# THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

FORMATION 1 EXAMINATION - AUGUST 2005 Time Allowed: 3 hours and 10 minutes to read the paper Answer 5 questions Only the first five questions answered will be marked. All questions carry equal marks.

1.

The battery production machine of Superior products will reach the end of its life in 2 years. The machine was purchased 5 years ago and can now be sold for 10,000. As the company’s financial accountant you are considering three options:

Option 1: Replace the machine now. A new machine can be purchased for 55,000. It has a life of 8 years, will require maintenance after 4 years at a cost of 10,000 and further maintenance after 6 years at a cost of 20,000. Option 2: Replace the machine after 1 year. In the meantime, the machine will require maintenance now of 5,000. Option 3: Replace the machine after 2 years. In the meantime, the machine will need maintenance now of 5,000 and 9,000 at the end of 1 year.
The company’s cost of capital is 12%. (For simplicity assume in all cases that the machine, at the end of year 8, can be sold for 5,000). You are asked to: (i) (ii) Set out the cash flows for the three options. (10 Marks)

Recommend the most appropriate action for the company based on the Net Present Value of the cash flows. (10 Marks) [Total 20 Marks]

2.

After the last census, the Department of the Environment carried out a survey of the age distributions of the population in Munster to collect data on the working population. The following data was obtained. You are asked to present a report on the data. Age Group 0 - 14 15 - 29 30 - 44 45 - 59 60 - 74 75 and over Total As part of your report: (i) (ii) Calculate the mean and standard deviation for each distribution. (10 Marks) Males (000s) 75 59 46 43 31 6 260 Females (000s) 72 58 47 48 41 14 280

Obtain a relative measure of dispersion for each distribution and explain the results obtained. (10 Marks) [Total 20 Marks]
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3.

In a recent customer study, Eircom found that the average time a customer spent on the internet was 49 minutes. In a previous study it was found that the standard deviation was 16 minutes and that the times were normally distributed. Using this information: (i) Estimate the probability that a customer will spend at least 60 minutes on the internet. (6 Marks) (ii) Estimate the probability that a customer will spend not more than 30 minutes on the internet. (6 Marks) For the 10% who spend most time on the internet, estimate the amount of time they spend on it. (8 Marks) [Total 20 Marks]

(iii)

4.

The main distributor of Quality Foods Supermarkets outlines the prices and values of bulk sales to the supermarkets in the following table: 1999 Price per 1,000 kgs Sales ( m) Price per 1,000kgs 2004 Sales ( m)

Flour Sugar Oil

142 156 192

384 468 768

180 160 225

540 640 900

From this information: (i) (ii) Calculate a Paasche index for 2004 prices using 1999 as the base year (=100). Outline your reason for using a Paasche index in preference to a Laspeyres Index. (10 Marks) (10 Marks) [Total 20 Marks]

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5.

The investment adviser to CPA accounting has been asked to deal with the problems which are set out below. Provide solutions to the following with details of your calculations. (i) The interest quoted to DIB Manufacturing Ltd. for a short term loan of 1 year by Electra Finance is 2.5% per month. Calculate the APR (annual percentage rate). (6 Marks) Find the first (Q1) and third (Q3) quartiles for the wages for 65 employees of DIB Ltd. as set out in the following table: (6 Marks) Wages 250 - 299 300 - 399 400 - 499 500 - 599 600 - 699 700 - 799 800 - 899 (iii) No. of employees 8 10 16 14 10 5 2

(ii)

DIB Ltd. estimates that it will have to spend 300,000 on new plant in 2 years from now. Current investment rates are a nominal 10%. Calculate the sum that should now be invested if compounding is at 6-monthly intervals. (8 Marks) [Total 20 Marks]

6.

At the Institute of Directors a paper was presented which discussed a wide range of quantitative methods. The following terms were used: (i) ‘the accountants role in investment appraisal’ (ii) ‘the interpretation of r in correlation analysis’ (iii) ‘differences between descriptive and inferential statistics’. Briefly set out your understanding of the above. [Total 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

FORMATION 1 EXAMINATION - AUGUST 2005 TUTORIAL CONTENT The objective of this subject is to examine students’ ability to manipulate quantitative and numerical data. It is directly related to other subjects in Formation 2 and the Professional Levels and provides an introduction to the quantitative areas. QUESTION 1 The purpose of the question was to outline, in chronological order, the cash flows for each option. This is generally an area of difficulty where students do not distinguish between ‘cash outflows’ and ‘cash inflows’ or incorrectly state them, thereby providing an incorrect solution to further elements of the question. To calculate the PV of each option it was necessary to tabulate the discount factors and apply to each cash flow. Some students provided the information in tabular format which was concise and intelligible. Others did not use this structure. Some students added the cash flows and applied 12 % compound interest for a period of 8 years. SOLUTION 1. (i) Outline of Cash Flows Col 1 Year Col 2 Discount Factor 12% 1 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 NPV 5,000 2,020 (59,480) (20,000) (10,140) (20,000) 5,000 (9,040) 2,020 (66,805) (20,000) 5,000 (8,080) 2,020 (68,002) (10,000) (6,360) (10,000) (5,670) (10,000) (5,070) Col 3 Option 1 New Col 4 PV of Option 1 Col 5 Option 2 Replace after 1 year (5,000) (55,000) Col 6 PV of Option 2 Col 7 Option 3 Replace after 2 years (5,000) (9,000) (55,000) Col 8 PV of Option 3

0 1 2 3 4 5 6 7 8

(55,000) 10,000

(45,000)

(5,000) (49,115)

(5,000) (8,037) (43,835)

The cash flows are set out in Cols 3, 5 and 7. Since the life span of the three options is different, the net value of the cash outflow would be calculated on an equivalent annual basis. For simplicity, a disposal value of the machine at the end of year 8 was taken. It should be noted that the maintenance took place 4 and 6 years after the machine was purchased in all three options. (ii) Net Present Value of cash flows. The present values of the cash flows are set out in cols 4, 6 and 8. Under the criterion set out, the option with the minimal cash flow is selected. In the present case, Option 1 is preferred.

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TUTORIAL CONTENT

QUESTION 2. This question sought the calculation of both the mean and the standard deviation. The mean was generally calculated correctly but a number of students were unable to calculate the standard deviation or attempted to do so without using the mean. There was obvious lack of practice in using formula provided to students in the ‘Statistical Formulae’ handout

SOLUTION 2. (i) Class Boundaries 0 - 14 15 - 29 30 - 44 45 - 59 60 - 74 75 - 79 ∑ Mean = Freq (f) 75 59 46 43 31 6 260 x = = Mid Point (x) 7.5 22.5 37.5 52.5 67.5 77.5 MALES fx 562.5 1327.5 1725.0 2257.5 2092.5 465.0 8430.0 ∑fx ∑f = = 8430.0 260 - x)2 = = (x – x) -24.92 -9.92 5.08 20.08 35.08 45.08 (x – x)2 621.0 98.40 25.81 403.21 1230.6 2032.2 f(x – x)2 46575.5 5805.98 1187.09 17337.87 38148.79 12193.24 121248.47 32.42 years

Standard deviation

σ

√ ∑ f (x
∑f

121248.47 260 = 21.59 0.666 =66.6%

= Co-efficient of variation =

√ 466.34
σ
X = 21.59 32.42

=

FEMALES Class Boundaries 0 - 14 Freq (f) 72 58 47 48 41 14 280 Mid Point (x) 7.5 22.5 37.5 52.5 67.5 77.5 fx 540.0 1305.0 1762.5 2520.0 2767.5 1120.0 10,015.0 (x – x) -28.77 -13.27 1.73 16.73 31.73 41.73 (x – x)2 799.19 176.09 2.99 279.9 1006.8 1742.4 f(x – x)2 57541.9 10213.4 140.7 13434.9 41278.5 2437 146988.9

15 - 29 30 - 44 45 - 59 60 - 74 75 - 79 ∑

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Mean =

x

=

∑fx ∑f

=

10,015.0 280

= 35.77 years

Standard deviation

=

σ

=

√ ∑ f (x
∑f

- x)2

=

146988.9 280

= Co-efficient of variation =

√ 524.96
22.91 35.77

= = =

22.91 0.6405 64.05%

σ
X

=

(ii)

In this case, we are comparing dispersions between series by using the co-efficient of variation. This measures the relative dispersion or spread between the distributions. The relative dispersion between the distributions in the present case is small – 66% for the males and 64% for the females. The standard deviation measures dispersion within each series but to measure relative dispersion we must also take the mean into account.

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TUTORIAL CONTENT QUESTION 3. The purpose of this question was to examine the knowledge of students in normalising data and their ability to use the Standard Normal Tables to determine probabilities. Often a request is made to provide probability diagrams to illustrate the data and the normalised values. This information is seldom provided in examinations and is a useful way for students to demonstrate their understanding. Some were able to derive the z score but were unable to progress further. This type of question appears to cause the greatest difficulty in examinations. SOLUTION 3. (i) In this case find P(x ≥ 60). At x = 60, z = x - µ where

σ

x = 60, µ = 49, therefore,

σ=

16; = 11 = 16 0.69;

z = 60 - 49 16

From the Normal Distribution tables, P(x ‹ 60) = 0.5000 + 0.2549 = 0.7549 P(x ≥ 60) = 1 - P(x < 60) = 1 - 0.7549 = 0.2451. The probability is 24.51%. In this case we find P(x ≤ 30) At x = 30, , z = 30 - 49 16 = 19 = 16 - 1.19;

(ii)

P(x ≤ 30) = 0.5000 - 0.3830 = 0.1170 The probability is 11.71%. In this case find the z score so that P(z ≥ z score) = 0.10 A z score of 1.28 cuts off 10% in the upper tail. Now solve for the corresponding value of x. 1.28 = x - 49 16 x = 49 + 16 x 1.28 = 69.48. Therefore, 10% of subscribers spend 69.48 minutes or more on the internet.

(iii)

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TUTORIAL CONTENT QUESTION 4. The objective was to determining if students understood the concept of indexes rather than injecting values into a formula. In order to derive the index it was necessary to determine the ‘quantities’ from the value of ‘sales’. A number used ‘sales’ in the Paasche Index unaware that ‘sales’ was not ‘Q’. This was a reminder to students that questions should be read in advance of attempting a solution.

SOLUTION 4. (i) 1999 Price per 1000 kgs Flour Sugar Oil 142 156 192 Sales ( m) 284 468 768 Price per 1000 kgs 180 160 225 2004 Sales (m) 540 640 900

We are given the price but not the quantities. To calculate both indexes we need to derive both Q0 and Qn. From the above data the Paasche and Laspeyres price indexes are calculated as follows: 1999 P0 Flour Sugar Oil 142 156 192 P0Q0 284 468 768 1520 Paasche Price Index: = Q0 2 3 4 Pn 180 160 225 2004 PnQn 540 640 900 2080 Qn 3 4 4 P0Qn 426 624 768 1818 PnQ0 360 480 900 1740

∑PnQn x 100 (current year quantities used as weights) ∑P0Qn 2080 x 100 1818 = 1.1441

=

Laspeyres Price Index: =

∑PoQ0 x 100 (base year quantities used as weights) ∑PoQ0 1740 x 100 1520 = 1.1447

=

(ii)

In the Laspeyres index base year weights are taken. This implies that the quantities bought do not vary over time. This is not correct in many cases. If a cost of living index is based on 1985 and one of the items included is product x, the index for 2004 would assume that we bought the same quantity as in 1985. But over this period there could have been a substantial increase in the price of this commodity resulting in a fall in demand. Because of this fall in quantity purchased the Laspeyres Index tends to overstate increases in price. Another problem is that tastes tend to change very markedly over a period of time so that weights that were appropriate for 1985 may not be appropriate for 2004 or today. For example the purchase of many consumer products or substitutes that were popular in 1985 may be reversed today. In an effort to overcome this problem, statisticians use current year quantities as weights. The approach here is different – it asks what is the total outlay in the base year if we bought current year quantities and compare this with current year outlay. In the particular case in part (i) there is insignificant difference in the indexes possibly due to the short time period involved.
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TUTORIAL COMMENT QUESTION 5. This was a multipart question containing elements from the financial mathematics section of the course and the descriptive statistics section. The objective was to ensure that students were familiar with elements of compounding and discounting and to understand the difference between APR and monthly / quarterly / biannual interest rates that can be charged. Some students used the ogive to derive the quartiles – acceptable alternative solution. SOLUTION 5. (i) The annual percentage rate (APR) is calculated by the following: APR = [1(1 + i)t - 1] x 100 where i = compound interest t = number of time periods. Therefore, APR = = = = (ii) Wages 250 - 299 300 - 399 400 - 499 500 - 599 600 - 699 700 - 799 800 - 899 No. of employees 8 10 16 14 10 5 2 65 Q1: The first quartile is the wage obtained by counting N/4 = 65/4 = 16.25 of the cases beginning with the first lowest class. Since the first class contains 8 cases, 8.25 cases must be taken from the 2nd class. Therefore, Q3: Q1 = 299.5 + 8.25/10 x 100 = 382 [1(1 + 0.025)12 - 1] x 100 (1.02512 - 1) x 100 0.3449 x 100 34.49%

The third quartile is obtained by taking 3/4 N = 3/4 (65) = 48.75 of the cases. Since the first four classes comprise 48 cases, 0.75 (48.75 - 48) of the 10 cases must be taken from the fifth class. Therefore, Q3 = 599.5 + 0.75/10 x 100 = 607

Both quartiles can be obtained easily from an ogive.

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(iii)

Since compounding is six monthly, the investment P must accrue to a value of monthly periods. The interest rate for each 6-monthly period is 5% (10%/2). Therefore, 300,000 P = = = P(1 + 0.05)4 300,000/1.054 300,000/1.2155 = 246,812

300,000 after four six-

This is the amount to be invested now.

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TUTORIAL COMMENT QUESTION 6. The objective of this question was to give students an opportunity to provide their broad understanding of aspects of the course. The main difficulty to solutions in examinations is the lack of qualitative knowledge in these areas and the extremely disjointed way in which the information is presented. Many attempts at this question were very inadequate and did not demonstrate an understanding of the sections / terms examined.

SOLUTION 6. (i) The Accountant’s role in investment appraisal. Because of the long-term nature of investments, the amounts of finance involved, investment decisions are taken by the senior management team. The management team is provided with all the data and an analysis of the financial implications of the decision and this is the primary task of the accountant. He/she collects the data, co-ordinates the estimates of the various functional specialists – marketing, production, human resources and adds his/her expertise in finance and taxation areas. The accountant then analyses the data using a range of appraisal techniques and presents the analysis to the management team. The accountant does not make the investment decision or take responsibility for the quality of the basic information. He/she performs an essential role in collating, analysing the data and presenting the appraisal. He/she also provides a range of analyses to test the sensitivity of the result to a range of variables and uncertainties such as unpredictable changes in cash flows, compare the expected returns with the investment, how the expected returns are measured and how the appraisal is carried out. As a key member of the senior management team, the accountant plays a key role in the team and is accepted as such because of the nature of his/her specialist expertise. In many cases of capital investments presentations are made to the executive or board of the company to gain approval for the expenditure. The accountant is the person who presents the proposal, answers the financial queries and is considered as the person who is marshalling the proposal through to completion.

(ii)

The interpretation of r in correlation analysis. The co-efficient of determination is denoted by r2. The square root of r2 is the co-efficient of correlation and is denoted by r. The correlation co-efficient is positive when the least squares line has an upward slope and negative when the line has a downward slope. When r equals +1, -1 or 0 there is no problem about the interpretation of r. It is +1, -1 when all the points fall on a straight line and it is zero when the fit of the least squares line is so poor that knowledge of x does not help in the prediction of y. In general, the definition of r tells us that 100r2 is the percentage of the total variation of the ys that is explained by, or is due to, their relationship with x. This is an important measure of the relationship between two variables; beyond this it permits valid comparisons of the strength of several relationships. There are several pitfalls in the interpretation of the co-efficient of correlation – it is often overlooked that r measures only the strength of linear relationships; a strong correlation does not necessarily imply a cause-effect relationship. If r is calculated indiscriminately the possibility of a gross error of measurement or an error in recording may be the case. Thus before we calculate r, we should plot the data to see whether there is reason to believe that the relationship is linear. The fallacy of interpreting a high value of r as an indication of a cause-effect relationship may be explained by both variables depending on the size of the population. The effect sometimes quoted is the high positive correlation between crime and the annual sales of chewing gum – both variables depend on the size of the population. It is this mutual relationship with a third variable (population size) that produces the positive correlation.

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(iii)

Differences between descriptive and inferential statistics. Governments and business organisations have used censuses and collected data to count persons and property and the problem of describing, summarising, analysing this data led to the development of methods that constituted the basic principles of ‘statistics’. These methods, which at first consisted primarily of presenting data in the form of tables and charts make up what is now called descriptive statistics. This includes anything done to data without attempting to infer anything that goes beyond the data themselves. For example if we performed tests on a range of cars (say 10) imported in 2004 and showed that each was able to accelerate for 0 to 60 miles per hour in different times (between 12 and 16 seconds) and we report that half of them accelerated from 0 to 60 mph in less that 16 seconds, this analysis belongs to the domain of descriptive statistics. It would also be the case if we gave an average acceleration for the cars and computed a standard deviation. Although descriptive statistics is an important branch of statistics much information arises from samples and this means that its analysis requires generalisations that go beyond the data. As a result, the most important feature has been a shift in emphasis from methods that describe to methods that make generalisations – a move from descriptive statistics to the methods of statistical inference. In many areas, business, medicine, government there are uncertainties because there is partial information and the methods of statistical inference are needed. Problems like these are treated with probability theory where methods are used that generalise from observed data. In general sampling is concerned with the collection of data from some defined population. The usefulness of this data however will depend on the sample design, method of measurement and the sampling error. If we want to be certain about our results we include all members of the population in our sample. However, this is unnecessary, time consuming and costly for most purposes and likely to give a level of accuracy not required. Therefore, statistical inference is concerned with the ways we use sample results to estimate or infer values for the population. A sample mean is used to estimate the population average. In assessing the sample results we write probability statements which gives a sampling error – this is a measurement of how close to the population value we expect the sample result to be.

MARKING SCHEME BUSINESS MATHEMATICS AND QUANTITATIVE METHODS

Q.1. (i)

The cash flow for each option was awarded 2 marks, the presentation of comparative cash flows in tabular format 4 marks (total 10 marks). The PV for each option was awarded 2 marks and the analysis / recommendation awarded 4 marks (total 10 marks).

(ii)

Grand total: 20 marks

Q.2. (i) (ii)

Mean and standard deviation for each distribution was awarded 5 marks (total 10 marks). The relative dispersion for each distribution was awarded 3 marks and 4 marks for analysis of the results (total 10 marks). Grand total: 20 marks

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Q.3. (i) (ii)

Calculation of z score, 3 marks; estimating the probability from Normal tables, 3 marks (total 6 marks) Calculation of z score, 3 marks – in this case the student had to deal with a negative z score; estimating the probability from Normal tables, 3 marks (total 6 marks) Reading the z score from the tables, 3 marks, and thereby using the normal transformation to find the value of x, 5 marks (total 8 marks).

(iii)

Grand total: 20 marks

Q.4. (i) (ii)

Deriving the value of Quantity for each year, 5 marks; calculating the index using the formula, 5 marks. Providing characteristics of Paasche Index, 4 marks; providing characteristics of Laspeyres Index, 4 marks; reason for using one in preference to another, 2 marks (total 10 marks).

Grand total: 20 marks

Q.5. (i) (ii) (iii)

Use of formula for APR, 3 marks; calculation of APR using the formula, 3 marks (total 6 marks). Deriving 1st quartile, 3 marks; deriving 3rd quartile, 3 marks (total 6 marks). Use of formula for compounding, setting out the number of periods (n) and the interest rate for each period i.e. 5%, 3 marks; calculating the investment using the data derived above, 5 marks (total 8 marks).

Grand total: 20 marks

Q.6. (i) (ii) (iii)

Required to provide information on accountants role with respect to investment appraisal, 6 marks Information on r and its interpretation, 6 marks Describe the nature and characteristics of both descriptive and inferential statistics, 8 marks

Grand total: 20 marks

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