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Monitoring Test MT1B

Financial
Management

F9FM-MT1B-X09-A

Answers & Marking Scheme



Accountancy Tuition Centre Ltd

ATC
INTERNATIONAL

Accountancy Tuition Centre (International Holdings) Ltd 2009 2
1 ROCKY CO LTD
(a) The following are among the major factors to be considered by Rocky in deciding on the
method of financing the proposed expansion project.
1 Liquidity during the development period
Ideally, the finance selected should minimise the drain on cash flows during the development
period.
2 Term of finance
Finance is required for at least four to seven years; hence short-term loans which may require
re-financing are not suitable. However, long-term or permanent finance may produce an
excess of funds after the development period if the project proves to be unsuccessful.
3 Risk
Debt with contractual interest and repayment patterns may prove risky for Rockys cash
management activities. Equity, which has no contractual dividend requirements, may be the
finance source with the lowest risk for Rockys management.
4 Debt capacity
There may be good grounds for issuing debt, thereby utilising some unused debt capacity and
taking advantage of the tax deductibility of debt interest.
5 Possibility of further finance required
It is possible that further finance will be required after the development period. This should
be taken into consideration when evaluating the different types of finance available.
6 Dilution
An increase in equity by issuing shares to new shareholders will, depending upon the issue
price and quantity of shares issued, reduce the control and the wealth of existing shareholders.
7 Use of funds raised
Funds should be raised only if their use appears to be productive. Points concerning the
suitability of the three types of finance include the following:
(i) From Rockys viewpoint:
Equity
Suitable from the liquidity aspects as dividend need not be paid. If the project is not
successful, permanent funds will result. However, if the project is extremely
successful, the greater equity base will provide even more debt capacity to facilitate
further expansion. It would dilute the holdings of current shareholdings.

Accountancy Tuition Centre (International Holdings) Ltd 2009 3
Loans
These would absorb some unused debt capacity. Interest payments would be
required under all circumstances but would be tax deductible. Term of the loan may
be difficult to arrange in order to provide the medium-term (up to four to seven
years) or long-term finance.
Convertible debentures
These have the advantage that interest payments are tax deductible. However, they
are usually lower than the interest rate on ordinary loans, thereby conserving cash
during the development period. If the project proves successful, the debt will be
converted into equity and can then provide the equity base for further debt-financed
expansion. If the project is not successful, conversion will not take place and the
debenture can be repaid. Conversion into equity will usually result in fewer new
shares being issued, with consequent less dilution.
(ii) From the finance providers point of view
Equity enables participation in the success of the firm but provides no security in the
event of the project proving unsuccessful.
Loans provide security and regular interest payments but will not permit
participation in any success of the firm.
Convertible debentures provide the security of a loan with the possibility of
favourable (but not unfavourable) equity participation. However, in order to obtain
this protected position the interest received is usually lower than that of a normal
loan, and the conversion terms result in fewer shares than would be obtained by an
initial investment in equity.
In the circumstances of Rocky, the use of convertible debentures is recommended as they will
utilise debt capacity and provide medium-term or long-term finance, as determined by the
outcome of the project. The debentures should be convertible into equity from about year 4
onwards at the holders option, unless previously repaid by Rocky. Rocky should arrange a
repayment option during the period of about years 4-7. The debenture could be secured on
the land and buildings to be purchased.
(b) Y
0
Y
1
Y
2
Y
3
Y
4
Y
5

1 Jan 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
19X2 19X2 19X3 19X4 19X5 19X6
$ $ $ $ $ $
Equipment (90,000) 25,000
Tax saving on
capital allowances 7,425 5,569 4,177 4,280
Operating savings 30,000 30,000 30,000 30,000
Tax on operating savings (9,900) (9,900) (9,900) (9,900)
______ ______ ______ ______ ______ ______
Net cash flow (90,000) 30,000 27,525 25,669 49,277 (5,620)
PVF @ 10% 1.000 0.909 0.826 0.751 0.683 0.621

NPV = $9,449

Accountancy Tuition Centre (International Holdings) Ltd 2009 4
Tax saved @ 33% Date saved
$ $
Initial cost 90,000
Capital allowance 31 Dec 19X2 22,500 7,425 31 Dec 19X3
______
67,500
Capital allowance 31 Dec 19X3 16,875 5,569 31 Dec 19X4
______
50,625
Capital allowance 31 Dec 19X4 12,656 4,177 31 Dec 19X5
______
37,969
Balancing allowance 31 Dec 19X5 12,969 4,280 31 Dec 19X6
______
Sale proceeds 25,000
______
2 MICRON COMPUTERS LTD
(a) Overtrading
Overtrading occurs in a business where the capital base is inappropriate to the level of
operational activity. Where a business expands rapidly, as in the case of Micron Computers
Ltd, there is a need to increase the level of working capital and fixed assets in line with the
increase in sales. This means that the business must be adequately funded by appropriate
long-term and short-term sources of finance. Failure to do this can result in difficulties in
supplying customers (as inventory levels will be insufficient to meet demand) and liquidity
problems.
Possible consequences

Liquidity problems may take various forms, e.g.:
exceeding overdraft limits;
failing to pay interest on borrowing or make capital repayments on due dates;
slow payment of trade payables, etc.
Management of the business during a period of overtrading is often reduced to reacting to
crises as they occur, e.g.:
dealing with an irate supplier demanding payment;
finding money to pay wages and salaries, etc.
This can be very time consuming and can detract managers from more profitable use of their
time.
At the extreme, overtrading can result in the business having to cease trading because it does
not have the necessary cash resources to meet obligations as they fall due.

Accountancy Tuition Centre (International Holdings) Ltd 2009 5
(b) Causes of overtrading
Overtrading is a symptom of weak financial management. It can arise in a
relatively new business, such as Micron Computers Ltd, from a failure to foresee its
growth potential and thereby failing to invest sufficient start-up capital in order to
deal with the level of demand.
Undercapitalisation can also arise because the owners do not have sufficient
resources to invest and are unable to persuade others to invest in the business.
Errors and miscalculations may result in overtrading. For example:
if forecast levels of profits and cash flows fail to materialise, there will be
increasing strain on working capital and fixed asset requirements;
failure to control costs leading to a drain on liquidity and investment in
fixed assets without sufficient finance being in place.
How management might overcome the problem
Management should ensure that the permanent capital base matches the level of
activity. This may require an increase in the equity and/or borrowings of the
business.
Where a business is unable to find new finance, the level of activity should be
reduced in line with the available capital. This may mean turning down profitable
opportunities in order to ensure the long-term future of the business.
Available capital must be used as effectively and efficiently as possible. This means
monitoring fixed asset utilisation and having tight control over working capital
requirements.
(c) Financial ratios
Explanation of significance
Average inventory holding
=
month per sold goods of Cost
inventory Average

=
12 000 , 422
) 000 , 26 000 , 22 ( 5 . 0

+

= 0.7 months
The average inventory holding period is less than
one month. This is rather low and may suggest
that the company is unable to invest sufficiently in
inventories to meet the requirements of its
customers. Too low an inventory holding period
can lead to lost sales and lost customer goodwill.
Average payables payment period
=
month per purchases Credit
payables Trade

=
88 000
426 000 12
,
,
= 2.5 months
The company is taking 2 months, on average, to
pay suppliers. This is relatively long and may
indicate inability to pay due to liquidity problems.

Accountancy Tuition Centre (International Holdings) Ltd 2009 6

Average receivables payment period
=
month per sales Credit
s receivable Trade

=
59 000
660 000
,
,
= 1.1 months
Credit customers are taking an average of 1.1
months to pay what they owe. Where a company
is overtrading, customer payment periods may be
reduced to a minimum in order to improve cash
flows.
Sales/fixed assets (or fixed asset
turnover)
=
660 000
84 000
,
,
= 7.9 times
Every $1 invested has generated $7.9 of sales in
the year. Such a high ratio suggests that the
company has under-invested in fixed assets for the
level of turnover achieved.
Acid-test (quick) ratio
=
s liabilitie Current
inventory) (less assets Current

=
59 000
105 000
,
,
~ 0.6
This ratio compares liquid assets with maturing
obligations. If it is less than one, as here, the
company has insufficient liquid funds to meet
short-term obligations. Therefore, Micron
Computers is in a weak liquidity position.

Note: Other equally acceptable ratios include current ratio, sales/total assets, sales/working
capital and total debt/total assets.
(d) EOQ
Co = $25 h = $0.50 D = 2,500
EOQ = = [(2 25 2,500)/0.5] = 500
Order 200 (Annual costs)
$
Fixed order costs (
200
500 , 2
$25) 312.50
Holding costs (
2
200
$0.50) 50.00

362.50

Order 500 (Annual costs)
$
Fixed order costs (
500
500 , 2
$25) 125.00
Holding costs (
2
500
$0.50) 125.00

250.00

Comparing these figures the annual saving is $112.50.


Accountancy Tuition Centre (International Holdings) Ltd 2009 7
Marking Scheme
Marks Marks
1 ROCKY CO LTD
(a) 2 marks per well explained factor max 8
Suitability of finance- one mark each type, from both sides 6
Recommendation, one mark per reasonable point 3

__
17


(b) Cost/salvage 1
Tax savings on capital allowances 4
Operating savings 1
Tax on savings 1
NPV calculations 1

__

8

__

25

__

2 MICRON COMPUTERS LTD
(a) Definition 2
Possible consequences 2

__

4
(b) 1 mark per reasonable cause 3
1 mark per explained solution 3

6
(c) 1 mark per useful ratio 5
1 mark per significance explained 5

10
(d) Calculation of EOQ 2
Calculation of cost of each strategy and difference 3

5

25

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