CHARTERED ACCOUNTANCY PROFESSIONAL II

(CAP-II)

Revision Test Paper

Group II
December 2020

Education Division
The Institute of Chartered Accountants of Nepal

The Revision Test Papers are prepared by the institute with a view to assist the students in their study.
The suggested answers given here are indicative and not exhaustive. Students are expected to apply their
knowledge and write the answer in the examinations taking the suggested answers as guide. Due care has
been taken to prepare the revision test paper. In case students need any clarification, creative feedbacks or
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Paper 4: Financial Management

Paper 4: Financial Management

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Revision Questions
STRATEGIC FINANCE AND POLICY

Long term financing

Question No. 1

Shivam Limited is a listed company having a share capital of Rs. 1,000 million consisting of 10
million shares of Rs. 100 each. Its net equity at book value, as of Ashad end 2077 was Rs. 2,000
million. The company maintains a debt equity ratio of 70:30 based on market value. Long term
debt constitutes 90% of total liabilities of the company. It is the policy of the company to invest
60% of its total assets in listed securities. The correlation between the market value of these
listed securities held by the company and the Index is 1.1. On Ashad end 2077, the company’s
shares were traded at price to book value ratio of 1.4.
During the month of Shrawan 2077, the Index fell by 20%. This fall in Index also affected the
market price of the company’s shares and as of Shrawan end 2077, they were being traded at
price to book value ratio of 0.9.There was no significant change in the amount of liabilities and
other assets of the company during this month.

Required:
(a) Compute the amount of fresh equity required to be injected as of Shrawan end 2077 in order
to maintain the debt equity ratio.
(b) The company has been approached by Mr. Chaudhary, a large investor, who has offered to
provide the required capital as computed in (a) above at a discount of 10% of market value.
Compute the % holding of Mr. Chaudhary in the company, if his proposal is accepted.

Operating and financial gearing

Question No. 2

Mainawati Steel Industry is engaged in the manufacture of Galvanized Iron (GI) pipes. Its
summarized financial statements for the year ended Ashad 31, 2077 are as follows:

Statement of Financial Position

Particulars Rs.
Equity and Liabilities
Share capital 1,250,000
Reserves 5,250,000
Long term debt 2,500,000
Current liabilities 625,000

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9,625,000
Assets
Fixed assets 7,500,000
Inventory 750,000
Receivables 875,000
Cash 500,000
9,625,000

Income Statement
Particulars Rs.
Sales of 12,500 units 11,718,750
Variable costs (7,812,500)
Fixed costs (1,750,000)
Interest expense (10%) (250,000)
Profit before tax 1,906,250
Tax (35%) (667,188)
Net profit 1,239,062

Owing to competitive pressures, the industry plans to reduce the prices of existing products by
6%. However, variable and fixed costs (excluding interest) are expected to increase by 5% and
10% respectively. Interest rate is floating and is expected to increase to 10.6% per annum.

Besides this, the management is also considering to launch a new product. Based on market
research, it has identified the following options:
Option 1 Option 2
Light Medium
Initial investment (Rs.) 3,000,000 7,000,000
Unit price (Rs.) 15,000 5,000
Fixed cost (Rs.) 200,000 300,000
Expected sales (units) 200 1,000
Variable costs (% of sales) 78% 73%

The management plans to invest in any one of these options. The investment would be financed
through long term loan from the Nepal Bank which is available at 12% per annum.

Required:
(a) Calculate the amount of sales that the industry should achieve in the following year to enable
it to maintain its existing total leverage. Show how this change would affect the operating and
financial leverages.

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(b) Calculate the impact of each of the above launching options on industry’s operating and
financial leverages for the next year ending. Which option would you recommend and why?
(Assume that implementation of the above options would have no impact on the sales of existing
products as computed in (a) above).

Cost of Capital

Question No. 3

Katmandu Limited intends to raise financing for the company’s expansion project but is
concerned about the impact of proposed additional financing on the company’s existing cost of
capital. The management is aware that there is an inverse relationship between interest cover
and cost of long term debt and the following relationship exist between interest cover and cost of
debt:
Interest cover (times) 2 to 4 4 to 6 6 to 8 8 above
Cost of long term debt 13% 11% 9% 8%

The management has found that the following two debt equity ratios are usually prevalent in the
industry and are also acceptable to the company’s banker.
(i) 70% equity, 30% debt by market values
(ii) 50% equity, 50% debt by market values

The latest audited financial statements depict the following position:

Rs. in million
Net profit before tax 272
Depreciation 50
Interest @ 9% 55

Market value of existing equity and debt is Rs. 825 million and Rs. 550 million respectively. The
company’s equity beta is 1.25 and its debt beta may be assumed to be zero. The risk-free rate of
return and market return are 7% and 15% respectively. Applicable tax rate is 35%. Assume that
market value of the company at the existing weighted average cost of capital after the proposed
expansion would remain the same.

Required:
Calculate the weighted average cost of capital under the current as well as each of the above debt
equity ratios being considered by the company.

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Capital Structure

Question No. 4

Hulas Electronics Ltd., one of the listed companies, is renowned for its quality products. The
company has 100,000 ordinary shares and the market value of its shares is Rs. 4,650,000 cum-
dividend. The next annual dividend of Rs. 900,000 is due to be paid within a few days. It
is generally expected that the company’s dividends will remain indefinitely at the current
level. The company has no capital carrying fixed charges.

The company is considering an investment project that would require the immediate investment
of Rs. 500,000 and would produce net annual inflows of Rs. 132,000 indefinitely. The first one
would arise after one year. Details of the project have not yet announced publicly. All receipts
from the project would be distributed as dividends when received. If the project was
accepted, the management’s expectation of future results would be communicated to and
believed by, the stock market and that the market would perceive the risk of the company to
be unaltered. The project would be financed in one of the following three ways:
(i) A right issue of one new share for every four held at a price of Rs. 20 per share
(ii) A reduction of Rs. 500,000 in the current dividend
(iii) A public issue of ordinary shares
Note: In above (i) and (iii), the new shares would rank for dividend one year after issue.

Further , the Chief Operating Officer (COO) of the Company is of the view that the proposed
price of the rights issue seems rather low and he suggests one for five rights issue at a
price of Rs. 25 per share nearer to the current market value of ordinary shares.

Ignoring the issue cost of new shares and taxation, you are required to:

(a) Estimate the new market price per ordinary share, ex-dividend if the project is accepted and
financed by:
i. one for four rights issue, or
ii. a reduction in the current dividend
(b) Calculate the price at which new shares should be issued under option (iii) if the total
benefit from the project is to go to existing shareholders.
(c) Calculate the total gain made by present shareholders under each of the three
financing options
(d) Comment briefly on the views expressed by COO

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Question No. 5

Akash Ltd. and Bikash Ltd. are identical companies except for capital structures. Akash Ltd.
consists of 50% debt and 50% equity whereas Bikash Ltd consists of 20% debt and 80%
equity. The percentage of debt and equity of both companies have been expressed in
terms of market value. The borrowing rate for both companies is 8% in a no-tax
jurisdictions and capital markets are assumed to be perfect. Both companies have net operating
income of Rs. 720,000. You own 10% of the equity of Akash Ltd.
Required:
(i) What is your rupee return if the overall capitalization rate of the company is 18%?
What is the implied required rate of return on equity of Akash Ltd.?
(ii) What is the implied required equity return of Bikash Ltd.? Why does it differ from that of
Akash Ltd.?

ANALYSIS OF FINANCIAL STATEMENTS

Financial Statement Analysis

Question No. 6

Century Noodles Ltd. is performing quite well in the last many years in terms of market
share. The company’s turnover was Rs. 7 million last year earning 10% profit after tax.
Presently, the company is facing difficulties to pay its accounts payable in time. Though, the
terms of purchase are net 30 days, but its accounts payable represent 60 days purchases.
The company intends to increase bank borrowings in order to meet its current trade obligations.
The statement of financial position of the company is as under:

Century Noodles Ltd.

Statement of Financial Position
As on Mid-July, 2019
Assets Rs. in '000
Cash 200
Accounts receivable 600
Inventory 2,800
Land and buildings 1,200
Equipment 1,200
Total assets 6,000

Liabilities and equity Rs. in '000

Accounts payable 1,200

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Bank demand loan 1,400

Accruals 400
Long-term debt 1,400
Share capital (Rs. 10 each) 600
Retained earnings 1,000
Total liabilities and equity 6,000

Required:
a) How much bank financing is needed to eliminate the past due accounts payable of Century
Noodles Ltd.?
b) Would you as a bank credit officer make the loan? Justify your decision based on ratio
analysis.

Ratio Analysis

Question No. 7

The following accounting information and financial ratios relate to the Sunrise Ltd.:
(i) Accounting information
Direct wages 10% of works cost
Stock of raw material 3 months’ usage
Stock of finished goods 6% of works cost
Raw material consumed 20% of works cost
Debt collection period 60 days
Gross profit 15% of sales
Net profit 8% of sales
All sales on credit

(ii) Ratios
Fixed asset to sales 1:3
Fixed assets to current assets 13:11
Current ratios 2
Long term loan to current liability 2:1
Capital to reserve and surplus 1:4

If the value of fixed assets amounted to Rs. 2.6 million, prepare a statement of financial
position of the company.

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Distribution Policy

Question No. 8

Yeti Ltd is an all equity financed company listed in the stock exchange. Over recent years, the
management has adopted a fairly conservative policy of not seeking expansion, but has been
content to earn a steady level of profits and most of which have been distributed as dividends.

Recently, new board of directors has been elected from annual general meeting. The new board
has pressurized the management to actively seek more new investment opportunities. In the
financial year which has just ended the company reported profits of Rs. 5 million, a similar
figure to that of recent years. It has been estimated that the company's cost of equity is 15% per
annum. The management has identified four investment projects all of which could commence
immediately. The estimated cash flows and timings of these projects are as follows.
Rs.in million
Project
Year Arun Barun Chitse Dotse
0 (2.00) (2.00) (3.00) (1.00)
1 0.75 0.65 0.80 0.50
2 0.75 0.65 0.80 0.50
3 0.75 0.65 0.80 0.50
4 0.65 0.80
5 0.65 0.80
5 0.65 0.80

Each of these projects is in the same risk class as the company's existing projects.

You, as CFO of the company, have been asked by the board to give your advice on dividend
policy at coming board meeting.

Requirements:
(a) Calculate how much Yeti Ltd. should pay to shareholders as a dividend in respect of the
company's financial year which has just ended under Modigliani and Miller dividend policy.
(b) Also identify the four reasons why the company's board may decide not to pay the level of
dividend which you indicated in (a). Your comments must relate to the particular circumstances
of Yeti Ltd.

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Mutual Fund

Question No. 9

(a) Sahepati mutual fund has the following assets under it on the close of business as on:
No. of Shares 20 August 2020 21 August 2020
Company Market price per share Market price per share
Rs. Rs.
Beni Hydro Ltd. 20,000 20 20.5
National Microfinance Ltd. 30,000 312.4 360
Supreme Insurance Ltd. 20,000 361.2 383.1
Apex Insurance Ltd. 60,000 505.1 503.9
Total no. of units 600,000

Required:
(i) Calculate NAV of the fund?
(ii) Mr. Keshav submits a cheque of Rs. 3,000,000 to the mutual fund and the fund manager
purchases 8,000 shares of National Microfinance Ltd. and the balance amount is held in the
vault. In such a case, what would be the position of the fund? Also find new NAV of the fund as
on 21 August, 2020?

CAPITAL INVESTMENT DECISION

Investment Appraisal

Question No. 10

Pokhara Domestic Airport is modernizing its facilities in anticipation of soon completion of

Pokhara International Airport which is just about 3 KMs away. It believes there will be
significant growth in the number of passengers using the airport due to opening of international
airport. Further, it is expected that the number of passengers will increase by 10% per annum in
the airport due to increase in number of international arrivals as a result of opening international
airline new routes.

At present, the airport has only one food outlet selling snacks and other cold food and drinks. To
improve the facilities available to customers, the management of the airport is considering
opening a restaurant selling a range of hot food and drinks. The cost of fitting out the new
restaurant, which will have to be fully refurbished after four years, is estimated to be Rs.
350,000. These assets are expected to have a residual value of Rs. 30,000 at the end of four
years. PK consultants carried out an extensive study in relation to this project at a cost of Rs.

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30,000. The key findings from their report, regarding expected revenue and contribution from the
restaurant are as follows:
Average revenue: Rs. 9.00 per customer
Average variable cost: Rs. 5.00 per customer
Demand in year 1: 500 customers per day
Future demand for the restaurant is expected to rise in line with passenger numbers.
The airport operates for 360 days per year.

Other relevant information from the consultants’ report is listed below:

1. Staffing of the new restaurant

Number of employees (Years 1 and 2): 4
Numbers employees (Years 3 and 4): 5
Average salary per employee: Rs. 20,000 per annum

2. Overheads
The annual budgeted fixed overhead of the airport which will be apportioned to the restaurant is
Rs. 80,000.
The annual overheads apportioned to the cold food outlet will be Rs. 30,000.
The airport’s overheads are expected to increase by the following annual amounts as a direct
result of the opening of the restaurant:
Electricity: Rs. 40,000
Advertising: Rs. 20,000
Audit: Rs. 10,000

3. Cold food outlet

The average contribution from the sale of cold food is Rs. 2.50 per customer. If the restaurant is
not opened it is expected that the cold food outlet will sell to 1,200 customers per day in the
coming year and in subsequent years the customer numbers will rise in line with passenger
numbers.
If the restaurant is opened, the consultants expect sales from the existing cold food outlet to
initially reduce by 40% in year 1 and then to increase in line with passenger numbers.

4. Tax related information

Tax depreciation: 25% reducing balance per annum.
The first year’s tax depreciation allowance is used against the first year’s net cash inflows.
Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it arises, the
balance is paid the following year.
Any taxable losses resulting from this investment can be set off against profits made by the
airport company’s other business activities since the airport company is profitable.

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Now you, as an investment analyst, is required to advise calculating net present value of the
restaurant project based on above information. You may assume that post-tax cost of capital is
8% per annum to evaluate projects of this type.

Capital Rationing

Question No. 11

Nice Ltd. has identified the following investment projects.

Rs. in 000
Year 0 Year 1 Year 2
Project A (100) (100) 304
Project B (50) (100) 219
Project C (200) 100 108
Project D (100) (50) 309
Project E (200) (50) 345

Advise in the following circumstances:

(a) The company faces a perfect capital market where the appropriate discount rate is 10%. All
projects are independent and divisible. Which projects should the firm accept?
(b) The company faces capital rationing at Year 0. There is only Rs. 225,000 of finance
available. None of the projects can be delayed. Which projects should the firm accept?
(c) The situation is as in part (b) above, except that you are now informed that projects A and B
are mutually-exclusive. Which projects should now be accepted?
(d) The solution is as in part (b) above, except that you are now told that all projects are
independent but indivisible. Which projects should be accepted? What will be the maximum
NPV available to the company?

Time Value of Money

Question No. 12

You have recently qualified as Chartered Accountant. Now, you have been just offered to join
the multinational companies namely International Ltd. and Global Ltd. They have offered you
two different salary arrangements but both in terms of US dollar. International Ltd. offered you
to have $95,000 per year for the next two years. Global Ltd. offered you to have $70,000 per
year for the next two years, along with a $45,000 signing bonus today. The bonus is paid
immediately, and the salary is paid at the end of each year. If the interest rate is 10 percent

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compounded monthly, which multinational company you prefer to join? Ignore foreign exchange
factors and non-financial factors.

VALUATION OF SECURITIES

Valuation of Bond

Question No. 13

Platinum Bond is a premium bond with a 12 percent coupon. Diamond Bond is a 6 percent
coupon bond currently selling at a discount. Both bonds make annual payments, have an YTM of
9 percent, and have five years to maturity. What is the current yield for both bonds? If interest
rates remain unchanged, what is the expected capital gains yield over the next year for both
bonds? Also explain your answers and the interrelationships among these yields.
Assume that the par value of both bonds is Rs. 1,000.

Valuation of Shares

Question No. 14

Everest Limited currently pays Rs.3.20 annual dividend on its common stock in a single annual
instalment, and the management plans on raising this dividend by 6 percent per year indefinitely.
If the required return on this stock is 12 percent, what is the current share price?
Now let’s suppose the company actually pays its annual dividend in equal quarterly instalments
instead of single annual instalment; thus, the company has just paid Rs.80 dividend per share, as
it has for the previous three quarters. What is the value for the current share price now?

Risk and Return

Question No. 15

You have Rs. 1,000,000 to invest. Given following information, what amount should it be
needed to make investment in Stock C and risk free asset to create a portfolio equally as risky as
the market?

Asset Investment Beta

Stock A Rs. 210,000 0.85
Stock B Rs. 320,000 1.20
Stock C 1.35

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WORKING CAPITAL MANAGEMENT AND FINANCIAL FORECASTING

Working Capital and Financial Forecasting

Question No. 16

On Shrawan 1 of the current year, a client of yours, Ankit International has approached their
banker for working capital loan, who have agreed to the same after having review of forecasted
statement of working capital requirements along with forecasted income statement and balance
sheet. They have, now, asked you to prepare these statements as required by the banker. The
following information is made available to you:
a) Issued and paid-up capital Rs. 200,000.
b) 5% Debentures (secured on assets) Rs. 50,000.
c) Fixed assets valued at Rs. 125,000 on Ashad end of the previous year.
d) Production during the previous year was 60,000 units; it is planned that this level of activity
should be maintained during the present year.
e) The expected ratios of cost to selling price are: raw materials 60 per cent, direct wages 10 per
cent and overheads 20 per cent.
f) Raw materials are expected to remain in store for an average of two months before these are
issued for production.
g) Each unit of production is expected to be in process for one month. Full unit of raw materials
is required in the beginning of production.
h) Finished goods will stay in warehouse for approximately three months.
i) Creditors allow credit for 2 months from the date of delivery of raw materials.
j) Credit allowed to debtors is 3 months from the date of dispatch.
k) Selling price per unit is Rs 5.
l) There is a regular production and sales cycle.
m) Debtor to be valued at cost for bank’s requirement.

Required:
(a) Forecast working capital requirement
(b) Forecast income statement and balance sheet at the end of the year.

Receivable Management

Question No. 17

Riddi Ltd. has received an order from NB Ltd. for the machinery at Rs. 50,000 to be supplied on
60 days credit. The variable costs of production which would be incurred by Riddi Ltd. in

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meeting the order amount to Rs. 40,000. NB Ltd.’s creditworthiness is a suspicious and the
following estimates have been made:
Probability of NB Ltd. paying in full in 60 days 60%
Probability of NB Ltd. completely defaulting 40%

However, if the order is accepted by Riddi Ltd. and if NB Ltd. does not default, then there
appears to be a probability of about 70% that a further eight identical orders will be placed by
NB Ltd. in exactly 1 year time, and further orders in later years may also be forth coming.
Experience has shown that once a firm meets the credit terms on an initial order, the probability
of default in the next year reduces to 10%. Any work carried out on NB’s Ltd. order would take
place in otherwise idle time and would not encroach upon Riddi Ltd’s other activities. Should
NB Ltd. defaults, the legal and other costs of debt recovery would equal any money obtained.
Riddi Ltd. finances all trade credit with overdrafts at a cost of 12% p.a. An appropriate discount
rate for long term decisions is 15% p.a. A year may be taken as 360 days.

Evaluate the proposal if:

(i) only one order is expected from NB Ltd.,
(ii) further orders are also expected from NB Ltd.,

Inventory Management

Question No. 18

Hulas Sports starts each period with 10,000 badminton sets in stock. This stock is depleted each
month and reordered. If the carrying cost per badminton set is Rs. 1 and the fixed order cost is
Rs. 5; Is Hulas Sports following an economically advisable strategy?

Question No. 19

What are the emerging roles of financial manager?

Question No. 20

Distinguish between:

a. Transaction motive and Precautionary motive

b. Credit standards and Credit terms
c. Growth firms and declining firms under Walter’s Dividend Model
d. Traditional and modern techniques of capital budgeting
e. American Depository Receipt and Global Depository Receipt

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f. Interest Coverage Ratio and Dividend Coverage Ratio

g. Dematerialization and Rematerialization

Question No. 21

Write short notes on:

a. Zero Working Capital Strategy

b. Assumptions of MM Theory on Dividend Policy
c. Significance of cost of capital
d. EBIT-EPS analysis
e. ASBA and C-ASBA
f. Basic assumptions of capital budgeting
g. Nature of financial management

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Answers/Hints

STRATEGIC FINANCE AND POLICY

Long term financing

Answer No. 1
(a) Fresh equity required to be injected on Shrawan end 2077

Particulars Rs. in million

Market value of equity on Ashad end 2077 (WN- 1) 2,800
Market value of equity on Shrawan end 2077 (WN-2) 700
Fresh equity required 2,100

Since the market value of debt on Shrawan end 2077 is the same as the market value of debt on
Ashad end 2077, the company has to maintain the same level of equity also.

Working Notes (WNs):

1. Market value of net equity and debt as of Ashad end 2077
Rs. in million
Net equity at book value 2,000
Market value of the company's shares (2,000 x 1.4) 2,800
Existing debt (2,800 x 70/30) 6,533.33

2. Market value of net equity as of Shrawan end 2077

Book value of net equity as of Ashad end 2077 2,000

Less: Loss on listed securities portfolio (WN 3) 1,222.22
Net Equity as at Shrawan end 2077 777.78
Market value of equity as at Shrawan end 2077 (Rs. 777.78 x 0.9) 700

3. Loss on listed securities portfolio

Decline in Stock 20%

Correlation 1.1
Decline in company’s portfolio value 22%
Listed portfolio value as at Ashad end 2077 (Rs. in million) 5,555.56
(WN-4)
Loss on portfolio (5,555 x 22%) (Rs. in million) 1,222.22

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4. Listed portfolio value as at Ashad end 2077

Rs. in million
Value of long term debt (WN-1) 6,533.33
Value of other liabilities (6,533.33 ÷ 90 x 10) 725.93
Value of equity 2,000
Total Assets 9,259.26
Listed securities (60% of total assets) 5,555.56

(b) % holding of Mr. Chaudhary

Market value of required new equity (Rs. in million) 2,100
Current market price (700 ÷ 10) (Rs.) 70
Number of shares [2,100 ÷ (70 x 90%)] (shares in million) 33.33
Already issued shares (shares in million) 10.00
Total number of shares (shares in million) 43.33
% holding (33.33 ÷ 43.33) 76.92%

Operating and financial gearing

Answer No. 2

(a) Computation of existing combined leverage

Contribution Margin
Combined leverage =
Earnings Before Tax

11,718,750 − 7,812,500
Combined leverage =
1,906,250

= 2.05

Determination of sales value where total leverage remains intact

Contribution Margin
Combined leverage =
Earnings Before Tax

Contribution Margin % ∗ Sales

2.05 =
Contribution Margin % ∗ Sales − Fixed cost − Interest Expenses

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K
2.05 =
K − 1,750,000 ∗ 110% − 2,500,000 ∗ 10.6%

K
2.05 =
K − 1,925,000 − 265,000

K
2.05 =
K − 2,190,000

2.05 K − 4,489,500 = K
1.05 K = 4,489,500
1.05 (Contribution Margin % ∗ Sales ) = 4,489,500
(sales ∗ 937.5 ∗ 94 % − Sales ∗ 625 ∗ 105% ) = 4,275,714 (WN -1)
225 sales = 4,275,714
Sales = 19,003 units
Sales amount = 19,003 * 937.50 * 94% = Rs. 16,746,394

Effects on Operating Leverage and Financial Leverage

Contribution Margin
Operating leverage =
Earnings Before Interest and Tax

Earnings Before Interest and Tax

Financial leverage =
Earnings Before Tax

Existing Revised
(11,718,750- 7,812,500)/2,156,250 4,275,675/2,350,675 (WN-2)
Operating Leverage
= 1.81 =1.82
2,156,250/1,906,250 2,350,675/2,085,675 (WN-2)
Financial Leverage
= 1.13 = 1.13

(b) Comment on the behavior of operating and financial leverages ratio in relation to launching
of either Product Light or Product Medium

Existing Light Medium Existing as Existing as per

as per per (a) (a)
Particulars (a) + Light + Medium
Sales 16,746,394 3,000,000 5,000,000 19,746,394 21,746,394
Variable cost 12,470,719 2,340,000 3,650,000 14,810,719 16,120,719
Contribution 4,275,675 660,000 1,350,000 4,935,675 5,625,675

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Fixed Costs 1,925,000 200,000 300,000 2,125,000 2,225,000

Earnings before
2,350,675 460,000 1,050,000 2,810,675 3,400,675
interest and tax
Interest expense 265,000 360,000 840,000 625,000 1,105,000
Earnings before tax 2,085,675 100,000 210,000 2,185,675 2,295,675

Operating Leverage 1.82 1.76 1.65

Financial Leverage 1.13 1.29 1.48

Comment:
a) Operating leverage is declining under each of the two options, which is a favourable
condition.
b) Financial leverage would be considerably high, in case the company opts for launching
Product Medium, although it is also accompanied by a higher profit.
c) In case the management is willing to accept the higher risk as referred to in (b) above, it
would be preferable to launch Product Medium. Otherwise, it would opt to launch
Product Light.

Working Notes (WNs):

1. Calculation of per unit sale price and variable cost
Sales Variable cost
Total 11,718,750 7,812,500
Units 12,500 12,500
Per Unit 937.50 625.00

2. Forecasted Income Statement

Rs.
Sales 16,746,394
Variable cost 12,470,719
Contribution 4,275,675
Fixed Costs 1,925,000
Earnings before interest and tax 2,350,675
Interest expense 265,000
Earnings before tax 2,085,675

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Paper 4: Financial Management

Cost of Capital

Answer No. 3
Existing debt equity ratio
Equity = 825 / 1375 = 60%
Debt = 550 / 1375 = 40%

Calculation of cost of debt:

At existing capital structure

After tax cost of debt (Kd) = 9% * 65% = 5.85%

At 70% equity 30% debt

Since interest cover has an inverse relationship, assuming decline in debt moves the company to
lower category of interest rate:
30% debt in existing market value of the company (30% x 1375) = 412.50
Cost of debt = (8% x 412.5) = 33
Interest cover = (327/33) = 9.91 (Profit before interest and tax/ Interest)
Kd (after tax) = 8% *65%= 5.20%

At 50% equity 50% debt

Since interest cover has an inverse relationship, assuming increase in debt moves the company to
upper category of interest rate:
50% debt in existing market value of the company (50% x 1375) = 687.50
Cost of debt = (11% x 687.5) = 75.63
Interest cover = (327/75.63) = 4.32
Kd (after tax) = 11%*65%= 7.15%

Calculation of Cost of equity:

Equity Debt (1 − tax)

β ( Asset) = β ( Equity) ∗ + β ( Debt) ∗
Equity + Debt (1 − tax) Equity + Debt (1 − tax)
825
β ( Asset) = 1.25 ∗ +0
825 + 550 ∗ 65%
β ( Asset) = 0.872

We have, Ke = rf + (rm - rf) β

where ,
Ke = Cost of equity
rf = Risk free rate of return

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Paper 4: Financial Management

rm = market return
βe = beta equity

At existing capital structure

Ke = 7% + (15% - 7%) x 1.25 = 17%

At 70% equity 30% debt

Equity + Debt (1 − tax)
βe = β(Asset) ∗
Equity
0.7 + .3 ∗ 65%
= 0.872 ∗
0.7

=1.115

Ke = 7% + (15% - 7%) x 1.115 = 15.92%

At 50% equity 50% debt

Equity + Debt (1 − tax)
βe = β(Asset) ∗
Equity
0.5 + .5 ∗ 65%
= 0.872 ∗
0.5
=1.439

Ke = 7% + (15% - 7%) x 1.439 = 18.51%

Calculation of Weighted Average Cost of Capital (WACC):

Equity Debt Cost of Cost of WACC (a*c

Case proportions proportions Equity debt +b*d)
(a) (b) (c ) (d)
At existing capital structure 60% 40% 17.00% 5.85% 12.54%
At 70% equity 30% debt 70% 30% 15.92% 5.20% 12.70%
At 50% equity 50% debt 50% 50% 18.51% 7.15% 12.83%

Capital Structure

Answer No. 4

(a)
i. Calculation of market price per ordinary share, ex-dividend using rights issue

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Required rate of return by shareholders = 900,000/(4,650,000-900,000)

=900,000 /3,750,000
=24.00%
Ex-dividend value of company after project accepted equals to present value of increased annual
dividends to perpetuity after project accepted.

Rs.
Annual Dividends before projected is accepted 900,000.00
Net annual inflows from the project 132,000.00
Increased annual dividends 1,032,000.00
Present Value of increased annual dividends to perpetuity 1,032,000/24% = 4,300,000

Number of shares after right issue = 100,000*5/4 = 125,000

Ex-dividend price per share = 4,300,000/125,000 = Rs. 34.40

ii. Calculation of market price per ordinary share, ex-dividend using retained earnings

Present Value of increased annual dividends to perpetuity = Rs. 4,300,000

Numbers of shares (no issue) = 100,000
Ex-dividend price per share = 4,300,000/100,000
= Rs. 43.00

(b) Financing from public issue of shares (If total benefit from the project goes to existing
shareholders)

Rs.
Ex-dividend value of company after project accepted 4,300,000.00
Less: Value of new shares issued 500,000
Value of original shares after project accepted 3,800,000.00

Since the original number of shares = 100,000

Issued price = 3,800,000/100,000= Rs 38 per share
Since the new shareholders make no gain, the shares should be issued at Rs. 38 per share

(c) Calculation of gain made by present shareholders

Gain made by the present shareholders Rs.

(i) Right issue

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Value of total shareholding after issue (125,000* 34.40) 4,300,000.00

Value of total shareholding before issue (100,000* 37.50) 3,750,000.00
Gain in value of shareholdings 550,000.00
Less: Cash outflow on right issue 500,000.00
Net Gain 50,000.00

(ii) Retained earnings

Value of total shareholding after use of dividend (100,000* 43) 4,300,000.00
Value of total shareholding before use of dividend (100,000* 37.50) 3,750,000.00
Gain in value of shareholdings 550,000.00
Reduction in dividend 500,000.00
Net Gain 50,000.00

(iii) Public issue

Value of total shareholding after issue (100,000* 38) 3,800,000.00
Value of total shareholding before issue (100,000* 37.50) 3,750,000.00
Gain in value of shareholdings 50,000.00

(d) Comment on the views expressed by COO

The price of the rights issue is irrelevant given that all the cash asked for by the company is
received. The existing shareholders are contributing cash in the proportions in which they are
holding the shares currently and will continue to hold the same proportion of the shares in the
company if they accept the offer. If the right issue calculations is made based on one for five
issue at Rs. 25 per share, the gain made by the shareholders will be same, regardless of the fact
that the share price settles at a higher future.

Answer No. 5
Akash Ltd.

Particulars Rs.
Net Operating Income-1 720,000.00
Overall Capitalization Rate-2 18%
Total Value-1/2 4,000,000.00
Market Value of Debt (50%) 2,000,000.00
Market Value of Equity (50%) 2,000,000.00

Net Operating Income 720,000.00

Interest cost on debt @ 8% 160,000.00
Earnings available 560,000.00

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Return in Rs. = 10%* Rs. 560,000

= Rs. 56,000

Implied required rate of return on equity of Akash Ltd. = Rs. 560,000/ Rs. 2,000,000
= 28%

Bikash Ltd.

Particulars Rs.
Total Value (as calculated above) 4,000,000.00
Market Value of Debt (20%) 800,000.00
Market Value of Equity (80%) 3,200,000.00

Net Operating Income 720,000.00

Interest cost on debt @ 8% 64,000.00
Earnings available 656,000.00

Implied required rate of return on equity of Bikash Ltd. = Rs. 656,000 / Rs. 3,200,000
= 20.50%
It is lower because Bikash Ltd uses lesser debt in capital structure. As the equity capitalization is
a linear function of debt equity ratio, when we use the net operating income approach, decline in
required equity return offsets exactly the minuses of not employing so much in the way of
cheaper debts.

ANALYSIS OF FINANCIAL STATEMENTS

Financial Statement Analysis

Answer No. 6
a. Calculation of bank financing needed

Amount of financing
= (Accounts payable balance /Days Payables Outstanding) *(Days outstanding – days as per
term)
= Rs. 1,200,000/60 * (60-30)
= Rs. 600,000

b. Given the information, decision can be based on following ratios comparison:

Ratios:

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Paper 4: Financial Management

Current Ratio = Rs. 3,600 /Rs. 3,000 = 1.20 ( see WNs)

Quick Ratio = Rs .800 /Rs. 3,000 = 0.27 ( see WNs)

Debt Ratio =Rs. 4,400 /Rs.6, 000 =0.73 or 73% ( see WNs)

Observations:
a) The current ratio seems to be low but current assets could cover current liabilities if all
accounts receivable can be collected and if the inventory can be realized at its book value.
b) The quick ratio indicates that currents assets exclusive of inventory are only sufficient to
cover 27 % of current liabilities which appears to be very bad.
c) Company’s debt ratio is 73% which is almost 3/4th financing of assets by total debts. This
indicates the company has been undercapitalized.
d) The company appears to be holding inventory at excessively level and financing debt with
extensively. Borrowings in term of bank demand loan and long term debt are already high
and liquidity situations is even poorer.

Decision:
On the basis of above observations, the loan should be denied and the company should be
advised to seek permanent capital, especially equity capital.

Working Notes (WNs):

Current Assets = Cash + Accounts receivable + Inventory
=200+ 600+2800
=Rs. 3,600
Quick Assets = Cash + Accounts receivable
=200+ 600
=Rs .800
Current liabilities =Accounts payable + Bank loans + Accruals
= 1,200 + 1,400 + 400
= Rs. 3,000
Total debt = 3,000 + 1,400
= Rs. 4,400
Total fund =Rs.6, 000

Ratio Analysis

Answer No. 7
(1) Calculation of sales
Fixed asset to sales = 1:3

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Sales/ fixed assets = 3

Sales / 2,600,000 = 3
Sales = 3× 2,600,000
= Rs. 7,800,000

(2) Calculation of current assets

Fixed asset to current assets = 13:11
Current assets = fixed assets × 11/13
= 2,600,000× 11/13
= Rs. 2,200,000

(3) Calculation of raw material consumption Rs.

Sales 7,800,000
Less: gross profit (15% of sales) 1,170,000
Works cost 6,630,000
Raw material consumption (20% of works cost) 1,326,000
Direct wages (10% of works cost) 663,000

(4) Calculation of stock of raw materials

Stock of raw material = 3 months usage
= 1,326,000× 3/12
= Rs. 331,500

(5) Calculation of stock of finished goods

Stock of finished goods = 6% of works cost
= 6,630,000 × 6%
= Rs. 397,800

(6) Calculation of current liabilities

Current ratio = 2
Current asset/current liability = 2
2,200,000 /current liabilities = 2
Current liabilities = Rs. 1,100,000

(7) Calculation of debtors

Average collection period = 60 days
(Debtors / Credit sales) ×365 = 60 days
Debtors = (7,800,000×60)/365
= Rs. 1,282,000 (rounded to nearest thousand)

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(8) Calculation of long term loan

Long term loan to current liabilities = 2:1
Long- term loan /Current liabilities = 2
Long term loan = 2×1,100,000 = Rs. 2,200,000

(9) Calculation of cash Balance Rs.

Current assets 2,200,000
Less:
Debtors 1,282,000
Raw material 331,500
Finished goods stock 397,800
Cash balance 188,700

(10) Calculation of net worth Rs.

`
Fixed assets 2,600,000
Current assets 2,200,000
Total assets 4,800,000
Less:
Long term loan 2,200,000
Current liabilities 1,100,000
Net worth 1,500,000

Net worth = share capital + reserves

Capital to Reserves and surplus = 1:4

Share capital = 1,500,000 ×1/5 = Rs. 300,000
Reserve & surplus = 1,500,000 ×4/5 = Rs. 1,200,000

Sunrise Ltd.
Statement of Financial Position
Liabilities Rs.
Share capital 300,000
Reserves & surplus 1,200,000
Long term loans 2,200,000
Current liabilities 1,100,000
Total 4,800,000

Assets Rs.
Fixed assets 2,600,000

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Current assets :
Stock of raw material 331,500
Stock of finished goods 397,800
Debtors 1,282,000
Cash 188,700
Total 4,800,000

Distribution Policy

Answer No. 8

Net present value of projects can be obtained as follows:

NPV = – Initial outlays +Annual cash flows * CDF for required years at 15%
Arun = – 2m + (0.75m * 2.283) = – Rs. 0.288 million
Barun = – 2m + (0.65m * 3.352) = Rs. 0.179 million
Chitse = – 3m + (0.8m * 3.352) = – Rs. 0.318 million
Dotse = – 1m + (0.5m * 2.283) = Rs. 0.142 million

As there is sufficient capital to undertake all positive NPV projects, the company should invest in
Barun and Dotse and utilize Rs. 3 million.

The dividend under the Modigliani and Miller policy is the residue dividend
i.e. Rs. 5 million – Rs.3 million = Rs. 2 million.

(b) Reasons the company may not pay Rs. 2 million dividend

The above analysis assumes a perfect capital market and that any imperfections will impair the
conclusion. The major imperfections that may cause Yeti Ltd. to reconsider its dividend are
given below:

Information content of dividends

In a perfect market, investors know everything about a company and its intentions, and in
particular know that a dividend is reduced only in order to fund attractive projects. In reality,
information is restricted and many investors may not be aware of the reasons. The dividend itself
is taken as an important indicator of company health, and cutting the dividend from its previous
fairly constant level may convince the investors of problems in the company. If enough
shareholders decide to sell their holding the share price will drop.

Tax preferences of shareholders

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A perfect capital market assumes indifference between income in the form of dividends and
capital gains made as the share price rises. In reality, however, the different tax positions of
investors will mean that some prefer dividend income, while some prefer an increase in share
prices.

Clientele theory
It follows that Yeti Ltd should discover whether its shareholders prefer dividends or capital
gains.
However, as the company has been following a policy of paying out most of its profits as
dividends for a number of years, it is likely to have attracted those investors (or the clientele)
who prefer this policy. A change to one of retaining profits in order to give a capital gain may
well be unpopular with these current investors, and may prompt a wide trading of the shares as
they are replaced by investors who prefer a policy of retention.

Preference for cash now

Some investors will prefer to take the dividend now, rather than rely on an increase in future
years.
In a perfect market this will be fully reflected in the discount rate (cost of equity) used and so be
compensated in the share price; in real life this may not be so.

Notes: Other valid reasons are also equally acceptable.

Mutual Fund

Answer No. 9
Calculation of Net Assets Value (NAV)
Rs.
20 August 2020 21 August 2020

Company No. of Market Value of No. of Market Value of

Shares price per securities Shares price per securities
share share
Beni Hydro Ltd. 20,000 20 400,000 20,000 20.5 410,000
National
Microfinance 30,000 312.4 9,372,000 38,000 360 13,680,000
Ltd.
Supreme
20,000 361.2 7,224,000 20,000 383.1 7,662,000
Insurance Ltd.
Apex Insurance
60,000 505.1 30,306,000 60,000 503.9 30,234,000
Ltd.

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47,302,000 51,986,000
Cash (Note 1) - 500,800
Total NAV 47,302,000 52,486,800
Units (Note 2) 600,000 638,051.75
NAV per unit 78.84 82.26

Notes:
1. Cash Balance = Rs. 3,000,000- 8,000 * 312.4 = Rs. 500,800
2. Additional Units= 3,000,000 / 78.84 = 38,051.75 units

CAPITAL INVESTMENT DECISION

Investment Appraisal

Answer No. 10

Restaurant: Number of customers in Year 1 = (500 x 360) = 180,000

Contribution per meal = Rs. 4
Total contribution = Rs. 720,000

Cold food outlet: Number of meals in Year 1 = (1,200 x 360) = 432,000

Contribution per meal = Rs. 2.50
Total contribution = Rs. 1,080,000
Reduction in contribution = Rs. 1,080,000 x 40%
= Rs. 432,000

All figures in Rs.

Cash flows Year 1 Year 2 Year 3 Year 4

Restaurant Contribution 720,000 792,000 871,200 958,320
Reduction in contribution from cold food (432,000) (475,200) (522,720) (574,992)
Salaries (80,000) (80,000) (100,000) (100,000)
Additional overheads (70,000) (70,000) (70,000) (70,000)
Net cash flows 138,000 166,800 178,480 213,328

Tax Calculation Year 1 Year 2 Year 3 Year 4

Net Cash flows 138,000 166,800 178,480 213,328
Depreciation as per tax ( WN1) 87,500 65,625 49,219 117,656
Taxable Profit 50,500 101,175 129,261 95,672
Tax @ 30% 15,150 30,353 38,778 28,702

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Calculation of Net Present Value

Year 0 Year 1 Year 2 Year 3 Year 4 Year5
Net Cash flows (350,000) 138,000 166,800 178,480 213,328
Salvage value 30,000
Tax payment -50% (7,575) (15,176.25) (19,389.19) (14,350.76)
Tax Payment -50% (7,575) (15,176) (19,389) (14,351)
Net Cash flows
(350,000) 130,425 144,049 143,915 209,588 (14,351)
after tax
Discount factor 1 0.9259 0.8573 0.7938 0.7350 0.6806
Present Value (350,000) 120,764 123,499 114,244 154,053 (9,767)

Net Present Value Rs. 152,793

Advise: The restaurant project gives positive Net Present Value (NPV) of Rs. 152,793, so the
project should be opened.

Working Note:
1. In Rs.
Calculation of depreciation Year 1 Year 2 Year 3 Year 4
Opening Value 350,000 262,500 196,875 147,656
Depreciation as per tax @ 25% 87,500 65,625 49,219 117,656
Closing Value 262,500 196,875 147,656 30,000*

* salvage value at disposal

Capital Rationing

Answer No. 11
Rs. in 000
Project A Project B Project C Project D Project E
Year 0 (100.00) (50.00) (200.00) (100.00) (200.00)
Year 1 (100.00) (100.00) 100.00 (50.00) (50.00)
Year 2 303.60 218.90 107.80 309.10 345.40
PV factor
Year 0 1 1 1 1 1
Year 1 0.91 0.91 0.91 0.91 0.91
Year 2 0.83 0.83 0.83 0.83 0.83
PV
Year 0 (100.00) (50.00) (200.00) (100.00) (200.00)

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Year 1 (90.91) (90.91) 90.91 (45.45) (45.45)

Year 2 250.91 180.91 89.09 255.45 285.45
NPV 60.00 40.00 (20.00) 110.00 40.00

a. All projects with NPV > 0 should be accepted. So, accept Projects A, B, D and E.

b. Using net benefit cost ratios (NPV/Initial investment), we have as follows:

Project A Project B Project C Project D Project E
Initial Investment (Rs.in 000) 100.00 50.00 200.00 100.00 200.00
NPV (Rs. in 000 ) 60.00 40.00 (20.00) 110.00 40.00
NPV/Initial investment ratio 0.60 0.80 (0.10) 1.10 0.20
Rank 3 2 5 1 4

Since Rs. 225,000 is finance available, accept projects D, B and 3/4th of A.

c. Using the rankings from (b) above,

The possible two alternative project combinations are as follows:

D, B, 37.5 of % E: NPV (Rs. in 000) = 110 + 40 + 15 = 165

D, A, 12.5 of % E: NPV (Rs. in 000) = 110 + 60 + 5 = 175

Accept the better combination of projects which is D, A and 12.5% of E.

d. Given the limited finance available, possible combinations are as follows:

A and B: NPV (Rs. in 000) = 60 +40 =100

A and D: NPV (Rs. in 000) =60 +110 =170
B and D: NPV (Rs. in 000) =64 +110 =150

Examining all the different whole project combinations shows that A and D produce the
maximum amount of total NPV, the amount being Rs. 170,000. Hence, accept Project A and D.

Time Value of Money

Answer No. 12

Since we have an internal rate compounded monthly but with an annual payment, we must first
convert the interest rate to an Effective Annual Interest Rate (EAR) so that the compounding
period is the same as the cash flows.
EAR = [1 + (.10 / 12)] 12 – 1

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= 1.104713 – 1
= .104713
= 10.4713%

PV Option 1= $95,000 {[1 – (1 / 1.104713)2] / .104713} = $163,839.09

PV Option 2= $45,000 + $70,000{[1 – (1/1.104713)2] / .104713} = $165,723.54

It is better to choose the second option offered by Global Ltd. since it has a higher Present Value
(PV).

VALUATION OF SECURITIES

Valuation of Bond

Answer No. 13

To find the capital gains yield and the current yield, we need to find the price of the bond. The
current price of Platinum Bond and the price of Platinum Bond in one year is:

Platinum
P0 = Rs. 120(PVIFA 9%, 5) + Rs.1, 000 (PVIF 9%, 5)
= Rs. 120 * 3.8897 + Rs.1, 000 * 0.6499
= Rs. 1,116.69

P1 = Rs.120 (PVIFA 9 %, 4) + Rs. 1,000 (PVIF 9%,4)

= Rs. 120 * 3.2397 + Rs. 1,000 * 0.7084
= Rs. 1,097.19

Current yield = Rs.120 / Rs. 1,116.69 = 10.75%

The capital gains yield is:
Capital gains yield = (New Price – Current price) / Current price
Capital gains yield = (Rs. 1,097.19 – 1,116.69) / Rs. 1,116.69 = –1.75%

The current price of Diamond Bond and the price of Diamond Bond in one year is:

Diamond
P0 = Rs. 60 (PVIFA 9%, 5) + Rs. 1,000 (PVIF 9%,5)
= Rs. 60 * 3.8897 + Rs. 1,000 * 0.6499
= Rs.883.31

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P1 = Rs. 60 (PVIFA 9%, 4) + Rs. 1,000 (PVIF 9%, 4)

= Rs. 60 * 3.2397 + Rs. 1,000 * 0.7084
= Rs.902.81

Current yield = Rs. 60 / Rs. 883.31 = 6.79%

Capital gains yield = (Rs. 902.81 – 883.31) / Rs. 883.31 = +2.21%

All other things remaining constant, premium bonds pay high current income while having price
depreciation as maturity nears; discount bonds do not pay high current income but have price
appreciation as maturity nears. For either bond, the total return is still 9%, but this return is
distributed differently between current income and capital gains.

Valuation of Shares

Answer No. 14

First Part

Using the constant growth model, the price of the stock paying annual dividends will be:
P0 = D0 (1 + g) / (R–g)
= Rs. 3.20 *(1+0.06) / (.12 – .06)
= Rs. 56.53

Second part

If the company pays quarterly dividends instead of annual dividends, the quarterly dividend will
be one-fourth of annual dividend
Quarterly dividend: Rs. 3.20 *1.06 /4 = Rs. 0.848

To find the equivalent annual dividend, we must assume that the quarterly dividends are
reinvested at the required return. We can then use this interest rate to find the equivalent annual
dividend. In other words, when we receive the quarterly dividend, we reinvest it at the required
return on the stock. So, the effective quarterly rate is:
Effective quarterly rate: 1.12.25– 1 = .0287 =2.87%

The effective annual dividend will be the future value (FV) of the quarterly dividend payments at
the effective quarterly required return. In this case, the effective annual dividend will be:
Effective D1= Rs. 0.848 * (FVIFA 2.87%, 4) = Rs. 3.54
Now, we can use the constant growth model to find the current stock price as:
P0= Rs. 3.54 / (.12 – .06) = Rs. 59.00

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Risk and Return

Answer No. 15

Since the portfolio is as risky as the market, the beta of the portfolio must be equal to one. We
also know the beta of the risk-free asset is zero. We can use the equation for the beta of a
portfolio to find the weight of the third stock.

Beta (p) = 1.0 = Weight Stock (A) * 0.85 + Weight Stock (B) *1.20 + Weight Stock (C) *1.35 +
Weight Stock (Risk free Asset) * 0
1.0 = (210,000/1,000,000)*0.85 +(320,000/1,000,000) * 1.20 + (C/1,000,000)* 1.35
1.0 =0.1785 + 0.384 + (C/1,000,000)* 1.35
0.4375 = 1.35 C / 1,000,000
437,500 = 1.35 C
C= Rs. 324,074.07
Investment in stock C = Rs. 324,074.07

We know the total portfolio value and the investment of three stocks in the portfolio, so we can
find value of investment in risk free asset as follows:
Total portfolio value =Rs. 1,000,000
210,000 + 320,000 + 324,074.07 + Risk free asset = 1,000,000
Investment in Risk free asset = Rs. 145,925.93

WORKING CAPITAL MANAGEMENT AND FINANCIAL FORECASTING

Working Capital and Financial Forecasting

Answer No. 16

(a) Forecast of working capital of Ankit International

Rs.
A. Current assets:
(i) Raw materials (60,000 × Rs 3 × 2/12) 30,000
(ii) Work-in-process (60,000 × Rs 3.75 × 1/12) 18,750
(Rs 3 material cost + 50 per cent of wages and overheads i.e., Rs 1.5)
(iii) Finished goods (60,000 × Rs 4.5 × 3/12) 67,500
(iv) Debtors (60,000 × Rs 4.5 × 3/12) 67,500
Total current assets 183,750

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B. Current liabilities
Creditors (60,000 × Rs 3 × 2/12) 30,000
Net working capital (A – B) 153,750

(b) Forecasted Income Statement of current year

Rs.
Sales revenue (60,000 × Rs 5) 300,000
Less: Cost of sales:
Raw material (0.60 × Rs 3,00,000) 180,000
Direct wages (0.10 × Rs 3,00,000) 30,000
Overheads (0.20 × Rs 3,00,000) 60,000
Total cost of sales 270,000

Less: Interest (Rs 50,000 × 0.05) 2,500

Profit 27,500

Forecasted balance sheet at the end of current year

Liabilities Rs. Assets Rs.

Share capital 200,000 Fixed assets 125,000
Reserve & Surplus 36,250 Current assets:
Profit & loss A/c (bal. figure) :8,750 Raw material 30,000
Profit of the current year :27,500 Work-in-progress 18,750
Finished goods 67,500
5% Debenture 50,000 Debtors (selling price) 75,000
Creditors 30,000 (15,000 units × Rs 5)

Total 316,250 Total 316,250

Receivable Management

Answer No. 17
Evaluation of credit decision

i. If only one order is expected from NB Ltd

If amount received in full in 60 days

Rs.
Selling price 50,000

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Less: variable cost 40,000

10,000
Less: finance cost 800
(40,000 *12%× (60 / 360)
Net profit 9200

If NB Ltd. defaulted
Loss 50,000

Expected return:
If paid in 60 days 9,200 × 60% 5,520
If defaulted 50,000 × 40% (20,000)
(14,480)
If only one order is received from NB Ltd, it need not be accepted by Riddi Ltd. as expected net
receipt is negative.

ii. If further orders are expected from NB Ltd.

Rs.
Net return from each order (if not defaulted) 9,200
For 8 orders 73,600
Return expected if defaulted (400,000)
Net expected return from further orders
[(73,600 x 90%) + (- 400,000 x 10%)] 26,240
PV of expected return from further orders
[26,240 x 70% x 1/ 1.15] 15,972
Revised value of initial order [15,972 -14,480] 1,492
Revised value of initial order on the basis of possibility of receiving further orders is Rs. 1,492;
so proposal should be accepted.

Inventory Management

Answer No. 18

First calculating Hulas’s carrying and restocking costs. The average inventory is 5,000 clubs and
because the carrying costs are Rs. 1 per badminton set, total carrying costs are Rs. 5,000. Hulas
restocks every month at a fixed order cost of Rs. 5, so the total restocking costs are Rs. 60.

Here, carrying costs are large relative to reorder costs, so Hulas is carrying too much inventory
and not following economic strategy.

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To determine the optimal inventory policy, we can use the EOQ model. Because Hulas orders
10,000 badminton sets 12 times per year, total needs (A) are 120,000 badminton sets. The fixed
order cost (O) is Rs. 5, and the carrying cost per unit (C) is Rs. 1.

The EOQ is therefore:

EOQ =√2AO/C
EOQ =√2 ∗ 120,000 ∗ 5/ 1
EOQ = 1,095.45 units

In this case, the average inventory is about 550* badminton sets, so the carrying cost is Rs. 550.
Hulas will have to reorder 120,000/1,095.45 = 109.54 = 110 times. The fixed order cost is Rs.5,
so the total restocking cost is also Rs.550. At optimal policy, carrying cost is equal to ordering
cost.

*1,095.45/2 = 547.72= rounded to 550 badminton sets

Answer No. 19

There are two essential aspects of finance function: one, procurement of funds and two, an
effective utilization of these funds in the business. In respect of these two aspects, the role of the
finance manager is as follows:
The traditional role of the finance manager is to confine to the raising of funds in order to meet
operating requirements of the business. This traditional approach has been criticized by modern
scholars on the following grounds. It was prevalent till the mid-1950s.
a) The traditional approach of raising funds alone is too narrow and thus it is outsider-looking-
in approach
b) It viewed finance as a staff specialty.
c) It has little concern how the funds are utilized.
d) It over-emphasized episodic events and non-recurring problems like the securities and its
markets, incorporation, merger, consolidation, reorganization, recapitalization and liquidation
etc.
e) It ignored the importance of working capital management.
f) It concentrated on corporate finance only and ignored the financial problems of sole trader
and partnership firms.
g) Traditional approach concentrated on the problems of long-term financing and ignored the
problems of short-term financing.
There was a change from traditional approach to the modern concept of finance function since
the mid-1950s.The industrialization, technological innovations and inventions and a change in
economic and environment factors since the mid-1950s necessitated the efficient and effective
utilization of financial resources. Since then, finance has been viewed as an integral part of the

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management. The finance manager is, therefore, concerned with all financial activities of
planning, raising, allocating and controlling the funds in an efficient manner. In addition, profit
planning is another important function of the finance manager. This can be done by decision
making in respect of the following areas:
a) Investment Decisions for obtaining maximum profitability after taking the time value of the
money into account.
b) Financing decisions through a balanced capital structure of Debt-Equity ratio, sources of
finance, EBIT/EPS computations and interest coverage ratio etc.
c) Dividend decisions, issue of Bonus Shares and retention of profits with objective of
maximization of market value of the equity share.
d) Best utilization of fixed assets.
e) Efficient working capital management (inventory, debtors, cash marketable securities and
current liabilities)
f) Taking the cost of capital, risk, return and control aspects into account.
g) Tax administration and tax planning.
h) Pricing, volume of output, product-mix and cost-volume-profit analysis (CVP Analysis).
i) Cost control.
j) Stock Market: Analyse the trends in the stock market and their impact on the price of
Company’s share and share buy-back.

Answer No. 20

a. Transaction motive refers to the holding of cash to meet routine cash requirements in the
ordinary course of business. A firm enters into a number of transactions which requires cash
payment. For example, purchase of materials, payment of wages, salaries, taxes, interest etc.
Similarly, a firm receives cash from cash sales, collections from debtors, return on
investments etc. But the cash inflows and cash outflows do not perfectly synchronise.
Sometimes, cash receipts are more than payments while at other times payments exceed
receipts. The firm must have to maintain sufficient (funds) cash balance if the payments are
more than receipts. Thus, the transactions motive refers to the holding of cash to meet
expected obligations whose timing is not perfectly matched with cash receipts. Though, a
large portion of cash held for transactions motive is in the form of cash, a part of it may be
invested in marketable securities whose maturity conform to the timing of expected payments
such as dividends, taxes etc.

Apart from the non-synchronisation of expected cash receipts and payments in the ordinary
course of business, a firm may fail to pay cash for unexpected contingencies. For example,
strikes, sudden increase in cost of raw materials, etc. Cash held to meet these unforeseen
situations is known as precautionary cash balance and it provides a caution against them. The
amount of cash balance under precautionary motive is influenced by two factors i.e.

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predictability of cash flows and the availability of short term credit. The more unpredictable
the cash flows, the greater the need for such cash balance and vice versa. If the firm can
borrow at short-notice, it will need a relatively small balance to meet contingencies and vice-
versa. Usually, precautionary cash balance are invested in marketable securities so that they
contribute something to profitability.

b. The term credit standards represent the basic criteria for extension of credit to customers. The
levels of sales and receivables are likely to be high if the credit standards are relatively loose,
as compared to a situation when they are relatively tight. The firm’s credit standards are
generally determined by the five “C’s”. Character, Capacity, Capital, Collateral and
Conditions. Character denotes the integrity of the customer, i.e. his willingness to pay for the
goods purchased. Capacity denotes his ability to manage the business. Capital denotes his
financial soundness. Collateral refers to the assets which the customer can offer by way of
security. Conditions refer to the impact of general economic trends on the firm or to special
developments in certain areas of economy that may affect the customer’s ability to meet his
obligations.

Credit terms refers to the terms under which a firm sells goods on credit to its customers. The
two components of the credit terms are (a) Credit Period and (b) Cash Discount. Extending
the credit period stimulates sales but increases the cost on account of more tying up of funds
in receivables. Similarly, shortening the credit period reduces the profit on account of
reduced sales, but also reduces the cost of tying up of funds in receivables. Determining the
optimal credit period, therefore, involves locating the period where the marginal profits on
increased sales are exactly offset by the cost of carrying the higher amount of accounts
receivable. The effect of allowing cash discount can also be analysed on the same pattern as
that of the credit period. Attractive cash discount terms reduce the average collection period
resulting in reduced investment in accounts receivable. Thus, there is a saving in capital
costs. On the other hand, cash discount itself is a loss to the firm. Optimal discount is
established at the point where the cost and benefit are exactly offsetting.

c. Growth firms are characterized by an internal rate of return (r) > cost of the capital (k). These
firms will have surplus profitable opportunities to invest. Because of this, the firms in growth
phase can earn more return for their shareholders in comparison to what the shareholders can
earn if they reinvested the dividends somewhere else. Hence, for growth firms, the optimum
dividend pay-out ratio is 0%.

Declining firms have an internal rate of return (r) < cost of the capital (k). Declining firms
make returns that are less than what shareholders can make on their investments. So, it is
illogical to retain the company’s earnings. In fact, the best scenario to maximize the price of

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the share is to distribute entire earnings to their shareholders. Hence, for declining firms, the
optimum dividend pay-out ratio is 100%.

d. Traditional or non- discounted cash flow techniques do not discount the cash flows to find
out their present worth. There are two such methods available i.e. (i) payback period method,
and (ii) accounting rate of return method. The payback period method estimates the time
required by the project to recover, through cash inflows, the firm’s initial cash outlay.
Accounting rate of return method uses accounting rate of return calculated by dividing
earnings by capital invested, the result of which is compared against minimum rate of return
(cut off rate) for investment decision.

The traditional techniques takes no account of the time value of the money. Present
inflationary conditions magnify the difference. This is the principal fact that modern or
discounted cash flow technique have incorporated to improve on the past procedures. Under
this method, the cash flows are discounted at the projects discount rate to the present time for
purpose of investment decision. Broadly, there are three discounted cash flow methods for
evaluating capital investment proposals i.e. Net Present Value Method, Internal Rate of
Return Method and Profitability Index or Benefit Cost (B/C) Ratio Method.

e. An American Depository Receipt (ADR) is a negotiable receipt which represents one or

more depository shares held by a US custodian bank, which in turn represent underlying
shares of non US issuer held by a custodian in the home country. Investors of US who are
willing to invest in the securities of non -US issuers finds ADR as an attractive means of
investment. In short, American depositary receipts are stocks that trade on U.S. exchanges
but represent shares in a foreign companies. Thus, American Depository Receipts (ADRs)
offer US investors a means to gain investment exposure to non-US stocks without the
complexities of dealing in foreign stock markets.

Global Depository Receipts (GDRs) means negotiable instruments issued by a domestic

company in the abroad to raise funds in the home country. A Global Depository Receipt is
denominated in US Dollar terms. Under the GDR arrangement, a domestic company with the
help of an Overseas Depository Bank (ODB) issues certificate in the form of shares of the
foreign company or Foreign Currency Convertible Bonds. The ODB is authorized by the
domestic company to issue the securities only after the instructions of the custodian domestic
bank of the domestic company. Generally, the shares and foreign currency convertible bonds
are handed over to the domestic custodian bank of the domestic company. This custodian
bank then issues instructions to the ODB for issuance of GDR securities to non-residents
against the shares or bonds held by it. GDRs help the domestic company to get exposure to
the global equity markets by raising foreign currency capital or equity.

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f. Interest Coverage Ratio is a financial ratio that is used to determine how well a company can
pay the interest on its outstanding debts. This ratio is commonly used by lenders, creditors,
and investors to determine the riskiness of lending capital to a company. The interest
coverage ratio is also called the times interest earned ratio. The interest coverage ratio
formula is calculated as follows:
Interest Coverage Ratio = Earnings before Interest and Tax (EBIT) / Interest expenses
The lower the interest coverage ratio, the greater the company’s debt and the possibility of
bankruptcy. Intuitively, a lower ratio indicates that less operating profits are available to meet
interest payments and that the company is more vulnerable to volatile interest rates.
Therefore, a higher interest coverage ratio indicates stronger financial health, the company is
more capable of meeting interest obligations.

Dividend Coverage Ratio, also known as dividend cover, is a financial metric that measures
the number of times that a company can pay dividends to its shareholders. The dividend
coverage ratio is the ratio of the company’s net income divided by the dividend paid to
shareholders. The general formula for calculating DCR is as follows:
Dividend Coverage Ratio = Net income / Dividend declared
There are also some modified versions of the dividend coverage ratio.
The first variation is used to determine the number of times a company can pay dividends to
ordinary shareholders when the company also has preference shares to take into
consideration. The formula is:
DCR = (Net income – Required preference dividend payments) / Dividends declared to
ordinary shareholders
The next variation can also be used to determine the number of times a company can pay
dividends to preference shareholders. The formula is:
DCR = Net income / Dividends declared to preference shareholders
Generally, higher dividend coverage ratio indicates that the earnings generated by the
company are enough to serve shareholders with their dividends. A consistently low or a
deteriorating dividend cover may signal poor company profitability which may mean the
company will be unable to sustain its current level of dividend payouts.

g. Dematerialization is the process of converting the physical share certificates and debenture
certificates into electronic form. On dematerialization of shares, the account of the shares in
the electronic form is maintained in the DEMAT Account by Depository Participants. Due to
dematerialization, the actual possession of shares and securities passes from the investors to
Depository Participants. Dematerialization can lead to paperless trading. When the shares are
dematerialized, they lose their independent identity and so they do not possess distinctive
number.

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The process in which shares and debentures in electronic form are converted again into
physical form is called Rematerialization. On rematerialization of shares, the account of the
shares in physical form is maintained by the company. Due to rematerialization, the actual
possession of shares and securities passes from Depository Participant to investors.
Rematerialization involves physical trading. Rematerialized shares have their distinctive
number.

Answer No. 21

a. Zero working capital is a situation in which there is no excess of current assets over current
liabilities to be funded. The concept is used to drive down the level of investment required to
operate a business, which can also increase the return on investment for shareholders.
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. There are two requirements to implement zero working
capital i.e. (a) demand based production where 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. (b) Receivable and payable terms under which
credit is granted to customers must be curtailed, while payment terms to suppliers must be
extended. Ideally, cash should be received from customers before it is due for payment to
suppliers. This essentially means that customer payments are directly funding the payments
to suppliers. Zero working capital would call for a fine balancing act in Financial
Management, and the success in this endeavour would get reflected in healthier bottom
lines.

b. MM theory on dividend policy is based on the following assumptions:

1) Capital markets are perfect. It implies that all information are freely available in the
market; there is no transaction cost; no investor can influence market prices; and there is
no tax differential between dividends and retained earnings or between dividends
and capital gains.
2) All investors are rational.
3) The investment policy adopted by the company is fixed.
4) Investment opportunities and future profits of all companies are known to investors with
certainty.
The perfect certainty assumption is later dropped by the theory.

c. Cost of capital has a great significance in financial decisions. Specially, in capital budgeting,
cost of capital plays a vital role. In the present value method of capital budgeting decisions,
cost of capital is used as the discount rate for the purpose of measuring the net present value
(NPV) of the projects. In the profitability index method of capital budgeting decisions,

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cost of capital is applied in ascertaining the present value of future cash flows. In the
internal rate of return (IRR) method of capital budgeting decisions, the computed IRR is
compared with the cost of capital. It provides a yardstick to measure the worth of investment
proposals and also acts as an ‘accept-reject’ criterion in capital budgeting decisions.

The concept of cost of capital also plays an important role in making capital structure
decisions. The cost of capital is influenced by changes in capital structure. In trying to
achieve its target capital structure over time, a firm should aim at minimizing the cost of
capital and maximizing the market value of the firm.

Apart from the above, cost of capital is also used in some other areas such as market value of
share, earning capacity of securities etc. Hence, it plays a major part in the financial
management.

d. EBIT-EPS analysis is one of the most widely used techniques employed in designing
an appropriate capital structure. It is an analysis by which the sensitivity of EPS to
changes in EBIT under different financing alternatives can be measured. EBIT-EPS
analysis examines the effect of financial leverage on the behaviour of EPS under different
financing alternatives and with varying levels of EBIT. This analysis provides great insight
into the relative advantages of the financing alternatives. A company has the choice to
raise funds for financing its investment proposals from different sources in different
proportions. If the EBIT-EPS analysis is used for making the choice of the combination of
the various sources, the alternative that yields the highest EPS should be selected as the most
profitable financing plan.

e. Application Supported by Blocked Amount (ASBA) is a process of withholding the amount

equal to the value of the securities applied by the investors from their bank account when
applying for purchase of public/rights issues. Application money is blocked in the investor’s
bank account until the allotment of securities and after the allotment, the allotted amount is
withdrawn from bank account and the remaining blocked amount is released. It allows to
invest directly without going to collection center specified by issue manager to apply for
securities.

In order to make the ASBA system more organized, accessible and efficient, CDS and
Clearing Limited developed integrated software “Centralized ASBA (C-ASBA)”. It links all
the banks and financial institutions providing ASBA related services and DEMAT account
creating centralized system. It allows for the verification of the bank account details of the
investors before entering the application of the investors. Banks and financial institutions
provide C-ASBA Registration Number (CRN) to each investor after verifying DEMAT
account of investor. Investor who have CRN can apply for purchase of securities from their

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bank account. Since this system verifies all details itself, issue manager need not to re-verify
again thereby allowing the allotment of shares within short span of time.

f. Capital budgeting relies on the following assumptions:

1) Decisions are based on cash flows: The decisions are not based on accounting concepts
such as net income.
2) Timing of cash flows are crucial.
3) Cash flows are based on opportunity costs: The incremental cash flows that occur with an
investment is compared to cash flows that would have been without the investment.
4) Cash flows are analysed on an after tax basis: Taxes must be fully reflected in all capital
budgeting decisions
5) Financing costs are ignored: Financing costs are reflected in the required rate of return. If
we include financing costs in the cash flows and in the discount rate, there will be double
counting of the financing costs. So, even though a project may be financed with some
combination of debt and equity, we ignore these costs, focusing on the operating cash
flows and capturing the costs of debt (and other capital) in the discount rate.

g. Financial management is about planning and controlling the financial affairs of an

organisation to ensure that the organisation achieves its objectives, particularly its financial
objectives. This is concerned with:
1) how much finance the business needs for its operations, both its day-to-day operations
and for longer-term investment projects
2) where the finance should be obtained from: long-term finance is raised as equity capital
or as debt capital, and short-term finance is obtained mainly from suppliers and bank
overdrafts
3) what should be the balance between long-term and short-term finance, and what should
be the balance between equity capital and debt capital (in other words, what should be the
capital structure of the organisation?)
4) investing short term cash surpluses
5) ensuring that the providers of finance are suitably rewarded: the organisation must make
sure that it can meet the interest payments on its borrowing and that shareholders receive
an appropriate dividend out of profits
6) where appropriate, protecting the organisation against financial risks.

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Paper 5: Cost and Management Accounting

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Revision Questions
Costs concepts and costing methods
Question No. 1

a) Explain the stages in Zero-based budgeting.

b) What are the limitations of marginal costing?

c) Mention and explain types of responsibility centres.
d) Explain obsolescence and circumstances under which materials become obsolete.
State the steps to be taken for its treatment.

Material Control
Question No. 2

A company manufactures a product from a raw material, which is purchased at Rs.

180 per kg. The company incurs a handing cost of Rs. 1,460 plus freight of Rs. 940
per order. The incremental carrying cost of inventory of raw material is Rs. 2.5 per kg
per month. In addition, the cost of working capital finance on the investment in
inventory of raw material is Rs. 18 per kg per annum. The annual production of the
product is 1,00,000 units and 2.5 units are obtained from one kg. of raw material.
Required:
(i) Calculate the economic order quantity of raw materials.
(ii) Determine, how frequently company should order for procurement be placed.
(iii) If the company proposes to rationalize placement of orders on quarterly basis,
Determine the percentage of discount in the price of raw materials should be
negotiated?
Assume 360 days in year.

Labour Control
Question No. 3

Following data have been extracted from the books of M/s. ABC Private Limited:
Salary (each employee, per month) Rs. 30,000
Bonus 25% of salary
Employer’s contribution to PF, ESI etc. 15% of salary
Total cost at employees’ welfare activities Rs. 6,61,500 per annum
Total leave permitted during the year 30 days

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No. of employees 175

Normal idle time 70 hours per annum
Abnormal idle time (due to failure of power supply) 50 hours
Working days per annum 310 days of 8 hours
You are required to calculate:
a) Annual cost of each employee
b) Employee cost per hour
c) Cost of abnormal idle time, per employee

Overhead
Question No. 4

a) Shyam Ltd. having fifteen different types of automatic machine furnishes information
as under for 2076/77.
i) Overhead expenses: Factory rent Rs. 1,80,000 (Floor area 1,00,000 sq. ft.),
Heat and gas Rs. 60,000 and Supervision Rs. 1,50,000.
ii) Wages of the operator are Rs. 200 per day of 8 hours. Operator attends to one
machine when it is under set up and two machines while they are under
operation.
In respect of machine B (one of the above machines) the following particulars are
furnished:
i) Cost of machine Rs. 1,80,000, Life of machine – 10 years and scrap value at
the end of its life Rs. 10,000
ii) Annual expenses on special equipment attached to the machine are estimated
as Rs. 12,000
iii) Estimated operation time of the machine is 3,600 hours while set up time is
400 hours per annum
iv) The machine occupies 5,000 sq. ft. of floor area.
v) Power costs Rs.5 per hour while machine is in operation.
Estimate the comprehensive machine hour rate of machine B. Also find out
machine costs to be absorbed in respect of use of machine B on the following
two work orders
Work order - 1 Work order - 2
Machine set up time (Hours) 15 30

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Machine operation time (Hours) 100 190

b) MST Limited has collected the following data for its two activities. It calculates
activity cost rates based on cost driver capacity.
Activity Cost Capacity Cost (Rs.)
Driver
Power Kilowatt hours 50,000 kilowatt 40,00,000
hours
Quality Inspections Number of 10,000 60,00,000
Inspections Inspections

The company makes three products M, S and T. For the year ended Ashadh 31, 2077,
the following consumption of cost drivers was reported:
Product Kilowatt hours Quality Inspections
M 10,000 3,500
S 20,000 2,500
T 15,000 3,000

Required:
i) Prepare a statement showing cost allocation to each product from each
activity.
ii) Calculate the cost of unused capacity for each activity.
iii) State the factors the management considers in choosing a capacity level to
compute the budgeted fixed overhead cost rate.

Costs Accounts System, Cost Control (Integrated and Non-integrated Accounting System)

Question No. 5

The Trading and Profit and Loss Account of a company for the year ended 31-03-2077 is as
under:
Trading and Profit and Loss Account
Particulars Rs. Particulars Rs.
To Materials 26,80,000 By Sales (50,000 units) 62,00,000

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To Wages 17,80,000 By Closing stock (2,000 units) 1,50,000

To Factory expenses 9,50,000 By Dividend received 80,000
To General administrative 4,80,200
expenses
To Selling Expenses 2,50,000
To Preliminary expenses written 70,000
off
To Net profit 2,19,800
64,30,000 64,30,000
In the Cost Accounts:
(i) Factory expenses have been allocated to production at 20% of Prime Cost.
(ii) General administrative expenses absorbed at 10% of factory cost.
(iii) Selling expenses charged at Rs. 10 per unit sold.
Required:
Prepare the Costing Profit and Loss Account of the company and Reconcile the Profit/Loss
with the profit as shown in the Financial Accounts.

Methods of Costing
Question No. 6

a) KT Ltd. produces a product EMM which passes through two processes before it is
completed and transferred to finished stock. The following data relate to Ashoj 2077:
Particulars Process Finished stock
A (Rs.) B (Rs.) Rs.
Opening Stock 5,000 5,500 10,000
Direct Materials 9,000 9,500
Direct Wages 5,000 6,000
Factory Overheads 4,600 2,030
Closing Stock 2,000 2,490 5,000
Inter-process profit included in opening stock 1,000 4,000
Output of Process A is transferred to Process B at 25% profit on the transfer price and
output of Process B is transferred to finished stock at 20% profit on the transfer price.
Stock in progress is valued at prime cost. Finished stock is value at the price at which
it is received from Process B. Sales during the period are Rs. 75,000.

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Prepare the Process cost accounts and Finished stock account showing the profit
element at each stage.

b) A company has been asked to quote for a job. The company aims to make a net profit
of 30% on sales. The estimated cost for the job is as follows:
Direct materials 10 kg @ Rs. 10 per kg
Direct labour 20 hours @ Rs. 5 per hour
Variable production overheads are recovered at the rate of Rs. 2 per labour hour.
Fixed production overheads for the company are budgeted to be Rs. 1,00,000 each
year and are recovered on the basis of labour hours.
There are 10,000 budgeted labour hours each year. Other costs in relation to selling,
distribution and administration are recovered at the rate of Rs. 50 per job.
Determine quote for the job by the Company.

c) Construction company undertook a contract at an estimated price of Rs. 108 lakhs,

which includes a budgeted profit of Rs. 18 lakhs. The relevant data for the year ended
31.03.2077 are as under:
Particulars (Rs. ‘000)
Materials issued to site 5,000
Direct wages paid 3,800
Plant hired 700
Site office costs 270
Materials returned from site 100
Direct expenses 500
Work certified 10,000
Work not certified 230
Progress payment received 7,200

A special plant was purchased specifically for this contract at Rs. 8,00,000 and after
use on this contract till the end of 31.03.2077, it was valued at Rs. 5, 00,000. The cost
of materials at site at the end of the year was estimated at Rs. 18,00,000. Direct wages
accrued as on 31. 03.2077 was Rs. 1,10,000.
Required: Prepare the contract Account for the year ended 31st Ashadh, 2077.

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d) M/s XY Travels has been given a 25 km. long route to run an air –conditioned Mini
Bus. The cost of bus is Rs. 20,00,000. It has been insured @3% premium per annum
while annual road tax amounts to Rs. 36,000. Annual repairs will be Rs. 50,000 and
the bus is likely to last for 5 years. The driver’s salary will be Rs. 2,40,000 per annum
and the conductor’s salary will be Rs. 1,80,000 per annum in addition to 10% of the
taking as commission (to be shared by the driver and the conductor equally). Office
and administration overheads will be Rs. 18,000 per annum. Diesel and oil will be Rs.
1,500 per 100 km. The bus will make 4 round trips carrying on an average 40
passengers on each trip.
Assuming 25% profit to taking and considering that the bus will run on an average 25
days in a mounth, you are required to:
i) Prepare operating cost sheet (for the month)
ii) Calculate fare to be charged per passenger km.

Cost Concepts for Decision Making

Question No. 7

A Company gives the following information

Margin of Safety Rs. 7,50,000
Total Cost Rs.7,75,000
Margin of Safety (Qty.) 15,000 units
Break Even Sales in units 5,000 units
You are required to calculate :
(i) Selling price per unit
(ii) Profit
(iii) Profit / Volume Ratio
(iv) Break Even Sales (in Rupees)
(v) Fixed Cost

Costing for planning and Control –Budgets

Question No.8

a) AB manufacturing Company manufactures two products A and B. Both Products use

a common Raw Material “C”. The Raw Material “C” is purchased at the rate of Rs. 45
per kg. from the Market. The Company has made estimates for the year ended 31st
Ashadh 2077 (the budget period) as under:

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Products
A B
Sales in Units 36,000 16,700
Finished Goods Stock Increase By year-end (in 860 400
Units)
Post-production Rejection Rate (%) 3 5
Material “C” completed Unit net of wastage 4 kg 5 kg
Material “C” wastage in % 5 4
Additional information available is as under:
• Usage of Raw Material “C” is expected to be at a constant rate over the period.
• Annual cost of holding one unit of Raw Material “C” in stock is 9% the
Material Cost.
• The cost of placing an order is Rs. 250 per order.
You are required to :
(i) Prepare Functional Budgets for the year ended 31st Ashadh, 2077 under the
following categories.
(A) Production Budget for Products A and B in Units.
(B) Purchases Budget for Raw Material “C” in kg and value.
(ii) Calculate the Economic Order Quantity (EOQ) in kg for Raw Material “C”.

b) During the FY 2076-77, GP Limited has produced 30,000 units operating at 50%
capacity level. The cost structure at the 50% level of activity is as under:
Particulars Rs.
Direct Material 150 per unit
Direct Wages 50 per unit
Variable Overheads 50 per unit
Direct Expenses 30 per unit
Factory Expenses (25% fixed) 40 per unit
Selling and Distribution Exp.(80% variable) 20 per unit
Office and Administrative Exp. (100% fixed) 10 per unit
The company anticipates that in 2077-78, the variable costs will go up by 10% and
fixed costs will go up by 15%.

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The selling price per unit will remain unchanged at Rs. 400.
Required:
(i) Calculate the budgeted profit/ loss for the FY 2076-77.
(ii) Prepare an Expense budget on marginal cost basis for the FY 2077-78 for the
company at 50% and 60% level of activity and find out the profits at respective levels.

Standard Costing
Question No. 9

a) State distinct groups of variances that arises in Standard Costing.

b) A gang of workers normally consists of 30 skilled workers, 15 semi-skilled workers

and 10 unskilled workers. They are paid at standard rate per hour as under:
Skilled Rs. 70
Semi-skilled Rs. 65
Unskilled Rs. 50
In a normal working week of 40 hours, the gang is expected to produce 2,000 units of
output. During the week ended 31stAshadh, 2077, the gang consisted of 40 skilled, 10
semi-skilled and 5 unskilled workers. The actual wages paid were at the rate of Rs.
75, Rs. 60 and Rs. 52 per hour respectively. Four hours were lost due to machine
breakdown and 1,600 units were produced.
Calculate the following variances showing clearly adverse (A) or favourable (F)
i) Labour Cost Variance
ii) Labour Rate Variance
iii) Labour Efficiency Variance
iv) Labour Mix Variance
v) Labour Idle Time Variance

Uniform Costing and Inter-firm comparison

Question No. 10

a) Explain the concept and requisites of uniform costing.

b) What is Inter-firm comparison and explain Purpose of Inter-Firm Comparison

Cost control and cost reduction

Question No. 11

What is Cost Control and explain Characteristics of Cost Control.

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Answers/Hints:
Costs concepts and costing methods
Question No. 1 (a)

Solution:
Zero –based budgeting (ZBB) involves the following stages:
i) Identification and description of Decision packages
Decision packages are the programs or activities for which decision is required to
be taken. The programs or activities are described for technical specifications,
financial impact in the form of cost benefit analysis and other issues like
environmental, regulatory, social etc.
ii) Evaluation of Decision packages:
Once Decision packages are identified and described, it is evaluated against factors
likes synchronization with organizational objectives, availability of funds,
regulatory requirement etc.
iii) Ranking (Prioritization) of Decision packages:
After evaluation of the decision packages, it is ranked on the basis priority of the
activities. Because of this prioritization feature ZBB is also known as Priority-
based Budgeting.
iv) Allocation of Resources:
After ranking of decision packages, resources are allocated for decision packages.
Budgets are prepared like it is done first time without taking reference to previous
budgets.

Question No. 1 (b)

Solution:
Limitations of Marginal Costing
i) Difficulty in classifying fixed and variable elements: It is difficult to classify
exactly the expense into fixed and variable category. Most of the expenses are
neither totally variable nor wholly fixed. For example, various amenities provided
to workers may have no relation either to volume of production or time factor.
ii) Dependence on key factors: Contribution of product itself is not a guide for
optimum profitability unless it is linked with the key factor.
iii) Scope for Low Profitability: Sales staff may mistake marginal cost for total cost
and sell at a price; which will result in loss or low profits. Hence, sale staff should
be cautioned while giving marginal cost.

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iv) Faulty valuation: Overheads of fixed nature cannot altogether be excluded

particularly in large contracts, while valuing the work-in-progress. In order to
show the correct position fixed overheads have to be included in work-in-progress.
v) Unpredictable nature of Cost: Some of the assumption regarding the behavior of
various costs are not necessarily true in a realistic situation.
vi) Marginal costing ignores time factor and investment: The marginal cost of two
jobs may be the same but the time taken for their completion and the cost of
machines used may differ. The true cost of job which takes longer time and uses
costlier machine would be higher. This fact is not disclosed by marginal costing.
vii) Understanding of W-I-P: Under marginal costing stock and work in progress are
understated.

Question No. 1 (c)

Solution:
There are types of responsibility centres:
i) Cost Centres: The responsibility centre which is held accountable for incurrence
of costs which are under its control. The performance of this responsibility centre
is measured against pre-determined standards or budgets. The cost centres are of
two types:
a) Standard Cost Centre and
b) Discretionary Cost Centre
ii) Revenue Centres: The Responsibility centres which are accountable for
generation of revenue for entity. Sales Department for example, is the responsible
for achievement of sales target and revenue generation. Though, revenue centers
does not have control on the all expenditures it incurs but some time expenditures
related with selling activities like commission to sales person etc. are incurred by
revenue centres.
iii) Profit Centres : These are the responsibility centres which have both
responsibility of generation of revenue and incurrence of expenditures. Since,
managers of profit centers are accountable for both costs as well as revenue,
profitability is the basis for measurement of performance of these responsibility
centers. Examples of profit centres are decentralized branches of an organization.
iv) InvestmentCentres: These are the responsibility centres which are not only
responsible for profitability but also has the authority to make capital investment
decision. The performance of these responsibility centres is measured based on
Return on Investment (ROI) besides profit.

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Question No. 1 (d)

Solution:
Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of an asset due to
its supersession".
Materials may become obsolete under any of the following circumstances:
i) where it is spare part, or a component of machinery used in manufacture and that
machinery becomes obsolete;
ii) where it is used in the manufacture of a product which has become obsolete;
iii) where the material itself is replaced by another material due to either improved
quality or fall in price.
Treatment: In all three cases, the value of the obsolete material held in stock is a
total loss and immediate steps should be taken to dispose it off at the best available
price. The loss arising out of obsolete materials on abnormal loss does not from
part of the cost of manufacture.

Material Control
Question No. 2

Solution:
(i) Calculation of Economic Order Quantity (E.O.Q)
Annual requirement (usage) of raw material in kg.(A) = 1,00,000 units / 2.5 units per kg.
= 40,000 kg.
Ordering cost (Handing & freight cost) (O) = Rs. 1,460 + Rs. 940 = Rs.2,400
Carrying cost per unit per annum (C) i.e. inventory carrying cost + working capital cost
= (Rs. 2.5 × 12 months)+ Rs.18 = Rs. 48 per kg.
E.O.Q. = √2AO/C = √2×40,000 kg.×Rs. 2,400/ Rs. 48 =2,000 kg.

(ii) Frequency of placing orders for procurement:

Annual consumption (A) = 40,000 kg.
Quantity per order (E.O.Q) =2,000 kg.
No. of orders per annum (A/ E.O.Q) =40,000kg./ 2,000 kg =20 orders

Frequency of placing orders (in days) =360 days/ 20 orders =18 days

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(iii) Percentage of discount in the price pf raw materials to be negotiated:

Particulars On Quarterly Basis On E.O.Q. Basis
1. Annual Usage (in kg.) 40,000 kg. 40,000 kg.
2. Size of the order 10,000 kg. 2,000 kg.
3. No. of orders (1÷2) 4 20
4. Cost of placing orders or Rs. 9,600 Rs. 48,000
Ordering cost
(4 order ×Rs. 2,400) (20 orders ×Rs. 2,400)
(No. of orders × Cost per
order)
5. Inventory carrying cost Rs. 2,40,000 Rs. 48,000
(Average inventory ×
(10,000 kg. ×1/2 ×Rs. (2,000 kg × ½ ×Rs.
Carrying cost per unit)
48) 48)
6. Total Cost (4+ 5) Rs. 2,49,600 Rs. 96,000

When order is placed on quarterly basis the ordering cost and carrying cost increased by Rs.
1,53,600 (Rs. 2,49,600-Rs. 96,000).
So, discount required = Rs. 1,53,600
Total annual purchase = 40,000 kg. × Rs.180 = Rs. 72,00,000
So, Percentage of discount to be negotiated = Rs. 1,53,600/ Rs. 72,00,000 × 100 = 2.13%

Labour Control
Question No. 3

Solution:
a.
Annual cost of each employee Rs.
Salary (30,000 × 12) 3,60,000
Bonus (25% of Salary) 90,000
Employees Contribution to PF (15% of Salary) 54,000
Employers welfare (6,61,500/175) 3,780
Total Annual Cost 5,07,780

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b.
Effective Working hours (310 days × 8 hours) 2480 hours
Less: Leave days (30 days × 8 hours) 240 hours*
Available Working hours 2240 hours
Less: Normal Loss @ 70 hours
2170 hours

Employee Cost per hour = 507780/2170 =Rs. 234

* It is assumed 310 working days are without taking leave permitted into consideration.

c. Cost of abnormal idle time per employee = Rs. 234 × 50 hours = Rs. 11,700

Alternative solution for part (b) and (c)

b) Calculation of Employee cost per hour:

Working hours per annum 2480*
Less: Normal Idle time hours 70
Effective hours 2,410
Employee cost 5,07,780
Employee cost per hour 210.70
* It is assumed 310 working days are after adjusting leave permitted during the year.

c) Cost of abnormal idle time per employee:

Abnormal Idle time hours 50
Employee cost per hour 210.70
Cost of Abnormal idle time (210.70 × 50) 10,534.85

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Overhead
Question No. 4 (a)

Solution:
Shyam Ltd.
Statement showing comprehensive machine hour rate of Machine B
Rs.
Standing Charges:
Factory rent (Rs. 1,80,000/100,000 sq. ft.) × 5,000 Sq.ft. 9,000
Heat and Gas (Rs. 60,000/15 machines) 4,000
Supervision (Rs. 1,50,000/15 machines) 10,000
Depreciation ( Rs. 1,80,000 – Rs. 10,000) /10 years 17,000
Annual expenses on special equipment 12,000
52,000
Fixed cost per hour (Rs. 52,000/ 4,000 hrs) 13

Set up rate Per Operational rate

hour (Rs.) Per hour (Rs.)
Fixed Cost 13.00 13.00
Power - 5.00
Wages 25.00 12.50
Comprehensive machine hour rate per hour 38.00 30.50

Statement of ‘B’ machine costs

to be absorbed on the two work orders
Work Order -1 Work Order -1
Hour Rate Amount Hours Rate Amount
Rs. Rs. Rs. Rs.
Set up time cost 15 38.00 570 30 38.00 1,140
Operation time cost 100 30.50 3,050 190 30.50 5,795
Total cost 3,620 6,935

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Question No. 4 (b)

Solution:
i) Statement of cost allocation to each product from each activity
Product
M (Rs.) S (Rs.) T (Rs.) Total (Rs.)
Power (Refer to 8,00,000 16,00,000 12,00,000 36,00,000
working note)
(10,000 kWh × (20,000 kWh× Rs. (15,000 kWh× Rs. 80)
Rs. 80) 80)

Quality Inspection 21,00,000 15,00,000 18,00,000 54,00,000

(Refer to working
(3,500 inspections (2,500 inspections (3,000 inspections ×
note)
× Rs. 600) × Rs. 600) Rs. 600)

Working Note:
Rate per unit of cost driver:
Power : (Rs. 40,00,000 / 50,000 kWh) = Rs. 80 / kWh
Quality Inspection : ( Rs. 60,00,000/ 10,000 inspections) = Rs. 600 per inspection

ii) Calculation of cost of unused capacity for each activity:

Rs.
Power (Rs. 40,00,000 – Rs. 36,00,000) 4,00,000
Quality Inspections ( Rs. 60,00,000- Rs. 54,00,000) 6,00,000
Total cost of unused capacity 10,00,000

iii) Factors management consider in choosing a capacity level to compute the budgeted
fixed overhead cost rate:
- Effect on product costing & capacity management
- Effect on pricing decisions
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements
- Difficulties in forecasting for any capacity level.

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Costs Accounts System, Cost Control (Integrated and Non-integrated Accounting System)

Question No. 5

Solution:
a) Workings:
Preparation of Cost Sheet /Cost Statement
Particulars Amount (Rs.)
Materials 26,80,000
Wages 17,80,000
Prime Cost 44,60,000
Add : Factory expenses (20% of Rs. 44,60,000) 8,92,000
Factory cost/ Cost of Production 53,52,000
Less: Closing Stock ( Rs. 53,52,000/52,000 units) ×2000 units (2,05,846)
Cost of Goods Sold 51,46,154
Add: General administrative expenses ( 10% of Rs. 53,52,000) 5,35,000
Add: Selling Expenses ( Rs. 10 × 50,000 units) 5,00,000
Cost of Sales 61,81,354
Profit (Balancing figure) 18,646
Sales Value 62,00,000

Costing Profit and Loss Account

Particulars Amount (Rs.) Particulars Amount (Rs.)
To Materials 26,80,000 By Sales 62,00,000
To Wages 17,80,000 By Closing stock 2,05,846
To Factory expenses 8,92,000
To General Administrative Exp. 5,35,200
To selling expenses 5,00,000
To Profit (Balancing figure) 18,646
64,05,846 64,05,846

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Reconciliation of profit as per Cost Accounts and as per Financial Accounts

Particulars Amount (Rs.)
Profit as per Cost Accounts 18,646
Additions:
General administrative expenses (Over-absorbed) (Rs. 5,35,200- Rs. 4,80,200) 55,000
Selling expenses (Overcharged) ( Rs. 5,00,000 – Rs. 2,50,000) 2,50,000
Dividend received 80,000
4,03,646
Deductions:
Factory expenses (Under- absorbed) ( Rs. 9,50,000 – Rs. 8,92,000) 58,000
Closing stock (Over-valued) (Rs. 2,05,846 – Rs. 1,50,000) 55,846
Preliminary expenses written Off 70,000
1,83,846
Profit as per Financial Accounts 2,19,800

Methods of Costing

Question No. 6 (a)

Solution:
Process –A A/c
Particulars Total Cost Profit Particulars Total Cost Profit

Rs. Rs. Rs. Rs. Rs. Rs.

Opening 5,000 5,000 - Process B 28,800 21,600 7,200

Stock A/c

Direct 9,000 9,000 -

materials

Direct wages 5,000 5,000 -

19,000 19,000 -

Less: Closing (2,000) (2,000) -

Stock

Prime Cost 17,000 17,000 -

Overheads 4,600 4,600 -

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Process Cost 21,600 21,600 -

Profit 7,200 - 7,200

(33.33% of
total cost)

28,800 21,600 7,200 28,800 21,600 7,200

Process –B A/c
Particulars Total Cost Profit Particulars Total Cost Profit

Rs. Rs. Rs. Rs. Rs. Rs.

Opening 5,500 4,500 1,000 Finished stock A/c 61,675 41,550 20,125
Stock

Process A A/c 28,800 21,600 7,200

Direct 9,500 9,500 -
materials

Direct wages 6,000 6,000 -

49,800 41,600 8,200

Less: Closing (2,490) (2,080) (410)

Stock

Prime Cost 47,310 39,520 7,790

Overheads 2,030 2,030 -

Process Cost 49,340 41,550 7,790

Profit (25% of 12,335 - 12,335

total cost)
61,675 41,550 20,125 61,675 41,550 20,125

Finished Stock A/c

Particulars Total Cost Profit Particulars Total Cost Profit

Rs. Rs. Rs. Rs. Rs. Rs.

Opening 10,000 6,000 4,000 Costing P&L A/c 75,000 44,181 30,819
Stock

Process B A/c 61,675 41,550 20,125

71,675 47,550 24,125

Less: Closing (5,000) (3,369) (1,631)
Stock

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COGS 66,675 44,181 22,494

Profit 8,325 - 8,325

75,000 44,181 30,819 75,000 44,181 30,819

Question No. 6 (b)

Solution:
Determination of quotation price for the job
Cost Rs.
Direct Material (10kg × Rs. 10) 100
Direct Labour ( 20hrs × Rs. 5) 100
Variable production overheads (20hrs × Rs.2) 40
Fixed Overheads (Rs. 1,00,000/ 10,000 budgeted hours) ×20 200
hours
Other costs 50
Total costs 490

Net profit is 30% of sales, therefore total costs represent 70% (Rs.490×100) /70 = Rs.700
price to quote for job.
(To check answer is correct; profit achieved will be Rs. 210 (Rs. 700-Rs. 490)
= Rs. 210 /700 = 30%

Question No. 6 (c)

Solution:
a) Contract Account for the year ended 31st Ashadh, 2077
Particulars (Rs. ‘000) Particulars (Rs. ‘000)
To Material issued to site 5,000 By Material at site 1,800
To Direct wages 3,800 3,910 By Material returned 100
Add: Outstanding Wages 110
To Plant hire 700 By Work-in-progress:

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To Site office cost 270 - Value of work 10,000

certified
To Direct expenses 500 - Work uncertified 230
To Depreciation ( special 300
plant)
To Notional profit c/d 1,450
12,130 12,130

Question No. 6 (d)

Solution:
i) Statement showing the Operating Cost per Passenger-km
Yearly (Rs.) Monthly (Rs.)
(A) Standing Charges:
Insurance Charge Rs. 20,00,000 × 3% 60,000 5,000
Road Tax 36,000 3,000
Depreciation (20,00,000/5) 4,00,000 33,333.33
Total 4,96,000 41,333.33
(B) Maintenance Charges:
Annual Repairs 50,000 4,166.67
Office and administration overheads 3,18,000 26,500
Total 3,68,000 30,666.67
(C) Running Cost/Charges:
Driver’s Salary 2,40,000 20,000
Conductor’s Salary 1,80,000 15,000
Diesel & Oil ( 60,000 × 1,500/100) 9,00,000 75,000
Total 13,20,000 41,333.33
Total (A+B+C) Cost before commission and profit 21,84,000 1,82,000
Commission (33,60,000 × 10%) (working note 2) 3,36,000 28,000
Profit (33,60,000 × 25% ) (working note 2) 8,40,000 70,000
Taking (working note 1) 33,60,000 2,80,000

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ii) Fare per Passenger–km = Total Collection-Takings/Total Passenger –km (Working note 3)
= 33,60,000/24,00,000 = Rs. 1.40
Or
Fare per Passenger –km (Monthly) = 2,80,000/200,000 = Rs. 1.40

Working note:
1. Cost before commission (10%) and profit (25%) is 21,84,000 which is 65% of total
takings. So total takings is (21,84,000/ 65) × 100 = Rs. 33,60,000
2. Commission is 10 % of Rs. 33,60,000 = Rs. 3,36,000 and Profit is 25% of Rs. 33,60,000
= Rs. 8,40,000
3. Total Km is (4 Round Trips × Days in a month × Month
= (4× 2 × 25 × 25 × 12) = 60,000 km
Passenger km is 60,000 km × 40 passenger = 24,00,000

Cost Concepts for Decision Making

Question No. 7

Solution:
(i) Selling Price per unit = Margin of Safety in Rupee value / Margin of Safety in Quantity
= Rs. 7,50,000 / 15,000 units = Rs.50

(ii) Profit = Sales Value – Total Cost

= Selling price per unit × (BEP units + MoS units) – Total Cost
= Rs. 50× (5,000 + 15,000 ) units – Rs. 7,75,000
= Rs. 10,00,000 – Rs. 7,75,000 = Rs. 2,25,000
(iii) Profit/Volume (P/V) Ratio = (Profit / Margin of Safety in Rupee value) × 100
= Rs. 2,25000 /Rs. 7,50,000 × 100 =30%
(iv) Break Even Sales (in Rupees) = BEP units × Selling Price per unit
= 5,000 units ×Rs. 50 =Rs. 2,50,000

(v) Fixed Cost = Contribution – Profit

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= Sales Value ×P/V Ratio – Profit

= (Rs. 10,00,000 × 30%) – Rs. 2,25,000
= Rs. 3,00,000 – Rs. 2,25 000 = Rs. 75,000

Costing for planning and Control –Budgets

Question No.8 (a)

Solution:
(i) (A) Production Budget (in units) for the year ended 31st Ashadh, 2077
Product A Product B
Budgeted sales (units) 36,000 16,700
Add: Increases in closing stock 860 400
No. of good units to be produced 36,860 17,100
Post production rejection rate 3% 5%
No. of units to be produced 38,000 18,000
(36,860/0.97) (17,100/0.95)

(B) Purchase budget (in kgs and value) for Material C

Product A Product B
No. of units to be produced 38,000 18,000
Using of Material C per unit of production 4 kg 5kg
Material needed for production 1,52,000 kg 90,000kg
Materials to be purchased 1,60,000 kg. 93,750 kg.
(1,52,000/0.95) 90,000/0.96
Total quantity to be purchased 2,53,750 kg.
Rate per kg. of Material C Rs. 45
Total purchase price Rs 1,14,18, 750

(ii) Calculation of Economic Order Quantity for Material C

EOQ =√ (2×2,53,750×Rs. 250)/ (45×9%) = √12,68,75,000 / 4.05 = 5,597 kg . (Approx.)

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Question No.8 (b)

Solution:
i) Calculation of Budgeted profit for the FY 2076-77
30,000 units
Per unit (Rs.) Amount (Rs.)
Sales (A) 400.00 1,20,00,000
Less: Variable Costs
Direct Material 150.00 45,00,000
- Direct Wages 50.00 15,00,000
- Variable Overheads 50.00 15,00,000
- Direct Expenses 30.00 9,00,000
- Variable factory expenses (75% of Rs. 40 30.00 9,00,000
p.u.)
- Variable Selling & Dist. exp. ( 80% of Rs. 16.00 4,80,000
20 p.u.)
Total Variable Cost (B) 326.00 97,80,000
Contribution (C) = (A-B) 74.00 22,20,000
Less : Fixed Costs:
- Office and Admin. Exp. (100%) 3,00,000
- Fixed factory exp. (25%) 3,00,000
- Fixed Selling & Dist. Exp. (20%) 1,20,000
Total Fixed Costs (D) 7,20,000
Profit (C-D) 15,00,000

ii) Expenses Budget of GP Ltd. for the FY 2077-78 at 50% & 60% level
30,000 units 36,000 units
Per unit Amount Per unit Amount
(Rs.) (Rs.) (Rs.) (Rs.)
Sales (A) 400.00 120,00,000 400.00 1,44,00,000
Less: Variable Costs

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- Direct Material 165.00 49,50,000 165.00 59,40,000

- Direct Wages 55.00 16,50,000 55.00 19,80,000
- Variable Overheads 55.00 16,50,000 55.00 19,80,000
- Direct Expenses 33.00 9,90,000 33.00 11,88,000
- Variable factory expenses 33.00 9,90,000 33.00 11,88,000
- Variable Selling & Dist. exp. 17.60 5,28,000 17.60 6,33,600
Total Variable Cost (B) 358.60 107,58,000 358.60 1,29,09,600
Contribution (C) = (A-B) 41.40 12,42,000 41.40 14,90,400
Less : Fixed Costs:
- Office and Admin. Exp. (100%) 3,45,000 3,45,000
- Fixed factory exp. (25%) 3,45,000 3,45,000
- Fixed Selling & Dist. Exp. 1,38,000 1,38,000
(20%)
Total Fixed Costs (D) 8,28,000 8,28,000
Profit (C-D) 4,14,000 6,62,400

Standard Costing
Question No. 9 (a)

Solution:
The three distinct groups of variances that arises in standard costing are:
i) Variances of efficiency: These are the variance, which arise due to efficiency or
inefficiency in use of material, labour etc.
ii) Variance of price and rates: These are the variances, which arise due to changes in
procurement price and standard price.
iii) Variances due to volume: These represent the effect of difference between actual
activity and standard level of activity.
Question No. 9 (b)

Solution :
i) Labour Cost Variance = Standard Cost – Actual Cost
= Rs. 1,14,400- Rs. 1,54,400
= 40,000 (A)
(1,600× 75 + 400× 60 + 200× 52 = Rs. 1,54,400)

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Or
Types of worker Standard Cost – Actual Cost Amount (Rs.)
Skilled Workers (30×40×70/2,000×1,600)- (40×40×75) 52,800 (A)
= 67,200-1,20,000
Semi- Skilled (15×40×65/2,000×1,600) – (10×40×60) 7,200 (F)
= 31,200-24,000
Un-Skilled Workers (10×40×50/2,000×1,600) – (5×40×52) 5,600 (F)
=16,000-10,400
Total 1,14,400- 1,54,400 40,000 (A)

ii) Labour Rate Variance

Types of worker Actual Hours × (Standard Rate – Actual Rate) Amount (Rs.)
Skilled Workers 1,600 hours ×(Rs. 70- Rs.75) 8,000 (A)
Semi- Skilled 400 hours × ( Rs. 65 – Rs. 60) 2,000 (F)
Un-Skilled Workers 200 hours × (Rs. 50- Rs. 52) 400 (A)
Total Rs. 8,000 (A) + Rs. 2,000 (F) + Rs. 400 (A) 6,400 (A)

iii) Labour Efficiency Variance

Types of worker Standard Rate × (Standard Hours – Actual Hours) Amount (Rs.)
Skilled Workers Rs. 70 × (960 hours – 1,440 hours) 33,600(A)
Semi- Skilled Rs. 65 × (480 hours – 360 hours) 7,800 (F)
Un-Skilled Workers Rs. 50 × (320 hours – 180 hours) 7,000 (F)
Total 33,600 (A) + 7,800 (F) + 7,000 (F) 18,800 (A)
Alternatively labour efficiency can be calculated on basis of labour hour paid
Types of worker Standard Cost – Actual Cost Amount (Rs.)
Skilled Workers Rs. 70 × (960 hours – 1,600 hours) 44,800(A)
Semi- Skilled Rs. 65 × (480 hours – 400 hours) 5,200 (F)
Un-Skilled Workers Rs. 50 × (320 hours – 200 hours) 6,000 (F)
Total 44,800 (A) + 5,200 (F) + 6,000 (F) 33,600 (A)

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Paper 5 : Cost and Management Accounting

iv) Labour Mix Variance

= Total Actual Time Worked (hours) × (Average Standard Rate per hour of Standard
Gang less Average Standard Rate per hour of Actual Gang) @ on the bais of hours
worked
= 1,980 hours (Rs.1,14,400/1760hrs – (1440hrs × Rs.70 + 360 hrs ×
Rs.65+180hrs×Rs.50)/1980 hrs
=Rs. 4,500 (A)
Or
Labour Mix Variance
Types of worker Std.Rate × ( Revised Actual Hours Worked – Amount (Rs.)
Actual Hour Worked)
Skilled Workers Rs. 70 × (1,080 hours – 1,440 hours) 25,200 (A)
Semi- Skilled Rs. 65 × (540 hours – 360 hours) 11,700 (F)
Un-Skilled Workers Rs. 50 × (360 hours – 180 hours) 9,000 (F)
Total Rs. 25,200 (A) + Rs. 11,700 (F) + Rs. 9,000 4,500 (A)
(F)

v) Labour Idle Time Variance

Types of worker Standard Rate ×(Hours Paid –Hours Worked) Amount (Rs.)
Skilled Workers Rs. 70 × (1,600 hours – 1,440 hours) 11,200 (A)
Semi- Skilled Rs. 65 × (400 hours – 360 hours) 2,600 (A)
Un-Skilled Workers Rs. 50 × ( 200 hours – 180 hours ) 1,000 (A)
Total 11,200 (A) + 2,600 (A) + 1,000 (A) 14,800 (A)

Verification:
Labour Cost Variance
= Labour Rate Variance + Labour Efficiency Variance + Labour Idle Time Variance
= 6,400 (A) + 18,800 (A) + 14,4800 (A) = Rs. 40,000 (A)

Labour Cost Variance

= Labour Rate Variance + Labour Efficiency Variance

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Paper 5 : Cost and Management Accounting

= 6,400 (A) + 33,600 (A) = 40,000 (A)

In this case, labour idle time variance is part of labour efficiency variance.
Working Notes:
Category Standard Cost Actual (1,600 units) Revised
Actual Hours

Hours Rate Amt. (Rs.) Hours Rate Amt. (Rs.)

Skilled 960 70 67,200 1,440 (40W×36) 75 1,08,000 1,080

(30W×40×1,600/ (1,980×6/11)
2,000)

Semi- 480 65 31,200 360 (10W×36) 60 21,600 540

Skilled (15W×40×1,600/ (1,980×3/11)
2,000

Un- 320 50 16,000 180 (5W×36) 52 9,360 360

Skilled (10W×40×1,600/ (1,980×2/11)
2,000

Total 1,760 65 1,14,400 1,980 1,38,960 1,980

Uniform Costing and Inter-firm comparison

Question No. 10 (a)

Solution:

Concept:
Uniform costing is not a particular method of costing. It is adoption of common accounting

principles and in some cases common methods by member companies in the same industry so

that their cost figures may be comparable. Uniform costing can be defined as the ‘use by

several undertakings of the same costing principle and practices’.

In other words, it is a technique or method of costing by which different firms of a field or

industry apply similar costing system so as to produce cost data which have maximum

comparability. Standard costs may be developed and cost-control is secured in firm through

mutual comparison.

Relative efficiency and inefficiencies in production may be identified and suitable steps may

be suggested to control and reduce the cost. The objectives of uniform costing are to

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Paper 5 : Cost and Management Accounting

standardize accounting methods and to assist in determining suitable prices of products of

firms which adopt this method.

Requisites of Uniform Costing:

Uniform costing can be adopted if certain pre-conditions exists. The success of a uniform

costing system depends primarily on the cooperation extended by different units or firm

towards the working of the system. Every unit should agree to supply required accounting and

costing information without reservation to a central body formed by them for implementation

of the uniform costing scheme. This body has to correlate, analyze and consolidate the

information received from the different units.

Following are pre-requisites of uniform costing:

(a) Firms or units adopting uniform costing must be ready to provide and share accounting

and costing information freely.

(b) They should adopt a common system of costing regarding classification, distribution and

absorption of costs. They must agree on a common technique of costing e.g., absorption

costing, standard costing or marginal costing.

(c) The firms must use a common terminology and procedure for cost ascertainment and cost

control.

(d) There should not be any restriction from the Government in adopting uniform costing.

(e) A central body or proper organisation must be set up for preparing comparative statistics

for the use of member units participating in the uniform costing.

(f) Above all, the most important is that units or firms must have mutual trust, confidence and

cooperation.

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Paper 5 : Cost and Management Accounting

Question No. 10 (b)

Solution:
Inter-firm comparison is a natural outcome of uniform costing system. Uniform costing is
the foundation stone over which the structure of IFC is developed and adopted in a large
scale. Inter-firm comparison can be defined as the technique of evaluating the relative
performance, efficiency, costs and profits of firms in a given industry’. The meaning of
IFC can be easily explained by considering the main object of the system.
Purpose of Inter-Firm Comparison:
It has already been stated above that the purpose of inter-firm comparison is to compare
the efficiency of one firm with that of other belonging to the same group of industry and
helps the management to locate the problems or reasons for such inefficiency (if any) and
to take the corrective measures for its improvement.

It has also mentioned in the earlier paragraph that there must be a central body/agency
(like Chamber of Commerence) who will work i.e., will collect and analyze the
information on behalf of the members by which many snags or drawbacks can be
controlled However, some of the problems are enumerated below

(i) Is profit adequate ?

(ii) How efficient is production ?
(iii) How efficient is selling ?
(iv) Is Working Capital sufficient ?
(v) Is stock-turnover adequate ?

Cost control and cost reduction

Question No. 11

Solution:
Cost control is a tool of management executives to regulate the working of the
manufacturing concern. Under the globalize economy, mere planning is not enough.
Efforts are constantly made to scrutinize the results of the workings. If so, out of control
situations may be find out and eliminated immediately, with the help of cost control, the
executives can limit the costs within the planned level.
Characteristics of Cost Control
The characteristics of cost control are presented below:

1. Delineation of Centers of Responsibility: Overlapping operations and responsibilities

destroy the very essence of cost control.

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Paper 5 : Cost and Management Accounting

2. Delegation of Authority: If persons are charged with responsibility without authority,

the cost control will be ineffective. Hence, proper or adequate delegation of authority is
necessary for proper cost control.
3. Measurement of Performance: A performance is to be measured with the help of
reasonable criteria. Standard costing can be used as reasonable criteria. The person whose
performance is being measured should participate in setting the standards.
4. Relevance of Controllable Cost: Only few costs are controllable at different levels of
management. The management evaluates the performance of an employee with the help of
costs incurred that are controllable.
5. Cost Reporting: Cost report provides a basis for effective cost control. Hence, if the
cost reports is not prepared and submitted in time, the cost control cannot be exercised.
6. Constant Efforts: The measurement of performances, knowing functioning of
manufacturing department and analysis of costs require constant efforts. This type of
constant efforts leads to cost consciousness and result in cost control.
7. Policies and General Objectives: All the employees of the organization are
communicated the policies and general objectives. If so, cost control is very easy.

© The Institute of Chartered Accountants of Nepal 31

Paper 6A : Business Communication

Paper 6A: Business Communication

© The Institute of Chartered Accountants of Nepal 1

Paper 6A : Business Communication

Revision Questions
Question No. 1
Read the following case carefully, and answer the questions given below:
Samrant Singh, a PhD scholar in International Business Communication is requested by a
reputed multinational company for presenting a paper in their annual celebration on
'promoting intercultural communication in the diverse workplace'. The administration
director of the company has also informed Mr Singh that conflicts usually arise in their
workplace without any apparent reason. According to the director, no significant attention
was paid towards communication aspect in the beginning, but they have come to realize now
that the main cause of the usual conflicts in the operational level is lack of proper
communication among the staff, who represent from different cultural and national
backgrounds.
Mr Singh is provided with the required data, and is requested to suggest some important
strategies through the presentation paper to promote intercultural communication in the
company. From a preliminary survey Mr Singh has found that the company has more than
one hundred employees having at least twelve nationalities. He is now expecting to learn
more about the code they use while they are in work and the approach they take while they
make decisions.
a) Mr Singh is expecting to learn more about the variety of code the staffs use while they are
in work and the approach they take while they make decisions. Now, write an e-mail on
behalf of Mr Singh to the administration director asking about the information that he is
expecting to learn.
b) In this specific context, what strategies of intercultural communication do you think will
be involved and discussed in the presentation paper of Mr Amayta?
c) Do you believe that conflicts arise in the workplace due to the lack of proper
communication? What can be done to overcome such conflicts?

Question No. 2

Read the following case carefully, and answer the questions given below: (5*4=20)
Dr Aditya Sharma, a consultant business researcher primarily works in the organizational
management sector, and has conducted varieties of research including case study, action
research, business surveys, and so on about varieties of organizational issues such as auditing,
business administration, conflict management, marketing, advertising, international
relationships, etc. Dr Sharma is asked by one of the multinational companies based on
Kathmandu, Nepal to conduct a comprehensive study and submit the report about the
business problems seen in the changing context of Nepal. Nepal's Regional Office of the
company has investigated from the preliminary study that the company is bearing 12% loss
every year for the recent three years. The new executive director of the company has decided
to conduct an intensive study about the potential causes and problems of the company's loss,
and has appointed Dr Sharma as the chief researcher who is expected to lead a task force.

Mr Sharma has recently started the preliminary activities and procedures of the research. The
research is problem based, and immediate solutions are expected. The TOR has mentioned
that the report must include practice related and policy related recommendations. The
research team of Mr Sharma has organized a meeting, and conceptualized the design and

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Paper 6A : Business Communication

procedures of the research. They have prepared the time framework, and have planned about
the tools and procedures for data collection.

Questions:
a) Which type of report is Mr. Sharma asked to prepare: analytical or investigative?
What are the major components of this type of report? Describe each in brief.
b) What would be the most efficient tools for gathering information for this report?
Discuss any two of them in brief.
c) How can data be analyzed and interpreted?
d) Write statement of problem and objectives of Mr. Sharma's report.

Question No. 3
Write persuasive letter of application for the post of online marketing assistant as required by
New Era Enterprises. 10

Question No. 4
Write short notes on:
a. Executive summary
b. Process of communication
c. Features of business e-mail
d. Writing in international communication
e. Persuasion in business writing

Question No. 5
What are the specific communication strategies for succeeding in the new workplace?
Discuss them in brief.

Question No. 6.
What are the basic features of analytical report? What are its major components?

Question No. 7
Answer these questions:
a) Suppose you are preparing a report on shareholders’ attitudes of one of the banks in
Kathmandu. Prepare a set of questionnaire for the survey as one of the tools of data
collection.
b) How is information organized in this report? Illustrate.

Question No. 8
Discuss the importance of ethics in business communication, and differentiate between
ethical dilemmas and ethical lapses.

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Paper 6A : Business Communication

Answers/Hints:

Answer No 1
(a):
From: [email protected]
To: [email protected]
Sub: general information

Dear Mr. Agrawal,

I received what you wrote about the current situation of your diverse workforce. I'm working
on the same paper that I'm asked to present at the annual ceremony. I'd be much pleased if
you sent me some information about the variety of code you and your staffs use during work,
and about the approach you adopt while making important decisions. Please, make it clear
whether you use multiple languages, or international codes, or any others. Similarly, please
also mention whether you involve your staffs in the important in-house decisions or not. If
you do so, which approach do you adopt?

Regards,
Samrant Singh

(b):

The researches have pointed out that intercultural communication in the diverse workplace can be
managed as an organizational asset with some specific efforts and strategies. In order to reduce
the misunderstandings caused by work place diversity, cross cultural communication networks
need to be established. The followings are some of the important strategies that can be adopted for
the management of the cultural diversity in a workplace, and that can be involved and discussed
in a presentation paper:
• Promoting cross-cultural relationship between /among people of diverse cultures
working in diverse work situation, each respecting each other’s cultural norms and values,
and Changing traditional cultural perceptions incompatible with the changing needs of today
with the help of frequent meetings and training programs.
• Allowing different languages for official work. Cultures of even minorities need to
be acknowledged.
• Conducting seminars, workshops, etc. to familiarize people with each other.
• Building cohesive multi-cultural work teams.
• Creating a corporate culture that can accommodate diversity to maximize the
potential of the workforce.

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Paper 6A : Business Communication

(c):

Obviously, conflicts arise in the workplace due to the lack of proper communication systems and channels
in an organization. Communication is one of many causes of conflict in a workplace. In the multicultural
context as in the given case, lack of proper communication may create very serious misunderstandings and
conflicts among the co-workers. However, conflicts can be managed with the help of appropriate skills and
strategies. Firstly, intercultural communication should be made easy and effective in the diverse
workplace. Similarly, people need to be trained not only about verbal communication tools but also about
non verbal and paralinguistic ones. Additionally, values, beliefs and practices of each culture should be
equally acknowledged in order to overcome such conflicts. International code can also be much useful.
Stories, songs, videos, etc. can be exposed to the people so that they can understand each other’s cultures,
values and practices.

Answer No. 2
a)
Since Mr. Sharma is asked to carry out a critical analysis of a particular business situation with an
aim at investigating the major problems and recommending the effective solutions, this report is
investigative in nature. Unlike informative reports, this type of report is more focused to a specific
problem of the organization. The major components of investigative report include:

• Introduction
• Statement of problem
• Objectives
• Methodology (sampling, data collection tools and procedures, …)
• Analysis and interpretation of data
• Findings, Conclusion and Recommendations
• Bibliography

(b)
The major tools for data collection for the research report of Mr Sharma may include:
• interview
• questionnaire
• observation
• focused group discussion
• interactions with clients and retailers
• …
Interview: it is a face to face interaction of the researcher with the sampled subjects such as
clients, retailers, dealers, and other stakeholders. Interview can be of two types: structured and
unstructured. Structured interview involves systematic planning about the questions to be asked to
the subjects. For this report, the questions can be structured within the framework or the contents
such as popularity of the brand, marketing strategies, prices, consumer satisfaction, delivery
process, dealership model, and so on. The unstructured interviews are open in nature. The
questions are not set before the interview. Interaction is often context dependent.
Focused group discussion: this technique is really worth talking for the particular case of the
given report. The representatives of the stakeholders such as staff, clients, retailers, dealers, etc.
can be put together in a meeting or a discussion session. Their opinions, reflections and reactions
can be recorded as the data for detecting the problems.

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(c)
The data collected by different tools can be analyzed by using different strategies and procedures.
The qualitative information is gathered and analyzed by categorizing it into different themes,
titles and options. The common tendencies of the data are elaborated, and verified with the
previously defined theories and facts. The quantitative data are analysed in terms of different
statistical tools such as mean, standard deviation, correlation coefficient, and so on. The data are
presented in the tables, charts, graphs, etc. The analysis is done in line with the objectives set for
the research. Report is produced on the basis of the findings attained by analysis and
interpretation of the data.
(d)
Statement of problem :The present report is prepared focusing basically on the problems that are
implicitly and explicitly associated with the business strategies adopted by the regional office of
Anuradha International Company (Kathmandu Branch). The causes of consistent loss seen in the
recent annual reports are the primary issues that this report deals with. The research emerges out
of the basic problem related to the decreasing financial growth of the company. The latest audit
report shows that the company is bearing gross loss of 12%. The research question is: what is the
factor that affects the financial status of the company?
Objectives
The report has the following specific objectives:
• to study and analyze managerial efficiency of the company
• to find out the marketing strategies of the company
• to analyze consumer responses of the products
• to explore the problems related to management, marketing, sales and public
dealing
• to recommend potential solutions of the identified problems.

Answer No. 3:
Kathmandu-14
Kalanki, Kathmandu

June 2, 2019

Dr. Suren Malla

Executive Director
New Era Enterprises
Anamnagar, Kathmandu
Subject: An application for the post of online marketing assistant

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Paper 6A : Business Communication

Dear Dr. Malla,

I am writing you in response to the online announcement that you had uploaded a couple
of days before calling for applications for the post of marketing assistant of online mode.
I’m highly interested in working in the online marketing sector since I have been involved
in the same field for some years.

I have successful professional story in online marketing. I have established a new and
innovative technique of online marketing in an international company. Since I have to
carry both my CA study and marketing career in Nepal, I’m intending to quit the present
job at New Delhi, and join one in Kathmandu.

I have stated every detail about my qualifications, experiences and skills in my resume
which I have attached along with this application. If you think you may call me in person,
my cell no. for Kathmandu contact is 98510XXXXX.

I’m looking forward to your positive respose.

Sincerely yours,
………………
Vijeta Sinha

Answer No. 4:
a) Executive summary is an important component of a long report. It is prepared with
an aim to help the executive of the concerned organization to go through the main
concerns and themes of the report. In research reports, this kind of summary is
called an abstract. It presents the objectives, analysis, findings, results and
conclusion in brief so that the concerned authority can read and learn quickly about
the report.

b) Communication process in general involves two participants: receiver and sender.

The sender encodes meaning or message into certain language, then it is
transmitted through media to the receiver. This message is decoded by the mental
framework of the receiver. The roles of sender and receiver may change regularly
during the communication process.

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Paper 6A : Business Communication

c) E-mail is an electronic mail that is usually quick, short and effective. It can be both
formal and informal. In the business sector, it is often formal and straight forward.
It has made business transactions much fair, quick and efficient. It has components
such as heading, body and closing. Long documents can also be attached with e –
mail.

d) Writing in international communication characterizes specific register, i.e. style of

language. It requires grammar and vocabulary of your writing be simple, precise
and clear. If you relax your language and avoid jargons, it may help you establish
relationships and convey a good impression to your audience.

e) Persuasion is an important quality of business communication. One is always

trying to persuade clients and others towards one’s goods and service. This is a
quality of speech or writing that attracts people’s attention and develops positive
attitude. Usually business ads, applications and resumes use persuasive language.
Rhetoric is also used in persuasion.

Answer No. 5:
Succeeding in the new workplace is an opportunity as well as a challenge for the business
practitioners. Basically, communication skills and strategies are central in this issue of success.
Taylor (2013, p.11) suggests that one needs to build great relationships at work to ensure success
in it. Some of the key factors suggested by her regarding better relationships and workplace
success are as follows:
• Be courteous: Courtesy is said to be a key to success and happiness. It refers to the
polite behavior of yours to others such as clients, staff, colleagues, etc.
• Find common interests: If you can establish common interests in your organization,
you can implement your ideas in more efficient way. This leads you towards business
success.
• Build credibility: It is basic to your success in new workplace. If you can share your
knowledge and skill with others, obviously you can get things done better and more
effectively.
• Make others feel important: Success lies among cooperation and interaction. If you
can value others, only then they value your business and its mission.
• Show humility: it is believed that if you want to improve relationships, you must
practice humility. It’s a strength, not a weakness.
• Listen actively: Active listening leads your communication and transaction towards
success. It refers to your action reacting to someone’s speech.

Answer No. 6:
• An analytical repot is usually a research report. It is also called investigative report.
• It is prepared on the basis of the information obtained from respondents of the related field.
• It requires basically the research tools such as questionnaires, interview, focused group
discussion, observation report, tests, discourse analysis, etc.
• Scientific analysis and possible interpretations of the data are made in this type of report.

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Paper 6A : Business Communication

• The basic components of an analytical report are: introduction, background, statement of

problem, objectives, methodology, analysis and interpretation, findings, and
recommendations.

Answer No. 7(a):

Tick the best option. (SA: strongly agree, A: agree, NA: not agree)
Attitudes SA A NA
1. I prefer risks and challenges in business; they help to
grow the company.
2. Risks are useful to motivate me to work and
concentrate on duty.
3. I don’t like to be tied up by business commitments and
relationships. It’s good to keep on what is with us
conventionally.
4. I’m ready to allow the BoD to invest excessively on
new technology and globalization of market.
5. I don’t care whether one failure in business loses
everything. So, our bank must invest as required on the
innovative activities.
6. I’d like to follow the same pattern of business since it
has to bear less or no risk.
7. …

Answer No. 7(b):

• The information can be organized systematically by categorizing it into different issue
based themes.
• Then the information is tabulated to ensure more systematic data for the report.
• The data can be organized and analysed using tables, graphs, statistical tools such as
percentage, mean, standard deviation, etc.
• The irrelevant ideas/options are avoided from analysis.
• Analysis should be based on the objectives of the research/report.

Answer No. 8:
• Ethics in business communication generally refers to the set of principles guided for good
conduct of business dealings. They govern a business person or a group so that trust can
be derived from communication as well as from transaction.
• Ethical people are perceived by consumers and others as trust worthy, fair and impartial,
respecting the rights of others and showing concern about the impact of their actions on
the society. They usually obey the communicative maxims of cooperative and politeness
principles.
• Ethical communication can obviously lead the business activities towards success and
perfection. Ethical communication includes all relevant information that excludes false
traps and tricks. The massage is true in every sense, and is not deceptive in any way. In
contrast, unethical communication can include falsehoods and misleading information.
Ethical communication is a major key for the success of a business transaction.
• Ethical behavior is a companywide concern, of course, but every company has
responsibilities to its each stakeholder. In some situations, what is right for a group or a

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Paper 6A : Business Communication

person can be wrong for another. There can be many alternative solutions for a particular
issue, but they cannot be equally favorable for all people. In such situations, ethical people
may not be able to tell the truth or to take absolutely right decisions. They're forced to
think about a better choice among many different valid alternatives. This is known as
ethical dilemma.
• On the other hand, the term 'an ethical lapse' refers to a clearly unethical or illegal choice,
When a person (e.g. an official) or a group knows that something is wrong, and yet does it
anyway, it is known as ethical lapses.

© The Institute of Chartered Accountants of Nepal 10

Paper 7 : Income Tax and VAT

Paper 7: Income Tax and VAT

© The Institute of Chartered Accountants of Nepal 1

Paper 7 : Income Tax and VAT

Revision Questions
Income Tax

1. The information for FY 2076.77 of Juvenile Products pvt. Ltd is given below, based on the
information calculate the tax liability of the company for fiscal year 2076.77 as per latest
provisions on Income tax act 2058 as amended by Finance Act 2077.78.

Particulars Amount (Rs.) Remarks

Sales of goods 67,732,946.00
35% previously disallowed as bad debt
Bad Debt Recovered 552,546.00 expense
Miscellaneous Income 1,088,356.00
Closing Stock of goods 1,559,860.00
Total of Credit Side 70,933,708.00
Opening Stock of Goods 12,012,906.00
Purchase of Raw Materials 9,975,640.00
The cost of electricity includes the
electricity bill of Rs. 24500 per month
Electricity 1,285,860.00 for 12 month of the house of Directors
Wages 15,900,000.00
Rs. 275,000 is advance salary provided
to sick employee, related to month
Salary 12,228,920.00 Shrawan of 2077.
Rs. 770,000 is the amound paid to retired
employee for which provision is made as
Gratuity expense 2,234,960.00 per Labor Act 2048 on Jestha 2077
Bad Debt for the year 769,600.00
Rs. 240000 is telephone bill of mobile
Telephone 990,000.00 phone of wife of Director
Medical Expenses 162,450.00
Sales promotion expenses 9,579,960.00
Repair of Machine 1,224,560.00
Repair of Building 1,591,450.00
Repair of Truck 192,450.00
Repair of Car 61,350.00
Depreciation 1,050,000.00
Net Profit before tax 1,673,602.00

Total of Debit Side 70,933,708.00 -

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Paper 7 : Income Tax and VAT

Additional Information:

a) The Assets details is as follows

Asset Opening WDV of Asset

Building 5,602,546.00
Machine and Trucks 10,178,000.00
Car 1,598,000.00

2. The Recovery Drugs Pvt. Ltd. located at Simra of Bara Districts have furnished you the
following information, calculate the tax liability of the company for the fiscal year with
latest provisions of income tax act. The sales of medicines is made half within Neplal and
half of the products are exported to Bhutan.

Particulars Amount (Rs.)

Sales of goods 116,050,000.00
Miscellaneous Income (includes Rs. 750,000 interest income from Nepal Bank Ltd
with net of TDS on Fixed Deposit) 1,732,940.00
Closing Stock of goods 7,969,500.00
Total of Credit Side 125,752,440.00
Opening Stock of Goods 10,627,740.76
Purchase of Raw Materials 27,860,560.00
Electricity 4,773,849.60
Wages 14,065,584.00
Salary 3,703,356.80
Gratuity expense 1,608,380.80
Bad Debt for the year 525,116.80
Telephone 160,784.00
Sales promotion expenses 2,666,612.00
Repair of Machine 1,248,000.00
Repair of Building 1,653,600.00
Repair of Delivery Truck 197,600.00
Repair of Car 61,360.00
Depreciation 1,092,000.00
Net Profit before tax 55,507,895.24
Total of Debit Side 125,752,440.00

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Paper 7 : Income Tax and VAT

Pool Opening WDV of Asset

A 5,590,000.00
D 11,190,500.00
C 799,000.00

3. Rising Resorts Pvt. Ltd. was established 4 years ago with capital of 60 crores, and during
this year converted into public ltd company. The operation was started from this year on 1st
of Baisakh, the opening WDV of assets is the Work in progress upto last year classified as
respective assets on this year. The interest on loan borrowed as capitalized upto last year,
for this year the same is charged to revenue. Calculate the tax liability of the public limited
company for this year with latest provisions of income tax act 2058.

Particulars Amount (Rs.)

Sales Revenue 134,750,000.00
Total 134,750,000.00
Cost of Food 24,750,000.00
Cost of Beverage 19,250,000.00
Cost of Room consumables 15,950,000.00
Employee Cost 24,420,000.00
Selling & Administrative Expenses 13,035,000.00
Repair and improvement of Bed/furnishing set of room 3,916,000.00
Interest Cost for the year 14,560,900.00
Total 115,881,900.00
Net Profit 18,868,100.00
Particulars Opening
Leasehold Building 17,500,000.00
Room Bed and Furniture 12,250,000.00
Green plate tourist carrier and safari vehicle 2,545,000.00

4. Suryadeep Multiporpose Cooperative Ltd is located at Birgunj Metropolis, calculate tax

liability for the cooperative for FY 2076.77 with latest provisions of income tax act 2058.
For benefit of members, it sells various goods with 30% Gross Profit.

Particulars Amount (Rs.)

Interest income 94,416,600.00
Interest Expenses 65,034,900.00
Net Interest income 29,381,700.00
Add

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Gross profit on sales of Goods to members (Goods are sold with 30% margin) 22,045,600.00
Service Fee 11,599,500.00
commission and charges 5,061,600.00
other miscellaneous income 1,716,060.00
Less
Administrative Expenses 10,085,460.00
Loan Loss Provision for year 2,491,950.00
Net Income 35,181,450.00
Gross Loan on Year end 187,035,000.00
Loan loss provision upto last year 16,379,160.00

5. Greenhill Services Pvt. Ltd. has constructed the deluxe class furnished apartment at
Bhaisipati, Lalitpur. The construction completed and are rented out from 1st of Magh 2076
to tenants. As per government policy one month rent is waived for month of Chaitra 2076.
There are 120 apartments and rent per month is Rs. 45,000. As per Bill of Quantities (BoQ)
of construction consultant engineer the total cost of building is 60% civil structure, 10 – 10
% each for electrical fittings and water/sanitary fittings. Rent structure is 10% Elevator and
10% Furniture. Calculate the tax liability for the FY 2076.77 as per latest provisions on
income tax act 2058. The Capital WIP (work in progress) heading on the 1st of Magh as per
books shows Rs. 350 lacs.

Particulars Amount
Rent Income 27,000,000.00
Total Income 27,000,000.00
Expenses
Salary of staff 3,075,600.00
Interest on Loan (for the whole year) 4,560,000.00
Buildings upkeeps 980,000.00
Water & Electricity 90,600.00
Office Expenses 50,680.00
Total Expenses 8,756,880.00

6. As per the information given calculate the tax liability of Navin Upadhaya, CEO of Nepal
Reinsurance Company Ltd, who is retired from Nepal Rastra Bank and receiving Rs.
45,000 per month pension from NRB. The facilities from Nepa Reinsurance Compamy Ltd
is as follows:

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- Salary Rs. 225,000 per month

- Festival Allowance of one month salary
- Nepal Reinsurance Company Ltd is listed with Social Security Fund (SSF) as
contributor and thus 31% of salary is deposited with the SSF each month
- He has deposited with Nagarik Lagani Kosh (NLK) Rs. 10,000 per month
- 25% performance allowance is provided by the company, for the year the same is given
for 9 months based on business of the company
- Vehicle facility is provided by the company

7. Mr. Ganpati Bohora is retired from Nepal Government and living is ‘C’ Class district. He is
disabled and has opted for couple for the year. The monthly pension is Rs. 80,000 and Rs.
29,000 paid as life insurance premium and Rs. 21,000 is paid as health insurance premium.
Further he donated Rs. 34,000 to tax exempted organization of the district on the year.
Calculate how much tax he need to pay during the year.

8. From the given below information for Rajan Khakurel, calculate the tax liability applicable
to him for the fiscal year 2076.77 as per income tax act 2058.

Salary Rs. 375,000 per month

The employer is not listed with Social Security fund and has continued to contribute 10%
Provident fund. Gratuity provision of 8.33% is made but not deposited for the whole year.
One month Dashian allowance and one month medical allowance is provided by the
employer. He has personally deposited Rs. 35,000 per month to approved retirement fund.
The life insurance and health insurance premium of Rs. 35,000 and Rs. 45,000 is paid by
Rajan and Rs. 88,900 is donated to Pashupati Area trust which is tax exempted. Calculate
the tax as per couple treatment.

9. Mr. Hari Tiwari has involved in disposal of Listed company share on FY 2075.76 and
incurred loss of Rs. 6 lacs and same is carried forwarded to next year, since there was no
other transaction of Mr. Tiwari on that year. In the FY 2076.77 he has sold land on Rs. 100
lacs and the outgoings of the land was Rs. 80 lacs. Show how the gain on sale of land is

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treated on tax calculation. The land was in the category of Non Business Chargeable
Assets.

10. Janaki Insurance Ltd has following information for the FY 2076.77, based on the same
calculate the tax liability of the company.

Particulars Amount (Rs.)

1 Net Premium received 400,000.00
2 Commission received on reinsurance ceded 20,000.00
3 FY 2075.76 unexpired risk reserve 150,000.00
4 FY 2075.76 provision for claims - reserve for unsettled claim 23,000.00
5 commission paid on reinsurance accepted 10,000.00
6 Agent commission of year 15,000.00
7 Management expenses 100,000.00
8 Claim paid on FY 2076.77 100,000.00
9 Claimed but not settled on FY 2076.77 30,000.00
10 Investment returns of FY 2076.77 - interest 50,000.00
11 Allowable Depreciation 60,000.00
12 Miscellaneous income 25,000.00

11. Nepal Commercial Ltd holds 70% on share of Nepal Commercial and Estates Pvt. Ltd. On
2077.03.15 the holding company transferred the Building having WDV of Rs. 1,45,60,000
to the subsidiary. On the same day the market price of the building is Rs. 175,00,000.
Describe the treatment of the disposal proceeds price on the books of seller and buyer and
its tax treatment. What happens if there was no relationship between the companies.

12. Janardan Dhakal retired from Finance and Credit Bank Ltd on 2077 Ashad end. On
retirement he received Rs. 600,000 as gratuity and Rs. 600,000 as Employee Welfare Fund
from the bank. The welfare fund is received as per Employee Bylaw of the bank where on
retirement of employees some amount is paid from the fund created by the bank. How the
amount is taxed on the payment.
How the tax will be treated, if the Gratuity fund is contributed by the bank to the Approved
Fund maintained within the bank.

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13. Discuss in Brief.

a) Couples
b) Repair and Improvement Expenses
c) Tax Exempted Incomes
d) Medical Tax Credit and Approved Medical Expenses
e) Basis of Tax Accounting

14. Define the followings with respect to Income Tax Act 2058.
a) Permanent Establishment
b) Non Business Chargeable Asset
c) Exempt Organization
d) Company
e) Service Fee

15. Discuss the following with withholding tax applicability as per income tax act 2058.
a) Nepal Cements Pvt. Ltd. has appointed General Trading Pvt. Ltd. as dealer, and as per
agreement 5% of sales is provided to the dealer if the annual sales crosses 3 crores. For
FY 2076.77, the sales by dealer is Rs. 450 lacs.
b) Nepal Trade Centre Pvt. Ltd. has sold goods of Rs. 10 lacs plus VAT to Mr Hareram
and the Mr Hareram has paid the amount through electronic medium, and Nepal Trade
Centre has refunded the 10% of VAT amount (Rs. 1300) to Mr Hareram as incentive.
c) Mrs. Jenika has insured herself with Star Life Insurance Ltd for policy value of Rs. 15
lacs, and the premium paid till FY 2076.77 just before maturity is Rs. 10 lacs. The
maturity amount is paid on FY 2076.77 to her and she has employment income on the
fiscal year.

Value Added Tax

16. Nepal Management Service Pvt. Ltd. has obtained ‘A’ Class construction license from
Ministry of Physical Planning and Works, Nepal Government. Further, it provides the
construction consultancy services to various national and international organizations. For
FY 2076.77 the following is available, calculate the VAT payable/ receivable by the
company.

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Particulars Amount (Rs.)

Construction activity sales to Province 5, Ministry of Physical Works 204,000,000.00
Construction consultancy sales to Neal Electricity Authority 456,000,000.00
Construction activity sales to SAARC Development Fund for project at
Bangladesh 145,689,000.00
Sales of Land to individuals on FY 2076.77 (the land was purchased on 5
crore on FY 2071.72) 99,000,000.00
Purchase of Construction raw materials 32,500,000.00
Purchase of construction equipments 225,600,000.00
Audi Car for CEO 15,500,000.00
Consultancy service for the hire of foreign expert to NEA construction
consultancy from USA 5,000,000.00

17. Buddha Air Pvt. Ltd. has entered into agreement with Royal Aeronautics Society of UK for
providing latest Air navigation online Sky/Air Map and training to its air fleet operation.
The cost of that operation is 450,000 GBP. Based on the same technology, Buddha Air Pvt.
Ltd. has provided same technology and training to Summit Air Pvt. Ltd. on FY 2076.77
after being fully expert on the same technology for Rs. 1 crore. Buddha Air and Summit
Air are both domestic airlines in Nepal. Discuss the applicability of VAT to Buddha Air.

18. Global Visa Support Service Pvt Ltd. is operating as approved education consultancy at
Dillibazar. The Occupation English Test (OET) facilitation is done by the company to the
Nepal service seekers. The cost of OET is 250 USD and need to be paid to US based
Global Services Centre. Each Nepali who wish to appear on the test should go through the
Nepali company for the exam appearance. The company further collects Rs. 15,000 as test
preparation and facilitation services. Discuss the impact of VAT on above transaction.

19. Nepal Exports Pvt. Ltd. exports different kinds of Nepali pickle to abroad since last 5
years. On FY 2076.77 it received order to export Handicrafts and Wooden arts to US.
Discuss the impact of VAT on export of Handicrafts and Wooden arts.

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20. Discuss in brief the provision of VAT Act/Rule on the following:

a) What is market Value as per Value Added Tax 2052? Mention the relevant provision
applicable to market Value as per Value Added Tax 2052?

b) Describe the circumstances beyond the control to submit return and pay taxes under the
value Added Tax Act, 2052.
c) What is the provision for time and place of supply.
d) Differentiate between No VAT and Zero VAT
.

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Answers/ Hints:
Income Tax
Q. No. 1

Particulars Amount (Rs.) Remarks

Disposal of Trading Stock 67,732,946.00
35% previously disallowed as bad debt
Bad Debt Recovered 359,154.90 expense, so 65% included in income now.
Miscellaneous Income 1,088,356.00
Total of Income 69,180,456.90
Opening Stock + Purchase + direct expenses -
Cost of Disposal of closing stock, Rs. 24500 pm of electricity bill
Trading Stock 38,880,406.00 disallowed.
Rs. 275,000 is advance salary provided to sick
employee, related to month Shrawan of 2077
Salary 1,305,000.00 disallowed
All the gratuity paid for previous year
provision as per Labor Act 2048 allowed, and
in current Labor Law and Social Security law
the gratuity is paid on each month, so all the
Gratuity 2,234,960.00 expenses is allowed.

Bad Debt for the year - bad debt disallowed

Rs. 240000 is telephone bill of mobile phone
Telephone 750,000.00 of wife of Director disallowed
Medical Expenses 162,450.00
Sales promotion expenses 9,579,960.00
Repair 1,216,498.22 Note 1
Depreciation 2,835,236.40 Note 1
Total deduction 56,964,510.62
taxable income 12,215,946.28

tax rate 0.20 tax rate for special industry is 20%

tax 2,443,189.26

P
o Opening Dep rate Allowed
ol WDV of assets (%) Dep Repair 7% of WDV repair

A 5,602,546.00 6.67 373,503.07 1,591,450.00 392,178.22 392,178.22

2,035,600.00 712,460.00

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D 10,178,000.00 20.00 1,417,010.00 712,460.00

C 1,598,000.00 26.67 426,133.33 192,450.00 111,860.00 111,860.00

2,835,236.40 1,216,498.22

- The depreciation rate for special industry is inflated by 1/3rd on the normal rates
- The repair allowed is 7% of WDV or actual whichever is lower

Q. No. 2
The tax benefit for special industry is on inflation of rate of depreciation by 1/3rd, the rate of tax
for special industry is 20% and rate of tax for export by special industry is further 25% reduction
on rate of tax thus net rate is 15%.

Particulars Sales in Nepal Export Sales

Sales (Disposal of Trading Stock) 58,025,000.00 58,025,000.00
Miscellaneous Income (includes Rs. 750,000 interest
income from Nepal Bank Ltd with net of TDS on 866,470.00 866,470.00
Fixed Deposit)
Total of Income 58,891,470.00 58,891,470.00
Cost of Disposal of Trading Stock
Opening Inventory 5,313,870.38 5,313,870.38
Purchase 13,930,280.00 13,930,280.00
Direct Expenses
Electricity 2,386,924.80 2,386,924.80
Wage 7,032,792.00 7,032,792.00
Closing Inventory (3,984,750.00) (3,984,750.00)
Cost of Disposal of Trading Stock 24,679,117.18 24,679,117.18
Salary 1,851,678.40 1,851,678.40
Gratuity 804,190.40 657,973.96
Bad Debt for the year - -
Telephone 80,392.00 80,392.00
Sales promotion expenses 1,466,636.60 1,199,975.40
Repair 602,657.50 602,657.50
Depreciation 1,411,916.67 1,411,916.67
Total deduction 30,896,588.75 30,483,711.11
taxable income/(Loss) 27,994,881.25 28,407,758.89
tax rate 20.00% 15.0%
tax 5,598,976.25 4,261,163.83

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The depreciation and repair for each segment is half of the below allowed amount.
Allowed
P repair
o Opening WDV of Dep rate Actual (Minimum of
ol Asset (%) Depreciation Repair 7% of wdv Actual or 7%)

A 5,590,000.00 6.67 372,666.67 1,157,520.00 391,300.00 391,300.00

D 11,190,500.00 20.00 2,238,100.00 1,346,800.00 783,335.00 783,335.00

C 799,000.00 26.67 213,066.67 30,680.00 55,930.00 30,680.00

2,823,833.33 2,535,000.00 1,205,315.00

Q. No. 3

Particulars Amount (Rs.)

Sales Revenue 134,750,000.00
Total 134,750,000.00
Cost of Sales 59,950,000.00
Cost of Food 24,750,000.00
Cost of Beverage 19,250,000.00
Cost of Room consumables 15,950,000.00
Repair 285,833.33
Depreciation 1,073,833.33
Interest Cost (section 14) (For the year of operation the interest is fully
claimed as cost under section 14) 14,560,900.00
General Deduction (Employee & Selling & Administrative Expenses) 37,455,000.00
Total Deduction 98,764,666.67
Taxable Income for FY 2076.77 35,985,333.33
Tax Rate (10% Rebate for private company converted into public company
with 50 crore and more capital) 22.50
Tax Liability 8,096,700.00

Pool A C D
Allowable assets for depreciation
– the opening of resort is on
Baisakh 1 so the 1/3rd is allowed
(The Bed/Furnishing for Hotel
Industry are Core Assets, and thus
need to classified as Pool D) 5,833,333.33 848,333.33 4,083,333.33

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Depreciation Rate 0.05 0.20 0.15

Depreciation 291,666.67 169,666.67 612,500.00
7% Cap for Repair 408,333.33 59,383.33 285,833.33
Actual Repair - - 3,916,000.00
Allowed Repair - - 285,833.33

Q. No. 4
Cooperative Trading
Particulars
Business Business
Interest Income (Investment income directly related to business)
94,416,600.00 73,485,333.33
/Sales
Service Fee 11,599,500.00 -
Commission and charges 5,061,600.00 -
Other Miscellaneous income 1,716,060.00 -
Loan Loss provision included in income 7,027,410.00 -
Total Income 119,821,170.00 73,485,333.33
Deductions
Interest Expenses /Cost of Sales 65,034,900.00 51,439,733.33
Administrative Expenses 5,647,857.60 4,437,602.40
Loan Loss provision - -
Total Deduction 70,682,757.60 55,877,335.73
Taxable Income 49,138,412.40 17,607,997.60
Tax Rate 0.10 0.25
Tax 4,913,841.24 4,401,999.40

Calculation of Allowable LLP

Gross Loan 187,035,000.00

5% of Gross Loan 9,351,750.00

Loan Loss provision claimed upto last year 16,379,160.00

This year allowed Loan Loss Provision (This should be included in income) 7,027,410.00

The cooperative business ratio is 56%, and trading business ratio is 44%. The miscellaneous
income is included in the cooperative business, and administrative expenses is segregated in the
ratio.

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The rate of tax for cooperative (saving and credit) in Municipality is 10% and for the sale of
goods (trading) is 25%.

Q. No. 5
Particulars Amount
Rent Income 27,000,000.00
Total Income 27,000,000.00
Expenses
Salary of staff 3,075,600.00
Interest on Loan (for the whole year) 4,560,000.00
Buildings upkeeps 980,000.00
Water & Electricity 90,600.00
Office Expenses 50,680.00
Depreciation 1,866,666.67
Total Expenses 10,623,546.67
Taxable Income 16,376,453.33
Tax 25%
Tax liability 4,094,113.33

Allowed amount for

depreciation(2/3rd
because ready to
Capitalized move is on 1st of
Pool Portion Amount Magh) (DBV) Rate Depreciation
A (Building, Electrical
and Water/sanitation
structure) 80.00 28,000,000.00 18,666,666.67 5% 933,333.33

B (Furniture) 10.00 3,500,000.00 2,333,333.33 25% 583,333.33

D (Elevator) 10.00 3,500,000.00 2,333,333.33 15% 350,000.00

1,866,666.67

Q. No. 6
S.
No. Particulars Unit Amount Total Amount (Rs.)

1 Salary 12.00 225,000.00 2,700,000.00

2 Pension 12.00 45,000.00 540,000.00

3 Festival Allowance 225,000.00 225,000.00

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1.00

4 Performance Allowance 9.00 56,250.00 506,250.00

5 Vehicle Facility quantification 12.00 1,125.00 13,500.00

6 Contribution to SSF by employer 12.00 45,000.00 540,000.00

Total Assessable Income 4,524,750.00
(lower of Rs. 500,000 or 1/3 of AI or Actual)- The Approved retirement fund
deduction is not allowed if the SSF deduction is claimed 500,000.00
Taxable Income before pension 4,024,750.00
less pension 100,000.00
taxable income for tax calculation 3,924,750.00
Tax calculation

First – No social security tax 400,000.00 1% 0.00

Next slab 100,000.00 10% 10,000.00

Next slab 200,000.00 20% 40,000.00

Next slab 1,300,000.00 30% 390,000.00

Surcharge 1,924,750.00 36% 692,910.00

Total Tax 1,132,910.00

Q. No. 7
Particulars Unit Amount Total Amount (Rs.)

Pension 12.00 80,000.00 960,000.00

Total Assessable Income 960,000.00

Remote Area Allowance 1.00 30,000.00 30,000.00

Disabled Allowance 1.00 225,000.00 225,000.00

Pension 1.00 112,500.00 112,500.00

Life Insurance 1.00 25,000.00 25,000.00

Health Insurance 1.00 20,000.00 20,000.00

Donation (5% or 960,000 or 100,000 or
actual 34,000 take lowest) 34,000.00
Taxable Income 513,500.00
First 0%

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450,000.00 0.00

Next slab 63,500.00 10% 6,350.00

Total Tax 6,350.00

Q. No. 8
Particulars Amount Unit Total Amount (Rs.)
Basic Salary 375,000.00 12.00 4,500,000.00
Provident Fund 37,500.00 12.00 450,000.00
Festival Allowance 375,000.00 1.00 375,000.00
Medical Allowance 405,000.00 1.00 405,000.00
Assessable income (AI) 5,730,000.00
Reduction
Donation (Min of below three conditions)
5% of AI (5% of 5730000) 286,500.00
Rs. 100,000 100,000.00
Actual 88,900.00 88,900.00
Life Policy (Minimum of below two conditions)
Rs. 25,000 25,000.00 25,000.00
Actual paid 35,000.00
Heatth Policy (Minimum of below two
conditions) -
Rs. 20,000 20,000.00 20,000.00
Actual paid 35,000.00
Approved Retirement Fund (Minimum of below
three conditions)
Rs. 300000 300,000.00 300,000.00
1/3rd of AI 1,910,000.00
Actual 1,320,000.00
Taxable income 5,296,100.00
1% for 450,000 4,000.00
10% for Next 100,000 10,000.00
20% for Next 200,000 40,000.00
30% for Next 1250000 375,000.00
36% for 3296100 1,186,596.00
Total Tax 1,615,596.00

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Q. No. 9
On FY 2075.76 the loss on Investment is Rs. 6 lacs and the same is carried forwarded to next
year. On FY 2076.77 the incomings on sale of NBCA is Rs. 100 lacs and outgoings on the
purchase of NBCA was Rs. 80 lacs, thus the gain on disposal of NBCA (i.e investment income)
is Rs. 20 lacs. The 20 lacs gain on investment is allowed to be set off with the loss on investment
carried forwarded, thus the net gain on investment for the FY 2076.77 is Rs. 14 lacs.

Q. No. 10

Particulars Amount (Rs.)

1 FY 2075.76 unexpired risk reserve 1,425,000.00
2 FY 2075.76 provision for claims - reserve for unsettled claim 218,500.00
3 Net Premium received 3,800,000.00
4 Commission received on reinsurance ceded 190,000.00
5 Investment returns of FY 2076.77 - interest 475,000.00
6 Miscellaneous income 237,500.00
Total Income 6,346,000.00
Deductions
1 Claim paid on FY 2076.77 - section 60 950,000.00
2 Agent commission of year 142,500.00
3 commission paid on reinsurance accepted 95,000.00
4 Management expenses 950,000.00
5 Allowable Depreciation 570,000.00
6 Claimed but not settled on FY 2076.77 - 115% of claims not settled (section 60) 327,750.00
7 Unexpired risk reserve of this year (50% of net premium - section 60) 1,900,000.00
Total Deductions 4,935,250.00
Taxable Income 1,410,750.00
Tax 0.30
Tax liability 423,225.00

Q. No 11

As per section 45(3), on transfer of depreciable assets between associated individuals, the price
for seller/buyer is the WDV on the books of seller. The same price is cost price as acquisition
cost for the buyer. So in the books of seller (holding company) there is no gain on sale of assets.

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The market price is not considered as disposal proceeds for the transaction between associated
individuals.

If the companies have no relationship, the price should be market price. If the companies have
not done the transaction in market price (arm length transaction) the Department have power to
investigate the case as per section 35 (General Anti Avoidance Rule).

Q. No 12
The retirement payment from non - contributory fund taxed at the rate of 15% as per section 65.
So for both the cases, the tax @ 15% is applied.

If the gratuity is paid from the fund which is approved retirement fund from Inland Revenue
Department, then tax is applied @ 5% on the gratuity and 15% on the welfare amount payment.

Q. No 13

a) As per section 50,

i) A resident natural person and a resident spouse of the person may, by notice in
writing elect to be treated as a single individual for a particular income year.
ii) Each spouse of a couple making an election as above with respect to an income-year
is jointly and severally liable with the other spouse for any tax payable by the couple
for the year.
iii) What so ever mentioned in above (i) and (ii) resident widow or widower responsible
to take care of dependents shall be treated as couple.

b) As per Section 16, Repair and Improvement Costs provision is as follows;

i) For the purpose of calculating a person’s income for an income – year from any
business or investment, there shall be deducted all costs to the extent incurred during
the year in respect of the repair or improvement of depreciable assets owned and used
by the person during the year in the production of the person’s income from the
business or investment.
ii) Notwithstanding mentioned in (i), the deduction allowed with respect to all
depreciable assets in a particular pool of depreciable assets of the person shall not
exceed seven percent of depreciation basis of the pool at the end of the income year.
However, the limitation shall not be applicable on overhauling of aircraft as required by
Standards of Civil Aviation Authority of Nepal.
iii) Any excess cost of repair and improvement, or a part thereof, for which a deduction

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is not allowed as a result of the limitation of (ii), can be added to the depreciation basis
prevailing in the beginning of the subsequent income year, of the pool to which it
relates.

c) As per Section 10 of Income Tax Act, the following amounts are tax exempted
incomes:
i) Amounts derived by a person entitled to privileges under a bilateral or a multilateral
treaty concluded between Nepal Government and a foreign country or an international
organization.
ii) Amounts derived by an individual from employment in the public service of the
government of a foreign country.
Provided that The individual is a resident person solely by reason of performing the
employment or is a non-resident person; and The amounts are payable from the public
funds of the country.
iii) Amounts derived from public fund of the foreign country by an individual who is
not a citizen of Nepal as referred to in paragraph (ii) or by a member of the immediate
family of the individual.
iv) Amounts derived by an individual who is not a citizen of Nepal from employment
by Nepal Government on terms of tax exemption.
v) Allowances paid by Nepal Government to widows, elder citizens, or physically
disabled individuals.
vi) Amounts derived by way of gift, bequest, inheritance, or scholarship, except as
required to be included in calculating income under section 7, 8 or 9 and
vii) Amounts derived by an exempt organization by way of
a) Gift; or
b) Other contributions that are directly related to the organization’s function referred to
in paragraph(s) (1) of the definition of exempt organization in section 2, whether or not
the contribution is made in return for consideration provided by the organization, or
c) Income earned by Nepal Rastra Bank as per its objective, or
d) Income earned by Securities Board of Nepal as per its objective.
viii) Pension received by a Nepali citizen retired from the army or police service of a
foreign country provided the amounts are payable from the public fund of that country.
ix) Any income of Nepal Government.

d) If a resident natural person becomes ill, his treatment cost is qualify for medical tax
credit under Sec. 51. Eligible Medical Cost (EMC) is cost of treatments including fee
paid to doctor, lab cost, dispensary cost and other associated costs. In EMC, cosmetic
medical cost is not included. If a person has medical insurance, premium paid for it is
deemed as EMC.

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Medical Tax Credit Limit (MTCL) is as follows:

= (EMC + Medical Insurance Premium – Insurance Compensation) * 15%
Maximum limit of medical tax credit is Rs. 750 for a year. If a person has MTCL is
more than Rs. 750 or have tax payable is less than Rs. 750, any unrelieved MTCL is
carried forward to next years.
As per Rule 17(1), the following shall be treated as approved medical expenses:
•Health Insurance Premium
•Amount as per bill including medical expenses of approved hospital, nursing home,
health center or doctor

As per Rule 17(2), the following shall not be included in approved medical expenses:
•Expenses of Cosmetic Surgery
•Insurance claimed medical expenses

e) Basis of Tax Accounting

As similar in accounting, basis of accounting is also cash basis of accounting and
accrual basis of accounting. Both cash basis and accrual basis are not conceptually
same for both tax and accountings.
Statutory cash basis for tax: Income from employment and income from investments
in case of a natural person has to be accounted in cash basis of accounting.
Statutory accrual basis for tax: Company should keep its tax accounts on accrual
basis of accounting.
Banking business, as licensed from Nepal Rastra Bank can keep its accounts based on
directives. Again, co-peratives can maintain its interest income in cash basis.
Optional basis for tax: Income from business of a natural person and income of entity
other than a company (partnership and trust) may opt either basis for taxation.

Q. No 14

a) Permanent Establishment as per section 2 (Ka) (Da)( s) (b): „Permanent

Establishment‟ (PE) means an establishment where a person wholly or partly carries on
a business. The establishment refers to the head office, factory, premises, site office,
branch office etc. In additional to that, these
undernoted establishment are also defined as PE :
- An establishment where a person wholly or partially carries on a business through an
agent, when the agent is not a general agent of independent status.
- An establishment where a person has, is using, or is installing main equipment or
machineries (factory premises).

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- One or more establishment within a country where a person furnishes, whether

through employees or otherwise, technical, professional, or consultancy service for a
period or periods aggregating more than 90 days within any 12 months.
- An establishment where a person is engaged in a construction, assembly, or
installation project for 90 days or more, and a place where a person conducting
supervisory activities in relation to such a project.

b) Non Business Chargeable Asset

As per paragraph (b) of Section 2 of Income Tax Act 2058; NBCA means
securities or an interest
in an entity as well as land and building but excludes the following assets:

- Business Assets, depreciable assets or trading stock

- A private resident of an individual that has been
Owned continuously for ten years or more, and
Lived in by the individual continuously or intermittently for a total of ten years or
more.
Clarification: For the purpose of this paragraph private residence means private
building and area of land covered by building or one ropani land, whichever is lower.

- Interest of any beneficiary in retirement fund.

- A land, land and building and private residence of an individual that is disposed of for
less than 30 lakhs.
- Assets of an individual that is disposed of by way of any type of transfer other than
sales and purchase made within three generations.

c) As per paragraph (w) of Section 2 of Income Tax Act, exempt organization means the
following entities:
- Following entities registered with the Department as an exempt organization:
i) A social, religious, educational, or a charitable organization of public character
established without having a profit motive,
ii) An amateur sporting association formed for the purpose of promoting social or
sporting facilities not involving the acquisition of gain.
- A political party registered with the Election Commission
- A village municipality, municipality/sub-metropolis/metropolis or district
coordination committee, provided that, any entity, giving benefit to any person from
the assets of, and amounts derived by the entity except in pursuit of the entity’s
function as per its objectives or as payment for assets or service rendered to the entity
by the person, is not exempt from tax.

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d) As per paragraph (8) of Section 2, company means a company established under the
company laws for the time being in force and the following institutions shall also be
treated as company for tax purpose:
- Corporate body established under the laws for the time being in force
- Any unincorporated association, committee, institution, society, or group of persons
other than a partnership or a proprietorship firm (whether or not registered) or a trust
- A partnership firm (whether or not registered under the laws for the time being in
force) that has 20 or more partners, a retirement fund, a co-operative, a unit trust, or a
joint venture;
- Foreign company; and
- Any foreign institution prescribed by the Director-General

e) As per paragraph (s d) of section 2, service fee means any fee paid to a person based on
market values, for services rendered by the person and includes a commission or a
meeting allowance, management fee, or technical service fee.

Q. No 15

a) As per section 88(1), the sales bonus of Rs. 450*5% = 22.5 lacs is withholding tax attractive
@ 15%. Here, we can - not treat the case as section 88(1)(4) as service fee and TDS on service
fee @ 1.5% for VAT registered person, since the case is sales bonus not the service fee.

b) The incentive paid to taxpayers for paying the bill through electronic medium, no withholding
tax is applicable.

c) On the maturity payment of life policy, the withholding tax @ 5% is applied on net gain. Net
gain is policy maturity value less the premium payments
Net gain = 15-10 = 5 lacs
Tax = 5% = 25,000
Net amount received = 14,75,000

The payment is final withholding, thus the amount need not be included in tax calculation for the
year.

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Value Added Tax (VAT) Act

Q. No 16

Particulars (Output Tax

and Ratio of taxable and
non taxable sales) Total Taxable (13%) Taxable (0%) Tax Non Taxable
Construction activity
sales to Province 5,
Ministry of Physical
Works 204,000,000.00 204,000,000.00 26,520,000.00 -
Construction
consultancy sales to Neal
Electricity Authority 456,000,000.00 456,000,000.00 59,280,000.00 -
Construction activity
sales to SAARC
Development Fund for
project at Bangladesh 145,689,000.00 145,689,000.00 - -
Sales of Land to
individuals on FY
2076.77 (the land was
purchased on 5 crore on
FY 2071.72) 99,000,000.00 - 99,000,000.00

Total 904,689,000.00 660,000,000.00 145,689,000.00 85,800,000.00 99,000,000.00

Ratio 100.00% 72.95% 16.10% 10.94%

The taxable sales is 89.06% of total sales, but all the inputs except the Car purchase are directly
used on sales so full claim is allowed. For car, 40% is input credit is allowed, and 89.06% of the
allowed part is claimed.
Tax Paid/
Particulars Amount Collected Allowed tax
Construction activity sales to Province
5, Ministry of Physical Works 204,000,000.00 26,520,000.00 26,520,000.00
Construction consultancy sales to Neal
Electricity Authority 456,000,000.00 59,280,000.00 59,280,000.00
Construction activity sales to SAARC
Development Fund for project at
Bangladesh 145,689,000.00 -
Sales of Land to individuals on FY
2076.77 (the land was purchased on 5
crore on FY 2071.72) 99,000,000.00 -
Total Output tax 85,800,000.00

Purchase of Construction raw materials 32,500,000.00 4,225,000.00 full allowed

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Purchase of construction equipment 225,600,000.00 29,328,000.00 full allowed

40% allowed, and
Audi Car for CEO 15,500,000.00 717,823.60 ratio applied on 40%
Consultancy service for the hire of
foreign expert to NEA construction this is reverse vat,
consultancy from USA 5,000,000.00 650,000.00 full allowed

Total input tax 34,920,823.60

Net VAT Payable 50,879,176.40

Q. No 17
Air travel is VAT exempted activity (listed in Schedule 1) of VAT Act. The import of service
from UK is VAT attractive and Buddha Air need to pay reverse charge VAT on equivalent
450,000 GBP payment to UK.
The consultancy service to Summit Air is VAT attractive and amount is exceeding 20 lacs on FY
2076.77. So VAT need to be collected by Buddha Air from Summit Air on that transaction.

Q. No 18
The educational services by the Universities and Schools are exempted from VAT, but the case
above mentioned for OET test is not exempted. Thus the Nepali company Global Visa Support
Service Pvt. Ltd. need to collect VAT on exam fee 250 USD (equivalent NRs) from each Nepali
service seeker, and on the Rs. 15,000 test preparation and facilitation fee is also VAT attractive.
On payment to US based company by Nepali Company, reverse VAT is applicable.

Q. No. 19
The Handicrafts and Wooden arts are exempted goods listed in Schedule 1 of VAT Act. So no
VAT is attractive on export of those goods.

Q. No. 20
a) Market Value
As per section 2(k) of Value Added Tax Act 2052, "Market Value" means the price as
determined pursuant to Section 13;

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As per section 13 of Value Added Tax Act 2052, market value related provisions are:
(1) The market value of goods or services shall be determined as the consideration in
money which the supply of these goods or services would generally be agreed on if the
transaction were made under similar circumstances at that date in Nepal taking into
consideration the characteristics, quality, quantity, materials, and any other relevant
factor, being a supply freely offered and made between persons who are unrelated.

(2) For the purpose of this section the method for the determination of market value hall
be as prescribed.
(3) Where the market value of goods or services could not be determined under
subsection 1) and
(2), it shall be determined in accordance with a process determined by the Director
General.

In addition to this section, Section 22 of Value Added Rules 2053 mention that, for
determining the market value under Section 13 of the Act, the tax officer shall determine
the market value by studying the transactions and value of other vendors registered in
regard to the transaction of the same nature. In cases where the market value of any
goods or services cannot be determined as set forth in sub-section (3) of Section 13 of the
Act, the Director General shall determine the value on the basis also of the information
received in that regard by him from the registered persons of the same nature.

b) Circumstances beyond control

As per Rule 35 of Vat Rule 2053, the following circumstances shall be deemed to be
circumstances beyond control for the purpose of sub-section (4) of Section 19 of the Act;

i. In case the person required to pay tax becomes disabled due to falling ill; up to seven
days of the date of his recovery.
ii. In case the person required to pay tax is to obsequies; up to seven days of the end of the
obsequies,
iii. In case a woman required to pay tax delivers a child; up to thirty five days of the date of
delivery,
iv. In case the person required to pay tax dies or become insane or disappears and his heir or
guardian submits an application within thirty five days of the date of such incident; up to
seven days of receipt of such application,
v. In circumstances when the person required to pay tax has not been able to come to the
IRO because of the closure of a road due to floods, landslides of similar other reasons;
up to seven days of opening of the road,
vi. In circumstances when he cannot come to the IRO due to total Strike of transport; up to
the next day of the end of such strike.

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vii. In case where the natural calamities like fire earthquake, arises; up to thirty days from the
date when such calamities occur.

In case an additional time limit shall be required to be requested due to circumstances beyond
control referred to point (ii),(iii),(iv),(v) & (vii) above; the recommendation of the concerned
Village Development Committee or Municipality shall be submitted.

While requesting for an additional time-limit due to the circumstance referred to point
no,(vi), the recommendation of the Village Development Committee or Municipality
concerned with the place where the Strike of means of transport has taken place, shall be
submitted.

c) Time and Place of Supply

As per Section 6 of VAT Act, the time of supply goods or services shall be considered to
have taken place at the earliest time of the following times:
a) The time supplier issued an invoice
b) In the case of the supply of goods, when the recipient removes or takes possession of the
goods from the supplier's transaction place;
c) In the case of the supply of services when the services are provided; and
d) When the supplier receives a consideration for goods or services

Following shall be the provision for the time of supply in the following cases :

(a) In the case of services which are continuously provided, namely, telecommunication services
or similar other public services, when the invoice is issued;

(b) Where there is a contractual provision for paying partially the value of goods or services in
more than one day on an installment basis, the supply time shall be the earliest day on which the
payment is made or the day on which the payment is to be made according to the contract;

(c) In the case of goods or service which are so used as not to be allowed an offset under this
Act, the time when such Goods or Services are used;

As per Rule 15 of VAT Rules 2054 the following places shall be deemed to be the place of
supply of goods:-

(a) In the case of movable goods transferred by sale, the place where such goods were sold or
transferred,

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(b) In the case of any immovable goods whose location can't be transferred even if their
ownership is changed, the place where such goods are located,

c) In the case of imported goods, the customs point in the Kingdom of Nepal through which such
goods are imported into the Kingdom of Nepal,

(d) In case any producer or vendor supplies the goods to himself, the place where the producer
or vendor of such goods resides.

As per Rule 16 of VAT Rules 2054 the following places shall be deemed to be the place of
supply of services:-

The place of supply of a service shall be the place where the benefit of that service is received.

d) Zero VAT and No VAT

Schedule 1 of VAT Act 2052 (and amended by latest Finance Act) has listed the VAT exempt
goods and services and Schedule 2 of the act has listed the goods and services for which VAT is
payable at Zero rate.

VAT exempt goods and services are those goods and services, for which the application of VAT
(economic value addition) is not relevant, whereas for the goods and services listed under zero
rates category the payment of VAT is at Zero rate.

In practice, zero rate has more financial benefit to the business unit compared with VAT exempt
goods/services.

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