Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

Paper-12: FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Time Allowed: 3 Hours Full Marks: 100

The figures in the margin on the right side indicate full marks.
Answer Question No. 1 from Part A which is compulsory and any five questions from Part B.
Working notes should form a part of the answer
“Wherever necessary, suitable assumptions should be made and indicated in answers by the
candidates”

PART A (25 Marks)

Question.1
(a) In each of the cases given below, one out of four answers is correct. Indicate the correct
answer (= 1 mark) and give workings/reasons briefly in support of your answer (= 1 mark)
[2 × 8]

(i) A company issues a new 15 per cent debentures of ` 1,000 face value to be
redeemed after 10 years. The debenture is expected to be sold at 5 per cent
discount. It will involve floatation costs of 2.5 per cent of face value. The company’s
tax rate is 35 per cent. The cost of debt using short-cut method would be —
A. 10.9%;
B. 10.21%;
C. 10.44%;
D. 10.76%.

(ii) If the value of a Malaysian Ringgit ($/MR) was 0.2632, and the value of an Indian
rupee ($/`) was 0.02212. The value of a Malaysian Ringgit in terms of Indian rupee
will be —
A. 10.21
B. 5.90
C. 11.90
D. None of the above.

(iii) Cactus Limited paid a dividend of ` 5 per share for 2013-14. The company follows a
fixed dividend payout ratio of 60%. The company earns a return of 20% on its
investment. The cost of capital to the company is 14%. What would be the expected
market price of its share, using the Walter Model?
A. ` 69.69;
B. ` 50.50;
C. ` 60.69;
D. ` 70.10.

(iv) A project has an equity beta of 1.2 and is going to be financed by 30% debt and
70% equity. Assume debt beta = 0, Rf = 10% and Rm = 18%. What is the required rate
of return?
A. 8.4%;
B. 18%;
C. 16.72%;
D. 10%.

(v) The interest rate in the United States is 5%, in Japan, the comparable rate is 1.5%.
The spot rate for the yen is $ 0.012067821. If the interest rate parity holds, what is the
90-day forward rate on the Japanese yen?
A. $ 0.01248;
B. $ 0.01359;
Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

C. $ 0.01350;
D. $ 0.01195.

(vi) The capital structure of a company is as under:

3,00,000 Equity Shares of ` 10 each,
32,000, 12% Preference Shares of ` 100 each,
General Reserve ` 15,00,000,
Securities Premium Account ` 5,00,000,
25,000, 14% Fully Secured Debentures of ` 100 each,
Term Loan of ` 13,00,000.
Based on these, the leverage of the company is —
A. 60.22%;
B. 58.33%;
C. 55.21%;
D. 62.10%.

(vii) The capital of PQR Limited is as follows :

9% preference shares of ` 10 each ` 3,00,000
Equity shares of ` 10 each ` 8,00,000
Following further information is available:
Profit after Tax ` 2,70,000
Equity Dividend paid 20%
The market price of equity shares ` 40 each
Then the EPS and PE ratio are:
A. ` 3.12 and 10.80;
B. ` 3.33 and 10.34;
C. ` 4.51 and 12.56;
D. ` 3.04 and 13.16.

(viii) Calculate the future value of ` 1,000 invested in State Bank Cash Certificate scheme
for 2 years @ 5.5% p.a., compounded semi-annually.
A. ` 1,114.62;
B. ` 1,104.62;
C. ` 1,401.51;
D. ` 1,141.51.

Answer:
(i) A.
` 150(1 0.35)  (` 1,000  ` 925)/10
Kd  = 10.9 per cent
(` 1,000  ` 925)/ 2
Kd = 10.9%

(ii) C.
We have $/MR and $/`. We need to find `/MR.
`/MR = `/$ × $/MR.
= 1/(`/$) × $/MR
= 1/0.02212 × 0.2632 = 11.90.

(iii) A.
Dividend `5
EPS =   ` 8.33
Payout ratio 0.6
r
D+(E-D)
According to Walter model, P = k
k

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

0.20
5+(8.33-5)
 0.14
0.14
=` 69.69

(iv) C.
Beta of portfolio = 
βequity ×E /(D +E)
+
βdebt ×D /(D +E)

= (1.2 × 0.70) + (0 × 0.30) = 0.84
Therefore, required rate of return =Rf  βp(Rm  Rf )
= 10% + 0.84 (18% – 10%)
= 16.72%

(v) A.
As per Interest Rate Parity Theory, the 90 day forward rate on the yen should be equal
to —
$ 0.012067821 [(1+0.05/4) ÷ (1+0.015/4)]
= $ 0.012067821 [(1.05/4) ÷ (1.015/4)]
= $ 0.012067821 × 1.034482759 = $ 0.0124839
or $ 0.01248

(vi) B.
Fixed Income Funds = ` (32,00,000 + 25,00,000 + 13,00,000)
Equity Funds = ` (30,00,000 + 15,00,000 + 5,00,000)
Fixed Income Funds
Leverage =
Fixed Income Funds  Equity Funds
` 70,00,000
 = 58.33%
` 1,20,00,000

(vii) D.
PAT  Preference dividend
EPS =
No. of Equity Shares
` (2,70,000  27,000)
  ` 3.04
80,000
Market Price ` 40
PE Ratio =   13.16
EPS ` 3.04

(viii) A.
mn
 c
FVn  PV 1
 m 
22
 0.055 
 1,000 1
 2 
 1,000 (1.0275)4  `1,114.62

(b) State if each of the following sentences is true or false: [1 × 9]

(i) Low financial leverage indicates high financial risk and vice –versa.
(ii) An investor expecting a fall in interest rates buys a floor and also a cap.
(iii) Treasury management includes risk management.
(iv) Profitability Index is the profit expected in capital budgeting.
(v) In the CAPM model, ‘systematic risk’ is the risk that cannot be eliminated by
diversification, it being common to all firms.
(vi) There is no relevance of firm’s production policy in determining the working
capital requirement of a firm.
Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

(vii) Stochastic model is one of the various ways in determining the optimum level of
cash balances of a company.
(viii) Cost plus pricing is normally followed in those public enterprises which have no
domestic competition and whose production costs are higher than the price of
similar imported products.
(ix) Risk Adjusted Discount Rate is a conventional technique to analyse risk.

Answer:
(i) False: Low financial leverage indicates less risky situation, low operating leverage
combined with low financial leverage will constitute an ideal situation.
(ii) True: A Cap provides variable rate borrowers with protection against rising interest
rates while also retaining the advantages of lower or falling interest rate. Floors are
used to obtain certainty for investments and budgeting by setting minimum
interest rate on investments.
(iii) True: the scope of treasury management function is quite vast and it includes
Foreign Exchange Risk Management, Financial Risk Management etc.
(iv) False: Profitability Index is the present value of an anticipated future cash inflows
divided by the initial outlay.
(v) True: Systematic risk arises out of external and uncontrollable factors. This risk
cannot be avoided.
(vi) False: The firm‘s production policy (manufacturing cycle) is an important factor to
decide the working capital requirement of a firm. The working capital
requirement will be higher with varying production schedules in accordance with
the changing demand.
(vii) True: The optimum level of cash balances of a company can be determined in
various ways, such as — Inventory model (Economic Order Quantity) to cash
management, Stochastic model, Probability model.
(viii) False: Import-based pricing is normally followed in those public enterprises which
have no domestic competition and whose production costs are higher than the
price of similar imported products.
(ix) True: Risk Adjusted Discount Rate or RADR is a conventional technique to analyse
risk. It is based on the premise that riskiness of a proposal may be taken care of,
by adjusting the discount rate.

PART B (75 MARKS)

Question 2.
(a) An oil company imports crude oil at the rate of 100 tonnes per month. The price of crude
oil in the month of January is ` 5,000 per barrel (1 tonne = 7.33 barrel). It is forecasted that
in the month of March the price per barrel of crude oil is likely to touch ` 6,000. The
company wants to hedge against the rising price for its requirement in March. The futures
contract price for March is now traded at ` 5,700 per barrel for 100 barrels.
Required:
(i) Explain how the oil company can hedge its exposure against the rising price of crude
oil, and state the number of contracts it should book for it.
(ii) What will be the effective price per barrel if in the month of March the price of crude
oil is as under:
Spot price — ` 5,500 per barrel
Futures — ` 5,800 per barrel. [(3+2)+5]

Answer:
(i) The oil company must go long on futures of crude oil. Hedging strategy would be to take
position in the futures market opposite to that of in the physical market. The hedging
strategy should be:
January — buy futures contract now

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

March — purchase crude oil at the price prevailing then in spot market, and sell the
futures contract.
Quantity to be imported/hedged = 100 tonnes or 733 barrels
Contract size = 100 barrels
No. of contract bought = 733/100
= 7.33 (rounded to 8)
(ii) Position in March :
Spot price = ` 5,500
Future price = ` 5,800
Purchase price in spot = 733 × ` 5,500 = ` 40,31,500
Cash flow on future position:
Buying price = ` 5,700 per barrel
Selling price = ` 5,800 per barrel
Profit = ` 100 per barrel
Realization from futures market = ` 8 × 100 × 100 = ` (–) 80,000
` 39,51,500
Effective price per barrel = ` 39,51,500/733
= ` 5,391.

(b) What do you understand by ‘Trading on Equity’? State the limitations of Trading on Equity?
[1+4]
Answer:
The use long-term fixed interest bearing debt and preference share capital along with equity
share capital is called ‗Trading on Equity‘ or Financial Leverage.

Trading on Equity suffers from the following limitations:

(i) It is a double-edged weapon.
(ii) It is beneficial only to companies having stability in earnings, such as an electricity
company;
(iii) It increases risk and rate of interest;
(iv) It is liable to restrictions from financial institutions.

Question 3.
(a) You are given the middle rates as under :
` 80/£ 1 in London,
` 47 /US $ in Delhi, and
US $ 1.58/£ 1 in New York.
Compute the Arbitrage gain on ` 8,00,000. [5]

Answer:
The following sequential transactions will serve the purpose:
(i) Buy US $ in Delhi and get 17,021.277 US $ for ` 8,00,000;
(ii) Sell the above US $ in N.Y for £ and get ($ 17,021.277 ÷ $ 1.58) = £ 10,772.96
(iii) Sell the £ obtained in (ii) for INR in London
£ 10,772.96 × 80 = ` 8,61,836.80.

Arbitrage gain will be ` (8,61,836.80 – 8,00,000) = ` 61,836.80.

(b) A firm’s sales, variable costs and fixed cost amount to ` 75,00,000, ` 42,00,000 and `
6,00,000 respectively. It has borrowed ` 45,00,000 at 9 per cent and its equity capital
totals ` 55,00,000.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low
asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to ` 50,00,000, what will the new EBIT be?
(vi) At what level will the EBT of the firm equal to zero? [1+1+1+3+1+1]

Answer:
(i) ROI = EBIT / Investment
EBIT = Sales – VC – FC = ` 75 lakh – ` 42 lakh – ` 6 lakh = ` 27 lakh
ROI = ` 27 lakh / ` 100 lakh = 27%

(ii) Yes, the firm has favourable financial leverage as its ROI is higher than the interest on
debt.

(iii) Asset turnover = Sales / Total assets or Total investments

= ` 75 lakh / ` 100 lakh = 0.75. It is lower than the industry average.

(iv) Operating leverage  Sales - Variable cost

EBIT
= (` 75 – ` 42) lakh / ` 27 lakh
= 1.22
EBIT ` 27 lakh
Financial levarage   = 1.18
EBIT - Interest ( ` 27 lakh - ` 4.05 lakh)
Sales - Variable cost ` 33 lakh
Combined leverage =  = 1.44
EBIT - Interest ` 22,95,000
Alternatively = OL × FL = 1.22 × 1.18
= 1.44

(v) EBIT at sales level of ` 50 lakh : `

Sales revenue 50,00,000
Less: Variable costs (50 lakh × 0.56) 28,00,000
Less: Fixed costs 6,00,000
EBIT 16,00,000

(vi) Zero EBT implies break-even sales ratio (BESR)

Break-even sales ratio = FC/CV ratio,
CV ratio = ` 33 lakh / ` 75 lakh = 44%
BESR = (` 6 lakh + ` 4.05 lakh) / 0.44 = ` 22,84,091.

(c) Write briefly on Foreign Direct Investment. [2]

Answer:
Foreign Direct Investment (FDI) is that investment which is made to serve the business interest
of the investors in a company, which is in a different country of the investor. FDI flows like the
flow in the capital market, have been the fastest growing component of long term flow to
developing countries as a whole. FDI is considered to be an essential tool for jump starting
economic growth of a country by bolstering domestic capital, productivity and employment.
FDI has an impact on country‘s trade balance as well. In India FDI is guided by certain
regulatory norms and investments are allowed in specified percentages.

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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

Question 4.
(a) AMRITAM Ltd. has a total sale of ` 3.2 crores and its average collection period is 90 days.
The past experience indicates that bad debts losses are 1.5% on sales. The expenditure
incurred by the firm in administering its receivable collection efforts is ` 5,00,000. A factor
is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an Interest rate of 18% per annum after withholding
10% as reserve. Assume 360 days in a year. Calculate the effective cost of factoring to
the firm. [7]

Answer:
Average level of receivables = ` 3.2 crores x 90/360 ` 80,00,000
Factoring commission = ` 80 lakhs x 2 / 100 ` 1,60,000

Factoring reserve = ` 80 lakhs x 10% ` 8,00,000

Amount available for advance = ` [80-(1.6 +8)] lakhs ` 70,40,000

Factor will deduct his interest @ 18% ` 67,23,200

70.4lakhs 18  90
  3,16,800
100  360
Therefore, Advance to be paid = ` (70,40,000–3,16,800)

Annual cost of factoring to the firm: ` 6,40,000

360
Factoring commission  1,60,000 x
90
360 ` 12,67,200
Interest charges ` 3,16,800 x
90
Total ` 19,07,200
Firm‘s saving on taking factoring service: ` 5,00,000
Cost of credit administration saved
1.5 ` 4,80,000
Cost of Bad debts ` 3.20Cr. x avoided
100
Total ` 9,80,000

Net cost to the firm = ` (19,07,200 – 9,80,000)= ` 9,27,200

Net cost 9,27,200
Effective rate of interest to the firm    100  13.79%
Advance to pay 67,23,200

(b) VEDAVYAS Ltd. is considering two mutually exclusive projects M and project N. The
Finance Director thinks that the project with higher NPV should be chosen, whereas the
Managing Director thinks that the one with the higher IRR should be undertaken,
especially as both projects have the same initial outlay and length of life. The company
anticipates a cost of capital of 10% and the net after-tax cash flow of the projects are as
follows:
Year 0 1 2 3 4 5
Cash flows (`)

Project M (4,00,000) 70,000 1,60,000 1,80,000 1,50,000 40,000

Project N (4,00,000) 4,36,000 20, 000 20, 000 8,000 6,000

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

You are required to:

(i) Calculate the NPV and IRR of each project.
(ii) State with reasons, which project you would recommended. [(3+3)+2]

Answer:
(i) Calculation of NPV and IRR

NPV of Project M:
Year Cash Flows Discount Discounted Discount Discounted
(`) factor Values (`) factor Values (`)
(10%) (20%)

0 (4,00,000) 1.000 (4,00,000) 1.000 (4,00,000)

1 70,000 0.909 63,630 0.833 58,310
2 1,60,000 0.826 1,32,160 0.694 1,11,040
3 1,80,000 0.751 1,35,180 0.579 1,04,220
4 1,50,000 0.683 1,02,450 0.482 72,300
5 40,000 0.621 24,840 0.402 16,080
NPV 58,260 (38,050)

IRR of Project M:
At 20%, NPV is (-) ` 38,050 and at 10% NPV is ` 58,260
58,260
IRR  10   10  10  6.05  16.05%
58,260  38,050

NPV of Project N:
Year Cash Flows Discount Discounted Discount Discounted
(`) factor Values(`) factor Values (`)
(10%) (20%)

0 (4,00,000) 1.000 (4,00,000) 1.000 (4,00,000)

1 4,36,000 0.909 3,96,324 0.833 3,63,188
2 20,000 0.826 16,520 0.694 13,880
3 20,000 0.751 15,020 0.579 11,580
4 8,000 0.683 5,464 0.482 3,856
5 6,000 0.621 3,726 0.402 2,412
NPV 37,054 (5,084)

IRR of Project M:
At 20%, NPV = (-) ` 5,084 and at 10% NPV = ` 37,054
37,054
IRR  10   10  10  8.79%  18.79%
37,054  5,084

(ii) Both the projects are acceptable because they generate the positive NVP at the
company‘s cost of capital at 10%. However, the company will have to select project M
because it has higher NPV. If the company follows IRR method, then Project N should be
selected because of higher internal rate of return (IRR). But when NPV and IRR give
contradictory results, a project with higher NPV is generally preferred because of higher
return in absolute terms. Hence, Project M should be selected.

Question 5.

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

(a) A company is faced with the problem of choosing between two mutually exclusive
projects. Project A requires a cash outlay of ` 1,00,000 and cash running expenses of `
35,000 per year. On the other hand, Project B will cost ` 1,50,000 and require cash running
expenses of ` 20,000 per year. Both the machines have an eight-year life. Project A has a
salvage value of ` 4,000 and Project B has a salvage value of ` 14,000. The company’s
tax rate is 50% and it has a 10% required rate of return.

Assuming depreciation on straight line basis and that there is no funds constraint for the
company, ascertain which project should be accepted. Present value of an annuity of ` 1
for 8 years = 5.335 and present value of ` 1 at the end of 8 years = 0.467, both at the
discount rate of 10%.

Please solve the problem by an incremental cash flow approach. [10]

Answer:
A Company
Financial Evaluation of Project A & Project B
Project A (`) Project B (`) Incremental
Cash flows (`)
Cash outflows 1,00,000 1,50,000 50,000
Cash running expenses 35,000 20,000 15,000
Depreciation 12,000 17,000 (5,000)
Total saving 10,000
Less : Tax @ 50% (5,000)
Saving after tax 5,000
Add : Depreciation (not being cash 5,000
outflow)
Net Saving 10,000
Salvage value at the end of year 8 4,000 14,000 10,000
Present value of annual saving 53,350
for 8 years = PV of annuity × Net
savings
for 8 years = 10,000 × 5.335
Present value of incremental 4,670
salvage value at end of year 8
= 0.467 × 10,000
Total 58,020
Less : Cash outflow (incremental) (50,000)
Net Present value (incremental) 8,020

Recommendation:
Since Project B has positive NPV over and above the NPV of Project A at 10% Discount rate,
Project B is recommended for acceptance.

Note: Working for depreciation:

Project A (` 1,00,000 – ` 4,000) / 8 years = ` 12,000
Project B (` 1,50,000 – ` 14,000) / 8 years = ` 17,000.

(b) Write down the steps in Project Management. [5]

Answer:
Project management consists of the following steps:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

 Combining activities into ―Work packages‖, which have the features of a project i.e.,
the work packages are related to one another, and they all contributes to the same
goal(s), and bound by time, cost and performance targets.
 Entrusting whole project to a single responsibility centre called the ―Project Manager‖
for coordinating, directing and controlling the project.
 Choosing a suitable organisation structure to support and service the project
internally, and through vendors and contractors externally.
 Building up commitment through negotiations, coordinating and directing towards
goals through schedules, budgets and contracts.
 On the basis of schedules, budgets and contracts, ensuring that goals are achieved
through continuous monitoring and control.

Question 6.
(a) An extract from exchange rate list of a Kolkata based bank is given below:
`/¥ = 0.3992 : 0.4002
(i) How many Yen will it cost for a Japanese tourist visiting India to purchase ` 2,500
worth of jackfruit?
(ii) How much will Mr. Basu in Kolkata have to spend in rupees, to purchase a Sony
Camcorder worth Yen 1,25,000? [2+2]

Answer:
(i) The Japanese will have to pay —
(` 2500/0.3992 or) ¥ 6263 for the jackfruit.

(i) Mr. Basu will have to pay —

(¥ 125000 × 0.4002) or ` 50,025 for the Camcorder.

(b) An Indian importer has to settle a bill for US $ 1,50,000. There are two options available:
Option A - Pay immediately by drawing from the bank overdraft account bearing interest
@ 15% p.a.
Option B - Pay after 3 months with interest @ 5% p.a. in foreign currency.
The exchange rates are as under:
Spot (`/US $) = ` 50.50/ ` 51.00
3 months forward (`/US $) = ` 51.50/ ` 52.00
Evaluate the two options and advise. [4+1]

Answer:
Option A — Pay immediately
`
(i) Bill value converted to Ind rupees US $ 1,50,000 × ` 51 76,50,000
(ii) Interest for 3 months on Bank overdraft (3/12) 2,86,875
79,36,875

Option B — Pay after 3 months with Interest to foreign Bank

(i) Bill value US $ 1,50,000
(ii) Interest @ 5% for 3 months 3/12 US $ 1,875
US $ 1,51,875 converted to Ind ` at forward rate of ` 52 78,97,500

Option B is better as outflow in Rupees is less.

(c) Z Co. has a capital structure of 30% debt and 70% equity. The company is considering
various investment proposals costing less than ` 30 Lakhs. The company does not want to
disturb its present capital structure. The cost of raising the debt and equity are as follows:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

Project Cost Cost of Debt Cost of Equity

Upto ` 5 Lakhs 9% 13%
Above ` 5 Lakhs and upto ` 20 Lakhs 10% 14%
Above ` 20 Lakhs and upto ` 40 Lakhs 11% 15%
Above ` 40 Lakhs and upto ` 1 Crore 12% 15.55%

Assuming the tax rate is 50%, compute the cost of two projects A and B, whose fund
requirements are ` 8 Lakhs and ` 22 Lakhs respectively. If the projects are expected to
yield after tax return of 11%, determine under what conditions it would be acceptable.
[6]
Answer:

Particulars Kd (Debt)% Ke (Equity) % WACC = K0

% of Debt and Equity 30% 70%
Upto ` 5 Lakhs 9×50% = 4.5% 13% 4.5×30%+13×70% = 10.45%
Above ` 5 Lakhs upto ` 20 10×50% = 5.0% 14% 5.0×30%+14×70% = 11.30%
Lakhs
Above ` 20 Lakhs upto ` 40 11×50% = 5.5% 15% 5.5×30%+15×70% = 12.15%
Lakhs
Above ` 40 Lakhs upto ` 1 12×50% = 6.0% 15.55% 6.0×30%+15.55×70% = 12.69%
Crore

Project Investment WACC Return Decision

A ` 8.00 Lakhs 11.3% (5L to 20L) 11% ROI < WACC

B ` 22.00 Lakhs 12.15% (20L to 40L) 11% ROI < WACC

Decision: If ROI 11%, Project is acceptable only if —

(i) Project Investment is less than or upto ` 5 Lakhs.
(ii) Fractional Investment is possible on a divisible project — Investment is less than or upto ` 5
Lakhs.

Question 7.
(a) From the following information of A Ltd., calculate (i) Gross Operating Cycle, (ii) Net
Operating Cycle, and (iii) No. of operating cycles in a year.

Particulars `
Raw material inventory consumed during the year 60,00,000
Average stock of raw material 10,00,000
Factory cost of goods produced 1,05,00,000
Average stock of work-in-progress 4,37,500
Cost of goods produced 1,14,00,000
Average stock of finished goods 9,50,000
Average trade debtors 11,25,000
Cost of credit sales 90,00,000
Average trade creditors 5,00,000
Expenses for the year 30,00,000
Average creditors for expenses 5,00,000
No. of working days in a year (Assume 360 days)
[9]
Answer:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

Average stock of raw material

Raw material storage period 
Average cost of raw material consumption per day

` 10,00,000
 = 60 days
` 60,00,000 / 360

Average stock of work - in-progress

Work-in-progress holding period =
Average cost in W.I.P. per day

` 4,37,500
 = 15 days
` 1,05,00,000 / 360

Average stock of finishedgoods

Finished goods storage period 
Average cost of goods produced per day

` 9,50,000
 = 30 days
` 1,14,00,000 / 360

Average trade debtors

Debtors collection period =
Average of cost of credit sales per day

` 11,25,000
 = 45 days
` 90,00,000 / 360

Average trade creditors

Creditors' payment period=
Average credit purchases per day

` 5,00,000
 = 30 days
` 60,00,000 / 360

Average creditors for expenses

Average time lag in payment of expenses =
Average expenses per day

` 5,00,000
 = 60 days
` 30,00,000 / 360

Gross operating cycle = 60 + 15 + 30 + 45 = 150 days

Net operating cycle = 60 + 15 + 30 + 45 – 30 – 60 = 60 days

No. of days in a year 360 days

No. of operating cycle in a year = 
Net operating cycle 60 days

= 6 operating cycles in a year.

(b) The paid-up capital of a company is ` 100 lakh. It has been declaring 20% dividend for
the last 5 years. It has under consideration an expansion programme involving an
investment of ` 100 lakh and its board of directors desires to raise the dividend to 25%.
The expansion programme can be financed by four alternatives – A) 100% equity; B) 18%
institutional loan (debt) and equity 50:50; C) Equity and debt, 70:30; and D) 100% debt.
Income tax and dividend tax rate are 35% and 10% respectively.
Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

Assuming rate of return as X, analyse the various financing alternatives from the point of
view of taxes. [6]

Answer:
Effect of Taxes on Financing Alternatives
(` in lakhs)
Particulars A B C D
Return on ` 100 lakh 100X 100X 100X 100X
Less : Interest (0.18) — 9 5.4 18
Balance 100X 100X-9 100X-5.4 100X-18
Less : Tax (0.35) 35X 35X-3.15 35X-1.9 35X-6.30
Balance 65X 65X-5.85 65X-3.50 65X-11.70
Add : Distributable profit before 20 20 20 20
expansion
(0.20 × ` 100 lakh)
Total profits available for distribution (i) 20 + 65X 14.15 + 65X 16.50 + 65X 8.30 + 65X
Expected rate of dividend (%) 25 25 25 25
Expected dividend [0.25 × (` 100 lakh 50 37.50 42.50 25
+ new capital)]
Dividend tax (0.10) 5 3.75 4.25 2.50
Total of dividend and dividend tax (ii) 55 41.25 46.75 27.50
Rate of return (value of X) to pay 54 42 47 30
dividend and dividend tax [value of X
if (i) = (ii)]%

Note: 20 + 65X = 55 or, X = 35/65 = 53%; other values are also determined like this.

Question 8.
Write Short Notes on any three of the following. [5×3]
(a) Asset Securitisation
(b) Project Life Cycle
(c) Zero working capital
(d) Foreign Collaboration

Answer:
(a) Asset securitisation is the process by which non-tradable assets are converted into
tradable securities. Assets like mortgages, loans receivables, cash credit receivables etc.
on the balance sheet of user-originator (say, Housing Finance Co.) are packaged,
underwritten and sold in the form of securities to investors through carefully structured
process. These securities may be in the form of commercial paper, certificate of deposits,
notes, etc.

Process:
(i) The originator owing the assets, indentifies a pool of homogenous assets, which are
held for securitisation.
(ii) The pool of assets is then transferred to a different entity, known as Special Purpose
Vehicles (SPV).
(iii) The SPV issues the securities backed by the pool of assets. They also indicate the
liability for the cash consideration received from the investors.
(iv) The consideration is remitted by the SPV to the originator, which then replaces the
securitised assets from its balance sheet with the consideration received.

(b) Project Life Cycle:

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

The method of dividing the phases in a project. It provides a framework for budgeting
manpower and resources allocation and for scheduling project milestones and project
reviews. The various phases are:

(i) Concept or initialization phase — project idea emerges and the management
decide on the need for a project.
(ii) Project definition phase — this phase includes techno-economic viability,
technical configuration, performance requirement, cost estimates with limits and
schedule of implementation.
(iii) Growth or organization phase — it includes establishing infrastructure, project
engineering design, setting up project organization, preparation of schedules
and budgets-raising finance-obtain licenses-tenders etc.
(iv) Implementation phase — preparation of specifications, placing orders, invite
bids, evaluating bid, issuing construction drawings, installation, piping, testing,
commissioning of the plant.
(v) Project shutdown and clean-up — P & M built and erected with the active
involvement handed over for production to a different agency.

(c) Zero working capital:

Working capital is the comparison of current assets to current liabilities. For most
organizations, current assets exceed current liabilities and working capital therefore
represents the liquid reserves for meeting current obligations. Creditors prefer high levels
of working capital since they are concerned about receiving payment. However,
management prefers low levels of working capital since working capital earns an
extremely low rate of return. Some companies are now driving working capital to record
low levels, so-called Zero Working Capital. By keeping working capital at zero, funds are
released for many other opportunities.

Zero Working Capital requires major changes in how an organization functions. One way
to implement Zero Working Capital is to have a demand-based organization. Demand-
based organizations do everything only as they are demanded: Fill customer orders,
receive supplies, manufacture products, and other functions are done only as needed.
The production facilities run 24 hours a day non-stop according to the demands within
the marketplace. There are no inventories; everything is supplied immediately as needed.
The end result of this demand driven organization is that little, if any, working capital is
necessary to run the business.

Companies like GE (General Electric) and Campbell Soup have made Zero Working
Capital a major strategic objective for the organization. As more and more businesses
find faster ways of servicing customers, the concept of Zero Working Capital will become
more main stream.

(d) In a project environment, foreign collaborations are normally entered into by industries
where a sophisticated technology (not available indigenously) is required or where
upgradation of existing technology is necessary, or where import of technology and
capital is involved (e.g. petro-chemicals). Foreign collaborations could be purely
technical collaboration where only transfer of technology is involved, or technical-cum-
financial collaboration involving both transfer of technology and capital. All proposals for
setting up foreign collaboration require prior approval of the Government. Govt‘s
approval is guided by ‗need and appropriateness of technology‘ to the growth of the
industry.

Foreign collaboration projects have separate tax implications. Various aspects of Foreign
collaboration project could be broadly classified into three sections, viz. —
(1) Outline of Govt. Policy Framework (reg. need of foreign technology/royalty
payments/collaboration agreement/Foreign investment);

Academics Department, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament)
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 Answer to PTP_Final_Syllabus 2008_Dec 2014_Set 2

(2) Procedural aspects of setting up a project; and

(3) Tax aspects of foreign collaboration.

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