- This topic has 9 replies, 4 voices, and was last updated 4 years ago by
.
- Posts
Dear Mr Moffat,
I came across below question but I have few concerns. Could you kindly help me?
Mrs Glam wants to expand her clothes shop. Mrs Clam has commissioned a market research company at a cost of $ 3000 to research her options for her. The company have offered two options:
Options 1
Remain in her the current premises and undertake an advertising campaign at a cost of $2000 to increase the profile of the shop in the area. It is estimated that revenue will increase by 10% from its current level of $50000 per year. The contribution earned on revenue is 30%.Options 2
Move the shop to a more central location and undertake an advertising campaign to both increase the profile and the move to the new premises. This more extensive campaign would cost $4000 but revenue would be expected to increase by 18% from its current level. The level of contribution earned on revenue is not expected to change.
There would be further costs involved in moving location which have been estimated
Moving costs are estimated to be $1500. This includes the cost of refitting the shop, and would be payable immediately.
New shop fittings will be required costing $2500. These will be depreciated on straight line basis.
Rate of $4000 will be payable yearly in advance. This cost is 15% higher then Mrs Cglam currently pays, due to the locationOther information
Mrs Glam uses a cost of capital of 10%
Required:
a)State if the following items relating to Mrs Glam’s decision how to expand are relevant or irrelevant cash flows in a net present value calculation:
$3000 market research fee
Depreciation of $625 per year for the new shop fitting
The cost of $1500 incurred in moving to the new premises(My question)
No problem with the depreciation that is irrelevant for cash flows, however I don’t understand why the 3000 marked research fee is irrelevant whereas the 1500 is relevant.
b) Calculate the present value of the INCREMENTAL contribution cash flow that will arise if option 2 is pursued.
(This is the solution provided by the book)
Option 1
Contribution 50000 *1.1*0.3= $16,500
Present value of contribution $16500 *3.170 = $52.305.
Option 2
Contribution 50000*1.18*0.3 = 17,700 per annum
Present value of contribution 17700 *3.170 =56109Incremental contribution 56109-52305= 3804
The question says that the discount rate is 10% (no problem), however I don’t understand why it has been used the the rate for 10% years 4.
c) Calculate the present value of the cash flows relating the Incremental rates that will arise if option 2 is pursued
book answer
Rates are paid in advance so payment will occur in years 0,1,2 and 3. The annuity factor is for year 0 to 3 = 3,487
PV of new rates = 4000 *3,487 = 13948
PV of old rates (4000-(4000/115*15) *3,487 =12129Incremental rates 13948-12129 = 1,819
I don’t understand where do they take the annuity rate discount from. I could not find on the annuity table that 3,487 is the rate for year 3 at discount of 10%.
I am really confuse with this question and a bit worry for the exam if this is the type of question that we will be asked.
Thanks
Gabbi
The market research is a sunk cost (it has already been spent) and is therefore not relevant.
We are only interested in future, incremental (extra), cash costs.I do not understand the 4 years either – the question as you have typed it does not say how long the shop will last. Clearly it is 4 years and I can only guess that the question missed that out by accident.
The reason for the 3.487 is that annuity factors give the total from 1 to anything.
So in part (b) no problem – the four year annuity factor at 10% is 3.170.
However for part (c) the money is paid at the start of each year. So for the first year it is paid immediately – i.e. at time 0; for the second year it is paid at the start of the year which is one year from now – i.e. at time 1. And so on.
So it is paid at time 0, and then times 1 to 3.
For the PV at time 0 we just multiply by 1. For the PV for 1 to 3 we multiply by the 3 year annuity factor, which is 2.487.
So the two together give 1 + 2.487 = 3.487.I would be surprised if you were to get a question in the exam with all these complications in it.
sir, I’ve got these type of questions in section b of my exam and I marginally failed the exam but now I am not able to find questions like this one. can you suggest some source? I have got 87% in open tuition mock and also in all other mocks I gave I got marks at least more than 74% but still failed. its been a week im shattered, please enlighten me on my next steps.
(a) State if the following items relating to Mrs Glam’s decision how to expand are
relevant or irrelevant cash flows in a net present value calculation:
(i) The $3,000 market research fee (1 mark)
(ii) Depreciation of $625 per year for the new shop fittings. (1 mark)
(iii) The costs of $1,500 incurred in moving to the new premises. (1 mark)
(b) Calculate the present value of the INCREMENTAL contribution cash flow that will
arise if option 2 is compared to option 1. (2.5 marks)
(c) Calculate the present value of the cash flows relating to the INCREMENTAL rates
that will arise if option 2 is compared to option 1.sir, the statement i saw in kaplan book is different from the one mentioned above and I don’t understand it either way please explain me (b) and (c).
The BPP Revision Kit has a few questions like this (and this question is only asking several individual Section A type exercises, of which again there are several in the Revision Kit). I don’t know about the Kaplan Exam Kit but I would imagine that they have also.
Incremental means extra.
The answer that gabbi08 typed out is correct but it has been done in a complicated way. It works out what the NPV of the new total contribution will be in each case and then looks at the difference.
Easier is just to say that the extra contribution if option 1 is done is 50,000 x 10% x 0.3 = 1,500
The extra contribution if option 2 is done is 50,000 x 18% x 0.3 = 2,700.So comparing option 2 to option 1 gives an extra 1,200 per year.
The present value of this is 1,200 x 3.170 = $3,804.For the rates, if the do option 2 then the rates will be $4,000.
This is 15% more than the rates of the current shop (which is where they will stay if they do option 1.
Therefore the option 1 rates are 100/115 x 4,000 = 3,478.Therefore the extra for option 2 as against option 1 is 522.
The present value of this is 522 x 3.487 = $1,820Good day sir, am trying to mark my exams that i have wrote in section B of the exam but i seem not to get the worked out answers am only getting the the answer without any calculations is it supposed to be like that or its my technical error.
I do not really understand what you are asking.
Which exam are you asking about? If you are meaning the mock exam on our website, then for Section B it does not show the workings (although if you use the search tab on this page you will find previous posts of mine giving the workings).
Please do not only use our mock exam – there are several specimen exams on the ACCA website and, of course, there will be several mock exams in your Revision Kit.
- The topic ‘Section B Exam’ is closed to new replies.