financial management and control revision series 2004

On completion o f this paper candidates should be able to: • explain the role and purpose o f financial management • evaluate the overall management o f working capital • evaluate approp

The official text for the professional qualification

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British L ib rary Cataloguing-in-Publication D ata

A catalogue record for this book is available from the British Library

Published by AT Foulks Lynch Ltd

4, The Griffin Centre

Acknowledgements

The past ACCA examination questions are the copyright o f the Association o f Chartered Certified Accountants The original answers to the questions from June 1994 onwards were produced by the examiners themselves and have been adapted by AT Foulks Lynch Ltd

We are grateful to the Chartered Institute o f Management Accountants and the Institute of

Chartered Accountants in England and Wales for permission to reproduce past examination questions The answers have been prepared by AT Foulks Lynch Ltd

All rights reserved No part o f this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission o f AT Foulks Lynch Ltd

C O N TE N TS

This book includes a wide selection of questions from past ACCA exams, including the latest papers In

addition, there are full answers, many prepared by the examiner This is the ONLY publication to include actual questions and official answers from the previous four sittings of the examination (at the date of

publication)

Page

Index to questions and answers iv

Syllabus and examination form at vii

Analysis of past papers xi

Revision guidance xiii

Examination techniques xv

Mathematical tables xvii

Section 1 Practice questions 1

2 Scenario-based questions 61

3 Answers to practice questions 81

4 Answers to scenario-based questions 245

5 Mock examination questions 295

6 Answers to mock examination questions 301

7 December 2003 examination questions 315

8 Answers to December 2003 examination questions 321

Sources of finance

13 Associated International Supplies Ltd 10 108 Pilot 01

Capital investment appraisal

INDEX TO QUESTIONS AND ANSWERS

/ Page number

Standard costing and variance analysis

-Budgeting and budgetary control and decision-making

INDEX TO QUESTIONS AND ANSWERS

S Y LLA B U S A N D

E X A M IN A TIO N FO R M A T

Format of the examination

Section A: One compulsory scenario-based question

Section B: Choice of 2 from 4 questions (25 marks each)

Number of marks

50 50

o f management accounting techniques for business planning and control

On completion o f this paper candidates should be able to:

• explain the role and purpose o f financial management

• evaluate the overall management o f working capital

• evaluate appropriate sources of finance for particular situations

• appraise capital investment through the use o f appropriate methods

• identify and discuss appropriate costing systems and techniques

• prepare budgets and use them to control and evaluate organisational performance

• understand the basic principles of performance management

• critically assess the tools and techniques o f financial management and control

• demonstrate the knowledge, understanding, skills, abilities and critical evaluation expected

Objectives

in part 2

SYLLABUS AND EXAMINATION FORMAT

Position of the paper in the overall syllabus

Students must have a thorough knowledge o f the material in Paper 1.2 Financial Information for Management and a good knowledge of other Part 1 papers

Financial Management and Control is integrated with other Part 2 papers by providing a

management decision framework within which some aspects of the Part 2 syllabus are developed The effects of capital allowances and corporation tax on capital investment appraisal are

examinable Knowledge gained from Paper 2.3 Business Taxation (UK) will be useful in this respect

Financial Management and Control is developed in Part 3 into advanced study of Performance

Management (Paper 3.3) and Strategic Financial Management (Paper 3.7)

Syllabus content

1 Financial management objectives

(a) The nature, purpose and scope of financial

management

(b) The relationship between financial

management, management accounting and

financial accounting

(c) The relationship of financial objectives and

organisational strategy

(d) Problems of multiple stakeholders in

financial management and the consequent

(a) Financial intermediation and credit creation

(b) Money and capital markets

(i) Domestic and international

(ii) Stock markets (both major markets

and small firm markets)

(c) The Efficient Markets Hypothesis

(d) Rates of interest and yield curves

(e) The impact of fiscal and monetary policy on

business

(f) Regulation of business (for example, pricing

restrictions, green policies and corporate

governance)

3 Management of working capital

(a) The nature and scope of working capital management

(b) Funding requirements for working capital.(c) Working capital needs of different types of business

(d) The relationship of working capital management to business solvency

(e) Management of stock, debtors, short term funds, cash, overdrafts and creditors.(f) Techniques of working capital management (including ratio analysis, EOQ, JIT, credit evaluation, terms of credit, cash discounts, factoring and invoice discounting, debtors cycles, efficient short-term fund investing, cash forecasting and budgets, Miller-Orr model, basic foreign exchange methods, probabilities and risk assessment, terms of trade with creditors)

4 Sources of finance

(a) Sources and relative costs (including issuecosts) of various types of finance and their suitability to different circumstances and organisations (large and small, listed and unlisted) including:

(i) access to funds and the nature of business risk

(ii) the nature and importance of internally generated funds

SYLLABUS AND EXAMINATI ON FORMAT

(iii) capital markets (types of share

capital, new issues, rights issues,

loan capital, convertibles, warrants)

(iv) the effect of dividend policy on

financing needs

(v) bank finance (short, medium and

long term, including leasing)

(vi) trade credit

(vii) government sources: grants, regional

and national aid schemes and tax

incentives

(viii) problems of small company

financing (collateral, maturity

funding gap, risk)

(ix) problems of companies with low

initial earnings (R&D, Internet, and

other high-technology businesses)

(x) venture capital and financial sources

particularly suited to the small

company

(xi) international money and capital

markets, including an introduction to

international banking and the finance

of foreign trade

(b) Requirements of finance (for what purpose,

how much and for how long) in relation to

business operational and strategic

objectives

(c) The importance of the choice of capital

structure: equity versus debt and basic

analysis of the term profile of funds

(d) Financial gearing and other key financial

ratios and analysis of their significance to

the'organisation

(e) Appropriate sources of finance, taking into

account:

(i) cost of finance

(ii) timing of cash payments

(iii) effect on gearing and other ratios

(iv) effect on company’s existing

investors

5 Capital investment appraisal

(a) Discounted cash flow techniques

(i) simple and compound interest

(ii) net present value

(iii) annuities and perpetuities

(iv) internal rate of return

(V) future value

(vi) nominal interest(b) Appraisal of domestic capital investmentopportunities for profit making and not-for- profit organisations through the use of appropriate methods and techniques(i) the risk / return relationship(ii) return on capital employed(iii) payback

(iv) internal rate of return(v) net present value(vi) single and multi-period capital rationing

(vii) lease or buy decisions(viii) asset replacement using equivalent annual cost Including (in categories(i)-(viii)) the effects of taxation, inflation, risk and uncertainty (probabilities, sensitivity analysis, simulation)

6 Costing system s and techniques

(a) The purpose of costing as an aid to planning, monitoring and control of business activity

(b) Different approaches to costing(c) Costing information requirements and limitations in not-for-profit organisations.(d) Behavioural implications of different costing approaches including performance evaluation

(e) Implications of costing approaches for profit reporting, the pricing of products and internal activities/ services

7 Standard costing and variance analysis

(a) Standard costing(i) determination of standards(ii) identification and calculation of sales variances (including quantity and mix), cost variances (including mix and yield); absorption and marginal approaches

(iii) significance and relevance of variances

(iv) operating statements(v) interpretation and relevance of variance calculations to business performance

(b) Planning and operational variances

(c) Behavioural implications of standard costing and variance reporting

SYLLABUS AND EXAMINATION FORMAT

8 Budgeting and budgetary control

(a) Objectives of budgetary planning and

control systems including aspects of

behavioural implications

(b) Evaluation of budgetary systems such as

fixed and flexible, zero based and

incremental, periodic, continuous and

activity based

(c) Development, implementation and

coordination of budgeting systems: '

functional, subsidiary and master/ principal

budgets (including cash budgeting); budget

review

(d) Calculation and cause of variances as aids to

controlling performance

(e) Quantitative aids to budgeting and the

concepts of correlation, basic time series

analysis (seasonality) and forecasting; use

of computer based models

(f) Behavioural implications of budgeting and

budgetary control

9 Performance measurement

(a) Measurement of productivity, activity, profitability and quality of service(b) Relationship of measure to type of entity and range of measures, both monetary and non-monetary

(c) Indices to allow for price and performance changes through time

(d) Evaluating performance against objectives and plans, and identifying areas of concern from the information produced

(e) The impact of cost centres, revenue centres, profit centres and investment centres on management appraisal

(f) Difference between business performance and management performance

(g) Benchmarking

Excluded topics

The following topics are specifically excluded from the syllabus:

• Calculations involving the derivation o f cost o f capital in discounting problems Candidates will always be supplied with an appropriate discount rate

• Calculations relating to Modigliani and Miller propositions

Additional information

Present value and annuity tables will be provided in the examination The Study Guide provides more detailed guidance on the syllabus

Approach to examining the syllabus

The examination is a three hour paper in two sections Financial management issues will always, but not exclusively, be examined in Section A The Section A question will typically be a scenario- based question Most o f the Section B questions will contain a mix o f computation and discursive elements although it is intended that at least one question will be entirely discursive The balance between computation and discursive elements will remain largely constant from one examination to the next

2 Ratio analysis (growth and liquidity) Sources o f finance for fixed assets.

3 Asset replacement decision Limitations o f NPV

4 Variance analysis (including mix and yield) and interpretation

2 Uses of standard costing Review o f standards Non-financial objectives

3 Opportunity cost Relevant cost calculation SMEs and sources o f finance

4 Working capital funding Factoring Credit control function

5 Budget preparation Proposed evaluation Responsibility accounting in non-profit organisations

June 2002

Section A

1 NPV calculation Problems with NPV analysis Trend analysis Cost forecasting

Section B

2 Zero based budgeting Employee participation in budgeting

3 Convertible debentures Intermediation in banking

4 Process costing Costing for services

5 Forecast P&L account Funding requirements Objectives: stakeholder groups, multiple objectives

December 2002

Section A

1 Cash budget JIT stock management Financing needs and working capital management

Section B

2 Stakeholder groups and corporate governance

3 Operating statement and variance analysis Interpretation

4 NPV calculation: operating lease v finance lease v purchase Capital rationing

5 Traditional absorption costing and ABC

ANALYSIS OF PAST PAPERS

2 Sales forecasting: trend line and seasonal variations Top-down and bottom-up budgeting

3 Early settlement discount (evaluation) Financing working capital

4 Stock market efficient Value for money (VFM) and maximisation of shareholder wealth

5 Limiting factor analysis Make-or-buy decision Limitations o f marginal costing for

4 Problems o f monopoly Raising long-term finance

5 Variance analysis, including materials mix and yield variances

Note:

The syllabus for paper 2.4 changes from June 2004 Some additional topics have been introduced

to the syllabus, but it is not yet clear how they might be examined New topics include performance measurement (including index numbers)

It seems possible that some questions on relevant costing may continue to appear This has been the case in the past, when decision-making had only a small mention in the syllabus Some questions

on this topic have therefore been included here

REVISIO N G U ID A N C E

i

Planning your revision

Practice preparing

answer plans, then

compare your plan to

the suggested answer

Practice exam-standard

questions, under tim ed

conditions

I f you get stuck on topics,

find someone to explain

them to you (your tutor or

a colleague, for example)

Read recent articles on the ACCA website or

in the student magazine

Go through your notes, textbook and workbook, highlighting the

im portant points

Read good newspapers and professional journals

Revision techniques

Think o f examples that illustrate concepts and ideas that might arise in the exam - you

m ight be able to use them in a written

Use the Foulks Lynch Lynchpins

to revise when you're on the move

Y ou m ight want to produce your own set

o f summarised notes

List key words for each

^ topic to remind you o f the

answer

EXA M IN A TIO N T E C H N IQ U E S

• You might want to spend the first few minutes of

the examination reading the paper.

• Where you have a choice of question, decide

which questions you will do

• Unless you know exactly how to answer the

question, spend some time planning your answer.

proportion to the marks on offer One suggestion

is to allocate 1 Vi minutes to each mark available,

so a 10 mark question should be completed in 15

minutes

• Spend the last five minutes reading through your

answers and making any additions or

corrections.

structure It should contain a brief introduction, a

main section and a conclusion Be concise It is

better to write a little about a lot of different

points than a great deal about one or two points

• If you get completely stuck with a question,

leave space in your answer book and return to it

later.

• Stick to the question and tailor your answer to

what you are asked Pay particular attention to the

verbs in the question

• If you do not understand what a question is

asking, state your assumptions Even if you do

not answer in precisely the way the examiner

hoped, you should be given some credit, if your

assumptions are reasonable

• You should do everything you can to make things

easy for the marker The marker will find it easier

to identify the points you have made if your

answers are legible.

an easy option - you could lose marks by rushing into your answer Read the questions carefully and work through any calculations required If you don’t know the answer, eliminate those options you know are incorrect and see if the answer becomes more obvious

answers, but could also involve paragraphs of text which require you to fill in a number of missing blanks, or for you to write a definition of a word

or phrase Others may give a definition followed

by a list of possible key words relating to that description Whatever the format, these questions

require that you have learnt definitions, know key

words and their meanings and importance, and

understand the names and meanings of rules,

concepts and theories

workings in your answers Many computational questions require the use of a standard format: company profit and loss account, balance sheet and cash flow statement for example Be sure you know these formats thoroughly before the examination and use the layouts that you see in the answers given in this book and in model answers

identify the area in which there is a problem, outline the main principles/theories you are going

to use to answer the question, and then apply the principles/theories to the case

questions ask you to present your answer in the form of a report or a memo or other document So use the correct format - there could be easy marks

to gain here

Discount factor

(l + r)

M A T H E M A T I C A L T A B L E S

Present value table

Present value o f 1 i.e (l + r)~n where r = discount rate, n « number o f periods until payment

is to increase the wealth o f shareholders Tagna is financed as follows:

£m

7.5Tagna has the agreement o f its existing shareholders to make a new issue o f shares on the stock market but has been informed by its bank that current circumstances are unsuitable.The bank has stated that if new shares were to be issued now they would be significantly under-priced by the stock market, causing Tagna to issue many more shares than necessary

in order to raise the amount o f finance it requires The bank recommends that the company waits for at least six months before issuing new shares, by which time it expects the stock market to have become strong-form efficient

The financial press has reported that it expects the Central Bank to make a substantial

increase in interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in inflation The financial press has also reported that the rapid increase in consumer demand has been associated with an increase in consumer credit to record levels

Required:

(a) Discuss the meaning and significance o f the different forms o f market efficiency (weak, semi-strong and strong) and comment on the recommendation o f the bank that Tagna waits for six months before issuing new shares on the stock market (9 m arks)(b) On the assumption that the Central Bank makes a substantial interest rate increase, discuss the possible consequences for Tagna in the following areas:

(i) sales

(ii) operating costs, and

Briefly discuss whether this satisfactorily describes the purposes o f management

(b) A company, which is engaged in retailing food and household products, has stores in many towns These stores, whilst managed locally, report to a Head Office and are served from a few strategically located warehouses by the company’s own transport fleet

Required:

Discuss the management accounting information which is likely to be provided in

(Total: 20 m arks)

4 NEWS FOR YOU

News For You operate a chain o f newsagents and confectioner’s shops in the south of England, and are considering the possibility of expanding their business across a wider geographical area The business was started in 20X2 and annual turnover grew to £10

million by the end o f 20X6 Between 20X6 and 20X9 turnover grew at an average rate o f 2% per year

The business still remains under family control, but the high cost o f expansion via the

purchase or building of new outlets would mean that the family would need to raise at least

£2 million in equity or debt finance One of the possible risks o f expansion lies in the fact that both tobacco and newspaper sales are falling New income is being generated by

expanding the product range stocked by the stores, to include basic foodstuffs such as bread and milk News For You purchases all o f its products from a large wholesale distributor which is convenient, but the wholesale prices leave News For You with a relatively small gross margin The key to profit growth for News For You lies in the ability to generate sales

(ii) The annual rate o f inflation is now 1.2%, down from 1.3% in the previous quarter, and 1.7% 12 months ago The rate is now at its lowest for 25 years, and no further falls in the rate are expected over the medium/long term.

(iii) Personal and corporation tax rates are expected to remain unchanged for at least 12 months

(iv) Taxes on tobacco have been increased by 10% over the last 12 months, although no further increases are anticipated

(v) The government has initiated an investigation into the food retail sector focusing on the problems o f ‘excessive’ profits on certain foodstuffs created by the high prices being charged for these goods by the large retail food stores

(a) Briefly outline the role o f a management accountant using a profit-seeking

(b) Contrast the main features o f a non-profit-seeking organisation, with one that is profit- seeking, which makes management accounting in this environment different

(6 m arks)(c) Discuss how a management accountant may respond to the challenge o f providingappropriate information in a non-profit-seeking organisation (8 m arks)

P R A C T I C E Q U E S T I O N S : S ECTI ON 1

(c) Explain the meaning of the term ‘Value for Money’ in relation to the management of

(Total: 20 m arks)

7 PLANKERS LTD

Assume that ‘now’ is June-20X3

You are in charge o f developing long term plans for your business, Plankers Ltd Plans are developed on the basis that the business has a single objective and seeks to maximise its profits as measured by profit after tax

The company has a loan facility from its bank o f £8m at 8% annually The outstanding liability at 31 May 20X3 is £7m It is possible to extend the facility up to £12m but only at

an interest cost of 9% on the whole outstanding balance The condition attached to this loan

is that interest cover should at least be equal to 3: that is, profit before interest and tax (PBIT) should be at least three times the interest If the condition is breached then the loan becomes repayable immediately

Interest charges in the profit and loss accounts are calculated on year-end balances (at

31 May each year) For example, interest charges in the year-end 31 May 20X3 profit and loss account were based on year-end balances at 31 May 20X3

Targets set by the directors o f Plankers are as follows:

1 cash balances must not fall below £lm , and

2 it is desirable that Basic Earnings per Share should not fall below 20p per share The company has in issue 4m £1 ordinary shares

The constraint set by the bank and the targets set by the directors are measured and assessed

at each year-end The summary profit and loss account for the year just ended (31 May 20X3) and a summary balance sheet are shown below along with forecasts for the next 2 years:

31 May 20X3 31 May 20X4 31 May 2C

depreciation on it The corporation tax rate is 30%

The company is planning a major building programme on 1 June 20X5 at which time a cash outflow of £12m would have to be paid 50% of this expenditure will be depreciated at the rate of 15% per annum (the company has no other depreciable assets) This depreciation has been agreed as allowable for tax purposes with the tax authorities

The directors of Plankers are considering utilising the loan facility to help meet the funding requirements of the building programme, but are wondering whether their targets will be met

S E CT I O N 1 : P R A C T I C E Q U E S T I O N S

or whether the loan conditions will be breached They have asked you to conduct an analysis

o f the company’s financial position at 31 May 20X6 assuming the building programme begins on the 1 June 20X5 For 20X6 only, the company will not pay any dividends to minimise its refinancing needs

Required:

(a) (i) Prepare a forecast summary profit and loss account for the year to 31 May 20X6

assuming that the building programme is undertaken at 1 June 20X5 and that any additional funds are provided by an extension of the bank loan

Assume that tax is paid in the year in which incurred

Work to 3 decimal places of £m in your answer (5 m arks)(ii) Assess whether, at 31 May 20X6 and based on the scenario in (i) above, the loan condition would be breached and whether the directors’ targets would be achieved

Work to 3 decimal places o f £m in your answer (3 m arks)(iii) Identify 5 options the company could use, assuming it faced a cash shortfall, to

(iv) Explain, without further computations, whether each o f the options in (a)(iii) islikely to meet Planker’s requirements for additional capital and also the

(b) Whilst the financial plans o f the business are based on a single objective, it faces a number o f constraints that put pressure on the company to address more than one objective simultaneously

M A N A G E M E N T O F W O R K IN G C A P IT A L

8 HEXICON PLC

(a) Give reasons, with a brief explanation, why the net present value (NPV) method o finvestment appraisal is thought to be superior to other approaches (5 m arks)(b) Hexicon pic manufactures and markets automatic washing machines Among the many hundreds o f components which it purchases each year from external suppliers for assembling into the finished article are drive belts, o f which it uses 40,000 units pa

It is considering converting its purchasing, delivery and stock control o f this item to a just-in-time system This will raise the number o f orders placed but lower the

administrative and other costs o f placing and receiving orders If successful, this will provide the model for switching most o f its inwards supplies on to this system Details

of actual and expected ordering and carrying costs are given in the table below

PRACTICE QUESTIONS SCCTIOH 1

(as a percentage of lt»e purchase cost)

To implement the new arrangements will require ‘oiie-ofT reorganisation costs

estimated at £4,000 which will be treated as a revenue Item for lax puiposcs The rale

of Ctìnporaũon tax is 33% and Hexicon can obtain finance a! Ĩ 2% , The effective life

span o f the Determine new system can be assumed 10 be eight years,

(c) Yơu are required to briefly explain the nature and objectives o f JIT purchasing

agreements concluded between components users and suppliers, (5 m arks)

(Total: 20 ftmrks)

9 DELCARS PLC

(a) Explain, wiih the use o f a numerical example, ihc meaning o f the term ‘cash operating cyclc’ and its significance in relation to working capita! management, (6 m arks)(b) Dclcars pic own a total of len franchises, in a variety o f United Kingdom locations, for

Ü1C sale and serv icing o f new and used cars Six o f the franchises sell just second hand vchiclcs wilh ihc remaining four operating a car servicc ccntrc in addition to retailing both new and used vehicles Dclcars operate different systems for banking of sales receipts, depending on the type o f sale All monies from new car sales must be banked

by the garage on the day of ihe sale; receipts from second hand car sales arc banked once a week on Mondays, and rcccipts from car servicing work arc banked twice a week on Wednesdays and Fridays No banking facilities arc available al the weekendi.e Saturdays and Sundays The sales mix o f Ü1C three elements (as a pcrccnlagc o f Dclcars* total revenue) is as follows: 60% new vehicles; 25% sccond hand vehicles; 15% servicing Total sales for all three business areas amounted to £25 million in the Iasi financial year Del cars pays interest at a rate o f 8.5% per annum on an average overdraft o f £65,000 and ihc company’s ftnancc director has suggested that the company could significanily rcducc ihc interest chargc if ail sales receipts were

banked on (he day o f sale All fhc garages arc open every day cxcept Sunday, Assume lhal the daily sales value (for all three areas of business) is spread evenly across the

week

Required:

Calcúlate (he value o f the annual interest which could be saved if all ten franchises adopted the financc directors suggestion o f daily banking (8 mark«)(c) Using the example o f a car dealership such a* Dclcars, as given in (b) above, outline

the advantages and disadvantages o f centralisation o f the treasury function (6 m arks)

(Total: 20 m arks)

S E CT I O N 1 : P R A C T I C E Q U E S T I O N S

10 VELM PLC

Velm pic sells stationery and office supplies on a wholesale basis and has an annual turnover

o f £4,000,000 The company employs four people in its sales ledger and credit control department at an annual salary o f £12,000 each All sales are on 40 days’ credit with no discount for early payment Bad debts represent 3% o f turnover and Velm pic pays annual interest o f 9% on its overdraft The most recent accounts o f the company offer the following financial information:

Velm pic: Balance Sheet as at 31 Decem ber 20X2

1,530

4017,540Creditors: amounts falling due after more than one year

retirement Two -thirds of customers are expected to take advantage o f the discount

Required:

(a) Using the information provided, determine whether a discount for early payment ofone per cent will lead to an increase in profitability for Velm pic (5 m arks)(b) Discuss the relative merits of short-term and long-term debt sources for the financing

(c) Discuss the different policies that may be adopted by a company towards the financing

of working capital needs and indicate which policy has been adopted by Velm pic

(7 m arks)(d) Outline the advantages to a company of taking steps to improve its working capitalmanagement, giving examples of steps that might be taken (7 m arks)

(Total: 25 m arks)

P R A C T I C E Q U E S T I O N S : S ECTI ON 1

11 SPECIAL GIFT SUPPLIES PLC

Special Gift Supplies pic is a wholesale distributor of a variety o f imported goods to a range

of retail outlets The company specialises in supplying ornaments, small works o f art, high value furnishings (rugs, etc) and other items that the chief buyer for the company feels would have a market in the UK In seeking to improve working capital management, the financial controller has gathered the following information

Months

Average period for which items are held in stock 3.5

Average debtors collection period/ 2.5

Average creditors payment period 2.0

Required:

(a) Calculate Special Gift Supplies’ funding requirements for working capital measured in

(b) In looking to reduce the working capital funding requirement, the financial controller

o f Special Gift Supplies is considering factoring credit sales The company’s annual turnover is £2.5m o f which 90% are credit sales Bad debts are typically 3% o f credit sales The offer from the factor is conditional on the following:

(1) The factor will take over the sales ledger o f Special Gift Supplies completely.(2) 80% of the value of credit sales will be advanced immediately (as soon as sales are made to the customer) to Special Gift Supplies, the remaining 20% will be paid to the company one month later The factor charges 15% per annum on credit sales for advancing funds in the manner suggested The factor is normally able to reduce the debtors’ collection period to one month

(3) The factor offers a ‘no recourse’ facility whereby they take on the responsibility for dealing with bad debts The factor is normally able to reduce bad debts to

2% of credit sales

(4) A charge for factoring services o f 4% of credit sales will be made

(5) A one-off payment o f £25,000 is payable to the factor

The salary of the Sales Ledger Administrator (£12,500) would be saved under the proposals and overhead costs of the credit control department, amounting to £2,000

per annum, would have to be reallocated Special Gift Supplies’ cost of overdraft finance is 12% per annum Special Gift Supplies pays its sales force on a commission only basis The cost o f this is 5% of credit sales and is payable immediately the sales are made There is no intention to alter this arrangement under the factoring proposals.Required:

Evaluate the proposal to factor the sales ledger by comparing Special Gift Supplies’ existing debtor collection costs with those that would result from using the factor (assuming that the factor can reduce the debtors’ collection period to one month)

(8 m arks)(c) As an advisor to Special Gift Supplies pic, write a report to the financial controller that outlines:

(i) how a credit control department might function

(ii) the benefits of factoring and

(iii) how the financing of working capital can be arranged in terms o f short and long term sources of finance

The last twelve months of credit sales o f £67.5 million show an increase o f 10% over the previous year, but the company’s overdraft, on which it is charged 12% p.a has also

increased (by £1.8 million) over the last year The company is concerned to reduce its

working capital requirements by reducing the debtor collection period

Fenton’s management accountant has extracted an aged debtors profile which is shown below:

% o f total debtor payments Average collection period

Bad debts currently stand at £2 million per annum

Fenton is considering the introduction o f early settlement discounts The current invoicing terms require payment to be made within 30 days o f the date o f issue o f the invoice The management accountant has suggested that a 1 % discount be offered to all customers who

comply with these payment terms, and he estimates that 50% o f total payments (by value) would be on these terms (an average settlement period o f 30 days for these payments can be assumed) The discount scheme would be expected to be taken up by customers who already pay in 75 days or less

As an alternative way of reducing the debtors figure, Fenton could use a with recourse debt collection service, which has quoted a price o f 1%» o f sales receipts It is estimated that using the service will have the effect o f reducing debtor days by 20 and eliminating 50% o f bad debts

Required:

(a) Calculate the change in working capital requirements and bad debts which would result from:

(i) the introduction of the early settlement discounts

(ii) the use o f the debt collection service

and recommend which (if either) policy should be adopted by Fenton Your answer

(b) There are a number o f methods that can be adopted to assess the credit-worthiness o f apotential credit customer Describe and comment upon two such methods that Fenton could adopt to help reduce the current level o f bad debts (5 m arks)(c) Explain the term ‘invoice discounting’ and the pros and cons o f its use as a way of

(Total: 20 m arks)

P R A C T I C E Q U E S T I O N S : SECTI ON 1

S O U R C E S O F F IN A N C E

13 ASSOCIATED INTERNATIONAL SUPPLIES LTD

The following are summary financial statements for Associated International Supplies Ltd

Cost of sales, expenses and interest 1,102 2,860

Notes: Cost of sales was £530,000 for 20X4 and £1,330,000 for 20X9.

Debtors are 50% o f current assets and trade creditors are 25% of current liabilities for bothyears

An appendix to the report should be used to outline your calculations (17 marks)

(b) Explain and evaluate the sources of finance available to small businesses for fixed

(Total: 25 marks)

14 PLY, SPIN AND AXIS

Food retailers: Ordinary shares, Key stock m arket statistics

Share price (pence) Dividend yield ompany Current 52 week high 52 week low (%)

(b) Using data in the above table, calculate the dividend cover for Spin and Axis, andexplain the meaning and significance o f the measure from the point of view of equity

In the past, Phoenix has followed a rather conservative financial policy, with restricted dividend payouts and relatively low borrowing levels It now faces the issue o f how to utilise

an unexpectedly sizeable cash surplus Directors have made two main suggestions One is to redeem the £10m 7% secured loan stock issued to finance a capacity increase several years previously, the other is to increase the dividend payment by the same amount

Phoenix’s present capital structure is shown below:

£mIssued share capital (25p par value) 70

Creditors falling due after more than one year:

Further information

(i) Phoenix has not used an overdraft during the two years

(ii) The rate of corporate tax is 33%

(iii) The dividend paid by Phoenix in 20X5-20X6 was 1.50 pence per share

(iv) Sector averages currently stand as follows:

dividend cover 2.6 timesgearing (long-term debt/equity) 45%

interest cover 6.5 times

P R AC T I C E Q U E S T I O N S : SE CTI ON 1

16 JERONIMO P IC

Jeronimo pic currently has 5 million ordinary shares in issue, which have a market value o f

£ 1.60 each The company wishes to raise finance for a major investment project by means of

a rights issue, and is proposing to issue shares on die basis o f 1 for 5 at a price o f £ U 0 each.James Brown currently owns 10,000 shares in Jeronimo pic and is seeking advice on whether

or not to lake up the proposed rights

Jeronim o pic:

Current share price: £1.60Number o f shares in issue: 5 millionCurrent earnings: £ 1.5 millionDividend Paid (Pence per share):

20X520X620X720X820X9

89

1111

12

( D ^The formula for the dividend growth model is as follows: R 3:1 — - + g

V M V *

Where R = Percentage required return on equity

x 100(4 m arks)

(d) If the stock market is believed to operate with a strong level o f efficiency, what cficctmight this have on the behaviour o f the finance directors o f publicly quoted

Assume an investor required return o f 15%

Ignore taxation in your answer

S E C TI O N 1 : P R A C T I C E Q U E S T I O N S

Required:

(a) Briefly explain why convertibles might be an attractive source o f finance for

(b) (i) Estimate the current market value o f the debentures, assuming conversion takes

place, using net present value methods and assess if it is likely that conversion

(ii) Identify and briefly comment on a single major reservation you have with your

(c) Explain why an issuing company seeks to maximise its conversion premium and whycompanies can issue convertibles with a high conversion premium (4 m arks)(d) Explain what is meant by the concept o f intermediation (the role o f a banking sector)and how such a process benefits both investors and companies (10 m arks)

(b) (i) Explain the differences between NPV and IRR as methods o f Discounted Cash

(ii) A company with a cost o f capital o f 14% is trying to determine the optimal replacement cycle for the laptop computers used by its sales team The following information is relevant to the decision:

The cost of each laptop is £2,400 Maintenance costs are payable at the end o f

each fu ll year of ownership, but not in the year of replacement, e.g if the laptop is

owned for two years, then the maintenance cost is payable at the end o f year 1

Interval between Trade-in value Maintenance cost replacement (years) (£)

2 800 £75 (payable at end o f Year 1)

3 300 £150 (payable at end o f Year 2)

Required:

Ignoring taxation, calculate the equivalent annual cost o f the three different

replacement cycles, and recommend which should be adopted What other factors should the company take into account when determining the optimal cycle? (8 m arks)

P R A C T I C E Q U E S T I O N S : SE CTI ON 1

Year Maintenance Resale

per annum value

(a) Calculate the preferred replacement policy for the ovens in a choice between a year or three-year replacement cycle (12 m arks)(b) Identify the limitations of Net Present Value techniques when applied generally to

(Total: 25 m arks)

20 HOWDEN PLC

(a) Explain how inflation affects the rate o f return required on an investment project, andthe distinction between a real and a nominal (or ‘money term s’) approach to the evaluation o f an investment project under inflation (6 m arks)(b) Howden pic is contemplating investment in an additional production line to produce its range o f compact discs A market research study, undertaken by a well-known firm

o f consultants, has revealed scope to sell an additional output o f 400,000 units p.a The study cost £0.1 m but the account has not yet been settled

The price and cost structure o f a typical disc (net o f royalties),

£

Costs per unit of output

Material cost per unit 1.50Direct labour cost per unit 0.50Variable overhead cost per unit 0.50Fixed overhead cost per unit 1.50

(4.00)

The fixed overhead represents an apportionment o f central administrative and

marketing costs These are expected to rise in total by £500,000 pa as a result of undertaking this project The production line is expected to operate for five years and require a total cash outlay of £1 lm, including £0.5m o f materials stocks The

equipment will have a residual value o f £2m Because the company is moving towards

a JIT stock management policy, it is expected that this project will involve steadily reducing working capital needs, expected to decline at about 3% pa by volume The production line will be accommodated in a presently empty building for which an offer of £2m has recently been received from another company If the building is retained, it is expected that property price inflation will increase its value to £3m after five years

is as follows:

£

S E CT I O N 1 : P R A C T I C E Q U E S T I O N S

While the precise rates o f price and cost inflation are uncertain, economists in

Howden’s corporate planning department make the following forecasts for the average annual rates o f inflation relevant to the project:

Direct labour wage rates 7% paVariable overhead costs 7% paOther overhead costs 5% pa

Note: you may ignore taxes and capital allowances in this question.

Required:

Given that Howden’s shareholders require a real return o f 8.5% for projects o f this degree o f risk, assess the financial viability o f this proposal (13 m arks)(c) Briefly discuss how inflation may complicate the analysis o f business financial

specialises in the development and production o f water- and air-filtering devices to reduce the emission o f effluents Its small but ingenious R & D team has recently made a technological breakthrough which has revealed a number o f attractive

investment opportunities It has applied for patents to protect its rights in all these areas However, it lacks the financial resources required to exploit all o f these projects, whose required outlays and post-tax NPVs are listed in the table below Filtrex’s managers consider that delaying any o f these projects would seriously undermine their profitability, as competitors bring forward their own new developments All projects are thought to have a similar degree o f risk

oject Required outlay N P V

o f which offer a return well below 18% post-tax

P R A C T I C E Q U E S T I O N S : SECTI ON 1

(c) Explain how, apart from delaying projects, Filtrex pic could manage to exploit more of

(Total: 25 m arks)

22 ARMCLIFF LTD

Armcliff Ltd is a division o f Shevin pic which requires each o f its divisions to achieve a rate

of return on capital employed of at least 10% pa For this purpose, capital employed is defined as fixed capital and investment in stocks This rate o f return is also applied as a hurdle rate for new investment projects Divisions have limited borrowing powers and all capital projects are centrally funded

The following is an extract from A rm cliff s divisional accounts:

P rofit and loss account for the y ear ended 31 D ecem ber 20X4

A rm cliff s production engineers wish to invest in a new computer-controlled press The equipment cost is £ 14m The residual value is expected to be £2m after four years operation, when the equipment will be shipped to a customer in South America

The new machine is capable of improving the quality of the existing product and also of producing a higher volume The firm’s marketing team is confident o f selling the increased volume by extending the credit period The expected additional sales are:

Year 1 2,000,000 units

Year 2 1,800,000 units

Year 3 1,600,000 units

Year 4 1,600,000 units

Sales volume is expected to fall over time due to emerging competitive pressures

Competition will also necessitate a reduction in price by £0.5 each year from the £5 per unit proposed in the first year Operating costs are expected to be steady at £1 per unit, and allocation of overheads (none o f which are affected by the new project) by the central

finance department is set at £0.75 per unit

Higher production levels will require additional investment in stocks o f £0.5m, which would

be held at this level until the final stages o f operation of the project Customers at present settle accounts after 90 days on average

Required:

(a) Determine whether the proposed capital investment is attractive to Armcliff, using the average rate of return on capital method, as defined as average profit-to-average

capital employed, ignoring debtors and creditors

S E CT I O N 1 : P R A C T I C E Q U E S T I O N S

(b) (i) Suggest three problems which arise with the use o f the average return method

(ii) In view of the problems associated with the ARi^ method, why do companiescontinue to use it in project appraisal? (3 m arks)(c) Briefly discuss the dangers o f offering more generous credit, and suggest ways ofassessing customers’ creditworthiness (9 m arks)

(Total: 25 m arks)

23 CHROMEX PLC

Chromex pic manufactures bicycles for the UK and European markets, and has made a bid of

£150 million to take over Bexell pic, their main UK competitor, which is also active in the German market Chromex currently supplies 24% o f the UK market and Bexell has a 10% share o f the same market

Chromex anticipates labour savings o f £700,000 per year, created by more efficient

production and distribution facilities, if the take-over is completed In addition, the company intends to sell off surplus land and buildings with a balance sheet value o f £15 million, acquired in the course of the take-over

Total UK bicycle sales for 20X7 were £400 million For the year ended 31 December 20X7, Bexell reported an operating profit of £10 million, compared with a figure of £55 million for Chromex In calculating profits, Bexell included a depreciation charge o f £0.5 million

N ote: The take-over is regarded by Chromex in the same way as any other investment, and is

appraised accordingly

Required:

(a) Assuming that the bid is accepted by Bexell, calculate the payback period (pre-tax) forthe investment, if the land and buildings are immediately sold for £5 million less than the balance sheet valuation, and Bexell’s sales figures remain static (3 m arks)(b) Chromex has also appraised the investment in Bexell by calculating the present value

of the company’s future expected cash flows What additional information to that required in (a) would have been necessary? (5 m arks)(c) Explain how and why the UK government might seek to intervene in the take-over bid

(d) Suggest four ratios, which Chromex might usefully compute in order to compare thefinancial performance o f Bexell with that o f companies in the same manufacturing sector You should include in your answer a justification o f your choice of ratios Briefly explain why it is important to base a comparison on companies in the same

(Total: 20 m arks)

24 SLUDGEWATER PLC

Sludgewater pic, a furniture manufacturer, has been reported to the anti-pollution authorities

on several occasions in recent years, and fined substantial amounts for making excessive toxic discharges into the air Both the environmental lobby and Sludgewater’s shareholders have demanded that it clean up its operations

If no clean up takes place, Sludgewater estimates that the total fines it would incur over the next three years can be summarised by the following probability distribution (all figures are expressed in present values.)

FOULKS LYNCH

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A firm of environmental consultants has advised that spray painting equipment can be installed at a cost of £4m to virtually eliminate discharges Unlike fines, expenditure on pollution control equipment is tax-allowable via a 25% writing-down allowance (reducing balance, based on gross expenditure) The rate o f corporation tax is 30%, paid with a one- year delay The equipment will have no scrap or resale value after its expected three year working life The equipment can be in place ready for Sludgewater’s next financial year.

A European Union grant o f 25% o f gross expenditure is available, but with payment delayed

by a year The consultant’s charge is £200,000 and the new equipment will raise annual production costs by 2% o f sales revenue Current sales are £15 million per annum, and are expected to grow by 5% per annum compound No change in working capital is envisaged.Sludgewater applies a discount rate o f 10% after tax on investment projects o f this nature.All cash inflows and outflows occur at year ends

Required:

(a) Calculate the expected net present value o f the investment

(b) Write a memorandum to Sludgewater’s management in respect o f the potentialinvestment taking into account both financial and non-financial criteria (8 m arks)

(Total: 20 m arks)

Leaminger pic has decided it must replace its major turbine machine on 31 December 20X2 The machine is essential to the operations o f the company The company is, however,

considering whether to purchase the machine outright or to use lease financing

P urchasing the machine outright

The machine is expected to cost £360,000 if it is purchased outright, payable on 31

December 20X2 After four years the company expects new technology to make the machine redundant and it will be sold on 31 December 20X6 generating proceeds of £20,000 Capital allowances for tax purposes are available on the cost o f the machine at the rate o f 25% per annum reducing balance A full year’s allowance is given in the year o f acquisition but no writing down allowance is available in the year o f disposal The difference between the proceeds and the tax written down value in the year o f disposal is allowable or chargeable for tax as appropriate

The company has approached its bank with a view to arranging a lease to finance the

machine acquisition The bank has offered two options with respect to leasing which are as follows:

S E C T I O N 1 : P R A C T I C E Q U E S T I O N S

G eneral

For both the purchasing and the finance lease option, maintenance costs o f £15,000 per year are payable at the end o f each year All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposes in full in the year o f payment Assume thattax is payable one year after the end o f the accounting year in which the transaction occurs.For the operating lease only, contracts are renewable annually at the discretion o f either party Leaminger pic has adequate taxable profits to relieve all its costs The rate of

corporation tax can be assumed to be 30% The company’s accounting year-end is 31

December The company’s annual after tax cost o f capital is 10%

Required:

(a) Calculate the net present value at 31 December 20X2, using the after tax cost o f capital, for:

(i) purchasing the machine outright

(ii) using the finance lease to acquire the machine

(iii) using the operating lease to acquire the machine

(b) Assume now that the company is facing capital rationing up until 30 December 20X3 when it expects to make a share issue During this time the most marginal investment project, which is perfectly divisible, requires an outlay o f £500,000 and would

generate a net present value o f £100,000 Investment in the turbine would reduce funds available for this project Investments cannot be delayed

Calculate the revised net present values o f the three options for the turbine given capital rationing Advise whether your recommendation in (a) would change

(5 m arks)(c) As their business advisor, prepare a report for the directors o f Leaminger pic thatassesses the issues that need to be considered in acquiring the turbine with respect to

(Total: 25 m arks)

26 PRIME PRINTING PLC

(a) Explain the cash flow characteristics o f a finance lease, and compare it with the use o f

a bank loan or cash held on short-term deposit Your answer should include some comment on the significance o f a com pany’s anticipated tax position on lease versus

(b) Prime Printing pic has the opportunity to replace one o f its pieces o f printing

equipment The new machine, costing £120,000, is expected to lead to operating savings o f £50,000 per annum and have an economic life o f five years The com pany’s after tax cost o f capital for the investment is estimated at 15%, and operating cash flows are taxed at a rate of 30%, one year in arrears

The company is trying to decide whether to fund the acquisition o f the machine via a five-year bank loan, at an annual interest rate o f 13%, with the principal repayable at the end o f the five-year period As an alternative, the machine could be acquired using

a finance lease, at a cost o f £28,000 p.a for five years, payable in advance The

machine would have zero scrap value at the end of five years

Note: due to its current tax position, the company is unable to utilise any capital

allowances on the purchase until year one

P R A C T I C E Q U E S T I O N S : SECTI ON 1

Required:

Assuming that writing-down allowances of 25% p.a are available on a reducing balance basis, recommend, with reasons, whether Prime Printing should replace the machine, and if so whether it should buy or lease (15 m arks)

(Total: 25 m arks)

27 BENLAND PLC

Benland pic manufacture and fit 9 variety of children’s playground equipment The company

at present purchases the rubber particles used in the playground surfacing from an outside supplier, but is considering investing in equipment which would process and shred used vehicle tyres to produce equivalent rubber particles One tonne of purchased particles is saved per tonne of tyres processed Disposal of used tyres is becoming an environmental problem, and Benland believes that it could charge £40 per tonne to garages/tyre distributors wishing to dispose of their old tyres This price would be 20 per cent lower than the cost of the landfill sites currently being used, and so Benland believes that it would face no risk or shortage o f supply of what would be a key raw material for the business The price charged

by Benland for tyre disposal (£40 per tonne) remains fixed for the next five years

The cost to Benland o f purchased particles is £3.50 per tonne for each o f the next five years, and the price has been contractually guaranteed If the contract is terminated within the next two years, Benland will be charged an immediate termination penalty o f £100,000 which will not be allowed as a tax deductible expense

The machine required to process the tyres will cost £1.06 million, and it is estimated that at the end of year five the machine will have a second-hand value o f £120,000 before selling costs o f £5,000

Sales o f the playground surfacing which uses rubber particles are forecast to be £1.2 million

in year one, rising by 10% per year until year five but prices will remain constant The new equipment will result in Benland incurring additional maintenance costs of £43,000 per year.80,000 tonnes of tyres need to be processed in order to meet the raw material requirement for the forecast sales in year one Processing costs are estimated at £37 per tonne (excluding additional depreciation and maintenance)

Benland is subject to corporation tax at a rate of 33%, payable one year in arrears Capital expenditure is eligible for 25% allowances on a reducing balance basis, and sales proceeds of assets are subject to tax Benland has sufficient profits to fully utilise all available capital allowances

Required:

(a) Using 12% as the after-tax discount rate, advise Benland on the desirability of

purchasing the tyre processing equipment (12 m arks)(b) Discuss which cash flows are most important in determining the outcome of the

proposed investment and how Benland might seek to minimise the risk o f large

(Total: 20 m arks)

administrative/management function and a central services function.

The following cost information is available for the year ended 30 June 20X7:

(1) O ccupancy costs

Total £1,500,000 Such costs are apportioned on the basis o f area used which is:

(2) A dm inistration/m anagem ent costs

Direct costs: £1,775,000

Indirect costs: an apportionment o f occupancy costs

Direct and indirect costs are charged to degree courses on a percentage basis

(3) F aculty costs

Direct costs: £700,000

Indirect costs: an apportionment o f occupancy costs and central service costs

Direct and indirect costs are charged to teaching departments

(4) Teaching d ep artm ents

Indirect costs: an apportionment o f occupancy costs

Direct and indirect costs o f central services have in previous years been charged to users on a percentage basis A study has now been completed which has estimated what user areas would have paid external suppliers for the same services on an

individual basis For the year ended 30 June 20X7, the apportionment o f the central services cost is to be recalculated in a manner which recognises the cost savings achieved by using the central services facilities instead o f using external service companies This is to be done by apportioning the overall savings to user areas in proportion to their share o f the estimated external costs