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# Institute of Chartered Financial Analysts of India (ICFAI) University 2007 C.A Chartered Accountant Cost-Fm Solved - Question Paper

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Solved Cost-Fm May 2007

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT

 All questions are compulsory.

 Working notes should form part of the answer wherever appropriate,

 suitable assumpti ons should be made.

 Question 1

 Answer any five of the following: (i ) Usi ng Tayl ors differential piece rate system, find the earning of A from the following

 particulars: Standard time per piece

 12 minutes

 Normal rate per hour (in a 8 hours day) Rs. 20 A produced

 37 Uni ts

 (i i) Briefly discuss, how the synergetic effect help in reducti on in costs. (i ii) Explain in brief the expli cit cost with examples. (i v) Explain briefly the conditions when supplementary rates are used. (v) The average annual consumption of a material is 18,250 units at a price of Rs. 36.50 per

 unit. The stor age cost is 20% on an average inventory and the cost of pl acing an or der is Rs. 50. How much quantity is to be purchased at a time?

 (vi) Enumerate the various methods of Time booking. (5 2 = 10 Marks)

 Answer

 60

 8

 (i) Standard output per day units

 40

 12

 Actual output = 37 units

 Effici ency percentage 92.5%

 100

 40 37

 Under this method lower rate i s 83% of the normal piece rate and is applicable i f effici ency of wor ker is below 100%.

 Earning rate per unit = 83% of unit

 per

 3.32

 or

 5 20

 *

 Earning = 37 3.32 = Rs. 122.84

 minutes

 60

 * In one hour, pr oducti on wi ll be =

 units

 5

 minutes

 12

 i.e.

 peice,

 per

 time

 standard

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 4

 (ii) Two or more products are produced and managed together.

 The result of combined efforts are higher than sum of the r esults of individual pro ducts. Analysis of synergetic effect is helpful in cost control.

 (iii) Out of pocket cost, involving immediate payment of Cash. Salaries, Wages, Postage and

 Telegram, Pri nting and Stationery, Interest on Loan are some examples of Explicit Costs.

 (iv) When the amount of under absorbed and over absorbed overhead is si gni ficant or l arge,

 because of differences due to wrong esti mati on, then the cost of product needs to be adjusted by using supplementary rates (under and over absorption/actual overhead) to avoid misleading i mpression.

 (v) Quantity to be purchased

 50

 18,250

 2

 units

 500

 2,50,000

 36.5

 of

 20%

 (vi) The various methods of time booking are:

 (a) Job ticket. (b) Combined time and job ti cket. (c) Dail y time sheet. (d) Piece work card. (e) Clock card.

 Question 2

 A company has three production departments (M1 , M2 and A1 ) and three service department, one of whi ch Engineering service department, servicing the M1 and M2 only. The rel evant informations are as follows:

 Product X Product Y

 M1 10 Machine hours 6 Machine hours M2 4 Machine hours 14 Machine hours

 A1 14 Direct Labour hours 18 Direct Labour hours

 The annual budgeted overhead cost for the year are

 Indirect Wages Consumabl e Supplies

 (Rs.)

 ( Rs.)

 46,520

 12,600

 M1

 41,340

 18,200

 M2

 16,220

 4,200

 A1

 Stores

 8,200

 2,800

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 5

 Engineering Servi ce 5,340

 4,200

 General Service 7,520

 3,200

 Rs.

 Depreci ation on Machinery 39,600

 Insurance of

 7,200

 Machinery

 Insurance of Building 3,240 (Total building insurance cost for

 M1 i s one third of annual premium

 Power

 6,480

 Light

 5,400

 12,675 (The general servi ce deptt. is

 Rent

 l ocated in a building owned by the company. It is val ued at Rs. 6,000 and is charged into cost at notional value of 8% per annum. This cost i s additional to the re nt shown above)

 The value of issues of materials to the production departments are i n the

 same propor tion as shown above for the Consumable suppli es.

 The followi ng data are also avail abl e: Department Book value

 Area

 Effective

 Production

 Capacity

 Machinery

 (Sq. ft.)

 H.P. hours %

 Direct

 Machi ne

 (Rs.)

 Labour

 hour

 hour

 M1 1,20,000 5,000 50 2,00,000 40,000 M2 90,000 6,000 35 1,50,000 50,000 A1 30,000 8,000 05 3,00,000 Stores 12,000 2,000 Engg. Service 36,000 2,500 10 General Service 12,000 1,500 Required: (i ) Prepare a overhead analysis sheet, showing the bases of apportionment of overhead to

 departments.

 (i i) Allocate service department overheads to production department ignoring the

 apportionment of service department costs among servi ce departments.

 (i ii) Calculate suitable overhead absorpti on rate for the production departments.

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 6

 (i v) Calculate the overheads to be absorbed by two products, X and Y.

 (6 + 4 + 3 + 2 = 15 Marks)

 Answer (i)

 Summary of Apportionment of Overheads

 (Rs.)

 Produc tion Deptt. Service Deptt.

 Basis of Apportionment

 Total Amount M 1 M2 A1 Store

 Items

 Engineering

 General Service

 Service

 Service

 In direct wages

 Allocation given 1,25, 140 46,520 41,340 1 6,220 8,200 5,340 7, 520

 Consu mable stores

 Allocation given 45,20 0 12,600 18,200 4,200 2,800 4,200 3, 200

 Depreciation Capital value of

 39,60 0 15,840 11,880 3,960 1,584 4,752 1, 584

 machine

 In surance of Machine

 Capital value of machine

 7,20 0 2,880 2,160 720 288 864 288

 In surance on Building 3

 3,24 0 1,080 648 864 216 270 162

 1 to MI

 Balance area basis

 Power HP Hr% 6,48 0 3,240 2,268 324 648 Light Area 5,40 0 1,080 1,296 1,728 432 540 324 Rent Area 12,67 5 2,535 3,042 4,056 1,014 1,268 760 Rent of gen eral service

 Direct 8% of 6,000

 48 0

 480

 _______ ______ ______ ______ ______ ______

 _ _____

 Tota l 2,45, 415 85,775 80,834 3 2,072 14,534 17,882 14, 318

 (ii) Allocation of service department s overheads

 Production Deptt. Service Deptt.

 Basis of

 Apportionment M1 M2 A1 Store

 Service Deptt.

 Engineering

 General

 Service

 Service

 Service

 Store Ratio of

 consumable value (126 :182 : 42)

 5,232 7,558 1,744 (14,534)

 Engineering service

 In Machine hours Ratio of M1 and M2 (4 : 5) 7,948 9,934 (17,882)

 General service

 LHR Basis 20 : 15 : 30 4,406 3,304 6,608

 (14,318)

 Production Department allocated in (i) _______ 85,775 80,834 32,072 Total 2,45,415 1,03,361 1,01,630 40,424

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 7

 (iii)

 Overhead Absorpt ion rate

 M1 M2 A1

 Total overhead all ocated 1,03,361 1,01,630 40,424 Machi ne hours

 40,000 50,000

 Labour hours

 3,00,000

 Rate per MHR

 2.584 2.033

 Rate per Direct labour

 0.135

 (iv) Statement showing overhead absorption for Product X and Y

 Machine

 Absorpti on

 Product X

 Product Y

 Deptt.

 Rate

 Hours Rs.

 Hours Rs.

 M1 2.584 10 25.84 6 15.50 M2 2.033 4 8.13 14 28.46

 A1 .135 14 .54 18 2.43

 34.51

 46.39

 Question 3

 (a) AKP Builders Ltd. Commenced a contract on Apri l 1, 2005. The total contract was for Rs.

 5,00,000. Actual expendi ture for the period April 1, 2005 to March 31, 2006 and estimated expenditure for April 1, 2006 to December 31, 2006 are given below:

 2005-06

 2006-07 (9 months)

 (Actuals)

 (Estimated)

 Rs.

 Rs.

 Mater ial Issued

 90,000 85,750

 Labour : Paid

 75,000 87,325

 Outstanding at the end

 6,250 8,300

 Plant

 25,000

 Sundry Expenses : Paid 7,250 6,875 Prepaid at the end

 625

 Establishment charges

 14,625

 A part of the material was unsuitabl e and was sold for Rs. 18,125 (Cost bei ng Rs. 15,000) and a part of plant was scrapped and disposed of for Rs. 2,875. The val ue of plant at site on 31 March, 2006 was Rs. 7,750 and the value of material at site was Rs. 4,250. Cash received on account to date was Rs. 1,75,000, representing 80% of the work certified. The cost of work uncertified was val ued at Rs. 27,375.

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 8

 The contractor estimated further expendi ture that would be incurred i n completion of the contract:

 The contract would be completed by 31st December, 2006. A further sum of Rs. 31,250 would have to be spent on the plant and the residual val ue of the pant on the completi on of the contract would be Rs. 3,750. Establishment charges would cost the same amount per month as in the previous year. Rs. 10,800 would be sufficient to provi de for conti ngencies.

 Required: Prepare Contract account and calculate estimated total profit on this contract. Profit transferrable to Profit and Loss account is to be calculated by reducing estimated Profit in proportion of work certified and contract price.

 (8 Marks)

 (b) A Company produces two joint products P and Q in 70 : 30 ratio from basic raw materi al s

 in department A. The input output ratio of department A is 100 : 85. Product P can be sold at the split of stage or can be processed further at department B and sol d as pr oduct AR. The i nput output ratio is 100 : 90 of department B. The department B i s created to process product A only and to make it product AR. The selli ng prices per kg. are as under: Product P Rs. 85 Product Q Rs. 290 Product AR Rs. 115 The production will be taken up in the next month. Raw materials 8,00,000 Kgs. Purchase price Rs. 80 per Kg.

 Deptt. A Deptt. B

 Rs. Lacs Rs. Lacs

 Direct materials

 35.00 5.00

 Direct labour

 30.00 9.00

 Variable overheads

 45.00 18.00

 Fixed overheads

 40.00 32.00

 Total

 150.00 64.00

 Selling Expenses:

 Rs. in Lacs

 Product P

 24.6

 Product Q

 21.6

 Product AR

 16.8

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 9

 Required: (i) Prepare a statement showing the apportionment of j oint costs. (ii) State whether it is advisable to produce product AR or not. (8 Marks)

 Answer (a)

 AKP Builders Lt d.

 Contract Account (20052006)

 Particulars

 Rs. Par ticulars Rs.

 To Material issued 90,000 By Materi al (sold) 18,125 To Labour 75,000 By Plant (sold) 2,875

 Add: Outstanding 6,250 81,250 By Plant at si te 7,750

 To Plant

 25,000 By Materi al at site 4,250

 To Sundry Expenditure 7,250

 Less: Pre-paid 625 6,625

 To Establishment charges 14,625 By Bal ance c/d 1,87,625 To Profit and Loss A/c

 (Profit on sale of material)

 3,125

 _______

 2,20,625

 2,20,625

 To Balance b/d

 1,87,625 By Work in progress

 To Balance c/d

 58,500 Certi fied 2,18,750 _______ Uncertified 27,375 2,46,125

 2,46,125

 To Profit and Loss A/c* 29,960.55 By Bal ance 58,500 To Work i n progress 28,539.45

 _______

 58,500

 58,500

 certified

 Work

 * Profit to Profit and Loss A/c =

 Profit

 Estimated

 price

 Contract

 29,960.55

 Rs.

 68,481.25

 5,00,000 2,18,750

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 10

 Memorandum Contract Account (9 months)

 Particulars Rs. Rs. Particulars Rs.

 To Material

 By Contractees A/c 5,00,000

 (90,000 + 3,125 18,125)

 75,000

 Add: New Addition 85,750 1,60,750

 To Plant (25,000 2,875) 22,125

 Add: New (+) 31,250 Less: Closing ( ) 3,750 49,625

 To Es tablishment charges 14,625

 Add: For nine months

 14,625 10,968.75 25,593.75

 9

 12

 To Sundry Expenditure 6,625

 Add: New (+) 6,875 Previous prepaid (+) 625 14,125.00

 To Labour 81,250

 Add: (87,325 6,250) (+) 81,075 Outstanding (+) 8,300 1,70,625

 To Reserve for

 10,800

 contingencies

 To Es timated Profit 68,481.25

 _______

 5,00,000

 5,00,000

 (b) Input in Deptt. A 80,000 kgs.

 Yield 85% Therefore Output = 85% of 8,00,000 = 6,80,000 kgs. Ratio of output for P and Q = 70 : 30. Product of P = 70% of 6,80,000 = 4,76,000 kgs. Product of Q = 30% of 6,80,000 = 2,04,000 kgs.

 Statement showing apportionment of joint cost

 P Q Total

 Product kgs.

 4,76,000 2,04,000

 Selling pr ice per kg. Rs. 85.00 290.00

 Rs. l akhs Rs. lakhs Rs. l akhs

 Sales

 404.60 591.60 996.20

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 11

 Less: Selling expenses

 24.60 21.60 46.20

 Net sales

 380 570 950

 Ratio

 40% 60% 100%

 Rs. lakhs

 Raw materials (8,00,000 kgs. Rs. 80)

 640

 Process cost of department A

 150 790

 Apportionment of Joint Cost

 (In the rati o of Net Sales i.e. P : Q., 40% : 60%. Joint Cost of P = Rs. 316 lakhs Joint Cost of Q = Rs. 474 lakhs

 Statement showing the profitability of further processing of

 product P and converted into product AR

 Product AR

 Output = 90% of 4,76,000 kgs. = 4,28,400 kgs.

 Rs. l akhs

 Joint costs

 316

 Cost of Department B

 64

 Selling expenses

 16.80 396.80

 492.66

 Sales value (Rs. 115 4,28,400)

 Profit (492.66 396.80)

 95.86

 If P is not processed profitability is as under.

 Rs. l akhs

 Sales

 380

 Less: Joint expense

 316

 Profit

 64

 Further pr ocessing of product P and converting into product AR is beneficial to the company because the profi t increaser by Rs. 31.86 lakhs (95.86 64.00).

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 12

 Question 4

 Answer any three of the following: (i ) Discuss the treatment of spoilage and defectives. (i i) What items are general ly incl uded in good uniform costing manual? (i ii) Oper ation costing is defined as r efinement of Process costing. Explain it. (i v) Enumerate the factors which cause difference in profits as shown in Financial Accounts

 and Cost Accounts.

 (3 3 = 9 Marks)

 Answer (i) Treatment of spoilage and defecti ves:

 Spoilage:

 Normal spoilage are incl uded in cost either by charging the loss to the producti on order or charging i t to production overhead. The cost of abnormal spoil age is charged to costing profi t and loss account.

 Defectives:

 Normal defectives can be recovered : charged to good production

 : charged to general overhead : charged to department.

 If defectives are abnormal and are due to causes beyond the control of organization then they should be charged to profi t and loss account.

 (ii) Uniform costi ng manual includes essential informations and instructions to implement

 accounting procedures. (a) Introduction: It includes objects and scope of the planning. (b) Accounti ng procedure and pl anning includes rules, and general princi ple to be

 followed.

 (c) Cost accounting planning i ncludes methods of costing, relation between cost and

 financial accounts and methods of integration.

 (iii) Operation costing is concerned with the determination of the cost of each operation

 rather than the process:

 In the i ndustries where process consist of distinct operations, the operation costing method is appl ied. It offers better control and faci litates, the computati on of unit operation cost at the end of each operation.

 (iv) Causes of difference:

 (a) Items included in financi al accounts but not in cost accounts such as:

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 13

 Interest received on bank deposits, loss/profit on sale of fixed assets and investments, dividend, rent recei ved.

 (b) Items included in cost accounts on notional basis such as rent of owned buil ding,

 interest on own capital etc.

 (c) Items whose treatment is different in the two sets of accounts such as i nventory

 val uation.

 Question 5

 Answer any five of the following: (i ) Define Modi fied Internal Rate of Return method. (i i) Explain the need of debt-service coverage ratio. (i ii) Explain the term Ploughing back of Profi ts. (i v) ABC Li mited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The

 Financial leverage ratio for the company is 0.60. Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent.

 (v) Explain in brief the assumptions of Modigli ani-Mil ler theory. (vi) A person is required to pay four equal annual payments of Rs. 4,000 each in hi s Deposit

 account that pays 10 per cent interest per year. Find out the future value of annuity at the end of 4 years.

 (5 2 = 10 Marks)

 Answer (i) Modified Internal Rate of Return (MIRR): There are several limitations attached with

 the concept of the conventional Internal Rate of Return. The MIRR addresses some of these deficiencies. For example, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and pr oduces results, which are consistent with the Net Present Value method. Under this method, all cash flows, apart from the initi al i nvestment, are brought to the terminal val ue using an appropriate di scount rate(usually the cost of capital). Thi s results in a single stream of cash infl ow in the terminal year. The MIRR is obtai ned by assuming a single outflow in the zeroth year and the terminal cash in flow as mentioned above. The di scount rate which equates the present value of the terminal cash in flow to the zeroth year outfl ow i s called the MIRR.

 (ii) Debt Service Coverage Ratio: Lenders are i nterested in this rati o to judge the fi rms

 ability to pay off current interest and installments.

 service

 debt

 for

 available

 Earnings

 ratio

 coverage

 service

 Debt

 Instalment

 Interest

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 14

 Where, Earning for debt service = Net profit

 + Non- cash operating expenses li ke depreciation and other

 amortizations

 + Non-operating adjustments li ke loss on sale of + Fi xed assets + Interest on Debt Fund.

 (iii) Ploughing back of Profits: Retained earni ngs means retention of profit and reinvesting

 it in the company as long term funds. Such funds belong to the or di nary shareholders and increase the net worth of the company. A publi c li mited company must plough back a reasonable amount of profit every year keeping i n view the legal requirements in thi s regard and its own expansion plans. Such funds also entai l almost no risk. Further, control of pr esent owners i s also not diluted by retaining profits.

 (iv) ROE = [ROI + {(ROI r) D/E}] (1 t)

 = [0.20 + {(0.20 0.10) 0.60}] (1 0.40) =[ 0.20 + 0.06] 0.60 = 0.1560

 ROE = 15.60%

 (v) Assumptions of Modigliani Miller Theory

 (a) Capital markets are perfect. All information is freely available and there is no

 transaction cost.

 (b) All investors ar e rational. (c) No existence of corporate taxes. (d) Fi rms can be grouped into Equivalent risk classes on the basis of thei r business

 risk.

 1

 i)

 (1

 (vi) i

 A

 FVA n

 1

 .10)

 (1

 4,000 n

 0.1

 4,000 4.641 = Rs. 18,564 Future Value of Annuity at the end of 4 years = Rs. 18,564

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 15

 Question 6

 The Balance Sheet of JK Li mited as on 31st March, 2005 and 31st March, 2006 are given below:

 Balance Sheet as on

 (Rs. 000)

 Liabi liti es 31.03.05 31.03.06 Assets 31.03.05 31.03.06 Share Capital 1,440 1,920 Fixed Assets 3,840 4,560 Capital Reserve

 48 Less: Depreci ation 1,104 1,392

 General Reserve 816 960

 2,736 3,168

 Profit and Loss Account

 288 360 Investment 480 384

 9% Debenture 960 672 Cash 210 312 Current Liabilities 576 624 Other Current

 Assets

 Proposed Dividend 144 174 (including Stock) 1,134 1,272 Provisi on for Tax 432 408 Preliminary

 96 48

 Expenses

 Unpaid Dividend 18

 _____ _____

 4,656 5,184

 4,656 5,184

 Additional Informations: (i ) During the year 2005-2006, Fixed Assets with a book value of Rs. 2,40,000 ( accumulated

 depreciation Rs. 84,000) was sold for Rs. 1,20,000.

 (i i) Provided Rs. 4,20,000 as depreciation. (i ii) Some investments are sol d at a profit of Rs. 48,000 and Profit was credited to Capital

 Reserve.

 (i v) It decided that stocks be valued at cost, whereas previously the practice was to value

 stock at cost less 10 per cent. The stock was Rs. 2,59,200 as on 31.03.05. The stock as on 31.03.06 was cor rectly valued at Rs. 3,60,000.

 (v) It decided to write off Fixed Assets costing Rs. 60,000 on which depreciati on amounting

 to Rs. 48,000 has been provided.

 (vi) Debentures are redeemed at Rs. 105. Required: Prepare a Cash Flow Statement.

 (15 Marks)

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 16

 Answer

 Cash flow Statement (31s t March, 2006)

 (A) Cashflows from Operating Activities

 Profit and Loss A/c (3,60,000 (2,88,000 + 28,800)

 43,200

 Adjustments:

 Increase in General Reserve 1,44,000 Depreciati on

 4,20,000

 Provi sion for Tax

 4,08,000

 Loss on Sale of Machi ne 36,000 Premium on Redemption of

 14,400

 Debenture

 Proposed Dividend 1,74,000 Preliminary Exp. w/o 48,000 Fi xed Assets w/o

 12,000 12,56,400

 Funds from Operation

 12,99,600

 Increase in Sundry Current Liabilities

 48,000

 Increase in Current Assets 12,72,000 (11,34,000 + 28,800)

 (1,09,200)

 Cash before Tax

 12,38,400

 Tax paid

 4,32,000

 Cash from Operating Activities

 8,06,400

 (B) Cash from Investing Activities

 Purchases of fixed assets

 (10,20,000)

 Sale of Investment

 1,44,000

 Sale of Fixed Assets

 1,20,000 (7,56,000)

 (C) Cash from Financing Activities

 Issue of Share Capital

 4,80,000

 Redemption of Debenture

 (3,02,400)

 Dividend paid

 (1,26,000) 51,600

 Net increase in Cash and Cash equivalents

 1,02,000

 Openi ng Cash and Cash equivalents

 2,10,000

 Closing Cash

 3,12,000

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 17

 Fixed Assets Account

 Particulars

 Rs. Particul ars Rs.

 To Balance b/d 27,36,000 By Cash 1,20,000 To Purchases (Balance) 10,20,000 By Loss on sales 36,000

 By Depr eciation 4,20,000 By Assets w/o 12,000

 ________ By Balance 31,68,000 37,56,000

 37,56,000

 Depreciation Account

 Particulars

 Rs. Particul ar s Rs.

 To Fixed Assets (on sales) 84,000 By Balance b/d 11,04,000 To Fixed Assets w/o 48,000 By Profit and Loss a/c 4,20,000 To Balance

 13,92,000

 ________

 15,24,000

 15,24,000

 Question 7

 (a) The following details of RST Limited for the year ended 31March, 2006 are given below:

 Operating leverage

 1.4

 Combined leverage

 2.8

 Fixed Cost (Excluding interest)

 Rs. 2.04 l akhs

 Sales

 Rs. 30.00 l akhs

 12% Debentures of Rs. 100 each

 Rs. 21.25 l akhs

 Equity Share Capital of Rs. 10 each

 Rs. 17.00 l akhs

 Income tax rate

 30 per cent

 Required: (i) Calculate Financial lever age (ii) Calculate P/V ratio and Earning per Share (EPS) (iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a

 high or low assets leverage?

 (iv) At what l evel of sal es the Earning before Tax (EBT) of the company will be equal to

 zero?

 (b) The turnover of PQR Ltd. is Rs. 120 lakhs of whi ch 75 per cent is on credit. The variable

 cost ratio is 80 per cent. The credit terms are 2/10, net 30. On the current level of sales, the bad debts are 1 per cent. The company spends Rs. 1,20,000 per annum on

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 18

 administering its credit sales. The cost includes salaries of staff who handle credi t checking, collection etc. These are avoidable costs. The past experience indicates that 60 per cent of the customers avail of the cash di scount, the remaining customers pay on an average 60 days after the date of sale. The Book debts (receivable) of the company are presently being financed in the ratio of 1 : 1 by a mix of bank borrowings and owned funds which cost per annum 15 per cent and 14 per cent respectively. A factoring firm has offered to buy the fi rms recei vables. The main el ements of such deal structured by the factor are: (i) Factor reserve, 12 per cent (ii) Guaranteed payment, 25 days (iii) Interest charges, 15 per cent, and (iv) Commission 4 per cent of the value of receivables. Assume 360 days i n a year. What advise would you give to PQR Ltd. - whether to conti nue with the in house management of receivabl es or accept the factoring firms offer? (8 + 8 = 16 Marks)

 Answer (a) (i) Financial leverage

 Combined Leverage = Operati ng Leverage (OL) Financial Leverage (FL)

 2.8 = 1.4 FL FL = 2

 Fi nancial Leverage = 2

 (ii) P/V Ratio and EPS

 P/V ratio = 100

 S C

 C

 Operating leverage = 100

 F

 C

 C

 1.4

 2,04,000

 C

 1.4 (C 2,04,000) = C 1.4 C 2,85,600 = C

 2,85,600

 C

 0.4

 C = 7,14,000

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 19

 7,14,000

 P/V = 23.8%

 100

 30,00,000

 Therefore, P/V Ratio = 23.8%

 tax

 after

 Profit

 EPS = shares

 equity

 of

 No.

 EBT = Sales V FC Interest

 = 30,00,000 22,86,000 2,04,000 2,55,000 = 2,55,000

 PAT = EBT Tax

 = 2,55,000 76,500 = 1,78,500

 EPS 1.05

 1,70,000 1,78,500

 (iii) Assets turnover

 Sales

 Assets turnover =

 0.784

 0

 38,25,000 30,00,000

 Assets

 Total

 0.784 < 1.5 means lower than industry turnover.

 (iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales

 have to be dropped by 100/2.8 = 35.71%. Hence new sales will be

 30,00,000 (100 35.71) = 19,28,700.

 Therefore, at 19,28,700 level of sales, the Earnings before Tax of the company will be equal to zero.

 (b) In-house Decision

 Rs.

 1,08,000

 Cash discount (Rs. 90 lakhs .60 .02)

 Bad debts losses (90,00,000 .01)

 90,000

 Administration cost

 1,20,000

 Cost of funds in recei vables*

 1,08,750 4,26,750

 *Average collection period (10 .6) + (60 days .40) = 30 days

 Average investments in debtors = lakhs

 7.5

 12 90

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 20

 Cost of Bank funds .15

 7.5

 Rs.

 2 1

 56,250

 1

 Cost of Owned funds .14

 7.5

 Rs.

 2

 52,500 1,08,750

 Offer Alternative

 3,60,000

 Factoring commissi on (Rs. 90 lakhs .04)

 25 79,200

 Interest charges .88(90 lakhs 3,60,000) = 76,03,200 .15

 360

 Cost of owned funds invested i n receivables

 25

 (90,00,000 76,03,200) .14 360

 13,580

 4,52,780

 Decision: PQR should not go for the factori ng al ternative as the cost of factoring is more.

 Cost of In-house Deci sion

 4,26,750

 Cost of Factoring Firm

 4,52,780

 Net l oss

 (26,030)

 Question 8

 Answer any three of the following: (i ) Differentiate between Business ri sk and Financial ri sk. (i i) Diagrammatically present the DU PONT CHART to calcul ate return on equity. (i ii) What are the main responsi bilities of a Chief Fi nancial Officer of an organisation? (i v) Explain in brief the features of Commercial Paper. (3 3 = 9 Marks)

 Answer (i) Business Risk and Financial Risk

 Business risk refers to the ri sk associated with the firms operations. It is uncertainty about the future operating income, i.e. how wel l can the operating income be predicted? It can be measured by standard deviation of basic earni ng power rati o. Whereas, Financial risk refers to the additional risk pl aced on firms shareholders as a result of debt use in financi ng. Companies that issue mor e debt instruments would have higher financi al ri sk than companies financed mostly by equity. Financial risk can be

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 21

 measured by ratios such as firms financial leverage mul tiplier, total debt to assets ratio etc.

 (ii) Du Pont Chart

 There are three components in the calculati on of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equi ty multiplier. By exami ning each input indivi dual ly, the sour ces of a company's return on equity can be discovered and compared to its competitors. Return on Equi ty = (Net Profit Margin) (Asset Turnover) (Equi ty Multipl ier)

 Profit Margin = EBIT Sales

 Return on Net Assets (RONA) = EBIT NA

 Assets Turnover = Sales NA

 Financial Leverage (Income) = PAT E BIT

 Return on Equity (ROE) = PAT NW

 Financial Leverage (Balance Sheet) = NA NW

 Du Pont Chart

 (iii) Responsibilities of Chief Financial Officer (CFO)

 The chief financial officer of an organisati on plays an impor tant role in the company s goals, poli cies, and financi al success. His main responsib ilities incl ude: (a) Fi nancial analysis and planning: Determining the proper amount of funds to be

 employed in the firm.

 (b) Investment decisions: Efficient al location of funds to specific assets. (c) Fi nancial and capital structure decisions: Raising funds on favourable terms as

 possible, i.e., determining the composition of liabil ities.

 (d) Management of financial resources (such as working capital). (e) Risk Management: Protecting assets.

 (iv) Features of Commercial Paper (CP)

 A commercial paper is an unsecured money market instrument issued in the form of a promissory note. Since the CP represents an unsecured borrowing i n the money market,

 PROFESSIONAL COMPETENCE EXAMINATION : MAY, 2007

 22

 the regulation of CP comes under the purview of the Reserve Bank of India which issued guidelines in 1990 on the basis of the recommendations of the Vaghul Working Group. These guidelines were aimed at: (i) Enabling the highly rated corporate borrowers to di versify thei r sources of short term

 borrowings, and

 (ii) To provi de an additional instrument to th e shor t term investors. It can be issued for maturi ties between 7 days and a maximum upto one year from the date of issue. These can be issued in denominati ons of Rs. 5 lakh or multipl es therefore. All el igible i ssuers are required to get the credit rati ng from credi t rating agencies.

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