VIEWS: 5 PAGES: 8 POSTED ON: 4/15/2012
FINANCIAL CONCEPTS B MODEL ANSWERS MAY 2011 SECTION A QUESTION 1 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 i PV= K1,000,000 X (1-1.08-7) (2 marks) 0.08 =K5,206,370 (2 marks) c) Question requires 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 QUESTION 2 a) The contribution per unit is K(4-2) = K2.00 (1 mark) Contribution required to breakeven = fixed costs =K24,000 (1 mark) Breakeven point =24,000/2 =12,000 units (1 mark) In revenue terms, BEP = (12,000 X 4) =K48,000 (1 mark) b) Required contribution = fixed costs plus profit = K43,000 + K17,000 = K60,000 (2 marks) Required sales =12,000 units Required contribution/unit sold =5 (1 mark) Variable cost per unit =12 1 Required sales price/unit =17 (1 mark) c) Contribution required to breakeven K70,000 Volume of sales 10,000 units Required contribution/unit 70,000/10,000 K7.00 (2 marks) Variable cost per unit K7.00 Required sales price/unit K14.00 (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 QUESTION 3 a) (30+20)-15 =35 days (2 marks) b) Any five of 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) c) 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 operating cash cycle (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 2 QUESTION 4. (a) (i) The critical test in deciding if an investee is a subsidiary is whether the investor is able to control the investee. 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. Where the investor is able to exercise significant influence but not control, the investee is an associate. Significant influence is defined as ‘the power to participate in the financial and operating policy decisions of the investee’. Participation is demonstrated by a number of factors, such as representation on the board of directors. Significant influence is presumed to exist if the investor holds at least 20% of the voting power of the investee. 1 mark per valid point to a maximum of (4 marks) (ii)While both an associate and a subsidiary will be included in the consolidated financial statements, the method of consolidation for each is different. In the case of a subsidiary, the approach is to include the total value of each asset and liability on a line by line basis. Therefore the statement of financial position will report the total value of the combined assets and liabilities of the investor and its investee (s). The non-controlling interest reports the value of the net assets not controlled by the investor. When carrying out the consolidation process, the cost of the investment in the investor’s statement of financial position is offset against the equity of the investee. This effectively cancels out these values, with the remaining balance representing goodwill. Any intra group transactions or balances must also be eliminated on consolidation. An associate is consolidated using the equity method of accounting. This means that the investment is initially recorded at cost. Subsequently, the consolidated statement of financial position will include the subsidiary at cost plus any profit attributable to the investor (or less any attributable loss). The remainder of the assets and liabilities reported on the consolidated statement of financial position will only include the assets and liabilities of the investor, and there will be no non-controlling interest to report. 1 mark per valid point to a maximum of (4 marks) (b) (i) K5 million + K3 million = K8 million (2 marks) (ii) 10% of K3 million = K300,000 (2 marks) 3 (iii)K5 million + 90% of K3 million =K 7.7million (3 marks) Total 15 marks SECTION B QUESTION 5 (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) (c) The cash flows at inflated values are as follows. Year Fixed Income Other savings Running costs Net Cash flow K K K K 1 2,500 500 (1,000) 2,000 (2 marks) 2 2,500 525 (1,100) 1,925 (2 marks) 3 2,500 551 (1,210) 1,841 (2 marks) 4 2,500 579 (1,331) 1,748 (2 marks) The NPV of the project is as follows. Year Cash flow Discount Factor PV K 16% K 0 (5,000) 1.000 (5,000) (1 mark) 1 2,000 0.862 1,724 (1 mark) 2 1,925 0.743 1,430 (1 mark) 3 1,841 0.641 1,180 (1 mark) 4 1,748 0.552 965 (1 mark) 4 +299 The NPV is positive and the project would therefore seem to be worthwhile. (13 marks) Total 20 marks QUESTION 6 The figures can be brought to end-of-year 5 price levels by applying the following adjustment factors Year 4 Year 3 Year 2 Year 1 282.0 282.0 282.0 282.0 (2 marks) 273.9 268.5 253.3 245.9 1.0296 1.0503 1.1133 1.1468 (2 marks) The annual figures can now be adjusted to a common price level, end-of-year 5 prices, as follows Year 5 Year 4 Year 3 Year 2 Year 1 Inflation factor 1.0 1.0296 1.0503 1.1133 1.1468 K’000 K’000 K’000 K’000 K’000 Turnover 4,360.7 4,376.4 4,374.5 4,591.0 4,455.3 PAT 53.8 49.4 48.0 51.1 49.1 EPS (t) 8.4 7.8 7.7 8.3 8.0 EFPS (t) 255.5 258.8 261.6 274.8 279 (12 marks i.e. 3 marks for each row) comment: By adjusting the figures for inflation, any significant changes or trends becomes easily discernible. In the analysis above, the fall in turnover, profits and earnings per share in Year 3 is clear, and the fall in equity funds per share has been continuous since Year 1. (4 marks) Total 20 marks QUESTION 7 (a) The major benefit of an audit is that it provides an independent opinion on the truth and fairness of the information in the financial statements. A key point is that an auditor’s opinion is independent, and well informed. The need to subject financial statements to such scrutiny is useful in a number of ways. At the most basic level, the audit provides a check on the work carried out to produce the financial statements. As in any task, the need to have work checked can improve the quality of the work, as it encourages a degree of care which will contribute towards minimizing errors. 5 The fact that auditors must be professionally qualified means that the financial statements are likely to conform with generally accepted accounting practice. Furthermore, as the activities of auditors are subject to monitoring and regulation, a further level of assurance is inherent in the process. If the auditor discovers that misstatement has occurred, the preparers of the financial statements will be asked to correct the misstatement. Thus the results which are finally published will be more reliable. The audit can also act as a deterrent to carrying out improper practices (e.g. fraud or misstatement of figures). Although the audit is not intended to detect fraud, it is reasonable to conclude that the incidence of fraud would be higher if no audit was conducted. Overall, these benefits increase the reliability of financial statements which will in turn increase the confidence of users. Such reliability and confidence are key factors in promoting economic stability and growth. Mark allocation: up to 2 for each valid point, to a maximum of 6 marks (b) In considering what is meant by the term ‘fairly presented’, it is often useful to clarify that it does NOT mean ‘correct’. Nor does an unqualified audit opinion provide a guarantee that the audit opinion can be relied on. The main reason for this is that the conduct of the audit, like accounting in general is based on the concept of materiality. Thus, ‘fairly presented’ means that the financial statements are free from material misstatement. In addition, ‘fairly presented’ means that: The financial statements provide a faithful representation of the transactions carried out by the entity; Assets and liabilities are properly classified; There is satisfactory disclosure to enable users to understand the financial statements (this refers to both the nature and the amount of information); Appropriate accounting policies have been selected; The selected accounting policies have been properly applied; and The information is relevant, reliable, understandable and comparable. Not ‘correct’/not a guarantee 2 marks each 4 For other comments, 1 mark per valid point to a maximum of 4, total 8 marks (b) It is advisable to read the auditor’s report first as this will have the following advantages: It will confirm whether the financial statements have been audited or not. It will confirm which portion of the financial statements has been subject to audit. This is done by specifying the pages in the financial statements that are covered by the auditor’s report. 6 It will confirm if the auditor’s opinion is qualified or unqualified. This is of great importance to the banker, as the auditor’s qualified opinion might point towards potential risk involved if credit were to be granted to the company. Banks often have special requirements in their credit policies referring to the procedures to be followed when dealing with qualified auditor’s report. 2 marks each a total of 6 marks. Total 20 marks QUESTION 8 (a) Any of two of Economic order quantity Buffer stocks and lead times Just-in-time inventory policies (2 marks) (b)Stocks and debtors will increase and/or trade creditors will be reduced. The current ratio should therefore be higher. (2 marks) (c) Introduction of New Capital This is likely to be an issue of shares that debt since, with liquidity under pressure due to overtrading, management will be keen to avoid further straining cash flow by increasing interest payments. Improved Working Capital Management Overtrading could also be attached through better control and management of working capital, for example by chasing accounts. Since overtrading is more likely if an aggressive funding policy is being followed, adoption of a matching or more relaxed approach to funding could pay dividends. Reducing Business Activities If necessary, a company could choose to rein back the level of its business activity in order to consolidate its trading position and to allow time for its capital base to build up through retained earnings, though this is considered somewhat drastic. Applying inflation accounting principles This is important for a banker as it will assist to determine if the business is creditworthy. 2 marks per valid explanation, to a maximum of 3 items (6 marks) 7 (d) Overtrading means a business is trying to maintain a certain level of turnover on operations without the required level of resources such as capital, equipment etc. It is often identified with fast growing businesses. (2 marks) Any of the following: There is rapid increase in turnover There is a rapid increase in the volume of current assets and possibly also fixed assets. Stock turnover and debtors turnover might slow down, in which case the rate of increase in stocks and debtors would be even greater than the rate of increase in sales. There is only a small increase in proprietors’ capital (perhaps through retained profits). Most of the increase in assets is financed by credit, especially: (i) Trade creditors—the payment period to creditors is likely to lengthen (ii) A bank overdraft—which often reaches or even exceeds the limit of the facilities agreed by the bank. Some debt ratios and liquidity ratios alter dramatically: (i) The proportion of total assets financed by proprietors capital falls, and the proportion financed by credit rises (ii) The current ratio and the quick ratio fall (iii) The business might have a liquid deficit, i.e., an excess of current liabilities over current assets Selling of non-current assets to obtain cash Deteriorating inventory turnover and receivable ratios Declining profitability, perhaps due to using discounts to increase sales A lack of cash and cash equivalents (liquid investments) as seen in cash flow statement. (2 marks per point up to 4 items =8 marks) Total 20 marks 8
"Financial Concepts B - SOLUTIONS"