Qa FRM

Finance Resources Management
Revision Q&A
I. Working Capital Management ............................................................................... 2

II. Decision Making .................................................................................................. 30
III. Marginal Costing & Break-even Analysis ............................................................. 44
IV. Valuation of Equities/Bonds ................................................................................ 50
V. Portfolio, Risk and CAPM .................................................................................. 57
VI. Discount Cash Flow ............................................................................................. 64
VII. Decision Tree & Uncertainty ............................................................................... 74
VIII. Limited Resources ............................................................................................... 87
IX. Ratio Analysis ...................................................................................................... 92
Page 1
I. Working Capital Management
Question 1
i. Compare the financial costs in the two cases below, using a bank overdraft rate
of 15% and analyze the impact on pre-tax profit of speeding up the moving of
stock.
ii. Explain the implication.
Slow stock – average stock holding = $100,000

Quick Stock – average stock holding = $50,000
The company has a turnover of $400,000 and a profit margin of 10% (profit before
interest and tax)
Solution
i. Slow stock – financial cost = 15% x 100,000 = 15,000

Quick stock – financial cost = 15% x 50,000 = 7,500
Slow Stock Quick Stock

Net Profit before interest and tax (10% x 400,000) 40,000 40,000
Financial Cost 15,000 7,500
Profit before Tax 25,000 32,500
ii. Clearly, quicker stock movement can generate improvement in profitability,

especially for a small company operating in a harsh environment.
Question 2
If Sino Ltd extends credit to a customer without first conducting a credit check on the
customer, there is a 15% probability that the customer will default, and the debt will
have to be written off. The cost of the credit check is $180.
The company sells a variety of products, but for everything that it sells, the cost
structure and profit margin are as follows:
Page 2
%
Variable Cost 60
Fixed Cost 10
70
Profit 30
Sales Price 100
What is the minimum order size per customer that would justify conducting a credit
check?
Solution:
Lost in case of default = 60% of Sales
Expected cost of default = 60% * 15% * Sales = Cost of credit check = $180
Sales = $2000
Question 3
Holt plc sells its products in two distinct and separate markets, the "North" and "South".
Sales for the forthcoming year are expected to amount to $1.2 million, spread evenly
throughout the year, and to be split 40% North and 60% South. All sales are on credit
and the variable cost of Holt's products is 80% of sales price. It is expected that North's
customers will take an average 72 days credit whereas South's will take an average of
50 days. No bad debts are expected.
A change in the level of advertising would both increase total invoiced sales for the year
by 20% and change the mix of sales to 60% North and 40% south. This increase in sales
would be achieved without alteration to stock levels or creditors. However, such a
change would increase the period of credit taken and cause bad debts to occur. The
expected pattern of receipts for the new level of sales is:
Exact no. of No cash discount

days
Credit taken North South
% %
30 10 8
60 20 10
90 68 80
Bad Debts 2 2
Page 3
Short term finance is readily available at a cost of 11% per annum. (Assume a 360 day
year.)
Required:
Ignoring the introduction of cash discount, determine:
i. The effect of the introduction of the advertising campaign on Holt's debtors

position net of bad debts;
ii. The maximum amount it would be worth paying, at the end of the year, for the
advertising campaign.
Solution
i. Increase in debtors: (in thousands)
Current debtors : (sales $1.2 M)

North : 1200x40% x 72/360 = 96
South : 1200x60% x 50/360=100
New debtors
Sales 1.2M x 1.2 = $1.44M
New debtors:
North:
30 days- 30/360 x 1440x60%x 10%=7.2
60 days- 60/360 x 1440x60%x 20%=28.8
90 days- 90/360 x 1440x60%x 68%=146.88
Total = 182.88
South
30 days- 30/360 x 1440x40%x 8%=3.84
60 days- 60/360 x 1440x40%x 10%=9.6
90 days- 90/360 x 1440x40%x 80%=115.2
Total = 128.64
Total debtor at the new level = 311.52

Current level of debtor = 196.00
Page 4
Difference = 115.52
ii. Maximum amount to be paid for advertising campaign
$'000
Additional sales $1200 x 20% = 240
Additional contribution = 240x20% = 48.0
Bad debts: $1.2M*1.2x2% 28.8
Increased capital tied up in debtor :115.52
Financial cost thereof: 115.52x 11% 12.7
Incremental benefits 6.5
Therefore the maximum amount for advertising is $6500
Question 4
Pondwond is a SME company engages in manufacturing. Sales for the next year are
expected to be 85,500 units at a basic unit price of $50. Direct materials, direct wages
and direct energy costs are expected to be $15.51 per unit, $17.35 per unit and $4.95 per
unit respectively. Administrative salaries are forecast to be $264,000, and distribution
and other overheads a total of $92,000.
Pondwood offers its customers a 2.5% cash discount for payment within 14 days. On
average 40% of customers take this discount, and the remainders take an average of 10
weeks to pay for their goods.
Raw materials equivalent to 4 weeks usage are held, and finished goods equivalent to 8
weeks demand. Pondwood is allowed 8 weeks credit form its supplies of raw materials
and 6 weeks credit for distribution and other fixed costs. Energy bills are payable
quarterly in arrears.
The company pays wages one week in arrears and salaries one month in arrears (one
month may be assumed to be 4 weeks.)
Required:
Evaluate whether, on the basis of the above information, the company's overdraft
facility (at present $800,000) is sufficient to finance the company's working capital
needs for the next year.
Page 5
Solution
Estimated working capital requirement
Sales = 85,500 x 50 4,275,000

Credit given to discount customers (2 weeks):
$4,275,000x40%x0.975x2/52 64,125
Credit given to other customers (10 weeks):
$4,275,000x60%x10/52 493,269
Debtors working capital requirement 557,394
Stocks - raw materials 85,500x$15.51x 4/52 102,008
Finished goods
- materials 85,500x$15.51x 8/52 204,016
- direct wages 85,500x$17.35x 8/52 228,219
- direct energy 85,500x$4.95x 8/52 65,112
Total Stock 599,355
Total financing requirement 1,156,749
Less: financing by creditors:
Stocks 85,500 x $15.51x8/52 204,016
Direct energy 85,500 x $4.95x13/52 105,806
Direct wages 85,500 x $17.35 x1/52 28,527
Administrative salaries $264,000 x 4/52 20,308
Distribution costs $92,000x 6/52 10,615
(369,272)
Net working capital financing requirement: 787,477
787,477 is less than 800,000. The OD facility is thus sufficient.
Question 5
You are the accounting manager of an estate management company. Your staff has
prepared the Budget Profit and Loss Account for next year as follow:
Budget Profit & Loss for 2004/05 $'000 $'000 Note

Management Fee 6575 1
Expenditure
Payroll 2918 2
Cleansing 658 3
Security 823 3
Utilities 324 4
Depreciation 100 5
Page 6
Miscellaneous 830 5653 6

Net Profit/(Loss) 922
Note:
1. The profile of account receivables for management fee is as follow
Category % Settle the outstanding

within
A 60 1 month
B 25 2 months
C 10 3 months
D 5 4 months
2. 80 % of the payroll is in half-month arrears while the rest is in one month arrears.
3. Cleansing and security is in one month arrears
4. Utilities are now paying quarterly.
5. 20% depreciation is charged on a straight-line basis at present.
6. Miscellaneous are payable in two months arrears.
i. Calculate the working capital requirements for coming year.

ii. At present, your company is financing the working capital using overdraft facility
of 7% interest rate. A housing manager proposes to outsource the management fee
collection operations to a local bank, the bank claims to improve the profile of the
accounts receivable as follow:
Category % Settle the outstanding

within
A 80 1 month
B 15 2 months
C 5 3 months
Suggest the maximum services charge that your company would like to offer.
Solution
Management Fee
60% x 6,575 x 1/12 328.8

25% x 6,575 x 2/12 274.0
Page 7
10% x 6,575 x 3/12 164.4

5% x 6,575 x 4/12 109.6
Accounts Receivable 876.7
Payroll
80% x 2,918 x 0.5/12 97.3
20% x 2,918 x 1/12 48.6
Cleansing 658 x 1/12 54.8
Security 823 x 1/12 68.6
Utilities 324 x 3/12 81.0
Miscellaneous 830 x 2/12 138.3
Accounts Payable 488.7
Working capital requirements = 876.7 - 488.7 = $388k
ii.
Management Fee
80% x 6,575 x 1/12 438.3

15% x 6,575 x 2/12 164.4
5% x 6,575 x 3/12 82.2
Accounts Receivable 684.9
Reduction in accounts receivable investment = 876.7 - 684.9 = 191.8k, maximum

services charge can be offered = 191.8k*0.07 = 13.4k per year.
Question 6
Castle Ltd. has received an order from a potential new customer in an oversea country
for 5,000 staplers at a unit price of $1.75. Castle's terms of sale for export orders are a
10% initial deposit, payable with order, with the balance payable in 180 days. The 10%
deposit has been received with the order.
Customers from the overseas country have in the past usually taken approximately one
year's credit before making payment, and several have defaulted on payment. On the
basis of past experience, Castle's management estimates that there is a 35% chance of
the new customer defaulting on payment if the order is accepted, and only 50% chance
of payment within one year.
Incremental costs associated with the production and delivery of staplers would be
Page 8
$1.25 per unit and, in addition, there is an estimated cost of $500 for special attempts to
collect an overdue debt, this cost being incurred one year after the sale is made. When
this extra cost is incurred there is a 30% chance of obtaining quick payment of the debt.
If, after this action, payment is not received the debt is written off.
The company considers the granting of export credit to be a form of investment

decision, with 14% per year as the appropriate discount rate.
Evaluate whether Castle should accepted the order from the new customer on the basis
of the above information
Solution
Reject Order
Payment
Received 30%
A $(500)
Take Action
Payment Not
Received in Yr 1 B
50%
Default 70%
Take No Action
Payment
Received in Yr 1
50%
Outstanding Balance to be collected:

(1.75*5000*0.9) =$7,875
At decision point B, the company would clearly choose to spend the extra $500. The
expect value of this course of action would be:
(30%x$7875x50%) + (70% x0) -$500 = $681
At decision point A, the company has to decide whether to accept the order. The
Page 9
expected value of accepting would be:
If Accept the order, the relevant cash flow =

875+[(50%x7875)+$681]/1.14 - 6250=($1,328)
If Reject the order, the relevant cash flow = $0
Note:
The initial 10% deposit (10% x 5000 * 1.75) = $875
The cost of producing and delivering the staplers: 5000*1.25=$6,250
On this basis, the project should be rejected.
Question 7
The budget of XY Ltd. for the coming year is as follow:
$’000
Turnover 6,400
Expenditures
Staff Cost 2,400
Variable Overheads 1,200
Depreciation 1,000
Operating Profit 1,800
Extract of the current year’s working capital is as follow:
Current Year Next Year

(Projection)
$’000 $’000
Current Assets
Debtor 1,500 1800
Cash 800 ???
2300 ???
Current Liabilities
Staff Cost 600 800
Trade Creditors 550 700
Loan 1,000 1200
2150 2700
Page 10
Tax and dividend to be paid is $600,000 what will be the cash balance next year?
Solution
Cash generated from operations net of tax and dividend:

$1,800 + $1,000 (depreciation) - $600 = $2800 - $600 = $2,200
$2,200 shall be equal to the movement in working capital = Closing Working Capital –
Opening Working Capital, i.e.
(1,800 + Cash Balance – 2,700) – (2,300 – 2,150) = 2,200

Cash Balance = $3,250
Question 8
Donald Ltd has budgeted the following for a month:
$’000
Operational Profit 40,000
Interest to be paid 3,000
Tax to be paid 2,000
Dividend declared 1,000
Increase In debtors (before provisions) 10,000
Increase In inventory 15,000
Increase In creditors 15,000
Depreciation 30,000
Increase in provision of doubtful debt 8,000
What is the budgeted increase in cash balances for the month?
Solution
Cash Profit = Operational Profit – Interest/Tax/Dividend Paid + Non-cash Accounting
adjustments:
= $40000 – $3000 - $2000 – $1000 + $30000 + $8000 = $72000

Increase in cash
= Cash Profit – Movement in Working Capital other than cash.
= $72000 – ($10000 + $15000 - $15000)
= $62000
Page 11
Question 9
Peter, the CEO of Fortune Estate Management Limited is wondering whether the
company will have enough cash to settle the loan amount to $1,000,000 which will be
due at the end of next year. His accountant provided him the budget for the coming
year:
$’000
Turnover 5,400
Expenditures
Staff Cost 2,400
Cleansing Services 1,200
Depreciation 300
Operating Profit 1,500
If the loan at 5% interest and the tax and dividend are estimated to be $400,000, payable
within next year. What will be the cash generated from operations next year?
Extract of the current year’s working capital is as follow:
$’000
Current Assets
Debtor 1,060
Cash 80
Current Liabilities
Staff Cost 600
Cleansing Contractor 350
Loan 1,000
40% of the customers will be paid within 1 month whilst the rest will be paid in 2
months. Staff cost is in 1 month arrears and the cleansing contractor is normally paid
bi-monthly.
Will the Company have sufficient cash to settle the loan next year?
Solution
Cash generated from operation:
= $1,500,000 + $300,000 (Depreciation) – $50,000 (Interest) - $400,000 (Tax and
Dividend)
= $1,350,000
Page 12
New debtor =
5,400,000 x 40% x 1/12 + 5,400,000 x 60% x 2/12 = $720,000
New Staff Cost Outstanding = 2,400,000 x 1/12 = $200,000

New Cleansing Outstanding = 1,200,000 x 2/12 = $200,000
Existing
Debtor – Current Liabilities (Excluding Loan) = $110,000
New
Current Assets – Current Liabilities (Excluding Loan) = $720,000 - $400,000 =
$320,000
New Cash Balance = Cash generates from operations (after interest, tax and dividend)
increase in working capital (excluding cash and loan) + Opening Cash Balance
= $1,350,000 - ($320,000 - $110,000) + $80,000
= $1,220,000
=> Sufficient to repay the loan.
Question 10
Tommy sells 300,000 units of Product B per annum to retailers. Their variable costs are
$20 per unit, with a fully absorbed cost of $23 and a selling price of $25. All their sales
are on credit, and the collection time is 45 days. Tommy is considering different
proposal: -
Proposal I : Change in Credit Term:

To extend the credit period to 60 days, which, it is estimated, will increase sales by 8%,
with the selling price remains the same. Under the new credit term, it is estimated that
1% of the outstanding debtor will turn into bad debt. The company's required rate of
return is 20%.
Proposal II : By Marketing Strategy:

The proposed increase in sales can be attained by advertisement without changing the
credit term, the bad debt level will not be affected as well.
i. Would you advise Tommy to increase the credit term (i.e. Proposal I)?
Page 13
ii. What would be the maximum cost on advertisement if the Proposal on Credit
Term is Not Considered?
iii. What would be the maximum cost on advertisement if the Proposal on Credit
Term is Considered?
(Assume 360 days per year.)
Solution
Increase in Sales = 300,000 x 8% = 24,000
If fixed total costs remain constant, the estimated increase in contribution on the new
sales would be 24,000 units x (25-20) =$120,000
Average current debtors owe money in respect of 300,000 x 25 x 45/360 =937,500. If

the new policy is adopted, the figure would be (300,000+24,000) x 25 x 60/360 =
1,350,000 units.
$
Proposed level of 1,350,000
debtors
Current level of debtors 937,500
Additional investment 412,500
Financial cost at 20% 82,500
Bad Debt 1,350,000 x 1% 13,500
Total cost = $ 82,500 + $13,500 = $96,000 which is less than the increase in
contribution $120,000
As the additional contribution to be made from the extended credit terms is greater than
the increase in costs, it would be profitable for Tommy to revise their credit terms.
ii. Maximum Cost on advertisement if the Proposal on Credit Term is not

considered
New debtor = 324,000 x 25 x 45/360 = $1,012,500

$
Proposed level of 1,012,500
debtors
Current level of debtors 937,500
Additional investment 75,000
Financial cost at 20% 15,000
Page 14
Maximum cost on advertisement = $120,000 – $15,000 = $105,000
iii. Maximum Cost on advertisement if the Proposal on Credit Term is Considered
Maximum cost on advertisement = $96,000 – $15,000 = $81,000
Question 11
Mickey Ltd has budgeted the following for a month:
$’000
Accounting net profit 40,000
Increase In debtors (before provisions) 20,000
Increase In inventory 15,000
Increase In creditors 15,000
Depreciation 30,000
Increase In provisions
Doubtful debts 5,000
What is the budgeted increase in cash balances for the month?
Solution
Operational Cash Profit after Tax net of accounting provisions:
$40,000 + $30,000 + $5,000 = $75,000.

$75,000 shall be equal to the movement of working capital during the period.
i.e. Movement of Working Capital = Increase in Cash + Increase in debtor + Increase in

Inventory – Increase in Creditor = $75,000
=> Increase in Cash + $20,000 + $15,000 - $15,000 = $75,000
=> Increase in Cash = $55,000
Question 12
DEF Ltd. has the following receipt pattern:
5% cash discount is allowed for payment in the current month and 20% of each
month’s sales qualify for this discount. 50% of each month’s sales are received in
the following month, 20% in the 3rd month and 8% in the fourth month. The
balance of 2% represents anticipated bad debts.
Page 15
If the estimated sales are as follow:
$’000
January -
February 800
March 900
April 1,000
May 1,000
Calculate the amount receivable from customers in May.
c.
Jan Feb Mar Apr May
$ $ $ $ $ $
Jan sales - - - - - -
Feb 800,000 - 152,000 400,000 160,000 64,000
Mar 900,000 - - 171,000 450,000 180,000
Apr 1,000,000 - - - 190,000 500,000
May - - - - - 190,000
Total - 152,000 571,000 800,000 934,000
Receipts
Question 13
Johnson sells 500,000 units of Product A per annum to customers. The variable costs
are $20 per unit, with a fully absorbed cost of $23 and a selling price of $25. All the
sales are on credit and the average collection time is 45 days.
Johnson is considering whether to adjust the marketing strategy. He predicts that the
sales will go up 20% and the sales price can also be increased to $28 without affecting
the unit cost by launching a marketing campaign. The cost of the marketing campaign
will be $1,500,000. Meanwhile, Johnson expects that the existing credit policy may
need to be adjusted. He will offer 5% discount to the cash-sales customers to speed up
the cash flow. Johnson expects that 40% of the customers will enjoy the discount and
the average collection time for the rest of the customers will increase to 60 days. Under
the new credit term, it is estimated that 2% of the outstanding debtor will turn into bad
debt. The required rate of return of Johnson is 20%. (Assume 360 days per year.)
Would you advise Johnson to adjust the marketing strategy?
Page 16
Solution
Relevant Benefit:
Relevant Benefit:
Existing Contribution ->500000 * ($25 - $20) = $2,500,000
New Contribution-> 500000 * 1.2 * ($28 - $20) = $4,800,000
Increase in Contribution = $4,800,000 - $2,500,000 = $2,300,000
Relevant Costs:
i. Cost of Discount = 500,000 * 1.2 * $28 * 40% * 5% = $336,000
ii. Cost of Bad Debt = 500,000 * 1.2 * $28 * 60% * 60/360 * 2% = $33,600
iii. Cost of Marketing Campaign = $1,500,000
iv. Cost of additional finance cost on debtor:
- Old Debtor: 500,000 * $25 * 45/360 = $1,562,500
- New Debtor: 500,000 * $28 * 1.2 * 60% * 60/360 = $1,680,000
- Increase in Debtor: $1,680,000 - $1, 562,500 = $117,500
- Financial Cost: $117,500 * 20% = $23,500
Total Cost = i + ii + iii + iv = $1,893,100
As the additional contribution to be made from the new marketing strategy is greater
than the increase in costs, ($406,900) Johnson shall be advised to proceed with the
strategy.
Question 13
The following details relating to Johnson who wants to start trading business. You
are required to calculate.
(a) Estimate profit.

(b) Working capital requirements.
Estimate annual sales – $. 12,000,000

Gross Profit Margin – 30% on Sales
Other Fixed Cost $. 1,000,000
Depreciation amounts to $. 600,000 and
Page 17
Other Variable Cost chargeable to P&L a/c equal 10% of sales.

Stock-tum over – 6 times
Sales and purchases will occur evenly throughout the year
Creditors allowed 1 month credit
Debtors allowed 2 months credit
30% of cash sales.
Assuming Stock-turn over = COGS / Closing Stock
Solution
$
Sales 12,000,000
COGS 8,400,000
Gross Profit 3,600,000
Other Fixed Cost 1,000,000
Other Variable Cost 1,200,000
Net Profit 1,400,000
Debtor – 2 month credit

Credit Sales =
12,000,000 * 70% = 8,400,000
Debtor = 8,400,000 * 2/12 = $1,400,000
Stock Turnover = COGS / Closing Stock = 6

Closing Stock = COGS / 6 = $8,400,000/6 = $1,400,000
COGS = OS + Purchase - CS = 8,400,000
Purchase = $7,000,000
Other Cost (excluding Depreciation) = $1,000,000 + $1,200,000 - $600,000 = $1,600,000
Creditors arising from other cost = $1,600,000 * 1/12 = $133,333

Creditors arising from purchase = $7,000,000 * 1/12 = $583,333
Working Capital Requirement
Current Assets (Stock $1,400,000 + Debtors $1,400,000 = $2,800,000)

Current Liabilities (Total Creditors $133,333 + $583,333 = $716,666)
Page 18
Working Capital Requirement = $2,800,000 - $716,666 = $2,083,334
Question 14
The following details relating to ABC Ltd., a new startup business.
1. Sales
 Estimate annual sales: – $12,000,000
 30% of the sales are cash sales whereas the remaining are sales in credit
 60% credit sales customers will settle in 2 months and 40% will settle in 3 months.
2. Gross Profit Margin: – 30% on Sales
3. Operating Cost including

 Fixed Cost: – $400,000
 Depreciation: – $600,000 and
 Variable Cost equals to 15% of sales.
4. Stock Tumover: – 6 times, you may assume the opening stock is nil.
5. Creditors
 Trade creditor relating to purchases of goods and will be paid 1 month in arrears
 Other operating cost (for fixed and variable cost) will be paid 1.5 month in arrears
6. ABC Ltd. will maintain 1 month sales as cash balance for transaction purposes.
7. Sales and purchases will occur evenly throughout the year

8. Assuming Stock-turn over = COGS / Closing Stock
You are required to calculate for ABC Ltd.:
(a) Estimate Net Profit.

Page 19
Solution
$
Sales 12,000,000
COGS 8,400,000
Gross Profit (30% sales) 3,600,000
Fixed Cost 400,000
Variable Cost 1,800,000
Depreciation 600,000
Net Profit 800,000
30% of the sales are cash sales whereas the remaining are sales in credit
60% credit sales customers will settle in 2 months and 40% will settle in 3 months.
Credit Sales =
12,000,000 * 70% = 8,400,000
Debtor = 60% * 8,400,000 * 2/12 + 40% * 8,400,000 * 3/12 = $1,680,000
Stock Turnover = COGS / Closing Stock = 6

Closing Stock = COGS / 6 = $8,400,000/6 = $1,400,000
COGS = OS + Purchase - CS = 8,400,000
Purchase = COGS + C/S = $8,400,000 + $1,400,000 = $9,800,000
Other Operating Cost* = $1,800,000 + $400,000 = $2,200,000

* Excluding depreciation
Creditors arising from Other Operating Cost = $2,200,000 * 1.5 /12 = $275,000
Creditors arising from Purchase = $9,800,000 * 1/12 = $816,667
Cash - 1 month sales as cash balance for transaction purposes

Cash = $12,000,000/12 = $1,000,000
Page 20
Working Capital Requirement
Current Assets (Stock $1,400,000 + Debtors $1,680,000 + Cash $1,000,000)

= $4,080,000
Current Liabilities (Total Creditors $275,000 + $816,667) = $1,091,667
Working Capital Requirement = $4,080,000 - $1,091,667 = $2,988,333
Question 15
Thomas has been made redundant recently and he intends to start up a business on his
own account, using $15,000 as the start –up capital. He also plans to approach bank for
additional finance where required.
Arrangements have been made to purchase fixed assets at the end of June. The assets
cost $8,000 and are expected to have a five-year economic life. Fixed assets have to be
paid on June.
Inventories costing $5,000 will be acquired by end June and subsequently monthly
purchase will be at a level sufficient to replace forecast sales for the month.
Forecast monthly sales are $3,000 for July, $6,000 for August and September, and
$10,500 from October onwards.
Selling price is fixed at inventory plus 50%
Two months’ credit will be allowed to customers but only one month’s credit will be
received from suppliers of inventory.
Running expenses, including rent but excluding depreciation of fixed assets are
estimated at $1,600 per month.
Thomas also intends to make monthly cash drawings of $1,000.
Prepare a cash budget for six months to December
Page 21
Solution
Jul Aug Sep Oct Nov Dec

$ $ $ $ $ $
Cash b/f 7,000 -600 -5,200 -8,800 -9400 -13000
Receipts 3,000 6,000 6,000 10,500
Purchases
5,000 2,000 4,000 4,000 7,000 7,000
(Note 1)
Drawings 1,000 1,000 1,000 1,000 1,000 1,000
Running
1,600 1,600 1,600 1,600 1,600 b1,600
expenses
Total
7,600 4,600 6,600 6,600 9,600 9,600
Payment
Cash c/f -600 -5,200 -8,800 -9,400 -13,000 -12,100
Note 1

Sales 3,000 6,000 6,000 10,500 10,500 10,500
Purchase required 2,000 4,000 4,000 7,000 7,000 7,000
Question 16
The following information relates to ABC Ltd..:
$’000
Sales revenue 5,242.0
Variable Cost of Sales 3,145.0
Inventory 603.0
Receivables 744.5
Payables 574.5
Page 22
Segment analysis of receivables
Balance Avg. Payment Discount Bad Debt

Period
Class 1 200,000 30 days 1.0% None
Class 2 252,000 60 days Nil 12,600
Class 3 110,000 75 days Nil 11,000
Overseas 182,500 90 days Nil 21,900
744,500 45,500
The receivable balances given are before taking account of bad debts. All sales are on
credit. Production and sales take place evenly throughout the year. Current sales for
each class of receivables are in proportion to their relative year-end balance before bad
debt.
It has been proposed that the discount for early payment to be increased from 1% to
1.5% for settlement within 30 days.
It is expected that this will lead to 50% of existing Class 2 receivables becoming Class
1 receivables, as well as attracting new business worth $500,000 in revenue. The new
business would be divided equally between Class 1 and Class 2 receivables. Fixed cost
would not be increase as a result of introducing the discount. The cost of capital would
be 8%.
Calculate the net benefit or cost of increasing the discount for early payment and
comment on the acceptability of the proposal.
Solution
Before ($’000) After ($’000)

Sales revenue 5,242.0 5,742.0
Variable Cost of Sales 3,145.0 3,443.0
Inventory 603.0
Receivables 744.5
Payables 574.5 574.5*5742/5242 = 628.9
Page 23
Balance Avg. Payment Discount

Period
Class 1 200,000 30 days 1.0%
Class 2 252,000 60 days Nil
Class 3 110,000 75 days Nil
Overseas 182,500 90 days Nil
744,500
Increase in Benefit
Contribution margin = (5242-3145)/5242 = 40%
i) Increase in contribution = $500,000 * Contribution margin = $500,000 * 40% =

$200,000.
The receivable profile
Existing Avg. Discount Credit Sales New Balance

Balance Payment ($’000)
Period
Class 1 200,000 30 days 1.0% 200,000 * 365/3 200,000+252,000*0.5
0 = 2,433 +500,000*0.5*30/365
=326,546
Class 2 252,000 60 days Nil 252,000 * 365/6 252,000*0.5+500,000
0 = 1,533 *0.5*60/365
=167,096
Class 3 110,000 75 days Nil 110,000 * 365/7 110,000
5 = 535
Overseas 182,500 90 days Nil Balance = 741 182,500
744,500 5,242 786,142
Increase in receivables = $786,142 - $744,500 = $41,642
ii) Increase in Cost of Finance = $41,642 * 8% = $3,331
Existing Discount = 1% * 2433,000 = 24,330

New Discount = 1.5% * (2,433,000 + 1,,533,000*0.5+250,000) = $51,743
iii) Increase in discount - $51,743 - $24,330 = $27,413
Existing Class 2 Bad Debt $12,600

New bad debt = new Class 2 sales (252000*0.5 + 500,000*0.5) * 12,600 / 252,000 =
Page 24
$18,800
iv) Increase in Bad Debt = $18,800 - $12,600 = $6,200
Net Effect
i) Increase in contribution : $200,000
Less:
ii) Increase in Cost of Finance: $3,331
iii) Increase in discount $27,413
iv) Increase in Bad Debt $6,200
Net Effect $163,056
As benefit greater than cost, the proposal shall be accepted.
Question 17
A company has the following income statement:
$’000 $’000
Non-current Assets 1,000
Current Assets
Inventories 200
Receivables 150
Cash 100
450
Current Liabilities
Payables 200
Net Current Assets 250
1,250
Over next year, the company would double the sales, the company does not plan to
invest in any non-current assets, but inventory, receivable and payables shall all move
in line with sales. What will be the projected cash balance in one-year’s time assuming
there will be no additional finance, no movement in non-current assets and all profit
will be distributed as dividend?
Solution
$’000 $’000
Page 25
Non-current Assets 1,000

Current Assets
Inventories 400
Receivables 300
700
Current Liabilities
Cash (Overdraft) 50
Payables 400
Net Current Assets 250
1,250
Question 18
A company has annual credit sales of $27 million and related cost of sales of $15
million. The company has the following targets for next year:
Trade receivable days 50 days

Inventory days 60 days
Trade payables 45 days
Assume 360 days a year and there is no movement in inventory..
What is the working capital requirement?
Solution
Debtor = 50/360 * 27M = 3.75M
Inventory = 60/360 * 15M = 2.5M
Creditor = 45/360 * 15 (W1) = 1.875M
Working capital requirement = 3.75+2.5-1.875 = 4.375M
W1
COGS = O/S + Purchase – C/S
Assuming there is no movement in inventory, O/S = C/S
COGS =Purchases = 15M
Question 19
A company has sales revenue of $30M and its customer take an average of 75 days to
pay at present. The company offers a 1% discount to customers who pay in 30 days.
Calculate the anticipated receivables balance if 60% of customers take up the offer of
Page 26
discount and the rest pay in 75 days. Assuming 360 days in a year.
Solution
Anticipated Receivables Balance

40% * $30M * 75/360 + 60% * $30M * 30/360 = 0.1875 + 0.175 = $4M
Question 20
Mile Co. is looking to change its working capital policy to match the rest of the industry.
The following results are expected for the coming year:
Revenue 20.5M
Cost of Sales 12.8M
Gross Profit 7.7M
The working capital ratio of Miles Co. as compared with the industry are as follow:
Mile Co. Industry

Receivable days 50 42
Inventory days 45 35
Payable days 40 35
Assuming 365 days in each year.

What will be the impact on working capital?
Solution
At Present Future Net

Receivable 20.5M * 50/365 20.5M * 42/365 (0.449)M
Inventory 12.8M*45/365 12.8M*35/365 (0.35)M
Payable 12.8M*40/365 12.8M*35/365 0.175M

(0.624M)
Page 27
Question 21
One of your clients, John plans to start up a new business with $2,000,000 as the initial
capital and he approaches you for advice on cash management.
He plans to purchase fixed assets at the end of June. The assets cost $900,000 and are
expected to have a five-year economic life. Fixed assets have to be paid in June.
Inventories costing $500,000 will be acquired by end June and subsequently monthly
purchase will be at a level sufficient to replace forecast sales for the month.
Forecast monthly sales are $300,000 for July, $600,000 for August and September, and
$900,000 from October onwards.
Selling price is fixed at inventory plus 50%
Two months’ credit will be allowed to customers but only one month’s credit will be
received from suppliers of inventory.
The service contract on leasing and housing management will start from Jul.
Running expenses, starting from Jul are as follow:
Monthly Expenses $ Remarks

Salaries 80,000 Pay by end of the month
Housing Management Fee 5,000 3-month deposit is required and
will pay one month in arrears
subsequently.
Leasing Fee 40,000 Two-month deposit and one
month in advance
Utilities 4,000 Pay quarterly, 1st payment due
in Sept
Depreciation 15,000
Sundries 6,000 One month in arrears
Total 150,000
Note: All deposits shall be payable in June.

Prepare a cash budget for six months to December and advise whether John is required
to approach bank for additional finance.
Page 28
Solution

$ $ $ $ $ $
Cash b/f (Note
965,000 345,000 14,000 (229,000) (160,000) (291,000)
1)
Receipts 300,000 600,000 600,000 900,000
Purchases
500,000 200,000 400,000 400,000 600,000 600,000
(Note 2)
Salaries 80,000 80,000 80,000 80,000 80,000 80,000
Housing
Management 5,000 5,000 5,000 5,000 5,000
Fee
Leasing Fee 40,000 40,000 40,000 40,000 40,000 40,000
Utilities 12,000 12,000

Sundries 6,000 6,000 6,000 6,000 6,000
Total Payment 620,000 331,000 543,000 531,000 731,000 743,000
Cash c/f 345,000 14,000 (229,000) (160,000) (291,000) (134,000)
Note 1
Cash b/f for Jul = $2,000,000 - $900,000 – (3 x 5,000) - (3 x 40,000) = 965,000
Note 2

Sales 300,000 600,000 600,000 900,000 900,000 900,000
Purchase required 200,000 400,000 400,000 600,000 600,000 600,000
As negative cash balance will happen from Sept onward, additional finance is required.
Page 29
II. Decision Making
Question 1
A decision has to be made whether to use production method A or B
The cost figures are as follow:
Method A Method B
Cost Last Expect Cost Cost Last Expect Cost
Year Next Year Year Next Year
Fixed Costs 5000 7000 5000 7000
Variable Cost per Unit
 Labour 2 6 4 12
 Materials 12 8 15 10
Solution
First ignore past cost and second, exclude fixed costs as they are the same for both
alternatives and may therefore be ignored.
Hence the only relevant cost:
Method A Method B
Variable Cost per Unit
 Labour 6 12
 Materials 8 10
14 22
i.e. Method A should be adopted due to the lower relevant cost.
Question 2
Z Ltd is pricing its job by using of 20 hours of skill labour and 50 hours of semi-skill
labour.
The four existing workers are paid $15 per hour with a minimum weekly wage of $450.
Page 30
They are currently working 24 hours a week.
The semi skilled workforce are currently fully utilized. They are paid $10 per hour, with
time and a half overtime. Additional workers may be hired for $12 per hour.
What labour costs should be included in the price for Z Ltd.’s job?
Solution
Skilled workers:
Minimum weekly wage cover $450/$15 = 30 hours work. Each worker therefore has 6
hours per week spare capacity which is already paid for 6 x 4 = 24 hours which is
sufficient for the job => relevant cost = 0
Semi-skill workers
Overtime cost = $10x 1.5 = $15. It is therefore cheaper to hire additional workers
Relevant cost = 50 x $12 = $600
Question 3
A firm has some material which originally cost $45,000. It has a scrap value of $12,500
but if reworked at a cost of $7,500, it could be sold for $17,500.
What would be the incremental effect of reworking and selling the material?
Solution
=17500 –(12500+7500)
=-2500, i.e. a loss of 2500
Question 4
A company is considering accepting a one-year contract which will require four skilled
employees. The four skilled employees could be recruited on a one-year contract at a
cost of $400,000 per employee. The employees would be supervised by an existing
manager who earn $600,000 per year. It is expected that the supervision of the contract
would take 10% of the manager’s time.
Instead of recruiting new employees, the company could retrain some existing
Page 31
employees who currently earn $300,000 per year. The training would cost $150,000 in
total. If these employees were used, they would need to be replaced at a total cost of
$1,000,000.
Solution
The relevant cost is the lower of the relevant costs of each option
Recruitment: 4 x 400,000 = 1,600,000

Retrain and replace: 150,000+1,000,000 = 1,150,000
Retrain and replace has a lower relevant cost and thus the solution.
Question 5
Lucky Ltd is considering whether to set up a division in order to manufacture a new
product, Product A. A feasibility study recently undertaken at a cost of $850,000 has
suggested that Product A should be sold for $200, at which price sales would be
approximately 10,000 for each of the next four years. An initial investment of $200,000
is required for the setup of the new division.
The accountant produced the following figures:
Note $’000 $’000

Annual Income (10,000 x 200) 2,000
Expenses
Wages 1 450
Salaries 2 120
Materials 3 350
Variable Overheads 4 40
Rent 5 120
Depreciation 6 800
Head Office Expenses 7 300 (2,180)
Loss (180)
Notes
1. The wages figures represent three hours per unit at $15 per hour.
2. The salaries figure is made up of a foreman’s salary of $70,000 p.a. and a worker’s
salary of $50,000. Both are currently employed by Lucky Ltd. If Product A is not
produced, the foreman will still remain in employment but the worker will be
‘persuaded’ to take early retirement.
Page 32
3. Each unit of Product A needs 1kg of material costing $35 per kg.
4. Variable overheads would be $4 per unit
5. The new division would occupy a factory rented especially for the purpose at an
annual rental of $120,000
6. Manufacture of Product A would require a machine costing $4,000,000, scrap value
of $800,000 was expected at the end of the fourth year. Lucky Ltd charge
depreciation on a straight line basis.
7. Lucky Ltd allocates its fixed head office costs at the rate of $10 per direct labour.
Total head office costs would increase by $50,000 p.a. if the new division were set
up.
The cost of capital of Lucky Ltd is estimated at 8% p.a. in real terms.
You are required to advise the management of Lucky Ltd. whether the investment in
Product A shall be proceeded.
Solution
Consider cash flow only
Year 0 Year Year 2 Year 3 Year 4

1
$’000 $’000 $’000 $’000 $’000
Machinery (4,000)
Initial Investment (200)
Machinery Scrap Value 800
Annual Income 2,000 2,000 2,000 2,000
Expenses
Wages 450 450 450 450
Salaries 50 50 50 50
Materials 350 350 350 350
Variable Overheads 40 40 40 40
Rent 120 120 120 120
Head Office 50 50 50 50
Net Cash Flow (4,200) 940 940 940 1740
Performing DCF calculations for the division
$’000 DF PV
(8%)
Year 0 (4,200) 1 (4,200)
Page 33
Year 1 940 0.926 870.44

Year 2 940 0.857 805.58
Year 3 940 0.794 746.36
Year 4 1,740 0.735 1,278.9
Net Present Value (498.72)
Since the net present value of the project is negative, the company should reject the
project.
Question 6
A 1-year contract has been offered to produce 10,000 unit of a new product – product
FRM. The following information is given for the new product:
 Four type of material would be needed for the contract as follows:
Units Price/Unit
Material In Stock Required Purchase Current Current
for the Price Buy-in Resale Price
contract Price
$ $ $
W 12,000 3,000 18.0 15.0 12.0
X 2,000 11,000 7.5 28.0 21.0
Y 30,000 6,000 5.0 8.0 6.0
Z 18,000 12,000 18.0 20.0 19.0
W and Z are in regular use within the firm. X could be sold if not used for the contract
and there are no other uses for Y, which has been deemed to be obsolete.
 FRM would be manufactured in a factory owned by the firm in China, the annual
depreciation charge of which is $800,000. At present the factory is sub-let at
$300,000 annually.
 The manufacture and sale of FRM is expected to cause sales of an existing product,
HFA to fall by 3,000 unit per annum. The contribution of FRM is $90 per unit.
Page 34
Labour requirements for FRM are:
Hours/Unit of Hourly Rate

FRM
Skilled 4 $30.0
Semi-skilled 3 $22.0
Unskilled 2 $18.0
 It is expected that there will be shortage of skilled labour in the first year only so the
manufacture of FRM will make it necessary for the skilled labour to be diverted
from other work on which a contribution of $45 per hour is earned, net of wage
costs. The firm currently has a surplus of semi-skilled labour paid at full rate but
doing unskilled work. The labour concerned could be transferred to provide
sufficient labour for the manufacture of FRM and would be replaced by unskilled
labour.
 A market research study carried out three months ago into the sales potential of
FRM cost $250,000
 The manufacture of FRM require the services of an existing manager who would be
paid $360,000 p.a.. If not required for FRM, the manager would be made redundant
and would receive $120,000 p.a. under the service agreement.
 The product will utilise an existing machine that is only suitable for such contract
work. The machine cost $250,000 five years ago and has been depreciated $40,000
per year on a straight line basis and thus has a book value of $50,000. The machine
can be sold now for $80,000 or in 1 year’s time for $10,000.
You are required to calculate the lowest price for the contract.
Solution
 The market research cost is a sunk cost and is irrelevant

the purchase of the machine is a relevant cost. Depreciation are non-cash flow and is
irrelevant.
 Material Costs
W Although there is sufficient in stock, the use of 3000 units for the contract would
necessitate the need of replenishment at the current market price.
Page 35
i.e. relevant cost=3,000*$15.0=$45,000
X If the contract were not accepted, 2,000 units of X could be sold at $21.0 per unit.
The balance of 9,000 units required would be bought at the current buying-in price of
$28.0
i.e. relevant cost=2,000*$21.0+9,000*$28.0=$290,400
Y If the 6,000 units were used on the contract, they could not be sold so the
opportunity cost is the current resale price of $6.0 per unit.
i.e. relevant cost=6,000*$6.0=$36,000
Z Similar to W, replenishment at current buy-in price
i.e. relevant cost=12,000*$20=$240,000
Total relevant material cost: $45,000 + $290,400 + $36,000 + $240,000 = $611,400
 Manufacture of FRM would mean that the present rental, $300,000 received would
be foregone so it is a relevant cost.
 The relevant wages costs per unit of FRM are:
$ $
Skilled 4*(30+45) 300
Semi-skilled 3*18.0 54.0
Unskilled 2*18.0 36.0
Total: 390
i.e. relevant cost for labour per unit of FRM = 54+36+300=390

for 10,000 unit =390 * $10,000 = $3,900,000
 If the manufacture of FRM causes a sales loss elsewhere then this is a relevant cost
applicable to the FRM decision:
Relevant Sales loss=3,000*90=$270,000
 Relevant cost of the manager=360,000-120,000=$240,000
Page 36
 Machinery: relevant Cost $80,000 - $10,000 = $70,000
Lowest price of the contract = Total Relevant Cost of the contract = $611,400 +
$300,000 + $3,900,000 + $270,000 + $240,000 + $70,000 = $5,391,400
Question 7
You are the management accountant of a housing management company. Your

company had been requested by a major client to make a quotation on a special
assignment which last for 6 months.
Because of existing commitments, skill staff force is in shortage. If the company takes
up the assignment, over-time charging 50% above the normal hourly wage is expected.
On the other hand, the company has a surplus for un-skill staff force paying at the full
rate.
A trainee accountant has produced the following cost estimate based upon the resources
required as specified by the production manager.
$
Direct Materials - Special parts (book value) 5,000
- Cleansing Material (purchase 2,400
price)
Staff Force -Skilled 500 hours @ 40 20,000
-Unskilled 600 hours @ 20 12,000
Variable Overheads 500 hours @ 4.00 2,000
Special Machine 200 hours @ 25 5000
Depreciation
Equipment 5,000
Fixed production cost 350 hours @ 6.00 2,100
Estimating department 400
cost
Salary of the Engineer 20,000
73,900
As the management would like to maintain a good relationship with the client, you are
request to make the quotation on the basis of 10% margin on the minimum relevant
cost.
The following notes are relevant to the cost estimate above:
Page 37
1. The special parts to be used are currently in stock at a value of $5,000. It is of an

unusual component which has not been used for some time. The replacement price
of the special parts is $8,000, whilst the scrap value of that in stock is $2,500.
Management does not foresee any alternative use for the special parts if it is not
used for this assignment.
2. The cleansing materials required are not held in stock. They would have to be
purchased in bulk at a cost of $3,000. 80% of the cleansing materials purchased
would be used in this assignment. No other use is foreseen for the remainder.
3. Skilled staff force is in short supply, in case of overtime, $60 per hour is required.
4. Unskilled labour is currently under-utilized and at present 200 hours per month are
recorded as idle time. If the assignment is carried out, additional temporary staff
can be acquired at an hourly rate of $25.
5. Variable overhead is charged according to the direct skill staff force.
6. When not being used by the company, the special machine is hired to outside
companies for 60 per hour. This earns a contribution of 30 per hour. There is
unlimited demand for this facility.
7. A special equipment is required for this assignment. The equipment can be leased
at a quarterly cost of $2,500. However, minimal leasing period is 3 quarters
according to the leasing contract.
8. Fixed production costs are those incurred by and absorbed into this assignment,
using an hourly rate based on budgeted activity.
9. The cost of the estimating department represents time spent in preparing the
proposal to the client.
10. The assignment requires the services of an existing engineer of whom the monthly
salary is $10,000. The engineer has recently tendered his resignation for
retirement. If the assignment is taken up, the engineer agrees to extend the contract
for one month.
a). You are required to work out the proposed quotation price for this assignment.
Solution
a).
$
Direct Materials - Special parts (book
2,500
value)
- Cleansing Material 3,000
(purchase price)
Page 38
Staff Force -Skilled 500 hours @ 60 30,000

-Unskilled 400 hours @ 25 10,000
Variable Overheads 500 hours @ 4.00 2,000
Special Machine 200 hours @ 30 6,000
Equipment 7,500
Minimal Relevant Cost 71,000
Price To be Quoted 10% margin 78,100
Question 8
You are the management accountant of a housing management company. Your company had
been approached by a new client to make a quotation on a special project. The project shall last
for 6 months.
A newly employed clerk has prepared the following preliminary estimation:
$ Note
Direct Materials - Special parts (book value) 5,000 1
- Cleansing Material 2,400 2
(purchase price)
Staff Force -Skilled 500 hours @ 40 20,000 3
-Unskilled 600 hours @ 20 12,000 4
Variable Overheads 500 hours @ 4.00 2,000 5
Special Machine 200 hours @ 25 5,000 6
Depreciation
Equipment to be leased 2,500 7
Depreciation of the 5,000 8
existing equipment
Fixed production cost 350 hours @ 6.00 2,100 9
Estimating department 400 10
cost
Salary of the Engineer 60,000 11
116,400
1. The special parts to be used are currently in stock at a value of $5,000. It is of an unusual
component which has not been used for some time. The replacement price of the special
Page 39
parts is $8,000, whilst the scrap value of that in stock is $2,500. Management does not
foresee any alternative use for the special parts if it is not used for this project.
2. The cleansing materials required are not held in stock. They would have to be purchased
in bulk at a cost of $3,000. 80% of the cleansing materials purchased would be used in this
project. No other use is foreseen for the remainder.
3. Skilled staff force is in short supply, in case of overtime, $60 per hour is required.
However, the task performed by the skilled staff force can be outsourced at a lump sum
cost of $25,000
4. Unskilled labour is currently under-utilized and at present 200 hours per month are
recorded as idle time. If the assignment is carried out, additional temporary staff can be
acquired at an hourly rate of $25.
5. Variable overhead is charged according to the direct skill staff force.
6. When not being used by the company, the special machine is hired to outside companies
for 60 per hour. This earns a contribution of 30 per hour. There is unlimited demand for
this facility.
7. A special equipment is required only for the first month of the project. The equipment can
be leased at a monthly cost of $2,500. However, minimal leasing period is 3 months
according to the leasing contract.
8. The project also requires to utilize another existing equipment which is of no use and no
disposal market value. Annual depreciation is $10,000 and net book value is $20,000. A
vendor offers a trade-in value of $3,000 for another agreed purchase. However, the
trade-in offer only last for one month.
9. Fixed production costs are those incurred by and absorbed into this assignment, using an
hourly rate based on budgeted activity.
10. The cost of the estimating department represents time spent in preparing the preliminary
proposal to the client. If the project is proceeded, a detail cost estimation is required at a
later stage. Additional estimated cost is $7,000
11. The project requires the services of an existing engineer of whom the monthly salary is
$10,000. The engineer has recently tendered his resignation for retirement. If this project
is taken up, the engineer agrees to extend the contract for another three months.
12. Due to resource constraint, if this project is proceeded, another minor project of
contribution $20,000 may needed to be outsourced. The cost of outsourcing will be
$6,000 higher than in-house cost.
13. It is the normal practice of the company to have a 30% mark-up on total relevant costs.
You are required to work out the proposed quotation price for this assignment.
Page 40
Solution
a).
$ Remarks
Direct Materials - Special parts (book value) 2,500
- Cleansing Material 3,000
(purchase price)
Staff Force -Skilled 25,000 The lower of outsource
and in-house cost (500 x
$60)
-Unskilled 10,000 400 hours x $25
Variable Overheads 2,000 500 hours x $4.00
Special Machine 6,000 200 hours x $30
Equipment 7,500 Minimum 3 months
Lost in trade-in value 3,000
Additional Estimated 7,000
Cost
Increase in cost of 6,000
outsource
Minimal Relevant Cost 102,000
Price To be Quoted 132,600 30% mark-up
Question 9
You are the general manager of a housing management company managing a large
commercial complex. As the economy has been hardly hit by the COVID-19 pandemic,
your company is now considering a special promotion event in the commercial
complex to boost the turnover.
According to the agreement with the tenants, your company can share the increase in
turnover according to following scheme during the promotion period:
Increase in turnover ($’000) Turnover Sharing

($’000)
Under 5.000 0
> 5,000 and below 10,000 100
> 10,000 and below 20,000 400
> 20,000 800
The marketing manager provides the estimation on the probability as follow:
Page 41
Increase in turnover ($’000) Probability

Under 5.000 40%
> 5,000 and below 10,000 30%
> 10,000 and below 20,000 20%
> 20,000 10%
The account assistant provides you the cost estimation regarding the special promotion
event:
$
$’000
Cost of Outsourcing 80
Mobile application 524
development cost
Direct Labour -Grade 1 250 hours @ 40 10
-Grade 2 500 hours @ 35 17.5
Variable Overheads 350 hours @ 40 14
Depreciation of the 200 hours @ 25 5
special machine
Fixed cost 350 hours @ 60 21
Planning cost 40
Total 711.5
You are aware that considerable publicity could be obtained for the company if you are
able to win this order and the price quoted must be very competitive.
1. The special promotion event will be outsourced to a local firm at a cost of $80,000.
2. For the long term development of the business, the company has engaged a
software company to develop a mobile application for the tenancy management of
the commercial complex at a total cost of $500,000 6 months ago. The system is
due to put into production in coming month. According to the software vendor, an
additional cost $24,000 is required if the application is enhanced to cater for the
special promotion event.
3. Grade 1 labour is charging at a standard rate of $40 per hour. However, as the
promotion event will be held in peak season, it is expected that Grade 1 labour will
be in short supply and the general manager expected an extra 50% on the standard
rate is necessary if Grade 1 labour is acquired.
4. Grade 2 labour at a standard charging rate of $35 is in surplus currently. Grade 2
labour will be fully reimbursed by government’s subsidy. If not for government’s
special subsidies, the staff concerned shall have been made redundant.
5. Variable overhead represents the operating cost of special promotion event.
Page 42
6. When not being used by the company, the special machine is hired to outside
companies for $80 per hour. This earns a contribution of $30 per hour. There is
unlimited demand for this facility.
7. It is the company’s policy to allocate the fixed costs into different promotion
events by hourly rate based on budgeted activity.
8. Planning cost represents the cost already incurred for planning this special
promotion event.
a. You are required to advise whether the proposal shall be accepted.
Solution
Relevant cost of the event
$’000
Cost of Outsourcing 80
Mobile application 24
development cost
Direct Labour -Grade 1 250 hours @ 60 15
-Grade 2 0
Variable Overheads 350 hours @ 40 14
Loss on contribution 200 hours @ 30 6
from the machine
Total 139
Expected Sharing of Turnover
Increase in turnover Turnover Probability ($’000)

($’000) Sharing
($’000)
Under 5.000 0 40% 0
> 5,000 and below 100 30% 30
10,000
> 10,000 and below 400 20% 80
20,000
> 20,000 800 10% 80
Total 190
Expected Value on the Sharing of Turnover is $190,000 is greater than the relevant cost
of the event, i.e. $139,000, the special promotion event shall be proceeded,
Page 43
III. Marginal Costing & Break-even Analysis
Question 1
a). Your assistant provided you the following information in relating to a normal
production volume of 10,000 units. You may assume that except the fixed overheads,
all the production costs are variable in nature.
$/Unit $/Unit
Selling Price 120
Production Cost
Labour 20
Material 15
Variable Overheads 8
Fixed Overheads 20 (63)
Gross Profit 57
i. What are the fixed overheads and the budgeted gross profit?
ii. How many units need to be sold to make a gross profit of $400,000
iii. Prepare a flexible budget for the production volume of 15,000 units.
iv. What would be the budget gross profit if there is a 10% increase on labour cost
and the budget volume is 10,000 units?
Solution
a.
i. Fixed Overheads = $20 x 10000 = $200,000
Budget Gross Profit = $57 x 10000 = $570,000
ii. Contribution per unit = 120- (20+15+8) = $77
Let X be the required quantity
77X = $200,000 + $400,000 = $600,000
X = 7,792 units
iii. Flexible Budget
$/Unit 10000 Units 15000 Units

$’000 $’000
Selling Price 120 1,200 1,800
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Production Cost
Labour 20 200 300
Material 15 150 225
Variable Overheads 8 80 120
Fixed Overheads 20 200 200
Gross Profit 570,000 955,000
iv.. 10% increase in labour cost

Budget gross profit = 570,000 – 200,000 x 10% = $550,000
Question 2
You are given the following information:
$/Unit $/Unit
Selling Price 100
Production Cost
Labour 20
Material 15
Variable Overheads 5
Fixed Overheads 20* (60)
Gross Profit 40
* This represent budgeted costs of $200,000 spread over budgeted sales of 10,000 units.
1. What is the budgeted gross profit?

2. What would be the effect on gross profit of a 20% fall in sales volume
3. How many units need to be sold to make a gross profit of $500,000
Solution
i. Budget gross profit:

Contribution per unit = 100 – (20+15+5) = $60
When sales = 10,000 units, total contribution = $600,000
Gross profit = $600,000 – 200,000 (fixed cost) = $400,000
ii. When there is a 20% fall in sales volume:
Total sales = 8,000 units, total contribution = 8000 x $60 = $480,000

Gross profit = $480,000 – 200,000 (fixed cost) = $280,000
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iii. How many units need to be sold to make a gross profit of $500,000
Total Contribution - Fixed Cost = Gross Profit

i.e. Total Contribution = Gross Profit + Fixed Cost = $500,000 + $200,000
Let Y be the required units to be sold

60Y= 700,000
Y = 11667 units
Question 3
E plc operates a marginal costing system. For the forthcoming year, variable costs are
budgeted to be 60% of sales value and fixed costs are budgeted to be 10% of sales value.
If E plc increases its selling prices by 10%, and fixed cost, variable costs and sales
volume remain unchanged, what will be the effect on total contribution?
Solution
Let S be the existing sales
Existing Contribution = S – 0.6S = 0.4S
New Sales = 1.1S
New Contribution = 1.1S-0.6S=0.5S
i.e. increase 0.5/0.4 –1 = 25%
Question 4
You are the accounting manager of a cleansing services company, your boss has
provided you the following budget information:
Monthly Budget Note

Direct labour 30,000 1
Consumables 4,000 2
Other Variable overheads 6,000
Depreciation – Fixed 10,000
Other office overheads 50,000 3
The figures are based on the existing service contract of providing cleansing services to
a commercial building with internal floor areas (IFAs) of 200,000 square feet.
Note:
1. Labour cost is now charging on hourly basis. You may assume the labour cost
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directly proportion to the internal floor area. However, 10% efficiency gain
(on total labour cost) can be obtained if the total IFAs exceeding 500,000 sq
feet.
2. Consumables cost is variable in nature.
3. Office Overheads are mainly fixed in nature. However, if the total IFAs
exceeding 350,000 sq feet, the company needs to employ an additional
supervisor of salary equal to $10,000.
4. Monthly service charge is at present $0.5 per IFA.
a. Prepare a flexible budget if the total IFAs equal to:

i. 300,000 sq feet
ii. 400,000 sq feet
iii. 600,000 sq feet
b. What is the Average Breakeven service charge per IFA under the 3 scenarios
c. On the top of the existing service contract (i.e. 200,000 sq feet), your company is
now bidding other service contracts of 100,000, 200,000 and 400,000 sq feet
respectively. What is the Lowest Service Price (per IFA) for EACH service contract
your company can offer?
(Assuming there is no dependency amongst the three service contracts)
i. 100,000 sq feet
ii. 200,000 sq feet
iii. 400,000 sq feet
d. Suppose the likely offer price for the 3 services contracts are as follow:
i. 100,000 sq feet $0.5 per sq feet

ii. 200,000 sq feet $0.4 per sq feet
iii. 400,000 sq feet $0.3 per sq feet
If your company can ONLY select ONE contract, which contract shall you
recommend?
Solution
Page 47
IFAs (sq. feet) 200,000 300,000 400,000 600,000

Income 100,000 150,000 200,000 300,000
Expenditure
Variable Cost
Indirect labour – Variable 30,000 45,000 60,000 81,000
Consumables – Variable 4,000 6,000 8,000 12,000
Other Variable overheads 6,000 9,000 12,000 18,000
40,000 60,000 80,000 111,000
Fixed Cost
Depreciation – Fixed 10,000 10,000 10,000 10,000
Other fixed overheads 50,000 50,000 60,000 60,000
Total Cost 100,000 120,000 150,000 181,000
Profit Nil 30,000 50,000 119,000
b. Average Breakeven service charge per IFA
Total Cost 100,000 120,000 150,000 181,000

Total IFAs 200,000 300,000 400,000 600,000
Breakeven cost per IFA 0.50 0.40 0.375 0.302
Lowest service charge per IFA
Total Incremental Cost 20,000 50,000 81,000

Total Incremental IFAs 100,000 200,000 400,000
Lowest Service Price (per IFA) 0.20 0.25 0.203
d.
Price offer by client $0.50 $0.40 $0.30

Lowest Service Price (per IFA) $0.20 $0.25 $0.203
Contribution per IFA $0.30 $0.15 $0.097
Total Incremental IFAs 100,000 200,000 400,000
Incremental Contribution 30,000 30,000 38,800
The contract of $400,000 IFAs gives the highest incremental contribution and shall be
recommended.
Question 5
Wall Ltd has the chance to pursue a short term venture that will utilize some spare
resources. Possible sales volume is as follows:
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Sales Volume (Units) Probability

2,000 0.3
5,000 0.6
10,000 0.1
The sales price will be $65 per unit and promotion costs will amount to $50,000. This is
a new product and no finished stocks are currently held. 5kg of material will be required
per unit produced. 20,000kg of material are in stock at a book value of $6 per kg. The
material is obsolete and could be sold off for $7 per kg. The current replacement price is
$9 per kg.
Two hours of labour at $3 per hour are required per unit. If the venture is not undertaken,
there are expected to be 10,000 hours of paid idle time.
Variable overhead is incurred at a rate of $5 per active labour hour. Fixed overhead will
not be affected by the venture.
i. What is the expected value of incremental profit from the venture.
Solution
Sales Volume (Unit)

2,000 5,000 10,000
Sales 65*2000 130,000 65*5000 325,000 65*10,000 650,000
Relevant cost of W1 70,000 W2 185,000 W3 410,000
material
Relevant cost of W4 0 W5 0 W6 30,000
labour
Variable 5*2*2000 20,000 5*2*5000 50,000 5*2*10000 100,000
Overhead
Marketing 50,000 50,000 50,000
Expense
Incremental Profit (10,000) 40,000 60,000
W1: (2000 Units)

Required material = 5kg * 2000 = 10,000kg
Relevant cost = $7 * 10,000 = $70,000
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W2 (5000 Units)
Relevant cost = $7 * 20,000 + $9 * 5000 = $185,000
W3 (10000 Units)
Relevant cost = $7 * 20,000 + $9 * 30,000 = $410,000
W4 (2000 Units)
Required labour hour= 2 * 2000 = 4000
Relevant cost = $0
W5 (5000 Units)
Relevant cost = $0
W5 (10000 Units)
Relevant cost = 10000 * $3 = $30,000
Expected value of incremental profit:

(10,000) * 0.3 + 40,000 * 0.6 + 50,000 * 0.1
= 27,000
ii. What is the probability of at least breakeven on the venture?
0.6 + 0.1 = 0.7
IV. Valuation of Equities/Bonds
Question 1.
a). ABC Ltd. has the following long term sources of capital:
 100 million $1 Ordinary Shares with a current market value of $1.4

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 20 million of $1 Preference Shares with a current market value of $0.925

 $75 million Debenture Stock with a current value of $90 per $100 nominal value
The individual component costs have been estimated at 16%, 12% and 8% respectively,
calculate the Weighted Average Cost of Capital (WACC) of ABC Ltd.
b). XYZ Ltd. has a constant dividend policy of paying $0.35 per share. The market
value of a share is $3.2, calculate the cost of capital:
Solution
a. Total Capital = 100 * 1.4 + 20 * 0.925 + 75 * 90/100 = 226 million
Proportion of Ordinary Share = 100*1.4/226 =62%

Proportion of Preference Share = 20*0.925/226 =8%
Proportion of Debenture = 75*90/100/226 =30%
WACC = 62%*16% + 8%*12% + 30%*8% = 13.28%
b. r=0.35/3.2 = 11%
Question 2
TS Ltd. has 200,000 $1 ordinary shares in issue which have a current market price of $2.
The company is making a 2 for 5 rights issue at a price of $l.50.
(i) Calculate the theoretical ex-rights price.

(ii) Calculate the value of the rights per new share.
Solution
$
5 shares valued at $2 each 10
2 shares issued at $l.50 each 3
13
(i) the theoretical ex-rights price is:

$ 13/7 = $1.86
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(ii) the value of the rights is:

$1.86 - $1.50. =$0.36 per share
Question 3
Suppose there are about 20 million shares of HSBC 5.5% preferred stock outstanding.
The par value is HK$85. You estimated that the discount rate on HSBC preferred stock
is 5%. Use the zero growth model to determine the value of HSBC’s preferred stock.
Solution
We need to determine D. Since the par value is $85, the annual
dividend is equal to [HK$85 x 0.055] = HK$4.675
MVHSBC = D/r = HK$4.675/0.05 = HK$93.5
Question 4
A one-year zero coupon bond is selling at $950, and a two-year zero coupon bond is selling at
$852. They both have a face value of $1,000. Calculate the yields for both of the bonds.
Solution
1-year zero coupon bond: (1000/950)–1=5.26%
2-year zero coupon bond: (1000/852)1/2 –1=8.34%
Question 5
Bond Z with par value $1,000 and coupon rate 5% is now trading at market price
$948.11. The maturity of the bond is one year.
i. Calculate the expected return of bond Z.

ii. If investors of bond Z require a risk premium of 0.5% and the probabilities of the
risk free interest rate are as follow:
Risk Free Interest Rate Probability

5% 0.2
6% 0.3
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7% 0.5
What will be the expected market price of the bond?
Solution
i. (1050/948.11) - 1 = 10.7%
ii.
Expected Value of Risk Free Return
Risk Free Probability Expected Value
Interest Rate
5% 0.2 1.0%
6% 0.3 1.8%
7% 0.5 3.5%
6.3%
Required return for the bond = 6.3% + 0.5% = 6.8%

Expected market price of bond Z = 1050/(1+6.8%) = $983
Question 6
Lucky Star Ltd. needs to raise $500,000 to finance a large scale project which would
produce pre-tax earnings of $105,000 in perpetuity, but the company is undecided as
how the money should be raised.
The company has an issued share capital of 4 million ordinary shares of $1 each with a
current market price of $1.38 cum div. The annual dividend (which has been constant
for many years) of $360,000 is about to be paid.
Different methods of raising capital are being considered: a public issue, rights issue at
$1.0 or raising 10% loan. Prevailing tax rate is at 15%.
You are required to calculate:

i. The price at which the public issue should be made if all benefits go to existing
shareholders;
ii. The price at which you would expect shares to stand immediately after the rights
issue;
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iii. The share price if the company finance by raising loan.
Solution
Calculation of cost of capital
Dividend per share = $0.09

Ex div market price =$1.29
Cost of capital = 0.09/1.29 = 7%
NPV of project = $(500,000) + $105,000(1-15%)/0.07 = $775,000
i). Price of a public issue

Considering existing shareholders’ shares and assuming that the aim is to maximize the
gain of existing shareholders:
New market value = old market value + NPV of the project

= $5,160,000+$775,000
=$5,935,000
New market price = $5,935,000/4M = $1.484
New share shall be issued at a price of $1.484
ii). Price of shares after rights issue
New market value = old market value + NPV of the project + capital raised
= $5,160,000+$775,000+$500,000 = $6,435,000
New unit market price = $6,435,000/(4,000,000+500,000)=$1.43
iii) If raise by 10% loan
NPV of project =$[105,000 – 50,000(interest)](1-15%)/0.07 – 500,000 = $167,857

New market value = $5,160,000+$167,857 + 500,000= $5,827,857
New unit market price = $5,827,857/(4,000,000)=$1.457
Page 54
Question 7
a). A public company is to be established to exploit some newly developed

technology. It is estimated that $10 million will be required and that this will generate
earning before interest and taxation of $2,200,000 p.a. Two proposals are under
consideration. The first is to finance the company through an issue of 10,000,000
ordinary $1 shares at par. The second s to issue only 5,000,000 ordinary $1 shares along
with $5,000,000 9% loan stock. If the all equity financing is used it is estimated that the
ordinary shareholders will expect to see the company earn a return after corporate tax of
10%. However, because of the additional risk which will arise if loan stock is used, then
in this case the shareholders will expect the return to be 15%.
Corporate taxation is 50%. Assume that all earnings are paid out by way of dividend.
You are required to:

Calculate the theoretical market value of the ordinary shares immediately after the issue
for both proposals. Consider earnings of $2,200,000.
Solution
Finance by ordinary shares
$
Earnings 2,200,000
Taxation 1,100,000
Dividend 1,100,000
Capitalization at required return of 10%

ordinary shareholders
Market value of ordinary shares 11,000,000
Market value per share $1.1
Finance by ordinary shares and debt

$
Earnings 2,200,000
Interest 450,000
1,750,000
Taxation 875,000
Dividend 875,000
Capitalization at required return of 15%

ordinary shareholders
Market value of ordinary shares 5,833,333
Market value per share $1.17
Page 55
Question 8
Calculate the Market Value of for a 4% loan stock with maturity period of 4 years and
face value of $10,000 if the cost of capital is
i. 3%
ii. 4%
iii. 5%
Given: 4% Loan Stock with Face Value $10,000 and maturity period of 4 years
Calculate the Market Value if the expected return are i) 3%, ii) 4% and iii) 5%
respectively
Solution
Expected Return 3% 4% 5%
CF DF PV CF DF PV CF DF PV
YR1 400 97.09% 388.35 400 96.15% 384.62 400 95.24% 380.95
YR2 400 94.26% 377.04 400 92.46% 369.82 400 90.70% 362.81
YR3 400 91.51% 366.06 400 88.90% 355.60 400 86.38% 345.54
YR4 10,400 88.85% 9,240.27 10,400 85.48% 8,889.96 10,400 82.27% 8,556.11
Total i. 10,371.71 ii. 10,000.00 iii. 9,645.40
Page 56
V. Portfolio, Risk and CAPM
Question 1
You are considering investing in one or both of the two security, X and Y, and you are
given the following information:
Security X Security Y
Possible rates of Probability of Possible rates of Probability of
return occurrence return occurrence
% %
30 0.3 50 0.2
25 0.4 30 0.6
20 0.3 10 0.2
You are required to:
i. Calculate the expected return for each security separately and for a portfolio
comprising 60% X and 40%Y, and the expected risk of each security separately
ii. Calculate the standard deviation of the portfolio if there is no correlation between
X and Y
iii. Calculate the standard deviation of the portfolio if X and Y are perfectly positively
correlated.
iv. Calculate the standard deviation of the portfolio if X and Y are perfectly
negatively correlated.
Security X Security Y
% Probability Weighted % Probability Weighted
Return average Return average
% %
30 0.3 9 50 0.2 10
25 0.4 10 30 0.6 18
20 0.3 6 10 0.2 3
25 30
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Assuming a positive correlation between the two securities the expected return for the
portfolio is simply a weighted average:
Expected return of the portfolio = (0.6x25%)+(0.4x30%)=27%
The calculation of risk is an application of elementary statistics. The standard deviation

 = variance1/2, where variance is calculated as:
N
 (Xi-Xa)2 P(Xi)
i=1
Where Xi is outcome of X under situation i

Xa is the average outcome
P(Xi) is the probability of Xi
Thus if the various outcome can be substituted in the formula the risk can be
established.
Outcomes Probability of Xi
Xi Xa (Xi-Xa)2 P(Xi) (Xi-Xa)2 P(Xi)
30 25 25 0.3 7.5
25 25 0 0.4 0
20 25 25 0.3 7.5
15
Standard deviation = 151/2 = 3.87%
Outcomes Probability of Yi
Yi Ya (Yi-Ya)2 P(Yi) (Yi-Ya)2 P(Yi)
50 30 40 0.2 80
30 30 0 0.6 0
10 30 40 0.2 80
160
Standard deviation = 1601/2 = 12.65%
ii.
For the portfolio, each security has three outcomes given nine possible combinations
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where the return on X is weighted by 60%
Outcome (Fi-Fa) 2 P(Fi)= (Fi-Fa)2 x

P(Fi)
Fi Fa=27 [P(Xi)xP(Yi)]
30(0.6)+50(0.4)=38 121 0.06 7.26
30(0.6)+30(0.4)=30 9 0.18 1.62
30(0.6)+10(0.4)=22 25 0.06 1.5
25(0.6)+50(0.4)=35 64 0.08 5.12
25(0.6)+30(0.4)=27 0 0.24 0
25(0.6)+10(0.4)=19 64 0.08 5.12
20(0.6)+50(0.4)=32 25 0.06 1.5
20(0.6)+30(0.4)=24 9 0.18 1.62
20(0.6)+10(0.4)=16 121 0.06 7.26
1.00 31
Standard deviation of the portfolio (F)= 311/2 = 5.57%
As an alternative, you may use the following formulae:
Var(F) = W12Var(X)+W22Var(Y)+2W1W2XYxy
Where
Var(F) = Variance of the Portfolio F

Var(X) = Variance of the investment X
Var(Y) = Variance of the investment Y
W1 = Weight of X in Portfolio F
W2 = Weight of Y in Portfolio F
X = Standard deviation of X
Y = Standard deviation of Y
xy = Correlation Coefficient of X and Y
If there is no correlation between X and Y, xy = 0.
i.e. Var(F) = (0.6)2(15)+(0.4)2(160)+2(0.6)(0.4)(3.87)(12.65)(0)

Standard deviation of the portfolio (F)= 31 = 5.57%
iii. If there is perfectly positive correlated between X and Y, xy = 1.
Var(F) = (0.6)2(15)+(0.4)2(160)+2(0.6)(0.4)(3.87)(12.65)(1) = 54.5
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Standard deviation of the portfolio (F)= 54.5 = 7.38%
iv. If there is perfectly negative correlated between X and Y, xy = -1.
Var(F) = (0.6)2(15)+(0.4)2(160)+2(0.6)(0.4)(3.87)(12.65)(-1) = 6.5

Standard deviation of the portfolio (F)= 6.5 = 2.55%
Question 2
Suppose you have the following investments
Investment X: return = 15% and variance = 10%

Investment Y: return = 25% and variance = 18%
i. Assume X and Y are perfectly negative correlated, construct a portfolio of X and Y

which is risk free.
ii. Calculate the expected return of the resulting portfolio
Solution
i. Var(F) = W12Var(X)+W22Var(Y)+2W1W2XYxy
As the portfolio F is risk free, Var(F) = 0,

Moreover, X and Y are perfectly negative correlated, xy=-1, i.e.
0 = W12Var(X)+W22Var(Y)-2W1W2XY
=> (W1X - W2y) 2 = 0
Also W1 + W2 = 1 => W2 = (1-W1)
Solving the equation W1X - (1-W1) y =0

W1 (X+y) - y = 0
W1 = y / (X+y) = 18 / (18 + 10) = 57%
W2 = 1-W1 = 43%
i.e. the portfolio should comprise of 57% of X and 43% Y
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ii. Expected return of the portfolio:
57% x 15% + 43% x 25% = 19.3%
Question 3
Security A has an expected rate of return of 12%, with a standard deviation of 32.65%.
i. Given that the correlation coefficient of the return on security A with the return on
the market portfolio is 25% and that the standard deviation for the market portfolio is
13.5%, you are required to calculate the Beta factor for security A
ii. Given that the risk-free rate of return is 8%, you are required to calculate the
expected rate of return on the market portfolio.
Solution
i. Beta A = Covariance (A, M)/ M2
Covariance (A, M)/ (M *A) = Correlation Coefficient of A&M, i.e. AM
i.e. Beta A = AM x A / M
= 25% x 32.65%/13.5% = 0.6
ii. EA = RF+(Em-RF)A
12%=8%+ (Em -8%)0.6

Em = 14.6%
Question 4
Let’s say you’ve used historical data to obtain the following information:
Market risk premium = 10%
The required rate of return of an individual stock = 16%
The beta coefficient of the individual stock = 1.2
What are the:
Page 61
1. Risk Free Return

2. Market Return
Solution
1. E(ri) = rf + ßi[E(rM) – rf]
16% = rf + 1.2 x 10%
rf = 4%
2. E(rM) – rf = 10%
E(rM) = 14%
Question 5
PQ Ltd. paid a $2 dividend last year. An investor projects that next year's dividend will
be 10% higher and that the stock will be selling for $30 at the end of the year. The risk
free rate of interest is 8%, the market return is 13% and the stock's beta is 1.2.
(i) Calculate the expected return of PQ Ltd.

(ii) Calculate the value of share of PQ Ltd.
Solution
i. Required return for the stock = 8% + 1.2 x (13% - 8%) = 14%
ii. Value of the stock = ($30 + $2.2) / 1.14 = $28.25
Question 6
Suppose you have the following Securities
Security X: return = 15% and variance = 10%

Security Y: return = 25% and variance = 18%
Market Return = 20% and Risk Free Return = 8%
Page 62
i. Assume the correlation coefficient between X and Y are 0.5, what will be the
standard deviation of a portfolio comprising 60% X and 40% Y.
ii. Calculate the expected return of the resulting portfolio
iii. Calculate the beta coefficient of X, Y and the resulting portfolio
Solution
i. x,y2 = Wx2x2+Wy2y2+2WxWyxyxy
= (60%)2 (10%)+(40%)2(18%)+2(60%)(40%)√10%√18%(0.5)
= 9.7%
x,y = 3.11%
ii. Expected Return = 60% (15%) + 40% (25%) = 19%

iii.
ßx = (15% - 8%) / (20% - 8%) = 0.583
ßy = (25% - 8%) / (20% - 8%) = 1.417
ßxy = 60% (0.583) + 40%(1.417) = 0.917
Page 63
VI. Discount Cash Flow

Question 1
Your company has 5 new capital projects on hand. Given the cost of capital is 20%,
Expressed in $’000
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A -9500 3000 4700 4800 3200
B -6000 2000 3000 4000
C -15000 7000 7000 4000 4000 3000
D -7500 6000 2000 3000
E -12000 5000 1000 6000 3000
a. What would you suggest which project(s) shall be proceeded if there is no capital
restriction?
b. What if your company only has initial capital of $20M and assuming the
investment per project is indivisible (i.e. cannot be pro-rata), how do you
recommend?
i. If there is no dependency amongst projects
ii. If Project A & D is mutual exclusive
c. If the investment in the project is divisible (i.e. can be pro-rata) and the capital
restriction is again $20M, how do you recommend?
i. If there is no dependency amongst projects

ii. If Project A & D is mutual exclusive
Solution
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 NPV

A -9500 2500 3264 2778 1543 0 585
B -6000 1667 2083 2315 0 0 65
C -15000 5833 4861 2315 1929 1206 1,144
D -7500 5000 1389 1736 0 0 625
E -12000 4167 694 3472 1447 0 (2,220)
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Discount
Factor 0.833333 0.694444 0.578704 0.482253 0.401878
a. Project A, B, C, D should be recommended as all get a positive NPV
b. Under 20M restriction and capital indivisible

i. Projects A & D give the highest NPV, therefore A&D shall be recommended.
ii. If A&D is mutually exclusive, only C can be recommended.
c. If investment in the projects is divisible:
Project NPV NPV/Capital

A 585 6.2%
B 65 1%
C 1,144 7.6%
D 625 8.3%
E (2,220) -
Project D gives the highest NPV/Capital Invested, therefore the investment strategy
shall be invested all in D and the rest in C.
Same as above.
Question 2
Four projects, P, Q, R and S, are available to a company which is facing shortages of
capital over the next year but expects capital to be freely available from then on
Project P Q R S
$’000 $’000 $’000 $’000
Total Capital required over the life 10 60 20 20
of the project
Capital required in the next year 10 20 15 16
NPV of the project at the 30 80 50 30
company’s cost of capital
In what sequence should the projects be selected if the company wishes to maximize net
present value?
Page 65
Solution
Project P Q R S
$’000 $’000 $’000 $’000
Capital required in the next year 10 20 15 16
NPV of the project at the 30 80 50 30
NPV/Capital required in next year 3 4 3.33 1.875
Ranking 3 1 2 4
Question 3
The managing director of Johnson Ltd is now considering whether to accept the
proposal made by the general manager. The first-year income statement of the 4-year
contract details as follow:
Note $’000 $’000

Annual Income 1 2,800
Expenses
Wages 2 800
Salaries 3 240
Other Overheads 4 600
Rent 5 120
Depreciation 6 500
Allocated Head Office 300 (2,560)
Expenses
Profit 240
Notes
1. Upon the successful completion of the contract, there will be an additional bonus of
$500,000 payable at contract end.
2. It is expected that there will be a annual salary increment of 5%
3. The contract requires the services of an existing manager who would be paid $240,000 per
annum. If not required for the contract, the manager would be made redundant and would
receive $120,000 per annum under the service agreement.
4. Other overheads are totally attributed to the contract.
5. Rent represents a 50% sharing of the existing office
6. Depreciation represents the initial investment in equipment solely for this contract,
initial cost of $2,400,000 with scrap value $400,000
Page 66
7. Allocated head office expenses represent 40% sharing of head office cost plus an
annual outsourcing cost of $50,000 solely for this contract.
8. The contract stipulates that Johnson needs to purchase a performance bond of
$2,000,000 with annual return of 5%. The bond can be disposed upon the
completion of contract.
9. You can assume that the investment in equipment and the purchasing of
performance bond is incurred at the beginning of the year whilst all other receipts
and payments are incurred at the end of the year.
10. In order to take up the contract, the company has to engage a consultancy service to
review the existing business processes, the one-off cost of the consultancy services
will be $800,000 payable at the start of the contract.
The cost of capital of Johnson Ltd is estimated at 10% p.a. in real terms.
You are required to advise whether Johnson Ltd. shall proceed with this contract.
Solution
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4
(In thousand)
Receipts
Annual Income 2,800 2,800 2,800 2,800
Bonus 500
Dispose Performance Bond 2,431
Scrap value of Equipment 400
Payments
Wages (800) (840) (882) (926)
Salaries (120) (120) (120) (120)
Other Overheads (600) (600) (600) (600)
Cost of outsourcing (50) (50) (50) (50)
Performance Bond (2,000)
Equipment (2,400)
Consultancy Service (800)
Net Cash Flow (5,200) 1,230 1,190 1,148 4,435
NPV of the contract (in thousand):
-5200 + 1230/1.1 + 1190/1.12 + 1148/1.13 + 4435/1.14

=793
The NPV is > 0 and therefore is recommended.
Page 67
Question 4
The Housing Manager had put forward proposal of acquiring new machine to improve
profitability of the company for your consideration. The project will last for 5-years and
he presented you the following information:
i. The cost of the new machine is $127,000

ii. Installation cost $20,000
iii. $4,000 in net working capital will be needed at the time of installation and
become zero at year 5.
iv. Disposal value of the machine after 5 years will be $40,000
v. The project will increase revenues by $85,000 per year
vi. Operating costs before depreciation will also increase by 35% of the revenue
increase per year.
Moreover, according to the Finance Manager,
 5-year straight line depreciation is adopted

 Cost of capital is 15%
Calculate the following:

(a) NPV
(b) Payback Period
(c) Accounting Rate of Return (ARR)
Solution
NPV
Y0 Y1 Y2 Y3 Y4 Y5
Cost of new machine (127,000)
Installation Cost (20,000)
Net of Income * 55,250 55,250 55,250 55,250 55,250
Disposal Value of the 40,000
machine
Movement in Working (4,000) 4,000
Capital
Net Cash Flow (151,000) 55,250 55,250 55,250 55,250 99,250
Discount Factor 1 0.87 0.76 0.66 0.57 0.50
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* = 85,000 – 35% 85,000 = 55,250
NPV = $56,640
Payback
Cash Flow Cumulated

Cash Flow
Y0 (151,000) (151,000)
Y1 55,250 (95,750)
Y2 55,250 (40,500)
Y3 55,250 14,750
Y4 55,250 70,000
Y5 99,250 169,250
Payback = 2 + 40500/55250 = 2.74 years
Accounting Rate of Return
Depreciation =(127,000 + 20,000 – 40,000)/5 = 107,000/5 = $21,400

Average annual profit = $55,250 - $21,400 = $33,850
Total Capital Employed = $151,000
ARR = 33,850/151,000 = 22.4%
Question 5
ABC Ltd is considering to invest in a new piece of machinery. The initial cash outlay
will be HK$120,000 and working capital of $15,000. The machine has an expected life
of six years with scrap value of $20,000. The cash inflows expected from the machine
are shown below :
Year Cash inflows

1 20,000
2 30,000
3 30,000
4 40,000
5 50,000
Page 69
The investment is expected to be recovered with 5 years with an accounting rate of 10%
per annum.
(a) What is the NPV of the project?
(b) What is the discounted payback period of the project?
Solution
(a) What is the discounted payback period of the project?
Year Cash inflows Present Value Cumulative PV

0 (135,000) (135,000) (135,000)
1 20,000 18,181.82 (116,818.18)
2 30,000 24,793.39 (92,024.79)
3 30,000 22,539.44 (69,485.35)
4 40,000 27,320.54 (42,164.81)
5 85,000* 52,778.31 10,613.50
Total: 10,614
* 50000+20000+15000
NPV = $10,614
(b) What is the discounted payback period of the project?

= 4+42,164.81/52,778.31 = 4.8yrs
Question 6
(a) ABC Ltd plans to purchase a machine costing $28,000 to reduce labour costs
through efficiency savings. Labour savings would be $9,000 in the first year and
would increase annually by 10% up to the 3rd year in money term. The estimated
general annual rate of inflation is 10% and the company’s real cost of capital is
estimated at 12%. The machine has a three-year life with an estimated disposal
value of $8,000 receivable at the end of year 3. All cash flow occurs at the year-end.
(b) A company has four independent projects available
Capital Required at time 0 NPV

Project 1 10,000 30,000
Project 2 8,000 25,000
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Project 3 12,000 30,000

Project 4 16,000 36,000
If the company has $32,000 to invest at time 0, and each project is infinitely divisible
but none can be delayed, what is the maximum NPV that can be earned?
Solution
(a)
Year $ DF PV
Y0 (28,000) 1 1.000 (28,000.00)
Y1 9,000 1/(1.1*1.12) 0.812 7,305.19
Y2 9,900 1/(1.1*1.12)^2 0.659 6,522.50
Y3 10,890 1/(1.1*1.12)^3 0.535 5,823.66
Y3 8,000 1/(1.1*1.12)^3 0.535 4,278.17
NPV: (4,070.48)
As the NPV is negative, the company SHALL NOT proceed with the plan.
(b)
Capital Cum Cum NPV

NPV / Capital
Rank Invested Capital
Required
Invested.
Project 1 30,000/10,000= 3 1 10,000 10,000 30,000
Project 2 25,000/8,000= 3.125 2 8,000 18,000 55,000
Project 3 30,000/12,000= 2.5 3 12,000 30,000 85,000
Project 4 36,000/16,000= 2.25 4 2,000 32,000 89,500
Question 7
The managing director of Johnson Ltd is now considering whether to accept the
proposal made by a housing manager on a newly developing area. The first-year
income statement of the 4-year contract details as follow:
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Note $’000 $’000

Annual Income 1 2,800
Expenses
Salaries – Front Line 2 800
Salaries – Manager 3 240
Other Overheads 4 600
Rent 5 120
Depreciation 6 500
Allocated Head Office 300 (2,560)
Expenses
Profit 240
Notes
11. Upon the successful completion of the contract, there will be an additional bonus of
$500,000 payable at contract end.
12. It is expected that there will be an annual salary increment of 5%
13. The contract requires the services of an existing manager who would be paid
$240,000 per annum. If not required for the contract, the manager would be made
redundant and would receive $120,000 per annum under the service agreement.
14. Other overheads are totally attributed to the contract.
15. Rent represents a 50% sharing of the existing office
16. Depreciation represents the initial investment in equipment solely for this contract,
initial cost of $2,400,000 with scrap value $400,000
17. Allocated head office expenses represent 40% sharing of head office cost plus an
annual outsourcing cost of $50,000 solely for this contract.
18. The contract stipulates that Johnson needs to purchase a performance bond of
$2,000,000 with annual return of 5%. The bond can be disposed upon the
completion of contract.
19. You can assume that the investment in equipment and the purchasing of
performance bond is incurred at the beginning of the year whilst all other receipts
and payments are incurred at the end of the year.
20. In order to take up the contract, the company has to engage a consultancy service to
review the existing business processes, the one-off cost of the consultancy services
will be $800,000 payable at the start of the contract.
The cost of capital of Johnson Ltd is estimated at 10% p.a. in real terms.
You are required to advise the:
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(a) NPV
(b) Payback Period.
Solution
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4
(In thousand)
Receipts
Housing Management 2,800 2,800 2,800 2,800
Income
Bonus 500
Dispose Performance Bond 2,431
Scrap value of Equipment 400
Payments
Salaries – Front Line (800) (840) (882) (926)
Salaries – Manager (120) (120) (120) (120)
Other Overheads (600) (600) (600) (600)
Cost of outsourcing (50) (50) (50) (50)
Performance Bond (2,000)
Equipment (2,400)
Consultancy Service (800)
Net Cash Flow (5,200) 1,230 1,190 1,148 4,435
NPV of the contract (in thousand):
-5200 + 1230/1.1 + 1190/1.12 + 1148/1.13 + 4435/1.14

=793
The NPV is > 0 and therefore is recommended.
Payback Period
Period Cash Flow Cumulative Cash Flow

Y0 (5,200) (5,200)
Y1 1,230 (3,970)
Y2 1,190 (2,780)
Y3 1,148 (1,632)
Y4 4,435 2,803
Payback Period = 3 + 1632/4435 = 3.368 years.
Page 73
VII. Decision Tree & Uncertainty
Question 1
The Goodwill Ltd is considering expanding its activities either in the UK, Europe or
Asia. It can at this time only expand in one region.
i. If it expands in UK, the profit will be $1,000,000, $2,800,000 or $3,500,000 with

probability of 0.3, 0.5 or 0.2 respectively.
ii. If it expands in Europe, the profit will be $1,800,000 or $2,400,000 with
probability of 0.6, 0.4 respectively.
iii. If it expands in Asia, Goodwill can either conduct the business with a partner or
conduct the business on its own. If Goodwill conducts the business with a partner,
there is a probability of 0.3 that the company will incur a loss $1,000,000 or 0.7
that the profit will be $4,500,000. If Goodwill conducts the business on its own, the
profit will be $1,500,000 or $2,700,000 with probability of 0.4, 0.6 respectively.
Use a decision tree to determine where should Goodwill be expanded.
Solution
EVE = (0.7 x 4.5) - (0.3 x 1) = 2.85M

EVF = (0.4 x 1.5) + (0.6 x 2.7) = 2.22M
EVD = higher of EVE or EVF = 2.85M
EVC = (0.6 x 1.8) + (0.4 x 2.4) = 2.04M
EVB = (0.3 x 1.0) + (0.5 x 2.8) + (0.2 x 3.5) = 2.4M
EVA = highest of EVB or EVC or EVD = 2.85M
Goodwill should invest in Asia and conduct the business with a partner.
Page 74
1.0M
0.3
0.5 2.8M
B=2.4
0.2
UK 3.5M
0.6
1.8M
Europe C=2.04
A=2.85
0.4
2.4M
(1.0M)
Asia 0.3
E=2.85
With Partner 0.7

4.5M
D=2.85
On its own
0.4 1.5M
F=2.22
0.6
2.7M
The accountant of Goodwill provides the following additional information:
i. Investment cost respectively in UK, Europe and Asia will be $5,000,000;

$4,000,000 and $3,000,000 respectively.
ii. Assume, the cash receipts projection will last for perpetuity
iii. Due to differences of risk factors in different markets, the discount rates for UK,
Europe and Asia will be 10%, 15% and 20% respectively
b. What would be your advice to Goodwill Ltd.?
Expected NPV in UK = -$5M + $2.4M / 10% = $19M

Expected NPV in Europe = -$4M + $2.04M / 15% = $9.6M
Expected NPV in Asia = -$3M + $2.85M / 20% = $11.25M
Goodwill Ltd. shall invest in UK which yields the highest expected NPV.
Question 2
Page 75
ABC Ltd’s accountant is preparing a budget for sales and profitability of one of the
company’s products. He has available the following data for last year.
Sales $20,000
Variable Cost 60% of sales
Fixed Cost $80,000
He is worried that costs will rise next year and the estimate of inflation that he has
prepared is based on a probabilistic approach, as follow:
Average Inflation Rate Probability

compared with previous year
5% 0.8
7% 0.2
Inflation would affect all variable costs and all fixed costs, except:
(a) Depreciation
(b) Factory rental costs, which are fixed by lease at $15,000 p.a.
The sales manager has informed the accountant that it might be difficult to raise selling
prices, despite inflation, and that at most, selling prices could be raised by 5% above
their current level.
His estimate of sales demand is:
(a) At current prices:

Sales Probability
$
Most Likely 220,000 0.6
Optimistic 260,000 0.4
(b) If sales prices go up 5%

Sales Probability
$
Most Likely 190,000 0.7
Optimistic 240,000 0.3
The decision whether or not to raise sales prices must be made at the beginning of the
year, to allow the company to issue its price lists to dealers.
Page 76
a) You are required to calculate for each price level:

i. the probability of at least break even;
ii. the probability of achieving a profit of at least $10,000
b) What do you suggest?
Solution
If inflation = 5%
Fixed Cost =[ 80,000 – 15,000 (Depreciation) – 15,000 (Rental)] * 1.05 + 30,000
=$82,500
If inflation = 7%
Fixed Cost =[ 80,000 – 15,000 (Depreciation) – 15,000 (Rental)] * 1.07 + 30,000
=$83,500
Profit = Sale – Variable Cost – Fixed Cost
At Current Price Level
Fixed Profit
Sales Variable Cost Probability
Cost /Loss
5% Inflation
Most Likely 220000 220000x0.6x1.05=138600 82500 (1100) 0.8x0.6=0.48
Optimistic 260000 260000x0.6x1.05=163800 82500 13700 0.8x0.4=0.32
7% Inflation
Most Likely 220000 220000x0.6x1.07=141240 83500 (4740) 0.2x0.6=0.12
Optimistic 260000 260000x0.6x1.07=166920 83500 9580 0.2x0.4=0.08
If Sales Prices go up 5%
Fixed Profit
Sales Variable Cost Probability
Cost /Loss
5% Inflation
Most Likely 190000 190000/1.05x0.6x1.05=114000 82500 (6500) 0.8x0.7=0.56
Optimistic 240000 240000/1.05x0.6x1.05=144000 82500 13500 0.8x0.3=0.24
7% Inflation
Most Likely 190000 190000/1.05x0.6x1.07=116171 83500 (9671) 0.2x0.7=0.14
Optimistic 240000 190000/1.05x0.6x1.07=146743 83500 9757 0.2x0.3=0.06
i. the probability of at least break even;

At Current Price Level = 0.32 + 0.08 = 0.4
Page 77
If Sales Prices go up 5% = 0.24 + 0.06 = 0.3
ii. the probability of achieving a profit of at least $10,000

At Current Price Level = 0.32
If Sales Prices go up 5% = 0.24
b.
At Current Price Level
Profit/Loss Probability Expected Value
(1100) 0.48 (528)
13700 0.32 4384
(4740) 0.12 (569)
9580 0.08 766
If Sales Prices go up 5%
Profit/Loss Probability Expected Value

(6500) 0.56 (3640)
13500 0.24 3240
(9671) 0.14 (1354)
9757 0.06 585
(1169)
The expected value of maintaining current price level is higher than that of raising price
of 5% -〉Suggest to maintain the current price level.
Question 3
In the market for one of its products, MD and its two major competitors (CN and KL) together
account for 95% of total sales. The quality of MD’s products is viewed by customers as being
somewhat better than that of its competitors and therefore at similar prices it has an advantage.
During the past year, however, when MD raised its prices to $1.2 per litre, competitors kept
their prices at $1.0 per litre and MD’ sales declined.
MD is now considering whether to raise or reduce its price for the coming year. Its expectation
about its likely volume at various prices charged by itself and its competitors are as follows:
Prices per litre $ Expected Sale

MD CN KL Million Litre
Page 78
1.2 1.2 1.2 2.7

1.2 1.2 1.1 2.3
1.2 1.2 1.0 2.2
1.2 1.1 1.1 2.4
1.2 1.1 1.0 2.2
1.2 1.0 1.0 2.1
1.1 1.1 1.1 2.8
1.1 1.1 1.0 2.4
1.1 1.0 1.0 2.3
1.0 1.0 1.0 2.9
Experience has shown that CN tend to react to MD’s price level and KL tends to react to CN’s
price level. MD therefore assesses that the following probabilities:
MD’s Price CN’s Price Probability

1.2 1.2 0.2
1.1 0.4
1.0 0.4
1.1 1.1 0.3

1.0 0.7
1.0 1.0 1.0
If CN’s Price is KL’s Price Probability

1.2 1.2 0.1
1.1 0.6
1.0 0.3
1.1 1.1 0.3

1.0 0.7
1.0 1.0 1.0
Costs per litre of product are as follows:
Direct Wages 0.24

Direct Materials 0.12
Departmental Expense
Indirect Wages 16.66% of direct wage
Supervision and Depreciation 540,000
50% of total direct
General Expenses (Allocated) cost
Page 79
You are required to determine the optimized pricing strategy for MD.
Solution
A decision has to be made as to the selling prices for MD’s products. Since a decision is
involved, only relevant costs should be used. The supervision and depreciation, and allocated
expenses should be ignored.
The aim should be to maximize profits by maximizing the total contribution.
The variable cost per unit sold is:
Direct Wages 0.24

Direct Materials 0.12
Indirect Wages* 0.04
Indirect Cost = 0.24 * 16.66%=0.04
Relevant Cost per Litre = 0.24 + 0.12 + 0.24 * 16.66%=0.4
Million Expected
Pro. Litre Contribution Contribution
MD CN KL Pcn Pkl (A) (B) (C) (Million) (AxBxC)
1.2 1.2 1.2 0.2 0.1 0.02 2.7 1.2-0.4=0.8 0.043
1.2 1.2 1.1 0.2 0.6 0.12 2.3 1.2-0.4=0.8 0.221
1.2 1.2 1.0 0.2 0.3 0.06 2.2 1.2-0.4=0.8 0.106
1.2 1.1 1.1 0.4 0.3 0.12 2.4 1.2-0.4=0.8 0.230
1.2 1.1 1.0 0.4 0.7 0.28 2.2 1.2-0.4=0.8 0.493
1.2 1.0 1.0 0.4 1.0 0.40 2.1 1.2-0.4=0.8 0.672
1.765
1.1 1.1 1.1 0.3 0.3 0.09 2.8 1.1-0.4=0.7 0.176

1.1 1.1 1.0 0.3 0.7 0.21 2.4 1.1-0.4=0.7 0.353
1.1 1.0 1.0 0.7 1.0 0.70 2.3 1.1-0.4=0.7 1.127
1.656
1.0 1.0 1.0 1.0 1.0 1.00 2.9 1.0-0.4=0.6 1.740
Pcn = Probability of CN’s Pricing

Pkl = Probability of KL’s Pricing
Pro. = Probability of CN and KL’s Pricing
Page 80
On the basis of expected values, the decision should be to set a price of $1.2, since this offers
the highest expected value of contribution. However, in view of the possible uncertainty, the
price of $1.0 may also be recommended at there is a guarantee contribution of $1,740,000.
Question 4
Optimal Ltd has four mutually exclusive investment opportunities, each one yielding
different profits depending on the state of the market. There are four possible market
states which could arise. The probability of each of these states, together with the
incremental profits with each project, are shown in the following pay-off table:
Market State
I II III IV
Probability 0.3 0.2 0.4 0.1
Investment $’M $’M $’M $’M
Opportunities
North 38 47 42 44
South 40 70 52 62
East 60 35 48 38
West 46 60 56 58
Using the highest expected value of profits as the selection criterion, which one of the
four mutually exclusive projects should be undertaken?
Solution:
Expected value of:
North = 0.3 * 38 + 0.2 * 47 + 0.4 * 42 + 0.1* 44 = 42
South = 0.3 * 40 + 0.2 * 70 + 0.4 * 52 + 0.1* 62 = 53
East = 0.3 * 60 + 0.2 * 35 + 0.4 * 48 + 0.1* 38 = 48
West = 0.3 * 46 + 0.2 * 60 + 0.4 * 56 + 0.1* 58 = 54 (highest)
Question 6
An engineering company has been offered a one-year contract to supply a motor car
component XY at a fixed price of $8 per unit. Its normal capacity for this type of
component is 25,000 units a year. The estimated costs to manufacture are shown below.
These costs are considered to be firm except for the direct material price.
Variable costs per unit
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$
Direct wages 1.50
Direct material 2.25
Direct expenses 0.65
Total 4.40
Semi-variable costs per annual:
Output Levels
80% 100% 120%
$ $ $
Indirect wages 15,400 16,000 23,100
Indirect material 8,600 9,000 9,900
Indirect expenses 2,000 2,500 3,000
Fixed costs per annum:
$
Supervisory 10,000
Salaries
Depreciation 4,000
Other overheads 16,000
Total: 30,000
a) Calculate the total cost and total annual profit assuming that the customer’s orders
in the year total:
- 20,000 components;
and that direct material is $2.25 per unit
b) Calculate the estimated profit for the year if it is assumed that the probability of the
total order is:
- 0.3 for 20,000 components;
and that direct material is:
- 0.5 for $2.25 per unit;
Page 82
Solution:
a. Contribution per unit: $8 - $4.4 = $3.6
Output Levels (Unit)

20,000( 80%) 25,000 (100%) 30,000 (120%)
$ $ $
Total contribution 72,000 90,000 108,000
Less:
Indirect wages 15,400 16,000 23,100
Indirect material 8,600 9,000 9,900
Indirect expenses 2,000 2,500 3,000
Total fixed costs 30,000 30,000 30,000
Total fixed and indirect
56,000 57,500 66,000
cost:
Profit: 16,000 32,500 42,000
b)
If direct material is
$2.25 per unit; contribution per unit = $8 – (1.5 + 2.25 + 0.65) = $3.60
Sales Probability Contribution Total Total Total Profit Expected

per unit Contribution indirect fixed Profit
cost cost
20,000 0.3 * 0.5 3.60 72,000 26,000 30,000 16,000 2,400
0.3 * 0.3 3.35 67,000 26,000 30,000 11,000 990
0.3 * 0.2 3.10 62,000 26,000 30,000 6,000 360
25,000 0.6 * 0.5 3.60 90,000 27,500 30,000 32,500 9,750
0.6 * 0.3 3.35 83,750 27,500 30,000 26,250 4,725
0.6 * 0.2 3.10 77,500 27,500 30,000 20,000 2,400
30,000 0.1 * 0.5 3.60 108,000 36,000 30,000 42,000 2,100
0.1 * 0.3 3.35 100,500 36,000 30,000 34,500 1,035
0.1 * 0.2 3.10 93,000 36,000 30,000 27,000 540
Total: 24,300
Page 83
Question 7
Sino Ltd is considering 3 different projects which are mutually exclusive.
i. Project A requires an initial investment of $5,000,000 and the project will last for
3 years. Annual net cash flow generated will be $1,000,000, $2,800,000 or
$3,500,000 for EACH of the coming 3 years, with probability of 0.3, 0.5 or 0.2
respectively.
ii. Project B requires an initial investment of $3,000,000. The project will last for 2
years. First year annual net cash flow will be $1,800,000 or $2,400,000 with
probability of 0.6, 0.4 respectively and the second year net cash flow will be
$1,500,000.
iii. Project C requires an initial investment of $4,000,000 and the project will generate
an annual cash inflow of $450,000 in perpetuity.
a). You are required to advise which project should be proceeded if the expected
return of Sino Ltd. is 10%
Solution
a).
Project A
EV of annual net cash flow:
$1,000,000 x 0.3 + $2,800,000 x 0.5 + $3,500,000 x 0.2 = $2,400,000
NPV of Project A:
($5,000,000) + $2,400,000/1.1 + $2,400,000/1.12 + $2,400,000/1.13 = $968,445
Project B
EV of annual net cash flow in year 1
$1,800,000 x 0.6 + $2,400,000 x 0.4 = $2,040,000
NPV of Project B:
($3,000,000) + $2,040,000/1.1 + $1,500,000/1.12 = $94,215
Project C
EV of annual net cash flow in year 1
$1,800,000 x 0.6 + $2,400,000 x 0.4 = $2,040,000
Page 84
NPV of Project C:
($4,000,000) + $450,000/0.1 = $500,000
Sino Ltd. shall invest in Project A as it has the highest expected NPV.
Question 8
Hip Hong Housing Management Co. has recently been offered a new project. Due to keen
market competition, the project may have the risk of project failure. Hip Hong is now
considering whether to take up the contract directly or to engage a feasibility study beforehand.
• In case Hip Hong takes up the project without commissioning a feasibility study, the
project success to failure ratio will be 70:30
• In case Hip Hong conducts the feasibility study:
– If the study indicates a “Recommend”, the project will be proceeded right away.
The subsequent project success to failure ratio will be 90:10
– If the study indicates a “Not Recommend”, project success to failure ratio will
be 20:80. Hip Hong will only proceed with the project if the expected value of
the project is positive.
– The probability of “Recommend” or “Not Recommend” is 80:20
according to experience
• In case of project success, profit will be $3 million whist in case of project failure, there
will be a lost of $800,000
• The cost of the feasibility study is $100,000.
a) Use a Decision Tree to decide on the best course of action.
Solution
Page 85
EV(A) = $3M x 0.9 - $0.8M x 0.1 = $2.62M

EV(B) = $3M x 0.2 - $0.8M x 0.8 = ($0.04M)
DP(C) = The higher of EV(B) and Not Proceed, i.e. DP(C) = $0
EV(D) = $2.62M x 0.8 + $0 x 0.2 = $2.096M
EV(E) = $3M x 0.7 - $0.8M x 0.3 = $1.86M
DP(F) = The higher of Conduct Feasibility Study, i.e. [EV(D) - $0.1M] and Not Conduct
Feasibility Study, i.e. EV(E)
[EV(D) - $0.1M] = $1.996M
EV(E) = $1.86M
The best course of action is to conduct the feasibility study
Page 86
VIII. Limited Resources
Question 1
Two projects, A & B are available to a company
Project A B
$’000 $’000
Total Capital required over the life 30 60
of the project
Capital required in the next year 10 20
NPV of the project at the 30 80
In what sequence should the projects be selected if the company wishes to maximize
net present value, if the company is facing shortages of capital over the next year but
expects capital to be freely available from then on
Solution
For Project A, NPV/limited resources = 30/10 = 3
For Project B, NPV/limited resources = 80/10 = 4
The company shall invest in Project B
Question 2
a). XYZ Ltd. makes three products from the same type of labour. Unit cost
details of P，Q and R are as follow:
Product P Q R
$ $ $
Sales 80 50 60
Direct Labour 20 12 16
Direct Material 40 20 30
Fixed Cost (allocated) 10 8 4
Profit 10 10 10
Labour hours/Unit 5 3 4
Notes:
1. Labour hours are limiting to 1500 hours and charging at a rate of $4 per hour.
Page 87
2. XYZ has entered a contract with a customer to produce at least 60 units of P, Q &
R respectively.
3. Maximum demand for P Q and R are 150, 200 and 320 units respectively.
4. Fixed cost is the overheads allocated from headquarters.
i. Calculate the contribution per unit for product P, Q & R

ii. Calculate the maximum contribution.
iii. If extra labour hours can be obtained by arranging overtime, calculate the
maximum average overtime charge to exhaust all outstanding demand.
Solution
i. Contribution per unit: = Profit + Fixed Cost
i.e. P = $20, Q = $18, R = $14
ii.
P Q R
Contribution $20 $18 $14
Labour hours/Unit 5 3 4
Contribution/Labour Hr $4 $6 $3.5
Min. Demand 60 60 60
Max. Demand 150 200 320
Ranking 2 1 3
First exhaust the minimum demand

60 x (5+3+4) = 720 hours
Remaining hours = 1500 – 720 = 780 hours.
First to produce (200-60) Q, it requires 140 x 3 hours = 420 hours

Remaining hours = 780 – 420 = 360 hours
Then produces P = 360/5 = 72 units
The labour hours should be allocated as follow:
Unit Labour Hrs Labour Hrs Contribution Total

allocated Per Unit Per Unit Contribution
P 132 (72+60) 5 660 20 2,640
Q 200 3 600 18 3,600
R 60 4 240 14 840
1,500 $7,080
Page 88
Maximum contribution XYZ can earn is $7,080
iii.
Max. Unit Remaining Labour Labour Contribution Total

Demand allocated Demand Hrs Per Hrs Per Unit Contribution
Unit required
P 150 132 18 5 90 20 360
Q 200 200 0 3 0 18 0
R 320 60 260 4 1040 14 3640
1130 4000
Additional labour hours required = 1130 hrs.

Average contribution per hour = $4000/1130 = $3.54
Maximum OT charge per labour hour = $4 + $3.54 = $7.54 per hour.
Question 3
DIY Ltd is considering three projects I, II, III with the following estimated cash
Project Year 0 Year 1 Year 2
$ $ $
I (15,000) 9,000 10,500
II (30,000) 21,000 15,000
III (45,000) 15,000 45,000
a. If cost of capital is 10%, the amount available for investment is restricted to

$64,000, and the projects are divisible, which projects should be undertaken:
Solution
PV of the Project I II III Discount Factor
$ $ $
Year 0 (15,000) (30,000) (45,000) l.00
Year 1 8,181 19,089 13,635 0.909
Year 2 8,673 12,390 37,170 0.826
NPV 1,854 1,479 5,805
NPV/Capital 0.124 0.049 0.129
Ranking 2 3 1
Page 89
DIY shall invest in Project III (i.e. $45,000) completely with the remainder ($19,000)
invested in Project I
Question 4
ABC Ltd manufactures four products, W, X, Y and Z, on specialized machines. Of the

21 machine available, 9 are suitable for all four products, but 12 are suitable only for
products X and Z.
Each machine has a capacity of 46 weeks per year, and can only be used for making a
given product for whole weeks and not for fractions of a week.
Information on the four products is as follows:
Product Contribution per unit $ Units produce per machine

per week
W 115 22
X 80 8
Y 160 14
Z 125 16
There is unlimited demand for all four products, and market requirements dictate that a
minimum of 500 units of each product should be produced and sold each year. What are
the maximum contribution that the company could be earned?
Solution:
Deployment of Machine
(Machine wk)
Product Contribution per Rank Special (12) General (9) Total
machine week Contribution
W 115*22=2530 1 378 956,340
X 80*8=640 4 63 40,320
Y 160*14=2240 2 36 80,640
Z 125*16=2000 3 489 978,000
Total 12*46 = 552 9*46 = 414 2,055,300
Question 5
Goodwill Ltd makes three products which both use the same type of materials and grade of
Page 90
labour, but in different quantities:
Product A Product B Product C

Material (Kg)/Unit 2Kg 1Kg 3Kg
Labour (Hr)/Unit 3Hr 4Hr 2Hr
Sales Price($)/ Unit $150 $160 $140
Maximum demand (Unit) 300 300 400
Maximum labour hours available is limit to 1,400 Hr. and the maximum material available is
limited to 3,000 Kg. per month.
Additional information is provided as follow:
Material Cost: $15 per Kg

Labour Cost: $20 per Hour
a). Identify the scarce resource(s) for Goodwill Ltd.

b). Calculate the maximum contribution per month
c). If extra 500 labour hours can be obtained by overtime, calculate the maximum overtime
charge per hour.
Solution
a) Check whether Material is the scarce resource

To produce the maximum quantity of Product A, B & C requires (300 x 2) + (300 x 1) + (400 x
3) kg. of material, i.e. 2,100 kg.
Material available is 3,000 kg. => Material is not the scarce resource.
Check whether Labour Hour is the scarce resource

To produce the maximum quantity of Product A, B & C requires (300 x 3) + (300 x 4) + (400 x
2) kg. of material, i.e. 2,900 Hr.
Labour hour available is 1,400 => Labour hour IS the scarce resource.
b) Maximum contribution
Product A Product B Product C

Sales Price($)/ Unit $150 $160 $140
Material ($15/Kg) $30 $15 $45
Labour ($20/Hr) $60 $80 $40
Page 91
Contribution ($)/ Unit $60 $65 $55
Contribution / Labour Hr $60/3= $20 $65/4=$16.25 $55/2= $27.5

Rank 2 3 1
Maximum demand (Unit) 300 300 400
As such, the production plan and the contribution is as follow:
Labour Hour Used Labour Hour R Contribution

emained
1,400
1st Produce 400 unit of C 400 x 2=800 600 400 x $55=$22,000
2nd Produce 200 unit of A 200 x 3=600 - 200 x $60=$12,000
Maximum Contribution = $34,000
c). If extra 500 labour hours are available:
The company shall first produce 100 unit of Product A (300 hours) and then 50 unit of Product
B (200 hours)
Extra contribution = 100 x $60 (Product A)+ 50 x $65 (Product B) = $9,250.

Extra OT pay per hour = $9250 /500 = $18.5
Maximum OT charge per hour = $18.5 + $20 = $38.5
IX. Ratio Analysis
Question 1
The Arthur Corporation is considering restructuring its capital structure. Management
has proposed to issue $100 million of share capital to redeem the long-term debt.
Interest saving on the redemption of debt would be $14 million. The company’s tax rate
is 20% of pretax income.
FY 2003/2004 $’ Million
Sales 1982
Cost of Goods sold 1507
Operating Expenses 194
Page 92
Operating Profit 281

Interest Expense 36
Operating Profit before Taxation 245
Taxation 49
Operation Profit after interest and 196
taxation
Fixed Assets 855

Current Assets 267
Current Liabilities 252
Long Term Debts 275
Shareholders’ equity 595
i. Compute Arthur Corporations return on equity for 2004 as reported.

ii. Compute the return on equity for Arthur Corporation if the management proceeds
with the proposal of capital restructuring. You may assume that the addition in
profit due to interest saving will increase the cash balance of the company.
iii. Based on these computations, would the change in capital structure be good for the
shareholders of Arthur Corporation?
Solution
i. Return on equity = $196 / $595 = 33.0%
ii. Revised financial statement numbers:
FY 2003/2004 $’ Million
Sales 1982
Cost of Goods sold 1507
Operating Expenses 194
Operating Profit 281
Interest Expense 22 36 – 14 new
Operating Profit before Taxation 259
Taxation 52 260 x 20%
Operation Profit after interest and 207 Increase 207-196=13
taxation
Fixed Assets 855

Current Assets 280 267+13
Current Liabilities 252
Long Term Debts 175
Shareholders’ equity 708 595+100+13
Return on Equity = 207/708 = 29.2%
Page 93
iii. The redemption of long term debt with equity finance will increase the operating
profit after interest and taxation. However, due to the increase in the equity base, the
return on equity will be diluted (decreasing from 33% to 29.2%). Based on this
information, from shareholder’s perspective, increasing financial leverage is not
recommended on the ground that the return is diluted. However, if the market perceives
that the finance leverage risk of the company is reduced, the risk premium required may
be reduced and this may benefit the existing shareholders.
Page 94

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Finance Resources Management

I. Working Capital Management ............................................................................... 2

I. Working Capital Management

ii. Explain the implication.

Slow stock – average stock holding = $100,000

i. Slow stock – financial cost = 15% x 100,000 = 15,000

Slow Stock Quick Stock

ii. Clearly, quicker stock movement can generate improvement in profitability,

Exact no. of No cash discount

i. The effect of the introduction of the advertising campaign on Holt's debtors

i. Increase in debtors: (in thousands)

Current debtors : (sales $1.2 M)

Total debtor at the new level = 311.52

ii. Maximum amount to be paid for advertising campaign

Therefore the maximum amount for advertising is $6500

Estimated working capital requirement

Sales = 85,500 x 50 4,275,000

787,477 is less than 800,000. The OD facility is thus sufficient.

Budget Profit & Loss for 2004/05 $'000 $'000 Note

Miscellaneous 830 5653 6

1. The profile of account receivables for management fee is as follow

Category % Settle the outstanding

i. Calculate the working capital requirements for coming year.

Category % Settle the outstanding

60% x 6,575 x 1/12 328.8

10% x 6,575 x 3/12 164.4

Working capital requirements = 876.7 - 488.7 = $388k

80% x 6,575 x 1/12 438.3

Reduction in accounts receivable investment = 876.7 - 684.9 = 191.8k, maximum

The company considers the granting of export credit to be a form of investment

Outstanding Balance to be collected:

expected value of accepting would be:

If Accept the order, the relevant cash flow =

If Reject the order, the relevant cash flow = $0

On this basis, the project should be rejected.

The budget of XY Ltd. for the coming year is as follow:

Extract of the current year’s working capital is as follow:

Current Year Next Year

Cash generated from operations net of tax and dividend:

(1,800 + Cash Balance – 2,700) – (2,300 – 2,150) = 2,200

Donald Ltd has budgeted the following for a month:

What is the budgeted increase in cash balances for the month?

= $40000 – $3000 - $2000 – $1000 + $30000 + $8000 = $72000

Extract of the current year’s working capital is as follow:

New Staff Cost Outstanding = 2,400,000 x 1/12 = $200,000

Proposal I : Change in Credit Term:

Proposal II : By Marketing Strategy:

(Assume 360 days per year.)

Average current debtors owe money in respect of 300,000 x 25 x 45/360 =937,500. If

ii. Maximum Cost on advertisement if the Proposal on Credit Term is not

New debtor = 324,000 x 25 x 45/360 = $1,012,500

Maximum cost on advertisement = $120,000 – $15,000 = $105,000

iii. Maximum Cost on advertisement if the Proposal on Credit Term is Considered

Maximum cost on advertisement = $96,000 – $15,000 = $81,000

What is the budgeted increase in cash balances for the month?

$40,000 + $30,000 + $5,000 = $75,000.

i.e. Movement of Working Capital = Increase in Cash + Increase in debtor + Increase in

If the estimated sales are as follow:

Inventory 12.8M45/365 12.8M35/365 (0.35)M

Payable 12.8M40/365 12.8M35/365 0.175M