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PAPER – 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT

Question Nos. 1 and 6 are compulsory.

Attempt three questions out of the remaining Question Numbers 2, 3, 4 and 5 and attempt two
questions from the remaining Question Nos. 7, 8 and 9.
Working notes should form part of the answer.
Question 1
(a) ABC Bank is examining the profitability of its Premier Account, a combined Savings and
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 Rs. 50,000 or more receive unlimited free use of services.
Depositors with minimum balance of less than Rs. 50,000 pay Rs. 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 2005-06 by three customers is as follows:
Activity- Account Usage
Based Cost Customer Customer Customer
Per
X Y Z
Transaction
Deposits/withdrawal with teller Rs. 125 40 50 5
Deposits/withdrawal with
automatic teller machine (ATM) Rs. 40 10 20 16
Deposits/withdrawal on pre-
arranged monthly basis Rs. 25 0 12 60
Bank Cheques written Rs. 400 9 3 2
Foreign Currency drafts Rs. 600 4 1 6
Inquiries about Account Rs. 75 10 18 9
balance
Average Premier Account Rs. Rs. Rs.
balance for 2005-06 55,000 40,000 12,50,000

Assume Customer X and Z always maintains a balance above Rs. 50,000, whereas
Customer Y always has a balance below Rs. 50,000.
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4 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Required:
(i) Compute the 2005-06 profitability of the customers X, Y and Z Premier Account at
ABC Bank.
(ii) What evidence is there of cross-subsidisation among the three Premier Accounts?
Why might ABC Bank worry about this Cross-subsidisation, if the Premier Account
product offering is Profitable as a whole?
(iii) What changes would you recommend for ABC Bank’s Premier Account?
(b) Discuss the treatment of Idle time and Overtime premium in Cost Accounting.
(c) Discuss the essential requisites for the installation of Uniform costing system.
(11 + 4 + 3 = 18 Marks)
Answer
(a) (i) Customer Profitability Analysis
ABC Bank – Premier Account
Activity Activity Customers
based
cost
X Y Z
Rs. Rs. Rs. Rs.
Deposits/withdr
awal with teller 125 5,000 6,250 625
(40 × 125) (40 × 125) (5 × 125)
Deposits/withdr
awal with ATM 40 400 800 640
(10 × 40) (20 × 40) (16 × 40)
Deposits/withdr
awal on
prearranged 0 300 1,500
monthly basis 25 (0 × 25) (12 × 25) (60 × 25)
Bank cheques
written 400 3,600 1,200 800
(9 × 400) (3 × 400) (2 × 400)
Foreign
currency drafts 600 2,400 600 3,600
(4 × 600) (1 × 600) (6 × 600)
Inquiries about
Account 750 1,350 675
balance 75 (10 × 75) (18 × 75) (9 × 75)
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 5

Customer cost 12,150 10,500 7,840

(A)
Spread on
Average
balance 1,650 1,200 37,500
maintained 3% (3% × 55,000) (3% × 40,000) (3% × 12,50,000)
Service fee Rs. 12,000
1,000
p.m.
Customer benefit 1,650 13,200 37,500

Customers
X Y Z
Customer Profitability Rs. (10,500) Rs. 2,700 Rs. 29,660
(Benefits – Costs)

(ii) 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 Rs. 50,000 to Rs.
1,00,000.
• Charge for value added services like Foreign Currency Drafts.
• Do not allow deposits/withdrawal below Rs. 10,000 at the teller. Only ATM
machine withdrawal be allowed.
• Inquiries about account balance to be entertained only through Phone
Banking/ATM.
(b) Treatment of Idle time and Overtime Premium in Cost Accounting
• Normal idle time is treated as a part of the cost of production. Thus, in the case of
direct workers, an allowance for normal idle time is built into labour cost rates. In
case of indirect workers, normal idle time is spread over all the products or jobs
through the process of absorption of factory overheads.
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6 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

• Abnormal idle time cost is not included as a part of production cost and is shown as
a separate item in costing Profit and Loss Account.
• Management should aim at eliminating controllable idle time and on a long-term
basis reduce even the normal idle time.
• If overtime is resorted to at the desire of the customer , then overtime premium may
b charged to the job directly.
• If overtime is required to cope with general production programme or for meeting
urgent orders, the overtime premium should be treated as overhead cost of the
particular department/cost centre.
(c) Essential requisites for the Installation of Uniform Costing System
• The firm in the industry should be willing to share/furnish relevant data/information.
• A spirit of cooperation and mutual trust should prevail among the participating firms.
• Mutual exchange of ideas, methods used, and special achievements made,
research and know-how should be frequent.
• Uniformity must be established with regard to following points:
1. Size of the various units covered by uniform costing.
2. Production methods.
3. Accounting methods, principles and procedures used.
Question 2
(a) PQR Limited produces a product which has a monthly demand of 52,000 units. The
product requires a component X which is purchased at Rs. 15 per unit. For every
finished product, 2 units of Component X are required. The Ordering cost is Rs. 350
per order and the Carrying cost is 12% p.a.
Required:
(i) Calculate the economic order quantity for Component X.
(ii) If the minimum lot size to be supplied is 52,000 units, what is the extra cost, the
company has to incur?
(iii) What is the minimum carrying cost, the Company has to incur?
(b) Discuss the treatment of Under-absorbed and Over-absorbed overheads in Cost
Accounting. (8 + 6 = 14 Marks)
Answer
2AO
(a) (i) EOQ =
c×i
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 7

2 × (52,000 × 12) × 350

=
15 × 0.12

= 15,578 units of components.

(ii) Extra cost incurred by the company
Total cost (when order size is 52,000 units) = Total ordering cost + Total carrying
cost
A Q
= ×O + ×C×i
Q 2
 52,000 × 12  52,000
= × Rs. 350  + × 15 × 12 %
 52,000  2
= Rs 4,200 + Rs 46,800
= Rs 51,000
Total cost when order size is 15,578 units
 52,000 × 12  15,578
= × Rs. 350  + × 15 × 12 %
 15,578  2
= 14,020 + 14,020 = 28,040
Extra cost incurred = 51,000 – 28,040 = Rs 22,960
(iii) Minimum carrying cost, the company has to incur
Q
= ×C×i
2
15,578
= × Rs. 15 × 12%
2
= Rs 14,020
Alternative solution
(a) Assuming the annual demand of ‘x’ is 1,04,000 units (2 × 52,000 units) as per instruction
that for every finished product , 2 units of component ‘x’ are required , the calculation of
2(a)(i),(ii) and (iii) will be as follows:
2AO
(i) EOQ =
c×i
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8 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

2 × (2 × 52,000 × 12) × 350

=
15 × 0.12
= 22,030 units of component ‘x’
(ii) Extra cost incurred by the company
Total cost (when order size is 52,000 units) = Total ordering cost + Total carrying
cost
A Q
= ×O + ×C×i
Q 2
 2 × 52,000 × 12  52,000
= × Rs. 350  + × 15 × 12%
 52,000  2
= Rs. 55,200
Total cost (when order size is 20,030 units)
 2 × 52,000 × 12  22,030
= × Rs. 350 + × 15 × 12%
 22,030  2
Total cost incurred = 19,828 + 19,827 = 39,655.
Extra cost incurred = 55,200 – Rs. 39,655 = Rs. 15,545.
(iii) Minimum carrying cost, the company has to incur
Q
= ×C×i
2
22,030
= × Rs. 15 × 12%
2
= Rs. 19,827.
(b) Treatment of under-absorbed and over-absorbed overheads in Cost Accounting
Overhead expenses are usually applied to production on the basis of pre-determined
rates
Estimated / normal overheads for the period
Pre determined overhead rate =
Budgeted number of units during the period
The under/over absorption may take place due to variation in actual overhead rate due to
any of the following:
(i) The actual level of production may be different from budgeted level during the
period.
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 9

(ii) The actual overheads incurred during the period may be different from the budgeted
ones.
(iii) Both the overheads and level of activity may be different from budgeted levels
during the period.
If the amount of overheads under/over absorption is insignificant/small, it may be
transferred to Costing Profit and Loss Account.
Where the difference is large due to wrong estimation, it would be desirable to adjust the
cost of products manufactured as otherwise the cost figures would convey a misleading
impression.
However, over or under recovery of overheads due to abnormal reasons, such as
abnormal over or under capacity utilisation should be transferred to Costing Profit and
Loss Account.
Question 3
(a) RST Construction Limited commenced a contract on April 1, 2005. The total contract
was for Rs. 49,21,875. It was decided to estimate the total Profit on the contract and to
take to the Credit of Profit and Loss Account that proportion of estimated profit on cash
basis, which work completed bore to total Contract. Actual expenditure for the period
April 1, 2005 to March 31, 2006 and estimated expenditure for April 1, 2006 to
September 30, 2006 are given below:
April 1, 2005 to April 1, 2006 to
March 31, 2006 September 30, 2006
(Actuals) (Estimated)
Rs. Rs.
Materials Issued 7,76,250 12,99,375
Labour: Paid 5,17,500 6,18,750
: Prepaid 37,500
: Outstanding 12,500 5,750
Plant Purchased 4,00,000
Expenses: Paid 2,25,000 3,75,000
: Outstanding 25,000 10,000
: Prepaid 15,000
Plant returns to Store (historical cost) 1,00,000 3,00,000
(On September (On September 30,
30, 2005) 2006)
Work certified 22,50,000 Full
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10 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Work uncertified 25,000

Cash received 18,75,000
Materials at site 82,500 42,500

The plant is subject to annual depreciation @ 25% on written down value method. The
contract is likely to be completed on September 30, 2006.
Required:
(i) Prepare the contract A/c. Determine the profit on the contract for the year 2005-06
on prudent basis, which has to be credited to Profit and Loss Account.
(b) Distinguish between any two of the following:
(i) Profit Centres and Investment Centres.
(ii) Product Cost and Period Cost.
(iii) Job Costing and Batch Costing. (10 + 4 = 14 Marks)
Answer
(a) Contract Account for the year ending March 31, 2006
Rs. Rs.

To Materials issued 7,76,250 By Work-in-progress

To Labour 5,17,500 Certified 22,50,000

Add: Outstanding 12,500 Uncertified 25,000 22,75,000

Less: Prepaid 37,500 4,92,500 By Plant returned to store

To Plant 4,00,000 on 30.09.2005

To Expenses 2,25,000 (1,00,000 – 25% × ½) 87,500

Add: Outstanding 25,000 By Plant at site

Less: Prepaid 15,000 2,35,000 (3,00,000 – 25%) 2,25,000

By Materials at site 82,500

To Notional Profit c/d 7,66,250

26,70,000 26,70,000

To Profit and Loss A/c By Notional Profit b/d 7,66,250

22,50,000 18,75,000 3,89,000
10,21,125 × ×
49,21,875 22,50,000

To WIP (Reserve) 3,77,250

7,66,250 7,66,250
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 11

Contract Account (for entire life period April 1, 2005 to September 30, 2006)
Rs. Rs.

To Materials issued By Contractee A/c 49,21,875

(7,76,250 + 12,99,375) 20,75,625 By Materials at site 42,500

To Labour (5,17,500 37,500 + By Plant returned on

12,500 + 6,18,750 + 37,500 – September 30, 2005
12,500 + 5,750) 11,42,000 (1,00,000 – 12,500) 87,500
To Plant 4,00,000 By Plant returned on
To Expenses 6,10,000 September 30, 2006 3,00,000

(2,25,000 + 25,000 – 15,000 + Depreciation for 2005- 75,000

3,75,000 – 25,000 + 15,000 + 2006 @ 25% 2,25,000
10,000)

To Estimated profit on contract 10,21,125 Depreciation 2006-

2007(1/2) 28,125 1,96,875

52,48,750 52,48,750

(b) (i) Profit Centres and investment centres

A profit centre is a centre where the manager has the responsibility of generating
and maximising profits. In such centres, the manager is responsible for revenue and
cost.
Investment centres are those centres which are concerned with earning an
adequate ROI. In such centres, the manager is responsible for investment,
revenue and cost.
(ii) Product costs and period costs
Product costs are costs which are associated with purchase and sale of goods.
These are costs are used for inventory valuation and incurred up to factory stage.
Period costs are costs, which are not assigned to the products but are charged as
expenses against revenues of the period in which they are incurred e.g. Selling,
General Administrative and Distribution overheads.
(iii) Job Costing and Batch costing
In case of Job costing, the cost of each job is ascertained separately. Such a
method is suitable in case of printing press, motor workshop, etc.
Batch costing is the extension of Job costing. A batch may represent a number of
small orders passed through the factory in batches. Each batch is treated as a unit
of cost and thus separately costed. Here cost per unit is determined by dividing the
cost of batch by the number of units produced in the batch.
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12 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Question 4
(a) Discuss the reconciliation of Profit as per Cost Accounts and Financial Accounts.
(b) XYZ Auto Ltd. is in the business of selling cars. It also sells insurance and finance as
part of its overall business strategy. The following information is available for the
company.
Physical Units Sales Value
Sales of Cars 10,000 Cars Rs. 30,000 lacs
Sales of Insurance 6,000 Policies Rs. 1,500 lacs
Sales of Finance 8,000 Loans Rs. 19,200 lacs

The Revenue earnings from each line of business before expenses are as follows:
Sale of Cars 3% of Sales value
Sale of Insurance 20% of Sales value
Sale of Finance 2% of Sales value

The expenses of the company are as follows:

Salesman salaries Rs. 200 lacs
Rent Rs. 100 lacs
Electricity Rs. 100 lacs
Advertising Rs. 200 lacs
Documentation cost per insurance policy Rs. 100
Documentation cost for each loan Rs. 200
Direct sales expenses per car Rs. 5,000

Indirect costs have to be allocated in the ratio of physical units sold.

Required:
(i) Make a cost sheet for each product allocating the direct and indirect costs and also
showing the product wise profit and total profit.
(ii) Calculate the percentage of profit to revenue earned from each line of business.
(6 + 8 = 14 Marks)
Answer
(a) Reconciliation of Profits as per Cost Accounts and Financial Accounts
When cost accounts and financial accounts are kept separately, it is imperative that
these should be reconciled.
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 13

Items included in the financial accounts but not in Cost Accounts

• Income tax
• Profit and loss appropriations
• Dividend paid
• Amounts written off – goodwill, preliminary expenses
Matters of Pure Finance
• Interest received on bank deposits
• Dividends received
• Profits/loss made on sale of fixed assets
• Expenses of the Company’s Share transfer office
Items included in Cost Accounts only
• Opportunity cost of faculties used
• Under/Over absorbed overheads
• Difference due to different basis of inventory valuation.
(b) Product Cost Sheet
Total Cars Insurance Finance
Sales units 10,000 6,000 8,000
Sales value 30,000 1,500 19,200
(Rs in lakhs)
Revenue earnings 3% 20% 2%
Revenue earned 1584 900 300 384
(Rs in lakhs)
Direct costs 522 500 6 16
(Rs in lakhs) (5000 × 10000) (100 × 6000) (200 × 8000)
Indirect costs
(allocated in the ratio
of physical units sold)
0.4167:0.25:0.3333
Salesman salaries
(Rs in lakhs) 200
Rent (Rs in lakhs) 100
Electricity (Rs in lakhs) 100
Advertising (Rs in
lakhs) 200
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14 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

600 250 150 200

Total costs 1122 750 156 216
Profits
(Revenue – Total cost) 462 150 144 168
% of Profits to revenue
earned 29.17% 16.67% 48% 43.75%

Question 5
(a) A Company produces a component, which passes through two processes. During the
month of April, 2006, materials for 40,000 components were put into Process I of which
30,000 were completed and transferred to Process II. Those not transferred to Process II
were 100% complete as to materials cost and 50% complete as to labour and overheads
cost. The Process I costs incurred were as follows:

Direct Materials Rs.15,000

Direct Wages Rs.18,000
Factory Overheads Rs.12,000
Of those transferred to Process II, 28,000 units were completed and transferred to
finished goods stores. There was a normal loss with no salvage value of 200 units in
Process II. There were 1,800 units, remained unfinished in the process with 100%
complete as to materials and 25% complete as regard to wages and overheads.
No further process material costs occur after introduction at the first process until the end
of the second process, when protective packing is applied to the completed components.
The process and packing costs incurred at the end of the Process II were:

Packing Materials Rs.4,000

Direct Wages Rs.3,500
Factory Overheads Rs.4,500

Required:
(i) Prepare Statement of Equivalent Production, Cost per unit and Process I A/c.
(ii) Prepare statement of Equivalent Production, Cost per unit and Process II A/c.
(b) Discuss the accounting of Selling and Distribution overheads. (10 + 4 = 14 Marks)
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 15

Answer
(a) Process I
Statement of Equivalent Production and Cost
Material Labour and Overheads Total
Units completed 30,000 30,000
Closing Inventory 10,000 5,000
Equivalent Production 40,000 35,000
Rs Rs Rs
Current Process cost 15,000 30,000 45,000
Cost/unit 0.375 0.8571
Closing inventory cost 3,750 4,286 8,036
Material transferred to 36,964
Process II

Process I Account
Units Rs. Units Rs.
Direct material 40,000 15,000 Process II A/c 30,000 36,964
Direct wages 18,000 Work-in-progress inventory 10,000 8,036
Factory 12,000
overheads
40,000 45,000 40,000 45,000

Process II
Statement of Equivalent Production and Cost
Material Labour and Overheads Total
Units completed 28,000 28,000
Closing Inventory 1,800 450
Equivalent Production 29,800 28,450
Process cost 36,964 8,000 44,964
Cost/unit 1.24 0.2812
Closing inventory 2,232 127 2,359
42,605
Packing material cost 4,000
Rs. 46,605
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16 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Process II Account
Units Rs. Units Rs.
To Material 30,000 36,964 By Finished goods 28,000 46,605
transferred from stores A/c
Process I
To Packing Material 4,000 By WIP stock 1,800 2,359
To Direct wages 3,500 By Normal loss 200
To Factory 4,500
overheads ______ ______
30,000 48,964 30,000 48,964
(b) Accounting of Selling and Distribution Overheads
It is difficult to determine an entirely satisfactory basis for computing the overhead rate
for absorbing selling and distribution overheads. The basis usually adopted is:
• Sales value of goods
• Cost of goods sold
• Gross profit on sales
• Number of orders or units sold
Expenses Basis for allocation
Salaries in Sales Department. Estimated time devoted to the sale of various products.
Advertisements Actual amount incurred for each product
Show room expenses Average space occupied by each product
Rent of finished goods, go downs Average quantities delivered during a period
and expenses on own delivery
vans.

Question 6
(a) A company is considering a proposal of installing a drying equipment. The equipment
would involve a cash outlay of Rs. 6,00,000 and net working capital of Rs. 80,000. The
expected life of the project is 5 years without any salvage value. Assume that the
company is allowed to charge depreciation on straight-line basis for Income-tax purpose.
The estimated before-tax cash inflows are given below:
Before-tax Cash inflows (Rs. ‘000)
Year 1 2 3 4 5
240 275 210 180 160
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 17

The applicable Income-tax rate to the company is 35%. If the company’s opportunity
cost of capital is 12%, calculate the equipment’s discounted payback period, payback
period, net present value and internal rate of return.
The PV factors at 12%, 14% and 15% are:
Year 1 2 3 4 5
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194
PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972

(b) Discuss the changing scenario of Financial Management in India. (10 + 6 = 16 Marks)
Answer
(a) (i) Equipment’s initial cost = Rs. 6,00,000 + 80,000 = Rs. 6,80,000
(ii) Annual straight line depreciation = Rs. 6,00,000/5 = Rs. 1,20,000
(iii) Net cash flows can be calculated as follows:
= Before tax Cash Flows × (1 – Tc) + Tc × Depreciation
(Rs. ‘000)
Cash flows
Year 0 1 2 3 4 5
Initial cost (680)
Before tax cash flows 240 275 210 180 160
Tax @ 35% 84 96.25 73.5 63 56
After tax cash flows 156 178.75 136.5 117 104
Depreciation tax shield
(Depreciation × Tc) 42 42 42 42 42
Working capital released 80
Net Cash Flow 198 220.75 178.5 159 226
PVF at 12% 1.00 0. 8929 0.7972 0.7118 0.6355 0.5674
PV (680) 176.79 175.98 127.06 101.04 128.24
NPV 29.12

0 1 2 3 4 5
PVF at 15% 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV (680) 172.18 166.91 117.36 90.92 112.37
NPV (20.26)

Internal Rate of Return

29.12
IRR = 12% + × 3%
49.38
= 13.77%
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18 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Discounted Payback Period

Discounted Cash flows at K = 12% considered
99.13
= 176.79 + 175.98 + 127.06 + 101.04 + 12 ×
128.24
= 4 years and 9.28 months
Payback Period (Net Cash flows are considered)
82.75
= 198 + 220.75 + 178.5 + 12 ×
159
= 3 years and 6.25 months

(b) Changing Scenario of Financial Management in India

Modern Financial Management has come a long way from the traditional corporate
finance. As the economy is opening up and global resources are being tapped, the
opportunities available to finance managers virtually have no limits. The finance
manager is now responsible for shaping the fortunes of the enterprise, and is involved in
the most vital decision of the allocation of capital.
Due to the changes in the global environment the finance manager needs to have a
broader and far-sighted outlook, and must realize that his actions would have far-
reaching consequences for the firm because they influence the size, profitability, growth,
risk and survival of the firm, and as a consequence, affect the overall value of the firm.
Some of the important changes in the environment are:
• Interest rates have been freed from regulation.
• The rupee has become fully convertible on current account.
• Optimum debt-equity mix is possible. The firms have to take advantage of financial
leverage to increase shareholders’ wealth.
• Free pricing and book building for IPOs, seasoned equity offerings.
• Share buybacks and reverse book building.
• Raising resources globally through ADRs/GDRs.
• Treasury management.
• Risk Management due to introduction of options and futures trading.
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 19

Question 7
JKL Limited has the following Balance Sheets as on March 31, 2006 and March 31, 2005:
Balance Sheet
Rs. in lakhs
March 31, 2006 March 31, 2005
Sources of Funds
Shareholders Funds 2,377 1,472
Loan Funds 3,570 3,083
5,947 4,555
Applications of Funds
Fixed Assets 3,466 2,900
Cash and bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407
Other Current Assets 1,567 1,404
Less: Current Liabilities (3,937) (3,794)
5,947 4,555

The Income Statement of the JKL Ltd. for the year ended is as follows:
Rs. in lakhs
March 31, 2006 March 31, 2005
Sales 22,165 13,882
Less: Cost of Goods Sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative Expenses 1,135 752
Earnings before Interest and Tax (EBIT) 170 586
Interest Expense 113 105
Profit before Tax 57 481
Tax 23 192
Profit after Tax (PAT) 34 289

Required:
(i) Calculate for the year 2005-06:
(a) Inventory turnover ratio
(b) Financial Leverage
(c) Return on Investment (ROI)
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20 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

(d) Return on Equity (ROE)

(e) Average Collection period.
(ii) Give a brief comment on the Financial Position of JKL Limited. (12 Marks)

Answer
Ratios for the year 2005-2006
(i) (a) Inventory turnover ratio
COGS
=
Average Inventory
20,860
=
(2,867 + 2,407)
2
= 7.91
(b) Financial leverage 2005-06 2004-05

EBIT 170 586

= = =
EBIT − I 57 481
= 2.98 = 1.22

(c) ROI
NOPAT Sales
= ×
Sales Average Capital employed
57 × (1 − .4) 22,165
= ×
22,165 (5,947 + 4,555)
2
34.2 22,165
= ×
22,165 5,251
= 0.65%
(d) ROE
PAT
=
Average shareholders' funds
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 21

34
=
(2,377 + 1,472)
2
34
=
1,924.5
= 1.77%
(e) Average Collection Period
22,165
Average Sales per day = = Rs. 60.73 lakhs
365
Average Debtors
Average collection period =
Average sales per day
(1,495 + 1,168)
= 2
60.73
1,331.5
=
60.73
= 22 days
(ii) Brief Comment on the financial position of JKL Ltd.
The profitability of operations of the company are showing sharp decline due to increase
in operating expenses. The financial and operating leverages are becoming adverse.
The liquidity of the company is under great stress.
Question 8
(a) Discuss the major considerations in Capital Structure Planning.
(b) A Company issues Rs. 10,00,000 12% debentures of Rs. 100 each. The debentures are
redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax
bracket.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
(a) Par
(b) 10% Discount
(c) 10% Premium.
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
(6 + 6 = 12 Marks)
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22 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Answer
(a) Major Considerations in Capital Structure Planning
There are three major considerations, i.e. risk, cost of capital and control, which help the
finance manager in determining the proportion in which he can raise funds from various
sources.
Although, three factors, i.e., risk, cost and control determine the capital structure of a
particular business undertaking at a given point of time. The finance manager
attempts to design the capital structure in such a manner that his risk and costs are the
least and the control of the existing management is diluted to the least extent. However,
there are also subsidiary factors like marketability of the issue, maneuverability and
flexibility of the capital structure and timing of raising the funds which affect the capital
structure planning. Structuring capital is a shrewd financial management decision and is
something which makes or mars the fortunes of the company.
As discussed earlier, there are three major considerations i.e. risk, cost of capital and
control, which help the finance manager in determining the proportion in which he can
raise funds from various sources. Risk is of cash insolvency and of variation in the
expected earnings available to the equity shareholders. Since a business should be at
least capable of earning enough revenue to meet its cost of capital and finance its
growth. Hence, along with risk as a factor, the finance manager has to consider the
cost aspect carefully while determining the capital structure.
The other considerations which the finance manager has to keep in mind while planning
for capital structure are corporate taxation, trading on equity, Government policies on
interest rates and lending priority sectors, legal requirements, marketability,
maneuverability, flexibility, timing, dilution in EPS, BVPS and control, size of company,
purpose of financing, period of finance, nature of enterprise, requirement of investors and
provision for future.
(RV − NP)
I (1 − Tc ) +
(b) K d = N
 RV + NP 
 
 2 
Where,
I = Annual Interest Payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
T c = Income tax rate
N = Life of debentures
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 23

(i) (a) Cost of debentures issued at par

(10,00,000 − 10,00,000)
1,20,000 × (1 − 0.35) +
= 7
 10,00,000 + 10,00,000 
 
 2 
78,000
= = 7.8%
10,00,000
(b) Cost of debentures issued at 10% discount

(10,00,000 − 9,00,000)
1,20,000 × (1 − 0.35) +
= 7
 10,00,000 + 9,00,000 
 
 2 
78,000 + 14,286
= = 9.71%
9,50,000
(c) Cost of debentures issued at 10% premium

(10,00,000 − 11,00,000)
1,20,000 × (1 − 0.35) +
Kd = 7
 10,00,000 + 11,00,000 
 
 2 
78,000 − 14,286
= = 6.07%
10,50,000
(ii) Cost of debentures, if brokerage is paid at 2% and debentures are issued at
par
(10,00,000 − 9,80,000)
1,20,000 × (1 − 0.35) +
Kd = 7
 (10,00,000 − 20,000) + 10,00,000 
 
 2 
80,857
= = 8.17%
9,90,000
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24 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Question 9
(a) A company has sales of Rs. 25,00,000. Average collection period is 50 days, bad debt
losses are 5% of sales and collection expenses are Rs. 25,000. The cost of funds is
15%. The company has two alternative collection programmes:
Programme I Programme II
Average Collection Period reduced to 40 days 30 days
Bad debt losses reduced to 4% of sales 3% of sales
Collection Expenses Rs. 50,000 Rs. 80,000

Evaluate which Programme is viable.

(b) Write short notes on any two of the following:
(i) Debt Securitisation
(ii) American Depository Receipts
(iii) Bridge Finance. (6 + 6 = 12 Marks)
Answer
(a) Evaluation of Alternative Collection Programmes
Present 1st 2nd
Programme Programme Programme
Rs. Rs. Rs.
Sales revenues 25,00,000 25,00,000 25,00,000
Average collection period (days) 50 40 30
Receivables (Rs.) 3,42,466 2,73,973 2,05,479
 50 
 25,00,000 × 
 365 

Reduction in receivables from

present level (Rs.) 68,493 1,36,987
Savings in interest @ 15% p.a. (A) 10,274 20,548
% of Bad debt loss 5% 4% 3%
Amount (Rs.) 1,25,000 1,00,000 75,000
Reduction in bad debts from
present level (B) 25,000 50,000
Incremental benefits from present
level (C) = (A) + (B) 35,274 70,548
Collection expenses (Rs.) 25,000 50,000 80,000
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PAPER 4 : COST ACCOUNTING AND FINANCIAL MANAGEMENT 25

Incremental collection expenses

from present level (D) 25,000 55,000
Increment net benefit (C – D) 10,274 15,548

Conclusion: From the analysis it is apparent that Programme I has a benefit of Rs.
10,274 and Programme II has a benefit of Rs. 15,548 over present level. Whereas
Programme II has a benefit of Rs. 5,274 more than Programme I. Thus, benefits accrue
at a diminishing rate and hence Programme II is more viable.
(b) (i) Debt Securitisation
It is a method of recycling of funds. It is especially beneficial to financial
intermediaries to support the lending volumes. Assets generating steady cash flows
are packaged together and against this asset pool market securities can be issued.
The basic debt securitization process can be classified in the following three
functions:
• The origination function
• The pooling function
• The securitisation function
The process of securitization is generally without recourse i.e. investors bear the
credit risk and issuer is under an obligation to pay to investors only if the cash flows
are received by him from the collateral. The benefits to the originator are that assets
are shifted off the balance sheet, thus giving the originator recourse to off-balance
sheet funding.
(ii) American Depository Receipts
Depository Receipts issued by Indian company in the USA are known as American
Depository Receipts (ADRs). Such receipts have to be issued in accordance with
the provisions stipulated by the Securities and Exchange Commission (SEC), USA,
which are very stringent.
These are securities offered by non-US companies who want to list on any of the
US exchange. Each ADR represents a certain number of a company's regular
shares. ADRs allow US investors to buy shares of these companies without the
costs of investing directly in a foreign stock exchange. ADRs are issued by an
approved New York bank or trust company against the deposit of the original
shares. These are deposited in a custodial account in the US. Such receipts have to
be issued in accordance with the provisions stipulated by the SEC, USA which are
very stringent.
ADRs can be traded either by trading existing ADRs or purchasing the shares in the
issuer's home market and having new ADRs created, based upon availability and
market conditions. When trading in existing ADRs, the trade is executed on the
secondary market on the New York Stock Exchange (NYSE) through Depository
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26 PROFESSIONAL EDUCATION (EXAMINATION II) : MAY, 2006

Trust Company (DTC) without involvement from foreign brokers or custodians. The
process of buying new, issued ADRs goes through US brokers, Helsinki Exchanges
and DTC as well as Deutsche Bank. When transactions are made, the ADRs
change hands, not the certificates. This eliminates the actual transfer of stock
certificates between the US and foreign countries.
(iii) Bridge Finance
Bridge finance refers to loans taken by a company normally from commercial banks
for a short period, pending disbursement of loans sanctioned by financial
institutions. Normally, it takes time for financial institutions to disburse loans to
companies. However, once the loans are approved by the term lending institutions,
companies, in order not to lose further time in starting their projects, arrange short
term loans from commercial banks. Bridge loans are also provided by financial
institutions pending the signing of regular term loan agreement, which may be
delayed due to non-compliance of conditions stipulated by the institutions while
sanctioning the loan. The bridge loans are repaid/ adjusted out of the term loans as
and when disbursed by the concerned institutions. Bridge loans are normally
secured by hypothecating movable assets, personal guarantees and demand
promissory notes. Generally, the rate of interest on bridge finance is higher as
compared to term loans.