Management of Working Capital – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Management of Working Capital – CA Inter FM Study Material

Question 1.
What is factoring? Enumerate the main advantages of factoring. (5 Marks May 2011, 4 Marks May 2017)
Answer:
Factoring: Factoring is an agreement between factor and business firm. Factor provides various services to business firm as per the factoring agreement. Generally factoring services consists to credit investigation, sales led ger management, purchase and collection of debts, credit protection and risk bearing. In advance factoring factor purchase account receivables and provide advance to businessman after withholding factor reserve, factor charges commission and interest and bears the credit risks associated with the accounts receivables purchased by it.

Advantages of Factoring:

1. Firm receives advance against accounts receivables.
2. Advance is received easily comparative to traditional bank loan.
3. Bad debt losses are suffered by factor.
4. Firm receives cash in definite pattern.
5. There is no need of the credit department.

Question 2.
Write short note on William J, Baumol Vs. Miller-Orr cash management model. (4 Marks May 2011)
Answer:
William J. Baumol Model (1952): William J. Baumol developed a model for optimum cash balance which is normally used in inventory management. This model is also known as EOQ model. As per this model optimum cash bal ance is the balancing between cost of holding cash and the transaction cost. Optimum cash balance refers to the level of cash at which total holding cost is equal to the total transaction cost.

Formula of optimum cash balance is:

Optimum Cash Balance = \(\sqrt{\frac{2 \mathrm{AT}}{\mathrm{H}}}\)
Where,
A = Annual Cash disbursements
T = Transaction cost (Fixed cost) per transaction
H = Opportunity cost one rupee per annum (Holding cost)

Miller-Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the return point; and zero as the lower limit

• When the cash balance reaches the upper limit, the transfer of cash equal to h – z is invested in marketable securities account.
• When it touches the lower limit, a transfer from marketable securities account to cash account is made.
• During the period when cash balance stays between (h, z) and (z, 0) i. e. high and low limits no transactions between cash and marketable securities account is made.

Question 3.
What are the forms of bank credit? (4 Marks Nov. 2012)
Answer:
The bank credit will generally be in the following forms:

1. Cash Credit: Under this facility banker sanctions a specific limit for borrower. The borrower doesn’t need holding a credit balance in an account. The borrower cannot withdraw more than the limits sanctioned by the bank.
2. Bank Overdraft: Overdraft is a short-term borrowing facility made avail able to the business firms. Banker set overdraft limit of business firm and firm can use this limit as per the requirement. This loan is quickly repayable. Banker has right to call for return of overdraft amount at short notice.
3. Bills Discounting: When a company sells its goods on credit, it draws a bill on the buyer and after acceptance of bill company has an option to discount it with bank and receive discounted money.
4. Bilb Acceptance: is a unique type of bank credit, under this arrangement a company draws a bill of exchange on bank. The bank accepts the bill thereby promising to pay out the amount of the bill at some specified future date.
5. Line of Credit: Under this arrangement Bank commits to lend a certain amount of funds on demand specifying the maximum amount.
6. Letter of Credit: On the instructions of a customer, bank issues letter of credit and undertakes to pay against prescribed documents.
7. Bank Guarantees: It is given by the banks on behalf of their customer. Bank guarantee is in favour of third parties who will be the beneficiaries of the guarantee.

Question 4.
Distinguish between factoring and bill-discounting. (4 Marks May 2013, 2015, 2017)
Answer:
Differentiation between Factoring and Bills Discounting

S.N	Factoring	Bills Discounting
1	It is also known as invoice factoring.	It is also known as invoice discounting.
2	There are three parties involved in factoring viz. client, factor and debtor.	There are three parties involved in bill discounting viz. drawer, drawee and payee.
3	Factor collects amount from debtor on behalf of supplier and charge commission.	Drawer receives discounted amount today and Bank collect amount from drawee on due date.
4	Bad debt is suffered by factor.	In case of dishonour of bill, Bank collects amount of bill from the party who discounted bill.
5	For factoring there is no specific Act.	Negotiable Instruments Act is applicable on bills discounting.

Question 5.
State the advantage of Electronic Cash Management System. (4 Marks May 2013)
Answer:
Advantages of Electronic Cash Management System

1. Significant saving in time.
2. Decrease in interest costs.
3. Less paper work.
4. Greater accounting accuracy.
5. More control over time and funds.
6. Supports electronic payments.
7. Faster transfer of funds from one location to another, where required.
8. Speedy conversion of various instruments into cash.
9. Making available funds wherever required, whenever required.
10. Reduction in the amount of ‘idle float’ to the maximum possible extent.
11. Ensures no idle funds are placed at any place in the organization.
12. It makes inter-bank balancing of funds much easier.
13. It is a true form of centralised ‘Cash Management’.
14. Produces faster electronic reconciliation.
15. Allows for detection of book-keeping errors.
16. Reduces the number of cheques issued.
17. Earns interest income or reduce interest expense.

(Student can mention any four)

Question 6.
What is Virtual Banking? State Its advantages. (4 Marks Nov. 2013)
Answer:
Virtual Banking: Virtual banking or Net-banking or E-banking refers to the online banking services like: NEFT, RTGS, IMPS, online DD, and online bank statement etc.

Advantages of virtual banking services are as follows:

1. It reduces handling cost of transaction.
2. Speedy response to customer and execution of requirements.
3. It reduces branch operating cost.
4. Reduction in banking staff.
5. Increase in accuracy and convenience.

Question 7.
‘Management of marketable securities is an integral part of investment of cash.’ Comment. (4 Marks Nov. 2013)
Answer:
Management of Marketable Securities is an Integral Part of Investment of Cash: In case of surplus cash balance finance manager purchases marketable securities and earn profit on these securities. Finance manager sells these securities when firm needs liquidity. Thus Management of marketable secu rities is an integral part of investment of cash.

Firm needs cash for its day to day operations, in season firm face excess cash balance situation and in off season deficit cash balance situation. Efficient management of marketable securities provides solution of surplus and deficit cash balance situations. Selection of marketable securities should be done with consideration of three principles namely safety, maturity and marketability.

Question 8.
Explain the following:
(1) Concentration Banking
(2) Lock Box System (4 Marks May 2014, Nov. 2017)
Answer:
(1) Concentration Banking: Concentration banking refers to the process of creating number of strategic collection centers in various regions instead of a single collection center at the head office to reduce size of float. This system is used to reduce period between the events a customer mails in his remittances and when the funds deposited in company’s account. First collection centres receive payment from customers after that such payments are deposited with their respective local bank and at last all local banks transfer all surplus funds to the concentration bank of head office.

(2) Lock Box System: Under lock box system, company rents the local post office box, Company’s bank has authorization to collect remittances in the boxes. Authorize bank collects remittance several times a day and deposits the cheques in the company’s account. Customers are billed with instructions to mail their remittances to the lock boxes. This system increases the flow of funds. Company selects lock boxes on regional basis according to its billing patterns.

Question 9.
Explain four kinds of float with reference to management of cash. (4 Marks Nov. 2014)
Answer:
Float: Float refers to the time consumed in collection process. There are four types of floats as:

1. Billing Float: Time gap between sale and mailing of the invoice to the buyer is known as billing float.
2. Mail Float: Time consumed in processing of a cheque by post office, messenger service, courier service or other means of delivery when buyer sends cheque to the company.
3. Cheque processing float: Time consumed by the company in depositing cheque into the bank.
4. Bank processing float: Time consumed from the deposit of the cheque to the crediting of funds in the seller’s account.

Question 10.
Explain Miller-Orr Cash Management Model. (4 Marks May 2015)
Answer:
Miller – Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the return point; and zero as the lower limit.

• When the cash balance reaches the upper limit, the transfer of cash equal to h – z is invested in marketable securities account.
• When it touches the lower limit, a transfer from marketable securities account to cash account is made.
• During the period when cash balance stays between (h, z) and (z, 0) i. e. high and low limits no transactions between cash and marketable securities account is made.

Question 11.
Discuss the risk-return considerations in financing current assets. (4 Marks Nov. 2015)
Answer:
There are three approaches to finance current assets:

Conservative approach: As per this approach permanent current assets and portion of temporary current assets are financed through long term funds involved higher cost and lower risk of non-liquidity.

Matching approach: As per this approach permanent current assets are financed through long term funds and temporary current assets through short term funds.

Aggressive approach: As per this approach temporary current assets and portion of permanent current assets are financed through short term funds involved lower cost and higher risk of liquidity.

Finance manager should maintain balancing between risk and return to select appropriate approach. It is advised to follow matching approach to finance current assets.

Question 12.
Evaluate the role of cash budget in effective cash management system. (4 Marks Nov. 2015)
Answer:
Finance manager prepares cash budget to plan and control receipts and payments. The various roles of cash budgets in effective cash management system are:

1. Cash budget indicates future expected surplus and deficit cash balance situations;
2. It helps to arrange funds in future to fulfil expected shortage on favourable term.
3. It helps to evaluate and select future short term investment in case of expected surplus.
4. It helps to avoid future liquidity issues and therefore goodwill of company will not damage.

Question 13.
Describe the three principles relating to selection of marketable securities. (4 Marks May 2016)
Answer:
The three principles relating to selection of marketable securities are:

1. Safety: Objective of investment in marketable securities is ensuring liquidity, minimum risk is the criterion of selection.
2. Maturity: Maturity date of marketable securities should be matched with the date of future needs of cash.
3. Marketability: Marketable securities should be converted into cash in convenient and speedy way with less transaction cost.

Question 14.
Explain briefly the functions of Treasury Department. (4 Marks Nov. 2016)
Answer:
The functions of treasury department are:

1. Cash Management: The efficient collection and payment of cash both inside and outside the organization is the function of treasury department. Treasury normally manages surplus funds in an investment portfolio.
2. Currency Management The treasury department manages the foreign currency risk exposure of the company. It advises on the currency to be used when invoicing overseas sales. It also manages any net exchange exposures in accordance with the company policy.
3. Fund Management: Treasury department is responsible for planning and sourcing the company’s short, medium and long-term cash needs. It also participates in the decision on capital structure and forecasts future interest and foreign currency rates.
4. Banking: Since short-term finance can come in the form of bank loans or through the sale of commercial paper in the money market, therefore, treasury department carries out negotiations with bankers and acts as the initial point of contact with them.
5. Corporate Finance: Treasury department is involved with both acquisition and disinvestment activities within the group. In addition, it is often responsible for investor relations.

Question 15.
What are the sources of short term financial requirement of the com-pany? (4 Marks May 2018)
Answer:
Following are the sources of short term finance:

1. Short term loans
2. Overdraft
3. Clean overdrafts
4. Cash credits
5. Advances against goods
6. Bills discounting
7. Advance against documents of title to goods
8. Advance against supply of bills
9. Factoring etc.

Question 16.
Explain Electronic Cash Management System. (4 Marks Jan. 21)
Answer:
Today’s world is known as digital world. Today we are using digital cash management system. Data and funds are transferred digitally. Various el ements in the process of cash management are linked through a satellite. Various places that are interlinked may be the place where the instrument is collected, the place where cash is to be transferred in company’s ,account, the place where the payment is to be transferred etc.

Certain networked cash management system may also provide a very limited access to third parties like parties having very regular dealings of receipts and payments with the company etc. A finance company accepting deposits from public through sub-brokers may give a limited access to sub-brokers to verify the collections made through him for determination of his commission among other things.

Practical Problems

Cash Budget

Question 1.
Following information relates to ABC company for the year 2016:
(a) Projected sales (₹ in lakhs)

August	September	October	November	December
35	40	40	45	46

(b) Gross profit margin will be 20% on sale.

(c) 10% of projected sale will be cash sale. Out of credit sale of each month, 50% will be collected in the next month and the balance will be collected during the second month following the month of sale.

(d) Creditors will be paid in the first month following credit purchase. There will be credit purchase only.

(e) Wages and salaries will be paid on the first day of the next month. The amount will be ₹ 3 lakhs each month.

(f) Interim dividend of ₹ 2 lakhs will be paid in December 2016.

(g) Machinery costing ₹ 10 lakhs will be purchased in September 2016. Repayment by instalment of ₹ 50,000 p.m. will start from October 2016.

(h) Administrative expenses of ₹ 1,00,000 per month will be paid in the month of their incurrence.

(i) Assume no minimum cash balance is required. Opening cash balance as on 1-10-2016 is estimated at ₹ 10 lakhs.

You are required to prepare the monthly cash budget for the 3-month period (October 2016 to December 2016). (8 Marks Nov. 2016)
Answer:
Cash Budget
(From Oct 2016 to December 2016)

Question 2.
Slide Ltd is preparing a cash flow forecast for the three months period from January to the end of March. The following sales volumes have been forecasted:

	December	January	February	March	April
Sales (units)	1,800	1,875	1,950	2,100	2,250

Selling price per unit is ₹ 600. Sales are all on one month credit. Production of goods for sales takes place one month before sales. Each unit produced requires two units of raw material costing ₹ 150 per unit. No raw material inventory is held. Raw materials purchases are on one month credit.

Variable overheads and wages equal to ₹ 100 per unit are incurred during pro duction and paid in the month of production. The opening cash balance on 1st January is expected to be ₹ 35,000. A long term loan of ₹ 2,00,000 is excepted to be received in the month of March. A machine costing ₹ 3,00,000 will be purchased in March.

(a) Prepare a cash budget for the months of January, February and March and calculate the cash balance at the end of each month in the three month period.

(b) Calculate the forecast current ratio at the end of the three months period. (10 Marks Nov. 2019)

Answer:

(a) Cash Budget
(for three months period January to March)

(b) Forecast Current Ratio at the end of three month period:

Forecast Current Ratio \(=\frac{\text { Expected Current Assets at the end of March }}{\text { Expected Current Liabilities at the end of March }}\)
= \(\frac{9,02,500+12,60,000+9,00,000}{6,75,000}\)
= 4.537 times
Current Assets = Cash and bank balance + Sundry debtors + Finished goods stock
Current Liabilities = Sundry creditors

Working note:

(a) Calculation of Collection from debtors, payment for Purchases, Variable overheads and Wages:

(b) Valuation of Finished goods stock at the end of March:
Valuation of Stock = Production cost of 2,250 units
= 2,250 units × (2 units of raw material × ₹ 150 + ₹ 100 Variable OH and wages)
= 9,00,000

Optimum Cash Transaction

Question 3.
VK Co. Ltd. has total cash disbursement amounting ₹ 22,50,000 in the year 2017 and maintains a separate account for cash disbursements. Company has an administrative and transaction cost on transferring cash to disbursement account 15 per transfer. The yield rate on marketable securities
is 12% per annum.
Determine the optimum cash balance according to William J Baumol model. (5 Marks May 2017)
Answer:
Optimal transfer size = \(\sqrt{\frac{2 \mathrm{UP}}{\mathrm{S}}}\) = \(\sqrt{\frac{2 \times 22,50,000 \times 15}{0.12}}\) = 23,717

Evaluation Of Credit Policies

Question 4.
The marketing manager of XY Ltd. is giving a proposal to the board of directors of the company that an increase in credit period allowed to customers front the present one month to two months will bring a 25% increase in sales volume in the next year.
The following operational data of the company for the current year are taken from the records of the company:

Selling price : ₹ 21 per unit
Variable cost : ₹ 14 per unit
Total cost : ₹ 18 per unit
Sales value : ₹ 18,90,000

The board, by forwarding the above proposal and data requests you to give your expert opinion on the adoption of the new credit policy in next year subject to a condition that the company’s required rate of return on investments is 40%. (8 Marks May 2011)

Answer:

Statement of Evaluation

Analysis: The proposal for a more liberal extension of credit by increasing the average collection period from one month to two months is suggested to adopt.

Working notes:

Calculation of required return on investment in cost of debtors:
Existing = (12,60,000 + 3,60,000) × 1/12 × 40% = 54,000
Proposed = (15,75,000 + 3,60,000) × 2/12 × 40% = 1,29,000

Question 5.
PTX Limited is considering a change in its present credit policy. Currently it is evaluating two policies. The company is required to give a return of 20% on the investment in new receivables. The company’s variable costs are 70% of selling price.

Information regarding present and proposed policies are as follows:

Note: Return on investment in new account receivable is based on cost of investment in debtors.
Which option would you recommend? (8 Marks Nov. 13)
Answer:
Statement of Evaluation

Note: In the above solution, investment in accounts receivable is based on total cost of goods sold on credit. Since fixed costs are not given in the problem, therefore, it is assumed that there are no fixed costs and investment in receivables is determined with reference to variable costs only. The above solution may alternatively be worked out on the basis of incremental approach. However, the recommendation would remain the same.

Question 6.
A trader whose current sales are ₹ 4,20,000 per annum and an average collection period of 30 days, wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following information:
Credit Policy Increase in Collection Period Increase in Sales Present default anticipated

Credit Policy	Increase in Collection Period	Increase in Sales	Present default anticipated
I	10 days	₹ 21,000	1.5%
II	30 days	₹ 52,500	3%
III	45 days	₹ 63,000	4%

The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable cost per unit is ₹ 2. The current bad-debts loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.
Which of the above policies would you recommend for adoption ? (8 Marks May 2016)
Answer:
Statement of Evaluation of Credit Policies

Working notes:

Calculation of cost required rate of return:

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

Question 7.
MN Ltd has a current turnover of ₹ 30,00,000 p.a. Cost of sale is 80% of turnover and bad debts are 2% of turnover. Cost of sales includes 70% Variable cost and 30% Fixed cost, while company’s required rate of return is 15%. MN Ltd. currently allows 15 days credit to its customer, but it is considering increase this to 45 days credit in order to increase turnover.

It has been estimated that this change in policy will increase turnover by 20%, while bad debts will increase by 1%. It is not expected that the policy change will result in an increase in fixed cost and creditors and stock will be unchanged.

Should MN Ltd introduce the proposed policy? (Assume 360 days year) (10 Marks Nov. 2018)

Answer:

Statement of Evaluation

Yes, the firm should change its credit period

Working Notes:

Calculation of required return in debtors:
Existing = (16,80,000 + 7,20,000) × 15/360 × 15% = 15,000
Proposed = (20,16,000 + 7,20,000) × 45/360 × 15% = 51,300

Evaluation Of New Customers

Question 8.
A new customer with 10% risk of non-payment desires to establish business connection with you. He would require 1.5 month of credit and is likely to increase you sales by ₹ 1,20,000 p.a. Cost of sales amounted to 85% of sales. The tax rate is 30%. Required rate of return is 40% (after tax). Should you accept the offer? (4 Marks Nov. 2011)
Answer:
Statement of Evaluation

Conclusion: Since company has negative benefit after tax, offer should be rejected.

Question 9.
A new customer has approached a firm to establish new business connection. The customer require 1.5 month of credit. If the proposal is accepted, the sales of the firm will go up by ₹ 2,40,000 per annum. The new customer is being considered as a member of 10% risk of non-payment group. The cost of sales amounted to 80% of sales. The tax rate is 30% and required rate of return is 40% (after tax).
Should the firm accept the offer? Give your opinion on the basis of calculations. (5 Marks May 2015)
Answer:
Statement of Evaluation

Conclusion: Since company has positive benefit after fulfil of required return from investment in debtors, offer should be accepted.

Working notes: –
Calculation of cost of investment in debtors:
Existing = 1,92,000 × 15/12 × 4096 = 9,600

Evaluation Of Cash Discount Policies

Question 10.
A company is presently having credit sales of ₹ 12,00,000. The existing credit terms are 1/10 net 45 days and average collection period is 30 days. The current bad debts loss is 1.5%. In order to accelerate the collection process further as also to increase sales, the company is contemplating liberalization of its existing credit terms to 2/10 net 45 days.

It is expected that sales are likely to increase 1/3 of existing sales, bad debts increase to 2% of sales and average collection period to decline to 20 days. The contribution to sales ratio of the company is 22% and opportunity cost of investment in receivables is 15 per cent (pre tax). 50 per cent and 80 per cent of customers in term of sales revenue are expected to avail cash discount under existing and liberalisation scheme respectively. The tax rate is 30%.

Should the company change its credit terms? (Assume 360 days in a year). (5 Marks May 2012)

Answer:

Statement of Evaluation

Advise: Company should change its credit terms having higher net benefit.

Working notes:

(1) Calculation of opportunity cost of investment in receivables:
Existing = 9,36,000 × 15% × 30/360 = 11,700
Proposed = 12,48,000 × 15% × 20/360 = 10,400

(2) Calculation of cash discount:
Existing = 12,00,000 × 50% × 1% = 6,000
Proposed = 16,00,000 × 80% × 2% = 25,600

Question 11.
A current credit sales of a firm is ₹ 15,00,000 and the firm still has an unutilized capacity. In order to boost its sales, the firm is willing to relax its credit policy. The firm proposes a new credit policy of 2/10 net 60 days as against the present policy of 1 /10 net 45 days. The firm expects an increase in the sales by 12%.

However, it is also expected that bad debts will go upto 2% of sales from 1.5%. The contribution to sales ratio of the firm is 28%. The firm’s tax rate is 30% and firm requires an after tax return of 15% on its investment. 50 per cent and 80 percent of customers in term of sales revenue are expected to avail cash discount under existing and liberalization scheme respectively.

Should the firm change its credit period? (8 Marks Nov. 2017)

Answer:

Statement of Evaluation

Yes, the firm should change its credit period Working notes:

Working notes:

1. Calculation of opportunity cost of investment in receivables:
Existing = 10,80,000 × 15% × 27.5 (.5 × 10 + .5 × 45)/365 = 12,205
Proposed = 12,09,600 × 15% × 20 (.8 × 10 + .2 × 60)/365 = 9,942

2. Calculation of cash discount:
Existing = 15,00,000 × 50% × 1% = 7,500
Proposed = 16,80,000 × 80% × 2% = 26,880

Evaluation Of Collection Policies

Question 12.
PQR Ltd. having annual sales of ₹ 30,00,000, is reconsidering its pres ent collection policy. At present the average collection period is 50 days, bad debt losses are 5% of sales. The company is incurring an expenditure of ₹ 30,000 on account of collection of receivables. Cost of funds is 10 per cent.
The alternative policies are:

Evaluate the alternatives on the basis of incremental approach and state which alternative is more beneficial. (8 Marks Nov. 2014)
Answer:
Statement of Evaluation

Analysis: Since incremental benefit over present policy is higher in case of alternative II, select Alternative II. It is suggested to reduce the collection period from existing 50 days to 30 days.

Working Notes:

Calculation of cost of investment in debtors:
Existing = 30,00,000 × 50/365 × 10% = 41,096
Alternative I = 30,00,000 × 40/365 × 10% = 32,877
Alternative II = 30,00,000 × 30/365 × 10% = 24,658

Factoring

Question 13.
A firm has total sales as ₹ 200 lakhs of which 80% is on credit. It is offering credit term of 2/40, net 120. Of the total, 50% of customers avail of discount and the balance pay in 120 days. Past experience indicates that bad debt losses are around 1% of credit sales. The firm spends about ₹ 2,40,000 per annum to administer its credit sales. These are avoidable as a factor is prepared to buy the firm’s receivables.

He will charge 2% commission. He will pay advance against receivables to the firm at an interest rate of 18% after withholding 10% as reserve,

(i) What is the effective cost of factoring? Consider year as 360 days.
(ii) If bank finance for working capital is available at 14% interest, should the firm avail of factoring service? (8 Marks Nov. 2015)

Answer:

(i) Statement of Effective Cost of Factoring to the Firm

Alternatively:

If cost of factoring is calculated on the basis of total amount available for advance, then, it will be
Rate of effective cost = (\(\frac{4,83,200}{31,28,889}\) × 100) = 15.44%

(ii) If bank finance for working capital is available at 14%, firm will not avail factoring services as 14% is less than 16.08% (or 15.44%).

Working Notes:

(1) Calculation of advance:

(2) Average collection period = 40 Days × 1/2 + 120 Days × 1/2 = 80 Days

Assumptions:

1. Factoring commission will be paid in advance.
2. Factor will bear bad debt losses (Non recourse factoring).

Question 14.
A company is considering to engage a factor. The following information is available:

• The current average collection period for the company’s debtors is 90 days and l’2% of debtors default. The factor has agreed to pay money due after 60 days, and will take the responsibility of any loss on account of bad debts.
• The annual charge for the factoring is 2% of turnover. Administration cost saving is likely to be ₹ 1,00,000 per annum.
• Annual credit sales are ₹ 1,20,00,000. Variable costs is 80% of sales price. The company’s cost of borrowings is 15% per annum. Assume 360 days in a year.

Should the company enter into a factoring agreement? (8 Marks May 2018)

Answer:
Statement of Evaluation

* Presently, the debtors of the company pay after 90 days. However, the factor has agreed to pay after 60 days only. So, the investment in Debtors will be reduced by 30 days.
Conclusion: Yes, company should enter into factoring agreement.

Operating Cycle Method

Question 15.
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:
Particulars Particulars


The opening and closing balances of debtors were ₹ 1,50,000 and ₹ 2,00,000 respectively whereas opening and closing creditors were ₹ 2,00,000 and ₹ 2,40,000 respectively.

You are required io ascertain the working capital requirement by operat ing cycle method. (8 Marks Nov. 2011)
Answer:

= (₹ 20,00,000 – ₹2,50,000) × \(\frac{110.24}{365}\) = ₹ 5,28,548
Operating cycle =R + W + F + D – C
= 64.21 + 18.96 + 68.13 + 31.94 – 73 = 110.24 Days

Calculations:

Raw materials storage period
\(=\frac{\text { Average stock of raw materials }}{\text { Average cost of raw materials consumption per day }}\)
= \(\frac{1,90,000}{10,80,000 \div 365}\) = 64.21 days
Raw materials consumed = Opening RM + Purchases – Closing RM
= 1,80,000 + 11,00,000 – 2,00,000 = 10,80,000
WIP holding period \(=\frac{\text { Average stock of WIP }}{\text { Average cost of production per day }}\)
= \(\frac{80,000}{15,40,000 \div 365}\) = 18.96 days
Cost of Production = RMC + Wages + Production expenses + Op. WIP – Closing WIP
= 10,80,000 + 3,00,000 + 2,00,000 + 60,000 – 1,00,000
= 15,40,000

Finished Goods storage period \(=\frac{\text { Average stock of FG }}{\text { Average cost of goods sold per day }}\)
= \(\frac{2,80,000}{15,00,000 \div 365}\) = 68.13 days
Cost of goods sold = COP + Opening FG – Closing FG
= 15,40,000 + 2,60,000 – 3,00,000
= 15,00,000
Debtors collection period \(=\frac{\text { Average debtors }}{\text { Average credit sales per day }}\)
= \(\frac{1,75,000}{20,00,000 \div 365}\) = 31.94 days
Credit period availed \(=\frac{\text { Average trade creditors }}{\text { Average credit purchases per day }}\)
= \(\frac{2,20,000}{11,00,000 \div 365}\) = 73 days

Calculation of averages:
Average stock of raw materials = (1,80,000 + 2,00,000) ÷ 2 = 1,90,000
Average stock of WIP = (60,000 + 1,00,000) ÷ 2 = 80,000
Average stock of FG = (2,60,000 + 3,00,000) ÷ 2 = 2,80,000
Average debtors = (150,000 + 2,00,000) ÷ 2 = 1,75,000
Average trade creditors = (2,00,000 + 2,40,000) ÷ 2 = 2,20,000

Question 16.
The following information is provided by the DPS Limited for the year ending 31st March, 2013

Raw material storage period : 55 days
Work-in progress conversion period : 18 days
Finished Goods storage period : 22 days
Debt collection period : 45 days
Creditor’s payment period : 60 days
Annual Operating cost (including depreciation of ₹ 2,10,000) : ₹ 21,00,000
1 year : 360 days

You are required to calculate:

I. Operating Cycle period.
II. Number of Operating Cycle in a year.
III. Amount of working capital required of the company on a cash cost
IV. The company is a market leader in its product, there is virtually no competitor in the market. Based on a market research it is planning to discontinue sales on credit and deliver products based on pre-payment. Thereby, it can reduce its working capital requirement substantially. What would be the reduction in working capital requirement due to such decision? (8 Marks May 2013, 2015)

Answer:

I. Operating cycle = R + W + F + D- C
= 55 + 18 + 22 + 45 – 60 = 80 Days
II. No. of operating cycle = \(\frac{360}{80}\) = 4.5 times
III.

IV. In case of cash sales operating cycle period will reduce by 45 Days (Debt collection period).
Revised operating cycle period = 55 + 18 + 22 – 60 = 35 Days
Revised working capital = (₹ 21,00,000 – ₹ 2,10,000) × \(\frac{35 \text { Days }}{360 \text { Days }}\)
= ₹ 1,83,750
Reduction in working capital = ₹ 4,20,000 – ₹ 1,83,750 = ₹ 2,36,250
Or
Reduction in working capital = (₹ 21,00,000 – ₹ 2,10,000) × \(\frac{80 \text { Days }-35 \text { Days }}{360 \text { Days }}\)
= ₹2,36,250

Question 17.
Following information has been extracted from the books of ABS Limited:

All purchases and sales are on credit basis. Company is willing to know:

(1) Net operating cycle period.

(2) Amount of working capital requirement (Assume 360 days in a year). (8 Marks Nov, 2018)
Answer:
(1) Operating cycle = R + W + F + D – C
= 19 + 19 + 28 + 18 – 72 = 12 Days

Calculations:
Raw materials storage period (R)
\(=\frac{\text { Average stock of raw materials }}{\text { Average cost of raw materials consumption per day }}\)
= \(\frac{(1,00,000+70,000) \div 2}{16,00,000 \div 360}\) = 19 days
= Opening RM + Purchases – Closing RM
= 1,00,000 + 15,70,000 – 70,000 = 16,00,000
WIP holding period \(=\frac{\text { Average stock of WIP }}{\text { Average cost of production per day }}\)
= \(\frac{(1,40,000+2,00,000) \div 2}{32,90,000 \div 360}\) = 19 days
Cost of Production = RM consumed + Wages and OH + Opening WIP – Closing WIP
= 16,00,000 + 17,50,000 + 1,40,000 – 2,00,000
= 32,90,000

Finished Goods storage period
\(=\frac{\text { Average stock of } \mathrm{FG}}{\text { Average cost of goods sold per day }}\)
= \(\frac{(2,30,000+2,70,000) \div 2}{32,50,000 \div 360}\) = 28 days
Cost of Goods Sold = Cost of Production + Opening FG – Closing FG
= 32,90,000 + 2,30,000 – 2,70,000
= 32,50,000

Debtors collection period \(=\frac{\text { Average book debts }}{\text { Average credit sales per day }}\)
= \(\frac{2,10,000}{42,00,000 \div 360}\) = 18 days
Credit period availed \(=\frac{\text { Average trade creditors }}{\text { Average credit purchases per day }}\)
= \(\frac{3,14,000}{15,70,000 \div 360}\) = 72 days

(2) Amount of working capital required
Working Capital \(=\frac{\text { Annual Cost of Sales }}{360}\) × Operating Cycle Period
= \(\frac{35,70,000}{360}\) × 12 = ₹ 1,19,000
Cost of Sales = Cost of Goods Sold + Selling expenses
= 32,50,000 + 3,20,000 = 35,70,000

Question 18.
The following information is provided by MNP Ltd. for the year end ing 31st March, 2020:

Raw material storage period : 45 days
Work-in progress conversion period : 20 days
Finished Goods storage period : 25 days
Debt collection period : 30 days
Creditor’s payment period : 60 days
Annual Operating cost (including depreciation of ₹ 2,50,000) : ₹ 25,00,000
Assume 360 days in a year.

You are required to calculate:

I. Operating Cycle period.

II. Number of Operating Cycle in a year.

III. Amount of working capital required of the company on a cash cost basis.

IV. The company is a market leader in its product, there is virtually no competitor in the market. Based on a market survey it is planning to discontinue sales on credit and deliver products based on pre-payment in order to reduce its working capital requirement substantially. You are required to compute the reduction in w’orking capital requirement in such a scenario. (5 Murks Jan. 2021)

Answer:
I. Operatingcycle = R + W + F + D – C
= 45 + 20 + 25 + 30 – 60 Days

II. No. of operating cycle = \(\frac{360}{60}\) = 6 times

III.

= (₹ 25,00,000 – ₹ 2,50,000) × \(\frac{60 \text { Days }}{360 \text { Days }}\)
= ₹ 3,75,000

IV. Reduction in working capital
= (₹ 25,00,000 – ₹ 2,50,000) × 30 days/360 days = ₹ 1,87,500

Components Wise Estimation Method (Cash Cost App-Roach)

Question 19.
The management of MNP Company Ltd. is planning to expand its business and consult you to prepare an estimated working capital statement.

The records of the company revealed the following annual information:

Sales:
Domestic at one month’s credit : ₹ 24,00,000
Export at three month’s credit : ₹ 10,80,000
(Sales price 10% below Domestic price)
Material used (suppliers extend two months credit) : ₹ 9,00,000
Lag in payment of wages – 1/2 month: ₹ 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month: ₹ 10,80,000
Lag in payment of administrative expenses – 1 month : ₹ 2,40,000
Sales promotion expenses payable quarterly in advance : ₹ 1,50,000
Income tax payable in four instalments (of which one falls in the next financial year) : ₹ 2,25,000

Rate of gross profit is 20%. Ignore work-in-progress and depreciation. The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping ₹ 2,50,000 available to it including the over draft limit of ₹ 75,000 not yet utilized by the company. The management is also of the opinion to make 12% margin for contingencies on computed figure.

You are required to prepare the estimated working capital statement for next year. (16 Marks May 2011)

Answer:

Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:

1. Projected Income Statement

2. Calculation of Cash cost of Debtors:
Export sales (10% below domestic sales price) = 10,80,000
Export sales equivalent to domestic sales = 10,80,000 × \(\frac{100}{90}\)
= 12,00,000
Total equivalent domestic sales = 24,00,000 + 12,00,000
= 36,00,000

Apportionment of cash cost of sales except sales promotion expenses in proportion of equivalent domestic sales between Domestic and Foreign Sales:
Domestic sales = 29,40,000 × \(\frac{24,00,000}{36,00,000}\) = 19,60,000
Foreign sales = 29,40,000 × \(\frac{12,00,000}{36,00,000}\) = 9,80,000
Apportionment of sales promotion expenses between Domestic and Foreign Sales in sales ratio:
Domestic sales = 1,50,000 × \(\frac{24,00,000}{34,80,000}\) = 1,03,448
Foreign sales = 1,50,000 × \(\frac{10,80,000}{34,80,000}\) = 46,552

Question 20.
STN Ltd. is a readymade garment manufacturing company. Its production cycle indicates that materials are introduced in the beginning of the production phase; wages and overhead accrue evenly throughout the period of cycle.

The following figures for the 12 months ending 31st December 2011 are given:
Production of shirts : 54,000 units
Selling price per unit : ₹ 200
Duration of the production cycle : 1 month
Raw material Inventory held : 2 month’s consumption
Finished goods stock held for : 1 month
Credit allowed to debtors : 1.5 months
Credit allowed by creditors : 1 month

Wages are paid in (lie next month following the month of accrual. In the work in progress 50% of wages and overheads are supposed to be conversion costs. The ratios of cost to sales price are raw materials 60%, direct wages 10% and overheads 20%. Cash is to be held to the extent of 40% of current liabilities and safety margin of 15% will be maintained.

Calculate amount of working capital required for the company on a cash cost basis. (8 Marks May 12)
Answer:
Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:
Projected Income Statement

Question 21.
Black Limited has furnished the following cost sheet:

Factory overheads includes depreciation of ₹ 15 per unit at budgeted level of activity

Additional Information:

1. Average raw material in stock : 3 weeks
2. Average work-in-progress : 2 weeks
   (% of completion with respect to Materials 75% and Labour and Overhead 70%)
3. Finished goods in stock : 4 weeks
4. Credit allowed to debtors : 2.5 weeks
5. Credit allowed by creditors : 3.5 weeks
6. Time lag in payment of labour : 2 weeks
7. Time lag in payment of factory overheads : 1.5 weeks
8. Company sells, 25% of the output against cash
9. Cash in hand and bank is desired to be maintained ₹ 2,25,000
10. Provision for contingencies is required @ 4% of working capital requirement including that provision.

You may assume that production is carried on evenly throughout the year and labour and factory overheads accrue similarly.

You are required to prepare a statement showing estimate of working capital needed to finance a budgeted activity level of 1,04,000 units of production. Finished stock, debtors and overheads are taken at cash cost. (8 Marks May 2014)
Answer:
Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:

Projected Income Statement (Production of 1,04,000 units)

Question 22.
PQ Limited wants to expand its business and has applied for a loan from a commercial bank for its growing financial requirements. The re cords of the company reveals that the company sells goods in the domestic market at a gross profit of 25% not counting depreciation as part of the cost of goods sold.

The following additional information is also available for you:
Home at one month’s credit : ₹ 1,20,00,000
Export at three month’s credit : ₹ 54,00,000
(Sales price 10% below’ Home price)
Material used (suppliers extend two months’ credit) : ₹ 45,00,000
Wages paid month in arrear : ₹ 36,00,000
Manufacturing expenses (cash) paid (1 month in arrear) : ₹ 54,00,000
Administrative expenses paid 1 month in arrear : ₹ 12,00,000
Income tax payable in four instalments (of which one falls in the next financial year) : ₹ 15,00,000

The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping ₹ 10,00,000 available to it including the over draft limit of ₹ 5,00,000 not yet utilized by the company. Assume a 15% margin for contingencies.

You are required to ascertain the requirement of the working capital of the company. (8 Marks May 2017)
Answer:
Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:

(A) Calculation of Cash cost of Debtors:

Export sales (10% below home sales price) = 54,00,000
Export sales equivalent to home sales = 54,00,000 × \(\frac{100}{90}\)
= 60,00,000
Total equivalent home sales = 1,20,00,000 + 60,00,000
= 1,80,00,000
Apportionment of cash cost of COGS and administrative expenses in proportion of equivalent home sales between Home and Foreign Sales:
Home sales = 1,47,00,000 × \(\frac{1,20,00,000}{1,80,00,000}\) = 98,00,000
Foreign sales = 1,47,00,000 × \(\frac{60,00,000}{1,80,00,000}\) = 49,00,000

(B) Projected Income Statement

Question 23.
Day Ltd., a newly formed company has applied to the Private bank for the first time for financing its working capital requirements.

The following information is available about the projection for the current year:

Estimated level of activity : Completed units of production 31,200 units Plus units of WIP 12,000
Raw material cost : ₹ 40 per unit
Direct wages cost : ₹ 15 per unit
Overhead : ₹ 40 per unit
(Inclusive Depreciation ₹ 10 per unit)
Selling Price : ₹ 130
Raw material in stock : Average 30 days consumption
work in progress stock : Material 100% and conversion cost 50%
Finished goods stock : 24,000 units
Credit allowed by suppliers : 30 days
Credit allowed to purchasers : 60 days
Direct wages (lag in payment) : 15 days
Expected cash balance : ₹ 2,00,000

Assume that production is carried on evenly throughout the year (360 days) and w’ages and overhead accrue similarly. All sales are on credit basis.

You are required to calculate the Net Working Capital requirement on Cash Cost Basis. (10 Marks May 2018)
Answer:
Statement of Working Capital Requirement

Projected Cost of Goods Sold

Question 24.
PK Ltd. a manufacturing company, provides the following information:

Particulars	₹
Sales	1,08,00,000
Raw material consumed	27,00,000
Labour paid	21.60.000
Manufacturing overhead (including depreciation for the year ₹ 3,60.000)	32,40,000
Administrative and Selling overheads	10,80,000

Additional information:

(a) Receivables are allowed 3 months’ credit.
(b) Raw material supplier extends 3 months’ credit.
(c) Lag in payment of labour is 1 month.
(d) Manufacturing overheads are paid one month in arrear.
(e) Administrative and Selling overhead is paid 1 month advance.
(f) Inventory holding period of raw material and finished goods are of 3 months.
(g) Work-in-progress is Nil.
(h) PK Ltd. sells goods at cost plus 33 1/3%.
(i) Cash balance ₹ 3,00,000.
(j) Safely margin 10%.

You are required to compute the working capital requirements of PK Ltd. on cash cost basis. (10 Marks Nov. 2020)

Answer:

Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:
Projected Income Statement (Cash Cost Basis)

Components Wise Estimation Method (Total Approach)

Question 25.
Bita Limited manufactures a product used in the steel industry. The following information regarding the company is given for your consideration:

1. The cost structure for Bita Limited’s product is as follows:
   
2. Expected level of production 9,000 units per annum.
3. Raw materials are expected to remain in stores for an average of two months before issue to production.
4. Work-in-progress (50% complete as to conversion cost) will approxi-mately to 1/2 month’s production.
5. Finished goods remain in warehouse on an average for one month.
6. Credit allowed by supplier is one month.
7. Two month’s credit is normally allowed to debtors.
8. A minimum cash balance of ₹ 67,500 is expected to be maintained.
9. Cash sales are 75% less than the credit sales.
10. Safety margin of 20% to cover unforeseen contingencies.
11. The production pattern is assumed to be even during the year.

You are required to estimate the working capital requirement of Bita Limited. (10 Marks May 2019)

Answer:

Statement of Working Capital Requirement

Working Notes:

1. Projected Income Statement (Production of 9,000 units)

2. Proportion between cash and credit sales:
Let Credit sales be x then cash sales will be 0.25 × (x – 75%)
Cash Sales : Credit Sales = x :.25x = 1 :.25 = 4:1

Important Questions

Question 1.
From the following information relating to a departmental store, you are required to prepare for the three months ending 31st March, 2019:

(a) Month-wise cash budget on receipts and payments basis; and
(b) Statement of Sources and uses of funds for the three months period.

It is anticipated that the working capital at 1st January, 2019 will be as follows:


Depreciation amount to ₹ 60,000 is included in the budgeted expenditure for each month.
Answer:
(a) Cash Budget
(3 months ending 31st March, 2019)

Calculation of receipts from debtors and payment to creditors:

(b) Statement of Sources and uses of Funds (3 months ending 31st March, 2019)

Statement of Changes in Working Capital

Question 2.
You are given below the Profit & Loss Accounts for two years for a company:

Sales are expected to be ₹ 12,00,00,000 in year 3.

As a result, other expenses will increase by ₹ 50,00,000 besides other charges. Only raw materials are in stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same amount as between years 1 and 2. You may assume that no dividend is being paid. The Company can use 75% of the cash generated to service a loan.
Compute how much cash from operations will be available in year 3 for the purpose? Ignore income tax.
Answer:
Projected Profit and Loss Account for the year 3 (₹ in Lakhs)

Cash Flow:

Available for servicing the loan: 75% of ₹ 2,54,00,000 or ₹ 1,90,50,000

Working Notes:
(a) Material consumed in year 2 = ₹ 350 Lakhs ÷ ₹ 1,000 lakhs
= 35% of sales
Likely consumption in year 3 = ₹ 1,200 Lakhs × 35%
= ₹ 420 Lakhs
(b) Stores are 12% of sales, as in year 2
(c) Manufacturing expenses are 16% of sales

Note: The above also shows how a projected profit and loss account is prepared

Question 3.
Prachi Ltd. is a manufacturing company producing and selling a range of cleaning products to wholesale customers. It has three suppliers and two customers. Prachi Ltd. relies on its cleared funds forecast to manage its cash.

You are an accounting technician for the company and have been asked to prepare a cleared funds forecast for the period Monday 7 August to Friday 11 August 2019 inclusive. You have been provided with the following infor-mation:

(1) Receipts from customers

(а) Receipt of money by BAGS (Bankers’ Automated Clearing Services) is instantaneous.

(b) X Ltd.’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale is made and will clear on the third day following this (excluding day of payment).

(2) Payments to suppliers

(a) Prachi Ltd. has set up a standing order for ₹ 45,000 a month to pay for supplies from A Ltd. This will leave Prachi’s bank account on 7 August.

Every few months, an adjustment is made to reflect the actual cost of supplies purchased (you do not need to make this adjustment).

(b) Prachi Ltd will send out, by post, cheques to B Ltd. and C Ltd. on 7 August. The amounts will leave its bank account on the second day following this (excluding the day of posting).

(3) Wages and salaries

	July 2019	August 2019
Weekly wages Monthly salaries	₹ 12,000 ₹56,000	₹ 13,000 ₹59,000

(a) Factory workers are paid cash wages (weekly). They will be paid one week’s wages, on 11 August, for the last week’s work done in July (i.e. they work a week in hand).

(b) All the office w’orkers are paid salaries (monthly) by BACS. Salaries for July will be paid on 7 August.

(4) Other miscellaneous payments

(a) Every Monday morning, the petty cashier withdraws ₹ 200 from the company bank account for the petty cash. The money leaves Prachi’s bank account straight away.

(b) The room cleaner is paid ₹ 30 from petty cash every Wednesday morning.

(c) Office stationery will be ordered by telephone on Tuesday 8 August to the value of ₹ 300. This is paid for by company debit card. Such payments are generally seen to leave the company account on the next working day.

(d) Five new softwares will be ordered over the Internet on 10 August at a total cost of ₹ 6,500. A cheque will be sent out on the same day. The amount will leave Prachi Ltd’s bank account on the second day following this (excluding the day of posting).

(5) Other informatian
The balance on Prachi’s bank account will be ₹ 200,000 on 7 August 2019. This represents both the book balance and the cleared funds.

Prepare a cleared funds forecast for the period Monday 7 August to Friday 11 August 2019 inclusive using the information provided. Show clearly the uncleared funds float each day.
Answer:
Clear Fund Forecast

Note : ₹ 1,70,000 Cheque to B Ltd. for ₹ 75,000 ánd Cheque to C Ltd. for ₹ 95,000.

Question 4.
Slow Payers are regular customer of Goods Dealers Ltd., Calcutta and have approached the sellers of extension of a credit facility for enabling them to purchase goods from Goods Dealer Ltd. On an analysis of past per-formance and on the basis of information supplied, the following pattern of payment schedule is regard to Slow Payers:

Slow Payers want to enter Into a firm commitment for purchase of goods of ₹ 15 Lacs in 2017, deliveries to be made in equal quantities on the first day of each quarter in the calendar year.

The price per unit of commodity is ₹ 150 on which a profit of ₹ 5 per unit is expected to be made. It is anticipated by Goods Dealers Ltd. that taking up of this contract would mean an extra recurring expenditure of ₹ 5,000 per annum.

If the opportunity cost of funds in the hands of Goods dealers is 24% per annum, would you as the finance manager of the seller recommend the grant of credit to Slow Payers? Workings should form part of your answer. Assume year of 365 days,
Answer:
Statement of Evaluation of Credit Policy

Recommendation: The proposed policy should not be adopted since the net benefit under this policy is negative.

Working notes:

Calculation of Average collection period’:
Average collection period = 30 days × 15% + 60 days × 34% + 90 days × 30% + 100 days × 20% = 71.90 Days

Question 5.
Star Limited manufacturer of color TV seta, are considering the liberalization of existing credit terms to three of their large customers A B and C. The credit period and likely quantity of TV sets that will be lifted by the customers are as follows:

The selling price per TV set is ₹ 9,000. The expected contribution is 20% of the selling price. The cost of carrying debtors averages 20% per annum.

You are required:

(a) Determine the credit period to be allowed to each customer. (Assume 360 days in a year for calculation purposes).

(b) What other problems the company might face in allowing the credit period as determined in (a) above?

Answer:

(a) Determination of credit period to be allowed to customers A, B and C. In case of customer A there will be constant sales irrespective of the credit period allowed. Hence, it is suggested not to extend any credit period to customer A. The only analysis to be made about the profitability of extending different credit periods with different sales levels.

Analysis:

(a) It is suggested to allow credit period upto 90 days to both customers B and C.

(b) By giving credit period of 90 days to customers B and C and no credit allowed to customer A may cause to stop purchase T. V. sets from the company by customer A.

Question 6.
The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s records by the owner, Mr. Gautam, revealed that payments are usually made 15 days after purchases are made. When asked why the firm did not take advantage of its discounts, the accountant, Mr. Rohit, replied that it cost only 2 percent for these funds, whereas a bank loan would cost the company 12 percent.

(a) Analyse, what mistake is Rohit making?
(b) If the firm could not borrow from the bank and was forced to resort to the use of trade credit funds, what suggestion might be made to Rohit that would reduce the annual interest cost? Identify.

Answer:

(a) Rohit is confusing the percentage cost of using funds for 5 days with the cost of using funds for a year. These costs are clearly not comparable. One must be converted to the time scale of the other.
Real cost of not taking advantage of discount is = \(\frac{2}{98}\) × \(\frac{365}{5}\) × 100 = 148.98%

(b) Assuming that the firm has made the decision not to take the cash discount, it makes no sense to pay before the due date. In this case payment should be made after 30 days rather than 15 days and it would reduce the annual interest cost to 37.24 percent
= \(\frac{2}{98}\) × \(\frac{365}{5}\) × 100 = 37.24%

Question 7.
PQ Ltd. a company newly commencing business in 2020 has the under-mentioned projected P & L Account:


The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the year’s production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses. The company believes in keeping materials equal to two months consumption in stock.

All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months credit. Sales will be 20% for cash and rest at two months credit. 70% of the income tax will be paid in advance in quarterly instal-ments, The company wishes to keep ₹ 8,000 in cash. 10% has to be added to the estimated figure for unforeseen contingencies.
Prepare an estimate of working capital an cash cost basis.
Answer:
Statement of Working Capital Requirement

Working Notes:
Projected Income Statement

Question 8.
M.A. Limited is commencing a new project of a plastic component. The following cost information has been ascertained for annual production of 12,000 units which is the full capacity.

The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per unit 80% of which is variable. In the first two years of operation, produc tivity and sales are expected to be as follows:

To assess the working capital requirement, the following additional information is available:

(a) Stock of Materials : 2.25 months average
(6) Work-in-Progress : Nil
(c) Debtors : 1 month’s average sales
(d) Cash balance : ₹ 10,000
(e) Creditors for supply of materials : 1 month’s average purchase
(f) Creditors for expenses : 1 month average of all expenses

You may make any relevant assumption. Prepare for two years:

(I) Projected Statement of Profit and Loss (ignoring taxation) and
(II) Projected Statement of working capital requirements.

Answer:

(I) PS Limited
Projected Statement of Profit and Loss

(II) Projected Statement of Working Capital Requirement

Question 9.
Samreen Enterprises has been operating its manufacturing facilities till 31.03.2020 on a single shift working with the following cost structure:

In view of increased market demand, it is proposed to double production by working an extra shift. It is expected that a 10% discount will be available from suppliers of raw materials in view of increased volume of business. Selling price will remain the same.

The credit period allowed to customers will remain unaltered. Credit availed of from suppliers will continue to remain at the present level i.e. 2 months. Lag in payment of wages and expenses will continue to remain half a month.

You are required to assess the additional working capital requirement, if the policy to increase output is implemented.
Answer:
Statement of Cost at Single Shift and Double Shift Working

Statement of Working Capital for Single Shift and Double Shift Working

Increase in working capital requirement is ₹94,800 (₹2,86,800 – ₹1,92,000).

Notes:

1. The quantity of material in process will not change due to double shift working since work started in the first shift will be completed in the second shift.
2. It is given in the question that the WIP is valued at prime cost hence, it is assumed that the WIP is 100 complete in respect of material and labour.
3. In absence of any information on proportion of credit sales to total sales, debtors quantity has been doubled for double shift.
4. It is assumed that all purchases are on credit.
5. The valuation of work-in-progress based on prime cost as per the policy of the company.

CA Inter FM ECO Question Paper 2 – CA Inter FM ECO Study Material is designed strictly as per the latest syllabus and exam pattern.

FM ECO CA Inter Question Paper 2

Time Allowed – 3 Hours
Maximum Marks – 100

Section A – Financial Management

Question 1.
Answer the following. (4 × 5 = 20 Marks)
(a) Following information relating to Jee Ltd. are given:
Profit after tax : ₹ 10,00,000
Dividend payout ratio : 50%
Number of Equity shares : 50,000
Cost of equity : 10%
Rate of return on investment : 12%

(1) What would be the market value per share as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of equity share at that payout ratio?
Answer:
(1) Market value (P) per share as per Walter’s Model:
P (Market value of share) = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\)
= \(\frac{10+(20-10) \times \frac{0.12}{0.10}}{0.10}\) = ₹ 220.00
E (EPS) = ₹ 10,00,000 (PAT) ÷ 50,000 shares
= ₹ 20

(b) Tarus Ltd. has an estimated cash payments of ₹ 8,00,000 for a one month period and the payments are expected to steady over the period. The fixed cost per transaction is ₹ 250 and the interest rate on marketable securities is 12% p.a.
Calculate the optimal transaction size, average cash and number of transactions during one month.
Answer:
Optimal transaction size = \(\sqrt{\frac{2 \times 8,00,000 \times 12 \times 250}{0.12}}\) = ₹ 2,00,000
Number of transactions p.m. = Monthly cash requirement ÷ Transaction size
= ₹ 8,00,000 ÷ ₹ 2,00,000 = 4 transactions

(c) RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000 and cost of equity K_e 21%. The company wants to buyback equity shares worth ₹ 5,00,000 by issuing and raising 15% perpetual amount (Debt).

Rate of tax may be taken as 30%. After the capital restructuring and applying
MM model with taxes.
You are required to calculate:
(a) Market value of RES Ltd.
(b) Cost of Equity K_e.
(c) Weighted average cost of capital and comment on it.
Answer:
(a) Market Value (MV) of RES Ltd:
MV before restructuring (V_UL) = 25,00,000
MV after restructuring (V_L) = V_UL + Debt × Tax
= 25,00,000 + 5,00,000 × 30%
= 26,50,000

(b) Cost of Equity:
K_e = K₀ + (K₀ – K_d) × \(\frac{\mathrm{D}(1-\mathrm{t})}{\mathrm{E}}\)
= .21 + (.21 -.15) × \(\frac{5,00,000(1-.30)}{21,50,000}\) = 21.97%
Here,
K_d = before tax cost of debt
K₀ = K₀ of unlevered firm
K₀ of unlevered firm = K_e of unlevered firm = 21%
E = Value of Equity
E = Value of firm – Value of Debt
= 26,50,000 – 5,00,000 = 21,50,000

(c) Weighted average cost of capital:
WACC = K_eW_e + K_dW_d
= 21.97% × \(\frac{21,50,000}{26,50,000}\) + 10.50% × \(\frac{5,00,000}{26,50,000}\) = 19.806%
Comment: WACC af ter restructuring is lower than before restructuring. Hence, company should restructure the firm.

(d) Door Ltd. is considering an investment of ₹ 4,00,000 this investments expected to generate substantial cash inflows over the next five years. Unfortunately the annual cash flows from this investment is uncertain, but the following probability distribution has been established:

Annual Cash Flow (₹)	Probability
50,000	0.3
1,00,000	0.3
1,50,000	0.4

At the end of its 5 years life, the investment is expected to have a residual value of ₹ 40,000. The cost of capital is 5%.
(1) Calculate NPV under the three different scenarios.
(2) Calculate expected net present value
(3) Advise Door Ltd. on whether the investment is to be undertaken.

Years	1	2	3	4	5
DF @ 5%	0.952	0.907	0.864	0.823	0.784

Answer:
(1) NPV under different sccnarios:
NPV = PV of inflow – Initial Investment
Situation 1 = 50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = (1,52,140)
Situation 2 1,00,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 64,360
Situation 3 = 1,50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 2,80,860

(2) Expected NPV:
Expected NPV = PV of expected inflow – Initial Investment
= 1,05,000 × 4.33 + 40,000 × 0.784 – 4,00,000
= 86,010
Expected Inflow = 50,000 × 0.3 + 1,00,000 × 0.3 + 1,50,000 × 0.4
= 1,05,000

(3) Advise: Door Ltd. should accept the proposal having positive expected NPV.

Question 2.
SRS Ltd has furnished the following ratios and information relating to the year ended 31st March, 2015.
Sales : ₹ 60,00,000
Return on Net Worth : 25%
Rate of Income Tax : 50%
Share Capital to Reserve : 7: 3
Current Ratio : 2
Net Profit to Sales (after tax) : 6.25%
Inventory Turnover : 12
(Based on cost of goods sold and closing stock)
Cost of Goods Sold : ₹ 18,00,000
Interest on Debenture @ 15% : ₹ 60,000
Sundry Debtors : ₹ 2,00,000
Sundry Creditors : ₹ 2,00,000

You are required to:
(i) Calculate the operating expenses for the year ended 31st March,2015.
(ii) Prepare Balance Sheet as on 31st March, 2015. (10 Marks)
Answer:
(i) Operating Expenses = Gross Profit – EBIT
= ₹ 42,00,000 – ₹ 8,10,000 = ₹ 33,90,000
Working:
Calculation of EBIT

(ii) Balance Sheet (As on 31.03.2015)

Question 3.
ANP Ltd. Is providing the following information:
Annual cost of saving : ₹ 96,000
Useful life : 5 years
Salvage value : zero
Internal rate of return : 15%
Profitability index : 1.05

Table of discount factor:

Discount	Years
Factor	1	2	3	4	5	Total
15%	0.870	0.756	0.658	0.572	0.497	3.353
14%	0.877	0.769	0.675	0.592	0.519	3.432
13%	0.886	0.783	0.693	0.614	0.544	3.52

You are required to calculate:
(a) Cost of the project
(b) Payback period
(c) Net present value of cash inflow
(d) Cost of capital (10 Marks)
Answer:
(a) Cost of the project:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor @ IRR for 5 years
= ₹ 96,000 × 3.353
= ₹ 3,21,888
Cost of project = ₹ 3,21,888

(b) Payback Period:
Payback period = \(\frac{\text { Initial Outflow }}{\text { Equal Annual Cash Inflows/ Saving }}\)
= \(\frac{3,21,888}{96,000}\) = 3.353 years

(c) Net Present Value of cash inflows:
PI = \(\frac{\text { PV of Inflows }}{\text { PV of Outflows }}\)
1.05 = \(\frac{\text { PV of Inflows }}{3,21,888}\)
PV of Inflows = 3,21,888 × 1.05 = ₹ 3,37,982.4
NPV = PV of inflows – PV of outflows
= ₹ 3,37,982.40 – ₹ 3,2 1,888 = ₹ 16,094.40

(d) Cost of Capital:
Cum DF @ cost of capital for 5 years
= \(\frac{\text { Present Value of Inflows }}{\text { Annual Inflows }}\)
= \(\frac{3,37,982.40}{96,000}\) = 3.52065
Cost of capital = 13% (Given in table)

Question 4.
The management of Royal industries has called for a statement showing the working capital needs to finance a level of 1,80,000 units of output for the year. The cost structure for the company’s product for the above mentioned activity level is detailed below:

Additional Information:
(a) Minimum desired cash balance is ₹ 20,000.
(b) Raw materials are held in stock on an average for 2 months.
(c) Work-in-progress (assume 50% completion stage) will approximate to half month’s production.
(d) Finished goods remain in warehouse on an average for a month.
(e) Suppliers of materials extend a month’s credit and debtors are provided two month’s credit.
(f) Cash sales are 25% of total sales.
(g) There is a time lag in payment of wages of a month and half a month in case of overheads.

From the above data, you are required to:
(1) Prepare a statement showing working capital needs; and
(2) Determine the maximum working capital finance available under the first two methods suggested by Tandon Committee. (10 Marks)
Answer:
(1) Statement of Working Capital Requirement

(2) Calculation of Maximum Permissible Bank Finance under the suggestion of Tandon Committee:
Method 1 = 75% (CA – CL) = 75% of 18,20,000 = ₹ 13,65,000
Method 2 = (75% CA) – CL = (75% 22,70,000) – 4,50,000 = ₹ 12,52,500

Working Notes:
Projected Income Statement

Question 5.
A company had the following Balance Sheet as on 31st March, 2014:

The additional information given is as under:
Fixed cost per annum (excluding interest) : 4 crores
Variable operating cost ratio : 65%
Total assets turnover ratio : 2.5
Income Tax rate : 30%

Required:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage (10 Marks)
Answer:
(i) Calculation of EPS:
EAT = \(\frac{\text { EAT }}{\text { No. of Shares }}\) = \(\frac{840 \text { Lakhs }}{50 \text { Lakhs }}\) = 16.80

(ii) Calculation of OL:
OL = \(\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{17.50 \text { Crores }}{13.50 \text { Crores }}\) = 1.296 times

(iii) Calculation of FL:
FL = \(\frac{\text { EBIT }}{\text { EBT }}\) = \(\frac{13.50 \text { Crores }}{12.00 \text { Crores }}\) = 1.125 times

(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times

Working Notes:
Income Statement

Question 6.
Answer the following:
(a) Explain in brief following Financial Instruments:  (1 × 4 = 4 Marks)

1. Euro Bonds
2. Floating Rate Notes
3. Euro Commercial paper
4. Fully Hedged Bond

Answer:

1. Euro bonds: Euro bonds are debt instruments which are not denominated in the currency of the country in which they are issued. E.g. a Yen note floated in Germany.
2. Floating Rate Notes: Floating Rate Notes are issued up to seven years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans.
3. Euro Commercial Paper (ECP): ECPs are short term money market instruments. They are for maturities less than one year. They are usually designated in US Dollars.
4. Fully Hedged Bond: In foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate the risk by selling in forward markets the entire stream of principal and interest payments.

(b) Discuss the Advantages of Leasing. (4 Marks)
Answer:
(i) Lease may low cost alternative: Leasing is alternative to purchasing. As the lessee is to make a series of payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is based on a comparison between leasing and buying an asset. Many lessees find lease more attractive because of low cost.

(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less than that available for lease payment

(iii) Working capital conservation: When a firm buy an equipment by bor-rowing from a bank (or financial institution), they never provide 10096 financing. But in case of lease one gets normally 10096 financing. This enables conservation of working capital.

(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing debt equity ratio. This enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt financing is called debt capacity (also, reserve debt capacity).

(v) Obsolescence and Disposal: After purchase of leased asset there may be technological obsolescence of the asset. That means a technologically upgraded asset with better capacity may come into existence after purchase. To retain competitive advantage the lessee as user may have to go for the upgraded asset.

(c) Write two main objectives of Financial Management. (2 Marks)
Answer:
Two Main Objective of Financial Management are:’

1. Profit Maximisation: It has traditionally been argued that the primary objective of a company is to earn profit; hence the objective of financial management is also profit maximisation.
2. Wealth/Value Maximization: Shareholders wealth are the result of cost benefit analysis adjusted with their timing and risk i.e. time value of money. This is the real objective of Financial Management. So, Wealth = Present Value of benefits – Present Value of Costs.

Section B – Economics For Finance

Question 7.
(1) “World Trade Organisation (WTO) has a three-tier system of decision making.” Explain. (2 Marks)
Answer:
The World Trade Organization has a three-tier system of decision making. The WTO’s top level decision-making body is the Ministerial Conference which can take decisions on all matters under any of the multilateral trade agreements. The Ministerial Conference meets at least once every two years. The next level is the General Council which meets several times a year at the Geneva head-quarters.

The General Council also meets as the Trade Policy Review Body and the Dispute Settlement Body. At the next level, the Goods Council, Ser-vices Council and Intellectual Property (TRIPS) Council report to the General Council. These councils are responsible for overseeing the implementation of the WTO agreements in their respective areas of specialisation. The three also have subsidiary bodies. Numerous specialized committees, working groups and working parties deal with the individual agreements.

(2) In a two sector economy, the business sector produces 7,500 units at an average price of ₹ 7.  (3 Marks)
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 75 percent of their income, what is the total con-sumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output? (5 Marks)
Answer:
(a) The money value of output equals total output times the average price per unit. The money value of output is:
= 7,500 × 7 = ₹ 52,500

(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore, the money income of households is the same as the money value of output i.e ₹ 52,500.

(c) Total spending by households = ₹ 52,500 × 0.75 = ₹ 39,375

(d) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 39,375.

(e) The business sector makes payments of ₹ 52,500 to produce output, whereas the households purchase only output worth ₹ 39,375 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 13,125. They should be expected to decrease output.

(3) Explain the objectives of Fiscal Policy. (3 Marks)
Answer:
Objectives of Fiscal Policy: Fiscal Policy refers to the policy of government related to public revenue and public expenditure. The objectives of fiscal policy are derived from the aspirations and goals of the society and vary from country to country. The most common objectives of fiscal policy are:

• Achievement and maintenance of full employment,
• Maintenance of price stability,
• Acceleration of the rate of economic development,
• Equitable distribution of income and wealth,
• Eradication of poverty, and
• Removal of regional imbalances in different parts of the country.

The importance as well as order of priority of these objectives may vary from country to country and from time to time. For instance, while stability and equality may be the priorities of developed nations, economic growth, employment and equity may get higher priority in developing countries. Also, these objectives are not always compatible; for instance the objective of achieving equitable distribution of income may conflict with the objective of economic growth and efficiency.

Question 8.
(1) Which types of Government interventions are applied for correcting information failure? (2 Marks)
Answer:
Government Interventions: For combating the problem of market failure due to information failure the following interventions are resorted to:

• Government makes it mandatory to have accurate labelling and content disclosures by producers.
• Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.
• Regulation of advertising and setting of advertising standards to make advertising more responsible, informative and less persuasive.

A few examples are: SEBI mandates on accurate information disclosure to prospective buyers of new stocks, mandatory statutory information, licensing of doctors practicing medicine, awareness campaigns and funding of organisations to influence public, media and government attitudes.

(2) Compute M1 supply of money from the data given below:
Currency with public : ₹ 2,13,279.8 Crores
Time deposits with bank : ₹ 3,45,000.7 Crores
Demand deposits with bank : ₹ 1,62,374.5 Crores
Post office savings deposit : ₹ 382.9 Crores
Other deposits of RBI : ₹ 765.1 Crores (3 Marks)
Answer:
Ml = Currency and coins with the people + demand deposits of banks (current and saving accounts) + other deposits of the RBI.
= ₹ 2,13,279.8 + ₹ 1,62,374.5 + ₹ 765.1 = ₹ 3,76,419.4 Crores

(3) Describe the determinants of demand for money as identified by Mil-ton Friedman in his restatement of Quantity Theory of demand for money. (3 Marks)
Answer:
According to Milton Friedman, Demand for money is affected by the same factors as demand for any other asset, namely:

1. Permanent income.
2. Relative returns on assets (which incorporate risk).

Friedman maintains that it is permanent income – and not current income as in the Keynesian theory – that determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present expected value of all future income. To Friedman, money is a good as any other durable consumption good and its demand is a function of a great number of factors. Friedman identified the following four determinants of the demand for money. The nominal demand for money:

• is a function of total wealth, which is represented by permanent income divided by the discount rate, defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds, equity, physical capital and human capital.
• is positively related to the price level, P. If the price level rises the demand for money increases and vice versa.
• rises, if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and vice versa.
• is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby increasing the opportunity costs of money holdings.

(4) The Nominal Exchange rate of India is ₹ 56/1$, Price Index in India is 116 and Price Index in USA is 112. What will be the Real Exchange Rate of India?   (2 Marks)
Answer:
The ‘real exchange rate’ describes ‘how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a foreign country. Thus it incorporates changes in prices

Real Exchange rate = Nominal exchange rate × (Domestic price index/Foreign price index)
= 56 × \(\frac{116}{112}\) = 58

Question 9.
(1) The table given below shows the number of labour hours required to produce Sugar and Rice in two countries X and Y:

Commodity	Country X	Country Y
1 Unit of Sugar	2.0	5.0
1 unit of Rice	4.0	2.5

(a) Compute the Productivity of labour in both countries in respect of both commodities.
(b) Which country has absolute advantage in production of Sugar?
(c) Which country has absolute advantage in production of Rice? (3 Marks)
Answer:
(a) Productivity of labour (output per labour hour = the volume of output produced per unit of labour input) = output/input of labour hours

Output of commodity	Units in Country X	Units in Country Y
Sugar	0.5	0.20
Rice	0.25	0.40

(b) A country has an absolute advantage in producing a good over another country if it requires fewer resources to produce that good. Since one hour of labour time produces 0.5 units of sugar in country X against
0. 20 units in country Y, Country X has absolute advantage in production of sugar.

(c) Since one hour of labour time produces 0.40 units of rice in country Y against 0.25 units in country X, Country Y has absolute advantage in production of rice.

(2) Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the following data:
Income : ₹ 4,000
Consumption : ₹ 3,000 (2 Marks)
Answer:
The average propensity to consume (APC) is the ratio of consumption expenditures (C) to disposable income (DI):
APC = C/DI = 3,000/4,000 = 0.75
The average propensity to save (APS) is the ratio of savings to disposable income:
APS = S/DI = 1,000/4,000 =0.25

(3) Explain with example how Ad Valorem Tariff is levied. (3 Marks)
Answer:
An ad valorem tariff is a duty or other charges levied on an import item on the basis of its value and not on the basis of its quantity, size, weight, or any other factor.

It is levied as a constant percentage of the monetary value of one unit of the imported good. For example, a 20% ad valorem tariff on a computer generates ₹ 2,000 government revenue from tariff on each imported computer priced at ₹ 10,000 in the world market. If the price of computer rises to ₹ 20,000, then it generates a tariff of ₹ 4,000.

(4) Describe features of public goods. (2 Marks)
Answer:
Features of public goods:

1. Public goods yield utility and their consumption is essentially collective in nature.
2. Public goods are non rival in consumption i.e. consumption of a public good by one individual does not reduce the quality or quantity available for all other individuals
3. Public goods are non-excludable i.e. consumers cannot (at least at less than prohibitive cost) be excluded from consumption benefits
4. Public goods are characterized by indivisibility, each individual may consume all of the good i.e. the total amount consumed is the same for each individual.
5. Once a public good is provided, the additional resource cost of another person consuming the good is zero. No direct payment by the consumer is involved in the case of pure public goods and these goods are generally more vulnerable to issues such as externalities, inadequate property rights, and free rider problems
6. Competitive private markets will fail to generate economically efficient outputs of public goods. E.g. national defence.

Question 10.
(1) Distinguish between Personal Income and Disposable Personal Income. (3 Marks)
Answer:
Personal Income: Personal Income is the income received by the household sector including Non-Profit Institutions Serving Households. Thus, while na-tional income is a measure of income earned and personal income is a measure of actual current income receipts of persons from all sources which may or may not be earned from productive activities during a given period of time.

In other words, it is the income ‘actually paid out’ to the household sector, but not necessarily earned. Examples of this include transfer payments such as social security benefits, unemployment compensation, welfare payments etc. Individuals also contribute income which they do not actually receive; for example, undistributed corporate profits and the contribution of employers to social security. Personal income forms the basis for consumption expenditures and is derived from national income as follows:

PI = NI + income received but not earned – income earned but not received

Disposable Personal Income (DI): Disposable personal income is a measure of amount of the money in the hands of the individuals that is available for their consumption or savings. Disposable personal income is derived from personal income by subtracting the direct taxes paid by individuals and other compulsory payments made to the government.
DI = PI – Personal Income Taxes

(2) Explain the role of Government in a market economy as stated by Richard Musgrave. (3 Marks)
Answer:
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch taxonomy of the role of government in a market economy. The objective of the economic system and the role of government is to improve the wellbeing of individuals or households. According to ‘Musgrave Three-Function Framework’, the functions of government are to be separated into three, namely, resource allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization.

The allocation and distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic function. The allocation function aims to correct the sources of inefficiency in the economic system while the distribution role ensures that the distribution of wealth and income is fair. The stabilization branch is to ensure achievement of macroeconomic stability, maintenance of high levels of employment and price stability.

(3) Why is the central bank referred to as a “banker’s bank”? (2 Marks)
Answer:
A central bank of a country is called a ‘bankers’ bank because it acts as a banker to the community of commercial banks and provides them with financial services to facilitate their efficient functioning.

• The central bank acts as a custodian of cash reserves of commercial banks in the country.
• The central bank provides efficient means of funds transfer for all banks. All commercial banks maintain accounts with the central bank and it enables smooth and swift clearing and settlements of inter-bank transactions and interbank payments.
• The central bank acts as a lender of last resort. It provides liquidity to banks when the latter face shortage of liquidity. The scheduled commercial banks can borrow from the discount window against the collateral of securities like commercial bills, government securities, treasury bills, or other eligible papers.

(4) “World Trade Organisation (WTO) has a three-tier system of decision making.” Explain. (2 Marks)
Answer:
The World Trade Organization has a three-tier system of decision making. The WTO’s top level decision-making body is the Ministerial Conference which can take decisions on all matters under any of the multilateral trade agreements. The Ministerial Conference meets at least once every two years. The next level is the General Council which meets several times a year at the Geneva headquarters.

The General Council also meets as the Trade Policy Review Body and the Dispute Settlement Body. At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS) Council report to the General Council. These councils are responsible for overseeing the implementation of the WTO agreements in their respective areas of specialisation. The three also have subsidiary bodies. Numerous specialized committees, working groups and working parties deal with the individual agreements.

Question 11.
(1) Describe the meaning and mechanism of ‘crowding out’ effect of public expenditure. (3 Marks)
Answer:
Crowding Out Meaning: ‘Crowding out’ effect is the negative effect fiscal policy may generate when spending by government in an economy substitutes private spending. For example, if government provides free computers to students, the demand from students for computers may not be forthcoming.
Crowding Out Mechanism:
The interest rates in an economy increase when:

• Government increases its spending by borrowing from the loanable funds from market and thus the demand for loans increases.
• Government increases the budget deficit by selling bonds or treasury bills and the amount of money with the private sector decreases.

Due to high interest, private investments, especially the ones which are inter-est – sensitive, will be reduced. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion in demand resulting from an increase in government expenditure.

(2) “Money has four functions: a medium, a measure, a standard and a store.” Elucidate. (2 Marks)
Answer:
Money performs many important functions in an economy:
1. Money is a convenient medium of exchange or it is an instrument that
facilitates easy exchange of goods and services. Money, though not having any inherent power to directly satisfy human wants, by acting as a medium of exchange, it commands purchasing power and its possession enables us to purchase goods and services to satisfy our wants.

By acting as an intermediary, money increases the ease of trade and reduces the inefficiency and transaction costs involved in a barter exchange. By decomposing the single barter transaction into two separate transactions of sale and purchase, money eliminates the need for double coincidence of wants. Money also facilitates separation of transactions both in time and place and this in turn enables us to economize on time and efforts involved in transactions. ‘

2. Money is a ‘common measure of value’. The monetary unit is the unit of measurement in terms of which the value of all goods and services is measured and expressed. It is convenient to trade all commodities in exchange for a single commodity. So also, it is convenient to measure the prices of all commodities in terms of a single unit, rather than record the relative price of every good in terms of every other good.

A common unit of account facilitates a system of orderly pricing which is crucial for rational economic choices. Goods and services which are otherwise not comparable are made comparable through expressing the worth of each in terms of money.

3. Money serves as a unit or standard of deferred payment i.e money facilitates recording of deferred promises to pay. Money is the unit in terms of which future payments are contracted or stated. However, variations in the purchasing power of money due to inflation or deflation, reduces the efficacy of money in this function.

4. Like nearly all other assets, money is a store of value, .’eoplc prefer to hold it as an asset, that is, as part of their stock of wealth. The splitting of purchases and sale into two transactions involves a separation in both time and space. This separation is possible because money can be used as a store of value or store of means of payment during the intervening time.

Again, rather than spending one’s money at present, one can store it for use at some future time. Thus, money functions as a temporary abode of purchasing power in order to efficiently perform its medium of exchange function. Money also functions as a permanent store of value. Money is the only asset which has perfect liquiuity.

(3) What will be the total credit created by the commercial banking system for an initial deposit of ?3,000 at a Required Reserve Ratio (RRR) of 0.05 and 0.08 respectively? Also compute credit multiplier. (2 Marks)
Answer:
Credit Multiplier = 1/Required Reserve Ratio
For RRR 0.05 Credit Multiplier = 1/0.05 = 20
For RRR 0.08 Credit Multiplier = 1 / 0.08 = 12.5
Credit Creation = Initial Deposit × Credit Multiplier
For RRR 0.05 Credit creation = ₹ 3,000 × 20 = ₹ 60,000
For RRR 0.08 Credit creation = ₹ 3,000 × 12.5 = ₹ 37,500

(4) What are the modes of Foreign Direct Investment (FDI)?   (3 Marks)
Answer:
Foreign direct investment is defined as the process whereby the resident of one country (i.e. home country) acquires more than 10 percent ownership of an asset in another country (i.e. the host country) and such movement of capital involves ownership, control as well as management of the asset in the host country. Various modes are:

1. Opening of a subsidiary or associate company in a foreign country,
2. Equity injection into an overseas company,”
3. Acquiring a controlling interest in an existing foreign company,
4. Mergers and acquisitions (M&A),
5. Joint venture with a foreign company,
6. Green field investment (establishment of a new overseas affiliate for freshly starting production by a parent company).

CA Inter FM ECO Question Paper 1 – CA Inter FM ECO Study Material is designed strictly as per the latest syllabus and exam pattern.

FM ECO CA Inter Question Paper 1

Time Allowed – 3 Hours
Maximum Marks – 100

Section A – Financial Management

Question 1.
Answer the followings:

(a) The Sale revenue of TM excellence Ltd. @ ₹ 20 per unit of output is ₹ 20 lakhs and Contribution is ₹ 10 lakhs. At the present level of output the DOL of the company is 2.5. The company does not have any Preference , Shares. The number of Equity Shares are 1 lakh. Applicable corporate income tax rate is 50% and the rate of interest on Debt Capital is 16% p.a.
What is the EPS (At sales revenue of ₹ 20 lakhs) and amount of Debt Capital of the company if a 25% decline in Sales will wipe out EPS.
Answer:
(A) Earnings Per Share = \(\frac{(\text { EBIT }-\mathrm{I})(1-\mathrm{t})}{\text { Equity shares }}\)
= \(\frac{(4,00,000-1,50,000)(1-0.50)}{1,00,000}\) = ₹ 1.25
(B) Amount of DEBT = Interest ÷ Rate of interest
= 1,50,000 ÷ 16% = ₹ 9,37,500

Working Note:
(1) Calculation of Fixed Cost:
DOL = \(\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{10,00,000}{\text { EBIT }}\) = 2.5 times
EBIT = 10,00,000 ÷ 2.5 = ₹ 4,00,000
Fixed Cost = Contribution – EBIT
= 10,00,000 – 4,00,000 = ₹ 6,00,000

(2) Calculation of Degree of Combined Leverage:
Question says that 25% change in sales will wipe out EPS. Here wipe out means it will reduce EPS by 100%.
DCL = \(\frac{\% \text { Change in EPS }}{\% \text { Change in Sales }}=\frac{100 \%}{25 \%}\) = 4 times

(3) Calculation of EBT and Interest:
DCL = \(\frac{\text { Contribution }}{\text { EBT }}=\frac{10,00,000}{\text { EBT }}\) = 4 times
EBT = 10,00,000 ÷ 4 = ₹ 2,50,000
Interest = EBIT – EBT = 4,00,000 – 2,50,000
= ₹ 1,50,000

(b) The following figures are collected from the annual report of XYZ Ltd.:

Net Profit	₹ 30 lakhs
Outstanding 12% preference shares No. of Equity shares Return on Investment Cost of capital i.e. (Ke)	₹ 100 lakhs 3 lakhs 20% 16%

What should be the approximate dividend payout ratio so as to keep the share price at ₹ 42 by using Walter model?
Answer:

Divided Payout ratio:
= \(\frac{\text { DPS }}{\text { EPS }}\) × 100 = \(\frac{3.12}{6}\) × 100 = 52%

(c) Alpha Ltd. requires funds amounting to ₹ 80,00,000 for its new project. To raise the funds, the company has following two alternatives:

(1) To issue Equity Shares of ₹ 100 each (at par) amounting to ₹ 60,00,000 and borrow the balance amount at the interest of 12% p.a.; or
(2) To issue Equity Shares of ₹ 100 each (at par) and 12% Debentures in equal proportion.
Find out the point of in difference between two modes of financing and state which option will be beneficial in different situations assuming tax rate 30%.
Answer:
Calculation of Indifference two modes of financing:
\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)
\(\frac{(\text { EBIT }-12 \% \text { of } 20 \text { lakhs) }(1-0.30)}{60,000}\) = \(\frac{(\text { EBIT }-12 \% \text { of } 20 \text { lakhs) }(1-0.30)}{40,000}\)
EBIT = ₹ 9,60,000
Course of action:
(a) If expected EBIT is less than ₹ 9,60,000 : Alternate 1
(b) if expected EBIT is equal to ₹ 9,60,000 : Alternate 1 or 2
(c) If expected EBIT is more than ₹ 9,60,000: Alternate 2

(d) From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
Working capital: ₹ 2,40,000
Bank overdraft : ₹ 40,000
Fixed assets to proprietary ratio : 0.75
Reserves and Surplus : ₹ 1,60,000
Current ratio : 2.5
Liquid ratio : 1.5
Answer:
Balance Sheet As at 31.03.2002

Working Notes:
1. Current assets and Current liabilities computation:
\(\frac{\mathrm{CA}}{\mathrm{CL}}\) = 2.5
CA = 2.5 CL
Working capital = CA – CL
2,40,000 = 2.5 CL – CL
CL = 1,60,000
CA = 1,60,000 × 2.5 = ₹ 4,00,000

2. Computation of stock:
Liquid ratio = \(\frac{\text { Liquid Assets }}{\text { Current Liabilities }}\)
1.5 = \(\frac{\text { Current Assets-Stock }}{1,60,000}\)
1.5 × 1,60,000 = 4,00,000 – Stock
Stock = 1,60,000

3. Computation of Proprietary fund. Fixed assets, Capital and Sundry Creditor
\(\frac{\text { Fixed Assets }}{\text { Proprietary Fund }}\) = 0.75
Fixed assets = 0.75 Proprietary fund
Net working capital = 0.25 Proprietary fund
2,40,000 = Proprietary fund
Proprietary fund = \(\frac{2,40,000}{0.25}\) = 9,60,000
Fixed assets = 0.75 Proprietary fund
= 0.75 × 9,60,000 = 7,20,000
Share Capital = Proprietary fund – R & S
= 9,60,000 – 1,60,000 = 8,00,000
Sundry creditors = CL – Bank overdraft
= 1,60,000 – 40,000 = 1,20,000

Question 2.
A company has to make a choice two machines ‘X’ and ‘Y’. The two machines have identical capacity, do exactly the same job, but designed differently.

Machine X costs ₹ 5,50,000 and will last for three years. It costs ₹ 1,25,000 per year to run. Machine Y is an economic model costing ₹ 4,00,000 will last for two years. It costs ₹ 1,50,000 per year to run.

The cash flows of machine ‘X’ and ‘Y’ are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore taxes. The present value factors at 12% are:

Years	t1	t2	t3
PVIF0.12t	0.8929	0.7972	0.7118
PVIFA0.12.2 = 1.6901
PVIFA0.12.3 = 2.4019

Which machine would you recommend the company to buy? (10 Marks)
Answer:
Statement Showing Evaluation of Two Machines

Select the Machine X having lower equivalent annualized outflow.

Question 3.
The R & G Company has following capital structure at 31st March, 2004, which is considered to be optimum:
13% debenture : ₹ 3,60,000
11% preference share capital : ₹ 1,20,000
Equity share capital (2,00,000 shares) : ₹ 19,20,000
The company’s share has a current market price of ₹ 27.75 per share. The expected dividend per share in next year is 50 per cent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

The company can issue 14 per cent new debenture. The company’s debenture is currently selling at ₹ 98. The new preference issue can be sold at a net price of ₹ 9.80, paying a dividend of ₹ 1.20 per share. The company’s marginal tax rate is 50%.

(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that retained earning available for next year’s investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part (iii)] if the company can sell new ordinary shares to net ₹ 20 per share? The cost of debt and of preference capital is constant. (10 Marks)
Answer:
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

Name of source	Amount (₹)	Proportion
13% debentures	3,60,000	0.15
11% Preference	1,20,000	0.05
Equity share capital	19,20,000	0.80
Total	24,00,000	1.00

(i) (a) After tax cost of new debt
K_d = \(\frac{I(1-t)}{N P}\) × 100 = \(\frac{14(1-.50)}{98}\) × 100 = 7.143%
After tax cost of new preference shares
K_p = \(\frac{\mathrm{PD}}{\mathrm{NP}}\) × 100 = \(\frac{1.20}{9.80}\) × 100 = 12.25%

(b) Cost of new equity (comes from retained earnings)
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0 \text { (old) }}\) + g = \(\frac{1.3865}{27.75}\) + 0.12 = 17%

(ii) MCC (K₀) = K_dW_d + K_pW_p + K_eW_e
= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%

(iii) The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital
Therefore, investment before new issue = \(\frac{2,77,300}{80 \%}\) = ₹ 3,46,625
Retained earnings = ₹ 1.3865 × 2,00,000
= ₹ 2,77,300

(iv) MCC (K₀)
= K_dW_d + K_pW_p + K_eW_e
= 7.14396 × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than ₹ 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
K_e = \(\frac{D_1}{P_0(\text { new })}\) + g = \(\frac{1.3865}{20}\) + 0.12 = 18.93%

Question 4.
Q Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of production.
Its annual figures are as under:
Sales (at 2 months’ credit) : ₹ 24,00,000
Materials consumed (suppliers credit 2 months) : ₹ 6,00,000
Wages paid (monthly at the beginning of the subsequent month) : ₹ 4,80,000
Manufacturing expenses (cash expenses are paid one month in arrear) : ₹ 6,00,000
Administration expenses (cash expenses are paid one month in arrear) : ₹ 1,50,000
Sales promotion expenses (paid quarterly in advance) : ₹ 75,000
The company keeps one month stock each of raw materials and finished goods. A minimum cash balance of ₹ 80,000 is always kept. The company wants to adopt a 10% safety margin in the maintenance of working capital. The company has no work-in-progress.

Find out the requirements of working capital of the company on cash cost basis. (10 Marks)
Answer:
Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:
Projected Income Statement

Question 5.
RST Ltd. is expecting an EBIT of ₹4,00,000 for F.Y. 2015-16. Presently the company is financed by equity share capital ₹ 20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different options and also state which is the best option. (10 Marks)
Answer:
Statement of Value of Firm and Cost of Capital

Decision: Company should opt for 30% debt finance having higher Value of firm and lower K₀.

Question 6.
(a) Briefly explain the three finance function decisions. (3 Marks)
Answer:
The finance functions are divided into long term and short term functions/ decisions:
Long term Finance Function Decisions
(i) Investment decisions (I):
These decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for various fixed assets and also for current assets.

(ii) Financing decisions (F):
These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the sources of available funds and their respective costs and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity capital and debt.

(iii) Dividend decisions (D):
These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any profit-making organization looks for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.

Short-term Finance Decisions/Function
Working capital Management (WCM): Generally short term decision is reduced to management of current asset and current liability (ie., working capital Management).

(b) Explain the steps while using the equivalent annualized criterion. (3 Marks)
Answer:
Equivalent Annualized Criterion: This method involves the following steps:

1. Compute NPV using the WACC or discounting rate.
2. Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period of each project.’
3. Divide NPV computed under step (i) by PVAF as computed under step (ii) and compare the values.

(c) Explain the significance of Cost of Capital. (4 Marks)
OR
Briefly describe any four sources of short-term finance.
Answer:
ignificance of the Cost of Capital: The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision making:

(i) Evaluation of investment options:
The estimated benefits (future cash flows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).

(ii) Performance Appraisal:
Cost of capital is used to appraise the performance of a particulars project or business. The performance of a project or business in compared against the cost of capital which is known here as cut-off rate or hurdle rate.

(iii) Designing of optimum credit policy:
While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.

OR

Sources of Short Term Finance: There are various sources available to meet short-term needs of finance. The different sources are discussed below-

(i) Trade Credit:
It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to almost all business operations. It can be in the form of an ‘open account’ or ‘bills payable’.

(ii) Accrued Expenses and Deferred Income:
Accrued expenses represent liabilities which a company has to pay for the services which it has already received like wages, taxes, interest and dividends. Such expenses arise out of the day-to-day activities of the company and hence represent a spontaneous source of finance.

Deferred Income:
These are the amounts received by a company in lieu of goods and services to be provided in the future. Since these receipts increases a company’s liquidity, they are also considered to be an important sources of short-term finance.

(iii) Advances from Customers:
Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing or construction time usually demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful.

(iv) Commercial Paper:
A Commercial Paper is an unsecured money market instrument issued in the form of a promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.

(v) Treasury Bills:
Treasury bills are a class of Central Government Securities. Treasury bills, commonly referred to as T-Bills are issued by Government of India to meet short term borrowing requirements with maturities ranging between 14 to 364 days.

(vi) Certificates of Deposit (CD):
A certificate of deposit (CD) is basically a savings certificate with a fixed maturity date of not less than 15 days up to a maximum of one year.

(vii) Bank Advances:
Banks receive deposits from public for different periods at varying rates of interest. These funds are invested and lent in such a manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met and a reasonable profit is made. A bank’s lending policy is not merely profit motivated but has to also keep in mind the socio-economic development of the country. Some of the facilities provided by banks are Short Term Loans, Overdraft, Cash Credits, Advances against goods, Bills Purchased/Discounted.

(viii) Financing of Export Trade by Banks:
Exports play an important role in accelerating the economic growth of developing countries like India. Of the several factors influencing export growth, credit is a very important factor which enables exporters in efficiently executing their export orders. The commercial banks provide short-term export finance mainly by way of pre and post-shipment credit. Export finance is granted in Rupees as well as in foreign currency.

(ix) Inter Corporate Deposits:
The companies can borrow funds for a short period say 6 months from other companies which have surplus liquidity. The rate of interest on inter corporate deposits varies depending upon the amount involved and time period.

(x) Certificate of Deposit (CD):
The certificate of deposit is a document of title similar to a time deposit receipt issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encash the deposit before maturity period and the investor is assured of liquidity because he can sell the CD in secondary market.

(xi) Public Deposits:
Public deposits are very important source of short-term and medium term finances particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid up capital and reserves, from the public and shareholders.

These deposits may be accepted for a period of six months to three years. Public deposits are unsecured loans; they should not be used for acquiring fixed assets since they are to be repaid within a period of 3 years. These are mainly used to finance working capital requirements.
Note: Student may write any six.

Section B – Economics For Finance

Question 7.
(a) Calculate Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) from the following data: (2 Marks)

Answer:
(a) MPC (b) = ∆C/∆Y
= (9,000 – 6,000) ÷ (12,000 – 8,000) = 0.75
(b) MPS = 1 – b = 1 – 0.75 = 0.25

(b) Why is there a need for the government to resort to resource allocation? (3 Marks)
Answer:
Market failures provide the rationale for government’s allocative function. Market failures are situations in which a particular market, left to itself, is inefficient and leads to misallocation of society’s scarce resources. In the absence of appropriate government intervention in resource allocation, the resources are likely to be misallocated with too much production of certain goods or too little production of certain other goods. The allocation responsibility of the governments involves suitable corrective action when private markets fail to provide the right and desirable combination of goods and services to ensure optimal outcomes in terms of social welfare.

(c) Suppose in an economy:
Consumption Function = 150 + 0.75Y_d
Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) = 40
Exports (X) = 35
Imports (M) = 15 + 0.1Y
Where, Y and Y_d are National Income and Personal Disposable Income respectively. All figures are in rupees.

Find:
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level (5 Marks)
Answer:
(a) The equilibrium level of National Income:
Y =C + I + G + (X – M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 4- 0.5 = 800

(b) Consumption at equilibrium level:
C = 150 + 0.75Y_d
Y_d = Y – Tax + Transfer Payments,
= Y – (20 + 0.2Y) + 40 = 0.8Y + 20,
and C = 150 + 0.75Y_d
= 150 + 0.75 (0.8Y + 20) (where Y_d = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800 = 645

(c) Net Exports at equilibrium level:
X – M = 35 – (15 + 0.1Y)
= 35 – (15 + 0.1 × 800) = – 60
There is adverse balance of trade

Question 8.
(a) Explain the leakages and Injections in the circular flow of Income. (2 Marks)
Answer:
Leakages:
A leakage is an outflow or withdrawal of income from the circular flow. Leakages are money leaving the circular flow and therefore, not available for spending on currently produced goods and services. Leakages reduce the flow of income.

Injections:
An injection is a non-consumption expenditure. It is an expenditure on goods and services produced within the domestic territory but not used by the domestic household for consumption purposes. Injections are exogenous additions to the circular flow and add to the total volume of the basic circular flow.

In the two-sector model with households and firms, household saving is the only leakage and investment is the only injection. In the three-sector model which includes the government, saving and taxes are the two leakages and investment and government purchases are the two injections. In the four-sector model which includes foreign sector also, saving, taxes, and imports are the three leakages; investment, government purchases, and exports are the three injections.

The state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports

(b) Define ‘Market power’. What Is Its disadvantage? (2 Marks)
Answer:
Market power is the ability of a price making firm to profitably raise the market price of a good or service over its marginal cost and thus earn supernormal profits or positive economic profits. Market power is an important cause of market failure. Market failure occurs when the free market outcomes do not maximize net benefits of an economic activity and therefore there is deadweight losses and inefficient allocation of resources.

Excess market power causes a single producer or a small number of producers to strategically reduce their supply and charge higher prices compared to competitive market. Market power can cause markets to be inefficient because it keeps price and output away from the equilibrium of supply and demand. Market power thus results in suboptimal outcomes such as deadweight loss, underproduction of goods and services, higher prices and loss of consumer surplus.

(c) The RBI published the following data as on 31st March, 2018. You are required to compute M4: (3 Marks)
(₹ in crores)
Currency with the public : ₹ 1,12,206.6
Demand Deposits with Banks : ₹ 1,93,300.4
Net Time Deposits with Banks : ₹ 2,67,310.2
Other Deposits of RBI : ₹ 614.8
Post Office Savings Deposits : ₹ 277.5
Post Office National Savings Certificates (NSCs) : ₹ 110.5
Answer:
M4 = Currency and coins with the people + demand deposits with the banks (Current and Saving accounts) + other deposits with the RBI + Net time deposits with the banking system + Total deposits with the Post Office Savings (excluding National Savings Certificate

Components	₹ in Crores
Currency with the public Demand deposits with banks Other deposits with the RBI Net time deposits with the banking system	1,12,206.6 1,93,300.4 2,67,310.2 614.8
Post office saving deposits	277.5
Total	5,73,709.5

(d) Explain the role of Monetary Policy Committee (MPC) In India. (3 Marks)
Answer:
Monetary Policy Committee (MPC) constituted by the Central Government is an empowered six-member committee with RBI Governor as the chairperson. Under the Monetary Policy Framework Agreement, the RBI will be responsible for price stability and for containing inflation targets at 496 (with a standard deviation of 296) in the medium term.

The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months. MPC has complete control over monetary policy decisions to ensure economic growth and price stability. The MPC decides the changes to be made to the policy rate (repo rate) so as to contain inflation within the target level specified to it by the central government.

Fixing of the benchmark policy interest rate (repo rate) is made in a more consultative and participative manner and on the basis of majority vote by this panel of experts. This has added lot of value and transparency to monetary policy decisions.

Question 9.
(a) From, the following data, compute the Gross National Product at Market Price using Value Added method: (3 Marks)

Answer:
Value Added Method:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 800 – 300 + 1,000 – 400 + 3,000 – 900 = 3,200 Crores
GNP_MP = GDP_MP + NFIA
= 3,200 – 100 = 3,100 Crores

(b) Describe the limitations of fiscal policy. (3 Marks)
Answer:
The following are the significant limitations in respect of choice and implementation of fiscal policy: ‘
1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is the different types of lags involved in fiscal policy action. There are significant lags such as recognition lag, decision lag, implementation lag and impact lag.

2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an expansionary policy is initiated when the economy is already on a path of recovery and vice versa.

3. There are difficulties in instantaneously changing governments’ spending and taxiftion policies.

4. It is practically difficult to reduce government spending on various items such as defence and social security as well as on huge capital projects which are already midway.

5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.

6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and also promptly determining the accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal policy such that a policy designed to achieve one goal may adversely affect another. For example, an expansionary fiscal policy may worsen inflation in an economy.

8. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example, increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security benefits may adversely affect incentives to work and save.

9. Deficit financing increases the purchasing power people. The production of goods and services, especially in under developed countries may not catch up simultaneously to meet the increased demand. This will result in prices spiraling beyond control.

10. Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid. If the economy lags behind in productive utilization of borrowed money, sufficient surpluses will not be generated for servicing debts. External debt burden has been a constant problem for India and many developing countries.
11. An increase in the size of government spending during recessions will ‘crowd out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long run economic growth.

12. If governments compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may not be realized.
Note: Student may write any six.

(c) Explain the Monetary Policy Framework Agreement. (2 Marks)
Answer:
The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the Monetary Policy Framework Agreement. It is an agreement reached between the Government of India and the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability.

The amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation targeting framework’ by abandoning the ‘multiple indicator’ approach. The inflation target is to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly –

• The Central Government has notified 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5,2016 to March 31, 2021 with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.
• The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and the forecasts of inflation for the coming period of six to eighteen months.

(d) Explain ‘depreciation’ and ‘appreciation’ of home currency under floating exchange rate. (2 Marks)
Answer:
Under a floating rate system, home currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies i.e. there is an increase in the home currency price of the foreign currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹ 70 and ₹ 72 in June, then the Indian Rupee has depreciated in its value with respect to the US dollar and the value of US dollar has appreciated in terms of the Indian Rupee.

On the contrary, home currency appreciates when its value increases with respect to the value of another currency or a basket of other currencies i.e. there is a decrease in the home currency price of foreign currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹72 and ₹70 in June, then the Indian Rupee has appreciated in its value with respect to the US dollar and the value of US dollar has depreciated in terms of the Indian Rupee.

Question 10.
(a) What is meant by quasi public goods? (2 Marks)
Answer:
A quasi public good or near public good has many but not all the characteristics of a public good. These are goods which have an element of non-excludability and non rivalry.
Quasi public goods are:
(i) Not completely non rival. For example, public roads wi-fi networks and public parks do not get congested so as to reduce the space available for others when extra consumers use them only up to an optimal point. When more people use it beyond that, the amount others can benefit from these is reduced to some extent, because there will be increased congestion.

(ii) It is easy to keep people away from quasi public goods by charging a price or fee. For example, it is possible to exclude some users by building toll booths to charge for road usage on congested routes. Other examples are education, and health services. It is easy to keep people away from them by charging a price or fee.

However, it is undesirable to keep people away from such goods because the society would be better off if more people consume them. This particular characteristic namely, the combination of virtually infinite benefits and the ability to charge a price results in some quasi-public goods being sold through markets and others being provided by government.

(b) What is meant by expansionary fiscal policy? Under what circumstances does government pursue expansionary policy? (3 Marks)
Answer:
An expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes.

The objectives of expansionary fiscal policy are reduction in cyclical unemployment, increase in consumer demand and prevention of recession and possible depression. In other words, it aims to close a ‘recessionary gap’ or a contractionary gap wherein the aggregate demand is not sufficient to create conditions of full employment.

This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes. Government uses subsidies, transfer payments, welfare programmes, corporate and personal income tax cuts and increased spending on public works such as on infrastructure development to put more money into consumers’ hands to give them more purchasing power.

(c) Mention the general characteristics of Money. (2 Marks)
Answer:
There are some general characteristics that money should possess in order to make it serve its functions as money. Money should be:

• Generally acceptable
• Durable or long-lasting
• Effortlessly recognizable
• Difficult to counterfeit i.e. not easily reproducible by people
• Relatively scarce, but has elasticity of supply
• Portable or easily transported
• Possessing uniformity; and
• Divisible into smaller parts in usable quantities or fractions without losing value.

(d) Explain the classical theory of Comparative Advantage as given by David Ricardo. (3 Marks)
Answer:
The law of comparative advantage states that even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of both commodities, there is still scope for mutually beneficial trade.

The first nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage). Labour differs in its productivity internationally and different goods have different labour requirements, so comparative labour productivity advantage was Ricardo’s predictor of trade.

The theory can be explained with a simple example Output per Hour of Labour

Commodity	Country .4	Country R
Wheat (bushels/hour)	6	1
Cloth (yards/hour)	4	2

Country B has absolute disadvantage in the production of both wheat and cloth. However, since B’s labour is only half as productive in cloth but six times less productive in wheat compared to country A, country B has a comparative advantage in cloth. On the other hand, country A has an absolute advantage in both wheat and cloth with respect to the country B, but since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), country A has a comparative advantage in wheat.

According to the law of comparative advantage, both nations can gain if country A specialises in the production of wheat and exports some of it in exchange for country B’s cloth. Simultaneously, country B should specialise in the production of cloth and export some of it in exchange for country A’s wheat.

If country A could exchange 6W for 6C with country B, then, country A would gain 2C (or save one-half bour of labour time) since the country A could only exchange 6W for 4C domestically. The 6W that the country B receives from the country A would require six hours of labour time to produce in country B. With trade, country B can instead use these six hours to produce 12C and give up only 6C for 6W from the country A. Thus, the country B would gain 6C or save three hours of labour time and country A would gain 2C. However, the gains of both countries are not equal.

Question 11.
(a) Explain the different mechanism of monetary policy which influences the price level and national income. (3 Marks)
Answer:
The process or channels through which the evolution of monetary aggregates affects the level of product and prices is known as ‘monetary transmission mechanism’. There are mainly four different mechanisms, namely, the interest rate channel, the exchange rate channel, the quantum channel, and the asset price channel.

The interest rate channel: A contractionary monetary policy-induced increase in interest rates increases the cost of capital and the real cost of borrowing for firms and households with the result that they cut back on their investment expenditures and durable goods consumption expenditures respectively.

A decline in aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of capital for firms and cost of borrowing for households.

The exchange rate channel: The exchange rate channel works through expenditure switching between domestic and foreign goods. Appreciation of the domestic currency makes domestically produced goods more expensive compared to foreign-produced goods. This causes net exports to fall; correspondingly domestic output and employment also fall.

The quantum channel: (e.g., relating to money supply and credit) Two distinct credit channels: the bank lending channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate through the real economy. Credit channel operates by altering access of firms and households to bank credit.

A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest rates works to increase the payments that the firm must make to service its floating rate debts. An indirect effect sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long-lived assets.

The asset price channel: Asset prices respond to monetary policy changes and consequently impact output, employment and inflation. A policy-induced increase in the short-term nominal interest rates makes debt instruments more attractive than equities in the eyes of investors leading to a fall in equity prices, erosion in household financial wealth, fall in consumption, output, and employment.

(b) How does international trade Increase economic efficiency? Explain. (3 Marks)
Answer:
International trade is a powerful stimulus to economic efficiency and contributes to economic growth and rising incomes.
(i) The wider market made possible owing to trade induces companies to reap the quantitative and qualitative benefits of extended division of labour. As a result, they would enlarge their manufacturing capabilities and benefit from economies of large scale production.

(ii) The gains from international trade are reinforced by the increased competition that domestic producers are confronted with on account of internationalization of production and marketing requiring businesses to invariably compete against global businesses. Competition from foreign goods compels manufacturers, especially in developing countries, to enhance competitiveness and profitability by adoption of cost reducing technology and business practices. Efficient deployment of productive resources to their best uses is a direct economic advantage of foreign trade. Greater efficiency in the use of natural, human, industrial and financial resources ensures productivity gains.

Since international trade also tends to decrease the likelihood of domestic monopolies, it is always beneficial to the community.

(iii) Trade provides access to new markets and new materials and enables sourcing of inputs and components internationally at competitive prices. Also, international trade enables consumers to have access to wider variety of goods and services that would not otherwise be available. It also enables nations to acquire foreign exchange reserves necessary for imports which are crucial for sustaining their economies.

(iv) International trade enhances the extent of market and augments the scope for Mechanization and specialisation.

(v) Exports stimulate economic growth by creating jobs, reducing poverty and augmenting factor incomes and in so doing raising standards of livelihood and overall demand for goods and services.

(vi) Employment generating investments, including foreign direct investment, inevitably follow trade.

(vii) Opening up of new markets results in broadening of productive base and facilitates export diversification.

(viii) Trade also contributes to human resource development, facilitates fundamental and applied research and exchange of know-how and best practices between trade partners

(ix) Trade strengthens bonds between nations by bringing citizens of different countries together in mutually beneficial exchanges and thus promotes harmony and cooperation among nations.
Note: Student may write any six.

(c) What is meant by ‘Mixed tariffs’? (2 Marks)
Answer:
Mixed tariffs are expressed either on the basis of the value of the imported goods (an ad valorem rate) or on the basis of a unit of measure of the imported goods (a specific duty) depending on which generates the most income (or least income at times) for the nation. For example, duty on cotton: 5 per cent ad valorem or ₹ 3,000 per tonne, whichever is higher.

(d) Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). (2 Marks)
Answer:
Foreign direct investment takes place when the resident of one country (i.e. home country) acquires ownership of an asset in another country (i.e. the host country) and such movement of capital involves ownership, control as well as management of the asset in the host country. Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than ‘real capital’ and does not involve ownership or control on the part of the investor.

Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)

Foreign Direct Inwsttnenr (FDI)	Foreign Portfolio Investment (FPI)
Investment involves creation of physical assets	Investment is only in financial assets
Has a long term interest and therefore remain invested for long	Only short term interest and generally remain invested for short periods
Relatively difficult to withdraw	Relatively easy to withdraw
Not inclined to be speculative	Speculative in nature
Often accompanied by technology transfer	Not accompanied by technology transfer
Direct impact on employment of labour and wages	No direct impact on employment of labour and wages
Enduring interest in management and control	No abiding interest in management and control
Securities are held with significant degree of influence by the investor on the management of the enterprise	Securities are held purely as a financial investment and no significant degree of influence on the management of the enterprise

Employee Cost – CA Inter Costing Study Material is designed strictly as per the latest syllabus and exam pattern.

Employee Cost – CA Inter Costing Study Material

1. Straight Time Rate System: Wages is paid on the basis of time irrespective of production volume.
Wages = Time Worked (Hours/Days/Months) × Time Rate

• Straight Piece Rate System: Wages is paid on the basis of number of units produced irrespective of lime spent for production.
  Wages = Number of units produced × Rate per unit
• Halsey Premium Plan = Time taken × Time rate + 50% of time saved × Time rate
• Rowan Premium Plan:
  = Time Taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Taken × Rate per hour

2. Employee Efficiency: It the time taken by a worker on a job equals or less i than the standard time, then he is rated efficient.
Efficiency (%) = \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × 100

3. Employee Productivity: It is used for measuring the efficiency of individual workers. It is an index of efficiency in the utilisation of human resources, materials, capital, power and all kinds of services and facilities.
= \(\frac{\text { Standard time for doing actual work }}{\text { Actial time }}\)

4. Employee (Labour) Turnover: It is the rate of change in the composition of employee force during a specif ied period measured against a suitable index.
Methods of calculating employee turnover;
Replacement Method = \(\frac{\text { No. of employees Replaced during the period }}{\text { Average No. of employees during the period on roll }}\) × 100

Separation Method:
= \(\frac{\text { No. of employees Separated during the period }}{\text { Average No. of employees during the period on roll }}\) × 100

Flux Method:

Equivalent Employee (Labour) Turnover Rate: Ii is used when data given is for a period other than a year to convert it into equivalent annual employee turnover rate.
= \(\frac{\text { Employee Turnover rate for the period }}{\text { Number of days in the period }}\) × 365

Question 1.
Distinguish between ‘Direct and Indirect labour costs’. [CA In ter Nov. 2001, 2 Marksj
Answer:
Direct Labour Cost is the cost of benefits paid or payable to the employees which can be directly attributed to a cost object in an economically feasible manner. This can be easily identified and allocated to an activity, contract, cost centre, customer, process, product etc.

Indirect Labour Cost is the cost of benefits paid or payable to the employees, which cannot be directly attributable to a particular cost object in an economically feasible manner.

The direct labour cost can be identified with and can be charged to the job. However, indirect labour costs cannot be so charged and is therefore, to be treated as part of the factory OH and it is to be included in the cost of production.

Question 2.
Discuss any four objectives of ‘Time keeping’ in relation to attendance and payroll procedures. [CA Inter Nov. 2020, 4 Marks]
Answer:
The objectives of time-keeping in relation to attendance and paxroll procedures are as follows:

• For the preparation of payrolls.
• For calculating overtime.
• For ascertaining and controlling employee cost.
• For ascertaining idle time.
• For disciplinary purposes.
• For overhead distribution.

Question 3.
Enumerate the various methods of Time booking. [CA Inter May 2007, 2 Marks]
Answer:
Following are the methods of Time Booking:

• Job ticket
• Combined Time and Job ticket.
• Daily time sheet
• Piece work card
• Clock card

Question 4.
Discuss accounting treatment of idle capacity costs in cost accounting. [CA Inter May 2009, May2006, May 2005, May 2003, 3 Marks]
Answer:
Idle time is the time during which no production is carried out because the workers remain idle hut are paid. In other words, it is the difference between the lime paid and the time booked. Idle time can be normal or abnormal.

Treatment of Idle Capacity Cost:
(i) Normal idle time: It is the time which cannot be avoided or reduced in the normal course of business. E.g., Time lost between factory gate and place of work, interval between one job and another, machine setup time, normal rest time, lunch break etc.

Normal idle time cost will be treated as a part of cost of production. In case of direct workers, an allowance for normal idle time is considered setting of standard hours or standard rate and in case of indirect workers, normal idle time is considered for the computation of overhead rate.

(ii) Abnormal idle time: There may be some factors which may give rise to abnormal idle time such as lack of coordination, power failure, machine breakdown, non-availability of raw materials, strikes, lockouts, poor supervision, fire, flood etc.
Abnormal idle time cost is not included as a part of production cost, but it is shown as a separate item in the Costing Profit and Loss Account.

Question 5.
Discuss the effect of overtime payment on productivity. [CA Inter Nov 2001, 3 Marks]
Answer:
Effect of overtime payment on productivity:
Overtime work should be resorted to, only when it is extremely essential because it involves extra cost. The overtime payment increases the cost of production in the following ways:

1. The overtime premium paid is an extra payment in addition to the normal rate.
2. The efficiency of operators during overtime work may fall and thus output may be less than normal output.
3. In order to earn more, workers may not concentrate on work during normal time and thus the output during normal hours may also fall.
4. Reduced output and increased premium of overtime will bring about an increase in costs of production.

Question 6.
Discuss the treatment of overtime premium in Cost Accounting. [CA Inter May 2008, May 2006, Nov. 2004, May 2003, 3 Marks]
Answer:

• If overtime is resorted to at the desire of the customer, then overtime premium may be charged to the job directly.
• If overtime is required to cope with general production programmes or for meeting urgent orders, the overtime premium should be treated as overhead cost of the particular department or cost centre which works overtime.
• If overtime is worked in a department due to the fault of another department, the overtime premium should be charged to the latter department.
• Overtime worked on account of abnormal conditions such as flood, earthquake etc., should not be charged to cost, but to Costing Profit and Loss Account.

Question 7.
State the circumstances in which time rate system of wage payment can be preferred in a factory. [CA Inter Nov 2001, 3 Marks]
Answer:
Time rate system of wage payment is suitable for the employees:

• whose services cannot be directly or tangibly measured, e.g. general helpers, supervisory and clerical staff etc.
• engaged on highly skilled jobs.
• where the pace of output is independent of the operator e.g., automatic chemical plants.

Question 8.
Describe briefly, how wages may be calculated under the following systems:
(i) Rowan system
(ii) Halsey system. [CA Inter Nov 2008, 9 Marks}
Answer:
(i) Rowan System: Under the Rowan system, a standard time allowance is fixed for the performance of a job and bonus is paid if time is saved. Under Rowan System the bonus is that proportion of the time wages as time saved bears to the standard time.
Time taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time allowed }}\) × Time taken × Rate per hour

(ii) Halsey System: Under the Halsey system, a standard time is fixed for
each job or process and the workers are encouraged to do the job in less than the standard time. If there is no saving on this standard time allowance, the worker is paid only his day rate. He gets his time rate even if he exceeds the standard time limit, since his day rate is guaranteed. If, however, he does.the job in less than the standard time, he gets a bonus of 50% of the wages of time saved; the employer benefits by the other 50%.
Time taken × Time rate + 50% of time saved × Time rate.

Question 9.
Which is better plan out of Halsey 50% bonus scheme and Rowan bonus scheme for an efficient worker? In which situation the worker get came bonus in both schemes? [CA Inter May 2010, 3 Marks]
Answer:
Rowan Bonus Scheme pays more bonus if the time saved is below 50% of time allowed and if the time saved is more than 50% of time allowed then Halsey bonus scheme pays more bonus. Generally, time saved by a worker is not more than 50% of time allowed. So, the Rowan bonus scheme is better for an efficient worker. When the time saved is equal to 50% of time allowed then both plans pays same bonus to a worker.
Bonus under Halsey Plan = Time saved × 50% × Time rate
Bonus under Rowan Plan
\(\frac{\text { Time taken }}{\text { Time allowed }}\) × Time saved × Rate per hour
Bonus under Halsey Plan will be equal to the Bonus under Rowan Plan when the following condition holds good:
Time saved × 50% × Time rate = \(\frac{\text { Time taken }}{\text { Time allowed }}\) × Time saved × Time rate
50% = \(\frac{\text { Time taken }}{\text { Time allowed }}\)
Hence, when the actual time taken is 50% of the time allowed, the bonus under Halsey and Rowan Plans is equal.

Question 10.
List important factors which must be taken into consideration for increasing labour productivity. [CA Inter May 2018, 4 Marks]
Answer:
The important factors which must be taken into consideration for increasing labour productivity are as follows:

• Employing only those workers who possess the right type of skill.
• Placing a right type of man on the right job.
• Training young and old workers by providing them the right types of opportunities.
• Taking appropriate measures to avoid the situation of excess or shortage of labour at the shop floor.
• Carrying out work study for the fixation of wage rate, and for the simplifi-cation and standardisation of work.

Question 11.
What do you understand by labour turnover? How is it measured? [CA Inter Nov.2014, Nov. 2010, Nov. 2004, May 2003, 5 Marks]
Answer:
Employee turnover or labour turnover in an organisation is the rate of change in the composition of employee force during a specified period measured against a suitable index.

The standard of usual employee turnover in the industry or locality or the employee turnover rate for a past period may be taken as the index or norm against which actual turnover rate is compared.

The methods for measuring labour turnover are:
(i) Replacement Method: This method takes into consideration actual replacement of employees irrespective of number of persons leaving
the organisation.

Note: New employees appointed on account of expansion plan of the organisation are not included in number of replacements.

(ii) Separation Method: In this method employee turnover is measured by dividing the total number of employees separated during the period by the average total number of employees on payroll during the same period.

(iii) Flux Method: This method takes both the number of replacements as well as the number of separations during the period into account for calculation of employee turnover.

When number of accessions are considered for measuring employee turnover, the employee turnover rate by Flux method may be computed by using any one of the following expressions:

Question 12.
Enumerate the causes of labour turnover. [CA Inter May 2011, 4 Marks]
Answer:
The main causes of labour turnover in an organisation/industry can be broadly classified under the following three heads:
(a) Personal Causes: These are the causes which induce or compel workers to leave their jobs such as change of jobs for betterment; premature retirement due to ill health or old age; domestic problems and family responsibilities; discontent over the jobs and working environment.

(b) Unavoidable Causes: These are the causes under which it becomes obligatory on the part of management to ask one or more of their employees to leave the organisation such as seasonal nature of the business; shortage of raw material, power, slack market for the product; change in the plant location; marriage (generally in the case of women) etc.

(c) Avoidable Causes: These are the causes which require the attention of management on a continuous basis so as to keep the labour turnover ratio as low as possible. The main causes are dissatisfaction with job, remuneration, hours of work, working conditions; strained relationship with management, supervisors or fellow workers; lack of training facilities and promotional avenues; low wages and allowances.

Question 13.
Discuss the two types of cost associated with labour turnover. [CA Inter Nov. 20033 Marks]
Answer:
The two types of costs associated with labour turnover are:
(a) Preventive Costs: These costs are incurred to prevent employee turnover or keep it as lowest as possible. It includes cost of medical benefit provided to the employees, cost incurred on employees’ welfare like pension etc., cost on other benefits with an objective to retain employees.

(b) Replacement Costs: These are the costs which arise due to employee turnover. If employees leave soon after they acquire the necessary’ training and experience of good work, additional costs will have to be incurred on new workers, i e., cost of recruitment, training and induction, abnormal breakage and scrap and extra wages and overheads due to the inefficiency of new workers.

A company will incur very high replacement costs if the rate of employee turnover is high. Similarly, only adequate preventive costs can keep Employee turnover at a low level. Therefore, each company must work out the optimum level of Employee turnover keeping in view its personnel policies and the behaviour of replacement cost and preventive costs at various levels of Employee turnover rates.

Question 14.
Describe the remedial steps to be taken to minimize the labour turnover. [CA Inter May 2019, Nov. 2007, 4 Marks]
Answer:
The following steps are useful for minimizing labour turnover:

• Exit interview: An interview to be arranged with each outgoing employee to ascertain the reasons of his leaving the organisation.
• Job analysis and evaluation: to ascertain the requirement of each job.
• Organisation should make use of a scientific system of recruitment, placement and promotion for employees.
• Organisation should create healthy atmosphere, providing education, medical and housing facilities for workers.
• Committee for settling workers grievances.

Practical Questions

Calculation of Employee Cost With Idle Time

Question 1.
Following data have been extracted from the books of M/’s. ABC Private Limited:

(i) Salary (each employee, per month)	₹ 30.000
(ii) Bonus	25% of salary
(iii) Employer’s contribution to PF, ESI etc.	15% of salary
(ir) Total cost at employees’ welfare activities	6,61,500 per annum
(v) Total leave permitted during the year	30 days
(vi) No. of employees	175
(vii) Normal idle time	70 hours per annum
(viii) Abnormal idle time (due to failure of power supply)	50 hours
(ix) Working days per annum	310 days of 8 hours

You are required to calculate:
(i) Annual cost of each employee
(ii) Employee cost per hour
(iii) Cost of abnormal idle time, per employee. [CA Inter Nov 2018, 5 Marks]
Answer:
(i) Calculation of Annual Cost of each employee

	₹
Salary (₹ 30,000 × 12)	3,60,000
Bonus (25% of salary)	90,000
Contribution to PF, ESI (15% of salary)	54,000
Cost of employees welfare activities (₹ 6,61,500/175 employees)	3,780
Total Annual cost of each employee	5,07,780

(ii) Calculation of Employee cost per hour

	Hours
Working Hours (310 days × 8 hours)	2,480
Less: Employee leave hours (30 days × 8 hours)	240
Available working Hours	2,240
Less: Normal Idle Time	70
Effective Working Hours	2,170

Employee Cost per Hour = ₹ 5,07,780/2,170 hours = ₹ 234
Note: It is assumed that 310 working days does not include leave days permitted to the employees.

(iii) Cost of abnormal idle time, per employee will be ₹ 11,700 (₹ 234 × 50 hours).

Incentive Plans: Rowan And Halsey

Question 2.
X executes a piece of work in 120 hours as against 150 hours allowed to him. His hourly rate is ₹ 10 and he gets a dearness allowance ₹ 30 per day of 8 hours worked in addition to his wages. You are required to calculate total wages received by X under the Rowan Premium Plan. [CA Inter Nov 2011, 5 Marks]
Answer:
Rowan Premium Plan:

	₹
Normal wages (₹ 10 × 120 hrs)	1,200
Dearness allowance (120 hrs/8 hrs × ₹ 30)	450
Bonus \(\frac{30 \mathrm{hrs}}{150 \mathrm{hrs}}\) × 120 hrs × ₹ 10 150 hrs	240
Total Wages	1,890

Question 3.
Rowan Premium Bonus system does not motivate a highly efficient worker as a less efficient worker and a highly efficient worker can obtain same bonus under this system. Discuss with an example.
Answer:
In Rowan premium bonus system a worker cannot increase his earnings or bonus by merely increasing its work speed. The reason for this is that the bonus under Rowan Scheme is maximum when the time taken by worker on a job is half of the time allowed.
Example:
Time allowed – 10 hours
Time rate – ₹ 20.00
Time taken by Mr. X (highly efficient worker) – 4 hours
Time taken by Mr. Y (less efficient worker) – 5 hours
Now,
Bonus to Mr. X = AH / SH (SH – AH) × R = 4/10(10 – 4) × 20 = ₹ 48
Bonus to Mr. Y = AH / SH (SH – AH) × R = 5/10(10 – 5) × 20 = ₹ 50
Hence it can be said that under Rowan Premium Bonus System even a highly efficient worker can get same bonus as a less efficient worker.

Question 4.
A worker takes 15 hours to complete a piece of work for which time allowed is 20 hours. His wage rate is ? 5 per hour. Following additional in-formation are also available:

Material cost of work	₹ 50
Factory overheads	100% of wages

Calculate the factory cost of work under the following methods of wage payments:
(i) Rowan Plan
(ii) Halsey Plan [CA Inter May 2018, 5 Marks]
Answer:
Calculation of Factory Cost of Work:

	Rowan Plan (₹)	Halsey Plan (₹)
Materials Direct Wages (Refer W.N.)	50 93.75	50 87.50
Prime Cost Factory Overheads (100% of Direct Wages)	143.75 93.75	137.50 87.50
Factory Cost	237.50	225.00

Working Note:
Calculation of Direct Wages:
Rowan Plan = Time Taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Taken × Rate per hour
= 15 hours × 5 + \(\frac{5 \text { hours }}{20 \text { hours }}\) × 15 hours × 5
= 93.75
Halsey Plan = Time Taken × Time Rate + 50% of Time Saved × Time Rate
= 15 hours × 5 + (50% of 5 hours) × 5
= 87.50

Question 5.
A skilled worker is paid a,guaranteed wage rate of ₹ 150 per hour. The standard time allowed for a job is 50 hours. He gets an effective hourly rate of wages of ₹ 180 under Rowan Incentive Plan due to saving in time. For the same saving in time, calculate the hourly rate of wages he will get, if he is placed under Halsey Premium Scheme (50%). [CA Inter Nov 2017, May 2013, Nov 2009, 5 Marks]
Answer:
Increase in hourly rate of wages under Rowan Plan is ₹ 30 ie. (₹ 180 – ₹ 150)
\(\frac{\text { Time saved }}{\text { Time Allowed }}\) × ₹ 150 = ₹ 30 (Refer Working Note)
Or, \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × ₹ 150 = ₹ 30
Or, Time Saved = \(\frac{₹ 30 \times 50 \text { hours }}{₹ 150}\) = 10 hours
Therefore, Time Taken is 40 hours i.e. (50 hours – 10 hours)

Effective Hourly Rate under Halsey System:
Time Saved = 10 Hours
Bonus 50% = 10 hours × 50% × ₹ 150 = ₹ 750
Total wages = ₹ 150 × 40 hours + ₹ 750 = ₹ 6,750
Effective hourly rate = ₹ 6,750/40 = ₹ 168.75

Working Note:
Effective Hourly Rate

Question 6.
You are given the following information of a worker:

(i) Name of worker	‘X’
(ii) Ticket No.	002
(iii) Work started	1-4-20 at 8 a.m.
(iv) Work finished	5-4-20 at 12 noon
(v) Work allotted	Production of 2,160 units
(vi) Work done and approved	2,000 units
(vii) Time and units allowed	40 units per hour
(viii) Wages rate	₹ 25 per hour
(ix) Bonus	40% of time saved
(x) Worker X worked	9 hours a day

You are required to calculate the remuneration of the following basis:
(i) Halsey plan and
(ii) Rowan plan [CA Inter May 2011, 5 Marks]
Answer:
No. of units, produced and approved = 2,000
Standard time = 40 units per hour
Hourly Wages Rate = 25
Time allowed = 40 units per hour
Time allowed for 2,000 units = \(\frac{2,000}{40}\) = 50 hours

(i) Calculation of Remuneration under Halsey Plan:

Standard time allowed for 2,000 units Actual time taken for 2,000 units	50 hours 40 hours
Time saved (W.N.2)	10 hours
Basic wages for time taken (40 hours @ ₹ 25) Bonus (40% of time saved of 10 hrs × ₹ 25)	₹ 1,000 ₹ 100
Total	₹ 1,100

(ii) Calculation of Remuneration Under Rowan Plan:
Basic wages for time taken (40 hours @ ₹ 25) = ₹ 1,000
Bonus = \(\frac{40}{50}\) × 10 × ₹ 25 = ₹ 200
Total = ₹ 1,200

9 hrs per day from 1.4.2020 to 4.4.2020 ie. 36 hrs + 4 hrs on 5.4.2020 = 40 hrs.

Question 7.
M/s. Zeba Private Limited allotted a standard time of 40 hours for a job and the rate per hour is 75, The actual time taken by a worker is 30 hours.
You are required to calculate the total earnings under the following plans:
(i) Halsey Premium Plan (Rate 50%)
(ii) Rowan Plan
(Hi) Time Wage System
(iy) Piece Rate System [CA Inter May 2019, 5 Marks]
Answer:
(i) Halsey Premium Plan:
= Time taken × Time Rate + 50% of time saved × time rate
= (30 hrs × ₹ 75) + (40 hrs – 30 hrs) × 50% ₹ 75
= ₹ 2,625

(ii) Rowan Plan:
= Time taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time taken × Rate per hour
= 30 hours × ₹ 75 + \(\frac{10 \mathrm{hrs}}{40 \mathrm{hrs}}\) × 30 hrs × ₹ 75
= ₹ 2,812.50

(iii) Time Wage System:
= Hours Work × Rate Per hour
= 30 hours × ₹ 75
= ₹ 2,250

(iv) Piece Rate System:
Std. Time × Rate per hour
= 40 × ₹ 75 = ₹ 3,000

Question 8.
Zico Ltd. has its factory at two locations viz Nasik and Satara. Rowan plan is used at Nasik factory and Halsey plan at Satara factory. Standard time and basic rate of wages are same for a job which is similar and is carried out on similar machinery. Normal working hours is 8 hours per day in a 5 day week.
Job in Nasik factory is completed in 32 hours while at Satara factory it has taken 30 hours. Conversion costs at Nasik and Satara are ₹ 5,408 and ₹ 4,950. Overheads account for ₹ 25 per hour.
Required:
(i) To. find out the normal wages; and
(ii) To compare the respective conversion costs. [CA Inter Nov. 2019, 10 Marks]
Answer:
Calculation of Total labour costs at both the factories

	Nasik	Satara
Hours worked Conversion Costs Less: Overheads	32 hrs. ₹ 5,408 ₹ 800 (₹ 25 × 32 hrs.)	30 hrs. ₹ 4,950 ₹ 750 (₹ 25 × 30 hrs.)
Labour Costs	₹ 4,608	₹ 4,200

(i) Calculation of Normal wages rate:
Let Wage rate be ₹ R per hour which is same for both the Nasik and Satara factory.
Normal time allowed for completing the job is 40 hours i.e. 8 hours per day × 5 days.
Normal wage rate can be found out taking total cost of either factory.
Nasik: Rowan Plan
Total Labour Cost = Wages for hours worked + Bonus as per Rowan plan
₹ 4,608 = Time taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time taken × Rate per hour
₹ 4,608 = 32 hrs × R + \(\frac{40-32}{40}\) × 32 × R
₹ 4,608 = 32R + 6.4R
R = ₹ 120 per hour
OR
Satara: Halsey Plan
Total Labour Cost = Wages for hours worked + Bonus as per Halsey plan
₹ 4,200 = Time taken × Time Rate + 50% of time saved × time rate
₹ 4,200 = 30 hrs × R + 50% of (40 hrs – 30 hrs) × R
₹ 4,200 – 35 R
R = ₹ 120

(ii) Comparative Statement of respective conversion costs

	Nasik (₹)	Satara (₹)
Normal Wages	3,840 (₹ 120 × 32)	3,600 (₹ 120 × 30)
Bonus	768 (6.4 × ₹ 120)	600 (5 × ₹ 120)
Factory overhead	800	750
Conversion costs	5,408	4,950

Question 9.
Two workmen, A and B, produce the same product using the same material. A is paid bonus according to Halsey plan, while B is paid bonus according to Rowan plan. The time allowed to manufacture the product is 100 hours. A has taken 60 hours and B has taken 80 hours to complete the product. The normal hourly rate of wages of workman A is ₹ 24 per hour. The total earnings of both the workers are same. Calculate normal hourly rate of wages of workman B. [CA Inter May 2009, 2 Marks]
Answer:

Now, it is said that the total earnings of both the workers are same and therefore,
Total earnings of A = Total earnings of B
1,920 = 96R
R = 1,920/96
R = 20
So, the hourly rate of wages of the worker B is ₹ 20 per hour.

Question 10.
A skilled worker is paid a guaranteed wage rate of ? 120 per hour. The standard time allowed for a job is 6 hour. He took 5 hours to complete the job. He is paid wages under Rowan Incentive Plan.
(i) Calculate his effective hourly rate of earnings under Rowan Incentive Plan.
(ii) If the worker is placed under Halsey Incentive Scheme (50%) and he wants to maintain the same effective hourly rate of earnings, calculate the time in which he should complete the job. [CA Inter Dec. 2021, May 2013, 5 Marks]
Answer:
(i) Effective hourly rate of earnings under Rowan Incentive Plan Earnings under Rowan Incentive plan
= Actual Time Taken × Wage rate + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Taken × Wage Rate
= (5 hours × ₹ 120) + \(\frac{1 \text { hour }}{6 \text { hours }}\) × 5 hours × ₹ 120
= ₹ 600 + ₹ 100 = ₹ 700
Effective Hourly Rate = ₹ 700/5 hours = ₹ 140/hour

(ii) Let time taken = T

Or, 140T = 120T + 360 – 60T
Or, 80T = 360
Or, T = \(\frac{360}{80}\) = 4.5 hours
Therefore, to earn effective hourly rate of ₹ 140 under Halsey Incentive Scheme-worker has to complete the work in 4.5 hours.

Question 11.
Two workmen ‘A’ and ‘B’, produce the same product using the same material. Their normal wage rate is also the same. ‘A’ is paid bonus according to the Rowan system, while ‘B’ is paid bonus according to the Halsey system. The time allowed to make the product is 50 hours. ‘A’ takes 30 hours while ‘B’ takes 40 hours to complete the product. The factory overhead rate is 5 per man-hour actually worked. The factory cost for the product for ‘A is ₹ 3,490 and for ‘B’ it is ₹ 3,600.
Required:
(a) Compute the normal rate of wages;
(b) Compute the cost of materials cost;
(c) Prepare a statement comparing the factory cost of the products as made by the two workmen. [ICAJModule] .
Answer:
Let X be the cost of material and Y be the normal rate of wages per hour. Bonus:
Workman A under Rowan plan = \(\frac{20}{50}\) × 30 × Y = 12Y
Workman B under Halsey plan = 50% of (50 – 40) × Y = 5Y
Factory cost = Material cost + Wages + Bonus + Overhead For Workman A:
X + 30Y + 12Y + (30 hrs. × ₹ 5) = ₹ 3,490
X + 42Y + ₹ 150 = ₹ 3,490
X + 42Y = ₹ 3,340 ……………………….. equation (i)
For Workman B:
X + 40Y + 5Y + (40 hrs. × ₹ 5) = ₹ 3,600
X + 45Y + ₹ 200 = ₹ 3,600
Subtracting equation (i) from equation (ii)

Therefore, normal rate of wages is ₹ 20 per hour.
X + 45Y = ₹ 3,400
X + (45 × 20) = ₹ 3,400
X = ₹ 2,500
Therefore, the cost of material is ₹ 2,500.

Comparative Statement of the Factory Cost of two workmen

Question 12.
The management of a company wants to formulate an incentive plan for the workers with a view’ to increase productivity. The following particulars have been extracted from the books of company.
Piece Wage rate ₹ 10
Weekly working hours 40
Hourly wages rate ₹ 40 (guaranteed)
Standard/normal time taken per unit is 15 minutes.
Actual output for a week:
Worker A 176 pieces
Worker B 140 pieces
Differential piece rale: 80% of piece rate when output below normal and 120% of piece rate when output above normal.
Under Halsey scheme, worker gets a bonus equal to 50% of Wages of time saved.
Calculate the earnings of workers under Halsey’s and Rowan’s premium scheme. [CA Inter May 2012, 8 Marks]
Answer:
Calculation of earnings for workers under different incentive plans:

Halsey’s Premium Plan:

Rowan’s Premium Plan:

	Worker A	Worker B
Minimum Wages	₹ 1,600	₹ 1,600
Bonus   \(\frac{4 \mathrm{hrs}}{44 \mathrm{hrs}}\) × 40 hrs × ₹ 40 = 145.45	No Bonus
Earning	1745.45	1,600

Question 13.
The finishing shop of a company employs 60 direct workers. Each worker is paid ₹ 400 as wages per week of 40 hours. When necessary, over-time is worked up to a maximum of 15 hours per week per worker at time rate plus one-half as premium. The current output on an average is 6 units per man hour which may be regarded as standard output. If bonus scheme is introduced, it is expected that the output will increase to 8 units per man hour. The workers will, if necessary, continue to work Overtime up to the specified limit although no premium on incentives will be paid.

The company is considering introduction of either Halsey Scheme or Rowan Scheme of Wage Incentive system. The budgeted weekly output is 19,200 units. The selling price is ₹ 11 per unit and the direct Material Cost is ₹ 8 per unit. The variable overheads amount to ₹ 0.50 per direct labour hour and the fixed overhead is ₹ 9,000 per week.
Prepare a Statement to show the effect on the Company’s weekly Profit of the proposal to introduce (a) Halsey Scheme, and (b) Rowan Scheme. [CA Inter May 2002, 8 Marks]
Answer:
Present System:

Normal wage rate (₹ 400/40 hours)	₹ 10 per hour
Overtime Rate (Normal rate + 50%)	₹ 15 per hour
Average current output per hour	6 units
Hours to be worked for budgeted weekly output (19,200 units/6)	3200 man hours
Total normal hours available in a week (60 workers × 40 hours)	2,400 man hours
Overtime required to be worked (3,200 hours – 2,400 hours)	800 man hours

Calculation of total wages under the present scheme

	₹
Normal wages for total hours worked (3,200 hours ×  ₹ 110 per hour)	32,000
Add: Overtime Premium (800 hours × ₹ 5 per hour (₹ 15 – ₹ 10)	4,000

Proposed scheme:
Time taken for 19,200 units = 19,200/8 = 2,400 man hours
Time saved = 3,200 – 2,400 = 800 man hours

Total wages under the proposed scheme:
(i) Under Halsey Scheme:

	₹
Normal wages for total hours worked (2,400 hours × ₹ 10 per hour)	24,000
Add: Bonus (800 hours × 50% × ₹ 10 per hour)	4,000
Total	28,000

(ii) Under Rowan Scheme:

	₹
Normal wages for total hours worked (2,400 hours × ₹ 10 per hour)	24,000
Add: Bonus (800 hours × 2,400/3,200 × ₹ 10 per hour)	6,000
Total	30,000

Statement of Profit

Question 14.
ZED Limited Is working by employing 50 skilled workers. It is considered the introduction of incentive scheme-either Halsey scheme (with 50% bonus) or Rowan scheme of wage payment for increasing the labour productivity to cope up the Increasing demand for the product by 40%. It is believed that proposed incentive scheme could bring about an average 20% Increase over the present earnings of the workers; If could act as sufficient incentive for them to produce more.
Because of assurance, the increase In productivity has been observed as revealed by the figures for the month of April, 2020.
Hourly rate of wages (guaranteed) ₹ 30
Average time for producing one unit by one worker at the previous performance (This may be taken as time allowed) 1.975 hours

Number of working hours per day of each worker	8
Number of working days in the month	24
Actual production during the month	6,120

Required:
(i) Calculate the effective rate of earnings under the Halsey scheme and the Rowan scheme,
(ii) Calculate the savings to the ZED Limited in terms of direct labour cost per piece.
(iii) Advise ZED Limited about the selection of the scheme to fulfil his assurance. [CA Inter May 2004, 8 Marks]
Answer:
Working Notes:
1. Computation of time saved (in hours) per month:
= Standard production time of 6,120 units – Actual time taken by the workers
= (6,120 units × 1.975 hrs. – 24 days × 8 hours/day × 50 skilled workers)
= 12,087 hrs. – 9,600 hrs.
= 2,487 hours

2. Computation of bonus for time saved (in hours) under Halsey & Rowan Plan:
Time saved = 2,487 hrs.
Wage rate = ₹ 30 per hour
Bonus under Halsey Scheme = 2,487 hrs. × 50% × ₹ 30 = ₹ 37,305
Bonus under Rowan scheme = \(\frac{2,487 \mathrm{hrs} .}{12,087 \mathrm{hrs} .}\) × 9,600 hrs × ₹ 30
= ₹ 59,258

(i) Computation of effective rate of earning under the Halsey & Rowan Scheme
Total earnings under Halsey Scheme = Time wages + Bonus
(W.N.2) = 24 days × 8 hrs × 50 skilled × ₹ 30 + ₹ 37,305
= ₹ 3,25,305
Effective earnings rate per hour = ₹ 3,25,305/9,600 hrs = ₹ 33.89
Total earning under Rowan Scheme = Time wages + Bonus
(W.N.2) = 2,88,000 + 59.258
= ₹ 3,47,258
Effective earnings rate per hour = ₹ 3,47,258/9,600 hrs = ₹ 36.17

(ii) Saving to ZED Ltd. in direct labour cost per piece:
Direct labour cost per unit under times wages system ₹ 59.25
(1.975 times per unit × ₹ 30)
Direct labour cost per unit under Halsey Plan ₹ 53.15
(₹ 3,25,305/6,120 units)
Direct labour cost per unit under Rowan plan ₹ 56.74
(₹ 3,47,258/6,120 units)
Savings of direct labour cost per piece under:
Halsey Plan (₹ 59 25 – ₹ 53.15) ₹ 6.10
Rowan Plan (₹ 59.25 – ₹ 56.74) ₹ 2.51

(iii) Advised to ZED Ltd:
Halsey scheme brings more saving to the management of ZED Ltd. over the present earning of ? 2,88,000, but the other scheme Le. Rowan fulfil the promise of 2096 increase over the present earnings of ₹ 2,88,000 by paying 20.58% in the form of Bonus. Hence, Rowan Plan should be adopted.

Question 15.
The existing Incentive system of Alpha Limited is as under:

Normal working week	5 days or 8 hours each plus 3 late shifts of 3 hrs. each
Rate of Payment	Day work: 160 per hour Late shift: 225 per hour
Average output per operator for 49 hours week i.e. including 3 late shifts.	120 articles

In order to increase output and eliminate Overtime, it was decided on to a system of payment by results. The following information is obtained.

Time rate (as usual)	60 per hour
Basic time allowed for 15 articles	5 hours
Piece-work rate	Add 20% to basic piece- rate
Premium Bonus	Add 50% to time.

Required:
Prepare a Statement showing hours worked, weekly earning, number of articles produced and labour cost per article for one operator under the following systems:
(a) Existing time-rate
(b) Straight piece-work
(c) Rowan system
(d) Haisey premium system .
Assume that 135 articles are produced in a 40-hour week under straight piece work, Rowan Premium system, and Halsey premium system above and workers earn half the time saved under Halsey premium system. [CA Inter Nov 2005, 8 Marks]
Answer:
Table showing Labour Cost per Article

Working Notes:
Existing time rate:
Weekly wages 40 hrs @ ₹ 160/hr
9 hrs @ ₹ 225/hr

Price rate system:
Basic Time is 5 hours for 15 articles
Cost of 15 articles at hourly rate of 160/hr.
Add: 20%

Therefore, Rate per article = ₹ 960/15 = ₹ 64
Earnings for the week = 135 articles × ₹ 64 = ₹ 8,640

Rowan premium System:
Basic Time 5 hrs for 15 articles
Add: 50% to time (m)
Total time 7.5 hrs for 15 articles or 30 minutes per article
Time allowed for 135 articles = 67.5 hrs.
Actual time taken for 135 article = 40 hrs.
Earnings = Time Taken × Rate per hour + \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Taken
= 40 hrs × ₹ 160 + \(\frac{67.5 \mathrm{hrs}-40 \mathrm{hrs}}{67.5 \mathrm{hrs}}\) × 40 hrs × ₹ 160
= 9,007.41

Halsey premium system:
Earnings = Time Taken × Time Rate + 50% of Time Saved × Time Rate
= 40 hrs × ₹ 160 + 50% of 27.5 hrs (67.5 hrs – 40 hrs) × ₹ 160
= ₹ 8,600

Labour Turnover

Question 16.
The information regarding number of employees on roll in a shopping mall for the month of December, 2020 are given below:

Number of employees as on 01-12-2020	900
Number of employees as on 31-12-2020	1,100

During December, 2020, 40 employees resigned and 60 employees were discharged. 300 employees were recruited during the month. Out of these 300 employees, 225 employees were recruited for an expansion project of the mall and rest were recruited due to exit of employees.
Assuming 365 days in a year, calculate Employee Turnover Rate and Equivalent Annual Employee Turnover Rate by applying the following:
(i) Replacement Method
(ii) Separation Method
(iii) Flux Method [CA Inter May 2018, May 2001, 10 Marks]
Answer:
(i) Replacement Method:
Employee Turnover Rate
= \(\frac{\text { Number of employees Replaced during the period }}{\text { Average number of employees during the period on roll }}\) × 100
= \(\frac{75}{1,000}\) × 100 = 7.5%
Equivalent Annual Turnover Rate = \(\frac{7.59}{31}\) × 365 = 88.31%

(ii) Separation Method:
Employee Turnover Rate
= \(\frac{\text { Number of employees Separated during the period }}{\text { Average Number of employees during the period on roll }}\) × 100
= \(\frac{40+60}{1,000}\) × 100 = 10%
Equivalent Annual Turnover Rate = \(\frac{10 \%}{31}\) × 365 = 117.7496

(iii) Flux Method:
Employee Turnover Rate

Question 17.
Following information is given of a newly setup organisation for the year ended on 31st march, 2021.

Number of workers replaced during period	50
Number of workers left and discharged during the period	25
Average Number of workers on the roll during the period	500

You are required to:
(i) Compute the employee turnover rates using Separation Method and Flux Method.
(ii) Equivalent Employee Turnover Rates for (i) above, given that the organisation was setup on 31st January, 2021. [CA Inter July 2021, 5 Marks]
Answer:
(i) Employee Turnover Rates using Separation Method and Flux Method

(ii) Equivalent Employee Turnover Rates

Question 18.
RST Company Ltd. has computed labour turnover rates for the quarter ended on 31st March, 2020 as 20%, 10% and 5% under flux method, replacement method and separation method respectively, if the number of workers replaced during that quarter 1s50, find out (i) Workers recruited and joined (ii) Workers left and discharged and (iii) Average number of workers on roll, (iv) Number of workers at the beginning of the Quarter. [CA Inter May 2018, May 2017, Nov. 2013, Nov. 2O12 8 Marks]
Answer:
1. Average Number of workers on roll during the quarter:
Employee turnover rate using Replacement method
= \(\frac{\text { No of Replacements }}{\text { Avg. No. of workers on roll }}\)
10% = \(\frac{50}{\text { Avg. No. of workers on roll }}\)
Average Number of workers on roll = 500

2. Number of workers left and discharged:
Employee turnover rate using Separation method

No. of Separations = 25

3. Number of workers recruited and joined
Employee turnover rate under Flux Method

No. of workers recruited and joined = 75

4. No. of workers at the beginning of the Quarter:
Let workers at the beginning of the quarter were ‘X’
Average No. of workers on roll

Question 19.
Human Resources Department of A Ltd. computed labour turnover by replacement method at 3% for the quarter ended on June 2021. During the quarter, fresh recruitment of 40 workers wras made. The number of workers at the beginning and end of the quarter was 990 and 1,010 respectively.
You are required to calculate the labour turnover rate by Separation Method and Flux Method. [CA Inter Nov. 2015, 5 Marks]
Answer:
Labour Turnover by Replacement Method

Or, No. of workers replaced during the quarter = 0.03 × 1,000 = 30 workers

(i) Labour Turnover by Separation Method

(ii) Labour Turnover by Flux Method

Miscellaneous

Question 20.
The management of a company is worried about their increasing labour turnover in the factory and before analysing the causes and taking remedial steps, they want to have an idea of the profit foregone as a result of labour turnover in the last year.
Last year sales amounted to ₹ 83,03,300 and the profit-volume ratio was 20%. The total number of actual hours worked by the Direct Labour Force was 4.45 lakhs. As a result of the delays by the Personnel Department in filling vacancies due to labour turnover, 1,00,000 potentially productive hours (excluding unproductive training hours) were lost. The actual direct labour hours included 30,000 hours attributable to training new recruits, out of which half of the hours were unproductive.

The costs Incurred consequent on labour turnover revealed on analysis the following:

Settlement costs due to leaving ₹ 43	820
Recruitment costs ₹  26	740
Selection costs ₹ 12	750
Training costs ₹ 30	490

Assuming that the potential production lost as a consequence of labour turnover could have been sold at prevailing prices, find the profit foregone last year on account of labour turnover. [CA Inter Nov 2019, Nov 2001, 5 Marks]
Answer:
Actual Production Hours:
Actual Hours worked (including hrs. attributable to training new recruits) 4,45,000
Less: Unproductive hours (30,000 ÷ 2) 15,000

Productive hours lost:
Loss of potential productive hours 1,00,000
Add: Unproductive training hours 15,000

Loss of contribution due to unproductive hours:
Contribution from 4,30,000 Productive Hrs.
(Sales value × PV ratio) = 83,03,300 × 20% = 16,60,660
Contribution from 1,15,000 productive hours lost
= \(\frac{16,60,660}{4,30,000}\) × 1,15,000 = 4,44,130

Profit foregone as a result of labour turnover:
Contribution foregone = 4,44,130
Settlement costs due to leaving = 43,820
Selection costs = 12,750
Training costs = 30,490
Recruitment costs = 26,740

Question 21.
A Company is undecided as to what kind of wage scheme should be introduced. The following particulars have been compiled in respect of three systems, which are under consideration of the management:

For the purpose of piece rate, each minute is valued at ₹ 0.10. You are required to calculate the wages of each worker under:
(i) Guaranteed hourly rates basis
(ii) Piece work earnings basis, but guaranteed at 75% of basic pay (guaranteed hourly rate) If his earnings are less than 50% of basic pay.
(iii) Premium bonus basis where the worker receives bonus based on Rowan scheme. [CA Inter Nov. 2002, 9 Marks]
Answer:
(i) Computation of wages of each worker under guaranteed hourly rate basis

(ii) Computation of wages of each worker under piece work earnings basis

Since each worker has been guaranteed at 75% of basic pay, if his earnings are less than 50% of basic pay (guaranteed hourly rate), therefore, earning of the workers will be as follows Workers A and C will be paid the wages as computed viz., ₹ 228 and ₹ 315 respectively. The computed earnings under piece rate basis for worker B is ₹ 75 which is less than 50% of basic pay i.e., ₹ 100 (₹ 200 × 50) therefore he would be paid ₹ 150 Le. 75% × ₹ 200.

Working Notes:
1. Piece rate/per unit

2. Time allowed to each worker
Worker A = (21 units × 12 min) + (36 units × 18 min) + (46 units × 30 min)
= 2,280 min or 38 hours
Worker B = 25 units × 30 min
= 750 min or 12.5 hours
Worker C = (60 units × 12 min) + (135 units × 18 min)
= 3,150 min or 52.5 hours

(iii) Computation of wages of each worker under Premium bonus basis
(where each worker receives bonus based on Rowan Scheme)

Question 22.
Following are the particulars of two workers ‘R’ and ‘S’ for a month:

The normal working hours for the month are 200 hrs. Overtime is paid at double the total of normal wages and dearness allowance. Employer’s contribution to State Insurance and Provident Fund are at equal rates with employees’ contributions.
Both workers were employed on jobs A, B and C in the following proportions:

Overtime was done on job ‘A’
You are required to:
(i) Calculate ordinary wages rate per hour of ‘R’ and ‘S’.
(ii) Allocate the worker’s cost to each job ‘A’, ‘B’ and ‘C’. [CA Inter Nov. 2020, 6 Marks]
Answer:
(i) Calculation of Net Wages paid to Workers ‘R’ and ‘S’

Calculation of ordinary wage rate per hour of Workers ‘R’ and ‘S’

(ii) Statement Showing Allocation of workers cost to each Job

Working Note:
Normal Wages are considered as basic Wages

Question 23.
AD V Pvt. Ltd. manufactures a product which requires skill and precision in work to get quality products. The company has been experiencing high labour cost due to slow speed of work. The management of the company wants to reduce the labour cost but without compromising with the quality of work. It wants to introduce a bonus scheme but is indifferent between the Halsey and Rowan scheme of bonus.
For the month of November 2020, the company budgeted for 24,960 hours of work. The workers are paid ? 80 per hour.
Required: CALCULATE and suggest the bonus scheme where the time taken (in%) to time allowed to complete the works is
(a) 100%
(b) 75%
(c) 50% &
(d) 25% of budgeted hours. [CA Inter Nov 2019, RTPJ
Answer:
The Cost of labour under the bonus schemes are tabulated as below:

Bonus under Halsey Plan = 50% of (Time Allowed – Time Taken) × Rate per hour
Bonus under Rowan Plan= \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Saved Rate per hour
Rowan scheme of bonus keeps checks on speed of work as the rate of incentive increases only up to 50% of time taken to time allowed but the rate decreases as the time taken to time allowed comes below 50%. It provides incentives for efficient workers for saving in time but also puts check on careless speed. On implementation of Rowan scheme, the management of ADV Pvt. Ltd. would resolve issue of the slow speed work while maintaining the skill and precision required maintaining the quality of product.

Question 24.
IBL Sisters operates a boutique which works for various fashion houses and retail stores. It has employed 26 workers and pays them on time rate basis. On an average an employee is allowed 8 hours for boutique work on a piece of garment. In the month of December 2020, two workers M and J were given 15 pieces and 21 pieces of garments respectively for boutique work. The following are the details of their work:

	M	J
Work assigned	15 pcs.	21 pcs.
Time taken	100 hours	140 hours

Workers are paid bonus as per Halsey System. The existing rate of wages is ₹ 60 per hour. As per the new wages agreement the workers will be paid 172 per hour w.e.f. 1st January 2021. At the end of the month December 2020, the accountant of the company has wrongly calculated wages to these two workers taking ₹ 72 per hour.
Required:
(i) Calculate the loss incurred due to incorrect rate selection.
(ii) Calculate the loss incurred due to incorrect rate selection, had Rowan scheme of bonus payment followed.
(iii) Calculate the loss/savings if Rowan scheme of bonus payment had followed.
(iv) Discuss the suitability of Rowan scheme of bonus payment for JBL Sisters? [CA Inter May 2021, RTP]
Answer:
(i) Calculation of loss incurred due to incorrect rate selection
(While calculating loss only excess rate per hour has been taken)

(ii) Calculation of loss incurred due to incorrect rate selection had Rowan scheme of bonus payment followed:

(iii) Calculation of amount that could have been saved if Rowan Scheme were followed

	M (₹)	J(₹ )	Total (₹)
Wages paid under Halsey Scheme	1,320	1,848	3,168
Wages paid under Rowan Scheme	1,400	1,960	3,360
Difference (loss)	(80)	(112)	(192)

(iv) Rowan Scheme of incentive payment has the following benefits, which is suitable with the nature of business in which JBL Sisters operates:(a) Under Rowan Scheme of bonus payment, workers cannot increase their earnings or bonus by merely increasing its work speed. Bonus under Rowan Scheme is maximum when the time taken by a worker on a job is half of the time allowed. As this fact is known to the workers, therefore, they work at such a speed which helps them to maintain the quality of output too.

(b) If the rate setting department commits any mistake in setting standards for time to be taken to complete the works, the loss incurred will be relatively low.

Question 25.
GZ Ltd. pays the following to a skilled worker engaged in production works. The following are the employee benefits paid to the employee:

(a) Basic salary per day	₹  1,000
(b) Dearness allowance (DA)	20% of basic salary
(c) House rent allowance	16% of basic salary
(d) Transport allowance	₹  50 per day of actual work
(e) Overtime	Twice the hourly rate (considers basic and DA), only if works more than 9 hours a day otherwise no overtime allowance. If works for more than 9 hours a day then overtime is considered after 8th hour.
(f) Work of Holiday and Sunday	Double of per day basic rate provided works atleast 4 hours. The holiday and Sunday basic is eligible for all allowances and statutory deductions.
(g) Earned leave & Casual leave	These are paid leave
(h) Employer’s contribution to Provident fund	12% of basic and DA
(i) Employer’s contribution to Pension fund	7% of basic and DA

The company normally works 8-hour a day and 26 day in a month. The company provides 30 minutes lunch break in between.
During the month of August 2020, Mr. Z works for 23 days including 15th August and a Sunday and applied for 3 days of casual leave. On 15th August and Sunday he worked for 5 and 6 hours respectively without lunch break.
On 5th and 13th August he Worked for 10 and 9 hours respectively. During the month Mr. Z worked for 100 hours on Job no. HT 200.
You are required to calculate:
(i) Earnings per day
(ii) Effective wages rate per hour of Mr, Z
(iii) Wages to be charged to Job no. HT 200. [CA Inter Nov. 2020, RTP]
Answer:
(i) Calculation of earnings per day

	₹
Basic salary (₹  1,000 × 26 days)	26,000
Dearness allowance (20% of basic salary)	5,200
	31,200
House rent allowance (16% of basic salary)	4,160
Employer’s contribution to Provident fund (12% × ₹ 31,200)	3,744
Employer’s contribution to Pension fund (7% × ₹ 31,200)	2,184
	41,288

(ii) ) Calculation of effective wage rate per hour of Mr. Z:

(iii) Calculation of wages to be charged to Job no. HT 200
= ₹ 240 × 100 hours = ₹ 24,800

Question 26.
Z Ltd. is working by employing 50 skIlled workers. It Is considering the introduction of an Incentive scheme . either Halsey Scheme (with 50% Bonus) or Rowan Scheme – of wages payment for Increasing the labour productivity to adjust with the increasing demand for Its products by 40% The company feels that If the proposed Incentive scheme could bring about an average 20% increase over the present earnings of the workers, it could act as sufficient incentive for them to produce more and the company has accordingly given assurance to the workers.

Because of this assurance, an increase in productivity has been observed as revealed by the figures for the month of April, 2020:

Hourly rate of wages (guaranteed)	₹ 50
Average time for producing one unit by one worker at the previous performance (ibis may be taken as time allowed)	1.975 hours
Number of working days in a month	24
Number of working hours per day of each worker	8
Actual production during the month	6,120 units

Required:
(i) Calculate the effective increase in earnings of workers in percentage terms under Halsey and Row an scheme.
(ii) Calculate the savings to Z Ltd. in terms of direct labour cost per unit under both the schemes.
(iii) Advise Z Ltd. about the selection of the scheme that would fulflil its assurance of incentivizing workers and also to adjust with the increase in demand. [CA Inter January 2021, 10 Marks]
Answer:
Working Notes:
1. Total time wages of 50 workers per month
= No. of working days in the month × No. of working hours per day of each worker × Hourly rate of wages × No. of workers
= 24 days × 8 hrs. × ₹ 50 × 50 workers = ₹ 4,80,000

2. Time saved per month:
Time allowed per unit to a worker = 1.975 hours
No. of units produced during the month by 50 workers = 6,120 Units
Total time allowed to produce 6,120 units (6,120 × 1.975 hrs) = 12,087 hours
Actual time taken to produce 6,120 units (24 days × 8 hrs. × 50 workers) = 9,600 hours
Time saved (12,087 hours – 9,600 hours) = 2,487 hours

3. Bonus under Halsey scheme to be paid to 50 workers .
Bonus = (50% of time saved) × hourly rate of wages
= 50/100 × 2,487 hours × ₹ 50 = ₹ 62,175
Total wages to be paid to 50 workers is ₹ 5,42,175 (₹ 4,80,000 + ₹ 62,175), if Z Ltd, considers the introduction of Halsey.Incentive Scheme to increase the worker productivity.

4. Bonus under Rowan Scheme to be paid to 50 workers:
Bonus taken = \(\frac{\text { Time saved }}{\text { Time Allowed }}\) × Time Saved × Hourly rate
= \(\frac{9,600 \text { hours }}{12,087 \text { hours }}\) × 2,487 hrs × ₹ 50 = ₹ 9,764
Total wages to be paid to 50 workers are (₹ 4,80,000 + ₹ 98,764) ₹ 5,78,764, if Z Ltd. considers the introduction of Rowan Incentive Scheme to increase the worker productivity.

(i) (a) Effective hourly rate of earnings under Halsey scheme
(Refer to working Notes 1, 2 and 3)

(b) Effective hourly rate of earnings under Rowan scheme
(Refer to Working Notes 1, 2 and 4)

(ii) (a) Saving in terms of direct labour cost per unit under Halsey scheme:
(Refer to Working Note 3)
Labour cost per unit (under time wage scheme)
= 1.975 hours × ₹ 50 = ₹ 98.75
Labour cost per unit (under Halsey scheme)
= \(\frac{\text { Total wages paid under the scheme }}{\text { Total number of units produced }}\) = ₹ \(\) = ₹ 88.60
Saving per unit = ₹ 98.75 – ₹ 88.60 = ₹ 10.15

(b) Saving in terms of direct worker cost per unit under Rowan Scheme:
(Refer to Working Note 4)
Labour cost per unit under Rowan scheme = ₹ 5,78,764/6,120 units = ₹ 94.57
Saving per unit = ₹ 98.75 – ₹ 94.57 = ₹ 4.18

(iii) Calculation of Productivity

Normal Production Hours worked/Unit per Hour (9,600/1.975)	4,861
Actuals Production Units	6,120
Increase in labour productivity	1,259
% Productivity i.e. increase in production/Norma! production	25.9%

Advice: Rowan plan fulfils the company’s assurance of 20% increase over the present earnings of workers. This would increase productivity by 25.9% only. It will not adjust with the increase in demand by 40%.

Question 27.
In a factory, the basic wages rate is ₹ 100 per hour and overtime rates are as follows:

Before and after normal working hours	175% of basic wage rate
Sundays and holidays	225% of basic w age rate
During the previous year, the following hours were worked
Normal lime	1,00.000 hours
Overtime before and after working hours	20,000 hours
Overtime on Sundays and holidays	5,000 hours
Total	1,25,000 hours

The following hours have been worked on job ‘Z

Normal	1000 hours
Overtime before and alter working hrs.	100 hours
Sundays and holidays	25 hours
Total	1,125 hours

You are required to CALCULATE the labour cost chargeable to job ‘Z’ and overhead in each of the following instances:
(a) Where overtime is worked regularly throughout the year as a policy due to the workers’ shortage.
(b) Where overtime is worked irregularly to meet the requirements of production.
(c) Where overtime is worked at the request of the customer to expedite the job. [lCAI Module]
Answer:
Computation of effective average wage rate (including overtime premium):

	₹
Normal wages (1,00,000 hrs. × ₹ 100)	1,00,00,000
Wages for overtime before and after working hours (20,000 hrs. × ₹ 100 × 175%)	35,00,000
Wages for overline on Sundays and holidays (5,000 hrs. × ₹ 100 × 225%)	11,25,000
Total Wages for 1,25,000 hrs.	1,46,25,000

Effective average wage rate = \(\left(\frac{₹ 1,46,25,000}{1,25,000 \text { hours }}\right)\) = ₹ 117

(a) Where overtime is worked regularly as a policy due to workers’ shortage:
The overtime premium is treated as a part of employee cost and job is charged at an effective average wage rate.
Employee cost chargeable to Job Z = 1,125 hrs. × ₹ 117 = ₹ 1,31,625

(b) Where overtime is worked irregularly to meet the requirements of production:
Basic wages will be charged to the job and overtime premium will be charged to factory overheads.
Employee cost chargeable to Job Z = 1,125 hours × ₹ 100 = ₹ 1,12,500
Factory overhead:
= [100 hrs. × (₹ 175 – ₹ 100)] + [25 hrs. × (₹ 225 – ₹ 100)]
= ₹ 7,500 + ₹ 3,125 = ₹ 10,625

(c) Where overtime is worked at the request of the customer, to expedite the job:
Overtime premium will also be charged to Job Z.
Employee cost of Job Z:
Normal wages (1,125 hrs. × ₹ 100) = ₹ 1,12,500
Overtime premium .
[(100 hrs. × ₹ 75) + (25 hrs. × ₹ 125)] = ₹ 10.625
Total ₹ 1,23,125

Question 28.
It is seen from the job card for repair of the customer’s equipment that a total of 154 labour hours have beep put in as detailed below:


In terms of an award in employee conciliation, the workers are to be paid dearness allowance on the basis of cost of living index figures relating to each month which works out @ ₹ 968 for the relevant month. The dearness allowance is payable to all workers irrespective of wages rate if they are present or are on leave with wages on all working days.
Sunday is a weekly holiday and each worker has to work for 8 hours on all week days and 4 hours on Saturdays; the workers are however paid full wages for Saturday (8 hours for 4 hours worked).
Overtime is paid twice of ordinary wage rate if a worker works for more than nine hours in a day or forty-eight hours in a week. Excluding holidays, the total number of hours works out to 176 in the relevant month. The company’s contribution to Provident Fund and Employees State Insurance Premium are absorbed into overheads.
Calculate the wages payable to each worker. [ICAI Module]
Answer:
Calculation of equivalent hours to be paid to the workers

Dividend Decisions – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Dividend Decisions – CA Inter FM Study Material

Theory Questions

Question 1.
Following information relating to Jee Ltd. are given:

Profit after tax	:	₹ 10,00,000
Dividend payout ratio	:	50%
Number of Equity shares	:	50,000
Cost of equity	:	10%
Rate of return on investment	:	12%

(1) What would be the market value per share as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of equity share at that payout ratio? (5 Marks Nov 2018)
Answer:
(1) Market value (P) per share as per Walter’s Model:
P (Market value of share) = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{10+(20-10) \times \frac{0.12}{0.10}}{0.10}\) = ₹ 220.00
E (EPS) = ₹ 10,00,000 shares (PAT) ÷ 50,000 = ₹ 20

(2) According to Walter’s Model when the return on investment is more than the cost of equity capital, the price per share increases as the dividend payout ratio decreases. Hence, the optimum dividend payout ratio in this case is Nil. So, at a payout ratio zero, the market value of company’s share will be:
P (Market value of share) = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{0+(20-0) \times \frac{0.12}{0.10}}{0.10}\) = ₹ 240.00

Question 2.
The following information is supplied to you:
Tolal Earning : ₹ 40,00,000
Number of Equity Shares f of ₹ 100 each) : 4,00,000
Dividend Per Share : ₹ 4
Cost of Capita : 16%
Internal Rate of Return : 20%
Retention Ratio : 60%

Calculate the market price of a share of company by using:
(1) Walter’s Formula.
(2) Gordon’s Formula. (5 Marks May 2019)
Answer:
(1) Market Price of Share (P) as per Walter’s Formula:
P (Market value of share) = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{4+(10-4) \times \frac{0.20}{0.16}}{0.16}\) = ₹ 71.875
E (EPS) = ₹ 40,00,000 (Earning) ÷ 4,00,000 shares = ₹ 10

(2) Market Price of Share (P) as per Gordon’s Formula:
P₀ (Market value of share) = \(\frac{\mathrm{D}_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{4.00}{0.16-0.12}\) = ₹ 100.00
G (Growth Rate) = b × r = 20% × .6 = 12%

Question 3.
Following figures and information were extracted from the company A Ltd.
Earnings of the company : ₹ 10,00,000
Dividend paid : ₹ 6,00,000
No. of shares outstanding : 2,00,000
Price earnings ratio : 10
Rate of return on investment : 20%

You are required to calculate:
(1) Current market price of the share.
(2) Capitalization rate of its risk class.
(3) What should be the optimum payout ratio?
(4) What should be the market price per share at optimal payout ratio?
(use Walter’s model) (5 Marks Nov 2019)
Answer:
(1) Current market price of share:
Current Market Price of Share = EPS × PE Ratio = \(\frac{10,00,000}{2,00,000}\) × 10 = ₹ 50

(2) Capitalization rate of its risk class:
Capitalization rate (K_e) = 1/PE = 1/10 = 0.10

(3) Optimum payout:
r > K_e, Therefore dividend payout should be NiL

(4) Market Price of Share (P) as per Walter’s Formula as per optimal payout ratio:
P (Market price of share) = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{0+(5-0) \times \frac{0.20}{0.10}}{0.10}\) = ₹ 100

Question 4.
The following figures are extracted from the annual report of RJ Ltd.:

Net Profit	₹ 50 lakhs
Outstanding 13% preference shares	₹ 200 lakhs
No. of Equity shares	6 lakhs
Return on Investment	25%
Cost of capital i.e. (Ke)	15%

You are required to compute the approximate dividend payout ratio by keeping the share price at ₹ 40 by using Walter model? (5 Marks Nov 2020)
Answer:

Question 5.
The following information is taken from ABC Ltd.
Net Profit for the year : ₹ 30,00,000
12% Preference shares capital : ₹ 1,00,00,000
Equity share capital (Share of ₹ 10 each) : ₹ 60,00,000
Internal rate of return on investment : 22%
Cost of Equity capital : 18%
Retention ratio : 75%

Calculate the market price of the share using:
1. Gordon’s Model
2. Walter’s Model (5 Marks Jan 2021)
Answer:
1. Calculation of Price of share as per Gordon model:
P₀ = \(\frac{D_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{3 \times 0.25}{0.18-0.165}\) = ₹ 50

2. Calculation of Price of share as per Walter model:
P = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{0.75+(3-0.75) \times \frac{0.22}{0.18}}{0.18}\) = ₹ 19.44

Working note:
(a) Growth = b × r = 22% × .75 = 16.50%

(b) EPS = (PAT – PD) ÷ Number of shares
= (30,00,000 – 12% of 1,00,00,000) ÷ 6,00,000 = ₹ 3

(c) DPS = EPS × Payout ratio = ₹ 3 × 25% = ₹ 0.75

Important Questions

Question 1.
AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has outstanding 10,000 shares selling at ₹ 100 each. The firm is contemplating the declaration of a dividend of ₹ 5 per share at the end of the current financial year. It expects to have a net income of ₹ 1,00,000 and has a proposal for making new investments of ₹ 2,00,000.

Required:
1. Calculate value of firm when dividends are not paid.
2. Calculate value of firm when dividends are paid.
Answer:
1. Value of the firm when dividends are not paid:
Step 1: Calculate price at the end of the period:
P₀ = \(\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}\)
₹ 100 = \(\frac{P_1+0}{1+0.10}\) or P₁ = ₹ 110

Step 2: No. of shares required to be issued:

2. Value of the firm when dividends are paid:
Step 1: Calculate price at the end of the period:
P₀ = \(\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}\)
₹ 100 = \(\frac{P_1+5}{1+0.10}\) or P₁ = ₹ 105

Step 2: No. of shares required to be issued:

Thus, it can be seen that the value of the firm remains the same in either

Question 2.
The following information is supplied to you:

Total Earnings	₹ 2,00,000
No. of equity shares (of ₹ 100 each)	20,000
Dividend paid	₹ 1,50,000
Price/Earnings ratio	12.5

Applying Walter’s Model:
1. Ascertain whether the company is following an optimal dividend policy.
2. Find out what should be the P/E ratio at which the dividend policy will have no effect on the value of the share.
3. Will your decision change, if the P/E ratio is 8 instead of 12.5?
Answer:
1. K_e = \(\frac{1}{\mathrm{PE}}\) = \(\frac{1}{12.5}\) = 8%
r = \(\frac{\text { Total Earnings }}{\text { Total Funds }}\) × 100 = \(\frac{2,00,000}{20,000 \text { Shares } \times 100 \text { per share }}\) × 100 = 10%
r > K_e, Therefore as per Walter model optimum dividend payout is Nil and company is paying dividend to shareholders means company is not following optimum dividend policy.

2. The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the k_e would be equal to the rate of return (r) of the firm.
K_e = r = 10%
PE = \(\frac{1}{\mathrm{KE}}\) = \(\frac{1}{.10}\) = 10 times

3. If the P/E is 8 instead of 12.5, then the K_e which is the inverse of P/E ratio, would be 12.5:
K_e = \(\frac{1}{\mathrm{KE}}\) = \(\frac{1}{8}\) = 12.5%
In such a situation K_e > r and optimum dividend payout will be 100%.

Question 3.
With the help of following figures calculate the market price of a share of a company by using:
1. Walter’s formula
2. Dividend growth model (Gordon’s formula)

Earning per share (EPS)	₹ 10
Dividend per share (DPS)	₹ 6
Cost of capital (k)	20%
Internal rate of return on investment	25%
Retention Ratio	40%

Answer:
1. Walter’s formula:
P = \(\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{6+(10-6) \times \frac{0.25}{0.20}}{0.20}\) = ₹ 55

2. Gordon’s formula (Dividend Growth model):
P₀ = \(\frac{\mathrm{D}_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{6}{0.20-0.10}\) = ₹ 60
G = b × r = 25% × .4 = 10%

Question 4.
In May, 2020 shares of RT Ltd. was sold for ₹ 1,460 per share. A long term earnings growth rate of 7.5% is anticipated. RT Ltd. is expected to pay dividend of ₹ 20 per share.
(a) Calculate 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?
(b) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of earnings. In this case, Slate whether, there would be any change in growth rate and cost of Equity?
Answer:
(a) K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}\) + g = \(\frac{20}{1,460}\) + 7.5% = 8.87%

(b) With rate of return on retained earnings (r) 1096 and retention ratio (b) 60%, new growth rate will be as follows:
g (revised growth rate) = b × r = 0.10 × 0.60 = 0.06 or 696
Accordingly, 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 retained earnings (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
EPS = ₹ 20 ÷ 0.25 (.75 retention) = ₹ 80
Revised D₁ = ₹ 80 × 0.40 = ₹ 32
Revised K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}\) + g = \(\frac{32}{1,460}\) + 6% = 8.19%

Question 5.
A&R Ltd. is a large-cap multinational company listed in BSE In India with a face value of ₹ 100 per share. The company is expected to grow 15% p.a. for next four year then 5% for an indefinite period. The shareholders expect 20% return on their share Investments. Company paid ₹ 120 as dividend per share for the FY 2020-21. The shares of the company traded at an average price of ₹ 3,122 on last day.

Find out the intrinsic value of per share and state whether shares are overpriced or underpriced.
Answer:
Calculation of Present Value or Current Market Value or Intrinsic Value of Share

Year	Expected benefits	PVF @ 20%	DCF
1	120.00+ 15% = 7138.00	0.833	114.95
2	138.00 + 15% = 7158.70	p.694	110.14
3	158.70 + 15% = 7182.50	0.579	105.67
4	182.50 + 15% = 7209.88	0.482	101.16
(5 to ∞)	P4 = ₹ 1,469.16	0.482	708.13
Present value of all future benefits or Intrinsic value of Share			₹ 1,140.05

P₄ = \(\frac{\mathrm{D}_5}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{209.88+5 \%}{20 \%-5 \%}\) = ₹ 1,469.16
Intrinsic value of share is 1,140.05 as compared to latest market price of ₹ 3,122. Market price of a share is overpriced by ₹ 1,98 1.95.

Question 6.
The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend policy with a multiplier of 9, what will be the P/E ratio.
Answer:
Since the dividend payout ratio is 40%
D = 40% of E i.e. 0.4 E
P = M (D + E/3) = 9 (D + E/3) = 9 (0.4E + E/3)
P = 9(0.4E + E/3) = 9\(\left(\frac{1.2 \mathrm{E}+\mathrm{E}}{3}\right)\) = 3(2.2E) = 6.6E
P/E ratio = \(\frac{\mathrm{MPS}}{\mathrm{EPS}}\) = \(\frac{\mathrm{P}}{\mathrm{E}}\) = \(\frac{6.6 \mathrm{E}}{\mathrm{E}}\) = 6.6 times

Question 7.
Given the last year’s dividend is ₹ 9.80, speed of adjustment = 45%, target payout ratio 60% and EPS for current year ₹ 20.
Calculate cutretit year’s dividend using Linter’s model.
Answer:
D₁ = D₀ + [(EPS × Target payout) – D₀] × Af
= 9.80 + [(20 × 60%) – 9.80] × 0.45 = ₹ 10.79

Activity Based Costing (ABC) – CA Inter Costing Study Material is designed strictly as per the latest syllabus and exam pattern.

Activity Based Costing (ABC) – CA Inter Costing Study Material

Theory Questions

Question 1.
Explain Activity Based Budgeting. [CA Inter Nov. 2018, 5 Marks]
Answer:

• Activity Based Budgeting analyse the resource input or cost for each activity.
• It provides a framework for estimating the amount of resources required as per the budgeted level of activity.
• Actual results can be compared with budgeted results to highlight (both in financial and non-financial terms) those activities with major discrepancies from budget for potential reduction in supply of resources.
• It is a planning and control system which seeks to support the objectives of continuous improvement.
• It means planning and controlling the expected activities of the organi-sation to derive a cost effective budget that meet forecast workload and agreed strategic goals.
• ABB is the reversing of the ABC process to produce financial plans and budgets.

Question 2.
What is the fundamental difference between Activity Based Costing System (ABC) and Traditional Costing System? Why more and more organisations in both the manufacturing and non-manufacturing industries are adopting ABC? [ICAI Module]
Answer:
Fundamental difference between ABC and Traditional costing are as follows:

Activity Based Costing	Traditional Absorption Costing
OH are related to activities grouped into cost pools.	OH are related to cost centers/depart­ments.
Costs are related to activities and hence are more realistic.	Costs are related to cost centers and hence not realistic of cost behaviour.
Activity-wise Cost Drivers are deter­mined.	Time (Hours) is assumed to be the only cost driver governing cost in all departments.
Specific activity-wise recovery rates are used. There is no concept of single over­head recovery rate.	Either multiple overhead recovery rates (for each department) or single overhead recovery rate may be used.
Costs are assigned to Cost Objects, e.g. customers, services, distribution channels, products, departments, etc.	Costs are assigned to Cost Units, i.e. to products or jobs or hours.
Essential activities can be simplified and unnecessary activities can be eliminated. Thus, corresponding costs are also re­duced/’ minimized. Hence ABC aids cost control.	Cost Centers/departments cannot be eliminated. Hence, not suitable for cost control.

Question 3.
Explain the following terms:
(i) Cost Object
(ii) Cost Driver
(iii) Cost Pool [ICAI Module]
Answer:
(i) Cost Object: It is an item for which cost measurement is required e.g. product or customer.

(ii) Cost Driver: It is a factor that causes a change in the cost of an activity. Categories of cost driver:

• Resource Cost Driver: It is a measure of quantity of resources con-sumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
• Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

(iii) Cost Pool: It represents a group of various individual cost items. It consists of costs that have same cause and effect relationship e.g. machine set-up.

Question 4.
Describe the various levels of activities under ‘ABC’ methodology. [CA Inter Nov. 2020, 4 Marks]
Answer:
1. Unit level activities: Those activities for which the consumption of resources can be identified with the number of units produced e.g. use of indirect materials/consumables tends to increase in proportion to the number of units produced.

2. Batch level activities: The activities such as setting up of a machine or processing a purchase order are performed in batches. The cost of batch related activities varies with number of batches made, but is common (or fixed) for all units within the batch e.g.

• Material ordering, where an order is placed for every batch of production; or
• Machine set-up costs, where machines need resetting between each different batch of production.

3. Product level activities: Activities which are performed to support dif-ferent products in product line e.g. designing the product, producing parts specifications, keeping technical drawings of products up to date.

4. Facilities level activities: Those activities which cannot be directly attributed to individual products. These activities are necessary to sustain the manufacturing process and are common and joint to all products manufactured e.g. maintenance of buildings, plant security.

Question 5.
What are the advantages of ABC? [ICAI Module]
Answer:

• More accurate costing of products/services.
• Overhead allocation is done on logical basis.
• Enables better pricing policies by supplying accurate cost information.
• Utilizes unit cost rather than just total cost.
• Help to identify non-value added activities which facilitates cost reduction.
• It is helpful to the organizations with multiple products.
• It highlights problem areas which require attention of the management.

Question 6.
State the limitations of ABC? [ICAI Module]
Answer:

• It is more expensive, particularly in comparison with traditional costing system.
• It is not helpful to the small organizations.
• It may not be applied to organizations with limited products.
• Selection of the most suitable cost driver may not be easy.

Question 7.
Which are the stages required in the implementation of ABC? [ICAI Module]
Answer:

• Staff Training: Workforce co-operation is essential for successful implementation of ABC. Staff training should be done to create an awareness on the purpose of ABC.
• Process Specification: Informal, but structured interviews with key members of personnel will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks.
• Activity Definition: The activities must be defined clearly in the early stage in order to manage the problems, if any, effectively.
• Activity Driver Selection: Cost driver for each activity shall be selected.
• Assigning Cost: A single representative activity driver can be used to assign costs from the activity pools to the cost objects.

Question 8.
What are the key elements of Activity Based Budgeting? [ICAI Module]
Answer:
The three key elements of activity based budgeting are as follows:

• Type of work to be done
• Quantity of work to be done
• Cost of work to be done

Question 9.
What are the benefits of Activity Based Budgeting? [ICAI Module]
Answer:

• It can enhance accuracy of financial forecasts and increasing manage-ment understanding.
• When automated, ABB can rapidly and accurately produce financial plans and models based on varying levels of volume assumptions.
• It eliminates much of the needless rework created by traditional bud-geting techniques. .

Practical Questions

Question 1.
A company manufacturing two products furnishes the following data for a year:

The annual overheads are as under:
Volume-related activity costs ₹ 5,50,000
Set up related cost ₹ 8,20,000
Purchase-related costs ₹ 6,18,000
You are required So calculate the cost per unit of each Product A and B based on:
(i) Traditional method of charging overheads
(ii) Activity based costing method. [CA Final Nov. 2002, 9 Marks]
Answer:
(i) Statement showing overhead cost per unit (based on traditional method of charging overheads)

Machine Hour Rate for absorbing overheads = \(\frac{\text { Total Annual Overheads }}{\text { Total Machine Hours }}\)
= \(\frac{19,88,000}{1,40,000}\) = ₹ 14.2 per hour.

(ii) Statement showing overhead cost per unit (based on Activity Based Costing method)

Calculation of Cost Driver Rates

Question 2.
MNP suits is a ready-to-wear suit manufacturer. It has four customer wholesale-channel customers and two retail-channel customers. MNP suits has developed the following activity-based costing system:

Activity	Cost Driver	Rate in 2021
Order processing	Number of purchase order	1,225 per order
Sales visits	Number of customer visits	7,150 per visit
Delivery-regular	Number of regular deliveries	1,500 per delivery
Delivery rushed	Number of rushed deliveries	4,250 per delivery

List selling price per suit is 1,000 and average cost per suit is 550.
The CEO of MNP suits u’ants to evaluate the profitability of each of the four customers in 2020 to explore opportunities for increasing profitability of his company in 2021. The following data are available for 2020:

Required:
(i) Calculate the customer-level operating income in 2020
(ii) What do you recommend to CEO of MNP suits to do to increase the Company’s operating income in 2021?
(iii) Assume MNP suits’ distribution channel costs are ₹ 17,50,000 for its wholesale customers and ₹ 10,50,000 for the retail customers. Also, assume that its Corporate sustaining costs are ₹ 12,50,000. Prepare Income statement of MNP suits for 2021. [CA Final Nov. 2004, 10 Marks]
Answer:
(i) Computation of Customer level operating income in 2020:

(ii) The key challenges that may be faced by CEO:

• Reduce level of price discounting, especially by the wholesale customer ‘W’.
• Reduce level of Customer level costs’, especially by retail cus-tomers R&T.
• ABC cost system highlights some of the problem areas regarding the customers R and T. Such as:
  • high number of orders,
  • high number of customer visits,
  • high number of rushed deliveries.
• The CEO needs to consider whether this high level of activity can be reduced without reducing customer revenues.

(iii) Income Statement of MNP suits for 2020:

Question 3.
ABCD Co. Ltd. produces and sells four products A, B, C and D. These products are similar and usually produced in production runs of 10 units and sold in a batch of 5 units. The production details of these, products are as follows:

The production overheads during the period are as follows:
Factory works expenses ₹ 22,500
Stores receiving costs ₹ 8,100
Machine set up costs ₹ 12,200
Cost relating to quality control ₹ 4,600
Material handling and dispatch ₹ 9.600 ₹ 57, 000

Cost	Cost drivers
Factory works expenses	Machine hours
Stores receiving costs	Requisitions raised
Machine set up costs	No. of production runs
Cost relating to quality control	No. of production runs
Material handling and dispatch	No. of orders executed

The number of requisitions raised on the stores was 25 for each product and number of orders executed was 96, each order was in a batch of 5 units.
Required:
(i) Total cost of each product assuming the absorption of overhead on machine hour basis;
(ii) Total cost of each product assuming the absorption of overhead by using activity base costing; and
(iii) Show the differences between (i) and (ii) and comments. [CA Final May 2005, 12 Marks]
Answer:
(i) Statement showing total cost of each product by absorbing overheads on machine hour rate basis:

Machine hour over-head Rate = \(\frac{\text { Total overhead costs }}{\text { Total machine hrs }}=\frac{₹ 57,000}{1,900 \mathrm{hrs}}\) = ₹ 30/machine

(ii) Statement showing total cost of each product by absorbing overheads on activity based cost method:

Total Production overhead and Production OH/Cost driver:

(iii) Statement showing Difference between (i) and (ii) :

• The above analysis shows that, ‘A’ consumes comparatively more of Machine hours.
• On the use of activity based costing gives different product costs than what were arrived at by utilising traditional costing.
• The product cost is more precise by using ABC because in this method of absorption overhead have been identified with specific activities.

Question 4.
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The budgeted costs and production for the year ending 31st March are as follows:

The budgeted direct labour rate was ? 10 per hour, and the budgeted material cost w as ₹ 2 per kg. Production overheads were budgeted at ₹ 99,450 and were absorbed to products using the direct labour hour rale. ABC Ltd. followed the Absorption Costing System.

ABC Ltd. is now considering to adopt an Activity Based Costing system. The following additional information is made available for this purpose.
1. Budgeted overheads were analysed into the following:

	₹
Material handling	29,100
Storage costs	31,200
Electricity	39,150

You are requested to:

2. The cost drivers identified were as follows:

Material handling	Weight of material handled
Storage costs	Number of batches of material
Electricity	Number of Machine operations

3. Data on Cost Drivers was as follows:

You are requested to:
1. Prepare a statement for management showing the unit costs and total costs of each product using the absorption costing method.
2. Prepare a statement for management showing the product costs of each product using the ABC approach.
3. State what are the reasons for the different product costs under the two approaches? [ICAI Module]
Answer:
1. Traditional Absorption Costing
Total budgeted direct labour hours:
\(\frac{4,000 \times 30 \mathrm{~min}+3,000 \times 45 \mathrm{~min}+1,600 \times 60 \mathrm{~min}}{60 \mathrm{~min}}\)
Total joint cost Total sale value = 5,800 hours
Overhead rate per direct labour hour:
= Budgeted overheads ÷ Budgeted labour hours
= ₹ 99,450 ÷ 5,850 hours
= ₹ 17 per direct labour hour

Unit Costs:

2. Activity Based Costing

Material handling rate per kg. = ₹ 29,100 4- 38,800 kg. = ₹ 0.75 per kg.
Electricity rate per machine operations = ₹ 39,150 4- 36,200
= ₹ 1.081 per machine operations

Storage rate per batch = ₹ 31,200 4- 30 batches
= ₹ 1,040 per batch

Unit Costs:

3. The difference in the total costs under the two systems is due to the differences in the overheads borne by each of the products. The Activity Based Costs appear to be more precise.

Question 5.
An engine manufacturing company has two production departments: (i) Snow mobile engine and (ii) Boat engine and two service departments: (i) Maintenance and (ii) Factory office.
Budgeted cost data and relevant cost drivers are as follows:

Departmental costs:	₹
Snow mobile engine	6,00,000
Boat engine	17,00,000
Factory office	3,00,000
Maintenance	2,40,000
Cost drivers:
Factory office department:	No. of employees
Snow mobile engine department	1,080
Boat engine department	270
Maintenance department	150
	1,500
Maintenance department:	No. of work orders
Snow mobile engine department	570
Boat engine department	190
Factory office department	40
	800

Required:
(i) Compute the cost driver allocation percentage and then use these percentages to allocate the service department costs by using direct method.
(ii) Compute the cost driver allocation percentage and then use these percentages to allocate the service department costs by using non-reciprocal method/step method. [CA Final May 2005, 5 Marks]
Answer:
(i) Direct Method:
Cost Driver Allocation Percentage:

Factory office dept.	No. of employees	% used
Snow mobile engine	1,080	80%
Boat engine	270	20%
Total	1,350	100%
Maintenance dept.	Number of work orders
Snow mobile engine	570	75%
Boat engine	190	25%
	760	100

Service Department Allocation:

(ii) Step Method:
Cost Driver Allocation Percentage:

Factory office dept.	Number of employees	% used
Snow mobile engine	1,080	72%
Boat engine	270	18%
Maintenance dept.	150	10%
	1,500	100%
Maintenance dept.	Work order	% used
Snow mobile engine	570	75%
Boat engine	190	25%
	760	100%

Service Department Allocation:

Question 6.
A bank offers three products, viz., deposits, Loans and Credit Cards. The bank has selected 4 activities for a detailed budgeting exercise, following activity based costing methods.
The bank wants to know the product wise total cost per unit for the selected activities, so that prices may be fixed accordingly.
The following information is made available to formulate the budget:

The activity drivers and their budgeted quantities are given below:

	Deposits	Loans	Credit Card
No, of ATM Transactions	1,50,000		50,000
No. of Computer Processing Transactions	15,00,000	2,00,000	3,00,000
No. of Statements to be issued	3,50,000	50,000	1,00,000
Telephone Minutes	3,60,000	1,80,000	1,80,000

The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and 14,000 Credit Card accounts.
You are required to:
(i) Calculate the budgeted rate for each activity.
(ii) Prepare the budgeted cost statement activity wise. Find the budgeted product cost per account for each product.
(iii) Find the budgeted product cost per account for each product using (i) and (ii) above. [CA Final May 2009, 12 Marks]
Answer:
Statement showing Budget Cost per unit

Working Note:

Activity	Budgeted Cost (₹)	Remark
ATM Services
(a) Machine Maintenance	4,00,000	All fixed, no change.
(b) Rents	2,00,000	Fully fixed, no change.
(c) Currency Replenishment Cost	2,00,000	Doubled during budget period
Total	8,00,000
Computer Processing	2,50,000	₹ 2,50,000 (half of ₹ 5,00,000) is fixed and no change is expected
	7,50,000	₹ 2,50,000 (variable portion) is expected to increase to three times the current level.
Total	10,00,000
Issuing Statements	18,00,000	Existing
	2,00,000	2 lakhs statements are expected to be increased in budgeted per­iod. For every increase of one lakh statement, one lakh rupees is the budgeted increase.
Total	20,00,000
Computer Inquiries	3,60,000	Estimated to increase by 80% dur­ing the budget period. (₹ 2,00,000 x 180%)    ‘
Total	3,60,000

Question 7.
AML Ltd. is engaged in production of three types of ice-cream products Coco, Strawberry and Vanilla. The company presently sells 50,000 units of Coco @ ₹ 25 per unit, Strawberry 20,000 @ ₹ 20 per unit and Vanilla 60,000 units @ ₹ 15 per unit. The demand is sensitive to selling price and it has been observed that every reduction of ₹ 1 per unit in selling price, increases the demand for each product by 10% to the previous level. The company has the production capacity of 60,500 units of Coco, 24,200 units of Strawberry and 72,600 units of Vanilla. The company marks up 25% on cost of the product.
The Company management decides to apply ABC analysis. For this purpose it identifies tour activities and the rates as follows :

Activity	Cost Rate
Ordering	₹ 800 per purchase order
Delivery	₹ 700 per delivery
Shelf stocking	₹ 199 per hour
Customer support and assistance	₹ 1.10 per unit sold.

The other relevant information for the products are as follows:

	Coco	Strawberry	Vanilla
Direct Material per unit	8	6	5
Direct Labour per unit	5	4	3
No. of purchase orders	35	30	15
No. of deliveries	112	66	48
Shelf stocking hours	130	150	160

Under the traditional costing system, store support costs are charged @ 30% of prime cost. In ABC these costs are coming under customer support and assistance.
Required:
(i) Calculate target cost for each product after a reduction of selling price required to achieve the sales equal to the production capacity.
(ii) Calculate the total cost and unit cost of each product at the maximum level using traditional costing.
(iii) Calculate the total cost and unit cost of each product at the maximum level using activity based costing.
(iv) Compare the cost of each product calculated in (i) and (ii) with (iii) and comment on it. [CA Final May 2010, 12 Marks]
Answer:
(i) Cost of products under target costing
Demanded unit and selling price

Target cost of each product after reduction in selling price

	Coco	Strawberry	Vanilla
Selling price alter reduction	23.00	18.00	13.00
Profit marks up 25% on cost i.e. 20ao on selling price	4.60	3.60	2.60
Target cost of production (per unit)	18.40	14.40	10.40

(ii) Cost of product under traditional costing

	Coco	Strawberry	Vanilla
Units	60,500	24,200	72,600
Material cost (8, 6, 5 per unit)	8	6	5
Labour cost (5, 4, 3 per unit)	5	4	3
Prime cost	13	10	8
Store support costs (30% of prime)	3.90	3	2.40
Cost per unit	16.90	13.00	10.40

(iii) Cost of product under activity based costing

	Coco	Strawberry	Vanilla
Units	60,500	24,200	72.600
Materia] cost (8, 6, 5 per unit)	4,84,000	1,45.200	3,63,000
Labour cost (5, 4, 3 per unit)	3,02,500	96,800	2,17,800
Prime cost	7,86,500	2,42,000	5,80,800
Ordering cost @ ₹ 800 (35, 30, 15)	28,000	24,000	12,000
Delivery cost @ ₹ 700 (112, 66, 48)	78,400	46,200	33,600
Shelf stocking @ ₹ 199 (130, 150, 160)	25,870	29,850	31,840
Customer Support ₹ 1.10	66,550	26,620	79,860
Total Cost	9,85,320	3,68,670	7,83,100
Cost Per unit	16.29	15.23	10.17

(iv) Comparative Analysis of cost of production

	Coco	Straw­berry	Vanilla
(a) As per Target Costing	18.40	14.40	10.40
(b) As per traditional Costing	16.90	13.00	.10.40
(c) As per Activity Based Costing	16.29	15.23	10.17
(a)-(c)	2.11	-0.83	0.23
(b)-(c)	0.61	-2.23	0.23

Note: The cost of product of strawberry is higher in ABC method in comparison to target costing and traditional methods. It indicated that actual profit under target costing is less than targeted. For remaining two products, ABC is most suitable.

Question 8.
A Drug Store is presently selling three types of drugs namely ‘Drug A’, ‘Drug B’ and ‘Drug C’. Due to some constiaints, it has decided to go for only one product line of drugs. It has provided the following data for year 202021 for each product line:

Following additional information is also provided:

You are required to:
(i) Calculate the operating income and operating income as a percentage (%) of revenue of each product line if:
(a) All the support costs (Other than cost of goods sold) are allocated in the ratio of cost of goods sold.
(b) All the support costs (Other than cost of goods sold) are allocated using activity-based costing system.
(ii) Give your opinion about choosing the product line on the basis of operating income as a percentage (%) of revenue of each product line under both the situations as above. [CA Inter Dec. 2021, Nov. 2010, 10 Marks]
Answer:
(i) (a) Statement of operating income and operating income as a percentage (%) of revenue of each product line where all the support costs (Other than cost of goods sold) are allocated in the ratio of cost of goods sold.

Workings:

Calculation of Total Support Cost:	₹
Drug License lees	5,00,000
Ordering Cost	8,30,000
Delivery Cost	18,20,000
Shelf-stocking cost	32,40,000
Customer support cost	28,20,000
Total Support Cost	92,10,000

Percentage of support cost to COGS = \(\frac{\text { Total Support Cost }}{\text { Total COGS }}\)
= \(\frac{₹ 92,10,000}{₹ 2,30,25,000}\) × 100 = 40%

(b) Statement of operating income and operating income as a percentage (%) of revenue of each product line where all the support costs (Other than cost of goods sold) are allocated using activity-based costing system.

Workings: Calculation of Cost Driver Rate

Activity	Cost (₹)	Allocation base	Cost Driver Rate
Ordering Cost	8,30,000	2,000 pur. orders	₹ 415/order
Delivering Cost	18,20,000	2,800 deliveries	₹ 650/delivery
Shelf-stock cost	32,40,000	4,500 hours	₹ 720/hour
Customer support	28,20,000	4,70,000 units sold	₹ 6/ unit

(ii) Choosing the product line on the basis of operating income as a percentage (%) of revenue of each product line:
When using COGS as the basis for allocating support costs, Drug A seems to be most profitable @ 22% and Drug C seems to be least profitable @ 9.32%. But this can be deceptive, since above method uses COGS as a flat rate for allocating support costs.
ABC method on the other hand uses the cost driver in each of the support costs for allocating it to the product line. Thus, it is much more accurate.
Accordingly now Drug C seems to be most profitable at 15.78% and Drug A seems to be the least profitable at 8.81%
Therefore, it is suggested that company should go with Drug C for Product line.

Question 9.
DEF Bank operated for years under the assumption that profitability can be increased by increasing Rupee volumes. But that has not been the case. Cost Analysis has revealed the following:

Activity	Activity cost (₹)	Activity Driver	Activity   capacity
Providing ATM service	1,00,000	No. of transactions	2,00,000
Computer processing	10,00,000	No. of transactions	25,00,000
Issuing Statements	8,00,000	No. of statements	5,00,000
Customer inquiries	3,60,000	Telephone minutes	6,00,000

The following annual information on three products was also made available:

	Checking Accounts	Personal Loans	Gold Visa
Units of product	30,000	5,000	10,000
ATM transactions	1,80,000	0	20,000
Computer transactions	20,00,000	2,00,000	3,00,000
Number of statements	3,00,000	50,000	1,50,000
Telephone minutes	3,50,000	90,000	1,60,000

Required:
(i) Calculate rates for each activity.
(ii) Using the rates computed in requirement (i), calculate the cost of each product. [CA Final May 2013, 8 marks]
Answer:
Computation showing Rates for each Activity

Question 10.
MK Ltd. manufactures four products, namely A, B, € and D using the same plant and process. The following information relates to a production period:

The four products are similar and are usually produced in production runs of 24 units and sold in batches of 12 units. The total overheads incurred by the company for the period are as follows:

	₹
Machine operation and maintenance cost	63,000
Setup costs	20,000
Store receiving	15,000
Inspection	10,000
Material handling and dispatch	2,592

During the period the fallowing cost drivers are to be used for the overhead cost:

Cost	Cost Driver
Setup cost	No. of production runs
Store receiving	Requisitions raised
Inspection	No. of production runs
Material handling and dispatch	Orders executed

It is also determined that:

• Machine operation and maintenance cost should be apportioned be-tween setup cost, store receiving and inspection activity in the ratio 4:3:2.
• Number of requisition raised on store is 50 for each product and the No. of orders executed is 192, each order being for a batch of 12 units of a product.

Calculate the total overhead cost per unit of each product using activity based costing after finding activity wise overheads allocated to each product. [CA Final Nov. 2013, 8 Marks]
Answer:
Statement Showing Overhead Cost per unit

Workings:
Calculation of No. of Production runs and No. of Batches

Allocation of Machine Operation and Maintenance Cost

Calculation of Cost Driver Rate

Question 11.
Linex Limited manufactures three products P, 0 and R which are similar in nature and are usually produced in production runs of 100 units. Product P and R require both machine hours and assembly hours, whereas product 0 requires only machine hours. The overheads incurred by the company during the first quarter are as under:

	₹
Machine Department expenses	18,48,000
Assembly Department expenses	6,72,000
Setup costs	90,000
Stores receiving cost	1,20,000
Order processing and dispatch	1,80,000
Inspection and Quality control cost	36,000

The data related to the three products during the period are as under:

Prepare a statement showing details of overhead costs allocated to each product type using activity based costing. [CA Final May 2015, 8 Marks]
Answer:
Computation of Activity Rate

*Number of production Runs is 450 (150 + 120 + 180)
Statement Showing Overhead Allocation

Question 12.
PCP Limited belongs to the apparel industry. It specializes in the distribution of fashionable garments. It buys from the industry and resells the same to the following two different supermarkets:
(i) Supermarket A dealing in Adults’ garments (Age group 15 – 30)
(ii) Supermarket B dealing in Kids’ garments (Age group 5 – 10)
The following data for the month of April in respect of PCP Limited has been reported:

	Supermarket A (₹)	Supermarket B (₹)
Average revenue per delivery	1,69,950	57,750
Average cost of goods sold per delivery	1,65,000	55,000
Number of deliveries	660	1,650

In the past, PCP Limited has used gross margin percentage to evaluate the relative profitability of its supermarket segments.
The company plans to use activity-based costing for analysing the profitability of its supermarket segments.
The April month’s operating costs (other than cost of goods sold) of PCP Limited are ? 16,55,995. These operating costs are assigned to five activity areas. The cost in each area and Activity analysis including cost driver for the month of April are as follows:

	Supermarket A	Supermarket B
Total number of store deliveries	1,100	2,805
Average number of cartons shipped per store delivery	250	50
Average number of hours of shelf-stock­ing per store delivery	6	1.5
Average number of line items per order	14	12
Total number of orders	770	1,980

Other data for the month of April include the following:

Activity Area	Total costs (₹)	Cost Driver
Store delivery	3,90,500	Store deliveries
Cartons dispatched to store	4,15,250	Cartons dispatched to a store per delivery
Shelf-stocking at customer store	64,845	Hours of shelf-stocking
Line-item ordering	3,45,400	Line-Items per purchase order
Customer purchase order processing	4,40,000	Purchase orders by customers

Required:
(i) Compute gross-margin percentage for each of its supermarket segments and compute PCP Limited’s operating income.
(ii) Compute the operating income of each supermarket segments using the activity-based costing information. [CA Inter RTP May 2022]
Answer:
(i) Statement of operating income and gross margin percentage for each of its supermarket segments:

(ii) Operating Income Statement of each distribution channel in April (Using the Activity based Costing information)

Calculation of Cost Driver Rate

Question 13.
Speedo Limited is a specialist car manufacturer that produces various models of cars. The organization is due to celebrate its 100th anniversary next year. To mark the occasion, Speedo Limited intends to produce a sports car, the Model Royal. As this will be a special edition, production will be limited to 1,000 numbers of Model Royal Cars.
Speedo Limited is considering using a target costing approach and has conducted market research to determine the features that consumers require in a sports car. Based on this market research and knowledge of competitor’s products, company has decided to price the Model Royal at ₹ 9.75 lakhs. Company requires an operating profit margin of 25% of the selling price of the car. Details for the forthcoming year are as follows:
Forecast of direct costs for a Model Royal Car

Labour	₹ 2,50,000
Material	₹ 4,75,000

Forecast of annual overhead costs

	₹ in lakhs	Cost driver
Production line cost	2,310	See note 1
Transportation cost	900	See note 2

Note 1:
The production line that would be used for Model Royal has a capacity of
60.0 machine hours per year. The production line time required for Model Royal is 6 machine hours per err. This production line will also be used to make other cars and will be working at full capacity.
Note 2:
Some models of cars are delivered to showrooms using car transporters 60% of the transportation costs are related to the number of deliveries made. 40% of the transportation costs are related to the distance travelled. The car transporters have forecast to make a total of 640 deliveries in the year and carry 10 cars each time. The car transporter will always carry its maximum capacity of 10 cars.
The total annual distance travelled by car transporters is expected to be 2.25.0 kms. 50,000 kms of this is for the delivery of Model Royal cars only. All 1,000 Model Royal cars that will be produced will be delivered in the year using the car transporters.
Required:
(1) Calculate the forecast total cost of producing and delivering a Model Royal car using Activity Based Costing principles to assign the overhead costs.
(2) Calculate the cost gap that currently exists between the forecast total cost and the target total cost of a Model Royal car. [CA Final Nov. 2016, 10 Marks]
Answer:
Statement showing ‘Cost Driver Rate’

(i) Forecast Total Cost using Activity Based Costing Principles

(ii) Calculation of Cost Gap Between Forecast Total Cost and the Target Total Cost:

	₹
Target selling price	9,75,000.00
Less: Operating Profit Margin (₹ 9,75,000 × 25%)	2,43,750.00
Target Total Cost	7,31,250.00
Forecast Total Cost	7,64,537.50
Cost Gap	33,287.50

Question 14.
A company can make any or both of products A and B in a production period not exceeding a total of 10,000 units due to non-availability of the required material and labour. Until now, the company had been taking decisions on the product mix, based on the following marginal cost analysis.

	A	B
Selling Price	100	120
Variable Cost	60	70
Contribution	40	50
Total fixed costs			3,00,000

Since the decisions based on the above approach did not yield the required results, the fixed costs were analysed as follows for 10,000 units of only A or 10,000 units of only B.

₹ 30,000 can be taken as the unanalysed fixed cost, and unavoidable whether A or B or both are produced.
The following cost reduction measures were taken by the Product Managers of A and B:

	A	B
Increase in number of units per run to	2,000 units	1,250 units
Increase in the number of units per box distributed to	30 units	125 units

Further, the Management ensured availability of raw material and labour to support a production of 15,000 units of either A or B or both together. There was no change to the step costs or contribution. However, the total unanalysed fixed cost increased to ₹ 32,000.
(i) Based on the principles of Activity Based Costing, prepare a statement showing the contribution and item wise analysed overheads for each product, arrive at the profitability of A and B and then the final profits it 15,000 units of only A or 15,000 units of only B are manufactured.
(ii) Find the minimum break-even point in units if only product A is manufactured after the cost reduction. [CA Final May 2017, 12 Marks]
Answer:
(i) Statement Showing “Profitability of Product A & B”

(ii) Break Even Point ‘A’
Un-analyzed Fixed Cost is ₹32,000
Minimum units for BEP = \(\frac{₹ 32,000}{40}\) = 800 units
Setup Cost (fixed for 2,000 units); 1 Production Run; ₹ 4,000
Distribution Cost will have to be recovered on the basis of 30 units.
Let BEP (units) = ‘K’
40 × K = ₹ 32,000 + ₹ 8,000 + \(\frac{\mathrm{K}}{30 \text { units }}\) Boxes × ₹ 120
K = 1,111.11 units
Refining, 1,111.11 will have 37.03 boxes or say 38 boxes. The last box will cost ₹ 120 which is equivalent to contribution from 3 units. Hence, BEP is 1,114 units.

Question 15.
PQR Pens Ltd. manufactures two products – Gel Pen and Ball Pen. It furnishes the following data for the year 2020:

The annual overheads are as under:

	₹
Volume related activity costs	4,75.020
Set up related costs	5,79.988
Purchase related costs	5,04,992

Calculate the overhead cost per unit of each Product – Gel Pen and Ball Pen on the basis of:
(i) Traditional method of charging overheads
(ii) Activity based costing method and
(iii) Find out the difference in cost per unit between both the methods. [CA In ter May 2018, 10 Marks]
Answer:
(i) Statement showing Overhead Cost per unit using Traditional method

	Gel Pen	Ball Pen
Units	5,500	24,000
Overheads (₹)	4,80,000 (20 × 24,000 hrs)	10,80,000 (20 × 54,000)
Overhead Cost Per Unit (₹)	87.27 (₹ 4,80,000 ÷ 5,500)	45 (₹ 10,80,000 ÷ 24,000)

Overhead Rate per Machine Hour

(ii) Statement Showing “Activity Based Overhead Cost”

(iii) Calculation of difference in cost between above methods

	Gel pen	Ball Pen
Overheads Cost per unit (₹) (Traditional Method)	87.27	45
Overheads Cost per unit (₹) (ABC)	95.39	43.13
Difference per unit	-8.12	+ 1.87

Note: Volume related activity cost, set up related costs and purchase related cost can also be calculated under Activity Base Costing using Cost driver rate. However, there will be no changes in the final answer.

Question 16.
ABC Ltd. manufactures three products X, Y and Z using the same plant and resources. It has given the following information for the year ended on 31st March, 2020:

Budgeted direct labour rate was 4 per hour and the production overheads, shown in table below, wrere absorbed to products using direct labour hour rate. Company followed Absorption Costing Method. However, the company is now considering adopting Activity Based Costing Method:

Required:
1. Calculate the total cost per unit of each product using the Absorption Costing Method
2. Calculate the total cost per unit of each product using the Activity
Based Costing Method. [CA Inter January 2021, 10 Marks]
Answer:
Traditional Absorption Costing

Overhead rate per direct labour hour:
= Budgeted overheads/Budgeted labour hours
= (₹ 50,000 + ₹ 40,000 + ₹ 28,240 + ₹ 1,28,000)/27,360 hours
= ₹ 2,46,240/27,360 hours
= ₹ 9 per direct labour hour

Unit Costs:

Calculation of Cost-Driver level under Activity Based Costing

Calculation of Cost-Driver rate

Calculation of total cost of products using Activity Based Costing

Question 17.
Ms. HMB Limited is producing a product in 10 batches each of 15,000 units in a year and incurring following overheads thereon:

	₹
Material procurement	22,50,000
Maintenance	17,30,000
Set-up	6,84,500
Quality control	5,14,800
Total	51,79,300

The prime costs for the year amounted to ₹ 3,01,39,000.
The company is using currently the method of absorbing overheads on the basis of prime cost. Now it wants to shift to activity based costing. Information relevant to Activity drivers for a year are as under:

Activity Driver	Activity Volume
No. of purchase orders	1,500
Maintenance hours	9,080
No. of set-ups	2,250
No. of inspections	2,710

The company has produced a batch of 15,000 units and has incurred ₹ 26,38,700 and ₹ 3,75,200 on materials and wages respectively.
The usage of activities of the said batch are as follows:

Material orders	48 orders
Maintenance hours	810 hours
No. of set-ups	40 set-ups
No. of inspections	25 inspections

You are required to:
(i) Find out cost of product per unit on absorption costing basis for the said batch.
(ii) Determine cost driver rate, total cost and cost per unit of output of the said batch on the basis of activity based; costing. [CA Inter Nov. 2018, 10 Marks]
Answer:
Overhead Absorption rate = \(\frac{\text { Total Overheads }}{\text { Prime Cost }}\) × 100
= \(\frac{₹ 51,79,300}{₹ 3,01,39,000}\) × 100 = 17.18%

(i) Cost of Product Under Absorption Costing

(ii) Calculation of cost driver rate:

Calculation of Total Cost an d Cost per unit:

Question 18.
MNO Ltd. manufactures two types of equipments A and B and absorbs overheads on the basis of direct labour hours. The budgeted overheads and direct labour hours for the month of March 2021 are 15,00,000 and 25,000 hours respectively. The information about the company’s products is as follows:

	Equipment
	A	B
Budgeted Production Volume	3,200 units	3,850 units
Direct Material Cost	₹ 350 per unit	₹ 400 per unit
Direct Labour Cost
A; 3 hours @ ₹ 120 per hour	₹ 360
B: 4 hours @ ₹ 120 per hour		₹ 480

Overheads of ₹ 15,00,000 can be identified with the following three major activities:

Order processing	₹ 3, 00,000
Machine processing	₹ 10, 00, 000
Product Inspection	₹ 2, 00, 000

These activities are driven by the number of orders processed, machine hours worked and inspection hours respectively. The data relevant to these activities is as follows:

Equipment

Orders processed

Machine hours worked

Inspection hours

Required:
(i) Prepare a statement showing the manufacturing cost per unit of each product using the absorption costing method assuming the budgeted manufacturing volume is attained.
(ii) Determine cost driver rates and prepare a statement showing the manufacturing cost per unit of each product using activity based costing, assuming the budgeted manufacturing volume is attained.
(iii) MNO Ltd.’s selling prices are based heavily on cost. By using direct labour hours as an application base, calculate the amount of cost distortion (under costed or over costed) for each equipment. [CA Inter May 2019, Final Nov. 2006, 10 Marks]
Answer:
(i) Overheads Application Base: Direct Labour hours

Equipment (A) (₹)	Equipment (B) (₹)
Direct Material Cost	350	400
Direct Labour Cost	360	480
Overheads	180	240
	890	1,120

* Per-determined rate = \(\frac{\text { Budgeted Overheads }}{\text { Budgeted direct labour hours }}\)
= \(\frac{₹ 15,00,000}{25,000 \text { hours }}\)
= ₹ 60

(ii) Estimated Cost Driver Rate:

Statement showing the manufacturing cost per unit using activity based costing

(iii) Calculation of Cost Distortion

Cost distortion
Low volume product A is under-costed and high volume product B is over costed using direct labour hours for overhead absorption.

Question 19.
PQR Ltd. has decided to analyse the profitability of its five new customers. It buys soft drink bottles in cases at 45 per case and sells them to retail customers at a list price of 54 per case. The data pertaining to five customers are given below:

Its five activities and their cost drivers are:

Activity	Cost Driver
Order taking	200 per purchase order
Customer visits	300 per each visit
Deliveries	4.00 per delivery km travelled
Product Handling	100 per case sold
Expedited deliveries	100 per each such delivery

You are required to:
(i) Compute the customer level operating income of each of five retail customers by using the Cost Driver rates.
(ii) Examine the results to give your comments on Customer ‘D’ in comparison with Customer ‘C’ and on Customer ‘E’ in comparison with Customer ‘A’. ]CA Inter Nov. 2019, 10 Marks]
Answer:
Computation of revenues (at listed price), discount, cost of goods sold and Customer level operating activities costs:

(i) Computation of Customer level operating income

(ii) Comments:
Customer D in comparison with Customer C:
Operating income of Customer D is more than of Customer C, despite having only 61.29% (38,000 units) of the units volume sold in comparison to Customer C (62,000 units). Customer C receives a higher per cent of discount Le. 9.26% (₹ 5) while Customer D receives a discount of 7.04% (₹ 3.80). Though the grpss margin of customer C (₹ 2,48,000) is more than Customer D (₹ 1,97,600) but total cost of customer level operating activities of C (₹ 1,44,400) is more in comparison to Customer D (₹ 93,600). As a result, operating income is more in case of Customer D.

Customer E in comparison with Customer A:
Customer E is not profitable while Customer A is profitable. Customer E receives a discount of 10% (₹ 5.4) while Customer A doesn’t receive any discount. Sales Volume of Customers A and E is almost same. However, total cost of customer level operating activities of E is far more (₹ 43,200) in comparison to Customer A (₹ 29,120). This has resulted in occurrence of loss in case of Customer E.

Question 20.
PQR Ltd. Is engaged in the production of three products P, Q and R. The company calculates activity cost rates on the basis of cost Driver capacity which is provided as below:

The consumption of activities during the period is as under:

	P	Q	R
Direct Labour hours	10,000	8,000	6,000
Production runs ‘	200	180	160
Quality Inspection	3000	2500	1500

You are required to:
(i) Compute the costs allocated to each Product from each Activity,
(ii) Calculate the cost of unused capacity for each Activity.
(iii) A potential customer has approached the company for supply of 12,000 units of a new product ‘S’ to be delivered in lots of 1500 units per quarter. This will involve an initial design cost of 30,000 and per quarter production will involve the following:

Direct Material	18,000
Direct Labour hours	1,500 hours
No. of Production runs	15
No. of Quality Inspection	250

Prepare cost sheet segregating Direct and Indirect costs and compute the Sales value per quarter of product ‘S’ using ABC system considering a markup of 20% on cost. [CA Inter July 2021, Final May 2004, 10 Marks]
Answer:
(i) Statement of Cost Allocation

Working note: Calculation of Cost driver rate

(ii) Calculation of cost of unused capacity for each activity
Direct Labour hours = ₹ 3,00,000 – ₹ 2,40,000 = ₹ 60,000
Production runs = ₹ 1,80,000 – ₹ 1,62,000 = ₹ 18,000
Quality Inspection = ₹ 2,40,000 – ₹ 2,10,000 = ₹ 30,000

(iii) Cost Sheet

Question 21.
ABC Bank is examining the profitability of its Premier Account, a combined Savings & Cheque account. Depositors receive a 7% annual interest on their average deposit. ABC Bank earns an interest rate spread of 3% (the difference between the rate at which it lends money and rate it pays to depositors) by lending money for home loan purpose at 10%.
The Premier Account allows depositors unlimited use of services such as deposits, withdrawals, cheque facility, and foreign currency drafts. Depositors with Premier Account balances of ₹ 5.0,000 or more receive unlimited free use of services. Depositors with minimum balance of less than ₹ 50,000 pay ₹ 1,000 a month service fee for their Premier Account ABC Bank recently conducted an activity-based costing study of its services. The use of these services in 2020-21 by three customers is as follows:

Assume Customer X and Z always maintain a balance above ₹ 50,000, whereas Customer Y always has a balance below ₹ 50,000.
Required:
(i) Compute the 2020-21 profitability of the customers X, Y and Z Premier Account at ABC Bank.
(ii) Premier Accounts? Why might ABC bank worry about this Cross subsidization, if the Premier Account product offering is profitable as a whole?
(iii) What changes would you recommend for ABC Bank’s Premier Account? [CA Final May 2006, 11 Marks]
Answer:
(i) Customer Profitability Analysis of ABC Bank Premier Account

(ii) Above computation shows that Customer Z is most profitable and is cross-subsidising the most demanding customer X. Customer Y is paying for the services used, because of not being able to maintain minimum balance. No doubt, ‘Premier Account’ product offering is profitable as a whole, but the worry is of not finding customers like customer Z who will maintain a balance higher than the stipulated minimum. It appears, the minimum balance stipulated is inadequate considering the services availed by depositors in ‘Premium Account’.

(iii) The changes suggested to ABC Bank’s ‘Premier Account’ are as follows:

• Increase the requirement of minimum balance from ₹ 50,000 to ₹ 1,00,000.
• Charge for value added services like Foreign Currency Drafts.
• Do not allow deposits/withdrawal below ₹ 10,000 at the teller. Only ATM machine withdrawal is allowed.
• Inquiries about account balance to be entertained only through Phone Banking/’ATM.

Question 22.
PQ Ltd. makes two products P and 0, which are similar products with dimensions, but use the same manufacturing process facilities. Production may be made interchangeably after altering machine setup. Production time is the same for both products. The cost structure is as follows:

(Figures per unit)	P	0
Selling Price	100	120
Variable manufacturing cost	45	50
(directly linked to units produced) Contribution	55	70
Fixed manufacturing cost	10	10
Profit	45	60

Fixed cost per unit has been calculated based on the total practical capacity of 20,000 units per annum (which is either P or Q or both put together). Market demand is expected to be the deciding factor regarding the product mix for the next 2 years. The company does not stock inventory of finished goods. The company wishes to know whether ABC system is to be set up at a cost of 10,000 per month for the purpose of tracking and recording the fixed overhead costs for allocation to products. Support your advice with appropriate reasons.
Independent of the above, if you are told to assume that fixed costs stated above, consist of a non-cash component of depreciation to plant at ₹ 90,000 for the year, will your advice change? Explain. [CA Final Nov. 2011, 8 Marks]
Answer:

Data	Reasoning
Similar Products, Similar Production Resources	Overhead Cost based on production units is appro­priate. ABC will also yield identical results	ABC system not required for Over­head allocation
Present overhead Cost = ₹ 10/unit Proposed Increase due to ABC system: 1,20,000/ 20,000 = ₹ 6/unit	Current overhead cost of ₹ 10/unit will increase by ₹ 6 per unit due to installing ABC system (60% increase)	For allocation purpose. ABC not justified
Both have positive con­tribution/ unit Market demand determines the mix	OH allocation has no role in decision making	No need for ABC System
For the purpose of OH allocation, ABC need not be installed. However, if the fixed overhead of ₹ 2,00,000 are analysed by activity and thereby a saving of at least ₹ 1,20,000 be expected (which is the cost of installing ABC system), then, ABC system may be installed.
For the non-cash component of depn.= ₹ 90,000, Fixed cost that can be saved is a maximum of ₹ 1,10,000 (₹ 2,00,000 – ₹ 90,000).
Hence, this is clearly less than ABC cost installation. Hence do not install ABC System.

Question 23.
Traditional Ltd. is a manufacturer of a range of goods. The cost structure of its different products is as follows:

	Product A	Product B	Product C
Direct materials	50	40	40
Direct labour @10 /hour	30	40	50
Production overheads	30	40	50
Total Cost	110	120	140
Quantity produced	10,000	20,000	30,000 units

Traditional Ltd. was absorbing overheads on the basis of direct labour hours. A newly appointed management accountant has suggested that the company should introduce ABC system and has identified cost drivers and cost pools as follows:

Activity Cost Pool	Cost Driver	Associated Cost (%)
Stores Receiving	Purchase Requisitions	2,96,000
Inspection	Number of production runs	8,94,000
Dispatch	Orders Executed	2,10,000
Machine Set-up	Number of Setups	12,00,000

The following information is also supplied:

	Product A	Product B	Product C
No. of Setups	360	390	450
No. of Orders Executed	180	270	300
No. of Production runs	750	1,050	1,200
No. of Purchase Requisitions	300	450	500

You are required to calculate activity based production cost of all the three products. [CA Final May 2009, 5Marks]
Answer:
The total production overheads are ₹ 26,00,000.
Product A: 10,000 × 30 = ₹ 3,00,000
Product B: 20,000 × 40 = ₹ 8,00,000
Product C: 30,000 × 50 = ₹ 15,00,000
On the basis of ABC analysis this amount will be apportioned as follows:

Statement of Activity Based Production Cost

Question 24.
X Ltd. makes a single product with the following details:

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 analysed. There are changes as proposed above for the next production period for the same volume of output.
(i) How many units and in how many production runs should X Ltd. produce in the changed scenario in order to break-even?
(ii) Should X Ltd. continue to break up the remaining fixed costs into activity based costs? Why? [CA Final Nov. 2015, 8 Marks]
Answer:
Statement Showing ‘Non-unit Level’ Overhead Costs

(i) Break Even Point (Changed Scenario)

(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 breakup of 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 -Space to write important points for revision single-product setting.

Question 25.
ABC Ltd. is engaged in production of three types of Fruit Juices: Apple, Orange and Mixed Fruit.
The following cost data for the month of March 2020 are as under:

Particulars	Apple	Orange	Mixed Fruit
Units produced and sold	10,000	15,000	20,000
Material per unit (₹)	8	6	5
Direct Labour per unit (₹)	5	4	3
No. of Purchase Orders	34	32	14
No. of Deliveries	110	64	52
Shelf Stocking Hours	110	160	170

Overheads incurred by the company during the month are as under:

	₹
Ordering costs	64,000
Delivery costs	1,58,200
Shelf Stocking costs	87,560

Required:
(i) Calculate cost driver’s rate.
(ii) Calculate total cost of each product using Activity Based Costing. [CA Inter Nov. 2020, 6 Marks]
Answer:
(i) Calculation Cost-Driver’s rate

(ii) Calculation of total cost of products using Activity Based Costing

Question 26.
KD Ltd. is following Activity based costing. Budgeted overheads, cost drivers and volume are as follows:

Cost pool	Budgeted over­heads (₹)	Cost driver	Budgeted volume
Material procure­ment	18,42,000	No. of orders	1,200
Material handling	8,50,000	No. of movement	1,240
Maintenance	24,56,000	Maintenance hours	17,550
Set-up	9,12,000	No. of set-ups	1,450
Quality control	4,42,000	No. of inspection	1,820

The company has produced a batch of 7,600 units, its material cost was ₹ 24,62,000 and wages ₹ 4,68,500. Usage activities of the said batch are as follows:

Material orders	56
Material movements	84
Maintenance hours	1,420 hours
Set-ups	60
No. of inspections	18

Required:
(i) CALCULATE cost driver rates.
(ii) CALCULATE the total and unit cost for the batch. [CA Inter Nov. 2020, RTP]
Answer:
(i) Calculation of cost driver rate

Cost pool	Budgeted overheads (₹)	Cost driver	Cost driver rate (₹)
Material procurement	18,42,000	1,200	1,535.00
Material handling	8,50,000	1,240	685.48
Maintenance	24,56,000	17,550	139.94
Set-up	9,12,000                .	1,450	628.97
Quality control	4,42,000	1,820	242.86

(ii) Calculation of cost for the batch

Question 27.
Following are the data of three product lines of a departmental store for the year 2020-21:

Additional information related with the store are as follows:

Required:
CALCULATE the total cost and operating income using Activity Based Costing method. [CA Inter May 2020, RTP]
Answer:
Calculation of Total Support costs

	₹
Bottles returns	60,000
Ordering	7,80,000
Delivery	12,60,000
Shelf-stocking	8,64,000
Customer support	15,36,000
Total support cost	45,00,000

Computation of Cost Driver Rate

Statement of Total cost and Operating income

Question 28.
SMP Pvt. Ltd. manufactures three products using three different machines. At present the overheads are charged to products using labour hours. The following statement for the month of September 2021, using the absorption costing method has been prepared:

The following additional information is available relating to overhead cost drivers.

Actual production and budgeted production for the month is same. Workers are paid at standard rate. Out of total overhead costs, 30% related to machine set-ups, 30% related to customer order processing and customer complaint management, while the balance proportion related to material ordering.
Required:
(i) Compute overhead cost per unit using activity based costing method.
(ii) Determine the selling price of each product based on activity-based costing with the same profit mark-up on cost. [CA Inter Nov 2019, RTP]
Answer:
Total labour hours and overhead cost

Cost per activity and driver

(i) Computation of Overhead cost per unit:

(ii) Determination of Selling price per unit

Question 29.
MM Ltd. has provided the following information about the items in its inventory.

Item Code Number	Units	Unit Cost (₹)
101	25	50
102	300	01
103	50	80
104	75	08
105	225	02
106	75	12

MM Ltd. adopted the policy of classifying the items constituting 15% or above of Total Inventory Cost as ‘A’ category, items constituting 6% or less of Total Inventory Cost as ‘C’ category and the remaining items as ‘B’ category.
You are request to:
(i) Rank the items on the basis of % of Total Inventory Cost.
(ii) Classify the items into A, B and C categories as per ABC Analysis of Inventory Control adopted by MM Ltd. [CA Inter July 2021, 5 Marks]
Answer:
Statement showing % of Total inventory Cost and Rank

Statement Showing classification of items into ABC

Financing Decisions-Capital Structure – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Financing Decisions-Capital Structure – CA Inter FM Study Material

Theory Questions

Question 1.
What is Net Operating income theory of capital structure? Explain the assumptions on which the NOI theory is based. (4 Marks May 2012)
Answer:
Net Operating Income (NOI) Theory of Capital Structure: According to NOI approach, there is no relationship between the cost of capital and value of the firm i.e. the value of the firm is independent of the capital structure of the firm.
Assumptions:

1. The corporate income taxes do not exist.
2. Debt Equity mix is irrelevant for computation of market value of firm.
3. With the increase in debt proportion, financial risk and expectations of shareholders increase.
4. The overall cost of capital (K₀) remains constant for all degrees of debt equity mix.

Question 2.
List the fundamental principles governing capital structure. (4 Mark. Nov. 2012, May 2016)
Answer:
Fundamental Principles Governing Capital Structure are:
(1) Financial leverage or Trading on Equity:
Debt is cheaper source of finance and interest is also allowed expense as per tax. When a firm raise funds through long-term fixed interest bearing debt and preference share capital along with equity share capital, EPS will increase if cost of fixed funds is lower than rate of return earned by firm. It is called as favourable leverage situation. If cost of fixed fund is higher than rate of return then leverage work adversely. Therefore, it needs caution to plan the capital structure of a firm.

(2) Growth and stability of sales:
Growth and stability of sales is most important factor to decide capital structure. Firm with stable sale can raise higher amount of debt because with stable revenue we can easily pay debt. Similarly, the rate of the growth in sales also provides confidence to management that they can easily pay interest and principal on time. With greater rate of growth of sales, firm can raise funds through debt. If sales of any firm is fluctuating then firm should not go with debt finance.

(3) Cost Principle:
As per cost principle, optimum capital structure is that debt equity mix at which cost of capital is lowest and market value of firm is highest.

(4) Risk Principle:
Due to commitment of fixed payment, debt is a risky source of finance and equity is non-risky source. Higher proportion of debt and accordingly higher risk is not recommended.

(5) Control Principle:
If we raise additional funds through issue of equity shares then control over company of existing shareholders will be diluted. Existing management control and ownership remains undisturbed with debt finance.

(6) Flexibility Principle:
Firm should arrange funds in an efficient manner so that we can increase or decrease company’s fund base according to requirement.

(7) Other Considerations:
Other factors such as nature of business, market situation, existing and future market scenario, government policies, timing of issue and competition in market etc. should also be considered.

Question 3.
What is Over capitalisation? State Its causes and consequences. (4 Marks Nov. 2013)
Answer:
Over capitalization: It is a situation where a firm has excess capital or funds are higher than requirement. In this situation assets are worth less than its issued share capital, and earnmgs are not sufficient to pay dividend and interest.

Causes of Over Capitalization.

1. Raising higher amount through issue of shares or debentures than company needs.
2. Raising higher amount of debt at higher rate than rate at which company can earn.
3. Huge payment for the acquisition of fictitious assets like high payment is made to purchase goodwill etc.
4. Provision for depreciation is not made properly.
5. Payment of dividend with high rate.
6. Estimation of earnings and capitalization was wrong.

Consequences of Over-Capitalisation

1. Decrease in the rate of dividend and interest payments.
2. Decrease in the market price of shares.
3. Decrease in market value of firm.
4. Firm may use window dressing.
5. Reorganisation of company.
6. Liquidation in worst scenario.

Question 4.
What do you mean by capital structure? State Its significance in financing decision. (4 Marks Nov. 2013)
Answer:
Capital structure:
Capital structure refers to the combination of funds from different sources of finance. Company can arrange funds through equity share capital, retained earnings, preference share capital and long term debts.

Significance:The primary objective of any firm is wealth maximisation. Value of any firm is calculated by capitalisation of it’s after tax earnings. Cost of capital is used as rate of capitalisation. Lower rate of cost of capital leads higher market value of firm and cost of capital is lowest at optimum capital structure.

So capital structure is relevant in maximizing value of the firm and minimizing overall cost of capital. To finance any investment or arrange any single rupee, firm has to take capital structure decision.

Practical Problems

M. M. Approach:

Question 1.
RES Ltd. Is an all equity financed company with a market value of ₹ 2500,000 and cost of equity K_e 21%.The company wants to buyback equity shares worth ₹ 5,00,000 by Issuing and raising 15% perpetual amount (Debt).

Rate of tax may be taken as 30%. After the capital restructuring and applying MM model with taxes.

You are required to calculate:
(a) Market value of RES Ltd.
(b) Cost of Equity K_e.
(c) Weighted average cost of capital and comment on it . (4 Marks May 2012)
Answer:
(a) Market Value (MV) of RES Ltd:
MV before restructuring (V_UL) = 25,00,000
MV after restructuring (V_L) = V_UL + Debt × Tax

(b) Cost of Equity:
K_e = K₀ + (K₀ – K_d) × \(\frac{D(1-t)}{E}\)
= 21 + (.21 – .15) × \(\frac{5,00,000(1-.30)}{21,50,000}\) = 21.97%
Here,
K_d = before tax cost of debt
K₀ = K₀ of unlevered firm
K₀ of unlevered firm = K_e of unlevered firm = 21%
E = Value of Equity
E = Value of firm – Value of Debt
= 26,50,000 – 5,00,000 = 21,50,000

(c) Weighted average cost of capital:
WACC = K_eW_e + K_dW_d
= 21.97% × \(\frac{21,50,000}{26,50,000}\) + 10.50% × \(\frac{5,00,000}{26,50,000}\)
= 19.806%
Here,
K_d = I(1 – t) = 15% (1 – .30) = 10.50%
Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure the firm.

Question 2.
A’ Ltd. and ‘B’ Ltd. are Identical In every respect except capital structure. ‘A’ Ltd. does not use any debt in its capltalstructure whereas ‘B’ Ltd. employs 12% debentures amounting to ₹ 10,00,000. AssumIng that:

1. AU assumptions of MM model are met; .
2. Income tax rate Is 30%;
3. EBIT is ₹ 2,50,000 and
4. The equity capitalization rate of ‘A’ Ltd. Is 20%.

Calculate the value of both the companies and also find out Weighted Average Cost of Capital for both the companies. (5 Marks Nov. 2014)
Answer:
Calculation of value of ‘A’ Ltd and ‘B’ Ltd:
Value of ‘A’ Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-\mathrm{t})}{\mathrm{K}_{\mathrm{e}}}\) = \(\frac{2,50,000(1-.30)}{.20}\) = 8,75,000
Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd + Debt × Tax
= 8,75,000 + 10,00,000 × 30% = 11,75,000

Calculation of WACC of ‘A’Ltd and ‘B’ Ltd :
K₀ of ‘A’ Ltd. = K_e of ‘A’ Ltd = 20% [In case of All equity company K₀ = K_e]
K₀ of ‘A’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100
= \(\frac{2,50,000(1-.30)}{11,75,000}\) × 100 = 14.89%

Question 3.
PNR Limited and PXR Limited are Identical In every respect except capital structure. PNR limited does not employ debts in its capital structure whereas PXR Limited employs 12% Debentures amounting to 20,00,000.
The following additional Information are given to you:
(i) Income tax rate is 30%
(ii) EBIT is ₹ 5,00,000
(iii) The equity capitalization rate of PNR Limited Is 20% and
(iv) All assumptions of Modigliani. Miller Approach are met.

Calculate:
(i) Value of both the companies,
(ii) Weighted average cost of capital for both the companies. (8 Marks May 2017)
Answer:
Calculation of WACC of ‘PNR’ Ltd and ‘PXR’ Ltd:
Value of of ‘PNR’ Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-t)}{\mathrm{K}_{\mathrm{e}}}\)
= \(\frac{5,00,000(1-.30)}{.20}\) = 17,50,000
Value of ‘PXR’ Ltd. (Levered) = Market value of ‘PNR’ Ltd + Debt × Tax
= 17,50,000 + 20,00,000 × 30% = 23,50,000

Calculation of WACC of ‘PNR’Ltd and ‘PXR’ Ltd:
K₀ of ‘PNR’ Ltd = K_e of ‘PNR’ Ltd = 20% [In case of All equity company K₀ = K_e]
K₀ of ‘PXR’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100
= \(\frac{5,00,000(1-.30)}{23,50,000}\) × 100 = 14.89%

Question 4.
Stopgo Ltd. an all equity financed company is considering the repurchase of ₹ 200 Lakhs equity and to replace it with 15% debentures of the same amount. Current market value of the company is ₹ 1140 Lakhs and it’s cost of capital is 20%. It’s earning before interest and tax (EBIT) are expected to remain constant in future. It’s entire earnings are distributed as dividend. Applicable tax rate is 30%.

You are required to calculate the impact on the following on account of the change in the capital structure as per MM Hypothesis:
(1) The market value of the company.
(2) It’s cost of capital, and
(3) It’s cost of equity. (5 Marks May 2018)
Answer:
(1) Market Value (MV) of Stopgo Ltd:
MVbeforerepurchase(V_UL) = 1,140 Lakhs
MV after repurchase (V_L) = V_UL + Debt × Tax
= 1,140 L + 200 L × 30% = 1,200 Lakhs
Impact on MV of firm = Increase by 60 Lakhs(1,200 L – 1,140 L)

(2) Weighted average cost of capital:
WACC before repurchase = 20%
WACC after repurchase = K_eW_e + K_dW_d
= 20.70% × \(\frac{1,000 \mathrm{~L}}{1,200 \mathrm{~L}} \frac{1,000 \mathrm{~L}}{1,200 \mathrm{~L}}\) + 10.50% × \(\frac{200 \mathrm{~L}}{1,200 \mathrm{~L}}\) = 19%
Impact on MV of firm = Decrease by 1% (20% – 19%)
Here,
K_d = I (1 – t) = 15% (1 – .30) = 10.50%

(3) Cost of Equity:
K_e before repurchase = 20%
K_e after repurchase = K₀ + (K₀ – K_d) × \(\frac{D(1-t)}{E}\)
= 20 + (.20 – .15) × \(\frac{200 \mathrm{~L}(1-.30)}{1,000 \mathrm{~L}}\) = 20.70%
Impact on MV of firm = Increase by 0.70% (20.70% – 20%)
Here,
K_d = before tax cost of debt
K₀ = K₀ of unlevered firm
K₀ of unlevered firm = K_e of unlevered firm = 20%
E = Value of Equity
E = Value of firm – Value of Debt
= 1,200 L – 200 L = 1,000 L

Question 5.
The following data relate to two companies belonging to the same risk class:

	A Ltd.	B Ltd.
Expected Net operating Income	₹ 18,00,000	₹ 18,00,000
12% Debt	₹ 54,00,000	–
Equity Capitalization Rate	–	18

Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for each company assuming 40% taxes as per M.M. Approach. (10 Marks Nov. 2018)
Answer:
(a) Various calculation without tax:
Market Value of firms:
Market Value of B Ltd. (V_UL) = EBIT ÷ K_e
= ₹ 18,00,000 ÷ 18% = ₹ 1,00,00,000
Market Value of A Ltd. (V_L) = Value of unlevered = ₹ 1,00,00,000

Equity Capitalization Rate:
Equity Capitalization Rate (B Ltd.) = 18% (given in the question)
Equity Capitalization Rate (A Ltd.) = (EBIT – I) ÷ *E (Value of Equity)
= (₹ 18,00,000 – 1296 × ₹ 54,00,000) ÷ ₹ 46,00,000 = 25.04%
‘Value of Equity (E) of A Ltd. = Value of Firm – Debt
= ₹ 1,00,00,000 – ₹ 54,00,000 = ₹ 46,00,000

Weighted Average Cost of Capital:
Weighted Average Cost of Capital (B Ltd.) = K_e = K₀ = 18%
Weighted Average Cost of Capital (A Ltd.) = EBIT ÷ V (Value of Firm)
= ₹ 18,00,000 = ₹1,00,00,000 = 18%

(b) Various calculation with tax:
Market Value of firms:
Market Value of B Ltd. (V_UL) = EBIT (1 – t) ÷ K_e or K₀
= ₹ 18,00,000 (1 – 0.40) ÷ 18% = ₹ 60,00,000
Market Value of A Ltd. (V_L) = Value of unlevered + Debt × Tax
= ₹ 60,00,000 + ₹ 54,00,000 × .4 = ₹ 81,60,000

Equity Capitalization Rate:
Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) (I – t) ÷ *E (Value of Equity)
= (₹ 18,00,000 – 12% × ₹ 54,00,000) (1 -.4) ÷ ₹ 27,60,000
= 25.04%
*Value of Equity (E) of A Ltd. = Value of Firm – Debt
= ₹ 81,60,000 – ₹ 54,00,000 = ₹ 27,60,000

Weighted Average Cost of Capital:
Weighted Average Cost of Capital (B Ltd.) = K_e = K₀ = 18%
Weighted Average Cost of Capital (A Ltd.) = EBIT(1 – t) ÷ V (Value of Firm)
= ₹ 18,00,000 (1 – 0.4) ÷ ₹ 81,60,000
= 13.24%

Selection of Best Option (K₀ based)

Question 6.
RST Ltd. is expecting an EBIT of ₹ 4,00,000 for F.Y, 2015-16. Presently the company Is financed by equity share capital ₹ 20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different options and also state which is the best option. (8 Marks Nov. 2015)
Answer:
Statement of Value of Firm and Cost of Capital

Decision: Company should opt for 30% debt finance having higher Value of firm and lower K₀.

Implied Return

Question 7.
A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt and 40 per cent equity, whereas B Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market value terms). The borrowing rate for both companies is 8 per cent in a no-tax world, and capital markets are assumed to be perfect.

(a) (i) If X, own 3 per cent of the equity shares of A Ltd., determine his return if the Company has net operating income of ₹ 4,50,000 and the overall capitalisation rate of the company, K₀ is 18 per cent.
(ii) Calculate the implied required rate of return on equity of A Ltd.

(b) B Ltd. has the same net operating income as A Ltd.
(i) Calculate the implied required equity return of B Ltd.
(ii) Analyse why does it differ from that of A Ltd. (10 Marks Jan. 2021)
Answer:
(a) Value of the A Ltd. = \(\frac{\mathrm{NOI}}{\mathrm{K}_{\mathrm{o}}}\) = \(\frac{4,50,000}{18 \%}\) = ₹ 25,00,000
Value of Shares of A Ltd. = 40% of ₹ 25,00,000 = ₹ 10,00,000
(i) Return of X on Shares on A Ltd.

(ii) Implied required rate of return on Equity
= \(\frac{3,30,000}{10,00,000}\) × 100 = 33%

(b) (i) Return on Shares on B Ltd.

Value of Shares of Beta Ltd. = 80% of ₹ 25,00,000
Implied required rate of return on Equity = \(\frac{4,10,000}{20,00,000}\) × 100 = 20.50%

(ii) It is lower than the A Ltd. because B Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

Selection of Financial Plan (EPS based)

Question 8.
India Limited requires ₹ 50,00,000 for a New Plant. This Plant is expected to yield Earnings before Interest and Taxes of ₹ 10,00,000. While deciding about the Financial Plan, the Company considers the objective of maximizing Earnings per Share.

It has 3 alternatives to finance the Project: by raising Debt of ₹ 5,00,000 or ₹ 20,00,000 or ₹ 30,00,000 and the balance in each case, by issuing Equity Shares. The Company’s Share is currently selling at ₹ 150, but it is expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹ 20,00,000.

The Funds can be borrowed at the rate of 9% upto ₹ 5,00,000, at 14% over ₹ 5,00,000 and upto ₹ 20,00,000 and at 19% over ₹ 20,00,000. The Tax rate applicable to the Company is 40%.

Which form of financing should the Company choose? Show EPS Amount upto two decimal points. (Marks 8 Nov, 2016)
Answer:
Statement of EPS

Decision: The earning per share is higher in alternative II Le. if the company finance the project by raising debt of ₹ 20,00,000 & issue equity shares of ₹ 30,00,000. Therefore, the company should choose this alternative to finance the project.

Question 9.
Y Limited requires ₹ 50,00,000 for a new project. This project is expected to yield earnings before interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company considers the objective of maximizing earnings per share. It has two alternatives to finance the project – by raising debt of ₹ 5,00,000 or ₹ 20,00,000 and the balance, in each case, by issuing equity shares. The company’s share is currently selling at ₹ 300, but is expected to decline to ₹ 250 in case the funds are borrowed in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 12% upto K 5,00,000 and at 10% over ₹ 5,00,000. The tax rate applicable to the company is 25%.
Which form of financing should the company choose? (5 Marks Nov. 2018)
Answer:
Statement of EPS

Decision: The earning per share is higher in alternative II Le. if the company finance the project by raising debt of ₹ 20,00,000 & issue equity shares of ₹ 30,00,000. Therefore, the company should choose this alternative to finance the project.

Question 10.
RM Steels Limited requires ₹ 10,00,000 for the construction of new plant. It is considering three financial plans:
(1) The Company may issue 1,00,000 ordinary shares at ₹ 10 per share.
(2) The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.
(3) Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.

If RM Steels Limited’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000.
You are required to compute the earning per share under each of the three plans? Which alternative would you recommend for RM Steels and why? Tax rate is 50%. (10 Marks May 2019)
Answer:
1. Statement showing EPS with respect to various plans & different EBIT:
a. Equity Financing

b. Debt – Equity Mix

c. Preference Share – Equity Mix

*10,000 is the tax saving in case of loss’
**In case of cumulative preference shares, the company has to pay cumulative dividend to preference shareholders, when company earns sufficient profits.

2. Recommendation:
(a) If expected EBIT is less than₹ 80,000 : Equity Finance (Alternative 1)
(b) If expected EBIT is equal to ₹ 80,000 (Alternative 1 or 2) : Equity or Debt – Equity Mix
(c) If expected EBIT is more than ₹ 80,000 : Debt – Equity Mix (Alternative 2)

Rate of Preference Dividend

Question 11.
X Ltd. is considering the following two alternative financing plans:

The indifference point between the plans is 2,40,000. Corporate tax rate 30%. Calculate the rate of dividend on preference shares. (Marks 5 Nov. 2013)
Answer:

Indifference point

Question 12.
The management of Z Company Ltd. wants to raise its funds from market to meet out the financial demands of its long-term projects. The company has various combinations of proposals to raise its funds. You are given the following proposals of the company:

2. Cost of debt and preference shares is 10% each.
3. Tax rate 50%.
4. Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
5. Total Investment to be raised ₹ 40,00,000.
6. Expected earnings before interest and tax ₹ 10,00,000,

From the above proposals the management wants to take advice from you for appropriate plan after computing the following:
(1) Earnings per share
(2) Financial break-even-point
(3) Compute the EBIT range among the plans for indifference. Also indicate if any of the plans dominate. (12 Marks May 2011)
Answer:
(1) Statement of EPS

Recommendation: Company should select debt option having highest EPS among different plans.

(2) Financial Break Even Point (EBIT equals to fixed financial cost):
Proposal P Financial B.E.P. = NoFixed Financial Cost = Zero
Proposal Q Financial B.E.P. = Interest on Debt = 2,00,000
Proposal R Financial B.E.P, = Gross Preference Dividend = \(\frac{\text { Preference Dividend }}{(1-\mathfrak{t})}\)
= \(\frac{2,00,000}{(1-0.50)}\)= 4,00,000

(3) Indifference Point:
Between Proposal P & Q:

Beiween Proposal Q & R: If No. of equity shares between two plans are same then, indifference point cant be calculate due to difference in fixed financial cost in Proposal Q and R. Proposal Q having lower financial fixed cost is always better than Proposal R having higher financial fixed cost.
Alternatively:

There is no indifference point between proposal ‘Q’ and proposal ‘R’

Analysis: It can be seen that financial proposal ‘Q’ dominates proposal ‘R’, since the financial break-even-point of the former is only ₹ 2,00,000 but in case of latter, it is ₹ 4,00,000.

Question 13.
Alpha Ltd. requires funds amounting to ₹ 80,00,000 for its new project. To raise the funds, the company has following two alternatives:
(1) To issue Equity Shares of 1100 each (at par) amounting to ₹ 60,00,000 and borrow the balance amount at the interest of 12% p.a.; or
(2) To issue Equity Shares of ₹ 100 each (at par) and 12% Debentures in equal proportion.
Find out the point of indifference between two modes of financing and state which option will be beneficial in different situations assuming tax rate 30%. (Marks 5 Nov. 2014)
Answer:
Calculation of Indifference between two modes of financing:

Course of action:
(a) If expected EBIT is less than ₹ 9,60,000 : Alternate 1
(b) If expected EBIT is equal to ₹ 9,60,000 : Alternate 1 or 2
(c) If expected EBIT is more than ₹ 9,60,000 : Alternate 2

Question 14.
The X Ltd. Is willing to raise funds for its new project which requires an investment of ₹ 84,00,000. The company has two options:
Option 1: To issue Equity Shares (₹ 10 each) only.
Option 2: To avail term loan at an interest rate of 12%. But in this case, as insisted by the financing agencies, the company will have to maintain a debt equity ratio of 2 : 1.
Find out the point of indifference for the project if corporate tax rate is 30%. (Marks 5 Nov. 2017)
Answer:
Calculation of point of Indifference:
\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)
\(\frac{(\text { EBIT }- \text { Nil })(1-0.30)}{8,40,000}\) = \(\frac{(\text { EBIT }-12 \% \text { of } 56,00,000)(1-0.30)}{2,80,000}\)
EBIT = ₹ 10,08,000
Calculation of amount of Debt and Equity in option 2:
Debt amount = 84,00,000 × 2/3 = 56,00,000
Equity amount = 84,00,000 × 1 /3 = 28,00,000

Question 15.
Sun Ltd. is considering two financing plans. Details of which are as under:
(a) Funds requirement is ₹ 100 Lakhs.
(b) Financial plans:

(c) Cost of debt is 12% p.a.
(d) Tax rate is 30%
(e) Equity shares ₹ 10 each, issued at a premium of ₹ 15 per share
(f) Expected earnings before interest and tax (EBIT) ₹ 40,00,000

You are required to compute:
(1) EPS in each of them plan
(2) The Financial break-even-point
(3) Indifference point between I and II (5 Marks May 2018)
Answer:
(1) Statement of EPS

Calculation of amount of number of Equity shares:
Under Plan I = 1,00,00,000 ÷ 25(10 + 15) = 4,00,000
Under Plan I = 25,00,000 ÷ 25(10 + 15) = 1,00,000

(2) Financial Break Even Point (EBIT equals to fixed financial cost):
Plan I Financial B.E.P. = No Fixed Financial Cost = Zero
Plan II Financial B.E.P. = Interest on Debt = 9,00,000

(3) Indifference Point:
\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)
\(\frac{(\text { EBIT }- \text { Nil })(1-0.30)}{4,00,000}\) = \(\frac{(\text { EBIT }-9,00,000)(1-0.30)}{1,00,000}\)
EBIT = ₹ 12,00,000

Question 16.
J Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ₹ 4,00,000.
(b) Plans showing the Financing proportion:

(c) Cost of debt is 10%
Cost of preference shares is 10%
(d) Tax rate 50%
(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(J) Expected EBIT is ₹ 1,00,000.

You are required to compute the following for each plan:
(1) Earnings per share (EPS)
(2) Financial break-even-point
(3) Indifference point between the plans and indicate if any of the plans dominate. (10 Marks Nov. 2020)
Answer:
(1) Statement of EPS

(2) Financial Break Even Point (EBIT equals to fixed financial cost):
Proposal X Financial B.E.P. = No Fixed Financial Cost = Zero
Proposal Y Financial B.E.P. = Interest on Debt = 20,000
Proposal Z Financial B.E.P. = \(\frac{\text { Preference Dividend }}{(1-t)}\)
= \(\frac{20,000}{1-0.50}\) = 40,000

(3) Indifference Point:
Between Proposal X & Y

There is no indifference point between the financial plans Y and Z.

It can be seen that Financial Plan Y dominates Plan Z. Since, the financial break-even point of the former is only ₹ 20,000 but in case of latter it is ₹ 40,000.

Important Questions

Question 1.
X Ltd. and Y Ltd. are identical except that the former uses debt while the latter does not. Thus levered firm has issued 10% Debentures of ₹ 9,00,000. Both the firms earn EBIT of 20% on total assets of ₹ 15,00,000. Assuming tax rate is 50% and capitalization rate is 15% for an all equity firm.

(i) Compute the value of the two firms using NI approach.
(ii) Compute the value of the two firms using NOI approach.
(iii) Calculate the overall cost of capital, K₀ for both the firms using NOI approach.
Answer:
(i) Calculation of Value of firms by NI Approach:

(ii) Values of the firm as per NOI Approach:
Value of unlevered firm (Y Ltd) = \(\frac{{EBIT}(1-\mathrm{t})}{\mathrm{K}_{\mathrm{0}}}\) = \(\frac{3,00,000(1-0.30)}{0.15}\)
Value of levered firm (X Ltd) = Value of unlevered firm + Debt × tax
= ₹ 10,00,000 + 9,00,000 × 50% = ₹ 14,50,000
This value of ₹ 14,50,000 can be bifurcated into Debt of ₹ 9,00,000 and Equity of ₹ 5,50,000.

(iii) Calculation of K₀ under NOI Approach:
Y Ltd (K₀) = K_e = 15%
X Ltd (K₀) = K_eW_e + K_dW_d
= 19.1% × \(\frac{5,50,000}{14,50,000}\) + 5% × \(\frac{9,00,000}{14,50,000}\) = 10.34%

Working Notes:
Calculation of K_e of X Ltd:
K_e = \(\frac{\text { Earning for Equity }}{\text { Market value of Equity }}\) × 100 = \(\frac{(3,00,000-90,000)(1-0.50)}{5,50,000}\) × 100
= 19.10%

Question 2.
‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘X Ltd. does not use any debt in its capital structure whereas ‘B’ Ltd. employs 12% debentures amounting to ₹ 10,00,000. Assuming that:

1. All assumptions of MM model are met;
2. Income tax rate is 30%;
3. EBIT is ₹ 2,50,000 and
4. The equity capitalization rate of ‘A’ Ltd. is 20%.

Calculate the value of both the companies and also find out Weighted Average Cost of Capital for both the companies.
Answer:
Calculation of value of ‘A’ Ltd. and ‘B’ Ltd
Value of ‘A’Ltd. (Unlevered) = \(\frac{\text { EBIT }(1-t)}{K_e}\) = \(\frac{2,50,000(1-.30)}{.20}\) = 8,75,000
Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd. + Debt × Tax
= 8,75,000 + 10,00,000 × 30% = 11,75,000
Calculation of WACC of A’Ltd and B’Ltd:
K₀ of ‘A’Ltd. = K_e of ‘A’Ltd. = 20%
K₀ of ‘B’ Ltd. = \(\frac{\text { EBIT }(1-t)}{V}\) × 100 = \(\frac{2,50,000(1-.30)}{11,75,000}\) × 100 = 14.89%

Question 3.
RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000and cost of equity K_e 21%. The company wants to buyback equity shares worth ₹ 5,00,000by issuing and raising 15% perpetual amount (Debt).
Rate of fax may be taken as 30%. After the capital restructuring and applying MM model with taxes.
You are required to calculate:
(a) Market value of RES Ltd.
(b) Cost of Equity K_e.
(c) Weighted average cost of capital and comment on it.
Answer:
(a) Market Value (MV) of RES Ltd:
MV before restructuring (V_UL) = 25,00,000
MV after restructuring (V_L) = V_UL + Debt × Tax
= 25,00,000 + 5,00,000 × 30% = 26,50,000

(b) Cost of Equity:
K_e = K₀ + (K₀ – K_d) × \(\frac{D(1-t)}{E}\)
= 2.1 + (.21 – .15) × \(\frac{5,00,000(1-.30)}{21,50,000}\) = 21.97%
Here,
K_d = before tax cost of debt
K₀ = K₀ of unlcvered firm
K₀ of unlevered firm = K_e of unlevered firm = 21%
E = Value of Equity
E = 26,50,000 – 5,00,000 = 2 1,50,000

(c) Weighted average cost of capital:
WACC = K_eW_e + K_dW_d
= 21.97% × \(\frac{21,50,000}{26,50,000}\) + 10.50% × \(\frac{5,00,000}{26,50,000}\)
= 19.81%
K_d = I(1 – t) = 15%(1 – .30) = 10.50%
Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure the firm.

Question 4.
ABC Ltd. with EBIT of ₹ 3,00,000 is evaluating a number of possible capitals below. Which of the capital structure will you recommend, and why?

Answer:
Statement of K_o and Value of Firm

The capital structure (Plan I) having ₹ 3,00,000 of debt has the lowest cost of capital consequently the highest market value, should be accepted.

Question 5.
Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market value terms). The borrowing rate for both companies is 8 per cent in a no-tax world, and capital markets are assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., determine your return if the company has net operating income of ₹ 3,60,000 and the overall capitalisation rate of the company, K_o is 18 per cent?
(ii) Calculate the implied required rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd.
(i) Determine the implied required equity return of Beta Ltd.?
(ii) Analyse why does it differ from that of Alpha Ltd.?
Answer:
(a) Value of the Alpha Ltd. = \(\frac{\mathrm{NOI}}{\mathrm{K}_{\mathrm{o}}}\) = \(\frac{3,60,000}{18 \%}\) = ₹ 20,00,000
Value of Shares of Alpha Ltd. = 50% of ₹ 20,00,000 = ₹ 10,00,000
(i) Return on Shares on Alpha Ltd.

(ii) Implied required rate of return on Equity = \(\frac{2,80,000}{10,00,000}\) × 100 = 28%

(b) (i) Return on Shares on Beta Ltd.

Value of Shares of Beta Ltd. = 80% of ₹ 20,00,000 = ₹ 16,00,000
Implied required rate of return on Equity = \(\frac{3,28,000}{16,00,000}\) × 100 = 20.50%

(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity capitalization is a linear function of the debt-to-equity ratio when we use the net operating income approach, the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

Question 6.
Following data is available in respect of two companies having same business risk:
Capital employed = ₹ 2,00,000 .
EBIT = ₹ 30,000
K_e = 12.5%

Investor is holding 15% shares in levered company.
Calculate increase in annual earnings of investor if he switches his holding from levered to unlevered company.
Answer:
1. Calculation of Value of firms:

Value of Levered company is more than that of unlevered company therefore investor will sell his shares in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow proportionate amount and invest that amount also in shares of unlevered company.

2. Investment & Borrowings:

3. Change in Return:

Question 7.
Following data Is available in respect of two companies having same business risk:
Capital employed = ₹ 2,00,000
EBIT = ₹ 30,000

Investor is holding 15% shares in Unlevered company.
Calculate increase in annual earnings of investor if he switches his holding from unlevered to levered company.
Answer:
1. Calculation of Value of firms:

Value of Unlevered company is more than that of Levered company therefore investor will sell his shares in unlevered company and buy shares in levered company. Market value of Debt and Equity of Levered company are in the ratio of ₹ 1,00,000: ₹ 1,00,000, i.e., 1:1. To maintain the level of risk he will lend proportionate amount (50%) and invest balance amount (50%) in shares of Levered company.

2. Investment:

3. Change in Return:

Question 8.
The Modern Chemicals Ltd. requires ₹ 25,00,000 for a new plant. This plant is expected to yield earnings before interest and taxes of ₹ 5,00,000. While deciding about the financial plan, the company considers the objective of maximizing earnings per share.

It has three alternatives to finance the projects by raising debt of ₹ 2,50,000 or ₹ 10,00,000 or ₹ 15,00,000 and the balance in each case, by issuing equity shares. The company’s share is currently selling at ₹ 150, but is expected to decline to ₹ 125 in case the funds are borrowed in excess of ₹ 10,00,000. The funds can be borrowed at the rate of 10% up to ₹ 2,50,000 at 15% over ₹ 2,50,000 and upto ₹ 10,00,000 and at 20% over ₹ 10,00,000. The tax rate applicable to the company is 50%.

Which form of financing should the company choose?
Answer:
Statement of EPS

Decision: The earning per share is higher in alternative II i.e. if the company finance the project by raising debt of ₹ 10,00,000 & issue equity shares of ₹ 15,00,000. Therefore, the company should choose this alternative to finance the project.

Question 9.
A Company earns a profit of ₹ 3,00,000 per annum after meeting its interest liability of ₹ 1,20,000 on 12% debentures. The Tax rate is 50%. The number of Equity Shares of ₹ 10 each are 80,000 and the retained earnings amount to ₹ 12,00,000. The company proposes to take up an expansion scheme for which a sum of ₹ 4,00,000 is required.

It is anticipated that after expansion, the company will be able to achieve the same return on investment as at present. The funds required for expansion can be raised either through debt at die rate of 12% or by issuing Equity Shares at par.
Required:
(i) Compute the Earnings Per Share (EPS), if:
(a) The additional funds were raised as debt
(b) The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.
Answer:
(i) Statement of EPS

Working notes:
1. Calculation of capital employed before expansion plan:
Equity share capital : ₹ 8,00,000
Retained earnings : ₹ 12,00,000
Debentures (1,20,000/12%) : ₹ 10,00,000
Total capital employed : ₹ 30,00,000

2. Earnings before the payment of Interest and tax (EBIT):
Profit before tax : ₹ 3,00,000
Interest : ₹ 1,20,000
EBIT : ₹ 4,20,000

3. Return on Capital Employed (ROCE):
ROCE = \(\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100 = \(\frac{4,20,000}{30,00,000}\) × 100 = 14%

4. After expansion capital employed = ₹ 34,00,000 (₹ 30,00,000 + ₹ 4,00,000)

(ii) Advise to the company: Since EPS is greater in the case when company arranges additional funds as debt. Therefore, the company should finance the expansion scheme by raising debt.

Question 10.
The following data are presented in respect of Quality Automation Ltd.:

The company is planning to start a new project requiring a total capital outlay of ₹ 40,00,000. You are informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio to 8 and rises the interest rate on additional amount borrowed at 14%.

Find out the probable price of share if:
(1) The additional funds are raised as a loan.
(2) The amount is raised by issuing equity shares.
(Note: Retained earnings of the company is 11.2 crore)
Answer:
In this question EBIT after proposed extension is not given. Therefore, we can assume that existing return on capital employed will be maintained.

Statement of Market Value Per Share (MPS)

Working notes:
1. Calculation of capital employed before expansion plan:
Equity share capital (8,00,000 shares × ₹ 10) : ₹ 80,00,000
Retained earnings : ₹ 1,20,00,000
Debentures (12,00,000/12%) : ₹ 1,00,00,000
Total capital employed : ₹ 3,00,00,000

2. Return on Capital Employed (ROCE):
ROCE = \(\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100 = \(\frac{52,00,000}{30,00,000}\) × 100 = 17%

3. Debt Equity Ratio if ₹ 40,00,000 is raised as Debt:
= \(\frac{1,40,00,000(1,00,00,000+40,00,000)}{3,40,00,000(3,00,00,000+40,00,000)}\) × 100 = 41.18%
As the debt equity ratio is more than 35% the P/E ratio will be brought down to 8 in Plan 1

4. Debt Equity Ratio if ₹ 40,00,000 is raised as Equity:
= \(\frac{1,00,00,000}{3,40,00,000}\) × 100 = 29.41%
As the debt equity ratio is less than 3596 the P/E ratio in this case will remain at 10 times in Plan 2.

5. Number of Equity Shares to be issued in Plan 2 = \(\frac{40,00,000}{25}\) = 1,60,000 shares

Decision: Though loan option has higher EPS but equity option has higher MPS therefore company should raise additional fund through equity option.

Question 11.
Yoyo Limited presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes to finance a ₹ 40,00,000 expansion programme and is considering three alternatives: additional debt at 12 per cent interest, preference shares with an 11 per cent dividend, and the issue of equity shares at ₹ 16 per share. The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax bracket.

(a) If earnings before interest and taxes are presently ₹ 15,00,000, what would be earnings per share for the three alternatives, assuming no immediate increase in profitability?
(b) Analyse which alternative do you prefer? Compute how much would EBIT need to increase before the next alternative would be best?
Answer:
(a) Statement of EPS

(b) For the present EBIT level, equity share is clearly preferable. EBIT would need to increase by ₹ 23,76,000 – ₹ 15,00,000 = ₹ 8,76,000 before an indifference point with debt is reached. One would want to be comfortably above this indifference point before a strong case for debt should be made. The lower the probability that actual EBIT will fall below the indifference point, the stronger the case that can be made for debt, all other things remain the same.

Working Note:
Indifference Point between Equity and Debt plan:
\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_{\mathrm{E}}}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_{\mathrm{D}}}\)
\(\frac{(\text { EBIT }-3,60,000)(1-0.40)}{10,50,000}\) = \(\frac{(\text { EBIT }-8,40,000)(1-0.40)}{8,00,000}\)
EBIT = ₹ 23,76,000

Question 12.
Ganapati Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ₹ 2,00,000.
(b) Financing proportion of Plans:

(c) Cost of debt is 8%
Cost of preference shores is 8%
(d) Tax rate 50%
(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share
(f) Expected EBIT is ₹ 80,000.

You ate required to determine for each plan:
(1) Earnings per share
(2) Financial break-even-point
(3) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.
Answer:
(1) Statement of EPS

(2) Financial Break Even Point (EBIT equals to fixed financial cost):
Proposal A Financial B.E.P. = No Fixed Financial Cost = Zero
Proposal B Financial B.E.P. = Interest on Debt = 8,000
Proposal C Financial B.E.P. = \(\frac{\text { Preference Dividend }}{(1-\mathrm{t})}\)
= \(\frac{8,000}{1-0.50}\) = 16,000

(3) Indifference Point:
Between Proposal A & B:

There is no indifference point between the financial plans B and C.
It can be seen that Financial Plan B dominates Plan C. Since, the financial break-even point of the former is only ₹ 8,000 but in case of latter it is ₹ 16,000.

Question 13.
RM Steels Limited requires ₹ 10,00,000 for the construction of new plant. It is considering three financial plans:

1. The Company may issue 1,00,000 ordinary shares at ₹ 10 per share.
2. The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 debentures of ₹ 100 denomination bearing 8% rate of interest.
3. The Company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100 per share bearing a 8% rate of dividend.

If RM Steels Limited’s earnings before interest and taxes are ₹ 20,000, ₹ 40,000, ₹ 80,000, ₹ 1,20,000 and ₹ 2,00,000.
You are required to compute the earning per share under each of the three plans? Which alternative would you recommend for RM Steels and why? Tax rate is 50%.
Answer:
1. Statement showing EPS with respect to various plans & different EBIT:
a. Equity Financing

b. Debt – Equity Mix

c. Preference Share – Equity Mix

*10,000 is the tax saving in case of loss.
** In case of cumulative preference shares, the company has to pay cumulative dividend to preference shareholders, when company earns sufficient profits.

2. Recommendation:
(a) If expected EBIT is less than ₹ 80,000 : Equity Finance (Alternative 1)
(b) If expected EBIT is equal to ₹ 80,000 : Equity or Debt – Equity Mix (Alternative 1 or 2)
(c) If expected EBIT is more than ₹ 80,000 : Debt – Equity Mix (Alternative 2)

Financing Decisions-Leverages – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Financing Decisions-Leverages – CA Inter FM Study Material

Theory Questions

Question 1.
Distinguish between business risk and financial risk or “Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement. (4 Marks Nov. 2012, May 2013, Nov. 2014)
Answer:
Business Risk: Business risk refers to the risk associated with the firm’s operations. It is an unavoidable risk because of the environment in which the firm has to operate. The business risk is represented by the change in earnings before interest and tax (EBIT).The change in turn is influenced by revenues and expenses. Revenues and expenses are affected by demand of firm’s products, changes in prices and proportion of fixed cost in total cost.

Financial Risk: Financial risk refers to the additional risk associated with use of debt or preference share capital. If company raise higher amount from Debt or/and Preference share capital then such company have higher financial risk than companies financed through equity. Financial risk is measured through financial leverage, total debt to assets ratio etc.

Practical Problems

Question 1.
You are the given two financial plans of a company which has two financial situations. The detailed information are as under:
Installed capacity : 10,000 units
Actual production and sales : 60% of installed capacity
Selling price per unit : ₹ 30
Variable cost per unit : ₹ 20
Fixed Cost:
Situation A : ₹ 20,000
Situation B : ₹ 25,000

Capital structure of the company is as follows:

You are required to calculate operating leverage and financial leverage of both the plans. (4 Marks May 2011)
Answer:
Statement Showing Operating & Financial leverage

Question 2.
Alpha Ltd. has furnished the following Balance Sheet as on March 31, 2011:

Additional information:

1. Annual Fixed Cost other than Interest : ₹ 28,00,000
2. Variable Cost Ratio : 60% of sales
3. Total Assets Turnover Ratio : 2.5 times
4. Tax Rate : 30%

You are required to calculate:

(i) Earning per Share (EPS), and
(ii) Combined Leverage.

Answer:

(i) Combined leverage = Contribution ÷ EBT = 48 lacs ÷ 15.80 lacs
= 3.04

(ii) Calculation of EPS:

Question 3.
The capital structure of JCPL Ltd. is as follows:
Equity share capital of ₹ 10 each : ₹ 8,00,000
8% Preference share capital of ₹ 10 each : ₹ 6,25,000
10% Debenture of ₹ 100 each : ₹ 4,00,000

Additional Information:

Profit after tax (tax rate 30%) : ₹ 1,82,000
Operating expenses (including depreciation ₹ 90,000) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : ₹ 20.00

Required to calculate:

(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio. (8 Marks May 2012)

Answer:

(i) Operating & Financial leverage:

(ii) calculation of cover the preference & equity share dividends:

(iii) Earning yield & price earning ratio.
Earning Yield Ratio \(=\frac{\text { EPS }}{\text { MPS }}\) × 100 = \(\frac{1.65}{20.00}\) × 100 = 8.25

(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 1,82,000 – 50,000 – 1,20,000 + 90,000 = ₹ 1,02,000

Calculation of contribution:

Question 4.
X Limited has estimated that for a new product its break-even point is 20,000 units if the item is sold for ₹ 14 per unit and variable cost ₹ 9 per unit. Calculate the degree of operating leverage for sales volume 25,000 units and 30,000 units. (5 Marks Nov. 2012)
Answer:
Statement of Operating Leverage

Calculation of operating fixed cost:
Contribution at BEP = Fixed Cost
₹ 5 × 20,000 Units = ₹ 1,00,000

Question 5.
The following information related to XL company Ltd. for the year ended 31st March, 2013 are available to you:
Equity share capital of ₹ 10 each : ₹ 25,00,000
11 % Bonds of ₹ 1,000 each : ₹ 18,50,000
Sales : ₹ 42,00,000
Fixed cost (Excluding Interest) : ₹ 3,48,000
Financial leverage : 1.39
Profit Volume Ratio : 25.55%
Income Tax Rate : 35%

You are required to calculate:

(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning Per Share. (6 Marks May 2013)

Answer:

(i) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{10,73,100}{7,25,100}\) = 1.48 times

(ii) Combined Leverage = OL × FL = 1.48 × 1.39 = 2.06 times

(iii)

Working Notes:

(1) Contribution = Sales × PV Ratio
= 42 Lacs × 25.55% = 10,73,100

(2) EBIT = Contribution – Operating Fixed Cost
= 10,73,100 – 3,48,000 = 7,25,100

(3) Profit after tax = (EBIT- Interest) (1 – t)
= (7,25,100- 11% of 18,50,000) (1 – 0.35)
= 3,39,040

Question 6.
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms:

(5 Marks Nov. 13)
Answer:
Statment of the Degree of OL, Degree of FL and the Degree of CL

Question 7.
A company had the following Balance Sheet as on 31st March, 2014:

The additional information given is as under:
Fixed cost per annum (excluding interest) : 4 crores
Variable operating cost ratio : 65%
Total assets turnover ratio : 2.5
Income Tax rate : 30%

Required:

(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage

Answer:

(i) Calculation of EPS:
EPS \(=\frac{\text { EAT }}{\text { No. of Shares }}\) \(=\frac{840 \text { Lakhs }}{50 \text { Lakhs }}\) = ₹ 16.80

(ii) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) \(=\frac{17.50 \text { Crores }}{13.50 \text { Crores }}\) = 1.296 times

(iii) Calculation of FL:
FT \(=\frac{\text { EBIT }}{\text { EBT }}\) \(=\frac{13.50 \text { Crores }}{12.00 \text { Crores }}\) = 1.125 times

(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times

Working Notes:

Income Statement

Question 8.
The capital structure of RST Ltd. is as follows:

Equity share capital of ₹ 10 each : ₹ 8,00,000
10% Preference share capital of ₹ 100 each : ₹ 5,00,000
12% Debenture of ₹ 100 each : ₹ 7,00,000

Additional Information:

Profit after tax (tax rate 30%) : ₹ 2,80,000
Operating expenses (including depreciation ₹ 96,800)
Equity share dividend paid : 15%
Market price per equity share : ₹ 23.00

Required to calculate:

(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.

Note: All operating expenses (excluding depreciation) are variable. (8 Marks Nov. 2014)

Answer:

(i) Operating & Financial leverage:

(ii) Calculation of cover the preference & equity share dividends:

(iii) Earning yield & price earning ratio:

(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 2,80,000 – 50,000 – 1,20,000 + 96,800
= ₹ 2,06,800

Calculation of contribution

Question 9.
Following information are related to four firms of the same industry:

Find out:

(i) Degree of operating leverage, and
(ii) Degree of combined leverage of all the firms. (5 Marks May 2015)

Answer:

(i)

(ii)

Question 10.
The capital structure of the ABC Ltd. as at 51.03.15 consists of ordinary share capital of ₹ 5,00,000 (face value ₹ 100 each) and 10% debentures of ₹ 5,00,000 (₹ 100 each). In the year ended March 15, sales decreased from 60,000 units to 50,000 units. During the year and in the previous year, the selling price is ₹ 12 per unit; variable cost stood at ₹ 8 per unit and fixed expenses were at ₹ 1,00,000 p.a. The income tax rate was 30%.

You are required to calculate the following:

(i) The percentage decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units. (5 Marks June 2015)

Answer:

(i) Calculation of % decrease in EPS

% Decrease in EPS = \(\frac{12.60-7.00}{12.60}\) × 100 = 44.44%

(ii) Degree of Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 60,000 units = \(\frac{2,40,000}{1,40,000}\) = 1.71 times
At 50,000 units = \(\frac{2,00,000}{1,00,000}\) = 2 times

(iii) Degree of Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
At 60,000 units = \(\frac{1,40,000}{90,000}\) = 1.56 times
At 50,000 units = \(\frac{1,00,000}{50,000}\) = 2 times

Question 11.
From the following details of X Ltd., prepare the Income Statement for the year ended 31st December 2014:
Financial Leverage : 2
Interest : ₹ 2,000
Operating Leverage : 3
Variable cost as a % of sales : 75%
Income tax rate : 30%
(5 Marks Nov. 2015)

Answer:

Income Statement for the year ended 31st December, 2014

Working Notes:

(a) Calculation of EBIT:

(b) Calculation of Contribution:

(c) Calculation of Sales

Question 12.
A company had the following Balance Sheet as on 31st March, 2015.

The additional information given is as under:
Fixed cost per annum (excluding interest) : ₹ 32,00,000
Variable operating cost ratio : 70%
Total assets turnover ratio : 2.5
Income Tax rate : 30%

Required:

(i) Operating Leverage,
(ii) Financial Leverage,
(iii) Combined Leverage and
(iv) Earnings Per Share (5 Marks May 2016)

Answer:

(i) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{1,20,00,000}{88,00,000}\) = 1.364 times

(ii) Calculation of FL:
FL \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) = \(\frac{88,00,000}{76,00,000}\) = 1.158 times

(iii) Calculation of CL:
CL = OL × FL = 1.364 × 1.158 = 1.579 times

(iv) Calculation of EPS
EPS \(=\frac{\text { EAT }}{\text { No. of Shares }}\) = \(\frac{53,20,000}{4,00,000}\) = ₹ 13.30

Working Notes:

Income Statement

Question 13.
The following information related to YZ company Ltd. for the year ended 31st March, 2016 are available to you:

Equity share capital of ₹ 10 each : ₹ 50,00,000
12% Bonds of ₹ 1,000 each : ₹ 37,00,000
Sales : ₹ 84,00,000
Fixed cost (Excluding Interest) : ₹ 6,96,000
Financial leverage : 27.55%
Profit Volume Ratio : 40%
Income Tax Rate :

You are required to calculate:

(a) Operating Leverage;
(b) Combined Leverage; and
(c) Earning Per Share [upto two decimal points] (5 Marks Nov. 2016)

Answer:

(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{23,14,200}{16,18,200}\) = 1.43 times
(b) Combined Leverage = OL × FL = 1.43 × 1.49 = 2.13 times
(c)

Working Notes:

1. Contribution = Sales × PV Ratio = 84 Lacs × 27.55%
= 23,14,200
2. EBIT = Contribution – Operating Fixed Cost
= 23,14,200 – 6,96,000 = 16,18,200
3. Profit after tax = (EBIT – Interest) (1 – t)
= (16,18,200 – 12% of 37,00,000) (1 – 0.40)
= 7,04,520

Author Note: Calculation of interest through financial leverage will provide different interest, therefore this question alternatively can be solved by taking interest on the basis of following calculation:

Financial Leverage = EBIT ÷ EBT = 16,18,2004 ÷ EBT = 1.49
EBT = 16,18,200 ÷ 1.49 = 10,86,040
Interest = EBIT – EBT = 16,18,200 – 10,86,040
= 5,32,160

Question 14.
You are given the following information of 5 firms of the same industry:

Firm	Change in Revenue	Change in Operating Income	Change in EPS
M	28%	26%	32%
N	27%	34%	26%
P	25%	38%	23%
Q	23%	43%	27%
R	25%	40%	28%

Find out:

(a) Degree of operating leverage, and
(b) Degree of combined leverage of all the firms. (5 Marks May 2017)

Answer:

(a) Degree of Leverage \(=\frac{\% \text { Change in operating income }}{\% \text { Change in revenue }}\)
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60

(b) Degree of Combined Leverage \(=\frac{\% \text { Change in EPS }}{\%_0 \text { Change in revenue }}\)
M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12

Question 15.
The following details of a company for the year ended 31 March, 2017 are given below:

Operating leverage : 2 times
Combined leverage : 2.5 times
Fixed Cost (Excluding interest) : ₹ 3.04 lakhs
Sales : ₹ 50.00 lakhs
8% Debentures of ₹ 100 each : ₹ 30.25 lakhs
Equity Share Capital of ₹ 10 each ₹ 34.00 lakhs
Income tax rate 30 per cent

Required:

(i) Calculate Financial Leverage.
(ii) Calculate P/V ratio and Earning Per Share (EPS).
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero? (8 Marks Nov. 2017)

Answer:

(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.50 ÷ 2 = 1.25

(ii) P/V Ratio and EPS:

Calculation of contribution

Operating leverage \(=\frac{\text { Contribution }}{\text { Contribution }-\mathrm{FC}}\) \(=\frac{\text { Contribution }}{\text { Contribution }-3,04,000}\) = 2 times
2 Contribution – 6,08,000 = Contribution = 6,08,000

Calculation of PAT:
Profit after tax = (Contribution – fixed cost – interest) (1 – t)
= (6,08,000 – 3,04,000 – 8% of 30,25,000)(1 – 0.30)
= 43,400

Author Note: Calculation of interest through financial leverage will provide different interest, therefore this question alternatively can be solved by taking interest on the basis of following calculation:

Financial Leverage EBIT ÷ EBT = 6,08,000 – 3,04,000 ÷ EBT
= 1.25 = 3,04,000 ÷ EBT
EBT = 3,04,000 ÷ 1.25 = 2,43,200
Interest = EBT – EBT = 3,04,000 – 2,43,200
= 60,800

(iii) Assets turnover:
Assets turnover \(=\frac{\text { Sales }}{\text { Total Assets }}\) = \(\frac{50,00,000}{64,25,000}\) = .778
0.778 < 1.5 means lower than industry assets turnover.

(iv) Level of saks ro earn zero EBT:
EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 87.84% sales – 3,04,000 – 2,42,000
12.16% of sales = 5,46,000
Sales = 44,90,132

Question 16.
Following are the selected financial information of A Ltd. and B Ltd. for the year ended March 31, 2018:

You are required to find out:

(1) EBIT
(2) Sales
(3) Fixed cost
(4) Identify the company which is better placed with reasons based on leverages. (5 Marks May 2018)

Answer:

(1) Financial Leverage \(=\frac{\text { EBIT }}{\text { EBIT – Interest }}\)
Financial Leverage (A Ltd.) \(=\frac{\text { EBIT }}{\text { EBIT }-20,000}\) = 3 times
EBIT = ₹ 30,000
Financial Leverage (B Ltd.) \(=\frac{\text { EBIT }}{\text { EBIT }-1,00,000}\) = 2 times
EBIT = ₹ 2,00,000

(2) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
Operating Leverage (A Ltd.) \(=\frac{\text { Contribution }}{30,000}\) = 5 times
Contribution = ₹ 1,50,000
Sales = ₹ 1,50,000 ÷ 40% (PV) = ₹ 3,75,000
Operating Leverage (B Ltd.) \(=\frac{\text { Contribution }}{2,00,000}\) = 2 times
Contribution = ₹ 4,00,000
Sales = ₹ 4,00,000 ÷ 50% (PV) = ₹ 8,00,000

(3) Contribution = EBIT + Fixed Cost
Contribution (A Ltd.) = 30,000 + Fixed Cost = ₹ 1,50,000
Fixed cost = ₹ 1,20,000
Contribution (B Ltd.) = 2,00,000 + Fixed Cost = ₹ 4,00,00
Fixed cost = ₹ 2,00,000

(4) Comment based on leverage: B Ltd. is better than A Ltd. having lower degree of Business risk, Financial risk and overall risk.

Question 17.
The following data have been extracted from the books of LM Ltd:

Sales : ₹ 100 Lakhs
Interest payable per annum : ₹ 10 Lakhs
Operating leverage : 1.2
Combined leverage : 2.16

You are required to find out:

(1) The Financial leverage
(2) Fixed cost and
(3) P/V ratio (5 Marks May 2018)

Answer:

(1) Financial Leverage = Combined leverage ÷ Operating leverage
= 2.16 ÷ 1.2 = 1.8 times

(2) Calculation of fixed cost:
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBIT – Interest }}\) = 1.8 times
\(=\frac{\text { EBIT }}{\text { EBIT }-10,00,000}\) = 1.8 times
EBIT = ₹ 22,50,000
Operation Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = 1.2 times
Contribution = ₹ 2,50,000 × 1.2 = ₹ 27,00,000
Fixed cost = Contribution – EBIT
= ₹ 27,00,000 – 2,50,000 = ₹ 4,50,000

(3) P/V ratio = Contribution ÷ Sales
= 27,00,000 ÷ 1,00,00,000 = 27%

Question 18.
Following is Balance Sheet of Soni Ltd. as on 31st March, 2018.

Additional information:

Fixed cost per annum (excluding interest) : ₹ 20,00,000
Variable operating cost ratio : 60%
Total assets turnover ratio : 5 times
Income Tax rate : 25%

You are required to:

(1) Prepare Income Statement
(2) Calculate the following and comment:

(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage (10 Marks Nov. 2018)

Answer:

(1) Income Statement

(2) Calculation of OL:
OL \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{2,00,00,000}{1,80,00,000}\) = 1.11 times

It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.

Calculation of FL:
FL \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) = \(\frac{1,80,00,000}{1,74,00,000}\) = 1.03 times

The financial leverage is very comfortable since the debt service obli-gation is small vis-a-vis EBIT.
Calculation of CL:
CL = OL × FL = 1.11 × 1.03 = 1.15 times
The combined leverage studied the choice of fixed cost in cost struc-ture and choice of debt in capital structure. It studies how sensitive the change in EPS is vis-a-vis change in sales.

Question 19.
A company has sales of ₹ 1,00,00,000; variable cost is 55% of sales and fixed cost is ₹ 6,00,000. The capital structure of the company is: Equity ₹ 20,00,000 and 8% Debt ₹ 80,00,000.

Calculate:

(1) Operating, Financial and Combined Leverages.
(2) If the sales amount is increased by 12%, by what percentage EBIT will increase? (5 Marks Nov. 2018)

Answer:

(1) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{1,00,00,000 \times 45 \%}{45,00,000-6,00,000}\) = 1.154 times
Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
= \(\frac{39,00,000}{39,00,000-8 \% \text { of } 80,00,000}\) = 1.196 times
Combined Leverage = OL × FL
= 1.154 × 1.196 = 1.38 times

(2) % increase on EBIT:
Δ EBIT (in %) = Δ sales × DOL
= 12% × 1.154
= 13.84%

Question 20.
The capital structure of the Shiva Ltd. consists of an ordinary share capital of ₹ 20,00,000 (share of ₹ 100 par value) and ₹ 20,00,000 of 10% debentures.

Sales increased by 20% from 2,00,000 units to 2,40,000 units, the selling price is ₹ 10 per unit; variable cost amounts to ₹ 6 per unit and fixed expenses amount to ₹ 4,00,000.
The income tax rate is assumed to be 50%.

You are required to calculate the following:

(1) The percentage increase in earnings per share;
(2) Financial leverage at 2,00,000 units and 2,40,000 units.
(3) Operating leverage at 2,00,000 units and 2,40,000 units.
(4) Comment on the behaviour of operating and financial leverages in relation to increase in production from 2,00,000 units to 2,40,000 units. (10 Marks May 2019)

Answer:

(1) Calculation of % increase in EPS

% increase in EPS = \(\frac{9.00-5.00}{5.00}\) × 100 = 80%

(2) Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }}\)
At 2,00,000 units = \(\frac{4,00,000}{2,00,000}\) = 2 times
At 2,40,000 units = \(\frac{5,60,000}{3,60,000}\) = 1.56 times

(3) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 2,00,000 units = \(\frac{8,00,000}{4,00,000}\) = 2 times
At 2,40,000 units = \(\frac{9,60,000}{5,60,000}\) = 1.71 times

(4) Increase in production and sales will result in decrease in risk

Question 21.
The balance sheet of Gitashree Ltd. is given below:

The company’s total assets turnover ratio is 4 times, its fixed operating cost is ₹ 2,00,000 and its variable operating cost ratio is 60%. The income tax rate is 30%.

You are required to:

1. (a) Degree of Operating Leverage.
(b) Degree of Financial Leverage.
(c) Degree of Combined Leverage.

2. Determine the likely level of EBIT if EPS is
(A) ₹ 1.00,
(B) ₹ 2.00 and
(C) ₹ Nil. (10 Marks Nov. 2019)

Answer:

1.
(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{96,000}{76,000}\) = 1.26
(b) Financial Leverage \(=\frac{\text { EBIT }}{\mathrm{EBT}}\) = \(\frac{76,000}{7,36,000}\) = 1.03
(c) Combined Leverage = OL × FL = 1.26 × 1.03 = 1.30

2. Calculation of likely level of EBIT:
Earnings Per Share \(=\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{t})}{\mathrm{N}}\)

Working Note:

Income statement

Question 22.
The following data is available for Stone Ltd.:

Using the concept of leverage, find out:

(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%. Also verify the results in each of the above case. (10 Marks Nov. 2020)

Answer:

(i) % change in taxable income (EBT) = % increase in EBIT × FL
= 10% × 1.333 times = 13.33%
(ii) % change in EBIT = % increase in Sales × OL
= 10% × 3 times = 30%
(iii) % change in taxable income (EBT) = % increase in Sales × CL
= 10% × 4 times = 40%

Verification in each case:

(i) % change in taxable income if EBIT increases by 10%:
Revised taxable income (EBT) = EBIT + 10% – Interest
= 1,00,000 + 10% – 25,000 = 85,000
% change in taxable income = \(\frac{85,000-75,000}{75,000}\) × 100 = 13.33%

(ii) % change in EBIT if Sales increases by 10%:
Revised EBIT = (Sales + 10%) – Variable cost @ 40% – Fixed cost
= (5,00,000 + 10%) – 40% of 5,50,000 – 2,00,000
= 1,30,000

(iii) % change in taxable income if Sales increases by 10%:
Revised taxable income (EBT)
= (Sales+10%) – Variable cost@40% – Fixed cost – Interest
= (5,00,000 + 10%) – 40% of 5,50,000 – 2,00,000 – 25,000
= 1,05,000
% change in taxable income = \(\frac{1,05,000-75,000}{75,000}\) × 100 = 40%

Working Note:

(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{3,00,000}{1,00,000}\) = 3 times

(b) Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
= \(\frac{1,00,000}{75,000}\) = 1.333 times

(c) Combined Leverage = OL × FL
= 3 × 1.333 = 4 times

Question 23.
The following information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as follows:

Equity share capital of ₹ 100 each : ₹ 50 Lakhs
12% Bonds of ₹ 1,000 each : ₹ 30 Lakhs
Sales : ₹ 84 Lakhs
Fixed cost (Excluding Interest) : ₹ 7.5 Lakhs
Financial leverage : 1.39
Profit Volume Ratio : 25%
Market Price per Equity Share : ₹ 200
Income Tax Rate Applicable : 30%

You are required to calculate:

(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning Per Share
(iv) Earning Yield (10 Marks Jan. 2021)

Answer

(i) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
= \(\frac{21,00,000}{13,50,000}\) = 1.56 times

(ii) Combined Leverage = OL × FL
= 1.56 × 1.39 = 2.16 rimes

(iii) Earnings Per Share \(=\frac{\text { PAT }}{\text { No of Equity shares }}\)
= \(\frac{6,93,000}{50,000}\) = ₹ 13.86

(iv) Earnings Yield \(=\frac{E P S}{\text { MPS }}\) × 100
= \(\frac{13.86}{200}\) × 100 = 6.93%

Working Notes:

(1) Contribution Sales × PV Ratio
= 84 Lakhs × 25% = 21,00,000

(2) EBIT = Contribution – Fixed Cost
= 21,00,000 – 7,50,000 = 13,50,000

(3) Profit after tax = (EBIT – Interest) (1 – t)
= (13,50,000 – 12% of 30,00,000) (1 – 0.30)
= 6,93,000

Important Questions

Question 1.
Z Limited is considering the installation of a new project costing ₹ 80,00,000. Expected annual sales revenue from the project is ₹ 90,00,000 and its variable costs are 60 per cent of sales. Expected annual fixed cost other than interest is ₹ 10,00,000. Corporate tax rate is 30 per cent. The company w’ants to arrange the funds through issuing 4,00,000 equity shares of ₹ 10 each and 12 per cent debentures of ₹ 40,00,000.

You are required to:

(i) Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
(ii) Determine the likely level of EBIT, if EPS is ₹ 4, or ₹ 2, or Zero.

Answer:

(i)

(ii) Calculation of likely level of EBIT:

Question 2.
Calculate the operating leverage, financial leverage and combined leverage from the following data under situations I and II and financial plans A and B:

Installed capacity : 4,000 units
Actual production and sales : 75% of the Capacity
Selling price : ₹ 30 per unit
Variable cost : ₹ 15 per unit
Fixed cost:
Under situation I : ₹ 15,000
Under situation II : ₹ 20,000

Answer:
Statement of showing OL, FL and CL

Question 3.
The capital structure of the Progressive Corporation consists of an ordi nary share capital of ₹ 1,00,00,000 (share of ₹ 100 par value) and ₹ 10,00,000 of 10% debentures.

Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is ₹ 10 per unit; variable cost amounts to ₹ 6 per unit and fixed expenses amount to ₹ 2,00,000.

The income tax rate is assumed to be 50%.

You are required to calculate the following:

(i) The percentage increase in earnings per share;
(ii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.
(iii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.
(iv) Comment on the behaviour of operating and financial leverages in relation to increase in production from 1,00,000 units to 1,20,000 units.

Answer:

(i) Calculation of % increase in EPS

% increase in EPS = \(\frac{0.90-0.50}{0.50}\) × 100 = 80%

(ii) Degree of Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\)
At 1,00,000 units = \(\frac{4,00,000}{2,00,000}\) = 2 times
At 1,20,000 units = \(\frac{4,80,000}{2,80,000}\) = 1.71 times

(iii) Degree of Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\)
At 1,00,000 units = \(\frac{2,00,000}{1,00,000}\) = 2 times
At 1,20,000 units = \(\frac{2,80,000}{1,80,000}\) = 1.56 times
(iv) Increase in production and sales will result in decrease in risk.

Question 4.
A company had the following Balance Sheet as on March 31, 2006

The additional information given is as under:
Fixed costs per annum (excluding interest) : ₹ 8 Crores
Variable operating costs ratio : 65% of sales
Total Assets turnover ratio : 2.5 times
Income tax rate : 40%

Calculate

(i) Earnings per share,
(ii) Operating Leverage,
(iii) Financial Leverage,
(iv) Combined Leverage and comment on all leverages.

Answer:

(i) Statement of EPS

(ii) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) \(=\frac{35 \text { Crores }}{27 \text { Crores }}\) = 1.296 times
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.

(iii) Financial Leverage \(=\frac{\mathrm{EBIT}}{\mathrm{EBT}}\) \(=\frac{27 \text { Crores }}{24 \text { Crores }}\) = 1.125 times
The financial leverage is very comfortable since the debt service obli-gation is small vis-a-vis EBIT.

(iv) Combined Leverage = OL × FL = 1.296 × 1.125 = 1.458 times

The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure. It studies how sensitive the change in EPS is vis-a-vis change in sales.

Question 5.
From the following information, prepare Income Statement of Company A & B:

Particulars	Company A	Company B
Margin of safety	0.20	0.25
Interest	₹ 3.000	₹ 2,000
Profit volume ratio	25%	33.33%
Financial Leverage	4	3
Tax rate	45%	45%

Answer:
Income Statement

(a) Company A:
Financial Leverage = EBIT/(EBIT – Interest)
= EBIT/(EBIT – ₹ 3,000) = 4 times
EBIT = 4 EBIT – ₹ 12,000
EBIT = ₹ 4,000

Company B:
Financial Leverage = EBIT/(EBIT – Interest)
= EBIT/(EBIT – ₹ 2,000) = 3 times
EBIT = 3 EBIT – ₹ 6,000
EBIT = ₹ 3,000

(b) Company A:
Operating Leverage = 1/Margin of Safety
1/0.20 = 5 times
Operating Leverage = Contribution/EBIT
= Contribution/₹ 4,000 = 5 times
Contribution = ₹ 20,000
Company B:
Operating Leverage = 1/ Margin of Safety
= 1/0.25 4tirncs
Operating Leverage = Contnbution/EBIT
= Contribution/₹ 3,000 = 4 times
Contribution = ₹ 12,000

(c) company A:
Sales = Contribution/PV Ratio
= ₹ 20,000/0.25 = ₹ 80,000

company B:
Sales = Contribution/PV Ratio
= ₹ 20,000/0.3333 = ₹ 36,000

Question 6.
A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹ 6,00,000. It has a debt of ₹ 45,00,000 at 9% and equity of ₹ 55,00,000.

(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?

Answer:

Income Statement

(i) ROI \(=\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100
= \(\frac{27,00,000}{45,00,000+55,00,000}\) × 100 = 27%

(ii) ROI is 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.

(iii) Capital Turnover \(=\frac{\text { Net Sales }}{\text { Capital }}\) = \(\frac{75,00,000}{1,00,00,000}\) = 0.75
Firm has very low capital turnover as compared to industry average of 3.

(iv) Calculation of Operating, Financial and Combined leverages:
Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{33,00,000}{27,00,000}\) = 1.222
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }}\) = \(\frac{27,00,000}{22,95,000}\) = 1.176
Combined Leverage = OL × FL = 1.222 × 1.176 = 1.437

(v) Operating leverage is 1.22. So if sales is increased by 10% then EBIT will be increased by 1.222 × 10 i.e. 12.22% (approx)

(vi) EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 56% sales – 6,00,000 – 4,05,000
44% of sales = 10,05,000
Sales = 22,84,091
Hence at ₹ 22,84,091 sales level EBT of the firm will be equal to Zero.

(vii) Financial leverage is 1.176. So, if EBIT increases by 20% then EBT will increase by 1.18 × 20% = 23.52% (approx)

Question 7.
You are given the following information of 5 firms of the same industry:

Finn	Change in Revenue	Change in Operating Income	Change in EPS
M	28%	26%	32%
N	27%	34%	26%
P	25%	38%	23%
0	23%	43%	27%
R	25%	40%	28%

Find out:

(a) Degree of operating leverage, and
(b) Degree of combined leverage of all the firms.

Answer:

(a) Degree of Operating Leverage \(=\frac{\% \text { Change in operating income }}{\% \text { Change in revenue }}\)
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60

(b) Degree of Combined Leverage \(=\frac{\% \text { Change in EPS }}{\% \text { Change in revenue }}\)
M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12

Question 8.
The net Sales of A Ltd. is ₹ 30 crores. Earning before interest and tax of the company as a percentage of net sales is 12%. The capital employed comprises ₹ 10 crores of Equity, ₹ 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of ₹ 6 crores. Income tax rate is 40%.

Required:

(i) Calculate the Return on Equity (ROE) for the Company and indicate its segments due to the presence of Preference Share Capital and Bor rowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that its Combined Leverage is 3.

Answer:

(i) Calculation of ROE :
ROE \(=\frac{\text { Earnings for Equity Shareholders }}{\text { Equity Shareholder’s Fund }}\) × 100
\(=\frac{1.36 \text { Crores }}{10 \text { Crores }}\) × 100 = 13.60%

Segment:

ROCE/ROI \(=\frac{\text { EBIT }}{\text { Capital Employed }}\) × 100
\(=\frac{3.60 \text { crores }}{18 \text { crores }}\) × 100 = 20%
Segment due to Preference Share Capital
= [20% (1 – 40) – 13%] × \(\frac{2}{10}\) = -20%
Segment due to Debentures
= [(20% – 15%) (1 -40)] × \(\frac{6}{10}\) = 1.80%
Return on Equity with segment effect
= ROI (1-t) -.20% + 1.80%
= [20% (1-.40)] -.20% + 1.80% = 13.60%

(ii) Operating Leverage = Combined Leverage ÷ Financial Leverage
= 3 times ÷ 1.59 times = 1.89 times

Working Notes:

1. Calculation of Earnings Available for Equity Shareholders

2. Calculation of Financial Leverage:
Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }-\frac{\text { Preference Dividend }}{1-\text { Tax }}}\)
\(=\frac{3,60,00,000}{2,70,00,000-\frac{26,00,000}{1-0.40}}\) = 1.59 times

Question 9.
The following details of RST Limited for the year ended 31 March, 2006 are given below:

Operating leverage : 1.4 times
Combined leverage : 2.8 times
Fixed Cost (Excluding interest) : ₹ 2.04 lakhs
Sales : ₹ 30.00 lakhs
12% Debentures of ₹ 100 each : ₹ 21.25 lakhs
Equity Share Capital of ₹ 10 each : ₹ 17.00 lakhs
Income tax rate : 30 per cent

Required:

(i) Calculate Financial Leverage.
(ii) Calculate P/V ratio and Earning Per Share (EPS).
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero?

Answer:

(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.80 ÷ 1.40 = 2 times

(ii) P/V Ratio and EPS:
p/v ratio \(=\frac{\text { Contribution }}{\text { Sales }}\) × 1oo = \(\frac{7,14,000}{30,00,000}\) × 100 = 23.80%
EPS \(=\frac{\text { PAT }}{\text { No. of Shares }}\) = \(\frac{1,78,500}{1,70,000}\) = ₹ 1.05
Calculation of contribution:
Operating leverage \(=\frac{\text { Contribution }}{\text { Contribution }-\mathrm{FC}}\)
\(=\frac{\text { Contribution }}{\text { Contribution }-2,04,000}\) = 1.4 times
1.4 Contribution – 2,85,600 = Contribution = 7,14,000
Calculation of PAT:
Profit after tax (Contribution – fixed cost – interest) (1 – t)
= (23.80% of 30 lacs – 2.04 lacs – 12% of 21.25 lacs)(1 – 0.30)
= 1,78,500

(iii) Assets turnover:
Assets turnover \(=\frac{\text { Sales }}{\text { Total Assets }}\) = \(\frac{30,00,000}{38,25,000}\) = .784
0.784 < 1.5 means lower than industry assets turnover.

(iv) Level of sales to earn zero EBT:
EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 76.20% sales – 2,04,000 – 2,55,000
23.80% of sales = 4,59,000
Sales = 19,28,571

Question 10.
The capital structure of JCPL Ltd. is as follows:

Equity share capital of ₹ 10 each : ₹ 8,00,000
8% Preference share capital of ₹ 10 each : ₹ 6,25,000
10% Debenture of ₹ 100 each : ₹ 4,00,000

Additional Information:

Profit after tax (tax rate 30%) : ₹ 1,82,000
Operating expenses (including depreciation ₹ 90,000) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : ₹ 20.00

Required to calculate:

(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.

Answer:

(i) Operating & Financial leverage:

(ii) Calculation of cover the preference & equity share dividends:
Cover the Preference Share Dividend

Cover the Equity Share Dividend

(iii) Earning yield & price earning ratio:

(iv) Net fund flow:
Net fund flow = PAT – Preference dividends – Equity dividends + Depreciation
= 1,82,000 – 50,000 – 1,20,000 + 90,000 = ₹ 1,02,000
Calculation of contribution:

Cost of Capital – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Cost of Capital – CA Inter FM Study Material

Theory Questions

Question 1.
Explain the significance of cost of capital. (4 Marks Nov. 2019)
Answer:
The cost of capital is one of the most important component to take financial decisions. The correct calculation of cost of capital helps in the following decision making:
(1) Evaluation of investment options:
Present value of all future benefit is calculated by discounting them with the relevant cost of capital. Different investment options have different cost of capital so we have to calculate cost of capital related to every project and then present value of future benefits related to these projects.

(2) Financing Decision:
Finance managers obtains funds from various sources with consideration of cost, risk and control. Finance manager can easily compare cost of different sources and select source with lowest cost.

(3) Designing of optimum credit policy:
In modern world firm has to sell its products or services on credit. For evaluation of credit period cost of capital is used, benefit though credit should be higher than cost of funds blocked in credit.

Question 2.
Distinguish between Unsystematic Risk & Systematic Risk. (2 Marla Nov. 2020)
Answer:
Unsystematic Risk :
Risk which is associated with performance of company is known as company specific risk or unsystematic risk. This risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable risk.

Systematic Risk:
Risk which is associated with macro-economic or market under which a firm is doing business is known as unsystematic risk. This risk cannot be eliminated by the diversification of the securities portfolio, it is also known as non-diversifiable risk. The examples are Center and State government policies, inflation, GDP, per capita income, interest rate etc. This risks are assessed in terms of beta coefficient (b or (3) and calculated through regression equation between return of a security and the return on a market portfolio.

Practical Problems

Cost Of Debt

Question 1.
A company issues 25,000,14% debentures of ₹ 1,000 each. The debentures are redeemable after the expiry period 5 years. Tax rate applicable to the company is 35%.

Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost. (5 Marks Nov. 2015)
Answer:
K_d = \(\frac{\mathrm{I}(1-\mathrm{t})+\left(\frac{\mathrm{RV}-\mathrm{NP}}{\mathrm{n}}\right)}{\frac{\mathrm{RV}+\mathrm{NP}}{2}}\) × 100
= \(\frac{140(1-0.35)+\left(\frac{1000-930}{5}\right)}{\frac{1000+930}{2}}\) × 100
Net Proceeds = 1,000 – 5% Discount – 2% Flotation cost = 930
Note: Flotation cost has been calculated on the basis of face value (i.e. 2% of ₹ 1,000 or ₹ 950 whichever is higher).

Question 2.
TT Ltd. issued 20,000,10% Convertible debentures of ₹ 100 each with a maturity period of 5 years. At maturity the debenture holders will have the option to convert the debentures into equity shares of the company in the ratio of 1 : 5 (5 shares for each debenture). The current market price of the equity shares is ₹ 20 each and historically the growth rate of the shares are 4% per annum. Assuming tax rate is 25%.

Compute the cost of 10% debentures using Approximation Method and Internal Rate of Return Method.
PV Factor are as under:

Year	1	2	3	4	5
PV Factor @ 10%	0.909	0.826	0.751	0.683	0.621
PV Factor (S’ 15%	0.870	0.756	0.658	0.572	0.497

Answer:
(a) Calculation of Cost of Convertible debenture using Approximation Method:
K_d = \(\frac{\mathrm{I}(1-t)+\frac{\mathrm{CV}-\mathrm{NP}}{\mathrm{n}}}{\frac{\mathrm{CV}+\mathrm{NP}}{2}}\) × 100
= \(\frac{10(1-0.25)+\frac{121.67-100}{5}}{\frac{121.67+100}{2}}\) × 100 = 10.68%

(b) Calculation of Cost of Convertible debenture using IRR Method Calculation of NPV at two discount rates:

Year	Cash Flow	Present Value		Present Value
		10%	DCF	15%	DCF
0	(100)	1.000	(100)	1.000	(100)
1 – 5	7.50	3.790	28.43	3.353	25.15
5	121.67	0.621	75.56	0.497	60.47
NPV			+3.99		-14.38

IRR/K_d = LR + \(\frac{\mathrm{NPV}_{\mathrm{L}}}{\mathrm{NPV}_{\mathrm{L}}-\mathrm{NPV}_{\mathrm{H}}}\) × (H – L)
= 10% + \(\frac{3.99}{3.99-(-14.38)}\) × (15% – 10%)
= 11.09%
Determination of Convertible value:
Higher of
(i) The cash value of debentures = ₹ 100
(ii) Value of equity shares = 5 shares × ₹ 20 (1 + 0.04)⁵
= 5 shares × ₹ 24.333 = ₹ 121.67
₹ 121.67 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Cost of Preference Share Capital

Question 3.
A company issued 40,000,12% Redeemable Preference Shares of ₹ 100 each at a premium of ₹ 5 each, redeemable after 10 year at a premium of 110 each. The flotation cost of each share is ₹ 2.
You are required to calculate cost of preference share capital ignoring dividend tax. (5 Marks May 2013)
Answer:
K_ρ = \(\frac{\mathrm{PD}+\left(\frac{\mathrm{RV}-\mathrm{NP}}{\mathrm{n}}\right)}{\frac{\mathrm{RV}+\mathrm{NP}}{2}}\) × 100
= \(\frac{12+\left(\frac{110-103}{10}\right)}{\frac{110+103}{2}}\) × 100
= 11.92%

Cost of Equity

Question 4.
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of ₹ 20 and proposes to pay 60% dividend at the current year end with a P/E ratio 6.25, it wants to offer the issue at market price. The flotation cost is expected to be 4% of the issue price.
You are required to determine rate of return for equity share (cost of equity) before the issue and after the issue. (5 Marks May 2018)
Answer:
Market price of share (MPS/P₀) = EPS × PE = ₹ 20 × 6.25 = ₹ 25
Net proceeds = 125 – 4% = ₹ 120
Return on Equity (ROE) = 1/PE = 1/6.25 = 16%
Growth rate = r × b = 1696 × 40% = 6.40%
K_e (before issue) = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{60 \% \text { of } 20}{125}\) + 6.40% = 16%

K_e (after issue) = \(\frac{\mathrm{D}_1}{\mathrm{NP}}\) + g = \(\frac{60 \% \text { of } 20}{120}\) + 6.40% = 16.40%

Question 5.
ABC Company’s equity share is quoted in the market at ₹ 25 per share currently. The company pays a dividend of ₹ 2 per share and the investor’s market expects a growth rate of 6% per year.
You are required to:
(i) Calculate the company’s cost of equity capital.
(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share.
(iii) If the company issues 10% debentures of face value of ₹ 100 each mid realises ₹ 96 per debenture while the debentures are redeemable after 12 years at a premium of 12%, what will be the cost of debenture? Assume Tax Rate to be 50%. (5 Marks Nov. 2016)
Answer:
(i)

Note: Thc cost of equity can be calculated with taking the effect of growth on dividend (i.e. D₁ = 2.12).

(ii) P₀ = \(\frac{D_1}{\mathrm{Ke}-\mathrm{g}}\) = \(\frac{2}{14 \%-8 \%}\) = ₹ 33.33

(iii) K_d = \(\frac{\mathrm{I}(1-\mathrm{t})+\left(\frac{\mathrm{RV}-\mathrm{NP}}{\mathrm{n}}\right)}{\frac{\mathrm{RV}+\mathrm{NP}}{2}}\) × 100
= \(\frac{10(1-0.50)+\left(\frac{112-96}{12}\right)}{\frac{112+96}{2}}\) × 100
= 6.089%

Weighted Average Cost of Capital

Question 6.
Beeta Ltd. has furnished the following information:
Earning per share (EPS) : ₹ 4.00
Dividend payout ratio : 25%
Market price per share : ₹ 40.00
Rate of tax : 30%
Growth rate of dividend : 8%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% upto ₹ 2 lakhs and 15% beyond that.
Compute the after tax cost equity and debt and the weighted average cost of capital. (4 Marks Nov. 2011)
Answer:
K₀ = K_e W_e + K_d1 W_d1 + K_d2 W_d2
= 10.7% × \(\frac{6}{10}\) + 7% × \(\frac{2}{10}\) + 10.50% × \(\frac{2}{10}\) = 9.92%
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{4.00 \times 25 \% \times 108 \%}{40}\) + 0.08 = 10.70%
K_d1 = I (1 – t) = 10% (1 – 0.30) = 7%
K_d2 = I (1 – t) = 15% (1 – 0.30) = 10.50%
Assumption: DPS ₹ 1.00 is treated at D₀.

Question 7.
The following details are provided by GPS Limited:
Equity Share capital : ₹ 65,00,000
12% Preference Share Capital : ₹ 12,00,000
15% Redeemable Debentures : ₹ 20,00,000
10% Convertible Debentures : ₹ 8,00,000
The cost of equity capital for the company is 16.30% and Income Tax Rate for the company is 30%.
You are required to calculate the Weighted Average Cost of Capital (WACC) of the company. (5 Marks May 2014)
Answer:
WACC = K_e W_e + K_p W_p + K_rd W_rd + K_cd W_cd
Working Notes:
(i) Calculation of cost of Preference Share capital (K_p) :
K_p = Rate of Preference Dividend = 12%

(ii) Calculation of cost of Redeemable Debentures (K_rd):
K_rd = I (1 – t) = 15% (1 – 0.30) = 10.50%

(iii) Calculation of cost Convertible Debentures (K_cd):
K_cd = I (1 – t) = 10% (1 – 0.30) = 7%

Question 8.
A Ltd. wishes to raise additional finance of ₹ 30 lakhs for meeting its investment plans. The company has ₹ 6,00,000 in the form of retained earnings available for investment purposes. The following are the further details:
Debt equity ratio : 30:70
Cost of debt:
Upto ₹ 3,00,000 : 11% (before tax) and
Beyond ₹ 3,00,000 : 14% (before tax)
Earning per share : ₹ 15 per share
Dividend payout : 70% of earnings
Expected growth rate : 10%
Current market price : ₹ 90 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%

You are required to:
1. Calculate the post tax average cost of additional debt.
2. Calculate the cost of retained earnings and cost of equity.
3. Calculate the overall weighted average (after tax) cost of additional (8 Marks May 2015)
Answer:
Total capital required is ₹ 30 lakhs. With a debt-equity ratio of 30 : 70. It means ₹ 9 lakhs is to be raised through debt and ₹ 21 lakhs through equity. Out of ₹ 21 lakhs, ₹ 6 lakhs are available in the form of retained earnings hence ₹ 15 lakhs will have to raise by issuing equity shares.

1. Post tax average cost of additional debt:
K_d1 = I (1 – t) = 11% (1 – 0.30) = 7.70%
K_d2 = I (1 – t) = 14% (1 – 0.30) = 9.80%
Average K_d = K_d1W_d1 + K_d2W_d2 = 7.7% × \(\frac{3}{9}\) + 9.8% × \(\frac{6}{9}\) = 9.10%

2. Cost of retained earning & cost of equity:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{10.50+10 \%}{90}\) + 0.10 = 22.83%
K_r = K_e (1 – PT) = 22.83% (1 – .20) = 18.27%
D₀ = ₹ 15 × 70% = ₹ 10.50

3. Overall cost of additional finance:
K₀ = K_e W_e + K_r W_r + K_d W_d
= 22.83% × \(\frac{15}{30}\) + 18.27% × \(\frac{6}{30}\) + 9.10% × \(\frac{9}{30}\)
= 17.80%
Assumption: DPS ₹ 10.50 is treated at D₀.

Question 9.
The X Company has following capital structure at 31st March, 20015, which is considered to be optimum:
14% debenture : ₹ 3,00,000
11% preference share capital : ₹ 1,00,000
Equity share capital (1,00,000 shares) : ₹ 16,00,000
The company’s share has a current market price of ₹ 23.60 per share. The expected dividend per share in next year is 50 per cent of the 2015 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

The company issued new debentures carrying 16% rate of interest and the current market price of debenture is ₹ 96. Preference shares ₹ 9.20 (with dividend of ₹ 1.1 per share) were also issued. The company is in 50% tax bracket.

(i) Calculate the after tax cost of (a) New Debts, (b) New Preference Share, and (c) New Equity Share (assuming new equity from retained earnings).
(ii) Calculate the marginal cost of capital when no new share was issued.
(iii) How much can be spent for capital investment before new ordinary shares must be sold? Assuming that retained earnings for next year’s investment are 50% of 2015.
(iv) What will be marginal cost of capital when the fund exceeds the amount calculated in (iii), assuming new equity is issued at ₹ 20 per share? (8 Marks May 2016)
Answer:
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

Name of source	Amount(₹)	Proportion
14% debentures	3,00,000	0.15
11% Preference	1,00,000	0.05
Equity share capital	16,00,000	0.80
Total	20,00,000	1.00

(i) (a) After tax cost of new debt

(ii) MCC(K₀) when no new equity share was issued:
K_dW_d + K_p W_p + K_r W_r = 8.33% × .15 + 11.96% × .05 + 15% × .80 = 13.85%

(iii) The company can pay the following amount before issue of new shares:
Equity (retained earnings in this case) = 80% of the total capital
Therefore, investment before new issue = \(\frac{1,18,000}{80 \%}\) = ₹ 1,47,500
Retained earnings = ₹ 2.36 × 50% × 1,00,000 = ₹ 1,18,000

(iv) MCC (K₀) when funds exceeds ₹ 1,47,500
K_dW_d + K_pW_p + K_eW_e = 8.33% × .15 + 11.96% × .05 + 15.90% × .80 = 14.57%
If the company pay more than ₹ 1,47,500, it will have to issue new shares. The cost of new issue of ordinary share is:
K_e = \(\frac{D_1}{P_0(\text { new })}\) + g = \(\frac{1.18}{20}\) + 20 = 15.90%
WN: Calculation of growth:
Growth from year 2006 to 2007 = (1.10 – 1.00) ÷ 1.00 = 10%
[Same rate of growth is found in future years]

Question 10.
Following is the capital structure of RBT Ltd. As on 31st March, 2016:

Sources of Fund	Book Value	Market Value
Equity Share of ₹ 10 each Retained Earnings 11% Preference Share of ₹ 100 each 14% Debentures of ₹ 100 each	₹ 50,00,000 ₹ 13,00,000 ₹ 7,00,000 ₹ 30,00,000	₹ 1,05,00,000 Nil ₹ 9,00,000 ₹ 36,00,000

Market price of equity shares is ₹ 40 per share and it is expected that a dividend of ₹ 4 per share would be declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate applicable to the company is 40% and shareholder’s personal income tax rate is 20%.

You are required to calculate:
(i) Cost of capital for each source of capital,
(ii) Weighted average cost of capital on the basis of book value weights,
(iii) Weighted average cost of capital on the basis of market value weights. (8 Marks Nov. 2016)
Answer:
(i) Calculation of cost of capital for each source of capital:
K_e = \(\frac{D_1}{P_0(\text { new })}\) + g = \(\frac{4}{40}\) + 0.08 = 18%
K_r = K_e (1 – PT) = 18%(1 – 0.20) = 14.40%
K_d = I (1 – t) = 14% (1 – 0.40) = 8.40%
K_p = Rate of PD = 11%

(ii) Calculation of WAC.C (K₀) using book value proportions

Name of Source	Amount	Proportion	K	K0
Equity Share Capital	50,00,000	0.50	18%	9.00%
Retained Earnings	13,00,000	0.13	14.40%	1.87%
Preference Share Capital	7,00,000	0.07	11%	0.77%
Debentures	30,00,000	0.30	8.40%	2.52%
Total	1,00,00,000	1.00	WACC	14.16%

(iii) Calculation of WACC(K₀) using market value proportions

Name of Source	Amount	Proportion	K	K0
Equity Share Capital	83,33,333	0.555	18%	9.99%
Retained Earnings	21,66,667	0.145	14.40%	2.09%
Preference Share Capital	9,00,000	0.060	11%	0.66%
Debentures	36,00,000	0.240	8.40%	2.02%
Total	1,50,00,000	1.000	WACC	14.76%

Market value of Equity Share Capital = ₹ 1,05,00,000 × 50/63 = ₹ 83,33,333
Market value of Retained Earnings = ₹ 1,05,00,000 × 13/63 = ₹ 21,66,667
‘Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

Question 11.
Alpha Ltd. has furnished the following information:
Earning per share (EPS) : ₹ 4.00
Dividend payout ratio : 25%
Market price per share : ₹ 50
Rate of tax : 30%
Growth rate of dividend : 10%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% upto ₹ 2 lakhs and 15% beyond that.
Compute the after tax cost equity and debt and the weighted average cost of capital. (5 Marks May 2019)
Answer:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{4.00 \times 25 \% \times 110 \%}{50}\) + 0.10 = 12.20%
K_d1 = I (1 – t) = 10% (1 – 0.30) = 7%
K_d2 = I (1 – t) = 15% (1 – 0.30) = 10.50%
K₀ = K_e W_e + K_d1 W_d1 + K_d2 W_d2
= 12.20% × \(\frac{6}{10}\) + 7% × \(\frac{2}{10}\) + 10.50% × \(\frac{2}{10}\) = 10.82%

Question 12.
A company wants to raise additional finance of ₹ 5 crores in next year. The company expected to retain ₹ 1 crore in next year. Further details are as follows:
(i) The amount will be raised by equity and debt in the ratio of 3 : 1.
(ii) The additional issue of equity shares will result in price per share being fixed at ₹ 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first ₹ 75 lakhs and 12 % for the next ₹ 50 lakhs.
(iv) The net expected dividend on equity shares is ₹ 2.00 per share. The dividend is expected to grow at the rate of 5%.
(v) Income tax rate of 25%.

You are required:
(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post tax average cost of additional debt.
(c) To determine the cost of retained earning and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax. (10 Marks Nov, 2019)
Answer:
(a) Total capital required is ₹ 5 crores. With a debt-equity ratio of 1:3. It means ₹ 1.25 crores is to be raised through debt and ₹ 3.75 crores through equity. Out of ₹ 3.75 crores, ₹ 1 crore are available in the form of retained earnings hence ₹ 2.75 crore will have to raise by issuing equity shares.

(b) Post tax average cost of additional debt:
K_d1 = I (1 – t) = 10% (1 – 0.25) = 7.5%
K_d2 = I (1 – t) = 12% (1 -0.25) = 9%
Average K_d = K_d2 W_d2 + K_d2 W_d2
= 7.5% × \(\frac{75}{125}\) + 9% × \(\frac{50}{125}\) = 8.10%

(c) Cost of retained earning & cost of equity:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{2}{25}\) + 0.05 = 13%
K_r = K_e = 13%

(d) Overall cost of additional finance:
K₀ = K_e W_e + K_r W_r + K_d W_d
= 13% × \(\frac{275}{500}\) + 13% × \(\frac{100}{500}\) + 8.10% × \(\frac{125}{500}\) = 11.78%

Question 13.
The capital structure of PQR Ltd. is as follows:
10% Debentures : ₹ 3,00,000
12% Preference shares : ₹ 2,50,000
Equity shares (face value ₹ 10 per share) : ₹ 5,00,000
Additional information:

1. ₹ 100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market price per debenture is ₹ 110.
2. ₹ 100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The market price per preference share is ₹ 108.
3. Equity share has ₹ 4 floatation cost and market price per share of ₹ 25. The next year expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
4.  Corporate Income tax rate is 30%.

Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights. (10 Marks Jan. 2021)
Answer:
Calculation of Weighted Average Cost of Capital by Using Market Value Weight

Particular	Market value	Weight	Cost	Weighted cost
10% Debenture	3,30,000	0.178	7.27%	1.294%
12% Preference share	2,70,000	0.146	12.49%	1.823%
Equity Share Capital	12,50,000	0.676	14.52%	9.816%
Total	18,50,000	1.000	WACC	12.933%

Working notes:
1. Calculation of specific cost of various sources of funds:

2. Calculation of market value of various sources of funds:
Debentures = 3,00,000 × 110/100 = 3,30,000
Preference shares = 2,50,000 × 108/100 = 2,70,000
Equity shares = 5,00,000 × 25/10 = 12,50,000

Important Questions

Question 1.
A company issued 10,000,15% Convertible debentures of ₹ 100 each with a maturity period of 5 years. At maturity the debenture holders will have the option to convert the debentures into equity shares of the company in the ratio of 1 : 10 (10 shares for each debenture). The current market price of the equity shares is ₹ 12 each and historically the growth rate of the shares are 5% per annum.
Compute the cost of debentures assuming 35% tax rate.
Answer:
Determination of Redemption value:
Higher of
(i) The cash value of debentures = ₹ 100
(ii) Value of equity shares = 10 shares × ₹ 12(1 + 0.05)⁵
= 10 shares × 15.312 = ₹ 153.12
₹ 153.12 will be taken as redemption value as it is higher than the cash option and attractive to the investors.
Calculation of Cost of Convertible debenture:
Alternative 1: Using approximation method:
K_d = \(\frac{\mathrm{I}(1-\mathrm{t})+\left(\frac{\mathrm{RV}-\mathrm{NP}}{\mathrm{n}}\right)}{\frac{\mathrm{RV}+\mathrm{NP}}{2}}\) × 100 = \(\frac{15(1-0.35)+\frac{153.12-100}{5}}{\frac{153.12+100}{2}}\) × 100 = 16.09%

Alternative 2: Using present value method:
Calculation of NPV at two discount rates:

Question 2.
RBML is proposing to sell a 5-year bond of ₹ 5,000 at 8 percent rate of interest per annum. The bond amount will be amortised equally over its life.
What is the bond’s present value for an investor if he expects a minimum rate of return of 6 percent?
Answer:
The amount of interest will go on declining as the outstanding amount of bond will be reducing due to amortisation. The amount of interest for five years will be:
First year : ₹ 5,000 × 0.08 = ₹ 400
Second year : ₹ (5,000 – ₹ 1,000) × 0.08 = ₹ 320
Third year : ₹ (4,000 – ₹ 1,000) × 0.08 = ₹ 240
Fourth year : ₹ (3,000 – ₹ 1,000) × 0.08 = ₹ 160; and
Fifth year : ₹ (2,000 – ₹ 1,000) × 0.08 = ₹ 80.

The outstanding amount of bond will be zero at the end of fifth year. Since RBML will have to return ₹ 1,000 every year, the outflows every year will consist of interest payment and repayment of principal:
First year : ₹ 1,000 + ₹ 400 = ₹ 1,400
Second year : ₹ l1,000 + ₹ 320 = ₹ 1,320
Third year : ₹ 1,000 + ₹ 240 = ₹ 1,240
Fourth year : ₹ 1,000 + ₹ 160 = ₹ 1,160; and
Fifth year : ₹ 1,000 + ₹ 80 = ₹ 1,080.
The above cash flows of all five years will be discounted with the cost of capital. Here the expected rate i.e. 6% will be used. Value of the bond is calculated as follows:
V_B = \(\frac{1,400}{(1.06)^1}+\frac{1,320}{(1.06)^2}+\frac{1,240}{(1.06)^3}+\frac{1,160}{(1.06)^4}+\frac{1,080}{(1.06)^5}\)
= ₹ 1,320.75 + ₹ 1,174.80 + ₹ 1,041.14 + ₹ 918.88 + ₹ 807.05 = ₹ 5,262.62

Question 3.
Mr. Mehra had purchased a share of Alpha Limited for ₹ 1,000. He received dividend for a period of five years at the rate of 10 per cent. At the end of the fifth year, he sold the share of Alpha Limited for ₹ 1,128.
You are required to compute the cost of equity as per realised yield approach.
Answer:
Calculation of IRR/K_e
K_e = LR + \(\frac{\mathrm{NPV}_{\mathrm{L}}}{\mathrm{NPV}_{\mathrm{L}}-\mathrm{NPV}_{\mathrm{H}}}\) × (H – L) = 11% + \(\frac{38.50}{38.50-(-35.80)}\) × (13% – 11%) = 12.04%
Calculation of NPV at two discount rates:

Question 4.
Calculate the cost of equity from the following data using realized yield approach:

Answer:
In this questions we will first calculate yield for last 4 years and then calculate it geometric mean as follows:

Geometric mean:
K_e = [(1 + Y₁) × (1 + Y₂) × (1 + Y_n)]^1/n – 1
K_e = [1.1944 × 1.2821 × 1.0609 × 1.0772]^1/4 – 1 = 0.15 or 15%

Question 5.
The following is the capital structure of Simons Company Ltd. as on 31.12.1998:

The market price of the company’s share is ₹ 110 and it is expected that a dividend of ₹ 10 per share would be declared for the year 1998. The dividend growth rate is 6%.
(i) If the company is in the 50% tax bracket, compute the WACC.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of ₹ 10,00,000 bearing 14% rate of interest, What will be the company’s revised weighted average cost of Capital? This financing decision is expected to increase dividends from ₹ 10 to ₹ 12 per share. However, the market price of equity share is expected to decline from ₹ 110 to ₹ 105 per share.
Answer:
In this questions we will first calculate yield for last 4 years and then calculate it geometric mean as follows:
WACC(K₀) = K_e W_e + K_p W_p + K_d W_d
= 15.09% × \(\frac{10}{20}\) + 10% × \(\frac{4}{20}\) + 6% × \(\frac{6}{20}\) = 11.35%
K_e = \(\frac{D_1}{P_0}\) + g = \(\frac{10}{110}\) + 0.6 = 15.09%
K_p = Rate of preferential dividend [FV = NP] = 10%
K_d = I (1 – t) = 12% (1 – 0.50) = 6%

(ii) Calculation of Revised WACC
Revised WACC (K₀)
= K_e W_e + K_p W_p + K_d W_d + K_TL W_TL
= 17.43% × \(\frac{10}{30}\) + 10% × \(\frac{4}{30}\) + 6% × \(\frac{6}{30}\) + 7% × \(\frac{10}{30}\) = 10.68%
Revised K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{12}{105}\) + .06 = 17.43%
K_TL = I (1 – t) = 14%(1 – 0.50) = 7%

Question 6.
XYZ Ltd. has the following book value capital structure:
Equity Share Capital (₹ 10 each, fully paid up at par)  :  ₹ 15 crores
11% Preference Share Capital (₹ 100 each, fully paid up at par)  :  ₹ 1 crores
Retained Earnings : ₹ 20 crores
13.5% Debentures (of ₹ 100 each) : ₹ 1o crores
15% Terms Loans : ₹ 12.5 crores
The next expected dividend on equity shares per share is ₹ 3.60; the dividend per share Is expected to grow at the rate of 7%. The market price per share is ₹ 40. Preference stock, redeemable after 10 years, is currently selling at ₹ 75 per share. Debentures, redeemable after six years, are selling at ₹ 80 per debenture. The income – tax rate for the company is 40%.

Required:
(i) Calculate the weighted average cost of capital (K₀) using:
a. Book value proportions; and
b. Market value proportions.
(ii) Define the weighted marginal cost of capital schedule for the company, if it raises ₹ 10 crores next year, given the following information:
a. The amount will be raised by equity and debt in equal proportions;
b. The company expects to retain ₹ 1.5 crores earnings next year;
c. The additional Issue of equity shares will result In the net price per share being fixed at ₹ 32;
d. The debt capital raised by way of term loans will cost 15% for the first ₹ 2.5 crores and 16% for the next ₹ 2.5 crores.
Answer:
(i) Calculation of WACC(K₀)
(a) By Using Book Value Proportions

*K_c & K_r are same, so calculated together.

(ii) Weighted Marginal Cost of Capital Schedule and Marginal WACC:
Marginal Cost of Capital Schedule:
Finance through Equity:
Retained earnings = ₹ 1.5 crores
New issue = ₹ 3.5 crores
Finance through Debt:
15% Debt = ₹ 2.5 crores
16% Debt = ₹ 2.5 crores
Marginal Cost of Capital

Working Notes:
Calculation of existing K_e, K_r, K_d, K_p and K_TL:

K_TL = I (1 – t) = 15% (1 – 0.40) = 9%
Calculation of revised K_e, K_r, K_d1 and K_d2
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{3.60}{32}\) + 0.07 = 18.25%
K_r = K_e (existing) = 16%
K_d1 = I (1 – t) = 15% (1 – 0.40) = 9%
K_d2 = I (1 – t) = 16% (1 – 0.40) = 9.60%

Question 7.
Calculate the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:
Debentures (₹ 100 per debenture)  :  ₹ 5,00,000
Preference shares (₹100 per share)  :  ₹ 5,00,000
Equity shares (₹10 per share)  :  ₹ 10,00,000
The market prices of these securities are:
Debentures  :  ₹ 105 per debenture
Preference shares  :  ₹ 110 per share
Equity shares  :  ₹ 24 each
Additional information:

1. ₹100 per debenture redeemable at par, 10% coupon rate, 4% floatation cost, 10 years of maturity. The market price per debenture is ₹ 105.
2. ₹ 100 per preference share redeemable at par, 5% coupon rate, 2% floatatlon cost, 10 years of maturity.
3. Equity share has ₹ 4 floatation cost and market price per share of ₹ 24, The next year expected dividend is ₹ 1 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends. Corporate Income-tax rate is 50%.

Answer:
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight

Question 8.
ABC Ltd. wishes to raise additional finance of ₹ 20 lakhs for meeting its Investment purpose. The company has ₹ 4,00,000 in the form of retained earnings available for Investment purposes. The following are the further details:
Debt equity ratio : 25 : 75
Cost of debt:
Upto ₹ 2,00000 : 10% (before tax) and
Beyond ₹ 200000 : 13% (before tax)
Earning per share : ₹ 12 per share
Dividend payout : 50% of earnings
Expected growth rate : 10%
Current market price : ₹ 60 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%.

Required:
(i) Calculate the post tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional
Answer:
Total capital required is ₹ 20 lakhs. With a debt-equity ratio of 1 : 3. It means ₹ 5 lakhs is to be raised through debt and ₹ 15 lakhs through equity. Out of ₹ 15 lakhs, ₹ 4 lakhs are available in the form of retained earnings hence ₹ 11 lakhs will have to raise by issuing equity shares.

(i) Post tax average cost of additional debt:
K_d1 = I (1 – t) = 10% (1 – 0.30) = 7%
K_d2 = I(1 – t) = 13%(1 0.30) = 9.10%
Average K_d = K_d1 W_d1+ K_d2 W_d2
= 7% × \(\frac{2}{5}\) + 9.10% × \(\frac{3}{5}\) = 8.26%

(ii) Cost of retained earning & cost of equity:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}\) + g = \(\frac{6+10 \%}{60}\) + 0.10 = 21%
K_r = K_e(1 – PT) = 21% (1 – .20) = 16.80%
D₀ = ₹ 12 × 5096 = ₹ 6

(iii) Overall cost of additional finance:
K₀ = K_e W_e + K_r W_r + K_d w_d
= 21% × \(\frac{11}{20}\)+ 16.80% × \(\frac{4}{20}\) + 8.26% × \(\frac{5}{20}\) = 16.98%
Assumption: DPS is treated at D₀.

Question 9.
The R & G Company has following capital structure at 31st March, 2004, which is considered to be optimum:
13% debenture  :  ₹ 3,60,000
11% preference share capital  :  ₹ 1,20,000
Equity share capital (2,00,000 shares)  : ₹ 9,20,000
The company’s share has a current market price of ₹ 27.75 per share. The expected dividend per share in next year is 50 per cent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

The company can issue 14 per cent new debenture. The company’s debenture is currently selling at ₹ 98. The new preference issue can be sold at a net price of ₹ 9.80, paying a dividend of ₹ 1.20 per share. The company’s marginal tax rate is 50%.

(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that retained earning available for next year’s investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part (iii)] if the company can sell new ordi-nary shares to net ₹ 20 per share? The cost of debt and of preference capital is constant.
Answer:
Assumption. The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

Name of source	Amount(₹)	Proportion
13% debentures	3,60,000	0.15
11% Preference	1,20,000	0.05
Equity share capital	19,20,000	0.80
Total	24,00,000	1.00

(i) (a) After tax cost of new debt
K_d = \(\frac{\mathrm{I}(1-\mathrm{t})}{\mathrm{NP}}\) × 100 = \(\frac{14(1-.50)}{98}\) × 100 = 7.143%
After tax cost of new preference shares
K_p = \(\frac{\text { PD }}{\mathrm{NP}}\) × 100 = \(\frac{1.20}{9.80}\) × 100 = 12.25%

(b) Cost of new equity (comes from retained earnings)
K_e = \(\frac{D_1}{P_0 \text { (old) }}\) + g = \(\frac{1.3865}{27.75}\) + 0.12 = 17%
(ii) MCC(K₀) = K_d W_d + K_p W_p + K_e W_e
= 7.143% × .15 + 12.245% × .05 +17% × .80 = 15.28%

The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital
Therefore, investment before new issue = \(\frac{2,77,300}{80 \%}\) = ₹ 3,46,625
Retained earnings = ₹ 1.3865 × 2,00,000 = ₹ 2,77,300

(iv) MCC(K₀) = K_d W_d + K_p W_p + K_e W_e
= 7.143% × . 15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than ₹ 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0(\text { new })}\) + g = \(\frac{1.3865}{20}\) + 0.12 = 18.93%

Question 10.
Determine the cost of capital of Best Luck Limited using the book value (BV) and market value (MV) weights from the following information:

Sources of Fund	Book Value	Market Value
Equity Shares	₹ 1,20,00,000	₹ 2,00,00,000
Retained Earnings	₹ 30,00,000	Nil
Preference Shares	₹ 36,00,000	₹ 33,75,000
Debentures	₹ 9,00,000	₹ 10,40,000

Additional Information:

1. Equity: Equity shares are quoted at ₹ 130 per share and a new issue priced at ₹ 125 per share will be fully subscribed; floatation costs will be ₹ 5 per share.
2. Dividend: During the previous 5 years, dividends have steadily increased from ₹ 10.60 to ₹ 14.19 per share. Dividend at the end of the current year is expected to be ₹ 15 per share.
3. Preference Shares: 15% Preference shares with face value of ₹ 100 would realise ₹ 105 per share.
4. Debentures: The company proposes to issue 11 year 15% debentures but the yield on debentures of similar maturity and risk class is 16%; floatation cost is 2%.
5. Tax: Corporate tax rate is 35%. Ignore dividend tax.

Answer:
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight

MV of Debenture = \(\frac{\text { Interest }}{\text { Market rate of Interest }}\) = \(\frac{15 \% \text { of } 100}{16 \%}\) × 100 = ₹ 93.75
NP of Debenture = MV of Debenture – Floatation Cost
= ₹ 93.75 – ₹ 2 (2% of ₹ 100) = ₹ 91.75

Note: Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures at discount.
Market value of Equity Shares = ₹ 2,00,00,000 × 120/150 = ₹ 1,60,00,000
Market value of Retained Earnings = ₹ 2,00,00,000 × 30/150 = ₹ 40,00,000
Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.