acca f9 interim assessment answers june11

ACCA

Paper F9

Financial Management

June 2011

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.

ACCA F9 FINANCIAL MANAGEMENT

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2010

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INTERIM ASSESSMENT ANSWERS

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1

Key answer tips

Part (a): To evaluate lease v buy the examiner’s preferred approach is to perform two separate calculations. A combined approach will also gain credit but be careful of the signs of cash flows.

In part (b) the key is to recognise that there will be ten payments with an interest rate of 5% per six months.

In part (c) ensure you cover both the explanation of what causes the differences in objectives as well as the potential conflicts. The highlighted words are key phrases that markers are looking for.

(a)

Tutorial note:

Particular care is needed regarding the timing of the cash flows. The asset would be bought on the first day of a new accounting period and, in this question, the tax flows are paid one year in arrears. When evaluating the leasing option remember that the lease payments are in made advance.

Borrowing to buy evaluation

Year 0 Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 $000

Purchase and sale (320) 50 Capital allowance tax benefits 24 18 39 Maintenance costs (25) (25) (25) Maintenance cost tax benefits 8 8 8 ––––– –––––– –––––– –––––– –––––– Net cash flow (320) (25) 7 51 47 Discount factors (7%) 1.000 0.935 0.873 0.816 0.763 ––––– –––––– –––––– –––––– –––––– Present values (320) (23) 6 42 36 ––––– –––––– –––––– –––––– –––––– PV of borrowing to buy = –$259,000

Workings: Capital allowance tax benefits

Year Capital allowance Tax benefit Timing

1 320,000 × 0.25 = 80,000 80,000 × 0.3 = 24,000 Year 2

2 80,000 × 0.75 = 60,000 60,000 × 0.3 = 18,000 Year 3

3 Balancing allowance =130,000 130,000 × 0.3 = 39,000 Year 4

Balancing allowance = (320,000 – 50,000) – (80,000 + 60,000) = $130,000


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Leasing evaluation Year 0 Year 1 Year 2 Year 3 Year 4 $000 $000 $000 $000 $000 Lease rentals (120) (120) (120) Lease rental tax benefits 36 36 36 ––––– ––––– ––––– ––––– ––––– Net cash flow (120) (120) (84) 36 36 Discount factors (7%) 1.000 0.935 0.873 0.816 0.763 ––––– ––––– ––––– ––––– ––––– Present values (120) (112) (73) 29 27 ––––– ––––– ––––– ––––– ––––– PV of leasing = –$249,000

On financial grounds, leasing is to be preferred as it is cheaper by $10,000. Note that the first lease rental is taken as being paid at year 0 as it is paid in the first month of the first year of operation.

Tutorial note:

An alternative form of evaluation combines the cash flows of the above two evaluations. Because this evaluation is more complex, it is more likely to lead to computational errors.

Combined evaluation

Year 0 Year 1 Year 2 Year 3 Year 4

$000 $000 $000 $000 $000

Purchase and sale (320) 50

Capital allowance tax benefits 24 18 39

Maintenance costs (25) (25) (25)

Maintenance cost tax benefits 8 8 8

Lease rentals saved 120 120 120

Lease rental tax benefits lost (36) (36) (36)

––––– ––––– ––––– ––––– –––––

Net cash flow (200) 95 91 15 11

Discount factors (7%) 1.000 0.935 0.873 0.816 0.763

––––– ––––– ––––– ––––– –––––

Present values (200) 89 79 12 8

––––– ––––– ––––– ––––– –––––

The PV of –$12,000 indicates that leasing would be $12,000 cheaper than borrowing. The difference between this and the previous evaluation is due to rounding.

(b) (i) The offer of 10% per year with interest payable every six months means that the bank will require 5% every six months. This is equivalent to an annual percentage rate of 10.25% (100 × (1.052 – 1)) before tax.

OR

1 + annual rate = (1 + six monthly rate)2 = 1.052 = 1.1025


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(ii) To calculate the repayment schedule use:

PV of repayments = PV of amount borrowed

Here we have a simple annuity, so

Instalment (A) × annuity factor = 320,000

where we want an annuity discount factor for ten payments and a rate of 5%.

Using annuity tables: A = 320,000/7.722 = $41,440

(c) It may be argued that managers and owners of a business may not have the same interests because of the divorce between ownership and control. In many organisations, the shareholders will have very little influence over the day to day operations and management of the business. Managers will be aware of the need to seek to increase the wealth of the shareholders, but at the same time they may be equally concerned to serve their own needs/interests. For example, shareholders may be highly risk averse, looking only for reasonable and steady income from their investment. By contrast, a manager may by nature be more of a risk taker, because he considers that his career may progress faster if he is successful in the risks taken. In such a scenario, if the manager follows his instincts in selecting business opportunities, then the shareholders objectives are not met. The reverse situation may be equally true, whereby shareholders believe that management are excessively cautious in their selection of business opportunities, but management are very wary of taking risks as they wish to avoid large scale losses which might threaten their personal position. In both instances there is a gulf between the objectives of the manager and owners.

Another example of where objectives might conflict is in the case of mergers and takeovers. If a company has been reporting poor results and becomes the victim of a take-over bid, the shareholders are likely to be pleased as they will see an increase in the value of their investment. In contrast, the managers of the victim company may well be very unhappy, as they sense the risk of redundancy.

Williamson suggested that many of the aims of managers actually work in direct conflict with those of the owners, because managers look for perquisites and self aggrandisement, which add to company costs. Shareholders may be happy if the managers owned Ford Mondeos for company cars. The managers may well seek to have Mercedes instead! Similarly, having a large office and many staff to supervise is good for a manger’s self esteem, but they may not be essential to the efficient running of the business; owners may be better off without them.

One key area where owner-manager objectives may conflict is in terms of the time horizon used to judge success. Owners are often looking long-term in setting their objectives whereas a manager may need to have short-term successes on order to further his/her career prospects.


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ACCA marking scheme Marks (a) Purchase price 0.5 Sales proceeds 0.5 Capital allowances 1 Balancing allowance 1 Capital allowance tax benefits 1.5 Maintenance costs 1 Maintenance costs tax benefits 1 Discount factors 0.5 NPV of borrowing to buy 1 Lease rentals 1 Lease rentals tax benefits 1 NPV of leasing 1 Selection of cheapest option 1

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12 (b) Annual percentage rate 2 Amount of equal installments 3

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5 (c) Separation of ownership and control 2 Importance of different time horizons 1 Importance of different attitudes to risk 2 Examples of potential conflicts 1 mark each maximum of 3 3

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8 –––

Total 25 –––


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2

Key answer tips

This is a very typical style question in the key examinable area of working capital management. The detailed requirements mean you can choose which areas to tackle first. Parts (c), (d) & (e) are stand alone sections that could be attempted first in order to get capture some of the easier marks early within your answer. The highlighted words are key phrases that markers are looking for.

(a)

Tutor’s top tips:

From the information provided, it is clear that two EOQ calculations.are required. The holding cost may be difficult to spot. Remember, in the formula, CH is the cost of holding one item of inventory for one year. This should signal that the percentage provided in the question needs to be applied to the price per item of inventory.

Currently: D = 20,000 CO = $31.25 CH = 20% × $6.25 = $1.25

EOQ = 1.25

20,00031.252 ×× = 1,000

Revised: CO = $120 CH = 20% × $6 = $1.20

EOQ = 1.20

20,0001202 ×× = 2,000

The new system will double the EOQ.

(b)

Tutor’s top tips:

For the proposed changes to be worth implementing, the total cost of the new system must be less than the current system. To tackle this part of the requirement you must start by figuring out how much less. You can then compare this to the initial investment to calculate the payback.


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Current cost:

$

Ordering cost = $31.25 × 1,00020,000

= 625

Holding cost = $1.25 × 2

1,000 = 625

Purchasing cost = $6.25 × 20,000 = 125,000 ______

TOTAL 126,250 ______

Revised cost:

$

Ordering cost = $120 × 2,000

20,000 = 1,200

Holding cost = $1.20 × 2

2,000 = 1,200

Purchasing cost = $6.00 × 20,000 = 120,000 ______

TOTAL 122,400 ______

Annual saving = $126,250 − $122,400 = $3,850

Initial investment = $10,000

Payback period = $10,000/$3,850 = 2.6 years, or 2 years and 7 months

The payback period is quite short, so from a financial viewpoint it is worth changing to the new system.

(c)

Tutor’s top tips:

To “discuss suitability” means that both benefits and drawbacks should be explored. Your points can be lifted straight out of your.text book although the requirement to “discuss” implies more than just a list is needed.

The benefits of using the payback period for project evaluation are as follows:

• It is simple to calculate and communicate. This is a significant advantage if a company lacks resources for more extensive analysis or if results are to be communicated to non-experts.

• For companies facing adverse cash flow conditions, it represents a way of selecting projects that will quickly generate positive cash flow.

• All other things being equal, the return on shorter-term projects is more certain than that on longer-term projects because market conditions are more likely to remain stable over the shorter term.


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• It is useful as a second appraisal technique when using the NPV criteria, as a way of taking into account the risk of a project. For example, only undertake investments with a positive NPV and a payback period quicker than three years (say).

The limitations of the payback period include the following points:

• It does not take into account the time value of money, although of course it is possible to calculate the discounted payback period.

• Cash flows occurring after the payback period are ignored

• Project profitability cannot be assessed.

(d)

Tutor’s top tips:

The requirement to “explain” means each benefit you identify must be justified as to why it is a benefit. For 5 marks you should aim for at least 3 good points.

JIT inventory management is about the reduction and possibly the elimination of all forms of inventory (raw material, WIP and finished goods).

By holding little or no inventory, huge savings may be made in the form of holding costs. These costs include the storage costs for the inventory, deterioration, etc as well as the interest cost of holding inventory.

In a JIT system, raw material inventory is delivered straight to the factory rather than going into a warehouse to await being needed in the factory. A JIT system will also often mean a change in factory layout, reducing the amount of WIP inventory. In addition, items are not produced for inventory, but for customer demand. This means that, as soon as production is complete, the items will be delivered to the customer, eliminating finished good inventory.

All of this reduction in inventory can hugely reduce the storage space required, leading to large savings in terms of warehousing, storekeepers’ wages, insurance, etc. The other big advantage is that less cash is tied up in inventory, resulting in often fairly substantial savings in interest.

JIT necessitates a close working relationship with the supplier of raw materials. The purchaser requires guarantees on both quality and reliability of delivery from the supplier in order to avoid disruptions to production. In return for these commitments, the supplier can benefit from long-term purchase agreements, since a company adopting JIT purchasing methods will concentrate on dealing with those suppliers who are able to offer goods of the required quality at the right time.


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(e)

Tutor’s top tips:

The requirement to “identify” means just listing or stating your points will be sufficient. The options are really just common sense and this part should therefore provide some easy marks.

When faced with cash flow shortages, a company may consider one or more of a number of possible remedies:

• Postpone non-essential capital expenditure.

• Offer discounts for early payment by debtors.

• Chase overdue accounts.

• Use the services of a factor.

• Use invoice discounting.

• Sell any cash investments.

• Delay payment to creditors.

• Reschedule loan repayment.

• Reduce dividend payments (this, though, could be taken as a sign of financial weakness).

ACCA marking scheme Marks (a) Each EOQ 1½ marks × 2 3 (b) Current cost 2 Revised cost 2 Payback period 1 Comment 1

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6 (c) 1–2 marks for each valid point 6 (d) 1–2 marks for each valid point 5 (e) 1–2 marks for each valid point 5

––– Total 25

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3

Key answer tips

Tackling this question requires a methodical and logical approach. The requirements must be attempted in the order given. It is an excellent test of your understanding on the key investment appraisal topic. The highlighted words are key phrases that markers are looking for.

(a)

Tutor’s top tips:

A careful read of the question is essential. For example, the increases in maintenance payments only occur after the first payment (which will be made at the end of the first year of the project i.e. T1). This could easily have been mis-interpretted. Writing down the timescales is a good way of ensuring you have everything clear in your mind.

With so many calculations, be careful to layout your workings neatly and cross reference fully where applicable.

Let Jan 1 20X5 = Year 0, Dec 31 20X5 = Year 1, Dec 31 20X6 = Year 2, etc.

Replace the machine:

Year Capital cost and maintenance

Contribution Net cash flow

Cumulative inflows

$ $ $

0 45,000 (45,000)

1 2,500 15,000 12,500 12,500

2 2,500 × 1.075 = 2,687 17,000 14,313 26,813

3 2,500 × 1.0752 = 2,889 19,000 16,111 42,924

4 2,500 × 1.0753 = 3,106 21,000 17,895 61,819

5 2,500 × 1.0754 = 3,339 22,000 18,661

Payback period = 3 years + 17,895

42,92445,000 − × 12 months = 3 years 1 month

Overhaul the machine:

Tutorial note:

An inflation index is just another way of presenting inflation rates. Rather than report the annual inflation rate for each year, an index is provided which shows how prices in that year relate to the ‘base’ year (the year where the index has been set to 100). This method of presentation actually makes your calculations in the exam a little easier.



Year Capital cost and maintenance

Contribution Net cash flow

Cumulative inflows

$ $ $

0 27,500 (27,500)

1 4,000 13,000 9,000 9,000

2 4,000 1.105 = 4,420 14,500 10,080 19,080

3 4,000 1.221 = 4,884 15,500 10,616 29,696

4 4,000 1.349 = 5,396 16,000 10,604

5 4,000 1.491 = 5,964 16,000 10,036

Tutorial note:

An alternative layout would be to calculate net cumulative cash flows (i.e including the outflow in year 0). This would be perfectly acceptable.

Payback period = 2 years + 10,616

19,08027,500 − × 12 months = 2 years 10 months

(b)

Replace the machine Overhaul the machine Year Discount factor

(12%) Net

cash flow Present value

Net cash flow

Present value

$ $ $ $

0 1.000 (45,000) (45,000) (27,500) (27,500)

1 0.893 12,500 11,163 9,000 8,037

2 0.797 14,313 11,408 10,080 8,034

3 0.712 16,111 11,471 10,616 7,559

4 0.636 17,895 11,381 10,604 6,744

5 0.567 18,661 10,581 10,036 5,690

11,004 8,564

Tutor’s top tips:

The above shows a really efficient layout for your workings since it minimises the number of times you need to copy down information relating to the discount factors.



(c)

Replace the machine Overhaul the machine Year Discount factor

(20%) Net cash

flow Present value

Net cash flow

Present value

$ $ $ $

0 1.000 (45,000) (45,000) (27,500) (27,500)

1 0.833 12,500 10,413 9,000 7,497

2 0.694 14,313 9,933 10,080 6,996

3 0.579 16,111 9,328 10,616 6,146

4 0.482 17,895 8,625 10,604 5,111

5 0.402 18,661 7,502 10,036 4,034

801 2,284

IRR of replacement = 12 + 80111,004

11,004−

× (20 − 12) = 12 + 8.6 = 20.6%

IRR of overhaul = 12 + 2,2848,564

8,564−

× (20 − 12) = 12 + 10.9 = 22.9%

Tutor’s top tips:

Don’t forget, the IRR formula is not supplied in the exam so you will need to memorise it.

Tutorial note:

20% is not the only possible discount factor to use here; any value over 12% is acceptable. The IRR may differ slightly, but should not be significantly different if alternative values are used.

(d)

Tutor’s top tips:

This part of the question is just about clearly stating what all of your calculations mean and why.

All three methods of investment appraisal use relevant cash flows to appraise the alternative investments.

The payback period calculates the time taken to pay back the initial investment. Using this criterion, overhauling the machine is the better option, with the slightly lower payback period.



The net present value takes into account the time value of money. It is the profit in present value terms. If the cost of capital is 12%, the machine should be replaced, since this option has the higher NPV.

The internal rate of return is the percentage return on the investment, taking into account the time value of money. The higher the return, the better. Overhauling the current machine has a higher IRR and so should be chosen using this appraisal technique.

Overall, to maximise shareholder wealth, the project with the highest NPV should be chosen which means that, provided the outcomes are not risky and 12% is the appropriate cost of capital, the machine should be replaced.

ACCA marking scheme Marks (a) Capital and maintenance cost of replacement 2 Net cash flow 1 Payback period 1 Capital and maintenance cost of overhaul 2 Net cash flow 1 Payback period 1

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8 (b) Discount factors at 12% 1 Present values of each alternative, 1½ × 2 3 NPV for each alternative, 1 × 2 2

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6 (c) NPV at an alternative rate, for each machine, 1½ × 2 3 IRR for each alternative, 1½ × 2 3

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6 (d) 1 mark each for discussion of appraisal methods × 3 3 2 marks for discussion and final conclusion 2

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5 –––

Total 25 –––



4

Key answer tips

Part (a) involves some fairly straightforward calculations although to score well you must ensure you comment on your findings.

To answer part (b), you will need to evaluate both the costs and benefits associated with offering the discount. This is best tackled on a line by line basis and even if your answer is not 100% accurate, you will still earn marks for each element you calculate correctly.

Parts (c) and (d) offer an opportunity for some relatively easy marks but you must ensure you relate your comments to the scenario presented.

The highlighted words are key phrases that markers are looking for.

(a)

Tutor’s top tips:

To comment effectively on the length of a cash operating cycle you must always have some form of benchmark. In this instance, the sector average information can be used.

Calculation of ratios

Inventory days (900/(4,000 × 80%)) × 365 = 103 days Sector average: 90 days Receivables days (550/4,000) × 365 = 50 days Sector average: 45 days Payables days (330/(4,000 × 80%)) × 365 = 38 days Sector average: 60 days

Cash operating cycle = 103 + 50 – 38 = 115 days Cash operating cycle (sector avg) = 90 + 45 – 60 = 75 days

The cash operating cycle or working capital cycle gives the average time it takes for the company to receive payment from receivables after it has paid its trade payables. This represents the period of time for which inventory and receivables require financing.

Velm’s cash operating cycle is 40 days longer than the sector average. This is primarily caused by a much higher inventory days figure of 103 days compared to just 90 days for the sector. The other significant variance is in payables days, where Velm Co pays suppliers after an average of just 38 days compared to the sector average of 60 days.



If working capital management could be improved in order to bring the cash operating cycle down to the sector average, the amount of funds tied up in working capital could be reduced by approximately $362,000 [(4,000 × 80% × (103 – 90) ÷ 365) + (4,000 × (50 – 45) ÷ 365) + (4,000 × 80% × (60 – 38) ÷ 365)].

(b)

Tutor’s top tips:

To reach a decision on a change in policy like this you must directly compare the costs (the discount itself) with the benefits (reduction in financing costs resulting from a lower level of receivables, reduction in the level of bad debts and salary savings).

The benefits of the proposed policy change are as follows.

Trade terms are 40 days, but customers are taking 365 x $550,000/4 million = 50 days.

Current level of receivables = $550,000.

Cost of 1% discount = 0.01 x $4m x 2/3 = $26,667.

Proposed level of receivables = ($4,000,000 – $26,667) x (26/365) = $283,000.

Reduction in receivables = $550,000 – $283,000 = $267,000.

Receivables appear to be financed by the overdraft at an annual rate of 9%.

$ Reduction in financing cost $267,000 × 9% 24,030

Reduction of 0.6% in bad debts 0.6% × $4 million 24,000

Salary saving from early retirement 12,000 –––––– Total benefits 60,030 Cost of 1% discount (see above) (26,667) –––––– Net benefit of discount 33,363 ––––––

A discount for early payment of one per cent will therefore lead to an increase in profitability for Velm Co.

(c) Working capital policies on the method of financing working capital can be characterised as conservative, moderate and aggressive. A conservative financing policy would involve financing working capital needs predominantly from long-term sources of finance. If current assets are analysed into permanent and fluctuating current assets, a conservative policy would use long-term finance for permanent current assets and some of the fluctuating current assets. Such a policy would increase the amount of lower-risk finance used by the company, at the expense of increased interest payments and lower profitability.



Velm Co is clearly not pursuing a conservative financing policy, since long-term debt only accounts for 2.75% (40/1,450) of non-cash current assets. Rather, it seems to be following an aggressive financing policy, characterised by short-term finance being used for all of fluctuating current assets and most of the permanent current assets as well. Such a policy will decrease interest costs and increase profitability, but at the expense of an increase in the amount of higher-risk finance used by the company.

Between these two extremes in policy terms lies a moderate or matching approach, where short-term finance is used for fluctuating current assets and long-term finance is used for permanent current assets. This is an expression of the matching principle, which holds that the maturity of the finance should match the maturity of the assets.

(d)

Tutor’s top tips:

When answering this part of the requirement you can easily draw upon the calculations you performed in part (a).

The objectives of working capital management are often stated to be profitability and liquidity. These objectives are often in conflict, since liquid assets earn the lowest return and so liquidity is achieved at the expense of profitability. However, liquidity is needed in the sense that a company must meet its liabilities as they fall due if it is to remain in business. For this reason cash is often called the lifeblood of the company, since without cash a company would quickly fail. Good working capital management is therefore necessary if the company is to survive and remain profitable.

The fundamental objective of the company is to maximise the wealth of its shareholders and good working capital management helps to achieve this by minimising the cost of investing in current assets. Good credit management, for example, aims to minimise the risk of bad debts and expedite the prompt payment of money due from debtors in accordance with agreed terms of trade. Taking steps to optimise the level and age of receivables will minimise the cost of financing them, leading to an increase in the returns available to shareholders.

A similar case can be made for the management of inventory. It is likely that Velm Co will need to have a good range of stationery and office supplies on its premises if customers’ needs are to be quickly met and their custom retained. However, currently their inventory days figure is 13 days higher than the sector average. Good inventory management, for example using techniques such as the economic order quantity model, ABC analysis, stock rotation and buffer stock management can minimise the costs of holding and ordering stock. The application of just-in-time methods of stock procurement and manufacture can reduce the cost of investing in inventory. Taking steps to improve inventory management can therefore reduce costs and increase shareholder wealth.



Management of accounts payable is another area where Velm Co could improve. Accounts payable are effectively a free source of finance and so Velm Co could seek to take as long a credit period from its suppliers as possible. Care must be taken not to damage relationships as this could lead to indirect costs such as loss of goodwill, price increases or even lost sales if a supplier was to refuse to supply further items until payment is made. Taking further credit must also be balanced against the possibility of obtaining discounts for prompt payment.

Cash budgets can help to determine the transactions need for cash in each budget control period, although the optimum cash position will also depend on the precautionary and speculative need for cash. Cash management models such as the Baumol model and the Miller-Orr model can help to maintain cash balances close to optimum levels.

The different elements of good working capital management therefore combine to help the company to achieve its primary financial objective.

ACCA marking scheme Marks (a) Inventory days 1 Receivables days 1 Payables days 1 Length of cash operating cycle 1 Comment 2

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6 (b) Reduction in receivables 1

Cost of discount 1 Reduction in financing costs 1 Reduction in bad debts 1 Calculation of net benefit and conclusion 1

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5 (c) Permanent and fluctuating current assets 2 Explanation of financing policies 4 Discussion and link to Velm Co 1

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7 (d) Objectives of working capital management 2 Receivables management 1 Inventory management 1 Trade payables management 1 Cash management 1 Discussion and link to Velm Co Max 3

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Max 7 –––

Total 25 –––

acca f9 interim assessment answers june11

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