Financial Concepts B May 2013

FINANCIAL CONCEPTS B – MAY 2013

MODEL ANSWERS

SECTION A

(a) An annuity is a series of fixed payments required from, or paid to,an individual at a specified frequency over the course of a fixed period of time. (2 marks)

(b)PV=annuity x 1-(1+i)-n

PV= K1,000,000 x(1-1.08-7) (2 marks)

0.08

=K10,412,740 (2 marks)

(c) The question requires the candidates to find the compounding rate given the relationship between the present value and a future value.

FV = 2PV (2 marks)

FV= PV x (1+r%) n, n=7 (1 mark)

2PV = PV x (1+r%) 7 (1 mark)

2= (1+r%)7 (1 mark)

r% = 21/7 -1

=10.41% (2 marks)

(d) Bond C is being quoted at a price significantly lower than its current value and would therefore make a wise purchase. The other two bonds are being quoted a price that is higher than their current value. (2 marks)

Total 15 marks

(a) The contribution per unit is K(8-4) = K4.00 (1 mark)

Contribution required to breakeven = fixed costs =K48,000 (1 mark)

Breakeven point =48,000/4 =12,000 units (1 mark)

In revenue terms, BEP = (12,000 X 8) =K96,000 (1 mark)

(b) Required contribution = fixed costs plus profit

= K86,000 + K34,000

= K120,000 (2 marks)

Required sales =24,000 units

Required contribution/units to be sold =5 (1 mark)

Variable cost per unit=24

Required sales price/unit=29 (1 mark)

Volume of sales20,000 units

Required contribution per unit140,000/20,000

K7.00 (2 marks)

Variable cost per unitK14.00

Required sales price/unitK21.00 (1 mark)

(d) Any two of:

(i)A breakeven chart can only apply to a single product or a single mix of a group of products

(ii)Assumes fixed costs are constant at all levels of output

(iii)Assumes that variable costs are the same per unit at all levels of output

(iv)Assumes that sales prices are constant at all levels of output

(v)Assumes that production and sales are the same (stock levels are ignored)

(vi)It ignores the uncertainty in the estimates of fixed costs and variable costs per unit. (4 marks)

Total 15 marks

(a) (i)Term loans are loans of a fixed amount for an agreed time and on specified terms to include issues, such as repayment schedule. These term loans can be relatively short term or much longer term. Often the paperwork is more extensive for a term loan because of the lender’s longer term commitment and its need for greater financial protection although from the viewpoint of the borrower there is more certainty about repayments, amounts and general timescale involved.

(ii) Factoring (or invoice finance) companies provide three important services to organisations with outstanding debtors, as follows:

the immediate transfer of cash, based on the understanding that when the debtor subsequently pays the amount goes to the factor. The factor will typically lend around 80% of the debtor amount.
sales ledger administration on behalf of organisations, coupled with the collection of outstanding debts.
Credit insurance that protects against the possibility that a customer will not pay the amount owed.

(iii) Leasing –this is similar to hire purchase in that an equipment owner (the lessor)

conveys the right to use the equipment in return for regular payments by the

equipment user (the lessee) over an agreed period of time. The essential differencewith leasing is that the user of the equipment never becomes the legal owner; the legal title to the equipment always belongs to the leasing company. A distinction is made between operating lease (short term operating contract) which can be terminated at short notice and a finance lease (often called a capital lease or a full payout lease) where the finance provider expects to recover most of the cost, if not the full cost, of the particular equipment concerned.

(3 marks each, total 9 marks)

(b) Any six of the following:

Bank current accounts (‘’sight’’ deposits)
Bank deposit accounts (‘’time’’ deposits)
Interbank lending in any available currency
Certificate of deposits (CDs)
Treasury Bills
Bank bills (acceptance credits)
Local authority deposits
Money market funds
Gilts
Corporate bonds
Eurobonds
Commercial paper
Shares
Derivatives (6 marks)

Total 15 marks

(a)Any five of the following sources:

Sale of non-current assets e.g. property, plant and equipment
Retained profits
Trade credit (buying supplies on credit)
Bank overdraft
Short term lease
Factor finance
Issue of shares (5 marks)

(b) (60+40)-30=70 days

(c) The operating cash cycle (OCC) is the time period between the outlay of cash for the purchase of stocks and the ultimate receipt of cash from the sale of the goods. For a business that purchases goods in their completed state and then re-sells them, the operating cash cycle can be calculated as follows:

Average stock turnover period + Average settlement period for debtors – average settlement period for creditors (4 marks)

The OCC is important because it can have significant influence on the financing needs of a business: the longer the OCC of a business the greater its financing needs. In addition, the longer the OCC the greater the financing risks associated with the business. As a result, a business will usually monitor its OCC carefully and will seek to reduce it where possible. (4 marks)

Total 15 marks

5.(a)

(i)Group is the parent and its subsidiaries. It functions as a single economic unit, controlled by the directors of the parent company (1 mark)

(ii) Group financial statements or consolidated financial statements usually include

Consolidated Statement of Financial Position and Consolidated Income Statement;
Alternative forms of group financial statements. These can consist of separate financial statements for each of the subsidiaries, or statements attached to the financial statements of the parent company with information about the subsidiaries, or more than one set of consolidated

financial statements, or a combination of these.

If other alternative forms of reporting are being used, the auditor of the holding company must report the decision to the other members of the holding company. (3 marks)

(iii)Parent is an entity which controls another entity or an entity with one or more subsidiaries. (1 mark)

(iv)Subsidiary is an entity which is controlled by another entity (parent) (1 mark)

(v)Control is the power to govern the financial and operating policies of the investee, so as to obtain economic benefit from its activities.

Both IFRS 3 and IAS state that control is presumed to exist when the investor holds more than 50% of the voting power of the investee.However, an investor holding less than 50% of the voting power may still be able to exercise control, perhaps through having the power to appoint or remove the majority of the directors of the investee. (2 marks)

(b)

(i) K10 million + K6 million = K16 million (2 marks)

(ii) 20% of K6 million = K1.2 million (2 marks)

(iii)K10 million + 80% of K6 million = K 14.8 million (3 marks)

Total 15 marks

SECTION B

(a) Because the benefits and costs generated by an investment project do not occur in the same period of time, there is need to compare negative and positive values in different years. These values cannot simply be added because money has a time value and a given amount of money received or paid out in the future has a relatively smaller value today than if the same amount was received or paid out in the current period. Also, consumption is more valuable today than in the future. (any two valid points up to a maximum of two) = (2 marks)

(b) In order to survive, all businesses must retain an uninterrupted capacity to pay debts and when they fall due. As debts are normally paid in the form of cash, the cash flows of a business should be a matter of intense interest to its managers. A forecast cash flow statement helps managers to monitor future movements in cash. It sets out the anticipated cash inflows and outflows arising over a particular forecast period and so can provide an early warning of problems. This allows managers a better opportunity to deal with these problems. For example, a forecast cash flow statement may help to identify future breaches of an overdraft limit that has been agreed with the bank which may allow managers time to review their plans. Where the forecast cash flow statement indicates a cash surplus, managers have the opportunity to consider whether this surplus should be re-invested or distributed to shareholders. (5 marks, depending on the depth of arguments)

YearFixed IncomeOther savingsRunning costsNet Cash flow

KK K K

1 250,00050,000(100,000)200,000(2 marks)

2 250,00052,500(110,000)192,500 (2 marks)

3 250,00055,100(121,000)184,100 (2 marks)

4 250,00057,900(133,100)174,800 (2 marks)

The NPV of the project is as follows.

YearCash flowDiscount FactorPV

K16%K

0(500,000)1.000 (500,000) (1 mark)

1200,0000.862 172,400 (1 mark)

2192,5000.743 143,000 (1 mark)

3184,1000.641 118,000 (1 mark)

4174,8000.55296,500 (1 mark)

+29,900

The NPV is positive and the project would therefore seem to be worthwhile. (15 marks, with a maximum of 13 marks)

Total 20 marks

(a) (i) Earnings Per Share : Profit on ordinary activities after tax and preference dividend

Number of ordinary shares in issue*

*weighted average numberof ordinary shares outstanding during the period.

(ii) Dividend Cover : Profit on ordinary activities after tax and preference dividend

Ordinary dividend

OR EPS

Net Dividend per Share

(iii) P/E Current mid-market price

EPS

(iv) Earnings Yield EPS

Mid-market price

(Any three, 1mark for naming, 1 mark for correct formula, up to 3, total 6 marks)

(b)(i) Profitability ratios

Liquidity ratios

Capital structure/financial risk ratios

Working capital structure/working capital ratios and efficiency ratios

(1 mark each= 4 marks)

(ii) The significance for:

Profitability ratios – to assess profitability

Liquidity ratios – to evaluate whether cash flows are good or adequate to

meet short-term commitments

Capital structure/financial risk ratios – to test long-term solvency

Working capital structure/working capital ratios and efficiency ratios– to

measure the adequacy or efficiency of a company’s working capital

(1 mark each= 4 marks)

(i) The models provide both the banker and the management of the business witha

good indication of financial success or failure if the business is to continue with its

current policies and strategies in the future.

(ii) The problem areas within the business financial strategies and policies can be

identified and precautionary measures put in place to rectify it.

(iii) From the bankers point of view it can form a basis for discussion when

interviewing the business client.

(1.5 marks per one correct answer, up to two=3 marks)

Disadvantages of Financial Forecasts Models to a banker

(i)Since in the process of credit risk assessment the analysis and interpretation of financial statements is only one aspect considered, the results from these models must evaluated within the total context of qualitative and quantitative information on both the financial history and financial budgets and business plans for the future.

(ii)Prediction models take little or no account of economic conditions occurring when they are used, and the effect that economic variables may have on the figures used in the models.All failure prediction models are based largely on historical financial records and do not properly take into consideration the general economic environment. Corporate failures are more likely to occur during a recession, for example, than during an economic upturn.

(iii)Most financial models are based on the results of listed companies only and are not representative of the total business sector.

(iv)It is difficult to value the equity in a private company, which may make the use of the models for private company analysis difficult and extremely subjective.

(v)Some of these models have been developed and researched some time ago and do not take new trends and changes in recent years within companies into consideration. The information they use reflects the past and is thus out of date. The problem is exacerbated by the delay in the publication of company accounts. The published financial figures of a company are always at least several months out of date when they become available to the public. Failure might occur before relevant data becomes available.

(vi)Many assumptions have to be made in interpreting information, including the methods of accounting which have been used. Indeed, any limitations in the accounting data used will also affect the models i.e.failure prediction models share the limitations of the generally accepted accounting practices by which the accounts are prepared.

(vii)Companies may manipulate the measures used in the models in order to prevent predictions of failure.

(viii)It is very difficult to define corporate failure because companies which would otherwisehave been liquidated can be ‘’rescued’’ or taken over. Similarly, businesses may close for reasons other than failure, e.g. a private company may cease to operate because the owner-manager wishes to retire.

(1.5 marks per one correct answer, up to two=3 marks)

Total 20 marks

(a) Any of two of

Economic order quantity (EOQ)
Buffer stocks and lead times
Just-in-time inventory policies (1 mark each, maximum 2 marks)

Explanations

(i)Economic Order Quantity (EOQ)

Is an inventory-relatedequation that determines the optimum order quantity that a company should hold in itsinventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs.The full equation is as follows:

where:
S = Setup costs
D = Demand rate
P = Production cost
I = Interest rate (considered an opportunity cost, so the risk-free rate can beused).

(ii)Buffer stocks and lead times

Safety stock (also called buffer stock) is a term used by logisticians to describe a level of extra stock that is maintained to mitigate risk of stockouts (shortfall in raw material or packaging) due to uncertainties in supply and demand. Adequate safety stock levels permit business operations to proceed according to their plans. Safety stock is held when there is uncertainty in the demand level or lead time for the product; it serves as an insurance against stockouts.

The amount of safety stock an organization chooses to keep on hand can dramatically affect their business. Too much safety stock can result in high holding costs of inventory. In addition, products which are stored for too long a time can spoil, expire, or break during the warehousing process. Too little safety stock can result in lost sales and, thus, a higher rate of customer turnover. As a result, finding the right balance between too much and too little safety stock is essential.

(iii)Just-in-time inventory policies

JIT, or just in time, inventory is a inventory management strategy that is aimed at monitoring the inventory process in such a manner as to minimize the costs associated with inventory control and maintenance. To a great degree, a just-in-time inventory process relies on the efficient monitoring of the usage of materials in the production of goods and ordering replacement goods that arrive shortly before they are needed. It helps to prevent incurring the costs associated with carrying large inventories of raw materials at any given point in time.

Another application of a just in time inventory focuses not on raw materials but on finished goods. Again, the idea is to develop a solid understanding of what is needed to produce goods and schedule them for shipment to customers within the shortest time frame possible.

Many purchasing departments employ a just in time inventory for such key items as raw materials and machine parts. This means that records are kept that make it possible to place a new order for a given component when the number of units on hand decreases to a pre-determined point.

(2.5 marks for each explanation of the selected inventory management method, with a maximum of two methods = 5 marks)

(b)Cost of stockholding

Any four of:

(i)Cost of stock, less any available discount (e.g. for bulk purchasing)

(ii)Providing finance – since stock is money, there is the cost of financing it, which may be taken as the weighted cost of capital. There is also an opportunity cost to consider, as funds tied up in stock cannot be used for other, more profitable investments and so potential income will be forgone.

(iii)Stock handling – such as the costs of the stores installation (like racks, bins, paperwork systems, insurance and maintenance cost and security).

(iv)Holding losses – these costs include evaporation, deterioration, obsolescence, theft, damage in stores and in transit. There may well be holding gains such as in times of inflation which may well be offset by higher costs of funds in such periods.

(v)Procurement costs – the costs of obtaining stock (clerical and administrative costs of procurement such as salaries, purchasing office, telephones, letters, etc; Transportation costs; and related costs of tooling, production, scheduling etc associated with internal order, where stocks are produced internally).

(vi)Shortage or stock-out costs – the costs of being without stock for a period of time. These include: Loss of contribution through the lost sale caused by stock-out; loss of future custom competitors; idle time caused by breaks in production; overtime, rescheduling and related costs, arising from the need to expedite a ‘’rush’’ order, lost production and higher prices. (4 marks)

(c)Candidates could base their answers on the following points:

(i)Stock control – improvements using computerised systems and techniquses such as economic order quantity and jus-in-time. Achieving faster stack turnover can reduce costs of stockholding.

(ii)Cash control – use of cash flow forecasts can help identify likely surpluses and deficits of cash. Surpluses can be invested and short-term overdrafts arranged to cover deficits.

(iii)Trade payables – it may be possible to delay payments to creditors but this can have adverse effects on relationships with suppliers and the company could incur interest payments on accounts.

(3 marks each, depending on the depth of arguments. Total= 9 marks)

Total 20 marks

(a)Compounding refers to when the interest ‘’gets added to the account’’ (1 mark)

(b)(i)With annual interest, the FV of MK1,000,000 at 12% for one year is

1,000,000 + (12%x1,000,000) = MK1,120,000

(ii)With semiannual compounding, FV = 1,000,000(1.06)(1.06)=1,060,000(1.06) = MK1,123,600

(iii)With quarterly compounding, FV of MK1,000,000 at 12% for one year = 1,000,000(1.03)(1.03)(1.03)(1.03) = MK1,125,500