Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

Paper – 8: Cost Accounting & Financial Management

Full Marks: 100 Time Allowed: 3 Hours

This paper contains 3 questions. All questions are compulsory, subject to instruction provided
against each question. All workings must form part of your answer.
Assumptions, if any, must be clearly indicated.

1. Answer all questions: [2×10=20]

(a) If the minimum stock level and average stock level of raw material X are 6,000 and 11,000
units respectively, find out its re-order quantity.
Answer:
Average Stock Level = Minimum stock level + ½ of Re-order quantity
11,000 units = 6,000 units + ½ of Re-order quantity
½ of Re-order quantity = 5,000 units
Therefore, Re-order quantity = 10,000 units

(b) Two workmen, X and Y, produce the same product using the material. X is paid bonus
according to Halsey plan, while Y is paid bonus according to Rowan plan. The time allowed
to manufacture the product is 100 hours. X has taken 60 hours and Y has taken 80 hours to
complete the product. The normal hour rate of wages of workman X is `20 per hour. The total
earnings of both the workers are same. Calculate the normal hour arte of wages of workman
Y.
Answer:
Wages of X under Halsey Plan = Hours worked × Rate per hour + (50% × time saved × rate per
hour)
= 60 hors × `20 + [50% × (100-60) × `20]
= `1,600
Let normal hourly rate of wages of workman Y = `a per hr
Wages of Y under Rowan Plan = Hours worked × Rate per hou + (Time taken / Time allowed ×
time saved × rate per hrs)
= 80hrs × `a + (80 /100 ×20 × `a)
= `96a
Earnings of Y = Earnings of X
`96a = `1,600
Therefore, a = `16.67 per hour
Thus normal hourly rate of wages of workman Y = `16.67 per hr.

(c) State the cost units applicable to the following industries:

Cement, Goods Transport, Education, BPO
Answer:
Cost units for the following industries
Industry Cost unit
Cement Tonnes Any unit of weight is acceptable (like quintals,
kg, etc)
Goods Tonnes- Any unit that is a product of weight and
Transport Kilometer length(distance) (like ton-miles, quintal-miles,
etc)
Education Student year Any unit that is a product of no. of students and
the duration -days/months or years

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

BPO Accounts Any unit in terms of number of transactions, or a

handled product of number and value of transactions

(d) List the objective of CAS-4.

Answer:
Objectives of CAS-4: Cost Accounting Standard on Cost of Production for Captive
Consumption are:
 The purpose of this standard is to bring uniformity in the principles and methods used for
determining the cost of production of excisable goods used for captive consumption.
 The cost statement prepared based on standard will be used for determination of
assessable value of excisable goods used for captive consumption.
 The standard and its disclosure requirement will provide better transparency in the
valuation of excisable goods used for captive consumption.

(e) Compute the Inventory turnover ratio from the following information:
Opening Stock - ` 50,000; Closing Stock - ` 80,000; Material Consumed - ` 3,90,000
Answer:
Cost of stock of raw mterialconsumed ` 3,60,000
Inventory turnover ratio =   5.54 times
Average stock of raw material `65,000
(Refer to working note)
365 days 365 days
Average number of days   =65.88 days = 66 days
Inventoryturnover ration 5.54
Working note:
`
Opening stock of raw material = 50,000
Add: Material purchases during the year = 3,90,000
Less: Closing stock of raw material = 80,000
Cost of stock of raw material consumed 3,60,000

1  
 
Average stock of raw material = Opening stock of  Closing stock of
2  raw material 
 raw material 
1
 {` 50,000+`80,000} = `65,000
2

(f) Write the conditions when supplementary rates are used.

Answer:
This is the most ideal way to treat the under or over absorbed overheads. The supplementary
rate is calculated either as rate per hour or as a percentage of overheads already
absorbed. This rate is then applied to the cost of sales, closing stock of finished goods and
the closing stock of work-in-progress. The method is used when the amount is large. Under
this method, the adjustment is made in the current year and the next year. Hence, neither
the profit of one particular year is heavily affected nor does it clash with the going concern
principle.

(g) The average daily sales of a company are `5 lac. The company normally keeps cash
balance of `80000.If the weighted operating cycle of the company is 45 days, what will be
the working capital.
Answer:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 2
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

The working capital requirement is for 45 days of the weighted operating cycle plus normal
cash balance
= Sales per day * weighted operating cycle+ cash balance requirement
= ` 5 lac *45 + `0.80 lac=` 225.80 lac.

(h) Airtel Communications is trying to estimate the first – year operating cash flow (at t=1) for a
proposed project. The finance staff has collected the following information:
Projected sales =`1 crore
Operating costs =`70 lakhs (not including depreciation)
Depreciation =`20 lakhs
Interest expense = `20 lakhs
The company faces a 40% tax rate. What is the project‟s operating cash flow for the year
(t=1)?
Answer:
Operating cash Flow: (t=1)
Sales revenue 100,00,000
Operating costs 70,00,000
Depreciation 20,00,000
Operating income before taxes 10,00,000
Taxes (40%) 4,00,000
Operating income after taxes 6,00,000
Add back depreciation 20,00,000
Operating cash flow 26,00,000

(i) GEMINI LTD. has total assets of `60 crore and a Debt/equity ratio of 0.5. Its sales are `27 crore
and it has total fixed cost of `7 crore. If the company‟s EBIT is `6 crore, its tax rate is 40% and
the interest rate on debt is 12%, the ROE of GEMINI LTD. would be how much?
Answer:
Total Equity+ Total Debt =`60 crore
Total equity= (60/1.5) =`40 crore
Total Debt= (60-40) =`20 crore
Net income= [(EBIT)-I] × (1-t) = (6-2.40) (1-.40)
=3.60×0.6
= `2.16 crore.
ROE = (2.16/40) ×100 = 5.40%

(j) What will be the effect on NPV of a one year project if fixed costs are increased from `200 to
`300. When the firm is profit making, pays tax @ 35% and has 12% cost of capital?
Answer:
NPV decrease by `58.04
Increase in Fixed Cost =`100, increase, in each outflow after tax =`65, NPV =65/1.12 =
`58.04 decrease in NPV

2. (Answer any three questions) [3×16=48]

(a)
(i) PC Company purchases a specialized item and the quantity to be purchased is 2,500 pieces
at a price of `200 per piece. Ordering cost per order is `200 and carrying cost is 2% per year
of the inventory cost. Normal lead time is 20 days and safety stock is nil. Assume yearly
working days as 250.
I. Calculate the Economic Ordering Quantity.
II. Re-order Inventory Level.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 3
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

III. If a 2% discount on price is given for order quantity 1,250 pieces or more in a lot, should
the company accept the offer of discount? [2+2+4]
Answer:
2  2,500 200
I. EOQ 
2%  200
10,00,000

4
= 500 units
2,500
II. Reorder level = Normal lead time x normal usage  20   200
250

III. Evaluation of offer for quantity discount

Since EOQ is 500 units, the minimum quantity to get a discount is 1,250 is used for
evaluation. Moreover, in this analysis, if the ordering cost is reduced to one order of 2,500
units, carrying cost will be much more and hence evaluation of this order size is not
useful.
Based on EOQ Discount offer
Annual Demand = d 2,500 2,500
Order size (q units) 500 1,250
No. of orders 5 2
Ordering cost at 200 `/ order 1,000 400
Purchase price `/ unit =p 200 196
Purchase cost = d × o 5,00,000 4,90,000
Carrying cost = 2% × (q/ 2)× p 1,000 2,450
Total Cost = Purchase cost + ordering cost + 5,02,000 4,92,850
carrying costs

The discount offer is more profitable

(ii) The following details are available in respect of a Consignment of 1,250 kgs. of materials „X‟:
 Invoice price-`20 per kg.
 Excise duty-25% of invoice price.
 Sales Tax-8% on Invoice price including Excise Duty
 Trade discount-10% on Invoice price
 Insurance-1% of aggregate net price
 Delivery charges-`250
 Cost of containers @`60 per container for 50 kg. of material. Rebate is allowed @ `40 per
container if returned within six weeks, which is a normal feature.
 One container load of material was rejected on inspection and not accepted.
 Cost of unloading and handling @ 0.25% of the cost of materials ultimately accepted.
On the basis of above you are required to find out the landed cost per kg. of material „X‟.
[8]
Answer:
Computation of landed cost of Material „X‟
Total cost for 1,250 kg in ` Cost per kg. in `
Invoice price 25,000.00 20.00
Add: Excise Duty (25,000×25%) 6,250.00 5.00
31,250.00 25.00
Add: Sales Tax (31,250×8%) 2,500.00 2.00
33,750.00 27.00

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 4
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

Less: Trade Discount @ 10% on invoice 2,500.00 2.00

price
31,250.00 25.00
Add: Insurance @ 1% on above 312.50 0.25
31,562.50 25.25
Add: Delivery Charges 250.00 0.20
Cost of container @ `60 for 50Kg. 1,500.00 1.20
33,312.50 26.65
Less: Cost of material returned* 1,332.50 --------
31,980.00 26.65#
Add: Cost of handling @0.25% 79.95 0.07#
32,059.95 26.72#
Less: Credit for container returnable @ 960.00 0.80#
Total landed cost 31,099.95 25.92#

*1Container of 50kg. rejected. (33,312÷1,250)×50 =`1,332.50

@Total consignment 1,250 kg. less 50 kg. (1 container returned) =1,200 kg.
Credit (`40÷50)×1,200kg =`960
#Per unit cost is determined by dividing 1,200kg. and not by 1,250 kg. as 1 container of
50kg. was returned.

(b)
(i) A company produces a single product in three sizes X, Y and Z. Prepare a statement showing
the selling and distribution expenses apportioned over these three sizes, on the bases
indicated, and express the total apportioned to each size as:
I. cost per unit sold, and
II. a percentage of sales turnover.
The expenses and bases of apportionment are:
Expenses Amount (`) Basis of apportionment
Sales salaries 20,000 Direct charge
Sales commission 60,000 Sales turnover
Sales office expenses 20,960 Number of orders
Advertising : Specific 2,20,000 Direct charge
General 50,000 Sales turnover
Packing 30,000 Size of product
Delivery expenses 40,000 Size of product
Warehouse expenses 10,000 Size of product
Credit Collection expenses 12,960 Number of orders

Data relating to the three sizes are as follows:

Total X Y Z
No. of salesmen, all paid same salary 20 8 10 2
Number of orders 1,600 700 800 100
% of specific advertising 100 30 40 30
Number of units sold 8,240 3,440 3,200 1,600
Sales turnover `20,00,000 5,80,000 8,00,000 6,20,000
Capacity in cu ft per unit 5 8 17
[5+5]
Answer:
Comparative Statement of Costs
Items of Expenses Basis of apportionment Total Production sizes

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 5
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

X Y Z
` ` `
Sales salaries No. of salesmen 20,000 8,000 10,000 2,000
Sales commission 3% of sales 60,000 17,400 24,000 18,600
Sales office expenses Number of orders 20,960 9,170 10,480 1,310
Advertising:
Specific Direct (3:4: 3) 2,20,000 66,000 88,000 66,000
General Sales value 50,000 14,500 20,000 15,500
Packing Cubic capacity of 30,000 7,371 10,971 11,658
units sold (17,200 :
25,600 : 27,200)
Delivery expenses " 40,000 9,829 14,628 15,543
Warehouse expenses " 10,000 2,457 3,657 3,886
Credit Collection No of orders 12,960 5,670 6,480 810
Total 4,63,920 1,40,397 1,88,216 1,35,307

Total X Y Z
Cost as apportioned (`) 4,63,920 1,40,397 1,88,216 1,35,307
Units sold 8,240 3,440 3,200 1,600
I.  Cost per unit sold (`) 56.3 40.8 58.8 84.6
Sales value ('000s) (`) 2,000 580 800 620
II. Cost of percentage of sales value 23.2% 24.2% 23.5% 21.8%

Notes:

 Total sales commission: `60,000

Total sales: `20,00,000
60,000
% of sales =  100 = 3%
20,00,000

 Cubic capacity of units sold:

X : 3,440 × 5 = 17,200
Y : 3,200 × 8 = 25,600
Z : 1,600 × 17 = 27,200
70,000

(ii) Distinguish between “Incentives to indirect workers” and “Indirect incentives to direct
workers”. [6]
Answer:
Incentive schemes for workers are made to motivate workers for increasing output and
quality production, saving time, reducing labour turnover and building sense of belonging.
Obviously, these schemes focus on performance of workers. While performance of direct
workers is easy to measure, that of auxiliary or indirect staff is not. Accordingly, incentive
schemes differ between direct workers and indirect workers.
Incentive schemes for indirect workers include:
 Bonus to foremen and supervisors based on output, saving in time, quality improvement,
reduction in scrap, etc.
 Bonus to repairs and maintenance staff for routine and repetitive jobs, based on
reduction in number of complaints or breakdown.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 6
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

 Bonus to stores staff, based on the value of materials handled or the number of
requisitions per period.
Indirect Incentives to direct workers include:
 Monetary schemes like profit sharing, co-partnership, co-ownership;
 Non-monetary schemes like education and training facilities, health and safety devices,
facilities for sports and housing, subsidized canteen and purchase coupon, pension,
creation of sick and benevolent funds, arrangement of tour programs etc.

(c)
(i) The production department of factory furnishes the following information for the month of
March 2014:
Materials used `54,000
Direct wages `45,000
Overheads `36,000
Labour hours worked 36,000
Hours of machine operation 30,000
For an order executed by the department during a particular period, the relevant
information was as under:
Materials used `6,00,000
Direct Wages `3,20,000
Labour hours worked 3,200
Machine hours worked 2,400
Calculate the overhead charges chargeable to the job by the following methods:
I. Direct materials cost percentage rate
II. Labour hour rate; and
III. Machine hour rate [6]
Answer:
I. Direct material cost percentage rate= (overheads/ direct material) X 100
=(`36,000/54,000) X100 =66.67%
Materials used on the order `6,00,000, so overhead will be @ 66.67% `4,00,000.
II. Labour hour rate=Overhead/Direct labour hours
=36,000/36,000 =Re.1
Overheads will be @ Re.1=3,200 hrs X 1=`3,200
III. Machine hour rate=Overhead/Machine hours
=`36,000/30,000 =`1.2
Overheads will be `1.2 per hour X 2,400 hours=`2,280

(ii) An engineering company produces a standard metallic product. There are three processes -
Foundry, Machining and Assembly. 130 tonnes of raw material at `500 per tonne were issued to
Foundry. The yield at the Foundry is 90% (both standard and actual). The normal and actual yield
at the Machining Process is 95%. There is no loss in the Assembly Process. You may consider the
losses as occurring at the end of the respective processes. The other details are as follows:

Process Direct Labour Overheads

Foundry 200 hours at `100 per hour `150 per labour hour
Machining 100 hours at `50 per hour ` 200 per labour hour
Assembly 100 hours at `150 per hour `100 per labour hour
Prepare a Cost Sheet showing the element wise cost of output and cost per tonne of output.
[8]
Answer:
Raw material input 130 117 111.15

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 7
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

Loss 13 5.85 0
Output 117 111.15 111.15
Material Cost 500/tonne of input to foundry

Elements of Cost Cost of total output Cost/tone of output

Raw Material 65,000 584.80
130 x 500
Labour 20,000 179.94
Foundry: 200 hrs x 100 `/hr
M/cng: 100 hrs @ 50/hr 5,000 44.98
Assembly: 100 hrs @ 150/hr 15,000 134.95
Subtotal - Labour 40,000 359.87
Overheads:
Foundry 200 hrs @ 150/hr 30,000 269.91
M/ cng: 100 hrs @ 200/hr 20,000 179.94
Assembly : 100 hrs @100/hr 10,000 89.97
Subtotal – Overheads 60,000 539.81
Total Cost 1,65,000 1,484.48

(iii) State the treatment of Market Research the in the Cost Accounts. [2]
Answer:
Treatment of Market Research expenses in Cost Records:
Many times organizations appoint professional bodies or conduct by themselves a study of
potential market for their products. This study is aimed at finding the customer's needs, their
habits, changing market for the products, technological changes in the product,
competition etc., such expenses are to be treated as a part of Sales and Distributive Costs.

(d)
(i) The details of present output of a manufacturing department are given below:
Average output per week from 160 employees 48,000 units
Saleable value of output `6,00,000
Contribution made by output towards fixed expenses and profit `2,40,000
The Board of Directors plans to introduce more mechanization into the department at a
capital cost of `1,60,000. The effect of this will be to reduce the number of employees to 120,
and increasing the output per individual employees by 60%.
To provide the necessary incentive to achieve the increased output, the Board intends to
offer a 1% increase on the piece work rate of `1 per unit for every 2% increase in average
individual output achieved.
To sell the increased output, it will be necessary to decrease the selling price by 2%.
Calculate the extra weekly contribution resulting from the proposed change and evaluate
for the Board‟s information, the desirability of introducing the change. [10]
Answer:
48,000units
Average output per employee   300 units
160 employees
Planned output per employee = 300 units × 160% = 480 units
Total output per week as per plan = 480 units × 120 employee = 57,600 units
Existing piece work rate = `1 per unit
60%
New piece work rate = `1  `1 = `1.30
2

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 8
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

`6,00,000
Existing selling piece per unit =   `12.50
48,000units
New selling price per unit = `12.50 × 98% = `12.25
Existing total variable cost = Sales –Contribution
= `6,00,000 - `2,40,000
= `3,60,000
Existing material cost = Total variable cost – Labour cost
= `3,60,000 – (`1 per unit × 48,000 units)
= `3,12,000
` 3,12,000
Existing, material cost per unit =   `6.50
48,000units
New variable cost per unit = Material cost per unit + New labour cost per unit
= `6.50 + `1.30 = `7.80
New total variable cost = `7.80 per unit × 57,600 units
= `4,49,280
New saleable value of the output = `12.25 per unit × 57,600 units
= `7,05,600
New contribution of the output = `7,05,600 - `4,49,280
= `2,56,320
Increase in contribution = `2,56,320 - `2,40,000
= `16,320

Comments: The proposal should be accepted since the contribution per week has
increased.
Note: Capital cost of mechanization has been ignored because the useful life and salvage
value of the machine have not been given.

(ii) Explain the methods of disposal of under /over absorbed overheads. [4]
Answer:
Over absorption means that overheads absorbed in the production are more than the
actual overheads. In other words, if actual expenses fall short of the amount absorbed, there
is said to be over absorption of overheads. For example, if during the month of March 2014,
overheads absorbed are `30,000 and the actual overheads are `29,500, there is an over
absorption to the extent of `500.
Under absorption means that the overheads absorbed in the production are less than the
actual overheads. In other words, if the actual expenses exceeds the amount of overheads
absorbed in production, this is a case of under absorption.
For example, if overheads absorbed are `11,000 and the actual overheads are `12,000,
there is an under absorption to the extent of `1,000.
Treatment: The under or over absorbed overheads may be disposed off in any of the
following ways:
 Write off to Costing Profit and Loss Account
 Carry forward to the next accounting period
 Use of Supplementary Rates.

(iii) State the objective of Cost Accounting. [2]

Answer:
The following are the main objectives of Cost Accounting:
 To ascertain the Costs under different situations using different techniques and systems of
costing
 To determine the selling prices under different circumstances

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 9
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

 To determine and control efficiency by setting standards for Materials, Labour and
Overheads
 To determine the value of closing inventory for preparing financial statements of the
concern.
 To provide a basis for operating policies which may be determination of Cost Volume
relationship, whether to close or operate at a loss, whether to manufacture or buy from
market, whether to continue the existing method of production or to replace it by a
more improved method of production etc.

3. (Answer any two questions) [2×16=32]

(a)
(i) The following information has been extracted from the records of a Company :
Product cost sheet `/unit
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 20
Selling price 125

 Raw materials are in stock on an average of two months.

 The materials are in process on an average for 4 weeks. The degree of completion is
50%.
 Finished goods stock on an average is for one month.
 Time lag in payment of wages and overheads is 1 ½ weeks.
 Time lag in receipt of proceeds from debtors is 2 months.
 Credit allowed by suppliers is one month.
 20% of the output is sold against cash.
 The company expects to keep a Cash balance of `1,00,000.
 Take 52 weeks per annum.

The Company is poised for a manufacture of ` 1,44,000 units in the year.

You are required to prepare a statement showing the Working Capital requirements of
the Company. [8]
Answer:
Working capital requirement

` `
Current Assets :

Raw Material Stock [ ` 64,80,000 x 2/12 ] 10,80,000

Work in Process [`1,51,20,000 × 4/52 ×50% ] 5,81,538
Finished goods [`1,51,20,000 × 1/12 ] 12,60,000
Debtors [` 30,00,000 × 80% ] 24,00,000
Cash in hand 1,00,000 54,21,538

Current Liabilities :
Creditors for materials [` 64,80,000 × 1/12 ] 5,40,000
Creditors for wages & overheads [` 86,40,000 × 1.5/52 ] 2,49,231 7,89,231
Working Capital Requirement 46,32,307

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 10
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

Working Notes:
 Total cost
Annual raw materials requirements = 1,44,000 units × ` 45 / unit = `64,80,000
Annual direct labour cost = 1,44,000 units × `20 / unit = ` 28,80,000
Annual Overhead cost = 1,44,000 units × `40 / unit = `57,60,000
`1,51,20,000
 Sales for 2 months = 1,44,000 units × `125/unit × 2/12 = `30,00,000

(ii) Explain the procedure involved in the 'Forfeiting' Financial Service. [4]
Answer:
Forfeiting Financial Service
The term "a forfait" in French means, "relinquish a right". It refers to the exporter relinquishing
his right to a receivable due at a future date in exchange for immediate cash payment, at
an agreed discount, passing all risks and responsibilities for collecting the debt to the
forfeiter.
It is the discounting of international trade receivable on a 100% "Without recourse" basis.
"Without recourse" means the client gets full credit protection and all the components of
service, i.e., short-term finance, administration of sales ledger are available to the client.
Forfeiting transforms the supplier's credit granted to the importer into cash transaction for the
exporter protecting him completely from all the risks associated with selling overseas on
credit. It effectively transforms a credit sale into a cash sale.
Procedure
 The exporter sells the goods to the importer on a deferred payment basis spread over 3-5
years.
 The importer draws a series of promissory notes in favour of the exporter for the payments
to be made inclusive of interest charges.
 Such promissory notes are availed or guaranteed by a reputed international bank which
can also be the importer's banker, (it is endorsed on the promissory note by the
guaranteeing bank that it covers any default of payment of the buyer).
 The exporter now sells the availed notes to a forfeiter (which may be the exporter's
banker) at a discount without recourse.
 The forfeiter may hold these notes till maturity or sell them to group of investors interested
in taking up such high-yielding unsecured paper.

Graphical
representation of

Forfeiting

1 = Promissory notes sent for availing to the importer's banker

2 = Availed notes returned to the importer
3 = Availed notes sent to exporter
4 = Availed notes sold at a discount to a forfeiter on a non - recourse basis
5 = Exporter obtains finance
6 = Forfeiter holds the notes till maturity or sells the short-term paper either to a group of
investors or to investors in the secondary market.

(iii) Write a short note on Foreign Currency Convertible Bonds (FCCBs) [4]

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 11
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

Answer:
Foreign Currency Convertible Bonds (FCCBs)
The FCCB means bonds issued in accordance with the relevant scheme and subscribed by
a non-resident in foreign currency and convertible into ordinary shares of the issuing
company in any manner, either in whole or in part, on the basis of any equity related
warrants attached to debt instruments. The FCCBs are unsecured; carry a fixed rate of
interest and an option for conversion into a fixed number of equity, shares of the issuer
company. Interest and redemption price (if conversion option is not exercised) is payable in
dollars. Interest rates are very low by Indian domestic standards. FCCBs are denominated in
any freely convertible foreign currency.
FCCBs have been popular with issuers. Local debt markets can be restrictive in nature with
comparatively short maturities and high interest rates. On the other hand, straight equity-
issue may cause a dilution in earnings, and certainly a dilution in control, which many
shareholders, especially major family shareholders, would find unacceptable. Thus, the low
coupon security which defers shareholders dilution for several years can be alternative to an
issuer. Foreign investors also prefer FCCBs because of the Dollar denominated servicing, the
conversion option and the arbitrage opportunities presented by conversion of the FCCBs
into equity at a discount on prevailing India market price.

(b)
(i) X Ltd. is foreseeing a growth rate of 14% per annum in the next 2 years. The growth rate is
likely to fall to 12 % for the third year and fourth year. After that the growth rate is
expected to stabilize at 10% per annum. If the last dividend paid was `2.25 per share
and the investors‟ required rate of return is 18%, find out the intrinsic value per share of X
Ltd. as of date. You may use the following table:
Years 0 1 2 3 4 5
Discounting Factor at 18% 1 0.85 0.72 0.61 0.52 0.44
[10]
Answer:
Present value of dividend stream for first 2 years.
` 2.25 (1.14)  .85 + 2.25 (1.14) 2  .72
` 2.565  .85 + 2.924  .72
` 2.18 + 2.11 = 4.29 (A)
Present value of dividend stream for next 2 years
` 2.924 (1.12)  .61 + 2.924 (1.12) 2  .52
` 3.27  .61 + 3.67  .52
` 2 + 1.91 = 3.91 (B)
Market value of equity share at the end of 4th year computed by using the constant
dividend growth model would be:
D5
P4 
K s - gn
Where D 5 is dividend in the fifth year, g n is the growth rate and K s is required rate of
return.
Now D 5 = D4 (1 + g n)
 D5 = `3.67 (1 + 0.10)
= `4.037
 P4=`4.037/ (.18-.10) =4.037/.08=`50.46

Present market value of P 4 = 50.46  .52 = `26.239 (C)

Hence, the intrinsic value per share of X Ltd. would be
A + B + C i.e. `4.29 + 3.91 + 26.239 = `34.439

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 12
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

(ii) Explain the main features of SEBI. [6]

Answer:
The main features of SEBI are as follows:
 SEBI is an autonomous body created by the Government of India in 1988 and given
statutory form in 1992 with the SEBI Act 1992.
 Its Head office is in Mumbai and has regional offices in Chennai, Kolkata, and Delhi.
 SEBI is the regulator of Securities markets in India.
 SEBI has to be responsive to the needs of three groups, which constitute the market:
 The issuers of securities.
 The investors.
 The market intermediaries.
 SEBI has three functions rolled into one body quasi-legislative, quasi-judicial and quasi-
executive.
 It drafts regulations in its legislative capacity, it conducts investigation and enforcement
action in its executive function and it passes rulings and orders in its judicial capacity.
 Though this makes is very powerful, there is an appeal process to create accountability.
There is a Securities Appellate Tribunal which is a three member body.
 A second appeal lies directly to the Supreme Court.

(c)
(i) XYZ Ltd. is considering two mutually- exclusive projects. Both require an initial cash outlay
`10,000 each for machinery and have a life of 5 Years. The Company‟s required rate of return
is 10% and it pays tax at 50%. The projects will be depreciated on a straight-line basis. The
net cash flows (before taxes) expected to be generated by the projects and the present
value (PV) factor (at 10%) are as follows:
Year
1 2 3 4 5
` ` ` ` `
Project 1 4,000 4,000 4,000 4,000 4,000
Project 2 6,000 3,000 2,000 5,000 5,000
PV factor (at 10%) 0.909 0.826 0.751 0.683 0.621
You are required to calculate
I. The Pay Back Period of each project;
II. The NPV and the profitability index of each project. [5+5]
Answer:
CALCULATION OF NET INCOME AND NET CASH FLOW AFTER TAXES:
Project – 1

Year Cash Flow Depreciation Income Tax (`) Net Net cash Flow
before tax (`) (`) before tax (`) Income (`) after tax (`)
1 4,000 2,000 2,000 1,000 1,000 3,000
2 4,000 2,000 2,000 1,000 1,000 3,000
3 4,000 2,000 2,000 1,000 1,000 3,000
4 4,000 2,000 2,000 1,000 1,000 3,000
5 4,000 2,000 2,000 1,000 1,000 3,000

Project – 2

Year Cash Flow Depreciation Income Tax Net Net cash Flow
before tax (`) (`) before tax (`) (`) Income (`) after tax (`)

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 13
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

1 6,000 2,000 4,000 2,000 2,000 4,000

2 3,000 2,000 1,000 500 500 2,500
3 2,000 2,000 - - - 2,000
4 5,000 2,000 3,000 1,500 1,500 3,500
5 5,000 2,000 3,000 1,500 1,500 3,500

I. Pay Back Period:

PROJECT – 1
Cash outlay `10,000
Cash flow p.a. `3,000
Payback period: 10,000 / 3,000 = 3.33 years

PROJECT – 2
Cash inflows: ` (4,000 + 2,500 + 2,000) = `8,500 in 3 Years.
4th Year Balance - `1,500.
Therefore, 1,500/3,500 = 0.43 Years
Payback period = 3 Years + 0.43 Years = 3.43 years.

II. Net Present value (NPV):

PROJECT – 1:
Present value = 3,000 x 3.790 = ` 11,370
(0.909 + 0.826 + 0.751 + 0.683 + 0.621)
Less: Initial cash outlay = `10,000
Net Present value (NVP) = `1,370

PROFITABILITY INDEX = 11,370/10000 = 1.1370

PROJECT – 2:

Net cash flow after tax (`) PV factor Present Value (`)
4,000 0.909 3636.00
2,500 0.826 2065.00
2,000 0.751 1502.00
3,500 0.683 2390.50
3,500 0.621 2173.50
11,767
Less: Initial cash outlay 10,000.00
Net Present value (NPV) 1,767

PROFITABILITY INDEX = 11,767/10,000 = 1.177

(ii) Write the basic propositions and the assumptions of the MM Approach. [2+4]
Answer:
Basic Propositions:
M -M Hypothesis can be explained in terms of two propositions of Modigliani and Miller. They
are:
 The overall cost of capital (Ko) and the value of the firm are independent of the capital
structure. The total market value of the firm is given by capitalizing the expected net
operating income by the rate appropriate for that risk class.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 14
 Answer to PTP_Intermediate_Syllabus 2012_Dec2014_Set 3

 The financial risk increases with more debt content in the capital structure. As a result
cost of equity (Ke) increases in a manner to offset exactly the low-cost advantage of
debt. Hence, overall cost of capital remains the same.

Assumptions of the MM Approach:

 There is a perfect capital market. Capital markets are perfect when
 Investors are free to buy and sell securities,
 They can borrow funds without restriction at the same terms as the firms do,
 They behave rationally,
 They are well informed, and
 There are no transaction costs.
 Firms can be classified into homogeneous risk classes. All the firms in the same risk class
will have the same degree of financial risk.
 All investors have the same expectation of a firm’s net operating income (EBIT).
 The dividend payout ratio is 100%, which means there are no retained earnings.
 There are no corporate taxes. This assumption has been removed later.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 15