Part A

Question 1:

a. Define the relevant cash flows, sunk costs and the Opportunity
costs. Give examples of the relevant revenue/cash inflows.

• A relevant cash flow is a cost or revenue which can be changed

depending on the outcome of a decision. A cash flow that cannot be
changed by a decision is not a relevant cash flow to that decision.
• A sunk cost is a cost which has already been incurred and paid, or
must be paid in the future regardless of what decision is made.
Sunk costs are irrelevant to decisions about the future, precisely
because they cannot be changed by those decisions. In spite of this,
people often erroneously let them influence their decisions.
• Opportunity cost is cash inflow which would have been received,
but which will not be received if a project under consideration goes
ahead. For example the opportunity cost of discontinuing
manufacturing product B to focus solely on product A is the sales
of product B which would have been made if both were
manufactured. Like sunk costs, people also have a tendency to
ignore opportunity costs.

Relevant revenue (cash inflows) includes:

– increases in revenue
– reductions in cash outflows due to cost savings, e.g.:
- less raw material to be purchased in the future
- reductions in staff labor time which result in lower staff
cost
- reduction in overheads which can be directly attributed
to the project – for example, reduction in energy cost or
fuel cost due to greater efficiency
– Cash flow from the disposal of old equipment.
 b. CAL Company makes professional calculators. The profit plan
and actual results for the previous year, 2018, are as follows:
Actual Results Profit Plan
Pounds Volume Pounds Volume
1,920,00 1,750,00
60,000 50,000 Sales
0 0
Cost of Goods Sold
880,000 8,000 600,000 5,000 Raw material (KG)
680,000 8,000 800,000 10,000 Raw material (L)
320,000 16,000 312,500 12,500 Labor (Hours)
40,000 37,500 Contribution Margin
Other costs
8,000 6,000 Energy
4,000 6,000 Maintenance
5,000 7,000 Depreciation
5,000 1,000 Selling expenses
5,500 15,000 Advertising
12,500 2,500 Profit before interest and tax

The plant manager, Rasha, has instructed the plant management accountant to
prepare a detailed report to be sent to corporate headquarters comparing each
component’s actual result with the amounts set forth above in the annual
budget.

Required:
Explain the difference between the expected and actual profit, show
your workings and draw the variances tree.

Explaining the difference between the expected and actual profit:

The competitive effectiveness:
a- The impact of the change in sales volume:
The sales (market) variance = (actual volume – planned volume) ×
planed price
The sales (market) variance = (60,000 – 50,000) × (1,750,000 ÷
50,000)
The sales (market) variance = $350,000 (F)

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b- The impact of the change in price:
The sales price variance = actual volume × (actual price - planed
price)
The sales price variance = 60,000 × [(1,920,000 ÷ 60,000) -
(1,750,000 ÷ 50,000)]
The sales (market) variance = $180,000 (U)

The operating efficiency:

a- The impact of the change in raw material (KGs):
 The efficiency (quantity) variance = (actual volume - planned
volume) × planned price
The efficiency (quantity) variance = (8,000-5,000) × (600,000 ÷
5,000)
The efficiency (quantity) variance = $360,000 (U)
 The spending variance = (actual price - planned price) × actual
volume
The spending variance = [(880,000 ÷ 8,000) - (600,000 ÷ 5,000)] ×
8,000 = $80,000 (F)

b- The impact of the change in raw material (Liters):

 The efficiency (quantity) variance = (actual volume - planned
volume) × planned price
The efficiency (quantity) variance = (8,000 – 10,000) × (800,000
÷ 10,000)
The efficiency (quantity) variance = $160,000 (F)
 The spending variance = (actual price - planned price) × actual
volume
The spending variance = [(680,000 ÷ 8,000) - (800,000 ÷ 10,000)] ×
8,000 = $40,000 (U)

c- The impact of the change in labor:

 The efficiency (hours) variance = (actual hours - planned hours)
× planned labor rate

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 The efficiency (hours) variance = (16,000 – 12,500) × (312,500 ÷
12,500)
The efficiency (hours) variance = $87,500 (U)
 The spending variance = (actual labor rate - planned labor rate) ×
actual hours
The spending variance = [(320,000 ÷ 16,000) - (312,500 ÷
12,500)] × 16,000 = $80,000 (F)

The impact of the change in other costs: (3 marks)

Variance ($) Actual Results Profit Plan Other costs
2,000 (U) 8,000 6,000 Energy
2,000 (F) 4,000 6,000 Maintenance
2,000 (F) 5,000 7,000 Depreciation
4,000 (U) 5,000 1,000 Selling expenses
6,500 (F) 5,500 15,000 Advertising
7,500 (F) Total

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 The tree of variance analysis:

Change in profits
$10,000 (F)

Competitive effectiveness Operating efficiency

$170,000 (F) $160,000 (U)

Variance due to market Variance due to selling Variance associated Variance associated
(sales) price with direct costs with other costs
$350,000 (F) $180,000 (U) $167,500 (U) $7,500 (F)

Variance associated
Variance associated with direct labor
with direct material $7,500 (U)
(KG) $280,000 (U)

Variance associated with

direct material (L)
Eff. Var. Spend. var Eff. Var. Spend. var
$120,000 (F)
$360,000 $80,000 $87,500 (U) $80,000 (F)
(U) (F)

.Eff. Var Spend. var

$160,000 (F) $40,000 (U)

The Company showed a favorable change in profit of $10,000; which is

the result of a $170,000 as a favorable competitiveness effectiveness

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variance and a $160,000 as an unfavorable operating efficiency variance.
(1 mark)

Part B:
Question 2:
a. Discuss the Balanced Scorecard (BSC) and its key elements;
support your discussion by a diagram. Elaborate on three of the
major problems with using the Balanced Scorecard system
outlined by Smith in 2006.

The balanced scorecard is based on the philosophy of bringing into focus the
management processes that are important for long-term survival and growth
of a business and that will add value to the business. It translates an
organization’s mission and strategy into a comprehensive set of measures, its
measurements provide feedback on how well the organization is
implementing its strategy and it reduced the emphasis on short-term financial
goals. Kaplan and Norton (1992) proposed a four-dimensional model of
performance measurement, giving equal attention to short-term and long-term
considerations:
– Financial performance
– Customer issues
– Internal business processes
– Organization learning and growth.

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 The major problems with using the Balanced Scorecard system
(Smith, 2006):
1. Poorly defined metrics: "A system that has sloppy or inconsistently
defined metrics will be vulnerable to criticism by people who want to
avoid accountability for results."
2. Lack of efficient data collection and reporting: companies should
prioritize performance indicators and allocate research money
accordingly allowing for the most vital information to be reported.
3. Lack of formal review structure: "Scorecards work best when they are
reviewed frequently enough to make a difference."
4. No Process Improvement Methodology: instead use time-tested process
improvement methodologies in conjunction with problem solving
methodologies.
5. Too much internal focus: consider beginning with external focus and
then reflecting on the business' strengths, weaknesses, opportunities
and threats.

b. The following summary information is available regarding ABD

Plc.
ADB Plc.

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 Profit Plan
For the year ending Dec. 31, 2018
$2,400,000 Sales Revenue
$600,000 Net Income
$3,600,000 Total Assets
$1,500,000 Operating Assets
$1,600,000 Total Liabilities
20% WACC
18% Tax rate
$125,000 Return from Project A
$80,000 Cost of project A

Required: Compute and analyze the:

- Return on Investment (ROI) for project A
- Return on Equity (ROE) and its components for
the company.
- Residual income (RI)

Computing ROI:
Gain from Investment – Cost of
Investment ROI =
Cost of Investment

0.5625or ($125,000-80,000)
= ROI =
56.25% (80,000)

The ROI compares the return from an investment with the amount of the
investment. In this case, project A will generate a return of 56.25%

Computing ROE:
Net Income
Shareholders’ ROE =
equity

0.3 or 30% = $600,000 ROE =

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 (3,600,000 –
1,600,000)

Analyzing ROE:

Total Assets Net

Sales
Income
× × ROE =
Shareholders’
Total Assets Sales
equity

3,600,000 2,400,000 600,000

× × ROE =
2,000,000 3,600,000 2,400,000

0.3 or 0.25 (or

= 1.8 × 0.666 t × ROE =
30% 25%)

Financial Asset Turnover Profitabilit

× × ROE =
Leverage Ratio Ratio y Ratio

We can see that the company is projected to earn 25% net income on sales
with asset turnover of 0.666 times and a leverage ratio of 1.8. The
combination of these three indicators yields ROE of 30%.

Computing RI:
Residual income (RI) = Operating income – (WACC x Operating assets)
= 731,707.32* - (20% x 1,500,000) = $431,707.32

*Net Income = Operating Income * (1-Tax Rate)

Operating Income = Net Income / (1-Tax Rate) = 600,000/ (1-18%) =
$731,707.32

A residual income approach to measuring performance moves away from

calculating a return in the form of a percentage, as the ROI does, to focus
on the return as an absolute monetary amount the company will generate an
RI of $431,707.32

Question 3:
Kamel Company has $200,000 to invest and wishes to evaluate the
following three projects.
C ($) B ($) A ($) Years

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 (60,000) (100,000) (80,000) 0
50,000 60,000 40,000 1
30,000 30,000 40,000 2
10,000 40,000 40,000 3
60,000 40,000 4
10% 10% 10% cost of capital

Required:
Which project(s) would you recommend using?
a. Payback Period (PP) in nominal and discounted values.
b. Net Present Value (NPV)
c. Profitability Index (PI)
d. The internal rate of return (IRR) (hint: use 35%)

1-a- The nominal PP:

-A = 2 years
-B = 2.25 years (2+ 10,000/40,000)
-C = 1.33 years (1 + 10,000/30,000)

The discounted PP:

Yea
CCFC PVC CCFB PVB CCFA PVA
r
-60,000 -60,000 -100,000 -100,000 -80,000 -80,000 0
-14,545 45,455 -45,455 54,545 -43,636 36,364 1
10,248 24,793 -20,661 24,793 -10,579 33,058 2
17,761 7,513 9,391 30,053 19,474 30,053 3
0 50,372 40,981 46,795 27,321 4
PPC = 1.586 years PPB = 2.687 years PPA = 2.352 years

The company should invest in C and A projects using both the nominal
and the discounted cash flows.

Year
PVC PVB PVA (1+ r)n C ($) B($) A ($)
s
-
1 -60,000 -80,000 0
100,000
45,455 54,545 36,364 1.1 50,000 60,000 40,000 1
24,793 24,793 33,058 1.21 30,000 30,000 40,000 2
7,513 30,053 30,053 1.331 10,000 40,000 40,000 3
0 40,981 27,321 1.4641 60,000 40,000 4
77,761 150,372 126,795 PV = 10% 10% 10% r
17,761 50,372 46,795 b – NPV

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1.296018 1.5037224 1.5849327 c – PI

According to both NPVs and PIs, the company should choose projects B
and A.

d-The NPV at 35%: (A and B are chosen)

PVC PVB PVA Year
(100,000
(60,000) ) (80,000) 0
37,037.0 44,444.4 29,629.6
4 4 3 1
16,460.9 16,460.9 21,947.8
1 1 7 2
4,064.42 16,257.6 16,257.6
1 8 8 3
18,064.0 12,042.7
9 3 4
57562.3 95,227.1 79,877.9
6 3 2 PV
- -
2,437.64 4,772.87 -122.083 NPV @35%

According to the IRRs the company should choose projects A and B:

IRRs:
- A: 10 + (25 * 46,794.62 / 46,916.7) = 34.9%

- B: 10 + (25 * 50,372.2 / 558,145.07) = 32.9%

- C: 10 + (25 * 17,761.08 / 20,198.72) = 31.9%

Question 4:

a. Discuss the Bonds and elaborate on the world’s bond markets.

The financial markets provide the means for organizations to borrow money
by the issuance of securities in the form of notes or bonds. These typically
have maturities in the range of 1 to 30 years. Longer dated, occasionally

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undated or perpetual bonds, with no defined maturity date, are also issued,
although such issues are infrequent. The bulk of funding activity in the bond
(or capital) markets is in maturities of up to 10 years.

The world’s bond markets can be subdivided into the following categories:
– Domestic and foreign bond markets: Organizations can raise funds
both in the market of their home country (domestic bond) or in that of a
foreign country. In the latter case the issue is called a foreign bond.
– International markets: These markets operate outside the jurisdiction
of a single country. The best example of an international market is the
Eurobond market. Here the term ‘euro’ simply means international
since they are outside the country of origin of the issuer.
– The global market: A global bond is the simultaneous issue of a bond
into a number of markets; for example, an issue of a US dollar-
denominated bond in the US market and the simultaneous launch of the
same bond (denominated similarly in US dollars) in the European and
Asian markets.

b. A Company has average trade receivables of $1,050,000 and annual sales

of $4.2 million. It is considering the use of factoring given that this would
result in a reduction in credit control costs of $150,000 per annum. The
factoring house charges a fee of 1.6% of sales. It will provide an advance to
the company of 82% of its receivables and will charge interest on this
advance of 10% per annum.
Required: Assess whether it is financially beneficial for the company to
enter into this factoring arrangement.
Suggested answer:
The estimated annual costs to the company from the factoring
arrangement would be
Factoring fee = 1.6% × $4.2 million = $67,200
Interest = 82% × $1,050,000 × 10% = $86,100
Total cost = $153,300
Savings on credit control costs = $150,000
Loss to the company = ($3,300)

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It is not beneficial for the company to proceed with factoring.

c. KPL Company has 2.1 million shares in issue. The current market
price is $42 per share. The company’s debt is publicly traded on the
London Stock Exchange and the most recent quote for its price was
at 97% of face value. The debt has a total face value of $12 million
and the company’s credit risk premium is currently 2.5%. The risk-
free rate is 3.9% and the equity market risk premium is 7.8%. The
company’s beta is estimated at 1.2 and its corporate tax rate is 18%.
Required: Calculate the company’s WACC.
Suggested answer:
Current cost of equity = 3.9% + (1.2 x 7.8%) = 13.26%
The current cost of debt = 3.9% + 2.5% = 6.4%
The market value of equity = $42 x 2.1 million = $88.2 million
The market value of debt = 0.97 x $11 million = $10.67 million
Total debt + equity = $98.87 million
So debt is 10.79% of the total and equity 89.21%.

WACC = [89.21% x 13.26%] + [10.79% x 6.4% x (1-18%)] = 12.39%

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