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NOTES & EXERCISES ON Financial Management -For ICM Students

INTRODUCTION A company is an association of people who have contributed money for the purpose of carrying on business to make a profit. A company is formed using contributions from many people each putting in a share of the total money required to operate the business. All companies are regulated by the Companies Act 1985 (as Amended by 1989). The companies Act of 1985 & 1989 therefore sets out the basic format and content of a published accounts. The people who contribute the money in forming the company are called the shareholders. They own the company but usually do not participate in the management of the company. The shareholders therefore appoint Directors to management the company on their behalf.

CHAPTER ONE COMPANY ACCOUNTS

FORMATION OF A COMPANY
A company cannot form itself. Companies are formed by promoters. A promoter is a person who sees to the formation of a company. In small companies, they are usually the owners who act as the promoters of the company. The formation of a company requires only a minimum of two founders who are willing to subscribe (buy) the share capital. There is no maximum limit. The procedure involved in forming a limited company is a little more complex than the procedures involved in other business units. A company is formed by the issue of certificate of registration by the Registrar of Companies. To obtain a certificate of incorporation two important documents are required to be sent to the Registrar at Company House. These documents are Memorandum of Association and Article of Association. MEMORANDUM OF ASSOCIATION AND ARTICLE OF ASSOCIATION A limited company must prepare two important documents that will be sent to the Registrar of Companies, at Company House for the company to obtain approval before it can start business. There documents govern the company. The documents are: 1. MEMORANDUM OF ASSOCIATION: The memorandum of association is a document which contains information concerning a companys relation with the external world/outsiders. The document gives the external view of the company to the public, including details of its name, addresses, registered office, share capital, a statement indicating whether it is a Limited company or not and the objectives or purposes of the company. 2. ARTICLE OF ASSOCIATION: This document gives the internal view of the company and relates to the rules and regulations governing the internal organization of the company such as voting rights, powers of directors and conduct of meetings.

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NOTES & EXERCISES ON Financial Management -For ICM Students The purpose of the Memorandum of Association and the Article of Association is to define what the company is and how its business and affaires are to be conducted. The memorandum sets out the basic elements and the articles are mainly internal rules. THE CORPORATE CONSTITUTION (The Contents of the Article & Memorandum of Association) The constitution of a company consists of its memorandum of association and its articles of association. 1. The Memorandum of Association For a company limited by shares, the memorandum must contain the following: (a) Name Clause CA 1985, s.25 - the name of a public limited company must end with the words "public limited company", (PLC), the name of a private limited company must end with the word "Limited". Abbreviations may be used instead: "plc" or "Ltd". A company cannot be registered under a name which is identical to a name already registered. A company must have its name printed on all business documents and it must be displayed at the registered office and all business premises. A company can change its name by special resolution. (b) Registered Office Clause This establishes companys nationality and its domicile, but not its residence. (c) Objects Clause Companys memorandum must contain an objects clause - a clause which states the purpose or purposes for which the company was incorporated or established.

The Ultra Vires Rule


If the company does something beyond the scope of its objects clause, this is said to be ultra vires (beyond the powers of the company). A director may be liable to the company for any costs incurred by the company on an ultra vires transaction.

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NOTES & EXERCISES ON Financial Management -For ICM Students Problems from this rule can be avoided by stating in the memorandum that, the object is to carry on as a general commercial company. (ii) Change of Objects Clause A company can change its objects clause by special resolution. (d) Limitation of Liability Clause If members liability is to be limited, this must be stated in the memorandum. (e) Capital Clause Limited companies with share capital must have a clause stating the total amount of share capital with which it proposes to be registered and the division of that capital into shares of a fixed amount. (f) Alteration of Memorandum A company cannot change its memorandum except in the circumstances and manner expressly provided for in the Act. Memorandum can be altered to change company from public to private and vice versa. However this requires special resolution of shareholders. Company can be changed from unlimited company to limited by special resolution - change from limited to unlimited requires written consent of all the members. Reduction of share capital requires special resolution When company resolves to alter its memorandum, a copy of the resolution, and the amended memorandum, must be sent to the Registrar within 15 days - failure to do this is a criminal offence punishable by a fine. 2. Articles of Association (a) Articles Generally The articles govern the internal management and organization of the company. The articles are secondary to the memorandum - if there is conflict between the articles and the memorandum, the memorandum prevails. 3. Legal Effect of Memorandum and Articles The memorandum and articles operate as a contract between the company and its members, which both parties are bound to honour. The effect of this is:

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NOTES & EXERCISES ON Financial Management -For ICM Students (a) Each member, in his capacity as a member, is bound to the company as if he personally had signed the memorandum and articles. (b)The company is bound to each member in his capacity as a member. (c)The memorandum and articles do not constitute a contract binding the company or any member to an outsider - or to a shareholder in any other capacity than as a member. (d) A member has a right to compel the company to act according to the articles even if not enforcing a right which is personal to himself as a member. (e) The memorandum and articles constitute a contract between each member and every other member.

MEETINGS AND RESOLUTIONS


1. Shareholders and Shares It must be noted that the day to day management of a company is in the hands of the directors, not the shareholders - but the shareholders retain some important powers - many decisions require a resolution of the shareholders and cannot be decided by the directors alone. (a) Who is a "Member?" A member is: (i) Anyone who subscribes the memorandum. (ii)Any other person who agrees to become a member and whose name is entered on the register of members. (b) Register of Members CA 1985 requires every company to keep a register of its members. The register must show: - Name and address of each member. - Date each person became a member and, where applicable, the date he ceased to be a member. - The number of shares held by each member and the amount paid on them. 2. MEETINGS Kinds of Meetings

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NOTES & EXERCISES ON Financial Management -For ICM Students (a) Annual General Meeting Most companies must hold an AGM. An AGM must be held every calendar year with not more than 15 months between meetings. A newly incorporated company must hold its first AGM within 18 months of incorporation. If a company does not hold an AGM as required, any member can apply to the Secretary of State to call or to direct the calling of the meeting. Members of a private company can choose to dispense with the holding of an AGM by elective resolution - but any member of such a company can require that an AGM be held in a particular year by giving notice at least 3 months before the end of the year. (b) Usual Business of an AGM Directors lay before the company annual accounts and reports for the most recent financial period. Auditor's term of office ends at AGM, so they must be re-appointed or new auditors must be appointed. Director's recommendation for the dividend to be paid to shareholders will be voted on. The Articles may provide that directors are to retire in rotation. Some directors will retire at the AGM and must be re-appointed or replaced. Resolutions may be required to pay directors and auditors fees. (Now normally fixed by contract). Shareholders may have their own resolutions placed on the agenda. (c) Extraordinary General Meetings This is any meeting which is not an AGM. Table A provides that only directors can call an EGM, unless there are too few directors in the UK to make up a quorum - then any member can call one. Public company must hold an EGM if the companys net assets have fallen to less than half of its called up capital. Meeting must be called within 28 days of the directors becoming aware of the loss of capital, and must be held within 56 days of that date. Where auditor has resigned and has made a statement of circumstances he thinks should be brought to the attention of creditors and shareholders - the auditor can requisition the directors to hold an EGM so that he can explain the circumstances of his resignation.

TYPES/ CLASSIFICATION OF COMPANIES


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NOTES & EXERCISES ON Financial Management -For ICM Students Companies are usually classifies as a) Limited Companies or Unlimited Companies b) Private Companies or Public Companies NOTE: The word limited liability means that shareholders liability is limited to the unpaid nominal capital for which they have subscribed for. A) LIMITED COMPANIES AND UNLIMITED COMPANIES. LIMITED COMPANIES These are companies that have the liability of its members limited. The liability of the members in these types of companies depends on whether the company is any of the following i. A Company Limited by Shares: This is the type of company in which the liability of the members is limited to the amount of money they owe in respect of the shares they subscribes (applied). The members liability to contribute towards the debt of the company (e.g. if the company is owing and about to be wound up and therefore cannot pay its debts) is limited to the shares for which they have subscribed and once the shares have been paid up, they are not under any further liability. ii. Companies Limited by Guarantee There are no shares in this type of company. Any person who is accepted as a member of the company is made to make a promise or guarantee of an amount that he will contribute upon the liquidation of the company. The members liability is limited to the amount they guarantee. That is, the amount each member has pledged to contribute in the event of the company being wound up. Such companies are non-profit organizations such as charities and Trade Association. UNLIMITED COMPANIES In this type of company, the liability of the members is unlimited, meaning that, shareholders can be made personally liable for the debts of the company even if they have finished paying for their shares subscribed. It is the direct opposite of limited companies. The position of the members is like that of partners in a partnership firm. B: PRIVATE OR PUBLIC COMPANIES PRIVATE COMPANY: A private company is any company that is not registered as a public company. Private companies can not invite the public to subscribe (buy) their shares. That is they cannot sell their shares to the public. PUBLIC COMPANIES A public company is the one which i. Is limited by shares or guarantee and has a share capital ii. Is registered as a public company; and iii. Whose memorandum states that it is a public company. iv. Its name must have the words Public Ltd Company or PLC

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NOTES & EXERCISES ON Financial Management -For ICM Students

ADVANTAGES OF COMPANIES The advantages of forming a company are as follows: a) It has a separate legal entity from the shareholders. b) There is limited liability. The liability of its members is limited to the amount (if any) which remains unpaid on their shares. c) Ownership and management of the business is separate so that investors can put money into shares without taking part in running the company. d) Large amount of capital can be raised from many investors. e) There is perpetual succession. That is the continuation and legal standing of a company is not affected by the death of a director or withdrawal of a director of the company. This is not so in sole proprietorship businesses. DISADVANTAGES OF COMPANIES a) The procedure for forming a company is costly and complicated as compared to other forms of business ownership. b) Public companies are more venerable to takeovers. c) Mangers are not likely to put in much of their efforts as in the case of sole proprietorship. d) Shareholders (i.e. the owners of the company) may have little control and involvement in the management of the company especially with PLCs.

FINAL ACCOUNTS OF LIMITED COMPANIES


THE CAPITAL OF A COMPANY
Nature of Shares and Share Capital A company raises capital by the issue of shares. Shareholders are then issued a share certificate which shows their ownership in the company. A shareholder is therefore a part-owner of a company. What is a Share? A share is the unit of a capital structure of a company. That is the unit of measure for determining a members interest in the company. TYPES OF SHARES There are two main types of share; 1) Ordinary shares / Equity shares 2) Preference share

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NOTES & EXERCISES ON Financial Management -For ICM Students ORDINARY SHARES: Ordinary shares are the shares which do not carry a fixed dividend. Instead, the directors decide how much to pay to the shareholders each year. Ordinary shares are the most common type of shares issued by a company. The normal rights of ordinary shareholders are to vote at company meetings and to receive dividends from profit. PREFERENCE SHARES: Preference shares are shares carrying fixed rate of dividend. The dividend is paid first before any dividend is paid to ordinary shareholders. Preference shares usually give a preferential right to repayment of capital on a winding up. Preference shareholders normally have restrictions placed on their power to vote at general meetings. TYPES OF PREFERENCE SHARES 1. Cumulative preference shares: This is the type of preference shares in which unpaid dividends are accumulated and carried forward. That is if the company is not able to pay for dividends due to losses or low profit, the unpaid dividend is carried forward to the following year and paid in the following year(in addition to the dividend payable in the current year). 2. Participating preference shares: Theses shareholders have the right to participate in the sharing of profit after the entire capital has been paid during the winding up of a company. 3. Non-participating preference shares: These shareholders do not have such right to participate in the sharing of profit after the entire capital has been paid during the winding up of a company. 4. Redeemable preference shares: These are the shares which allows the company to buy back (redeem) the shares from the shareholders after sometime. 5. Irredeemable preference shares: These shares cannot be bought back by a company.

THE SHARE CAPITAL OF A COMPANY


We shall now look at some terms which are used in company accounts. 1. STATED CAPITAL This is the capital of the company that has been provided by the members or owners of the company. This amount may include the following: i. ii. iii. The total amount (proceeds) received from the sale of the issue of shares. Any other value received apart from cash. Any other transfer to reserves.

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NOTES & EXERCISES ON Financial Management -For ICM Students 2. AUTHORIZED SHARE CAPITAL This represents the maximum amount of shares that the company is allowed to allot or issue to the public. It is also known as nominal or registered capital. 3. ISSUED SHARE CAPITAL/ ALLOTTED SHARE CAPITAL: This is that part of the authorized shares that the company has actually allotted or issued to the public for subscription. 4. PAID-UP SHARE CAPITAL: This is the amount that members have paid on their shares, excluding any premium. That is, the amount of called up capital that has actually been paid by shareholders. 5. CALLED-UP SHARE CAPITAL: This is the part of issued share capital which has been demanded by the company from shareholders. This happens because sometimes a company may not need the full amount of shares from the shareholders at once. Therefore the company calls for such money when it needs it. 6. UNCALLED CAPITAL AND RESERVE CAPITAL: Uncalled capital is the amount owing on partly paid shares which members have not yet been called on to pay. Reserve capital is uncalled capital the company has resolved not to call unless the company is wound up. 7. UNISSUED CAPITAL: This is the part of the authorized capital which has not yet been issued to the public.

DIVIDEND: This is the interest payable on the shares to the shareholders. Dividend is charged against the appropriation accounts. Dividend can be either interim or final. I Interim dividend: This is the dividend which is declared and paid during the year by the board of directors. Final Dividend: This is dividend which is paid at the end of the year. It is proposed by the Directors and approved by management. RIGHT ISSUE A right issue is a situation where a company issues its shares to the existing shareholders in proportion to their existing shareholding at a favorable price. To do this the company contacts the existing shareholders and informs them of the number of shares which each one of them is entitled to buy of the new issue. It is one way through which to reduce the cost of raising new shares. It is a device used by companies whose shares are listed on the stock to raise additional capital. Existing ordinary shareholders are

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NOTES & EXERCISES ON Financial Management -For ICM Students given a right certificate which entitles them to take up a specified number of shares at a specified price. The right issue price is sufficiently below listed price to make the offer attractive. Shareholders who do not wish to exercise any or all of their rights may sell them to third parties who then apply for the shares or he may renounce his right. DEBENTURES A debenture is defined as a written acknowledgement of debt by a company, containing provisions as to the payment of interest and the repayment of the principal. FORMS/ TYPES OF DEBENTURES Debentures can take any of the following forms. 1. Naked (unsecured) debenture: They are debentures which have not been guaranteed with any collateral. It is not secured against any property. It does not carry any fixed charge against the assets of the company. 2. Secured/ mortgage debenture: This debentures are secured and carry a fixed charge on the assets to the company. 3. Redeemable debentures: These are debentures which the company aggress to repay at a fixed determinable future date. 4. Irredeemable debentures: These are debentures which the company cannot redeem or payback.

THE PROFIT AND LOSS ACCOUNT AND THE BALANCE SHEET


THE TRADING ACCOUNT It shows the total sales revenue less the cost of goods sold. It is the first to be prepared and therefore comes before the profit and loss account. The difference between the sales revenue and the cost of goods sold is termed GROSS PROFIT.
FORMAT FOR INTERNAL USE MORE LTD TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 31ST DECEMBER 2006 Sales XXX Less: Returns inwards XX Net sales XXX Less Cost of Sales: Opening stock XX

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NOTES & EXERCISES ON Financial Management -For ICM Students


Add: purchases Carriage inwards Less returns outwards Goods available for sale Less closing stock Cost of XXX Gross XXX Add other income: Rent received Discount received Decrease in provision for bad debt Profit on sale of assts Investment income XXX XXX Less expense: Rent and rates Selling and distribution expenses Wages and salaries Light and heating Postage and stationary Discount allowed Interest Insurance Increase in provision for bad debt Bad debt written off Loss on disposal/ sale of asset Vehicle expenses Auditors fees General expenses Depreciation Other expenses XXX Net profit XXX Taxation (XX) Net profit XXX Dividends: Interim dividends paid Proposed dividends (XX) XX XX XX XX XX sales profit XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX before tax

after

tax

XX XX

X X Transfer (XX) Profit XXX to and capital loss reserves c/d

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NOTES & EXERCISES ON Financial Management -For ICM Students

BALANCE SHEET AS AT 31 AUGUST 2005 FIXES ASSETS Intangible (e.g. Goodwill) Premises/ Land& buildings Furniture and fittings Motor vehicles XXX Other assets XXX Equipment XXX XXX CURRENT ASSETS: Stocks Trade debtors Less provision for bad debt Prepayment Other receivables Cash & Bank CURRENT LIABILITIES: Trade creditors Debenture interest unpaid Other owing Provision for taxation Proposed dividends Working XXX Net XXX Financed by: 1 ordinary share capital XXX Profit and Loss account XXX Debentures XXX Long term Loan XXX Net XXXX assets COST XXX XXX XXX XXX XXX XXX XXX XXX XXX (XX) XXX XXX XXX XXX XXX DEP. XX XX XX NBV XXX XXX XXX XX XX XX XX

XXX XXX XXX XXX XXX

(XXX) capital

Worth

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NOTES & EXERCISES ON Financial Management -For ICM Students

FOR PUBLICATION

This section concentrates on the syllabus of financial management. However, students who have difficulty or whose first time in accounting is at this level should refer to page (xxx) for brief introduction before reading this section.

If the final account is for publication or for presentation to members (shareholders), the Profit and Loss Account and the Balance Sheet are prepared in a summarized form and the details are then presented in the form of a note to the accounts. The format for accounts for publication is provided by the companies Act 1985. The format may be different from business to business and a particular format to use in an examination depends on the question given. (For details of the format, refer to Frank Wood Business Accounting 2) The format is presented below. Once again students must remember that, for our examination purpose, the format has been limited the questions set in our examination for easy understanding. Notes to the accounts are not required by the syllables and therefore it is excluded from this manual. A specimen format is presented below: THE PROFIT AND LOSS ACCOUNT ABC LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST DECEMBER Turnover XXX Cost of sales Gross operating profit/ (loss) Distribution cost XX Administrative Expenses XX Net profit before interest and tax Interest Net profit before taxation Taxation for the year Net profit after tax Dividends (proposed and paid) Transfer to capital surplus

2006 (XX) XX XX XX (XX) XX (XX) XX (XX) (XX)

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NOTES & EXERCISES ON Financial Management -For ICM Students Net profit c/d XXX

THE BALANCE SHEET ABC LTD BALANCE SHEET AS AT 31ST DECEMBER 2006 Fixed Assets Intangible assets (e.g. Goodwill) Tangible assets Long term investment Current Assets Stocks Debtors Cash Bank Prepayment Other receivables Current liabilities Trade creditors Bank overdraft Taxation Proposed dividends Accrued expenses (owing) Other payables Working capital XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

XXX XXX XXX XXX

(XXX) XXX XXX XXX XXX (XXX) XXXX XXX XXX XXX XXX XXX XXX

Debentures Other Long term liabilities Net assets CAPITAL AND RESERVES: Ordinary share capital Preference share capital Share premium Profit and loss account/Revenue reserves Capital reserves Shareholders fund/Net worth

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NOTES & EXERCISES ON Financial Management -For ICM Students Tutorial: i. The format provided above does not contain all items in the format as contained in the companies Act 1985. The standard format can be obtained from Frank Wood Accounting 2. ii. Debentures and other long term loans: These can be deducted from the assets or added to capital and reserves. iii. Debtors are stated after deducting provision for bad debt.

Example1. The following information has been extracted from the mores of Fordham Ltd as at 31st December 2007 Dr Cr Bank 2,000 Capital: 100,000 ordinary shares fully paid (1 each) 100,000 8%50,000 preference shares fully paid (1 each) 50,000 Debenture loan stock (10%-repayable 2009) 30,000 Debenture loan interest 3,000 Discount allowed 2,000 Discount received 5,000 Dividend received 700 Dividend paid: ordinary interim 5,000 Preference 4,000 Freehold land (at cost) 200,000 Investments (listed: market value at 31/12/2007- 11,000) 10,000 Office expenses 15,000 Office salaries 35,000 Motor van (at cost) 15,000 Motor van: accumulated depreciation (1/1/2007) 6,000 Motor van expenses 2,700 Purchases 220,000 Sales 300,000 Retained profit (1/1/2007) 9,000 Share premium account 10,000 Stocks (1/1/2007) 20,000 Trade creditors 50,000 Trade debtors 27,000 560,700 560,700

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NOTES & EXERCISES ON Financial Management -For ICM Students Additional information 1. The stocks as at 31st December 2007 were valued at cost at 40,000 2. Depreciation is to be charged on the motor van at a rate of 20% per annum on cost. No depreciation is to be charged on the freehold land. 3. Corporation tax (based on profits for the year at the rate of 35%) has been estimated at 10,000 4. The directors proposed a final ordinary dividend of 10p per share. 5. The authorized share capital of the company is as follows: a) 150,000 ordinary shares of 1 each and b) 75,000 preference shares of 1 each REQUIRED: a) Prepare Fordham Ltds trading, profit and loss account for the year end 31st December 2007 b) The balance sheet as at that date Solution

QUESTION 2 You have obtained the following information in respect of BOB Ltd. For the year ended th 30 June 2007 000 Sales (all credit) 1,800 Cost of sales 700 Administration expenses 400 Distribution costs 250 Interest paid 10 Provision for taxation 50 Proposed dividend 80

TASKS Prepare a summarised Profit & Loss account for the year 30 June 2007. Solution: a) BOB LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007 Turnover 1,800,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Less cost of sales Gross Profit Less Expense: Administrative Expenses Distribution cost Net profit before interest and Tax Less Interest paid Net profit before Tax Less Provision for taxation Net profit after tax Less Proposed Dividends Net profit c/d QUESTION 3 (JUNE 2005) Q.2 The following information relates to TLC Ltd. and has been taken from their books as at 31 May 2005: Turnover 990,000 Administration expenses 140,000 Cost of sales 370,000 Taxation for the year 40,000 Interest paid 20,000 Distribution costs 190,000 Proposed dividends 40,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 May 2005 was 6.00 per share. TASKS a) Prepare the Profit & Loss account of TLC Ltd. for the year ended 31 May 2005. b) Calculate the following i. The EPS ii. The PE ratio iii. The dividend per share iv. The interest cover v. The profit after tax to sales percentage SOLUTION TO QUESTION 2: a) TLC Ltd PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005 Turnover 990,000 Cost of sales (370,000) Gross profit 620,000 700,000 1,100,000 400,000 250,000 (650,000) 450,000 10,000 440,000 50,000 390,000 80,000 310,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Less Expenses: Administration expenses 140,000 Distribution costs 190,000 (330,000) Net profit before Interest & Tax 290,000 Interest Paid (20,000) Net profit before Tax 270,000 Taxation for the year (40,000) Net profit after tax 230,000 Proposed dividends (40,000) Profit & Loss Account c/d 190,000 b) i. Earnings Per Share (EPS) = Net profit after tax Preference share dividend No. of ordinary shares Note: there are no preference shares. We only have ordinary shares of 500,000 shares in the question. = 230,000 X100= 46p per share (or 0.46 per share) 500,000 shares ii. Price Earnings (P E ) ratio = Market Price per share EPS = 6.0 0.46 iii. Dividend per share = = 13.04 times dividend paid/proposed No. of shares

= 40,000 X 100 = 0.08 or 8% per share = 8P per share 500,000 iv. Interest cover = Net profit before Interest and Tax Interest = 290,000 = 14.5 times 20,000 v. Profit after tax to sales percentage = Net profit after tax X 100 Sales = 230,000 X 100 990,000 = 23.23% QUESTION 3 (September 2005 Q.2) The following information relates to AVCE Ltd. and has been taken from their books as at

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NOTES & EXERCISES ON Financial Management -For ICM Students 31 August 2005 Turnover 1,120,000 Administration expenses 170,000 Cost of sales 460,000 Taxation for the year 90,000 Interest paid 25,000 Distribution costs 210,000 Proposed dividends 90,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 August 2005 was 4.90 per share. TASKS a) Prepare the Profit & Loss account of AVCE Ltd. for the year ended 31 August 2005 b) Calculate the following i. The EPS ii. The PE ratio iii. The dividend per share iv. The interest cover v. The profit after tax to sales percentage SOLUTION TO QUESTION 3: a) AVCE Ltd PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST AUGUST 2005 Turnover 1,120,000 Cost of sales (460,000) Gross profit 660,000 Administration expenses 170,000 Distribution costs 210,000 (380,000) Net profit before Interest & Tax 280,000 Interest Paid (25,000) Net profit before Tax 225,000 Taxation for the year (90,000) Net profit after tax 165,000 Proposed dividends (90,000) Profit & Loss Account c/d 75,000 b) i. Earnings Per Share (EPS) = Net profit after tax Preference share dividend No. of ordinary shares

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NOTES & EXERCISES ON Financial Management -For ICM Students Note: There is no preference share dividend in the question and so nothing was deducted = 165,000 = 33p per share (or 0.33 per share) 500,000 shares ii. Price Earnings (P E ) ratio = Market Price per share EPS = 4.90 = 14.84 times .0.33 Dividend per share = share iv. 500,000 Interest cover = Net profit before Interest and Tax Interest = 280,000 = 11.2 times 25,000 Profit after tax to sales percentage = Net profit after tax X 100 Sales = 165,000 X 100 1,120,000 = 14.73% QUESTION 4 You have obtained the following information/data of Slingsbury Ltd. as at 31 May 2005: Stock 130,000 Creditors 210,000 Fixed assets at cost 350,000 Cumulative depreciation of fixed assets 65,000 1 Ordinary share capital 100,000 Debtors 140,000 Proposed dividend 30,000 Provision for company tax 20,000 Bank overdraft 13,000 Long-term loans outstanding 40,000 Share premium account 20,000 Revenue reserves 122,000 TASKS a) Prepare the balance sheet of Slingsbury Ltd. as at 31 May 2005. b) Calculate TWO liquidity ratios. dividend No. of shares = 90,000 = 18P per share or 18% per

iii.

v.

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NOTES & EXERCISES ON Financial Management -For ICM Students SOLUTION QUESTION 4(a) SLINGSBURY LTD BALANCE SHEET AS AT 31 MAY 2005 ASSETS: NBV Fixed Assets 285,000 285,000 CURRENT ASSETS: Stocks Debtors CURRENT LIABILITIES: Creditors Bank overdraft Provision for taxation Proposed dividends Working (3,000) Net 282,000 210,000 13,000 20,000 30,000 COST 350,000 350,000 130,000 140,000 270,000 DEP. 65,000 65,000

(273,000) capital assets

Financed by: 1 ordinary share capital 100,000 Revenue reserves (P&L) 122,000 Share Premium Account 20,000 Long term Loan 40,000 Net Worth 282,000 b) TWO LIQUIDITY RATIOS i. Current Ratio = Current Assets : 1 = 270,000 : 1 = 0.99:1 Current Liabilities 273,000 ii. Quick/Acid Test Ratio = Current Assets Stocks: 1 Current liabilities = 270,000-130,000 :1 =140,000 :1 273,000 273,000

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NOTES & EXERCISES ON Financial Management -For ICM Students = 0.51:1 QUESTION 5 The following list of balances as at 31 August 2005 of GHB Ltd. has been taken from the books AFTER the trading account has been completed: 000 000 Dr Cr Gross profit for the year 270 Equipment at cost 280 Equipment depreciation (01 09 04) 112 Ordinary share capital 200 Distribution costs 110 Administration expenses 90 Interim dividend paid 10 Stock at 31 08 05 240 Trade debtors 190 Trade creditors 70 Cash and Bank 20 6% Debentures (redeemable 2009) 200 Profit & Loss account (01 09 04) 88 940 940 Notes: Equipment is to be depreciated at 10% on cost. Interest on debentures is still unpaid. The provision for tax is estimated at 12,000. A final dividend of 10 pence per share is proposed. TASKS a) Prepare the Profit & Loss and appropriation account for the year ended 31 August 2005. b) Prepare the balance sheet as at 31 August 2005. c) Calculate the EPS. d) Calculate the dividend cover.

SOLUTION: question 5 a) GHB LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST 2005 Gross profit 270,000 Distribution cost 110,000 Administrative expenses 90,000 Depreciation (280,000 X10%) 28,000 (228,000) Net profit before interest and tax 42,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Debenture interest unpaid (6% X 200,000) Net profit before tax Taxation Net profit after tax Profit and Loss account balance b/d Dividends: paid Proposed (10% 200,000) Profit and Loss c/d b) GHB LTD 10,000 20,000 (12,000) 30,000 (12,000) 18,000 88,000 106,000 (30,000) 76,000

BALANCE SHEET AS AT 31 AUGUST 2005 FIXES ASSETS : Equipment 140,000 140,000 CURRENT ASSETS: Stocks Trade debtors Cash & Bank CURRENT LIABILITIES: Trade creditors Debenture interest unpaid Provision for taxation Proposed dividends 336,000 Net 476,000 Financed by: 1 200,000 Profit 76,000 Long 200,000 Net 476,000 ordinary and term 70,000 12,000 12,000 20,000 (114,000) assets COST DEP. 280,000 280,000 240,000 190,000 20,000 450,000 NBV 140,000 140,000

share Loss

capital account Loan Worth

c) The EPS. Earnings Per Share (EPS) = Net profit after tax preference shares dividend No. of ordinary shares

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NOTES & EXERCISES ON Financial Management -For ICM Students = 18,000 200,000 = 9 pence per share (or 0.09 per share)

d) The dividend cover = Net profit after tax = 18,000 Dividend 30,000 = 0.6 per share (or 60 pence per share) QUESTION 6 The following trial balance has been extracted from the books of Dessorch plc. for the year ended 28 February 2007: dr cr Land and Buildings at cost400,000 Plant and Machinery at cost150,000 Office equipment at cost60,000 Vehicles at cost 50,000 Depreciation accounts (01 03 06): Plant and machinery 50,000 Office equipment 20,000 Vehicles 25,000 Trade debtors 155,000 Bank overdraft 10,000 Cash 3,000 Trade creditors 120,000 Long-term loan 80,000 Sales (all on credit) 2,230,000 Purchases 1,300,000 Stock (01 03 06) 200,000 Wages and salaries 450,000 Business rates and insurance60,000 Heating and lighting 30,000 Vehicle expenses 31,000 Distribution costs 45,000 Interest paid 6,000 Profit and loss account (01 03 06) 205,000 1 Ordinary shares 200,000 ------------------2,940,000 2,940,000 NOTES at 28 February 2007: Stock in hand was valued at 105,000. Wages owing amounted to 5,000. Business rates prepaid amounted to 1,000. Plant and machinery is to be depreciated at 25% on cost. Office equipment is to be depreciated at 20% on cost. Vehicles are to be depreciated at 25% of net book value. It has been established that included in the 155,000 of trade debtors is an amount of 5,000 owing from a company which has ceased to trade, and has large debts. Consequently it is felt that the whole amount should be written off. More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students It has been decided to create a provision for doubtful debts equal to 5% of the final end of year trade debtor figure. The directors estimate the tax liability to be 30,000. The directors have declared a final dividend of 9p.

TASKS a) Prepare the trading and profit and loss account for the year ended 28 February 2007. b) Prepare the balance sheet as at 28 February 2007. SOLUTION Q6. (a) DESSORCH PLC
TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 28 FEBRUARY 2005

Sales Cost of sales Gross profit Distribution cost Administrative expenses Net profit before interest and tax Interest paid Net profit before tax Taxation Net profit after tax Dividends: Proposed (9% x 200,000) Profit and Loss account balance b/d Profit and Loss c/d

2,230,000 (1,395,000) 835,000 45,000 643,500 (688,250) 146,750 (6,000) 140,750 (30,000) 110,750 (18,000) 92,750 205,000 297,750

(b) DESSORCH PLC BALANCE SHEET AS AT 28 FEBRUARY 2005 FIXES ASSETS : NBV Land & Buildings 400,000 Plant & Machinery 62,500 COST 400,000 150,000 DEP. 87,500

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NOTES & EXERCISES ON Financial Management -For ICM Students Motor Vehicle 18,750 Office Equipment 28,000 509,250 CURRENT ASSETS: Stocks Trade debtors (155,000 5,000 -7,500) Rent prepaid Cash & Bank CURRENT LIABILITIES: Trade creditors Wages owing Bank overdraft Provision for taxation Proposed dividends 68,500 Net 577,750 Capital & Reserves 1 ordinary 200,000 Profit and 297,750 Long 80,000 Net Worth 577,750 Workings: 1. COST OF SALES: Opening stock Purchases Closing stock Cost of sales 120,000 5,000 10,000 30,000 18,000 50,000 60,000 660,000 31,250 32,000 150,750 105,000 142,000 1,000 3,000 251,500

(183,000) assets

share Loss term

capital account Loan

200,000 1,300,000 1,500,000 (105,000) 1,395,000

2. ADMINISTRATIVE EXPENSES Wages and salaries Add wages owing Heating and lighting Vehicle expenses Business rates Less prepaid 450,000 5,000 60,000 1,000

455,000 30,000 31,000 59,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Bad debt written off Provision for bad debt (155,000-5,000) x 5% Depreciation: Plant and machinery (150,000x25%) Office equipment (60,000x20%) Vehicles (50,000-25,000) x 25%) 5,000 7,500 37,500 12,000 6,250 643,250

QUESTION 7 You are the account officer of MORE LTD which has a registered capital of 1,500,000 divided into 2,400,000 ordinary share of 50p each and 600,000 8% preference shares of 50p each. The following balances have been extracted from the books of the company after preparing the trading profit and Loss Accounts for the year ended 30 June 2007. Dr Cr Ordinary share capital 300,000 8% preference shares 90,000 General Reserve 15,000 Premises (cost) 420,000 Bank 24,600 Light & heating owing 2,640 Profit & Loss A/c bal (1July 2006) 57,600 Debtors & Creditors 17,400 3,360 Stocks 115,020 Cash 120 Plant & Machinery (at cost) 150,000 Net profit for the year ended (30 June 2007) 121,800 Insurance prepaid 2,460 Provision for depreciation: Plant & Machinery 90,000 705000 705,000 Additional information: The directors of MORE LTD have made the following Recommendations. 1. Corporate tax provision of 25,200 2. The payment of preference share dividend 3. A maximum dividend on ordinary shares which would maintain a working capital ratio of 1:5:1, the balance remaining from profits to be transferred to general reserves. Required: a) Prepare the profit and loss A/c for the year ended 30 June 2007 b) Prepare the balance sheet as at 30 June 2006. SOLUTION: Q7 Note: The additional information on ordinary share dividends requires the preparation of the balance sheet first

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NOTES & EXERCISES ON Financial Management -For ICM Students MORE LTD Profit and Loss Account for the Year ended 30th June 2007 Net profit for the year 121,800 Taxation provision (25,200) Net profit after tax 96,600 Dividend: Preference shares (8% x 90,000) 7,200 Ordinary shares (w1) 27,000 34,200 General reserve (Balance remaining) (62,400) P & L Bal b/d 57,600 57,600 MORE LTD BALANCE SHEET AS AT 30TH JUNE 2007 FIXES ASSETS : NBV Premises 420,000 Plant & Machinery 60,000 480,000 CURRENT ASSETS: Stocks Trade debtors Insurance prepaid Cash CURRENT LIABILITIES: Trade creditors Light & heating owing Bank overdraft Proposed dividends: ordinary shares Preference shares Provision for taxation 45,000 Net 525,000 Capital & Reserves 1 ordinary 300,000 Preference 90,000 3,360 2,640 24,600 27,000 7,200 25,200 115,020 17,400 2,460 120 135,000 COST 420,000 150,000 570,000 DEP. 90,000 90,000

(90,000) assets

share

capital shares

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NOTES & EXERCISES ON Financial Management -For ICM Students Profit 297,750 General 77,400 Net Worth 525,000 and reserves Loss (15,000 account +62,400)

WORKINGS: DIVIDENDS Preference share dividends: (90,000x 8%) 7,200 Ordinary shares dividend: After paying the ordinary shares the working capital ratio (current assets divided by current liabilities) must give a ratio of 1.5:1(i.e. should be 50% more than the current liabilities). The total current asset was 135,000. This means that to get a current ratio of 1.5:1 and the total current liabilities must be 90,000. Total liabilities before ordinary shares were 63,000. Therefore 27,000 must be paid as dividends on ordinary shares to make total liabilities equal 90,000 (63,000 +27,000) which will give a working capital ratio of 1.5:1 (135,000 90,000). The remainder of the profit for the year 62,400 is transferred to the general reserve in the balance sheet. QUESTION 8(MARCH 2007) The following information relates to Rollo Ltd and has been extracted from their books as at 28 February 2007: Turnover 2,900,000 Selling and distribution costs250,000 Taxation for the year 160,000 Stock at 01 03 06 360,000 Purchases 1,200,000 Stock at 28 02 07 380,000 Administration expenses 240,000 Interest paid 110,000 Proposed ordinary dividend100,000 Issued ordinary share capital 1,000,000 Current market price per ordinary share TASKS a) Prepare the profit and loss account for the year ended 28 February 2007. b) Calculate the following: i the gross profit to sales percentage ii the profit after tax to sales percentage iii the earnings per share (EPS) iv the PE ratio v the stock turnover period in days c) Comment on the financial performance via the use of ratios.

16

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NOTES & EXERCISES ON Financial Management -For ICM Students

SOLUTION: a) ROLLO LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENED 28TH FEBRUARY 2007 Turnover 2,900,000 Cost of sales (1,180,000) Gross profit 1,720,000 Administrative expenses 240,000 Selling and distribution expenses 250,000 (490,000) Net profit before interest and tax 1,230,000 Interest paid (110,000) Net profit before Tax 1,120,000 Taxation (160,000) Net profit after tax 960,000 Proposed dividends (100,000) Profit and loss c/d 860,000 b) i. Gross profit percentage = Gross profit X 100 = 1,720,000 X 100 Sale 2,900,000 =59.3% Profit after tax to sales percentage = Net profit after tax X 100 Sales = 960,000 X 100 2,900,000 = 33.1% EPS = Net profit after tax = 960,000 No. of shares 1,000,000 PE ratio = Market price per share times EPS = 16 0.96 = 96p per share

ii.

iii.

iv.

= 16.67

Stock turnover (in days) = Average stock X 365 days Cost of sales Average Stock = opening stock + closing stock= 360,000 +380,000 = 370,000 2 2 Stock turnover = 370,000 X 365 days 1,180,000 = 114 days v.

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NOTES & EXERCISES ON Financial Management -For ICM Students c) Comment of the financial performance of Rollo Ltd: The gross profit of 59.3% seems fairly good even though previous years performance is not available for comparison. The EPS seems high compared with the 1,000,000 shares in issue. However, the company is not able to sell its stock quickly enough. This may suggest lack of demand for the goods otherwise management are taking advantage of bulk purchase as the stock turnover stood at 114days. QUESTION 10(MARCH 2008-ACCOUNTING III) The following trial balance has been extracted from the books of Yousef plc for the year ended 29 February 2008: dr cr Premises 400,000 Machinery 150,000 Vehicles 60,000 VAT refund due 10,000 Trade debtors 360,000 Prepayments 4,000 Bank 6,000 Cash 1,000 Trade creditors 140,000 Long-term loan 110,000 Hire purchase account 90,000 Sales (all on credit) 2,076,000 Purchases 990,000 Stock (01 03 07) 59,000 Wages and salaries 410,000 Business rates 70,000 Energy costs 65,000 Interest paid 8,000 Vehicle running expenses 36,000 Distribution costs 42,000 Advertising expenses 65,000 Communication expenses 70,000 Profit and loss account (01 03 07) 237,500 1 Ordinary shares 100,000 Machinery depn. a/c (01 03 07) 37,500 Vehicle depn. a/c (01 03 07) 15,000 ------------------2,806,000 2,806,000 ======== ======== Notes at 29 February 2008: Stock was valued at 64,000 The analysis of the hire purchase account revealed that 20,000 falls due for payment by 30 June 2008 and that the rest falls due for payment in the year 2012. Machinery AND vehicles are to be depreciated at 25% on cost. The directors have decided to provide the following provisions: o Corporation tax of 56,000 o An ordinary dividend of 80 pence per share

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NOTES & EXERCISES ON Financial Management -For ICM Students TASKS a) Prepare the trading and profit and loss account for the year ended 29 February2008. [9] b) Prepare the balance sheet as at 29 February 2008.[8] c) Calculate the following accounting ratios: i gross profit percentage ii the profit before tax percentage of sales iii the current ratio iv the acid test SOLUTION: Q 8 (a) YOURSEF PLC TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 29TH FEBRUARY 2008 Sales Opening stock Purchases Closing stock Gross profit EXPENSES: Wages & salaries Business Rates Energy costs Interest paid Vehicles running expenses Distribution costs Communication expenses Advertising Depreciation: Machinery (25% X 150,000) Vehicle (25% X 60,000) Net profit before tax Corporation tax Net profit after tax Dividends (0.8 X 100,000) Retained profit for the year Net profit b/d Net profit c/d 2,076,000 59,000 990,000 1,049,000 (64,000) (985,000) 1,091,000 410,000 70,000 65,000 8,000 36,000 42,000 70,000 65,000 37,500 15,000 (818,500) 272,500 (56,000) 216,500 (8,000) 208,500 237,500 446,000

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NOTES & EXERCISES ON Financial Management -For ICM Students

(b) YOUSEF PLC BALANCE SHEET AS AT 29TH FEBRUARY 2008 FIXES ASSETS : NBV Premises 400,000 Vehicles Machinery 75,000 505,000 CURRENT ASSETS: Stocks Trade debtors Vat refund Bank Cash Prepayments CURRENT LIABILITIES: Trade creditors Hire purchase Corporate tax Dividends 221,000 COST 400,000 60,000 30,000 150,000 610,000 64,000 360,000 10,000 6,000 1,000 4,000 445,000 140,000 20,000 56,000 8,000 DEP. 30,000 75,000 105,000

(224,000) (70,000) (110,000) assets

Hire purchase account (90,000-20,000) Long term loan Net 546,000 Capital & Reserves

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NOTES & EXERCISES ON Financial Management -For ICM Students 1 100,000 Net profit Net Worth 546,000 ordinary share 446,000 capital

(c) i. Gross profit percentage = Gross profit X 100 = 1,091,000 X 100 = 52.55% Sale 2,076,000 ii. 100 = 13.1% 2,076,000 iii. Current Ratio = Current Assets Current Liabilities = 445,000 = 1.98:1 224,000 = 455,000 224,000 Profit before tax to sales percentage = Net profit before tax X = 272,500 Sales X 100

iv. Quick/Acid Test Ratio = Current Assets Stock 64,000 = 381,000 = 1.7:1 Current Liabilities 224,000

QUESTION 9 ( past Question) The following trial balance has been taken from the books of RAB Ltd. as at 30 April 2007: Turnover 1,960,000 Purchases 1,120,000 Stock (01 05 06) 76,000 Communication expenses28,000 Rent, rates and insurance 53,000 Marketing expenses 95,000 Heating and lighting 29,000 Auditors fee 7,000 Salaries 168,000 Debenture interest 3,000 Wages 210,000 Creditors 55,000 Provision for doubtful debts 2,000 Equipment at cost 530,000 Depreciation of equip. (01 05 06) 90,000 Debentures (6%) 50,000 Ordinary share capital (1) 200,000 Profit and loss a/c bal (01 05 06) 102,000 Debtors 130,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Bank balance Notes at 10,000 2,459,000 ------2,459,000

30 April 2007: Stock is valued at 74,000. Salaries owing amounted to 6,000. Marketing expenses prepaid amounted to 8,000. The provision for doubtful debts is to be increased to 4,000. The equipment is to be depreciated by 25% pa on cost. The directors wish to provide 38,000 for corporation tax. The directors have declared an ordinary dividend of 12p per share.

TASKS a) Prepare the profit and loss account for the year ended 30 April 2007. b) Prepare the balance sheet as at 30 April 2007

Solution: Q9(b) RAB LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED Turnover 1,960,000 Cost of sales: Opening stock Purchases Cost of goods available for sale Closing stock Cost of sales (1,122,000) Gross profit 838,000 EXPENSES: Communication expenses Rent, rates & Insurance Marketing expenses 95,000 Less prepaid (8,000) Heating and lighting Auditors fees Salaries 168,000, Add owing 6,000 Wages Increase in prov. for bad debts (4,000 -2,000) Debenture interest 30TH APRIL 2007

76,000 1,120,000 1,196,000 (74,000)

28,000 53,000 87,000 29,000 7,000 174,000 210,000 2,000 3,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Depreciation: equipment (25%x 530,000) (722,500) Net profit before tax 115,500 Taxation (38,000) Net profit after tax 74,500 Proposed dividends (12% x 200,000) (24,000) Retained profit for the year 50,500 P & L Account Bal. b/d 102,000 P&L Account c/d 152,500 132,500

RAB LTD BALANCE SHEET AS AT 30 APRIL 2007 FIXES ASSETS : NBV Equipment 307,500 307,500 CURRENT ASSETS: Stocks Debtors Less provision for bad debt Marketing expense prepaid Bank balance CURRENT LIABILITIES: Trade creditors Salaries owing Provision for taxation Proposed dividends 95,000 402,500 6% (50,000) Net 352,500 Capital & Reserves 530,000 530,000 74,000 130,000 4,000 126,000 8,000 10,000 218,000 222,500 222,500 COST DEP.

55,000 6,000 38,000 55,000

(123,000)

Debentures assets

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NOTES & EXERCISES ON Financial Management -For ICM Students 1 200,000 Profit 152,500 Net Worth 352,500 ordinary and share Loss capital account

TRY QUESTIONS: 1. You work as the accountant for a client named Dusty, and have just taken out the trial balance as at 30 April 2007: dr cr Capital as at 01 05 06 219,000 Long-term loan 40,000 Sales 1,879,000 Purchases 1,210,000 Stock as at 01 05 06 74,000 Debtors 82,000 Prov. for doubtful debts 1,000 Creditors 67,000 Business rates 38,000 Insurances 45,000 Light and heat 42,000 Motor expenses 18,000 Staff salaries 82,000 Loan interest 2,000 Buildings at cost 400,000 Vehicles at cost 50,000 Vehicle depreciation 01 05 06 20,000 Wages 155,000 Bank 6,000 Cash 1,000 Drawings 21,000 2,226,000 2,226,000 ======== ======== Notes at 30 April 2007: Stock was valued at 71,000. Insurance prepaid amounted to 2,000. Wages owing amounted to 5,000. The accountants fee outstanding is estimated to be 4,000. The accountant has reviewed the debtors outstanding and advises Dusty to write off 2,000. After writing off the bad debt you suggest that the provision for doubtful debts should be increased to 3,000. The vehicles are to be depreciated by 20% on cost. TASKS a) Prepare Dustys trading and profit and loss account for the year ended 30 April 2007. b) Prepare Dustys balance sheet as at 30 April 2007. Question 2. More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students The following information relates to Status Ltd. and has been taken from their books as at 31 March 2006: Turnover 1,400,000 Administration expenses210,000 Cost of sales 480,000 Taxation for the year 100,000 Interest paid 20,000 Distribution costs 230,000 Proposed dividends 80,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 March 2006 was 11.20 per share. TASKS Prepare the Profit & Loss account of Status Ltd. for the year ended 31 March 2006. Question 3 The following are the assets and liabilities of Chantal Ltd. as at 30 April 2007: 000 Premises 800 Bank overdraft 130 Creditors 110 Goodwill 150 Debtors 400 Vehicles (net) 190 Ordinary share capital 700 Preference share capital 300 Share premium 140 Tax owing 110 Dividends owing 80 Equipment 460 Closing stock 300 Profit and loss account balance 400 Long-term loans 330 The following information has also been gathered: Credit sales 3,400 Opening stock 260 Purchases TASKS a) Prepare the balance sheet of Chantal Ltd. as at 30 April 2007. b) Calculate the following ratios: i current ii acid test iii the debtor collection period in days iv the rate of stock turnover

1,500

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NOTES & EXERCISES ON Financial Management -For ICM Students c) Comment briefly on the liquidity position of Chantal Ltd. as at 30 April 2007. Question 4 The following are the assets and liabilities of RebEt Ltd. as at 30 November 2005: 000 Equipment (net) 280 Bank overdraft 110 Creditors 156 Goodwill 190 Debtors 412 Vehicles (net) 140 Ordinary share capital 500 Preference share capital 200 Share premium 120 Tax owing 90 Dividends owing 100 Premises 700 Closing stock 224 Profit & Loss account balance 390 Long-term loans 280 TASKS a) Prepare the balance sheet of RebEt as at 30 November 2005. b) Calculate the following ratios: i current ii acid test c) Comment briefly on the liquidity position of RebEt as at 30 November 20

CHAPTER THREE ACCOUNTING RATIOS


INTRODUCTION An accounting ratio is a mathematical relationship between two accounting figures which can be presented in the form of numerals, percentage, a fraction or a decimal. Each expression attracts a special care. Financial ratios or Accounting ratios are useful indicators of a firm's performance and financial situation. Ratios can be used to analyze trends

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NOTES & EXERCISES ON Financial Management -For ICM Students and to compare the firm's financials position to those of other firms. In some cases, ratio analysis can predict future bankruptcy. USERS OF ACCOUNTING RATIOS 1. Trade Creditors: These groups of people are interested in the companys ability to pay its short term debts as and when they fall due. Their analysis will usually concentrate on the evaluation of the companys liquidity position (i.e. Liquidity ratios). 2. Lenders of long term loan (e.g. debenture holders): They are concerned with the companys long term solvency and its survival in the future. Their analysis will concentrate on the firms profitability over time, its ability to generate cash to pay them (i.e. the lenders) their interest when due and the payment of the principal money. Their focus will be on the companys capital structure (i.e. the relationship between the various sources of funds- equity and debt capital) 3. Investors: These people are mostly concerned with the companys earnings. Investors have more confidence in companies that shows a steady growth in earnings. Their analysis concerns an evaluation of the companys present and future profitability. They are also interested in the capital structure of the company to prevent greater risks and any structure which can influence the earrings ability of the firm. 4. Management: Management/Directors of the company are the stewards of the company. They are therefore interested in every aspect of the analysis. CATEGORIES /TYPES OF ACCOUNTING RATIO Financial ratios can be classified according to the information they provide. They can be classified in to five main groups. 1. PROFITABILITY RATIOS 2. LIQUIDITY RATIOS 3. ACTIVITY RATIOS OR EFFICIENCY RATIOS 4. LONG-TERM SOLVENVY/GEARING OR LEVERAGE RATIOS 5. INVESTMENT/ STOCK MARKET RATIOS. In general, Profitability ratios measures the overall performance of the company, Liquidity ratios measures the firms ability to meet current debts as they become due for payment, Activity/ efficiency ratios reflects the firms efficiency in utilizing its assets, Gearing/Leverage ratios measures the proportion of debt and equity in financing the assets of the company and Stock market ratios evaluate the firms growth earnings. These categories have a number of ratios under each type. These are discussed in details below.

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NOTES & EXERCISES ON Financial Management -For ICM Students 1) PROFITABILITY RATIOS These ratios measure the businesss potential to make profit in excess of its operating cost. It is one of the most important measures of a companys success. These ratios are used to measure the trading performance of the business in terms of profit to sales or capital. They compare profits at different levels with other figures and are often presented as percentages. The main purpose of these ratios is to measure the profit made by a business within one year. Profitability is a primary measure of the overall success of a company. Indeed, it is necessary for a companys survival. The main profitability ratios are: a) Gross Profit (Margin) percentage/ratios b) Net profit percentage/ ratio c) Return On Capital Employed (ROCE) d) Return on Total Assets e) Return on Net Worth f) Expenses to Net profit ratio (percentage.) g) Expenses to sales percentage A) GROSS PROFIT PERCENTAGE: This is Gross Profit divided be Sales. This ratio measures the average gross profit/margin on sales of goods. It expresses the proportion of the selling price which represents gross profit. It is calculate by the formulae below: Gross profit percentage = Gross Profit X 100 Sales The answer you get represents the amount of gross profit for every 100 of sales revenue. For instance, if the answer is 20%, this would mean that for every 100 of sale you make, 20 gross profit is made before any expense is paid. Interpreting the gross profit percentage Normally this ratio is expected to remain reasonably constant overtime. Manufacturing industries with high operating cost/overheads would usually have higher margins whilst industries with high volumes of sales like food retailing have low margins. Low margins usually suggest poor performance. But sometimes it may be due to expansion cost undertaken by the company such as launching a new product, trying to increase market share etc. Above average margins are usually a sign of good management. However, too high margins may make competitors enter the market to compete with the business. High profit margins could also mean the effectiveness of the sales team, pricing policies, purchasing methods, and the production process.

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NOTES & EXERCISES ON Financial Management -For ICM Students The ratio is expected to remain constant over time. Therefore if there is a change in this ratio over various accounting periods, the change may be traced to a change in any of the following: a) Selling price- increase or decrease in selling price over the periods, which is sometimes deliberate; perhaps in order to increase sales. b) Stocks- wrong valuation of stocks or errors in accounting for stocks etc. c) Production cost- increase or decrease in the production cost over the period e.g. Increase in raw materials which has not been possible to pass on to customers in the form of higher prices. d) Sales mix- a change in sales mixed; if several different products are been sold they will not all be equally profitable; it is possible that in the current year, the company sold a higher proportion of less profitable products. Assuming you calculate the ratio and there is a decline or reduction, how do you interpret this? Possible factors for interpreting this may include Sales revenue declined Sales revenue remained the same, but costs increased over the year Sales increased, but costs increased in greater proportion Suppliers increased their prices or the business lost trade discount There was a change in the sales mix; more of less profitable goods were sold this year. B) NET PROFIT RATIO (PERCENTAGE) The net profit percentage expresses an organizations net profit as a percentage of total sales. It is calculated as: Net profit percentage = Net profit x100 Sales The factors that affect the gross profit as stated above affects the net profit percentage in the same way. Other factors affecting the Net profit which will cause the percentage to change over accounting period or between companies more importantly includes the following: i. Depreciation policy adopted ii. Change in selling and administrative expenses. C) RETURN ON CAPITAL EMPLOYED (ROCE) It is the net profit before interest and tax divided by capital employed. ROCE is the most important profitability ratio and is probably the most important of all the other ratios. It states the profit as a percentage of the amount of capital employed. It is often referred to as the primary ratio. In its simplest form, it attempts to measure the performance of the business by comparing profit with the funds used to generate them. It is considered the most important because, growth of

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NOTES & EXERCISES ON Financial Management -For ICM Students profit can only be assessed properly when the profit is related to the capital used or employed in generating the profits. ROCE = Profit before Interest & Tax Capital Employed X 100

Unfortunately, the term capital employed has more than one meaning. The most common meanings are: Capital Employed= TOTAL ASSETS CURRENT LIABILITIES (i.e. Fixed Assets +Current Assets Current Liabilities) OR Capital employed = shareholders fund + Long term creditors (amount falling due after more than one year) + any long term provision for liabilities and charges. D) RETURN ON NET WORTH This ratio expresses the net profit as a percentage of owners equity. It is calculated as: Net profit X 100 Net worth (owners equity) E) RETURN ON TOTAL ASSETS This is the net profit expressed as a percentage of total assets. It is calculated as: = Net profit X 100 Total Assets F) EXPENSES TO NET PROFIT PERCENTAGE: This is the total expenses expressed as a percentage of Net profit. It is calculated by the following formulae: Total expenses to Net profit percentage = Total expenses X 100 Net profit This ratio shows how net profit can pay off expenses. The usefulness of this ratio is that, it helps management to take steps to control expenses when the ratio is getting high. For example if the total expenses amount to 5,000 and the net profit is 10,000, this means that, expenses is 50% of net profit. Thus net profit can pay off expenses twice over. A low rate means good expenditure control. Thus Expenses to Net profit percentage = 5,000 X 100 = 50% 10,000 If in the subsequent period, expenses to net profit percentage is 75%, thus if expenses has increased to 7,500, then this is an indication to management to take steps to control the level of expenditure in the business. NOTE: The individual expenses ratios can also be calculated in the same way. For example, Distribution cost to net profit ratio, administrative expenses to net profit ratio etc.

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NOTES & EXERCISES ON Financial Management -For ICM Students G) Expense to Sales Ratio This is the total expenses expressed as a percentage of sale revenue or turnover. It is calculated by the following formulae: Expenses to sales percentage= Total expenses X100 Sales EXAMPLE 1: You have obtained the following information in respect of BOB Ltd. For the year ended th 30 June 2007 000 Sales (all credit) 1,800 Cost of sales 700 Administration expenses 400 Distribution costs 250 Interest paid 10 Provision for taxation 50 Proposed dividend 80 Closing value of fixed assets 700 Closing stock 90 Closing debtors 100 Closing cash/bank balance 30 Closing creditors 40 Issued ordinary share capital () 500 TASKS a) Prepare a summarised Profit & Loss account for the year 30 June 2007 b) Calculate the following ratios: i the gross profit to sales percentage ii the net profit before tax as a percentage of sales iii the operating profit as a percentage of sales iv the total expenses as a percentage of sales

Solution: a) BOB LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007 Sales Less cost of sales 700,000 Gross Profit Less Expense: Administrative Expenses Distribution cost Interest paid 1,800,000 1,100,000 400,000 250,000 10,000

660,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Net profit before Tax Less Provision for taxation Net profit after tax 390,000 Less Proposed Dividends Net profit c/d 440,000 50,000 80,000 310,000

b) i) The gross profit percentage = Gross Profit X 100 = 1,100,000 X 100 = 61.1% Sales 1,800,000 ii) Net profit before tax as a percentage of sales =Net profit before tax X100 = 440,000 X 100 = 24.4% Sales 1,800,000 iii) The operating profit as a percentage of sales = Net profit after tax X 100 = 390,000 X100 =21.67% Sales 1,800,000 iv) The total expenses as a percentage of sales = Total expenses X 100 = 660,000 X 100 = 36.67% Sales 1,800,000 Example 2 Study the following information regarding Companies A and B for the year ended 30 June 2007 Profit and Loss account Company A Company B Turnover 9,000 24,000 Cost of goods 5,000 10,500 Other expenses: Selling 500 4,750 Administration 750 2,250 Financial 300 500 TASKS: a) Prepare the Profit and Loss Accounts for the year ended 30th June 2007 b) Calculate the following ratios: i. Gross profit percentage ii. Net profit percentage

Solution: a) Profit and Loss account for the year ended 30th June 2007 Company A B Turnover 9,000 24,000 Cost of sales (5,000) (10,500) Gross profit 4,000 13,500 Selling expenses (500) (4,750) Administrative expenses (750) (2,250)

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NOTES & EXERCISES ON Financial Management -For ICM Students Financial expenses Net profit b) i) Gross profit percentage: Gross profit X 100 13,500 X100 Turnover 24,000 = 56.25% ii) Net profit Percentage = Net profit X100 = 6,000 X100 Sales 24,000 = 25% LIQUIDITY RATIOS These ratios measure the ability of a business to pay its current liabilities as and when they fall due. It is also known as short-term solvency ratios. A liquidity ratio measures the extent to which current assets can be quickly turned into cash. In other words they show how much cash the entity has available in the short term. Liquidity ratios are probably the most commonly used of all the business ratios. A companys creditors may often be particularly interested in this because they show the ability of the business to quickly generate the cash needed to pay its bills. Liquidity is the amount of cash a company can put its hands on quickly to settle its debts. Liquidity ratios are sometimes called working capital ratios because that, in essence, is what they measure. Liquidity ratios provide information about a firm's ability to meet its shortterm financial obligations. They are of particular interest to those extending short-term credit to the firm. TYPES OF LIQUIDITY RATIOS Two frequently-used liquidity ratios are A. THE CURRENT RATIO (OR WORKING CAPITAL RATIO) B. THE QUICK RATIO/ ACID TEST RATIO A. CURRENT RATIO: It is current assets divided by current liabilities. The current ratio is used to evaluate the liquidity or the ability to meet short term debts. The standard test of liquidity is the Current Ratio. The current ratio measures the adequacy of current assets to meet short term liabilities. The current ratio is the ratio of current (300) 2,450 (500) 6,000 4,000 X100 9,000 = 44.44% = 2,450 X100 9,000 = 27.22%

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NOTES & EXERCISES ON Financial Management -For ICM Students assets to current liabilities. It is calculated by the following formulae: Current ratio = Current assets Current liabilities The answer is expressed as a factor, e.g. 2 to 1 or 2:1, 3:1, 1.6:1 etc. The idea behind this is that the company should have enough current assets to pay off its current liabilities. Obviously, a ratio in excess of 1.0 should be expected. Otherwise there would be the prospect that the company might be unable to pay its debts on time. Traditionally, a current ratio of 2 or higher was regarded as appropriate for most businesses to maintain credit worthiness. However, in recent times a ratio of 1.5 may be regarded as the norm. Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. One drawback/disadvantage of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. Interpretation A reducing current ratio might mean a sign of deteriorating financial condition. It might also be the result of eliminating obsolete stock. An increasing current ration may mean a good financial situation. But it can also mean an unnecessary piling of stock which may have other negative effects like increase in stockholding cost. A low current ratio has any of the following consequences: i. ii. iii. iv. Delays in payment to creditors. This will lead to loss of discount Creditors will withhold supplies because of late payments There will be constant problem as to how to find cash to pay weekly bills Investment plans will have to be postponed

Too high ratios on the other hand may have the following consequences: NB: The current ratio is very useful in assessing the performance of a business but very tricky to interpret the answer. Therefore it is useful that the analyst take a careful look at the individual assets and liabilities when

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NOTES & EXERCISES ON Financial Management -For ICM Students interpreting the ratio. Consider the individual assets and liabilities and note any changes too much stock, higher bad debt provision etc. B. QUICK RATIO/ACID TEST RATIO This is the current assets less closing stock divided by current liabilities. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. Most companies are not able to convert all their current assets into cash very quickly. Manufacturing companies in particular may hold large quantities of raw materials stock, finished goods, WIP. For this reason we calculate an additional liquidity ratio known as the Quick / Acid test ratio. The quick ratio is defined as follows: Quick or Acid test ratio = Current Assets - stock Current Liabilities This ratio should ideally be at least 1.0 for companies with a slow stock turnover, for companies with a fast stock turnover; a quick ratio can be comfortably less than 1.0 without suggesting that the company should be in cash flow trouble. Example 3: The following information relates to MORE LTD at the end of three consecutives years ending 31 December 2006. Year 2006 Creditors 12,565 Bank 1,500 Loan (long term) 10,000 Capital 26,220 50,285 Cash in hand 250 Bank Debtors 9,165 Stocks 10,120 100 1,450 8,455 4,575 100 1,750 7,940 6,230 2004 6,480 12,500 24,100 43,080 2005 9,740 10,500 24,180 44,420

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NOTES & EXERCISES ON Financial Management -For ICM Students Shop fittings 5,750 Premises 25,000 50,285 TASKS: a) Calculate the amount of the working capital at the end of each year b) Calculate the ratio of current assets to current liabilities to one decimal place at the end of each year c) Calculate the acid test correct to one decimal place at the end of each year d) Which year do you consider has been the safest as far as MORE LTDs debt paying ability is concern? Solution: MORE LTD BALANCE SHEET AS AT
2004 2005 2006 Fixed assets Premises 25,000 Shop fittings 5,750 30,750 Current Assets Cash in hand 250 Bank Stocks 10,120 Debtors 9,165 19,535 Current Liabilities Creditors 6,480 Bank Overdraft -(14,065) Working capital 5,470 Net Assets 36,220 Financed by: Capital 26,220 Long term Loan 10,000 36,220 25,000 3,500 28,500 100 1,450 4,575 8,455 14,580 9,740 -8,100 36,600 1,750 25,000 3,400 28,400 100 6,230 7,940 16,020 12,565 1,500 6,280 34,680

3,500 25,000 43,080

3,400 25,000 44,420

(6,480)

(9,740)

24,100 12,500 36,600

24,180 10,500 34,680

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NOTES & EXERCISES ON Financial Management -For ICM Students a) Working capital at the end of each period 5,470 b) Current ratio = Current Assets Current Liabilities Years Current Ratio = 2004 14,580 6,480 = 2.3:1 c) Acid test ratio = Current Assets stocks Current Liabilities Years Acid Test ratio 10,120 0.7:1 EXAMPLE 4: The following trial balance has been extracted from the books of Tourist PLC. for the year ended 31 August 2005: dr cr Property (31 08 05) 340,000 Plant and Machinery (31 08 05) 36,000 Office equipment (31 08 05)40,000 Vehicles (31 08 05) 30,000 VAT refund due 46,000 Trade debtors 533,800 Prepayments 4,200 Bank overdraft 160,000 Cash 2,000 Trade creditors 270,000 Long-term loan 80,000 Hire purchase account 48,000 Sales (all on credit) 1,980,000 Purchases 1,200,000 Stock (01 09 04) 100,000 Wages and salaries 420,000 Business rates 48,000 Heating and lighting 30,000 Vehicle expenses 22,000 2004 = 14,580 4575 6,480 = 1.5:1 2005 = 16,020 6,230 9,740 =1:1 2006 = 19,535 14,065 = 2005 16,020 9,740 =1.6:1 2006 19,535 14,065 = 1.4:1 = 8,100 6,280

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NOTES & EXERCISES ON Financial Management -For ICM Students Distribution costs 46,000 Interest paid 10,000 Depreciation for the year20,000 Profit & Loss account (01 09 04) 1 Ordinary shares 2,928,000

190,000 200,000 2,928,000

NOTES at 31 August 2005: Stock was valued at 108,000. The analysis of the hire purchase account revealed that 8,000 falls due for payment by 31 March 2006, and that the rest falls due for payment after 1 September 2006. The directors have decided to provide the following provisions: Corporation tax of 65,000 An ordinary dividend of 10 pence per share TASKS a) Prepare the Trading and Profit & Loss account for the year ended 31 August 2005. b) Prepare the balance sheet as at 31 August 2005. c) Calculate the following accounting ratios for the two years: i gross profit percentage ii the profit after tax percentage iii the acid test iv the current ratio TOURIST PLC. TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 AUGUST 2000 Sales 1,980,000 Cost of sales: Stock 100,000 Purchases 1,200,000 1,300,000 Closing stock (108,000) (1,192,000) Gross profit 788,000 Wages 420,000 Business rates 48,000 Heating and lighting 30,000 Vehicle expenses 22,000 Distribution costs 46,000 Depreciation for the year 20,000 Interest paid 10,000 (596,000)

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NOTES & EXERCISES ON Financial Management -For ICM Students Net 192,000 Taxation (65,000) Net 127,000 Dividend (20,000) 7,000 Profit 190,000 Profit 297,000 and and profit before tax

profit

after

tax (200,000X10%) 10

Loss Loss

Account Account

bal. bal.

b/d c/d

TOURIST PLC. BALANCE SHEET AS AT 31 AUGUST 2000 FIXES ASSETS : NBV Property 340,000 Plant 36,000 Vehicle 30,000 Office 40,000 CURRENT ASSETS: Stocks Trade debtors Vat refund due Prepayment Cash CURRENT LIABILITIES: Trade creditors Bank overdraft Hire purchase account Provision for taxation Proposed dividends 171,000 270,000 160,000 8,000 65,000 20,000

&

Machinery

Equipment 446,000 108,000 533,800 46,000 4,200 2,000 694,000

(563,000)

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NOTES & EXERCISES ON Financial Management -For ICM Students 617,000 Long term liabilities: Long term loan Hire purchase account (48,000 - 8,000) (120,000) Net 497,000 Capital & Reserves 1 ordinary 200,000 Profit and 297,000 Shareholders fund 497,000 c) i. 1,980,000 = 39.79% ii. Profit after tax percentage = Net profit after tax X100 Sales = 127,000 X 100 1,980,000 = 6.4% Acid Test ratio = Current Assets Stock 108,000 Current Liabilities Current Ratio = Current Assets Current liabilities = 694,000 Gross profit percentage = Gross profit X100 = 788,000 X 100 Sales share Loss

80,000 40,000 assets

capital account

iii.

563,000 = 1.04: 1

iv.

= 694,000 563,000 = 1.2: 1

2) EFFICIENCY RATIO/ACTIVITY RATIOS These ratios show how effective the resources of the business have been utilized to generate income. They measure the efficiency of the management of assets (both fixed assets and current assets). Thus activity ratios measure how well the assets of the organization have been used to attain the objectives of the organization. The following are the major activity or efficiency ratios. A). STOCK TURNOVER RATIO

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NOTES & EXERCISES ON Financial Management -For ICM Students Stock turnover refers to the number of times/days that stocks are sold and replenished during a year. It is an indication of a business selling efficiency. The stock turnover can be measured in two ways. The stock turnover ratio is calculated as follows: 1. Stock turnover ratio (in days) = Average stock x 365 days Cost of sales 2. Stock turnover (No. of times) = cost of sales Average stock Average Stock = opening stock + closing stock 2 Note that, one is the opposite of the other. The greater the stock turnover, the more efficient the entity would appear to be in purchasing and selling goods. A stock turnover of say 2 times would suggest that the company has about six month of sales in stock. Interpretation: When interpreting the stock turnover, it is important to compare or relate the answer with the previous years stock turnover. If the rate of turnover is slowing down (i.e. reduction in the stock turnover) it might mean that, the business is holding or keeping too much stock- i.e. waste of resources. It can also mean that business is slowing down and that customers are not buying the product anymore. (e.g. Stocks may be pilling up and not being sold and this could lead to liquidity problems). however, the increases in stock may be deliberates (management may intentionally increase stock to take advantage of discounts on large purchase or management may anticipate shortage in stock in the near future and therefore may decide to keep stock levels high to meet long term demand). A slow rate will affect the cash position of the businesscash used in buying the stocks are not realised early. Increase in stock turnover may indicate greater efficiency. The rate of stock turnover depends on the type of goods sold. For example supermarkets may have high stock turnover because it sells daily. Goods like cars may have a low turnover rate. The stock turnover should be compared with the gross profit percentage to see the effect of selling price on turnover. If say stock turnover increases, it may mean that the company has reduced its selling price in order to increase sales. B). Debtors Collection Period (Average Collection Period) This is the average length of time taken by customers to settle their accounts. Thus the number of days it takes the company to collect its debts. It is calculated by the following formula:

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NOTES & EXERCISES ON Financial Management -For ICM Students Debtors Collection Period (in days) = Debtors (Closing Balance) X 365 days Sales Interpretation: The result (answer) you get should be compared with the credit policy (the number of days credit normally allowed by the business to its customers. The ideal collection period should by some what 30 days. This is because sales are usually made in terms of payment within 30 days or at the end of the month following the month in which the invoice is sent out. Therefore debtors collection period which is too much in excess of 30 days might indicate poor management of funds. Thus a long average collection period indicates a poor credit control. However, some companies may also give long credit period in order to attract customers. The answer you get depends on the type of organisation and the industry of that business. ASSET TURNOVER RATIO It is a measure of how effectively the assets of the company are being used to generate income. They sometimes are referred to as asset utilization ratios, or asset management ratios. It is calculated by the following formulae: Asset Turnover Ratio = net profit Total Assets Note that Total assets current liabilities = Capital Employed Interpretation: Low Assets turnover: Where the Asset Turnover Ratio is lower than that of competitors; it might mean over- investment in assets. However it may also mean that the assets are new (hence they have high values) than that of competitors. Again it could mean that depreciation charges are lower that that of competitors. High Asset Turnover: A high Asset turnover ratio suggests that selling prices have been reduced or suppressed in order to increase sales volume.

CASH OPERATING CYCLE/(WORKING CAPITAL CYCLE) This is the period of time that elapse between the payment for the goods supplied and the receipts of cash from customers in respect of the sales made.

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NOTES & EXERCISES ON Financial Management -For ICM Students That is the length of time between when the business makes payment to its suppliers for the materials and stock and when the business receives payment for the resources from its customer. The number of days in the cash operating cycle equal to: Debtors collection period Add stock turnover (in days) Less creditors payment period (days) CASH OPERATING CYCLE THE CONCEPT OF OVERTRADING Overtrading occurs when a firm has inadequate finance to support its level of trading activities. This is when a firm tries to undertake more business than is financial resources permit. Overtrading is a common source of a businesss insolvency and explains why a firm which makes high profit can fail to pay its short term debts as and when they fall due. COMMON SIGNS OR SYMPTONS OF OVERTRADING The following, when seen in the business operation van indicate that the business is overtrading. 1. 2. 3. 4. 5. 6. rapid growth in sales static long term finance a sharp increase in debtors and debtors collection period a sharp increase in creditors and creditors payment period a sharp fall in cash balances and increase in overdraft A sharp change in stocks. An increase in stock means that excess production or lack of demand for the product. A decrease means that the company is not able to produce to meet demand. 7. a sharp decrease in profit margin 8. A sharp increase in asset turnover ratio. INVESTORS RATIO/STOCK MARKET RATIO These ratios focus more on the investors viewpoint. Investment ratios provide information to investors to enable them judge the profitability of the investment. It tells whether current investors should continue to hold their investment in the company or they should sell their investment. Potential investors also use these ratios to decide which company they should invest. These ratios cornered mostly ordinary shareholders. XX XXX XXX XXX

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NOTES & EXERCISES ON Financial Management -For ICM Students The major ratios under these sets are: 1. Price Earnings Ratio (P/E) 2. Earnings Per Share (EPS) 3. Dividend Per Share 4. Dividend Cover 5. Dividend Yield 6. Earnings Yield 1) PRICE/ EARNINGS RATIO(P/E RATIO) This ratio expresses the current market price (market value) as a multiple of the Earnigns Per Share (EPS). It indicates the number of years it would take to recover the share price (cost of the investment in shares) out of the current earnings of the company. The P/E ratio is simply a measure of the relationship between the market value of a companys share and the earnings from those shares. It is the most important yardstick for assessing the relative worth of a share. P/E Ratio = Market Price per share Earnings per share (EPS) For example a P/E ratio of 12.5 (i.e. 20.16), this means that, it will take about 12 and half years to repay the cost of investment in the shares. The higher the P/E, the longer the payback. The lower the P/E ratio, the better the investment. The value of the P/E ratio reflects the markets appraisal of the shares future prospects. In other words if one company has a higher P/E ratio than another, it is because investors either expect its earnings to increase faster than the others or investors consider that, it is less risky company or it is in a more secure industry The P/E ratio is expected not to vary much over time. If there is a change in the P/E ratios of companies overtime, it may be due to several factors: I. If interest rate goes up, investors will be attracted away from shares and into debt capital will generate high interest. Share price will fall and so P/E ratio will fall. The opposite happens when interest rates goes down. II. If the future prospects of the companys profit improves, share prices will go up and P/E ratios will rise. Share prices depend on expectations of future earnings, and so a change in prospects, perhaps caused by a substantial rise in international trade or economic recession will affect prices and P/E ratios Earnings Per Share (EPS) : The earnings per share looks at the profit which could be in theory be paid to each ordibnary shareholder. It is usually looked at from the ordinary shareholder It is calculated by the following formular EPS = Net profit after tax Preference Share Dividends No. Of ordianry shares in issue DIVIDEND COVER (DIVIDEND PAYOUT):

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NOTES & EXERCISES ON Financial Management -For ICM Students This measures the ability of the firm to pay current dividend level in the future. It indicated the proportion of the Net profit which is retained for by management for future investment. The dividend cover is calculated as follows: Dividend cover = Net profit after tax& preference share dividends Ordinary share dividend LONG-TERM SOLVENCY /GEARING /LEVERAGE RATIOS These ratios are used to help predict the long term solvency of a firm. These ratios indicates the relationship between funds provided by the actual owners of the company and the funds provided by outsiders/ long term creditors such as debenture holders. They emphasizes on the capital structure of the firm and how the company is financed by debt capital or long term loan. Solvency refers to the ability of a company to pay its long term debts. The following ratios are mostly used to measure solvency ratios. i. Debt- equity ratio ii. Interest cover iii. Fixed dividend cover iv. It is measured as: Prior charge capital Total capital *prior charge capital is capital carrying a right to a fixed return. It will include preference share and debentures. Total capital = ordinary shares capital and reserves +prior capital plus any long term liabilities and provisions. OR TOTAL ASSETS- CURRENT LIABILITIESrovide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. The debt ratio is defined as total debt divided by total assets: INTEREST COVER This ration indicates whether a company is earning enough profit to meet interest payment. That is whether net profit before interest and tax is able to pay for the interest. Thus how well the firm's earnings can cover the interest payments on its debt. This ratio is calculated as follows: Interest Cover = Net profit before interest and tax Interest ADVANTAGES OF ACCOUNTING RATIOS Ratios are the most powerful tools for analysing financial statement. The following are the advantages of ratio analysis. 1. ratios helps to know the ability of the company to pay its short term debts

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NOTES & EXERCISES ON Financial Management -For ICM Students 2. it also helps us know the extent to which the company has used its assets effectively and efficiently 3. it helps to assess the overall operating efficiency and effective performance of the organisation 4. ratios provide a simple and convenient way of comparing companies 5. the pattern of performance over several years can be clearly identified LIMITATIONS/DISADVANTAGES OF RATIO ANALYSIS 1. Ratios are normally calculated from past historical accounting figure and therefore might not be indications of current/ future events 2. inflation/price level changes can render the interpretation of ratios risky 3. Accounting policies of companies can influence ratios. Example, the type of depreciation policy adopted and the rates used can affect the net profit ratio greatly. This can make comparison very difficult. 4. Management of a company can influence the ratios by engaging in window dressing actions prior to the preparation of financial statement to make them look better. 5. There is more than one definition for some of the ratios, making them difficult to compare with other companies in the same industry. QUESTIONS AND ANSWERS QUESTION 1. (Past question) You have obtained the following information/data in respect of three companies for the year ended 31 May 2005: Company X Y Z 000 000 000 Sales (all on credit) 750 950 1,200 Cost of sales 310 390 510 Administration expenses 160 190 210 Distribution costs 100 130 160 Interest paid 5 5 5 Provision for taxation 20 50 70 Proposed ordinary dividend 15 30 90 Issued share capital (1 ordinary)200 200 400 Long-term loans outstanding 100 100 100 Retained profit (01 06 04) 130 210 300 TASKS a) Prepare summarised Profit & Loss accounts (for EACH company) for the year ended 31 05 05. [ b) Calculate the following ratios (for EACH company): i the gross profit as a percentage of sales ii the operating profit as a percentage of sales

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NOTES & EXERCISES ON Financial Management -For ICM Students iii iv v c) (PE ratio). the earnings per share (EPS) the dividend cover the gearing percentage Explain the significance of a companys Price Earnings Ratio

SOLUTION TO QUESTION 1 a) PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST MAY 2005 Company X Y Z Sales 750,000 950,000 1,200,000 Cost of sales (310,000) (390,000) (510,000) Gross profit 440,000 560,000 690,000 Administrative expenses (160,000) (190,000) (210,000) Distribution costs (100,000) (130,000) (160,000) Net profit before interest and tax 180,000 240,000 320,000 Interest paid (5,000) (5,000) (5,000) Net profit before tax 175,000 235,000 315,000 Taxation provision (20,000) (50,000) (70,000) Net profit after tax 155,000 185,000 245,000 Proposed dividend (15,000) (30,000) (90,000) Net profit for the year 140,000 155,000 155,000 Net profit b/d 130,000 210,000 300,000 Net profit c/d 270,000 365,000 455,000 b) COMPANY Y X i) The gross profit as a percentage of sales: X

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NOTES & EXERCISES ON Financial Management -For ICM Students = Gross Profit X 100 X100 690,000 X100 Sales 1,200,000 440,000 X100 750,000 = 58.67% 58.95% 57.5% ii) Operating profit as a percentage of sales: = Net Profit before Interest &Tax X 100 240,000 X100 320,000 X100 Sales 950,000 1200,000 25.26% = 26.67% = 155,000 = 200,000 = 0.775 0.0.62 iv) The dividend cover = dividend 90,000 = Net profit after tax 185,000 245,000 =0.37 times v) The gearing percentage = long term debt 100,000 X100 = 100,000 X 100 Capital employed 300,000 400,000 33.33% 25% = 100,000 X100 = = 15,000 155,000 = 0.097 times = 0.162 times 30,000 =0.925 180,000 X 100 750,000 = 24% iii) The earnings per share (EPS) = Net profit after tax 185,000 245,000 No. of shares 200,000 400,000 = 560,000 950,000

300,000 = 33.33%

QUESTION 2 Barclays Bank Ltd and Standard Chartered Bank Ltd are two independent companies in the banking industry. The following information has been extracted from the books of the two companies for the year ended 31 st July 2007. Stanbic Bank Stanchat Bank Net Fixed assets 58,500 6,000 Intangibles 6,000 -

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NOTES & EXERCISES ON Financial Management -For ICM Students Investments (Long term) 19,500 Stocks Debtors Advances Cash & liquid assets Investments 130,500, 150,000 Taxation Creditors Current and 136,500 Bank 138,000 10% debenture stock 750 Shareholders funds 1 ordinary shares Reserves 11,250 1,500 72,000 deposits 10,500 84,000 1,500 accounts --49,500 15,000 1,500 3,000 8,250 150,000 150,000 Additional information: 1. The Net Profit before tax for the companies are: Stanbic Bank Ltd 3,750 Stanchat Bank Ltd 3,900 2. proposed dividends for the year are: Stanbic Bank Ltd 1,050 Stanchat Bank Ltd 600 REQUIRED: As a young financial adviser, you have been asked to assess the situation of both companies. Choose the appropriate ratios that you consider will reveal the differences between the two companies. Discuss your calculations from the point of view of profitability and financial stability. SOLUTION: Note: Profitability measures the relationship between the profit and the assets or resources used in generating the profit. Financial stability measures the ability of a firm to pay its debts when due to prevent it from collapse. STANBIC STANCHAT 3,000 40,500 37,500 4,500 82,500 31,500 88,500 10,500 150,000 67,500 13,500

16,500

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NOTES & EXERCISES ON Financial Management -For ICM Students Current ratio =Current assets 130,500 Current Liabilities 138,000 = 0.96:1 Acid test ratio=Current Assets- stocks 130,500 Current Liabilities 138,000 = 0.96:1 Earnings per share=Net profit after tax = 3,750 -1,500 3,900 -1,500 No. of shares 3,000 = 15p per share 80p per share Dividend per share = 600 3,000 = 7p per share = 20p per share Dividend cover = 3,900 1,500 times Gearing Ratio = long term debt 750 X100 Capital employed 12,000 6.25% QUESTION 3 You have obtained the following information in respect of BOB Ltd. For the year ended 30 June 2008 000 Sales (all credit) 1,800 Cost of sales 700 Administration expenses 400 = 49,500 X100 = 66,000 = 75% = net profit Dividend paid = 3,750 -1,500 1,050 = 2.1 times = 600 =4 dividend No. of shares = 1,050 = 15,000 = 15,000 = = 82,500 40,500 = 84,000 = 0.5:1 = 82,500 = 84,000 = 0.98:1

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NOTES & EXERCISES ON Financial Management -For ICM Students Distribution costs 250 Interest paid 10 Provision for taxation 50 Proposed dividend 80 Closing value of fixed assets 700 Closing stock 90 Closing debtors 100 Closing cash/bank balance 30 Closing creditors 40 Issued ordinary share capital () 500 TASKS Prepare a summarised Profit & Loss account for the year. Calculate the following ratios: i the gross profit to sales percentage ii the net profit before tax as a percentage of sales iii the operating profit as a percentage of sales iv the earnings per share (EPS) v the debtor collection period in days vi the total expenses as a percentage of sales vii the current ratio viii the acid test

a) b)

SOLUTION: QUESTION 3 a) BOB LTD PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007 Sales Less cost of sales 700,000 Gross Profit Less Expense: Administrative Expenses Distribution cost Interest paid Net profit before Tax Less Provision for taxation Net profit after tax 390,000 Less Proposed Dividends Net profit c/d 1,800,000 1,100,000 400,000 250,000 10,000

660,000 440,000 50,000 80,000 310,000

b) i) The gross profit percentage = Gross Profit X 100 Sales = 1,100,000 X 100 = 61.1% 1,800,000

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NOTES & EXERCISES ON Financial Management -For ICM Students ii) Net profit before tax as a percentage of sales =Net profit before tax X100 = 440,000 X 100 = 24.4% Sales 1,800,000 iii) The operating profit as a percentage of sales = Net profit after tax X 100 = 390,000 X100 =21.67% Sales 1,800,000 iv) The earnings per share (EPS) = Net profit after tax 0.78 per share No. of shares = 390,000 500,000 =

v) The debtor collection period in days = Trade debtors X 365 days = 100,000 X 365days = 21 days Sales 1,800,000 vi) The total expenses as a percentage of sales = Total expenses X 100 Sales 660,000 X 100 = 36.67% 1,800,000 vii) Current ratio =Current assets Current Liabilities viii) Acid test ratio=Current Assets- stocks Current Liabilities Workings: Current assets: Closing stock Closing debtors Closing cash/bank balance Total current assets Current liabilities Provision for taxation Proposed dividend Closing creditors Total current liabilities = 220,000 170,000 = 1.29:1 = 220,000 90,000 170,000 = 0.76:1

90,000 100,000 30,000 220,000 50,000 80,000 40,000 170,000

QUESTION 4(COMPREHENSIVE QUESTION) You are provided with the following information relating to KASAPA LTD. KASAPA LTD. Trading Profit and Loss Account for the year ended 31st December 2007 2006 2007

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NOTES & EXERCISES ON Financial Management -For ICM Students 000 Sales Less cost of sales: Opening stock Purchases Closing stock (180) Gross profit 15 150 165 (21) 96 27 1.5 18 49.50 (22.50) 27 (15) 12 6 18 3 7.5 9 18 (46.5) 24 (144) 195 216 (56) 90 36 000 240 000 21 000 270

EXPENSES: Administrative expenses Loan Interest 1.5 Selling &Distribution expenses (61.50) Net profit before tax 28.50 Taxation (9.00) Net profit after tax 19.50 Dividends: Preference shares (paid)3 Ordinary shares (Proposed) 12 (10.50) Retained profit Net profit b/d Profit and Loss account c/d 27

KASAPA LTD BALANCE SHEET


FIXES ASSETS COST DEP.

2006

NBV

COST DEP

2007

NBV

000 000 000 Freehold property90 90 Vehicles 63 21 42 153 21 132


CURRENT ASSETS Stocks Bank Debtors 21 4.5 55.55

000 000 000 90 90 72 33 39 162 33 129


36 90 277.50 9 6 93 7.5 (109.50) 147

30

1.5

CURRENT LIABILITIES Creditors 15 Tax 22.50 Proposed dividends 12 (46.50) 18 138

Financed by: Ordinary share capital 1.00

60

60

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NOTES & EXERCISES ON Financial Management -For ICM Students 10% preference shares Profit and loss account Shareholders fund 117 5% debenture loan 30 18 108 30 30 27 30

138 147 Additional information: 1. Purchases and sales were made evenly throughout the year. 2. all purchases and sales were made on credit 3. assume the prices were stable throughout the year 4. The company sells only one product. In 2006 60,000 mobile phones were sold and in 2007, 90,000 were sold. 5. no fixed asset was sold during the year 6. the market value of the ordinary shares are estimated to be 3.45 per share at 31 December 2006 and 2.70 per share at 31 December 2007. REQUIRED: CALCULATE the following ratios a) PROFITABILITY RATIO i. Return On Capital Employed\ ii. Gross profit percentage iii. Net profit Percentage b) LIQUIDITY RATIO i. Current Ratio ii. Acid test ratio c) EFFECIENCY RATIO i. Stock turnover (rate & in days) ii. Fixed assets turnover iii. Debtors collection period iv. Creditors payment period d) INVESTMENT RATIO i. P/E ratio ii. EPS iii. Dividend cover iv. Capital Gearing v. Dividend per share vi. Dividend yield e) Comment on the results of KASSAPA LTD for the year to 31 December 2007 SOLUTION: Q4 2006 a) PROFITABILY RATIO Gross profit percentage: Gross profit X 13,500 X100 100 4,000 X100 2007

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NOTES & EXERCISES ON Financial Management -For ICM Students Sales = 52.25% ii) Net profit Percentage = Net profit X100 6,000 X100 Sales 24,000 = 25% Current ratio =Current assets 130,500 Current Liabilities 138,000 = 0.96:1 Acid test ratio=Current Assets- stocks 130,500 Current Liabilities 138,000 = 0.96:1 Earnings per share=Net profit after tax = 3,750 -1,500 3,900 -1,500 No. of shares 3,000 = 15p per share 80p per share Dividend per share = 600 3,000 = 7p per share = 20p per share Dividend cover = 3,900 1,500 600 = 2.1 times times =4 Dividend Net profit after tax = 3,750 -1,500 = 1,050 dividend No. of shares = 1,050 = 15,000 = 15,000 = = 82,500 40,500 = 84,000 = 0.5:1 = 82,500 = 84,000 = 0.98:1 = 2,450 X100 9,000 =27.22% = 9,000 = 44.44% 24,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Gearing Ratio = long term debt 750 X100 Capital employed 12,000 6.25% QUESTION 5: (September 2005 ACCOUNTING 2) The following details have been obtained from the final accounts of REM plc for the last three years: 2002 2003 2004 m m m Sales all on credit110 140 210 Cost of sales 70 80 90 Total expenses 30 40 50 Closing debtors 21 22 24 Average stock 11 12 13 TASKS a) Calculate for EACH of the three years: i the gross profit percentage ii the net profit percentage iii the expenses to sales percentage iv the debtor collection period in days v the stock turnover in days b) Comment on the trends as revealed by your answer to a) above. SOLUTION: REM PLC PROFIT AND LOSS ACCOUNT 2002 2004 m m Sales (all on credit) 210 Cost of sales (90) Gross profit 120 Total expenses (50) Net profit 70 i) Gross profit percentage: = Gross profit X100 = 120 X100 110 (70) 40 (30) 10 (80) 60 (40) 20 m 140 2003 = 49,500 X100 = 66,000 = 75% =

= 40 X100

= 60 X100

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NOTES & EXERCISES ON Financial Management -For ICM Students Sales 210 = 57.14% ii) Net profit percentage: Net profit X100 = 70 X100 Sales 210 =33.33% iii) Expenses to sales percentage: = Total expenses X 100 = 50 X100 Sales 210 =28.57% =23.8% = 30 X100 110 = 27.27% iv) Debtors collection period: = Debtors X 365 days = 24 X365 Sales 210 57days =42days = 21 X 365 110 = 70days v) Stock Turnover (in days): = average Stock X 365days = 13 X365 Cost of sales 90 53days b) Comment of the financial performance of the company: QUESTION 6: (MARCH 207 ACCOUNTING 3) The following summarised information has been extracted from the accounts of three companies: Profit and loss extracts for year ended 28 February 2007: D E F Profit before tax 13,000 9,000 5,000 = 11X 365 70 = 57days =12 X 365 80 55days =22 X 365 140 = = 40 X100 140 =10X100 110 = 9.09 = 20 X100 140 14.28% 110 =36.36% 140 = 42.87%

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NOTES & EXERCISES ON Financial Management -For ICM Students Taxation Profit after tax 10,000 Dividends Retained profit for the year (3,000) 6,900 (4,000) 6,000 (2,100) 3,200 (2,000) 4,900 (1,800) (1,000) 2,200

Balance sheet extracts as at 28 February 2007: Ordinary share capital (1) Long-term loans nil Cumulative retained profit 5,000 2,000 8,000 3,000 5,000 4,000 1,000 2,000

On 28 February 2007 the market price of an ordinary share was: Company D 15 Company E 24 Company F 35 TASKS a) Calculate the following for EACH of the three companies: i the profit after tax as a percentage of shareholders funds ii the earnings per share (EPS) iii the PE ratio iv the dividend cover v the gearing percentage b) From the standpoint of a potential investor comment on the performance of the three companies. Solution: The shareholders fund is calculated as follows: SHARESHOLDERS FUND: D E F Ordinary shares 5,000 3,000 1,000 Cumulative retained profit 8,000 4,000 2,000 Shareholders fund 13,000 7,000 3,000 Company D E F a) i) Profit after tax as a percentage of Shareholders fund: = Net profit after tax X 100 = 10,000 X100 = 6,900 X100 = 3,200 X100 Shareholders fund 13,000 7,000 3,000 = 76.9% = 98.6% = 106%

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NOTES & EXERCISES ON Financial Management -For ICM Students ii) EPS = Net profit after tax = 3,200 No. of shares 1,000 = 3.2 per share iii) P/E ratio: =Market price per share = 35 EPS 3.2 = 10.9 times iii) Dividend Cover: = Net profit after tax = 3,200 Dividend 1,000 = 3.2 times = 15 2 = 7.5 times = 10,000 4,000 = 2.5 times = 24 2.3 = 10.4 times = 6,900 2,000 = 3.45 times = 10,000 5,000 = 2 per share = 6,900 3,000 =2.3 per share

vi.

Gearing Percentage = Long term debt X 100 5,000 X 100 Capital employed 8,000 = 62.5%

0 x, 100 13,000 = 0%

2000X100 9,000 = 22.22%

b) Comment on the performance of the three companies Question 7: Study the following information regarding Companies A and B Profit and Loss account Company A Company B Turnover 9,000 24,000 Cost of goods 5,000 10,500 Other expenses: Selling 500 4,750 Administration 750 2,250 Financial 300 500 Balance Sheet Fixed assets 7,000 10,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Current assets 4,275 6,750 Current Liabilities 2,000 3,500 TASKS: a) Prepare the Profit and Loss Accounts for the year ended 30th June 2007 and the Balance sheet as at that date b) Calculate the following ratios: iii. Gross profit percentage iv. Net profit percentage v. Return on capital c) The working capital and working capital ratio d) A brief comment on the results comparing the two firms. SOLUTION: Q7 a) PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 30 JUNE 2007 COMPANY A B Turnover 9,000 24,000 Cost of goods 5,000 10,500 Gross profit 4,000 13,500 Less: expenses Selling expenses 500 4,750 Administrative expenses 750 2,250 Financial charges 300 (1,550) 500 (7,500) Net Profit 2,450 6,000 BALANCE SHEET AS AT 30TH JUNE 2007 COMPANY B Fixed Assets 10,000 Current Assets 6,750 Current liability (3,500) 3,250 13,250 TRY QUESTIONS QUESTION 1 You have obtained the following data in respect of two firms: 4,275 (2,000) 2,275 9,275 A 7,000

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NOTES & EXERCISES ON Financial Management -For ICM Students X Y 000 000 Sales (all on credit) 400 820 Cost of sales 190 330 Total expenses 130 190 Closing debtors 35 45 Average value of stock 17 21 TASKS a) For both companies calculate the following: i the gross profit percentage. ii the net profit percentage iii the expenses percentage iv the stock turnover v the debtor collection period b) Compare the financial performance of BOTH firms. QUESTION 2: The following summarised information has been extracted from the accounts of three companies: Profit and loss extracts for year ended 28 February 2007: D E F Profit before tax 13,000 9,000 5,000 Taxation (3,000) (2,100) (1,800) Profit after tax Dividends 10,000 6,900 (4,000) 6,000 3,200 (2,000) 4,900 (1,000) 2,200 1,000 2,000

Retained profit for the year Balance sheet extracts Ordinary share capital (1) Long-term loans nil Cumulative retained profit

as at 28 February 2007: 5,000 3,000 2,000 5,000 8,000 4,000

On 28 February 2007 the market price of an ordinary share was: Company D 15 Company E 24 Company F 35 TASKS a) Calculate the following for EACH of the three companies: i the profit after tax as a percentage of shareholders funds ii the earnings per share (EPS) iii the PE ratio iv the dividend cover v the gearing percentage b) From the standpoint of a potential investor comment on the performance of the three companies.

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NOTES & EXERCISES ON Financial Management -For ICM Students QUESTION 3 The following details have been obtained from the final accounts of Kulio plc for the last three years: 2003 2004 2005 m m m Sales all on credit 140 190 290 Cost of sales 70 85 100 Total expenses 40 50 65 Closing debtors 20 23 26 Average stock 12 14 14 Closing creditors 8 10 12 TASKS a) Calculate for EACH of the three years: i the gross profit percentage ii the net profit percentage iii the creditor payment period in days iv the debtor collection period in days v the stock turnover in days b) Comment on the trends as revealed by your answer to a) above. QUESTION 4: Explain the purpose of the following rations: i. Current ratio ii. Assets turnover iii. Interest cover iv. Dividend per share v. Net profit ratio QUESTION 5 The following figures have been extracted from Horace Ltd.s accounts for the two years to 30 November 2006: 2006 2005 BALANCE SHEET CLOSING BALANCES: Stock 170,000 120,000 Debtors 350,000 190,000 Cash in bank 40,000 Creditors Bank overdraft Long-term loans 50,000 600,000 230,000 300,000 210,000

Issued share capital 500,000 500,000 Retained profit 260,000 210,000 TASKS a) For BOTH years calculate the following: i the current ratio[3] ii the acid test ratio[3] iii the gearing percentage[3]

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NOTES & EXERCISES ON Financial Management -For ICM Students b) Comment on the liquidity position of Horace Ltd.[5] c) Explain the importance of preparing and monitoring a cash budget.[6]

SUMMARY OF RATIOS
i. ii. iii. Gross profit ratio = Gross profit X100 Sales

Net profit ratio = Net profit before tax x100 Sales ROCE = Net profit after tax X 100 Share holder fund OR = Net profit before tax and interest X 100 Share holders fund +long term loan = OR Net profit before tax X 100 Share holders funds

ROCE

ROCE iv. v.

Expenses to Net profit percentage = Expenses x100 Net profit Expenses to sales percentage = Expenses X 100 Sales

LIQUIDITY RATIO:
i. Current ratio= Current Assets Current Liabilities Acid Test ratio = Current Assets - Stocks Current Liability

ii.

EFFICIENCY RATIOS /ACTIVITY RATIOS i. Stock Turnover ( in days) = Average Stock X 365 days Cost of sales

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NOTES & EXERCISES ON Financial Management -For ICM Students ii. iii. Rate of stock Turnover = Cost of sales Average Stock Debtors Collection Period = Trade Debtors X 365 days Credit Sales Creditors Payment Period = Creditors X 365 days Credit purchases Fixed Assets Turnover = Total Sales X 100 Fixed Assets

iv. v.

INVESTORS RATIOS/ STOCK MARKET RATIO i. issue ii. iii. iv. Price Earnings(P/E) Ratio = Market price per share EPS Dividend Per Share = Dividend No. of shares Dividend Cover = Net profit after tax & preference share dividends Dividend Dividend Yield = Dividend per share Market price per share Earnings Per Share (EPS) =Net profit after tax & preference share dividend No. of ordinary shares in

v.

LONG-TERM SOLVENCY RATIO:

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NOTES & EXERCISES ON Financial Management -For ICM Students

CHAPTER THREE CASH FLOW STATEMENT


Introduction Historically the financial statements of a business have been two; a) The Profit and Loss Account, showing increase or decrease in the wealth of the business for a given period. b) The Balance Sheet, showing the position of the business at one point in time. However, during the late 1960s and the early 1970s, the Accounting Standards Committee (ASC) considered it necessary to have a third type of statement which will focus on the flow of resources through a business between two balance sheet dates. The aim of the statement was to show the sources and application of funds. The statement was also aimed at highlighting a businesss cash flow position for a particular accounting period. The concept of Fund Flow Statement was then introduced into UK accounting standards. In 1975, the ASC produced a standard, SSAP 10 (The Statement for Sources and Application of Funds) to deal with this issue. It was named Funds Flow Statement. Note that, Standards produced by ASC were called SSAPs. SSAPs = Statement of Standard Accounting Practices. In August 1990, a new independent body called the Accounting Standard Board (ASB) was formed to takeover the responsibilities of the ASC. Standards Produces by ASB were called Financial Reporting Standards. In September 1991, the ASB issued its first standards, known as the Financial Reporting Standards No.1 (FRS 1): The Cash Flow Statement. FRS 1 came to replace SSAP 10, hence SSAP 10 ceased to apply. FRS 1 basically has the same purpose as the old SSAP 10 (Funds Flow Statement). That is, they all emphasize on a businesss cash inflow and outflow of cash during the financial year. In 1996, FRS1 was revised to include a statement which reconciles cash flow to movement in net debt.

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NOTES & EXERCISES ON Financial Management -For ICM Students FRS 1 requires large companies/organizations preparing true and fair accounts to prepare CASH FLOW STATEMENT. Smaller companies are also encouraged to do so, though some Small & Medium Enterprises use FRSSE. ADVANTAGES OF CASH FLOW STATEMENT Cash flow statements help users understand performance and position of the company better by explaining the difference cash inflows/outflows and profit & Loss. The main advantages of cash flow statements include: 1. The cash flow statement helps in assessing the current liquidity position of the business. 2. It also provides additional information on business activities 3. It provides a mechanism for estimating the future cash flow of the business 4. It helps in determining cash flows generated from trading as opposed to other sources of finance. 5. The statement also allows the user to see the major types of cash inflows and outflows of the business 6. It helps the user to estimate the future cash flows of the business 7. It helps in comparing the performance of different enterprises because it eliminates the effect of different treatments of the same transaction by these companies. 8. It helps evaluate management performance 9. It commits management to consider the going concern of the organization 10. Creditors can assess the companies ability to pay amount owed them. DISADVANTAGES OF CASH FLOW STATEMENT Cash flows statements have some limitations. They include the following a. They place undue reliance on cash flow. Although cash flow is important, it is not enough in assessing the performance of the company. b. Too much cash in the short term will prevent future growth. WHY DOES PROFIT NOT EQUAL TO CASH? If a company makes higher profit, it does not necessarily mean the company has more cash. In the short term, profits and cash/bank need not be equal and a high profit does not necessary mean the company has generated large cash surplus. The following are some of the reasons why profit may not be equal to cash. 1) Profit is calculated on accrual basis. Thus revenue is recognized (recorded) when it is earned, not when it is received and expenses are recorded when it is incurred, not when it is paid. On the other hand, cash/bank will change only when money is paid or money received. Therefore cash and profit will differ due to certain items such as accruals, prepayment, unpaid debtors etc.

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NOTES & EXERCISES ON Financial Management -For ICM Students 2) The calculation of profit is affected by certain items which do not affect cash or affects it differently. For example, depreciation affects profit but do not affect cash, because depreciation does not involve the payment (movement) of cash. Also provision for doubtful debts affects profit but do not affect cash. Other items include taxation in the current year, proposed dividends, profit or loss on disposal of fixed assets etc. These items affect cash differently. 3) Cash is affected by transaction such as purchase of fixed assets which do not affect profit. Profit is only affected by the depreciation of the fixed asset. Items such as repayment of loan, issue of shares etc do not affect profit but does affect cash. In the long term, profits will be equal to cash. For instance, debtors will be realized (i.e. collected), the depreciation charged will be equal to the total cash expended and provisions will either be written back and accrued income received. However, since short term position of the business is relevance to shareholders, there should be proper cash management for the companys survival. Many businesses fail and are wound up because of cash shortages, despite adequate profit made. Cash flow statements help to notify the possibility of cash shortage FRS 1: STANDARD HEADINGS OF CASH FLOW STATEMENT In 1996, the ASB (Accounting Standards Board) revised FRS1, extending the analysis to eight (8) key headings. The standard headings include the following: 1. Operating activities: These are cash flows relating to operating or trading activities. They are cash flows generated from the main/principal revenue generating activities of the business. 2. Dividends from joint ventures and associates (not examinable at ICM level): 3. Returns on investment and servicing of finance: These are receipts resulting from investment in other companies and payments made for the providers of finance to the company (those who have invested in the company). Cash inflows under this heading may include interest received, dividend received. Cash outflows include interest paid, dividend paid on non-equity share (Preference shares). 4. Taxation: This heading covers the cash outflows (and sometimes inflows) to tax authorities (IRS) relating to profits and capital gains. It does not include VAT. 5. Capital expenditure and Financial Investment: This covers all purchase and sale of fixed assets. Cash inflows include sale (disposal of fixed assets and cash outflows are the purchase of fixed assets. 6. Acquisition & Disposals: This relates to cash flows arising from acquisitions or disposals of a trade or business or an investment in a subsidiary, associate or joint venture. (This is not examinable at ICM level).

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NOTES & EXERCISES ON Financial Management -For ICM Students 7. Equity dividend paid: This relates to cash outflows relating to equity dividend paid. (That is dividend on ordinary shares) 8. Management of liquid resource: These are cash flows relating to withdrawal from short-term deposits (not examinable) 9. Financing Activities: These are receipts or payments of principal for or to external providers of finance. Cash Inflows include cash received from shares issued and debentures (long term loans). Outflows include payment of Loans/debentures the capital element of finance lease (though not examinable at ICM level), payment of expense on share issues etc. The individual items under the above standard headings are as follows. a. operating activities: a) Net profit before taxation b) Adjustments for non-cash flow expenses like deprecation, loss on disposal of asset, profit on sale of asset etc. c) Adjustments to the movement in working capital (stock, debtors and creditors) b. Returns on investment and servicing of finance: a) Interest received/ investment income received b) Dividend received c) Interest paid c. Taxation d. Capital expenditure and financial investment: a) Purchase of fixed assets b) Sale/disposal of fixed assets e. Acquisitions and disposals: a) Cash flow from the acquisition of business b) Cash flow from the disposal of business f. Equity dividend paid g. Management of financial resources a) Cash flow from the acquisition or disposal of short-term investment h. Financing: a) Issue of shares or debentures b) Payment of shares or debentures c) Payment of other long term loan. This is summarized in the table below

PREPARING THE CASH FLOW STAMENT

We have explained the standard headings under which cash flow statements are prepared as required by FRS1. Students must note the sequence of the headings when preparing the cash flow statement. The standard format in which cash flow statement should be prepared is given in this chapter but for the purpose of our exams, some of the items are not applicable at our level.

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NOTES & EXERCISES ON Financial Management -For ICM Students For the purpose of our study, the following sequence should be noted when preparing the cash flow statement. 1. Net cash flow from operating Activities: These are flows which resulted from trading (operation) activities. They are primarily derived from the principal revenue generating activities of the business. 2. Returns on investment and servicing of finance: These are items such as interest paid, interest received, dividend received, preference share dividend paid etc. 3. Taxation: These are cash flows resulting from tax paid during the year to the Inland Revenue. 4. Investing activity/ capital expenditure/financial Activities: These cash flows arise from the purchase or sale of fixed assets. 5. Equity dividend paid: this is sometimes classified under returns on investment and servicing of finance but can also be classified separately. These cash flows relate to payments of dividends to ordinary shareholders. 6. Financing Activities: These are cash flows resulting from the capital structure of the business. Cash inflows items under this heading include issues of shares (both preference and ordinary shares), additional long term loans obtained, and debenture loans. Cash outflows include repayment of loan and debentures and expenses relating to issue of shares. Students should note that depending on the question given, some of the items listed under the various headings may not be available. Where some of the items are not given in the question, proceed to the next. Remember also that the starting point of the preparation of the cash flow is the calculation of the Net cash flow from operating activities. The format for preparing cash flow statement is discussed below. Two formats are provided; the standard format which is provided be FRS1 (CASH FLOW STATEMENT) The second format is a summarized form of the standard as a result of the nature of ICM questions. Students should therefore not get confused about the formats. What is important is to grasp the principles behind the cash flow statement and you can solve any question given in the exams. FORMAT OF CASH FLOW STATEMENT FORMAT A- For the purpose of exams: Note that, this is provided based on the nature of ICM questions. It may not be the same for all questions. MORE LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006 Net cash inflow/ (outflow) from operating activities (note1) xx

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NOTES & EXERCISES ON Financial Management -For ICM Students Returns on investment &serving of finance: Interest received Interest paid Preference dividend paid
Net cash inflow/ (outflow) from return on investment &serving

xx (xx) (xx)
of finance

xx Taxation paid Capital expenditure & financial investment: Payment to acquire tangible fixed assets Receipts from sale of fixed assets

xx (xx) xx

Net cash inflow/ (outflow) from capital expenditure/financial activities

xx Equity dividend paid xx Financing Activities: Issue of ordinary share capital xx Repurchase of debenture (xx) Issue of loan and debentures xx Net cash inflow/ (outflow) from financing activities xx Increase/ (decrease) in cash xxx FORMAT B- STANDARD FORMAT MORE LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DEC. 2006 Net cash inflow/ (outflow) from operating activities (note1) xx Dividends from joint venture xx Returns on investment &serving of finance: Interest received xx Interest paid (xx) Preference dividend paid (xx)
Net cash inflow/ (outflow) from return on investment &serving of finance

xx Taxation paid Capital expenditure & financial investment: Payment to acquire intangible fixed assets Payment to acquire tangible fixed assets Receipts from sale of fixed assets xx Acquisition and disposals: Purchase of subsidiary Sale of business
Net cash inflow/ (outflow) from

xx (xx) (xx) xx

Net cash inflow/ (outflow) from capital expenditure/financial activities

(xx) xx
acquisitions and disposal

xx Equity dividend xx Management of liquid resources: More Lecture Series by TIMORE B. F


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paid

NOTES & EXERCISES ON Financial Management -For ICM Students Cash withdrawn from deposit Purchase of government securities Sale of corporate bond xx (xx) xx
xx

Net cash inflow/ (outflow) from management of liquid resources

Financing Activities: Issue of ordinary share capital Repurchase of debenture loan Issue of loan and debentures Expenses paid in connection with share issue
Net cash inflow/ (outflow) from

xx (xx) xx (xx)
financing activities

xx Increase/ xxx

(decrease)

in

cash

THE CASH FLOW FROM OPERATING ACTIVITIES: The starting point for cash flow statement is the Net cash flow from operating activities. There are two alternatives ways in which FRS1 allows cash flows from operating statement may be calculated. 1) The Indirect Method (Net method) 2) The Direct method (Gross Method). Both methods give the same value for Net cash flows from operating activities. THE INDIRECT METHOD (exam approach) This method starts with the operating profit and makes adjustment to non-cash flow items (such as depreciation) and changes in working capital (i.e. changes in stock, debtors and creditors) so that one figure of operating cash flow is shown. Thus we reconcile the operating profit to the net cash inflows or outflows so that we show only one figure in the cash flow statement. Using the indirect method, the Net cash flow is calculated as follows: The indirect method is one often used and this book focuses the indirect method USING THE INDIRECT METHOD RECONCIALIATION OF OPERATING PROFIT TO NET CASH INFLOWS/ (OUTFLOWS) FROM OPERATING ACTIVITIES 000 Operating profit xxx Add: Depreciation charges for the year xx Loss on sale of assets xx Less: Profit on sale of asset xx (Increase)/Decrease in stock xx (Increase)/Decrease in Debtors xx Net cash inflows/outflows from operating activities xxx Note: readers must note that, the reconciliation of operating profit to net cash flow does not form part of the statement. It is shown as a note to the statement. EXPLANATION:

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NOTES & EXERCISES ON Financial Management -For ICM Students 1. Operating profit: This is given in the exams and it is the net profit before interest and tax but after depreciation has been deducted. Profit increase cash but a loss reduces cash i.e. takes away cash from the business. 2. Depreciation: The purpose of charging depreciation in the profit and loss account is that sales during the year benefited from the use of the assets on which depreciation is charged. Depreciation therefore reduces profit made but depreciation does not involve current cash outflow. Therefore add back depreciation charged for the current year to the operating profit. Note that were the profit is given as profit before depreciation it means that depreciation has not been deducted from the profit and therefore no need to add back depreciation again. 3. stocks: a) Decrease in stock: Compare the stocks of the previous year to the stocks for the current year in the balance sheet. If there is a decrease in stock (i.e. if last years stock is lower that this years stock), the business has been able to sell more of its goods to customers (hence the reduction in stock). If more stocks are sold during the year, then more cash has come into the business (cash inflows). Therefore add decrease in stocks. b) Increase in stock: Again compare the stocks figure in the balance sheet. If there is an increase, it means that more money has been used to purchase stocks during the year. This represents a cash outflow (cash gone out of the business). Therefore deduct all increases in stock during the year. 4. Debtors: a) Decrease in debtor: When the amount of debtors reduces during the year, it means that, debtors (people who owe us) have paid us their debts, so we have received cash/cheque. This increases our cash balance in the business, hence increase in debtors represents cash inflows b) Increase in debtors: An increase in debtors means that, goods/services are sold without collecting the cash. Customers are allowed more credit terms and are required to pay later. Thus allowing the debtors balance to increase means stopping cash from coming in. 5. Creditors: a) Increase in Creditors: When there is an increase, it means we have taken more credit from our suppliers and did not pay cash for the goods. More we have therefore saved cash in the business which are supposed to be paid to suppliers/creditors b) Decrease in creditors: A decrease in creditors means we have paid our creditors. THE DIRECT METHOD: This method calculates the cash flow by comparing the cash received from customers (cash inflows) with the cash out for goods and services paid to suppliers and employees.

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NOTES & EXERCISES ON Financial Management -For ICM Students Thus it involves showing all the individual operating cash receipts and payments such as cash receipts from customers, cash payment to suppliers and cash payment to employees. Using the Direct method the Net cash flows from operating activities is calculates as follows: DIRECT METHOD Sale (Receipts from Customers) XXX Cash paid for: Purchases (suppliers) XXX Payment to employees XXX Other cash payment XXX XXX Net cash flow from operating activities XXX The purchases and sales must be calculated as follows: SALE xxx xxx xxx xxx PURCHASES xxx xxx xxx xxx

Bal. in P&L account Add: opening debtors & creditors BAL. Less: Closing debtors & Creditors Cash from sales & purchases

NOTE: The opening balances of debtors (customers) and creditors (suppliers) are added to sales and purchases respectively. This is because they represent cash flow transactions which took place the previous but are received in the current year. The closing balances are deducted because those cash are going to be received next year hence they are not cash inflows and outflows for the current year. QUESTION 1: (ICM-Financial Management- March 2007) The summarised financial statements of Carla Ltd. for 2005 and 2006 were as follows: Carla Ltd. balance sheets as at 31 December 2005 2006 000 000 000 000 Fixed assets at cost15,000 18,000 Depreciation (7,000) 8,000 (9,000) 9,000 Current assets Stock Debtors Bank 7,000 11,000 3,000 -------23,000 -------3,000 5,000 10,000 4,000 9,000

-------21,000 -------Current liabilities Creditors 6,000 Taxation 4,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Dividends 3,000 -------13,000 -------8,000 (3,000) -------13,000 -------9,000 4,000 13,000 4,000 -------12,000 -------11,000 (4,000) -------16,000 -------11,000 5,000 16,000

Working capital Long-term loans

Capital and reserves: Ordinary shares (1) Profit and loss account

Carla Ltd. profit and loss account for the year ended 31 December 2006: 000 Operating profit 11,000 Interest paid (1,000) Profit before tax 10,000 Taxation Profit after tax Dividend Retained profit (5,000) 5,000 (4,000) -------1,000

TASKS a) Prepare a cash flow statement for Carla Ltd. for the year ended 31 December 2006. b) Calculate the following: i the dividend per share for BOTH years ii the EPS for year ended 31 December 2006 c) Comment briefly on the financial performance during year ended 31 December 2006. QUESTION 1: SOLUTION CARLA LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2006 000 000 Net cash inflows from operating activities (note 1) 9,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Returns on investment and servicing of Finance: Interest paid (1000) Net cash outflows from returns on investment & servicing of finance (1000) Tax paid (4,000) Capital Expenditure/financial investment: Purchase of Fixed asset (18,000 -15,000) w2 (3,000) Net cash outflows from capital expenditure/financial investment (3,000) Equity dividend paid (w3) (3,000) Financing Activities: Long term loan (4,000 -3,000) 1,000 Issue of ordinary Shares (11,000 -9,000) 2,000 Net cash inflows from financing Activities 3,000 Increase in cash & cash equivalents/net cash inflows 1000 NOTE 1: NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOWS Operating Profit 11,000 Add: depreciation (9,000 7,000) 2,000 Increase in stock (9,000 7,000) (2,000) Decrease in Debtors (11,000 10,000) 1,000 Creditors (Decrease) 6,000 -3,000 (3,000) Net cash Inflows from operating Activities 9,000 WORKINGS: (W1) TAXATION ACCOUNT Bank (bal. figure) 4,000 4,000 Balance c/d 5,000 9,000 9,000 5,000 P& L Balance. b/d

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NOTES & EXERCISES ON Financial Management -For ICM Students

W3 EQUITY DIVIDEND ACCOUNT Bank (bal. figure) 3,000 Bal. c/d 4,000 7,000 7,000 W2 FIXED ASSETS ACCOUNT Bal. b/d Purchase (bal. figure) 18,000 18,000 18,000 ANALYSIS OF MOVEMENT IN CASH 2005 2006 Changes during the Year Bank balance 10,880 (10,880) Bank overdraft (2,320) (2,320) (13,200) NOTE: i. Net cash inflows form operating activity: the first figure we need for the cash flow statement is the cash flow from operating activity. This is usually done in a reconciliation statement by adjusting the operation profit before interest and tax with the changes in stocks, debtors and prepayments (if any) and creditors and accruals ii. Deprecation: the deprecation charge for the year (which is the difference between the two depreciation amounts is always added. This is not a cash flow item and therefore should not be deducted from profit b) i) Dividend Per Share 2006 = Dividend 4,000 No. of shares 11,000 2005 = 3,000 9,000 15,000 3,000 Bal. c/d 4,000 P&L 3,000 Bal. b/d

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NOTES & EXERCISES ON Financial Management -For ICM Students = 0.33 Per share = 0.36 Per share ii) = 5,000 11,000 =0.45 Per share QUESTION 2: (I C M) You work for a small limited company and are assisting in the preparation of the annual accounts for the year ending 30th may 2007 ASPEN LIMITED BALANCE SHEET AS AT 30TH MAY 2005 2006 Fixed assets (at cost) 173,000 243,400 Less depreciation 57,800 115,200 78100 165,300 Current assets: Stock 74,400 72,080 Debtors 97,920 100,020 Bank 10,880 183,200 172,100 Current Liabilities: Creditors 41,440 37,080 Overdraft 2,320 Provision for tax 17,120 12,400 Proposed dividends 10,000 (68,560) 114,640 12,000 (63,800) 108,300 229,840 273,600 Financed by: 1 ordinary shares 200,000 220,000 Reserves 29,840 53,600 EPS = Net profit No. after of tax shares

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NOTES & EXERCISES ON Financial Management -For ICM Students 229,840 273,600 ASPEN LTD Profit and Loss account for the year ended 30th May 2007 Operating profit for the year 49,160 Interest payable (1,000) Profit after interest 48,160 Provision for tax (12,400) Profit after tax 35,760 Proposed dividend (12,000) 23,760 Profit & Loss balance b/f 29,840 Profit & Loss balance c/f 53,600 Requires: a) Prepare a cash flow statement of MORE LTD for the year ended 30 May 2007 b) Compute the current ratios for both years SOLUTION TO QUESTION 2: ASPEN LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 30TH MAY 2007 Net cash inflows from operating activities (note 1) 65,320 Returns on investment and servicing of Finance: Interest paid (1,000) Taxation (17,120) Capital Expenditure/financial investment: Purchase of Fixed asset (70,400) Net cash outflows from capital expenditure/financial investment (70,400) Equity dividend paid (W2) (10,000) Financing Activities: Issue of Shares (220,000-200,000) W3 20,000 Net cash inflows from financing Activities 20,000 Decrease in cash (13,200)

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NOTES & EXERCISES ON Financial Management -For ICM Students NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOWS Operating Profit 49,160 Add: depreciation (78,100-57,800) * 20,300 Decrease in Stocks (44,400-72,080) 2,320 Increase in Debtors (100,020-97,920) (2,100) Creditors (Decrease) (41,400-37,080) (4,360) Net cash Inflows from operating Activities 65,320 WORKINGS: W1 TAXATION ACCOUNT Bank (bal. figure) 17,120 17,120 Balance c/d 12,400 29,520 29,520 W2 EQUITY DIVIDEND ACCOUNT Bank (bal. figure) 10,000 Bal. c/d 12,000 27,000 27,000 W3 FIXED ASSETS ACCOUNT Bal. b/d Purchase (bal. figure) 243,400 243,000 ANALYSIS OF MOVEMENT IN CASH 173,000 70,400 243,400 Bal. c/d 12,000 P&L 10,000 Bal. b/d 12,400 P& L Balance. b/d

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NOTES & EXERCISES ON Financial Management -For ICM Students 2005 Bank balance Bank overdraft 10,880 2006 Changes during the Year (10,880) (2,320) (2,320) (13,200)

Note: The depreciation calculation can also be controlled in a T Account as follows DEPRECIATION ACCOUNT Balance. b/d 57,800 Balance c/d 20,300 78,100 78,100 78,100 P& L (balancing fig.)

QUESTION 3 (I C M) You work in the accounts office of XYZ Ltd and the accountant has provided you with the following information at the end of the financial period, 2007 BALANCE SHEET OF XYZ AS AT 31 December 2007
2006 2007 2006 2007 Freehold property (cost) 30,000 Equipment (note 1) 33,000 Stock in trade Debtors Bank 4,000 13,000 75,000 80,000 The companys summarized profit calculation for the ended 31 March 2007 revealed: 2006 2007 Sales 95,000 100,000 Profit on sale of equipment 2,500 80,000 75,000 25,000 18,000 16,400 13,600 2,000 25,000 22,200 Issued share capital Profit and Loss A/c 30,000 27,000 6,000 12,000

17,800 Corporation Tax due: 14,000 1 January 1,000 1 January Creditor

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95,000 102,500 LESS: Cost of sales and other expenses 84,800 92,500 Net profit before tax 10,200 10,000 Corporate tax on profit of the year 6,000 4,000 Retained profit of the year after tax 4,200 4,000 NOTE 1: Equipment movements during the year ended 31 March 2007. Cost Deprecation Net Balance at March 2006 30,000 12,000 18,000 Additions during the year 9,000 Depreciation provided during the year 3,800 39,000 15,800 Disposals during the year (4,000) (3,000) Balance at 31 March 35,000 12,800 22,200 Required: Prepare a cash flow statement for the year ended 31 March 2007.

QUESTION 3:SOLUTION ABC LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST MARCH 2007 Net cash inflows from operating activities (note 1) 57,275 Returns on investment and servicing of Finance: Preference shares dividend paid (2,000) Net cash outflows from returns on investment & servicing of finance (2000) Taxation: tax paid (12,500) Capital Expenditure/financial investment: Purchase of Fixed asset (63,000) Net cash outflows from capital expenditure/financial investment (63,000) Equity dividend paid (6000) Financing Activities: Debenture loan (50,000 -35,000) 15,000 Preference Shares (25,000 -15,000) 10,000 Net cash inflows from financing Activities 25,000 Decrease in cash (1,225)

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NOTES & EXERCISES ON Financial Management -For ICM Students NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOWS Operating Profit 44,150 Add: depreciation 8,000 Stocks (decrease) 1950 Debtors (Increase) (3725) Creditors (Increase) 6900 Net cash Inflows from operating Activities 57,275 WORKINGS TAXATION ACCOUNT Bank (bal. figure) 12,500 Balance. b/d 12,500 Balance c/d 15,000 27,500 27,500 ORDINARY DIVIDEND ACCOUNT Bank (bal. figure) 6,000 Bal. c/d 12,500 FIXED ASSETS ACCOUNT Bal. b/d 8,000 Purchase (bal. figure) 195,000 203,000 63,000 203,000 Bal. c/d 140,000 Depreciation 6,500 12,500 P&L 6,500 6000 Bal. b/d (y1) 15,000 P& L

ANALYSIS OF MOVEMENT IN CASH Year 1 Year 2 Changes during the Year Cash balance 500 500 Bank 4,150 2925 (1225) 4,650 3425 (1225)

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NOTES & EXERCISES ON Financial Management -For ICM Students INTERNATIONAL ACCOUNTING STANDARDS 7 (IAS 7): CASH FLOW STATEMENT Apart from FRS 1, there is IAS 7(International Accounting Standard- 7) which also requires companies to prepare a cash flow statement. The two standards are similar; the only difference is that IAS 7 is less detailed than FRS 1. Under IAS 7, the Cash flow statement is prepared under three (3) major headings. The headings under IAS7 are: i. OPERATING ACTIVITIES ( i.e. cash flow from operation activities) ii. INVESTING ACTIVITIES (i. e. cash flows from investing Activities) iii. FINANCING ACTIVITIES (i.e. Cash flows from financing activities) CHAPTER QUESTIONS AND SUGGESTED SOLUTION QUESTION 1 You have just been employed as the accountant of Timore Ltd and your first assignment is to prepare the cash flow statement to be included in the annual report for the year ended 2007. The following information is made available to you by the managing director. TRADING PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DECEMBER 2007 Sales 1,500,000 Less cost of sales: Opening stock 300,000 Purchases 1,050,000 1,350,000 Less closing stock 450,000 900,000 Gross profit 600,000 Operating expenses (375,000) Net profit 225,000 Taxation 75,000 Net profit after tax 150,000 Dividends 90,000 Retained profit for the year 60,000 TIMORE LTD BALANCE SHEET AS AT 31 DECEMBER 2007 2006 2007 Fixed assets (at cost) 1,350,000 1,575,000 Less accum. Dep. 225,000 1,125,000 382,500 1,192,500 Current asset: Stock 300,000 450,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Trade debtors Cash 180,000 30,000 510,000 225,000 67,500 742,000 135,000 75,000 90,000 300,000

Current liabilities: Trade creditors 105,000 Taxation 60,000 Proposed dividends 45,000 210,000 300,000 442,500 1,425,000 1,635,000

Capital & Reserves: Ordinary share capital (1) 1,125,000 Profit and Loss Account 360,000 Loans: 10% debenture stock 150,000

1,125,000 300,000 1,425,000 -- - 1,485,000

1,425,000 1,635,000 REQUIRED: Prepare the cash flow statement for the year ended 31 December 2007 NB: Show all workings. SUGGESTED SOLUTION: QUESTION 1 TIMORE LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2007 Net cash inflows from operating activities (note 1) 232,500 Returns on investment and servicing of Finance: Interest Paid(10% debentures) (15,000) Net cash outflows from returns on investment & servicing of finance (15,000) Taxation: Tax paid (60,000) Capital Expenditure Purchase of Fixed asset (225,000) Net cash outflows from capital expenditure/financial investment (225,000)

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NOTES & EXERCISES ON Financial Management -For ICM Students Equity dividend paid (45,000) Financing Activities: Debenture loan 150,000 Net cash inflows from financing Activities 150,000 Increase in cash 37,500 NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOWS Operating Profit (225,000 +15,000) (10% interest on debentures) 240,000 Add: depreciation (382,500-225,000) 157,500 Increase in stocks (450,000 300,000) (150,000) Increase in debtors (225,000-180,000) (45,000) Increase in creditors (135,000 105,000) 30,000 Net cash Inflows from operating Activities 232,500

TAXATION ACCOUNT Bank (bal. figure) 60,000 Balance. b/d 60,000 Balance c/d 75,000 135,000 135,000 ORDINARY DIVIDEND ACCOUNT Bank (bal. figure) 45,000 Bal. c/d 90,000 135,000 135,000 FIXED ASSETS Opening balance Closing balance 1,350,000 1,575,000 90,000 P&L 45,000 Bal. b/d (y1) 75,000 P& L

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NOTES & EXERCISES ON Financial Management -For ICM Students Additional purchase 225,000 ANALYSIS OF MOVEMENT IN CASH 2006 2007 Changes during the Year Cash balance 30,000 67,500 37,500 Increase in cash 37,500 Question 2 You are presented with the following information: MORE LTD BALANCE SHEET AS AT 31 DECEMBER 2006 31/12/2005 31/12/2006 Fixed Assets: Land & Buildings at cost 1,050,000 Current Assets: Stocks 180,000 Debtors 375,000 Cash 570,000 Current Liabilities: Creditors (330,000) 240,000 1,290,000 Capital & Reserves: 1 ordinary share capital 1,200,000 Profit & Loss Account 90,000 1,290,000 900,000

150,000 300,000 9,000 15,000 459,000 (270,000) 189,000 1,089,000 1,050,000 39,000 1,089,000

Task: prepare the cash flow statement for MORE LTD for the year ended 31 December 2006. SUGGESTED SOLUTION: QUESTION 2 MORE LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2006 Net cash inflows from operating activities 6,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Capital expenditure/investing activities: Purchase of (150,000) Financing activities: Issues of ordinary 150,000 Increase in 6,000 fixes share assts capital cash

Reconciliation of operating profit to net cash inflows from operating activities Operating profit (90,000 39,000) 51,000 Increase in stock (180,000 150,000) (30,000) Increase in debtors (370,000 300,000) (75,000) Increase in creditors (330 270) 60,000 Net cash inflows from operating activities 6,000 Analysis of movement /changes in cash: 2005 during the year Cash balance 9,000 6,000 Increase in 6,000 2006 change 15,000 cash

QUESTION: 3 The following information relates to CAR Ltd for the year ended 30 June 2007 Profit and Loss account for the year ended 30 June 2007 Gross profit 322,000 Administrative expenses 106,400 Loss on sale of vehicle 4,200 Increase in provision for bad debt 1,400 Depreciation (vehicles) 49,000 (161,000)

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NOTES & EXERCISES ON Financial Management -For ICM Students Net profit 161,000 Taxation (91,000) Net profit 70,000 Dividends (35,000) Retained profit for the year 35,000 before tax

after

tax

BALANCE SHEET AS AT 30 JUNE 2007 2006 2007 Fixed assets: Vehicles at cost 280,000 Less depreciation (140,000) 140,000 Current Assets: Stocks 70,000 Debtors provision 133,000 Cash 11,200 214,200 Current Liabilities: Trade creditors Taxation Proposed dividends (200,200) 14200 154,000 210,000 (105,000) 105,000 84,000 112,000 (5,600) 106,400 8,400 198,800 84,000 72,800 28,000 74,200 91,000 35,000 140,000 (7,000)

(184,800)

14,000 119,000

Capitals & Reserves:

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NOTES & EXERCISES ON Financial Management -For ICM Students Ordinary share 105,000 Profit and Loss account 49,000 154,000 Additional information: i. During the year, the company sold a vehicle for 16,800 in cash. The vehicle had originally cost 35,000 and a depreciation charges amounted to 14,000 ii. A new vehicle costing 105,000 was purchased during the year. Required: You are required to prepare the Cash Flow statement for the year ended 30 June 2007. QUESTION 7: (SEPTEMBER 2005 ACCOUNTING II) The summarised financial statements of Axenby Ltd. for 2003 and 2004 were as follows Axenby Ltd. balance sheets as at 31 December: 2003 2004 000 000 000 000 Fixed assets at cost 13,000 28,000 Depreciation (6,000) 7,000 (8,000) 20,000 Current assets: Stock 8,000 16,000 Debtors 6,000 8,000 Bank 1,000 2,000 15,000 26,000 Current liabilities: Creditors 3,000 Taxation 1,000 Dividends 2,000 6,000 Working capital Long-term loans Capital and reserves Ordinary shares (1) Profit & Loss account 9,000 (5,000) 11,000 5,000 6,000 11,000 6,000 2,000 3,000 11,000 15,000 (9,000) 26,000 10,000 16,000 26,000 105,000 14,000 119,000

Axenby Ltd. Profit & Loss account for the year ended 31 December 2004: 000 Operating profit 16,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Interest paid Profit before tax Taxation Profit after tax Dividend Retained profit (1,000) 15,000 (2,000) 13,000 (3,000) 10,000

TASKS a) Prepare a cash flow statement for Axenby Ltd. for the year ended 31 December 2004. b) Calculate the following for BOTH years: i the current ratio ii the acid test c) Comment briefly on the financial performance during 2004. AXENBY LTD CASH FLOW STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2004 Net cash inflows from operating activities (note 1) 11,000 Returns on investment and servicing of Finance: Interest Payable (1,000) Net cash outflows from returns on investment & servicing of finance (1,000) Taxation (1,000) Capital Expenditure/financial investment: Purchase of Fixed asset (15,000) Net cash outflows from capital expenditure/financial investment (15,000) Equity dividend paid (2,000) Financing Activities: Debenture loan (9,000 - 5,000) 4,000 Ordinary Shares (10,000 - 5,000) 5,000 Net cash inflows from financing Activities 9,000 Increase in cash (1,000) NOTE 1: RECONCILIATION OF OPERATING PROFIT TO NET CASH INFLOWS Operating Profit 16,000 Add: depreciation (8,000- 6,000) 2,000 Increase in stocks (16,000 8,000) (8,000) Increase in Debtors (8,000 6,000) (2,000)

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NOTES & EXERCISES ON Financial Management -For ICM Students Increase Creditors (6,000 -3,000) Net cash Inflows from operating Activities 11,000 TAXATION ACCOUNT Bank (bal. figure) 1,000 Balance. b/d 1,000 Balance c/d 2,000 3,000 3,000 NB: the tax paid during the year is sometimes (but not always) equal to the tax figure for the previous year in the question given you. DIVIDEND ACCOUNT Bank (bal. figure) 2,000 Bal. c/d 3,000 5,000 FIXED ASSETS Opening balance at cost (2003) Closing balance at cost (2004) Purchased during the year 13,000 28,000 15,000 P&L 3,000 5,000 2,000 Bal. b/d 2,000 P& L 3,000

ANALYSIS OF MOVEMENT IN CASH 2003 2004 Changes during the Year Bank 1,000 2,000 1,000 Increase in cash (1000) b) Year 2003 = 15,000 X100 6,000 = 2.5:1 = 2.36:1 ii) Acid Test Ratio =Current Assets- stocks 26,000 -16,000 Current liabilities 11,000 = 15,000 - 8,000 6,000 2004 =

i) Current ratio= Current Assets 26,000 X100 Current liabilities 11,000

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NOTES & EXERCISES ON Financial Management -For ICM Students = 1.16:1 = 0.9:1 QUESTION 7 :( MARCH 2006 FINANIAL MANAGEMENT) a) Prepare a cash flow statement of a company called LED plc for the year ended 31 March 2006 from the following data: 000 Purchase of new machinery 180 Purchase of new vehicles 80 Tax paid 110 Equity dividends paid 90 Proceeds from share issue 510 Repayment of long-term loans370 Interest paid 40 Interest received 5 Investment income 15 Cash inflow from operating activities 190 b) Comment on the cash flow position of LED plc during year ended 31 March 2006.

SOLUTION TO QUESTION 7: LED PLC CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 2006

Net cash inflows from operating activities 190,000 Returns on investment and servicing of Finance: Interest Paid Interest Received Investment income
Net cash outflows from returns on investment & servicing of finance

(40,000) 5,000 15,000

(20,000) Taxation (110,000) Capital Expenditure/financial investment: Purchase of new machinery (180,000) Purchase of Vehicle (80,000) Net cash outflows from capital expenditure/financial investment (260,000) Equity dividend paid (90,000) Financing Activities:0 Proceeds for issue of shares 510,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Repayment of long term loan (370,000) Net cash inflows from financing Activities 140,000 Decrease in cash (150,000)

CHAPTER FOUR CAPITAL INVESTMENT APPRAISAL


Introduction
Capital investment decisions are those decisions that involve current outlays (cash outflow) in return for future benefits (cash inflows). In other words, when a company makes a capital investment, it makes an initial cash outlay (outflow) for benefits to be received or realized in the future. Such investments are made in the long-term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firm is used to invest in assets that will enable the firm to generate revenues several years into the future. Normally the funds raised to invest in such assets are not available.

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Therefore the firm must budget/plan correctly, how these funds will be invested.

DEFINITION: CIMA defines Capital Investment Appraisal as follows: An evaluation of the costs and benefits of a proposed investment in operating assets Capital Investment Appraisal (sometimes called capital budgeting) is therefore the process of planning capital investment and evaluating and selecting from a range of possible choices /alternatives.
Because capital budgeting decisions have a major impact on the firm for several years, they must be carefully planned. A bad decision can have a significant effect on the firms future operations. Again, the timing of the decisions is important. Many capital budgeting projects take years to implement. If managers do not plan accordingly, they might find that the timing of the capital budgeting decision is too late (i. e costly with respect to competition. Decisions that are made too early can also be problematic because capital budgeting projects generally are very large investments, thus early decisions might generate unnecessary costs for the firm.

A proposed investment is judged by a number of appraisal techniques before they are undertaken and therefore Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a finance manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternative projects/investments. A sound procedure to evaluate, compare, and select projects is needed by the finance manager. REASONS WHY COMPANIES USE APPRAISAL TECHNIQUES The following are some reasons why companies evaluate potential investment projects before beginning such projects 1. It involves substantial expenditure. The sum (cash) involved is relatively large hence a bad decision and choice may have very serious consequence on the company. 2. The benefits may be spread over many years. The time scale over which the benefits (cash inflows) will be received is relatively large and cover a series of years hence proper assessment of the project must be made. 3. Capital investment, when undertaken, are irreversible decisions, hence they require proper analysis. 4. Uncertainty: The expected cash flows are computed based on future expectations. Since the future is uncertain, correct decisions may sometimes prevent disastrous consequences.

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CHARACTERISTICS/ FEATURES OF CAPITAL INVESTMENT DECICIONS


Capital investment decisions have certain characteristics which are not always present in other management decisions, and as a result, special techniques are required to ensure that only the best information is available to the decision maker. These characteristics are: A significant outlay of cash; Long term involvement with greater risks and uncertainty (because forecasts of the future are less reliable) 3. Irreversibility of some projects due to the specialised nature of, for example, plant which having been bought with a specific project in mind may have little or no scrap value; 4. A significant time lag between commitment of resources and the receipt of benefits; 5. Project completion time requires adequate continuous control information as costs can be exceeded by a significant amount.
1. 2.

INVESTMENT APPRAISAL TECHNIQUES/METHODS


There are several methods for evaluating capital expenditure projects but no matter what method is used it is important to realize that the information used for the evaluation has to be properly screened as it can materially affect the evaluation. The most commonly used techniques can be classified into two main groups. A) NON-DISCOUNTED CASH FLOW TECHNIQUES These are sometimes referred to as the traditional appraisal techniques The two popular traditional methods of comparing the attractiveness of competing projects are: 1) The Accounting Rate of Return (ARR) 2) The Payback period B) DISCOUNTED CASH FLOW TECHNIQUES 3) Net Present Value (NPV) 4) Internal Rate of Return (IRR) 5) Profitability Index (P I) Each of these methods will be described and an example given of the calculations involved. Then the acceptance criterion for each will be stated. We share consider investment projects in circumstances

1.

ACCOUNTING RATE OF RETURN (ARR)

It is defined as the ratio of average profit, after depreciation, to the capital invested. That is, the average earnings/profit of a project expressed as a percentage of the average or initial capital invested in the project. This is sometimes known as the Return On Capital Employed (ROCE).

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It is calculated by the formulae: ARR= Average annual profit after depreciation Initial Investment

X 100

Average Annual profit=Total annual profit (cash inflows minus depreciation) x100 No. of years Note that Capital invested is the cost of the project. In the calculation the initial investment or Average investment can be used i.e. ARR can be calculated using either the total initial investment (total cost of the project) or on the Average initial investment (half of the cost of the project) Where ARR is calculated using average investment, the formula becomes ARR= Average annual profit after depreciation X 100 Average Investment Note that, AVERAGE INVESTMENT= TOTAL INVESTMENT 2 DEPRECIATION: From our previous discursion on company accounts, we learnt that, when we buy assets, its value reduces every year. In project appraisal, the general assumption still holds that, when a project is undertaken, the value of the project losses its value every year. The ARR method of investment appraisal uses Accounting profit but not the cash flow in the assessment of the projects worthiness. Remember that profit is not necessarily the same as cash. Since Net profit is different from cash flow, we must calculate the depreciation and deduct from the cash flow from the project to get the profit. We can then use the profit in the calculation of the ARR. There are a number of methods that can be used to calculate the depreciation of a fixed asset. The most commonly used ones are the Reducing Balance method and the Straight Line method. In this chapter, we shall assume that only the straight line method is used in calculation of the projects depreciation. The formula for the depreciation using the straight line method is: Depreciation = cost residual value No. of years In the project appraisal, it is usually assumed that the residual value or scrap value will be zero but this is not true for all cases. In some cases there could be residual value at the end of the projects life. Let us consider the following examples and see how the ARR is calculated

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NOTES & EXERCISES ON Financial Management -For ICM Students Example 1 Etienne Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,100 Cash flows: Year 1 500 Year 2 900 Year 3 1,000 Year 4 800 Year 5 500 TASKS: Calculate the ARR (accounting rate of return) Solution :( with explanation) example one ARR= Average annual profit (after depreciation) X 100 Initial investment Average Annual Profit= Total annual Profit (after depreciation) No. of years Note: in the example, we are given the case flows for the project over 5 years. These case flows are not profit. It means that we need to subtract the depreciation of the project to get the profit. Annual depreciation = cost- residual value = 2,100,000 = 420,000 No. of years 5 years That is, the depreciation for every year is 420,000. Therefore we have to deduct this depreciation from each years cash flow to get the profit. Cash flows profit Year Year Year Year Year 1 2 3 4 5 Depreciation Annual

500,000 900,000 1,000,000 800,000 500,000 3,700,000 1,600,000 now since the ARR can now be calculated ARR= Average annual profit X 100 Initial investment

420,000 80,000 420,000 480,000 420,000 580,000 420,000 380,000 420,000 80,000 2,100,000 profit has been calculated,

Average Annual Profit= Total annual Profit = 1,600,000 = 320,000 No. of years 5 years Therefore ARR = 320,000 X 100 2,100,000 = 15.23%

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Tutorial

The solution appears to be too long. This is due to the explanation. The explanations is not necessary in exams. Let us now take a look at some few points in the above solution.

a. The general assumption is that the straight line method will be used in the calculation of the depreciation. Therefore remember to use it when no other method is given to you. b. From example one, the annual depreciation was 420,000. You can see that the total depreciation for the years is equal to the cost of the project which is 2,100,000. The reason is that, there is no scrap or residual value at the end of the projects life. Therefore we can assume
that the total annual depreciation is equal to the cost of the project. This cost of the project can therefore be used as the total depreciation when the straight line method is used and there is no residual value c. Unless you are told to use the average investment, always use the initial investment

Let us look at the example below. This time no explanation is provided. EXAMPLE 2 Mars Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,500 Cash flows: Year 1 600 Year 2 1,000 Year 3 1,100 Year 4 700 Year 5 300 Calculate the ARR (accounting rate of return). SOLUTION: EXAMPLE 2 ARR= Average annual profit X 100 Initial investment Annual Profit = Total cash inflows Total depreciation Total cash inflows (000) = 600+1,000+1,100+700+300 = 3,700 Annual depreciation = cost- residual value = 2,500 - 0= 500,000 No. of years 5 years Total depreciation for years = 500,000X 5 = 2,500,000
Note: Total depreciation = cost of project = 2,500,000

Average Annual profit = 3,700,000 2,500,000 = 1,200,000 = 240,000 5 years 5 More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students There fore ARR = 240,000 X 100 2,500,000 = 9.6%

Example 3: GATO Ltd is considering investing in a new project. The details of the projects are as follows. Cost of project 10,000 Estimated life 10 years Estimated net profit: Year 1 24,000 2 36,000 3 60,000 4 50,000 5 10,000 Total net profit 180,000 Note: the estimated residual value of the project at the end of the 10 years is 20,000 REQUIRED: calculate the Accounting Rate of Return (ARR) using b)The initial capital invested c) The average capital invested ADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR) 1) It is simple to calculate 2) It is easy to understand 3) It is consistent with the short-term profit maximizing objectives 4) It is consistent with Return-on Investment (ROI); a measure which is used in most companies to compare divisional performance. 5) The Data for its calculation is readily available to calculate it. DISADVANTAGES OF ACCOUNTING RATE OF RETURN (ARR) 1) It does not allow for the timing of outflows and inflows. That is, since it is an average, it takes no account of the timing of the profit 2) It does not take account of the size of the investment 3) It uses accounting profit as a measure. Accounting profit is affected by accounting concepts and conventions such as the method of depreciation of assets. These are subjective, hence not appropriate for investment decisions. 4) There is no universally accepted method of calculating Accounting Rate of Return

THE PAYBACK (PB) METHOD

Payback period is defined as the the time required for the cash inflows from a capital investment project to equal the cash outflow . Thus the period of time required for the return on an investment to "repay" the

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NOTES & EXERCISES ON Financial Management -For ICM Students sum of the original investment. This period is the number of years it takes to recoup the original investment. It is the length of time it takes a project to recoup its initial cost out of the cash receipts that it generates. This period is referred to as the period that it takes the project to pay for itself. It is intuitively the measure that describes how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods. Note: this is a cash measure and therefore measures the number of years taken to recoup the investment in cash. PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOW Where the cash flow is constant over the period, (i.e. where there is even cash inflow) the pay back is calculated as follows: Payback = Initial Investment Annual Cash inflows

PROJECTS WITH EQUAL/CONSTANT ANNUAL CASH FLOW

Where the cash flow is constant over the period, (i.e. where there is even cash inflow) the pay back is calculated as follows: Payback = Initial Investment Annual Cash inflows Example1: PROJECTS WITH EQUAL (EVEN CASH FLOW) MORE LTD is considering an investment in a new plant. The following information has been provided on the project: Cost of plant (Initial Investment) 50,000 Yearly Cash inflows: Year 1 12500 Year 2 12500 Year 3 12500 Year 4 12500 Year 5 12500 Year 6 12500 Required: Calculate the payback period for the project SOLUTION: EXAMPLE 3 NB: the yearly cash inflows are constant (i.e. 12,500 for each year) Payback Period = Initial Investment Total Net cash inflows = 50,000 = 4yrs 12,500

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NOTES & EXERCISES ON Financial Management -For ICM Students Therefore it will take 4 years to get the amount invested in the project (i.e. 50,000)
**Check: 12,500 X4 years =50,000

Note: projects with equal cash flow hardly appear in our exams. So we will concentrate more on projects with unequal cash flow as this is the usual way of the questions. PROJECTS WITH UNEQUAL CASH FLOWS Where there are uneven cash flows, the payback period is calculated as follows Payback period = year(s) before full recovery + unrecovered cost at beginning of the year Cash flows during the year Example 1 More Investments Ltd is considering an investment in a machine. The machine would cost $50,000 and would generate net cash receipts as follows: 1st year 2nd year 3rd year 4th year 5th year 15,000 30,000 10,000 5,000 2,000

It is expected that, the machine will last for five years Required: Calculate the payback period of the machine. Solution: Payback period = 2yrs + 5,000 X 12 months 10,000 = 2years 6 months. Tutorial: 1. after one year we would have recouped $15,000 2. after the 2rnd year the total would be (15,000 + 30,000) = 45,000 3. we will be left with $5,000 to achieve the total of $50,000, i.e. the initial investment but the 3rd years cash inflows is $10,000, which is more than the $5,000 we need. 4. This means that, when we enter year 3, we will need about 6 months (half of the year) to get the $5,000. More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students The remaining balance is therefore divided by the cash inflows during that year (5,000 10,000). Since it is less than a year, we will express it in months by multiplying it by 12 months. QUESTION 2 You are working on the evaluation of a number of potential projects, one of which involves the opening of a training centre for your firms staff. It would cost 120,000 to renovate and refurbish a building ready for training purposes. Your company expects to save the following net cash costs on external training fees over the next five years at present day prices: Year 1 42,000 Year 2 53,000 Year 3 59,000 Year 4 61,000 Year 5 65,000 TASKS a) Calculate the payback period. 5. SOLUTION: Payback period = 2 yrs + (120,000 95,000) X 12 months 59,000 = 2 yrs + 25,000 X 12 months 59,000 = 2yrs + 5.08 months Therefore the payback period of the project is 2years 5 months. Tutorials 6. At the end of year 2, only 95,000 (i.e. 42,000 + 53,000) have been recouped or realised from the project. Since the cost of the project is 120,000, we need about 25,000 (120,000 -95,000) before the cost is fully recouped. 7. If we add year 3 cash flows, the total will be more than 120,000 (95,000 +59,000) 8. So we need only 25,000 from the 59,000 to top up. 9. Note how the payback is expressed. That is in years and in month. Example 3. MORE LTD has an investment projects. The estimated costs and returns are as follows: Project A Cost Year 1 Cash inflows Year 2 Cash inflows Year 3 Cash inflows Year 4 Cash inflows 215,000 44,000 96,000 90,000 70,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Tasks: Calculate the payback period of project A (in years and months) SOLUTION a) Payback period: Year 1 Cash inflow Year 2 Cash inflows Payback period PROJECT A 000 44,000 96,000 140,000 = 2years + (215,000 -140,000) X 12 months 90,000 = 2yr + 75,000 X 12 months 90,000 = 2yrs 9.99 months = 2yrs 10 months

ADVANTAGES OF PAYBACK METHOD 1. It is simple to calculate and understand 2. It is more objectively based because it uses the projects cash flows instead of the accounting profit which is very subjective and can be manipulated 3. DISADVANTAGES OF PAY BACK PERIOD

simple payback does not take into account the time value of money it ignores cash flows received after the end of the payback period it does not take into account the overall profitability of the project Net Present Value (NPV)

DISCOUNTED CASH FLOW TECHNIQUES The discounted cash flow (or DCF) approach describes a method to value a project using the concepts of the time value of money. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital. The main methods under this approach are: 1) Net Present Value (NPV) 2) Internal Rate of Return (IRR)

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NOTES & EXERCISES ON Financial Management -For ICM Students 3) Profitability Index (PI)

Discount factor
The discount factor, P (T), is the number by which a future cash flow to be received at time T must be multiplied in order to obtain the current present value. Thus for a fixed annually compounded discount rate r we have

The discount Factor is usually provided in an exams in the form of a discount factor table. However, let us see how this is calculated using our own calculators Question Calculate the discount factor for the following discount rates a) b) c) d) e) 8% 9% 10% 15% 20%

THE NET PRESENT VALUE (NPV) NPV is concerned with cash flows (based on relevant costs and benefits) rather than profits. The net present value method of project appraisal is a more sophisticated technique than payback since it takes into account the time value of money while considering relevant cash flows over the entire life of the project. By identifying an appropriate cost of capital and utilizing discount tables, this enables us to calculate the present values of cash flows over the life of a project. The total of the discounted cash flows is known as the net present value (NPV). Using this technique, so long as a project yields a positive NPV (at the relevant cost of capital) it will be recommended on financial grounds. A negative NPV will result in the project being rejected. The higher the NPV, the more desirable a project is on financial grounds. With mutually exclusive projects the project with the highest NPV would be preferred. By taking into account the time value of money and discounting cash flows according to when monies are paid out or received, projects can be appraised before the investment decision is made. It is important to note that it is the cash flows of the project that are discounted, not the profits.

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NOTES & EXERCISES ON Financial Management -For ICM Students When performing NPV calculations, the following approach should be taken:

identify the relevant cash inflows and outflows of the project, not forgetting the initial investment set up a table and discount each of the cash flows to its present value, using the company's required rate of return - discount tables will be provided on the day to facilitate calculations calculate the net present value of the project by taking the outflows away from the inflows decide whether or not the project should be accepted on the basis of whether or not it has a positive NPV.

The advantages and disadvantages of NPV as a method of project appraisal are set out below: Advantages shareholder wealth is maximised

it takes into account the time value of money it is based on cash flows, which are less subjective than profits.

Disadvantages

it can be difficult to identify an appropriate discount rate Cash flows are usually assumed to occur at the end of a year, but in practice this is over simplistic.

INTERNAL RATE OF RETURN (IRR) IRR can be defined as the Discount rate which gives zero NPV. The Internal Rate of Return (IRR) is the discount rate that will cause the present value of the benefits to equal the present value of the cost. In other words, the IRR is the situation described in the middle line of the above table. We use a trial-and-error process to find this percentage rate. Once the IRR has been computed, it is compared to the companys Required Rate of Return (cost/ discount factor). The required rate of return is simply the minimum rate of return that an investment project must yield to be acceptable. If the IRR is greater then or equal to the required rate of return, then the project is acceptable. If the IRR is less than the required rate of return, then the project is rejected. The IRR can be estimated by the following formulae:
IRR = Negative Positive rate + Positive NPV X (Positive-

Positive NPV + Negative NPV

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NOTES & EXERCISES ON Financial Management -For ICM Students OR IRR = L + WHERE: L = Lower Rate of interest H = Higher rate of Interest NL = NPV at Lower rate of interest NH = NPV at Higher rate of interest NL NL - NH x(H- L)

The reasons are that if a project cannot earn returns which is more or greater than the cost of investment (the cost of capital) then the project is not profitable). In order to calculate IRR it is necessary to calculate the NPV of the investment at two different costs of capital rates. (one cost of capital giving a positive NPV and the other a negative NPV.) Having calculated the two NPVs, the technique is to interpolate to try to estimate the IRR. The internal rate of return tells us the rate at which the NPV of a project is neither positive nor negative. There are four steps to an IRR calculation: 1. Calculate the project's NPV at any reasonable discount rate (this may be given to you in the exam). 2. If the above NPV is positive, choose a higher discount rate (again this may be given in the exam) and calculate the NPV again. If the above NPV was negative, choose a lower discount rate. 3. Either way, you must end up with one positive and one negative NPV. You must now calculate Where A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the NPV at the higher rate. 4. The IRR must then be compared to the company's required rate of return. If it is higher than the required rate of return, the project should be accepted. If it is lower than the required rate of return, the project should be rejected. EXAMPLE 1:

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NOTES & EXERCISES ON Financial Management -For ICM Students MORE LTD is considering investment of $ 24,000 in a project which is expected to generate the following cash flows. Cash inflows ($) Year 1 Year 2 Year 3 Year 4 Year 5 7,800 6,000 4,200 7,400 9,200

Please note that all workings should be shown when performing NPV calculations. Even if you are using a sophisticated calculator to help you, you won't gain full marks unless your workings are clearly set out. Such calculators are really not that useful in this exam, and will not give you a competitive advantage. The advantages and disadvantages of IRR as a method of project appraisal are set out below: Advantages

it takes into account the time value of money, which is a good basis for decision-making results are expressed as a simple percentage, and are more easily understood than some other methods It indicates how sensitive decisions are to a change in interest rates.

Disadvantages

projects with unconventional cash flows can have either negative or multiple IRRs - this can be confusing to the user IRR can be confused with ARR or Return on Capital Employed since all methods give answers in percentage terms - hence, a cash-based method can be confused with a profit-based method it may give conflicting recommendations to NPV some managers are unfamiliar with the IRR method IRR cannot accommodate changes in interest rates over the life of a project it assumes funds are re-invested at a rate equivalent to the IRR itself, which may be unrealistically high.

PROFITABILITY INDEX (PI) The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project. More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students

PI =

PVCF Initial investment

In this method, a project with a PI greater than 1 is accepted, but a project is rejected when its PI is less than 1. Note that the PI method is closely related to the NPV approach. In fact, if the net present value of a project is positive, the PI will be greater than 1. On the other hand, if the net present value is negative, the project will have a PI of less than 1. The same conclusion is reached, therefore, whether the net present value or the PI is used. In other words, if the present value of cash flows exceeds the initial investment, there is a positive net present value and a PI greater than 1, indicating that the project is acceptable. PI is also known as a benefit/cash ratio.

POST-COMPLETION/ POST IMPLEMENTATION APPRAISAL


This is a review of all aspects of a completed project in order to assess whether its objectives were achieved or it has lived up to expectation. IMPORTANCE OF POST-IMPLEMENTAION REVIEW i. it enables speedy modification of under-performing or overperforming projects, by identifying the reasons for over/under performance it provides a means of improving control mechanisms by highlighting areas where weakness have caused problems. It highlights reasons for successful projects. It improves the quality of decision making by providing a mechanism whereby past experience can be made available for future decision makers. Thus it can produce lessons for decision making process and people will make better evaluation and significance of future projects It makes it more likely that bad projects are terminated/abandoned and at an earlier stage. It improves a companys performance. It allows changes to be made more swiftly in projects which are not doing well.

ii. iii. iv.

v. vi. vii.

QUESTION 1 MORE LTD has a choice of two investment projects. The estimated costs and returns are as follows: Project B Project A

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NOTES & EXERCISES ON Financial Management -For ICM Students Cost Year 1 Cash inflows Year 2 Cash inflows Year 3 Cash inflows Year 4 Cash inflows 215,000 44,000 96,000 90,000 70,000 154,000 (18,000) 115,000 76,000 57,500

Tasks: a) Calculate the payback period of project B (in years and months) b) The payback period of A is 2 years 9 months. Advice the management of MORE LTD which project is better investment. Give reasons for your answer. c) Using a discount factor of 15%, calculate the net present Value for project B. Extracts from NPV (DCF) tables: Rate of discount8% 9% 10% 15% Year 1 .926.917 .909 .870 Year 2 .857.842 .826 .756 Year 3 .794 .772 .751 .658 Year 4 .735 .708 .683 .572 d) Using the same discount rate of 15%, the Net Present Value of project A is (4,884) and at a discount rate of 10%, it has a positive value of 19,692. Calculate the Internal Rate of return (IRR) of project A. QUESTION 1:SOLUTION a) Payback period: Year 1 Cash inflow Year 2 Cash inflows Payback period PROJECT A 000 44,000 96,000 140,000 = 2years + (215,000 -140,000) X 12 months 90,000 = 2yr + 75,000 X 12 months 90,000 = 2yrs 9.99 months = 2yrs 10 months Explanation: At the end of year 2, 140,000 has been recouped/ earned; remaining 75,000 so that the full amount of 215,000 would be recouped (that is the amount used to invest in the project) This we will get from year 3 cash inflows which is equal to the cost of the project less the cash flow./ c) Year Cash flow (CF) DCF (15%) PV (DCF x CF)

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NOTES & EXERCISES ON Financial Management -For ICM Students 0 (154,000) 1 2 3 4 (18,000) 115,000 76,000 57,500 0.870 0.756 0.658 0.572 (15,660) 86,940 50,008 32,890 N (154,000) 1.000

PV 178 QUESTION 2 Marstep Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,500 Cash flows: Year 1 600 Year 2 1,000 Year 3 1,100 Year 4 700 Year 5 300 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly if you think that the project is viable. e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums. Solution: a) Pay back period b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) X100 Initial Investment Average annual profit = total annual profit No. of years = 600,000 + 1000,000 +1,100,000 +700,000 +300,000 = 3700,000 = 740,000

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NOTES & EXERCISES ON Financial Management -For ICM Students 5 years 5 years ARR = 740,000 X 100 2,500,000 =29.6% c) Year Year Year Year Year Year Year 0 1 2 3 4 5 Cash flow (CF) DCF (8%) PV (DCF x CF)

(2,500,000) 1.000 600,000 .857 1,000,000 .794 1,100,000 .735 700,000 .681 300,000 .630

(2,500,000) 550,200 857,000 873,400 514,500 204,300 NPV 499,400

QUESTION 2 You are working on the evaluation of a number of potential projects, one of which involves the opening of a training centre for your firms staff. It would cost 120,000 to renovate and refurbish a building ready for training purposes. Your company expects to save the following net cash costs on external training fees over the next five years at present day prices: Year 1 42,000 Year 2 53,000 Year 3 59,000 Year 4 61,000 Year 5 65,000 The firms cost of capital is 8%. Present Value Factors 8% Year 1 .926 Year 2 .857 Year 3 .794 Year 4 .735 Year 5 .681 Year 6 .630 TASKS a) Calculate the payback period. b) Calculate the Accounting Rate of Return. c) Calculate the net present value. d) Explain briefly whether, in your opinion, the firm should invest in the training centre project. e) Explain the importance of capital budgeting. SOLUTION: QUESTION 2 a) Payback period = 2 yrs + (120,000 95,000) X 12 months 59,000

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NOTES & EXERCISES ON Financial Management -For ICM Students = 2 yrs + 25,000 X 12 months 59,000 = 2yrs + 5.08 months Therefore the payback period of the project is 2years 5 months. b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) Initial investment Average Annual Profit after depreciation = 280,000 120,000 = 32,000 5years ARR = 32,000 X 100 120,000 = 26.67% Year Year Year Year Year Year Year 0 1 2 3 4 5 Cash flow (CF) DCF (8%) PV (DCF x CF)

(2,500,000) 1.000 600,000 .917 1,000,000 .857 1,100,000 .794 700,000 .735 300,000 .681

(2,500,000) 550,200 857,000 873,400 514,500 204,300 NPV 499,400

NET PRESENT VALUE QUESTION 3 SOB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,200,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .917 .909 2 .857 .841 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS

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NOTES & EXERCISES ON Financial Management -For ICM Students a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project d) State which project you would recommend (if any). e) Explain why it is important to use investment appraisal techniques, and to monitor actual results. QUESTION 4 REM Ltd is considering investing in a project, which has the following cash flows: 000 Initial investment 2,100 Cash flows: Year 1 700 Year 2 900 Year 3 1,100 Year 4 800 Year 5 400 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly whether you think that the project is viable. e) Explain why firms increasingly look at non-financial factors during the decision-making process. QUESTION 5 SOB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,200,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600

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NOTES & EXERCISES ON Financial Management -For ICM Students Year 5 400 400 The cost of capital to SOB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 1 .926 .917 .909 2 .857 .841 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project. d) State which project you would recommend (if any). e) Explain why it is important to use investment appraisal techniques, and to monitor actual results.

10%

QUESTION 6 DEC Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,300,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400 The cost of capital to FGT Ltd. is 10%. Extracts from NPV tables are as follows: Year 8% 10% 12% 1 .926 .909 .893 2 .857 .826 .797 3 .794 .751 .712 4 .735 .683 .636 5 .681 .621 .567 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project. d) State which project you would recommend (if any). e) Explain why it is important to monitor the actual performance of the investment choice throughout the lifetime of the project.

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NOTES & EXERCISES ON Financial Management -For ICM Students QUESTION 6: SOLUTION a) Payback period: PROJECT B 000 Cash inflows: year 1 800 year 2 1,100 1,900 Payback period = 2years + (2,300 1,700) X 12 months years+ (2,300 1,900) X 12months 1,000 1,300 = 2yr + 7.2 months 2yrs + 3.69 months = 2yrs 7months = 2yrs 4 months 2 PROJECT A 000 700 1,000 1,700

b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) X 100 Initial investment Average Annual Profit before depreciation 000 000 Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400 4,000

Note that, the total represents the cash inflows from the project. At the end of the 5years, the total depreciation charges will be equal to the initial cist of the project.

4,300

Average Annual Profit after depreciation =total profit total depreciation No. of years PROJECT A PROJECT B = 4,000,000 2,300,000 X100 4,300,000 2,300,000 X 100 5years 5years =

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NOTES & EXERCISES ON Financial Management -For ICM Students Average Annual Profit after depreciation =1,700,000 2,000,000 5 yrs 5yrs =340,000 400,000 Accounting Rate of Return (ARR) = 340,000 X 100 400,000 X 100 2,300,000 2,300,000 = 14.78% = 17.39% TRY QUESTIONS 1. ROB Ltd. has a limited capital budget available for investment in suitable projects this year and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,700,000 2,900,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows:000 000 Year 1 700 800 Year 2 1,100 1,200 Year 3 1,400 1,900 Year 4 700 1,000 Year 5 200 500 The cost of capital to ROB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .917 .909 2 .857 .842 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project. d) Explain which project you would recommend (if any).

2. (Cost accounting September 2005) HJB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,400,000 2,300,000 Expected life 5 years 4 years Residual value nil nil

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NOTES & EXERCISES ON Financial Management -For ICM Students Budgeted cash inflows: 000 Year 1 120 Year 2 900 Year 3 1,100 Year 4 800 Year 5 600 The cost of capital to HJB Ltd. is 9%. 000 700 1,400 1,600 500 -

a) b) b) c)

Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .909 .893 2 .857 .826 .793 3 .794 .751 .712 4 .735 .683 .567 5 .630 .621 .507 TASKS Calculate the payback period for EACH project. Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project.[8] State which project you would recommend (if any) Explain why it is important to use investment appraisal techniques.

Disadvantages

simple payback does not take into account the time value of money it ignores cash flows received after the end of the payback period it does not take into account the overall profitability of the project Net Present Value (NPV)

POST-COMPLETION/ POST IMPLEMENTATION APPRAISAL


This is a review of all aspects of a completed project in order to assess whether its objectives were achieved or it has lived up to expectation. IMPORTANCE OF POST-IMPLEMENTAION REVIEW
viii.

it enables speedy modification of under-performing or overperforming projects, by identifying the reasons for over/under performance it provides a means of improving control mechanisms by highlighting areas where weakness have caused problems. It highlights reasons for successful projects. It improves the quality of decision making by providing a mechanism whereby past experience can be made available for future decision makers. Thus it can produce lessons for decision

ix. x.
xi.

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NOTES & EXERCISES ON Financial Management -For ICM Students making process and people will make better evaluation and significance of future projects
xii.

It makes it more likely that bad projects are terminated/abandoned and at an earlier stage. It improves a companys performance. It allows changes to be made more swiftly in projects which are not doing well.

xiii. xiv.

QUESTION 1 MORE LTD has a choice of two investment projects. The estimated costs and returns are as follows: Project B Cost Year 1 Cash inflows Year 2 Cash inflows Year 3 Cash inflows Year 4 Cash inflows 215,000 44,000 96,000 90,000 70,000 154,000 (18,000) 115,000 76,000 57,500 Project A

Tasks: d) Calculate the payback period of project B (in years and months) e) The payback period of A is 2 years 9 months. Advice the management of MORE LTD which project is better investment. Give reasons for your answer. f) Using a discount factor of 15%, calculate the net present Value for project B. Extracts from NPV (DCF) tables: Rate of discount8% 9% 10% 15% Year 1 .926.917 .909 .870 Year 2 .857.842 .826 .756 Year 3 .794 .772 .751 .658 Year 4 .735 .708 .683 .572 d) Using the same discount rate of 15%, the Net Present Value of project A is (4,884) and at a discount rate of 10%, it has a positive value of 19,692. Calculate the Internal Rate of return (IRR) of project A. QUESTION 1:SOLUTION a) Payback period: Year 1 Cash inflow Year 2 Cash inflows PROJECT A 000 44,000 96,000 140,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Payback period = 2years + (215,000 -140,000) X 12 months 90,000 = 2yr + 75,000 X 12 months 90,000 = 2yrs 9.99 months = 2yrs 10 months Explanation: At the end of year 2, 140,000 has been recouped/ earned; remaining 75,000 so that the full amount of 215,000 would be recouped (that is the amount used to invest in the project) This we will get from year 3 cash inflows which is equal to the cost of the project less the cash flow./ c) Year Cash flow (CF) DCF (15%) PV (DCF x CF) 0 (154,000) 1 2 3 4 (18,000) 115,000 76,000 57,500 0.870 0.756 0.658 0.572 (15,660) 86,940 50,008 32,890 N (154,000) 1.000

PV 178 QUESTION 2 Marstep Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,500 Cash flows: Year 1 600 Year 2 1,000 Year 3 1,100 Year 4 700 Year 5 300 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return).

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NOTES & EXERCISES ON Financial Management -For ICM Students c) Calculate the NPV (net present value). d) Explain briefly if you think that the project is viable. e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums. Solution: a) Pay back period b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) X100 Initial Investment Average annual profit = total annual profit No. of years = 600,000 + 1000,000 +1,100,000 +700,000 +300,000 = 3700,000 = 740,000 5 years 5 years ARR = 740,000 X 100 2,500,000 =29.6% c) Year Year Year Year Year Year Year 0 1 2 3 4 5 Cash flow (CF) DCF (8%) PV (DCF x CF)

(2,500,000) 1.000 600,000 .857 1,000,000 .794 1,100,000 .735 700,000 .681 300,000 .630

(2,500,000) 550,200 857,000 873,400 514,500 204,300 NPV 499,400

QUESTION 2 You are working on the evaluation of a number of potential projects, one of which involves the opening of a training centre for your firms staff. It would cost 120,000 to renovate and refurbish a building ready for training purposes. Your company expects to save the following net cash costs on external training fees over the next five years at present day prices: Year 1 42,000 Year 2 53,000 Year 3 59,000 Year 4 61,000 Year 5 65,000 The firms cost of capital is 8%. Present Value Factors 8%

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NOTES & EXERCISES ON Financial Management -For ICM Students Year Year Year Year Year Year 1 2 3 4 5 6 .926 .857 .794 .735 .681 .630

TASKS a) Calculate the payback period. b) Calculate the Accounting Rate of Return. c) Calculate the net present value. d) Explain briefly whether, in your opinion, the firm should invest in the training centre project. e) Explain the importance of capital budgeting. SOLUTION: QUESTION 2 a) Payback period = 2 yrs + (120,000 95,000) X 12 months 59,000 = 2 yrs + 25,000 X 12 months 59,000 = 2yrs + 5.08 months Therefore the payback period of the project is 2years 5 months. b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) Initial investment Average Annual Profit after depreciation = 280,000 120,000 = 32,000 5years ARR = 32,000 X 100 120,000 = 26.67% Year Year Year Year Year Year Year 0 1 2 3 4 5 Cash flow (CF) DCF (8%) PV (DCF x CF)

(2,500,000) 1.000 600,000 .917 1,000,000 .857 1,100,000 .794 700,000 .735 300,000 .681

(2,500,000) 550,200 857,000 873,400 514,500 204,300 NPV 499,400

NET PRESENT VALUE QUESTION 3

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NOTES & EXERCISES ON Financial Management -For ICM Students SOB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,200,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .917 .909 2 .857 .841 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project d) State which project you would recommend (if any). e) Explain why it is important to use investment appraisal techniques, and to monitor actual results. QUESTION 4 REM Ltd is considering investing in a project, which has the following cash flows: 000 Initial investment 2,100 Cash flows: Year 1 700 Year 2 900 Year 3 1,100 Year 4 800 Year 5 400 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683

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NOTES & EXERCISES ON Financial Management -For ICM Students Year 5 Year 6 .681 .630 .650 .596 .621 .564

a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly whether you think that the project is viable. e) Explain why firms increasingly look at non-financial factors during the decision-making process. QUESTION 5 SOB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,200,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 200 300 Year 2 800 900 Year 3 1,400 1,500 Year 4 700 600 Year 5 400 400 The cost of capital to SOB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .917 .909 2 .857 .841 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project. d) State which project you would recommend (if any). e) Explain why it is important to use investment appraisal techniques, and to monitor actual results. QUESTION 6 DEC Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,300,000 2,300,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows: 000 000

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NOTES & EXERCISES ON Financial Management -For ICM Students Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400 The cost of capital to FGT Ltd. is 10%. Extracts from NPV tables are as follows: Year 8% 10% 12% 1 .926 .909 .893 2 .857 .826 .797 3 .794 .751 .712 4 .735 .683 .636 5 .681 .621 .567 TASKS a) Calculate the payback period for EACH project. b) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project. d) State which project you would recommend (if any). e) Explain why it is important to monitor the actual performance of the investment choice throughout the lifetime of the project. QUESTION 6: SOLUTION a) Payback period: PROJECT B 000 Cash inflows: year 1 800 year 2 1,100 1,900 Payback period = 2years + (2,300 1,700) X 12 months years+ (2,300 1,900) X 12months 1,000 1,300 = 2yr + 7.2 months 2yrs + 3.69 months = 2yrs 7months = 2yrs 4 months 2 PROJECT A 000 700 1,000 1,700

b) Accounting Rate of Return (ARR) = Average Annual Profit (after depreciation) X 100 Initial investment

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NOTES & EXERCISES ON Financial Management -For ICM Students Average Annual Profit before depreciation 000 000 Year 1 700 800 Year 2 1,000 1,100 Year 3 1,200 1,300 Year 4 800 700 Year 5 300 400 4,000

Note that, the total represents the cash inflows from the project. At the end of the 5years, the total depreciation charges will be equal to the initial cist of the project.

4,300

Average Annual Profit after depreciation =total profit total depreciation No. of years PROJECT A PROJECT B = 4,000,000 2,300,000 X100 4,300,000 2,300,000 X 100 5years 5years Average Annual Profit after depreciation =1,700,000 2,000,000 5 yrs 5yrs =340,000 400,000 Accounting Rate of Return (ARR) = 400,000 X 100 2,300,000 = 14.78% = 17.39% TRY QUESTIONS 1. ROB Ltd. has a limited capital budget available for investment in suitable projects this year and has short-listed two possible choices. Details are as follows: Project A Project B Capital cost 2,700,000 2,900,000 Expected life 5 years 5 years Residual value nil nil Budgeted cash inflows:000 000 Year 1 700 800 More Lecture Series by TIMORE B. F
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340,000 X 100 2,300,000

NOTES & EXERCISES ON Financial Management -For ICM Students Year 2 1,100 1,200 Year 3 1,400 1,900 Year 4 700 1,000 Year 5 200 500 The cost of capital to ROB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .917 .909 2 .857 .842 .826 3 .794 .772 .751 4 .735 .708 .683 5 .630 .650 .621 TASKS Calculate the payback period for EACH project. Calculate the accounting rate of return for EACH project. Calculate the NPV for EACH project. Explain which project you would recommend (if any).

a) b) c) d)

2. (Cost accounting September 2005) HJB Ltd. has a limited capital budget available for investment in suitable projects this year, and has short-listed two possible choices. Details are as follows: Project X Project Y Capital cost 2,400,000 2,300,000 Expected life 5 years 4 years Residual value nil nil Budgeted cash inflows: 000 000 Year 1 120 700 Year 2 900 1,400 Year 3 1,100 1,600 Year 4 800 500 Year 5 600 The cost of capital to HJB Ltd. is 9%. Extracts from NPV tables are as follows: Year 8% 9% 10% 1 .926 .909 .893 2 .857 .826 .793 3 .794 .751 .712 4 .735 .683 .567 5 .630 .621 .507 TASKS a) Calculate the payback period for EACH project.

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NOTES & EXERCISES ON Financial Management -For ICM Students b) b) c) Calculate the accounting rate of return for EACH project. c) Calculate the NPV for EACH project.[8] State which project you would recommend (if any) Explain why it is important to use investment appraisal techniques.

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CHAPTER FIVE BUDGETING


THE BASIC FRAMEWORK OF BUGDETING Budget defined: A budget is a detailed plan for acquiring and using financial and other resources over a specific period of time. A detailed and formal definition is given by CIMA as: A quantitative statement, for a defined period of time, which may include planned revenue, expenses, assets, liabilities and cash flows The act of preparing a budget is called budgeting. The use of budgets to control firms activities is known as budgetary control (to be discussed later in this chapter). Budgets has four main purposes (1) to co-ordinate the activities of the various departments in the organization to achieve a single goal; (2) to communicate the targets to the departmental managers; (3) to establish a system of control by comparing the budgeted and the actual results and (4) to compel planning. FUNTIONS/ OBJECTIVES OF BUDGETS Budgets serve a number of useful purposes which include the following 1) Planning annual operations 2) Co-ordinating the activities of the various of the organization and ensuring that all parts of the organization are in harmony with each other. 3) Communicating plans to the various responsibilities (departmental) center managers. 4) Motivating managers to strive to achieve the organizational goals 5) Controlling activities 6) Evaluating the performance of managers ADVANTAGES OF BUDGETING The advantage of budgeting stems from the functions budget plays in an organization. Among the benefits that companies realize from budgeting program are: 1. Budgets provide a means of communicating managements plans throughout the organization. 2. Budgets forces managers to think and plan for the future. 3. the budgeting process provides a means of allocating resources to those parts of the organization where they can be used more effectively 4. the budgets process can uncover potential bottlenecks before they occur 5. Budgets coordinate the activities of the entire organization by integrating the plans of the various parts. Budgets ensure that everyone in the organization is pulling in the same direction. 6. Budgets define goals and objectives that serve as benchmarks for evaluating performance.

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PROBLEMS IN BUDGETING Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms. 1. Budgets can be seen as pressure devices imposed by management, thus resulting in: a) Bad Labour relations b) Inaccurate record-keeping. Departmental conflict arises due to: a) Disputes over resource allocation b) Departments blaming each other if targets are not attained. It is difficult to reconcile personal/individual and corporate goals. Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with "empire building" in order to enhance the prestige of a department. Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs. 5. Managers may overestimate costs so that they will not be blamed in the future should they overspend.

2. 3. 4.

DEFINITION OF TERMS: BUDGET: A plan quantified in monetary terms, prepared and approved prior to a defined period of time, usually showing planned income to be generated and/or expenditure to be incurred during that period and the capital to be employed to attain a given objective. BUDGET PERIOD: The period for which a budget is prepared and used, which may then be subdivided into control periods over which controls takes place. BUDGETARY CONTROL: The establishment of budgets relating the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with actual budgeted results, either to secure by individual action, the objective of that policy or to provide a basis for its revision. FIXED BUDGET: A budget which is designed to remain constant (unchanged) irrespective of the volume of output or sales achieved FLEXIBLE BUDGET: A budget which, by recognizing the difference in cost behavior between fixed cost and variable costs in relation to fluctuations in output, turnover or other variable factors such as number of employees, is designed to change appropriately with such change or fluctuations. MASTER BUDGET: A budget which is prepared from, the functional budgets and summarizes the functional budgets. PRINCIPAL BUDGET FACTOR / LIMITING FACTOR: A factor which at any particular time, or over a period will limit the activities of an organisation and therefore taking into account in preparing the budgets. DIRECT EXPENSES: costs other than materials or labour which can be identified in a specific product or saleable service.

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NOTES & EXERCISES ON Financial Management -For ICM Students DIRECT LABOUR COST: The cost of remuneration for employees efforts and skills applied to a product or saleable service.

BUDGETARY CONTROL
DEFINITION: Budgetary control is a system of controlling costs through budgets. Budgeting is thus only a part of budgetary control. Budgetary control is one of the key tools for planning and control. It involves a constant comparison of actual performance with budgeted goals of the organization. ICMA (London) defined budgetary control as the establishment of budgets relating to the responsibilities or executives of a policy and the continuous comparison of the actual with the budgeted results either to secure by individual action, the objectives of the policy or by individual to provide a basis of its revision. The use of budgets in controlling operations is known as budgetary control. The centrepiece of budgetary control is the use of budget reports that compare actual results with planned objectives. The budget reports provide the feedback needed by management to see whether actual operations are on course. OBJECTIVES OF BUDGETRY CONTROL The objectives of budgetary control are as follows: (1) To Coordinate: Budgetary assists managers in coordinating the activities / efforts of the organization so that objectives of the organization in general will be in harmony with individual departmental objectives. Budgets thus help all departments to work in the same direction. For example the production budget is prepared in co-ordination with the sales budget. (2)To communicate: A budget is a communicating device. Usually, when a budget is approved, copies are distributed to all management personnel for them to understand what is expected of them and the policies to be followed to achieve the set targets before the budget is carried out. Thus budget communicates management plans to all people in an organization. (3) To Control: Control is the action which is required to ensure that plans and objectives are being achieved. Thus control is necessary to ensure that plans and objectives as laid down in the budget are being achieved. In budgeting, control is a systematic effort that aims at keeping management informed of whether the plans are being followed/ conformed to or whether they are not followed. (4) To Plan: A budget provides a detailed plan of action for a business over a definite period of time. Planning helps to anticipate many problems before they arise and the possible solutions can be sought to solve these problems. CHARACTERISTICS / FEATURES OF BUDGETRY CONTROL 1. Establishment of performance standards / budget for each department 2. Record the actual performance 3. Compare the actual performance with the budgeted performance. 4. Evaluate / calculate variances (differences) and analysis the reasons for the variances

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NOTES & EXERCISES ON Financial Management -For ICM Students 5. Take corrective/ suitable remedial actions to correct the variance immediately to achieve performance. ADVANTAGES /BENEFITS OF BUDGETARY CONTROL Benefits that may be obtained by the business that adopts budgetary control are as follows. 1) Budgetary control coordinates the activities of various departments and functions of the organization. Co-ordinated managerial activity is facilitated 2) Budgetary control aims at maximization of profit through careful planning and control. 3) It provides a yardstick against which actual results can be compared. 4) Budgetary control system creates the necessary condition for the introduction of standard costing techniques 5) Budgetary control creates cost consciousness and introduces an attitude of mind which waste and efficiency cannot thrive 6) The technique relates the overall objectives to specific managers and identifies the part each executive must play in converting the intentions of top management into reality. 7) Accountability for results is secured in financial terms on an organized basis through the medium of plans which have been expressed in terms of their profit impact on the company. 8) In the control situation, management is provided with information as a routine which would be difficult to obtain promptly without the budgetary control system. DISADVANTAGES/LIMITATIONS OF BUDGETARY CONTROL Budgetary controls have some drawbacks. Factors preventing the most effective budgetary control technique are as follows: 1) Rigidity: There is a danger that the budget program will be too rigid to accommodate changing conditions. A budget program must be dynamic and continuously change with the changing circumstances 2) High cost of installation: The installation and operation of budgetary control system is a costly and expensive as it may call for the employment of specialized staff and other expenditure. Due to the high cost, small businesses can not afford to adopt it. 3) Use of estimates: Budgets are based on estimates and forecast. The strength and weakness of a budgetary control therefore based on the accuracy of the forecast. 4) Staffs regard the technique as a pressure rather than a procedure to assist the executive to do a better job. 5) Because the technique is so closely identified with the management control process, executives imagine that the technique can replace management. There is no substitute for good management. 6) The required degree of management co-operation may not be obtained and top management support may be inadequate
BUDGET ORGANIZATION AND ADMINISTRATION:

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In organizing and administering a budget system the following characteristics may apply:

a) Budget centre

Units responsible for the preparation of budgets. A budget centre may encompass several cost canters. b) Budget committee: This may consist of senior members of the organization, e.g. departmental heads and executives (with the managing director as chairman). Every part of the organization should be represented on the committee, so there should be a representative from sales, production, marketing and so on

FUNCTIONS OF THE BUDGET COMMITTEE Functions of the budget committee include:

a) to provide historical data to all departmental heads to help them in estimation b) issue instructions to departments regarding requires, dates of submission of estimates etc c) To defined the general policies of the management in relation to the budget. d) To record budget estimates from variances departments for consideration and review. e) To discuss difficulties with departmental heads and suggest possible revision.
f) g) h) i) Coordination of the preparation of budgets, including the issue of a manual Issuing of timetables for preparation of budgets Provision of information to assist budget preparations Comparison of actual results with budget and investigation of variances.

c) BUDGET OFFICER: Controls the budget administration. The job involves: i. ii. iii. iv. liaising between the budget committee and managers responsible for budget preparation dealing with budgetary control problems ensuring that deadlines are met Educating people about budgetary control.

d) Budget manual: i. ii. iii. iv. details the budget procedures contains account codes for items of expenditure and revenue timetables the process Clearly defines the responsibility of persons involved in the budgeting system.

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TYPES OF BUDGETS There are several ways in which budgets can be classified. One way is to classify them into the different purposes they serve. Budgets can be classified by 1) The coverage the encompass a) Functional budgets b) Master budgets 2) The capacity to which they are related a) Fixed budget b) Flexible budget 3) The condition on which they are based a) Basic budget b) Current Budget 4) The period with which they cover a) Long-term budget b) Short-term budgets TYPE OF BUDGEGET

COVERAGE

CAPACITY

CONDITION

PERIOD

Functional master term short-term Budget budget budget budget

fixed budget

flexible budget

basic budget

current budget

long-

FUNTIONAL BUDGET: A functional budget is a budget which relates to any of the functions of an organization. They are subsidiary to the master budget. The most frequently used functional budgets are: a. Sales budget b. Production budget (which comprise Raw material budget, Labour budget, overheads etc.) c. Purchase budget d. Plant utilization budget e. Capital expenditure budget f. Administrative cost budget g. Selling and distribution cost budget h. Cash budget etc. MASTER BUDGET: It is defined by the Institute of Cost and Management Accountants as the summary budget, incorporating its components functional budgets and which is faintly approved, adopted and employed

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NOTES & EXERCISES ON Financial Management -For ICM Students The master budget is a collection of the individual budgets that encompasses the planed operating and financial activities throughout the firm. It is a summary of a companys plans that sets specific targets for sales, production, distribution and financing activities. It generally culminates in a cash budget, a budgeted income statement (profit and loss) and a budgeted balance sheet. This budget summarizes the various functional budgets to produce a Budgeted Profit and Loss Account at the end of the budget period. The master budget is prepared by the budget committee on the basis of coordinated functional budgets and becomes the basis for the target of the company during the budget period when the committee finally approves it. In short, it represents a comprehensive expression of managements plans for the future and how these plans are to be accomplished. MASTER BUDGET INTERRELATIONSHIPS

FIXED BUDGET: It is defined as a budget which is designed to remain unchanged irrespective of the volume of activity or turnover attained. It is a budget prepared for a given level of activity. It is a single budget with no analysis of cost. It does not take into consideration any change in expenditure arising out of changes in the level/ volume of activity. The major purpose of fixed budget is at the planning stage when it serves to define the broad objectives of the organization. FLEXIBLE BUDGET: It is defined as A budget which, by recognising different cost behaviour patterns, is designed to change as the volume of activity changes

THE BUDGETING PROCESS

The stages in the budgetary process can be summarized into three:


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. Identify the limiting factor/principal budget factor: The limiting factor or principal budget factor is the factor which limits the activities of an organization. 2. Prepare the functional budgets. The functional budget may include the following i. The sales budget ii. The production budget iii. The direct material usage budget iv. Direct material purchase budget v. Direct Labour cost budget vi. Overheads cost budget vii. Selling and administrative cost budget viii. Capital expenditure budget ix. The cash budget x. PREPARING THE BUDGETS
1. STAGES INVOLVED IN THE PREPARATION OF FUNCTIONAL BUDGETS 1. THE SALES BUDGET: The sales budget is the starting point in the preparation of the functional budgets. The sales budget is prepared in units of production and sales value. The finished goods stock budget can be prepared at the same time. The finished goods stock budget shows the planned increase or decrease in stock levels. 2. THE PRODUCTION BUDGET: With the information from the sales and stock budget, the production budget can be prepared. This is simply the sales budget (plus or minus increase or decrease in the stock levels). The production budget is stated in terms of production units. It lists the number of units that must be produced to meet the sales budget.

THE SALES BUDGET


A sales budget is a detailed schedule which shows the expected sales for the budget period. The sales budget is expressed / prepared in units of production and sales value. It is therefore the bases of all the other budgets. Example 1 MORE LTD produces two products: P.K and Tom-tom. The forecasted sales of the two products for the second quarter will be 15,000 units of P.K and 22,500 units of Tom-tom. The marketing manager has estimated the selling price of P.K to be 45 and the selling price of Tom-tom to be 37.5 Required: Prepare the sales budget.

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Suggested Answer: example 1 MORE LTD: Sales Budget Products P.K TOMTOM Selling price 45 37.5 Sales (units) 15,000 22,500 Sales budget 675,000 1,518,750 Workings: P.K (15000 units X 45) = 675,000 Tom-tom (22,500 X 37.5) =843,750

TOTAL 843,750

Example 2 More Co. Ltd has two core products, A and B. The next years forecasts for the products are estimated to be: A (21,000 units at a selling price of 300) B (19,000 units at a selling price of 310) Required: Prepare the sales budget Solution: example 2 Products Sales (units) Selling price Sales budget 12,190,000 A 21,000 300 6,300,000 B Total 19,000 310 5,890,000

EXAMPLE 3: FORDHAM INSTITUTE produces to products, Books and Pens. Sales for the year 2008 are budget to be as follows: Books: 12000 copies @ 300 Pens : 9000 boxes @ 360 Required: Prepare the sales budget for the year 2008. Solution: example 3 Products: sales (units) selling price Total sales () Books 12,000 300 3,600,000 Pens 6,000 360 2,160,000 5,760,000 TRY QUESTION

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NOTES & EXERCISES ON Financial Management -For ICM Students MORE LTD produces three kinds of medicines which are sold in the government hospitals. The estimated sales for the next 3 months are as follows: Medicine APC PARA B.CO Sales (In packets) 1000 1,200 1,500 Selling price 110 80 100 Required: prepare the sales budget for the three months period.

THE PRODUCTION BUDGET:


This is simply the sales budget (plus or minus increase or decrease in the stock levels). The production budget is stated in terms of production units/quantities. It lists the number of units that must be produced to meet the sales budget. It is prepared as follows: Budgeted sales (units) XXX Add: Expected closing stock of finished goods XXX XXX Less: closing stock of finished goods XXX Budgeted production XXX NB: The production budget changes from the sales budget when there is opening or closing stock. Budgeted production = budgeted sales (units) opening stock + closing stock

EXAMPLE 4 MORE Systems Ltd produces and sells computers. Next years budgeted sales are estimated to be as follows: Computers Budgeted sales (quantities) Laptops 9,500 Desktop 14,250

At the beginning of the year, the following quantities were in stock- Laptop 950 unites and desktop 4750 units. It is planed that, the stock level of Laptops should be increased by 10% and decrease the stock level of Desktop by 50%. Required: Prepare the production budget for MORE Systems LTD Solution: Production Budget Products Budgeted sales (units) Add: expected closing stock: Laptops (110% x 950) Desktop (4750 x 50%) Less: Opening stock Laptop 9,500 1,045 (950) 2,375 (4,750) Desktop 14,250

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NOTES & EXERCISES ON Financial Management -For ICM Students Budgeted production 11,875 9,595

Tutorial: i. Closing stock- the stock levels at the beginning of the year were, Laptops- 950 and Desktops 4750 units. The stock level of Laptops is to be increased by 10% (10% x 950 = 95 unites). Therefore total closing stock level for Laptop= 95 +950= 1,045 units. This can be calculated as 110% x 950 = 1,045 ii. Desktop stock level is to be decreased/ reduced by 50% (4750x 50%) = 2,375. Closing stock level will be 4750-2375 = 2375 EXAMPLE 5: FORDHAM INSTITUTE produces to products, Books and Pens. Sales for the year 2008 are budget to be as follows: Books: 12000 copies @ 300 Pens : 9000 boxes @ 360. The company plans to keep the following as closing stock at the end of 2008. Books 4,000 copies Pens 3,000 boxes Opening stocks in the warehouse were: books 2,000 copies and Pens 1,600 boxes. Required: prepare the production budget for the year 2008. Solution: example 5 Required: Prepare the sales budget for the year 2008. Solution: Example 5 Production Budget Products Books Budgeted sales (units) 12,000 9,000 Add: closing stock 4,000 3,000 Less: Opening stock (2,000) (1,600) Budgeted production 14,000 10,400

Pens

DIRECT MATERIAL USAGE BUDGET This budget shows the direct materials that must be purchased in order to meet production requirement (i.e. the production budget) and sometimes to meet closing stock requirement. It is calculated as follows: Raw materials to meet production schedule Add: expected closing stock of raw materials Raw materials needed Less opening stock of raw materials Raw materials to be purchased XXX XXX XXX XXX XXX

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MATERIAL PURCHASE BUDGET Example 1 Young Manufacturing Company Ltd manufactures two products, Milo and Chocolate which uses the same raw materials cocoa and sugar. One unit tin of Milo uses 3kg of cocoa and 4kgs of sugar. One tin of chocolate uses 5kg of cocoa and 2kg of sugar. A kg of cocoa is expected to cost 3.00 and a kg of sugar will cost 7.00 per kg. Budgeted sales for 2008 were 8,000 tins of Milo and 6,000 tins of Chocolate. Finished goods in stock at 1st January 2008 are; 1,500 tins of Milo and 300 tins of chocolate. The company has decided to have a closing stock of 600 tins of each product at the end of the year. The stocks of raw materials are; 6,000 kg of cocoa and 2,800kg of sugar as at 1st January 2008. Again the company plans to hold 5,000kg of cocoa and 3,500kg of sugar at the end of the year. The warehouse and stores manager has suggested that a provision of should be made for damages and deterioration of items in the store as follows: Product: Milo Chocolate Material: Cocoa Sugar loss loss loss loss of of of of 50 tins 100 tins 500kg 200kg

TASK: You are required to prepare the material purchase budget for the year 2008.

COMPREHENSIVE QUESTION MORE INVESTMENT LTD manufactures one product called NOKIA N95. The following information relates to the preparation of the budget for the year ended January 2009. 1) Sales budget for the NOKIA N 95 are: Expected sales (units): 10,000 Selling price 100. All sales are made on credit basis 2) To manufacture one NOKIA N95 requires 5 units of material E and 10 units of material C. The cost of material E is expected to be 3.00 per unit, and the cost of material C is expected to be 4.00 per unit. 3) Two departments are involved in producing NOKIA N95: Machining and Assembling. The following information is relevant:

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Direct labor per Labour rate Unit of product hour Machining Assembling 1.00 0.50 (hours)

Direct per 6 8

4) The finished production overhead costs are expected to amount to 100,000. 5) At 1st April 2008, 800 units of NOKIA N95 are expected to be in stock at a value of 52,000, 4500 units of raw material E at a value of 13,500, and 12000 units of raw materials are planed to be 10% above the expected opening stock levels as at 1st April 2008. 6) Administration, selling and distribution overhead is expected to amount to 150,000. 7) Other relevant information include the following: a. Opening trade debtors are expected to be 80,000. Closing trade debtors are expected to amount to 15% of the total sales for the year. b. Opening trade creditors are expected to be 28,000. Closing trade creditors are expected to amount to 10% of the purchases for the year. c. All other expenses will be paid in cash during the year. d. Other balances at 1st April 2008 are expected to be as follows: i. ii. iii. iv. v. Share capital: ordinary shares 255,000 Retained profits Proposed dividend Fixed assets at cost Less Accumulated depreciation Cash at bank and in hand 17,500 75,000 250,000 100,000 150,000 2,000

8) Capital expenditure will amount to 50,000 payable in cash on 1 April 2008. 9) Fixed assets are depreciated on a straight-line basis at a rate of 20% per annum on cost.

Required: Prepare the annual budget for More Investment Ltd for the year to 31 January 2009.

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SOLUTION To make it easier for you to understand what is happening, the procedure will be out lined step by step. Step 1: prepare the sales budget SALES BUDGET Sales (Units) Selling price per unit (100) Sales () 10,000 1,000,000

Step 2: prepare the production budget PRODUCTION BUDGET Sales budget (units) Less : opening stock

10,000 800

9,200 Add: desired closing stock (opening stock+10%)* 880 Production required 10,080 *Desires closing stock= 800x 10% = 88 plus opening stock (800) =880 Step 3: prepare the direct material usage budget Direct material: E: 5units X 10,080 C: 10units X 10,080 50,400units 100,800units

Step 4: prepare the direct materials purchases budget Direct materials E (units) (units) Usage (as per step 3) 100,800 Less: opening stock 12,000 C

50,400 4,500 45,900

88,800 Add:desired closing stock (opening stock + 10%) 13,200 50,850 102,000

4,950

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NOTES & EXERCISES ON Financial Management -For ICM Students QUESTION: MORE COMPUTERS manufactures two products: Keyboard and Mouse. The 2009 annual budget is about to be prepared and the following information has been gathered PRODUCT Demand/sales Selling price Opening stock (finished goods) Required closing stock Material: A (Kg/unit) B (Kg/unit) Expected closing stock of material Opening stock of material Direct labour hours required per unit 6hours KEYBOARD 600 60 500 1200 4kg 8kg 200 600 4hours 400 6kg 12kg 600 500 MOUSE 1000 80 1400

Other information received from the accounts departments shows the following estimates. Material A is expected to cost 3.00 per Kg and material B is expected to cost 4.00 per kg.

SOLUTION: SALES BUDGET PRODUCTS Sales (Units) Total Revenue Keyboard 6,000 60 Mouse 10,000 Budgeted sales Selling price per unit 360,000 80 800,000 1,160,000 Mouse 10,000 400 10,400 1,400 9,000 B (kg) (9,000 X 6kg

PRODUCTION BUDGET Keyboard Budgeted sales 6,000 Add expected closing stock 1,200 7,200 Less Opening stock 500 Budgeted production 6,700 MATERIAL USAGE BUDGET MATERIAL A (kg) Keyboard: (6,700X 4kg per unit) 26,800 per unit) 54,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Mouse: (6,700X8kg per unit) unit) 108,000 Materials to meet production 162,000 Add expected closing stock 600 162,600 Less opening stock 500 Material usage 162,100 53,600 80,400 200 80,600 600 80,000 (9,000 X 12kg per

MATERIAL PURCHASE BUDGET

EXAMPLE 3: (MASTER BUDGET) The following information relates to the accounts of AMBA ltd as at January 2008. Total fixed asset (at cost) Less accumulated depreciation 30,720 97,280 Current assets: Stocks Debtors Current Liabilities: Bank overdraft Proposed dividends 62,720 Long term loan (15%) Net assets CAPITAL AND RESERVES: Ordinary shares Retained profit 128,000

38,720 40,000 78,720 1,600 14,400 (16,000) 160,000 64,000 96,000 64,000 32,000 96,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Additional information: c) The companys sales, purchases and expenses are estimated to be as follows: January march Sales 480,000 Purchases 448,000 Total expenses 48,000 240,000 160,000 32,000 320,000 240,000 40,000 February

d) All sales are made on credit. Past experience shows that, 80% of sales made in a particular month are paid in the same month. A discount of 4% is given for payment within this period. The remaining 20% is paid in subsequent month e) Purchases are paid for in the month of purchase in order to take advantage of a 10% discount on the total purchases in the month f) There are no changes in the stock levels for the period g) Machinery is depreciated at 12% per annum. This is included in the total expenses. It is the companys policy to charge depreciation on one-month ownership. h) Expenses are paid for in the month in which they are incurred. i) The 15% loan interest will be paid in march 2008 j) Proposed dividends will be paid in January 2008 REQUIRED: a) Prepare the cash budget for the three month January to march 2008 b) Prepare the budgeted profit and loss account for the period c) Prepare the budgeted balance sheet SOLUTION AMBA LTD CASH BUDGET FOR THE PERIOD JANUARY MARCH 2008 JAN. FEB Balance b/d (14,400) 33,600 72,640 RECEIPTS Debtors: (Current months sales)-80% 192,000 384,000 (4% discount) (7,680) (15,360) Previous months sales 40,000 64,000 209,920 505,280

MAR

256,000 (10,240) 48,000 327,360

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NOTES & EXERCISES ON Financial Management -For ICM Students PAYMENTS Purchases 448,000 Discount received (10%) (44,800) Expenses (less depreciation) 46,720 Dividend Loan interest 2,400 410,272 Balance c/d 95,000

160,000 (16,000 30,720 1,600 176,320 33,600 )

240,000 (24,000) 38,720

254,720 72,640

AMBA LTD PROFIT AND LOSS ACOOUNT FOR THE PERIOD ENDED 31ST MARCH 2008 Sales 1,040,000 Less cost of sales: Opening stock 38,720 Purchases 848,000 Goods available for sale 886,720 Less closing stock (38,720) (848,720) Gross profit 192,000 Add discount received 84,000 276,800 Expenses (including depreciation) 120,000 Interest on loan 2,400 Discount allowed 33,280 (155,680) Net profit 121,120 AMBA LTD BUDGETED BALANCE SHEET AS AT 31ST MARCH 2008

CASH BUDGET
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of the business at defined intervals.

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NOTES & EXERCISES ON Financial Management -For ICM Students It is a detailed plan that shows how cash resources will be acquired and used over a specific period of time. OBJECTIVES OF CASH BUDGET The objectives of a cash budget include the following. i. To anticipate cash shortages or surpluses and how plans should be made to invest the surplus or go for overdraft. ADVANTAGES /USEFULNESS OF CASH BUDGET The cash budget has the following benefits i. It shows the cash effect of all plans made within the budgetary process and hence its preparation leads to the medication of the annual budgets. ii. It also gives management an indication of potential problems that could arise and allows them the opportunity to take action to avoid problems iii. Also, it may be used in planning your short-term credit needs. iv. The cash budget determines your future ability to pay debts as well as expenses. v. Banks and other credit-granting institutions are more inclined to grant you loans under favourable terms if your loan request is supported by a methodical cash plan. vi. Also, a monthly cash budget helps pinpoint estimated cash balances at the end of each month which may foresee short-term cash shortfalls. FORMAT OF CASH BUDGET MORE LTD CASH BUDGET FOR THE PERIOD JANUARY JUNE 2008 JAN MAY BAL b/d XXX RECEIPTS DEBTORS XX XX INVESTMENT INCOME XX XX SALE OF ASSETS XX XX GOVERNMENT GRANT XX XX CAPITA INTRODUCED XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX JUNE XXX XXX XXX XXX XXX FEB MARCH APRIL

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NOTES & EXERCISES ON Financial Management -For ICM Students OTHER ICOMES XX XX TOTAL RECEIPTS XX XX PAYMENTS CREDITORS XX XX WAGES/SALARY XX XX PURCHASE OF ASSET ----EXPENSES XX XX OTHER EXPENSES XX XX TOTAL PAYMENTS XX XX XX XX XX XX XX XX XX XX

XX XX XX XX --XX XX XX XX XX XX

XX XX XX XX XX XX

XX XX -XX XX XX

EXAMPLES 1: CASH BUDGET The following is the forecast data of a company for the first three months of its budget cycle: APRIL MAY JUNE JULY Sales 120,000 140,000 180,000 160,000 Purchases 70,000 110,000 100,000 90,000 Overheads 24,000 24,000 26,000 26,000 Wages 20,000 21,000 21,000 22,000 Other Information: 50% of sales are on a cash basis, and 50% are on a credit basis. Debtors are given one months credit. Suppliers give one months credit. Overheads are paid one month in arrears. Overheads include 4,000 in respect of the depreciation of fixed assets. Wages are paid in the month in which they are incurred. New equipment costing 80,000 will be paid for in May. The sale of old equipment will bring income of 5,000 in June. A Government grant of 10,000 is due in June. The bank balance is predicted to be 18,000 on 1 May 2007. TASKS a) Prepare a receipts schedule for the period MayJuly 2007. b) Prepare a payments schedule for the period MayJuly 2007. c) Prepare a cash budget for the period MayJuly 2007. d) Outline the benefits of maintaining a budgetary control system.

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SOLUTION: EXAMPLE 1 a) RECEIPTS SCHEDULE FOR THE PERIOD MAY JULY 2007 May 70,000 60,000 ----130,000 June 90,000 70,000 5,000 10,000 175,000 July 80,000 90,000 ---------170,000

Debtors: 50% cash 50% credit Sale of equipment Government Grant Total receipts

b) PAYMENT SCHEDULE FOR THE PERIOD MAY JULY 2007 May June Purchases 70,000 100,000 Wages 21,000 20,000 Overheads 20,000 20,000 Equipment 80,000 --Total payments 191,000 144,000 c) CASH BUDGET FOR THE PERIOD MAY JULY 2007 MAY JUNE Balance b/d 18,000 (19,000) Receipts: Debtors 130,000 170,000 Government Grant 10,000 Sale of equipment 5,000 148,000 151,000 Payments: Purchases Wages Overheads Purchase of equipment Total payments 144,000 70,000 21,000 20,000 80,000 110,000 21,000 20,000 --191,000

July 110,000 22,000 22,000 -151,000

JULY (43,000) 160,000 --132,000

100,000 22,000 22,000 ---151,000

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NOTES & EXERCISES ON Financial Management -For ICM Students EXAMPLE 2 The following information relates to a proposed business partnership, for the six months ending 31Decmber 2003: a. Sales (in units at 60 per unit) July Aug Sept Oct Nov Dec Units 250 425 580 560 770 850 b. All sales will be on credit and debtor will be given two months credit. c. Production July Aug Sept Oct Nov Dec Unit 600 450 600 750 750 900 d. Materials have been costed at 31 per unit, suppliers give on e months credit. e. Direct labour will cost 8 per unit, payable during the month of production. f. The partners will rent a small unit at an annual rent of 6000. However, they have negotiated an initial rent free period of three months. Subsequent payments are to be made quarterly in advance. g. Office salaries will cost 350 per month for the first four months and then an office junior will be employed from 1 November at an annual salary of 3000. h. Other fixed costs are anticipated to be at the rate of 425 per month, and variable cost at the rate of 6 per unit, payable during the month of production. i. A partner (J Raul) has purchased 6000 of equipment personally already, and wishes to be reimbursed in full equally over the three months of production. j. Additional equipment will be purchased on 1 October at a cost of 2000. k. The other partner (Mrs Smith) will introduce 9000 in cash on 1 July and Mr Raul will contribute 5000 on 1 July. l. The partners will cash draw 800 per month from the business, with Mrs Smith withdrawing an additional 1,200 in December. TASKS: Prepare a cash budget for the six month ending 31 December 2003, clearly showing the net cash flow of funds per month, and cash balance at the end of each month. SOLUTION: EXAMPLE 2
CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008 JULY AUG SEPT. OCT. NOV. DEC. Balance b/d 5625 (20,150) (28,975) (31,650) (35,375) RECEIPTS Debtors 34,800 Capital ------33,600 14,000 -----------15,000 ----25,000 -----

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14,000 5,625 (5,150) (3,475) (3,150) (1,775) PAYMENTS Direct material --18,600 13,950 18,600 23,250 23,250 Direct labour 4,800 3,600 4,800 6,000 6,000 7,200 Rent ----1,500 ----1,500 Office salaries 350 350 350 350 1,750 1,750 Fixed costs 425 425 425 425 425 425 Equipment (re-imburse) 2,000 2,000 2,000 ----------Equipment-purchase ----------2,000 -------Drawings 800 800 800 800 800 2,000 8,375 25,775 23,825 28,175 32,225 36,125 Balance c/d 5,625 (20,150) (28,975) (31,650) (35,375) (37,900)

WORKINGS: JULY SALES(UNITS) 770 850 SELLING PRICE (60) SALES () 46,200 51,000 SALES AUG 250 15,000 SEPT. 425 25,500 OCT. 580 NOV. 560 33,600 DEC

34,800

PRODUCTION COST JULY AUG SEPT. OCT. Production (UNITS) 600 450 600 750 900 Material (31/unit) 18,600 13,950 23,250 27,900 Direct labour (8/unit) 4,800 3,600 6,000 7,200 Variable cost (6/unit) 3,600 2,700 4,500 5,400 NOV. 18,600 4,800 3,600 DEC 23,250 6,000 4,500

750

Tutorial i. ii. Debtors: sales are made on credit. Customers are allowed two months credit. Therefore sales in July will be received in September (two months after sales). Raw materials: The suppliers of the raw material for production give one month credit. This means purchase of raw material in July will actually be paid in August and purchases for August paid in September in that order.

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EXAMPLE 3:
You are given the information below by your Director for the period November 2007 to June 2009 Sales capital expenditure November 2007 ----December 2007 --January 2008 60,000 February 2008 ---March 2008 --April 2008 80,000 May 2008 --June 2008 ---160,000 purchases wages overheads dividends

80,000

20,000

20,000

---

200,000

120,000

24,000

20,000

40,000

220,000

160,000

32,000

30,000

---

260,000

180,000

40,000

30,000

---

280,000

210,000

48,000

30,000

---

300,000

260,000

56,000

40,000

----

320,000

280,000

64,000

40,000

---

360,000

300,000

72,000

40,000

80,000

Additional information:

1. Sales are 40% cash and 60% credit. All credit sales are paid in two months after the
month of sales 2. suppliers are paid the month following purchase 3. Wages: 75% of wages are paid in the month they are incurred. The remaining 25% is paid in the following month. 4. Overheads are paid in the month after they are incurred.

EXAMPLE 4 As the accountant of SUANAD enterprise, you are preparing the budget for the three months ending June 30 2008. You are given the following data d) Sales are projected to be 2008

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January February March April May June July 31,500 24,000 30,000 39,000 36,000 42,000 45,000

e) All sales are on credit and on avereage 80% of the sales results in the customer paying in the month of sales, taking a 5% setlement discount, 10% pay in the month following the sale and 8% in the second month following the sale. 2% prove uncollectable. f) Goods are purchesed on anticipation os sales in the months preceeding the sales. Sales are invoiced at cost plus 20% g) Suppliers are paid two months after receiveing the goods. h) Overheads are 7,500 per month and are paid as incurred. i) The overdraft as at march 30 2008 will be 4,650 REQUIRED: you are required to prepare:

EXAMPLE 5: FANMILK Ltd supplies Ice cream in Ghana. The following forecast were made for a quqter of a year ending September 2008.

JUNE CASH SALES 240,000 CREDIT SALES 560,000 CREDIT PURCHASES 304,000 SELLING EXPENSES 44,000 184,000

JULY

AUGUST 212,000 520,000 360,000 38,000

SEPT. 220,000 530,000 280,000 42,000

480,000 240,000 34,000

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ADM. EXP. 36,000 DEPRECIATION 30,000 CAPITAL EXPENDICTURE 24,000 30,000 32,000 30,000 90,000 30,000 30,000 -

NOTES:

1. 40% of credit sales are collected the month of sales. The balance of 60% is collected in the month following sales. 2. 50%of credit purchases are paid for in the month of purchase and the rest paid in the next month. 3. The opening balance was in overdraft of 200,000. 4. All other expenses are paid for in the month they are incurred except capital expenditure which is spread over six months starting from the month it is incurred.
YOU are required to prepare the cash budget for the quarter ending 30 September 2008. SOLUTION:
CAHS BUDGET FOR THE SIX MONTH ENDING 31 DECEMBER 2008 JULY AUG SEPT. Balance b/d (200,000) 138,000 475,000 RECEIPTS Debtors Cash sales 496,000 212,000 508,000 524,000 542,000 220,000 240,000 882,000 1,257,000

PAYMENTS Creditors Selling expenses Administrative expenses Capital expenditure

300,000 38,000 32,000 --370,000

320,000 42,000 30,000 15,000 407,000

292,000 44,000 36,000 15,000 387,000

Bal c/d

138,000

475,000

870,000

WORKINGS: DEBTORS SCHEDULE JULY June sales (60% X 480,000) AUG 288,000 SEPT

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July sales (40% X 520,000) (60% X 520,000) August (40% X 530,000) (60% X 530,000) September sales (40% X 560,000) --------496,000 -------524,000 208,000 312,000 212,000 318,000 224,000 ----------524,000

CREDITORS SCHEDULE JULY June Purchase (50% X 240,000) AUG 120,000 SEPT

July purchase (50% X 360,000) 180,000 (50% X 360,000) August purchase (50% X 280,000) (50% X 280,000) September purchase (50% X 304,000) --------300,000 -------320,000 180,000 140,000 140,000 152,000 ----------292,000

Note: depreciation is non-cash flow item hence not treated in the cash budget.

QUESTION 2: The managing director of MORE LTD, has asked you to prepare his cash budget for the coming period. He provide you with the following information to enable you do the job for him i. EXAMPLE 3 (JUNE 2006) Q 6 Mirzer Ltd. intends to commence business on 1 July 2006 with share capital of 180,000. On 1 July 2006 Mirzer Ltd. will also receive

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NOTES & EXERCISES ON Financial Management -For ICM Students 30,000 in various grants from government and EU sources.Other Information: Mirzer Ltd. will spend 90,000 on fixed assets on 1 July 2006. The following are the costs per unit: Direct material 8 Direct wages 6 Variable overhead 4 18 The selling price will be 25 per unit. Mirzer Ltd. have agreed to pay rent of 40,000 per year payable quarterly in advance. Other fixed overheads are estimated to be 14,000 per month payable in arrears. Budgeted production will be 10,000 units per month for the first three months, increasing to 12,000 units per month thereafter. Budgeted sales are estimated to be 9,000 units per month for the first three months, increasing to 12,000 per month thereafter. All sales are to be on credit. Mirzer Ltd. will allow one months credit. The suppliers of direct material will allow one months credit. Direct wages costs will be paid in the month of production. Variable overheads will be paid for in the month following production. TASKS a) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31 December 2006, clearly showing the budgeted cash balance at the end of each month. b) c) Ltd. Comment on the budgeted cash flow position of Mirzer Ltd. Outline the potential sources of short-term finance available to Mirzer

QUESTION 4: Mr. Timore has just decided to enter into the production and sale of A4 Rimes starting on 1st July 2008. He has a personal savings amounting to 15,000 of which he wants to start the business with. This amount will be paid into the companies account non 1st July 2008. The forecasted cash flow for the first six (6) month is as follows:

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1) Production: He plans to produce 1,500 Rims per month for the first 6 months for the printing industry. 2) Sales: The selling price of each Rim will be 37.5. The sales for the six month will be as follows: July August September October November December 1200 1440 1440 1680 1920 1200 3) Variable overheads: Variable Overheads per Rim (based on output) will be 4.5. This will be payable in the month of production. 4) Fixed cost: A fixed cost of 3,000 will be incurred per month, payable after the month of production. 5) Wages: Wages of production staff will be 9 per Rim, payable in the month of production. 6) Salaries: Salaries of 1,500 per month will be paid until October when salaries are expected to increase by 10% for the rest of the months. 7) 24,000 will be used to purchase a new plant in September. The seller of the plant has agreed to accept a deposit of 25% and the balance paid in equal installment in October and November. 8) Raw materials: cost per Rim of raw material will be 6. The supplier of the material will allow one month credit period. 9) Debtors: Sales are basically on credit. Debtors are expected to pay in one month following their purchases. You are required to prepare the cash budget for the six month period ending 31st December 2008 SOLUTION: CASH BUDGET FOR 6 MONTH ENDING 31 DECEMBER 2008 Jul. Aug. Sept. Nov. Dec. Bal. b/d Receipts Capital 15,000 Debtors 45,000 54,000 72,000 45,000 Total receipts 15,000 Payments Overhead (4.5X1500) 6,750 6,750 wages TRY QUESTIONS 6,750 6,750 6,750

Oct.

63,000

6,750

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NOTES & EXERCISES ON Financial Management -For ICM Students 1. Bonedage is to open a retail clothes store on 1 June 2007. He will put in 130,000 in the bank as capital. His plans are as follows: On 1 June to buy and pay for premises 75,000, shop fittings 14,000 and a vehicle 13,000. To employ two staff each to get a salary of 1,700 per month (ignore tax and NI). To buy the following quantity of garments: June Aug. inclusive 600 Sept. Nov. inclusive 700 To sell the following quantity of garments: June Aug. inclusive 500 Sept. Nov. inclusive 650 The average cost per garment will be 8, and the suppliers will be paid in the same month. The average selling price per garment will be 25. 90% of the sales will be on a cash basis. The other 10% will be on one months credit. Bonedge will draw 1,800 per month as drawings. Bonedge expects to spend 1,000 per month on advertising. This is to be paid in the same month. Other expenses are estimated to be 2,000 per month, payable in the month following. Bonedge plans to depreciate the fittings at the rate of 10% pa, and the vehicle at the rate of 20% pa. TASKS a) Prepare a cash-flow budget for the period 1 June 2007 to 30 November 2007. b) Comment on the budgeted cash-flow position of Bonedge. c) Explain the benefits of maintaining cash budgets. Q2. Cost accounting (September 2005) The following is the forecast data of a company for the first three months of 2006: DEC (05) JAN FEB MAR Sales 90,000 130,000 140,000 160,000 Purchases 45,000 70,000 80,000 95,000 Overheads 22,000 24,000 27,000 28,000 Wages 18,000 22,000 24,000 26,000 Other Information: 50% of sales are on a cash basis, and 50% are on a credit basis. Debtors are given one months credit. Suppliers give one months credit. Overheads are paid one month in arrears. Overheads include 4,000 in respect of the depreciation of fixed assets. Wages are paid in the month in which they are incurred. New equipment costing 60,000 will be paid for in March.

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NOTES & EXERCISES ON Financial Management -For ICM Students The sale of old equipment will bring income of 5,000 in March. The bank balance is predicted to be 30,000 on 1 January, 2006. TASKS a) Prepare cash budget for the period January March 2006. Comment on the budgeted cash position of the company. c) Explain the principal benefits of preparing and monitoring a cash budget.

b)

Question 3 (cash budget): The following projections were obtained from SUANAD Ltd, Retail Company for the years 2008 and 2009. NOV. DEC. JAN. FEB. MAR. APR. 2008 2008 2009 2009 2009 2009 000 000 000 000 000 000 Bills issued 940 1,020 1,280 1,420 1,080 1,800 Rights issue -------50 120 20 --Interest receivable 25 23.50 32.50 30 28.50 25 Loan payable 120 110 98 95 92 89 New equipment 1,800 Additional information: 1) Recurrent expenditure is estimated at 40% of bills issued and is paid every month. 2) 60% of bills issued is collected in the month after issue and 30% in the next month. 3) The new equipment will be paid for in two equal installments starting from the month of purchase. 4) All the other receivables and payables are settled in the month in which they occur. 5) Any shortfall will be financed by an overdraft which is obtained in multiples of 50,000 at 5% interest per month payable in the next month. 6) The opening balance will be an overdraft of 50,000. You are required to prepare a cash budget for Suanad Ltd for the first four months of the year 2009.

CHAPTER SIX BREAK-EVEN ANALYSIS Introduction Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

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It is a term used to describe the study of the relationship between costs, volume and profit at different levels of activities. It shows the relationship that exists between cost, revenue, level of output and profit. Another term for Break-even analysis is Cost-Volume-Profit analysis. Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). An important factor in break-even analysis is the ability to distinguish total cost into fixed costs and variable cost. FIXED COST AND VARIABLE COST FIXED COST: Fixed costs are those business costs that are not directly related to the level of production or output. It is defined by CIMA as a cost which is incurred for an accounting period, and which, within certain output or turnover limits, tends to be unaffected by fluctuations in the level of activity (output or turnover In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs include: Rent and rates, depreciation, research and development, marketing cost (I .e. none-revenue related cost) VARIABLE COST: Variable costs are those costs which vary directly with the level of output. It is defined as a cost which varies with a measure of activity They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between the following: "DIRECT" VARIABLE COSTS: Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples. INDIRECT VARIABLE COSTS cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are called semi-variable costs. ASSUMPTIONS OF BREAK-EVEN ANALYSIS The main assumptions behind C-V-P/Break-even Analysis includes

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NOTES & EXERCISES ON Financial Management -For ICM Students 1) 2) 3) 4) 5) 6) 7) All costs can be classified into fixed and variable costs Fixed costs will remain constant over relevant range Costs and revenues behave in a linear fashion. Volume or output is the only factor which affects costs and revenue. Technology, production methods and efficiency remain unchanged. All quantities produced are sold. There are no stock level changes and stocks are valued at marginal costs only.

BREAKEVEN ANALYSIS MATHEMATICAL METHOD C.V. P analysis can be done using simple formulae 1. Break-even point (in units) = fixed costs Contribution per unit 2. Break-even point ( sales) = fixed cost X selling price Contribution per unit

OR Fixed costs Contribution to sales ratio(C/S ratio) 3. (C/S Ratio) = contribution per unit Selling price X 100

4. Level of sales to achieve a target profit (in units) = Fixed cost +Target profit Contribution per unit

Level of sales to achieve a target profit ( sales) = fixed cost + target profit The Break-Even Chart X selling price

THE BREAK EVEN CHART In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "breakeven point" and is represented on the chart below by the intersection of the two lines:

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In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. QUESTION 1 A company is about to bring a new product to the market. The following budgeted data has been gathered: Direct material cost per unit 30 Direct labour cost per unit 30 Variable overhead cost per unit 50 Selling price per unit 200 Fixed overhead cost 420,000 Planned production and sales 12,000 units. Maximum possible output 16,000 units. TASKS: a) Calculate the original budgeted profit. b) Calculate the original budgeted break-even point. c) The sales manager thinks that if he was allowed to spend an extra 100,000 on marketing, the company would be able to sell 14,000 units at a price of 210 per unit. Calculate the profit. d) The production manager thinks that if he implemented a cost reduction programme he could reduce direct materials by 10%, direct labour by 5% and variable overheads by 5%. He also thinks that he could achieve saving of 30,000 on fixed overheads. Calculate the profit based on selling 12,000 units at 200 each. e) Explain which option you would recommend. SOLUTION: QUESTION 1

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NOTES & EXERCISES ON Financial Management -For ICM Students a) Sales (200 X 12,000) 2,400,000 Variable costs: Direct material (30 X 12,000) Direct labour (30 X12, 000) Variable overheads (50 X12,000) (1,320,000) Total contribution 1,080,000 Fixed overhead cost (420,000) Budgeted profit 660,000 b) Break-even point = Fixed cost Contribution per unit

360,000 360,000 600,000

Contribution per unit = total contribution = 1,080,000 = 90.00 No. of units 12,000 Break-even point = 420,000 = 4,667 units 90 c) Sales (210 X 14,000) 2,940,000 Variable costs: Direct material (30 X 14,000) Direct labour (30 X14, 000) Variable overheads (50 X14, 000) (1,540,000) Total contribution 1,400,000 Fixed overhead cost (420,000 +100,000) (520,000) Net profit 880,000 d) Sales (200 X 12,000) 2,400,000 Variable costs: Direct material (27 X 12,000) Direct labour (28.5 X12, 000) Variable overheads (47.5 X12,000) (1,236,000) Total contribution

420,000 420,000 700,000

324,000 342,000 570,000

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NOTES & EXERCISES ON Financial Management -For ICM Students 1,164,000 Fixed overhead cost (420,000-30,000) (390,000) Budgeted profit 774,000 e) From the above calculations, I will recommend option (c) since it produces the highest profit. Tutorial: i. The extra 100,000 on marketing is a fixed cost hence it is added to the fixed overheads ii. The (d) part of the question requires the following calculations: Direct material (30x10%= 3; it is to be reduced by 10% = 30 -3=27. it can be calculated as 90% x 30= 27 (i.e 100% 10% = 90%) Direct Labour (95%x 30= 28.50) Variable overheads (50x95%) = 47.50 Q2 . Cost accounting (September 2005) A company is about to bring a new product to the market. The following budgeted data has been collected: Direct material cost per unit 30 Direct labour cost per unit 40 Variable overhead cost per unit 50 Selling price per unit 230 Fixed overhead cost 1,000,000 Planned production and sales 18,000 units. Maximum possible output 22,000 units. TASKS: a) Calculate the original budgeted profit. b) Calculate the original budgeted break even point. c) It is thought that if an extra 80,000 was spent on marketing it would be possible to sell 19,500 units at the original budgeted selling price. Calculate the profit. d) It is thought that if the price was increased to 260 per unit it would only be possible to sell 15,000 units. Calculate the profit. e) It is thought that by improving the product, at a cost of 10 extra per unit, and increasing the selling price to 270 per unit it would be possible to sell 18,500 units. Calculate the profit f) Explain the term margin of safety.

SOLUTION: QUESTION 1 a) Sales (230 X 18,000) 4,140,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Variable costs: Direct material (30 X 18,000) Direct labour (40 X18, 000) Variable overheads (50 X18,000) (2,160,000) Total contribution 1,980,000 Fixed overhead cost (1,000,000) Budgeted profit 980,000 b) Break-even point = Fixed cost Contribution per unit

540,000 720,000 900,000

Contribution per unit = total contribution = 1,980,000 = 110.00 No. of units 18,000 Break-even point = 1,000,000 = 9,091 units 110 c) Sales (230 X 19,500) 4,485,000 Variable costs: Direct material (30 X 19,500) Direct labour (40 X19, 500) Variable overheads (50 X19, 500) (2,340,000) Total contribution 2,145,000 Fixed overhead cost (1,000,000 +80,000) (1,080,000) Budgeted profit 1,065,000 d) Sales (260 X 15,000) 3,900,000 Variable costs: Direct material (30 X 15000) Direct labour (40 X15000) Variable overheads (50 X15000) (1,800,000) Total contribution 2,100,000 Fixed overhead cost (1,000,000) (1,000,000)

585,000 780,000 975,000

450,000 600,000 750,000

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NOTES & EXERCISES ON Financial Management -For ICM Students Budgeted profit 1,100,000 e) Sales (270 X 18,500) 4,995,000 Variable costs: Direct material (30 X 18,500) Direct labour (40 X18, 500) Improvement (10 x 18,500) Variable overheads (50 X18, 500) (2,405,000) Total contribution 2,590,000 Fixed overhead cost (1,000,000 +80,000) (1,000,000) Budgeted profit 1,590,000

555,000 740,000 185,000 925,000

f) From the above calculations, I will recommend option (c) since it produces the highest profit. Tutorial: i. The extra 100,000 on marketing is a fixed cost hence it is added to the fixed overheads ii. The (d) part of the question requires the following calculations: Direct material (30x10%= 3; it is to be reduced by 10% = 30 -3=27. it can be calculated as 90% x 30= 27(i.e 100% 10% = 90%) Direct Labour (95%x 30= 28.50) Variable overheads:(50x95%) = 47.50

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CHAPTER SEVEN SOURCES OF BUSINESS FINANCE


Sources of finance refer to the various means or areas through which a business gets funds to achieve its objectives. Sources of finance can be grouped into two main groups: A. LONG TERM SOURCES OF FINANCE B. SHORT TERM SOURCES OF FINANCE

LONG TERM SOURCES OF FINANCE


1. SHARE CAPITAL:

A major source e of finance for companies is through the issue shares to existing or new members. A company willing to raise additional capital issues shares. There are two main types of share of a company.

Ordinary (equity) shares


These are shares that have no special rights or privilege in relation to dividends or the sharing of assets on dissolution of the company. Ordinary are the shares which do not carry a fixed dividend. Instead, the directors decide how much to pay to the shareholders each year (after considering the profit made for the year. It is the commonest type of shares. Ordinary shareholders carry the risks of the business and will only receive dividend when preference shareholders are paid dividend. In the event of the company dissolution, they can only get a share of the money received from the sale of the assets after all the debts of the company is paid. Normally each ordinary shareholder has a voting right. Non-voting ordinary shares (called A shares) may be issued. The voting ordinary shareholders are called B shares a) PREFERENCE SHARES: Preference shares are shares carrying fixed rate of dividend. The dividend must be paid first before any dividend is paid to ordinary shareholders. Preference shares have a fixed percentage
dividend before any dividend is paid to the ordinary shareholders. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available, although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders.

ADVANTAGES OF PREFERENCE SHARES

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NOTES & EXERCISES ON Financial Management -For ICM Students 1. Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures). 2. Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not. 3. Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference shares are normally treated as debt when gearing is calculated. 4. The issue of preference shares does not restrict the company's borrowing power, at least in the sense that preference share capital is not secured against assets in the business. 5. The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders. DISAVANTAGES OF PREFERENCE SHARES 1. Dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. 2. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks. 3. For the investor, preference shares are less attractive than loan stock because:
a) They cannot be secured on the company's assets b) The dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved.

RIGHT ISSUE A right issue represents the offer of shares to existing shareholders in proportion of their shareholding at a stated price usually below the current market price of the shares. Existing ordinary shareholders are given a right certificate which entitles them to take up a specified number of shares at a specified price. The right issue price is sufficiently below listed price to make the offer attractive. Shareholders who do not wish to exercise any or all of their rights may sell them to third parties who then apply for the shares or he may renounce his right. It is one way through which to reduce the cost of raising new shares and another device used by companies whose shares are listed on the stock exchange is to make right issues to its existing shareholders A rights issue provides a way of raising new share capital by means of an offer to existing shareholders, inviting them to subscribe cash for new shares in proportion to their existing holdings. A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid excessive dilution of the earnings per share.

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NOTES & EXERCISES ON Financial Management -For ICM Students ADVANTAGES OF RIGHT ISSUES AS A SOURCE OF FINANCE i. A right issue is the simple and cheapest way by which a company can get funds ii. It has a greater chance of success since the buyers are the existing known shareholders of the company. iii. Shareholders of the company have the choice either to accept the offer or sell their right to other shareholders for money. iv. A right issue enables the company to at least maintain its dividends. v. A right issue automatically lowers the gearing ratio of the company vi. The finance is fully guaranteed if the issue is underwritten. vii. It might give the impression that the company is expanding. viii. Investors see a right issue as a healthy sign of future growth prospect of the company. DISADVANTAGES OF RIGHT ISSUE i. The amount of money required may not be able to obtain. ii. Right issues are normally made at a discount, which usually involves diluting the Earnings Per Share of the company. iii. Underwriters fees and other administrative expenses of the issue may be costly. iv. The market is often skeptical about the reason for the right issue, tending to assume that the company needs cash seriously. v. A right issue usually forces shareholders to either buy the shares or sell their right. 2. RETAINED EARNINGS (Plough-back profit) Simply retaining profits, instead of paying them out in the form of dividends, offers an important, simple low-cost source of finance, although this method may not provide enough funds, for example, if the firm is seeking to grow. This is where earnings from operations are ploughed.
For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: a) The use of retained earnings as a source of funds does not lead to a payment of cash. Retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. c) The use of retained earnings as opposed to new shares or debentures avoids issue costs. d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares.

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Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods. A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

back into the firm, i.e. they are used for investment in other potential profitable projects. The use of retained earnings is the most common source of finance in practice. ADVANTAGES: 1. Flexible, particularly for small amounts 2. No cost involved in raising the finance 3. No new shareholders are involved hence all gains from any investment will go to the existing shareholders 3. BANK LOAN
Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company.

ADVANTAGES OF BANK LOAN

4. DEBENTURES Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. Debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. a) Fixed charge: Security would be related to a specific asset or group of assets, typically land and buildings. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

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b) Floating charge: With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset. Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified period. Most organisations owning property which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of the value of the property. As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax.

LEASING
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases".

Operating Leases Operating leases are rental agreements between the lessor and the lessee whereby: a) The lessor supplies the equipment to the lessee b) The lessor is responsible for servicing and maintaining the leased equipment c) The period of the lease is fairly short, less than the economic life of the asset, so that at the end of the lease agreement, the lessor can either i) Lease the equipment to someone else, and obtain a good rent for it, or ii) sell the equipment second-hand. Finance Leases Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most, or all, of the assets expected useful life. Other important characteristics of a finance lease:

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a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not involved in this. b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out. The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment. c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period, in return for a very low nominal rent or the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) . Why might leasing be popular The attractions of leases to the supplier of the equipment, the lessee and the lessor are as follows: 5. The supplier of the equipment is paid in full at the beginning. The equipment is sold to the lessor, and apart from obligations under guarantees or warranties, the supplier has no further financial concern about the asset. 6. The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease payments from the lessee. Provided that a lessor can find lessees willing to pay the amounts he wants to make his return, the lessor can make good profits. He will also get capital allowances on his purchase of the equipment. 7. Leasing might be attractive to the lessee: i) if the lessee does not have enough cash to pay for the asset, and would have difficulty obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the use of it at all; or ii) Finance leasing is cheaper than a bank loan. The cost of payments under a loan might exceed the cost of a lease. Operating leases have further advantages: i. The leased equipment does not need to be shown in the lessee's published balance sheet, and so the lessee's balance sheet shows no increase in its gearing ratio. j. The equipment is leased for a shorter period than its expected useful life. In the case of high-technology equipment, if the equipment becomes out-ofdate before the end of its expected life, the lessee does not have to keep on using it, and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand.

6. HIRE PURCHASE
Hire purchase is a form of installment credit. Hire purchase is similar to leasing, with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit installment, whereas a lessee never becomes the owner of the goods.

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Hire purchase agreements usually involve a finance house. i) The supplier sells the goods to the finance house. ii) The supplier delivers the goods to the customer who will eventually purchase them. iii) The hire purchase arrangement exists between the finance house and the customer. The finance house will always insist that the hirer should pay a deposit towards the purchase price. The size of the deposit will depend on the finance company's policy and its assessment of the hirer. This is in contrast to a finance lease, where the lessee might not be required to make any large initial payment. An industrial or commercial business can use hire purchase as a source of finance. With industrial hire purchase, a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance
The government provides finance to companies in cash grants and other forms of direct assistance, as part of its policy of helping to develop the national economy, especially in high technology industries and in areas of high unemployment.

Venture capital
The term 'venture capital' is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme. Venture capital is money put into an enterprise which may all be lost if the enterprise fails. The institution that puts in the money recognises the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialise. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk. A venture capital organisation will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its "exit", that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd. The directors of the company must then contact venture capital organisations, to try and find one or more which would be willing to offer finance. A venture capital organisation will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management: a) a business plan

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b) details of how much finance is needed and how it will be used c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast d) details of the management team, with evidence of a wide range of management skills e) details of major shareholders f) details of the company's current banking arrangements and any other sources of finance g) any sales literature or publicity material that the company has issued. A high percentage of requests for venture capital are rejected on an initial screening, and only a small percentage of all requests survive both this screening and further investigation and result in actual investments.

FRANCHISING
Franchising is an arrangement whereby a franchisee pays a franchisor for the right to operate a local business, under the franchisor's trade name. The franchisor must bear certain costs such as establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs. These regular payments will usually be a percentage of the franchisee's turnover. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost. THE ADVANTAGES OF FRANCHISES The advantages of franchises to the franchisor are as follows: i. The capital outlay needed to expand the business is reduced substantially. ii. The image of the business is improved because the franchisees will be motivated to achieve good results and will have the authority to take
whatever action they think fit to improve the results.

SHORT TERM SOURCES OF FINANCE

Short term sources of finance are defined as those which allow a company to borrow money for up to a year before repayment is due. That is, a debt originally scheduled for payment within one year. A variety of short term finance is available to companies and the finance manager must know the advantages and the disadvantages associated with each option. The advantage of a franchise to a franchisee The major short term sources of finance are described below: More Lecture Series by TIMORE B. F
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1.

TRADE CREDIT: In the ordinary course of business, a firm may buy


its goods and services from other companies without paying for them immediately. Trade credit is a spontaneous financing in that it arises from the ordinary business transactions. Delaying settlement of debts enables firms to use internally the funds that otherwise would be paid to suppliers or creditors. Trade credit is free, no interest charges are involved. However, discounts that could have been earned on cash purchase will be lost. Also suppliers will eventually refuse credit and demand cash payment on delivery. ADVANTAGES OF TRADE CREDIT AS A SOURCE OF

FINANCE i. Trade credit convenient and easily accessible by small and large companies than loan from the bank.

2. BILL OF EXCHANGE:

Bills of exchange are used by firms to raise short-term finance by selling the bill to the discount house. A bill of exchange is defined in section 3 of the bill of exchange Act 1882 as an unconditional order in writing, address by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time a sum certain in money to or to the order of s specified person or bearer. The bill of exchange is originated by a creditor and addressed to the debtor who by signing the bill agrees to pay the bill at maturity. The creditor can sell the bill immediately on the discount market. 3. BANK OVERDRAFT This is a short term source of finance to small and large companies where the company is permitted to withdraw in excess of their current account balance or deposit. It is a common source of short term finance where the company is not able to secure loan from the bank. To obtain an overdraft, the company must have an account with the bank. Thus the main difference between a bank loan and an overdraft is that, a bank loan does not require an account with the bank before one can secure the loan, whereas a bank overdraft requires and account with the bank. Usually, the bank has limits at which the company may be allowed overdraft. When the limit is exceeded, further overdraft may not be allowed. The bank charges interest on the overdraft and the company can be called to pay the overdraft at any time. ADVANTAGES OF BANK OVERDRAFT AS A SOURCE FINANCE i. Lower interest rate: Overdraft interests are lower than long term loan. ii. Flexibility: overdraft are more flexible in terms of payment than bank loan iii. Tax-deductible interest: The interest paid on overdraft is allowed as a deductible expense by the tax authorities. More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students DISADVANTAGES The major problems of overdraft interest are i. Technically overdrafts are payable on demand ii. Interests rates may increase due to inflation

4. FACTORING & INVOICE DISCOUNTING


Factoring involves the outright sale (at a discount) of debts owed to the company to an outside body in exchange for cash. Thus companies can use factoring to raise immediate cash on the security of the companies debt. A company anxious to restore liquidity can be helped by a factor. Factors are specialist financial institutions, usually a subsidiary of major banks) The factor takes over the administration of the client companys invoices, collects the money and also assumes the risk of customer default. How much is paid for the invoice is subject to negotiation but usually depends on the volume of debt involve, degree of customer default and the extent of paperwork involve. A typical factoring arrangement include the following a. The company sells and invoices goods to customers b. The company (supplier) sells the debt/ the invoice amount to the factor c. The factor then releases a loan of about 80% of the invoice amount to the supplier d. At the agreed payment date by the customer, the customer pays the amount to the factor e. The factor then releases the remaining 20% to the company after deducting interest charges and commission. A typical factors cost can be divided into the following: i. A service charge ( usually 1% or 2% of the sales value) to cover the cost of administering the invoices ii. A finance charge (i.e. loan interest) on the amount paid by the factor to the company, usually between 3% - 4%. The interest is calculated up the time that debtors settle their bills. iii. A premium ( about 1% ) to cover bad debts iv. Extra charges for legal fees incurred by the factor during the debt collection 5. INVOICE DISCOUNTING This involves the buying of invoices issued to customers by the discounter. The discounter then issues immediate cash to the supplier up to say 80% of the invoice values. That is with invoice discounting, the company receives a cash payment (thus a loan) from the invoice discounter against the value of the invoices issued to customers but the company retains the responsibility for the debts collection but not the discounter who collects the debt as in factoring. Charges in invoice discounting are usually higher than factoring.

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NOTES & EXERCISES ON Financial Management -For ICM Students One advantage of invoice discounting is that, customer goodwill is maintained

ADVANTAGES OF FACTORING & INVOICE DISCOUNTING 1. Factors are experts in debt collection and may be able to persuade debtors to settle their outstanding debts more conveniently than the companys own accounting staff. 2. Factoring speeds up cash flows of a company thereby preventing cash flow difficulties. DISADVANTAGES OF FACTORING & INVOICE DISCOUNTING 1. One of the problems with factoring is that, the client company looses contact with its customers. The factor may collect the debts in its own name or under the letter head of the come. Some times the customer is irritated during the process. 2. Factors are not always interested to deal with small companies where the debt is small. 3. The interest charged by these factors are usually costly 4. Factoring can be applied to few customers with huge debt.

6. DEFERED TAX PAYMENT Another source of short-term funds similar character to trade credit is the credit supplied by the tax authority. This is created by the interval that elapses between the earnings of the profits by the company and the payment of the taxes due on them. As long as the company continues to earn stable or expanding profit, tax payment deferred in this way comprises a virtually permanent source of finance. Provisional assessments and payment of deposit on account by Ghana tax authorities has render this source of finance non-effective.

CHAPTER EIGHT MERGERS AND TAKEOVERS

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NOTES & EXERCISES ON Financial Management -For ICM Students A merger is a combination of two companies into one larger company. MERGER means the combination of two or more firms to form a single company.Thus a merger is the joining of two separate companies to form a single company It is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. Corporate mergers may be aimed at reducing market competition, cutting costs (for example, laying off employees, operating at a more technologically efficient scale, etc.), reducing taxes, removing management, "empire building" by the acquiring managers, or other purposes which may or may not be consistent with public policy or public welfare. . A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and in new branding; in some cases, terming the combination a "merger" rather than an acquisition is done purely for political or marketing reasons. Acquisition on the other hand is the purchase of a controlling interest in another company. TYPES OF MERGER: Mergers can be classified into four groups: 1. horizontal merger 2. vertical merger 3. concentric/ congeneric merger 4. conglomerate merger 1) HORIZONTAL MERGER: This is a combination of two or more companies that produce the same type of goods and services. Horizontal mergers take place where the two merging companies produce similar product in the same industry. That is when one firm combines with another in its same line of business. eg MTN & TIGO 2) VERTICAL MERGER: A merger between a firm and one of its suppliers or customers e.g. a steel company acquiring a coal mining firm. Vertical mergers occur when two firms, each working at different stages in the production of the same good, combine. 3) COMGLOMERATE MERGER: A merger of companies in totally different industries. Conglomerate mergers take place when the two firms operate in different industries. Hostile Merger: A form of merger where the target firms management resists or opposes the acquisition. Friendly Merger: A merger whose which is supported and whose terms are approved by the management of the two companies.

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ACQUISITION
Acquisition or takeover is the purchase of a controlling interest in one company by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target's board has no prior knowledge of the offer. Acquisition usually involves a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger or longer established company and keep its name for the combined entity. NOTE: Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. REASONS FOR MERGER: A. SYNERGY: the conditions where in the whole is greater than the sum of its parts. In a synergistic merger, the post -merger value exceeds the sum of the separates companies pre-merger values. The primary motivation for most mergers is to increase the value at the combined enterprise. e.g. If A Ltd and B Ltd merge to form AB Ltd AB Ltd values exceeds that of A and B taken separately then synergy is said to exist Synergy effect can arise from 4 sources 1. operating the economies of scale generally cost reduction 2 .Financial economies lower cost of debt greater debt capacity. 3. Differential management efficiency 4. Increase market power resulting from reduced competition. 2. Tax consideration: Tax consideration has stimulated a number of merges e.g. a company which is highly profitable and has highest tax could acquire a company with large accumulated tax losses, and set off the losses to its profit. A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. B. PURCHASE OF ASSETS BELOW THEIR REPLACEMENT COST Another reason which will allow firms to merge is the fact that sometimes the replacement cost of the assets of the target company is higher than its market value. C. ECONOMIES OF SCALE: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit. REASONS FOR ACQUISITIONS The following are some reasons why one company may decide to acquire a controlling interest in another company. 1) Marketing advantages: More Lecture Series by TIMORE B. F
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NOTES & EXERCISES ON Financial Management -For ICM Students a. To eliminate major competitor and protect the companys existing market. b. To enter an new market ( i. g . enter overseas market) c. To buy a market presence The classic reasons for acquisition as a part of the broader corporate strategy are as follows: 1) MARKETING ADVANTAGES i. To buy a new product range. ii. To buy a market presence (especially true if acquiring a company with overseas offices and contracts that can be utilized by the mother company). iii. To eliminate competition or to protect an existing market. iv. To unify sales departments or to rationalize distribution and advertising. 2) PRODUTION ADVANTAGES i. To gain a higher utilization of production facilities and reap economic of scale y larger runs, less time spent on change over ii. To buy in technology and skills iii. To obtain greater production capacity iv. To safeguard future supplies of raw materials. v. To improve the purchasing position through better bulk purchasing opportunities 3) FINANCE AND MANAGEMENT i. To buy a high quality management team, which exist in the acquired company. ii. To obtain cash resources where the acquired company is very liquid. iii. To gain under valued assets or surplus assets that ca be sold off. iv. To obtain tax advantages (e.g. purchase of a tax loss company). 4) RISK SPREADING i. Reduce the risk of reliance on a single market or product. 5) TO RETIAN INDEPENDENCE :A company threatened by a takeover might take over another company just to make itself bigger and so a more expensive target for the predator company. 6) INCREASED MARKET SHARE: This can increase market power: In an oligopoly market, increased market share generally allows companies to raise prices. 7) RESOURCE TRANSFER: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources The following must also be evaluated before the merger or acquisition. 1. The prospects of technological change in the industry. 2. The size and strength of competitors. 3. The reaction of competitors to an acquisition.

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NOTES & EXERCISES ON Financial Management -For ICM Students 4. The likelihood of government intervention and legislation. 5. The state of the industry and its long term prospects. 6. The amount of synergy obtainable from the merger or acquisition. Whatever the reason for the merger or acquisition, it is unlikely it is unlikely to be unless if offers the company opportunities that cannot be found within the company itself and unless the new subsidiary fits closely into the strategic plan outlined for growth. 1. 2. 3. 4. 5. 6. Increase in sales/revenues Venture into new businesses and markets Profitability of target company Increase market share Decrease competition (from the perspective of the acquiring company) Reduction of overcapacity in the industry

DISADVANTAGES OF MERGERS AND ACQUISITIONS 1. 2. 3. 4. Reduced competition and choice for consumers in oligopoly markets Likelihood of price increases and job cuts Cultural integration/conflict with new management Hidden liabilities of target entity.

CHAPTER NINE: PAST QUESTIONS


JUNE 2009 FINANCIAL MANAGEMENT

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1. Explain the following terms: a) Underwriting fees b) The major contents of a prospectus (as regards an offer for shares) c) Gilt-edged securities d) Debenture The following information relates to Clifton Ltd and has been taken from their books as at 31 May 2009: Turnover 1,600,000 Administration expenses 280,000 Cost of sales 510,000 Taxation for the year 100,000 Interest paid 50,000 Distribution costs 260,000 Proposed dividends 80,000 OTHER INFORMATION: There are 400,000 1 ordinary shares in issue. The market price of an ordinary share on 31 May 2009 was 17 per share. TASKS a) Prepare the profit and loss account of Clifton Ltd for the year ended 31 May 2009. b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the operating profit as a percentage of sales

2.

c)

The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (75% of the shares) 24 Tangible assets 30 14 54 14 Current Assets Stock 20 7 Debtors 15 9 Bank 5 3 40 19 Current Liabilities Creditors Capital and reserves Ordinary share capital Profit and loss account balance TASK Construct the group balance sheet immediately after acquisition. OR Explain the following terms: i Minority interest ii An associated company 3. Homunol plc is considering investing in a project that has the following cash flows: 000 Initial investment 3,200 Cash flows: Year one 900 (15) 79 === 60 19 === (5) 28 === 20 8 ===

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Year two 1,200 Year three 1,800 Year four 1,200 Year five 600 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year one .926 .917 .909 Year two .857 .842 .826 Year three .794 .772 .751 Year four .735 .708 .683 Year five .681 .650 .621 Year six .630 .596 .564 TASKS a) Calculate the payback period. b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly if you think that the project is viable. e) Outline any non-financial factors that might be considered by Homunol plc during the decision making process. f) Explain the importance of a project review. 4. a) Prepare a cashflow statement of a company called BMU plc for the year ended 31 May 2009 from the following data: 000 Purchase of new premises 290 Purchase of new computers 80 Tax paid 140 Equity dividends paid 90 Proceeds from share issue 560 Repayment of long-term loans 380 Interest paid 40 Interest received 5 Investment income 10 Cash inflow from operating activities 240 b) Comment on the cashflow position of BMU plc during the year ended 31 May 2009. c) Explain the principal sources of long-term finance available to a plc. The following figures have been extracted from Piterson Ltds accounts for the two years to 31 May 2009: 2008 2009 BALANCE SHEET CLOSING BALANCES: Stock 110,000 180,000 Debtors 180,000 290,000 Cash in bank 20,000 Creditors Bank overdraft Long-term loans Issued share capital Retained profit 130,000 200,000 500,000 190,000 180,000 30,000 450,000 500,000 200,000

5.

TASKS a) For BOTH years calculate the following: i the current ratio ii the acid test ratio iii the gearing percentage b) Comment on the liquidity position of Piterson Ltd.

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c) 6. a) b) c) Explain the importance of using a cash budget to control and monitor the cash flow position of a business. Explain what you understand by the term vertical integration. Explain what you understand by the term horizontal integration. Explain the potential sources of short-term finance available to a large company.

7.

Write notes on FOUR of the following: a) the principal role of a central bank b) VAT c) a rights issue d) intangible fixed assets e) breakeven analysis f) a master budget g) venture capitalists MARCH 2009 FINANCIAL MANAGEMENT

1.

Explain the following terms: a) a share issue b) marginal costing c) gilt-edged securities d) a cash flow statement The following figures have been extracted from Ronon Ltds accounts for the two years to 28 February 2009: 2009 2008 BALANCE SHEET CLOSING BALANCES: Stock 170,000 110,000 Debtors 310,000 200,000 Cash in bank 30,000 Creditors Bank overdraft Long-term loans 230,000 30,000 480,000 180,000 240,000 500,000 210,000

2.

Issued share capital 500,000 Retained profit 290,000 TASKS a) For BOTH years calculate the following: i the current ratio ii the acid test ratio iii the gearing percentage b) Comment on the liquidity position of Ronon Ltd. c) Explain what a rights issue is. 3. a) b)

Explain the importance of an efficient budgetary control system. Explain which ratios you might use to measure the efficiency of your management of working capital.

4.

a) Prepare a cashflow statement of a company called Venasius plc for the year ended 28 February 2009 from the following data: 000 Purchase of new machines 170 Purchase of new computers 80 Tax paid 140 Equity dividends paid 70

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Proceeds from share issue 480 Repayment of long-term loans 240 Interest paid 25 Interest received 5 Cash inflow from operating activities 290 Comment on the cashflow position of Venasius plc during the year ended 28 February 2009. Explain the sources of long-term capital available to a major company.

b) c) 5.

The following information relates to Shabalal Ltd and has been taken from their books as at 28 February 2009: Turnover 2,100,000 Administration expenses 360,000 Cost of sales 550,000 Taxation for the year 140,000 Interest paid 40,000 Distribution costs 290,000 Proposed dividends 220,000 OTHER INFORMATION: There are 1,500,000 1 ordinary shares in issue. The market price of an ordinary share on 28 February 2009 was 5.80 per share. TASKS a) Prepare the profit and loss account of Shabalal Ltd for the year ended 28 February 2009. b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover c) The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (60% of the shares) 20 Tangible assets 28 10 ------48 10 ------Current Assets Stock Debtors Bank 20 12 3 ---35 ------(12) ---71 === 60 11 6 6 1 ---13 ----(2) ---21 === 15 6 ===

Current Liabilities Creditors

Capital and reserves Ordinary share capital Profit and loss account balance

=== TASK Construct the group balance sheet immediately after acquisition. OR

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Explain the following terms: i Minority interest ii An associated company 6. a) Explain why a company will use investment appraisal techniques in the choice of allocating finance to potential investment projects. b) Explain the role of an external auditor. c) Explain the role of a financial director. Write notes on FOUR of the following: a) VAT b) vertical integration c) horizontal integration d) intangible fixed assets e) goodwill f) venture capitalists g) a bonus issue of shares DECEMBER 2008 FINANCIAL MANAGEMENT 1. 2. a) b) Explain the BENEFITS of a budgetary control system.[12] Explain the sources of short-term finance available to a large company.[8]

7.

The following information relates to JayJay B Ltd and has been taken from their books as at 31 November 2008: Turnover 1,450,000 Administration expenses 220,000 Cost of sales 430,000 Taxation for the year 110,000 Interest paid 25,000 Interest received 5,000 Distribution costs 190,000 Proposed dividends 60,000 OTHER INFORMATION: There are 1,000,000 1 ordinary shares in issue. The market price of an ordinary share on 30 November 2008 was 6.60 per share. The total capital employed in the business on 30 November 2008 was 1,600,000. TASKS a) Prepare the profit and loss account of JayJay B Ltd for the year ended 30 November 2008. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover v the operating profit (PBIT) as a percentage of total capital employed.[2 each] c) Explain what a bonus issue of shares is.[5] Carbus Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,800 Cash flows: Year 1 800 Year 2 1,300 Year 3 1,200 Year 4 700 Year 5 300

3.

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The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 a) b) c) d) e) a) b) a) 8% 1.000 .926 .857 .794 .735 .681 .630 9% 1.000 .917 .842 .772 .708 .650 .596 10% 1.000 .909 .826 .751 .683 .621 .564

4. 5.

b) c) 6.

TASKS Calculate the payback period (in years and months).[2] Calculate the ARR (accounting rate of return).[2] Calculate the NPV (net present value).[4] Explain briefly if you think that the project is viable.[4] Explain the sources of long-term finance available to a large company.[8] Fully explain the synergetic benefits usually associated with a takeover.[12] Explain the function of a stock exchange. [8] A company makes a single product. The following is the cost structure: Selling price per unit 90 Direct material cost per unit 20 Direct labour cost per unit 30 Variable overhead cost per unit 10 Total fixed costs 590,000 ======= Budgeted production and sales 50,000 units. Maximum possible production 64,000 units. TASKS i Calculate the budgeted profit.[3] ii Calculate the break even point in units.[2] iii Calculate the profit if an extra 80,000 was spent on marketing and 56,000 units are made and sold.[3] Explain the term MINORITY INTEREST.[6] Explain the importance of the audit function.[6]

The following are the assets and liabilities of Rovfort Ltd as at 30 November 2008: 000 Premises 800 Bank overdraft 190 Creditors 190 Goodwill 100 Debtors 300 Vehicles (net) 250 Ordinary share capital 700 Preference share capital 100 Share premium 120 Tax owing 110 Dividends owing 100 Equipment 400 Closing stock 230 Profit and loss account balance 320 Long-term loans 250

The following information has also been gathered:

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Credit sales 2,900 Opening stock 240 Purchases 1,290 TASKS a) Prepare the balance sheet of Rovfort Ltd as at 30 November 2008.[8] b) Calculate the following ratios: i current ii acid test iii the debtor collection period in days iv the rate of stock turnover[2 each] c) Comment briefly on the liquidity position of Rovfort Ltd as at 30 November 2008.[4] 7. Write notes on FOUR of the following: a) the purposes of a cash budget b) accounting standards c) a cash flow statement (FRS 1) d) financial gearing (leverage) e) efficiency ratios f) IRR g) a rights issue[5 each]

SEPTEMBER 2008 FINANCIAL MANAGEMENT 1. Explain the following terms: a) cash budget b) stock exchange c) a share prospectus d) marginal costing[5 each] The following information relates to LEN Ltd and has been taken from their books as at 31 August 2008: Turnover 1,960,000 Administration expenses 280,000 Cost of sales 530,000 Taxation for the year 270,000 Interest paid 25,000 Interest received 10,000 Distribution costs 210,000 Proposed dividends 120,000 OTHER INFORMATION: There are 1,000,000 1 ordinary shares in issue. The market price of an ordinary share on 31 August 2008 was 9.40 per share. The total capital employed in the business on 31 August 2008 was 1,850,000. TASKS a) Prepare the profit and loss account of LEN Ltd for the year ended 31 August 2008. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the dividend cover v the profit before tax to total capital employed percentage[2 each] Note. The following ratios on 31 08 07 were: EPS 52 pence per share PE ratio 12 times c) Give an opinion as regards the performance of LEN Ltd from the view of an existing shareholder. [5]

2.

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3.Giles Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,600 Cash flows: Year 1 600 Year 2 900 Year 3 1,100 Year 4 600 Year 5 200 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period (in years and months).[2] b) Calculate the ARR (accounting rate of return).[2] c) Calculate the NPV (net present value).[4] d) Explain briefly if you think that the project is viable.[4] e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums. [8] 4. Explain the importance of using an effective budgetary control system.[20] 5. a) Prepare a cash flow statement for KAB plc from the following data: 000 Purchase of fixed assets 260 Tax paid 70 Equity dividends paid 50 Interest paid 60 Interest received 10 Increase in long-term loans 200 Issue of ordinary shares 500 Cash inflow from operating activities 250[6] Explain the sources of long-term capital that might be considered by KAB plc.[8] Explain briefly why a large company may wish to expand by taking over a number of smaller competitors. [6]

b) c) 6.

The following are the assets and liabilities of Lucas Ltd as at 31 August 2008: 000 Premises 700 Bank overdraft 100 Creditors 110 Goodwill 150 Debtors 370 Vehicles (net) 190 Ordinary share capital 600 Preference share capital 300 Share premium 140 Tax owing 110 Dividends owing 70 Equipment 450 Closing stock 320 Profit and loss account balance 400 Long-term loans 350

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The following information has also been gathered: Credit sales 3,700 Opening stock 290 Purchases 1,400 TASKS a) Prepare the balance sheet of Lucas Ltd as at 31 August 2008.[8] b) Calculate the following ratios: i current ii acid test iii the debtor collection period in days iv the gearing percentage[2 each] c) Comment briefly on the liquidity position of Lucas Ltd as at 31 August 2008.[4] 7. Write notes on FOUR of the following: a) accounting standards (or international accounting standards) b) group accounts c) short-term sources of finance d) the role of an external auditor e) a rights issue f) the role of a management accountant g) IRR [5 each] JUNE 2008 FINANCIAL MANAGEMENT 1. The summarised financial statements of Barista Ltd for 2006 and 2007 were as follows: Barista Ltd balance sheets as at 31 December 2006 2007 000 000 000 000 Fixed assets at cost 19,000 35,000 Depreciation (9,000) 10,000 (13,000) 22,000 Current assets Stock Debtors Bank 10,000 15,000 8,000 -------33,000 -------6,000 5,000 2,000 -------13,000 -------20,000 (5,000) -------25,000 -------10,000 8,000 17,000 1,000 -------26,000 -------2,000 3,000 3,000 -------8,000 -------18,000 (10,000) -------30,000 -------14,000

Current liabilities Creditors Taxation Dividends

Working capital Long-term loans

Capital and reserves: Ordinary shares (1)

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Profit and loss account 15,000 16,000 --------------25,000 30,000 --------------Barista Ltd profit and loss account for the year ended 31 December 2007: 000 Operating profit 8,000 Interest paid (1,000) --------Profit before tax 7,000 Taxation (3,000) -------Profit after tax 4,000 Dividend (3,000) -------Retained profit 1,000 --------

TASKS Prepare a cash flow statement for Barista Ltd for the year ended 31 December 2007.[10] Calculate the following: i the dividend per share for BOTH years[3] ii the EPS for year ended 31 December 2007[2] c) Comment briefly on the major inflows and outflows of cash during the year ended 31 December 2007.[5] a) b) 2. A company is about to bring a new product to the market. The following budgeted data has been assembled: Direct material cost per unit 40 Direct labour cost per unit 20 Variable overhead cost per unit 50 Selling price per unit 170 Fixed overheads allotted to the product 320,000 The first draft budgeted production and sales is 12,000 units. The maximum possible output is 20,000 units. TASKS a) Calculate the first draft budgeted profit.[3] b) Calculate the first draft budgeted break-even point.[2] c) The marketing department have carried out some market research and are convinced that if an extra 50,000 was spent on marketing sales would rise to 15,000 units. Calculate the profit.[3] d) It is thought that if the selling price is increased to 180 per unit it would only be possible to sell 11,000 units. Calculate the profit. [3] e) The production department thinks that by improving the quality and packaging of the product by spending an extra 4 per unit making the product, sales would rise to 14,500 units. The selling price would be kept at 170. Calculate the profit.[3] f) Fully evaluate the above options.[6] The following information relates to Karos Ltd and has been extracted from their books as at 31 May 2008: Turnover (all credit sales) 2,200,000 Selling and distribution costs 220,000 Taxation for the year 140,000 Stock at 01 06 07 300,000 Purchases 970,000 Stock at 31 05 08 280,000 Administration expenses 230,000 Interest paid 90,000 Proposed ordinary dividend 100,000

3.

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------------Issued ordinary share capital 1,000,000 Current market price per ordinary share 15 Total closing debtors 190,000 TASKS a) Prepare the profit and loss account for the year ended 31 May 2008.[5] b) Calculate the following: i the gross profit to sales percentage ii the operating profit (PBIT) to sales percentage iii the earnings per share (EPS) iv the PE ratio v the debtor collection period in days[10] c) Comment on the financial performance of Karos Ltd.[5] 4. Domone plc is considering investing in a project that has the following cash flows: 000 Initial investment 2,700 Cash flows: Year one 700 Year two 1,000 Year three 1,100 Year four 600 Year five 300 The cost of capital is 9%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year one .926 .917 .909 Year two .857 .842 .826 Year three .794 .772 .751 Year four .735 .708 .683 Year five .681 .650 .621 Year six .630 .596 .564 TASKS a) Calculate the payback period.[2] b) Calculate the ARR (accounting rate of return).[2] c) Calculate the NPV (net present value).[4] d) Explain briefly if you think that the project is viable.[4] e) Explain the long-term sources of finance available to Domone plc.[8] a) b) Explain why budgetary control is used by most successful companies.[12] Explain the importance of controlling inventory (stock) levels.[8]

5. 6. 7.

Explain why the international trend is for growth via mergers or takeovers.[20] Explain FOUR of the following: a) share issues b) cash budgets c) accounting standards d) gilt edged securities e) liquidity ratios f) the potential dangers of high gearing g) the role of a central bank[5 each]

MAY 2008 FINANCIAL MANAGEMENT

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1. a) Explain the term SYNERGY, and outline the typical synergetic benefits gained by a company that acquires a major competitor.[10] b) Explain the major sources of long-term finance available to a large plc company.[10] The following information relates to Column Ltd and has been taken from their books as at 31 April 2008: Turnover 1,900,000 Administration expenses 460,000 Cost of sales 680,000 Taxation for the year 90,000 Interest paid 25,000 Distribution costs 330,000 Proposed dividends 120,000 Other information: There are 800,000 1 ordinary shares in issue. The market price of an ordinary share on 31 April 2008 was 7 per share. TASKS a) Prepare the profit and loss account of Column Ltd for the year ended 31 April 2008.[5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the dividend cover[2 each] c) The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed assets Investments in S (80% of the shares) 24 Tangible assets 26 13 50 13 Current assets Stock 14 9 Debtors 8 6 Bank 4 3 26 18 Current liabilities Creditors (10) (6) 66 25 === === Capital and reserves Ordinary share capital 50 10 Profit and loss account balance 16 15 === == Construct the group balance sheet immediately after acquisition.[7] OR Explain the following terms: i Minority interest[4] ii An associated company[3] 3. 4. a) b) Explain the major reasons for using a budgetary control system.[12] Explain the process of raising finance via a new issue of shares. [8]

2.

EITHER

a) Prepare a cashflow statement of a company called ROK plc for the year ended 31 April 2008 from the following data: 000 Purchase of new machinery 1800 Purchase of new vehicles 80 Tax paid 120

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Equity dividends paid 100 Proceeds from share issue 600 Repayment of long-term loans 350 Interest paid 30 Interest received 10 Investment income 25 Cash inflow from operating activities 230[5] Comment on the cashflow position of ROK plc during year ended 31 April 2008.[5] Explain a rights issue.[5] Sketch a breakeven chart, clearly labelling the key features.[5]

b) c) d) 5.

The following figures have been extracted from Jasper Ltds accounts for the two years to 31 April 2008: 2008 2007 BALANCE SHEET CLOSING BALANCES: Stock 170,000 120,000 Debtors 350,000 190,000 Cash in bank 40,000 Creditors Bank overdraft Long-term loans 230,000 50,000 600,000 210,000 300,000

Issued share capital 500,000 500,000 Retained profit 260,000 210,000 TASKS a) For both years calculate the following: i the current ratio[3] ii the acid test ratio[3] iii the gearing percentage[3] b) Comment on the liquidity position of Jasper Ltd.[5] c) Explain the importance of preparing and monitoring a cash budget.[6] 6. a) Explain why a company will use investment appraisal techniques in the choice of allocating finance to potential investment projects.[10] b) Explain the potential sources of short-term finance available to a large company.[10] Write notes on FOUR of the following: a) accounting standards b) company taxation c) gilt edged securities d) depreciation e) arbitrage f) currency hedging g) venture capitalists h) the role of an auditor[5 each] MARCH 2008 1. FINANCIAL MANAGEMENT Explain the following terms: a) A public issue of shares[8] b) Capital investment appraisal[12] The following information relates to Diamonte Ltd and has been taken from their books as at 29 February 2008: Turnover 2,100,000 Administration expenses 590,000

7.

2.

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Cost of sales 650,000 Taxation for the year 110,000 Interest paid 30,000 Distribution costs 340,000 Proposed dividends 190,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 29 February 2008 was 11.40 per share. The total revenue reserves at 1 March 2007 was 1,420,000. Diamonte Ltd do NOT have any form of long-term loan finance. TASKS a) Prepare the summarised published profit and loss account of Diamonte Ltd for the year ended 29 February 2008. [4] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the dividend cover v the operating profit as a percentage of total capital employed[2 each] c) The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (75% of the shares) 34 Tangible assets 41 19 75 19 Current Assets Stock 19 12 Debtors 15 9 Bank 7 4 41 25 Current Liabilities Creditors (12) (6) 104 38 === === Capital and reserves Ordinary share capital 80 20 Profit and loss account balance 24 18 === === TASK Construct the group balance sheet immediately after acquisition.[6] 3. a) b) Explain the importance of budgetary control.[15] A company is about to introduce a new product to the market. The cost data is as follows: Selling price per unit 95 Direct material cost per unit 24 Direct wages cost per unit 22 Variable overhead cost per unit 24 Associated total fixed costs 200,000 The company thinks that it can make and sell 20,000 units. TASKS i Calculate the budgeted profit.[3] ii Calculate the break-even point in units.[2]

4.

a) Prepare a cashflow statement of a company called RSP plc for the year ended 29 February 2008 from the following data: 000

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Purchase of new computer equipment 140 Purchase of new vehicles 80 Tax paid 120 Equity dividends paid 100 Proceeds from share issue 620 Repayment of long-term loans 240 Interest paid 40 Interest received 10 Investment income 20 Cash inflow from operating activities 340[5] Comment on the cashflow position of RSP plc during the year ended 29 February 2008.[5] Explain what a rights issue is.[5] Explain the term synergy.[5]

b) c) d) 5.

The following figures have been extracted from Vijay Ltds accounts for the two years to 29 February 2008: 2008 2007 BALANCE SHEET CLOSING BALANCES: Stock 210,000 190,000 Debtors 420,000 210,000 Cash in bank 30,000 Creditors Bank overdraft Long-term loans 280,000 40,000 700,000 200,000 200,000

Issued share capital 400,000 400,000 Retained profit 310,000 290,000 TASKS a) For BOTH years calculate the following: i the current ratio[3] ii the acid test ratio[3] iii the gearing percentage[3] b) Comment on the liquidity position of Vijay Ltd.[5] c) Explain the importance of preparing and monitoring a cash budget.[6] 6. 7. a) b) Explain potential sources of long-term funding available to a large plc.[10] Explain the potential sources of short-term finance available to a large plc.[10]

Write notes on FOUR of the following: a) the principal role of a central bank b) company taxation c) gilt edged securities d) depreciation e) arbitrage f) currency hedging g) venture capitalists[5 each] DECEMBER 2007 FINANCIAL MANAGEMENT

1.

The following information relates to Yasmin Ltd and has been taken from their books as at 30 November 2007: Turnover 1,800,000 Administration expenses 300,000 Cost of sales 520,000 Taxation for the year 110,000

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Interest paid 30,000 Distribution costs 270,000 Proposed dividends 90,000 Other Information: There are 400,000 1 ordinary shares in issue. The market price of an ordinary share on 30 November 2007 was 22.00 per share. TASKS a) Prepare the profit and loss account of Yasmin Ltd for the year ended 30 November 2007[5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the profit before tax as a percentage of sales[2 each] c) The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (80% of the shares) 22 Tangible assets 25 12 47 12 Current Assets Stock 18 8 Debtors 11 7 Bank 2 1 31 16 Current Liabilities Creditors (10) (4) 68 24 === === Capital and reserves Ordinary share capital 50 20 Profit and loss account balance 18 4 === === TASK Construct the group balance sheet immediately after acquisition.[7] OR Explain the following terms: i Minority interest[4] ii An associated company[3] Explain the following terms: a) Underwriting fees b) A subsidiary company c) Gilt edged securities d) Contribution[5 each] a) b) Explain the principal purposes of using a budgetary control system.[12] Explain the sources of finance available to a multinational company. [8]

2.

3. 4.

a) Prepare a cashflow statement of a company called VFR plc. for the year ended 30 November 2007 from the following data: 000 Purchase of new equipment 210 Purchase of new computers 90 Tax paid 130 Equity dividends paid 80 Proceeds from share issue 540 Repayment of long-term loans 350

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Interest paid 30 Interest received 5 Investment income 10 Cash inflow from operating activities 220[5] Comment on the cashflow position of VFR plc. during the year ended 30 November 2007.[5] Explain the purpose of accounting standards.[5] Explain the difference between fixed and variable costs.[5]

b) c) d) 5.

The following figures have been extracted from Gleeson Ltd.s accounts for the two years to 30 November 2007: 2007 2006 BALANCE SHEET CLOSING BALANCES: Stock 190,000 120,000 Debtors 320,000 190,000 Cash in bank 30,000 Creditors Bank overdraft Long-term loans 240,000 40,000 550,000 210,000 250,000

Issued share capital 600,000 600,000 Retained profit 240,000 180,000 TASKS a) For both years calculate the following: i the current ratio[3] ii the acid test ratio[3] iii the gearing percentage[3] b) Comment on the liquidity position of Gleeson Ltd.[5] c) Explain the importance of monitoring the cash flow position of a business.[6] 6. a) Explain why a company will use investment appraisal techniques in the choice of allocating finance to potential investment projects.[10] b) Explain the potential sources of short-term finance available to a large company.[10] Write notes on FOUR of the following: a) the principal role of a central bank b) VAT c) a rights issue d) intangible fixed assets e) goodwill f) currency hedging g) venture capitalists[5 each]

7.

SEPTEMBER 2007 FINANCIAL MANAGEMENT 1. The following information relates to Steric Ltd and has been taken from their books as at 31 August 2007: 000 Taxation for the year 15,000 Turnover (all credit sales) 290,000 Distribution costs 28,000 Stock at 01/09/06 42,000 Purchases 142,000 Administration expenses 36,000 Stock at 31/08/07 44,000

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Interest paid 11,000 Investment income 5,000 Balance on profit and loss account 01/09/06 121,000 Other information: The market price of an ordinary (equity) share on 31 August 2007 was 1.50 per share. There are 1 million ordinary shares in issue. TASKS a) Prepare a profit and loss account for the year ended 31 August 2007.[8] b) Calculate the following: i the gross profit as a percentage of sales ii the profit before tax as a percentage of sales iii the EPS iv the PE ratio[2 each] Comment on the profitability of Steric Ltd.[4]

c) 2.

The following are the assets and liabilities of Didi Ltd as at 31 August 2007: 000 Creditors 140 Share premium account 40 Equipment (net) 60 Premises (net) 200 Debtors 210 Stock 280 Goodwill 110 Vehicles (net) 140 Dividends owing 80 Tax owing 80 Long-term loans 160 Overdraft 80 Ordinary share capital 200 Retained profits 220 TASKS a) Prepare the balance sheet as at 31 August 2007.[8] b) Calculate TWO liquidity ratios.[4] c) Calculate the gearing ratio.[2] d) Explain the generally accepted advantages and disadvantages of a company being high geared.[6] a) b) Explain the advantages of leasing fixed assets (e.g. vehicles, computers, etc.) as opposed to outright purchase.[10] Explain the potential sources of long-term finance available to a large PLC.[10] Explain the following terms: i vertical integration ii horizontal integration iii conglomerate integration[12] Explain the terms: i minority interest ii associated company[4 each]

3.

4.

a)

b)

5.

A company is about to introduce a new product. The following budgeted data has been prepared: Direct material cost per unit 60 Direct labour cost per unit 30 Variable overhead cost per unit 80 Proposed selling price per unit 220 Fixed costs allocated to the product 750,000 The first draft budgeted production and sales is 18,000 units. The maximum possible output is 24,000 units.

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TASKS a) Calculate the first draft budgeted profit.[3] b) Calculate the following based on the first draft budget: i breakeven point in units ii margin of safety in units[3] c) It is thought that if an extra 20 per unit was spent on improving the quality and presentation of the product, 23,000 units could be sold at 230 each. Calculate the profit.[4] d) It is thought that if an extra 50,000 was spent on advertising the product, and the quality and price kept as per the first draft budget, 22,000 units could be sold. Calculate the profit.[4] e) Sketch a breakeven chart/graph based on the first draft budgeted data.[6] 6. a) Explain the advantages and disadvantages of the following three commonly used capital appraisal techniques: i payback ii accounting rate of return iii net present value (NPV)[4 each] b) Explain the following terms: i a bonus issue of shares ii a rights issue of shares[4 each] Write notes on FOUR of the following: a) budgetary control b) accounting standards c) gilt edged securities d) venture capital e) a stock exchange f) monitoring financial performance g) a cash flow statement[5 each]

7.

JUNE 2007 FINANCIAL MANAGEMENT 1. Explain the following terms: a) group accounts b) master budget c) a rights issue d) horizontal integration

[5 each]

2. The following information relates to RIC Ltd. and has been taken from their books as at 30 April 2007: Turnover 1,650,000 Administration expenses 260,000 Cost of sales 470,000 Taxation for the year 120,000 Interest paid 22,000 Interest received 5,000 Distribution costs 189,000 Proposed dividends 65,000 OTHER INFORMATION: There are 1,000,000 1 ordinary shares in issue. The market price of an ordinary share on 30 April 2007 was 5.00 per share. The total capital employed in the business on 30 April 2007 was 1,680,000. TASKS a) Prepare the profit and loss account of RIC Ltd. for the year ended 30 April 2007.

[5]

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b) Calculate the following: i the EPS ii the interest cover iii the dividend per share iv the dividend cover v the operating profit to total capital employed percentage [2 each] c) Explain what a bonus issue of shares is. [5] Nathalie Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,800 Cash flows: Year 1 700 Year 2 1,000 Year 3 1,400 Year 4 700 Year 5 300 The cost of capital is 9%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period (in years and months). [2] b) Calculate the ARR (accounting rate of return). [2] c) Calculate the NPV (net present value). [4] Explain briefly if you think that the project is viable. [4] e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums. [8] Explain why many large companies seek to continue to expand by merging with or taking over smaller competitors. Explain the process of setting a budget. a)

3.

d)

4.a) b) 5.

[10] [10]

b) c)

Prepare a cash flow statement from the following data: 000 Purchase of fixed assets 250 Tax paid 60 Equity dividends paid 70 Interest paid 30 Interest received 10 Long-term loan paid off 400 Issue of ordinary shares 600 Cash inflow from operating activities150 [6] Explain the consequences of over borrowing during a recession. [8] Explain the reasons why firms monitor financial performance via the use of financial ratios. [6] The following are the assets and liabilities of Chantal Ltd. as at 30 April 2007: 000

6.

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Premises Bank overdraft Creditors Goodwill Debtors Vehicles (net) Ordinary share capital Preference share capital Share premium Tax owing Dividends owing Equipment Closing stock Profit and loss account balance Long-term loans 800 130 110 150 400 190 700 300 140 110 80 460 300 400 330

The following information has also been gathered: Credit sales 3,400 Opening stock 260 Purchases 1,500 TASKS a) Prepare the balance sheet of Chantal Ltd. as at 30 April 2007. [8] b) Calculate the following ratios: i current ii acid test iii the debtor collection period in days iv the rate of stock turnover [2 each] c) Comment briefly on the liquidity position of Chantal Ltd. as at 30 April 2007. 7. Write notes on FOUR of the following: a) international accounting standards b) stock markets c) a share prospectus d) the role of an external auditor e) accounting concepts f) the role of a management accountant g) IRR [4]

[5 each]

MARCH 2007 FINANCIAL MANAGEMENT 1. The summarised financial statements of Carla Ltd. for 2005 and 2006 were as follows: Carla Ltd. balance sheets as at 31 December 2005 2006 000 000 000 000 Fixed assets at cost 15,000 18,000 Depreciation (7,000) 8,000 (9,000) 9,000 Current assets Stock 7,000 9,000 Debtors 11,000 10,000 Bank 3,000 4,000 21,000 23,000 Current liabilities Creditors 6,000 3,000 Taxation 4,000 5,000 Dividends 3,000 4,000

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13,000 Working capital Long-term loans Capital and reserves: Ordinary shares (1) Profit and loss account 8,000 (3,000) 13,000 12,000 11,000 (4,000) 16,000 11,000 5,000 16,000

9,000 4,000 13,000 Carla Ltd. profit and loss account for the year ended 31 December 2006: 000 Operating profit 11,000 Interest paid (1,000) --------Profit before tax 10,000 Taxation (5,000) -------Profit after tax 5,000 Dividend (4,000) -------Retained profit 1,000 -------TASKS a) Prepare a cash flow statement for Carla Ltd. for the year ended 31December2006. b) Calculate the following: i. the dividend per share for BOTH years ii the EPS for year ended 31 December 2006 c) Comment briefly on the financial performance during year ended December2006. 2. A company is about to bring a new product to the market. The following budgeted data has been assembled: Direct material cost per unit 30 Direct labour cost per unit 20 Variable overhead cost per unit 40 Selling price per unit 150 Fixed overheads allotted to the product 400,000

a) b) c) d) e)

f) 3.

The first draft budgeted production and sales is 15,000 units. The maximum possible output is 20,000 units. TASKS Calculate the first draft budgeted profit. [3] Calculate the first draft budgeted break even point. [2] The marketing department have carried out some market research and are convinced that if an extra 60,000 was spent on marketing Sales would rise to 18,000 units. Calculate the profit. [3] It is thought that if the selling price is increased to 175 per unit it would only be possible to sell 13,500 units. Calculate the profit. [3] The production department think that by improving the quality and Packaging of the product by spending an extra 6 per unit making the Product, sales would rise to 18,000 units. The selling price would be kept at 150. Calculate the profit [3] Fully evaluate the above options. [6] The following information relates to Rollo Ltd and has been extracted from their books as at 28 February 2007: Turnover 2,900,000 Selling and distribution costs 250,000

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Taxation for the year 160,000 Stock at 01 03 06 360,000 Purchases 1,200,000 Stock at 28 02 07 380,000 Administration expenses 240,000 Interest paid 110,000 Proposed ordinary dividend 100,000 Issued ordinary share capital 1,000,000 Current market price per ordinary share 16 TASKS a) Prepare the profit and loss account for the year ended 28 February 2007 b) Calculate the following: i the gross profit to sales percentage ii the profit after tax to sales percentage iii the earnings per share (EPS) iv the PE ratio v the stock turnover period in days c) Comment on the financial performance via the use of ratios. 4. [5]

[10] [5]

Boris Ltd is considering investing in a project that has the following cash flows: 000 Initial investment 3,200 Cash flows: Year one 800 Year two 1,200 Year three 1,400 Year four 700 Year five 400 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year one .926 .917 .909 Year two .857 .842 .826 Year three .794 .772 .751 Year four .735 .708 .683 Year five .681 .650 .621 Year six .630 .596 .564 TASKS a) Calculate the payback period [2] b) Calculate the ARR (accounting rate of return). [2] c) Calculate the NPV (net present value). [4] d) Explain briefly if you think that the project is viable. [4] e) Explain why large firms often seek to grow larger by taking over or merging with a similar business. [8] Explain the following terms: a) Purchased goodwill b) Share capital c) Sale and leaseback d) Group accounts

5.

[5 each]

6. Capers Ltd. intends to commence business on 1 April 2007 with share capital of 250,000. On 1 April 2007 Capers Ltd. will also receive 40,000 in various grants from government and EU sources. Other Information: Capers Ltd. will spend 80,000 on machinery and office equipment on 1 April 2007. The following are the costs per unit: Direct material 7

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Direct wages Variable overhead 8 4 19

TASKS

The selling price will be 27 per unit. Capers Ltd. have agreed to pay rent of 30,000 per year payable monthly in arrears. Other fixed overheads are estimated to be 18,200 per month payable in arrears. This INCLUDES depreciation of 1,200. Budgeted production will be 10,000 units per month for the first three months, increasing to 11,000 units per month thereafter. Budgeted sales are estimated to be 8,000 units per month for the first three months, increasing to 11,000 per month thereafter. 50% of sales are to be on credit. Capers Ltd. will allow one months credit. 50% of sales are to be on a cash basis. The suppliers of direct material will allow one months credit. Direct wages costs will be paid in the month of production. Variable overheads will be paid for in the month following production.

a) Prepare the cash budget for Capers Ltd. for the period 1 April to 30 September 2007, clearly showing the budgeted cash balance at the end of each month. [10] b) Comment on the budgeted cash flow position of Capers Ltd. [5] c) Outline the potential sources of long-term finance available to Capers Ltd. [5] 7. Write notes on FOUR of the following: a) A rights issue b) An offer of shares to the general public c) Accounting standards d) gilt edged securities e) The principal benefits of budgetary control f) The potential dangers of high gearing g) The role of a central bank MAY 2007 FINANCIAL MANAGEMENT (ROI) 1. a) Explain the principal sources of long-term finance available to a multi-national company. b)

[5 each]

[10]

A company is experiencing short-term cash flow problems. The company has a good track record as regards profits, and is low geared. Explain how the company might go about solving the short-term cash flow position. [10] The following information relates to CAL Ltd. and has been taken from their books as at 30 April 2007: Turnover 1,450,000 Administration expenses 240,000 Cost of sales 450,000 Taxation for the year 110,000 Interest paid 22,000 Interest received 4,000 Distribution costs 182,000 Proposed dividends 60,000

2.

OTHER INFORMATION: There are 1,000,000 1 ordinary shares in issue. The market price of an ordinary share on 30 April 2007 was 4.60 per share.

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The total capital employed in the business on 30 April 2007 was 1,550,000. TASKS Prepare the profit and loss account of CAL Ltd. for the year ended 30 April 2007. [5] Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover v the operating profit to total capital employed percentage [2 each] Explain what a bonus issue of shares is. [5] Marstep Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,500 Cash flows: Year 1 600 Year 2 1,000 Year 3 1,100 Year 4 700 Year 5 300 The cost of capital is 8%.

a) b)

c) 3.

Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period (in years and months). [2] b) Calculate the ARR (accounting rate of return). [2] c) Calculate the NPV (net present value). [4] d) Explain briefly if you think that the project is viable. [4] e) Explain the benefits of using investment appraisal techniques in the allocation of large capital sums. [8] 4.a) Fully explain the synergetic benefits usually associated with a takeover. b) Explain the function of a stock exchange. [12] [8]

5.

a)

Prepare a cash flow statement from the following data: 000 Purchase of fixed assets 220 Tax paid 70 Equity dividends paid 80 Interest paid 40 Interest received 10 Long-term loan paid off 340 Issue of ordinary shares 500 Cash inflow from operating activities 130

[6] [8] [6]

b) Explain the disadvantages that a low gear company might suffer from during a sustained period of very low operating profits c) Explain the advantages of an existing company raising finance via a rights issue.

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6.

The following are the assets and liabilities of Narich Ltd. as at 30 April 2007: 000 Premises 900 Bank overdraft 180 Creditors 160 Goodwill 150 Debtors 410 Vehicles (net) 180 Ordinary share capital 800 Preference share capital 200 Share premium 140 Tax owing 90 Dividends owing 100 Equipment 490 Closing stock 270 Profit and loss account balance 420 Long-term loans 310 The following information has also been gathered: Credit sales 3,100 Opening stock 250 Purchases 1,400 TASKS a) Prepare the balance sheet of Narich Ltd. as at 30 April 2007 .[8] b) Calculate the following ratios: i current ii acid test iii the debtor collection period in days iv the rate of stock turnover [2 each] Comment briefly on the liquidity position of Narich Ltd. as at 30 April 2007 . Write notes on FOUR of the following: a) accounting standards b) the importance of monitoring working capital c) budgetary control d) the role of an auditor e) efficiency ratios f) the role of a management accountant g) IRR [4]

c) 7.

[5 each]

DECEMBER 2006 FINANCIAL MANAGEMENT 1.a) b) Explain the typical synergetic benefits gained by a company that acquires a major competitor. [8]

Explain the principal sources of long-term finance available to a multinational company. [12]

2. The following information relates to Sirus Ltd. and has been taken from their books as at 30 November 2006: Turnover 1,800,000 Administration expenses 450,000 Cost of sales 670,000

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Taxation for the year 100,000 Interest paid 20,000 Distribution costs 310,000 Proposed dividends 60,000 OTHER INFORMATION: There are 600,000 1 ordinary shares in issue. The market price of an ordinary share on 30 November 2006 was 6.20 per share. TASKS Prepare the profit and loss account of Sirus Ltd. for the year ended 30 November 2006. [5] Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the dividend cover [2 each] The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (80% of the shares) 22 Tangible assets 25 12 47 12 Current Assets Stock Debtors Bank 12 6 4 22 8 7 2 17

a) b)

c)

Current Liabilities Creditors Capital and reserves Ordinary share capital Profit and loss account balance TASK Construct the group balance sheet immediately after acquisition OR Explain the following terms: i Minority interest ii An associated company 3.a) b) 4.a) (9) 60 === 50 10 === [7] [4] [3] (5) 24 === 10 14 ===

Explain the principal purposes of using a budgetary control system. [12] Explain the process of raising finance via a new issue of shares. [8] Prepare a cashflow statement of a company called CRE plc for the year ended 30 November 2006 from the following data: 000 Purchase of new machinery 200 Purchase of new vehicles 90 Tax paid 130 Equity dividends paid 100 Proceeds from share issue 580 Repayment of long-term loans 250 Interest paid 30

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Interest received Investment income Cash inflow from operating activities b) 5 20 230 [5]

Comment on the cash flow position of CRE plc during the year ended 30 November 2006. [5] c) Explain a rights issue. [5] d) Explain the term contribution. [5] The following figures have been extracted from Horace Ltd.s accounts for the two years to 30 November 2006: 2006 2005 BALANCE SHEET CLOSING BALANCES: Stock 170,000 120,000 Debtors 350,000 190,000 Cash in bank 40,000 Creditors Bank overdraft Long-term loans Issued share capital Retained profit 230,000 50,000 600,000 500,000 260,000 210,000 300,000 500,000 210,000 [3] [3] [3] [5] [6]

5.

TASKS a) For BOTH years calculate the following: i the current ratio ii the acid test ratio iii the gearing percentage b) Comment on the liquidity position of Horace Ltd. c) Explain the importance of preparing and monitoring a cash budget.

6.a) Explain why a company will use investment appraisal techniques in the choice of allocating finance to potential investment projects. [10] b) Explain the potential sources of short-term finance available to a large company. [10] 7. Write notes on FOUR of the following: a) the principal role of a central bank b) company taxation c) gilt edged securities d) depreciation e) arbitrage f) currency hedging g) venture capitalists

[5 each]

SEPTEMBER 2006 FINANCIAL MANAGEMENT 1.a) b) 2. Explain the principal elements of a master budget. [10] Explain the principal sources of long-term finance available to a large international company. [10] The following information relates to FHB Ltd. and has been taken from their books as at 31 August 2006: Turnover 1,230,000 Administration expenses 190,000

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Cost of sales 380,000 Taxation for the year 90,000 Interest paid 20,000 Interest received 5,000 Distribution costs 175,000 Proposed dividends 50,000 OTHER INFORMATION: There are 1,000,000 1 ordinary shares in issue. The market price of an ordinary share on 31 August 2006 was 3.80 per share. The total capital employed in the business on 31 August 2006 was 1,350,000. TASKS a) Prepare the profit and loss account of FHB Ltd. for the year ended 31 August 2006. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover v the profit before tax to total capital employed percentage [2 each] c) Explain what a rights issue is. [5] 3. Rebet Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,400 Cash flows: Year 1 700 Year 2 1,100 Year 3 1,200 Year 4 800 Year 5 400 The cost of capital is 9%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS Calculate the payback period (in years and months). Calculate the ARR (accounting rate of return). Calculate the NPV (net present value). Explain briefly if you think that the project is viable. Explain the purpose of a breakeven chart. Explain briefly the role of venture capitalists. a) b) a) b) c)

a) b) c) d) e) f) 4. 5.

[2] [2] [4] [4] [4] [4]

Fully explain the synergetic benefits usually associated with a takeover. [12] Explain the function of a stock exchange. [8] Explain the role of accounting standards. Explain the importance of the audit function. Explain the term financial gearing. [8] [6] [6]

6.

The following are the assets and liabilities of EtNat Ltd. as at 31 August 2006: 000 Premises 750

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Bank overdraft Creditors Goodwill Debtors Vehicles (net) Ordinary share capital Preference share capital Share premium Tax owing Dividends owing Equipment Closing stock Profit and loss account balance Long-term loans 160 170 204 400 152 600 200 140 90 100 380 250 416 260

The following information has also been gathered: Credit sales 2,700 Opening stock 230 Purchases 1,240 TASKS a) Prepare the balance sheet of EtNat Ltd. as at 31 August 2006. b) Calculate the following: i current ratio ii iii iv acid test ratio the debtor collection period in days the rate of stock turnover

[8]

[2 each] [4]

c) Comment briefly on the liquidity position of EtNat Ltd. as at 31 August 2006. 7. Write notes on FOUR of the following: a) horizontal integration b) the importance of monitoring working capital c) a cash flow statement (FRS 1) d) limiting factors e) efficiency ratios f) the role of a management accountant g) IRR JUNE 2006 FINANCIAL MANAGEMENT 1.

[5 each]

The summarised financial statements of Gucki Ltd. for 2004 and 2005 were as follows: Gucki Ltd. balance sheets as at 31 December 2004 2005 000 000 000 000 Fixed assets at cost 12,000 17,000 Depreciation (6,000) 6,000 (8,000) 9,000 Current assets Stock Debtors Bank 8,000 10,000 4,000 -------22,000 -------11,000 9,000 7,000 -------27,000 --------

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Current liabilities Creditors Taxation Dividends

6,000 5,000 4,000 -------15,000 -------7,000 (2,000) -------11,000 -------8,000 3,000 -------11,000 --------

4,000 7,000 6,000 -------17,000 -------10,000 (4,000) -------15,000 -------9,000 6,000 -------15,000 --------

Working capital Long-term loans

Capital and reserves: Ordinary shares (1) Profit and loss account

Gucki Ltd. profit and loss account for the year ended 31 December 2005: 000 Operating profit 16,500 Interest paid (500) --------Profit before tax 16,000 Taxation (7,000) -------Profit after tax 9,000 Dividend (6,000) -------Retained profit 3,000 -------TASKS a) Prepare a cash flow statement for Gucki Ltd. for the year ended 31 December 2005.[10] b) Calculate the following for BOTH years: i the current ratio ii the acid test ratio[6] c) Comment briefly on the financial performance during 2005.[4] 2. A company is about to bring a new product to the market. The following budgeted data has been assembled: Direct material cost per unit 40 Direct labour cost per unit 25 Variable overhead cost per unit 50 Selling price per unit 200 Fixed overheads allotted to the product 600,000 The first draft budgeted production and sales is 11,000 units. The maximum possible output is 15,000 units. TASKS a) Calculate the first draft budgeted profit.[3] b) Calculate the first draft budgeted break even point.[2] c) The marketing department are convinced that if an extra 40,000 was spent on marketing, sales would rise to 14,000 units. Calculate the profit.[3] d) It is thought that if the selling price is increased to 220 per unit it would be possible to sell 10,000 units. Calculate the profit. [3]

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e) The production department think that by improving the quality and packaging of the product by spending an extra 5 per unit making the product, sales would rise to 14,500 units. The selling price would be kept at 200. Calculate the profit.[3] f) Fully evaluate the above options.[6] 3. The following information relates to Dormey Ltd. and has been extracted from their books as at 31 May 2006: Turnover 2,500,000 Selling and distribution costs 230,000 Taxation for the year 140,000 Stock at 01 06 05 350,000 Purchases 1,000,000 Stock at 31 05 06 390,000 Administration expenses 230,000 Interest paid 120,000 Proposed ordinary dividend 150,000 ------------Issued ordinary share capital 400,000 Current market price per ordinary share 30 TASKS a) Prepare the profit and loss account for the year ended 31 May 2006.[5] b) Calculate the following: i the gross profit to sales percentage ii the operating profit to sales percentage iii the earnings per share (EPS) iv the dividend payable per share v the price earnings ratio (PE ratio)[10] c) Explain the importance of monitoring financial performance via the use of ratios.[5] Vaughn Ltd. is considering investing in a project that has the following cash flows: 000 Initial investment 4,800 Cash flows: Year one 900 Year two 1,400 Year three 1,600 Year four 1,100 Year five 600 The cost of capital is 9%.

4.

Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year one .926 .917 .909 Year two .857 .842 .826 Year three .794 .772 .751 Year four .735 .708 .683 Year five .681 .650 .621 Year six .630 .596 .564 TASKS a) Calculate the payback period.[2] b) Calculate the ARR (accounting rate of return).[2] c) Calculate the NPV (net present value).[4] d) Explain briefly if you think that the project is viable.[4] e) Outline the potential sources of long-term capital available to Vaughn Ltd.[8] 5. Explain the following terms: a) A rights issue

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b) c) d) 6. Vertical integration Master budget Group accounts [5 each]

Mirzer Ltd. intends to commence business on 1 July 2006 with share capital of 180,000. On 1 July 2006 Mirzer Ltd. will also receive 30,000 in various grants from government and EU sources. Other Information: Mirzer Ltd. will spend 90,000 on fixed assets on 1 July 2006. The following are the costs per unit: 8 6 4 --18 -- The selling price will be 25 per unit. Mirzer Ltd. have agreed to pay rent of 40,000 per year payable quarterly in advance. Other fixed overheads are estimated to be 14,000 per month payable in arrears. Budgeted production will be 10,000 units per month for the first three months, increasing to 12,000 units per month thereafter. Budgeted sales are estimated to be 9,000 units per month for the first three months, increasing to 12,000 per month thereafter. All sales are to be on credit. Mirzer Ltd. will allow one months credit. The suppliers of direct material will allow one months credit. Direct wages costs will be paid in the month of production. Variable overheads will be paid for in the month following production. TASKS a) Prepare the cash budget for Mirzer Ltd. for the period 1 July to 31 December 2006, clearly showing the budgeted cash balance at the end of each month.[10] b) Comment on the budgeted cash flow position of Mirzer Ltd. [5] c) Outline the potential sources of short-term finance available to Mirzer Ltd.[5] Direct material Direct wages Variable overhead

7.

Write notes on FOUR of the following: a) international accounting standards b) an offer of shares to the general public c) a bonus issue of shares d) the functions of a stock exchange e) the principal contents of a balance sheet f) efficiency ratios g) minority interest[5 each]

MARCH 2006 FINANCIAL MANAGEMENT 1. a) The trend of international acquisitions and mergers continues. Explain the reasons for such takeovers/mergers.[12] b) Explain the following terms: i a rights issue ii underwriting fees[4 each] a) Prepare a cashflow statement of a company called LED plc for the year ended 31 March 2006 from the following data: 000 Purchase of new machinery 180

2.

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Purchase of new vehicles 80 Tax paid 110 Equity dividends paid 90 Proceeds from share issue 510 Repayment of long-term loans 370 Interest paid 40 Interest received 5 Investment income 15 Cash inflow from operating activities 190[5] Comment on the cashflow position of LED plc during year ended 31 March 2006.[5 Explain the purpose of accounting standards.[5] Explain the term break-even point.[5]

b) c) d) 3.

The following figures have been extracted from Jasper Ltd.s accounts for the two years to 31 March 2006: 2006 2005 Balance sheet closing balances: Stock 160,000 110,000 Debtors 340,000 180,000 Cash in bank 40,000 Creditors Bank overdraft Long-term loans 220,000 50,000 600,000 200,000 300,000

Issued share capital 500,000 500,000 Retained profit 250,000 200,000 TASKS a) For both years calculate the following: i the current ratio[3] ii the acid test ratio[3] iii the gearing percentage[3] b) Comment on the liquidity position of Jasper Ltd. [5] c) Explain the importance of maintaining safe levels of liquidity.[6] 4. The following information relates to Status Ltd. and has been taken from their books as at 31 March 2006: Turnover 1,400,000 Administration expenses 210,000 Cost of sales 480,000 Taxation for the year 100,000 Interest paid 20,000 Distribution costs 230,000 Proposed dividends 80,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 March 2006 was 11.20 per share. TASKS a) Prepare the Profit & Loss account of Status Ltd. for the year ended 31 March 2006. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the operating profit as a percentage of sales[2 each] c) The following are the simplified individual balance sheets of two companies P (the parent company) and S (the subsidiary company) immediately after acquisition: m m P S Fixed Assets Investments in S (70% of the shares) 18 -

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Tangible assets Current Assets Stock Debtors Bank 20 38 12 9 2 23 9 9 7 6 1 14

Current Liabilities Creditors Capital and reserves Ordinary share capital Profit & Loss account balance

(8) 53 === 40 13 53 ===

(3) 20 == 10 10 20 ===

TASK Construct the group balance sheet immediately after acquisition.[7] OR Explain the following terms: i Minority interest[4] ii An associated company[3] 5. 6. a) b) Explain the principal purposes of using a budgetary control system.[12] Explain the sources of short-term finance available to a large company. [8]

a) Explain why a company will use investment appraisal techniques in the choice of allocating finance to potential investment projects.[10] b) Explain the potential sources of long-term finance available to a large company.[10] Write notes on FOUR of the following: a) the principal role of a central bank b) company taxation c) gilt edged securities d) intangible fixed assets e) goodwill f) currency hedging g) venture capitalists[5 each]

7.

DECEMBER 2005 1. FINANCIAL MANAGEMENT a) Explain the principal sources of long-term finance available to a large PLC.[10] b) A company is facing short-term cash flow difficulties. The company is making good profits, has a good track record and has excellent long-term financing in place. Explain how the company might solve the short-term cash flow problems.[10] The following information relates to REB Ltd. and has been taken from their books as at 30 November 2005: Turnover 980,000 Administration expenses 160,000 Cost of sales 340,000 Taxation for the year 70,000 Interest paid 20,000 Distribution costs 155,000 Proposed dividends 40,000

2.

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OTHER INFORMATION: There are 400,000 1 ordinary shares in issue. The market price of an ordinary share on 30 November 2005 was 8.00 per share. The total capital employed in the business on 30 November 2005 was 720,000. TASKS a) Prepare the Profit & Loss account of REB Ltd. for the year ended 30 November 2005. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover v the operating profit to total capital employed percentage[2 each] c) Explain the term floatation costs.[5] 3. Eteinne Ltd is considering investing in a project which has the following cash flows: 000 Initial investment 2,100 Cash flows: Year 1 500 Year 2 900 Year 3 1,000 Year 4 800 Year 5 500 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% Year 0 1.000 1.000 Year 1 .926 .917 Year 2 .857 .842 Year 3 .794 .772 Year 4 .735 .708 Year 5 .681 .650 Year 6 .630 .596 TASKS a) Calculate the payback period (in years and months).[2] b) Calculate the ARR (accounting rate of return).[2] c) Calculate the NPV (net present value).[4] d) Explain briefly whether you think that the project is viable.[4] e) Explain the term marginal costing.[4] f) Explain the term absorption costing.[4] 4. a) b) 10% 1.000 .909 .826 .751 .683 .621 .564

c) 5. 6.

Explain the synergetic benefits usually associated with a takeover.[10] Gilt-edged securities are often referred to as: i shorts ii mediums iii longs Outline the meaning of these THREE descriptions.[2 each] Distinguish between a rights issue and a bonus issue.[4]

Budgetary control is at the centre of a firms management accounting system. Discuss.[20] The following are the assets and liabilities of RebEt Ltd. as at 30 November 2005: 000 Equipment (net) 280 Bank overdraft 110 Creditors 156 Goodwill 190 Debtors 412

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Vehicles (net) 140 Ordinary share capital 500 Preference share capital 200 Share premium 120 Tax owing 90 Dividends owing 100 Premises 700 Closing stock 224 Profit & Loss account balance 390 Long-term loans 280 TASKS a) Prepare the balance sheet of RebEt as at 30 November 2005.[8] b) Calculate the following ratios: i current c) d) 7. ii acid test[2 each] Comment briefly on the liquidity position of RebEt as at 30 November 2005.[4] Explain briefly the reasons for accounting standards.[4]

Write notes on FOUR of the following: a) gearing b) the importance of monitoring working capital c) a cash flow statement (FRS 1) d) fixed assets e) efficiency ratios f) the function of a stock market g) IRR [5 each] SEPTEMBER 2005 FINANCIAL MANAGEMENT

1. b)

a)

Explain the typical synergetic benefits gained by a company that acquires a major competitor. [12] Explain the following terms: i arbitrage ii the average cost of capital [4 each] The following information relates to AVCE Ltd. and has been taken from their books as at 31 August 2005: Turnover 1,120,000 Administration expenses 170,000 Cost of sales 460,000 Taxation for the year 90,000 Interest paid 25,000 Distribution costs 210,000 Proposed dividends 90,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 August 2005 was 4.90 per share.

2.

TASKS a) Prepare the Profit & Loss account of AVCE Ltd. for the year ended 31 August 2005. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend per share iv the interest cover

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v c) 3. the profit after tax to sales percentage Explain the term floatation costs. [2 each] [5]

REM Ltd is considering investing in a project, which has the following cash flows: 000 Initial investment 2,100 Cash flows: Year 1 700 Year 2 900 Year 3 1,100 Year 4 800 Year 5 400 The cost of capital is 8%. Extracts from NPV (DCF) tables: Rate of discount 8% 9% 10% Year 0 1.000 1.000 1.000 Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564

TASKS a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly whether you think that the project is viable. e) Explain why firms increasingly look at non-financial factors during the decision-making process. f) Explain the IRR investment appraisal method/technique. 4 .a) Explain the principal sources of long-term capital available to a very large international company. b) Explain the importance of Modigliani and Miller as regards capital structure and valuation. [10] 5.

[2] [2] [4] [4] [4] [4] [10]

a) Prepare a cashflow statement of a company called HUG plc for the year ended 31 August 2005 from the following data: 000 Purchase of new computers 120 Purchase of new vehicles 90 Tax paid 100 Equity dividends paid 80 Proceeds from share issue 420 Repayment of long-term loans 330 Interest paid 30 Interest received 5 Investment income 10 Cash inflow from operating activities 180 [5] Comment on the cashflow position of HUG plc during the year ended 31 August 2005 [5] Explain the purpose of a cashflow statement. Cashflow is more important than profitability. Discuss.

b) c) d)

[5] [5]

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6. The following figures have been extracted from VROOM Ltd.s accounts for the two years to 31 August 2005: 2005 2004 BALANCE SHEET CLOSING BALANCES: Stock 140,000 100,000 Debtors 350,000 190,000 Cash in bank 50,000 Creditors Bank overdraft Long-term loans 230,000 60,000 500,000 200,000 350,000

Issued share capital 500,000 500,000 Retained profit 300,000 250,000 TASKS a) For BOTH years calculate the following: i the current ratio [3] ii the acid test ratio [3] iii the gearing percentage [3] b) Comment on the liquidity position of VROOM Ltd. [5] c) Explain briefly why new businesses will often prefer to lease fixed assets rather than buy them. [6] 7. Write notes on FOUR of the following: a) the principal role of a central bank b) the importance of monitoring working capital c) gilt edged securities d) intangible fixed assets e) international accounting standards f) currency hedging g) venture capitalists JUNE 2005 FINANCIAL MANAGEMENT 1. a) Explain the principal sources of finance available to a large plc company. [9] b) Explain briefly the principal role of a stock exchange. [5] c) Explain briefly the following: i ii a rights issue a bonus issue [3 each]

[5 each]

2.

The following information relates to TLC Ltd. and has been taken from their books as at 31 May 2005: Turnover 990,000 Administration expenses 140,000 Cost of sales 370,000 Taxation for the year 40,000 Interest paid 20,000 Distribution costs 190,000 Proposed dividends 40,000 OTHER INFORMATION: There are 500,000 1 ordinary shares in issue. The market price of an ordinary share on 31 May 2005 was 6.00 per share. TASKS

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a) Prepare the Profit & Loss account of TLC Ltd. for the year ended 31 May 2005. [5] b) Calculate the following: i the EPS ii the PE ratio iii the dividend cover iv the interest cover v the operating profit to sales percentage [2 each] c) Outline the contents of a prospectus (re. a share issue). [5] 3. LBW Ltd is considering investing in a project that has the following cash flows: 000 Initial investment 3,800 Cash flows: Year 1 900 Year 2 1,200 Year 3 1,500 Year 4 900 Year 5 600

The cost of capital is 9%. Extracts from NPV (DCF) tables: Rate of discount 8% Year 0 1.000 Year 1 .926 Year 2 .857 Year 3 .794 Year 4 .735 Year 5 .681 Year 6 .630

9% 1.000 .917 .842 .772 .708 .650 .596

10% 1.000 .909 .826 .751 .683 .621 .564 [2] [2] [4] [4] [8] [10] [10]

TASKS a) Calculate the payback period (in years and months). b) Calculate the ARR (accounting rate of return). c) Calculate the NPV (net present value). d) Explain briefly if you think that the project is viable. e) Explain the process of project review and post audit. 4.a) Explain the synergetic benefits usually associated with a merger or takeover b) Explain the importance of managing working capital effectively 5.

Explain briefly the following: a) the Capital Asset Pricing Model b) The advantages of leasing high value and hi-tech equipment c) Arbitrage Pricing Theory d) The risk-return relationship

[5 each]

6.

The following are the assets and liabilities of Milo Ltd. as at 31 May 2005: 000 Long-term loans 160 1 preference share capital (6%) 300 1 ordinary share capital 500 Stock 280 Debtors 435 Goodwill 100 Dividends owing 100 Tax owing 140 Land and buildings 655

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Equipment 270 Creditors 135 Bank overdraft 80 Vehicles 170 Share premium 30 Profit & Loss account balance (31 05 05) 465 TASKS a) Prepare the balance sheet of Milo Ltd. as at 31 May 2005. b) Calculate the following: i the current ratio ii the acid test iii the gearing ratio c) Comment on the liquidity position of Milo Ltd. 7. Write notes on FOUR of the following: a) the beta factor b) the ASB c) the average cost of capital d) intangible assets e) efficiency ratios f) gilt-edged securities g) IRR h) budgetary control

[8]

[2 each] [6]

[5 each]

MARCH 2001 PART A: 1. The summarised accounts of Trusso Ltd are shown below Profit and loss account for the year ended: 31/1/00 31/1/01 000 000 Sales 2,661 3,219 Cost of goods sold (1,464) (1,674) Gross profit 1197 1545 Less expenses (997) (1191) Operating profit 200 354 Interest paid (20) (12) Net profit before tax 180 342 Corporation tax (36) (68) Net profit after tax 144 274 Dividends (50) (75) Retained profit 94 199 Summarized Balance sheet as at: 000 000 690 880 366 633 999 (175) (36) (50) (28) (289) (120) 1479 372 596 25 993 (186) (68) (75) (329) (65)

Fixed assets Current assets: Stock Debtors Bank Creditors due in one year Creditors and accruals Taxation Dividends owing Bank overdraft Creditors due in over one year Bank loan Net assets 1280

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Issued share capital Reserves Shareholders funds TASK: a) Calculate for both years i. Three profit ratios ii. Two liquidity ratios iii. Two efficiency ratios

800 480 1280

800 679 1479

b) Comment on the financial progress of Trusso Ltd during the year ended 31/12/01. 2. The following are the capital structures of two companies and their operating profits their first year of trading. COMPANY X 000 300 100 400 120 2 Y 000 1 ordinary shares 600 1 preference shares Debenture stock (10%) 200 Operating profit 120 Ordinary share price at year end 1.6 TASK: a) Calculate the commencing gearing ratio of each company b) Prepare Vertical schedules which show the interest payable, tax charge and preference dividends. Note: corporation tax is 20% of taxable profit. c) Calculate for both companies the EPS d) Calculate for both companies the PE ratio e) Comment briefly on the financial position of both companies from the standpoint of an ordinary shareholder. 3. Module Ltd is considering investing in a project which has the following budgeted cash flows: 000 Initial investment (1,200) Cash flows: Year 1 300 Year 2 500 Year 3 700 Year 4 600 Year 5 200 The cost of capital is 8%. DCF tables: Rate of discount 8% 9% 10% Year 1 .926 .917 .909 Year 2 .857 .842 .826 Year 3 .794 .772 .751 Year 4 .735 .708 .683 Year 5 .681 .650 .621 Year 6 .630 .596 .564 TASKS a) Calculate the payback period b) Calculate the Accounting rate of return c) Calculate the NPV d) Explain whether or not your would advise Module Ltd to invest in e project e) Explain the following terms: i. Risk free rate of interest ii. Risk adverse investor 4. a) Prepare a cash flow statement from the following data:

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Equity dividends paid Tax paid Cash outflow from operating activities Interest paid Purchase of premises Issue of equity shares Purchase of plant and equipment 36,000 30,000 58,000 10,000 120,000 274,000 100,000

b) Explain the principal sources of finance of long term capital available to a private Ltd company. c) Explain the term venture capital 5. a) Explain the following terms: i. Horizontal merger (or horizontal integration) ii. Vertical merger (or vertical integration) iii. Conglomerate merger (conglomerate integration) b) Explain the principal general reasons for mergers. 6. a) Explain the principal benefits of a successful budgetary control system b) Explain the following TWO terms: i. Break-even analysis ii. Contribution pricing 7. Write notes on four of the following i. CAPM ii. Flotation costs iii. Intangible assets iv. Lease financing v. Historic cost vi. Standard costing vii. Cash budget viii. Inflation.

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