FIN4001 Assessment Questions 1

FIN 4001 Introduction to Finance

Assessment Questions

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Question 1

(a) Comply or explain model

The comply or explain model of corporate governance is used as a regulatory approach in

the United Kingdom and some other European countries. This model dictates that rather than

setting stringent rules and regulations, a code of corporate governance is developed. Listed

companies either have to comply to this code, or in a case where they are not able to do so,

they have to explain why they are not complying with the code. Such a model allows

regulators to be able to set a minimum standard and then leave it on the companies

themselves and the stakeholders to determine what the compliance of a listed company

should be (Martin et al., 2008). This takes the responsibility away from the regulators and

gives it to the market environment around the company who gets to decide what should be

complied with and what should be disclosed to the public.

This develops a subset of the code of governance which is applicable to individual

companies on a case by case basis. This model rejects the thesis that all companies should be

made to follow a single set of code of corporate governance as each company will have its

own requirements of disclosures it has to make to the public. If the investors feel that the

company has deviated from the code and the disclosures do not meet their requirements or

that the explanations given are not adequate, they can choose to sell the shares. This creates a

sanction made and applied by the market rather than having one where the regulators are

imposing any legal sanctions on the company by themselves.

(b) Characteristics of filing

A company that is incorporated in the UK needs to file its financial statements with two

authorities. One of the filings has to take place with the Companies House which is tasked

with making sure that the company is compliant to its regulatory requirements and gets to
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apply the Companies Act on the companies. The other filing that has to take place is with the

London Stock Exchange where the share prices of the listed companies are quoted. Before

2013, the Financial Service Authority was tasked with regulating the financial services

market. Due to this, one of the responsibilities that it had to carry out was to oversee the

listing and financial reporting of the companies quoted on the stock exchange.

After April 2013, the Financial Service Authority was divided into two bodies namely

Financial Conduct Authority and Prudential Regulation Authority. The responsibilities of the

authority were also divided up between these two bodies. The purview of regulating the stock

exchange now lies with the Financial Conduct Authority and it has the task to make sure that

the interest of the financial industry is protected. This means that the consumers and investors

of the industry are protected and that the markets keep functioning properly with healthy

competition existing between the competitors who are operating in the industry.

The companies which have listed shares or listed forms of debt, the rules and regulations

dictating the filing of financial statements is set out in the Disclosure and Transparency Rules

which state that annual reports are required to be filed within 4 months after the year end of

the company has taken place. These rules are also applicable on companies which are

incorporated in the EU region where consolidated accounts have to be filed and the annual

reports must adhere to IFRS standards which are used in the European Union as opposed to

UK GAAP which are followed in the UK. In addition to this, companies which have a

premium listing of equity shares in the UK have to also report their application of UK

Corporate Governance Code which has to be attached with the financial statements of the

companies as well. Premium listings mean that the company is committed with meeting the

highest standards of regulation and corporate governance set out in the regulations which

allows the company to have access to capital at lower cost as they are practicing transparently

and see higher investor confidence.

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Question 2

(a) Payback Period Calculation

In order to find the payback period, the initial investments of both the projects has to be

seen. It can be seen that for the Edinburgh route the following structure will be created

£ 000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
Investmen
t
Franchise 8,700
fee
New buses 4,120
Inflows
Revenue 3,780 4,150 4,550 5,120 4,900
Scrap 110
buses
(12,820) 3,780 4,150 4,550 5,120 5,010

In order to find the payback period, it has to be seen when the initial investment made

by the company is earned back. The initial investment of £12,820,000 is earned back by

the company in 3.066 years or 3 years and 23 days. Similar analysis is carried out for the

Newcastle route and the following inflow and outflow structure is created

£ 000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial
Investmen
t
Franchise 7,950
fee
New buses 3,890
Inflows
Revenue 3,500 3,850 4,200 5,150 4,950
Scrap 95
buses
(11,840) 3,500 3,850 4,200 5,150 5,045
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In order to find the payback period, it has to be seen when the initial investment made

by the company is earned back. The initial investment of £11,840,000 is earned back by

the company in 3.056 years or 3 years and 20 days. The analysis shows that regardless of

the initial investment and the different inflows earned by the company, the payback

period is coming out to be similar between the two companies.

(b) Accounting Rate of Return

In order to find the accounting rate of return, the formula applied is as follows:

Accounting Rate of Return = Average Annual Profit / Initial Investment

The first step to carry out in order to find the accounting rate of return is to find the

average annual profit for the two companies. The annual profit is calculated by taking the

cash inflows for the year and subtracting depreciation from them. Based on the cost, scrap

value and life of the assets, the depreciation can be determined for the two companies. For the

Edinburgh route, the calculation will be as follows:

£ 000 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Inflow 3,780 4,150 4,550 5,120 4,900
Depreciation (802) (802) (802) (802) (802)
Annual Profit 2,978 3,348 3,748 4,318 4,098

Based on these annual profits, it can be seen that average annual profit is 3,698 and when

taken with the initial investment, the ARR comes out to be 28.85%. Similar calculations are

carried out for Newcastle on Tyne

£ 000 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Inflow 3,500 3,850 4,200 5,150 4,950
Depreciation (759) (759) (759) (759) (759)
Annual Profit 2,741 3,091 3,441 4,391 4,191
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Based on these annual profits, it can be seen that average annual profit is 3,571 and when

taken with the initial investment, the ARR comes out to be 30.16%

(c) Payback Method

The payback method is able to provide a manager with the knowledge on when the

company will be able to earn back its initial investment based on the cash inflows earned in

the future. This method is popular as it is easy to understand and calculate for the manager.

The amount of inputs required for the calculation of the payback period is low and it is easy

to calculate in comparison to the other capital budgeting tools that are available. Shorter

payback periods show that a project is low risk and managers prefer projects which are able

to earn back the investment in a short period of time. In terms of the disadvantages, it is seen

that the method ignores the concept of time value of money. This leads to a distortion of

value of cash flows that are earned (Bierman and Smidt, 2012). The payback method also

considers only cash flows that are earned till the payback condition is met. Any cash flows

earned after that time are ignored and are not taken into account. Another limitation is the

fact that this method is seen as being unrealistic. Business environments do not have the

scenarios that are considered by this method and investments are not just made one time.

Lastly, this method also does not take into account profitability.

(d) IRR Method

When a company is looking to invest in a project, it is important for the company to

understand the risk and return that the project will entail. In terms of the advantages of IRR, it

is seen that IRR takes time value of money into account which sees the value of a dollar as

being higher currently compared to a date in the future. IRR is also simple to interpret and

understand as the decision rule used in IRR is that if IRR is higher than the cost of capital, the

project is accepted otherwise it is rejected. The disadvantages of this method are that it
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ignored economies of scale and assumes that the increase in size of the company will have no

impact on the cost structure of the company. In addition to that, it assumes that the

reinvestment rate will remain the same and will not change which is unrealistic. The method

becomes useless if there is a mix of positive and negative cash flows over the life of the

project. It can also be that if the cash inflows are not able to cover the initial cost, the IRR is

not calculated at all and increase in wealth of the company cannot be calculated by IRR

which is possible in the NPV method.

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Question 3

(a) Contribution and CVP techniques

Contribution is an importance concept as it allows a manager to be able to carry out Cost

Volume Price analysis. Contribution is seen as the difference between the selling price of a

product and the variable cost per unit associated with that product. It is helpful for a manager

as it allows the manager to determine breakeven quantities, values and levels that will be

required by the company based on its fixed costs. The goal of CVP technique is to aid the

manager in being able to determine the output levels that the company needs to produce

where it is able to cover all of its costs and with the use of contribution, a manager is able to

do that.

(b) Use of CVP technique for dropping a product or special order

CVP technique allows a manager to be able to make a decision based on how the product

or service being provided can be carried out into the future. A manager uses CVP technique

to see how much contribution a product or service is adding to the profitability of a company.

Fixed costs are costs which are incurred and carried out regardless of the fact that the

company carries out production or not. Variable costs, however, are linked to the production

of a product or supply of a service (Guidry, Horrigan and Craycraft, 1998). Any product

which is yielding a negative contribution means that the variable costs of production are more

than the selling price. In case of a negative contribution, it will be better for a company to

discontinue the product as it is accumulating costs in the long run. If the contribution is

positive but the company is making a loss on the product due to fixed costs, it might still be

reasonable and feasible to continue production as the contribution is covering the variable

costs and contributing something towards the fixed costs as well.

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Due to this fact, it will be better to continue production. Sometimes, customers ask for

special orders where the price is discounted as the demand for the product increases. The

manager can again use CVP techniques to see whether he has additional capacity which can

be used for this purpose. If the additional capacity is present and the amount of contribution

added after the quantity of special order is taken into account, the manager should take the

special order.

(c) Limitations of CVP technique

CVP techniques are used by companies in order to make a decision regarding quantity of

production, cost and price levels as the company is impacted by fixed costs, variable costs

and selling price of the product. CVP techniques are used in managerial accounting as they

allow a manager to manage the day to day operations of the company. The CVP analysis does

have certain limitations in regards to its application as it takes into account a small time

period and the analysis is marginal in nature. The assumptions being made regarding stable

costs and revenue per unit means that only small deviations can be accounted for and when

large deviations do take place, the analysis becomes useless. This is due to the fact that costs

and prices change in the long run and all costs become variable costs in a large time frame.

In addition to that, it is difficult to identify costs as being rather fixed or variable and it is

difficult to categories costs which have both a fixed and variable component. Fixed costs are

also unlikely to stay constant over time as there is a tendency for all costs to change. Another

limitation of the analysis is that the analysis works for the range that was specified in the

beginning. If the variables go outside that range, the analysis becomes meaningless. The

analysis assumes that only production has an impact on the costs, however, factors like

inflation, efficiency, capacity and technology also have a significant impact on costs. It is
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also assumed that the sales mix in terms of product range and prices remains same when the

market demand level will dictate how the products are sold and marketed.
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Question 4

(a) Opening statement of Financial Position

The opening statement of the financial position of the company will look like this at the

start of the year on July 20X5

Fashion Clothing
Statement of Financial Position
As at 1st July 20X5
£ £ £
Non-current assets      
Tangible non-current assets     150,000
     
Current Assets      
Bank     50,000
     
Total Assets     200,000
     
Financed by:      
Capital     200,000
     
Total Capital plus liabilities     200,000

(b) Forecasted Monthly Cash Budget

In order to make the forecasted cash budget, the first task is to take the cash inflows

and outflows into account. The cash inflows for the company for the respective months were

from sales receipts which will be accounted for first. The next step is to take the cash

outflows which include the payment for materials as provided. The labor expenses are

divided over the 6 months to find the monthly cash outflows (Lerner, 1968). In terms of the

other expenses, the depreciation expense which has been given is a non cash expense. It is

taken into consideration when profit is calculated and it is deducted from cash outflows as it

will not be paid out of cash. The remaining figure of £330,000 is divided over the 6 months.

Lastly, the tax bill will be paid in December 20X5 which has been taken into account as well.
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The net cash change is calculated and then the cash balance at the start of year is taken which

was £50,000. The closing balance for each month is calculated and the cash budget forecast is

prepared. The amount of cash at the bank is seeing to be negative throughout the 6 months

which shows the amount of overdraft facility that will be availed by the company from the

bank.

£ July August Septembe October November Decembe

r r

Cash Inflows
Sales receipt
150,00 120,000 150,000 210,000 260,000 285,000
0

Total Inflows
150,00 120,000 150,000 210,000 260,000 285,000
0
Cash outflows
Payment for materials
120,00 100,000 60,000 60,000 60,000 60,000
0
Labour expenses
80,000 80,000 80,000 80,000 80,000 80,000
Other expenses
55,000 55,000 55,000 55,000 55,000 55,000
Tax bill
20,000

Total Outflows
255,00 235,000 195,000 195,000 195,000 215,000
0

Net change in cash - - -

105,00 115,000 45,000 15,000 65,000 70,000
0
Cash at beginning of - - - - -
month 50,000 55,000 170,000 215,000 200,000 135,000
Cash at end of month - - - - - -
55,000 170,000 215,000 200,000 135,000 65,000

(c) Expense unaccounted for

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One of the expenses that has not been taken into account is the interest expense that

will be charged by the bank on the overdraft facility. It can be seen that the company will be

availing overdraft facility from July till December 20X5, however, no expense for interest

has been taken into account. A more accurate budget forecast would take this expense into

account as it will be charged by the bank and will have to be paid by the company.
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References

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of

investment projects. Routledge.

Guidry, F., Horrigan, J.O. and Craycraft, C., 1998. CVP analysis: a new look. Journal of

Managerial Issues, pp.74-85.

Lerner, E.M., 1968. Simulating a cash budget. California Management Review, 11(2), pp.79-

86.

Martin, L.M., Warren‐Smith, I., Scott, J.M. and Roper, S., 2008. Boards of directors and

gender diversity in UK companies. Gender in Management: An International Journal.