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+
+
=
( )
13,359 699) (8000)(3.1 12000 - NPV
10 . 0 1 10 . 0
1
10 . 0
1
8000 12000 - NPV
1
4
1
= + =
(
+
+ =
25
Assume cash flows are 350 probability = 50%
If cash flows are 350 the NPV is negative. We would not accept a negative NPV and
so the project is cancelled. If it is cancelled the NPV = 0.
The new NPV with options dynamic NPV
NPV
0
= -5000 + (0.7)[13359/(1+0.10)] + (0.3)[0] = 3501 (8 marks)
Note the dynamic NPV is greater than the traditional or static NPV
The difference is the value of the option to abandon - 3501-3254 = 247 (2
marks)
Comment difficult to say value of option is significant depends on past experience
and confidence in data. Some managers will not be sure if this helps decision. (4
marks)
(Total 19 marks)
Answer (b)
Flexibility in MNCs this gives more opportunities to consider ROA
Flexibility is very important in MNCs. Multinational companies can move production
or operations to another country for various reasons:
Avoid government regulation
Changes in exchange rates
Tax reduction
Lower labour rates
MNC can also enter new markets to diversify and reduce risk (4 marks)
Awareness of ROA
Experience is very important. Difficult to measure awareness of real options and
whether this affects performance
Difficult to identify benefits of using advanced techniques. Additional costs may be
incurred with more staff and training. Difficult to judge quality of decisions and
relevance of existing experience to a decision.
Difficult to find evidence that introducing real options analysis helped the MNC to
outperform competitors. Managers want to show that using real options analysis gives
them a competitive advantage. (4 marks)
Complexity of decisions
Some companies find it difficult to implement real options decisions can be seen as
very complex.
Research - 88.6% of Fortune 1000 companies they consulted never or rarely used
ROA
Ryan PA, Ryan GP. Capital budgeting practices of the fortune
1000: how have things changed?. Journal of Business and
Management 2002;8:35564.
( )
905 - 699) (3500)(3.1 12000 - NPV
10 . 0 1 10 . 0
1
10 . 0
1
3500 12000 - NPV
1
4
1
= + =
(
+
+ =
26
ROA cannot be described as best practice.
Managers may find it difficult to build appropriate models to analyse a problem.
Oversimplification of models is also an issue. Also difficult to get all managers to
participate in models. Many managers in MNC will find technical complexity is very
high and will also have difficulty with data unavailability for the option inputs.
(6 marks)
(Total 19 marks)
Question 7 May 2011
[a] Good answer will cover the following
Criteria for an effective transfer pricing system
Criteria aim of system of transfer pricing is to ensure a group of companies overall
profits is as high as possible
Objectives of transfer pricing system
Encourage goal congruence between divisional managers, central Board, and
company shareholders
Motivate divisional managers in both the selling and the buying divisions
Promote realistic appraisal of divisional managers performance
Promote effective decision making within decisions
Preserve as much autonomy as possible for individual divisional managers.
(basically one mark for each point although up to two marks for a particular point
well explained)
(5 marks)
Marginal cost
Approach which procedures optimum group profit.
Buying division managers are given accurate information for decision making.
But for the selling divisions managers there could be adverse motivational issues as
no profit or contribution would be earned from internal sales. This problem could be
alleviated by transferring at standard variable cost.
(3 marks)
Opportunity cost
This transfer pricing base uses market price (less any internal savings) where an
external price exists.
If no external market for the transferred product, but where there is a market for
another product using the same resources, then the contribution lost by supplying the
internal purchaser is added to the sellers variable cost to arrive at the transfer price.
27
Use of market price will motivate selling divisions managers.
Preserve autonomy of divisional managers.
Permit realistic performance appraisal but could have adverse impact on both
motivation and on the price/output decisions of purchasing division managers.
Where no external market exists, then greater influence over decisions by head office.
(3 marks)
Cost plus
No encouragement to efficiency within the selling division as inefficiencies can
be passed on to buying division.
Buying division will treat transfer price as a variable cost and so reach divisional
optimisation at a lower output level.
Therefore performance appraisal and consequently motivation will be compromised.
(3 marks)
[b] [i] For B & Bplc to maximise its profit the following pricing approach should be
adopted:
The CIC division should offer to transfer the nitrate food supplement to the SF
division at marginal cost plus opportunity cost. This would apply as follows :
400000 litres at 10.50 per litre since this is the price that could be achieved from
sales to external customers of B & Bplc.
600000 litres at 5 per litre marginal cost since no alternative opportunities for
external sales exist.
Then SF division has a sales forecast of 3 600 000 sacks of feed. This will require 900
000 litres of nitrate supplement input.
Based on the pricing by CIC division indicated above, the SF division should choose
to purchase 600 000 litres of the nitrate from the CIC division at 5 per litre since this
is less than 5.50 per litre quoted by external supplier Hawkeshead.
SF division would purchase its remaining requirement of 300 000 litres of the
supplement from Hawkeshead at 5.50 per litre since this is less than the 10.50 per
litre at which the CIC division would offer to transfer its remaining output given
that it can sell this amount to external customers of B & B.
[9 marks]
28
Question 8 May 2010
Answer (a)
ENPV without abandonment
PV Cash flow year
1
PV Cash flow year
2
Total
PV Prob EV
Scenario
1 455 331 785 0.14
11
0
455 413 868 0.35
30
4
455 496 950 0.21
20
0
Scenario
2 636 512 1,149 0.21
24
1
636 579 1,215 0.06 73
636 702 1,339 0.03 40
0
EPV
96
8
Investmen
t
85
0
ENPV
11
8
Assuming there is an option to abandon
Investment PV cf Year 1 PV cf Year 2 NPV
Scenario 1 Option
-850
455 455 59.1
Abandon
-850 455 421 26.03
No
abandon
Scenario 2 Option -850 636 455 241
Abandon
-850
636 545 331
No
abandon
Value of option to abandon = 23
Probabilty NPV
Scenario 1 0.7 59.1 41.36
Scenario 2 0.3 331 99.30
ENPV 140.66
117.52
23.14
Decision is quite marginal.
29
Answer (b)
Students should emphasise that real options do not replace traditional DCF analysis.
Need to help managers make optimal investment decision
Some embedded real options may lead to completely different investment decisions
compared to decision based on traditional DCF analysis.
Real options may identify investment worth considerably more.
Abandonment option
High salvage values are attractive. Probability of success difficult to estimate
Useful when wanting to get out of loss making business.
Growth options
Refer to flexibility to increase scale of investment. Example add postgraduate option
for undergraduates. Students can stay with university and use exemptions from
previous study. Difficult to forecast demand.
Expansion option
Similar to growth. BT has expanded into broadband. Need to identify how many
customers buy additional products.
Investment timing option
Invest now or later. Particularly important for technology companies. Waiting may
help company avoid less profitable option. Being the first into a market is not
necessarily better. The cost is that company forgoes cash flows in early year(s)
Students should finish by discussing problem of making decision too complex. More
complexity does not mean there will be a more accurate result. Also have to think
how we get managers to provide and interpret range of probabilities! Also consider
what to do when more than one real option is identified and not all can be considered
at the same time. The real options may be seen as less reliable when complexity
increases.
Question 9 May 2010
After tax cost of debt 7.00%
WACC 11.21%
Division A Division B Total
ROI Before Product X 20.00% 13.33% 15.56%
RI - Before Product X 120,000.00 40,000.00 160,000.00
After Product X
Division A
After
Before
ROI 1mark before 2 after 19.44% 20.00%
RI 1mark before 2 after 134,000 120,000.00
Division B
After
Before
ROI 1mark before 2 after 13.64% 13.33%
RI 1mark before 2 after 54,000 40,000
30
(a) Students use calculations to show Division A has fall in ROI if accept Product
X. Risk Bonus. Division B will increase ROI if accept Product X improve
Bonus. 6 marks calculation 3 marks discussion
(b) RI shows improvement for both Divisions. Better for company if either
division accepts. 6 marks calculation 4 marks discussion
Question 10 May 2009
[a] A good answer will cover as a minimum the following (including 3 marks for
evidence of reading beyond the lecture material):
The global profile of environmental issues has risen significantly during the past two
decades, precipitated in part by major incidents such as the Bhopal chemical leak
(1984) and the Exxon Valdez oil spill (1989).
These events received worldwide media attention and increased concerns over major
issues such as global warming, depletion of non-renewable resources, and loss of
natural habitats.
This has led to a general questioning of business practices and numerous calls for
change.
Businesses have become increasingly aware of the environmental implications of their
operations, products and services. Environmental risks cannot be ignored, they are
now as much a part of running a successful business as product design, marketing,
and sound financial management.
Poor environmental behaviour may have a real adverse impact on the business and its
finances. Punishment includes fines, increased liability to environmental taxes, loss in
value of land, destruction of brand values, loss of sales, consumer boycotts, inability
to secure finance, loss of insurance cover, contingent liabilities, law suits, and damage
to corporate image.
EMA is the generation and analysis of both financial and non-financial information in
order to support internal environmental management processes. It is complementary
to the conventional financial management accounting approach, with the aim to
develop appropriate mechanisms that assist in the identification and allocation of
environment-related costs The major areas for the application for EMA are:
- in the assessment of annual environmental costs/expenditures
- product pricing
- budgeting
- investment appraisal
- calculating costs
and
- savings of environmental projects, or setting quantified performance targets.
EMA is as wide-ranging in its scope, techniques and focus as normal management
accounting. There is still no precision in the terminology associated with EMA'. EMA
viewed as being an application of conventional accounting that is concerned with the
environmentally-induced impacts of companies, measured in monetary units, and
company-related impacts on environmental systems, expressed in physical units.
31
EMA can be viewed as a part of the environmental accounting framework and is
defined as 'using monetary and physical information for internal management use'.
[18 marks]
[b] Environmental Review of Conventional Management Accounting
A good answer will cover as a minimum the following (including 3 marks for
evidence of reading beyond the lecture material):
Nearly all aspects of business are affected by environmental pressures, including
accounting. From an accounting perspective, the initial pressures were felt in external
reporting, including environmental disclosures in financial reports and/or the
production of separate environ However, environmental issues cannot be dealt with
solely through external reporting. Environmental issues need to be managed before
they can be reported on, and this requires changes to management accounting
systems.
In an ideal world, organisations would reflect environmental factors in their
accounting processes via the identification of the environmental costs attached to
products, processes, and services. Nevertheless, many existing conventional
accounting systems are unable to deal adequately with environmental costs and as a
result simply attribute them to general overhead accounts.
Consequently, managers are unaware of these costs, have no information with which
to manage them and have no incentive to reduce them (United Nations Division for
Sustainable Development (UNDSD), 2003)). It must be recognised that most
management accounting techniques significantly underestimate the cost of poor
environmental behaviour. Many overestimate the cost and underestimate the benefits
of improving environmental practices.
Management accounting techniques can distort and misrepresent environmental
issues, leading to managers making decisions that are bad for businesses and bad for
the environment. The most obvious example relates to energy usage. A recent UK
government publicity campaign reports that companies are spending, on average, 30%
too much on energy through inefficient practices. With good energy management, we
could reduce the environmental impact of energy production by 30% and slash 30%
of organisations' energy expenditure.
Frost and Wilmhurst suggest that by failing to reform management accounting
practices to incorporate environmental concerns, organisations are unaware of the
impact on profit and loss accounts and the balance sheet impact of environment-
related activities. Moreover, they miss out on identifying cost reduction and other
improvement opportunities, employ incorrect product/service pricing, mix and
development decisions.
This leads to a failure to enhance customer value, while increasing the risk profile of
investments and other decisions with long-term consequences. If management
accounting as a discipline is to contribute to improving the environmental
performance of organisations, then it has to change. Environmental Management
Accounting (EMA) is an attempt to integrate best management accounting thinking
and practice with best environmental management thinking and practice.
32
[15 marks]
Total 33 marks
[a] A good answer will cover as a minimum the following (including 3 marks for
evidence of reading beyond the lecture material):
The global profile of environmental issues has risen significantly during the past two
decades, precipitated in part by major incidents such as the Bhopal chemical leak
(1984) and the Exxon Valdez oil spill (1989).
These events received worldwide media attention and increased concerns over major
issues such as global warming, depletion of non-renewable resources, and loss of
natural habitats.
This has led to a general questioning of business practices and numerous calls for
change.
Businesses have become increasingly aware of the environmental implications of their
operations, products and services. Environmental risks cannot be ignored, they are
now as much a part of running a successful business as product design, marketing,
and sound financial management.
Poor environmental behaviour may have a real adverse impact on the business and its
finances. Punishment includes fines, increased liability to environmental taxes, loss in
value of land, destruction of brand values, loss of sales, consumer boycotts, inability
to secure finance, loss of insurance cover, contingent liabilities, law suits, and damage
to corporate image.
EMA is the generation and analysis of both financial and non-financial information in
order to support internal environmental management processes. It is complementary
to the conventional financial management accounting approach, with the aim to
develop appropriate mechanisms that assist in the identification and allocation of
environment-related costs The major areas for the application for EMA are:
- in the assessment of annual environmental costs/expenditures
- product pricing
- budgeting
- investment appraisal
- calculating costs
and
- savings of environmental projects, or setting quantified performance targets.
EMA is as wide-ranging in its scope, techniques and focus as normal management
accounting. There is still no precision in the terminology associated with EMA'. EMA
viewed as being an application of conventional accounting that is concerned with the
environmentally-induced impacts of companies, measured in monetary units, and
company-related impacts on environmental systems, expressed in physical units.
EMA can be viewed as a part of the environmental accounting framework and is
defined as 'using monetary and physical information for internal management use'.
[18 marks]
33
[b] Environmental Review of Conventional Management Accounting
A good answer will cover as a minimum the following (including 3 marks for
evidence of reading beyond the lecture material):
Nearly all aspects of business are affected by environmental pressures, including
accounting. From an accounting perspective, the initial pressures were felt in external
reporting, including environmental disclosures in financial reports and/or the
production of separate environ However, environmental issues cannot be dealt with
solely through external reporting. Environmental issues need to be managed before
they can be reported on, and this requires changes to management accounting
systems.
In an ideal world, organisations would reflect environmental factors in their
accounting processes via the identification of the environmental costs attached to
products, processes, and services. Nevertheless, many existing conventional
accounting systems are unable to deal adequately with environmental costs and as a
result simply attribute them to general overhead accounts.
Consequently, managers are unaware of these costs, have no information with which
to manage them and have no incentive to reduce them (United Nations Division for
Sustainable Development (UNDSD), 2003)). It must be recognised that most
management accounting techniques significantly underestimate the cost of poor
environmental behaviour. Many overestimate the cost and underestimate the benefits
of improving environmental practices.
Management accounting techniques can distort and misrepresent environmental
issues, leading to managers making decisions that are bad for businesses and bad for
the environment. The most obvious example relates to energy usage. A recent UK
government publicity campaign reports that companies are spending, on average, 30%
too much on energy through inefficient practices. With good energy management, we
could reduce the environmental impact of energy production by 30% and slash 30%
of organisations' energy expenditure.
Frost and Wilmhurst suggest that by failing to reform management accounting
practices to incorporate environmental concerns, organisations are unaware of the
impact on profit and loss accounts and the balance sheet impact of environment-
related activities. Moreover, they miss out on identifying cost reduction and other
improvement opportunities, employ incorrect product/service pricing, mix and
development decisions.
This leads to a failure to enhance customer value, while increasing the risk profile of
investments and other decisions with long-term consequences. If management
accounting as a discipline is to contribute to improving the environmental
performance of organisations, then it has to change. Environmental Management
Accounting (EMA) is an attempt to integrate best management accounting thinking
and practice with best environmental management thinking and practice.
[15 marks]
Total 33 marks
34