SECTION A 20 MARKS Question One 1.1 The answer is D 1.2 The answer is C Sensitivity measures the percentage change in a key input (for example initial outlay, direct material, direct labour, residual value) needed to make a project break even, in other words to have a project with a zero NPV. Whatever key factor we are looking at we always need to work out its PV when comparing it to the projects NPV. Sensitivity = NPV / PV of key input In this question we are looking at the sensitivity of variable costs which is $40,000 per annum being material and labour costs combined. This cost is the same amount being incurred every year for the life of the project (being 5 years), therefore we can use cumulative or discount factors (CDF) to work this out. The CDF for 5 years at 10% is 3.791 according to the tables. Therefore: NPV of variable costs = $40,000 x 3.791 = $151,640 Sensitivity = ($50,000 / $151,640) x 100% = 32.97% or 33% 1.3 The answer is B This is a question where you have to use the high-low method to solve, however in the first instance we need to remove inflation from the figures to ensure that they are like for like high. $10,500 / 1.05 = $10,000 $13,390 / 1.03 = $13,000 Using high-low method, compare the change in activity to the change in cost. Units produced Total cost ($) 8,000 13,000 6,000 10,000 2,000 3,000 $3,000 / 2,000 units = $1.50 direct cost per unit produced - 1 -
Now to obtain the correct figure we must apply inflation index being 1.06: $1.50 x 1.06 = $1.59 1.4 The answer is B Sales price variance Did sell (actual quantity sold x actual price) X Should sell (actual quantity sold x standard price) (X) Sales price variance X 15,750 x ($6.60-6) = $9,450 (F) 1.5 The answer is A Sales volume profit variance Did sell (actual quantity sold) Should sell (budget quantity sold) Sales volume profit variance units X (X) X x standard profit per unit* X *Standard profit would be used if the organisation uses absorption costing methods, when using marginal costing methods, the standard contribution volume variance, rather than standard volume profit variance would be used. The proforma above would be the same however the difference in units above would be multiplied by the standard contribution per unit rather than standard profit per unit. Budgeted sales = $15,650 / 1.05 = 15,000 units (15,750 15,000) x $2 Standard contribution per bar = $1,500 (F) - 2 -
1.6 The answer is $395,000 Kg Opening inventory 3,000 Material purchases (balance) 49,400 52,400 Less material usage (W1) 48,000 Closing inventory (W2) 4,400 Value of purchases $ $8 per Kg x 49,000 Kg 392,000 $7.50 x 400 Kg 3,000 395,000 Workings W1 - Material usage Production 12,000 x 4 Kg = 48,000 Kg W2 Closing inventory Closing inventory at the end of each month would be 110% of next month s production. Therefore: 12,000 units/12 x 4 Kg = 4,000 Kg. 4,000 Kg x 1.1 = 4,400 Kg. 1.7 The answer is $111.10 We know the yield to maturity or IRR is 3%, this means that if we discount the bond at this rate the NPV of the bond will be zero. The balancing figure will be the market value of the bond Therefore: Year Cash flow $ DF 3% PV 0 Market value MV 1.000 (MV) 1-4 Interest 6 3.717 22.3 4 Capital repayment 100 0.888 88.8 NPV 0 MV = 22.3 + 88.8 = $111.10-3 -
1.8 The answer is $140,000 Project EV A (400 x 0.3) + (500 x 0.2) + (700 x 0.5) = $570,000 B (800 x 0.3) + (300 x 0.2) + (200 x 0.5) = $400,000 C (500 x 0.3) + (600 x 0.2) + (400 x 0.5) = $470,000 Project A has the highest expected value being $70,000. To calculate the value of perfect information with respect to the preferences: Preferences Best projects in preferences Probability Net cash inflows 1 B 0.3 $800,000 $240,000 2 C 0.2 $600,000 $120,000 3 A 0.5 $700,000 $350,000 EV with perfect information $710,000 EV without perfect information ($570,000) Value of perfect information $140,000 EV - 4 -
SECTION B 30 MARKS Some of the answers that follow in Section B are more comprehensive than expected for a well-prepared candidate. Question Two Part (a) Explain the stages in the budget setting process for a company that uses a zerobased budgeting system. (5 marks) Zero based budgeting (ZBB) has three main stages: Decision packages are created which include the activities that are being considered. There are often more than one decision package being proposed and the advantage and disadvantages of them are listed. They are then ranked and evaluated against each other being different ways of accomplishing the same objective competing for the same resources. Both financial and non-financial costs and benefits are considered. The packages are then either approved or disapproved by management, and this may result in the rejection of packages used last year, this means that all packages are given a fair consideration on whether or to undertake. The successful packages are then budgeted and allocated resources. The budget should include all aspects of analysis such as costs, revenues and resource usage. Question Two Part (b) (i) Identify which order level would be selected if AP applied: a. the maximin decision criterion b. the maximax decision criterion (2 marks) The maximin decision criterion. AP would choose the medium level of order as the worst case scenario is $300 profit being the best of all the worst case scenarios. The maximax decision criterion AP would choose the high level of order as the best outcome is $600 profit being the best of all the best outcomes. (ii) Identify, using a minimax regret table, the order level that would be selected if AP applied the minimax regret decision criterion. (3 marks) The key point to understand here is that you need to find the solution that will minimise the maximum opportunity cost or if you like regret. - 5 -
We work out how much profit we would lose for those orders we did not sell. For example if we there was a demand level of good then we had ordered at a high level then there would be no regret as we would not be able to achieve anymore profit because we had sold everything bought.. If however we had ordered at the medium level we know we could only have made profits of $300. The amount of regret is worked out by comparing to the most amount of profit made, therefore $300. If however we had ordered at the low level we know we could only have made profits of $100. The amount of regret is again worked out by comparing to the most amount of profit made, therefore $500. We continue this person for each level of demand. See table below: Level of order If actual High Medium Low weather is: Good $0 $300 $500 Average $200 0 $300 Poor $400 0 $100 The maximum regret for: High level is $400 Medium level is $300 Low level is $500 Therefore to minimise the maximum regret AP should order at the medium level. Question Two Part (c) Decision rules based on excited values assume that the decision maker is risk neutral (i) Explain the above statement. (2 marks) Expected values are no good for one off decisions; they work out a long-run average when a decision is made over and over again. Expected values rely heavily on probability estimates when decisions are being made which can be very subjective. How do we arrive at the % chance of something occurring? If for example you are asked 10 economists to forecast the rate of interest for the UK in 12 months time, they may all give you differing opinions, but all very valid, depending on what viewpoint they held. - 6 -
An outcome is either one or the other never an average but probabilities determine outcomes using an average (expected) approach. Risk neutral managers go for the most likely return and will use expected values in order to make a decision. (ii) Describe TWO other attitudes to risk. (3 marks) Risk seeking attitude (maximax attitude or optimist ) go for the best outcome ignoring the probability of actually attaining it, when making decisions, therefore aim to maximise the maximum or best return from a decision. Risk adverse attitude (maximin attitude or pessimist ) assume always the worse outcome will arise, therefore aim to maximise the returns from the worst outcomes. Question Two Part (d) (i) Calculate the expected receipts from customers during the year. (3 marks) Trade receivable at the end of the year = ($492,750 / 365) x 60 days = $81,000 Bad debts = ($492,750 - $81,000) x 5% = $20,587.50 Cash collected = $83,000 + $492,750 - $81,000 - $20,587.50 = $474,162.50 (ii) Describe TWO methods that RX could use to reduce the possibility of bad debts occurring. (2 marks) An investigation into the credit worthiness of new customers is conducted before credit is given. Investigations could include references obtained from the bank, other companies that have dealings with them or credit rating agencies. Invoices should be sent on time to customers. Full terms of payment should be clearly on all invoice and how to make payment. Penalties and interest charges should be used if customer payments are late and should be mentioned on the invoice. There should be regular statements of accounts sent to customers showing what is outstanding. There should be regular review of customer accounts to ensure that there are no outstanding amounts that should be paid. Credit limits should be withdrawn if customers are not paying on time and a stop put on the account until full payment received. An aged trade receivables list should produced on a regular basis and reviewed by credit control and management to focus on recovering old debts. - 7 -
There should also be policies on persuading debtors to pay promptly i.e. discount schemes. We can consider the use of factoring services. Question Two Part (e) Explain the advantages AND disadvantages to the company of each of the investments. You should consider the return offered and the level and type of risk involved with each investment. You should assume that there are no other investments available and that these investments are only available now. (5 marks) The first thing we need to do is work out the returns on these 2 investments on a comparable basis. They both have different times when they pay interest and so it s best to annualise the returns so they can be compared on a fair basis. Deposit account annual return = (1 + 0.11) 4-1 = 0.0447 or 4.47% Government bond annual return = (1 + 0.025) 2-1 = 0.0506 or 5.06% The deposit account can be accessed should the company require a call on cash surpluses as it is not fixed for any length of time. There is also the possibility of greater returns in the future as it is a variable rate, therefore even though currently it gives a lower annual return when compared to the government bond. The deposit account has the disadvantage of interest rates falling and giving an even lower rate of return than currently is being received. There is also more chance that a bank will fail especially given the recent banking crisis compared to a government issuing a bond. The government bond has a higher return than the deposit account and is fixed for the year, so any uncertainty of returns on the bond is completely removed. The bond is considered risk free as governments do not tend to go bankrupt unlike banks. The government bond has the disadvantage of not being able to be cashed early should the company require it as it is fixed for the year and therefore lacks the flexibility of the deposit account. The return on the bond is fixed which guarantees in come, however there maybe other investments in the market which maybe just as risky but give a higher return but the company cannot take advantages of those as they cannot switch investments away from the bonds as they are locked in for the year. - 8 -
Question Two Part (f) Calculate the length of WCC s working capital cycle to the nearest 0.1 of a day. (5 marks) 1 Average time raw materials are in stock (Raw materials / purchases) x 365 days (85 / 915) x 365 = 33.9 days 2 Time taken to produce goods (Work in progress & finished goods / cost of sales) x 365 days (90 / 1,215) x 365 = 27.0 days 3 Time taken by customers to pay for goods (Trade receivables / credit sales) x 365 days [185 / (80% x 1,400)] x 365 = 60.3 days 4 Period of credit taken from suppliers (Trade payables / purchases) x 365 days (125 / 95% x 915) x 365 = 52.5 days Working capital cycle = 33.9 + 27.0 + 60.3 52.5 = 68.7 days If the concert is advertised the expected profit will be $25,600 as opposed to not advertising the expected profit will only be $13,000, therefore the concert should be advertised. - 9 -
SECTION C 50 MARKS Question Three (a) Calculate the profit per procedure for each of the three procedures, using the current basis for charging the costs of support activities to procedures. (5 marks) Workings (W1) - Follow up s Hip Knee Shoulder $ $ $ Fee charged to patient 8,000 10,000 6,000 Surgeon s fee (1,200) (1,800) (1,500) Fee for follow-up s (W1) (24) (15) (30) Medical supplies (400) (200) (300) Overhead cost (W2) (5,200) (6,500) (3,900) Profit per procedure 1,176 1,485 270 Hip = $300 x 8% = $24 Knee = $300 x 5% = $15 Shoulder = $300 x 10% = $30 (W2) Overhead cost We need to work out what percentage overhead costs are of total sales revenue and then we use this percentage to apparition costs per procedure. Total overhead costs ($000) = $864 + $1,449 + $5,428 + $1,216 + $923 = $9,880 Total sales revenue Total ($000) Hip $8,000 x 600 = $4,800 Knee 10,000 x 800 = $8,000 Shoulder $6,000 x 400 = $2,400 $15,200 Overheads as a percentage of sales revenue = (9,880 / 15,200) x 100% = 65% Cost per hip operation = $8,000 x 65% = $5,200 Cost per knee operation = $10,000 x 65% = $6,500 Cost per shoulder operation = $6,000 x 65% = $3,900-10 -
(b) Calculate the profit per procedure for each of the three procedures using activity based costing. (13 marks) Theatre preparation for each session This cost is driven by number of theatre preparations. Hip procedure = 600 / 2 = 300 procedures per theatre session Knee procedure = 800 / 1 = 800 procedures per theatre session Shoulder procedure = 400 / 4 = 100 procedures per theatre session Total procedures = 300 + 800 + 100 = 1,200 procedures per theatre session $864,000 / 1,200 procedures = $720 per procedure for each theatre session Operating theatre usage This cost is driven by the number of hours to perform the procedure. Hip procedure = 600 x 2 hrs = 1,200 hrs Knee procedure = 800 x 1.2 hrs = 960 hrs Shoulder procedure = 400 x 1.5 hrs = 600 hrs Total hours = 1,200 + 960 + 600 = 2,760 hrs $1,449,000 / 2,760 hrs = $525 per hour Nursing and ancillary services This cost is driven by the number of in-patient days. Hip procedure = 600 x 3 days = 1,800 days Knee procedure = 800 x 2 days = 1,600 days Shoulder procedure = 400 x 1 days = 400 days Total hours = 1,800 + 1,600 + 400 = 960 + 600 = 3,800 days $1,449,000 / 3,800 days = $1,428 per day Administration This cost is driven by sales revenue. Total sales revenue we worked out in part (a) as being $15,200,000. $1,216,000 / $15,200,000 = $0.08 per $ of sales revenue. Other overheads This cost is driven by number of procedures. Total number of procedures = 600 + 800 + 400 = 1,800 $923,000 / 1,800 = $513 per procedure - 11 -
Overhead cost Hip Knee Shoulder per procedure Theatre prep for each session $720 / 2 = $360 $720 / 1 = $720 $720 / 4 = $180 Operating there usage $525 x 2 = $1,050 $525 x 1.2 = $630 $525 x 1.5 = $788 Nursing and ancillary $1,428 x 3 = $4,284 $1,428 x 2 = $2,856 $1,428 x 1 = $1,428 Administration $8,000 x $0.08 = $640 $10,000 x $0.08 = $800 $6,000 x $0.08 = $480 Other overheads $513 $513 $513 Total $6,847 $5,519 $3,389 Hip Knee Shoulder Profit per procedure from part (a) $1,176 $1,485 $270 Add: overheads from part (a) $5,200 $6,500 $3,900 Less: overheads using ABC ($6,847) ($5,519) ($3,389) Profit per procedure using ABC ($471) $2,466 $781 (c) Discuss the ways in which the information obtained by the project team may be of benefit to the management of the company. (13 marks) Activity based costing (ABC) looks in more detail about what causes fixed overhead to be incurred and works out many cost drivers (activities). Management can obtain a more accurate picture of how fixed overhead are driven and used within products and services sold to customers. There would be more efficient management of resources by understanding what drives fixed overhead incurred, for example elimination, reduction or improvement in the efficiency of how resources are used can improve profitability. There would be better costing information for planning and control e.g. how different products, customers or distribution channels consume different resources. In the scenario it appears that the ABC system has shown different levels of profit for the different procedures when compared to the existing absorption costing system. The hip procedure is showing a loss of $471 under the ABC system where as it was showing a profit of $1,176 in the absorption costing system, in addition both the knee and shoulder procedures are showing greater profits under the ABC system. Management will be able to review the additional information they have obtained from the overhead costs analysis under ABC and can see that there are more costs allocated to the hip procedure. This is due to the days that the patient has to stay in the hospital and the time it takes to perform the hip procedure is greater than the other procedures, as a result of this management can take action to make the hip procedure profitable. - 12 -
Management could consider increasing the price for a hip procedure but this is subject to the price competition from other suppliers and the effect this would have on the company. Management could consider ways of reducing some of the costs in the hip procedure to increase profitability now that they have better analysis of overheads. If it is not possible to make the hip procedure profitable then management should consider discounting and perform other procedures that are profitable. The knee procedure is making a very large profit per unit from the ABC system information. Management may consider reducing the price to increase the number of procedures sold and increasing total profit overall. The shoulder procedure is making a much lower profit margin per unit and management may take steps in increasing the price to increase overall profitability, but this is subject to the price competition from other suppliers and the effect this would have on the company. Question Four (a) Calculate for Project 1 the relevant cash flows that the accountant should have used for year 1 when appraising the project. All workings should be in $000. (6 marks) Internal failure cost savings Expected value of internal failure costs = ($300 x 0.5) + ($500 x 0.3) + ($700 x 0.2) = $440 Expected savings from internal failure costs = $440 x 80% x 1.04 = $366 External failure cost savings Expected value of external failure costs = ($1,300 x 0.6) + ($1,900 x 0.3) + ($3,000 x 0.1) = 1,650 Expected savings from external failure costs = $1,650 x 80% x 1.04 = $1,373 Raw material costs = 50,000 x $62 x 1.04 = $3,224,000 or $3,224 (nearest $000) Net cash flows for year 1 = $366 + $1,373 + $3,224 = $4,963-13 -
(b) Calculate for Project 2: (i) (ii) the net present value (NPV) the internal rate of return (IRR) All workings should be in $000. (10 marks) (i) Year 0 ($000) 1 ($000) 2 ($000) 3 ($000) 4 ($000) 5 ($000) Investment (15,000) Cost savings (W1) 5,720 5,949 6,187 6,434 6,691 Fixed costs (W2) (2,000) (2,000) (2,000) (2,000) (2,000) Working capital (1,000) 1,000 Net cash flows (16,000) 3,720 3,949 4,187 4,434 5,691 DF @ 8% x 1 x 0.926 x 0.857 x 0.794 x 0.735 x 0.681 PV (16,000) 3,445 3,384 3,324 3,259 3,876 NPV $1,288 Workings (W1) Cost savings Savings on cost of per component if new machine introduced = $370 - $260 = $110 Total savings on components = 50,000 x $110 = $5,500,000 Increase in production volume by 4% each year, therefore ($000): Year 1 savings = $5,500 x 1.04 = $5,720 Year 2 savings = $5,720 x 1.04 = $5,949 Year 3 savings = $5,949 x 1.04 = $6,187 Year 4 savings = $6,187 x 1.04 = $6,434 Year 5 savings = $6,434 x 1.04 = $6,691 (W2) Fixed costs Fixed costs of $5m include depreciation which is not a relevant cost and needs to be removed. Depreciation = $15,000,000 / 5 = $3,000,000 Relevant fixed costs ($000) = $5,000 - $3,000 = $2,000-14 -
(ii) We know that at a cost of capital of 8% the investment has an NPV of $1,288. The internal rate of return (IRR) is that cost of capital where the NPV of a project is zero. This is achieved through trial and error and then interpolation. If we have a cost of capital which yields a positive NPV then we need to find a cost of capital when applied to the investment will give a negative NPV. In order to achieve a negative NPV we must select a higher cost of capital than 10% because this effectively increases the discounting effect on the cash flows and therefore giving a negative NPV. Choose the largest cost of capital given to you in the formulae sheet in the exam. This is 20% and will hopefully give a negative NPV. You do not have to choose a 20% you can choose another cost of capital, for example 17% but it may not be large enough to give you a negative NPV, and therefore you would have do the calculation again for a higher cost of capital. Year 0 1 2 3 4 5 $000 $000 $000 $000 $000 $000 Cashflow (16,000) 3,720 3,949 4,187 4,434 5,691 DF @ 20% x 1 x 0.833 x 0.694 x 0.579 x 0.482 x 0.402 PV (16,000) 3,099 2,741 2,424 2,137 2,288 NPV = ($3,311) In this case we have a negative NPV. Apply the interpolation formula to find the IRR: A + [ a x (B-A) ] a b Where: A = lower discount factor B = higher discount factor a = NPV at A b = NPV at B 8 + [ (1,288 / (1,288 - -3,311) x (20-8) ] = 11.36% - 15 -
(c) Advise the company directors which of the two investment projects should be undertaken. (4 marks) The company should normally select the project with the highest NPV. In this case the company should choose project 1 has it gives an NPV of $1,388 which is higher than the NPV of project 2 being $1,288. Other things should also be considered such as qualitative factors. These are not expressed in numbers and therefore cannot be normally included in NPV calculations however are important as they have an impact on the viability of the project. Examples of qualitative factors are expressions of opinion perhaps on the outlook of the car industry and change in consumption of cars by consumers. Project 2 requires $4m less initial investment compared to project 1, if the difference could be invested in other projects giving NPV s in excess of the difference between projects 1 and 2 then it maybe worthwhile investing in project 2. (d) Discuss potential reasons why the conflict between the NPV and IRR ranking may have arisen. (5 marks) Multiple IRRs NPV % Cost of capital IRR IRR You can have multiple IRRs for the same project, usually if non-conventional cash flows arise over the life of the project (see diagram above). Non-conventional cash flows are when there is a mixture of overall negative and positive cash flows throughout each of the periods of a project. Conventional cash flows are when you have an initial negative cash flow and then a series of overall positive cash flows for each of the periods of the project. If non-conventional cash flows occur then for each change in overall cash flow (negative to positive or positive to negative) from one period to another the project line will fall below or rise above the cost of capital axis, thus causing multiple IRRs. - 16 -
This now makes it impossible to conclude whether a project should be accepted or not because it is unclear as to which IRR we should use to assess the project. Incorrect project ranking NPV 4m Lower IRR Project B Higher IRR Project A 2m 0 10% Company s cost of capital % Cost of capital IRR may rank projects incorrectly. NPV being always the clear decision rule (see diagram above). Looking at the diagram under IRR decision criteria we should select that project with the highest IRR and this will also give us the project with the highest NPV so in this case it would be project A. This is incorrect because at the cost of capital being used to discount the projects being 10% it is project B which has the highest NPV at 4m. The reason why IRR has selected the wrong project is because they intersect one another. NPV is the only method that will always give the correct decision. - 17 -