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ACCA

Paper F9

Financial Management

June 2009

Interim Assessment – Answers

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© Kaplan Financial Limited, 2008

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ANSWER 1

(a) Not-for-profit organisations include public sector bodies such as the National Health Service or local councils, charitable bodies e.g. Oxfam, and other organisations whose purpose is to serve the broader community interests, rather than the pursuit of profit. In broad terms, such organisations seek to serve the interests of society as a whole, and so they give non-financial objectives priority of place.

It is reasonable to argue that they best serve society's interests when the gap between the benefits they provide, and the cost of that provision is greatest. This is commonly termed value for money, and it is not dissimilar to the concept of profit maximisation, but for the fact that public welfare is being maximised rather than profit.

In practice it is incredibly difficult to quantify, for example, the benefits from an operation such as the UK's National Health Service. How does one put a value on a life which has been prolonged by 'x' number of years, or on the easing of pain which is brought about by the replacement of an arthritic joint? The benefits extend beyond factors which can be measured in purely financial terms. Nonetheless, financial criteria can be used to appraise the extent to which such organisations offer value for money, and hence make good use of the funds provided to them.

The major difficulty for public sector bodies lies in precisely how to measure the achievement of the non-financial objectives. Value for money as a concept assumes that there is a yardstick against which to measure success, i.e. achievement of objectives. In reality, the indicators of success are open to debate. For example, in a health service is success measured in terms of fewer patient deaths per hospital admission, shorter waiting lists for operations, average speed of patient recovery and so on? As long as objectives are difficult to specify, so too will it remain difficult to specify where there is value for money. Comparative performance measures are useful, but care must be taken not to read too much into limited information.

(b) The profit motive is not applicable in most public sector situations. Instead we must measure the services provided, in relation to the cost of providing those services. In recent years successive governments have been concerned with measuring service provision. They have employed a VFM (value for money) audit that aims to get ‘the best possible combination of services from the least possible resources’. This is done by pursuing the three Es:

Effectiveness: this is the achievement of the objectives. For example, in the waste management department of a local council the task is to collect household waste. An effective service provision will have few customer complaints and all refuse collected on a regular basis. In this situation customer complaints could be a performance measure.

Economy: this is reducing costs. The organisation should have a system of cost control to ensure that costs are kept to a minimum. In the past, public sector organisations in the United Kingdom had poor cost control, but more recently systems have been put in place to reduce the costs of the organisations. Performance can be measured by calculating various cost statistics.

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(c) To ensure that the scarce resources which have been placed at their disposal are used efficiently and effectively, public sector services such as education need to place a high priority on their financial control and performance. There has always been a quest for 'yard sticks' in such organisations, i.e. ways in which performance can be measured, compared and evaluated.

One of the measures which tends to be used in education is the amount spent on each pupil/student i.e. the cost per pupil/student for each school or college, etc. It should be noted, however, that the amount spent per head is no indication that the amount involved has been spent wisely and is not necessarily a measure of efficiency. It can be used in two ways:

(i) to support the view that it is possible to provide a similar service at a lower cost, or

(ii) by political parties who point to the fact that, in their areas of influence, more is spent per pupil/student on education.

Where the educational establishment provides a meals service, comparisons can be made using the cost of each meal served or on a cost per pupil/student basis. Such comparisons would only be valid if the meals mix and volume of meals served were similar. Where the meals service was revenue earning, performance could also be evaluated using ratios for profitability, etc.

In cases where the educational establishment provides a library, cost comparisons could be made with similar sized libraries using the cost per book, or cost per pupil or cost of new books. Examples of measures and comments; 1 mark for each

valid point – maximum 5 marks 3 _

5 __

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ANSWER 2

The new system will double the EOQ.

(b) Current cost:

TOTAL 126,250 ______

Revised cost:

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

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(c) 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.

• 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) 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.

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(e) 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).

MARKING GUIDE

Marks

(a) Each EOQ 1½ marks × 2 3

(b) Current cost 2

Revised cost 2

Payback period 1

Comment 1 _

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 __

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ANSWER 3

(a) 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

Contribution Net

cash flow

Replace the machine Overhaul the machine Year Discount factor

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(c)

Replace the machine Overhaul the machine Year Discount factor

(20%)

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) 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.

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MARKING GUIDE

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

8

(b) Discount factors at 12% 1

Present values of each alternative, 1½ × 2 3 NPV for each alternative, 1 × 2 __ 2

6

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

6

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

5 __

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ANSWER 4

Maintenance (10,000) (13,000) (16,000) (19,000) (22,000) 11%

discount actor f

1.000 0.901 0.812 0.731 0.659 0.593

_______ ______ _______ _______ _______ _______ (238,850) _______ (9,010) (10,556) ______ _______ _______(11,696) _______ (12,521) _______ (13,046)

Present value of costs = $295,679 Annuity factor for five years at 11% = 3.696

Equivalent annual cost = 295,679/3.696 = $80,000 per year

Machine Two

Year 0 1 2 3 4

$ $ $ $ $

Initial investment (215,000)

Maintenance (10,000) (15,000) (20,000) (25,000)

11% discount factor _______ 1.000 ______ 0.901 _______ 0.812 _______ 0.731 _______ 0.659 (215,000) _______ (9,010) ______ _______ (12,180) _______ (14,620) _______ (16,475)

Present value of costs = $267,285 Annuity factor for four years at 11% = 3.102

Equivalent annual cost = 267,285/3.102 = $86,165 per year

Machine One should be bought as it has the lowest equivalent annual cost. (b) Sales volume reaches the maximum capacity of the new machine in Year 4.

Year 1 2 3 4 5

$ $ $ $ $

Sales revenue 312,000 432,000 562,500 702,000 Marginal cost (243,300) (337,600) (438,500) (547,200) Fixed cost (10,600) (11,236) (11,910) (12,625)

Maintenance (10,000)______ (15,750)______ (22,050)______ _______ (28,941) Taxable cash

flow

48,100 68,214 90,040 113,234

Taxation (14,430) (20,464) (27,012) (33,970) WDA tax benefit ______ ______ 16,125 ______ 12,094 _______ 9,070 27,211

Net cash flow 48,100 69,909 81,670 95,292 (6,759)

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$ Sum of present values 218,594 Initial investment 215,000 ______ Net present value ______ 3,594

The positive NPV indicates that the investment in Machine Two is financially acceptable, although the NPV is so small that there is likely to be a significant possibility of a negative NPV.

Workings

Year 1 2 3 4

Selling price ($/unit) 10.40 10.82 11.25 11.70 Sales (units/yr) 30,000 40,000 50,000 60,000 Sales revenue ($/yr) 312,000 432,800 562,500 702,000

Year 1 2 3 4

Marginal cost ($/unit) 8.11 8.44 8.77 9.12 Sales (units/yr) 30,000 40,000 50,000 60,000 Marginal cost ($/yr) 243,300 337,600 438,500 547,200

Year 1 2 3 4

Maintenance ($/yr) 10,000 15,000 20,000 25,000 Inflated cost ($/yr) 10,000 15,750 22,050 28,941

Writing down allowances and tax benefits Allowances Benefits

$ $

Total accounting profit = 319,588 – 215,000 = $104,588 Average annual accounting profit = 104,588/4 = $26,147

Average investment = 215,000/2 = $107,500 Return on capital employed = 100 × 26,197/107,500 = 24.3%

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MARKING GUIDE

Marks (a) Equivalent annual cost of machine 1 2

Equivalent annual cost of machine 2 2 Selection of lowest equivalent annual cost __ 1

5

(b) Sales volume and revenue 2

Marginal costs 2

Maintenance costs 1

Incremental fixed costs 1

Taxation 2

Capital allowances and tax benefits 4

Net cash flow 1

Discount factors 1

Net present value 1

Comment __ 2

17 (c) Average annual accounting profit 1

Average investment 1

ROCE and comment __ 1

3 __

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