Icaew Cfab Mi 2018 Sample Exam 1
Icaew Cfab Mi 2018 Sample Exam 1
SAMPLE PAPER 1
2018
This sample paper is made up of questions from the hard copy question bank for exams in
2018. As such we advise that you look at any errata sheet that has been issued for this question
bank. The weighting of topics in this paper has been designed to show the weighting that you
may experience in your assessment.
The question bank chapter (C) and question (Q) references are noted in the answers for each
question, along with the learning outcome/s (LO) covered
QUESTIONS
VanHensen plc has two production departments (Assembly and Finishing) and two service
departments (Stores and Maintenance). Its budgeted overheads for the next quarter (July to
September) are as follows:
£
Rent and rates 80,000
Plant depreciation 100,000
Light and heat 50,000
Canteen costs 85,000
Finishing costs 32,000
These overheads are to be allocated and apportioned as fairly as possible to the four
departments using the information contained in the table below.
Plant
depreciation
Light and heat
Canteen costs
© ICAEW 2017
Finishing costs
In the following quarter (October to December) VanHensen’s accountant has already completed
the initial allocation and apportionment of budgeted overheads to the four departments and now
wishes to reapportion the service department overheads to the production departments. He has
provided the following information:
Stores works 50% of the time for Assembly, 30% for Maintenance and the balance for Finishing.
Its costs should be reapportioned first. Maintenance looks after the plant in each department.
In the next quarter (January to March) the budgeted overhead in Finishing was £243,000 and
the budgeted labour hours were 20,250. The budgeted overhead absorption rate was £8 per
machine hour in Assembly based on budgeted labour hours of 15,000. In fact 15,876 hours
were actually worked.
Calculate the budgeted overhead absorption rate per labour hour in Finishing:
© ICAEW 2017
1. Adam is responsible for preparing a monthly analysis of total department costs for the
Managing Director of XYZ. Adam’s boss, the Department Manager, has asked Adam to
exclude a number of costs from the monthly analysis to ‘give a better impression’ of the
department, and has threatened to start disciplinary proceedings against Adam for poor
work if he fails to do so.
A. Familiarity
B. Self-interest
C. Intimidation
D. Self-review
2. F and G are two divisions of a company. Division F manufactures one product, Rex. Unit
production cost and the market price are as follows:
£
Variable materials 24
Labour 16
Variable fixed overhead 8
48
Prevailing market price 64
Product Rex is sold outside the company in a perfectly competitive market and also to
division G. If sold outside the company, Rex incurs variable selling costs of £8 per unit.
Assuming that the total demand for Rex is more than sufficient for division F to
manufacture to capacity, what is the price per unit (in round £s) at which the company
would prefer division F to transfer Rex to division G.
A. £64
B. £56
C. £40
D. £48
© ICAEW 2017
3. A company has recorded the following costs over the last six months.
Using the high-low method, which of the following represents the total cost equation?
A. Zero as the starting point for budgeting the coming year's overheads
B. A zero variance between budgeted and actual overhead
C. An assumed sales level of zero as the starting point for budgeting the coming year's
overheads
D. An overhead budget of zero
© ICAEW 2017
7. An extract from next year’s budget for a manufacturing company is shown below.
Month 3 Month 4
£ £
Closing inventory of raw materials 22,000 12,000
A. £36,400
B. £42,400
C. £46,400
D. £56,400
8. You are given the following budgeted cost information for Verlaine plc for January.
Sales £120,000
Unit selling price £2
Gross profit 30% margin on sales
Opening inventory 6,000 units
Sales volumes are increasing at 20% per month and company policy is to maintain 10% of
next month’s sales volume as closing inventory.
A. £84,000
B. £85,680
C. £120,000
D. £122,400
Which two of the following actions would not be appropriate to make use of the surplus?
© ICAEW 2017
10. A retailing company's current assets and current liabilities consist of inventory at cost
£2,100, receivables, cash and trade payables. Its financial ratios include the following:
The opening inventory, receivables and payables balances are the same as the closing
balances.
A. £3,100
B. £2,170
C. £1,000
D. £100
11. A retail company extracts the following information from its accounts at 30 June 20X6:
£
Average inventory 490,000
Average receivables 610,000
Average payables 340,000
Cost of sales 4,500,000
Purchases 4,660,000
Gross profit margin 32%
A. 34 days
B. 44 days
C. 47 days
D. 51 days
© ICAEW 2017
12. Total usage of one item of Archer Ltd’s inventory for the next month is estimated to
be 100,000 units. The costs incurred each time an order is placed are £180. The
carrying cost per unit of the item each month is estimated at £2. The purchase price
of each unit is £4. The economic order quantity formula is:
(2cd) / h
When using this formula to find the optimal quantity to be ordered, identify the amounts
that are included in the calculation.
13. Shown below is a diagram of a simple control cycle. What should appear in the box
marked ‘X’?
A. Feedback
B. Fixed costs
C. Activity levels
D. Budgets and standards
© ICAEW 2017
The following information relates to questions 15 and 16
Telgar plc uses a standard costing system, with its material inventory account being
maintained at standard cost. The following details have been extracted from the standard
cost card in respect of materials.
The following details relate to actual materials purchased and issued to production during
April when actual production was 870 units.
A. £286 adverse
B. £286 favourable
C. £328 adverse
D. £328 favourable
A. £152.00 favourable
B. £152.00 adverse
C. £159.60 adverse
D. £280.00 adverse
17. A company manufactures a single product and has drawn up the following flexed budget
for the year.
60% 70% 80%
£ £ £
Variable materials 120,000 140,000 160,000
Variable labour 90,000 105,000 120,000
Production overhead 54,000 58,000 62,000
Other overhead 40,000 40,000 40,000
Total cost 304,000 343,000 382,000
What would be the total cost in a budget that is flexed at the 77% level of activity?
A. £330,300
B. £370,300
C. £373,300
D. £377,300
© ICAEW 2017
18. Within decentralised organisations there may be cost centres, investment centres and
profit centres. Which of the following statements is true?
19. A manager of a trading division of a large company has complete discretion over the
purchase and use of non-current assets and inventories. Head Office keeps a central bank
account, collecting all cash from receivables and paying all suppliers. The division is
charged a management fee for these services. The performance of the manager of the
division is assessed on the basis of her controllable residual income. The company
requires a rate of return of 'R'. Using the following symbols:
Divisional profit P
Head office management charges (M)
Divisional net profit N
Which of the following is the correct formula for calculating the controllable residual income
of the division?
A. P – [(F + S) R]
B. N – [(F + S) R]
C. N – (Z R)
D. P – (Z R)
20. To reconcile the budgeted contribution to the actual contribution, which of the following
must be accounted for?
© ICAEW 2017
21. When absorbing variable overheads on the basis of machine hours, the total variable
overhead variance can be worked out by comparing actual variable overheads in a period
with the product of the absorption rate and which of the following?
22. The following is extracted from Proteus Ltd's monthly management reporting:
The purchasing manager decided to buy a superior quality material that was more
expensive than the standard material for use in October. This superior material causes
less waste. Labour was able to convert this superior material into the final product in less
than the standard time. A wage rise, agreed in July and implemented at the beginning of
October, also impacted on the results.
The decision to buy the superior quality materials caused the profit in October to change.
Select which of the following best describes that change.
A. Fall by £1,600
B. Rise by £4,800
C. Fall by £6,000
D. Rise by £2,000
23. The Finance Assistant from Castle Associates has recently returned from a management
accounting seminar at which she was introduced to some new management accounting
terms and formulae. She has now got several of the terms and formulae mixed up in her
mind.
© ICAEW 2017
24.
£
100,000
80,000
30,000
Level of activity
10,000 (units)
The above breakeven chart has been drawn for a company’s single product. Which of the
following statements about the product are correct?
© ICAEW 2017
25. Green Ltd manufactures two components, the Alpha and the Beta, using the same
machines for each. The budget for next year requires the production of 4,000 units of each
component.
Only 16,000 machine hours will be available next year. A sub-contractor has quoted the
following unit prices to supply components: Alpha £29; Beta £40.
26. A company has only 6,000 kg of an irreplaceable raw material called Grunch. Grunch can
be used to make three possible products X, Y and Z, details of which are given below:
X Y Z
Maximum demand (units) 4,000 3,000 5,000
Constant unit selling price (£/unit) £3.00 £4.00 £5.00
Constant unit variable cost (£/unit) £1.50 £2.40 £2.60
Fixed costs (£/unit) £1.80 £2.20 £2.40
Quantity of raw material Grunch to make one unit of 0.30 0.40 0.80
product (kg)
X Y Z
Units Units Units
A. 2,666 3,000 5,000
B. 4,000 3,000 5,000
C. 4,000 2,000 5,000
D. 4,000 3,000 4,500
© ICAEW 2017
27. A project analyst has just completed the following evaluation of a project which has an
initial cash outflow followed by several years of cash inflows:
She then realises that the company's annual cost of capital is 12% not 10% and revises
her calculations.
Select the option for what will happen to each of the IRR and DPP figures when the
calculations are revised.
IRR
A. No change
B. Increase
C. Decrease
DPP
D. No change
E. Increase
F. Decrease
28. A project has an initial cash outflow followed by a series of positive future cash inflows
where the internal rate of return is unique and the net present value is positive at the
opportunity cost of capital.
A. The internal rate of return is always greater than the opportunity cost of capital.
B. The internal rate of return is sometimes lower than the opportunity cost of capital.
C. The internal rate of return is always lower than the opportunity cost of capital.
D. The internal rate of return is sometimes greater than the opportunity cost of capital.
© ICAEW 2017
29. A company has identified three independent projects, X, Y and Z. It has estimated the
cash flows and positive internal rates of return (IRRs) as follows:
If the three projects are of equivalent risk and the company aims to maximise shareholder
wealth, at which of the following costs of capital would all three projects be deemed to be
acceptable by the company?
A. 12%
B. 8%
C. 6%
D. 4%
30. A company is to spend £60,000 on a machine that will have an economic life of 10 years
and no residual value. Depreciation is to be charged using the straight-line method.
Estimated operating cash flows are:
Year £
1 – 2,000
2 + 13,000
3 + 20,000
4–6 + 25,000 each year
7–10 + 30,000 each year
What is the average accounting rate of return (ARR), calculated as average annual profits
divided by the average investment?
A. 75%
B. 55%
C. 38%
D. 28%
© ICAEW 2017
31. A project has an initial investment cost of £200,000. It is expected to generate a net cash
inflow of £20,000 at the end of its first year. This will rise to £25,000 at the end of the
second year and remain at £25,000 per annum in perpetuity. The relevant cost of capital is
expected to be 8% in the first year and 10% in the second and subsequent years.
What is the net present value of the project (to the nearest £100)?
A. £29,000
B. £45,800
C. £50,000
D. £68,500
32. A project can be expected to generate 10 annual cash inflows of £30,000 starting
immediately. The project requires an initial cash outlay of £150,000 and a final cash
outlay at the end of 10 years of £50,000.
If the annual cost of capital is 10%, what is the net present value of the project (to the
nearest £100)?
A. £15,100
B. £23,500
C. £31,600
D. £33,500
© ICAEW 2017
Management Information
SAMPLE PAPER 1
2018
ANSWERS
VanHensen
C12 Q5
Reapportion the service department overheads (Stores and Maintenance) to the production
departments (Assembly and Finishing):
© ICAEW 2017
Calculate the budgeted overhead absorption rate per labour hour in Finishing:
1. C Intimidation
2. B Because the demand for Rex is more than sufficient for division F to manufacture to
capacity, the price that the product should be transferred to division G should represent
the same profit margin as if the product were sold externally. The external selling price is
£64 but if an external sale is made then additional selling overhead of £8 would be
incurred. The net transfer price is therefore £56.
The £64 price doesn’t reflect the saving in selling costs. £40 and £48 give lower profit
margins for the producing division F, hence they would want to sell outside.
C5 Q29, LO 1f
£
Highest production 3,000 units 74,000
Lowest production 1,500 units 69,500
1,500 4,500
The statement 'All budgets are prepared in financial terms' is incorrect as often a budget
could include, for example, tonnage of raw material needed or quantity (in units) of finished
product.
© ICAEW 2017
The statement 'The master budget consists of a budgeted income statement and a
budgeted balance sheet' is incorrect as a master budget would also contain a cash flow
budget.
The statement 'A flexible budget adjusts both fixed and variable costs for the level of
activity' is incorrect as a flexible budget adjusts just variable costs for the level of activity
and not fixed costs.
C6 Q44, LO 2c
5. A Zero-based budgeting, by its very definition, starts from zero and is built upwards.
The statement 'a zero variance between budgeted and actual overhead' is incorrect as this
merely refers to the comparison of actual performance with budgeted performance.
The statement 'an assumed sales level of zero as the starting point for budgeting the
coming year's overheads' is a meaningless statement as an overhead budget would be
based on budgeted sales not zero sales.
The high-low method uses the highest and lowest costs in the budget period for the
extrapolation process itself.
The high-low method estimates a single cost at a certain level of activity and not a range of
costs. C6 Q46, LO 2a
7. A Month 4 materials cost included within cost of sales is £116,000 40% = £46,400.
Inventory of materials are budgeted to reduce from £22,000 to £12,000 and therefore
budgeted materials purchased in the month would be (£46,400 + £12,000 – £22,000) =
£36,400.
£46,400 (see above) represents the materials cost of sales rather than purchases.
£46,400 - £12,000 + £22,000 = £56,400 incorrectly deducts closing inventory and adds the
opening. 40% (£116,000 + £12,000 - £22,000) = £42,400 incorrectly applies the 40%
adjustment to the materials inventory figures.
C6 Q47, LO 2b
8. B As sales are increasing at 20% per month the expected sales for February are
£120,000 120% = £144,000. As the gross margin is 30% on sales the cost of sales for
February is expected to be £144,000 70% = £100,800.
The company policy is to maintain closing inventory at 10% of the expected next month’s
sales. The closing inventory for January is therefore £10,080. The cost of a unit is
£2 70% = £1.40, meaning the closing inventory for January is £10,080/£1.40 = 7,200
units.
© ICAEW 2017
The budgeted cost of production for January would therefore need to cover January sales
(£120,000/£2 per unit = 60,000 units) plus an increase in inventory from 6,000 to 7,200
units, ie a total of 61,200 units. This is a cost of 61,200 £1.40 = £85,680.
If you incorrectly calculated the cost of production as £84,000 then you calculated the
production volume as 60,000 units (the number sold in January) and did not allow for an
increase in inventory levels.
If you incorrectly calculated the cost of production as £120,000 then you again calculated
the production volume as 60,000 units in error and made a further error in valuing this
volume at the selling price of £2 per unit rather than the cost price.
If you incorrectly calculated the cost of production as £122,400 then you correctly
calculated the production volume as 61,200 units but in error valued this volume at the
selling price of £2 per unit rather than the cost price.
C6 Q48, LO 2b
Buying back the company’s shares would be a suitable use of a long-term surplus (but not
short-term), by returning surplus cash to the shareholders.
Increasing payables would increase the surplus still further because additional credit would
be taken from suppliers.
C7 Q20, LO 2g
10. A The inventory value is £2,100. The rate of inventory turnover is 10 times p.a.,
therefore the annual cost of sales is £21,000 (we are told opening inventory equals closing
inventory). The gross profit margin is 30% which means annual sales are £21,000/0.7 =
£30,000.
The receivables collection period is 1 month, which means closing receivables are
£30,000/12 = £2,500.
The payables payment period is 1.6 months, which means closing payables are
£21,000/12 1.6 = £2,800.
The quick ratio is 2:1 which means current assets (excluding inventory) are £2,800 2 =
£5,600. As receivables are £2,500 the cash balance must be (£5,600 – £2,500) = £3,100.
If you calculated incorrectly the cash balance as £1,000 then you probably incorrectly
calculated closing payables as £21,000/12 = £1,750 which would mean current assets
(excluding inventory) of £3,500 and cash of (£3,500 – £2,500) = £1,000.
If you calculated incorrectly the cash balance as £100 then you probably incorrectly
calculated closing receivables as £2,100/12/0.7 = £250 and closing payables as £2,100/12
= £175 and therefore current assets (excluding inventory) of £350.
C7 Q31, LO 2d
© ICAEW 2017
11. C The company’s cash operating cycle is calculated as:
Note: The cost of sales value is used for the inventory days and also to calculate sales
(using the gross margin of 32%). However, the purchases figure is used to calculate the
payables days.
The answer is therefore (39.7 + 33.6 – 26.6) days = 46.7 days (rounded to 47).
If you incorrectly calculated the answer as 34 days then you probably rounded up the
inventory days to 40 days, added the payables days in error (also rounded up at 27 days)
and then deducted the receivables days (rounded down to 33 days).
If you incorrectly calculated the answer as 44 days then you probably used the purchases
figure of £4,660,000 in the calculations for inventory days and receivables days rather than
the cost of sales figure.
If you incorrectly calculated the answer as 51 days you probably calculated the inventory
days and payables days correctly but used the wrong gross margin to calculate the sales
figure in the receivables days formula (using 22% margin rather than 32%).
C7 Q33, LO 2e
12. A, C, F
Cost per order (£180) – Included
Carrying cost per unit per month (£2) – Included
Purchase price per unit (£4) – Not included
In the formula, c = the cost of placing one order; d = the estimated usage of an inventory
item over a particular period; and h = the cost of holding one unit of inventory for that
period. The purchase price per unit is not a constituent part of the formula.
C7 Q49, LO 2f
The term 'feedback' describes the whole process of reporting control information to
management and might also refer to the control information itself.
Information about fixed costs and activity levels might be included with the control
information but they are not a separate element of the control cycle itself.
C8 Q1, LO 3c
Reports should be communicated to the manager who has responsibility and authority to
act on the information. There is no point in distributing reports to managers who cannot act
on the information contained therein.
© ICAEW 2017
In this situation managers could suffer from information overload where they are supplied
with so much information that their attention is not drawn clearly to that which is
specifically relevant to them. Important information could be overlooked or simply ignored.
C8 Q2, LO 3d
£
8,200 kg did cost 6,888
But should have cost (x £0.80) 6,560
328(A)
If you calculated the variance to be £286 you based your calculations on the materials
issued to production. However, the material inventory account is maintained at standard
cost, therefore the material price variance is calculated when the materials are
purchased. If you selected £328 favourable you calculated the size of the variance
correctly but you misinterpreted it as favourable.
C9 Q4, LO 3e
16. B £152 adverse
If you selected £152 favourable you calculated the size of the variance correctly but you
misinterpreted it as favourable.
If you selected £159.60 adverse you evaluated the usage variance in kg at the actual price
per kg, instead of the standard price per kg.
The result of £280 adverse bases the calculation of standard usage on the budgeted
production of 850 units. This is not comparing like with like. The comparison should be
based on a flexed budget for the actual production level.
C9 Q5, LO 3e
17. B £370,300
Production overhead £
At 60% activity 54,000
At 80% activity 62,000
Change 20% 8,000
© ICAEW 2017
Variable cost per 1% change in activity is (£8,000 / 20) = £400
£'000
Variable material 77 x £2,000 154.0
Variable labour 77 x £1,500 115.5
Production overhead
Variable 77 x £400 30.8
Fixed 30.0
Other overhead 40.0
370.3
If you selected £330,300 you did not include a fixed cost allowance for the other overhead.
The option of £373,300 ignores the fact that production overhead is a semi-variable cost
and the option of £377,300 simply multiplies the total cost for 70% activity by a factor of
1.1. This makes no allowance for the fact that there is an element of fixed costs within
production overhead, and other overhead is wholly fixed.
C8 Q20, LO 3e
18. B Cost centres have the lowest degree of autonomy with managers only able to control
costs. Profit centres have a higher degree of autonomy as managers can not only control
costs but can also control sales prices and revenue. Investment centres have the highest
degree of autonomy as managers can not only control costs and revenues but can also
make investment decisions not open to managers in either of the other two centres.
C8 Q21, LO 3a
19. A Controllable residual income is defined as controllable profit less the 'cost of capital'
used in the business, to the extent that capital is controllable.
Controllable profit is not N (as management cannot control the head office management
charges) but is P.
The cost of capital will be R multiplied by the controllable capital. As head office collects
cash from receivables and pays suppliers then D and L do not form part of controllable
capital. The division has complete control over non-current assets (F) and inventory (S)
and therefore controllable capital is (F + S). The 'cost of capital' is therefore (F + S) R.
If you selected the formula N – [(F + S) R] then you correctly excluded the non-
controllable receivables and payables balances but you included the non-controllable head
office management charges.
© ICAEW 2017
If you selected the formula P – (Z R) then you incorrectly included the non-controllable
receivables and payables balances.
If you selected the formula N – (Z R) then as well as incorrectly including the non-
controllable receivables and payables balances you included the non-controllable head
office management charges.
C8 Q22, LO 3b
Budgeted contribution is different from actual contribution because of all of the sales and
marginal cost variances which have arisen.
C9 Q13, LO 3e
21. D Absorption costing always uses the budgeted (or standard) production time, as flexed
by the actual output in a period. This means that the actual output is multiplied by the
standard machine hours per unit in order to establish a flexed budget of machine hours
for the actual production. The value of overheads absorbed would therefore be the
absorption rate multiplied by this flexed budget.
If you selected (planned output) (standard machine hours per unit) then the result would
be the budgeted level of absorbed overhead rather than the actual absorbed overhead.
If you selected (actual output) (actual machine hours per unit) then the result would
include any production efficiencies or inefficiencies in the actual machine hours and this
would result in an incorrect calculation of absorbed overhead.
If you selected (planned output) (actual machine hours per unit) then you have reversed
the selections you should have made.
C9 Q28, LO 3e
22. D The first important consideration is to ignore the effect of the wage rise, because this
did not arise because of the decision to procure the superior quality material. The adverse
labour rate variance should therefore be discounted.
The favourable material usage variance arose because the superior material generated
less waste. However, the superior material was more expensive leading to the adverse
material price variance, and also could be converted by the workforce more efficiently,
leading to the favourable labour efficiency variance.
The answer is therefore 8,000F + 4,800F – 10,800A = 2,000F. A favourable cost variance
means that profits will rise.
If you selected a rise of £4,800 then you incorrectly ignored the labour efficiency and
material price variances.
If you selected a fall of £1,600 then you incorrectly also included the adverse labour rate
variance of £3,600.
If you selected a fall of £6,000 then you included the material price and usage variances
but incorrectly ignored the favourable labour efficiency variance.
C9 Q30, LO 3f
© ICAEW 2017
23. C Total fixed costs
Contribution required to break even is the same value as total fixed costs.
Unit selling price less unit variable cost is the unit contribution.
Total fixed costs/Contribution ratio provides the sales revenue at breakeven point.
C10 Q1, LO 4a
Statement (1) is correct. The line which passes through the origin indicates the sales
revenue at various levels of activity. At an activity level of 10,000 units, the sales revenue
is £100,000 therefore the selling price is £10 per unit.
Statement (2) is incorrect. The sloping line which intercepts the vertical axis at £30,000
shows the total cost at various levels of activity. The total cost for 10,000 units is £80,000,
from which we subtract the £30,000 fixed costs to derive the variable cost of 10,000 units,
which is £50,000. Therefore the variable cost per unit is £5.
Statement (3) is correct. The fixed cost is the cost incurred at zero activity and is shown as
a horizontal line at £30,000.
Statement (4) is incorrect. The profit for 10,000 units is the difference between the sales
value (£100,000) and the total cost (£80,000) which amounts to £20,000.
C10 Q13, LO 4b
25. D Alpha: Produce 4,000 units
The units subcontracted should be those which add least to the costs of Green Ltd. The
cheapest policy is to subcontract work which adds the least extra cost per machine hour
saved.
Alpha Beta
£ £
Variable cost of internal manufacture 20 36
Variable cost of buying 29 40
Extra variable cost of buying 9 4
It is cheaper to buy Betas than to buy Alphas. Therefore the priority for making the
components in-house will be to allocate the available hours to the manufacture of Alphas.
© ICAEW 2017
Production Hours Hours
Component Units per unit allocated
Alpha 4,000 3 12,000
Beta 2,000 2 4,000
16,000
The remaining 2,000 units of Beta should be purchased from the sub-contractor.
C10 Q23, LO 4b
26. D This question relates to limiting factor analysis. The key to these questions is ranking
the contribution per unit of the limiting factor, in this case Grunch. In this question the
contribution per unit of Grunch will be calculated pre-fixed costs, as these will be constant
whatever production schedule is chosen.
The production schedule that will maximise profit will therefore be:
This is a total of 2,400kg and therefore 3,600kg of the 6,000kg will be available to
manufacture Product Z. This will produce 3,600/0.8 units = 4,500 units.
27. A, E A project’s IRR is the return at which the net present value (NPV) of the cash flows is
zero. The IRR is therefore independent of a company’s cost of capital. The revision to the
cost of capital by the project analyst will therefore not impact on the IRR, hence there is no
change.
A project’s DPP is the period of time taken for the project’s cumulative discounted cash
flows to turn from the initial negative outflow to a cumulative positive position. The revision
to the cost of capital from 10% to 12% will reduce each future discounted cash inflow, and
therefore increase the time taken for the cumulative discounted cash flows to become
positive.
C11 Q26, LO 4c
28. A As the net present value of the project’s cash flows is positive at the opportunity cost
of capital, this means that the project is viable and its IRR must be higher than the cost of
capital.
© ICAEW 2017
If the internal rate of return of a project were sometimes lower than the opportunity cost of
capital then the net present value in those instances would be negative.
If the internal rate of return were always lower than the opportunity cost of capital then the
net present value would always be negative.
If the internal rate of return of a project were sometimes higher than the opportunity cost of
capital then this would imply that sometimes it would be lower.
C11 Q28, LO 4d
29. B The best way to attempt this question is to draw graphs of the net present value of
each project at various discount rates. The IRR of each project tells us at what point the x-
axis is crossed and the number of changes in sign of the cash flows (from positive to
negative or vice versa) tells us how many changes in direction each graph will have. The
starting sign (positive or negative) for the graph can be easily established at a discount
factor of 0% by adding the cash flows up.
The graphs of net present values for Projects X, Y and Z must look like this:
£ Project X
10% %
£ Project Y
7% %
£ Project Z
5% 50% %
© ICAEW 2017
The answer is 8% because at a discount factor of 8% the NPV of project X is positive
(accepted), project Y is also positive (accepted) and project Z is also positive (accepted).
At a discount factor of 12% the NPV of project X is negative (rejected), project Y is positive
(accepted) as is project Z.
30. B The ARR in this question is defined as average annual profits divided by the average
investment.
The investment in Year 1 is £60,000 and the investment in Year 10 is £nil. The average
investment is therefore (£60,000)/2 = £30,000
£22,600 £60,000 = 38%, i.e. incorrect using the initial investment and average cast flow
C11 Q30, LO 4c
© ICAEW 2017
31. C The cash flows for the project are:
T0 -£200,000
T1 +£20,000
The T1 inflow is discounted for one year at 8%, giving a NPV of £20,000/(1.08) = £18,519
Thereafter we have a perpetuity at a discount rate of 10% starting after one year. The
perpetuity factor is 1/0.1 = 10, and therefore the NPV is £25,000 10/1.08 = £231,481.
B Incorrectly discounting the perpetuity back from T1 at 10% (rather than 8%) gives
C11 Q31, LO 4c
32. D As the ten annual inflows start immediately then in Year 0 the net outflow is actually -
£150,000 + £30,000 = –£120,000.
The NPV of the nine remaining annual cash inflows (years 1 to 9) of £30,000 each can be
found from the discount tables by taking the annuity factor for years 1 to 9 at 10%. This is
5.759. Therefore the NPV of these cash inflows is £30,000 5.759 = £172,770.
The NPV of the outlay at the end of ten years is –£50,000 0.386 = –£19,300.
If you incorrectly calculated the NPV as £15,100 (to the nearest £100) then you treated the
ten annual inflows as being received in Years 1 to 10 rather than Years 0 to 9. This meant
you calculated the NPV as –£150,000 + £30,000 6.145 – £19,300 = £15,050.
If you incorrectly calculated the NPV as £31,600 (to the nearest £100) then you probably
completed every calculation correctly except the discounting of the final £50,000. You
probably used a discount factor of 0.424 rather than 0.386 meaning the NPV became
£31,570 (£31,600 to the nearest £100).
C11 Q32, LO 4c
© ICAEW 2017