SECTION A

QUESTION 1

a. Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing employees to accept tips. Customers who once said, "Keep the change," now have to get used to waiting for their nickels. Management even instituted a policy of requiring that the change be thrown out if a customer drives off without it. Asa frequent customer who gets coffee and doughnuts for the office, you notice that the lines are longer and that more mistakes are being made in your order. Explain why tips could be viewed as similar to stock options and why the delays and incorrect orders could represent a case of agency costs. If tips are gone forever, how could Donut Shop reduce these agency costs?

b. Explain why sound corporate governance is important to a corporation and assess the consequences of corporate governance failures.

QUESTION 2

a. What are the potential problems associated with using ratio analysis to analyze the financial health and performance of companies?

b. The economic order quantity model is used as a way of managing inventory. Discuss the limitations of economic order quantity (EOQ).

QUESTION 3

C Berhad places monthly orders with a supplier for 10,000 components, which are used, in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which C Berhad meets and the cost per component is RM7.50. The cost of ordering is RM200 per order, while the cost of holding components in inventory is RM1.00 per component per year.

The supplier has offered a discount of 3.6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to RM2.20 per component per year due to the need for a larger storage facility.

Required:

Calculate if C Berhad will benefit financially by accepting the offer of the bulk purchase discount.

SECTION B

QUESTION 4

Argnil Co is appraising the purchase of a new machine, costing RM1.5 million, to replace an existing machine which is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows:

Year                                        1                 2               3               4

Sales volume (units/year)        350,000       380,000      400,000      400,000

The new machine will incur fixed annual maintenance costs of RM145,000 per year. Variable costs are expected to be RM3.00 per unit and selling price is expected to be RM5.65 per unit. These costs and selling price estimates are in current price terms and do not take account of general inflation, which is forecast to be 4.7% per year.

It is expected that the new machine will need replacing in four years' time due to advances in technology. The resale value of the new machine is expected to be RM200,000 at that time, in future value terms.

The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine. Working capital investment of RM150,000 will already exist at the start of the four-year period, due to the operation of the existing machine. This investment in working capital is expected to increase in nominal terms in line with the general rate of inflation.

Argnil Co pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%.

Required:
Using a nominal terms net present value approach, evaluate whether purchasing the new machine is financially acceptable.

QUESTION 5

a. "The capital asset pricing model offers a better estimate of the cost of equity of a company than the dividend growth model" Discuss the validity of this statement.

b. Discuss the extent to which the assumptions underlying Miller and Modigliani's "Dividend Irrelevance Theory" fail to mirror the real world. Do you consider this failure to invalidate the usefulness of their theory?