15083755 acca f9 financial management solved past papers 2

8/12/2019 15083755 ACCA F9 Financial Management Solved Past Papers 2

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Financial

Management

Time allowed

Reading and planning: 15 minutes

Writing: 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

P

ap

er

F9

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.

Income statement information for the last year

$000 Profit before interest and tax 7,000

Interest (500)

Profit before tax 6,500

Tax (1,950)

Profit for the period 4,550

Balance sheet for the last year $000 $000

Non-current assets 20,000

Current assets 20,000

Total assets 40,000

Equity and liabilities

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.

Average sector ratios:

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 lifeof 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

Economic order quantity

Miller Orr Model

The Capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordons growth approximation

The weighted average cost of capital

The Fisher formula

Purchasing power parity and interest rate parity

=2C D

C

o

H

Return point = Lower limit + (1

3x sppread)

Spread = 3

x transaction cost x va34

rriance of cash flows

interest rate

1

33



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End of Question Paper



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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 Cash flow $ 10% DF PV ($) 5% DF PV ($)

0 market value (105) 1.000 (105) 1.000 (105) 18 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 byeach source of finance depends on its risk from an investor point of view, with equity (ordinary shares) being seen as the mostrisky 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 debtis 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 willincrease at high levels of gearing due to the possibility of bankruptcy. At high levels of gearing, the cost of equity will increaseto 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 ofequity 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 theeffect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view, therefore, DroxfolCo can gear up using debt and reduce its WACC to a minimum, at which point its market value (the present value of futurecorporate cash flows) will be maximised.

In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital market, Miller and Modiglianidemonstrated that the WACC remained constant as a company geared up, with the increase in the cost of equity due tofinancial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capitalmarket the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing levels and the market value ofthe company is also constant. Miller and Modigliani showed, therefore, that the market value of a company depends on itsbusiness 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 paymentson debt reduced tax liability, which meant that the WACC fell as gearing increased, due to the tax shield given to profits. Onthis 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 interestpayments is more than offset by the effects of bankruptcy risk and other costs associated with the need to service large amountsof debt. Droxfol Co should therefore be able to reduce its WACC by gearing up, although it may be difficult to determine whetherit 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. Followingthe new loan note issue, however, interest coverage is less than half of the sector average, perhaps indicating that DroxfolCo 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

Income statement after one year $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 loannote issue it is 29% more (in relative terms). This level of financial gearing may be a cause of concern for investors andthe 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 bewelcomed. 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 companys 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 existing10% 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 securityfor 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 af ter both eight years and ten years. Ten years may therefore be too short a maturity for thenew 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 anissue 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 thetransaction is settled, the sterling receipt will have fallen to $5,435. Transaction risk therefore affects cash flows and for thisreason most companies choose to hedge or protect themselves against transaction risk.

Translation risk

This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known asaccounting 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 ofthe asset has changed from $10 million to $9.3 million, resulting an unrealised (paper) loss of $0.7 million. Translation riskdoes not involve cash flows and so does not directly affect shareholder wealth. However, investor perception may be affectedby 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).

Economic risk

Transaction risk is seen as the short-term manifestation of economic risk, which could be defined as the risk of the presentvalue of a companys expected future cash flows being affected by exchange rate movements over time. It is difficult to measureeconomic 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 exchangerates over time must reflect relative changes in inflation between two countries. If purchasing power parity holds true, theexpected 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 forecastingexchange rates several years in the future, rather than for periods of less than one year. For shorter periods, forward rates can becalculated using interest rate parity theory, which suggests that changes in exchange rates reflect differences between interestrates 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. Itis traded on a futures exchange and settlement takes place in three-monthly cycles ending in March, June, September andDecember, ie a company can buy or sell September futures, December futures and so on. The price of a currency futurescontract 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, thebuyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Equally, profits are creditedto 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 theinitial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. Again 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 sterlingcurrency futures contracts in the US and since it is 1 April, would buy June futures contracts. In June, Nedwen Co could sellthe 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 isallowed to vary between the lower and upper limits calculated by the model. If the lower limit is reached, an amount of cashequal to the difference between the return point and the lower limit is raised by selling short-term investments. If the upper limitis reached an amount of cash equal to the difference between the upper limit and the return point is used to buy short-terminvestments. The model therefore helps Renpec Co to decrease the risk of running out of cash, while avoiding the loss of profitcaused by having unnecessarily high cash balances.

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

Policy formulation 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 earlysettlement discounts: deciding whether to charge interest on overdue accounts; determining procedures to be followed whengranting credit to new customers; establishing procedures to be followed when accounts become overdue, and so on.

Credit analysis

Assessment of creditworthiness depends on the analysis of information relating to the new customer. This information is oftengenerated by a third party and includes bank references, trade references and credit reference agency reports. The depth ofcredit analysis depends on the amount of credit being granted, as well as the possibility of repeat business.

Credit control 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 administrativeprocedures are timely and robust, for example sending out invoices and statements of account, communicating with customersby telephone or e-mail, and maintaining account records.

Collection of amounts due

Ideally, all customers will settle within the agreed terms of trade. If this does not happen, a company needs to have in placeagreed procedures for dealing with overdue accounts. These could cover logged telephone calls, personal visits, charginginterest on outstanding amounts, refusing to grant further credit and, as a last resort, legal action. With any action, potentialbenefit should always exceed expected cost.

(d) When considering how working capital is financed, it is useful to divide assets into non-current assets, permanent currentassets and fluctuating current assets. Permanent current assets represent the core level of working capital investment neededto support a given level of sales. As sales increase, this core level of working capital also increases. Fluctuating current assetsrepresent the changes in working capital that arise in the normal course of business operations, for example when someaccounts 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 capitalfunding policy, therefore, long-term finance is used for both permanent current assets and non-current assets. Short-termfinance 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 highercompensation 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 madewhen 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 favourableterms.

A conservative working capital funding policy will use a higher proportion of long-term finance than a matching policy, therebyfinancing some of the fluctuating current assets from a long-term source. This will be less risky and less profitable than amatching 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, financingsome of the permanent current assets from a short-term source such as an overdraft. This will be more risky and moreprofitable 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, anaggressive or a matching approach. Previous funding decisions will determine the current position being considered in policyformulation. The size of the organisation will influence its ability to access different sources of finance. A small company, forexample, may be forced to adopt an aggressive working capital funding policy because it is unable to raise additional long-termfinance, 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 Capital allowances Tax benefits 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 themachine 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 cashflow (DCF) method and so takes account of the time value of money. It also considers cash flows over the whole of the projectlife and is sensitive to both the amount and the timing of cash flows. It is preferred by some as it offers a relative measure ofthe value of a proposed investment, ie the method calculates a percentage that can be compared with the companys 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 foundusing 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 inthe value of cash flows, giving rise to evaluation difficulties. There is a potential conflict between IRR and NPV in the evaluationof mutually exclusive projects, where the two methods can offer conflicting advice as which of two projects is preferable. Wherethere is conflict, NPV always offers the correct investment advice: IRR does not, although the advice offered can be amendedby considering the IRR of the incremental project. There are therefore a number of reasons why IRR can be seen as an inferiorinvestment 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 78 Conclusion 1

Maximum 8

(c) Analysis of interest coverage ratio 23 Analysis of financial gearing 23 Analysis of earnings per share 23 Comment 23

Maximum 8

25

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

6

(b) Discussion of purchasing power parity 45 Discussion of interest rate parity 12

Maximum 6

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

Sterling value of 1-year receipt 13

(d) Evaluation of money market hedge 4 Comment 1

5

(e) Definition of currency futures contract 12 Initial margin and variation margin 12 Buying and selling of contracts 12 Hedging the three-month receipt 12

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 12 Credit analysis 12 Credit control 12 Collection of amounts due 12

Maximum 6

(d) Analysis of assets 12 Short-term and long-term debt 23 Discussion of policies 23 Other factors 12

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 113

(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 23 Weaknesses of IRR 56

Maximum 7

25



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Financial

Management and

Control

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 be

answered

Section B TWO questions ONLY to be answered

Formulae sheet, present value and annuity tables are on

pages 10 and 11 P

ap

er

2.

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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 in

the process of planning the initial cash flows of the business. He estimates that there will not be any sales demand

in January 2003 so production in that month will be used to build up stocks to satisfy the expected demand in

February 2003. Thereafter it is intended to schedule production in order to build up sufficient finished goods stock at

the end of each month to satisfy demand during the following month. Production will, however, need to be 5% higher

than sales due to expected defects that will have to be scrapped. Defects are only discovered after the goods have

been 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 as

follows:

High Medium Low

demand demand demand

February 22,000 20,000 19,000

March 26,000 24,000 23,000

April 30,000 28,000 27,000

May 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 demand

occurring each month is as follows:

High 005; Medium 085; Low 010.

It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making small

purchases. The remaining 90% of sales will be made on two months credit. A 25% discount will, however, be

offered to credit customers settling within one month. It is estimated that customers, representing half of credit sales

by 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 300

Materials 200

Variable overhead 100

Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears and variable

overheads 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 February

2003. Smelting machinery will be purchased on 1 January 2003 for 200,000 payable in February 2003. Further

machinery will be purchased for 50,000 in March 2003 payable in April 2003. This machinery is highly specialised

and 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 pay

into his bank account on 1 January 2003 as the initial capital of the business. He realises that this will be insufficient

for his business plans, so he is intending to approach his bank for finance in the form of both a fixed term loan and

an overdraft. The only asset Jack has is his house that is valued at 200,000, but he has an outstanding mortgage

of 80,000 on this property.

The consultants advising Jack have recommended that rather than accumulating sufficient stock to satisfy the

following months demand he should not maintain any stock levels but merely produce sufficient in each month to

meet the expected demand for that month.

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Jacks production manager objected: I need to set up my production schedule based on the expected average demand

for the month. I will reduce production in the month if it seems demand is low. However, there is no way production

can be increased during the month to accommodate demand if it happens to be at the higher level that month. As a

result, under this new system, there would be no stocks to fall back on and the extra sales, when monthly demand

is high, would be lost, as customers require immediate delivery. In respect of this, an assessment of the impact of

the 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 1,704

flow ()

Month-end 143,000 (80,279) (87,866) (138,533) (136,690) (134,986)

balance ()

Required:

(a) Prepare a monthly cash budget for Jack Geeps 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 the

net 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 the

consultants. 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 an

assessment of the wider implications of just-in-time stock management in the particular circumstances of

Jack Geeps 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 companys financing needs and describe how this might be achieved.

Where appropriate, show supporting calculations. (17 marks)

(50 marks)

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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 arising

from the divergent interests of multiple stakeholder groups in private sector companies in the UK.

(13 marks)

(25 marks)

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3 Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been disappointing in

recent years and a new managing director, Peter Beech, was appointed to raise production volumes. After an initial

assessment 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 of

higher 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 320 per kg 8000

Labour 4 hours at 8 per hour 3200

Variable overheads 4 hours at 4 per hour 1600

Fixed overhead 4 hours at 16 per hour 640019200

Selling price 22000

Standard profit 2800

Overheads are absorbed on the basis of labour hours and the company uses an absorption costing system. There were

no 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 350 280,000

Labour 16,000 hours at 7 112,000

Variable overhead 60,000

Fixed overhead 196,000

Total production cost (3,600 benches) 648,000

Closing stock (400 benches at 192) 76,800

Cost of sales 571,200

Sales (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 budgets

had previously been set at this level. Very few operating variances had historically been generated by the standard

costs used.

Mr Beech has made some significant changes to the operations of the company. However, the other directors are now

concerned that Mr Beech has been too ambitious in raising production targets. Mr Beech had also changed suppliers

of raw materials to improve quality, increased selling prices, begun to introduce less skilled labour, and significantly

reduced fixed overheads.

The finance director suggested that an absorption costing system is misleading and that a marginal costing system

should 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 should

reconcile 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 on

the 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)

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4 Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The machine is essential

to the operations of the company. The company is, however, considering whether to purchase the machine outright

or to use lease financing.

Purchasing the machine outright

The machine is expected to cost 360,000 if it is purchased outright, payable on 31 December 2002. After four

years the company expects new technology to make the machine redundant and it will be sold on 31 December 2006

generating 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 years allowance is given in the year of acquisition but no writing

down allowance is available in the year of disposal. The difference between the proceeds and the tax written down

value in the year of disposal is allowable or chargeable for tax as appropriate.

Leasing

The company has approached its bank with a view to arranging a lease to finance the machine acquisition. The bank

has offered two options with respect to leasing which are as follows:

Finance Operating

Lease Lease

Contract length (years) 4 1

Annual rental 135,000 140,000

First rent payable 31 December 2003 31 December 2002

General

For both the purchasing and the finance lease option, maintenance costs of 15,000 per year are payable at the end

of each year. All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposes

in full in the year of payment. Assume that tax is payable one year after the end of the accounting year in which the

transaction 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 be

30%. The companys accounting year-end is 31 December. The companys 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 make

a share issue. During this time the most marginal investment project, which is perfectly divisible, requires an

outlay of 500,000 and would generate a net present value of 100,000. Investment in the turbine would

reduce 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. Advise

whether 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 that

need to be considered in acquiring the turbine with respect to capital rationing. (8 marks)

(25 marks)

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This is a blank page.

Question 5 begins on page 8.

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5 Abkaber plc assembles three types of motorcycle at the same factory: the 50cc Sunshine; the 250cc Roadster and

the 1000cc Fireball. It sells the motorcycles throughout the world. In response to market pressures Abkaber plc has

invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size

of its workforce.

Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering

introducing Activity Based Costing (ABC). Abkaber plcs accountant has produced the following analysis.

Annual

Annual Direct Raw

Output Labour Selling material

(units) Hours Price cost

( per unit) ( per unit)

Sunshine 2,000 200,000 4,000 400

Roadster 1,600 220,000 6,000 600

Fireball 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 showrooms

Set-ups the number of times the assembly line process is re-set to accommodate a production run ofa different type of motorcycle

Purchase 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 of

deliveries set-ups purchase

to retailers orders

Sunshine 100 35 400

Roadster 80 40 300

Fireball 70 25 100

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

Deliveries to retailers 2,400,000

Set-up costs 6,000,000

Purchase 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 that

activity 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 least

cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages

costs for our entire production.

The managing director argued: I believe that activity based costing would be an improvement but it still has its

problems. For instance if we carry out an activity many times surely we get better at it and costs fall rather than remain

constant. 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 which

method of allocating overheads we use. It seems to make no difference to me.



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Required:

(a) Calculate the total profit on each of Abkaber plcs three types of product using each of the following methods

to 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 issues

raised by each of the directors.

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

(25 marks)

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End of Question Paper



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Answers



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Part 2 Examination Paper 2.4

Financial Management and Control December 2002 Answers

1 (a) Jack Geep

High Medium Low Expected

demand demand demand demand

February 22,000 x 005 20,000 x 085 19,000 x 01 20,000March 26,000 x 005 24,000 x 085 23,000 x 01 24,000

April 30,000 x 005 28,000 x 085 27,000 x 01 28,000

May 29,000 x 005 27,000 x 085 26,000 x 01 27,000

June 35,000 x 005 33,000 x 085 32,000 x 01 33,000

January February March April May June

Receipts

Capital 150,000

Cash sales (W1) 2,000 2,400 2,800 2,700 3,300

Credit sales (W1) 8,775 10,530 12,285 11,846

Credit sales (W1) 9,000 10,800 12,600

Payments

Fixed assets 200,000 50,000

Labour (W2) 6,300 7,560 8,820 8,505 10,395 10,395

Materials (W2) 4,200 5,040 5,880 5,670 6,930

Overheads (W2) 2,100 2,520 2,940 2,835

Fixed costs 7,000 7,000 7,000 7,000 7,000 7,000

Consultant 12,000

Net cash flow 136,700 (228,760) (11,785) (51,575) (220) 586

Bal 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 3,300

Credit

(90% x 05 x 0975) 8,775 10,530 12,285 11,846

(90% x 05) 9,000 10,800 12,600

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


Labour (3/6) 6,300 7,560 8,820 8,505 10,395 10,395

Materials (2/6) 4,200 5,040 5,880 5,670 6,930

Overheads (1/6) 2,100 2,520 2,940 2,835

(W3) Production costs:


Cost 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



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(b) Note

Only the cash flows for sales and labour are required. The remainder of the cash budget is provided to prove the figures

supplied in the question.

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

Medium Low Expected

demand demand sales

February 20,000 x 09 19,000 x 01 19,900

March 24,000 x 09 23,000 x 01 23,900

April 28,000 x 09 27,000 x 01 27,900

May 27,000 x 09 26,000 x 01 26,900

June 33,000 x 09 32,000 x 01 32,900


Receipts

Capital 150,000

Cash sales (W4) 1,990 2,390 2,790 2,690 3,290

Credit sales (W4) 8,731 10,486 12,241 11,802

Credit sales (W4) 8,955 10,755 12,555

PaymentsFixed assets 200,000 50,000

Labour (W5) 6,269 7,529 8,789 8,474 10,364

Materials (W5) 4,179 5,019 5,859 5,649

Overheads (W5) 2,090 2,510 2,930

Fixed costs 7,000 7,000 7,000 7,000 7,000 7,000

Consultant 12,000

Net cash flow 143,000 (223,279) (7,587) (50,667) 1,843 1,704

Bal 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 June

Cash (10%) 1,990 2,390 2,790 2,690 3,290

Credit

(90% x 05 x 0975) 8,731 10,486 12,241 11,802

(90% x 05) 8,955 10,755 12,555

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

February March April May June

Labour (3/6) 6,269 7,529 8,789 8,474 10,364

Materials (2/6) 4,179 5,019 5,859 5,649

Overheads (1/6) 2,090 2,510 2,930

(W6) Production costs:

February March April May June

Cost of sales 11,940 14,340 16,740 16,140 19,740

Defects 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.



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(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 138,533

rather than 155,640. There is also a more rapidly improving deficit thereafter, with the balance falling to 134,986

by the end of June. In the longer term, however, there is continued loss of profitability due to lost sales when demand

is high.

The primary reason for this is the reduced investment in stock that is tying up cash. Under the original proposal there

is surplus stock amounting to the next months sales which means production is necessary at an earlier stage thereby

using 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 progress

and 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 accommodate

demand above the mean expected level as no stock is carried. This, however, amounts to only 100 per month of sales

on 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. They

may go elsewhere not just for the current sale but also for future sales if Mr Geep is seen as an unreliable supplier. This

results 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 production

within the month. If the majority of demand is at the beginning of each month this would cause problems without a

level 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 at

selling values thus an extra 1,200 at variable cost. This is significantly lower than a whole months production but

would accommodate peak demand.

(2) Liquidity is very important initially as the business attempts to become established. Minimal stocks could be held in the

early months therefore, with perhaps slightly increased stocks once the business and its cash flows become established.

(d) REPORT

To: Mr J Geep

From: An Accountant

Date December 2002

Subject: 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 uncertainty

but the reliability and probability of these estimates will need to be established by appropriate market research. If sales

are lower than expected then any bank finance will take longer to repay, thus increasing the amount of finance needed

and 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 fur ther purchases of fixed assets) as follows:

Sales 33,000

Discounts (33,000 x 45 x 025) (371)

Labour (9,900)

Material (6,600)

Variable overheads (3,300)(19,800) x 105 (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 take

place, excluding interest charges. Any variation in these estimates would, however, affect the amount of the financingneeded.



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In addition to uncertain trading results affecting the amount of future financing, there is an additional requirement to

finance future capital investment as the business expands. This is likely to be a major financing need in the future

depending on the rate of expansion.

The levels of the drawings, taxation and interest charges will also extend the amount of finance needed, as these items

were 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 as

expected 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 security

in that it cannot be recalled unless there is a breach in the terms. Most likely it would come from a bank, the issue of

debentures being entirely out of the question on the grounds of scale. Other considerations would be the term of the

loan, 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 of

finance 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 to

be any property, the machinery has a low net realisable value and there is little stock, which is normally poor

security anyway. An overdraft may also require security but may place increased emphasis on the cash generating

potential of the business to make appropriate repayments. Ultimately, however, this is an unlimited business and

Mr Geeps 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 reduce

the 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 on

demand, and thus the bank needs less protection from other clauses in the contact. There are, however, likely to

be restrictive covenants in overdraft agreements.

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

costs.

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

medium-term loan.

(7) The purpose of the finance is also likely to affect the form of finance. For example, if funds are required to finance

fixed assets then it might be appropriate to use long-term finance to match the long-term usage of the asset.

(iii) Working Capital Management

It has already been seen (in requirement (b)) that a reduction in stock due to the introduction of just-in-time stock

management can improve liquidity by improving cash flows and reducing any cash deficit. The same principle can be

applied to other types of working capital.

Some of the same arguments also apply, however, in that while liquidity may be improved there could be offsetting

disadvantages 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 months credit (33,000 x 90% x 50% x 0975) 14,479

Two 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.



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Whether the credit terms themselves can be changed may depend upon the credit terms of competitors when set

alongside the other conditions of sale. If the business is out of line with competitors then lost sales may result and a

balance 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 done

in this area given the current credit terms.

Accelerated payment could be encouraged by a higher cash discount but this is expensive, particularly as customers

who would pay within one month anyway would also receive a greater reduction in price without any benefit to the

business.

Invoice discounting and debt factoring may be alternatives but these are expensive and in the particular circumstances

of the business, where there are expected to be no late payers or bad debts, it might seem inappropriate to use outside

assistance.

Creditors

It 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 interest

are likely to exist. Conflicts also exist not just between groups but within stakeholder groups. This might be because sub

groups exist e.g. preference shareholders and equity shareholders. Alternatively it might be that individuals have different

preferences (e.g. to risk and return, short term and long term returns) within a group. Good corporate governance is partly

about the resolution of such conflicts. Stakeholder financial and other objectives may be identified as follows:

Shareholders

Shareholders are normally assumed to be interested in wealth maximisation. This, however, involves consideration of potential

return and risk. Where a company is listed this can be viewed in terms of the share price returns and other market-based

ratios 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, market

share. 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 other

stakeholder groups. Thus, shareholders, as a group, might be interested in profit maximisation; they may also be interested

in the welfare of their employees, or the environmental impact of the companys operations.

Directors and managers

While directors and managers are in essence attempting to promote and balance the interests of shareholders and other

stakeholders 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 giving

them the capacity to take decisions which are consistent with their own reward structures and risk preferences. Directors may

thus 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 difficult

to separate from their financial impact.

Lenders

Lenders are concerned to receive payment of interest and ultimate re-payment of capital. They do not share in the upside of

very 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).

Employees

The primary interest of employees is their salary/wage and security of employment. To an extent there is a direct conflict

between 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 drawing

the divergent interests together.

Suppliers and customers

Suppliers 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 partly

dependent upon the company in question. Nevertheless it is important to consider and measure the relationship in term of

financial objectives relating to quality, lead times, volume of business, price and a range of other variables in considering any

organisational strategy.



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(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 devolved

that power. Part of that duty of accountability is discharged by disclosure both of performance in the normal financial

statements 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 to

disclose 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 corporate

governance regulation in the UK (including Cadbury, Greenbury and Hampel) has therefore focused on the control of this

group and disclosure of its activities. This is to assist in controlling their ability to promote their own interests and make more

visible 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 single

board). This contrasts to Germany for instance where there is more independence between the groups in the form of two tier

boards.

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 how

it has been achieved.

Overall, the visibility given by corporate governance procedures goes some way toward discharging the directors duty of

accountability to stakeholders and makes more transparent the underlying incentive systems of directors.

3 Woodeezer

(a) Operating statement

Budgeted profit (4,000 x 28) 112,000

Sales Volume Profit Variance (3,200 4,000) 28 (22,400) A

Standard profit on actual sales 89,600

Selling Price Variance (220 225) 3,200 16,000 F105,600

Cost variances

Fav Adv

Material Usage [(3,600 x 25) 80,000] 32 32,000

Material Price (32 3.5) 80,000 24,000

Labour efficiency [(4 x 3,600) 16,000)] 8 12,800

Labour rate (8 7) 16,000 16,000

Var O/H eff [(4 x 3,600) 16,000)] 4 6,400Var O/H exp (4 x 16,000) 60,000 4,000

Fixed O/H exp (256,000 196,000) 60,000

Fixed O/H eff [(4 x 3,600) 16,000)] 16 25,600

Fixed O/H capacity [16,000 (4 x 4,000)] 16 nil 112,000 68,800 43,200


(b) Motivation and budget setting

Absorption 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 that

employees were expected to achieve.Mr Beech appears to have considered the evidence that suggests that the best budget for motivating employees to maximise

achievement (in this case output) is one which is difficult but credible (an aspirations budget). In maximising actual

performance, however, it is normally expected that production will fall short of the budget target. This means that there is an

expectation of adverse planning variances.



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Explanations of Variances

The 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 it

may explain a higher price resulting in an adverse MPV. Conversely, however, with better materials there may be less waste

and 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 labour

may 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 functions

of the LEV. Their meaning is questionable however, as variable overheads seldom vary proportionately to labour hours. By

definition fixed overheads do not vary with labour hours and this variance merely balances the books in an absorption costing

system.

The fixed overhead expenditure variance is significant and requires further consideration. This is particularly the case if it

involves discretionary expenditure which has been reduced but which may have a long-term impact on the business.

(c) Marginal costing

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

Budgeted contribution (4,000 x 92) 368,000

SVV (3,200 4,000) 92 (73,600) A

Standard contribution on actual sales 294,400

SPV (220 225) 3,200 16,000 F310,400

Cost variances

Fav Adv

MUV [(3,600 x 25) 80,000] 32 32,000

MPV (32 35) 80,000 24,000

LEV [(4 x 3,600) 16,000)] 8 12,800

LRV (8 7) 16,000 16,000

Var O/H eff [(4 x 3,600) 16,000)] 4 6,400

Var O/H exp (4 x 16,000) 60,000 4,000 52,000 43,200 8,800

Actual contribution 319,200

Fixed overheads

Budgeted 256,000

Expenditure variance 60,000

(196,000)


Reconciliation

Absorption costing profit 148,800

Fixed 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 being

written off in the current month but are being carried forward as part of closing stock, notwithstanding that they are period

costs 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.



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4 Leaminger plc

(a) Purchase outright

2002 2003 2004 2005 2006 2007

Outlay/NRV (360,000) 20,000

Maintenance (15,000) (15,000) (15,000) (15,000)

Taxation 4,500 4,500 4,500 4,500

WDA Tax Effect (W1) 27,000 20,250 15,188 11,391

Bal Allowance (W2) 28,172 Cash flow (360,000) 12,000 9,750 4,688 20,891 32,672

DF 10 0909 0826 0751 0683 0621

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 Effect

b/d 25% 30%

2002 360,000 90,000 27,000

2003 270,000 67,500 20,250

2004 202,500 50,625 15,1882005 151,875 37,969 11,391

2006 113,906

(W2) Balancing allowance

TWDV 113,906

Proceeds 20,000

Bal Allow 93,906

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

Finance lease

Annuity Factor (AF) at 10% for 4 years is 317

Thus PV outflows = (135,000 + 15,000)317 = (475,500)

PV tax relief = [(150,000 x 03)317]/11 = 129,682Net Present Cost = (345,818)

Operating lease

Annuity Factor (AF) at 10% for 3 years is 2487

Thus PV outflows = (140,000)(2487 +1) = (488,180)

PV tax relief = (140,000 x 03)(2487 +1)/11 = 133,140


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



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(b) Each 1 of outlay before 31 December 2003 would mean a loss in NPV on the alternative project of 020. There is thus

an opportunity cost of using funds in 2002.

Purchasing

Net Present Cost (302,959)

Opportunity cost (02 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 lease


Opportunity cost (02 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) REPORT

To: The Directors of Leaminger plcFrom: A business advisor

Date: December 2002

Subject: Acquiring the turbine machine

Introduction

In financial terms, and without capital rationing, the purchasing outright method is the preferred method of financing as it

has the lowest negative NPV. With capital rationing, a finance lease becomes the preferred method. There are, however, a

number 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 thus

purchasing becomes relatively more attractive.

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

for liquidity.

(3) The use of a 10% cost of capital may be inappropriate as these are financing issues and are unlikely to be subject to

the average business risk. Also they may alter the capital structure and thus the financial risk of the business and thus

the 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 the

lessor may refuse to lease the turbine at the end of any annual contract thus making it unavailable from this particular

source. On top of capital rationing, we need to consider the availability of finance as a continuing source under the

operating lease.

(5) Conversely, however, with the operating lease Leaminger plc can cancel if business conditions change (e.g. a

technologically 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 and

hence capital rationing might be more severe.

(6) On the issue of maintenance costs of 15,00

15083755 acca f9 financial management solved past papers 2

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