Acca f9 Interim Assessment Answers d10

KAPLAN PUBLISHING 1

ACCA

Paper F9

Financial Management December 2010

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the corporate mock questions and submitted them for marking.

ACCA F9 FINANCIAL MANAGEMENT

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© Kaplan Financial Limited, 2010

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INTERIM ASSESSMENT ANSWERS

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1.

Key answer tips

This is not the usual style of question that can be expected in the exam but nevertheless is a good question for testing your understanding of these foundation topics.

(a) It may be argued that managers and owners of a business may not have the same interests because of the divorce between ownership and control. In many organisations, the shareholders will have very little influence over the day to day operations and management of the business. Managers will be aware of the need to seek to increase the wealth of the shareholders, but at the same time they may be equally concerned to serve their own needs/interests. For example, shareholders may be highly risk averse, looking only for reasonable and steady income from their investment. By contrast, a manager may by nature be more of a risk taker, because he considers that his career may progress faster if he is successful in the risks taken. In such a scenario, if the manager follows his instincts in selecting business opportunities, then the shareholders objectives are not met. The reverse situation may be equally true, whereby shareholders believe that management are excessively cautious in their selection of business opportunities, but management are very wary of taking risks as they wish to avoid large scale losses which might threaten their personal position. In both instances there is a gulf between the objectives of the manager and owners.

Another example of where objectives might conflict is in the case of mergers and takeovers. If a company has been reporting poor results and becomes the victim of a take-over bid, the shareholders are likely to be pleased as they will see an increase in the value of their investment. In contrast, the managers of the victim company may well be very unhappy, as they sense the risk of redundancy.

Williamson suggested that many of the aims of managers actually work in direct conflict with those of the owners, because managers look for perquisites and self aggrandisement, which add to company costs. Shareholders may be happy if the managers owned Ford Mondeos for company cars. The managers may well seek to have Mercedes instead! Similarly, having a large office and many staff to supervise is good for a manger’s self esteem, but they may not be essential to the efficient running of the business; owners may be better off without them.

One key area where owner-manager objectives may conflict is in terms of the time horizon used to judge success. Owners are often looking long-term in setting their objectives whereas a manager may need to have short-term successes on order to further his/her career prospects.

(b) Corporate social responsibility can be defined in a number of ways, but the term refers, in general, to the ways in which a privately owned company needs to be aware of and respect the needs of the wider community. The responsibility to shareholders is reasonably clearly defined and monitored by the financial markets and company reporting systems. Corporate responsibilities to customers, employees and the community at large are less well defined.

A company may be regarded as having responsibilities to its customers in terms of providing them with a quality product, at an appropriate price, which is supplied in a


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timely and efficient manner. The duty to the general public involves a responsibility not to endanger the public in any way, to respect the environment and to support the local community where possible. Social responsibility also extends to creditors, who should expect to be paid accurately and promptly. In the UK, there have been calls for legislation to restrict the period of credit which can be claimed from small companies.

National and local government are also affected by the activities of business and hence come under the remit of areas of social responsibility. Companies have a duty to pay their taxes as due, and comply with national and local laws e.g. planning/health and safety regulations. Lastly, companies have a responsibility to take care of their employees, ensuring a safe working environment and paying fair wages.

In conclusion, it is no longer sufficient for a company to think that it need only serve the interests of its shareholders. It is now regarded as good practice to look to the needs of the broader stakeholder group and so take on a wider social responsibility.

(c) At its simplest, 'Value for Money' (VFM) means getting the best possible service at the least possible cost. Public services are funded by the taxpayers and in seeking value for money, the needs of the taxpayer are being served, insofar as resources are being used in the best manner to provide essential services.

It is important to note that VFM does not mean lowest cost per se: it assesses cost in relation to the service provided. Three aspects of VFM are of relevance: efficiency, economy, and effectiveness. Efficiency relates to the level of output generated by a given input. Reducing the input:output ratio is an indication of increased efficiency. Economy measures the cost of obtaining the required quality of inputs needed to produce the service. The aim is to acquire the necessary inputs at the lowest possible cost. Effectiveness measures the extent to which the service meets its declared objectives. For example, a refuse collection service is only effective if it meets its target of, say, weekly collections from domestic premises. The service is economic if it is able to minimise the cost per weekly collection, and not suffer from wasted use of resources. The service is increasing its efficiency if it is able to raise the number of collections per vehicle per week.

MARKING GUIDE Marks (a) Separation of ownership and control 2 Importance of different time horizons 2 Importance of different attitudes to risk 2 Examples of potential conflicts 1 mark each maximum of 3 3

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9 (b) Definition of social responsibility 3 Identification of stakeholder groups 2 Responsibilities toward stakeholder groups 2 Conclusion 2

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9 (c) Definition of value for money 3 Discussion of 3 Es 4

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7 __

Total 25 __


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2 Walk in the footsteps of a top tutor

Key answer tips

This is a very typical style question in the key examinable area of working capital management. The detailed requirements mean you can choose which areas to tackle first. Parts (c), (d) & (e) are stand alone sections that could be attempted first in order to get capture some of the easier marks early within your answer.

(a)

Tutor’s top tips:

From the information provided, it is clear that two EOQ calculations.are required. The holding cost may be difficult to spot. Remember, in the formula, CH is the cost of holding one item of inventory for one year. This should signal that the percentage provided in the question needs to be applied to the price per item of inventory.

Currently: D = 20,000 CO = $31.25 CH = 20% × $6.25 = $1.25

EOQ = 1.25

20,00031.252 ×× = 1,000

Revised: CO = $120 CH = 20% × $6 = $1.20

EOQ = 1.20

20,0001202 ×× = 2,000

The new system will double the EOQ.

(b)

Tutor’s top tips:

For the proposed changes to be worth implementing, the total cost of the new system must be less than the current system. To tackle this part of the requirement you must start by figuring out how much less. You can then compare this to the initial investment to calculate the payback.


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Current cost:

$

Ordering cost = $31.25 × 1,00020,000

= 625

Holding cost = $1.25 × 2

1,000 = 625

Purchasing cost = $6.25 × 20,000 = 125,000 ______

TOTAL 126,250 ______

Revised cost:

$

Ordering cost = $120 × 2,000

20,000 = 1,200

Holding cost = $1.20 × 2

2,000 = 1,200

Purchasing cost = $6.00 × 20,000 = 120,000 ______

TOTAL 122,400 ______

Annual saving = $126,250 − $122,400 = $3,850

Initial investment = $10,000

Payback period = $10,000/$3,850 = 2.6 years, or 2 years and 7 months

The payback period is quite short, so from a financial viewpoint it is worth changing to the new system.

(c)

Tutor’s top tips:

To “discuss suitability” means that both benefits and drawbacks should be explored. Your points can be lifted straight out of your.text book although the requirement to “discuss” implies more than just a list is needed.

The benefits of using the payback period for project evaluation are as follows:

• It is simple to calculate and communicate. This is a significant advantage if a company lacks resources for more extensive analysis or if results are to be communicated to non-experts.

• For companies facing adverse cash flow conditions, it represents a way of selecting projects that will quickly generate positive cash flow.

• All other things being equal, the return on shorter-term projects is more certain than that on longer-term projects because market conditions are more likely to remain stable over the shorter term.

• It is useful as a second appraisal technique when using the NPV criteria, as a way of taking into account the risk of a project. For example, only undertake


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investments with a positive NPV and a payback period quicker than three years (say).

The limitations of the payback period include the following points:

• It does not take into account the time value of money, although of course it is possible to calculate the discounted payback period.

• Cash flows occurring after the payback period are ignored

• Project profitability cannot be assessed.

(d)

Tutor’s top tips:

The requirement to “explain” means each benefit you identify must be justified as to why it is a benefit. For 5 marks you should aim for at least 3 good points.

JIT inventory management is about the reduction and possibly the elimination of all forms of inventory (raw material, WIP and finished goods).

By holding little or no inventory, huge savings may be made in the form of holding costs. These costs include the storage costs for the inventory, deterioration, etc as well as the interest cost of holding inventory.

In a JIT system, raw material inventory is delivered straight to the factory rather than going into a warehouse to await being needed in the factory. A JIT system will also often mean a change in factory layout, reducing the amount of WIP inventory. In addition, items are not produced for inventory, but for customer demand. This means that, as soon as production is complete, the items will be delivered to the customer, eliminating finished good inventory.

All of this reduction in inventory can hugely reduce the storage space required, leading to large savings in terms of warehousing, storekeepers’ wages, insurance, etc. The other big advantage is that less cash is tied up in inventory, resulting in often fairly substantial savings in interest.

JIT necessitates a close working relationship with the supplier of raw materials. The purchaser requires guarantees on both quality and reliability of delivery from the supplier in order to avoid disruptions to production. In return for these commitments, the supplier can benefit from long-term purchase agreements, since a company adopting JIT purchasing methods will concentrate on dealing with those suppliers who are able to offer goods of the required quality at the right time.

(e)

Tutor’s top tips:

The requirement to “identify” means just listing or stating your points will be sufficient. The options are really just common sense and this part should therefore provide some easy marks.


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When faced with cash flow shortages, a company may consider one or more of a number of possible remedies:

• Postpone non-essential capital expenditure.

• Offer discounts for early payment by debtors.

• Chase overdue accounts.

• Use the services of a factor.

• Use invoice discounting.

• Sell any cash investments.

• Delay payment to creditors.

• Reschedule loan repayment.

• Reduce dividend payments (this, though, could be taken as a sign of financial weakness).

MARKING GUIDE Marks (a) Each EOQ 1½ marks × 2 3 (b) Current cost 2 Revised cost 2 Payback period 1 Comment 1

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6 (c) 1–2 marks for each valid point 6 (d) 1–2 marks for each valid point 5 (e) 1–2 marks for each valid point 5

__ Total 25

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Key answer tips

Tackling this question requires a methodical and logical approach. The requirements must be attempted in the order given. It is an excellent test of your understanding on the key investment appraisal topic.

(a)

Tutor’s top tips:

A careful read of the question is essential. For example, the increases in maintenance payments only occur after the first payment (which will be made at the end of the first year of the project i.e. T1). This could easily have been mis-interpretted. Writing down the timescales is a good way of ensuring you have everything clear in your mind.

With so many calculations, be careful to layout your workings neatly and cross reference fully where applicable.

Let Jan 1 20X5 = Year 0, Dec 31 20X5 = Year 1, Dec 31 20X6 = Year 2, etc.

Replace the machine:

Year Capital cost and maintenance

Contribution Net cash flow

Cumulative inflows

$ $ $

0 45,000 (45,000)

1 2,500 15,000 12,500 12,500

2 2,500 × 1.075 = 2,687 17,000 14,313 26,813

3 2,500 × 1.0752 = 2,889 19,000 16,111 42,924

4 2,500 × 1.0753 = 3,106 21,000 17,895 61,819

5 2,500 × 1.0754 = 3,339 22,000 18,661

Payback period = 3 years + 17,895

42,92445,000 − × 12 months = 3 years 1 month

Overhaul the machine:

Tutorial note:

An inflation index is just another way of presenting inflation rates. Rather than report the annual inflation rate for each year, an index is provided which shows how prices in that year relate to the ‘base’ year (the year where the index has been set to 100). This method of presentation actually makes your calculations in the exam a little easier.


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Year Capital cost and maintenance

Contribution Net cash flow

Cumulative inflows

$ $ $

0 27,500 (27,500)

1 4,000 13,000 9,000 9,000

2 4,000 1.105 = 4,420 14,500 10,080 19,080

3 4,000 1.221 = 4,884 15,500 10,616 29,696

4 4,000 1.349 = 5,396 16,000 10,604

5 4,000 1.491 = 5,964 16,000 10,036

Tutorial note:

An alternative layout would be to calculate net cumulative cash flows (i.e including the outflow in year 0). This would be perfectly acceptable.

Payback period = 2 years + 10,616

19,08027,500 − × 12 months = 2 years 10 months

(b)

Replace the machine Overhaul the machine Year Discount factor

(12%) Net

cash flow Present value

Net cash flow

Present value

$ $ $ $

0 1.000 (45,000) (45,000) (27,500) (27,500)

1 0.893 12,500 11,163 9,000 8,037

2 0.797 14,313 11,408 10,080 8,034

3 0.712 16,111 11,471 10,616 7,559

4 0.636 17,895 11,381 10,604 6,744

5 0.567 18,661 10,581 10,036 5,690

11,004 8,564

Tutor’s top tips:

The above shows a really efficient layout for your workings since it minimises the number of times you need to copy down information relating to the discount factors.


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(c)

Replace the machine Overhaul the machine Year Discount factor

(20%) Net cash

flow Present value

Net cash flow

Present value

$ $ $ $

0 1.000 (45,000) (45,000) (27,500) (27,500)

1 0.833 12,500 10,413 9,000 7,497

2 0.694 14,313 9,933 10,080 6,996

3 0.579 16,111 9,328 10,616 6,146

4 0.482 17,895 8,625 10,604 5,111

5 0.402 18,661 7,502 10,036 4,034

801 2,284

IRR of replacement = 12 + 80111,004

11,004−

× (20 − 12) = 12 + 8.6 = 20.6%

IRR of overhaul = 12 + 2,2848,564

8,564−

× (20 − 12) = 12 + 10.9 = 22.9%

Tutor’s top tips:

Don’t forget, the IRR formula is not supplied in the exam so you will need to memorise it.

Tutorial note:

20% is not the only possible discount factor to use here; any value over 12% is acceptable. The IRR may differ slightly, but should not be significantly different if alternative values are used.

(d)

Tutor’s top tips:

This part of the question is just about clearly stating what all of your calculations mean and why.

All three methods of investment appraisal use relevant cash flows to appraise the alternative investments.

The payback period calculates the time taken to pay back the initial investment. Using this criterion, overhauling the machine is the better option, with the slightly lower payback period.



The net present value takes into account the time value of money. It is the profit in present value terms. If the cost of capital is 12%, the machine should be replaced, since this option has the higher NPV.

The internal rate of return is the percentage return on the investment, taking into account the time value of money. The higher the return, the better. Overhauling the current machine has a higher IRR and so should be chosen using this appraisal technique.

Overall, to maximise shareholder wealth, the project with the highest NPV should be chosen which means that, provided the outcomes are not risky and 12% is the appropriate cost of capital, the machine should be replaced.

MARKING GUIDE

Marks (a) Capital and maintenance cost of replacement 2 Net cash flow 1 Payback period 1 Capital and maintenance cost of overhaul 2 Net cash flow 1 Payback period 1

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8 (b) Discount factors at 12% 1 Present values of each alternative, 1½ × 2 3 NPV for each alternative, 1 × 2 2

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6 (c) NPV at an alternative rate, for each machine, 1½ × 2 3 IRR for each alternative, 1½ × 2 3

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6 (d) 1 mark each for discussion of appraisal methods × 3 3 2 marks for discussion and final conclusion 2

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5 __

Total 25 __




Key answer tips

This is a common style of exam question, with calculations in part (a) and a discussional element in part (b). They key to success is not to get bogged down in the calculations at the expense of the discussional part, which will often yield the easier marks. Where discussional aspects do not refer specifically to previous calculations, it is a good exam technique to tackle these parts first.

(a) (i)

Tutor’s top tips:

The total figure for receivables is the total of those due to customers taking the discount and those not taking the discount.

Key to your success in this question is recognising that the time taken for those not taking the discount can be calculated by first calculating the value of receivables due to those taking the discount using the known information.

Average receivables days = Sales

Debtors × 365

Half of receivables take the discount. This represents sales revenue of $2.6 million.

Assuming that those taking the discount pay in 14 days, then for these customers receivables days = 14

Receivables days = 14 = receivables/sales × 365

Receivables = 2.6m × 14/ 365 = $100,000

Tutorial note:

The above calculation can also be performed working in weeks:

Average receivables weeks = Sales

Debtors × 52

For those taking the discount (50% of all sales), assume they all take 14 days (2 weeks), so that:

2 = £2.6m

Debtors × 52

Receivables (debtors) = 52£2.6m2×

= $100,000.



As all receivables total $500,000, the value of receivables from debtors who don't take the discount must be $400,000.

Average debtor days for these = 2.6m

400,000 × 365 = 56 days

Tutorial note:

Again, the above calculation can be performed working in weeks:

Average debtor days for these = 2.6m

400,000 × 52= 8 weeks

Other methods giving the same answer (in either weeks or days) will earn maximum marks.

(ii) Current costs

Tutor’s top tips:

This part of the question can still be tackled even if part (i) eluded you. The key is to just keep going, doing the parts you can do and not getting too delayed by those you can’t.

$ Cost of financing receivables $500,000 × 12% 60,000 Irrecoverable debts $5.2m × 1% 52,000 Cost of discount 2% × $5.2m × 50% 52,000

_______ Total cost 164,000

_______

(iii) New scheme

The new scheme will increase the sales revenue, which will, in turn, increase the operating profit.

New level of sales revenue = $5.2m × 1.1 = $5.72m

Extra sales revenue is therefore $520,000

Extra profit from these sales is 25% of $520,000 = $130,000

Under the new scheme, the time taken to pay by debtors NOT taking the discount will increase by 1 week from 8 to 9 weeks. The average debtor balance will then be:



Those who take the discount

522£5.72m75% ×× $165,000

Those who don’t take the discount

529£5.72m25% ×× $247,500

Total new debtor balance ________$412,500 ________

Tutorial note:

Again, whether you’ve tackled this calculation in weeks or days will make no difference to your mark allocation, provided your technique is correct.

Costs of new scheme

$

Cost of financing receivables $412,500 × 12% 49,500

Irrecoverable debts 0.5% × $5.72m 28,600

Cost of discount 4% × $5.72m × 75% 171,600 _______

Total costs 249,700 Less: Additional profit (130,000)

_______ Net costs of new scheme 119,700

_______

The new scheme costs less than the old scheme (a difference of $44,300). It is worthwhile switching to the new policy – offering a 4% discount.

(b) Inventory. Any policy which reduces inventory levels will reduce the opportunity cost of holding inventory e.g. better inventory control, faster inventory turnover, lower re-order points, just-in-time relationships with suppliers. However, the danger of reducing inventory levels is that the risk of a stockout increases. This results in loss of orders, loss of profits and loss of goodwill.

Cash needs to be monitored closely via budgets and models (such as the Baumol or Miller-Orr models) to ensure that cash does not fall below minimum required levels, that future financing requirements are anticipated, and that any surpluses can be invested in the money markets (cash can even be invested overnight). Centralised cash holding in an organisation may offer more control. Again, lower cash levels give opportunity savings, but increase the danger of illiquidity.

Creditor payments can be delayed, which will reduce a company's cash cycle and therefore reduce financing costs. However, this may prove expensive because of missing cash discounts (which are often worth a high percentage when annualised), and upsetting supplier relations.



MARKING GUIDE Marks (a) (i) Current time to pay 3 (ii) Current costs – financing receivables 1 Irrecoverable debts 1 Discounts 1 Total 1 (iii) Cost of new scheme: Revised sales value and margin 1 Revised new debtor balance 2 Revised cost of financing receivables 1 Revised irrecoverable debts and discounts 2 Revised total 1 Advice 1

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15 (b) Discussion of inventory 4

Discussion of cash 4 Discussion of creditor payments 2

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10 __

Total 25 __

Acca f9 Interim Assessment Answers d10

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