LEARNING MEDIA

APPLIED MANAGEMENT ACCOUNTING AND FINANCE

MAF 402

MODULE 2 – 2020
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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

Zimbabwe Certificate in Theory of Accounting (CTA) – FULL-TIME

Applied Management Accounting and Finance (MAF402)

Applied Management Accounting and Finance All rights reserved. No part of this
Module and Question Bank publication may be reproduced, stored in a
retrieval system or transmitted, in any
1st Edition 2017 form or by any means, electronic,
2nd Edition 2018 mechanical,
photocopying, recording or otherwise,
3rd Edition 2019 without the prior written permission of
4th Edition 2020 CAA Learning Media.
Published and Printed in Zimbabwe by We are grateful to the Institute of
Chartered Accountants of Zimbabwe
CAA Learning Media (ICAZ) for permission to reproduce past
2nd Floor Strachans Building examination questions. The suggested
solutions in the practice answer bank have
66 Nelson Mandela been prepared by CAA Learning Media,
Harare unless otherwise stated.
Zimbabwe

www.caa.ac.zw
[email protected]

CAA Learning Media is an ICAZ Approved Learning Partner. This

means we work closely with ICAZ to ensure this Study Text contains
the information you need to Adequately prepare for your CTA
Examinations and ultimately ICAZ ITC.
In this Study Text, which has been reviewed by the CAA
examination team, we:
• Highlight the most important elements in the syllabus and the
key skills you need
• Signpost how each chapter links to the syllabus and the study
guide
• Provide lots of exam focus points demonstrating what is
expected of you in the exam
• Emphasise key points in regular fast forward summaries
• Test your knowledge in quick quizzes
• Examine your understanding in our practice question bank
• Slides, video material accessible through MyCAA learning portal
supports this module

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

Table of Contents
Introduction and Welcome ....................................................................................................... iv
Study Unit 1: Transfer Pricing .................................................................................................... 1
Study Unit 2: Performance Evaluation..................................................................................... 28
Study Unit 3: Treasury, Financial Risk Management & International Finance ........................ 61
Study Unit 4: Dividend Decision............................................................................................... 82
Integrated Question Bank ...................................................................................................... 103

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

A1. Introduction and Welcome

Note from the Management Accounting and Finance Team

Congratulations on successful enrolment for the CTA Fulltime program and wishing you all
the best in the examinations. CTA is not an easy course but as you have made it from a long
history of courses and exams some of which were extremely difficult, we believe that you
have what it takes to pass it. This module has been written to help you in your preparation of
your CTA examinations. It is important for you to ensure that you grasp the principles and the
integration that is needed in the CTA examination. As CAA we are proud to partner ICAZ in
delivering the Zimbabwean CTA Course.

What is Management Accounting and Finance (MAF)?

MAF is concerned with providing both financial and non-financial information that will help
decision makers to make the best decisions in the interests of their organisations. In order
to understand MAF, you need to understand the decision-making process, and also be
aware of the various users of accounting information.

We will take this opportunity to take you through a model study technique that you can
adopt during the course of the year.

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

Study technique

NB: This is a model study technique. Different people will have different styles of studying
and hence must tweak this model to fit their personal styles.

1. LECTURES
1.1. Pre-read the section that will be lectured in the week.
1.2. Watch the video lecture for the week’s topic
1.3. Note down any points which you do not understand.
1.4. Attend the lecture and be attentive (take down notes).
2. AFTER LECTURE
2.1. Revise the lecture including your lecture notes.
2.2. Attempt the lecture examples and note what you don't understand.
2.3. Attempt one of your tutorials to see if you understand the topic (note down
anything you don't understand or identify what you are always missing out).
3. DOING TUTORIALS
3.1. Do tutorials prior to going for your tutorial.
3.2. Attempt the seen tutorials first and then the Unseen i.e. do the tutorials where you
have the solution.
3.3. Do all tutorials blind i.e. do not look at solutions.
3.4. Stick to the time allocated for the tutorial question i.e. 1.5 minutes per mark.
3.5. After the time limit continue writing with a different colour pen.
3.6. Mark your tutorial against the solution and identify:
3.6.1. Where you are losing marks after the time limit then you have a time
problem. Work on your time.
3.6.2. Where you are losing marks within the time limit then you have concept
problems.
3.6.3. Note down what you don't understand and write down the principles
regarding the issues you don't understand.
3.6.4. Participate in the tutorial and ask questions on the issues you don't
understand down what you don't understand.
4. ATTEMPTING QUESTIONS
4.1. Use about 10% of the allocated time to read the question and plan.
4.2. Read the given information for the first time.
4.3. Read the given information in detail for a second time and underline or highlight the
key points.
4.4. Read all the required questions briefly and see whether there are linkages between
the questions.
4.5. Also identify questions which are not linked and can be answered in isolation. This
helps identify easy marks.
4.6. Read the first required in detail:
4.6.1. Highlight the key points the question requires you to address (therefore do
not do what the question is not asking as this will lead to time wasting).

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

4.6.2. Determine whether you have identified all the information to answer the
question.
4.6.3. Attempt to answer the question.

Lecturers
Name Contact details
Elliot T. Wonenyika CA(Z) [email protected]
(04) 702532/5, +2638644121786
Elles Mukunyadze CA(Z) [email protected]
(04) 702532/5, +2638644121786
Mutsawashe Mubaiwa [email protected]
(04) 702532/5, +2638644121786
Innocent Sithole [email protected]
(04) 702532/5, +2638644121786

Once again, all the best and may God bless you as you engage on this journey.

Phillippians 3:13 “Brothers, I do not consider that I have made it my own. But one thing I do:
forgetting what lies behind and straining forward to what lies ahead.”

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

A2. Management Accounting and Finance Course Overview

Nature of the Course

This course is divided into two main areas.

• Financial Management
• Management Accounting.

Outline of the course

Management Accounting is concerned with providing both financial and non-financial

information that will help decision-makers make good decisions. In order to understand
management accounting, you need to know something about the decision-making process,
and also be aware of the various users of accounting information. (Drury, 2012).

The focus of the course is to evaluate how management accounting systems and tools can
best be used to aid decision-making to achieve the strategic goals of the company. Strategic
development as well as strategy implementation will also be considered, as well as the
consideration of good management and leadership styles. The implications of different
business contexts, competitive environments and strategies and the impact of these on the
application of management accounting tools will also be considered. The goal of this course
is to equip students to identify and develop a company strategy in the context of a given
competitive environment, and to identify and use the various management accounting tools
to make good long-term decisions to support this strategy and in so doing maximize the long-
term profitability and sustainability of the company. Financial management refers to the
efficient and effective management of funds and resources of a corporation in such a manner
as to accomplish the objectives of the organization financial management involves planning,
organizing, directing and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It relates to applying general management principles to
financial resources of the enterprise in order to create wealth for investors. It includes how
to raise capital, and how to allocate it i.e. capital budgeting. In addition to long term budgeting
it also relates to the allocation of short-term resources such as current assets. It also deals
with the dividend policies of the shareholders. In summary financial management is the study
and implementation of 3 key decisions: investment, finance and dividend.

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Scope

1. Investment decisions includes investment in fixed assets (known as capital budgeting).

Investment in current assets is also a part of investment decisions called working capital
decisions.
2. Financing decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and the
returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
I. Dividend for shareholders- Dividend and the rate of it has to be decided.
II. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.
The objectives are:

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders this will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized
in the maximum possible way at the least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that an
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

Prescribed Textbooks
Man Acc:
Colin Drury (2012). "Management and Cost Accounting". 8th South African Edition, South-
Western Cengage Learning. This textbook is the same textbook as was prescribed for
Management Accounting and Finance III.

Finance:
Carlos Correia, Enrico Uliana & Michael Wormald (2011). "Financial Management". 7"'
Edition, Juta. This textbook is the same textbook as was prescribed for Management
Accounting and Finance III.

6. Test bank questions and recommended self-study questions:

Test bank questions are a combination of tests and exams from prior years. It is
recommended that these questions are completed;

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

a) on your own
b) without looking at the solution, and
c) under time constraints
Students who wish to attempt further questions are encouraged to complete additional
questions from the prescribed textbooks. Many of these questions have solutions at the back
of the same textbook or in the student's manual that-accompanies the textbook.

7. Tests and Examinations

There will be three Semester class tests during the year, as well as 2 exams. The composition
of the final year mark is in your general information pack

8. Consultations

Presenters on the course will schedule student consultation times on a weekly basis. The
academic trainees involved on the program will also be available for consultation.
Consultation times and booking schedules will be found outside the relevant presenter or
academic trainee office.

9. General

Many students have experienced difficulties with passing Management Accounting and
Finance IV and past statistics indicate a pass rate of between 35%-50%. This means that, on
average, at least 50% of students fail the course. There are a number of reasons we have
identified for these statistics. Firstly, students do not spend sufficient time studying for this
course. In this regard students should ensure that they attend lectures and tutorials, read the
prescribed textbook and additional material.

Secondly, students sometimes audit the solutions to their tutorials, as opposed to doing them
under time pressure in the absence of the solution. Students therefore lose the benefit of the
learning experience and are misled as to the completeness of their understanding and exam
readiness. Another problem is that students study topics in isolation and therefore do not
consider how topics interlink until they are faced in the exam with an integrated question.
Therefore, it is important that students consider the integration between topics as they study
them.

10. Access to MyCAA

Access to MyCAA will be granted at the beginning of the year. Through MyCAA students will
have access to slides, tutorial questions, videos as well as other material relating to the
course. Important announcements and administrative arrangements will be posted on
MyCAA therefore please check it regularly.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

Course Outline
1. SEMESTER ONE

1.1. Block One

1.1.1. Corporate Strategy
1.1.2. Enterprise Risk Management
1.1.3. Financial Statement Analysis
1.1.4. Working Capital Management
1.1.5. Cost Classification
1.1.6. Inventory Costing
1.1.7. Activity-based Costing
1.1.8. Cost Volume Profit Analysis
1.1.9. Cost of Capital and Capital Structure

1.2. Block Two

1.2.1. Relevant Costing and Constraint Optimization
1.2.2. Capital Investment Appraisal
1.2.3. Capital Investment Appraisal – Risk and Uncertainty
1.2.4. Business Valuations
1.2.5. Mergers and Acquisitions

2. SEMESTER TWO

2.1. Block Three

2.1.1. Standard Costing
2.1.2. Performance Evaluation
2.1.3. Transfer Pricing
2.1.4. Treasury, Financial Risk Management and International Finance
2.1.5. Dividend Policy

2.2. Block Four

2.2.1. Revision for End of Year Exams

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

A3. Overview of the Management Accounting and Financial Management Syllabus

Management Accounting and

Finance

A. Management Accounting B. Financial Management C. Auxillary Subjects

Information systems,
technology, culture, ethics,
organisation, environmental
factors, communication, report
writing, legal and political
environments

A. Management Accounting

A1. Cost A2. Planning and A3. Decision

Accounting control making

Design and analysis of cost Relevant costing, planning

Strategy formulation,
accounting systems product/ tools, optimisation of
budgeting, variance analysis,
bottlenecks and constraints,
activity/process/ job/ performance evaluation of
pricing decisions, analytical
managers vs. divisions
service costing methods methods

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 APPLIED MANAGEMENT ACCOUNTING AND FINANCE – MODULE 2 MAF 402

B. Financial Management

B1. Investments B1. Markets

Project analysis, valuation,

capital budgeting, working
capital policies and B1.1 Finance B1.2 Treasury
management, growth and
ratio analysis

Source of finance, capital

Cash and foreign
structure and financial
exchange management,
distress, dividend policy,
exchange rate and interest
cost of capital short and
rate risk management
long term deb

A1.1 Structure of the Syllabus

Objectives
The objectives have been formulated to develop core competence (the acquisition of
knowledge, skills and values) in the field of management accounting and financial
management.

Levels of learning
The ITC syllabus defines levels of learning giving a list of “action verbs” for each level. These
are summarised as follows:

Level 1 - Knowledge and comprehension

Level 2 - Application and analysis
Level 3 - Integration

The above terms can be illustrated as follows:

Level 1 – the candidate should be able to:

• Understand the terms and be able to describe what it is.

Level 2 – the candidate should be able to:

• Identify the underlying problem; and
• Perform a simple calculation.

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Level 3 - the candidate should be able to:

(Level 1 and level 2 knowledge and application is expected, and candidates should also be
able to do the below)
• Perform complex calculations; and
• Answer an integrated question relating to the specific topics.

MANAGEMENT ACCOUNTING
Management accounting utilizes cost and other relevant data for the purposes of planning,
control and decision making. As management accounting and planning and control are so
closely interrelated that it is difficult to differentiate between the two areas, no attempt is
made to distinguish between them in this syllabus. Cost is concerned with the process of
ascertaining the cost of products or services for use in management, planning and control.
There continues to be much criticism of the state of management accounting worldwide. One
reason for this is that distortions are imposed by external financial requirements. The syllabus
attempts to avoid these distortions by focusing on the information required by management
decision-makers. The curriculum confines the environment to manufacturing, service and
retail organisations. In particular, a greater emphasis on management of the business by
recording, evaluating and interpreting costs, rather than the more narrow emphasis on
control of costs is adopted. Attention must also be paid to the advances in manufacturing and
information technology and the impact that these advances have on conventional approaches
to the practice of management accounting.

Aims
A1. Cost accounting: To gain an understanding of costing concepts and their application in
the design, implementation and operation of costing systems.

A2. Planning and control: To develop the ability to devise appropriate indicators of
performance, to measure and evaluate management performance and provide information
for management control.

A3. Decision making: To develop the ability to identify relevant information and provide
information for decision making and system design.

Objectives

Candidates should be able to do the following:

• Design and evaluate costing systems appropriate for various types of organisations
and processes;
• Calculate, record and report information necessary for effective cost management;
• Apply cost management techniques which achieve the strategic objectives of the
business;
• Advise on the issues and principles of control centers; and
• Build and manipulate simple financial models and test assumptions.
• Provide appropriate information for decision making.

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Knowledge
Level
Cost accounting
Nature of costs
▪ Cost classification 3
▪ Cost behaviour 3
▪ Cost-volume-profit analysis 3
▪ Cost estimation
o High-low 3
o Scattergraphs 1
o Regression 1
▪ Cost objects 3
▪ Joint and by-products 3
The focus will be on the relevance and allocation basis of costs, not
financial accounting recording thereof. The focus in respect of joint and by-
products will be on the significance of the costs from a decision-making
perspective, not on the allocation thereof
Costing and cost management: Material
▪ Recording material costs (direct and related) 3
Is required as base knowledge for other areas – will not be specifically
examined
▪ Bases of inventory valuation
o FIFO 3
o Weighted average 3
o Standard cost 3
o Specific identification 3
Inventory valuation bases will not be examined beyond knowledge level 1.
Material cost will only be examined to the degree that as part of total cost
it may influence decisions under consideration or performance
management
Costing and cost management: Labour
▪ Recording labour costs’ 3
Is required as base knowledge for other areas – will not be specifically
examined. Labour costing only to be examined to the degree that as part
of total cost it may influence decisions under consideration or performance
management
▪ Bases of assigning costs 3
▪ Time 3
▪ Piece 3
▪ Management of labour costs 3
Costing and cost management: Overheads
▪ Recording overhead costs 3

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Knowledge
Level
Is required as base knowledge for other areas – will not be specifically
examined
▪ Bases of assigning overheads to cost objects 3
o Absorption vs variable costing
o Traditional volume-based measures
o Activity-based costing and cost drivers
Product or service costing
▪ Types of costing systems 3
o Job costing (batch costing)
o Process costing systems
Is required as base knowledge for other areas – will not be specifically
examined. Emphasis should be placed on the principal of equivalent units
and the impact of spoilage on product costs
▪ Information technology implications (integration) 1
Planning and control
Budgeting and control
▪ Corporate strategy and long-term planning (as it relates to budgeting)
1
o Value chain
o Supply chain 1
▪ Budgeting
o Responsibility centres 3
o Behavioural aspects 2
o Master, capital, cash and subsidiary budgets 3
o Fixed and flexible budgeting 3
o Zero-base budgeting 1
o Activity-based budgeting 1
o Rolling forecasts 1
▪ Cost management 1
o Activity-based management
o Business process re-engineering
o Total quality management
o Costs of quality
o Just In time
o Target costing
o Life cycle costing
Standard costing
▪ Design of standard costing systems 3
▪ Variance analysis (calculation and interpretation of variances)
3
Capacity, efficiency and idle time variances will not be examined
▪ Reporting on variance analysis 3
▪ Reconciliation of budget to actual 3
▪ Investigation of variances 1

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Knowledge
Level
▪ Pro-rating of variances and compliance with the relevant accounting
standard 3
Performance management
▪ The role of decentralised control 3
▪ Responsibility accounting 3
▪ Performance measurement and incentivisation of managers
3
o Possible performance measures
o Including economic value added and market value added 2
o Advantages and disadvantages of each 3
o Behavioural aspects 3
o Incentivisation (long-term reward strategy) 2
o Share based compensation (see Section III - Accounting and external 2
reporting, for reporting requirements)
▪ Transfer pricing 2
See taxation syllabus for tax implications. Focus will be on the behavioural
aspects of transfer pricing as well as the calculation of minimum and
maximum transfer prices
▪ Non-financial performance measures including environmental, social, 2
and governance factors
▪ Balanced scorecard 1
▪ Benchmarking 1
Decision making
▪ Criteria for relevant information 3
▪ Application to decisions 3
o Pricing (long-term and short-term pricing, relevant costing) 3
o Capacity utilisation 3
o Scenarios
o Special orders 3
o Make or buy 3
o Product mix 3
o Theory of constraints 1
o Sell or process further 3
o Product line decisions 3
o Adding / dropping parts of operation 3
o Identification of the requirement for, and the ability to apply, the
following decision-making criteria: 3
o Contribution per unit of limiting factor 1
Doing linear programming is not required. The focus will be on the
circumstances under which linear programming would be required to solve
a multi-product, multi-constraint scenario and which elements are
required to do the programming (instruct the tool). Candidates must also
be able to interpret the results of such linear programming. In other
words, candidates are required to consider and conclude on whether linear

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Knowledge
Level
programming is required, but the execution thereof is excluded from the
core competencies

▪ Short-term vs long-term implications and relationship and integration 3

with capital budgeting
o Including an analysis on the six capitals from a short- and long-term 3
perspective in line with the company’s strategy
▪ Sensitivity analysis (application of CVP to decision making) 2
▪ Risk and uncertainty (in the context of management accounting and
decision making) 2

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FINANCIAL MANAGEMENT
Financial management relates broadly to the making of investment and financing decisions
within the context of strategic management. Investment decisions are necessary for both fixed
and current operating assets as well as for financial assets. All investment decisions take place
within the context of portfolio theory. Financing decisions require insight into both capital and
money markets in the context of optimal capital structures and cost of capital theory and may be
seen to include the dividend decisions.
Certain prerequisite knowledge is required in order to apply the concepts and techniques of
financial management. Financial accounting is closely related to financial management in that it
provides information for financial decisions and reflects the financial effects resulting from those
decisions.

Aims

B1. To gain an understanding of the investment, financing and dividend decisions relating to the
enterprise and its activities, within the context of its environment. To develop the ability to make
recommendations designed to responsibly manage the entity through effective use of financial
resources and in accordance with the strategic objectives of the firm.

B2. To gain an understanding of markets specifically the finance and treasury sides.

Objectives
Candidates should be able to do the following:
• Identify and interpret appropriate measures of performance, risk and uncertainty;
• Advise on the investment, financing and dividend decisions;
• Apply the principles of finance to the valuation of a business entity and to the valuation of
financial assets using appropriate techniques;
• Advise on management of working capital;
• Advise on change in ownership transactions; and
• Evaluate and select appropriate financing instruments for effective risk minimisation.

B. FINANCIAL MANAGEMENT
Knowledge
Level
Function of financial management
▪ Objective of the firm 2
▪ Sustainable wealth creation
▪ Shareholder value maximisation
▪ Other financial and non-financial objectives
▪ Forms of business organisations
▪ Environmental, social and governance factors
▪ Efficiency of markets

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Knowledge
Level
▪ Socio-economic conditions
▪ Shareholders vs management

This section must be read together with the Strategy, Risk Management
and Governance knowledge list
Analysis of financial information
▪ Objective of analysis 2
▪ Calculation and interpretation of ratios 3
▪ Discussion and conclusion 3
Analysis of non-financial information
▪ Contents of the integrated report in terms of strategy and risk 2
▪ Ratios and targets 2
▪ Interpretation 2
Businesses in difficulty
▪ Business recovery and restructuring
▪ Tools used to measure performance of a business 1
▪ Strategies for avoiding and dealing with business failure 1
▪ Refinancing a business (specifically as it relates to businesses in difficulty) 1
▪ Companies Act requirements relating to business rescue 1
Valuations
▪ Valuation of –
▪ equity shares 3
▪ preference shares 3
▪ debentures and bonds 3
▪ convertible securities 1
▪ options (including the use of the Black-Scholes model – understanding 1
how model works, numbers to be provided, only include Black
Scholes model to the extent of understanding how changes in the key
drivers impact option value)
▪ Selection of the appropriate valuation basis:
▪ Earnings 3
▪ Dividend growth model 1
▪ Net assets (incorporating liquidation basis) 3
▪ Free cash flow 3
▪ Market-based approaches (e.g. market to book ratio, price to sales 2
ratio, EBIT, EBITDA)
▪ Valuations for mergers 3
▪ Qualitative factors for valuations 3

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Knowledge
Level
Risk and return
▪ Risk assessment 2
▪ Business risk and financial risk
▪ Unsystematic and systematic risk
▪ Return
▪ Measurement of return
▪ Portfolio theory (effect of portfolio diversification, systematic risks ‒ no 1
calculations required)
The cost of capital
▪ Cost of debt 3
▪ Cost of preference shares 3
▪ Cost of equity
▪ Consider factors affecting cost of equity (such as dividends, and the 3
capital asset pricing model (including asset specific betas))
▪ Weighted average cost of capital (including consideration of the 3
appropriateness of using WACC)
▪ Project specific cost of capital 3
▪ Asset betas 2
▪ Interaction of the investment and financing decisions 2
▪ Cost of capital for foreign investments 2
Capital investment appraisal
▪ Capital budgeting decisions 3
▪ Replacement
▪ Acquisition of new capital assets
▪ Strategic management decisions
▪ Capital budgeting techniques
▪ Payback and discounted payback 3
▪ Net present value 3
▪ Internal rate of return 3
▪ Accounting rate of return 3
▪ Modified internal rate of return (no calculation) 1
▪ Issues in investment appraisal
▪ Differing project life cycles 3
▪ Capital rationing 3
▪ Possibility of abandonment or expansion 3
▪ Impact of inflation 3
▪ Analysis of and allowance for risk 2
▪ Probabilities and decision trees 1
▪ Sensitivity analysis (including the use of equivalent annual annuities) 3

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Knowledge
Level
▪ Scenario and Montecarlo analysis 1
▪ Qualitative factors 3
▪ Post-investment audit 1
▪ International capital budgeting 2
▪ Sustainability factors 1
Sources and forms of finance
▪ Capital and money markets as potential sources of finance 2
▪ Identification of possible markets and most appropriate market 2
▪ Basic understanding of the workings of capital and money markets 1
▪ The theory of capital structure 2
▪ Long- and short-term finance 2
▪ Asset securitisation 1
▪ Discounting and factoring of accounts receivable 1
▪ Leasing vs borrowing 2
▪ Foreign finance 2
The dividend decision
▪ Factors affecting the dividend decision 2
▪ Relevance and irrelevance theories 2
▪ Setting appropriate dividend policies 2
▪ Scrip dividends 2
▪ Share buy-backs 2
Management of working capital
▪ Accounts receivable (excluding discounting and factoring which are 3
included under sources and forms of finance above)
▪ Inventories (including a basic knowledge of EOQ) 3
▪ Accounts payable 3
▪ Working capital cycle 3
Treasury function
▪ Role of treasury 1
▪ Cash management (excluding Baumol & Miller-Ore) 3
▪ Workings of foreign exchange and interest rates 2
▪ Understanding risks related to – 2
▪ foreign exchange
▪ interest rate
▪ duration
▪ refinancing and liquidity risks
▪ Hedging and risk management
▪ Operational hedges (natural hedges) 2
▪ Forwards (e.g. FECs) 2

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Knowledge
Level
▪ Futures 2
▪ Options 2
▪ The use of caps, floors and collars in relation to interest rates 1
(excluding the pricing thereof, as well as the offsetting of risk from
the perspective of the financial institution)
▪ Swaps (no detailed calculations for interest rate swaps) 1
Note:
The candidates must be aware of and understand the drivers of value of the various
derivatives. In particular the drivers of value of FECs and interest rate swaps need to be
understood in order to support financial reporting requirements. (See the Accounting and
External Financial Reporting examinable pronouncements for the level at which the
accounting implications of derivatives are required)

For the purposes of the competency framework, derivatives are included from the
perspective of their role in risk management. While speculation and trading strategies are
excluded from the core competencies and this knowledge list, it is important that
candidates are able to discriminate between instances of hedging and speculation.
Mergers, takeovers and divestitures
▪ Strategic context 1
▪ Behavioural implications (including defensive strategies) 1
▪ Growth strategies of the predator 1
▪ Legal implications 1

▪ Impact on pricing considerations 2

▪ Impact of synergy
▪ Financing considerations 2
▪ Effects on EPS and NAV 2
▪ Management buy-outs 2
▪
1
▪ Post-acquisition review 1
▪ Due diligence 1

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CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING AND FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 1: TRANSFER PRICING

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Contents
1. INTRODUCTION ............................................................................................................................... 3
2. Unit Objective ................................................................................................................................. 3
3. Study material ................................................................................................................................. 3
4. Competence Framework expectation ............................................................................................ 4
5. Examination possibilities................................................................................................................. 4
6. Assumed Knowledge ....................................................................................................................... 4
7. Integration ...................................................................................................................................... 5
8. Course notes ................................................................................................................................... 5
8.1. What is transfer pricing? ............................................................................................................. 5
8.2. Goals of transfer pricing.............................................................................................................. 6
8.3. Purpose of transfer pricing ......................................................................................................... 7
8.4. Type of transfer pricing methods: .............................................................................................. 7
8.5. Resolving transfer pricing conflicts ........................................................................................... 13
8.6. International Transfer Pricing ................................................................................................... 14
9. Practice Questions ........................................................................................................................ 16

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1. INTRODUCTION
The use of financial measurement tools to evaluate divisional
performance will take a different angel when divisions transfer
goods and services to each other. In this type of organisation set-up
the established transfer price is a cost to the receiving division and
revenue to the supplying division, which means that whatever price
is set affect the profitability of each division. The transfer pricing
decision will influence each division’s input and output decision, and
thus total company profits. The most important principle in transfer
pricing is to determine a transfer price that will encourage divisional
managers to take actions that will improve reported profits of their
divisions and at the same time also improves the profits of the
company as a whole.

2. Unit Objective
After studying this unit, you should be able to:

• describe the different purposes of a transfer pricing system;

• identify and describe five different transfer pricing methods;
• explain why the correct transfer price is the external market price when there is a
perfectly competitive market for the intermediate product;
• explain why cost-plus transfer prices will not result in the optimum output being
achieved;
• Determine the minimum and maximum transfer price
• explain two methods of transfer pricing that have been advocated to resolve the
conflicts between the decision-making and performance evaluation objectives;
• describe the additional factors that must be considered when setting transfer prices
for multinational transactions.

3. Study material
• Collin Drury Chapter 20 (10th Edition)
• Video Lecture
• CAA Applied Management Accounting and Finance MAF 402 Module 2

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4. Competence Framework expectation

Management Decision Making and Control
VI-3 Evaluates internal cost allocation and transfer pricing options
VI-3.1 Evaluates transfer pricing options between operational divisions
Level X
Evaluates transfer pricing options with consideration to –
• the entity’s operating environment and strategies
• decision-making consequences
• motivational factors and performance evaluation of the respective divisions
and other units comprising the entity’s organisational structure

Identifies the transfer pricing options (e.g. market price, negotiated price, cost-
based) that are suitable and recommends a course of action

5. Examination possibilities
Decision Explanation
Determine the optimal production to Normally this would apply in a divisionalised
maximise company profit set-up and students will be expected to
company up with production output that
would enable the company to achieve the
highest profit. To enable the student to
determine this, they would also be expected
to determine the transfer price from the
receiving department, which is normally the
variable cost-plus opportunity cost of the
transferring department.
Determine the minimum and maximum The key is to encourage optimal decision
transfer price to be charged making at divisional level which will ensure
between/amongst transferring divisions profitability at division level and company
which will enable the maximisation of level.
company profits.

6. Assumed Knowledge
The following is assumed knowledge which you should already have before studying
this topic:
1. Relevant costing principles;
2. Variable costing and Absorption costing;
3. Income Tax Implications of transfer pricing;

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7. Integration
Topic Explanation
Strategy May be expected to evaluate whether a company transfer pricing
policy are in line with its overall strategic objectives.
Costing In determining appropriate transfer pricing, need to apply
principles variable costing principles and relevant costing principles
CVP Analysis Mainly relevant in determining max and min prices, as for
example the maximum price that will be acceptable by a receiving
division is the point at which they break even.
Performance Transfer pricing can be used as a tool for performance evaluation
measurement especially in situations where divisions are set-up as profit
and evaluation centres.

This topic is mainly used with reference to performance measurement and evaluation
and can is normally integrated with costing principles.

8. Course notes

8.1. What is transfer pricing?

Transfer pricing is used when divisions of an organisation need to charge other
divisions of the same organisation for goods and services, they provide to them. For
example, division A might make a component that is used as part of a product made
by division B of the same company, but that can also be sold to the external market,
including makers of rival products to division B's product. There will therefore be two
sources of revenue for A.

a) External sales revenue from sales made to other organisations

b) Internal sales revenue from sales made to other responsibility centres within the
same organisation, valued at the transfer price

Transfer Price?

Division A Division B

Market Market
Price Price

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External market for External market for final

intermediate product/service product/service

Should we even process the intermediate product/service further?

Only if incremental revenue from the final product is greater than the incremental
cost to further process the intermediate product/service.

8.2. Goals of transfer pricing

The backbone of any transfer pricing discussion question is the following three
points:

Goal congruence
This is the harmonising of managers' goals with organisation goals. The goal is to
maximise the profit of the company as a whole by making decisions that maximise
the contribution margin of the company. The only way for this to happen is for the
best decision for the manager to also be the best decision for the company.
Therefore, to achieve this goal congruence transfer pricing maybe used to determine
how much of the intermediate product will be produced by the supplying division
and how much will be acquired by the receiving division to maximise company
profits.

Performance evaluation
• Transfer price affects profit of each division, therefore has a direct effect on
performance evaluation of each division
• The transfer pricing system should be fair. Consider whether it allows for some
profit at a divisional/sub-unit level. If not, the system could be demoralising for
staff and not give a fair reflection of their efforts.
• The transfer pricing system should be economically realistic. The results of the
division should be comparable to similar stand-alone companies in order to
assess the performance of management properly.
• Finally, the transfer pricing system should encourage cost control. A transfer
pricing system that guarantees that costs will be covered by allowing the
division to add a mark-up to actual costs does not achieve this. Inefficiencies will
be passed from one division to another and will cause the results of subsequent
divisions to appear poorer than they are.

Preserving autonomy
This is the freedom of managers to operate their sub-units as decentralised entities
without undue influence from top executives. This is to help ensure that managers
are only evaluated based on what they can control.

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8.3. Purpose of transfer pricing

• Provide information that motivates divisional mangers to make good economic
decisions
• Provide information that is useful for evaluating the managerial and economic
performance of the divisions
• To intentionally move profits between divisions or locations
• To ensure that divisional autonomy is not undermined

8.4. Type of transfer pricing methods:

8.4.1. Market Based Transfer Pricing

Where there is a perfectly competitive market for the intermediate product,

the current market price is the most suitable basis for setting the transfer
prices. Thus, a transferor division should be given the freedom to sell output
on the open market, rather than to transfer it within the company.

In most cases where the transfer price is at market price, internal transfers
should be expected, because the buying division is likely to benefit from a
better quality of service, greater flexibility and dependability of supply. Both
divisions may benefit from cheaper costs of administration, selling and
transport. Using a market price as the transfer price would therefore result in
decisions which would be in the best interests of the company or group as a
whole.

Market price – Selling & distribution cost/unit = Transfer Price

However, many products do not have an equivalent market price so that the
price of a similar, but not identical, product might have to be chosen. In such
circumstances, the option to sell or buy on the open market does not really
exist. The market price may be a temporary one, induced by adverse
economic conditions or dumping, or it might depend on the volume of output
supplied to the external market by the profit centre. There might be an
imperfect external market for the transferred item so that, if the transferring
division tried to sell more externally, it would have to reduce its selling price.

Market-based transfer prices allow the supplying division to make a profit,

however the profit is unrealised from a financial reporting perspective and
must be eliminated.

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8.4.2. Marginal Cost Transfer Pricing

When the market for the intermediate product is imperfect or even non-
existent, marginal cost transfer prices can motivate both the supplying and
receiving division managers to operate at output levels that will maximise
overall company profits. The transfer price is set to equal the supplying
division’s variable cost of production. This is the theoretically correct
minimum price. The variable cost of the supplying division is the same as the
variable cost to the company. Thus, the receiving division is correctly
motivated. This is because the receiving division will make decisions that
maximise its own contribution margin, which will use the transfer price as one
of the variable costs. If the transfer price is the same as the company’s variable
cost, the receiving division will arrive at the same contribution margin as that
calculated from a company perspective. This results in goal congruence. The
problem of premature cut-off is also avoided (see note on cost plus pricing).

Variable cost/unit assumptions:

• Assumed to be equal to marginal cost/unit

• Assumed to be constant throughout the relevant output range

Economic theory indicates TP (transfer pricing) based on the MC (marginal

cost) of producing the intermediate product, will motivate the divisional
managers to operate at output levels that will maximise overall company
profits.

The receiving division will purchase the intermediate product up to the point
where netMR (marginal revenue) = MC. It will therefore be the optimal output
from the overall company perspective (Q2). If a higher transfer price is set to
cover the fixed costs or a mark-up, then the supplying division will restrict
output to the sub-optimal level (Q1).

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This method has a short-term focus, as the fixed costs of the supplying division
are not considered. Fixed costs are therefore deemed to irrelevant and
unavoidable, which is a false assumption in the long-run. Step fixed costs can
be overlooked for the entire output range. A marginal cost transfer price also
fails to provide any profit to the supplying division, which can result in
demoralisation as the supplying division is essentially being forced to make
sales at a loss (equal to Fixed Costs). Conversely the profit of the receiving
division will be overstated. Opportunity costs are also ignored if this method is
used.

8.4.3. Full Cost Transfer Pricing

Under this approach, the full cost (including fixed overheads absorbed)
incurred by the supplying division in making the 'intermediate' product is
charged to the receiving division. Managers view product-related decisions as
long-run decisions and therefore require a measure of long-run marginal cost.

The obvious drawback to this is that the division supplying the product makes
no profit on its work so is not motivated to supply internally. In addition, there
are several alternative ways in which fixed costs can be accounted for, which
can provide poor estimates of long-run marginal costs.

8.4.4. Cost Plus Mark-Up Transfer Pricing

Cost plus a mark-up represent an attempt to meet the performance
evaluation purpose of transfer pricing by enabling the supplying divisions to
obtain a profit at the expense of the buying division.

However, because transfer price is in excess of variable costs, this will cause
inter-divisional transfers to be less than the optimal level for the company (see
above graph). Further, short-term decision making is not supported due to the
inclusion of fixed costs. Where more than two divisions transact, then the
percentage margin will be accumulatively excessive when it reaches the final
division. Finally, financial reporting is made more difficult due to the existence
of unrealised profit in inventory balances.

It is important to consider whether actual or standard cost is to be used in the

preceding three transfer prices (Variable, Full cost- and Cost-plus transfer
pricing). The use of actual prices will not encourage cost control, as the
supplying division will always be able to pass on inefficiencies to the receiving
division. Similarly, any good cost control will be passed on the receiving
division. This does not support performance evaluation in the receiving
division.

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8.4.5. Negotiated Transfer Pricing

Managers can negotiate a single transfer price so that the overall contribution
to corporate profit from a given internal transfer would be shared between the
buying and selling divisions on some mutually agreeable basis. The underlying
assumption is, divisional managers are competent to analyse accounting
information and make decisions which maximise total company profits. It is
also a motivational tool, of giving managers full independence over their input
and output decisions.

Although this supports goal congruence, the process could be lengthy and
hindered by unequal bargaining power between the managers. It is important
that managers have equal bargaining power otherwise transfer will be based
on bargaining power or negotiating skills. Negotiations might lead to conflict
between divisions requiring top management to mediate.

8.4.6. Marginal cost-plus opportunity cost (“the golden rule”)

Setting transfer prices at the marginal (i.e. incremental) cost of the supplying
division per unit transferred plus the opportunity cost per unit of the
supplying division is often cited as a general rule that should lead to optimum
decisions for the company as a whole. Opportunity cost is the maximum
contribution forgone by the supplying division in transferring internally rather
than selling goods externally.

This rule is expressed below:

Minimum Maximum
Transfer Price ≤ Transfer Price ≤ Transfer Price

Variable Cost + Net Marginal

Opportunity Cost ≤ Transfer Price ≤ Revenue

The limits within which transfer prices should fall are as follows.
• The minimum. The sum of the supplying division's marginal cost and
opportunity cost of the item transferred.
• The maximum. The lowest market price at which the receiving division
could purchase the goods or services externally, less any internal cost
savings in packaging and delivery or its equal to the Net marginal revenue.

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The variable costs exclude any costs not incurred on internal transfers.

Opportunity cost

External Market?
If there is no external market for the item being transferred, and no
alternative uses for the division's facilities, the transfer price = standard
variable cost of production.

This is the optimal output level for the company as a whole, where:
MC of supplying division + MC of receiving division = MR of receiving division
MC of supplying division = MR of receiving division – MC of receiving division
MC of supplying division = NMR of receiving division

If there is an external market for the item being transferred and no

alternative, more profitable use for the facilities in that division, the transfer
price = the market price – selling costs.

Spare Capacity?
Whether or not there is an opportunity cost depends on the spare capacity in
the supplying division. Spare capacity is found after considering all other sales
that the supplying division would otherwise make (including special orders) i.e.
positive contribution margin.

If there is spare capacity, the opportunity cost for the units that use up this
capacity is $ Nil, the transfer price = standard variable cost of production

If there is no spare capacity, the opportunity cost is the contribution margin

that the supplying division loses out on, i.e. selling price that would have been
achieved less variable costs that would have been incurred. Thus, transfer
price = the market price – selling & distribution costs.

This means that there could be more than one minimum transfer price if the
required sales to the receiving division exceed the spare capacity.

There may be a range of prices within which both profit centres can agree on
the output level that would maximise their individual profits and the profits of
the company as a whole. Any price within the range would then be 'ideal'.

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The theory of the different transfer pricing methods discussed above may be
tested by requiring the candidate to evaluate a transfer pricing system that is
already in place or by requiring the candidate to compare two or more of the
different methods.

8.5. Resolving transfer pricing conflicts

We have established that transfers at marginal and full cost are unsuitable for
performance evaluation since they do not provide an incentive for the supplying
division to transfer goods and services internally. However, cost-plus a mark-up
creates the opposite conflict. Here the transfer price meets the performance
evaluation requirement but will not induce managers to make optimal decisions.

To resolve the above conflicts the following transfer pricing methods have been
suggested:
• Adopt a dual-rate transfer pricing system;
• Transfer at a marginal cost plus a fixed lump-sum fee.

Dual-rate transfer pricing

This is where two separate transfer prices are used, one for the supplying division and
one for the receiving division.

This can be used for the purpose of motivating the manager of the receiving division
to make the optimal economic decisions. The transfer price would be based on
variable cost. For the purpose of fairly evaluating performance of the supplying
division, the transfer price would be a market price allowing for a normal profit margin
to the supplying division.

This can achieve goal congruence in the short term, but it is not a long-term solution.
Dual transfer prices protect the divisions from competition by:

• Making it so that the supplying division is always the cheapest for the receiving
division; and
• Making it so that the price offered by the receiving division is always the highest
for the supplying division.

Thus, a false sense of profitability can be created.

Dual-rate transfer prices are not widely used in practice for several reasons. First, the
use of different transfer prices causes confusion, particularly when the transfers
spread beyond two divisions. Secondly, they are considered to be artificial. Thirdly,
they reduce divisional incentives to compete effectively and improve their
productivity. Lastly, it can result in misleading information and create a false
impression of divisional profits.

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Marginal (Variable) costs plus a fixed lump-sum fee

With this system, individual transfers will be at variable cost to the supplying division
and the lumpsum charged will be for the period. The lumpsum is to compensate the
supplying division for the capacity that it has dedicated to the receiving division.
Therefore, this method is ideal when a large amount of capacity and therefore fixed
costs are dedicated to supplying the receiving division.

The lumpsum can be based on:

• Capacity in the supplying division used to supply the receiving division:

Units transferred to
Fixed Costs in Receiving Division
Supplying x Total units produced in
Division Supplying Division

This system is intended to motivate receiving division to equate MC of

transfers with its net marginal revenue to determine optimum company profit
maximizing output level. At the same time, it enables supplying division to
cover its fixed costs and earn a profit on interdivisional Transfers through the
fixed fee charged for the period.

• Required return on capital:

Required Divisional Profit Actual Divisional Profit

_
(ROI x Net Investment) (before the lumpsum)

8.6. International Transfer Pricing

Where divisions are located in different countries taxation implications become
important and transfer pricing (TP) has the potential to ensure that most of the profits
on interdivisional transfers are allocated to the low taxation country.

Example
Supplying division in country A (Tax rate = 25.75%)
Receiving division in country B (Tax rate = 40%)

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Motivation is to use highest possible TP so receiving division will have high costs and
low profits whereas supplying division will have high revenues and high profits.

Taxation authorities in most countries are wise to companies using TP to manipulate

profits and seek to apply OECD guidelines based on arm ’s length pricing principles.
TP can also have an impact on import duties and dividend repatriations.

You also need to link to transfer pricing principles that you covered as part of your
tax syllabus.

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9. Practice Questions

Question 1: (AEDI Company Pvt Ltd) [25 Marks]

The AEDI Company (Pvt) Ltd manufactures a range of genetically modified pesticides that are
environmentally safe. One of its divisions, namely Division A, produces a product called MK-
23 that is a safe pesticide for tomato farmers. Division A has the capacity to produce 1 200
000 kilograms of this pesticide on an annual basis. Currently, the division services orders for
1 000 000 kilograms and, therefore, has some spare capacity that it would like to utilize. Just
recently, the management of the AEDI Company prepared some budgeted data for the 2018
year ahead, and this information is found in the table below:

Budgeted Data
Financial Data for Division A $ x000
Net profit after tax 1 119 (includes depreciation of 1 200)
Fixed assets less depreciation 7 200
Current assets 560
Current liabilities 300

Unit Financial Data for MK-23 $/unit

Selling price per kilogram $ 30
Variable cost per kilogram $3

Non-Financial Data for AEDI Co. %

Cost of debt (before tax) 9%
Cost of equity (before tax) 14%
Debt to equity ratio 30:70
Budget tax rate 25.75 %

Net profit after tax (NPAT) included a pre-tax charge of $2 000 000 for research and
development expenditure that will provide benefits to the company for the next five years.
Pre-tax interest of $350 000 on long term funding was also included. Furthermore, NPAT
included a pre-tax charge for depreciation of $1 200 000 that was calculated on a straight-line
basis. Depreciation, calculated on an economic basis, estimated to be $750 000.

A second division, namely Division B, has indicated that it could use some of the spare capacity
of Division A. In this regard, Division B has indicated that it can modify MK-23 to produce a
home-based pesticide sold in powder form. In order to do this, further conversion costs of $4
per kilogram are required. Division B estimates that it can sell this product for $20 per
kilogram to urban based families. This home pesticide, however, will compete with other
brands on the market and initial surveys by the marketing department indicate that the
product is price sensitive.

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The sales division estimated the demand for the home pesticide at two different selling prices:

Selling Price: $22 $20

Demand (Kg): 100 000 150 000

Division B has proposed that, because Division A has spare capacity, a transfer price for MK -
23 should be the variable cost of production per kilogram in Division A, namely, $3 per
kilogram plus a mark-up of 33 1/3 %. Division A is unhappy about this because a long-term
forecast indicates that there is 60% possibility that it can fill the spare capacity in 2021 at its
normal price of $30 per kilogram. Furthermore, it will earn very little contribution if the
transfer price is set based on Division B’s proposal. It has been estimated that if Division A
supplies between 100 000 and 200 000 kilograms to Division B, it will need to increase its
working capital level by $90 000.

You are required to:

(a) Ignoring the 60% possibility of selling the spare capacity externally, calculate the range
of transfer prices, for one kilogram of MK-23, that would motivate both divisions to
transfer and receive the optimum quantity of Division A’s spare capacity of MK-23, from
a company perspective. [12 marks]
(b) Calculate the EVA of Division A both before and after the transaction with Division B
and briefly comment on the difference. Use the transfer price calculate in a). Consider
the long-term implications of this supply relationship for Division A. [13 marks]

(Total Question: 25 Marks/60 Minutes)

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Suggested Solution

Part (a)
Step 1: Determine the optimal decision from the company’s perspective.
100 000 KG 150 000 KG
$ $
Selling price 22 20
Less
Variable Cost: DIV A 3 3
DIV B 4 4
Contribution / unit 15 13
Total Contribution $1 500 000 $1 950 000

Therefore, from a company perspective, the optimal solution is when Division B sources
150 000kg’s of MK-23 from Division A and sells it after conversion at $20 per kg.

• Division B will maximize group profit if it orders 150 000KG of MK23.

• Minimum Transfer Price = $3 (variable cost of Division A) and maximum profit for the
group is guaranteed at a transfer price of $3, as the marginal cost transfer price always
results in the optimal decision from a company’s profit perspective.
• If there was no second pricing option, the maximum transfer price would be:
Maximum transfer price is the point at which division B will achieve a minimum of zero
profit
0 = Selling Price – Variable Cost division B – Transfer price from
Division A
0 = $20 - $4 – TP
TP = $20 - $4
TP = $16
• At this transfer price, Division B would break-even, therefore any transfer price above
this would result in a loss for Division B and they would not demand any MK-3 from
Division A. However, because Division B has two pricing options, at this transfer price,
Division B would prefer to select a selling price of $22 as this would result in a profit
of $200 000 and not zero. Therefore, because there are two pricing options, the
maximum Transfer price needs to be calculated by determining the indifference point
of the two selling prices (whether it receives 150 000KG or 100 000KG).

Indifference Point: 150 000 kg x($20-$4-TP) = 100 000 kg x ($22-$4-TP)

TP = $12

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• At this transfer price Division B would be indifferent between the two selling price
options and would contribute of $600 000 whether it chooses a selling price of $20 or
$22.
• At any price below $12 Division B will order 150 000KG because this will maximise its
own divisional contribution. At any price above $12 Division B will only order 100
000KG as this will maximise the divisional profit.
• As the company’s profit is maximised when Division B sells 150 000kg at $20, the
transfer price should not exceed $12 otherwise it will select an option that is not in
the best economic interests of the company.
Therefore, the maximum Transfer Price = $12/KG of MK-23, in order to ensure that Division
B is encouraged to make the optimal decision from a company perspective.
If the 60% probability of additional external orders is ignored, Division A would also be
encouraged to make the right decision and to supply to Division B with 150 000kg, because
for every sale to Division B, Division A makes a contribution of $9 ($12-$3). If it supplies
100 000 units, it will make an additional $900 000 contribution and if it supplies 150 000 it
will make incremental contribution of $1 350 000. Therefore, any transfer price above $3
(minimum transfer price) will encourage Division A to decide to supply the optimal quantity
of MK-23 to Division B from a company perspective.
Therefore, the optimal transfer price range is between $3 and $12.
In this range, both divisions will be encouraged to transfer 150 000kg of MK-23.
Part (b)
If Division A sells 150 000KG of MK-23 to Division B it will increase Division A’s contribution
by ($12-$3) x 150 000kg’s = $1 350 000

EVA = Adjusted Net profit after tax less Return on Assets Employed (Net Assets * Cost of
Capital)

EVA Division A: Before Internal Transaction $ 000

NPAT 1 119
add back
Research and Development 2 000
less Amortisation (1/5 x 2 000 0 (400)
Interest on long-term loans (350 x 74.25%) 260
Depreciation 1 200
less Economic Depreciation (750)
Adjusted NPAT 3 429

Assets employed
Non-current assets [7 200 + 2 000 – 400 + 1 200 – 750] 9 250

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Current assets 560

less Current liabilities (300)
Net Assets Employed 9 510

Cost of Capital
0.3 x 9% (1-25.75% tax) + 0.7 x 14% 11.80%

EVA before
$3 429 000 – (11.80% x $9 510 000 $2 306 820

EVA: Division A After Transaction

(It is assumed that the full tax on transfer is born by Division A. This may not be the reality,
however there is no indication in the question).

NPAT = $3 429 000 + $1 350 000 x (100%-25.75%) $4 431 375

Assets Employed = [$9 510 000 + $90 000] $9 600 000
WACC 11.80%
EVA = $4 431 375 – (11.80% x $9 600 00) $3 298 575
EVA as a result of the internal transaction with Division B increases by $991 755 or 43%.

Other Comment
If Division A sells 150 000KG of capacity outside, it will generate 150 000 ($30-$3) x 60%
probability = $2 430 000 compared to $1 350 000. This represents an 80% increase in
contribution above that earned from sales to Division B. However, nothing in the question
indicates that Division A cannot decide at a later stage to supply to the external market.
Therefore, Division A should commence supplying Division B until outside demand becomes
available.

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Question 2: Mupfure River Company [35 marks]

The Mupfure River Company, located in Beatrice, manufactures and sells chemical
compounds that form inputs for the pharmaceutical industry. The company has been in
operation for several years and has a reputation as a reliable supplier. In recent times
transport costs to Harare have increased significantly as a result of the increased toll fees on
the Harare Masvingo highway and the increasing cost of fuel. The company’s management is
conservative and have invested considerable past earnings in government bonds.
Management, however, is worried about the long-term position of the company as the raw
material supply of its compounds is increasingly difficult to obtain.

In recent times the pharmaceutical industry has changed considerably. New entrants like
Genentec have revolutionised research and development technology to bring a new class of
drugs onto the market at much lower levels of cost. The managing director has suggested that
once internal capacity has been optimised the company should rethink the future.

Interdivisional Trading
The Mupfure River Company has four divisions, namely, A, B, C and D. Divisions B, C and D are
organised as profit divisions whilst Division A is classified as a cost center. Division A processes
a raw material to provide an input to Division B. Division B further processes these inputs and
converts them to a basic chemical compound called (B4H). Currently there is no intermediate
market for B4H, but Division B has been set up as a profit center in order to motivate the
divisional management. Division B sells B4H to Divisions C and D that further process this
input to produce Bayon and Calamite respectively. These products are sold in an external
market in the pharmaceutical sector. Both products are price sensitive. The variable cost
structure for Divisions A and B are on the following page:

Cost Element DIV A DIV B

$ $
Raw Material per Kg 0.05
Direct Cost per Kg: Bought in 0.02
Variable Overhead per Kg 0.05 0.04
Transport cost per Kg 0.02

Division B has a capacity limit of 10 000 kilograms whilst divisions C and D have capacity limits
of 4 000 kilograms and 6 000 kilograms respectively. Given the high cost of storing B4H, Bayon
and Calamite, Mupfure River divisions produce no more than the quantities they plan to sell.
Divisions C and D sell Bayon and Calamite in separate markets.

The total revenues and additional processing costs (excluding the costs of B4H) for the two
divisions are as follows:

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DIVISION C:
Kilograms of B4H Total Cost Total Revenue
Processed ($) ($)
1000 1000 1500
2000 1900 2950
3000 3000 4350
4000 4200 5700

DIVISION D:
Kilograms of B4H Total Cost Total Revenue
Processed ($) ($)
1000 2000 2600
2000 3800 5100
3000 5650 7550
4000 7700 9950
5000 9900 12300
6000 12300 14600

You are required to:

(a) Determine what quantity of B4H Division B should produce in order to maximise
the profitability of the Mupfure River Company. Also indicate how this quantity
should be allocated to divisions C and D. If Division A could reduce variable cost
per unit by 40% how would this affect the decisions of Divisions C & D?
(Marks 15)

(b) From a motivation and performance evaluation perspective determine the range
of transfer prices that would motivate divisions C and D to purchase the required
quantities of B4H that would maximise Mupfure River profitability determined in
a) above, as well as motivate Division B. Calculate ranges for the current cost
structure, as well as for where the cost reduction in Division A has taken place.
(Marks 10)

(c) Discuss some of the options that Mupfure River Company could consider with
respect to the optimal long-term positioning of the company in the
pharmaceutical industry.
(Marks 10)

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(Total Question: 35 Marks/52.5 Minutes)

Suggested Solution - Question 2

Part (a) i
MC of Division B = Variable cost of (DIV A + DIV B)
= $ 0.10 + $ 0.08
= $ 0.18/unit

The profitability of Mupfure is maximised as long as the net marginal revenue of Division C
and D is greater than the marginal cost of B4H produced by division B, which is $0.18/unit.

Net Marginal Revenue (NMR) = Marginal Cost – Marginal Revenue

DIVISION
Description B DIVISION C DIVISION D
Production Marginal Marginal Marginal NMR Notes Marginal Marginal NMR Notes
Kg’s Cost Cost Revenue Cost Revenue
1000 180 1000 1500 500 2000 2600 600
2000 180 900 1450 550 1800 2500 700
3000 180 1100 1400 300 1850 2450 600
4000 180 1200 1350 150 < mc 2050 2400 350
5000 180 Accept 3000kg’s 2200 2350 150 <mc
6000 180 2400 2300 -100
7000 180 Produce 7 000kg’s Accept 4000 kg’s
8000 180
9000 180
10000 180

Optimum Choice of Output from DIV B: Current Cost Structure

In order to optimise group profitability Division B will initially produce 7 000 kg of B4H.
• DIV C will accept 3000 kgs because NMR > $ 0.18 ($300/1000kg = $0.30) whilst
• DIV D will accept 4000 kgs because NMR > $ 0.18 ($350 / 1000kg = $ 0.35).

If the divisions accept greater amounts of BH4, their total profitability will be reduced, as
the marginal cost of $0.18 per kg is above the net marginal revenue of $0.15 per kg

Part (a) ii

MC of Division B = Variable cost of DIV A + DIV B

= $ 0.10 (1-40%) + $ 0.08 = $ 0.14

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DIVISION
Description B DIVISION C DIVISION D
Production Marginal Margina Marginal NMR Notes Marginal Marginal NMR Notes
Kg’s Cost l Cost Revenue Cost Revenue
1000 140 1000 1500 500 2000 2600 600
2000 140 900 1450 550 1800 2500 700
3000 140 1100 1400 300 1850 2450 600
4000 140 1200 1350 150 2050 2400 350
5000 140 Accept 4 000kg’s (max 2200 2350 150
production capacity)
6000 140 2400 2300 -100 <mc
7000 140 Accept 5 000kg’s
8000 140
9000 140 Produce 9 000 kg’s
10000 140

Optimum Choice of Output from DIV B: 40% Cost Reduction

If DIV A can reduce variable costs by 40%, the variable or marginal cost of production of B4H
in Division B will drop to $ 0.14 per kg. If this is the case, Division B will want to supply 9
000kg of B4H:
• DIV C will accept 4 000kgs and
• DIV D will accept 5 000 kg’s.
Output of Division B can thus be expanded by 2000 kg’s as a result of Division A reducing their
variable costs by 40%.

Part (b)(i): Where Division A’s variable cost has not been reduced:
Now that the optimal quantities to be transferred between the divisions (that maximize
company profit) have been established, part B asks what the range of transfer prices would
be that result in this optimal quantity being transferred.
• The minimum transfer price is always the marginal cost, but a range of transfer
prices that would result in the correct economic decision being taken by all the three
divisions is necessary, as Division B is classified as a profit centre, and therefore some
profits must be generated by Division B to meet performance evaluation
requirements, while still encouraging all the divisions to transfer and receive the
optimal quantities of B4H that maximize the profit of the company as a whole.
• Min transfer price: Always the variable or marginal cost, which in this question is
$180 for 1 000kgs or 0.18 per kg. The minimum transfer price generally is always
from the supplying division’s perspective as they are not going to be prepared to

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produce units at a loss, therefore the minimum that they would be prepared to
accept is the marginal cost for a unit of production.
• Max transfer price: That could be charged is usually determined by looking at the
receiving divisions, which in this question is Division C and D. It is the maximum price
that could be charged but that would still result in Division C and D making the
correct decision in terms of purchasing optimal quantities that maximize company
profits. – (NMR – TP = 0 at the optimal level of supply).
o Div C at 3 000 units: (NMR – TP = 0) = $300 –TP = $300
▪ Per unit TP = $300/1000 units = $0.3
o Div D at 4 000 units: (NMR – TP = 0) = $350 –TP = 0
▪ Per unit TP = $350/1000 units = $0.35
o Therefore, the lower one must apply, resulting in a max transfer price of
$0.30.
Therefore, the range of transfer prices that will result in all divisions making the optimal
economic decisions that will maximize the company’s profit is: $0.18 – $0.30

Part (b)(ii): Where Division A’s variable cost has been reduced by 40%
If the cost of division A is reduced by 40% this means variable or marginal cost for Division B
is reduced to $ 0.14.
• Min transfer price: Always the variable or marginal cost, which in this question is
$140 for 1 000kgs or 0.14 per kg. The minimum transfer price generally is always
from the supplying division’s perspective as they are not going to be prepared to
produce units at a loss, therefore the minimum that they would be prepared to
accept is the marginal cost for a unit of production at the optimal level of
production.
• Max transfer price: That could be charged is usually determined by looking at the
receiving divisions, which in this question is Division C and D. It is the maximum price
that could be charged but that would still result in Division C and D making the
correct decision in terms of purchasing optimal quantities that maximize company
profits. – (NMR – TP = 0 at the optimal level of supply).
o Div C at 4 000 units: (NMR – TP = 0) = $150 –TP = $150
▪ Per unit TP = $150/1000 units = $0.15
o Div D at 5 000 units: (NMR – TP = 0) = $150 –TP = 0
▪ Per unit TP = $150/1000 units = $0.15
o Therefore, both divisions have the same maximum transfer price of $0.15 per
kg of B4H.
Therefore, the range of transfer prices that will result in all divisions making the optimal
economic decisions that will maximize the company’s profit is between $0.14 and $0.15
per kg.

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Part (c)
i. As the company has invested considerable reserves in government bonds, these
funds can be used to finance a growth/expansion strategy.
ii. Forward integration to purchase an existing manufacturer of pharmaceutical
products may be an option. However, the company must consider whether it has
the necessary expertise to run such a company, and the funds to finance the
research and development costs that are essential to a company in the
pharmaceutical industry.
iii. The company could purchase a company that produces generic medication. The
market for such medication is large, as medical aids only cover the generic
medication cost, therefore most purchases of medication would choose generic
medication over the original medication.
iv. As there is a potential supply problem of the raw material that the company uses
as its main raw material, backward integration would be a potential option that
would resolve this problem. The company has the funds to finance this acquisition,
and this would resolve a major concern and risk/threat of the company.
v. Finding a supplier of raw materials that is located close to the company to
purchase would in turn reduce transport costs.
vi. Although the company is risk averse, supply of raw materials is essential to going
concern, therefore the risk profile of the company would not nullify this option.
vii. As costs have a critical impact on demand, the company should invest in initiatives
to improve efficiency and reduce costs. The fact that Division A was able to reduce
costs by 40% shows clearly that there is a great opportunity to do this. Therefore,
the same cost cutting exercise should be applied to the other divisions, and where
possible costs should be benchmarked against competitors. This could improve the
profitability of the company and will result in the company taking on very little
risk.
viii. Costs such as fuel, tolls and transport costs make up a major portion of the
company’s costs. The company has no control of the increasing of these costs,
other than to find alternate forms of transport. Therefore, the company should
investigate options such as:
ix. Using rail to transport raw materials which would reduce the impact of toll and
fuel price increases on the company.
x. Alternatively, Mupfure River Company needs to see how transport cost can be
reduced by way of long-term transport contracts.
xi. Find raw material supplier to purchase that is near the company factory to reduce
transport cost.
xii. Mupfure River Company should attempt to exploit full capacity of DIVS A and B
and examine if the modification of B4H could be sold externally. With the cost
reduction in Division A, there is very little scope for increasing production in

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Division C and D, as Division C is already at maximum capacity, and Division D only

has 1 000kg of Capacity available.
xiii. However, Division’s C & D could also examine the development of new compounds
and broaden its customer base and increase capacity as this new market is
developed.
xiv. The price elasticity of Bayon and Calamite is a clear indication of the
competitiveness in these markets. The company should ensure that customer
relations are maintained.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 2: PERFORMANCE EVALUATION

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Contents
1. Introduction ...................................................................................................................... 30
2. Learning objectives under Performance Evaluation ........................................................ 30
3. Study material................................................................................................................... 30
4. Competence Framework expectation .............................................................................. 31
5. Examination possibilities .................................................................................................. 32
6. Assumed Knowledge ........................................................................................................ 33
7. Integration ........................................................................................................................ 33
8. Course Notes .................................................................................................................... 34
8.1. Goals of Performance Evaluation ................................................................................. 34
8.2. Responsibility accounting ............................................................................................. 34
8.3. Financial performance measures.................................................................................. 35
8.4. Return on Investment (ROI) .......................................................................................... 37
8.5. Residual income (RI) ..................................................................................................... 39
8.6. Economic Value Added (EVA) ....................................................................................... 40
8.7. Accounting-based measures and a company-wide WACC ........................................... 41
8.8. Ways of over-coming the disadvantages ...................................................................... 41
8.9. Financial statement Analysis and Ratios....................................................................... 42
8.10. Non-financial performance measures ...................................................................... 44
8.11. The Balanced Scorecard ............................................................................................ 45
8.12. Tips and examination technique ............................................................................... 46
8.13. Performance evaluation: Guidelines ......................................................................... 46
9. Practice Question ............................................................................................................. 48

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1. Introduction
This unit provides guidance on the principles behind performance
evaluation. Performance evaluation can be noted as an effective
communication tool between the employee and employer and a
method used to analyse and document the execution of actions by
an employee against set organisational goals and standards. A
performance measurement system should provide in detail what is
being measured, how it is going to be measured, what performance
measurement indicators are going to be used and how the data
obtained through performance evaluation is going to be used to
produce some meaningful intended outcomes.

2. Learning objectives under Performance Evaluation

After studying this unit, one should be able to:
• Understand why performance measurement is important;
• Distinguish between functional and divisionalised organisation structures, and
between management performance and division performance;
• Calculate Return on Investment (ROI), Residual Income (RI) and Economic Value
Added (EVA) and how they tie into Net Present Value;
• Understand EVA and EVA adjustments;
• Understand the different strategies a firm can adopt;
• Understand the Balanced Scorecard, and its link to financial outcomes;
• Understand the integration of the Balanced Scorecard with other syllabus areas.

3. Study material
• Colin Drury (2012). "Management and Cost Accounting". 8th South African Edition,
South – Western Cengage Learning.
• CAA Applied Management Accounting and Finance MAF 401/2 Module 2

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4. Competence Framework expectation

COMPETENCE AREA: MANAGEMENT DECISION MAKING AND CONTROL

VI-1.1 Identifies management’s information needs and the entity’s key

performance indicators

− Determines what information is relevant and useful to both management and

the governing body for the purposes of decision making and control based on
the entity’s mission, vision and strategies and competitive position, economic,
competitive and operating environments, products and governance structure
− Identifies key performance indicators, including any sector-specific tracking
needs
− Describes and gives examples of non-financial key performance indicators that
might be suitable for evaluating the entity’s effectiveness, such as – market
share, customer satisfaction, health and safety record, sales (or other) volume
comparisons, impact of economic, environmental, social and governance
factors, service delivery, economic, efficient and effective use of the limited
resources.
− Considers the applicability of the following performance measurement and
control techniques and tools, including – activity-based costing, activity-based
management, balanced score card and benchmarking

VI-1.2 Evaluates the design of the entity’s responsibility accounting system

− Gains an understanding of the arrangement of an entity’s governance

structure and responsibility accounting centres.
− Evaluates the impact of the structures on performance evaluation and
incentivisation, in the context of the entity’s strategies and enhancement of
shareholder wealth and fulfilment of stakeholder expectations or mandate.
− Evaluates the effectiveness and appropriateness (including strengths,
weaknesses and effect of accounting distortions) of the performance incentive
mechanisms (including measures of profit, return on investment, residual
income and economic value added) and makes suggestions for improvement.
− Considers the creation of medium- to long-term value for stakeholders or
fulfilment of mandate.

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VI-1.3 Analyses the financial performance of an entity and makes and/or

evaluates recommendations for improvement

− Analyses, evaluates and explains the financial performance of the entity, or

division, branch, department, etc., in the context of the entity’s product,
competitive position, strategic plans, operations and activities during the
period(s) and with consideration to cash flows, business risks, other financial
risks, working capital policies, financial management principles, and
management control mechanisms in place, where appropriate.
− Identifies and uses financial analysis tools and methods appropriate to the
purpose of the evaluation, including – ratio and trend analysis, CVP and
sensitivity analysis and appropriate categorisation, allocation and
presentation of financial information.
− Identifies, determines, explains and excludes the effect of any distortions
resulting from the application of IFRS or the entity’s internal or external
accounting policies on the financial performance of the entity.
− Identifies reasons for any areas of strength or concern in performance,
including management control over the entity and decision making, as well as
the nature of the entity’s product, competitive position, operations, activities
and operating environment.
− Identifies areas and makes and/or evaluates suggestions for potential
improvement in profitability, management of resources, enhancement of the
value of the entity or fulfilment of a mandate (or maximisation of service
delivery outcomes).
− Conducts further analysis of recommendations, utilising decision-making
techniques, and identifies further relevant financial considerations and
appropriate cost management techniques (including, but not limited to, cost
driver identification and analysis, the behaviour and relevance of costs to long-
term decision making and control and control mechanisms

5. Examination possibilities
Performance evaluation has been examined frequently in the ITC. However, you
should be aware of the behavioural implications of performance evaluation systems.

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6. Assumed Knowledge
The following is assumed knowledge which you should have to tackle Performance
Evaluation.
1. Corporate Strategy
2. Governance structure, linking with compensation structure
3. Activity-based costing and Activity-based management
4. CVP and sensitivity analysis
5. Working capital management
6. Financial statement and ratio analysis

7. Integration
This topic can be integrated with Relevant Costing (decision making), Transfer Pricing,
Standard Costing, Sustainability and Corporate Governance linking with compensation
structure.

Transfer Pricing
Standard Costing

Performance
Evaluation

Ratio analysis
Compensation
schemes
(governance)

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8. Course Notes
In the transfer pricing section, we highlighted the advantages and disadvantages of
decentralisation. Decentralisation highlights the problems of goal congruence, managerial
effort, and sub-unit autonomy. Thus, we need to consider the measurement of segment
performance in developing management motivation toward the achievement of
organisational goals. Performance evaluation is closely linked to the incentives and
rewards offered to management thus, it is important to select a performance evaluation
system that does not encourage mischievous behaviour.

8.1. Goals of Performance Evaluation

• Encourage cost control;
• Fairness in terms of only holding managers accountable for results within their
control;
• Encourage goal congruence;
• Hold managers accountable for resources/assets under their control; and
• Penalise mangers for actions that are not in the best interest of the company.

8.2. Responsibility accounting

Responsibility accounting is the term used to describe decentralisation of authority,
with the performance of the decentralised units measured in terms of accounting
results.

With a system of responsibility accounting there are five types of responsibility

centre: cost centre; revenue centre; profit centre; contribution centre; and
investment centre.

Type of Principal performance

Manager has control over…
responsibility measures
centre

Cost centre Controllable costs

• Variance analysis
• Efficiency measures

Revenue centre Revenues only • Revenues

Profit centre − Controllable costs • Profit

− Sales prices (including
transfer prices)
Contribution As for-profit centre except that • Contribution
centre expenditures reported on a
marginal cost basis

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Type of Principal performance

Manager has control over…
responsibility measures
centre

Investment − Controllable costs • Return on

centre − Sales prices (including investment
transfer prices) • Residual income
− Output volumes • Other financial ratios
− Investment in non-
current assets and
working capital

There are strong arguments for producing two measures of divisional profitability —
one to evaluate managerial performance and the other to evaluate the economic
performance of the division.

Controllable profit is the most appropriate measure of a divisional manager’s

performance (should be measured relative to budget performance).

Looking at how the Invested Capital should be measured for performance evaluation:

a) If a manager's performance is being evaluated, only those assets which can be

traced directly to the division and are controllable by the manager should be
included.

b) If it is the performance of the investment centre that is being appraised, a

proportion of the investment in head office assets would need to be included
because an investment centre could not operate without the support of head
office assets and administrative backup. A similar point of view is that, these costs
would be incurred had the division been a stand-alone company.

8.3. Financial performance measures

a) Return on investment (ROI)

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b) Residual income (RI)

c) Economic value added (EVA™)

Notes
ROI Profit Profit is usually NOPAT + [i x (1-t)
If NPBT is given, the adjustment for interest is (NPBT + i) x
Net Investment 74.25%
When evaluating an individual, allocated costs, such as
head
office costs are excluded from profit, as these are not
controllable by the manager. They can be included for the
evaluation of a division as they are costs that would be
incurred
had the division been a stand-alone company.
Profit - WACC x Net Investment = Total Assets - Current Liabilities or
RI Net
Investment Net Investment = Equity + Long Term Liabilities.
Only permanent sources of finance must be used when
calculating the net investment, i.e. the current portion of a
long
term liability is excluded from current liabilities.
Whether or not a source of finance is permanent depends
on the nature of the business. For example in a large
EVA (Profit ± adjustments) – retailer,
[WACC x (Net investment Trade payables could be a permanent source of finance if
± they
adjustments)] always make all purchases on credit, compared to a smaller
business where trade payables might just be bridging
form of finance.

The assets that are included in net investment are those that
are
controllable by the manager/division. Assets managed
centrally
are not included. Take note of whether the division is a profit
or
Investment
centre.

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Net book value is often used to reflect the investment

although
this is often conceptually incorrect. It is preferable to
ascertain the
assets present value or replacement cost less
depreciation.

8.4. Return on Investment (ROI)

Return on investment (ROI) shows how much profit has been made in relation to the
amount of capital invested and is calculated as (profit/capital employed) x 100%.

The profit figure for ROI should always be the amount before any interest is charged.

Profit is usually - NOPAT + [interest x (1 – t)]

- If NPBT is given, the interest adjustment is (NPBT + interest) x 74.25%

ROI can have behavioural implications and lead to dysfunctional decision-making

when used as a guide to investment decisions. It focuses attention on short-run
performance whereas investment decisions should be evaluated over their full life.
Therefore, profit can be evaluated using either net assets or gross assets employed:

- NOPAT/Net Assets employed

- NOPAT/Net Assets + Accumulated Depreciation (Gross Assets)
- Net Assets employed = Total Assets – Current Liabilities

Note: Only permanent sources of finance must be used when calculating Net Assets.
Idle assets and assets acquired for future use (not employed in current year) are
omitted from the calculation.

Profit after depreciation as a % of net assets employed

This is probably the most common method, but it does present a problem. If an
investment centre maintains the same annual profit and keeps the same assets
without a policy of regular replacement of non-current assets, its ROI will increase
year by year as the assets get older. This can give a false impression of improving
performance over time. Therefore, there could be a disincentive to investment centre
managers to reinvest in new or replacement assets.

Profit after depreciation as a % of gross assets employed

This would remove the problem of ROI increasing over time as non-current assets
get older.

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The ROI based on gross book value suggests that the asset will perform consistently
in each of the years they are employed, which is probably a more valid conclusion.

However, using gross book values to measure ROI has its disadvantages. Most
important of these is that measuring ROI as return on gross assets ignores the age
factor and does not distinguish between old and new assets.

• Older non-current assets usually cost more to repair and maintain

• Inflation and technological change alter the cost of non-current assets

The theoretical solution to the problem is to value assets at their economic cost (i.e.
the present value of future net cash inflows) but this presents serious practical
difficulties.

An alternative calculation of ROI is the Du Pont model:

ROI = [Sales/Invested Capital = (Asset turnover) ] x [Net Income/Sales = (N.P margin)]

= Net Income/Invested Capital

8.4.1. Massaging the ROI

If a manager's large bonus depends on ROI being met, the manager may feel
pressure to massage the measure. The asset base of the ratio can be altered
by increasing/decreasing payables and receivables (by speeding up or delaying
payments and receipts).

8.4.2. ROI and new investments

If investment centre performance is judged by ROI, we should expect that the

managers of investment centres will probably decide to undertake new capital
investments only if these new investments are likely to increase the ROI of
their centre and thus the required rate of return(WACC) of the company might
be disregarded.

8.4.3. Advantages of using ROI

• As it is a relative measure (%), therefore comparisons with other divisions,
companies and available investments are possible;
• It reveals information about cost control and asset management; and
• It is simple to calculate and easily understood by managers.
• External stakeholders (analysts/investors) usually use ROI as a measure of
overall company performance.

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8.4.4. Disadvantages of using ROI

• It encourages management to either not replace assets or inappropriately
sell assets. This decreases the denominator and increases ROI;
• ROI does not support goal congruence. The acceptable return on a new
project for the company is WACC. If WACC< Project A < ROI, such a project
will not be accepted as it will reduce the ROI of the division, but it would
have created value for the company. If Project A is an existing project, a
manager might discontinue it in order to boost ROI resulting in shrinkage
of the business;
• ROI can result in acceptance of value destroying projects. If ROI < Project
A< WACC, Project A will be accepted, as it will boost the ROI of the division,
but since the return is less than WACC, value is being destroyed; and
• ROI encourages management to target percentage returns and not to
maximise returns in absolute terms i.e. they will rather accept a R5m
investment that returns 30% (R1.5m) rather than a R10m investment that
returns 20% (R2m). As long as WACC is less than 20% the second
investment should be accepted.
• It is easily manipulated (i.e. increasing/decreasing payables and
receivables, by speeding up or delaying payments and receipts, alters the
Net Assets).

8.5. Residual income (RI)

An alternative way of measuring the performance of an investment centre, instead of
using ROI, is residual income (RI). Residual income is a measure of the centre's profits
after deducting a notional or imputed interest cost.

Formula = Profit – (WACC x Net Investment)

Only permanent sources of finance must be used when calculating the net investment
(i.e. the current portion of a long-term liability is excluded from current liabilities)

The imputed cost of capital might be the organisation's/division’s cost of borrowing

or its weighted average cost of capital.

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8.5.1. Advantages of RI
a) It is claimed that RI is more likely to encourage goal congruence
Residual income will increase if a new investment is undertaken which earns
a profit in excess of the imputed interest charge on the value of the asset
acquired. In contrast, when a manager is judged by ROI, a marginally
profitable investment would be less likely to be undertaken because it would
reduce the average ROI earned by the centre as a whole.
b) Aligned with NPV principles, this encourages long-term based decisions.
c) Residual income is more flexible since it enables different cost of capital
percentages to be applied to different investments that have different levels
of risk.

8.5.2. Disadvantages of RI
a) It is an absolute measure and therefore comparisons are difficult; and
b) It encourages cutting of discretionary expenditure that could have long-
term benefit, for example training costs.

If RI is used it should be compared with budgeted/target levels which reflect

the size of the divisional investment.

8.6. Economic Value Added (EVA)

EVA is based on the residual income concept. It incorporates adjustments to the
divisional financial performance measure for distortions introduced by GAAP. EVA is
designed to measure the value added to shareholder wealth and to motivate
managers to maximise shareholder value.

EVA = (Profit ± adjustments) – [WACC x (Net Investments ± adjustments)]

a) Managers can increase shareholders value by:

i. Increasing the return on existing assets;
ii. Investing in new assets which generate a return which is higher than the
WACC; and
iii. Selling assets where the return on capital is below the WACC. This happens
when the present value of the future economic cash flows (economic
value) is less than the disposal value.
b) Adjustments are intended to convert historic accounting profit to an
approximation of economic profit. Certain accounting adjustments typically made
are:
c) Expenditure that has the potential for enduring benefit. For example, the costs of
a major marketing campaign would be expensed in the year incurred, but from an
EVA perspective, these costs would be capitalised and impaired over the period
that the benefits were expected to accrue.

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d) Operating leases are capitalised and expensed over the life of the asset. This is
because the asset base would otherwise be understated. The opening balance of
the leases that is included is the present value of the lease commitments. The pre-
tax cost of debt is used as the discount rate. The net profit is adjusted by adding
back the lease expense and replacing this with the depreciation of the capitalised
lease.
e) The profit must be adjusted from the absorption costing to variable costing basis.

8.6.1. Advantages of EVA

i. It considers risk (WACC)
ii. Flexible measure (i.e. WACC can be adjusted for divisional specific risk)
iii. Avoids accounting manipulation
iv. It is based on NPV and working capital management principles
v. It motivates decisions in the interest of the business.

8.6.2. Disadvantages of EVA

i. It is an absolute measure (i.e. difficult to compare organisations which are
different in size).
ii. Complex calculation
iii. Accounting based measure

8.7. Accounting-based measures and a company-wide WACC

Disadvantages of using accounting-based measures and a company-wide WACC
include:

• Managers are encouraged to reduce potentially beneficial discretionary

expenditure;
• Accounting figures can be manipulated;
• Accounting measures do not represent free cash flow; and
• The company WACC might not be representative of the risk of the division being
evaluated, which could make results look artificially poor or impressive.

8.8. Ways of over-coming the disadvantages

Ways of over-coming the disadvantages using accounting-based measures and a
company-wide WACC :

• More than one measure should be used;

• Some non-financial measures should also be used to evaluate performance
(consider the use of a balanced score card);
• Accounting figures can be adjusted in a similar manner to calculating EVA;
• Discounted EVA can be applied.

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8.9. Financial statement Analysis and Ratios

This is a common method which is used to measure performance particularly
between companies, different departments or comparing with prior years.

SUMMARY OF COMMON FINANCIAL RATIOS

RATIO CALCULATION INTERPRETATION

Profitability ratios

Gross profit Sales − Cost of sales Indication of the

margin Sales margin available to
cover non-production
expenses
Operating profit Profit before interests and taxes Indication of the firm’s
margin Sales profitability without
regard to the interest
charges resulting from
the capital structure
Net profit Profit after taxes Shows after tax profit
margin Sales per dollar of sales.
Unacceptably low
margins could indicate
relatively low sales
prices or relatively high
costs (or both)
Return on total Profit before tax + interest Measure of return on
assets Sales total
investment in the
enterprise (from both
shareholders and
lenders)
Return on equity Profit after tax Measures return on
Shareholders equity investment by ordinary
shareholders
Earnings per Profit after tax − pref div Measures earnings
share Weighted Ave Number Of Shares available for each
ordinary share in issue
Liquidity ratios

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Current ratio Current assets Measures extent to

Current liabilities which short-term
creditors are covered
by short-term assets
(payable/ realisable
within a year)
Quick ratio (acid Current assets − inventory Measures ability to pay
test) Current liabilities short term obligations
without relying on sale
of inventories
Inventory to net Inventory Measures extent to
working capital Current assets − Current liabilities which the firm’s
working capital is tied
up in stock
Solvency ratios

Debt to assets Total debt Measures extent to

(Gearing ratio) Total assets which operations have
been financed by
borrowed funds

Debt to equity Total debt Measures funds

Shareholders equity provided by lenders
versus funds provided
by owners

Interest cover Profit before interest and tax Measures extent to

Total interest expense which earnings can
decline without the
firm defaulting on
finance costs

Efficiency ratios

Inventory Sales Indicates

turnover Finished goods on hand appropriateness of
inventory of finished
goods held

Accounts Accounts receivable Measures average

× 365
receivable Credit sales length of time for the
collection period

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firm to collect its credit

sales

Fixed assets Sales Measures utilisation of

turnover Fixed assets the firm’s assets

Other

P/E ratio Current market price per share Measures market

After tax earnings per share expectations of future
earnings

Dividend pay-out Annual dividend per share Indicates the

ratio After tax earnings per share percentage of profits
paid out as dividends

Dividend cover Profit after tax − pref div Measures the capacity
Dividend paid to ordinary shareholders of an organisation to
pay dividends out of
the profit attributable
to shareholders

8.10. Non-financial performance measures

Non-financial performance measures are important if the available financial
performance measures not completely reflect the manager’s contribution to the
firm’s total value. Again, non-financial performance measures serve as an indicator for
the firm’s long-term performance. From a motivation point of view, non-financial
measures can be helpful because any combination of performance measures that
reduces the risk imposed on the agent through a contract is beneficial to the principal.
Furthermore, combining different performance measures may help the principal in
inducing specific activities, and thereby to reduce managerial short-sightedness.

Generally, non-financial measures have no intrinsic value for the director. Rather, they
are leading indicators that provide information on future performance not contained
in accounting measures.

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8.11. The Balanced Scorecard

The need to integrate financial and non-financial measures of performance and
identify key performance measures that link measurements to strategy led to the
emergence of the balanced scorecard. The balanced scorecard was devised by Kaplan
and Norton in 1992. According to Kaplan and Norton, previous performance
measurement systems that incorporated non-financial measurements used ad hoc
collections of such measures, more like checklists of measures for managers to keep
track of and improve than a comprehensive system of linked measurements. The
balanced scorecard philosophy creates a strategic focus by translating an
organization’s vision and strategy into operational objectives and performance
measures for the following four perspectives.

Strategy is implemented by specifying the major objectives for each of the four
perspectives and translating them into specific performance measures, targets and
initiatives. There may be one or more objectives for each perspective and one or more
performance measures linked to each objective. Only the critical performance
measures are incorporated in the scorecard.

8.11.1. Four components of the balanced scorecard

a. The Learning and Growth Perspective - improve and create value?
To ensure that an organization will continue to have loyal and satisfied
customers in the future and continue to make excellent use of its resources,
the organization and its employees must keep learning and developing. Hence
there is a need for a perspective that focuses on the capabilities that an
organization needs to create long-term growth and improvement. This
perspective stresses the importance of organizations investing in their
infrastructure (people, systems and organizational procedures) to provide the
capabilities that enable the accomplishment of the other three perspectives’
objectives.
b. The Internal Business Process Perspective - where must we excel?
The internal business perspective requires that managers identify the critical
internal processes for which the organization must excel in implementing its
strategy. Critical processes should be identified that are required to achieve
the organization’s customer and financial objectives.

c. The Customer Perspective - how do customers see us?

The customer perspective should identify the customer and market segments
in which the business unit will compete. The customer perspective underpins
the revenue element for the financial perspective objectives. Typical generic
objectives in this quadrant increasing market share, increasing customer

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retention, increasing customer acquisition, increasing customer satisfaction

and increasing customer profitability.
d. The Financial Perspective - how do we look to shareholders?
The financial perspective specifies the financial performance objectives
anticipated from pursuing the organization’s strategy and the economic
consequences of the outcomes expected from achieving the objectives
specified from the other three perspectives. Therefore, the objectives and
measures from the other perspectives should be selected to ensure that the
financial outcomes will be achieved. Three core financial themes that drive the
business strategy include revenue growth and mix, cost reduction and asset
utilization.

Examples
Internal business Process – internal measures of efficiency, variances, quality and time
Learning and growth – innovation, new products
Customer – new customers, customer satisfaction
Financial – RI, ROI, focus on cost reduction, asset utilisation, revenue growth

8.12. Tips and examination technique

It is important to identify that the appropriate type of responsibility centre will depend
on the degree of autonomy given to the manager. Managers cannot be held
responsible for issues beyond their control.

With investment centres there are two generally accepted measurement techniques,
Return on Investment and Residual Income. While these two performance
measurement methods are very similar, the residual income is regarded as being
conceptually superior as it sets managers the correct hurdle rate for decision-making.

8.13. Performance evaluation: Guidelines

How to approach a question:

− Make sure you understand how to analyse Income statement and Balance sheet –
− Go through the financial statements and identify unusual items, or big changes
between current and preceding years.
− Go through ratios to identify problem areas (Traditional, Line-by-line = common
size, Non-financial ratios)
− Understand information in question:
• What has been provided: internal management accounts (Variable costing
analysis, good for breakeven point and capacity analysis)/ external Annual

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Financial Statements (IFRS) – good for seeing if company has even made a
profit or if there is a positive cash balance
• Ensure the problem areas identified in ratios tie into information about
company eg, poor debtors collection ties into high debtors; huge restructuring
in current period ties into a large increase in fixed costs, working capital
management issues etc.
− Structure:
− General comments from scenario – issues identified through reading through
question, for example:
• Sales decreasing
• High debtors: now selling more on credit
• High stock, short shelf life
• Ratio analysis focusing on problem areas
− Discuss working capital management (if applicable)
− Discuss profitability and sustainability issues
− Break Even Point, capacity and borrowings (Debt/Equity) – especially if the company
has made a loss, can it ever break even!
− If possible, discuss Economic Value Added

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9. Practice Question
Background
Zip Bottling Co. Ltd has been in business for five hectic years. During this time the business
has grown enormously. The reason for this is the drink called Zip which has taken a small but
profitable share of the market for low alcohol drinks. Zip Bottling Co. Ltd obtained the
franchise for the drink in Japan at the beginning of 2005 and has manufactured in a single
manufacturing facility ever since then. Expansion of the facility commenced in 2008 and was
completed in May 2009. Expansion consisted of additional fermentation, packaging and
pasteurising facilities. The plant had been considered too large when it was completed but it
is now well utilised even to the extent of sometimes working double shifts. No revaluation of
plant and machinery is put through the books and the figure shown in the balance sheet is
cost less accumulated depreciation. The property on which the business is situated, has
appreciated over the years and the company has re-valued the land and buildings each year.

Of late, the growth in volume sales has slipped somewhat, as the price of the product has
increased over the five years to the point that it is now creating some market resistance. The
main cause of the increase in selling price is considered by management to be the increase in
raw material costs.

The key ingredient in Zip is a base supplied by Japan which defies all analysis but smells like a
mixture of cream soda and yeast. It causes the fermentation of the basic mix of rice mash and
fruit juices and adds some flavour as well. As this is an imported component, it is subject to
exchange rate fluctuations as well as normal price increases and is now becoming very
expensive. The problem is that the drink cannot be made without the base. The company uses
a variable costing system and, as these are internal management financial statements, stocks
are valued at variable cost. The company has a stable labour force and treats all labour costs
as fixed costs. Thus, variable costs are primarily raw materials.

Zip was originally marketed through bottle stores but in later years has been marketed
through supermarkets as well. The supermarkets have had their effect on the credit terms
granted. Most of the volume is now through the supermarket chains.

Zip has an alcohol level of 1.5% and is slightly fizzy. It has a sweetish taste and is considered
to appeal to the younger set. Because of this the company has recently launched a massive
TV and radio advertising campaign. The bulk of this cost is still to be incurred in the coming
year. The management are a little concerned as they have stocked up with the product in
anticipation, but the shelf life of the product is only eight weeks. After eight weeks it starts to
go sour and darkens unacceptably.

The company only sells Zip in a non-returnable 500ml bottle which is shrink wrapped in a six
pack. The storage of the finished product is on pallets. The company has started on a

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programme to replace the pallets as many of them are five years old and are starting to break
up. (Note that there are 200 bottles in a hectolitre - hl).

Set out below are the balance sheet, income statement and cash flow statement prepared by
the accountant. He has also calculated some ratios.

ZIP Bottling Company Limited

Statement of Financial Position as at 31 2008 2009 2010
March

Capital
Share capital 2 000 000 2 000 000 2 000 000
Non-distributable reserve 485 490 629 100 754 510
Retained earnings 1 935 160 4 322 390 7 007 070
4 420 650 6 951 490 9 761 570
Interest bearing debt
Bank overdraft 6 450 562 640 1 509 850
Long term loans 0 476 630 1 813 620
6 450 1 039 270 3 323 470
Capital employed 4 427 100 7 990 760 13 085 040

Non-current assets
Land and buildings 1 528 600 1 672 210 1 797 620
Plant and machinery 952 800 1 644 300 2 393 600
Motor vehicles 286 000 339 000 691 000
Returnable containers and pallets 193 400 283 800 419 000
2 960 800 3 939 310 5 301 220

Current assets
Bank and cash 6 800 9 400 1 160
Debtors - Trade 1 253 790 3 182 290 5 487 640
- Other 32 770 52 830 79 230
Stocks - Finished goods 303 030 719 790 1 458 930
- Work in progress 71 960 133 690 310 330
- Raw materials 977 390 2 018 130 3 829 690
- Other 38 650 101 660 237 670
2 684 390 6 217 790 11 404 650

Current liabilities
Creditors - Trade 517 900 922 100 1 859 930

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- Excise 373 800 644 800 975 470

- Accruals & Prov. 12 710 21 680 42 330
Receiver of Revenue 313 680 577 760 743 100
1 218 090 2 166 340 3 620 830
Net working capital 1 466 300 4 051 450 7 783 820
Employment of capital 4 427 100 7 990 760 13 085 040
ZIP Bottling Company Limited

Income Statement for year ended 31

March 2008 2009 2010

SALE VOLUME hls 107 100 154 300 188 600

PRODUCTION VOLUME hls 108 500 165 100 214 400
GROSS SALES INCOME 21 094 900 35 563 570 51 998 730
Excise duty 4 772 100 8 231 370 12 452 800
Promotional discount 772 600 1 163 400 2 197 430
NET SALE INCOME 15 550 200 26 168 800 37 348 500
Variable cost of sales 4 908 540 8 443 170 13 071 820
GROSS MARGIN 10 641 660 17 725 630 24 276 680
Fixed costs 7 082 350 12 253 620 18 103 320
Depreciation 274 340 361 640 595 610
3 284 970 5 110 370 5 577 750
Interest received 3 800 5 500 5 800
Miscellaneous income 7 440 9 140 15 280
OPERATING PROFIT 3 296 210 5 125 010 5 598 830
Interest - Long term loan 0 88 970 340 960
- Other 850 60 130 283 850
PROFIT BEFORE TAX 3 295 360 4 975 910 4 974 020
Taxation 1 614 730 2 338 680 2 039 350
PROFIT AFTER TAX 1 680 640 2 637 230 2 934 670
Dividends paid 200 000 250 000 250 000
1 480 640 2 387 230 2 684 670

ZIP BOTTLING COMPANY LTD CASH FLOW STATEMENT FOR YEAR ENDED 31 MARCH

2008 2009 2010

Cash generated from operating activities: $000's $000's $000’s

Operating profit 3 296 210 5 125 010 5 598 830

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Add: Depreciation 274 340 361 640 595 610

Cash generated from operations 3 570 550 5 486 650 6 194 440
Cash utilised/generated - working capital

- Stock 554 320 1 582 240 2 863 350

- Debtors 443 970 1 948 560 2 331 750
- Creditors & accruals (156 440) (684 170) (1 289 150)
Cash generated from operating activities 2 728 700 2 640 020 2 288 490
Finance costs 850 149 100 624 810
Taxation paid 1 386 910 2 074 600 1 874 010
Cash available from operating activities 1 340 940 416 320 (210 330)
Dividends 200 000 250 000 250 000
Cash retained from operating activities 1 140 940 166 320 (460 330)

Cash utilised in investment activities:

Additions to fixed assets
- Capital cost of:
- Maintaining operations 197 140 437 930 1 327 200
- Expanding operations 960 280 758 610 504 910
Net cash invested 1 157 420 1 196 540 1 832 110
Funding requirement 16 480 1 030 220 2 292 440

Cash injected from financing activities

Bank overdraft 6 450 556 190 947 210
Long term loan 0 476 630 1 336 990
Increase/(Decrease) in borrowings 6 450 1 032 820 2 284 200
Decrease/(Increase) in cash on hand 10 030 (2 600) 8 240
Total financing 16 480 1 030 220 2 292 440

ZIP Bottling Company Limited

Ratios at 31 March 2008 2009 2010

GROSS MARGIN % 68.4% 67.7% 65.0%

Gross margin x 100
Net sales income

OPERATING PROFIT TO SALES 21.2% 19.6% 15.0%

Operating profit x 100
Net sales income

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SALES TO CAPITAL EMPLOYED 3.51 3.27 2.85

Net sales income
Capital employed

DEBTORS DAYS 22.3 33.2 39.1

Total debtors x 365
Gross sales

STOCK DAYS (TOTAL STOCK) 103.4 128.5 163.0

Total stock x 365
Cost of sales

STOCK DAYS (FINISHED GOODS STOCK) 22.5 31.1 40.7

Finished goods stock x 365
Cost of sales

STOCK DAYS (RAW MATERIAL STOCK) 72.7 87.2 106.9

Raw material stock x 365
Cost of sales

CREDITORS DAYS 38.5 39.9 51.9

Trade creditors x 365
Cost of sales
(in the absence of a purchases figure)

TRADE CYCLE 87.2 121.8 150.2

RETURN ON CAPITAL EMPLOYED 74.5% 64.1% 42.8%
Operating profit x 100
Capital employed

RETURN ON EQUITY 38.0% 37.9% 30.1%

Net profit after tax x 100
Shareholders' equity

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Required

Management has asked you to analyse and report on the reasons for the poor results for
the year and to suggest any ways to improve profitability in both the short and the long
term. If insufficient information is supplied for full comment, indicate what further
information you would call for.

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Suggested Solution

Analyse and report on the reasons for the poor results for the year and to suggest any
ways to improve profitability in both the short and the long term.

• If insufficient information is supplied for full comment, indicate what further

information you would call for.
This is an internal set of financial statements and thus they do not have the same format as
published statements. The intention is for the analysis to be on the company’s performance
from a managerial accounting point of view.

This is further emphasised by the ratios supplied (mostly focusing on operating profit and
asset management) and by the low gearing (interest bearing debt to share capital and
reserves is 34% in 2010).

The company has made some poor strategic decisions, and this has placed the company in
danger of not continuing its profitability in the long term. For this reason, the headings
chosen are:

• Profitability
• Asset management
• Liquidity and cash flow management
• Risk

Profitability:

Operating profit generated from sales:

This ratio depends on selling prices, volumes, variable cost management and fixed cost
management.

Selling prices and contribution:

As the company manufactures and sells one product, it is possible to analyse its pricing
strategy. The selling prices and contributions for the respective years are:

2008 2009 2010

Gross selling price per hl 196.96 230.48 275.71
Gross selling price per bottle 0.98 1.15 1.38
Percentage increase 17.0% 19.6%
Excise per hl 44.56 53.35 66.03
Percentage increase 19.7% 23.8%
Net selling price per hl 145.19 169.60 198.03
Percentage increase 16.8% 16.8%
Variable cost per hl 45.83 54.72 69.31

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Percentage increase 19.4% 26.7%

Contribution per unit 99.36 114.88 128.72
Percentage increase 15.6% 12.0%
It is evident that the management was unable to pass the excise increase on to the
customer. This is evidenced by the fact that even with this lower selling price increase, the
increase was met with resistance from the market.

The excise per hl increased by 19.7% in 2009 yet the gross selling price increased by only
17%.

In 2010 the excise increased by 23.8% yet the gross selling price increased by only 19.6%.

The gross selling price per unit has been calculated to compare to the prices charged by
similar products per bottle.

This is the wholesale price and the bottle store or supermarket will need to add its mark
up. The price does not seem excessive but a comparison to cider, beer etc. is needed.

It seems that the management consider the product to be price sensitive. There are four
clues that this may be so:

• The comment in the details of the case that the selling price is creating some
resistance.
• The reluctance of management to pass on all the excise cost increase.
• The change to marketing through supermarkets to endeavour to gain more sales
with a lower retail mark up
• The high promotional discounts offered to attempt (presumably) to generate
additional sales volume.

This pricing policy had an effect on the net income per unit which is increasing by 16.8%
year on year.

When this net income per unit is compared to the variable cost per unit, it is evident that
the pricing policy has not taken cost increases into account.

Variable costs have increased by 19.4% in 2009 and a huge 26.7% in 2010.

The net effect of this is the poor contribution per unit. This combined with the huge
increases in fixed costs makes the break-even units higher each year:

The break-even units on these fixed costs, using the contribution per unit calculated above,
would be:

2008 2009 2010

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Calculation $7 356 690/$99.36 $12 615 260/$114.88 $18 698

930/$128.72

BEP units = 74 041 = 109 813 = 145 269

For a product, such as this, which could have a short life cycle, it seems foolish to increase
the fixed costs by 71.5% in 2009 and 48.2% in 2010.

It appears the company is increasing capacity and operating gearing in the assumption that
volume will continue to increase year after year.

If inflation is assumed at 15% and 2008 is taken as a base, the fixed costs (including
depreciation) for the three years should have been:

2008 2009 2010

Fixed costs $7 356 690 $8 460 194 $9 729 223

It is no wonder that the operating profit to sales ratio has declined from 21.2% to 19.6% to
15% over the three years.

Taking the above into account the company should consider several actions which include:

− Investigate the pricing of the product to ensure that the maximum cost is passed
onto the consumer without affecting the volume and the total sales

− Forecast the volume anticipated with that volume and ensure that the facilities are
not expanded if not required.

− Consolidate and make full use of the current infrastructure without incurring any
additional fixed costs. The use of activity-based costing could be of benefit to
identify value added and non-value-added costs in the operating areas and
discretionary and fundamental costs in the support areas. It should be possible to
manage the fixed costs down as it is likely that there is excessive spending.

− Implement a variable cost management programme to ensure that there is

minimum wastage. A part of the variable cost increase is the imported base. An
analysis of this cost should be undertaken to ensure that there is minimum loss.
Perhaps negotiations can be instituted with the supplier to reduce the price.

Asset management:

Sales generated from assets:

The sales to capital employed ratio has declined from 3.51 to 3.27 to 2.85. This could either
be viewed as reducing the number of times fixed assets plus working capital has turned

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over or a reduction in the rand sales generated by the asset base. Either way, there is a
problem.

In analysing the problem, it is useful to separate working capital from fixed assets and
calculate the ratio for these separately. (Net sales are used as the company does not benefit
from the gross sales). Note that as assets are not re-valued, the net book value of fixed
assets may give a distorted picture.

2008 2009 2010

Net sales to fixed assets: 5.25 6.64 7.05

Net sales to working capital: 10.61 6.46 4.80

Despite the substantial increases in fixed assets, the problem clearly lies in working capital
management.

This conclusion is supported by the increase in the net trade cycle which has increased from
87.2 days to 121.8 days to 150.2 days.

Looking at the individual elements of working capital:

− Debtors days have extended from 22.3 days to 33.2 days to 39.1 days. Much of this
is due to the change in policy where sales are being made through supermarkets.
− These organisations usually take longer credit terms. The carrying cost of these
debtors is increasing each year and is placing pressure on the company to borrow
to finance these debtors. In addition, problems with bad debts could arise.

− Stock days reflect a major problem in the company. Production seems to have
delusions about the possible sales and each year are manufacturing more than is
being sold (see income statement volumes).
− There is clearly a problem with forecasting and producing to anticipated demand
rather than to actual demand. There is excessive stock in all categories of stock
particularly finished goods and raw materials.
− With a shelf life of 8 weeks, the company is facing possible large stock write offs.
Further, the carrying cost of this excessive stock is placing pressure on the company
to finance its working capital.

− Creditors days have been estimated using cost of sales. This is not an accurate figure
but does reflect that the company is taking an increasingly long time to pay its
accounts.
− The result is either a loss of discounts or an increase in price from the supplier to
cover the longer terms taken. The company may be losing its good relationships
with its suppliers.

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Clearly the company is overtrading. Actions that management should consider include:

Formulation of a credit policy and the institution of credit management to ensure that the
laid down terms are adhered to.

A major drive on both production costs and stock levels is required. This points to the need
to institute JIT principles. The company needs have a good look at its production process to
ensure minimum non-value-added time such as wait, set up, inspection, move times etc.
They need to set up controls over variable costs. Production should be changed to the pull
system with quantities geared to actual demand rather than anticipated demand.

Liquidity and cash flow management:

Because of poor operating management, i.e. cost and working capital management, there
has been a decrease in profitability and an increase in working capital.

As a result, the company has been forced to fund operating costs and working capital from
borrowings.

The problem is not serious as yet, but the cash flow statement shows cash retained from
operating activities to have declined from 1 140 940 in 1988 to 166 320 in 2009 and a
negative 460 330 in 2010.

The company has invested in fixed assets consistently over the three years, both to
maintain operations and to expand operations.

This has resulted in an increase in borrowings and in turn in the interest on those
borrowings. Interest cover (using cash generated from operating activities) has declined
from 17.7 times [$2640020/($88970+$60130)] in 2009 to 3.7 times
[$2288490/$340960+$283850)] in 2010.

The average time take to pay total liabilities, using cash generated from operations
(operating profit plus non-cash items), is still low and has increased as follows:

2008 2009 2010

Total liabilities $1 224 540/$3 570 $3 205 610/$5 486 $6 944 300/$6 194
550 650 440

= 0.34 = 0.58 = 1.12

There are no specific management actions that need to be directed toward liquidity
management.

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If the overall stock level is reduced by, say, 40 days, this would release approximately
$ 1.4 million (based on 40 times the daily cost of sales) into the business.

Similarly, if debtors were reduced by, say, 5 days this would release approximately
$700 000 (based on 5 times the daily gross sales) into the business.

Some of this would be used to reduce creditors days but will still have a considerable impact
on the interest-bearing debt.

Risk

The return on equity of this business has declined considerably in 2010.

Several factors need to be considered when assessing whether the 30.1% return is still
acceptable.

This appears to be a high after-tax return, but fixed assets have not been revalued. If this
were done, the return would decline.

One also must take into consideration, the likelihood of the return continuing in future
years and the vulnerability of the company to fluctuations in economic activity.

The company is reliant on a single product which may have a short product life cycle.
Despite this, the company has invested considerable amounts in anticipation of future
growth in sales.

If the product goes out of favour with the group who are currently buying it, the company
will not be able to generate sufficient sales to be profitable.

The company should be investigating entering the market in similar product such as cider.

The low alcohol market is very competitive, and the company is faced with tough
competitor action if it grows too big.

The company is reliant on an overseas supplier who is the only supplier of a key ingredient.
This adds to the risk as this source of supply can be removed at any time unless there is a
contract.

The high level of working capital and fixed costs makes it difficult for the company to reduce
its scale of operations quickly if volumes change downwards.

The huge increases in fixed costs coupled with the decline in contribution per unit has
resulted in an ever-increasing break even.

Any change in the economic climate could place the company in a non-profitable situation.

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Conclusion

The company should stop expanding with immediate effect and instead determine demand
for Zip in the current market. This may require them to undertake market research to
establish this. This may result in the company having to reduce capacity in the most cost-
effective way.

The company should look for new customers to sell their product to as well as opportunities
to differentiate their product in order to stimulate sales demand.

The company should improve working capital management by introducing a new working
capital policy (benchmarked with other companies selling to supermarkets), as well as a
new working capital system to manage working capital more efficiently.

This will resolve to a large extent the liquidity problems. The company should introduce JIT
to reduce the large quantities of the different types of inventory on hand.

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CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING AND FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 3 – TREASURY, FINANCIAL RISK MANAGEMENT AND

INTERNATIONAL FINANCE

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Contents
1. Introduction ...................................................................................................................... 63
2. Objective of International Finance ................................................................................... 63
3. Study material................................................................................................................... 63
4. Competence Framework expectation .............................................................................. 64
5. Examination possibilities .................................................................................................. 65
6. Assumed Knowledge ........................................................................................................ 66
7. Integration ........................................................................................................................ 66
8. Course Notes .................................................................................................................... 66

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1. Introduction

Introduction

This unit provides guidance on the principles of international

financial management and the goal of the finance manager with
regards international investments.

2. Objective of International Finance

After studying this unit, you should be able to:

• Understand how the foreign exchange market operates.

• Determine how exchange rates are quoted in the spot and forward markets.
• Understand the determinants of currency rate movements.
• Describe the types of foreign exchange exposure that a firm is required to manage
• Determine how hedging techniques such as forward contracts and money market
hedges can be used to avoid transaction exposure.
• Indicate when and how currency options should be used to avoid exchange rate risk.
• Describe the use of futures contracts to hedge against foreign currency exposure.

3. Study material
• Financial Management 8th Edition by Carlos Correa (Chapter 19)
• CAA Applied Management Accounting and Finance MAF 402 Module 2

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4. Competence Framework expectation

Competencies Level Students are expected to:
Establishes or evaluates ✓ Gain an understanding of the
overall financial goals financial objectives that form part
✓ Understands Awareness of the entity’s finance strategy in
financial objectives Awareness the light of the entity’s overall
✓ Understands the objective, vision, mission and
legal form and mandate.
structure of the ✓ Gain an understanding of the
entity inter-relationship of the financial
objectives with the other
resources and capitals which
impact on the entity’s business
model.
Management of financial ✓ Develop and evaluate risk
risks as part of the entity’s management policies that relate
risk specifically to financial risk (e.g.,
management policy hedging policy, investment policy,
✓ Develops and Intermediary and insurance coverage), so that
evaluates risk policies are consistent with the
management entity’s overall risk management
policies related to policies.
financial risk. ✓ Monitor exposure in order to
manage the level of these
financial risks.
✓ Monitor changes in the economy
(e.g. changes in interest rates,
foreign exchange, employment,
and fiscal and monetary policy)
and changes within the entity,
assessing their impact on the
entity’s finances.
✓ Recommend changes to risk
management policies in line with
the assessment of the impact on
the entity’s finances
✓ Evaluates the use of Intermediary ✓ Identify the significant risks within
derivatives. an entity, including interest rate
risks, foreign exchange risks, and
commodity risks.

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✓ Analyze various derivative

instruments that are available to
mitigate risks.
✓ Identify the need for, and
evaluates on a preliminary basis,
the usefulness of forward and
future contracts, swaps, put and
call options (including warrants)
and other derivatives, in meeting
the entity’s objectives and staying
within its risk tolerance level.
✓ Suggest appropriate derivative
instruments to mitigate risks.
✓ Differentiate between the use of
derivatives for hedging and
speculation purposes.

Knowledge Reference List Level

Treasury function
✓ Role of treasury Awareness (1)
✓ Cash management (excluding Baumol & Miller-Ore) Advanced (3)
✓ Workings of foreign exchange and interest rates Intermediary (2)
Understanding risks related to –
✓ foreign exchange Intermediary
✓ interest rate (2)
✓ duration
✓ refinancing and liquidity risks
Hedging and risk management
✓ Operational hedges (natural hedges)
✓ Forwards (e.g. FECs)
✓ Futures Intermediary
✓ Options (2)
✓ The use of caps, floors and collars in relation to interest
rates (excluding the pricing thereof, as well as the
offsetting of risk from the perspective of the financial
institution)
✓ Swaps (no detailed calculations for interest rate swaps)

5. Examination possibilities
Highly examinable in a strategy question to:

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✓ Expand operations to another country

✓ Obtaining or issuing a foreign loan

6. Assumed Knowledge
The following is assumed knowledge which you should already have at CTA level.

1. Enterprise Risk Management

2. Financial Engineering

7. Integration
This topic can be integrated with the following topics/ subject areas
• Strategy and Risk Management
• Enterprise Risk Management
• IAS 21- The Effects of Changes in Foreign Exchange Rates
• Taxation
✓ Gross Income
✓ Allowable and Prohibited Deductions
✓ Double Taxation Relief

8. Course Notes

8.1. The treasury function

In many large organisations, there is a treasury function or treasury department.
The role of the treasury department consists mainly of:
• managing the liquidity and cash flows of the organisation
• managing the foreign exchange positions and cash flows
• helping to obtain finance for the organisation
• managing the exposures to financial risk, by hedging currency exposures, interest
rate exposures and other risk exposures.

8.1.1. Cash flow forecasting and cash management

Cash flow forecasting is an important aspect of treasury management. A
company must have enough cash (or access to borrowing, such as a bank
overdraft facility) to meet its payment obligations. Cash forecasts are
therefore made and revised regularly, to establish whether the organisation
expects to have a cash surplus or to be short of cash.
• If a cash deficit is forecast, measures should be taken to ensure that
cash will be available. It might be necessary to ask a bank for more
finance. Some expenditure might be deferred. Alternatively, measures
might be taken to speed up receipts from customers.
• If a cash surplus is forecast, the treasury department will consider how
the surplus funds should be used. For example, if the surplus is

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expected to be temporary, how long will the surplus last and what is
the most profitable method of investing the money (without risk) for
that period?
Short-term cash forecasts can be prepared using receipts and payments cash
budgets. Longer-term cash forecasts can be made by preparing an expected
cash flow statement for the forecast period.
8.1.2. Cash management
• A centralised treasury department is able to manage the cash position of
the group as a whole. It can manage total cash receipts, total cash
payments and total net cash balances One technique for doing this is to
pool bank accounts. All the bank accounts throughout the group for a
particular currency might be pooled. At the end of each day, the balances
in each account are transferred to a centralised cash account. (The cash is
‘pooled’). The cash deficits in some accounts and cash surpluses in other.
• Accounts are therefore netted. In this way, the company can avoid interest
charges on accounts that are in deficit, and transfer cash between accounts
as required.
• Pooling and netting of cash flows therefore improves cash management.
However, for pooling and netting to be effective, the cash must be
managed by a central treasury department.

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8.2. Context
Risk Management:

- King IV requirements
- Board responsibility
- Identify risks
- Risk management strategies (avoid,
mitigate, transfer, accept)

Financial Risk areas: Other key risk areas:

- Interest rate risk - IT (systems, technology

- Refinancing risk risk)
- Currency risk - Operational
- Market risk - Human Resources
- Inflation risk - Internal Controls
- Liquidity Risk - Fraud
- Credit risk - Environmental
Regulatory/legal risk -

8.3. Key financial risks

Description Issues Response

Interest rate risk

Exposure to Direct effects - Identify all borrowings (loans,

interest rates creditors, leases etc) subject
- extent of floating rate debt
to interest rate changes
- effect of movement of interest
- Matching profile of debt to
rate on interest expense
interest income generating
(income) and on value of debt
assets
(floating rate bonds, debentures
- Mix of fixed and floating rate
etc)
debt
- Maturities spread out
Indirect effects - Avoid concentration of
interest rate resets
- effect on consumer spending
- Interest rate swaps (fixed to
and firm revenue
variable, and variable to
fixed)
- Forward Rate Agreements
(FRA’s)(with banks)
- Caps, floors and collars
Refinancing risk

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Inability (or lack of Debt matures at a time of - spread out maturities

desirability) to - various sources of finance
- financial stress (for firm)
renew (roll over) (type and financier)
- high interest rates
loan at date of - maintain credit rating
- (Vice versa for financial assets)
maturity
- general financial crisis
Liquidity risk

Insufficient funds - Companies act requirements - Hold sufficient cash or

to meet short term (liquidity tests for certain unused overdraft facilities
financial transactions, including - Planning and budgeting
commitments distributions to shareholders) (detail suggestions)
(including paying - Management of cash and
creditors) working capital
- Analysis of cash balances,
budgets and banking facilities
Currency (Foreign exchange) risk

Transaction Arises from transactions with - Monitor and report on

exposure foreign entities (import, export, exposure
raising finance) - Hedge material net exposure
(after natural hedges)
Forwards (FRA), Futures

Options, Money market

(Foreign borrowings /
investments – Chp 19)

- Leads and lags

Translation Accounting issue: Effect on - Do NOT hedge!

exposure reporting at SOFP date

Economic exposure Longer term effect of exchange - Operational and competitive

rate volatility on operations and practices
competition

Credit risk

Counterparty not Effect on firm’s - Debtor analysis and control

able to meet their (age analysis)
- own credit rating
obligation(s) - Credit evaluations/ checks
- operations
- Avoid concentration of
- liquidity
exposure

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- Insurance
- Derivative: spread of high
Debtors policy (working capital)
quality counterparties NB
Market and commodity price risk

Change in price of a - cost structure and sensitivity Hedge using:

commodity analysis
- Futures
(significant input or
- Forwards
output, including
- Swaps
substitutes)
- Options
- Natural hedges
Inflation risk Inability to pass inflationary - Operational response
increases in costs on to customers

Legal / regulatory Contravention of law / regulation - Monitor compliance

risk - Good legal advice
- Legal structures and
guarantees

Basis risk Result of an exact hedge being

unavailable: some exposure
remains (possibly the derivative
and the commodity are not the
same, but only related)

Systems and - effect of failures and - Corporate Governance and

technology weaknesses in this area on firm’s internal control
ability to manage risk
- errors, fraud, non-reporting of
issues, interruption to
operations etc

8.4. Derivates
8.4.1. Interest rate swaps
Two parties (companies), enter into an agreement to swap their interest
obligations, usually on a net basis. Primarily used to switch variable rate for
fixed (and vice versa, obviously).

The party with variable rate debt may be concerned about interest rate risk,
while the party with fixed rate debt may be less concerned about interest

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rate risk or desire exposure to interest rate risk on their borrowings due to
the second party having exposure to interest rate risk on their assets.

Specifics:

▪ Agreement usually based on a notional amount (not necessarily

amount of actual borrowings)
▪ Rates that either 1 or both parties are able to achieve is/are better
than going to a bank directly, due to the favourable borrowing
situations of the various parties
▪ Either or both parties may charge a slight premium to their actual
position, depending on the extent to which their actual borrowings
are at favourable conditions relative to the banks
▪ One party can be a bank

8.4.2. Forwards and Futures

Forward Future

Description Contract to purchase a Contract to purchase a commodity

commodity (including (including foreign currency, shares,
foreign currency or shares) indexes etc) at a specific price at a
at a specific price at a specific date in the future
specific date in the future

Flexibility Customised contract as Standardised contracts

unique as the
counterparties require

Market Over the counter (between Formal Exchange

any two parties)

Cash flows On resolution only – date as Initial deposit into margin account
per contract when contract entered in to
(usually between 5% and 10% of
contract value)

Profits and losses on contracts are

settled daily, thus daily updates and
cash flows to margin account.
Reduced counterparty risk.

Resolution The commodity is delivered The contract is closed out by taking

by one party to the other up the opposite position on the

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party, and the other party futures exchange at spot. This can
pays the agreed price, on be done at any time on or before
the date specified in the the date specified in the original
contract. contract. Delivery of commodity
usually does not occur (Although
SAFEX does make provision for
this).

Short position: Either the actual or contractual position to sell the commodity
(or financial instrument etc.)

Long position: Either the actual or contractual position to buy the commodity
(or financial instrument etc.)

i.e. A farmer of maize is said to be short in the commodity, while the cereal
producer would be long in the commodity.

Further, a person who entered into a futures contract to sell a commodity (or
financial instrument etc ) forward is said to have taken up a short position,
while conversely the person who enters into a futures contract to purchase a
commodity (or financial instrument etc) forward has taken up a long position.

A few specifics relating to futures:

▪ Future contracts originally arose for agricultural products, but financial

futures now more prolific.
▪ Benefit of trading on exchange is the management of counterparty risk
through the daily marking-to-market and daily settlement process.
Counterparty risk is essentially SAFEX. This is less risky than the
counterparty risk inherent in a forward contract.
▪ Mark-to-market price is the mid point of the bid-ask spread, plus some
specific rules about the day’s high’s and low’s.

Contracts for differences (CFD’s)

While these are not futures and are traded Over The Counter (OTC), they are
similar to futures in principle, and are becoming increasingly popular.

A CFD is a derivative where the buyer pays a margin on the price of the share
and pays interest on the difference between that margin and the share price.
The buyer is then entitled to receive any dividends and any increase in the

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value of the share. If the share devalues, then the buyer has to make margin
deposits (i.e. pays any devaluation to the buyer).

Basically, the buyer of a CFD is put into the risks and rewards position of
owning the share (without having to pay the majority of the share price to
acquire that), while the provider of the CFD is indifferent to any movement in
the share price (or dividends received) and while the provider owns the share
(and has cash tied up in it) they are not losing out on interest as they are being
paid interest by the buyer of the CFD.

Factors determining the forward/future price:

The factors that determine the forward price are simply a collection of the
financial consequences of acquiring the asset now through a future, rather
than acquiring the physical asset now, (i.e. think relevant costing and time
value of money!):

Say there is an asset that you wanted to hold in 1 years’ time, but you need to
acquire it now in order to avoid volatility in prices. You could either:

• purchase the asset now (cash outflow now at t0) and incur insurance and
storage costs for a year (in the case of physical assets), or receive dividends
for a year (in the case of shares), (there is also value in the case of
commodities of having the asset under your control, as this gives can allow
you to take advantage of opportunities as they arise, which you cannot do
when you are only acquiring the asset at a set future date under a
future/forward contract)

OR

• purchase an asset forward using either a forward or future contract (which

you only pay for in the future at t1) and avoiding the insurance and storage
costs but miss out on the dividends and convenience value).
• And because there’s a time difference between these cash flows (even if
it’s just a few months), the time value of money has to be taken into
account (at the risk-free rate).

Consequently, the variables that determine the future price are as follows:

• The current spot price (starting point)

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• Dividends would be not be received on financial futures (but would be if

you were holding the share)
• Storage etc costs would not be incurred on commodity futures, but would
be if you bought the asset
• Convenience value
• Interest rates (risk free rate applies – arbitrage opportunity) (applied to all
4 cash flows above!)

This results in the following formula:

Commodity:
Forward/Futures price = (Spot price + PV (Storage + Insurance) – PV
Convenience ) x (1+r)

Financial future (share price or index):

Forward/Futures price = (Spot price – PV Dividend) x (1+r)

Study note: You do not need to be able to calculate this for exam purposes
(although the time value and relevant costing maths is hardly beyond you),
however you do need to understand how the various variables together
determine the futures price.

8.4.3. Options
What are they?

An option contract gives:

• the buyer (holder) of the option

• the right, but not obligation,
• to purchase (in the case of a call option) or sell (in the case of a put option)
a specified asset
• for a predetermined price (exercise / strike price)
• at a future date (on a future date only, in the case of a European option,
and up to including on a future date in the case of an American option).

The buyer of the option pays the writer (seller) of the option an amount (the
option premium), for this privilege.

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Value of an option

Study Note:
The actual numerical computation to value an option is outside the scope of
the syllabus. However, it is important that you understand the variables that
drive an options value, especially given the integration of options into financial
accounting, particularly in the areas of share-based payments and financial
instruments. Employee share options (while not issued for hedging purposes)
are frequently encountered in practice, and in your accounting.

Value of an option = intrinsic value + time value (this statement is a concept –

not a formula!!)

• Intrinsic value: Difference between price of underlying asset currently and

the strike price, (limited to zero, intrinsic value can’t be negative)
• Call option: Current share price - Strike price
• Put option: Strike price - Current share price
• If option has intrinsic value, said to be “in the money” (and if not, the
option is “out of the money”)
• Time value: the value resulting from the probability that the share price
will exceed the strike price by expiration date (in the case of a call option),
vice versa in the case of a put option.

Variables determining the value of an option:

• The current share (underlying asset) price

• The exercise / strike price
• The interest rate
• Time to exercise date
• Volatility of share price (underlying asset price)

Popular models used to value options:

• Black-Scholes Option Pricing Model

• Binomial Option Pricing Model

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8.5. International Financial Management

International Financial Management is a well-known term in today’s world, and it is also

known as international finance. It means financial management in an international
business environment. It is different because of the different currency of different
countries, dissimilar political situations, imperfect markets, diversified opportunity sets
etc. International Financial Management came into being when the countries of the
world started opening their doors for each other.

The goal of International Finance is to maximize the shareholder’s wealth. The goal is
not only limited to the ‘Shareholders but extends to all stakeholders, employees,
suppliers, customers etc. The growing popularity and rate of globalization has magnified
the importance of international finance.

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8.6. Why organizations are motivated to expand their businesses internationally

A saturated domestic industry leaves few opportunities for companies to snap up
clients. This drives them to look abroad for new customers and markets. For example,
developing countries can provide an ample opportunity for new revenue sources.
Discovering resources or creating partnership opportunities may also contribute to
their ability to tap into overseas consumer markets.

Expanded markets and increased sales mean more profits. Profits mean success for a
business. They also mean that a business can make contributions to causes that they
believe in. By searching outside of their own borders, companies hope to find more
economical solutions to the production and manufacturing problems they have. A
business might choose to take advantage of lower labour costs, they might move
manufacturing plants closer to natural resources (e.g. Nike’s manufacturing
operations located outside the USA), invest in new and more efficient technology, or
profit from another country’s innovations or tax structures.

Companies may have a foothold in several countries, so they don’t have to depend on
the economy of one country. Companies engaged in international business can
protect their investments and their markets by dealing with countries in a variety of
countries. A recession in one country will not have a huge effect if business is doing
well in another country.

8.7. Risks of International Trade

International financial markets face a variety of risks and they are collectively known
as international finance risks. When an organization decides to engage in
international financing activities, they also take on additional risk as well as
opportunities. These risks may sometimes make it difficult to maintain constant and
reliable revenue.

Economic and Political Risk

Economic risk: This risk refers to a country's ability to pay back its debts. A country
with stable finances and a stronger economy should provide more reliable
investments than a country with weaker finances or an unsound economy.

Political risk: This risk refers to the political decisions made within a country that
might result in an unanticipated loss to investors. While economic risk is often
referred to as a country's ability to pay back its debts, political risk is sometimes
referred to as the willingness of a country to pay debts or maintain a hospitable
climate for outside investment. Even if a country's economy is sound, if the political
climate is unfriendly (or becomes unfriendly) to outside investors, the country may
not be a good candidate for investment.

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Foreign Exchange Risk

The primary financial risk associated with internal business is foreign exchange
fluctuations. This refers to the effect of exchange rate movements on the
international competitiveness of a company and refers to the effect on the present
value of longer-term cash flows. For example, a UK company might use raw materials
which are priced in US dollars but export its products mainly within the EU. A
depreciation of sterling against the dollar or an appreciation of sterling against other
EU currencies will both erode the competitiveness of the company. Economic
exposure can be difficult to avoid, although diversification of the supplier and
customer base across different countries will reduce this kind of exposure to risk.

Causes of exchange rate fluctuations

Factors influencing the exchange rate include the comparative rates of inflation in
different countries (purchasing power parity), comparative interest rates in different
countries (interest rate parity), the underlying balance of payments, speculation and
government policy on managing or fixing exchange rates.

Currency supply and demand. The exchange rate between two currencies – i.e. the
buying and selling rates, both 'spot' and ‘forward’ – is determined primarily by supply
and demand in the foreign exchange markets. Demand comes from individuals, firms
and governments who want to buy a currency and supply comes from those who want
to sell it. Supply and demand for currencies are in turn influenced by:

o The rate of inflation, compared with the rate of inflation in other countries
o Interest rates, compared with interest rates in other countries
o The balance of payments
o Sentiment of foreign exchange market participants regarding economic
prospects
o Speculation
o Government policy on intervention to influence the exchange rate

8.8. Balance of payment

Balance of payments is a summary of transactions between domestic and foreign
residents for a specific country over a specified period. Inflows of funds generate
credits for the country’s balance, while outflows of funds generate debits.

The current account summarizes the flow of funds between one specified country
and all other countries due to purchases of goods or services, or the provision of
income on financial assets. Key components of the current account include the
balance of trade, factor income, and transfer payments.

The capital/financial account summarizes the flow of funds resulting from the sale of
assets between one specified country and all other countries. The key components

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of the capital account are direct foreign investment, portfolio investment, and other
capital investment.

8.9. The Fisher Effect

The term Fisher effect is sometimes used in looking at the relationship between
interest rates and expected rates of inflation. The rate of interest can be seen as made
up of two parts: the real required rate of return (real interest rate) plus a premium for
inflation. Then:

[1 + nominal rate] = [1 + real interest rate] [1 + Inflation rate]

(1 + I) = (1 + r) (1 + h)

Countries with relatively high rates of inflation will generally have high nominal rates
of interest, partly because high interest rates are a mechanism for reducing inflation,
and partly because of the Fisher effect:

higher nominal interest rates serve to allow investors to obtain a high enough
real rate of return where inflation is relatively high.

According to the international Fisher effect, interest rate differentials between

countries provide an unbiased predictor of future changes in spot exchange rates. The
currency of countries with relatively high interest rates is expected to depreciate
against currencies with lower interest rates, because the higher interest rates are
considered necessary to compensate for the anticipated currency depreciation.

Given free movement of capital internationally, this idea suggests that the real rate of
return in different countries will equalise as a result of adjustments to spot exchange
rates.

The international Fisher effect can be expressed as:

8.10. Foreign Currency Risk Management

Foreign currency risk can be managed, in order to reduce or eliminate the risk.
Measures to reduce currency risk are known as 'hedging'.

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Basic methods of hedging risk include matching receipts and payments, invoicing in
own currency, and leading and lagging the times that cash is received and paid. Other
common hedging methods are the use of forward exchange contracts and money
market hedging.

Netting

Netting is a process in which credit balances are netted off against debit balances so
that only the reduced net amounts remain due to be paid by actual currency flows.

The objective is simply to save transactions costs by netting off intercompany balances
before arranging payment. Many multinational groups of companies engage in
intragroup trading. Where related companies located in different countries trade with
one another, there is likely to be inter-company indebtedness denominated in
different currencies.

Example

A UK company expects to receive US$400,000 in two months’ time and to make

payments of $600,000, also in two months. To hedge its currency exposures, the
company can net $400,000 of receipts and payments, leaving a net exposure of just
$200,000 in payments. This exposure might be hedged with a forward exchange
contract.

Leading and lagging

Payments in a foreign currency may be made in advance when the company expects
the foreign currency to increase in value up to the settlement date for the transaction.
With a lead payment, paying in advance of the due date, there is a finance cost to
consider. This is the interest cost on the money used to make the payment, but early
settlement discounts may be available.

Payments in a foreign currency may be delayed until after the due settlement date
when it is expected that the currency will soon fall in value. However, delaying
payments and taking more than the agreed amount of credit is questionable business
practice.

Currency of invoice

One way of avoiding exchange risk is for exporters to invoice their foreign customer in
their domestic currency, or for importers to arrange with their foreign supplier to be
invoiced in their domestic currency. However, although either the exporter or the
importer can avoid the transaction risk through invoicing in domestic currency, only
one of them can do it. The other must deal in a foreign currency and must accept the

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exchange risk. This is the risk of adverse movement in the exchange rate up to the
date of settlement of the invoice.

Other hedging methods

International investors have several options when it comes to managing currency risk,
including things like currency futures, forwards and options. But these instruments are
often expensive and complicated to use for individual investors.

Money market hedging

Money market hedging involves borrowing in one currency, converting the money
borrowed into another currency and putting the money on deposit until the time the
transaction is completed, hoping to take advantage of favourable exchange rate
movements.

Suppose a British company needs to pay a supplier in Swiss francs in three months'
time. It does not have enough cash to pay now but will do in three months' time.
Instead of negotiating a forward contract, the company could:

i. Borrow the appropriate amount in sterling now.

ii. Convert the sterling to francs immediately at the spot rate.
iii. Put the francs on deposit in a Swiss franc bank account.
iv. When the time comes to pay the company:
a. Pay the supplier out of the franc bank account.
b. Repay the sterling loan.

The effect is the same as using a forward contract and will usually cost almost the
same amount. If the results from a money market hedge were very different from a
forward hedge, speculators could make money without taking a risk. Market forces
therefore ensure that the two hedges produce very similar results.

This transaction is called a money market hedge because the company is borrowing
and investing in the money markets to create the currency hedge.

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CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 4: DIVIDEND DECISIONS

 APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402 – MODULE 2 2020

TABLE OF CONTENTS PAGE

Contents
1. Introduction ...................................................................................................................... 82
2. Learning objectives under Dividend Decisions ................................................................. 82
3. Study material................................................................................................................... 82
4. Competence Framework expectation .............................................................................. 82
5. Examination possibilities .................................................................................................. 83
6. Assumed Knowledge ........................................................................................................ 83
7. Integration ........................................................................................................................ 83
8. Dividend theories ........................................................................................................... 83
8.1. Dividend Relevance ....................................................................................................... 83
8.2 Dividend Irrelevance View ............................................................................................ 84
9. Factors affecting the dividend decision ........................................................................ 83
10. Disadvantages of switching investments in companies ............................................... 85
11. Dividend Payment Policies ............................................................................................ 86
12. Bonus Issues and Share splits ....................................................................................... 88
13. Dividend reinvestment plans (DRP) and Scrip dividends .............................................. 88
14. Share buy-backs ............................................................................................................ 89
15. In conclusion, do dividends matter? ............................................................................. 91
 APPLIED MANAGEMENT ACCOUNTING AND FINANCE MAF 402 – MODULE 2 2020

1. Introduction
Three distinct, yet connected decisions affect the sustainable growth
rate of the firm. These are the Financing decision, Investment
decision and the Dividend decision. In making the dividend decision
some of the common questions include:
Does the dividend decision, along with the investment and financing
decisions affect the value of the company? / Is the dividend merely
a consequence of the other two decisions? / If a firm chooses to
finance a new investment by a cut in the dividend what is the impact
on existing shareholders and share price of the company?

2. Learning objectives under Dividend Decisions

After studying this unit, one should be able to:
• Contrast the active variable and passive residual approaches to managing dividends;
• Explain the effect of payments on the dividend growth model;
• Calculate the dividend by applying the residual approach;
• Identify factors that affect the dividend decision;
• Identify alternative dividend payout policies;
• List important dates in the declaration and payment of dividends;
• Explain alternative methods of making distributions to shareholders;
• Describe why share buybacks occur as an alternative to dividends; and
• Explain how dividend re-investment plans (DRPS) work

3. Study material
• Carlos Correia, Enrico Uliana & Michael Wormald (2011). "Financial Management".
7"Edition,
• CAA Applied Management Accounting and Finance MAF 402 Module 2

4. Competence Framework expectation

Competence area: Financial Management
V-3.4 Evaluates decisions related to distribution of profits
Level I
− Evaluates the manner in which an entity distributes profits to shareholders
− Incorporates tax considerations
− Recommends the most appropriate method to distribute profits
The dividend decision Knowledge level
▪ Factors affecting the dividend decision 2

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▪ Relevance and irrelevance theories 2

▪ Setting appropriate dividend policies 2
▪ Scrip dividends 2
▪ Share buy-backs 2

5. Examination possibilities
Dividend decisions are highly examined at CTA level and not regularly in the ITC.

6. Assumed Knowledge
All financial management topics are assumed knowledge so that a dividend decision
is made. These include topics covering the financing decision and the investment
decision. Income tax principles are also assumed knowledge.

7. Integration
This topic can be integrated with any topic, including corporate governance and risk
in relation to whether the distribution of dividends to shareholders follows relevant
legislation.

8. Dividend theories
(Is the dividend an active variable OR a passive residual?)

There are two schools of thought:

– A dividend affects the value of a company - it is relevant and has to be actively managed
– Alternatively, a dividend has no effect on value - it is irrelevant and remains a balancing
figure dependant on financing decisions
Differential tax rates could be the deciding factor for an investment preference between
capital growth or a cash dividend.

8.1. Dividend Relevance

Illustration

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8.1.1. Dividends and capital structure

The capital structure of a company = debt and equity. Equity includes original invested capital
and retained earnings. The payment of a dividend reduces a company’s retained earnings.
This may deprive the firm of equity capital to be used for profitable investments. A reduction
in retained earnings may reduce the firm’s borrowing capacity

8.1.2. Valuation of ordinary shares using the dividend discount model

Value = D1/(k-g).

This is the dividend discount model of valuation.

Question: Is it possible to increase the value by increasing the current dividend?
Answer: Increasing D1 will increase the value ONLY if this does not reduce the growth rate, g.
The growth rate depends on the reinvestment of retained earnings and we may reduce the
value of the company by increasing the dividend.

8.2 Dividend Irrelevance View

Proponents of the irrelevance view believe that:

− The payment of the dividend REDUCES the growth potential of a company and
consequently lowers future dividends
− A dividend should only be paid if a company has no other profitable use for the funds.
− Payment of a dividend is indicative of failure by management to find suitable
investments
− A dividend can only be assessed once investment decisions and financing policies have
been established

This view manifests itself in the Residual Approach to dividends

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8.2.1. Bird in the hand theory (Dividends positively affect value)

An increased expected dividend = an increase in the value of the company. Why? A dividend
paid is more valuable than uncertain future growth. However, a counter argument is that re-
invested dividends are again subject to uncertain future growth.

8.2.2. The Millar-Modigliani Argument

The M-M argument assumes that, given certain assumptions, dividend policy has no effect on
the value of a company. Why?
− If a company with a viable financial policy pays a dividend in cash to shareholders, it
will have to raise the finance by issuing new shares amounting to the value of the
dividend.
− More shares will be in issue for the same assets.
− The shareholder is in the same position.

8.2.3. The Residual Approach

The Residual approach suggests that dividends are a passive variable. Dividends represent
“what is left over after financing and investment decisions have been made.” To adopt the
residual approach a company should identify:
− Its set of investment opportunities
− It’s required rate of return
− And its target debt ratio
− A company should accept all projects exceeding its required rate of return (cost of
capital)
− Any funds remaining should be paid as a dividend

9. Factors affecting the dividend decision

9.1. Legal and other requirements

Dividends may not be paid out of contributed share capital. The book value of the company’s
assets must exceed its liabilities. Dividends may be distributed out of profits without first
providing for past losses or depreciation of fixed assets. Working capital, depreciation and
losses should be considered and losses in previous years may be disregarded. Realized profits
on sale of fixed assets are available for distribution and unrealized profits on fixed and current
assets are available for distribution in certain circumstances. In relation to inflation there is
no requirement to maintain “real” capital

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9.2. Information content of dividends

Investors find the annual financial statements a valuable but limited source of information.
Dividends signal the well-being of the company. Management’s confidence about future
earnings is reflected by increasing or decreasing dividends. An increase in dividends is a signal
that current earnings and dividends are seen by management to be sustainable, for example,
if a company records an increase in earnings AND increases its dividend, then management is
signaling that the increase in earnings is sustainable.

As dividends and earnings per share (EPS) are regarded as prime indicators by analysts,
companies ensure that their dividend figure is acceptable to investors. However, sound
financial practice for companies in the growth phase is to fund growth from retained earnings
and not pay out dividends. Companies will NOT reduce dividends unless this is absolutely
necessary. This is because management wishes to signal that any reduction in earnings is
temporary.

CSL recorded a significant fall in earnings per share in 2003. Yet the company maintained its
dividend per share.

Illustration

CSL’s management is trying to convey to the market that any reduction in EPS is temporary.
Is the conventional wisdom still true? FBL, a USA utility cut its dividend – “the dividend cut
heard around the world”. What happened to its share price? First it fell and then recovered
and the company outperformed other utilities when analysts understood that this was a
strategic decision and not a decision made under stress.

9.3. Taxation – dividends versus capital gains?

Dividends mean that a company will have to pay Dividend Withholding Tax (DWT). Capital
gains are now also taxed. What is better – to pay dividends or reinvest so that investor pays
Capital Gains Tax? Otherwise, should the company retain earnings and pay a dividend later?
Share dealer – subject to normal tax (Not CGT)

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9.4. The Nature of the Shareholders

Shareholders are attracted to companies that satisfy their needs regarding the balance
between cash income and capital growth. This is known as the “clientele effect.”
Shareholders who require income will invest in companies with a higher dividend yield, for
example, utilities have traditionally paid a high level of dividends. Shareholders who require
growth and prefer capital gains will invest in low dividend yield but high growth companies.

Management is responsible for maximizing shareholders’ wealth and may choose to reinvest
rather than distribute dividends. However, management may decide to increase its dividend
payout policy if there are limited investment opportunities. In either case, the company may
see a change in the profile of its shareholders.

Why is the clientele effect important when shareholders can sell shares to obtain income?
Why should management consider the clientele effect when shareholders can switch
investments by selling and buying shares?
If a high dividend company decides to change its payout policy then shareholders can sell their
shares and buy into another company with a more appropriate dividend payout policy. Yet,
there are disadvantages of switching investments and buying and selling shares. What are
the disadvantages?

10. Disadvantages of switching investments in companies

− Transaction costs of selling and buying shares
− Gains may be classified as trading income and investors may be charged a higher tax
rate than the capital gains tax rate.
− Shareholders may be precluded by internal rules from disposing of the investment in
the company
− Loss of control. Dilution of the voting control of current shareholders will occur if the
company issues new shares in the future.
− Flotation costs are incurred when new shares are issued. It is cheaper for a company
to retain earnings rather than pay dividends and issue new shares

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Business Stages

11. Dividend Payment Policies

The conflict for managers who have to maximize value for the business and keep shareholders
satisfied is reduced by setting a dividend policy.

− A stable dividend amount regardless of annual earnings.

− A stable payout ratio (stable dividend cover) which means that the company pays out
a fixed proportion of earnings as dividends.
− A stable dividend plus bonus for companies subject to volatile trading conditions.

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Dividend Policies (Graph)

11.1. Payment of Dividends

The Dates associated with the payment of dividends are the:

i. Declaration date – the date on which the directors in meeting decide to pay a
dividend.
ii. Ex-dividend date – shareholders who purchase on or after the ex-dividend date will
not receive the dividend. A company’s share price will normally fall by close to the
dividend amount when it goes ex-dividend.
iii. Last day for registration (LDR) – shareholders registered on this day will receive the
dividend.
iv. Payment date - the date set by the directors to pay the shareholders registered by the
LDR.

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12. Bonus Issues and Share splits

A Bonus Issue or Capitalization Award is the allotment of additional shares to all existing
shareholders at no cost to the shareholders. A Share Split is the division of existing shares into
a proportionately greater number of shares. Bonus shares and share splits do not affect the
value of the firm as there is no change in the firm’s cash flows, no cash paid, or change in risk
profile. However, the value per share changes. Companies will often undertake a share split
when the share price reaches a certain level and the company wishes to bring the share price
within a normal trading range to encourage affordability and liquidity.

Share splits example

Assume Econet’s share price rises from $10 to $30 per share. Econet then decides to do a
share split of 2 for 1, by issuing 2 additional shares for every 1 share owned. If you owned
1000 shares at $30 per share, you will now own 3000 shares priced at $10 per share. Your
wealth will not have changed.

Do companies that do well always undertake share splits? There is one notable exception.
Warren Buffet’s company, Berkshire Hathaway has never had a share split and the share price
in April 2014 was about US$190 000 per share.

Reasons companies undertake these distributions

If the shares have a high market value, then;
− Bonus shares and share splits reduce the price of each share, thus making them more
marketable
− Managers of organisations, precluded from using capital for operating expenses,
dispose of the additional shares to generate income
− Bonus shares and share splits signal management’s confidence in continuing good
performance.

13. Dividend reinvestment plans (DRP) and Scrip dividends

A company can offer shareholders the option of receiving the dividend in cash or as additional
shares. The shareholders who elect to receive a scrip dividend will own a greater proportion
of the company after the issue (unless all shareholders elect to take the shares). A scrip
dividend will not attract with-holding tax whilst the company is able to retain the capital for
investment purposes. Investors will usually receive shares at a discount of the current share
price. Investors also avoid brokerage and stamp duty costs. DRPs enable companies to
increase the payout ratio and retain capital for investment purposes. DRPs are affected by
the company’s debt-equity ratio and availability of profitable investment opportunities.

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14. Share buy-backs

Companies buy their own shares as an alternative to declaring a cash dividend. Shareholders’
equity is reduced by the par value of shares acquired. Any premium over par may be paid out
of reserves.
Restrictions (from Companies Act):
– Special resolution required
– Repurchase is not permitted if the company cannot settle debts or if liabilities exceed assets
– Offer made to all shareholders

What is the effect of a share buy-back on a company’s balance sheet?

Example
Zimnat’s share price is $3.00 and Zimnat wishes to undertake a buy-back for $90m. What is
the effect on Zimnat’s Statement of Financial Position?

Before After buy-

Statement of Financial Position buy-back back
$m $m
Cash 120 30
Other non-current assets 60 60
Non-current assets 120 120
300 210
Contributed equity (100m shares
@$0.50: 75m @ $0.50) 50 35
Retained profits 250 175
300 210

A share buy-back will usually result in an increase in EPS due to the reduction in the number
of shares in issue.

14.1. Why do companies undertake share buybacks?

a. Signaling
Dividends signal a commitment to future levels of cash payments. If the company is uncertain
about sustaining the dividend it can rather buy back shares.

b. Flexibility
The declaration of a special dividend that does not imply ongoing commitment is a firm
commitment with specified date of payment. A repurchase plan allows for more time or
partial purchase if need be.

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c. Taxation
If capital gains and dividends are taxed at different rates shareholders can manage tax more
efficiently and decide not to sell shares back to the company and avoid CGT.

d. Control
A share repurchase reduces the shares in issue. Shareholders not selling back to the company
hold a greater portion and form a block of influence over the firm.

e. Share price
If the share price is perceived to be undervalued, buying back shares concentrates true value
in shareholders’ hands, signals confidence and helps stem share price reductions.

f. Capital structure management

Company’s shares can be managed inexpensively through repurchase and sale of shares.

14.2. Share Buy-back or Declaration of a dividend?

Share repurchases are preferable if:
✓ there is uncertainty about sustainability of future cash flows
✓ future investment needs are uncertain
✓ share price is under-rated by market
✓ shareholders’ preferences relating to capital gains and ZIMRA rulings relating to the
dividends and capital gains.
✓ timing of cash flows are required to be spread out over a longer period of time.

14.3. Is a share buy-back a Financing or Investment decision?

Although a share buy-back is often seen as a financing decision - a company is buying an asset,
its own shares. It is also an Investment decision
A share buy-back is an alternative way of paying cash back to the shareholders. Yet, although
we have included it under dividends, there are subtle and powerful differences. What is
driving the decision of the company to purchase its own shares? It appears to be a financing
decision, but it is really an investment decision.

Whilst setting a dividend may reflect the company’s dividend policy, the company is really
setting its reinvestment policy. What the company pays out, it does not retain. Why use a
share buy-back to pay money back to shareholders? Firstly, the company can exercise greater
flexibility in relation to share repurchases as compared to dividends. Secondly, there may be
tax advantages to a share buy-back. A share buy-back will enable the company to dramatically
alter its capital structure and increase its debt-equity ratio. Otherwise, the company may have
accumulated reserves and cash resulting in a debt-equity ratio that is far away from its target
capital structure. A share buy-back will enable the company to reduce its equity and move

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towards a debt-equity ratio that is more aligned to its target capital structure. The significant
fall in interest rates also enabled firms to issue corporate bonds at lower cost as compared to
equity.

14.4. When does a share buy-back reflect an investment decision?

If a company’s shares have fallen from grace and are trading at levels below its intrinsic value,
then a share buy-back is an investment decision and it is also a signal that management
believes that a company’s share price is undervalued.

14.5. Taxation consequences

− Withholding tax arises on cancellation of shares on distributable earnings portion
(includes earnings previously capitalised)
− Share buyback in hands of investor subject to CGT (Share dealer – normal tax)
− If held in subsidiary – marketable securities tax on gains

15. In conclusion, do dividends matter?

• Purely analytical point of view
➢ Don’t matter – homemade
➢ Dividend growth model rebalances
➢ M & M – but assumptions
➢ Residual approach
➢ Failure by management
➢ Taxation issues, DWT vs CGT
➢ Divisible profit – legal requirements

• Non-financial considerations
➢ Bird in the hand theory
➢ Cash information – strong information
➢ Can be managed, increases sustainable, declines long lasting
➢ Limitations of annual financial statements
➢ Complexity
➢ Manipulation
➢ Historic cost
➢ Clientele effect
➢ Transaction costs if no dividends (flotation, trading costs)
➢ Share dealer tax consequences
➢ Institutional rules
➢ Issues of control
➢ Volatility, therefore smoothed

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• Alternatives
➢ Scrip dividends
➢ Bonus dividend
➢ Capitalisation award / share split
➢ Share repurchases

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16. Practice Question

Background

Anglo Astounding Limited (AA) is one of the world`s largest mining groups. With its
subsidiaries, joint ventures and associates, it is a global leader in platinum group metals and
diamonds, with significant interests in coal, base and ferrous metals, as well as an industrial
minerals business. The Group is geographically diverse, with operations in Africa, Europe,
South and North America, Australia and Asia.

A friend of yours Professor Patrick Dickson, has approached you recently regarding his
minority investment in the company. Your friend is retired and uses his investment income
for his daily living expenses. Your friend has approached you for advice regarding the recent
dividend declaration for the 2018 final dividend for AA, where the company decided not to
pay any dividend. He is highly concerned and has asked whether you could explain to him the
dividend policy considerations which the company would have taken into account in reaching
this unexpected decision. Your friend has collected the following information to aid in your
explanation:

AA - Half Year Financial Report for the six months ended 30 June 2018
AA announces further progress on delivery of value financial results
- Group operating profit from core operations of $2.1 billion
- Underlying earnings of $1.1 billion and underlying earnings per share of $0.91
- Profit attributable to equity shareholders down 31% at $3.0 billion
- Net debt of $11.3 billion at 30 June 2018
- Committed undrawn bank facilities and cash of over $9 billion at 30 June 2018

Driving operational performance and delivering significant value

- Significant cost reductions achieved across the Group and global headcount
reduction ahead of target
- Delivery focused on high quality growth in most attractive commodities
- Development of three key strategic projects on track - Minas-Rio, Los Bronces
and Barro Alto
- Near term liquidity addressed - $6.5 billion raised through new financing and
proceeds from sale of residual shareholding in AngloGold Ashanti - Sale of Hulamin
shareholding for approximately $148 million

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HIGHLIGHTS FOR 6 months ended 30 June 6 months ended 30 June Change

2018 2017
$million $million
Group revenue 11 132 17 915 37.9%
Operating profit 2 054 5 974 65.6%
Basic earnings per share 2.47 3.56 30.6%
Underlying earnings per 0.91 2.90 68.6%
share

Jun Dec Jun Dec

PER SHARE/UNIT STATISTICS (cents per share/unit)
2018 2017 2017 2016
Interim Final Interim Final
D ebt : Equity ratio 0.81 0.99 0.67 0.61
Quick Ratio 0.73 0.52 0.87 0.66
Current Ratio 1.10 0.73 1.13 0.87
P:E ratio 10.84 6.75 14.64 14.08

Comments from an interview with the Chief Executive Officer (CEO):

"We took early and decisive action in order to respond effectively to the global economic downturn; we have
focused on driving operational performance, preserved capital through halving our planned capital expenditure
for the year, scaled back higher cost production and growth plans in platinum and coal and suspended dividend
payments. As expected, the market environment has been challenging in the first half of 2018 and AA`s
performance was impacted by the sharp declines in commodity prices against the prior year and anticipated
reductions in volumes, partially offset by exchange rate benefits compared to the first half of 2017.

We also successfully addressed our near-term liquidity in the first half, raising $6.5 billion of funding, including
two over-subscribed bond issues and the sale of our residual shareholding in AngloGold Ashanti. In combination
with the tough but necessary decisions we took around capital expenditure, production scheduling and dividends,
this positions the Group well to carry us through the downturn and enables us to preserve the development of our
key strategic growth projects, a key value driver for shareholders’’.

Dividends
The resumption of the payment of a dividend to shareholders remains a key priority for the
board. This will be considered against the background of the overall market environment, the
Group`s capital requirements, as well as the future earnings and cash performance of the
business.

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AA has leading positions in commodities where there is limited availability of new supply
sources, given the scarcity of attractive, large scale projects and capital constraints. Such
characteristics are typical of the platinum, diamond and iron ore industries, for example.
• AA benefits from being positioned in commodities that have attractive
industry cost structures, which drive both profitability and stability of production.
• AA has developed a portfolio of world-class operating assets and development
projects focused on those commodities with the most attractive risk-return profile.
The majority of AA`s capital is employed in platinum, iron ore and copper,
commodities that have generated the most attractive average returns on invested
capital for companies focused on those commodities.
• In addition to making targeted high-quality investments in nickel. The decision
to preserve the development of its three key near term strategic growth projects
during the economic downturn positions the Group to capitalise on the next phase of
global economic growth. The three projects are all well placed on their respective
industry cost curves, have long resource lives and are on track to enter production
from 2020 onwards, in what is expected to be a growing commodity demand
environment.

Outlook
• The global economic downturn had a profound effect on all commodity prices
in the second half of 2017 and early 2018. From their high points in the first half of
2017, the price of platinum had fallen by 59% by the end of the year; copper by 65%
and nickel by 69% - as the banking system came close to collapse, confidence and
credit drained from the system and global financial markets went into free fall. In the
second quarter of 2018, prices for a number of commodities strengthened. While such
price recovery offers grounds for increased optimism, the overall economic situation
remains fragile. Global GDP growth is forecast by the IMF to decline by 1.4% in 2018,
with major contractions in industrialised countries being partly offset by growth in the
emerging and developing economies, with China forecast to grow at above 7.5%.
• The long-term fundamentals for the mining industry remain very robust from
both the demand and supply sides. The industry has seen curtailment of many high
cost operations in nickel, iron ore and coking coal, while the difficult financing
conditions are expected to continue to impact the funding and timing of many
potential new mines and expansions, constraining supply as economic growth returns.
In terms of demand, whilst China is expected to support both near and long-term
demand growth for bulk commodities and base metals, the recovery of the OECD
countries, stimulated further by government spending programmes in many major
economies, will be an important factor, with upside for platinum group metals.

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The Group`s forecasts and projections, taking account of reasonably possible changes in
trading performance show that the Group will be able to operate within the level of its
current facilities.

We have continued to see that, although some emerging market economies are doing less
badly than others, the spread of globalisation over the last two decades, means that the
world is far more inter-connected than ever before. Thus, the recession is being felt even in
those countries that have pursued orthodox macro-economic policies and whose regulatory
systems have not failed. Against a background of great uncertainty about the length and
depth of the recession, your Board took the difficult decision to recommend that no dividend
should be paid. This was done with the greatest reluctance and with a full understanding of
the difficulties which our decision may cause for many individual and institutional investors.
We entered the recession with a strong balance sheet and with what had been thought of by
many, at the height of the boom, as a relatively conservative level of borrowing. However,
in the current context, $11 billion of borrowing represents a significant sum.

We believe it to be sustainable, against a background of halving our capital expenditure this

year and aggressive targets for savings from procurement and asset optimisation
programmes. Recently, we have further underpinned our position through the sale of the
last tranche of our stake in AngloGold Ashanti and a new bond issue. However, the Board
took the view that, in current conditions, cash preservation was paramount in order to
maintain the maximum degree of flexibility. We have a strong, long-term business and we
have taken difficult decisions intended to position the business for the upturn when it arrives.

During the year, the priorities for most of our businesses altered radically; moving from
wrestling with the need to expand production to the current focus on asset optimisation and
cash conservation. I recognise the very considerable strain that this has imposed upon our
people. It was, therefore, with considerable regret that, in February, we announced the need
to reduce our workforce - of employees and contractors - by some 19,000 people.

AA`s world-class strategic growth prospects

I have talked about the importance of continuing the development of our key strategic
growth projects, albeit on revised schedules. AA has one of the strongest and highest quality
project pipelines in world mining, focused on the most attractive commodity segments, with
projects approved or already under way totalling some $16 billion. These projects are a key
driver of future value creation for you, our shareholders. Our projects have the great benefits

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of large scale and long life: an average life of more than 40 years, against an industry average
of well under half that.

Outlook
In summary, commodity markets have experienced a turbulent six months, though prices for
most commodities appear to have stabilised more recently. Indeed, there are even signs of
some improvement.

Looking forward, we are confident that the medium- to long-term fundamentals are firmly in
place for strong commodity demand growth. We see significant value to be created by the
Group`s long-life, low-cost growth projects, several of which are well timed to enter
production in 2020, and our continued success at driving down our operating costs will
further strengthen our competitive position through the cycle.

Furthermore, let us not forget the effect of the downturn on many of the mining industry`s
junior players and the resulting impact on exploration activity, in addition to the
abandonment or delays to many major greenfield projects across some of the more
established players.

When the cycle turns, supply of many commodities is likely to be severely constrained. By
preserving our key growth projects, uplifting the performance of our existing operations and
continuing to drive down costs, AA is well placed to reap the rewards of that upswing.

Dividend Distributions

180
160
140
120
Special
100
Final
80
60 Interim
40
20
0
2010 2011 2012 2013 2014 2015 2016 2017 2018

Special dividends in 2014 and 2015 were paid out of proceeds from the sale of non-core
assets of the company.

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Share buybacks
2017 AFS
The $4 billion share buyback programme announced in August 2016 was suspended, with
around $1.7 billion of shares having been repurchased.

2016 AFS
The $3 billion share buyback program announced in February was completed in October 2016
and the additional share buyback program of $4 billion, announced in August, is 33%
complete with around $1.3 billion of shares having been repurchased at 19 February 2017.

REQUIRED Marks
a. Write a report to Professor Patrick Dickson explaining the dividend
policy considerations which the company would have considered in
reaching their unexpected dividend decision. Your answer should
explain:
• the current dividend theories, and how these would have been
applicable; 32
• how the circumstances of the company and financial position may have
affected the dividend decision, including how you feel the financial
indicators have affected the decision;
• what further information you would require to fully inform the
Professor?

b. Should he sell his shares due to the dividend cut? 3

c. The cancellation of the share buyback in 2017 was not viewed by the
investors as seriously as the cutting of the dividend in 2018. Explain why
this would have been viewed as being less serious by investors. 5

TOTAL 40

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Suggested Solution
Dividend Policy report
Professor Patrick Dickson
By: CTA Student

Date: DD/MM/YYYY

Dividend policy for 2019 dividend

Dear Patrick,
General

Dividends generally make no economic sense, retained earnings are cheapest form of
finance. (1)
Miller and Modigliani - when dividends are paid, there is need to raise new capital
thereby diluting value. But assumptions (1)
• No taxes - but AA will be subject to Capital Gains Tax (1)
• No transaction costs - but AA have listing costs, transaction costs, prospectus (1)
• No market imperfections - Markets are semi strong at best (1)
According to the dividend discount model, although you can increase the numerator
with a higher dividend the lower growth will cancel out any effect in value. For AA,
growth will increase value, not dividend. (1)
AA has not paid a dividend to fund growth opportunities, evidencing this relationship. (1)
Bird in hand theory, states dividends are better than uncertain future growth, but (1)
dividends are reinvested.
Asymmetry of information - management has more information (Agency theory) (1)
Profitability

Appears that AA is implementing a residual policy, where dividends are only paid if
there is surplus. (1)
Profits are down by 31%, therefore have reason in difficult environment to consider
cutting dividend. Revenue is down by 38%, profit down 66%, cash flows down 60%,
profitability position supports cut (1)
Profits are down due to environment, commodity prices low, volumes down, therefore
not in control of AA, and makes sense not to pay dividend. (1)
Debt and liquidity
AA does have cash on hand of $9 billion to pay dividends, so have cash, but $6.5 billion
was raised recently, to pay dividend out of new debt raised would not be appropriate. (1)
But with cash, are trying to grow, 3 new acquisitions which need available funding. (1)
Battling in recessionary environment. Makes sense to preserve and retain cash. (1)

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Debt: Equity ratio has deteriorated signalling concern on financial position, justified to
keep cash. (1)
Current liquidity - quick and current ratios look reasonable, therefore could pay (1)
dividend.
Sale of bonds oversubscribed, suggesting a large discount, need cash urgently, reducing
dividend. (1)
Debt capacity and debt rating may be affected if a dividend is paid. (1)
PE ratio

PE ratio is down, signalling share price has been hit hard, as Earrings will also be down,
Price must be down even further. Price hit harder than Earnings. (1)
PE however up from December, indicating that shareholders may be pricing in growth. (1)
Other measures

AA has already halved their planned capital expenditure, so have to cut back on
dividend to retain growth. (1)
Continuing with growth plans is doing what is best for the business. (1)
AA is still well placed in the commodity industry, with good assets, appears to be a (1)
sustainable company.
AA in fact is a good position to capitalise on the liquidity crisis to buy smaller weaker (1)
competitors.
Commodity prices have strengthened, indicating div resumption imminent. (1)
Cash retention stated to be for retaining flexibility, justified reason for cutting (1)
dividends.
Also retrenching staff shows AA is in difficulty, and perhaps the dividend cut justifiable.
Unions may react negatively if cut jobs and then pay dividends. (1)
Legal and other requirements

AA did make a profit, therefore according to companies act, can pay a dividend. (1)
Clientele effect - investor base

Patrick is retired and lives off income, therefore prefers dividend. (1)
Company will consider that some investors prefer capital growth, and others dividend
income. (1)
Environment

Decision based on uncertainty, as to depth and length of recession. (1)

Dividend cut may be accepted by market due to state of global economy. (1)

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But still should be questioned on how bad their circumstance is. (1)
This is countered by the information on strength of the company released by the CEO. (1)
AA in strong position to acquire or capitalise on their supply advantage when market
recovers. (1)
Banks will be slow to provide debt in a recessionary environment, perhaps reason for
bond issue? (1)
Previous years dividends

The company has a history of increasing interim and final dividends, will have created
an expectation for shareholders. (1)
Special dividends were paid in 2005 and 2006, for specific disposals, do not imply
sustainable. (1)
However, sale of Ashanti - would there not be expectation created for special dividend
on disposal? (1)
Continual increase, shows confidence in growth, good upward trend. (1)
Year 2018 shows a decline in dividends, in line with the recessionary economy, info
content bad. (1)
Although is in context of recessionary economy, and additional information to explain
decline. (1)
Information content of dividends

As you are a minority investor, will be reliant on dividend information content. (1)
Powerful cash backed form of information. Signal of wellbeing of company. (1)
Confidence about sustainability of earnings, therefore committed to dividend long term
if increase. (1)
If decrease, is a particularly bad signal, as dividends can be managed, signal of long-term
decline. (1)
Shortcomings of AFS. Historic, complexity, backward looking, timeliness. (1)
Other information you require

Overall profile of investor base for AA to assess clientele effect. (1)

Future projections of AA, particularly profitability and dividend. AA mentioned these
supports resuming dividend. (1)
Information on tax profile of investor base of AA. (1)
Conclusion
Circumstance seems to justify the cut in dividends, the additional information mitigates
the bad information content of the dividend. (1)

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Structure of report (1)

Flow of argument (1)
Logical structure (1)
Max 32

Part 2.
Should he sell his shares?

If he needs the cash dividends to live off, he could move his investment to a more stable
div payer, (1)
If not, the info content is bad, but other info shows company is well positioned going
forward. (1)
Could in the interim create a homemade dividend by selling shares to generate revenue,
but costs. (1)
Tax consequence - CGT will arise immediately. (1)
AA made statement that committed to resuming dividend, know this will affect
shareholders. (1)
Total 5
Max 3

Part 3.

Cancellation share buyback

Share buyback is not a commitment as a dividend is. (1)
There is no expectation of sustainability by shareholders (1)
Each shareholder does not benefit individually from a share buyback as with a
dividend. (1)
The information content was therefore not as significant as the cut in the dividend. (1)
With the decline in the share price, from a capital structure perspective, it probably
made sense not to continue repurchasing shares. (1)
Total 6
Max 5

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Integrated Questions: Table of Contents

Question 1 .................................................................................................................................. 103
Question 2 ................................................................................................................................... 110
Question 3 ................................................................................................................................... 116
Question 4 .................................................................................................................................. 133
Question 5 ................................................................................................................................... 153
Question 6 ................................................................................................................................... 159
Question 7 .................................................................................................................................. 169

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

Question 1: Willowvale Motors Ltd

Willowvale Motors Ltd is a well-established Zimbabwean vehicle manufacturer and produces the
CMW motor vehicle range, which includes the Series 1, Series 3, Series 5 and Series 7 CMW
vehicle models. The company recently identified a new expansion opportunity and is considering
taking advantage of this. Market research (costing $1 million) was undertaken and has
established that there is demand within Africa for two brand new models of CMW vehicles, the
Series 2 and the Series 8. The Series 2 and Series 8 are currently only in prototype form, but the
market research has made it clear that there is likely to be strong demand for these two vehicles,
especially amongst government officials in Africa. The new Series 8 is a large powerful vehicle
with bullet proof glass, and market research indicates that those in high levels of government are
interested in this new model due to the power and protection offered by the vehicle. The Series
2, on the other hand, is a small fast vehicle with attractive lines and appeals to the younger
generation.

The recently qualified financial manager Mr M Thanuel has compiled the following information
on the two new vehicle lines:
In order to produce the new CMW models, highly specialized machines costing $100 million per
annum will need to be leased for the production fitting line.

The materials required to produce the Series 2 and Series 8 include steel, engine components and
other components. The steel used to produce the Series 2 and Series 8 is different to that used in
the existing CMW product range. The steel required for the Series 2 and Series 8 can be purchased
at $20 per kg and the Series 2 requires 1.25 tons while the Series 8 requires two tons of steel. The
same basic engine components are used in all the CMW vehicle models and will also be used in
the Series 2 and Series 8 models. Engine components are estimated to cost $60 000 per vehicle.

The ‘other components’ required for the two new vehicle models include the leather, steering
wheel, dashboard, sound system, seatbelts, mats etc for the interior of the vehicle, and are
uniquely designed and produced for each model in the CMW range. The cost of these ‘other
components will amount to $30 000 for each Series 2 vehicle and $160 000 for each Series 8
vehicle. The design of these ‘other components’ was completed when the prototype was
originally designed.

The current labour force is employed on the existing production fitting line and has expertise in
producing the old CMW vehicle range. They are fully occupied on the existing production lines
and as a result new production labour will need to be employed if the Series 2 and 8 are
manufactured by Willowvale Motors Ltd. Existing production labour is currently paid $65 per
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hour per employee. All new labourers will need to be trained to produce both the Series 2 and
Series 8 model vehicles, at a total training cost of $5 000 per employee. Half of the training time
will be spent on the Series 2 fitting, and the other half will be spent on the Series 8 fitting. There
is currently a shortage of vehicle production labour and new staff can only be sourced if they are
paid $98 per hour. All labour is paid for a full hour where a part hour is worked. You may assume
that an adequate number of individuals are available in the labour market to be hired.

The production manager, Mr Cavalera, has great experience in the production of motor vehicles
and has indicated that production fitting labour will become more efficient as more batches are
produced. He has estimated that a learning curve of 95% will take place for the first 15 000
vehicles of each new model. 50 Series 2 vehicles will be processed through the production fitting
line at a time, while only 15 Series 8 vehicles will be produced at one time. The production fitting
labour time for the first batch of Series 2 and 8 vehicles is expected to be the same and is expected
to take 1 000 labour hours. The production fitting of the two new models is completely unique
therefore learning will take place independently on each line, although the staff will be involved
on both models of vehicles. New workers can work a maximum of 160 hours per month as the
company has a strict policy of not allowing overtime.

The variable manufacturing overheads currently amount to $10 000 per vehicle for the existing
CMW product range, but it is expected that for the two new vehicles this will increase to $11 000
for each Series 2 or 8 vehicle.

The total rental cost for the factory premises amounts to $96 million per annum. 80% of the
factory space is used to produce the existing CMW vehicle range. The remaining 20% floor space
is required in order to produce the two new CMW models. Previously this factory space was
vacant. No additional factory premises over and above this will be needed.

The other annual incremental fixed manufacturing costs estimated to be incurred if the two new
CMW vehicle models are launched, are described in the table below:
Description Amount
Engine tuning department $45 000 000
Vehicle fitting production line $30 000 000
Quality control inspection $20 000 000
Total $95 000 000

If the decision is taken to go ahead with the two new CMW models, a major advertising campaign
to create brand awareness will be undertaken and is expected to cost the company $12.5 million
per model.

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Total non-manufacturing costs for the entire CMW range is accurately presented by the following
cost function: Y= $50 000 000 + $1 500X

Variable non-manufacturing costs are driven by the total number of CMW vehicles sold. There
are no incremental fixed non-manufacturing costs incurred if the two new products are launched.

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Forecasted sales and production for the first year of operation:

Products Demand in units Selling Price per vehicle
Series 2 500 vehicles per month $150 000
Series 8 250 vehicles per month $400 000

The forecasts have been performed by a small new company and Mr Thanuel is concerned about
the reliability of these estimates, as they appear to him to be overly optimistic. However, Mr
Thanuel is relatively new to the industry and does not want to question the ‘so called experts’ on
their estimates. It is anticipated that no work-in-progress or finished goods inventories will be on
hand at the end of the financial year.

Willowvale Motors Ltd successfully introduced an Activity-Based-Costing (ABC) system in 2015,

and currently uses this system within its organisation. The company therefore has good insight
into costs causation and can identify how different motor vehicle models utilize resources within
the organisation. Mr Thanuel has held meetings with Mr Cavalera and together they have used
this insight to estimate how the two new CMW models will utilise the factory resources. Each
Series 2 vehicle will require 100 machine hours to manufacture while each Series 8 vehicle will
require three times this machining time. The vehicle production fitting line is where all the
internal components of the vehicle are fitted onto the body and where the engine is placed into
the vehicle. One model type will be processed at a time and this will take place in batches. 50
Series 2 vehicles will be processed through this production fitting line at a time, while only 15
Series 8 vehicles will be produced at one time. This is due to the high-quality components
required to be installed within the Series 8 vehicle, as well as the complex process of installing
the bullet proof windows. The time spent on the vehicle production fitting line by a batch of
Series 2 vehicles is the same as the time spent by a batch of Series 8 vehicles on the vehicle
production fitting line.

The engine tuning department assembles the engine components and tunes each engine to the
necessary specifications. Sufficient engines are tuned at one time, to be installed in each of the
vehicles on the production fitting line. As the Series 8 is a far more powerful vehicle, there is a lot
more engine tuning time required, and 45 engine tuning hours are required to tune the batch of
engines for one batch of Series 8 vehicles on the production fitting line. 10 engine tuning hours
are required for each batch of Series 2 vehicle engines tuned. All vehicles leaving the factory
undergo rigorous quality control inspection. Each Series 8 vehicle requires 5 inspection hours,
while a Series 2 vehicle requires half this time.

If the decision is taken to expand, then both new CMW models will be launched. The company
will not launch only one of the new models, as Mr Thanuel believes that the infrastructure

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investment will not be covered through the sale of only one new vehicle model. Therefore,
Willowvale Motors Ltd needs to decide whether to launch these two new models, or whether
they should delay expansion for another project. If the decision is taken to proceed with the
expansion, production will commence on the 1st of July 2019.

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REQUIRED Marks

a. Assume that Willowvale Motors Ltd has made the decision to go ahead with
the launch of the two new CMW models. Determine, for the first year of
39
production and sales, which of the two models will be more profitable.

b. Determine the relevant break-even point for the first year of production and
sales of the new venture. Discuss whether in your opinion whether
Willowvale Motors Ltd should go ahead with the launch of the two new
models. 8
(For purposes of your calculations assume that the company is still
considering launching both Series 2 and 8 models at the same time.)

c. Discuss other qualitative factors that should be considered, before

proceeding with the expansion project.
3

Total 50

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a) Part A: Profitability calculation of the two product lines Marks

Calculations
Selling price per
Products Demand per Month Demand P.A Total Revenue
car
Series 2 500 6,000 $150,000.00 900,000,000.00
Series 8 250 3,000 $400,000.00 1,200,000,000.00
Total Revenue 9,000 2,100,000,000.00

Materials Cost per unit of RM Series 2 Series 8 Total

Steel 20000 1.25 2
150,000,000 120,000,000 270,000,000.00
Engines 60,000 360,000,000 180,000,000 540,000,000.00

Other components 30,000 160,000

180,000,000 480,000,000 660,000,000.00

Production fitting line labour cost

Series 2
Y = PXq
Y = 1000 hours x 120 batches ln95%/ln2 701.68 cumulative average hours per batch 2
Total time: 84,202 701.68 hours per batch times 120 batches 1
Total labour Cost: Total hours @$98 per hour -8,251,796.00 1

Series 8
Y = PXq
Y = 1000 hours x 200 batches ln95%/ln2 675.65 cumulative average hours per batch 2
Total time: 135,131 675.65 hours per batch times 200 batches 1
Total labour Cost: Total hours @$98 per hour -13,242,838.00 1

Total hours for both car models 219,333 hours 0.5

One employee 160 hours x 12 months 1920 1

Number of employees : 114.24 (219 333 hours/ 1920 hours per employee) 0.5
Cannot train 0.24 of an employee, therefore will need to employ and train 115 employees 0.5

Training cost ( 115 employees x $5 000) 575,000.00 1

ABC Calculations
Description Series 2 Series 8 Total
Total cars produced 6,000 3,000 9,000

Machine Hours per unit 100 300

Total Machine hours 600,000 900,000 1,500,000 1

Size of batch 50 15 1
Number of batches 120 200 320 1

Engine tuning time per batch 10 45 1

Total engine tuning time 1,200 9,000 10,200 1

Inspection hours per car 2.5 5

15,000 15,000 30,000 1

Facility related fixed costs should not be allocated using ABC if relative profitability is trying to be assessed, which is the case in this question. 1
Therefore factory rental should not be allocated.

Level of Cost
Activities Cost Cost Driver Driver Rate per Cost Driver
Machine Rental 100,000,000.00 Machine Hours 1,500,000 66.67
Engine Tuning Dept 45,000,000.00 Tuning Hours 10,200.00 4,411.76
Production fitting line 30,000,000.00 No. of batches 320 93,750.00
Quality control Insp 20,000,000.00 Inspection Hours 30,000 666.67

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Description Series 2 Series 8

Per unit Total Per unit Total
Revenue 150,000.00 900,000,000.00 400,000.00 1,200,000,000.00 2

Total Costs 142,049.32 852,295,913.65 323,899.57 971,698,720.35

Variable Costs
Direct Materials
Steel(1 250kg*$20*6 000cars) & (2 000kg*$20*3 000cars) 25,000.00 150,000,000.00 40,000.00 120,000,000.00 2
Engines 60,000.00 360,000,000.00 60,000.00 180,000,000.00 1
Other Components 30,000.00 180,000,000.00 160,000.00 480,000,000.00 1
Labour 1,375.30 8,251,796.00 4,414.28 13,242,838.00 1
Variable overheads 11,000.00 66,000,000.00 11,000.00 33,000,000.00 1
Non- manufacturing variable costs 1,500.00 9,000,000.00 1,500.00 4,500,000.00 1
Contribution 21,124.70 126,748,204.00 123,085.72 369,257,162.00

Fixed Costs 13,221.94 79,331,617.65 47,081.13 141,243,382.35

Labour training costs 47.92 287,500.00 95.83 287,500.00 1
Advertising 2,083.33 12,500,000.00 4,166.67 12,500,000.00 1

FOHS - Allocated using ABC

Machine Rental ($100 million/1 500 000 machine hrs)x 600 000 hrs 6,666.67 40,000,000.00 20,000.00 60,000,000.00 2
Engine tuning department ($45 million /10 200 tuning hours) x 1200 t hrs 882.35 5,294,117.65 13,235.29 39,705,882.35 2
Production fitting line ($30 million / 320 batches) x 120 batches 1,875.00 11,250,000.00 6,250.00 18,750,000.00 2
Quality Control Inspection ($20 million / 30 000 inspection hrs) x 15 000 ins hrs 1,666.67 10,000,000.00 3,333.33 10,000,000.00 2

Profit per unit/ Total Profit 7,950.68 47,704,086.35 76,100.43 228,301,279.65 1

The Series 8 is a far more profitable vehicle therefore the sales strategy should be to emphasise this car to ensure 1
that the launch of this vehicle is successful, as this will determine the overall success and profitability of the venture 1
Max 39

Part B: Relevant break even point

Break-even point
Marks
Total fixed costs 220,575,000.00
Training cost ( 115 employees x $5 000) 575,000.00 From calc above 0.5
Rental of Machine 100,000,000.00 0.5
Fixed manufacturing costs 95,000,000.00 0.5
Market Research(Sunk cost) - 0.5
Factory rental expense (Sunk cost) - 0.5
Advertising costs 25,000,000.00 0.5
Non-manufacturing fixed costs-sunk - 0.5

Series 2 Series 8 Total

Contribution per unit 21,124.70 123,085.72 From calc above 1
Units to be sold 6,000 3,000 9,000 1
Weighted average contribution per unit: 14,083.13 41,028.57 55,111.71 2
(Fixed costs/ Weighted average contribution)
Therefore the break-even point in units = 4002.33 ($220 575 000 / $55 111.71) 1

Split between the two products: 2,669 1,335 1

The break-even point in revenue 400,350,000.00 534,000,000.00 or 1

Margin of safety:
Expected sales - break even sales 56%
Expected sales
1.5 bonus marks
Expected sales - break even sales 56%
Expected sales

The break-even point is well below the expected level of sales, therefore a substantial profit will be made if the venture goes ahead. 1
Assuming the estimated sales data is correct, the venture should proceed and the two new models of CMW should be launched. 1
Max 8

Part C: Qualitative factors that should be considered Marks

- The reliability of the market research data mus t be veri fi ed before a ny expa ns i on takes pl a ce. 1
- Existing labour wi l l be paid less tha n new l a bourers , res ul ting i n a reduction of staff morale and productivity. 1
- Demand for current products might decrease due the newer product bei ng i ntroduced. Thi s needs to be fa ctored i nto the profitability calculations. 1
- Recessionary effect currently bei ng experi enced on the s a l e of luxury motor vehicle sales ma y not ha ve been cons i dered by the ma rket res ea rch compa ny. 1
- There i s a ri s k due to the lack of experience of staff in ma ki ng the s eri es 2 & 8 a nd s ub s tanda rd ca rs ma y be produced. 1
- Other va l i d poi nts 1
Max 3

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Question 2: BigAchiever (40 marks)

BigAchiever (Pvt) Ltd is a manufacturing company located in Harare that manufactures

components for the automotive industry. Some of these components are sold as parts to other
automotive component companies, which are used to manufacture their final product, while
other more developed components are sold directly to the automotive assembly plants. The
motor vehicles are assembled at the automotive assembly plants.

BigAchiever has two manufacturing divisions, namely, the Brake Pad Division and the Braking
System Division. Both divisions manufacture a standard component, namely, brake pads and
braking systems, respectively. The Brake Pad Division supplies its brake pads to the Braking
System Division which assembles the braking system for entry level motor vehicles. It does this
by adding one set of brake pads, purchased either internally from the Brake Pad Division or
alternatively purchased externally. The brake pads are added to the divisions other components
which it manufactures internally, to form the final braking system which it sells directly to
automotive assembly plants. A rival company manufactures similar braking pads to those
manufactured by the Brake Pad Division but the management of BigAchiever (Pvt) Ltd has
instructed the Braking System Division not to purchase brake pads externally unless the Brake
Pad Division cannot supply them. The following table reflects details of the costs for 2018:

Brake Pad Division Braking System Division 1

Production Data 1 set of brake pads Braking System
Variable Costs
Direct material cost $30 $30
Purchased inputs $50 $20
Inter divisional transfers - $300
Direct labour
Unskilled $30 $10
Skilled $40 $30
Variable overhead $20 $20
Fixed Costs Monthly Cost Monthly Cost
Manufacturing $4 000 000 $1 750 000
Non-manufacturing $1 000 000 $500 000
Investment in division $ 795 000 000 $ 150 000 000
Cost of capital 11.5% 12%

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The external market for brake pads manufactured by the Brake Pad Division is classified as
perfect, whilst for the Braking System Division the external market is imperfect. The two divisions’
monthly sales demand in units at the respective selling prices for 2018 are set out below:
Brake Pad
Details Braking System Division
Division
Unit selling price $300 $600 $500 $400
Monthly external demand (units) 100 000 15 000 25 000 35 000
Monthly capacity (units) 130 000 40 000 40 000 40 000

The current rate of return for the Braking System Division is not satisfactory and the management
of BigAchiever (Pvt) Ltd are concerned, especially given the nature of the competitive
environment and the increased risk of selling this product. Simultaneously, the management of
the Braking System Division are extremely unhappy about the high transfer price of $300 per set
of brake pads that is supplied to them. The Brake Pad Division, however, has argued that this is
the external market price of its brake pads and that the Braking System Division would pay this
price if it purchased brake pads externally. The Braking System Division however maintain that
the Brake Pad Division is not operating at full capacity and should therefore charge out its brake
pads at a lower price which incorporates a reasonable mark-up.

In response to this debate, BigAchiever (Pvt) Ltd has contracted a management consultant to
calculate the Economic Value Added (EVA) of the two divisions, as the company has been advised
that this is a far superior measure to other performance measures. Management of the company
is considering basing the performance bonuses of staff members of the two divisions on these
results, instead of on the normal Return on Investment (ROI) and Residual Income (RI)
calculations prepared by the company.

The following EVA formula was used by the management consultant:

EVA = NIAT - Cost of Equity x (Total fixed assets + inventory + accounts receivable)

Notes relating to the EVA formula:

1. Current liabilities were not adjusted for, as there is no cash cost to the company.
2. The net income after tax (NIAT) was calculated using the maximum transfer price.

The following information was collated by the management accountant as he was searching for
information relating to his EVA calculations. He has summarised the information in the table
below, as he thought it may be of interest to the company’s management. The information
relates to the two divisions and has been collected for the 2017 and 2018 financial years, with

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some of the data for 2018 being estimated amounts. These are to be assumed to have been
correctly calculated.

Brake Pad Division Braking System Division

Description
2017 2018 2017 2018
Market share 13.5% 14.5% 16% Local 17% Local
Market size $ 50 000 m $ 55 000 m $ 110 000 m $ 110 000m
Customer satisfaction 79% 77% 82% 80%
Manufacturing cycle time 5 minutes 4.5 minutes 7 minutes 6.5 minutes
Returns from customers 5 000 6 000 4 200 4 000
Production defect rate 2% 3% <1% <1%
New product designs None 1 1 None
Economic Value Added $19 530 385 $23 630 789 $1 933 456 $2 867 898

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REQUIRED

a) Advise the management of BigAchiever (Pvt) Ltd whether the 7

introduction of Economic Value Added (EVA) as the main performance
evaluation tool will resolve the performance evaluation issues raised by
the two divisions. Provide reasons and calculations to support your
answer.
b) Discuss whether you agree with the approach taken by the management 2
consultant to calculate the EVA of the two divisions.
c) Identify and explain which of the non-financial measures are of particular 5
importance, given the nature of the company.

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Suggested Solution

a) Advise the management of BigAchiever (Pvt) Ltd whether the introduction of 7

Economic Value Added (EVA) as the main performance evaluation tool will resolve
the performance evaluation issues raised by the two divisions. Provide reasons
and calculations to support your answer.
Essence of EVA discussion - no performance measurement tool will ever rectify flaws in a
transfer pricing system!
The issue with the current performance evaluation system, is that not only is it only based 1
on financial, these financial measures
can be materially changed, and the relative performance altered, by moving the transfer 1
price up and down.
Therefore, to a large extent, the performance of the divisions is outside their control. This 1
can be seen in the calculations below,
where the ROI and RI change where the transfer price is moved to the lowest point in the
range
If the minimum transfer Brake Pad 12.08% Brake Pad US$457,500 2
price of $170 is charged Division Division RI
instead, the relative ROI
performance of the two
divisions is changed
substantially.
Braking 26.00% Braking US$2,100,000 2
System System
Division Division RI
ROI
Therefore, financial measures, including EVA, may not be the best basis to evaluate between 1
these two divisions.
The current EVA calculation is still at the max transfer price, so the same relative 1
performance will persist with performance of Braking System being overstated
and the relative performance will be completely dependent on the negotiating skills of each 1
of the two divisions.
Therefore, the introduction of EVA will not resolve the issues that currently exist in the 1
current performance evaluation system
Although EVA is superior to ROI and RI, it does not deal with the shortcomings of 1
performance evaluation where transfer pricing is used. This will therefore be used to
determining performance bonuses.

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Therefore, in order to evaluate the real performance of the two divisions, the non-financial 1
indicators should be considered
Max 7

b) Discuss whether you agree with the approach taken by the management consultant 2
to calculate the EVA of the two divisions.
The EVA calculation uses cost of equity, which is not appropriate, unless the company is 1
only financed with equity
EVA should be based on NOPAT and not net income after tax 1
The EVA formula does not deduct current liabilities. Although there is no cost of using 1
current liabilities, the fact that money now does not need to be sourced from elsewhere,
means that there is a relative saving in financing costs. Alt: current liabilities do not fund
invested capital
Max 2

c) Identify and explain which of the non-financial measures are of particular 5

importance, given the nature of the company.
The most important non-financial measures would be those relating to customer 1
satisfaction/quality of product
This is due to the nature of the produce been offered by the company
Should brake pads be faulty, this could result in deaths of customers, and legal risk to the 1
company
This will lead to a large decline in future sales, should brand damage result as a result of 1
litigation
The following ratios would therefore be of most importance to the company:
Customer Satisfaction 0.5
Returns from customers 0.5
Production defect rate 0.5
Of particular concern is the declining rate for the Brake Pad Division in all three of these 1
measures
The Braking System Division is improving in all these areas, therefore relatively they are 1
performing better than the pad division
This should be reflected in the bonuses paid to the two divisions. 1
Max 5

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Question 3: Palatable

Palatable is a 100-year-old agro-processing business focused on sugar cane. It operates four

sugar mills, two packaging plants and a central refinery in Gweru. Through its sugar
operations, Palatable produces a range of refined well known Zimbabwean carbohydrate
products.

Historically Palatable’ strategy has focused on growing market share within Zimbabwe.
However, over the last few years, local market conditions have been tough. There has been a
changing attitude towards sugar. Sugar has become enemy number one due to popular diets
such as Banting and Paleo being used on a widespread basis. Moreover, there have been a
flood of imported carbohydrate products into Zimbabwe.

Although its focus has been largely domestically focused, Palatable has not entirely ignored
the rest of the continent. It exports around 25% of its sales to major African markets like
Nigeria, Uganda and Ethiopia. Given the deteriorating condition at home, the board of
directors is of the view that the future growth of the company lies in a major expansion into
Africa.

Palatable is listed in the consumer staples sector of the Zimbabwe Stock Exchange (ZSE).
Palatable’s share price performance has been lack luster over the past few years. The market
capitalisation at 30 June 2016 was $12 billion. Both analysts and Palatable management feel
this to be an adequate fair value for the company.

The most recent financial information for Palatable Limited is as follows:

Palatable Ltd Statement of financial position

30-Jun-2016 30-Jun-2015
Note $'m $'m
ASSETS
Property, plant and equipment 15,000 16,095
Goodwill 300 350
Investments 1 30 20
Intangible assets 2 65 70
Non-current assets 15,395 16,535

Inventories 1,000 1,050

Trade and other receivables 3,000 2,600
Cash and cash equivalents 3,255 1,020
Current assets 7,255 4,670
Total assets 22,650 21,205
EQUITY AND LIABILITIES
Capital and reserves

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Share capital 150 150

Share premium 1,500 1,500
Non-distributable reserves 3,000 3,000
Retained income 5,450 5,040
Total shareholders' funds 10,100 9,690

Long term borrowings 3 5,000 4,500

Deferred tax 2,500 2,775
Provisions 4 800 800
Non-current liabilities 8,300 8,075
Trade and other payables 3,200 2,600
Short term borrowings 3 1,000 700
Taxation payable 50 140
Current liabilities 4,250 3,440
Total equity and liabilities 22,650 21,205

Palatable Ltd Statement of profit or loss and other comprehensive income

30-Jun-2016 30-Jun-2015
Note $'m $'m

Revenue 5 16,000 16,100

Cost of sales (12,500) (11,400)
Gross profit 3,500 4,700
Admin and other expenses 7 (1,200) (1,400)
Selling distribution and marketing
expenses (380) (340)
Research and development expenses (100) (250)
Operating profit 1,820 2,710
Finance costs (750) (600)
Finance income 1 70 40
Profit from continuing operations before
taxation 1,140 2,150
Taxation 6 (320) (580)
Profit for the year from continuing
operations 820 1,570
Dividend paid (410) (785)
Retained income 410 785

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Note 1

Investments comprise minority interests in companies. Finance income represents dividends

received.

Note 2

Intangible assets comprise old patents on Palatable’s advanced sugar cane extraction
processes and techniques. These are amortised in line with IFRS on a straight-line basis.

Note 3

Palatable has a long-standing relationship with Good Bank. During 2016, Palatable decided to
increase interest bearing borrowings in order to create the flexibility to expand quickly into
Africa. Palatable has traditionally used variable rate loans as its finance staff has limited
economic expertise in forecasting interest rates.

Note 4

The nature of the sugar cane extraction process results in harmful waste products that need
to be safely stored. This provision reflects the future waste product disposal costs that will
need to be incurred when the factory closes.

Note 5

75% of sales are generated domestically.

Note 6

The corporate tax rate in Zimbabwe is 25.75%.

Note 7

The depreciation, impairment and amortisation of property plant and equipment, goodwill
and intangible assets amounted to $1 150m in total in 2016 and $1 000m in total in 2015.
These amounts have been included in admin and other expenses.

Acquisition of UTO Incorporated- a Nigerian company

The most recent meeting of the board of directors was acrimonious. Institutional
shareholders have been putting increasing pressure on Palatable to expand into Africa.
However, many of the older, more conservative directors are concerned that the risks are too
high and that now is not the appropriate time in the current economic cycle to be entering
new markets. After heated discussion, and a close vote, the board decided to task the chief
financial officer (CFO), Dennis Big-eye, to investigate investment opportunities in Africa.

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Dennis has a strong view that Nigeria is Africa’s rising star and the best market to enter for
Palatable. Nigeria is one of the largest economies in Africa with a growing middle class with a
sweet tooth for sugar based products.

Dennis has done a thorough analysis of the listed food processing sector in Nigeria. There are
three listed companies that make up this sector. Details are as follows:

Company Sales (N’million) Products Interest PE

bearing Debt
to Equity
Company A 100 000 Diversified food 45% 16
producer (sugar,
flour, canned
vegetables, meat
and assorted fruit
drinks)
Company B 45 000 Sugar and cane 50% 19
syrup
Company C 35 000 Sugar and sugar 60% 21
based
carbonated
drinks
N = currency code for the Nigerian Naira

He also compared key economic and market indicators to those of Zimbabwe and found the
following at 30 June 2016:

Zimbabwe Nigeria
Local currency/US Dollar 1 13
5 year average GDP growth 2% 4%
5-year average inflation 5.5% 8%
10-year government bond 9% 16%*
yield
*Bond yields in Nigeria have been increasing during the last year

During his investigation of Nigeria, Dennis came across UTO Incorporated, a large unlisted
family-owned sugar processing company located in northern Nigeria. Dennis was excited
about the growth prospects for UTO. Although not big in the overall Nigeria market, UTO is
an important player in the northern region of the country. It has strong relationships with
customers (small spaza shops) as these are run by extended family members of UTO’s owners.

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However, the disadvantage of being locally based is that UTO’s factory processing plant is far
from sugar cane fields (the suppliers).

After extensive wrangling with UTO management, Dennis finally got hold of the most recent
years’ audited financials. These are not prepared in terms of IFRS and through further due
diligence Dennis has also made some notes. Below are the financials and his notes:

UTO Incorporated Statement of financial position

30-Jun-2016 30-Jun-2015
Note N'm N'm
ASSETS
Property, plant and equipment 30,000 31,000
Investments 1 30 30
Intangible assets 2 60 70
Non-current assets 30,090 31,100

Inventories 4,500 4,000

Trade and other receivables 10,000 6,650
Cash and cash equivalents 1,000 500
Current assets 15,500 11,150
Total assets 45,590 42,250
EQUITY AND LIABILITIES
Capital and reserves
Share capital 3 300 300
Share premium 3,000 3,000
Non-distributable reserves 6,000 6,000
Retained income 15,290 14,450
Total shareholders' funds 24,590 23,750

Long term borrowings 4 9,000 9,000

Deferred tax 5,400 4,500
Non-current liabilities 14,400 13,500
Trade and other payables 3,500 3,000
Short term borrowings 5 1,100 1,000
Taxation payable 8 2,000 1,000
Current liabilities 6,600 5,000
Total equity and liabilities 45,590 42,250

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UTO Incorporated Statement of profit or loss and other comprehensive income

30-Jun-2016 30-Jun-2015
Note N'm N'm

Revenue 6 40,000 35,000

Cost of sales (32,000) (28,000)
Gross profit 8,000 7,000
Admin and other expenses 7 (3,000) (2,500)
Selling distribution and marketing
expenses (1,400) (1,200)
Operating profit 3,600 3,300
Finance costs 4 (1,600) (1,600)
Profit from continuing operations before
taxation 2,000 1,700
Taxation 8 (800) (646)
Profit for the year from continuing
operations 1,200 1,054
Dividend paid (360) (316)
Retained income 840 738

Note 1

This represents a minority investment in an unlisted money-lending business controlled by a

brother-in-law of UTO’s chairman. The company has not paid a dividend for the last few years
as it was in its growth phase but now that it has matured, it is expected to pay a dividend of
N5 million to UTO in the 2017 financial year. Dividend growth of 8% is expected annually
thereafter and a return on equity of 20% is appropriate.

Note 2

These comprise patented sugar producing techniques. These are being amortised over their
useful lives.

Note 3

Issued share capital comprises 100 million shares of N3 each. These are all held by the UTO
family trust.

Note 4

This loan was obtained five years ago from the father-in-law of UTO’s managing director. It
bears interest at a fixed market-related interest rate and is secured over the property plant
and equipment. It is repayable in five years’ time in full.

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Note 5

UTO is currently in a legal dispute with the families of workers who died in a recent accident.
One of the boilers exploded killing 50 workers. After an investigation, poor boiler
maintenance and insufficient adherence to health and safety regulations were to blame. UTO
raised a provision in FY2016 to account for the potential legal costs and damage payments.
No other changes to provisions took place in 2016.

Note 6

All revenue is generated locally with sales taking place on a credit basis to Spaza shops.

Note 7

Administration and other costs in 2016 include N300 million for housing and entertainment
expenses for UTO’s directors and their wives. This is in addition to their market-related
salaries that are also reflected in the income statement.

Also, included in 2016 is N1010 million relating to depreciation and amortization of property
plant and equipment and intangibles. In 2015, it amounted to N1000 million.

Note 8

The tax line-item includes a bribe of N200 million paid by UTO to the Nigerian Environmental
Ministry. This was paid to waive minimum air pollution standards applicable to UTO’s sugar
factory. The statutory tax rate in Nigeria is 30%.

Expected synergies and valuation information

Dennis was also tasked with estimating the future combined cash flows of the new group. He
has come up with the following assumptions:

• Revenue
o Revenue of Palatable is expected to decline by 10% in 2017. Palatable will no
longer export to West Africa. It will supply its customers there through UTO.
This is expected to reduce transport and distribution costs for the group.
o UTO revenue growth is expected to accelerate to 25% in 2017 as they will take
over Palatable’ West African customers and continue their expansion.
o The combined group revenue (in $) is expected to grow annually by 9% from
2018 onwards

• Expected future Naira/ Dollar exchange rates

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o No futures market exists for the Nigerian Naira. Thus, Dennis has used
purchasing power parity (PPP) to estimate the future exchange rates. He
calculates that the average exchange rate for 2017 to be 14 Naira to the Dollar.

• Operating profit
o The operating profit percentage of the merged group is expected to remain
constant at 11.4%. The merged firm is able to achieve this by improving UTO’s
working capital and cost management. Palatable will introduce sophisticated
inventory management systems, be more stringent with payment terms for
customers and use its increased size to stretch suppliers.
o In addition, admin and other expenses will be reduced. The non-market related
fringe benefits paid to the former UTO directors and their families will be
scrapped. Furthermore, the UTO’s group finance function will be terminated
and this will all be done at Palatable’ head-office.
o Dennis estimates that non-cash expenses such as depreciation and
amortization of intangibles are expected to be 40% of operating profit.

• Effective tax rate

o The combined group effective tax rate is expected to be 26%. Dennis is friends
with Africa’s leading tax expert and he has suggested some aggressive transfer
pricing schemes.
o UTO effective tax rate will be substantially reduced by no longer paying bribes.

• Working capital
o Dennis estimates that working capital needs of the combined group at the end
of every year will be as follows:
▪ Current assets (trade and other receivables plus inventory) for the
combined group will be 27% of revenue (this takes into account the
improved revenue collection and inventory management expected at
UTO)
▪ Trade and other payables are expected to be 24% of total operating
expenses (cost of sales, administration and other expenses, research
and development expenses and marketing and distribution expenses)

• Investment strategy
o Dennis estimates that in order to continue growing and achieve operating
efficiencies the merged firm will continuously need to invest in new
technology. He expects to expand net investments in property, plant and
equipment by 5% of revenue annually.

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• Long-term growth rate

o Post 2018 the free cash flow generated by the combined firm in Dollars is
expected to grow by 9% annually.

• Group minority investments

o Both Palatable and UTO have numerous small investments in other businesses.
Dennis realized that book value of these investments was not a good indicator
of value. He therefore revalued them himself and came up with an estimated
combined worth of $40 million at 30 June 2016.

• Reorganization of the capital structure of the merged firm

o The purchase of UTO will provide an opportunity to reorganize the capital
structure of the group. Dennis and his team heard about the subsidized rates
that the Industrial Development Bank of Zimbabwe (IDBZ) was offering to
Zimbabwean companies expanding into Africa. Dennis decided to redeem the
high fixed interest Naira denominated shareholders loan that UTO had for
many years and Palatable ‘own long-term loan with the bank and replace them
with the new IDBZ loan.
o The new IDBZ loan will have the following features:
▪ The notional value of the loan is $6 700 million.
▪ The loan would be entered into from an effective date of 30 June 2016.
▪ The loan will have a four-year term and bears interest at a fixed rate of
10% per annum. The capital is repayable at the end of the loan.
▪ As a bonus, no interest will not be payable for the first two years. These
interest payments have been waived by the IDBZ and will not need to
be paid. Thereafter normal interest payments will resume and be paid
annually.
▪ The market-related interest rate on this loan is 14%.
o The weighted average cost of capital of the merged firm is 14.5%.

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Required Marks
a) Analyse and comment on the financial performance and financial position
30
of UTO Inc. for FY2016 and benchmark this against Palatable Ltd.
b) Perform a valuation of 100% of the ordinary shares of UTO Inc. at 30 June
2016 in order to determine a fair value in United States dollar for said shares
that will be used as the basis for negotiations in respect of the acquisition
deal. 20

50
TOTAL

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Suggested Solution

a)

Palatable UTO
2016 2015 2016 2015
Revenue growth -0.62% 14.29% 1
Gross profit % 21.88% 29.19% 20.00% 20.00% 1
Mark up % 28.00% 41.23% 25.00% 25.00% 1
Operating profit % 11.38% 16.83% 9.00% 9.43% 1

GP growth -25.53% 14.29% 1

Operating profit -32.84% 9.09% 1
growth

Earnings growth -47.77% 13.85% 1

Dividend cover 2.00 2.00 3.33 3.33 1

effective tax rate 28% 27% 40% 38% 1

effective interest rate 13% 12% 18% 18% 1

Return on invested NI 1360 2002 2320 2174

capital
Total 18400 17765 38990 37250
Assets
7.4% 11.3% 6.0% 5.8% 1

Return on assets NI 1,360 2,002 2320 2174

Total 22,650 21,205 45590 42250
Assets
6.00% 9.44% 5.09% 5.15% 1
Return on equity
NI 820 1570 1200 1054
Equity 10100 9690 24590 23750
8.12% 16.20% 4.88% 4.44% 1

Total Debt ratio 55% 54% 46% 44% 1

OR
Total assets: Total 180% 184% 217% 228%
Liabilities

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Interest Bearing debt 59% 54% 37% 38% 1

equity ratio
Interest Bearing Debt 2.02 1.40 1.95 2.09 1
to EBITDA
Interest cover ratio 2.43 4.52 2.3 2.1 1
Current ratio 1.71 1.36 2.35 2.23 1
Quick ratio 1.47 1.05 1.67 1.43 1
Cash ratio 0.77 0.30 0.15 0.10 1
Cash equity 0.32 0.11 0.04 0.02 1
Accounts receivable 68 59 91 69 1
days
Inventory days 29 34 51 52 1
Accounts payable days 93 83 40 39 1
Cash cycle 4 9 103 82 1
Max
10

Financial performance
Revenue
UTO revenue grew by approx. 15% in 2016. This is significantly better than 1
Palatable's stagnant revenue performance
This is not surprising as the Zimbabwean market is under pressure whereas the 1
Nigerian market is fast growing
This revenue growth is greater than the nominal growth in Nigeria (8%+4%) 1
Alt: UTO achieved real growth in revenue

Profitability
UTO GP% is stable at 20% 1
However, this is lower relative to Palatable 1
This indicates that Palatable is more efficient at controlling costs and has higher 1
productivity
One would expect that in Nigeria profit margin would be higher due to the lower 1
competition in the refined sugar market
But Palatable uses state of the art production techniques, greater mechanisation and 1
economies of scale and has a strong focus on cost control leading to a better GP%

OR discuss mark up
UTO mark-up is stable at 25%. 1
However, this is low relative to Palatable 1

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This indicates that Palatable is more efficient at controlling costs and has higher 1
productivity
One would expect that in Nigeria mark-up would be higher due to the lower 1
competition in the refined sugar market
But Palatable uses state of the art production techniques, greater mechanisation and 1
economies of scale and has a strong focus on cost control leading to a better mark
up
Operating profit
UTO's operating profit grew by 9% in 2016 1
This is significantly higher than that of Palatable whose operating profit fell sharply 1
However, this growth is significantly less than the revenue growth, indicating that 1
UTO is bad at managing costs
GP growth is in line with revenue growth (14%) but operating costs below the GP 1
line have increased significantly
Operating profit % has dropped slightly to 9% 1
Operating profit is low relative to Palatable 1
This indicates that UTO cost management is problematic and deteriorating 1

Earnings growth
UTO's earnings have increased by a solid 14% in 2016. 1
This is far better than Palatable's contraction of close to 48% 1
This reflects the fact that UTO is in a growing market while Palatable is under 1
pressure

Effective interest rate

The effective interest rate has remained stable at 18% 1
This reflects that UTO has a fixed rate loan. As interests are increasing in Nigeria this 1
is positive

However, 18% is high relative Palatable's 13% borrowing costs 1

This differential may reflect the higher risk of Nigeria and UTO's operations 1
This rate is quite good as only 2% above the 16% bond yield 1

Effective tax rate

UTO's effective tax rate at 40% is higher than 2015 and greater than the statutory 1
tax rate in Nigeria
This is irregular - bribe is included here 1
Palatable's effective tax rate is lower and close to the Zimbabwe corporate tax rate 1
The tax regime in Nigeria is less favorable than in Zimbabwe 1

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Dividends
UTO dividend cover has remained unchanged indicating that they follow a stable 2
pay-out ratio
UTO dividend cover is greater than that of Palatable 1
This is not surprising as UTO is growing and should be ploughing capital back in for 1
future development

Return on Assets/ Return on invested capital

ROA and ROIC in UTO have remained relatively stable 1
ROA and ROIC are low relative to Palatable 1
Additionally, ROA and ROIC is low relative to WACC 1
This low return reflects poor operational performance (see comments on cost 1
efficiencies above)
And the poor returns also reflect poor asset utilisation or over-capitalization 1
UTO may have over invested for the future (asset base is too high) 1

Return on Equity
UTO ROE is lower than the ROA 1
This means that UTO is not benefiting from financial leverage as the Cost of debt is 1
greater than the ROA
But it improved slightly in 2016 1
UTO ROE is lower than Palatable ROE and experiencing positive effects of gearing 1
This indicates UTO; s poor cost management, poor asset utilisation and high cost of 1
debt

Solvency
UTO DE and DR are stable 1
UTO DE and DR are lower than Palatable 1
OR
Total Assets: Total Liabilities also stable

UTO interest bearing debt to EBIDA is stable / falling slightly 1

This ratio is low and indicates UTO can pay off all borrowings in under three years 1
It is higher than Palatable in 2015 but lower than 2016 1
One should benchmark against 2015 not 2016 as Palatable has taken on more debt 1
in 2016 in anticipation of future acquisitions
Interest cover is stable in UTO as just above 2x 1
However, it is slightly lower than Palatable 1

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UTO debt level and interest cover is appropriate as the cost of debt in Nigeria is 1
higher than in Zimbabwe
This is risky - a healthy interest cover is in the region of 3 1

Liquidity
UTO's CR Quick ratio and cash ratio are stable 1
Although CR and Quick ratio are greater than in Palatable the cash ratio is lower 1

Similarly, the cash/equity ratio is also lower in UTO than in Palatable 1

This indicates that although UTO liquidity is good their current assets are dominated 1
by riskier inventory and accounts receivable and may also indicate excessive
accounts receivable and inventory
UTO is experiencing more pressure on its liquidity than Palatable 1

This may be indicative of poor working capital management 1

Working capital
Accounts receivable days has increased to 91 days from 69 1
Although revenue increased by 14% the quality of sales seems to have deteriorated 1
as UTO is taking more than 20 days longer to receive cash
This ratio is higher than Palatable 1
This may reflect the fact that Palatable is bigger and has more bargaining power with 1
its customers
UTO' s AR is higher credit risk compared to Palatable due to nature of customers 1
(Spaza shops vs established chain stores)
Inventory days is stable in UTO 1
However, inventory days is lower in Palatable 1
This indicates poor inventory management in UTO 1
This is contributing to poor profit margins and low ROA above 1

Accounts payable days in UTO is stable 1

However, it is much lower than Palatable 1
This indicates that Palatable is able to use its size to squeeze suppliers to maximum 1

Cash cycle in UTO has deteriorated due to issues described above 1

In addition, it is much higher than Palatable indicating poor working capital 1
management in UTO
Max 20
Total 30

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b)

Calculation of maintainable earnings

One can use 2016 earnings as a proxy maintainable earnings as earnings appear to 1
be increasing.
2016
N'm
Earnings 1200 1
Add back bribes 200 1
Add back extra ordinary fringe benefits 300 1

tax impact -90 1

Add back legal and damages fees 100 1

Tax impact 0 1
Maintainable earnings 1710

Average PE ratio of Co B and C 20 1

Exclude Co A as operations very different and too big 1

Discount for unlisted status -1 1

Discount for specific risks -1
Corrupt history bribes etc. -1 1
Poor working capital -1 1
Far from sugar cane fields -1 1

Increase PE
Increase PE lower financial leverage 1 1
Control premium 1 1
Strong family links 1 1
Other valid adjustment 2
20

Value of operations 34200 1

*Add investment 42 1
Total in N"m 34,242
Spot rate (195/15) 13 1
Value in R m 2,634

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*Value of investment
Last dividend 0
Growth 8%
Re 20%

Div1 given 5
Value of investment 42 1
Max 20

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Question 4: Leathersoft (100 marks)

LeatherSoft (Pvt) Ltd (LS) is a small Zimbabwean manufacturer and retailer. The company
manufactures and retails clothing and homeware; operating a divisionalised structure with
three main segments being Clothing, Homeware and Support Services. Each segment
operates entirely independently from each other (apart from services rendered by the
Support Services to other segments) and managers are rewarded based on segmental
performance.

Strategic objectives of LS

LS prides itself on the fact that it offers good quality products at reasonable prices. The
company aims to make customer satisfaction a priority, maintain acceptable operating
margins and achieve consistent growth in market share whilst maintaining an appropriate
dividend pay-out ratio. LS also encourages segments to prioritise the development and
motivation of their staff in order to create a positive and empowered workforce.

Furthermore, LS is proud of its involvement in uplifting the community as well as using

environmentally friendly raw materials and processes where possible. LS believes in building
long-term customer loyalty and enhancing its brand through sustainable business practices.

Company performance

The following information has been extracted from the Statement of Profit or Loss and Other
Comprehensive Income of LS for the year ended 31 March 2016 with added explanatory
notes:

$'000
Notes 2016 2015
Revenue 72 661 67 886
Retail sales and other revenue 1 72 590 67 800
Retail sales 68 520 64 250
Interest on trade receivables 3 840 3 550
Once-off insurance claim 230 -
Finance income received 71 86
Operating expenses 62 030 63 614
Cost of sales (incl. depreciation of equipment) 54 312 56 802
Finance costs 80 60
Provisions raised 3 480 4 500
Selling expenses 1 800 1 152
Advertising campaign 2 1 250 -
Administrative and other operating expenses 1 108 1 100

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Profit before taxation 3 10 631 4 272

Notes

1. Retail sales and other revenue broken down per segment in terms of IFRS 8:

$'000
Clothing Homeware Support Services* Interco eliminations Total
2016 2015 2016 2015 2016 2015 2016 2015 2016 2015
Revenue 60 757 38 430 11 723 29 310 2 220 2 210 -2 110 -2 150 72 590 67 800
External 60 757 38 430 11 723 29 310 110 60 72 590 67 800
Internal 2 110 2 150 -2 110 -2 150 - -

*Support Services offers services to the trading segments including information technology,
internal audit and finance. A small amount of support services is provided to external parties
as well.

2. The Clothing segment undertook an extensive advertising campaign at the start of

2016 to increase brand awareness. The segment’s manager is confident that the
campaign will bring about future economic benefits and believes that the benefit will
endure for five years.
3. A newly appointed management accounting intern calculated the 2016 Economic
Value Added (EVA) of LS incorrectly as follows:
▪ Profit before taxation – (WACC x Total Assets)
▪ $ 10 631 000 – (12% x $17 500 000)
▪ EVA = $8 531 000
4. Total assets as at 31 March 2016 was $17 500 000, and LS’s WACC is 12%.

Additional information obtained from financial statements, management accounts and

discussions with management:

Clothing Homeware
2016 2015 2016 2015
Staff turnover % 6 9 32 28
Carbon emissions (estimated tonnes) 87 104 163 138
% share of Clothing/ Homeware market 8% 3% 1% 2%
Overall net production variance Favourable Favourable Adverse Favourable

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Clothing

The clothing segment manufactures the stock it retails, in-house, from a rented production
facility in Willowvale. Clothing items move from Production department 1 into Production
department 2, with materials, WIP and finished goods stored in a Storage facility per issued
store requisitions. The segment has an appropriate distribution network in place to its various
retail stores and operates a normal, traditional absorption costing system.

Towards the end of 2015, the Clothing segment created a specialist trend team whose
mandate is to do appropriate research in order to keep up with latest trends. In addition, the
segment is also actively involved in social media to market their products and get feedback
on current stock and customer needs. The procurement officer of the Clothing segment
responded to an identified need of Clothing’s customer base for better quality products, by
sourcing exceptional quality raw materials in 2016 which resulted in customers
complimenting LS on social media on the good quality stock in its stores.

The better-quality materials also led to lower than expected inefficiencies in the production
processes, which, coupled with quantity discounts for ordering larger quantities of raw
materials at a time, in turn translated to lower prices being offered to customers. The
segment’s advertising campaign paid off, with much higher sales volumes actually being
achieved than budgeted sales volumes during 2016, countering the effect of lower selling
prices.

The employees in the company had asked LS for training on a new IT-system used throughout
the company, with Clothing successfully responding by providing extensive training during
three different workshops (in order to accommodate all staff on three different dates).
Clothing is considering expansion into new markets and has teamed up with a marketing firm
to establish the demand for new product ranges within its existing market space. Throughout
the year, the segment’s manager re-iterated the importance of doing market research and
product testing before embarking on major projects, to his team.

Employees in the segment are constantly looking for ways to improve processes and reduce
costs and as a result, the segment introduced various strategic management accounting tools
during 2016 which has improved efficiency significantly. Amongst the latter is a process which
Clothing has undertaken to improve supply chain optimisation and procurement practices,
which the segment manager believes will have enduring benefits.

During 2016, Clothing donated a significant amount of out-dated stock and undertook a
fundraising project to support local communities. The segment also teamed up with the
Sustainable Cotton Cluster (SCC) to increase the partnerships already in place in terms of
building a sustainable value chain. Clothing encourages cash sales and as a result, strong cash
flows support future growth and allowing the company to maintain an appropriate dividend

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pay-out ratio. Anticipating growth in its market share, during 2016 Clothing upgraded their
production equipment in order for the facility to be able to handle future increased demand.

Homeware

LS received numerous complaints from customers regarding the quality of the Homeware sold
during 2016, with a loss in market share resulting. The Homeware segment has not yet
responded to these complaints, with the segment manager not willing to refund the
customers, with the matter being escalated to the LS Board. The manager has defended her
segment’s decision in what she refers to as “a slight decrease in quality in order to provide a
lower selling price”. She explained that they also took the decision to sell older stock (even if
the quality was poor or the stock outdated) rather than donating it, as the latter would not
bring in any revenue. She continues: “We even tried to boost sales by providing extended
credit to regular customers”. Staff in the Homeware segment have been on a "go-slow" strike
as a result of the uncertainty in the segment.

LS Cutlery Production Facility

Despite the overall poor performance of the Homeware segment the manager in charge of
the production of cutlery is quite upbeat about his results for 2016. He thinks that despite the
drop-in sales he has exceeded his gross profit margin target by more than 10%.

The cutlery produced is quite easily identifiable by its unique design and by the colour of a
special coating that is applied to the cutlery towards the end of the production process. The
coating is applied to batches of 100 units at the time, but due to the nature of the production
process it has been found that 25% of all the units produced normally need to undergo the
coating process twice to meet the standards set by the quality control department.

During the year, a total of 3 328 kilograms of raw material were used to produce 20 800 units
of cutlery. Of the units produced, only 18 000 units were sold. The units produced were the
same as the production budget for the year. The number of labour hours used during the year
were 6 240 hours. The production process has two different types of variable overheads. The
Labour Variable Overhead is driven by labour hours, and the Machine Variable Overhead is
driven by the number of batches processed during the coating of the cutlery.

The fixed overheads are driven by machine hours. The actual number of machine hours used
during the year amounted to 39 520 while the budgeted number of machine hours per unit
was 2 hours. There was no opening or closing inventory of raw materials during the year.

The division uses a standard costing system. The standard cost per unit is the same for all the
cutlery produced. This is because each unit of cutlery is produced using a standard rectangular
piece of metal that it is then cut into the desired shape during production. The standard
amount of material per unit of cutlery is 150 grams, and the standard labour time per unit is
15 minutes. The budgeted standard gross profit per unit was $19.50.

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During the year, it was found that 50% of the units of cutlery had to undergo the coating
process twice.

The actual and budgeted data for the cutlery production facility for 2016 is as follows:

*Inventory balances are recorded at standard costs

2017 Budget

Clothing

The budgeted indirect manufacturing costs of the Clothing segment for the financial year
ended 31 March 2017 (FY2017) were as follows:

Factory rental $14 400 000

Factory electricity $ 4 000 000
Depreciation of equipment $ 472 000
HR-related costs $ 611 240
$19 483 240

Additional budgeted information relating to the Clothing segment for FY2017 follows:

CLOTHING
Production Production Storage
department 1 department 2
Direct labour hours 1 201 600 1 799 396 3004
Number of employees 650 980 22
Floor space (𝑚2 ) 8 640 17 600 5 760
Equipment value $1 699 200 $3 020 800 -

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Proportion of electricity 45% 50% 5%

bill
Store requisitions 1 200 800
Machine hours 80 000 120 000

There was no opening work-in-progress (WIP) in Production department 1 as at 1 April 2016.

80% of the stock manufactured in that department will be transferred to Production
department 2 during the year, with a resulting closing WIP balance in Production department
1 as at 31 March 2017. You may assume that direct manufacturing costs incurred in
Production department 1 for the 2017 year will amount to $16 million.

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Required
Marks
(Round your answers to two decimals, where applicable)
a) Critically evaluate the intern’s calculation of Economic Value Added (EVA)
for 2016.
• Your evaluation should include proposed adjustments to the
calculation and a brief reason for each proposal. 14
• You are not required to re-calculate the EVA. 1
Communication skills – clarity of expression
b) Given the strategic objectives of LS, analyse, compare and comment on
18
the non-financial performance of the Clothing and Home segments for the
year ended 31 March 2016.
1
Communication skills – layout and presentation
c) With regard to devising key performance indicators for the respective
segments of LS, identify and explain the issues which will need to be
11
considered.
d) Calculate an appropriate overhead absorption rate per machine hour for
the Clothing segment’s Production Department 1 (only) for the 2017 year 11
(year starting 1 April 2016)
e) If actual machine hours used in Production Department 1 during 2017
equals 85 500 hours, calculate the over-absorption of production
overheads and draw up T-accounts to illustrate the absorption of
overheads and any adjustments to be made in terms of IAS 2.
• You may assume that the budgeted overheads equal actual
10
overheads for the year.
• You need to do the following T-accounts for Production
Department 1:
o Manufacturing overheads
o WIP (Production Department 1)
f) Reconcile the budgeted profit to the actual profit for the cutlery
production facility by calculating applicable standard costing variances, in 25
as much detail as possible.
g) Critically evaluate the performance of the cutlery production facility based 8
on the variances calculated above, in order to assess whether the manager
is justified in thinking that he performed well.
Communication skills – clarity of expression 1
TOTAL
100

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Suggested Solution

Note 1: Segmental reporting in terms of IFRS 8

$'000

Clothing Homeware Central services Interco Total

eliminations

2016 2015 2016 2015 2016 2015 2016 2015 2016 2015

Revenue 38,430 11,723 29,310 2,220 2,210 -2,110 -2,150 72,590 67,800
60,757

38,430 11,723 29,310 110 60 72,590 67,800

External 60,757

2,110 2,150 -2,110 -2,150 - -

Internal

Note 2: Economic Value Added (EVA) calculated by the intern

2016
Profit before taxation 10,631
Required return (WACC*Total assets) 2,100
EVA calculated 8,531

a) Marks
The intern used the incorrect formula for calculation of EVA 1
The starting point of the calculation should be profit after taxation, not profit 1
before taxation.
Tax is an actual cash flow to ZIMRA; thus, we should use the after-tax amount. 1
The tax expense should be the cash tax related to operations, should exclude tax 1
consequences of finance income and finance expense (already considered in
WACC and do not relate to operations)
The profit after taxation needs to then be converted from an accounting profit 1
to an economic profit, thus many adjustments must be made.
Reverse the following costs:
Long term finance costs should be added back net tax as it is already considered 1
in the required rate of return (WACC).

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Depreciation should be added back as it is an accounting entry/ non-cashflow. 1

OR Would not need to adjust for depreciation if accounting depreciation =
economic depreciation 0.5
Economic depreciation should be deducted instead 0.5
The once-off insurance claim should be added back as it is not sustainable 1
income.
The provisions raised should be added back as it is an accounting entry/ non- 1
cashflow, the cash movement on provisions should be included
Given that investments would be separately valued, interest income after tax 2
should be removed from economic profit as well, so economic profit only reflects
profit from operations
The advertising cost should be reversed as it brings forth an enduring benefit to 1
LS.
An expense should then be deducted in terms of the economic amortisation of 0.5
the advertising benefit.
The amortisation deducted will be $1250/5 = $250 as straight-line economic 0.5
depreciation.
The amortised advertising amount must be capitalised as $1000 ($1250-$250) as 1
part of your asset base.
Investments should be removed from the investment base (Total Assets-Current 1
Liabilities) as investments will be separately valued.
Certain current liabilities should be removed from the investment base (Total 1
Assets-Current Liabilities) to reward LS for their use of working capital.
Only non-interest bearing, and non-permanent CL would be deducted, as these 1
are not included in the capital structure for WACC
Furthermore, capital structure would not include spontaneous financing 1
Max 14
Communication skills – clarity of expression (a) 1

CLOTHING HOMEWARE
2016 2015 2016 2015
Staff turnover % 6 9 32 28

Carbon emissions (estimated tonnes) 87 104 163 138

% share of Clothing/ Homeware 8% 3% 1% 2%

market

Overall net production variance Favourable Favourable Adverse Favourable

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Customer
satisfaction
measures:
Good quality Clothing sourced good quality raw materials which would 1
products: result in good quality products - should result in increased
market share
Homeware segment received various complaints on the 1
quality of their products, showing neglect regarding the
quality of their products.
This has led to a loss in market share - brand may be 1
damaged and other customers may follow suit.
At reasonable The better-quality materials led to lower inefficiencies led 1
prices: to lower product costs, which coupled with lower mark-
ups lead to reasonable prices.
Furthermore, clothing ordered materials in large 1
quantities which lead to quantity discounts, decreasing
product costs.
Lower-mark ups were countered by much higher sales 1
volumes (could also be due to the extensive marketing
campaign).
Customer Clothing has ensured that their retail customers are
satisfaction: satisfied with the quality of the product, by creating a
specialist trend team which does the appropriate research 1
and aims to keep up with latest trends.

Clothing is actively involved in social media to market their

products, but also to get feedback on current stock and 1
customer needs- innovative
Clothing does market research and product testing before 1
embarking on major projects.
Homeware has not replied to customer complaints or
issued refunds/exchanges. 1
Homeware tried to improve customer satisfaction by
increasing credit sales= which could lead to increased bad 1
debt in these poor economic times.
This may not be in line with the National Credit Act 1
regulations of extending credit.

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Growth in market Clothing has secured a larger portion of the Clothing 1

share: market, growing its market share from 3% to 8% during
2016. Linked to improved quality
Homeware has not grown but lost market share due to 1
poor quality products.

Internal measures
of quality,
efficiency:
Production The production performance of the Clothing appears to be
variances: good with an overall favourable net production variance. 1
The performance of the Homeware does not appear to be
good with an overall adverse net production variance,
caused by reworking of cutlery 1

Development and Clothing has successfully dealt with the training and 1
motivation of development of staff
staff: Staff in the Homeware segment is on a "go-slow" strike,
which could result in customer orders being late, poor 1
customer service etc.
Homeware's staff turnover has increased to 32% and is
much higher than the staff turnover % of the Clothing 1
segment-indicating unhappy staff.
Internal Clothing sourced good quality raw materials that could
efficiencies: decrease inefficiencies and losses in Production 1
department 2.

Innovation
measures:
Investment in Clothing is considering expansion into new markets,
viable projects/ invested R&D in development of new product ranges. 1
innovation: Clothing has introduced various strategic management
accounting tools which have improved efficiency 1
significantly.
Clothing has undertaken supply chain optimisation and
improved procurement practices, which will have 1
enduring benefit.
Homeware still stocks old stock, no new investments. 1

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Involvement in Clothing segment involved in CSI- donating old stock and

CSI/ Building fundraising projects to support local communities. 1
brand: Clothing has teamed up with the Sustainable Cotton
Cluster (SCC) to increase the partnerships already in place
in terms of building a sustainable value chain. 1
Homeware has created damage to the LS brand by not
dealing the quality issues timeously.
1
Reduction in Clothing uses better quality raw materials that have reduced
environmental harmful emissions from 104 tonnes to 87 tonnes. 1
impact:
Goal Congruence/ Clothing has incurred costs for future growth (re-
Long term vision: investment) - aligned with the strategy of increased 1
market share.
Strong cash flows support future growth while
maintaining an appropriate dividend pay-out ratio. 1
Therefore, Clothing has definitely been the better performing segment during
2016 when evaluated based on non-financial measures. 1
Any other valid point 1
Maximum 18
1
Communication skills – layout and presentation (b)

c)

LS should consider the structure of each segment and design measures 1

accordingly:
The clothing and Homeware segments are likely to operate as profit centres, 1
whereas the central services would want to cover their costs only for internal
services provided.
Because the two segments have different objectives (As one is a cost centre and 1
the other a profit centre), it would be unfair to evaluate them on the same basis
The services segment should have different measures relating to their internal 1
and external markets.
For the internal market: transfer prices should be set fairly between divisions to 1
not skew segmental performance.
Performance measures should be designed to encourage each segment to act in 1
line with LS's overall strategy (goal congruence).

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LS may need to align the performance measurement systems to managers' 1

compensation structure to encourage appropriate decision-making (managers
are rewarded based on divisional performance)
Items that are not within the control of the segments such as the head office 1
allocations should not be taken into account in measuring the segments'
performance/only items within the control of the company.
Consider incorporating financial and non-financial measures (balanced scorecard
approach)
Consider the size of the two entities in designing performance measures, as the 1
clothing segment is much bigger (And perhaps stronger/more bargaining power)
as a result
The KPI’s must measure the strategically important performance – i.e. the critical 1
success factors of each segment
Ideally, a balanced scorecard approach should be considered with multiple 1
indicators measuring different key performance areas and with weighting of KPIs
to get an overall view of performance of each of the respective KPAs
Deferral of bonuses to address short-termism 1
Transfer pricing- divisions may act in their own best interest, not in company 1
(goal congruence) - divisionalised structure
Maximum 11
d)

Budgeted indirect overheads (2017) for the clothing range production facility
$
Factory rental 14,400,000
Factory electricity 4,000,000
Depreciation of equipment 472,000
HR related indirect overheads -Clothing 611,240
19,483,240

Given: CLOTHING
Production Production Storage Total
department 1 department 2
Direct labour hours 1,201,600 1,799,396 3,004 3,004,000.00
Number of employees 650 980 22 1,652.00
Floor space (m2) 8,640 17,600 5,760 32,000.00
Equipment value 1,699,200 3,020,800 - 4,720,000.00
Proportion of electricity 45% 50% 5%
bill
Store requisitions 1,200 800 - 2,000.00

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Machine hours 80,000 120,000 - 200,000.00

Primary CLOTHING
allocation
Allocation Production Production Storage Total (check)
rate department department 14,400,000
1 2
Factory rental 450 3,888,000 7,920,000 2,592,000 4,000,000 1.5
Factory 1,800,000 2,000,000 200,000 1.5
electricity
Depreciation 0.10 169,920 302,080 - 472,000 1.5
of equipment
HR related 370 240,500 362,600 8,140 1.5
indirect 611,240
overheads -
Clothing
6,098,420 10,584,680 2,800,140 OH per 1.5
depart
19,483,240 ment

Secondary allocation Rate per store requisition $1 400.07

CLOTHING
Production Production Storage
department department 2
1
Overhead after 6,098,420 10,584,680 2,800,140
primary allocation
1,680,084 1,120,056 2,800,140 2
7,778,504 11,704,736 - 19,483,240 0.5
Pre-determined rate 97.23 per machine hour 1
(base- machine hours)
11
e)

Over-absorption of overheads: (Actual MH- Budgeted MH) * Rate

Actual MH 85,500.00
Budgeted MH 80,000.00
Hours 5,500.00
Over-absorption 534,772.15

IAS 2 states that overabsorption of overheads need to be pro-rated:

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Manufacturing overheads

Actual overhead Applied overhead (WIP) (85 2

(department 1) 7,778,504.00 500* $97.23) 8,313,165.00
Over-absorption 534,661.00
(Calculation using hours 1
or balancing figure)
1
8,313,165.00 8,313,165.00

WIP (Production department 1)

Direct manufacturing Production department 2 2
costs 16,000,000.00 (WIP x 80%) 19,450,532.00
Indirect overheads 8,313,165.00 Over-absorption (WIP) 106,932.20 2
applied (Over-absorption x 20%)
Closing WIP 4,755,700.80 1
Corrected closing WIP B
24,313,165.00 1
24,313,165.00

Production department 2 (not required)

WIP (Production department 2)
Production 19,450,532.00 Over-absorption (Department 427,728.80
department 1 2)
Closing balance Corrected 19,022,803.20
closing WIP B
19,450,532.00 19,450,532.00

Pro-rating check (inventory value as if no over-absorption) - Not required

WIP (Production department 1)
Direct manufacturing costs Production
16,000,000.00 department 2 19,022,803.20
Indirect overheads (if no over- 7,778,504.00 Closing WIP 4,755,700.80
absorption)

23,778,504.00 23,778,504.00
Total 10

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f)

Standard Cost Card per unit $ $

Materials (grams) 0.15 150 22.5
Labour (hours) 0.25 45 11.25
Variable O'H Labour (hours) 0.25 5 1.25

Variable O'H Machine (number of Batches) 1.25 2.4 3

Fixed O'H (machine hours) 2 20 40
78
Gross Profit 19.5
Sales Price 97.5

Budget 2016 Actual 2016

Sales (units) 20,800 18,000
Production (units) 20,800 20,800 2,800 C/B
16%
Sales 2,028,000.00 1,710,000.00
Material 468,000.00 465,920.00
Labour 234,000.00 287,040.00
Variable O'H Labour 26,000.00 16,640.00
Variable O'H Machine 62,400.00 78,880.00
Fixed O'H 832,000.00 629,440.00
C/B - -218,400.00
Manufacturing Costs 1,622,400.00 1,259,520.00
Gross Profit 405,600.00 450,480.00 44,880.00 1.11

$ OR Marks
Budgeted 405,600.00
Profit
Sales Price 95 97.5 -45,000.00
Variance 2
(Act SP - Bud 18,000.00
SP)xAV
Sales Volume 18,000 20,800 -54,600.00 (19.5- (95-
(Av-BV) 11.25-22.5-
xProfit/Unit 1.25-40-3) 2
19.5 *18000
Material 3,120 3,328 150 -31,200.00
Usage 2

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(Std Q - AQ) x
SR
Material Price 150 140.00 3328 33,280.00
(SP-AP)xAV 2
Labour 5,200 6,240 45 -46,800.00
Efficiency 2
(SHP-AH) xSR
Labour Rate 45 46 6240 -6,240.00
(SR-AR) xAH 2
Variable O'H 5 6240 16,640.00 14,560.00
Rate (Labour) 2
(SRxAH)-Act
Cost
Variable O'H 5,200 6240 5 -5,200.00
Efficiency 2
(Labour)
(SHP-AH) xSR
Variable O'H 240 312 78,880.00 -5,200.00 (5-2.67)
Rate (Batches) *6240 2
(SRxAct rounding =
Batches)-Act $14539
Cost
Budgeted
Number of 208
batches 52
plus 25% 260 1
Actual batches
Normal 208
operating
conditions
50% Repeat 104
Total batches 312 1
used

Variable O'H 260 312 240.00 -12,480.00 2

Efficiency
(Batches)
(Std Batches -
Act Batches) x
SR

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Fixed O'H 832,000.0 629,440. 202,560.00 24% 1

Expenditure 0 00
(Budgeted -
Actual)
Fixed O'H 0 1
Volume
As Budgeted
volume =
Actual volume
there is no
FOH volume
variance
Actual Profit Mark to be awarded for reconciling 450,480.00 1
not actual figure
Max 25

g)

Even though the actual gross profit is higher than the budgeted gross profit the 1
manager of the production facility should not be so upbeat because of the following:
The target level of sales has not been reached despite a reduction in the sales price. 1
This resulted in an adverse selling price variance of $45,000.00.
The drop in sales has also resulted in an increase in inventories as production was not 1
adjusted to meet the level of demand for the cutlery.
This inventory may need to be further discounted in order to sell it in the future.
There has been a favourable material price variance and an adverse material usage 1
variance. These two variances are interrelated as the material bought is of a lower
quality, thus making it harder to use during production.
The labour rate variance is adverse. This is the result of paying $46 rand instead of 1
$45 per hour.
The labour efficiency variance however is $46,000.00 adverse- due to the go-slow 1
strike or poor morale that the Homeware Segment is experiencing and may also
compromise future performance
The variable overhead (labour) rate variance is favourable, which might again indicate 1
that the manager is saving costs by buying cheaper supplies.
The number of batches used during the coating process is significantly higher than 1
expected. This has resulted in an adverse variable overhead (machine) efficiency
variance.
There might be a relationship between the favourable material price variance and the 1
adverse variable overhead (machine) efficiency variance. If the cheaper material
bought is also of a lower quality this may also be having an adverse effect during the

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coating process resulting in more batches having to be used to meet quality

standards.
The variable overhead (machine) rate variance is adverse, meaning that cost control 1
has not been as rigorous as it could have been.
The most worrying variance however is the favourable fixed overhead variance of 2
$202,560. This variance represents 24% of the budgeted expense and such a large
variance should not have arisen unless expenditure has been deferred or the original
budget was not properly calculated.
If expenditure on maintenance for example has not been incurred this will have a 2
knock-on effect on the future performance of the factory. The expenditure will need
to be incurred in 2017 which may also further compromise the capacity of the plant
to generate profits.
Maximum 8

Communication skills – clarity of expression (g) 1

TOTAL 100

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Question 5: Paintech (Pvt) Ltd

Paintech (Pvt) Ltd is a Zimbabwean entity that manufactures specialised paint for sale locally
and within Southern Africa. The company has secured a contract and supplied 1.2 million
litres of paint for the renovation of the National Sports Stadium in Harare. The company
operates a standard costing system. Mr Green was employed to ensure the production
scheduling was well planned and that there was enough supply of paint to meet the demand
as and when it arose on this particular contract. This was the company’s largest contract and
therefore the company was prioritising the customer’s needs.

In the past, the company has been more focused on the minimisation of costs and has not
been overly concerned about the environmental impact of its product or production
methods. Mr Green recognised this as an area for development for the company and has
indicated that in order for the company to secure future supply contracts, the company
should improve its environmental reputation.

The paint is mixed in batches and the optimal mix is found in the table below:
The standard optimal mix for a batch of 200 litres of paint
Component Standard Quantity Standard Price
Solvent 123.00 litres $ 1.10 per litre
Binder 61.50 litres $ 2.95 per litre
Pigment 16.40 litres $ 5.25 per litre
Additives 4.10 litres $ 10.13 per litre
Total input 205.00 litres

The solvent, xylene, is the component most responsible for environmental damage. The
heavy metals included in pigments are also an area of concern. Mr Green decided that he
would prefer to use his experience to reduce the use of the more damaging component
materials in the mix of paint, which has also improved the quality of the paint produced for
this project.

Mr Green secured a quantity discount on the solvent xylene, due to the large amount of this
component required. An amount of 666 353 litres of solvent was purchased in 100-litre drums

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at a cost $105 per drum. Mr Green sourced 96 924 litres of a very high-quality heavy metal
free pigment, at a price of $5.75 per litre of pigment. He also sourced 411 927 litres of
environmentally friendly binder at a cost of $150 for 50-litres for the project, while the 36 346
litres of additives actually cost $368 911.90. The company is able to purchase a partly filled
drum of either the binder or the solvent xylene, if necessary, from the supplier as long as this
is not done more than twice per month. If this happens less than twice per month, the same
price per litre would apply for these partly filled drums as for the normal size drums.

The paint was supplied to the customer in 200 litre drums, at a price of $1 520 per drum. This
paint is more expensive than conventional paint due to its specialised application.

REQUIRED Marks

a. Discuss and evaluate the performance of Mr Green, with respect to the

acquisition of inputs, mixing of these inputs and supplying the paint for this
particular contract. All interpretations should be in the context of the
scenario. Provide detailed calculations to support your discussion.

30

Total 30

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Workings
Optimal mix for a batch of 200L of paint
Standard Total
Component Standard Quantity Price Cost
Solvent 123 Litres @ 1.10 135.30 less
Binder 61.5 Litres @ 2.95 181.43 more
Pigment 16.4 Litres @ 5.25 86.10 same
Additives 4.1 Litres @ 10.13 41.53 more
Paint 205 Litres 444.36
Normal loss of 2.439% 2.4390%
Paint that comes out 200 litres

Need to supply 1.2 million litres of paint for the National Sports Stadium. 1,200,000

Price Variance (SP - AP) AQ

Solvent =( 1.1 - 1.05 ) 666 353 Amount Nature Marks

Binder = (2.95 - 3.00) * 411 927 -33,317.65 Favourable
Pigment = (5.25-5.75) * 96 924 20,596.35 Adverse 2
Additives = (10.13 - 10.15) * 36 346 48,462.00 Adverse 2
726.92 Adverse 2
36,467.62 Adverse 2
8

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Marks
Mix Variance (AQ in budgeted Mix - AQ ) SP
The total actual quantity of RM inputs: (666 353 + 411 927 + 96 924 + 36 346) = 1,211,550 litres of raw materials
Amount Nature
Solvent 1 211 550 *60% or 123/205 (726 930 - 666 353) 1.10 66,634.70 Favourable 2
Binder 1 211 550 *30% or 61.5/205 (363 465 - 411 927) 2.95 -142,962.90 Adverse 2
Pigment 1 211 550 *8% or 16.4/205 (96 924 - 96 924 ) 5.25 - 2
Additives 1 211 550 *2% or 4.1/205 (24 231 - 36 346) 10.13 -122,724.95 Adverse 2
-199,053.15 Adverse
Yield Variance
(What should have come out the process - Actual production ) x Std Price of each unit of output
(1 211 550 / 205 * 200 - 1 200 000) x $444,36/200 Standard Price of one batch:
(1 182 000 - 1 200 000) $2.2218 Solvent 135.30
(39,992.22) Favourable Binder 181.43 4.5
Pigment 86.10
Additives 41.53
444.36
litres of output = 200
SP per unit of output 2.2218
Usage Variance Max 12
You were required to calculate the mix and yield variance to evaluate Mr Green's performance. However the usage variance was not required, as the question
required you to evaluate Mr Green therefore the mix & yield variances are all that are needed. However 2 bonus marks were awarded
if the usage variance was calculated correctly as in the calculation below (adding mix and yield did not get these marks):
Total paint that came out of the process was 1 200 000 litres. Therefore we should have placed (1 200 000/200 * 205 ) 1 230 000 litres of RM into the process.
Solvent 1 230 000 *60% or 123/205 738,000 - 666,353 1.10 78,811 Favourable
Binder 1 230 000*30% or 61.5/205 369,000 - 411,927 2.95 (126,635) Adverse
Pigment 1 230 000 *8% or 16.4/205 98,400 - 96,924 5.25 7,749 Favourable
Additives 1 230 000 *2% or 4.1/205 24,600 - 36,346 10.13 (118,987) Adverse
(159,062) Adverse
Discussion
Total Variance Marks
Price Variance -36,467.62 Adverse
Mix Variance -199,053.15 Adverse
Yield Variance 39,992.22 Favourable
-195,528.55 Adverse 1

Sales revenue = 1.200 000/200litre drums x $1 520 per

drum 9,120,000 -2.14% 1

The adverse price variance of $36 467.62 shows that on average Mr Green purchased 1
the raw materials at a higher price than the standard.
This may be an indication that he purchased higher quality raw materials, not 1
currently reflected in the standard.
In addition he purchased environmentally friendly binder which is probably more 1
expensive than the standard binder, resulting in an adverse variance.
Mr Green purchases pigment that was heavy metal free, which is probably more 1
expensive than the standard pigment.
The price variance on solvent was $66 634.70 favourable, as Mr Green secured a 1
quantity discount. This may be evidence of his good negotiating skills.

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The overall adverse price variance does not necessarily reflect inefficiencies by Mr 1
Green as these purchases were more environmentally friendly & therefore more
expensive.
The overall mix variance was adverse ($199 053.15) indicating that: 0.5
• Mr Green used a greater proportion of the more expensive components, 1
binder and additives in the mix, resulting in an adverse variance for these two
items.
• The mix variance for solvent was favourable, indicated that Mr Green used less 1
of the environmentally damaging but cheaper solvent in the mix.
• The same proportion of pigment was used as standard, but it is now heavy 1
metal free.
A higher output than the standard was achieved by Mr Green, and is reflected in the 1
favourable yield variance of $39 992.22
As a result of this change in the quality of the mix and in the quality of some of the 1
raw materials sourced, a favourable yield would be expected.
However, the higher yield was not sufficient to recover the additional costs of sourcing 1
environmentally friendly raw materials and improving the quality of the mix.
Therefore, from a financial perspective, Mr Green has not been successful in 1
minimising costs, as the overall variance is $195 529 Adverse.
However, the positive impact of Mr Greens decision to produced quality, 1
environmentally friendly paint must be evaluated. or
The net adverse variance is not as a result of Mr Greens inefficiency, but rather as a 1
result of his decision to produce high quality environmentally friendly paint.
There could firstly be increased customer satisfaction as a result of: 0.5
The increased quality of the paint. The reputation risk of the company is greatly 1
reduced as greater quality paint has been supplied.
The environmental improvement of the order, which will please the customer. 1
Potential health lawsuits resulting from exposure to the paint is substantially reduced, 1
due to environmental compliance/improvement.
Mr Green has also provided the company with the opportunity to establish itself as a 1
company committed to quality and the environment, which is important:
As the market in which the company operates has clearly indicated the importance of 1
environmental considerations.
This may also result in new orders being secured, as certain buyers only source 1
environmentally friendly quality paint.
This may enable the company to raise the price of its paint in the future. 1
Conclusion
Mr Green should therefore not necessarily be reprimanded for the overall adverse 1
variance, but recognition should be given to the customer satisfaction as well as, for

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the future contracts that this may have resulted in due to the environmentally
strategic manner in which this order was fulfilled.
Maximum 30

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Question 6: Makadhi (Pvt) Ltd

Makadhi (Pvt) Ltd, (“Makadhi”), is a small manufacturing company that specialises in the
production and sales of plastic cards (the use of these cards is explained below). The company
has a 31 December 2014 year-end. The company has annual contracts with three customers
at present, resulting in three different product lines:
• Durable, full-colour Business Cards are made for a small stationary company called
“Printworks”
• Credit Cards are manufactured for Cash money Bank
• Electronic Mall Vouchers (for gift card purposes) are produced and sold to a retail mall
in Borrowdale, Harare.

Due to the risk of card fraud (fake credit cards and electronic mall vouchers), the location of
Makadhi has not been made public, and the manufacturing facility has been fitted with high-
tech security features. The security measures are intended to deter criminals from entering
the premises and accessing sensitive information, as well as to ensure that the production
facility is filmed with CCTV cameras to ensure that there is no theft from the factory.

Makadhi operates a standard costing system. The company has a contract with Cash money
Bank for 80 000 Credit Cards to be produced and supplied each month of the year. Makadhi
is further contractually bound to produce 120 000 Mall Vouchers monthly, and the expected
standard monthly production and sales of Printworks for January to June 2014 is 50 000
Business Cards (it is the standard practice for Printworks to place 100 orders per month, with
each order consisting of standard 500 business cards). The contracts with Cash money Bank
and the mall are entered annually. Makadhi has a policy of keeping no additional stock as it
poses a security risk due to the nature of some of their products, thus the company produces
units to match demand. Makadhi covers the cost of courier companies who collect the
personalised cards on behalf of the banks daily, mall vouchers are delivered on a weekly basis
and Printworks’ stock is couriered on a monthly basis.

The three types of products are made through a (mainly automated) process which involves
“Planning”, “Mixing”, “Printing” and “Compressing”:
Planning Mixing Printing Compressing

Step 1
The Planning phase involves the design and layout of the products to be
made: Makadhi’s designers collaborate with the clients to determine their
needs and propose designs. Once a design is approved, the production of the cards
commences. The design for Cash money Bank’s Credit Cards is already in place from previous
years (the bank has not changed its branding during the past two years). The mall however
changed their design in May 2014 for the Mall Voucher production going forward from then.

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Each Business Card’s design is determined by the stationery company (Printworks’)

clients. Both Makadhi and Printworks use a “cost-plus” mark-up policy to determine
the selling prices for their products and define “cost” as full cost per unit (being both
manufacturing and non-manufacturing costs).

Step 2
The Mixing step entails ink being mixed to colour specifications
according to the approved design (each card uses 10ml of ink).
Labourers then manually enter instructions and load the designs
onto the printing machines. The ink that is used in the mixing step is
made from secret ingredients by an approved supplier, who is
contractually bound through a confidentiality agreement to reduce
the likelihood of the ink being copied. A relationship exists between
the indirect mixing costs and the litres of ink mixed, and thus this cost should be allocated
based on the number of litres per product-line, as any other cost driver would not be
economically feasible. The mixing machines were due for a service in April 2014, but
management decided to cut costs by not servicing any machines during 2014.

Steps 3 and 4
Printing machines are filled with laminated sheets (which form the basis of all three product
lines), onto which the design is printed with the mixed ink. The final step in the common
production process involves steel presses compressing the cards at 150 degrees Celsius,
covered with a clear protective sheet. Each time a printing and compression cycle is run on
the machine, the printing and compressing costs are driven up. Credit Cards and Mall
Vouchers are produced in sheets of 1 000 cards, and Business Cards are produced separately
for each Printworks customer order.

Further processing
The Business Cards are counted, packaged and stored*. The Credit Cards and Mall Vouchers
however require one more step. Security measures such as UV-imprints, holograms, coded
chip-and-pin tags and magnetic strips are added to the latter two products before they are
counted, packaged and stored. Makadhi receives daily lists from the banks with their
customers’ details; which are then imprinted on the blank cards, along with the customers’
personal information which is added to the magnetic strip. Two-thirds of the security costs
(which includes the cost of the personalisation of the cards) relate to Credit Cards, the rest is
as a result of Mall Voucher production.
*You may assume that the packaging and storage costs are negligible.

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Traditional absorption standard costing system

Makadhi currently operates a traditional absorption standard costing system and allocates
indirect costs based on the number of cards produced.

The standard monthly indirect costs during 2014 are estimated to be $266 400. This amount
is made up of:
• $20 200 indirect fixed manufacturing costs as a result of the planning process;
• $40 000 relating to indirect fixed mixing costs;
• $6 200 to indirect printing and compressing costs (together),
• $80 000 to security costs and
• $120 000 to delivery costs.

Standard selling prices were based on the prevailing market prices for similar product
offerings. The standards have not been updated to reflect the actual selling prices (which are
determined in terms of the company’s cost-plus policy).

The projected standard profit per card for May 2014 was as follows:
Credit Cards Mall Vouchers Business Cards
$
Contribution before indirect cost allocation 2.50 3.00 1.00
Traditional indirect cost allocation -1.07 -1.07 -1.07
Standard profit per card 1.43 1.93 -0.07

Top management has been concerned about the profitability of the Business Cards and has
considered the implementation of an activity-based-costing (ABC) system as from May 2014
onwards to aid in evaluating the profitability of their customer base.

Actual results for May 2014

More raw material losses occurred than expected as a result of certain production
inefficiencies being identified. Labourers were required to work overtime to move boxes of
raw materials from the stock room where they were delivered to the production plant.
Differences in actual production and sales, and standard production and sales, resulted in
standard-costing-variances. An extract from the variance analysis report has been provided
below.

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Extract from variance analysis report- May 2014

Credit Cards Mall Vouchers Business Cards

Sales margin price variance Adverse Favourable Favourable
Sales margin volume variance Adverse

INK
Raw material price variance Favourable
Raw material usage variance Adverse

LABOUR
Direct labour rate variance Adverse
Direct labour efficiency variance Adverse

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Required Marks
a) Analyse and comment on the proposed budgeted profitability of
Makadhi's main customer base* for May 2014.
− Assess the profitability of each of the following contracts: Cash
money Bank, Borrowdale retail mall and Printworks.
− You may assume that there were 5 weeks/ 25 production days in
May 2014.
− Restrict your discussions to relevant points relating to the
20
scenario.
b) With reference to your calculations in (a), sales variances and other
information in the scenario, discuss the impact that the use of a
traditional costing system had on the sales during May 2014. 13

c) Briefly discuss potential causes for the raw material usage and direct
labour efficiency variances and suggest strategic management tools in
the context of the scenario that could have prevented these variances 7
from occurring.
*Provide your answer in the following table format:
Variance Reason Strategic management tools
Raw material usage variance
Direct labour efficiency variance

Total 40

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Suggested solution

a) Analyse and comment on the proposed budgeted profitability of Makadhi's main

customer base* for May 2014.
Indirect manufacturing costs to be allocated:
Activity Cost ($) Cost driver
Planning 20 200 Number of designs 1
Mixing 40 000 Paint volume/Number of cards as each
card uses 10ml of paint 1
Printing & Compressing 6 200 Number of batches 1
Security measures 80 000 Ratio given 1
Transport 120 000 Courier days 1
266 400

Cashmoney Borrowdale Printworks Total

bank retail mall
Number of designs - 1 100 101 1
Paint volume/number 80 000 120 000 50 000 250 000
of cards as each card
uses 10 ml of paint 1
OR Paint in ML 800 000 1 200 000 500 000 2 500 000 1
Number of batches 80 120 100 300 1
Ratio given 0.67 0.33 - 1 1
Courier days 25 5 1 31 1

Cashmoney bank Borrowdale retail Printworks

mall
Contribution (excl. 200 000 360 000 50 000 1C
indirect cost allocation)
Contribution 2.5 3 1
Cards 80 000 120 000 50 000

Total indirect cost (164 561) (67 902) (33 938) 1C

allocated
Planning - 200 20 000 1
Mixing 12 800 19 200 8 000 1
Printing & Compressing 1 653 2 480 2 067 1
Security measures 53 333 26 667 - 1
Transport 96 774 19 355 3 871 1
Profit 35 439 292 098 16 062 1C

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Analysis and commentary

When using ABC, all customers are profitable (as opposed to when traditional
costing was used 1
Traditional costing allocated the indirect costs based on cards produced and
has resulted in an arbitrary allocation of $1.07 to each card. 1
This allocation is not representative of the actual resource consumption by
the three products/ not a cause-and-effect allocation/random allocation. 1
Borrowdale
The supply of cards to Borrowdale mall is very profitable, with the single
client yielding $292 098 profit (88%). 1
Printworks
Printworks is proving to be a profitable client, however, still yields the lowest
profit of $16 062. 1
The low profit is mainly due to the fact that a new design is done for every
client, which results in high planning costs and relatively high printing and
compressing costs (done per batch of design). 1
Makadhi should consider discussing with Printworks the possibility of having
a couple of approved designs only for future clients. 1
Use standardised designs 1
Cash money bank
The daily courier of cards, results in much higher transport/courier costs than
the other clients. 1
Overall
Borrowdale retail mall is Makadhi's main client, contributing 59% of total
contribution/ 48 % of all cards sold is to Borrowdale mall. 1
Printworks is their smallest client and only accounts for 8.2% of the total
contribution/ only 20% of all cards sold. 1
Makadhi should assess the impact on demand if the contracts are amended
to have the clients collect their cards. 1
Any other valid point. 1

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b) With reference to your calculations in (a), sales variances and other information
in the scenario, discuss the impact that the use of a traditional costing system
had on the sales during May 2014.
Traditional costing allocated the indirect costs based on cards produced and
has resulted in an arbitrary allocation of $1.07 to each card. 1
This allocation is not representative of the actual resource consumption by
the three products/ not a cause-and-effect allocation/random allocation. 1
The indirect cost allocated per unit based on ABC:
Bank Mall vouchers Business
cards cards
Total indirect cost allocated 2.06 0.57 0.68 1.5
The use of traditional costing has resulted in the inaccurate costing of the
three products:
Bank cards have been UNDERCOSTED by 99 c [$1.07 - $2.06] 1
Mall vouchers have been OVERCOSTED by 50c [$1.07 - $0.57] 1
Business cards have been OVERCOSTED by 39c [$1.07 - $0.68] 1
Both Makadhi and Printworks uses a cost-plus policy on full costs to
determine their selling prices. 1
As such, an inaccurate cost price will lead to an inaccurate selling price which
may affect demand. 1
Printworks passes the higher selling price on to its clients. 1
Price variance
The difference in actual prices and standard prices as a result of the
inaccurate costing has led to the price variances. 1
Bank cards' selling price would be below the market price-resulting in an
adverse price variance. 1
Mall vouchers and Business cards' selling prices would be above the
prevailing market price, resulting in a favourable price variance. 1
Volume variance
Both Cash money bank and the Borrowdale retail mall are contractually
bound to the stipulated sales volumes and as a result there is no volume
variance for these two products. 1
However, given the inaccurate pricing (over costing of mall vouchers), the
products may be available at better prices in the market and the Borrowdale
retail mall may choose not to renew their contract in 2015. 1
Printworks' customers are more price sensitive as there are many stores that
offer the printing of business cards. 1
Due to the higher price than anticipated, the demand for business cards
decreased, leading to an adverse volume variance. 1
Any other valid point 1

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c) Briefly discuss potential causes for the raw material usage and direct labour
efficiency variances and suggest strategic management tools in the context of the
scenario that could have prevented these variances from occurring.
Variance Reason Strategic management tools
Raw Non-maintenance of Proper cost management would
material machinery could have require Makadhi to service their
usage resulted in more raw machinery more regularly.
variance materials being used. 1 1
Inferior quality raw materials A Total Quality Management
would have resulted in more philosophy should be adopted 1
raw materials being used.
1

Moving of boxes could have Materials should be delivered

damaged materials/ directly (non-value activities cut
opportunity for pilferage, out/JIT introduced 1
resulting in more usage. 1
Production inefficiencies has The investment has now been
resulted in more raw made in terms of the ABC
materials being used than analysis- activity-based
planned. 1 management should now be used
to manage the activities to reduce
costs and improve customer
value. / should monitor
production processes closer and
more regularly to prevent
losses/inefficiencies/ Kaizen 1
costing
Direct Labourers worked overtime Value-chain analysis to identify
labour on-moving boxes (non-value and eliminate the non-value
efficiency adding activities) adding activities- delivery of raw
variance 1 materials could be directly to the
production plant. / Production
improvements: the store room
should be moved closer to the
production plant. 1
Non-maintenance of Proper cost management would
machinery could have require Makadhi to service their
resulted in labourers being machinery more regularly. 1
less efficient. 1
Inferior quality raw materials TQM as discussed above 1
would have resulted in more
raw materials having to be
received and moved around
in the warehouse resulting in
labourers having to work
overtime 1

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Variance Reason Strategic management tools

Raw Non-maintenance of Proper cost management would
material machinery could have require Makadhi to service their
usage resulted in more raw machinery more regularly.
variance materials being used. 1 1
Inferior quality raw materials A Total Quality Management
would have resulted in more philosophy should be adopted 1
raw materials being used.
1

Moving of boxes could have Materials should be delivered

damaged materials/ directly (non-value activities cut
opportunity for pilferage, out/JIT introduced 1
resulting in more usage. 1
Production inefficiencies has The investment has now been
resulted in more raw made in terms of the ABC analysis-
materials being used than activity-based management
planned. 1 should now be used to manage
the activities to reduce costs and
improve customer value. / should
monitor production processes
closer and more regularly to
prevent losses/inefficiencies/
Kaizen costing 1
Direct Labourers worked overtime Value-chain analysis to identify
labour on-moving boxes (non-value and eliminate the non-value
efficiency adding activities) adding activities- delivery of raw
variance 1 materials could be directly to the
production plant. / Production
improvements: the store room
should be moved closer to the
production plant. 1
Non-maintenance of Proper cost management would
machinery could have require Makadhi to service their
resulted in labourers being machinery more regularly. 1
less efficient. 1
Inferior quality raw materials TQM as discussed above 1
would have resulted in more
raw materials having to be
received and moved around
in the warehouse resulting in
labourers having to work
overtime 1

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

Question 7: Adam Beed Furniture Limited

Background
Adam Beed Furniture Limited (“ABF”), a company with a 50 year history, markets and
distributes furniture and other household products worldwide. The company has developed
into a global retailer that provides everyday products at affordable prices, serving customers
at their convenience.

Adam Beed Furniture Limited, the parent company in the Adam Beed Furniture group, has its
primary listing on the Zimbabwe Stock Exchange (ZSE) and a secondary listing on the Frankfurt
Stock Exchange (DAX). As such its reporting currency is the United States Dollar (“USD”) and
is considered a Zimbabwean resident for tax purposes. Analysts have classified the group as
a “corporate mergers and acquisitions machine” as a result of the group’s aggressive
expansion in recent years in the United States, United Kingdom and Australia which has
transformed the group into a global integrated retailer. The takeover spree over the past
decade saw the company acquire over 60 companies; 20% of these companies had to be later
sold because of poor performance.

At the end of the 2018 financial period, the chief executive officer (CEO), Cranny Zulu, a
chartered accountant (CA(Z)), was pleased to report another very successful year that had
been completed. Both sales and net income from continuing operations increased strongly.
Management teams were rewarded for the strong financial performance that the group
achieved.

However, the 31 October 2018 year-end audit was not all smooth sailing for ABF as the
auditors refused to sign off on the audited financials as a result of reported accounting
irregularities contained in the financial statements. Subsequent investigations revealed that
Cranny Zulu along with fellow executives, conspired to manipulate some of the company’s
accounts by adding additional fictitious revenue from subsidiaries to help inflate the
company’s reported profits.

Industry prospects and the global economy

After a difficult operating period over the past three years there has been an improvement in
the global growth outlook. Global gross domestic product is expected to grow by 3.9% per
annum over the next five years.

The retail markets will experience growth similar to that of the global markets with smaller
companies expected to experience growth exceeding the industry average. This growth will
see more merger and acquisition activities. It is estimated that the average control premium
will be 30%.

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Greater merger and acquisition activity and increasing prospects for the global economy will
encourage new entrants to enter into the retail market. This will intensify competition and as
such revenue growth and gross margin expansion are likely to be slow.

New manufacturing division

ABF’s management believes that the company can earn higher margins if the furniture that
they distribute is manufactured internally and they are considering the possibility of opening
a manufacturing division. The process of successfully opening this division is expected to be
capital intensive and high risk.

In order to ensure that a thorough risk analysis compliments its decision making, ABF has
completed a sensitivity analysis for the new manufacturing division which is presented below.

Teechaz Home and Office (Pvt) Ltd takeover

ABF’s business development unit has identified the next target in its takeover spree. ABF plans
to acquire 70% of the issued ordinary equity of Teechaz Home and Office (Pvt) Ltd (“Teechaz
Home and Office”) which is one of the major retailers in Zimbabwe. The company was founded
in the 1980’s as a family business and continues to be run by the Teechaz family on a
conservative basis. Teechaz Home and Office’s success has been based on protecting brand
loyalty. The company has achieved this by recognising and celebrating Zimbabwean cultures.
Teechaz Home and Office has grown organically as the company believes that organic growth
is an extension of the company’s mode of operation and culture and it promotes stability.
These principles have ensured that the company continues to be sustainable and outperform
its competitors even during difficult economic times.

Teechaz Home and Office prides itself on the contribution it has made to Zimbabwe. It has
invested generously in social responsibility initiatives across the country. Furthermore, the

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company does not believe in “laying off” employees and would rather enhance the
effectiveness and efficiency of its operations before it considers retrenching staff. In addition
to this, the company has upheld the tradition of hiring senior managers who have grown with
the company as these individuals are in the best position to embrace and further the culture
of the company. The company was listed as one of the Top 10 best employers in Zimbabwe
in the 2018 year and has strengthened relationships with labour unions.

ABF directors have been in contact with Teechaz Home and Office’s directors to further the
transaction. MJV Advisory (“MJV”) has been given a mandate to advise ABF on the transaction.

MJV has provided the following historic and forecasted extract financial statements for the
merged firm (i.e. the combination of ABF and Teechaz Home and Office’s financials).

Extracts from the statement of profit or loss and other comprehensive income (merged
company)

Statement month October October October October October October

Reporting currency US$'m US$'m US$'m US$'m US$'m US$'m
Financial year 2016 2017 2018 2019 2020 2021
Notes Actual Actual Actual Forecast Forecast Forecast
Revenue 1 48,040 55,035 69,173 115,486 135,865 205,451
Cost of sales 2 (31,349) (38,277) (51,800) (75,401) (70,359) (69,233)
Gross profit 16,691 16,758 17,373 40,085 65,506 136,218
% growth 0.4% 0.4% 3.7% 130.7% 63.4% 107.9%

Tax expense 3 (481) (435) (863) (1,268) (1,954) (1,343)

Net margin 4 7.7% 6.9% 5.8% 18% 18% 18%

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Extracts from the statement of financial position (merged company)

Statement month October October October October October October

Reporting currency US$'m US$'m US$'m US$'m US$'m US$'m
Financial year 2016 2017 2018 2019 2020 2021
Notes
Actual Actual Actual Forecast Forecast Forecast
Assets
Intangible assets 5 17,675 35,390 49,406 60,435 66,116 135,072
Investments 4 4,518 8,703 3,237 3,816 14,622 22,566
Investment in associate 4 10 8 6 5 4 3
Property, plant and
equipment 6 37,792 74,786 77,026 ? ? ?
Inventory 7 4,520 8,813 14,431 16,320 18,455 26,394
Trade receivables 7 9,713 10,783 19,754 ? ? ?
Cash and cash equivalents 7 5,019 6,300 8,011 9,188 16,341 37,905

Equity
Ordinary shareholders 23,323 33,749 43,292 ? ? ?
interest
Outside shareholders
interest 8 2,696 3,025 6,508 6,467 1,541 1,087

Non-current liabilities
Long term interest bearing
loan
9 15,107 26,112 33,858 ? ? ?
Current liabilities
Trade payables 7 8,230 19,263 26,365 ? ? ?

Shares in issue (millions) 10 1,408 1,641 1,756 ? ? ?

Notes

1. Sales
ABF’s management is of the opinion that the acquisition of Teechaz Home and Office will
deepen its market share in the Zimbabwean market. This will allow the company to cross-
sell its products i.e. existing ABF products can be sold to Teechaz Home and Office
customers and vice versa. The company therefore expects that this will provide greater
diversification of revenues and bring stability to profits.

2. Cost of sales

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With a larger company generating larger sales, ABF’s management believes that they will
be able to streamline its operations and realise economies of scale which will reduce the
“per unit cost of production”. To realise this, the company will move some key operations
of Teechaz Home and Office from Zimbabwe to Europe where it has more advanced
factories. Any unused capacity in Zimbabwe as a result of this will be sold.

3. Tax expense
20% of the total tax expense recognised in the income statement annually relates to the
deferred tax expense.

4. Net margin
40% of the merged firm’s net profit is attributable to Teechaz Home and Office. The net
margin (calculated after-tax) was estimated after the following considerations:
i. Operating expenses
Operating expenses will decrease on the back of retrenchments in Teechaz Home
and Office once the merged firm is re-structured, and operations are moved to
European facilities. Furthermore, Teechaz Home and Office’s budget for investing
in social responsibility will be slashed in half and the funds reinvested in the
operations of the company.
ii. Depreciation and amortisation
Depreciation and amortisation will amount to a total of $2 897 million, $2 274
million and $5 502 million in 2019, 2020 and 2021 respectively.
iii. Extraordinary items
In 2018 one of ABF’s factories burnt down. The net after-tax expense after insurance
proceeds relating to this event was $72 million. This rare event has been included in
each of the forecast years at the 2018 amount.
iv. Other income
Included in net profit are the following items:
Actual Forecast
ZW$'m ZW$'m ZW$'m ZW$'m ZW$'m ZW$'m
Notes 2016 2017 2018 2019 2020 2021
Investment income 2 917 974 1,133 1,247 1,488 1,992
Interest expense (1,870) (2,149) (2,511) (3,267) (3,486) (3,830)
Associate companies 2 (4) (4) (4) (5) (10) (19)

The investment income accounts for dividends received from investments

recognised in the statement of financial position at cost. The investment relates to
161 850 shares held in Baido, an unlisted Chinese technology company. Historically
60% of Baido’s earnings have been paid out as a dividend. Comparable listed
companies have price-earnings ratios of approximately 12.

The associate company is ProMark which is one of ABF’s failed acquisitions. The
company has not performed well post acquisition and the divestment from it has
been on a piecemeal basis. The future of the company is grim due to poor market

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positioning and lack of management depth. ABF still owns 20% of the company,
however, they have convinced the other ProMark shareholders that the company
must be liquidated. This is in light of greater pressure from suppliers and financiers
who are threatening an application to force the company into liquidation. ABF
would like to finalise the liquidation before the conclusion of the merger with
Teechaz Home and Office.

5. Intangible assets
The intangible assets balance mainly represents goodwill from acquisitions.

6. Property, plant and equipment (PPE)

ABF revalues its property portfolio once every four years. It was identified that the
property portfolio might be overvalued by as much as 20% and a write-down will be
necessary immediately. This adjustment has not been provided for.

In line with plans to move operations to Europe (Note 4), the company will immediately
sell any excess capacity in the remaining Teechaz Home and Office facilities. 40% of the
property portfolio post the impairment adjustment has been marked for sale
immediately. The after-tax proceeds from the sale is estimated to be $18 883 million. This
cash will be reinvested into operations.

Following the acquisition, the PPE expenditure as a percentage of sales will be 5%.

7. Working capital
While inventory management will remain relatively the same as reflected by the
estimates, the accounts receivable days will be halved from the 2018 levels. The total
cash conversion cycle is expected to be five days throughout the forecast period.

Operating cash is expected to be 5% of the 2019 sales. Any excess cash will be paid out
as a dividend immediately.

8. Outside shareholders interest

The outside (non-controlling) shareholders relate to an 80% investment held in a
subsidiary listed on the ZSE. The subsidiary has a market-to-book ratio of 2.5.

9. Long-term interest-bearing loan

The balance closely represents the value of the liability.

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10. Issued shares

These issued shares only represent ABF’s issued shares which were trading at $80 per
share prior to the announcement of the potential merger. ABF’s share price is not
expected to change significantly during the transaction period.

Teechaz Home and Office’s 800 million shares have just been valued at $80 000 million as
a standalone company.

11. Synergies
The directors have aggressively proposed, that because of their acquisition expertise and
global footprint, ABF is entitled to 70% of the estimated synergies that will materialise
from the deal. ABF directors are unwilling to negotiate further on this matter.

12. Terminal growth

Free cash flows are expected to grow at 10% from 2022 onwards.

13. Deal terms

Payment terms
80% of the acquisition price will be paid through the issue of ABF shares and the balance
paid out in cash.

Merged firm capital structure

MJV has proposed that the capital structure of the merged firm should change such that
the capital structure exhibits a debt-equity ratio of 150%.

30% of the total debt will be debt with a yield of 12%; and the remaining 70% will be
preference shares having a yield of 16% and convertible into equity in 5-years’ time.
Payments on the preference shares are not tax deductible.

14. Capital markets

The following additional information has been gathered.
Consumer Top 20 All Share
services Companies Index
Return 24% 12% 14%
Beta* 0.79 1.27 1.32
*Sensitivity of ABF's share returns to the respective indices

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Government bonds
T-bill ZW170 ZW205
Years to maturity 91 days 8 years 40 years
Yield to maturity 6.87% 8% 9%

15. Tax
The Zimbabwean corporate tax rate is 25.75%.

16. Inflation
Unless otherwise mentioned, inflation has already been accounted for.

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REQUIRED Marks
Sub- Total
total
a) Identify and explain the risks that the Adam Beed Furniture Group
faces with regard to its group operations. (Exclude discussions
relating to the new manufacturing division and the Teechaz Home
and Office acquisition). 10

Communication skills – Clarity of expression 1 11

b) Discuss the key issues arising from the sensitivity analysis of the new
manufacturing project and propose two ways to address each issue
discussed. 9

Communication skills – Presentation and layout 1 10

c) With respect to the Teechaz Home and Office acquisition, analyse
the reasonability of the forecasted income statement. Briefly
conclude on how the forecasted numbers will affect the value of the
merged firm. 8 8
d) Identify and explain the most appropriate valuation method for
ProMark (Pvt) Ltd. Calculations are not necessary. 6

Communication skills – clarity of expression 1 7

e) Determine the appropriate cost of equity for the valuation of the
merged firm. 5 5
f) Discuss (without calculations) how the accounting irregularities in
ABF's books may affect the merged group's cost of equity. 3 3
g) Determine how many shares of Adam Beed Furniture Ltd the
shareholders of Teechaz Home and Office (Pvt) Ltd can expect to
receive from this transaction assuming a 15% cost of capital for the
merged firm. Further assume that the liquidation value of ProMark
(Pvt) Ltd is $2m. 35

Communication skills – Presentation and layout 1 36

h) Advise the shareholders of Teechaz Home and Office (Pvt) Ltd
whether they should approve the merger (ignore the payment
terms).

Your answer must address the following issues:

1. Cultural dynamics 7
2. Operational and financial structure 7

Communication skills – logical argument 1 15

i) Assuming that the shareholders of Teechaz Home and Office wish to
approve the merger, comment on the cash + share settlement
structure. 5 5
Total 100

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Suggested Solution

a. Identify and explain the risks that the Adam Beed Furniture Group faces with Marks
regard to its group operations. (Exclude discussions relating to the new
manufacturing division and the Teechaz Home and Office acquisition). 10

Communication skills – Clarity of expression 1

Expansion outside the African continent

• Complexities of operating in foreign territories (tax, legislation, economic
conditions, exchange control) 1
Currency risk
• The company operates in multiple countries and there is a risk that currency
conversions can be performed incorrectly. There is also a risk associated with
currency depreciation. 1
Aggressive expansion
• Exposes group to unexpected risks (knowledge of the industry, performance of
acquired companies may be below expectations and may not be identified as
part of the due diligence-unexpected risks) 1
Dual listing
• Dual listing implies that the company has to comply with the listing
requirements of both stock exchanges. 1
• Non-compliance could lead to fines/suspension/onerous requirements. 1
Reputational Risk & Ethics of key management and the board/ lack of corporate
governance
• Loss of credibility of financial information and reported profits. 1
• Loss of shareholder and employee confidence due to potential fraud. 1
• Loss of confidence of banks, supplies/ creditors 1
• Loss of credibility in the competence and credibility of the board of ABF as this
fraud happened under their watch. 1
Loss of Management expertise
• If the earnings manipulation allegations are true management will be forced to
resign leading to a loss of key management expertise albeit lacking integrity. 1
• Loss of key management who need to be replaced results in a risk that the
newly appointed management team would not understand the business and its
operations. 1
• An immediate resignation will mean there is no knowledge transfer to the new
directors 1
Management incentive based on financial performance
• Risk that Management will manipulate financial performance to earn higher
incentives. 1
Liquidation risk
• Release to the public of the earnings manipulation will lead to a significant
reduction in the share price which could result in a lack of marketability of
Adam Beed Furniture shares. 1

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• The unethical behaviour of the management team will negatively impact the
reputation of the company and could result in a substantial decrease in the
share price. 1
Refinancing risk
• In the event of a large reduction in share price the company will need to
reassess its financing. 1
Communication skills – Clarity of expression 1
Available 16
Maximum 11

b. Discuss the key issues arising from the sensitivity analysis of the new Marks
manufacturing project and propose two ways to address each issue discussed. 9
Issues Mitigating factors
The operating margin is the most 1 Management should review operating
sensitive input to the capital budget costs as regularly as possible to identify 1
and as such small changes will yield any major increases in operating costs.
huge changes in the NPV and
increase the risk of accepting a One way of doing this would be to
negative NPV project or rejecting a perform a variance analysis on say a
positive NPV monthly basis which would highlight in 1
particular adverse price variances
which could be responded to.
Determine whether certain operating
costs can be negotiated to be lower. 1

Entering into supply contracts with

suppliers in order to fix the cost of the
supply of key inputs - this will remove 1
the market/price risk for so long as the
supply agreement is in place.
Determine whether the costs included 1
in operating margins are correctly
addressed and if any costs have been
omitted
To reduce the impact which adverse 1
currency movements could have on
any imported supplies, hedging should
be considered in cases where
currency risk is predicted
The growth of units produced is the 1 Keep a strict eye on the industry 1
second most sensitive variable. competition so that counter strategies
Consideration has not been given to can be quickly developed to maintain
the point that the number of units competitiveness

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produced could be less than the Units can be increased by reducing 1

estimate. prices if the target market is price
sensitive/pricing strategies can be used
to penetrate the market
Design and execute very strong 1
marketing tactics to increase the
number of customers
The risk associated inflation seems 1 Review economic reports to ensure 1
low and management needs to alignment with forecasted inflation for
decide whether the cost of the capital budget
reviewing that information exceeds Consider ABF's ability to pass price 1
the benefits. increases on to customers
1 mark for each correctly explained issue and 2 marks for each mitigatory measure
per issue identified
Communication skills – Presentation and layout 1
Available 15
Maximum 10

c. With respect to the Teechaz Home and Office acquisition, analyse the Marks
reasonability of the forecasted income statement. Briefly conclude on how the
forecasted numbers will affect the value of the merged firm. 8
Financial year 2016 2017 2018 2019 2020 2021
Actual Actual Actual Forecast Forecast Forecast
Revenue growth 15% 26% 67% 18% 51%
COS growth 22% 35% 46% -7% -2% 1
GP Margin 35% 30% 25% 35% 48% 66% 1
% growth 0.4% 3.7% 130.7% 63.4% 107.9% given 1
It is clear from the forecasted numbers that the forecasts are aggressive 1
Despite the global economy growing by 3.9%, the merged firm is expected to grow
by 67% immediately which is unreasonable 1
Cost of sales is also decreasing which does not support the growth in sales and is far
out of line with prior history of between 22% and 46% 1
The decline in cost of sales unreasonably exceeds expected benefits from economies 1
of scale
The decline in COS may however reflect the increase in bargaining power 1
This results in the GP margin growing at an exponential rate which does not take into
account growing competition in the industry 1
The forecasted net margin of 18.0% is a huge deviation from the 3-year historic
average of 6.8% and the prior year's margin of 5.8% 1
All these will result in the following:
- overestimate of free cash flows and thus the merged firm 0.5
- overvaluation of synergies 0.5
- overpaying for the target 0.5
In the long run if the synergies are not realised, the value of the merged firm will
decrease significantly 0.5

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

Tax expense in the year 2020 is unreasonably low; this is likely due to unreasonable
growth in operating expenses in that year 1
Available 13
Maximum 8

d. Identify and explain the most appropriate valuation method for ProMark (Pvt) Marks
Ltd. Calculations are not necessary. 6
Communication skills – clarity of expression 1
As the future of ProMark is questionable, the company must liquidate to prevent
further value distraction 1
Liquidation will allow the company to settle outstanding debts 1
Value lies in the net assets rather than in the economic returns generated by the
assets 1
Liquidation valuation is appropriate as ProMark is not a going concern 1
Thus, a forced liquidation valuation approach would be appropriate 1
The assets will be valued at a huge discount to their current carrying value because
they will be under pressure to sell as fast as possible 1
Hence, they cannot be valued at realisable value but rather at the liquidation value 1
The liabilities would likely be settled at close to carrying value unless ProMark is
able to negotiate lower settlement values with creditors 1
ProMark's value = the difference between the discounted gross realisable value of
the assets and the book values of the liabilities less any liquidation costs 1
Any other valid point 1
Communication skills – clarity of expression 1
Available 10
Maximum 7

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

e. Determine the appropriate cost of equity for the valuation of the merged firm. Marks
5
Levered Beta of ABF before merger (given) 1.32 1
33858 68% 0.5
D/E ratio of ABF before merger = 43292+6508
100
Therefore, unlevered beta (asset beta) = 1.32 × 100+68×0.7425 0.88 1
Relever the unlevered beta to get beta of the merged firm
D/E ratio after merger (given) 150% 0.5
100
Therefore, levered beta = 0.88 ÷ 100+150×0.7425 1.85 1
Adjustment to beta
More diversified revenue -0.1 1
Adjusted beta 1.75

𝑅𝑓 (given) 8% 1
β 1.75
𝑅𝑚 14% 1
𝑅𝑒 = 8% + 1.75(14% - 8%) 18.5%
Available 7
Maximum 5

f. Discuss (without calculations) how the accounting irregularities in ABF's books Marks
may affect the merged group's cost of equity. 3
The accounting irregularities pose a unique risk for ABF and increases the overall
risk that shareholders are exposed to. 1
The CAPM only accounts for systematic risk 1
Therefore, an upward adjustment to the cost of equity will be necessary to capture
the specific risk of investing in ABF. 1
Available 3
Maximum 3

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

g. Determine how many shares of Adam Beed Furniture Ltd the shareholders of Marks
Teechaz Home and Office (Pvt) Ltd can expect to receive from this
transaction assuming a 15% cost of capital for the merged firm. Further
assume that the liquidation value of ProMark (Pvt) Ltd is $2m. 35

Communication skills – Presentation and layout 1

October October October Rep year
$'m $'m $'m $'m
2019 2020 2021 2022
Net profit (18%*forecast revenue) 20,787 24,456 36,981 1
Less:
Investment income (after-tax) (1,247) (1,488) (1,992) 1

Add:
Interest expense (after-tax) 2,426 2,588 2,844 1
Associate companies 5 10 19 1
Deferred tax (non-cash) 20% of total tax 254 391 269 1
Depreciation and amortisation 2,897 2,274 5,502 1
Extra-ordinary items (after-tax) 72 72 72 1
EBITDA 25,194 28,303 43,695

Working capital changes

Inventory days 79.00 95.74 139.15 1
Accounts receivable days 104.23 52.12 52.12 52.12 0.5
Accounts payable days (bal fig) 126.12 142.86 186.27 1
Cash conversion cycle (given) 5 5 5

Inventory (given) 14,431 14,431 16,320 18,455 26,394

Accounts receivable 19,754 9,877 16,490 19,400 29,336 1
Accounts payable (26,365) (26,365) (26,053) (27,538) (35,331) 1
Net working capital 7,820 (2,057) 6,757 10,317 20,399 1
Change in NWC 9,877 (8,814) (3,561) (10,081) 1

Change in Capital Expenditure

Capex/sales ratio = 5%
Capex (5,774) (6,793) (10,273) 1
FCFF 10,606 17,949 23,341 25,675
Terminal growth 10%
Terminal value 513,495 2
10,606 17,949 536,836
WACC (given) 15%
Value of operating assets 375,773 1
Non-operating assets 12,114
Excess cash - cash balance 2,237 1
Excess cash - working capital 9,877 1

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

Investments
Investment income 1,133
Payout ratio 60%
EPS 1,888 1

PE ratio 12 1
Adjustments:
Marketability/transferrability (1) 1
Liquidity (1) 1
Adjusted PE 10
Portfolio value 18,883 1

Associate 0.4 0.5

Property sold (after-tax) 0 0.5
Firm value 387,887
Less:
Long term liability (33,858) 1
Outside shareholders
Book value 6,508 1
Market-to-book 2.5
Value of OSH (16,270) 1
Value of Equity 337,759
Adam Beed Furniture - 70% 140,480 1
Teechaz Home and Office - 30% 80,000 0.5
Synergies 117,279 1

Stand-alone Post-merger
Synergies
value value

Adam Beed Furniture 140,480 82,095 222,575 0.5

Teechaz Home and Office 80,000 35,184 115,184 0.5
Total 220,480 117,279 337,759

# of shares
Post-merger (millions) Workings Share price
Adam Beed Furniture 1756 (222,575/1756) 127 0.5
Teechaz Home and Office 800 (115,184/800) 144 0.5
Exchange ratio 1.136 1
Teechaz Home and Office shares 800
Acquisition % 70% 1
Share issue % of total consideration 80% 1
Number of ABF shares to issue (800,000,000*70%*1.136*80%) 508,893,189 1

Alternative
Post-merger value of ABF 127 0.5
Value of 100% Teechaz Home and Office 115,184 1
115,184/127 0.5
Acquisition % 70% 1
Share issue % of total consideration 80% 1
Number of ABF shares to issue (115,184,000,000/127*70%*80%) 508,894,749 * 1
*small difference due to rounding off

Communication skills – Presentation and layout 1

Available 38
Maximum 36

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

h. Advise the shareholders of Teechaz Home and Office (Pvt) Ltd whether they Marks
should approve the merger (ignore the payment terms).

Your answer must address the following issues:

1. Cultural dynamics 7
2. Operational and financial structure 7
3. Conclusion 1
The offer price is at a premium of 43.4% 1
This is a very lucrative offer for Teechaz Home and Office's shareholders, but caution 1
must be taken that perhaps the synergies are overestimated
Cultural dynamics
Cultural harmony is important for the success of mergers 1
Teechaz Home and Office's success has been on the back of organic growth which
has ensured the sustainability of its business model 1
And the company has been conservatively managed to date - while the culture of
ABF seems far more aggressive 1
Adam Beed Furniture, however, focuses on acquisitions to fund growth and this
could lead to a clash in cultures 1
Huge reputation risk arises for ABF - further skeletons falling out of the closet in
future will render the ABF share worth even less going forward 1
This is further made worse by the 20% overvaluation of ABF's property portfolio.
Earnings manipulation? 1
If any accounting scandal is unveiled involving Adam Beed Furniture in the future,
this will have a large negative effect on the value of the merged group 1
Adam Beed Furniture has negotiated a large portion of the synergies and they are
unwilling to negotiate otherwise 1
This behaviour could be an indication that Adam Beed Furniture is generally not
open to negotiation and this could hurt the long term relationship between ABF
directors and those of Teechaz Home and Office 1
Any other valid point 1
Sub max 7

Operational structure
ABF plans to cut in half the budget for the social responsibility programme in which
Teechaz Home and Office has taken pride over the years 1
A major concern are the plans to migrate operations to Europe which will have
negative implications for Teechaz Home and Office including: 1
• reduced contribution to the Zimbabwean economy; 1
• divergence from Teechaz Home and Office's policy of low staff retrenchment; 1
• the merger will most likely introduce directors not grown from the business
which will hamper its long standing culture which has contributed to its stability
and success; 1
• relationships with unions are likely to weaken increasing the company's
sensitivity to strike action; 1
• lower staff morale will lead to poor performance and the loss of key personnel
as they seek employment elsewhere; 1

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2020

• products which do not embody cultural aspects of Zimbabwe 1

With 20% of past ABF acquisitions (including ProMark) proving unsuccessful, it raises
huge questions about ABF's management's abilities to create value 1
Financial structure
ABF plans an aggressive and risky recapitalisation programme by selling about 40%
of the merged firms combined assets 1
With all excess cash paid out to shareholders post the acquisition, little cash will be
left available to absorb any economic shocks or capitalise on future opportunities 1
The accounting practices of Adam Beed Furniture has come into question and affects
both its reputation and reliability of their forecasted numbers 1
The funding structure of 150% debt/equity is extremely aggressive and could expose
the new group to financial distress 1
Any other valid point 1
Sub max 7

Conclusion
There is sufficient quantitative and qualitative evidence to conclude that the merger 1
might not be a success in the long-run and will definitely not be in the best interest
of Teechaz Home and Office
The proposed post-merger operating model is very aggressive and is not in line with 1
the conservative manner in which Teechaz Home and Office has been run historically
Teechaz Home and Office shareholders should not approve the merger 1
Communication skills – logical argument 1
Available 27
Maximum 15

i. Assuming that the shareholders of Teechaz Home and Office wish to approve Marks
the merger, comment on the cash + share settlement structure. 5
A large portion (80%) of the consideration is to be settled in shares which forces
Teechaz Home and Office shareholders to share in the risk of future operations of
the merged firm. 1
The forecasts of synergies might be overstated and not realised considering that
historic accounting practices have been in question, thus increasing risk for the
shareholders. 1
The offer premium of 43.4% is very high compared to the expected industry average
of 30.0% 1
This could signify the overconfidence of ABF's directors to realise the estimated
synergies 1
The preference shares which are being used to finance the deal are convertible in 5
years, thus shareholdings will be diluted when this materialises 1
Therefore, to maximise the value of this transaction, shareholders of Teechaz Home
and Office should negotiate for a higher cash proportion in the payment terms thus
transfers more risk to the ABF shareholders. 1
Given the irregularities it can be argued that they should not accept shares! 1
Any other valid point 1

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Available 8
Maximum 5

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