SECTION A: COMPULSORY

Question 1 (25 marks)

K.......... is a manufacturing company that wishes to evaluate an investment in new

production machinery. The business is contemplating the production of product
‘T.......’, which has a short product life-cycle due to rapidly changing technology. The
machine is expected to cost $1.1 million. Production/sales of T....... are forerecast to
be as follows:

Year 1 2 3 4
Production and sales (units/year) 40,000 52,000 75,000 35,000

The selling price of T....... (in first year price terms) will be $20 per unit, while the
variable cost of the product (in current price terms) will be $12 per unit. Selling price
inflation is expected to be 5% per year and variable cost inflation is expected to be
4% per year. Fixed costs are not expected to increase but the company has decided to
reallocate an annual share of $10,000 to this new project. The level of working capital
investment at the start of each year is expected to be 10% of the sales revenue in that
year.

K......... Co pays tax of 25% per year in the year in which the taxable profit occurs.
Liability to tax is reduced by capital allowances on machinery (tax-allowable
depreciation), which K....... can claim on a reducing balance basis at the rate of 25%
p.a. The new machine is expected to have a scrap value of $200,000 at the end of the
four-year period.

K.......... Co uses a nominal (money terms) after-tax cost of capital of 11% for
investment appraisal purposes.

Required:

(i) Calculate the net present value of the proposed investment in product T......
(17 marks)

(ii) Calculate the internal rate of return of the proposed investment in product T....
(3 marks)

(iii) Should K.......... Co accept to invest in product T......? Explain your answer and
discuss the limitations of the evaluation you have carried out. (5 marks)

SECTION B: ANSWER ANY THREE QUESTIONS

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Question 2 (25 marks)
LMP Ltd has two divisions, Division LM and Division NY. Both divisions operate as
separate investment centre and each division is managed by a divisional manager.
The financial information of both divisions for the year that has recently ended is as
follows.

Division LM Division NY
Sales (Rs million) 458 524
Profit Margin 23% 21%
Net assets (Rs million) 735 821

Return on Investment (ROI) is used by the firm to measure performance of each

division. The target annual ROI for each division is 14% and employees of each
division are provided a bonus of 12% of their annual salary if their division’s ROI
exceeds the target of 14%. Each division is considering the following separate
projects.

New Project for New Project for

Division LM Division NY
Expected Sales to be generated (Rs 125 140
million)
Expected Profit Margin 16% 17%
Investment Required (Rs million) 165 195

The cost of capital of LMP Ltd is 11%.

Required:
(a) For each division, calculate the Return on Investment for the year that has
recently ended and explain whether each division’s employees are eligible for
bonus. (5 marks)
(b) For each division, calculate the Residual Income for the year that has recently
ended. (3 marks)
(c) Calculate the Return on Investment and Residual Income of the new project
for each division. (4 marks)
(d) Following your answer in (c), discuss the possible decisions of each divisional
manager regarding the new projects and explain the limitations of using only
Return on Investment to measure divisional performance. (6 marks)
(e) Discuss whether performance measurement should be based only on financial
performance measures. (7 marks)

Question 3 (25 marks)

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The following information relates to Daffodil Ltd and Navy Ltd. Both companies
manufacture and sell electronic tablets.

Daffodil Ltd Navy Ltd

Sales in units per year 50,000 50,000
Selling Price per unit Rs600 Rs600
Variable Cost per unit Rs300 Rs100
Annual Fixed Costs Rs3,000,000 Rs8,000,000

Required
(a) Calculate the Break Even Point in units for each company. (2 marks)
(b) Calculate the net profit of each company at the current sales level. (3 marks)
(c) Calculate the operating leverage of each company. (2 marks)
(d) Using the operating leverage of each company, calculate the new net profit of
each company if both companies experience an increase in sales volume by
40%. (4 marks)
(e) Explain how operational leverage can be both beneficial and detrimental to a
company. (6 marks)
(f) Critically evaluate the assumptions of cost-volume-profit analysis. (8 marks)

Question 4 (25 marks)

The capital structure of BLP Ltd as at 31 December 2018 is provided below. BLP Ltd
is a stock-exchange listed firm.

Rs million Rs million
Equity
Ordinary Share Capital 875
Reserves 418
1,293
10% Preference Share Capital 270
1,563
Non-Current Liabilities
Bond A 500
Bond B 325

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 825
2,388

The current market price of an ordinary share of BLP Ltd is Rs3.15. The firm has
paid an amount of Rs105 million as ordinary dividends for the year ended 31
December 2018. Dividends of BLP Ltd have been growing by an average rate of 6%
per year in last three years and are expected to continue for the foreseeable future.
The nominal price of an ordinary share of BLP Ltd is Rs2.50. The risk free rate is 4%
per year. The firm pays tax on profit at the rate of 15% per year.
The nominal price of one preference share of BLP Ltd is Rs1.80. One preference share
of the firm is currently traded at Rs2. Both Bond A and Bond B have a par value of
Rs1,000 per bond and they were issued at the same time. Bond A has eight years to
maturity and has a coupon rate of 8% per year. The market price of Bond A is Rs970
per bond. Bond B has five years to maturity and has a coupon rate of 6.5% per year.
The market price of Bond B is Rs1,055 per bond.

Required

(a) Calculate the weighted average after-tax cost of capital for BLP Ltd. Use
market values where appropriate. (15 marks)

(b) Explain fully the possible effects on the share price of a firm following a
change in dividend policy by the firm. (10 marks)

Question 5 (25 marks)

Part A
The recent statement of financial position for GNP Ltd is provided below.

Rs million Rs million
Assets
Non-current assets 457
Current assets
Inventory 46
Trade receivables 39 85
Total assets 542

Equity and Liabilities

Equity
Ordinary Share Capital 200

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 Reserves 115 315

Non-Current Liabilities
Long Term Loan 150
Current liabilities
Trade payables 38
Overdraft 39 77
Total Equity and Liabilities 542

Total sales of GNP Ltd for the year that has just ended was Rs125 million and credit
sales was equivalent to 80% of this amount. The firm pays interest at the rate of
5.75% per year on bank overdraft.
GNP Ltd is experiencing difficulties to manage its trade receivables. A factor has
proposed the firm to manage its trade receivables at a fee of 2.5% of credit sales on a
non-recourse basis. If the factor manages the trade receivables of GNP Ltd, the firm
will make an administrative costs savings of Rs370,000 per year. The factor will also
ensure that trade receivables period falls to 45 days. According to the factoring
agreement, GNP Ltd would have to take an advance equivalent to 70% of the revised
book value of trade receivables from the factor at an interest rate of 7.25% per year.
The current level of bad debt of GNP Ltd is 1.9% of credit sales.

Required
(a) Discuss the working capital financing policy of GNP Ltd. (6 marks)
(b) Calculate the value of the factor’s offer and explain whether the factor’s offer
is financially acceptable to GNP Ltd. (7 marks)

Part B

KLY has forecasted demand for its product ‘LY’ to be 400,000 units for the following
year. The existing policy of the firm is to order 20,000 units at a time and the cost per
order is Rs1,600. The holding cost per unit is Rs20 per unit per year. The firm is now
considering to use the economic order quantity model (EOQ) to determine order size
of the product ‘LY’. A buffer stock of 4,000 units of product ‘LY’ will be maintained
by the firm, irrespective of whether order are made according to existing policy or
using the EOQ model.
Required
(a) Calculate the inventory costs of KLY Ltd based on its existing ordering policy.
(2
marks)

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(b) Calculate the inventory costs of KLY Ltd using the economic order quantity
and advise the firm whether the economic order quantity is beneficial to the
firm.
(4 marks)
(c) KLY Ltd is considering to adopt the ‘Just-In-Time‘ approach to manage its
inventories. Explain fully the conditions that are important for a firm to be
able to operate with a ‘Just-In-Time‘ approach. (6 marks)

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