Paper 2.

4
Financial
Management and
Control
PART 2

WEDNESDAY 13 JUNE 2007

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST be

answered

Section B TWO questions ONLY to be answered

Formulae Sheet, Present Value and Annuity Tables are on

pages 7, 8 and 9.

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination

hall

The Association of Chartered Certified Accountants

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

1 The finance director of GTK plc is preparing its capital budget for the forthcoming period and is examining a number
of capital investment proposals that have been received from its subsidiaries. Details of these proposals are as follows:
Proposal 1
Division A has requested that it be allowed to invest £500,000 in solar panels, which would be fitted to the roof of
its production facility, in order to reduce its dependency on oil as an energy source. The solar panels would save
energy costs of £700 per day but only on sunny days. The Division has estimated the following probabilities of sunny
days in each year.
Number of sunny days Probability
Scenario 1 100 0·3
Scenario 2 125 0·6
Scenario 3 150 0·1
Each scenario is expected to persist indefinitely, i.e. if there are 100 sunny days in the first year, there will be 100
sunny days in every subsequent year. Maintenance costs for the solar panels are expected to be £2,000 per month
for labour and replacement parts, irrespective of the number of sunny days per year. The solar panels are expected to
be used indefinitely.
Proposal 2
Division B has asked for permission to buy a computer-controlled machine with a production capacity of 60,000 units
per year. The machine would cost £221,000 and have a useful life of four years, after which it would be sold for
£50,000 and replaced with a more up-to-date model. Demand in the first year for the machine’s output would be
30,000 units and this demand is expected to grow by 30% per year in each subsequent year of production. Standard
cost and selling price information for these units, in current price terms, is as follows:
£/unit Annual inflation
Selling price 12 4%
Variable production cost 4 5%
Fixed production overhead cost 6 3%
Fixed production overhead cost is based on expected first-year demand.
Proposal 3
Division C has requested approval and funding for a new product which it has been secretly developing, Product RPG.
Product development and market research costs of £350,000 have already been incurred and are now due for
payment. £300,000 is needed for new machinery, which will be a full scale version of the current pilot plant.
Advertising takes place in the first year only and would cost £100,000. Annual cash inflow of £100,000, net of all
production costs but before taking account of advertising costs, is expected to be generated for a five-year period. After
five years Product RPG would be retired and replaced with a more technologically advanced model. The machinery
used for producing Product RPG would be sold for £30,000 at that time.
Other information
GTK plc is a profitable, listed company with several million pounds of shareholders’ funds, a small overdraft and no
long-term debt. For profit calculation purposes, GTK plc depreciates assets on a straight-line basis over their useful
economic life. The company can claim writing down allowances on machinery on a 25% reducing balance basis and
pays tax on profit at an annual rate of 30% in the year in which the liability arises. GTK plc has a before-tax cost of
capital of 10%, an after-tax cost of capital of 8% and a target return on capital employed of 15%.

2
Required:
(a) For the proposed investment in solar panels (Proposal 1), calculate:
(i) the net present value for each expected number of sunny days;
(ii) the overall expected net present value of the proposal;
and comment on your findings. Ignore taxation in this part of the question. (9 marks)

(b) Calculate the net present value of the proposed investment in the computer-controlled machine (Proposal 2)
and advise whether the proposal is financially acceptable. Assume in this part of the question that tax is
payable and that writing down allowances can be claimed. (15 marks)

(c) Calculate the before-tax return on capital employed (accounting rate of return) of the proposed investment
in Product RPG (Proposal 3), using the average investment method, and advise on its acceptability.
(6 marks)

(d) Discuss how equity finance or traded debt (bonds) might be raised in order to meet the capital investment
needs of GTK plc, clearly indicating which source of finance you recommend and the reasons for your
recommendation. (12 marks)

(e) At the end of the first year of production after implementation of Proposal 2, the finance director noted that a
mistake had been made in forecasting selling price inflation, which should have been 1·5% instead of 4%. He
has gathered the following information regarding selling price and sales volume.
Forecast standard selling price (4% inflation) £12·48
Actual selling price £12·36
Forecast and actual standard variable cost £4·20
Forecast sales volume 30,000 units
Actual sales volume 32,000 units

Required:
(i) Using a marginal costing approach and ignoring the mistake in forecasting selling price inflation,
calculate the selling price variance and the sales volume contribution variance, and reconcile budgeted
contribution to actual contribution. (4 marks)
(ii) Using a marginal costing approach, evaluate the selling price variance from an operational and planning
perspective and discuss briefly whether your evaluation provides the finance director with useful
information. (4 marks)

(50 marks)

3 [P.T.O.
Section B – TWO questions ONLY to be attempted

2 Required:
(a) Outline the key stages in the planning process that links long-term objectives and budgetary control.
(10 marks)

(b) Explain the meaning of the terms ‘fixed budget’, ‘rolling budget’ and ‘zero-based budget’, and discuss the
circumstances under which each budget might be used. (10 marks)

(c) Discuss whether time series analysis may be preferred to linear regression as a way of forecasting sales
volume. (5 marks)

(25 marks)

3 Woodside is a local charity dedicated to helping homeless people in a large city. The charity owns and manages a
shelter that provides free overnight accommodation for up to 30 people, offers free meals each and every night of the
year to homeless people who are unable to buy food, and runs a free advice centre to help homeless people find
suitable housing and gain financial aid. Woodside depends entirely on public donations to finance its activities and
had a fundraising target for the last year of £700,000. The budget for the last year was based on the following forecast
activity levels and expected costs:
Free meals provision: 18,250 meals at £5 per meal
Overnight shelter: 10,000 bed-nights at £30 per night
Advice centre: 3,000 sessions at £20 per session
Campaigning and advertising: £150,000
The budgeted surplus (budgeted fundraising target less budgeted costs) was expected to be used to meet any
unexpected costs. Included in the above figures are fixed costs of £5 per night for providing shelter and £5 per advice
session representing fixed costs expected to be incurred by administration and maintaining the shelter. The number
of free meals provided and the number of beds occupied each night depends on both the weather and the season of
the year. The Woodside charity has three full-time staff and a large number of voluntary helpers.
The actual costs for the last year were as follows:
Free meals provision: 20,000 meals at a variable cost of £104,000
Overnight shelter: 8,760 bed-nights at a variable cost of £223,380
Advice centre: 3,500 sessions at a variable cost of £61,600
Campaigning and advertising: £165,000
The actual costs of the overnight shelter and the advice centre exclude the fixed costs of administration and
maintenance, which were £83,000.
The actual amount of funds raised in the last year was £620,000.

Required:
(a) Prepare an operating statement, reconciling budgeted surplus and actual shortfall and discuss the charity’s
performance over the last year. (13 marks)

(b) Discuss problems that may arise in the financial management and control of a not-for-profit organisation such
as the Woodside charity. (12 marks)

(25 marks)

4
4 TFR Ltd is a small, profitable, owner-managed company which is seeking finance for a planned expansion. A local
bank has indicated that it may be prepared to offer a loan of £100,000 at a fixed annual rate of 9%. TFR Ltd would
repay £25,000 of the capital each year for the next four years. Annual interest would be calculated on the opening
balance at the start of each year. Current financial information on TFR Ltd is as follows:
Current turnover: £210,000
Net profit margin: 20%
Annual taxation rate: 25%
Average overdraft: £20,000
Average interest on overdraft: 10% per year
Dividend payout ratio: 50%
Shareholders funds: £200,000
Market value of fixed assets £180,000
As a result of the expansion, turnover would increase by £45,000 per year for each of the next four years, while net
profit margin would remain unchanged. No capital allowances would arise from investment of the amount borrowed.
TFR Ltd currently has no other debt than the existing and continuing overdraft and has no cash or near-cash
investments. The fixed assets consist largely of the building from which the company conducts its business. The
current dividend payout ratio has been maintained for several years.

Required:
(a) Assuming that TFR is granted the loan, calculate the following ratios for TFR Ltd for each of the next four
years:
(i) interest cover;
(ii) medium to long-term debt/equity ratio;
(iii) return on equity;
(iv) return on capital employed. (10 marks)

(b) Comment on the financial implications for TFR Ltd of accepting the bank loan on the terms indicated above.
(8 marks)

(c) Discuss the difficulties commonly faced by small firms such as TFR Ltd when seeking additional finance.
(7 marks)

(25 marks)

5 [P.T.O.
5 The following financial information relates to PNP plc for the year just ended:
£000
Turnover 5,242·0
Variable cost of sales 3,145·0
Stock 603·0
Debtors 744·5
Creditors 574·5
Segmental analysis of debtors
Balance Average payment period Discount Bad debts
Class 1 £200,000 30 days 1·0% none
Class 2 £252,000 60 days nil £12,600
Class 3 £110,000 75 days nil £11,000
Overseas debtors £182,500 90 days nil £21,900
––––––––– ––––––––
£744,500 £45,500
––––––––– ––––––––
The debtor balances given are before taking account of bad debts. All sales are on credit. Production and sales take
place evenly throughout the year. Current sales for each class of debtors are in proportion to their relative year-end
balances before bad debts. The overseas debtors arise from regular export sales by PNP to the USA. The current spot
rate is $1·7348/£ and the three-month forward rate is $1·7367/£.
It has been proposed that the discount for early payment be increased from 1·0% to 1·5% for settlement within
30 days. It is expected that this will lead to 50% of existing Class 2 debtors becoming Class 1 debtors, as well as
attracting new business worth £500,000 in turnover. The new business would be divided equally between Class 1
and Class 2 debtors. Fixed costs would not increase as a result of introducing the discount or by attracting new
business. PNP finances debtors from an overdraft at an annual interest rate of 8%.

Required:
(a) Calculate the net benefit or cost of increasing the discount for early payment and comment on the
acceptability of the proposal. (9 marks)

(b) Calculate the current cash operating cycle and the revised cash operating cycle caused by increasing the
discount for early payment. (4 marks)

(c) Determine the effect of using a forward market hedge to manage the exchange rate risk of the outstanding
overseas debtors. (2 marks)

(d) Identify and explain the key elements of a debtor management system suitable for PNP plc. (10 marks)

(25 marks)

6
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7 [P.T.O.
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End of Question Paper