MANAGEMENT ACCOUNTING AND FM JUNE 2003

CAIIB ASSOCIATE EXAMINATION JUNE 2003 MANAGEMENT ACCOUNTING AND FINANCIAL MANAGEMENT
SECTION I
1. (A) Define any five of the following terms. i) Master Lease Master Lease provides for a period longer than the assets life and holds the lesser responsible for providing equipments in good working condition during the lease period. ii) Mixed Cost Costs that are fixed up to a certain level of output but will vary within certain range of output. iii) Earning Per Share Earning after-tax divided by number of common shares. iv) Call Option A contract which gives the holder the right to buy the physical or to buy the futures at a specific price within a specified period of time. v) IRR The internal rate of return (IRR) is calculated as being the rate at which the net present value of a project is Zero. vi) Opportunity Cost The value of the benefit sacrificed in favour of choosing a particular alternative or action. (B) Fill in the blanks with appropriate words / figures / phrases: i) ii) Loans and advances guaranteed by bank carry 20% risk weight. Inventories are valued at cost or REALISABLE VALUE whichever is LOWER.

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iii) iv) v) vi) vii)

In case of multiple facilities asset classification is done BORROWER WISE. Generally the importers bank AVALISE the bill of exchange in a forfeiting deal. Hire purchase is a method of financing in which the ownership of an asset automatically passes on to HIRER on payment of full installments. An issue of bearer security issued in a currency other than that of the country of issue and sold internationally to raise funds is known as EURO ISSUE. Capitalization rate for a highly risky venture would be HIGHER.

viii) Depreciation can be by two methods STRAIGHT LINE method and WRITTEN DOWN VALUE method. ix) x) (C) Fixed assets are those held not for SALE in usual course of business. Cash Flow is equal to net income plus DEPRECIATION.

State with reason/s in brief whether the following statements are TRUE or FALSE: i) Stock on hire is considered at full value by a lending banker while computing the receivable of a hire purchase company. FALSE: Hire purchase companies in their balance sheets show the receivables in the form of Stockon-hire, under hire purchase agreements (at agreement values less amounts received) at full value under current assets and un-accured portion of these receivables as Un-matured Finance charges under current liabilities. For computing lending limit, the net figure of stock-on-hire, i.e., stock-on-hire at full value less un-matured finance charges, should be included under current assets. ii) Decrease in value of stock is a source of fund. TRUE: Decrease in stock denotes sale of Final Product. Hence, it is source of fund to the organization. iii) Contribution means selling price minus fixed cost. FALSE: Contribution means selling price minus variable cost or Fixed cost plus profit. iv) Banks with higher C.A.R. charge higher rate of interest for their loans and advances. FALSE: Higher rate of interest for loans and advances means Higher risk assets portfolio which reduces the CAR. v) The purchase of book debts / receivables is central to factoring. TRUE: Factoring is defined as a continuing legal relationship between a financial institution (a Factor) and a business concern (the Client) selling goods or providing services to trade customers (the Customers) on open account basis whereby the Factor purchases the clients book debts (account receivables) either with or without recourse to the client and in relation there to controls the credit extended to customers and administers the sales ledgers.

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SECTION II
2. Answer any four questions explaining in short reason/s for your choice in not more than fifty words and also workings wherever required. i) Perusal of the balance sheet reveals that the current ration is 3:1. Net working capital is Rs.80,000/-. The current assets will amount to Rs.1,20,000. (a) Rs.2,40,000 (b) Rs.1,20,000 (c) Rs.40,000 (d) None of these

REASON: Net working capital = Current Assets Current Liabilities. Here current assets = 3, current liabilities = 1, Net working capital = 2. For 2 the net working capital is Rs.80,000 For 3 the current assets is ? = 3/2 x 80,000 = Rs.1,20,000 ii) In a branch of a bank, as of 31.3.2003 a borrowers account shows outstanding balance of Rs.5,50,00,000/- having primary security of Rs.7,50,00,000/- and collateral security of Rs.10,00,00,000/-. However the limits of the borrower have not been reviewed / renewed for more than one year. The provision required to be made for this account as of 31.3.2003 would more than one year. The provision required to be made for this account as of 31.3.2003 would be NONE OF THESE (PROVISION REQUIRED Rs.55,00,000. (a) Rs.Nil (b) Rs.27,50,000 (c) Rs.7,50,000 (d) None of these

REASON: The account should be treated as sub-standard asset because the borrower have not been reviewed / renewed for more than one year. Hence, 10% provision is to be provide on outstandings i.e., on Rs.5,50,00,000 = Rs.5,50,00,000 x 10% = Rs.55,00,000/iii) Sources of financing project cost excludes TRADE CREDIT. (a) Leasing (b) Subsidy (c) Deferred Credit (d) Trade Credit

REASON: Sources from which cost of project can be funded include equity, subsidy / govt. loan, venture capital, GDRs, FCCBs, Term Loans, Deferred Credit, Debentures, Public Deposits, leasing etc. iv) A company is offered discount of 2% by its suppliers if payment is made within 10 days, as against no discount for a credit period of 45 days. Companys rate of return on capital is 18%. Company should AVAIL OF DISCOUNT. (a) (c) (d) Avail of the discount Pay the creditors between 11th and 45th day Opt for none of these (b) Pay the creditors on 45 th day

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REASON: If the company differ the payment for 45 days, then the Rate of Return for 45 days is = 45 / 360 x 18 = 2.25% which is more than the discount offered by its suppliers, so the company should avail of the discount. v) A project is more acceptable for finance if IRR IS HIGHER THAN THE COST OF CAPITAL. (a) (b) (c) (d) break even point is high IRR is higher than the cost of capital neither (a) nor (b) both (a) and (b)

REASON: A project is acceptable for investment and finance if the IRR is more than the expected rate of return (determined by the management taking into account the opportunity cost of capital and risk factors involved). So, higher the IRR, better is the acceptability of the project. 3. Answer question number (i) and any three of the rest in 2 4 lines. i) What is marginal cost of capital ? Marginal cost of capital is the cost of raising an additional rupee of capital. It is derived when the average cost of capital is computed with marginal weights. The weights represent the proportion of funds, the firm intends to employ. The marginal cost of capital is calculated with the intended financial proportion of weights. The Component cost may remain constant up to a certain level and then start increasing. In that case both the average cost and marginal cost of capital will rise at a faster rate. ii) What is operating cycle ? The operating cycle is the length of time that elapses between the companys outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods. Stages generally are raw materials work in progress finished goods sales debtors cash. iii) What is pay-back method ? Pay-back method is a selection method in which a firm sets a maximum payback period during which cash inflows must be sufficient to recover the initial outlay. This method ignores the time value of money and cash flow beyond the payback period. iv) What is commercial paper ? Commercial paper is a short-term unsecured negotiable usance, money market debt instrument at a discount by well rated Corporates promising to pay the holder, the face value on a certain future date at a specific place. v) What is big ticket lease ? Lease of the assets of bigger value running into several crores is called big-ticket lease. Leasing of aircrafts, statellites etc. are typical examples.

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SECTION III
4. (A) Write short notes on: i) Asset Securitization Securitization is a process of transformation of illiquid asset into security which may be traded later in the open market. It is a process of transformation of assets of a lending institution into negotiable instruments. The term Securitization refers to both switching away from bank intermediation to direct financing via capital market and / or money market and the transformation of a previously illiquid asset like automobile loans, mortgage loans, trade receivables etc, into marketable instruments. This is a method of recycling of funds. It is beneficial to financial intermediaries, as it helps in enhancing lending funds. Future receivables EMIs and annuities are pooled together and transferred to a Special Purpose Vehicle (SPV). These receivables of the future are shifted to mutual funds and bigger financial institutions. This process is similar to that of commercial banks seeking refinance from NABARD, IDBI etc.

ii)

Financial Intermediation It involves financial institutions acquiring funds from the public by issuing their own instruments and then using the funds to buy primary securities. It is a sort of indirect financing in which savers deposit funds with financial institutions rather than directly buying bonds and the financial institutions, in turn lend to the ultimate borrowers. Financial intermediaries are in a better position than individuals to bear and spread risks of Primary security ownership. Because of their large size, intermediaries can diversify their portfolios and minimize the risk, involved in holding any security. They employ skilled portfolio managers, possess expertise in evaluation of borrowers creditworthiness can take advantage of economies in large-scale buying and selling. Financial intermediaries are firms that provide services and products that customers may not be able to get more efficiently by themselves in the financial market. A good example of a financial intermediaries is a mutual fund, which pulls the financial resources of a number of people and invests in a basket of securities.

4.

(B)

A company annually manufactures 10,000 units of a product at a cost of Rs.4 per unit, and there is home market for the entire quantity at the sale price of Rs.4.25 per unit. In the year 2003, there is a fall in the demand for home market which can absorb 10,000 units only at a sale price of Rs.3.72 per unit. The analysis of the cost per 10,000 units is as under:

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Rs. Material Wages Fixed overheads Variable overheads 15,000 11,000 8,000 6,000 40,000 The foreign market is explored and it is found that this market can take 20,000 units of the product if offered at a sale price of Rs.3.55 per unit. It is also discovered that for additional 10,000 units of the product (over initial 10,000 units) the fixed cost overheads will increase by 10%. Is it worthwhile to try to capture the foreign market ? ANSWER TO QUESTION NUMBER : 4 (B) YEAR Market Sales(Units) COSTS Material Wages Variable Overheads Fixed Overheads TOTAL Profit / (Loss) Sales 8000 40000 2500 42500 8000 40000 (2800) 37200 1600 65600 5400 71000 9600 105600 2600 108200 6000 6000 12000 18000 15000 11000 15000 11000 30000 22000 45000 33000 2003 Home 10000 2004 Home 10000 2004 Foreign 20000 2004 Total 30000

ANALYSIS: With the expansion of the market to foreign sources, the present profit will be increased by Rs.100/- (i.e., Rs.2,600 - Rs.2,500). Hence sale of goods in the foreign market along with the home market is recommended.

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5.

The following data is available for a manufacturing company for a period of 12 months (year) Rs. in Lakh Fixed Expenses Wages & salaries Rent rates and taxes Depreciation Sundry administrative expenses Semi-Variable Expenses (at 50% capacity) Maintenance and repairs Indirect Labour Sales departments salaries etc. Sundry administrative expenses Variable expenses ( at 50% capacity ) Materials Labours Other expenses Total cost 21.7 20.4 7.9 98.0 3.5 7.9 3.8 2.8 9.5 6.6 7.4 6.5

Assume that the fixed expenses remain constant at all levels of production; semi-variable expenses remain constant between 45% & 65% of capacity, increasing by 10% between 65% & 80% capacity and by 20% between 80% and 100% capacity. Sales at various levels are 50% capacity 60% capacity 75% capacity 90% capacity 100% capacity Rs. in Lakh 100 120 150 180 200

Prepare a flexible budget for the year at 60% and 90% capacities and estimate the profit at these level of output.

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ANSWER TO QUESTION NUMBER : 5 Particulars 60% Variable Expenses Materials Labour Other Expenses Total (A) 26.04 24.48 9.48 60.00 39.06 36.72 14.22 90.00 Capacity Level 90%

Semi-variable Expenses Maintenance & Repairs Indirect Labour Sales Dept. salaries Sundry Admn. Expenses Total (B) 3.50 7.90 3.80 2.80 18.00 Fixed Expenses Wages & Salaries Rent, Rates & Taxes Depreciation Sundry Admn. Expenses Total (C) i. ii. Total Cost (A) + (B) + (C) Sales PROFIT (ii i) 9.50 9.50 6.60 6.60 7.40 7.40 6.50 30.00 108.00 120.00 12.00 6.50 30.00 141.60 180.00 38.40 4.20 9.48 4.56 3.36 21.60

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SECTION IV
6. Explain elaborately the seven methods / ways of debit financing. Long-term debt financing may be undertaken by a company by way of Term Loan, Deferred Payment Guarantee (DPG), Debentures or Bonds, Leasing and Hire purchase, Public Deposits, Unsecured loans, Forfaiting, External Commercial Borrowings (ECBs), etc. i) TERM LOAN: Term Loan is a method of debt financing with maturity period of over one year to about 10 years. It provides for a fixed and often large amount of loan required either for setting up a new unit for financing the expansion / diversification / modernization of a project in terms of land, building, plant and machinery or permanent addition to current assets. Hence, term loan is also called Project Financing. DEFERRED PAYMENT GUARANTEE (DPG): A deferred payment guarantee is a contract under which a bank promises to pay the supplier the price of machinery supplied by him on deferred terms, in agreed instalments with stipulated interest in the respective due dates, in case of default in payment there of by the buyer. As far as the buyer of the plant and machinery is concerned, it serves the same purpose as term loan. iii) DEBENTURES: A debenture is a document issued by a company under its seal evidencing indebtedness of the Company to its holder for the amount stated in it. It is generally secured by a lien on the companys specific assets and is issued for maturity of about 7 years. FEATURES: A debenture is a long-term promissory note for raising loan capital. Debenture holders are the creditors of the company. They can sue the company and enforce the sale of security in case of default in redemption of their capital and payment of interest thereon at coupon or contractual rate and for period specified in the instrument. However, they have no voting rights. But, they can apply for foreclosure or even for winding up of the company to safeguard their interest. Debentures can be floated in private placement basis or through public issue. TYPES: A debenture can be convertible or non-convertible. A convertible debenture can be converted fully or partly into equity shares of the company as per the terms of its issue. Debentures which are not secured fully or partly by a charge on the assets of the company are called unsecured or naked debentures. Sometimes, a debentures has an attached warrant, as a Sweetener. A warrant entitles the holder to buy a fixed number of ordinary shares at a pre-determined price during a specified period. MERITS AND DE-MERITS: Compared to equity financing, debentures are less costly. Interest paid on it one tax deductible. There is no ownership dilution. Cash outflow is limited to interest and principal redemption and in certain. During inflationary period, debenture benefits the company as its payment obligation is fixed.

ii)

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iv)

LEASING AND HIRE PURCHASE: Leasing and Hire purchase are innovative methods of financing. Leasing is an arrangement under which a lessee (a firm or person) acquires the right to use an asset for a definite period, without owing it, in return for series of periodic lease rentals to the lessor (owner). In the case of hire purchase, ownership in assets gets automatically transferred to the hirer, if all instalments are paid. Hire purchase is, thus, bailment for deferred sale where the hirer (bailee) has the option to purchase or return the goods before the payment of last instalment.

v)

PUBLIC DEPOSITS: A non-banking non-financial company can raise unsecured fixed deposits from its members, directors and general public to the tune of 25% of its paid-up capital and free reserves for a period of more than six months and not more than three years. Public Deposits is a simple and less costly method of financing. No creation of charge in any asset of the company is necessary. A company can trade on equity by raising public deposit as the interest cost is fixed. But this mode of financing is dependant on the reputation of the company. The company has to maintain in liquid assets 15% of the amount of deposits maturing during the current financial year.

vi)

FORFAITING: Forfaiting in one of the innovative methods of post-shipment export finance where 100% medium-term export receivables are discounted on a without recourse basis to the exporter. This method of financing is essentially used for export of capital goods, project exports, commodities and services with deferred credit period 1 to 5 years.

vii) EXTERNAL COMMERCIAL BORROWING (ECB): Corporates can raise on their own strength External Commercial Borrowings (ECBs) which include suppliers credit, buyers credit , loan from commercial banks and credit from officially sponsored agencies but excludes all borrowing with a maturity of less than a year. Choice of currency of loan, the basis of interest rate (floating or fixed) and security to be provided to external commercial lenders are left to the borrowers. No sovereign guarantee is given to borrowings by public or private sector enterprises except in case of public sector units in power generation, energy and strategic defence. OR Explain with sufficient details implications of not meeting capital adequacy norms by the banks in India. The Implications of not meeting Capital Adequacy Norms (CAN) by the Banks are: a) Credibility : With increasing globalization of banking. Indian banks will be rated in terms of international standards. CAN enjoys world-wide consensus. So, all banks in India have to achieve it. Otherwise, the defaulting banks will lose credibility and acceptability - both domestically and internationally. To start with the foreign exchange business of such banks, will be adversely affected as banks and customers outside India may not accept LCs and guarantees issued by them. Banks which fail to meet CAN, cannot initiate cross-currency options.

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b)

Staunted deposit growth: Cash-rich public sector enterprises prefer to park their surplus funds only with banks, who have reached CAN. Individual depositors may also show the same preference. In that event, the deposit mobilization effort of such defaulting banks may be crippled. Expansion & operational flexibility : Attaining CAN is one of the criteria for banks to be eligible to open new branches. Foreign regulatory authorities also insist that individual foreign offices of Indian banks in those countries either meet CAN or face closure. Meeting CAN is also one of the parameters on the basis of which the Ministry of Finance, Government of India has decided to grant autonomy / flexibility in some administrative / operational areas. Profitability: Banks having problem of capital funds will, perforce, have to restrict their asset size. This pressure will force them to reduce their commercial lending. In the alternative, banks may increasingly deploy funds in zero-risk sovereign securities which offer lower yield compared to commercial lending. So, the average yield of funds will come down adversely affecting the bottom line. This scenario will also make lesser loanable funds available for trade and industry. Thus, economic growth will retard. Capital Market: Due to budgetary constraints. Government, the major owner of public sector banks in India, is unable to pump in further funds to bolster banks capital base. Alternatively, if a bank plans to raise capital through public issue, it may not secure a favourable response unless CAN is fulfilled. Cost of borrowing: Failure to meet CAN will adversely affect a banks credit rating. This will reduce the scope of its accessibility to market, increase the cost of borrowing and make the terms and conditions of borrowing both domestically and internationally unfavourable.

c)

d)

e)

f)

7.

X Ltd. An existing profit making company, is planning to introduce a new product with a projected life of 8 years. Initial equipment cost will be Rs.120 lakh and additional equipment costing Rs.10 lakh will be needed at the beginning of third year. At the end of the 8th year, the original equipment will have resale value equivalent to the cost of removal, but the additional equipment would be sold for Rs.1 lakh. Working capital of Rs.15 lakh will be needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the production and sales volume expected are as under. Year 1 2 3-5 6-8 Capacity in Percentage 20 30 75 50

A sale price of Rs.100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed operating cash cost are likely to be Rs.16 lakh per annum. In addition to this the advertisement expenditure will have to be incurred as under:

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Year Expenditure in Rs. lakh each year

1 30

2 15

3-5 10

6-8 4

The company is subject to 50% tax, straight line method of depreciation (permissible for tax purposes only). Taking 12% as appropriate after tax cost of capital, find out N P V of net cash flows and recommend whether the project should be accepted or not. P.V. factors @ 12% are mentioned below: Year P.V. Factor 1 ,893 2 .797 3 .712 4 .636 5 .567 6 .507 7 .452 8 .404

ANSWER TO QUESTION NUMBER:7 (a) Computation of initial cash outlay Equipment cost Working Capital TOTAL Calculation of cash-flow: Years Sales in Units 1 80,000 Rs. Contribution @ Rs.60 per unit Fixed cost Advertisement Depreciation Profit / (Loss) Tax @ 50% Profit / (Loss) After Tax Add: Depreciation Cash inflow (13,00,000) 15,00,000 28,00,000 13,00,000 15,00,000 28,00,000 68,75,000 16,50,000 85,25,000 41,75,000 16,50,000 58,25,000 48,00,000 16,00,000 30,00,000 15,00,000 (13,00,000) NIL 2 1,20,000 Rs. 72,00,000 16,00,000 15,00,000 15,00,000 26,00,000 13,00,000 3-5 3,00,000 Rs. 1,80,00,000 16,00,000 10,00,000 16,50,000 1,37,50,000 68,75,000 6-8 2,00,000 Rs. 1,20,00,000 16,00,000 4,00,000 16,50,000 83,50,000 41,75,000 (Rs. In lac) 120 15 135

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Computation of P.V. of CIF Years 1 2 3 4 5 6 7 8 CIF Rs. 2,00,000 28,00,000 85,25,000 85,25,000 85,25,000 58,25,000 58,25,000 74,25,000* P.V. Factor @ 12% .893 .797 .712 .636 .567 .507 .452 .404 Rs. 1,78,600 22,31,600 60,69,800 54,21,900 48,33,675 29,53,275 26,32,900 29,99,700 2,73,21,450

* Cash inflow Add: Equipment sold Working Capital

58,25,000 1,00,000 15,00,000 74,25,000 1,35,00,000 7,97,000 1,42,97,000 Rs.2,73,21,450 Rs.1,42,97,000 Rs.1,30,24,450

PV of cash outflow Additional Investment = Rs.10,00,000 x 7.97

NPV of Cash Inflow PV of Cash Outflow Positive NPV

Recommendation: Accept the project in view of positive NPV. OR The profit of X Ltd. for the year 2003 has been worked out to be 12.5% on the capital employed and the relevant figures are as under: Rs. Sales 5,00,000 Direct Material Direct Labour Variable overheads Capital Employed 2,50,000 1,00,000 40,000 4,00,000

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The new sales manager who has joined the company recently has estimated a profit of about 23% on the capital employed for the next year, provided the volume of sales increases by 10%, the selling price increases by 4% and there is an overall cost reduction (for all the cost elements) by 20%. You are required to find out (by giving details of computations) the cost and profit figures for the next year and make comments on the estimates of the sales manager. ANSWER TO ALTERNATIVE QUESTION NUMBER: 7 Calculation of costs for 2004 Particulars Cost for 2003 Add: 10% increase Due to increase in Volume Less: Cost Reduction by 20% Cost for 2004 55,000 2,20,000 22,000 88,000 8,800 35,200 12,000 48,000 Direct Material 2,50,000 25,000 2,75,000 Direct Labour 1,00,000 10,000 1,10,000 Variable Overheads 40,000 4,000 44,000 Fixed Overheads 60,000 0 60,000

Comparative statement of Profitability Particulars Sales Variable Cost Direct Material Direct Labour Variable overheads Total (B) 2,50,000 1,00,000 40,000 3,90,000 1,10,000 60,000 50,000 4,00,000 12.50% 2,20,000 88,000 35,200 3,43,200 2,28,800 48,000 1,80,800 4,00,000 45.20% (A) Year 2003 5,00,000 Year 2004 5,72,000

Contribution A B Less: Fixed Overheads PROFIT Capital Employed % of profit on capital employed

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Analysis: From the above workings it is observed it is observed that the estimates made by the new sales manager is nor correct since the estimated % of profit on capital employed comes to 45.20% which is very much higher than his estimate 23%. WORKING NOTES: 1. Profit on capital employed: Profit for the year 2003 on capital employed = Rs.4,00,000 x 12.50 / 100 = Rs.50,000. Profit for the year 2004 estimated by new sales manager @ 23% on capital employed = Rs.4,00,000 x 23/100 = 92,000 2. Sales: Rs. Sales for the year 2003 Add: Increase in volume by 10% 5,00,000 50,000 5,50,000 22,000 5,72,000

Add: Increase in selling price by 4%

3.

Calculation of fixed overheads of year 2003: Sales Less Profit Cost of goods sold 5,00,000 50,000 4,50,000

Less: Variable Cost Direct Material Direct Labour Variable overheads 2,50,000 1,00,000 40,000 Fixed overheads for the year 2003 3,90,000 60,000

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