2.4 June 07 - Q

PART 2 WEDNESDAY 13 JUNE 2007

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A

This ONE question is compulsory and MUST be answered

Section B

TWO questions ONLY to be answered

Formulae Sheet, Present Value and Annuity Tables are on pages 7, 8 and 9.

Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall

The Association of Chartered Certified Accountants

Paper 2.4

Financial Management and Control

Section A – This ONE question is compulsory and MUST be attempted 1

The finance director of GTK plc is preparing its capital budget for the forthcoming period and is examining a number of capital investment proposals that have been received from its subsidiaries. Details of these proposals are as follows: Proposal 1 Division A has requested that it be allowed to invest £500,000 in solar panels, which would be fitted to the roof of its production facility, in order to reduce its dependency on oil as an energy source. The solar panels would save energy costs of £700 per day but only on sunny days. The Division has estimated the following probabilities of sunny days in each year. Scenario 1 Scenario 2 Scenario 3

Number of sunny days 100 125 150

Probability 0·3 0·6 0·1

Each scenario is expected to persist indefinitely, i.e. if there are 100 sunny days in the first year, there will be 100 sunny days in every subsequent year. Maintenance costs for the solar panels are expected to be £2,000 per month for labour and replacement parts, irrespective of the number of sunny days per year. The solar panels are expected to be used indefinitely. Proposal 2 Division B has asked for permission to buy a computer-controlled machine with a production capacity of 60,000 units per year. The machine would cost £221,000 and have a useful life of four years, after which it would be sold for £50,000 and replaced with a more up-to-date model. Demand in the first year for the machine’s output would be 30,000 units and this demand is expected to grow by 30% per year in each subsequent year of production. Standard cost and selling price information for these units, in current price terms, is as follows: Selling price Variable production cost Fixed production overhead cost

£/unit 12 4 6

Annual inflation 4% 5% 3%

Fixed production overhead cost is based on expected first-year demand. Proposal 3 Division C has requested approval and funding for a new product which it has been secretly developing, Product RPG. Product development and market research costs of £350,000 have already been incurred and are now due for payment. £300,000 is needed for new machinery, which will be a full scale version of the current pilot plant. Advertising takes place in the first year only and would cost £100,000. Annual cash inflow of £100,000, net of all production costs but before taking account of advertising costs, is expected to be generated for a five-year period. After five years Product RPG would be retired and replaced with a more technologically advanced model. The machinery used for producing Product RPG would be sold for £30,000 at that time. Other information GTK plc is a profitable, listed company with several million pounds of shareholders’ funds, a small overdraft and no long-term debt. For profit calculation purposes, GTK plc depreciates assets on a straight-line basis over their useful economic life. The company can claim writing down allowances on machinery on a 25% reducing balance basis and pays tax on profit at an annual rate of 30% in the year in which the liability arises. GTK plc has a before-tax cost of capital of 10%, an after-tax cost of capital of 8% and a target return on capital employed of 15%.

2

Required: (a) For the proposed investment in solar panels (Proposal 1), calculate: (i) the net present value for each expected number of sunny days; (ii) the overall expected net present value of the proposal; and comment on your findings. Ignore taxation in this part of the question.

(9 marks)

(b) Calculate the net present value of the proposed investment in the computer-controlled machine (Proposal 2) and advise whether the proposal is financially acceptable. Assume in this part of the question that tax is payable and that writing down allowances can be claimed. (15 marks) (c) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment in Product RPG (Proposal 3), using the average investment method, and advise on its acceptability. (6 marks) (d) Discuss how equity finance or traded debt (bonds) might be raised in order to meet the capital investment needs of GTK plc, clearly indicating which source of finance you recommend and the reasons for your recommendation. (12 marks) (e) At the end of the first year of production after implementation of Proposal 2, the finance director noted that a mistake had been made in forecasting selling price inflation, which should have been 1·5% instead of 4%. He has gathered the following information regarding selling price and sales volume. Forecast standard selling price (4% inflation) Actual selling price Forecast and actual standard variable cost Forecast sales volume Actual sales volume

£12·48 £12·36 £4·20 30,000 units 32,000 units

Required: (i)

Using a marginal costing approach and ignoring the mistake in forecasting selling price inflation, calculate the selling price variance and the sales volume contribution variance, and reconcile budgeted contribution to actual contribution. (4 marks)

(ii) Using a marginal costing approach, evaluate the selling price variance from an operational and planning perspective and discuss briefly whether your evaluation provides the finance director with useful information. (4 marks) (50 marks)

3

[P.T.O.

Section B – TWO questions ONLY to be attempted 2

Required: (a) Outline the key stages in the planning process that links long-term objectives and budgetary control. (10 marks) (b) Explain the meaning of the terms ‘fixed budget’, ‘rolling budget’ and ‘zero-based budget’, and discuss the circumstances under which each budget might be used. (10 marks) (c) Discuss whether time series analysis may be preferred to linear regression as a way of forecasting sales volume. (5 marks) (25 marks)

3

Woodside is a local charity dedicated to helping homeless people in a large city. The charity owns and manages a shelter that provides free overnight accommodation for up to 30 people, offers free meals each and every night of the year to homeless people who are unable to buy food, and runs a free advice centre to help homeless people find suitable housing and gain financial aid. Woodside depends entirely on public donations to finance its activities and had a fundraising target for the last year of £700,000. The budget for the last year was based on the following forecast activity levels and expected costs: Free meals provision: Overnight shelter: Advice centre: Campaigning and advertising:

18,250 meals at £5 per meal 10,000 bed-nights at £30 per night 3,000 sessions at £20 per session £150,000

The budgeted surplus (budgeted fundraising target less budgeted costs) was expected to be used to meet any unexpected costs. Included in the above figures are fixed costs of £5 per night for providing shelter and £5 per advice session representing fixed costs expected to be incurred by administration and maintaining the shelter. The number of free meals provided and the number of beds occupied each night depends on both the weather and the season of the year. The Woodside charity has three full-time staff and a large number of voluntary helpers. The actual costs for the last year were as follows: Free meals provision: Overnight shelter: Advice centre: Campaigning and advertising:

20,000 meals at a variable cost of £104,000 8,760 bed-nights at a variable cost of £223,380 3,500 sessions at a variable cost of £61,600 £165,000

The actual costs of the overnight shelter and the advice centre exclude the fixed costs of administration and maintenance, which were £83,000. The actual amount of funds raised in the last year was £620,000. Required: (a) Prepare an operating statement, reconciling budgeted surplus and actual shortfall and discuss the charity’s performance over the last year. (13 marks) (b) Discuss problems that may arise in the financial management and control of a not-for-profit organisation such as the Woodside charity. (12 marks) (25 marks)

4

4

TFR Ltd is a small, profitable, owner-managed company which is seeking finance for a planned expansion. A local bank has indicated that it may be prepared to offer a loan of £100,000 at a fixed annual rate of 9%. TFR Ltd would repay £25,000 of the capital each year for the next four years. Annual interest would be calculated on the opening balance at the start of each year. Current financial information on TFR Ltd is as follows: Current turnover: Net profit margin: Annual taxation rate: Average overdraft: Average interest on overdraft: Dividend payout ratio: Shareholders funds: Market value of fixed assets

£210,000 20% 25% £20,000 10% per year 50% £200,000 £180,000

As a result of the expansion, turnover would increase by £45,000 per year for each of the next four years, while net profit margin would remain unchanged. No capital allowances would arise from investment of the amount borrowed. TFR Ltd currently has no other debt than the existing and continuing overdraft and has no cash or near-cash investments. The fixed assets consist largely of the building from which the company conducts its business. The current dividend payout ratio has been maintained for several years. Required: (a) Assuming that TFR is granted the loan, calculate the following ratios for TFR Ltd for each of the next four years: (i) (ii) (iii) (iv)

interest cover; medium to long-term debt/equity ratio; return on equity; return on capital employed.

(10 marks)

(b) Comment on the financial implications for TFR Ltd of accepting the bank loan on the terms indicated above. (8 marks) (c) Discuss the difficulties commonly faced by small firms such as TFR Ltd when seeking additional finance. (7 marks) (25 marks)

5

[P.T.O.

5

The following financial information relates to PNP plc for the year just ended: Turnover Variable cost of sales Stock Debtors Creditors

£000 5,242·0 3,145·0 603·0 744·5 574·5

Segmental analysis of debtors Balance Class 1 £200,000 Class 2 £252,000 Class 3 £110,000 Overseas debtors £182,500 ––––––––– £744,500 –––––––––

Average payment period 30 days 60 days 75 days 90 days

Discount 1·0% nil nil nil

Bad debts none £12,600 £11,000 £21,900 –––––––– £45,500 ––––––––

The debtor 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 debtors are in proportion to their relative year-end balances before bad debts. The overseas debtors arise from regular export sales by PNP to the USA. The current spot rate is $1·7348/£ and the three-month forward rate is $1·7367/£. It has been proposed that the discount for early payment be increased from 1·0% to 1·5% for settlement within 30 days. It is expected that this will lead to 50% of existing Class 2 debtors becoming Class 1 debtors, as well as attracting new business worth £500,000 in turnover. The new business would be divided equally between Class 1 and Class 2 debtors. Fixed costs would not increase as a result of introducing the discount or by attracting new business. PNP finances debtors from an overdraft at an annual interest rate of 8%. Required: (a) Calculate the net benefit or cost of increasing the discount for early payment and comment on the acceptability of the proposal. (9 marks) (b) Calculate the current cash operating cycle and the revised cash operating cycle caused by increasing the discount for early payment. (4 marks) (c) Determine the effect of using a forward market hedge to manage the exchange rate risk of the outstanding overseas debtors. (2 marks) (d) Identify and explain the key elements of a debtor management system suitable for PNP plc.

(10 marks) (25 marks)

6

Formulae Sheet

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End of Question Paper

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