Interim Assessment ACCA Paper F9 Financial Management June 2009 Interim Assessment – Answers To gain maximum benefit, not refer to these answers until you have completed the interim assessment questions and submitted them for marking KAPLAN PUBLISHING Page of 13 ACCA F9 Financial Management © Kaplan Financial Limited, 2008 All rights reserved No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing Page of 13 KAPLAN PUBLISHING Interim Assessment ANSWER (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 Efficiency: this is the achievement of objectives at minimum cost – a combination of the other two aims For example, the local council referred to above may look at the cost per household to clear refuse and compare it to what was achieved in previous years or what other councils have achieved They may also look at the number of bins emptied per day as an efficiency measure as the more emptied the lower the annual cost of this service KAPLAN PUBLISHING Page of 13 ACCA F9 Financial Management (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 MARKING GUIDE Marks (a) Description of organisations Comparison of VFM with profit maximisation Problems in quantifying benefits Need for yardsticks and suggestions for possible benchmarks _ 10 (b) VFM Economy Efficiency Effectiveness 3 _ 10 (c) Problems of cost-based measures Examples of measures and comments; mark for each valid point – maximum marks _ Total Page of 13 25 KAPLAN PUBLISHING Interim Assessment ANSWER (a) Currently: D = 20,000 CO = $31.25 × 31.25 × 20,000 = 1,000 1.25 EOQ = Revised: CH = 20% × $6.25 = $1.25 CO = $120 CH = 20% × $6 = $1.20 × 120 × 20,000 = 2,000 1.20 EOQ = The new system will double the EOQ (b) Current cost: $ 20,000 1,000 Ordering cost = $31.25 × Holding cost = $1.25 × Purchasing cost = $6.25 × 20,000 1,000 = 625 = 625 = 125,000 TOTAL 126,250 Revised cost: $ Ordering cost = $120 × 20,000 2,000 = 1,200 Holding cost = $1.20 × 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 years and months The payback period is quite short, so from a financial viewpoint it is worth changing to the new system One major reservation is: they have the space for the increase in inventory? KAPLAN PUBLISHING Page of 13 ACCA F9 Financial Management (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: (d) • 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 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 Page of 13 KAPLAN PUBLISHING Interim Assessment (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 1ẵ marks ì (b) Current cost Revised cost Payback period Comment 2 1 _ (c) 1–2 marks for each valid point (d) 1–2 marks for each valid point (e) 1–2 marks for each valid point Total KAPLAN PUBLISHING 25 Page of 13 ACCA F9 Financial Management ANSWER (a) Let Jan 20X5 = Year 0, Dec 31 20X5 = Year 1, Dec 31 20X6 = Year 2, etc Replace the machine: Year Capital cost and maintenance Contribution 45,000 2,500 $ Net cash flow $ Cumulative inflows $ 15,000 17,000 (45,000) 12,500 14,313 12,500 26,813 2,500 × 1.075 = 2,687 2,500 × 1.0752 = 2,889 19,000 16,111 42,924 = 3,106 21,000 17,895 61,819 = 3,339 22,000 18,661 2,500 × 1.075 2,500 × 1.075 Payback period = years + 45,000 − 42,924 × 12 months = years month 17,895 Overhaul the machine: Year Capital cost and maintenance 27,500 4,000 4,000 °1.105 4,000 °1.221 4,000 °1.349 4,000 °1.491 Payback period = years + Contribution = 4,420 = 4,884 = 5,396 = 5,964 $ Net cash flow $ 13,000 14,500 15,500 16,000 16,000 (27,500) 9,000 10,080 10,616 10,604 10,036 Cumulative inflows $ 9,000 19,080 29,696 27,500 − 19,080 × 12 months = years 10 months 10,616 (b) Year Discount factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567 Page of 13 Replace the machine Net Present cash flow value $ $ Overhaul the machine Net Present cash flow value $ $ (45,000) 12,500 14,313 16,111 17,895 18,661 (27,500) 9,000 10,080 10,616 10,604 10,036 (45,000) 11,163 11,408 11,471 11,381 10,581 11,004 (27,500) 8,037 8,034 7,559 6,744 5,690 8,564 KAPLAN PUBLISHING Interim Assessment (c) Year Discount factor (20%) 1.000 0.833 0.694 0.579 0.482 0.402 IRR of replacement = 12 + IRR of overhaul = 12 + Replace the machine Net cash Present flow value $ $ Overhaul the machine Net Present cash flow value $ $ (45,000) 12,500 14,313 16,111 17,895 18,661 (27,500) 9,000 10,080 10,616 10,604 10,036 (45,000) 10,413 9,933 9,328 8,625 7,502 801 (27,500) 7,497 6,996 6,146 5,111 4,034 2,284 11,004 × (20 − 12) = 12 + 8.6 = 20.6% 11,004 − 801 8,564 × (20 − 12) = 12 + 10.9 = 22.9% 8,564 − 2,284 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 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 KAPLAN PUBLISHING Page of 13 ACCA F9 Financial Management MARKING GUIDE Marks (a) Capital and maintenance cost of replacement Net cash flow Payback period Capital and maintenance cost of overhaul Net cash flow Payback period 1 1 (b) Discount factors at 12% Present values of each alternative, 1ẵ ì NPV for each alternative, × 2 (c) NPV at an alternative rate, for each machine, 1ẵ ì IRR for each alternative, 1ẵ ì (d) mark each for discussion of appraisal methods × marks for discussion and final conclusion Total Page 10 of 13 25 KAPLAN PUBLISHING Interim Assessment ANSWER (a) Machine One Year $ Initial investment Maintenance 11% discount factor $ $ $ $ $ (10,000) (13,000) (16,000) (19,000) (22,000) 1.000 0.901 0.812 0.731 0.659 0.593 _ (238,850) _ (9,010) _ (10,556) _ _ (11,696) _ _ (12,521) _ _ (13,046) _ (238,850) Present value of costs Annuity factor for five years at 11% Equivalent annual cost = 295,679/3.696 = $295,679 = 3.696 = $80,000 per year Machine Two Year Initial investment Maintenance 11% discount factor $ (215,000) 1.000 _ (215,000) _ $ $ $ $ (10,000) 0.901 (15,000) 0.812 _ (20,000) 0.731 _ (25,000) 0.659 _ (9,010) (12,180) _ (14,620) _ (16,475) _ Present value of costs Annuity factor for four years at 11% Equivalent annual cost = 267,285/3.102 = $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 Year Sales revenue Marginal cost Fixed cost Maintenance Taxable cash flow Taxation WDA tax benefit Net cash flow Discount factors Present values KAPLAN PUBLISHING $ 312,000 (243,300) (10,600) (10,000) 48,100 $ 432,000 (337,600) (11,236) (15,750) 68,214 $ 562,500 (438,500) (11,910) (22,050) 90,040 $ 702,000 (547,200) (12,625) (28,941) _ 113,234 48,100 0.901 43,338 (14,430) 16,125 69,909 0.812 56,766 (20,464) 12,094 81,670 0.731 59,701 (27,012) 9,070 _ 95,292 0.659 62,727 $ (33,970) 27,211 (6,759) 0.593 (4,008) Page 11 of 13 ACCA F9 Financial Management $ Sum of present values Initial investment 218,594 215,000 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 Selling price ($/unit) Sales (units/yr) Sales revenue ($/yr) 10.40 30,000 312,000 10.82 40,000 432,800 11.25 50,000 562,500 Year Marginal cost ($/unit) Sales (units/yr) Marginal cost ($/yr) 8.11 30,000 243,300 8.44 40,000 337,600 8.77 50,000 438,500 Year Maintenance ($/yr) Inflated cost ($/yr) 10,000 10,000 15,000 15,750 Writing down allowances and tax benefits 11.70 60,000 702,000 9.12 60,000 547,200 25,000 28,941 Allowances $ Benefits $ Year 1: 215,000 × 0.25 = 53,750 16,125 Year 2: 161,250 × 0.25 = 40,312 12,094 Year 3: 120,938 × 0.25 = 30,234 –––––– 124,296 90,704 –––––– 215,000 –––––– 9,070 Year 4: (215,000 – 124,296) = (c) 20,000 22,050 27,211 Total taxable cash flow = (48,100 + 68,214 + 90,040 + 113,234) Total depreciation Total accounting profit = 319,588 – 215,000 Average annual accounting profit = 104,588/4 Average investment = 215,000/2 = $319,588 = $215,000 = $104,588 = $26,147 = $107,500 Return on capital employed = 100 × 26,197/107,500 = 24.3% ROCE of 24.3% is slightly less than the target ROCE of 25%, indicating that buying the machine is not acceptable with respect to this criterion However, evaluation using the net present value approach is preferred for investment advice Page 12 of 13 KAPLAN PUBLISHING Interim Assessment MARKING GUIDE Marks (a) Equivalent annual cost of machine Equivalent annual cost of machine Selection of lowest equivalent annual cost 2 (b) Sales volume and revenue Marginal costs Maintenance costs Incremental fixed costs Taxation Capital allowances and tax benefits Net cash flow Discount factors Net present value Comment 2 1 1 17 (c) Average annual accounting profit Average investment ROCE and comment 1 Total KAPLAN PUBLISHING 25 Page 13 of 13 .. .ACCA F9 Financial Management © Kaplan Financial Limited, 2008 All rights reserved No part of this... retrieval system, without prior permission from Kaplan Publishing Page of 13 KAPLAN PUBLISHING Interim Assessment ANSWER (a) Not-for-profit organisations include public sector bodies such as the... measure as the more emptied the lower the annual cost of this service KAPLAN PUBLISHING Page of 13 ACCA F9 Financial Management (c) To ensure that the scarce resources which have been placed at their