Paper F9 Haroon Tabraze

Macroeconomic policy involves:

Objectives: aim of economic policy

Targets: quantified levels of

Policy instruments: Tools used to achieve objectives

Mission All embracing Mission statement is description of prevailing culture of

organization. It is a strategic tool, purpose for the
continued existence of the organization.
Goals General Goals are intentions behind decisions or actions. They
are derived from mission

Objectives Specific Objectives are goals expressed in form which can be

measured. They provide direction and measure
achievement
Strategy Detailed targets Strategies are course of action using specified resources
to achieve objectives

Tactics Implementation Tactics are actions carried out to put into effect detailed
Targets strategy, and they change according to situations.

Operational Action targets They relate to individuals, short term and subject to
plans immediate control.

Macroeconomic policy targets

1. Economic growth: increase in national income (disregarding inflation)

2. Price Inflation: exports may become expensive, need to devalue currency
3. Employment: Unemployment is low, period of unemployment is short
4. Balance of Payment: imports exceeding exports may damage growth

Monetary Policy: rate of interest, money supply (for inflation, balance of payment,
employment)

Fiscal Policy: Government spending, taxation

Prices and Income Policy: Inflation can be tackled by controlling prices

Exchange Rate Policy: strength and weakness of country's currency

External Trade Policy: Stimulating exports, import controls, protection of domestic
industry

To increase jobs – increase growth – increase in demand – increase in imports – deficit in

balance of payment – weaken currency – raise interest rate - raise cost of imports – price
rise

Fiscal Policy: can be used to manage 'demand'

Government spending is 'injection' in the economy

Taxes are withdrawal from economy

Increase government spending without raising tax – increase demand

Decrease taxation and keep spending constant – increase demand

Raising taxation (or decrease spending) – decrease demand

Increase in aggregate demand (AD) – increase in sales for business

Taxes – pass on to consumer – increase prices – decrease demand

Monetary and Interest Rate Policy:

Increase in 'Money Supply' – increase in prices

Increase credit lending – Lower interest rates – increase demand

High interest rates – low borrowings – low demand – low sales

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Increase in interest rate – lower business profits – lower returns to shareholders –

decrease share price

Increase interest rate – low consumer borrowing – low demand (sales)

High interest rate – high saving – low money supply – low disposable income

High interest rate – high cost of production – high cost of exports

Exchange rate policy

Low exchange rate – lower cost of exports – high exports

Low exchange rate – high cost of imports – low imports

Demand in economy – goods produced locally (which could be exported) and
imports

Full employment in country – output capacity stagnant – need for import

Growth in money supply – interest rates – domestic inflation

Trade deficit – fall in exchange rate

Trade surplus – raise exchange rate (nominally)

Exchange rate fluctuation – instability - exporters and importers face risk

Fixed exchange rate – inflation may grow – export prices will become uncompetitive
– trade deficit will grow

Fixed exchange rate – increase interest rate – capital come into country – put
pressure on exchange rate

Floating exchange rate – to stabilize government buy / sell foreign currency

Eliminating exchange rate risk

1. Buy currency in 'forward contracts'
2. deal in a stable foreign currency (dollar)
3. invoicing in domestic currency
4. outsource activities to local markets

Company's business may generate social costs i.e. pollution, environment etc.

Regulation is interference of Government with the operations of free market, which may be
through:

Control of prices, or profits

Control of emissions, pollution, banning smoking, and compulsory car insurance

Influencing consumer choices (consumer societies)

In many markets, participants may exercise self regulation (voluntarily), possibly to avert
state regulation. Examples are professions of Law, Accounting and Audit

Competition Policy
Imperfect competition: where once company's large share dominates market, resulting in
inefficient production, and excessive profits

Monopoly: one firm, sole producer of good, operates without any close substitute

In certain industries only monopoly will give company economies of scale (operating
on a very large scale, and reducing costs) that minimize price

Companies can impose higher prices, with excessive profits

Company does not have incentive to improve its operations, nor utilize its resources
for maximum benefit because of no competition

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Cash Operating Cycle

Raw Materials / WIP

R/M and Finished Goods remain in
the inventory
Finished Goods
Customers take time to pay

Accounts Receivable
Suppliers are paid

(Accounts Payable)

Average time raw materials remain in inventory = 1.0 month

Less: (Time taken to pay suppliers) =(2.5 months)
Add: Time taken to produce goods = 2.0 months
Add: Time taken by customers to pay = 1.5 months
2.0 months

A company is overcapitalized if it has excess working capital

A company is overtrading; it is expanding quickly and has little capital

Balance Sheet
Current Assets: Current Liabilities:
- Inventories 120 - Loan & Overdraft 50
- Accounts Receivable 400 - Taxation 65
- Short term investment 5 - Dividend Payable 20
- Cash and Bank 50 - Accounts Payable 370
575 505

Profit & Loss

Sales 2,000
Cost of Sales 1,475
Gross Profit 525

Notes:
1. Accounts Receivable include trade receivables of 330
2. Accounts Payable include trade payables of 235
3. There are no cash sales or purchases

Current Ratio = Current Assets 575 = 1.14

Current Liabilities 505
A ratio of more than 1 is expected.

Quick Ratio = Current Assets – Inventory 455 = 0.90

Current Liabilities 505
Inventory cannot be quickly turned into cash (is not liquid asset)

A/R payment Period = Trade Receivable x 365 330 x 365 = 60

Credit Sale Turnover 2,000

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Question A1
a) Calculate Accounts Receivable Days if trade receivables are 63.29 million and total
sales are 1,100 million, of which 60% are on credit.

b) A factoring company has offered to bring the credit days to 25. What will be the
level of Accounts Receivable?

Question A2

Current sales are 600 million per annum (all payable in the month of sale). Variable cost of
sales is 400 million per month.

a) Will it be financially beneficial to increase the number of A/R days to 45 if sales show
a corresponding increase of 25%? Cost of capital is 12% per annum.

b) What will happen if a prompt payment discount of 5% is offered for payments within
10 days, on the estimation that 40% customers will avail the benefit?

Question A3

Current sales are 750 million, of which 80% are on credit with a debtor's period of 30 days.
A factor has offered to take over accounts receivable management at an annual fee of 0.5%
of credit sales. The factor has claimed to reduce debtors by 30%; with a saving in
administration costs of 12,500. The factor will advance 75% of the debtors balance at an
interest rate of 8%. Current overdraft rate is 6%.

Baumol Model Miller Orr Model:

Q= 2CS Spread = 3 (3/4 x transaction cost x cashflow variance)1/3

i Interest rate

Return point = lower limit + (1/3 x spread)

Question A4 (December 2005)

Thorne Co values, advertises and sells residential property on behalf of its customers. The
company has been in business for only a short time and is preparing a cash budget for the
first four months of 2006. Expected sales of residential properties are as follows.
2005 2006 2006 2006 2006
Month December January February March April
Units sold 10 10 15 25 30

The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the
value of each property sold. Thorne Co receives 1% in the month of sale and the remaining
2% in the month after sale. The company has nine employees who are paid on a monthly
basis. The average salary per employee is £35,000 per year. If more than 20 properties are
sold in a given month, each employee is paid in that month a bonus of £140 for each
additional property sold.

Variable expenses are incurred at the rate of 0.5% of the value of each property sold and
these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are
paid in the month in which they arise. Thorne Co pays interest every three months on a
loan of £200,000 at a rate of 6% per year. The last interest payment in each year
is paid in December.

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An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne
Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000.
The cash balance at the start of January 2006 is expected to be a deficit of £40,000.

Required:
(a)Prepare a monthly cash budget for the period from January to April 2006. Your budget
must clearly indicate each item of income and expenditure, and the opening and closing
monthly cash balances. (10 marks)
(b)Discuss the factors to be considered by Thorne Co when planning ways to invest any
cash surplus forecast by its cash budgets. (5 marks)

(c)Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to

fund any cash shortages forecast by its cash budgets. (5 marks)

(d)Explain how the Baumol model can be employed to reduce the costs of cash
management and discuss whether the Baumol cash management model may be of
assistance to Thorne Co for this purpose. (5 marks)

Question A5 (June 2005)

TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling
price of £19 per unit and is purchased for £11 per unit from a supplier, MKR Co. TNG places
an order for 50,000 units of product X at regular intervals throughout the year. Because the
demand for product X is to some degree uncertain, TNG maintains a safety (buffer) stock of
product X which is sufficient to meet demand for 28 working days. The cost of placing an
order is £25 and the storage cost for Product X is 10 pence per unit per year.

TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for
cash settlement within 20 days.

TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365
days.

Required:
(a)Calculate the annual cost of the current ordering policy. Ignore financing costs in this
part of the question. (4 marks)

(b)Calculate the annual saving if the economic order quantity model is used to determine
an optimal ordering policy. Ignore financing costs in this part of the question. (5 marks)

(c)Determine whether the discount offered by the supplier is financially acceptable to TNG
Co. (4 marks)

(d)Critically discuss the limitations of the economic order quantity model as a way of
managing stock. (4 marks)

(e)Discuss the advantages and disadvantages of using just-in-time stock management

methods. (8 marks)

Question A6 (Pilot paper)

Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit,
although customers on average take ten days more than this to pay. Contribution
represents 60% of sales and the company currently has no bad debts. Accounts receivable
are financed by an overdraft at an annual interest rate of 7%.

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Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days
and to extend the maximum credit offered to 60 days. The company expects that these
changes will increase annual credit sales by 5%, while also leading to additional incremental
costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of
customers, with the remaining customers taking an average of 60 days to pay.

Required:

(a) Evaluate whether the proposed changes in credit policy will increase the profitability of
Ulnad Co. (6 marks)

(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of
$7,500. The average cost to the company of making deposits or selling investments is $18
per transaction and the standard deviation of its cash flows was $1,000 per day during the
last year. The average interest rate on investments is 5.11%.

Determine the spread, the upper limit and the return point for the cash account of Renpec
Co using the Miller- Orr model and explain the relevance of these values for the cash
management of the company. (6 marks)

(c) Identify and explain the key areas of accounts receivable management. (6 marks)

(d) Discuss the key factors to be considered when formulating a working capital funding
policy. (7 marks)

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Question B1
A project has the following cash flows:

Year 1 2 3 4 5
Sales 60,000 75,000 90,000 120,000 150,000

Variable cost of sales are 40% of the selling price, and fixed costs are 15,000 per year.

If the initial investment was 180,000 and Cost of capital is 9%, calculate for the project:
1. Payback period
2. ROCE
3. NPV

Question B2
A project has the following cash flows:

Year 1 2 3 4 5
Sales 60,000 60,000 60,000 90,000 120,000

Variable cost of sales are 50% of the selling price, and fixed costs are 15,000 per year. A
new machine with a cost of 90,000 (with a disposal proceed of 30,000 at end of year 5)
may reduce the variable cost of sales by 10% (to 40% of sales).

If the initial investment was 180,000 and Cost of capital is 9%, calculate for the machine:
1. Payback period
2. ROCE
3. NPV

Question B3
A new machine generates the following cash flows:

Year 1 2 3 4 5
Sales 60,000 75,000 90,000 120,000 150,000

Direct Materials are 15%, Direct Labor is 10%, and Variable overheads are 20% of the
selling price. Fixed costs are 15,000 per year.

General Inflation is expected to be 7%. Cost of materials is likely to increase by 9%, while
Labor costs will increase by 5%. Sales are in current price terms.

If the cost of machine was 120,000, with a life of 5 years, and Cost of capital is 9%,
calculate for the project:

1. Payback period
2. ROCE
3. NPV

IRR = a + NPVa (b-a) %

NPVa - NPVb

(1 + i) = (1+r) (1+h) where r= real rate of interest, and h= rate of inflation

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Question B4
A new machine is expected to produce:

Year 1 2 3 4 5
Sales (units) 600 750 900 1,200 1,500

Current Cost break-up per unit (today; before taking inflation) is:
Direct material = 25
Direct labor = 20
Variable overhead = 20

Fixed costs are 15,000 per year. Selling price per unit is 100 per unit.

General Inflation is expected to be 5%. Cost of materials is likely to increase by 9%, while
Labor costs will increase by 10%.

If the cost of machine was 80,000, with a life of 5 years, and Cost of capital is 9%,
calculate NPV for the project (ignore taxation):

Question B5
A new machine is expected to have the following savings:

Year 1 2 3 4 5
Savings 6,000 7,500 9,000 12,000 15,000

Cost of machine is 30,000 and it attracts 25% capital allowances every year, and will be
disposed off at the end of year 5 at price of 15,000. Tax rate is 30%, payable in next year.

Cost of capital is 9%, calculate NPV for the project (ignore inflation).

Question B6
A new machine is expected to produce:

Year 1 2 3 4 5
Sales (units) 600 750 900 1,200 1,500

Current Cost break-up per unit (today; before taking inflation) is:
Direct material = 20
Direct labor = 15
Variable overhead = 20

Fixed costs are 25,000 per year (including depreciation). Selling price per unit is 100 per
unit.

General Inflation is expected to be 10%. Cost of materials is likely to increase by 15%,

while Labor costs will increase by 5%.

Cost of machine was 80,000, with a life of 5 years, on which capital allowances can be
claimed at a rate of 25% (no residual value at end of year 5). Cost of capital is 12%. Rate
of tax is 30%.

1. Calculate NPV for the project.

2. The machine can be purchased with bank financing (available at rate of 15%).

3. The machine can be leased at an annual payment of 22,000 for five years.

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Question B7
You need a new car. You can either purchase one outright for $15,000 or lease one for
7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The
discount rate is 10 percent. Should you buy or lease? What is the maximum lease you
would be willing to pay? (Ignore taxation and inflation)

Question B8
Machines F and G are mutually exclusive and have the following investment and operating
costs. Note that machine F lasts for only 2 years:

Year 0 1 2 3
F 10,000 1,100 1,200 -
G 12,000 1,100 1,200 1,300

Calculate the equivalent annual cost of each investment using a discount rate of 10 %.
Which machine is the better buy?

Question B8
The finance director of GTK plc is preparing its capital budget for the forthcoming period
and is examining a number of capital investment proposals that have been received from
its subsidiaries. Details of these proposals are as follows:

Proposal 1
Division A has requested that it be allowed to invest £500,000 in solar panels, which would
be fitted to the roof of its production facility, in order to reduce its dependency on oil as an
energy source. The solar panels would save energy costs of £700 per day but only on sunny
days. The Division has estimated the following probabilities of sunny days in each year.
Number of sunny days Probability
Scenario 1 100 0—3
Scenario 2 125 0—6
Scenario 3 150 0—1

Each scenario is expected to persist indefinitely, i.e. if there are 100 sunny days in the first
year, there will be 100 sunny days in every subsequent year. Maintenance costs for the
solar panels are expected to be £2,000 per month for labour and replacement parts,
irrespective of the number of sunny days per year. The solar panels are expected to be
used indefinitely.

Proposal 2
Division B has asked for permission to buy a computer-controlled machine with a
production capacity of 60,000 units per year. The machine would cost £221,000 and have a
useful life of four years, after which it would be sold for £50,000 and replaced with a more
up-to-date model. Demand in the first year for the machine’s output would be 30,000 units
and this demand is expected to grow by 30% per year in each subsequent year of
production. Standard cost and selling price information for these units, in current price
terms, is as follows:

£/unit Annual inflation

Selling price 12 4%
Variable production cost 4 5%
Fixed production overhead cost 6 3%
Fixed production overhead cost is based on expected first-year demand.

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Equivalent annual cost = PV of cost over one replacement cycle

Annuity factor

Question B7
You need a new car. You can either purchase one outright for $15,000 or lease one for
7 years for $3,000 a year. If you buy the car, it will be worth $500 to you in 7 years. The
discount rate is 10 percent. Should you buy or lease? What is the maximum lease you
would be willing to pay? (Ignore taxation and inflation)

Question B8
Machines F and G are mutually exclusive and have the following investment and operating
costs. Note that machine F lasts for only 2 years:

Year 0 1 2 3
F 10,000 1,100 1,200 -
G 12,000 1,100 1,200 1,300

Calculate the equivalent annual cost of each investment using a discount rate of 10 %.
Which machine is the better buy?

Now suppose you have an existing machine. You can keep it going for 1 more year only,
but it will cost 2,500 in repairs and 1,800 in operating costs. Is it worth replacing now with
either F or G?

Question B9
Initial investment = 25,000
Year 1 2 3 4
Running cost 7,500 11,000 12,500 15,000
Resale value 15,000 10,000 7,500 2,500

Cost of capital is 10%. How frequently the machine should be replaced.

Question B10
You are operating an old machine that will last 2 more years before it gives up the ghost. It
costs $12,000 per year to operate. You can replace it now with a new machine, which costs
$25,000 but is much more efficient ($8,000 per year in operating costs) and will last for 5
years. Should you replace it now or wait a year? The opportunity cost of capital is 6
percent.

Profitability index = Net Present Value

Investment

Question B11
Opportunity cost of capital is 10 percent, and the Company has total resources of 20,000. It
is presented with the following project proposals

Year 0 1 2
Project L 3,000 2,200 2,420
Project M 5,000 2,200 4,840
Project N 7,000 6,600 4,840
Project O 6,000 3,300 6,050
Project P 4,000 1,100 4,840

Which projects to choose for investment?

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Sources of Finance:
Overdraft (Short / Long) Term loan
• Interest payable only when overdrawn • Interest payable for the loan term
• Bank can increase / decrease facility • Loan amount is fixed and is disbursed at
limit start of the term
• Repayable on demand • Repayable on maturity period of term

Question C1
What is the annual repayment of a 7 year loan of $30,000 at interest of 9%?

Reasons for seeking Debt:

Company does not want to issue equity because:
1. Current shareholders may be unwilling to contribute additional equity
2. New equity investors may put in extra requirements (seat on BOD)
3. Cost of raising equity is higher than issuing debt
4. Interest payable is a tax deductible item

Long term debt issued is called Loan notes, debentures or bonds

Interest on debt is called coupon rate

Question C2
What is the present value of a 10% bond issued at $100 (par value) and redeemable after
7 years at par value. Cost of capital is 8%.

Question C3
A 10% bond is issued at $90 (par value of $100) and is redeemable after 7 years at par
value. What is the present value if:
1. Cost of capital is 8%?
2. Cost of capital is 12%?

Question C4
What is the present value of a 2% bond issued at $60 (par value of $100) and redeemable
after 7 years at par value. Cost of capital is 8%.

Question C5
What is the present value of a zero coupon bond issued at $40 (par value of $100) and
redeemable after 7 years at par value. Cost of capital is 8%.

Question C6
Flick plc is to issue 10% convertible loan notes at par value of $100. The earliest date of
conversion is after four years, at a rate of 2 shares for each $100 loan note. Cost of capital
is 12%. What should be the minimum market value of shares after four years for
conversion to be acceptable?

Question C7
Flick plc is to issue 6% convertible loan notes at $75 (par value $100). The earliest date of
conversion is after four years, at a rate of 5 shares for each $100 loan note. Cost of capital
is 12%.
1. What should be the minimum market value of shares after four years for conversion
to be acceptable?
2. Alternately, loan notes could be redeemed at par value. What is the current market
value of loan notes, assuming estimated market value of shares of Flick plc at end of
four years will be $15 per share?
3. What will be the present market value of loan notes if the estimate market value of
shares of Flick plc at end of four years will be $25 per share?

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