2011

MBA 57582 FINANCIAL MANAGEMENT COURSE OCTOBER, 2011

INSTRUCTOR: PROF. DAVID DUFFIL

MID TERM ASSESSMENT AUSSIE PIES (B) CASE STUDY

Word count: 1,865 (exclude cover page & TOC)

Microeconomics of

Contents...............................

Introduction........................

1. Opening Balance Sheet.......

2. Balance Sheet and Income Statement.....

3.

Comments on Decision taken by managers...... 3.1 Depreciation..... 3.2 Capitalization of Start-up costs................................... 3.3 Dividend.................................. 3.4 Capital Expenditure..............................................

3-5 3-4 4 5 5

References.....

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Introduction The meat pie is a national snack food of Australia. The Australians consumed vast numbers of meat pies while watching a game. The average Australian will consume an average of 45 meat pies per year, and popular brand produced 50,000 pies per hour. Anna Amphlett and Andrew Ferris discovered business opportunity and decided to introduce the concept of the Australian meat pie to the American consumers. They have registered trademark the name, Aussie pie, to launch the new business. However, establishing a new business would require financing. As their resources are limited they depend on outside financing- bank loan- which require a complete set of projected financial statements for the start-up of the business as well as during the first year of operations. It is as follows: 1. Aussie Pie Statement of financial position as at 31 December 2005

2.

Aussie Pie

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Projected Statement of financial position as at 31 December 2006 Projected Income Statement for the year ended 31 December 2006

3.

Comments on decision taken by manager 3.1 Deprecation

Depreciation is an attempt to measure that portion of the cost (or fair value) of a non-current asset that has been used up in generating the revenue recognized during a particular period. It attempts to allocate the cost of the asset over its useful life. This is the period of time that it will be economically feasible to use an asset. The useful life of an asset is an estimate of how long the asset will be used (as opposed to how long the asset will last). There is the straight line method; an equal amount of depreciation is charged for each year that the asset is held, whereas the reducing balancing method applies a fixed percentage rate of depreciation to the carrying amount of the asset each year. The choice of the depreciation method should best match the depreciation expenses to the pattern of economic benefits that the asset provides. The straight line method is appropriate where the benefits are provided over time while the reducing-balance method is appropriate where the benefits provided decline over time. Although the profit over the estimated life time differs depending on the depreciation method, the total profit is the same. It allocates the same amount of total depreciation. It is only the amount allocated between the years that differ. Whenever estimates are used in accounting, the expected useful life of the asset is based on subjective judgment. Different judgment would result in depreciation charges over the life of the asset and thus differ in profits. In the case study, the expected useful life for building is 20 year, whereas the equipment, furniture, fixtures should be based on an estimated life of 7 years. The estimated useful life of 10 years, underestimate the depreciation charges over the life of the assets. However, it is possible to adjust the error of under-deprecation in the final year of an assets life, and so the total deprecation charge over the life of the assets will not be affected by the estimation error. The pattern of depreciation and total depreciation charged can be:

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Estimate (a) Year 1 2 3 4 5 6 7 Annual Deprecation Annual Deprecation Annual Deprecation Annual Deprecation Annual Deprecation Annual Deprecation Annual Deprecation $ 24,285.71 24,285.71 24,285.71 24,285.71 24,285.71 24,285.71 24,285.71 170,000.00 7 Under-depreciation Total deprecation 170,000.00 (b) $ 17,000.00 17,000.00 17,000.00 17,000.00 17,000.00 17,000.00 17,000.00 119,000.00 51,000.00 170,000.00

The final adjustments for under-deprecation are made as an extra expense, for the deprecation in the year. 3.2 Capitalizing Start-up costs To capitalize means to turn a cost into an asset rather than expense. For example, some start-up costs are considered longterm costs, so they are capitalized. This spreads the expense over more than one year. In general, capitalizing expenses is beneficial as companies acquiring new assets with a long-term lifespan can spread out the cost over a specified period of time. Companies take expenses that they incur today and deduct them over the long term without an immediate negative affect against revenues. Generally expenses are deductible under the cash method when paid. However, if the payment of the item creates an asset with a life that extends substantially beyond the close of the year, the amount must be capitalized and then amortized over the period to which it is applicable. Capital expenses can generally be divided into three categories: business start-up costs, assets, and the cost of improvements. Examples of these expenses are land, buildings, equipment, furniture, and repairs, which extend the life expectancy of an asset more than a year. These assets belong to the balance sheet of a company and can be capitalized, or expensed, through depreciation or amortization over time. All of these expenses create an investment for the business and allow for future revenue. Startup expenses would usually include, but are not limited to: the cost of travel, trade shows, educational or training seminars, accounting and legal fees, consulting fees, building costs, and supplies or materials needed to get your business started. Organizational fees include the costs relating to forming or creating the business: fees paid to obtain licenses, and accounting or legal fees for formation of the entity. Usually a cost or expense will be written off in the year in which the business pays for the item. This is called expensing the cost. However, if an asset or expense has a useful life of more than one year, it will be considered a capital asset and will need to be written off over its useful life. This is called depreciating an asset or, in some cases, amortizing an asset. Generally, a business can expense in the year purchased up to $5,000 for each of its startup costs and up to $5,000 of its organizational costs; any cost over that $5,000 maximum must be amortized over 15 years. Often startup costs and

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organizational costs are incurred prior to the actual formation and operation of the business. This will be important to know from day one, because it could affect when and how a business owner decides to incur a cost. That's because if those expenses incurred before forming the business, they would be considered a startup expense; only $5,000 would be deductible in the first year and the remaining $3,000 would have to be written off (amortized) over 15 years. But if those expenses incurred after forming her business, they will be considered a regular trade or business expense and will be expensed in their entirety in the first year.

3.3 Dividend Dividends represent drawings by the shareholders of the company. Dividends are paid out of the revenue reserves and should be deducted from these reserve, usually retained earing. The maximum legal dividend is the amount of the reserve revenue. Shareholders are often paid an annual dividend. Large companies tend to have a consistent policy toward payment of dividend. Any change in the policy is interpreted by shareholder as a signal of the directors views concerning the future. For example, an increase in dividend may be taken as signal that future prospects are bright: a higher dividend being seen as tangible evidence of their confidence. In the case study, there are assets with a total amount of $1,387,743 (before dividend deduction) to meet the banks loan of$ 647,309. It would be possible and legal for the company to pay a dividend of $120,000. This will not affect the bank in that there are total assets with a carrying amount of $1,267,743 to meet a claim of $ 647,309. Also the company has availability of cash of $344,743 to pay dividend. The difference between the amount of the borrowing and the total assets equals the equity total. Thus, the equity represents a margin of safety for lender and suppliers. The larger the amount of the owners claim withdrawal by the shareholders, the smaller is the potential margin of safety for lenders and suppliers. It is worth pointing out that long-term lenders would normally seek to secure a loan against an asset of the company, such as land. Although it is legally possible, rare companies that pays all its revenue as a dividend as they see profit as a major source of new finance. There are also factors that influence the dividend decisions; the availability of cash to pay dividend, the need of the business for finance for new investment, the exceptions of shareholders concerning the amount of dividends to be paid. 3.4 Capital Expenditure Capital expenditure is the money spent by the business to acquire and improve fixed assets of a company. These assets are property, building, and equipment that have a useful life of more than one year. It is a number the investment community uses to measure a firm's investment in future revenue-generating activities. A company with low capital expenditure may have fewer expenses. Capital expenditure can be calculated from the information found on the balance sheet. Calculate the year-over-year change in the assets by subtracting the total assets of the previous year to the current year. This will give the change in the assets. Then, calculate the year-over-year change in liabilities by subtracting the total liabilities for the previous year and the current year. Subtract the change in total liabilities from the change in total assets for the previous year and the current year. The result represents the amount spent on capital expenditures for the year. Capital expenditures that do not change from year to year can be assumed to be maintenance. When capital expenditures increase, it is generally assumed to be growth capital expenditure. In this case, it can be calculated as follows: Total assets (2005) - total assets (2006) 1,267,743 - 800,000= 467,743 Total liabilities (2005) - total liabilities (2006) 883,308 - 700,000 = 183,308 Total assets- total liabilities= 284,435

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The statement of financial position reveals a relatively high investment in non-current assets. It is more than 35% of the total investment in assets (443,000/1,267,743) has been in non-current assets. The investment in current assets exceeds the current liabilities by a large amount about 3 times. There is no sign of liquidity problem. When considering the long-term financing of the business, we can see that more than 62% (647,309/ (647,309+384,434) of the total long term finance for the business has been supplied by borrowings more than 35% (384,434/(647,309+384,434) by the owners. This level of long-term borrowing seems high. However, it is not a problematic as long as the business is able to service the borrowing; make interest payment and repayment of the amount borrowed.

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References:

Accounting An Introduction, Eddie McLaney, Peter Atrill, 5th edn, Financial Times Prentice Hall, 2010 Accounting Theory, Riahi-Belkaoui A., 5th edn, Thomson Learning, 2004, chapters 1, and 2 Barbara Weltman. How To Write Off Startup Costs, from American express.com http://www.openforum.com/articles/how-to-write-off-startup-costs Corporate Financial Accounting and Reporting, Sutton T., 2nd edn, Financial Times Prentice Hall, 2004, chapters, 2,8, and 10 Department of the Treasury Internal Revenue Service http://www.irs.gov/pub/irs-pdf/p946.pdf Lara Lawrence. (February 17, 2009).The difference between current and capital expenses, from helium.com http://www.helium.com/items/1344950-the-difference-between-current-and-capitalexpenses Russell Brooks. How To Calculate CAPEX, from how to do things.com http://www.howtodothings.com/business/how-to-calculate-cap Tiare Rath. Top 10 Small Business Tax Deductions, from about .com http://sbinformation.about.com/od/taxes/a/Topdeduction_ga.htm http://www.entrepreneur.com/article/178812

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