KOLEJ TUNKU ABDUL RAHMAN DIPLOMA IN BUSINESS STUDIES - ACCOUNTING ABBL 3033 BUSINESS LAW

NAME YAP KAH WEE GOH SHIN YING SIK KIM LIAN TEH KEEN TEEN HENG WEI SIM SIM KIM YUH

INDEX NO.

10WBD00451 10WBD01872 10WBD07457 10WBD00863 10WBD03013 10WBD06347

TUTORIAL GROUP NO.: 13 DATE OF SUBMISSION: 29.11.2011 (Tuesday) TUTORIAL WEEK: Week 11 TUTOR: Mr. Chai Ming Perng

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Programme Tutorial Group Date

Question 1 a) Prepare a monthly cash budget for each of the six months to 30 June 2007, showing the cash balance at the end of each month. Assume that the contract is completed on time.

Taiko Landscapes Cash Budget from January to June 2007 Notes Particulars CASH INFLOWS 1 2 9 Opening debtors Sales Sales proceeds from disposal of car Deposit refunded from return of the vehicles Total cash inflows 2,400 20,000
Nil Nil Nil Nil Nil Nil Nil

Jan RM

Feb RM

Mar RM

Apr RM

May RM

Jun RM

60,000
Nil

40,000
Nil Nil

40,000 3,000
Nil

40,000
Nil Nil

200,000
Nil Nil

2,500 62,500

22,400

40,000

43,000

40,000

200,000

CASH OUTFLOWS 3 4 5 Opening creditors: Materials Miscellaneous 6,600 2,570 6,000 2,500
Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil Nil

Diggers' cost Digger's deposit Purchases of raw materials: Soil Sand Cement Bricks/ Stones Turf Shrubs Other materials

12,600
Nil Nil Nil Nil Nil

2,200 3,100
Nil Nil Nil

76,500
Nil

43,200
Nil

6 7 8 9

Waste disposal cost Salary Bonus Leasing installments Purchases of new car Total cash outflows Net cash flow Opening balance Overdraft interest charges Closing balance

2,000 8,500 9,000

Nil

2,000
Nil

2,000
Nil

2,000
Nil

16,700 2,000
Nil

2,000
Nil

9,000
Nil

9,000
Nil

9,000
Nil

9,000
Nil

990
Nil

990
Nil

990
Nil

990 18,500 30,490 12,510 30,091

Nil

990
Nil

9,000 7,500 990

Nil

50,760 (28,360) (14,200) (142) (42,702)

11,990 50,510 (42,702) (427) 7,381

17,290 22,710 7,381

Nil

105,190 (65,190) 42,601

Nil

62,690 137,310 (22,589) (226) 114,495

10 11

30,091

42,601

(22,589)

Workings Note 1 Inflow: Opening debtors received in January. Note 2 Inflow: Received contract fee by installments. January: RM 400,000 5% = RM 20,000

February: RM 400,000 15% = RM 60,000 March: April: May: June: RM 400,000 10% = RM 40,000 RM 400,000 10% = RM 40,000 RM 400,000 10% = RM 40,000 RM 400,000 50% = RM 200,000

Note 3 Outflow: Paid opening creditors in January. Note 4 Outflow: Diggers cost paid in January. RM 1,200 5 = RM 6,000

Inflow: Deposits refunded from the return of the vehicles in February. RM 500 5 = RM 2,500 Note 5 Outflow: Purchases of raw materials varies from January to June. Note 6 Outflow: Waste disposal cost paid in January. Note 7 Outflow: Salary paid from January to June. (RM 21,600 12) 5 = RM 9,000 Bonus paid in June, as contract is assumed to be completed on time. RM 1,500 5= RM 7,500

 Note 8 Outflow: Leasing installments paid from January to June. (RM 3,960 12) 3 = RM 990 Note 9 Inflow: Sales proceeds from disposal of car for RM 3,000 in April. Profit on disposal of RM 600 is excluded as it is a non-cash item. Depreciation of RM 300 each month (old car) is excluded as it is a non-cash item.

Outflow: Purchase of new car for RM 18,500 in April. Depreciation of RM 385 each month (new car) is excluded as it is a non-cash item. Note 10 Opening balance of RM 14,200 (overdraft) for Taiko Landscapes. Note 11 Overdraft interest charges of 1% per month on an overdrawn balance on the closing bank balances each month.

b) In the past, Mr. Taiko has had problems with Sandy Ltd delivering the wrong materials or delivering the materials late. Its prices are so good that he does not want to buy from anybody else. However, it has been such a problem that he is considering making all of these purchases at the beginning of January. He feels that it would also be useful to have a basic understanding of the essential elements of a contract so that he knows his position when dealing with problems with suppliers.

Discuss the costs and benefits, for Mr. Taiko, of ordering materials early. No additional calculations are required.

Benefits Mr. Taiko will reduce his delivery costs since only one delivery from Sandy Ltd. He may also reduce his purchase costs by making purchases before any potential price rises come into effect. From an increased bulk purchase discount, he will also gain since he will now receive a 10% discount on the sand, cement, and bricks or stones. The materials will also be readily available as upon request. Workers will not have to sit idle waiting for materials to arrive. There will be a greater chance of the contract being completed on time. In turn, this means that the penalty will not be payable. Workers will also have additional capacity and time to start another job earlier should the contract be completed within the six month period. This will bring extra revenue to the business.

Costs If more materials are left on driveways for longer, there is an increased risk of stock loss either due to weather or accidents. Additional costs may increases as the sand and cement may get damaged by rain/wind, and the stones/bricks may get cracked. Since there is restricted storage space on the driveways anyway, some materials may need to be stored elsewhere, for which there will be a cost for example, local warehouse. Insurance costs will probably rise if greater quantities of stock are to be held at one time. There is also money and cost of capital being tied up in stocks. Finally, if the customer needs to change his requirements, pre-ordered materials may become surplus, resulting in increased costs for Mr. Taiko unless the contract states that changes the customer will be responsible for such costs.

c) The local building firm that Taiko Landscapes has entered into the new contract with has only been in business for five years. Mr. Taiko therefore had to check on the creditworthiness of the firm.

List four (4) external sources of information that Mr. Taiko may have used to provide assurance about the creditworthiness of the local building firm.

i. ii. iii. iv.

Bank references Trade references Credit reference agencies Informal conversations with people connected

Question 2 a) Explain the main principles used to differentiate between relevant and irrelevant costs for investment appraisal, using the information in the question to illustrate your points.

Relevant costs Relevant cost is a future cash flow arising as a direct circumstance of a particular decision. The following principles should be applied when identifying costs that are relevant to a period.

Relevant costs are future costs A decision is about the future that a cost has been incurred in the past is therefore totally irrelevant to any decision that is being made now. Costs that is relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs. Such past costs are called sunk costs is a cost incurred in the past that cannot be changed by current decisions and sunk costs are irrelevant costs which are simply costs that will not affect the decision therefore ignore sunk costs in decision-making. In Cantik Ltds project, the 1.5 million spent preparing the land for construction is a sunk cost, as is the 2 million down-payment to construction firms. These costs should be excluded when calculating the net present value of the project. Relevant costs are cash flows Only those future cots that are in the form of cash should be included and that will arise only if the capital project goes ahead .This is because relevant costing works on the assumption where a decision maker wishes to maximize profit and the profit that is earned will eventually produces a net inflow of an equal amount of cash. Therefore, costs which do not reflect cash expenditures should be ignored for the purpose of decision-making. Depreciation is a non cash-flow item, which indicates that the depreciation charges of 1.5 million should be ignored in the decision for Cantik Ltd.

Relevant costs are incremental costs A relevant cost is the increase or decrease in the cost as the result of taking this decision is relevant in decision making, cost which will change as a result of decision making should be considered. Any costs or benefits arising as a result of a past decision should be ignored.

Opportunity costs An opportunity cost is the profit foregone by selecting one alternative over another. It is the net return that could be realized if a resource were put to its next best use, this is the value of a benefit foregone as a result of choosing a particular course of action. Such costs will always be a relevant cost.

Irrelevant costs On the other hand, some other costs will be irrelevant to decision-making, such as committed costs. Committed costs are costs that will occur in the future, but will be incurred anyway. The 3 million restaurant costs represent such committed costs, and therefore, this will be ignored for the decision-making process. The interest costs of 2.5 million per annum are also ignored. This is not because they do not meet the above criteria, is because they are taken into account in the discounting process. If these costs were included as relevant they would be double counted.

b) Calculate the projects net present value (NPV) at the companys required rate of return. Conclude as to whether the company should accept the offer or continue with the project, giving a reason for your conclusion.

Net Present Value Year 3 RM000

0 RM000 Net sales proceeds forgone 1) Hotels construction costs 2) Lodges construction costs 3) Cost of furnishing hotels and lodges 4) Swimming pools 5) Restaurants 6) Small parade of shops 7) Annual cash overheads hotels 7) Revenue - hotels 8) Maintenance costs -lodges 9) Rental income lodges 10) Net income restaurants and shops Net relevant costs Cost of capital: 10% Present Value Net Present Value (NPV) (4,980)

1 RM000

2 RM000

4 RM000

5 RM000

Total RM000 (4,980)

(35,000) (4,000) (20,000) (3,200) (480) (12,000) (4,000) (2,000) 13,000 (280) 15,600 4,730 (8,980) 1.000 (8,980) (74,680) 0.909 (67,884.12) 31,050 0.826 25,647.3 (2,000) 13,000 (280) 15,600 4,730 31,050 0.751 23,318.55 (2,000) 13,000 (280) 15,600 4,730 31,050 0.683 21,207.15 (2,000) 13,000 (280) 15,600 4,730 31,050 0.621 19,282.05

(35,000) (24,000) (3,200) (480) (12,000) (4,000) (8,000) 52,000 (1,120) 62,400 18,920 40,540 12,590.93 12,591

Since net present value of the project shows positive of RM 12.591 million, by choosing this project, the company will maximize the shareholders wealth. Therefore, the company should continue with the project.

Notes:

Purchase cost of uninhabited island = sunk cost, not relevant in decision making and hence not made into account of NPV calculation. Net sales proceed forgone = RM 5,000,000 - 20,000 = RM 4,980,000

Set up costs will occur within the next year: Year 1

1) Hotels construction costs = RM 37,000,000 - RM 2,000,000 = RM 35,000,000 (RM 2,000,000 has already been spent = sunk cost, not relevant in decision making and hence not made into account of NPV calculation.) 2) Lodges construction costs = RM 24,000,000 (RM 4,000,000 of down payment need to be settled immediately.) 3) Cost of furnishing - hotels and lodges = RM 3,200,000 4) Swimming pools = RM 12,000 40 = RM 480,000 (40 pools that costs RM 12,000 each.) 5) Restaurants = RM 15,000,000 - RM 3,000,000 = RM 12,000,000 (RM 3,000,000 is bound to be paid = committed cost, not relevant in decision making and hence not made into account of NPV calculation. 6) Small parade of shops = RM 4,000,000

Annual revenues and overheads relate to the four years following by set-up costs: Year 2 to 5

7) Annual cash overheads - hotels = RM 2,000,000 per annum Revenue - hotels = RM 13,000,000 per annum 8) Maintenance costs - lodges = RM 7,000 40 = RM 280,000 (40 lodges that costs RM 7,000 of maintenance cost.) Rental income - lodges = RM 390,000 40 = RM 15,600,000 (40 lodges that are expected to earn RM 390,000 per annum per lodge.) 9) Depreciation = non-monetary item, not relevant in decision making and hence not made into account of NPV calculation. 10) Net income - restaurants and shops = RM 4,730,000 11) Interest on loan = sunk cost, not relevant in decision making and hence not made into account of NPV calculation.

c) Calculate the internal rate of return (IRR) for the project, using discount rates in the tables provided.

Formula of internal rate of return (IRR) is provided as follow:

a (a -

)]

A: The discount rate with a positive NPV B: The discount rate with a negative NPV a: The amount of the positive NPV b: The amount of the negative NPV

Year 0 1 2 3 4 5

Cash Flows (RM)

Discount rates at 10% 1.000 0.909 0.826 0.751 0.683 0.621

Present Value (8,980) (67,884) 25,647 23,319 21,207 19,282 12,591

Discount rates at 20% 1.000 0.833 0.694 0.579 0.482 0.402

Present Value (8,980) (62,208) 21,549 17,978 14,966 12,482 (4,213)

(8,980) (74,680) 31,050 31,050 31,050 31,050 Net Present Value

(Workings are to the nearest RM000.)

12,5 1 (12 5 1 - -4,213 )

10 = 17.49%

20

- 10

)]

d) Discuss how the net present value method investment appraisal contributes towards the objective of maximizing the wealth of shareholders.

The primary financial management objective of private sector companies is maximization of the wealth of its shareholders. Shareholder wealth increases through receiving dividends and through share prices increasing over time. Hence, changes in share prices can be used to assess whether a financial management decision is beneficial to shareholders. In fact, maximization of shareholders wealth is usually substituted by the objective of maximizing the share price of a company.

The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has a positive NPV. If a company accepts an investment with a positive NPV, the market value of the company, theoretically at least, increases by the amount of the NPV. For instance, a company with a market value of RM 10 million investing in a project with an NPV of RM 1 million will have a market value of RM 11 million once the investment is made. Shareholders wealth is therefore increased if positive NPV projects are accepted and, again, theoretically, shareholders wealth will be maximized if a company invests in all projects with a positive NPV. NPV is therefore usually referred to as the optimum investment schedule for a company.

The NPV investment appraisal method also contributes towards the objective of maximizing the wealth of shareholders by using the cost of capital of a company as a discount rate when calculating the present values of future cash flows. A positive NPV represents an investment return that is greater than that required by a companys providers of finance, offering the possibility of increased dividends being paid to shareholders from future cash flows.