2-4_2007_jun_a

Part 2 Examination – Paper 2.4Financial Management and Control June 2007 Answers 1(a)Expected net present value of Proposed 1Scenario 1Scenario 2Scenario 3Number of sunny days100125150Saving (£/day)700700700Annual saving (£)70,00087,500105,000Costs(24,000)(24,000)(24,000)–––––––––––––––––––––––––Net annual savings 46,00063,50081,000–––––––––––––––––––––––––Present value of net savings at 10%460,000635,000810,000Investment500,000500,000500,000–––––––––––––––––––––––––Net present value(40,000)135,000310,000–––––––––––––––––––––––––Probability30%60%10%Expected net present value = (–40,000 x 0·3) + (135,000 x 0·6) + (310,000 x 0·1) = £100,000The ENPV is £100,000 so if the investment is evaluated on this basis, it is financially acceptable. In reaching a decision, however, the company should consider that there is a 30% chance of making a loss. This may be seen as an unacceptably high risk. Furthermore, the number of sunny days each year will not be constant, as assumed here, and may or may not be exactly 100, 125 or 150 days. It is possible the net present values of Scenarios 1 and 3 represent extremes in terms of expectations, and that the net present value of Scenario 2 may be most useful as representing the most likely outcome, even on a joint probability basis. It is also worth noting that inflation has not been taken into account and that the ever-increasing cost of energy may make the proposed investment much more financially attractive if it were factored into the analysis.WorkingsPresent values must be calculated with the before-tax cost of capital of 10%, since before-tax cash flows are being evaluated here. The present value of a perpetuity is found by dividing the constant annual cash flow by the cost of capital.Present value of net savings, Scenario 1 = 46,000/0·10 = £460,000Present value of net savings, Scenario 2 = 63,500/0·10 = £635,000Present value of net savings, Scenario 3 = 81,000/0·10 = £810,000(b)Net present value of Proposal 2Year1234££££Contribution (W1)248,400334,230449,709550,800Fixed costs (W2)(185,400)(190,962)(196,691)(202,592)––––––––––––––––––––––––––––––––––––63,000143,268253,018348,208T axation (30%)(18,900)(42,980)(75,905)(104,462)––––––––––––––––––––––––––––––––––––44,100100,288177,113243,746T ax benefits (W3)16,57512,4319,32312,970––––––––––––––––––––––––––––––––––––After-tax cash flows60,675112,719186,436256,7168% discount factors0·9260·8570·7940·735––––––––––––––––––––––––––––––––––––Present values56,18596,600148,030188,686––––––––––––––––––––––––––––––––––––£Sum of present values489,501PV of scrap value (W4)36,750––––––––526,251Initial investment221,000––––––––Net present value305,251––––––––The net present value is positive and so Proposal 2 is acceptable. Note that the after-tax cost of capital of 8% is used to discount after-tax cash flows in evaluating this investment proposal.Workings(W1)Year1234Selling price (£/unit)12·4812·9813·5014·04Variable cost (£/unit)4·204·414·634·86––––––––––––––––––––––––––––––––Contribution (£/unit)8·288·578·879·18Sales volume (units/yr)30,00039,00050,70060,000––––––––––––––––––––––––––––––––T otal contribution (£/yr)248,400334,230449,709550,800––––––––––––––––––––––––––––––––(W2)T otal fixed production overhead cost in current price terms = 6 x 30,000 = £180,000Inflating this current cost at 3% per year:Year1234Fixed costs (£/yr)185,400190,962196,691202,592(W3)Year Capital allowances Tax benefits1221,000 x 0·25 =55,25055,250 x 0·3 =16,575255,250 x 0·75 =41,43841,438 x 0·3 =12,431341,438 x 0·75 =31,07831,078 x 0·3 =9,3234By difference43,23443,234 x 0·3 =12,970–––––––––––––––221,000 – 50,000 =171,00051,299–––––––––––––––(W4)Present value of scrap value = 50,000 x 0·735 = £36,750(c)Before-tax return on capital employed of Project 3T otal cash flow over five years before advertising and depreciation = £500,000T otal depreciation over five years = 300,000 – 30,000 = £270,000T otal accounting profit over five years = 500,000 – 100,000 – 270,000 = £130,000Average annual accounting profit = 130,000/5 = £26,000 per yearAverage investment = (initial investment + scrap value)/2 = (300,000 + 30,000)/2 = £165,000ROCE = 100 x (26,000/165,000) = 15·8%The ROCE of Proposal 3 is marginally greater than the target level of 15%. ROCE cannot be recommended as an investment appraisal method, however, and the NPV of Proposal 3 should be calculated in order to determine whether it is financially acceptable.(d)G TK plc is a company with a small overdraft and no long-term debt. If the three proposals represent the total capitalinvestment needs of the company, the amount of finance needed is as follows.Finance needed Project lifeProposal 1£500,000PermanentProposal 2£221,000Four yearsProposal 3£400,000*Five years–––––––––––£1,121,000–––––––––––*It is assumed that advertising costs would be met from finance raisedEquity financeThe equity financing choices available to GTK plc are a rights issue or a placing.Rights issueIn this method of raising new equity finance, new shares are offered to existing shareholders pro rata to their existing shareholdings, meeting the requirements of company law in terms of shareholders’ pre-emptive rights. Since GTK plc has several million pounds of shareholders’ funds, it may be able to raise £1·1 million through a rights issue, but further investigation will be needed to determine if this is possible. Factors to consider in reaching a decision will include the number of shareholders, the type of shareholders (institutional shareholders may be more willing to subscribe than small shareholders), whether a recent rights issue has been made, the recent and expected financial performance of GTK plc, and the effect of a rights issue on the company’s cost of capital. A rights issue would not necessarily disturb the existing balance of ownership and control between shareholders. Approximately half of the finance needed is for a permanent investment and the permanent nature of equity finance would match this.PlacingThis way of raising equity finance involves allocating large amounts of ordinary shares with a small number of institutional investors. Existing shareholders will need to agree to waive their pre-emptive rights for a placing to occur, as it entails issuing new shares to new shareholders. The existing balance of ownership and control will therefore be changed by a placing. Since GTK plc is a listed public limited company, 25% or more of its issued ordinary share capital will be in public hands and theIdentifying alternative courses of actionOnce organisational objectives have been identified, alternative courses of action that may lead to achieving those objectives can be identified. Strategic analysis of the organisation and its environment can indicate potential courses of action. For example, a company may look at its existing products and markets, its potential markets, the threat posed by its competitors, the impact of changes in technology on its products and production processes, and so on, and decide that a key objective is the development of new products to replace existing products in existing markets that are reaching the end of their product life cycle.Evaluating alternative courses of actionAt this stage the various alternative courses of action are considered from the point of view of suitability, feasibility and acceptability. In order for this to be done, detailed information about each alternative course of action needs to be gathered and analysed.Selecting alternative courses of actionOnce the most appropriate alternative courses of action have been selected, long-term plans to implement them are formulated. Because these plans are long-term in nature, they will of necessity be less detailed than short-term plans, and will need to allow a degree of flexibility in responding to the changing organisational environment.Preparing and implementing the budgetA budget is a short-term plan formulated in financial terms and will show in detail the short-term actions the organisation willtake in working towards its long-term objectives. Once the budget has been formulated, finalised and agreed it can be implemented.Monitoring actual resultsIn order to achieve the long-term objectives that are reflected in the budget, the organisation must ensure that actual performance is proceeding according to plan. It will therefore need to monitor actual performance and results.Responding to divergences from planDivergences from planned activity, as measured by variances from budget, can lead to action if they are deemed to be significant. This action may be corrective in nature, in order to bring actual activity back into line with planned activity, or may entail revision of the budget if one of its underlying assumptions is seen as being in error.(b) A fixed budget is one prepared in advance of the relevant budget period which is not changed or amended as the budgetperiod progresses. This budget represents a periodic approach to budgeting, since a new budget is prepared towards the end of the budget period for the subsequent budget period. In this way, an organisation may set a new budget on an annual basis.A rolling budget, sometimes called a continuous budget, represents an alternative approach to periodic budgeting. Here, aportion of the budget period is replaced on a regular basis so that the overall budget period remains unchanged. For example, with a budget period of one year, at the end of each quarter a new quarter could be added to the end of the budget period and the elapsed quarter could be deleted, so that the budget was always looking one year ahead. Continuous budgeting continues to increase in popularity.A zero-based budget is a periodic budget which seeks to dispose of the incremental approach to budgeting. In the incrementalapproach, an increment is added to the relevant figure from last year’s budget, for example to take account of inflation. In this way, inefficiency can become embedded in the annual budget and profitability may suffer as a result. With the zero-based approach, each element of planned activity is required to be justified in terms of its contribution towards achieving organisational objectives. This involves the formulation of decision packages, which describe particular activities in such a way that managers can compare them in terms of their competing claims on organisational resources, and then rank them from a cost-benefit point of view. In this way, zero-based budgeting looks at each budget period with a new perspective.A fixed budget is likely to be useful in circumstances where the organisational environment is relatively stable and can bepredicted with a reasonable degree of certainty.A rolling budget is likely to be useful in circumstances where the future is less certain and more flexibility is needed in theorganisational response to its changing environment. For this reason, rolling budgets are popular with new organisations. A cash budget is often a rolling budget because of the need to keep tight control of this area of financial management. A rolling budget is also supported by the availability of cheap and powerful information processing via personal computers and computer networks.A zero-based budgeting approach tends to be most beneficial when used with services and with discretionary activities, andso is most widely used in the public sector.(c)Linear regression is a powerful way of analysing past information in order to derive linear relationships and so is ideally suitedto deriving cost equations from past accounts. Sales volume, however, is unlikely to follow a linear relationship alone. Linear regression could be used to determine the overall trend being followed by sales volume on, for example, an annual basis, but inspection of historic sales volumes is likely to show variations about the trend. These could be due to seasonal variations, or longer-term cyclical variations. Time-series analysis can extract these seasonal and cyclical variations and therefore produce forecasts of sales volumes that are likely to be more accurate in a given period than forecasts based on the underlying trend alone. In forecasting future sales volumes, therefore, both quantitative methods have their place in increasing forecasting accuracy.3(a)Discussion of performance of Woodside CharityIn a year which saw fundraising fall £80,000 short of the target level, costs were over budget in all areas of activity except overnight shelter provision. The budget provided for a surplus of £98,750, but the actual figures for the year show a shortfall of £16,980.Free meals provision cost £12,750 (14%) more than budgeted. Most of the variance (69%) was due to providing 1,750 more meals than budgeted, although £4,000 of it was due to an increase of 20p in the average cost per meal.Variable cost of overnight shelter provision was £26,620 (11%) less than budgeted. £31,000 was saved because usage of the service was 1,240 bed-nights below budget, but an adverse variance of £4,380 arose because of an increase of 50p in the average unit cost of provision.Variable advice centre costs were £16,600 (37%) above budget. This was due to increased usage of the service, which was 17% up on budget from 3,000 to 3,500 sessions, and to an increase in the average cost of provision, which rose by 17% from £15 to £17·60 per session.Fixed costs of administration and centre maintenance were £18,000 (28%) above budget and the costs of campaigning and advertising were £15,000 (10%) above budget.While investigation of some of the variances in the reconciliation statement below may be useful in controlling further cost increases, the Woodside charity appears to have more than achieved its objectives in terms of providing free meals and advice.The lower usage of overnight shelter could lead to transfer of resources from this area in the next budget to the services that are more in demand. The reasons for the lower usage of overnight shelter are not known, but the relationship between the provision of effective advice and the usage of overnight shelter could be investigated.Operating statement£Budgeted surplus (W1)98,750Funding shortfall (W3)(80,000)–––––––££18,750Favourable AdverseFree meals (W4)Price variance4,000Usage variance8,750Overnight shelter (W5)Price variance4,380Usage variance31,000Advice centre (W6)Price variance9,100Usage variance7,500Campaigning and advertising (W7)Expenditure variance15,000Fixed cost (W8)Expenditure variance18,000––––––––––––––31,00066,730(35,730)–––––––Actual shortfall (W2)(16,980)–––––––Workings(W1)Budgeted figures£Free meals provision91,250(18,250 meals at £5 per meal)Overnight shelter (variable)250,000(10,000 bed-nights at £30 – £5 per night)Advice centre (variable)45,000(3,000 sessions at £20 – £5 per session)Fixed costs65,000(10,000 x £5) + (3,000 x £5)Campaigning and advertising150,000––––––––601,250Surplus for unexpected costs98,750––––––––Fundraising target700,000––––––––(W2)Actual figures£Free meals provision104,000(20,000 meals at £5·20 per meal)Overnight shelter223,380(8,760 bed-nights £25·50 per night)Advice centre61,600(3,500 sessions at £17·60 per session)Fixed costs83,000Campaigning and advertising165,000––––––––636,980Shortfall16,980––––––––Funds raised620,000––––––––(W3)Funding shortfall – 700,000 – 620,000 = £80,000 (A)(W4)Free meals price variance = (5·00 – 5·20) x 20,000 = £4,000 (A)Free meals usage variance = (18,250 – 20,000) x 5·00 = £8,750 (A)(W5)Overnight shelter price variance = (25·00 – 25·50) x 8,760 = £4,380 (A)Overnight shelter usage variance – (10,000 – 8,760) x 25 = £31,000 (F)(W6)Advice centre price variance = (17·60 – 15·00) x 3,500 = £9,100 (A)Advice centre usage variance = (3,000 – 3,500) x 15·00 = £7,500 (A)(W7)Campaigning and advertising expenditure variance = 150,000 – 165,000 = £15,000 (A)(W8)Fixed cost expenditure variance = 65,000 – 83,000 = £18,000 (A)(b)Financial management and control in a not-for-profit organisation (NFPO) such as the Woodside charity must recognise thatthe primary objectives of these organisations are essentially non-financial. Here, these objectives relate to helping the homeless and because the charity has no profit-related objective, financial management and control must focus on providing value for money. This means that resources must be found economically in order to keep input costs as low as possible; that these resources must be used as efficiently as possible in providing the services offered by the charity; and that the charity must devise and use effective methods to meet its objectives. Financial objectives could relate to the need to obtain funding for offered services and to the need to control costs in providing these services.Preparing budgetsThe nature of the activities of a NFPO can make it difficult to forecast levels of activity. In the case of the Woodside charity, homeless people seeking free meals would be given them, and more food would be prepared if necessary, regardless of the budgeted provision for a given week or month. The level of activity is driven here by the needs of the homeless, and although financial planning may produce weekly or monthly budgets that consider seasonal trends, a high degree of flexibility may be needed to respond to unpredictable demand. This was recognised by the charity by budgeting for a fundraising surplus for unexpected costs.It is likely that forecasting cost per unit of service in a NFPO can be done with more precision if the unit of service is small and the service is repetitive or routine, and this is true for the Woodside charity. It is unlikely, though, that a detailed analysis of costs has been carried out along these lines, and more likely that an incremental budget approach has been used on a total basis for each service provided. It depends on the financial skills and knowledge available to the charity from its three full-time staff and team of volunteers.Controlling costsBecause of the need for economy and efficiency, this is a key area of financial management and control for a NFPO. The costs of some inputs can be minimised at the point of buying, for example the Woodside charity can be economical when buying food, drink, crockery, blankets, cleaning materials and so on. The costs of other inputs can be minimised at the point of use, for example the Woodside charity can encourage economy in the use of heating, lighting, water consumption, telephone usage and postage. In an organisation staffed mainly by volunteers with an unpredictable clientele, cost control is going to depend to a large extent on the way in which responsibility and authority are delegated.Collecting informationCost control is not possible without collecting regularly information on costs incurred, as well as storing and processing this information. In the Woodside charity, provision has been made in the budget for fixed administration costs and the administration duties must hopefully relate in part to this collecting of costing information. Without it, budgeting and financial reporting would not be possible. Annual accounts would be needed in order to retain charitable status and to show providers of funds that their donations were being used to their best effect.Meeting objectivesA NFPO organisation must be able to determine and demonstrate whether it is meeting its declared objectives and so needsto develop measures to do this. This can be far from easy. The analysis of the performance of the Woodside charity over the last year shows that it may be possible to measure objective attainment quantitatively, i.e. in terms of number of free meals served, number of bed-nights used and number of advice sessions given. Presumably, objectives are being met to a greater extent if more units of service are being provided, and so the adverse usage variances for free meals and advice sessions can in fact be used to show that the charity is meeting a growing need.The meaning of quantitative measures of service provision may not be clear, however. For example, the lower usage of bed-nights could be attributed to the effective provision of advice to the homeless on finding housing and financial aid, and so may also be seen as a success. It could also be due to dissatisfaction amongst the homeless with the accommodation offered by the shelter. In a similar vein, the higher than budget number of advice sessions may be due to repeat visits by homeless people who were not given adequate advice on their first visit, rather than to an increase in the number of people needing advice. Qualitative measures of objective attainment will therefore be needed in addition to, or to supplement, quantitative ones.4(a)Profit and loss accounts for TFR Ltd for the four-year periodYear Current Year 1Year 2Year 3Year 4£££££T urnover210,000255,000300,000345,000390,000Expenses168,000204,000240,000276,000312,000––––––––––––––––––––––––––––––––––––––––Net profit42,00051,00060,00069,00078,000Interest2,00011,0008,7506,5004,250––––––––––––––––––––––––––––––––––––––––Profit before tax40,00040,00051,25062,50073,750T ax10,00010,00012,81315,62518,438––––––––––––––––––––––––––––––––––––––––Profit after tax30,00030,00038,43846,87555,313Dividend15,00015,00019,21923,43827,656––––––––––––––––––––––––––––––––––––––––Retained profit15,00015,00019,21923,43827,656––––––––––––––––––––––––––––––––––––––––Equity finance200,000215,000234,219257,656285,313Debt finance nil75,00050,00025,000nilInterest cover (times)21·04·66·910·618·4Debt/equity (%)nil352110nilReturn on equity (%)1514161819ROCE (%)2118212427ROCE (%)*1916202326*Including the existing and continuing overdraft in capital employedWorkingsAnnual interest (assuming the continuing overdraft is maintained at the current level)Year 1 interest payment = 100,000 x 0·09 = 9,000 + 2,000 = £11,000Year 2 interest payment = 75,000 x 0·09 = 6,750 + 2,000 = £8,750Year 3 interest payment = 50,000 x 0·09 = 4,500 + 2,000 = £5,500Year 4 interest payment = 25,000 x 0·09 = 2,250 + 2,000 = £4,250(b)Financial implications for TFR Ltd of accepting bank loanA key consideration is whether TFR Ltd will be able to meet the annual payments of interest and capital. It is assumed, inpreparing a cash flow forecast, that there is no difference between profit and cash, and that inflation can be ignored. The annual cash surplus after meeting interest and tax payments is therefore assumed to be equal to retained profit.Year1234Retained profit15,00019,21923,43827,656Capital repayment25,00025,00025,00025,000––––––––––––––––––––––––––––Net cash flow(10,000)(5,781)(1,563)2,656––––––––––––––––––––––––––––TFR Ltd is clearly not able to meet the annual capital repayments. In order to do so, it will need to change the dividend policy it appears to have maintained for several years of paying out a constant proportion of profit after tax as dividends. One possible course of action is to cut its dividend now and then increase it in the future as profitability allows. Since TFR Ltd is owner-managed, a change in dividend policy may be possible, depending of course on the extent to which the owner or owners rely on dividend income. The annual cash flow shortfall is less than the annual dividend payment, so a change in dividend policy would probably allow the loan to be accepted.Year1234Profit after tax30,00038,43846,87555,313Capital repayment25,00025,00025,00025,000––––––––––––––––––––––––––––Available funds5,00013,43821,87530,313––––––––––––––––––––––––––––It is useful to consider key financial information after the loan has been paid off, i.e. in year 5, assuming that no further turnover growth occurs after the fourth year:Year Year 5£T urnover390,000Expenses312,000––––––––Net profit78,000Interest2,000––––––––Profit before tax76,000T ax19,000––––––––Profit after tax57,000Dividend28,500––––––––Retained profit28,500––––––––Equity finance313,813Debt finance nilInterest cover (times)39Debt/equity (%)nilReturn on equity (%)18ROCE (%)25ROCE (%)*23*Including the existing and continuing overdraft in capital employedThe effect on financial risk of taking on the loan can be examined. If the interest and capital payments are kept up, financial risk will be lower than its current level at the end of four years, all things being equal. Interest cover increases from its current level after five years, from 21 times to 39 times, but is on the low side at the end of the first year (4·6 times), although an improved level is reached at the end of the second year (6·9 times), with further increases in subsequent years. The debt/equity ratio peaks at 35% at the end of the first year and falls rapidly thereafter, at no time looking dangerous, and TFR Ltd returns to its current ungeared position after five years. The bank, as provider of debt finance, would be interested in the trend in these ratios, as well as in the ongoing cash flow position.Both return on equity (ROE) and return on capital employed (ROCE) improve with growth in turnover, but are lower than current levels in the first and second years following taking on the loan. At the end of five years ROE has improved to 18% from 15% and ROCE from 19% to 23%. Interest and capital payments would not increase with inflation.Provided TFR Ltd can meet the interest and capital repayments, business expansion using debt finance may be financially feasible. However, this analysis has ignored any potential pressure for reduction or repayment of the overdraft. An average overdraft of £20,000 is quite large for a company with an annual turnover of £210,000 and therefore cannot be ignored in any assessment of financial risk. TFR Ltd may therefore consider asking for a longer repayment period, with lower annual capital repayments, if it plans to reduce the size of the overdraft or if it is concerned about future cash flow problems. (c)TFR Ltd is owner-managed and profitable, and financed by equity apart from its large overdraft. It is currently seeking a bankloan in order to finance an expansion of business.Equity financeThe owner could inject new equity finance himself but his personal financial situation may make this impossible. There are unlikely to be any wealthy individuals willing to invest in his company because there are likely to be more attractive investments elsewhere. Investing in a UK pension fund, for example, carries a tax incentive in that the UK government increases any contributions by the amount of income tax paid. There is therefore a disincentive to invest in the shares of a small company which may be difficult to sell in the future unless another investor can be found who wishes to buy the shares.However, there is in the UK a Business Angel network which can bring potential investors and small companies together, with the added bonus that the Business Angel may have expertise and experience to offer that could be useful in a small company situation. The owner of TFR Ltd may wish to look into this possibility.There is also a UK government initiative called the Enterprise Investment Scheme, which is of potential benefit to trading companies rather than service companies. The government offers tax advantages in terms of income tax and capital gains tax in order to encourage investment by individuals in the ordinary shares of small companies.A further UK government scheme offers tax advantages to Venture Capital T rusts, who are required to invest a large part oftheir funds in the ordinary shares of small companies.Other government assistance schemesA range of other UK and EU government assistance schemes exist but almost all of these are targeted towards companies inparticular geographic locations, or within particular ranges in terms of number of employees, or with particular funding requirements, for example training.Debt financeSmall companies are faced with a risk-averse attitude from banks when they seek to raise debt finance. Banks tend to ask for personal guarantees from owners and will set interest rates at higher levels than those charged to larger companies. TFR。