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SBCS Global Learning Institute

ACCA MA/FIA FMA

Management Accounting

Lecturer: Nanda Maharaj

Study School Day 1

Budgeting
Part C
Solutions
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(29) BDL plc is currently preparing its cash budget for the year to 31 March 20X8. An
extract from its sales budget for the same year shows the following sales values.
$
March 60,000
April 70,000
May 55,000
June 65,000
40% of its sales are expected to be for cash. Of its credit sales, 70% are expected to
pay in the month after sale and take a 2% discount; 27% are expected to pay in the
second month after the sale, and the remaining 3% are expected to be bad debts.
What is the value of sales receipts to be shown in the cash budget for May 20X7?
A $60,532 B $61,120 C $66,532 D $86,620

May
$
May = 55,000 x 40% = 22,000
April = 70,000 x 60% x 70% x 98% = 28,812
March = 60,000 x 60% x 27% = 9,720
Sales Receipts May = 60,532

Answer: A

(30) The following details have been extracted from the payables' records of X Co:
Invoices paid in the month of purchase 25%
Invoices paid in the first month after purchase 70%
Invoices paid in the second month after purchase 5%
Purchases for July to September are budgeted as follows:
July $250,000
August $300,000
September $280,000
For suppliers paid in the month of purchase, a settlement discount of 5% is received.
What is the amount budgeted to be paid to suppliers in September?
A $278,500 B $280,000 C $289,000 D $292,500

September
$
September = 280,000 x 25% x 95% = 66,500
August = 300,000 x 70% = 210,000
July = 250,000 x 5% = 12,500
Total Payments September = 289,000

Answer: C
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(31) This A company manufactures a single product. Budgeted production (in units) for
the first three months (M1, M2 and M3) of next year is as follows:
M1 M2 M3
4,000 5,000 3,500
Each unit of production uses 3 kg of raw material costing $4 per kg. The budgeted raw
material inventory at the end of each month is to be 10% of the following month’s
production.
What are the budgeted raw material purchases for month M2 next year?
A $58,200 B $59,400 C $60,600 D $61,800

Raw Material Purchases = Production + Closing Inventory – Opening Inventory

M2
Kg
Production = 5,000 x 3 kg = 15,000
+ Closing Inv = (10% x 3,500 x 3 kg) = 1,050
- Opening Inv = (10% x 5,000 x 3kg) = (1,500)
Purchases = 14,550
x price per kg = $4
Purchases ($) = $58,200

Answer: A

(32) The following data relates to a company’s overhead cost.

Time Output Overhead cost Price
(units) ($) index
2 years ago 1,000 3,700 121
current year 3,000 13,000 155

Using the high low technique, what is the variable cost per unit (to the nearest
$0.01) expressed in current year prices?
A $3.22 B $4.13 C $4.65 D $5.06

Inflated Price (current year) = 155/121 x 3,700 = $4,740

Variable cost per unit = 13,000 – 4,740 / 3,000 – 1,000 = 8,260 / 2,000 = $4.13

Answer: B
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(33)

Answer: A & D

(35) An accountant wishes to use the following spreadsheet to calculate budgeted

production units:

Which formula should be entered in cell B5?

A =B3-C4+B4 B =B3-B4 C =B3+C4 D =B3+C4-B4

Answer: D

(36)

Answer: B
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(37)

Answer: C

(38)

Production (units) = 36,800 + 7,600 – 3,000 / 0.92 = 45,000 units

Direct Labour hours = 45,000 units x 5 hrs = 225,000 hours

(39)
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September
$
Fixed Production Overhead = 9,440 – 2,280 = 7,160
Variable Prod O’H = August = 12,600 x $5 x 30% = 18,900
September = 5,500 x $5 x 70% = 19,250
Total Payment = 45,310

Answer: C
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Multi Tasks Questions (MTQs) Budgeting

Question 1
Kinn company produces a single product. Each finish product requires 3 kg of raw
materials. The raw material cost $6 per kg.

You are given the following information.

(1) Kinn Co. prepares budgets on a quarterly basis. Each quarter consists of 13 weeks,
with five working days per week.

(2) It is the company’s policy to maintain an inventory of finished goods at the end of
each quarter equal to five day’s demand for the next quarter whenever possible.

(3) It is not possible to hold raw material inventory because of its perishable nature, but
it is possible to hold inventory of finished goods at any level.

(4) Forecasts sales for the next four quarters are:

Quarter 1 1,950,000
Quarter 2 2,275,000
Quarter 3 3,250,000
Quarter 4 2,275,000

(5) Selling price is $56 per unit

(6) Kinn Co. aims to maximize its profits

Task 1 (2 marks)

Calculate the budgeted opening and closing finished goods inventory for Quarter
1 to the nearest thousand units

Opening Finished goods Inventory ‘000 units

Closing Finished goods Inventory ‘000 units

Opening Finished Goods Inventory = 1,950,000 / 13 = 150,000

Closing Finished Goods Inventory = 2,275,000 / 13 = 175,000

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Task 2 (2 marks)

The desired closing finished goods inventory in Quarter 4 is 150,000 units.

Calculate the budgeted number of units to be produced in quarter 4 to the nearest
thousand units.
Production in Quarter 4 ‘000 units

Quarter 4
‘000 units
Sales = 2,275
+ Closing Inventory = 150
- Opening Inventory = 2275/13 = (175)
Production = 2,250

Task 3 (2 marks)
Kinn Co budgets to produce 3,175,000 units in quarter 3 to meet sales demand and to
achieve a closing finished goods inventory of 175,000 units.
What is the budgeted cost for raw material usage in Quarter 3 to the nearest
thousand dollars? $ ‘000

Budgeted Cost Raw Material Usage = Production units x kg per unit

Budgeted Cost Raw Material Usage = 3,175,000 units x $18 = $57,150,000

Task 4 and 5 (4 marks)

The company’s raw material supplier has informed them that due to restrictions on the
manufacture of the material, the supply to the company will be restricted to 6,600,000
kg per quarter for the foreseeable future beginning from quarter 1. Kinn decides to
purchase the maximum amount of material available in each quarter and build up
inventory of finished goods whenever possible. Under these restrictions the budgeted
opening finished goods inventory in quarter 3 will be 325,000 units.

Task 4
Calculate a revised closing finished goods inventory for quarter 3 to the nearest
unit, taking into account restrictions on the raw material supply. Units

Units Produced = 6,600,000 / 3 kg = 2,200,000 units

Production (units) = 2,200,000

+ Opening Inventory = 325,000
- Sales = (2,525,000)
Closing Inventory = 0
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Answer: = 0

Sales Demand = 3,250,000; however the total units that can be supplied is
2,525,000. Hence Closing Inventory = 0

Task 5
Which TWO of the following would NOT help Kinn Co overcome problems caused
by the restriction in raw material supply?
o More efficient use of material
o Seeking alternative sources of supply
o Requesting a settlement discount
o Using the economic order quantity mo

Answer: C and D
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Question 2 – Torance
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Sales Budget
Quarter 1 2 3 4
units units units units
Trend 1,200 1,300 1,400 1,500
Seasonal Variation - 150 200 300 - 350
Forecast Sales 1,050 1,500 1,700 1,150
Selling Price per unit $250 $250 $250 $250
Forecast Revenue $262,500 $375,000 $425,000 $287,500

Production Budget
Quarter 1 2 3 4
units units units units
Sales 1,050 1,500 1,700 1,150
Closing Inventory (50%) 750 850 575 725
Opening Inventory (525) (750) (850) (575)
Production 1,275 1,600 1,425 1,300

Opening Inventory is the closing Inventory for the quarter before quarter 1, which
is calculated as 50% of quarter 1 sales i.e. 50% x 1,050 = 525

Closing Inventory Quarter 4 = 50% of Sales Quarter 1 2009 i.e.

Forecasted Sales Quarter 1 2009 = 1,600 – 150 = 1,450
Closing Inventory Quarter 4, 2008 = 50% x 1,450 = 725
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Question 3 : Cash Budget

Given below is the forecast statement of profit or loss for a business for the three
months ending 31 December together with forecast statements of financial position at
that date and also at the previous 30 September.

FORECAST STATEMENT OF PROFIT OR LOSS

FOR THE THREE MONTHS ENDING 31 DECEMBER
$'000
Revenue 860
Cost of sales (600)
Gross profit 260
Depreciation (20)
Overheads (100)
Profit from operations 140
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Task 1

Sales Receipts = 860 + 45 – 85 = $820,000

Purchase Payments = 600 + 75 – 100 = $575,000

Overhead Payments = 100 + 40 – 45 = $95,000

Task 2

Receipts March (January Sales) = 21,000 x $30 x 60% = $378,000

Receipts March (February Sales) = 22,000 x $31.20 x 40% = $274,560

Selling price per unit = $30 x 1.04 = $31.20

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Task 3

Answer: d
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Question: (4)

Task 1

Answer: C

Variable cost per unit = Difference between high and low cost
Difference between high and low output

Task 2

Y = Total Cost
a = Total Fixed Cost
b = Variable Cost per unit
x = forecasted units

Variable cost per unit = $259,541 - $214,559 / 85,620 – 64,200 = $2.10

Total Fixed Cost = $259,541 – (85,620 x $2.10) = $79,739

Y = $79,739 + $2.10x
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Task 3

Y = $79,739 + ($2.10 x 87,500) = $263,489

Task 4

Answer: Cash Flow Forecasting

Monthly Sales Analysis
Calculation of Depreciation
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Making Budgets Work

 Behavioural implications
 Participation
 Using budgets as targets
 Motivation and the management accountant

Behavioral Implications of Budgeting

Budgets as a source of conflict
• Budgeting is a multi-purpose activity and so it means different things to different
people.

Budget purposes
 A forecast
 A means of allocating resources
 A yardstick
 A target
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Negative affects of budgets include:

At the planning stage

 Managers may fail to coordinate plans with those of other budget centres.
 They may build slack into expenditure estimates.

When putting plans into action

 There could be minimal cooperation and communication between managers.
 Managers might try to achieve targets but not beat them.

Using control information

Resentment can occur when:

 Managers see the information as part of a system of trying to find fault with their
work
 There is scepticism as to the value of information (eg inaccurate, too late or not
understood)

Other forms of resentment

 The managers who set the budget or standards are often not the managers
who are then made responsible for achieving budget targets.

 The goals of the organisation as a whole, as expressed in a budget, may not

coincide with the personal aspirations of individual managers.

 Control is applied at different stages by different people. Different managers

can get in each others' way, and resent the interference from others.

Motivation
 Motivation is what makes people behave in the way that they do.
 It comes from individual attitudes, or group attitudes.
 Individuals will be motivated by personal desires and interests.
 It is vital that the goals of management and the employees harmonise with the
goals of the organisation as a whole.
 This is known as goal congruence.
 You will come across this term frequently in your future studies if you continue
with ACCA exams.
 Dysfunctional decision making occurs when goal congruence does not exist or
is impaired.
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Motivation and pay

 Pay can be an important motivator.
 However, formal reward and performance evaluation systems can
encourage dysfunctional behaviour.
 Eg managers pad their budgets in anticipation of cuts.
 Targets must be challenging, but fair, otherwise individuals will become
dissatisfied.
 Pay can be a demotivator as well as a motivator.

Budget setting styles

 Imposed (from the top down)
 Participative (from the bottom up)
 Negotiated

Advantages of participative approach

 More realistic budgets
 Coordination, morale and motivation improved
 Increased management commitment to objectives

Disadvantages of participative approach

 More time consuming
 Budgetary slack may be introduced
 Can support 'empire building'

Times when imposed budgets are effective

 In newly-formed organisations
 In very small businesses
 During periods of economic hardship
 When operational managers lack budgeting skills
 When the organisation's different units require precise coordination

Advantages of imposed-style approach

 Strategic plans likely to be incorporated into planned activities
 Enhanced coordination between plans and objectives of divisions
 Use of senior management's awareness of total resource availability
 Decrease the input from inexperienced or uninformed lower-level employees
 Decrease the period of time taken to draw up the budgets
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Disadvantages of imposed-style approach

 Dissatisfaction as it is hard to be motivated to achieve targets set by somebody
else.
 The feeling of team spirit may disappear.
 Acceptance of organisational goals may be limited.
 The feeling of the budget as a punitive device could arise.
 Managers who are performing operations on a day to day basis are likely to have
a better understanding of what is achievable.
 Unachievable budgets could result if consideration is not given to local operating
and political environments.
 Lower-level management initiative may be stifled.

Negotiated style of budgeting

 'A budget in which budget allowances are set largely on the basis of negotiations
between budget holders and those to whom they report'.
 (CIMA Official Terminology)

 A well-designed control system can help to ensure goal congruence.

 Continuous feedback prompting appropriate control action should steer the

organisation in the right direction.

Features of feedback
 Reports should be clear and comprehensive.
 The 'exception principle' should be applied so that significant variances are
highlighted for investigation.
 Reports should identify the controllable costs and revenues.
 reports should be timely to allow control action before any adverse results get
much worse.
 Information should be accurate.
 Reports should be communicated to the manager who has responsibility and
authority to act on the matter.

Budgetary slack
 The difference between the minimum necessary costs and the costs built into the
budget or actually incurred.

 Managers might deliberately overestimate costs and underestimate sales so that

they will not be blamed for overspending and poor results.
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Once decided, budgets become targets.

As targets, they can motivate managers to achieve a high level of performance.

There is likely to be a demotivating effect where an ideal standard of performance is

set.

A low standard of efficiency is also demotivating, because there is no sense of

achievement in attaining the required standards.

As 'normal' (level that has been achieved in the past) might encourage budgetary
slack.

To ensure managers are properly motivated, two budgets can be used:

 One for planning and decision making, based on reasonable expectations

(expectations budget)
 One for motivational purposes, with more difficult targets (aspirations budget)

Management and the management accountant require strategies and methods for
dealing with tensions and conflict.

 For example, should targets be adjusted for uncontrollable and unforeseeable

environmental influence?

 But what is then the effect on motivation if employees view performance

standards as changeable?

How senior management can offer support:

 Using a system of responsibility accounting
 Allowing managers to have a say in formulating their budgets
 Offering incentives to managers who meet budget targets
 Not regarding budgetary control information as a way of apportioning blame

The management accountant can aid budgetary control:

 Develop a working relationship with operational managers
 Explain the meaning of budgets and control reports
 Keep accounting jargon to a minimum
 Make reports clear and to the point
 Provide control information with a minimum of delay
 Make control information as useful as possible
 Make sure that actual costs are recorded accurately
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 Ensure that budgets are up-to-date and ensuring that standards are 'fair' so that
control information is realistic

A profit sharing scheme is a scheme in which employees receive a certain proportion

of their company's year-end profits (the size of their bonus being related to their position
in the company and the length of their employment to date).

Disadvantages of a profit sharing scheme

 Employees must wait until the year end for a bonus.
 Factors affecting profit may be outside the control of employees, in spite of
their greater efforts.
 Too many employees are involved in a single scheme for the scheme to have a
great motivating effect on individuals.

A share option scheme is a scheme which gives its members the right to buy shares in
the company for which they work at a set date in the future and at a price usually
determined when the scheme is set up.

An employee share ownership plan is a scheme which acquires shares on behalf of a

number of employees, and it must distribute these shares within a certain number of
years of acquisition

Disadvantages
 The benefits are not certain, as the market value of shares at a future date
cannot realistically be predicted in advance.

 The benefits are not immediate, as a scheme must be in existence for a number
of years before members can exercise their rights.
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Questions: Making Budgets Work

(1)

Answer: B

(2)

Answer: C

(3)

Answer: C
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(4)

Answer: A

(5)

Answer: D

(6)

Answer: C
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(7)

Answer: B

(8)

Answer: D
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Capital Expenditure Budgeting

Capital Expenditure is expenditure which results in the acquisition of non-current
assets or an improvement in their earning capacity or a part of cost that forms the total
purchase price of a non-current asset.

Revenue Expenditure is expenditure which is incurred for either of the following

reasons:

 For the purpose of the trade of the business. This includes expenditure classified
as selling and distribution expenses, administration expenses and finance
charges.

 To maintain the existing earning capacity of non-current assets.

The Main Principles used to Differentiate between Relevant and

Irrelevant Costs for Investment Appraisal is:

(1) Relevant Costs are Future Costs. Costs incurred in the past are not included such
as sunk costs.

(2) Relevant Costs are Cash Flows. Non-Cash items example depreciation is
excluded.

(3) Relevant Costs are Incremental Costs. Opportunity costs foregone are relevant as
well as the increase in costs and revenue as a result of making a decision.

(4) Finance Costs. Certain other costs will also be irrelevant to decision-making, such
as ‘finance costs’. This is because interest has already been taken into account in the
discounting process.

Examples of Relevant Cost

 Material regularly used bought at full replacement cost
 Opportunity cost of material no longer in use i.e.the resaleable value or the
substitute of another material which ever value is higher.
 Labour hired from outside
 Future purchase costs incurred
 Incremental increase in cost and revenue from making a particular decision.
 Savings in cost
 Opportunity cost in comparison to the proposed project
 Incremental increase in variable cost of buying
 Better option between two alternatives
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Relevant Cost of Material (Principles)

(1) Material regularly used in production – full amount of material required,

regardless of what is held in inventory at the current purchase cost.

(2) Material not regularly used in production – If there are insufficient to

satisfy the contract, the relevant cost would be additional units that will be
purchased at the current replacement cost plus the opportunity cost of the
existing material in inventory.

(3) Material not regularly used in production – there is sufficient material

in stock to satisfy the order, however there are more than one opportunity cost
that exist for the material. The relevant cost would be the higher of the
opportunity cost.

Relevant Cost of Labour (Principles)

(1) Labour must be hired from outside – Relevant cost would be the full
amount of hours @ the labour rate. This is because labour cost would be
considered a future cost incurred by the company.

(2) Spare Capacity exists. – Spare capacity is not relevant and is ignored. The
additional hours required to fulfill the contract is relevant @ the labour rate.

(3) Labour is in short supply. – If a shortage of labour exist and labour must
be diverted using the company’s existing staff, then they will not be able to
currently produce the company’s existing product, therefore contribution will be
lost. The relevant cost will be the hours required for the contract plus the
loss in contribution from diverting labour to complete the contract.
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Relevant Cost of Machinery (Principles)

(1) Depreciation charges on machinery are not relevant and must be ignored
when making a decision.

(2) Where machinery can be sold instead of being used on a contract, the
relevant costs will the loss sale proceeds on the machinery. If any additional
cost will be incurred from using the machine example disposal cost, the relevant
cost will be the loss sales proceeds plus disposal cost incurred on the machine.

(3) Capital expenditure principles are applied when determining the cost of a
machine. Example purchase cost plus installation cost, transport cost etc.
Maintenance and repairs are considered revenue expenditure and does not form
part of the cost of an asset.

Questions: Capital Expenditure

(1) Which of the following is not a capital expenditure?
A. Cost of trademarks, patents, copy rights, designs etc.
B. Up-keep and maintenance of motor cars and vans
C. Cost of installation of lights and fans
D. Erection cost of plane and machinery

Answer: B

(2) The following statements relate to spreadsheets:

(i) A spreadsheet consists of records and files.
(ii) Most spreadsheets have a facility to allow data within them to be displayed
graphically.
(iii) A spreadsheet could be used to prepare a budgeted profit and loss account.
(iv) A spreadsheet is the most suitable software for storing large volumes of data.
Which of the above statements are correct?
A (i) and (ii) only B (i), (iii) and (iv) only C (ii) and (iii) only D (iii) and (iv) only

Answer: C

(3) Which of these statements are untrue?

o Spreadsheets make the calculation and manipulation of data easier and quicker
o Spreadsheets are very useful for word processing
o Budgeting can be done very easily using spreadsheets
o Spreadsheets are useful for plotting graphs

Answer: B
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(4) You are currently employed as a Management Accountant in an insurance company.

You are contemplating starting your own business.
In considering whether or not to start your own business, what would your
current salary level be?
o An Incremental cost
o An Opportunity cost
o A sunk cost
o An irrelevant cost

Answer: B

(5) Which of the following would be part of the capital expenditure budget?
o Refurbishment of existing factory premises
o Purchase of raw materials
o Replacement of existing machinery
o Purchase of a new factory premises

Answer: A, C and D

(6) Which of the following relates to capital expenditure?

o Recorded as a liability in the statement of financial position
o Cost of acquiring or enhancing on-current assets
o Expenditure on the manufacture of goods or the provision of services
o Recorded as an asset in the income statement

Answer: B

(7) In decision making, costs which need to be considered are said to be relevant costs.
Which of the following are characteristics associated with relevant costs?
A. Differential costs B. Incremental costs C. Unavoidable costs D. Future costs

Answer: A, B and D
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(8)

Answer: C

(9) What costs should be used in decision-making?

A. Historic Costs B. Future Costs C. Committed Costs D. Current Costs

Answer: B

(10) A company is evaluating a project that requires two types of material (T and V).
Data relating to the material requirements are as follows:
Material Quantity needed Quantity Original cost of Current Current
type for project currently quantity in stock purchase resale
in stock price price
kg kg £/kg £/kg £/kg
T 500 100 40 45 44
V 400 200 55 52 40
Material T is regularly used by the company in normal production. Material V is no
longer in use by the company and has no alternative use within the business.
What is the total relevant cost of materials for the project?
A £40,400 B £40,900 C £43,400 D £43,900

Material T = 500 kg x $45 = $22,500

Material V = 200 kg x $52 = 10,400
200 kg x $40 = 8,000 $18,400
Relevant Cost = $40,900

Answer: B
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(11) A machine owned by a company has been idle for some months but could now be
used on a one year contract which is under consideration. The net book value of the
machine is £1,000. If not used on this contract, the machine could be sold now for a net
amount of £1,200. After use on the contract, the machine would have no saleable value
and the cost of disposing of it in one year’s time would be £800.
What is the total relevant cost of the machine to the contract?
A £400 B £800 C £1,200 D £2,000

Relevant Cost = Loss Sale Proceeds = $1,200

Disposal Cost = $ 800
Relevant Cost = $2,000

Answer: D

(12) The following statements relate to relevant cost concepts in decision making:
(i) Materials can never have an opportunity cost whereas labour can.
(ii) The annual depreciation charge is not a relevant cost.
(iii) Fixed costs would have a relevant cost element if a decision causes a change in
their total expenditure
Which statements are correct?
A (i) and (ii) only B (i) and (iii) only C (ii) and (iii) only D (i), (ii) and (iii)

Answer: C

(13) Equipment owned by a company has a net book value of £1,800 and has been idle
for some months. It could now be used on a six months contract which is being
considered. If not used on this contract, the equipment would be sold now for a net
amount of £2,000. After use on the contract, the equipment would have no saleable
value and would be dismantled. The cost of dismantling and disposing of it would be
£800.
What is the total relevant cost of the equipment to the contract?
A £1,200 B £1,800 C £2,000 D £2,800

Relevant Cost = Loss Sale Proceeds + Disposal Cost = $2,000 + $800 = $2,800

Answer: D
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(14) A contract is under consideration which requires 800 labour hours to complete.
There are 450 hours of spare labour capacity for which the workers are still being paid
the normal rate of pay. The remaining hours required for the contract
can be found either by overtime working paid at 50% above the normal rate of pay or by
diverting labour from the manufacture of product OT. If the contract is undertaken and
labour is diverted, then sales of product OT will be lost. Product OT takes seven labour
hours per unit to manufacture and makes a contribution of £14 per unit. The normal
rate of pay for labour is £8 per hour.
What is the total relevant labour cost to the contract?
A £3,500 B £4,200 C £4,500 D £4,900

350 hrs x $8 = $2,800

Loss Contribution = 350 hrs / 7 hrs x $14 = $ 700
Relevant Cost Labour = $3,500

Answer: A

(15) In a short-term decision-making context, which ONE of the following would

be a relevant cost?
A Specific development costs already incurred.
B The cost of special material which will be purchased.
C Depreciation on existing fixed assets.
D The original cost of raw materials currently in stock which will be used on the project

Answer: B
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Capital Investment Appraisal

Capital Investment Appraisal

Companies sometimes invest in Capital Expenditure or major investment projects where
large sums of capital are spent. An Organization would want to know whether it is
making a return on the capital invested.

The return on investment is calculated as Interest and this represents the amount of
money an investment earns over time.

(1) Simple Interest

Formula: S=P + (P * r * n)

P = Principal sum invested

r = Rate of interest
n = number period
S = Principal sum invested plus interest after the number of periods.
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Questions:
(1) The value of an initial investment of $5,500 in 8 months’ time at a simple
interest rate of 6% is?

S = $5,500 + (5,500 x .06 x 8/12) = $5,720

(2) The value of an initial investment of $8,200 in 16 months’ time at a simple

interest of 9% is?

S = $8,200 + (8,200 x .09 x 16/12) = $9,184

(3) A one-year investment yields a return of 15%. The cash returned from the
investment, including principal and interest, is $2,070. What is the interest?

Interest = 15/115 x $2,070 = $270

(2) Compound Interest

Formula: S ¿ P ¿

S = Future Value of the Investment after n years

P = the amount invested now
r = rate of interest
n = number of years of the investment

Questions:
(4) $10,000 is invested at 8% per annum and the interest is re-invested each year.
What is the value of the investment after two years?

S = $10,000 x (1 + .08) ² = $11,664

(5) The value of an initial investment of $6,400 in 4 years’ time at a compound

interest rate of 7% is?

S = $6,400 x (1 + .07) ^ 4 = $8,389

 35

(6) A sum of money was invested for 10 years at 7% per annum and is now worth
$2,000. What was the original amount invested (to the nearest $)?
A $1,026 B $1,016 C $3,937 D $14,048

r = (1 + .07) ^ 10 = 1.967

Original Amount = $2,000 / 1.967 = $1,016

Answer: B

(3) Effective Interest Rates

Formula: ¿ – 1 =? * 100 =? %

r = rate of interest for each time period

n = number of times interest is compounded per year

Questions:
(7) A bank account pays a nominal 4.5% per annum with interest payable every three
months.
What is the effective annual rate of interest?
a. 4.5% b. 4.5765% c. 1.125% d. 6.018%

Quarterly Rate = 4.5% / 4 = 1.125

Effective Rate = (1 + .01125) ^4 – 1 x 100 = 4.5765%

(8) What is the effective annual rate of interest of 2.1% compounded every three
months?

Effective Rate = ( 1 + .021) ^ 4 – 1 x 100 = 8.67%

(9) The nominal rate of interest is 8% per annum and interest is charged monthly. The
firm is going to invest for 12 months.
What is the effective annual interest rate?

Monthly Rate = 8% / 12 = 0.666%

Effective Rate = ( 1 + .0666) ^ 12 – 1 x 100 = 8.3%

 36

(10) The nominal rate of interest is 11% per annum and interest is quarterly. The firm is
going to invest for 12 months. What is the effective annual interest rate?

Quarterly Rate = 11% / 4 = 2.75%

Effective Rate = (1 + .0275) ^ 4 – 1 x 100 = 11.46%

(11) An investor has the choice between two investments. Investment Exe offers
interest of 4% per year compounded semi-annually for a period of three years.
Investment Wye offers one interest payment of 20% at the end of its four-year life.
What is the annual effective interest rate offered by the two investments?
Investment Exe Investment Wye
A. 4.00% 4.66%
B. 4.00% 5.00%
C. 4.04% 4.66%
D. 4.04% 5.00%

Exe = Semi Annual Rate = 4%/2 = 2%

Effective Rate = ( 1 + .02 ) ^2 – 1 x 100 = 4.04%

Wye = n = ¼ = 0.25

Effective Rate = (1 + .20) ^ 0.25 – 1 x 100 = 4.66%

Answer: C

(12)

Quarterly Rate = 8% / 4 = 2%

Effective rate = (1 + .02) ^4 – 1 x 100 = 8.243%

S = $12,000 x (1 + .08243) ^3 = $15,219

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(13)

Answer: D

(14)

Compound Monthly Rate = 6%/12 = 0.5%

S = (1 + .005) ^6 x $1,000 = $1,030.38

Interest = $1,030.38 - $1,000 = $30.38

(15)

Effective Rate = (1 + .02) ^12 – 1 x 100 = 26.8%

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(5) Perpetuities
Formula: Present value of a Perpetuity = annuity
Interest rate

Question: Perpetuities
(16)

Annuity Factor = $86,400 / $19,260 = 4.486

Annuity Factor % = 9%

(17)

PV Perpetuity = Annuity / Interest Rate

Present Value = $24,000 / .05 = $480,000

(18)

PV Perpetuity = $1,500 / .08 = $18,750

 39

Methods of Project Appraisal

(1) Payback Method
The payback period is the time taken for the initial investment to be recovered in the
cash inflows from the project.

It's particularly relevant if there are liquidity problems or if distant forecasts are very
uncertain.

It gives greater weight to cash flows generated in earlier years.

Note that cash flows are used, not profit.

Advantages: Payback method

 Simple to calculate and understand
 Concentrates on short-term, less risky flows
 Can identify quick cash generators

Disadvantages: Payback Method

 Ignores total project return
 Ignores time value of money (see next slide)
 Ignores timing of flows after payback period
 Arbitrary choice of cut-off

(2) Discounted Payback Period - The discounted payback technique is the

length of time it takes for a project to repay itself taking into account the time value of
money.

(3) Payback period with constant annual cash inflows

= Initial Investment
Annual Cash Inflow
 40

N.B.

(1) Discounted Payback period takes longer to repay itself that Non-Discounted
Payback because present values of cash flows are lower than cash flows.

(2) The higher the discount rate the lower the present values of cash flows and
the longer the discounted payback period. Example a discount rate of 20% will
take longer to repay itself than 10%

Questions: Payback
(1) An investment project with an initial cost of $55,000 is expected to have the following
cash inflows:
Year 1 - $10,000
Year 2 - $17,750
Year 3 - $25,000
Year 4 - $12,500
What is the payback period?
(a) More than four years (b) Between one and two years
(c) Between two and three years (d) Between three and four years

Answer: D

Cash Inflow = 10,000 + 17,750 + 25,000 + 12,500 = $62,250

Cash Outflow = ($55,000)

(2)

Answer: C

Payback = $90,000 / $30,000 = 3 years

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(3)

Answer: D

(4) A capital investment project has an initial investment followed by constant annual
returns.
How is the payback period calculated?
A initial investment ÷ annual profit
B initial investment ÷ annual net cash inflow
C (initial investment – residual value) ÷ annual profit
D (initial investment – residual value) ÷ annual net cash inflow

Answer: B

(5) A new machine, costing $100,000, has an estimated realisable value of $25,000
after five years. The expected profit from investment in the machine is $25,000 per year,
net of straight-line depreciation.
What is the payback period?
A 4.0 years B 3.0 years C 1.875 years D 2.5 years

Depreciation = $100,000 - $25,000 / 5 years = $15,000

Cash Inflow = $25,000 + $15,000 = $40,000

Payback = $100,000 / $40,000 = 2.5 years

 42

(6)

Payback Period = $100,000 / $30,000 = 3.3 years

(7)

Answer: A
 43

The Discounted Cash Flow / Net Present Value Method - The NPV
involves calculating the value in present day terms of the various cash inflows and
outflows expected to arise at differing periods in the future. To do this it is necessary to
estimate a discounting rate which is known as the cost of capital.

Calculation: Net Present Value (working backwards)

Cash Outflow = (X)
Present Value cash Inflow =X
(annual cash inflow x annuity factor)
+/- Net Present Value X

+ Net Present Value = Present Value Cash Inflow > Cash Outflow
- Net Present Value = Present Value Cash Inflow < Cash Outflow

Questions: Net Present Value

(1) A firm with a cost of capital of 12% per annum is considering investing $20,000 now
in order to receive 10 annual sums of $4,000 (commencing in one year’s time).
What is the net present value of the investment?

Cash Outflow = (20,000)

PV Cash Inflow = (4,000 x 5.60) = 22,600
+ Net Present Value = + 2,600

Annuity Factor = Year 10, 12% = 5.60

(2) Which of the following decision rules are correct in investment appraisal?
(1) Accept if the net present value is positive
(2) Accept if the internal rate of return is higher than the cost of capital
(3) Accept if the projects payback period is longer than the company’s target period

Answer: 1 and 2

(3) An investment project has a positive net present value (NPV) of $7,222 when its
cash flows are discounted at the cost of capital of 10% per annum. The net cash inflow
from the project is expected to be $18,000 per annum for five years. The cumulative
discount (annuity) factor for the five years at 10% is 3.791.
What is the investment at the start of the project? (to the nearest $)

Investment at Start = ?
PV Cash Inflow = (18,000 x 3.791) = 68,238
Net Present Value = + 7,222

+ NPV = PV Inflow > Cash Outflow

 44

Cash Outflow = 68,238 – 7,222 = $61,016

(4) Capital Investment appraisal for a new machine involving discounted cash flow
techniques would need to consider:
(i) The size of the initial financial outlay
(ii) The useful life of the machine
(iii) The cost of obtaining the initial finance
(iv) Annual depreciation of the machinery
Which of the above statements are correct?
A. (i), (ii) and (iv) only
B. B. (ii), (iii) and (iv) only
C. (i), (ii), (iii) only
D. (i), (ii), (iii) and (iv)

Answer: C

(5) Which of the following is not a capital expenditure?

E. Cost of trademarks, patents, copy rights, designs etc.
F. Up-keep and maintenance of motor cars and vans
G. Cost of installation of lights and fans
H. Erection cost of plane and machinery

Answer: B

(6)

Answer: D
 45

(7)

Answer: C

(8) A project has an initial outflow of $12,000 followed by six equal annual cash inflows,
commencing in one year’s time. The payback period is exactly four years. The cost of
capital is 12% per year.
What is the project’s net present value (to the nearest $)

Annual Cash Inflow = $12,000 / 4 = $3,000

Annuity Factor = 12%, 4 years = 4.111

$
Cash Outflow = (12,000)
PV Cash Inflow = 3,000 x 4.111 = 12,333
Net Present Value = + 333
 46

(9)

Answer: A and D

(10)

Annuity Factor Yr 1 – Yr 8 = 4.639

Annuity Factor Yr 1 – Yr 3 = 2.322
Annuity Factor Yr 4 – Yr 8 = 2.317

Present Value Cash Inflows = 2,600 x 2.317 = $6,024

Answer: A
 47

(11)

Investment at the Start = $200,000

Present Value Inflow = Annuity / Interest % = $23,000 / 0.1 = $230,000
Net Present Value = + $ 30,000

Answer: A
 48

Internal Rate of Return (IRR)

The Internal Rate of Return is the discount rate that results in a zero (0) net present
value.

Calculation: Internal Rate of Return Method (positive and negative

NPV)

IRR can be calculated using the formula: (Interpolation)

Formula: IRR = A + ( a x B - A)
a--b

Where A – is the discount rate which provides the positive NPV

a – is the amount of the positive NPV
B – is the discount rate which provides the negative NPV
b – is the amount of the negative NPV

N.B = IRR % > Cost of Capital % = + NPV

IRR % < Cost of Capital % = - NPV
 49

Questions: Internal Rate of Return

(1) A capital investment project has net present values as follows:
At 5% per annum discount rate $69,700 positive
At 14% per annum discount rate $16,000 positive
At 20% per annum discount rate $10,500 negative
What is the best approximation of the internal rate of return (%) to one decimal
Place?

IRR = 14% + (16,000 x 20 – 14) = 17.6%

16,000 - - 10,500)

(2) What is the Internal Rate of Return (IRR)?

a. The return on investment required by the management of a business
b. The discount rate that produces a zero net present value on an investment
c. The difference between the return on an investment and the cost of capital
d. The discount rate that equates the present value of future cash receipts from an
investment to zero

Answer: B

(3) The NPV of a project has been estimated as follows:

Discount rate NPV
10% +$96,000
15% +$36,000
20% +$4,000
Using this data, what is the best approximation of the IRR of the project?

IRR = 20% + (4,000 x 20 – 15) = 20.6%

(36,000 – 4,000)

(4) Net Present Value of an Investment at 18% is -$14,000 and at 14% is -$5,000.
Calculate IRR to the nearest %.

IRR = 14% - (5,000 x 18 – 14) = 12%

(14,000 – 5,000)
 50

(5) The statements below relate to the internal rate of return:

(i) calculates the highest possible net present value.
(ii) represents the intrinsic discount rate of an investment over its life.
(iii) will always give the investor the correct decision when comparing well behaved
projects.
Which of the above are NOT CORRECT?
A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)

Answer: B

(6)
(1) A machine has an investment cost of £60,000 at time 0. The present values (at time
0) of the expected net cashinflows from the machine over its useful life are:
Discount rate Present value of cash inflows
10% $64,600
15% $58,200
20% $52,100
What is the internal rate of return (IRR) of the machine investment?
A Below 10% B Between 10% and 15%
C Between 15% and 20% D Over 20%

10% = 64,600 – 60,000 = + NPV = +4,600

15% = 58,200 – 60,000 = - NPV = - 1,800

IRR is the discount rate where there is a zero NPV. Zero lies between positive and
negative.

Answer: B
 51

(7)

Answer: D

(8) A capital investment project has an initial cash outflow followed by a series of cash inflows.
NPV results are:
Negative when discounted at 18%
Negative when discounted at 15%
Negative when discounted at 12%
What will the IRR be?
A Below 12% B Between 12% and 15%
C Between 15% and 18% D Above 18%

Answer: A

The higher the discount rate, the higher will be the negative NPV
 52

(9) A capital investment project has the following NPV profile over a range of discount
rates. The cost of capital is 11%.

Which statement(s) is/are true in relation to the above diagram?

1 The IRR is greater than 15%
2 Based on DCF analysis, the project is worthwhile
3 The NPV is positive when discounted at 16%
4 The investment amount is $40,000
A 1 and 2 B 2 only C 3 and 4 only D 2, 3 and 4

Answer: B
 53

(10)

Answer: C

(11) Capital investment project has an initial cash outflow followed by net cash inflows
each year for 5 years. The net present value (NPV) of the project is:
Positive when cash flows are discounted at 5% per annum
Positive when cash flows are discounted at 10% per annum
Positive when cash flows are discounted at 15% per annum
What does the above data indicate about the internal rate of return (IRR)?
A It is below 5% B It is above 15%
C It is between 5% and 10% D It is between 10% and 15%

Answer: B

The higher the discount rate the lower is the NPV

 54

(12) Which of the following statements, about capital investment appraisal, is/are
TRUE?
(1) The discounted payback period of a viable investment project will always be longer
than the non-discounted payback period
(2) The present value of future cash outflows increases as the discount rate increases
(3) The present value of future cash inflows decreases as the discount rate increases
A 1 and 2 only B 1 and 3 only C 3 only D 2 only

Answer: B

(13)

Answer: B

(14)

Answer: B
 55

(16)

Answer: B

(17)

Answer: B

(18)

IRR = 15% + (5,000 x 20 – 15) = 18.1%

5,000 - - 3,000
 56

Section B Question 1 – Capital Investment Appraisal

Cab Co owns and runs 350 taxis and had sales of $10 million in the last year. Cab Co is
considering introducing a new computerized taxi tracking system.
The expected costs and benefits of the new computerized tracking system are as
follows:
(i) The system would cost $2,100,000 to implement.

(ii) Depreciation would be provided at $420,000 per annum.

(iii) $75,000 has already been spent on staff training in order to evaluate the potential of
the new system. Further training costs of $425,000 would be required in the first year if
the new system is implemented.

(iv) Sales are expected to rise to $11 million in Year 1 if the new system is implemented,
thereafter increasing by 5% per annum. If the new system is not implemented, sales
would be expected to increase by $200,000 per annum.

(v) Despite increased sales, savings in vehicle running costs are expected as a result of
the new system. These are estimated at 1% of total sales.

(vi) Six new members of staff would be recruited to manage the new system at a total
cost of $120,000 per annum.

(vii) Cab Co would have to take out a maintenance contract for the new system at a cost
of $75,000 per annum for five years.

(viii) Interest on money borrowed to finance the project would cost $150,000 per annum.

(ix) Cab Co’s cost of capital is 10% per annum.

 57

Required:
(a) State whether each of the following items are relevant or irrelevant cashflows
for a net present value (NPV) evaluation of whether to introduce the computerised
tracking system.

(i) Computerised tracking system investment of $2,100,000;

(ii) Depreciation of $420,000 in each of the five years;

(iii) Staff training costs of $425,000;

(iv) New staff total salary of $120,000 per annum;

(v) Staff training costs of $75,000;

(vi) Interest cost of $150,000 per annum.

Note: The following mark allocation is provided as guidance for this requirement:
(i) 0·5 marks (ii) 1 mark (iii) 0·5 marks (iv) 1 mark (v) 1 mark (vi) 1 mark
(5 marks)

(i) Relevant

(ii) Non-Relevant

(iii) Relevant

(iv) Relevant

(v) Non-Relevant

(vi) Non-Relevant

(b) Calculate the following values if the computerized tracking system is

implemented.
(i) Incremental sales in Year 1;
(ii) Savings in vehicle running costs in Year 1;
(iii) Present value of the maintenance costs over the life of the contract.
Note: The following mark allocation is provided as guidance for this requirement:
(i) 1 mark (ii) 0·5 marks (iii) 1·5 marks (3 marks)
 58

(i) Sales with system Year 1 = $11,000,000

Sales without system Year 1 = $10,200,000
Incremental Sales = $800,000

(ii) Savings in Vehicle Running Costs = $1,100,000 x 1% = $110,000

(iii) PV Maintenance Costs = 75,000 x 3.791 = $284,325

(c) Cab Co wishes to maximise the wealth of its shareholders. It has correctly
calculated the following measures for the proposed computerised tracking system
project:
– The internal rate of return (IRR) is 14%,
– The return on average capital employed (ROCE) is 20% and
– The payback period is four years.

Required:
Which of the following is true?
A The project is worthwhile because the IRR is a positive value
B The project is worthwhile because the IRR is greater than the cost of capital
C The project is not worthwhile because the IRR is less than the ROCE
D The project is not worthwhile because the payback is less than five years (2 marks)

Answer: B
 59

Question (3): Capital Investment Appraisal

Answer: Task 1 = A and E

Payback Period = 2 .25 years

10,000 / 40,000 = 0.25 years

 60

Answer: NPV = + $35,000

Discounted Payback = 2.76 years

Answer: True