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M.S.-04

Accounting and Finance for Managers

ASSIGNMENT SOLUTIONS GUIDE (2013-2014)
Disclaimer / Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the Assignments. These Sample Answers/Solutions are prepared by Tutor for the help of the student to get an idea of how he/she can answer the questions of the Assignments. Sample answers may be Seen as the Guide/Reference Book/Assignment Guide. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/Solutions. Please consult you Teacher / Tutor before you prepare a Particular Answer.
Q. 1. Explain the various accounting concepts and examine the role of accounting concepts in the preparation of financial statements. Ans. Business Entity Concept In accounting, a distinction is there between business and the owner. All the records are kept from the viewpoint of the business instead of the owners point of view. An enterprise is an economic unit, separate and apart from the owner. Transactions of the business and those of the owners are accounted for and reported separately. The distinction can easily be maintained in the case of a limited company as it has a legal entity of its own. Like human beings, it can engage itself in economic activities of producing, owning, managing, storing, transferring, lending, borrowing and consuming commodities and services. However, it is difficult in case of partnership and in case of one-man business. Accounting still maintains separation of owner and the business. This means the personal and household expenses of the owner will appear in the books of account. Its just for accounting purpose that partnerships and sole properiotorship are treated as separate and apart from the owners though the law does not make such a distinction. Justifying the creditor will involve both the business assets and personal property. In accounting we segregate the business and the owner. All the records are made from the viewpoint of the business, and not from that of the owner. An enterprise is an economic unit, and is treated separately from the owner, or owners. Transactions of the business and those of the owners are accounted for and reported separately. In recording a transaction, the important question is how it affects the business. For example, if the owner of a shop withdraw cash for meeting certain personal expenditure, the accounts would show that cash has been reduced even though it does not make any difference to the owner himself. This distinction can be easily maintained in the case of a limited company as a company has its own legal entity. It can perform various economic activities of producing, owning, managing, storing, transferring, lending, borrowing and consuming commodities and services. Somehow, distinction is difficult in case of partnership and even more difficult in the case of one-man business. Nevertheless, accounting still maintains separation of business and owner. This states that personal and household expenses of the owner will not appear in the books of account. It is only for accounting purposes that partnerships and sole proprietorships are treated as separate from the owners. Q. 2. Explain the meaning of fund flow statement. How would you compute funds from operations in order to prepare sources and usage statement of funds? Ans. Fund flow statementFunds Flow statement has two concepts in it. Funds means working capital, i.e., excess of current assets over current liabilities. Flow means changes, circulation or movement. Thus, flow of funds means movement of working capital from one asset to another or from one equity to another. In simple words, funds flow statement is a statement which shows the movement of working capital during an accounting period. Funds flow statement may be defined as statement which summarizes for the period covered by it, the changes in the working capital including the sources of funds and uses of funds. Sources of Funds Going through the possible sources of working capital we find the most important source is this internal generation. The very idea of internal sources states that there is something external. Internal Sources Internal source refers to the sources within the company. While examining the requirement for working capital, it can be checked whether the existing working capital is sufficient or not. Therefore, the first internal source is any excess working capital

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of the company. A company can also sell any of its non-current assets which do not have any use, thereby generating additional working capital. The important possible internal sources of funds are: 1. Funds generated from operations which is profit plus depreciation and other amortizations; and some other adjustments; 2. Sale of non-current assets; 3. Any surplus working capital. Funds from Operations The profit and loss of A.B.C. Company shows that operations have provided a gross addition of Rs. 360 million of funds during the period. These funds show the sale of proceeds of goods and services by the company and other incomes. A part of these funds has been used for meeting the cost of input like material, personnel and other operating costs. A.B.C. COMPANY Summarized Profit and Loss Account For the year ended March 31, 2006 Particulars Sales Other Income Costs of Goods Sold Gross Profit Operating Expenses: Personal Depreciation and Amortization Other Expenses Operating Profit Less: Interest Expense Net Profit before Income Taxes Less: Provision for Taxes Net Profit Less: Dividends Net Profit Retained Rs. in Million 350 10 360 150 210 60.00 11.90 13.10

Q. 3. What is CVP analysis? How does it differ from break-even analysis? Ans. Managers have to take various decisions for which he takes into consideration the selling prices, variable cost and fixed costs. These decisions are part of their planning responsibilities and are based on predictions about costs and revenues Horngren (1985, p. 43) states about cost- volume- profit relationships. The Cost-Volume-Profit (CVP) analysis is a subject inherently appealing to most students of management because it gives a sweeping overview of the planning process and because it provides a concrete example of the importance of understanding cost behavior- the response of costs to a wide variety of influences. Cost-Volume-Profit (CVP) analysis is very useful technique of planning. Various important managerial decisions are based on such analysis. The cost volume profit (CVP) analysis is used to measure the effect of change in volume, cost, price and product-mix on profits. These variables are inter-related and each one of them is affected by a number of internal and external factors. For example, cost differs due to choice of plant, scale of operation, technology, efficiency of work-force and management efficiency. CVP analysis is perceived as one of the decision-models which managers use to choose among alternative courses of action. The basic CVP model may be outlined as follows: Chart Break-even analysis is an integral part of CVP analysis even though the former is just incidental to the latter. The Cost-Volume-Profit (CVP) analysis is a tool to measure the effect of changes in volume, cost, price and product-mix on profits. These variables are inter- related, each one of them is affected by several internal and external factors. For example, costs vary due to choice of plant, scale of operation, technology, efficiency of work force and management efficiency. Cost of inputs bought externally is affected by market forces. There are many factors which influence costs and profits, the largest single variable affecting them in the short run is the volume of out put. Thus, the CVP relationship acquire a vital importance for the manager facing a wide spectrum of short run decisions like: what are the most profitable? And what are the least profitable products? How does volume or product- mix effect product costs and profits? How an increase in wages or other operating expenses will affect profit? etc . CVP analysis can be perceived as one of the decision models which managers employ choose among alternative courses of action. The basic CVP model is as follows: Profits are a function of the interplay of costs, prices, and each one of them is relevant to profit planning. Variance between actual and budgeted profit arises due to one or more of the following factors : selling price , volume of sales, variable costs and fixed costs.

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85 125 15 110 55 55 20 35

The four factors which cause deviations is planned profits vary from each other in terms of controllability by management. Selling prices largely depend upon external forces. Costs are more controllable. But they pose a problem of measurement. Q. 4. An analytical statement of Altos Limited is shown below. It is based on an output (sales) level of 80,000 units. Rs. Sales Variable Cost Revenue before fixed costs Fixed Costs Interest Earning beore tax Tax Net Income 9,60,000 5,60,000 4,00,000 2,40,000 1,60,000 60,000 1,00,000 50,000 50,000

Calculate the degrees of (i) operating leverage, (ii) financial leverage and (iii) the combined leverage from the above data. Ans. Sales 9,60,000 Variable Cost 5,60,000 Revenue before Fixed 4,00,000 Cost Contribution Fixed Cost 2,40,000 Earning before Interest 1,60,000 and Tax (EBIT) Interest 60,000 Earning Before Tax 1,00,000 Tax 50,000 Net Income 50,000 (i)

(ii)

Degree of Combined Leverage = DOL DOF = 2.5 1.6 = 4 Q. 5. What is meant by capital structure? Explain the theories of capital structure in brief. Ans. Capital structure is the composition of various sources of long-term-finance in the total capitalisation of the company. The two main sources are ownership and creditorship securities. Both types of securities as well as the long-term loans from financial institutions are used by most of the large industrial companies. Capital structure planning, initially and on continuing basis, is of great importance to any company at it has a considerable bearing on its profitability. A wrong initial decision in this respect may prove quite costly for the company. While taking a decision about capital structure, due attention should be paid to objectives like profitability, solvency and flexibility. The choice of the amount of debt and other fixed return securities on one hand and variable income securities, namely equity shares on the other, is made after a comparison of the characteristics of each kind of securities and after careful consideration of internal and external factors related to the firms operations. In real life situations compromises have to be made somewhere on the line between the expectations of companies seeking funds and the expectations of those that supply them. These compromises do not change the basic distinctions between debt and equity. Generally, the decision about financing is not of choosing between equity and debt, but is of selecting the deal combination of the two. The decision on debt-equity mix is affected by considerations of suitability, risk, income, control and timing. The weights assigned to these factors will vary from company to company depending on the characteristics of the industry and the particular situation of the company. There cannot perhaps

(iii)

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Degree of Operating Leverage = =
Contribution EBIT
40,000 = 2.50 1,60, 000

Degree of financial Leverage =

= 1.60

be an exact mathematical solution to the decision on capital structuring. Human judgement plays an important role in analysing the conflicting forces before a decision on appropriate capital structure is reached. The determinants of capital structure are as under: (1) Leverage or Trading on Equity: The use of sources of finance with a fixed cost to acquire the assets of the company is known as financial leverage or trading on equity. If the assets financed by debt get a return greater than the cost of the debt, the earnings per share will rise without an increase in the owners investment. Financial leverage is one of the important consideration in planning the capital structure of a company as it has a effect on the earnings per share. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can use the high degree of leverage profitably to increase return on the shareholders equity. A firm can examine the impact of leverage by analysing the relationship between Earnings Per Share (EPS) at various possible levels of EBIT under alternative methods of financing. (2) Cost of Capital: Measuring the costs of various sources of funds is a difficult subject. A firm desires to minimise the cost of capital and so cheaper sources are preferred, other things remaining the same. The expected return depends on the degree of risk assumed by investors. The company is legally bound to pay interest, whether it makes profits or loss to the debt-holders and the rate of interest is fixed. For shareholders the rate of dividend is not fixed and the board of directors has no legal obligation to pay dividends even if the profits have been made by the company. (3) Cash Flow: Convertism is one of the feature of a sound capital structure. Conservatism does not mean employing no debt or a small amount of debt. It is related to the assessment of the liability for fixed charges, made by the use of debt or preference capital in the capital structure to generate cash to meet these fixed charges. The fixed charges of a firm involve payment of interest, preference dividend and principal. The amount of fixed charges will be high when a firm employs a large amount of debt or preference capital. It is an obligation to pay interest and return the principal amount of debt. If a company is not able to generate enough cash to meet its fixed obligations, it may result in financial insolvency. The companies expecting large and stable cash inflows can employ a large amount of debt in their capital structure. However, it is risky to employ sources of capital with fixed charges. (4) Control: While designing the capital structure, at times the existing management is governed by its desire to continue control over the company. The existing management team not only want to be elected to the board of directors, but may also desire to control the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares there is a risk of class of control. Most of the shareholders are not interested in taking active part in the companys management. They do not have the time and desire to attend the meetings. They are just bothered about dividends and appreciation in the price of shares. However, it is important to maintain control in the case of a closely held company. A shareholder or a group of shareholders could purchase all or majority of the new shares and therefore control the company. A company may issue preference shares or raise debt capital to avoid such risks. (5) Flexibility: Flexibility refers to the ability of the firm to adapt its capital structure as per the changing conditions. The capital structure of a firm is flexible when it can easily change its sources of funds. The company should be able to raise funds without undue delay whenever required. The company should also be in position to redeem its preference capital or debt whenever warranted. The financial plan of the company should not be rigid so as to change the composition of the capital structure. (6) Size of the Company: The size of a company is influenced by the availability of funds from different sources. A small company often find it tough to obtain long-term loans. If in case, it manages to raise a long-term loan, rate of interest charged is very high and on inconvenient terms. The management may face difficulty in running business freely. Small companies, therefore, have to depend on owned capital and retained earnings. On the other hand, a large company has a great degree of flexibility in designing its capital structure. It can raise loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. (7) Marketability: Marketability refers to the ability of the firm to sell or market a particular type of security in a particular period of time which in turn depends upon the readiness of the investors to buy that security. It not necessarily influences the initial capital structure but is an important consideration in deciding the appropriate timing of security issues. Due to the changing market sentiments the company has to decide whether to obtain funds through common shares or debt. (8) Floatation Costs: Floatation costs are incurred when the funds are obtained. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a firm to use debt rather than issue ordinary shares. Floatation costs are not incurred if the owners capital is increased by retaining the earnings.

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