Paper 2.

4
Financial
Management and
Control
PART 2

WEDNESDAY 11 DECEMBER 2002

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A This ONE question is compulsory and MUST be

answered

Section B TWO questions ONLY to be answered

Formulae sheet, present value and annuity tables are on

pages 10 and 11
Section A – This ONE question is compulsory and MUST be attempted

1 Jack Geep will set up a new business as a sole trader on 1 January 2003 making decorative glassware. Jack is in
the process of planning the initial cash flows of the business. He estimates that there will not be any sales demand
in January 2003 so production in that month will be used to build up stocks to satisfy the expected demand in
February 2003. Thereafter it is intended to schedule production in order to build up sufficient finished goods stock at
the end of each month to satisfy demand during the following month. Production will, however, need to be 5% higher
than sales due to expected defects that will have to be scrapped. Defects are only discovered after the goods have
been completed. The company will not hold stocks of raw materials or work in progress.
As the business is new, demand is uncertain, but Jack has estimated three possible levels of demand in 2003 as
follows:
High Medium Low
demand demand demand
£ £ £
February 22,000 20,000 19,000
March 26,000 24,000 23,000
April 30,000 28,000 27,000
May 29,000 27,000 26,000
June 35,000 33,000 32,000
Demand for July 2003 onwards is expected to be the same as June 2003. The probability of each level of demand
occurring each month is as follows:
High 0·05; Medium 0·85; Low 0·10.
It is expected that 10% of the total sales value will be cash sales, mainly being retail customers making small
purchases. The remaining 90% of sales will be made on two months’ credit. A 2·5% discount will, however, be
offered to credit customers settling within one month. It is estimated that customers, representing half of credit sales
by value, will take advantage of the discount while the remainder will take the full two months to pay.
Variable production costs (excluding costs of rejects) per £1,000 of sales are as follows:
£
Labour 300
Materials 200
Variable overhead 100
Labour is paid in the month in which labour costs are incurred. Materials are paid one month in arrears and variable
overheads are paid two months in arrears. Fixed production and administration overheads, excluding depreciation, are
£7,000 per month and are payable in the same month as the expenditure is incurred.
Jack employed a firm of consultants to give him initial business advice. Their fee of £12,000 will be paid in February
2003. Smelting machinery will be purchased on 1 January 2003 for £200,000 payable in February 2003. Further
machinery will be purchased for £50,000 in March 2003 payable in April 2003. This machinery is highly specialised
and will have a low net realisable value after purchase.
Jack has redundancy money from his previous employment and savings totalling £150,000, which he intends to pay
into his bank account on 1 January 2003 as the initial capital of the business. He realises that this will be insufficient
for his business plans, so he is intending to approach his bank for finance in the form of both a fixed term loan and
an overdraft. The only asset Jack has is his house that is valued at £200,000, but he has an outstanding mortgage
of £80,000 on this property.
The consultants advising Jack have recommended that rather than accumulating sufficient stock to satisfy the
following month’s demand he should not maintain any stock levels but merely produce sufficient in each month to
meet the expected demand for that month.

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Jack’s production manager objected: ‘I need to set up my production schedule based on the expected average demand
for the month. I will reduce production in the month if it seems demand is low. However, there is no way production
can be increased during the month to accommodate demand if it happens to be at the higher level that month. As a
result, under this new system, there would be no stocks to fall back on and the extra sales, when monthly demand
is high, would be lost, as customers require immediate delivery.’ In respect of this, an assessment of the impact of
the introduction of just-in-time stock management on cash flows has been made that showed the following:
January February March April May June
Net cash 143,000 (223,279) (7,587) (50,667) 1,843 1,704
flow (£)
Month-end 143,000 (80,279) (87,866) (138,533) (136,690) (134,986)
balance (£)

Required:
(a) Prepare a monthly cash budget for Jack Geep’s business for the six month period ending 30 June 2003.
Calculations should be made on the basis of the expected values of sales. The cash budget should show the
net cash inflow or outflow in each month and the cumulative cash surplus or deficit at the end of each month.
For this purpose ignore bank finance and the suggested use of just-in-time stock management. (17 marks)

(b) Assume now that just-in-time stock management is used in accordance with the recommendations of the
consultants. Calculate for EACH of the six months ending 30 June 2003:
(i) receipts from sales; and
(ii) payments to labour. (6 marks)

(c) Evaluate the impact for Jack Geep of introducing just-in-time stock management. This should include an
assessment of the wider implications of just-in-time stock management in the particular circumstances of
Jack Geep’s business. (10 marks)

(d) Write a report to Jack Geep which identifies the financing needs of the company. It should consider the
following:
(i) the extent of financing required;
(ii) the factors that should be considered in determining the most appropriate mix of short-term financing
(e.g. overdraft) and long-term financing (e.g. fixed term bank loan); and
(iii) the extent to which improved working capital management (other than just-in-time stock management)
might reduce the company’s financing needs and describe how this might be achieved.
Where appropriate, show supporting calculations. (17 marks)
(50 marks)

3 [P.T.O.
Section B – TWO questions ONLY to be attempted

2 Private sector companies have multiple stakeholders who are likely to have divergent interests.

Required:
(a) Identify five stakeholder groups and briefly discuss their financial and other objectives. (12 marks)

(b) Examine the extent to which good corporate governance procedures can help manage the problems arising
from the divergent interests of multiple stakeholder groups in private sector companies in the UK.
(13 marks)
(25 marks)

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3 Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been disappointing in
recent years and a new managing director, Peter Beech, was appointed to raise production volumes. After an initial
assessment Peter Beech considered that budgets had been set at levels which made it easy for employees to achieve.
He argued that employees would be better motivated by setting budgets which challenged them more in terms of
higher expected output.
Other than changing the overall budgeted output, Mr Beech has not yet altered any part of the standard cost card.
Thus, the budgeted output and sales for November 2002 was 4,000 benches and the standard cost card below was
calculated on this basis:
£
Wood 25 kg at £3·20 per kg 80·00
Labour 4 hours at £8 per hour 32·00
Variable overheads 4 hours at £4 per hour 16·00
Fixed overhead 4 hours at £16 per hour 64·00
–––––––
192·00
Selling price 220·00
–––––––
Standard profit 28·00
–––––––
Overheads are absorbed on the basis of labour hours and the company uses an absorption costing system. There were
no stocks at the beginning of November 2002. Stocks are valued at standard cost.
Actual results for November 2002 were as follows:
£
Wood 80,000 kg at £3·50 280,000
Labour 16,000 hours at £7 112,000
Variable overhead 60,000
Fixed overhead 196,000
––––––––
Total production cost (3,600 benches) 648,000
Closing stock (400 benches at £192) 76,800
––––––––
Cost of sales 571,200
Sales (3,200 benches) 720,000
––––––––
Actual profit 148,800
––––––––
The average monthly production and sales for some years prior to November 2002 had been 3,400 units and budgets
had previously been set at this level. Very few operating variances had historically been generated by the standard
costs used.
Mr Beech has made some significant changes to the operations of the company. However, the other directors are now
concerned that Mr Beech has been too ambitious in raising production targets. Mr Beech had also changed suppliers
of raw materials to improve quality, increased selling prices, begun to introduce less skilled labour, and significantly
reduced fixed overheads.
The finance director suggested that an absorption costing system is misleading and that a marginal costing system
should be considered at some stage in the future to guide decision-making.
Required:
(a) Prepare an operating statement for November 2002. This should show all operating variances and should
reconcile budgeted and actual profit for the month for Woodeezer Ltd. (14 marks)
(b) In so far as the information permits, examine the impact of the operational changes made by Mr Beech on
the profitability of the company. In your answer, consider each of the following:
(i) motivation and budget setting; and
(ii) possible causes of variances. (6 marks)
(c) Re-assess the impact of your comments in part (b), using a marginal costing approach to evaluating the
impact of the operational changes made by Mr Beech.
Show any relevant additional calculations to support your arguments. (5 marks)
(25 marks)
5 [P.T.O.
4 Leaminger plc has decided it must replace its major turbine machine on 31 December 2002. The machine is essential
to the operations of the company. The company is, however, considering whether to purchase the machine outright
or to use lease financing.
Purchasing the machine outright
The machine is expected to cost £360,000 if it is purchased outright, payable on 31 December 2002. After four
years the company expects new technology to make the machine redundant and it will be sold on 31 December 2006
generating proceeds of £20,000. Capital allowances for tax purposes are available on the cost of the machine at the
rate of 25% per annum reducing balance. A full year’s allowance is given in the year of acquisition but no writing
down allowance is available in the year of disposal. The difference between the proceeds and the tax written down
value in the year of disposal is allowable or chargeable for tax as appropriate.
Leasing
The company has approached its bank with a view to arranging a lease to finance the machine acquisition. The bank
has offered two options with respect to leasing which are as follows:
Finance Operating
Lease Lease
Contract length (years) 4 1
Annual rental £135,000 £140,000
First rent payable 31 December 2003 31 December 2002
General
For both the purchasing and the finance lease option, maintenance costs of £15,000 per year are payable at the end
of each year. All lease rentals (for both finance and operating options) can be assumed to be allowable for tax purposes
in full in the year of payment. Assume that tax is payable one year after the end of the accounting year in which the
transaction occurs. For the operating lease only, contracts are renewable annually at the discretion of either party.
Leaminger plc has adequate taxable profits to relieve all its costs. The rate of corporation tax can be assumed to be
30%. The company’s accounting year-end is 31 December. The company’s annual after tax cost of capital is 10%.

Required:
(a) Calculate the net present value at 31 December 2002, using the after tax cost of capital, for
(i) purchasing the machine outright;
(ii) using the finance lease to acquire the machine; and
(iii) using the operating lease to acquire the machine.
Recommend the optimal method. (12 marks)

(b) Assume now that the company is facing capital rationing up until 30 December 2003 when it expects to make
a share issue. During this time the most marginal investment project, which is perfectly divisible, requires an
outlay of £500,000 and would generate a net present value of £100,000. Investment in the turbine would
reduce funds available for this project. Investments cannot be delayed.
Calculate the revised net present values of the three options for the turbine given capital rationing. Advise
whether your recommendation in (a) would change. (5 marks)

(c) As their business advisor, prepare a report for the directors of Leaminger plc that assesses the issues that
need to be considered in acquiring the turbine with respect to capital rationing. (8 marks)
(25 marks)

6
 This is a blank page.

Question 5 begins on page 8.

7 [P.T.O.
5 Abkaber plc assembles three types of motorcycle at the same factory: the 50cc Sunshine; the 250cc Roadster and
the 1000cc Fireball. It sells the motorcycles throughout the world. In response to market pressures Abkaber plc has
invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size
of its workforce.
Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering
introducing Activity Based Costing (ABC). Abkaber plc’s accountant has produced the following analysis.
Annual
Annual Direct Raw
Output Labour Selling material
(units) Hours Price cost
(£ per unit) (£ per unit)
Sunshine 2,000 200,000 4,000 400
Roadster 1,600 220,000 6,000 600
Fireball 400 80,000 8,000 900
The three cost drivers that generate overheads are:
Deliveries to retailers – the number of deliveries of motorcycles to retail showrooms
Set-ups – the number of times the assembly line process is re-set to accommodate a production run of
a different type of motorcycle
Purchase orders – the number of purchase orders.
The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:
Number of Number of Number of
deliveries set-ups purchase
to retailers orders
Sunshine 100 35 400
Roadster 80 40 300
Fireball 70 25 100
The annual overhead costs relating to these activities are as follows:
£
Deliveries to retailers 2,400,000
Set-up costs 6,000,000
Purchase orders 3,600,000
All direct labour is paid at £5 per hour. The company holds no stocks.
At a board meeting there was some concern over the introduction of activity based costing.
The finance director argued: ‘I very much doubt whether selling the Fireball is viable but I am not convinced that
activity based costing would tell us any more than the use of labour hours in assessing the viability of each product.’
The marketing director argued: ‘I am in the process of negotiating a major new contract with a motorcycle rental
company for the Sunshine model. For such a big order they will not pay our normal prices but we need to at least
cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages
costs for our entire production’.
The managing director argued: ‘I believe that activity based costing would be an improvement but it still has its
problems. For instance if we carry out an activity many times surely we get better at it and costs fall rather than remain
constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.’
The chairman argued: ‘I cannot see the problem. The overall profit for the company is the same no matter which
method of allocating overheads we use. It seems to make no difference to me.’

8
Required:
(a) Calculate the total profit on each of Abkaber plc’s three types of product using each of the following methods
to attribute overheads:
(i) the existing method based upon labour hours; and
(ii) activity based costing. (13 marks)

(b) Write a report to the directors of Abkaber plc, as its management accountant. The report should:
(i) evaluate the labour hours and the activity based costing methods in the circumstances of Abkaber plc; and
(ii) examine the implications of activity based costing for Abkaber plc, and in so doing evaluate the issues
raised by each of the directors.

Refer to your calculations in requirement (a) above where appropriate. (12 marks)
(25 marks)

9 [P.T.O.
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End of Question Paper

11