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Paper F9
Haroon Tabraze
Macroeconomic policy involves: Objectives: aim of economic policy Targets: quantified levels of Policy instruments: Tools used to achieve objectives Mission
Mission statement is description of prevailing culture of organization. It is a strategic tool, purpose for the continued existence of the organization. Goals are intentions behind decisions or actions. They are derived from mission
All embracing
Goals
General
Objectives
Specific
Objectives are goals expressed in form which can be measured. They provide direction and measure achievement Strategies are course of action using specified resources to achieve objectives
Strategy
Detailed targets
Tactics
Implementation Targets
Tactics are actions carried out to put into effect detailed strategy, and they change according to situations.
Action targets
They relate to individuals, short term and subject to immediate control.
Operational plans
Macroeconomic policy targets 1. 2. 3. 4.
Economic growth: increase in national income (disregarding inflation) Price Inflation: exports may become expensive, need to devalue currency Employment: Unemployment is low, period of unemployment is short Balance of Payment: imports exceeding exports may damage growth
Monetary Policy: rate of interest, money supply (for inflation, balance of payment, employment) Fiscal Policy: Government spending, taxation Prices and Income Policy: Inflation can be tackled by controlling prices Exchange Rate Policy: strength and weakness of country's currency External Trade Policy: Stimulating exports, import controls, protection of domestic industry
To increase jobs – increase growth – increase in demand – increase in imports – deficit in balance of payment – weaken currency – raise interest rate - raise cost of imports – price rise Fiscal
Policy: can be used to manage 'demand' Government spending is 'injection' in the economy Taxes are withdrawal from economy Increase government spending without raising tax – increase demand Decrease taxation and keep spending constant – increase demand Raising taxation (or decrease spending) – decrease demand Increase in aggregate demand (AD) – increase in sales for business Taxes – pass on to consumer – increase prices – decrease demand
Monetary and Interest Rate Policy: Increase in 'Money Supply' – increase in prices Increase credit lending – Lower interest rates – increase demand High interest rates – low borrowings – low demand – low sales
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www.ca.com.pk
Page 1
Paper F9
Haroon Tabraze Increase in interest rate – lower business profits – lower returns to shareholders – decrease share price Increase interest rate – low consumer borrowing – low demand (sales) High interest rate – high saving – low money supply – low disposable income High interest rate – high cost of production – high cost of exports
Exchange rate policy Low exchange rate – lower cost of exports – high exports Low exchange rate – high cost of imports – low imports Demand in economy – goods produced locally (which could be exported) and imports Full employment in country – output capacity stagnant – need for import Growth in money supply – interest rates – domestic inflation Trade deficit – fall in exchange rate Trade surplus – raise exchange rate (nominally) Exchange rate fluctuation – instability - exporters and importers face risk Fixed exchange rate – inflation may grow – export prices will become uncompetitive – trade deficit will grow Fixed exchange rate – increase interest rate – capital come into country – put pressure on exchange rate Floating exchange rate – to stabilize government buy / sell foreign currency Eliminating exchange rate risk 1. Buy currency in 'forward contracts' 2. deal in a stable foreign currency (dollar) 3. invoicing in domestic currency 4. outsource activities to local markets
Company's business may generate social costs i.e. pollution, environment etc. Regulation is interference of Government with the operations of free market, which may be through: Control of prices, or profits Control of emissions, pollution, banning smoking, and compulsory car insurance Influencing consumer choices (consumer societies) In many markets, participants may exercise self regulation (voluntarily), possibly to avert state regulation. Examples are professions of Law, Accounting and Audit Competition Policy Imperfect competition: where once company's large share dominates market, resulting in inefficient production, and excessive profits Monopoly: one firm, sole producer of good, operates without any close substitute In certain industries only monopoly will give company economies of scale (operating on a very large scale, and reducing costs) that minimize price Companies can impose higher prices, with excessive profits Company does not have incentive to improve its operations, nor utilize its resources for maximum benefit because of no competition
Haroon Tabraze
www.ca.com.pk
Page 2
Paper F9
Haroon Tabraze Cash Operating Cycle
Raw Materials / WIP R/M and Finished Goods remain in the inventory Finished Goods Customers take time to pay Accounts Receivable Suppliers are paid (Accounts Payable)
Average time raw materials remain in inventory Less: (Time taken to pay suppliers) Add: Time taken to produce goods Add: Time taken by customers to pay
= 1.0 month =(2.5 months) = 2.0 months = 1.5 months 2.0 months
A company is overcapitalized if it has excess working capital A company is overtrading; it is expanding quickly and has little capital
Current Assets: - Inventories - Accounts Receivable - Short term investment - Cash and Bank
Balance Sheet Current Liabilities: 120 - Loan & Overdraft 400 - Taxation 5 - Dividend Payable 50 - Accounts Payable 575
50 65 20 370 505
Profit & Loss Sales Cost of Sales Gross Profit
2,000 1,475 525
Notes: 1. Accounts Receivable include trade receivables of 330 2. Accounts Payable include trade payables of 235 3. There are no cash sales or purchases
Current Ratio =
Current Assets Current Liabilities A ratio of more than 1 is expected.
575 505
= 1.14
Current Assets – Inventory 455 Current Liabilities 505 Inventory cannot be quickly turned into cash (is not liquid asset)
= 0.90
Quick Ratio =
A/R payment Period =
Haroon Tabraze
Trade Receivable x 365 Credit Sale Turnover
www.ca.com.pk
330 x 365 2,000
= 60
Page 3
Paper F9
Haroon Tabraze
Question A1 a) Calculate Accounts Receivable Days if trade receivables are 63.29 million and total sales are 1,100 million, of which 60% are on credit. b) A factoring company has offered to bring the credit days to 25. What will be the level of Accounts Receivable? Question A2 Current sales are 600 million per annum (all payable in the month of sale). Variable cost of sales is 400 million per month. a) Will it be financially beneficial to increase the number of A/R days to 45 if sales show a corresponding increase of 25%? Cost of capital is 12% per annum. b) What will happen if a prompt payment discount of 5% is offered for payments within 10 days, on the estimation that 40% customers will avail the benefit? Question A3 Current sales are 750 million, of which 80% are on credit with a debtor's period of 30 days. A factor has offered to take over accounts receivable management at an annual fee of 0.5% of credit sales. The factor has claimed to reduce debtors by 30%; with a saving in administration costs of 12,500. The factor will advance 75% of the debtors balance at an interest rate of 8%. Current overdraft rate is 6%. Baumol Model
Miller Orr Model:
Q=
Spread = 3 (3/4 x transaction cost x cashflow variance)1/3 Interest rate
2CS i
Return point = lower limit + (1/3 x spread)
Question A4 (December 2005) Thorne Co values, advertises and sells residential property on behalf of its customers. The company has been in business for only a short time and is preparing a cash budget for the first four months of 2006. Expected sales of residential properties are as follows. 2005 2006 2006 2006 2006 Month December January February March April Units sold 10 10 15 25 30 The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the value of each property sold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after sale. The company has nine employees who are paid on a monthly basis. The average salary per employee is £35,000 per year. If more than 20 properties are sold in a given month, each employee is paid in that month a bonus of £140 for each additional property sold. Variable expenses are incurred at the rate of 0.5% of the value of each property sold and these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are paid in the month in which they arise. Thorne Co pays interest every three months on a loan of £200,000 at a rate of 6% per year. The last interest payment in each year is paid in December.
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Page 4
Paper F9
Haroon Tabraze
An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000. The cash balance at the start of January 2006 is expected to be a deficit of £40,000.
Required: (a)Prepare a monthly cash budget for the period from January to April 2006. Your budget must clearly indicate each item of income and expenditure, and the opening and closing monthly cash balances. (10 marks) (b)Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecast by its cash budgets. (5 marks) (c)Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cash shortages forecast by its cash budgets. (5 marks) (d)Explain how the Baumol model can be employed to reduce the costs of cash management and discuss whether the Baumol cash management model may be of assistance to Thorne Co for this purpose. (5 marks) Question A5 (June 2005) TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling price of £19 per unit and is purchased for £11 per unit from a supplier, MKR Co. TNG places an order for 50,000 units of product X at regular intervals throughout the year. Because the demand for product X is to some degree uncertain, TNG maintains a safety (buffer) stock of product X which is sufficient to meet demand for 28 working days. The cost of placing an order is £25 and the storage cost for Product X is 10 pence per unit per year. TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for cash settlement within 20 days. TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365 days. Required: (a)Calculate the annual cost of the current ordering policy. Ignore financing costs in this part of the question. (4 marks) (b)Calculate the annual saving if the economic order quantity model is used to determine an optimal ordering policy. Ignore financing costs in this part of the question. (5 marks) (c)Determine whether the discount offered by the supplier is financially acceptable to TNG Co. (4 marks) (d)Critically discuss the limitations of the economic order quantity model as a way of managing stock. (4 marks) (e)Discuss the advantages and disadvantages of using just-in-time stock management methods. (8 marks) Question A6 (Pilot paper) Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.
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Page 5
Paper F9
Haroon Tabraze
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay. Required: (a) Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co. (6 marks) (b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%. Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller- Orr model and explain the relevance of these values for the cash management of the company. (6 marks) (c) Identify and explain the key areas of accounts receivable management. (6 marks) (d) Discuss the key factors to be considered when formulating a working capital funding policy. (7 marks)
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Page 6
Paper F9
Haroon Tabraze
Question B1 A project has the following cash flows: Year Sales
1 60,000
2 75,000
3 90,000
4 120,000
5 150,000
Variable cost of sales are 40% of the selling price, and fixed costs are 15,000 per year. If the 1. 2. 3.
initial investment was 180,000 and Cost of capital is 9%, calculate for the project: Payback period ROCE NPV
Question B2 A project has the following cash flows: Year Sales
1 60,000
2 60,000
3 60,000
4 90,000
5 120,000
Variable cost of sales are 50% of the selling price, and fixed costs are 15,000 per year. A new machine with a cost of 90,000 (with a disposal proceed of 30,000 at end of year 5) may reduce the variable cost of sales by 10% (to 40% of sales). If the 1. 2. 3.
initial investment was 180,000 and Cost of capital is 9%, calculate for the machine: Payback period ROCE NPV
Question B3 A new machine generates the following cash flows: Year Sales
1 60,000
2 75,000
3 90,000
4 120,000
5 150,000
Direct Materials are 15%, Direct Labor is 10%, and Variable overheads are 20% of the selling price. Fixed costs are 15,000 per year. General Inflation is expected to be 7%. Cost of materials is likely to increase by 9%, while Labor costs will increase by 5%. Sales are in current price terms. If the cost of machine was 120,000, with a life of 5 years, and Cost of capital is 9%, calculate for the project: 1. Payback period 2. ROCE 3. NPV
IRR = a + NPVa (b-a) % NPVa - NPVb (1 + i) = (1+r) (1+h)
where r= real rate of interest, and h= rate of inflation
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Page 7
Paper F9
Haroon Tabraze
Question B4 A new machine is expected to produce: Year Sales (units)
1 600
2 750
3 900
4 1,200
5 1,500
Current Cost break-up per unit (today; before taking inflation) is: Direct material = 25 Direct labor = 20 Variable overhead = 20 Fixed costs are 15,000 per year. Selling price per unit is 100 per unit. General Inflation is expected to be 5%. Cost of materials is likely to increase by 9%, while Labor costs will increase by 10%. If the cost of machine was 80,000, with a life of 5 years, and Cost of capital is 9%, calculate NPV for the project (ignore taxation): Question B5 A new machine is expected to have the following savings: Year Savings
1 6,000
2 7,500
3 9,000
4 12,000
5 15,000
Cost of machine is 30,000 and it attracts 25% capital allowances every year, and will be disposed off at the end of year 5 at price of 15,000. Tax rate is 30%, payable in next year. Cost of capital is 9%, calculate NPV for the project (ignore inflation). Question B6 A new machine is expected to produce: Year Sales (units)
1 600
2 750
3 900
4 1,200
5 1,500
Current Cost break-up per unit (today; before taking inflation) is: Direct material = 20 Direct labor = 15 Variable overhead = 20 Fixed costs are 25,000 per year (including depreciation). Selling price per unit is 100 per unit. General Inflation is expected to be 10%. Cost of materials is likely to increase by 15%, while Labor costs will increase by 5%. Cost of machine was 80,000, with a life of 5 years, on which capital allowances can be claimed at a rate of 25% (no residual value at end of year 5). Cost of capital is 12%. Rate of tax is 30%. 1. Calculate NPV for the project. 2. The machine can be purchased with bank financing (available at rate of 15%). 3. The machine can be leased at an annual payment of 22,000 for five years.
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Paper F9
Haroon Tabraze
Question B7 You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The discount rate is 10 percent. Should you buy or lease? What is the maximum lease you would be willing to pay? (Ignore taxation and inflation) Question B8 Machines F and G are mutually exclusive and have the following investment and operating costs. Note that machine F lasts for only 2 years: Year F G
0 10,000 12,000
1 1,100 1,100
2 1,200 1,200
3 1,300
Calculate the equivalent annual cost of each investment using a discount rate of 10 %. Which machine is the better buy? Question B8 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. Number of sunny days Probability Scenario 1 100 03 Scenario 2 125 06 Scenario 3 150 01 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: £/unit Annual inflation Selling price 12 4% Variable production cost 4 5% Fixed production overhead cost 6 3% Fixed production overhead cost is based on expected first-year demand.
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Paper F9
Haroon Tabraze
Equivalent annual cost = PV of cost over one replacement cycle Annuity factor Question B7 You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The discount rate is 10 percent. Should you buy or lease? What is the maximum lease you would be willing to pay? (Ignore taxation and inflation) Question B8 Machines F and G are mutually exclusive and have the following investment and operating costs. Note that machine F lasts for only 2 years: Year F G
0 10,000 12,000
1 1,100 1,100
2 1,200 1,200
3 1,300
Calculate the equivalent annual cost of each investment using a discount rate of 10 %. Which machine is the better buy? Now suppose you have an existing machine. You can keep it going for 1 more year only, but it will cost 2,500 in repairs and 1,800 in operating costs. Is it worth replacing now with either F or G? Question B9 Initial investment = 25,000 Year 1 Running cost 7,500 Resale value 15,000
2 11,000 10,000
3 12,500 7,500
4 15,000 2,500
Cost of capital is 10%. How frequently the machine should be replaced. Question B10 You are operating an old machine that will last 2 more years before it gives up the ghost. It costs $12,000 per year to operate. You can replace it now with a new machine, which costs $25,000 but is much more efficient ($8,000 per year in operating costs) and will last for 5 years. Should you replace it now or wait a year? The opportunity cost of capital is 6 percent. Profitability index = Net Present Value Investment Question B11 Opportunity cost of capital is 10 percent, and the Company has total resources of 20,000. It is presented with the following project proposals Year Project L Project M Project N Project O Project P
0 3,000 5,000 7,000 6,000 4,000
1 2,200 2,200 6,600 3,300 1,100
2 2,420 4,840 4,840 6,050 4,840
Which projects to choose for investment?
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Page 10
Paper F9
Haroon Tabraze
Sources of Finance: Overdraft • Interest payable only when overdrawn • Bank can increase / decrease facility limit • Repayable on demand
• • •
(Short / Long) Term loan Interest payable for the loan term Loan amount is fixed and is disbursed at start of the term Repayable on maturity period of term
Question C1 What is the annual repayment of a 7 year loan of $30,000 at interest of 9%? Reasons for seeking Debt: Company does not want to issue equity because: 1. Current shareholders may be unwilling to contribute additional equity 2. New equity investors may put in extra requirements (seat on BOD) 3. Cost of raising equity is higher than issuing debt 4. Interest payable is a tax deductible item Long term debt issued is called Loan notes, debentures or bonds Interest on debt is called coupon rate Question C2 What is the present value of a 10% bond issued at $100 (par value) and redeemable after 7 years at par value. Cost of capital is 8%. Question C3 A 10% bond is issued at $90 (par value of $100) and is redeemable after 7 years at par value. What is the present value if: 1. Cost of capital is 8%? 2. Cost of capital is 12%? Question C4 What is the present value of a 2% bond issued at $60 (par value of $100) and redeemable after 7 years at par value. Cost of capital is 8%. Question C5 What is the present value of a zero coupon bond issued at $40 (par value of $100) and redeemable after 7 years at par value. Cost of capital is 8%. Question C6 Flick plc is to issue 10% convertible loan notes at par value of $100. The earliest date of conversion is after four years, at a rate of 2 shares for each $100 loan note. Cost of capital is 12%. What should be the minimum market value of shares after four years for conversion to be acceptable? Question C7 Flick plc is to issue 6% convertible loan notes at $75 (par value $100). The earliest date of conversion is after four years, at a rate of 5 shares for each $100 loan note. Cost of capital is 12%. 1. What should be the minimum market value of shares after four years for conversion to be acceptable? 2. Alternately, loan notes could be redeemed at par value. What is the current market value of loan notes, assuming estimated market value of shares of Flick plc at end of four years will be $15 per share? 3. What will be the present market value of loan notes if the estimate market value of shares of Flick plc at end of four years will be $25 per share?
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Page 11
Haroon Tabraze
Macroeconomic policy involves: Objectives: aim of economic policy Targets: quantified levels of Policy instruments: Tools used to achieve objectives Mission
Mission statement is description of prevailing culture of organization. It is a strategic tool, purpose for the continued existence of the organization. Goals are intentions behind decisions or actions. They are derived from mission
All embracing
Goals
General
Objectives
Specific
Objectives are goals expressed in form which can be measured. They provide direction and measure achievement Strategies are course of action using specified resources to achieve objectives
Strategy
Detailed targets
Tactics
Implementation Targets
Tactics are actions carried out to put into effect detailed strategy, and they change according to situations.
Action targets
They relate to individuals, short term and subject to immediate control.
Operational plans
Macroeconomic policy targets 1. 2. 3. 4.
Economic growth: increase in national income (disregarding inflation) Price Inflation: exports may become expensive, need to devalue currency Employment: Unemployment is low, period of unemployment is short Balance of Payment: imports exceeding exports may damage growth
Monetary Policy: rate of interest, money supply (for inflation, balance of payment, employment) Fiscal Policy: Government spending, taxation Prices and Income Policy: Inflation can be tackled by controlling prices Exchange Rate Policy: strength and weakness of country's currency External Trade Policy: Stimulating exports, import controls, protection of domestic industry
To increase jobs – increase growth – increase in demand – increase in imports – deficit in balance of payment – weaken currency – raise interest rate - raise cost of imports – price rise Fiscal
Policy: can be used to manage 'demand' Government spending is 'injection' in the economy Taxes are withdrawal from economy Increase government spending without raising tax – increase demand Decrease taxation and keep spending constant – increase demand Raising taxation (or decrease spending) – decrease demand Increase in aggregate demand (AD) – increase in sales for business Taxes – pass on to consumer – increase prices – decrease demand
Monetary and Interest Rate Policy: Increase in 'Money Supply' – increase in prices Increase credit lending – Lower interest rates – increase demand High interest rates – low borrowings – low demand – low sales
Haroon Tabraze
www.ca.com.pk
Page 1
Paper F9
Haroon Tabraze Increase in interest rate – lower business profits – lower returns to shareholders – decrease share price Increase interest rate – low consumer borrowing – low demand (sales) High interest rate – high saving – low money supply – low disposable income High interest rate – high cost of production – high cost of exports
Exchange rate policy Low exchange rate – lower cost of exports – high exports Low exchange rate – high cost of imports – low imports Demand in economy – goods produced locally (which could be exported) and imports Full employment in country – output capacity stagnant – need for import Growth in money supply – interest rates – domestic inflation Trade deficit – fall in exchange rate Trade surplus – raise exchange rate (nominally) Exchange rate fluctuation – instability - exporters and importers face risk Fixed exchange rate – inflation may grow – export prices will become uncompetitive – trade deficit will grow Fixed exchange rate – increase interest rate – capital come into country – put pressure on exchange rate Floating exchange rate – to stabilize government buy / sell foreign currency Eliminating exchange rate risk 1. Buy currency in 'forward contracts' 2. deal in a stable foreign currency (dollar) 3. invoicing in domestic currency 4. outsource activities to local markets
Company's business may generate social costs i.e. pollution, environment etc. Regulation is interference of Government with the operations of free market, which may be through: Control of prices, or profits Control of emissions, pollution, banning smoking, and compulsory car insurance Influencing consumer choices (consumer societies) In many markets, participants may exercise self regulation (voluntarily), possibly to avert state regulation. Examples are professions of Law, Accounting and Audit Competition Policy Imperfect competition: where once company's large share dominates market, resulting in inefficient production, and excessive profits Monopoly: one firm, sole producer of good, operates without any close substitute In certain industries only monopoly will give company economies of scale (operating on a very large scale, and reducing costs) that minimize price Companies can impose higher prices, with excessive profits Company does not have incentive to improve its operations, nor utilize its resources for maximum benefit because of no competition
Haroon Tabraze
www.ca.com.pk
Page 2
Paper F9
Haroon Tabraze Cash Operating Cycle
Raw Materials / WIP R/M and Finished Goods remain in the inventory Finished Goods Customers take time to pay Accounts Receivable Suppliers are paid (Accounts Payable)
Average time raw materials remain in inventory Less: (Time taken to pay suppliers) Add: Time taken to produce goods Add: Time taken by customers to pay
= 1.0 month =(2.5 months) = 2.0 months = 1.5 months 2.0 months
A company is overcapitalized if it has excess working capital A company is overtrading; it is expanding quickly and has little capital
Current Assets: - Inventories - Accounts Receivable - Short term investment - Cash and Bank
Balance Sheet Current Liabilities: 120 - Loan & Overdraft 400 - Taxation 5 - Dividend Payable 50 - Accounts Payable 575
50 65 20 370 505
Profit & Loss Sales Cost of Sales Gross Profit
2,000 1,475 525
Notes: 1. Accounts Receivable include trade receivables of 330 2. Accounts Payable include trade payables of 235 3. There are no cash sales or purchases
Current Ratio =
Current Assets Current Liabilities A ratio of more than 1 is expected.
575 505
= 1.14
Current Assets – Inventory 455 Current Liabilities 505 Inventory cannot be quickly turned into cash (is not liquid asset)
= 0.90
Quick Ratio =
A/R payment Period =
Haroon Tabraze
Trade Receivable x 365 Credit Sale Turnover
www.ca.com.pk
330 x 365 2,000
= 60
Page 3
Paper F9
Haroon Tabraze
Question A1 a) Calculate Accounts Receivable Days if trade receivables are 63.29 million and total sales are 1,100 million, of which 60% are on credit. b) A factoring company has offered to bring the credit days to 25. What will be the level of Accounts Receivable? Question A2 Current sales are 600 million per annum (all payable in the month of sale). Variable cost of sales is 400 million per month. a) Will it be financially beneficial to increase the number of A/R days to 45 if sales show a corresponding increase of 25%? Cost of capital is 12% per annum. b) What will happen if a prompt payment discount of 5% is offered for payments within 10 days, on the estimation that 40% customers will avail the benefit? Question A3 Current sales are 750 million, of which 80% are on credit with a debtor's period of 30 days. A factor has offered to take over accounts receivable management at an annual fee of 0.5% of credit sales. The factor has claimed to reduce debtors by 30%; with a saving in administration costs of 12,500. The factor will advance 75% of the debtors balance at an interest rate of 8%. Current overdraft rate is 6%. Baumol Model
Miller Orr Model:
Q=
Spread = 3 (3/4 x transaction cost x cashflow variance)1/3 Interest rate
2CS i
Return point = lower limit + (1/3 x spread)
Question A4 (December 2005) Thorne Co values, advertises and sells residential property on behalf of its customers. The company has been in business for only a short time and is preparing a cash budget for the first four months of 2006. Expected sales of residential properties are as follows. 2005 2006 2006 2006 2006 Month December January February March April Units sold 10 10 15 25 30 The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the value of each property sold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after sale. The company has nine employees who are paid on a monthly basis. The average salary per employee is £35,000 per year. If more than 20 properties are sold in a given month, each employee is paid in that month a bonus of £140 for each additional property sold. Variable expenses are incurred at the rate of 0.5% of the value of each property sold and these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are paid in the month in which they arise. Thorne Co pays interest every three months on a loan of £200,000 at a rate of 6% per year. The last interest payment in each year is paid in December.
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Page 4
Paper F9
Haroon Tabraze
An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000. The cash balance at the start of January 2006 is expected to be a deficit of £40,000.
Required: (a)Prepare a monthly cash budget for the period from January to April 2006. Your budget must clearly indicate each item of income and expenditure, and the opening and closing monthly cash balances. (10 marks) (b)Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecast by its cash budgets. (5 marks) (c)Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cash shortages forecast by its cash budgets. (5 marks) (d)Explain how the Baumol model can be employed to reduce the costs of cash management and discuss whether the Baumol cash management model may be of assistance to Thorne Co for this purpose. (5 marks) Question A5 (June 2005) TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling price of £19 per unit and is purchased for £11 per unit from a supplier, MKR Co. TNG places an order for 50,000 units of product X at regular intervals throughout the year. Because the demand for product X is to some degree uncertain, TNG maintains a safety (buffer) stock of product X which is sufficient to meet demand for 28 working days. The cost of placing an order is £25 and the storage cost for Product X is 10 pence per unit per year. TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for cash settlement within 20 days. TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365 days. Required: (a)Calculate the annual cost of the current ordering policy. Ignore financing costs in this part of the question. (4 marks) (b)Calculate the annual saving if the economic order quantity model is used to determine an optimal ordering policy. Ignore financing costs in this part of the question. (5 marks) (c)Determine whether the discount offered by the supplier is financially acceptable to TNG Co. (4 marks) (d)Critically discuss the limitations of the economic order quantity model as a way of managing stock. (4 marks) (e)Discuss the advantages and disadvantages of using just-in-time stock management methods. (8 marks) Question A6 (Pilot paper) Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers on average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%.
Haroon Tabraze
www.ca.com.pk
Page 5
Paper F9
Haroon Tabraze
Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay. Required: (a) Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co. (6 marks) (b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%. Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller- Orr model and explain the relevance of these values for the cash management of the company. (6 marks) (c) Identify and explain the key areas of accounts receivable management. (6 marks) (d) Discuss the key factors to be considered when formulating a working capital funding policy. (7 marks)
Haroon Tabraze
www.ca.com.pk
Page 6
Paper F9
Haroon Tabraze
Question B1 A project has the following cash flows: Year Sales
1 60,000
2 75,000
3 90,000
4 120,000
5 150,000
Variable cost of sales are 40% of the selling price, and fixed costs are 15,000 per year. If the 1. 2. 3.
initial investment was 180,000 and Cost of capital is 9%, calculate for the project: Payback period ROCE NPV
Question B2 A project has the following cash flows: Year Sales
1 60,000
2 60,000
3 60,000
4 90,000
5 120,000
Variable cost of sales are 50% of the selling price, and fixed costs are 15,000 per year. A new machine with a cost of 90,000 (with a disposal proceed of 30,000 at end of year 5) may reduce the variable cost of sales by 10% (to 40% of sales). If the 1. 2. 3.
initial investment was 180,000 and Cost of capital is 9%, calculate for the machine: Payback period ROCE NPV
Question B3 A new machine generates the following cash flows: Year Sales
1 60,000
2 75,000
3 90,000
4 120,000
5 150,000
Direct Materials are 15%, Direct Labor is 10%, and Variable overheads are 20% of the selling price. Fixed costs are 15,000 per year. General Inflation is expected to be 7%. Cost of materials is likely to increase by 9%, while Labor costs will increase by 5%. Sales are in current price terms. If the cost of machine was 120,000, with a life of 5 years, and Cost of capital is 9%, calculate for the project: 1. Payback period 2. ROCE 3. NPV
IRR = a + NPVa (b-a) % NPVa - NPVb (1 + i) = (1+r) (1+h)
where r= real rate of interest, and h= rate of inflation
Haroon Tabraze
www.ca.com.pk
Page 7
Paper F9
Haroon Tabraze
Question B4 A new machine is expected to produce: Year Sales (units)
1 600
2 750
3 900
4 1,200
5 1,500
Current Cost break-up per unit (today; before taking inflation) is: Direct material = 25 Direct labor = 20 Variable overhead = 20 Fixed costs are 15,000 per year. Selling price per unit is 100 per unit. General Inflation is expected to be 5%. Cost of materials is likely to increase by 9%, while Labor costs will increase by 10%. If the cost of machine was 80,000, with a life of 5 years, and Cost of capital is 9%, calculate NPV for the project (ignore taxation): Question B5 A new machine is expected to have the following savings: Year Savings
1 6,000
2 7,500
3 9,000
4 12,000
5 15,000
Cost of machine is 30,000 and it attracts 25% capital allowances every year, and will be disposed off at the end of year 5 at price of 15,000. Tax rate is 30%, payable in next year. Cost of capital is 9%, calculate NPV for the project (ignore inflation). Question B6 A new machine is expected to produce: Year Sales (units)
1 600
2 750
3 900
4 1,200
5 1,500
Current Cost break-up per unit (today; before taking inflation) is: Direct material = 20 Direct labor = 15 Variable overhead = 20 Fixed costs are 25,000 per year (including depreciation). Selling price per unit is 100 per unit. General Inflation is expected to be 10%. Cost of materials is likely to increase by 15%, while Labor costs will increase by 5%. Cost of machine was 80,000, with a life of 5 years, on which capital allowances can be claimed at a rate of 25% (no residual value at end of year 5). Cost of capital is 12%. Rate of tax is 30%. 1. Calculate NPV for the project. 2. The machine can be purchased with bank financing (available at rate of 15%). 3. The machine can be leased at an annual payment of 22,000 for five years.
Haroon Tabraze
www.ca.com.pk
Page 8
Paper F9
Haroon Tabraze
Question B7 You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The discount rate is 10 percent. Should you buy or lease? What is the maximum lease you would be willing to pay? (Ignore taxation and inflation) Question B8 Machines F and G are mutually exclusive and have the following investment and operating costs. Note that machine F lasts for only 2 years: Year F G
0 10,000 12,000
1 1,100 1,100
2 1,200 1,200
3 1,300
Calculate the equivalent annual cost of each investment using a discount rate of 10 %. Which machine is the better buy? Question B8 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. Number of sunny days Probability Scenario 1 100 03 Scenario 2 125 06 Scenario 3 150 01 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: £/unit Annual inflation Selling price 12 4% Variable production cost 4 5% Fixed production overhead cost 6 3% Fixed production overhead cost is based on expected first-year demand.
Haroon Tabraze
www.ca.com.pk
Page 9
Paper F9
Haroon Tabraze
Equivalent annual cost = PV of cost over one replacement cycle Annuity factor Question B7 You need a new car. You can either purchase one outright for $15,000 or lease one for 7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The discount rate is 10 percent. Should you buy or lease? What is the maximum lease you would be willing to pay? (Ignore taxation and inflation) Question B8 Machines F and G are mutually exclusive and have the following investment and operating costs. Note that machine F lasts for only 2 years: Year F G
0 10,000 12,000
1 1,100 1,100
2 1,200 1,200
3 1,300
Calculate the equivalent annual cost of each investment using a discount rate of 10 %. Which machine is the better buy? Now suppose you have an existing machine. You can keep it going for 1 more year only, but it will cost 2,500 in repairs and 1,800 in operating costs. Is it worth replacing now with either F or G? Question B9 Initial investment = 25,000 Year 1 Running cost 7,500 Resale value 15,000
2 11,000 10,000
3 12,500 7,500
4 15,000 2,500
Cost of capital is 10%. How frequently the machine should be replaced. Question B10 You are operating an old machine that will last 2 more years before it gives up the ghost. It costs $12,000 per year to operate. You can replace it now with a new machine, which costs $25,000 but is much more efficient ($8,000 per year in operating costs) and will last for 5 years. Should you replace it now or wait a year? The opportunity cost of capital is 6 percent. Profitability index = Net Present Value Investment Question B11 Opportunity cost of capital is 10 percent, and the Company has total resources of 20,000. It is presented with the following project proposals Year Project L Project M Project N Project O Project P
0 3,000 5,000 7,000 6,000 4,000
1 2,200 2,200 6,600 3,300 1,100
2 2,420 4,840 4,840 6,050 4,840
Which projects to choose for investment?
Haroon Tabraze
www.ca.com.pk
Page 10
Paper F9
Haroon Tabraze
Sources of Finance: Overdraft • Interest payable only when overdrawn • Bank can increase / decrease facility limit • Repayable on demand
• • •
(Short / Long) Term loan Interest payable for the loan term Loan amount is fixed and is disbursed at start of the term Repayable on maturity period of term
Question C1 What is the annual repayment of a 7 year loan of $30,000 at interest of 9%? Reasons for seeking Debt: Company does not want to issue equity because: 1. Current shareholders may be unwilling to contribute additional equity 2. New equity investors may put in extra requirements (seat on BOD) 3. Cost of raising equity is higher than issuing debt 4. Interest payable is a tax deductible item Long term debt issued is called Loan notes, debentures or bonds Interest on debt is called coupon rate Question C2 What is the present value of a 10% bond issued at $100 (par value) and redeemable after 7 years at par value. Cost of capital is 8%. Question C3 A 10% bond is issued at $90 (par value of $100) and is redeemable after 7 years at par value. What is the present value if: 1. Cost of capital is 8%? 2. Cost of capital is 12%? Question C4 What is the present value of a 2% bond issued at $60 (par value of $100) and redeemable after 7 years at par value. Cost of capital is 8%. Question C5 What is the present value of a zero coupon bond issued at $40 (par value of $100) and redeemable after 7 years at par value. Cost of capital is 8%. Question C6 Flick plc is to issue 10% convertible loan notes at par value of $100. The earliest date of conversion is after four years, at a rate of 2 shares for each $100 loan note. Cost of capital is 12%. What should be the minimum market value of shares after four years for conversion to be acceptable? Question C7 Flick plc is to issue 6% convertible loan notes at $75 (par value $100). The earliest date of conversion is after four years, at a rate of 5 shares for each $100 loan note. Cost of capital is 12%. 1. What should be the minimum market value of shares after four years for conversion to be acceptable? 2. Alternately, loan notes could be redeemed at par value. What is the current market value of loan notes, assuming estimated market value of shares of Flick plc at end of four years will be $15 per share? 3. What will be the present market value of loan notes if the estimate market value of shares of Flick plc at end of four years will be $25 per share?
Haroon Tabraze
www.ca.com.pk
Page 11
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