UNIVERSITY OF TORONTO
FACULTY OF APPLIED SCIENCE AND ENGINEERING
DEPARTMENT OF MECHANICAL AND INDUSTRIAL ENGINEERING
MIE 358F - ENGINEERING ECONOMICS AND ACCOUNTING - FALL 2003
MIDTERM EXAM - OCTOBER 16, 2003
Aid Permitted:
Notes:
Duration:
Electronic calculator
1.
This examination has 6 questions on 4 pages.
2.
Answer all questions in the booklets provided.
3.
Show all your calculations and reasoning.
4.
Put your tutorial section on your answer booklet.
5.
NO QUESTIONS will be answered during the test.
One hundred (100) minutes.
Question 1 (32 Marks)
Amsterdam Company manufactures and sells pen-like laser pointers for use by people
giving lectures or making presentations to audiences. The company started business on
October 1, 2003 and on that day it issued 10,000 common shares to shareholders for a
price of $100 per share. During the three months ended December 31, 2003, the business
transactions entered into by the company are summarized as follows:
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Purchased $200,000 of raw materials, and used $160,000 of these to make 10,000
pointers. The rest of the raw materials were still in the company’s warehouse.
Spent $220,000 to pay the direct labor workers in the factory.
Spent $80,000 to pay all employees who do not work in the factory.
Spent $30,000 to pay factory supervisors and managers
Spent $50,000 to pay other expenses related to operating the factory
Spent $20,000 to advertise its pointers.
Amsterdam sold 7,000 of the pointers that it produced, at a price of $80 each. The
remaining pointers were stored in the company’s warehouse.
Customers who purchased 6,000 of the pointers that the company sold had paid
the company for them by December 31. The other customers paid in January
2004.
The company did not pay any income taxes in 2003, but on March 31, 2004, it
will have to pay taxes at the rate of 40% of its net income for the period ended
December 31, 2003.
On December 31, 2003, the company purchased a computer system for $15,000. It
expects to use this system for 5 years.
Required
a) Determine Amsterdam Company’s net income for the three month period
ended December 31, 2003. (13 marks)
b) Assuming that all costs except materials and direct labor are fixed,
determine the company’s gross margin, and contribution margin for the
three month period ended December 31, 2003. (6 marks)
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c) Prepare a properly formatted balance sheet for Amsterdam Company as of
December 31, 2003. (13 marks)
Question 2 (16 Marks)
Tocchet Company manufactures CB1, a citizens’ band radio that is sold mainly to truck
drivers. The company’s plant in Windsor has an annual capacity of 50,000 units. Tocchet
currently sells 40,000 radios per year at a selling price of $105 each. It has the following
cost structure:
Variable manufacturing costs per unit
Total fixed manufacturing costs per year
Variable selling and distribution costs per unit
Fixed selling and distribution costs per year
$45
$800,000
$10
$600,000
Required:
(Consider each question independently, and ignore qualitative factors. Assume the
company’s objective is to maximize profits.)
a) Calculate the breakeven volume in units and dollars (4 marks)
b) The marketing department indicates that decreasing the selling price to $99 would
increase annual sales to 50,000 units. This strategy will require Tocchet to increase
its fixed advertising costs, although variable costs per unit will remain the same.
What is the maximum increase in annual fixed costs for which Tocchet will find it
worthwhile to reduce the selling price to $99, thereby selling 50,000 units? (5
marks)
c) The product design department proposes changes to the CB1 to add new features
to the product, which will enable Tocchet to increase the selling price. The changes
will increase annual fixed costs by $100,000, and variable manufacturing costs by
$2 per unit. At the current sales quantity of 40,000 units per year, what is the
minimum selling price above which Tocchet will find it worthwhile to add the new
features? (7 marks)
Question 3 (14 Marks)
The Wolverine Corporation is working at full production capacity producing 10,000 units
of a unique product, Rosebo. Manufacturing costs per unit of Rosebo are as follows:
Direct materials
$2
Direct manufacturing labour 3
Manufacturing overhead
5
$10
The unit manufacturing overhead cost is based on a variable cost per unit of $2 and
fixed costs of $30,000 (at full capacity of 10,000 units). The selling costs, all variable, are
$4 per unit, and the selling price is $20 per unit.
A customer, the Windsor Company, has asked Wolverine to produce 2,000 units of
Orangebo, a modification of Rosebo. Orangebo would require the very same variable
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manufacturing costs as Rosebo. There would be no change in fixed costs. The Windsor
Company has offered to pay Wolverine $15 per unit of Orangebo, and the selling costs per
unit of Orangebo would be 50% less than for Rosebo.
Required
(a) Based only on a quantitative analysis, should Wolverine agree to produce and sell the
2,000 units of Orangebo for the Windsor Company? (6 marks)
(b) The Buckeye Corporation has offered to produce 2,000 units of Rosebo for Wolverine
if Wolverine accepts the offer from the Windsor Company. That is, Wolverine would
manufacture 8,000 units of Rosebo and 2,000 units of Orangebo, and would purchase
2,000 units of Rosebo from Buckeye. Buckeye would charge Wolverine $14 per unit
for Rosebo. Should Wolverine accept this proposal? (8 marks)
Question 4 (8 Marks)
What are Generally Accepted Accounting Principles (GAAP)? Discuss the purposes they
are intended to serve.
Question 5 (21 Marks)
New York Company has the following capital structure, which it plans to maintain.
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5,000 bonds, with a face value of $1,000 each and a 10% coupon rate. The current
market rate of interest for these bonds is 9%. New bonds could be sold, with
floatation costs of 2% of the proceeds raised.
40,000 preferred shares, selling at a price of $90 each, and paying an annual
dividend of $10 per share. Floatation costs for preferred shares would be 3% of the
proceeds raised.
100,000 common shares with a current market price of $60 each. New common
shares could be issued at a price of $60, with floatation costs of 4% of the proceeds
raised.
The company does not retain any of its earnings, but pays them out as dividends.
Other information is as follows:
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The company’s income tax rate is 40%
The risk free rate of return is 5%, and the market risk premium for common stocks
is 12%. New York’s common shares have a Beta of 0.9
Required
a) How much will an investor pay for one of the bonds described above? (4
marks)
b) How much money will New York Company receive when an investor buys
one of these bonds when they are first issued? (3 marks)
c) Determine New York Company’s weighted average cost of capital, or
WACC. (12 marks)
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d) What is the relevance of your answer to part c) to an engineer trying to
persuade New York Company to invest in a new piece of equipment? (2
marks)
Question 6 (9 Marks)
Paula Warren Inc. (PWI) produces computers. A supplier of memory boards has offered to
sell the main memory boards to PWI for $38 each. PWI has been producing this
component internally at the following costs per unit: Direct Materials $12; Direct Labor
$18; Variable Overhead $6; Fixed Overhead $4 (based on an expected annual volume of
60,000 units). Of the fixed overhead, $1 per unit could be avoided if the company did not
produce the memory boards.
Required:
a)
Based upon quantitative analysis, should PWI continue to make the boards or
should it buy them? (5 marks)
b)
Suppose that in addition to the information above PWI has the opportunity to
rent out the production facilities it has been using to make the boards for annual
rent of $78,000. Does this change your answer to part a)? (2 marks)
c)
What are 2 qualitative issues PWI should consider before making this decision?
(2 marks)
FORMULAE
kd = Cost of debt = i(1-t) / (1-f)
i = effective interest rate
t = tax rate
f = floatation costs
kp = Cost of pref shares = D / P(1-f)
D = dividend per share
P = price per share
f = floatation costs
where:
where:
ke = Cost of common shares = [r + B(m)] / (1-f)
r = risk free rate of interest
B = beta
m = market risk premium
f = floatation costs
where:
WACC = kd($D/$T) + kp($P/$T) + ke($E/$T)
kd, kp, and ke are as per above formulae
$D = market value of total debt
$P = market value of total preferred shares
$E = market value of total common shares
$T = ($D + $P + $E)
where:
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