Past Papers YEAR 3 PDF

UNIVERSITY OF NAIROBI
Department of Management Science and Project Planning

DMS 311 CAT 1 15th March 2022 Time 1hr 30 Min
Attempt all questions
QUESTION ONE (30 marks)
Kabete paints is a privately owned company specializing in the production of paints. The selling prices and the associated
unit variable costs for two of its most popular brands Orange and United paints are shown in the Table below.
Paint type Selling price (Ksh) per litre Unit Variable Cost (Ksh) per
Litre
United 3.25 2.25
Orange 4 2.5
The company package the paint in four-liter containers. Each container of United Paint requires six minutes of skilled
labour while Orange Paints requires 12 minutes of skilled labor. In a given day, there are 40 skilled men working on
average 10 hours. In addition, there are 100 milliliters of an important blending chemical available each day, where each
container of United Paint needs 0.05millilitres while each container of Orange Paint requires 0.02 milliliters of the
blending chemical. The processing capacity at the plant is limited to 3,000 containers of paints per day.
The company is committed to supplying a leading retailer with 5,000 containers of United Paint and 2,500 containers of
Orange Paint each working week consisting of 5 days. In addition, there is an agreement with the union that at least 2,000
containers are produced each day. The company management would like to determine the daily production volume of each
of the two paints that will maximize total contribution.
Required
a) Develop a linear model of the production problem facing the company

b) Using a graphical approach, determine the optimum daily production plan and the consequent contribution
c) The union is pressing for an overtime wage rate of Ksh 20 per hour above the wage rate for skilled labor.
i. Is this a profitable possibility or not? Show your workings
ii. If it was profitable to pay the overtime, how many overtime hours per day would it be worth employing?
d) In the original problem (where overtime is not contemplated), determine the maximum range of variation in the
unit contribution figure on a container of Orange paint for the original solution to remain optimal.
QUESTION TWO (25 marks)

Campaign time is with us and Vpower airline LTD was established late last year to offer flight services across the country
to campaign teams. The company has a total of six aircraft of different types as shown in Table 1. For a given journey,
variable costs are computed based on the distance flown and the number of passengers being carried. Fixed costs are then
added to obtain the relevant total cost. The operating costs and passenger-carrying capacities details are shown in Table
1.
Aircraft No. of Aircraft operating costs (Ksh) Aircraft

type aircrafts Fixed cost Variable cost passenger-
per day Per KM Per carrying capacity
passenger
Turbo 3 10000 70 400 10
Fighter 2 8000 50 350 8
Jet 1 5000 110 250 4
Table 1
As you know, weekends are popular campaign days. Consequently, the company has to transport 5 different groups of
passengers from Nairobi to their campaign destinations. The number of passengers for each group and the distance to
each destination is shown in Table 2.
Passengers G1 G2 G3 G4 G5
group
Number of 10 2 8 5 3
passengers
Distance 300 600 300 350 500
(KM)
Table 2
The distances given in Table 2 are direct from Nairobi to each of the group’s destination. To minimize its risk exposure, the
company drops the passengers and returns backs immediately, thus in each case, the aircraft fly back empty. Consequently,
mileage costs will be incurred on both the outward and return journeys while the passenger variable cost is only on the
outward journey. All five return journeys can be completed within one Saturday and each aircraft can only fly one group
(remember the groups belong to different political camps). In addition, a group cannot be divided up and be carried in
different aircrafts.
Required
a) Using an appropriate Operation Research Model, determine which aircraft should be used for transportation of each
group in order to minimize total cost. 17 marks
b) What is the total cost of making the five deliveries? 5 marks
c) Determine if there is an alternate optimal solution 3 marks
QUESTION THREE (25 marks)
Consider a transportation problem in which the initial solution given below was arrived at through the least cost
method.
Required: Determine the optimal solution

Chapter 12 (11ed-11)
Cash Flow Estimation
and Risk Analysis
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated
MBA. The production line would be set up in unused space in Shrieves’ main plant. The
machinery’s invoice price would be approximately $200,000; another $10,000 in shipping
charges would be required; and it would cost an additional $30,000 to install the
equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a
special tax ruling which places the equipment in the MACRS 3-year class. The machinery
is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for four years at an
incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be
sold for $200 in the first year. The sales price and cost are expected to increase by 3% per
year due to inflation. Further, to handle the new line, the firm’s net operating working
capital would have to increase by an amount equal to 12% of sales revenues. The firm’s
tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent.
a. Define “incremental cash flow.”
Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the
project.
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we
apply the 10 percent cost of capital discount rate, hence including financing flows
would be "double counting." Put another way, if we deducted capital costs in the
table, and thus reduced the bottom line cash flows, and then discounted those CFS by
the cost of capital, we would, in effect, be subtracting capital costs twice.
a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Mini Case: 11 - 1
Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purposes. Since, it is a sunk cost, it should not be
included in the analysis.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000 a
year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this
project, it would forgo the opportunity to receive $25,000 in annual cash flows. This
represents an opportunity cost to the project, and it should be included in the analysis.
Note that the opportunity cost cash flow must be net of taxes, so it would be a
$25,000(1 - t) = $25,000(0.6) = $15,000 annual outflow.
a. 4. Finally, assume that the new product line is expected to decrease sales of the
firm’s other lines by $50,000 per year. Should this be considered in the analysis?
If so, how?
Answer: If a project affects the cash flows of another project, this is an "externality" which
must be considered in the analysis. If the firm's sales would be reduced by $50,000,
then the net cash flow loss would be a cost to the project. Note that this annual loss
would not be the full $50,000, because Shrieves would save on cash operating costs if
its sales dropped. Note also that externalities can be positive as well as negative.
b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis?
Answer: Get the depreciation rates from table 11-2 in the book. Note that because of the half-
year convention, a 3-year project is depreciated over 4 calendar years:
YEAR RATE  BASIS = DEPRECIATION

1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
$240
Mini Case: 11 - 2
c. Calculate the annual sales revenues and costs (other than depreciation). Why is
it important to include inflation when estimating cash flows?
Answer: With an inflation rate of 3%, the annual revenues and costs are:
Year 1 Year 2 Year 3 Year 4

Units 1250 1250 1250 1250
Unit Price $200.00 $206.00 $212.18 $218.55
Unit Cost $100.00 $103.00 $106.09 $109.27
Sales $250,000 $257,500 $265,225 $273,188

Costs $125,000 $128,750 $132,613 $136,588
The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other
words, it is larger than the real cost of capital. Similarly, nominal cash flows (those
that are inflated) are larger than real cash flows. If you discount the low, real cash
flows with the high, nominal rate, then the resulting NPV is too low. Therefore, you
should always discount nominal cash flows with a nominal rate, and real cash flows
with a real rate. In theory, you could do either way and get the correct answer.
However, there is no accurate way to convert a nominal cost of capital to a real cost.
Therefore, you should inflate cash flows and then discount at the nominal rate.
Here are the annual operating cash flows (in thousands of dollars):
1 2 3 4
Net Revenues $125 $125 $125 $125
Depreciation 79 108 36 17
Before-Tax Income $ 46 $ 17 $ 89 $108
Taxes (40%) 18 7 36 43
Net Income $ 28 $ 10 $ 53 $ 65
Plus Depreciation 79 108 36 17
Net Operating CF $107 $118 $ 89 $ 82
Mini Case: 11 - 3
d. Construct annual incremental operating cash flow statements.
Answer:
Sales $250,000 $257,500 $265,225 $273,188
Costs $125,000 $128,750 $132,613 $136,588
Depreciation $79,200 $108,000 $36,000 $16,800
Op. EBIT $45,800 $20,750 $96,612 $119,800
Taxes (40%) $18,320 $8,300 $38,645 $47,920
NOPAT $27,480 $12,450 $57,967 $71,880
Depreciation $79,200 $108,000 $36,000 $16,800
Net Operating CF $106,680 $120,450 $93,967 $88,680
e. Estimate the required net operating working capital for each year, and the cash
flow due to investments in net operating working capital.
Answer: The project requires a level of net operating working capital in the amount equal to
12% of the next year’s sales. Any increase in NOWC is a negative cash flow, and
any decrease is a positive cash flow.
Year 0 Year 1 Year 2 Year 3 Year 4

Sales $250,000 $257,500 $265,225 $273,188
NOWC (% of sales) $30,000 $30,900 $31,827 $32,783 $0
CF due to NOWC) ($30,000) ($900) ($927) ($956) $32,783
f. Calculate the after-tax salvage cash flow.
Answer: When the project is terminated at the end of year 4, the equipment can be sold for
$25,000. But, since it has been depreciated to a $0 book value, taxes must be paid on
the full salvage value. For this project, the after-tax salvage cash flow is:
Salvage Value $25,000

Tax On Salvage Value (10,000)
Net After-Tax Salvage Cash Flow $15,000
Mini Case: 11 - 4
g. Calculate the net cash flows for each year? Based on these cash flows, what are
the project’s NPV, IRR, MIRR, and payback? Do these indicators suggest that
the project should be undertaken?
Answer: The net cash flows are:

Initial Outlay ($240,000)
Operating Cash Flows $106,680 $120,450 $93,967 $88,680
CF Due To NOWC ($30,000) ($900) ($927) ($956) $32,783
Salvage Cash Flows $15,000
Net Cash Flows ($270,000) $105,780 $119,523 $93,011 $136,463
NPV = $88,030
IRR = 23.9%
MIRR = 18.0%
Payback = 2.5
h. What does the term “risk” mean in the context of capital budgeting, to what
extent can risk be quantified, and when risk is quantified, is the quantification
based primarily on statistical analysis of historical data or on subjective,
judgmental estimates?
Answer: Risk throughout finance relates to uncertainty about future events, and in capital
budgeting, this means the future profitability of a project. For certain types of
projects, it is possible to look back at historical data and to statistically analyze the
riskiness of the investment. This is often true when the investment involves an
expansion decision; for example, if Sears were opening a new store, if Citibank were
opening a new branch, or if GM were expanding its Chevrolet plant, then past
experience could be a useful guide to future risk. Similarly, a company that is
considering going into a new business might be able to look at historical data on
existing firms in that industry to get an idea about the riskiness of its proposed
investment. However, there are times when it is impossible to obtain historical data
regarding proposed investments; for example, if GM were considering the
development of an electric auto, not much relevant historical data for assessing the
riskiness of the project would be available. Rather, GM would have to rely primarily
on the judgment of its executives, and they, in turn would have to rely on their
experience in developing, manufacturing, and marketing new products. We will try to
quantify risk analysis, but you must recognize at the outset that some of the data used
in the analysis will necessarily be based on subjective judgments rather than on hard
statistical observations.
Mini Case: 11 - 5
i. 1. What are the three types of risk that are relevant in capital budgeting?
2. How is each of these risk types measured, and how do they relate to one
another?
Answer: Here are the three types of project risk:
 Stand-alone risk is the project’s total risk if it were operated independently. Stand-
alone risk ignores both the firm’s diversification among projects and investors’
diversification among firms. Stand-alone risk is measured either by the project’s
standard deviation of NPV (σNPV) or its coefficient of variation of NPV (CVNPV).
Note that other profitability measures, such as IRR and MIRR, can also be used to
obtain stand-alone risk estimates.
 Within-firm risk is the total riskiness of the project giving consideration to the firm’s
other projects, that is, to diversification within the firm. It is the contribution of the
project to the firm’s total risk, and it is a function of (a) the project’s standard
deviation of NPV and (b) the correlation of the projects’ returns with those of the rest
of the firm. Within-firm risk is often called corporate risk, and it is measured by the
project’s corporate beta, which is the slope of the regression line formed by plotting
returns on the project versus returns on the firm.
 Market risk is the riskiness of the project to a well-diversified investor, hence it

considers the diversification inherent in stockholders’ portfolios. It is measured by
the project’s market beta, which is the slope of the regression line formed by plotting
returns on the project versus returns on the market.
i. 3. How is each type of risk used in the capital budgeting process?
Answer: Because management’s primary goal is shareholder wealth maximization, the most
relevant risk for capital projects is market risk. However, creditors, customers,
suppliers, and employees are all affected by a firm’s total risk. Since these parties
influence the firm’s profitability, a project’s within-firm risk should not be
completely ignored.
Unfortunately, by far the easiest type of risk to measure is a project’s stand-alone
risk. Thus, firms often focus on this type of risk when making capital budgeting
decisions. However, this focus does not necessarily lead to poor decisions, because
most projects that a firm undertakes are in its core business. In this situation, a
project’s stand-alone risk is likely to be highly correlated with its within-firm risk,
which in turn is likely to be highly correlated with its market risk.
Mini Case: 11 - 6
j. 1. What is sensitivity analysis?
Answer: Sensitivity analysis measures the effect of changes in a particular variable, say
revenues, on a project’s NPV. To perform a sensitivity analysis, all variables are
fixed at their expected values except one. This one variable is then changed, often by
specified percentages, and the resulting effect on NPV is noted. (One could allow
more than one variable to change, but this then merges sensitivity analysis into
scenario analysis.)
j. 2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital
for the project. Assume that each of these variables can vary from its base case,
or expected, value by plus and minus 10, 20, and 30 percent. Include a
sensitivity diagram, and discuss the results.
Answer: The sensitivity data are given here in tabular form (in thousands of dollars):
NPV Deviation From Base Case

Deviation
From Units
Base Case WACC Sold Salvage
-30% $113,288 $16,668 $84,956
-15% $100,310 $52,348 $86,493
0% $88,030 $88,030 $88,030
15% $76,398 $123,711 $89,567
30% $65,371 $159,392 $91,103
Range 47,916 176,060 6,147
We generated these data with a spreadsheet model in the file ch 11 mini case.xls.
Mini Case: 11 - 7
WACC
Sensitivity Analysis Units Sold
Salvage
$180,000
$160,000
$140,000
$120,000
$100,000
NPV
$80,000
$60,000
$40,000
$20,000
$0
-40% -20% 0% 20% 40%
Deviation from Base-Case Value
A. The sensitivity lines intersect at 0% change and the base case NPV, $81,573.
Since all other variables are set at their base case, or expected values, the zero
change situation is the base case.
B. The plots for unit sales and salvage value are upward sloping, indicating that
higher variable values lead to higher NPVs. Conversely, the plot for cost of
capital is downward sloping, because a higher cost of capital leads to a lower
NPV.
C. The plot of unit sales is much steeper than that for salvage value. This indicates
that NPV is more sensitive to changes in unit sales than to changes in salvage
value.
D. Steeper sensitivity lines indicate greater risk. Thus, in comparing two projects,
the one with the steeper lines is considered to be riskier.
Mini Case: 11 - 8
j. 3. What is the primary weakness of sensitivity analysis? What is its primary
usefulness?
Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect
the effects of diversification and (2) that it does not incorporate any information about
the possible magnitudes of the forecast errors. Thus, a sensitivity analysis might
indicate that a project’s NPV is highly sensitive to the sales forecast, hence that the
project is quite risky, but if the project’s sales, hence its revenues, are fixed by a long-
term contract, then sales variations may actually contribute little to the project’s risk.
It also ignores any relationships between variables, such as unit sales and sales price.
Therefore, in many situations, sensitivity analysis is not a particularly good indicator
of risk. However, sensitivity analysis does identify those variables which potentially
have the greatest impact on profitability, and this helps management focus its
attention on those variables that are probably most important.
k. Assume that Sidney Johnson is confident of her estimates of all the variables that
affect the project’s cash flows except unit sales and sales price: if product
acceptance is poor, unit sales would be only 900 units a year and the unit price
would only be $160; a strong consumer response would produce sales of 1,600
units and a unit price of $240. Sidney believes that there is a 25 percent chance
of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent
chance of average acceptance (the base case).
k. 1. What is scenario analysis?
Answer: Scenario analysis examines several possible situations, usually worst case, most likely
case, and best case. It provides a range of possible outcomes.
Mini Case: 11 - 9
k. 2. What is the worst-case NPV? The best-case NPV?
k. 3. Use the worst-, most likely, and best-case NPVs and probabilities of occurrence
to find the project’s expected NPV, standard deviation, and coefficient of
variation.
Answer: We used a spreadsheet model to develop the scenarios (in thousands of dollars),
which are summarized below:
Scenario Probability Unit Sales Unit Price NPV
Best Case 25% 1600 $240 $278,965

Base Case 50% 1250 $200 $88,030
Worst Case 25% 900 $160 ($48,514)
Expected NPV = $101,628

Standard Deviation = $75,684
Coefficient Of Variation =
Std Dev / Expected NPV = 0.74
Mini Case: 11 - 10
l. Are there problems with scenario analysis? Define simulation analysis, and
discuss its principal advantages and disadvantages.
Answer: Scenario analysis examines several possible scenarios, usually worst case, most likely
case, and best case. Thus, it usually considers only 3 possible outcomes. Obviously
the world is much more complex, and most projects have an almost infinite number
of possible outcomes.
Simulation analysis is a type of scenario analysis which uses a relatively powerful

financial planning software such as interactive financial planning system (IFPs) or
@risk (a spreadsheet add-in). Simple simulations can also be conducted with other
spreadsheet add-ins, such as Simtools. Here the uncertain cash flow variables (such as
unit sales) are entered as continuous probability distribution parameters rather than as
point values. Then, the computer uses a random number generator to select values for
the uncertain variables on the basis of their designated distributions. Once all of the
variable values have been selected, they are combined, and an NPV is calculated. The
process is repeated many times, say 1,000, with new values selected from the
distributions for each run. The end result is a probability distribution of NPV based
on a sample of 1,000 values. The software can graph the distribution as well as print
out summary statistics such as expected NPV and σNPV. Simulation provides the
decision maker with a better idea of the profitability of a project than does scenario
analysis because it incorporates many more possible outcomes.
Although simulation analysis is technically refined, its usefulness is limited because

managers are often unable to accurately specify the variables’ probability
distributions. Further, the correlations among the uncertain variables must be
specified, along with the correlations over time. If managers are unable to do this
with much confidence, then the results of simulation analyses are of limited value.
Recognize also that neither sensitivity, scenario, nor simulation analysis provides a
decision rule--they may indicate that a project is relatively risky, but they do not
indicate whether the project’s expected return is sufficient to compensate for its risk.
Finally, remember that sensitivity, scenario, and simulation analyses all focus on
stand-alone risk, which is not the most relevant risk in capital budgeting analysis.
m. 1. Assume that Shrieves’ average project has a coefficient of variation in the range
of 0.2 - 0.4. Would the new line be classified as high risk, average risk, or low
risk? What type of risk is being measured here?
Answer: The project has a CV of 0.57, which is above the average range of 0.2-0.4, so it falls
into the high risk category. The CV measures a project’s stand-alone risk-it is merely
a measure of the variability of returns (as measured by NPV) about the expected
return.
Mini Case: 11 - 11
m. 2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of
capital to adjust for risk. Should the new furniture line be accepted?
Answer: Since the project is judged to have above-average risk, its differential risk-adjusted, or
project, cost of capital would be 13 percent. At this discount rate, its NPV would be
$60,541, so it would still be acceptable. If it were a low risk project, its cost of
capital would be 7 percent, its NPV would be $104,975, and it would be an even
more profitable project on a risk-adjusted basis.
m. 3. Are there any subjective risk factors that should be considered before the final
decision is made?
Answer: A numerical analysis such as this one may not capture all of the risk factors inherent
in the project. If the project has a potential for bringing on harmful lawsuits, then it
might be riskier than first assessed. Also, if the project’s assets can be redeployed
within the firm or can be easily sold, then, as a result of “abandonment possibilities,”
the project may be less risky than the analysis indicates.
Mini Case: 11 - 12
a.
Corporate finance provides the skills managers need to: (1) identify and select the
corporate strategies and individual projects that add value to their firm; and (2) forecast
the funding requirements of their company, and devise strategies for acquiring those
funds.
b.
The corporation's primary goal is stockholder wealth maximization, which translates to
maximizing 1he price of the firm's common stock.
(1) Firms have an ethical responsibility to provide a safe \Vorking environment, to

avoid polluting the air or \Vater, and to produce safe products. Ho\\'ever, the most
significant cost-increasing actions \\'ill have to be put on a mandatory rather than a
voluntary basis to ensure that the burden falls uniformly on all businesses.
(2) The same actions that maximize stock prices also benefit society. Stock price
maximization requires efficient, low-cost operations that produce high-quality goods and
services at the lowest possible cost. Stock price maximization requires the development
of products and services that consumers \Vant and need, so the profit motive leads to ne\v
technology, to ne\v products, and to new jobs. Also, stock price maximization
necessitates efficient and courteous service, adequate stocks of merchandise, and well-
located business establishments--factors that are all necessary to make sales, \Vhich are
necessary for profits.
(3) Yes. Results of a recent study indicate that the executives of most major firms in
the United States believe that firms do try to maintain high ethical standards in all of their
business dealings. Furthermore, most executives believe that there is a positive
correlation bet\veen ethics and long-run profitability.Conflicts often arise between profits
and ethics. Companies must deal "'ith these conflicts on a regular basis, and a failure to
handle the •ituation properly can lead to huge product liability suits and even to
bankruptcy.There is no room for unethical behaviour in the business world.
c.The three aspects of cash flo\v affect the value of any investment are belo\\':
(1) Amount of expected cash flows;
(2) Timing of the cash flo\v stream; and
(3) Riskiness of the cash flo\vs.
d.
Free cash flows are the cash flo\vs available for distribution to all investors (stockholders
and creditors) after paying expenses (including taxes) and making the necessary
investments 10 support growth. Three factors determine cash flows:
(1) Current level and gro\vth rates of sales;
(2) Operating expenses; and
(3) Capital expenses.
e.
The \Veighted average cost of capital (VJACC) is the average rate of return required by all
of the company's investors (stockholders and creditors). It is affected by the firm's
capital structure, interest rates, the firm's risk, and the market's overall attitude toward
risk.
f.
The follo\ving list contains some factors that affect the cost of money, both big and small.
1. Balance of trade and investment: The balance of trade and investment is often
cited by analysts as the most important influence on the cost of money with good reason.
The balance of investment, or financial account, represents the difference in exports and
imports of capital. If exports exceed imports, in either the current account or financial
account, it is called a surplus. When imports exceed exports, on the other hand, it is
referred to as a deficit.
2. Politics: Government policies often have a great impact on the cost of money.
Savvy foreign investors kno\\• to keep an eye on the state of our political affairs,
especially as they impact the strength of our economy and our ability to service the
national debt
4. Budget deficit and national debt: The US government's budget can affect the
dollar's value, too. If foreign investors see that the government is spending more money
than it currently has, they know that it \\•ill be forced to borro\v from future generations as
\Veil as from the private sector from foreign entities. The US national debt currently
stands at $9 trillion and is gro\ving by over $1 billion per day.
5. Little or no default on debt: When the government keeps a good credit history,
risk goes down and the dollar goes up. Fortunately, the US is currently considered the
\Vorld's most credit-\vorthy borro\\•er, \Vhich in large part explains why the dollar has
remained strong.
6. Terrorist attacks and \\•ar: Attacks damage consumer and business confidence,
hampering economic growth.They also increasethe likelihood of \var, and consequently,
a budget deficit to support associated spending. An ongoing \Var can quickly become
expensive. It makes investors nervous because it will likely increase our national debt,
and slightly increase the risk of default.
7. Economic theory: The laws of supply and demand are ever-present in economics,
and currency trading offers a prime example of this la\v in action. These are a fe\V of the
effects that supply and demand exert on the value of the dollar.
a. A firm's value is the sum of all future expected free cash flo\vs, converted into
today's dollars.
g.
Value = FCF 1 + FCF1 +...+ FCFm
(l + WACC) 1 (l + WACC) 2 (l + JfA
' CC)m
h.
No, in this case agency problem \vill not arise as agency problem arise whenever a
manager owns less than I00% of the firm's stock.
I.
Yes, in this case agency problem \Vil! arise. As agency problem arise whenever principal
hires agent to perform the function.
.
J.
The capital requirement met by the \Vay of bank loan \viii increase the agency problem. If
the operation is expanded and if it proves to be riokier, it might lead to 1000 or even
bankruptcy. In that case creditors \\rill be loser. But if it proves to be profitable then
benefits \Vill go to stockholders because loan rate are fixed.
k. Agency problem will increase on expanding the operation as managers tend to increase
the compensation to be paid to them. Agency problem'"ill increase in case of licensing
franchises and expansion of business on other campuses.
I. Ifthe operation is expanded and if it proves to be riskier, it might lead to loss or even
bankruptcy. In that case creditors \viii be loser. But if it proves to be profitable then
m.Here are some actions which the president can take to mitigate agency problem:
I. Managers can be encouraged to act in the shareholders' best interest through a set
of incentives, constraints and punishments.
2. Stockholders must incur agency costs, which include all cost borne shareholders
to encourage managers to maximize the firm's long-term stock price rather than act in
their own self interest.
Agency problem \viii increase on expanding the operation as managers tend to
increase the compensation to be paid to them. So bringing an IPO will increase agency
problem as the shares \vill get more diluted also.
n. The agency problem will be more likely if stayed as CEO and ran the company.
o. The reported earning is inflated to make the financial position stronger so as to attract
the interest of stockholders in the firm. But doing so \viii increase the burden of dividend
payment to 1he stockholders. And to distribute the dividend, company \\ill spend the
retained earnings.
p. Here are some actions which might be used to minimize agency problem:
Chapter 11 Question Review 1
Chapter 11 Questions
Multiple Choice
1. Two classifications appearing in the paid-in capital section of the balance sheet are
a. preferred stock and common stock.
b. paid-in capital and retained earnings.
c. capital stock and additional paid-in capital.
d. capital stock and treasury stock.
2. A disadvantage of the corporate form of organization is

a. professional management.
b. tax treatment.
c. ease of transfer of ownership.
d. lack of mutual agency.
3. Alt Corp. issues 5,000 shares of $10 par value common stock at $14 per share. When the transaction
is recorded, credits are made to:
a. Common Stock $50,000 and Paid-in Capital in Excess of Stated Value $20,000.
b. Common Stock $70,000.
c. Common Stock $50,000 and Paid-in Capital in Excess of Par Value $20,000.
d. Common Stock $50,000 and Retained Earnings $20,000.
4. If common stock is issued for an amount greater than par value, the excess should be credited to
a. Cash.
b. Retained Earnings.
c. Paid-in Capital in Excess of Par Value.
d. Legal Capital.
5. Stock dividends and stock splits have the following effects on retained earnings:
Stock Splits Stock Dividends

a. Increase No change
b. No change Decrease
c. Decrease Decrease
d. No change No change
6. Which one of the following events would not require a journal entry on a corporation’s books?
a. 2-for-1 stock split.
b. 100% stock dividend.
c. 2% stock dividend.
d. $1 per share cash dividend.
7. The term legal capital is a descriptive term for

a. stockholders’ equity.
b. par value.
c. residual equity.
d. market value.
8. The board of directors of Yancey Company declared a cash dividend of $1.50 per share on 42,000
shares of common stock on July 15, 20X1. The dividend is to be paid on August 15, 20X1, to stockholders
of record on July 31, 20X1. The correct entry to be recorded on August 15, 20X1, would be
a. Dividends Payable 63,000

Cash 63,000
b. Cash Dividends 63,000

Cash 63,000
c. Cash 63,000
Paid-in Capital 63,000
d. Dividends Payable 63,000

Paid-in Capital 63,000
9. On January 1, Ripken Corporation had 80,000 shares of $10 par value common stock outstanding.
On May 11 the company declared a 10% stock dividend to stockholders of record on May 25. Market
value of the stock was $13 on May 11. The entry to record the transaction of May 11 would include a
a. debit to Stock Dividends for $104,000.
b. credit to Cash for $104,000.
c. credit to Common Stock Dividends Distributable for $104,000.
d. credit to Common Stock Dividends Distributable for $24,000.
10. The amount of stock that may be issued according to the corporation’s charter is referred to as the
a. authorized stock.
b. issued stock.
c. unissued stock.
d. outstanding stock.
11. Dividends in arrears are dividends on

a. cumulative preferred stock that have been declared but have not been paid.
b. non-cumulative preferred stock that have not been declared for a given period of time.
c. cumulative preferred stock that have not been declared for a given period of time.
d. common dividends that have been declared but have not yet been paid.
12. Outstanding stock of the Bush Corporation included 40,000 shares of $5 par common stock and
20,000 shares of 5%, $10 par non-cumulative preferred stock. In 20X1, Bush did not declare or pay any
dividends. In 20X2, Bush declared and paid dividends of $24,000. How much of the 20X2 dividend was
distributed to preferred shareholders?
a. $14,000.
b. $18,000.
c. $10,000.
d. $20,000
13. Outstanding stock of the Bush Corporation included 40,000 shares of $5 par common stock and
20,000 shares of 5%, $10 par cumulative preferred stock. In 20X1, Bush did not declare or pay any
dividends. In 20X2, Bush declared and paid dividends of $24,000. How much of the 20X2 dividend was
distributed to preferred shareholders?
a. $14,000.
b. $18,000.
c. $10,000.
d. $20,000
14. Which of the following is not true of a corporation?

a. It may buy, own, and sell property.
b. It may sue and be sued.
c. The acts of its owners bind the corporation.
d. It may enter into binding legal contracts in its own name.
15. Tomlinson Packaging Corporation began business in 2017 by issuing 50,000 shares of $5 par
common stock for $8 per share and 5,000 shares of 6%, $10 par preferred stock for par. At year end, the
common stock had a market value of $10. On its December 31, 2017 balance sheet, Tomlinson
Packaging would report
a. Common Stock of $500,000.
b. Common Stock of $250,000.
c. Common Stock of $400,000.
d. Paid-in Capital of $330,000.
EXERCISES
1.
Identify (by letter) each of the following characteristics as being an advantage or a disadvantage of the
corporate form of business or not applicable to the corporate form of business organization.
A = Advantage
D = Disadvantage
N = Not Applicable
Characteristics
_____ 1. Separate legal entity
_____ 2. Taxable entity resulting in additional taxes
_____ 3. Continuous life
_____ 4. Unlimited liability of owners
_____ 5. Government regulation
_____ 6. Separation of ownership and management
_____ 7. Ability to acquire capital
_____ 8. Ease of transfer of ownership
2. On January 1, 20X1, Wooden Company issued 16,000 shares of $2 par value common stock for
$120,000. On March 1, 20X1, the company purchased 2,000 shares of its common stock for $15 per
share for the treasury.
Journalize the stock transactions of Wooden Company in 20X1.
Date Debit Credit

3. In its first year of operations, Martinez Corporation had the following transactions pertaining to its
$10 par value preferred stock.
Feb. 1 Issued 8,000 shares for cash at $24 per share.

July 1 Issued 6,000 shares for cash at $25 per share.
(a) Journalize the transactions.

Date Debit Credit
(b) Indicate the amount to be reported for (1) preferred stock, and (2) paid-in capital in excess of
par value—preferred stock at the end of the year.
4. The Huntsman Corporation has the following stockholders’ equity accounts:

Preferred Stock
Paid-in Capital in Excess of Par Value—Preferred Stock
Common Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Retained Earnings
Treasury Stock—Common
Classify each account using the following tabular alignment. (Put an “X” in the correct column)
Paid-in Capital
Account Capital Stock Additional Retained Other
Earnings
Preferred Stock
Paid-in Capital in Excess of
Par Value—Preferred Stock
Common Stock
Stated Value—Common
Stock
Retained Earnings
Treasury Stock—Common
5. The corporate charter of Torres Corporation allows the issuance of a maximum of 4,000,000 shares
of $1 par value common stock. During its first three years of operation, Torres issued 2,080,000 shares
at $15 per share. It later acquired 80,000 of these shares as treasury stock for $25 per share.
Based on the above information, answer the following questions:
(a) How many shares were authorized?
(b) How many shares were issued?
(c) How many shares are outstanding?
(d) What is the balance of the Common Stock account?
(e) What is the balance of the Treasury Stock account?

6.
On January 1, 20X1, Browning Corporation had 75,000 shares of $1 par value common stock issued and
outstanding. During the year, the following transactions occurred:
Mar. 1 Issued 90,000 shares of common stock for $675,000
June 1 Declared a cash dividend of $2.00 per share to stockholders of record on June 15
June 30 Paid the $2.00 cash dividend
Dec. 1 Purchased 5,000 shares of common stock for the treasury for $18 per share
Dec. 15 Declared a cash dividend on outstanding shares of $2.50 per share to stockholders of record
on December 31
Net income for 20X1 amounted to $951,000.
Prepare journal entries to record the above transactions.

Date Debit Credit
7.
On October 31 the stockholders' equity section of Eaton Company's balance sheet consists of common
stock $600,000 and retained earnings $400,000. Eaton is considering the following two courses of
action: (1) declaring a 10% stock dividend on the 60,000 $10 par value shares outstanding or
(2) a 2-for-1 stock split. The current market price is $15 per share.
Instructions
Prepare a tabular summary of the effects of the alternative actions on the company's stockholders' equity
and outstanding shares. Use these column headings: Before Action, After Stock Dividend, and After Stock
Split.
After After
Before Stock Stock
Action Dividend Split
Stockholders' equity
Paid-in capital
Common stock $600,000
In excess of par value 0
Total paid-in capital 600,000
Retained earnings 400,000
Total stockholders'
equity $1,000,000
Outstanding shares 60,000
Par value per share $10.00

Chapter 11 Solutions
Multiple Choice Solutions
1. C
2. B
3. C
4. C
5. B
6. A
7. B
8. A
9. A
10. A
11. C
12. C
13. D
14. C
15. B
Exercise Solutions
1.
1. A 5. D
2. D 6. A and D
3. A 7. A
4. N 8. A
2.
Date Debit Credit
Cash Jan. 1 120,000
Common Stock (16,000 shares × $2 par per share) 32,000
Paid-in Capital in Excess of Par Value—Common Stock 88,000
Treasury Stock Mar. 1 30,000

Cash 30,000
Chapter 11 Solutions (Cont.)

Exercise Solutions (Cont.)
3.
(a)
Date Debit Credit

Cash (8,000 shares × $24 market price per share) Feb. 1 192,000
Preferred Stock (8,000 shares × $10 par value per share) 80,000
Paid-in Capital in Excess of Par Value—Preferred Stock 112,000
Cash (6,000 shares × $25 market price per share) Jul. 1 192,000
Preferred Stock (6,000 shares × $10 par value per share) 60,000
Paid-in Capital in Excess of Par Value—Preferred Stock 90,000
(b)
(1) Preferred stock—$80,000 + $60,000 = $140,000.
(2) Paid-in Capital in Excess of Par Value—Preferred Stock—$112,000 + $90,000 = $202,000.
4.
Paid-in Capital Retained
Account Capital Stock Additional Earnings Other
Preferred Stock X
Par Value—Preferred Stock X
Common Stock X
Stated Value—Common Stock X
Retained Earnings X
Treasury Stock—Common X
Chapter 11 Solutions (Cont.)

Exercise Solutions (Cont.)
5.
(a) 4,000,000 shares were authorized.
(b) 2,080,000 shares were issued.
(c) 2,000,000 shares are outstanding (2,080,000 issued less 80,000 in treasury).
(d) The balance of the Common Stock account is $2,080,000; ($1 × 2,080,000 shares = $2,080,000). (sh.
iss. × par val./sh.)
(e) The balance of the Treasury Stock account is $2,000,000; ($25 × 80,000 shares = $2,000,000). (Trea.
sh. × cost/sh.)
6.
Date Debit Credit
Cash Mar. 1 675,000
Common Stock (90,000 shares × $1 par value per share) 90,000
Paid-in Capital in Excess of Par Value—Common Stock 585,000
Cash Dividends Jun. 1 330,000

Dividends Payable (165,000 shares × $2 = $330,000) 330,000
*(75,000 shares + 90,000 shares issued = 165,000 shares)
Dividends Payable Jun. 30 330,000

Cash 330,000
Treasury Stock (5,000 shares × $18 per share) Dec. 1 90,000

Cash 90,000
Cash Dividends (160,000 shares × $2.50) Dec. 15 400,000

Dividends Payable 400,000
*(165,000 shares- 5,000 shares bought back = 160,000 shares)
7.
After After
Before Stock Stock
Action Dividend Split
Stockholders' equity
Paid-in capital
Common stock $600,000 $660,000 $600,000
In excess of par value 0 30,000 0
Total paid-in capital 600,000 690,000 600,000
Retained earnings 400,000 310,000 400,000
Total stockholders'
equity $1,000,000 $1,000,000 $1,000,000
Outstanding shares 60,000 66,000 120,000
Par value per share $10.00 $10.00 $5.00
Stock Dividend
Total common stock increase= (60,000 shares x 10% stock dividend x $10 par value per share)
Total paid-in capital in excess of par increase= [60,000 shares x 10% stock dividend x ($15-$10)]
Total paid-in capital increase= (60,000 shares x 10% stock dividend x $15 market price per share)
Total retained earnings decrease= (60,000 shares x 10% stock dividend x $15 market price per share)
New Number of Shares = 60,000 shares X 1.10 = 66,000 shares
Stock Split
New Number of Shares = 60,000 shares X 2 = 120,000 shares
New par value = $10 par ÷ 2 = $5 par value
DPS 302: INVENTORY MANAGEMENT
QUANTITATIVE MODELS – PROBLEMS
Q1.The purchasing manager of Elstore Limited, an electrical components retailer holds a regular
stock of among other things, quasitrons. Over the past year he has sold, on average, 25 a week
and he anticipates that his rate of sale will continue during the next year (which you may take to
be 50 weeks). He buys quasitrons from his supplier at the rate of 5 for 10, and every time he
places an order it costs on average guide to the stockholding costs involved, the company usually
value their cost of capital at 20% and as the storage space required is negligible, he decides that
his figure is appropriate in this case. Furthermore, the prices charged to customers are
determined by taking the purchasing and stockholding costs and applying a standard mark up of
20%.
Required
a) Currently the manager is reviewing his ordering and pricing policies and needs to know
how many quasitrons he should order each time and what price he should charge. What
would be your advice? (State any assumptions that you make).
b) If he’ s now finds out that he can get a discount of 5% for ordering in batches of 1,000
would you advise him to amend the ordering and pricing policy that you have suggested
and, if so, to what?
c) How large would the percentage hold cost have to be for the manager to be indifferent
between taking advantage of the quantity discount and maintaining the original ordering
policy that you have suggested? Comment on the value that you have obtained.
Over the course of each year the Krispy Crisps Company Limited purchases a large number of
wooden pallets for use in the storage and transportation of its products to replace those lost or
damaged in transit. The average yearly requirement for the past two years has been 3,000 pallets,
a quantity which can be applied realistically to this year as well. The need for replacement
pallets is relatively constant and the cost associated with the placing and receipt of an order is 15.
The inventory cost policy that Krispy Crisps has traditionally employed is to charge 18% of the
1
purchase cost as the annual inventory holding cost for any item in inventory. The standard price
charged by the major manufacturing company is 8 per pallet.
Q2.Over the course of each year the Krispy Crisps Company Limited purchases a large number
of wooden pallets for use in the storage and transportation of its products to replace those lost or
damaging in transit. The average yearly requirement for the past two years has been 3,000
pallet, a quantity which can be applied realistically to this year as well. The need for replacement
pallets is relatively constant and the cost associated with the placing and receipt of an order is 15.
The inventory cost policy that Krispy Crisps has traditionally employed is to charge 18% of the
purchase cost as the annual inventory holding cost for any item in inventory. The standard price
charged by the major manufacturing company is 8 per pallet.
Required:
a) Determine the optimum order quantity and the consequent time between the orders.
b) Describe the assumptions you have made in part a) and assess their likely validity within
the context of this question.
c) The manufacturer offers a discount of 3.125% if Krispy Crisps order 2,000 or more
pallets at a time show that the discount is not financially beneficial to Krispy Crisps.
What percentage discount would be required for Krispy Crisps to order 2,000 or more
pallets at a time?
d) State the effect on the company’ s inventory policy described in 1) if the supply of
pallets has a variable lead time.
Q3. Demand for part CD 673 used by Samaki Ltd tends to be constant an annual rate of 400
units. The cost per unit for this part is Sh.200 and the cost of placing an order is Sh.5000 Samaki
Ltd estimates that the annual inventory carrying cost of the part expressed as a percentage of cost
of average stock is 20%.
Required:
2
a) Formulate the best (optimal) entry policy for part CD 673 i.e.
- Quantity to order (EOQ)
- Frequency for ordering and when to order
- Re-order level/point; For ROP take lead-time to be 15 days while one year has 300
working days
- Total cost associated with the policy.
b) Suppose it actually turns out that
c) Ordering cost per order = Sh.6000 and
d) Inventory hold cost percentage I = 15% and yet the policy formulated in (a) above is
implemented for a year determine the cost of predition error.
Q4. A company buys 30,000 units for an item per year at an ordering cost of Sh.2500 per
order and holding cost chards are 20% of the cost of average inventory per annum.
The following price quality schedule is available from the supplier.
Quantity (Unit) Unit price (Sh.)
3000 2:00
300 5000 !9:00
5000 7000 !7:00
7001 9000 !5:50
9001 and above !3:50
Required
Recommend the best inventory policy for this item.
5. Jericho Company manufacturers part B-2000 on a special lathe for us, in a continuous
assembly. The assemblies that use B-2000 are manufactured at a lower rate. This allows for
doing odd jobs on the special lathe when it is not being used for part B=2000. When parts are
3
being run, deliveries are made to the assembly area otherwise the assembly department draws
part from inventory.
The following data is given for part B=2000
Production rate = 4000 pieces a day.
Assembly requirements = 1200 pieces a day.
Inventory holding cost = Sh.20 per unit per year
Unit variable production cost = Sh.2000.
Set up cost = Sh.110000 per set up
Acquisition lead – time = 10 working days
1 yea = 250 working days
Required:
a) Calculate production departments economic batch quantity
b) Determine the length of
i) A production run
ii) Break between production runs
c) What is the total cost associated with production/inventory policy formulated in (a) and
(b) above?
d) Determine assembly departments re-order level.
e) Suppose it turns out that actual set-up cost is Sh.16 per unit per year and yet the policy
above is implemented for one year, determine the cost of prediction error.
Set up cost is 31,000 and holding cost is sh.16.
Q6. ABC Ltd has determined that its reader point is 50 units when there are no safety stocks.
Its carrying cost per unit per year is 5 and stock out cost is 40 per unit a customer misses.
ABC Ltd has experienced probability distribution for inventory demand during lead-time is
shown below;
4
No. of units Probability
30 020
40 0.20
50 0.30
60 0.25
70 0.05
1.00
Required
The optimal No. of orders is 6. What is the optimal level of safety stock and the associated re-
order point?
Q7. The Brown manufacturing company has compiled data for the last 100 reorder periods
for a purchased component as follows;
Usage during lend time No. of times this Quantity was used
90 07
95 10
100 25
105 50
110 6
115 2
100
The company has found the EOQ to be 250 units with an average daily usage of 5 units. Lead-
time is constant at 21 days. Cost of being out of stock is Sh.300 per component short and annual
carrying cost is Sh.40 per unit. The company works 300 days in a year.
Required:
Determine the best level of safety stock for the company and hence the revised reorder levels.
5
Q8. Suppose in the preceding illustration (Q7 Brown Company) stock out cost estimated is
not reliable and serviced level desire = 95% i.e. risk of a stock out is 5% , what is the best level
of safety stock and R.O.P?
Q9. After reviewing previous lead-time demand experience, an analyst feels reasonably
confident that lead-time demand can be quite adequately represented using a normal distribution
that has a mean of 60 units and a standard deviation of 8 units.
(i) What R.O.P will yield a service level of 95% and

(ii) What is the level of safety stock?
Q10. A newspaper vendor buys each newspaper copy at Sh.27 from the publisher and sells it
for Sh.35. If a paper is not sold on the particular day, it can be disposed of through other
channels later at Sh.4 per copy. From previous experience, the following data has been gathered.
No. of copies No. of days

Sold per day
110 10
120 20
130 40
140 70
150 40
160 10
170 10
200
Required
Recommended the best level of daily newspaper stock in order for the vendor to maximize long
term profitability.
Q11. DB plc operates a conventions stock control system based on re-order levels and
Economic Ordering Quantities. The various control levels were set originally based on estimates
which did not allow for any uncertainty and this has caused difficulties because in practice, lead
times, demands and other factor vary.
A part of a review of the system, a typical stock item, Part No. X206, has been studied in detail
as follows;
Data for Part No. X206
Lead times Probability

15 working days 0.2
20 working days 0.5
25 working days 0.3
Demand per working day Probability
6
5,000 units 0.5
7,000 units 0.5
It can be assumed that the demand would apply for the whole of the appropriate lead time.
DB plc works for 240 days per year and it costs 0.15 p.a. to carry a unit of x206 in stock. The re-
order level for this part is currently 150,000 units and the re-order cost is 1,000.
You are required:
a) To calculate the level of buffer stock implicit in a re-order level of 150,000 units;
b) To calculate the probability of a stock-out;
c) To calculate the expected annual stock-outs in ;
d) To calculate the expected annual stock-outs in unit;
e) To calculate the stock-out cost per unit at which it would be worthwhile raising the re-
order level to 175,000 units
f) To discuss the possible alternatives to re-order level EOQ inventory system and their
advantages and disadvantages.
Q12. a) Explain the meaning of the terms
i) Deterministic
ii) Stochastic
When applied to the planning and control of inventory
b) The manager of a large sports shop, open for 50 weeks each year, holds a regular stock of
quality golf balls. Although the manager has to purchase boxes of these golf balls at 9.60 per box
containing 12 balls, he is prepared to sell these balls as single items. Over the past year he has
sold, on average 12 boxes of golf balls each week and it is likely that his level of sales will
continue into the future.
Due to telephone, secretarial and transport costs it is estimated that the cost of receiving each
order is 16. The annual cost of storage a estimated at 20% of the stock item value and is based
on the cost of storage space and the company’ s cost of capital. The manager of the shop sets a
price for his goods by taking the sum of the purchase cost and the appropriately allocated
stockholding cost (storage and delivery) and then applying a mark up of 50%.
Required:
i) Determine the optimum number of boxes of golf balls the sports shop manager should
order at a time and the number of orders per year.
Show that the selling price per ball that results from this optimum policy is 24.
ii) The supplier offers a discount of 4% on the price of each box of golf balls if the manager
is prepared to purchase 500 boxes at a time. (It can be assumed that there are no price effects on
demand).
iii) What percentage discount is required for the order quantity of 500 boxes to be beneficial
to the shop customer?
7
Q13. A national boutique chain sells a wide range of high quality customized fashion goods.
One particular outfit is bought in at 80 and sold at 130. Mean holding costs per season per outfit
work out at 5 and it cost 800 to order and receive goods into stock. The manufacturers require
orders in advance and once a batch has been made, it is not possible to place a repeat order.
Further, it is not possible for delivery to be staggered over the fashion season.
When a customer buys an outfit, she has a fitting, any alternations or adjustments are made, and
she collects the outfit day or so later. Generally, if an outfit is out of stock at one boutique it can
be readily obtained from another branch, usually in a matter of hours. However, if the chain as a
whole runs out of an item, then not only is the profit not earned, but the 20 or so profit that
comes from the extras that customers disclose of the surplus outfits at 50 each.
The pattern of past sales of a comparable outfit shows the following profitability distribution for
the chain as a whole.
Outfits sold 1,100 1,200 1,300 1,400

Probability 0.30 0.40 0.20 0.10
The problem facing the management accountants of the chain is to decide how many outfits to
order for the season ahead in order to maximize expected profit, bearing in mind the penalties for
over and under ordering.
You are required to:

a) Determine the number of outfits to order maximize expected profits
b) Compare and contrast the model that you have developed with the classical economic
order model.
SPB Ltd is a small engineering company, which is open for 50 weeks each year and specializes
in the assembly of one component used in the motor industry. This component, for which there
is an annual demand of 20,000 components, is assembled from two types of bought-in part A and
B. The number of parts used in each component and their associated costs and lead times are
given in the following table.
Part Number per component Unit cost Lead times (weeks)

A 3 5 1
B 8 1 3
Currently SPB retain fairly high stock levels to ensure continuous production, but liquidity
difficulties seem to demand a reduction in stock levels. SPB’ s current stock control policy for
these parts is outlined in the table below.
Part Re-order quantity Re-order level

A 5,000 5,000
B 20,000 15,000
8
It is estimated that each time an order is placed for any part there is a cost of 100 per order plus
0.02 per item ordered. Also it is estimated that the storage costs of parts in stock is 20% per
annum of the value of parts in addition to a fixed annual holding cost of 5,000.
Required:
a) Briefly describe the basic principles of stock control and explain why a good stock
control policy is of value the management of SPB Ltd.
b) Determine the total annual cost incurred by SPB Ltd for production of these components,
using the current stock control policy.
c) Assuming the given lead times are constant.
(i) Show that the optimum re-order quantities for parts A and B are 3,464 and 12,649
respectively.
(ii) Find the optimum re-order levels for each part
Determine the annual savings, both in value and percentage terms, that can be obtained by
implementing this optimum stock control policy.
d) Describe the advantage of the current stock control policy compared with the optimum
one if the given lead times are stochastic.
Q15. Political Novelty Co. distributes seasonal and promotional items. They’ re trying to
decide how many Republican convention elephant hats to order for one of their stores.
The hats cost $5, and sell for $B. After-convention left over are sold to Jobbers for $1 a hall.
The historical demand pattern is:
D P(D) Cumulative Probability

10 .10 .10
11 .15 .25
12 .25 .50
13 .30 .80
14 20 1.00
Use marginal analysis to find the best order quantity for that particular store and the extend
marginal gain and loss.
Q16. The yearly demand for filters at ABC refinery id 5,000 units. A supplier offers the
following price schedule:
Up to 499 units - $3.00 a unit

500 to 1,999 units - $2.95 a unit
2,000 to 4,999 units - $2.85 a unit
5,000 or more units - $2.80 a unit
Ordering costs are $50 per order.
Carrying costs are 20 percent per year.
Find the best order quantity.
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Q17. Northwood industries produces mechanical parts for use in its assembly department. The
company can produce 40 units or part M – 15 a day, 250 days a year.
The demand for part M-15 is 4,000 a year, and each part is valued at $60. Management would
like to produce M-15 in the most economical manner. It is known that setting up the machine for
the M-15 production costs $45.
The company’ s estimate of the annual carrying (holding) inventory costs is 25 percent of the
value stored.
Determine:
a) The optimal production run (lot size), (L*):
b) The daily production schedule, i.e., when the company will produce M-15 (T1), is:
c) The total cost if the optimal solution is followed:
d) The maximum inventory level:
Given
P = 40 x 250 = 10,000 units/year
D = 4,000 units/year
K = $45
H = 25 x 60 = $15
Hookco make fishing kits, sold throughout Tourista Island. The yearly demand is known to be
20,000 units. The kits are prepared on an assembly line with a preparation (set up) cost of $150
per one production order. The fishing kits cost $50, keeping them in inventory costs Hookco 30
percent a year.
Hookco has a monopoly on fishing kits on Tourists. If a customer does not find a kit today he
will wait until he can get one. Thus, the company may have a backlog of orders, but some
tourists bring their own fishing kits from the mainland. Hookco estimates that such a loss of
goodwill costs them $5 per short unit per year.
The company would like to find out:
a) The optimal production of kits (order size)

b) The maximum inventory level
c) The annual shortage cost.
d) The annual total relevant cost as compared to the regular EOQ.
Q19. Perform ABC analysis using the following data:
10
Item Units Unit price Item Units Unit Price
(Rs) (Rs)
1 700 5.00 7 6,000 0.2
2 2,400 3.00 8 3.50
3 150 10.00 9 300 8.00
4 60 22.00 10 30 0.40
5 3,800 1.50 11 2,900 7.10
6 4,000 0.50 12 1,150 6.20
410
Question Twenty
A dealer supplies you the following information pertaining to an item of inventory

Annual demand : 800 units
Buying cost : Rs 150 per order
Inventory carrying cost : Rs 3 per unit per year
Back-ordering cost : Rs 20 per unit per year
(i) What will be the optimal number of units of the inventory item he should buy in one lot?
(ii) What quantity he should allow to be back-ordered?
(iii)What will be cost-savings, if any, resulting from back-ordering?
(iv) If the dealer wants that more than 25% of the units can be back-ordered, should the
policy of back ordering be adopted?
Here, D = 800 units, A = Rs 150/order, h = Rs3/unit/year and b = Rs 20/unit/year. With

these inputs
S* = √2ADh
Hb + b2
= √2 x 150 x 800 x 3 = 40 units
20 x 3 + 202
(iii) Cost savings from back ordering can be calculated as follows;
(iv) Total relevant cost (with back-order) =
Total relevant cost (without back-orders) =
Thus, cost saving by back-ordering
(v) Maximum inventory level
(vi) Here, the optimal number of units which can be back-ordered by the dealer is 40,
which is less than 25% (of the ordering ). Since the percentage of back-orders is
11
within the limit, specified, the given statement has no effect on the results
obtained. The policy of back-ordering should obviously be adopted.
Quest Twenty one
Perishable Products
Art Albert has a newsstand at the corner of Manhattan and Missouri streets. He must determine
how many copies to order of the Sunday Scoop, the area’ s newspaper. Papers cost him $1.00
and he can sell them for $1.50. The scoop does not allow him to return any unsold papers. This
is small town, and Albert estimates the demand for paper to be as follows;
Demand P(Demand)
50 0.05
51 0.13
52 0.19
53 0.21
54 0.24
55 0.12
56 0.06
1.00
Required
Determine the optimal number of papers to order.
Question Twenty Two
Perishable Product
The Sparta Plainsman is a daily newspaper with a wide circulation throughout several small
towns in Ohio. The paper has been plagued with returns of unsold copies, for which it gives full
credit. The company charges its dealers $0.09 per copy, the same price it pays the dealers when
it buys back unsold copies. Variable costs of printing are $0.03, and unsold copies can be
converted to scrap paper, brining in a net of $0.005 per copy. To Swetnam, the publisher, has
been trying to determine how many copies to print a day. Sales seem uniformly distributed
between 5,000 and 7,000 copies a day.
Required;
How many copies should be produced each day?
Question Twenty-Three
12
Safety Stock
MaBell Telephone Co. of Metropolies City has a policy letting customers have any model phone
they prefer, in 95 percent of the cases. One of the most popular models, Foxytel (a telephone
with a memory for 24 numbers), has an annual rate of demand of 18,000 units. The local office
orders the telephone from a manufacturing center. It takes ten days from the time that an order is
placed to the time that a
Foxytel is received and available for distribution. Foxytel demand fluctuates; during a ten-day
period it shows a normal distribution with a standard deviation of 75. The office is open to the
public Mondays through Fridays 8 1.m to 7 p.m. for a total of 240 days a year.
A Foxytel costs MaBell $50. The company figures on a 30 percent annual carrying cost, $150
ordering cost and an $80 “ shortage cost” (cost of loss of goodwill).
The company would like to find the inventory policy which will minimize its total cost, allowing
it to provide the desired service level.
Given:
D = 18,000 per year, or 75 per day
K = $150
H = .3 x $50 = $15/unit/year
B = $80/Shortage
Lend time = 10 days
Demand during lead time = 18,000 x 10 = 750 units
240
Desired service level = 95%
Standard deviation during lead time= 75 units
Question Twenty Four

Naivasha Traders Ltd operates a conventional inventory control system based on the economic
order quantity (BOQ) technique.
The management accountant has argued that the current inventory system is rigid and does not
allow for uncertainties. He is of the view that the system should be reviewed to allow for
uncertainities.
Art analysis of stock item x 100 has revealed the following details:
13
Lead time (days) Probability Demand per day (units) Probability
15 0.2 5,000 0.5
20 0.5 7,000 0.5
25 0.3
Additional information
1. It costs Sh.0.15 annum to carry a unit of stock item X100 in stock
2. The daily demand applies for the whole of the appropriate lead time.
3. The re-order level of item x 100 is currently held at 150,000 units and it costs Sh.1,000 to
execute an order
4. Assume a 240 day year.
Required:
(a) Calculate the level of buffer stock implicit in a re-order level of 150,000 unit. Interpret
your result
(b) Calculate the probability of a stock-out
(c) Calculate the expected annual stock-out in units.
(d) Determine the stock-out costs per unit at which it would be worth raising the re-order
level to 175,000 units.
(e) Indicating its advantages and disadvantages, briefly explain an alternative system to a
fixed order EOQ inventory system.
Kiwanda Manufacturing Company Ltd (KMCL), a small size company, is a client of Town bank.
The Managing Director of KMCL, visited the Town Bank offices to apply for an additional line
of credit in ensuring discussion the Town Bank loan officer noticed that KMCL could save a
substantial amount of money by improving on its inventory management.
As part of the bank’ s loan application analysis policy, the loan officer invited the Management
Accountant of KMCL for further consultation. From the conversion, it emerged that the
company holds a substantial quantity of a particular raw material in its warehouse. The
Management Accountant provide the following information on the raw material:
Invoice cost per unit Sh.120.00

Shipping charges Sh.2.50 per unit plus Sh.14,000 per shipment
Annual handling and inspection Sh.1.00 per unit per year
Inventory insurance
Cost of raw material Sh.2.60 per unit plus Sh.15,000 per year
14
Warehouse utilities Sh.980.00 per month
Warehouse rental Sh.11,500 per month
Unloading costs for units
Receiving supervisor’ s salary Sh.0.80 per unit
Processing invoices and other Sh.17,600 per month
Purchase document Sh.186 per order
The company’ s policy is to order 5,000 unit each time and maintain a safety stock of 3,000
units. The annual demand for the raw material is 45,000 units. The lead time for an order is 10
working days.
The Management Accountant has also indicated that if there is a stock-out, it would be necessary
to obtain the raw material by a special courier service at an additional cost of Sh.8,100 per stock-
out.
The probabilities of a stock-out at various safety stock levels were given as follows
Safety stock (unit) Probability of stock-out

500 0.25
1,000 0.08
1,500 0.02
2,000 0.01
1. The company’ s cost of capital is 10%
2. You are advised that there are 250 working days in a year
3. The raw material is ordered in multiples of 250 units
4. For analysis purposes, a stock-out probability of 0.02would be reasonable for order cost
determination in an optimal inventory policy.
Required:
(a) The annual cost of the company’ s present inventory policy
(b) Recommend an optimal quantity for the company based on the information provided
(c) Recommend an optimal safety stock level.
15
(d) Advise the management of KMCL on the savings to be realized from the optimal order
quantity in (b) above
(e) The reorder level for the company
Question Twenty Six
(a) Manukato Ltd, produces a designer perfume called “ Hint of Elegance” . Production of
the perfume involves the use of two ingredients x1 and x1 represented by the production
function given below:
Y = x1 x2
Where Y = Number of bottles of designer perfume produced
X1 = units of ingredient1.
X2= Units of ingredient 2.
Currently, the company is operating at a level where the daily usage of x1 and x2 is set at 250
units and 360 units respectively.
The price of the designer perfume and the cost of ingredients x1 and x2 are random variables.
The data below relate to the three random variables.
Selling price of Y (per bottle) Probabilities

Sh.
4,000 0.15
4,500 0.35
5,000 0.20
5,500 0.30
Sh.
1,000 0.10
1,500 0.05
2,000 0.35
2,500 0.50
Cost of ingredient X2 Probabilities

1,500 0.20
2,000 0.25
2,500 0.15
3,000 0.40
16
Required
(i) Calculate the daily expected profit of the company
(ii) Simulate the company’ s profit for 10 days using the following random numbers
58, 71, 96, 24, 18, 46, 23, 34, 27, 85, 13, 99, 24, 44, 49
18, 09, 79, 49, 74, 16, 32, 23, 02, 56, 88, 87, 59, 41, 06
(b) Nairobi manufacturers Ltd produces component X on machine Y at a rate of 4,000 units
per month. Machine Z uses component X at the rate of 1,000 units per month, the
remainder being put into stock. It costs Sh.2,000 to set up machine Y while the stock
holding cost is estimated at sh.2.50 per unit per annum plus a 20% opportunity cost of
capital per annual. Each component costs Sh.25 to produce.
Required:
(i) Compute the optimal batch size that should be produced using machine Y
(ii) Assume that the actual set-up cost of machine Y is Sh.1,000 instead of Sh.2,000.
Calculate the cost of prediction error.
Question Twenty Seven
Nyali Ltd is a distributor of an industrial chemical in the South Coast. The chemical is supplied
in drums which have to be stored at a controlled temperature. The company’ s objective is to
maximize profit, however the management team disagrees on the stock control policy and holds
the following different views:
The Managing Director’ s view
The company’ s managing director (MD) wishes to improve to improve the stock holding policy
by applying the economic order quantity (EOQ) model. Each drum of the chemical cost
Sh.5,000 from a supplier and is sold for Sh.6,000. The annual demand is estimated to be 10,000
drums which the MD assumes to be evenly distributed over the 300 working days in a year. The
cost of delivery is estimated at sh.2.500 per order and the annual variable holding cost per drum
at Sh.4,500 plus 10% of the purchase price.
The Purchasing the Manager’ s View
Provided in the employment contract of the company’ s purchasing manager (PM), is a clause
stating that he will receive a bonus (rounded to the nearest Sh.1000) calculated as follows:
b is the annual bonus

17
Oc is the annual ordering cost
He is the annual holding cost
Using the same assumption as the MD, the PM points out that in making his calculation, the MD
has not only ignored the bonus but also the fact suppliers offer quantity discounts on purchase
orders. Where if the order size is 200 drums or above. The price per drum for an entire
consignment is only Sh.4,990 compared to Sh.5,000 when the order is between 100 and 199
drums and Sh.5,010 when an order is between 50 and 90 drums.
The Finance Director’ s view
The company’ s finance director (FD) accepts the need to consider quantity discounts and pay a
bonus, but he also holds the view that the MDs approach is too simplistic. He points out that
there is a three days lead time for an order and that demand has not been entirely even over the
past. Moreover, if the company has no drums of the chemical in stock, if will lose specific
orders as potential customers will source the chemical from competitors. He gives the frequency
of lead time demand over the last year as follows:
Demand during lead time Frequency

(No. of drums)
106 4
104 10
102 16
100 40
98 14
96 14
94 2
Under the circumstances, the MD decided that he would seek further advice on the course of
action to be taken by the company.
Required
(a) The EOQ as originally determined by the company’ s managing director.
(b) Determine the optimum order quality, taking into consideration the MD’ s assumption
and after allowing for the purchasing manager’ s bonus and supplier quantity discount.
(c) The safety stock the company should maintain after applying the finance director’ s
assumptions and assuming further that the supplier’ s contract requires that the order
quantity be constant for all the orders in a year.
18
(d) As a consultant, write a brief report to the managing director on the company’ s stock
ordering and stock holding policies, referring where necessary to your answer in (a) to (c)
above. The report should refer to other factors that should be considered when making
the final decisions on stock ordering and holding policies.
Question Twenty Eight
(a) From past experience, a company operating a standard cost accounting system has
accumulated the following information in relation to variances in monthly management
accounts.
1. Its variance fall into two categories:
Percentage of total number of variances

Those which are not worth investigating 64
Those which are worth investigating 36
100
2. For the first category corrective action has eliminated 70% of the variances, but the
remainder have continued unchanged.
3. The cost of an investigation averages Sh.3,500 and that of correcting variances

average Sh.5,500.
4. The average cost of any variance not corrected is Sh.5,250 per month and the
company’ s policy is to assess the present value of such costs at 2% per month for a
period of five months.
Required:
(i) Two decision trees to represent the position if an investigation is carried out and
the position when an investigation is not carried on.
(ii) Recommend with supporting calculation whether or not the company should
follow a policy of investigation variances as a matter of routine.
(iii) Explain briefly two types of circumstances that would give rise to variances in the
first category and two types of circumstances that would give rise to variances in
the second category.
(b0 Kenya Fashions Ltd sells a wide range of high quality customized outfits. On particular
outfit is bought at Sh.800 and sold at Sh.1,300. Mean hold costs per season per outfit amounts to
19
Sh.50 and it costs Sh.8,000 to order and receive goods into stock. The manufacturers require
orders in advance and once a batch has been made, it is not possible to place a repeat order.
Further, it is not possible for delivery to be staggered over the fashion season.
When a customer buys an outfit, she has a fitting, any alterations or adjustments are made and
then she collects the outfits a day or so later. Generally if an outfit is out of stock at one branch,
it can be readily obtained from another branch, usually in a matter of hours. However, it the
company as a whole runs out of an item, then the cost of the stockout is Sh.200 per item. If the
company over buys for a season, then it is expected that it will be able to dispose of the surplus
outfits at Sh.500 each.
The patters of past sale of a comparable outfits shows the following probability distribution for
the chain as a whole
Outfits sold 1,100 1,200 1,300 1,400

Probability 0.30 0.40 0.20 0.10
The problem facing the management accountant of the company is to decide how many outfits to
order for the season ahead in order to maximize expected profit, bearing in mind the penalties for
over and under ordering.
Required:
i) Determine the number of outfits to order to maximize expected profits
ii) Compare and contrast the model that you have developed with the classical economic
order quantity model.
Question Twenty Nine
(a) Explain the advantages and disadvantages of the Just-In-Time (JIT) inventory system
(b) A company has determined that the EOQ for its only raw material is 2000 units every 30
days. The company knows with certainty that a four-day lead time is required for
ordering. The following is the probability distribution of estimated usage of the raw
material for the month of December 2002.
Usage (units) Probability
20
1800 0.06
1900 0.14
2000 0.30
2100 0.16
2200 0.13
2300 0.10
2400 0.07
2500 0.04
Stock-outs will cost the company Sh.100 per unit and the average monthly holding cost will be
Sh.10 per unit.
Required:
(i) Determine the optimal safety stock
(ii) Compute the probability or being out of stock
Question Thirty
Kako Ltd is a large cash and carry warehouse which sells electronics. Kiko Ltd purchases,
the most popular model of calculators (FX 100) directly from the manufacturer at a cost of
sh.250 each. Average sales per a 300 day year are 475 calculators. Whenever an order with
manufacturer is placed. Kiko Ltd incurs a cost of sh.50. The stock holding costs are
estimated at sh.12.50 plus 10% opportunity cost of capital. The lead time is three days.
During the last 50 stock cycles the demand during the lead time has generated the following
frequency distribution.
Lead time demand 0 1 2 3 4 5 6 - 8

Number of stock cycles 1 2 6 8 10 8 8 5 2
Each time the warehouse runs out of stock, an emergency order is placed with an extra cost
of Sh.20 per calculator.
Required
(a) The economic order quantity (EOQ) and the reorder level.
(b) The total annual relevant costs for the order quantity in (a) above.
21
Question Thirty One
Paul Akili, an aggressive entrepreneur, is working on some make or decisions and a related
inventory system. For one such product he decides to use the classic economic – lot – size
model with no stockouts to determine an optimal order quantity. He initially predicts that annual
demand will be 2000 units that each unit will cost Sh.2,565, that the incremental cost of
processing each order (and receiving the ordered goods) will be Sh.3,819 in this case and the
incremental cost of storage will be Sh.342 per physical unit per year.
Assume that the inventory cycle precisely repeats every year.
Required
(a) What is the optimal order quantity
(b) What are the total relevant costs of inventory from following your policy in (a) above?
(c) Suppose that Paul Akili is incorrect in his Sh.3,819 incremental – cost – per – order
prediction but is precisely correct in all other predictions.
State and solve the equation in predict the maximum amount Paul Akili should pay to
discover the true incremental cost per order if:
(i) This true cost is sh.1,881 per order and
(ii) In the absence of any knowledge to the contrary, Paul Akili will implement the
solutions in (a) above and will not alter it for one full year.
(d) What happens to your answer in (c) above if we admit that Paul Akili has also made
errors in predicting demand price and cost of storage?
(e) Suppose Paul Akili implements the solution in (a) above for two years.
Further suppose that all of his initial predictions were, and are, correct expect that the
actual incremental cost of storage is Sh.1,140 per average unit. If it costs Akili a total of
Sh.228 to alter his inventory policy, state the equation to determine the cost of prediction
error of not changing his inventory policy at the beginning of the second year.
Question Thirty Two
James Ugenya is the Financial Director of Ugenya Ltd. He wishes to install an inventory
control system and in particular calculate and utilize an optimal order quantity using the
EOQ model. He has collected the following data about inventory item NPD.
- Purchase price Sh.31.25 per unit

22
- Inventory insurance and other variable
- Cost of storage paid at year end Sh.0625 per unit
- Annual demand 1,250 units
Ugenya’ s opportunity rate of return is 10 per cent. He anticipates no need for a safety stock.
He is unsure about the cost behavior associated with ordering inventory. He collected some
data about the most recent 20 orders made for inventory item NPD. He also ran a regression
using the number of units in each other to predict the total cost of the order. The results are
as follows.
Total cost in shillings = 55.0 + 3.4215x
Standard errors of the coefficients 11.0 0.54
r2 = 0.83
x= number of units ordered
EOQ = 2AP
Where
A - Annual inventory requirement
P - Ordering cost per order
S - Carrying cost per item per annum
Required
(a) Using only the data given above, what optimal order quantity would you recommend?
(b) What is the 95% confidence interval of the variable ordering cost per unit ordered?
(c) List two regression assumptions that must be maintained in order to answer (b) above.
(d) The actual costs of ordering turned out to be sh.50 per order plus Sh.4,375 per unit
ordered.
Assuming that the recommendation in (a) above were implemented, what was Ugenya’ s
cost of prediction error.
23
QUESTION THIRTY THREE
a) ZED Ltd maintains a perpetual inventory system. The economic order quantity
(EOQ) model has established an economic order quantity of 2,5000 units with an
average daily usage of 50 units and a lead time of 20 days for its single input product
X.
The following information relates to the usage of product X during the re-order
period
Usage during the re-order period (units) Number of times the quantity was used
900 17
950 20
1,000 45
1,050 10
1,100 5
1,150 3
1. Stock-out cost is Sh.300 per unit
2. The optimum number of orders based on the EOQ model is 6 times per annum
3. The annual carrying cost per unit is sh.60
Required
(i) Advise the management accountant of ZED Ltd on the desired level of safety stock in
order to minimize total inventory costs.
(ii) State the assumptions of the economic order quantity (EOQ) model
(c) Upendo Ltd stocks a seasonal product named “ Tamu” at the beginning of every
Christmas period. The product costs Sh.5,000 and sells for Sh.10,000.
(d) The following data relate to the probability distribution of demand for the product.
Number of units stocked Probability of demand Cumulative probability

6,000 0.05 0.05
5,000 0.15 0.20
4,000 0.15 0.35
3,000 0.25 0.60
2,000 0.40 1.00
24
1. Upendo Ltd cannot re-order the product in the event of a shortage due to the long
delivery period required.
2. The stock-out cost is Sh.300 per product.
3. Any unit of the product unsold at the end the Christmas period has a salvage value of
sh.2,000.
4. The holding cost during the period is estimated at 10% of the cost of the product.
Required:
i) The expected net incremental gain (or loss) per unit of each of the above stock levels.
ii) Given the products out of stock can be re-ordered at a cost of Sh.7,400 per unit and that
iii) Customers will wait until the arrival of the product determine the optimal order level.
25
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was arrested and convicted. However, Inspector Sniff did not give Ole Ndume the
CPSP PART I reward. It is now three months since the arrest and Ole Ndume has learnt of the reward.
LAW OF CONTRACT He seeks your legal advice on whether he can successfully claim the reward. Advice
BLOCK RELEASE MAY 2018 Ole Ndume. (10 marks)
(d) In relation to the Law of Contract
i. Explain five essentials of a valid contract. (10 marks)
(a) How true is it to say that in order for a contract to be discharged by performance, the ii. Jackson entered into a contract with Jacinta whereby Jackson was to introduce
performance must be precise and exact? (10 marks) Jacinta to Tajiri with a view of Tajiri marrying Jacinta. Jackson asked Jacinta
(b) Annan agreed to paint Angela’s house at an agreed price. When Annan had finished to give him Sh. 10,000 which she did. Jackson then introduced Jacinta to
the work. Angela discovered that although most of the painting was satisfactory, Annan Tajiri and Tajiri promised to marry Jacinta in case his wife who was by then
had forgotten to apply a coat of gloss paint on one of the doors. Annan fell ill and could very ill in hospital passed away.
not complete the work. Angela refused to pay Annan the contractual price, claiming However, Tajiri’s wife Juliana underwent a successful surgery and fully
that the contract had not been fully executed and that therefore he was entitled to be paid recovered from the illness. Tajiri has now refused to marry Jacinta.
only a reasonable sum for the work he had actually undertaken. This, Annan claimed, Jacinta is aggrieved and wishes to sue Jackson and Tajiri. Advise her.
was much less than the contract price. Advise Annan. (10 marks)
(10 marks) (e) In relation to the Law of Contract, explain six ways in which a contract may be
(c) Sauti Cleaners Ltd. offered to clean two garments for the price of one. A notice was discharged.
displayed in the shop to this effect but with the addition in smaller print of a statement (12 marks)
that he customer must agree in return to accept full responsibility if anything should (f) Janet and Mary entered into a contract in which Janet was to sell a car to Mary, for Sh.
happen to the garments. 250,000. Unknown to the parties, the car which had been parked at John’s garage had
A similar statement was printed on the back of the tickets which were handed to been burnt down that morning following a fire outbreak at the garage. Mary had paid
customers when they disposed the garments. Nabayi bought two garments for cleaning. Janet Sh. 100,000 as deposit. She now intends to sue Janet for breach of contract.
Because of poor eye sight, She was unable to read the small print on the notice and she Advise Janet. (8 marks)
put the ticket in her pocket without reading. (g) Citing examples, write brief notes on the following:
(i) Contracts which must be under seal. (4 marks)
Some days later when Nabayi went to collect the garments, she saw that one garment (ii) Contracts which must be in writing. (4 marks)
had been badly torn. After wearing the other garment, she contracted a skin disease (iii) Contracts which must be evidenced in writing. (4 marks)
caused by a chemical which the cleaners had used. Advise Nabayi. (10 marks) (h) Explain the contents of the memorandum required as evidence of a contract.
(d) Many contractual clauses in a contract purport to exclude liability for injury, loss or (8 marks)
damage. Explain the general rules which will determine the effectiveness of such (i) Citing relevant case law, discuss the doctrine of equitable estoppel, outlining the
clauses. (10 marks) circumstances under which it arises. (12 marks)
(e) The law provides for various remedies that are available to a person who has suffered (j) Muthoga entered into a five year lease agreement for office premises with Njenga.
following a breach of contract. Some remedies may be claimed as of right whilst other After the end of the lease period, the parties agreed that Njenga would continue
remedies will depend upon the exercise of discretion by the court. occupying the office premises for another five years. On that basis, Njenga made
extensive renovations to the office premises.
Discuss this statement. (12 marks) Muthoga has now given Njenga notice to vacate the office premises claiming that the
lease agreement had expired. Advise Njenga on his legal rights. (8 marks)
(f) Mike is offered and accepts a post of an accountant to start work in three weeks. A
week later he receives a letter from his prospective employer stating that his services (k) Giving illustrations, explain the postal rules that govern offer and acceptance where
will not be required. contracts are communicated and concluded through post. (8 marks)
Advise Mike. (8 marks) (l) Saida planned to stage a big band concert and engaged a number of eminent musicians.
(a) Certain types of mistakes in the formation of a contract may affect the validity of a She paid each musician 10% of the agreed fee at the time the separate contracts were
contract. Discuss this statement explaining the mistakes. (6 marks) made. Five days before the concert, Saida was informed that three of the musicians
(b) What is meant by the expression “contractual capacity”? Illustrate your answer with Yvonne, Omar and Mike would not appear. Yvonne could not come as she was bed
use of appropriate examples. (4 marks) ridden with acute bronchitis. Omar was unable to attend the concert as his country was
(c) Inspector Sniff offered a reward to anyone who would assist in giving information that engaged in war and Mike could not show up because his fees was not large enough.
could lead to the arrest and subsequent conviction of Rastara, a “most wanted car jacker” Saida was concerned and feared that the concert would be a failure. Saida therefore
in the city. The reward of Sh. 100,000 was advertised in the local dailies. Ole Ndume decided to cancel the concert. Saida seeks your advice on her legal rights against the
who did not know of the reward volunteered information to Inspector Sniff and Rastara three musicians. Advise Saida. (12 marks)
(m) A contract is an agreement which is enforceable by the law. in the day, Mr. E, another potential buyer said that he would pay Sh. 600,000 in cash
(n) What are the prerequisites of a valid contract? (6 marks) for the car. Mr. A agreed to sell the car to Mr. E.
(o) Explain the validity of the following contracts entered into by Rita, aged 16 years: On Monday morning, Mr. A received Mr. B’s letter of acceptance. At the same time,
(i) A contract of apprenticeship as a hairdresser with Esther. (3 marks) Mr. E returned to complete the transaction. However, in the afternoon Mr. E
(ii) A contract of purchase share in Medium Mayenne Company Ltd. telephoned Mr. A to say that he had second thoughts and he no longer wished to
(4 marks) purchase the car.
(iii) A contract with Mrs. Bwisa Nyutu, a taxi driver to visit her mother in hospital. Citing relevant decided cases where applicable, explain the legal principles in the case
(4 marks) in relation to:
(iv) A guarantee by Mrs. Kimani and Miss Tomno for an overdraft with a bank. i. Mr. A (4 marks)
(3 marks) ii. Mr. B (4 marks)
(p) Explain the principle in the rule in Dunlop Pneumatic Tyre Co. Vs. Selfridge & Co. Ltd, iii. Mrs. C (4 marks)
(1915) and the exceptions thereof. (12 iv. Ms. D (4 marks)
marks) v. Mr. E (4 marks)
(q) Mr. Jumbe who was vying for the national chairmanship of a political party, engaged (Total: 20 marks)
Mr. Musika, a local musician to perform in a series of campaign meetings the political
rallies were scheduled to be held at the Wazalendo Stadium. Mr. Jumbe paid Mr. PART TWO
Musika fifty thousand shillings as part payment for the performance fee. 1. What is the difference between a condition and a warranty? (2 marks)
Explain the legal position, if before the first rally can be held: 2. Explain the meaning of the term “privity of contract” and outline the exceptions to that
i. The dais and seats at Wazalendo Stadium are burnt down and the rallies have rule. (5 marks)
to be cancelled. (4 marks) 3. For a contract to be discharged by performance, that performance must be precise and
ii. Mr. Musika is found guilty of being in possession of narcotics and selling it exact. Discuss this statement. (5 marks)
to minors. He is arrested and sentenced to a one year jail term. 4. S. a former student at Masaku High School owes the school Sh. 50,000 as fees in arrears.
(4 marks) Mr. P. the principal of the school wrote a demand letter to F. S’s father threatening to
(r) What is the difference between a condition and a warranty? (2 marks) sue S if the school fees in arrears was not cleared within seven days. F approached P
(s) Explain the meaning of the term “privity of contract” and outline the exceptions to that and offered to make payment by delivering 30 bags of maize valued at Sh. 30,000. On
rule. (5 marks) condition that it would be full and final payment of the debt owed to the school.
(t) For a contract to be discharged by performance, that performance must be precise and Mr. P accepted the offer and the maize was delivered to the school. Two years later, S
exact. Discuss this statement. (5 marks) was employed and Mr. P now intends to sue him for the fee balance.
(u) S. a former student at Masaku High School owes the school Sh. 50,000 as fees in arrears. Discuss the legal position of S. (8 marks)
Mr. P. the principal of the school wrote a demand letter to F. S’s father threatening to 5. When parties enter into a contract, the law provides that where a written contract does
sue S if the school fees in arrears was not cleared within seven days. F approached P not accurately express the intention of the parties, the court may rectify the contract to
and offered to make payment by delivering 30 bags of maize valued at Sh. 30,000. On make it express the true intentions. State the facts that a party seeking rectification
condition that it would be full and final payment of the debt owed to the school. must prove before the court can rectify the contract. (4 marks)
Mr. P accepted the offer and the maize was delivered to the school. Two years later, S (b) Explain the concept of illegality of contracts and give three types of contracts that are
was employed and Mr. P now intends to sue him for the fee balance. Discuss the legal considered illegal. (8 marks)
position of S. (8 marks) (c) Simiyu Tito requested Wanyonyi Peter to lend him Shs. 5,000 (five thousand shillings)
(v) Mr. A, a car dealer sells second hand cars. On Thursday last week, he placed an to be repaid within a month. Wanyonyi Peter enquired what Simiyu Tito needed the
advertisement in a daily newspaper which stated the following: money for and Simiyu Tito replied that he needed Shs. 2,000 (two thousand shillings)
“Once in a lifetime, opportunity to own a one year old Nissan Caravan, low mileage, to buy food for his children and Shs. 3,000 (three thousand shillings) to bribe someone
Kshs. 500,000 cash. The offer is valid for only one day and the car will go to the first who could fix for him a person who had been bothering him. Wanyonyi Peter lent
person who accepts it.” Simiyu Tito the money. A month later, when Wanyonyi Peter asked Simiyu Tito for
When Mr. B saw the advertisement, he immediately posted a letter of acceptance of repayment of the Shs. 5,000 (five thousand shillings), Simiyu Tito refused to do so.
Mr. A’s offer. Explain the legal principles applicable in this case and advise Wanyonyi Peter.
Mrs. C also saw the advertisement and came to inspect the car after which Mrs. C (8 marks)
offered Mr. A a cheque of Kshs. 500,000. However, Mr. A refused to accept the
cheque stating that another potential buyer had already offered to buy the car.
Later in the day Ms D, another interested buyer telephoned Mr. A informing him that
she was willing to buy the car but asked Mr. A if he would keep the offer open until
she could go to her bank to obtain a loan. Mr. A accepted the request. However later,
UNIVERSITY OF NAIROBI
Department of Management Science and Project Planning
DMS 311 CAT 1 15th March 2022 Time 1hr 30 Min
Attempt all questions
QUESTION ONE (30 marks)
Kabete paints is a privately owned company specializing in the production of paints. The selling prices and the associated
unit variable costs for two of its most popular brands Orange and United paints are shown in the Table below.
Paint type Selling price (Ksh) per litre Unit Variable Cost (Ksh) per
Litre
United 3.25 2.25
Orange 4 2.5
The company package the paint in four-liter containers. Each container of United Paint requires six minutes of skilled
labour while Orange Paints requires 12 minutes of skilled labor. In a given day, there are 40 skilled men working on
average 10 hours. In addition, there are 100 milliliters of an important blending chemical available each day, where
each container of United Paint needs 0.05millilitres while each container of Orange Paint requires 0.02 milliliters of the
blending chemical. The processing capacity at the plant is limited to 3,000 containers of paints per day.
The company is committed to supplying a leading retailer with 5,000 containers of United Paint and 2,500 containers of
Orange Paint each working week consisting of 5 days. In addition, there is an agreement with the union that at least
2,000 containers are produced each day. The company management would like to determine the daily production
volume of each of the two paints that will maximize total contribution.
Required
a) Develop a linear model of the production problem facing the company

b) Using a graphical approach, determine the optimum daily production plan and the consequent contribution
c) The union is pressing for an overtime wage rate of Ksh 20 per hour above the wage rate for skilled labor.
i. Is this a profitable possibility or not? Show your workings
ii. If it was profitable to pay the overtime, how many overtime hours per day would it be worth employing?
d) In the original problem (where overtime is not contemplated), determine the maximum range of variation in the
unit contribution figure on a container of Orange paint for the original solution to remain optimal.
QUESTION TWO (25 marks)

Campaign time is with us and Vpower airline LTD was established late last year to offer flight services across the country
to campaign teams. The company has a total of six aircraft of different types as shown in Table 1. For a given journey,
variable costs are computed based on the distance flown and the number of passengers being carried. Fixed costs are
then added to obtain the relevant total cost. The operating costs and passenger-carrying capacities details are shown in
Table 1.
Aircraft No. of Aircraft operating costs (Ksh) Aircraft

type aircrafts Fixed cost Variable cost passenger-
per day Per KM Per carrying capacity
passenger
Turbo 3 10000 70 400 10
Fighter 2 8000 50 350 8
Jet 1 5000 110 250 4
Table 1
As you know, weekends are popular campaign days. Consequently, the company has to transport 5 different groups of
passengers from Nairobi to their campaign destinations. The number of passengers for each group and the distance to
each destination is shown in Table 2.
Passengers G1 G2 G3 G4 G5
group
Number of 10 2 8 5 3
passengers
Distance 300 600 300 350 500
(KM)
Table 2
The distances given in Table 2 are direct from Nairobi to each of the group’s destination. To minimize its risk exposure,
the company drops the passengers and returns backs immediately, thus in each case, the aircraft fly back empty.
Consequently, mileage costs will be incurred on both the outward and return journeys while the passenger variable cost is
only on the outward journey. All five return journeys can be completed within one Saturday and each aircraft can only fly
one group (remember the groups belong to different political camps). In addition, a group cannot be divided up and be
carried in different aircrafts.
Required
a) Using an appropriate Operation Research Model, determine which aircraft should be used for transportation of
each group in order to minimize total cost. 17 marks
b) What is the total cost of making the five deliveries? 5 marks
c) Determine if there is an alternate optimal solution 3 marks
QUESTION THREE (25 marks)
Consider a transportation problem in which the initial solution given below was arrived at through the least cost
method.
Required: Determine the optimal solution
Chapter 12 (11ed-11)
Cash Flow Estimation
and Risk Analysis
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated
MBA. The production line would be set up in unused space in Shrieves’ main plant. The
machinery’s invoice price would be approximately $200,000; another $10,000 in shipping
charges would be required; and it would cost an additional $30,000 to install the
equipment. The machinery has an economic life of 4 years, and Shrieves has obtained a
special tax ruling which places the equipment in the MACRS 3-year class. The machinery
is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for four years at an
incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be
sold for $200 in the first year. The sales price and cost are expected to increase by 3% per
year due to inflation. Further, to handle the new line, the firm’s net operating working
capital would have to increase by an amount equal to 12% of sales revenues. The firm’s
tax rate is 40 percent, and its overall weighted average cost of capital is 10 percent.
a. Define “incremental cash flow.”
Answer: This is the firm’s cash flow with the project minus the firm’s cash flow without the
project.
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we
apply the 10 percent cost of capital discount rate, hence including financing flows
would be "double counting." Put another way, if we deducted capital costs in the
table, and thus reduced the bottom line cash flows, and then discounted those CFS by
the cost of capital, we would, in effect, be subtracting capital costs twice.
a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Mini Case: 11 - 2
Answer: The $100,000 cost to rehabilitate the production line site was incurred last year, and
presumably also expensed for tax purposes. Since, it is a sunk cost, it should not be
included in the analysis.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000 a
year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this
project, it would forgo the opportunity to receive $25,000 in annual cash flows. This
represents an opportunity cost to the project, and it should be included in the analysis.
Note that the opportunity cost cash flow must be net of taxes, so it would be a
$25,000(1 - t) = $25,000(0.6) = $15,000 annual outflow.
a. 4. Finally, assume that the new product line is expected to decrease sales of the
firm’s other lines by $50,000 per year. Should this be considered in the analysis?
If so, how?
Answer: If a project affects the cash flows of another project, this is an "externality" which
must be considered in the analysis. If the firm's sales would be reduced by $50,000,
then the net cash flow loss would be a cost to the project. Note that this annual loss
would not be the full $50,000, because Shrieves would save on cash operating costs if
its sales dropped. Note also that externalities can be positive as well as negative.
b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis?
Answer: Get the depreciation rates from table 11-2 in the book. Note that because of the half-
year convention, a 3-year project is depreciated over 4 calendar years:
YEAR RATE  BASIS = DEPRECIATION

1 0.33 $240 $ 79
2 0.45 240 108
3 0.15 240 36
4 0.07 240 17
$240
Mini Case: 11 - 3

Units 1250 1250 1250 1250
Unit Price $200.00 $206.00 $212.18 $218.55
Unit Cost $100.00 $103.00 $106.09 $109.27
Sales $250,000 $257,500 $265,225 $273,188

Costs $125,000 $128,750 $132,613 $136,588
The cost of capital is a nominal cost; i.e., it includes a premium for inflation. In other
words, it is larger than the real cost of capital. Similarly, nominal cash flows (those
that are inflated) are larger than real cash flows. If you discount the low, real cash
flows with the high, nominal rate, then the resulting NPV is too low. Therefore, you
should always discount nominal cash flows with a nominal rate, and real cash flows
with a real rate. In theory, you could do either way and get the correct answer.
However, there is no accurate way to convert a nominal cost of capital to a real cost.
Therefore, you should inflate cash flows and then discount at the nominal rate.
Here are the annual operating cash flows (in thousands of dollars):
1 2 3 4
Net Revenues $125 $125 $125 $125
Depreciation 79 108 36 17
Before-Tax Income $ 46 $ 17 $ 89 $108
Taxes (40%) 18 7 36 43
Net Income $ 28 $ 10 $ 53 $ 65
Plus Depreciation 79 108 36 17
Net Operating CF $107 $118 $ 89 $ 82
Mini Case: 11 - 4
d. Construct annual incremental operating cash flow statements.
Answer:
Sales $250,000 $257,500 $265,225 $273,188
Costs $125,000 $128,750 $132,613 $136,588
Depreciation $79,200 $108,000 $36,000 $16,800
Op. EBIT $45,800 $20,750 $96,612 $119,800
Taxes (40%) $18,320 $8,300 $38,645 $47,920
NOPAT $27,480 $12,450 $57,967 $71,880
Depreciation $79,200 $108,000 $36,000 $16,800
Net Operating CF $106,680 $120,450 $93,967 $88,680
e. Estimate the required net operating working capital for each year, and the cash
flow due to investments in net operating working capital.
Answer: The project requires a level of net operating working capital in the amount equal to
12% of the next year’s sales. Any increase in NOWC is a negative cash flow, and
any decrease is a positive cash flow.

Sales $250,000 $257,500 $265,225 $273,188
NOWC (% of sales) $30,000 $30,900 $31,827 $32,783 $0
CF due to NOWC) ($30,000) ($900) ($927) ($956) $32,783
f. Calculate the after-tax salvage cash flow.
Answer: When the project is terminated at the end of year 4, the equipment can be sold for
$25,000. But, since it has been depreciated to a $0 book value, taxes must be paid on
the full salvage value. For this project, the after-tax salvage cash flow is:
Salvage Value $25,000

Tax On Salvage Value (10,000)
Net After-Tax Salvage Cash Flow $15,000
Mini Case: 11 - 5
g. Calculate the net cash flows for each year? Based on these cash flows, what are
the project’s NPV, IRR, MIRR, and payback? Do these indicators suggest that
the project should be undertaken?
Answer: The net cash flows are:

Initial Outlay ($240,000)
Operating Cash Flows $106,680 $120,450 $93,967 $88,680
CF Due To NOWC ($30,000) ($900) ($927) ($956) $32,783
Salvage Cash Flows $15,000
Net Cash Flows ($270,000) $105,780 $119,523 $93,011 $136,463
NPV = $88,030
IRR = 23.9%
MIRR = 18.0%
Payback = 2.5
h. What does the term “risk” mean in the context of capital budgeting, to what
extent can risk be quantified, and when risk is quantified, is the quantification
based primarily on statistical analysis of historical data or on subjective,
judgmental estimates?
Answer: Risk throughout finance relates to uncertainty about future events, and in capital
budgeting, this means the future profitability of a project. For certain types of
projects, it is possible to look back at historical data and to statistically analyze the
riskiness of the investment. This is often true when the investment involves an
expansion decision; for example, if Sears were opening a new store, if Citibank were
opening a new branch, or if GM were expanding its Chevrolet plant, then past
experience could be a useful guide to future risk. Similarly, a company that is
considering going into a new business might be able to look at historical data on
existing firms in that industry to get an idea about the riskiness of its proposed
investment. However, there are times when it is impossible to obtain historical data
regarding proposed investments; for example, if GM were considering the
development of an electric auto, not much relevant historical data for assessing the
riskiness of the project would be available. Rather, GM would have to rely primarily
on the judgment of its executives, and they, in turn would have to rely on their
experience in developing, manufacturing, and marketing new products. We will try to
quantify risk analysis, but you must recognize at the outset that some of the data used
in the analysis will necessarily be based on subjective judgments rather than on hard
statistical observations.
Mini Case: 11 - 6
i. 1. What are the three types of risk that are relevant in capital budgeting?
2. How is each of these risk types measured, and how do they relate to one
another?
Answer: Here are the three types of project risk:
 Stand-alone risk is the project’s total risk if it were operated independently. Stand-
alone risk ignores both the firm’s diversification among projects and investors’
diversification among firms. Stand-alone risk is measured either by the project’s
standard deviation of NPV (σNPV) or its coefficient of variation of NPV (CVNPV).
Note that other profitability measures, such as IRR and MIRR, can also be used to
obtain stand-alone risk estimates.
 Within-firm risk is the total riskiness of the project giving consideration to the firm’s
other projects, that is, to diversification within the firm. It is the contribution of the
project to the firm’s total risk, and it is a function of (a) the project’s standard
deviation of NPV and (b) the correlation of the projects’ returns with those of the rest
of the firm. Within-firm risk is often called corporate risk, and it is measured by the
project’s corporate beta, which is the slope of the regression line formed by plotting
returns on the project versus returns on the firm.
 Market risk is the riskiness of the project to a well-diversified investor, hence it

considers the diversification inherent in stockholders’ portfolios. It is measured by
the project’s market beta, which is the slope of the regression line formed by plotting
returns on the project versus returns on the market.
i. 3. How is each type of risk used in the capital budgeting process?
Answer: Because management’s primary goal is shareholder wealth maximization, the most
relevant risk for capital projects is market risk. However, creditors, customers,
suppliers, and employees are all affected by a firm’s total risk. Since these parties
influence the firm’s profitability, a project’s within-firm risk should not be
completely ignored.
Unfortunately, by far the easiest type of risk to measure is a project’s stand-alone
risk. Thus, firms often focus on this type of risk when making capital budgeting
decisions. However, this focus does not necessarily lead to poor decisions, because
most projects that a firm undertakes are in its core business. In this situation, a
project’s stand-alone risk is likely to be highly correlated with its within-firm risk,
which in turn is likely to be highly correlated with its market risk.
Mini Case: 11 - 7
j. 1. What is sensitivity analysis?
Answer: Sensitivity analysis measures the effect of changes in a particular variable, say
revenues, on a project’s NPV. To perform a sensitivity analysis, all variables are
fixed at their expected values except one. This one variable is then changed, often by
specified percentages, and the resulting effect on NPV is noted. (One could allow
more than one variable to change, but this then merges sensitivity analysis into
scenario analysis.)
j. 2. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital
for the project. Assume that each of these variables can vary from its base case,
or expected, value by plus and minus 10, 20, and 30 percent. Include a
sensitivity diagram, and discuss the results.
Answer: The sensitivity data are given here in tabular form (in thousands of dollars):
NPV Deviation From Base Case

Deviation
From Units
Base WACC Sold Salvage
Case
-30% $113,288 $16,668 $84,956
-15% $100,310 $52,348 $86,493
0% $88,030 $88,030 $88,030
15% $76,398 $123,711 $89,567
30% $65,371 $159,392 $91,103
Range 47,916 176,060 6,147
We generated these data with a spreadsheet model in the file ch 11 mini case.xls.
Mini Case: 11 - 8
WACC
Sensitivity Analysis Units Sold
Salvage
$180,000
$160,000
$140,000
$120,000
$100,000
NPV
$80,000
$60,000
$40,000
$20,000
$0
-40% -20% 0% 20% 40%
Deviation from Base-Case Value
A. The sensitivity lines intersect at 0% change and the base case NPV, $81,573.
Since all other variables are set at their base case, or expected values, the zero
change situation is the base case.
B. The plots for unit sales and salvage value are upward sloping, indicating that
higher variable values lead to higher NPVs. Conversely, the plot for cost of
capital is downward sloping, because a higher cost of capital leads to a lower
NPV.
C. The plot of unit sales is much steeper than that for salvage value. This indicates
that NPV is more sensitive to changes in unit sales than to changes in salvage
value.
D. Steeper sensitivity lines indicate greater risk. Thus, in comparing two projects,
the one with the steeper lines is considered to be riskier.
Mini Case: 11 - 9
j. 3. What is the primary weakness of sensitivity analysis? What is its primary
usefulness?
Answer: The two primary disadvantages of sensitivity analysis are (1) that it does not reflect
the effects of diversification and (2) that it does not incorporate any information about
the possible magnitudes of the forecast errors. Thus, a sensitivity analysis might
indicate that a project’s NPV is highly sensitive to the sales forecast, hence that the
project is quite risky, but if the project’s sales, hence its revenues, are fixed by a long-
term contract, then sales variations may actually contribute little to the project’s risk.
It also ignores any relationships between variables, such as unit sales and sales price.
Therefore, in many situations, sensitivity analysis is not a particularly good indicator
of risk. However, sensitivity analysis does identify those variables which potentially
have the greatest impact on profitability, and this helps management focus its
attention on those variables that are probably most important.
k. Assume that Sidney Johnson is confident of her estimates of all the variables that
affect the project’s cash flows except unit sales and sales price: if product
acceptance is poor, unit sales would be only 900 units a year and the unit price
would only be $160; a strong consumer response would produce sales of 1,600
units and a unit price of $240. Sidney believes that there is a 25 percent chance
of poor acceptance, a 25 percent chance of excellent acceptance, and a 50 percent
chance of average acceptance (the base case).
k. 1. What is scenario analysis?
Answer: Scenario analysis examines several possible situations, usually worst case, most likely
case, and best case. It provides a range of possible outcomes.
Mini Case: 11 - 10
k. 2. What is the worst-case NPV? The best-case NPV?
k. 3. Use the worst-, most likely, and best-case NPVs and probabilities of occurrence
to find the project’s expected NPV, standard deviation, and coefficient of
variation.
Answer: We used a spreadsheet model to develop the scenarios (in thousands of dollars),
which are summarized below:
Scenario Probability Unit Sales Unit Price NPV
Best Case 25% 1600 $240 $278,965

Base Case 50% 1250 $200 $88,030
Worst Case 25% 900 $160 ($48,514)
Expected NPV = $101,628
Standard Deviation = $75,684
Coefficient Of Variation =
Std Dev / Expected NPV = 0.74
Mini Case: 11 - 11
l. Are there problems with scenario analysis? Define simulation analysis, and
discuss its principal advantages and disadvantages.
Answer: Scenario analysis examines several possible scenarios, usually worst case, most likely
case, and best case. Thus, it usually considers only 3 possible outcomes. Obviously
the world is much more complex, and most projects have an almost infinite number
of possible outcomes.
Simulation analysis is a type of scenario analysis which uses a relatively powerful

financial planning software such as interactive financial planning system (IFPs) or
@risk (a spreadsheet add-in). Simple simulations can also be conducted with other
spreadsheet add-ins, such as Simtools. Here the uncertain cash flow variables (such as
unit sales) are entered as continuous probability distribution parameters rather than as
point values. Then, the computer uses a random number generator to select values for
the uncertain variables on the basis of their designated distributions. Once all of the
variable values have been selected, they are combined, and an NPV is calculated. The
process is repeated many times, say 1,000, with new values selected from the
distributions for each run. The end result is a probability distribution of NPV based
on a sample of 1,000 values. The software can graph the distribution as well as print
out summary statistics such as expected NPV and σNPV. Simulation provides the
decision maker with a better idea of the profitability of a project than does scenario
analysis because it incorporates many more possible outcomes.
Although simulation analysis is technically refined, its usefulness is limited because

managers are often unable to accurately specify the variables’ probability
distributions. Further, the correlations among the uncertain variables must be
specified, along with the correlations over time. If managers are unable to do this
with much confidence, then the results of simulation analyses are of limited value.
Recognize also that neither sensitivity, scenario, nor simulation analysis provides a
decision rule--they may indicate that a project is relatively risky, but they do not
indicate whether the project’s expected return is sufficient to compensate for its risk.
Finally, remember that sensitivity, scenario, and simulation analyses all focus on
stand-alone risk, which is not the most relevant risk in capital budgeting analysis.
m. 1. Assume that Shrieves’ average project has a coefficient of variation in the range
of 0.2 - 0.4. Would the new line be classified as high risk, average risk, or low
risk? What type of risk is being measured here?
Answer: The project has a CV of 0.57, which is above the average range of 0.2-0.4, so it falls
into the high risk category. The CV measures a project’s stand-alone risk-it is merely
a measure of the variability of returns (as measured by NPV) about the expected
return.
Mini Case: 11 - 12
m. 2. Shrieves typically adds or subtracts 3 percentage points to the overall cost of capital to adjust
for risk. Should the new furniture line be accepted?
Answer: Since the project is judged to have above-average risk, its differential risk-adjusted, or project, cost of
capital would be 13 percent. At this discount rate, its NPV would be
$60,541, so it would still be acceptable. If it were a low risk project, its cost of capital would be 7
percent, its NPV would be $104,975, and it would be an even more profitable project on a risk-adjusted
basis.
m. 3. Are there any subjective risk factors that should be considered before the final decision is made?
Answer: A numerical analysis such as this one may not capture all of the risk factors inherent in the project. If the
project has a potential for bringing on harmful lawsuits, then it might be riskier than first assessed. Also,
if the project’s assets can be redeployed within the firm or can be easily sold, then, as a result of
“abandonment possibilities,” the project may be less risky than the analysis indicates.
a.
Corporate finance provides the skills managers need to: (1) identify and select the
corporate strategies and individual projects that add value to their firm; and (2) forecast
the funding requirements of their company, and devise strategies for acquiring those
funds.
b.
The corporation's primary goal is stockholder wealth maximization, which translates to
maximizing 1he price of the firm's common stock.
(1) Firms have an ethical responsibility to provide a safe \Vorking environment, to

avoid polluting the air or \Vater, and to produce safe products. Ho\\'ever, the most
significant cost-increasing actions \\'ill have to be put on a mandatory rather than a
voluntary basis to ensure that the burden falls uniformly on all businesses.
(2) The same actions that maximize stock prices also benefit society. Stock price
maximization requires efficient, low-cost operations that produce high-quality goods and
services at the lowest possible cost. Stock price maximization requires the development
of products and services that consumers \Vant and need, so the profit motive leads to ne\v
technology, to ne\v products, and to new jobs. Also, stock price maximization
necessitates efficient and courteous service, adequate stocks of merchandise, and well-
located business establishments--factors that are all necessary to make sales, \Vhich are
necessary for profits.
(3) Yes. Results of a recent study indicate that the executives of most major firms in
the United States believe that firms do try to maintain high ethical standards in all of their
business dealings. Furthermore, most executives believe that there is a positive
correlation bet\veen ethics and long-run profitability.Conflicts often arise between profits
and ethics. Companies must deal "'ith these conflicts on a regular basis, and a failure to
handle the •ituation properly can lead to huge product liability suits and even to
bankruptcy.There is no room for unethical behaviour in the business world.
c.The three aspects of cash flo\v affect the value of any investment are belo\\':
(1) Amount of expected cash flows;
(2) Timing of the cash flo\v stream; and
(3) Riskiness of the cash flo\vs.
d.
Free cash flows are the cash flo\vs available for distribution to all investors (stockholders
and creditors) after paying expenses (including taxes) and making the necessary
investments 10 support growth. Three factors determine cash flows:
(1) Current level and gro\vth rates of sales;
(2) Operating expenses; and
(3) Capital expenses.
e.
The \Veighted average cost of capital (VJACC) is the average rate of return required by all
of the company's investors (stockholders and creditors). It is affected by the firm's
capital structure, interest rates, the firm's risk, and the market's overall attitude toward
risk.
f.
The follo\ving list contains some factors that affect the cost of money, both big and small.
1. Balance of trade and investment: The balance of trade and investment is often
cited by analysts as the most important influence on the cost of money with good reason.
The balance of investment, or financial account, represents the difference in exports and
imports of capital. If exports exceed imports, in either the current account or financial
account, it is called a surplus. When imports exceed exports, on the other hand, it is
referred to as a deficit.
2. Politics: Government policies often have a great impact on the cost of money.
Savvy foreign investors kno\\• to keep an eye on the state of our political affairs,
especially as they impact the strength of our economy and our ability to service the
national debt
4. Budget deficit and national debt: The US government's budget can affect the
dollar's value, too. If foreign investors see that the government is spending more money
than it currently has, they know that it \\•ill be forced to borro\v from future generations as
\Veil as from the private sector from foreign entities. The US national debt currently
stands at $9 trillion and is gro\ving by over $1 billion per day.
5. Little or no default on debt: When the government keeps a good credit history,
risk goes down and the dollar goes up. Fortunately, the US is currently considered the
\Vorld's most credit-\vorthy borro\\•er, \Vhich in large part explains why the dollar has
remained strong.
6. Terrorist attacks and \\•ar: Attacks damage consumer and business confidence,
hampering economic growth.They also increasethe likelihood of \var, and consequently,
a budget deficit to support associated spending. An ongoing \Var can quickly become
expensive. It makes investors nervous because it will likely increase our national debt,
and slightly increase the risk of default.
7. Economic theory: The laws of supply and demand are ever-present in economics,
and currency trading offers a prime example of this la\v in action. These are a fe\V of the
effects that supply and demand exert on the value of the dollar.
a. A firm's value is the sum of all future expected free cash flo\vs, converted into
today's dollars.
g.
Value = FCF 1 + FCF1 +...+ FCFm
(l + WACC) 1 (l + WACC) 2 (l + JfA
' CC)m
h.
No, in this case agency problem \vill not arise as agency problem arise whenever a
manager owns less than I00% of the firm's stock.
I.
Yes, in this case agency problem \Vil! arise. As agency problem arise whenever principal
hires agent to perform the function.
.
J.
The capital requirement met by the \Vay of bank loan \viii increase the agency problem. If
the operation is expanded and if it proves to be riokier, it might lead to 1000 or even
bankruptcy. In that case creditors \\rill be loser. But if it proves to be profitable then
k. Agency problem will increase on expanding the operation as managers tend to increase
the compensation to be paid to them. Agency problem'"ill increase in case of licensing
franchises and expansion of business on other campuses.
I. Ifthe operation is expanded and if it proves to be riskier, it might lead to loss or even
bankruptcy. In that case creditors \viii be loser. But if it proves to be profitable then
m.Here are some actions which the president can take to mitigate agency problem:
Agency problem \viii increase on expanding the operation as managers tend to
increase the compensation to be paid to them. So bringing an IPO will increase agency
problem as the shares \vill get more diluted also.
n. The agency problem will be more likely if stayed as CEO and ran the company.
o. The reported earning is inflated to make the financial position stronger so as to attract
the interest of stockholders in the firm. But doing so \viii increase the burden of dividend
payment to 1he stockholders. And to distribute the dividend, company \\ill spend the
retained earnings.
p. Here are some actions which might be used to minimize agency problem:
I. Managers can be encouraged to act in the shareholders' best interest through

a set of incentives, constraints and punishments.
2. Stockholders must incur agency costs, which include all cost borne
shareholders to encourage managers to maximize the firm's long-term stock price
rather than act in their own self interest.
CPSP PART I
LAW OF CONTRACT
BLOCK RELEASE MAY 2018
(a) How true is it to say that in order for a contract to be discharged by performance, the performance must be precise and exact?
(10 marks)
(b) Annan agreed to paint Angela’s house at an agreed price. When Annan had finished the work. Angela discovered that although most of
the painting was satisfactory, Annan had forgotten to apply a coat of gloss paint on one of the doors. Annan fell ill and could not complete
the work. Angela refused to pay Annan the contractual price, claiming that the contract had not been fully executed and that therefore he
was entitled to be paid only a reasonable sum for the work he had actually undertaken. This, Annan claimed, was much less than the
contract price. Advise Annan.
(10 marks)
(c) Sauti Cleaners Ltd. offered to clean two garments for the price of one. A notice was displayed in the shop to this effect but with the
addition in smaller print of a statement that he customer must agree in return to accept full responsibility if anything should happen to the
garments.
A similar statement was printed on the back of the tickets which were handed to customers when they disposed the garments. Nabayi
bought two garments for cleaning. Because of poor eye sight, She was unable to read the small print on the notice and she put the ticket in
her pocket without reading.
Some days later when Nabayi went to collect the garments, she saw that one garment had been badly torn. After wearing the other
garment, she contracted a skin disease caused by a chemical which the cleaners had used. Advise Nabayi. (10 marks)
(d) Many contractual clauses in a contract purport to exclude liability for injury, loss or damage. Explain the general rules which will
determine the effectiveness of such clauses. (10 marks)
(e) The law provides for various remedies that are available to a person who has suffered following a breach of contract. Some remedies may
be claimed as of right whilst other remedies will depend upon the exercise of discretion by the court.
Discuss this statement. (12 marks)
(f) Mike is offered and accepts a post of an accountant to start work in three weeks. A week later he receives a letter from his prospective
employer stating that his services will not be required.
Advise Mike. (8 marks)
(a) Certain types of mistakes in the formation of a contract may affect the validity of a contract. Discuss this statement explaining the
mistakes. (6 marks) Mini Case: 11 - 30
(b) What is meant by the expression “contractual capacity”? Illustrate your answer with use of appropriate examples.
(4 marks)
(c) Inspector Sniff offered a reward to anyone who would assist in giving information that could lead to the arrest and subsequent conviction of
Rastara, a “most wanted car jacker” in the city. The reward of Sh. 100,000 was advertised in the local dailies. Ole Ndume who did not
know of the reward volunteered information to Inspector Sniff and Rastara was arrested and convicted. However, Inspector Sniff did not
give Ole Ndume the reward. It is now three months since the arrest and Ole Ndume has learnt of the reward. He seeks your legal advice
on whether he can successfully claim the reward. Advice Ole Ndume. (10 marks)
(d) In relation to the Law of Contract
i. Explain five essentials of a valid contract. (10 marks)
ii. Jackson entered into a contract with Jacinta whereby Jackson was to introduce Jacinta to Tajiri with a view of Tajiri marrying
Jacinta. Jackson asked Jacinta to give him Sh. 10,000 which she did. Jackson then introduced Jacinta to Tajiri and Tajiri
promised to marry Jacinta in case his wife who was by then very ill in hospital passed away.
However, Tajiri’s wife Juliana underwent a successful surgery and fully recovered from the illness. Tajiri has now refused to
marry Jacinta.
Jacinta is aggrieved and wishes to sue Jackson and Tajiri. Advise her.
(10 marks)
(e) In relation to the Law of Contract, explain six ways in which a contract may be discharged.
(12 marks)
(f) Janet and Mary entered into a contract in which Janet was to sell a car to Mary, for Sh. 250,000. Unknown to the parties, the car which had
been parked at John’s garage had been burnt down that morning following a fire outbreak at the garage. Mary had paid Janet Sh. 100,000
as deposit. She now intends to sue Janet for breach of contract. Advise Janet. (8 marks)
(g) Citing examples, write brief notes on the following:
(i) Contracts which must be under seal. (4 marks)
(ii) Contracts which must be in writing. (4 marks)
(iii) Contracts which must be evidenced in writing. (4 marks)
(h) Explain the contents of the memorandum required as evidence of a contract.
(8 marks)
(i) Citing relevant case law, discuss the doctrine of equitable estoppel, outlining the circumstances under which it arises.
(12 marks)
(j) Muthoga entered into a five year lease agreement for office premises with Njenga. After the end of the lease period, the parties agreed that
Njenga would continue occupying the office premises for another five years. On that basis, Njenga made extensive renovations to the
office premises.
Muthoga has now given Njenga notice to vacate the office premises claiming that the lease agreement had expired. Advise Njenga on his
legal rights. (8 marks)
(k) Giving illustrations, explain the postal rules that govern offer and acceptance where contracts are communicated and concluded through
post. (8 marks)
(l) Saida planned to stage a big band concert and engaged a number of eminent musicians. She paid each musician 10% of the agreed fee at
the time the separate contracts were made. Five days before the concert, Saida was informed that three of the musicians Yvonne, Omar and
Mike would not appear. Yvonne could not come as she was bed ridden with acute bronchitis. Omar was unable to attend the concert as his
country was engaged in war and Mike could not show up because his fees was not large enough. Saida was concerned and feared that the
concert would be a failure. Saida therefore decided to cancel the concert. Saida seeks your advice on her legal rights against the three
musicians. Advise Saida. (12 marks)
(m) A contract is an agreement which is enforceable by the law.
(n) What are the prerequisites of a valid contract? (6 marks)
(o) Explain the validity of the following contracts entered into by Rita, aged 16 years:
(i) A contract of apprenticeship as a hairdresser with Esther. (3 marks)
(ii) A contract of purchase share in Medium Mayenne Company Ltd.
(4 marks)
(iii) A contract with Mrs. Bwisa Nyutu, a taxi driver to visit her mother in hospital.
(4 marks)
(iv) A guarantee by Mrs. Kimani and Miss Tomno for an overdraft with a bank.
(3 marks)
(p) Explain the principle in the rule in Dunlop Pneumatic Tyre Co. Vs. Selfridge & Co. Ltd, (1915) and the exceptions thereof.
(12 marks)
(q) Mr. Jumbe who was vying for the national chairmanship of a political party, engaged Mr. Musika, a local musician to perform in a series of
campaign meetings the political rallies were scheduled to be held at the Wazalendo Stadium. Mr. Jumbe paid Mr. Musika fifty thousand
shillings as part payment for the performance fee.
Explain the legal position, if before the first rally can be held:
i. The dais and seats at Wazalendo Stadium are burnt down and the rallies have to be cancelled.
(4 marks)
ii. Mr. Musika is found guilty of being in possession of narcotics and selling it to minors. He is arrested and sentenced to a one year
jail term.
(4 marks)
(r) What is the difference between a condition and a warranty? (2 marks)
(s) Explain the meaning of the term “privity of contract” and outline the exceptions to that rule.
(5 marks)
(t) For a contract to be discharged by performance, that performance must be precise and exact. Discuss thisMini
statement.
Case: 11 - 31
(5 marks)
(u) S. a former student at Masaku High School owes the school Sh. 50,000 as fees in arrears. Mr. P. the principal of the school wrote a
demand letter to F. S’s father threatening to sue S if the school fees in arrears was not cleared within seven days. F approached P and
offered to make payment by delivering 30 bags of maize valued at Sh. 30,000. On condition that it would be full and final payment of the
debt owed to the school.
Mr. P accepted the offer and the maize was delivered to the school. Two years later, S was employed and Mr. P now intends to sue him for
the fee balance. Discuss the legal position of S. (8 marks)
(v) Mr. A, a car dealer sells second hand cars. On Thursday last week, he placed an advertisement in a daily newspaper which stated the
following:
“Once in a lifetime, opportunity to own a one year old Nissan Caravan, low mileage, Kshs. 500,000 cash. The offer is valid for only one
day and the car will go to the first person who accepts it.”
When Mr. B saw the advertisement, he immediately posted a letter of acceptance of Mr. A’s offer.
Mrs. C also saw the advertisement and came to inspect the car after which Mrs. C offered Mr. A a cheque of Kshs. 500,000. However, Mr.
A refused to accept the cheque stating that another potential buyer had already offered to buy the car.
Later in the day Ms D, another interested buyer telephoned Mr. A informing him that she was willing to buy the car but asked Mr. A if he
would keep the offer open until she could go to her bank to obtain a loan. Mr. A accepted the request. However later, in the day, Mr. E,
another potential buyer said that he would pay Sh. 600,000 in cash for the car. Mr. A agreed to sell the car to Mr. E.
On Monday morning, Mr. A received Mr. B’s letter of acceptance. At the same time, Mr. E returned to complete the transaction.
However, in the afternoon Mr. E telephoned Mr. A to say that he had second thoughts and he no longer wished to purchase the car.
Citing relevant decided cases where applicable, explain the legal principles in the case in relation to:
i. Mr. A (4 marks)
ii. Mr. B (4 marks)
iii. Mrs. C (4 marks)
iv. Ms. D (4 marks)
v. Mr. E (4 marks)
(Total: 20 marks)
PART TWO
1. What is the difference between a condition and a warranty? (2 marks)
2. Explain the meaning of the term “privity of contract” and outline the exceptions to that rule.
(5 marks)
3. For a contract to be discharged by performance, that performance must be precise and exact. Discuss this statement.
(5 marks)
4. S. a former student at Masaku High School owes the school Sh. 50,000 as fees in arrears. Mr. P. the principal of the school wrote a
demand letter to F. S’s father threatening to sue S if the school fees in arrears was not cleared within seven days. F approached P and
offered to make payment by delivering 30 bags of maize valued at Sh. 30,000. On condition that it would be full and final payment of the
debt owed to the school.
Mr. P accepted the offer and the maize was delivered to the school. Two years later, S was employed and Mr. P now intends to sue him for
the fee balance.
Discuss the legal position of S. (8 marks)
5. When parties enter into a contract, the law provides that where a
written contract does not accurately express the intention of the parties, the court may rectify the contract to make it express the true
intentions. State the facts that a party seeking rectification must prove before the court can rectify the contract. (4 marks)
(b) Explain the concept of illegality of contracts and give three types of contracts that are considered illegal.
(8 marks)
(c) Simiyu Tito requested Wanyonyi Peter to lend him Shs. 5,000 (five thousand shillings) to be repaid within a month. Wanyonyi Peter
enquired what Simiyu Tito needed the money for and Simiyu Tito replied that he needed Shs. 2,000 (two thousand shillings) to buy food
for his children and Shs. 3,000 (three thousand shillings) to bribe someone who could fix for him a person who had been bothering him.
Wanyonyi Peter lent Simiyu Tito the money. A month later, when Wanyonyi Peter asked Simiyu Tito for repayment of the Shs. 5,000
(five thousand shillings), Simiyu Tito refused to do so.
Explain the legal principles applicable in this case and advise Wanyonyi Peter.
(8 marks)
Mini Case: 11 - 32

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UNIVERSITY OF NAIROBI

Department of Management Science and Project Planning

a) Develop a linear model of the production problem facing the company

QUESTION TWO (25 marks)

Aircraft No. of Aircraft operating costs (Ksh) Aircraft

Required: Determine the optimal solution

a. Define “incremental cash flow.”

b. Disregard the assumptions in part a. What is Shrieves’ depreciable basis?

YEAR RATE  BASIS = DEPRECIATION

Year 1 Year 2 Year 3 Year 4

Sales $250,000 $257,500 $265,225 $273,188

Year 0 Year 1 Year 2 Year 3 Year 4

f. Calculate the after-tax salvage cash flow.

Salvage Value $25,000

Answer: The net cash flows are:

Year 0 Year 1 Year 2 Year 3 Year 4

Answer: Here are the three types of project risk:

 Market risk is the riskiness of the project to a well-diversified investor, hence it

i. 3. How is each type of risk used in the capital budgeting process?

NPV Deviation From Base Case

Range 47,916 176,060 6,147

k. 1. What is scenario analysis?

Scenario Probability Unit Sales Unit Price NPV

Best Case 25% 1600 $240 $278,965

Expected NPV = $101,628

Simulation analysis is a type of scenario analysis which uses a relatively powerful

Although simulation analysis is technically refined, its usefulness is limited because

(1) Firms have an ethical responsibility to provide a safe \Vorking environment, to

2. A disadvantage of the corporate form of organization is

Stock Splits Stock Dividends

7. The term legal capital is a descriptive term for

a. Dividends Payable 63,000

b. Cash Dividends 63,000

d. Dividends Payable 63,000

11. Dividends in arrears are dividends on

14. Which of the following is not true of a corporation?

_____ 1. Separate legal entity

_____ 2. Taxable entity resulting in additional taxes

_____ 3. Continuous life

_____ 4. Unlimited liability of owners

_____ 5. Government regulation

_____ 6. Separation of ownership and management

_____ 7. Ability to acquire capital

_____ 8. Ease of transfer of ownership

Journalize the stock transactions of Wooden Company in 20X1.

Date Debit Credit

Feb. 1 Issued 8,000 shares for cash at $24 per share.

(a) Journalize the transactions.

4. The Huntsman Corporation has the following stockholders’ equity accounts:

(b) How many shares were issued?

(c) How many shares are outstanding?

(d) What is the balance of the Common Stock account?

(e) What is the balance of the Treasury Stock account?

Net income for 20X1 amounted to $951,000.

Prepare journal entries to record the above transactions.

Outstanding shares 60,000

Par value per share $10.00

Treasury Stock Mar. 1 30,000

Chapter 11 Solutions (Cont.)

Date Debit Credit

(1) Preferred stock—$80,000 + $60,000 = $140,000.

(2) Paid-in Capital in Excess of Par Value—Preferred Stock—$112,000 + $90,000 = $202,000.

Chapter 11 Solutions (Cont.)