Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

(a) The management of Wambu Limited wants to make a decision whether to change its policy of purchasing raw material stocks.

The current policy is to purchase raw materials monthly, on the last day of each month, for consumption in the following month. Suppliers are paid at the end of the following month – purchases at the end of January would be paid for at the end of February.

The proposed policy is to purchase raw materials every 3 months; suppliers would then allow an extra 2 months‟ credit. The extra cost of stock holding under the proposed policy would be Sh.600,000 per annum.

The decision about which policy to adopt will be made in time to affect purchases at the end of December 2004, when the cost of materials for January 2005 would be Sh. 20,000,000.

A growth rate of 0.75% per month is expected in purchases into the indefinite future from January 2005 onwards.

The cost of capital is 1% per month compound.

Required:
Which policy should be preferred? (ignore taxation)

(b) You have just finished reading the budget speech the Minister of Finance where you came across the term “Public Sector Borrowing Requirements.” What is meant this term?
(3 marks)

(c) The Minister for Finance has stated that he wants to put a limit to the Public Sector Borrowing Requirements. What difficulties and economic problems are likely to arise due to this?
ANSWER
Existing policy

The purchases at end of December 2004 are for January 2005
Therefore: Expected purchases/payments = sh 20 millions in 1 months time
New policy

Assuming it‟s now 31stDecember and 0.75% growth rate in purchases and the firm has to make a 3 month purchase “now” the total amount of cost would be as follows


This is the cost for every 3 months purchase
Summery


(b) Public sector borrowing requirement (PSBR)
Government utilizes its revenue in 2 major ways

Revenue/current expenses Capital expenditure
The government revenue is in form of taxes, fees, fines, rates, profits from parastatals etc Deficit = Total revenue – (Current + Capital expenditure)
PSBR represents this deficit that should be borrowed to partly meet current and capital financing needs.

(c) Difficulties and Economic problems of Limiting PSB

It may lead to printing of money the government which will increase money supply and inflation External borrowing from donors may not be available
Without borrowing, investment the government is reduced and this will impair economic growth The government may not be able to implement its fiscal and monetary policies with Limited borrowing

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