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ASSIGNMENT COVER SHEET

GEERDHARRY
Surname
Bibi Shirin

First Name/s

M401000963

Student
Number

Accounting for Decision Making

Subject

Assignment
Number

Mr Phul

Tutor’s Name

MES

Examination
Venue

18 April 2011

Date
Submitted


First Submission Re-submission
Submission (√)

Labourdonnais Street

1
Postal Address Mahebourg

shirin_geerdharry@yahoo.co.uk

E-Mail

201 3636 (Work)

674 2184 (Home)

Contact 780 9719 (Cell)


Numbers

Course/Intake MBA Year 2 – January 2011

Declaration: I hereby declare that the assignment submitted is an original piece of work
produced by myself.

Signature: Date: 18 April 2011

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TABLE OF CONTENTS

Page No

Question 1…………………………………………………………………………………….1-6

Question 2…………………………………………………………………………………….7-11

Question 3……………………………………………………………………………………12-20

Question 4……………………………………………………………………………………21-24

Question 5……………………………………………………………………………………25-31

Bibliography…………………………………………………………………………………32

LIST OF FIGURES

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Page no.

Figure 1: Porter’s Five Forces Model………………………………………………………….5

Figure 2: Break-even point……………………………………………………………………15

Question 1

Information
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Telstar electronics manufactures product Z. An estimate of the number of units expected to be
sold in the first four months of 2011 is given below:

January 1000

February 1200

March 1600

April 2000

It is anticipated that:

• There will be no work-in-process at the end of any month.

• Finished units equals to 50% of the expected sales of the following month will be in
inventory at the end of each month (including December 2010).

The budgeted production and production costs for the year ending 31 December 2011 are as
follows:

Production 22 000 units

Direct material cost per unit R24

Direct labour cost per unit R14

Other manufacturing costs R66 000

1.1.1 Draw up the production budget that shows the number of units to be manufactured for
each month (January to March 2011).

Production Budget to show the number of units to be manufactured each month:

January February March


Budgeted sales 1000 1200 1600
Add desired ending inventory of finished
goods (50% of expected sales of the following
month) 600 800 1000
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Total needs 1600 2000 2600
Less beginning inventory of finished goods 500 600 800
Required Production 1100 1400 1800

1.1.2 The expected production cost for March 2011.

Other manufacturing costs for the Production of 22, 000 units is R66, 000

22 000 units cost R66 000

1 unit costs 66 000/22 000 = R3

Direct material cost per unit R 24

Direct labour cost per unit R 14

Other manufacturing cost per unit R 3

Therefore Expected production cost for the month of March = 1800(24+14+3) = R 73,800

1.2 “The task of preparing a sales budget is usually approached from two different angles viz.
judging and evaluating external influences and considering internal influences.”

Explain five external influences that may impact on the preparation of a sales budget.

According to F. Wood & A. Sangster (2008: 565), the first budget that should be prepared is the
sales budget. However, before doing so, the first thing to establish when preparing a budget is
what limiting factors exist that affects it.

• For example, it may be that sales cannot be pushed above a certain amount, or it might be
that the company could sell as much as it can produce, but productive capacity is limited.
There is no doubt that identification of the limiting factors is crucial if an achievable
budget is to be set. There would not, for instance, be much point in budgeting to

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manufacture more than 700; or budgeting for the sale of 1000 units a year if production
could not manufacture more than 700; or in budgeting to manufacture 2000 units a year if
only 1300 of them could be sold.

• The budgeting process usually begins with a sales budget. The sales budget reflects
forecasted sales volume and is influenced by previous sales patterns, current and
expected economic conditions, activities of competitors, and so forth. The sales budget is
complimented by an analysis of the resulting expected cash collections. Sales often occur
on account, so there can be a delay between the time of a sale and the actual conversion
of the transaction to cash. For the budget to be useful, careful consideration must also be
given to the timing and pattern of cash collections. (From principlesofaccounting.com)

The sales budget is, however, more than just a forecast of sales volume and sales revenue.
Budgets should show the actions that management is taking to influence future events. If an
increase in sales is desired, the sales budget may show extra sales, which may well also indicate
that management is going to attempt to increase sales by means such as extra television
advertisement, making a better product, or giving retailers better profit margins.

• The most difficult estimate to make when preparing a company’s budget is that of sales
volume and, then, sales revenue. This can be done using one of the two methods:

• Make a statistical forecast on the basis of the economic conditions relating to the goods
sold (e.g. how demand reacts to price changes) and what is known about the actions of
competitors.

o This approach has an external rather than internal focus. When adopted, it tends to
be performed at a high level in the organization, with relatively little consultation
involving employees actually engaged in the selling process.

• The alternative approach uses information gathered lower down in the organization. This
is usually done by asking each salesperson, or group of salespeople, to estimate the sales
in their own areas, and then adding together all the estimates.

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According to Kaplan (2009: 217), the PESTEL model is useful for identifying change factors
that can be taken as the external factors that affect sales budget. These are follows:-

Political Change

A change in government policy, for example fiscal policy, may affect the demand for an
organization’s products and/or costs incurred in providing them. Any such changes will affect
both short term and long term planning. This is one reason why planning is a continuous process.

Social Change

Changes in social responsibilities and people’s attitude towards them affect every organization.
In recent years there has been much more concern about social responsibilities, some of which
are now recognized by law. All of these factors may impinge on the plans of the organizations.

Economic Change

When there is a change in the economic climate from boom through to recession, the demands
upon people’s income become more focused. Money tends to be spent on necessary goods with
little left for ‘luxury goods’ & savings deters investment, with the result that plans have to be
modified if they are to be realistic targets.

Technological Change

When plans are made, they are based upon the use of certain methods and equipment. As
technology advances, the older methods are proven to be inefficient, with the result that
decisions are taken to update the operation. As a consequence, the aspects of the budgets and
plans which were related to the old method are no longer relevant. Revised plans must now be
drawn up on the basis of the new technology.

Legal Change

When plans are made they are based on the current legal framework and known changes to this
are also factored in over time. However, changes to legal framework can cause information that
is used when pulling budgets together to become redundant. An example of this might be the

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government introducing legislation that bans fast food from being advertised during the intervals
between children’s TV programmes.

The Porter’s five forces model can also have an impact on the preparation of a sales budget.

Figure 1: Porter’s Five Forces Model

Source: http://www.12manage.com/methods_porter_five_forces.html

According to 12manage- The Executive Fast Track, the Five Forces model of Porter is an
Outside-in business unit strategy tool that is used to make an analysis of the attractiveness
(value) of an industry structure. The Competitive Forces analysis is made by the identification of
5 fundamental competitive forces which are external factors that have an impact on the
preparation of a sales budget:

1. Entry of competitors. How easy or difficult is it for new entrants to start competing,
which barriers do exist.
2. Threat of substitutes. How easy can a product or service be substituted, especially made
cheaper.
3. Bargaining power of buyers. How strong is the position of buyers? Can they work
together in ordering large volumes?

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4. Bargaining power of suppliers. How strong is the position of sellers? Do many potential
suppliers exist or only few potential suppliers, monopoly?
5. Rivalry among the existing players. Does a strong competition between the existing
players exist? Is one player very dominant or are all equal in strength and size.

Sometimes a sixth competitive force is added:

6. Government.

Porter's Competitive Forces model is probably one of the most often used business strategy tools.
It has proven its usefulness on numerous occasions. Porter's model is particularly strong in
thinking Outside-in.

Question 2

2.1 Information
Extracts of the Income statements and Balance sheets for the year ended 31 December
2010 are given below for two companies viz. ABC Limited and XYZ Limited.

Extracts of Income Statements for the year ended 31 December 2010:

ABC Limited XYZ Limited

R R

Sales 3 300 000 1 080 000

Cost of sales 2 310 000 432 000

Depreciation 135 000 6 000


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Interest on loan 87 000 37 500

Other expenses 120 000 22 500

Income tax 194 400 174 600

Extracts of Balance Sheets as at 31 December 2010:

ABC Limited XYZ Limited

R R

Non-current assests 990 000 630 000

Current assets 847 500 195 000

Share capital (Par value R2) 1 000 000 500 000

Retained earnings 125 000 40 000

Non-current liabilities 510 000 240 000

Current liabilities 202 500 45 000

2.1.1 Compare and comment on the profitability of both companies by using the following ratios:

Return on Capital Employed (ROCE) is used in finance as a measure of returns that a


company is realizing from its capital employed.

Capital employed is represented as total assets minus current liabilities. In other words, it is the
value of the assets that contribute to a company’s ability to generate revenue.

It is expressed as:-

ROCE = (Earnings / Capital Employed) * 100

The numerator is Earnings before Interest and Tax. It is net revenue after all the operating
expenses are deducted.

The denominator (capital employed) denotes sources of funds, such as equity and short-term debt
financing which is used for the day-to-day running of the company.

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• Return on capital employed for company ABC Ltd

Return on capital employed = (Net Profit before interest & tax / capital employed) x 100

Capital employed = Total Assets – Current Liabilities

Total Assets = 990 000 + 847 500 = 1 837 500

Capital Employed = 1 837 500 – 202 500 = 1 635 000

Net profit before interest & Tax= sales – (Cost of sales + Depreciation + Other expenses)

= 3 300 000 – (2 310 000 + 135 000 + 120 000) = 735 000

Return on capital employed = (Net Profit before interest & tax / capital employed) x 100

• Return on capital employed for company ABC Ltd = 735 000 / 1 635 000 = 0.4495 =
44.95% = 45%

• Return on capital employed for company XYZ Ltd

Return on capital employed = (Net Profit before interest & tax / capital employed) x 100

Capital employed = Total Assets – Current Liabilities

Total Assets = 630 000 + 195 000 = 825 000

Capital Employed = 825 000 – 45 000 = 780 000

Net profit before interest & Tax= Sales – (Cost of sales + Depreciation + Other expenses)

= 1 080 000 – (432 000 + 6 000 + 22 500) = 619 500

Return on capital employed = (Net Profit before interest & tax / capital employed) x 100

• Return on capital employed for company XYZ Ltd = 619 500 / 780 000 = 0.7942 =
79.4%

Gross Profit
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• Gross Profit (Gross margin) ratio = Gross Profit / Sales x 100 %

• Gross Profit = sales – cost of sales

= 3 300 000 – 2 310 000 = 990 000

Gross Profit Ratio for ABC Ltd = Gross Profit / Sales x 100% = 990 000 / 3 300 000 *
100 = 30%

Gross profit Ratio for XYZ Ltd = 1 080 000 – 432 000 = 648 000

• Gross Profit Ratio for XYZ Ltd = Gross Profit / Sales x 100% = 648 000 / 1 080 000 *
100 = 60%

Net Profit (Profit margin)

Net Profit (Profit margin) ratio = Net Profit / Sales x 100%

ABC Limited XYZ Limited


R R
Sales 3 300 000 1 080 000
Cost of sales 2 310 000 432 000
Depreciation 135 000 6 000
Interest on loan 87 000 37 500
Other expenses 120 000 22 500
Income tax 194 400 174 600
Net Profit 453 600 407 400

Net Profit (Profit margin) ratio for company ABC Ltd = Net Profit / Sales x 100%

= 453 600 / 3 300 000 * 100 = 13.75%

Net Profit (Profit margin) ratio for company XYZ Ltd = Net Profit / Sales x 100%

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= 407 400 / 1 080 000 * 100 = 37.72%

2.2 The earnings per share (EPS) for ABC Ltd. 2009 was R 1.15 (115 cents) for 2009.

EPS = Net Profit after Tax / Number of ordinary shares issued

For ABC Ltd:

The share capital (Par value R2) is 1 000 000

No of ordinary shares issued by ABC Ltd = 1 000 000 / 2 = 500 000

Net Profit after tax = 453 600

The earnings per share for ABC Limited for 2010 = Net Profit after Tax / Number of ordinary
shares issued = R453 600 / 500 000 = R 0.9072 = 91 cents

The EPS has decreased from R1.15 in 2009 to R0.91 (91 cents) in 2010 – a decrease of 24 cents.
This will probably be viewed as unfavourable for ABC Ltd shareholders.

2.3 The dividend per share that I would recommend XYZ Ltd to declare for the year ended 31
December 2010 is R1.63 to motivate the shareholders. All the net profit value is taken as the
value of dividend payables.

For XYZ Ltd,

Dividend per share = Dividend payables / No of shares

Dividend payable = Net profit = 407 400

Share capital (Par value R2) = 500 000

No of shares = 500 000/2 = 250 000

Therefore, Dividend per share = Dividend payables / No of shares = 407 400 / 250 000 = R 1.63

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Question 3

3.1 Information

Sellrite Enterprises produces a single product. The following information for 2011 is
available:
Fixed manufacturing costs R160 000
Variable manufacturing costs per unit R28
Selling price per unit R66
Marketing costs:
Advertising R8 000 per month
Sales personnel’s salaries and commission R10 000 per month plus 6% of sales
Administration costs:
Salaries R24 000 per month
Other office costs R8 000 per month plus R4 per unit
sold
The number of units expected to be produced and sold is 15 000.

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3.1.1 The break-even quantity for January 2011.

No. of units expected to be produced & sold = 15 000

Total fixed cost = 160 000 + 8 000 + 10 000 + 24 000 + 8 000 = 210 000

Fixed Manufacturing
costs 160 000

Marketing costs:
Advertising 8 000
Sales personnel's salaries 10 000

Administration costs:
Salaries 24 000
Other office costs 8 000
Total fixed cost 210 000

Total variable cost = 15 000 x 28 + (0.06 x 66 x 15 000) + 4 (15 000)

Total variable cost = R 539 400

Sales = (66 * 15 000) 990 000


Less variable costs 539 400
Contribution 450 600
Less fixed cost 210 000
Profit 240 600

Selling price per unit 66


Less variable cost per unit 28
Contribution per amount 38

3.1.1 Breakeven Quantity for Jan 2011 = Fixed cost / contribution per amount

= 210 000 / 38 = 5 526.3 = 5 527

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3.1.2 Suppose Sellrite Enterprises is considering a R6 per unit decrease in the selling price of
the product with the expectation that this would increase sales by 12%.

Fixed manufacturing costs R 160 000


Variable manufacturing costs per unit R 28
Selling price per unit R60 (R 6 decrease)
Marketing costs:
Advertising R 8 000 per month
Sales personnel's salaries & commission R 10 000 per month plus 6% of sales
Administration costs:

Salaries R24 000 per month

Other office costs R8 000 per month plus R4 per unit sold

Total fixed costs = 8 000+10 000+24 000+8 000+160 000 = R 210 000

Total variable cost = (15 000 x 28) + (6/100 x 60 x 15 000) + (4 x 15 000)

= 420 000 + 54 000 + 60 000 = R 534 000

Selling price per unit (R6 decrease) 60


Less variable cost per unit 28
Contribution per amount 32

New break-even quantity if selling price is decreased by R6 = Fixed cost / contribution per
amount = 210 000 / 32 = 6562.5 = 6563

If Sellrite Enterprises is considering a R6 per unit decrease in the selling price of the product,
with the expectation that this would increase sales by 12%. This is not a good idea, since the

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break even quantity has been increased to 6563 (at which the selling price was R60) from 5527
(where the selling price was R66). More units will have to be produced in order to break-even.
The break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is
no net loss or gain. That in the case of Sellrite Enterprises, while considering a R6 per unit
decrease in the selling price; more units will have to be produced in order to start making a profit
as compared to the number of units produced when the selling price was R66.

Figure 1: Break-even point

Source: http://tutor2u.net/business/production/break_even.htm

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.

Alternatively

If selling price = R60, the fixed cost remains the same, only variable cost changes.

Expected sales = 16 800 units (12% increase in sales)

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Variable cost = 16 800*28 + (6/100 * 60 * 16 800) + 4 * 16 800 = R598 080

Sales = (60 * 15 000) 900 000


Less variable costs 598 080
Contribution 301 920
Less fixed cost 210 000
Profit 91 920

A decrease in selling price by R6, will cause a decrease in the overall profit of the enterprise by
R 148 680. (R 240 600 – R 91 920 = R 148 680). Therefore, it is not advisable for Sellrite
Enterprises to decrease its selling price of unit good by R6 even though this would increase sales
by 12%.

3.2 Information
The following figures (in ‘000 Rands) were extracted from the records of Zimbesi
Manufacturers:

Department

A B C D Total

Sales 150 300 450 600 1 500

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Variable manufacturing costs: (93) (267) (411) (548) (1 319)

Direct material 60 150 270 435 915

Direct labour 30 112 135 105 382

Factory overheads 3 5 6 8 22

Other variable costs (15) (23) (18) (15) (71)

Other fixed costs (8) (15) (8) (6) (37)

Profit (loss) 34 (5) 13 31 73

Required
On the basis of the above information, the management of Zimbesi Manufacturers
wants to close Department B and redeploy the employees to the other departments.
What advice would you offer the management of Zambesi Manufacturers? Support
your advice with the appropriate motivation.

Solution

Department

A B C D Total
Sales 150 300 450 600 1 500
% of sales 10 20 30 40 100
Variable manufacturing costs -93 -267 -411 -548 -1319
% of variable manufacturing
costs 7.05 20.24 31.16 41.55 100
Other variable costs -15 -23 -18 -15 -71
% of other variable costs 21.13 32.39 25.35 21.13 100
Total variable costs -108 -290 -429 -563 1390
% of total variable costs 7.77 20.86 30.86 40.5 100
Other fixed costs -8 -15 -8 -6 -37
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% of fixed costs 21.62 40.54 21.62 16.22 100
Profit (loss) 34 -5 13 31 73

Sales to fixed cost relationship

Department B has the highest fixed costs amount of 40.54% and its sales is 20%. Other
departments for example, department C & D have higher sales but have a lower fixed cost
amount. If the fixed cost is divided in an appropriate proportion in relation to sales then
Department B can make a profit therefore it is not wise to close department B as it can be made
to be profitable.

Also, if Department B, is closed the fixed costs of department A, C & D will increase therefore
their profit will decrease.

Scenario 1

Suppose the fixed cost is distributed in relation to sales of the department then the fixed cost will
be as follows:

Department
A B C D
Sales 150 300 450 600
% of sales 10 20 30 40
Sales - Total variable cost 42 10 21 37
Fixed cost (divided in proportion 3.7 7.4 11.1 14.8
of percentage sales)
Profit 38.3 2.6 9.9 22.2

In this case the profit for Department B will be R 2 600.

Scenario 2
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Suppose fixed cost is distributed equally between the departments in relation to sales then the
fixed cost will be as follows:

Department
A B C D
Sales - Total variable cost 42 10 21 37
Fixed cost (divided
equally) 9.25 9.25 9.25 9.25
Profit 32.75 0.75 11.75 27.75

In this case the profit for Department B will be R 750.

If the fixed cost is divided in proportion to sales then the Department B will be more profitable
with a profit equals to R2 600. Therefore, I would advise the management of Zimbesi
Manufacturers not to close Department B.

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Question 4

4.1 Information

Crimson Enterprises has set a number of transfer prices to be used by service departments within
the business, all of which used to be cost centres. One is for typing services. The charge is R15
per hour which is based on the total budgeted hours of available service and total budgeted costs
for the typing service pool. Budgeted costs for the pool are 75% fixed. The manager of one of
the operating departments has obtained a price of R10.50 per hour of typists’ time from an
outside agency. This manager informed B. Lara, the manager of the typing cost centre, of the
outside price. B. Lara replied that he could make use of the outside facility if he so desired, but
the price set internally would not be lowered from the existing rate of R15 per hour.

4.1.1 Describe two disadvantages to the supplying division of the transfer pricing method used
by Crimson Enterprises:-

1. The prices set for typing services at Crimson Enterprises are fixed at R15 per hour and
cannot be lowered, though the outside market price is better than that provided by
Crimson Enterprises.

2. The manager of one of the operating departments has obtained a price of R10.50 per hour
of typists’ time from an outside agency therefore he will opt to get his typing work from
outside, thus reducing the profit of the enterprise as a whole.

3. Outside rates are not fixed they may fluctuate depending on the amount of work.

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4. The main problem with this method is that supplying division will gain no profit from the
transfer and thus does not provide an incentive to the supplying division to transfer goods
internally. If internal transfers comprise a significant part of the supplying division’s
business, its profits will be understated.

According to Terry Lucey (2003:550), full cost transfer pricing suffers from a number of
limitations:

(a) The calculated cost is only accurate at one level of output.

(b) The validity of any pricing decision based on past cost is questionable.

(c) When transfers are made at full cost plus a profit markup the selling division is
automatically given a certain level of profit rendering genuine performance appraisal
difficult.

(d) When the selling division is inefficient or working at low volume the costs may be
unacceptably high as far as the buying division is concerned.

4.1.2 Comment on the position taken by B. Lara. Make your recommendations.

B. Lara, the manager of the typing cost centre has a budgeted costs for the pool fixed at 75%.
Therefore even if the outside price of providing typing services is lower than R15 per hour as
that provided by Crimson Enterprises, B. Lara could not decrease his prices lower than R15. The
manager of the typing cost centre has to adhere to the price fixed by the company, which is not in
the best interest of the enterprise as viewed as a whole.

The manager of the operating department will see where it is more profitable for him to do the
typing work. If the outside price is better, he will do it outside. If the price provided by Crimson
Enterprises is better, he will do it at Crimson Enterprises itself.

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4.2 Information

The summarised balance sheets of Beta Limited as at the end of 2010 and 2009 are given
below:
2010 (R) 2009 (R)
ASSETS
Non-current assets (Property, plant and equipment) 522 000 572 000
Current assets 398 000 286 000
920 000 858 000

EQUITY AND LIABILITIES


Ordinary share capital 388 000 388 000
Retained earnings (456 000) (332 000)
Shareholders’ equity (68 000) 56 000
Non-current liabilities 880 000 698 000
Current liabilities 108 000 104 000
920 000 858 000

Required
Study the balance sheets of Beta Limited and comment on its financial position.

Solution

The financial position of Beta Limited has improved by R62 000 from 2009 to 2010.

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Beta Limited Balance Sheet first lists the company’s assets. According to R. Libby, P.A. Libby
and D.G. Short, assets are economic resources owned by the entity. It next lists its liabilities and
stock holders’ equity. They are the sources of financing or claims against the company’s
economic resources – financing provided by creditors creates a liability.

Financing provided by owners creates owners’ equity. Since each asset must have a source of
financing, a company’s assets must, by definition, equal its liabilities and stockholder’s equity.
This basic accounting equation, often called the balance sheet equation, is written:

Asset = Liabilities + Stockholder’s Equity

Economic Resources Sources of financing for economic resources.

(e.g. Cash, inventory) Liabilities: From creditors

Stockholders’ Equity: From stockholders

Assets are the economic resources owned by the company. Every asset on the balance sheet is
initially measured as the total cost incurred to acquire it.

Liabilities are the company’s debts or obligations. Under the category Liabilities, two items are
provided: current and non-current liabilities.

Stockholder’s equity indicates the amount of financing provided by owners of the business and
earnings. It comes from two sources: (1) contributed capital, or the investment of cash and other
assets in the business by the owners, and (2) retained earnings, or the amount of earnings
(profits) reinvested in the business (and thus not distributed to stockholders in the form of
dividends).

Assets

The non-current assets (Property, plant and equipment) of Beta Limited have deteriorated from
2009 to 2010, whereas its current assets and the total assets have improved from 2009 to 2010.

Equity and Liabilities

The ordinary share capital has remained constant from 2009 to 2010.

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The value of retained earnings and shareholder’s equity has deteriorated from 2009 to 2010. The
value non-current and current liabilities have improved from 2009 to 2010.

Finally it can be deduced from the balance sheet that the overall financial position of Beta
Limited has improved from 2009 to 2010 by R 62 000.

Question 5
5.1 Information

SD Enterprises has the option to invest in machinery in projects A and B but finance is only
available to invest in one of them. You are given the following projected data:

Project A Project B

(R) (R)

Initial cost 302 000 150 000

Net profit:

Year 1 12 000 70 500

Year 2 25 000 70 500

Year 3 34 000 70 500

Year 4 43 000 70 500

Year 5 4 000 -

Additional information
1. All cash flows take place at the end of the year except the original investment in the
project which takes place at the beginning of the project.
2. Project A machinery will be disposed of at the end of year 5 with a scrap value of R42
000.
3. Project B machinery will be disposed of at the end of year 4 with a nil scrap value.
4. Depreciation is calculated on a straight line basis.
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5. The discount rate to be used by the company is 12%.
REQUIRED
5.1.1 Calculate the payback period for both projects.
(Answer must be expressed in years and months.)
5.1.2 Calculate the accounting rate of return (on average investment) for project B.
(Answer expressed to 2 decimal places)

5.1.3 Calculate the net present value of each project. (Round off amounts to the
nearest Rand)
5.1.4 Using your answers from question 5.1.3, which project should be chosen? Why?

Solution

For Project A,

Initial cost or initial investment = R 302 000

Project A machinery will be disposed of at the end of year 5 with a scrap value of R42 000

Depreciation = (Initial cost – Scrap value) / no. of years = (302 000 – 42 000) / 5 = 52 000

Cash Flow = Profit + Depreciation

Cash Flow for Project A

Depreciation for
Profit for Project A Project A Cash flow for Project A
Year 1 12 000 52 000 64 000
Year 2 25 000 52 000 77 000
Year 3 34 000 52 000 86 000
Year 4 43 000 52 000 95 000
Year 5 4 000 52 000 56 000

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5.1.1 Payback Period for Project A

Initial cost (302 000)


Year 1 64 000
(238 000)
Year 2 77 000
(161 000)
Year 3 86 000
(75 000)
Year 4 95 000
20 000

The payback period for project A = 3 years (75 000 / 95 000 * 12) = 3 years 9.5 months

For Project B,

Initial cost or initial investment = R 150 000

Project B machinery will be disposed of at the end of year 4 with a nil scrap value

Depreciation = (Initial Cost – Expected Scrap value) / No. of years = (150 000 – 0) /4 = R 37 500

Cash Flow = Profit + Depreciation

Cash Flow for Project B

Depreciation for
Profit for Project B Project B Cash flow for Project B
Year 1 70 500 37 500 108 000
Year 2 70 500 37 500 108 000
Year 3 70 500 37 500 108 000
Year 4 70 500 37 500 108 000

5.1.1 (Continued) Payback Period for Project B

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Initial cost (150 000)
Year 1 108 000
(42 000)
108 000

The payback period for Project B = 1 year (42 000 / 108 000) *12 = 1 year 4.7 months

5.1.2 The Accounting rate of return (on average investment) for project B.

ARR = (Average Profit / Average Cost) * 100

Average profit = R 70 500

Average cost = (Initial cost + Scrap value) / 2 = (150 000 +0) / 2 = 75 000

ARR = (Average Profit / Average Cost) * 100

ARR = (70 500 / 75 000) * 100 = 94% or 0.94

5.1.3 The net present value of project A

Cash flow – Depreciation = Profit

Cash flow = Profit + Depreciation

Depreciation = (Initial Cost – Expected Scrap value) / No. of years

Depreciation for project A = (302 000 – 42 000) / 5 = 52 000

A scrap value in this case, R42 000 is taken as an inflow in the last year.

Cash Flow for Project A

Depreciation for
Profit for Project A Project A Cash flow for Project A
Year 1 12 000 52 000 64 000
Year 2 25 000 52 000 77 000
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Year 3 34 000 52 000 86 000
Year 4 43 000 52 000 95 000
Year 5 4 000 52 000 56 000

Discounted Cash Flow


Statement

Product of cash flow &


Cash flow for Project A D.F D.F
Year 1 64 000 0.8929 57145.60
Year 2 77 000 0.7972 61 384.40
Year 3 86 000 0.7118 61 214.80
Year 4 95 000 0.6355 60 372.50
Year 5 56 000+42 000 = 98 000 0.5674 55 605.20
Less initial
investment ( 302 000)
NPV R (6 277.50)

Project A has a negative NPV, therefore it should be rejected.

5.1.3 (Continued) The net present value of project B

Cash flow = Profit + Depreciation

Depreciation = (Initial Cost – Expected Scrap value) / No. of years

Depreciation for project A = (150 000 – 0) / 4 = 37 500

Cash Flow for Project B

Depreciation for
Profit for Project B Project B Cash flow for Project B
Year 1 70 500 37 500 108 000
Year 2 70 500 37 500 108 000
Year 3 70 500 37 500 108 000
Year 4 70 500 37 500 108 000

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Discounted Cash Flow
Statement

Cash flow for Project B D.F Product of cash flow & D.F
Year 1 108 000 0.8929 96 433.20
Year 2 108 000 0.7972 86 097.60
Year 3 108 000 0.7118 76 874.40
Year 4 108 000 0.6355 68 634.00
Less initial
investment (150 000)
NPV R 178 039.20

Project B has a positive NPV (of R 178 039.20), therefore it should be accepted.

5.1.4 Since Project B has a positive value of NPV, therefore it should be chosen.

Also project B has a high value of ARR of 94%, the higher the ARR, the more attractive is the
project therefore it should be accepted.

5.2 Information

A machine with a purchase price of R280 000 is estimated to eliminate manual operations
by R86 000 per year. The machine will last 5 years and have no residual value at the
end of its life.

Required
Calculate the internal rate of return.
Solution

The Internal Rate of Return, by trial and error:

Initial Cost 280 000


Net Profit D.F = 10% D.F = 20%
Year 1 86 000 0.9091 78 182.6 0.8333 71 663.8
Year 2 86 000 0.8264 71 070.4 0.6944 59 718.4
Year 3 86 000 0.7513 64 611.8 0.5787 49 768.2
Year 4 86 000 0.683 58 738 0.4823 41 477.8
Year 5 86 000 0.6209 53 397.4 0.4019 34 563.4
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326 000.2 257 191.6
(280 000) (280 000)
46 000.2 (22 808.4)
Using IRR Formula

IRR = A + [a / (a - b) * (B – A)]

IRR = 10% + [46 000.2 / (46 000.2 - -22 808.4) * (20% - 10%)] = 10% + 6.69% = 16.7%

Therefore, the internal rate of return is equal to 16.7%

6.0 Bibliography

1. Frank Wood & Alan Sangster (eds) (2008) Business Accounting 2. Pearson Education
Ltd, Edinburgh Gate Harlow, Essex CM 20 2JE England.

2. Kaplan (eds) (2009) ACCA - The Association of Chartered Certified Accountants-


Official Test for the Professional Qualifications. Paper F5. By Kaplan Publishing U.K.

3. Terry Lucey (eds) (2003) Management Accounting. The Tower Building, 11 York Road,
London SE1 7NX. 370 Lexington Avenue, New York, NY 10017-6503

4. R. Libby, P.A. Libby & D. G. Short (eds) (2009) Financial Accounting. McGraw – Hill
Irwin, International Edition. Avenue of the Americas, New York. NY 10020.

5. Principlesofaccounting.com [Online]. Available from:


http://www.principlesofaccounting.com/chapter%2021.htm. [Accessed : 17 April 2011]

6. Tutor2u [Online]. Available from:


http://tutor2u.net/business/production/break_even.htm [Accessed : 17 April 2011]

7. 12Manage.The Executive Fast Track. Available from:


http://www.12manage.com/methods_porter_five_forces.html [Accessed : 17 April 2011]

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