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

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Solved Cost-Fm Nov 2007

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT

 All questions are compulsory.

 Wor king notes should form part of the answer.

 Quest ion 1

 Answer any five of the following: (i) Discuss briefly the relevant costs with examples. (ii) Calculate total passenger kilometres from the following information:

 Number of buses 6, number of days operating in a month 25, trips made by each bus per day 8, distance covered 20 kilometr es (one side), capacity of bus 40 passengers, normally 80% of capacity utilization.

 (iii) Explain the importance of an Escalation Clause in contract cost. (iv) Calculate Efficiency and Capacity ratio fr om the following figures:

 Budgeted production

 80 units

 Actual production

 60 units

 Standar d time per unit

 8 hours

 Actual hour s worked

 500

 (v) Explain Blanket overhead rate. (vi) Explain the cost accounting tr eatment of unsuccessful Research and Development cost.

 (10 Marks)

 Answer (i) Relevant costs are those expected future cost which are essential but differ for

 alternative course or action. ( a) Historical cost or sunk costs are irrelevant as they do not play any r ole in the

 decision making pr ocess.

 ( b) Var iable costs which will not differ under var ious alter natives are ir relevant.

 (ii) Calculation of passenger kilometers:

 6 25 8 2 20 40 80% = 15,36,000 passenger kms.

 (iii) Dur ing the execution of a contr act, the prices of materials, or labour etc., may rise

 beyond a certain limit. In such a case the contract price will be increased by an agr eed amount. Inclusion of such a clause in a contr act deed is called an Escalation Clause.

 hours

 standard

 of

 terms

 in

 output

 Actual

 (iv) Efficiency Ratio =

 100

 worked

 hour

 Actual

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 4

 480

 Or 96%

 100

 500

 worked

 hours

 Actual

 Capacity Ratio =

 100

 hours

 Budgeted

 500

 Or 78.12%

 100

 640

 (v) Blanket overhead rate refers to the computation of one single overhead r ate for the entire

 factory. This is also known as plantwise or the single overhead rate for the entire factory. It is determined as follows:

 period

 the

 for

 factory

 entire

 the

 for

 cost

 Hours)

 Machine

 Hours,

 (Labour

 period

 the

 for

 Base

 It is useful in companies producing the main product in continue process, e.g. chemical plant, glass plant etc.

 (vi) Cost of unsuccessful research is treated as factory overhead, provided the expenditure is

 normal and is provided in the budget. If it is not budgeted, it is written off to the profit and loss account. If the research is extended for long time, some failure cost is spread over to successful research.

 Quest ion 2

 KPR Limited operates a system of standard costing in respect of one of its products which is manufactured within a single cost centr e. The Standard Cost Car d of a product is as under: Standard

 Unit cost (Rs.)

 Direct material 5 kgs @ Rs. 4.20

 21

 Direct labour 3 hours @ Rs. 3.00

 9

 Factory overhead Rs. 1.20 per labour hour

 3.6

 Total manufacturing cost

 33.6

 The production schedule for the month of June, 2007 required completion of 40,000 units. However, 40,960 units were completed during the month without opening and closing work-in- process inventories. Purchases during the month of June, 2007, 2,25,000 kgs of material at the rate of Rs. 4.50 per kg. Production and Sales records for the month showed the following actual results. Material used 2,05,600 kgs. Direct labour 1,21,200 hours; cost incurred

 Rs. 3,87,840

 Rs. 1,00,000

 Sales

 40,000 units

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 5

 Selling price to be so fixed as to allow a mark-up of 20 per cent on selling price. Required: (i) Calculate material variances based on consumption of material. (ii) Calculate labour variances and the total var iance for factory over head. (iii) Prepare Income statement for June, 2007 showing actual gross margin. (iv) An incentive scheme is in operation in the company whereby employees are paid a

 bonus of 50% of dir ect labour hour saved at standard direct labour hour rate. Calculat e the Bonus amount.

 (15 Marks)

 ( a) Direct material cost variance = Standard cost Actual cost

 = 40,960 21 2,05,600 4.50 = 8,60,160 9,25,200 = 65,040 (A)

 ( b) Material price variance = AQ ( SP AP)

 = 2,05,600 (4.20 4.50) = 61,680 (A)

 ( c) Material usages variance = SP ( SQ AQ)

 = 4.20 ( 40,960 5 2,05,600) = 3,360 (A)

 (ii) Labour variances and overhead variances:

 ( a) Labour cost variance = Standar d cost Actual cost

 = 40,960 9 3,87,840 = 19,200 (A)

 ( b) Labour rate var iance = AH (SR AR)

 1,21,200 (3 3.20) = 24,240 (A)

 ( c) Labour efficiency variance = SR (SH AH)

 = 3 ( 40,960 3 1,21,200) = 5,040 (F)

 incurred

 = 40,960 3 1.20 1,00,000 = 47,456 (F)

 (iii)

 Preparation of income statement

 Calculation of unit selling price

 Rs.

 Direct material

 21

 Direct labour

 9

 3.6

 Factory cost

 33.6

 Margin 25% on factory cost

 8.4

 Selling price

 42

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 6

 Income statement

 Rs.

 16,80,000

 Sales 40,000 units 42

 Less: Standard cost of goods sold 40,000 33.60

 13,44,000

 3,36,000

 Less: Variances adverse Material price variance

 61,680

 Material quantity variance

 3,360

 Labour rate variance

 24,240 89,280

 2,46,720

 Add: Favourable variance Labour efficiency variance

 5,040

 47,456 52,496

 Actual gross margin

 2,99,216

 (iv) Labour hour saved

 Rs.

 1,22,880

 Standard labour hours 40,960 3

 Actual labour hour worked

 1,21,200

 Labour hour saved

 1,680

 Bonus for saved labour = .50 (1,680 3) = 2,520.

 Quest ion 3

 (a) ABC Limited manufactures a product ZX by using the pr ocess namely RT. For the

 month of May, 2007, the following datas ar e available:

 Process RT

 Material introduced (units)

 16,000

 Transfer to next process (units)

 14,400

 Work in pr ocess: At the beginning of the month (units)

 4,000

 (4/5 completed) At the end of the month (units)

 3,000

 (2/3 completed) Cost r ecords: Work in pr ocess at the beginning of the month

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 7

 Material

 Rs. 30,000

 Conver sion cost

 Rs. 29,200

 Cost during the month : materials

 Rs. 1,20,000

 Conver sion cost

 Rs. 1,60,800

 Nor mal spoiled units are 10% of goods finished output tr ansferred to next pr ocess. Defects in these units are identified in their finished state. Mater ial for the product is put in the process at the beginning of the cycle of operation, whereas labour and other indir ect cost flow evenly over the year. It has no realizable value for spoiled units. Required: ( i) Statement of equivalent pr oduction ( Average cost method) ; ( ii) Statement of cost and distribution of cost; ( iii) Process accounts.

 (b) A machine shop cost centre contains three machines of equal capacities. Three

 operators ar e employed on each machine, payable Rs. 20 per hour each. The factor y wor ks for fortyeight hours in a week which includes 4 hours set up time. The wor k is jointly done by operators. The oper ators are paid fully for the fortyeight hours. In additions they are paid a bonus of 10 per cent of productive time. Costs are reported for this company on the basis of thirteen four -weekly period. The company for the pur pose of computing machine hour rate includes the direct wages of the operator and also recoups the factory overheads allocated to the machines. The following details of factory overheads applicable to the cost centr e are available:

 Depreciation 10% per annum on original cost of the machine. Original cost of the each machine is Rs. 52,000. Maintenance and repairs per week per machine is Rs. 60. Consumable stores per week per machine are Rs. 75. Power : 20 units per hour per machine at the rate of 80 paise per unit. Apportionment to the cost centre : Rent per annum Rs. 5,400, Heat and Light per annum Rs. 9,720, and foremans salar y per annum Rs. 12,960.

 Required: ( i) Calculate the cost of running one machine for a four week period. ( ii) Calculate machine hour rate.

 (8 + 8 = 16 Marks)

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 8

 Answer (a) Statement of equivalent production of Process RT

 Input

 Details Output

 Equivalent Production

 units

 units

 Mater ial

 % Conversion cost

 % units

 units

 4,000 Opening WIP

 16,000 Introduced completed

 14,400 14,400 100% 14,400 100%

 and transfer to next

 Normal spoilage 1,440 1,440 100% 1,440 100% Abnormal Spoilage 1,160 1,160 100% 1,160 100% Closing WIP 3,000 3,000 100% 2,000 66.67%

 20,000

 20,000 20,000 19,000

 Stat ement showing cost of each element

 Opening Cost in

 Total Equivalent

 Cost per

 Process

 Units

 units

 (Rs.) ( Rs.) (Rs.)

 Mater ials 30,000 1,20,000 1,50,000 20,000 7.50 Conversion cost 29,200 1,60,800 1,90,000 19,000 10.00

 Statement of apportionment of cost

 Material 14,400 7.50

 Units completed

 Conver sion cost 14,400 10.00 2,52,000 Normal spoilage (10%)

 25,200

 Material

 3,000 7.50

 Closing stock

 Conver sion cost 2,000 10.00 42,500 Material

 1,160 7.50

 Abnor mal stock

 Conver sion cost 1,160 10.00 20,300

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 9

 Process Account

 Rs.

 Rs.

 T o Opening WIP 59,200 By Profit and Loss Account

 (Abnormal)

 20,300

 T o Material 1,20,000 By Transfer to next process 2,77,200 T o Conversion cost 1,60,800 By Closing WIP 42,500

 3,40,000

 3,40,000

 (b) Computation of cost of running one machine for a four week period

 Rs.

 Standing charges

 Per annum

 Rent

 5,400

 Heat and light

 9,720

 For mans salary

 12,960 28,080

 Rs.

 4

 28,080 2,880

 Total expenses for one machine for four week period =

 13

 3

 Wages: Hour s per week = 48 and hours for 4 weeks = 48 4 = 192

 Wages 192 20

 3,840

 352

 Bonus (192 16) = 176 20 .10

 (i) Total standing char ges

 7,072

 Machine Expenses:

 Rs.

 1,600

 4

 Depr eciation = 13

 10%

 52,000

 240

 Repairs and maintenance = (60 4)

 Consumable stores (75 4)

 300

 Power (192 16) = 176 20 .80

 2,816

 (ii) Total machine expenses

 4,956

 Total expenses (i) + ( ii)

 12,028

 12,028

 Machine hour r ate = 68.34.

 176

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 10

 Quest ion 4

 Answer any three of the following: (i) Explain essential pr e-requisites for integrated accounts. (ii) Explain, why the Last in First out (LIFO) has an edge over Fir st in First out (FIFO) or any

 other method of pricing material issues.

 (iii) Enumerate the r emedial steps to be taken to minimize the labour turnover. (iv) A company produces single pr oduct which sells for Rs. 20 per unit. Variable cost is Rs.

 15 per unit and Fixed overhead for the year is Rs. 6,30,000. Required: ( a) Calculate sales value needed to earn a profit of 10% on sales. ( b) Calculate sales price per unit to bring BEP down to 1,20,000 units. ( c) Calculate margin of safety sales if profit is Rs. 60,000. (3 3 = 9 Marks)

 Answer (i) Essential pre-requisites for integrated accounts:

 ( a) The managements decision about the extent of integration of the two sets of books. ( b) A suitable coding system must be made available so as to serve the accounting

 pur poses of financial and cost accounts.

 ( c) An agreed r outine, with regard to the tr eatment of provision for accruals, prepaid

 expenses, other adjustment necessar y for preparation of inter im accounts.

 ( d) Per fect coordination should exist between the staff responsible for the financial and

 cost accounts and an efficient processing of accounting document should be ensur ed.

 ( a) The cost of the material issued will be reflecting the current market price. ( b) The use of the method during the period of r ising pr ices does not r eflect undue high

 profit in the income statement.

 ( c) In the case of falling price, profit tend to rise due to lower mater ial cost, yet the

 finished goods appear to be more competitive and are at market price.

 ( d) During the period of inflation, LIFO will tend to show the cor rect profit.

 (iii) The following steps ar e useful for minimizing labour turnover:

 ( a) Exit interview: An interview be arranged with each outgoing employee to ascertain

 the reasons of his leaving the organization.

 ( b) Job analysis and evaluation: to ascertain the requirement of each job.

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 11

 ( c) Organisation should make use of a scientific system of r ecruitment, placement and

 promotion for employees.

 ( d) Organisation should create healthy atmosphere, providing education, medical and

 housing facilities for wor kers.

 ( e) Committee for settling workers grievances.

 (iv) ( a) Suppose sales units ar e x then

 S = V + F + P S = Sales V = Variable Cost F = Fixed Cost P = Profit 20x = 15x + 6,30,000 + 2x 20x 17x = 6,30,000

 6,30,000

 units

 2,10,000

 x

 3

 Sales value = 2,10,000 20 = Rs. 42,00,000

 ( b) Sales price to down BEP 1,20,000 units

 F

 20.25.

 Rs.

 15

 S

 V

 S

 1,20,000 6,30,000

 BEP

 New

 C

 60,000

 Profit

 ( c)

 100

 V

 P/

 where

 Sales

 S

 M

 S

 V

 P/

 ratio

 V

 P/

 5

 60,000

 25%.

 100

 Or

 2,40,000

 100

 20

 25

 Quest ion 5

 Answer any five of the following: (i) Explain the concept of leveraged lease. (ii) Discuss the features of deep discount bonds. (iii) What is optimum capital structur e? Explain. (iv) A firm has Sales of Rs. 40 lakhs; Variable cost of Rs. 25 lakhs; Fixed cost of Rs. 6 lakhs;

 10% debt of Rs. 30 lakhs; and Equity Capital of Rs. 45 lakhs. Required: Calculate operating and financial leverage.

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 12

 (v) The demand for a certain product is random. It has been estimated that the monthly

 demand of the product has a nor mal distribution with a mean of 390 units. The unit price of pr oduct is Rs. 25. Ordering cost is Rs. 40 per or der and inventor y carr ying cost is estimated to be 35 per cent per year. Required: Calculate Economic Order Quantity (EOQ).

 (vi) Explain the concept of Indian depository r eceipts. (5 2 = 10 Marks)

 Answer (i) Concept of Leveraged Lease: Leveraged lease involves lessor , lessee and financier.

 In leveraged lease, the lessor makes a substantial borrowing, even upto 80 per cent of the assets purchase price. He provides remaining amount about 20 per cent or so as equity to become the owner . The lessor claims all tax benefits related to the ownership of the assets. Lender s, generally large financial institutions, provide loans on a non- r ecourse basis to the lessor. Their debt is served exclusively out of the lease proceeds. To secure the loan provided by the lenders, the lessor also agrees to give them a mor tgage on the asset. Lever aged lease ar e called so because the high non-recourse debt cr eates a high degree of leverage.

 (ii) Features of Deep Discount Bonds: Deep discount bonds are for m of zer o interest

 bonds. These bonds ar e sold at discounted value and on matur ity; face value is paid to the investors. In such bonds, ther e is no inter est payout during the lock- in period. IDBI was the fir st to issue deep discount bonds in India in January 1993. The bond of a face value of Rs. 1 lakh was sold for Rs. 2700 with a maturity period of 25 years.

 (iii) Opt imum Capital Structure: Optimum capital str ucture deals with the issue of right mix

 of debt and equity in the long-ter m capital str ucture of a firm. Accor ding to this, if a company takes on debt, the value of the firm increases upto a certain point. Beyond that value of the fir m will start to decrease. If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select its appropriate capital structure with due consider ation of all factor s.

 (iv) Calculation of Operating and Financial Leverage

 Rs.

 Sales

 40,00,000

 Less: Var iable cost

 25,00,000

 Contr ibution (C)

 15,00,000

 Less: Fixed cost

 6,00,000

 EBIT

 9,00,000

 Less: Interest

 3,00,000

 EBT

 6,00,000

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 13

 15,00,000

 C

 Operating lever age = 1.67

 9,00,000

 EBIT

 EBIT

 Financial leverage = 1.50

 6,00,000 9,00,000

 EBT

 (v) Calculation of Economic Order Quantity (EOQ)

 The mean of monthly demand = 390 units, Annual demand (A) = 390 12 = 4,680 units Order ing cost ( O) = Rs. 40 per order, Cost per unit = Rs. 25. Inventory car rying cost of one unit (CC) = Rs. 25 35% = Rs. 8.75

 2AO

 40

 EOQ

 4,680

 2 = 206.85 or 207 units

 CC

 8.75

 (vi) Concept of Indian Deposit ory Receipts: The concept of the depository receipt

 mechanism which is used to raise funds in for eign currency has been applied in the Indian capital mar ket through the issue of Indian Depository Receipts (IDRs). Foreign companies can issue IDRs to r aise funds from Indian mar ket on the same lines as an Indian company uses ADRs/GDRs to raise foreign capital. The IDRs are listed and traded in India in the same way as other Indian securities are traded.

 Quest ion 6

 The Balance Sheet of X Ltd. as on 31st March, 2007 is as follows: Liabilities Rs. ( 000) Assets

 Rs. (000)

 Equity shar e capital 6,000 Fixed Assets (at cost) 16,250 8% Preference share capital

 3,250 Less: Depreciation wr itten

 5,200 11,050

 off

 Reserves and Surplus 1,400 Stock

 1,950

 10% Debentur es 1,950 Sundry debtor s

 2,600

 Sundry Creditors 3,250 Cash

 250

 Total

 15,850

 15,850

 The following additional information is available: (i) The stock tur nover ratio based on cost of goods sold would be 6 times. (ii) The cost of fixed assets to sales ratio would be 1.4. (iii) Fixed assets costing Rs. 30,00,000 to be installed on 1st April, 2007, payment would be

 (iv) In March, 2008, a dividend of 7 per cent on equity capital would be paid.

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 14

 (v) Rs. 5,50,000, 11% Debentures would be issued on 1st April, 2007. (vi) Rs. 30,00,000, Equity shares would be issued on 31st March, 2008. (vii) Creditors would be 25% of materials consumed. (viii) Debtors would be 10% of sales. (ix) The cost of goods sold would be 90 per cent of sales including material 40 per cent and

 depreciation 5 per cent of sales.

 (x) The profit is subject to debenture inter est and taxation @ 30 per cent. Required: (i) Prepare the projected Balance Sheet as on 31st Mar ch, 2008. (ii) Prepar e projected Cash Flow Statement in accordance with AS-3. (15 Marks)

 Fixed assets Rs. (1,62,50,000 + 30,00,000) = 1,92,50,000

 0

 1,92,50,00

 0

 1,37,50,00

 Sales

 1.4

 Cost of goods sold = 1,37,50,000 .90 = 1,23,75,000 Mater ial = 1,37,50,000 .40 = 55,00,000 Depreciation = 1,37,50,000 .05 = 6,87,500 Net profit = 1,37,50,000 .10 = 13,75,000

 Calculation of Net Fixed Assets

 Rs.

 Opening balance

 1,62,50,000

 30,00,000 1,92,50,000

 Less: Accumulated Depreciation 52,00,000 Additional Depr eciation

 6,87,500 58,87,500

 Closing balance of fixed assets

 1,33,62,500

 Calculation of Closing St ock

 sold

 goods

 of

 Cost

 stock

 Average

 ratio

 turnover

 Stock

 0

 1,23,75,00

 20,62,500

 6

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 15

 stock)

 Closing

 stock

 (Opening

 stock

 Average

 2

 stock)

 Closing

 (19,50,000

 20,62,500

 2

 Closing stock = 41,25,000 19,50,000 = 21,75,000 Calculation of Debtor s = 1,37,50,000 .10 =13,75,000 Calculation of Creditors = 55,00,000 .25 =13,75,000

 Calculation of Int erest and Provision f or Taxation

 Net profit

 13,75,000

 Less: Interest (19,50,000 10%)

 2,55,500

 (5,50,000 11%)

 11,19,500

 Less: Taxes

 3,35,850

 Net profit available for dividend

 7,83,650

 Less: Preference shar e dividend

 2,60,000

 Less: Equity dividend @ 7%

 4,20,000

 Transfer to r eserves and surplus

 1,03,650

 Reserves and Surplus

 Opening balance

 14,00,000

 1,03,650

 15,03,650

 Project ed Cash Flow St atement

 ( i) Cash flow f rom Operat ing Act ivit ies

 Profit after taxation

 7,83,650

 6,87,500 14,71,150

 Add: Increase in current liabilities and decrease in current assets Provision for taxation

 3,35,850

 Debtors (26,00,000 13,75,000)

 12,25,000

 Less: Incr ease in curr ent assets and decrease in current liabilities Stock (21,75,000 19,50,000) (2,25,000) Creditors ( 13,75,000 32,50,000) ( 18,75,000) (21,00,000)

 Net Cash f rom Operat ing Act ivit ies

 9,32,000

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 16

 ( ii) Cash flow f rom Investing Act ivities

 Pur chase of Fixed Assets

 (30,00,000)

 ( iii) Cash flow f rom Financing Activities

 Issue of Debenture

 5,50,000

 Issue of equity share capital

 30,00,000

 Dividend paid

 (6,80,000) 28,70,000

 Net increase in cash

 8,02,000

 Opening balance of cash

 2,50,000

 Closing balance

 10,52,000

 Projected Balance Sheet as on 31st March, 2008

 Liabilities Rs. ( 000) Assets

 Rs. ( 000)

 Equity shar e capital 9,000 Fixed Assets (at

 19,250

 cost)

 8% Preference share capital 3,250

 Less: Depreciation written off 5,887.5 13,362.5

 Reserves & Surplus 1,503.65 Stock

 2,175

 10% & 11% Debentures 2,500

 Sundry debtor s Cash

 1,375

 1,052

 Sundry Cr editor s 1,375 Provision for taxation 335.85

 _______

 Total 17,964.5 Total

 17,964.5

 Quest ion 7

 (a) A newly for med company has applied to the Commer cial Bank for the first time for

 financing its working capital requirements. The following information is available about the projections for the cur rent year:

 Per unit

 Elements of cost:

 (Rs.)

 Raw material

 40

 Dir ect labour

 15

 30

 Total cost

 85

 Profit

 15

 Sales

 100

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 17

 Other infor mation: Raw mater ial in stock : average 4 weeks consumption, Work in pr ogress ( completion stage, 50 per cent), on an average half a month. Finished goods in stock : on an average, one month. Credit allowed by suppliers is one month. Credit allowed to debtors is two months. Average time lag in payment of wages is 1 weeks and 4 weeks in overhead expenses. Cash in hand and at bank is desir ed to be maintained at Rs. 50,000. All Sales are on credit basis only. Required: ( i) Prepare statement showing estimate of wor king capital needed to finance an activity

 level of 96,000 units of production. Assume that production is car ried on evenly throughout the year, and wages and over head accrue similar ly. For the calculation pur pose 4 weeks may be taken as equivalent to a month and 52 weeks in a year.

 ( ii) From the above information calculate the maximum permissible bank finance by all

 the three methods for working capital as per Tondon Committee nor ms; assume the core curr ent assets constitute 25% of the current assets.

 (b) XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project

 is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State Government of Rs. 25,00,000 on capital investment. Initial equipment cost will be Rs. 1.75 crores. Additional equipment costing Rs. 12,50,000 will be purchased at the end of the thir d year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be needed and it will be r eleased at the end of eighth year. The project will be financed with sufficient amount of equity capital. The sales volumes over eight years have been estimated as follows:

 Year 1 2 3 4 5 6 8 Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

 A sales pr ice of Rs. 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash operating costs will amount Rs. 18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent to be an appropr iate after tax cost of capital for this pr oject. The company follows str aight line method of depreciation. Required: Calculate the net present value of the project and advise the m anagement to take appropriate decision.

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 18

 Note: The PV factor s at 12% are

 Year 1 2 3 4 5 6 7 8

 .893 .797 .712 .636 .567 .507 .452 .404

 (8 + 8 = 16 Marks)

 Answer (a) Calculation of Working Capital Requirement

 ( A) Current Assets

 Rs.

 (i) Stock of mater ial for 4 weeks ( 96,000 40 4/52) 2,95,385 (ii) Work in progress for month or 2 weeks

 Material (96,000 40 2/52) .50 73,846 Labour (96,000 15 2/52) .50 27,692 Over head (96,000 30 2/52) .50 55,385 1,56,923

 (iii) Finished stock (96,000 85 4/52)

 6,27,692

 (iv) Debtors for 2 months (96,000 85 8/52)

 12,55,385

 Cash in hand or at bank

 50,000

 Investment in Current Assets

 23,85,385

 ( B) Current Liabilit ies

 (i) Creditors for one month (96,000 40 4/52) 2,95,385 (ii) Average lag in payment of expenses

 Overheads (96,000 30 4/52) 2,21,538 Labour (96,000 15 3/104) 41,538 2,63,076 Current Liabilities

 5,58,461

 Net working capital ( A B)

 18,26,924

 Minimum Permissible Bank Finance as per Tandon Committ ee

 Method I : .75 (Current Assets Current Liabilities)

 .75 (23,85,385 5,58,461) .75 (18,26,924) 5,58,461 = Rs. 13,70,193

 Method II : .75 Current Assets Cur rent Liabilities

 .75 23,85,385 5,58,461

 17,89,039 5,58,461 = Rs. 12,30,578

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 19

 Method III: .75 (Current Assets CCA) Curr ent Liabilities

 .75 (23,85,385 5,96,346) 5,58,461 .75 (17,89,039) 5,58,461

 13,41,779 5,58,461 = Rs. 7,83,318

 (b)

 (Rs. 000)

 Year Sales VC FC D ep. Profit Tax PAT Dep. Cash

 inflow

 1 86.40 51.84 18 21.875 (5.315)

 21.875 16.56

 2 129.60 77.76 18 21.875 11.965

 1.995 4.655 21.875 26.53

 (5.315) =

 6.65 After

 of loss

 3 312.00 187.20 18 21.875 84.925 25.4775 59.4475 21.875 81.3225

 4 5 324.00 194.40 18 24.125 87.475 26.2425 61.2325 24.125 85.3575 6 8 216.00 129.60 18 24.125 44.275 13.2825 30.9925 24.125 55.1175

 Rs.

 Cost of New Equipment

 1,75,00,000

 Less: Subsidy

 25,00,000

 20,00,000

 Outflow

 1,70,00,000

 Calculation of NPV

 Year

 Cash inflows PV factor NPV

 (Rs.)

 ( Rs.)

 1

 16,56,000 .893 14,78,808

 2

 26,53,000 .797 21,14,441

 3 81,32,250 12,50,000 = 68,82,250 .712 49,00,162 4

 85,35,750 .636 54,28,737

 5

 85,35,750 .567 48,39,770

 6

 55,11,750 .507 27,94,457

 7

 55,11,750 .452 24,91,311

 8 55,11,750 + 20,00,000 + 1,25,000 = 76,36,750 .404 30,85,247

 Net Present Value 2,71,32,933

 PROFESSIONAL COMPETENCE EXAMINATION : NOVEMBER, 2007

 20

 NPV

 2,71,32,933

 Less: Out flow

 1,70,00,000

 Saving

 1,01,32,933

 Advise: Since the project has a positive NPV, therefore, it should be accepted.

 Quest ion 8

 Answer any three of the following: (i) Explain the assumptions of Net Operating Income appr oach (NOI) theory of capital

 structure.

 (ii) Explain the limitations of profit maximization objective of Financial Management. (iii) Explain the methods of venture capital financing. (iv) Z Ltd.s oper ating income (before interest and tax) is Rs. 9,00,000. The fir ms cost of

 debt is 10 per cent and curr ently firm employs Rs. 30,00,000 of debt. The over all cost of capital of firm is 12 per cent. Required: Calculate cost of equity.

 (3 3 = 9 Marks)

 Answer (i) Assumptions of Net Operating Income ( NOI) Theory of Capital Structure

 Accor ding to NOI approach, there is no r elationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.

 Assumptions

 ( a) The corporate income taxes do not exist. ( b) The market capitalizes the value of the fir m as whole. Thus the split between debt

 and equity is not important.

 ( c) The incr ease in proportion of debt in capital str ucture leads to change in r isk

 per ception of the shar eholders.

 ( d) The overall cost of capital (Ko ) remains constant for all degr ees of debt equity mix.

 (ii) Limitations of Profit Maximisation Object ive of Financial Management

 ( a) Time factor is ignored. ( b) It is vague because it is not clear whether the term relates to economic pr ofit,

 accounting profit, profit after tax or before tax.

 ( c) The term maximization is also ambiguous. ( d) It ignores the r isk factor.

 PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 21

 (iii) Some Common Methods of Venture Capital Financing

 ( a) Equity financing: The venture capital under taking requir es long-term funds but is

 unable to provide returns in initial stage so equity capital is the best option.

 ( b) Conditional Loan: A conditional loan is repayable in the form of a royalty after the

 venture is able to generate sales. No interest is paid on such loans.

 ( c) Income note: It is hybr id secur ity; the entrepr eneur has to pay both interest and

 royalty on sales but at substantially low rates.

 ( d) Par ticipating debenture: Such security carr ies charges in three phases - in the start-

 up phase, no interest is charged, next stage a low rate of inter est up to a particular level of operation is charged, after that, high rate of inter est is requir ed to be paid.

 (iv) Calculation of Cost of Equity

 EBIT

 Calculation of value of firm (v) =

 K

 capital

 of

 cost

 Overall

 o

 9,00,000

 00

 Rs.75,00,0

 0.12

 Mar ket value of equity (S) = V Debts

 = 75,00,000 30,00,000 = Rs. 45,00,000

 Mar ket value of debts (D) = 30,00,000

 K

 K

 equity)

 of

 (Cost

 K

 S D

 S V

 d

 o

 e

 0.1

 0.12

 45,00,000 30,00,000

 45,00,000 75,00,000

 = 0.20 .067 = .133 100 Ke = 13.3%.