Investment appraisal

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MODULEASSESSMENT Main Examination solutions

COLLEGE: Lincoln International Business School

SCHOOL: Accountancy, Finance and Economics

MODULE: Finance and Accounting

MODULE CODE: ACC9011M

LEVEL: Postgraduate

CO-ORDINATOR: Geeta Lakshmi

DATE: January 2019

TIME ALLOWED: 1 hour 15 minutes

==========================================================

INSTRUCTIONS TO STUDENTS:

QUESTIONS TO ANSWER: Question 1 is compulsory from Section A. Answer any TWO out of THREE

questions from Section B.

MARKING SCHEME: Question 1 (Section A) is worth 50 marks. Questions 2, 3, 4 (Section B) are worth 25 marks each. Total marks are 100.

MATERIALS PROVIDED: None

MATERIALS PERMITTED: Non programmable calculators may be used. Candidates whose first language is not English are permitted an translation dictionary into the examination. One unannotated text book.

NOTES TO STUDENTS: Show all workings. Present-Value tables and ratio-formulas tables included

Section A (Compulsory)

QUESTION 1

  1. What is the accounting equation in business and what impact does it have on the operations? (10 marks)
  2. Why is liquidity critical for the business and how might this affect decision making? (10 marks)

c) Why is Investment appraisal important to a business? Use exles to support your reasons. (10 marks)

d) What is meant by relevant costs and critically explain their role in decision making. (10 marks)

e) Discuss the benefits of the information contained in the Income statement/Profit and Loss Account. (10 marks)

TOTAL 50 MARKS

Section B (Attempt any 2 questions)

QUESTION 2

Lincoln Gardening Company sells garden pots at 15 per pot and each pot costs 10 to produce. Lincoln Gardening Company has annual fixed costs of 10,000 and a further 2,000 of additional costs of selling and distributing the goods.

Required:

a) Calculate the level of profit or loss the business will earn if it produces and sells 2,500 pots per year.

(5 marks)

b) What is the degree of operational leverage if sales go up by 20% on (a)?

(5 marks)

c) Calculate the break-even point in i) the number of items and ii) the sales figures.

(5 marks)

d) What are the weaknesses and limitations of break-even analysis?

(5 marks)

e) Calculate the number of pots that would need to be sold if the company wishes to achieve a margin of safety of 20%.

(5 marks)

TOTAL 25 MARKS

QUESTION 3

Nottingham Cars Plc is planning to manufacture a new electric car. The new car, which has a product design life of 5 years, will require installation of a conveyor belt which will cost 100,000. At the end of its life, the machine can be sold for 10,000. Demand for the new vehicles is expected to be 12,000 units in year 1 and 15,000 units in each of years 2 to 4. In the final year, it is estimated that only 8,000 units will be sold as new technology will overtake the design. The sale price will be 12,000 per unit; direct labour, direct material and variable overheads will cost 6,000 per unit and additional fixed expenses of 50,000 per annum will be incurred. Ignore depreciation and taxes. A discount rate of 12% should be applied to the project.

Required:

  1. Using the Net Present Value (NPV) method, recommend to the company whether it should undertake the investment. Show all workings.

(14 marks)

  1. What are the advantages and disadvantages of the Accounting Rate of Return method?

(6 marks)

  1. Critically explain the concept of “payback period”.

(5 marks)

TOTAL 25 MARKS

Question 4

Here is the data to the statement of financial position for Hearty Foods plc.

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 2018
2018
Non-current assets
Property plant and equipment 180,000
Current assets
Inventories 25,000
Trade receivables 55,000
Cash #038; cash equivalents 5,000
Total assets 265,000
Non-current liabilities
3% Notes payable 20,000
Current liabilities
Trade payables 45,000
Deferred tax  
 
Total liabilities 65,000
 
Equity and Reserves Share capital (1 per share) 100,000
Retained earnings 100,000
Total Equity and Liabilities 265,000

Question 4…(contd.)

Required:

  1. Calculate the leverage and liquidity ratios commenting on these particular aspects of the health of the Company. (15 marks)
  2. If dividends are declared of 50,000 and market price is 3 per share, calculate the dividend per share and price earnings ratios.

(4 marks)

  1. “While too much debt can be dangerous for a company, it also has certain advantages for the firm.” Name any three advantages of debt.

(6 marks)

TOTAL 25 MARKS

————————————————————————————————————

You have now reached the end of the examination. You should have answered the ONE question in Section A and TWO questions from Section B

Tables

PRESENT VALUES OF 1
YEAR 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% YEAR
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 1
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 2
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 3
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 4
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 5
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349 6
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791 7
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326 8
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938 9
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615 10
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346 11
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122 12
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935 13
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779 14
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649 15
CUMULATIVE PRESENT VALUES OF 1
YEAR 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% YEAR
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 1
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7832 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257 1.6053 1.5852 1.5657 1.5465 1.5277 2
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5770 2.5313 2.4868 2.4437 2.4019 2.3612 2.3217 2.2832 2.2460 2.2096 2.1743 2.1399 2.1064 3
4 3.9020 3.8077 3.7171 3.6299 3.5459 3.4651 3.3872 3.3120 3.2397 3.1698 3.1024 3.0374 2.9745 2.9138 2.8550 2.7983 2.7433 2.6901 2.6386 2.5887 4
5 4.8535 4.7134 4.5797 4.4518 4.3294 4.2124 4.1002 3.9926 3.8896 3.7907 3.6959 3.6048 3.5173 3.4332 3.3522 3.2744 3.1994 3.1272 3.0576 2.9906 5
6 5.7955 5.6014 5.4172 5.2421 5.0756 4.9174 4.7665 4.6228 4.4859 4.3552 4.2305 4.1114 3.9976 3.8888 3.7845 3.6848 3.5892 3.4976 3.4097 3.3255 6
7 6.7282 6.4720 6.2303 6.0020 5.7863 5.5825 5.3892 5.2063 5.0329 4.8684 4.7122 4.5637 4.4227 4.2884 4.1604 4.0386 3.9224 3.8115 3.7056 3.6046 7
8 7.6517 7.3255 7.0197 6.7327 6.4631 6.2099 5.9712 5.7466 5.5348 5.3349 5.1461 4.9676 4.7989 4.6390 4.4873 4.3436 4.2072 4.0775 3.9543 3.8372 8
9 8.5660 8.1623 7.7861 7.4353 7.1077 6.8018 6.5151 6.2468 5.9952 5.7590 5.5370 5.3282 5.1318 4.9465 4.7716 4.6066 4.4506 4.3030 4.1633 4.0310 9
10 9.4713 8.9826 8.5302 8.1109 7.7216 7.3602 7.0234 6.7100 6.4176 6.1445 5.8892 5.6502 5.4264 5.2162 5.0188 4.8333 4.6586 4.4941 4.3389 4.1925 10
11 10.3676 9.7869 9.2526 8.7605 8.3063 7.8870 7.4985 7.1389 6.8051 6.4950 6.2065 5.9377 5.6871 5.4528 5.2337 5.0287 4.8364 4.6560 4.4865 4.3271 11
12 11.2550 10.5754 9.9540 9.3851 8.8631 8.3840 7.9425 7.5360 7.1606 6.8136 6.4923 6.1944 5.9178 5.6604 5.4206 5.1972 4.9884 4.7932 4.6105 4.4393 12
13 12.1337 11.3484 10.6350 9.9857 9.3934 8.8528 8.3575 7.9037 7.4868 7.1033 6.7498 6.4236 6.1220 5.8425 5.5831 5.3424 5.1183 4.9095 4.7147 4.5328 13
14 13.0037 12.1063 11.2961 10.5632 9.8985 9.2951 8.7453 8.2442 7.7860 7.3666 6.9818 6.6282 6.3027 6.0022 5.7244 5.4676 5.2293 5.0080 4.8023 4.6107 14

Formulae for Ratios

– Gross profit margin = gross profit / turnover

– Net margin (operating profit) = EBIT / turnover

– ROCE = EBIT / (Debt + Equity)

– Gearing = Debt / (Debt + Equity)

– Interest cover = EBIT / Interest payable

– Fixed asset ratio = Non-current assets / current liabilities

– Current ratio = current assets / current liabilities

– Quick Ratio = (Current assets – inventory) / current liabilities

– Sales to capital employed = turnover / (Equity + Debt)

– Sales to fixed assets = turnover / non-current assets

– Inventory days = 365 x (inventory / cost of sales)

– Receivables days = 365 x (receivables / turnover)

– Payables days = 365 x (trade payables / cost of sales)

– EPS = profits after taxes / number of shares

– P/E = share price / EPS

– Dividend per share = dividends / number of shares

– Dividend yield = dividend per share / share price

– Dividend cover = EPS / dividend per share, or = Earnings / dividends

Solutions -illustrative

Q1 Two marks for every well-developed point.

  1. Accounting equation

The accounting equation states that assets are funded or equal to liabilities + capital. The reason for this is that the firm is an artificial entity and is not created with any previous wealth or funds of its own. Accordingly it borrows funds, with which its buys assets-thus the two sides of the equation need to numerically balance. These are represented in the balance sheet or SoFP. Thus debits are equal to credits and this is the basis of bookkeeping.

(10 marks)

  1. Liquidity is the concept of a business having enough cash to meet its cash commitments. It is measured by cash in hand and cash at bank and in a wider sense the excess of current assets over current liabilities. If a business does not have enough cash reserves it will be unable to pay its immediate commitments such as salaries, creditors. This will lead to bankruptcy. In the short run, cash is more important than profits.

(10 marks)

  1. Investment appraisal

Investment appraisal is also known as capital budgeting. It is to financial management where the firm has to decide what to invest in. An investment has costs incurred immediately but the timing of the benefits are asynchronous with the timing of the costs. It consists of methods which are discounted cash flow methods such as NPV, IRR and others which are non-discounted cash flow methods such as payback and ARR.

An exle of investment appraisal is purchase of a machine which needs to be paid for immediately but which will result in cost savings for years to follow.

(10 marks)

  1. Relevant Cost

While making decisions between alternative courses of action, relevant costs and irrelevant costs need to be considered. For exle, should we open another counter to sell popular products at the entrance of the store as well as in the existing area at the back of the store? The costs which count here are the additional costs incurred-an extra staff member may need to be recruited but costs of procurement remain unchanged and hence are irrelevant. In decision making, whereas many costs are visible, it is important to distinguish the ones relevant to the decision as other costs will not alter the decision to be taken. Opportunity costs are relevant costs but sunk (historical costs are not. Accounting costs like depreciation are irrelevant as are committed costs.

(10 marks)

  1. Income statement/Profit and Loss Account

Income statement is a statement of revenue over expenses. It measures flow over time usually a year. It shows net profitability and earnings per share and is different from Statement of Financial Position. Together with SoFP and cash flow statement it forms the set of final accounts. The record of flows of items may be cash or purely accounting based (such as depreciation).

(10 marks)

Q2 Lincoln Gardening Company sells garden pots at 15 which cost 10 to produce per pot. Lincoln Gardening Company has fixed costs of 10,000 and further 2,000 additional costs of selling and distribution expenses.

Required:

  1. Calculate the level of profit or loss the business will earn if it produces and sells 2500 pots per year. Contribution : 5, SP: 15, VC-10, FC: 12000

Profit=Sale units*contribution-FC=2500*5-12000=500

(2.5 marks formula/workings, 2.5 answer)

  1. What is the degree of operational leverage if sales go up by 20% on (a)?

New sales (20% increase) = 3,000 pots, new profit=3000*5-12000=3000, % change in profit=(3000-500)/500=500%, DOL= %change in EBIT / %change in sales =500%/20%=25

(2.5 marks formula/workings, 2.5 answer)

  1. Calculate the break-even point in i) the number of items and ii) the sales figures.

BEP=FC/contribution=12000/5=2400 units; 2400*15=36,000

(2.5 marks each)

  1. What are the weaknesses of break-even analysis?

It assumes that fixed cost can be separated from variable cost, no economies of scale, only one unit produced, no stock left (any 3 points)

(5 marks)

e) Calculate the number of pots to be sold if the company wishes to achieve a margin of safety of 20%.

Margin of safety-(actual sales-BEP sales)/actual sales=ASales-36000=.20*ASales (2 marks)

.80AS=36000, AS=3600000/80=45,000 (2 marks); no of posts is 45,000/15 =3000 (1 mark) pots

  contribution 6,000.00 6,000.00 6,000.00 6,000.00 6,000.00  
  sales no 12,000.00 15,000.00 15,000.00 15,000.00 8,000.00  
 /yr 0 1 2 3 4 5  
Cost (1 mark) – 100,000.00            
Scrap (1 mark)           10000  
Contribution (4 marks)   72,000,000.00 90,000,000.00 90,000,000.00 90,000,000.00 48,000,000.00  
FC (1 marks)   -50000 -50000 -50000 -50000 -50000  
Net flow (2 marks) – 100,000.00 71,950,000.00 89,950,000.00 89,950,000.00 89,950,000.00 47,960,000.00  
discount 1 0.8929 0.7972 0.7118 0.6355 0.5674  
DCF(2 marks) -100,000.00 64,244,155.00 71,708,140.00 64,026,410.00 57,163,225.00 27,212,504.00  
 
 
284,254,434  2 marks  Since +, go ahead (1 mark)          
 
               

Question 3 solution contd.

3b) ARR advantages: 3 marks:

Simple, popular as compares ARR with cost of capital, all data available readily (no need to estimate)

Disadvantages: 3 marks

Does not take into account time value of money, can have multiple definitions, accounting data can be manipulated and is subjective

c) Payback method is simple to use, easy to understand, popular with managers but doesn’t take into account the time value of money and ignores the flows after payback achieved. Good where volatile conditions expected in future. (5 points to justify 5 marks)

Q4 a) Leverage=gearing ratio=debt/equity=20,000/200,000=10% which is very small. Thus the company has low financial risk but this should be compared with the typical value in the industry.

Liquidity can be measured by current ratio or quick ratio=current ratio= current assets/current liabilities=85000/45000=1.89, quick ratio=(current assets-inventory)/current liabilities=(85000-25000)/45000=1.34. Both measures of liquidity are healthy. This might suggest that the firm is actually not making use of profitable opportunities if the industry norm is lower.

Calculation of ratios 4 marks each including interpretation +1 mark for profitability point in liquidity ratio.

b) Market price 3, nominal price is 1 so 100,000 shares, dividend per share=dividends/nominal price=50,000/100,000=0.5 (3 marks), PE ratio is market price/DPS=3/.5=6 times. Seems like a mature firm.(3 marks 2 marks calculation/1 interpretation)

(c)Three advantages of debt (2 mark for each point)

Debt is usually cheaper than equity because it carries less risk for the lender, interest on debt is tax deductible, debt imposes financial discipline on the company, debt is easy to issue.

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