Answers

Part 2 Examination Paper 2.4 Financial Management and Control 1 (a) Calculation of tax benefits of capital allowances Year Capital allowance Tax benefits Calculation of NPV of proposed investment: Year Sales Production costs Admin expenses Net revenue Tax payable Tax benefits Working capital Investment Project cash flows Discount factors Present values (400) (3,000) (3,400) 1000 (3,400) 0 000 1 000 2,750 (1,100) (220) 1,430 (429) 225 1,226 1,226 0893 1,095 2 000 2,750 (1,100) (220) 1,430 (429) 169 1,170 1,170 0797 9325 3 000 2,750 (1,100) (220) 1,430 (429) 127 1,128 1,128 0712 803 4 000 2,750 (1,100) (220) 1,430 (429) 95 1,096 1,096 0636 697 1 000 750 225 2 000 563 169 3 000 422 127 4 000 316 95

June 2003 Answers

5 000 949 284

5 000 2,750 (1,100) (220) 1,430 (429) 284 1,285 400 1,685 0567 9555

The net present value is approximately 1,083,000 An alternative answer using annuity factors is as follows. 000 PV of tax benefits = (225 x 0893) + (169 x 0797) + (127 x 0712) + (95 x 0636) + (284 x 0567) = PV of working capital recovered = 400 x 0567 = PV of revenue after tax = 1,430 x 07 x 3605 = Investment in working capital = Investment in new machinery = Net present value = The net present value is approximately 1,083,000 This (1) (2) (3) (4) (5) (b) analysis makes the following assumptions: The first tax benefit occurs in Year 1, the last tax benefit occurs in Year 5 Cash flows occur at the end of each year. Inflation can be ignored. The increase in capacity does not lead to any increase in fixed production overheads. Working capital is all released at the end of Year 5 6475 2268 3,6086 (400) (3,000) 1,0830

Administration and distribution expenses per unit = 220,000/5,500 = 40 per unit Net revenue from additional units sold = 500 200 40 = 260 per unit Present value of tax benefits = 647,500 Incremental working capital per unit = 400,000/5,500 = 7273 per unit Let annual sales volume be SV units NPV = [SV x 260 x (1 03) x 3605] + 647,500 [7273 x SV x (1 0567)] 3,000,000 = 0 (3,000,000 647,500) Hence SV = (65611 3149) 2,352,500 = = 3,766 units 62462

Annual increase in sales volume of 3,766 units will produce a zero NPV This is 31% (100 x 1,734/5,500) less than the expected increase in sales volume. (Note: working capital is assumed to depend on sales volume) (c) (i) The current gearing of Springbank plc = 100 x (35m/4m) = 875% Total debt after issuing 34m of debt = 35m + 34m = 69m New level of gearing = 100 x (69m/4m) = 1725% Current annual debenture interest = 350,000 (35m x 01) Current interest on overdraft = 400,000 350,000 = 50,000

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Annual interest on new debt = 272,000 (34m x 008) Expected annual interest = 400,000 + 272,000 = 672,000 Current profit before interest and tax = 15m Current interest cover = 375 (15m/04m) Assuming straight line depreciation, additional depreciation = 600,000 per year Expected profit before interest and tax = 15 + 143 06 = 233m Expected interest cover = 347 (233/0672) This is lower than the current interest cover and also assumes no change in overdraft interest. Thus, Springbanks gearing is expected to rise from slightly below the sector average of 100% to significantly more than the sector average. Springbanks interest cover is likely to remain at a level lower than the sector average of four times, and will be slightly reduced assuming no change in overdraft interest. (ii) Ratio calculations ROCE Net profit margin Asset turnover Current ratio Quick ratio Stock days Debtors ratio Sales/working capital Debt/equity Interest cover 2001 1,750/7,120 1,750/5,000 5,000/7,120 2,000/1,280 1,000/1,280 365 x 1,000/3,000 12 x 900/5,000 5,000/720 3,500/3,620 1,750/380 246% 35% 070 156 078 122 days 22 months 69 967% 46 2002 1,500/7,500 1,500/5,000 5,000/7,500 2,150/1,150 980/1,150 365 x 1,170/3,100 12 x 850/5,000 5,000/1,000 3,500/4,000 1,500/400 20% 30% 067 187 085 138 days 2 months 5 875% 375

The return on capital employed of Springbank has declined as a result of both falling net profit margin and falling asset turnover: while comparable with the sector average of 25% in 2001, it is well below the sector average in 2002. The problem here is that turnover has remained static while both cost of sales and investment in assets have increased. Despite the fall in profitability, both current ratio and quick ratio have improved, in the main due to the increase in stock levels and the decline in current liabilities, the composition of which is unknown. The current ratio remains below the sector average, however. The increase in both stock levels and stock days, together with the fact that stock days is now 53% above the sector average, may indicate that current products are becoming harder to sell, a conclusion supported by the failure to increase turnover and the reduced profit margin. The expected increase in sales volume is therefore likely to be associated with a new product launch, since it is unlikely that an increase in capacity alone will be able to generate increased sales. There is also the possibility that the static sales of existing products may herald a decline in sales in the future. The decrease in the debtors ratio is an encouraging sign, but the interpretation of the decreased sales/working capital ratio is uncertain. While the decrease could indicate less aggressive working capital management, it could also indicate that trade creditors are less willing to extend credit to Springbank, or that stock management is poor. The gearing of the company has fallen, but only because reserves have been increased by retained profit. The interest cover has declined since interest has increased and operating profit has fallen. Given the constant long-term debt, the increase in interest, although small, could indicate an increase in overdraft finance. Ratio analysis offers evidence that the financial performance of Springbank plc has been disappointing in terms of sales, profitability and stock management. It may be that the management of Springbank see the increase in capacity as a cure for the companys declining performance. (iii) Since the investment has a positive NPV it is acceptable in financial terms. The danger highlighted by the analysis of recent financial performance is that existing sales may generate a declining contribution towards meeting interest payments in the future. However, sensitivity analysis shows the proposed expansion is robust in terms of sales volume, since a 31% reduction in forecast sales is needed to eliminate the positive NPV. The proposed expansion is therefore acceptable, but the choice of financing is critical. Springbank should be able to meet future interest payments if the cashflow forecasts for the increase in capacity are sound. However, no account has been taken of expected inflation, and both sales prices and costs will be expected to change. There is also an underlying assumption of constant sales volumes, when changing economic circumstances and the actions of competitors make this assumption unlikely to be true. More detailed financial forecasts are needed to give a clearer indication of whether Springbank can meet the additional interest payments arising from the new debentures. There is also a danger that managers may focus more on the short-term need to meet the increased interest payments, or on the longer-term need to replace the machinery and redeem the debentures, rather than on increasing the wealth of shareholders. Financial risk has increased from a balance sheet point of view and this is likely to have a negative effect on how financial markets view the company. The cost of raising additional finance is likely to rise, while the increased financial risk may lead to downward pressure on the companys share price. The current debentures represent 54% of fixed assets and after the new issue of debentures, this will rise to 73% of fixed assets. The assets available for offering as security against new debt issues will therefore decrease, and continue to decrease as fixed assets depreciate.

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No information has been offered as to the maturity of the new debenture issue. If the matching principle is applied, a medium term maturity of five to six years is indicated. However, the 10% debentures are due for redemption in 2007 and it would be unwise to have two significant redemption calls so close to each other. On the basis of the above discussion, careful thought needs to be given to the maturity of any new issue of debentures and it may be advisable to use debt finance to meet only part of the financing need of the proposed capacity expansion. Alternative sources of finance such as equity and leasing should be considered. (d) Financing the investment by an issue of ordinary shares could offer several advantages to Springbank plc. Gearing would fall to 47% (35/74), less than half of the sector average of 100%, rather than increasing to significantly more than the sector average. Interest cover would increase to 58 (233/04) from 375, compared to a sector average of 4. The financial risk faced by the company would thus be reduced, making it a more attractive investment prospect on the stock market. This could have a positive effect on the companys share price. Ordinary shares do not carry a commitment to make regular payments such as interest on debt, giving Springbank plc a degree of flexibility in rewarding shareholders in financial terms. This must be balanced against the common desire of shareholders for a regular and increasing dividend. Ordinary shares are permanent capital since they do not need to be repaid. Springbank plc would thus avoid the need to find funds for redemption that would arise if it issued debentures. Because the fixed assets of the company would increase but its burden of long-tem debt would be unchanged, Springbank would find it easier to raise additional debt in the future. This could be useful when the need arises to redeem the existing debentures in 2007.

(a)

The centred moving averages can be compared with actual sales for each quarter in order to determine the seasonal variations. Quarter 2001 Q3 Q4 2002 Q1 Q2 Q3 Q4 actual sales 000 3,400 3,000 3,100 3,900 3,600 3,400 centred moving average 000 3,200 3,300 3,375 3,450 3,5625 3,6875 seasonal variation 000 200 (300) (275) 450 375 (2875)

The average seasonal variations and the residual error term can now be calculated. Quarter 1 0000 2001 2002 Average (275) (275) Quarter 2 000 450 450 Quarter 3 000 200 375 11875 Quarter 4 000 (300) (2875) (29375) Total 000

nil

Since the residual error term is nil, there is no need to net this off against the average seasonal variations. The average trend of the centred moving averages is (3,6875 3,200)/5 = 97,500 The sales for Quarter 3 of 2003 can now be forecast. Forecast centred moving average = 3,6875 + (3 x 975) = 3,980,000 Forecast sales for Quarter 3 = 3,980,000 + 118,750 = 4,098,750 The sales for Quarter 4 of 2003 can now be forecast. Forecast centred moving average = 3,6875 + (4 x 975) = 4,077,500 Forecast sales for Quarter 4 = 4,077,500 293,750 = 3,783,750 Both forecasts are higher than those made by the Sales Director (79% more for the Quarter 3 forecast and 51% for the Quarter 4 forecast). This may be because the Sales Director built some slack into his forecasts, or because the forecasts were made using data prior to the current year (although applying the additive model to earlier sales data does not support this). (b) The additive model assumes that the trend and seasonal variations are independent of each other, and that an increasing trend is not linked to increasing seasonal variations. There is no evidence of an increasing trend in the sales of Storrs plc, and in such circumstances use of the additive model may be acceptable. The model assumes that the historic pattern of the trend and the seasonal variations will continue in the future. This may not happen for a number of reasons, for example because of the occurrence of unexpected events or because of changes in consumer preferences. The forecast sales figures should be compared with the expectations and opinions of sales staff, who may have a more detailed knowledge of likely sales and market factors.

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The reliability of the forecasting method is linked to the amount and accuracy of the data analysed. Since only two years of data has been considered, the forecast is unlikely to be reliable. The reliability of the forecast will also decrease as the forecasting period increases, but the forecast period here is only six months. (c) The top-down approach to budget setting implies that budgets are imposed by senior management. This has the advantage that budgets are more likely to support the strategic objectives of the company, and the operations of different divisions are more likely to be co-ordinated. It may be an appropriate form of budget setting in small organisations, where senior managers are likely to have a detailed knowledge of all aspects of the business, or in situations where close control of planned costs is called for, such as business start up or difficult economic conditions. It also has the advantage of decreasing the amount of time taken, and the resources consumed, by budget preparation. There are number of difficulties with the top-down approach that make it likely that it will not regularly be used in isolation. Staff may be demotivated if they have not been involved in the formulation of budgets that produce targets they are expected to achieve, especially if their rewards and incentives are linked to their performance against budget. This reduction in motivation could result in strategic objectives and organisational goals being less than fully supported at the operational level, with company performance and profitability suffering as a result. Initiative and innovation could also be lost as staff simply work to budget, rather than making creative suggestions for improving performance that they feel are unlikely to be rewarded, or form part of future plans. The bottom-up approach to budget setting implies that functional and other junior managers participate in the preparation of budgets. This approach is likely to lead to more realistic and more co-ordinated budgets than the top-down approach if these managers have a more detailed knowledge of the operations and markets of the organisation. It is also likely to be useful in large, established companies where the complexity of the budget-setting process calls for detailed input from lower levels of the organisation. This approach will also lead to higher levels of motivation and commitment, since managers will have contributed towards the targets against which their performance will be measured. There are a number of difficulties with the bottom-up approach. For example, it can be more time-consuming than the top-down approach because of the larger number of participants in the budget-setting process. Participants may become dissatisfied if their budget proposals are subsequently amended by senior managers. Managers may introduce an element of budgetary slack into their budget estimates, giving them a zone of comfort in reaching budget targets. Any variances between planned and actual performance are then likely to be favourable ones. The bottom-up approach also requires detailed planning and co-ordination of the budget-setting process, perhaps supported by a budget manual. The top-down and bottom-up approaches represent two extremes of the budget-setting process. In practice, a compromise or negotiated approach is likely to be used, with senior management reviewing and amending the budget proposals of junior or operational managers in the light of the organisations strategic plan, and junior or operational managers negotiating amendments to aspects of the budget they find unacceptable.

(a)

The benefits of the proposed policy change are as follows. Trade terms are 40 days, but debtors are taking 365 x 0550/4 = 50 days Current level of debtors = 550,000 Cost of 1% discount = 001 x 4m x 2/3 = 26,667 Proposed level of debtors = (4,000,000 26,667) x (26/365) = 283,000 Reduction in debtors = 550,000 283,000 = 267,000 Debtors appear to be financed by the overdraft at an annual rate of 9% Reduction in financing cost = 267,000 x 009 = 24,030 Reduction of 06% in bad debts = 4m x 0006 = 24,000 Salary saving from early retirement = 12,000 Total benefits = 24,030 + 24,000 + 12,000 = 60,030 Net benefit of discount = 60,030 26,667 = 33,363 A discount for early payment of 1 per cent will therefore lead to an increase in profitability for Velm plc.

(b)

Short-term sources of debt finance include overdrafts and short-term loans. An overdraft offers flexibility but since it is technically repayable on demand, it is a relatively risky source of finance and a company could experience liquidity problems if an overdraft were called in, until an alternative source of finance were found. The danger with a short-term loan as a source of finance is that it may be renewed on less favourable terms if economic circumstances have deteriorated at its maturity, leaving the company vulnerable to short-term interest rate changes. Short-term finance will be cheaper than long-term finance, although this is based on the assumption of a normal shape to the yield curve. Economic circumstances could invert the yield curve, for example if short-term interest rates have been increased in order to curb economic growth or to dampen inflationary pressures. Long-term sources of debt finance include loan stock, debentures and long-term loans. These are relatively secure forms of finance: for example, if a company meets its contractual obligations on debentures in terms of interest payments and loan covenants it will not have to repay the finance until maturity. The risk for the company is therefore lower if it finances working capital from a long-term source.

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However, long-term finance is more expensive than short-term finance. The shape of the normal yield curve, for example, indicates that providers of debt finance will expect compensation for deferred consumption and default risk, as well as protection against expected inflation. The choice between short-term and long-term debt for the financing of working capital is hence a choice between cheaper but riskier short-term finance and more expensive but less risky long-term debt. (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 plc is clearly not pursuing a conservative financing policy, since long-term debt only accounts for 275% (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) 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 debtors 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 stock. It is likely that Velm plc 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. Good stock 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 stock. Taking steps to improve stock management can therefore reduce costs and increase shareholder wealth. 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.

(a)

Market efficiency is commonly discussed in terms of pricing efficiency. A stock market is described as efficient when share prices fully and fairly reflect relevant information. Weak form efficiency occurs when share prices fully and fairly reflect all past information, such as share price movements in preceding periods. If a stock market is weak form efficient, investors cannot make abnormal gains by studying and acting upon past information. Semi-strong form efficiency occurs when share prices fully and fairly reflect not only past information, but all publicly available information as well, such as the information provided by the published financial statements of companies or by reports in the financial press. If a stock market is semi-strong form efficient, investors cannot make abnormal gains by studying and acting upon publicly available information. Strong form efficiency occurs when share prices fully and fairly reflect not only all past and publicly available information, but all relevant private information as well, such as confidential minutes of board meetings. If a stock market is strong form efficient, investors cannot make abnormal gains by acting upon any information, whether publicly available or not. There is no empirical evidence supporting the proposition that stock markets are strong form efficient and so the bank is incorrect in suggesting that in six months the stock market will be strong form efficient. However, there is a great deal of evidence suggesting that stock markets are semi-strong form efficient and so Tagnas share are unlikely to be under-priced.

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(b)

A substantial interest rate increase may have several consequences for Tagna in the areas indicated. (i) As a manufacturer and supplier of luxury goods, it is likely that Tagna will experience a sharp decrease in sales as a result of the increase in interest rates. One reason for this is that sales of luxury goods will be more sensitive to changes in disposable income than sales of basic necessities, and disposable income is likely to fall as a result of the interest rate increase. Another reason is the likely effect of the interest rate increase on consumer demand. If the increase in demand has been supported, even in part, by the increase in consumer credit, the substantial interest rate increase will have a negative effect on demand as the cost of consumer credit increases. It is also likely that many chain store customers will buy Tagnas goods by using credit. Tagna may experience an increase in operating costs as a result of the substantial interest rate increase, although this is likely to be a smaller effect and one that occurs more slowly than a decrease in sales. As the higher cost of borrowing moves through the various supply chains in the economy, producer prices may increase and material and other input costs for Tagna may rise by more than the current rate of inflation. Labour costs may also increase sharply if the recent sharp rise in inflation leads to high inflationary expectations being built into wage demands. Acting against this will be the deflationary effect on consumer demand of the interest rate increase. If the Central Bank has made an accurate assessment of the economic situation when determining the interest rate increase, both the growth in consumer demand and the rate of inflation may fall to more acceptable levels, leading to a lower increase in operating costs.

(ii)

(iii) The earnings (profit after tax) of Tagna are likely to fall as a result of the interest rate increase. In addition to the decrease in sales and the possible increase in operating costs discussed above, Tagna will experience an increase in interest costs arising from its overdraft. The combination of these effects is likely to result in a sharp fall in earnings. The level of reported profits has been low in recent years and so Tagna may be faced with insufficient profits to maintain its dividend, or even a reported loss. (c) The objectives of public sector organisations are often difficult to define. Even though the cost of resources used can be measured, the benefits gained from the consumption of those resources can be difficult, if not impossible, to quantify. Because of this difficulty, public sector organisations often have financial targets imposed on them, such as a target rate of return on capital employed. Furthermore, they will tend to focus on maximising the return on resources consumed by producing the best possible combination of services for the lowest possible cost. This is the meaning of value for money, often referred to as the pursuit of economy, efficiency and effectiveness. Economy refers to seeking the lowest level of input costs for a given level of output. Efficiency refers to seeking the highest level of output for a given level of input resources. Effectiveness refers to the extent to which output produced meets the specified objectives, for example in terms of provision of a required range of services. In contrast, private sector organisations have to compete for funds in the capital markets and must offer an adequate return to investors. The objective of maximisation of shareholder wealth equates to the view that the primary financial objective of companies is to reward their owners. If this objective is not followed, the directors may be replaced or a company may find it difficult to obtain funds in the market, since investors will prefer companies that increase their wealth. However, shareholder wealth cannot be maximised if companies do not seek both economy and efficiency in their business operations.

(a)

The optimum production schedule is found using limiting factor analysis. Material R2 (/unit) Material R3 (/unit) Labour (/unit) Variable o/h (/unit) Variable costs (/unit) Selling price (/unit) Contribution (/unit) Material R2 (kg/unit) Contribution (/kg of R2) Ranking Product AR2 GL3 HT4 Demand (units) 950 1,000 900 AR2 25 x 2 = 500 2 x 2 = 400 4 x 06 = 240 110 1250 2100 850 2 85/2 = 425 1 R2 used (kg) 1,900 3,000 600 5,500 GL3 25 x 3 = 750 2 x 22 = 440 4 x 12 = 480 130 1800 2850 1050 3 105/3 = 350 2 Production (units) 950 1,000 200 HT4 25 x 3 = 750 2 x 16 = 320 4 x 15 = 600 110 1780 2730 950 3 95/3 = 317 3 Contribution () 8,075 10,500 1,900 20,475

The optimum production schedule is 950 units of Product AR2, 1,000 units of GL3 and 200 units of HT4, giving a total contribution of 20,475. The fixed production overheads are ignored in this analysis because they are assumed not to vary with changes in the level of production.

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(b)

Further supplies of Material R2 will be used to produce additional units of Product HT4. The contribution per kg of Material R2 of Product HT4 is 317 and so if Albion pays 317 + 250 = 567 per kg for Material R2, the additional units of Product HT4 produced will make a zero contribution towards fixed costs. 567 is therefore the maximum price. The variable cost of Product XY5: Material R3: 3 x 2 = Labour: 17 x 4 = Variable overhead: /unit 600 680 140 1420

(c)

The substitute offered by Folam gives a saving of 4 per unit. However, Albion plc would also pay an annual fee of 50,000 for the right to use the substitute. The company would need to manufacture more than 50,000/4 = 12,500 units per year of Product XY5, or 1,042 units per month, in order for the offered substitute to be financially acceptable. If it needed less than 12,500 units of Product XY5 per year, it would be cheaper to manufacture the product in house. This evaluation is from a short-term perspective: in the longer term, buying in may lead to fixed cost savings and lower investment, increasing the benefits of buying in and lowering the break-even point. Albion plc would also need to assure itself that the quality of the substitute was acceptable and that this quality could be maintained: the lower price offered by Folam might be associated with poorer quality than that deemed necessary by Albion plc. Orders for the substitute product would also need to be delivered promptly in order to avoid production hold-ups. Albion plc could also become dependent on Folam Limited for supplies of the substitute product and might be vulnerable to future price increases by the supplier. Such price increases might reduce or even eliminate the cost saving of buying in. (d) Marginal costing (variable costing) treats fixed costs as a period cost, on the assumption that fixed costs do not change in the short term. The difference between selling price and variable costs is the variable contribution made by units sold towards meeting fixed costs and generating profit. Marginal costing has traditionally been used for short-term decisions such as whether to cease production of a product, whether to make a product or buy it from a supplier, and how to allocate scarce resources in order to maximise contribution. A major limitation with using marginal costing as the basis for making short-term decisions is the assumption that fixed costs are irrelevant to short-term decisions. In the longer term, fixed costs will change: for example, rent is usually regarded as a fixed cost and in the longer term rent might be expected to increase due to inflation. However, a change in fixed costs may be the result of a short-term decision: for example, if a product is discontinued and as a result the work of the marketing department decreases, in the longer term marketing costs would be expected to decrease. This points to the danger of relying on a simplistic analysis of costs into fixed costs and variable costs, and of assuming that only variable costs are relevant for decision-making purposes. It is possible for a fixed cost to be a relevant cost. It is also possible for a variable cost to be irrelevant, for example in the case where a variable cost is common to two decision alternatives. If fuel costs are incurred whether a machine is leased or bought, for example, these costs are not relevant to the decision on whether to lease or buy. Reliance on marginal costing as a basis for making short-term decisions may therefore lead to sub-optimal decisions overall for a company, as the analysis may fail to consider all relevant costs. A relevant cost is an incremental or differential cost at the whole company level. If a cost changes or is incurred, now or in the future, as a result of a decision, it is a relevant cost and should be considered when making a decision. When making short-term decisions, therefore, it is essential to adopt a whole company perspective in determining relevant costs. When making short-term decisions, a detailed analysis of cost behaviour is therefore needed in order to determine not only variable costs and fixed costs, but relevant costs as well.

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Part 2 Examination Paper 2.4 Financial Management and Control

June 2003 Marking Scheme Marks 2 1 1 1 1 1 1 1 1 1 Marks

(a)

Calculation of capital allowances Calculation of tax benefits Calculation of net revenue Calculation of tax on net revenue Inclusion of tax benefits Treatment of working capital Capital investment Calculation of project cash flows Use of correct discount factors Calculation of NPV

11 (b) Formulation of solution Calculation of sales volume giving zero NPV Expression of volume change in relative terms 1 2 1 4 (c) (i) Calculation of current gearing Calculation of expected gearing Calculation of current interest cover Calculation/discussion of expected interest cover Comparison with sector averages 1 1 1 2 1 6 (ii) Calculation of relevant ratios Comment on recent financial performance 8 5 13 (iii) Comment on acceptability of expansion Ability to meet future interest payments Maturity of new debentures Financial risk and asset backing Comment on acceptability of proposed financing 2 2 2 2 2 10 (d) Up to 2 marks for each detailed advantage 6 50

(a)

Calculation of seasonal variations Calculation of average seasonal variations Consideration of residual error term Sales forecasts for quarter 3 and quarter 4 Discussion and explanation

2 1 1 2 2 8

(b)

Discussion of trend and seasonal variations Historic pattern may not be repeated Amount of data used in the analysis

2 2 1 5

(c)

Discussion of top-down budgeting Discussion of bottom-up budgeting

6 6 12 25

21

(a)

Reduction in debtors Cost of discount Reduction in financing cost Reduction in bad debts and salary saving Calculation of net benefit and conclusion

Marks 1 1 1 1 1

Marks

5 (b) Risks of short-term finance Cost of short-term finance Risks of long-term finance Cost of long-term finance Discussion and conclusion 2 1 1 1 1 6 (c) Permanent and fluctuating current assets Explanation of financing policies Discussion and link to Velm plc 2 4 1 7 (d) Advantages of working capital management Credit management Stock management Discussion and link to Velm plc 2 2 2 1 7 25

(a)

Pricing efficiency Meaning and significance of weak form Meaning and significance of semi-strong form Meaning and significance of strong form Comment on banks recommendation

1 2 2 2 2 9

(b) (c)

Up to 2 marks for each detailed consequence Value for money Maximisation of shareholder wealth 3 3

10

6 25

(a)

Calculation of contribution per unit Calculation of contribution per kg of R2 Optimum production schedule

2 2 4 8

(b)

Calculation of a maximum price Discussion

1 2 3

(c)

Calculation of cost saving Calculation of break-even point Discussion of relevant issues

1 1 5 7

(d)

Up to 2 marks for each detailed point made

7 25

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