5.

1 & Business finance

5.2 and its sources
Ideas for answers to progress
questions
1 The finance required to set up a business. This could be required for
premises, equipment, materials or advertising.
2 Working capital is the excess of current assets over current liabilities.
3 Revenue expenditure is on current assets items such as materials and wages.
They are used up in the short term. Capital expenditure is on non-current
assets such as machinery and vehicles which will be used in the business over
a long period.
4 Short-term sources of finance are those that are repayable within a 12-month
period. Long-term sources of finance are repayable over a period longer than
12 months and can be as long as 25 years or more in the case of a mortgage or
debentures.
5 Advantage: money does not need to be repaid to anyone; it can be a quick
source of finance.
Disadvantage: once sold the asset is not available to the business for use; the
amount raised might be small depending on the value of the asset sold.
6 Advantage: no repayment is required; no interest payable; immediately
available.
Disadvantage: not there if an emergency occurs; shareholders might prefer
higher dividends; might be insufficient.
7 Overdraft: can be used when there is a short-term cash deficit, e.g. to pay
wages for a week.
Short-term bank loan: longer term than an overdraft but perhaps used when
a large order has been received and additional materials need to be purchased.
The loan can be repaid when the order is delivered and paid for.
8 If the payment is due very soon then an overdraft would be the best option to
pay the wages because it can be repaid as soon as the payment is received and
interest is only charged for the days that the money was used.
9 The business might be new and not have the financial history that would be
required by a bank. The government might be charging a lower rate of interest
than other institutions. The repayment period might be longer than other
institutions.

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10 If the amount of money was large and was needed for a long period, e.g. more
than one year.
If it was not clear that the money could be repaid within a short period
of time.
11 Long-term bank loans, mortgages, debentures, government loans and
venture capital.
12 Venture capitalists usually require some ownership rights in return for their
investment.

Ideas for answers to case study

questions
Stage Productions Ltd
1 The finance needed to pay wages is a short-term requirement as the money
will be available once Stage Productions Ltd receive payment for organising
an event. An overdraft or a short-term bank loan would be appropriate.
The finance needed to purchase additional equipment requires a medium- to
long-term source of finance. This could be through a medium- to long-term
bank loan or by issuing more shares to existing shareholders. Any new
shareholders would have to be approved by the existing ones as this is not a
public limited company. There might be government grants available. Crowd
funding could also be used as the many people who attend the events might
be interested in having some financial link to the business.
The text does not say how long the business has been in existence.
This might affect the sources of finance available to them. Governments
often support new businesses or ones that are located in an area of
economic need.

Ideas for answers to exam-style

questions
1 These should be relevant, i.e. short-term sources of finance such as: negotiate
an overdraft; retained earnings; negotiate an extended credit period with
suppliers; sale of unwanted assets or a short-term bank loan.
“State” indicates that two sources should be given but explanation is not
required.
2 The development of a new product is likely to take a long time. It might be
some years before the new product gives any substantial return. A business
is likely to require a source of finance that does not need to be paid back for
some time or which does not require high interest payments. Short-term
sources of finance might not be large enough for product development. The
rate of interest on overdrafts is usually high and would be too expensive if the
business is paying this for a longer period of time.

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3 This is a new business so answers should show an awareness that potential
lenders might view any loan as risky and therefore will require a higher rate of
interest to be paid to reflect the risk involved.
Possible sources might be bank loans (both short and long term depending on
how much money is required and how long the finance will be required for).
The question does not state the size of the business. If this is a sole trader
then the owner’s savings and money from family and friends might be used.
A small-scale business might also obtain finance from a bank specialising in
micro-finance or from crowd funding. If the business is operating on a larger
scale from the outset then a venture capitalist might be prepared to offer
financial support.
Analysis of various sources is required and judgment about which source
might be best. Evaluation might be embedded in discussion of each source
by relating to the scale of the business or the likely market for the wooden
furniture. Local markets are less likely to attract a venture capitalist due to the
restricted market potential.
4 a Andre’s savings and finance from his family and friends. A bank loan
perhaps from a bank specialising in micro-finance. He might be able to buy
his van on hire purchase and may be able to negotiate credit terms for his
ingredients, although credit terms are often not given to a new business.
b Andre will not have any proof of his ability to repay a bank loan due
to not having any history of financial records to show to the bank and
because this is a new venture its potential for success might be uncertain.
His proposed business is small scale and therefore does not have many
assets (if any) that can be used as collateral. If he owns his own house this
might be used as collateral and make a bank loan more likely.

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5.3 Costs

Ideas for answers to progress

questions
1 To judge whether the business is covering its costs with the price being
charged. To decide whether or not to accept an order at a price lower than the
normal selling price. To decide whether to produce or buy a product.
2 A fixed cost does not vary with the level of output, e.g. rent or advertising
expenditure.
A variable cost changes according to the level of output, e.g. raw-material
costs or direct labour costs.
3 Fixed or semi-variable costs cannot easily be allocated to a specific product
or service. For example in a multi-product business the fixed element of
an electricity bill cannot be easily allocated to an individual product or
department. Rent paid for the total premises does not directly relate to each
product in a multi-product business.
4 $16 000.
5 $6000.
6 The level of output at which total cost is equal to total revenue.
The business makes neither a profit nor a loss.
7 Break-even 5
Fixed costs
Contribution (where contribution equals selling price 2 variable costs)
8 To see the possible effect of a change in costs on the break-even level of
output. To see what level of output must be achieved to reach a target level
of profit. To make a judgment between two possible products or different
locations. The one with the lowest break-even level is usually chosen.
9 Margin of safety is the difference between the actual level of output (when
that level is above break-even level) and the break-even level of output. It is
the amount by which output can fall and the business will still be in profit.
10 It assumes that all output is sold, which is not always the case as some can
remain as inventory. The accuracy of break-even is dependent on accurate cost
information. Cost and revenue lines are assumed to be linear, but if the level
of production required another machine to be purchased, the fixed-cost line
would be higher above a certain level of production.

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11 Yes they should accept the order because the fixed costs are covered by normal
production levels. Variable costs only need to be covered at $7. At a price of
$8 each shirt adds $1 to the profit of the business.
12 When deciding between two competing options, e.g. two products. The one
which makes the greatest contribution is likely to be chosen. When entering
a new market the business needs to cover its variable costs in the short term,
and once established the price can be increased so that fixed costs are also
covered. It might be that existing markets are covering fixed costs anyway.
Whether or not to accept a one-off order at a lower price. Deciding whether
to make or buy components or products. Whether or not to continue
production at all.
13 When all of the costs including a proportion of fixed costs have been
absorbed into the costs of production.
14 A business opportunity might be refused which might have been accepted
had marginal costing been used. Some departments might view the allocation
of fixed costs as being unfair.

Ideas for answers to case study

questions
SLD Plastics
1 To check that the correct quantity of plastic granules had been received and
invoiced; a typing error could have meant that 1000 kg of granules had been
charged for but only 100 kg delivered.
To check the price being charged; if this had been done Stephano would have
noticed the increase in price and might have been able to negotiate a lower
price or find a cheaper supplier.
2 Accurate cost information is essential to make sure that the price charged
is sufficient to cover all costs. Lack of accurate cost information can lead to
expenditure being higher than revenue. They could have been selling buckets
at a price below the cost of manufacture. Cost information can be used to
assess whether budgets have been met or if changes to budgets need to be
made in the future.
Changes in costs can be monitored and action taken if accurate information
is kept.

Bribeck Medical Appliances (BMA)

1 Variable costs: raw materials, labour costs, fuel for delivery vehicles and
electricity (electricity might have a standard charge element which would be
fixed, making this a semi-variable cost).
Fixed costs: salaries.
The cost of Olivia the medical consultant will be a fixed cost if she is
employed regardless of how many patients she assesses. Her pay will be a
variable cost if she is paid per patient assessed.
2 There might be marketing costs that have not been considered; how do they
make it known that the business exists?
Research and developments costs should also be considered. The equipment
is likely to be undergoing frequent development as new technology arrives.

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Sports Alive
Fixed costs 12 000
1 Break-even level of output 5 5
Contribution 5(15 2 10)
5 2400 pairs of football boots
Where contribution equals selling price minus variable costs.
Fixed costs 12 000
2 Break-even level of output 5 5
Contribution 3(12 2 9)
5 4000 football kits
The $1 donation is added to the variable costs.

Ideas for answers to exam-style

questions
1 Direct costs are those that can be directly linked to the making of a product.
They might be variable costs but are not necessarily so, for example the salary
of the production manager of wooden toys will be a fixed cost but will also be
a direct cost of the production of wooden toys.
Variable costs vary according to the level of output.
2 a The price charged must cover all of the costs involved if the business
is to survive. If the business is new or is facing strong competition the
price must cover costs even if profit is foregone in the short term. The
price charged usually includes a desired amount of profit. All of the costs
involved, for example the cost of raw materials, wages, packing, marketing
and a desired amount of profit, must be calculated. If the cost of raw
materials falls, the price charged might be reduced and vice versa.
b A large business is likely to have several departments and cost efficiency
levels between departments might vary.
The usefulness depends on the activities of each department and therefore
how accurate cost comparisons might be.
Cost information can be used to see if costs are rising from one period to
the next. Specific costs can be reviewed and compared across departments.
Comparison would need to be wary of varying sizes of departments.
For example, if wage costs in one department are much higher than all
others this might be due to there being more employees in the high-cost
department. Or it could be because the employees of one department
need to be more highly skilled and therefore more highly paid.
This question requires some discussion of typical business costs
accompanied by consideration of how easily they can be compared
between departments. Variations can be due to skill level of employees,
energy usage, administration costs, the amount of equipment used and
the technology involved. For example, a department that uses rapidly
changing technology is likely to have higher expenditure on equipment.
Or a research and development department that is currently developing a
larger number of products than normal is likely to have higher costs than
when fewer products are being developed.
Evaluation can be based on the similarities or differences between
departments and the types of costs involved in each case.

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3 a You can argue for or against in answer to this question. The sales revenue
is $220 000. Assuming that the fixed costs of $100 000 are the portion
of fixed costs to be covered by the production of Quizzles, the total costs
are $238 000 and so it appears that Quizzles are not profitable. However,
they should continue to produce Quizzles because ignoring fixed costs
the cost is then only $138 000, which means that there is a positive
contribution to fixed costs of $82 000. If production of Quizzles ceased
then other products in the range might not be purchased.
b They can change the way in which fixed costs are apportioned so that
other products cover a higher proportion. They can try to find cheaper
sources of materials but without any fall in quality. It is unlikely that they
can reduce labour costs (wages) because this might result in demotivated
employees whose productivity is negatively affected. Perhaps they can
link pay to performance so that the productivity outweighs the cost. They
might be able to increase the use of machinery which would increase
costs in the short term but then might enable labour costs to be cut or
production levels to increase so that unit costs are eventually lower.

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5.4 Accounting
fundamentals

Ideas for answers to progress

questions
1 10 000 : 5000 5 2 : 1.
2 A current ratio of 2 : 1 means that for each $1 of current liabilities the
business has $2 of current assets. This would be viewed as a good and safe
ratio. It might be too high for an all cash business because it does not need to
keep that level of assets in liquid form. Some of the cash could be invested to
give a better return for the business.
3 If inventory is removed from the calculation the ratio would be: 6000 : 5000 5
1.2 : 1 meaning that the business has $1.2 in liquid assets for each $1 of
current liabilities.
4 1.8 : 1
5 1.2 : 1
6 Inventory is the least liquid of the current assets and in reality might never
be sold, which is why it might be safer to exclude it from any calculation of
liquidity.
15 000 3 100
7 5 37.5%
40 000

15 000 3 100
8 5 16.67%
90 000
9 Gross profit margin includes the cost of products sold but does not include
any expenses incurred in bringing those products to the market. The profit
margin is calculated after taking into account the expenses incurred such as
wages, heat and light and administration expenses.
10 a 55 per cent.
b The overheads for 2014 are lower than in 2013 which implies that they
controlled their costs better in 2014.
11 To compare performance from one year to another. To compare performance
with other businesses in the industry. To present when applying for a loan.
12 Ratios ignore qualitative factors. They are based on past information – the
future might be different. Other businesses might have window dressed
their figures. Difficult to know when you are comparing like for like in inter-
business comparisons as different accounting techniques can be used; the
businesses might vary in size etc.

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13 A bank might want to judge the ability of a business to repay any loan it
might give. Shareholders might want to see how retained earnings are being
used, if they are being invested wisely instead of being given as dividends.
They might want to judge whether to sell their shares in that business.
14 They are historic and the future for the business might be very different.
They might have been window-dressed to give the best impression. The
performance of the whole business is reflected, not that of individual
departments or branches. It is quantitative information and does not convey
any qualitative information such as motivation levels.

Ideas for answers to exam-style

questions
1 a 2013 Current ratio 5 CA 4 CL 2014 Current ratio 5 CA 4 CL
5 32 000 5      16 000
16 000 32 000
5 2 : 1 5 0.5 : 1

b Between 2013 and 2014 cash and cash equivalents had fallen from
$20 000 to $0, reducing the current assets, although this was slightly
offset by an increase in inventory from $8000 to $12 000. Over the same
period the current liabilities had increased caused by an increase in trade
payables and an outstanding overdraft of $12 000 whereas in 2013 the
business had not had an overdraft.
2 a The ratio of current assets excluding inventory to current assets:
Current assets 2 inventory
Current liabilities
b Profitability ratios identify trends and can be used to assess whether the
profit is an unusual one or if it is constant (profit quality). For managers
to see if profit targets had been met. To see if profit ratios are rising
or falling. Comparing gross profit margin with profit margin allows
businesses to see how well expenses are being controlled.
3 Choose any two stakeholders, for example shareholders, managers, employees,
suppliers of finance, local community, government, customers.
Give details of how two of those groups might use the financial information.
For example, shareholders would want to see how profitably the company is
being managed and assess whether they are likely to receive an increased or
a decreased return on their investment (dividend). They might decide to sell
their shares if profits are not being maintained.
Managers might need to see if targets have been met such as an increase of
5 per cent in gross profit or a 10 per cent decrease in operating profit, which
would require expenses to have been reduced or gross profit to have increased.
Suppliers of finance look to judge if the business is still able to meet its
repayments of loans, and if further finance is being sought they can make a
judgment about the ability of the business to meet the additional payments.
“Discuss the usefulness” is asking for an evaluative approach. This can be
achieved by questioning the information. For example, the shareholders might

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 see an increase in profitability but might receive a decreased dividend because
the business has planned a large investment. Shareholders would need to
understand that short-term returns on their investment might be sacrificed
but that in the longer term, following investment, the profitability and their
dividends might increase substantially.
The information on the statement of financial affairs is only true on one
specific day and the situation might have changed since that date. This is also
true for the income statement. For example, an important customer might
have gone out of business and therefore the products it purchased on credit
that had appeared in the sales revenue will never be recovered, therefore the
actual profit would not be as high as stated.

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 Forecasting
5.5 cash flows and
managing working
capital
Ideas for answers to progress
questions
1 A cash flow forecast is a future financial plan of cash inflows and cash
outflows.
2 Cash is a liquid asset and is immediately available for use, e.g. bank notes and
coins and money in bank accounts.
Profit is the difference between sales revenue and the costs involved in a
business and includes money due from trade receivables but is not money that
is immediately available. Some profit is never realised due to customers never
paying their debts.
3 Cash is needed to pay immediate and short-term expenses, e.g. wages.
Employees need to be paid as agreed.
Suppliers need to be paid or they might refuse to supply products in future.
4 To show to a potential lender to prove the ability of the business to repay loans.
To forecast any periods of cash deficit to allow steps to be taken in good time,
e.g. obtain an overdraft to cover the shortfall.
5 A liquidity problem is the inability of a business to be able to cover its current
liabilities with its current assets. This is often a temporary situation while
waiting for customers to pay for products received.
6 Sometimes costs are hard to predict, e.g. in times of inflation. Revenue
forecasts might not be accurate because there is no guarantee that customers
will buy in the quantities anticipated. Interest rates might change causing a
change in the willingness/ability to borrow money. A new business has very
little information on which to base its predictions and might therefore be
less accurate.
7 Payments from debtors in April 5 175. Net cash flow for March 5 (150).
Closing balance for April 5 (150).
8 They have many loyal customers who might be unhappy at their debt being
sold to a third party and might not return to Antonio and James for clothes in
the future.
9 Reduce the time given to customers to pay. Reduce the amount of credit
given, i.e. a maximum of $100 value of products that can be obtained on
credit. Sale of assets assuming that the assets are no longer required. Arrange
an overdraft that will give the business a quick cash inflow and can be repaid
in the near future.

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10 The money received by the business is less than the full value of the invoices
because the debt factoring business will take a percentage of the debt. Loyal
customers might be unhappy that their debt to the business has been passed
to a business that they are not familiar with, therefore customers might be lost.
11 Customers might decide not to use the business if they can get better credit
terms from another business.

Ideas for answers to case study

questions
Midi Computers
1 He has made a profit on paper on the computers that he has sold, but he will
not have been paid for all of them because some have been sold on credit. Jan
will have had to pay his expenses but is still waiting for payment from some of
his customers. This temporary shortfall has caused the need for an overdraft.
2 More credit from Jan’s suppliers means that he can delay paying for his
products, therefore he might receive payment from his customers before he
needs to pay his suppliers. This might help him to better match his outflows
and his inflows of cash.

Large increase in the failure of small businesses

in Australia
1 The global slowdown resulted in a lack of confidence perhaps causing
customers to save rather than spend.
In an economic downturn people generally have less money to spend. Also the
tightening of credit terms can make it more difficult for customers to borrow;
if they cannot borrow they cannot spend.
2 Certain costs have to be covered such as loan repayments. Employees have to
be paid, and if they are paid an hourly rate the wage costs will not decrease
even if fewer products are produced.
Rent still has to be paid regardless of the level of sales.
3 To make sure that they can pay their suppliers and other expenses such as
rent, electricity, insurance etc.
Small businesses tend not to have as much cash reserves as a large business
therefore it is important to make sure that cash outflows can be covered by
cash inflows. If a small business forecasts a temporary cash shortfall it might
be necessary to arrange an overdraft but the charges can be higher for a small
business due to the banks perceiving them to be a higher risk and more likely
to not be able to repay the overdraft than a larger business would be. Small
businesses also have a lower level of collateral that can be offered to lenders
when a loan is needed.

Carrefour’s profit in France falls 40 per cent

in 2011
1 To increase its sales revenue. This was in the hope that customers would not
reduce demand in response to higher prices.
2 It hoped that its customers would return, lured by the lower prices. It hoped
to attract previously loyal customers away from its competitors.

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3 A possible loss of customer confidence in Carrefour. Demand for products
was price elastic causing a decrease in demand greater than the increase in
prices. After reducing prices customers failed to return, perhaps because they
had switched their loyalty to another supermarket.
4 The abandonment of the proposed merger and the postponement of shop
refurbishments will mean that whatever profit had been retained in the
business would not be depleted by the expense of the two projects. This
would increase the level of profit retained in the business. Future profit might
have been higher as a result of these two projects and that is now foregone.
The redundancy of some employees would reduce the labour costs and
therefore reduce a cash outflow. However, there would be a cash outflow caused
by the redundancy payments required for each employee whose job is lost.

Ideas for answers to exam-style

questions
1 Shows when the business is likely to have a surplus of cash plus bank balance.
Shows when a business needs short-term funding. Shows if the business
might need to restructure its payment pattern to avoid any potential deficits.
2 a No past information on which to base its forecast of costs and revenues
(outflows and inflows). The future is difficult to quantity for any business,
e.g. sales and expenses. Wage costs, warehousing costs, purchases etc.
are dependent on sales volume. Future prices might change in times of
inflation. Competition might increase or decrease, influencing the price
charged and the potential for sales. Someone setting up a new business
might lack experience of preparing financial information.
b By not allowing or reducing sales on credit. Increase marketing/
advertising to increase sales. Incentives to staff to increase sales. Find
a cheaper supplier for the products to be sold. Try to reduce expenses, e.g.
reduce the number of sales personnel or move to a cheaper location.
However, the evaluation might include arguments such as if the retail
premises are moved to a cheaper location they might see a decrease
in customers if their target customers do not visit the new location.
A decrease in credit facilities might result in customers going to another
business where credit is still offered, again resulting in a decrease in
customers. Cheaper suppliers might offer lower-quality products so
this might have a negative impact on the image of the business. If the
business aims to maintain a high-class image this method should not be
considered. If the shop aims to sell lower-standard products then this
might be an acceptable method.
3 $510 million.
4 The years 2013–14 are shown to be the development stage of the business
during which sales were not made. Shows short-term finance facilities
(e.g. overdraft or short-term bank loan) are needed until 2015. Might be
able to consider further investment from 2016 is sales of copper continue
to increase.
However, these figures are only predicted. The forecast is useful in that the
trend seems to be towards increasing liquidity, but caution must be exercised
because forecasts are what is expected to happen and not what is definitely

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 going to happen. Economic changes could occur which reduce the demand
for copper, or the market price of copper might fall if more deposits are
discovered causing an increase in supply in the market.
Predictions are usually more unreliable when they are estimating figures a
long way into the future.
5 The closing balance for June would be $1000. This assumes that the predicted
sales level for June is still achievable with this lower level of purchases.
6 Using the figures it shows that at the end of June it will have a negative cash
balance of $3000 and therefore might need to arrange some short-term
finance until the products are better known to their customers and sales
hopefully increase. It shows that initial impact of the new products is to
increase the expenses (outflows) but the sales (inflows) have not increased by
a proportionate amount, leading to a negative closing balance.

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5.6 Budgets

Ideas for answers to progress

questions
1 Budget is a term that describes a financial plan for the future. It can be for a
business, department or individual.
2 A forecast provides details of what we think is going to happen in the future,
whereas a budget provides details of what we want to happen in the future.
They are different because what we want does not always happen.
3 An important feature of motivation comes from a sense of achievement. Since
budgets provide targets, these become something for employees to aim at so
budgets can motivate.
4 If budgets are set unrealistically high employees may never get a sense of
achievement, and a sense of failure can demotivate.
5 Factors that help to ensure budgets work effectively include:
u Being realistic
u Flexibility
u Negotiated/discussed
u Regularly reviewed
u Aimed at helping not challenging.
6 If budgets are demotivating managers it is almost certainly because they
are unrealistic or do not help managers in their work. Redesigning them
by making them more realistic would help managers and they then might
motivate.
7 Zero budgets provide a “clean sheet”, in other words there are no hindrances
from the past. This means that people will take a fresh look at what they do,
not influenced by the past which can lead to innovation.
8 Managers like most people are reluctant to change. They will have got used to
existing budgets and they will expect future budgets to be similar if not better.
9 Assumptions that could be varied in a flexible budget include:
u Sales
u Input costs
u Productivity
u Capacity utilisation.

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Ideas for answers to case study
questions
Snazzy Clothes (SC)
1 Avoid arguments, identify problems, monitor progress, provide information.
2 Plans should be “integrated” – covering the whole business. Production plans,
sales plans etc.
3 Well worth discussing!

Ideas for answers to exam-style

questions
1 The variances are:
Activity Budget ($) Actual ($) Variance ($)
Ticket sales 25 000 26 000 21000
Other sales 1000 800 200
Wages 8000 8100 2100
Other variable costs 5000 6000 21000
Overheads 4000 5000 21000
Profits 9000 7700 1300

2 Favourable variances: Ticket sales.

Adverse variances: Other sales, wages, other variable costs, overheads, profits.
3 Some control needed over wages, but may be due to higher sales.
Other variable costs and overheads are worryingly large, and the business
should try to reduce these.
Small shortfall in “other sales” but is this significant?
4 u Ways in which budgets could be useful to the owners:
uuenables business to plan. Fall in “other sales” may suggest it needs to
plan better promotion strategies
uuimportant to plan for labour and hence wage costs. With an adverse
variance did it under-plan or overspend? Needs investigating. Budget
enables it to the plan better
uuclearly overheads have not turned out as expected. Maybe the
budget was over-optimistic, or perhaps it has over-spent. Well worth
reviewing
uuthese budgets and variances allow better planning and can provide
useful targets for employees and managers
uuthey provide a focus on what needs to improve/change
uuthe data indicates areas that it needs to monitor more closely such as
wages and overheads.
uuHowever, sometimes it is unrealistic to expect budgets to be close to outcomes
due to inherent uncertainties. To what extent is that relevant to a cinema?
uuConcluding balancing discussion.

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 Contents of
5.7 published
accounts
Ideas for answers to progress
questions
1 The new sales revenue figure would be $1 095 600.
Gross profit would equal $1 095 600 2 $333 000 5 $762 000
2 $418 000
3 Non-current assets: Vehicles would increase by $5000 to $55 000.
Cash and cash equivalents would increase to $163 000 ($112 000 2 $5000
(paid for car) 1 $56 000 received from customers).
Trade receivables figure would be $412 000 ($468 000 2 $56 000 paid by
customers).
4 The non-current assets section for machinery would increase from $80 000 to
$115 000.
The long-term loan of $130 000 would increase to $165 000.
5 Inventory should be valued at the lower of cost or net realisable value, which
in this case is $12.
$16 000 2 $1000 $15 000
6 5 5 $5000
3 3

Ideas for answers to exam-style

questions
1 Altrayne plc
Forecast income statement for the year ending 30 September 2015 for
Altrayne plc
$
Revenue 23 000
Cost of products sold 11 000
Gross profit 12 000
Overhead expenses 8 800
Net profit (before tax) 3 200

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2 Eladra plc
a The machines cost $110 each plus the $10 needed to repair each machine.
Therefore each machine costs $120 with a total cost of $12 000 for the
100 machines.
b Inventory is valued at cost or net realisable value whichever is the lower.
In this case the net realisable value is lower at $90 ($100 minus the repair
cost of $10) therefore the inventory is valued at $9000 (100 3 $90).
3 Ashoak Plastics plc
Ashoak Plastics plc
Statement of financial position at 30 November 2014 (Extract)
$000
Non-current assets 934
Current assets   185  
Total assets 1119  
Non-current liabilities (475)
Current liabilities   (195)
Total liabilities   (670)
Net assets   449  

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 Analysis of
5.8 published
accounts
Ideas for answers to progress
questions
400 000
1 5 14.29% (14.285714 rounded up)
2 800 000
2 This is a better return than most people can get on money deposited in
a bank, but how does it compare to previous years and to that of similar
businesses. If last year the ROCE was 20 per cent then this result is not
good. If the other similar businesses have a ROCE of 10 per cent then this is
probably good.
3 2013 ROCE 5 20% (170 4 850)
2014 ROCE 5 14% (98 4 700)
4 The annual profit in 2014 has fallen by more than 42 per cent (42.35).
Capital employed has also fallen but only by 18 per cent (17.65). Sales might
have fallen or, if this business buys in materials to sell, the cost of those
materials might have increased. The arrival of competition might have forced
the business to sell at a lower price resulting in a fall in sales revenue. The
business might have also experienced an increase in expenses leading to the
reduced operating profit figure. This could have been caused by an increase in
wages paid or in the cost of energy for heating and lighting etc.
5 Inventory turnover is nine times or 41 days (365 divided by 9 5 40.555).
6 This is probably acceptable. The blades are non-perishable and therefore
can be sold at a slower rate than perishable inventory. Blades for agricultural
equipment might be sold more in certain seasons and the 41 days is only an
average. In some seasons inventory turnover might be much faster.
7 30 days (29.95 days rounded up). This is likely to be acceptable if Treebo
is able to settle its debts to suppliers in 30 days or more because the money
due to it, from its customers, would be received in time for Treebo to pay its
suppliers.
8 Business X 5 23.69% (23.6923)
Business Y 5 45.05% (45.05494)
9 Investors are likely to prefer to invest in Business X due to it being a lower-
risk investment. If interest rates were to increase Business Y might experience
difficulty in servicing its debt, making it a riskier investment. Business X also
has the potential to take on more fixed interest-bearing debt if there was a
need to obtain more finance, for example to finance a programme of growth
or new developments.

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 Dividend per share 0.375
10 Dividend yield 5 5 5 8.93% (rounded up
Number of shares 4.20 from 8.92857)
(0.375 is found by dividing 225 000 by 600 000.)
11 This would be compared to the return that could be gained by depositing
money in a bank account or by comparing it to the return gained by buying
shares in a different company.
Profit after tax 532 000
12 Dividend cover 5 5 5 3.5 times
Dividend paid 152 000
Current market price of shares 7.80
13 Price/earnings ratio 5 5 5 12
Earnings per share 0.65
The current market price of the shares is 12 times greater than the earnings
per share.
Profit after tax
The earnings per share is calculated by 5
Number of ordinary shares
520
5 0.65
800
14 Different businesses might use different accounting techniques. Past results
might be not any indication of future results. Only quantitative information
is used, but there might vital qualitative information that would be useful to
potential investors. The information in the financial statements might have
been window-dressed to present a particular financial image. It might not be
the whole picture.
15 The dividend cover reflects the ease with which dividends due to shareholders
has been covered. A low rate of dividend cover might indicate that dividends
are too high and that future dividends might be lower.

Ideas for answers to exam-style

questions
Dividend per share 0.43
1 a Dividend yield 5 5 3 100 5 10.75%
Market price of share 4.00
Profit before tax and interest 24.3
b ROCE 5 5 3 100 5 16.53%
Capital employed 147
Long-term fixed interest-bearing capital 12
c Gearing 5 5 3 100 5 8.16%
Total capital 147
d This business could choose to raise the additional finance by either
method. The low gearing means that further borrowing could be
undertaken without putting the business at risk. Care needs to be taken
that interest payments must be paid or assets might be at risk. Interest
payments reduce profitability and might therefore cause a decrease in
dividends paid to shareholders who might be unhappy. This could also
result in shareholders selling shares, which could result in a lower market
price of shares therefore discouraging further purchase of shares. The
advantage of issuing more shares is that it is permanent capital and if the
company is unprofitable in the future, dividends need not be paid. The
raising of finance through a loan does not change the ownership of the
company whereas the selling of more shares to the general public dilutes
ownership. This can be avoided by selling shares to existing shareholders
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 (rights issue). If the shares are sold on the open market (through the stock
exchange) there is a danger that a rival business might buy the shares and
then bid to take over the company or at least to gain some control. This
can be avoided by taking a loan.
If retaining control of the business is most important then the finance

should be raised by obtaining a long-term loan.
Dividend per share 0.4375
2 a Dividend yield 5 5 3 100 5 7%
Market price of share 6.25
b The initial effect could be that shareholders will be unhappy at the
reduced return on their investment and they might decide to sell their
shares in Dansell plc. However, if the board of directors can give a good
reason for the reduced proposed dividend the shareholders might be
prepared to forego returns if a higher return is likely in the future. For
example the reduced dividend could be in order to increase retained profit
to finance expansion which is likely to yield more profit in the future. This
will depend on whether the shareholders are aiming for short-term or
long-term capital gains.
c Expansion of production facilities requires a long-term source of finance.
Sources could include a long-term bank loan, a government grant, issue of
debentures or the issue of more shares.
The advantages and disadvantages of each source can be explained with

the possible consequences of each source creating a basis for analysis.
For example, obtaining a government grant means that repayments are
not required and ownership is not diluted. However, the government
might only give the finance if certain conditions are met such as locating
in an area of high unemployment. This can mean that the business is not
located in the most cost-effective area or might not have access to the
labour force with the required level of skill. This can lead to a decrease in
the productivity and the cost-effectiveness of the business, which could
lead to a reduction in overall profitability.
A judgment must be given about which source is likely to be most

beneficial. There is no right or wrong answer, but whichever source is
chosen the preceding arguments must support the final conclusion.

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 5.9 Investment
appraisal

Ideas for answers to progress

questions
1 The aim of investment is to spend now in order to achieve a future gain. Most
other spending is spending now for benefit now (current spending).
2 With investments the returns are in the future. The future is unpredictable
and hence risky.
3 Net cash flow forecasts refer to an investment decision.
Cash flow forecasts refer to general business activity.
4 Advantages of payback include:
u It is quick and easy to understand
u It fits in with the ideas of borrowing for a fixed period
u It is easy to compare projects.
5 Advantages of using ARR include:
u It is easy to compare projects
u It is easy to compare with prevailing interest rates
u It uses returns for the whole period, unlike payback.
6 A bank would be interested in how quickly a business will be able to pay back
a loan. Payback provides just such information.
1
7 Payback 5 3 years
2
(1050 2 700)/5 100 3 (350/5)
100 3 5
700 700
100 3 70
5 10%5
700
8 NPV 5 (200 3 0.95 1 200 3 0.91 1 200 3 0.86 1 200 3 0.82 1 250 3
0.78) 2 600 5 $303
This shows that the lower the discount rate the more attractive the project
becomes.
9 Reasons for discounting the future include:
u Opportunity cost
u Time preference

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 uuUncertainty
uuInflation.
10 Discounting reduces the values of net cash inflows in the future. The further
ahead, the greater the reduction. When there is no discounting, as in payback,
there is no reduction.
11 The discount rate is chosen for a variety of reasons including the likely future
opportunity cost of money, uncertainty and risk. These are impossible to
predict with any certainty so that the discount rate itself is uncertain and
difficult to choose.
12 Discounted payback discounts future net cash flows, payback does not
discount at all.
13 The higher the risk the less likely the borrower will be able to pay back a loan.
So the quicker the payback, the better.
14 A lender will want to know when a loan is likely to be paid back. Payback
gives an indication of this.
15 Employees are the most valuable resource in a business. Without their
agreement to a major project it may be difficult to get their commitment, and
co-operation and motivation might be low. With their agreement might come
their support for the project and that will improve motivation, morale and
commitment.
16 The main disadvantage of IRR is that it is difficult to calculate and to
understand.

Ideas for answers to case study

questions
Ryan Restaurants (RR)
1 It needs to grow while still maintaining profits etc. It will want “value for
money”.
2 Costs, markets, customers, marketing, management.
3 Doing nothing is always an option!

Ideas for answers to exam-style

questions
Average annual net cash flow
1 a ARR 5
    expressed as %
Capital cost
(500 1 500 1 600 1 800 1 900 2 700)
5 100 3
700
2600
5 100 3 5 371%
700
b After one year it has earned $500 000 towards the $700 000. The
remaining $200 000 is earned at the rate of $500 000 per year.
2
 So payback 5 1 year 1 of a year 5 nearly 1 year 5 months.
5

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 c NPV 5
Year Cash flow ($000) DCF Present value
0 2700 1.00 2700
1 1500 0.91 1455
2 1500 0.83 1415
3 1600 0.75 1450
4 1800 0.68 1544
5 1900 0.62 1558
NPV 11722

2 In favour of country X:
Shorter payback, higher ARR, growing economy which may mean even better
returns, good labour factors such as good industrial relations and flexible
labour laws which are both attractive to investors. High income per head
means potentially large customer base with money to spend.
In favour of country Y:
Higher NPV, lower capital cost, few competitors.
For a restaurant, which is a risky business, it is difficult to judge. The
smaller investment for country Y is attractive, but so is the faster payback of
country X. It depends on whether the owners want a large project or a safer,
small one.
However, both projects look good.
The factors likely to sway the decision are the poor industrial relations
in country Y and the lack of potential for a strong, growing market. So
country X seems better.
3 Discounted payback:
uuDiscuss the advantages
uuDiscuss the disadvantages
uuIdentify circumstances where it is appropriate to use
uuIdentify circumstances where it is not appropriate to use
uuIdentify other techniques that may be better, or worse, in these
circumstances
uuConclude with a balancing argument as to whether it is useful.

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