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Accounting Business Reporting for Decision Making

SEMESTER REVISION Chapter TWO


2.5 Distinguish between morality and prudence. A distinction between acting in ones self interest (prudence) or acting as one ought to by taking into account the interests of other people (morality) is central to the theory of ethics. For example, a child is taught to eat vegetables, not to run across the road or to touch a hot cup of tea. These are instructions of self-interest. However, when a child is taught not to hit, share or be kind to others that is instruction on morality. So rules of morality and rules of prudence are taught together with no distinguishable differences (Beauchamp, Bowie and Arnold, 2009). In fact, most people in business are unconcerned about the motivations of the decision maker as long as the action is the right thing to do. Generally acting morally is prudent. However, the distinction is important because in business there are numerous cases where decisions have been made to act morally but it isnt prudent. Such as, the many examples of businesses that kept staff employed throughout the global financial crisis despite a downturn in their trade or hiring of disabled people despite in some circumstances their lower productivity. There are also examples where acting prudently was not moral, such as withholding information, stalling wage negotiations with unions to delay the increase in labour costs or misleading advertising. 2.10 What are the four key responsibilities of business? Do you think an entity should consider discretionary responsibilities? Why? According to Carroll, there are four key responsibilities of business which are economic, legal, ethical and discretionary. Organisations have an economic responsibility to provide goods and services at a fair price, to repay their creditors and to seek a reasonable return for their shareholders. Legally, they are required to uphold the laws of government and are ethically responsible to act the way society would expect. Discretionary responsibilities are carried out voluntarily. For instance, there may be no laws relating to the maximum volume of effluent discharge, but a company may choose to monitor and limit its discharge because society expects it to. It is an ethical responsibility. However, the firm may also choose to change equipment and processes so that there is no discharge at all and this would be classed as a discretionary responsibility. Over time, discretionary responsibilities may become ethical responsibilities or even legal responsibilities. If organisations dont address their pollution problems then the government will step in and regulate it. Whether or not you feel that firms should consider discretionary responsibilities depends on your view as to the objective of a firm. As discussed in the chapter, some believe that a firm only has a duty to its shareholders, while others believe that a firm has a wider responsibility to all stakeholders. Some reasons put forward why firms consider social and environmental issues are: economically in their best interest (has a benefit to the bottom line profit) to minimise government interference enlightened self interest genuinely want to do the right thing.

So, depending on what you believe will determine whether or not a firm has a responsibility to consider discretionary responsibilities

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2.13

Are ethics and corporate governance important topics in the study of accounting and the business environment? Why? Yes. It is necessary to study ethics because ethics is about human behaviour. Business is also about the behaviour of humans, and decisions made in business can alter the fate of individuals, groups, organisations and even countries. Corporate governance is about the ultimate decision making of enterprises. The boards of companies and the top executives make decisions that have far reaching consequences. They are entrusted with billions of dollars of capital, the labour of the world and the futures of not only the current generation but subsequent generations. It is therefore important that people entering the business world understand that responsibility and therefore that guidelines, expectations and an understanding of ethics be incorporated into business studies.

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Chapter THREE
Part A Explain the advantages and disadvantages of the sole trader form of business structure compared to the partnership form of business structure. Advantages of sole trader - Low start-up costs, minimal paperwork - Responsible for all business decision making (total autonomy). - Has access to all profits Disadvantages of sole trader - Limited capital - Limited ideas - Running business by self-compared with between partners. - No sharing of work load - No splitting of losses Define limited liability. Provide an illustration of the term in relation to public companies. Limited liability means that the owners (i.e. the shareholders) are not personally responsible for the debts of the company. Instead they are only liable for the unpaid balance of shares they agree to purchase in the company. For example, if a company issues $3 shares, with $2 payable on application and the remaining $1 payable in future instalments, then the liability of the shareholder is $1 on each share that they own. 3.3 List the characteristics that distinguish a company from a sole trader and partnership. The main difference between a company and a sole trader and partnership is the concept of limited liability and independent legal entity status. Limited liability means that the shareholders of the company are only liable to the subscription amount of the shares. Independent legal entity status means that companies are legally separate from the people who own, control and management them. This separate legal status means that the company can enter into contracts, incur debts and pay taxes independently of its owners. The owners of the company do not pay individual tax on all company profits; instead the owners pay individual taxes only on profits paid to them in the form of salaries, bonuses and dividends. The company, as a separate legal entity, is taxed on its own profits. At present the company tax rate is 30%. 3.4 What are two major advantages and disadvantages of a company structure? Two major advantages of a company structure are: (i) access to additional capital; (ii) limited liability for the shareholders in relation to the debts of the business. Two major disadvantages of a company structure are: (i) The time and money to establish the company form; (ii) The more complex regulatory requirements imposed on the company. 3.27 From the six scenarios described below, indicate (giving your reasons) the business form each one is likely to take sole trader, partnership, company or trust.

a. Sarah and Michaela wish to start an internet business, marketing cosmetics. They are concerned about the legal issues (for example, their personal liabilities) for this business once they start trading.

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Sarah and Michaela could enter into a partnership or a proprietary company. A partnership would suit them as they are probably bringing into the entity individual skills and knowledge about cosmetics and the internet. However, they have stated that they are concerned regarding their personal liabilities so therefore a proprietary company would mean the entity would be incorporated as a separate legal entity which would ultimately result in Sarah and Michaela only being held responsible to the extent of their capital contributions. b. Dean has just commenced a home maintenance business by himself, with the help of $2000 inherited from a rich aunt. He wishes to employ his wife as the bookkeeper. Dean appears to be the sole contributor of capital for his home maintenance business. Therefore, the sole trader form seems to be the appropriate form of business. Even though his wife will work as bookkeeper, Petko appears to be not only the sole contributor of capital but also the sole decision maker. c. As friends at university, John-Pierre, Janto and Nigel studied commerce. They are now setting up a small accounting business specialising in taxation returns and investment advice. John-Pierre, Janto and Nigel should consider the partnership form of business which is perfect for a group of people who band together combining skills, talent and knowledge. Many accounting entities are in fact partnerships. d. Two married brothers (Edmund and Sam), who are both trained and practising plumbers, wish to combine their businesses into one so that they can share resources and take more holidays. Edmund and Sam could enter into a partnership or even a proprietary company. The partnership would combine their skills and talent of plumbing and also would split profits and losses and decision-making etc. However, the attraction of the proprietary company is the limited liability aspect and the separate legal entity. e. Three engineers (Kwong, Mukesh and Binh) wish to set up a prospecting business searching for gold, and they want to list their business on the Australian Securities Exchange. If Kwong, Mukesh and Binh are serious about listing their entity on the ASX, then the only form appropriate is the public company. This form of entity is characterised by rigorous reporting requirements (i.e. Corporations Act, ASX Listing Rules) and also liability limited to the subscription price of the shares.

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Chapter FOUR
Business Transactions: Some transactions relating to White Ltd for the month of May are shown below. a) Issued shares for $15,000 cash b) Purchased $20,000 Inventory on account c) Incurred and paid $2,000 wages d) Sold inventory costing $3,200 for $5,000 cash e) Purchased $10,000 of Equipment, paying half in cash and agreeing to pay the remainder within 90 days f) Paid rent on sales facilities for the month $1800 g) Paid supplier for half of inventory purchased in b) h) Accrued $500 of wages i) Accrued $800 of interest on a loan payable to the Bank

Required: Draw up 5 columns in your answer booklet, one each for Assets, Liabilities, Owners Equity, Revenues and Expense. Show the effect, if any, of each transaction entry or adjustment listed by entering the amount, the account affected and whether it is a debit or credit

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Assets A Dr Cash 15,000

Liabilities

Owners Equity Cr Capital 15,000

Revenues

Expenses

Dr Inventory 20,000

Cr A/C Payable 20,000

Cr Cash 2,000

Dr Wages 2,000

Cr Inventory 3,200 Dr Cash 5,000

Sales 5,000

Dr COGS 1,800

Dr Equipment 10,000 Cr Cash 5,000

Cr A/C Payable 5,000

Cr Cash 1,800

Dr Rent 1,800

G Cr Cash 10,000

Dr A/C Payable 10,000

Cr Accrued Wages 500

Dr Wages Exp 500

Cr Accrued Interest 800

Dr Interest Exp 800

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Chapter FIVE
5.17 Identify whether the following assets would be classified as current or non-current as at the end of the reporting period. a. Raw materials to use in the production of goods b. Available for sale assets c. Property plant and equipment d. GST owing to the Tax Office e. Investments in shares f. Inventory of partly finished products that will take 2 more years to manufacture

The distinction between current and non-current assets is normally based on when the future economic benefit is expected to occur. If within 12 months (i.e. the next reporting period) the item is classified as current and if beyond 12 months the item is classified as non-current. a. b. c. d. e. f. Current asset Any assets to be sold within the next 12 months will be classified as current assets. Assets to be sold beyond the next reporting period will be classified as non-current assets. Non-current asset Current liability, as GST payable to the Tax Office must be settled within the next reporting period. Assuming the investments are held for the longer term and not for the purpose of resale within the next 12 months, a non-current asset classification is appropriate. As the inventory will take a further 2 years to manufacture, using the within or beyond 12 month rule, a non-current asset classification is appropriate. This example lends itself to using an alternative basis to classify assets as current or non current based on an entitys operating cycle. If the entity takes 3 years to manufacture the items that it sells then the 3 year period may be deemed its operating cycle and classifying assets into current and non-current would be based on whether the future economic benefits are expected to occur within the operating cycle (i.e. 3 years).

5.18 Identify whether the following liabilities would be classified as current or non-current as at the end of the reporting period. a. Bank overdraft b. Mortgage loan c. Provision for employee benefits d. Trade payables e. Term loan with 10 monthly repayments remaining f. Monies owed on a purchase with no repayments for two years

The distinction between current and non-current liabilities is usually based on when the future sacrifice of economic benefits is expected to occur. If within 12 months (i.e. the next reporting period) the item is classified as current and if beyond 12 months the item is classified as non-current. a. Current as technically it is payable on demand even if it is used as a permanent source of financing.

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b. c.

The principal payable in the next reporting period is classified as current. The principal payable beyond the next reporting period is classified as non current. The provision for employee benefits would be apportioned between current and non-current liabilities. The current portion would represent the benefit entitlements expected to be paid in the next reporting period. The non-current portion would represent the benefits expected to be paid beyond the next reporting period. Current, as monies owed to suppliers generally need to be paid within the next reporting period. The terms are generally payment within 30 days As the term loan is maturing within the next 12 months it would be classified as a current liability. As no sacrifice is required for 2 years, the purchase agreement would be a non-current liability. A friend who owns a small entity trading as Jobs Galore knows that you are studying accounting, and has asked if you would prepare the entitys classified balance sheet as at 30 June. The friend has provided you with the following list of assets and liabilities (the equity figure has not been provided) to perform this task. Cash Motor vehicles Equipment Monies owed by customers Monies owed to suppliers Loan Wages owed to employees Rent paid in advance $ 4,000 24,000 16,000 3,500 6,000 18,000 1,200 700

d. e. f. 5.25

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JOBS GALORE Balance Sheet as at 30 June $ Assets Current Cash........................................................................................................ Accounts receivable ................................................................................ Prepaid rent ............................................................................................ Total current assets................................................................................. Non-current assets Motor vehicles ......................................................................................... Equipment ............................................................................................... Total non-current assets ......................................................................... Total assets ........................................................................................... Liabilities Current Accounts payable.................................................................................... Accrued wages ....................................................................................... Total current liabilities ............................................................................. Non-current Loan ........................................................................................................ Total liabilities ....................................................................................... Net Assets ............................................................................................. Equity ..................................................................................................... 4 000 3 500 700 8 200 24 000 16 000 $

40 000 48 200

6 000 1 200

7 200 18 000 25 200 $23 000 $23 000

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Chapter SIX
6.4 Explain to a user of financial statements with no accounting background, why is depreciation an expense. Depreciation is the allocation of the cost of an asset over its useful life and represents the future economic benefits of the depreciable assets that have contributed to earning income in the period. Depreciation reduces the value of the asset in the balance sheet and consequently decreases the equity during the reporting period. Depreciation is an example of an expense that does not involve an outflow of cash. 6.26 A list of account balances for Mr Yens business (Yinyan) at the end of the 30 June 2013 reporting period is shown below. Produce the income statement for the reporting period, and the equity balance at the end of the year. Depreciation expense is the allocation of the depreciable amount of the asset in the current period and is shown in the Income Statement Accumulated depreciation represents the total (accumulated) depreciation that has been charged against the asset in the Balance Sheet

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YINYAN PTY LTD Income Statement for the 12-month period ended 30 June 2013 Service Revenue Rent Revenue Total Income Expenses Salaries Expense Supplies Expense Rent Expense Insurance Expense Depreciation Expense Total Expenses Profit 228 600 35 000 59 000 4 200 41 300 356 000 28 000 384 000

368 100 $15 900

YINYAN PTY LTD Statement of Changes in Shareholders Equity for the 12-month period ended 30 June 2013 Share capital at the beginning of period Retained earnings at the beginning of period Plus profit for reporting period Retained earnings at the end of period Shareholders Equity at the end of period 150 000 32 000 15 900 47 900 $197 900

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WEEK 2 ILLUSTRATIVE EXAMPLE The following information was obtained from the records of Shah Ltd: Inventory ............................................................... 44,000 Loan Payable(long term)....................................... 50,000 Sales ................................................................... 150,000 Selling, general and admin exp............................. 12,000 Buildings and equipment...................................... 84,000 Accounts Receivable ........................................... 20,000 Contributed capital ( 7000 shares) ....................... 35,000 Income tax expense ............................................. 14,000 Cash .................................................................... 32,000 Retained earnings, 1 January 2006 ..................... 21,500 Accrued liabilities .................................................... 3,000 Cost of goods sold ............................................... 90,000 Accumulated depreciation.................................... 36,000 Interest expense ................................................... 8,000 Accounts payable................................................. 15,000 Dividend declared and paid .................................. 6,500 Prepare an income statement and statement of changes in owners equity for the year ended 31 December 2006, and a balance sheet at 31 December, 2006. SOLUTION Shah Ltd Income Statement For the year ended 31 December, 2006 Sales Cost of goods sold Gross profit Selling general and administrative expenses Net profit from operations (EBIT/operating profit) Interest expense Earnings before tax Income tax expense Net profit $150 000 (90 000) (12 000) (8 000) (14 000) $ 60 000 $ 48 000 $ 40 000 $ 26 000

Shah Ltd Statement of Owners Equity For the year ended 31 December,2006 Contributed capital: Ordinary shares Retained earnings: Beginning balance Net profit for the year Less: Dividends declared and paid during the year Ending balance Total owners equity $ 35 000 $ 21 500 26 000 (6 500)

41 000 $ 76 000

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Shah Ltd Balance Sheet As at 31 December, 2006 Assets: Cash Accounts receivable Inventory Total current assets Buildings and equipment Less: Accumulated depreciation Total assets Liabilities: Accounts payable Accrued liabilities Loan payable (long term) Total liabilities Owners Equity: Ordinary shares Retained earnings Total Owners equity Total liabilities and owners equity $ 32 000 20 000 44 000 84 000 (36 000) $ 15 000 3 000 50 000 $ 35 000 41 000 $ 96 000 48 000 $144 000

$ 68 000

$ 76 000 $144 000

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Chapter EIGHT
Your parents are considering investing in Coca Cola shares. They ask you, an accounting expert, to comment upon the ratio information provided to them about liquidity and profitability. Required For each ratio, review the formula and what the ratio shows or assesses about a business. 1. Explain what the ratio shows (one sentence) 2. Comment on the meaning of the ratios below and what they show about the business. 2.1 Quick Asset Ratio 2001 .68 : $1 2002 .70 : $1 2003 .58 : $1

Current Assets Inventory Current Liabilities

Comments This ratio tells of the firms immediate ability to pay debts. If less than one the firm will probably be in financial difficulty. These figures indicate fluctuating liquidity but always less than one. 2.2 Return on Equity 2001 7.6% 2002 8.8% 2003 10.2%

Net profit after tax Shareholders equity

Comments This ratio shows the return after tax to the shareholders, that is the return on ownership. The return is increasing each year. 2.3 Net Profit Margin 2001 11.4% 2002 12.3% 2003 14%

Net profit after tax Net Sales

Comments This ratio shows the effectiveness of generating profit from sales for the year. That is, what percentage of sales revenue dollars results in Net Profit after Tax. It gives an indication of the how well management employs financial resources. In this case the ratio is increasing/improving. 2.4 Gross Profit Ratio 2001 46% 2002 47% 2003 43%

Gross Profit Net Sales

Comments Gross profit margin relates the gross profit of the business to the sales generated for the same period. Gross profit represents the difference between sales and the cost of sales, so it is a measure of profitability in buying and selling goods before other expenses are taken into account. These figures seem stable but would need to be compared with the industry average

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2 .5

Return on Assets 2001 12% 2002 11.5% 2003 10.6%

EBIT Total Assets

Comments Return on Assets is a fundamental measure of business performance. This ratio expresses the relationship between the net profit generated by the business and the assets owned by the business. These figures indicate decreasing profitability and if the trend were to continue it could be a major concern. 2.6 Asset Turnover 2001 22% 2002 28% 2003 29%

Sales Total Assets

Comments This ratio gives the level of sales that has been generated by the assets for the period. That is; the efficiency in generating income per dollar of investment in assets. Ideally more non-current assets should generate more sales. This shows an improving ratio of sales to assets 2.7 Inventory Turnover Average Inventory Cost of Sales 2001 4.6 times 2002 5.1times 2003 6. times

Comments Inventory turnover, measures the average period for which inventory is being held. Or, the average period of time it takes for an entity to sell its inventory. These figures indicate increasing periods which means the business may be having trouble selling their inventory or may have increasing amounts of funds tied up in inventory. 2.8 Debt to Equity Ratio Total Liabilities Total Equity (Owners) 2001 150% 2002 180% 2003 200%

Comments The debt to equity ratio indicates how many dollars of debt exist per dollar of equity financing. If this ratio exceeds 100 per cent then the entity is more reliant on debt funding than equity funding. This company is increasingly relying on debt funding which could be a problem for debt servicing

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Chapter NINE
9.35 Preparation of receipts from debtors schedule and cash budget Elvstrom Company prepares monthly cash budgets. Provided below is a set of relevant data extracted from existing reports, and the sub-budgets for the two months of September and October 2013

All sales are on credit. Collections from debtors normally have the following pattern: 60 per cent in the month of sale, 30 per cent in the month following the sale, and 10 per cent in the second month following the sale. Fortunately, Elvstrom does not have much trouble with bad debts. Sales in June, July and August were $295 000, $266 000 and $302 000 respectively. Direct material purchases are paid for in the month following the purchase. Purchases in August were $182 000. Manufacturing overhead includes $12 500 for depreciation expense, while the marketing and administration expenses include an amount off $5600 for depreciation expenses. Elvstrom expects to be able to repay the principal on a $50 000 loan in October. Required: a. Prepare a schedule of receipts from debtors for the two months ending 31 October 2013. b. c. Prepare a cash budget for September and October 2011. The cash balance at 31 August 2013 was $12 600. As part of its longer term plans, Elvstrom Company was hoping to commence a product reinvention program for one of its core products. The project would require an initial cash commitment of $30 000. Management was hoping to fund this from the cash flows of the business. Does this seem feasible?

a. Receipts from Debtors Schedule for two months ending 31 October 2013 July $266 000 August $302 000 September $314 000 October $412 000 #$266 000 x .1 %$302 000 x .3 @$412 000 x .6 September 26 600# 90 600% 188 400 $305 600 October 30 200 94 200 247 200@ $371 600

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b. Elvstrom Cash budget for 3 months ended 30 September 2013 Sep $ ANTICIPATED RECEIPTS Receipts from debtors Sale of old equipment Total receipts ANTICIPATED PAYMENTS Direct materials purchases Direct labour Manufacturing overhead IT equipment Marketing and admin Loan Total Payments Excess (Deficit) receipts over payments Bank balance at beginning of month Bank Balance at End of Month c. A program requiring an initial cash commitment of $30 000 from the cash flows of the business seems feasible. Based on current estimates and conditions, the cash balance at the end of October is expected to be $94 100 even after repaying the $50 000 loan. 305 600 305 600 182 000 51 400 9 100 16 500 33 400 292 400 13 200 12 600 $25 800 Oct $ 371 600 8 200 379 800 162 000 55 200 10 900 33 400 50 000 311 500 68 300 25 800 $94 100 Total $ 677 200 8 200 685 400 344 000 106 600 20 000 16 500 66 800 50 000 603 900 81 500 12 600 $94 100

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Chapter TEN
10.2 Using examples, distinguish between fixed and variable costs. What is a fixed cost? Fixed costs are those costs which remain the same in total (within a given range of activity and timeframe) irrespective of the level of activity. e.g. lease costs, depreciation charges. NOTE: the greater the number of units the less cost per unit. What is a variable cost? These change in total as the level of activity changes. e.g. costs of bricks to build a house or aviation fuel for Qantas NOTE: the cost is not incurred if the activity does not occur. What is the relevant range? The relevant range is the range of activity over which the cost behaviour is assumed to be valid. If the activity level goes outside the relevant range, then the expected behaviour of costs changes can no longer be assumed to be fixed. For example if the levels change an entity may be able to renegotiate their contracts. Coastal Surf provided the following cost information for a new surfboard the company is considering introducing: Expected variable unit costs: $ Direct materials ............................. 75.00 Direct labour ................................. 37.50 Selling expenses........................... 15.00 Expected annual fixed costs: $ Rent of building ...................... 40,000 Managers salary ................. 120,000 Admin expenses .................... 55,500 The surfboard is to be sold for $380 per unit. Required: (a) Compute the number of units that must be sold to breakeven. (b) Compute the number of units that must be sold if rent rises to $75,000, direct labour increases by $10.00 a unit and a target profit of $325,000 is required. (c) Calculate the sales revenue required under scenario 1 in (a) and scenario 2 as described in (b). (d) Calculate the profit that would be earned if 6,750 units of the new surfboard were sold. Assume that the costs remain the same as in the original estimates.

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SOLUTION Expected variable unit costs: Direct materials Direct labour Selling expenses Expected annual fixed costs: Rent of building Managers salary Administrative expenses 75.00 37.50 15.00

127.50

40,000 120,000 55,500

215,500

(a) Compute the number of units that must be sold to breakeven. Revenue per surfboard Variable costs per surfboard Contribution margin 380.00 127.50

252.50

Breakeven (units) = fixed costs/contribution margin =215,500/252.5 = 853 surfboards to breakeven (b) Compute the number of units that must be sold if the following occurs: rent rises to : $75,000 direct labor increases by : $10.00 $325,000 and a target profit of (i) Calculate changes: Expected variable unit costs: Direct materials Direct labour Selling expenses Expected annual fixed costs: Rent of building Managers salary Administrative expenses (ii) Calculate new Contribution Margin Revenue per surfboard Variable costs per surfboard Contribution margin (iii) Calculate Breakeven + Target Profit

a unit is required

OLD 75.00 37.50 15.00 127.50 40,000 120,000 55,500 215,500

NEW 75.00 47.50 15.00 137.50 75,000 120,000 55,500 250,500 380.00 137.50 242.50

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Breakeven (units) + Target Profit = fixed costs + target profit / contribution margin=

(250,500 + 325,000) / 242.50 = 2,373 units to be sold

(c) Calculate the sales revenue required under scenario 1 in (a) and scenario 2 as described in (b). SCENARIO 1 Revenue to achieve breakeven = fixed costs / CMR CMR = CM(SP-VC) / SP CMR = Revenue to achieve breakeven = fixed Cost / CMR = 252.5 / 380 0.6645 = 215,500 / .66 324,316.83 sales $'s = 853 x $380 324,140.00 sales $'s

ALTERNATIVELY units calculated in (a) x $'s per sale

SCENARIO 2 Revenue to achieve breakeven + target profit '= fixed costs + target profit / CMR CMR = CM(SP-VC) / SP = 242.5 / 380 CMR = 0.6382 Revenue to achieve breakeven + target profit = fixed costs + target profit / CMR

= 250,500 + 325,000 / 0.64 901,814.43 sales $'s = 2373 x $380 901,740.00 sales $'s

ALTERNATIVELY units calculated in (b) x $'s per sale

(d) Calculate the profit that would be earned if 6,750 units of the new surfboard were sold. Assume that the costs remain the same as in the original estimates. Sales less Variable Costs = Contibution Margin less Fixed Costs = Profit 6,750 @ $380 6,750 @ $127.50 6,750 @ 252.50 2,565,000 860,625 1,704,375 215,500 1,488,875

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Chapter TWELVE
Capital Investment. Question One. Gandolf Associates, public accounting consultants, is considering a project requiring considerable expansion of its current operations. This would require the purchase of equipment at a cost of $50,000. The new equipment would have a 5 year life and then have a resale value of $5000.. The new project would produce a net increase in cash inflows of $15,000 in year one, $16000 in year two, $15,500 in years three, four and five.. The company has a cost of capital of 12%, and a desired payback period of 3 years. Required: a) What is the payback period for the equipment? b) Calculate the Net Present Value of the equipment. ( Use the present value tables attached) c) Should the firm purchase the equipment? Why or Why not? Solution: a) Payback Period Amount to pay back - $50,000 in 3 years (desired) Year 1 2 3 4 5 Cash flows 15000 16000 15500 15500 20500 Cummulative 15000 31000 46500

Payback in greater than 3yrs 3 years plus $50,000-$46,500=$3,500 $3,500/$15,500 = 0.23 i.e. 3.23 years b) Net Present Value of the equipment Year 0 1 2 3 4 5 Cash flows -50000 15000 16000 15500 15500 20500 PV 12% 1 0.892 0.797 0.711 0.635 0.567 Net Present Value PV -50000 13380 12752 11020.5 9842.5 11623.5 $8,618.50
orignal purchase

$15,500 cash flow plus $5,000 resale value

c) The firm should purchase the equipment as it has a very high NPV, The desired payback was 3 years so the additional time to payback (extra 0.23 years) may affect this decision

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Exercise 3 1 HidiHo Ltd has an opportunity to invest in two projects. The required return is 20%. Project A has an initial outlay of $40 000 and Project B $60 000. The cash flows from the project are shown below. Each item will be fully depreciated over the life of the project. YR 1 2 3 4 5 Project A cash flow $ $25 000 $16 000 $11 000 $5 000 $10 000 Project B cash flow $ $40 000 $17 000 $15 000 $12 000 $7 000

Calculate the following: Payback period Net present value. Which project should be selected and why? SOLUTION Payback period Project A payback period is 1.94 years. Project B payback period is 3.2 years. Net Present Value NPV for Project A is $4 740. NPV for Project B is $2 420. Selection Project A should be selected as payback is less than 2yrs (B is 3.2yrs) and NPV is higher for A than B

IRM t/a Accounting for Business 2e by Jopling, Lucas and Norton

22

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Chapter THIRTEEN
13.9 Summarise the advantages and disadvantages of owning ordinary shares in a company compared with preference shares. Ordinary shares are the main type and common class of shares that are owned by investors. One of the advantages of ordinary share ownership is the limited liability and the voting rights that shareholders have at the Annual General Meeting of the company. Ordinary shares have no fixed maturity date and the shares continue to exist as long as the company exists. Ordinary shares rank last in the winding up of the company and also only receive dividends after preference shareholders have been paid their dividend. Preference shares have characteristics of both debt and equity. They are more likely to be classified as equity however they do attract a fixed rate of dividend (which is similar to interest with debt). They also rank ahead of ordinary shareholders for repayment if the company is wound up (which is again the same as debt finance). Additionally the preference shareholders rank ahead of ordinary shareholders in the payment of dividends. 13.35 Lakes, Oceans Rivers and Canals Ltd (LORC) builds luxury houseboats. The entity needs funds for expansion. It could take out a fixed rate or variable rate business loan over say 25 years. Another alternative is issuing new shares to investors in the form of a rights issue. Explain the issues relating to these different forms of finance. In your answer refer to current interest rates relating to fixed and variable rate loans and also what the potential costs are of offering shares via a rights issue. What other factors relating to LORC Ltd need to be taken into account in order to arrive at the best decision for the company for three sources of long term external finance? 1. Debt finance (Loans) are a common way to finance expanding a business. The advantage is the company knows the term the rate and the repayment schedule. 2. Offering ordinary shares as a method of obtaining finance is an alternative to debt finance. In a situation such as business expansion, share issues are a common form of obtaining finance. The advantage being often dividends do not have to be paid 3. Preference Shares have a lower risk than ordinary shares and are normally given a fixed rate of dividend. They also have priority over ordinary shares if the company is would up In summary, both debt and equity finance have their respective advantages and disadvantages. LORC Ltd would also need to take into account the competition in their houseboat building market, changes in technology which may have an impact on future costs of building houseboats and their current debt/equity structure. If they have relatively low levels of debt, then borrowing more debt is an option. If they have close to 70% debt relative to total assets, then borrowing more debt is an unlikely proposition for the entity.

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