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2.4 Mock Exam Jun 06 Answer-AJ PDF
2.4 Mock Exam Jun 06 Answer-AJ PDF
2.4 Mock Exam Jun 06 Answer-AJ PDF
QUESTION 1
1 (a) Estimated NPV £000
Year 0 1 2 3 4 5 6
Outlay 1500
Sales 3000 3000 3000 3000 3000 3000
Variable costs 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
(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.
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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)
N.B. –(.35x) 4.623 is the annual tax charge which is dependent upon the
unknown contribution.
Agreement life: The zero NPV life has a present value of annuity factor at 8% of
–1500 + 400x = 0, x = 3.75
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.
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Jun 06 Mock Exam suggested answers
7.34
This represents a change of ------ = 91.75%
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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.
(i) It treats variables as if they are independent and does not consider the
inter- relationships that might exist between variables.
(ii) There is no measure of the probability of changes in any of the variables
occurring.
(iii) 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.
(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).
(ii) How accurate are the estimated cash flows? What is the effect of inflation
on the cash flows?
(iii) What is the systematic risk of the project?
(iv) Is the agreement likely to be renewed after six years?
(v) If the project is successful is it possible to extend it to more books?
(vi) How secure is the market from competitors ? Is it possible to obtain patent
protection on the microbooks?
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Jun 06 Mock Exam suggested answers
QUESTION 2
(a) Benefit to Comfylot will be measured by the incremental effects of the
proposed changes, initially during the next year.
Export sales are £4.8m, £4.08m on credit (net of the 15% initial
deposit).
(2,797)
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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 209,885
17,439
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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.
Export sales are currently £4.8 million, £4.08m on credit after deducting the initial
deposit.
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Jun 06 Mock Exam suggested answers
Extra contribution
(£6.24m - £4.8m) x .35 = £504,000 - £50,000 (454,000)
-------------
Overall effect (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.
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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).
(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 long-
term debt than companies whose assets are primarily in the form of
debtors and stock.
(ii) Limitations imposed in the company’s 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
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Jun 06 Mock Exam suggested answers
(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.
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Jun 06 Mock Exam suggested answers
Mr R has used market values with both short and long-term loans and overdraft
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 cost-
based book values. For these reasons gearing based upon market values is
preferred.
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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 company’s assets (e.g. whether they are
easily realisable at book value or higher).
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:
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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.
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.
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Yours sincerely
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Jun 06 Mock Exam suggested answers
Question 4
Painting 20X1
Working notes: £
Overhead absorbed per house:
20% on material cost 15
100% on labour cost 270
285
Variable overhead element:
30% of material related 4.5
33⅓% of labour related 90
____
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Jun 06 Mock Exam suggested answers
Material payments:
Prior year creditors 2,100 1,823 1,914
Current year credit 16,402 17,223 18,084
Cash purchases 2,025 2,126 2,233
Labour payments:
Prior year accruals 2,800 2,916 3,120
Current year 69,984 74,883 80,124
Variable overhead:
Current year 24,664 26,144 27,713
Prior year creditors 600 851 902
Fixed overhead:
Avoidable 15,430 16,356 17,337
Head office 25,718 27,261 28,897
_____ ______ ______
Total cash flows 159,723 169,583 180,324
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.
(ii) Points in favour of the proposal include:
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Jun 06 Mock Exam suggested answers
4. What happens after the three year period? Will the outside
firm negotiate another contract? Would it be difficult to re-
establish 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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Question 5
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Jun 06 Mock Exam suggested answers
£
WALS (SP – AP) x Quantity used
(£60 - £57) x 2,850 * = 8,550 Fav
LOPS (£75 - £81) X 1,470 ** = 8,820 Ad
--------
270 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 = 10,530 Fav
- £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 = 9,450 Ad
---------
= 1,080 Fav
---------
(c) Reconciliation statement standard gross profit and actual gross profit
£
Sales 180 at £2,800 standard price 504,000
Standard cost of sales (a) 180 at £2,340 421,200
-----------
Standard gross profit 82,800
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Jun 06 Mock Exam suggested answers
Variances:
Fav Ad
Material price 270
Material usage 11,250
Direct wages rate 10,530
Direct wages efficiency 9,450
Fixed overheads:
Expenditure 600
Volume 4,200
---------- ---------
10,530 25,770
10,530 = 15,240 Ad
---------
Actual gross profit = 67,560
=====
Signed: ……………………….
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