Jun 06 Mock Exam suggested answers QUESTION 1 1 (a) Estimated NPV Year Outlay Sales Variable costs

0 1500

000 3

3000 3000 3000 3000 3000 3000 2385 2385 2385 2385 2385 2385 ____ ____ ____ ____ ____ ____ Taxable cash flow 615 615 615 615 615 615 Taxtion (35%) 215 215 215 215 215 215 ____ ____ ____ ____ ____ ____ ____ Net cash flow (1500) 400 400 400 400 400 400 Discounting at 8% the expected NPV is : (1500) + (400 x 4.623) = 349.2 or 349.200
Where 4.623 is the present value of an annuity of one FOR six years at 8%.

Notes: (i) Variable cost per unit is 3.95 x 20% (copyright) plus 1.50 x 40% (purchases from supplier) plus 0.20 (additional variable cost) = 1.59. (ii) Market research is a sunk cost. (iii) The financing cost is encompassed within the discount rate. The use of 8% as the discount rate discussed in part (b). (b) Assuming the company wishes to retain its existing capital structure the cost of finance of any project, no matter whether the actual source of finance can be identified, is best regarded as the cost of a pool of debt and equity weighted by their market proportions. The minimum acceptable return is the weighted average cost of debt and equity. In this question the weighted average used is the real cost of capital as the cash flows have not been adjusted for rising prices or cost (inflation) during the six year period. The use of 18% as a discount rate would produce an incorrect solution as real cash flows would be discounted by a nominal cost of capital. The 8% discount rate is unlikely to be satisfactory because: (i) The project might have a different systematic risk to Tigwoods normal activities, in which case the discount rate should reflect the different risk (ii) During the six years of the agreement prices and cost might increase at different rates. The effect of these differential price changes is not reflected by discounting real cash flows by a real discount rate. Discounting inflation adjusted nominal cash flows at a nominal rate, is recommended, and is likely to result in a different estimated net present value.

Jun 06 Mock Exam suggested answers (c) In sensitivity analysis all variable except the one under consideration are held constant, and an estimate is made of the value for the variable under consideration that produces a net present value of zero. Initial outlay: As the present value of net cash inflows is 1849.2, the value of the initial outlay would have to be 1849.2 to result in a zero NPV. 349.2 This represents a change of 1500 x 100% = 23.28% Contribution: The zero NPV annual contribution can be estimated by solving the following equation for x (the zero contribution) - 1500 + 4.623 x (.35x) 4.623 = 0 N.B. (.35x) 4.623 is the annual tax charge which is dependent upon the unknown contribution. Solving 3.005x = 1500, x = 499.16 The present annual contribution is 615, this represents a charge of 115.84 615 X 100% = 18.83% Agreement life: The zero NPV life has a present value of annuity factor at 8% of 1500 + 400x = 0, x = 3.75 From the annuity table: PV annuity for four years is 3.312 PV annuity for five years is 3.993 Extrapolating, the zero NPV life is 3.75 - 3.312 x 1 year = 4.643 years 4 years + 3.993 3.312 This is a reduction of 1.35 years of 22.61 % Discount rate : The zero NPV rate is where the present value of a six year annuity of 400 is zero. Solving 1500 + 400 x = 0, where x is the required rate = 3.75 From the present value of annuity table 15% has a PV annuity factor of 3.784, and 16% 3.685.

Jun 06 Mock Exam suggested answers

Extrapolating, the zero NPV rate is 3.784 3.75 15% + 3.784 3.685 x 1% = 15.34 % 7.34 This represents a change of ------ = 91.75% 8 These estimates suggest, not surprisingly, that the decision is most sensitive to a change in the annual contribution. The analysis does not, however, establish how sensitive the decision is to the sales price alone, or any of the elements of variable cost (assuming their relationship to sales price alters) Such information might be useful to the decision maker. Sensitivity analysis has several limitations: (i) (ii) (iii) It treats variables as if they are independent and does not consider the inter- relationships that might exist between variables. There is no measure of the probability of changes in any of the variables occurring. There is no automatic decision rule implied for managers. Managers do not know whether their decisions should be altered because of the level of sensitivity of a variable.

(d)

Information might include: (i) What relationship (if any) does Tigwood Ltd have with the suppliers of the microfiche readers? The success of the project is dependent upon the availability and sale of readers. What price are they to be sold at? How are they to be marketed? Would it be better for the project to be a joint venture between Tigwood and the manufacturer of microfiche readers (and possibly the photographic company that supplies the microfiche). How accurate are the estimated cash flows? What is the effect of inflation on the cash flows? What is the systematic risk of the project? Is the agreement likely to be renewed after six years? If the project is successful is it possible to extend it to more books? How secure is the market from competitors ? Is it possible to obtain patent protection on the microbooks?

(ii) (iii) (iv) (v) (vi)

Jun 06 Mock Exam suggested answers QUESTION 2 (a) Benefit to Comfylot will be measured by the incremental effects of proposed changes, initially during the next year. Domestic sales are 11.2m in total, 8.96 on credit. Export sales are 4.8m, 4.08m on credit (net of the 15% initial deposit). (i) Administration: Savings Factor cost credit sales of 8.96m x 1.5% Financing: Existing cost: 8.96m x 57 x 15% 365 Cost with factor: 8.96m x 57 x .8 x 15.5% 365 209,885 Incremental effects 85,000 (134,000) ------------(49,400)

the

(173,505)

8.96m x 57 x .2 x 15% ( 41,977) 365 ------------ (5,597) Redundancy payment (15,000) Saving in bad debts (as the factor is non-recourse) 8.96m x 0.75% 67,200 -----------(2,797)

Jun 06 Mock Exam suggested answers Although the incremental effect of using the factor appears to be unfavourable, the redundancy payment is a one-off cost which will not be repeated in future years. If the other net savings are maintained after year one, the use of the factor is likely to result in savings of approximately 12,200 per year. (ii) Cash discount: Current finance costs Costs with discount of customers not taking the discount 8.96m x .6 x 57 x 15% 365 Plus customers taking the discount 8.96m x .4 x .985 x 7 x 15% 365 Financing saving from the discount Cost of offering the discount 8.96m x .4 x 0.15 Administration cost Saving on bad debts 8.96 x .25% (10,155) 73,799 (53,760) (25,000) (22,400) ----------17,439 (125,931) 209,885

Jun 06 Mock Exam suggested answers

This saving is larger than the saving from using the factor. If the discount and the factor cannot both be used then the discount offers the higher financial again. However, other considerations might influence the decision such as the automatic increase in finance that is provided by the factor as sales increase, which could prevent overtrading. (iii) Export sales Although it is possible to estimate the expected increase in export sales (25.5%) and to calculate the incremental costs and benefits of this expected increase, it is more useful for the company to quantify the effects of all three stated sales increases. Export sales are currently 4.8 million, 4.08m on credit after deducting the initial deposit. The finance cost of these sales is 4.08m x 75 x 15% = 125,753 365 Bad debts are 4.08m x 1.25% = 51,000 20% sales increase New credit sales are 4.896m Finance costs 4.896m x 80 x 15% = 160,964 365 Bad debts 4.896m x 1.5% = 73,440 Contribution from extra sales (5.76m - 4.8m) x .35 = 336,000 - 30,000(admin) Overall effect 25% sales increase New credit sales 5.1m Finance costs 5.1m x 80 x 15% = 167,671 365 41,918 (306,000) (248,349) 35,211 22,440 Change in costs ()

Jun 06 Mock Exam suggested answers

Bad debts 5.1m x 1.5% = 76,500 Extra contribution (6m - 4.8m) x 3.5 = 420,000 - 40,000 Overall effect 30% sales in increase New credit sales 5.304m Finance costs 5.304m x 80 x 15% = 174,378 365 Bad debts 5.304m x 1.5% = 79,560 Extra contribution (6.24m - 4.8m) x .35 = 504,000 - 50,000 Overall effect

25,500 (380,000) (312,582)

48,625 28,560 (454,000) ------------(376,815)

Advertising costs 300,000. If sales increase by either 25% or 30%, the incremental benefits from increased sales are large enough to cover the cost of advertising. There is an 80% chance of this occurring. If sales increase by 20% the cost of advertising exceeds the expected benefits by 51,651. However, if the benefits of advertising last beyond the first year (without similar repeat advertising being necessary), then it is likely to be beneficial to undertake the advertising campaign even with a 20% sales increase.

Jun 06 Mock Exam suggested answers

Question 3 (a) Financial gearing is the ratio between ordinary share capital and interest bearing plus fixed dividend bearing securities (including preference shares). Financial gearing might be important to a company because: (i) It affects the income risk of shareholders and the providers of interest bearing and fixed dividend bearing finance. The higher the financial gearing the greater the interest payments a company must make before the ordinary shareholders and preference shareholders receive dividend payments. It profits fall and cash flow is limited high financial gearing might result in reduced dividends or no dividends and cause a fall in share price. Increased financial gearing also increases the probability of default on interest payments and increases income risk for providers of debt finance. (ii) It affects the capital risk for providers of funds. Increased financial gearing is likely to increase bankruptcy cost, agency costs and lead to a higher probability of corporate failure as there is a greater chance of default on payments on interest and principal. (iii) The level of financial gearing influences a companys ability to raise new finance, and the type of finance that might be available. A company with high gearing could experience difficulty in raising new debt finance or have to pay a higher price for both new debt and equity because of the higher financial risk. (iv) Financial gearing affects the companys cost capital. Initially the use of debt in the capital structure might reduce the weighted average cost of funds, but as financial risk increase and the required return on both debt and equity increases the weighted average cost of funds will increase. (b) Factors that might limit the amount of debt finance include: (i) Security. The amount and quality of assets, guarantees or other forms of security that are available to lenders. Companies with a high proportion of easily realisable fixed assets are likely to use more longterm debt than companies whose assets are primarily in the form of debtors and stock. (ii) Limitations imposed in the companys articles of association. (iii) The existing level of financial gearing. A company with high gearing might experience difficulty in raising further debt finance because of the extra risk to both shareholders and prospective lenders. Lenders (e.g. banks) might have perceptions of acceptable levels of gearing and be unwilling to lend beyond these levels. Additionally a company might

Jun 06 Mock Exam suggested answers have some desired target capital structure which approximately minimiss the weighted average cost of capital and maximises the market value of the company (assuming operating income is independent of capital structure). The relationship between the existing gearing level and the desired optimal gearing is likely to influence the decision of how much debt finance to use. Cash flow available to meet payments of interest and principal Most lenders will need to be convinced that future cash flows will safely meet these obligations. Alternatively accounting ratios such as estimated interest cover may be examined to see how high earnings before tax and interest are relative to forecast interest payments. Stability and growth of profits and sales. Stability of sales and profits mear companies can incur interest charges on debt with less risk than when sales and profits are volatile. The relative costs of debt and equity, particularly any tax advantages to either form of financing (it may be argued that in an efficient market debt and equity would be correctly priced according to their systematic risk). Covenants on existing debt restricting further debt financing. The attitude of the companys management towards risk and control. Raising new equity might affect the control and voting position of some companies (especially small companies) in which case debt finance might be favoured rather than equity finance. Risk averse management may deliberately limit debt financing to a substantially lower amount than a less risk averse management team operating in similar financial circumstances.

(iv)

(v) (vi) (vii) (viii)

(c)

All of the three managers have used some form of the ratio. debt -------- in their estimates of financial gearing equity Mr Y has used book values, and has only included medium and long-term debt in his estimate 5,600 + 1,800 Hence ------------------- = 89% 8,330 Mr Z has also used book values but has included short-term loans and overdraft in addition to long-term debt. 7,400 + 1,000 + 2,800 ------------------------------ = 134% 8,330

Jun 06 Mock Exam suggested answers Mr R has used market values with both short and long-term loans and overdraft 5,600 + 1,944 + 980 + 2,800 ---------------------------------------- = 55% 20,680 Mr Y might argue that many financial institutions measure financial gearing by relating the book value of medium and long-term debt to the book value of shareholders funds, and that Engot should use the same measure as such institutions, which might include potential lenders to the company. He might reject gearing based on market values because: (i) Market values, especially of equity can be volatile and make it difficult for a company to identify its optimal gearing (or range of gearing) (ii) Security is often based upon balance sheet values of fixed assets. (N.B. Balance sheet values often include revalued fixed assets.) Mr Z could extend Mr Ys arguments by pointing out that the company has a substantial amount of short-term loans and overdraft, which increase cash outflows on interest payments, and affect the companys interest cover and financial risk. Unless short-term loans and overdrafts are expected to be eliminated in the near future a gearing measure which does not take such loans into account would be incomplete and inaccurate. Mr R could argue that book values often bear little relationship to the current value to the business of assets and liabilities, especially fixed assets and should therefore, not be used to measure gearing. Financial decisions should be taken based upon market values rather than largely historic costbased book values. For these reasons gearing based upon market values is preferred. (d) Report on financing the proposed expansion Dear Sirs, Your choice of financing will be influenced by several factors including (i) Risk. (ii) Taxation and cost of alternative sources of finance. (iii) Likely efect on share price and earnings per share. (iv) Security available. If debentures are used financial gearing and financial risk will be increased. Gearing based upon book values of all loans and overdraft related to shareholders funds will initially increase to 11,200 + 5,000 = 194% 8,330 i.e loans are almost twice as high as shareholders funds Using market value gearing increases to (assuming no change in market prices) 11,324 + 5,000 = 79% 20,680

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Jun 06 Mock Exam suggested answers If a rights issue is used gearing, based upon the same measures, initially falls to 11,200 11,324 --------- = 84% and ---------- = 44% respectively 13,330 25,680 These appear to be quite high when debt finance is used especially for a company with potentially volatile sales and profits, However, no details are available of comparative gearing levels of other companies in the industry or the nature and current values of the companys assets (e.g. whether they are easily realisable at book value or higher). The expected profits are: 000 000 000 000 000 56,000 72,000 90,000 108,000 120,000 42,000 54,000 67,500 81,000 90,000 8,000 8,000 8,000 8,000 8,000 ---------- ---------- ------------------ ---------EBIT 6,000 10,000 14,500 19,000 22,000 At the lowest expected sales level interest cover using the debenture is Sales Variable costs Fixed costs 6,000 --------- = 3.63 times 1,654 (existing interest assumed constant, plus new interest payable). Although the minimum acceptable level is likely to differ between companies, a cover of 3.63 times (at worst) is likely to be acceptable to the providers of finance. The effects of the two financing sources on earnings per share are: Debentures EBIT Interest 000 6,000 1,654 -------Taxable 4,346 Taxation 1,521 --------Available to shareholders 2,825 -------EPS (22m shares) 12.8p 000 10,000 1,654 --------8,346 2,921 --------5,425 --------24.7p 000 14,500 1,654 ---------12,846 4,496 ---------8,350 ---------38.0p 000 19,000 1,654 ---------17,346 6,071 ---------11,275 ---------51.2p 000 22,000 1,654 ---------20,346 7,121 ---------13,225 --------60.1p

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Jun 06 Mock Exam suggested answers Rights issue 5m at a 15% discount or approximately 80p per share requires the issue of 6,250,000 new shares. 000 6,000 1,154 -------Taxable 4,846 Taxation 1,696 --------Available to shareholders 3,150 -------EPS (28.25m shares) 11.2p EBIT Interest 000 10,000 1,154 --------8,846 3,096 --------5,750 --------20.4p 000 14,500 1,154 ---------13,346 4,671 ---------8,676 ---------30.7p 000 19,000 1,154 ---------17,846 6,246 ---------11,600 ---------41.1p 000 22,000 1,154 ---------20,846 7,296 ---------13,560 --------48.0p

At all sales levels use of the debenture results in higher expected EPS. The level of sales at which the shareholders might be indifferent based on EPS is found by equating for both the rights issue and debenture issue. (Sales variable cost fixed costs interest) (1 -- tax) -------------------------------------------------------------------------Number of shares or (S - .75S 8 1.154) (.65) -----------------------------------28.25 = (S - .75S 8 1.654) (65) -----------------------------------22

Solving S = 45.66 million Sales would have to fall to approximately 45.66 million before shareholders became indifferent, based upon EPS, between the rights issue and debentures. At all levels above this (assuming linear relationships) debentures would be preferred. The book value of fixed assets is currently 16.7 million. This figure should increase with the proposed expansion. Taking into account the current level of overdrafts and loans adequate security should be available for a 5 million debenture issue. It would be useful to know what effect the two methods of financing would have on share price, in particular any relevant effects of changes in bankruptcy costs and agency costs on share price. However, it is difficult to quantify such factors.

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Jun 06 Mock Exam suggested answers Although a debenture issue appears to offer financial advantages, the decision on the financing choice must depend also upon management attitude to risk, the target gearing of the company, and the effect that the financing choice now will have on the companys long-term investment and financing plans. Yours sincerely C.O.D. & Co. Accountants

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Jun 06 Mock Exam suggested answers Question 4 Painting and Decorating Cost Budget 20X1 to 20X3 20X1 20X2 Direct material 20,250 21,263 Direct labour 72,900 78,003 Variable overhead 25,515 27,046 Fixed overhead: Avoidable 15,430 16,356 Depreciation 10,287 10,287 Head office 25,718 27,261 Total relevant cost 134,095 142,668 (excluding depreciation and head office costs) 428,558 Working notes: Overhead absorbed per house: 20% on material cost 100% on labour cost Variable overhead element: 30% of material related 33!% of labour related Total variable overhead per house Fixed overhead per house 20X3 22,326 83,463 28,669 17,337 10,287 28,897 151,795

Painting 20X1 15 270 285 4.5 90 ____ 94.5 _____ 190.5 =====

Budgeted fixed overhead for year = (150 + 120 ) x 190.5 = 51,435 The cost is compiled by multiplying the cost per house for material, labour and overhead by the number of houses budgeted to be painted each year ( 150 + 120 = 270 ). The fixed overhead is analysed into its component categories: avoidable, depreciation and head office costs. The 19X2 and 19X3 cost budgets are then compiled by multiplying by the appropriate cost factors given in the question: materials + 5%; labour + 7%; overhead + 6%

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Jun 06 Mock Exam suggested answers Painting and Decorating Cash Budget 20X1 Material payments: Prior year creditors Current year credit Cash purchases Labour payments: Prior year accruals Current year Variable overhead: Current year Prior year creditors Fixed overhead: Avoidable Head office Total cash flows 2,100 16,402 2,025 2,800 69,984 24,664 600 15,430 25,718 _____ 159,723

20X2 1,823 17,223 2,126 2,916 74,883 26,144 851 16,356 27,261 ______ 169,583

20X3 1,914 18,084 2,233 3,120 80,124 27,713 902 17,337 28,897 ______ 180,324

The cash budget is compiled using the cost budget data calculated above, together with the information regarding balances at 31 December 20X0 and the timing forecasts for payments in respect of materials, labour and overhead given in the question. Note that depreciation is omitted since it does not constitute a cash flow. (b) (i) The total relevant costs of operating the painting and decorating squad for the three year period are 428,558 as calculated above. The outside company quotation is for 3 x 135,000 = 405,000. The outside company offer should, therefore, be accepted on financial grounds. Points in favour of the proposal include: 1. Cost. The projected relevant costs for the maintenance department for the period 20X1 to 20X3 are 428,557. The outside company quotation is for 405,000 i.e. a saving of 23,557. 2. Any cash received on sale of residual stocks of paint, plumbing spares and electrical spares will further increase the savings to be made from the change. 3. It may be possible to sub-let premises e.g. stores and workshops which are no longer required and hence generate additional income.

(ii)

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Jun 06 Mock Exam suggested answers

4. The current internal operating costs may be understated. The cost budget in part (a) of the answer includes labour cost based on the 19X1 cost of 270 per house. The cost per house assumes that labour is a wholly variable cost which will be available at the times when individual houses require to be repainted. It may be necessary to consider labour as a semi-variable cost whereby a small team are employed permanently all year round with additional employees being recruited to cope with peaks of painting and decorating activity e.g. when the weather is particularly favourable. This strategy would mean an overall increase in labour cost from that stated in the cost budget. Points against the proposed closure: 1. Redundancy payments to employees may be considerable hence reducing the savings to be made from the change. 2. The housing association management may wish to employ inspectors to check that the work done by the outside contractor is of an acceptable standard. The salaries payable to such inspectors will reduce the savings to be made from the change. 3. The quality of work may be poorer than at present and cause dissatisfaction amongst tenants.

4. What happens after the three year period? Will the outside firm negotiate another contract? Would it be difficult to reestablish an internal maintenance function. The apparent savings from the proposal will also be affected by the accuracy of the estimates of maintenance cost per house. If the estimates are overstated the external quotation may be considerably higher than the costs which would be incurred by an internal maintenance provision. If the cost increase estimates used in compiling the 1992 and 1993 costs are inaccurate this will further distort the information being used in the cost comparison.

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Jun 06 Mock Exam suggested answers

Question 5 a) The standard product cost Standard Quantity Direct materials WALS LOPS 15 8 Standard Price 60 75 Standard Cost 900 600 -------1500 630 2,130 210 -------2,340 460 -------2,800 =====

Direct labour 60 hours at 10.50 per hour Standard prime cost Production overheads 504,000/2,400 Wallops 2,800 - 2,340

Standard profit (by deduction) Standard sales price

504,000/180 Wallops =

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Jun 06 Mock Exam suggested answers

(b)

(i)

Materials price variance WALS (SP AP) x Quantity used (60 - 57) x 2,850 * LOPS (75 - 81) X 1,470 ** = = 8,550 Fav 8,820 Ad -------270 Ad --------

Materials usage variance WALS opening stock Purchases

600 3,000 -------3,600 Closing stock 750 --------Quantity used = 2,850 * Standard 180 x 15 = 2,700 -------Ad = 150 x 60 = 9,000Ad Standard Price LOPS Opening stock 920 Purchases 1,000 -------1,920 Closing stock 450 -------Quantity used = 1,470 ** Standard 180 x 8 = 1,440 -------Ad = 30 x 75 = 2,250Ad Standard Price -------11,250 Ad

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Jun 06 Mock Exam suggested answers --------(ii) Direct labour rate variance (SR AR) X hours worked 112,320 (10.50 - ------------ = 9.60/hour 11,700 hours - 0.9 x 11,700 hours Direct wages efficiency variance (SH AH) X Std wage rate (180 x 60) 11,700) x 10.50 (10,800 11,700) x 10.50

10,530 Fav

= =

9,450 Ad --------1,080 Fav ---------

(iii)

Fixed production overhead expenditure variance (Budgeted overhead Actual overhead) 504,000 ------------- --- 42,600 12 months = 42,000 - 42,600 = 600 Ad Fixed production overhead volume variance (Budgeted volume Actual volume) x Overhead absorption rate per unit 42,000 (200 180) x ---------- = 210/unit 200 (20) x 210 = 4,200 Ad Underabsorbed overhead (i.e. 20 units x 210)

(c)

Reconciliation statement standard gross profit and actual gross profit Sales 180 at 2,800 standard price Standard cost of sales (a) 180 at 2,340 Standard gross profit 504,000 421,200 ----------82,800

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Jun 06 Mock Exam suggested answers Variances: Fav Material price Material usage Direct wages rate Direct wages efficiency Fixed overheads: Expenditure Volume 10,530 9,450 600 4,200 --------25,770 10,530 Ad 270 11,250

---------10,530 Actual gross profit (d)

= 15,240 Ad --------= 67,560 =====

To: Mr Jones for presentation to the board of directors From: Management accountant. Date: Subject: Reconciliation statement of standard gross profit and actual gross profit Taken alone, the reconciliation statement between the standard gross profit and the actual gross profit as shown in (c) above is of little value for the board of directors. It is the causes and the significance of the variances which are of much more importance than the figures themselves. Variance reports/statement should initiate the required action and this will depend on whether the reported variances are controllable or non-controllable for example: (1) Material price variance might be unavoidable because of general price rises whereas material usage variances may have resulted from the excessive waste of materials due to inefficiency of labour/condition(s) of machines/machinery. (2) Reduced quality of labour may have led to labour rate savings, but the inadequate quality/standard of skill(s) cause excessive efficiency variance (s) or is it that the equipment is outdated and is causing workers to take longer to meet the required level of satisfactory output. I recommend that as soon as possible the company implements a system which requires that all managers prepare for you a detailed report as to the causes and the implications of any variances for their respective departments. Signed: .

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