Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

Paper 8 – Cost Accounting & Financial Management

Section A – Cost Accounting – Prime Costs & Overheads

(Full Marks : 60)

Answer Question no.1 which is compulsory and any three from the rest in this section.

1. Answer the following [6 x 2 =12]

(a) What are the items to be „excluded‟ for the purpose of determining valuation of materials
as per CAS -6?
Answer.
The following items are to be „excluded‟ for the purpose of determining valuation of materials:
(i) Finance costs
(ii) Abnormal losses due to shrinkage or evaporation or gain due to elongation or
absorption of moisture before receipt of material
(iii) Changes in foreign exchange rate from the rate on date of transaction till date of
payment
(iv) Demurrage or detention charges or penalty levied by transport or other authorities
(v) Imputed costs
(vi) Cost of self-manufactured components and sub-assemblies shall not include share of
other administrative overheads, finance cost and marketing overheads
(vii) Material cost of abnormal scrap/defectives not to be included

(b) Consider the following data pertaining to the production of a company for a particular
month :
Opening stock of raw material ` 11,570
Closing stock of raw material ` 10,380
Purchase of raw material during the month ` 1,28,450
Total manufacturing cost charged to product ` 3,39,165
Factory overheads are applied at the rate of 45% of direct labour cost.
Calculate the amount of factory overheads applied to production.

Answer.
Raw material used = Op. Stock + Purchases – Cl. Stock
= ` 11,570 + ` 1,28,450 – ` 10,380 = ` 1,29,640
Manufacturing cost = Raw material used + Direct labour + Factory overhead
` 3,39,165 = ` 1,29,640 + Direct labour + 45% of Direct labour
1.45 Direct labour = ` 2,09,525
Direct labour = ` 1,44,500
The amount of factory overhead = 45% of ` 1,44,500 = ` 65,025.

(c) If the minimum stock level and average stock level of raw material “A” are 4,000 and
9,000 units respectively, find out its reorder quantity.

Answer.
Average stock level = Minimum stock level + ½ Reorder quantity
9,000 units = 4,000 units + ½ Reorder quantity
½ Reorder quantity = 9,000 units – 4,000 units
Reorder level = 5, 000 units / 0.5 = 10,000 units

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(d) A company is currently operating at 80% capacity level. The production under normal
capacity level is 1,50,000 units. The variable cost per unit is `14 and the total fixed costs are `
8,00,000. If the company wants to earn a profit of `4,00,000, what should be the price of the
product per unit ?

Answer.
Total fixed cost - ` 8,00,000
Expected profit - ` 4,00,000
Variable cost at 80% level
(80% x 1,50,000 units x ` 14) - ` 16,80,000
Total price - ` 28,80,000
Per unit price at 80% level = (` 28,80,000 / 1,20,000 units) = ` 24.00.

(e) The annual demand for a product is 6,400 units. The unit cost is `6 and inventory carrying
cost per unit per annum is 25% of the average inventory cost. If the cost of procurement is `75,
what is the time between two consecutive orders ?

Answer.
2 x 6,400 units x ` 75
EOQ = = 800 units
` 6 x 25/100

No. of orders p.a. = 6,400 units /800 units = 8 orders

Time taken between two orders = 12 months/ 8 orders = 1.5 months

(f) In Z Ltd. there were 680 employees on the rolls at the beginning of a year and 620 at the
end. During the year 30 persons left service. The company has computed its labour turnover
rates under flux method is 8%. The number of accessions during the period is :

Answer.
Average number of employees on the rolls = (680 + 620)/2 = 650
(No. of separation s No. of accessions )
Labour turnover rate (Flux Method) = x 100
Average employees on the rolls

8 30 x
100 650
3,000 + 100x = 8 x 650
100 x = 5,200 + 3,000
x = 2,200/100 = 22

No. of accession during the year = 22

2. (a) A re-roller produced 400 metric tons of M.S. bars spending ` 36,00,000 towards
materials and ` 6,20,000 towards rolling charges. Ten percent of the output was found to be
defective, which had to be sold at 10% less than the price for good production. If the sales
realization should give the firm an overall profit of 12.5% on cost, find the selling price per metric

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ton of both the categories of bars. The scrap arising during the rolling process fetched a
realization of ` 60,000. [4]

Answer.
Computation of Selling Price :
` `
Cost of Materials 36,00,000
Less: Scrap 60,000 35,40,000
Rolling charges 6,20,000
Total cost 41,60,000
Add Profit (12.5% on cost) 5,20,000
Sales value 46,80,000

9
Output (effective) = 360 MT + × 40 MT = 396 MT
10
Selling price per MT of good output = ` 46,80,000/396
= ` 11,818.18
Selling price of defective per MT = 0.9× ` 11,818.18
= ` 10,636.36

(b) The cost structure of an article, the selling price of which is ` 45,000 is as follows :
Direct Materials 50%
Direct Labour 20%
Overheads 30%

An increase of 15% in the case of materials and of 25% in the cost of labour is anticipated. These
increased costs in relation to the present selling price would cause a 25% decrease in the
amount of profit per article.
Your are required
(i) To prepare a statement of profit per article at present, and
(ii) The revised selling price to produce the same percentage of profit to sales as before. [3+3=6]

Answer.
Working Notes :
1. Let ‘x’ be the total cost and ‘y’ be the profit for an article whose selling price is ` 45,000
Hence x + y =` 45,000……………..(A)

2. Statement Showing Present and anticipated cost per article :

Item Present Cost Increase Anticipated
cost
` % ` `

(1) (2) (3) (4) (5)=(2) + (4)

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Direct Material Cost 0.5x 15 0.075x 0.575x

Direct Labour 0.2x 25 0.050x 0.250x

Overheads 0.3x -- -- 0.300x
x 0.125x 1.125x

3. The increase in the cost of direct material and direct labour has reduced the profit by 25 per
cent (as selling price remained unchanged). The increase in cost and reduction in profit
can be represented by the following relation:
1.125x + 0.75y = ` 45,000……………………..(B)
4. On solving relations (A) and (B) as obtained under working notes 1 and 3 above we get :
x = ` 30,000
y = ` 15,000

(i) Present Statement of Profit Per Article

` `
Direct Material Cost 0.5x 15,000
Direct Labour Cost 0.2x 6,000
Overheads 0.3x 9,000
Total Cost 30,000
Profit 15,000
Selling Price 45,000
Note: Profit as a percentage of Cost Price = (` 15,000/` 30,000) x 100
= 50%
Profit as a percentage of Selling Price = (` 15,000/` 45,000) x 100
= 33-1/3%
(ii) Statement of Revised Selling Price
` `
Direct Material Cost 0.575x 17,250
Direct Labour Cost 0.250x 7,500
Overheads 0.300x 9,000
Total Anticipated Cost 33,750
Profit (33-1/3% of selling price) 16,875
Selling Price 50,625
(` 33,750 x 100)/66.66

(c) What do you understand by the term „pre-determined rate of recovery of overheads‟? How
do over –absorption and under-absorption of overheads arise and how are they disposed off in
Cost Accounts? [2+1+3=6]

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Answer.

The term ‘pre-determined’ rate of recovery of overheads’ refers to a rate of overhead

absorption. It is calculated by dividing the budgeted overhead expenses for the accounting
period by the budgeted base for the period. This rate of overhead absorption is determined
prior to the start of the activity; that is why it is called a ‘pre-determined rate’. The use of the pre-
determined rate of recovery of overheads enables prompt preparation of cost estimates and
quotations and fixation of sales prices. For prompt billing on a provisional basis before
completion of work, as for example in the case of cost plus contracts, pre-determined overhead
rates are particularly useful.

Reason for over/under absorption of overheads: Over-absorption of overheads arises due to one
or more of the following reasons.

(i) Improper estimation of overhead.

(ii) Error in estimating the level of production.
(iii) Unanticipated changes in the methods or techniques of production.
(iv) Under-utilisation of the available capacity.
(v) Seasonal fluctuations in the overhead expenses from period to period.

Methods for absorbing under/over absorbed overheads: The over-absorption and under-
absorption of overheads can be disposed off in cost accounting by using any one of the
following methods:

(i) Use of supplementary rates

(ii) Writing off to costing profit & loss Account
(iii) Carrying over to the next year’s account

(i) Use of supplementary rates: This method is used to adjust the difference between
overheads absorbed and overhead actually incurred by computing supplementary
overhead rates. Such rates may be either positive or negative. A positive rate is intended to
add the unabsorbed overheads to the cost of production. The negative rate, however
corrects the cost of production by deducting the amount of over-absorbed overheads. The
effect of applying such a rate is to make the actual overhead get completely absorbed.
(ii) Writing off to costing profit & loss account: When over or under-absorbed amount is quite
negligible and it is not felt worthwhile to absorb it by using supplementary rates, then the
said amount is transferred to costing profit & loss Account. In case under-absorption of
overheads arises due to factors like idle capacity, defective planning etc., it may also be
transferred to costing profit & loss Account.
(iii) Carrying over the next year’s account: Under this method the amount of over/under
absorbed overhead is carried over to the next period. This method is not considered
desirable as it allows costs of one period to affect costs of another period. Further,
comparison between one period and another is rendered difficult. Therefore, this method is
not proper and has only a limited application. However, this method may be used when the

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normal business cycle extends over more than one year, or in the case of a new project, the
output is low in the initial years.

3. (a) A company has the option to procure a particular material from two sources:
Source I assures that defectives will not be more than 2% of supplied quantity.
Source II does not give any assurance, but on the basis of past experience of supplies received
from it, it is observed that defective percentage is 2.8%.
The material is supplied in lots of 1,000 units. Source II supplies the lot at a price, which is lower
by ` 100 as compared to Source I. The defective units of material can be rectified for use at a
cost of ` 5 per unit.
You are required to find out which of the two sources is more economical. [4]

Answer.
Comparative Statement of procuring material from two sources
Material source Material source
I II
Defective (in %) 2 2.8
(Future estimate) (Past experience)
Units supplied (in one lot) 1,000 1,000
Total defective units in a lot 20 28
(1,000 units×2%) (1,000 units ×2.8%)
Additional price paid per lot (`) (A) 100 –
Rectification cost of defect (`) (B) 100 140
(20 units x ` 5) (28 units × ` 5)
Total additional cost per lot (`): [(A)+(B)] 200 140
Decision: On comparing the total additional cost incurred per lot of 1,000 units, we observe
that it is more economical, if the required material units are procured from material
source II.

(b) A skilled worker in XYZ Ltd. Is paid a guaranteed wage rate of ` 30 per hour. The standard
time per unit for a particular product is 4 hours. P, a machine man, has been paid wages under
the Rowan Incentive Plan and he had earned an effective hourly rate of ` 37.50 on the
manufacture of that particular product.
What could have been his total earnings and effective hourly rate, had he been put on Halsey
Incentive Scheme (50%)? [4]
Answer.
Working note:
Let T hours be the total time worked in hours by the skilled worker (machine man P); ` 30/- is
the rate per hour; standard time is 4 hours per unit and effective hourly earning rate is ` 37.50
then
Time saved
Earning = Hours worked × Rate per hour + × Time taken × Rate per hour
Time allowed
(Under Rowan incentive plan)
(4 - T)
` 37.5 T = T × ` 30 + × T × Rs. 30
4
` 37.5 = ` 30 + (4 – T) × ` 7.5
Or ` 7.5 T = ` 22.5

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Or T = 3 hours

Total earnings and effective hourly rate of skilled worker (machine man P) under Halsey
Incentive Scheme (50%)

Total earnings = Hours worked × Rate per hour + ½ Time saved × Rate per hour
(under 50% Halsey Incentive Scheme)
= 3 hours × ` 30 + ½ × 1 hour × ` 30= `105
Total earnings Rs. 105
Effective hourly rate = Rs.35 /
Hours taken 3 hours

(c) Purchase of Materials `5,00,000 (inclusive of Trade Discount `8,000); Import Duty paid `45,000;
Freight inward `62,000 ; Insurance paid for import by air ` 28,000; Rebates allowed `10,000; Cash
discount `3,000; CENVAT Credit refundable `7,000; Abnormal Loss of Materials `14,000; Price
variation due to computation of cost under standard rates `1,500. Compute the landed cost of
material. [4]
Answer.
Computation of Landed Cost of Material

Particulars Amount (`)

Purchase price of Material 5,00,000

Add Import Duties of purchasing the material 45,000

Add Freight Inward during the procurement of material 62,000

Add Price Variation due to computation of cost under standard rates 1,500

Total 6,08,500

Less Trade Discount 8,000

Less Abnormal Loss of materials 14,000

Less Rebates 10,000

Value of Receipt of Material 5,76,500

Note:
(i) Normal loss is not deducted
(ii) Price variation is allowable inclusion as the cost was maintained on standard cost.

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(d) What are the methods of measuring labour turnover? [4]

Answer.
It is essential for any organisation to measure the Labour Turnover. This is necessary for having an
idea about the turnover in the organisation and also to compare the Labour Turnover of the
previous period with the current one. The following methods are available for measurement of
the Labour Turnover:-
(a) Additions Method: Under this method, number of employees added during a particular
period is taken into consideration for computing the Labour Turnover. The method of
computing is as follows.
Labour Turnover = (Number of additions/Average number of workers during the period) ×100
(b) Separation Method: In this method, instead of taking the number of employees added,
number of employees left during the period is taken into consideration. The method of
computation is as follows.
Labour Turnover = Number of separations/Average number of workers during the
period)×100
(c) Replacement Method: In this method neither the additions nor the separations are taken
into consideration. The number of employees replaced is taken into consideration for
computing the Labour turnover.
Labour Turnover = (Number of replacements/Average number of workers during the
period)×100
(d) Flux Method: Under this method Labour Turnover is computed by taking into consideration
the additions as well as separations. The turnover can also be computed by taking
replacements and separations also. Computation is done as per the following methods.
Labour Turnover = ½ [Number of additions + Number of separations] /Average number of
workers during the period X100
Labour Turnover = ½ [Number of replacements + Number of separations] /Average number
of workers during the period X 100

4. (a) PQR Ltd has its own power plant, which has two users, Cutting Department and
Welding Department. When the plans were prepared for the power plant, top management
decided that its practical capacity should be 1,50.000 machine hours. Annual budgeted
practical capacity fixed costs are `9,00,000 and budgeted variable costs are `4 per machine-
hour. The following data are available:
Cutting Welding Total
Department Department
Actual Usage in 2011-12 60,000 40,000 1,00,000
Machine hours)
Practical capacity for each 90,000 60,000 1,50,000
department (machine
hours)
Required

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(i) Allocate the power plant's cost to the cutting and the welding department using a single
rate method in which the budgeted rate is calculated using practical capacity and costs
are allocated based on actual usage.
(ii) Allocate the power plant's cost to the cutting and welding departments, using the dual -
rate method in which fixed costs are allocated based on practical capacity and variable
costs are allocated based on actual usage,
(iii) Allocate the power plant's cost to the cutting and welding departments using the dual-
rate method in which the fixed-cost rate is calculated using practical capacity, but fixed
costs are allocated to the cutting and welding department based on actual usage.
Variable costs are allocated based on actual usage.
(iv) Comment on your results in requirements (i), (ii) and (iii). [3+3+3+2=11]

Answer.
Working notes:
1. Fixed practical capacity cost per machine
hour:
Practical capacity (machine hours) 1,50,000
Practical capacity fixed costs (`) 9,00,000
Fixed practical capacity cost per machine hour `6
(` 9,00,000 / 1,50,000 hours)
2. Budgeted rate per machine hour (using practical capacity):
= Fixed practical capacity cost per machine hour + Budgeted variable cost per
machine hour
= ` 6 + ` 4 = ` 10

(i) Statement showing Power Plant's cost allocation to the Cutting & Welding departments by
using single rate method on actual usage of machine hours.
Cutting Welding Total
Department Department
` ` `
Power plants cost allocation by 6,00,000 4,00,000 10,00,000
using actual usage (machine (60,000 hours (40,000 hours
hours) × ` 10) × ` 10)
(Refer to working note 2)

(ii) Statement showing Power Plant's cost allocation to the Cutting & Welding departments by
using dual rate method.
Cutting Welding Total
Department Department
` `
`
Fixed Cost 5,40,000 3,60,000 9,00,000
(Allocated on practical Rs. 9,00,000 3 Rs. 9,00,000 2
capacity for each department 5 5
i.e.):
(90,000 hours : 60,000 hours)
Variable cost 2,40,000 1,60,000 4,00,000
(Based on actual usage of (60,000 hours (40,000 hours
machine hours) × ` 4) × `4)
Total cost 7,80,000 5,20,000 13,00,000

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(iii) Statement showing Power Plant's cost allocation to the Cutting & Welding Departments using
dual rate method
Cutting Welding Total
Department Department
` ` `
Fixed Cost 3,60,000 2,40,000 6,00,000
Allocation of fixed cost on actual (60,000 hours (40,000 hours
usage basis (Refer to working × ` 6) × ` 6)
note 1)
Variable cost 2,40,000 1,60,000 4,00,000
(Based on actual usage) (60,000 hours (40,000 hours
× ` 4) × ` 4)
Total cost 6,00,000 4,00,000 10,00,000
(iv) Comments:
Under dual rate method, under (iii) and single rate method under (i), the allocation of fixed
cost of practical capacity of plant over each department are based on single rate. The
major advantage of this approach is that the user departments are allocated fixed
capacity costs only for the capacity used. The unused capacity cost ` 3,00,00 (` 9,00,000 – `
6,00,000) will not be allocated to the user departments. This highlights the cost of unused
capacity.
Under (ii) fixed cost of capacity are allocated to operating departments on the basis of
practical capacity, so all fixed costs are allocated and there is no unused capacity
identified with the power plant.

(b) Explain the advantages that would accrue in using the LIFO method of pricing for the
valuation of raw material stock. [4]

Answer.
LIFO- Last-in-first-out: A method of pricing for the valuation of raw material stock. It is based on
the assumption that the items of the last batch (lot) purchased are the first to be issued.
Therefore, under this method, the price of the last batch (lot) of raw material is used for pricing
raw material issues until it is exhausted. If, however, the quantity of raw material issued is more
than the quantity of the latest lot, the price of the last but one lot and so on will be taken for
pricing the raw material issues.

The advantages that would accrue from the use of LIFO method of pricing the valuation of raw
materials, are as follows:-
(i) The cost of materials used is nearer to the current market price. Thus the cost of goods
produced depends upon the trend of the market price of materials. This enables the
matching of cost of production with current sales revenues.
(ii) Use of LIFO during the period of rising prices does not depict unnecessarily high profit in the
income statement; compared to the first-in-first-out or average methods. The profit shown
by the use of LIFO is relatively lower, because the cost of production takes into account the
rising trend of material prices.
(iii) When price of materials fall, the use of LIFO method accounts for raising the profits due to
lower material cost. In spite of this finished product appears to be more competitive and at
market prices.
(iv) Over a period, the use of LIFO will iron out the fluctuations in profit.

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(v) During inflationary period, the use of LIFO will show the correct profit and thus avoid paying
unduly high taxes to some extent.

5. (a) The finishing shop of a company employs 60 direct workers. Each worker is paid
` 400 as wages per week of 40 hours. When necessary, overtime is worked upto a maximum
of 15 hours per week per worker at time rate plus one-half as premium. The current output on
an average is 6 units per man hour which may be regarded as standard output. If bonus
scheme is introduced, it is expected that the output will increase to 8 units per man hour. The
workers will, if necessary, continue to work Overtime upto the specified limit although no
premium on incentives will be paid.
The company is considering introduction of either Halsey Scheme or Rowan Scheme of Wage
Incentive system. The budgeted weekly output is 19,200 units. The selling price is ` 11 per unit
and the direct Material Cost is ` 8 per unit. The variable overheads amount to ` 0.50 per
direct labour hour and the fixed overhead is Rs, 9,000 per week.
Prepare a Statement to show the effect on the Company‟s weekly Profit of the proposal to
introduce (a) Halsey Scheme, and (b) Rowan Scheme. [8]

Answer.
Working notes:
1. Total available hours per week 2,400
(60 workers × 40 hours)
2. Total standard hours required to produce 19,200 units 3,200
(19,200 units/6 units per hour)
3. Total labour hours required after the 2,400
introduction of bonus scheme to produce 19,200 units
(19,200 units / 8 units per man hour)
4. Time saved in hours 800
(3,200 hours – 2,400 hours)
5. Wage rate per hour (`) 10
(` 400/40 hours)
6. Bonus:
1
(a) Halsey Scheme = × Time saved × Wage rate per hour
2
1
= x 800 hours x ` 10 = ` 4,000
2
Time saved
(b) Rowan Scheme = × Time taken × Wage rate per hour
Time allowed

800 hours
= × 2,400 hours × ` 10
3,200 hours
= ` 6,000

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Statement showing the effect on the Company‟s Weekly

present profit by the introduction of Halsey & Rowan schemes
Present Halsey Rowan
` ` `
Sales revenue: (A) 2,11,200 2,11,200 2,11,200
(19,200 units × ` 11)
Direct material cost 1,53,600 1,53,600 1,53,600
(19,200 units × ` 8)
Direct wages 32,000 24,000 24,000
(Refer to working notes 2 & 3) (3,200 hrs 2,400 hrs (2,400 hrs.
× ` 10) × ` 10) ×` 10)
Overtime premium 4,000 - -
(800 hrs.
× ` 5)
Bonus - 4,000 6,000
(Refer to working notes 6 (i) & (ii))
Variable overheads 1,600 1,200 1,200
(3,200 hrs. (2,400 hrs. (2,400 hrs.
× 0.50 P) × 0.50 P) × 0.50 P)
Fixed overheads 9,000 9,000 9,000
Total cost : (B) 2,00,200 1,91,800 1,93,800
Profit: {(A)- (B)} 11,000 19,400 17,400

(b) A Ltd. Co. has capacity to produce 1,00,000 units of a product every month. Its works cost at
varying levels of production is as under:
Level Works cost per unit
`
10% 400
20% 390
30% 380
40% 370
50% 360
60% 350
70% 340
80% 330
90% 320
100% 310
Its fixed administration expenses amount to ` 1,50,000 and fixed marketing expenses amount
to ` 2,50,000 per month respectively. The variable distribution cost amounts to ` 30 per unit.
It can market 100% of its output at ` 500 per unit provided it incurs the following further
expenditure:
a. It gives gift items costing, ` 30 per unit of sale;
b. It has lucky draws every month giving the 1 st prize of ` 50,000; 2nd prize of ` 25,000, 3rd
prize of ` 10,000 and three consolation prizes of Rs, 5,000 each to customers buying the
product.

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c. It spends ` 1,00,000 on refreshments served every month to its customers;

d. It sponsors a television programme every week at a cost of ` 20,00,000 per month.
It can market 30% of its output at ` 550 per unit without incurring any of the expenses referred
to in (a) to (d) above.
Advise the company on its course of action. Show the supporting cost sheets. [8]

Answer.
Cost Sheet (for the month)
Level of capacity 30% 100%
Level of output Produce (Units) 30,000 1,00,000
Per Unit Total Per Unit Total (`)
(`) (`) (`)
Works cost 380.00 1,14,00.00 310,00 3,10,00,000
0
Add: Fixed administration 5.00 1,50,000 1.50 1,50,000
expenses
Cost of production 385.00 1,15,50,00 311,50 3,11,50,000
0
Add: Fixed marketing expenses 8.33 2,50,000 2.50 2,50,000
Add: Variable distribution cost 30.00 9,00,000 30.00 30,00,000
Add: Special cost
Gift items cost – – 30.00 30,00,000
Customer’s prizes – – 1.00 1,00,000
Refreshments – – 1.00 1,00,000
Television programme sponsorship – – 20.00 20,00,000
cost
Cost of sales 423.33 1,27,00,00 396.00 3,96,00,000
0
Profit 126.67 38,00,000 104.00 1,04,00,000
Sale revenue 550.00 1,65,00,00 500.00 5,00,00,000
0
Advise to the company about the course of action to be taken.
The profit of A Ltd. Co. is more by ` 66 lacs (` 104 lacs – ` 38 lacs), if uses its capacity to
produce 1,00,000 units of a product per month. Hence, it is advisable to the Company to
produce 1,00,000 units and incur the special costs for the marketing of its 100% output.

Section B – Financial Management

(Full Marks: 40)

Answer Question no.6 which is compulsory and any two from the rest in this section.

6. (a) M/s. Sagar Electrical Appliances furnish the following information –

Calculate net cash flow from financing activities :
Particulars 31.12.2011 31.12.2012
Equity share capital 2,00,000 4,50,000
10% debentures 1,00,000 -

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

6% preference shares - 3,00,000

Additional information :
(i) Interest paid on debentures ` 5,000/-
(ii) Dividend paid on equity shares ` 40,000/-
(iii) Bonus shares were issued to existing shareholders in the ratio of 4:1 during the year.[2]

Answer.
(a) Calculation of Net Cash Flow from Financing Activities
Particulars `
Cash proceeds from issues of preference shares 3,00,000
Cash proceeds from issues of equity shares 2,50,000
Redemption of 10% debentures (1,00,000)
Interest paid (5,000)
Dividend paid on equity shares (40,000)
Net cash flow from financing activity 4,05,000

(b) A firm has sales of ` 40 lakhs; variable cost of ` 25 lakhs; fixed cost of ` 6 lakhs; 10% debt
of ` 30 lakhs; and equity capital of ` 45 lakhs. Calculate operating and financial leverage.[2]

Answer.
`
Sales 40,00,000
Less : Variable cost 25,00,000
Contribution 15,00,000
Less : Fixed Cost 6,00,000
EBIT 9,00,000
Less : Interest 3,00,000
EBT 6,00,000

Operating leverage = Contribution/EBIT = 15,00,000/9,00,000 = 1.67

Financial leverage = EBIT/EBT = 9,00,000/6,00,000 = 1.50

(c) Explain the role of „Operational Efficiency‟ in the determination of working capital
requirement. [2]
Answer.
The firm with a better operational efficiency has to invest less in working capital because :
(i) They convert raw materials quickly into finished goods, and sell them at their earliest,
i.e., converts stock into sales quickly.
(ii) Promptly collects debts from debtors and bills receivable.

(d) What is Financial Risk ? How does it arise ? [2]

Answer.
It refers to the risk of the company not being able to cover its fixed financial cost. Fixed financial
cost includes payment of interest that is to be paid irrespective of profit.

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

The higher level of risk are attached to higher degrees of financial leverage. If EBIT (earnings
before interest and tax) decreases, financial risk increases as the firm is not in a position to pay its
interest obligations. Thus the risk of default is called Financial Risk. The firm should overcome the
situation accordingly or will be forced towards liquidation.

7. (a) The following is the capital structure of Simons Company Ltd. as on 31.12.2012:
`
Equity shares: 10,000 shares (of ` 100 each) 10,00,000
10% Preference Shares (of ` 100 each) 4,00,000
12% Debentures 6,00,000
20,00,000
The market price of the company‟s share is ` 110 and it is expected that a dividend of ` 10 per
share would be declared for the year 2012. The dividend growth rate is 6%:
(i) If the company is in the 40% tax bracket, compute the weighted average cost of capital.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund
of ` 10 lakh bearing 14% rate of interest, what will be the company‟s revised weighted
average cost of capital? This financing decision is expected to increase dividend from ` 10
to ` 12 per share. However, the market price of equity share is expected to decline from `
110 to ` 105 per share. [2+4=6]

Answer
(i) Computation of the weighted average cost of capital

Source of finance Proportion After tax cost (%) (1- Weighted average
tax rate i.e. 40%) cost of capital (%)
(a) (b) (c) (d)= (b) (c)

Equity share 0.5 15.09 7.54

(Refer to working note 1)
10% Preference share 0.2 10.00 2.00
12% Debentures 0.3 7.20 2.16
Weighted average cost of 11.70
capital

(ii) Computation of Revised weighted average cost of capital

Source of finance Proportion After tax cost (%) (1- Weighted average
tax rate i.e. 40%) cost of capital (%)
(a) (b) (c) (d)= (b) (c)

Equity share 0.333 17.42 5.80

(Refer to working note 2)
10% Preference share 0.133 10.00 1.33
12% Debentures 0.200 7.20 1.44
14% Loan 0.333 8.40 2.80
Revised weighted average cost of capital 11.37

Working Notes:
(1) Cost of equity shares (K e)
Dividend per share
Ke Growth rate
Marketprice per share

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

10
0.06
110
= 0.1509 or 15.09%
(2) Revised cost of equity shares (Ke)
12
Revised K e 0.06
105
= 0.1742 or 17.42%

(b) Following are the data on a capital project being evaluated by the management of X Ltd.
Project M
`
Annual cost saving 4,00,000
Useful life 4 years
I.R.R. 15%
Profitability Index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0

Find the missing values considering the following table of discount factor only:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
[6]
Answer
Cost of Project M
At 15% I.R.R., the sum total of cash inflows = Cost of the project i.e. Initial cash outlay
Given:
Annual cost saving ` 4,00,000
Useful life 4 years
I.R.R. 15%
Now, considering the discount factor table @ 15% cumulative present value of cash inflows
for 4 years is 2.855. Therefore, Total of cash inflows for 4 years for Project M is (` 4,00,000
2.855) = ` 11,42,000
Hence cost of project is = ` 11,42,000

Payback period of the Project M

Cost of the project Rs. 11,42,000
Pay back period
Annualcost saving 4,00,000
= 2.855 or 2 years 11 months approximately

Cost of Capital
If the profitability index (PI) is 1, cash inflows and outflows would be equal. In this case, (PI) is

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

1.064. Therefore, cash inflows would be more by 0.64 than outflow.

Discounted cash inflows
Profitability index (PI)
Cost of the project
Discounted cash inflows
Or 1.064
Rs. 11,42,000
or 1.064 ` 11,42,000 = ` 12,15,088. Hence, Discounted cash inflows = ` 12,15,088

Since, Annual cost saving is ` 4,00,000. Hence, cumulative discount factor for 4 years
12,15,088
Rs.
4,00,000
= 3.037725 or 3.038

Considering the discount factor table at discount rate of 12%, the cumulative discount factor
for 4 years is 3.038. Hence, the cost of capital is 12%.

Net present value of the project.

N.P.V. = Total present value of cash inflows – Cost of the project
= ` 12,15,088 – ` 11,42,000
= ` 73,088.

(c) S Ltd. has ` 10,00,000 allocated for capital budgeting purposes. The following proposals and
associated profitability indexes have been determined:
Project Amount Profitability
Index
`
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and
there is no alternative use of the money allocated for capital budgeting. [4]

Answer.
Statement showing ranking of projects on the basis of Profitability Index
Project Amount P.I. Rank
1 3,00,000 1.22 1
2 1,50,000 0.95 5
3 3,50,000 1.20 2
4 4,50,000 1.18 3
5 2,00,000 1.20 2
6 4,00,000 1.05 4

Assuming that projects are indivisible and there is no alternative use of the money allocated for
capital budgeting on the basis of P.I., the S Ltd., is advised to undertake investment in projects
1.3, and 5. However, among the alternative projects the allocation should be made to the
projects which adds the most to the shareholders wealth. The NPV method, by its definition, will

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

always select such projects.

Statement showing NPV of the projects

Project Amount P.I. Cash inflows N.P.V. of
(`) of project Project (`)
(`)
(i) (ii) (iii) (iv) = [(ii) (v) = [(iv) –
(iii)] (ii)]
1 3,00,000 1.22 3,66,000 66,000
2 1,50,000 0.95 1,42,500 ( )7,500
3 3,50,000 1.20 4,20,000 70,000
4 4,50,000 1.18 5,31,000 81,000
5 2,00,000 1.20 2,40,000 40,000
6 4,00,000 1.05 4,20,000 20,000

The allocation of funds to the projects 1, 3 and 5 (as selected above on the basis of P.I.) will give
N.P.V. of ` 1,76,000 and ` 1,50,000 will remain unspent.

However, the N.P.V. of the projects 3, 4 and 5 is ` 1,91,000 which is more than the N.P.V. of
projects 1, 3 and 5. Further, by undertaking projects 3, 4 and 5 no money will remain unspent.
Therefore, S Ltd. is advised to undertake investments in projects 3, 4 and 5.

8. (a) A newly formed company has applied to the commercial bank for the first time for
financing its working capital requirements. The following information is available about the
projections for the current year:

Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-
progress. Based on the above activity, estimated cost per unit is:

Raw material ` 80 per unit

Direct wages ` 30 per unit
Overheads (exclusive of depreciation) ` 60 per unit
Total cost ` 170 per unit
Selling price ` 200 per unit

Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50%

completion stage in respect of conversion cost) (materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1 ½ weeks
Cash at banks (for smooth operation) is expected to be ` 25,000

Assume that production is carried on evenly throughout the year (52 weeks) and wages and
overheads accrue similarly. All sales are on credit basis only.

Find out the net working capital required. [10]

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

Answer.
Estimate of the Requirement of Working Capital
` `
A. Current Assets:
Raw material stock 6,64,615
(Refer to Working note 3)
Work in progress stock 5,00,000
(Refer to Working note 2)
Finished goods stock 13,60,000
(Refer to Working note 4)
Debtors 29,53,846
(Refer to Working note 5)
Cash and Bank balance 25,000 55,03,461
B. Current Liabilities:
Creditors for raw materials 7,15,740
(Refer to Working note 6)
Creditors for wages 91,731 8,07,471
(Refer to Working note 7) ________
Net Working Capital (A-B) 46,95,990

Working Notes:
1. Annual cost of production
`
Raw material requirements (1,04,000 units ` 80) 83,20,000
Direct wages (1,04,000 units ` 30) 31,20,000
Overheads (exclusive of depreciation)(1,04,000 ` 60) 62,40,000
1,76,80,000
2. Work in progress stock
`
Raw material requirements (4,000 units ` 80) 3,20,000
Direct wages (50% 4,000 units ` 30) 60,000
Overheads (50% 4,000 units ` 60) 1,20,000
5,00,000
3. Raw material stock
It is given that raw material in stock is average 4 weeks consumption. Since, the
company is newly formed, the raw material requirement for production and work in
progress will be issued and consumed during the year.
Hence, the raw material consumption for the year (52 weeks) is as follows:
`
For Finished goods 83,20,000
For Work in progress 3,20,000
86,40,000
Rs. 86,40,000
Raw material stock 4 weeks
52 weeks
i.e. ` 6,64,615

4. Finished goods stock

8,000 units @ ` 170 per unit = ` 13,60,000

5. Debtors for sale

Credit allowed to debtors Average 8 weeks
Credit sales for year (52 weeks) i.e. (1,04,000 units- 96,000 units

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

8,000 units)
Selling price per unit ` 200
Credit sales for the year (96,000 units ` 200) ` 1,92,00,000
Debtors Rs.1,92,00,000
8 weeks
52 weeks
i.e ` 29,53,846

6. Creditors for raw material:

Credit allowed by suppliers Average 4 weeks
Purchases during the year (52 weeks) i.e. ` 93,04,615
(` 83,20,000 + ` 3,20,000 + ` 6,64,615)
(Refer to Working notes 1,2 and 3 above)
Creditors Rs. 93.04.615
4 weeks
52 weeks
i.e ` 7,15,740

7. Creditors for wages

Lag in payment of wages 1
Average 1 weeks
2
Direct wages for the year (52 weeks) i.e. ` 31,80,000
(` 31,20,000 + ` 60,000)
(Refer to Working notes 1 and 2 above)
Creditors Rs. 31,80,000 1
1 weeks
52 weeks 2
i.e. ` 91,731

(b) Explore the interrelationship between Investment, Finance and Dividend Decisions. [6]

Answer.
The finance functions are divided into three major decisions, viz., investment, financing and
dividend decisions. It is correct to say that these decisions are inter-related because the
underlying objective of these three decisions is the same, i.e. maximisation of shareholders’
wealth. Since investment, financing and dividend decisions are all interrelated, one has to
consider the joint impact of these decisions on the market price of the company’s shares and
these decisions should also be solved jointly. The decision to invest in a new project needs the
finance for the investment. The financing decision, in turn, is influenced by and influences
dividend decision because retained earnings used in internal financing deprive shareholders of
their dividends. An efficient financial management can ensure optimal joint decisions. This is
possible by evaluating each decision in relation to its effect on the shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and
to see how they can help in maximising the shareholders’ wealth i.e. market price of the
company’s shares.
Investment decision: The investment of long term funds is made after a careful assessment of the
various projects through capital budgeting and uncertainty analysis. However, only that
investment proposal is to be accepted which is expected to yield at least so much return as is
adequate to meet its cost of financing. This have an influence on the profitability of the
company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves
different issues. The finance manager has to maintain a proper balance between long-term and
short-term funds. With the total volume of long-term funds, he has to ensure a proper mix of loan

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

funds and owner’s funds. The optimum financing mix will increase return to equity shareholders
and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare
dividend. He assists the top management in deciding as to what portion of the profit should be
paid to the shareholders by way of dividends and what portion should be retained in the
business. An optimal dividend pay-out ratio maximises shareholders’ wealth.
We can infer from the above discussion that investment, financing and dividend decisions are
interrelated and are to be taken jointly keeping in view their joint effect on the shareholders’
wealth.

9. The following is the condensed Balance sheet of NHPC Ltd. at the beginning and end of the
year.
Balance Sheets
As at ………………..
Particulars 31.12.2011 31.12.2012
Cash 50,409 40,535
Sundry debtors 77,180 73,150
Temporary investments 1,10,500 84,000
Prepaid expenses 1,210 1,155
Inventories 92,154 1,05,538
Cash surrender value of Life Insurance Policy 4,607 5,353
Land 25,000 25,000
Building, machinery etc. 1,47,778 1,82,782
Debenture discount 4,305 2,867
5,13,143 5,20,380
Sundry creditors 1,03,087 95,656
Outstanding expenses 12,707 21,663
4% mortgage debentures 82,000 68,500
Accumulated depreciation 96,618 81,633
Allowance for inventory loss 2,000 8,500
Reserve for contingencies 1,06,731 1,34,178
Surplus in P & L A/c 10,000 10,250
Share capital 1,00,000 1,00,000
5,13,143 5,20,380

The following information concerning the transaction are available :

i. Net profit for 2012 as per Profit and loss account was ` 49,097
ii. A 10% cash dividend was paid during the year.
iii. The premium of Life Insurance Policies were ` 2,773 of which ` 1,627 was charged
to Profit and Loss Account of the year.
iv. New machinery was purchased for ` 31,365 and machinery costing ` 32,625 was
sold during the year. Depreciation on machinery sold had accumulated to `
29,105 at the date of sale. It was sold as scrap for ` 1,500. The remaining increase
in Fixed Assets resulted from construction of a Building.
v. The Mortgage Debentures mature at the rate of ` 5,000 per year. In addition to the
above, the company purchased and retired ` 8,500 of Debentures at ` 103. Both
the premium on retirement and the applicable discount were charged to Profit
and Loss Account.
vi. The allowance for Inventory Loss was created by a charge to expenses in each
year to provide for obsolete items.

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

vii.
A debit to reserve for contingencies of ` 11,400 was made during the year. This
was in respect of a past tax liability.
You are required to prepare a statement showing the Sources and Applications of funds for the
year 2012. [12]

Answer.

Earning profit is not sufficient, a business should earn sufficient profit to cover its cost of capital
and surplus to grow. Any surplus generated from operating activities over and above the cost of
capital is termed as Economic Value Added (EVA). Economic Value Added measures
economic profit/ loss as opposed to accounting profit/loss. EVA calculates profit/loss after taking
into account the cost of capital, which is the weighted average cost of equity and debt.
Accounting profit on the other hand ignores cost of equity and thus overstates profit or under
states loss.
EVA = NOPAT – K x WACC
Where,
NOPAT = Net operating profit after tax = EBIT (1 – t)
K = Capital employed (Equity + Debt)
WACC = Weighted average cost of equity and debt.

The estimates are fine-tuned through several adjustments. For instance, NOPAT is estimated
excluding non-recurring income or expenditure. PAT is shown in the profit and loss account to
include profit available to the shareholders, both preference and equity. Ability to maintain
dividend is not a test of profit adequacy.
EVA is the right measures for goal setting and business planning, performance evaluation, bonus
determination, capital budgeting and evaluation.
Simply stated Accounting Profit equals Sales Revenue minus all costs except the cost of equity
capital, while Economic Profit is Sales Revenue minus all costs including the opportunity cost of
equity capital. Thus economic profit may be lower than the accounting profit. If accounting
profit equals the opportunity cost of equity capital, economic profit is zero. Only when
accounting profit is greater than the opportunity cost of equity capital, economic profit is
positive. Under perfect competition, all firms in the long run earns zero economic profit.

a) Statement of Sources and Applications of Funds

For the year ended 31st December 2010
Sources ` Applications `
Sale of Machinery 1,500 Purchase of machinery 31,365
Trading profit (adjusted) 75,457 Payment for construction of 36,264
building
76,957 Dividend paid 10,000
Add: Decrease in working 28,600 Redemption of debentures 13,755
capital
Tax liability paid 11,400
Premium on Life Policy 2,773
(1,146 + 1,627)
1,05,557 1,05,557

Workings :
Statement of Change in Working Capital
2009 2010
` `

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Current Assets :
Cash 50,409 40,535
Sundry debtors 77,180 73,150
Temporary investments 1,10,500 84,000
Prepaid expenses 1,210 1,155
Inventories 92,154 1,05,538
3,31,453 3,04,378
Less : Current Liabilities :
Sundry creditors 1,03,087 95,656
Out. Expenses 12,707 21,663
1,15,794 1,17,319
Working capital 2,15,659 1,87,059
Decrease in working capital - 28,600
2,15,659 2,15,659

4% Mortgage Debenture A/c.

Dr. Cr.
Particulars ` Particulars `
To, 4% Mortgage debenture 13,500 By bal b/d 82,000
holders
To, Bal c/d 68,500
82,000 82,000

4% Mortgage Debenture holders’ A/c.

Dr. Cr.
Particulars ` Particulars `
To, Bank A/c. 13,755 By, 4% Mortgage debenture 13,500
a/c.
By, P & L A/c. 255
13,755 13,755

Accumulated Depreciation A/c.

Dr. Cr.
Particulars ` Particulars `
To, Building, machinery etc. 29,105 By, Bal b/d 96,618
To, Bal c/d 81,633 By, P & L A/c. 14,120
1,10,738 1,10,738

Allowance for Inventory Loss A/c.

Dr. Cr.
Particulars ` Particulars `
To, Bal c/d 8,500 By, Bal b/d 2,000
By, P & L A/c. (bal. fig.) 6,500
8,500 8,500

Reserve for Contingencies A/c.

Dr. Cr.
Particulars ` Particulars `
To, Tax liability (paid) 11,400 By, Bal b/d 1,06,731
To, Bal c/d 1,34,178 By, P & L A/c. (bal. fig.) 38,847
1,45,578 1,45,578

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

Life Insurance Policy A/c.

Dr. Cr.
Particulars ` Particulars `
To, Bal b/d 4,607 By, P & L A/c. (excess over 400
surrender value)
To, Bank (premium) 1,146 By, Balance c/d 5,353
5,753 5,753

Building and Machinery A/c.

Dr. Cr.
Particulars ` Particulars `
To, Balance b/d 1,47,778 By, Accumulated Dep. 29,105
To, Bank a/c (Purchase) 31,365 By, Bank a/c. (sales) 1,500
To, Bank a/c. (bal. fig.) 36,264 By, P & L a/c. (loss on sale) 2,020
(Construction cost of building)
By, Balance c/d 1,82,782
2,15,407 2,15,407

Debenture Discount A/c.

Dr. Cr.
Particulars ` Particulars `
To, Balance b/d 4,305 By, P & L a/c. (bal. fig.) 1,438
By, Balance c/d 2,867
4,305 4,305

Profit and Loss A/c.

Dr. Cr.
Particulars ` Particulars `
To, Dividend 10,000 By, Balance b/d 10,000
To, Life insurance policy 400 By, Trading profit (adjusted bal. 75,457
fig.)
To, Debenture discount 1,438
To, Reserve for contingencies 38,847
To, Allow. For inventory loss 6,500
To, 4% Mort. Debentureholders 255
To, Accumulated depreciation 14,120
To, Building and Mach. (loss) 2,020
To, Bank (life insurance 1,627
premium)
To, Balance c/d 10,250
85,457 85,457

(b) When a lease can be considered as a Financial Lease ? [4]

Answer.
A lease is considered as a Financial lease if the lessor intends to recover his capital outlay plus
the required rate of return on funds during the period of lease. It is a form of financing the assets
under the cover of lease transaction. A financial lease is a noncancellable contractual
commitment on the part of the lessee (the user) to make a series of payments to the lessor for

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 Answer to MTP_Intermediate_Syllabus 2012_Dec2013_Set 1

the use of an asset. In this type of leases, lessee will use and have control over the asset without
holding ownership of the asset. The lessee is expected to pay for upkeep and maintenance of
the asset. This is also known by the name ‘capital lease’. The essential point of this type of lease
agreement is that it contains a condition whereby the lessor agrees to transfer the title for the
asset at the end of the lease period at a nominal cost. At the end of lease it must give an option
to the lessee to purchase the asset he has used. Under this lease usually 90% of the fair value of
the asset is recovered by the lessor as lease rentals and the lease period is 75% of the economic
life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset
ownership and all the benefits arising therefrom is transferred to the lessee who bears the cost of
maintenance, insurance and repairs. Only the title deeds remain with the lessor.

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