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2-4_2003_jun_q

Section A – This ONE question is compulsory and MUST be attempted

1Springbank plc is a medium-sized manufacturing company that plans to increase capacity by purchasing new machinery at an initial cost of ￡3m. The following are the most recent financial statements of the company:

Profit and Loss Accounts for years ending 31 December

20022001

￡000￡000 Sales5,0005,000

Cost of Sales3,1003,000

––––––––––––Gross Profit1,9002,000

Administration and Distribution Expenses400250

––––––––––––Profit before Interest and T ax1,5001,750

Interest400380

––––––––––––Profit before T ax1,1001,370

T ax330400

––––––––––––Profit after T ax770970

Dividends390390

––––––––––––Retained Earnings380580

––––––––––––Balance Sheets as at 31 December

20022001

￡000￡000￡000￡000 Fixed Assets6,5006,400

Current Assets

Stock1,1701,000

Debtors850900

Cash130100

––––––––––––

2,1502,000

Current Liabilities1,1501,280

––––––––––––

1,000720

––––––––––––

7,5007,120 10% Debentures 20073,5003,500

––––––––––––

4,0003,620

––––––––––––Capital and Reserves4,0003,620

––––––––––––The investment is expected to increase annual sales by 5,500 units. Investment in replacement machinery would be needed after five years. Financial data on the additional units to be sold is as follows:

￡

Selling price per unit500

Production costs per unit200

Variable administration and distribution expenses are expected to increase by ￡220,000 per year as a result of the increase in capacity. In addition to the initial investment in new machinery, ￡400,000 would need to be invested in working capital. The full amount of the initial investment in new machinery of ￡3 million will give rise to capital allowances on a 25% per year reducing balance basis. The scrap value of the machinery after five years is expected to be negligible. T ax liabilities are paid in the year in which they arise and Springbank plc pays tax at 30% of annual profits.

The Finance Director of Springbank plc has proposed that the ￡3·4 million investment should be financed by an issue of debentures at a fixed rate of 8% per year.

Springbank plc uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its financial statements, Springbank plc uses straight-line depreciation over the expected life of fixed assets.

Average data for the business sector in which Springbank operates is as follows:

Gearing (book value of debt/book value of equity)100%

Interest Cover 4 times

Current Ratio2:1

Stock Days90 days

Return before Interest and T ax/Capital Employed25%

Required:

(a)Calculate the net present value of the proposed investment in increased capacity of Springbank plc, clearly

stating any assumptions that you make in your calculations.(11 marks)

(b)Calculate the increase in sales (in units) that would produce a zero net present value for the proposed

investment.(4 marks)

(c)(i)Calculate the effect on the gearing and interest cover of Springbank plc of financing the proposed

investment with an issue of debentures and compare your results with the sector averages.(6 marks)

(ii)Analyse and comment on the recent financial performance of the company.(13 marks)

(iii)On the basis of your previous calculations and analysis, comment on the acceptability of the proposed investment and discuss whether the proposed method of financing can be recommended.(10 marks)

(d)Briefly discuss the possible advantages to Springbank plc of using an issue of ordinary shares to finance the

investment.(6 marks)

(50 marks)

3[P.T.O.

Section B – TWO questions ONLY to be attempted

2It is mid-June and the new managing director of Storrs plc is reviewing sales forecasts for Quarter 3 of 2003, which begins on 1 July, and for Quarter 4. The company manufactures garden furniture and experiences seasonal variations in sales, which has made forecasting difficult in the past. Sales for the last two calendar years were as follows:

Year Quarter 1Quarter 2Quarter 3Quarter 4

2001￡2,700,000￡3,500,000￡3,400,000￡3,000,000

2002￡3,100,000￡3,900,000￡3,600,000￡3,400,000

Sales in Quarter 1 of 2003 were ￡3,600,000. There is two weeks to go until the end of Quarter 2 and the managing director of Storrs plc is confident that it will achieve sales of ￡4,400,000 in this quarter.

The existing sales forecasts for the two remaining quarters of the year were made by the sales director (who has been with the company for several years) during last year’s budget-setting process. These forecasts are ￡3,800,000 for Quarter 3 and ￡3,600,000 for Quarter 4. Budgets within Storrs plc have traditionally been prepared and agreed by the directors of the company before being implemented by junior managers.

As a basis for revising the sales forecasts for the two remaining quarters of 2003, the management accountant of Storrs plc has begun to apply time series analysis in order to identify the seasonal variations in sales. He has so far calculated the following centred moving averages, using a base period of four quarters.

Year Quarter 1Quarter 2Quarter 3Quarter 4

2001￡3,200,000￡3,300,000

2002￡3,375,000￡3,450,000￡3,562,500￡3,687,500

Required:

(a)Using the sales information and centred moving averages provided, and assuming an additive model, forecast

the sales of Storrs plc for Quarter 3 and Quarter 4 of 2003, and comment on the sales forecasts made by the sales director.

(Note that you are NOT required to use regression analysis)(8 marks)

(b)Discuss the limitations of the sales forecasting method used in part (a).(5 marks)

(c)Discuss the relative merits of top-down and bottom-up approaches to budget setting.(12 marks)

(25 marks)

3Velm plc sells stationery and office supplies on a wholesale basis and has an annual turnover of ￡4,000,000. The company employs four people in its sales ledger and credit control department at an annual salary of ￡12,000 each.

All sales are on 40 days’ credit with no discount for early payment. Bad debts represent 3% of turnover and Velm plc pays annual interest of 9% on its overdraft. The most recent accounts of the company offer the following financial information:

Velm plc: Balance Sheet as at 31 December 2002

￡000￡000￡000 Fixed assets17,500

Current assets

Stock of goods for resale900

Debtors550

Cash120

–––––

1,570

Creditors: amounts falling due within one year

T rade creditors330

Overdraft1,200

–––––

1,530

–––––

–––––––

17,540 Creditors: amounts falling due after more than one year

12% Debenture due 20102,400

–––––––

15,140

–––––––Ordinary shares3,500

Reserves11,640

–––––––

15,140

–––––––Velm plc is considering offering a discount of 1% to customers paying within 14 days, which it believes will reduce bad debts to 2·4% of turnover. The company also expects that offering a discount for early payment will reduce the average credit period taken by its customers to 26 days. The consequent reduction in the time spent chasing customers where payments are overdue will allow one member of the credit control team to take early retirement.

T wo-thirds of customers are expected to take advantage of the discount.

Required:

(a)Using the information provided, determine whether a discount for early payment of 1 per cent will lead to

an increase in profitability for Velm plc.(5 marks)

(b)Discuss the relative merits of short-term and long-term debt sources for the financing of working capital.

(6 marks)

(c)Discuss the different policies that may be adopted by a company towards the financing of working capital

needs and indicate which policy has been adopted by Velm plc.(7 marks)

(d)Outline the advantages to a company of taking steps to improve its working capital management, giving

examples of steps that might be taken.(7 marks)

(25 marks)

5[P.T.O.

4T agna is a medium-sized company that manufactures luxury goods for several well-known chain stores. In real terms, the company has experienced only a small growth in turnover in recent years, but it has managed to maintain a constant, if low, level of reported profits by careful control of costs. It has paid a constant nominal (money terms) dividend for several years and its managing director has publicly stated that the primary objective of the company is to increase the wealth of shareholders. T agna is financed as follows:

￡m

Overdraft1·0

10 year fixed interest bank loan2·0

Share capital and reserves4·5

–––

7·5

–––

T agna has the agreement of its existing shareholders to make a new issue of shares on the stock market but has been informed by its bank that current circumstances are unsuitable. The bank has stated that if new shares were to be issued now they would be significantly under-priced by the stock market, causing T agna to issue many more shares than necessary in order to raise the amount of finance it requires. The bank recommends that the company waits for at least six months before issuing new shares, by which time it expects the stock market to have become strong-form efficient.

The financial press has reported that it expects the Central Bank to make a substantial increase in interest rate in the near future in response to rapidly increasing consumer demand and a sharp rise in inflation. The financial press has also reported that the rapid increase in consumer demand has been associated with an increase in consumer credit to record levels.

Required:

(a)Discuss the meaning and significance of the different forms of market efficiency (weak, semi-strong and

strong) and comment on the recommendation of the bank that Tagna waits for six months before issuing new shares on the stock market.(9 marks)

(b)On the assumption that the Central Bank makes a substantial interest rate increase, discuss the possible

consequences for Tagna in the following areas:

(i)sales;

(ii)operating costs; and,

(iii)earnings (profit after tax).(10 marks)

(c)Explain and compare the public sector objective of ‘value for money’ and the private sector objective of

‘maximisation of shareholder wealth’.(6 marks)

(25 marks)

5The managers of Albion plc are reviewing the operations of the company with a view to making operational decisions for the next month. Details of some of the products manufactured by the company are given below.

Product AR2GL3HT4XY5

Selling price (￡/unit)21·0028·5027·30

Material R2 (kg/unit)2·03·03·0

Material R3 (kg/unit)2·02·21·63·0

Direct labour (hours/unit)0·61·21·51·7

Variable production overheads (￡/unit)1·101·301·101·40

Fixed production overheads (￡/unit)1·501·601·701·40

Expected demand for next month (units)9501,000900

Products AR2, GL3 and HT4 are sold to customers of Albion plc, while Product XY5 is a component that is used in the manufacture of other products. Albion plc manufactures a wide range of products in addition to those detailed above.

Material R2, which is not used in any other of Albion’s products, is expected to be in short supply in the next month because of industrial action at a major producer of the material. Albion plc has just received a delivery of 5,500 kg of Material R2 and this is expected to be the amount held in stock at the start of the next month. The company does not expect to be able to obtain further supplies of Material R2 unless it pays a premium price. The normal market price is ￡2·50 per kg.

Material R3 is available at a price of ￡2·00 per kg and Albion plc does not expect any problems in securing supplies of this material. Direct labour is paid at a rate of ￡4·00 per hour.

Folam Limited has recently approached Albion plc with an offer to supply a substitute for Product XY5 at a price of ￡10·20 per unit. Albion plc would need to pay an annual fee of ￡50,000 for the right to use this patented substitute.

Required:

(a)Determine the optimum production schedule for Products AR2, GL3 and HT4 for the next month, on the

assumption that additional supplies of Material R2 are not purchased.(8 marks)

(b)If Albion plc decides to purchase further supplies of Material R2 to meet demand for Products AR2, GL3 and

HT4, what should be the maximum price per kg that the company is prepared to pay?(3 marks)

(c)Discuss whether Albion plc should manufacture Product XY5 or buy the substitute offered by Folam Limited.

Your answer must be supported by appropriate calculations.(7 marks)

(d)Discuss the limitations of marginal costing (variable costing) as a basis for making short-term decisions.

(7 marks)

(25 marks)

7[P.T.O.

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End of Question Paper