Raju

Decision Making – CA Final SCMPE Study Material is designed strictly as per the latest syllabus and exam pattern.

Decision Making – CA Final SCMPE Study Material

Question 1.
Mr. Rachit Arora is a canteen contractor in Hindu College. He manages college canteen of 1,200 students where tea and snacks are served between 9 am to 5 pm. He has employed four supervisors for managing cash.
Mr. Rachit pays ₹ 400 per working day to every supervisor. The college remains closed on Saturday and Sunday. A solution provider has ap-proached Mr. Rachit for managing Cash. He has advised Rachit to install an automated payment mechanism for accepting payments through machines. Every student of college will swipe smart card for making the payment. The complete system would cost ₹ 3,35,000 with working life of 4 years with annual maintenance of ₹ 60,000. Only one supervisor will be required after the installation of machines.
Required
ADVISE Mr. Rachit on his plan of installation of automated payment mechanism. (Ignore the time value of money.) [Nov. 2020] (5 Marks)
Answer:
Advise
Considering the financial aspects only, it is advised to Mr. Rachit that automated payment mechanism shall be installed; because it will expected to result in net saving of ₹ 6,73,000 during its entire working life span as shown in working note 1 below.
But in order to be sustainable, business decision shall also take non-financial factors into consideration. The automated payment mechanism may be more efficient and faster than human supervisor, but also more rigid. In situation like, wherein student forget to carry the smart card or willing to order customise serving of snacks then automated payment mechanism may be less effective (because it is hard to quantify human aspects mechanically).
Mr. Rachit shall also consider the nature and terms of employment in case of those three supervisors who will be retrenched (or laid-off) and legal implications of this.
Smart card which to be used under automated payment mechanism is expected to be prepaid card, because have swipe feature instead of making cash payment; hence student need to pay in advance. Mr. Rachit also need to consider how many student willing to pay upfront (prior to the point, they suppose in current system).

Working Note:
Statement of Comparison of Costs and Benefits

Particulars	Amount in ₹
Cost of installing automated payment mechanism
Installation cost	3,35,000
Annual Maintenance Cost (₹ 60,000 × 4 Yrs.)	2,40,000
Total Cost to be incurred …(A)	5,75,000
Benefits (in form of savings) due to installation of automated payment mechanism
(3 supervisors × ₹ 400 per working day × 4 years × 52 weeks in a year × 5 working days in a week)	12,48,000
Total benefit in form of savings …(B)	12,48,000
Net Saving during entire span of automated payment mecha­nism (B)-(A)	6,73,000

Note – One supervisor will continue even in automated paym ent mechanism, hence saving is considered in respect to 3 supervisors only.

Author’s Note:

• This question can also be solved by assuming 365 days in a year.
• Therefore 261 working days in a year, after deducting 52 Saturdays and 52 Sundays. The calculation of supervisor’s salary will be changed as follows:
• (3 supervisors × ₹ 400 per working day × 4 years × 261 working days in a year) = ₹ 12,52,800; the net saving during entire span of automated payment mechanism will be ₹ 6,77,800 (₹ 12,52,800 – ₹ 5,75,000).
• Instead of making calculation for four years, this question can also be solved by calculating savings on yearly basis.
• Alternate non-financial factors are also possible.

Question 2.
Mr. Shiva manages the school canteen (approximately 1,600 students) at Nehru Place. The current cash payment system requires three clerks (paid 90 per hour), employed for about 4 hours a day. The canteen operates approximately 240 days a year. Mr. Shiva Is considering a Wireless Cash Management System (WCMS), where a student could just swipe an ID Card for payment. This system would cost 1,25,000 to setup and 36,000 per year to operate. Mr. Shiva believes that he could manage with one clerk If he were to implement the system.
Required
ADVISE Mr. Shiva on the choice of a plan, assuming working life of WCMS as 5 years. (Ignore the time value of money) (October 2020 MTPJ (5 Marks)
Answer:
For each day, Mr. Shiva spends 360 per clerk ( 90 per hr. × 4 hrs.).
Therefore, Mr. Shiva spends 1,080 per day to employ three clerks. Annually, this outlay amounts to 2,59,200 1,080 per day × 240 days).
Over five years, the outlay would be 12,96,000. If the WCMS is implemented, the initial cost is ₹ 1,25,000. If we add the annual cost of ₹ 36,000, the total cost over five years amounts to ₹ 3,05,000. Since one clerk will be needed as well, Mr. Shiva has to incur ₹ 4,32,000 over five years to pay clerk (₹ 4,32,000 = ₹ 90 × 4 hrs. × 1 clerk × 240 days × 5 years). Therefore, the total cost of this option is ₹ 7,37,000.
Accordingly, there is cost saving of ₹ 5,59,000 from WCMS implementation. Relevant Non-Financial Considerations
The WCMS may be a lot more efficient, but more rigid. For instance, what if, a student forgets to bring his/her card or transaction failure due to connectivity issue, and may not have enough cash to pay. Automated systems may be less able to handle these situations. Having clerks may add an aspect of flexibility and a human aspect that is hard to quantify.

Conclusion
Obviously, WCMS option is more cost effective for Mr. Shiva because there is a cost saving of ₹ 5,59,000. But, non-financial factors should also be taken into consideration.

Question 3.
(Activity Based CVP Analysis)
Core Ltd. makes a single product with the following details:

Description	Current Situation	Proposed Change
Selling Price (₹/unit)	10
Direct Costs (₹/unit)	5
Present number of setups per production period (before each production run, setup is done)	42
Cost per setup (₹)	450	Decrease by ₹ 90
Production units per run	960	1,008
Engineering hours for production period	500	422
Cost per engineering hour (₹)	10

The company has begun Activity Based Costing of fixed costs and has presently identified two cost drivers, viz, production runs and engineering hours. Of the total fixed costs presently at ₹ 96,000, after the above, ₹ 72,100 remains to be analyzed. There are changes as proposed above for the next production period for the same volume of output.
Required
(i) COMPUTE units and » reduction rues Core lid. should produce in the changed scenario for break-even.
(ii) ADVISE whether Core Ltd. should continue to break up the remaining fixed costs into activity-based costs.
Answer:
(i) Break Even Point (Changed Scenario)

= 18,144 units
Break Even Point (No. of Production Runs)
= Break Even (units) ÷ Production (units per run)
= \(\frac{18,144 \text { units }}{1,008 \text { units }}\)
= 18 Runs

(ii) A company should adopt Activity Based Costing (ABC) system for accurate product costing, as traditional volume based costing system does not take into account the Non-unit Level Overhead Costs such as Setup Cost, Inspection Cost, and Material Handling Cost etc. Cost Analysis under ABC system showed that while these costs are largely fixed with respect to sales volume, but they are not fixed to other appropriate cost drivers. If break up the remaining ₹ 72,100 fixed costs consist of only a small portion of these costs, ABC need not be applied. However, it may also be noted that the primary study has resulted in cost savings. If the savings in cost are expected to exceed the cost of study and implementing ABC, it may be justified. Further it is pertinent to mention that ABC offers no increase in product-costing accuracy for single-product setting.

Working Notes:
Statement Showing ‘Non-unit Level Overhead Costs’

Particulars	Current Situation	Proposed Situation
No. of Production Runs/ Setups	42	40
For proposed situation:		\( \frac{(960 \text { runs } \times 42 \text { setup })}{1,008 \text { Units }} \)
Cost per Setup	₹ 450	₹ 360
Production Units per run	960 units	1,008 units
Production Units (960 units × 42)	40,320	40,320
Engineering Hrs.	500	422
Engineering Cost per hour	₹ 10	₹ 10

Question 4.
(CVP Analysis in Service and Non-profit Organisations)
Toyada Services Pvt. Ltd. is planning to run a fleet of 15 buses in Seelampur City on a fixed route. Toyada has estimated a total of 2,31,85,000 passenger kilometers per annum. It is estimated buses to have 100% load factor. Buses are purchased at. a price of ₹ 44,00,000 per unit whose scrape value at the end of 5 years life is ₹ 5,50,000. Seating capacity of a bus excluding a Driver’s sea? is 42. Each bus can give a mileage of 5 kmpl. Average cost of fuel is ₹ 66 per liter. Cost of Lubricants & Sundries per 1,000 km would be 3,300. Company will pay ₹ 27,500 pe month to Driver and two attendants for each bus. Other annual charges per bus: Insurance ₹ 55,000, Garage Charges ₹ 33,000, RepaIrs & Maintenance ₹ 55,000. Route Permit Charges upto 20,000 km is ₹ 5,500 and ₹ 2,200 for every additional 5,000 km or part thereof.
Required
CALCULATE a suggested fare per passenger/km taking into account markup on cost @ 20% to cover general overheads and sufficient profit,
(ii) The Transport Sector of Seelampur is highly regulated. The Government has fixed the fare @ ₹ 1,35 for next 2 years. COMMENT on the two year’s proofitability taking into consideration the inflation rate of 8%.
Note: Route permit charges is not subject to Inflation
Answer:
(i) Statement Suggesting “Fare per passenger – km (Each Bus)”

Fixed Expenses:	₹
Insurance	55,000.00
Garage Charges	33,000.00
Depreciation	7,70,000.00
Running Expenses:
Repair and Maintenance	55,000.00
Cost of Lubricants and Sundries   „	1,38,517.50
Fuel Cost	5,54,070.00
Salary of Driver and Two Attendants	3,30,000.00
Route Permit Charges	16,500.00
Total Cost per annum	19,52,087.50
Add; Markup @ 20% of Total Cost or 16.67% of Total Revenue	3,90,417.50
Total Revenue	23,42,505.00

Rate per passenger- km equals to ₹ 1.395

Workings
Total Passenger Kms = 2,51,85,000
Total Buses = 15
Passenger Kms per bus = 16,79,000 (2,51,85,000 Kms/15)
Total Passenger Capacity per bus = 42 – 2 = 40
Annual Distance Covered by a bust = 41,975 Kms. (16,79,000 Kms/’ 40)
Regulated Fare per passenger km is ₹ 1.35

(ii) Profitability Statement for Each Bus

Particulars	Year 1 (₹)	Year 2 (₹)
Fixed Expenses:
Insurance	59,400,00	64,152.00
Garage Charges	35,640.00	38,491.20
Depreciation	7,70,000.00	7,70,000.00
Running Expenses:
Repair and Maintenance	59,400.00	64,152.00
Cost of Lubricants and Sundries	1,49,598.90	1,61,566.81
Fuel Cost	5,98,395,60	6,46,267.25
Salary of Driver and Two Attendants	3,56,400.00	3,84,912.00
Route Permit Charges	16,500.00	16,500.00
Total Cost …[A]	20,45,334.50	21,46,041.26
Total Revenue (Regulated) … [B]	22,66,650.00	22,66,650.00
Profit … [B] – [A]	2,21,315.50	1,20,608.74
Profit to Total Revenue	9.7696	5.3296

The gross margin is showing a downward trend because the cost components have taken into the effect of inflation hence increasing year by year but the total revenue has remained stagnant due to Government regulations which resulted in reduction in gross margin per bus.
The Toyada company’s gross margin to total revenue ratio has come out to be 9.7696 and 5.3296 in first and second year respectively but initially the Toyada company’s desired gross margin to total revenue ratio is 16,6796 to cover general overheads and sufficient profit. Though the amount of general overheads is not given but we can safely assume that they may also subject to inflation i.e. increase year by year then in such case the company needs to maintain or increase its gross margin per bus to maintain its net profit after general overheads which is not possible in regulated environment. The information about regulated fare in the given case is regarding first two years only but if this regulated fare scenario persists for further years then the project may not be viable for the company.

Question 5.
After the Second wave of COVID pandemic, Ministry of Health and Family Welfare along with Drug Control Department have come hard on health care centres tor charging exorbitant fees from their patients. Vedanta Health Care Ltd. (VHCL), a leading integrated health- rase deliver? provider company is feeling pinch of measures taken authorities and facing margin pressures due lo this. VHCL is operating in a competitive environment so; it’s difficult to increase patient numbers also. Management Consultant of the company has come out with some plan for cost control and reduction.
VHCL provides treatment under package system where fees is charged irrespective of days a patient stays in the hospital. Consultant has estimated 2.50 patient days per patient. He wants to educe it to 2 days. By doing Ibis, consultant has targeted the general variable cost of ₹ 500 per : patient day. Annually 15,000 patients visit to die hospital for treatment.
Medical Superintendent has sorne concerns with that of Consultant’s plan. According to him, reducing the patient stay would be detrimental to the full recovery of patient. They would come again for admission thereby increasing current readmlsslon rate from 3% to 5%; it means readmitting 300 additional patients. Company has to spend ₹ 25,00,000 naore to accommodate this increase in readmission. But Consultant has found bless In disguise in tuis. He said every readinision is treated as new admission so it would result in additional cash flow of ₹ 4,500 per patient, in the form of’admission fees.
Required
(i) CALCULATE the impact of Management Consultant’s plan on profit of the company.
(ii) Also COMMENT on result and other factors that should be kept in mind before taking any uccision. ’
Answer:
(i) Impact of Management Consultant’s Plan on Profit of the VHCL
Vedanta Health Care Ltd.
Statement Showing Cost Benefit Analysis

Particulars	₹
Cost:
Incremental Cost due to Increased Readmission	25,00,000
Benefit:
Saving in General Variable Cost due to Reduction in Patient Days [15,000 Patients × (2.5 Days – 2.0 Days) × ₹ 500]	37,50,000
Revenue from Increased Readmission (300 Patients × ₹ 4,500)	13,50,000
Incremental Benefit	26,00,000

(ii) Comment
Primary goal of investor-owned firms is shareholder wealth maximization, which translates to stock price maximization. Management consultant’s plan is looking good for the VHCL as there is a positive impact on the profitability of the company (refer Cost Benefit Analysis).
Also VHCL operates in a competitive environment so for its survival, it has to work on plans like above.
But there is also the other side of a coin that should also be considered i.e. humanity values and business ethics. Discharging patients before their full recovery will add discomfort and disruption in their lives which cannot be quantified into money. There could be other severe consequences as well because of this practice. For gaining extra benefits, VHCL cannot play with the life of patients. It would put a question mark on the business ethics of the VHCL.
May be VHCL would able to earn incremental profit due to this practice in short run but it will tarnish the image of the VHCL which would hurt profitability in the long run.
So, before taking any decision, Vedanta Health Care Ltd. should analyze both quantitative as well as qualitative factors.

Question 6.
(Ethical and Mon-Financial Considerations)
RANBAX Limited specializes in the manufacture of chemical intermedi ares in a very competitive business environment. RANBAX is a public iisted company, with majority of its shareholders being institutional investors like mutual funds, banks and insurance companies.
It is located in a water scarce zone in Karnataka. There are restrictions on the tapping and usage of groundwater under the relevant laws. Penal provisions of the law will apply in case of violations. The production process requires water and the amount of water that the company can draw is limited to 19,000 kilolitres (1 Kilolitre is 1,000 litres). Purchase of water is not an option as availability is highly erratic and exorbitant on cost.
RANBAX Ltd. manufactures two types of chemicals “AX” and “EX” and these are sold in kilograms. The company is in the process of making the
business plan for the year 2021.
Based on the actual operating data for 2020 and taking into consideration the inflation and possible price increases that it can obtain from the market, the following product costing details have been arrived at:

Product	AX	BX
Capacity Volume kg. (not inter-changeable)	8,25,000	9,30,000
Selling Price per kg.	₹ 2,000	₹ 1,000
Variable Cost per kg.	₹ 1,500	₹ 650
Water (litre/ kg.)	12.5	₹ 10

Under the relevant income tax laws prevalent, companies with a turnover of ₹ 250 Cr. (Crores) or less are taxed at a lower rate of 25% as against .the normal 30%, The company intends to keep its sales for 2021 equal to ₹ 250 Cr, or slightly lesser to avail this concessional income tax benefit.
With capacity constraints, the company has calculated that it would be still beneficial for the company to stick to ₹ 250 Cr. as only a marginal Increase in turnover is possible over.
₹ 250 Cr.; after a higher tax @30’%, the PAT would be still lower than the PAT arrived at after doing just ₹ 250 Cr. and availing the lower income iax rate.
CFO asked management consultant to work out the volumes in kg. of products “AX” and “BX” which would give an optimal (maximum) contribution given the constraints on capacity, water usage and turnover to avail ihe concessional income tax benefit.
Consultant work out with the following product mix using Linear Programming. She also proposes another mix which does not meet the constraint on water usage where the company could end up drawing excess water than permitted by 113 kilo-litres but would result in an increase of ? 30 lacs in contribution. She says that it is easily possible to do this by managing reporting to the water authorities.

Product		Optimal	Suggested
AX (Volume in kg.)		8,00,000	7,85,000
BX (Volume in kg.)		9,00,000	9,30,000
Contribution in ₹ Cr.		71.5	71.8
	Constraints
Sales	<= 250 Cr.	250	250
Volume of “AX” in kg.	<= 8,25,000	8,00,000	7,85,000
Volume of ‘’BX’’ in kg	<= 9,30,000	9,00,000	9,30,000
Water uasage (in KL)	<= 19,000	19,000	19,113

Required
The CFO is not satisfied with the calculations. He wants you (Sr. Finance Manager) to come up with a proper DISCUSSION. [May 2020MTP]
Answer:
Primary goal of investor – owned firms is shareholder wealth max-imisation, which translates to stock price maximisation. Management Consultant’s plan is looking good for the RANBAX Ltd as there is a positive impact on the profitability (? 30 lacs) of the company. Also, RANBAX Ltd. operates in a competitive environment so for its survival, it has to work on plans like above.
There is second side of coin that cannot also he ignored i.e. business ethics, It is easily possible to manage drawing of excess water, but it is not an ethical practice as the company has responsibilities towards use of natural resources like water and protecting the environment.
Besides, a whistle-blower complaint to the water authorities can land the company into trouble in terms of penalties, a financial impact and also such penalties are disallowed for income tax purposes. It is possible that such a violation may be reported in the media causing disrepute to the name of the company. It can also make investors in the share market stay away from the company as it has ethical governance issues. The company will face challenges in obtaining other government approvals when it will plan expansion as this violation may have to be reported on the applications seeking approvals.
Overall
May be RANBAX would able to earn profit due to this plan in short run but it will tarnish the image of the RANBAX which would hurt profitability in long run. Therefore, before taking any decision on this plan, RANBAX should analyse both qualitative and qualitative factors.

Question 7.
(Make or Buy)
AJanta Air Ltd., manufactures and sells 25,000 table fans annually. One of the components required for fans is purchased from an outside supplier at a price of ₹ 190 per unit, it is purchasing 25,000 components annually for its usage. The Production Manager is of the opinion that if all the components are produced at own plant, U is possible to maintain better quality in the finished product. Further, he proposed that the inhouse production of the component with other items will provide more flexibility to increase the annual production by another 5,000 units. He estimates the cost of making the component as follows:

	₹ Per unit
Direct materials	80
Direct labour	75
Factory overhead (70% variable)	40
Total Cost	195

The proposal of the Production Manager was referred to the Marketing Manager for his remarks. He pointed out that to market the additional units, the overall unit price should reduced by 5% and additionally ₹ 1,00,000 p.m. should be incurred fei advertising, Present selling price and
contribution per fan are ₹ 2, Of and ₹ 600 respectively.No other increase or decrease in all other expenses at a result of this proposal will arise.
Since the making cost of the component Is more than the buying cost, the Management asks you to:
(i) ANALYSE the make or buy decision on unit basis and total basis.
(ii) RECOMMEND the most profitable alternative [Nov. 2018] (10 Marks)
Answer:
(i) Ajanta Air Ltd. purchases 25,000 units of components to manufacture 25,000 fans annually. The external purchase price per component is ₹ 190 per unit. It has the option of manufacturing these components in house. The cost structure of manufacturing these components would be as below:
(a) Production Capacity will increase from 25,000 fans to 30,000 fans.
(b) Variable Cost of Production of fan would be ₹ 1,710 [(2,500 – 600) – 190] per unit.
(c) Fixed Factory Overhead off 12 per component would be incurred irrespective of whether component is produced or not. Therefore, this cost is not considered.
(d) Increase in advertising expense would be ₹ 1,00,000 per month or ₹ 12,00,000 annually.
(e) Overall selling price would reduce from the current rate of ₹ 2,500 per fan to ₹ 2,375 (95% of ₹ 2,500) per fan.
(f) Current contribution considering a procurement price of ₹ 190 per component unit, is ₹ 600 per fan. As calculated above, if produced in house, the variable cost would be ₹ 183 per component unit. This would result in an increase in contribution by ₹ 7 per fan (procurement price of f 190 per component unit less variable cost of ₹ 183 per component unit). In addition, there is an impact of f 125 on account of reduction in selling price. Therefore, the contribution if component produced in house would be ₹ 482 per fan (₹ 600 + ₹ 7 – ₹ 125).

To summarize the above figures:

Therefore, incremental loss by switching to in house production (on a total basis) would be ₹ 17,40,000 (incremental loss ₹ 5,40,000 – additional advertising expenses ₹ 12,00,000). On a per unit basis, it would result in a loss of ₹ 58 per fan.

(ii) Recommendation
As explained above, if production increases from 25,000 fans to 30,000 fans, it would not be profitable to make these components in house. Overall profit decreased by ₹ 17,40,000. However, Company may prefer to make component, even though it could be financially beneficial to buy from outside supplier. Sometimes qualitative factors become very important and can override some financial benefit. This can be coupled with uncertainty about the supplier’s ability or intention to maintain the price, quality, delivery dates of the components etc.
Alternatively, the company may continue with the sale of 25,000 units without any price reduction and advertising expenses. The component required for the 25,000 fans may be produced internally at a cost of ₹ 183 per unit. In this situation, the contribution shall be increased by ₹ 1,75,000 (₹ 7 × 25,000 units).
So, Ajanta Air Ltd. may recommend about the most profitable alternative after due and careful consideration of the facts illustrated above.

Question 8.
(Outsourcing Decision; Gain Sharing Arrangement)
High Sports Inc deals in. manufacturing of sports articles. Although HSI Is major market player but can capture the market further. Currently HSI manufactures five types of badminton shuttle named as PV, PW, PX, PY ana PZ, Production facilities are limiting factor at HSI. Production and marginal cost data of these 5 Products are specified in table below:

On drive to cost leadership strategy, HSI is thinking to out-source some of the products. Shuttles can be sourced from a well-established company Protease’ at the following prices. There is no tie-in between products, all products can outsources individually. These costs are on GIF basis;

Company-wide fixed overheads are of 15 Lacs each year. Out of which 2,40,000 is directly attributable to the production of these 5 products on annual basis. This fixed overhead of 2,40,000 is evenly split across such 5 products and entirely avoidable. Till date company does not have experience to outsource any element of production.
Mr. Singla who is newly appointed management accountant, bring the huge experience to the organization on cost control and reduction techniques. While discussing the possibility of outsourcing with CFO, Mr. Singh explained the limitation of out-sourcing and also presents a white paper on gain sharing arrangement; which can be entered with supplier to whom out-sourcing is considered.
Required
CEO post presentation /discussion seeks report from Mr. Singh to RECOMMEND, the product/(s) which should be outsourced. Report should also EXPLAIN gain sharing arrangement along with aspects that HSI need to consider, ensuring success out of gain sharing arrangement as a part of out-sourcing contract with Protease. [May 2020 RTF]
Answer:
Report to;
Office of CEO,
High Sports Inc (HSI),
Dated – 03rd Jan. 2020
Report on Outsourcing of Products to Protease
(i) Decision on out-sourcing of the products – Product PW and PY can be out-sourced, (see computations below)

Total monthly cost of in house production is ₹ 1,36,200 and Total comparable monthly cost of out-sourcing/Buy-in is ₹ 1,30,100. There is overall saving of ₹ 5,100, but since there is no tie-in between products, hence decision on all products whether can be outsources or produced in-house can be taken individually.
The above calculation suggests that only PW and PY can be sourced through out-sourcing due to, whereas PV, PX and PZ can be produced more cheaply in-house.
Since avoidable in nature, hence relevant for decision making. ₹ 2,40,000 is annual cost, hence monthly fixed overhead expenditure will be ₹ 20,000.
However, following aspects needs to be kept in mind, prior to entering to out-sourcing arrangement of product PW and PY
Issue 1
If products PW and PY are outsourced, the company would then have spare capacity. Since the production function/capacity is a limiting factor and there is scope of selling the further units of PV, PX and PZ; in order to acquire the market share. Hence, spare capacity of great importance and will be a powerful argument for outsourcing.

Issue 2
The reaction of the workforce at HSI is also need to be considered because of two reasons;
a. If production of PV, PX and PZ cannot be expanded to take up the spare capacity on account of out-sourcing of PW and PY, then lay-off may be required – Which may cause problem like strike by remain workforce or an industrial dispute.
b. Facts also suggest that products PW and PY are labour intensive (due to high comparative high labour cost). Hence even the spare capacity on account of out-sourcing of PWr and PY is used, and then also the some of labour forces need to be retrenched.

Issue 3
Even if lay-off is accepted by workforce, then also cost associated with redundancies may be critical. Such cost is relevant for decision-making, hence should be considered.

Issue 4
Since the HSI has no experience operating the out-sourcing till now, hence while dealing with Protease, HSI need to ensure;
a. Timely delivery in right quantity
b. Quality of material supplied
c. Penalties in case of default by outsource supplier.

(ii) Gain Sharing Arrangement by HSI as part of outsourcing agreement with Protease
Gain Sharing Arrangement is a contractual arrangement where, entity (HSI) & outsourcing supplier (In this case protease) share the financial gain which result out of either productivity gains or increased efficiency at end of outsourcing supplier from continuous improvement, transformation, or innovation.
This arrangement in form of clause is usually included in Master Agreement of outsourcing. Outsource supplier find it unique selling point and entity is also on for continuous improvement apart this both will get share in cost saved.
Although gain sharing arrangement is largely useful in case of outsourcing services agreement, but HSI can also while entering out-sourcing contract with Protease for PW and PY; but following aspects need to be considered;

Reason of failure of Gain Sharing Arrangement – Gain Sharing Arrangement sounds great but in practice it is quite difficult to execute. Even after a considerable level of efforts due to following reasons it may fail;
a. Unstructured/Poorly structured terms of arrangement, in outsourcing contracts.
b. Error in implementation.
c. Relationship between outsource supplier and entity.

Precaution need to be taken – Action plan for executing gain share arrangement must contain;
a. Be specific in outsourcing agreement.
b. Pre-defined formula for sharing of benefits and period thereof.
c. Effort from entity, because innovation is not only responsibility of outsource supplier.
d. Constitute innovation team to create an innovation structure, generate the idea and execution of same.

Overall
In consideration of above analysis, company should consider the outsourcing of PW and PY by entering out-sourcing contract with Protease. At this point, it is important to note that cost analysis emphasizes purely quantitative, financial considerations. However, outsourcing decisions are often influenced by qualitative factors, which are not directly affected in calculations. The impact of the same should also be taken into consideration. The issues suggested above are not exhaustive. Further, before opting gain sharing arrangement, the same should also be reviewed carefully from a business, legal, and tax perspective. I hope this helps – if you need any further information, please let me know.
Closure of Report
Mr. Singh,
Management Accountant
(For Management Accounting Division)
High Sports Inc (HSI)

Question 9.
(Sell or Further Process)
A process industry unit manufactures three joint products: A, B and C. € has no realisable value unless it undergoes further processing after the point of separation. The cost details of C are as follows:

Upto point of separation
Marginal cost	30
Fixed Cost	20
After point of separation
Marginal cost	15
Fixed cost	5
	70

C can be sold at ₹ 37 per unit and no more.
Cost incurred on Product ‘C’ upto point of separation is irrelevant for decision making as Product ‘C’ is a Joint Product. Joint Products are the result of same raw material & same process Operations.
Cost incurred after point of separation will be considered for decision making as specifically incurred for Product ‘C’.
Requirement
Calculate whether production of Product C is recommended?
Answer:
After further processing Product ‘C’ will contribute ₹ 17 per unit toward ‘Joint Production Cost’. Calculation is as follows

Particulars	Amount (₹)
Selling Price per unit	37.00
Less: Cost after separation:
Marginal Cost per unit	15.00
Fixed Cost per unit	5.00
Contribution toward ‘Joint Production Cost’	17.00

Hence, further processing of Product ‘C’ is recommended.

Particulars	Amount (₹)
Selling Price per unit	37.00
Less: Marginal Cost (₹ 30 + ₹ 15)	45.00
Contribution	(8-00)

Question 10.
(Minimum pricing decision)
MaLa Polymers, located in Sahibabad Industrial Area, manufactures high quality industrial products. AT Industries has asked Mala Polymers rot a special job that must be completed within one week.
Raw material R1 (highly toxic) will he needed to complete the AT Industries’ special job. MaLa Polymers purchased the Rt two weeks ago for ₹ 7,500 for a job ‘A’ that recently was completed. The R1 currently in stock Is the excess from that job and MaLa Polymers had been planning to dispose of it. MaLa Polymers estimates that it would cost them ₹ 1,250 to dispose of the R1. Current replacement cost of R1 is ₹ 6,000.
Special job will require 250 hours of labour G1 and 100 hours of labour G2. MaLa Polymers pays their G1 and G2 employees ₹ 630 and ₹ 336 respectively for 42 hours of work per week.
MaLa Polymers anticipates having excess capacity of 150 [G1] and 200 [G2] labour hours in the coming week. MaLa Polymers can also hire additional G1 and G2 labour on an hourly basis; these part-time employees are paid an hourly wage based on the wages paid to current employees.
Suppose that material and labour comprise MaLa Polymers’s only costs for completing the special job.
Required
CALCULATE the ‘Minimum Price’ that MaLa Polymers should bid on this job?
Answer:
Opportunity Cost of Labour – The G2 labour has zero opportunity cost as there is no other use for the time already paid for and is available. However, MaLa Polymers needs to pay an additional amount for G1 labour. This amount can be save if the special job were not there.

G1 labour:
Hours Required	250
Hours Available	150
Extra Flours Needed	100
Cost per hour (₹ 630/42 hrs)	₹ 15
Opportunity Cost	₹ 1,500

Thus, the ‘Opportunity Cost of Labour’ for completing the special job is ₹ 1,500.
Opportunity Cost of Material – MaLa Polymers has no alternative use for the Rl, they must dispose of it at a cost of ₹ 1,250. Thus, MaLa Polymers actually saves ₹ 1,250 by using the materials for the AT Industries special job. Consequently, the ‘Opportunity Cost of Material’ is – ₹ 1,250 (ie., the opportunity cost of this resource is negative).
The minimum price is the price at which MaLa Polymers just recovers its ‘Opportunity Cost’. MaLa Polymers’s ‘Total Opportunity Cost’ is t 250 (₹ 1,500 – 11,250). Accordingly, minimum Price for the Special Job is ₹ 250.

Question 11.
(CVP Analysis)
Recently, Ministry of Health and Family Welfare along with Drug Control Department have come hard on health care centres for charging exorbitant fees from their patients. Human Health Care Ltd. (HHCL), a leading integrated healthcare delivery provider company is feeling pinch of measures taken by authorities and facing margin pressures due to this. HHCL is operating in a competitive environment so; it’s difficult to increase patient numbers also. Management Consultant of the company has come out with some plan for cost control and reduction.
HHCL provides treatment under package system where fees is charged irrespective of days a patient stays in the hospital. Consultant has estimated 2.50 patient days per patient. He wants to reduce it to 2 days. By doing this, consultant has targeted the general variable cost of ₹ 500 per patient day. Annually 15,000 patients visit to the hospital for treatment.
Medical Superintendent has some concerns with that of Consultant’s plan. According to him, reducing the patient stay would be detrimental to the full recovery of patient. The* would come again for admission thereby increasing current readmission rate from 3% to 5%; it means readmitting 300 additional patients. Company has to spend ₹ 25,00.000 more to accommodate this increase in readmission. But Consultant has found bless in disguise in this. He said every readmission is treated as new admission so it would result in additional cash flow of ₹ 4,500 per patient in the form of admission fees.
Reauired
(i) CALCULATE the impact of Management Consultant’s plan on profit of the company.
(ii) Also COMMENT on result and other factors that should be kept in mind before taking any decision. [Mock Test Paper April 2019]
Answer:
(i) Impact of Management Consultant’s Plan on Profit of the HHCL
Human Health Care Ltd.
Statement Showing Cost Benefit Analysis

Particulars	₹
Cost:
Incremental Cost due to Increased Readmission	25,00,000
Benefit:
Saving in General Variable Cost due to Reduction in Patient Days	37,50,000
[15,000 Patients × (2.5 Days – 2.0 Days) × ₹ 500)
Revenue from Increased Readmission (300 Patients × ₹ 4,500)	13,50,000
Incremental Benefit	26,00,000

(ii) Comment
Primary goal of investor-owned firms is shareholder wealth maximization, which translates to stock price maximization. Management consultant’s plan is looking good for the HHCL as there is a positive impact on the profitability of the company (refer Cost Benefit Analysis).
Also HHCL operates in a competitive environment so for its survival, it has to work on plans like above.
But there is also the second side of a coin that cannot also be ignored i.e. humanity values and business ethics. Discharging patients before their full recovery wall add discomfort and disruption in their lives which cannot be quantified into money. There could be other severe consequences as well because of this practice. For gaining extra benefits, HHCL cannot play with the life of patients. It would put a question mark on the business ethics of the HHCL.
May be HHCL would able to earn incremental profit due to this practice in short run but It will tarnish the image of the HHCL which would hurt profitability in the long run.
So, before taking any decision on this plan, HHCL should analyze both quantitative as well as qualitative factors.

Question 12.
[Minimum Pricing]
Rayla runs the Planetarium Station in New Delhi, India. The strength of the station lies in its live interactions and programs for visitors, students and amateur astronomers. The station is always active with programs for school and college students and for amateur astronomers. One of the station’s key attractions is a big screen VMAX theatre. VMAX is a 70 mm motion picture film format which shows images of far greater size and resolution than traditional film systems. The VMAX cinema projection standards were developed in Canada in the late 1960s. Unlike traditional projectors, the film is run horizontally so that the image width is greater than the width of the film.
The Hobart School has approached Rayla about scheduling an extra show for its class VIII students. One hundred students and five teachers are expected to join the special show on the ‘Planets & Solar System’, a feature that is currently showing. The school has asked Rayla for a price i quote. The special show will take place at 08:30 AM when the VMAX is not usually open.
Required
RECOMMEND the minimum amount that Rayla should charge [May 2018 RTP]
Answer:
The incremental cost associated with the VMAX show appears to be ₹ 10,000 i.e. cost of running the show. The allocated fixed cost per show is not relevant because the total amount of fixed costs for the year will not change as a result of the special show. Further, the stated ticket prices are not relevant because the show will take place ai 08:30 AM when the VMAX is not usually open – thus, the students will not be displacing any regular visitors. Based on the financial data provided, the minimum price quote appears to be ₹ 10,000.

Rayla should consider the following factors:

• Does the station have a souvenir shop and/or cafeteria?
  If so, many students are likely to buy food and/or souvenir items, thereby increasing the station’s contribution. In turn, this would reduce the minimum price quote.
• What is the impact on future revenue?
  After seeing the show, many students may return with their parents, thereby increasing future revenue.
• Are there costs linked with the special showing that are not included in the ₹ 10,000 variable cost number?For example, will the station have to pay an overtime premium.
  Rayla should also consider the educational mission of the Planetarium Station. Such shows directly contribute to this mission, the station, and, hopefully, the betterment of the students. The special shows may be an H excellent way to expose some students to earth science -these students x may have never gone through the Planetarium Station if it were not for the school excursion.

Overall, the “best” price to charge is unclear and requires some judgment as Rayla needs to balance an array of financial and non-financial factors.

Question 13.
(Minimum Pricing; Pricing Decision)
Diyana inc is engaged in manufacturing chemicals products of different category, some of which are fast moving, some are slow moving and few are in non-moving category. The firm has a stock of 10 units of one
acm-moving toxic chemical. Its book value is ₹ 2,400, realizable value is ₹ 3.300 and replacement cost is ₹ 4.200,
One of the customers of the firm asks to supply 10 units of a product which needs all the 10 units of thettOtt-moving chemical as an input. The other costs associated with the production of the product are:
Allocated overhead expenses: ₹ 16 per unit Out of pocket expenses ₹ 50 per unit Labour cost ₹ 40 per hour.
For each unit two hours are required. Ollier material cost 80 per unit.
The labour force required for the production of the product will be
deployed from among the permanent employees of the firm. This temporary deployment will not lead to any loss of contribution.
Required
(i) RECOMMEND the minimum unit price to be charged to the customer u if bout any loss to the firm.
(ii) ANALYSE with reasons for the inclusion or exclusion of each of the cost associated with the production of the product.
(iii) ADVICE a pricing policy to be followed by Diyana in perfect competition.
Ans.
(i) Diyana has the opportunity to utilize 10 units of non-moving chemical as input to produce 10 units of a product demanded by one of its customers. The minimum unit price to be charged to the customer would be-

Cost Component	Cost per unit of product (₹)
Cost of Material (Realizable value = ₹ 3,500/10 units of chemical)	350
Out of Pocket Expenses	50
Other Material Cost	80
Minimum Unit Price that can be charged	480

Therefore, the minimum unit price that can be charged to the customer, without incurring any loss is ₹ 480 per unit of product. As explained below in point (ii), allocated overhead expenses and labour cost are sunk costs that have been ignored while calculating the minimum unit price to be charged.

(ii) Analysis
(a) Cost of Material: Relevant and hence included at realizable value. Diyana has 10 units of non-moving chemical input that has a book value of ₹ 2,400, realizable value of ₹ 3,500 and replacement cost of ₹ 4,200. Realizable value of ₹ 3,500 would be the salvage value of the chemical had it been sold by Diyana instead of using it to meet the current order. This represents an opportunity cost for the firm and hence included while pricing the product. Book value would represent the cost at which the inventory has been recorded in the books, a sunk cost that has been ignored. Replacement cost of ₹ 4,200 would be the current market price to procure 10 units of the input chemical. This would be relevant only when the inventory has to be replenished after use. This chemical is from the non-moving category, that means that it is not used regularly in production process and hence need – not be replenished after use. Therefore, replacement cost is also ignored for pricing.
(b) Labour Cost: Not relevant and hence excluded from pricing. It is given in the problem that this order would be met by permanent employees of the firm. Permanent employee cost is a fixed cost that Diyana would incur irrespective of whether this order is produced or not. No additional labour is being employed to meet this order. Therefore, this cost is a sunk cost, excluded from pricing.
(c) Allocated Overhead Expenses: These expenses have been incurred at another Cost Centre, typical example would be office and administration costs. Such costs are fixed in nature that would be J incurred irrespective of whether this order is produced or not. Therefore, this cost is a sunk cost, excluded from pricing.
(d) Out of Pocket Expenses: These are expenses that are incurred to § meet the production requirement of this order. These are addi- f tional variable expenses, that need to be included in pricing.
(e) Other Material Costs: These are expenses that are incurred to meet the production requirement of this order. These are additional variable expenses, that need to be included in pricing.

(iii) Advice on Pricing Policy
Under perfect competition conditions, Diyana can have no pricing policy of its own, here sellers are price takers. It cannot increase its price beyond the current market price. The firm can only decide on the quantity to sell and continue to produce as long as the marginal cost is recovered. When marginal cost exceeds the selling price, the firm starts incurring a loss.
Since Diyana cannot control the selling price individually in the market, it can adopt the going rate pricing method. Here it can keep its selling price at the average level charged by the industry. This would yield a fair return to the firm. An average selling price would help the firm attract a fair market share in competitive conditions.

Question 14.
[Keep or Drop Decision]
Riya Ltd. is considering the discontinuance of Division C. The following information is given:

The rules of variablc costs arc 90% ot the normal rales due to the eurrent volume of operation. There is adequate market demand.
For any lower volume of operation, the rates would go back to the normal rates. Facilities released by discontinuing Division C cannot be used for any other purpose.
Required
COMMENT on the decision to discontinue Division C using relevant cost approach.
Answer:
As given in the problem Riya Ltd. is considering to discontinue the Division C perhaps by seeing the Division C’s income as it is a loss of ₹ 1,72,500. Discontinuance of Division C might be saving ₹ 4,14,000 on specific fixed costs to the company but due to this decision company will not only be losing ₹ 2,41,500 contribution from the Division C but also an additional burden of variable cost of ₹ 2,30,000 to Divisions A & B and Riya Ltd. as a whole.

Let assess the decision of the Riya Ltd. with the help of the Relevant Cost approach.

In a nutshell considering the above analysis we can conclude that the decision of discontinuing Division C will not be beneficial for the Riya Ltd and it should review its decision on the basis of relevant cost approach to reach at right decision

Question 15.
(Special Order Decision)
ZAM Ltd. is engaged in the manufacture of plasiic bottles of a standard size and produced by a joint process of machines. The factory has 5 machines and capable of producing 40 bottles per hour. The variable cost per bottle is ₹ 0.32 and the selling price is ₹ 0.80 each. The company has received an offer from another company for manufacture of 40,000 units of a plastic moulded toy. The price per toy is ₹ 30 and the variable cost is ₹ 24 each. In case of the company takes up the job, it has to meet the expenses of making a special mould required for the manufacture of the toy. The cost of the mould is ₹ 1,00,000. The company’s time study analysis shows that the machines can produce only 16 toys per hour. The company has a total capacity of 10,000 hours during the period in which the toy is required to be manufactured. The fixed costs excluding the cost of construction of the mould during the period will be ₹ 10 Lakh. The jg company has an order for the supply of 3,00,000 bottles during the period
Required
(i) Do you ADVISE the company to take up the order for manufacturing plastic moulded toys during the time when it has an order in its book for the supply of 3,00,000 bottles. (3 Marks)
(ii) An associate company of ZAM Ltd. has idle capacity and is willing to take up the whole or part (3 Marks)
(iii) If the order for the supply of bottles increases to 4,00,000 bottles, will you ADVISE the company to accept the order for the supply of plastic moulded toys? State the reasons of the manufacturing of the plastic moulded toys on sub-contracting basis. The sub-contract price inclusive of the cost of construction of mould is ₹ 28 per toy. DETERMINE the minimum expected excess machine hour capacity needed to justify producing any portion of the toy order by the company itself rather than sub-contracting. (4 Marks) [May 2018] (3 + 3 + 4 Marks)
Answer:
Workings
Statement Showing “Contribution/Machine Hour”

	‘Bottle’	‘Toy’
Demand (units)	3,00,000	40,000
Sales (₹/u)	0.80	30.00
Less: Variable Cost (₹/u)	0.32	24.00
Less: Specific Fixed Cost (₹/u)	—	2.50
Contribution (₹/u)	0.48	3.50
Machine Hours Required per unit	0.025	0.0625
Contribution/Machine Hour	19.20	56.00

Advice on Supply of 3,00,000/4,00,000 Bottles
(i) ZAM Ltd. can accept plastic moulded toy’s order as sufficient number of hrs. ie. 2,500 hrs. (10,000 hrs.- 3,00,000 bottles × 0.025 hrs.) are available and would be able to generate additional benefit of ₹ 3.50 per unit on 40,000 units of toys i.e. ₹ 1,40,000.

(ii) If the order for the supply of bottles increases to 4,00,000 bottles, then 2,500 more hrs. will be required to produce the additional bottles. ZAM Ltd. has to decide whether to utilize 2,500 hrs. for existing bottle order or for toy Order.
Machine time is limiting factor. Therefore, contribution per machine hour from both the activities (ie. bottles and toys) should be calculated to decide whether the order should be accepted. Contribution per hour is more in case of toys (refer workings). Therefore, ZAM Ltd. should utilize the remaining 2,500 hours for manufacturing toys rather than to fulfil the order for supply of additional bottles.
Prioritizing production based on contribution per machine hour would maximize profits. However, existing order fulfilment is necessary for building long term and sustainable customer relationship. Developing and maintaining long term and intimate relationships with the profitable customers provides valuable benefits to the company as the relationships between company and customers grow, a customer who is satisfied with the company’s products and services, tends to commit the relationship, and buy more over time. Cost of keeping the existing customers is less expensive than the cost of acquiring new customers.
Hence, ZAM Ltd. should be taken into consideration long term supplier relation before accepting the toy order based on financial consideration as contribution per hour is more in case of toys. Further, company may also explore outsourcing opportunities for production of toys.

(iii) Minimum number of toys needed to be manufactured to justify the increase in fixed cost of ₹ 1,00,000 to make the mould is 25,000 toys {1,00,000/ (₹ 28 – ₹ 24). Thus, as long as company has excess capacity available to manufacture more than 25,000 toys it is cheaper to produce than to buy from sub-contractor.
Minimum Expected Excess Capacity hours to = 25,000 toys/16 toys justify
= 1,562.5 or 1,563 hours
This question has been solved by considering 7,500 hrs. (3,00,000 bottles/40 bottles per hr.) for bottles. This question can also be solved by taking alternative assumption as well.

Question 16.
Magic Automation Limited, a 150 persons engineering company, decided it was time to fire the company’s biggest client. Although the client provided close to 60% of the company’s annual revenue, Magic Automation Limited decided that dropping this client was necessary. The client was profitable.
Magic Automation Limited stated “We cannot be a great place to work -3 without employees, and this client was bullying my employees. Its demands g for turnaround were impossible to meet even with people working seven $ days a week. No client is worth losing my valued employees”.
The initial impact on revenues was significant. However, Magic Automation Limited was able to cut costs and obtain new customers to fill the void. Moreover, the dropped client later gave Magic Automation Limited two projects on more equitable terms.
Required
(i) DISCUSS the reasons behind dropping of a profitable client by j Magic Automation Limited.
(ii) STATE three qualitative factors that management should consider in outsourcing and make or buy decisions. [Nov. 2019 Exam] (2 + 3 Marks)
Answer:
(i) Decision Making – Magic Automation Ltd.
With increasing completion, dynamic market changes, changing needs of customers, non-financial and ethical considerations have gained relevance in the decision-making process. A company may face the dilemma of meeting customers’ needs while protecting employees’ rights. While there are no clear-cut parameters to measure the impact of such decisions, they have a long-term impact on the company’s op-erations that ensures profitability and sustainability of an organization.

In the given scenario, a customer who contributes close to 60% of Magic Automation Ltd.’s profits has been making turnaround demands that are unreasonable for the company employees to meet. Magic Automation Ltd. has to decide whether to continue doing business with the customer based on the current terms or protecting the work environment of its employees. In the current scenario, it is in Automation’s long term interests to protect its employees’ rights (a non-financial consideration). Keeping this approach in mind, Magic Automation Ltd. decided to terminate business with the profitable client. While this had a significant impact on revenues in the short term, in the long run Magic Automation Ltd. was able to get business from new clients. Also, realizing the value of service provided, the dropped client came back with projects on equitable terms. Therefore, even though it did not make financial sense in the short run, decisions based on non-financial metrics played an important role in ensuring Magic Automation Ltd.’s long term sustainability.

(ii) Qualitative factors to consider while making the outsourcing and make or buy decisions:
(a) Quality of goods produced outside vs. in-house production of the component. Outsourcing or buying a component from the external market, should not impact the overall quality of the product. Therefore, any component critical for a product would generally not be outsourced unless its supplier gives quality assurance.
(b) Reliability of suppliers in the outsourcing arrangement. Assurance must be given by the supplier in terms of both quality and timely delivery of components for the given price. Also, there must be a sufficient pool of suppliers from whom the company can buy the product. If one supplier closes shop, there must be alternate suppliers available.
(c) Availability of skilled labour and infrastructure to make the component in-house. If not available, then the component may have to be bought from the external market.
(d) Regularity of demand for the product-If made in-house, seasonal demand for a product may result in the risk of holding high inventories (including that of raw materials) or making high capital investments that will prove unproductive during off-season. Therefore, outsourcing or buying from external market may be more viable when the demand for the final product is seasonal
(e) Risk of technological obsolescence for the component -when the risk is higher company may favour outsourcing.
(f) Confidentiality of process or patent of process – Confidential processes or critical components may not be outsourced.
(g) The shutting down of company’s manufacturing facility might have a negative impact on the morale of remaining employees.

Question 17.
(Special order decision)
M2K Co. is the manufacturer and supplier of firefighting and safety equipment for industrial use and follows the international quality standards and uses the high grade raw material. It is a fast-growing brand that protects millions of people across the India, every single day. M2K has been offered a bid on a prospective export contract for 20,000 commercial fire extinguishers with following specification from 5USA buyer and the delivery terms is FOB.
“two-gallon cylinder holding 10 pounds of multi-purpose dry chemical at 380PSI”
M2K is exporting first time. The price computation per fire extinguisher is as follows:

	₹	₹
Direct Material
Circle Part Cost	620
Necking Part	30
Bottom Part	50
Fire Extinguisher Powder	590
Heal Process	50
Nozzle	60
Meter	20
Pipe	50
Nitrogen	30	1,500
Direct Labour (2 lirs. × ₹ 40)		80
Leakage Testing		50
Variable Overheads (including packing)		214
Export Clearance Charges on FOB term		36
Fixed Overhead		100
Total		1,980
Add: Markup @ 10%		198
Price		2,178
USD to INR		67
Price in USD		32.51

After quotation of USD 32.51, the buyer is negotiating the price and ready to pay only USD 28.50.
Required
ADVISE whether it is worth accepting at USD 28.50 considering other factors. [Nov. 2019, Nov. 2021 RTF] (10 Marks)
Answer:
1. Workings
Statement Showing Benefit from Prospective Export Contract

	₹
Direct Material	1,500
Direct Labour (2 hrs. × ₹ 40)	80
Leakage Testing	50
Variable Overheads (including packing)	214
Export Clearance Charges on FOB term	36
Total Relevant Cost	1,880
USD to INR	₹ 67
Relevant Cost	$28.06
Price Offered by Customer	$28.50
Benefit per extinguisher	$0.44
No. of Extinguishers	20,000
Total Benefit	$8,800

Advise
From financial perspective, it will be profitable for M2K to accept the contract because of gain of $8,800 (? 5,89,600) along with export incentives of drawback. Besides this, following consideration should also be taken into consideration while exporting fire extinguishers:

Statutory Compliances
Before exporting to a foreign country or even agreeing to sell to a new customer in a foreign country, M2K should be aware of foreign laws that might affect the sale. Export documentation is important as it plays a significant role in regulating the flow and movement of goods in international markets. Each country has its own prescribed statutory documents to be complied by exporters and importers. Thus, M2K should consider about the documentation and inspection compliances part of new buyer. It may include third party audit, commercial invoice and packaging list requirements, certificate requirements like- no child labour certificate, inspection certificate, reach compliance certificate etc. If any compliance requirement is not met, what will be the consequences? There may be stiff penalty has to be paid owing to non-compliance or failure to accurately comply with the export obligation.

Buyer Creditworthiness
It is necessary that before shipment the exporter to carry out its own credit check on the importer to determine creditworthiness. Thus, M2K should make a proper assessment of the creditworthiness of the foreign buyer and spend sufficient time in cross checking the credit worthiness of his counterpart to avoid any kind of unforeseen situation in future. Such information can be easily availed through contracts or through ECGC. Private agencies also provide information on paid service basis. However, this risk can be covered by asking for LC payment terms or 100% advance or opting for post shipment insurance for goods being exported.

Industry Analysis
Industry analysis involves such things as assessing the competition in the industry; the interplay of supply and demand in the industry; how the industry holds up against other industries that are emerging and providing competitions; the likely future of the industry, especially in light of technological developments; how credit works in the industry; and the exact extent of the impact that external factors have on the industry.
For M2K, it is worthwhile to know the current and future demand of fire extinguisher and factors influencing the growth of global fire extinguisher market. M2K can perform industry analysis through three main ways ie. the Competitive Forces Model (also known as Porter’s 5 Forces); the broad factors analysis, also known as PEST analysis; and SWOT Analysis. It may also arrange industry report from trusted sources.

Additional Terms
Ensure that the all terms are clear and suit the business purpose. For instance, delivery terms should provide date of shipment or means of determining the date. In some circumstances, a late delivery penalty may be incurred where goods are not supplied by a specific delivery date. Therefore, M2K should evaluate whether shipment date is attainable or not. If the target shipment date could not be met, what will be the charges? Further, M2Kmust also check whether the foreign bank charges are subject to beneficiary account. If yes, then the same must be considered in the quotation.
Overall, M2K should accept the proposed contract only after due and careful consideration of above factors.

Question 18.
(Product Mix Decision)
Rocky Ltd. is a manufacturing company. It manufactures two product, Product X and Product Y. Each product passes through two departments A and B before it becomes a finished product. The data for the year are as under:

	Product X	Product Y
Maximum Sales Potential (in units)	7,400	10,000
Product unit data:
Selling Price p. u.	₹ 90	₹ 80
Machine hrs. p.u.
Department A hrs. @ ₹ 40/hr.	0.50	0.30
Department B hrs. @ ₹ 60/hr.	0.40	0.45

Maximum Capacity of Department A is 3,400 hrs. and Department B is 3,640 hrs.
Maximum Quantity of Direct Materials available is 17,000 kgs. Each product requires 2 kg. of Direct Materials. The Purchase Price of direct materials is ₹ 5/kg.
Required
(i) FIND optimum product mix.
(ii) In view of the aforesaid production capacity constraints, the company has decided to produce only one of the two products during the year. Which of the two products should be produced and sold in the year to maximise profit? FIND the number of units of that product and relevant contribution.
Answer:
(i) Calculation of Optimum Production Mix Statement Showing Limiting Factor

Particulars	Material	Hours in Depart­ment A	Hours in Depart­ment B
Required: X	14,800 kg.	3,700 hrs.	2,960 hrs.
Required: Y	20,000 kg.	3,000 hrs.	4,500 hrs.
Total Requirement	34,800 kg.	6,700 hrs.	7,460 hrs.
Available Resources	17,000 kg.	3,400 hrs.	3,640 hrs.
Shortage	17,800 kg.	3,300 hrs.	3,820 hrs.

Hence all the three resources are limiting factors.

Statement of Rank

Particulars	Product X	Product Y
Sales	90	80
Less: Direct Material	10	10
Dept. A	20	12
Dept. B	24	27
Contribution p.u.	36	31
Contribution per kg. of Raw Material	18	15.5
Rank	I	n
Contribution/hr. of Dept. A	72	103.33
Rank	II	I
Contribution/hr. of Dept. B	90	68.89
Rank	I	II

To find the optimum mix of products that shall lead to maximum profits while taking into consideration of shortage of resources (ie. constraints), we have to use Linear Programming.

Let x₁ and x₂ donate quantities of product ‘x’ and product ‘y’ respectively The linear programming model for the given problem is


So, different combinations of product mix include,

Combination Q (4,171, 4,381) is not possible as it is satisfying three conditions out of above four conditions. To produce combination Q (4,171, 4,381), requirement of the material will be 17,104 Kgs. (2 Kg × 4,171 units + 2 Kg × 4,381 units). However, material is available 17,000 Kgs. Accordingly, this combination is not possible.
Therefore, optimum product mix = X 4,250 units and Y 4,250 units.

(ii) Statement Showing Product with Higher Contribution

Therefore, Product Y should be produced at 8,089 units resulting in a contribution of ? 2,50,759.

Question 19.
(CVP Analysis)
Hotel Bahaar, Zeeland, an affordable leisure hotel resort is an ideal retreat to escape, unwind and enjoy peace of mind. Set amid expansive tropical greenery in the enclave of Zeeland, Hotel Bahaar is designed for pleasure, where services reign supreme and Italian- style architecture of its 25 classic rooms harmonize with nature. Hotel Bahaar, Zeeland is a beachfront resort that features a good choice of swim-up pool bar, p gym, and variety of restaurants. A wide array of water sport activities like surfing, sailing, jet skiing etc. are available from beach operators at walking distance. The hotel is synonymous with enjoyment and value for I money, with a large choice of very attractive “All Inclusive” packages.
Bahaar charges guests ZD 2,700 per room per night, irrespective of single or double occupancy. The variable cost is ZD 900 per occupied room per night. The Bahaar is available throughout 365 days a year and has a 75% budgeted occupancy rate. Fixed costs are budgeted at ZD 9 million and are incurred evenly during the year.
During the second quarter (Q2) of the year, usually the room occupancy rates remains substantially below the levels expected at other quarters of j the year. Bahaar is expecting to sell 900 occupied room nights during Q2. Management is considering strategy to improve profitability, including j closing the Bahaar for the duration of Q2 or adopting one possible option
as follows –
There is scape to extend the Bahaar by creating enough space to run a Rustic Chic, Italian Style restaurant to serve its guests. The annual j revenues, costs and sales volumes for the combined operations are given in the following graph
Note
Zeeland’s home currency is the ZD.

Required
ANALYZE the profit improvement plan [Nov. 2019] [Nov. 2021 RTP]
Answer:
The Present Profit of Hotel Bahaar
Total Room Days = 25 Rooms × 365 days × 75% = 6,844

Profit = Total Contribution – Fixed Cost
= 6, 844 room days × (ZD 2,700 – ZD 900) – ZD 90,00,000
= ZD 33,19,200
Proposal of Opening an Italian Restaurant (If Bahaar is closed during Q2)
Opening a restaurant will increase the fixed costs of the Hotel Bahaar from ZD 9 million p.a. to ZD 12 million p.a. Thus, annual increment of ZD 3 million. Average Revenue per occupied room will rise from ZD 2,700 to ZD 3,636.36… (ZD 30 Million/8,250 rooms) because increasing guest expenditure in Italian restaurant.
The total cost predicted at a level of 8,250 occupied rooms is ZD 23.75 million which means the variable costs must be ZD 11.75 million (ZD 23.75 million – ZD 12 million fixed costs). This is a variable cost per occupied room of ZD 1,424.24… which is an increase of ZD 524.24…
Consequently, the breakeven point has gone up from 5,000 to 5,425 (as shown in the diagram) occupied rooms so the Bahaar is required to sell more room nights to cover costs. However, budgeted occupancy is now 7,310 occupied room nights which is 80.11% occupancy (7,310/9,125). This provides a margin of safety of 1,885 occupied room nights or 25.79%. At 7,310 occupied room nights, Bahaar’s budgeted profit would be ZD41,70,597 {7,310 × (ZD 3,636.36 – ZD 1,424.24) -12 million} which is more than present budgeted profit by ZD 8,51,397. So, it is better for Bahaar to go for opening an Italian Restaurant

Question 20.
(Design Making) Asiyana Colour paints is a manufacturer of industrial dyes. It has received an order for 200 kgs of powder dye that needs to be customized to certain specifications. The job would require the following materials:

(I) Material B is used regularly in production of all types of dyes that Asiyana Colour plaints produces. Therefore, any stock used towards this job order would need to be replaced to meet other production demands.
(II) Inventory of material C and D are from stock that was purchased in excess previously. Material C has no other use other than for this special order. Material D can be used as a substitute for 700 units of material Z which currently costs ₹ 11 per unit. The company does not have any inventory of material Z currently.
Required
ANALYSE the relevant costs of material while deciding whether to accept the order or not?
Answer:
Material A
The requirement of 2,000 units of Material A has to be purchased in entirety since there are no units in stock. Therefore, the relevant cost will be the replacement cost at ₹ 8 per unit, which for 2,000 units is ₹ 16,000 (2,000 units × ₹ 8 per unit).

Material B
There is a requirement of 3,000 units of Material B, of which 1,200 units are in stock. Material B used regularly in the production of all types of dyes. If the 1,200 units in stock are used, they need to be replenished (replaced) in order to meet production demands of other dyes. In addition, for the special order, additional 1,800 units of Material B is required to be procured from the market. Therefore, 3,000 units of Material B has to be procured if the special order is undertaken. The relevant cost will be the 1 replacement cost at ₹ 10 per unit, which for 3,000 units is ₹ 30,000 (3,000 units × ₹ 10 per unit).

Material C
1 There is a requirement of 2,000 units of Material C, of which 1,400 units are in stock. The balance 600 units have to be procured at the replacement § (market) price of ₹ 14 per unit, which would be ₹ 8,400. Material C has no other use, so if the special order is not undertaken the stock of 1,400 units 21 can be sold at ₹ 9 per unit. So, the opportunity cost of undertaking this order is ₹ 12,600. Therefore, the relevant cost for Material C is procurement cost of 600 units plus the opportunity cost of not disposing the current stock of 1,400 units, which would be ₹ 8,400 + ₹ 12,600 = ₹ 21,000.

Material D
The entire requirement of 500 units of Material D is in stock. If the special order is not accepted, Asiyana Colour paints has two options (i) sell the excess material at ₹ 12 per unit or (ii) use it as a substitute for Material Z, which would otherwise need to be procured.
(i) The realizable value of Material D is ₹ 6,000 (500 units × ₹ 12 per unit).
(ii) Material D can be used as a substitute for 700 units of Material Z. Since there is no stock of Material Z currently, if the special order is accepted, the entire quantity would have to be procured at ₹ 11 per unit. This would cost the company ₹ 7,700 (700 units × ₹ 11 per unit).

Both options (i) and (ii) represent opportunity cost if the special order is accepted. The relevant cost for Material D, if the special order is accepted would be higher of either of these two opportunity costs. The higher opportunity cost of that of procuring Material Z from the market at ₹ 7,700.
Therefore, the relevant cost for Material D is ₹ 7,700.
Therefore, the relevant cost to accepting the special order would be the cumulative of the relevant cost for Materials A, B, C and D. This works out to ₹ 74,700.

Question 21.
(Relevant Cost Concept)
Royal King Airlines Ltd. operates its services under the brand ‘Royal King’. The ‘Royal King’ route network spans prominent business metropolis as well as key leisure destinations across the Indian subcontinent. ‘Royal King’, a low-fare carrier launched with the objective of commoditizing air travel, offers airline seats at marginal premium to train fares across India.
Profits of the ‘Royal King’ have been decreasing for several years. In an effort to improve the company’s performance, consideration is being given to dropping several flights that appear to be unprofitable.

Income statement for one such flight from ‘Mew Delhi’ to ‘Leh’ (PP – 2) is given below (per flight):

* Based on obsolescence
The following additional information is available about flight PP-2.
1. Members of the flight crew are paid fixed annual salaries, whereas the flight assistants are paid by the flight.
2. The baggage loading and flight preparation expense is an allocation of ground crew’s salaries and depreciation of ground equipment.
3. One third of the liability insurance is a special charge assessed against flight PP-2 because in the opinion of insurance company, the destination of the flight is in a “high – risk” area.
4. The hanger parking fee is a standard fee charged for aircraft at all airports.
5. If flight PP-2 is dropped, ‘Royal King’ Airlines has no authorization at present to replace it with another flight.
Required
Using the data available, prepare an ANALYSIS showing what impact dropping flight PP-2 would have on the airline’s profit. [Nov. 2018 RTP]
Answer:
As per the statement given in the problem, Flight PP-2 incurs a net (loss) of ₹ 158,100. This is the net result of revenue less costs. Revenue is entirely variable depending upon passenger occupancy. Costs are both variable and fixed nature. To analyze the impact of dropping flight PP-2, we need to re-compute net gain/(loss) that Royal King earns when it operates the flight based on relevant costing principles.

Net Gain/(Loss) = Revenue earned from flight operations less Variable costs of operation
Revenue earned is the ticket revenue earned from flight operations of PP-2, this is entirely variable. Variable costs of flight operations are those expenses that would be incurred only when the flight is operated. These include variable expenses per passenger, salaries flight assistants, overnight costs for flight crew and assistants, fuel for aircraft, a third portion of flight insurance that is specifically related to this flight sector and flight promotion expense. These are expenses that will not be incurred if the flight is not operated. Hence, relevant for decision making.
Other expenses like salaries of flight crew and hanger parking fees for aircraft are fixed expenses that will be incurred even if the flight does not operate. Loading and flight preparation expense is an allocated cost that will continue to be incurred even if flight PP-2 does not operate. Depreciation of aircraft and liability insurance expense (2/3rd portion not related to a specific flight sector) are sunk costs. These expenses have already been incurred and hence are irrelevant to decision making. Therefore, these fixed, allocated and sunk expenses are ignored while analyzing the decision whether to continue operating flight PP- 2.
Flight PP-2
Statement Showing Net Gain/(Loss)

	₹	₹
Contribution Margin if the flight is continued		5,88,000
Less: Flight Costs
Flight Promotion	28,000
Fuel for Aircraft	2,38,000
Liability Insurance (1/3 × ₹ 1,47,000)	49,000
Salaries, Flight Assistants	31,500
Overnight Costs for Flight Crew and Assistants	12,600	3,59,100
Net Gain/(Loss)		2,28,900

If Royal King Airlines Ltd. discontinues flight PP-2, profits will reduce by ₹ 2,28,900. The statement showing loss in operations of ₹ 158,100 is misleading for decision making purpose because it accounts for costs that are fixed and irrelevant. However, since flight PP-2 yields a net gain of ₹ 2,28,900, flight operations should continue.

Question 22.
‘Rose Laundry* Is one of the largest laundry service provider for g
Suits. The firm has set a price of ₹ 510 for cleaning the “suit set”. ‘Rose Laundry’ derived this price as follows: cleaning materials ₹ 35, labour (3 %
hrs. (@ ₹ 50 per hr.) ₹ 150, variable overheads ₹ 70, fixed overheads (3 hrs. @ ₹ 15 per hr.) ₹ 45 plus mark-up 70% on total cost. ‘Rose Laundry’ is known for its quality work and timely delivery; hence, customers are willing to pay this premium price. Firm’s employees receive a fixed salary.
The “hourly rate” ₹ 50 is arrived by dividing the total salary by the total number of hours available. Variable overheads depend on the number of suits cleaned whereas fixed overheads rate is derived at by dividing the total cost of all related expenses by the number of labour hours available. Fixed overheads generally include office rent and administrative salary.
A local hotel approached ‘Rose Laundry’ as the regular cleaners of these suits are on strike, about the possibility of cleaning 130 suits in coming week and they need the work done on a rush basis. ‘Rose Laundry’ has sufficient quantity of required cleaning material in stock for special order.
It perceives that it could complete 60% of the special order during normal working hours. However, to complete the remaining 40%, some employees will have to work overtime. Overtime hours are paid at premium, which could be time and half the normal hourly rate.
Required
(i) ADVISE the price it shall quote for the special order?
(ii) Does special order decision deal with excess supply or excess demand? ANALYSE.
(iiii) Whether such special order be accepted on rush basis? COMMENT.
Answer:
(i) Firms can face situations where they are confronted with the opportunity of offering for a one-time special order. In this situation only the incremental costs of undertaking the order should be taken into consideration. Quote should be made at prices that exceeds incremental costs. Any excess of revenues over incremental costs will provide a contribution to committed fixed cost which would not otherwise have been gained.
‘Rose Laundry’ can use the incremental cost numbers for pricing the ‘rush order’.

Particulars	Amount (₹)
Cleaning materials (130 × ₹ 35)	4,550
Labour (130 × 3 × 4096 × ₹ 50 × 1.5)	11,700
Variable overheads (130 Suits × ₹ 70)	9,100
Incremental cost	25,350

However, in decision making other conditions are equally important. For instance, if this is a one-time deal with no prospect of repeat business, then ‘Rose Laundry’ might well charge a premium over the normal price. Long-term implications also matter. The prospect of “getting a foot in the door” to quote for future business would push the price downward Therefore, ‘Rose Laundry’ can price based on both the short-run benefits from accepting the order and the long-run consequences.

(ii) Such special order definitely gives ‘Rose Laundry’ opportunity to earn more profits, however, other aspects also need to be analysed. There is excess of cleaning material if the current special order does not use up available stock, the firm could store the cleaning material for later use. It is most likely that ‘Rose Laundry’ fixed overhead costs will not change due to the special order which mainly consists of rent and administrative salaries. If 6096 of the special order could be completed during normal working hours, then the firm clearly has some excess capacity in terms of labour horns. However, for the remaining 4096 of the special order, labour will have to work overtime and will be paid 1.5 times. This clearly indicates that different resources in the ‘Rose Laundry’ have differing capacity levels; a decision may impose constraints on particular resource. It is necessary to consider the opportunity cost of each resource when computing the total cost of a special order.

(iii) There are two sides in this scenario. On the one side, firm can earn more profits by taking the special order. On the other side, the order received needs to be delivered urgently. Therefore, accepting such rush orders may affect the quality of service and also timely delivery may not be complied with. Hence, the goodwill and brand name will be affected which in turn will affect the future profitability. Though immediate monetary benefits are seen, long time consequences also need to be analysed before accepting such rush orders. The firm manager would need to consider both the short-run benefits from accepting the order and the long-run consequences on profitability.

Question 23.
Ajay Group was established in 1975, manufactures and sells electronic personal grooming and beauty products. The group has two 100% subsidiaries HAUM Ltd. and HARZ Ltd. HAUM Ltd. manufactures luxury products that cater to niche customers who prefer specialized personal grooming and beauty care. HARZ Ltd. caters to regular daily beauty and grooming requirements that has a wide reach within the market. Factories of both companies are located within India. The products are sold to wholesalers, who supply these products to the retail market.
Ajay Group purchases its raw material requirements from both domestic and overseas markets. Additionally, certain products manufactured by HAUM Ltd. can be enhanced based on the products manufactured by HARZ Ltd. Therefore, as per production requirements, HAUM Ltd. sources some product components from HARZ Ltd.
Ajay Group has a centralized decision making set-up. Basic policy decisions for functions such as production planning, sales and client relationship, finance and human resources are handled at the group level. Individual units HAUM Ltd. and HARZ Ltd. concentrate on the manufacturing alone.
About You
You are an Assistant Manager in Finance and Accounts department of Ajay Group, headed by Director- Finance Ms. Elsea. You assist and report to Ms. Fiona, Manager of your department. Sometime you also assist Director Finance in analysing financial and non-financial information, drafting reports for board meetings, preparation of presentation and staff trainings.

Business Situation – 1
Yesterday, 5.15 P.M.
You got an email from Ms. Elsea, with Cc to Ms. Fiona. Ms. Elsea, asked you to prepare a cost statement for making a quotation to a new customer. She has also informed you that the customer can also maintain a long-term business relation with us. You have been requested to gather information related to the specification from Sales Manager.
Yesterday, 5.25 P.M.
You have been called by Ms. Fiona, and provided the product specification received from Sales-Manager for which quotation has to be quoted. Ms. Fiona has also requested you to gather relevant information to prepare I cost statement. Due to the expected long term business relationship that HAUM Ltd. wants to have with the customer, the sales manager wants to quote the lowest possible price. HAUM Ltd. currently has some spare j capacity that can be utilized to cater to this entire order. Therefore, only the relevant cost to HAUS Ltd. has to be considered to arrive at the quote.
After meeting with your reporting officer, you mailed to various concerned department and requested for data.

The following information has been obtained in relation to the contract:
Today, 10.05 AM.
You got an e-mail from Production Manager, it has been informed that 40 tonnes of material Dx would be required. This material is in regular use by HAUS and has a current purchase price of ₹ 380 per tonne. Currently, there are 5 tonnes in inventory which cost ₹ 350 per tonne. The resale value of the material in inventory is ₹ 240 per tonne.
Further, with regards to components, it has been informed that 4,000 components would be required. These could be bought externally for ₹ 15 each or alternatively they could be supplied by HARZ Ltd. The variable cost of the component if it were manufactured by HARZ Ltd. would be ₹ 8 per unit. HARZ Ltd. has sufficient capacity to produce 2,500 components without affecting its ability to satisfy its own external customers. However, in order to make the extra 1,500 components required by HAUM Ltd., HARZ Ltd. would have to forgo other external sales of ₹ 50,000 which have a contribution to sales ratio of 40%. To have uniformity in the quality of the component, it is assumed that HAUM Ltd. would procure its entire requirement of 4,000 components either externally or from HARZ Ltd. The transfer pricing policy of Ajay Group for sales between units aims at goal congruence. The unit selling the goods would be allowed to charge any opportunity cost on account of catering to internal demand, while the purchasing unit should ensure that the company is not at a loss. Jbday, 10.45 A.M.
You got an e-mail from Personnel Manager, it has been informed that 2,000 high skilled labour hours would be required. The grade of labour required is currently paid ₹ 5 per hour.
Highly skilled labour is in short supply and cannot be increased significantly in the short-term. This labour is presently engaged in meeting the, demand for product ‘G’, which requires 4 hours of highly skilled labour. The contribution from the sale of one unit of product L is ₹ 24.
It has also been informed that the contract would require a specialist machine. The machine could be hired for ₹ 15,000 or it could be bought for ₹ 50,000. At the end of the contract if the machine were bought, it could be sold for ₹ 30,000. Alternatively, it could be modified at a cost of ₹ 5,000 and then used on other contracts instead of buying another essential machine that would cost ₹ 45,000. The operating costs of the machine are payable by HAUS whether it hires or buys the machine. These costs would total ₹ 12,000 in respect of the new contract.

Supervisor
The contract would be supervised by an existing manager who is paid an annual salary of ₹ 50,000 and has sufficient capacity to carry out this supervision. The manager would receive a bonus of ₹ 5,000 for the additional work.

Development Time
15 hours of development time at a cost of ₹ 30,000 have already been worked in determining the resource requirements of the contract.
Fixed Overhead Absorption Rate ,
HAUS uses an absorption rate of ₹ 20 per direct labour hour to recover its general fixed overhead costs. This includes ₹ 5 per hour for depreciation.
Today, 11.15 A.M: Ms. Fiona called you in her place as asked you the following:
Required
(i) CALCULATE the relevant cost of the contract to HAUS. You must present your answer in a schedule that clearly shows the relevant cost value for each of the items identified above. You should also EXPLAIN
each relevant cost value you have included in your schedule and why any values you have excluded are not relevant. Ignore taxation and the time value of money.
(if) .DiSCUSS two problems that can arise as a result of setting prices using relevant costing.
Business Situation – 2
Today. 5.26 P.M: A memo from Managing Director of the group has been circulated to ail officers of the group which stated “My objective for the
forthcoming year is to reduce our quality costs in each of the primary activities in our value chain”. The company is keen to build a reputation for quality and gives a five-year guarantee with all of its products.
Today, 5.37 P.M: Ms. Fiona, called you in her piace and asked the following:
Required
EXPLAIX, by giving examples, how each of the four types of quality cost could be reduced. You should also IDEXTIFY in w hich primary activity each one of your examples would occur in Ajay Group’s value chain.
Answer:
(i) Statement Showing Relevant Cost

Type of Cost	Explanation	Amount (₹)
Material Dx (40 tonnes × ₹ 380)	1	15,200
Components	2	52,000
Direct labour (2,000 hrs. × ₹ 11)	3	22,000
Specialist machine	4	10,000
Machine operating cost	5	12,000
Supervision	6	5,000
Development time	7	Nil
General fixed overhead	8	Nil
Total relevant cost		1,16,200

Explanation:
1. Material Dx is in regular use by HAUM Ltd. and must be replaced. Consequently, its relevant value is its replacement cost. The historical cost is not relevant because it is a past cost and the resale value is not relevant because HAUM Ltd. is not going to sell it because the material is in regular use.

2. HAUM Ltd. would like to procure 4,000 components either from HARZ Ltd. or externally from the market. At the current production level, HARZ Ltd. (seller) has available capacity to accommodate part of HAUM Ltd.’s request to the extent of 2,500 components. At this point, HARZ Ltd. would be operating at its maximum capacity.
To cater to the remaining demand of 1,500 units from HAUM Ltd., HARZ Ltd. has to forego external sales of ₹ 50,000 to its own customers. Given that the contribution to sales ratio is 40%. Therefore, HARZ Ltd. has to forego contribution of ₹ 20,000 (40% of external sales foregone ₹ 50,000) in order to cater to HAUM Ltd.’s request. Fixed cost at HARZ Ltd. is irrelevant, since it would be incurred irrespective of whether HAUM Ltd.’s order to catered to or not.
Therefore, in spirit of goal congruence, the transfer price that HANZ Ltd. would charge HAUM Ltd. would be the variable cost of ₹ 8 per emit and ₹ 20,000 towards lost contribution as explained above. Therefore, the transfer price
= (₹ 8 per unit × 4,000 components) + ₹ 20,000
= ₹ 32,000 + ₹ 20,000
= ₹ 52,000 for 4,000 components
Therefore, per component, the price charged would be ₹ 52,000/4,000 = ₹ 13 per component. This is lower than the external market price of ₹ 15 per unit. Therefore, in the interest of goal congruence the cheaper option is preferred. HAUM Ltd. should source its components from HARZ Ltd., for a total procurement cost of ₹ 52,000.

3. Skilled labour is in short supply and can only be obtained by reducing the production of product ‘G’, resulting in a loss of contribution of ₹ 24 (given) or ₹ 6 per hour of skilled labour. Hence the relevant labour cost will be ₹ 6 (contribution lost per hour) + ₹ 5 (hourly rate of skilled labour) i.e. ₹ 11 per hour.

4. HAUM Ltd. has a number of options:
(a) If the machine were to be hired it would have a cost of ₹ 15,000;
(b) if the machine were bought and then sold at the end of the work it would have a net cost of ₹ 20,000; or
(c) if the machine were bought and then modified to avoid the need to buy the other machine it would have a net cost of ₹ 10,000 (₹ 50,000 plus ₹ 5,000 modifications less ₹ 45,000 cost of another machine). Thus, the most economic approach is buy the machine and then modify it so the relevant cost is ₹ 10,000.
5. The machine operating costs are future costs of doing the work and therefore are relevant.
6. The supervisor’s salary is irrelevant, but the bonus needs to be included because it is dependent on this work and therefore is relevant.
7. The development time has already been incurred. Therefore, it is a past cost and not relevant.
8. General fixed overhead costs and their absorption are not relevant because they will be incurred whether the work goes ahead or not. Depreciation is also not relevant because it is an accounting entry based on the historical purchase of assets. It is not affected by the work being considered

(ii) Two main issues arise when pricing work based on relevant costs:

• Profit reporting; and
• Pricing of future work.

With regard to profit reporting, the decision as to whether to proceed with the work will have been based on the use of relevant costs, but the routine reporting of the profit from the work will be based on the company’s normal accounting system. Since this system will be based on total cost, it is probable that the costs of the work reported will be greater than its relevant cost. Consequently, the amount of profit reported to have been made on this order will be lower than expected and may even be a loss. This may cause difficulties for the manager who accepted the work as an explanation will be required of the reasons why there is such a difference in profit.
With regard to the pricing of future work the difficulty lies in increasing the price for similar items for the same customer in future. Once a price is set, customers tend to expect that any future items will be priced similarly. However, where a special price has been offered based on relevant cost because of the existence of spare capacity the supplier would not be able to continue to price on that basis as it does not recover its long term total costs. There may also be difficulties created by this method of pricing as other customers are being charged on a full cost basis and if they were to discover that a lower price was offered to a new customer they would feel that their loyalty was being penalised.

(iii) Prevention
Operations: Preventative maintenance and checking of the calibration of machinery. This would reduce the number of potentially faulty products being produced and therefore reduce guarantee claims. Appraisal Inbound Logistics: Reduce costs of incoming inspections by building close links with suppliers and getting them to adopt TQM. If suppliers can guarantee their quality, then inbound inspections could be eliminated.

Internal Failure
Operations: Reduce costs of re-works by training employees on a continual basis e.g. quality circles. This would reduce failure costs and also improve quality.

External Failure
Service: Design quality into the product to try to prevent guarantee claims and therefore the cost of servicing/repairing the product.

Question 24.
Felicity Ltd. is a chemical manufacturing company. It has received a special project that needs to be completed executed 3 months from the time it is accepted. The management has to communicate its acceptance or rejection of the project within few days. They have approached you, the management accountant to work out the costing for this project. Following is the information available:
1. Financing:
The company would require a short-term overdraft of ₹ 5,00,000 immediately in order to execute the project. Bank charges an interest of 10% per annum on this overdraft. This overdraft facility would be needed for the duration of the project, that is 3 months and would be repaid in full at the end of the period.

2. Materials:
Felicity Ltd. has a stock of inventory of 5,000 kg on hand that is not of immediate use. It can be sold as scrap in the market at ₹ 250 per kg. The special project requires 3,000 kg of this inventory which can be replaced at the current market price of ₹ 300 per kg.

3. Labour:
(a) All skilled workers currently work full time in their respective departments, there are no idle hours. For this special project, 5 workers would be needed from other departments. They would totally devote 2,000 hours of labour time to this project. The cost of labour per hour is ₹ 300. Since their working hours have been diverted to this project, the production in the other departments cannot be met. Hence, the company would incur a loss of contribution of ₹ 1,00,000 for these 2,000 hours. Alternatively, the company can outsource the labour for this special project at a total cost of ₹ 6,25,000. The management will opt for the more cost-effective option as the quality of both in-house manufacturing and outsourcing is the same.

(b) Overtime payment to inspection supervisor, who checks the final products would be ₹ 25,000. This would be incurred irrespective of whether the labour is in-house or outsourced.

4. Machine X-2.1”
This project would require the use of an existing machine X-2.1”. Depreciation of X- 2.1 ” is ₹ 40,000 per annum. The variable operating cost of X-2.1” for the three-month period would be ₹ 3,00,000. At present, X-2.1 ” is operating at full capacity. By diverting it exclusively for the special project would cost the company a loss of contribution of ₹ 1,00,000 for the three-month period.

5. Administration overheads include apportionment cost of ₹ 25,000 and an incremental cost (incurred specifically due to the acceptance of ihe project) of ₹ 10,000.

6. Total revenue that the company can earn from the project is ₹ 20,00,000.
Required: COMMENT whether the special project should be accepted or not. Also give a complete ANALYSIS of the special project cost based on the principles of relevant costing. [Nov. 2021 RTP]

Solution: Special Project Cost

Comment
Revenue to be earned from the project is ₹ 20,00,000 while the cost of accepting the project would be ₹ 18,22,500. The project can yield a surplus of ₹ 1,77,500. Therefore, the special project can be accepted.

Notes:
Note 1: Project financing for 3 months through overdraft of ₹ 5,00,000 at interest of 10% per annum.
This is a relevant cost since it is an incremental cost to be incurred only if the project is accepted. The incremental cost is the interest to be paid on the overdraft of ₹ 5,00,000 for 3 months. At the end of three months, the overdraft will be repaid in full, therefore there will be no further incremental cost.

Note 2: Material cost
The company already has material worth 5,000 kg in its inventory. This is a sunk cost that has already been incurred. Materials requirement for this project is 3,000 kg which can be sourced from the current inventory of 5,000 kg. This material could have been sold as scrap at ₹ 250 per kg. However, since 3,000 kg of this material can be used for this project, the sale proceeds 5S from the scrap sale of 3,000 kg would be the opportunity cost that has to g be accounted for. This is the cash inflow forgone if the project is accepted, Replacement cost of 3,000 kg at ₹ 300 per kg would be irrelevant since there is no need to buy this material, it is already in inventory. Also the material has no further immediate use, so there is no need to replace it.

Note 3: Labour cost – Cost of in-house production v. cost of outsourcing the work for the project
Five skilled workers from other departments would need to devote 2,000 hours for this project. They are paid at ₹ 300 per hour. They are fully working in their respective departments and are not idle. The cost of labour of these 5 workers for 2,000 hours would be a relevant cost for the project, Total hours by 5 skilled workers = 2,000 hours Rate per hour = ₹ 300 per hour
Labour cost for in house skilled workers= 2,000 hours X ₹ 300 per hour
= ₹ 6,00,000
To this, the loss of contribution for diverting the skilled workers’ hours for the project represents an opportunity cost that is a relevant cost. This is the revenue forgone if the project is undertaken.
Total labour cost for in house production
= cost of skilled workers + contribution lost (opportunity cost)
= ₹ 6,00,000 + ₹ 1,00,000
= ₹ 7,00,000
The cost of outsourcing the work for this project is ₹ 6,25,000. Since the quality of work is the same under both options it is cost effective to outsource the labour for this special project. Therefore, the relevant cost for the special project is ₹ 6,25,000.

Note 4: Overtime paid to inspection supervisor
Overtime paid to inspection supervisor specially for this project is an incremental cost, a relevant cost.

Note 5: Machine X-2.1”
The operating cost of X-2.1” ₹ 3,00,000 is an incremental cost, therefore a relevant cost. The depreciation of ₹ 40,000 per annum on it is a sunk cost and hence not relevant.
This machine X-2.1” works at full capacity, no idle time. Hence the contribution loss of ₹ 1,00,000 for the three-month period due to this diversion will be an opportunity cost that has to be accounted for. This is revenue forgone if the project is accepted.

Note 6: Administrative overhead
Allocation of administrative overhead of ₹ 25,000 is not a relevant cost since this is a sunk cost already incurred. Incremental administrative cost of ₹ 10,000 incurred specifically for the project is a relevant cost and hence has to be accounted for.

Non-Resident Taxation – CA Final DT Question Bank is designed strictly as per the latest syllabus and exam pattern.

Non-Resident Taxation – CA Final DT Question Bank

Question 1.
Thomas, a non-resident Indian has the following sources of income in India. You are required to compute his total income and determine his tax liability:

Inflation index: 2006-07 = 122; 2020-21 = 301
The shares are sold through a recognised stock exchange and STT has been paid on it both at the time of sale and at the time of acquisition. The highest price quoted for such shares on the recognised stock exchange in total is ₹ 4,50,000 on 31.01.2018. The property was acquired partly out of a loan from HDFC. The repayment of loan made during the year amounted to ₹ 30,000. The assessee claims deduction of ₹ 50,000 towards repayment of loan taken for higher education in India in 2015 before his migration. [CA Final Nov. 2011] [6 Marks]
Answer:
As the assessee is a non-resident Indian, provisions of Chapter XII-A (com-prising of sections 115C to 115-1) can be made applicable to him or under section 115-1, he can opt for normal provisions.

Computation of Total income for A.Y. 2021-22

Notes:
1. It has been assumed that house property income here means the income from house property net of all deductions.

2. As per Sec. 112A, where the capital gains arises-from the transfer of long term equity shares, the tax payable by the assessee on such long term capital gains exceeding ₹ 1,00,000 shall be 10%, if .STT has been paid on acquisition and transfer of such shares.

The cost of acquisition of such shares for the purposes of computing capital gains shall be higher of the cost of acquisition of such shares or the FMV of such shares. The FMV in respect of listed shares shall mean the highest price quoted for such shares as on 31.01.2018 on the recognised stock exchange where such shares are listed. Since, the FMV of the shares as on 31.01.2018 is higher than the cost of acquisition, it shall be taken as the cost of acquisition as per Sec. 55(2)(ac).

Computation of tax liability

In the present case, the tax liability of Thomas, a non-resident India, will be lower if he does not opts for Chapter VII-A and therefore, it is beneficial for him to pay tax as per the normal provisions applicable to non-residents.

Question 2.
Ricky, a foreign national and a cricketer came to India as a member of South African Cricket Team in the year ended 31” March 2021. He received ₹ 4,00,000 for participation in matches in India. He also received ₹ 1,50,000 for an advertisement of a product on Radio. He wrote an article for a local newspaper and received ₹ 20,000 for it. During his stay in India, he also won a prize of ₹ 25,000 from horse racing in Kolkata. He has no other Income in India during the year. You are required to do the following:

(i) Compute his tax liability in India for AY. 2021.22.
(ii) Comment whether these incomes are subject to deduction of tax at source.
(iii) Comment whether he Is liable to file return of Income In India for A.Y. 2021-22.
(iv) What would have been his tax liability, had he been a match referee Instead of cricketer? [CA Final May 2018 (Old Syllabus), Nov. 2012] [8 Marks]
Answer:
(i) Computation of Total Income of Ricky

Computation of tax liability of Ricky

	₹
Tax u/s 115BBA [(₹ 4,00,000 + 1,50,000 + ₹ 20,000) × 20%]	1,14,000
Tax u/s 115BB [₹ 25,000 × 30%]	7,500
Total tax	1,21,500
Add: Health & Education cess @ 4%	4,860
Total tax liability	1,26,360

As per Sec. 194E, where any income referred to in Sec. 115BBA is payable to a non-resident sportsman which is not a citizen of India, the person responsible for making the payment shall, at the time of credit or payment, whichever is earlier, deduct tax from such income @ 20%. Therefore, the income from participation in matches, income from advertisement and income from writing an article for a news-paper shall be liable for deduction at source @ 20%.

As per Sec. 194BB, any person being the holder of license for the horse racing, who is responsible for paying any income by way of winnings from any horse race in an amount exceeding ₹ 10,000 shall, at the time of payment, deduct tax thereon at the rates in force. Therefore, the prize of ₹ 25,000 from horse racing shall be subject to deduction of tax @ 30%.

Since, Ricky is a non-resident, the amount of tax deducted at the pre-scribed rates would be increased by health & education cess @ 4%.

(iii) As per Sec. 115BBA, it shall not be necessary for the assessee to fur¬nish the return of income u/s 139(1) if his total income consists of income referred to in Sec. 115BBA only and tax has been deducted at source from it. However, in this case, the total income of Ricky also includes income from winnings from horse race and therefore, Ricky is required to file the return of income u/s 139(1).

(iv) If Ricky had been a match referee instead of cricketer, then the in¬come from participation in matches, income from advertisement and 1 income from writing an article for a newspaper shall not be taxable u/s ( 115BBA but, shall be taxable at normal rates. However, the winnings from horse racing shall be taxable u/s 115BB only.

Computation of tax liability of Ricky

Question 3.
SOL Inc, a notified Foreign Institutional Investor (FII), derived the following incomes from various sources for the financial year 2020-21:
(1) Income in respect of securities: ₹ 28,50,000
Expenses incurred in respect thereof: ₹ 50,000
(The above Income includes an interest of ₹ 16,00,000 received from p an Indian Company on the investment in rupee denominated bonds issued on 22.08.2019 and dividend income of ₹ 3,50,000 from a domestic company).
(2) Capital Gains:

Compute the taxable income of SOL Inc and tax liability for the assessment year 2021-22 as per applicable provisions of the Income-tax Act, 1961, assuming that no other income is derived by SOL Inc (FII) during the financial year 2020-21. [CA Final Nov. 2018 (Old Syllabus)] [10 Marks]
Answer:
Computation of total income of SOL Inc., a notified FII, for A.Y. 2021-22

Computation of tax liability of SOL Inc. for A.Y. 2021-22

Note:

1. The computation of total income and tax liability of an FII, whose income comprises solely of investment income and capital gains on sale of securities is governed by the provisions of section 115AD, as per which
   • no deduction is allowable in respect of expenditure to earn investment income and
   • benefit of indexation is not allowable in respect of long-term capital gains.
     The rates at which tax is to be calculated in respect of investment income and capital gains are also provided in section 115AD.
2. Since, Rupee Denominated Bonds are not issued between 18.09.2018 to 31.03.2019, interest on such RDBs shall not be exempt u/s 10(4C).
3. Since, STT has not been paid on sale of long term securities, sec. 112A shall not be applicable.

Question 4.
Mr. Rameshwarm, a non-resident Indian, acquired/purchased shares in foreign currency of a company XYZ Ltd. on 1.1.2011 for ₹ 10,00,000. These shares were sold by him in the recognized stock exchange through a broker on 1.1.2020 for ₹ 30,00,000. The amount of sales consideration of the shares of ₹ 30,00,000 so received by him was again invested in purchase of shares of other company ABC Ltd. on 31.03.2020. The shares of ABC Ltd. purchased on 31.03.2020 were also sold by him on 30.06.2020 for ₹ 35,50,000.

Discuss the tax implications relating to the two transactions of sales of the shares in the relevant assessment years under the Income-tax Act, 1961 by ignoring the effect of first proviso to section 48. [CA Final Nov. 2018 (Old Syllabus)] [4 Marks]
Answer:
As per Sec. 115F, where any long term capital gains arises from transfer of Specified Foreign Exchange Assets and the non-resident Indian reinvests the whole of the net sale consideration in specified assets within 6 months from the date of transfer, the whole such capital gains shall be exempt. However, the new asset acquired shall not be transferred within 3 years from the date of acquisition, otherwise the exemption granted earlier shall be deemed to be the Capital Gains in the year when the new asset is transferred.

In this case, Mr. Rameshwarm, has invested whole of the net consideration on transfer of a foreign exchange asset (being shares purchased in XYZ Ltd. in foreign currency), in shares of ABC Ltd., an Indian company, being a specified asset, within 6 months and therefore, the long-term capital gain of ₹ 20,00,000 (₹ 30,00,000, being the sale consideration (-) ₹ 10,00,000, being the cost of acquisition) would not be chargeable to tax during the assessment year 2020-21 as per section 115F.

However, in A.Y. 2021-22, Mr. Rameshwarm has sold the shares of ABC Ltd. and therefore, the amount not chargeable to tax in A.Y. 2020-21 i.e., ₹ 20,00,000 would be chargeable to tax as long-term capital gains in the assessment year 2021-22, being the year of sale of such shares.

Further, short-term capital gain of ₹ 5,50,000 (₹ 35,50,000 – ₹ 30,00,000) would arise on transfer of shares of ABC Ltd., since such asset is held for d a period of less than 12 months.

Note: It is assumed that STT has not been paid at the time of acquisition of shares and the transaction does not fall in the exempted category notified by the Central Government vide Notification No. S.0.1789(E) dated 5.6.2017.

Question 5.
Pranab, a non-resident Indian (aged 41) has furnished the following particulars of income relating to financial year 2020-21:

Compute tax payable by Pranab for Assessment Year 2021-22, assuming that he opts for provisions of Chapter XII-A of the Income-tax Act, 1961. [CA Final Nov. 2018 (Old Syllabus)] [6 Marks]
Answer:
As the assessee is a non-resident Indian, provisions of Chapter XHA (comprising of sections 115C to 115-1) can be made applicable to him or under section 115-I, he can opt for normal provisions.

Computation of total income for A.Y. 2021-22

Notes:
1. As per Sec. 71(3A), loss from house property shall be set off against income under the head only upto ₹ 2,00,000 and balance shall be allowed to be carried forward for set off in subsequent years. Therefore, out of loss of ₹ 2,50,000, only ₹ 2,00,000 shall be allowed to be set off against income from business and balance ₹50,000 (₹ 2,50,000 – ₹ 2,00,00) shall be carried forward to A.Y. 2022-23.

2. Indexation benefit would not be available for calculating cost of acquisition while computing long term capital gains under Chapter XII-A.

Computation of tax liability

	₹
Tax on interest as per section 115E @ 20% of ₹ 1,50,000 Tax on long term capital gains (₹ 2,88,000 × 10%) Tax on balance income of ₹ 6,15,000 (₹ 5,50,000 + ₹ 65,000)	30,000 28,800 35,500
	94,300
Add: Health & Education cess @ 4% Total Tax payable	3,772
	98,072
Total Tax payable (Rounded off)	98,070

Question 6.
Discuss the correctness or otherwise of the following with reference to the provisions of Income-tax Act, 1961:
A non-resident Indian despite having during the year ended on 31.3.2021 income in India from the investment and long term capital gains is not required to file the return of income for A.Y. 2021-22. [CA Final Nov. 2018 (Old Syllabus)] [2 Marks]
Answer:
The statement is correct/partially correct.
A non-resident Indian need not furnish a ROI u/s 139(1), if he satisfies both of the following conditions:-
(a) His total income consists only of investment income or income by way of long-term capital gains or both; and
(b) Tax deductible at source under the provisions of Chapter XVII-B has been deducted from such income.

Note: The statement would be correct only if both the above conditions are satisfied.

Question 7.
The following data is furnished by Mr. Sumedh, a non-resident and a person of Indian Origin, for the financial year ended 31-3-2021:

Compute balance tax payable/refund due for the A.Y. 2021-22 in accordance with special provisions applicable to non-resident.   [CA Final May 2019 (New Syllabus)] [6 Marks]
Answer:
If Mr. Sumedh opts for Chapter XII-A
Computation of Tax payable/Refund due to Mr. Sumedh for A.Y. 2021-22

Notes:
1. As per Sec. 115E, long term capital gains from foreign exchange asset shall be taxable @ 10% and interest on deposits with public limited companies, interest on government securities and dividends from domestic companies shall be taxable @ 20%. However, interest on deposits with private limited companies shall be taxable at normal tax rate, since it is not a specified foreign exchange asset.

2. As per Sec. 115D, no deduction under chapter VI-A shall be allowed from investment income. Therefore, investments made in notified savings certificates referred to Sec. 10(4B) shall not be allowed as deduction u/s 80C.

3. As Sec. 115F, long-term capital gain from transfer of specified foreign exchange asset shall be exempt if the non-resident Indian reinvests the whole or part of the net sale consideration in specified assets within 6 months from the date of transfer. In this case, Mr. Sumedh made investment in shares of Indian Public Limited companies on 31.12.2021 ie. after 6 months from the date of transfer and therefore, no exemption u/s 115F shall be allowed.

Tax Incidence in India – CA Final DT Question Bank is designed strictly as per the latest syllabus and exam pattern.

Tax Incidence in India – CA Final DT Question Bank

Question 1.
Poulomi, a Chartered Accountant, is presently working in a firm in India. She has received an offer for the post of Chief Financial Officer from a company at Singapore. As per the offer letter, she should join the company at any time between 1st September, 2020 and 31st October, 2020. She approaches you for your advice on the following issues to mitigate her tax liability in India:
(i) Date by which she should leave India to join the company;
(ii) Direct credit of part of her salary to her bank account In Kolkata maintained jointly with her mother to meet requirement of her family.
(iii) Period for which she should stay in India when she comes on leave. [CA Final Nov. 2012] [4 Marks]
Answer:
(i) Indian citizens, leaving India for employment outside India will be treated as residents only if the period of their stay in India during the relevant previous year is 182 days or more Since, Poulomi is leaving India for the purpose of employment outside India, she will be treated as resident only if the period of her stay during the previous year is 182 days or more.

Therefore, Pouiomi should leave India on or before 28th September, 2020, in which case, her stay in India during the previous year would be less than 182 days and she would become non-resident for the purpose of taxability in India. in such a case only the income which accrues or arises in India or which is deemed to accrue or arise in India or received or deemed to be received in India shall be taxable. The income earned by her in Singapore would not be chargeable to tax in India for A.Y. 202 1-22, if she leaves India on or before 28th September 2020.

(ii) If any part of Poulomi’s salary will be credited directly to her bank account in Kolkata then, that part of her salary would be considered as income received in India during the previous year and would be chargeable to tax even if she is a non-resident. Therefore, Poulomi should receive her entire salary in Singapore and then remit the required amount to her bank account in Kolkata in which case, the salary earned by her in Singapore would not be subject to tax in India.

(iii) In case Poulomi visits India after taking up employment outside India, she would be covered in the exception provided in (b) above and she will be treated as resident only if the period of her stay during the relevant previous year amounts to 182 days or more. Therefore, when Poulomi comes India on leave, she should stay in India for less than 182 days during the relevant previous year so that her status remains as a non-resident for the relevant previous year. Moreover, she should not visit India again during the current previous year i.e. P.Y. 2020-21.

Question 2.
Watson, a Non-Resident Indian, returned to India on 12th June 2020, for permanently residing in India after a stay of 20 years in UK. He provides the sources of his various incomes and seeks your opinion to know about his liability to Income-Tax in India in A.Y. 2021-22:

1. Rental income of a flat in Loudon which was deposited there in a bank. The flat was given on rent by him since July 2020, i.e. after his return to India.

2. Dividends on shares of three German Companies which are being collected in a Bank Account in London. He proposes to keep the dividend on shares in London with the permission of the Reserve Bank of India.

3. He has two sons, one of whom is 12 years. Both the sons are staying in London and not returned India with him. Each of his sons is having income of ₹ 75,000 in U.K. (not received in India) and of ₹ 20,000 in India.

4. During the preceding year when he was a Non-Resident, he had sold 1,000 Shares which were acquired by him in British Pound and the sale proceeds were repatriated. The profit in terms of British Pound on sale of these shares was 175% of the cost at ₹ 37,500 while in terms of Indian Rupee it was ₹ 50,000. [CA Final Nov. 2013] [7 Marks]
Answer:
Since, Watson is in India for 182 days or more during the PY. 2020-21 he would be resident in India for A.Y. 2021-22. However, he is not satisfying both the conditions laid u/s 6(6), as he was not in India from since last 20 years and therefore, the residential status of Watson is Resident but Not Ordinarily Resident for A.Y. 2021-22.

As per section 5(1), only income which is received/deemed to be received or accrued or arisen/deemed to accrue or arise in India is taxable in case of a Resident but not Ordinarily Resident. Income which accrues or arises outside India shall not be included in his total income, unless it is derived from a business controlled in, or a profession set up in, India. Accordingly:

1. Rental income from a flat in London which was deposited in a bank there shall not be taxable in the case of a resident but not ordinarily resident, since both the accrual and receipt of income are outside India.

2. Dividends from shares of three German Companies, collected in a bank account in London, would also not be taxable in the case of a resident but not ordinarily resident since both the accrual and receipt of income are outside India.

3. As per section 64(1 A), all income accruing or arising to a minor child is includible in the hands of the parent, after providing for deduction of ₹ 1,500 per child under section 10(32).

Accordingly, income accruing to his minor son in India is includible in the income of Watson, after providing deduction of ₹ 1,500. Therefore, ₹ 18,500 [₹ 20,000 – ₹ 1,500] is includible in the income of Watson. Income accruing to the minor child outside India (which is also received outside India) is not includible in the income of Watson. It is assumed that his other son is a major son and hence, his income is not includible in the income of Watson.

4. Repatriation of sale proceeds of 1,000 shares sold in the preceding accounting year, when Watson was a non-resident, is not taxable in the A.Y. 2021-22 since it is not the income of the RY. 2020-21

Consequently, only the income includible under section 64(1 A) would form part of the total income of Mr. Watson for A.Y. 2021-22. Since his total income (i.e., ₹ 18,500) is less than the basic exemption limit, there would be no liability to income-tax for A.Y. 2021-22.

Question 3.
State with reasons whether the following transactions attract Income-tax in India, in the hands of recipients’ u/s 9 of Income-tax Act, 1961:

(i) A non-resident German company, which did not have a permanent establishment in India, entered into an agreement for execution of electrical work In India. Separate payments were made towards drawings & designs, which were described as “Engineering Fee”. The assessee contended that such business profits should be taxable in Germany as there is no business connection within the meaning of section 9(1)(i) of the Income-tax Act, 1961.

(ii) A firm of solicitors in Mumbai engaged a barrister in UK for arguing a case before Supreme Court of India. A payment of 5000 pounds was made as per terms of professional engagement.

(iii) Amount paid by Government of India for use of a patent developed by Mr. A, who is a non-resident.

(iv) Sai Engineering, a non-resident foreign company entered into a collaboration agreement on 25.6 2020, with an Indian Company and was in receipt of interest on 8% debentures for ₹ 20 lakhs, issued by Indian Company, in consideration of providing technical know-how during previous year 2020-21. [CA Final Nov. 2014] [4 Marks]
Answer:
(i) In the given case, separate payments have been made towards drawings and designs which is described as engineering fee but are actually in the nature of fee for technical services. Therefore, it is taxable in India by virtue of section 9(1)(vii) – AegAktiengeSellSChaftv. CIT(2004) (Kar.).

As per Explanation to section 9, where income is deemed to accrue or arise in india under section 9(l)(vii, such income shall be included in the total income of the non-resident, irrespective of whether it has a residence or place of business or business connection in India. Thus, it will be taxable in the hands of the German Company even though it does not have a permanent establishment in India.

(ii) As per section 9(l)(ì), all income accruing or arising, whether directly or indirectly, through or from any business connection in India is deemed to accrue or arise in india.

In the given case, there exists a professional connection between the firm of solicitors in Mumbai and the barrister in UK. Further, the expression “business includes not only trade and manufacture; but also “profession”. Thus, such professional connection would amount
to “business connection” under section 9(1)(i) as per Supreme Court judgment in Barendia Prasad Royv. ITO(1981).

Hence, the amount of 5,000 pounds paid to the barrister in UK would be deemed to accrue or arise in India under section 9(1)(i) and it will be liable to tax in india.

(iii) As per section 9(1)(vi), income by way of royalty is deemed to accrue or arise in India if it is paid by the Government. “Royalty” has been defined to include even consideration for use of patent. Thus, the amount paid by Government of India for use of patent developed by Mr. A, a non-resident, is deemed to accrue or arise in India and hence, will be taxable in India.

(iv) Debentures of ₹ 20 lakhs issued by the Indian Company as consideration for providing technical know-how is in the nature of fee for technical services and hence as per Sec. 9(1)(vii) it will be deemed to accrue or arise in India. Thus, it will be liable to tax in India.

As per section 9(1)(v), income by way of interest payable by a person who is a resident of India is deemed to accrue or arise in India. So, interest income from these debentures of an Indian company will also be deemed to accrue or arise in India in the hands of Sai Engineering. Therefore, interest income will also be taxable.

Note: The provisions of double taxation avoidance agreement, if any, applicable in the above cases, have not been taken into consideration since the question specifically requires to examine the taxability of the above transactions under section 9.

Question 4.
In the context of provisions contained in the Income-tax Act, 1961 examine the correctness of the following.
Liaison Office maintained in India to explore the opportunity of business in India does not constitute business connection. [CA Final May 2016] [3 Marks]
Answer:
The statement is correct: If a Liaison Office is maintained solely for the purpose of carrying out activities which are preparatory or auxiliary in character, and such activities are approved by the Reserve Bank of India, then, no business connection is established. In this case, the Liaison Office is maintained for the purpose of exploring the opportunity of business in India, which is in the nature of preparatory or auxiliary activity. It is assumed that such activities are approved by the Reserve Bank of India. Since it does not undertake any commercial, trading or industrial activity, directly or indirectly, the Liaison Office does not constitute a business connection in this case.

Question 5.
As per agreement between S Limited, a company incorporated in Korea and Bharti Motors Limited, an Indian company, S Limited rendered both off-shore and on-shore technical services to Bharti Motors Limited for setting up a car manufacturing plant in Gujarat. S Limited rendered off-shore services and on-shore services at fee of ₹ 2 crore and ₹ 3 crore respectively. S Limited claims that it is not liable to tax in India in respect of fee of ₹ 2 crore as it is for rendering services outside India. Is the view taken by S Limited correct? [CA Final Nov. 2016, Nov. 2011] [4 Marks]
Answer:
Explanation to section 9(2) provides that income by way of, inter alia, fees for technical services for services utilized in India would be deemed to accrue or arise in India under section 9(l)(vn) in case of a non-resident and be included in his total income, whether or not such services were rendered in India.

In this case, the technical services rendered by the foreign company, S Ltd., were for setting up a car manufacturing plant in Gujarat. Therefore, the off-shore and on-shore services were utilized in India.

Consequently, as per section 9(2), the fee for technical services rendered by S Ltd. to Bharti Motors Ltd., is deemed to accrue or arise in India and includible in the total income of S Ltd.

Question 6.
Altant Italy, a company incorporated in France, was engaged in manufacture, trade and supply equipment and services for GSM Cellular Radio Telephones Systems. It supplied hardware and software to various entities in India. Software licensed by assessee embodies the process which is required to control and manage the specific set of activities involved in the business use of its customers. Software was also made available to its customers, who used it to carry out their business activities. The A.O. contented that the consideration for supply of software embedded in hardware in ‘Royalty’ u/s 9(1)(vi). Examine the correctness of the action of the A.O. [CA Final May 2017] [4 Marks]
Answer:
As per section 9(1)(vi Royalty is deemed to accrue or arise in India if the Intellectual Property Rights (in this case software) is used in India.

The issue is whether software provided along with the hardware of GSM mobile telephone system can be regarded as having independent status? If yes then the consideration for its use can he regarded as royalty.

Similar question arose in case of CIT y. Alcatel Lucen t Canada (2015) (Del). Here Delhi High Court observed that –

1. the software that was loaded on the hardware did not have any independent existence;
2. the software supply is an integral part of GSM mobile telephone system and is used by the cellular operators for providing cellular services to its customers;
3. the software is embedded in the system and there could not be any independent use of such software;
4. this software merely facilitates the functioning of the equipment and is an integral part of the hardware.

Further, the High Court had also referred the decision of the Apex Court in Tata Consultancy Services y. State of Andhra Pradesh (2004), wherein it was held that software incorporated on a media would be goods liable to sales tax.

Based on above discussion we conclude that where payment is made for hardware in which the software is embedded and the software does not have independent functional existence, no amount could be attributed as ‘royalty’ for software in terms of section 9(1)(vi).

Question 7.
LLM Bank Ltd. carrying on banking business is incorporated in Melbourne, Australia. It has branches in different countries including India. During the F.Y. 2020-21 the Indian branch of the bank paid interest of ₹ 20 lakhs and ₹ 15 lakhs respectively to its head office in Melbourne and to the branch office in California. State with reasons whether interest so paid shall be liable to tax in India in the hands of head office and California branch. [CA Final Nov. 2017] [4 Marks]
Answer:
As per Explanation to Sec. 9(l)(v), in the case of a non-resident, being a person engaged in the business of banking, any interest payable by the permanent establishment (PE) in India of such non-resident to the head office or any PE or any other part of such non-resident outside India shall be deemed to accrue or arise in India and shall be chargeable to tax in addition to any income attributable to the PE in India and the PE in India shall be deemed to be a person separate and independent of the non-resident person of which it is a PE and the provisions of the Act relating to computation of total income, determination of tax and collection and recovery shall apply accordingly.

In the given case, PE in India of the LLM Bank Ltd. has paid interest to its Head office and to another PE of the bank. Applying the above provisions, interest paid by the Indian branch of LLM Bank Ltd to head office in Melbourne and California branch shall be deemed to accrue or arise in India and the PE in India and its Head office in Melbourne and branch in California, shall all be deemed to be separate and independent. Thus, interest so paid shall be liable to tax in India in the hands of head office and California branch.

Question 8.
State with reasons whether the following transactions are subject to tax as deemed income.
(i) XYZ Ltd. is a broadcaster of News Channel In India. It had made payments to a Malaysian company having no PE in India for down-linking Television Channels into India and international ‘footprint through a channel.

(ii) Mr. A, a foreign citizen and a diamond merchant from US has earned income of ₹ 10 croresfrom display of uncut and unassorted diamonds in the Bharat Diamond Bourse a notified special zone in Surat. [CA Final May 2018 (New Syllabus)] [6 Marks]
Answer:
(i) As per Explanation 2 to Sec. 9(1)(vi), royalty means the consideration for, inter alia, transfer of all or any rights in respect of any copyright, literacy, artistic, scientific work including films or video tapes for use in connection with television or tapes or in connection with radio broadcasting. In this case, XYZ Ltd., a broadcaster of News channel in India has made payments to a Malaysian company having no PE in India for downlinking Television Channels into India and international footprint through a channel.

However, the payment in respect of downlinking television channels and international footprint through a channel does not amount to royalty as defined under Explanation 2 to Sec. 9(1)(vi). Therefore, the payment received by the Malaysian company shall not be taxable in India.

(ii) As per Explanation 1(e) to Sec. 9(l)(z), in case of a foreign company engaged in the business of mining of diamonds, no income shall be deemed to accrue or arise in India to it through or from the activities which are confined to the display of uncut and unassorted diamond in any special zone notified by the C.G. in the official gazette.

In this case, Mr. A, who is a foreign citizen and diamond merchant from US has earned income of ₹ 10 crores from display of uncut and unassorted diamonds in the Bharat Diamond Bourse, a notified special zone in Surat. Since, Mr. A is a foreign citizen and not a foreign company, Explanation 1(e) to Sec. 9(1)(i) shall not be applicable and the income earned of ₹ 10 crores by him shall deemed to accrue or arise in India.

Question 9.
Examine in the context of provisions contained under the Income-tax Act, 1961, each of the following independent cases and state in brief whether there exists business connection in each of the cases in India so as to bring the income earned, if any, to tax net in India:
(i) ABC Ltd., a company resident in Dubai, had set-up a liaison office at Mumbai to receive trade inquiries from customers in India. The work of the liaison office is not only restricted to forwarding of the trade Inquiries to ABC Ltd. but the liaison office also negotiates and enters into the contracts on behalf of ABC Ltd. with the customers in India.

(ii) XYZ Inc. a resident of USA, has set up a branch at Hyderabad for the purpose of purchase of raw materials for manufacturing its products. The branch office is also engaged in selling the products manufactured by XYZ Inc. and in providing sales related services to customers in India on behalf of XYZ Inc.

(iii) Mr. Rajesh, a resident in India and based at Delhi, is appointed as an agent by PQR Inc. a company incorporated in UK for tracking the Indian markets. He was canvassing the orders and then communicating to PQR Inc. in UK. He had no authority to accept the orders. All the orders were directly received, accepted and after receipt of the price/ value, the delivery of goods was given by PQR Inc. outside India. No purchase of raw material or manufacturing of finished goods took place in India. The agent was entitled to receive the commission on the sales so concluded by PQR Inc. [CA Final Nov. 2018 (Old Syllabus)] [6 Marks]
Answer:
(i) If a Liaison Off& is maintained solely for the purpose of carrying out activities which are preparatory or auxiliary in character, and such activities are approved by the Reserve Bank of India, then, no business connection is established.

In this case, had the liaison office’s activities been restricted to for warding of trade inquiries to ABC Ltd., a Dubai based company, its activities would not have constituted business connection. However, the activities of the liaison office extends to also negotiating and entering into contracts on behalf of ABC Ltd. with the customers in India, on account of which business connection is established.

(ii) As per Explanation 2 to section 9(1)(i) “business connection” shall include any business activity carried out through a person in.India acting on behalf of the non-resident. Accordingly in this case, since the branch office is carrying out a business activity by purchasing raw materials in India for XYZ Inc. and selling finished product manufactured by XYZ Inc. to customers in India and providing sales related services to them on behalf of XYZ inc., business connection is established.

It may be noted that as per clause (a) of Explanation 2, in the case of a non-resident, no business connection would be established if the activitics of the person acting on behalf of the non-resident were limited to the purchase of goods or merchandise for the non-resident.

In the present case, however, business connection would be established, since the branch set up at Hyderabad by XYZ Inc. is not solely engaged in purchase of raw materials for XYZ Inc. for manufacturing its products hut is also engaged in selling such manufactured products to customers in India and providing sales related services to them on behalf of XYZ Inc.

(iii) ‘Business connection’ shall include any business activity carried out through a person acting on behalf of the non-resident. For a business connection to be established, the person acting on behalf of the non-resident –
(a) must have an authority which is habitually exercised in India to conclude contracts on behalf of the non-resident or;
(b) in a case where he has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident, or
(c) habitually secures orders in India, mainly or wholly for the non-resident.

In the present case, business connection would not be established, since Mr. Rajesh does not have the authority to accept or conclude orders in India on behalf of PQR Inc. Moreover, all the orders were directly received, accepted and after receipt of the price/value, the delivery of goods was also given by PQR Inc. outside India. Hence, no business connection is established in this case.

Question 10.
Discuss the correctness or otherwise of the following with reference to the provisions of Income-tax Act, 1961: –
The contents of a business transaction done through e’-commerce are not different from that of a business transaction carried out through traditional means. Which are the distinct means/methods for doing e-business? [CA Final Nov. 2018 (Old Syllabus)] [2 Marks]
Answer:
The statement is not correct.
The content of business transaction done through e-commerce is not the same as the content of a business transaction carried out through traditional means. The taxation of e-commerce transactions poses a stiffer challenge as compared to taxation of traditional business transactions.

In e-commerce, there are three distinct means of doing business:

1. electronic advertising,
2. electronic sales; and
3. electronic delivery.

The presence of anyone or more of these is sufficient to characterize the business as e-commerce.

Question 11.
Red Ltd., a non-resident foreign company had entered into a collaboration agreement, approved by the Central Government, with Blue Ltd., an Indian company on February 21, 2004 and is in receipt of following payments during the previous year ending on March 31, 2021:

1. Interest on 8% debentures for ₹ 40 lakhs issued by Blue Ltd. on July 1, 2020 in consideration of providing of technical know-how, manufacturing process and designs (date of payment of interest being March 31 every year).
2. Service charges @ 2.5% of the value of plant and machinery for ₹ 500 Lakhs leased out to Blue Ltd. payable each year before March 31.
3. Apart from the above incomes, Red Ltd. received a long term capital gain amounting to ₹ 1.90 Lakhs on sale of debentures of Green Ltd., an Indian company, subscribed in US$.

Compute the Total Income of Red Ltd. and determine its tax liability for the assessment year 2021-22. [CA Final Nov. 2018 (New Syllabus)] [6 Marks]
Answer:
Computation of Total Income Red Ltd. for A.Y. 2021 -22

	₹
Value of debentures issued by Blue Ltd. (Note 1)	40,00,000
Interest on debentures issued by Blue Ltd. (₹ 40,00,000 × 8% × 9/12) (Note 1)	2,40,000
Service charges on leased out plant and machinery (₹ 500 lakhs × 2.5%)	12,50,000
Long term capital gain on sale of debentures of Green Ltd.	1,90,000
Total Income	56,80,000

Computation of Tax Liability

Notes:
1. ₹ 40,00,000, being the value of debentures issued by Blue Ltd. in consideration of providing technical know-how for use in its business in India, is in the nature of fee for technical services, deemed to accrue or arise in India to Red Ltd., a non-resident foreign company, u/s 9(1) (vii) and taxable in India.

Further, as per section 9(1)(v), interest payable by a person resident of India is deemed to accrue or arise in India and therefore, interest income from debentures of Blue Ltd. is deemed to accrue or arise in India in the hands of Red Ltd. by virtue of section 9(1)(v) and taxable in India.

2. As per Sec. 9(1)(i), income from property in India or from any asset or source of income in India would be deemed to accrue or arise in India. Therefore, service charges of ₹ 12,50,000 from leased out plant and machinery t6 Blue Ltd. shall be taxable in India.

3. As per Sec. 9(1)(i), capital gains arising through transfer of capital asset situated in India would be deemed to accrue or arise in India. Therefore, long term capital gains of ₹ 1,90,000 on sale of debentures of Green Ltd., an Indian company, shall be taxable in India.

Question 12.
John Butler Tex. Inc., is a company incorporated in Colombo, Sri Lanka. 60% of its shares are held by Pvt. Ltd., a domestic company. John Butler Tex. Inc. has its presence in India also. The data relating to John Butler Tex. Inc., are as under:

Particulars	India	Sri Lanka
Fixed assets at depreciated values for tax purposes (₹ in cores)	90 –	70
Intangible assets (₹ in cores)	40	180
Other assets (₹ in crores)	30	90
Income from trading operations (₹ in cores)	15	42
Income from investments (₹ in cores)	30	13
Number of employees (Residents in respective countries)	40	60

For POEM purposes, state whether,
(i) The company shall be said to be engaged in ‘active business outside India’.

(ii) Because of increased operations in India, more manpower is needed. 30 more employees may be required in this regard. The company can either take these employees directly in its roll or can outsource the increased operation to an external agency which will engage the 15 employees in its roll and finish the work for the company. Which choice will be better?

Note: If for any test, average figures are needed, the same may be ignored and the data as given above to the applicant may be used. [CA Final Nov. 2018 (New Syllabus)] [6 Marks]
Answer:
(i) The company shall be said to be engaged in ‘active business outside India’, only if the following conditions are simultaneously satisfied;

• Passive income is not more than 50% of its total income; and
• less than 50% of its total assets are situated in India; and
• less than 50% of total number of employees are situated in India or are resident in India; and
• the payroll expenses incurred on such employees is less than 50% of its total payroll expenditure.

Passive income means an income which is aggregate of:

• income from the transactions where both the purchase and sale of goods is from/to its associated enterprises; and
• income by way of royalty, dividend, capital gains, interest or rental income;

	Total	In India	%
Passive income (Income from trading operation + Income from investment)	100	45	45
Assets (Fixed assets + Intangible assets + Other assets)	500	160	32
Employee	100	40	40

John Butler Tex. Inc., shall be said to be engaged in ‘Active business outside India’, as all the conditions of “Active business outside India” (ABOI) test is satisfied.

(ii) Because of increased operations in India, if 30 employees are directly employed, then the conditions of ABOI test will not be fulfilled, as the percentage of employees situated in India shall be more than 50% of total number of employees in that case [i.e. 30 + 40/130 = 54%].

In case, if 15 employees are outsourced, then the percentage of employees situated in India will be within 50% and the conditions of ABOI test will be satisfied [i.e. 15 + 40/115 = 48%].

Therefore, outsourcing the work to external agency will be a better option for the company.

Question 13.
State with reasons whether the following income of the non-resident is deemed to accrue or arise in India:
(1) M/s XYZ Highway Ltd., a resident Indian company is engaged in the business of building highway projects in India. It has borrowed US $ 250 million from a financial institution resident in US to invest in one of its ongoing projects in India. The rate of interest charged is 8% p.a. Assume 1 US $ 69. Will your answer differ in case the money is invested in one of its ongoing projects in Sri Lanka?

(2) Mr. A, a non-resident, staying in England, holds 10% of the total share capital in M/s ABC Ltd. a company incorporated in England. M/s ABC Ltd. directly owns assets in India. Mr. A has transferred his entire share capital to Mr. B an Indian resident when he was in England. [CA Final Nov. 2019 (Old Syllabus)] [6 Marks]
Answer:
(1) As per section 9(1)(v), interest payable by a resident in respect of any debt incurred, or any moneys borrowed and used for the purpose of business or profession carried on by such person in India shall be deemed to accrue or arise in India. Therefore, interest of ₹ 1,3 80 million [($ 250 million × ₹ 69) × 8%] payable by M/s XYZ Ltd. for borrowings to be used in its ongoing project in India will be deemed to accrue or arise in India in hands of the financial institution being resident of US.

Yes, the answer will be different if the borrowed money is invested ‘ in one of its projects in Sri Lanka. In that case the income will not be deemed to accrue or arise in India since, Sec. 9(1)(v) provides that interest payable by a resident will not be deemed to accrue or arise in India where the interest is payable by a resident in respect of moneys borrowed and used for the purpose of business carried on by such person outside India or for the purpose of earning any income from any source outside India.

(2) As per section 9(1)(i), capital gains arising through the transfer of a capital asset situated in India would be deemed to accrue or arise in India irrespective of place of registration of the document or transfer or the place of payment of the consideration.

As per Explanation 5 to the section, shares in a company incorporated outside India shall be deemed to be situated in India, if the shares derive its value substantially from the assets located in India.

Further, as per Explanation 6 to the section, the shares will be deemed to derive its value substantially from the assets located in India. If on the specified date the value of such assets

1. exceeds Rs. 10 crore and
2. represents at least 50% of the value of all assets owned by the company of which shares are being transferred.

Thus, if shares of ABC Ltd. derive its value substantially from the assets located in India then the income will be deemed to accrue or arise in India. Otherwise, it will not be deemed to accrue or arise in India.

The said income will not be deemed to accrue or arise in India by virtue of Explanation 5 if conditions specified in Explanation 7 to the section are being satisfied.

Question 14.
ABC Ltd., a software giant in India, sets up a 100% subsidiary company by the name SHD Inc. in Switzerland on 1st April, 2020. The subsidiary company SHD Inc., is mainly engaged in the software services, hardware services and data backup services in three different countries viz., Switzerland, Sweden and India. The following information is furnished by SHD Inc. for the F.Y. 2020-21:

	In Switzerland	In Sweden	In India
Value of Assets as per books of account (in crores)	24	12	24
Number of Employees working (in thousands)	30	10	28
Pay Roll expenditure (in crores)	4	2.6	5.4
Total aggregate income earned	₹ 80 crores

Other Information:
I. Break up of total income:

• 28 crores derived from the transactions where purchases are made from associated enterprises and sold to non-associated enterprises;
• 24 crores derived from the transactions where both purchases and sales are made from/to associated enterprises;
• 16 crores derived from the transactions where purchases are made from non-associated enterprises and sold to associated enterprises:
• 8 crores by way of income from capital gains on trading of shares;
• 4 crores by way of interest from non-associated enterprises;

II. During FY 2020-21, total 5 board meetings were held, 2 in India, in Sweden and 2 in Switzerland.

Based on the above information, determine the residential status of SHD Inc., applying the provisions of POEM for the A.Y. 2021-22. [CA Final Nov. 2019 (New Syllabus)] [6 Marks]
Answer:
As per Sec. 6(3), a company is said to be resident in India in any previous year, if
(a) It is an Indian Company, or
(b) Its place of effective management (POEM) in that year, is in India.

Explanation to Sec. 6(3), defines POEM as a place where key management and commercial decision that are necessary for the conduct of business of an entity as a whole, are in substance made.

POEM is determined based on the fact as to whether or not the company is engaged in “active business outside India”.

The company shall be said to be engaged in ‘active business outside India’, only if the following conditions are simultaneously satisfied;

• Passive income is not more than 50% of its total income; and
• less than 50% of its total assets are situated in India; and
• less than 50% of total number of employees are situated in India or are resident in India; and
• the payroll expenses incurred on such employees is less than 50% of its total payroll expenditure.

Passive income means an income which is aggregate of:

• income from the transactions where both the purchase and sale of goods is from/to its associated enterprises; and
• income by way of royalty, dividend, capital gains, interest or rental income;

Calculation of Passive Income of SHD Income

	₹ in crores
Income where both purchase & sale are made to/from associated enterprises	24
Capital gains on trading of shares	8
Interest Income from Non-Associated enterprises	4
Total Passive Income	36

Determination of whether SHD Inc. is has engaged in “Active Business outside India”

	India	Total	% of India out of Total
Value of Assets (Cr.)	24	60	40.00 %
No. of employees (‘000)	28	68	41.17 %
Payroll expenses (Cr.)	5.4	12	45.00 %
Passive Income/Total Income (36/80)			45.00 %

Since, all the conditions are fulfilled, it can be said that SHD Inc. is engaged in Active Business outside India.

Now, POEM of a company, engaged in active business outside India shall be presumed to be outside India of the majority of board meetings are held outside India.

During EY. 2020-21, out of total 5 board meetings of SHD Inc., 3 arc held outside India and thus, POEM of SHD Inc. is said to be Outside India.

Thus, SHD Inc. is a Non-Resident Company in India as its POEM is outside India for A.Y. 2021-22.

Tax Planning, Tax Avoidance and Tax Evasion – CA Final DT Question Bank is designed strictly as per the latest syllabus and exam pattern.

Tax Planning, Tax Avoidance and Tax Evasion – CA Final DT Question Bank

Question 1.
Specify with reason, whether the following acts construe (i) Tax planning; or (ii) Tax management; or (iii) Tax evasion.
1. An individual taxpayer making tax saver deposit of ₹ 1,00,000 in a nationalised bank.
2. A partnership firm obtaining declaration from lenders/depositors in Form No. 15G/ L5H and forwarding the same to income-tax authorities

3. A company installed an air-conditioner costing ₹ 75,000 at the residence of a director a$ per terms of his appointment but treats it as fitted in quality control section in the factory. This is with the objective to treat it as plant for the purpose of computing depreciation.

4. RR Ltd. issued a credit note for ₹ 80,000 as brokerage payable to Mr. Ramana who is the son of the managing director of the company. The purpose is to increase the total income of Mr. Ramana from ₹ 4,00,000 to ₹ 4,80,000 and reduce the income of RR Ltd. correspondingly.

5. A company remitted provident fund contribution of both its own contribution and employees’ contribution on monthly basis before due date. [CA Final May 2015] [5 Marks]
Answer:
Tax Planning/Tax Management/Tax Evasion
1. Tax planning: Making a tax saver deposit in a nationalized bank for claiming deduction u/s 80C is a permitted tax planning measure under the provisions of income-tax law.

2. Tax management: Obtaining declaration from lenders/depositors in Form No. 15G/15H and forwarding them to Income-tax authorities is for the compliance of statutory obligation under the Income-tax Act, 1961.

3. Tax evasion: Air conditioner fitted at the residence of a director as per the terms of his appointment would be a furniture eligible for depreciation @ 10%, whereas an air-conditioner fitted in a factory would be a plant eligible for higher depreciation @ 15%. This false treatment unjustifiably increases depreciation and consequently, reduces profit and evades tax.

4. Tax evasion: The given fictitious transaction is a method of reducing the tax liability of the company. The company is liable to tax at a flat rate of 25% where total turnover of P.Y. 2018-19 does not exceed ₹ 400 crores or 30% in any other case, whereas Mr. Ramana is liable to pay tax (& 10% above the basic exemption limit of ₹ 2,50,000, since his total income does not exceed ₹ 5,00,000. Further, Mr. Ramana would also eligible for rebate upto ₹ 12,500 u/s 87A. Reducing tax liability by recording a fictitious transaction would be a tax evasion.

5. Tax management: Remitting of own contribution to provident fund and employees contribution to provident fund on a monthly basis before due date is proper compliance of the statutory obligations.

Question 2.
You are appointed as the taxation manager of Tatla Well Ltd. In the context of tax planning, what all are the tests that are to be satisfied for the tax planning strategy to be successful? State them briefly. [CA Final May 2019 (New Syllabus)] [4 Marks]
Answer:
Tests for evaluation of Successful Tax Planning: –
(i) Conformity with Law: The one who is planning his tax obligations should have complete knowledge of the applicable law, rules and regulations. Such knowledge is not only that of Tax Laws, but also Social and Personal branches of Law, so that the Tax planner’s scheme does not get defeated by the universal principles of ‘Jurisprudence’,

(ii) Flexibility: This ensures that the tax planning should not be nullified by statutory negations or interpretations. The tax planner should ensure that his scheme provides for suitable changes to meet his end. For this, he should be aware of all significant amendments and developments in his field.

(iii) Compliance: Tax planner should not avoid legislative intent. Tax planning in every case shall not see only tax benefits available, but also discharge all tax obligations, so that penal provisions are not attracted.

Question 3.
Examine whether General Anti-Avoidance Rules (GAAR) can be invoked to deny the treaty benefit in the following case, assuming that all other conditions prescribed for application of GAAR are being satisfied:

X Pvt. Ltd., an Indian Company and Y Pvt. Ltd. (100% subsidiary of YAN Ltd.) located in country “A” formed a joint venture company XY Pvt. Ltd. in India on 01.04.2020. As per the joint venture agreement, 51% of shares are held by X Pvt. Ltd. and 49% are held by Y Pvt. Ltd in XY Pvt. Ltd. There is no other business activity in Y Pvt. Ltd.

X Pvt. Ltd. is designated as Permitted Transferee of YAN Ltd. Permitted Transferee means though shares of XY Pvt. Ltd. are held by Y Pvt. Ltd. all rights of voting, management, right to sell etc. are vested with YAN Ltd.

On 19.03.2021, the shares held by Y Pvt. Ltd. in XY Pvt. Ltd. are sold to P Pvt. Ltd. which is a group company of X Pvt. Ltd. As per the tax-treaty between India and Country “A”, there is no tax for capital gains either in source country or in Country “A”. Consequently, the capital gains arising to Y Pvt. Ltd. are not taxable in India. [CA Final Nov. 2018 (Old Syllabus)] [3 Marks]
Answer:
GAAR may, prima facie, apply, when the following twin conditions are satisfied:

• Main purpose of the arrangement being tax benefit, and
• Existence of tainted benefit.

As per the tax treaty between India and Country “A”, there is no tax on capital gains either in the Source country or in Country “A”. Consequently, the capital gains arising to Y Pvt. Ltd. is not taxable in India.

The arrangement of routing investment through Country “A” would result in a tax benefit. Since, there is no business purpose in incorporating a company Y Pvt. Ltd. (100% subsidiary of YAN Ltd.) in Country “A”, it can be said that the main purpose of the arrangement is to obtain a tax benefit.

On the question of whether the arrangement has any tainted element, it is evident that there is no commercial substance in incorporating Y Pvt. Ltd. as it does not have any effect on the business risk of YAN Ltd. or cash flow of YAN Ltd. Additionally, the fact that all rights of shareholders of Y Pvt. Ltd. (designated as Permitted Transferee) are being exercised by YAN Ltd. instead of Y Pvt. Ltd., indicates that Y Pvt. Ltd. lacks commercial substance.

As the twin conditions of main purpose being tax benefit and existence of a tainted element are satisfied, GAAR may be invoked in this case.

Question 4.
Discuss the correctness or otherwise of the following with reference to the provisions of Income-tax Act, 1961:
Tax Avoidance is not defined in taxing statue. It is the outcome of actions taken by the assessee, none of which or no combination of which is illegal or forbidden by the law as such. The international literature tends to describe the tax avoidance in many ways. If yes, state briefly ways of tax avoidance. [CA Final Nov. 2018 (Old Syllabus)] [2 Marks]
Answer:
The statement is correct.

It is the outcome of action taken by the taxpayer, none of which or combination of which, is illegal or forbidden by law.

International literature on the subject tends to describe it in the following ways:

• Tax avoidance involves the legal exploitation of tax laws to one’s own advantage.
• Every attempt by legal means to prevent or reduce tax liability which would otherwise be incurred, by taking advantage of some provisions or lack of provisions in the law.
• An arrangement entered into solely or primarily for the purpose of obtaining a tax advantage. Taxpayers consider it their legitimate right to arrange their affairs in a manner as to pay the least tax possible.

Question 5.
Under the provisions of a tax treaty between India and Country V, if a resident of country V makes any capital gains by selling the shares in p, any Indian Company, such capital gains will be taxable only in Country V and it will be exempt from tax in India. However, as an exception it is also provided that, such exemption is not available if the, transferor holds more than 10% interest in the equity capital of the Indian Company. VFX Ltd., a resident in Country V floated two wholly owned subsidiaries in country V. On 1.4.2020, both the subsidiaries bought 9% shareholding in XYZ Co. Ltd., an Indian Company. These subsidiaries do. not have any other income. On 31.12.2020, both of them sold the investment in XYZ Co. Ltd. Each of the subsidiaries claim exemption from Indian capital gains tax amounting to ₹ 2.5 crores from such sale, as each is holding less than 10% equity shares in the Indian Company. Can GAAR be invoked in such case to deny the treaty benefit?

Will your answer be different if the capital gain tax on such sale is calculated at ₹ 1.2 crores each? [CA Final May 2019 (Old Syllabus) [4 Marks]
Answer:
The arrangement by VFX Ltd., a resident in Country V, of floating two wholly owned subsidiaries and splitting the investment in equity shares of the Indian company through such subsidiaries appears to be with the intention of obtaining tax benefit under the treaty between India and Country V, so that the individual subsidiaries do not hold more than 10% interest in the equity capital of the Indian company.

Further, there appears to be no commercial substance in creating two subsidiaries as they do not change the economic condition of investor VFX Ltd. in any manner (i.e. on business risks or cash flow), and reveals a tainted element of abuse of tax laws.

Since, the tax benefit in the P. Y. 2020-21 in aggregate is ₹ 5 crores (₹ 2.5 crores × 2), which exceeds the specified threshold of ₹ 3 crores, the arrangement can be treated as an impermissible avoidance arrangement and GAAR can be invoked. Consequently, treaty benefit would be denied by ignoring the two subsidiaries, or by treating the two subsidiaries as one and the same company for tax computation purposes.

If the capital gains tax on such sale is calculated at ₹ 1.2 crores each, the tax benefit of ₹ 2.4 crores would be less than the specified threshold of ₹ 3 crores. Hence, GAAR cannot be invoked in such case.

Question 6.
MNO Ltd. in Mumbai is a wholly owned subsidiary of a holding company located in Low Tax Jurisdiction (LTJ). MNO Ltd. has accumulated profit of ₹ 1,500 lakhs. It deposited ₹ 1,000 lakhs in fixed deposit with a branch of foreign bank located in India. Based on the security of the deposit, the holding company located in LTJ availed bank loan of ₹ 800 lakhs. Is this an impermissible arrangement lacking commercial substance? Support your answer with applicable legal provisions. [CA Final Nov. 2019 (New Syllabus)] [4 Marks]
Answer:
As per section 97, where a party is included in an.arrangement mainly for obtaining tax benefit to the taxpayer. Such party may be termed as ‘Accommodating’ party and consequently the arrangement shall be deemed to lack commercial substance.

In the above arrangement, MNO Ltd. is obtaining the loan facility through the accommodating party in LTJ in order to have tax benefit. Thus, the above arrangement is deemed to be an impermissible arrangement avoiding commercial substance.

Miscellaneous Topics, STT/ CTT and IFSC – CA Final DT Question Bank is designed strictly as per the latest syllabus and exam pattern.

Miscellaneous Topics, STT/ CTT and IFSC – CA Final DT Question Bank

Question 1.
Fearless General Finance & Investment Limited, a residuary non-banking company, accepts public deposits, issues deposit certificate and repays the same after some period of time along with interest, under different schemes run by it. Following transactions were noted from their books of account:
(i) Mr. A, an individual, has deposited ₹ 15,000 on 1st May, 2016 for 48 months by bearer cheque and another ₹ 15,000 on 30th June, 2019 in cash to purchase a new certificate of 48 months tenure.

(ii) Mr, A has applied for premature withdrawal against both the certificates and the company has paid him ₹ 16,500, by a bearer cheque, against principal and interest on 23rd March, 2020, due against his first certificate (purchased in 2016) and ₹ 15,500 in cash on 25th March, 2020, against the second certificate.

Discuss the violation of income tax provision, if any,” and consequential penalty for each transaction. Will it make any difference if the certificates were held jointly with Mrs. A, wife of Mr. A, while repaying back in cash or bearer cheque? [CA Final Nov. 2010] [7Marks]
Answer:
(i) There is no violation of section 269SS at the time of acceptance of the first deposit of ₹ 15,000 on 1.5.2016, since it is not in excess of the threshold limit of ₹ 20,000. However, violation under section 269SS is attracted at the time of acceptance of the second deposit in cash on 30th June, 2019, since as on that date, there is already an outstanding deposit of ₹ 15,000 and another cash deposit of 115,000 would take the aggregate to ₹ 30,000, which exceeds the threshold limit of ₹ 20,000. Therefore, penalty under section 27ID of a sum equal to the amount of deposit taken from Mr. A is attracted for failure to comply with the provisions of section 269SS.

(ii) In this case, there is a violation of section 269T at the time of first repayment by bearer cheque on 23rd March, 2020, since on that date, the aggregate amount of deposits held by Mr. A with the non-banking company (together with interest payable on such deposits) is more than ₹ 20,000. Therefore, penalty u/s 27IE equal to the amount of deposit so repaid will be attracted for failure to comply with the provisions
of section 269T.

However, the second repayment of ₹ 15,500 on 25th March, 2020 in cash cannot be considered as a violation of section 269T, since neither the amount of deposit with interest thereon nor the aggregate amount of deposits held by Mr. A on that date together with interest exceeds the threshold limit of ₹ 20,000.

The provisions of section 269T will be attracted even if the certificate is being held by Mr. A in joint name with his wife.

Question 2.
Mr. Prajapathi intends to sell a piece of urban residential plot held for 48 months, to Mr. Vasan, for a consideration of ₹ 2 crores, in February, 2021. This asset had been held as investment by Mr. Prajapathi. Both parties are willing to enter into a written agreement in this regard. Initial payment will be ₹ 40 lakhs. The buyer is given 12 months time for completing the sale, at Which point of time, balance amount has to be paid. – Following two options are considered:

(i) Payment of ₹ 10 lakhs by account payee cheque on the date of the agreement and ₹ 30 lakhs by cash, the samg day, and
(ii) Payment of ₹ 10 lakhs by account payee cheque on the date of the agreement and ₹ 30 lakhs by ECS through a bank within seven days.

An increase of 30% in stamp duty is anticipated with effect from 1st April, 2021. The parties seek your advice to plan suitably for reduction of capital gains. Advise them suitably as to what payment mode is to be adopted.
Should the agreement in question be registered? [CA Final May 2017] [4 Marks]
Answer:
As per Sec. 50C, in case of transfer of a capital asset being land or building or both, where the actual consideration is less than the value adopted or assessed by the stamp valuation authority, the stamp value so adopted or assessed shall be taken as the full value of consideration for computing capital gains.

However, where the stamp duty value does not exceed 105% of the actual consideration, the actual consideration so received shall be taken as the full value of consideration.

Where the date of the agreement fixing the amount of consideration and the date of registration are not the same, the stamp duty value may be taken as on the date of agreement provided that the consideration or part thereof has been received by way of an account payee cheque or account payee bank draft or use of electronic clearing system through a bank account or through such other electronic mode as may be prescribed, on or before the date of the agreement.

There is no specific requirement under the Act that the agreement should be registered.

Advice for reduction of capital gains tax liability
In both the options, part payment of ₹ 10 lakhs is made by account payee cheque on the date of the agreement. Therefore, in both the options, the stamp duty value on the date of agreement can be taken as the full value of consideration.

Mr. Prajapathi, thus, need not bear the burden of paying capital gains tax on increased stamp duty applicable from 1st April, 2021, if he exercises either of the options for making the initial payment of ₹ 40 lakhs.

Advice for mode of payment
In Option (i), however, the balance initial payment of ₹ 30 lakhs is proposed to be paid by way of cash. This would be in contravention of the provisions of section 269SS, which requires any sum of money receivable, whether as advance or otherwise, in relation to transfer of immovable property, to be paid by way of account payee cheque/bank draft or by way of electronic clearing system through a bank account, if the same exceeds the threshold of ₹ 20,000. Penalty equivalent to the sum so received in contravention of the provisions of section 269SS would be imposable u/s 27ID.

Therefore, if Option (i) is exercised, even though the capital gains tax liability of Mr. Prajapathi would not be affected, the provisions of section 269SS would be violated and penalty of ₹ 30 lakhs would be attracted u/s 271D.

Accordingly, Option (ii) should be exercised to get the benefit of adoption of stamp duty value on the date of agreement and avoid contravention of the provisions of section 269SS and the consequent penalty u/s 271D.

Question 3.
Kumar Bros, the assessee, is a partnership firm. During the course of assessment proceeding, the A.O. noticed that huge amount of cash was accepted by the firm from its partners during the relevant year corresponding to the AY. 202 1-22. The A.O. was of the view that interest was given to partners on amounts advanced, which conclusively proved that the transaction are between different persons whereby the firm has accepted loans in cash from the partners and thereby Initiated penalty proceeding u/s 271D In view of violation of Sec. 269SS.
Is the action of A.O. tenable in law? [CA Final May 201 7] [4 Marks]
Answer:
Issue involved: The issue under consideration is that whether loans or deposits received by the firm from its partners in violation of Sec. 269SS will attract penalty u/s 271D.

Provisions applicable: Section 269SS prohibits any person from taking any loan or deposit exceeding prescribed limit, otherwise than by way of account payee cheque or bank draft or use of electronic clearing system through bank account. In case of contravention of Sec. 269SS, penalty equal to the amount of loan or deposit is liable u/s 27ID.

However, as per Sec. 273B, no such penalty would be leviable if the assessee proves that there is reasonable cause for such failure.

Analysis: The facts of the case are similar to the facts in CIT v. Muthoot Financiers (2015), where the Delhi High Court observed two possible views. One view is that the partnership firm, not being a juristic person, the inter se transaction between the firm and partners will not be governed by the provisions of Sec. 269SS. A contrary view is that the partners of the firm are distinct as civil entities while the firm as such is a separate and distinct unit for the purpose ‘of assessment.

Conclusion: The Delhi High Court, considering the two different legal interpretations on a relationship between the firm and the partners being a debatable one, held that there was reasonable, cause for not invoking Sec. 27ID. Hence, by applying the rationale of Delhi High Court ruling to the case on hand, the action of the A.O., in levying penalty u/s 27ID is not tenable in law.

Question 4.
The regular assessment of Ms. Swati for the A.Y. 2016-17 was completed u/s 143(3) on 16-07-2018. On 18-01-2020 she received a notice
issued u/s 148 for Income escaping assessment for the same A.Y. 20 16-17. Further on 25.03.2020, during the pendency of such proceeding for income escaped assessment, the A.O. attaches the house property of Ms. Swati.

Now, aggrieved Swati seeks your opinion (being a Chartered Accountant) as to:
(i) The circumstances under which the A.O. can make provisional attachment of property of the assessee?
(ii) The period of time for which such attachment can take place?
(iii) Can such attachment be revoked by the A.O. and if yes, how?
Discuss the relevant provisions of law to satisfy the aggrieved assessee Ms. Swati? [CA Final May 2018 (New Syllabus)] [5 Marks]
Answer:
(i) As per Sec. 28IB, where during the pendency of any proceeding for the assessment of any income or for the assessment or reassessment of any income which has escaped assessment, the A.O. is of the opinion that, for the purpose of protecting the interest of the Revenue, it is necessary to do so, he may, by an order in writing, attach provisionally any property belonging to the assessee.

However, before passing an order, the A.O. is required to take prior permission of the Principal CCIT or CCIT or Principal CIT or CIT.

(ii) Every provisional attachment would cease to be effective after the expiry of 6 months from the date on which order for the attachment is passed by the A.O.

Provided that the PCCIT or CCIT or PCIT or CIT is entitled, for the reasons to be recorded in writing, to extend the validity of the period during which the” order for attachment would be operative by such I further period or periods as he deems fit. But, in no case the total period of provisional attachment of the property shall exceed 2 years or 60 days after the date of order of assessment or reassessment, whichever is later.

Provided also that the period during which the proceedings for assessment or reassessment are stayed by an order or injunction of any court shall be excluded from the period specified in the first provison.

(iii) Where the assessee furnishes a guarantee from a scheduled bank for an amount not less than the FMV of the property provisionally attached, the A.O. shall, by an order in writing, revoke such attachment.

In case the guarantee from a scheduled bank is lower than the FMV of the property, the A.O. may accept such guarantee and revoke attachment provided he is satisfied that such guarantee is sufficient to protect the interests of the revenue.

Question 5.
During the pendency of reassessment proceedings, the A.O. has provisionally attached the property of the assessee, Mr. Malhothra in accordance with powers vested u/s 281B on 21st December, 2020. The FMV in lieu of provisional attachment of property and approached the A.O. to revoke the attachment. A.O. refused such proposal. Answer the following issues in the context of relevant provisions of the Act:

(i) Whether A.O. can refuse to accept bank guarantee, if not, is it mandatory on his part to pass revocation order for the provisional attachment of property?
(ii) Specify circumstances under which the A.O. is empowered to invoke the bank guarantee. [CA Final Nov. 2018 (Old Syllabus)] [4 Marks]
Answer:
(i) Since. Mr. Malhothra proposes to furnish a bank guarantee from a scheduled bank for an amount equal to the fair value of the property, the A.O. has to revoke provisional attachment of property.

In such situation, as per section 28 IB, the A.O. cannot refuse to accept bank guarantee, and has to mandatorily pass an order in writing revoking the provisional attachment of property.

(ii) Circumstances under which the A.O. can invoke the bank guarantee:

• Where a notice of demand specifying a sum payable is served upon Mr. Malhothra, and he fails to pay such sum within the time specified in the notice of demand;
• Where Mr. Malhothra fails to renew the bank guarantee or fails to furnish a new guarantee from a scheduled bank for an equal amount 15 days before the expiry of such guarantee.

Question 6.
Mr. B proposes to purchase for his business, certain raw materials from Mr. S. In view of the scarcity of the products, S insists on cash payments for the purchases, to which B agrees. On 27.3.2021, the purchases are effected through a cash invoice for ₹ 3,20,000.

In respect of the above transactions, will there be any detrimental effect in the hands of B and S under the provisions of the Income-tax Act, 1961? Explain briefly.

Will your answer be different, if the cash purchases are effected by the buyer B on two different dates for different raw materials for ₹ 1,80,000 and ₹ 1,40,000 respectively? [CA Final Nov. 2018 (.New Syllabus)] [5 Marks]
Answer:
As per section 40A(3), where the assessee incurs any expenditure for which payment or aggregate of payment made to a person in a day, otherwise than by an account payee cheque drawn on a bank or account payee bank draft or use of electronic clearing system (ECS) though a bank account, exceeds 110,000, no deduction shall be allowed in respect of such expenditure.

As per Sec. 269ST, no person shall receive an amount of ₹ 2,00,000 Or more:
(a) in aggregate from a person in a day; or
(b) in respect of a single transaction; or
(c) in respect of transaction relating to one event or occasion from a person.

otherwise than by account payee cheque or an account payee bank draft or use of ECS through a bank account.

Further as per Sec. 27IDA, any person receiving any amount in contravention of Sec. 269ST, shall be liable for penalty which is equal to amount of such receipt.

Treatment in the hands of Mr. B:
Since, the cash payment made by Mr. B to Mr. S for purchase of raw ; material is in excess of ₹ 10,000, Mr. B shall not be allowed deduction of ₹ 3,20,000 as business expenditure u/s 40A(3). Answer will be same even ‘ if Mr. B paid amount of ₹ 1,80,000 and ₹ 1,40,000 in different dates, since it is in excess of ₹ 10,000.

Treatment in the hands of Mr. S:
Since, Mr. S has received ₹ 3,20,000 (which is more than ₹ 2,00,000) from a person in a day otherwise than by an account payee cheque or an account payee bank draft or use of ECS through a bank account, provisions of , Sec. 27IDA shall be attracted and Mr. S shall be liable to pay a penalty of ₹ 3,20,000

Answer will be changed if Mr. S received ₹ 1,80,000 and ₹ 1,40,000 with tw different dates. In this case there is a no violation of provisions of Sec. 269ST.

Question 7.
Mr. A an agriculturist has made an agreement to sell his 10 acres of , agricultural land situated in a remote village at a price of 1 lakh per acre to Mr. B, for constructing a farmhouse. Mr. A has received an advance of 1 lakh by way of a crossed cheque. Later on, the agreement Was rescinded as Mr. B could not pay the balance amount within the stipulated time as per the agreement. Mr. A returned the advance by a crossed cheque, The assessing officer has proposed to levy a penalty u/s 271 D on, Mr. A. ; Examine the validity of the Assessing Officer’s action. [CA Final Nov. 2019 (Old Syllabus)] [4 Marks]
Answer:
As per section 269SS, no person shall take or accept from any other person any loan or deposit or specified sum otherwise than by an account payee cheque or account payee draft or use of ECS through a bank account or through such other mode as may be prescribed, if amount of such deposit or advance or loan is ₹ 20,000 or more.

As per section 269T, no person shall repay any loan or deposit made with it or any specified advance received by it, otherwise than by an account payee cheque or account payee bank draft or use of ECS through a bank account or through such other electronic mode as may be prescribed, if amount of the loan or deposit or specified advance together with interest payable thereon is ₹ 20,000 or more.

“Specified sum” means any sum of money receivable, whether as advance or otherwise, in relation to transfer of an immovable property, whether or not the transfer takes place.

As per section 271D, the A.O. may impose a penalty equal to loan or deposit or specified sum so taken or accepted against the contravention of section 269SS. However, where the assessee has contravened Sec. 269SS and becomes liable u/s 27ID for penalty, he shall not be liable for penalty u/s 271E in respect of such amount on contravention of Sec. 269T.

In this case, Mr. A has received an advance of ₹ 1 lakh in respect of selling of 10 acres of agricultural land by way of a crossed cheque. Thereafter, where the agreement gets rescind, he returned such amount also by way of a crossed cheque. Therefore, he has contravened both Sec. 269SS and 269T, but he shall only be liable for a penalty u/s 27ID. Thus, the action of the A.O. is valid in law.

Deduction, Collection and Recovery of Tax – CA Final DT Question Bank is designed strictly as per the latest syllabus and exam pattern.

Deduction, Collection and Recovery of Tax – CA Final DT Question Bank

Tax Deduction and Collection at Source

Question 1.
Explain the applicability of the provision relating to the deduction of tax at source in the following transactions:
(i) Max Limited pays ₹ 1.20 lakhs to Mini Limited, a resident contractor who, under the contract dated 15th October, 2020, manufactures a product according to specification of Max Limited by using materials purchased from Max Limited.
(ii) A company operating a television channel makes payment of ₹ 5 lakhs to a former cricketer for making running commentary of a one-day cricket match.
(iii) EL Ltd., a foreign company, pays outside India, salary to its employee, Mr. Raghavan, a foreign national and a non-resident, for services rendered in India. [CA Final May 2010] [6 Marks]
Answer:
(i) The definition of “work” u/s 194C includes manufacturing or supplying product as per the requirement or specification of a customer by using material purchased from such customer or its associate. In the instant case, Mini Limited manufactures the product as per the specification given by Max Limited by using the raw materials purchased from Max Limited.

Therefore, it falls within the definition of “work” u/s 194C. Consequently, tax is to be deducted on the invoice value excluding the value of material purchased from such customer if such value is mentioned separately in the invoice. If the material component is not mentioned separately in the invoice, tax is to be deducted on the whole of the invoice value.

(ii) Provisions for deduction of tax at source u/s 194J are attracted in respect of payment of fees for professional services, if the amount of such fees exceeds ₹ 30,000 in the relevant financial year. The service rendered by a commentator in relation to sports activities has been notified by the CBDT as professional service for the purpose of section194J vide its Notification No. 88 dated 21st August, 2008. Therefore, tax is required to be deducted @ 10% from the fee of ₹ 5 lakhs payable to the former cricketer.

(iii) Section 195 requires deduction of tax at source by any person responsible for making payment to a non-resident, any interest or any other sum chargeable under the provisions of the Income-tax Act, 1961 (other than income chargeable under the head “Salaries”).

Section 192(1) requires “any person” responsible for paying income under the head “Salaries” to deduct tax at source. Therefore, even if the payer is a foreign company, section 192 would be applicable.

TDS provisions u/s 192 are attracted, if the salary payable to a non-resident is chargeable to tax in India. U/s 9(1)(ii), income which falls under the head “Salaries” shall be deemed to accrue or arise in India, if it is earned in India. Salary payable for service rendered in India shall be regarded as income earned in India.

Therefore, salary paid to Mr. Raghavan, a non-resident, attracts tax liability in India, as he has rendered services in India and the salary is attributable to such services. The Supreme Court in the case of CIT v. Eli Lilly & Co. (India) P. Ltd. has expressed the same view.

Therefore, the foreign company, EL Ltd., is liable to deduct TDS u/s 192 from the salary of Mr. Raghavan.

Question 2.
Bharathi Cements Ltd., the assessee, purchases jute bags from Raj Kumar & Co. The latter has to supply the jute bags with the logo and address of the assessee, printed on it. From 01.09.2020 to 20.03.2021, the value of jute bags supplied is ₹ 8,00,000, for which the invoice has been raised on 20.03.2021. While effecting the payment for the same, is the assessee bound to deduct tax at source, assuming that the value of the printing component involved is ₹ 60,000. The assessee has not sold any material to Raj Kumar & Co. and the latter has to manufacture the jute bags in its plant using raw materials purchased from outsiders. [CA Final May 2010] [2 Marks]
Answer:
As per the definition u/s 194C “work” shall not include manufacturing or supplying a product according to the requirement or specification of a customer by using raw material purchased from a person, other than such customer or its associate, i.e. such a contract would be in the nature of contract for ‘sale’.

The problem clearly states that Raj Kumar & Co. have to manufacture the jute bags using raw materials purchased from outsiders and that the assessee has not sold any material to them. Therefore, in this case, it is a contract for sale. Hence, the provisions of section 194C would not be attracted and no liability to deduct tax at source would arise.

Question 3.
R Limited transferred a building worth ₹ 25 lakhs to the Chief Executive Officer, Mr. Mohan Lai, a resident individual on his retirement under an agreement for not carrying on any activity related to its business ; for a period of five years. In course of assessment u/s 143(3), the A.O. found that no tax had been deducted at source by R Limited and on that ground, he disallowed 30% of the expenditure by invoking the provision of section 40(a)(ia). Examine the correctness of the action of the Assessing Officer. [CA Final Nov. 2010] [6 Marks]
Answer:
As per section 194J, any person, who is responsible for paying to a resident, any sum by way of fees for professional services, or fees for technical services or royalty or non-compete fees referred to in section 28{va) is required to deduct tax at source.

As per section 28(va), any sum received or receivable in cash or in kind under an agreement for not carrying out any activity in relation to any business is chargeable to tax under the head “Profits and gains of business or profession”.

Therefore, the obligation to deduct tax u/s 194J arises even if the non-compete fee is payable in kind. It is the responsibility of the payer to recover the amount of tax deductible from the recipient of the non-compete fee in kind.

As per Sec. 40(a)(ia), 30% of any sum payable to a resident on which tax is deductible at source shall not be allowed as a deduction on which tax has not been deducted or after deduction has not been paid to the credit of Central Government in due time. Therefore, the action of the Assessing Officer to disallow 30% of expenditure is correct.

Question 4.
Maya Bank credited ₹ 73,50,000 towards interest on the deposits in a separate account for macro-monitoring only by using Core-branch Banking Solutions (CBS) software. No tax was deducted at source in respect of interest on deposits so credited even where the interest in respect of some deposits exceeded the limit of ₹ 40,000. The Assessing Officer disallowed the entire interest expenditure where the interest on time deposits credited exceeded the limit of ₹ 40,000 and also levied penalty under section 271C.
Decide the correctness of action of the Assessing Officer. [CA Final May 2011] [4 Marks]
Answer:
Explanation to Section 194A provides that where any interest income (other than interest on securities) is credited to any account, whether called ‘Interest payable account’ or ‘Suspense account’ or by any othername, in the books of account of the person liable to pay such income, such crediting shall be deemed to be credit of such income to the account of the payee and provisions of section 194A shall apply accordingly.

However, CBDT vide Circular No. 3/2010 dated 02.03.2010 has clarified that Explanation to section 194A will not apply in cases of banks where credit is made to provisioning account on daily/monthly basis for the purpose of macro monitoring only by the use of CBS software, since no constructive credit to the depositor’s/payee’s account takes place while calculating interest on daily/monthly basis in the CBS software used by banks.

In such cases, tax shall be deducted at source on accrual of interest at the end of the financial year or at periodic intervals as per practice of the bank or as per the depositor’s or payee’s requirement or on maturity or on encashment of time deposit, whichever event takes place earlier.

In view of above, the action of the A.O. in disallowing the interest expenditure credited in a separate account for macro monitoring purpose is not valid and consequent penalty proceedings are also not tenable in law.

Question 5.
What are the consequences of not collecting tax at source (TCS) in respect of sale of scrap by a manufacturing company? State the circumstances under which the TCS provisions are not applicable in the above case. [CA Final May 2012] [5 Marks]
Answer:
As per section O6C, every person being a seller of, inter alia, scrap, shall, at the time of debiting of the amount payable by the buyer to the account of the buyer or at the lime of receipt of such amount from the buyer, whichever is earlier, collect tax @ source Çoe 1% of the said amount from the buyer. If the seller does not collect tax at source on sale of scrap, then, the following would be the consequences:

1. He shall be deemed to be an assessee in default in respect of the tax not collected.
2. He shall be liable to pay the tax, which he ought to have collected, to the credit of the Central Government, even if he has not actually collected the tax.
3. He shall be liable to pay simple interest @ 1% per month or part thereof on the amount of such tax from the date on which such tax was collectible till the date on which the tax was actually paid. Such interest shall be paid before furnishing the quarterly statement for each quarter.
4. Penalty equal to the amount of tax which is not collected can be levied u/s 271CA.

However, the seller, who does not collect tax at source, shall not be deemed to be an assessee in default in respect of such tax if the buyer:

1. has furnished his return of income u/s 139; and
2. has taken into account such sum for computing income in such return of income; and
3. has paid the tax due on the income declared by him in such return of I income; and
4. the payer furnishes a certificate to this effect from an accountant in such form as may be prescribed.

In such cases, the seller shall be liable to pay interest from the date on which such tax was collectible to the date of furnishing of return of income by such buyer. :

The seller, however, would not be liable to collect tax at source in the following cases:
(i) If the buyer is a resident and he furnishes to the person responsible for collecting tax, a declaration’in the prescribed form to the effect that scrap is to be utilized for the purpose of manufacturing, processing , or producing articles or things or for the purposes of generation of power and not for trading purposes.

(ii) If scrap is sold to a public sector company, the Central Government, a State Government, an embassy, a high commission, legation, commission, consulate and the trade representation of a foreign State or a club.

(iii) If the buyer, in the retail sale of scrap, has purchased the scrap for his personal consumption.

Question 6.
B. Airways Ltd. sold tickets to the travel agents in India at a minimum fixed commercial price. The agents were permitted to sell the tickets at a higher price, however, up to a maximum of published price. Commission at the rate of 9% of published price was payable to the agents of the airlines company, on which tax was deducted under section 194H by the company. The Assessing Officer raised the issue of further liability of tax deduction at source on the amount of difference between the actual sales price and the minimum fixed commercial price by treating it as “additional special commission” in the hands of the agents. Whether the contention raised by the Assessing Officer is tenable in law? Critically examine. [CA Final May 2012] [4 Marks]
Answer:
The facts of the case are similar to the facts in CIT v. Qatar Airways (2011) where the Bombay High Court held that the difference between the published price and the minimum fixed commercial price cannot be treated as additional special commission in the hands of the agents of an airline company to attract TDS provisions u/s 194H as the airline company has no information about the exact rate at which tickets are ultimately sold by the agents.

In order to deduct tax at source, the exact income in the hands of the agents must necessarily be ascertainable by the airline company. Further, it would be impracticable and unreasonable to expect the airline company to get a feedback from its numerous agents in respect of each ticket sold.

Applying the rationale of the above case, B. Airways Ltd. is not liable to deduct tax at source u/s 194H on the difference between the actual sale price and the minimum fixed commercial price, even though the amount earned by the agent over and above minimum fixed commercial price would be taxable as income in the hands of the agent.

Therefore, the contention raised by the Assessing Officer is not tenable in law.

Question 7.
Amisha Hotels and Resorts Ltd. is engaged in business of owning, operating and managing hotels. The tips are paid by the guests by way of charge to the credit cards in the bills. The company disburses the same to the employees at periodic intervals. Explain with reasons whether the company is responsible for deducting tax at source from disbursement of tips to its employees. [CA Final Nov. 2012] [4 Marks]
Answer:
The liability to deduct tax at source will arise only if the impugned payments disbursed to the employees by the assessee-company are regarded as “Salaries” under section 192.

The facts of this case are similar to the facts of CIIXTDS) v. ITC Ltd [2011] in which the Delhi High Court observed that the tips charged from the customers by the employer creates an obligation on the part of the employer to disburse them to the employees and by virtue of employer-employee relationship, the employees also have a right to claim such tips. Therefore, the tips constitute an additional income for the employees and thus, would be taxable under the head “Salaries” and the company was liable to deduct tax at source from such payments u/s 192.

However, the liability to deduct tax will arise only if the amount of salaries after considering the permissible deductions exceeds the basic exemption limit in the hands of the recipient of such tips.

Question 8.
Discuss the liability for deduction of tax at source In the following cases:
(i) Mr. A has been running a sole proprietary business having total turn over of ₹ 1.5 crore in the immediately preceding financial year. He pays a monthly rent of ₹ 15,000 for the office premises to Mr. X, the landlord besides, he also pays service charge of ₹ 10,000 per month to Mr. X towards the use of furniture and fixtures.

(ii) By virtue of an agreement with a nationalized bank, a catering organization receives ₹ 50,000 per month towards supply of food, snacks, etc. during the office hours to the employees of the bank.

(iii) A notified infrastructure debt fund eligible for exemption u/s 10(47) of the Income-tax Act, 1961 pays interest of ₹ 5 lakhs to a company incorporated in USA. The US Company incurred expenditure of ₹ 12,000 for earning such interest. The fund also pays interest of ₹ 3 lakhs to Mr. X, who is a resident of a notified jurisdictional area. Discuss the liability for deduction of tax at source. [CA Final May 2013] [8 Marks]
Answer:
(i) Where an individual or HUF, whose total turnover exceeds ₹ 1 crore in the immediately preceding financial year, pays rent exceeding ₹ 2,40,000, liability to deduct tax 10% u/s 194-1 shall arise. Therefore, Mr. A, being an individual, having total turnover of ₹ 1.5 crore in the immediately preceding financial year shall be liable to deduct tax at source u/s 194-I in respect of rental payments made during the current financial year.

As per Explanation to section 194-I, rent includes any payment, by whatever name called, for the use of land, building, furniture, fittings, etc. Therefore, in the given case, along with the rent of 15,000 p.m. for office premises the service charges of 10,000 p.m. for use of furniture and fixtures would also attract TDS u/s 194-I.

Further, since the aggregate rental payments (for both premises and furniture/fittings) made to Mr. X during the financial year 2020-21 exceeds ₹ 2,40,000, tax has to be deducted on ₹ 3 lakhs @ 10%. The tax to be deducted u/s 194-I would, therefore, be ₹ 30,000.

(ii) Under section 194C, the definition of ‘work’ includes catering services also and therefore, TDS 2% under section 194C will get attracted in respect of payments to the catering organization. As the payment exceeds ₹ 1,00,000, the nationalized bank is required to deduct tax @ 2% on payment made to the catering organisation, thereby, tax to be deducted would be ₹ 12,000 (i.e., 2% of ₹ 6,00,000).

If the catering organization is owned by an individual or HUF, tax is to be deducted 1% under section 194C.

(iii) As per section 194LB, tax would be deductible 5% on gross inter est paid/credited by a notified infrastruclure debt fund, eligible for exemption u/s 10(47), to a foreign company.

In the first case, since the payment is made to a foreign company, health & education cess @ 4% have to be added to the applicable rate of TDS. Therefore, the tax deductible u/s 194LB would be ₹ 26,000 (i.e., 5.20% of ₹ 5 lakhs).

However, in case the notified infrastructure debt fund pays interest to a person who is a resident of a notified jurisdictional area, section 94A will apply. Accordingly, tax would be deductible @30% (plus health & education cess @ 4%) u/s 94A, even though section 194LB provides for deduction of tax at a concessional rate of 5%. Therefore, the tax deductible in respect of payment of ₹ 3 lakh to Mr. X, who is a resident of a notified jurisdictional area, would be ₹ 93,600, being 31.2% of ₹ 3,00,000.

Question 9.
Explain in the context of provisions contained in Chapter XVII of the Act and also work out the amount of tax to be deducted by the payer of income in the following cases:
(i) Payment of ₹ 5 lakhs made by JCP & Co. to Pingu Events Co. Ltd. for organization of a debate competition on the subject “Preservation of Rural Heritage of Rajasthan”.
(ii) “Profit Commission” of ₹ 1 lakh paid by a re-insurance company to the insurer company after the expiry of the term of insurance where there was no claim during the treaty.
(iii) KD, a part time director of DAF Pvt. Ltd. faas paid an amount of ₹ 2,25,000 as fees which was actually in the nature of commission on sales for the period 01.07.2020 to 30.09.2020. [CA Final Nov. 2013] [6 Marks]
Answer:
(i) For the purpose of section 194J, CBDT has notified the services of ‘Event Managers in relation to Sports activities’ alone as “professional services”. However, in the given case, payment has been made to an event management company for organising a debate competition. Hence, the TDS provisions u/s 194J would not be attracted in this case.

However, TDS provisions u/s 194C, relating to payment to contractors, would be attracted and consequently tax has to be deducted @ 2% under section 194C which will be 10,000, being 2% of ₹ 5 lakhs.

(ii) As per section 194D, tax shall be deductible at source 5% on insurance commission. But re-insurance differs from insurance since there is no direct contractual relationship between the person insured and the re-insurer.

Section 194D shall be levied on the commission or any other payment, which is given as a remuneration or reward for soliciting or procuring the insurance business. However, the insurance companies do not procure business for the reinsurance company nor does the reinsurer pay- commission for soliciting the business from the insurance companies; therefore, section 194D has no application.

Therefore, when profit commission is paid by a reinsurance company to insurance company, after the expiry of the term of insurance, in respect of such cases where there is no claim during the operation of the reinsurance treaty, TDS under section 194D is not attracted.

(iii) Section 194J provides for deduction of tax at source @ 10% on any remuneration or fees or commission, by whatever name called, paid to a director, which is not in the nature of salary on which tax is deductible at source u/s 192. Section 197B provides that where the requirement of deduction of tax falls during the period 14.05.2020 to 31.03.2021, then tax shall be deducted at A of the rate specified in the section.

Therefore, in this case, since the payment is made during the period 14.05.2020 to 31.03.2021, tax is to be deducted @ 7.5 (3/4th of 10%) by DAF Pvt. Ltd. on the commission of ₹ 3,75,000 paid to KD, a part time director.

Question 10.
Discuss whether tax has to be deducted under the provisions of the Income-tax Act, 1961 in the following situations? .
(i) M/s. Shiva & Co., partnership firm, pays a sum of ₹ 43,000 as interest on loan borrowed from Indian branch of a foreign bank.
(ii) Above firm has paid ₹ 14,000 as interest on capital to partner Mr. Vishnu, a resident in India and ₹ 22,000 as interest’ on capital to partner Mr. Brahma, a non-resident.
(iii) Above firm has paid ₹ 45,000 being share of profit of partner Mr. Brahma, a non-resident. [CA Final May 2014] [6 Marks]
Answer:
(i) As per Sec. 195, any person responsible for paying to a non-resident or a foreign company, any interest (other than interest n/s 194LB or 194LC or 194LD) or any other sum chargeable under this Act (other than salary) shall, at the time of credit or payment whichever is earlier, deduct income tax thereon at the rates in force. In the given case, the payment of interest on loan has been made to a branch of a foreign bank. The branch of the foreign bank would be considered as foreign company in India, assuming that its place of effective management is not in India. Hence M/s. Shiva & Co. needs to deduct tax u/s 195 in case of payment of ₹ 43,000 as interest on loan borrowed from Indian branch of a foreign bank.

However, the foreign banking company may make an application in Form No. 15C to the A.O. for grant of a certificate authorising him to receive such sum without TDS. Such certificate shall be granted by the A.O. subject to the conditions prescribed in rule 29B. So, if the foreign banking company has been granted a certificate of non-deduction of tax by the A.O. then no tax shall be deducted.

AUTHOR S NOTE:
A different view has been expressed in the suggested solution published for CA Final May, 2014 as under –
Section 194A deals with deduction of tax at source on interest, other than interest on securities, subject to the provisions of this section. Section 194A further provides that tax is not required to be deducted from interest credited or paid to any banking company to which the Banking Regulation Act, 1949 applies. A foreign bank operating in India is governed by the Banking Regulation Act. Therefore, M / s Shiva & Co. is not required to deduct tax from interest on loan payable to Indian Branch.

The author does not agree to the view expressed above since the branch of a foreign company is not a resident in India and hence Sec. 194A would not be applicable to it.

(ii) Section 194A also provides that tax is not to be deducted from interest paid or payable by a partnership firm to its partner resident in India. Hence, the firm need not deduct tax at source from payment of interest to its partner, Mr. Vishnu.

However, interest paid by the firm to its non-resident partner shall be governed by section 195 which requires deduction of tax at source from interest paid or payable to any non-resident. Therefore, the ex-elusion from TDS provisions of section 194A will not be applicable on interest paid to Mr. Brahma, a non-resident and tax has to be deducted at rates in force u/s 195 on the amount of ₹ 22,000.

(iii) As per section 10(2A), share of profit received by a partner from the firm is exempt from tax. Therefore, the share of profit paid to nonresident partner is not liable for TDS.

However, as per section 195(6) the person responsible for paying any sum to a non-corporate non-resident or to a foreign company, shall be required to furnish the information relating to payment of such sum in the prescribed form and manner, whether or not chargeable to tax.

Question 11.
A foreign company seconded some employees to the assessee, an Indian collaborator. The assessee had not deducted tax on the home salary/special allowance or allowances (education allowance or retention allowance) payments made by foreign company/HO to its employees (expatriated to India) outside India in foreign currency. The Revenue authorities, holding the assessee as an ‘assessee-in-default’ u/s 201 of the Income-tax Act, 1961, levied interest and penalty on it. Is the same justified? [CA Final May 2014] [4 Marks]
Answer:
On facts similar to the given problem, the question which arose before the Supreme Court in the case of CIT v. Eli Lilly & Co.(India) (P.) Ltd. was that whether the Indian assessee was required to deduct tax u/s 192 on the home salary and special allowances paid by the foreign company abroad for rendering services in India.

The Supreme Court held that if the home salary and special allowance payment made by the foreign company abroad is for rendition of services in India and if no work is found to have been performed for foreign company, then such payment would certainly come u/s 192( 1) of the Income-tax Act.

The Supreme Court held that it was duty bound to deduct tax at source u/s 192(1) from the home salary/special allowance(s) paid abroad by the foreign company, particularly when no work stood performed for the foreign company and the total remuneration stood paid only on account of services rendered in India during the period in question. In this case, A.O. is therefore justified in levying penalty and interest u’/s 201(1).

However, as per Sec. 273B, if the Indian collaborator was under the genuine and bona fide belief that it was not under any obligation to deduct tax at source from the special allowance paid by the foreign company, no penalty u/s 271C would be attracted.

Question 12.
Discuss and compute the liability for deduction of tax at source, if any, in the cases stated hereunder, for the financial year ended 31st , March, 2021.
(i) Mr. X, a resident, acquired a house property at Mumbai from Mr. Y for a consideration of ₹ 90 lakhs, on 20.6.2020. On the same day, Mr. : X made two separate transactions, thereby acquiring an urban plot in Kolkata from Mr. C for a sum of ₹ 49,50,000 and rural agricultural ; land from Mr. D for a consideration of ₹ 60 lakhs.

(ii) A commission of ₹ 50,000 was retained by the consignee ‘ABC Packaging Ltd.’ and not remitted to the consignor ‘XYZ Developers’, while remitting the sale consideration. Examine the obligation of the consignor to deduct tax at source.

(iii) Raj is working with AB Ltd. He is entitled to a salary of ₹ 50,000 per month w.e.f. 1.4.2018. He has a house property which is self- occupied. He paid an interest of ₹ 80,000 on loan, during the previous year 2020-21. The loan was taken for construction of house. He has notified his employer AB Ltd. that there will be a loss of ₹ 80,000 in respect of this house property for financial year ended 31.3.2021. [CA Final Nov. 2014] [6 Marks]
Answer:
(i) Since, the consideration for transfer House Property at Mumbai, exceeds ₹ 50 lakhs, Mr. X, being the transferee, is required to deduct tax 1% of ₹ 90 lakhs u/s 194-IA.

As per Sec. 197B, as inserted by the Taxation and Other Laws (Relaxations and Amendment of Certain Provisions) Act, 2020, where the requirement of deduction of tax at source falls during the period 14.05.2020 to 31.03.2021, the rate of deduction shall he 3/4th of rate prescribed in the section. Therefore, in this case, since the tax is required to be deducted at source on 20.06.2020, the raie of deduction shall be 0.75% (3’/4th of 1 %) and the amount of TDS would he ₹ 67,500.

Mr. X is not required to deduct tax at source u/s 194-IA from the consideration of ₹ 49,50,000 paid to Mr. C for transfer of urban plot, since the consideration is less than ₹ 50,00,000.

Mr. X is also not required to deduct tax at source u/s 194-IA from the consideration of ₹ 60 lakhs paid to Mi’. D for transfer of rural agricultural land, since the same is specifically excluded from the scope of immovable property for the purpose of tax deduction u/s 194-IA.

(ii) As per Sec. 194H, tax has to be deducted 5% on commission or brokerage paid to residents. However, no TDS if the amount of commission or brokerage does not exceed ₹ 15,000 in a financial year.

In the given case, ABC Packaging Ltd., the consignee, has not remitted the full sale consideration to the consignor but retained its commission of ₹ 50,000 and then remitted balance amount to the consignor. Such retention of commission by the consignee amounts to constructive payment of the same by the consignor and would not obviate the consignor from liability to deduct tax [CBDT Circular No. 619 dated 4-12-19911. Hence, XYZ Developers, being the consignor, has to deduct tax @ 5% (3/4th ii requirement of deduction of tax Falls during the period 14.05.2020 to 3 1.03.2021) on ₹ 50,000 u/s 194H. Thus, the amount of TDS would be ₹ 2,500.

(iii) AB Ltd. is required to deduct tax at source on the salary of ₹ 50,000 p.m. paid to Mr. Raj as under:

Question 13.
Examine the taxability and applicability of TDS provisions in the following cases:
(i) Miss Sony, a resident, received ₹ 4,60,000 on 01.04.2020 on maturity of her life insurance policy taken on 01.04.2011. The policy sum assured is ₹ 2,00,000 and the annual premium being ₹ 45,000.
(ii) Miss Puja, a resident, received ₹ 1,20,000 on 01.04.2020 on maturity of her life insurance policy taken on 01.04.2017. The policy sum assured is ₹ 1,00,000 and the annual premium being ₹ 8,000. [CA Final May 2015] [4 Marks]
Answer:
(i) In the first case, since the policy has been taken before 01.04.2012, the annual premium should not exceed 20% of the sum assured. Thus, the annual premium should not exceed ₹ 40,000 being 20% of ₹ 2,00,000. Since, the annual premium is ₹ 45,000 which exceeds ₹ 40,000 and the payment is made on or after 1.10.2014, maturity proceeds of ₹ 4,60,000 arc not exempt u/s 10(10D) in the hands of Miss Sony. Therefore, tax is required to be deducted @ 5% u/s 194DA on the amount of income comprised therein i.e. on ₹ 55,000 (₹ 4,60,000, being maturity proceeds – ₹ 4,05,000, being the entire amount of insurance premium paid).

(ii) In the second case, since the policy has been taken after 01.04.2012, the annual premium should not exceed 10% of the sum assured. Thus, the annual premium should not exceed ₹ 10,000 being 10% of ₹ 1,00,000. Since, the annual premium is ₹ 8,000 which does not exceed ₹ 10,000, the maturity proceeds of ₹ 1,20,000 would be exempt u/s 10(10D) in the hands of Miss Puja. Thus, TDS provisions u/s 194DA wòuld not be attracted and no tax is required to be deducted.

Question 14.
A sum of ₹ 60,000 was paid to Mr. Dastur, an advocate, on 1st July, 2020 towards fees for his professional services without deducting tax 1 at source. Later on, a further sum of ₹ 70,000 was due to him on 27th February, 2021 from which tax of ₹ 13,000 was deducted at source. The tax so deducted was deposited on 25th June, 2021. Compute the interest payable by the deductor u/s 201(1A). [CA Final May 2015, Nov. 2011] [4 Marks]
Answer:
In this case, tax is deductible @ 7.5% (3/4th of 10% as per Sec. 197B) u/s 194J in respect of fees for professional services. Since, there has been a delay in deduction and deposit of tax, interest u/s 201(1 A) is attracted.

As per the provisions of section 201(1 A), if a person who is liable to deduct tax at source fails to deduct tax at source or after deducting such tax, fails to pay the tax as required, then he is liable to pay interest as follows:

1. 1% for every month or part of month on the amount of such tax from the date on which such tax was deductible to the date on which such tax is actually deducted.
2. 1 1/2% for every month or part of month on the amount of such tax from the date on which such tax was deducted to the date on which tax is actually paid.

Therefore, in the given case, interest under section 201(1 A) would be computed as follows:

Question 15.
Smt. Vijaya, proprietor of Lakshmi Enterprises, made turnover exceeding ₹ 100 lakhs during the P.Y. 2019-20. Her turnover for the year ended 31.03.2021 was t 90 lakhs.

Decide whether provisions relating to deduction of tax at source are attracted for the following payments made during the F.Y. 2020-21:
(i) Purchase commission paid to one agent ₹ 25,000 towards purchases made during the year.
(ii) Payments to Civil engineer of ₹ 5,00,000 for construction of residential house for self use. [CA Final Nov. 2015] [4 Marks]
Answer:
(i) An individual or HUFshall be liable to deduct tax u/s 194H on payments made by way of commission or brokerage to a resident, only if the I total sales, gross receipts or turnover from the business or profession ; carried on by him exceed ₹ 1 crore in case of business or ₹ 50 lakhs in case of profession in the immediately preceding financial year in which such commission or brokerage is credited or paid by him. The rate of TDS u/s 194H is 5%.

In the given case, Smt. Vijava will be liable to deduct tax u/s 194H @ 5% for the purchase commission of ₹ 25,000 paid to one agent because the turnover of Smt. Vijava during the preceding financial year exceeds ₹ 1 crore. The fact that the turnover of the current year is ₹ 90 lakhs is not relevant. Also, the amount of commission exceeds the threshold limit of ₹ 15,000.
Note: It is assuified that the agent receiving commission is a person resident in India.

(ii) Since, payment to civil engineer is made for construction of residential house for self use, sec. 194J or Sec. 194C shall not be applicable. However, as per Sec. 194M, an individual, who is not required to deduct tax at source u/s 194C, 194H or 194J, shall be liable to deduct tax at source u/s 194M in respect of any payment made for carrying out any work in pursuance of a contract or for fees for professional services where the aggregate payments exceed ₹ 50 lakhs during the financial ear. In this case, since the payment does not exceed ₹ 50 lakhs, not s tax shall be deducted at source by Smt. Vijava from payment made to civil engineer for construction of residential house for self use.

Question 16.
State with reasons whether Chapter XVII-B are attracted in the following case and what is the net amount receivable by the payee. Mr. Sharma is an employee of M/s. ABC Ltd. since 01-04-2017. He has resigned on 31.03.2021 and has withdrawn the amount of ₹ 50,000 being the balance in his EPF account. [CA Final May 2016] [2 Marks]
Answer:
Sec. 192 A provides for TDS @ 10% (If PAN provided otherwise at MMR) on pre-mature withdrawal made by the employee, before the continuous service of 5 years, from the accumulated fund of EPF (except in cases of termination due to ill health, contraction or discontinuance of business, cessation of employment or any cause beyond the control of employee) and does not opt for transfer of accumulated balance to new employer.

Here, in this case, the provisions of sec. 192A shall be applicable and tax will be deducted @ 10% on ₹ 50,000 as Mr. Sharma had withdrawn amount before the continuous service of 5 years. The net amount receivable to the payee Le. Mr. Sharma shall be ₹ 45,000 (₹ 50,000 – 10%). It is assumed that Mr. Sharma had furnishes his PAN.

Question 17.
‘X’ while making payment “net of tax” to a non-resident for providing technical services on a world bank aided project had deducted tax out of such payments as per rates prescribed but says that the payee is not entitled for the TDS certificate. Examine. [CA Final May 2016] [3 Marks]
Answer:
As per section 198, any sum deducted in accordance with the provisions of Chapter XVII-B of the Income-tax Act, 1961 is deemed to be income received while computing the income of the payee. As per section 203, every person deducting tax at source shall furnish to the payee a certificate in the prescribed form within the prescribed time.

As per Circular No. 785, even if the tax has been borne by the payer of in-come still the payer shall be required to issue a TDS certificate to the payee.

Therefore, in this case, ‘X’ has to issue TDS Certificate to the payee even if the payment is made “Net of Tax”.

Question 18.
State the rate at which the tax either is to be deducted or collected under the provisions of the Act in the following cases:
(i) A partnership firm making sales of the timber which was procured and obtained under a forest lease.
(ii) Payment of income on investments in the securities to the Foreign Institutional Investor.
(iii) A nationalized bank receiving professional services from a registered society made provision of an amount of ₹ 25 lakhs against the service charges bills to be received.
(iv) Payment of ₹ 5 lakhs made to Mr. Phelps who is an athlete by a manufacturer of a swim wear for brand ambassador. [CA Final May 2016] [4 Marks]
Answer:
Applicable Rate of TDS/TCS

Situation	TCS/TDS	Rate	Note
(i) Partnership firm selling timber obtained under forest lease	TCS	2.5%	1
(ii) Payment of income on investments in the se­curities to the Foreign Institutional Investors In case the securities are Government securities	TDS	20.8% 5.20%	2
(iii) Professional services rendered by a registered society to a nationalised bank	TDS	10%	3
(iv) Payment by a manufacturer of swim wear to its brand ambassador Mr. Phelps, an athlete If Mr. Phelps is a resident If Mr. Phelps is a non-resident	TDS	10% 20.80%	4

Notes:
(1) As per section 206C(1), tax has to be collected at source @ 2 1/2 % by the partnership firm, being a seller, at the time of debiting of the amount payable by the buyer to the account of the buyer or at the time of receipt of such amount, whichever is earlier.

(2) As per section 196D, tax has to be deducted at source (a 20.80% (20% plus cess @ 4%) by any person who is responsible for paying to a Foreign Institutional Investor, any income by way of interest on securities ; at the time of credit of such income to the account of the payee or at : the time of payment of such income, whichever is earlier

Alternatively, if the said securities are assumed to be government i securities, tax is deductible @ 5.20% (i.e., 5% plus cess @ 3%) under section 194LD.

(3) Tax has to be deducted at source @10% under section 194J, by the nationalized bank at the time of credit of fees for professional services
to the account of the registered society (i.e., on 31.3.2020), even though 1 payment is to be made after that date.

(4) Tax has to be deducted at source @ 10% under section 194J in respect of income of ₹ 5 lakhs paid to Mr. Phelps, athlete, for, advertisement, on the inherent presumption that Mr. Phelps is a resident.

Alternatively, if Mr. Phelps is assumed to be a non-resident, who is not a citizen of India, tax has to be deducted at source @ 20.8% (20% plus cess 4%) under section 194E in respect of income of ₹ 5 lakhs paid to Mr. Phelps, an athlete, for advertisement referred under section 115BBA.

Question 19.
Examine the applicability of provisions relating to deduction of tax at source and compute the liability, if any, for deduction of tax at source In the following cases for the financial year ended 31-03-202 1:
(i) ₹ 80,000 towards Interest on compensation credited to the account of the payee by Motor Accidents Claim Tribunal on 30-11-2020.
(ii) ₹ 2,50,000 paid on 30.09.2020 as consideration to Mr. B, a resident in India, on account of compulsory acquisition of his residential building acquired for laying railway tracks.
(iii) Ravi Kumar aged 67 years derived ₹ 6,00,000 as salary from his employer, XYZ Ltd. for the year ended 31.03.2021. The following details are provided by him to the employer:

Particulars	₹
Loss from self-occupied house property at Mumbai	2,00,000
Net loss from let-out property	2,00,000
Net loss from business activity	1,00,000
Interest income from bank	3,20,000

[CA Final Nov. 2016] [6 Marks]
Answer:
(i) As per Sec. 194A, income paid by way of interest on compensation amount awarded by Motor Accident Claim Tribunal is liable for tax deduction @ 10%, where the aggregate amount of such income paid during the financial year does not exceed ₹ 50,000. In the given question, amount of ₹ 80,000 towards interest on compensation is only credited to the account of payee by Motor Accident Claim Tribunal and not paid. So no tax is to be deducted at source.

(ii) As per section 194LA, any person responsible for paying to a resident of any consideration on account of compulsory acquisition of immovable property other than the agricultural land, shall at the time of payment of such consideration, deduct tax @ 10% on such consideration. However, no tax shall be deducted if the amount of consideration does not exceed ₹ 2,50,000 during a financial year. In this case, the amount paid to Mr. B does not exceed ₹ 2,50,000 and therefore, the payer is not liable to deduct tax on such consideration.

(iii) As per section 192(2B), the employer shall deduct tax considering the other incomes of the employee under the different heads, where an employee has furnished statement of such other incomes also. However, for determining the estimated income of an employee, losses other than the loss under the head ‘Income from House Property’ shall not be considered.

XYZ Ltd. is required to deduct tax at source on the salary of ₹ 6,00,000 paid to Ravi Kumar as under:

As per Sec. 7 1(3A), loss from house property can be set-off against other income, only to the extent of ₹ 2,00,000 for any assessment year.

Question 20.
Discuss the liability for tax deduction at source in the following cases:
(i) Wings Ltd. has paid amount of ₹ 15 lakhs to Airports Authority of India towards landing and parking charges. [CA Final May 2016, May 2014, Nov. 2011] [4 Marks]

(ii) Omega Ltd., an event management company, organized a concert of international artists in India. In this connection, it engaged the services of an overseas agent Mr. John from UK to bring artists to India. He contacted the artists and negotiated with them for performance in India in terms of the authority given by the company. He did not take part in event organized in India. The company made the payment of commission of ₹ 1 lakh to the overseas agent. [CA Final May 2017, May 2016] [3 Marks]

(iii) Ramesh gave a building on sub-lease to Mac Ltd. with effect from 01.07.2020 on a rent of ₹ 20,000 per month. The company also took on hire machinery from Ramesh with effect from 01.11.2020 on hire charges of ₹ 15,000 per month. The rent of building and hire charges of machinery for the year 2020-21 were credited by the company to the account of Ramesh in its books of account on 31.03.2021. [CA Final May 2017, May 2016] [3 Marks]

(iv) ₹ 1,95,000 paid to Mr. X on 01.02.2021 by Karnataka State Government on compulsory acquisition of his urban land. What would be your answer if the land is agriculture land? [CA Final May 2016] [2 Marks]
Answer:
(i) TDS on landing and parking charges: The Supreme Court in the case of Japan Airlines Co. Ltd. y. CIT and CIT y. Singapore Airlines Ltd. (2015) observed that the landing and parking charges which are fixed by the Airports Authority of India are not merely for the ‘use of the land’. These charges are also for services and facilities offered in connection with the aircraft operation at the airport which include providing of air traffic services, ground safety services, aeronautical communication facilities, installation and maintenance of navigational aids and meteorological services at the airport.

Thus, tax is not deductible u/s 194-1 which provides deduction of tax for payment in the nature of rent. Hence, tax is deductible @ 2% u/s 194C by the i airline company, Wings Ltd., on payment of ₹ 15 lakhs made towards landing and parking charges to the Airports Authority of India for P.Y. 2020.21.

(ii) TDS on services of overseas agent outside India: An overseas agent of an Indian company operates in his own country and no part of his income accrues or arises in India. His commission is usually remitted directly to him and is, therefore, not received by him or on his behalf in India. The commission paid to the non-resident agent for services rendered outside India is, thus, not chargeable to tax in India [DIT (International Taxation) v. Wizcraft International Entertainment (P.) Ltd. (2014) (Bom.)].

Since commission income for contacting and negotiating with artists by Mr. John, a non-resident, who remains outside India is not subject to tax in India, consequently, there is no liability for TDS. It is assumed that the commission of ₹ 1 lakh was remitted to Mr. John outside India.

(iii) TDS on rent for building and machinery: Tax is deductible on rent under section 194-1, if the aggregate amount of rental income paid or credited to a person exceeds ₹ 2,40,000. Rent includes payment for use of, inter alia, building and machinery. The aggregate payment made by Mac Ltd. to Ramesh towards rent in P.Y. 2020-21 is ₹ 2;55,000 (i.e., ₹ 1,80,000 for building and ₹ 75,000 for machinery).

Hence, Mac Ltd. has to deduct tax @ 10% on rent paid for building and tax @ 296 on rent paid for machinery. However, since the requirement of deduction of tax at source falls during the period 14.05.2020 to 31.03.2021, tax shall be deducted at 3/4th of these rates i.e. 75% on rent paid for building and 1.5% on rent paid for machinery.

(iv) TDS on compensation for compulsory acquisition: Tax is deductible at source @10% under section 194LA, where payment is made to a resident as compensation or enhanced compensation on compulsory acquisition of any immovable property (other than agricultural land).

However, no tax deduction is required if the aggregate payments in a year does not exceed ₹ 2 lakh. Therefore, no tax is required to be deducted at source on payment of ₹ 1,95,000 to Mr. X, since the aggregate payment does not exceed ₹ 2.5 lakh. Since the definition of immovable property specifically excludes agricultural land, no tax is deductible at source on compensation paid for compulsory acquisition of agricultural land.

Question 21.
M/s Avtar Limited entered into an agreement for the warehousing of its products with ABC Warehousing and deducted tax at source as per provisions of section 194C out of warehousing charges paid during the year ended on 31.03.2021. The Assessing Officer, while completing the assessment for A.Y. 2021-22 of Avtar Limited asked the company by treating the warehousing charges as rent as defined in section 194-1 and asked the company to make payment of difference amount of TDS with interest. It was submitted by the company that the recipient had already paid tax on the entire amount of warehousing charges and therefore, now the difference amount of TDS cannot be recovered. However, it will make the payment of due interest on the difference amount of TDS. Examine critically the correctness of the action or the treatment given. [CA Final May 2017] [3 Marks]
Answer:
Section 201 provides that the payer (including the principal officer of the company) who fails to deduct the whole or any part of the tax on the amount credited or payment made to a payee shall not be deemed to be an assessee-in-default in respect of such tax if such payee –

• has furnished his return of income under section 139;
• has taken into account such sum for computing income in such return of income; and
• has paid the tax due on the income declared by him in such return of income,

and the payer furnishes a certificate to this effect from an accountant in such form as may be prescribed.

However, where the payer fails to deduct the whole or any part of the tax on the amount credited or payment made to a payee and is not deemed to be an assessee-in-default under section 201 (1) as mentioned above, interest under section 201(1 A)(i) i.e., @1% p.m. or part of month, shall be payable by the payer from the date on which such tax was deductible to the date of furnishing of return of income by such payee.

Therefore, M/s Avtar Limited shall not be required to pay the difference tax in case the above mentioned conditions are fulfilled. However, the assessee shall be liable to make payment of interest from the date on which such tax was deductible to the date of furnishing of return of income by ABC Warehousing.

Therefore, the submission of the assessee company, in this case, is correct.

Question 22.
Jashan Hotels Pvt. Ltd., engaged in the business of owning, operating and managing hotels, allowed its employees to receive tips from the customers, by the virtue of their employment. The tips were also collected directly by the hotel-company from the customers, when payment was made by them through credit cards. The hotel-company thereafter disbursed the tips to the employees. The Assessing Officer treated the receipt of the tips as income under the head “salary” in the hands of the various employees and held that the company was liable to deduct tax at source from such payments under section 192. Since the company had not deducted tax at sources on such payments, the Assessing Officer treated the company as an assessee-in-default under section 201 (1) of the Act. Discuss the correctness of the action of the Assessing Officer. [CA Final Nov 2017] [4 Marks]
Answer:
Issue involved: The issue under consideration is whether tips received by the hotel from customers who made payment through credit card and distributed to employees would constitute as salary to attract the provisions for TDS u/s 192.

Provisions applicable: Section 192 provides obligation to deduct tax at source only to person responsible for paying any income under the head “salaries” and such person is only the employer. Further as per sec. 201, if any person who is liable to deduct TDS does not deduct the whole or any part of the tax or after deducting fails to pay the fax, he shall, be deemed to be an assessee in default.

Analysis: The facts of the case are similar to the facts in ITC Ltd. v. CIT [2016] 384 ITR 14, wherein the above issue came up before, the Supreme Court. The Apex Court observed that the person who is responsible for I paying the employee is not the employer at all, but a third party, namely, the customer. Thus, income from tips would be chargeable in the hands of employees as “Income from Other Sources” and therefore, section 192 would not get attracted.

The Supreme Court further observed that the tips paid by the employer to the employees had no reference to the contract of employment at all as they were received by the employer in a fiduciary capacity as trustee for payments which is later on disbursed to the employees for service rendered to the customer. So there was no reference to the contract of employment when these amounts were paid by the employer to the employee.

The Supreme Court, therefore, held that there is no liability on the assessee company to deduct tax at source u/s 192 and hence, it cannot be treated as an assessee in default for non-deduction of tax at source from the amount of tips collected and distributed to its employees.

Conclusion: Thus, applying the rationale of the Supreme Court ruling to the present case, there is a no liability to the Jashan Hotels Pvt. Ltd to deduct ; tax at source u/s 192 on the payment of tips which is received from the customer and passed on to the employee. Further assessee company shall not be treated as assessee in default u/s 201(1). Therefore action taken by the Assessing Officer is not correct in the eyes of law.

Question 23.
Discuss the TDS/TCS applicability in context of A.Y. 2021-22 in the following cases and state the amount of the TDS/TCS as per Income-tax Act, 1961. (AH issues as under are independent)
(i) Mr. Shan, an individual, whose turnover from the business carried on by him during the financial year immediately preceding the financial year exceed ₹ 100 lakh, paid fee to an architect of ₹ 50,000 for furnishing his residential house.
(ii) Mr. Shyam purchased a house in Mumbai for consideration of ₹ 90 lakh by cheque from the builder for the use of his residence.
(iii) Mr. Soham purchased licensed copy of computer software from the software vendor (resident of India) along with all right to use it for ₹ 50,000 to be used for business purposes (not in respect of cinematographic films). [CA Final Nov. 2017] [6 Marks]
Answer:
(i) As per Sec. 194J, an individual whose total turnover from business exceeds ₹ 1 crore in the immediately preceding financial year shall be liable to deduct tax at source u/s 194J @ 10% in respect of fees for professional services exceeding ₹ 30,000 paid to a resident during any financial year. However, Sec. 194J would not be attracted, if the fee is paid exclusively for personal purposes.

However, the Finance (No. 2) Act, 2019 has inserted Sec. 194M which provides that an individual who is not required to deduct tax at source u/s 194J in respect of payment of fees for professional services shall be ; required to deduct tax at source u/s 194M @ 5% where the aggregate payment during the financial year exceeds ₹ 50,00,000.

In this case, the fee paid by Mr. Shan is for furnishing of his residential house which is a personal purpose and therefore Sec. 194J shall not be applicable. Further, the fees paid does not exceed ₹ 50,00,000 and therefore, Mr. Shan shall not be liable to deduct tax u/s 194M also.

(ii) As per section 194-IA, tax is required to be deducted at source @1% on the amount of consideration paid for purchase of a residential house, being an immovable property, if the amount of consideration is ₹ 50 lakhs or more.

Therefore, Mr. Shyam is required to deduct tax at source of ₹ 90,000 (1 % of ₹ 90,00,000) from the amount of consideration paid for purchase of a residential house in Mumbai.

(iii) As per Explanation 4 to section 9(1)(vi), consideration for transfer of all or any right to use of computer software (including granting of a licence) would fall within the meaning of “royalty”.

As per Sec. 194J, an individual whose total, turnover from business exceeds ₹ 1 crore in the immediately preceding financial year shall be liable to deduct tax at source u/s 194J @ 10% in respect of payment of royalty exceeding ₹ 30,000 paid to a resident during any financial year.

In this case, by assuming that the turnover of Mr. Soham exceeds ₹ 1 crore in the preceding financial year, he shall be liable to deduct tax at source @ 10% u/s 194J on ₹ 50,000 paid for purchasing license copy of computer software. Therefore. Mr. Soham shall deduct ₹ 5,000 (10% of ₹ 50,000) from the amount paid to software vendor.

Question 24.
Syed & Co., a dealer in motor cycles conducted motor cycle race on k the occasion of its 25th year anniversary. The prize was given to first 3 winners by way of a luxury motor cycle which was worth ₹ 2,00,000 each. The assessee did not deduct tax at source on the prize given to the winners. S The Assessing Officer treated the assessee as an assessee in default and passed order under section 201(1) and 201(1A). The assessee seeks your advise on the validity of the order and other legal consequences. Advise. [CA Final May 2018 (OM Syllabus)] [4 Marks]
Answer:
Issue involved: The issue under consideration is whether the assessee can be treated as an assessee in default u/s 201 where he fails to deduct tax at source in respect of winnings which are wholly in kind u/s 194B.

Provisions applicable: As per Sec. 194B, the person responsible for paying any income by way of winnings which are wholly in kind shall, before releasing the winnings, ensure that the tax has been paid in respect of said winnings. Also, Sec. 201 provides that where any person is liable to deduct to tax at source does not deduct the whole or any part of the tax or after deducting fails to pay to tax, he shall, be deemed to be an assessee default.

Analysis: The facts of the case are similar to the case of CIT v. Hindustan Lever Ltd. (2014), where the Karnataka High Court observed that Sec. 194B read with Sec. 201 do not cast any duty to deduct tax at source where the winnings are wholly in kind. If the winnings are wholly in kind, as a matter of fact, there cannot be any deduction of tax at source.

The word “deduction” in this provision postulates a reduction or subtraction of an amount from a gross sum to be paid and payment of the net amount thereafter. Where the winnings are wholly in kind the question of deduction of any sum therefrom does not arise and in that evenluality, the only responsibility, as cast u/s 194B, is to ensure that tax is paid by the winner of the prize before the prize or winnings are released in his favour. Therefore, the High Court , held that proceedings u/s 201 cannot be initiated against the assessee.

The High Court, therefore, held that proceedings u/s 201 cannot be initiated against the assessee.

Conclusion: By applying the above rationale, the action of the A.O. to treat the assessee as assessee in default on the ground that the assessee did not deduct tax at source on the prize given to the winners is not correct. However, instead of treating an assessee as assessee in default, there may be other legal consequences.

The other legal consequences may be that the assessee may be subjected to penalty equal to the amount of tax not paid u/s 271C by the Joint Commissioner and may also be subjected to rigorous imprisonment u/s 276B for a term which shall not be less than 3 months but which may extend to 7 years and with fine.

Question 25.
Amin Co. (P) Ltd. is a dealer of motor cars manufactured by Zeet Ltd. Amin Co. (P) Ltd. paid through banking channel ₹ 110 lakhs to Zeet Ltd. for purchase of cars in January 2021. Of the total motor cars so purchased, 4 motor cars cost ₹ 11 lakhs each and 7 motorcars are for the balance % amount. Decide whether any TDS/TCS provisions will apply. Will your answer be different if Amin Co. (P) Ltd. is not a dealer of motor cars and had acquired the same for the purpose of plying cars on hire? [CA Final May 2018 (Old Syllabus)] [3 Marks] )
Answer:
If Amin Co. (P.) Ltd. is a dealer:
As per Sec. 206C(1F), every person who receives any amount from sale of a motor vehicle exceeding ₹ 10,00,000 shall at the time of receipt of such income, collect from the buyer 1 % of such amount as income tax. However, there is no requirement to collect tax at source on sale of motor vehicles by manufacturers to dealers/distributors.

Here, the seller i.e. Zeet Ltd. is a manufacturer and the buyer ie. Amin Co. (P.) Ltd. is a dealer and therefore, no tax is required to be collected at source, since the provisions of TCS are not applicable on sale of motor vehicles by manufacturer to dealers.

If Amin Co. (P) Ltd. has acquired the motor cars for plying them on hire:
If the motor vehicles are purchased by Amin Co. (P.) Ltd. for the purpose ; of plying them on hire, then the position would be different. The total cars purchased are 11 out of which 4 motor cars cost ₹ 11 lakhs each and remaining 7 costs total of ₹ 66 lakhs ie. less than ₹ 10 lakhs each. Therefore, the TCS provisions shall be applicable only in respect of 4 motor cars, since it cost exceed ₹ 10 lakhs and no tax is required to be collected in respect of balance 7 cars.

Question 26.
Mr. Ramesh is employed in Raghu Ltd. as senior executive. He availed leave travel assistance (LTA) of ₹ 60,000 in January 2021. He did not produce any evidence for the expenditure incurred. His salary income (computed) before allowing exemption for LTA is ₹ 12,50,000. Mr. Ramesh claimed interest on moneys borrowed for acquisition of his residential house of ₹ 96,000 but did not produce the name, address and PAN of the lender. As employer, how will you treat the claim of exemption of LTA and deduction of housing loan interest claimed by Mr. Ramesh? [CA Final May 2018 (Old Syllabus)] [3 Marks]
Answer:
As per Sec. 192, the employer shall, for the purposes of estimating income of the assessee or computing tax deductible, obtain from the assessee the evidence or proof of particulars of prescribed claims (including claim for set-off of loss) under the provisions of the Act in such form and z manner as may be prescribed.

Rule 26C provides for the evidence or particulars which the employee is g required to furnish to the employer in respect of claims made by him for the purpose of estimating his income or computing the amount of tax deduction at source. Where the employee makes a claim in respect of Leave Travel Concession, he is required to produce evidence of expenditure incurred to the employer. In respect of claim made for deduction of interest under the head “Income from House Property”, the employee is required produce the particulars of name, address and PAN of the lender.

However, in this case, the employee Mr, Ramesh did not produce any evidence for expenditure incurred in respect of claim of Leave Travel Concession. Also, he did not produce the particulars the name, address and PAN of the lender in respect of claim made for deduction of interest under the head “Income from House Property”. Therefore, the employer may do not consider such claims of Mr. Ramesh.

Question 27.
Discuss the TDS/TCS implications if any, for the following transactions. What is the amount payable to the payee:
(i) X is a bookmaker and Mr. Y is a punter. On 22.01.2021, B has won ₹ 50,000 in Horse Race 1 and suffered a loss of ₹ 20,000 in Horse Race 2.
(ii) Mr. Santosh has let out his house property on a monthly rent of ₹ 60,000 from 15.01.2021 to Mrs. Preeti.
(iii) H Ltd., a manufacturer of luxury cars sold 50 cars on 01.09.2020 to NMP Ltd. its dealer, each car cost ₹ 20 Lakhs.
(iv) AKL Ltd., a third party administrator on behalf of an Insurance Company has settled medical bills of ₹ 5,00,000 submitted by Kay Hospitals Ltd. from a patient under a cashless scheme. [CA Final May 2018 (New Syllabus)] [6 Marks]
Answer:
(i) As per Sec. 1 94BB, any person, being a bookmaker or a holder of license for the horse racing, who is responsible for paving lo any person an income by way of winnings from horse race in amount exceeding ₹ 10,000 shall, at the time of payment thereof, deduct tax at source @ 30%.

Here, B has won ₹ 50,000 in Horse race I and therefore, X being a bookmaker is required to deduct tax at source @ 30go on ₹ 50,000. However, B has suffered a loss of ₹ 20,000 in Horse race 2 and there fore, no tax is required to be deducted at source in respect of such loss. Therefore, Mr. X is liable to deduct tax of ₹ 15,000 (₹ 50,000 × 30%) from winrings of ₹ 50,000 and the net amount payable to B shall be ₹ 15,000 (₹ 50,000 – ₹ 15,000 – ₹ 20,000).

(ii) As per Sec. 194-I, any person, not being an individual or HUF whose total sales or gross receipts from business/profession does not exceed ₹ 1 crore in case of business or ₹ 50 lakhs in cast of profession in the immediately preceding financial year, making payment to a resident any income by way of rent, shall at the time of credit or payment, whichever is earlier, deduct tax thereon 10% for th use of, inter alio., land or building or land appurtenant to the building. However, no deduction shall be made where the amount of rent does not exceed ₹ 2,40,000 during a financial year.

In this case, if it is assumed that the total sales or gross receipts of Mrs. Preeti exceeds the limits prescribed in the immediately preceding financial year, then she will be made liable For deduction of tax at source u/s 194-I in respect of rent paid to Mr, Santosh. But since, the total amount of rent paid does not exceed ₹ 2,40,000 during the F.Y. 2020-2 1, she is not liable for deduction of tax at source u/s 194-I.

Alternative:
As per Sec. 194-IB, any individual or HUF other than those whose total sales or gross receipts from the business/profession exceed 1 crore in case of business or ₹ 50 lakhs in case of profession in the immediately preceding financial year, making payment to a resident any income by way of rent exceeding ₹ 50,000 for a month or part of the month during the previous year, shall deduct tax thereon @ 5%.

The tax shall be deducted at the time of credit of rent for the last month of the previous year or the last month of tenancy (if the property is vacated during the year) or at the time of payment thereof, whichever is earlier.

In this case, if it assumed that the total sales or gross receipts of Mrs. Preeti does not exceed the limits prescribed in the immediately preceding financial year, then she will be liable for deduction of tax at source @ 5% on 1,50,000 (₹ 60,000 + ₹ 60,000 + ₹ 30,000) in respect of amount of rent paid or payable to Mr. Santosh in the month of March i.e. last month of the previous year or at the time of payment, whichever is earlier.

However, since such requirement of deduction of tax at source falls during the period 14.05.2020 to 31.03.2021, tax shall be deducted @ 3.75% (3/4th of 5%) and the net amount payable to Mr. Santosh shall be ₹ 1,44,375 (₹ 1,50,000 × 96.25%).

(iii) As per Sec. 206C( IF), every person who receives any amount from sale of a motor vehicle exceeding ₹ 10,00,000 shall at the time of receipt of such income, collect from the buyer 1% of such amount as income tax. However, no tax is required to collected tax at source on sale of motor vehicles by manufacturers to dealers. In this case, H Ltd., a manufacturer of luxury cars sold 50 cars costing ₹ 20 lakhs each to NMP Ltd., its dealer. Since, H Ltd. has sold the cars to its dealers, no tax is required to be collected at source by H Ltd. Therefore, NMP Ltd. is required to pay only ₹ 20,00,000 to H Ltd.

(iv) As per Circular No. 8/2009, Third Party Administrators (TPAs) who are making payment on behalf of insurance companies to hospital for settlement of medical/insurance claims, etc., under various schemes including cashless schemes, are liable to deduct tax at source u/s 194J @ 10%.

Therefore, AKL Ltd. is required to deduct tax at source @ 10% in respect of settlement of medical bills of ₹ 5,00,000 submitted by Kay Hospitals Ltd. from a patient under a cashless scheme. Therefore, net amount payable to Kay Hospitals Ltd. shall be ₹ 4,50,000 (₹ 5,00,000
× 90%).

Question 28.
Examine the applicability of provisions relating to deduction/collection of tax at source and compute the liability, if any, for deduction/ collection of tax at source in the following cases for financial year ended 31st March, 2021 as per provisions contained under the Income-tax Act, 1961:
(i) In terms of agreement between A (the Owner of land) and B (Developer and Builder) the Developer, B agrees to allot 5 apartments to the owner in part consideration for providing his land and also agreed to pay a sum of ₹ 25,00,000. In terms of the agreement, Mr. B issued a cheque for ₹ 15,00,000 towards part of consideration on 30.03.2021.

(ii) (1) Rent of ₹ 60,000 per month deposited by Mr. Shrikanth, software employee on 1st of every month in advance, in the account of Mr. Ashok, who does not provide his PAN. The house was taken on rent with effect from 01.07.2020 and he vacated the house on 28.02.2021.
(2) Would there be any change in TDS, if Mr. Ashok furnished his PAN to the tenant?

(iii) ₹ 19,50,000 credited to the account of Digitec Studios (a partnership firm) on 31.03.2021 by B-TV, Television channel, towards part consideration for shooting of Tele Episode for 10 weeks as per the storyline, contents and specifications of B-TV channel. [CA Final Nov 2018 (Old Syllabus)] [6 Marks]
Answer:
(i) Since the agreement between the owner of land, A, and the develop er and builder, B, is in the nature of specified agreement u/s 45(5A), which involves cash consideration as well, TDS @ 7.5% (3/4th of 10% as per Sec. 1978) on ₹ 25,00,000, being the cash component payable to A, is deductible u/s 194-IC. Assuming that only ₹ 15,00,000, being the amount paid to A on 30.3.2021, has actually been credited to the account of A in the books of B in the P.Y.020-21, the TDS liability would be ₹ 1,12,500, being 7.5% of ₹ 15,00,000.

However, if it is assumed that ₹ 25,00,000 has been credited to the account of A in the P.Y. 2020-21, even though only ₹ 15,00,000 has been actually paid in that year, then, tax has to be deducted @ 7.5% on ₹ 25,00,000, being the amount credited to the account of A and TDS liability would be ₹ 1,87,500, being 10% of ₹ 25,00,000.

(ii) (1)Since Mr. Shrikanth pays rent exceeding ₹ 50,000 per month in the F.Y. 2020-21, he is liable to deduct tax at source @ 3.75 (3/4th of 5%
as per Sec. 197B) u/s 194-IB on such rent for F.Y. 2020-21.

However, since Mr. Ashok does not provide his PAN to Mr. Shrikanth, tax would be deductible 20%, instead of 3.75%.

Tax has to be deducted from rent payable for the last month of the P.Y. 2020-21. However, since he vacated the premises in February, 2021, tax has to be deducted from rent paid on 1.2.2021 for the month of February, 2021. Tax of ₹ 96,000 [₹ 60,000 × 20% × 8] has to be deducted but the same has to be restricted to ₹ 60,000, being rent For February, 2021.

(2) If Mr. Ashok furnished his PAN to Shrikanth, tax would be deductible @ 3.75%.
Tax of ₹ 18,000 (₹ 60,000 × 8 × 3.75%) has to be deducted from rent paid on 01.02.2021 for the month of February, 2021.

(iii) Shooting of Tele Episode for B-TV as per the storyline, contents and specifications of B-TV falls within the scope of “work” u/s 194C. Since, the amount credited exceeds the specified limit of ₹ 30,000, TDS @ 1.5 (3/4th of 2% as per Sec. 197B) u/s 194C is attracted on ₹ 19,50,000 credited to the account of Digitec Studios, a partnership firm. TDS liability would be ₹ 29,250 [being 1.5% of ₹ 19,50,000]

Question 29.
Tulsi Pvt. Ltd., a company engaged in ship breaking activity, sold some old and used plates, wood, etc., in respect of which it did not collect tax from the buyer. The company claimed that such items are usable as such. Hence these are not ‘scrap’ to attract the provisions for collection of tax at source. The Assessing Officer treated such items in the nature of ‘scrap’ and raised a demand u/s 201(1) and interest u/s 201(1A).
Is the action of the Assessing Officer in treating such items as ‘scrap’ ten-able in law? Discuss. [CA Final Nov 2018 (New Syllabus)] [4 Marks]
Answer:
As per Sec. 206C(1), every person, being a seller shall, at the time of debiting the amount payable by the buyer or at the time of receipt, which-ever is earlier, collect 1% as TCS from buyer on sale, of scrap to the buyer.

The issue under consideration is whether items of finished products from ship breaking activity which are usable as such be treated as “Scrap” to attract provisions for tax collection at source u/s 206C?

The facts of the case are similar to the facts in CIT v. Priya Blue Industries (P) Ltd (2016), where the Gujarat High Court observed that where the assessee is engaged in ship breaking activity, the products obtained from the activity were finished products which are usable as such and hence, are not ‘waste and scrap’ though commercially known as scrap. Accordingly, the High Court held that any material which is usable as such would not fall within the ambit of the expression ‘scrap’ as defined in clause (b) of the Explanation to section 206C.

Accordingly, action of the Assessing Officer in treating such items as ‘scrap’ is not tenable in law.

Question 30.
Discuss whether liability to deduct tax at source arises in the under-mentioned (Independent) situations in respect of following payments
made by residents in India:
(i) Dindayal & Co., a partnership firm, has credited a sum of ₹ 67,000 and ₹ 4,000 respectively, as interest to partners L (Resident in India) and M (non-resident) respectively. [4 Marks]
(ii) Payment of ₹ 5 lakhs made by Shiv & Company (partnership firm) to Jyoti & Company Ltd. for organising debate competition on the subject ‘Rural Heritage of Rajasthan’. [2 Marks] [CA Final Nov 2018 (New Syllabus)]
Answer:
(i) As per Sec. 194A, any person other than an Individual/HUF whose sales or gross receipts from his business or profession does not exceed ₹ 1 crore in case of business or ₹ 50 lakhs in case of profession in the immediately preceding financial year, making payment of interest other than interest on securities to any resident, shall at the time of credit or payment, whichever is earlier, required to deduct tax at source on such interest @ 10%.

However, no tax is required to deduct in case of any interest credited or paid by a firm to its partner. Therefore, no tax is required to be deducted at source u/s 194A on interest on capital of ₹ 67,000 paid, by the firm to L, a resident partner.

As per Sec. 195, any person responsible for paying to a non-resident or a foreign company, any interest or any other sum chargeable under this Act, shall, at the time of credit or payment, whichever is earlier, deduct income tax thereon at the rates in force. Also, this section does not provide for any exclusion in respect of payment of interest by a firm to its non-resident partner. Therefore, tax has to be deducted u/s 195 at the rates in force in respect of interest on capital of ₹ 4,000 paid to partner M, a non-resident partner.

(ii) The services of Event Managers in relation to sports activities alone have been notified by the CBDT as “professional services” for the purpose of section 194J. In this case, payment of ₹ 5 lakhs was made to an event management company for organization of a debate competition. Hence, the provisions of section 194J are not attracted. However, TDS provisions under section 194C relating to contract payments would be attracted and consequently, tax has to be deducted @ 2% under section 194C. The tax deductible under section 194C would be ₹ 10,000, being 2% of ₹ 5 lacs.

Question 31.
Discuss the liability of TDS provisions in the following independent cases:
(i) X Ltd. is a producer of natural gas. During the year, it sold natural gas worth ₹ 20,50,000 to M/ s Hawa Co., a partnership firm. It also incurred ₹ 2,00,000 as freight for the transportation of gas. It raised the invoice and clearly bifurcated the value of gas as well as the transportation charges.
(ii) Beta Ltd., gave a contract to Alpha Ltd. for the supply of 2,000 pens on which the logo of Beta Ltd. was printed. The raw materials were purchased by Alpha Ltd. from C Ltd., which is not related to Beta Ltd. The consideration paid for the pens was ₹ 1,50,000.
(iii) M/s. Taba Ltd. enters into a contract with Mr. Babu for the transportation of its products from its plant to warehouses. It pays a lump-sum
amount of ₹ 2,50,000 to Mr. Babu for the year at the year end. Mr. Babu is engaged in the business of plying goods carriages on hire. Mr. Babu is not an assessee under Income-tax Act and thus did not provide PAN to Taba Ltd.
(iv) M/s. Sunivesh Investors is engaged in the business of stock broking, depositories, mobilisation of deposits and marketing of public issues. It is a registered member of Bombay Stock Exchange. Every year it makes payment amounting to ₹ 10 lakhs, to the Stock Exchange by way of transaction charges in respect of fully automated online trading facility. This service is available to all members of the stock exchange in respect of every transaction that is entered into. Would it be liable for tax deduction u/s 194J? [CA Final May 2019 (Op Syllabus)] [8 Marks]
Answer:
(i) TDS u / s 194C is attracted on any sum payable to a resident contractor for carrying out any work. Since X Ltd., the producer of natural gas sells as well as transports the gas to the purchaser, M/s. Hawa Co., a partnership firm, till the point of delivery, where the ownership of gas is simultaneously transferred, the manner of raising the sale bill (whether the transportation charges are embedded in the cost of gas or shown separately) does not alter the basic nature of such contract which remains essentially a ‘contract for sale’ and not a ‘works contract’ as envisaged in section 194C.

Therefore, in such circumstances, TDS provisions u/s 194C are not applicable on the component of Gas Transportation Charges payable by M/s. Hawa Co. to X Ltd. Consequently, there is no liability to deduct tax at source u/s 194C in this case.

(ii) TDS u/s 194C is attracted on any sum payable to a resident contractor for carrying out any work. However, “work” shall not include manufacturing or supplying a product according to the requirement or specification of a customer by using raw material purchased from a person, other than such customer or its associate, as such a contract is a ‘contract for sale’.

In this case, since Alpha Ltd. has to supply pens to Beta Ltd. by using materials purchased from C Ltd. who is not related to Beta Ltd., the contract for supply of pens is a ‘contract for sale’ and not a works contract. Consequently, there is no liability to deduct tax at source u/s 194C in this case.

(iii) No tax is required to be deducted at source u/s 194C from the sum credited or paid to the account of a contractor, during the course of the business of plying, hiring or leasing goods carriages, if he furnishes his PAN to the deductor.

In this case, since Mr. Babu has not furnished his PAN to M/s. Taba Ltd., M/s. Taba Ltd. has to deduct tax at source @ 20% as per section 206AA on lump sum payment of ₹ 2,50,000 to Mr. Babu, since the same exceeds the aggregate threshold of ₹ 1,00,000.

(iv) Under section 194J, TDS is attracted in respect of, inter alia, fees for technical services. Technical services like managerial and consultancy services are in the nature of specialised services made available by the service provider to cater to the special needs of the customer-user as may be felt necessary. It is the above feature that distinguishes or identifies a service provider from a facility offered.

However, the service provided by the BSE for which transaction charges are paid does not satisfy the test of specialized, exclusive and individual requirement of the user or the consumer who may approach the service provider for such assistance or service. Therefore, the transaction charges paid to BSE by its members are not for technical services but are in the nature of payments made for facilities provided by the stock exchange. Such payments would, therefore, not attract the provisions of tax deduction at source under section 194J.

Accordingly, payment of transaction charges of ₹ 10 lakhs by M/s. Sunivesh Investors to BSE in respect of fully automated online trading facility would not be liable for tax deduction at source under section 194J.

Question 32.
Deer Co. Ltd. engaged in the business of manufacture of furniture items on contract basis. It sub-contracted the production of cushion for the chairs to M/s Lion & Co., a sole proprietary concern. The sub-contractor M/s. Lion & Co procured the raw materials for production of cushions, performed further labour works and supplied the same to Deer Co. Ltd. It raised its bill on Deer Co. Ltd., showing the cost of raw materials ₹ 4,00,000 and labour charges ₹ 1,50,000 separately. Explain briefly the tax deduction requirement in the hands of Deer Co. Ltd. [CA Final May 2019 (New Syllabus)] [2 Marks]
Answer:
As per Sec. 194C, any person responsible for paying any sum for carrying out any work pursuance to contract shall at the time of credit or payment, whichever is earlier, deduct income tax:

• @ 1% in case recipient is individual or HUF;
• @ 296 in case of any other assessee.

Work shall include, inter alia, manufacturing or supplying a product according to the requirement or specification of a customer by using material purchased from such customer or its associate. However, it shall not include manufacturing or supplying a product according to the requirement or specification of a customer by using material purchased from a person, other than such customer or its associate.

In this case, Deer Co. Ltd., engaged in the business of manufacture of furniture items, has sub-contracted the production of cushion for the chairs to M/s Lion & Co. and M/s Lion & Co. has procured the materials from third person and not from the Deer Ltd. or its associate and therefore, no TDS liability shall arise u/s 194C.

Question 33.
M/s PMPC, a partnership firm, is engagec in the manufacture of cardboard carton boxes used in packaging industry. During the year it has sold cutting waste generated amounting to ₹ 30 lakhs to M/s PAPC Ltd, a paper manufacturing company. It uses such cutting waste purchased as raw material for its production.
Discuss the implication of this transaction with respect to tax collected at source. [CA Final May 2019 (New Syllabus)] [2 Marks]
Answer:
As per Sec. 206C(1), the seller of scrap shall at the time of debit or receipt, collect 1% of the purchase price as income tax. Further the term seller shall be other than individual or HUF whose sales or gross receipts from his business/profession does not exceed ₹ 1 crore in case of business or ₹ 50 lakhs in case of profession in the immediately preceding financial year.

In this case, M/s PMPC has sold cutting waste to M/s PAPC Ltd. which uses such cutting waste as raw material for its production. Thus, it has sold scrap to M/s PAPC Ltd. Further, since M/s PMPC is a partnership firm it will be required to collect tax irrespective of its sales or gross receipts in the immediately preceding financial year.

Thus, in the given case, M/s PMPC will be required to collect tax amounting to ₹ 30,000 (i.e. ₹ 30 lakh × 1%) from M/s PAPC Ltd.

Question 34.
Maha Bank Ltd accepted fixed deposits of ₹ 20 crores in the name of Registrar General of the High Court and issued a fixed deposit receipt in compliance with a direction passed by the court in relation to certain proceedings. The Bank did not deduct tax on the interest accrued. The A.O. issued a notice to the bank to show cause as to why it should not be treated as an assessee in default u/s 201(1) and 201(1A) for not deducting tax at source on interest accrued. Examine whether the bank is correct in not deducting tax on the interest accrued. [CA Final May 2019 (New Syllabus)] [4 Marks]
Answer:
The issue under consideration is that whether tax is required to be deducted on interest on fixed deposits accepted by the bank in the name of Registrar General of the High Court on the directions of the Court.

The facts of the case is similar to the facts of the case UCO Bank v. Dy. CIT (2014), where the Delhi High Court opined that the actual payee is not ascertainable and also the person in whose name the interest is credited is not a person liable to pay tax under the Act. The High Court observed that in the absence of a payee, the machinery provisions for deduction of tax to his credit are ineffective.

The expression “payee” u/s 194A would mean the recipient of income whose account is maintained by the person paying interest. The Registrar General is neither recipient of the amount credited to his account nor to interest accruing thereon. Therefore, he cannot be considered as a “payee” for the purposes of section 194A. Thus, the credit by the bank in the name of the Registrar General would not attract the provisions of section 194A.

Also, the CBDT has accepted this judgment vide Circular No. 23/2015.

In this case, Maha Bank Ltd. has accepted fixed deposits of ₹ 20 crores in the name of Registrar General of the High Court and issued a fixed deposit receipt in compliance with a direction passed by the court in relation to certain proceedings. By applying the rationale of Delhi High Court, the action of the A.O. to issue show cause notice to the bank as to why it should not be treated as an assessee in default u/s 201(1) and 201(1 A) is not correct.

Question 35.
“Blue Moon” a popular television channel incurred the following expenses:
(a) It paid ₹ 50 lakhs as prize money to the winner of a famous quiz programme “Who will be a Millionaire?”
(b) It paid ₹ 6 lakhs to a cameraman for shooting multi-episodes of a long documentary serial.
Examine TDS obligations in the hands of television channel for the above said payments. [CA Final May 2019 (New Syllabus)] [4 Marks)
Answer:
(a) As per Sec. 194B, the person responsible for paying by way of winnings from any card game and other game in an amount exceeding ₹ 10,000 shall at the time of payment deduct income tax thereon @ 30%. Therefore, tax of ₹ 15 lakhs has to be deducted at source from the price money of ₹ 50 lakhs payable to the winner.

(b) Fees for professional services are liable for TDS u/s 194J. CBDT has notified the profession of “film artist” for the purpose of sec. 194J which inter alia includes any person engaged in professional capacity as a cameraman. Thus, “Blue Moon” shall be required to deduct tax @ 10% u/s 194J as the amount paid exceeds ₹ 30,000 during a financial year. Thus, tax of ₹ 60,000 (₹ 6,00,000 × 10%) shall be deducted by the T.V. channel.

Question 36.
Examine the applicability of TDS provisions and TDS amount in the following cases as per provisions of Income Tax Act, 1961 with reference to A.Y. 2021-22:
(1) Payment of fees .of ₹ 28,000 for technical services and of ₹ 35,000 for Royalty to Mr. Raj Pal who is having PAN.
(2) Payment of ₹ 2,25,000 made to Mr. Anthony for compulsory acquisition of his house as per the law of State Government. [CA Final Nov 2019 (Old Syllabus)] [4 Marks]
Answer:
As per the amendment made by the Finance Act, 2020, tax @ 2% is r required to be deducted at source u/s 194J in respect of payment made or credited for fees for technical services (not being professional services).

In respect of royalty not in the nature of consideration for sale, distribution or exhibition of cinematographic films, the tax is required to be deducted @ 10%

However, no tax is required to be deducted at source, where payment does not exceed ₹ 30,000 during a financial year for each type of pay-ment.

In this case, ₹ 28,000 have been paid in respect of fees for technical services and ₹ 35,000 in respect of royalty to Mr. Raj. Therefore, no tax is to be deducted for payment of technical fees since it does not exceed ₹ 30,000 but tax at the rate of 10% is required to be deducted at time of credit or payment whichever is earlier for payment of royalty as it exceeds the threshold limit. Here it is assumed that Mr. Raj Pal is a resident Indian and the royalty is not in the nature of consideration for sale, distribution or exhibition of cinematographic films.

(2) Section 194LA provides for deduction of tax at source on payment of compensation for compulsory acquisition of immovable property being land or building. However, no tax is required to be deducted at source where amount of compensation does not exceed ₹ 2,50,000 during a financial year.

Since, the amount of compensation paid to Mr. Anthony does not exceed ₹ 2,50,000, no tax is required to be deducted at source.

Question 37.
(i) Nath Ltd., an Indian company, pays ₹ 8,40,000 to its Chief Financial Officer Mr. Raman as gross salary including taxable allowances and bonus. Besides that, it also provides Non-monetary perquisites which cost the company ₹ 1,50,000. Discuss the TDS implication in the hands of Nath Ltd. as well as in the hands of Raman as regards non-monetary perquisite.

(ii) KLS Ltd. givqs a multilevel parking building in front of a shopping mall in Delhi to PQR Ltd. on lease of 90 years. PQR Ltd. is liable to pay ₹ 3 crores as one time lease premium in addition to an annual lease rent of ₹ 26 lakhs. What will be the TDS/TCS liability in the hands of KLS Ltd. as well as in the hand of PQR Ltd.? What will be your answer if PQR Ltd. does not have PAN?

(iii) Ranu Ltd., engaged in manufacturing of paper, pays ₹ 4,00,000 to the head of labour union to be distributed to various workmen as per the work done by them. The A.O. wants the assessee to deduct tax on such payment under section 194C. Is the action of A.O. tenable in law? [CA Final Nov 2019 (New Syllabus)] [8 Marks]
Ans.
(i) As per Section 192(1 A), the person responsible for paying any income by way of a non-monetary perquisite, may pay, at his option tax on the whole or part of such income without making any deduction therefrom at the time when such tax was otherwise deductible under the provisions of sec. 192(1).
If Nath Ltd, opt for Sec. 19211A):

Tax on non-monetary perquisites at ‘average rate of tax’ shall be 11.12% of ₹ 1,50,000 = ₹ 16,680.

Such tax born by employer is exempt in the hands of Mr. Raman as per Sec 10(10CC) and also Nath Ltd. shall not get any deduction for such tax payment. Total Income of Mr. Raman shall remain ₹ 9,90,000 and Nath Ltd. shall deduct tax of ₹ 7,320 [(₹ 1,04,520 – ₹ 16,680)/12] every month from the salary of Mr. Raman and pay ₹ 1,390 every month to the credit of Central Government.

If Nath Ltd, does not opt for Sec. 19211A1:
Nath Ltd. shall deduct ₹ 8,710 (₹ 1,04,520/12) every month and pay to the credit of the Central Government.

(ii) As per Sec. 194-1, any person making lease payment in respect of use of building to any resident shall at the time of payment or credit, whichever is earlier, deduct tax @10% where the aggregate amount exceeds ₹ 2,40,000 during a financial year.

The Delhi High Court in the case of Indian Newspaper Society held that the lease premium paid by the assessee for acquiring a plot of land on a long-term lease was in the nature of capital expenditure not falling within the ambit of section 194-1.

Thus, lease premium paid by PQR Ltd. amounting to ₹ 3 crores as one-time lease premium for acquiring a plot of land on 90 years lease is a capital expenditure and no tax is required to be deducted on it. However, every person who grants lease license or transfers any right or Interest in any parking lot or toll plaza or mine or quarry, to any other person for the use of such parking plot or toll plaza for the purpose of business shall at the time of debit or receipt whichever is earlier collect from the license or lessee 2% of such amount as Income tax u/s 206C(1C).

Thus, KLS Ltd. is required to collect tax @ 2% of 26 lakhs = ₹ 52,000 while receiving payment of lease rent.

If PQR Ltd. does not have PAN, tax shall be collected at higher of
(a) twice the rate specified in relevant provisions (i.e. 2%) = 4%
(b) at the rate of 5%
If PQR Ltd. does not have PAN then as per sec. 206CC, KLS Ltd. shall collected tax @ 5% on 26 lakhs.

(iii) The head of the labour union is employed by the labour union to collect the money in bulk and distribute the same amongst the labourers, who are ultimate beneficiaries and not the head of the union. The head is remunerated by the union only for the job done.

The collected money is distributed amongst the labourers by the head of the union on behalf of the assessee and as such deducting of tax at source from the said payment does not arise at all. Therefore, no tax shall be deducted at source u/s 194C by the Ranu Ltd. for the payment made to the head of the union to be distributed to the various workmen for the work done by them. The action of the A.O. is therefore, not correct.

Question 38.
Mr. Bhist, a non-resident individual, earned an interest income of 12 lakhs on an investment made in a notified Infrastructure Debt Fund set up in India eligible for exemption u/s 10(47). Further, he incurred an expenditure of 15,000 for earning such interest income. Examine the Tax implications in the hands of both Fund and Mr. Bhist and justify your conclusions with relevant provisions of Income-tax Act, 1961 in two situations, when:

1. Mr. Bhist is residing in Notified Jurisdictional Area; and
2. Mr. Bhist is stationed outside India, in a place other than NJA.

Will there be any change in tax liability of Mr. Bhist, if the income received is fee for technical services from an Indian Company in lieu of interest income from Infrastructure Debt Fund? [CA Final Nov 2019 (New Syllabus)] [6 Marks]
Answer:
As per Sec. 1151 l)(a), interest received from an Infrastructure debt fund referred u/s 10(47) by a non-resident shall be chargeable to tax at the flat I rate of 5%. As per section 194LB, tax would be deductible @ 5% on gross interest paid/credited by a notified infrastructure debt fund, eligible for exemption u/s 10(47), to a non-resident individual.

Since the payment is made to a non-resident individual, health & education cess @ 496 have to be added to the applicable rate of TDS.

However, in case the notified infrastructure debt fund pays interest to a person who is a resident of a notified jurisdictional area, section 94A will apply. Accordingly, tax would be deductible @ 30% (plus health & education cess @ 4%) u/s 94A, even though section 194LB provides for deduction of tax at a concessional rate of 5%.

(i) If Mr. Bhist is residing in Notified Jurisdictional Area: Tax shall be deductible by the notified infrastructure fund @ 30% (plus health and education cess @ 4%) on ₹ 12,00,000 paid to Mr. Bhist Therefore, tax deductible shall be 3,74,400 (₹ 12,00,000 × 31.2%). No deduction of any expenditure incurred shall be allowed.

(ii) If Mr. Bhist is stationed outside India, in a place other than NJA: Tax shall be deductible @ 5% (plus health and education cess @ 4%) i.e. ₹ 62,400 (₹ 12,00,000 × 5.2%)

If the income is received as a fee for Technical services from an Indian Company, Mr. Bhist shall be taxable at the flat tax rate of 10% and tax amount shall be ₹ 1,24,800 (₹ 12,00,000 × 10.4%) by assuming that agreement for fees for technical services is approved by the Central Government.

Collection and Recovery of Tax

Question 1.
The procedure relating to the recovery of tax due or the arrears of taxes from a non-resident is different than the resident assessee. Comment and state how such recovery is to be made along with its limitation. [CA Final May 2011] [6 Marks]
Answer:
The provisions for recovery of tax in respect of non-residents are contained in section 173. According to this section, the tax chargeable on the income, which is deemed to accrue or arise in India u/s 9(l)(z), in the name of the non-resident or his agent who is liable as a representative assessee, may be recovered by deduction of tax at source under any of the provisions of Chapter XVII-B.

Any arrears of tax may be recovered also in accordance with the provisions of the Income-tax Act, 1961. However, the limitation contained in section 173 is that such recovery can be made only from any assets of the non-resident which are within India or which may at any time come within India.

Alternative:
Where the Central Government has entered into an agreement for recovery of tax with the Government of the country where the non-resident resides, the provisions of section 228A provide for an exception to the limitation contained in section 173.

Under section 90A( 1), the Central Government may enter into an agreement with the Government of any country outside India or specified territory outside India for, inter alia, recovery of income-tax under the Income-tax Act, 1961 and under the corresponding law in force in that country or specified territory.

Section 228A provides for the procedure of recovery of tax in pursuance of an agreement entered into by the Central Government with the Government of any country outside India. Sub-section (2) thereof provides that where an assessee is in default or is deemed to be in default in making a payment of tax, the Tax Recovery Officer may, if the assessee has property in a country outside India, forward to the Board a certificate drawn up by him under section 222 and the Board may take such action thereon as it may deem appropriate having regard to the terms of the agreement with such country.

Question 2.
The assessment for assessment year 2020-21 of XYZ Pvt. Ltd. was completed u/s 143(3) by making additions and thus creating a demand. The company filed an appeal against this order before the CIT(A) and was allowed relief. However, this order of CIT(A) was challenged by the department and was reversed by the ITAT. In this context, explain the liability of the company as to payment of interest charged by the A.O. from the date of order of CIT(A) till the date of order by the ITAT u/s 220(2) in the following conditions:
(i) The tax demanded as per order was paid in full within the time allowed as per notice issued u/s 156.
(ii) The tax demanded as per order was not paid. [CA Final Nov. 2013] [4 Marks]
Answer:
(i) Where the tax demanded as per order was paid in full within the time allowed as per notice issued u/s 156
Interest u/s 220(2) would be attracted if there is a notice of demand EH u/s 156 and there is a default in paying the amount so demanded within the time stipulated in the notice.

In this case, the company has paid the tax demanded as per the order in full within the time allowed as per the notice issued u/s 156. Therefore, the company is not liable to pay interest u/s 220(2) for the period from the date of order of CIT(A) to the date of Order of ITAT.

(ii) Where tax demanded as per the order was not paid
Where the assessment made originally by the A.O. is either varied or even set aside by one appellate authority but on further appeal, the original order of the Assessing Officer is restored either in part or wholly, the interest payable u/s 220(2) will be computed with reference to the due date reckoned from the original demand notice.

Therefore, if the company has not paid the tax demanded as per the order within 30 days of service of the notice of demand u/s 156, it shall be liable to pay simple interest @1% for every month or part of the month comprised in the period commencing from the day immediately following the expiry of the period specified in the original notice of demand till the taxes are paid in full.

Question 3.
The assessment of SBC Ltd. was completed u/s 143(3) and a notice of demand u/s 156 was issued for ₹ 13 lakhs for the assessment year 2020-21 requiring the company to pay the demand within 30 days.
On appeal before the Commissioner (Appeals), the demand was reduced to ₹ 10 lakhs. Is the A.O. required to issue a fresh notice of demand to continue tax recovery proceedings?
What would be your answer, if the CIT(A) enhanced the income and the resultant tax demand is ₹ 15 lakhs i.e., an increase of ₹ 2 lakhs? [CA Final May 2015] [4 Marks]
Answer:
(i) Demand reduced in the order Commissioner (Appeals): As per Sec. 220(1 A), no fresh notice of demand is required to be served by the Assessing Officer. The Assessing Officer is only required to give an intimation of the fact of reduction of demand to ₹ 10 lakhs to SBC Ltd. Thus, the proceedings may be continued on the basis of the original notice of demand in relation to the reduced amount of ₹ 10 lakhs from the stage at which such proceedings stood immediately before disposal of appeal.

(ii) Demand enhanced in the order of Commissioner (Appeals): As per Sec. 220(1 A), a fresh notice of demand has to be given only in respect of ₹ 2 lakhs, being the amount of enhancement. Proceedings in relation to ₹ 13 lakhs which is covered by the original notice of demand may be continued from the stage at which such proceedings stood immediately before disposal of appeal.

Question 4.
Discuss the correctness or otherwise of the following with reference to the provisions of Income-tax Act, 1961:
Rose N. LLP of UK carried business in India against which a demand of ₹ 50 lakhs for A.Y. 2020-21 is outstanding. The LLP does not have any assets in India and has also closed the business. The Tax Recovery Officer (TRO) cannot recover such demand by having attachment on the assets of Rose N. LLP located in UK. [CA Final Nov. 2018 (Old Syllabus)] [2 Marks]
Answer:
The statement is correct.
Where an assessee is in default or is deemed to be in default in making a payment of tax, the TRO may, if the assessee has property in a country outside India (being a country with which India has an agreement for the recovery of income-tax under this Act and the corresponding law in force in that country), forward to the CBDT a certificate drawn up by him u/s of the agreement with such country.

Accordingly, since India has an agreement with UK, the Tax Recovery Officer (TRO) cannot recover such demand by having attachment on the assets of Rose N. LLP located in UK, but has to forward to the CBDT, a certificate drawn up by him u/s 222.

Modern Business Environment – CA Final SCMPE Study Material is designed strictly as per the latest syllabus and exam pattern.

Modern Business Environment – CA Final SCMPE Study Material

Question 1.
(Components of Cost of Equity)
Classify the following items under appropriate categories of quality costs, viz., Prevention Costs (PC), Appraisal Costs (AC), Internal Failure Costs (IFC) and External Failure Costs (EFC):
(i) Unplanned replacement to customers
(ii) Correction of a bank statement
(iii) Design review
(iv) Equipment accuracy check
(v) Staff training
(vi) Reprocessing of a loan operation
(vii) Product liability warranty
(viii) Product acceptance
(ix) Wastage of material
(x) Planned maintenance of equipment
(You may opt for the following format and fill in the appropriate Roman numerals under each column):

Answer:
Appropriate Categories of Quality Costs

Question 2.
(Cost of Quality) RAX is a market manufacturing organization produces and sells a single product. The cost data per unit for the year 2021 is predicted as below:

	₹ per unit
Direct Material	35
Direct Labour	25
Variable Overheads	15
Selling Price	90

RAX has forecast that demand for the product during the year 2021 will be 28,000 units. However, to satisfy this level of demand, production quantity will be increased?
There are no opening stock and closing stock of the product.
The stock level of material remains unchanged throughout the period.

The following additional information regarding costs and revenue are given:

• 12.5% of the items delivered to customers will be rejected due to specification failure and will require free replacement. The cost of delivering the replacement item is ₹ 5 per unit.
• 20% of the items produced will be discovered faulty at the inspection stage before they are delivered to customers.
• 10% of the direct material will be scrapped due to damage while in storage. Due to above, total quality costs for the year is expected to be ₹ 10,75,556.

The company is now considering the following proposal:
1. To introduce training programs for the workers which, the management of the company believes, will reduce the level of faulty production to 10%, This training program will cost ₹ 4,50,000 per annum.
2. To avail the services of quality control consultant at an annual charges of ₹ 50,000 which would reduce the percentage of faulty items delivered to customers to 9.5%.
Required
(i) PREPARE a statement of expected quality costs the company would incur if it accepts the proposal. Costs are to be calculated using the four recognised quality costs heads.
(ii) Would you RECOMMEND the proposal? Give financial and non-financial reasons. [MTP Oct. 2018/RTPNov. 2021]
Answer:
(i) Statement of‘Expected Quality Costs’

Particulars	Current Situation (₹)	Proposed Situation (₹)
Prevention Costs	—	4,50,000
Appraisal Costs	—	50,000
External Failure Costs	3,20,000	2,35,120
Internal Failure Costs	7,55,556	3,91,538
Total Quality Costs	10,75,556	11,26,658

Workings
External Failure Cost

Internal Failure Cost

(ii) Recommendation
On purely financial grounds RAX should not accept the proposal because there is an increase of ₹ 51,102 in quality costs. However there may be other factors to consider as the company may enhance its reputation as a company that cares about quality products and this may increase the company’s market share. On balance RAX should accept the proposal to improve its long-term performance.

Question 3.
(Optimal Cost of Quality)
Gaur Hari Ltd. produces and sells a single product. Presently the company is having its quality control system in a small way at an annual external failure and internal failure costs of ₹ 4,40,000 and ₹ 8,50,000 respectively. As the company is not able to ensure supply of good quality products upto the expectations of its customers and wants to manage competition to retain market share considers an alternative quality control system. It is expected that the implementation of the system annually will lead to a prevention cost of ₹ 5,60,000 and an appraisal cost of ₹ 70,000. The external and internal failure costs will reduce by ₹ 1,00,000 and ₹ 4,10,000 respectively in the new system. All other activities and costs will remain unchanged.
Required
(i) EXAMINE the new quality control proposal and recommend the acceptance or otherwise of the proposal both from financial and non-financial perspectives.
(ii) What is your ADVICE to the company, if the company wants to achieve zero defect through a continuous quality improvement, program?
(iii) SUGGEST a suitable quality control level at a minimum cost. [May 2018](I0 Marks)
Answer:
(i) Implementation of new system will reduce costs of the non-conformance (internal and external failure) by ₹ 5,10,000 (-40%). However, this will also increase costs of conformance by ₹ 6,30,000. There is inverse relationship between the costs of the conformance and the costs of non-conformance. Gaur Hari Ltd. should try to avoid costs of non- conformance because both internal and external failure affect customer’s satisfaction and organisations profitability. The company should focus on preventing the error such that it ensures that product is of good quality when it reaches the customer at the very first instance. This enhances the customer experience and therefore eliminating the scope for external failures like sales returns and warranty claims. Better quality can yield further sales. Therefore, an increase in spending on quality measures is justified since it not only yields significant improvements to quality but also brings in more sales orders.

Accordingly, from the financial perspective point of view the new proposal for quality control should not be accepted as it will lead to an additional cost of ₹ 1,20,000 (₹ 6,30,000 – ₹ 5,10,000). However, from non-financial perspective point of view as stated above the company should accept the new proposal.

(ii) It is possible to increase quality while at the same time reducing both conformance and non-conformance costs if a programme of aiming for zero defect/and or continuous improvement is followed. Zero defect advocates continuous improvement. To implement this elimination of all forms of waste, including reworks, yield losses, unproductive time, over-design, inventory, idle facilities, safety accidents, etc. is necessary.

(iii) To achieve 0% defects, costs of conformance must be high. As a greater proportion of defects are accepted, however, these costs can be reduced. At a level of 0% defects, cost of non-conformance should be nil but these will increase as the accepted level of defects rises. There should therefore be an acceptable level of defects at which the total costs of quality are at a minimum

Question 4.
(Cost of Quality; SIT) A manufacturing organization Brain Grain is producing a single product RAXY which require three component.
Brain Grain purchases each of these component from three suppliers AZ Ltd, BZ Ltd and CZ Ltd. The following information are available;

If the defectives are not detected they are utilized in production earning a damage of ₹ 200per 100 units of the component. Total requirements is 12,000 units of the components,
The company intends to introduce a system of inspection for the components on receipt. The inspection cost is estimated at ₹ 26 per 100 units of the components. Such as inspection will be able to detect only 90% of the defective components received. No payment will be made for components found to be defective in inspection,
Required
(i) ADVICE whether inspection at the point of receipt is justified
(ii) Which of the three suppliers should be asked to supply? [Nov. 2018](10Marks)
Answer:
(i) A. Statement Showing Effective Cost before Inspection

Particulars	AZ Ltd.	BZ Ltd.	CZ Ltd.
Units Supplies (Nos.) Defectives Expected (Nos.)	12,000 360	12,000 600	12,000 240
Costs: Purchase of Components Add: Production Damage on Defective Components (@₹ 200 per 100 compo­nents)	28,800 720	28,080 1,200	31,200 480
Total	29,520	29,280	31,680
Good Components (Nos.) Cost per 100 Good Components	11,640 253.61	11,400 256.84	11,760 269.39

B. Statement Showing Effective Cost after Inspection

Particulars	AZ Ltd.	BZ Ltd.	CZ Ltd.
Units Supplies (No.s) Defects Not Expected (No.s) Defectives Expected (No.s) Components Paid For	12,000 36 324 11,676	12,000 60 540 11,460	12,000 24 216 11,784
Costs: Purchase of Components Add- Inspection Cost	28,022.40 3,120.00	26,816.40 3,120.00	30,638.40 3,120.00
Add: Production Damage on Defective Components (@₹ 200 per 100 components)	72.00	120.00	48.00
Total	31,214.40	30,056.40	33,806.40
Good Components (Nos.) Cost per 100 Good Components	11,640 268.16	11,400 263.65	11,760 287.47

ADVICE Whether Inspection at the Point of Receipt is Justified
On comparing the cost under situation, A and B shown above, we find that it will not be economical to install a system of inspection.
Further we also need to consider that presently many organizations are undergoing Just in Time (JIT) implementation. JIT aims to find a way of working and managing to eliminate wastes in a process. Achievement of this is ensured through eliminating the need to perform incoming inspection. Inspection does not reduce the number of defects, it does not help in improving quality. In general inspection, does not add value to the product. It simply serves as a means of identifying defects the supplier has failed to recognize subsequent to the manufacturing of the product.
As a matter of fact, organizations implementing JIT are seeking eventually to eliminate the need for performing incoming inspection activities through a combination of reducing the supplier base, selection through qualification and vendor development. Vendor development and its proper management seeks to assist the supplier who maintains an interest in striving to provide 10096 defect-free materials and parts.
So, to decision whether inspection at the point of receipt is justified or not will also depend on Qualitative factors as well.

(ii) On comparing the buying cost of components under different situations, as analysed and advised above, if company decides not to install a system of inspection, supplier AZ would be cheaper otherwise supplier BZ would be cheaper and company may choose supplier accordingly.

Note:
This question can also be solved by assuming receipt of good components as requirement ie. 12,000 units.

Question 5.
(Cost of Quality) Olive Ware Private Ltd. manufactures electronic components for cars. Car manufacturers are the primary customers of these products. Raw material components are bought, assembled and the electronic car components are sold to the customers.

Selling price	₹ 2,500 per unit
Raw material cost	₹ 900 per unit
Assembly & machine cost	₹ 500 per unit
Delivery cost	₹ 100 per unit
Contribution	₹1,000 per unit

The customers due to defects in the product return 5,000 units each year. They are replaced free of charge by Olive Ware. The replaced components cannot be repaired and do not have any scrap value. If these defective components had not been supplied, that is had the sale returns due to defective units been nil, customers’ perception about the quality of the product would improve. This could yield 10% increase in market share for Olive ware that is demand for its products could increase to 150,000 units per annum.
Required
(i) ANALYZE, the cost of poor quality per annum due to supply of defective items to the customers.
(ii) The company management is considering a proposal to implement an inspection process immediately before delivery of products to the customers. This would ensure nil sales returns. The cost of having such a facility would be ₹ 2 crores per annum, this would include materials and equipment for quality check, overheads and utilities, salaries to quality control inspectors etc. ANALYZE the net benefit, if any, to the company if it implements this proposal.
(iii) Quality control investigations reveal that‘defective production is entirely on account of inferior quality raw material components procured from a large base of 30 suppliers. Currently there is no inspection at the procurement stage to check the quality of these materials. The management has a proposal to have inspectors check the quality control at the procurement stage itself. Any defective raw material component will be replaced free of cost by the supplier. This will ensure that no product produced by Olive Ware is defective. The cost of inspection for quality control (materials, equipment, salaries of inspectors etc.) would be ? 4 crore per annum. ANALYZE the net benefit to the company if it implements this proposal? Please note that scenarios in questions (ii) and (iii) are independent and not related to each other.
(iv) Between inspection at the end of the process and inspection at the raw material procurement stage, ADVISE a better proposal to implement (a) in terms of profitability and (b) in terms of long term business strategy? [RTP May 2019](20 Marks)
Answer:
(i) Customer demand for Olive Ware’s products is 1,00,000 units per annum. However, 5,000 defective units supplied are to be replaced free of charge by the company. Therefore, the total number of items supplied to customers per annum = 1,00,000 + 5,000 units = 1,05,000 units. The cost of replacement would include raw material cost, assembly & machining cost and delivery cost of 5,000 units = 5,000 units X j (900+500+100) per unit = 5,000 units × ₹ 1,500 per unit = ₹ 75,00,000 per annum.

Further, had the sale returns not happened, market share would have increased by 50,000 units. Contribution is ₹ 1,000 per unit, for 50,000 units contribution would be ₹ 5,00,00,000. Therefore, the ) cost of poor quality per annum = cost of replacement + contribution from lost sales = ₹ 75,00,000 + ₹ 5,00,00,000 = ₹ 5,75,00,000 per annum.

(ii) Inspection at the end of the process would detect defects before delivery to the customers. This would ensure that the sale returns would be nil. Given in the problem, 5,000 units supplied are defective and would ig need to be replaced, in other words, they need to be manufactured again. In other words, inspection after production, before delivery to customers would not prevent production of defective units. However, compared to the current scenario, since these defective units have not yet been delivered to the customer, the cost for additional delivery of replaced products would be saved. This savings in the extra delivery cost = 5,000 units × ₹ 100 per unit = ₹ 5,00,000 per annum. Further, had the sale returns not happened, market share would have increased by 50,000 units. Contribution is ₹ 1,000 per unit, for 50,000 units it would be ₹ 5,00,00,000 per annum. However, additional failure cost for 2,500 units due to increase in sales from 1,00,000 to 1,50,000 units would be incurred. Since these defective units have not yet been delivered to the customer, this cost would be net of delivery cost. This additional failure cost = 2,500 units × ₹ 1,400 per unit = ₹ 35,00,000 per annum. Therefore, the total benefit from the inspection process before delivery to customers = savings on delivery costs + contribution from incremental sales – additional failure cost = ₹ 5,00,000 + ₹ 5,00,00,000 – ₹ 35,00,000 = ₹ 4,70,00,000 per annum. The cost to the company to maintain good quality of its products through inspection = ₹ 2,00,00,000 per annum. Therefore, the net benefit to the company would be ₹ 2,70,00,000 per annum.
His question can also be solved by taking 7,895 defectives on 1,50,000 good units. For 95,000 good units, gross production is 1,00,000 units. For, 1,50,000 good units, gross production would be 1,57,895 units (1,00,000/95,000 × 150,000). Therefore total defective units will be 7,895.

(iii) Inspection of raw material at the procurement stage could entirely eliminate defective production. The benefit would be two-fold, the current replacement cost for 5,000 units will no longer be incurred. Secondly, due to better customer perception, market share would increase, resulting in an increased contribution/revenue to the company. In other words, the cost of poor quality will be nil.

As explained in solution (i), the cost of poor quality per annum = cost of replacement + contribution from lost sales = ₹ 75,00,000 + ₹ 5,00,00,000 = ₹ 5,75,00,000 per annum. This would be the benefit by implementing the proposal.
Olive Ware has to incur an inspection cost to ensure this highest standard of quality (0% defects) which would cost ₹ 4,00,00,000 per annum. Therefore, the net benefit to the company would be ₹ 1,75,00,000 per annum.

(iv) (a) The proposal to implement inspection immediately before delivering goods to the customers results in a net benefit of ₹ 2,70,00,000 per annum. Alternately, the proposal to implement inspection at the raw material procurement stage results in a net benefit of ₹ 1,75,00,000 per annum. Therefore, from a profitability point of view, inspection immediately before delivery of goods to the customer would the preferred option.

(b) The drawback of inspection at the end of the production process is that (1) it cannot prevent production of defective goods and (2) information regarding the root cause of defective production, in this case, supply of defective raw materials will not get tracked. Therefore, inspection at the end of production does not contribute to resolving the root cause of defective production. On the other hand, inspection at the procurement stage can eliminate production of defective goods. This will ensure a much higher quality of production, better utilization of resources and production capacity. Therefore, from a long-term strategy point of view, inspection at the raw material procurement stage will be very beneficial. Currently the cost of ensuring this highest quality of production (0% defects) is ₹ 4 crores per annum. The cost of ensuring 100% quality is quite high, such that the net benefit to the company is lesser than the other proposal. However, due to its long-term benefit, Olive Ware may consider some minimum essential quality control checks at the procurement stage. Although j selective quality check might not ensure complete elimination of defective production, it can contribute towards reducing it. At the same time cost of selective quality check would not be so high as to override its benefits. To determine the extent of quality control inspection, Olive Ware should determine its tolerance limit for defective production and do an analysis of the quality cost trade-off.

Question 6.
(Cost of Quality; TPM; TQM) Star Automobile Group is among top 20 business houses in India. It has been founded in the year 1940, at the height of India’s movement for independence from the British, the 1 group has an illustrious history. Star’s footprint stretches over a wide range of industries, spanning automobiles (two wheelers manufacturer and three wheelers manufacturer). Star’s headquarter is located at Hyderabad. Bike Production is one of segment of Star Group. Management of Star wants to analyse the following actual information for the April:

Cost Data
Customer Complaints Centre Cost	35 per hr.
Equipment Testing Cost	18 per hr.
Warranty Repair Cost	1,560 per bike
Manufacturing Rework Cost	228 per bike

Volume and Activity Data:

Bikes Requiring Manufacturing Rework	3,200 bikes
Bikes Requiring Warranty Repair	2,600 bikes
Production Line Equipment Testing Time              .	1,600 hrs.
Customer Complaints Centre Time	2,000 hrs.

Additional Information
Due to the quality issues in the month, the bike production line experienced unproductive ‘down time’ which cost ₹ 7,70,000. Star carried out a quality review of its existing suppliers to enhance quality levels during the month at a cost of ₹ 1,25,000.
Required
(i) PREPARE a statement showing ‘Total Quality Costs’.
(ii) ADVISE any TWO measures to reduce the non- conformance cost. [RTP Nov. 2019][Afov. 2021]
Answer:
(i) Statement Showing ‘Total Quality Costs’

Particulars of Costs	₹
Prevention Costs
Supplier Review	1,25,000
Appraisal Costs
Equipment Testing (₹ 18 × 1,600 hrs.)	28,800
Internal Failure Costs
Down Time	7,70,000
Manufacturing Rework (₹ 228 × 3,200 bikes)	7,29,600
External Failure Costs
Customer Complaints (₹ 35 × 2,000 hrs.)	70,000
Warranty Repair (₹ 1,560 × 2,600 bikes)	40,56,000
Total Quality Costs	57,79,400

(ii) The reporting of quality costs highlights the cost of quality activities at Star. The total quality costs statement clearly displays the relationship between conformance costs (prevention and appraisal costs) and non-conformance costs (internal failure and external failure costs) and the drivers of a reduction in the overall spending on quality. Statement indicates that only 2.16% of the total quality cost is the cost of preventing quality problems while 0.50% is the cost of appraisal activities. Thus, prevention and appraisal costs make up only 2.66% of total quality costs. In contrast, 97.34% of quality control costs are incurred for internal and external failure costs. Following two measures can be used to reduce non-conformance cost:

Total Productive Maintenance (TPM) is a system of maintaining and improving the integrity of production and quality system through keeping all equipment in top working condition so as to avoid breakdowns and delays in manufacturing processes. It involves identifying machines in every division (including planning, manufacturing, maintenance) and then planning & executing a maintenance programme covering their entire useful life.

In this scenario, TPM will help in reducing internal failure cost (i.e., downtime and manufacturing rework cost), which constitutes 25.95% of total quality cost, by keeping all equipment in good working conditions so that there is no downtime or machine breakdown and ensuring that all equipment run smoothly. If machines work properly, the chances of rework will reduce, ultimately will also reduce chances of warranty repair and cus-tomer complaints (comprising 71.39% of total quality cost which is major part of total quality cost).

Total Quality Management (TQM) aims at improving the quality of organisational output, including goods and services, through continual improvement of internal practices. Its objective is to eradicate waste and increase efficiency without compromising with the quality. It requires that company maintain this quality standards in all aspects of business by ensuring that things are done right the first time so that defects and waste are eliminated from operation.

It appears that Star is not a TQM company at present due to huge disparity between conformance costs and non-conformance costs. In order to make Star to be successful, all staff at Star must be engaged in the improvement process and share in the continuous improvement ethos. In order to establish a reputation as a high-quality bike manufacturer Star must ensure staff are focused on quality and attitudes changed toward the importance of conformance activities, for instance, Star can conduct third party inspection of raw material at supplier’s workplace leading to maintenances of quality standards.

Overall, while applying above two measures, in the Star, consid-eration must therefore be given to the optimum balance between the costs of conformance and the costs of non-conformance.

Question 7.
FIZI is a new banking company which is about to open its first branch in INDIA. FIZI believes that in order to win customers from the market, it needs to offer potential customers a new banking experience. Other banking companies are focusing on interest rates and bank charges, whereas FIZI believes that quality and timely availability of service is an important factor to attract customers.
Required
EXPLAIN how Total Quality Management would enable FIZI to gain competitive advantage in the banking sector. [RTP May 2018]
Answer:

• Total Quality Management is a management philosophy.
• It concerns itself with managing processes and people to make sure that the customer is satisfied at each and every stage.
• This means making the needs of the customer the priority, expanding the relationship beyond traditional services and incorporating the customer’s needs in the company’s business plan and corporate strategy.
• In TQM, the concept of “quality” is perceived exclusively from the frame of reference of the customer.
• These customers can be internal, such as, those working in another department and there can be external customers who are the end recipients of the product or services.
• The organisation should attempt for continuous improvement in the quality that it delivers with the ultimate aim of achieving zero defects in this quality.

TQM should be view as an investment rather than as a cost that should be minimised. There are many ways in which investment can be made in TQM.:

• fine-tuning the product mix,
• fine-tuning of the processes of ensuring quality,
• introducing employee development programmes with the nature of an academic course,
• empowering the employees professionally and personally,
• improving the top management commitment to quality,
• monitoring of the performances and proper rewarding based on achievements,
• ensuring the customer satisfaction etc.

FIZI could provide its employees with training in the technical aspects of banking practice as well as in customer care.

• Customers would thus get a better service not only technically but also from a customer care perspective.
• This should lead to smaller customer complaints and greater customer satisfaction.
• It could also motivate customers to recommend others to use , this bank.
• TQM also requires FIZI to respond to its customer’s requirements immediately for example by providing more staff to reduce the lengths of queues in festive/seasonal/busy time.
• If Bank could also be opened for longer hours to allow customers to complete their bank related requirements and have meetings with bank employees at a time that is more convenient for the customer, this would lead to more satisfaction to customers.
• In long run, if bank continue to follow TQM, the bank would I have higher profits and competitive advantage in banking sector despite incurring additional expenditure to improve quality.

Financial perspective – Required Cost
Non-Financial Perspective – Long term, its Good

Question 8.
(Total Quality Management) Kasan Ltd. is a manufacturing company, which is engaged in production of wide range of consumer products for home consumption. Among its all product CFL lamp are its most efficient and environmental friendly product. Kasan has a quality control department that monitor the quality of the products produce by company.
As per the recent cost of poor quality report, the current rejection rate for CFL lamps is 5% of units input. 5,000 units of input go through the process each day. Each unit that is rejected results in a ₹ 200 loss to the Kasan Ltd. company. The quality control department has proposed few changes to the inspection process that would enable early detection of defects. This would reduce the overall rejection rate from 5% to 3% of units input. The improved inspection process would cost the company ₹ 15,000 each day.
Required
(i) ANALYSE the proposal and suggest if it would be beneficial for the Kasan to implement it.
(ii) After implementation, ANALYSE the maximum rejection rate beyond which the proposal ceases to be beneficial? [MTP Oct. 2020; MTP April 2019]
Answer:
(i) Analysis of the proposal to make changes to the inspection process: The Kasan company wants to reduce the cost of poor quality on account of rejected items from the process. The current rejection rate is 5% that is proposed to be improved to 3% of units input.
The expected benefit to the company can be worked out as follows: The units of input each day = 5,000. At the current rate of 5%, 250 units of input are rejected each day. It is proposed to reduce rejection rate to 3%, that is 150 units of input rejected each day. Therefore, improvements to the inspection process would reduce the number of units rej ected by 100 units each day. The resultant cost of poor quality would reduce by ₹ 20,000 each day (100 units of input × ₹ 200 cost of one rejected unit).
The cost of implementing these additional controls to the inspection process would be ₹ 15,000 each day.
The net benefit to the company on implementing the proposal would be ₹ 5,000 each day. Therefore, the Kasan company should implement the proposal.

(ii) Analysis of maximum rejection rate beyond which the proposal ceases to be beneficial
The cost of improving controls to the inspection process is ₹ 15,000 each day. The number of units of input processed each day is 5,000. The cost of rejection is ₹ 200 per unit.
It makes sense to implement the improvements to controls only if the benefit is greater than the cost involved. To find out the point where the benefits equal the cost, solve the following equation.
Let the number of reduction in rejections each day due to improved controls be R. At ₹ 200 per unit, benefits from reduction in rejection would be ₹ 200 × R.
At what point, would this be equal to the cost of control of ₹ 15,000 per day?
Solving ₹ 200 × R = ₹ 15,000; R = 75 units. That is if the improvements to inspection process control reduces the number of rejections by 75 units each day, the benefit to the Kasan company would be ₹ 15,000 each day.
That is if the rejection rate improves by 1.5% (75 units/5,000 units) then the benefits accruing to the company will equal the cost incurred.
In other words, when the rejection rate is 3.5% (current rate 5% – improvement of 1.5% to the rate) or below, the proposal will be beneficial. In this range, the savings to the cost of poor quality will be more than the cost involved. For example, as explained above, when the improved rejection rate is 3%, the net benefit to the company is ₹ 5,000 each day.
Beyond 3.5% rejection rate, the proposal will result in savings to the cost of poor quality that is less than the cost involved of ₹ 15,000 each day.

Question 9.
Delicious Box Ltd. is a manufacturer and supplier of android set up boxes for various DTH operators. This is very popular with the operators as it converts normal TV to a smart TV. To ensure supply of good quality products to meet the expectations of the viewers, it has set up quality control department that regularly conducts quality inspection and submits its report to the management on weekly basis.
As per the latest quality inspection report submitted by the department, it reflects that the current rejection rate is 7% of units input into the manufacturing system due to poor quality. 3,000 units of input go through the process every day. As per analysis, for each rejection, there is loss of ₹ 150 to the company. The management is very much worried due to high rate of rejection of input units.
The management has asked for suggestions from the quality control department in this regard. The department has suggested implementation of new system for inspection for early detection of defective units. This change would result in drop of rejection rate to 4% from earlier 7%. The cost of new system will be ₹ 12,000 per day.
Required
(i) ANALYSE the Proposed new system for inspection and suggest if it would be beneficial for the company.
(ii) Also CALCULATE the minimum reduction in number of rejections each day upto which the proposed system will be beneficial. [Nov. 2020](5 Marks)
Answer:
(i) Analysis of the Proposal
DTH Box Ltd. wants to reduce the cost of poor quality on account of rejected items from the manufacturing system. The current rejection rate is 7% that is proposed to be improved to 4% of units input.
The expected benefit to the company can be worked out as follows: The units of input each day = 3,000. At the current rate of 7%, 210 units of input are rejected each day. It is proposed to reduce rejection rate to 4%, that is 120 units of input rejected each day. Therefore, new system would reduce the number of units rejected by 90 units each day. The resultant cost of poor quality would reduce by 1 13,500 each day (90 units of input X ₹ 150 cost of one rejected unit).
The cost of implementation of the new system on the inspection pro-cess would be ₹ 12,000 each day.
The net benefit to the DTH Box Ltd on implementing the proposal would be ₹ 1,500 each day. Therefore, the company should implement the proposal.

(ii) Let the number of reductions in reactions each day due to proposed system be X. At ₹ 150 per unit, benefits from reduction in rejection would be ₹ 150 × X.
Point, at which this will be equal to the cost of new system of 12,000 per day: Solving ₹ 150 × X = ₹ 12,000; X = 80 units
Therefore, minimum reduction in number of rejections each day up to which the proposed system will be beneficial is 80 units.
.
Question 10.
(Cost of Quality, TQM)
ORG is a Smart TV manufacturer. Smart TV is a technological convergence of computers, television sets and set-top boxes provided through traditional broadcasting media. It is relatively a new company in the market and the directors are keen to establish a reputation of high quality.
The CEO of the company has heard that “There is no better cost to eliminate than the cost of poor quality”
The board of directors decided in the board meeting to establish a culture of Total Quality Management at the company. For this purpose they have collected the following actual information for the most recent quarter of the current year:

Cost data	$
Customer support centre cost per hour	116
Equipment testing cost per hour	60
Manufacturing rework cost per TV	760
Warranty repair cost per TV	5,200
Volume and activity data
TVs requiring manufacturing rework	800 TVs
TVs requiring warranty repair	650 TVs
Customer support centre time	500 hours
Production line equipment testing time	400 hours

Additional information
ORG during the quarter, undertook a quality review of its existing suppliers at a cost of $1,20,000.
The TV production line experienced periods of unproductive ‘down time’ due to the quality issues in the quarter which cost $750,000.
Required;
(a) PREPARE a Cost of Quality report using four recognized quality cost headings for ORG.
(b) Explain how a Cost of Quality report would support the development of a TQM culture at ORG.
Answer:
(a) Cost of Quality Report

	Volume	Rate $	Cost $
Prevention costs
Supplier review			120,000
Appraisal costs
Equipment testing	400	60	24,000
Internal failure costs
Down time			750,000
Manufacturing rework	800	760	608,000
Total internal failure costs			1,358,000
External failure costs
Customer support	500	116	58,000
Warranty repair	650	5,200	3,380,000
Total external failure costs			3,438,000
Total quality costs			4,940,000

(b) A Total Quality Management (TQM) culture is one where all depart-ments and staff are committed to a process of continuous improve-ment. The aim of the organization is to achieve a zero defect position where products are produced on a consistently high quality basis and the focus of the organisation is on improving processes to attain this state.
The quality costs report highlights the cost of quality activities at ORG. Highlighting the quality activities and reporting on money spent on quality failures helps to strengthen the TQM.
Quality is concerned with conformance to specification; ability to satisfy customer expectations and value for money. Recognizing the importance of cost of quality is important in terms of continuous improvement. The quality cost report display the relationship between conformance costs (prevention and appraisal costs) and non-confor-mance costs (internal failure and external failure costs) and the drivers of a reduction in the overall spending on quality.

Question 11.
(Total Quality Management)
PRADO is a chocolates manufacturing company however due to some quality reason company has incurred huge losses and fall in market reputation. For the purpose of improvement of profitability the financial manager of PRADO has advise the company to implement TQM.
The company has provided the following information to the board of director in Extraordinary general meeting. This information contain list of performance measurement before the implementation of a Total Quality Management Programme (Pre-TQM) and after its implementation (Post-TQM).

	Pre-TQM performance %	Post-TQM performance %
Returns by customers due to packaging defects	5	2
Rejections on final inspection	6	4
Losses in production	3	1

Required
(i) CALCULATE how many units must be input to the process to achieve final sales of 2,000 units:
(a) before the TQM programme
(b) after the TQM programme
(ii) COMMENT on the implementation of TQM in PRADO Company.
Answer:
(i) Calculation of input to the process to achieve final sales of 1,000 units before and after TQM programme.

Performance
	Pre-TQM Units	Post-TQM Units
Sales Packaging Failures	2,000,100	2,000,40
Rejected Units	2,100,134	2,040,86
Process losses	2,234,70	2,126,22
Units to be input	2,304	2,148

(ii) Comment: The TQM improvements have led to a reduction of about 796 (156/2,304) in the quantity of units that need to be input to produce 2,000 units of output.
TQM is “integrated and comprehensive system of planning and controlling all business functions so that products or services are produced which meet or exceed customer expectations. TQM is philosophy of business behaviour, embracing principles such as employee involvement, continuous improvement at all levels and customer focus, as well as being a collection of related techniques aimed at improving quality”.
TQM requires ensuring that things are done right the first time and that defects and waste are eliminated from operations.

Question 12.
(Cost of Quality; TPM; TQM; JIT)
Mega Bike (MB) is large national bike manufacturing organisation established in the year 2003. Mega Bike has a strong position in the market and has also traditionally achieved a good market share however facing tough competition. The Board of Mega Bike recognises that it needs to make fundamental changes to its production approach in order to combat increased competition from foreign manufacturers. Mega Bike is now being seen as non-lucrative, pollutive and with less safety features in comparison to the foreign bikes. The Board plans to address this by improving the quality of its bikes as well as financial performance.
The components are sourced directly by Mega Bike. Suppliers are located worldwide. Suppliers are evaluated on an ongoing basis, including an assessment of whether to utilise new or alternative suppliers to improve capacity and performance. The company is having lot of components piled up in stock and few of them are becoming obsolete. There is lots of reworking as both internal and external failure are more, so the wastage of resources in reworking needs to be controlled. The Board is convinced S that Lean Manufacturing is the best approach to be adopted.
In Mega Bike, production process is grouped by function and production teams comprised a number of permanent members, who had acquired their positions through seniority and a few newly selected specialist staff who had yet to discuss their position in any team.
The process of making a bike can be roughly divided into stamping, welding, painting, assembly and inspections, which takes about 11-12 hours in total. The standard time to manufacture a similar bike in industry is 8-9 hours. The nature of end product demand is unstable due to economic factors. However, Mega Bike forecasts demand based on its internal policies and historical trends. Mega Bike sells its bikes in retail stores located in over 10 metro cities. It focuses on building close relationships with retailers, working with them to sell its bikes in a compelling manner.
Enclosed Annexure
Required:
You are newly appointed to Management Accounting Department of MB, Chief Management Accountant asked you to draft a report for CEO, containing-
(i) ANALYSIS of quality costs and ADVISE on two measures to reduce the non-conformance cost,
(ii) ADVISE on implementation of just-in-time purchasing and production
Annexure
Statement Showing ‘Total Quality Costs

Particulars of Costs	₹
Prevention Costs Supplier Review	2,50,000
Appraisal Costs Equipment Testing (₹ 36 × 1,600 hrs.)	57,600
Internal Failure Costs Down Time Manufacturing Rework (₹ 456 × 3,200 bikes)	15.40,000 14,59,200
External Failure Costs Customer Complaints (₹ 70 × 2,000 hrs.) Warranty Repair (₹ 3,120 × 2,600 bikes)	1,40,000 81,12,000
Total Quality Costs	1,15,58,800

Answer:
Addressed to: Office of CEO, Mega Bikes
Dated -6th May, 2020
Report
Analysis of Quality Costs
The reporting of quality costs highlights the cost of quality activities at MB, The total quality costs statement clearly displays the relationship between conformance costs (prevention and appraisal costs) and non-conformance costs (internal failure and external failure costs) and the drivers of a reduction j in the overall spending on quality. Statement indicates that only 2.16% of the total quality cost is the cost of preventing quality problems while 0.50% is the cost of appraisal activities. Thus, prevention and appraisal costs make up only 2.66% of total quality costs. In contrast, 97.34% of quality control costs are incurred for internal and external failure costs.

Two measures to reduce non-conformance cost
Total Productive Maintenance (TPM) is a system of maintaining and improving the integrity of production and quality system through keeping all equipment in top working condition so as to avoid breakdowns and delays in manufacturing processes. It involves identifying machines in every division (including planning, manufacturing, maintenance) and then planning & executing a maintenance programme covering their entire useful life.

In this case, TPM will help in reducing internal failure cost (Le., downtime and manufacturing rework cost), which constitutes 25.95% of total quality cost, by keeping all equipment in good working conditions so that there is no downtime or machine breakdown and ensuring that all equipment run smoothly. If machines work properly, the chances of rework will reduce, ultimately will also reduce chances of warranty repair and customer complaints (comprising 71.39% of total quality cost which is a major part of total quality cost).

Total Quality Management (TQM) aims at improving the quality of organsational output, including goods and services, through continual improve-ment of internal practices. Its objective is to eradicate waste and increase efficiency without compromising with the quality. It requires maintaining quality standards in all aspects of business by ensuring that things are done right the first time so that defects and waste are eliminated from operations.

It appears that MB is not a TQM company at present, due to huge disparity between conformance costs and non-conformance costs. In order to make MB to be successful, all staff at MB must be engaged in the improvement process and share in the continuous improvement ethos. In order to establish a reputation as a high- quality bike manufacturer MB must ensure, staff is having attitude towards the importance of conformance activities, for f instance, MB can conduct third party inspection of components at supplier’s j workplace leading to maintenances of quality standards.

Overall, while applying above two measures, in the MB, consideration must therefore be given to the optimum balance between the costs of conformance and the costs of non-conformance.

Implementation of Just in Time
Just in time purchasing and production technique will put an end to the harrowing task of inventory management. In this form of pull system, purchasing of components and production of bikes will be based on customer demands and MB will have to accordingly coordinate with its suppliers to supply the right quantity of components required at the right time. JIT inventory management calls for having the inventory as and when needed also taking care of massive holding cost suffered related to large build ups. In this environment, MB will also be able to reduce the manufacturing time around 3 hours by streamlining the flow of information in entire supply chain.

Mega is assessing alternative suppliers on continuous basis to improve capacity and performance. It means it is changing sources of material regularly
or using multi-suppliers. In contrast, JIT is based on reduced number of supplier and move towards single sourcing. It is easier to develop long term cooperative relationships with a smaller number of suppliers. The quality of internal services and an organisation’s ability to provide quality products or services to its customers depends upon this relationship. However, this relationship is obviously missing in MB.
MB has close relationship with the retailers but relationship with suppliers is equally important.

It appears that firm is also importing its requirements from abroad. In JIT environment, it is important that suppliers are, to the extent practical, located in close proximity to the manufacturing plant. Carefully selected suppliers are capable of delivering high quality materials in a timely manner, directly at the shopfloor, reducing the material receipt time. Therefore, selection of right supplier located in close proximity to the manufacturing plant is vital for the proper implementation of JIT.

It is also important to note that every supplier is different, but the MB has to be able to view each as one of its part only. The supplier’s network must be able to call up and communicate directly with the MB’s network, obtaining manufacturing schedules and product specification in real time. ERP and other sources of electronic data interchange between supplier and MB will act as backbone in supporting the JIT activity.

On the whole, MB’s management has to treat suppliers as partners with significant influence on the success of the organization.
The functional division is less appropriate in JIT environment. JIT produc-tion requires multi- skilled teams. In MB, teams need to be formed to work by product ie., type of bike rather than by the type of work performed. In addition, staff will need training to work in the new teams, measures surrounding the amount and effectiveness of training will be required. A JIT system works best when employees pitch in with suggestions for improvements. The performance can be measured by computing the number of ideas per worker, the number of ideas suggested in total, the number of ideas implemented, or the proportion of ideas suggested that are implemented.

MB forecasts demand based on its internal policies and historical trends. Today demand in every sector of the market changes by leaps and bounds, so using historical data is not at all recommended. Demand forecasts should be pulled by current market trends and prediction of future market sentiments. However, in case of MB, demand is unstable. In this case, in order to prevent stock-outs, inventory managers can only increase the Kanban numbers of each product; the greater are the variations, the greater is the need of Kanban cards and, thus, the higher is stock level and need more working capital per rupee of sales.

Conclusion
The Board desires to improve the quality as well as financial position which can be achieved through successfully implementation of quality control and lean system. However, the factors discussed above should be taken care of. It is worthwhile to note that any return on investment in proposed system must be viewed long term rather than short term since optimum results may not be realized until the system has been in place for some time.
Further details can be tabled on requisition basis. Closure of Report
Chief Management Accountant
(For Management Accounting Department)
Mega Bikes

Question 13.
(The Business Excellence Model)
As a guest lecturer at a symposium for Business Excellence where you are giving a lecture on “Sustaining Business Excellence”. A manufacturer of a fashion clothing line is one of the participants at the symposium. He has the following query:
“We are an apparel company that manufacture and sell our fashion clothing and accessories directly through 30 stores spread across India. Shortly we are planning to establish similar outlets overseas. Our business is under constant change due to changing customer trends. At the same time, we are the largest company in our industry segment in India, both in terms of market share and profits. We have a satisfied base of customers who are loyal to our brand. Shareholders are also satisfied stakeholders due to good returns provided on their investments. What would be the relevance of Business Excellence model to our company?
Thank you!”
You are required to frame an appropriate response to this query. Required
(i) EXPLAIN the importance of business excellence to an organization,
(ii) LIST the tool available to achieve and sustain excellence.
(iii) APPLY the fundamentals of EFQM model on the apparel company.
(iv) EXPLAIN the relationship between various criteria of the model in general terms. [RTP May 2019]
Answer:
(i) Business Excellence is a philosophy for developing and strengthening the management systems and processes of an organization to improve performance and create value for stakeholders. Stakeholders in an organization are not limited to shareholders (business) alone. They include also customers, employees (people) and society. What an organization does impact all the stakeholders in different ways, yet they are all interlinked to each other. Customers’ needs are of paramount importance to companies. Yet given uncertain conditions, shareholders demand challenging return on their investments. Employees need more from their company than just their pay-check. They want the company to enable to grow their knowledge and experience that can improve their career growth. Society expects companies to operate ethically and for the overall betterment of the society and environment.

For several years businesses have been operating under challenging circumstances. For example, landline phones have been entirely replaced by mobile phones. Television programs can be watched seamlessly on internet enabled mobile phones. Not just this, today’s smartphones have computing capability much more than the computers that were used in Apollo Mission to send the first man to moon! The proliferation of mobile phones has changed not just the telecom industry but also others like communication, banking, e-commerce etc. The pace of change is both exhilarating and challenging.

To manage this complex scenario, a company cannot focus on only one aspect of their operations. Optimize processes, delivery quality to customers, manage employee talents, earn required return on investment while managing to be a socially responsible organization. In short, the company should achieve excellence in all aspects of its operations. This is business excellence. Business excellence principles emerged because of development of quality drive into traditional business management. It is imperative not just to achieve excellence but also to sustain it.

Business excellence models are holistic tools that help companies develop stakeholder focused strategy. Each operation within a company enables a corresponding result. Business models present a formal, standardized cause effect relationship between different operations (enablers) and their resultant consequences. If the company want to achieve a different result, it has to do things differently. This can be better analysed through these models. Continuous improvement on various operations will ultimately lead to excellence. More importantly, these models need to be used to sustain and maintain excellence to retain their competitive advantage. They are not to be taken as one time exercise by the company. Assessments using this model have to be made periodically so that timely action can be taken to achieve the desired result.

(ii) Some of the popular business excellence models are
(i) the European Foundation Quality Management (EFQM) model
(ii) Baldrige Criteria for Performance Excellence
(in) Singapore BE Framework
(iv) Japan Quality Award Model and
(iv) Australian Business Excellence Frame-work.

(iii) The apparel company is a well-established player in the industry. It is a growing company that is looking to expand its operations overseas.
To achieve business excellence in this environment, the company could adopt the EFQM model, which is a popular model.
The EFQM model was developed by the European Foundation for Quality Management. The model provides an all-round view of the organization and it can be used to determine how different methods fit together and complement each other. It can help the company understand the cause and effect relationships between what their wl organization does and the results it achieves. Creating an EFQM Management Document gives the organization a holistic overview of its g* strategic goals, the key approaches it has adopted and the key results § it has achieved.

The fundamental concepts for excellence are the basic principles that describe the essential foundation for any organization to achieve sus-tainable excellence. With respect to the company they can be detailed as below:
(a) Adding value to customers: Companies need to understand their customers, their needs, anticipate their needs and make use of opportunities to fulfil their expectations. In the current case, fashion apparel business is ever changing and dynamic due to the changing trends in customer’s tastes. This could differ across locations within India and abroad. In the era of e-commerce, competition would be cut-throat. Before going to “how” it can meet customer’s needs, the company should be clear on “what” need of the customer it can satisfy. For example, should the company cater to Indian apparel market, western apparel market, men or women or children apparel market etc. Once the “what” is clear, the company should have mechanisms in place to find out and anticipate customer tastes. Accordingly, it should structure its operations to add value to the customers in terms of quality, availability, support, and experience.

(b) Creating a sustainable future: Society and environment (People and Planet of Triple Bottomline concept) play a major role in ensuring the sustainability of business. A company should have as much positive impact on its surroundings and try to minimize any negative impact on the same. Here, the company should assess the environmental impact of its operations, measures to minimize adverse impacts, business impact on the society etc. For example, leather is contended to be harmful to the environment since it requires the skin of animals specially cattle hide, needs huge amount of energy and chemicals to process it. This has a negative environmental impact. As regards societal impact, suppliers of cloth to the apparel company should not indulge in labor malpractice like child labor and should adhere to safety standards within its factories. The company should procure cloth only from suppliers who adhere to such standards.

(c) Developing Organizational Capability: Companies need to man age change within the organization and beyond. The company should identify “what it is capable of being great at?” in order to differentiate it from its competitors. For example, the apparel company may have the capability of tracking its inventory at the stores on real time basis. As soon as the inventory falls below a certain level, the stores issues fresh products to stock up. This ensures that there are no stock outs at the retail outlet. This ability to track inventory real time and ability to stock up quickly may be unique to the company that gives it a competitive edge. Another can be the ability to quickly change the apparel production to meet changing trends. Likewise, the company should identify and develop unique capabilities to have a competitive edge in the market.

(d) Harnessing creativity and innovation: Continuous improvement and innovation brings value to the company. The company should promote a working environment that enables and appreciates creativity and innovation. For example, new apparel designs can be promoted to test the market. If found feasible, the company can go for mass production of the same.

(e) Leading with vision, inspiration, and integrity: The tone at the top defines the rest of the company. The leaders and management of the company should have a clear vision of what the company wants to achieve, develop strategy to achieve it, work with integrity and ethics. Leaders shape the future of the organization.

(f) Managing with agility: Agility would be the capability to identify and effectively respond to opportunities and threats. For example, although the apparel company is in an expansionary phase, it should consider the threat, yet opportunity of using e-commerce as a platform to reach out to customers directly. Brick and mortar stores are becoming largely redundant due to online platforms, a threat the company should recognize and act upon.

(g) Succeeding through the talent of people: An organization is only as good as the people who work in it. There should be an atmosphere of teamwork that enable achievement of organizational and personal goals. Performance evaluation, reward and recognition programs, training and talent network are ways to cultivate talent within the organization.

(h) Sustaining outstanding results: Use of EFQM model is not a onetime exercise. Constant and periodic evaluation is required to keep up and sustain excellence.

(iv) The criteria of the model are comprised of 5 enablers and 4 results. Enablers covers what an organization does (its objective) and how it does it (strategy, use of resources to achieve it).
(a) Leadership: A leader defines the organization’s culture. They enable the organization to achieve its goals by taking the correct decisions at the correct time. To do this they should have sufficient skill, work as per the company’s code of conduct and should be ethical in their dealings.
(b) Strategy: Operations should be planned and directed as per a clearly defined strategy. The company’s vision and mission statement with respect to its various stakeholders are the goals that the organization wishes to achieve. Strategy (plan) enables the company to achieve these goals.
(c) People: Excellence is possible only if the people working in the company wish to achieve it. They must be motivated, recognized, and managed to enable them to work towards the company’s vision and mission. The work culture should be that this opens up opportunities for personal development as well. This would cultivate a bond with the organization, which enables people working within to strive for excellence.
(d) Partnerships and resources: Effective management of partnerships that the company has with other organizations is critical to success. Partners could be external vendors, suppliers, and service providers. The services of partners enable business to operate smoothly. Resources, both tangible and intangible should be managed optimally. Tangible resources can be financial (cash, bank accounts) and physical assets (machinery, building, land etc.). Intangible resources would be intellectual property rights, information technology, licenses etc. Proper management of resources enables optimal results.

(e) Processes, Products, and Services: A company exists because of its processes, products, and services. They should be managed and continuously improved to create value to the stakeholders.
Results are what the organization achieves following its operations and decisions. As explained before, the stakeholders of the company are investors (business), people (employees), customers and society. In order to track performance, the company has to develop Key Performance Indicators (KPI)s for each of the stakeholder groups. Results should be tracked periodically. Changes to targets and benchmarks should be continuously made to reflect the current objectives that the company wants to achieve. Some of the results that the company can look at are:
(a) Customer results: Are the customers of the company satisfied with the products and service? How does the company fare in terms of brand loyalty? Is the customer base growing to indicate increasing market share?
(b) People results: Does the company have skilled and motivated employees? What is the employee turnover with reasons for the same? Does the company have proper access to hire required talent? Are the employees motivated, trained, recognized, and rewarded for their performance? What is performance measurement system, is it robust and accurate to measure performance?
(c) Society results: Is the company a good corporate citizen. Are the objectives of corporate social responsibility being met? If the organization is a not for profit organization, is it meeting its objectives and goals?
(d) Business results: Is a for profit organization achieving the required return on investment, profitability that the shareholders and other investor demand? Has the company been able to manage financial and other risks properly?
Enablers enable achievement of results. EFQM model documents this flow and symbiosis in a structured way. It highlights the strength and weakness of the enablers. With this information, the company can alter its operations and strategy to achieve desired results. On assessment, there is a flow from results to enablers. If the results have been achieved, enablers continue to operate status quo. If the results fall short of targets, changes have to be made to enablers to improve performance.

Therefore, it can be concluded the EFQM model encourages constant self- assessment to achieve excellence.
When a company wins an excellence award based on a business excellence model, it gains in stature within the industry. This recognition could work to its advantage financially and otherwise.

Question 14.
(Theory of Constraint)
R Plus Security (RPS) manufactures surveillance camera equipment that are sold to various office establishments. The firm also installs the equipment at the client’s place to ensure that it works properly. Each camera is sold for ₹ 2,500. Direct material cost of ₹ 1,000 for each camera is the only variable cost. All other costs are fixed. Below is the information for manufacturing and installation of this equipment:

Particulars	Manufacture	Installation
Annual Capacity (camera units)	750	500
Actual Yearly Production and Installation (camera units)	500	500

Required
The questions below are separate scenarios and are not related to each other.
(i) IDENTIFY the bottleneck in the operation cycle that RPS should focus on improving. Give reasoning for your answer.
(ii) An improvement in the installation technique could increase the number of installations to 550 camera units. This would involve total additional expenditure of ₹ 40,000. ADVISE RPS whether they should implement this technique?
(iii) Engineers have identified ways to improve manufacturing technique that would increase production by 150 camera units. This would in* volve a cost ₹ 100 per earner a unit due to necessary changes to made in direct materials. ADVISE RPS whether they should implement this new technique. [RTP May 2018/2020]
Answer:
The feedback of information relates to the reporting of things that have happened in the past. For example,
(i) Identification of Bottleneck: Installation of cameras is the bottleneck in the operation cycle. The annual capacity for manufacturing and installation are given to be 750 camera units and 500 camera units respectively. Actual capacity utilization is 500 camera units, which is the maximum capacity for the installation process. Although, RPS can additionally manufacture 250 camera units, it is constrained by the maximum units that can be installed. Therefore, the number of units manufactured is limited to 500 camera units, subordinating to the bottleneck installation operation. Therefore, RPS should focus on improving the installation process.

(ii) Improving Capacity of Installation Technique: Every camera sold increases the through put contribution by ₹ 1,500 per camera unit (sale price ₹ 2,500 per camera unit less direct material cost ₹ 1,000 per camera unit). By improving the current installation technique an additional 50 camera units can be sold and installed. This would involve total additional expenditure of ₹ 40,000. Hence, the incremental benefit would be:

Particulars	Amount (₹)
Increase in throughput contribution (additional 50 camera units ₹ 1,500 per camera unit)	75,000
Less: Increase in total expenditure	40,000
Incremental benefit	35,000

Since the annual incremental benefit is ₹ 35,000 per annum, RPS should implement this improvement to installation technique, the current bottleneck operation.

(iii) Improving Manufacturing Capacity: Every camera sold increases the throughput contribution by ₹ 1,500 per camera unit (sale price ₹ 2,500 per camera unit less direct material cost ₹ 1,000 per camera unit). By improving the current manufacturing technique an additional 150 camera units can produced. This would involve a cost ₹ 100 per camera unit due to necessary changes to made in direct materials. Therefore, number of units manufactured can increase to 650 camera units. However, production of 150 camera units will not translate into additional sales, because each sale also requires installation by RPS. In a year only 500 camera installations can be made, leading to an inventory pile up of 150 camera units. This is detrimental to RPS, since it does not earn any contribution by holding inventory. Therefore, RPS should not go ahead with the proposal to improve the manufacturing technique.

Question 15.
(Theory of Constraints)
Shrya Steel Company produces three grades of steel – Class i, Class ii and Class iii grade. Each of these products (Grades) has high demand in the market and company is able to sell as much as it can produce these products.
The furnace operation is a bottle-neck in the process. The company is running at 100% of capacity. The company wants to improve its profitability. The variable conversion cost is ₹ 100 per process hour. The fixed cost is ₹ 48,00,000. In addition, the Cost Accountant was able to determine the following information about the three products (grades):

	Class i Grade	Class ii Grade	Class iii Grade
Budgeted Units Produced	6,000	6,000	6,000
Total process hours per unit	12	12	10
Furnace hours per unit	6	5	4
Unit Selling Price	₹ 3,600	₹ 3,400	₹ 3,000
Direct Material cost per unit	₹ 2,100	₹ 1,900	₹ 1,720

The furnace operation is part of the total process for each of these three products. Thus furnace hours are the part of process hours.
Required
(i) DETERMINE the unit contribution margin for each product.
(ii) Give an ANALYSIS to determine the relative product profitability, assuming that the furnace is a bottleneck.
(iii) Managements wishes to improve profitability by increasing prices on selected products. At what price would Class i and Class ii grades need to be offered in order to produce the same relative profitability as Class iii grade steel? [May 2018](20 Marks)
Answer:
(i) Contribution Margin per unit

(ii) The contribution margin per unit may give false signals when an organization has production bottlenecks. Instead, Company should use the contribution margin per bottleneck hour to determine relative product profitability, as follows:

Particulars	Class i	Class ii	Class iii
	Grade	Grade	Grade
Contribution Margin per unit (₹)	300	300	280
Furnace Bottleneck hrs. per unit	6	5	4
Contribution Margin per furnace hour	50	60	70

Analysis
The Class i and Class ii Grade steel have the highest contribution margin per unit (₹ 300); however, the Class iii grade has the highest contribution margin per furnace hour (₹ 70).
Thus, using production bottleneck analysis indicates that the Class iii Grade is actually more profitable at a ₹ 70 contribution margin per furnace hour than Class i Grade’s ₹ 50 or Class ii Grade’s ₹ 60 contribution margin per furnace hour.
Therefore, the company would want to sell product in the following preference order:
I. Class iii Grade
II. Class ii Grad
III. Class i Grade

(iii) One way is to revise the pricing would be to increase the price to the point where all three products produce profitability equal to the highest profit product. This would be determined as follows:

Contribution Margin per furnace hour for Class iii Grade

Or, ₹ 420 = Revised Price of Class i Grade – ₹ 3,300
Class i grade steel would require a revised price of ₹ 3,720 in order to deliver the same contribution margin per bottleneck hour as does Class iii Grade steel.
Contribution Margin per furnace hour for Class iii Grade

Class ii grade steel would require a revised price of ₹ 3,450 in order to deliver the same contribution margin per bottleneck hour as does Class iii Grade steel

Question 16.
(Throughput Accounting)
Naya company produces three products Le, Mi and Ne. The capacity of Naya’s plant is restricted by process in machine M2. Process in Machine M2 is expected to be operational for eight hours per day and can produce 1,200 units of Le per hour, 1500 units of Mi per hour, and 600 units of Ne per hour.
The Selling prices and material costs for each product are as follows:

Product	Selling price $ per unit	Material cost $ per unit	Throughput $ per unit
Le	75	40	35
Mi	65	20	45
Ne	150	50	100

Operating costs are $360,000 per day.
Required
(a) Calculate the profit per day if daily output achieved is 6,000 units of Le, 4,500 units of Mi and 1,200 units of Ne.
(b) Calculate the Throughput Accounting ratio for each of the product. :
(c) In the absence of demand restrictions for the three products, advise Naya management on the optimal production plan.
Answer:
(a) Calculation of profit per day if daily output achieved is 6,000 units of Le, 4,500 units of Mi and 1,200 units of Ne.
= Throughput contribution – Operating costs
= [($35 × 6,000) + ($40 × 4,500) + ($100 × 1,200)] – $360,000
= $150,000 (Profit per day)

(b) Calculation of TA ratio for each of the product.
TA Ratio = \(\frac{\text { Throughput per factory hour }}{\text { Operating costs per factory hour }}\)

Product	Throughput per factory hour	Operating Cost per factory hour	TA Ratio
Le	₹ 35 × 1,200 = $ 42,000	₹ 45,000	0.93
Mi	₹ 45 × 1,500 = $ 67,500	₹ 45,000	1.50
Ne	₹ 100 × 600 = $ 60,000	₹ 45,000	1.33

= Operating costs per factory hour = $360,000/8 = $45,000

Note
(c) If it is not possible to increase the number of factory hours available, priority should be given to making and selling Product Mi, since it has the highest TA ratio. If only Product Mi is made and sold (since there is no restriction on sales demand), total output per day would be (1,500 × 8 hours) = 12,000 units of Product Mi. Total throughput would be $540,000 (= 12,000 units × $45) per day. Total profit per day would be $540,000 – $360,000 = $180,000.
This is $30,000 more per day than the profit from the production mix in the answer to part (a).

Question 17.
(Throughput Accounting Ratio)
Oppi Popcorn Manufactures readymade popcorn packets that has a selling price of ₹ 40. The material costs are ₹ 16 per unit of readymade popcorn packets. Total operating expenses each month are ₹ 240,000
Machine capacity is the key constraint on production. There are only 1200 machine hours available each month, and it takes six minutes of machine time to manufacture each unit of Readymade popcorn packets.
Required
(a) Calculate the throughput accounting ratio for oppi.
(b) List how this ratio might be increased?
Answer:
(a) Throughput per unit of Packet of Popcorn = ₹ 40 – ₹ 16 = ₹ 24.
Machine time per unit of Packet of Popcorn = 6 minutes = 0.10 hours.
Throughput per machine hour = ₹ 24/0.10 = ₹ 240.
Operating expenses per machine hour = ₹ 2,40,000/1200 Hours = ₹ 200
TA ratio for Oppi = ₹ 240/₹ 200 = 1.20

(b) In the following cases it might be possible for Oppi to increase the Throughput Accounting ratio
(i) Raise the selling price for readymade popcorn packet for each unit sold, to increase the throughput per packet.
(ii) Improve the efficiency of machine time used, and so manufacture Popcorn packet in less than six minutes.
(iii) In order to reduce the operating expenses per machine hour, find ways of reducing total operating

Question 18.
RIYAN. Ltd. manufactures three products. The material cost, selling price and bottleneck resource details per unit are as follows:

Particulars	Product A	Product B	Product C
Selling Price (₹)	66	75	90
Material and Other Variable Cost (₹)	24	30	40
Bottleneck Resource Time (Minutes)	15	15	20

Budgeted factory costs for the period are ₹ 2,21,600. The bottleneck resources time available is 75,120 minutes per period.
Required
(i) Company adopted throughput accounting and products are ranked according to ‘product return per minute’. Select the highest rank product.
(ii) CALCULATE throughput accounting ratio and COMMENT on it.
Answer:
(i) Calculation of Rank According to ‘Product Return per minute’

Particulars	A	B	C
Selling Price	66	75	90
Variable Cost	24	30	40
Throughput Contribution	42	45	50
Minutes per unit	15	15	20
Contribution per minute	2.8	3	2.5
Ranking	II	I	III

(ii) Ranking Based on ‘TA Ratio’

Contribution per minute	2.80	3.00	2.50
Factory Cost per minute(2,21,600/75,120)	2.95	2.95	2.95
TA Ratio (Cont. per minute/Cost per minute)	0.95	1.02	0.85
Ranking Based on TA Ratio	II	I	III

Comment
Product B yields more contribution compared to average factory” contribution per minute, whereas A and C yield less.

Question 19.
Shooter Limited produces three products S, 0 and L which use the same resources but in varying quantities. Product S uses one unit of component P which is purchased from outside suppliers at, ₹ 120 per unit. Details of the three products are as follows :

	S	Q	L
Annual Demand (units)	9,000	5,700	7,800
	Per unit ₹	Per unit ₹	Per unit ₹
Selling Price	310	275	224
Component P	120	–	–
Direct materials (₹ 8per kg.)	24	32	24
Skilled labour (₹ 40 per hour)	20	60	40
Unskilled labour (₹ 24per hour)	18	24	36
Variable Overhead (₹ 6 per machine hour)	18	24	24
Annual fixed costs are 115,00,000

Maximum availability of skilled labour is 16,200 hours. Other resources are sufficient to meet the annual demand/sales.
Engineering division of the company came forward with a proposal to make the component ‘P’ in house with the following costs break up :

Direct materials (₹ 8 per kg.)	₹ 24
Skilled labour (₹ 40 per hour)	₹ 40
Unskilled labour (₹ 24 per hour)	₹ 8
Variable Overhead (₹ 6 per machine hour)	₹ 18
	₹ 90

For in-house making of the component ‘P’ there will not be any change in the annual fixed costs of the company. The company can either buy | the component ‘P’ or make it in house.
Required
RECOMMEND the optimum production plan and profit for the year. Show calculation in support of your answer [Nov. 2019] (10 Marks)
Answer:
(a) Option-1
Shooter Ltd. produces 3 products Product S, Product Q and Product L. Each unit of Product S requires one unit of component P, which is currently procured from the external market at ₹ 120 per unit. There is a constraint in terms of skilled hours available for production, the maximum available is 16,200 hours. Given this constraint, the production plan should be based on the contribution derived per skilled labor hour spent on each product.

Calculation of skilled hour requirement for each of the products and component P

Particulars	S	Component P	0	L
Skilled Labour Cost per unit	20	40	60	40
Skilled Labour Rate per hour	40	40	40	40
Skilled Hours per unit (Step 1/ Step 2)	0.5	1	1.5	1

Note: When component P is manufactured, in-house Product S would require 1.5 hours of skilled labor hour per unit.
Contribution per unit and contribution per skilled hour (when component P is purchased)

Particulars	S Per unit ₹	Q Per unit ₹	L Per unit ₹
Selling Price	310	275	224
Variable Cost
i. Component P (purchased)	120	0	0
ii. Direct Materials	24	32	24
iii. Skilled Labor	20	60	40
iv. Unskilled Labor	18	24	36
v. Variable Overhead	18	24	24
Total Variable Cost (Sum of steps i to v)	200	140	124
Contribution perunit(Step 1 – Step 2)	110	135	100
Skilled Hour per unit (refer skilled hour table – Step 3)	0.5	1.5	1
Contribution per skilled hour (Step 3/Step 4)	220	90	100
Ranking Based on Contribution per skilled hour	1	3	2

Based on this, Shooter Ltd. would first produce Product S, then Product L and then Product Q. The constraint of 16,200 hours of skilled labor has to be taken into account while drawing up the production plan. Production plan as per above ranking will be as below:

First, 9,000 units Product S is produced, this requires 4,500 hours of skilled labor. After production of Product S, 11,700 hours of skilled labor remain. (16,200 hours – 4,500 hours). Next 7,800 units of Product L can be produced, for which the skilled hours used are 7,800 hours. The remaining 3,900 hours would be used to produce Product Q.
Volume of Product Q that can be produced in 3,900 hours = 3,900/1.5 hours per unit = 2,600 units.
Therefore, profitability of Shooter Ltd. when component P is purchased:

(b) Option-2
Contribution when component P is manufactured in-house.
It may be noted that Product S requires 0.5 hours and component P would require 1 hour of skilled labor per unit. If component P, a part of Product S is manufactured in-house, then Product S would in all require 1.5 hours of skilled labor per unit.

Based on this, contribution per unit and contribution per skilled hour if component P is manufactured is:

Note 1
Component P has a variable cost, sum of direct material + skilled labor + unskilled labor + variable overhead, given to be ₹ 90 per unit
Each unit of Product S requires 1 more hour of skilled labor to manu-facture component P. Skilled labor is a limited resource that costs ₹ 40 per hour. The savings Shooter Ltd. earns by manufacturing component P in-house is only ₹ 30 (external purchase cost is ₹ 120 per unit – cost of manufacturing component P in-house is ₹ 90 per unit). Therefore, it is profitable to purchase component P from the external market. For further analysis, the impact of producing component P in-house would be:

Based on the revised ranking, Shooter Ltd. would first produce Product L, then Product S and then Product Q. The production plan is component P is made in-house would be

First, 7,800 units Product L is produced, this requires 7,800 hours of skilled labor. After production of Product L, 8,400 hours of skilled labor remain. (16,200 hours – 7,800 hours). The remaining 8,400 units would be used to produce Product S. Volume of Product S that can be produced in 8,400 hours = 8,400/1.5 hours per unit = 5,600 units. In this constraint, Product Q cannot be produced.

The profitability of Shooter Ltd. if component P is manufactured in house:

When component P is purchased, annual profits would be ₹ 6,21,000. When component P is manufactured in-house, annual profits would be ₹ 64,000, a reduction of ₹ 557,000 per year. Therefore, component P has to be bought externally. Optimum production plan would be
Product S – 9,000 units;
Product Q – 2,600 units;
Product L – 7,800 units;
The decision to outsource make or buy decision might have strategic implications for the Shooter and should be formulated from strategic perspective with senior management’s involvement.

Question 20.
Xtream Digital Solutions (XDS) is a renowned name for manfacturing a wide variety of digital stationery products for office and academic use. The ‘Abacus division’ of XDS is engaged in the production ef basic calculators, capable of academic and commercial use. Presently Abacus is manufacturing only three models, named C-100, C-125, and €-500. These calculators are sold to customers through wide-spread retailers and distributors’ network across the country.
During manufacturing process, each calculator needs to pass through various steps, before it gets ready. PC-IA is the essential step and performed manually, where processing chip is being installed, activated, and tested. The production capacity of Abacus is constraint by PC- IA. The basic information pertaining to top-line and the prime cost is as follows , (Amount in ₹)-

Particulars	C-100	C-125
Sale price per unit	140	200
Material cost per unit	72	104
Labour cost per unit	30	52.5

All the process and division at XDS are operating for a single shift of 8 hours in a day. Conversion cost per hour (including labour cost) is 5600. The standard out-put for PC-IA during a day is the processing of either 800 units of C-100 or 560 units of C-125, or 320 units of C-500. XDS is capable of sale more than, what they are presently capable to produce in all range of models. The CEO of XDS recently attended a science fair, Robo-tech 4.0; where he saw a Robot developed by Synergy Robotics Limited, capable to assembly including installation of processing chip to any sort of device.
Required
Management hired you as cost consultant, advice on following aspects
(i) On a random day if 480 units, 140 units and 120 units of C-100, C-125, and C-500 respectively are produced and sold, CALCULATE at what efficiency level current constraint (bottleneck) is operational. INTERPRET the same. COMPUTE profit earned during such day.
(ii) FIND production of which model is more beneficial, considering the ranking (based upon throughput performance ratio).
(iii) APPLY Goldratt’s five steps to remove the bottleneck at Abacus.
Answer:
(i) Efficiency level can be measured with help of Efficiency Ratio, which is one among the control ratios.
Efficiency ratio indicates the degree of efficiency attained in produc-tion. It is expressed in term of standard hours for actual production as a percentage of the actual hours spent in producing that work.
= \(\frac{\text { Standard hours for actual production } * 100}{\text { Actual hours worked }}\)
= (9.8/8) × 100
= 122.5%
Working Note – Standard hour required for actual production.

Interpretation – 122.5% signifies that efficiency (usage) of exploiting bottle-neck activity is 22.5% better than the standard use. PC-IA is producing out-put which require 9.8 hours, in 8 hours.
Profit earned during the day

Particulars	Amount in
Revenue [(480 × 140) + (140 × 200) + (120 × 450)]	1,49,200
Less: Material Cost [(480 × 72) + (140 × 104) + (120 × 200)]	73,120
Lass/Conversion Cost (including labour cost) [5,600 × 8hrs.]	44,800
Profit	31,280

(ii) Statement of ranking, based upon throughput performance ratio (using throughput contribution)

Considering the throughput performance ratio (or TA ratio) and ranking above most beneficial model to produce is-C-500 followed by C-100 and
TA Ratio = Throughput Contribution/Conversion cost Throughput accounting developed by Galloway and Waldron which use the term factory cost and completely relay upon the Goldratt’s theory of constraints which use the term operating expenses, but the meaning of factory cost and operating expenses used at both places are identical.
Theory of constraints consider short-run time horizons and assume other current operating cost to be fixed costs.

(iii) Application of Goldratt’s five steps to remove the bottleneck at Abacus
Goldratt’s theory of constraints describes the following mentioned five steps process of identifying and taking steps to remove the bottlenecks that restrict output.
1. Identifying the System Bottlenecks – At Abacus division of XDS, PC-IA is bottleneck
2. Exploit the Bottlenecks – Bottleneck activities’ capacity must be fully utilised. Although the efficiency of bottleneck activity is al-ready 122.5% but further attention on the possibility to enhance the flow of products from bottleneck activity is needful.
3. Non-bottleneck activities are subordinate – Bottleneck activity should setup the pace for non-bottleneck activities. Abacus shall plan its production keeping PC-IA at the centre point, because even if the efficiency of other activities which are non- bottleneck enhanced beyond current level; the output can be maximum possible by PC-IA.
4. Elevate the bottleneck – Eliminate the bottleneck by enhancing the capacity and efficiency. Major change (business reengineer-ing) or continuous minor change (kaizen) may do. In the case of Abacus, the introduction of the robot may be a way to elevate the bottleneck.
Note – There will always be one bottleneck in the system, if such bottleneck is eliminated then a new constraint emerges as a bot-tleneck. Hence this process continues. Ultimately improvement is a never-ending continues process.
5. Repeat the process – Apply step 1 to new bottleneck activity which emerges at Abacus and repeat the process.

Question 21.
ZED produces two types of products ZP and DP at its manufacturing plant. Both the products are produced using the same materials, machinery and skilled labour. Machine hours available for the year is 4,000 hours.
Information relating to products are as follows:

Particulars	ZP	DP
Selling Price per unit	₹ 16,000	₹ 4,000
Material Costs per unit	₹ 7,000	₹ 1,200
Machine Hours per unit	1.6 hrs.	0.8 hrs.
Maximum Annual Demand	2,000 units	1,600 units
Online Booking (already accepted for)	400 units	1,200 units

Due to poor productivity levels, late order and declining profits over recent years, the CEO has suggested the introduction of throughput accounting in the company.
The total of all factory costs is ₹ 1,42,60,000, excluding material.
Required
(i) Using throughput accounting, PREPARE statement to determine the optimum production mix and maximum profit for the next year.
(ii) CALCULATE the amount of profit lost due to acceptance of online booking of the products.
(iii) RECOMMEND the options to be followed in order to avoid any loss of profit.
(iv) LIST various ways through which price customization could be done.
(v) Given that products ZP and DP are respectively in ‘maturity stage’ and ‘introduction stage’ of their life cycle. STATE the most appropriate pricing policy that could be followed by the ZED for ZP and DP as per their life cycle. . [RTF Nov. 2020]
Answer:
(i) Statement Showing Machine Hours

Product	Maximum De­mand	Machine Hours/ Unit	Total Machine Hours
ZP	2,000 units	1.6	3,200
DP	1,600 units	0.8	1,280
Total machine hours required to meet maximum demand			4,480
Machine hours available			4,000
Shortage of machine hours			480

‘Machine hours’ is the bottleneck activity.

Particulars	ZP	DP
Selling Price per unit	₹ 16,000	₹ 4,000
Less: Material Costs per unit	₹ 7,000	₹ 1,200
Throughput per unit	₹ 9,000	₹ 2,800
Machine Hour Required per unit	1.6	0.8
Throughput Return per hour	₹ 9,000/1.6	₹ 2,800/0.8
	= ₹ 5,625	= ₹ 3,500
Throughput Accounting (TA) Ratio	5,625/3,565	3,500/3,565
(throughput return per hour/cost per factory hour)	= 1.58	= 0.98
Ranking	I	II

Cost per factory hour = ₹ 1,42,60,000/4,000 hrs. = ₹ 3,565

Optimum Production Plan

(ii) Had there been no online booking first product ZP should be produced = 2,000 units using 3,200 machine hours (2,000 × 1.6). Because of online booking already accepted for 1,200 units of product DP, unfulfilled demand of product ZP = 2,000 – 1,900 = 100 units.

Machine Hrs. Required for 100 units of ZP (100 × 1.6)	160 hrs.
Throughput Lost for Product ZP (160 hrs. × 5,625)	₹ 9,00,000
Throughput Return Earned for Product DP (160 hrs. × 3,500)	₹ 5,60,000
Throughput lost	₹ 3,40,000

(iii) Recommendation Option-1
Throughput accounting ratio is the throughput return earned in an hour divided by the factory cost (labour and overheads) incurred by the factory in one hour. Factory cost is generally fixed in nature. A ratio above 1 signifies that the throughput return is greater than the factory cost and therefore the product is profitable. Product ZP has a throughput accounting ratio of 1.58 while Product DP has a throughput accounting ratio of 0.98, this indicates that hourly return from Product ZP can cover the hourly factory cost it is profitable. Product DP does
not yield enough hourly return to cover the hourly factory cost, it is not profitable. Therefore, ZED should consider ways of improving throughput accounting ratio of Product DP (i.e. above 1.0). TA ratio could be improved by:

• Increasing the selling price of the Product DP but the demand may fall.
• Reducing the material cost per unit as well as operating costs. However, there may be quality issues.
• Improving efficiency e.g. increase number of units that are made in each bottleneck hour.
• Raising up bottleneck so that more hours are available of bottleneck resource.

Option-2
ZED has to prioritize production of Product ZP since it is more profitable than Product DP. As per the throughput accounting ratio, Product DP does not yield sufficient return per hour to cover the hourly overhead cost therefore, gets second priority over Product ZP. Since machine hours are the bottleneck, if production for entire 4,000 hours is focused on Product ZP, return yielded would be sufficient to cover the factory overheads. However, Product ZP has a maximum demand of 2,000 units, that requires 3,200 machine hours (2,000 units X 1.6 hours per unit of production). Remaining 800 machine hours can be devoted to Product DP, during which 1,000 units can be produced (800 machine hours/0.8 hours per unit). Maximum demand for Product DP is 1,600 units. Therefore, the balance demand of 600 units of Product DP will remain unsatisfied.
However, to meet unsatisfied demand of Product DP, ZED may consider the option of sub-contracting either a part of whole of theproduction of Product DP. This way it can meet the entire demand for Product DP for 1,600 units. If it subcontracts the entire production of Product DP, it can also scale down its in-house capacity. Sub-contracting decision requires suitable cost benefit analysis. Moreover, the risk associated with outsourcing like unsatisfactory quality and service or failure of supplier cannot be ignored.
Overall, to enhance profitability or avoid any type of loss of profit, ZED may consider the options recommended above with a long-term perspective.

(iv) Pricing of a product is sometimes customized keeping taste, preference, and perceived value of a customer into consideration. Price customization is done in the following ways:

• Based on product line: When products are customized as per the customer’s requirements, pricing can be adapted based on the customer’s specifications. Standard products can have a base price, to which the company can top-up charges to any additional customization.
• Based on customer’s past behaviour: Customers with good payment record have established their credit-worthiness. To sustain business, they may be extended additional discounts as compared to other customers.
• Based on demographics: Different pricing strategies may be adopted based on age or social status. For example, railway fare discounts for senior citizens or concessional price tickets for military personnel.
• Based on time differential: Different price for different time periods. If a customer extends a long-term contract, an additional discount may be extended since business is contracted for a longer period of time. Example, discounted price for data usage provided by a broadband service provider if subscription paid for six months or more.
• Apart from the above accounting principles, other macro economic and legal factors should also be given importance while chalking out a pricing strategy.

(v) The life-cycle of a product has 4 stages namely Introductory stage, Growth stage, Maturity stage and Decline stage.
Product ZP is given to be in the maturity stage. This third stage of product life cycle is characterized by an established market for the product. After rapid growth in sale volume in the previous stages, growth of sales for the product will saturate. Competition would be high due to large number of rivals in the market, this may lead to decreasing market share. Unit selling price may remain constant since the market is well established. Occasional offers may be used to tempt customers, otherwise this stage will mark consolidation of the market. Product DP is in the introduction stage, the first stage of product life cycle. Penetration pricing is adopted to charge a low price in the initial stage for penetrating the market as quickly as possible. For a new product this low price strategy will popularize the product. Once the market is established, the price may be increased. Penetration pricing will be suitable when:

• Demand for the product is elastic, more demand when prices are low.
• Large scale production of the product yields economies of scale.
• Threat of competition requires prices to be set low. It serves as an entry barrier to prospective competitors as well.

However, if Product DP is a highly innovative product, it may adopt Skimming price policy. The product with unique features will differentiate it from other products leading to a revolutionary impact on market and customer behaviour. Customers may not mind paying a premium for the unique product offering. Focus may be on promoting the product to gain market share. Skimming price policy may work when:

• There seem to be no competitors providing similar products.
• Demand is inelastic.

Over time, competitors can reverse engineer and offer similar products. Therefore, the price may be lowered in the long run to retain market share.

Question 22.
(Case Study)
Power Electronics manufactures and sells various electronic goods like mobile phones, laptops, televisions, refrigerator etc. The company sells f these goods through the 30 stores situated in different parts of the country. The store managers place a request to the centralised team situated I in Mumbai on a monthly basis. One store can send only one requisition per month.
The requirements of the stores are forwarded to the production planning team which is responsible for scheduling

the manufacturing of these prod-ucts. Once the goods are manufactured, the goods are sent to a central warehouse in Mumbai and are dispatched to different stores according to the store requirements. The time taken from placing a request from store to the delivery of product to the store takes about 30-40 days on an average. In the process the company procures parts from more than 100 vendors. The company has faced quality related issues with many vendors leading to delay in production.
The average holding period of inventory in Power Electronics is very high at 45 days as against an industry average of 15 days. Since the order to delivery time at a store is very high, the company has traditionally allowed high inventory holding to reduce the stock outs at store level. The company is under severe pressure to improve its working capital cycle.
A high amount of inventory held at each store also means that the products become obsolete quickly. In case of products like mobile phones, new and upgraded versions are available in the market as early as six months from the date of initial launch of a particular model. A significant portion of inventory of mobile phones becomes obsolete every year. The company generally resorts to a discounted sale to liquidate such obsolete models. The management at Power Electronics has identified e-commerce as an opportunity for faster growth, both in terms of revenues and profitability. The company is considering launch of its own e-commerce website to sell all products which are currently being sold in physical stores. Depending upon the success of online sales, the company might choose to optimize and close certain physical stores in the next couple of years.
The management of the company is cognizant of the fact that existing inventory procurement and management system will not fit in the new e-commerce business. E-commerce works on a inventory light model and quick as well as on time delivery of products of the customers. The fact that customers could be from a location other than those where Power Electronics has physical presence makes the matter complex.
Required
The company is considering implementation of a supply chain management system. Will a supply chain management system be of use to Power Electronics in light of the e-commerce venture? You are required to EXPLAIN the concept of Supply Chain Management and EVALUATE the applicability of in the current case. [MTP Oct. 2020]
Answer:
Issue
Power electronics manufactures and sells various electronic products through its physical stores. The existing manufacturing system does not take into consider the demand of products in the market. Store managers are allowed to submit only one order per month. A high level of inventory can be seen at Power Electronics as compared to the industry average. The store managers tend to keep high level of inventories as a safeguard against stock-outs. Whereas, keeping inventory to meet customer requirement is good, high level of inventories due to inefficient processes is not advisable.
The company also has a longer working cycle because of a long order to deliver time and excess holding of inventory. A significant amount of working capital is blocked due to this practice. Technology changes rapidly and the company is expected to roll out latest products in the market. A product like mobile gets outdated very soon and the company has to resort to discounted sales. This results in financial losses to the company.
The company has identified an opportunity in e-commerce. E-commerce businesses require leaner models and faster response time. The production must be based on the demand from the customer and not on an ad hoc basis.
In the following paragraphs, the importance of supply chain management (SCM) and its applicability in the current case is discussed.

Supply Chain Management (SCM)
Supply Chain Management can be defined as the management of flow of products, services and information, which begins from the origin of products and ends at the product’s consumption at consumer’s end. SCM also involves movement and storage of raw material, work-in-progress and finished goods. In other words, supply chain management involves management of all activities associated with moving goods from the raw materials stage to the end user. An important objective of SCM is to cor-relate the production and distribution of goods and services with demand of the product.

The following are the various activities which an organisation carries out to meet the customer requirements (Primary activities under value chain model) –

• Inbound Logistics covering procurement and related activities.
• Operations covering conversion of rawr materials into finished products
• utbound Logistics covering movement of products from plants to end users
• Marketing and Sales
• Service

Supply Chain Management looks each of the above activities as integrated and interrelated to each other. None of the activities can be looked in silos.
In the case of Power Electronics, there is a restriction on number of orders which a store manager can place. This would lead to excess ordering because of the fear of stock-outs.
The customer demand is completely ignored and hence the production is not in sync with the market demand. This could lead to excess production, higher inventory holding and longer working capital cycles.

The facts presented in the case indicate the following problems at Power Electronics:

• Production planning is not based on customer demand & is done on an ad-hoc basis.
• Inventory Holding period is very high (45 days against an industry average of 15 days).
• The working capital cycle is longer.
• The time take to fulfil an order from the store is very high.
• The production is dispatched to a central warehouse for further deliveries to the stores. This could be an inefficient process.
• Liquidation of products at discount for products with low shelf life.

SCM Process and applicability to Power Electronics
The SCM process is explained below:

• Plan – The first step in SCM process is to develop a plan to address the requirements of the customer. Power Electronics must shift its focus from ad hoc and predetermined production planning to understanding the requirements of customers. Production must be planned based on the demand of products. The focus must be on producing what the customer wants.
• Develop (procure) – In this step, the materials required for production is sourced from various suppliers. A good relationship with supplier is required to ensure that the parts/materials are received as and when required by the production team. It is also important that the vendors supply quality material which is not the case in Power Electronics. The company must select suppliers which are dependable and can deliver quality products in the stipulated time. The company must focus in reducing the lead time required for sourcing materials which will reduce the inventory holding period.
• Make – The third step is making or manufacturing the products required by the customer. This is quite different from the existing practice in Power Electronics where store managers are allowed to place only one order. This would mean that the company is not considering the ever changing demands and tastes of the customers.
• Deliver – The fourth stage is to deliver the products manufactured for the customers. This stage is concerned with logistics. The time required to deliver to the store in case of Power Electronics is very high. The company must evaluate if the centralized warehouse is causing delay in delivery of products to the stores.

Logistics is one of the important component of the entire supply chain process. Right from procurement of material, movement of raw material in the plants and final delivery of products of customers, logistics play a critical role. An excellent system must be in place to ensure that the movement of materials and final product are uninterrupted.
Warehousing also plays an important role in today’s business environment. The company has a centralised warehouse to meet the needs of all its stores.
This would not be the most efficient way. The company must evaluate creation of additional storage facility which would ensure timely delivery of goods to the stores. Newer products can reach the market faster.

Benefits of SCM to Power Electronics
SCM looks at the entire value chain process as an integrated process. There is a seamless flow of information and products between suppliers and customers. The customer’s requirements would be captured to plan the production. The suppliers would be intimated to supply the materials according the production plan. An effective logistics system ensures that movement of materials is seamless. Power Electronics can also consider implementing an integrated ERP which would also interact with vendors on real time basis.

The following benefits of SCM can be envisaged for Power Electronics –

• Better Customer Service as customer is supplied with what he/she wants in the minimum time.
• Better delivery mechanism for goods.
• Improves productivity across various functions and departments.
• Minimises cost (both direct and indirect).
• Reduces the inventory holding time and improves the working capital cycle.
• Enhances inventory management and assists in implementation of JIT systems.
• Assists companies in minimising wastes and reduce costs.
• Improves supplier relationship.

E-Commerce and SCM
The SCM is the backbone of E-commerce industry. Customers buying products online want deliveries to be faster. Another distinct feature of e-commerce is that buyers could be located in any corner of the country and not just restricted to the cities where Power Limited has physical presence. This definitely means that the company must have an effective Supply Chain Management in place which could meet the customer’s requirement.
The existing practice of one order per month from each store would not work in the e -commerce space. Orders can come at any time and from anywhere. Supply Chain Management would be required for success of e-commerce business.

Customer Orders
The company must have an effective mechanism to capture customer orders and feed it into the production planning on a real time basis. An integrated
ERP system would be required for this purpose. Any delay in intimating the production team would mean delay in production and delivery which would not be taken positively by the customers. The existing system of one order per month from a store would not fit the purpose. A real time flow of information would mean lower inventory holding.

Procurement
The material requirements must be communicated to suppliers seamlessly. The company must identify those vendors who can deliver quality materials in the required time frame. A delay in supplies would delay the production process. A company cannot afford this in e-commerce business. Automatic exchange of information using EDI (Electronic Data Interchange) or Integrated ERP systems would ensure that the vendors receive material requirements in a timely manner.

Production
As discussed earlier, the production must be in accordance with the customer order. This requires a shift in approach of the production team. Business environments have shifted from “Customer will buy what we produce” to “We have to produce what the customers require”. The company would ideally not produce products to store them and sell later.

Logistics
Logistics would be the backbone of entire e-commerce set up. Right from sourcing of materials to delivery of products at the customer’s door step, logistics would play an important role. If the company has an in-house logistics facility, the logistics team must be trained with the requirement of the new business. If the company has outsourced the logistics, vendors must be briefed about the requirements of the e-commerce. The company might have to tie up with new logistic vendors to avoid, any delay in deliveries.

Question 23.
A clothing manufacturing company has a factory in Ahmedabad, making soft denim clothing for customers of all ages. It sells its clothing from its factory outlet store located within the city. Until 6 months back, the company had a business model wherein the products manufactured at its factory would be sent to its factory outlet store. Customers would visit the store and choose apparel suiting their tastes. Production was based on prediction of customer demand. This “made to stock” model has been placed for many years.
Few months back, the store manager noticed many customers exiting without making any purchases. Tracking this and after obtaining feedback from customers over sometime, it was found that many products were unacceptable to the customers’ tastes – either the shade or design of denim was not what they wanted or that the apparel was not of the correct fit for them. The management then decided to provide customers a choice of either choosing from their standard apparel range that has already been made (“made to stock” model) or to offer them a “made to order” option.
The company now displays its range of denim material at the factory outlet. Customers can go through the samples and choose the material of their choice. Company certified tailors would then take measurements based on the customers’ preferences. A detailed order customized to the customers’ needs would then be drawn up. The factory has set up a separate tailoring division that would stich the apparel specifically for these “made to order” sales. For this new machines and production line resources have been put in place.
Customized products are manufactured and be made available to the customer within 3 working days’ time from the date of placing the order. The customer comes to the store and picks up the apparel ordered. For delays beyond this timeline, the customer gets to pay 5% less on the order value. This is done to attract and maintain customers, who would other-wise choose to purchase apparel offered by rival competitors. Therefore, speed of delivery of the customized product is critical for the company. This is the main selling point for the company to operate the “made to order” business model.
If further modifications are needed due to errors on part of the company (quality/finishing issues), the apparel would need to be modified/restitched once again. The company will bear the cost of modification or replacement of garment.
This new “made-to-order” has been in place for the past 6 months. At the stage of project proposal, the management found it a lucrative option for the company because:
(i) Customers are willing to pay a higher price to have customized clothing as compared to the standard fitting.
(ii) It would attract more customers to the store
(iii) If the model works well, the dependence on the “made to stock” model can reduce. Savings in inventory stock, obsolescence and warehousing costs will benefit the company’s bottom-line.
Customers have been very enthusiastic in availing this customization facility/offered by the company. Sales have increased manifold in the last few months. Therefore, the management is interested to understand the metrics related to their “made to order” business mode to assess its success and risks. Some of the non-financial metrics are:

Required
ANALYZE the non-financial measures of quality of the division over the six-month period. Focus on the production performance, delivery cycle performance and customer satisfaction. [RTP Nov. 2020]
Answer:
Analysis of the operating data of the “made to order” at the business 1 store revealed the following:
Production Performance:
(i) Modifications to orders: This company has to bear the cost of modification/replacement of the garment incurred on account of error in its order taking or manufacturing process. Therefore, orders needing such modification should be kept at the minimum. Such instances were higher than 10% in the first three months. With experience, either in the order taking process or manufacturing process, these errors have reduced substantially in the later months. The managers of the order taking and manufacturing departments need to understand and constantly keep track of these errors in order to keep them at a bare minimum. Management may want to set a benchmark, financially in terms of the cost of modification and non- financially in terms of the acceptable threshold for such instances. Monthly tracking of this metric will help detection of errors earlier.

(ii) Production downtime: Production downtime normally occurs either due to break down of machinery or plant maintenance. It is unproductive time, reducing the machine’s capacity. It must be kept minimum. Downtime hours have been steadily increasing in the past 3 months, the overall monthly average being 91.67 hours. The production manager has to analyze and take corrective action at the earliest. Urgency of the issue can be compounded by the fact that sales orders under the “make to order” model have been increasing steadily over the last few months. In the latest month, 3896 of the overall sales was from this model. Therefore, the production capacity should be utilized optimally to ensure ability to meet delivery deadlines.

(iii) Labor Idle time: Labor Idle time due to unavailability of material is another unproductive waste of resource. The procurement department can address unavailability of material. On an average 20.5 hours of labor time is idle due to unavailability of the appropriate material. Appropriate steps with suppliers can lead to agreements to ensure seamless supply of material when required. This will enable the company to meet delivery deadlines given to customers.

Delivery Cycle Performance:
(i) On-time delivery: The orders need to be delivered to the store within 3 working days of placing order. The customer picks up the order from the store. Speed of delivery is critical to the company. Any delay beyond this timeline, the customer benefits by a 596 reduced price on the order as compensation for delay. Prompt delivery is also the company’s selling point to attract customers, who would otherwise patronize its rivals. On an average 596 of the orders are not delivered within time. Therefore, average delivery success rate is only 9596. The management has to take steps that this is kept to the minimum in order not to stem loss of revenue as also to build brand loyalty with the customer base.

Customer Satisfaction:
(i) Repeat orders by customers: Prompt, quality delivery of the customized order would ensure that customers return in future with further orders. Statistics shows that repeat orders have steadily increased, which is a very positive signal to the management. Initially, only 496 of the customers under this model placed repeat orders. This increased substantially. Now almost 63% of the customers who purchase under this model come back with more orders!
(ii) Sales mix: Popularity among customers for customized services is further validated by the steady increase in the ratio of such sales to the overall sales of the company from the factory outlet. Now, this model generates an average of 28% of the total sales from the outlet, with a likely projection of having a higher share in the overall sales mix. Therefore, the “make to order” model can be termed a success.

Workings

Question 24.
(Supply Chain Management)
Happy day Travels is a tour operator offering holiday packages to a variety of customers. They advertise and promote their packages using print advertising in newspapers and colourful brochures. A basic holiday package would include transport from the city to the destination, stay, food, attractions, or activities. Happy day Travels has been in business for the past 15 years. It has standard agreements with its suppliers based on which it has been offering standard holiday packages to its customers. Profitable business over these years has resulted in surplus cash that the company intends to reinvest in its business. Recently, the management has noticed increase in the number of complaints regarding these packages. This has resulted in lesser number of customers opting for these tours.
A study of these complaints has indicated that customer expectations from a holiday trip vary depending on their age group. Accordingly, Happy day Travels wants to offer customized holiday package trips that would suit the travellers’ expectations. It wants to increase the number of packages offered to customers in addition to adding variety to them. This would provide customers the choices from which they can customize 4 their holidays with the help of Happy day Travels.
The management wants to understand the need and importance of supplier chain management in a service organization such as itself.
Required
(i) DEFINE the objective Travels should have when considers incorporating the supply chain management framework into its business model.
(ii) IDENTIFY possible components of Happy day Travels’ upstream supply chain.
(iii) SUGGEST the key processes in the business model of Happy day Travels.
Answer:
(i) Happy day Travels is providing a service wherein it uses its assets, staff, and resources to provide customized travel packages to its customers. It should consider how to utilize its assets and staff to design and manage its supply chain such that it meets the customers ’demand in a cost-effective manner. Customers’ demand is uncertain due to
(a) customization of holiday packages to suit their individual expectations and
(b) sensitivity of travel to factors like economic prosperity, law, and order etc.
Business processes must be effectively coordinated across organizations and functions to meet the customers’ expectation in the best posable manner. The ability of Happy day Travels to respond to its customers’ demand defines its operational capacity. Having more capacity (capability) to meet customers’ demand helps it be more responsive and flexible. However, this has to be balanced with its ability to maintain an effective supply chain management. A supply chain is effective only when Happy day Travels and consequently the ultimate customer, is able to get the required level of service from its suppliers.

(ii) As mentioned in the problem, a basic holiday package would include transport from the city to the destination, stay, food, attractions, or activities. Accordingly, possible components of Happy day Travels upstream supply chain would include partnerships with:
(a) Transport providers – road, rail, and air travel providers. This includes travel to the holiday destination as well as the local transport within that location.
(b) Lodging and accommodation providers – hotels, bed, and break-fast providers etc.
(c) Local food producers and restaurants.
(d) Providers of tourist attractions and activities.

(iii) Key processes in the business model of Happy DayTravels would be: Information Flow
Information flow is critical at various stages:

• to understand expectations of customers
• to share this information with the suppliers of service with whom Happy Day Travels has partnership
• to establish clear service level agreements with these suppliers and to clearly define the scope of work
• to be able to monitor the performance of these suppliers. Performance has to be monitored because it will impact payment settlements with these suppliers
• to collect constructive feedback from customers about the performance of these suppliers

Capacity and Skills Management
Happy Day Travels has to develop the ability to cater to various expectations of its customers. It has to develop assets and skilled staff who can attract customers and help them customize their holiday packages. To enable this, the company has to invest in its organization, processes, assets and staff. As mentioned above in point (a), information flow is a key process in this business model. The company has to invest in , its processes to ensure that information flow is smooth and accurate. Similarly, it has to invest in assets like IT infrastructure, offices and aho develop a skilled staff who can provide quality service. Happy Day Travels should also have the ability to develop pool of suppliers who provide good quality service. Better capacity to cater to customers’ demand better will ensure that Happy Day Travel can develop and maintain its business efficiently. However, since building capacity and developing skills comes with a cost, that has to be balanced out with the revenue it generates.

Demand Management
Happy Day Travels will have to focus on how to generate demand for its products. In time with changing times, Happy Day Travels will have to change its marketing from print based advertising to online advertising in order to have a larger outreach to attract customers. The company should be able to manage variation in customers’ ex-pectations in a cost- effective way. As explained in point (b) above, this will be determined by the capacity of its operations and skills of its employees. Higher the capacity more the flexibility in its operations.

Customer Relationship Management
Customer segmentation and monitoring help in understanding cus-tomer’s needs in a better way and to focus on efforts to meet those needs through proper and timely communication of information with its service suppliers. However, the cost of maintaining this framework should not exceed the revenue that each customer segment generates. Accordingly, customer account profitability analysis should be prepared for each customer segment.

Supplier Relationship Management
As part of the customer relationship management, specific needs of customers would be identified. Based on these needs, potential suppliers who provide services of the requisite quality need to be identified. Service level agreements need to be drawn up after comprehensive rounds of negotiations. It is imperative to have a clear understanding with these suppliers regarding the quality service expected.

Service Delivery Management
Agreements with suppliers will help to ensure that expectations of customers of Happy Day Travels are being met. Service performance must be monitored, checked continuously for compliance. Any deviation from scope may have an impact on the payment settlement to be made with the supplier.

Cash Flow
As mentioned above, service delivery should be monitored to ensure that payment is made only to the extent the agreed quality of service is delivered. Periodic payments to suppliers should be made based on service level agreements. Similarly, cash inflow from customers should be monitored to avoid any bad debts. Pricing for packages should be based on the level of service offered. Again, clear understanding of the terms of contract is essential to avoid uncertainties.

All processes within the company are linked to each other. Under-standing the customers’ expectations have a direct impact on the supply chain. Therefore, proper co-ordination is required for smooth functioning of the organization and its supply chain.

Question 25.
(Customer Life time Value)
MultiCinema is a movie theater is located in a town with many colleges and universities around it. The town has a substantial student population, most of whom are avid movie goers. Business for MultiCinema has been slow in the recent years due to the advent of streaming websites, that show the latest and popular movies online. However, the management n of MultiCinema continue to feel students would still enjoy the watching movies on big-screen, along with the facilities and ambience that only a movie theater can offer. Accordingly, they have framed a plan to attract students by offering discounts on movie tickets.
The average time a student spends at the college or university is 4 years, which is the average duration of any course. For a nominal one-time subscription fee, MultiCinema plans to offer students discounts on movie tickets for a period of 4 years. By attracting more footfalls, MultiCinema targets to cross sell it food & beverages and souvenirs. This would help it sustain a reasonable revenue each year.
MultiCinema would attract attention to the plan by initially offering free tickets, food and beverage and gift vouchers. This one time initial expense, net of the one-time subscription fee collected, would cost ₹ 5,000 per student. On subscription to the plan, the viewership and purchases of each student is expected to be as follows:

Particulars	Years 1 and 2	Years 3 and 4
Spend on movie tickets per year	2,000	1,500
Spend on food and beverage per year	4,000	3,000
Spend on souvenirs and accessories per year	2,250	750

Assumptions
1. Only 50% of the subscribers are expected to visit the theatres in years 3 and 4.
2. Across all years, only 75% of the subscribers who visit the theatre are expected to buy food and beverage.
3. Only 25% of the subscribers who visit are expected to buy souvenirs in years 1 and 2, and 10% of them in years 3 and 4.
Given that PVIFA of ₹ 1 for 4 years at 10% = 3.169 and PVIFA of ₹ 1 for 2 years at 10% = 1. 735.
Required
CALCULATE the customer lifetime value per subscriber for the above plan. [RTP May 2019]
Answer:
Customer lifetime value per subscriber can be found by calculating the present value of the revenue that is generated over the period of 4 years. This netted out with the cost incurred to attract subscribers, would give the customer lifetime value per subscriber.

Note 1:
PVIFA (10%, 4 years) = 3.169 and PVIFA (10%, 2 years) is 1.735. Therefore, PVIF for years 3 and
4 = PVIFA (10%, 4 years) – PVIFA (10%, 2 years) = 3.169 – 1.735 = 1.434.

Note 2:
Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 75% are expected to buy food and beverage. Therefore, only 38% of the subscribers (75% of 50% subscribers who visit) are expected to buy souvenirs in years 3 and 4.

Note 3:
Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 10% are expected to buy souvenirs. Therefore, only 5% of the subscribers (10% of 50% subscribers who visit) are expected to buy souvenirs in years 3 and 4
Present value of total revenue generated over the four-year period by a customer is ₹ 12,393 while the corresponding expense is ₹ 5,000. Therefore, the customer lifetime value per subscriber is ₹ 7,393. MultiCinema has to multiply this with the expected number of subscribers each year, to find out if this would be a profitable proposition.

Question 26.
Ray Health Care Limited is a leading healthcare service provider in Mumbai, it has approximately 450 potential beds, it provides diagnostic and day care speciality facilities also. In its diagnostic centres they are using traditional devices for CT Scan and MRI which are not enough as per demand. Patients waited more than weeks for CT and MRI scans, this problem can cause delay in diagnosing illness; waste of time and other resources; not just in radiology but throughout the healthcare system.
Ray has planned to outsource CT Scan and MR1 services to Livlife, which has world-class international chain of diagnostic centre. Livlife promise to provide radiologist report within 24 hours. However, finance manager of Ray doubt that it will not be a profitable arrangement. For the satisfaction of Ray, Livlife has entered an agreement to provide its services to Ray with no guarantee of receiving payment.

Ray agree to the following conditions:

• Cost savings generated in first year, the same will be retained by Livlife.
• Cost savings generated in second and third year will be shared between Ray and Livlife at a ratio of 30%: 70%.
• Cost savings generated in the fourth year will be passed to Ray.
• Any cost savings generated by an idea proposed exclusively by Ray that does not require capital investment by Livlife will be immediately passed along to Ray.

Required
DISCUSS the agreement between Ray and Livlife. [RTPMay 2020]
Answer:
The agreement between Ray and Livlife is Gain Sharing Arrangement. Gain sharing (also known as cost saving sharing) arrangement is an approach to the review and adjustment of an existing contract, or series of contracts, where the adjustment provides benefits to both parties. A fundamental form of gain-sharing is where a supplier agrees to perform its side of the contract with no guarantee of receiving a payment. Instead, any payment received is based upon the benefits that emerge to the customer as a result of the successful completion of the supplier’s side of the bargain.
Livlife and Ray has also entered into such arrangement. This is clearly a risky stance for the supplier ie. Livlife, because-it could spend a fortune and walk away with nothing.
Alternatively, if the benefits to Ray are substantial, Livlife could find itself rewarded with a large return.
Cost savings might be attained from reducing the cost of supplies, imple-menting new skill and technologies, revised delivery time, improvements in operations etc.
The gain, benefit, or advantage to be shared is not necessarily financial, although financial benefits are expected to occur frequently. The Ray, for instance, will not necessarily take cost savings in the form of a lower contract value but might require a higher specification for medical treatment. However, to assess any financial benefit, both parties have to provide each other with access to relevant cost numbers to determine the basis for the assessment of the benefit and the calculation and sharing of the benefit.

Many contracts involving these arrangements have emphasis on greater openness and shared development and improvement. In the given case gain-sharing deals are, on the face of it, a win-win situation for both Ray and Livlife, interest of both are aligned. Livlife is trying to save costs of Ray while Ray is trying to get world class services.

Question 27.
(Case Study: Value Chain Analysis, Stage of Product Life Cycle, Outsourcing)
Jovial Hotels was established 10 years ago as a budget hotel in the vicinity of Mumbai airport. It provides accommodation for cost-conscious travelers visiting the city for short stay lasting a day or two. Typically, a room would provide comfortable beds, high speed internet connection, | air conditioning facility, coffee machine, fridge and free television service.
Food service based on a limited menu is provided on the premises. It g has few conference rooms that provide space for guests to hold business S meetings. This saves them precious time otherwise wasted in travelling on £ congested city roads. The hotel provides free shuttle service to and from the airport at specific times during the entire day. Hotel’s proximity to the airport, the free shuttle service and convenience of conducting work at the conference rooms have been marketed to attract guests to stay here. The guests also comprise of people who are in transit between airports. Also, when there are long- duration delays in flight operation due to which passengers need to be provided overnight accommodation, few airline operators host their guests here. Like all other guests, these airline operators are also interested in Jovial for its location and low-cost room rental.
Over the past decade, management of Jovial has ploughed in profits from this establishment to acquire similar properties in other major cities. They function based on business model similar to the original establishment in Mumbai. All of them are now functioning as well-established budget hotels near city airports for cost-conscious business travelers. In all, Jovial hotels have 18 properties spread over 15 cities. To keep its costs of operations within control, Jovial hotels has outsourced its cleaning and food service to specialized vendors. Cleaning service includes cleaning of kitchen crockery, bedding, laundry and housekeeping of premises. The entire set of activities related to preparation of food has been outsourced.
Vendor service has been satisfactory, barring few instances where guests have complained of unhygienic rooms or non-palatable food service. However, due to high guest volume and quick turnover of guests due to short stay periods, this has never been a hindrance to business.
This business model has been profitable since its establishment. Jovial Hotels has a sizeable market share in this segment. Competition has increased in the recent past. Price wars have put pressure on profit margins in this segment. The management plans to continue to operate in this segment to maintain its market presence. At the same time, to sustain business in the long term, the management of Jovial Hotels now wants to foray into developing properties for luxury resorts. Target guest segment are vacationing tourists interested in an enjoying a laid-back time in scenic places. These guests would not mind paying premium for availing good quality service.
Required
(i) IDENTIFY and EXPLAIN the various primary activities of Jovial in its value chain.
(ii) IDENTIFY and EXPLAIN the stage of product life-cycle.
(iii) EVALUATE the risks of outsourcing cleaning and food services for the luxury resort properties. [Nov. 2019 RTP] (20 Marks)
Answer:
(i) The five Primary Activities of Michael Porter’s Value Chain Model Inbound Logistics
Activities related to receiving, handling of materials from the supplier and their storage until further use later in operations. In the case of Jovial Hotels, materials would include food service received from the vendor. This needs to be stored and maintained properly until the item is ordered by the guest. Similarly, the vendor delivering freshly laundered crockery, bedding and laundry would be materials that [ need to be stored until their use to serve the guests. These are inbound I logistics for the hotel.

Operations
Activities related to converting inputs into production of output or service. In the case of Jovial Hotels, operations would include maintenance of hotel premises including guest rooms, conference rooms and common area. Activities related to ensuring cleanliness and safety of rooms, working order of facilities offered like TV and internet service, coffee machines, shuttle service are part of hotels operations.

Outbound Logistics
Storage and movement of the end product from the production line to the customer. In the case of Jovial Hotels, it includes activities such as maintaining “non- smoking” rooms as such, so that when the customer finally uses it comes across as a “non-smoking” room. Likewise, the food should be prepared in a professional manner, stored in such a way that it ensures customer satisfaction and safety. Therefore, the review of food items to remove the ones past expiry would be part of Outbound Logistics. Therefore, any activity relating to making sure that the guests get what they have ordered for, would be part of out-bound logistics.

Marketing and Sales
The activities related to communicating, selling, and delivering the product or service to the customer. In the case of Jovial Hotels, advertising its properties to the cost and time conscious traveller would be a marketing activity. Free shuttle service is a promotional activity to attract guests. Any agreement with airline companies to accommodate guests would also form part of this activity.

Service
All types of service such as after sale service, handling customer com-plaints, customer support, training etc. In the case of Jovial, service is one of the most important activities in their value chain model. Good service ensures happy guests. Therefore, all activities from front- desk, room service, catering, repair services, shuttle service would be included here. All employees have to trained to handle needs of the guests in an effective and efficient manner.

(ii) Product Life-cycle Stage of Jovial Hotels
“Budget Accommodation” to the cost and time conscious traveller is the current product offering of Jovial Hotels. Starting out with a single establishment, Jovial Hotels ploughed in profits to expand its business offering to other cities as well. The product has been well established in the past decade. Competition is intense indicating similar offering by rivals. Price wars have put pressure on profit margins. Jovial Hotels plans to continue in this segment due to its sizeable market share. This information indicates that Jovial Hotels is in the maturity stage of its product lifecycle. It has a well-established product, with a sizeable market share at the same time it is now facing competition. Business has hit a plateau. Hence, Jovial Hotels needs to improve its product offering to beat competition. The management’s plans to foray into luxury resort business is an indication of its future plans to sustain business.

(iii) Risks of Outsourcing Cleaning and Food Service under the Luxury Resort Model
Jovial Hotels is a budget accommodation provider to the cost and time conscious traveller. Primary feature of this model is “value for money”. To remain profitable the cleaning and food service has been j outsourced, which enables Jovial Hotels to keep the costs of operation low. There have been instances of dissatisfaction among guests as regards quality of cleaning and food service. However, since the turnover of guests is quick due to high volume and short stay period, it has not negatively impacted business.

In the luxury resort business, the target guests are travellers on leisure, The primary feature of this model would be “good quality of service ”.
Maintaining cleanliness of premises and food service are critical activ-ities in the operation of luxury hotels. Therefore, customer satisfaction . on these metrics is paramount to sustain and grow business. With the – ability to post reviews online on booking portals, any negative review (whether justified or not) can reach very easily to a large number of potential guests. This can negatively impact future business. Hence, Jovial Hotels has to ensure that the quality of service that it provides in terms of cleanliness and food should meet and beat the guest’s expectation.

Outsourcing these services to well established vendors is advantageous since the focus can remain on improving guest experience. It may also | be cost advan tageous in many cases. However, there a number of risks in this model. Detailed service level agreements need to be drawn up to ensure that the required quality of service is being provided. Jovial j Hotels should be able to monitor the performance of these vendors, j In cases of non-delivery of the required level of service, the agreement ] should provide for means of redressal. This could vary from compensation for any loss in business to immediate termination of service. ! Jovial Hotels should ensure that it can easily and economically switch service providers if required. For this it has to identify alternate vendors who can provide the same level of service as the current ones. The j other risk in outsourcing could be of instances where well performing vendors could go bankrupt and shut shop. In such cases, Jovial Hotel’s operations could be immediately impacted since such services can no longer be availed from these vendors. Again, list of alternate service providers is a necessary back-up that the hotel should have.

Alternatively, since these are very critical activities to business operations, Jovial Hotels may choose to have complete control over them. This can be achieved by having in-house departments that cater to cleanliness and food service. Control over factors such as input material used, the performance of service, equipment used, training of staff and other essential activities can ensure that the required service quality can be achieved Better service enhances guest experience. Compared to outsourcing, this might be a costlier option. However, since the guests are ready to pay a premium for service quality, within reasonable limits cost need not be a primary concern for Jovial Hotels for this business model.

Question 28.
(Case Scenario) Nitco Tiles Production Limited (NTPL) is large manufacturer of floor tiles and interlocking tiles. NTPL enjoyed reasonable market share and brand reputation up till couple of year ago. Since then, NTPL is facing problem of decline in productivity. NTPL deals in variety of tiles with different brand-name, some of their brands are in development stage and some in maturity. Majority of customer are from middle class, who are price sensitive; hence cost of production is critical aspect for NTPL and resultantly productivity too become critical factor.
Workers at NTPL are allocated with specific roles and responsibilities. Workers are supposed to work strictly according to specific set of guidelines provided by superior. Workers used to complain about job role allocations, because allocations are not as per skill set of workers. In some of case task become monotonous; as learning curve exhausted. Management and operational decision are centralised in nature, participation of workers is limited up-to day end report only.
Remunerations at NTPL are paid based on hourly rate. Hourly rate is fixed based upon number of years of working in NTPL, irrespective of importance of task allocated to such worker. Since payment are fixed in nature hence workers at NTPL are hardly concern about quality. Some of skilled workers are getting less pay in comparison to other staff. NTPL recently retrench some of senior workers, who possess reasonable operational skills; but not good in technology part which is essential to operate machines; recently installed at NTPL plant.
Since there are varieties of tiles available in stock that’s too with different design, hence in past there are handful instances where material delivered to customer was different from what being ordered. Due to large volume of inventory at store, some category of tiles is further manufactured even lying available in store and stock of some remains always short.
Required
You are newly appointed to Management Accounting Department of NTPL, Management Accountant asked you to draft a report for CEO, containing brief explanation to
(i) Productivity, stating in context of what it should be measured?
(ii) Productivity enhancement techniques, which can be applied at NTPL in order to enhance productivity?
Answer:
Addressed to:
Office of CEO,
Nitco Tiles Production Limited (NTPL). Dated -11th April, 2020
Report
Report on Productivity Enhancement Techniques
(i) Productivity – Productivity is all about efficient and effective use of all resources. Resources can be time, people, knowledge, information, finance, equipment, space, energy and material.
Productivity is usually linked to ‘time and motion’, in order to

• Put pressure on worker to perform faster.
• Increase the productivity either by increasing the value or reducing the time required to create that value.

Note – Responsibility of productivity is largely on the person who organising the work rather individual worker.

(ii) Productivity Improvement Techniques
(a) Value Analysis/Engineering – Value engineering improve value of product at every state of product life cycle; Since products of NTPL is lying either in development stage or in maturity stage, hence

• At development stage – NTPL can reduce cost without reducing quality by establishing design and processes accordingly.
• At maturity stage – NTPL can reduce cost by replacing costly component with cheaper one. But may result in reduction in quality to some extent, hence consumer behaviour is important. Since customer base is price sensitive hence this strategy may work.

(b) Quality Circles – Quality circle is small group of employees, usually in size of 5-6 members in order to-

• Meet regularly to identify, analysis and solve problem of their departments.
• Advice the management to implement new methods to solve work-related problems.

Since NTPL facing criticism from worker class and method of working is selected by superior hence quality circle can be solu-tion to these problematic aspects.
Note – This technique originated in Japan in 1960s

(c) Financial & Non-Financial incentives – Incentives are real cause of motivation to worker and may be financial and non-financial in nature.

• Financial incentive includes better wages and salaries, bonus etc.
• Non-financial incentive includes better working condition, welfare facilities, worker participation in management.

Since the incentive scheme is not linked to employees’ productivity and skill hence redrafting of incentive schemes incorporating financial and non-financial incentives can promote productivity.

(d) Operations Research – Management at NTPL need to incorporate operation research and technique thereof in the decision-making process. Use mathematical & scientific methods may solve the problems of productivity (by using techniques such as LPP etc).

(e) Training – Rather than retrenching the employees who are operationally sound and weak in using the technology, they must be trained on technological part. Training is process of knowledge & skill enhancement of employee and will result in increased efficiency of employee.

(f) Job Enlargement & Job Enrichment – Job Enlargement is hor-izontal expansion of job which increase the varieties of job & work knowledge (make job interesting and satisfying), whereas Job Enrichment is vertical expansion of job which makes routine job more meaningful and satisfying. With this NTPL can solve the problem of monotonous nature of task and can enhance the productivity.

(g) Job Evaluation – In order to enhance the productivity, NTPL should do job evaluation. Fixing value of each job in the organ-isation. This is essential for moral boosting for employees.

(h) Inventory Control & Material Management – Optimum usage of material in manufacturing process need to be ensured by NTPL, whereas overstocking and under-stocking should be avoided, through

• Scientific Purchase
• Systematic Store Keeping
• Proper Inventory Control, etc.

Because overstocking may result in blockage of fund, chance of misuse/mishandling & spoilage of material and under-stocking results in shortage or sale out situation which result in loss of contribution.

(i) Quality Control – NTPL should ensure identification of causes of quality deviation & correction thereof, in order to produce goods with quality at lowest prices & to reduce wastage.

(j) Human Factor Engineering – Understanding of technology and human requirement (psychological & physiological character), of task and worker both; in order to ensure fitment of job to men; to increase human efficiency & wellbeing. NTPL can do skill mapping as part of this technique.
Further details can be tabled on requisition basis. Closure of
Report
Signature
(For Management Accounting Division)
Nitco Tiles Production Limited.

Security Valuation – CA Final SFM Study Material is designed strictly as per the latest syllabus and exam pattern.

Security Valuation – CA Final SFM Study Material

Part – 1 (Theory)

Question 1.
Write a short note on Zero coupon bonds [May 2012] [4 Marks]
Answer:
Zero coupon bonds are issued by Banks, Government and Private Sec-tor companies. These bonds do not pay interest during the life of the bonds. Instead, they are issued at discounted price to their face value, which is the amount a bond will be worth when it matures or comes due. When it matures, the investor receives a lump sum amount equal to the initial investment plus interest that has been accrued on the investment made. The maturity dates on zero coupon bonds are usually long term. Bonds issued by corporate sector carry a potentially higher degree of risk, depending on the financial strength of the issuer and longer maturity period, but they also provide an opportunity to achieve a higher return.

Question 2.
Write a short note on Traditional & Walter Approach to Dividend Policy. [May 2014] [4 Marks]
Answer:
Traditional approach:
It is also known as the “The Graham and Dodd model” as it was expounded by him. According to the model, the stock market places considerably more weight on dividends than on retained earnings. This is expressed quantitatively in the following valuation model:
P = m(D + E/3)
Where, P = Market price of the share
D = Dividend per share
E = Earnings per share
m = a multiplier.

This model is based on the following assumptions:
(a) Investors are rational
(b) Under conditions of uncertainty, they turn risk averse.
Under this model, the weight attached to dividends is equal to four times the weight attached to retained earnings. The weights provided by Graham and Dodd are based on their subjective judgment and not derived from any empirical analysis.
Investors discount distant dividends at a higher rate than they discount nearby dividend. This is because nearby dividends are more certain than distant dividends.

Walter approach:
The Walter’s Model propounded in 1963 by John E Walter supports the doc-trine that dividends are relevant. The investment policy of the firm cannot be separated from its dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the value of any firm. It is based on the following assumptions:
(a) The firm is an all equity firm.
(b) The firm will use only retained earnings to finance its investments.
(c) The rate of return on investment is constant and so is the cost of equity. This means that with every additional investment, business risk remains unaltered.
(d) All earnings are either distributed or retained internally.
(e) The firm has a perpetual or very long life.
(f) Earnings and dividends don’t change over the life of the firm.

Walter argued that the market price of a share is the sum of the present value of the following two cash flow streams:

• Infinite stream of constant future dividends.
• Infinite stream of capital gains.

Walter model is based on the premise that there is a relationship between the return on a firm’s investment or its internal rate of return (r) and its cost of capital (ke). The firm would have an optimum dividend policy which will be determined by the relation between (r) and (ke). If r is greater than ke, the firm should retain the earnings and if r is less than ke, it must distribute the earnings.

Question 3.
Why should the duration of a coupon carrying bond always be less than the time to its maturity? [May 2009] [3 Marks]
Answer:
The concept of duration can be defined as the percentage change in price of a bond for a 100 basis point change in interest rates. However, there is another concept of duration ie. the time concept of duration according to which duration is nothing but the average time taken by an investor to collect his/her investment. It is the weighted average time to receive the present value of the bond. Therefore, if an investor receives a part of his/her investment over the time on specific intervals before maturity, the investment will offer him the duration which would be lesser than the maturity of the instrument. Higher the coupon rate, lesser would be the duration. The duration of a Zero coupon bond is always equal to its maturity period.

Question 4.
Write a note on buy-back of shares by companies and what is the impact on P/E Ratio upon buy-back of shares? [Nov. 2019 (Old Syllabus)] [4 Marks]
Answer:
Buy-Back of Shares: The buy-back of shares means the repurchase of its own shares by a company and to return money to the holders of these shares. The cash is exchanged for a reduction in the number of outstanding shares. Since this process involves outflow of cash resources, it is adopted when the company has sufficient cash resources. The buy-back is a method of financial engineering which enables the company to go back to its shareholders and offers to purchase from them the shares they hold. However, the companies have to fulfil some legal conditions for buy-back of shares.

Impact of Buy-Back on P/E Ratio:
P/E Ratio is given by the following formula :
P/E = \(=\frac{\text { Market Price of the Share }}{\text { Earnings per Share }}\)
The buy back of shares by the company reduces the number of shares. In this case if the earnings remain constant, there is a rise in the Earnings Per Share ie. EPS.
After buy back, the market price of the share generally increases. Thus, there is increase in Market price of share Le. MPS.
As the numerator and denominator in the formula tend to increase, the impact on P/E will depend upon the quantum of relative increase in the two factors.

Part – 2 (Numerical Problems)

Question 1.
An investor is considering the purchase of the following Bond:

Face Value	₹ 100
Coupon rate	11%
Maturity	3 years

(i) If he wants a yield of 13%, what is the maximum price he should be ready to pay for?
(ii) If the Bond is selling for ₹ 97.60, what would be his yield? [Nov. 2009] [4 Marks]
Answer:
(i) Calculation of Maximum price
The present value of future inflows (comprising both interest as well as redemption value) discounted at 13% is the maximum price the investor would be ready to pay.
Annual Interest (I) = Rs. 100 × \(\frac{11}{100}\) = Rs. 11
Redemption Value (RV) = Rs. 100
Maturity Period (n) = 3 Years
Accordingly, Present value of future inflows can be calculated as
= ₹ 11 × PVIFA_{(13%, 3)} + ₹ 100 PVIF_{(13%, 3)}
= ₹ 11 × 2.361 + ₹ 100 × 0.693
= ₹ 25.97 + 69.30
= ₹ 95.27
The maximum price that the investor is ready to pay is Rs. 95.27.

(ii) Calculation of yield
It may be noted that the price of bond and yield/return are inversely related. The fair value is Rs. 95.28 at 13% yield. It means, if the bond is selling at higher than this fair value at Rs. 97.60, the return will be less than 13%.

Let us find out approximate yield:

= 0.1194 or 11.94%
The present value of future inflows (comprising both interest as well as Value at 12%
= ₹ 11 × PVIFA(12%3) + 100 × PVIF(12% 3)
= ₹ 11 × 2.402 + ₹ 100 × 0.712
= ₹ 26.42 + ₹ 71.20
= ₹ 97.62
This value is almost equal to the price of ₹ 97.60. Therefore, the YTM of the bond would be 12%.

Question 2.
The Nominal value of 10% Bonds issued at par by M/s SK Ltd. is Rs. 100. The bonds are redeemable at Rs. 110 at the end of year 5.
(I) Determine the value of the bond if required yield is : [Nov. 2019 Old Syllabus [5 Marks]]
(i) 8%
(ii) 9%
(iii) 10%
(iv) 11%
(II) When will the value of the bond be highest ?
Given below are Present Value Factors :

Answer:
Given
Coupon rate 10%
Face value Rs. 100
Redemption Value Rs. 110
Life 5 yrs.
(I) Value of the bond if required yield is

(II) The price and yield are inversely related. Therefore, the highest price will be at the lowest yield. In the given case the value of the bond will be highest when yield is 8%.

Question 3.
Calculate Market Price of:
(i) 10% Government of India security currently quoted at ₹ 110, but interest rate is expected to go up by 1%.
(ii) A bond with 7.5% coupon interest, Face Value ₹ 10,000 & term to maturity of 2 years, presently yielding 6%. Interest payable half yearly. [Nov. 2010] [5 Marks]
Answer:
(i) Current yield:
= (Coupon Interest/Market Price) × 100 = (10/110) × 100 = 9.09%
When current yield go up by 1%:
Expected Yield = Current Yield + 1% = 9.09% + 1 = 10.09%
Calculation of new market price at a yield of 10.09%:
Yield =(Coupon Interest/Market Price) × 100 Or 10.09
= 10/Market Price × 100 New Market Price
= ₹ 99.11

(ii) Market Price of Bond:
The market price of the bond shall be the present value of future inflows, which comprises interest as well as redemption value.
Market Price = P. V. of Interest + P. V. of Principal
Half-yearly Interest (I) = Rs. 10,000 × \(\) = Rs. 375
Redemption Value (RV) = Rs. 10,000
Maturity Period (n) = 2 Years or 4 half Years
YTM (r) = 6% p.a. or 3% half yearly
Market Price = ₹ 375 × PVIFA_(3%4) + ₹ 10,000 × PVIF_(3%4)
= (₹ 375 × 3.7171) + (₹ 10,000 × .8885)
= ₹ 1,394 + ₹ 8,885
= ₹ 10,279

Tutorial Note:
Since, the coupon (7.5%) is higher than YTM (6%), therefore the bond will be selling at premium i.e. above Rs. 10,000.

Question 4.
Based on the credit rating of the bonds, A has decided to apply the following discount rates for valuing bonds:

Credit rating	Discount rate
AAA	364-day T-bill rate + 3% spread
AA	AAA + 2% spread
A	AAA + 3% spread

He is considering to invest in a AA rated ₹ 1,000 face value bond currently selling at ₹ 1,025.86. The bond has five years to maturity and the coupon rate on the bond is 15 per cent per annum payable annually. The next inter-est payment is due one year from today and the bond is redeemable at par.
(Assume the 364-day T-bill rate to be 9 per cent).
You are required to calculate:
(i) The intrinsic value of the bond for A. Should he invest in the bond?
(ii) The Current Yield (CY) and
(iii) The Yield to Maturity (YTM) of the bond. [Nov. 2011] [8 Marks]
Answer:
(i) Calculation of Intrinsic Value of the bond:
As per table given in the question, the appropriate discount rate for valuing the AA rated bond for A is:
YTM = 996 + 396 + 2% = 1496
The other parameters are:
Annual Interest (I) = 1596 of Rs. 1,000 = Rs. 150
Redemption Value (RV) = Rs. 1,000
Maturity Period (n) = 5 Years
Accordingly, Intrinsic Value of future inflows can be calculated as = ₹ 150 × PVIFA(14%5) + ₹ 1,000 × PVIF(14%>5)
= ₹ 150 × 3.4331 + ₹ 1,000 × 0.5194
= ₹ 514.96 + ₹ 519.40 = ₹ 1,034.36
The current market value (Rs. 1,025.86) is less than the intrinsic value (Rs. 1,034.36) of the bond. Therefore, the bond is underpriced. So, Mr. A should buy the bond.

(ii) Calculation of Current Yield (CY):
Current yield = Annual Interest/Price = ₹ 150/₹ 1,025.86
= 14.6296

(iii) Calculation of Yield to Maturity (YTM):
Since, the coupon rate is 15% and bond is redeemable at par, therefore the price of the bond at 15% YTM will be Rs. 1,000.

Yelid	Value (Rs)
15%	1,000
14%	1,034.36

YTM at Rs, 1025.86 can be calculated using interpolation as per the manner given below.
By interpolation, the YTM is
= 14% + \(\frac{34.36-25.86}{34.36}\) × (15% – 14%)
= 14% + \(\frac{8.5}{34.36}\)%
= 14.24796

Question 5.
A bond is held for a period of 45 days. The current discount yield is 6 per cent per annum. It is expected that current yield will increase by 200 basis points and current market price will come down by Rs. 2.50.
Calculate
(i) Face Value of the Bond
(ii) Bond Equivalent yield. [May 2017] [4 Marks]
Answer:
(i) Let the Face value of bond be Re. 1

The difference in bond price due to 200 basis increase in interest rates is a decrease of Re. 0.0025. Therefore, by applying unitary method, if the actual difference is Rs. 2.50 the face value of the bond will be \(\frac{2.5}{0.0025}\) × 1 = Rs. 1,000
Face Value of the Bond = Rs. 1,000

(ii) Bond Equivalent yield

Question 6.
Bright Computers Limited is planning to issue a debenture series with a face value of ₹ 1,000 each for a term of 10 years with the following coupon rates:

Years	Rates
1-4	8%
5-8	9%
9-10	13%

The current market rate on similar debenture is 15% p.a. The company proposes to price the issue in such a way that a yield of 16% compounded rate of return is received by the investors. The redeemable price of the debenture will be at 10% premium on maturity. What should be the issue price of debenture?
PV @ 16% for 1 to 10 years are: .862, .743, .641, .552, .476, .410, .354, .305, .263, .227 respectively. [May 2016] [5 Marks]
Answer:
The issue price of the debentures will be the sum of present value of interest payments during 10 years and present value of redemption of debenture.
Interest (first 4 Years) = Rs. 1,000 @ 8% = Rs. 80
Interest (Next 4 Years) = Rs. 1,000 @ 9% = Rs. 90
Interest (Next 2 Years) = Rs. 1,000 @ 13% = Rs. 130
Redemption Value (10th Year) = Rs. 1,100
Maturity = 10 Years YTM = 16%

The cash inflows of the interest part are not constant throughout the period and the present value factors are given in the question. Therefore, it would be better to solve in the following tabular form.

Years	Cash outflow (Rs.)	PVF @ 16%	PV
1	80	0.862	68.96
2	80	0.743	59.44
3	80	0.641	51.28
4	80	0.552	44.16
5	90	0.476	42.84
6	90	0.410	36.90
7	90	0.354	31.86
8	90	0.305	27.45
9	130	0.263	34.19
10	130	0.227	29.51
10	1,100 (RV)	0.227	249.70
			676.29

The company should issue the debentures at a price at ₹ 6/6.29.

Question 7.
Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity. Both the bonds have a face value of ₹ 1,000 and coupon rate of 8% (with annual interest payments) and both are selling at par.
(i) Assume that the yields of both the bonds fall to 6%, whether the price of bond will increase or decrease?
(ii) What percentage of this increase/decrease comes from a change in the present value of bond’s principal amount and what percentage of this increase/decrease comes from a change in the present value of bond’s interest payments? [May 2009] [8 Marks]
Answer:
(i) The price of bond and yield are inversely related. Since the yield falls to 6%, the price of bonds will increase. The increase in price of the bond with higher maturity period will be higher.

If yield falls to 6%

Price of 5 years bond
= ₹ 80 × PVIFA(6% 5) + ₹ 1,000 × pvif(6% 5) = (₹ 80 × 4.2124) + (₹ 1,000 × 0.7473) = 336.99 + 747.30 = ₹ 1,084.29	Increase in price Rs. 84.29
Price of 20 years bond
= ₹ 80 × pvifa(6%20) + ₹ 1,000 × PVIF(6%20) = (₹ 80 × 11.4699) + (₹ 1,000 × 0.3118) = 917.59 + 311.80 = ₹ 1,229.39	Increase in price Rs. 229.39

(ii) Price increase in Bond:
(a) Due to change in the present value of bond’s principal amount:

Price of 5 years bond
= Principal × [PVIF(6%,5) – PVIF(8%,5)] = 1,000 × [0.7473 – 0.6806] = Rs. 66.70	Percentage Increase \( \frac{\text { Rs. } 66.70}{\text { Rs. } 84.29} \) × 100 = 79.13%
Price of 20 years bond
= Principal × [PVIF(6%,5) – PVIF(8%,5)] = 1,000 × [0.3118 – 0.2145] = Rs. 97.30	Percentage Increase \( \frac{\text { Rs. } 97.30}{\text { Rs. } 229.39} \) × 100 = 42.42%

(b) Due to change in the present value of bond’s Interest amount:

Price of 5 years bond
= Interest × [PVIF(6%,5) – PVIF(8%,5)] = 80 × [4.2124 – 3.9927] = Rs. 17.59	Percentage Increase \( \frac{\text { Rs. } 17.59}{\text { Rs. 84.29 }} \) × 100 = 20.87%
= Interest × [PVIF(6%,5) – PVIF(8%,5)] = 80 × [11.4699 – 9.8181] = Rs. 132.14	Percentage Increase \( \frac{\text { Rs. } 132.14}{\text { Rs. } 229.39} \) × 100 = 57.58%

Tutorial Note:
The segment of increase in the price of the bond due to interest part is higher mease of bond with higher maturity.

Question 8.
Pet feed pic has outstanding, a high yield Bond with the following features:

Face value	£10,000
Coupon	10%
Maturity period	6 years
Special feature	Company can extend the life of Bond to 12 years.

(a) If an investor expects that interest will be 8%, six years from now then how much he should pay for this bond now.
(b) Now suppose, on the basis of that expectation, he invests in the Bond,
but interest rate turns out to be 12%, six years from now, then what will be his potential loss/gain if company extends the life of bond another 6 years [RTP Nov. 2018]
Answer:
(a) If the current interest rate is 896, the company will not extend the duration of Bond and the maximum amount the investor would be ready to pay will be:
= £ 1,000 PVIFA (8%, 6) + £10,000 PVIF (8%,6)
= £1,000 × 4.623 + £10,000 × 0.630
= £4,623 + £ 6,300
= £10,923

(b) If the current interest rate is 1296, the companies will extend the duration of Bond. After six year the value of Bond will be =£ 1,000 PVIFA (1296,6) + £10,000 PVIF (1296,6)
= £1,000 × 4.111 + £10,000 × 0.507
= £ 4,111 + £ 5,070
= £ 9,181
Potential gain = £9,181 – £10.923 = -£1,742
Thus, potential loss will be £1,742

Question 9.
On 31st March 2013, the following information about bond is available:

i. If 10 year yield is 7.5% p.a., what price the Zero coupon Bond would fetch on 31st March 2013?
ii. What will be the annualized yield if the T-Bill is traded @ Rs. 98,500?
iii. If 10.71% GOI 2023 Bond having yield to maturity is 8% what price would it fetch on April 1, 2013 (after coupon payment on 31st March)?
iv. If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2013 (after coupon payment on 31st March)? [May 2015][8 Marks]
Answer:
(i) Price of Zero coupon bond on 31.3.2013:
= 10,000 PVIF (7.5%, 10)
= 10,000 × 0.4852
= Rs. 4,852

(ii) Annualized yield on T-Bill = \(\frac{F-P}{P} \times \frac{365}{M}\) × 100
\(\frac{1,00,000-98,500}{98,500} \times \frac{365}{81}\) × 100 = 6.

(iii) 10.71 PVIFA (8%, 10) + 100 PVIF (8%, 10)
= 10.71 × 6.7101 + 100 × 0.4632
= 71.87 + 46.32
= Rs. 118.19

(iv) 5 PVIFA (496,10) + 100 PVIF (4%, 10)
= 5 × 8.111 + 100 × 0.6756
= 40.56 + 67.56
= Rs.108.12

Question 10.
Consider a bond selling at its par value of ₹ 1,000, with 6 years to maturity and a 7% coupon rate (with annual interest payment).
(a) What is bond’s duration? [May 2009] [6 Marks]
(b) If the YTM of the bond in (a) above increases to 10%, how it affects the bond’s duration? And why? [3 Marks]
Answer:
(i) Determination of Duration of the Bond:
The following steps are to be taken:
Step 1: Calculation of YTM (Yield to maturity).
Since, the coupon rate is 7°-6 and bond is redeemable at par, and the price of the bond is Rs. 1,000 i.e. the bond is selling at par therefore the YTM ‘ will be 7%.

Step 2 : Calculation of Duration.
The duration of a bond is the weighted average of the time it takes to return the investor’s money. The present values of cash flows are to be taken as weights (w).

Year Cash flows(Rs.) PVIF@ PV of cash flows (?) Weighted Time

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\text { Rs. } 5,100}{\text { Rs.1,000 }}\) = 5.10 Years

Alternative Method for determination of Duration:

Formula method	Where,
Duration = \( \frac{1+y}{y-}-\frac{(1+y)+\text { Period }(c-y)}{c\left[(1+y)^{\text {Period }}-1\right]+y} \)	y = Yield to maturity c = Coupon rate

Duration = \(\frac{1+0.07}{0.07}-\frac{(1+0.07)+6(0.07-0.07)}{0.07\left[(1+0.07)^6-1\right]+0.07}\)
= \(\frac{1.07}{0.07}-\frac{1.07}{0.10505}\)
= 15.2857 – 10.1855 = 5.10 Years (approx.)

(ii) Effect of increase in YTM on duration of the Bond:
The calculations are similar to first part except changes in Present value factors.

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\text { Rs. } 4369.751}{\text { Rs. } 869.364}\) = 5.025 Years

Alternative Method for determination of Duration:

Formula method	Where
Duration = \( \frac{1+y}{y}-\frac{(1+y)+\operatorname{Period}(c-y)}{c\left[(1+y)^{\text {Period }}-1\right]+y} \)	y = Yield to maturity c = Coupon rate

Duration = \(\frac{1+0.1}{0.1}-\frac{(1+0.1)+6(0.07-0.1)}{0.07\left[(1+0.1)^6-1\right]+0.1}\)
= \(\frac{1.1}{0.1}-\frac{.92}{0.154}\)
= 11 – 5.975 = 5.025 Years (approx.)
The duration of bond decreases, reason being the receipt of slightly higher portion of one’s investment on the same intervals as the present value or purchase price is less.

Question 11.
Mr. A will need ₹ 1,00,000 after two years for which he wants to make one time necessary investment now. He has a choice of two types of bonds. Their details are as below:

	Bond X	Bond Y
Face value	₹ 1,000	₹ 1,000
Coupon	7% payable annually	8% payable annually
Years to maturity	1	4
Current price	₹ 972.73	₹ 936.52
Current yield	10%	10%

Advice Mr. A whether he should invest all his money in one type of bond or he should buy both the bonds and, if so, in which quantity?
Assume that there will not be any call risk or default risk. [Nov. 2015] [6 Marks]
Answer:
Step 1: Determination of duration of the bonds available for investment.
Duration of the bond X:
Since the year to maturity of Bond X is one year, therefore all the cash flows will be at the end of 1st year only. Hence, the duration will be 1 year.

Duration of the bond Y:

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\text { Rs. } 3,335.824}{\text { Rs. } 936.584}\) = 3.5617 Years

Step 2 : Determination of investment to be made today to meet obligation after 2 years:
= Amount of obligation × PVIF_{(10% 2)}
= Rs. 1,00,000 × 0.8264
= Rs. 82,640

Step 3 : Determination of proportion of investment in Bond X & Bond Y
The duration of both the bonds is different and the duration of liabilities is 2 years. Our objective is to match the duration of the liability with the duration of investment in bonds. Therefore, the weighted average of duration of bonds should be equal to 2 years.
Let x₁ be the investment in Bond X and therefore investment in Bond Y shall be (1 – x₁). The proportion of investment in these two bonds shall be computed as follows:
Required duration= [x₁ × Duration of Bond X] + [(1 – x₁) × Duration of Bond Y]
2 = x₁(1) + (1 – x₁) 3.5617
x₁ = 0.6096 = 61% (appx.)
Therefore, 61 % investment should be made in Bond X and balance 39% in Bond Y.

Step 4 : Investments in Bond X and Bond Y

Mr. A must invest in both the bonds in above manner and remain invested for 2 years. Since the duration of Bond X is one year, therefore he should reinvest at the end of first year.

Question 12.
The following data are available for three bonds A, B and C. These bonds are used by a bond portfolio manager to fund an outflow scheduled in 6 years. Current yield is 9%. All bonds have face value of Rs. 100 each and will be redeemed at par. Interest is payable annually.

Bond	Maturity (years)	Coupon rate
A	10	10%
B	8	11%
C	5	9%

(i) Calculate the duration of each bond.
(ii) The bond portfolio manager has been asked to keep 45% of the portfolio money in Bond A. Calculate the percentage amount to be invested in bonds B and C that need to be purchased to immunize the portfolio.
(iii) After the portfolio has been formulated, an interest rate change occurs, increasing the yield to 11%. The new duration of these bonds are: Bond A = 7.15 years, Bond B = 6.03 years and Bond C= 4.27 years.
Is the portfolio still immunized? Why or why not?
(iv) Determine the new percentage of B and C that are needed to immunize the portfolio. Bond A remaining at 45% of the portfolio.
Present values be used as follows: [Nov. 2018] [12 Marks]

Answer:
(i) Determination of duration of the bonds available for investment.
(a) Bond A:

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\mathbf{R s . 7 3 6 0 . 2 4}}{\text { Rs.106.404 }}\) = 6.863 Years

(b) Bond B:

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\text { Rs. } \mathbf{6 4 8 . 2 2}}{\text { Rs. } \mathbf{1 1 1 . 0 7 4}}\) = 5.8359 Years

(c) Bond C:

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\mathrm{R s . 4 2 4}}{\mathrm{R s . 1 0 0}}\) = 4.24 Years (approx.)

Formula method	Where
Duration = \( \frac{1+y}{y}-\frac{(1+y)+\text { Period }(c-y)}{c\left[(1+y)^{\text {Periad }}-1\right]+y} \)	y = Yield to maturity c = Coupon rate

(ii) Determination of proportion of investment in Bond B & Bond C given that 45% is invested in Bond A
The duration of the bonds is different and the duration of liabilities is 6 years. Our objective is to match the duration of the liability with the duration of investment in bonds. Therefore, the weighted average of duration of bonds should be equal to 6 years.
Let x₁ be the investment in Bond B and therefore investment in Bond C shall be (1 – 0.45 – x₁) as 45% is invested in Bond A. The proportion of investment in these two bonds shall be computed as follows:

Required duration
= [0.45 × Duration of Bond A]+ [x₁ x Duration of BondB] + [(0.55 – x₁) × Duration of Bond C] = 6
0.45 × 6.863 + x₁(5.8354)+ (0.55 – x₁) 4.24 = 6
3.08835 + 5.8354x₁ + 2.332 – 4.24x₁ = 6
5.42035 + 1.5954 x₁ = 6
1.5954 x₁ =0.57965
x₁ = 0.3633 = 36% (approx.)

Therefore, 45% investment should be made in Bond A, 36% investment should be made in Bond B and balance 19% in Bond C.
Weighted Duration = W_A (D_A) + W_B (D_B) + W_C (D_C)
= 0.45(6.863) + 0.36(5.8354) + 0.19(4.24)
= 6 Yrs. App.

(iii) Weighted Duration of the portfolio, if the Yield changes to 11% and the new duration of the three Bonds are given as under:

Bond	Duration
A	7.15
B	6.03
C	4.27

Weighted Duration = W_A (D_A) + W_B (D_B) + W_C (D_C )
= 0.45(7.15) + 0.36(6.03) + 0.19(4.27)
= 6.1996
The Liability is not immunized as the duration of Bond A with highest maturity and highest weight has increased thereby increasing the duration of the portfolio and since it is slightly beyond 6 years the liability is not immunized.

(iv) New percentage ofB and C: Let x₁ be the investment in Bond B and there-fore investment in Bond C shall be (1- 0.45 – x₁) as 45% is invested in Bond A. The proportion of investment in these two bonds shall be computed as follows:
Required duration
= [0.45x Duration of Bond A]+ [x₁ × Duration of Bond B] + [(0.55 – x₁) × Duration of Bond C] = 6
= 0.45 × 7.15 + x₁(6.03)+ (0.55 – x₁) 4.27
= 6 3.2175 + 6.03x₁ + 2.3485 – 4.27x₁
= 6 5.566 + 1.76x = 6 1.76x₁ = 0.434
x = 0.2466 = 24.66%
Therefore, 45% investment should be made in Bond A, 24.66% investment should be made in Bond B and balance 30.34% in Bond C.
Weighted Duration = W_A (D_A) + W_B (D_B) + W_C (D_C)
= 0.45(7.15) + 0.2466(6.03) + 0.3034(4.27)
= 6 Yrs.

Question 13.
The following data is available for a bond:

Face value	₹ 1,000
Coupon Rate	11%
Years to Maturity	6
Redemption Value	₹ 1,000
Yield to Maturity	15%

(Round-off your answers to 3 decimals)
Calculate the following in respect of the bond:
(i) Current Market Price.
(ii) Duration of the Bond.
(iii) Volatility of the Bond.
(iv) Expected market price if increase in required yield is by 100 basis points,
(v) Expected market price if decrease in required yield is by 75 basis points. [Nov. 2015] [5 Marks]
Answer:
(i) Current Market Price = \(\frac{\text { Coupon Interest }}{\text { Yield } \%}\)
= \(\frac{110}{15 \%}\)
= ₹ 733.33

(ii) Determination of Duration of the Bond:
The following steps are to be taken:
Step 1 Calculation of YTM (Yield to maturity).
It is given in the question as 1596
Step 2 Calculation of Duration.
The duration of a bond is the weighted average of the time it takes to return the investor’s money. The present values of cash flows are to be taken as weights (w).

Duration = \(\frac{\text { Weighted Time }}{\text { Purchase Price }}=\frac{\sum a d}{\sum d}=\frac{\text { Rs. } 3883.10}{\text { Rs. } 848.59}\)4.576 Yrs.
Alternative Method for determination of Duration:

Formula method	Where,
Duration = \( \frac{1+y}{y}=\frac{(1+y)+\text { Period }(c-y)}{c\left[(1+y)^{\text {Period }}-1\right]+y} \)	y = Yield to maturity c = Coupon rate

Duration = \(\frac{1+0.15}{0.15}-\frac{(1+0.15)+6(0.11-0.15)}{0.11\left[(1+0.15)^6-1\right]+0.15}\)
= \(\frac{1.15}{0.15}-\frac{0.91}{02944}\)
= 7.6667 – 3.091 = 4.576 Years (approx.)

(iii) Volatility of the Bond

The negative sign indicates that the price will be inversely related to the change in interest rates and the number 3.979 indicates the magnitude of the sensitivity. This means that for every 100 basis points i.e. 1% rise in interest rates the price of the bond will fall approximately by 3.979% and vice versa.

(iv) Expected Market price if increase in requiredyield is by 100 basis points
= (-) 3.979 × \(\frac{100}{100}\) = -3.979%
848. 59 × 3.979% = ₹ 33.77
= Then Market Price will fall by Rs. 33.77 and it will be = 848.59 – 33.77
= ₹ 814.82

(v) Expected Market Price if Decrease in requiredyield is by 75 basis points
(-) 3.979 × \(\frac{100}{100}\) = 2.984%
= 848.59 × 2.984% = 25.32
= Therefore Market Price will rise by Rs. 25.32 and it will be = 848.59 + 25.32 = ? 873.91

Question 14.
XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1, 2007. These debentures have a face value of ? 100 and is currently traded in the market at a price of ₹ 90.
Interest on these NCD will be paid through post-dated cheques dated June 30 and December 31. Interest payments for the first 3 years will be paid in advance though post-dated cheques while for the last 2 years, post-dated cheques will be issued at the third year. The bond is redeemable at par on December 31, 2011 at the end of 5 years.
Required:
(i) Estimated the current yield at the YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the realized yield on the NCD. [Nov. 2008] [6 Marks]
Answer:
(i) Current yield:
= (Coupon Interest/Market Price) × 100= (14/90) × 100 = 15.55%

(ii) Determination of Duration of the Bond:
The following steps are to be taken:
Step 1: Calculation of YTM (Yield to maturity).
YTM in this case shall be calculated by interpolation. Since, the coupon rate is 1% half yearly and bond is redeemable at par, and the price of the bond is Rs. 90 i.e. the bond is selling below par therefore the YTM will be more than 1% half yearly and as per the current yield also it is 15.55% p.a so the first trial is assumed at 7.5%.
Half yearly Interest (I) = Rs. 100 × = Rs. 7
Redemption Value (RV) = Rs. 100
Maturity Period (n)= 5 Years =10 half years

Accordingly, Present value of future inflows can be calculated as
= ₹ 7 (PVIFA_{(7.5%, 10)}) + ₹ 100 × PVIF_(7.5%,10)
= ₹ 7 × 6.8641 + ₹ 100 × 0. 4852
= ₹ 48.0487 + 48.52
= ₹ 96.568

Alternative Method

Since the present value is required to be brought down, the next trial should be at higher rate of interest. Taking 9%, the present value will be:
= ₹ 7 × PVIFA_{(9% 10)} + ₹ 100 × PVIF_{(9% 10)}
= ₹ 7 × 6.418 + ₹ 100 × 0.4224
= ₹ 44.93 + 42.24
= ₹ 87.17

Calculation of Yield to Maturity (YTM):

Yield	Value (Rs.)
7.5%	96.57
9uo	87.17

YTM at Rs. 90 can be calculated using interpolation as pei the manner given below
By interpolation, the YTM is
= 7.5% + \(\frac{96.57-90}{96.57-87.17}\) × (9% – 7.5%)
= 7.5% + \(\frac{6.57}{9.4}\) × (1.5%)
= 8.548% semi annual
Therefore, annualized ytm = 8.548% × 2=17.10% app.

Step 2: Calculation of Duration.
The duration of a bond is the weighted average of the time it takes to return the investor’s money. The present values of cash flows are to be taken as weights (w).

= 3.682 yrs.

Alternative Method for determination of Duration:

Formula Method	Where,
Duration = \( \frac{1+y}{y}-\frac{(1+y)+\text { Period }(c-y)}{c\left[(1+y)^{\text {Period }}-1\right]+y} \)	Y = Yelid to maturity c = Coupon rate

Duration = \(\frac{1+0.0855}{0.0855}-\frac{(1+0.0855)+10(0.07-0.0855)}{0.07\left[(1+0.0855)^{10}-1\right]+0.0855}\)
= \(\frac{1.0855}{0.0855}-\frac{0.9305}{0.1745}\)
= 12.696 – 5.332= 7.364 half Years (approx.) = \(\frac{7.364}{2}\) = 3.682 year

(i) If the interest received is not reinvested then realized yield can be calcu-lated as follows:
Half yearly Interest (I) = Rs. 100 × \(\frac{7}{100}\) = Rs. 7

(ii) Redemption Value (RV) = Rs. 100

(iii) Maturity Period (n) = 5 Years =10 half years

(iv) Total amount from interest = 7 × 10 = Rs. 70
Total realized Value = Rs. 170
Realized Yield. 170 = 90 (1 + r)5
Solving for r:
r = 13.5696

Question 15.
The Nominal value of 12% bonds issued by a company is Rs.100. The bonds are redeemable at Rs. 105 at the end of year 5. Coupons are paid annually.
Determine the duration and convexity of the bond at required annual yield rate of 10%. [Practice question]
Answer:
(i) Determination of duration and convexity of the bond:

Question 16.
The following is the yield structure of AAA rated debenture:
Period-Yield (%)
3 months-8.5%.
6 months-9.25
1 year-10.50
2 years-11.25
3 years and above-12.00
(i) Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, w hat will be the percentage change in the price of the bond having a maturity of 5 years? Assume that the bond is fairly priced at the moment at ₹ 1,000. [Nov. 2008] [4 Marks]
Answer:
(i) Implicit 1 year forward rates for year 2 and year 3

(ii) If fairly priced at ₹ 1,000 and rate of interest increases to 12.596, the percentage change will be as follows:

Question 17.
Consider the following data for Government Securities:

Calculate the forward interest rates. [May 2010] [8 Marks]
Answer:
To get forward interest rates,
(i) For 1 year, the one year Government Security.
₹ 91,000 = ₹ 1,00,000/(1 + r)
r = 0.099
r = 9.9%

(ii) The two years Government Security
₹ 99,000 = (₹ 10,500/1.099) + (₹ 1,10,500/(1.099) (1+r))
r = 0.124
r = 12.4%

(iii) The three years Government Security
₹ 99,500 = (11,000/1.099) + [(₹ 11,000/1.099) (1.124)] + [(₹ 1,11,000/1.099) (1.124(1 +r)]
r = 0.115
r = 11.5%

(iv) The four years Government Security
₹ 99,000 = (₹ 11,500/1.099) + [(₹ 11,500/1.099) (1.124)] + [(₹? 11,500/1.099) (1.124) (1.115)] + [(₹ 1,11,500/1.099) (1.124) (1.115) (1 + r)]
r = 0.128
r = 12.8%

Question 18.
Sonic Ltd. issued 8% 5 year bonds of Rs. 1,000 each having a maturity of 3 year. The present rate of interest is 12% for one year tenure. It is expected that forward rate of interest for one year tenure is going to fall by 75 basis points and further by 50 basis points for next year. This bond has a beta value of 1.02 and is more popular in the market due to less credit risk.
Calculate:
(i) Intrinsic value of bond.
(ii) Expected price of bond in the market. [Nov. 2013] [Nov. 2018 old syllabus] [5 Marks]
Answer:
The following information is available :

Face Value	1000
Coupon rate	8%
Remaining Life	3 Years
Present rate of Interest	12%
Forward rate after one year	11.25% (12 – 0.75)
Forward rate after 2 years	10.75% (11.25 – 0.50)
Beta	1.02

(i) Intrinsic Value of the Bond:

The intrinsic value of the Bond is Rs. 918.27

(ii) Expected Price of the Bond:
= Intrinsic value × Beta
= 918.27 × 1.02
= Rs. 936.64

Question 19.
Sabanam Ltd. has issued convertible debenture with coupon rate 11%. Each debenture has an option to convert to 16 equity shares at any time until the date of maturity. Debentures will be redeemed at Rs.100 on maturity after 5 years. An investor generally requires a rate of return of 8% p.a. on a 5 year security. As an advisor, when will you advise the investor to exercise conversion for given market prices of the equity share of (i) Rs. 5 (ii) Rs. 6 and (iii) Rs. 7.10. [May 2018 New syllabus] [8 Marks]

Cumulative PV factor for 8% for 5 year	3.993
P.V factor for 8% for year 5	0.681

Answer:
The value of Debentures if conversion option is not exercised:
Artnual Interest (I) = Rs. 100 × \(\frac{11}{100}\) = Rs. 11
Redemption Value (RV) = Rs. 100
Maturity Period (n) = 5 Years

Accordingly, Present value of future inflows can be calculated as
= Rs. 11 PVIFA_(8%5) + Rs. 100 PVIF_{(8% 5)}
= Rs. 11 3.993 + Rs. 100 0.681
= Rs. 43.923 + 68.10
= Rs. 112.023

The value of Shares if conversion option is exercised at various prices:

S. No.	If the price of the share is	Com ersion Value
(i)	R.s. 5	Rs. 80 (5 × 16)
(ii)	Rs. 6	Rs. 96 (6 × 16)
(iii)	Rs. 7.10	Rs. 113.60(7.1 × 16)

Conclusion: Conversion value is more than straight value of the bond only at the price of Rs. 7.10, therefore the conversion option is exercisable only if the share price is Rs. 7.10.

Question 20.
Pineapple Ltd. has Issued fully convertible 12 per cent debentures of ₹ 5,000 face value, convertible into 10 equity shares. The current market price of the debentures is ₹ 5,400. The present market price of equity shares is ₹ 430.
Calculate:
(i) The conversion value [3 Marks]
(ii) The conversion percentage premium [Nov. 2011] [3 Marks]
Answer:The following information is given in the question:
Face Value of the Debenture : Rs. 5,000
Coupon Rate : 12%
Conversion Ratio: 10 Equity Shares for 1 Debenture
Market Price of the Debenture Rs. 5,400
Market Price of Equity Share Rs. 430

(i) Calculation of Conversion Value per Debenture:
Conversion Value of Debenture = Value of Shares received per debenture
= Market Price per share × Conversion Ratio
= 430 × 10
= Rs. 4,300

(ii) Calculation of Conversion Percentage premium:
Market Conversion Price = \(\frac{\text { Market Price of the Debenture }}{\text { Conversion Ratio }}\)
= \(\frac{R s .5,400}{10}\) = Rs. 540

Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 540 – Rs. 430
= Rs. 110

Conversion Premium per Share = \(\frac{\text { Conversion Premium per Share }}{\text { Market Price per Share }}\)
= \(\frac{R s .110}{430}\) × 100
= 25.58%

Question 21.
The data given below relates to a convertible bond:

Face Value	₹ 250
Coupon rates	12%
No. of shares per bond	20
Market price of share	₹ 12
Straight value of bond	₹ 235
Market price of convertible bond	₹265

Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock. [Nov. 2008] [8 Marks]
Answer:
The following information is given in the question:
Face Value of the Bond : Rs. 250
Coupon Rate : 12%
Conversion Ratio : 20
Equity Shares for 1 Bond
Market Price of the Convertible Bond : Rs. 265
Market Price of Equity Share : Rs. 12
Straight Value of Bond : Rs. 235
(i) Calculation of Stock Value or Conversion Value of Bond:
Conversion Value of Bond = Value of Shares received per Bond
= Market Price per share × Conversion Ratio
= 12 × 20 = Rs. 240

(ii) Percentage of Down side Risk
Market Price of the Bond = \(\frac{\text { Market Price of the Bond-Straight Value of the Bond }}{\text { Straight Value of the Bond }} \) × 100
= \(\frac{R s .265-235}{235}\) × 100
= 12.77%

(iii) Calculation of Conversion Percentage premium:
Market Conversion Price = \(=\frac{\text { Market Price of the Bond }}{\text { Conversion Ratio }}\) × 100
= \(\frac{R s .265}{20}\) = Rs. 13.25

Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 13.25 – Rs. 12
= Rs. 1.25

Conversion Percentage Premium = \(\frac{\text { Conversion Premium per Share }}{\text { Market Price per Share }}\)
= \(\frac{R s .1 .25}{12}\) × 100
= 10.42%

(iv) The Conversion Parity Price Or the Market Conversion Price
Market Conversion Price = \(\frac{\text { Market Price of the Bond }}{\text { Conversion Ratio }}\)
= \(\frac{R s .265}{20}\) = Rs. 13.25

Question 22.
The following is the data related to 9% fully convertible (into equity shares) debentures issued by Delta Ltd. at Rs.1000

Market price of 9% Debenture Rs.	1,000
Conversion Ratio (No. of shares)	25
Straight value of 9% Debentures	800
Market price of Equity share on the date of conversion Rs.	30
Expected Dividend per share Rs.	1

Calculate:
(а) Conversion value of Debenture;
(b) Market conversion Price;
(c) Conversion premium per share;
(d) Ratio of conversion premium;
(e) Premium over straight value of Debenture;
(f) Favourable income differential per share and
(g) Premium pay back period
Answer:
The following information is given in the question:

Face Value of the Debenture : Rs. 1,000
Market price of the debenture : Rs. 1,000
Coupon Rate : 9%
Conversion Ratio : 25 Equity Shares for 1 debenture
Expected dividend per share : Re. 1
Market Price of Equity Share : Rs. 30
Straight Value of 9% debenture : Rs. 800

(a) Calculation of Stock Value or Conversion Value of Debenture:
Market Price of one equity share × Conversion ratio = 30 × 25
= Rs. 750.

(b) Market Price of the debenture = \(\frac{\text { Market Price of the debenture }}{\text { Conversion Ratio }}\)
= \(\frac{\text { Rs. } 1000}{25}\) = Rs. 40

(c) Calculation of Conversion premium:
Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 40 – Rs. 30
= Rs. 10

(d) Ratio of conversion Premium
\(\frac{\text { Premium per share }}{\text { Price of the share }} \) × 100
= \(\frac{\text { Rs. } 10}{30}\) × 100
= 33.33%

(e) Premium over straight value of debenture
Market Conversion Price of the Share- Straight Price of the share based on straight value of bond i.e. Rs. 800/25 = 32
= Rs. 8 per share
= \(\frac{\text { Rs. } 8}{32}\) × 100 = 25%
Or
\(\frac{\text { Market Price of the debenture }}{\text { Straight value of debenture }}\) – 1 = (\(\frac{R s .1000}{800}\) – 1) × 100 = 25%

(f) Favourable income differential per Share:
\(\frac{\text { Coupon interest from debenture }- \text { Conversion ratio } \times \text { Expected dividend per share }}{\text { Conversion ratio }}\) × 100
= \(\frac{90-25 \times 1}{25}\) = Rs. 2.6

(g) Premium pay back period
\(\frac{\text { Conversion premium per share }}{\text { Favourable income differential per share }}=\frac{\text { Rs.10 }}{\text { Rs.2.6 }}\) = 3.846 years

Question 23.
The following is the data related to 8.5% fully convertible (into equity shares) debentures issued by JAC Ltd. at Rs.1000

Market price of 9% Debenture Rs.	900
Conversion Ratio (No. of shares)	30
Straight value of 9% Debentures	700
Market price of Equity share on the date of conversion Rs.	25
Expected Dividend per share Re.	2

Calculated:
(a) Conversion value of Debenture;
(b) Market conversion Price;
(c) Conversion premium per share;
(d) Ratio of conversion premium;
(e) Premium over straight value of Debenture
(f) Favourable income differential per share; and
(g) Premium pay back period [Mock Test August 2018] [8 Marks]
Answer:
The following information is given in the question:
Face Value of the Debenture : Rs. 1,000
Market price of the debenture : Rs. 900
Coupon Rate Conversion Ratio : 8.5%
Expected dividend per share : 30
Equity Shares for 1 debenture : Re. 1
Market Price of Equity Share : Rs. 25
Straight Value of 9% debenture : Rs. 700
(a) Calculation of Stock Value or Conversion Value of Debenture:
Market Price of one equity share × Conversion ratio = 25 × 30 = Rs. 750.

(b) Market Conversion Price = \(\frac{\text { Market Price of the debenture }}{\text { Conversion Ratio }}\)
= \(\frac{\text { Rs. } 900}{30}\) = Rs. 30

(c) Calculation of Conversion premium:
Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 30 – Rs. 25 = Rs. 5

(d) Ratio of conversion Premium
\(\frac{\text { Premium per share }}{\text { Price of the share }}\) × 100 = \(\frac{\text { Rs. } 5}{25}\) × 100 = 20%

(e) Premium over straight value of debenture
Market Conversion Price of the Share – Straight Price of the share based on straight value of bond i.e. Rs. 700/30 = 23.33
Rs. 30 – Rs. 23.33 = Rs. 6.67 per share
= \(\frac{R s .6 .67}{23.33}\) × 100 = 28.60% approx.

Or \(\frac{\text { Market Price of the debenture }}{\text { Straight value of debenture }}\) – 1 = [\(\frac{R s .900}{700}\) – 1] × 100 = 28.57%

(f) Favourable income differential per share:
\(\frac{\text { Coupon interest from debenture }- \text { Conversion ratio } \times \text { Expected dividend per share }}{\text { Conversion ratio }}\) × 100

(g) Premium pay back period
\(\frac{\text { Conversion premium per share }}{\text { Favourable income differential per share }}=\frac{\text { Rs. } 5}{\text { Rs. } 1.833}\) = 2.73 vears

Question 24.
GUI Ltd., AAA rated company has issued fully convertible bonds on the following terms, a year ago:
Face value of bond : ₹ 1,000
Coupon (interest rate) : 8.5%
Time to Maturity (remaining) : 3 years
Interest Payment : Annual at the end of year
Principal Repayment : At the end of bond maturity
Conversion ratio (No. of shares per bond) : 25
Current market price per share : ₹ 45
Market price of convertible bond : ₹ 1, 175
AAA rated company can issue plain vanilla bonds without corn ersion option at an interest rate of 9.5%.
Required:
Calculate as of today:
(i) Straight Value of bond.
(ii) Conversion Value of the bond.
(iii) Conversion Premium.
(iv) Percentage of downside risk,
(v) Conversion Parity Price.

[May 2014] [4 + 1 + 1 + 1 + 1 = 8 Marks]
Answer:
The following information is given in the question:
Face Value of the Bond : Rs. 1, 000
Coupon Rate : 85%
Conversion Ratio : 25 Equity Shares for 1 bond
Market Price of the Convertible : Rs. 1, 175
Bond Market Price of Equity Share : Rs. 45
Remaining life of Bond ie. Maturity : 3yrs
Interest payments : Anuual
Redemption at maturity : At par
This question is different from previous as the straight value of Bond is required to be calculated and therefore maturity period and redemption price is also given in the question.
(i) Calculation of Straight Value of Bond
The present value of future inflows (comprising both interest as well as redemption value) discounted at 9.5% is the straight value of the Bond.
Annual Interest (I) = Rs. 1000 × \(\frac{8.5}{100}\) = Rs. 85
Redemption Value (RV) = Rs. 1000
Maturity Period (n) = 3 Years

Accordingly, Present value of future inflows can be calculated as
= ₹ 85 × PVIFA (9.5%,3) + ₹ 1000 × PVIF (9.5%,3)
= ₹ 85 × 2.5089 + ₹ 1000 × 0.7617
= ₹ 213.26 + 761.7 = ₹ 974.96

(ii) Calculation of Stock Value or Conversion Value of Bond:
Conversion Value of Bond = Value of Shares received per Bond
= Market Price per share × Conversion Ratio
= 25 × 45
= Rs. 1125

(iii) Calculation of Conversion premium:
Market Conversion Price = \(\frac{\text { Market Price of the Bond }}{\text { Conversion Ratio }}\)
= \(\frac{\mathrm{Rs} .1175}{25}\) = Rs. 47

Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 47 – Rs. 45
= Rs. 2

(iv) Percentage of Down side Risk
\(\frac{\text { Market Price of the Bond }- \text { Straight Value of the Bond }}{\text { Straight Value of the Bond }}\) × 100
= \(\frac{\text { Rs. } 1175-974.96}{974.96}\) × 100 = 20.52%

(v) The Conversion Parity Price or the Market Conversion Price
Market Conversion Price = \(\frac{\text { Market Price of the Bond }}{\text { Conversion Ratio }}\)
= \(\frac{\text { Rs. } 1175}{25}\) = Rs. 47

Question 25.
A Ltd. has issued convertible bonds, which carries a coupon rate of 14%. Each bond is convertible into 20 equity shares of the company A Ltd. The prevailing interest rate for similar credit rating bond is 8%. The convertible bond has 5 years maturity. It is redeemable at part at ? 100.

You are required to estimate:
(Calculations be made up-to 3 decimal places)
(i) current market price of the bond, assuming it being equal to its funda-mental value;
(ii) Minimum market price of equity share at which bond holder should exercise conversion option; and
(iii) duration of the bond.
Answer:
The following information is given in the question:
Face Value of the Bond : Rs. 100
Coupon Rate : 14%
Conversion Ratio : 20 Equity Shares for 1 Bond
Remaining life of Bond i.e. Maturity : 5 yrs.
Interest payments : Annual
Redemption at maturity : At Par

(i) Calculation of Current Market Price or the Straight Value of Bond
The present value of future inflows (comprising both interest as well as redemption value; discounted at 8% is the market price or the straight value of the Bond.
Annual Interest (I) = Rs. 100 × \(\frac{14}{100}\) = Rs. 14
Redemption Value (RV) = Rs. 100
Maturity Period (n) = 5 Years
Accordingly, Present value of future inflows can be calculated as
= ₹ 14 × PVIFA (896,5) + ₹ 1000 × PVIF (8%,5)
= ₹ 14 × 3.993 + ₹ 100 × 0.681
= ₹ 55.902 + 68.1
= ₹ 124.002 = Rs. 124 (Approx.)

Alternatively:
Current Market Price of Bond

₹ 124

(ii) Minimum Price at which Bond holder should exercise Conversion:
It should be the Market conversion price which is calculated as below:
\(\frac{\text { Market Price of the Bond }}{\text { Conversion ratio }}=\frac{124.002}{20 \text { shares }}\) = ₹ 6.20 Per Share

(iii) Duration of Bond (Formula method)
Formula method
Duration = \(\frac{1+y}{y}-\frac{(1+y)+\text { Period }(c-y)}{c\left[(1+y)^{\text {Period }}-1\right]+y}\)

Where,
y = Yield to maturity
c = Coupon rate

Duration = \(\frac{1+0.08}{0.08}-\frac{(1+0.08)+5(0.14-0.08)}{0.14\left[(1+0.08)^5-1\right]+0.08}\)
= \(\frac{1.08}{0.08}-\frac{1.38}{0.1457}\)
= 13.5 – 9.472 = 4.028 Years (approx)

Question 26.
XYZ company has current earnings of 13 per share with 5,00,000 shares outstanding. The company plans to issue 40,000, 7% convertible preference shares of ₹ 50 each at par. The preference shares are convertible into 2 shares for each preference shares held. The equity share has a current market price of ₹ 21 per share.
(i) What is preference shares’ conversion value?
(ii) What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of the Issue on the basic earning per share (a) before conversion (b) after conversion.
(iv) If profits after tax increases by ₹ 1 million what will be the basic EPS
(a) before conversion and (b) on a fully diluted basis? [Nov. 2009] [8 Marks]
Answer:
The following information is given in the question:
Face Value of the Share : Rs. 50 1%
Rate of Preference Share : 7%
Conversion Ratio : 2 Equity Shares for 1 Preference Share
Market Price of the Preference Share : Rs. 50
Market Price of Equity Share : Rs. 21
No. of Equity Shares Outstanding : 5,0, 000
EPS : Rs. 3 per Share
Total number of convertible preference shares to be issued : 40,000

(i) Calculation of Conversion Value of Preference Shares:
Conversion Value of Pref. Share = Value of equity Shares received per Pref. Share
= Market Price per Equity share × Conversion Ratio
= Rs. 21 × 2 = Rs. 42

(it) Calculation of Conversion Percentage premiunv
Market Conversion Price = \(\frac{\text { Market Price of the Pref. Share }}{\text { Conversion Ratio }}\)
= \(\frac{R s .50}{2}\) = Rs. 25
Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 25 – Rs. 21 = Rs. 4
Conversion Percentage Permium = \(\frac{\text { Conversion Premium per Share }}{\text { Market Price per Share }}\)
= \(\frac{R s .4}{21}\) × 100
= 19.05%

(iii) Statement of EPS before Conversion

Particulars	Amount (₹)
Total earning [3 × 5,00,000]	15,00,000
(-) Preference dividend (40,000 × 50 × 1%)	(1,40,000)
Earnings for Equity Shareholders	13,60,000
No. of Equity Shares	5,00,000
EPS	2.72

Statement of EPS After Conversion

Particulars	Amount (₹)
Total earning No. of Equity shares [5,00,000 + (40,000 × 2)]	15,00,000 5,80,000
EPS	2.586

(iv) If Profits increase by 10 Lakhs
Statement of EPS before Conversion

Particulars	Amount (₹)
Total earning [(3 × 5,00,000) + 10,00,000] (-) Preference dividend Earnings for Equity Shareholder No. of Equity Shares	25,00,000 (1,40,000)
	23,60,000 5,00,000
EPS	4.72

Statement of EPS after Conversion

Particulars	Amount (₹)
Total earning No. of Equity Shares [5,00,000 + (40,000 × 2)]	25,00,000 5,80,000
EPS	4.31

Question 27.
P Ltd. has current earnings of ₹ 6 per share with 10,00,000 shares outstanding. The company plans to issue 80,000,8% convertible preference shares of ₹ 100 each at par. The preference shares are convertible into 2 equity shares for each preference share held. The equity share has a current market price of ₹ 42 per share. Calculate:
(i) What is preference share’s conversion value?
(ii) What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of the issue on the basic earnings per share (A) before conversion (B), after conversion.
(iv) If profits after tax Increases by ₹ 20 Lakhs what will be the basic EPS, (A) before conversion and (B) on a fully diluted basis? [May 2017] [8 Marks]
Answer:
The following information is given in the question:
Face Value of the Share : Rs. 100
Rate of Preference Dividend : 8%
Conversion Ratio : 2 2 Equity Shares for 1 Preference Share
Market Price of the Preference Share : Rs. 100
Market Price of Equity Share : Rs. 42
No. of Equity Shares Outstanding : 10,00,000
EPS : Rs. 6 per shares
Total number of convertible preference shares to be issued : 80,000

(i) Calculation of Conversion Value of Preference Shares:
Conversion Value of Pref. Share = Value of equity Shares received per Pref. Share
= Market Price per Equity share × Conversion Ratio
= Rs. 42 × 2 = Rs. 84

(ii) Calculation of Conversion Percentage premium:
Market Conversion Price = \(\frac{\text { Market Price of the Pref. Share }}{\text { Conversion Ratio }}\)
= \(\frac{\mathrm{Rs} \cdot 100}{2}\) = Rs. 50
Conversion Premium per Share = Market Conversion Price – Market Price per Share
= Rs. 50 – Rs. 42 = Rs. 8
Conversion Premium Premium = \(=\frac{\text { Conversion Premium per Share }}{\text { Market Price per Share }}\)
= \(\frac{\text { Rs. } 8}{42}\) = 19.05%

(iii) Statement of EPS before Conversion

Particulars	Amount (₹)
Total earning [6 X 10,00,0001 (-) Preference dividend (80,000 × 100 × 8%)Earnings for Equity Shareholders No. of Equity Shares	60,00,000 (6,40,000)
	53,60,000 10,00,000
	5.36

Statement of EPS after Conversion

Particulars	Amount (₹)
Total earning No. of Equity shares (10,00,000 + (80,000 × 2)]	60,00,000 11,60,000
EPS	5.17

(iv) If Profits increase by 20 Lakhs
Statement of EPS before Conversion

Particulars	Amount (₹)
Total earning [6 × 10,00,0001 + 20,00,000] (-) Preference dividend (80,000 × 100 × 8%)Earnings for Equity Shareholder No. of Equity Shares	80,00,000 (6,40,000)
	73,63,000 10,00,000
EPS	7.36

Statement of EPS after Conversion

Particulars	Amount (₹)
Total earning No. of Equity Shares [10,00,000 + (80,000 × 2)]	80,00,000 11,60,000
EPS	6.90

Question 28.
ABC Ltd. has ₹ 300 million, 12 per cent bonds outstanding with six years remaining to maturity. Since interest rates are falling, ABC Ltd. is contemplating of refunding these bonds with a ₹ 300 million issue of 6 year bonds carrying a coupon rate of 10 per cent. Issue cost of the new bonds will be ₹ 6 million and the call premium is 4 per cent. ₹ 9 million being the unamortized portion of issue cost of old bonds can be written off no sooner the old bonds are called off. Marginal tax rate of ABC Ltd. is 30 per cent. You are required to analyse the bond refunding decision. [May 2009] [6 Marks]
Answer:
1. Calculation of initial outlay:

	₹ (million)
a. Face value	300
Add: Call premium	12
Cost of calling old bonds	312
b. Gross proceed of new issue	300
Less: Issue costs	6
Net proceeds of new issue	294
c. Tax savings on call premium and unamortized cost 0.30 (12 + 9)	6.3
Initial outlay = ₹ 312 million – ₹ 294 million – ₹ 6.3 million = ₹ 11.7 million	6.3

2. Calculations of net present value of refunding the bond:

Saving in annual interest expenses	7 (million)
[300 × (0.12-0.10)] Less: Tax saving on interest and amortization	6.00
0.30 × [6 + (9 – 6)/6]	1.95
Annual net cash saving	4.05
PVIFA (7% 6 years)	4.766
Present value of net annual cash saving	= ₹ 19.30 million
Less: Initial outlay	= ₹ 11.70 million
Net present value of refunding the bond Decision: The bonds should be refunded.	₹ 7.60 million

Question 29.
M/s. Earth Limited has 11% bond worth of ₹ 2 crores outstanding with 10 years remaining to maturity.
The company is contemplating the issue of a ₹ 2 crores 10 years bond carrying the coupon rate of 9% and use the proceeds to liquidate the old bonds.
The unamortized portion of issue cost on the old bonds is ₹ 3 lakhs which can be written off no sooner the old bonds are called. The company is paying 30% tax and it’s after tax cost of debt is 7%. Should Earth Limited liquidate the old bonds?
You may assume that the issue cost of the new bonds with be ₹ 2.5 lakhs and the call premium is 5%. [May 2013] [6 Marks]
Answer:
1. Computation of initial outlay:

		(₹ lakhs)
(a)	Face value	200.00
	Add: Call premium	10.00
	Cost of calling old bonds	210.00
(b)	Gross proceed of new issue	200.00
	Less: Issue costs	2.50
	Net proceeds of new issue	197.50
(c)	Tax savings on call premium and unamortized costs 0.30 (10 + 3)	3.90 lakhs
	Therefore, Initial outlay = ₹  210 lakhs – ₹  197.50 lakhs – ₹  3.90 lakhs

2. Computation of net present value of refunding the bond:

	₹ lakhs
Saving in annual interest expenses[₹ 200 (0.11 – 0.09)]	4.000
Less: Tax saving on interest and amortization 0.30 [4 + (3 – 2.5)/10]	1.215
Annual net cash saving	2.785
PVIFA (7%, 10 years)	7.024
Present value of net annual cash saving	₹ 19.56 lakhs
Less: Initial outlay	₹ 8.60 lakhs
Net present value of refunding the bond	₹ 10.96 lakhs

Decision, Since the NPV of refunding the bond is favourable, the bonds should be refunded.

Question 30.
Tangent Limited is considering calling Rs. 3 crores of 30 years, Rs. 1000 bond issued 5 years ago with a coupon interest rate of 14 per cent. The bonds have a call price of Rs. 1,150 and had initially collected proceeds of Rs. 2.91 crores since a discount of Rs. 30 per bond was offered. The initial floating cost was Rs. 3,90,000. The company intends to sell Rs. 3 crores of 12 per cent coupon rate, 25 years bonds to raise funds for retiring the old bonds. It proposes to sell the new bonds at their par value of Rs. 1,000. The estimated floatation cost is Rs. 4,25,000. The company is paying 40% tax and its after tax cost of debt is 8 per cent. As the new bonds must first be sold and then their proceeds to be Used to retire the old bonds, the company expects a two months period of overlapping interest during which interest must be paid on both the old and the new bonds. You are required to evaluate the bond retiring decision. [PVIFA_8%,25 = 10.675] [Nov. 2018] [8 Marks]
Answer:
1. Computation of initial outlay:

	(Rs. in lakhs)
(a) Face value	300.00
Add: Call premium	45.00
Cost of calling old bonds	345.00
(b) Gross proceed of new issue	300.00
Less: Issue costs	4.25
Net proceeds of new issue	295.75
(c) Tax savings on call premium and unamortized costs 0.40 (45+10.75)(W.N.)	22.30
(d) Overlapping Interest after tax (300 × 0.14 × \(\frac{2}{12}\)) (1-0.4)	= 4.2
Therefore, Initial outlay = ₹ 345 + 4.2 – (₹ 295.75 + 22.30) 31.15

2. Annual cash flow savings: (Rs. in Lakhs)
(a) Old bond

(i) Interest cost after tax (300 × 0.14)(1 – 0.4)	25.20
(ii) Tax saving on amortization of discount (9,00,000/30) (0.40)	0.12
(iii) Tax saving on amortization of floatation costs (390000/30)(0.40)	0.052
Annual cost	25.028

(b) New bond

(i) Interest cost after tax (300 × 0.12)(1 – 0.4)	21.60
(ii) Tax saving on amortisation of discount	Nil
(iii) Tax saving on amortisation of floatation costs (425000/25 × 0.40)	0.068

Annual cost

Saving in annual expenses Annual net cash saving (25.028 – 21.532)	3.496
PVIFA (8°o, 25 years)	10.675
∴ Present value of net annual cash saving	Rs. 37.31980 lakhs
Less: -Initial outlay	Rs. 31.15 lakhs
Net present value of refunding the bond	Rs. 6.1698 lakhs

Decision Since the NPV of refunding the bond is favourable, the bonds should be refunded.

Working Note:
UnamortizedDiscount and issue costs:

Question 51.
A firm had been paid dividend at ₹ 2 per share last year. The estimated growth of the dividends from the company is estimated to be 5% p.a. Determine the estimated market price of the equity share if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also find out the present market price of the share, given that the required rate of return of the equity investors is 15.5%. [Nov. 2009] [6 Marks]
Answer:
In this case the company has paid dividend of ₹ 2 per share during the last year.
The growth rate (g) is 5%. Then, the current year dividend (D₁) with the expected growth rate of 5°o will be = D₀( 1+g) = ₹ 2.10.
The share price is P₀ = \(\frac{D_1}{K_e-g}\)
= \(\frac{\text { Rs. } 2.10}{0.155-0.05}\)
= ₹ 20

In case the growth rate rises to 8% then the dividend for the current year. (Dt) would be ₹ 2.16 and market price would be
= \(\frac{R s .2 .16}{0.155-0.08}\)
= ₹ 28.80
In case growth rate falls to 3% then the dividend for the current year (D,) would be ₹ 2.06 and market price would be –
= \(\frac{R s .2 .06}{0.155-0.03}\)
= ₹ 16.48
Conclusion:
The market price of the share is expected to vary in response to change in expected growth rate in dividends.

Question 32.
Shares of Volga Ltd. are being quoted at a price-earnings ratio of 8 times. The company retains 50% of its Earnings per Share. The company’s EPS is Rs. 10.
You are required to determine:
(1) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) The indicative market price with the same cost of capital and if the anticipated growth rate is 16% p.a.
(3) The market price per share if the company’s cost of capital is 20% p.a. and the anticipated grow th rate is 18% p.a. [Nov. 2018] [8 Marks]
Answer:
(1) As per Dividend Discount Model approach the firm’s expected or required return on equity is computed as follows:
K_c = \(\frac{\text { Expected dividend at the end of year } 1\left(\mathbf{D}_1\right)}{\text { Current Market Price }\left(\mathbf{P}_0\right)}\) + Expected Growth Rate of Dividend
Current Market Price = P/E ratio × EPS = 8 × 10 = Rs. 80
D0= 50% of EPS and EPS is Rs. 10
Therefore, D0= Rs. 5.0
Expected Dj= Rs. 5(1.15) = Rs. 5.75
Since, K_e = \(\frac{D_1}{p}\) + g
Therefore, K_e = \(\frac{5.75}{80}\) + 15% = 0.071875 + 0.15 = 0.221875 = 22.19%

(2) When anticipated growth rate changes to 16% and Cost of capital as calcu¬lated in (i) above ie. 22.19%, the indicative market price will be as follows.
P = \(\frac{D_1}{K_e-g}=\frac{5(1.16)}{0.2219-0.16}\) = Rs. 93.70 approx

Question 33.
Shares of Voyage Ltd. are being quoted at a price-earnings ratio of 8 times. The company retains 45% of its earnings which are ₹ 5 per share.
You are required to compute
1. The cost of equity to the company if the market expects a growth rate of 15% p.a. [May 2011] [3 Marks]
2. If the anticipated growth rate is 16% per annum, calculate the indicative market price with the same cost of capital. [3 Marks]
3. If the company’s cost of capital is 20% p.a. and the anticipated growth rate is 19% p.a., calculate the market price per share. [2 Marks]
Answer:
1. Cost of Capital
Retained earnings (45%) = ₹ 5 per share
Therefore, Dividend= (100 – 45)= (55%) = ₹ 6.11 per share
EPS (100%) = ₹ 11.11 per share
P/E Ratio = 8 times
Market price EPS × PE Ratio = ₹ 11.11 × 8 = ₹ 88.88
P₀ = \(\frac{D_1}{K_e-g}\)
Ke = \(\frac{R s .6 .11}{R s .88 .88}\) + 0.15 = 21.87%

2. Market Price if growth rate is 16%
P₀ = \(\frac{D_1}{K_e-g}=\frac{R s .6 .11}{(21.87 \%-16 \%)}\) = 104.08 per share

3. Market Price if growth rate is 19% and cost of capital is 20%
= \(\frac{R s .6 .11}{(20-1996)}\) = ₹ 611.00 per share

Question 34.
A company has a book value per share of ₹ 137.80. Its return on equity is 15% and follows a policy of retaining 60 per cent of its annual earnings. If the opportunity cost of capital is 18 per cent, what is the price of its share? [adopt the perpetual growth model to arrive at your solution). [Nov. 2011] [5 Marks]
Answer:
The Company’s earnings and dividend per share after a year are expected to be:
EPS = ₹ 137.80 × 0.15 = ₹ 20.67
Dividend = 0.40 × 20.67 = ₹ 8.27
The growth in dividend would be: e = 0.6 × 0.15 = 0.09

Perpetual growth model Formula : P₀ = \(\frac{\text { Dividend }}{K_e-g}\)
P₀ = \(\frac{8.27}{0.18-0.09}\)
P₀ = ₹ 91.89

Question 35.
In December, 2011 AB Co.’s share was sold for ₹ 146 per share. A long term earnings growth rate of 7.5% is anticipated. AB Co. is expected to pay dividend of 7 3.36 per share.
(i) What rate of return an investor can expect to earn assuming that dividends are expected to grow along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that AB Co. will earn about 10% on book Equity and shall retain 60% of earnings. In this case, whether, there would be any change in grow th rate and cost of Equity? [May 2012] [6 Marks]
Answer:
(i) As per Dividend Discount Model approach the firm’s expected or required return on equity is computed as follows:
K_e = \(\frac{\text { Expected dividend at the end of year } 1\left(D_1\right)}{\text { Current Market Price }\left(P_0\right)}\) + Expected Growth Rate of Dividend
Therefore, K_e = \(\frac{3.36}{146}\) + 7.5%
= 0.230 + 0.075 = 0.098
K_e = 9.80%

(ii) When rate of return is 10% and retention ratio (b)is 60%, new growth rate will be as follows.
g = br
= 0.10 × 0.60 = 0.06
Thus dividend will also get changed and to calculate this, first we shall calculate previous retention ratio (b₁) and then EPS assuming that rate of return on equity (r) is same.
With previous Growth Rate of 7.5% and r= 10% the retention ratio comes out to be:
0.075 = b₁ × 0.10
b₁ = 0.75 and payout ratio = 0.25
With 0.25 payout ratio the EPS will be as follows:
\(\frac{3.36}{0.25}\) = 13.44
With new 0.40 (1 – 0.60) payout ratio the new dividend will be
D, = 13.44 × 0.40 = 5.376
Accordingly new K_e will be
K_e = \(\frac{5.376}{146}\) + 6.0%
K_e = 9.68%

Question 36.
Given the following information :

Current Dividend	₹ 5.00
Discount Rate	10%
Growth rate	2%

(i) Calculate the present value of the stock.
(ii) Is the stock over valued if the price is ₹ 40, ROE = 8% and EPS = ₹ 3.00
Show your calculations under the PE Multiple approach and Earnings Growth model. [Nov. 2012] [8 Marks]
Answer:
(i) Present Value of the Stock:
P₀ = \(\frac{5.00(1.02)}{0.10-0.02}\) = 63.75

(ii) Value of Stock under the PE Multiple Approach

Particulars	₹
Actual Stock Price	40.00
Return on equity	8%
EPS	3.00
PE Multiple (1/Return on Equity) =1/8%	12.50
Market Price per Share EPS × PE	37.50

Since, Actual Stock Price is higher, hence it is overvalued.

(iii) Value of the Stock under the Earnings Growth Model

Particulars	₹
Actual Stock Price	40.00
Return on equity	8%
EPS	3.00
Growth Rate	2%
Market Price per Share [EPS × (1+g)]/ (Ke -g) = ₹ 3.00 × 1.02/0.06	51.00

Since, Actual Stock Price is lower, hence it is undervalued.

Question 37.
X Limited, just declared a dividend of ? 14.00 per share. Mr. B is plan¬ning to purchase the share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three years. He also expects the market price of this share to be ? 360.00 after three years.
You are required to determine:
The maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per annum. [May 2013] [4 Marks]
(ii) The maximum price Mr. B will be willing to pay for share, if he is of the opinion that the 9% growth rate can be maintained indefinitely and require 13% rate of return per annum. [2 Marks]
(iii) The price of share at the end of three years, if 9% growth rate is achieved and assuming other conditions remaining same as in (ii) above.
Calculate rupee amount up to two decimal points.

	Year-1	Year-2	Year-3
FVIF @ 9%	1.090	1.188	1.295
FVIF @ 13%	1.130	1.277	1.443
PVlF @ 13%	0.885	0.783	0.693

Answer:
(i) Expected dividend for next 3 years.
Year 1 (D₁) ₹ 14.00 (1.09) = ₹ 15.26
Year 2 (D₂) ₹ 14.00 (1.09) = ₹ 16.63
Year 3 (D₃) ₹ 14.00 (1.09) = ₹ 18.13
Required rate of return = 13% (Ke)
Market price of share after 3 years = (P₃) = ₹ 360
The present value of share

P₀ = 15.26 (0.885) + 16.63 (0.783) + 18.13 (0.693) + 360 (0.693)
P₀ = 13.50 + 13.02 + 12.56 + 249.48
P₀ = ₹ 288.56

(ii) When the growth rate 9% is achieved for indefinite period, then maximum price of share should Mr. A willing be to pay is
P₀ = \(\frac{D_1}{(k e-g)}=\frac{R s .15 .26}{0.13-0.09}=\frac{R s .15 .26}{0.04}\) = ₹ 381.50

(iii) Assuming that conditions mentioned above remain same, the price expected after 3 years will be:
P₃ = \(\frac{D_4}{k_e-g}=\frac{D_3(1.09)}{0.13-0.09}=\frac{18.13 \times 1.09}{0.04}=\frac{19.76}{0.04}\) = Rs. 494

Question 38.
The shares of G Ltd. are currently being traded at Rs. 46. The company published its result for the year ended 31st March, 2019 and declared a dividend of Rs.5. The company made a return of 15% on its capital and expects that to be the norm in which it operates. G Ltd. also expects the dividends to grow at 10% for the first three years and thereafter at 5%.
You are required to advise whether the share of the company is being traded at a premium or discount.
PVIF @ 15% for the next 3 year is 0.870, 0.756 and 0.658 respectively. [May 2019][8 Marks]
Answer:
Expected dividend for next 3 years.
Year 1 (D₁) =Rs. 5.00 (1.10) = Rs. 5.50
Year 2 (D₂) =Rs. 5.00 (1.10)² = Rs. 6.05
Year 3 (D₃) =Rs. 5.00 (1.10)³ = Rs, 6.655
After 3rd year, the dividends will grow at a normal rate of 5% till perpe-tuity.
Therefore, dividend in the year 4, (D₄) = (D₃)(1.05) = Rs. 6.655 (1.05) = Rs. 6.98775
Required rate of return = 15% (Ke)
= Rs. 69.8775
The present value of share

P₀ = 5.50 (0.870) + 6.05 (0.756) + 6.655 (0.658) + 69.8775 (0.658)
P₀ = 4.785 + 4.5738 + 4.3790 + 45.9794
P₀ = Rs. 59.7172
The share of the company is traded at discount. The intrinsic value of the share is Rs. 59.7172 (ex-dividend), whereas, the share is being traded at a price of Rs. 46 (assuming, cum-dividend). Therefore, the share is traded at a discount.

Question 39.
An investor is considering purchasing the equity shares of LX Ltd. whose current market price (CMP) is Rs. 150. The Company is proposing a dividend of Rs. 6 for the next year. LX is expected to grow @18 per cent per annum for the next four years. The growth will decline linearly to 14 per cent per annum after first four years. Thereafter, it will stabilize at 14 per cent per annum infinitely. The required rate of return is 18 per cent per annum.
You are required to determine:
(i) The intrinsic value of one share
(ii) Whether it is worth to purchase the share at this price.

Answer:
(i) Expected dividend for next 8 years.

After 9th year, the dividends will grow at a normal rate of 14% till perpetuity. Required rate of return = 18% (Ke)
Market price of share after 8 years = (P_s) = \(\frac{(\mathrm{D} 9)}{k e-g}=\frac{20}{0.18-0.14}\) = Rs. 500.00
The present value of share = Sum of dividends + Present value of price after 8 years.
P₀ = \(\frac{D_1}{(1+k e)}+\frac{D_2}{(1+k e)^2}+\frac{D_3}{(1+k e)^3}+\frac{D_4}{(1+k e)^4}+\frac{D_5}{(1+k e)^5}+\frac{D_0}{(1+k e)^6}+\frac{D_7}{(1+k e)^7}+\frac{D_8}{(1+k e)^8}+\frac{P_8}{(1+k e)^8}\)
P₀ = 39.83 + \(\frac{500}{(1+0.18)^8}\)
P₀ = 39.83 + 500 (0.266)
P₀ = 39.83 + 133 = Rs. 172.83
The intrinsic value of the share is = Rs. 172.83

(ii) The share of the company is traded at discount. The intrinsic value of the share is Rs. 172.83 whereas, the share is being traded at a price of Rs. 150. Therefore, the share is worth purchasing.
Note: There are two issues in this question:
(a) ‘The PVIF values for year 4 are given twice and are different, therefore, it y should be year 5 and not year 4 (it must be a misprint in the paper). The correction has been done.
(b) The growth rate is declining linearly from 18°o to 14%. But the question is silent as to the period over which the growth will decline, therefore, it is assumed that the 4°o decline is to occur gradually over a period of 4 years.

Question 40.
The current EPS of M/s VEE Ltd. is Rs. 4. The company has shown an extraordinary growth of 40% in its earnings in the last few years. This high growth rate is likely to continue for the next 5 years after which growth rate in earnings will decline from 40% to 10% during the next 5 years and remain stable at 10% thereafter. The decline in the growth rate during the five year transition period will be equal and linear. Currently, the company’s pay-out ratio is 10%. It is likely to remain the same for the next five years and from the beginning of the sixth year till the end of the 10,h year, the pay-out will linearly increase and stabilize at 50% at the end of the 10th year. The post tax cost of capital is 17% and the PV factors are given below :

You are required to calculate the intrinsic value of the company’s stock based on expected dividend. If the current market price of the stock is Rs. 125, suggest if it is advisable for the investor to invest in the company’s stock or not. [Nov. 2019 Old Syllabus] [8 Marks]
Answer:
Expected dividend for next 10 years.

After 10th year, the dividends will grow at a normal rate of 10% till perpetuity.
Post tax cost of capital (Ke) = 17%
E₁₁ = E10 (1 + g) = 57.441 (1.10) = Rs. 63.186
D₁₁ = E₁₁ × Payout Ratio = 63.186 × 0.50
= Rs. 31.593
Market price of share after 10 years = (P₁₀) = \(\frac{\left(D_{11}\right)}{\mathrm{Ke}-\mathrm{g}}=\frac{31.593}{0.17-0.10}\) = Rs. 451.33
The present value of share (P₀) = Total PV of dividends + Present value of price after 10 years.
P₀ = 24.475 + 451.33 × (0.209)
P₀ = 24.475 + 94.33 = Rs. 118.80
The intrinsic value of the share is = Rs. 118.80
The intrinsic value of the share is Rs. 118.80 whereas, it is being traded at a price of Rs. 125.
The share of the company is traded at premium. Therefore, the investor is advised NOT to invest in this share.

Question 41.
A share of Tension – free Economy Ltd. is currently quoted at a price earnings ratio of 7.5 times. The retained earning being 37.5% is ₹ 3 per share.
Calculate:
(i) The company’s cost of equity, if investors’ expected rate of return is 12%.
(ii) Market price of share, if anticipated growth rate is 13% per annum with same cost of capital.
(iii) Market price per share, if the company’s cost of capital is 18% and anticipated growth rate is 15% per annum, assuming other conditions remaining the same. [Nov. 2013] [8 Marks]
Answer:
(i) Calculation of Cost of Capital: In the question investor’s expected rate of return can be assumed as rate of return on retained earnings and thus cost of equity shall be computed as follows:
g = b × r
g = 0.375 × 12% = 4.5%

Retained earnings	37.5%	₹ 3 per share
Dividend	62.5%	₹ 5 per share
EPS	100.0%	₹ 8 per share
P/E Ratio	7.5 times

Market price is ₹ 7.5 × 8 = ₹ 60 per share
Cost of equity capital = (Dividend/Price × 100) + growth %
= (5/60 × 100) + 4.59-6 = 12.8396
(\(\frac{R s .3}{37.5}\) + 62.5 = Rs. 5)
(ii) With the growth rate given (13%) the Market price of share shall become negative, which is not possible.
(iii) Market price = Dividend/(cost of equity capital % – growth rate %)
= 5/(18% – 15%)
= 5/3%
= ₹ 166.66 per share.

Question 42.
MNP Ltd. has declared and paid annual dividend of ? 4 per share. It is expected to grow @ 20% for the next two years and 10% thereafter.
The required rate of return of equity investors is 15%. Compute the current price at which equity shares should sell.
Note: Present Value Interest Factor (PVIF) @ 15%:
For year 1 = 0.8696;
For year 2 = 0.7561 [May 2014] [5 Marks]
Answer:
Dividend = ₹ 4 per share
growth rate = 20% for 2 years
10% thereafter
MV [Market Price] = \(\frac{D_1}{K_e-b r}\)

Years	Dividend
1	₹ 4 + 20% = 4.8
2	4.8 + 20% – 5.76
3	5.76 + 10% = 6.34

[P₂ = \(\frac{6.34}{15 \%-10 \%}=\frac{6.34}{5 \%}\)]
= ₹ 126.8 Price per share

PV of cash flows

Year	Cash Flow	Discounted Fac­tor	Discounted Cash Flow
1	4.8	0.8696	4.174
2	5.76	0.7561	4.355
2	126.8	0.7561	95.87
			104.402

Current price of the equity shares = ₹ 104.402 per share

Question 43.
XY Ltd., a Cement manufacturing Company has hired you as a financial consultant of the company. The Cement industry has been very stable for some time and the cement companies SK Ltd. & AS Ltd. are similar in size and have similar product market mix characteristic. Use comparable method to value the equity of XY Ltd. In performing analysis, use the following ratios:
(i) Market to book value
(ii) Market to replacement cost
(iii) Market to sales
(iv) Market to Net Income
The following data are available for your analysis:
(Amount in Rs.)

	SKLtd.	AS Ltd.	XY Ltd.
Market Value	450	400
Book Value	400	300	250
Replacement Cost	600	550	500
Sales	550	450	500
Net Income	18	16	14

[Nov. 2019 Old Syllabus] [5 Marks]
Answer:
Value of equity share of XY Ltd. using Comparable method and ratios.

Value of XY Ltd. share = Simple Average of the Price Calculated based on 4 ratios.
= \(\frac{307.25+369.25+426.50+350}{4}\)
= \(\frac{1453}{4}\) = Rs. 363.25

Question 44.
You are interested in buying some equity stocks of RK Ltd. The company has 3 divisions operating in different industries. Division A captures 10% of its industries sales which is forecasted to be Rs. 50 crore for the industry. Divisions B and C captures 30% and 20% of their respective industry’s sales, which are expected to be Rs. 20 crore and Rs.8.5 crore respectively. Davison A traditionally had a 5% net income margin, w’hereas divisions B and C had 8% and lOWnet income margin respectively. RK Ltd. has 3,00,000 shares of equity stock outstanding, which sell at Rs. 250.
The company has not paid dividend since it started its business 10 years ago. However from the market sources you come to know that RK Ltd. will start paying dividend in 3 years time and the pay-out ratio is 30%. Expecting this dividend, you would like to hold the stock for 5 years. By analyzing the past financial statements, you have determined that RK Ltd.’s required rate of return is 18% and that P/E ratio of 10 for the next year and on ending P/E ratio of 20 at the end of the fifth year are appropriate.
Required:
(i) Would you purchase RK Ltd. equity at this time based on your one year forecast ?
(ii) If you expect earnings to grow @ 15% continuously, how much are you willing to pay for the stock of RK Ltd. ?
Ignore taxation.
PV factors are given below :

[Nov. 2019 Old Syllabus] [8 Marks]
Answer:
(i) Calculation showing whether the share of RK Ltd. he purchased or not:

Current P/E Ratio:
Total Earnings = 25 Lac + 48 Lac + 17 Lac = Rs. 90,00,000
No. of Shares = Rs. 3,00,000
Market Price of (MPS) Share = 250
EPS = \(\frac{90,00,000}{3,00,000}\) = Rs. 30
PE = \(\frac{\mathrm{MPS}}{\mathrm{EPS}}\) = \(\frac{250}{30}\) = 8.33

The P.E. Ratio is expected to be 10 for the next year. As the Company is not paying any dividend and there is an increase in P/E Ratio, the price after 1 year = 30 × 10 = 300.
Return = \(\frac{\mathrm{P}_1-\mathrm{P}_0}{\mathrm{P}_0}\) × 100 = \(\frac{300-250}{250}\) × 100
The return is more than required return of 18%. Therefore, RK Ltd.’s share should be purchased.

(ii) Calculation of Price If the earnings will grow @ 15% till perpetuity:

After 5th year, the dividends will grow at a normal rate of 15% till perpetuity.
Past tax cost of capitals = 18% (Ke)
D₆ = D₅ (1+ g) = 18.10 (1.15) = 20.815
Market price of share after 5 years = (P₅) = \(\frac{\left(D_6\right)}{\mathrm{Ke}-\mathrm{g}}=\frac{20.815}{0.18-0.15}\) = Rs. 694
Approx.
The present value of share = Sum of dividends + Present value of price after 5 years.
P₀ = 24.37 + \(\frac{694}{(1+0.18)^5}\)
P₀ = 24.37 + 694 (0.437)
P₀ = 24.37 + 303.28 = Rs. 327.65
The intrinsic value of the share is = Rs. 327.65 this is amount than can be paid for the stock of RK Ltd. It may be noted that fifth year price may also be taken on the bases of P/E ratio of 20 as given in the question.

Question 45.
You are requested to find out the approximate dividend payment ratio as to have the Share Price at ₹ 56 by using Walter Model, based on following information available for a Company.

	₹
Net Profit	50 lakhs
Outstanding 10% Preference Shares	80 lakhs
1 Number of Equity Shares	5 lakhs
Return on Investment	15%
Cost of Capital (after Tax) (k )	12%

Answer:
Calculation of Dividend Payout ratio

56 × 0.12 = D + 10.5 – 1.25 D
6.72 – 10.5 = -0.25 D
D = 15.12

Question 46.
The following information relates to Maya Ltd.:

Earnings of the company	₹ 10,00,000
Dividend payout ratio	60%
No. of shares outstanding	2,00,000
Rate of return on investment	15%
Equity capitalization rate	12%

(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of company’s share at that payout ratio? [Nov. 2010] [8 Marks]
Answer:
(i) Computation of market-value per share as per Walter’s Model
P = \(\frac{D+\left(\frac{r}{k_e}\right)(E-D)}{k_e}\)
Market price per share
E = Earnings per share = ₹ 5
D = Dividend per share = ₹ 3
r = Return earned on investment = 15%
K_e = Cost of equity capital = 12%
∴ p = \(\frac{3+(5-3) \times \frac{0.15}{0.12}}{0.12}=\frac{3+2 \times \frac{15}{12}}{0.12}\) = Rs. 4.83

(ii) Optimum Dividend Pay out Ratio
As per Walter’s model, when the return on investment is more than the cost of equity capital the price per share increases as the dividend pay-out ratio decreases. Therefore, the optimum dividend pay-out ratio becomes zero. The market value of the company’s share will be :
= \(\frac{0+(5-0) \times \frac{.15}{.12}}{0.12}\) = ₹ 52.08

Question 47.
A company has an EPS of Rs. 2.5 for the last year and the DPS of Re.
1. The earnings is expected to grow at 2% a year in long run. Currently it is trading at 7 times its earnings. If the required rate of return is 14% compute
the following:
(i) An estimate of the P/E ratio using Gordon growth model.
(ii) The long-term growth rate implied by the current P/E ratio. [Nov. 2018] [8 Marks]
Answer:
Given:

Particulars
EPS0	2.5
DPS0	1
DPS1 = DPS0(l+g),	1(1.02) = 1.02
g	296
P.E Ratio	7%
Ke	14%

Price = \(\frac{D_1}{K_e-g}\)
(i) Estimate of P/E ratio using Gordon growth model

(ii) Long term growth rate implied by the current P.E ratio.

Question 48.
The following information is given for QB Ltd.

Earning per share	₹ 12
Dividend per share	₹ 3
Cost of capital	18%
Internal Rate of Return on investment	22%
Retention Ratio	40%

Calculate the market price per share using
(i) Gordon’s formula
(ii) Walters formula
Answer:
(i) Gordon’s Formula
P₀ = \(\frac{E(1-b)}{k-b r}\)
Where:
P₀ = Present value of Market price per share
E = Earnings per share
K = Cost of Capital
b = Retention Ratio (%)
r = rate of return
br = Growth Rate
P₀ = \(\frac{R s .12(1-0.40)}{0.18-(0.40 \times 0.22)}\)
= \(\frac{R s .7 .20}{0.18-0.088}=\frac{R s .7 .20}{0.092}\) = 78.26

(ii) Walter Formula
P₀ = \(\frac{D+\frac{r}{k}(E-D)}{k}\)
Where
P₀ = Market Price
D = Dividend per share
r = rate of return
k = Cost of Capital
E = Earnings per share
= \(\frac{R s .3+\frac{0.22}{0.18}(R s .12-R s .3)}{0.18}\)
= \(\frac{R s .3+R s .11}{0.18}\) = ₹ 77.77
Authprs Note : There is inconsistency in dividend paid and payout ratio

Question 49.
X Ltd. has an internal rate of return (5: 20%. It has declared dividend @ 18% on its equity shares, having face value of ₹ 10 each. The pay-out ratio is 36% and Price Earning Ratio is 7.25. Find the cost of equity according to Walter’s Model and hence determine the limiting value of its shares in case the pay-out ratio is varied as per the said model. [May 2012] [8 Marks]
Answer:
Rate of Return (r) = 0.20
Dividend (D) = 1.80
Earnings Per share (E) = \(\frac{1.80}{0.36}\) = 5
Price of share (P) = 5 × 7.25 = 36.25

Since the firm is a growing firm, then 100% pay-out ratio will give limiting value of shares. At 100% payout, the price will be:
P = \(\frac{5.0+\frac{0.20(5-5)}{0.16}}{0.16}\)
= \(\frac{5.0}{0.16}\)
= ₹ 31.25
Thus limiting value is ₹ 1 1.25

Question 50.
X Ltd. earns ₹ 6 per share having a capitalization rate of 10 per cent and has a return on investment of 20% . According to Walter’s model, what
should be the price of the share at 25% dividend payout? [Nov. 2012] [5 Marks]
Answer:
As per Walter Model:
P₀ = \(\frac{D+\frac{r}{k_e}(E-D)}{k_e}\)
P₀ = Market value of the share
r = Return on retained earnings
Ke = Capitalization rate
E = Earnings per share
D = Dividend per share
Dividend per share = 25% of ₹ 6 = 1.5 ₹
Therefore, Price of the share

Question 51.
Goldilocks Ltd. was started a year back with equity capital of 40 lakhs.
The other details are as under:

Earnings of the company	4,00,000
Price Earnings ratio	12.5
Dividend paid	3,20,000
Number of Shares	40,000

Find the current market price of the share. Use Walter’s Model.
Find whether the company’s D/P ratio is optimal, use Walter’s formula. [Nov. 2014] [5 Marks]
Answer:
As per Walter’s Model:

As per Walter’s Model if ‘r’ is more than ‘k ’ optimal payout ratio for the firm is ‘NIL’. The company’s D/P ratio is not optimal.
So, if the payout ratio is zero, the market value of the company’s share will be:
= \(\frac{0+(10-0) \frac{0.10}{0.08}}{0.08}\) = ₹ 156.25

Question 52.
The following information is collected from the annual reports of J Ltd.:

Profit before tax	₹ 2.50 crores
Tax rate	40 per cent
Retention ratio	40 per cent
Number of outstanding shares	50,00,000
Equity capitalization rate	12 per cent
Rate of return on investment	15 per cent

What should be the market price per share according to Gordon’s model of dividend policy? [May 2015] [4 Marks]
Answer:
Profit after tax = ₹ 2.5 crore – 40%
= ₹ 1.5 crore
EPS per share = ₹ 1.5 crore/50,00,000 shares
= ₹ 3
As per Gordon’s formula P₀ = \(\frac{E(1-b)}{k-b r}\)
P₀ = Market price of the share
E = EPS
k = Cost of Capital
b = Retention ratio
r = return on equity
br = Growth rate
P₀ = \(\frac{R s .3(1-0.40)}{0.12-(0.4 \times 0.15)}\)
= \(\frac{1.8}{0.12-0.06}\)
= ₹ 30

Question 53.
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares and the current market price is ₹ 100. IT expects a net profit of ₹ 2,50,000 for the year and the Board is considering dividend of ₹ 5 per share.
M Ltd. requires to raise ₹ 5,00,000 for an approved investment expenditure. Show, how does the MM approach affect the value of M Ltd., if dividends are paid or not paid. [May 2008] [8 Marks]
Answer:
A. When dividend is paid
(a) Price per share at the end of year 1
100= \(\frac{1}{1.10}\) (₹ 5 + P₁)
110 = ₹ 5 + P₁
P, = 105

(b) Amount required to be from issue of new shares
₹ 5,00,000 – (2,50,000 – 1,25,000)
₹ 5,00,000 – 1,25,000 = ₹ 3,75,000

(c) Number of additional shares to be issued
\(\frac{3,75,000}{105}\) = 3572 shares

(d) Value of M Ltd.
(Number of shares × Expected Price per share)
ie. (25,000 + 3,572) × ₹ 105 = ₹ 30,00,060

B. When dividend is not paid
(a) Price per share at the end of year 1
100 = \(\frac{P_1}{1.10}\)
P₁ = 110

(b) Amount required to be raised from issue of new shares
₹ 5,00,000 – 2,50,000 = 2,50,000

(c) Number of additional shares to be issued
\(\frac{2,50,000}{110}\) = 2273 shares (approx).

(d) Value of M Ltd.
(25,000 + 2,273) × ₹ 110
= ₹ 30,00,000

Conclusion:
Whether dividend is paid or not, the value of the firm remains the same

Question 54.
Buenos Aires Limited has 10 lakhs equity shares outstanding at the begin¬ning of the year 2013. The current market price is Rs. 150 and the directors have recommended a dividend of Rs. 9 per share. The rate of capitalization, appropriate to its risk class is 10%.
(i) Applying MM model calculate the fair price of the share when
(a) dividend is declared and
(b) dividend is not declared.
(ii) If the investment budget is Rs. 500 lakhs and anticipated profit is Rs. 200 lakhs, compute how many share are to be issued if
(a) dividend is declared and
(b) dividend is not declared. [Nov. 2014] [May 2018 Adapted][8 Marks]
Answer:
(i)

(ii) It is assumed that there is no retained fund. For the raising fund, equity shares to be issued at fair price as calculated above.

Question 55.
DEF Ltd. has been regularly paying a dividend of ₹ 19,20,000 per annum for several years and it is expected that same dividend would continue at this level in near future. There are 12,00,000 equity shares of ₹ 10 each and the share is traded at par.
The company has an opportunity to invest ₹ 8,00,000 in one year’s time as well as further ₹ 8,00,000 in two year’s time in a project as it is estimated that the project will generate cash inflow of ₹ 3,60,000 per annum in three year’s time which will continue forever. This investment is possible if dividend is reduced for next two years.
Whether the company should accept the project? Also analyze the effect on the market price of the share, if the company decides to accept the project. [May 2012] [8 Marks]
Answer:
Cost of Equity (K_e)

= – 6,89,655 – 5,94,530 + 1672,116.50
= Rs. 3,87,931.50

Conclusion:
As NPV of the project is positive, the value of the firm will increase by ₹ 3,87,931.50 and this value spread over the number of shares i.e. \(\frac{3,87,931.50}{12,00,000}\) = 0.323 the market price per share will increase by 32 paisa (appn.).

Question 56.
Wonderland Limited has excess cash of ₹ 20 lakhs, which it wants to invest in short term marketable securities. Expenses relating to investment will be ₹ 50,000.
The securities invested will have an annual yield of 9%.
The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%.
(ii) the minimum period for the company to break even its investment expenditure ignore time value of money. [Nov. 2014] [5 Marks]
Answer:
(i) Pre-tax income = ₹ 20 lakh × 5% = ₹ 1,00,000
T Expenses ₹ 50,000
₹ 1,50,000
Earnings in a year = ₹ 20,00,000 × 9% = ₹ 1,80,000
So Period of investment to earn ₹ 1,50,000
= 1,50,000 × \(\frac{12}{1,80,000}\) = 10 months

(ii) Break even income (B.E.I,) / Since expenses are ₹ 50,000, therefore B.E.I. = ₹ 50,000, It shall be earned in
= 50,000 × \(\frac{12}{1,80,000}\) = 3.33 months

Question 57.
X Ltd. is a Shoes manufacturing company. It is ail equity financed and has a paid-up Capital of ₹ 10,00,000 (₹ 10 per share)
X Ltd. has hired Swastika consultants to analyse the future earnings.
The report of Swastika consultants states as follows;
(i) The earnings and dividend will grow at 25% for the next two years.
(ii) Earnings are likely to grow at the rate of 10% from 3rd year and onwards.
(iii) Further, if there is reduction in earnings growth, dividend payout ratio will increase to 50%.
The other data related to the company are as follows:

You may assume that the tax rate is 30% (not expected to change in future) and post tax cost of capita! is 15%.
By using the Dividend Valuation Model, calculate
(i) Expected Market Price per share
(ii) P/E Ratio. [Nov. 2015] [6 Marks]
Answer:
(i) Dividend valuation Model:
P₀ = \(\frac{D_1}{K_e-g}\)
K_e = Cost of Capital
g = Growth rate
D₁ = Dividend at the end of year 1
On the basis of ike information given, the following projection can be made:

‘Payout Ratio changed to 50%.
After 2017, the perpetuity value assuming 10% constant growth is:
D₁ = ₹ 8.25 × 110% = ₹ 9.075
Therefore P₀ at the end of 2017
\(\frac{R s .9 .075}{0.15-0.10}\) × =Rs. 181.50
This must be discounted back to the present value, using the 3 year discount factor @ 15% which is 0.658.

(ii) P/E Ratio
P/E Ratio when P = 133.57 and E = 9.60
P/E Ratio = \(\frac{\text { Price }}{\text { Earning }}=\frac{133.57}{9.6}\) = 13.90

Question 58.
SAM Ltd. has just paid a dividend of ₹ 2 per share and it is expected to grow @ 6% p.a. After paying dividend, the Board declared to take up a project by retaining the next three annual dividends. It is expected that this project is of same risk as the existing projects. The results of this project will start coming from the 4th year onward from now. The dividends will then be ₹ 2.50 per share and will grow @ 7% p.a.
An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least ₹ 2,000 p.a. from this investment.
Show that the market value of the share is affected by the decision of the Board. Also show as to how the investor can maintain his target receipt from the investment for first 3 years and improved income thereafter, given that the cost of capital of the firm is 8%. [May 2016] [8 Marks]
Answer:
Value of share at present = \(\frac{D_1}{K_e-g}\)
= \(\frac{2(1.06)}{0.08-0.06}\) = ₹ 106
However, if the Board implement its decision, no dividend would be payable for 3 years and the dividend for year 4 would be ₹ 2.50 and growing at 1% p.a. The price of the share, in this case, now would be:
P₀ = \(\frac{2.50}{0.08-0.07} \times \frac{1}{(1+0.08)^3}\) = ₹ 198.46
So, the price of the share is expected to increase from ₹ 106 to ₹ 198.45 after the announcement of the project. The investor can take up this situation as follows:

In order to maintain his receipt at ₹ 2,000 for first 3 year, he would sell
10 shares in first year @ ₹ 214.33 for ₹ 2,143.30
9 shares in second year @ ₹ 231.48 for ₹ 2,083.32
8 shares in third year @ ₹ 250 for ₹ 2,000.00
At the end of 3rd year, he would be having 973 shares valued @ ₹ 250 each i.e. ₹ 2,43,250. On these 973 shares, his dividend income for year 4 would be @ ₹ 2.50 i.e. ₹ 2,432.50. So, if the project is taken up by the company, the investor would be able to maintain his receipt of at least ₹ 2,000 for first three years and would be getting increased income thereafter.

Question 59.
XYZ Ltd. paid a dividend of ₹ 2 for the current year. The dividend is expected to grow at 40% for the next 5 years and at 15% per annum thereafter. The return on 182 days T-bills is 11% per annum and the market return is expected to be around 18% with a variance of 24%.
The co-variance of XYZ’s return with that of the market is 30%. You are required to calculate the required rate of return and intrinsic value of the stock. [May 2016] [8 Marks]
Answer:
Dividend = 2
Growth = 40% for 5 years
Growth = 15% after that
R_f = 11%
R_m = 18%
β = \(\frac{\text { Covariance of } X Y Z \text { with market }}{\text { Variance }}\) = 1.25
= \(\frac{30}{24}\) = 1.25
Required Rate of Return (As per CAPM) = R_t + β (R_m – R_f)
= 11 + 1.25 (18 – 11)
= 19.75%
Intrinsic value (The present value of future cash inflows)

D₆ = D₅(1 + g)
= 10.7565(1.15)
= 12.37.
PV of Terminal Value = \(\frac{12.37}{0.1975-0.15} \times \frac{1}{(1.1975)^5}\) = 260.42 × 0.406 = 105.73
∴ Total Intrinsic Value = Rs. 16.358 + Rs. 105.73 = 122.088

Question 60.
Abinash is holding 5,000 shares of Future Group Limited. Presently the rate of dividend being paid by the company is ₹ 5 per share and the share is being sold at ₹ 50 per share in the market. However, several factors are likely to change during the course of the year as indicated below:

Risk free rate Market risk premium Expected growth rate Beta value
In view of the above factors whether Abinash should buy, hold or sell the shares? Narrate the reason for the decision to be taken. [May 2016] [8 Marks]
Answer:
Existing Rate of Return : (As per CAPM)
Return = R_f – β (R_m – R_f)
= 12.5 + 1.5 (6)
= 21.5%

Revised Rate of Return:
Return = R_f – β (R_m – R_f)
= 10+ 1.25 (4.8)
= 16%

Price of Share (Existing) :
P₀ = \(\frac{D_0(1+g)}{k_e-g}=\frac{5(1.05)}{0.215-0.05}=\frac{5.25}{0.165}\) = 31.82

Price of Share (Revised) :
P₀ = \(\frac{5(1.08)}{0.16-0.08}\) = 67.50

• Under Existing scenario, market price is ₹ 50 per share and equilibrium price is ₹ 31.82. So the shares need to be sold because they are over priced.
• Under Revised scenario, market price is ₹ 50, return is decreased but price is likely to increase, so, Mr. Abhilash should hold the shares.

Question 61.
Following Financial data are available for PQR Ltd. for the year 2008 :

	(₹ in lakh)
8% debentures	125
10% bonds(2007)	50
Equity shares (₹ 10 each)	100
Reserves and Surplus	300
Total Assets	600
Assets Turnovers ratio	1.1
Effective interest rate	8%
Effective tax rate	40%
Operating margin	10%
Dividend payout ratio	16.67%
Current market Price of Share	14
Required rate of return of investors	15%

You are required to :
(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate
(iii) Calculate the fair price of the Company’s share using dividend discount model, and
(iv) What is your opinion on investment in the company’s share at current price? [Nov. 2009] [6 Marks]
Answer:
(i) Given :
Asset turnover ratio = 1.1
Total Assets = ₹ 600
Turnover (₹ 600 lakhs × 11) = ₹ 660 lakhs
Effective Interest rate = \(\frac{\text { Total Interest }}{\text { Total Liabilities }}=\frac{14}{175}\) × 100 = 8%
Liabilities = ₹ 125 lakhs + 50 lakhs = 175 lakhs
Interest = ₹ 175 lakhs × 0.08 = ₹ 14 lakhs
Operating Margin = 10%
Operating cost = (1 – 0.10) ₹ 660 lakhs = ₹ 594 lakh
Dividend Payout = 16.67%
Tax Rate = 40%
ROE = \(\frac{\text { PAT }}{\text { Net worth }(\mathrm{NW})}\) = ₹ 100 lakh + ₹ 300 lakh = 400 lakhs
ROE = \(\frac{R s .31 .2 \text { lakhs }}{R s .400 \text { lakhs }}\) × 100 = 7.8%
SGR = 0.078 (1 – 0.1667) = 6.5%

(iii) Calculation of fair price of share using dividend discount model

(iv) Since the current market price of share is ₹ 14 the share is overvalued. Hence the investor should not invest in the company.

Question 62.
Following Financial Data for Platinum Ltd. are available:

For the year 2011:	(₹ in lakhs)
Equity Shares (? 10 each)	100
8% Debentures	125
10% Bonds	50
Reserves and Surplus	200
Total Assets	500
Assets Turnover Ratio	1.1
Effective Tax Rate	30%
Operating Margin	10%
Required rate of return of investors	15%
Dividend payout ratio	20%
Current market price of shares	₹ 13

You are required to:
(i) Draw income statement for the year
(ii) Calculate the sustainable growth rate
(iii) Compute the fair price of the company’s share using dividend discount model, and
(iv) Draw your opinion on investment in the company’s share at current price. [Nov. 2012] [8 Marks]
Answer:
Working Notes:
Asset turnover ratio = 1.1
Total Assets = ₹ 500 lakhs
Turnover ₹ 500 lakhs × 1.1 = ₹ 550 lakhs
Effective interest = ₹ 125 lakhs × 0.08 + ₹ 50 lakhs × 0.10
= ₹ 15 lakh
Operating Margin = 10%
operating cost = (1 – 0.10) ₹ 550 lakhs = ₹ 495 lakh
Dividend Payout = 20%
Tax rate = 30%

(i) Income statement

	(₹ Lakhs)
Sale	550.00
Operating Exp.	495.00
EBIT	55.00
Interest (8% × 125 + 10% × 50)	15.00
EBT	40.00
Tax @ 30%	12.00
EAT	28.00
Dividend payout 20%	5.60
Retained Earnings	22.40

(ii) Computation of sustainable Growth Rate
SGR = G = ROE (1 – pay-out)
ROE = \(\frac{P A T}{\text { Net worth }}\), and NW = ₹ 100 lakhs + ₹ 200 lakhs = ₹ 300 lakhs
ROE = \(\frac{R s .28 \text { lakhs }}{R s .300 \text { lakhs }}\) × 100 = 9.33%
SGR = 0.0933 (1 – 0.20) = 7.47%

(iii) Computation of fair price of share using Dividend Discount Model

Conclusion:
Since the current market price of share is ₹ 13.00, the share is overvalued. Therefore the investor should not invest in the company.

Question 63.
Following Financial information are available for XP Ltd. for the year 2018:

For the year 2018:	(Rs. in lakhs)
Equity Share Capital (Rs. 10 each)	200
Reserves and Surplus	600
10% Debentures (Rs. 100 each)	350
Total Assets	1200
Assets Turnover Ratio	2 times
Tax Rate	30%
Operating Margin	10%
Dividend payout ratio	20%
Current market price of shares	Rs. 28
Required rate of return of investors	18%

You are required to :
(i) Prepare income statement for the year 2018.
(ii) Determine its sustainable growth rate.
(iii) Determine the fair price of the company’s share using dividend discount model.
(iv) Give your opinion on investment in the company’s share at current price. [May 2019] [8 Marks]
Answer:
Working Note:
Asset turnover ratio = 2 times
Total Assets = Rs. 1200 lakhs
Turnover Rs. 1200 lakhs × 2 = Rs. 2400 lakhs
Interest cost = Rs. 35 lakhs (350 lakhs × 0.10)
Operating Margin = 10%
Hence operating cost = (1-0.10) Rs. 2400 lakhs = Rs. 2160 lakhs
Dividend Payout = 20%
Tax rate = 30%

(i) Income statement

	(Rs. in Lakhs)
Sale	2400.00
Operating Exp.	2160.00
EBIT	240.00
Interest	35.00
EBT	205.00
Tax @ 30%	61.50
EAT	143.50
Dividend @ 20% of earnings	28.70
Retained Earnings	114.80

(ii) Determination of sustainable Growth Rate
SGR = G = ROE (1 – pay-out)
ROE = \(\frac{P A T}{N W}\) and NW = Rs. 200 lakhs + Rs. 600 lakhs = Rs. 800 lakhs
ROE = \(\frac{R s .143 .50}{R s .800 \text { lakhs }}\) × 100 = 17.9375%
SGR = 0.179375 (1 – 0.20) = 14.35%

(iii) Determination of fair price of share using Dividend Discount Model
P₀ = \(\frac{D_0(1+g)}{K_e-g}\)
Dividend per share = \(\frac{R s .28 .70 \text { lakhs }}{20 \text { lakhs }}\) = Rs. 1.435
Growth Rate = 14.35%
Hence P₀ = \(\frac{R s .1 .435(1+0.1435)}{0.18-01435}=\frac{R s .1 .6409}{0.0365}\)
= Rs. 44.956 = Rs. 45 approx.

(iv) Opinion:
Since the current market price of share is Rs. 28.00, the share is undervalued. Therefore the investor should invest in the company.

Question 64.
The risk free rate of return R_f is 9 per cent. The expected rate of return on the market portfolio R_m is 13 per cent. The expected rate of growth for the dividend of Platinum Ltd. is 7 per cent. The last dividend paid on the equity stock of firm A was ₹ 2.00. The beta of Platinum Ltd. equity stock is 1.2.
(i) What is the equilibrium price of the equity stock of Platinum Ltd.?
(ii) How would the equilibrium price change when

• The inflation premium increases by 2 per cent?
• The expected growth rate increases by 3 per cent?
• The beta of Platinum Ltd. equity rises to 1.3? [Nov. 2014] [8 Marks]

Answer:
(i) Equilibrium price of Equity using CAPM
= 9% + 1.2 (13% – 9%)
= 996 + 4.8% = 13.8%
P = \(\frac{D_1}{K_e-g}=\frac{2.00(1.07)}{0.138-0.07}=\frac{2.14}{0.068}\) = Rs. 31.47

(ii) New Equilibrium price of Equity using CAPM
= 9.1896 + 1.3 (1396 – 9.1896)
= 9.1896 + 4,966% = 14.14696
P = \(\frac{D_1}{K_e-g}=\frac{2.00(1.10)}{0.14146-0.10}=\frac{2.20}{0.04146}\) = ₹ 53.06

Question 65.
The risk free rate of return Rf is 5 per cent. The expected rate of return on the market portfolio R.n is 11 per cent. The expected rate of growth for the dividend of X Ltd. is 8 per cent. The last dividend paid on the equity stock of firm A was Rs. 2.00. The beta of X Ltd. equity stock is 1.5.
(i) What is the equilibrium price of the equity stock of X Ltd.?
(ii) How would the equilibrium price change when

• The inflation premium increases by 3 per cent?
• The expected growth rate increases by 3 per cent?
• The beta decreases to 1.3? [May 2018] [4 Marks]

Answer:
(i) Equilibrium price of Equity using CAPM
= 5% + 1.5(11% – 5%)
= 5% + 9% = 14%
P = \(\frac{D_1}{K_e-g}=\frac{2.00(1.08)}{0.14-0.08}\) = Rs. 36

(ii) New Equilibrium price of Equity using CAPM
= 5.15% + 1.3 (11% -5.15%)
= 5.15%+ 7.605%= 12.755%
P = \(\frac{D_1}{K_e-g}=\frac{2.00(1.11)}{0.12755-0.11}=\frac{2.22}{0.01755}\) = Rs. 126.50

Question 66.
Rahim Enterprises is a manufacturer and exporter of woolen garments to European countries. Their business is expanding day by day and in the previous financial year the company has registered a 25% growth in export business. The company is in the process of considering a new investment project. It is an ail equity financed company with 10,00,000 equity shares of face value of ₹ 50 per share. The current issue price of this share is ₹ 125 ex-dividend. Annual earnings are ₹ 25 per share and in the absence of new investments will remain constant in perpetuity. All earnings are distributed at present. A new investment is available which will cost ₹ 1,75,00,000 in one year’s time and will produce annual cash inflows thereafter of ₹ 50,00,000. Analyse the effect of the new project on dividend payments and the share price. [Nov. 2017] [8 Marks]
Answer:
Cost of Equity (KJ
D₁ = ₹ 25
P₀ = 125
K_e = \(\frac{D}{P}=\frac{R s .25}{125}\) = 20%
Therefore,
P/E = \(\frac{125}{25}\) = 5

NPV of the project :
NPV = \(\frac{-1,75,00,000}{(1+0.20)}+\frac{50,00,000}{0.20} \times \frac{1}{(1+0.20)}\)
= -1,45,83,333 + 2,08,33,333
= Rs. 62,50,000

Conclusion:
As NPV of the project is positive, the value of the firm will increase by ₹ 62,50,000 and ₹ 62,50,000 spread over the number of shares i.e., \(\frac{62,50,000}{10,00,000}\) the market price per share will increase by Rs. 6.25 per share.

Question 67.
Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of ₹ 90 lakhs. Its present borrowings are as follows:

	(₹ Lakhs)
12% term loan	300
Working capital borrowings:
From Bank at 15%	200
I Public Deposit at 11%	100

The sales of the company are growing and to support this, the company proposes to obtain additional borrowing of ₹ 100 lakhs expected to cost 16%.
The increase in EBIT is expected to be 15%.
Calculate the change in interest converge ratio after the additional borrowing is effected and comment on the arrangement made. [Nov. 2012] [8 Marks] [June 2009] [6 Marks]
Answer:
Computation of Present Interest Coverage Ratio
Present EBIT = ₹ 90 lakhs

Interest Charges (Present)	(₹ Lakhs)
Term loan @ 12%	36.00
Bank Borrowings @ 15%	30.00
Public Deposit @ 11%	11.00
	77.00

Present Interest Coverage Ratio = \(\frac{E B I T}{\text { Interest Charges }}\)
\(\frac{R s .90 \text { lakhs }}{R s .77 \text { lakhs }}\) = 1.169

Calculation of Revised Interest Coverage Ratio
Revised EBIT (115% of × 90 lakhs) = ₹ 103.50 lakhs
Proposed interest charges
Existing charges = ₹ 77.00 lakhs
ThW: Additional charges (16% of additional = ₹ 16.00 lakhs
Borrowings i.e. = ₹ 100 lakhs)
Total = ₹ 93.00 lakhs

Revised Interest Coverage Ratio = \(\frac{R s .103 .50 \text { lakhs }}{R s .93 .00 \text { lakhs }}\) = 1.113
Thus, with the proposed increase in the sales the burden of interest on additional borrowings of ₹ 100 lakhs will adversely affect the interest coverage ratio which has been reduced, (i.e. from 1.169 to 1.113). Therefore, the proposal is not worth implementing.

Question 68.
AMKO limited has issued 75,000 equity shares of ₹ 10 each. The current market price per share is ₹ 36. The company has a plan to make a right issue of one new equity share at a price of ₹ 24 for every four shares held.
You are required to:
(i) Calculate the theoretical post-rights price per share.
(ii) Calculate the theoretical value of the right alone. [Nov. 2018 Old Syliabus][4 Marks]
Answer:
Ex-Right Price = \(\frac{(\text { No. of Existing Shares } \times \text { Existing Price })+(\text { Right Shares } \times \text { Right Price })}{\text { No. of existing Shares }+ \text { Right Shares }}\)
= \(\frac{(4 \times 36)+(1 \times 24)}{4+1}=\frac{168}{5}\) = ₹ 33.60
Value of Right = Existing Price – Ex-Right Price = ₹ 36 – 33.60 = ₹ 2.40

Question 69.
ABC Limited’s shares are currently selling at ₹ 13 per share. There are 10,0, 000 shares outstanding. The firm is planning to raise ₹ 20 lakhs to finance a new project.
Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases shareholders’ wealth? [Nov. 2004] [6 Marks]
Answer:
(i) When the firm offers one Right Share for every two shares held:
Number of shares to be issued = 10,00,000 × \(\frac{1}{2}\) = 5,00,000 Shares
Amount to be raised = ₹ 20,00,000
Therefore, Right Price = ₹ 20,00,000 ÷ 5,00,000 = ₹ 4 per share

Ex-Right Price = \(\frac{(\text { No. of Existing Shares } \times \text { Existing Price })+(\text { Right Shares } \times \text { Right Price })}{\text { No. of existing Shares }+ \text { Right Shares }}\)
= \(\frac{(10,00,000 \times R s .13)+(5,00,000 \times R s .4)}{10,00,000+5,00,000}\) = ₹ 10
Value of Right = Existing Price – Ex-Right Price = ₹ 13 – ₹ 10 = ₹ 3

(ii) When the firm offers one right share for every four shares held:
Number of shares to be issued = 10,00,000 × \(\frac{1}{4}\) = 2,50,000 Shares
Amount to be raised = ₹ 20,00,000
Therefore, Right Price = ₹ 20,00,000 + 2,50,000 = ₹ 8 per share

Ex-Right Price = \(\frac{(\text { No. of Existing Shares } \times \text { Existing Price })+(\text { Right Shares } \times \text { Right Price })}{\text { No. of existing Shares }+ \text { Right Shares }}\)
= \(\frac{(10,00,000 \times R s .13)+(2,50,000 \times R s .8)}{10,00,000+2,50,000}\) = ₹ 12
Value of Right = Existing Price – Ex-Right Price = ₹ 13 – ₹ 12 = Re. 1

(iii) Calculation of effect of right issue on Shareholder’s wealth:
Let us consider the case of a shareholder who is holding 100 shares.
(a) When firm offers one share for two shares held.

Value of Shares after right issue (150 × ₹ 10) (Total No. of Shares × Ex-Right Price)	₹ 1,500
Less: Amount paid to acquire right shares (50 × ₹ 4)	₹ 200
Value of Shares AFTER Right Issue	₹ 1,300
Value of Shares before Right Issue (100 × ₹ 13)	₹ 1,300
Effect of right issue on Shareholder’s wealth	No Effect

(b) When firm offers one share for every four shares held.

Value of Shares after right issue (125 × ₹ 12) (Total No. of Shares X Ex-Right Price)	₹ 1,500
Less: Amount paid to acquire right shares (25 × ₹ 8)	₹ 200
Value of Shares AFTER Right Issue	₹ 1,300
Value of Shares before Right Issue (100 × ₹ 13)	₹ 1,300
Effect of right issue on Shareholder’s wealth	No Effect

Question 70.
Eager Ltd. has a market capitalization of ₹ 1,500 crores and the current market price of its share is ₹ 1500. It made a PAT of 200 crores and the Board is considering a proposal to buy back 20% of the shares at a premium of 10% to the current market price. It plans to fund this through a 16% bank loan. You are required to calculate the post buy back earning per share (EPS). The company’s corporate tax rate is 30%. [Nov. 2018 old syllabus] [5 Marks]
Answer:
Number of Shares = \(\frac{1500}{1500}\) = 1 Crores
PAT = 200 Crores
Number of Shares Bought Back = 20 lakhs (20% of 1 crore)
Number of shares after buy-back = 80 lakhs
Price of buy-back = 1500 +10% = ₹ 1650
Amount of Loan @16% = 20 lakhs × 1,650
= ₹ 33000 lakhs
Interest on loan = ₹ 5,280 lakhs
Interest cost after tax @30% = ₹ 3,696 lakhs
New EPS = \(\frac{200-36.96}{0.8}=\frac{163.04}{0.8}\)
= ₹ 203.80 per share

Question 71.
ABB Ltd. has a surplus cash balance of ₹ 180 lakhs and wants to distribute 50% of it to the equity shareholders. The company decides to buy-back equity shares. The company estimates that its equity share price after re-purchase is likely to be 15% above the buy-back price, if the buy-back route is taken.
Other information is as under:
(si) Number of equity shares outstanding at present (Face Value × 10 each) is 20 lakhs.
(2) The current EPS is ₹ 5.
You are required to calculate the following:
(i) The price at which the equity shares can be re-purchased, if market capitalization of the company should be ₹ 400 lakhs after buy-back.
(ii) Number of equity shares that can be re-purchased.
(iii) The impact of equity shares re-purchase on the EPS, assuming that the net income remains unchanged. [May 2019 New Syllabus] [8 Marks]
Answer:
(i) Determination of Buy-Back Price, if market capitalization of the company should be ₹ 400 lakhs after buy-back.
Let the buy-back price be ₹ x
Surplus Cash = ₹ 180 Lakhs
Amount utilised for Buy-Back (₹ 180 Lakhs X 50%) = ₹ 90 Lakhs
Therefore, number of shares bought back = \(\frac{\text { Rs. } 90 \text { Lakhs }}{\text { Rs. X }}\)
Number of shares left after buy-back = 20,00,000 – \(\frac{\text { Rs. } 90 \text { Lakhs }}{\text { Rs. X }}\)
Market price after buy-back = 115% of ₹ X = 1.15X

Market capitalisation after buy-back
= No. of shares after buy-back X Market price after buy-back
= [20,00,000 – \(\frac{\text { Rs. } 90 \text { Lakhs }}{\text { Rs. X }}\)] × 1.15 X {It should be equal to ₹ 400 Lakhs}
400 Lakhs = [20,00,000 – \(\frac{\text { Rs. } 90 \text { Lakhs }}{\text { Rs. X }}\)] × 1.15X

By solving for X
X = ₹ 21.89
Hence, the share should be re-purchased @ ₹ 21.89.

(ii) Calculation of number of equity shares that can be re-purchased.
Number of Shares brought back = \(\frac{\text { Rs. } 90 \text { Lakhs }}{\text { Rs. X }}=\frac{\text { Rs.90 Lakhs }}{\text { Rs. } 21.89}\)
= 4,11,147 Shares

(iii) Determination of impact of buy-back on the EPS:
Number of shares after buy-back = 20,00,000 – 4,11,147 Shares = 15,88,853
Total Earnings = No. of shares before Buy-Back × Current EPS = 20,00,000 × ₹ 5 = ₹ 100 Lakhs
EPS = \(\frac{\text { Earnings }}{\text { No. of shares }}=\frac{\text { Rs.100 Lakhs }}{15,88,853}\) = ₹ 6.29
So EPS increases by 1.29.

Question 72.
Rahul Ltd. has a surplus cash balance of ? 100 lakhs and wants to distribute 27% of it to the equity shareholders. The company decides to buyback equity shares. The company estimates that its equity share price after re-purchase is likely to be 10% above the buyback price, if the buyback route is taken. The number of equity shares outstanding at present (Face Value ₹ 10 each) is 10 lakhs and the current EPS is ₹ 3.
You are required to determine:
(i) The price at which the equity shares can be re-purchased, if market capitalization of the company should be ₹ 210 lakhs after buy-back.
(ii) Number of equity shares that can be re-purchased.
(in) The impact of equity shares re-purchase on the EPS, assuming that the net income remains unchanged. [Nov. 2010] [8 Marks]
Answer:
(1) Determination of Buy-Back Price, if market capitalization of the company should be 1210 lakhs after buy-back.
Let the buy-back price be ₹ x
Surplus Cash = ₹ 100 Lakhs
Amount utilised for Buy-Back (₹ 100 Lakhs × 27%) = ₹ 27 Lakhs
Therefore, number of shares bought back = \(\frac{\text { Rs.27 Lakhs }}{\text { Rs. X }}\)
Number of shares left after buy-back = 10,00,000 – \(\frac{\text { Rs.27 Lakhs }}{\text { Rs. X }}\)
Market price after buy-back = 110% of ₹ X = 1.10X

Market capitalisation after buy-back
= No. of shares after buy-back × Market price after buy-back
= [10,00,000 – \(\frac{\text { Rs. } 27 \text { Lakhs }}{\text { Rs. X }}\)] × 1.10X {It should be equal to ₹ 210 Lakhs}
210 Lakhs = [10,00,000 – \(\frac{\text { Rs. } 27 \text { Lakhs }}{\text { Rs. X }}\)] × 1.10 X

By solving for X
X = ₹ 21.79
Hence, the share should be re-purchased @ ₹ 21.79.

(ii) Calculation of number of equity shares that can be re-purchased.
Number or shares bought back = \(\frac{\text { Rs.27 Lakhs }}{\text { Rs. X }}=\frac{\text { Rs.27 Lakhs }}{\text { Rs.21.79 }}\)
= 1,23,910 Shares

(iii) Determination of impact of buy-back on the EPS:
Number of shares after buy-back = 10,00,000 – 1,23,910 Shares
= 8,76,090 Shares
Total Earnings = No. of shares before Buy-Back × Current EPS
= 10,00,000 × ₹ 3 = ₹ 30 Lakhs
EPS = \(\frac{\text { Earnings }}{\text { No. of shares }}=\frac{\text { Rs.30 Lakhs }}{8,76,090 \text { im }}\) = ₹ 3.424

Question 73.
Mr. A is thinking of buying shares at ₹ 500 each having face value of ₹ 100. He is expecting a bonus at the ratio of 1:5 during the fourth year. Annual expected dividend is 20% and the same rate is expected to be maintained on the expanded capital base. He intends to sell the shares at the end of seventh year at an expected price of ₹ 900 each. Incidental expenses for purchase and sale of shares are estimated to be 5% of the market price. He expects a minimum return of 12% per annum. Should Mr. A buy the share? If so, what maximum price should he pay for each share? Assume no tax on dividend income and capital gain. [May 2010] [4 Marks]
Answer:
P.V. of dividend stream and sales proceeds

Year	Dividend/Sale	PVF (12%)	PV(₹)
1	₹ 20	0.893	17.86
2	₹ 20	0.797	15.94
3	₹ 20	0.712	14.24
4	₹ 24	0.636	15.26
5	₹ 24	0.567	13.61
6	₹ 24	0.507	12.17
7	₹ 24	0.452	10.85
7	₹ 1,026 (₹ 900 × 1.2 × 0.95)	0.452	463.75
	LESS: Cost of share (₹ 500 × 1.05)		₹ 563.68 ₹ 525.00
	Net gain		₹ 38.68

Since Mr. A is gaining ₹ 38.68 per share, he should buy the share.
Maximum price: Mr. A should be ready to pay is ₹ 563.68 which will include incidental expenses. So the maximum price should be ₹ 563.68 × (100/105), which comes at ₹ 536.84