MANAGERIAL FINANCE

PROFESSIONAL 1 EXAMINATION - AUGUST 2009

NOTES:
Section A – Answer Question 1 and Question 2 and either Part A or Part B of Question 3.
Section B – Answer Question 4 and either Part A or Part B of Question 5.
(If you provide answers to both Parts A and B in Question 3 and/or Question 5, you must draw a clearly
distinguishable line through the answer Part(s) not to be marked. Otherwise, only the first answer(s) to hand for
each of these questions will be marked.)

MANAGERIAL FINANCE TABLES ARE PROVIDED

TIME ALLOWED:
3 hours, plus 10 minutes to read the paper.

INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence
writing in your answer book. Please read each Question carefully.

Marks for each question are shown. The pass mark required is 50% in total over the whole paper.

Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills
and care must be taken regarding the format and literacy of the solutions. The marking system will take
into account the content of the candidates' answers and the extent to which answers are supported with
relevant legislation, case law or examples where appropriate.

List on the cover of each answer booklet, in the space provided, the number of each question(s)
attempted.

The Institute of Certified Public Accountants in Ireland,17 Harcourt Street, Dublin 2.

 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

MANAGERIAL FINANCE
PROFESSIONAL 1 EXAMINATION – AUGUST 2009

Time allowed 3 hours, plus 10 minutes to read the paper.

SECTION A
(Answer Questions 1 and 2 and either Part A or Part B of Question 3.)

1. D Limited, a Galway based manufacturer of wooden garden furniture is considering purchasing a licence to
manufacture and sell a plastic decking product. The decking has been created by a Slovakian company, its
unique selling proposition being that the customer will not have to treat the decking for ten years (compared to
annual treatment for conventional wood decking). An initial licence will be granted for a period of three years.

Summarised details of the proposal are as follows:

Proposed Licence
• D Limited will purchase the licence at a one off cost of €500,000 payable immediately.
• a royalty payment of €10 is payable per metre of decking manufactured.
• the maximum royalty payable in any one year will be €500,000.
• royalty payments are paid in the year of production.
• production will be on Just-In-Time (JIT) basis.

Investment
D Limited will have to acquire additional plant costing of €1,000,000. This will be leased over three years at an
annual lease cost of €400,000.

Taxation
• lease premiums are fully tax deductible in the year of payment.
• corporation tax is paid/repaid one year in arrears.
• corporation tax is currently paid at 12.5%. This rate is expected to continue for the foreseeable future.
• the licence cost will attract 20% reducing balance annual writing down allowance.
• balancing charges/allowances are calculated in the year of expiry of the licence.

Staffing
The substantial increase in volume of production as a result of the new proposed product will require an increase
in staff numbers. Projected staff number increases are:
Annual Cost
Details Present Proposed Per Staff Member €
Supervisory Staff 1 2 35,000
Production Operatives 14 20 27,000
Maintenance Staff 2 3 32,000
Procurement Staff 1 2 30,000
Accounting Staff 2 4 28,000
Quality Control 0 1 45,000

A wage freeze has been agreed with the trade union for the next two years. All wages are expected to increase
by 5% in three years from now.

Materials and Overheads

The polymer required for the decking product will be purchased from Denmark. The polymer presently costs €20
per Kg. Each metre of decking requires an input of two Kg of polymer. As the polymer is an oil based product it
is anticipated that the price will reduce by 10% in year 2 (as the price of crude oil falls) of the project and stay at
that price for the foreseeable future. The polymer will be shipped to Galway at a cost of €10,000 per 1,000 Kgs
shipped. This price will remain fixed for the duration of the proposed licence.

Page 1
 The decking will cost €5 per metre in variable overheads. There are no expected increased costs in factory rental
or management salaries.

Sales
The company’s pricing policy will be to set a prestige price in accordance with the quality image of the product.
Wood decking presently sells at €40 per metre to DIY stores and €30 per metre to construction companies. The
new plastic decking will be sold for three times these prices.

Modest sales are expected in the first year. However, this is projected to increase significantly as customers begin
to appreciate the durability of the product.

Sales projections are as follows:

D Limited - Projected Sales (metres)

Customer/Year 2010 2011 2012
To DIY Stores 5,000 10,000 40,000
To Construction Companies 5,000 10,000 35,000

Other Information:
D Limited has a post-tax cost of capital of 10%.

D Limited assesses potential investments using the following criteria:

• Net Present Value (NPV)

and
• Payback period of two years or less

REQUIRED:

Prepare a report for the Board of D Limited which:

a) Recommends whether or not to purchase the licence; and (15 Marks)

b) Presents five non-financial factors to be considered when making the decision whether or not to purchase the
licence. (10 Marks)

[Total : 25 Marks]

Page 2
2. Opera PLC, a manufacturer of jewellery has enjoyed considerable growth over the last five years. Extracts from
the most recent Balance Sheet and Income Statements for the year ended 19th December 2008 read as follows:

Opera PLC
Balance Sheet as at 19th December 2008

Non Current Assets at NBV

€Ms

Property and Plant 751

Fixtures & Fittings 262
Total Non-Current Assets 1,013

Current Assets
Inventories 68
Trade Receivables 32
Cash & Cash Equivalents 179
Total Current Assets 279

Total Assets 1,292

Equity & Liabilities

Equity Attributable to Equity Holders

Share Capital (@ €1 each) 400
Retained Revenue Reserves 215
6% €1 Preference Shares 300
8% Debentures Redeemable 19/12/2010 200
1,115
Non Current Liabilities
Long term borrowings 0

Current Liabilities
Trade payables 39
Dividends Payable 138
Current portion of long term borrowings 0
Total Current Liabilities 177

Total Liabilities 1,292

Opera PLC
Income Statement - Year Ended 19th December 2008

Profit Before Interest & Taxation 466

€Ms

Finance Charges 16
Corporation Tax 124
Profit after Interest & Taxation 326
Proposed Dividend 138
Retained Profit for the year 188

Notes
1) Opera PLC recently proposed a dividend of €.30 (30 cent) per ordinary share relating to the year ended
19th December 2008.
2) The company’s equity shares are presently trading at €2.30 cum div.
3) Opera PLC’s dividend policy is to maintain growth of 10% each year.
4) The preference shares are trading at €1.66 cum div.
5) No preference or ordinary share dividends relating to the year ended 19th December 2008 have been paid
as yet.
6) Debenture interest for the year ended 19th December 2008 has been paid in full.
7) Opera PLC’s debentures are currently trading at 90% of par value.
8) Opera PLC pays corporation tax at a rate of 20%.
It is expected that profits will increase by 12% over the year ended 19th December 2008.

Page 3
 The company’s Board of Directors is contemplating building a state of the art production facility costing €800
million. It is expected that this facility will reduce the company’s annual recurrent cost base by €164 million. The
Board has been considering the options available to finance the purchase of the production facility. The short
listed options are:

Option 1
Issues 6% debentures at par redeemable in 2020.

Option 2
Issue equity shares at a price of €4.00

REQUIRED:
1) Calculate Opera PLC’s Weighted Average Cost of Capital (WACC) as at 19th December 2008. (10 Marks)

2) For each of the two options outlined draft the projected Income Statement for the year ended 19th December
2009, and evaluate the competing financing options from the perspective of an equity shareholder.
(10 Marks)
[Total : 20 Marks]

3.
(Part A)

Discuss each of the following:

1) The stages in Target Costing. (8 Marks)

2) The importance of understanding the behaviour of costs. (7 Marks)

[Total : 15 Marks]

or
(Part B)

1) Describe and discuss five factors to be considered when deciding on dividend policy. (8 Marks)

2) Describe the management tool Standard Costing and identify for difficulties that may be encountered when
setting standard costs. (7 Marks)
[Total : 15 Marks]

Page 4
 SECTION B
(Answer Question 4 and either Part A or Part B of Question 5)

The following multiple choice question contains 8 sections, each of which is followed by a choice of
answers. Only one of the offered solutions is correct. Each question carries 2.5 marks. Give your
answer to each section on the answer sheet provided.

4. Phil PLC is considering a proposed takeover of a private company David Limited.

David Limited’s most recent summarised Balance Sheet reads as follows:

David Limited
Balance Sheet as at 30th June 2009

Non Current Assets at NBV

€000s

Freehold Land & Buildings 1,600

Property and Plant 240
Fixtures & Fittings 60
Total Non-Current Assets 1,900

Current Assets
Inventories 260
Trade Receivables 440
Cash & Cash Equivalents 0
Total Current Assets 700

Total Assets 2,600

Equity & Liabilities

Equity Attributable to Equity Holders

Share Capital (@ €5 each) 1,000
Other Reserves 1,100
2,100
Non Current Liabilities
Long term borrowings 100

Current Liabilities
Trade payables 300
Dividend payable 0
Short Term Borrowings 50
Current portion of long term borrowings 50
Total Current Liabilities 400

Total Liabilities 2,600

The due diligence audit revealed the following findings:

David Limited
Non Current Assets at Market Values
Freehold Land & Buildings 1,200
€000s

Property and Plant 400

Fixtures & Fittings 20

• €25,000 of the trade receivables are considered uncollectible.

• €100,000 of inventories are considered to be obsolete.
• the market value of all other balance sheet items are considered to equal their balance sheet values.
• David Limited has reported average post tax profits for the last five years of €120,000 per annum.

Phil PLC does not plan to assume any of David Limited’s borrowings.

Page 5
 Phil PLC plans to rationalise David Limited’s office at a post tax cost of €2 million. The annual recurrent pre tax
savings of doing so are expected to be €600,000.

Phil PLC pays corporation tax at 25%.

Extracts taken from the Stock Exchange for both Joanne PLC and Ruth PLC, which have similar business and
financial risk profile to David Limited read as follows:.

Share Earnings Yield EPS Dividend Cover PE Multiple

Joanne PLC 11.11% 10 cent 3 times 9

Share MV (Cent) Dividend Cover PE Multiple

Ruth PLC 440 5 11

It is generally agreed that the price earnings multiple of a quoted company should be reduced by 30% to value
an unquoted company.

Phil PLC recently proposed (not paid as yet) a total dividend of €500,000 to its one million shareholders last year.
The dividends paid by Phil PLC have been increasing by 5% over the last three years. Phil PLC’s shares are
presently trading at €4 cum div.

Phil PLC recently tendered to build a new machine for a client in Co. Waterford. A summary of the cost estimates
are as follows:

Cost Estimates – Waterford Client

Direct Materials – Steel 400
€000s

Direct Materials – Wiring and ancillaries etc 40

Direct Labour-Engineering-3000 hours @ €50 per hr 150
Direct Labour - Unskilled 10000 hours @ €20 per hr 200
Variable Overheads 110
Fixed Overheads Absorbed 100
Total Estimated Cost 1,000

Phil tendered at a price of €1.25 million by adding on the standard industry mark-up of 25% to the above costs.
It has just been informed that its tender was unsuccessful.

Phil PLC’s Managing Director has asked you for your opinion as to whether the costing upon which the price was
based was correct. You have reviewed the working files and have discerned that:

• engineering hours are in short supply and earn a contribution per hour of €20. If Phil PLC decides to build
this machine this contribution will be foregone.
• due to the recent cancellation of an order the company expects to have available 4,000 idle unskilled hours
available to work on the job. Any additional unskilled labour required is employed on a casual basis.
• the wiring was already in stock for the previous job that was cancelled. The wiring has no other use and
was to be scrapped at a cost of €10,000.
• steel was in stock and cost €400,000. It is regularly used and would be replaced at a cost of €350,000.
• The fixed overhead is an allocation of central overheads, plus contract specific fixed costs of €20,000
• Variable overheads accurately represent light and heat costs.

REQUIRED:

Q1) The value of one David Limited share using the net assets method (based on market values) of share valuation
is:

a) €8.48 per share

b) €9.48 per share
c) €10.48 per share
d) €11.48 per share

Page 6
Q2) The post-acquisition value of one David Limited share using the price earnings ratio method of share valuation
is:

a) €9.95 per share

b) €10.95 per share
c) €11.95 per share
d) €12.95 per share

Q3) Joanne PLCs market value per share is:

a) 90 cent
b) 100 cent
c) 110 cent
d) 120 cent

Q4) Ruth’s PLC’s most recent dividend paid per share was:

a) 4 cent
b) 8 cent
c) 12 cent
d) 16 cent

Q5) Using Gordon’s Growth Model, Phil PLC’s cost of equity is:

a) 10%
b) 20%
c) 30%
d) 40%

Q6) The total relevant total cost of all materials for the Co. Waterford client’s job is:

a)
b)
€440,000

c)
€400,000

d)
€340,000
€350,000

Q7) The relevant total cost of labour for the Co. Waterford client’s job is:

a)
b)
€350,000

c)
€330,000

d)
€270,000
€150,000

Q8) The total relevant total cost of the Co. Waterford client’s job is:

a)
b)
€700,000

c)
€800,000

d) [Total: 20 Marks]
€900,000
€1,000,000

Page 7
 Answer either Part A or Part B of Question 5

5. (Part A)
Avril Limited manufactures and sells radiator covers. Prior to commencing business two year’s ago Avril Devine
the company’s Managing Director spent considerable time establishing the standard cost of producing one cover.
The unit standard cost card is provided below:

Standard Cost Per Radiator Cover

Material - Wood (2 metres @ €10 per metre) 20
€

Direct labour (4 hours @ €15 per hour) 60

Variable Overhead (4 hours @ €5 per hour) 20
Standard Cost Per Radiator Cover 100

Avril Limited budgeted to manufacture and sell 10,000 covers during April 2009, thus incurring a budgeted total
manufacturing cost of €1,000,000

During April 2009 12,000 radiator covers were actually produced. The actual spend can be analysed as follows:

Actual Costs - April 2009

Wood - 26,400 metres 290,400
€

Labour - 42,000 hours 588,000

Variable Overhead 231,000
Total Costs Incurred 1,109,400

Despite the detailed analysis carried out to establish the standard cost and strict cost controls employed during
the manufacturing process the Managing Director is disappointed that the total cost incurred during April 2009
reveals an apparent overspend of €109,400.

REQUIRED:
a) Prepare a statement that reconciles the flexed budgeted cost (base on actual level of production) to the actual
cost of production for April 2009. (15 Marks)

b) Comment briefly on the Managing Director’s view that there was an overspend of €109,400 during April 2009.
(5 Marks)
[Total : 20 Marks]

or

Page 8
5. (Part B)
A friend is planning to invest in the following portfolio of investments. Invest €60,000 in London Commercial
Property. Expected annual returns are as follows:

Annual Investment Return Probability of Occurrence

12% .4
24% .6

Invest €40,000 in French Residential Property. Expected annual returns are as follows:

Annual Investment Return Probability of Occurrence

10% .3
20% .7

The co-efficient of correlation between the two investments is +.75.

You have researched the equity and bond markets and have estimated the:
Return on government bonds = 4%
Return expected from the Global Property Market Portfolio = 10%
Measure of risk of Market portfolio = 6%

REQUIRED:
Advise your friend on the following issues relating to his proposed investment:

a) Explain the terms portfolio theory and unsystematic risk. (5 Marks)

b) Calculate the expected return from each investment and the proposed portfolio. (2 Marks)
c) Calculate the standard deviation of each investment and the proposed portfolio. (8 Marks)
d) Using the Capital Asset pricing Model advise as to whether the proposed portfolio is
efficient or inefficient. (5 Marks)
[Total: 20 Marks]

END OF PAPER

Page 9
 SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

MANAGERIAL FINANCE
PROFESSIONAL 1 EXAMINATION – AUGUST 2009

SOLUTION 1

Report
To: Board of Directors, D Limited
From: Accountant Advisor
Date: 30th September 2009
Subject: Potential Purchase of Licence

Introduction
This report advises on whether or not to purchase the licence to manufacture and sell the plastic decking product.

Findings
The proposal delivers a positive NPV over its three year duration of €512,746. However it does not payback the
initial investment until year three of the proposal.

Net Present Value - Plastic Decking Proposal

Details Yr 0 Yr1 Yr 2 Yr 3 Yr 4
Initial Licence Cost -500000
Royalty -100,000 -200,000 -500,000
Gross Income (Note1) 1,050,000 2,100,000 7,950,000
Wages (Note 2) -360,000 -360,000 -378,000
Overhead Costs -50,000 -100,000 -375,000
Materials -400,000 -720,000 -2,700,000
Lease -400,000 -400,000 -400,000
Shipping Costs -200,000 -400,000 -1,500,000
Cash profits before taxation -460,000 -80,000 2,097,000
Taxation (Note3) 73,125 19,375 -224,625

Investment Criterion - Net Present Value (NPV)

Net Annual Cash Flows -500,000 -460,000 -6,875 2,116,375 -224,625
Discount Factor @ 10% 1 0.9091 0.8264 0.7513 0.6830
Present Values -500,000 -418,186 -5682 1,590,033 -153,419
Net Present Value 512,746

Net Annual Cash Flows -500,000 -460,000 -6875 2,116,375 -224,625

Cumulative Net Annual Cash Flows -500,000 -960,000 -966,875 1,149,500 924,875
Payback Period 3rd Year

Supporting notes can be found at appendix A to this report.

Qualitative factors to consider

• Can D Limited secure the exclusive rights to the product
• What competitor products are out there?
• How long established is the Slovakian company?
• Is the process patented?
• Can we buy an option to terminate early/extend the licence?
• Have we the physical capacity to produce the product?
• How will it impact on our present sales?
• How established is the technology?
• Can staff train easily to produce the product?

Page 10
Conclusion
D Limited must consider this investment carefully especially given that it does not pay back within two years. It
should be borne in mind that payback is often used as a screening device only. Most investment decisions will be
based on the more detailed NPV analysis.

Appendix A

Notes to Financial Projections

Note 1 - Sales Revenues Yr 1 Yr 2 Yr 3

Forcast Sales - DIY Stores 5,000 10,000 40,000
Price Per metre 120 120 120
Total DIY Income 600,000 1,200,000 4,800,000
Forcast Sales - Construction 5,000 10,000 35,000
Price Per metre 90 90 90
Total Construction Income 450,000 900,000 3,150,000
Total Income 1,050,000 2,100,000 7,950,000

Note 2) Incremental Wage Costs

New Staff Salary Yr 1 Cost
Supervisors 1 35,000 35,000
Operatives 6 27,000 162,000
Maintenance 1 32,000 32,000
Procurement 1 30,000 30,000
Accounting 2 28,000 56,000
Quality 1 45,000 45,000
Year 1 Cost 360,000
Year 2 Cost 360,000
Year 3 Cost (5% Uplift) 378,000

Note 3) CT Payments
Yr 1 Yr 2 Yr 3 Yr 4
Cash Profits before Tax -460,000 -80,000 2,097,000
Capital Allowances - Licence -125,000 -75,000 -60,000
Balancing Allowance - Licence -240,000
Taxable Profits -585,000 -155,000 1,797,000
Tax @ 12.5% -73,125 -19,375 224,625
Tax payable -73,125 -19,375 224,625

Page 11
SOLUTION 2
a)

WACC Note MV (Ms) % Cost Weighting % Weight Weighted

Ordinary Shares (ex div) 1 800 26.50% 800/1460 54.79% 14.52%
Preference Shares (ex div) 2 480 3.75% 480/1460 32.88% 1.23%
Debentures at MV 3 180 12.42% 180/1460 12.33% 1.53%
Weighted Average Cost of Capital 1460 100.00% 17.28%

Note 1)Cost of Equity (Gordon's Growth Model)

[.30*(1+.10)/(2.30- .30)] +.10 = 26.50%

Note 2)Cost of Preference Shares

Interest Payable/Ex Div. Market value = 6/(166-6) * 100 = 3.75%

*€1 @ 6% = 6 cent dividend per share yet to be paid.

Note 3)Cost of Debentures (IRR Calculation)

Year Value Interest Tax Relief Redeem Net C flow

0 -180 -180.00
€000s €000s €000s €000s €000s

1 16 -3.2 12.80
2 16 -3.2 200 212.80

Discount @ 10% Discount @ 15%

Year Net C flow D factor PV Net C flow D factor PV

0 -180.00 1 -180.00 -180.00 1 -180.00

€000s €000s €000s €000s

1 12.80 0.9091 11.64 12.80 0.8696 11.13

2 212.80 0.8264 175.86 212.80 0.7561 160.90
Net Present Value + 7.49 Net Present Value - -7.97

IRR(Cost of Debentures)=10%+[7.49/(7.49+7.97)]*(15%-10%) = 12.42%

b) Opera PLC

Projected Income Statement - Y/E 19th December 2009

Option 1 Option 2
Details
PBIT 686 686
€Ms €Ms

Finance Charges -64 -16

Corporation Tax -124 -134
PAIT 498 536
Dividend -152 -228
Retained Profit 346 308

Interpretation
Whilst both options deliver increased profits for Opera PLC, as an equity investor in Opera PLC I would
probably prefer the second option for the following reasons:

• there are more residual profits belonging to equity holders

• there is lower capital gearing, thus reduced investment risk
• there is a higher interest cover/income gearing, thus less financial risk

The only significant downside it that by raising equity finance my shareholding and control will by definition
be diluted.

Page 12
Solution 3
a) Stages in Target Costing

Target Costing
This is an approach which in its most basic form involves the following steps:

Step 1 – Market mapping

This involves researching an organisation’s market in order to determine the following:

• What specification customers require

• What price customers will be willing to pay for a particular specification
• What sales volumes are likely to be achieved for the particular specification at the suggested price

Step 2 - Deducting an agreed and acceptable level of margin from the target price.
this results in the target cost at which the product/service must be made/delivered.

Step 3 – Meeting The Target Cost Challenge

The accountants, engineers and designers etc. set about the challenge to make/supply the product/service
to the desired specification within the target cost

If successful, target costing should ensure that the necessary specification can be made at a cost which will
enable a price to be set which will deliver the level of margin and sales volume required to satisfy the
financial objectives set for that particular product.

Importance of Understanding Cost Behaviours

It is critical that organisations understand the impact of the different cost behaviours for each of their
products/services. By understanding actual cost behaviours management will be aided greatly in the
following critical processes:
• determining unit costs and profitability
• determining unit and overall business break-even points
• decision making e.g. acceptance of a one –off contract
• budgeting
• setting standard costs

b)
(1) Factors to Consider in Making the Dividend Decision

Liquidity of Company
The company must have the cash resources to pay a proposed dividend.

Tax treatment of capital gains

Dividends and Capital Gains may be treated differently for tax purposes. Companies will plan to minimise
the tax liability of its investors.

Shareholder Preferences/Clientele Theory

Some shareholders may prefer dividends, others capital gains. Institutional investor preferences may have
a significant impact.

Shareholder Expectations
Historic dividend policy may create investor expectations.

Signalling Theory
Reducing dividends may send an adverse signal to the investment community and lower share price and
visa versa.

Legality
Dividends can only be paid from realised reserves.

Page 13
(2) A Standard Cost is a planned unit cost of a product, component or service. A standard cost card shows the
full details of the standard cost of each product. Standard Costing is a control technique that reports
variances from the standard expectation for each control period (normally monthly). It does so by comparing
actual costs and revenues to pre set standards. This helps facilitate management by exception as
management can concentrate on acting on the most significant variances.

There are a number of problems associated with standard setting including:

1) deciding on how to incorporate inflation into planned unit costs

2) agreeing on the performance standard expected for labour inputs e.g. attainable or ideal
3) deciding on the quality of materials to be used
4) estimating material prices where seasonal or commodity market variations may be significant

Page 14
Solution 4

1 David Limited
Net Asset Valuation
Freehold Land at Market Value 1200
€000s

Property and Plant at Market Value 400

Fixtures & Fittings at Market Value 20
Inventories (260-100) 160
Trade Receivables (440-25) 415
Trade Payables -300
Total Net Assets to Take Over 1895
Divided by: Shares In Issue 200
Indicative Per Share Valuation 9.48

2 David Limited
Earnings Valuation
Averaged Post Tax Profits (last five years) 120
€000s

Office savings (€600K-25% tax) 450

Annual Recurrent Post Tax Profits 570
Multiplied by:P/E ratio (9+11)/2*70% 7
Indicative Valuation 3990
Less: Redundancy & Closure Costs -2000
Final Indicative Valuation 1990
Divided by: Shares In Issue 200
Indicative Per Share Valuation 9.95

3 MV = EPS/Earnings Yield = 10/.111 = 90 cent

4 Dividend Paid = EPS/Dividend Cover = 440/11 = 40/5 = 8 cent

5 Cost of Equity (Gordon's Growth Model)

[.50*(1+.05)/(4 -.50)] +.05 = 20.00%

6 Relevant Cost of Materials

Steel @ replacement cost 350
€000s

less:savings on wire scrappage -10

Net Relevant Cost 340

7 Relevant Cost of Labour

Unskilled Casual Hours 120
€000s

Engineering Hours 150

Engineering Opportunity Cost (3000*€20) 60
Net Relevant Cost 330

8 Relevant Cost of Job

Materials 340
€000s

Labour 330
Variable Overhead 110
Fixed Overhead 20
Net Relevant Cost 800

Page 15
SOLUTION 5 (PART A)

Avril Limited - Operating Statement - Month Ended April 2009

Variances
Details Note Favourable Adverse Total
Budgeted Cost 9 1,200,000
Variances
Direct Materials Price 1 26,400
Direct Materials Usage 2 24,000
Direct Labour Rate 3 42,000
Direct Labour Efficiency 4 90,000
Variable Overhead Expenditure 5 21,000
Variable Overhead Efficiency 6 30,000
Sub Totals 162,000 71,400
Net Variance -90,600
Actual Cost 1,109,400

Supporting Notes

Note 1) Direct Materials Price Variance

(Standard Unit Cost - Actual Unit Cost ) * Actual Units Purchased

(10 - 11) * 26,400 = 26,400 Adverse

Note 2) Direct Materials Usage Variance

(Standard Unit Usage (for the actual level of production)- Actual Units Used) * Standard Cost Per Unit
(24,000 - 26,400) * 10 = 24,000 Adverse

Note 3) Direct Labour Rate Variance

(Standard Hourly Rate - Actual Rate Per Hour ) * Actual Hours Worked
(15 - 14) * 42,000 = 42,000 Favourable

Note 4) Direct Labour Efficiency Variance

(Standard Hours (for the actual level of production)- Actual Hours Worked) * Standard Rate Per Hour
(48,000 - 42,000) * 15 = 90,000 Favourable

Note 5) Variable Overhead Expenditure Variance

(Standard Hourly Cost - Actual Cost Per Hour ) * Actual Hours Worked
(5 - 5.5) * 42,000 = 21,000 Adverse

Note 6) Variable Overhead Efficiency Variance

(Standard Hours (for the actual level of production)- Actual Hours Worked) * Standard Cost Per Hour
(48,000 - 42,000) * 5 = 30,000 Favourable

Overspend of €109,400
You are of the opinion that you overspent by €109,400 during April 2009. However, this is based on a comparison
of the budgeted cost to make 10,000 radiator covers and the actual cost of making 12,000 covers.

The operating statement presented above compares the budgeted cost of making 12,000 radiator covers and the
actual cost of making 12,000 covers. You will note that you actually underspent by €90,600 for the month. Thus,
your cost controls have been effective.

Page 16
SOLUTION 5 (PART B)

Briefing on Portfolio Investment and Diversification

Portfolio Theory
A portfolio is a collection of different investments that comprise an investor’s total holding. Such a portfolio may
include different types of investments e.g. property, equities and government bonds. Portfolio theory is concerned
with setting guidelines for selecting a portfolio of investments and the measurement of risk and return of a portfolio
and, understanding the impact that investment diversification will have on the risk and return of a portfolio.

Unsystematic Risk
Unsystematic Risk – This is risk that is specific to a specific investment/industry. Some investments are considered
to be more risky than others. An example would be that the property development industry would probably be
considered more risky compared to the retail industry. Unsystematic risk can be diversified away by investing in a
portfolio of investments in different industries.

Risk and Return of Proposed Portfolio

The annual return expected from your planned investment is 19.2% and the risk attaching thereto measured by
standard deviation is 5.88%. They are calculated as follows:

Investment in London Property

Deviation S Deviation =
% Return Probability Expectation Deviation Squared Square Root
x P x*p x - EV (x-EV)2 p(x-EV)2 p(x-EV)3
12 0.4 4.8 -7.2 51.84 20.736
24 0.6 14.4 4.8 23.04 13.824
Expected Value (EV) 19.2 34.56 5.88

Investment in French Property

Deviation S Deviation =
% Return Probability Expectation Deviation Squared Square Root
x P x*p x - EV (x-EV)2 p(x-EV)2 p(x-EV)3
10 0.3 3 -7 49 14.7
20 0.7 14 3 9 6.3
Expected Value (EV) 17 21 4.6

The overall expected return from your proposed portfolio is 18.32%. This is a weighted average of the expected
return of both investments in the proposed portfolio, using the proportion of the investment in each share as the
respective weights.

Expected Portfolio Return

Expected
Investment Expected Weighted Portfolio
Share % Return Investment Return
London Property 0.192 60% 0.1152
French Property 0.17 40% 0.068
Expected Return(EV) 18.32%

The risk of the proposed portfolio (as measured by standard deviation) is 5.06% as calculated below:

SD Portfolio = (.6)2(5.88)2 + (.4)2(4.6)2 + (2)(.6)(.4)(.75)(5.88)(4.6)

= 5.06 = 25.57

= 5.06%

Page 17
CAPM based return
Risk free return (Rf) 4.00%

Plus: Risk Premium B(Rm-Rf)

Beta factor (note 1) 0.843
*Rm- Rf = (10%-4%) = .843 (6%) 6%
5.06%
CAPM Based Return 9.06%

Expected Return 18.32%

Note 1)Determination of Beta Factor for Portfolio

Risk of Market Portfolio 6.00%
Risk of Proposed Portfolio 5.06%
Portfolio Beta Factor =5.06%/6%
Portfolio Beta Factor 0.843

The proposed portfolio is efficient. i.e. the expected return there from exceeds by 9.26% (18.32% - 9.06%) the
return which would have been expected using capital Asset Pricing Model (CAPM) principles to assess risk and
return.

Page 18