profit = 130,000/5 = £26,000 per year

Average investment = (initial investment + scrap value)/2 = (300,000 + 30,000)/2 = £165,000

ROCE = 100 x (26,000/165,000) = 15·8%

The ROCE of Proposal 3 is marginally greater than the target level of 15%. ROCE cannot be recommended as an investmentappraisal method, however, and the NPV of Proposal 3 should be calculated in order to determine whether it is financiallyacceptable.

(d) GTK plc is a company with a small overdraft and no long-term debt. If the three proposals represent the total capitalinvestment needs of the company, the amount of finance needed is as follows.

Finance needed Project lifeProposal 1 £500,000 PermanentProposal 2 £221,000 Four yearsProposal 3 £400,000* Five years

–––––––––––£1,121,000–––––––––––

*It is assumed that advertising costs would be met from finance raised

Equity financeThe equity financing choices available to GTK plc are a rights issue or a placing.

Rights issueIn this method of raising new equity finance, new shares are offered to existing shareholders pro rata to their existingshareholdings, meeting the requirements of company law in terms of shareholders’ pre-emptive rights. Since GTK plc hasseveral million pounds of shareholders’ funds, it may be able to raise £1·1 million through a rights issue, but furtherinvestigation will be needed to determine if this is possible. Factors to consider in reaching a decision will include the numberof shareholders, the type of shareholders (institutional shareholders may be more willing to subscribe than smallshareholders), whether a recent rights issue has been made, the recent and expected financial performance of GTK plc, andthe effect of a rights issue on the company’s cost of capital. A rights issue would not necessarily disturb the existing balanceof ownership and control between shareholders. Approximately half of the finance needed is for a permanent investment andthe permanent nature of equity finance would match this.

PlacingThis way of raising equity finance involves allocating large amounts of ordinary shares with a small number of institutionalinvestors. Existing shareholders will need to agree to waive their pre-emptive rights for a placing to occur, as it entails issuingnew shares to new shareholders. The existing balance of ownership and control will therefore be changed by a placing. SinceGTK plc is a listed public limited company, 25% or more of its issued ordinary share capital will be in public hands and the

14



effect of a placing on this fraction will need to be considered. There may be a change in shareholder expectations after theplacing, depending on the extent to which institutional investors are currently represented among existing shareholders, butsince the company is listed there is likely to be a significant institutional representation.

Traded debtA new issue of traded debt could be redeemable or irredeemable, secured or unsecured, fixed rate or floating rate, and mayperhaps be convertible. Deep discount bonds and zero coupon bond are also a possibility, but much rarer. The effect of anissue of debt on the company’s cost of capital should also be considered.

SecurityBonds may be secured on assets in order to reduce the risk of the bond from an investor point of view. Fixed charge debt issecured on specified fixed assets, such as land or buildings, while floating charge debt is secured on all assets or on aparticular class of assets. In the event of default, holders of secured debt can take action to recover their investment, forexample by appointing a receiver or by enforcing the sale of particular assets.

RedemptionIrredeemable corporate debt is very rare and a new issue of traded debt by GTK plc would be redeemable, i.e. repayable ona specified future date. The project life of two of the proposed capital investments suggests that medium-term debt would beappropriate.

Fixed rate and floating rateFixed rate debt gives a predictable annual interest payment and, in terms of financial risk, makes the company immune tochanges in the general level of interest rates. If interest rates are currently low, GTK plc could lock into these low rates untilits new debt issue needs to be redeemed. Conversely, if interest rates are currently high and expected to fall in the future,GTK plc could issue floating rate debt rather than fixed rate debt, in the expectation that its interest payments would decreaseas interest rates fell.

Cost of capitalGTK plc has no long-term debt and only a small overdraft. Since debt is cheaper than equity in cost of capital terms, thecompany could reduce its overall cost of capital by issuing traded debt. A decrease in the overall cost of capital could benefitthe company and its shareholders in terms of an increase in the market value of the company, and an increase in the numberof financially acceptable investment projects.

(e) (i) Standard contribution using original forecast selling price = 12·48 – 4·20 = £8·28

Selling price variance = (12·48 – 12·36) x 32,000 = £3,840 (A)Sales volume variance = (30,000 – 32,000) x 8·28 = £16,560 (F)Budgeted contribution = 30,000 x 8·28 = £248,400Actual contribution = 32,000 x (12·36 – 4·20) = £261,120Reconciliation: 248,400 – 3,840 + 16,560 = £261,120

(ii) Revised standard selling price using actual inflation = 12·00 x 1·015 = £12·18Planning selling price variance = (12·48 – 12·18) x 32,000 = £9,600 (A)Operational selling price variance = (12·18 – 12·36) x 32,000 = £5,760 (F)

Whether this analysis provides the finance director with useful information will depend on the way in which GTK plcuses responsibility accounting and whether reward systems are linked to performance against budget. In terms ofoperational responsibility, an adverse selling price variance of £3,840 has become a favourable selling price variance of£5,760 and thus may be an occasion for praise or reward for the manager concerned. The planning selling pricevariance shows the effect on sales revenue of the mistake in forecasting the selling price and if the cause of the mistakecan be identified, improved forecasting may become possible.

Examiner’s Note: a planning selling price variance using the budgeted sales volume of 30,000 units would also gaincredit.

2 (a) The key stages in the planning process that links long-term objectives and budgetary control can be divided between long-term planning and the budgeting process. Long-term planning involves identifying objectives, and identifying, evaluating andselecting alternative courses of action. The budgeting process involves implementing the long-term plan in the annual budget,monitoring actual results and responding to divergences from plan1.

Identifying objectivesThe planning process cannot take place unless organisational objectives are identified, since these determine what theorganisation is seeking to accomplish through its operations and activities. These objectives will be long-term or strategic innature and will give direction to the organisation’s operational activities.

1 Drury, C. (2004) Management and Cost Accounting, 6th edition, Thomson Learning, pp.590–593

15



Identifying alternative courses of actionOnce organisational objectives have been identified, alternative courses of action that may lead to achieving those objectivescan be identified. Strategic analysis of the organisation and its environment can indicate potential courses of action. Forexample, a company may look at its existing products and markets, its potential markets, the threat posed by its competitors,the impact of changes in technology on its products and production processes, and so on, and decide that a key objective isthe development of new products to replace existing products in existing markets that are reaching the end of their productlife cycle.

Evaluating alternative courses of actionAt this stage the various alternative courses of action are considered from the point of view of suitability, feasibility andacceptability. In order for this to be done, detailed information about each alternative course of action needs to be gatheredand analysed.

Selecting alternative courses of actionOnce the most appropriate alternative courses of action have been selected, long-term plans to implement them areformulated. Because these plans are long-term in nature, they will of necessity be less detailed than short-term plans, andwill need to allow a degree of flexibility in responding to the changing organisational environment.

Preparing and implementing the budgetA budget is a short-term plan formulated in financial terms and will show in detail the short-term actions the organisation willtake in working towards its long-term objectives. Once the budget has been formulated, finalised and agreed it can beimplemented.

Monitoring actual resultsIn order to achieve the long-term objectives that are reflected in the budget, the organisation must ensure that actualperformance is proceeding according to plan. It will therefore need to monitor actual performance and results.

Responding to divergences from planDivergences from planned activity, as measured by variances from budget, can lead to action if they are deemed to besignificant. This action may be corrective in nature, in order to bring actual activity back into line with planned activity, ormay entail revision of the budget if one of its underlying assumptions is seen as being in error.

(b) A fixed budget is one prepared in advance of the relevant budget period which is not changed or amended as the budgetperiod progresses. This budget represents a periodic approach to budgeting, since a new budget is prepared towards the endof the budget period for the subsequent budget period. In this way, an organisation may set a new budget on an annual basis.

A rolling budget, sometimes called a continuous budget, represents an alternative approach to periodic budgeting. Here, aportion of the budget period is replaced on a regular basis so that the overall budget period remains unchanged. For example,with a budget period of one year, at the end of each quarter a new quarter could be added to the end of the budget periodand the elapsed quarter could be deleted, so that the budget was always looking one year ahead. Continuous budgetingcontinues to increase in popularity.

A zero-based budget is a periodic budget which seeks to dispose of the incremental approach to budgeting. In the incrementalapproach, an increment is added to the relevant figure from last year’s budget, for example to take account of inflation. Inthis way, inefficiency can become embedded in the annual budget and profitability may suffer as a result. With the zero-basedapproach, each element of planned activity is required to be justified in terms of its contribution towards achievingorganisational objectives. This involves the formulation of decision packages, which describe particular activities in such away that managers can compare them in terms of their competing claims on organisational resources, and then rank themfrom a cost-benefit point of view. In this way, zero-based budgeting looks at each budget period with a new perspective.

A fixed budget is likely to be useful in circumstances where the organisational environment is relatively stable and can bepredicted with a reasonable degree of certainty.

A rolling budget is likely to be useful in circumstances where the future is less certain and more flexibility is needed in theorganisational response to its changing environment. For this reason, rolling budgets are popular with new organisations. Acash budget is often a rolling budget because of the need to keep tight control of this area of financial management. A rollingbudget is also supported by the availability of cheap and powerful information processing via personal computers andcomputer networks.

A zero-based budgeting approach tends to be most beneficial when used with services and with discretionary activities, andso is most widely used in the public sector.

(c) Linear regression is a powerful way of analysing past information in order to derive linear relationships and so is ideally suitedto deriving cost equations from past accounts. Sales volume, however, is unlikely to follow a linear relationship alone. Linearregression could be used to determine the overall trend being followed by sales volume on, for example, an annual basis, butinspection of historic sales volumes is likely to show variations about the trend. These could be due to seasonal variations,or longer-term cyclical variations. Time-series analysis can extract these seasonal and cyclical variations and therefore produceforecasts of sales volumes that are likely to be more accurate in a given period than forecasts based on the underlying trendalone. In forecasting future sales volumes, therefore, both quantitative methods have their place in increasing forecastingaccuracy.

16



3 (a) Discussion of performance of Woodside CharityIn a year which saw fundraising fall £80,000 short of the target level, costs were over budget in all areas of activity exceptovernight shelter provision. The budget provided for a surplus of £98,750, but the actual figures for the year show a shortfallof £16,980.

Free meals provision cost £12,750 (14%) more than budgeted. Most of the variance (69%) was due to providing 1,750more meals than budgeted, although £4,000 of it was due to an increase of 20p in the average cost per meal.

Variable cost of overnight shelter provision was £26,620 (11%) less than budgeted. £31,000 was saved because usage ofthe service was 1,240 bed-nights below budget, but an adverse variance of £4,380 arose because of an increase of 50p inthe average unit cost of provision.

Variable advice centre costs were £16,600 (37%) above budget. This was due to increased usage of the service, which was17% up on budget from 3,000 to 3,500 sessions, and to an increase in the average cost of provision, which rose by 17%from £15 to £17·60 per session.

Fixed costs of administration and centre maintenance were £18,000 (28%) above budget and the costs of campaigning andadvertising were £15,000 (10%) above budget.

While investigation of some of the variances in the reconciliation statement below may be useful in controlling further costincreases, the Woodside charity appears to have more than achieved its objectives in terms of providing free meals and advice.The lower usage of overnight shelter could lead to transfer of resources from this area in the next budget to the services thatare more in demand. The reasons for the lower usage of overnight shelter are not known, but the relationship between theprovision of effective advice and the usage of overnight shelter could be investigated.

Operating statement£

Budgeted surplus (W1) 98,750Funding shortfall (W3) (80,000)

–––––––£ £ 18,750

Favourable AdverseFree meals (W4)

Price variance 4,000Usage variance 8,750

Overnight shelter (W5)Price variance 4,380Usage variance 31,000

Advice centre (W6)Price variance 9,100Usage variance 7,500

Campaigning and advertising (W7)Expenditure variance 15,000

Fixed cost (W8)Expenditure variance 18,000

––––––– –––––––31,000 66,730 (35,730)

–––––––Actual shortfall (W2) (16,980)

–––––––

Workings

(W1) Budgeted figures £Free meals provision 91,250 (18,250 meals at £5 per meal)Overnight shelter (variable) 250,000 (10,000 bed-nights at £30 – £5 per night)Advice centre (variable) 45,000 (3,000 sessions at £20 – £5 per session)Fixed costs 65,000 (10,000 x £5) + (3,000 x £5)Campaigning and advertising 150,000

––––––––601,250

Surplus for unexpected costs 98,750––––––––

Fundraising target 700,000––––––––

17



(W2) Actual figures £Free meals provision 104,000 (20,000 meals at £5·20 per meal)Overnight shelter 223,380 (8,760 bed-nights £25·50 per night)Advice centre 61,600 (3,500 sessions at £17·60 per session)Fixed costs 83,000Campaigning and advertising 165,000

––––––––636,980

Shortfall 16,980––––––––

Funds raised 620,000––––––––

(W3) Funding shortfall – 700,000 – 620,000 = £80,000 (A)

(W4) Free meals price variance = (5·00 – 5·20) x 20,000 = £4,000 (A)Free meals usage variance = (18,250 – 20,000) x 5·00 = £8,750 (A)

(W5) Overnight shelter price variance = (25·00 – 25·50) x 8,760 = £4,380 (A)Overnight shelter usage variance – (10,000 – 8,760) x 25 = £31,000 (F)

(W6) Advice centre price variance = (17·60 – 15·00) x 3,500 = £9,100 (A)Advice centre usage variance = (3,000 – 3,500) x 15·00 = £7,500 (A)

(W7) Campaigning and advertising expenditure variance = 150,000 – 165,000 = £15,000 (A)

(W8) Fixed cost expenditure variance = 65,000 – 83,000 = £18,000 (A)

(b) Financial management and control in a not-for-profit organisation (NFPO) such as the Woodside charity must recognise thatthe primary objectives of these organisations are essentially non-financial. Here, these objectives relate to helping thehomeless and because the charity has no profit-related objective, financial management and control must focus on providingvalue for money. This means that resources must be found economically in order to keep input costs as low as possible; thatthese resources must be used as efficiently as possible in providing the services offered by the charity; and that the charitymust devise and use effective methods to meet its objectives. Financial objectives could relate to the need to obtain fundingfor offered services and to the need to control costs in providing these services.

Preparing budgetsThe nature of the activities of a NFPO can make it difficult to forecast levels of activity. In the case of the Woodside charity,homeless people seeking free meals would be given them, and more food would be prepared if necessary, regardless of thebudgeted provision for a given week or month. The level of activity is driven here by the needs of the homeless, and althoughfinancial planning may produce weekly or monthly budgets that consider seasonal trends, a high degree of flexibility may beneeded to respond to unpredictable demand. This was recognised by the charity by budgeting for a fundraising surplus forunexpected costs.

It is likely that forecasting cost per unit of service in a NFPO can be done with more precision if the unit of service is smalland the service is repetitive or routine, and this is true for the Woodside charity. It is unlikely, though, that a detailed analysisof costs has been carried out along these lines, and more likely that an incremental budget approach has been used on atotal basis for each service provided. It depends on the financial skills and knowledge available to the charity from its threefull-time staff and team of volunteers.

Controlling costsBecause of the need for economy and efficiency, this is a key area of financial management and control for a NFPO. The costsof some inputs can be minimised at the point of buying, for example the Woodside charity can be economical when buyingfood, drink, crockery, blankets, cleaning materials and so on. The costs of other inputs can be minimised at the point of use,for example the Woodside charity can encourage economy in the use of heating, lighting, water consumption, telephone usageand postage. In an organisation staffed mainly by volunteers with an unpredictable clientele, cost control is going to dependto a large extent on the way in which responsibility and authority are delegated.

Collecting informationCost control is not possible without collecting regularly information on costs incurred, as well as storing and processing thisinformation. In the Woodside charity, provision has been made in the budget for fixed administration costs and theadministration duties must hopefully relate in part to this collecting of costing information. Without it, budgeting and financialreporting would not be possible. Annual accounts would be needed in order to retain charitable status and to show providersof funds that their donations were being used to their best effect.

Meeting objectivesA NFPO organisation must be able to determine and demonstrate whether it is meeting its declared objectives and so needsto develop measures to do this. This can be far from easy. The analysis of the performance of the Woodside charity over thelast year shows that it may be possible to measure objective attainment quantitatively, i.e. in terms of number of free mealsserved, number of bed-nights used and number of advice sessions given. Presumably, objectives are being met to a greaterextent if more units of service are being provided, and so the adverse usage variances for free meals and advice sessions canin fact be used to show that the charity is meeting a growing need.

18



The meaning of quantitative measures of service provision may not be clear, however. For example, the lower usage of bed-nights could be attributed to the effective provision of advice to the homeless on finding housing and financial aid, and somay also be seen as a success. It could also be due to dissatisfaction amongst the homeless with the accommodation offeredby the shelter. In a similar vein, the higher than budget number of advice sessions may be due to repeat visits by homelesspeople who were not given adequate advice on their first visit, rather than to an increase in the number of people needingadvice. Qualitative measures of objective attainment will therefore be needed in addition to, or to supplement, quantitativeones.

4 (a) Profit and loss accounts for TFR Ltd for the four-year period

Year Current Year 1 Year 2 Year 3 Year 4£ £ £ £ £

Turnover 210,000 255,000 300,000 345,000 390,000Expenses 168,000 204,000 240,000 276,000 312,000

–––––––– –––––––– –––––––– –––––––– ––––––––Net profit 42,000 51,000 60,000 69,000 78,000Interest 2,000 11,000 8,750 6,500 4,250

–––––––– –––––––– –––––––– –––––––– ––––––––Profit before tax 40,000 40,000 51,250 62,500 73,750Tax 10,000 10,000 12,813 15,625 18,438

–––––––– –––––––– –––––––– –––––––– ––––––––Profit after tax 30,000 30,000 38,438 46,875 55,313Dividend 15,000 15,000 19,219 23,438 27,656

–––––––– –––––––– –––––––– –––––––– ––––––––Retained profit 15,000 15,000 19,219 23,438 27,656

–––––––– –––––––– –––––––– –––––––– ––––––––

Equity finance 200,000 215,000 234,219 257,656 285,313Debt finance nil 75,000 50,000 25,000 nil

Interest cover (times) 21·0 4·6 6·9 10·6 18·4Debt/equity (%) nil 35 21 10 nilReturn on equity (%) 15 14 16 18 19ROCE (%) 21 18 21 24 27ROCE (%)* 19 16 20 23 26

*Including the existing and continuing overdraft in capital employed

Workings

Annual interest (assuming the continuing overdraft is maintained at the current level)Year 1 interest payment = 100,000 x 0·09 = 9,000 + 2,000 = £11,000Year 2 interest payment = 75,000 x 0·09 = 6,750 + 2,000 = £8,750Year 3 interest payment = 50,000 x 0·09 = 4,500 + 2,000 = £5,500Year 4 interest payment = 25,000 x 0·09 = 2,250 + 2,000 = £4,250

(b) Financial implications for TFR Ltd of accepting bank loan

A key consideration is whether TFR Ltd will be able to meet the annual payments of interest and capital. It is assumed, inpreparing a cash flow forecast, that there is no difference between profit and cash, and that inflation can be ignored. Theannual cash surplus after meeting interest and tax payments is therefore assumed to be equal to retained profit.

Year 1 2 3 4Retained profit 15,000 19,219 23,438 27,656Capital repayment 25,000 25,000 25,000 25,000

––––––– ––––––– ––––––– –––––––Net cash flow (10,000) (5,781) (1,563) 2,656

––––––– ––––––– ––––––– –––––––

TFR Ltd is clearly not able to meet the annual capital repayments. In order to do so, it will need to change the dividend policyit appears to have maintained for several years of paying out a constant proportion of profit after tax as dividends. One possiblecourse of action is to cut its dividend now and then increase it in the future as profitability allows. Since TFR Ltd is owner-managed, a change in dividend policy may be possible, depending of course on the extent to which the owner or owners relyon dividend income. The annual cash flow shortfall is less than the annual dividend payment, so a change in dividend policywould probably allow the loan to be accepted.

Year 1 2 3 4Profit after tax 30,000 38,438 46,875 55,313Capital repayment 25,000 25,000 25,000 25,000

––––––– ––––––– ––––––– –––––––Available funds 5,000 13,438 21,875 30,313

––––––– ––––––– ––––––– –––––––

It is useful to consider key financial information after the loan has been paid off, i.e. in year 5, assuming that no furtherturnover growth occurs after the fourth year:

19



Year Year 5£

Turnover 390,000Expenses 312,000

––––––––Net profit 78,000Interest 2,000

––––––––Profit before tax 76,000Tax 19,000

––––––––Profit after tax 57,000Dividend 28,500

––––––––Retained profit 28,500

––––––––

Equity finance 313,813Debt finance nil

Interest cover (times) 39Debt/equity (%) nilReturn on equity (%) 18ROCE (%) 25ROCE (%)* 23

*Including the existing and continuing overdraft in capital employed

The effect on financial risk of taking on the loan can be examined. If the interest and capital payments are kept up, financialrisk will be lower than its current level at the end of four years, all things being equal. Interest cover increases from its currentlevel after five years, from 21 times to 39 times, but is on the low side at the end of the first year (4·6 times), although animproved level is reached at the end of the second year (6·9 times), with further increases in subsequent years. Thedebt/equity ratio peaks at 35% at the end of the first year and falls rapidly thereafter, at no time looking dangerous, and TFRLtd returns to its current ungeared position after five years. The bank, as provider of debt finance, would be interested in thetrend in these ratios, as well as in the ongoing cash flow position.

Both return on equity (ROE) and return on capital employed (ROCE) improve with growth in turnover, but are lower thancurrent levels in the first and second years following taking on the loan. At the end of five years ROE has improved to 18%from 15% and ROCE from 19% to 23%. Interest and capital payments would not increase with inflation.

Provided TFR Ltd can meet the interest and capital repayments, business expansion using debt finance may be financiallyfeasible. However, this analysis has ignored any potential pressure for reduction or repayment of the overdraft. An averageoverdraft of £20,000 is quite large for a company with an annual turnover of £210,000 and therefore cannot be ignored inany assessment of financial risk. TFR Ltd may therefore consider asking for a longer repayment period, with lower annualcapital repayments, if it plans to reduce the size of the overdraft or if it is concerned about future cash flow problems.

(c) TFR Ltd is owner-managed and profitable, and financed by equity apart from its large overdraft. It is currently seeking a bankloan in order to finance an expansion of business.

Equity financeThe owner could inject new equity finance himself but his personal financial situation may make this impossible. There areunlikely to be any wealthy individuals willing to invest in his company because there are likely to be more attractiveinvestments elsewhere. Investing in a UK pension fund, for example, carries a tax incentive in that the UK governmentincreases any contributions by the amount of income tax paid. There is therefore a disincentive to invest in the shares of asmall company which may be difficult to sell in the future unless another investor can be found who wishes to buy the shares.

However, there is in the UK a Business Angel network which can bring potential investors and small companies together, withthe added bonus that the Business Angel may have expertise and experience to offer that could be useful in a small companysituation. The owner of TFR Ltd may wish to look into this possibility.

There is also a UK government initiative called the Enterprise Investment Scheme, which is of potential benefit to tradingcompanies rather than service companies. The government offers tax advantages in terms of income tax and capital gains taxin order to encourage investment by individuals in the ordinary shares of small companies.

A further UK government scheme offers tax advantages to Venture Capital Trusts, who are required to invest a large part oftheir funds in the ordinary shares of small companies.

Other government assistance schemesA range of other UK and EU government assistance schemes exist but almost all of these are targeted towards companies inparticular geographic locations, or within particular ranges in terms of number of employees, or with particular fundingrequirements, for example training.

Debt financeSmall companies are faced with a risk-averse attitude from banks when they seek to raise debt finance. Banks tend to askfor personal guarantees from owners and will set interest rates at higher levels than those charged to larger companies. TFR

20



Ltd has fixed assets which are much greater in terms of value than the amount of its overdraft and so the company may beable to offer these as security for a loan. In fact, it is almost certain that the loan under consideration would be secured insome way. Many small companies, particularly service companies, may not be in a position to offer other than personalguarantees.

Examiner’s Note: candidates will be given credit for providing local examples of financial assistance available to small firmsseeking additional finance.

5 (a) Effect on profitability of implementing the proposal

Benefits: £ £Increased contribution (W1) 200,000Decrease in bad debts (W2) 6,300 206,300

––––––––Costs

Increase in current Class 1 discount (W3) 12,167Discount from transferring Class 2 debtors (W4) 11,498Discount from new Class 1 debtors (W5) 3,750Increase in bad debts, new Class 2 debtors (W6) 2,055Increase in financing cost from new debtors (W7) 4,932 34,402

–––––––– ––––––––Net benefit of implementing the proposal 171,898

––––––––

The proposed change appears to be financially acceptable and so may be recommended. Uncertainty with respect to someof the assumptions underlying the financial evaluation would be unlikely to change the favourable recommendation.

WorkingsContribution/sales ratio = 100 x (5,242 – 3,145)/5,242 = 40%Bad debts ratio for Class 2 debtors = 100 x (12,600/252,000) = 5%Increase in Class 1 debtors from new business = 250,000 x 30/365 = £20,548Increase in Class 2 debtors from new business = 250,000 x 60/365 = £41,096

(W1) Contribution from increased business = 500,000 x 40% = £200,000(W2) Decrease in bad debts for transferring current Class 2 debtors = 12,600 x 0·5 = £6,300

(Note that other assumptions regarding bad debts are possible here)(W3) Current sales of Class 1 debtors = 200,000 x (365/30) = £2,433,333

Rise in discount cost for current Class 1 debtors = 2,433,333 x 0·005 = £12,167(W4) Current sales of Class 2 debtors = 252,000 x (365/60) = £1,533,000

Discount cost of transferring Class 2 debtors = 1,533,000 x 0·5 x 0·015 = £11,498(W5) Discount cost for new Class 1 debtors = 250,000 x 0·015 = £3,750(W6) Bad debts arising from new Class 2 debtors = 41,096 x 0·05 = £2,055

(Note that other assumptions regarding bad debts are possible here)(W7) Increase in financing cost from new debtors = (20,548 + 41,096) x 0·08 = £4,932

(Note that it could be assumed that transferring debtors pay after 30 days rather than 60 days)

Examiner’s Note: because of the various assumptions that could be made regarding bad debts and payment period, otherapproaches to a solution are also acceptable.

(b) Current cash operating cycle

Stock days = (603/3,145) x 365 = 70 daysCreditor days = (574·5/3,145) x 365 = 67 daysAverage debtor days = (744·5/5,242) x 365 = 52 daysCash operating cycle = 70 + 52 – 67 = 55 days

After implementation of the proposal, it is reasonable to assume that stock days and creditor days remain unchanged. Totaldebtors have increased by £61,644 to £806,144 and turnover has increased to £5·742m. Average debtor days are now365 x (806/5,742) = 51 days. The cash operating cycle has marginally decreased by one day to 54 days (70 + 51 – 67).

(c) Current sterling value of overseas debtors = £182,500Current dollar value of overseas debtors = 182,500 x 1·7348 = $316,601A forward market hedge (i.e. a forward exchange contract) will lock the sterling value of the debtors at the three-monthforward rate.Hedged sterling value of overseas debtors in three months = 316,601/1·7367 = £182,300This is less than the current sterling value of the overseas debtors because sterling is expected to appreciate against the dollar.

(d) The key elements of a debtor management system may be described as establishing a credit policy, credit assessment, creditcontrol and collection of amounts due.

21



Establishing credit policyThe credit policy provides the overall framework within which the debtor management system of PNP plc operates and willcover key issues such as the procedures to be followed when granting credit, the usual credit period offered, the maximumcredit period that may be granted, any discounts for early settlement, whether interest is charged on overdue balances, andactions to be taken with accounts that have not been settled in the agreed credit period. These terms of trade will depend toa considerable extent on the terms offered by competitors to PNP plc, but they will also depend on the ability of the companyto finance its debtors (financing costs), the need to meet the costs of administering the system (administrative costs) and therisk of bad debts.

Credit assessmentIn order to minimise the risk of bad debts, PNP plc should assess potential customers as to their creditworthiness beforeoffering them credit. The depth of the credit check depends on the amount of business being considered, the size of the clientand the potential for repeat business. The credit assessment requires information about the customer, whether from a thirdparty as in a trade reference, a bank reference or a credit report, or from PNP itself through, for example, its analysis of aclient’s published accounts. The benefits of granting credit must always be greater than the cost involved. There is no point,therefore, in PNP plc paying for a detailed credit report from a credit reference agency for a small credit sale.

Credit controlOnce PNP plc has granted credit to a customer, it should monitor the account at regular intervals to make sure that the agreedterms are being followed. An aged debtor analysis is useful in this respect since it helps the company focus on those clientswho are the most cause for concern. Customers should be reminded of their debts by prompt despatch of invoices and regularstatements of account. Customers in arrears should not be allowed to take further goods on credit.

Collection of amounts dueThe customers of PNP plc should ideally settle their accounts within the agreed credit period. There is no indication as towhat this might be, but the company clearly feels that a segmental analysis of its clients is possible given their paymenthistories, their potential for bad debts and their geographical origin. Clear guidelines are needed over the action to take whencustomers are late in settling their accounts or become bad debts, for example indicating at what stage legal action shouldbe initiated.

Overseas debtorsPNP plc will need to consider the ways in which overseas debtors differ from domestic debtors. For example, overseas debtorstend to take longer to pay and so will need financing for longer. Overseas debtors will also give rise to exchange rate risk,which will probably need to be managed. The credit risk associated with overseas customers can be reduced in several ways,however, for example by using advances against collection, requiring payment through bills of exchange, arrangingdocumentary letters of credit or using export factoring.

22




Marks Marks1 (a) Annual savings 1

Annual costs 1Present value of net annual savings 2Net present values 1Expected net present value 2Discussion 2

––––9

(b) Sales revenue 2Variable costs 2Fixed costs 2Taxation 1Capital allowance tax benefit 3Present value of scrap value 1Choice of discount rate 1Present values 1Net present value 1Discussion 1

––––15

(c) Average annual accounting profit 2Average investment 1Return on capital employed 1Discussion and conclusion 2

––––6

(d) Discussion of equity finance 6–8Discussion of debt finance 6–8Recommendation 1


(e) (i) Selling price variance 1Sales volume variance 1Reconciliation 2

––––4

(ii) Planning selling price variance 1Operational selling price variance 1Discussion 2

––––4

–––50

2 (a) Relevant discussion of key stages 10

(b) Fixed budget 3–4Rolling budget 3–4Zero-based budget 4–5


(c) Relevant discussion 5–––25

23



Marks Marks3 (a) Operating statement 8–9

Discussion of performance 4–6––––

Maximum 13

(b) Discussion of relevant problems 12–––25

4 (a) Forecast profit and loss accounts 2Interest cover 2Debt/equity ratio 2Return on equity 2Return on capital employed 2

––––10

(b) Cash flow implications 3Dividend implications 2Other relevant discussion, including ratios 3–5


(c) Discussion of difficulties faced by small companies 7–––25

5 (a) Increased contribution 1Decrease in bad debts 1Increase in current Class 1 discount 1Discount from transferring Class 2 debtors 1Discount from new Class 1 debtors 1Increase in bad debts 1Increase in financing cost 2Net benefit of proposal 1Comment 1


(b) Current cash operating cycle 2Revised cash operating cycle 2

––––4

(c) Current dollar value of overseas debtors 1Forward sterling value of overseas debtors 1

––––2

(d) Credit policy 2–3Credit assessment 2–3Credit control 2–3Collection of amounts due 2–3Overseas debtors 2–3


–––25

24



Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours




During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.


Pape

r F9Financial

Management

Thursday 6 December 2007





1 (a) Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the samebusiness sector. Financial information on Danoca Co, which is shortly to pay its annual dividend, is as follows:

Number of ordinary shares 5 millionOrdinary share price (ex div basis) $3·30Earnings per share 40·0cProposed payout ratio 60%Dividend per share one year ago 23·3cDividend per share two years ago 22·0cEquity beta 1·4

Other relevant financial informationAverage sector price/earnings ratio 10Risk-free rate of return 4·6%Return on the market 10·6%

Required:

Calculate the value of Danoca Co using the following methods:

(i) price/earnings ratio method;(ii) dividend growth model;

and discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the currentmarket value of Danoca Co. (11 marks)

(b) Phobis Co has in issue 9% bonds which are redeemable at their par value of $100 in five years’ time.Alternatively, each bond may be converted on that date into 20 ordinary shares of the company. The currentordinary share price of Phobis Co is $4·45 and this is expected to grow at a rate of 6·5% per year for theforeseeable future. Phobis Co has a cost of debt of 7% per year.

Required:

Calculate the following current values for each $100 convertible bond:

(i) market value;(ii) floor value;(iii) conversion premium. (6 marks)

(c) Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss thesignificance to a listed company if the stock market on which its shares are traded is shown to be semi-strongform efficient. (8 marks)

(25 marks)

2



2 Duo Co needs to increase production capacity to meet increasing demand for an existing product, ‘Quago’, which isused in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg ofQuago per year, could be bought for $800,000, payable immediately. The scrap value of the machine after four yearswould be $30,000. Forecast demand and production of Quago over the next four years is as follows:

Year 1 2 3 4Demand (kg) 1·4 million 1·5 million 1·6 million 1·7 million

Existing production capacity for Quago is limited to one million kilograms per year and the new machine would onlybe used for demand additional to this.

The current selling price of Quago is $8·00 per kilogram and the variable cost of materials is $5·00 per kilogram.Other variable costs of production are $1·90 per kilogram. Fixed costs of production associated with the new machinewould be $240,000 in the first year of production, increasing by $20,000 per year in each subsequent year ofoperation.

Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances (tax-allowabledepreciation) on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation.

Duo Co uses its after-tax weighted average cost of capital when appraising investment projects. It has a cost of equityof 11% and a before-tax cost of debt of 8·6%. The long-term finance of the company, on a market-value basis,consists of 80% equity and 20% debt.

Required:

(a) Calculate the net present value of buying the new machine and advise on the acceptability of the proposedpurchase (work to the nearest $1,000). (13 marks)

(b) Calculate the internal rate of return of buying the new machine and advise on the acceptability of theproposed purchase (work to the nearest $1,000). (4 marks)

(c) Explain the difference between risk and uncertainty in the context of investment appraisal, and describe howsensitivity analysis and probability analysis can be used to incorporate risk into the investment appraisalprocess. (8 marks)

(25 marks)

3 [P.T.O.



3 The following financial information relates to Echo Co:

Income statement information for the last year$m

Profit before interest and tax 12Interest 3

–––Profit before tax 9Income tax expense 3

–––Profit for the period 6Dividends 2

–––Retained profit for the period 4

–––

Balance sheet information as at the end of the last year$m $m

Ordinary shares, par value 50c 5Retained earnings 15

–––Total equity 208% loan notes, redeemable in three years’ time 30

–––Total equity and non-current liabilities 50

–––

Average data on companies similar to Echo Co:Interest coverage ratio 8 timesLong-term debt/equity (book value basis) 80%

The board of Echo Co is considering several proposals that have been made by its finance director. Each proposal isindependent of any other proposal.

Proposal AThe current dividend per share should be increased by 20% in order to make the company more attractive to equityinvestors.

Proposal BA bond issue should be made in order to raise $15 million of new debt capital. Although there are no investmentopportunities currently available, the cash raised would be invested on a short-term basis until a suitable investmentopportunity arose. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ timeat par.

Proposal CA 1 for 4 rights issue should be made at a 20% discount to the current share price of $2·30 per share in order toreduce gearing and the financial risk of the company.

Required:

(a) Analyse and discuss Proposal A. (5 marks)

(b) Evaluate and discuss Proposal B. (7 marks)

(c) Calculate the theoretical ex rights price per share and the amount of finance that would be raised underProposal C. Evaluate and discuss the proposal to use these funds to reduce gearing and financial risk.

(7 marks)

(d) Discuss the attractions of operating leasing as a source of finance. (6 marks)

(25 marks)

4



4 PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager ofPKA Co has been investigating the working capital management of the company and has gathered the followinginformation:

Inventory managementThe current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meetproduction requirements during the next year is 625,000 units. The cost of placing and processing an order is €250,while the cost of holding a unit in stores is €0·50 per unit per year. Both costs are expected to be constant duringthe next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week yearand that demand is constant throughout the year.

Accounts receivable managementDomestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the averageaccounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debtsas a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.

Accounts payable managementPKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. Thefinancial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge thecurrency risk of this account payable. The following information has been provided by the company’s bank:

Spot rate ($ per €): 1·998 ± 0·002Six months forward rate ($ per €): 1·979 ± 0·004

Money market rates available to PKA Co:Borrowing Deposit

One year euro interest rates: 6·1% 5·4%One year dollar interest rates: 4·0% 3·5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

(a) Identify the objectives of working capital management and discuss the conflict that may arise between them.(3 marks)

(b) Calculate the cost of the current ordering policy and determine the saving that could be made by using theeconomic order quantity model. (7 marks)

(c) Discuss ways in which PKA Co could improve the management of domestic accounts receivable.(7 marks)

(d) Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedgethe foreign account payable. (8 marks)

(25 marks)

5 [P.T.O.



6

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The Capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordon’s growth approximation

The weighted average cost of capital

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Answers



Fundamentals Level – Skills Module, Paper F9Financial Management December 2007 Answers

1 (a) (i) Price/earnings ratio method valuationEarnings per share of Danoca Co = 40cAverage sector price/earnings ratio = 10Implied value of ordinary share of Danoca Co = 40 x 10 = $4·00Number of ordinary shares = 5 millionValue of Danoca Co = 4·00 x 5m = $20 million

(ii) Dividend growth modelEarnings per share of Danoca Co = 40cProposed payout ratio = 60%Proposed dividend of Danoca Co is therefore = 40 x 0·6 = 24c per share

If the future dividend growth rate is expected to continue the historical trend in dividends per share, the historic dividendgrowth rate can be used as a substitute for the expected future dividend growth rate in the dividend growth model.Average geometric dividend growth rate over the last two years = (24/ 22)1/2 = 1·045 or 4·5%(Alternatively, dividend growth rates over the last two years were 3% (24/23·3) and 6% (23·3/22), with an arithmeticaverage of (6 + 3)/2 = 4·5%)

Cost of equity of Danoca Co using the capital asset pricing model (CAPM)= 4·6 + 1·4 x (10·6 – 4·6) = 4·6 + (1·4 x 6) = 13%

Value of ordinary share from dividend growth model = (24 x 1·045)/(0·13 – 0·045) = $2·95Value of Danoca Co = 2·95 x 5m = $14·75 million

The current market capitalisation of Danoca Co is $16·5m ($3·30 x 5m).The price/earnings ratio value of Danoca Cois higher than this at $20m, using the average price/earnings ratio used for the sector. Danoca’s own price/earnings ratiois 8·25. The difference between the two price/earnings ratios may indicate that there is scope for improving the financialperformance of Danoca Co following the acquisition. If Phobis Co has the managerial skills to effect this improvement,the company and its shareholders may be able to benefit as a result of the acquisition.

The dividend growth model value is lower than the current market capitalisation at $14·75m. This represents aminimum value that Danoca shareholders will accept if Phobis Co makes an offer to buy their shares. In reality theywould want more than this as an inducement to sell. The current market capitalisation of Danoca Co of $16m mayreflect the belief of the stock market that a takeover bid for the company is imminent and, depending on its efficiency,may indicate a fair price for Danoca’s shares, at least on a marginal trading basis. Alternatively, either the cost of equityor the expected dividend growth rate used in the dividend growth model calculation could be inaccurate, or the differencebetween the two values may be due to a degree of inefficiency in the stock market.

(b) Calculation of market value of each convertible bondExpected share price in five years’ time = 4·45 x 1·0655 = $6·10Conversion value = 6·10 x 20 = $122Compared with redemption at par value of $100, conversion will be preferredThe current market value will be the present value of future interest payments, plus the present value of the conversion value,discounted at the cost of debt of 7% per year.Market value of each convertible bond = (9 x 4·100) + (122 x 0·713) = $123·89

Calculation of floor value of each convertible bondThe current floor value will be the present value of future interest payments, plus the present value of the redemption value,discounted at the cost of debt of 7% per year.Floor value of each convertible bond = (9 x 4·100) + (100 x 0·713) = $108·20

Calculation of conversion premium of each convertible bondCurrent conversion value = 4·45 x 20 = $89·00Conversion premium = $123·89 – 89·00 = $34·89This is often expressed on a per share basis, i.e. 34·89/20 = $1·75 per share

(c) Stock market efficiency usually refers to the way in which the prices of traded financial securities reflect relevant information.When research indicates that share prices fully and fairly reflect past information, a stock market is described as weak-formefficient. Investors cannot generate abnormal returns by analysing past information, such as share price movements inprevious time periods, in such a market, since research shows that there is no correlation between share price movementsin successive periods of time. Share prices appear to follow a ‘random walk’ by responding to new information as it becomesavailable.

When research indicates that share prices fully and fairly reflect public information as well as past information, a stock marketis described as semi-strong form efficient. Investors cannot generate abnormal returns by analysing either public information,such as published company reports, or past information, since research shows that share prices respond quickly andaccurately to new information as it becomes publicly available.

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If research indicates that share prices fully and fairly reflect not only public information and past information, but privateinformation as well, a stock market is described as strong form efficient. Even investors with access to insider informationcannot generate abnormal returns in such a market. Testing for strong form efficiency is indirect in nature, examining forexample the performance of expert analysts such as fund managers. Stock markets are not held to be strong form efficient.

The significance to a listed company of its shares being traded on a stock market which is found to be semi-strong formefficient is that any information relating to the company is quickly and accurately reflected in its share price. Managers willnot be able to deceive the market by the timing or presentation of new information, such as annual reports or analysts’briefings, since the market processes the information quickly and accurately to produce fair prices. Managers should thereforesimply concentrate on making financial decisions which increase the wealth of shareholders.

2 (a) Net present value evaluation of investment

After-tax weighted average cost of capital = (11 x 0·8) + (8·6 x (1 – 0·3) x 0·2) = 10%

Year 1 2 3 4 5$000 $000 $000 $000 $000

Contribution 440 550 660 660Fixed costs (240) (260) (280) (300)

––––– ––––– ––––– –––––Taxable cash flow 200 290 380 360Taxation (60) (87) (114) (108)CA tax benefits 60 45 34 92Scrap value 30

––––– ––––– ––––– ––––– –––––After-tax cash flows 200 290 338 310 (16)Discount at 10% 0·909 0·826 0·751 0·683 0·621

––––– ––––– ––––– ––––– –––––Present values 182 240 254 212 (10)

––––– ––––– ––––– ––––– –––––

$000Present value of benefits 878Initial investment 800

––––Net present value 78

––––

The net present value is positive and so the investment is financially acceptable. However, demand becomes greater thanproduction capacity in the fourth year of operation and so further investment in new machinery may be needed after threeyears. The new machine will itself need replacing after four years if production capacity is to be maintained at an increasedlevel. It may be necessary to include these expansion and replacement considerations for a more complete appraisal of theproposed investment.

A more complete appraisal of the investment could address issues such as the assumption of constant selling price andvariable cost per kilogram and the absence of any consideration of inflation, the linear increase in fixed costs of productionover time and the linear increase in demand over time. If these issues are not addressed, the appraisal of investing in thenew machine is likely to possess a significant degree of uncertainty.

Workings

Annual contributionYear 1 2 3 4Excess demand (kg/yr) 400,000 500,000 600,000 700,000New machine output (kg/yr) 400,000 500,000 600,000 600,000Contribution ($/kg) 1·1 1·1 1·1 1·1

–––––––– –––––––– –––––––– ––––––––Contribution ($/yr) 440,000 550,000 660,000 660,000

–––––––– –––––––– –––––––– ––––––––

Capital allowance (CA) tax benefits

Year Capital allowance ($) Tax benefit ($)1 200,000 (800,000 x 0·25) 60,000 (0·3 x 200,000)2 150,000 (600,000 x 0·25) 45,000 (0·3 x 150,000)3 112,500 (450,000 x 0·25) 33,750 (0·3 x 112,500)

––––––––462,50030,000 (scrap value)

––––––––492,500

4 307,500 (by difference) 92,250 (0·3 x 307,500)––––––––800,000––––––––

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(b) Internal rate of return evaluation of investment

Year 1 2 3 4 5$000 $000 $000 $000 $000

After-tax cash flows 200 290 338 310 (16)Discount at 20% 0·833 0·694 0·579 0·482 0·402

––––– ––––– ––––– ––––– –––––Present values 167 201 196 149 (6)

––––– ––––– ––––– ––––– –––––

$000Present value of benefits 707Initial investment 800

––––Net present value (93)

––––

Internal rate of return = 10 + [((20 – 10) x 78)/(78 + 93)] = 10 + 4·6 = 14·6%

The investment is financially acceptable since the internal rate of return is greater than the cost of capital used for investmentappraisal purposes. However, the appraisal suffers from the limitations discussed in connection with net present valueappraisal in part (a).

(c) Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an investmentproject and the likelihood of each outcome occurring can therefore be quantified. Uncertainty refers to the situation whereprobabilities cannot be assigned to expected outcomes. Investment project risk therefore increases with increasing variabilityof returns, while uncertainty increases with increasing project life. The two terms are often used interchangeably in financialmanagement, but the distinction between them is a useful one.

Sensitivity analysis assesses how the net present value of an investment project is affected by changes in project variables.Considering each project variable in turn, the change in the variable required to make the net present value zero is determined,or alternatively the change in net present value arising from a fixed change in the given project variable. In this way the keyor critical project variables are determined. However, sensitivity analysis does not assess the probability of changes in projectvariables and so is often dismissed as a way of incorporating risk into the investment appraisal process.

Probability analysis refers to the assessment of the separate probabilities of a number of specified outcomes of an investmentproject. For example, a range of expected market conditions could be formulated and the probability of each market conditionarising in each of several future years could be assessed. The net present values arising from combinations of future economicconditions could then be assessed and linked to the joint probabilities of those combinations. The expected net present value(ENPV) could be calculated, together with the probability of the worst-case scenario and the probability of a negative netpresent value. In this way, the downside risk of the investment could be determined and incorporated into the investmentdecision.

3 (a) Echo Co paid a total dividend of $2 million or 20c per share according to the income statement information. An increase of20% would make this $2·4 million or 24c per share and would reduce dividend cover from 3 times to 2·5 times. It isdebatable whether this increase in the current dividend would make the company more attractive to equity investors, whouse a variety of factors to inform their investment decisions, not expected dividends alone. For example, they will considerthe business and financial risk associated with a company when deciding on their required rate of return.

It is also unclear what objective the finance director had in mind when suggesting a dividend increase. The primary financialmanagement objective is the maximisation of shareholder wealth and if Echo Co is following this objective, the dividend willalready be set at an optimal level. From this perspective, a dividend increase should arise from increased maintainableprofitability, not from a desire to ‘make the company more attractive’. Increasing the dividend will not generate any additionalcapital for Echo Co, since existing shares are traded on the secondary market.

Furthermore, Miller and Modigliani have shown that, in a perfect capital market, share prices are independent of the level ofdividend paid. The value of the company depends upon its income from operations and not on the amount of this incomewhich is paid out as dividends. Increasing the dividend would not make the company more attractive to equity investors, butwould attract equity investors who desired the new level of dividend being offered. Current shareholders who were satisfiedby the current dividend policy could transfer their investment to a different company if their utility had been decreased.

The proposal to increase the dividend should therefore be rejected, perhaps in favour of a dividend increase in line withcurrent dividend policy.

(b) The proposal to raise $15 million of additional debt finance does not appear to be a sensible one, given the current financialposition of Echo Co. The company is very highly geared if financial gearing measured on a book value basis is considered.The debt/equity ratio of 150% is almost twice the average of companies similar to Echo Co. This negative view of the financialrisk of the company is reinforced by the interest coverage ratio, which at only four times is half that of companies similar toEcho Co.

Raising additional debt would only worsen these indicators of financial risk. The debt/equity ratio would rise to 225% on abook value basis and the interest coverage ratio would fall to 2·7 times, suggesting that Echo Co would experience difficultyin making interest payments.

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The proposed use to which the newly-raised funds would be put merits further investigation. Additional finance should beraised when it is needed, rather than being held for speculative purposes. Until a suitable investment opportunity comesalong, Echo Co will be paying an opportunity cost on the new finance equal to the difference between the interest rate on thenew debt (10%) and the interest paid on short-term investments. This opportunity cost would decrease shareholder wealth.Even if an investment opportunity arises, it is very unlikely that the funds needed would be exactly equal to $15m.

The interest charge in the income statement information is $3m while the interest payable on the 8% loan notes is $2·4m(30 x 0·08). It is reasonable to assume that $0·6m of interest is due to an overdraft. Assuming a short-term interest ratelower than the 8% loan note rate – say 6% – implies an overdraft of approximately $10m (0·6/0·06), which is one-third ofthe amount of the long-term debt. The debt/equity ratio calculated did not include this significant amount of short-term debtand therefore underestimates the financial risk of Echo Co.

The bond issue would be repayable in eight years’ time, which is five years after the redemption date of the current loan noteissue. The need to redeem the current $30m loan note issue cannot be ignored in the financial planning of the company.The proposal to raise £15m of long-term debt finance should arise from a considered strategic review of the long-term andshort-term financing needs of Echo Co, which must also consider redemption or refinancing of the current loan note issueand, perhaps, reduction of the sizeable overdraft, which may be close to, or in excess of, its agreed limit.

In light of the concerns and considerations discussed, the proposal to raise additional debt finance cannot be recommended.

AnalysisCurrent gearing (debt/equity ratio using book values) = 30/20 = 150%Revised gearing (debt/equity ratio using book values) = (30 + 15)/20 = 225%

Current interest coverage ratio = 12/3 = 4 timesAdditional interest following debt issue = 15m x 0·1 = $1·5mRevised interest coverage ratio = 12/(3 + 1·5) = 2·7 times

(c) AnalysisRights issue price = 2·30 x 0·8 = $1·84Theoretical ex rights price = (1·84 + (2·30 x 4))/5 = $2·21 per shareNumber of new shares issued = (5/0·5)/4 = 2·5 millionCash raised = 1·84 x 2·5m = $4·6 millionNumber of shares in issue after rights issue = 10 + 2·5 = 12·5 million

Current gearing (debt/equity ratio using book values) = 30/20 = 150%Revised gearing (debt/equity ratio using book values) = 30/24·6 = 122%

Current interest coverage ratio = 12/3 = 4 timesCurrent return on equity (ROE) = 6/20 = 30%

In the absence of any indication as to the return expected on the new funds, we can assume the rate of return will be thesame as on existing equity, an assumption consistent with the calculated theoretical ex rights price.After-tax return on the new funds = 4·6m x 0·3 = $1·38 millionBefore-tax return on new funds = 1·38m x (9/6) = $2·07 millionRevised interest coverage ratio = (12 + 2·07)/3 = 4·7 times

The current debt/equity and interest coverage ratios suggest that there is a need to reduce the financial risk of Echo Co. Arights issue would reduce the debt/equity ratio of the company from 150% to 122% on a book value basis, which is 50%higher than the average debt/equity ratio of similar companies. After the rights issue, financial gearing is still therefore highenough to be a cause for concern.

The interest coverage ratio would increase from 4 times to 4·7 times, again assuming that the new funds will earn the samereturn as existing equity funds. This is still much lower than the average interest coverage ratio of similar companies, whichis 8 times. While 4·7 times is a safer level of interest coverage, it is still somewhat on the low side.

No explanation has been offered for the amount to be raised by the rights issue. Why has the Finance Director proposed that$4·6m be raised? If the proposal is to reduce financial risk, what level of financial gearing and interest coverage would beseen as safe by shareholders and other stakeholders? What use would be made of the funds raised? If they are used to redeemdebt they will not have a great impact on the financial position of the company, in fact it appears likely that that the overdraftis twice as big as the amount proposed to be raised by the rights issue. The refinancing need therefore appears to be muchgreater than $4·6m. If the funds are to be used for investment purposes, further details of the investment project, its expectedreturn and its level of risk should be considered.

There seems to be no convincing rationale for the proposed rights issue and it cannot therefore be recommended, at least onfinancial grounds.

(d) Operating leasing is a popular source of finance for companies of all sizes and many reasons have been advanced to explainthis popularity. For example, an operating lease is seen as protection against obsolescence, since it can be cancelled at shortnotice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange forcontinuing leasing business. This flexibility is seen as valuable in the current era of rapid technological change, and can alsoextend to contract terms and servicing cover.

14



Operating leasing is often compared to borrowing as a source of finance and offers several attractive features in this area.There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided,existing assets need not be tied up as security and negative effects on return on capital employed can be avoided. Since legaltitle does not pass from lessor to lessee, the leased asset can be recovered by the lessor in the event of default on lease rentals.Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt.

Operating leasing can also be cheaper than borrowing to buy. There are several reasons why the lessor may be able to acquirethe leased asset more cheaply than the lessee, for example by taking advantage of bulk buying, or by having access to lowercost finance by virtue of being a much larger company. The lessor may also be able use tax benefits more effectively than thelessee. A portion of these benefits can be made available to the lessee in the form of lower lease rentals, making operatingleasing a more attractive proposition that borrowing.

Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of theleased asset does not appear in the balance sheet.

4 (a) The objectives of working capital management are profitability and liquidity. The objective of profitability supports the primaryfinancial management objective, which is shareholder wealth maximisation. The objective of liquidity ensures that companiesare able to meet their liabilities as they fall due, and thus remain in business.

However, funds held in the form of cash do not earn a return, while near-liquid assets such as short-term investments earnonly a small return. Meeting the objective of liquidity will therefore conflict with the objective of profitability, which is met byinvesting over the longer term in order to achieve higher returns.

Good working capital management therefore needs to achieve a balance between the objectives of profitability and liquidityif shareholder wealth is to be maximised.

(b) Cost of current ordering policy of PKA CoOrdering cost = €250 x (625,000/100,000) = €1,563 per yearWeekly demand = 625,000/50 = 12,500 units per weekConsumption during 2 weeks lead time = 12,500 x 2 = 25,000 unitsBuffer stock = re-order level less usage during lead time = 35,000 – 25,000 = 10,000 unitsAverage stock held during the year = 10,000 + (100,000/2) = 60,000 unitsHolding cost = 60,000 x €0·50 = €30,000 per yearTotal cost = ordering cost plus holding cost = €1,563 + €30,000 = €31,563 per year

Economic order quantity = ((2 x 250 x 625,000)/0·5)1/2 = 25,000 unitsNumber of orders per year = 625,000/25,000 = 25 per yearOrdering cost = €250 x 25 = €6,250 per yearHolding cost (ignoring buffer stock) = €0·50 x (25,000/2) = €0·50 x 12,500 = €6,250 per yearHolding cost (including buffer stock) = €0·50 x (10,000 + 12,500) = €11,250 per yearTotal cost of EOQ-based ordering policy = €6,250 + €11,250 = €17,500 per year

Saving for PKA Co by using EOQ-based ordering policy = €31,563 – €17,500 = €14,063 per year

(c) The information gathered by the Financial Manager of PKA Co indicates that two areas of concern in the management ofdomestic accounts receivable are the increasing level of bad debts as a percentage of credit sales and the excessive creditperiod being taken by credit customers.

Reducing bad debtsThe incidence of bad debts, which has increased from 5% to 8% of credit sales in the last year, can be reduced by assessingthe creditworthiness of new customers before offering them credit and PKA Co needs to introduce a policy detailing how thisshould be done, or review its existing policy, if it has one, since it is clearly not working very well. In order to do this,information about the solvency, character and credit history of new clients is needed. This information can come from a varietyof sources, such as bank references, trade references and credit reports from credit reference agencies. Whether credit isoffered to the new customer and the terms of the credit offered can then be based on an explicit and informed assessment ofdefault risk.

Reduction of average accounts receivable periodCustomers have taken an average of 75 days credit over the last year rather than the 30 days offered by PKA Co, i.e. morethan twice the agreed credit period. As a result, PKA Co will be incurring a substantial opportunity cost, either from theadditional interest cost on the short-term financing of accounts receivable or from the incremental profit lost by not investingthe additional finance tied up by the longer average accounts receivable period. PKA Co needs to find ways to encourageaccounts receivable to be settled closer to the agreed date.

Assuming that the credit period offered by PKA Co is in line with that of its competitors, the company should determinewhether they too are suffering from similar difficulties with late payers. If they are not, PKA Co should determine in what wayits own terms differ from those of its competitors and consider whether offering the same trade terms would have an impacton its accounts receivable. For example, its competitors may offer a discount for early settlement while PKA Co does not andintroducing a discount may achieve the desired reduction in the average accounts receivable period. If its competitors areexperiencing a similar accounts receivable problem, PKA Co could take the initiative by introducing more favourable earlysettlement terms and perhaps generate increased business as well as reducing the average accounts receivable period.

15



PKA Co should also investigate the efficiency with which accounts receivable are managed. Are statements sent regularly tocustomers? Is an aged accounts receivable analysis produced at the end of each month? Are outstanding accounts receivablecontacted regularly to encourage payment? Is credit denied to any overdue accounts seeking further business? Is interestcharged on overdue accounts? These are all matters that could be included by PKA Co in a revised policy on accountsreceivable management.

(d) Money market hedgePKA Co should place sufficient dollars on deposit now so that, with accumulated interest, the six-month liability of $250,000can be met. Since the company has no surplus cash at the present time, the cost of these dollars must be met by a short-term euro loan.

Six-month dollar deposit rate = 3·5/2 = 1·75%Current spot selling rate = 1·998 – 0·002 = $1·996 per euroSix-month euro borrowing rate = 6·1/2 = 3·05%

Dollars deposited now = 250,000/1·0175 = $245,700Cost of these dollars at spot = 245,700/1·996 = 123,096 eurosEuro value of loan in six months’ time = 123,096 x 1·0305 = 126,850 euros

Forward market hedgeSix months forward selling rate = 1·979 – 0·004 = $1·975 per euroEuro cost using forward market hedge = 250,000/1·975 = 126,582 euros

Lead paymentSince the dollar is appreciating against the euro, a lead payment may be worthwhile.Euro cost now = 250,000/1·996 = 125,251 eurosThis cost must be met by a short-term loan at a six-month interest rate of 3·05%Euro value of loan in six months’ time = 125,251 x 1·0305 = 129,071 euros

Evaluation of hedgesThe relative costs of the three hedges can be compared since they have been referenced to the same point in time, i.e. sixmonths in the future. The most expensive hedge is the lead payment, while the cheapest is the forward market hedge. Usingthe forward market to hedge the account payable currency risk can therefore be recommended.

16



Fundamentals Level – Skills Module, Paper F9Financial Management December 2007 Marking Scheme

Marks Marks1 (a) Price/earnings ratio value of company 2

Proposed dividend per share 1Average dividend growth rate 1Cost of equity using CAPM 1Dividend growth model value of company 2Discussion 4

––––11

(b) Conversion value 1Market value 2Floor value 2Conversion premium 1

––––6

(c) Weak form efficiency 1–2Semi-strong form efficiency 1–2Strong form efficiency 1–2Significance of semi-strong form efficiency 2–3


––––25

2 (a) After-tax weighted average cost of capital 2Annual contribution 2Fixed costs 1Taxation 1Capital allowance tax benefits 3Scrap value 1Discount factors 1Net present value 1Comment 1–2


(b) Net present value calculation 1Internal rate of return calculation 2Comment 1–2


(c) Risk and uncertainty 2–3Discussion of sensitivity analysis 2–3Discussion of probability analysis 2–3


––––25

17



Marks Marks3 (a) Discussion of proposal to increase dividend 5

(b) Evaluation of debt finance proposal 3–4Discussion of debt finance proposal 4–5


(c) Theoretical ex rights price per share 1Amount of finance raised 1Evaluation of rights issue proposal 2–3Discussion of rights issue proposal 3–4


(d) Discussion of attractions of leasing 6––––

25

4 (a) Profitability and liquidity 1Discussion of conflict between objectives 2

––––3

(b) Cost of current ordering policy 3Cost of EOQ-based ordering policy 3Saving by using EOQ model 1

––––7

(c) Reduction of bad debts 3–4Reduction of average accounts receivable period 3–4Discussion of other improvements 1–2


(d) Money market hedge 3Forward market hedge 2Lead payment 2Evaluation 1

––––8

––––25

18










Pape

r F9Financial Management

Thursday 5 June 2008





1 Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the companyat the current time:

Number of ordinary shares 20 millionBook value of 7% convertible debt $29 millionBook value of 8% bank loan $2 million

Market price of ordinary shares $5·50 per shareMarket value of convertible debt $107·11 per $100 bond

Equity beta of Burse Co 1·2Risk-free rate of return 4·7%Equity risk premium 6·5%

Rate of taxation 30%

Burse Co expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can beredeemed at par in eight years’ time, or converted in six years’ time into 15 shares of Burse Co per $100 bond.

Required:

(a) Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions thatyou make. (12 marks)

(b) Discuss the circumstances under which the weighted average cost of capital can be used in investmentappraisal. (6 marks)

(c) Discuss whether the dividend growth model or the capital asset pricing model offers the better estimate ofthe cost of equity of a company. (7 marks)

(25 marks)

2



2 THP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash for theshares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20% discount to itscurrent share price.

The purchase price of the 1 million issued shares of CRX Co would be equal to the rights issue funds raised, lessissue costs of $320,000. Earnings per share of CRX Co at the time of acquisition would be 44·8c per share. As aresult of acquiring CRX Co, THP Co expects to gain annual after-tax savings of $96,000.

THP Co maintains a payout ratio of 50% and earnings per share are currently 64c per share. Dividend growth of 5%per year is expected for the foreseeable future and the company has a cost of equity of 12% per year.

Information from THP Co’s statement of financial position:

Equity and liabilities $000Shares ($1 par value) 3,000Reserves 4,300

––––––7,300

Non-current liabilities8% loan notes 5,000Current liabilities 2,200

–––––––Total equity and liabilities 14,500

–––––––

Required:

(a) Calculate the current ex dividend share price of THP Co and the current market capitalisation of THP Cousing the dividend growth model. (4 marks)

(b) Assuming the rights issue takes place and ignoring the proposed use of the funds raised, calculate:

(i) the rights issue price per share;(ii) the cash raised;(iii) the theoretical ex rights price per share; and(iv) the market capitalisation of THP Co. (5 marks)

(c) Using the price/earnings ratio method, calculate the share price and market capitalisation of CRX Co beforethe acquisition. (3 marks)

(d) Assuming a semi-strong form efficient capital market, calculate and comment on the post acquisition marketcapitalisation of THP Co in the following circumstances:

(i) THP Co does not announce the expected annual after-tax savings; and(ii) the expected after-tax savings are made public. (5 marks)

(e) Discuss the factors that THP Co should consider, in its circumstances, in choosing between equity financeand debt finance as a source of finance from which to make a cash offer for CRX Co. (8 marks)

(25 marks)

3 [P.T.O.



3 FLG Co has annual credit sales of $4·2 million and cost of sales of $1·89 million. Current assets consist of inventoryand accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rateof 7% per year. The company gives two months’ credit to its customers and is allowed, on average, one month’s creditby trade suppliers. It has an operating cycle of three months.

Other relevant information:Current ratio of FLG Co 1·4Cost of long-term finance of FLG Co 11%

Required:

(a) Discuss the key factors which determine the level of investment in current assets. (6 marks)

(b) Discuss the ways in which factoring and invoice discounting can assist in the management of accountsreceivable. (6 marks)

(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost offinancing its current assets. (6 marks)

(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000units per year. Inventory management costs for this raw material are as follows:

Ordering cost: $6 per orderHolding cost: $0·5 per unit per year

The supplier of this raw material has offered a bulk purchase discount of 1% for orders of 10,000 units or more.If bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material willincrease to $2 per unit per year.

Required:

(i) Calculate the total cost of inventory for the raw material when using the economic order quantity.(4 marks)

(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost ofinventory for the raw material. (3 marks)

(25 marks)

4



4 SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle dueto rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P areforecast to be as follows:

Year 1 2 3 4Production and sales (units/year) 35,000 53,000 75,000 36,000

The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (incurrent price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable costinflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacityin both space and labour terms.

Producing and selling product P will call for increased investment in working capital. Analysis of historical levels ofworking capital within SC Co indicates that at the start of each year, investment in working capital for product P willneed to be 7% of sales revenue for that year.

SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capitalallowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the four-year life of the proposed investment. The new machine is expected to have no scrap value at the end of the four-year period.

SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

(a) Calculate the net present value of the proposed investment in product P. (12 marks)

(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)

(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of theevaluations you have carried out. (5 marks)

(d) Discuss how the net present value method of investment appraisal contributes towards the objective ofmaximising the wealth of shareholders. (5 marks)

(25 marks)

5 [P.T.O.



6

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7 [P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate n = number of periods until payment

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15



8

Annuity Table

Present value of an annuity of 1 i.e.

Where r = discount rate n = number of periods

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r




Answers



Fundamentals Level – Skills Module, Paper F9Financial Management June 2008 Answers

1 (a) Calculation of weighted average cost of capital (WACC)

Cost of equityCost of equity using capital asset pricing model = 4·7 + (1·2 x 6·5) = 12·5%

Cost of convertible debtAnnual after-tax interest payment = 7 x (1 – 0·3) = $4·90 per bondShare price in six years’ time = 5·50 x 1·066 = $7·80Conversion value = 7·80 x 15 = $117·00 per bondConversion appears likely, since the conversion value is much greater than par value.The future cash flows to be discounted are therefore six years of after-tax interest payments and the conversion value receivedin year 6:

Year Cash flow $ 10% DF PV ($) 5% DF PV ($)0 market value (107·11) 1·000 (107·11) 1·000 (107·11)1–6 interest 4·9 4·355 21·34 5·076 24·876 conversion 117·00 0·564 66·00 0·746 87·28

––––––– ––––––––(19·77) 5·04––––––– ––––––––

Using linear interpolation, after-tax cost of debt = 5 + [(5 x 5·04)/(5·04 + 19·77)] = 6·0%.

(Note that other after-tax costs of debt will arise if different discount rates are used in the linear interpolation calculation.)

We can confirm that conversion is likely and implied by the current market price of $107·11 by noting that the floor value ofthe convertible debt at an after-tax cost of debt of 6% is $93·13 (4·9 x 6·210 + 100 x 0·627).

Cost of bank loanAfter-tax interest rate = 8 x (1 – 0·3) = 5·6%This can be used as the cost of debt for the bank loan.An alternative would be to use the after-tax cost of debt of ordinary (e.g. not convertible) traded debt, but that is not availablehere.

Market valuesMarket value of equity = 20m x 5·50 = $110 millionMarket value of convertible debt = 29m x 107·11/100 = $31·06 millionBook value of bank loan = $2mTotal market value = 110 + 31·06 + 2 = $143·06 million

WACC = [(12·5 x 110) + (6·0 x 31·06) + (5·6 x 2)]/143·06 = 11·0%

(b) The weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal provided that the risksof the investment project being evaluated are similar to the current risks of the investing company. The WACC would thenreflect these risks and represent the average return required as compensation for these risks.

WACC can be used in investment appraisal provided that the business risk of the proposed investment is similar to thebusiness risk of existing operations. Essentially this means that WACC can be used to evaluate an expansion of existingbusiness. If the business risk of the investment project is different from the business risk of existing operations, a project-specific discount rate that reflects the business risk of the investment project should be considered. The capital asset pricingmodel (CAPM) can be used to derive such a project-specific discount rate.

WACC can be used in investment appraisal provided that the financial risk of the proposed investment is similar to thefinancial risk of existing operations. This means that financing for the project should be raised in proportions that broadlypreserve the capital structure of the investing company. If this is not the case, an investment appraisal method called adjustedpresent value (APV) should be used. Alternatively, the CAPM-derived project-specific cost of capital can be adjusted to reflectthe financial risk of the project financing.

A third constraint on using WACC in investment appraisal is that the proposed investment should be small in comparison withthe size of the company. If this were not the case, the scale of the investment project could cause a change to occur in theperceived risk of the investing company, making the existing WACC an inappropriate discount rate.

(c) The dividend growth model has several difficulties attendant on its use as a way of estimating the cost of equity. For example,the model assumes that the future dividend growth rate is constant in perpetuity, an assumption that is not supported by theway that dividends change in practice. Each dividend paid by a company is the result of a dividend decision by managers,who will consider, but not be bound by, the dividends paid in previous periods. Estimating the future dividend growth rate isalso very difficult. Historical dividend trends are usually analysed and on the somewhat risky assumption that the future willrepeat the past, the historic dividend growth rate is used as a substitute for the future dividend growth rate. The model alsoassumes that business risk, and hence business operations and the cost of equity, are constant in future periods, but realityshows us that companies, their business operations and their economic environment are subject to constant change. Perhapsthe one certain thing about the future is its uncertainty.

11



It is sometimes said that the dividend growth model does not consider risk, but risk is implicit in the share price used by themodel to calculate the cost of equity. A moment’s thought will indicate that share prices fall as risk increases, indicating thatincreasing risk will lead to an increasing cost of equity. What is certainly true is that the dividend growth model does notconsider risk explicitly in the same way as the capital asset pricing model (CAPM). Here, all investors are assumed to holddiversified portfolios and as a result only seek compensation (return) for the systematic risk of an investment. The CAPMrepresent the required rate of return (i.e. the cost of equity) as the sum of the risk-free rate of return and a risk premiumreflecting the systematic risk of an individual company relative to the systematic risk of the stock market as a whole. This riskpremium is the product of the company’s equity beta and the equity risk premium. The CAPM therefore tells us what the costof equity should be, given an individual company’s level of systematic risk.

The individual components of the CAPM (the risk-free rate of return, the equity risk premium and the equity beta) are foundby empirical research and so the CAPM gives rise to a much smaller degree of uncertainty than that attached to the futuredividend growth rate in the dividend growth model. For this reason, it is usually suggested that the CAPM offers a betterestimate of the cost of equity than the dividend growth model.

2 (a) Calculation of share priceTHP Co dividend per share = 64 x 0·5 = 32c per shareShare price of THP Co = (32 x 1·05)/(0·12 – 0·05) = $4·80Market capitalisation of THP Co = 4·80 x 3m = $14·4m

(b) Rights issue priceThis is at a 20% discount to the current share price = 4·80 x 0·8 = $3·84 per share

New shares issued = 3m/3 = 1mCash raised = 1m x 3·84 = $3,840,000

Theoretical ex rights price = [(3 x 4·80) + 3·84]/4 = $4·56 per share

Market capitalisation after rights issue = 14·4m + 3·84m = $18·24 – 0·32m = $17·92mThis is equivalent to a share price of 17·92/4 = $4·48 per shareThe issue costs result in a decrease in the market value of the company and therefore a decrease in the wealth of shareholdersequivalent to 8c per share.

(c) Price/earnings ratio valuationPrice/earnings ratio of THP Co = 480/64 = 7·5

Earnings per share of CRX Co = 44·8c per shareUsing the price earnings ratio method, share price of CRX Co = (44·8 x 7·5)/100 = $3·36Market capitalisation of CRX Co = 3·36 x 1m = $3,360,000

(Alternatively, earnings of CRX Co = 1m x 0·448 = $448,000 x 7·5 = $3,360,000)

(d) In a semi-strong form efficient capital market, share prices reflect past and public information. If the expected annual after-tax savings are not announced, this information will not therefore be reflected in the share price of THP Co. In this case,the post acquisition market capitalisation of THP Co will be the market capitalisation after the rights issue, plus the marketcapitalisation of the acquired company (CRX Co), less the price paid for the shares of CRX Co, since this cash has left thecompany in exchange for purchased shares. It is assumed that the market capitalisations calculated in earlier parts of thisquestion are fair values, including the value of CRX Co calculated by the price/earnings ratio method.

Price paid for CRX Co = 3·84m – 0·32m = $3·52mMarket capitalisation = 17·92m + 3·36m – 3·52m = $17·76mThis is equivalent to a share price of 17·76/4 = $4·44 per share

The market capitalisation has decreased from the value following the rights issue because THP Co has paid $3·52m for acompany apparently worth $3·36m. This is a further decrease in the wealth of shareholders, following on from the issue costsof the rights issue.

If the annual after-tax savings are announced, this information will be reflected quickly and accurately in the share price ofTHP Co since the capital market is semi-strong form efficient. The savings can be valued using the price/earnings ratio methodas having a present value of $720,000 (7·5 x 96,000). The revised market capitalisation of THP Co is therefore $18·48m(17·76m + 0·72m), equivalent to a share price of $4·62 per share (18·48/4). This makes the acquisition of CRX Coattractive to the shareholders of THP Co, since it offers a higher market capitalisation than the one following the rights issue.Each shareholder of THP Co would experience a capital gain of 14c per share (4·62 – 4·48).

In practice, the capital market is likely to anticipate the annual after-tax savings before they are announced by THP Co.

(e) There are a number of factors that should be considered by THP Co, including the following.

Gearing and financial riskEquity finance will decrease gearing and financial risk, while debt finance will increase them. Gearing for THP Co is currently68·5% and this will decrease to 45% if equity finance is used, or rise to 121% if debt finance is used. There may also be

12



some acquired debt finance in the capital structure of CRX Co. THP Co needs to consider what level of financial risk isdesirable, from both a corporate and a stakeholder perspective.

Target capital structureTHP Co needs to compare its capital structure after the acquisition with its target capital structure. If its primary financialobjective is to maximise the wealth of shareholders, it should seek to minimise its weighted average cost of capital (WACC).In practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than equity,while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffersfrom the costs of financial distress).

Availability of securityDebt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specifiedclass of assets). The amount of finance needed to buy CRX CO would need to be secured by a fixed charge to specific fixedassets of THP Co. Information on these fixed assets and on the secured status of the existing 8% loan notes has not beenprovided.

Economic expectationsIf THP Co expects buoyant economic conditions and increasing profitability in the future, it will be more prepared to take onfixed interest debt commitments than if it believes difficult trading conditions lie ahead.

Control issuesA rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors. The choicebetween offering new shares to existing shareholders and to new shareholders will depend in part on the amount of financethat is needed, with rights issues being used for medium-sized issues and issues to new shareholders being used for largeissues. Issuing traded debt also has control implications however, since restrictive or negative covenants are usually writteninto the bond issue documents.

WorkingsCurrent gearing (debt/equity, book value basis) = 100 x 5,000/7,300 = 68·5%Gearing if equity finance is used = 100 x 5,000/(7,300 + 3,840) = 45%Gearing if debt finance is used = 100 x (5,000 + 3,840)/7,300 = 121%

3 (a) There are a number of factors that determine the level of investment in current assets and their relative importance variesfrom company to company.

Length of working capital cycleThe working capital cycle or operating cycle is the period of time between when a company settles its accounts payable andwhen it receives cash from its accounts receivable. Operating activities during this period need to be financed and as theoperating period lengthens, the amount of finance needed increases. Companies with comparatively longer operating cyclesthan others in the same industry sector, will therefore require comparatively higher levels of investment in current assets.

Terms of tradeThese determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, andany penalties for late payment. A company whose terms of trade are more generous than another company in the sameindustry sector will therefore need a comparatively higher investment in current assets.

Policy on level of investment in current assetsEven within the same industry sector, companies will have different policies regarding the level of investment in current assets,depending on their attitude to risk. A company with a comparatively conservative approach to the level of investment incurrent assets would maintain higher levels of inventory, offer more generous credit terms and have higher levels of cash inreserve than a company with a comparatively aggressive approach. While the more aggressive approach would be moreprofitable because of the lower level of investment in current assets, it would also be more risky, for example in terms ofrunning out of inventory in periods of fluctuating demand, of failing to have the particular goods required by a customer, offailing to retain customers who migrate to more generous credit terms elsewhere, and of being less able to meet unexpecteddemands for payment.

Industry in which organisation operatesAnother factor that influences the level of investment in current assets is the industry within which an organisation operates.Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to manufacturefinished goods and so will have comparatively higher levels of investment in current assets than industries such assupermarket chains, where goods are bought in for resale with minimal additional processing and where many goods haveshort shelf-lives.

(b) Factoring involves a company turning over administration of its sales ledger to a factor, which is a financial institution withexpertise in this area. The factor will assess the creditworthiness of new customers, record sales, send out statements andreminders, collect payment, identify late payers and chase them for settlement, and take appropriate legal action to recoverdebts where necessary.

The factor will also offer finance to a company based on invoices raised for goods sold or services provided. This is usuallyup to 80% of the face value of invoices raised. The finance is repaid from the settled invoices, with the balance being passedto the issuing company after deduction of a fee equivalent to an interest charge on cash advanced.

13



If factoring is without recourse, the factor rather than the company will carry the cost of any bad debts that arise on overdueaccounts. Factoring without recourse therefore offers credit protection to the selling company, although the factor’s fee (apercentage of credit sales) will be comparatively higher than with non-recourse factoring to reflect the cost of the insuranceoffered.

Invoice discounting is a way of raising finance against the security of invoices raised, rather than employing the creditmanagement and administration services of a factor. A number of good quality invoices may be discounted, rather than allinvoices, and the service is usually only offered to companies meeting a minimum turnover criterion.

(c) Calculation of size of overdraftInventory period = operating cycle + payables period – receivables period = 3 + 1 – 2 = 2 monthsInventory = 1·89m x 2/12 = $315,000Accounts receivable = 4·2m x 2/12 = $700,000Current assets = 315,000 + 700,000 = $1,015,000Current liabilities = current assets/current ratio = 1,015,000/1·4 = $725,000Accounts payable = 1·89m x 1/12 = $157,500Overdraft = 725,000 – 157,500 = $567,500

Net working capital = current assets – current liabilities = 1,015,000 – 725,000 = $290,000

Short-term financing cost = 567,500 x 0·07 = $39,725Long-term financing cost = 290,000 x 0·11 = $31,900Total cost of financing current assets = 39,725 + 31,900 = $71,625

(d) (i) Economic order quantity = (2 x 6 x 60,000/0·5)0·5 = 1,200 unitsNumber of orders = 60,000/1,200 = 50 order per yearAnnual ordering cost = 50 x 6 = $300 per yearAverage inventory = 1,200/2 = 600 unitsAnnual holding cost = 600 x 0·5 = $300 per yearInventory cost = 60,000 x 12 = $720,000Total cost of inventory with EOQ policy = 720,000 + 300 + 300 = $720,600 per year

(ii) Order size for bulk discounts = 10,000 unitsNumber of orders = 60,000/10,000 = 6 orders per yearAnnual ordering cost = 6 x 6 = $36 per yearAverage inventory = 10,000/2 =5,000 unitsAnnual holding cost = 5,000 x 2 = $10,000 per yearDiscounted material cost =12 x 0·99 = $11·88 per unitInventory cost = 60,000 x 11·88 = $712,800Total cost of inventory with discount = 712,800 + 36 + 10,000 = $722,836 per year

The EOQ approach results in a slightly lower total inventory cost

4 (a) Calculation of net present value

Year 0 1 2 3 4$ $ $ $ $

Sales revenue 728,000 1,146,390 1,687,500 842,400Variable costs (441,000) (701,190) (1,041,750) (524,880)

––––––––– –––––––––– ––––––––––– –––––––––Contribution 287,000 445,200 645,750 317,520Capital allowances (250,000) (250,000) (250,000) (250,000)

––––––––– –––––––––– ––––––––––– –––––––––Taxable profit 37,000 195,200 395,750 67,520Taxation (11,100) (58,560) (118,725) (20,256)

––––––––– –––––––––– ––––––––––– –––––––––After-tax profit 25,900 136,640 277,025 47,264Capital allowances 250,000 250,000 250,000 250,000

––––––––– –––––––––– ––––––––––– –––––––––After-tax cash flow 275,900 386,640 527,025 297,264Initial investment (1,000,000)Working capital (50,960) (29,287) (37,878) 59,157 58,968

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––Net cash flows (1,050,960) 246,613 348,762 586,182 356,232Discount at 12% 1·000 0·893 0·797 0·712 0·636

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––Present values (1,050,960) 220,225 277,963 417,362 226,564

––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––

NPV = $91,154

14



Workings

Sales revenueYear 1 2 3 4Selling price ($/unit) 20·80 21·63 22·50 23·40Sales volume (units) 35,000 53,000 75,000 36,000Sales revenue ($) 728,000 1,146,390 1,687,500 842,400

Variable costsYear 1 2 3 4Variable cost ($/unit) 12·60 13·23 13·89 14·58Sales volume (units) 35,000 53,000 75,000 36,000Variable costs ($) 441,000 701,190 1,041,750 524,880

Total investment in working capitalYear 0 investment = 728,000 x 0·07 = $50,960Year 1 investment = 1,146,390 x 0·07 = $80,247Year 2 investment = 1,687,500 x 0·07 = $118,125Year 3 investment = 842,400 x 0·07 = $58,968

Incremental investment in working capitalYear 0 investment = 728,000 x 0·07 = $50,960Year 1 investment = 80,247 – 50,960 = $29,287Year 2 investment = 118,125 – 80,247 = $37,878Year 3 recovery = 58,968 – 118,125 = $59,157Year 4 recovery = $58,968

(b) Calculation of internal rate of return

Year 0 1 2 3 4$ $ $ $ $

Net cash flows (1,050,960) 246,613 348,762 586,182 356,232Discount at 20% 1·000 0·833 0·694 0·579 0·482

––––––––––– –––––––– –––––––– –––––––– ––––––––Present values (1,050,960) 205,429 242,041 339,399 171,704

––––––––––– –––––––– –––––––– –––––––– ––––––––

NPV at 20% = ($92,387)NPV at 12% = $91,154

IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%

(c) Acceptability of the proposed investment in Product PThe NPV is positive and so the proposed investment can be recommended on financial grounds.

The IRR is greater than the discount rate used by SC Co for investment appraisal purposes and so the proposed investmentis financially acceptable. The cash flows of the proposed investment are conventional and so there is only one internal rateof return. Furthermore, only one proposed investment is being considered and so there is no conflict between the adviceoffered by the IRR and NPV investment appraisal methods.

Limitations of the investment evaluationsBoth the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been forecast andso SC Co should investigate the key assumptions underlying these forecast volumes. It is difficult to forecast the length andfeatures of a product’s life cycle so there is likely to be a degree of uncertainty associated with the forecast sales volumes.Scenario analysis may be of assistance here in providing information on other possible outcomes to the proposed investment.

The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future periods. Inreality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unitwill lead to unanticipated changes in both of these project variables. The assumption of constant inflation rates limits theaccuracy of the investment evaluations and could be an important consideration if the investment were only marginallyacceptable.

Since no increase in fixed costs is expected because SC Co has spare capacity in both space and labour terms, fixed costsare not relevant to the evaluation and have been omitted. No information has been offered on whether the spare capacityexists in future periods as well as in the current period. Since production of Product P is expected to more than double overthree years, future capacity needs should be assessed before a decision is made to proceed, in order to determine whetherany future incremental fixed costs may arise.

(d) The primary financial management objective of private sector companies is often stated to be the maximisation of the wealthof its shareholders. While other corporate objectives are also important, for example due to the existence of other corporatestakeholders than shareholders, financial management theory emphasises the importance of the objective of shareholderwealth maximisation.

15



Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes in shareprices can therefore be used to assess whether a financial management decision is of benefit to shareholders. In fact, theobjective of maximising the wealth of shareholders is usually substituted by the objective of maximising the share price of acompany.

The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has a positiveNPV. If a company accepts an investment with a positive NPV, the market value of the company, theoretically at least,increases by the amount of the NPV. A company with a market value of $10 million investing in a project with an NPV of $1 million will have a market value of $11 million once the investment is made. Shareholder wealth is therefore increasedif positive NPV projects are accepted and, again theoretically, shareholder wealth will be maximised if a company invests inall projects with a positive NPV. This is sometimes referred to as the optimum investment schedule for a company.

The NPV investment appraisal method also contributes towards the objective of maximising the wealth of shareholders byusing the cost of capital of a company as a discount rate when calculating the present values of future cash flows. A positiveNPV represents an investment return that is greater than that required by a company’s providers of finance, offering thepossibility of increased dividends being paid to shareholders from future cash flows.

16



Fundamentals Level – Skills Module, Paper F9Financial Management June 2008 Marking Scheme

Marks Marks1 (a) Calculation of cost of equity 2

Calculation of cost of convertible debt 5Calculation of cost of bank loan 1Calculation of market values 2Calculation of WACC 2

––––12

(b) Discussion of business risk 2–3Discussion of financial risk 1–2Discussion of other relevant factors 1–2


(c) Discussion of dividend growth model 2–3Discussion of capital asset pricing model 2–3Conclusion 1–2


–––25

2 (a) Dividend per share 1Ex dividend share price 2Market capitalisation 1

––––4

(b) Rights issue price 1Cash raised 1Theoretical ex rights price per share 1Market capitalisation 2

––––5

(c) Calculation of price/earnings ratio 1Price/earnings ratio valuation 2

––––3

(d) Calculations of market capitalisation 2–3Comment 3–4


(e) Relevant discussion 6–7Links to scenario in question 2–3


–––25

17



Marks Marks3 (a) Discussion of key factors Maximum 6

(b) Discussion of factoring 4–5Discussion of Invoice discounting 1–2


(c) Value of inventory 1Accounts receivable and accounts payable 1Current liabilities 1Size of overdraft 1Net working capital 1Total cost of financing working capital 1

––––6

(d) (i) Economic order quantity 1Ordering cost and holding cost under EOQ 1Inventory cost under EOQ 1Total cost of inventory with EOQ policy 1

––––4

(ii) Ordering cost and holding cost with discount 1Inventory cost with discount 1Total cost of inventory with bulk purchase discount 1Conclusion 1


–––25

4 (a) Inflated sales revenue 2Inflated variable costs 2Capital allowances 2Taxation 1Working capital 3Discount factors 1Net present value calculation 1

––––12

(b) Net present value calculation 1Internal rate of return calculation 2

––––3

(c) Net present value comment 1Internal rate of return comment 1–2Discussion of limitations 3–4


(d) Discussion of shareholder wealth maximisation 1–2Link to share price maximisation 1–2Discussion of NPV investment appraisal method 2–3


–––25

18










Pape

r F9Financial Management

Thursday 4 December 2008





1 Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand itsexisting business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price ofDartig Co is $2·50 per share and the rights issue price will be at a 20% discount to this. The finance director of DartigCo expects that the expansion of existing business will allow the average growth rate of earnings per share over thelast four years to be maintained into the foreseeable future.

The earnings per share and dividends paid by Dartig over the last four years are as follows:

2003 2004 2005 2006 2007Earnings per share (cents) 27·7 29·0 29·0 30·2 32·4Dividend per share (cents) 12·8 13·5 13·5 14·5 15·0

Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recentyears. Ignore issue costs.

Required:

(a) Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion.(3 marks)

(b) Calculate the expected share price following the proposed business expansion using the price/earnings ratiomethod. (3 marks)

(c) Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rightsissue, and evaluate the expected effect on the wealth of the shareholders of Dartig Co. (5 marks)

(d) Using the information provided, calculate the ex div share price predicted by the dividend growth model anddiscuss briefly why this share price differs from the current market price of Dartig Co. (6 marks)

(e) At a recent board meeting of Dartig Co, a non-executive director suggested that the company’s remunerationcommittee should consider scrapping the company’s current share option scheme, since executive directors couldbe rewarded by the scheme even when they did not perform well. A second non-executive director disagreed,saying the problem was that even when directors acted in ways which decreased the agency problem, they mightnot be rewarded by the share option scheme if the stock market were in decline.

Required:

Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducingthe agency problem in a stock-market listed company such as Dartig Co. (8 marks)

(25 marks)

2



2 The following financial information related to Gorwa Co:

2007 2006$000 $000

Sales (all on credit) 37,400 26,720Cost of sales 34,408 23,781

––––––– –––––––Operating profit 2,992 2,939Finance costs (interest payments) 355 274

––––––– –––––––Profit before taxation 2,637 2,665

––––––– –––––––

2007 2006$000 $000 $000 $000

Non-current assets 13,632 12,750Current assets

Inventory 4,600 2,400Trade receivables 4,600 2,200

–––––– ––––––9,200 4,600

Current liabilitiesTrade payables 4,750 2,000Overdraft 3,225 1,600

–––––– ––––––7,975 3,600

Net current assets 1,225 1,000––––––– –––––––14,857 13,750

8% Bonds 2,425 2,425––––––– –––––––12,432 11,325––––––– –––––––

Capital and reservesShare capital 6,000 6,000Reserves 6,432 5,325

––––––– –––––––12,432 11,325––––––– –––––––

The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years’ time.

A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save$100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoringagreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%.

Required:

(a) Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase in interest rates andadvise the company of steps it can take to protect itself against interest rate risk. (7 marks)

(b) Use the above financial information to discuss, with supporting calculations, whether or not Gorwa Co isovertrading. (10 marks)

(c) Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average costof short-term finance in this part of the question only. (8 marks)

(25 marks)

3 [P.T.O.



3 Rupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery. Themachinery would enable the company to satisfy increasing demand for existing products and the investment is notexpected to lead to any change in the existing level of business risk of Rupab Co.

The machinery will cost $2·5 million, payable at the start of the first year of operation, and is not expected to haveany scrap value. Annual before-tax net cash flows of $680,000 per year would be generated by the investment ineach of the five years of its expected operating life. These net cash inflows are before taking account of expectedinflation of 3% per year. Initial investment of $240,000 in working capital would also be required, followed byincremental annual investment to maintain the purchasing power of working capital.

Rupab Co has in issue five million shares with a market value of $3·81 per share. The equity beta of the companyis 1·2. The yield on short-term government debt is 4·5% per year and the equity risk premium is approximately 5%per year.

The debt finance of Rupab Co consists of bonds with a total book value of $2 million. These bonds pay annual interestbefore tax of 7%. The par value and market value of each bond is $100.

Rupab Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable depreciation)on machinery are on a straight-line basis over the life of the asset.

Required:

(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)

(b) Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate andcomment on its net present value. (8 marks)

(c) Explain how the capital asset pricing model can be used to calculate a project-specific discount rate anddiscuss the limitations of using the capital asset pricing model in investment appraisal. (11 marks)

(25 marks)

4



4 Three years ago Boluje Co built a factory in its home country costing $3·2 million. To finance the construction of thefactory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates atthe time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchangerate at the time was 5·00 pesos/$.

Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6·1%. Thebonds will be redeemed in five years’ time at par. The current cost of debt of peso-denominated bonds of similar riskis 7%.

In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales inpesos. Approximately 40% of production is exported to the foreign country.

The spot exchange rate is 6·00 pesos/$ and the 12-month forward exchange rate is 6·07 pesos/$. Boluje Co canborrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per yearin the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of thisquestion.

Required:

(a) Briefly explain the reasons why a company may choose to finance a new investment by an issue of debtfinance. (7 marks)

(b) Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of thenew factory. (4 marks)

(c) Assume that Boluje Co has no surplus cash at the present time:

(i) Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk inrelation to the dollar cost of the interest payment to be made in one year’s time on its foreign bonds.

(4 marks)

(ii) Compare the relative costs of a money market hedge and a forward market hedge. (2 marks)

(d) Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk.(8 marks)

(25 marks)

5 [P.T.O.



6

Formulae Sheet


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13

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7 [P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate n = number of periods until payment

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5

6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8 9 0·941 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10

11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·305 11 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5

6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10

11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15



8

Annuity Table

Present value of an annuity of 1 i.e.

Where r = discount rate n = number of periods

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10

11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10

11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

1 – (1 + r)–n————––

r




Answers



11

Fundamentals Level – Skills Module, Paper F9Financial Management December 2008 Answers

1 (a) Rights issue price = 2·5 x 0·8 = $2·00 per shareTheoretical ex rights price = ((2·50 x 4) + (1 x 2·00)/5=$2·40 per share

(Alternatively, number of rights shares issued = $5m/$2·00 = 2·5m sharesExisting number of shares = 4 x 2·5m = 10m sharesTheoretical ex rights price per share = ((10m x 2·50) + (2·5m x 2·00))/12·5m = $2·40)

(b) Current price/earnings ratio = 250/32·4 = 7·7 timesAverage growth rate of earnings per share = 100 x ((32·4/27·7)0·25 – 1) = 4·0%Earnings per share following expansion = 32·4 x 1·04 = 33·7 cents per shareShare price predicted by price/earnings ratio method = 33·7 x 7·7 = $2·60Since the price/earnings ratio of Dartig Co has remained constant in recent years and the expansion is of existing business,it seems reasonable to apply the existing price/earnings ratio to the revised earnings per share value.

(c) The proposed business expansion will be an acceptable use of the rights issue funds if it increases the wealth of theshareholders. The share price predicted by the price/earnings ratio method is $2·60. This is greater than the current shareprice of $2·50, but this is not a valid comparison, since it ignores the effect of the rights issue on the share price. The rightsissue has a neutral effect on shareholder wealth, but the cum rights price is changed by the increase in the number of sharesand by the transformation of cash wealth into security wealth from a shareholder point of view. The correct comparison iswith the theoretical ex rights price, which was found earlier to be $2·40. Dartig Co shareholders will experience a capital gaindue to the business expansion of $2·60 – 2·40 = 20 cents per share. However, these share prices are one year apart andhence not directly comparable.

If the dividend yield remains at 6% per year (100 x 15·0/250), the dividend per share for 2008 will be 15·6p (otherestimates of the 2008 dividend per share are possible). Adding this to the capital gain of 20p gives a total shareholder returnof 35·6p or 14·24% (100 x 35·6/240). This is greater than the cost of equity of 10% and so shareholder wealth hasincreased.

(d) In order to use the dividend growth model, the expected future dividend growth rate is needed. Here, it may be assumed thatthe historical trend of dividend per share payments will continue into the future. The geometric average historical dividendgrowth rate = 100 x ((15·0/12·8)0·25 – 1) = 4% per year.

(Alternatively, the arithmetical average of annual dividend growth rates could be used. This will be (5·5 + 0·0 + 7·4 + 3·5)/4= 4·1%. Another possibility is to use the Gordon growth model. The average payout ratio over the last 4 years has been47%, so the average retention ratio has been 53%. Assuming that the cost of equity represents an acceptable return onshareholders’ funds, the dividend growth rate is approximately 53% x 10% = 5·3% per year.)

Using the formula for the dividend growth model from the formula sheet, the ex dividend share price = (15·0 x 1·04)/(0·1– 0·04) = $2·60

This is 10 cents per share more than the current share price of Dartig Co. There are several reasons why there may be adifference between the two share prices. The future dividend growth rate for example, may differ from the average historicaldividend growth rate, and the current share price may factor in a more reasonable estimate of the future dividend growth ratethan the 4% used here. The cost of equity of Dartig Co may not be exactly equal to 10%. More generally, there may be adegree of inefficiency in the capital market on which the shares of Dartig Co are traded.

(e) The primary financial management objective of a company is usually taken to be the maximisation of shareholder wealth. Inpractice, the managers of a company acting as agents for the principals (the shareholders) may act in ways which do notlead to shareholder wealth maximisation. The failure of managers to maximise shareholder wealth is referred to as the agencyproblem.

Shareholder wealth increases through payment of dividends and through appreciation of share prices. Since share pricesreflect the value placed by buyers on the right to receive future dividends, analysis of changes in shareholder wealth focuseson changes in share prices. The objective of maximising share prices is commonly used as a substitute objective for that ofmaximising shareholder wealth.

The agency problem arises because the objectives of managers differ from those of shareholders: because there is a divorceor separation of ownership from control in modern companies; and because there is an asymmetry of information betweenshareholders and managers which prevents shareholders being aware of most managerial decisions.

One way to encourage managers to act in ways that increase shareholder wealth is to offer them share options. These arerights to buy shares on a future date at a price which is fixed when the share options are issued. Share options will encouragemanagers to make decisions that are likely to lead to share price increases (such as investing in projects with positive netpresent values), since this will increase the rewards they receive from share options. The higher the share price in the marketwhen the share options are exercised, the greater will be the capital gain that could be made by managers owning the options.



12

Share options therefore go some way towards reducing the differences between the objectives of shareholders and managers.However, it is possible that managers may be rewarded for poor performance if share prices in general are increasing. It isalso possible that managers may not be rewarded for good performance if share prices in general are falling. It is difficult todecide on a share option exercise price and a share option exercise date that will encourage managers to focus on increasingshareholder wealth while still remaining challenging, rather than being easily achievable.

2 (a) Financial analysisFixed interest debt proportion (2006) = 100 x 2,425/ 2,425 + 1,600) = 60%Fixed interest debt proportion (2007) = 100 x 2,425/(2,425 + 3,225) = 43%Fixed interest payments = 2,425 x 0·08 = $194,000Variable interest payments (2006) = 274 – 194 = $80,000 or 29%Variable interest payments (2007) = 355 – 194 = $161,000 or 45%

(Alternatively, considering the overdraft amounts and the average variable overdraft interest rate of 5% per year:Variable interest payments (2006) = 1·6m x 0·05 = $80,000 or 29%Variable interest payments (2007) = 3·225m x 0·05 = $161,250 or 45%)Interest coverage ratio (2006) = 2,939/ 274 = 10·7 timesInterest coverage ratio (2007) = 2,992/ 355 = 8·4 timesDebt/equity ratio (2006) = 100 x 2,425/ 11,325 = 21%Debt/equity ratio (2007) = 100 x 2,425/ 12,432 = 20%Total debt/equity ratio (2006) = 100 x (2,425 +1,600)/ 11,325 = 35%Total debt/equity ratio (2007) = 100 x (2,425 +3,225)/ 12,432 = 45%

DiscussionGorwa Co has both fixed interest debt and variable interest rate debt amongst its sources of finance. The fixed interest bondshave ten years to go before they need to be redeemed and they therefore offer Gorwa Co long term protection against anincrease in interest rates.

In 2006, 60% of the company’s debt was fixed interest in nature, but in 2007 this had fallen to 43%. The floating-rateproportion of the company’s debt therefore increased from 40% in 2006 to 57% in 2007. The interest coverage ratio fellfrom 10·7 times in 2006 to 8·4 times in 2007, a decrease which will be a cause for concern to the company if it were tocontinue. The debt/equity ratio (including the overdraft due to its size) increased over the same period from 35% to 45% (ifthe overdraft is excluded, the debt/equity ratio declines slightly from 21% to 20%). From the perspective of an increase ininterest rates, the financial risk of Gorwa Co has increased and may continue to increase if the company does not take actionto halt the growth of its variable interest rate overdraft. The proportion of interest payments linked to floating rate debt hasincreased from 29% in 2006 to 45% in 2007. An increase in interest rates will further reduce profit before taxation, whichis lower in 2007 than in 2006, despite a 40% increase in turnover.

One way to hedge against an increase in interest rates is to exchange some or all of the variable-rate overdraft into long-termfixed-rate debt. There is likely to be an increase in interest payments because long-term debt is usually more expensive thanshort-term debt. Gorwa would also be unable to benefit from falling interest rates if most of its debt paid fixed rather thanfloating rate interest.

Interest rate options and interest rate futures may be of use in the short term, depending on the company’s plans to deal withits increasing overdraft.

For the longer term, Gorwa Co could consider raising a variable-rate bank loan, linked to a variable rate-fixed interest rateswap.

(b) Financial analysis2007 2006

Inventory days (365 x 2,400)/23,781 37 days(365 x 4,600)/34,408 49 days

Receivables days (365 x 2,200)/26,720 30 days(365 x 4,600)/37,400 45 days

Payables days (365 x 2,000)/23,781 31 days(365 x 4,750)/34,408 51 days

Current ratio 4,600/3,600 1·3 times9,200/7,975 1·15 times

Quick ratio 2,200/3,600 0·61 times4,600/7,975 0·58 times

Sales/net working capital 26,720/1,000 26·7 times 37,400/1,225 30·5 times

Turnover increase 37,400/26,720 40%Non-current assets increase 13,632/12,750 7%Inventory increase 4,600/2,400 92%Receivables increase 4,600/2,200 109%Payables increase 4,750/2,000 138%Overdraft increase 3,225/1,600 102%



13

DiscussionOvertrading or undercapitalisation arises when a company has too small a capital base to support its level of business activity.Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they falldue. Overtrading is often associated with a rapid increase in turnover and Gorwa Co has experienced a 40% increase inturnover over the last year. Investment in working capital has not matched the increase in sales, however, since the sales/networking capital ratio has increased from 26·7 times to 30·5 times.

Overtrading could be indicated by a deterioration in inventory days. Here, inventory days have increased from 37 days to 49 days, while inventory has increased by 92% compared to the 40% increase in turnover. It is possible that inventory hasbeen stockpiled in anticipation of a further increase in turnover, leading to an increase in operating costs.

Overtrading could also be indicated by deterioration in receivables days. In this case, receivables have increased by 109%compared to the 40% increase in turnover. The increase in turnover may have been fuelled in part by a relaxation of creditterms.

As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-termsources of finance, including overdraft, trade payables and leasing. The overdraft of Gorwa Co has more than doubled in sizeto $3·225 million, while trade payables have increased by $2·74 million or 137%. Both increases are much greater thanthe 40% increase in turnover. There is evidence here of an increased reliance on short-term finance sources.

Overtrading can also be indicated by decreases in the current ratio and the quick ratio. The current ratio of Gorwa Co hasfallen from 1·3 times to 1·15 times, while its quick ratio has fallen from 0·61 times to 0·58 times.

There are clear indications that Gorwa Co is experiencing the kinds of symptoms usually associated with overtrading. A morecomplete and meaningful analysis could be undertaken if appropriate benchmarks were available, such as key ratios fromcomparable companies in the same industry sector, or additional financial information from prior years so as to establishtrends in key ratios.

(c) Current receivables = $4,600,000Receivables under factor = 37,400,000 x 30/365 = $3,074,000Reduction in receivables = 4,600 – 3,074 = $1,526,000

Reduction in finance cost = 1,526,000 x 0·05 = $76,300 per yearAdministration cost savings = $100,000 per yearBad debt savings = $350,000 per yearFactor’s annual fee = 37,400,000 x 0·03 = $1,122,000 per yearExtra interest cost on advance = 3,074,000 x 80% x (7% – 5%) = $49,184 per yearNet cost of factoring = 76,300 + 100,000 + 350,000 – 1,122,000 – 49,184 = $644,884

The factor’s offer cannot be recommended, since the evaluation shows no financial benefit arising.

3 (a) Calculation of weighted average cost of capital

Cost of equity = 4·5 + (1·2 x 5) = 10·5%The company’s bonds are trading at par and therefore the before-tax cost of debt is the same as the interest rate on the bonds,which is 7%.After-tax cost of debt = 7 x (1 – 0·25) = 5·25%Market value of equity = 5m x 3·81 = $19·05 millionMarket value of debt is equal to its par value of $2 millionSum of market values of equity and debt = 19·05 + 2 = $21·05 millionWACC = (10·5 x 19·05/21·05) + (5·25 x 2/21·05) = 10·0%

(b) Cash flow forecast

Year 0 1 2 3 4 5 6$000 $000 $000 $000 $000 $000 $000

Cash inflows 700·4 721·4 743·1 765·3 788·3Tax on cash inflows 175·1 180·4 185·8 191·4 197·1

–––––– –––––– –––––– –––––– –––––– –––––700·4 546·3 562·7 579·6 596·9 (197·1)

CA tax benefits 125·0 125·0 125·0 125·0 125·0–––––– –––––– –––––– –––––– –––––– –––––

After-tax cash flows 700·4 671·3 687·7 704·6 721·9 (72·1)Initial investment (2,500)Working capital (240) (7·2) (7·4) (7·6) (7·9) 270·1

––––––– –––––– –––––– –––––– –––––– –––––– –––––Net cash flows (2,740) 693·2 663·9 680·1 696·7 992·0 (72·1)Discount factors 1·000 0·909 0·826 0·751 0·683 0·621 0·564

––––––– –––––– –––––– –––––– –––––– –––––– –––––Present values (2,740) 630·1 548·4 510·8 475·9 616·0 (40·7)

––––––– –––––– –––––– –––––– –––––– –––––– –––––

NPV = $500



14

The investment is financially acceptable, since the net present value is positive. The investment might become financiallyunacceptable, however, if the assumptions underlying the forecast financial data were reconsidered. For example, the salesforecast appears to assume constant annual demand, which is unlikely in reality.

Workings

Capital allowance tax benefitsAnnual capital allowance (straight-line basis) = $2·5m/5 = $500,000Annual tax benefit = $500,000 x 0·25 = $125,000 per year

Working capital investmentYear 0 1 2 3 4 5Working capital ($000) 240 247·2 254·6 262·2 270·1Incremental investment ($000) (7·2) (7·4) (7·6) (7·9) 270·1

(c) The capital asset pricing model (CAPM) can be used to calculate a project-specific discount rate in circumstances where thebusiness risk of an investment project is different from the business risk of the existing operations of the investing company.In these circumstances, it is not appropriate to use the weighted average cost of capital as the discount rate in investmentappraisal.

The first step in using the CAPM to calculate a project-specific discount rate is to find a proxy company (or companies) thatundertake operations whose business risk is similar to that of the proposed investment. The equity beta of the proxy companywill represent both the business risk and the financial risk of the proxy company. The effect of the financial risk of the proxycompany must be removed to give a proxy beta representing the business risk alone of the proposed investment. This betais called an asset beta and the calculation that removes the effect of the financial risk of the proxy company is called‘ungearing’.

The asset beta representing the business risk of a proposed investment must be adjusted to reflect the financial risk of theinvesting company, a process called ‘regearing’. This process produces an equity beta that can be placed in the CAPM in orderto calculate a required rate of return (a cost of equity). This can be used as the project-specific discount rate for the proposedinvestment if it is financed entirely by equity. If debt finance forms part of the financing for the proposed investment, a project-specific weighted average cost of capital can be calculated.

The limitations of using the CAPM in investment appraisal are both practical and theoretical in nature. From a practical pointof view, there are difficulties associated with finding the information needed. This applies not only to the equity risk premiumand the risk-free rate of return, but also to locating appropriate proxy companies with business operations similar to theproposed investment project. Most companies have a range of business operations they undertake and so their equity betasdo not reflect only the desired level and type of business risk.

From a theoretical point of view, the assumptions underlying the CAPM can be criticised as unrealistic in the real world. Forexample, the CAPM assumes a perfect capital market, when in reality capital markets are only semi-strong form efficient atbest. The CAPM assumes that all investors have diversified portfolios, so that rewards are only required for acceptingsystematic risk, when in fact this may not be true. There is no practical replacement for the CAPM at the present time,however.

4 (a) Pecking order theory suggests that companies have a preferred order in which they seek to raise finance, beginning withretained earnings. The advantages of using retained earnings are that issue costs are avoided by using them, the decision touse them can be made without reference to a third party, and using them does not bring additional obligations to considerthe needs of finance providers.

Once available retained earnings have been allocated to appropriate uses within a company, its next preference will be fordebt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is that insufficient retainedearnings are available and the investing company prefers issuing debt finance to issuing equity finance.

Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financedby equity, which is expensive compared to debt. Issuing debt here will lead to a reduction in the WACC and hence an increasein the market value of the company. One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchythan equity, since ordinary shareholders are paid out last in the event of liquidation. Debt is even cheaper if it is secured onassets of the company. The cost of debt is reduced even further by the tax efficiency of debt, since interest payments are anallowable deduction in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project.Equity finance is permanent finance and so may be preferred for investment projects with long lives.

(b) Annual interest paid per foreign bond = 500 x 0·061 = 30·5 pesosRedemption value of each foreign bond = 500 pesosCost of debt of peso-denominated bonds = 7% per yearMarket value of each foreign bond = (30·5 x 4·100) + (500 x 0·713) = 481·55 pesosCurrent total market value of foreign bonds = 16m x (481·55/500) = 15,409,600 pesos



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(c) (i) Interest payment in one year’s time = 16m x 0·061 = 976,000 pesosA money market hedge would involve placing on deposit an amount of pesos that, with added interest, would besufficient to pay the peso-denominated interest in one year. Because the interest on the peso-denominated deposit isguaranteed, Boluje Co would be protected against any unexpected or adverse exchange rate movements prior to theinterest payment being made.Peso deposit required = 976,000/ 1·05 = 929,524 pesosDollar equivalent at spot = 929,524/ 6 = $154,921Dollar cost in one year’s time = 154,921 x 1·04 = $161,118

(ii) Cost of forward market hedge = 976,000/6·07 = $160,790The forward market hedge is slightly cheaper

(d) Boluje receives peso income from its export sales and makes annual peso-denominated interest payments to bond-holders.It could consider opening a peso account in the overseas country and using this as a natural hedge against peso exchangerate risk.

Boluje Co could consider using lead payments to settle foreign currency liabilities. This would not be beneficial as far as peso-denominated liabilities are concerned, as the peso is depreciating against the dollar. It is inadvisable to lag payments to foreignsuppliers, since this would breach sales agreements and lead to loss of goodwill.

Foreign currency derivatives available to Boluje Co could include currency futures, currency options and currency swaps.

Currency futures are standardised contracts for the purchase or sale of a specified quantity of a foreign currency. Thesecontracts are settled on a quarterly cycle, but a futures position can be closed out any time by undertaking the oppositetransaction to the one that opened the futures position. Currency futures provide a hedge that theoretically eliminates bothupside and downside risk by effectively locking the holder into a given exchange rate, since any gains in the currency futuresmarket are offset by exchange rate losses in the cash market, and vice versa. In practice however, movements in the twomarkets are not perfectly correlated and basis risk exists if maturities are not perfectly matched. Imperfect hedges can alsoarise if the standardised size of currency futures does not match the exchange rate exposure of the hedging company. Initialmargin must be provided when a currency futures position is opened and variation margin may also be subsequently required.Boluje Co could use currency futures to hedge both its regular foreign currency receipts and its annual interest payment.

Currency options give holders the right, but not the obligation, to buy or sell foreign currency. Over-the-counter (OTC) currencyoptions are tailored to individual client needs, while exchange-traded currency options are standardised in the same way ascurrency futures in terms of exchange rate, amount of currency, exercise date and settlement cycle. An advantage of currencyoptions over currency futures is that currency options do not need to be exercised if it is disadvantageous for the holder to doso. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allowtheir options to lapse. The initial fee paid for the options will still have been incurred, however.

Currency swaps are appropriate for hedging exchange rate risk over a longer period of time than currency futures or currencyoptions. A currency swap is an interest rate swap where the debt positions of the counterparties and the associated interestpayments are in different currencies. A currency swap begins with an exchange of principal, although this may be a notionalexchange rather than a physical exchange. During the life of the swap agreement, the counterparties undertake to serviceeach others’ foreign currency interest payments. At the end of the swap, the initial exchange of principal is reversed.



17

Fundamentals Level – Skills Module, Paper F9Financial Management December 2008 Marking Scheme

Marks Marks1 (a) Rights issue price 1

Theoretical ex rights price per share 2––––

3

(b) Existing price/earnings ratio 1Revised earnings per share 1Share price using price/earnings method 1

––––3

(c) Discussion of share price comparisons 3–4Calculation of effect on shareholder wealth and comment 1–2


(d) Average dividend growth rate 2Ex div market price per share 2Discussion 2

––––6

(e) Discussion of agency problem 4–5Discussion of share option schemes 4–5


–––25

2 (a) Discussion of effects of interest rate increase 3–4Relevant financial analysis 1–2Interest rate hedging 2–3


(b) Financial analysis 5–6Discussion of overtrading 4–5Conclusion as to overtrading 1


(c) Reduction in financing cost 2Admininstration cost and bad debt savings 1Factor’s fee 1Interest on advance 2Net cost of factoring 1Conclusion 1

––––8

–––25



Marks Marks3 (a) Cost of equity 2

Cost of debt 1Market value of equity 1Market value of debt 1WACC calculation 1

––––6

(b) Inflated cash flows 1Tax on cash flows 1Capital allowance tax benefits 1Working capital – initial investment 1Working capital – incremental investment 1Working capital – recovery 1Net present value calculation 1Comment 1

––––8

(c) Explanation of use of CAPM 5–6Discussion of limitations 6–7


–––25

4 (a) Relevant discussion 7

(b) Market value of each foreign bond 3Total market value of foreign bonds 1

––––4

(c) (i) Explanation of money market hedge 2Illustration of money market hedge 2

––––4

(ii) Comparison with forward market hedge 2

(d) Discussion of natural hedge 1–2Description of other hedging methods 6–7


–––25

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f9 past years

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