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Model Paper
Model Paper
FINANCIAL MANAGEMENT
Ans. Certain objections have been raised against the goal of profit maximization
which strengthen the case for wealth maximization as the goal of business
enterprise. The objections are :- (a) Profit cannot be ascertained well in
advance to express the probability of return as future is uncertain. It is not at
all possible to maximize what cannot be known. Moreover, the return profit
vague and has not been explained clearly what it means. It may be total profit
before tax and after tax of profitability tax. Profitability rate, again is
ambiguous as it may be in relation to capital employed, share capital, owner’s
fund or sales. This vagueness is not present in wealth maximisation goal as the
concept of wealth is very clear. It represents value of benefits minus the cost
of investment.
(b) The executive or the decision maker may not have enough confidence in
the estimates or future returns so that he does not attempt further to
maximize.It is argued that firm’s goal cannot be to maximize profits but to
attain a certain level or rate of profit holding certain share of the market or
certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.
(c) There must be a balance between expected return and risk. The possibility of
higher expected yields are associated with greater risk to recognize such a
balance and wealth maximisation is brought in to the analysis. In such cases,
higher capitalization rate involves. Such combination of expected returns with
risk variations and related capitalization rate cannot be considered in the
concept of profit maximisation.
(e) The criterion of profit maximisation ignores time value factor. It considers the
total benefits or profits in to account while considering a project where as the
length of time in earning that profit is not considered at all. Whereas the
wealth maximization concept fully endorses the time value factor in
evaluating cash flows. Keeping the above objection in view, most of the thinkers
on the subject have come to the conclusion that the aim of an enterprise should be
wealth maximisation and not the profit maximisation.
To make a distinction between profits and profitability. Maximisation of profits
with a view to maximizing the wealth of share holders is clearly an unreal motive.
On the other hand, profitability maximisation with a view to using resources to
yield economic values higher than the joint values of inputs required is a useful
goal. Thus, the proper goal of financial management is wealth maximisation.
Ques. 2 Explain the mechanics of calculating the present value of cash flows.
It is one of the Discounted Cash Flow (DCF) or time adjusted methods. It is also
Known as ‘Discounted Benefit – cost ratio method’. This method takes into
account the time value of money and all cash flows are expressed in terms of their present
value. It also takes into account all the benefits and costs occurring throughout the useful
life time of a project. This method is used on the assumption that the value of present
investments cannot be equal to future amounts of cash inflows from this investment. This
problem can be solved by converting the future amounts of earnings to their present
values. The steps involved in computing the present values of investment outlays and
cash inflows are recapitulated as follows :
(a) Determination of the rate of discount, i.e., cut-off rate. This discount rate is
the cost of capital of the firm or the rate of return desired by the firm on its
investment.
(b) Determination of cash outlays, both initial and subsequent , and cash inflows
for different years.
(c) Computation of the present value of cash outlays of the project by discounting
future cash outlays at the pre – determined discount rate. In case, the capital
asset has any salvage value, it present value of the cash outlays. For
computing the present value of cash flows at different periods, present value
factor may be calculated by the following formula :
N = Number of years.
Present values of all cash inflows and cash outflows for different periods are
added together respectively which serve as an accept – reject criterion. In case
the present value of cash outflows, the project will be accepted otherwise
rejected.
Where PV is the present value cash inflows and C is the present value of cash
outflows or outlays.
Ques.3 Explain the merits and Demerits of the time. adjusted methods of
evaluating the investment projects.
1. This method takes into account the entire economic life of an investment and
income therefrom . It gives the true rate of return effected by a new project.
2. It gives due weight to time factor of financing. In the words of Charles Horn
green : “ Because the discounted returns on method explicitly and routinely
weights the time value of money, it is the best method to use for long-range
decisions.”
3. It permits direct comparison of the projected returns on investment with the cost
of borrowing money which is not possible in other methods.
4. It makes allowance for difference in the time at which investment generate their
income.
5. This approach by recognizing the time factor makes sufficient provision for
uncertainty and risk. It offers a good measure or relative profitability of capital
expenditure by reducing the earnings to the present value.
DEMERITS
Ans. Earnings per share (EPS) is simply a measure of profits reported available for
equity shareholders during a period divided by the total number of equity shares
outstanding at the end of that period.
EBIT or EBT
EBIT – Interest
The financial leverage in our hypothetical company can be analyzed, by using the
following formula :
Table 1
PAT 45 72
Percentage increase in EBIT1
Operating leverage =
40
= = 4
10
EBIT
Financial leverage =
EBIT – Interest
150
= = 1.5
100
Thus, an increase in sales @ 10% will cause an increase in EBIT of 6 times or 60%. By
combining, the operating leverage and financial leverage, we get 4 * 1.5 = 6. It means
that an increase in sales of 10% brings an increase in EBIT of 40% and an increase in
profits of 60%. Similarly a decrease of 10% in sales will mean a full in EBIT of 20% and
a decline in PBT of 60%.
From the shareholders point of view, the value of leverage depends upon whether
it is helping or hurting them. So long as shareholders find rising sales and EBIT levels,
leverage is advantages or favorable to them, because it tends to maximize the related
increase in EPS, DPS and possible market price. On the other hand , when sales and
EBIT levels are falling leverage tends to be disadvantageous since it maximizes the
related decline in EPS1.
According to the net operating income (NOI) approach the market value of the
firm is not affected by the capital structure changes. The market value of the firm is
found out by capitalizing the net operating income at the over all or the weighted average
cost of capital, which is constant.
The overall capitalization rate depends on the business risk of the firm. It is
independent of financial mix. If NOI and average cost of capital are independent of
financial mix, market value of firm will be a constant and independent of capital structure
changes. The critical assumptions of the NOI approach are :
a) The market capitalizes the value of the firm as a whole. Thus the split between
debt and equity is not important.
b) The market uses an overall capitalization rate, to capitalize the net operating
income. Overall cost of capital depends on the business risk. If the business risk is
assumed to remain unchanged, overall cost of capital is a constant.
c) The use of less costly debt funds increases the risk to shareholders. This causes
the equity capitalization rate to increase. Thus, the advantage of debt is offset
exactly by the increase in the equity – capitalisation rate.
(d) The debt capitalisation rate is constant.
(e) The corporate income taxes do not exist.
Thus, we find that the weighted cost of capital is constant and the cost of equity increase
as debt is substituted for equity capital.
Ques.7Explain the concept of working capital. Discuss the working capital need of a
manufacturing firm.
Ans. Money required by the company to meet out day – today expenses to finance
production and stocks to pay wages and other production etc. is called the working
capital of the company. Working capital is used in operating the business. It is mostly
dept is circulation by releasing it back after selling the products and reinvesting it in
further production. It is because of this regular cycle that the working capital
requirements are usually for short periods. Though, both fixed and working capitals shall
be recovered from the business, the differences lies in the rate of their recovery. Working
capital shall be recovered much more quickly as compared to fixed capitals which would
last for several years. As the process of production become more round about and
complicated the production to fixed working capital increase correspondingly.
Therefore, working capital management refers to the management of current assets and
current liabilities. Working capital, however, represents investment in current assets, such
as cash, marketable securities, inventories and bills receivables. Current liabilities mainly
include bills payable, notes payable and miscellaneous accruals. Net working capital is
the excess of current assets over current liabilities here. Current assets are those assets
which are normally converted into cash within an accounting year; and current liabilities
are usually paid within an accounting year.
What for is working capital required by firm very much depends on the nature of the
business which the firm is conducting. If the firm has business which deals with public
utility services, obviously the requirement will be low. It is primarily because the amount
becomes available as soon as services are sold and also the services arranged by the firm
and immediately sold, without much difficulty and complication. On the other hand
trading concerns need heavy amounts because these require funds for carrying goods
traded. Similarly many industrial units will also need heavy amounts for carrying on their
business. Many manufacturing concerns will also need sufficiently heavy amounts, that
of course depends on the nature of commodities which are being manufactured.
MANUFACTURING FIRM
Ans. Economic order quantity refers to the size of the order which gives maximum
economy is purchasing any item of raw materials or finished product. It is fixed mainly
after talking into account the following costs :
II ORDERING COST
It is the cost of placing an order and securing the supplies. It various from time to
time depending upon the number of orders placed and the number of times
ordered. The more frequently the orders are placed and fewer the quantities
purchased an each order, the greater will be the ordering cost and vice versa.
The economic ordering quantity can be determined by any of the following two
methods :
1) FORMULA METHOD
In this case the EOQ can be determined as per the following for formula :
Where :
I. The firm knows with certainly the annual usage or demand of the particular item
of inventories.
II. The rate at which the firm uses the inventories or makes sales is constant through
out a year.
III. The order the replenishment of inventory are placed exactly when inventories
reach the zero level.
The above assumption may also be called as limitation of EOQ modes. There is every
likelihood of a discrepancy between actual and estimated demand for a particular items of
inventory. Similarly, the assumptions as to constant usage or sale of inventories and
instantaneous replenishment of inventories are also of doubtful validity. On account of
these reasons, EOQ model may sometimes give wrong estimate about economic order
quantity.
2 .TABULAR METHOD
Calculating the Economic Ordering Quantity using Tabular Method on the basis of data
given.
Annual Orders Units per Order Avg. Carrying Total
Requirement per year order placing stock in costs amount
costs units cost
(50% of
order
placed)
1600 1 1600 100 800 6400 6500
2 800 200 400 3200 3400
3 533 300 267 2136 2436
4 400 400 200 1600 2000
5 320 500 160 1280 1780
6 267 600 134 1072 1672
7 229 700 115 920 1620
8 200 800 100 800 1600
9 178 900 89 712 1612
10 160 1000 80 640 1640
The above table shows that total cost is the minimum when each is of 200 units.
Therefore, economics ordering quantity is 200 units only.
A graphic presentation of the economic ordering quantity on the basis of figures given in
the above table will be as follows :
0 1 2 3 4 5 6 7 8 9 10
ACCOUNTING FOR MANAGERS
Ques.8 “Standard costs are bases for a proper managerial control of manufacturing
operation,” Explain.
Ans. Standard costs are bases for a proper managerial control of manufacturing
operation. Management can control costs on information being provided to it
immediately for comparison of results. The advantages of standard costing can be listed
as follows :
Standard costing provides a stable and sound basis for comparison of actual costs
with standard costs according to different elements separately. It beings out
clearly the impact of external factors and internal courses on the cost and
performance of the concern. Thus, it indicates places where remedial action is
necessary and how for improvement is possible in the long run.
c) COST CONSCIOUSNESS
A tighter, more accurate and effective budget can be formulated for the coming
years by once knowing the deviations of actual costs from standard costs. Data are
available at an early stage and the capacity to anticipate about changing
conditions is developed.
e) DELEGATION OF AUTHORITY AND FIXATION OF RESPONSIBILITY
The net profit is analyzed and responsibility can be placed on the person incharge
for any variations form the standards. The sphere of operations of adverse
variations is disclosed and particular production department or centre can be held
accountable for it. Thus, delegation of authority and fixation of responsibility can
be done by management to control the affairs in different departments.
f) MANAGEMENT BY ‘EXCEPTION’
The principle ‘management by exception’ can be made applicable on cases in the
business. This helps the management in concentrating its attention on cases which
are off – standard i.e below or above the standard set in. The trend of costs is
portrayed and therefore, a pattern is provided for the elimination of undesirable
factors causing damage to the business.
Ques.1 Explain concepts and conventions. Give examples of different transactions which
may influence assets, liabilities and owners funds.
The accounting records are based on cost concept. This concept is closely related
to the going concern concept. The assets and liabilities of a business are shown at
a cost which has been paid or agreed upon between the parties. The figures are
recorded on objectivity basis.
ACCOUNTING CONVENTIONS
1. CONVENTION OF DISCLOSURE
2. CONVENTION OF CONSISTENCY
3. CONVENTION OF CONSERVATISM
The convention of conservatism means a cautions approach or policy of ‘Play
safe’. This convention ensures that uncertainties and risks inherent in business
transactions should be given a proper consideration. If there is a possibility of
loss, it should be taken into account at the earliest. On the other hand, a prospect
of profit should be ignored upto the time it does not materialize.
4. CONVENTION OF MATERIALITY
According to this convention only those events should be recorded which have
significant bearing and insignificant things should be ignored. The avoidance of
insignificant things will not materially affects the records of the business. It
should be seen that the efforts involved in recording the events should be worth
the labour involved in it.
Ques.3 What is the key question in assessing liquidity ? What ratios are used in this
regard?
The short term creditors of a company like supplies of good of credit and
Commercial banks providing short-term loans, are primarily interested in
knowing the companies ability to meet its current or short term obligations of a firm can
be met only when there are sufficient liquid assets. Therefore, a firm must ensure that it
does not suffer from lack of liquidity or the capacity to pay its current obligations due to
lack of good liquidity position, its goodwill in the market is likely to be effected beyond
repair.
Two types of ratios can be calculated for measuring short term financial position
or short term solvency of a firm.
A. LIQUIDITY RATIOS
Liquidity refers to the ability of a concern to meet its current obligations as and
when there become due. The short-term obligations are met by realizing amounts
from current, floating or circulating assets. The current assets should either be
liquid or near liquidity . These should be convertible into cash for paying
obligations of short-term nature. The sufficiently or insufficiency of current
assets should be assessed by comparing them with short term liabilities. If current
assets can pay off current liabilities, then liquidity position will be satisfactory.
On the other hand if current liabilities may not be easily met out of current assets
then liquidity position will be bad. The bakers, suppliers of goods and other
short-term creditors are interested in the liquidity of the concern. They will
extend credit only if they are sure that current assets are enough to pay out the
obligations. To measure the liquidity of a firm, the following ratios can be
calculated :
I. Current Ratio.
II. Quick or Acid Test or liquid ratio.
III. Absolute liquid ratio or cash position ratio.
I CURRENT RATIO
Current ration may be defined as the relationship between current assets and
current liabilities. This ratio, also known as working capital ratio, is a measure of general
liquidity and is most widely used to make the analysis of a short-term financial position
or liquidity of a firm. It is calculated by dividing the total of current assets by total of the
current liabilities. Thus,
Current assets
Current Ratio =
Current liabilities
Or
Quick ratio, also known as acid test or liquid ratio, is a more rigorous test of liquidity
than the current ratio. The term liquidity refers to the ability of a firm to pay its short term
obligations as and when they become due. The two determinants of current ratio, as a
measure of liquidity, are current assets and current liabilities. Current assets include
inventories and prepaid expenses which are not easily convertible into cash within as
short period. Quick ratio may be defined as the relationship between quick / liquid assets
and current or liquid liabilities. An asset is said to be liquid if it can be converted into
cash within a short period without loss of value. In that sense, cash in hand and cash at
bank are the most liquid assets.
A. COLLECTION OF INFORMATION
B. EVALUATION OF INFORMATION
The next duty of the management accountant after the collection of information is
to evaluate it. The whole information may not be needed at present.
C. INTERPRETATION OF INFORMATION
Current liabilities
S. Creditors 8000 5400 2600
Bills payable 1200 800 400
Provision for
doubtful debts 400 600 200
13800 6800
7000
Increase in 13800 13800
working capital
F.F.O 36000
Funds Flow Statement
Sources Amount Uses Amount
Purchase of investment 1000
purchase of
Funds from operation 36000 Purchase of plant 3000
Interim dividend 8000
Provision for tax 17000
Incharge in working 7000
capital
36000 36000
Building A/C
Particular Amount Particular Amount
To balance b/d 40000 By depreciation a/c 4000
By balance c/d 36000
40000 40000
Plant A/C
Particulars Amount Particulars Amount
To balance b/d 37000 By depreciation a/c 4000
To cash purchases 3000 By balance b/d 36000
40000 40000
35000 35000
Ans.7
7000 units
Flexible Budget
Particulars Per unit Total
Marginal cost :
132.5 927500
Fixed Cost :
30.71 215000