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CA IPCC : Question Paper (with Answers) - COST ACCOUNTING & FINANCIAL MANAGEMENT Nov 2009

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PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT All questions are compulsory Working notes should form part of the answer Question 1 Answer any five of the following: (i) Define the following: (a) Imputed cost (b) Capitalised cost (ii) Calculate efficiency and activity ratio from the following data: Capacity ratio = 75% Budgeted output = 6,000 units Actual output = 5,000 units Standard Time per unit = 4 hours (iii) List the Financial expenses which are not included in cost. (iv) Mention the main advantage of cost plus contracts. (v) A Company sells two products, J and K. The sales mix is 4 units of J and 3 units of K. The contribution margins per unit are Rs.40 for J and Rs.20 for K. Fixed costs are Rs.6,16,000 per month. Compute the break-even point. (vi) When is the reconciliation statement of Cost and Financial accounts not required? (5 2=10 Marks) Answer (i) (a) Imputed Cost: These costs are notional costs which do not involve any cash outlay. Interest on capital, the payment for which is not actually made, is an example of Imputed Cost. These costs are similar to opportunity costs. (b) Captialised Cost: These are costs which are initially recorded as assets and subsequently treated as expenses. (ii) Capacity Ratio 75% = Actual Hours 100 Budgeted Hours = AH 6000 Units 4 hour per unit INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 AH 24000 Hours .75 = AH = 18000 Hours Actual Output in term of S tan dard Hours 100 Actual Working Hours 5000 units 4 hours per unit 100 18000 Hours = 20000 Hours 100 = 111.11% 18000 Hours = Actual Output in term of S tan dard Hours 100 Budgeted Output in term of S tan dard Hours = 20000 Units 100 6000 Units 4 hour per unit = Activity Ratio = = Efficiency Ratio 20000 Units 100 = 83.33% 24000 Units (iii) Financial expenses which are not included in cost accounting are as follows: Interest on debentures and deposit Gratuity Pension Bonus of Employee, Income Tax, Preliminary Expenses Discount on issue of Share Underwriting Commissions. (iv) Main advantages of cost plus contracts are: Contractor is protected from risk of fluctuation in market price of material, labour and services. Contractee can insure a fair price of the market. It is useful specially when the work to be done is not definitely fixed at the time of making the estimate. Contractee can ensure himself about the cost of the contract , as he is empowered to examine the books and documents of the contractor to ascertain the veracity of the cost of the cotract. 40 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT (v) Let 4x = No. of units of J Then 3x = No. of units of K BEP in x units Rs.616000 Fixed Cost = = Contribution 4( 40) 3(20) Or 616000 =2800 units 220 Break even point of Product J = 4 2800 = 11200 units Break even point of Product K = 3 2800 = 8400 units (vi) Circumstances where reconciliation statement can be avoided When the Cost and Financial Accounts are integrated - there is no need to have a separate reconciliation statement between the two sets of accounts. Integration means that the same set of accounts fulfill the requirement of both i.e., Cost and Financial Accounts. Question 2 Mega Company has just completed its first year of operations. The unit costs on a normal costing basis are as under: Rs. Direct material 4 kg @ Rs.4 = 16.00 Direct labour 3 hrs @ Rs.18 = 54.00 Variable overhead 3 hrs @ Rs.4 = 12.00 Fixed overhead 3 hrs @ Rs.6 18.00 = 100.00 Selling and administrative costs: Variable Rs.20 per unit Fixed Rs.7,60,000 During the year the company has the following activity: Units produced = 24,000 Units sold = 21,500 Unit selling price = Rs.168 Direct labour hours worked = 72,000 41 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 Actual fixed overhead was Rs.48,000 less than the budgeted fixed overhead. Budgeted variable overhead was Rs.20,000 less than the actual variable overhead. The company used an expected actual activity level of 72,000 direct labour hours to compute the predetermine overhead rates. Required : (i) Compute the unit cost and total income under: (a) Absorption costing (b) Marginal costing (ii) Under or over absorption of overhead. (iii) Reconcile the difference between the total income under absorption and marginal costing. (15 Marks) Answer (i) Computation of Unit Cost & Total Income Unit Cost Absorption Costing (Rs.) Marginal Costing (Rs.) Direct Material 16.00 16.00 Direct Labour 54.00 54.00 Variable Overhead 12.00 12.00 Fixed Overhead 18.00 - Unit Cost 100.00 82.00 Income Statements Absorption Costing Sales 36,12,000 (21500 Rs.168) Less: Cost of goods sold (21500 100) 21,50,000 Less: Over Absorption 28,000 21,22,000 14,90,000 Less: Selling & Distribution Expenses 11,90,000 Profit 3,00,000 42 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT Marginal Costing Sales 36,12,000 Less: Cost of goods sold (21500 82) Add: Under Absorption 17,63,000 20,000 Less: Selling & Distribution Expenses Contribution Less: Fixed Factory and Selling & Distribution Overhead (38,400 + 7,60,000) Profit 17,83,000 18,29,000 4,30,000 13,99,000 11,44,000 2,55,000 (ii) Under or over absorption of overhead: Budgeted Fixed Overhead Rs. 72,000 Hrs. Rs.6 4,32,000 Less: Actual Overhead was less than Budgeted Fixed Overhead Actual Fixed Overhead 48,000 3,84,000 Budgeted Variable Overhead 72,000 Hrs. Rs.4 2,88,000 Add: Actual Overhead was higher than Budgeted Budgeted 20,000 3,08,000 Both Fixed & Variable Overhead applied 72,000 Hrs Rs,10 7,20,000 Actual Overhead (3,84,000 + 3,08,000) 6,92,000 Over Absorption 28,000 (iii) Reconciliation of Profit Difference in Profit: Rs.3,00,000 2,55,000 = Rs.45,000 Due to Fixed Factory Overhead being included in Closing Stock in Absorption Costing not in Marginal Costing. Therefore, Difference in Profit = Fixed Overhead Rate (Production Sale) 18 (24,000 21,500) = Rs.45,000 Question 3 (a) XP Ltd. furnishes you the following information relating to process II. 43 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 (i) Opening work-in-progress NIL (ii) Units introduced 42,000 units @ Rs.12 (iii) Expenses debited to the process: Rs. Direct material = 61,530 Labour = 88,820 Overhead = 1,76,400 (iv) Normal loss in the process = 2 % of input. (v) Closing work-in-progress 1200 units Degree of completion - Materials 100% Labour 50% Overhead 40% (vi) Finished output 39,500 units (vii) Degree of completion of abnormal loss: Material 100% Labour 80% Overhead 60% (viii) Units scraped as normal loss were sold at Rs.4.50 per unit. (ix) All the units of abnormal loss were sold at Rs.9 per unit. Prepare: (i) Statement of equivalent production: (ii) Statement showing the cost of finished goods, abnormal loss and closing workin-progress. (iii) Process II account and abnormal loss account. (8 Marks) (b) The following information is available from the cost records of Vatika & Co. For the month of August, 2009: Material purchased 24,000 kg Rs.1,05,600 Material consumed 22,800 kg Actual wages paid for 5,940 hours Rs.29,700 Unit produced 2160 units. Standard rates and prices are: Direct material rate is Rs.4.00 per unit. 44 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT Direct labour rate is Rs.4.00 per hour Standard input is 10 kg. for one unit Standard requirement is 2.5 hours per unit. Calculate all material and labour variances for the month of August, 2009. (8 Marks) Answer (a) Statement of Equivalent Production Particulars Output Material Labour Overhead Units % Units % Units % Finished Output Normal Loss 2% of 42,000 units 39,500 39,500 100% 39,500 100% 39.500 100% 840 - - - - - - Abnormal Loss (42,000 39,500 840 1200) 460 460 100% 368 80% 276 60% 1,200 1,200 100% 600 50% 480 40% 42,000 41,160 Closing W.I.P. 40,468 Statement of Cost 40256 Rs. Units Introduced 42,000@12 5,04,000 Add: Material 61,530 5,65,530 Less: Value of Normal Loss 3,780 5,61,750 Cost per Unit Material 5,61,750 41,160 88,820 40,468 Overhead Rs.2.195 1,76,400 40,256 Labour Rs.13.648 Rs.4.382 20.225 Abnormal Loss: Material 460 13.648 6,278.08 Labour 368 2.195 807.76 45 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 Overheads 276 4.382 1,209.42 8,295.26 Closing W.I.P. Material 1,200 13.648 16,377.60 Labour 600 2.195 1,317.00 Overheads 480 4.382 2,103.36 19,797.96 Finished Goods 39,500 20.225 Rs.7,98,887.50 Process II Account Particulars Units Particulars Amount Rs. To Opening WIP - Nil By Input Direct Material - 61,530 Labour - Overhead - 1,76,400 Amount Rs. 88,820 Units Normal Loss 3,780 Abnormal Loss 460 8,295 Finished Goods 42,000 5,04,000 840 39,500 7,98,877 1,200 19,798 42,000 8,30,750 Units Amount Rs. Closing WIP 42,000 8,30,750 Abnormal Loss Account Particulars To Units Process II Particulars Amount Rs. 460 8,295 By Cash 460 4,140 - 4,155 460 8,295 (Sold@Rs.9) . 460 . Costing P & L 8,295 (b) Material Variances: (i) Material Cost Variance = (SQ SP) (AQ AP) = (2,160 4 10) (22,800 4.40) = Rs.86,400 Rs.1,00,320 = 13,920 (A) 46 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT (ii) Material Price Variance = AQ (SP AP) = 22,800 Kg (4 4.40) = 9,120 (A) (iii) Material Usage Variance = SP (SQ AQ) = 4 (21,600 22,800) = 4,800 (A) Note : unit basis for direct material has been taken as kg. hence, direct material rate is Rs. 4 per kg. Verification:MCV = MPV + MUV 13,920 (A) = 9,120 (A) + 4,800 (A) Labour Variances: (i) Labour Cost Variance = (SH SR) (AH AR) = (2,160 2.50 4) (29,700) = 21,600 29,700 = 8,100 (A) (ii) Labour Rate Variance = AH (SR AR) = 5,940 (4 5) = 5,940 (A) (iii) Labour Efficiency Variance = SR (SH AH) = 4 (5,400 5,940) = 2,160 (A) Verification:LCV = LRV + LEV 8,100 (A) = 5,940 (A) + 2,160 (A) SH = 2,160 Units 2.50 Hours = 5,400 Hrs. Question 4 Answer any three of the following: (i) Standard Time for a job is 90 hours. The hourly rate of Guaranteed wages is Rs.50. Because of the saving in time a worker a gets an effective hourly rate of wages of Rs.60 under Rowan premium bonus system. For the same saving in time, calculate the hourly rate of wages a worker B will get under Halsey premium bonus system assuring 40% to worker. 47 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 (ii) Explain briefly, what do you understand by Operating Costing. How are composite units computed? (iii) The following information relating to a type of Raw material is available: Annual demand 2000 units Unit price Rs.20.00 Ordering cost per order Rs.20.00 Storage cost 2% p.a. Interest rate 8% p.a. Lead time Half-month Calculate economic order quantity and total annual inventory cost of the raw material. (iv) List the eight functional budgets prepared by a business. (3 3=9 Marks) Answer (i) Increase in Hourly Rate of Wages (Rowan Plan) is (Rs.60 Rs.50) = Rs.10 This is Equal to Time Saved Hourly rate S tan dard Time Or 10 = Or Time Saved 50 S tan dard Time Time Saved 50 90 Time Saved = = 10 900 50 = 18 Hours Time Taken = (90 18) = 72 Hours Effective Hourly Rate under Halsey System Time Saved = 18 Hours Bonus @ 40% = 18 40% 50 = Rs.360 Total Wages = (50 72 + 360) = 3,960 Effective Hourly Rate = 3,960 72 Hours = Rs.55 (ii) Operating Costing: It is method of ascertaining costs of providing or operating a service. This method of costing is applied by those undertakings which provide services rather 48 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT than production of commodities. This method of costing is used by transport companies, gas and water works departments, electricity supply companies, canteens, hospitals, theatres, schools etc. Composite units may be computed in two ways: (a) Absolute (weighted average) tones kms, quintal kms etc. (b) Commercial (simple average) tones kms, quintal kms etc. Absolute tonnes-kms are the sum total of tonnes kms arrived at by multiplying various distances by respective load quantities carried. Commercial tonnes-kms, are arrived at by multiplying total distance kms, by average load quantity. (iii) EOQ = = 2 Annual Consumption Buying Cost per Order Storage Cost per unit 2 2,000 20 = 2 8 Rs.20 100 80,000 = 200 Units 2 Total Annual Inventory Cost Cost of 2,000 Units @ Rs.20 (2,000 20) = Rs.40,000 2000 No. of Order = Rs.10 200 Ordering Cost 10 20 = Rs.200 200 10 Carrying cost of Average Inventory 20 = Rs.200 2 100 = Rs.40,400 (iv) The various commonly used Functional budgets are: Sales Budget Production Budget Plant Utilisation Budget Direct Material Usage Budget Direct Material Purchase Budget Direct Labour (Personnel) Budget Factory Overhead Budget Production Cost Budget Note: In addition to above, there are many more functional budgets which the student can write alternatively. 49 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 Question 5 Answer any five of the following: (i) Explain briefly the limitations of Financial ratios. (ii) What do you understand by Business Risk and Financial Risk? (iii) Differentiate between Factoring and Bills discounting. (iv) Differentiate between Financial Management and Financial Accounting. (v) Y Ltd. retains Rs. 7,50,000 out of its current earnings. The expected rate of return to the shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax bracket. Calculate the cost of retained earnings. (vi) From the information given below calculate the amount of Fixed assets and Proprietor s fund. Ratio of fixed assets to proprietors fund = 0.75 Net Working Capital = Rs. 6,00,000 (5 2 =10 Marks) Answer (i) Limitations of Financial Ratios The limitations of financial ratios are listed below: (a) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons. (b) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios. (c) Seasonal factors may also influence financial data. (d) To give a good shape to the popularly used financial ratios (like current ratio, debtequity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change. (e) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios. (f) There is no standard set of ratios against which a firm s ratios can be compared: Sometimes a firm s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. 50 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT On the other hand, for a below average firm, industry averages become too high a standard to achieve. (g) It is very difficult to generalise whether a particular ratio is good or bad: For example, a low current ratio may be said bad from the point of view of low liquidity, but a high current ratio may not be good as this may result from inefficient working capital management. (h) Financial ratios are inter-related, not independent: Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis. (Note : Students to write any four limitations) (ii) Business Risk and Financial Risk Business Risk: It is an unavoidable risk because of the environment in which the firm has to operate and the business risk is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm s products, variations in prices and proportion of fixed cost in total cost. Financial Risk: It is the risk borne by a shareholder when a firm uses debt in addition to equity financing in its capital structure. Generally, a firm should neither be exposed to high degree of business risk and low degree of financial risk or vice-versa, so that shareholders do not bear a higher risk. (iii) Differentiation between Factoring and Bills Discounting The differences between Factoring and Bills discounting are: (a) Factoring is called as Invoice Factoring whereas Bills discounting is known as Invoice discounting. (b) In Factoring, the parties are known as the client, factor and debtor whereas in Bills discounting, they are known as drawer, drawee and payee. (c) Factoring is a sort of management of book debts whereas bills discounting is a sort of borrowing from commercial banks. (d) For factoring there is no specific Act, whereas in the case of bills discounting, the Negotiable Instruments Act is applicable. (iv) Differentiation between Financial Management and Financial Accounting Though financial management and financial accounting are closely related, still they differ in the treatment of funds and also with regards to decision - making. Treatment of Funds: In accounting, the measurement of funds is based on the accrual principle. The accrual based accounting data do not reflect fully the financial conditions of the 51 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 organisation. An organisation which has earned profit (sales less expenses) may said to be profitable in the accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result of say, uncollectible receivables. Whereas, the treatment of funds, in financial management is based on cash flows. The revenues are recognised only when cash is actually received (i.e. cash inflow) and expenses are recognised on actual payment (i.e. cash outflow). Thus, cash flow based returns help financial managers to avoid insolvency and achieve desired financial goals. Decision-making: The chief focus of an accountant is to collect data and present the data while the financial manager s primary responsibility relates to financial planning, controlling and decision-making. Thus, in a way it can be stated that financial management begins where financial accounting ends. (v) Computation of Cost of Retained Earnings (Kr) Kr = k (1-TP) (1-B) Kr = 0.10 (1- 0.30) (1- 0.03) = 0.10 (0.70) (0.97) = 0.0679 or 6.79% Cost of Retained Earnings = 6.79% (vi) Calculation of Fixed Assets and Proprietor s Fund Since Ratio of Fixed Assets to Proprietor s Fund = 0.75 Therefore, Fixed Assets = 0.75 Proprietor s Fund Net Working Capital = 0.25 Proprietor s Fund 6,00,000 = 0.25 Proprietor s Fund Therefore, Proprietor s Fund = Rs. 6,00,000 0.25 = Rs. 24,00,000 Proprietor s Fund = Rs. 24,00,000 Since, Fixed Assets = 0.75 Proprietor s Fund Therefore, Fixed Assets = 0.75 24,00,000 = Rs.18,00,000 Fixed Assets = Rs. 18,00,000 52 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT Question 6 The Balance Sheets of a Company as on 31st March, 2008 and 2009 are given below: Liabilities 31.3.08 31.3.09 Rs. Equity share capital Capital reserve 14,40,000 - Assets Rs. 19,20,000 Fixed assets 48,000 Less: depreciation General reserve 8,16,000 9,60,000 Profit & Loss A/c 2,88,000 3,60,000 Investment 9% debentures 9,60,000 6,72,000 Sundry debtors Sundry creditors 5,50,000 5,90,000 Stock Bills payables 26,000 34,000 Cash in hand Proposed dividend 1,44,000 1,72,800 Preliminary Expenses Provision for tax 4,32,000 - 51,84,000 Rs. 38,40,000 45,60,000 11,04,000 13,92,000 27,36,000 31,68,000 4,80,000 3,84,000 12,00,000 14,00,000 1,40,000 1,84,000 4,000 - 96,000 48,000 19,200 46,56,000 Rs. 31.3.09 4,08,000 Unpaid dividend 31.3.08 46,56,000 51,84,000 Additional information: During the year ended 31st March, 2009 the company: (i) Sold a machine for Rs.1,20,000; the cost of machine was Rs. 2,40,000 and depreciation provided on it was Rs. 84,000. (ii) Provided Rs. 4,20,000 as depreciation on fixed assets. (iii) Sold some investment and profit credited to capital reserve. (iv) Redeemed 30% of the debentures @ 105. (v) Decided to write off fixed assets costing Rs. 60,000 on which depreciation amounting to Rs. 48,000 has been provided. You are required to prepare Cash Flow Statement as per AS 3. 53 (15 Marks) INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 Answer Cash Flow Statement for the year ending 31 st March, 2009 (A) Cash Flows from Operating Activities Rs. Profit and Loss A/c (3,60,000 2,88,000) 72,000 Adjustments: Increase in General Reserve 1,44,000 Depreciation 4,20,000 Provision for Tax 4,08,000 Loss on Sale of Machine Premium on Redemption Debentures of Proposed Dividend 36,000 14,400 1,72,800 Preliminary Expenses written off 48,000 Fixed Assets written off Interest on Debentures* 12,000 60,480 13,15,680 Funds from Operations 13,87,680 Increase in Sundry Creditors 40,000 Increase in Bills Payable 8,000 48,000 Increase in Sundry Debtors (2,00,000) Increase in Stock (44,000) (1,96,000) Cash before Tax 11,91,680 Less: Tax paid 4,32,000 Cash flows from Operating Activities 7,59,680 (B) Cash Flows from Investing Activities Purchase of Fixed Assets (10,20,000) Sale of Investment 1,44,000 Sale of Fixed Assets 1,20,000 54 (7,56,000) PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT (C) Cash Flows from Financing Activities Issue of Share Capital 4,80,000 Redemption of Debentures (3,02,400) Dividend Paid (1,44,000 19,200) (1,24,800) Interest on Debentures (60,480) (7,680) (4,000) Net increase in Cash and Cash Equivalents 4,000 Cash and Cash Equivalents at the beginning of the year NIL Cash and Cash Equivalents at the end of the year * It is assumed that the 30 percent debentures have been redeemed at the beginning of the year. Fixed Assets Account Particulars Rs. Particulars Rs. To Balance b/d 27,36,000 By Cash To Purchases (Balance) 10,20,000 By Loss on Sales By Depreciation By Assets written off By Balance c/d ________ 1,20,000 36,000 4,20,000 12,000 31,68,000 37,56,000 37,56,000 Question 7 (a) From the following financial data of Company A and Company B: Prepare their Income Statements. Company A Company B Rs. Rs. Variable Cost 56,000 60% of sales Fixed Cost 20,000 - Interest Expenses 12,000 9,000 5:1 - - 4:1 30% 30% - 1,05,000 Financial Leverage Operating Leverage Income Tax Rate Sales 55 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 (b) A hospital is considering to purchase a diagnostic machine costing Rs. 80,000. The projected life of the machine is 8 years and has an expected salvage value of Rs. 6,000 at the end of 8 years. The annual operating cost of the machine is Rs. 7,500. It is expected to generate revenues of Rs. 40,000 per year for eight years. Presently, the hospital is outsourcing the diagnostic work and is earning commission income of Rs.12,000 per annum; net of taxes. Required: Whether it would be profitable for the hospital to purchase the machine? Give your recommendation under: (i) Net Present Value method (ii) Profitability Index method. PV factors at 10% are given below: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 (8 + 8 = 16 Marks) Answer (a) Income Statements of Company A and Company B Company A Company B Rs. Rs. Sales 91,000 1,05,000 Less: Variable cost 56,000 63,000 Contribution 35,000 42,000 Less: Fixed Cost 20,000 31,500 Earnings before interest and tax (EBIT) 15,000 10,500 Less: Interest 12,000 9,000 3,000 1,500 900 450 2,100 1,050 Earnings before tax (EBT) Less: Tax @ 30% Earnings after tax (EAT) Working Notes: Company A (i) Financial Leverage = EBIT EBIT Interest 56 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 5= (ii) EBIT EBIT 12,000 5 (EBIT 12,000) = EBIT 4 EBIT = 60,000 EBIT = Rs.15,000 Contribution = EBIT + Fixed Cost = 15,000 + 20,000 = Rs. 35,000 (iii) Sales = Contribution + Variable cost = 35,000 + 56,000 = Rs. 91,000 Company B (i) Contribution = 40% of Sales (as Variable Cost is 60% of Sales) = 40% of 1,05,000 = Rs. 42,000 (ii) Financial Leverage = 4= Contribution EBIT 42,000 EBIT EBIT = 42,000 = Rs.10,500 4 (iii) Fixed Cost = Contribution EBIT = 42,000 10,500 = Rs. 31,500 (b) Advise to the Hospital Management Determination of Cash inflows Sales Revenue 40,000 Less: Operating Cost 7,500 32,500 Less: Depreciation (80,000 6,000)/8 9,250 Net Income 23,250 Tax @ 30% 6,975 Earnings after Tax (EAT) 16,275 Add: Depreciation 9,250 57 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 Cash inflow after tax per annum 25,525 Less: Loss of Commission Income 12,000 Net Cash inflow after tax per annum 13,525 In 8th Year : New Cash inflow after tax 13,525 Add: Salvage Value of Machine 6,000 Net Cash inflow in year 8 19,525 Calculation of Net Present Value (NPV) Year CFAT PV Factor @10% 1 to 7 13,525 4.867 65,826.18 8 19,525 0.467 9,118.18 Present Value of Cash inflows 74,944.36 Less: Cash Outflows 80,000.00 NPV Sum of discounted cash inflows Profitability Index Present value of cash outflows = (5,055.64) 74,944.36 0.937 80,000 Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the hospital should not purchase the diagnostic machine. Note: Since the tax rate is not mentioned in the question, therefore, it is assumed to be 30 percent in the given solution. Question 8 Answer any three of the following: (i) Explain the two basic functions of Financial Management. (ii) Explain the following terms: (a) Ploughing back of profits (b) Desirability factor. (iii) What do you understand by Weighted Average Cost of Capital? (iv) There are two firms P and Q which are identical except P does not use any debt in its capital structure while Q has Rs. 8,00,000, 9% debentures in its capital structure. Both the firms have earning before interest and tax of Rs. 2,60,000 p.a. and the capitalization rate is 10%. 58 PAPER 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT Assuming the corporate tax of 30%, calculate the value of these firms according to MM Hypothesis. (3 3 = 9 Marks) Answer (i) Two Basic Functions of Financial Management Procurement of Funds: Funds can be obtained from different sources having different characteristics in terms of risk, cost and control. The funds raised from the issue of equity shares are the best from the risk point of view since repayment is required only at the time of liquidation. However, it is also the most costly source of finance due to dividend expectations of shareholders. On the other hand, debentures are cheaper than equity shares due to their tax advantage. However, they are usually riskier than equity shares. There are thus risk, cost and control considerations which a finance manager must consider while procuring funds. The cost of funds should be at the minimum level for that a proper balancing of risk and control factors must be carried out. Effective Utilization of Funds: The Finance Manager has to ensure that funds are not kept idle or there is no improper use of funds. The funds are to be invested in a manner such that they generate returns higher than the cost of capital to the firm. Besides this, decisions to invest in fixed assets are to be taken only after sound analysis using capital budgeting techniques. Similarly, adequate working capital should be maintained so as to avoid the risk of insolvency. (ii) (a) Ploughing Back of Profits: Long term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company. A public limited company must plough back a reasonable amount of its profits each year keeping in view the legal requirements in this regard and its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits. (b) Desirability Factor: In certain cases we have to compare a number of proposals each involving different amount of cash inflows. One of the methods of comparing such proposals is to work out, what is known as the Desirability Factor or Profitability Index . In general terms, a project is acceptable if the Profitability Index is greater than 1. Mathematically, Desirability Factor Sum of Discounted Cash inflows Initial Cash Outlay or Total Discounted Cash outflows (iii) Weighted Average Cost of Capital The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken in proportion of each source of funds in capital structure while making financial decisions. The weighted average cost of capital is 59 INTEGRATED PROFESSIONAL COMPETENCE EXAMINATION: NOVEMBER, 2009 calculated by calculating the cost of specific source of fund and multiplying the cost of each source by its proportion in capital structure. Thus, weighted average cost of capital is the weighted average after tax costs of the individual components of firm s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital. (iv) Calculation of Value of Firms P and Q according to MM Hypothesis Market Value of Firm P (Unlevered) Vu EBIT (1 - t ) Ke 2,60,000 (1- 0.30 ) 10 % Rs. 1,82,000 Rs. 18,20,000 10 % Market Value of Firm Q (Levered) VE = Vu + DT = Rs.18,20,000 + (8,00,000 0.30) = Rs.18,20,000 + 2,40,000 = Rs. 20,60,000 60

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