PAPER – 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT …

PAPER – 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT Question No. 1 is compulsory.

Attempt any five questions from the remaining six questions. Working notes should form part of the answers.

Question 1 Answer the following: (a) The following particulars refer to process used in the treatment of material subsequently,

incorporated in a component forming part of an electrical appliance:

(i) The original cost of the machine used (Purchased in June 2008) was ` 10,000. Its estimated life is 10 years, the estimated scrap value at the end of its life is ` 1,000, and the estimated working time per year (50 weeks of 44 hours) is 2,200 hours of which machine maintenance etc., is estimated to take up 200 hours.

No other loss of working time expected, setting up time, estimated at 100 hours, is regarded as productive time. (Holiday to be ignored).

(ii) Electricity used by the machine during production is 16 units per hour at cost of a 9 paisa per unit. No current is taken during maintenance or setting up.

(iii) The machine required a chemical solution which is replaced at the end of week at a cost of ` 20 each time.

(iv) The estimated cost of maintenance per year is ` 1,200.

(v) Two attendants control the operation of machine together with five other identical machines. Their combined weekly wages, insurance and the employer's contribution to holiday pay amount ` 120.

(vi) Departmental and general works overhead allocated to this machine for the current year amount to ` 2,000.

You are required to calculate the machine hour rate of operating the machine. (b) A dairy product company manufacturing baby food with a shelf life of one year furnishes

the following information:

(i) On 1st January, 2016, the company has an opening stock of 20,000 packets whose variable cost is `180 per packet.

(ii) In 2015, production was 1,20,000 packets and the expected production in 2016 is 1,50,000 packets. Expected sales for 2016 is 1,60,000 packets.

© The Institute of Chartered Accountants of India

PAPER – 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 47

(iii) In 2015, fixed cost per unit was ` 60 and it is expected to increase by 10% in 2016. The variable cost is expected to increase by 25%. Selling price for 2016 has been fixed at ` 300 per packet.

You are required to calculate the Break-even volume in units for 2016. (c) (i) What is a sinking fund and how is it calculated ?

(ii) A company has purchased a plant for ` 10,00,000 with a useful life of 6 years. It expects that ` 15,00,000 will be required to replace the plant after 6 years. To ensure that money is available at the time of replacement, the company has created a sinking fund.

You are required to determine the amount to be deposited annually, if the fund earns interest at 8% per annum. Given CVFA0.08,6 = 7.336.

(d) A company had the following balance sheet as on 31st March, 2015

Liabilities Amount (`) Assets Amount (`) Equity share capital of ` 10 each 40,00,000 Fixed Assets (Net) 1,28,00,000 Reserve & Surplus 8,00,000 Current Assets 32,00,000 15% Debentures 80,00,000 Current Liabilities 32,00,000 1,60,00,000 1,60,00,000

The additional information given is as under:

Fixed cost per annum (excluding interest) ` 32,00,000 Variable operating cost ratio 70% Total assets turnover ratio 2.5 Income tax rate 30%

Calculate the following: (i) Operating Leverage (ii) Financial Leverage (iii) Combined Leverage (iv) Earning per share (5 × 4 = 20 Marks)

Answer (a) Working Notes:

(i) Total Productive hours = Estimated Working hours – Machine Maintenance hours = 2,200 hours – 200 hours = 2,000 hours


48 INTERMEDIATE (IPC) EXAMINATION: MAY, 2016

(ii) Depreciation per annum = 10,000 - 1,00010years

` ` = ` 900

(iii) Chemical solution cost per annum = ` 20 × 50 weeks = ` 1,000

(iv) Wages of attendants (per annum) = ×120 50 weeks6 machines

` = ` 1,000

Calculation of Machine hour rate

Particulars Amount (per annum)

Amount (per hour)

A. Standing Charge (i) Wages of attendants 1,000

(ii) Departmental and general works overheads 2,000 Total Standing Charge 3,000

Standing Charges per hour 3,0002,000

1.5

B. Machine Expense (iii) Depreciation 900 0.45 (iv) Electricity

0.09×16units×1,900hours2,000hours

`

- 1.37

(v) Chemical solution 1,000 0.50 (vi) Maintenance cost 1,200 0.60 Machine operating cost per hour (A + B) 4.42

(b) Working Notes: Particulars 2015 (`) 2016 (`) Fixed Cost 72,00,000

(` 60 × 1,20,000 units) 79,20,000

(110% of ` 72,00,000) Variable Cost 180 225

(125% of ` 180)

Calculation of Break-even Point (in units): Since, shelf life of the product is one year only, hence, opening stock is to be sold first.



(`) Total Contribution required to recover total fixed cost in 2016 and to reach break-even volume.

79,20,000

Less: Contribution from opening stock {20,000 units × (` 300 – ` 180)}

24,00,000

Balance Contribution to be recovered 55,20,000

Units to be produced to get balance contribution

= 55,20,000300 225−

`

` ` = 73,600 packets.

Break-even volume in units for 2016

Packets From 2016 production 73,600 Add: Opening stock from 2015 20,000 93,600

(c) (i) It is the fund created for a specified purpose by way of sequence of periodic payments over a time period at a specified interest rate. Size of the sinking fund is calculated as follows: FVA = R[FVIFA (i,n)]

Where, ‘FVA’ is the amount to be saved, ‘R’ is the periodic payment and ‘n’ the payment period.

Alternatively, the sinking fund amount can be calculated by using following formula.

Maturity value of Sinking Fund = Sinking Fund deposit × n(1 i) 1

i+ −

(ii) Amount to be deposited annually

= (8%,6years)

Future ValueCVFA

= 15,00,0007.336

` = ` 2,04,471.10

Alternatively, amount to be deposited can be calculated as follows:

Maturity value of Sinking Fund = Sinking Fund deposit × n(1 i) 1

i+ −

15,00,000 = Sinking fund amount × (1+0.08)6 – 1 / 0.08 Sinking fund amount to be deposited = `2,04,464



(d) Workings:

Total Assets Turnover Ratio i.e. SalesTotalAssets

= 2.5

Since total Assets = ` 1,60,00,000 So, Sales = 2.5 × ` 1,60,00,000 = ` 4,00,00,000

Computation of Profit after tax (PAT/ EAT):

Particulars Amount (`)

Sales Turnover 4,00,00,000 Less: Variable Cost (70% of ` 4,00,00,000) (2,80,00,000) Contribution 1,20,00,000 Less: Fixed Costs (32,00,000) Earnings Before Interest and Tax (EBIT) 88,00,000 Less: Interest on Debenture (15% of ` 80,00,000) (12,00,000) Earnings Before Tax (EBT) 76,00,000 Less: Income Tax @30% (22,80,000) Earnings After Tax (EAT or PAT) 53,20,000

(i) Operating Leverage = ContributionEBIT

= 1,20,00,00088,00,000

`

` = 1.36

(ii) Financial Leverage = EBITEBT

= 88,00,00076,00,000

`

` = 1.16

(iii) Combined Leverage = ContributionEBT

= 1,20,00,00076,00,000

`

` = 1.58

Or Combined Leverage = Operating Leverage × Financial Leverage

= 1.36 × 1.16 = 1.58

(iv) Earning per share = PAT / EATNo.of Shares

= 53,20,0004,00,000shares

` = ` 13.30

Question 2 (a) The following information is available from a company's records for March, 2016:



(a) Opening Balance of Creditors Account ` 25,000 (b) Closing Balance of Creditors Account ` 40,000 (c) Payment made to Creditors ` 5,80,000 (d) Opening Balance of Stores Ledger Control Account ` 40,000 (e) Closing Balance of Stores Ledger Control Account ` 65,000 (f) Wages paid (for 8000 hours) 20% relate to indirect workers ` 4,00,000 (g) Various indirect expenses incurred ` 60,000 (h) Opening balance of WIP control account ` 50,000 (i) Inventory of WIP at the end of the month includes material worth ` 35,000 on

which 400 labour hours have been booked. (j) Factory overhead is charged to production at budgeted rate based on direct

labour hours. (k) Budgeted overhead cost is ` 20,80,000 for budgeted direct labour hours

1,04,000.

You are required to prepare Creditors A/c, Stores Ledger Control A/c, WIP Control A/c, Wages Control A/c and Factory Overhead Control A/c. (8 Marks)

(b) With the following ratios and further information given below prepare a Trading Account, Profit and Loss Account and Balance Sheet of ABC Company.

Fixed Assets `40,00,000 Closing Stock `4,00,000 Stock turnover ratio 10 Gross profit ratio 25 percent Net profit ratio 20 percent Net profit to capital 1/5 Capital to total liabilities 1/2 Fixed assets to capital 5/4 Fixed assets/Total current assets 5/7

(8 Marks)

Answer (a) Creditors A/c

Dr. Cr. Particulars (`) Particulars (`) To Bank A/c 5,80,000 By Balance b/d 25,000



To Balance c/d 40,000 By Stores ledger control A/c (Materials purchased)(Bal. figure)

5,95,000

6,20,000 6,20,000

Stores Ledger Control A/c

Dr. Cr. Particulars (`) Particulars (`) To Balance b/d 40,000 By WIP control A/c

(Balancing figure) 5,70,000

To Creditors A/c (Materials purchased)

5,95,000 By Balance c/d 65,000

6,35,000 6,35,000

Work-in-Process Control A/c

Dr. Cr. Particulars (`) Particulars (`) To Balance b/d 50,000 By Finished goods control A/c

(Balancing figure) 10,05,000

To Stores ledger control A/c 5,70,000 By Balance c/d: To Wages control A/c (80% of ` 4,00,000)

3,20,000 - Material 35,000

63,000

- Labour (` 50* × 400 hours)

20,000

- Factory Oh (` 20** × 400 hours)

8,000

To Factory Overhead control A/c

1,28,000

10,68,000 10,68,000

* Direct Labour Hour Rate = ` 3,20,000/ 6,400 hours = ` 50 ** Factory Overhead Rate = ` 20,80,000/ 1,04,000 = ` 20

Wages Control A/c

Dr. Cr. Particulars (`) Particulars (`) To Bank A/c 4,00,000 By WIP control A/c

(80% of ` 4,00,000) 3,20,000



By Factory OH Control A/c (20% of ` 4,00,000)

80,000

4,00,000 4,00,000

Factory Overhead Control A/c

Dr. Cr. Particulars (`) Particulars (`) To Wages control A/c 80,000 By WIP control A/c

(` 20 × 6,400 hours) 1,28,000

To Bank A/c (Indirect expenses)

60,000 By Balance c/d 12,000

1,40,000 1,40,000

(b) Workings:

(i) Fixed Assets 5TotalCurrent Assets 7

=

Or, Total Current Assets = ×40,00,000 75

` = ` 56,00,000

(ii) Fixed Assets 5Capital 4

= Or, Capital = ×40,00,000 45

` = ` 32,00,000

(iii) Capital 1TotalLiabilities * 2

= Or, Total liabilities = ` 32,00,000 × 2 = ` 64,00,000

*It is assumed that Total liabilities does not include capital.

(iv) NetPr ofit 1Capital 5

= Or, Net Profit = ` 32,00,000 × 1/5 = ` 6,40,000

(v) NetPr ofit 1Sales 5

= Or, Sales = ` 6,40,000 × 5 = ` 32,00,000

(vi) Gross Profit = 25% of ` 32,00,000 = ` 8,00,000

(vii) Stock Turnover = Cost of GoodsSold(i.e .Sales Grossprofit) 10AverageStock

−=

= −=

32,00,000 8,00,000 10AverageStock

` `



Or, Average Stock = ` 2,40,000 Or, +OpeningStock 4,00,0002

` = ` 2,40,000

Or, Opening Stock = ` 80,000 Trading Account

Particulars (`) Particulars (`) To Opening Stock 80,000 By Sales 32,00,000 To Manufacturing exp./ Purchase (Balancing figure)

27,20,000

To Gross Profit b/d 8,00,000 By Closing Stock 4,00,000 36,00,000 36,00,000

Profit and Loss Account Particulars (`) Particulars (`) To Operating Expenses (Balancing figure)

1,60,000 By Gross Profit c/d 8,00,000

To Net Profit 6,40,000 8,00,000 8,00,000

Balance Sheet Capital and Liabilities (`) Assets (`) Capital 32,00,000 Fixed Assets 40,00,000 Liabilities 64,00,000 Current Assets: Closing Stock 4,00,000 Other Current Assets

(Bal. figure)

52,00,000 96,00,000 96,00,000

Question 3 (a) X Associates undertake to prepare income tax returns for individuals for a fee. They use

the weighted average method and actual costs for the financial reporting purposes. However, for internal reporting, they use a standard costs system. The standards, based on equivalent performance, have been established as follows: Labour per return 5 hrs @ ` 40 per hour Overhead per return 5 hrs @ ` 20 per hour



For March 2015 performance, budgeted overhead is `98,000 for standard labour hours allowed.

The following additional information pertains to the month of March 2015:

March 1 Return-in-process (25% complete) 200 No. Return started in March 825 Nos March 31 Return-in-process (80% complete) 125 Nos

Cost Data:

March 1 Return-in-process labour ` 12,000 - Overheads ` 5,000 March 1 to 31 Labour : 4,000 hours ` 1,78,000 Overheads ` 90,000

You are required to compute:

(a) For each element, equivalent units of performance and the actual cost per equivalent unit.

(b) Actual cost of return-in-process on March 31.

(c) The standard cost per return.

(d) The labour rate and labour efficiency variance as well as overhead volume and overhead expenditure variance. (8 Marks)

(b) A trader whose current sales are ` 4,20,000 per annum and an average collection period of 30 days, wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following information:

Credit Policy Increase in Collection Period

Increase in Sales Present default anticipated

I 10 days ` 21,000 1.5% II 30 days `52,500 3% III 45 days `63,000 4%

The selling price per unit is ` 3. Average cost per unit is `2.25 and variable cost per unit is ` 2. The current bad-debts loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.

Which of the above policies would you recommend for adoption? (8 Marks)



Answer (a) (a) Statement Showing Cost Elements Equivalent Units of Performance and the

Actual Cost per Equivalent Unit Detail of Returns Detail of

Input Units

Details Equivalent Units Output Units

Labour Overheads Units % Units %

Returns in Process at Start

200 Returns Completed in March

900 900 100 900 100

Returns Started in March

825 Returns in Process at the end of March

125 100 80 100 80

1,025 1,025 1,000 1,000

Costs: (`) (`) From previous month 12,000 5,000

During the month 1,78,000 90,000 Total Cost 1,90,000 95,000 Cost per Equivalent Unit 190.00 95.00

(b) Actual cost of returns in process on March 31: Numbers Stage of

Completion Rate per

Return (`) Total

(`) Labour 125 returns 0.80 190.00 19,000 Overhead 125 returns 0.80 95.00 9,500 28,500

(c) Standard Cost per Return: Labour 5 Hrs × ` 40 per hour = ` 200 Overhead 5 Hrs × ` 20 per hour = ` 100 ` 300 Budgeted volume for March = ` 98,000 / 1000 = 980 Returns

Actual labour rate = ` 178000 / 4000 = `44.50



(d) Computation of Variances: Statement Showing Output (March only) Element Wise Labour Overhead Actual performance in March in terms of equivalent units as Calculated above

1,000

1,000

Less: Returns in process at the beginning of March in terms of equivalent units i.e. 25% of returns (200)

50

50

950 950

Variance Analysis: Labour Rate Variance = Actual Time × (Standard Rate – Actual Rate) = Standard Rate × Actual Time – Actual Rate × Actual Time = ` 40 × 4,000 hrs. – ` 1,78,000 = ` 18,000(A) Labour Efficiency Variance = Standard Rate × (Standard Time – Actual Time) = Standard Rate × Standard Time – Standard Rate × Actual Time = ` 40 × (950 units × 5 hrs.) – ` 40 × 4,000 hrs. = ` 30,000(F) Overhead Expenditure or Budgeted Variance = Budgeted Overhead – Actual Overhead = ` 98,000 – ` 90,000

= ` 8,000(F)

Overhead Volume Variance = Recovered/Absorbed Overhead – Budgeted Overhead = 950 Units × 5 hrs. × `20 – ` 98,000 = ` 3,000(A)

(b) A. Statement showing the Evaluation of Debtors Policies (Total Approach) Particulars Present Policy

(30 days) Proposed

Policy I (40 days)

Proposed Policy II

(60 days)

Proposed Policy III (75 days)

(`) (`) (`) (`) A. Expected Profit: (a) Credit Sales 4,20,000 4,41,000 4,72,500 4,83,000 (b) Total Cost (other than



Bad Debts) (i) Variable Costs [Sales x ` 2/` 3]

2,80,000 2,94,000 3,15,000 3,22,000

(ii) Fixed Costs (W.N. 1)

35,000 35,000 35,000 35,000

Total Cost (Variable Cost + Fixed Cost)

3,15,000 3,29,000 3,50,000 3,57,000

(c) Bad Debts 4,200 (1% of

4,20,000)

6,615 (1.5% of

4,41,000)

14,175 (3% of

4,72,500)

19,320 (4% of

4,83,000) (d) Expected Profit [(a) –

(b) – (c)] 1,00,800 1,05,385 1,08,325 1,06,680

B. Opportunity Cost of Investments in Receivables *

5,25030 20

(3,15,000x x )360 100

7,31140 20

(3,29,000x x )360 100

11,66760 20

(3,50,000x x )360 100

14,875

75 20(3,57,000x x )

360 100

C. Net Benefits (A – B) 95,550 98,074 96,658 91,805

Recommendation: The Proposed Policy I (i.e. increase in collection period by 10 days or total 40 days) should be adopted since the net benefits under this policy are higher as compared to other policies. Working Note- 1: (i) Calculation of Fixed Cost

= [Average Cost per unit – Variable Cost per unit] × No. of Units sold = [(2.25 – 2) × (` 4, 20,000/3)] = ` 35,000 *Calculation of Opportunity Cost of Average Investments

Opportunity Cost = Total Cost × Collectionperiod Rate of return360days 100

×

Note 1 : It is assumed that all sales are credit sales only. Note 2 : This question can also be solved based on incremental approach as well as by computing Expected Rate of Return.

Question 4 (a) A factory producing article A also produces a by-product B which is further processed

into finished product. The joint cost of manufacture is given below:



Material ` 5,000 Labour ` 3,000 Overhead ` 2,000 ` 10,000

Subsequent cost in ` are given below:

A B Material 3,000 1,500 Labour 1,400 1,000 Overhead 600 500 5,000 3,000

Selling prices are A ` 16,000 B ` 8,000 Estimated profit on selling prices is 25% for A and 20% for B.

Assume that selling and distribution expenses are in proportion of sales prices. Show how you would apportion joint costs of manufacture and prepare a statement showing cost of production of A and B. (8 Marks)

(b) Given below are the data on a capital project 'C':

Cost of the project ` 2,28,400 Useful life 4 years Profitability index 1.0417 Internal rate of return 15% Salvage value 0

You are required to calculate:

(i) Annual cash flow

(ii) Cost of capital

(iii) Net present value (NPV)

(iv) Discounted payback period

Given the following table of discount factors:

Discount Factor 15% 14% 13% 12% 1 years 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

(8 Marks) Answer (a) Apportionment of Joint Costs

Particulars A (`) B (`) Selling Price 16,000 8,000 Less: Estimated profit 4,000

(25% of `16,000) 1,600

(20% of ` 8,000) Cost of sales 12,000 6,400 Less: Selling & Distribution exp. (Refer working note)

267 (` 400 × 2/3)

133 (` 400 × 1/3)

Less: Subsequent cost 5,000 3,000 Share of Joint cost 6,733 3,267

So, Joint cost of manufacture is to be distributed to A & B in the ratio of 6733 : 3267 Statement showing Cost of Production of A and B

Elements of cost Joint Cost Subsequent Cost Total Cost A B A B A B

Material 3,367 1,633 3,000 1,500 6,367 3,133 Labour 2,020 980 1,400 1,000 3,420 1,980 Overheads 1,346 654 600 500 1,946 1,154

Cost of production 11,733 6,267

Working Note: Calculation of Selling and Distribution Expenses

Particulars (`) Total Sales Revenue (` 16,000 + ` 8,000) 24,000 Less: Estimated Profit (` 4,000 + ` 1,600) (5,600) Cost of Sales 18,400 Less: Cost of production: - Joint Costs (10,000) - Subsequent costs (` 5,000 + ` 3,000) (8,000) Selling and Distribution expenses (Balancing figure) 400



(b) (i) Annual Cash Flow: At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project i.e. initial cash outlay Cost of the Project = ` 2,28,400 and Useful life = 4 years Considering the discount factor table @ 15%, cumulative present value of cash inflows for 4 years is 2.855 (0.869 + 0.756 + 0.658 + 0.572) So, Annual cash flow × 2.855 = ` 2,28,400

Hence, Annual Cash flow = 2,28,4002.855

` = ` 80,000

(ii) Cost of Capital:

Profitability index = Project the ofCost

inflows Cash Discounted of Sum

Sum of Discounted Cash inflows1.0417 = 2,28,400`

Sum of Discounted Cash inflows = ` 2,28,400 × 1.0417 = ` 2,37,924.28 Since, Annual Cash Inflows = ` 80,000

Hence, cumulative discount factor for 4 years = 2,37,924.2880,000

` = 2.974

From the discount factor table, at discount rate of 13%, the cumulative discount factor for 4 years is 2.974 (0.885 + 0.783 + 0.693 + 0.613 ) Hence, Cost of Capital = 13%

(iii) Net Present Value (NPV): NPV = Sum of Present Values of Cash inflows – Cost of the Project

= ` 2,37,924.28 – ` 2,28,400 = ` 9,524.28 Net Present Value = ` 9,524.28

Alternative

NPV = Cost of Project × (Profitability Index – 1) = 2,28,400 × (1.0417 – 1) or 2,28,400 × 0.0417 = 9,524.28

(iv) Discounted Payback Period : Year Annual Cash

flow PV of Re.1 @

13% PV of Cash

flow Cumulative PV of

Cash inflow 1 80,000 0.885 70,800 70,800



2 80,000 0.783 62,640 1,33,440 3 80,000 0.693 55,440 1,88,880 4 80,000 0.613 49,040 2,37,920

Discounted Payback Period = 39,5203+ = 3.8059 years49,040

Or = 3 years, 9 Months and 21 days Question 5 (a) State the difference between cost control and cost reduction. (b) Write treatment of items associated with purchase of material:

(i) Cash discount

(ii) Subsidy/Grant/Incentives

(iii) VAT or State Sales Tax

(iv) Commission/ brokerage paid

(c) Distinguish between operating lease and finance lease. (d) Describe the three principles relating to selection of marketable securities. (4 × 4 = 16 Marks) Answer (a) Difference between Cost Control and Cost Reduction

Cost Control Cost Reduction 1. Cost control aims at

maintaining the costs in accordance with the established standards.

1. Cost reduction is concerned with reducing costs. It challenges all standards and endeavours to better them continuously.

2. Cost control seeks to attain lowest possible cost under existing conditions.

2. Cost reduction recognises no condition as permanent, since a change will result in lower cost.

3. In case of Cost Control, emphasis is on past and present.

3. In case of cost reduction it is on present and future.

4. Cost Control is a preventive function.

4. Cost reduction is a corrective function. It operates even when an efficient cost control system exists.

5. Cost control ends when targets are achieved.

5. Cost reduction has no visible end.



(b) Treatment of items associated with purchase of material

Sl. No. Items Treatment (i) Cash discount Cash discount is not deducted from the

purchase price. (ii) Subsidy/Grant/Incentives Any subsidy/ grant/ incentive received from the

Government or from other sources deducted from the cost of purchase.

(iii) VAT or State Sales Tax State Sales Tax/VAT is paid on intra-state sale and collected from the buyers. It is excluded from the cost of purchase if credit for the same is available. Unless mentioned specifically it should not form part of cost of purchase.

(iv) Commission or brokerage paid

Commission or brokerage paid is added with the cost of purchase.

(c) Distinguish between Operating Lease and Financial Lease

Point Operating Lease Finance Lease Ownership The lessee is only provided the

use of the asset for a certain time. Risk incident to ownership belongs only to the lessor.

The risk and reward incidental to ownership are passed on to the lessee. The lessor only remains the legal owner of the asset.

Bearing risk

The lessor bears the risk of obsolescence.

The lessee bears the risk of obsolescence.

Purchase option

The lessee does not have any option to buy the asset during the lease period.

It allows the lessee to have a purchase option during the lease period.

Expenses borne

Usually, the lessor bears the cost of repairs, maintenance or operations.

The lessor does not bear the cost of repairs, maintenance or operations.

Treatment Lease payment is treated like operating expenses like rent.

Finance lease is generally treated like a loan.

(d) Three principles relating to selection of marketable securities are as follows Safety: Return and risks go hand in hand. As the objective in this investment is ensuring liquidity, minimum risk is the criterion of selection. Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities fluctuate more with changes in interest rates and are therefore, more risky.



Marketability: It refers to the convenience, speed and cost at which a security can be converted into cash. If the security can be sold quickly without loss of time and price it is highly liquid or marketable.

Question 6 (a) (i) The M-Tech Manufacturing Company is presently evaluating two possible

processes for the manufacture of a toy. The following information is available:

Particulars Process A (`) Process B (`) Variable cost per unit 12 14 Sales price per unit 20 20 Total fixed costs per year 30,00,000 21,00,000 Capacity (in units) 4,30,000 5,00,000 Anticipated sales (Next year, in units) 4,00,000 4,00,000

Suggest: 1. Which process should be chosen? 2. Would you change your answer as given above, if you were informed that the

capacities of the two processes are as follows: A - 6,00,000 units; B - 5,00,000 units? Why? (4 Marks)

(ii) State the difference between Fixed Budget and Flexible Budget. (4 Marks)

(b) The X Company has following capital structure at 31st March, 2015 which is considered to be optimum.

` 14% Debentures 3,00,000 11% Preference Shares 1,00,000 Equity (1,00,000 shares) 16,00,000 20,00,000

The company’s share has a current market price of `23.60 per share. The expected dividend per share next year is 50% of 2015 EPS. The following are the earning per share figure for the company during proceeding ten years. The past trends are expected to continue.

Year EPS (`) Year EPS (`) 2006 1.00 2011 1.61 2007 1.10 2012 1.82



2008 1.21 2013 1.95 2009 1.33 2014 2.15 2010 1.46 2015 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is ` 96.

Preference shares ` 9.20 (with dividend of ` 1.1 per share) were also issued. The company is in 50% tax bracket. (i) Calculate after tax cost of (a) New debt (b) New Preference share (c) New equity

share (consuming new equity from retained earnings). (ii) Calculate marginal cost of capital when no new shares was issued. (iii) How much can be spent for capital investment before new ordinary shares must be

sold? Assuming the retained earning for next year's investment are 50% of 2015. (iv) What will be the marginal cost of capital when the funds exceeds the amount

calculated in (iii), assuming new equity is issued at ` 20 per share? (8 Marks) Answer (a) (i) (1) Comparative Profitability Statements

Particulars Process- A (`) Process- B (`) Selling Price per unit 20.00 20.00 Less: Variable Cost per unit 12.00 14.00 Contribution per unit 8.00 6.00 Total Contribution 32,00,000

(` 8 × 4,00,000) 24,00,000

(` 6 × 4,00,000) Less: Total fixed costs 30,00,000 21,00,000 Profit 2,00,000 3,00,000 *Capacity (units) 4,30,000 5,00,000 Total Contribution at full capacity 34,40,000

(` 8 × 4,30,000) 30,00,000

(` 6 × 5,00,000) Fixed Cost 30,00,000 21,00,000 Profit 4,40,000 9,00,000

Process- B should be chosen as it gives more profit. (2)

Particulars Process- A (`) Process- B (`) *Capacity (units) 6,00,000 5,00,000



Total contribution 48,00,000 (` 8 × 6,00,000)

30,00,000 (` 6 × 5,00,000)

Fixed Cost 30,00,000 21,00,000 Profit 18,00,000 9,00,000

Process-A be chosen. *Note: It is assumed that capacity produced equals sales.

(ii) Difference between Fixed and Flexible Budgets

Fixed Budget Flexible Budget 1. It does not change with actual

volume of activity achieved. Thus it is rigid

It can be re-casted on the basis of activity level to be achieved. Thus it is not rigid.

2. It operates on one level of activity and under one set of conditions

It consists of various budgets for different level of activity.

3. If the budgeted and actual activity levels differ significantly, then cost ascertainment and price fixation do not give a correct picture.

It facilitates the cost ascertainment and price fixation at different levels of activity.

4. Comparisons of actual and budgeted targets are meaningless particularly when there is difference between two levels.

It provided meaningful basis of comparison of actual and budgeted targets.

(b) (i) Calculation of after tax cost of the followings:

(a) New Debentures (Kd) = I(1- t)NP

= 16 (1-0.5) x 100 96

`

` = 8.33%

New Preference Shares (Kp) = Preference DividendNet Proceed

= 1.10 x 100 9.20

`

`= 11.96%

(b) Equity Shares (Consuming New Equity from Retained Earnings) (Ke)

= 1

0

Expecteddividend(D ) + Growthrate (G)Current market price (P )



= *50% of 2.36 100 + 10% 23.60

`

`= 5% + 10% = 15%

* Growth rate (on the basis of EPS) is calculated as below :

EPS in current year - EPS in previous yearEPS in previous year

= 2.36 - 2.15 100 2.15

` `

`= 10%

(Approximate 10% figure is taken because of decimal figures) [*Alternative calculation of Growth rate:- Growth rate is calculated on basis

average growth of EPS i.e. 10 + 10 + 9.92 + 9.77 + 10.27 + 13.04 + 7.14 + 10.25 + 9.76 = 90.15 / 9 =10.01 or 10%

Or,

The EPS for 2006 is given `1 and whereas for 2015 is given at ` 2.36. This has resulted in increase of ` 1.36 over a period of 9 years.

The growth rate can be calculated by using formula:

Et = E0 ( 1 + g)t

2.36 = 1 ( 1 + g)9 , using the CVF table, ` 1 becomes ` 2.36 at the end of 9th year at the compound interest rate of 10%. Therefore, the growth rate is taken at 10%.]

(ii) Calculation of Marginal cost of capital (on the basis of existing capital structure):

Source of capital

Weight

(a)

After tax Cost of capital (%)

(b)

Weighted Average Cost of Capital [WACC (%)]

(a) × (b)

Debenture 0.15 8.33% 1.25 Preference shares

0.05 11.96% 0.60

Equity shares 0.80 15.00% 12.00 Marginal cost of capital

13.85

(iii) The company can spent for capital investment before issuing new equity shares and without increasing its marginal cost of capital: Retained earnings can be available for capital investment = 50% of 2015 EPS × equity shares outstanding



= 50% of ` 2.36 × 1,00,000 shares = ` 1,18,000 Since, marginal cost of capital is to be maintained at the current level i.e. 13.85%, the retained earnings should be equal to 80% of total additional capital for investment.

Thus, investment before issuing equity 1,18,000 ×10080

` = ` 1, 47,500

The remaining capital of ` 29,500 i.e. (` 1,47,500 – ` 1,18,000) shall be financed by issuing New Debenture and New Preference Shares in the ratio of 3 : 1 (3,00,000 : 1,00,000 ) respectively.

(iv) If the company spends more than ` 1, 47,500 as calculated in part (iii) above, it will have to issue new shares at ` 20 per share. The cost of new issue of equity shares will be:

Ke= 1

0

Expecteddividend(D ) + Growthrate (g)Current market price (P )

= 50% of 2.36 100 + 10%20

`

`

= 5.9% + 10% = 15.9%

Calculation of marginal cost of capital (assuming the existing capital structure will be maintained):

Source of capital

Weight (a)

Cost (%) (b)

Weighted Average Cost of Capital [WACC (%)]

(a) × (b) Debenture 0.15 8.33 1.25 Preference shares 0.05 11.96 0.60 Equity shares 0.80 15.90 12.72 Marginal cost of capital 14.57

Question 7 Answer any four of the following: (a) What is cost plus contract? What are its advantages? (b) Narrate the objectives of cost accounting. (c) State, which of the following would result in inflow/outflow of funds, if the funds were

defined as working capital. (i) Purchase of a fixed asset on credit of two months. (ii) Sale of a fixed asset (book value ` 8,000) at a loss of `7,000.



(iii) Payment of final dividend already declared. (iv) Writing off Bad debts against a provision for doubtful debts.

(d) State the principles that should be followed while designing the capital structure of a company.

(e) Explain what do you mean by:

(i) Leveraged Lease

(ii) Profit Centres (4×4 =16 Marks)

Answer (a) Cost plus contract: Under cost plus contract, the contract price is ascertained by adding

a percentage of profit to the total cost of the work. Such types of contracts are entered into when it is not possible to estimate the contract cost with reasonable accuracy due to unstable condition of material, labour services etc. Following are the advantages of cost plus contract: (i) The contractor is assured of a fixed percentage of profit. There is no risk of

incurring any loss on the contract.

(ii) It is useful specially when the work to be done is not definitely fixed at the time of making the estimate.

(iii) Contractee can ensure himself about the ‘cost of contract’ as he is empowered to examine the books and documents of the contractor to ascertain the veracity of the cost of contract.

(b) The main objectives of introduction of a Cost Accounting System in a manufacturing organization are as follows: (i) Ascertainment of cost: The main objective of a Cost Accounting system is to

ascertain cost for cost objects. Costing may be post completion or continuous but the aim is to arrive at a complete and accurate cost figure to assist the users to compare, control and make various decisions.

(ii) Determination of selling price: Cost Accounting System in a manufacturing organisation enables to determine desired selling price after adding expected profit margin with the cost of the goods manufactured.

(iii) Cost control and Cost reduction: Cost Accounting System equips the cost controller to adhere and control the cost estimate or cost budget and assist them to identify the areas of cost reduction.

(iv) Ascertainment of profit of each activity: Cost Accounting System helps to classify cost on the basis of activity to ascertain activity wise profitability.



(v) Assisting in managerial decision making: Cost Accounting System provides relevant cost information and assists managers to make various decisions.

(c)

Sl. No. Result in inflow/ outflow of funds (i) outflow, Total current liabilities are increased but total current assets

remain unchanged. (ii) Inflow, current assets are increased but total current liabilities remain

unchanged. (iii) No effect, Both the total current assets and current liabilities remain

unchanged. OR If examinees assumed that proposed dividend as Non- current liability then payment of final dividend is considered as out flow of fund.

(iv) No effect, Neither the total current assets nor the total current liabilities are affected.

(d) The fundamental principles are: (i) Cost Principle: According to this principle, an ideal pattern or capital structure is

one that minimises cost of capital structure and maximises earnings per share (EPS).

(ii) Risk Principle: According to this principle, reliance is placed more on common equity for financing capital requirements than excessive use of debt. Use of more and more debt means higher commitment in form of interest payout. This would lead to erosion of shareholders value in unfavourable business situation.

(iii) Control Principle: While designing a capital structure, the finance manager may also keep in mind that existing management control and ownership remains undisturbed.

(iv) Flexibility Principle: It means that the management chooses such a combination of sources of financing which it finds easier to adjust according to changes in need of funds in future too.

(v) Other Considerations: Besides above principles, other factors such as nature of industry, timing of issue and competition in the industry should also be considered.

(e) (i) Leveraged Lease: Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and asset so purchased is held as security against the



loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance.

(ii) Profit Centres are the part of a business which is accountable for both cost and revenue. These are responsible for generating and maximizing profits. Performance of these centres is measured with the volume of profit it earns.


PAPER – 3 : COST ACCOUNTING AND FINANCIAL MANAGEMENT …

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