UNIVERSITY OF TORONTO

FACULTY OF APPLIED SCIENCE AND ENGINEERING

DEPARTMENT OF MECHANICAL AND INDUSTRIAL ENGINEERING
MIE 258F – ENGINEERING ECONOMICS AND ACCOUNTING – FALL 2007
MIDTERM EXAM – OCTOBER 22, 2007
INSTRUCTIONS

Duration: Ninety (90) minutes

Aid: Non-programmable calculator
This exam consists of 6 questions on 14 pages for 90 marks.
Show all calculations to obtain maximum marks. Answer questions in the space provided.
NO QUESTIONS will be answered by the invigilators during the test.

MARKS:

Q1: _______ /32

Q2: _______ /17

Q
3: _______/09

Q4: _______ /06

Q5: _______ /20

Q
6: _______/06

Total: _______ / 90

Name: ________________________________

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Student Number: _______________________

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, 2006 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, 2006, the business
transactions entered into by the company are summarized as follows:

 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
2007.
 The company did not pay any income taxes in 2006, but on March 31, 2007, it
will have to pay taxes at the rate of 40% of its net income for the period ended
December 31, 2006.
 On December 31, 2006, the company purchased a computer system for $15,000. It
expects to use this system for 5 years, starting January 1, 2007.

Required
a) Determine Amsterdam Company’s net income for the three month period
ended December 31, 2006. (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, 2006. (6 marks)
c) Prepare a properly formatted balance sheet for Amsterdam Company as of
December 31, 2006. (13 marks)

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SOLUTION:
Q1, Part a). (all numbers in thousands except per unit amounts)
Cost of products made:
Raw materials 160 2 marks
Direct labor 220 1 mark
Other factory labor 30 1 mark
Factory overhead 50 1 mark

Total cost to make 10,000 units is $460, which is $46 per unit
Of these, 70% were sold, so the costs are .7x$460 = $322.The balance of $138 is in
inventory. So, net income is:

Revenues 7,000 units x $80 each 560 1 mark

Expenses:
Cost of goods sold 7,000 x $46 322 2 marks
Salaries 80 1 mark
Advertising 20 1 mark

Income before taxes 138

Taxes @ 40% 55.2 2 marks
Net income 82.8 1 mark

Q1, Part b)
Gross margin = revenues – cost of goods sold = 560 – 322 = 238, as above calculation
2 marks
Contribution margin = 7,000 units x [80 price – (16 + 22) variable costs per unit] = 294
1 mark for using 7,000 units; 1 mark for using $80 price; 2 marks for using $38 variable
costs

Q1, Part c)
The following is the balance sheet. The student MUST get the correct caption, have it
shown in the correct category, AND have the correct number to get any of the marks for
that item.

ASSETS
Cash 865 3 marks [1,000-200-220-80-30-50-20-
15+(6,000 units x $80]
Accounts receivable 80 1 mark [1,000 units not paid for x $80]
Raw material inventory 40 1 mark [$200 purchased - $160 used]
Finished goods inventory 138 2 marks [see part a) above]

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Computer 15 1 mark [no depreciation, as it was
bought
on the last day]
TOTAL ASSETS 1,138

LIABILITIES
Income taxes payable 55.2 1 mark [as per income calculation]

SHAREHOLDERS’ EQUITY
Common shares 1,000 1 mark [shares sold at the beginning]
Retained earnings 82.8 2 marks [the net income]

TOTAL L + SE 1,138

+ 1 mark for correct headings of “Assets”, “Liabilities”, and “Shareholders’ Equity”

Question 2 (17 Marks)

New York Ltd. has a book-value capital structure that comprises $10 million each of long
term debt (bonds), preferred shares (1,000,000 preferred shares outstanding), common
shares (500,000 common shares outstanding), and retained earnings. Some other salient
information includes:
 The current market rate on the long-term debt is 9 percent for bonds with a
$1,000 face-value, and that pay a coupon rate of 10%. Assume the bonds have
no maturity date.
 The preferred shares have a current market price of $60, a $50 book value, and
a 12 percent (as a percentage of book value) dividend rate.
 Common stock sells in the market for $80. The current risk free rate is 5% and
the market risk premium is 7%. The Beta coefficient for this company is 1.6.
 The firm’s tax rate is 34%.
Required
a) Using these data, compute the weighted average cost of capital (WACC), assuming
the firm intends to maintain its current capital structure. (14 marks)
b) What is the relevance of this number (the WACC) to the company’s team of
engineers in charge of new product design? (3 marks)

SOLUTION:
a)
kd = 9%, which is the yield (market rate) x (1-.34) = 5.94% 3 marks
$D = ($1,000 x .10) / .09 = $1,111, so the total is $11,111,000 3 marks

kp = (.12 x $50) / $60 = 10% 3 marks

$P = $60 x 1,000,000 shares = $60,000,000 1 mark

ke = 5% + 1.6(7%) = 16.2% 3 marks

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$E = $80 x 500,000 shares = $40,000,000 1 mark

WACC = [5.94% x (11.111/111.111] + [10% x (60/111.111)] + [16.2% x (40/111.111)]

= 11.82% 3 marks
b) The WACC = MARR, which tells the engineer the minimum rate of return the new
products must produce in order to be acceptable. 3 marks
Question 3 (9 Marks)
Sunspot Company manufactures and sells sunglasses. Price and cost data are as follows:

Selling price per pair of sunglasses $25.00

Variable costs per pair of sunglasses:
Raw materials $11.00
Direct labor 5.00
Manufacturing overhead 2.50
Selling expenses 1.30
$19.80
Annual fixed costs:
Manufacturing overhead $192,000
Selling and administrative 276,000
$468,000
Forecasted annual sales volume (120,000 pairs) $3,000,000
Income tax rate 40%

Required:

a) Sunspot Company estimates that its direct labor costs will increase 8 percent next
year. How many units will Sunspot have to sell next year to reach breakeven? (4
marks)
b) If Sunspot Company's direct labor costs do increase 8 percent, what selling price
per unit of product must it charge to maintain the same contribution margin ratio?
(5 marks)

SOLUTION:
a) New CM per unit = (25-19.80-(5x0.08)) = 4.80 2 marks
BEP = 468,000 / 4.80 = 97,500 units 2 marks

b) Current CM ratio = (25-19.80) / 25 = 20.8% 2 mark

New VC per unit = 19.80+(5 x .08) = 20.20 1 mark

c) Price required is X where:

$(X – 20.20) / X = .208
X = $25.51 2 marks

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Question 4 (6 Marks)
In class, we said that “using operating leverage creates both risk and opportunities for a
company”. Define operating leverage and briefly discuss why this statement is true.
Discuss how operating leverage and financial leverage are similar.

SOLUTION:
Operating leverage refers to the relative degree of fixed costs in the cost structure
2 marks
The following points must be made for 1 mark each:
 The risk comes from the fact that fixed costs must be paid regardless of volume
achieved.
 The opportunity comes from the fact that if there are high fixed costs, the variable
ones are usually low, so there is a higher CM per unit
 Financial leverage refers to the degree of debt in the capital structure, which creates
risk because the interest must be paid regardless of success.
 The opportunity comes from being able to borrow funds at x% and use them to earn
> x%, in which case the shareholders benefit.

Question 5 (20 Marks)

Altaco, Ltd. manufactures one product in its Edmonton factory. The general manager, Ellen
Simpson, has just received a special request from a customer for 10,000 units of this
product to be produced and delivered this month. The customer has suggested a selling
price of $3.00 per unit. Simpson is unsure whether she should accept this offer. The
company normally produces and sells 50,000 units per month and capacity is at 70,000
units per month. The normal selling price is $4.00 per unit.

Simpson approached Frank Giterman, the plant accountant, with the issue. Giterman was
unable to provide a proper analysis at that time because he had a meeting to attend.
However, in quickly reviewing his files, he provided the following schedule of cost
information:

Level of Activity
(units of production per month) Average Unit Cost
40,000 $3.6750
50,000 3.50
60,000 3.3833

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 70,000 3.41

As he rushed off for his meeting, Giterman indicated that if production exceeds 62,000
units per month, an additional supervisor must be hired and costs will increase by $7,700
per month. This is included in the numbers in the above table.

Required
Note: All requirements are independent situations. Expected activity levels do not include
the 10,000 units from the special request.

a) Assume that the company already expects to be working at a level of 50,000 units
for the month. Calculate the minimum price the company could charge for this
special order without reducing its expected net income. (6 marks)
b) If the company expects to produce and sell 55,000 units this month, calculate the
minimum price the company could charge the customer for this special-order job
without reducing its expected net income. (7 marks)
c) Assume that the company expects to produce and sell 65,000 units this month.
Should the manager accept the customer's order? Support your decision with
appropriate calculations. (7 marks)

SOLUTION:

Analysis of Costs:Change in costs between 40,000 and 50,000 units = $175,000 – 147,000 = $28,000
Variable cost per unit = $28,000 / 10,000 = $2.80 2 marks
Fixed costs = $175,000 – (50,000 x 2.80) = $35,000 1 mark
Check: 60,000 units: (60,000 x 2.80) + 35,000 = $203,000 / 60,000 = 3.3833 average
70,000 units: (70,000 x 2.80) + 35,000 + 7,700 = 238,700 / 70,000 = $3.41

a. Minimum price = $2.80 3 marks

b. $2.80 + 7,700 / 10,000 = $2.80 + .77 = $3.57 7 marks

c. Contribution margin lost = 5,000 units x (4.00 – 2.80) = $6,000 3 marks

Minimum price = $2.80 + 6,000 / 10,000 = $2.80 + 0.60 = $3.40 3 marks
Therefore, reject the order 1 mark

Question 6 (6 Marks)
Discuss the purposes that Generally Accepted Accounting Principles (GAAP) are intended
to serve.

SOLUTION:
Key points required, 2 marks each:
 GAAP provides a framework and a set of rules that are to be followed in preparing
financial statements
 They need to be followed only if the statements are for use by people external to
the management of the company

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  GAAP are intended to ensure that financial information can be relied upon and used
by others; i.e. that the information is a true representation of what really happened,
not just something made up by management so things look good.
Any other reasonable comment is worth 1 mark

SELECTED FORMULAE

kd = Cost of debt = i(1-t) where:

i = market interest rate
t = tax rate

kp = Cost of pref shares = D / P where:

D = dividend per share
P = price per share

ke = Cost of common equity = Rf + Beta(Rm - Rf) where:

Rf = risk free rate of interest
Rm = market rate of return on common shares

WACC = kd($D/$T) + kp($P/$T) + ke($E/$T) where:

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)

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