# Financial Concepts B - SOLUTIONS by tangshuming

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```									         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

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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
      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

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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)

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(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

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.

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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

   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.

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   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.

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)

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(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

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