KOLEJ TUNKU ABDUL RAHMAN

DIPLOMA IN BUSINESS STUDIES - ACCOUNTING

ABBL 3033 BUSINESS LAW

NAME INDEX NO.YAP KAH WEE 10WBD00451

GOH SHIN YING 10WBD01872SIK KIM LIAN 10WBD07457

TEH KEEN TEEN 10WBD00863HENG WEI SIM 10WBD03013SIM KIM YUH 10WBD06347

TUTORIAL GROUP NO.: 13

DATE OF SUBMISSION: 29.11.2011 (Tuesday)

TUTORIAL WEEK: Week 11

TUTOR: Mr. Chai Ming Perng

SCHOOL OF BUSINESS STUDIESPlagiarism Statement

We confirm that the submitted work are all our own work and are in our own words.

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Question 1

a) Prepare a monthly cash budget for each of the six months to 30 June 2007, showing the cash balance at

the end of each month. Assume that the contract is completed on time.

Taiko LandscapesCash Budget from January to June 2007

NotesParticulars

Jan Feb Mar Apr May Jun

RM RM RM RM RM RM

CASH INFLOWS

1 Opening debtors 2,400 Nil Nil Nil Nil Nil

2 Sales 20,000 60,000 40,000 40,000 40,000 200,000 9 Sales proceeds from disposal of car Nil Nil Nil 3,000 Nil Nil

Deposit refunded from return of the vehicles Nil 2,500 Nil Nil Nil Nil

Total cash inflows 22,400 62,500 40,000 43,000 40,000 200,000

CASH OUTFLOWS

3 6,600 Nil Nil Nil Nil Nil

2,570 Nil Nil Nil Nil Nil

4 Diggers' cost 6,000 Nil Nil Nil Nil Nil

Digger's deposit 2,500 5 Purchases of raw materials: Nil Nil Nil Nil Nil Nil

12,600 Nil Nil Nil Nil Nil

Sand Nil Nil 2,200 Nil Nil Nil

Cement Nil Nil 3,100 Nil Nil Nil

Bricks/ Stones Nil Nil Nil Nil 76,500 Nil

Turf Nil Nil Nil Nil Nil 43,200 Shrubs Nil Nil Nil Nil 16,700 Nil

Other materials 2,000 2,000 2,000 2,000 2,000 2,000 6 Waste disposal cost 8,500 Nil Nil Nil Nil Nil

7 Salary 9,000 9,000 9,000 9,000 9,000 9,000 Bonus Nil Nil Nil Nil Nil 7,500

8 Leasing installments 990 990 990 990 990 990 9 Purchases of new car Nil Nil Nil 18,500 Nil Nil

Total cash outflows 50,760 11,990 17,290 30,490 105,190 62,690

Net cash flow (28,360) 50,510 22,710 12,510 (65,190) 137,310 10 Opening balance (14,200) (42,702) 7,381 30,091 42,601 (22,589)

Opening creditors: Materials Miscellaneous

Soil

Workings

Note 1

Inflow: Opening debtors received in January.

Note 2

Inflow: Received contract fee by installments.

January: RM 400,000 × 5% = RM 20,000

February: RM 400,000 × 15% = RM 60,000

March: RM 400,000 × 10% = RM 40,000

April: RM 400,000 × 10% = RM 40,000

May: RM 400,000 × 10% = RM 40,000

June: RM 400,000 × 50% = RM 200,000

Note 3

Outflow: Paid opening creditors in January.

Note 4

Outflow: Digger’s cost paid in January.

RM 1,200 × 5 = RM 6,000

Inflow: Deposits refunded from the return of the vehicles in February.

RM 500 × 5 = RM 2,500

Note 5

Outflow: Purchases of raw materials varies from January to June.

Note 6

Outflow: Waste disposal cost paid in January.

Note 7

Outflow: Salary paid from January to June.

(RM 21,600 ÷ 12) × 5 = RM 9,000

Bonus paid in June, as contract is assumed to be completed on time.

RM 1,500 × 5= RM 7,500

Note 8

Outflow: Leasing installments paid from January to June.

(RM 3,960 ÷ 12) × 3 = RM 990

Note 9

Inflow: Sales proceeds from disposal of car for RM 3,000 in April.

Profit on disposal of RM 600 is excluded as it is a non-cash item.

Depreciation of RM 300 each month (old car) is excluded as it is a non-cash item.

Outflow: Purchase of new car for RM 18,500 in April.

Depreciation of RM 385 each month (new car) is excluded as it is a non-cash item.

Note 10

Opening balance of RM 14,200 (overdraft) for Taiko Landscapes.

Note 11

Overdraft interest charges of 1% per month on an overdrawn balance on the closing bank balances each

month.

b) In the past, Mr. Taiko has had problems with Sandy Ltd delivering the wrong materials or delivering the

materials late. Its prices are so good that he does not want to buy from anybody else. However, it has been

such a problem that he is considering making all of these purchases at the beginning of January. He feels

that it would also be useful to have a basic understanding of the essential elements of a contract so that he

knows his position when dealing with problems with suppliers.

Discuss the costs and benefits, for Mr. Taiko, of ordering materials early. No additional calculations

are required.

Benefits

Mr. Taiko will reduce his delivery costs since only one delivery from Sandy Ltd. He may also reduce his

purchase costs by making purchases before any potential price rises come into effect. From an increased

bulk purchase discount, he will also gain since he will now receive a 10% discount on the sand, cement, and

bricks or stones. The materials will also be readily available as upon request. Workers will not have to sit

idle waiting for materials to arrive. There will be a greater chance of the contract being completed on time.

In turn, this means that the penalty will not be payable. Workers will also have additional capacity and time

to start another job earlier should the contract be completed within the six month period. This will bring

extra revenue to the business.

Costs

If more materials are left on driveways for longer, there is an increased risk of stock loss either due to

weather or accidents. Additional costs may increases as the sand and cement may get damaged by rain/wind,

and the stones/bricks may get cracked. Since there is restricted storage space on the driveways anyway,

some materials may need to be stored elsewhere, for which there will be a cost for example, local

warehouse. Insurance costs will probably rise if greater quantities of stock are to be held at one time. There

is also money and cost of capital being tied up in stocks. Finally, if the customer needs to change his

requirements, pre-ordered materials may become surplus, resulting in increased costs for Mr. Taiko unless

the contract states that changes the customer will be responsible for such costs.

c) The local building firm that Taiko Landscapes has entered into the new contract with has only been in

business for five years. Mr. Taiko therefore had to check on the creditworthiness of the firm.

List four (4) external sources of information that Mr. Taiko may have used to provide assurance

about the creditworthiness of the local building firm.

i. Bank referencesii. Trade references

iii. Credit reference agenciesiv. Informal conversations with people connected

Question 2

a) Explain the main principles used to differentiate between relevant and irrelevant costs for investment

appraisal, using the information in the question to illustrate your points.

Relevant costs

Relevant cost is a future cash flow arising as a direct circumstance of a particular decision. The following

principles should be applied when identifying costs that are relevant to a period.

Relevant costs are future costs

A decision is about the future that a cost has been incurred in the past is therefore totally irrelevant to any

decision that is being made now. Costs that is relevant with respect to a particular decision. A relevant cost

for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also

called differential costs.

Such past costs are called “sunk costs” is a cost incurred in the past that cannot be changed by current

decisions and sunk costs are irrelevant costs which are simply costs that will not affect the decision

therefore ignore sunk costs in decision-making. In Cantik Ltd’s project, the £1.5 million spent preparing the

land for construction is a sunk cost, as is the £2 million down-payment to construction firms. These costs

should be excluded when calculating the net present value of the project.

Relevant costs are cash flows

Only those future cots that are in the form of cash should be included and that will arise only if the capital

project goes ahead .This is because relevant costing works on the assumption where a decision maker

wishes to maximize profit and the profit that is earned will eventually produces a net inflow of an equal

amount of cash. Therefore, costs which do not reflect cash expenditures should be ignored for the purpose

of decision-making. Depreciation is a non cash-flow item, which indicates that the depreciation charges of

£1.5 million should be ignored in the decision for Cantik Ltd.

Relevant costs are incremental costs

A relevant cost is the increase or decrease in the cost as the result of taking this decision is relevant in

decision making, cost which will change as a result of decision making should be considered. Any costs or

benefits arising as a result of a past decision should be ignored.

Opportunity costs

An opportunity cost is the profit foregone by selecting one alternative over another. It is the net return that

could be realized if a resource were put to its next best use, this is the value of a benefit foregone as a result

of choosing a particular course of action. Such costs will always be a relevant cost.

Irrelevant costs

On the other hand, some other costs will be irrelevant to decision-making, such as ‘committed costs’.

Committed costs are costs that will occur in the future, but will be incurred anyway. The £3 million

restaurant costs represent such committed costs, and therefore, this will be ignored for the decision-making

process. The interest costs of £2.5 million per annum are also ignored. This is not because they do not meet

the above criteria, is because they are taken into account in the discounting process. If these costs were

included as relevant they would be double counted.

b) Calculate the project’s net present value (NPV) at the company’s required rate of return.

Conclude as to whether the company should accept the offer or continue with the project, giving a

reason for your conclusion.

Net Present Value

Year

0 1 2 3 4 5 Total

RM’000 RM’000 RM’000 RM’000 RM’000 RM’000 RM’000

Net sales proceeds forgone

(4,980) (4,980)

1) Hotels construction costs

(35,000) (35,000)

2) Lodges construction costs

(4,000) (20,000) (24,000)

3) Cost of furnishing – hotels and lodges

(3,200) (3,200)

4) Swimming pools (480) (480)5) Restaurants (12,000) (12,000)6) Small parade of

shops(4,000) (4,000)

7) Annual cash overheads – hotels

(2,000) (2,000) (2,000) (2,000) (8,000)

7) Revenue - hotels 13,000 13,000 13,000 13,000 52,0008) Maintenance costs

-lodges(280) (280) (280) (280) (1,120)

9) Rental income -lodges

15,600 15,600 15,600 15,600 62,400

10) Net income - restaurants and shops

4,730 4,730 4,730 4,730 18,920

Net relevant costs (8,980) (74,680) 31,050 31,050 31,050 31,050 40,540Cost of capital: 10% 1.000 0.909 0.826 0.751 0.683 0.621

Present Value (8,980) (67,884.12) 25,647.3 23,318.55 21,207.15 19,282.05 12,590.93

Net Present Value (NPV)

12,591

Since net present value of the project shows positive of RM 12.591 million, by choosing this project, the company will maximize the shareholder’s wealth. Therefore, the company should continue with the project.

Notes:

Purchase cost of uninhabited island = sunk cost, not relevant in decision making and hence not made into

account of NPV calculation.

Net sales proceed forgone = RM 5,000,000 - 20,000 = RM 4,980,000

Set up costs will occur within the next year: Year 1

1) Hotels construction costs = RM 37,000,000 - RM 2,000,000 = RM 35,000,000

(RM 2,000,000 has already been spent = sunk cost, not relevant in decision making and hence not made into

account of NPV calculation.)

2) Lodges construction costs = RM 24,000,000

(RM 4,000,000 of down payment need to be settled immediately.)

3) Cost of furnishing - hotels and lodges = RM 3,200,000

4) Swimming pools = RM 12,000 × 40 = RM 480,000

(40 pools that costs RM 12,000 each.)

5) Restaurants = RM 15,000,000 - RM 3,000,000 = RM 12,000,000

(RM 3,000,000 is bound to be paid = committed cost, not relevant in decision making and hence not made into

account of NPV calculation.

6) Small parade of shops = RM 4,000,000

Annual revenues and overheads relate to the four years following by set-up costs: Year 2 to 5

7) Annual cash overheads - hotels = RM 2,000,000 per annum

Revenue - hotels = RM 13,000,000 per annum

8) Maintenance costs - lodges = RM 7,000 × 40 = RM 280,000

(40 lodges that costs RM 7,000 of maintenance cost.)

Rental income - lodges = RM 390,000 × 40 = RM 15,600,000

(40 lodges that are expected to earn RM 390,000 per annum per lodge.)

9) Depreciation = non-monetary item, not relevant in decision making and hence not made into account of NPV

calculation.

10) Net income - restaurants and shops = RM 4,730,000

11) Interest on loan = sunk cost, not relevant in decision making and hence not made into account of NPV calculation.

c) Calculate the internal rate of return (IRR) for the project, using discount rates in the tables provided.

Formula of internal rate of return (IRR) is provided as follow:

IRR = A + [ a(a - b )

× ( B - A ) ]

A: The discount rate with a positive NPV

B: The discount rate with a negative NPV

a: The amount of the positive NPV

b: The amount of the negative NPV

YearCash Flows

(RM)Discount rates

at 10%Present Value

Discount rates at 20% Present Value

0 (8,980) 1.000 (8,980) 1.000 (8,980)1 (74,680) 0.909 (67,884) 0.833 (62,208)2 31,050 0.826 25,647 0.694 21,5493 31,050 0.751 23,319 0.579 17,9784 31,050 0.683 21,207 0.482 14,9665 31,050 0.621 19,282 0.402 12,482

Net Present Value 12,591 (4,213)

(Workings are to the nearest RM’000.)

IRR = 10% + [ 12,591(12 , 591 - (- 4,213 ) )

× ( 20% - 10% ) ]

= 17.49%

d) Discuss how the net present value method investment appraisal contributes towards the objective of

maximizing the wealth of shareholders.

The primary financial management objective of private sector companies is maximization of the wealth of

its shareholders. Shareholder wealth increases through receiving dividends and through share prices

increasing over time. Hence, changes in share prices can be used to assess whether a financial management

decision is beneficial to shareholders. In fact, maximization of shareholder’s wealth is usually substituted by

the objective of maximizing the share price of a company.

The net present value (NPV) investment appraisal method advises that an investment should be accepted if

it has a positive NPV. If a company accepts an investment with a positive NPV, the market value of the

company, theoretically at least, increases by the amount of the NPV. For instance, a company with a market

value of RM 10 million investing in a project with an NPV of RM 1 million will have a market value of RM

11 million once the investment is made. Shareholder’s wealth is therefore increased if positive NPV projects

are accepted and, again, theoretically, shareholder’s wealth will be maximized if a company invests in all

projects with a positive NPV. NPV is therefore usually referred to as the optimum investment schedule for a

company.

The NPV investment appraisal method also contributes towards the objective of maximizing the wealth of

shareholders by using the cost of capital of a company as a discount rate when calculating the present values

of future cash flows. A positive NPV represents an investment return that is greater than that required by a

company’s providers of finance, offering the possibility of increased dividends being paid to shareholders

from future cash flows.