VARIENCE ANALYSIS 1

Variance Analysis

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Allen Ltd produces three products. The budgeted profits for 2018 are £360,000, and the

budgeted revenues and cost are shown in the table below.

Sales Revenue £’000

Product A 1,500

Product B 1,430

Product C 900

Total Sales Revenue 3,830

Cost

Production Costs 1,150

Rent 600

Storage Costs 180

Wages 450

Marketing 600

Electricity 300

Other Overheads 190

Total Costs 3470

Profits 360

From the information provided below

i) Prepare a table showing the original budget and the flexed budget based on Allen

Ltd Actual Costs and Revenues for 2018.

Budgeted Flexible

Sales Revenue £’000

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Product A 1,500 1,350

Product B 1,430 1,144

Product C 900 1035

Total Sales Revenue 3,830 3,529

Cost

Production Costs 1,150 1,380

Rent 600 600

Storage Costs 180 216

Wages 450 450

Marketing 600 660

Electricity 300 330

Other Overheads 190 167.2

Total Costs 3470 3803.2

Profits/Loss 360 (274.2)

ii) Calculate the variance highlighted by the table you have prepared in a) Stating

which variances are favsourable and which are Adverse

Variance Formula Calculation Favourable/Adverse

Sales Volume budgeted selling price*(actual sales Product A (1350-1500) =-150 150 A

Variance volume-budgeted sales volume) Product B (1144-1430) =-286 286 A

Product C (1035-900) =135 135 F

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Production Total Cost Variance =Actual Cost- 1380-1,150 =230 230A

Variance Budgeted Costs

Total Overhead Total Overhead Cost= Actual Electricity (330-300) 30 30A

Variance Overhead- Budgeted Overhead Other Overhead 167.2-190 22.8 F

Question 2

To what extent does information printed in a published annual report enable an investor to

assess the strengths and weaknesses of the company performance and position

The purpose of the financial statement is to provide information about the financial

position and performance of the company. The financial statements are specially designed to

give the external stakeholder such as investors, competitors, government and general public

information regarding the performance and financial position of the company for decision

making. Since the external stakeholder are not involved in company operation, the financial

statement provided must be reliable, accurate, and relevant. Otherwise, the use of the

financial statement will lead to the wrong economic decision.

In the perfect world, it is assumed that both the internal and external stakeholders

have full confidence with the published annual report. For example, the investors are

presumed to rely on the information printed in the financial statement to decide on whether to

trade the company stock. Unfortunately, the real investment world is totally different, for a

number of reasons. The reasons include, the published financial statement depends on

estimates and judgement, which might be challenging to achieve even if all the accounting

standards are followed to the letter. The accounting standards which are meant to enable

comparison between the company may not be the most accurate method to judge the financial

performance and position of the company. Lastly, the financial statements are prepared by an
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insider who may have a conflict of interest and strong incentives to inoculate error into the

financial statement intentionally.

According to the (Sharif, 2019), investors cannot solely rely on the financial

statement for investment decisions since the performance, and financial position of the

company depends on many factors such as the market condition, the legal environment and

economic condition. Moreover, according to (Outa, Eisenberg, and Ozili,2017), investors

and other external stakeholders may rely on accounting information published annual report

subject to a number of limitations. These limitations are integral to accounting information.

First, the information in the published financial report provides only the historical snapshot of

the company performance and position. The accounting standards are subject to

interpretations and evolution and change.

Therefore, the investors and other external stakeholders should only use the

information printed in a published annual report to the extent they feel that the financial

information is reliable assuming that the financial statement had been prepared based on the

financial standard. Moreover, the investors should also use other methods like technical

analysis, background check of the directors, environmental analysis such as economic,

political and country stability to assess the financial performance and position of the

company.

Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is a critical tool in capital budgeting and

business valuation analysis. The tool is used by the internal analyst looking to make capital

budgeting decisions and external analyst analyzing the effectiveness firm’s capital decisions.

The WACC is premised on the fact that firms use a variety of methods from equity, debt, and
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preference share. The WACC helps firms to balance between the cost of financing its

operations through equity, debt finance. The formula for calculating WACC is outlined

below;

The following equation determines WACC:

WACC = wdrd(1 - T) + wpsrps + wsrs

Where,

ws = the proportion of total capital represented by common equity.

rs = rate on common equity.

wps = the proportion of total capital represented by the preferred stock.

rps = Dps / Pps = rate on preferred stock.

wd = the proportion of total capital represented by debt.

rd = interest rate on new debt (before tax)

rd (1-T) = rL = after-tax interest rate on new debt, where T = firm’s marginal tax

Rate. Assume the current Tax Rate of 19%

Numerical Example

Assume Allen Ltd has the following balance sheet at the end of the 2019 financial

year. We can use WACC to determine the cost of capital.

Debt £200 million

Equity £400 million

Total Market Value: £800 million

Cost of Common Equity 10%

Cost of Preferred stock 5%

Cost of Debt 7%
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To calculate the Weighted Average Cost of Capital (WACC) for Allen Ltd we must

be cognizant that the cost of equity, debt and preference stocks is exogenous, that is they

depend on the factors beyond the firm. The figures given are subjective; each firm or

investors have their expectations which leads to understatement or overstatement of the return

and cost. Therefore, the analyst responsibility is to find the most accurate figures of these

variables as possible.

The Weighted Average Cost of Capital (WACC) is calculated by multiplying the cost

of each capital (debt and equity) by the respective weight, and then adding the product

together to determine the value.

The WACC is dividend into two components

wdrd(1 - T) the debt component

wpsrps + wsrs the equity component

The calculation for Allen Ltd WACC will be as follows

WACC = wdrd(1 - T) + wpsrps + wsrs

200 200 400

WACC= ∗7 %∗( 1−19 % )+ ∗5 %+ *10%
800 800 800

(0.014175+0.0125+0.05)*100= 7.67%

The Weighted Cost of Capital (WACC) for Allen Ltd is 7.67% which means that no

project should be accepted if the rate of return is less than this value. The rate of return of any

project should be higher than WACC in order to cover the cost of capital and give return to

the firm.

Merger and Acquisitions

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In the recement days, the corporate world has registered a number of merger and

acquisition amounting to billions of pounds. In 2020 alone the European Union has recorded

1,200 Merger deals amounting to 883.2 billion Euros with the largest deal amounting to

204.8 billion according to Goldman Report. The significant merger and acquisition occurred

cross border and within-border as firms sought to combine their positions within the national

markets.

One of the major reasons for consolidation is to increase company efficiency and

synergy. However, the acquirer and target firm have a different motive; the acquirers engage

in merger and acquisition deal only if the deal adds value that exceeds the cost of acquisition.

On the other hand, the target company only agree to enter into a merger and acquisition deal

if only it has a positive return to its shareholder.

In both cases, the deal must have a positive return to its shareholder, according to

(Kansal and Chandani, 2014) merger and acquisition should only happen two companies’

combined are more valuable than two distinct companies. Therefore, the major reason for

Merger and Acquisition is to create shareholder value over and above two separate company

value. That being said, the major question remains whether all the merger and acquisitions

deals have a positive return to their shareholders.

According to (Le, 2017), merger and acquisition should provide something that

shareholder cannot get by holding to their respective company stocks. Nevertheless, studies

of the impact of merger and acquisition on the shareholder wealth indicate that shareholder

for target companies experience cumulated abnormal returns whether the deal is successful or

unsuccessful. In a study conducted by Jarrell, Brickley, and Netter in 2014, among 550

merger and acquisition activities that happened from 2003 to 2013 in the United States,
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successful merger and brought nearly 25-30% of abnormal return to the target company but

only 5-7% was recorded for the bidder company (Jarrell, Brickley, and Netter, 2014).

The shareholder for the target company experiences a higher return in terms of a stock

price increase during the bidding period. However, due to the uncertainty of the outcome, the

shareholder for the acquirer experience a slight decline in their wealth as a result of a decline

in stock prices. According to an analysis conducted by (Rani, Yadav, and Jain, 2014) most of

acquirer company experience a significant negative return in the range of 5-9%, especially

before the announcement to the shareholder. However, in the long run, the wealth of

acquiring shareholder increase significantly due to gain from efficiency and synergy.

In the short run, the wealth of the target shareholder increases abnormally, especially

during the announcement stage. But in the long run, the change of the target shareholder

wealth depends on the success of the merger and acquisition.

The increase or decrease of the shareholder wealth depends on the success of the

merger and acquisition. When the acquisition succeeds both shareholders in target and

acquirer companies receive a positive increase in their wealth. However, if the consolidation

fails, the shareholder receives a post-merger decline of their wealth. The failure of merger

and acquisition means that the consolidated entity didn’t attain the value higher than the

acquisition cost.

According to Merger and Acquisition literature, the success rate of any merger and

acquisition is lower compared to the failure. However, the merger and acquisition deal

continue to increase even though most of them are bound to fail. According to (Gaughan,

2010) synergy is the main reason why the company engage merger accusations. According to

the analysis conducted by Dodd and Ruback in 1977 more examined 172 cases of merger and

acquisition in the united states; target companies shareholder experience a significant

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increase in their shareholding during the months of the announcement and successful biding

but the gains are eroded when the deals fail (Dodd and Ruback, 1977).

Synergy occurs when two companies combine to produce greater effect together than

the two separate companies could provide. In their work, why companies decide to

participate in merger and acquisition transactions, Duksaitė and Tamošiūnienė (2011) argue

that synergy is created under the phenomenon of 2+2=5. Two entities are more efficient when

combined compared to when two companies are operating independently could account for.

The synergy can be in the form of operating synergy or operating synergy. The

operating synergy occurs when combining entities which to attain the economics of scale and

economies of scope. On the other hand, financial synergy is attained when merger and

acquisition present investment opportunity with the internally generated funds.

Apart from synergy and efficiency, there are several other reasons why companies

engage in merger and acquisition, yet so many fails. The motives include; the improvement

of management, tax benefits, change in technology in the industry, cost reduction by reducing

the general workforce only retaining the talented workforce, and obtaining a new customer

base since each company has their own customer even though they operate in the same

industry.

Factors that Affect Aggregate Demand (AD) and Aggregate Supply

In macro-economics, the consumption and output are measured in terms of aggregate

demand and aggregate supply. The level of output is measured in terms of both the aggregate
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demand and supply within an economy. Aggregate supply can be defined as the total amount

of goods and services that the firms are willing to sell at a given price in an economy. On the

other hand, the aggregate demand is defined as the total amounts of goods and services that

consumers are willing to purchase at all possible price levels.

In most of the macroeconomics theory, the aggregate demand interacts with the

aggregate supply to determine the short performance of the economy. However, the

performance of the economy, in the long run, is only determined by aggregate supply (Dutt,

2006). In the long run, the economy is always at full employment and therefore, the

aggregates demand does not affect the economic performance.

The aggregate demand and aggregate supply model I used in the analysis of

economic performance in neoclassical or New Classical economics. The model depicts the

output and the price level at the point where the aggregate demand intersects with the

aggregate supply. The AD-AS model is used to demonstrates how the equilibrium of the

economy is affected both in the short and long run. In this section, we are going to investigate

how investment, consumption, government spending and technology affect the AD and AS

model.

How Investment Affects Aggregates Demand and Supply

In economics, investment is the purchase of goods and services that are rather

consumed today but on the future date. In other words, investment refers to an increase in

capital assets by both the firms, individual and the government. In the AD-AS model,

investment is the component of the aggregate demand curve whereby the change in the

investment shifts the aggregate demand curve by the amount of investment change time the

investment multiplier.
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In the short run, the changes in investment cause both the aggregate supply and

demand to change. The graph below shows how the investment variable affects economic

performance.

Price Level %
Interest Rate in %

8% A

6% B c D

ID

$950 $1000 I $8,000 $8,100output

When the interest rates are reduced from 8% to 6%, the level of investment

increases by $50 billion per year. The multiplier effect causes the aggregate demand to

increase from $800 billion GDP to $8,100 billion GDP. From the point, C to point B. Any

reduction in investment will shift the aggregate demand curve to the left by the same amount

equal to the multiplier time the change in investment.

How Consumption Affects both the Aggregate Demand and Supply

Consumption can be defined as the use of good and services by the households. The

neoclassical scholars view consumption as the final purpose of economic activity. Since

consumption is the final economic activity, it is a good metric for measuring the national

output in the economy. According to the father of economics, Adam Smith consumption is

the only purpose of all economic activities.

The shift of consumption has a huge impact on economic performance; for instance,

the increase in consumer confidence will increase the demand for major items such as cars

and furniture. However, a decline in the consumer confidence will lead to a decrease in

consumption and conversely decreasing the aggregate demand.

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The graph below shows how the change in consumers and firms can Affect both AD

and AS

shifts in Aggregate Demand. (a) An increase in consumer confidence or business confidence

can shift AD to the right, from AD0 to AD1.

When AD shifts to the right, the new equilibrium (E1) will have a higher quantity of output

and also a higher price level compared with the original equilibrium (E0). In this example, the

new equilibrium (E1) is also closer to potential GD

How Government Spending Affects the Aggregate Demand and Aggregate Supply

Government spending refers to the money spent by both the local and the federal

government through the acquisition of goods and services such as education, healthcare and

security. The government expenditure can be classified into three major categories; the

current expenditure and the capital expenditure and direct transfer. The current expenditure
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occurs when the government buy good and services for current use by the member of the

community. On the other hand, capital expenditure includes the spending on goods and

services that have future returns to the government and the community. Lastly, the direct

transfer occurs when the government support its citizen directly by transferring money in the

form of social security.

Government spending has a huge impact on Aggregate demand and supply. The

government influence the economy by either decreasing or increasing the aggregate demand.

The increase in government spending will cause the AD to shift to the right. On the other

hand, a decrease in government spending will shift the AD to the left, as shown in the figure

below.

Recession

and Full Employment in the AD/AS Model. Whether the economy is in a recession is

illustrated in the AD/AS model by how close the equilibrium is to the potential GDP line as

indicated by the vertical LRAS line.

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Reference

Dodd, P. and Ruback, R., 1977. Tender offers and stockholder returns. Journal of Financial

Economics, 5(3), pp.351-373.

Duksaitė, E. and Tamošiūnienė, R., 2011. Why Companies Decide to Participate in Mergers

and Acquisition Transactions. Mokslas - Lietuvos ateitis, 1(3), pp.21-25.

Dutt, A., 2006. Aggregate Demand, Aggregate Supply and Economic Growth. International

Review of Applied Economics, 20(3), pp.319-336.

Gaughan, P., 2010. Mergers, Acquisitions, and Corporate Restructurings.

Jarrell, G., Brickley, J. and Netter, J., 1988. The Market for Corporate Control: The Empirical

Evidence Since 1980. Journal of Economic Perspectives, 2(1), pp.49-68.

Kansal, S. and Chandani, A., 2014. Effective Management of Change During Merger and

Acquisition. Procedia Economics and Finance, 11, pp.208-217.

Le, T., 2017. The efficiency effects of bank mergers: An analysis of case studies in

Vietnam. Risk Governance and Control: Financial Markets and Institutions, 7(1),

pp.61-70.

Outa, E., Eisenberg, P. and Ozili, P., 2017. The impact of corporate governance code on

earnings management in listed non-financial firms. Journal of Accounting in

Emerging Economies, 7(4), pp.428-444.

Rani, N., Yadav, S. and Jain, P., 2014. Impact of Domestic and Cross-Border Acquisitions on

Acquirer Shareholders’ Wealth: Empirical Evidence from Indian

Corporate. International Journal of Business and Management, 9(3).