Paper 2.

4
Financial
Management and
Control
PART 2

WEDNESDAY 15 DECEMBER 2004

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 7, 8 and 9.

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination

hall

The Association of Chartered Certified Accountants

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

1 Sassone plc is a medium-sized profitable company that manufactures engineering products. Its stated objectives are
to maximise shareholder wealth and to maintain an ethical approach to the production and distribution of engineering
products. It has in issue two million ordinary shares, held as follows:
Number of shares
Pension funds 550,000
Insurance companies 250,000
Investment trusts 200,000
Unit trusts 100,000
Directors of Sassone 350,000
Other shareholders 550,000
––––––––––
2,000,000
––––––––––
The Managing Director of Sassone plc is considering three items that have been placed on the agenda of the next
Board Meeting:
1. Complaint by institutional investors
A number of institutional investors complained at the recent Annual General Meeting of the company that
expenditure on environmentally-friendly and socially responsible projects was at too high a level, resulting in a
less than acceptable increase in annual dividend payments. They had warned that they would vote against the
re-appointment of directors if matters had not improved by the next Annual General Meeting.
2. Proposal to change variance reporting procedure
The Production Director has asked that the company amend its current variance reporting procedures in order to
report planning and operational variances rather than variances based only on start-of-period standard costing
information. In support of his request he has highlighted a £33,000 adverse direct material usage variance for
the last period for Product Z, which he claims is not the responsibility of his staff since he believes that most of
this variance is due to the use of an out-of-date standard.
The Production Director states that the standard cost of materials of Product Z at the start of the period was 5 kg
per unit at £7·50 per kg, and that budgeted production and sales of Product Z for the period were 11,000 units.
During the period, actual production and sales of Product Z were 10,000 units and 54,400 kg of materials were
used at a cost of £408,000. The Production Director believes that, due to the age of the machinery used to make
Product Z, the standard usage of materials should be revised to 5·3 kg per unit.
3. Proposal to increase manufacturing capacity
The directors of Sassone plc need to increase capacity in order to meet expected demand for a new product,
Product G, which is to be used in the manufacture of new-generation personal computers. Product G cannot be
manufactured on existing machines. The directors have identified two machines which can manufacture
Product G, each with a capacity of 60,000 units per year, as follows:
Machine One
This machine will cost £238,850 and last for five years, at the end of which time it will have zero scrap value.
Maintenance costs will be £10,000 in the first year of operation, increasing by £3,000 per year for each year of
operation.
Machine Two
This machine will cost £215,000 and last for four years, at the end of which time it will have zero scrap value.
Maintenance costs will be £10,000 in the first year of operation, increasing by £5,000 per year for each year of
operation.

2
 Sassone plc expects demand for Product G to be 30,000 units per year in the first year, and to increase by a
further 10,000 units per year in each subsequent year. Selling price is expected to be £10·00 per unit and the
marginal cost of production is expected to be £7·80 per unit. Incremental fixed production overheads of £10,000
per year will be incurred. Selling price and costs are all in current price terms.
Annual inflation rates are expected to be as follows:
Selling price of Product G: 4% per year
Marginal cost of production: 4% per year
Maintenance costs: 5% per year
Fixed production overheads: 6% per year
Other information
Sassone plc has a real cost of capital of 8% and uses a nominal (money) cost of capital of 11% in investment
appraisal. The company pays tax one year in arrears at an annual rate of 30% and can claim capital allowances on
a 25% reducing balance basis, with a balancing allowance at the end of the life of the machines. The company
depreciates fixed assets on a straight-line basis over the life of the asset and has a target before-tax return on capital
employed (accounting rate of return) of 25%.

Required:
(a) Calculate the planning and operational direct material usage variances for Product Z and comment on the
views of the Production Director. (4 marks)

(b) Using equivalent annual cost and considering machine purchase prices and maintenance costs only,
determine which machine should be purchased by Sassone. Ignore inflation and taxation in this part of the
question only. (6 marks)

(c) Calculate the net present value of the incremental cash flows arising from purchasing Machine Two and
advise on its acquisition. (18 marks)

(d) Calculate the before-tax return on capital employed (accounting rate of return) of the incremental cash flows
arising from purchasing Machine Two based on the average investment and comment on your findings.
(4 marks)

(e) Discuss the conflict that may arise between corporate objectives, using the information provided on Sassone
plc to illustrate your answer. (10 marks)

(f) Discuss how lifecycle costing and target costing may assist Sassone plc in controlling costs and pricing
engineering products. (8 marks)

(50 marks)

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

2 Mermus plc is comparing budget and actual data for the last three months.
Budget Actual
£ £ £ £
Sales 950,000 922,500
Cost of sales
Raw materials 133,000 130,500
Direct labour 152,000 153,000
Variable production overheads 100,700 96,300
Fixed production overheads 125,400 115,300
–––––––– ––––––––
511,100 495,100
–––––––– ––––––––
438,900 427,400
–––––––– ––––––––
The budget was prepared on the basis of 95,000 units produced and sold, but actual production and sales for the
three-month period were 90,000 units.
Mermus uses standard costing and absorbs fixed production overheads on a machine hour basis. A total of 28,500
standard machine hours were budgeted. A total of 27,200 machine hours were actually used in the three-month
period.

Required:
(a) Prepare a revised budget at the new level of activity using a flexible budgeting approach. (4 marks)

(b) Calculate the following:

(i) raw material total cost variance;
(ii) direct labour total cost variance;
(iii) fixed overhead efficiency variance;
(iv) fixed overhead capacity variance;
(v) fixed overhead expenditure variance. (8 marks)

(c) Suggest possible explanations for the following variances:

(i) raw materials total cost variance;
(ii) fixed overhead efficiency variance;
(iii) fixed overhead expenditure variance. (6 marks)

(d) Explain three key purposes of a budgeting system. (7 marks)

(25 marks)

4
3 Tirwen plc is a medium-sized manufacturing company which is considering a 1 for 5 rights issue at a 15% discount
to the current market price of £4·00 per share. Issue costs are expected to be £220,000 and these costs will be paid
out of the funds raised. It is proposed that the rights issue funds raised will be used to redeem some of the existing
debentures at par. Financial information relating to Tirwen plc is as follows:
Current Balance Sheet
£000 £000 £000
Fixed assets 6,550
Current assets
Stock 2,000
Debtors 1,500
Cash 300
––––––
3,800
Current liabilities
Trade creditors 1,100
Overdraft 1,250
––––––
2,350
––––––
Net current assets 1,450
––––––
Total assets less current liabilities 8,000
12% debentures 2012 4,500
––––––
3,500
––––––
Ordinary shares (par value 50p) 2,000
Reserves 1,500
––––––
3,500
––––––
Other information:
Price/earnings ratio of Tirwen plc: 15·24
Overdraft interest rate: 7%
Corporation tax rate: 30%
Sector averages: debt/equity ratio (book value): 100%
interest cover: 6 times

Required:
(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue, calculate:
(i) the theoretical ex rights price per share;
(ii) the value of rights per existing share. (3 marks)

(b) What alternative actions are open to the owner of 1,000 shares in Tirwen plc as regards the rights issue?
Determine the effect of each of these actions on the wealth of the investor. (6 marks)

(c) Calculate the current earnings per share and the revised earnings per share if the rights issue funds are used
to redeem some of the existing debentures. (6 marks)

(d) Evaluate whether the proposal to redeem some of the debentures would increase the wealth of the
shareholders of Tirwen plc. Assume that the price/earnings ratio of Tirwen plc remains constant.
(3 marks)

(e) Discuss the reasons why a rights issue could be an attractive source of finance for Tirwen plc. Your discussion
should include an evaluation of the effect of the rights issue on the debt/equity ratio and interest cover.
(7 marks)

(25 marks)

5 [P.T.O.
4 At a recent board meeting of Spring plc, there was a heated discussion on the need to improve financial performance.
The Production Director argued that financial performance could be improved if the company replaced its existing
absorption costing approach with an activity-based costing system. He argued that this would lead to better cost
control and increased profit margins. The Managing Director agreed that better cost control could lead to increased
profitability, but informed the meeting that he believed that performance needed to be monitored in both financial and
non-financial terms. He pointed out that sales could be lost due to poor product quality or a lack of after-sales service
just as easily as by asking too high a price for Spring plc’s products. He suggested that while the board should consider
introducing activity-based costing, it should also consider ways in which the company could monitor and assess
performance on a wide basis.

Required:
(a) Describe the key features of activity-based costing and discuss the advantages and disadvantages of adopting
an activity-based approach to cost accumulation. (14 marks)

(b) Explain the need for the measurement of organisational and managerial performance, giving examples of the
range of financial and non-financial performance measures that might be used. (11 marks)

(25 marks)

5 Umunat plc is considering investing £50,000 in a new machine with an expected life of five years. The machine will
have no scrap value at the end of five years. It is expected that 20,000 units will be sold each year at a selling price
of £3·00 per unit. Variable production costs are expected to be £1·65 per unit, while incremental fixed costs, mainly
the wages of a maintenance engineer, are expected to be £10,000 per year. Umunat plc uses a discount rate of 12%
for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

Required:
(a) Explain why risk and uncertainty should be considered in the investment appraisal process. (5 marks)

(b) Calculate and comment on the payback period of the project. (4 marks)

(c) Evaluate the sensitivity of the project’s net present value to a change in the following project variables:
(i) sales volume;
(ii) sales price;
(iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)

(d) Upon further investigation it is found that there is a significant chance that the expected sales volume of
20,000 units per year will not be achieved. The sales manager of Umunat plc suggests that sales volumes could
depend on expected economic states that could be assigned the following probabilities:
Economic state Poor Normal Good
Probability 0·3 0·6 0·1
Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (6 marks)

(25 marks)

6
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7 [P.T.O.
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End of Question Paper