SUGGESTED SOLUTIONS TO SELECTED QUESTIONS

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1 SUGGESTED SOLUTIONS TO SELECTED QUESTIONS Chapter Journal entries: 1. Funds introduced to business Dr Cash 50,000 Cr Proprietorship 50, Recording purchase of business Dr Plant 5,000 Dr Inventory 15,000 Cr Cash 20, Investment purchased with cash Dr Investment 10,000 Cr Cash 10, Credit sales Dr Debtor 900 Cr Sales Received cash on account Dr Cash 300 Cr Debtor Cash sales Dr Cash 560 Cr Sales Inventory purchased Dr Purchases 400 Cr Cash Purchase of plant Dr Plant 1,000 Cr Cash 1, Introduction of extra capital Dr Cash 4,000 Cr Capital - Proprietorship 4, Drawing of $1,000 of cash Dr Proprietorship 1,000 Cr Cash 1, Drawing of $440 of goods Dr Proprietorship 440 Cr Inventory Wages paid to staff Dr Wages 1,680 Cr Bank 1, Interest receipt Dr Cash 400 Cr Interest Received Purchase of inventory Dr Purchases 2,480 Cr Creditors 2, Goods returned Dr Sales 200 Cr Debtor Goods returned to supplier,

2 Financial Management and Decision Making Dr Purchases 600 Cr Creditors Cash received from debtor Dr Cash 380 Cr Debtor Discount allowed Dr Discount allowed 20 Cr Debtor Creditor paid Dr Creditor 1,820 Cr Cash 1, Discount on inventory purchased Dr Creditor 60 Cr Discount received Sales on account Dr Debtors 7,700 Cr Sales 7, Inventory purchased Dr Purchases 4,360 Cr Creditors 4,360 T' accounts: Cash Proprietorship (1) 50,000 20,000 (2) (10) 1,000 50,000 (1) (5) ,000 (3) (11) 440 4,000 (9) (6) (7) (9) 4,000 1,000 (8) (13) 400 1,000 (10) (17) 380 1,680 (12) 1,820 (19) Inventory Sales (2) 15, (11) (15) (4) 560 (6) 7,700 (21) Debtors Creditors (4) (5) (19) 1,820 2,480 (14) (21) 7, (15) (20) 60 4,360 (22) 380 (17) (16) (18), +

3 , - Suggested Solutions to Selected Questions 485 Plant Sales Discount (2) 5,000 (18) 20 (8) 1,000 Investment Wages (3) 10,000 (12) 1,680 Interest Received Purchases Discount 400 (13) 60 (20) Purchases (7) (16) (14) 2480 (22) 4360 Trial Balance Dr Cr Proprietorship 52,560 Sales 8,960 Sales Discount 20 Creditors 4,360 Interest received 400 Cash 19,740 Inventory 14,560 Debtors 7,700 Purchases 6,640 Purchases discount 60 Investment 10,000 Wages 1,680 Plant 6,000 66,340 66,340

4 Financial Management and Decision Making Income Statement for period concerned Sales 8,960 less sales discount 20 less cost of goods sold: Opening Inventory 14,560 plus purchases 7,840 less discounts 60 7,780 22,340 less closing inventory 18,000 8,940 4,340 Gross Profit - operations 4,600 plus other income - interest 400 5,000 less expenses - wages 1,680 Net Operating Profit 3,320 Balance Sheet Proprietorship 52,560 plus Net Profit 3,320 Represented by: Current Assets Cash 19,740 Inventory 18,000 Debtors 7,700 45,440 Current Liabilities Creditors 5,560 55,880 39,880 Investments 10,000 Plant 6,000 55,880, +

5 , - Suggested Solutions to Selected Questions T' accounts: Cash/Bank Proprietorship (a) 10, (b) (g) ,000 (a) (h) 1,680 1,000 (d) (l) 240 (p) 5, (f) (q) 200 (r) 1, (g) (u) 1,320 4,000 (j) 2,760 (n) 200 (q) 680 (v) 100 (w) Creditors - Wholesaler Ltd Debtors - A. Consumer (i) 860 7,770 (e) (k) 2, (m) (j) 4,000 2,080 (t) 1,560 (r) (n) 2, (s) (o) 80 Creditors - Fittings Ltd Sales (d) 1,000 2,120 (c) (m) 480 1,680 (h) 2,560 (k) 1,320 (u) Rent Trade Expenses (b) 500 (v) 680 Shop Fittings Interest Expense (c) 2,120 (w) 100 Wages Sales Discount (f) 240 (s) 40 Inventory Loan - R. Uncle (e) 7, (i) 5,000 (p)

6 Financial Management and Decision Making (t) 2, (l) Purchases Discount 80 (o) Note: Transaction (m) assumes that the customer was credited with the sale price. No account has been taken of the value of inventory. Inventory will be sorted via stock take (periodic inventory system). Trial Balance Proprietorship 9,080 Sales 5,080 Sales Discount 40 Loan - R. Uncle 5,000 Creditors - Fittings Ltd 1,120 - Wholesaler Ltd 2,150 Bank 9,600 Debtors 480 Inventory 8,750 Shop fittings 2,120 Wages 240 Interest 100 Rent 500 Trade Expenses 680 Purchases discount 80 22,510 22,510 Chapter Income Statement for the year ended X8 Sales 530,000 Less: Cost of Goods Sold Opening Inventory 160,000 Purchases 200,000 Freight inward 15, ,000 Less: Closing Inventory 170, ,000, +

7 , - Suggested Solutions to Selected Questions 489 Gross Profit 325,000 Less: Expenses Selling Costs Advertising 17,000 Freight o/w 8,000 25,000 Administration Costs Rental 18,500 Salaries 60,000 Audit fees 800 Power, phone 2,600 Depreciation 36,000* 117,900 Financial Costs Interest 16,000 Total Expenses 158,900 NET PROFIT $166,100 * Here we must assume that this asset is brand new, otherwise: (a) accumulated depreciation would be shown (it isn't); or (b) $360,000 is the NET book value of the asset, in which case we could not determine the historical cost for depreciation purposes. Balance Sheet as at X8 Proprietorship: Capital 254,400 Plus: Net Profit 166,100 $420,500 Represented by: Current Assets Bank 13,000 Inventory 170,000 Accounts Receivable 18, ,000 Term Assets Plant and Equipment 360,000 less depreciation 36, ,000 Total Assets 525,000 Less: Current Liabilities Accounts Payable 24,500 Term Liabilities

8 Financial Management and Decision Making Bank Loan 80, ,500 $420, Horace Hardware Income Statement for year ended March 31 Sales 36,300 less: Cost of Goods Sold 17,400 Gross Profit 18,900 less: Selling Expenses Advertising 310 Administration Expenses Wages 8,000 Power/Phone 910 Rates 400 Depreciation 200 9,510 Finance Expenses Mortgage Interest 840 Total Expenses 10,660 NET PROFIT BEFORE TAXATION 8,240 less 45% 3,708 NET PROFIT AFTER TAX $ 4,532 Horace Hardware Balance Sheet as at March 31 Proprietorship: Capital 23,200 Plus: Net Profit 4,532 27,732 Less: Drawings 1,400 $26,332 Represented by: Current Assets Bank 450 Inventory 6,000* Accounts Receivable 840 7,290 Term Assets Land and Buildings 24,000 Plant/Equipment 8,200 less accumulated depreciation 600 7,600, +

9 , - Suggested Solutions to Selected Questions 491 Total Assets 38,890 Less: Current Liabilities A/c Payable 1,250 Tax payable 3,708 4,958 Term Liabilities Mortgage 7,600 12,558 $26,332 * Must assume that: inventory in trial balance = closing inventory [included as the COGS figure = Opening Inventory + Purchases (both normally in TB) - Closing Inventory (not normally in TB, so added back)] 5.17 Parklands Ltd Manufacturing Statement for year ended 31 December 19X4 Opening Work in Process 82,000 Direct Materials Opening Inventory 54,000 Purchases 306,000 Less: Closing Inventory (48,000) Direct Materials Used 312,000 Direct Labour 240,000 Factory Overheads: Insurance 40,000 Light & Power 86,000 Repairs 34,000 Indirect Labour 108,000 Supplies 68, , ,000 Less: Closing Work in Process 90,000 Cost of Goods Manufactured $880,000

10 Financial Management and Decision Making Chapter Workings From: Debt ratio = D/TA = 43% Equity ratio = E/TA = 57%, so TA = 87,500 = $1,535, and TL = (TA - E) = $660,088 From: Total A = Current A + Fixed A (650,000) CA = $885,088 From: Current Ratio = CA/CL = ,088 = C.Liab (acc. payable) = $590, and LTD = (TL - CL) = 660, ,059 = $70,029 From: Sales to Total Assets = 3.5 Sales = $5,372,808 ($14,720 per day) From: Average Collection period = 23 days Accounts Receivable = 23 = AR Average Daily Sales 14,720 AR = $338,560 From: Quick Ratio = CA - I = 0.75 CL 885,088 - I = ,059 I = $442,544 From: CA = Cash + Inv + AR Cash = 885, , ,560 = $103,984 Incomplete Ltd Balance Sheet as at 31 March 1989 Cash 103,984 Current liabilities 590,059 Inventory 442,544 Long term debt 70,029 Accounts receivable 338,560 Total current assets 885,088 Total liabilities 660,088 Fixed assets 650,000 Shareholders' funds 875,000, +

11 , - Suggested Solutions to Selected Questions 493 $1,535,088 $1,535, Balance Sheet Current assets 51,000 Current liabilities 30,000 Fixed assets 17,000 Long term debt 5,925 Shareholders' funds 32,075 $68,000 $68,000 Income Statement Sales 95,200 less Cost of goods sold 67,592 Gross profit 27,608 less Operating expenses 22,848 E.B.I.T. 4,760 less interest 1,488 3,272 less tax 1,571 Net profit $ 1,701 Calculations: sales = 1.4 (1) total assets sales = 5.6 fixed assets sales = 5.6 total assets - current assets current assets = 1.7 current liabilities current assets = 51,000 sales = 5.6 total assets - 51,000 therefore, from (1): (5.6 x total assets) - 285,600 = sales (5.6 x total assets) - 285,600 = (1.4 x total assets) 4.2 x total assets = 285,600 Total Assets = $68,000 debt = 1.12 equity debt = ,000 - debt

12 Financial Management and Decision Making debt = 1.12 (68,000 - debt) = 76,160 - (1.12 x debt) (2.12 x debt) = 76,160 therefore, debt = $35,925 sales = 1.4 total assets sales = ,000 therefore, sales = $95,200 gross profit =.29 sales therefore, gross profit = $27,608 operating profit =.05 sales therefore, operating profit = $95,200 x.05 = $4,760 Note: Operating Profit Margin should be treated as EBIT/Sales in this question. EBIT = 3.2 interest therefore, interest = 4,760/3.2 = $1,488 Chapter 8 8.5b Required Sales volume = FC + (desired after tax income)/(1-t) (unit selling price - unit variable cost) = $12,000 + $30,000/(1-0.45) ($ $2.00) = $66,545 / $2.40 = 27,727 units sold 8.10d Margin of safety = (43,077-18,077) = 25,000 units or 58% of sales, +

13 , - Suggested Solutions to Selected Questions e Net profit at current operating level $ Sales ($2.10 x 50,000) 105,000 Variable costs ($0.90 x 50,000) 45,000 Contribution margin 60,000 Fixed costs 37,000 NET OPERATING PROFIT $ 23,000 Chapter a Sales 2,000 7,000 3,000 13,000 V.C. 1,400 4,200 1,800 6,400 CM Product 600 2,800 1,200 4,600 less I.F.C ,000 Product Margin 450 2, ,600 less F.Costs Unidentifiable F.C.* 2,000 Admin. Costs 1, * (Product Margin - Gross Margin) for A, B, and C ( ) + (2,200-1,000) + ( ) = , = 2,000 These should be worked out as above and not as a difference figure. Therefore, product C should not be dropped. If it were, the remaining products would carry the $300,000 administration costs and $750,000 fixed production costs (in "cost of goods sold") currently allocated to C. If product C is dropped, net income will fall by $950,000, that is, by the product margin of C Costs: $ Additional traceable fixed costs 6,000 Loss of contribution on gauges (1,200 x $40) 48,000 Additional labour 90,000 Materials cost 270,000 $414,000 (Note: untraceable fixed cost allocation irrelevant to decision) So for feasibility, need at least: 6,000 $x = $414,000 so x = $69

14 Financial Management and Decision Making Chapter (a) variable cost = 79,430-23,200 7,300-1,000 = $8.925 fixed costs = 23,200 - ($8.925 x 1,000) = $14,275 (b) Regression analysis is the theoretically superior technique since it includes consideration of all cost points, whereas the high low method ignores all cost points other than the highest and the lowest. However, in this case one of the cost points appears to be out of line with the others. The cost at the 4,800 unit level appears to be unusually high. As this cost is probably the result of an unusual occurrence, it should be ignored in calculating the fixed and variable portions of total costs. In this example, therefore, regression does not give the best estimate of fixed and variable costs because the results are influenced by the unusually high cost. In this case the high low method is the most appropriate. 10.9d Budgeted total costs = x 3, ,280 = $574,290 Since actual costs in February are more than would be expected at an output level of 3,500 pairs, cost control appears to have been lax (a) Units: 30,000 45,000 60,000 indirect labour (0.60) 18,000 27,000 36,000 indirect materials (1.00) 30,000 45,000 60,000 maintenance (0.15) 4,500 6,750 9,000 electricity (0.11) 3,300 4,950 6,600 supervisors' salaries 20,000 20,000 20,000 depreciation 8,000 8,000 8,000 other fixed overhead 3,000 3,000 3,000 $86,800 $114,700 $142,600 (b) Budget Actual Variance indirect labour 27,000 25,000 2,000 F indirect materials 45,000 47,500 2,500 U maintenance 6,750 6, F electricity 4,950 5, U supervisors' salaries 20,000 24,000 4,000 U depreciation 8,000 8,000 0 other fixed overhead 3,000 2, F $114,700 $118,200 $3,500 U, +

15 , - Suggested Solutions to Selected Questions 497 (c) total cost = (1.86 x units produced) + 31,000 Chapter b rate: 600 x 9-5,200 = 200 favourable efficiency: 500 x x 9 = 900 unfavourable 11.8 Actual costs Budget based on Budget based Actual DLHs on std hrs for output produced Indirect labour 32,000 33,600 32,000 Maintenance 5,000 4,200 4,000 Lubricants 3,000 2,100 2,000 Electricity 2,500 2,940 2,800 42,500 42,840 40,800 \ / \ / 340 F 2,040 U spending variance = 340 favourable efficiency variance = 2,040 unfavourable flexible budget variance = 1,700 unfavourable 11.19b Variable Overhead actual costs variable overhead variable overhead based on actual DLHs based on std hrs for actual output 17,000 x 3.80 (8,000 x 2) x ,300 = 64,600 = 16,000 x 3.8 = 60,800 \ / \ / spending variance efficiency variance 8,700 U 3,800 U \ / flexible budget variance 12,500 U Fixed Overhead

16 Financial Management and Decision Making actual costs budgeted applied 8,000 x ($6.30 x 2) 27, ,000 = 100,800 \ / \ / spending variance volume variance 1,800 U 25,200 U The report should include: - there is a substantial variable overhead unfavourable variance, - although output was 2,000 units less than expected this should not have affected the variable overhead variances, - the fixed overhead spending variance of $1,800 unfavourable is only 1.4% over budget, which may be quite acceptable and the volume variance is directly attributable to the lower than expected (20%) output, - the fixed overhead volume variance does not imply any internal efficiency control problems Actual Flex. Budg. Flex. Budg. Spending Efficiency actual DLH standard DLH Variance Variance indirect labour 46,000 45,000 37,500 1,000 U 7,500 U maintenance 8,750 9,000 7, F 1,500 U electricity 20,050 19,800 16, U 3,300 U indirect materials 17,500 18,000 15, F 3,000 U lubricants 9,460 10,800 9,000 1,340 F 1,800 U 101, ,600 85, F 17,100 U Chapter M = $74,000 + (1/9 x C) 2. C = $42,000 + (1/12 x M) Substituting for C in equation 1: M = $74, /9($42, /12 x M) = $74,000 + $4, /108 x M 107/108 x M = $78,667 M = $79,402 Substituting M into equation 2: C = $42,000 + (1/12 x $79,402) = $42,000 + $6,617 C = $48, , +

17 , - Suggested Solutions to Selected Questions 499 Total Price/ Sales % of Joint cost Units unit value total Whosits 1, , ,800 Howsits 2, , ,200 $172, $32,000 Whosits: Total cost = Proportion of Joint Cost$20,800 + Further Processing Cost $80,000 $100,800 Divided by no. of units 1,400 = $72.00 per unit Howsits: Total cost = Proportion of Joint Cost $11,200 + Further Processing Cost $46,000 $57,200 Divided by no. of units 2,000 = $28.60 per unit Chapter a = 3,162 units or 3,200 units (to nearest 100 units) 13.4a 2 x 300,000 x EOQ = 2 x 14,000 x 20 1 = 748 pairs The optimal inventory policy is to order 748 pairs e 2 X 120,000 X 600 X = $1,399,428.5 therefore, 1,399,428.5 / 600 = 2, Note: should really be rounded up to 2,333

18 Financial Management and Decision Making Chapter Maximum price = 1,500 x Annuity Factor 15% for 12 yrs = 1,500 x = $8, ,000/1,906 = = PV Annuity Factor 7% for 3 yrs (2.6243) The interest rate is 7% (closest) Total amount outstanding = 1, = 1,025 PV Annuity Factor 14% for 4 yrs = ,025 / = $ ,000 = ,053 = PV single sum 16% for 10 yrs (closest) Chapter The price of the ten year bond would be more variable. The market price of a bond varies as market interest rates vary. Interest rates rise and fall daily. A rise in market rates causes a loss in value for bondholders who are locked into a contract paying a coupon rate of less than the market rate. Thus, bondholders are exposed to risk from changing market interest rates. The exposure to interest rate risk is higher for the holder of a ten year bond than for a holder of a five year bond. As a result of the relatively high degree of exposure to interest rate changes, the price of the long term bond will be more variable than that of the five year bond. The effect can be illustrated by means of an example of the valuation process. Both bonds have a face value of $1,000 and a coupon rate of 10%. Assuming a market interest rate of 12%: value = 100 x PV Annuity Factor 12% for 5 yrs + 1,000 x PV single sum 12% for 5 yrs 5 yrs = 100 x ,000 x.5674 = $ value = 100 x PV Annuity Factor 12% for 10 yrs + 1,000 x PV single sum 12% for 10 yrs 10 yrs = 100 x ,000 x.322 = $887.00, +

19 , - Suggested Solutions to Selected Questions 501 Assuming a market interest rate of 16%: value = 100 x ,000 x yrs = $ value = 100 x ,000 x yrs = $ Fall in value: 5 year bond: 13.41% (- $124.40) 10 year bond: 19.96% (- $177.00) Required return on $1 invested is $1.10, or, $1 = $1.10 (1+ r ) 2 (1 + r) 2 = r = r = 4.88% 75 price = = = $ = 25 x Annuity Factor x% for 4 periods + 1,000 x PV x% for 4 periods At 6%, = 25 x ,000 x.7921 = = At 3%, = 25 x ,000 x.8885 = = Therefore, 3% quarterly or 12% per annum (if simple). 1, Solve for g: =.96(1 + g).13 - g g = g

20 Financial Management and Decision Making = 13.56g g =.05 Solve for P 6 : Since D 0 = 0.96 P = 6 D7 k - g P 6 = 0.96 (1.05) = $16.89 * * * * * * * * ,000 x PV single sum 15% for 8 yrs = 60,000 x.3269 = $19,614 Chapter a R port =.3 x x.15 = 15.9% SD port =.30 x x.10 + (2 x.3 x.7 x.35 x.12 x.1) = b Shares in company C are the most risky as they have a higher standard deviation b =.54 x x =.54 x = 13.06% = 11 + x(15-11) 2.06 = 4x x = = 60.38%, +

21 , - Suggested Solutions to Selected Questions c.567, from covim β = 2 SDm cov = im = SD = m = β =.567 Chapter K RE = 15% and K e = 16.04% from: d 1 P + g =.15 0 d 1 = P0 d =.12 P K = 1 0 K d = 4.16% up to $100,000 debt, 5.2% thereafter Debt = 52.4% (1.1/2.1) Equity = 47.6% (1.0/2.1) e = 0.12 P 0.92 P 0 0 d P Weighted MCC: 9.32% up to $190,840 (break caused by increase in debt cost) 9.87% up to $252,101 (break caused by increase in equity cost) 10.36% over $252,101 Accept projects D and C Average cost to finance project B: 1 n + g +.03 = 16.04%

22 Financial Management and Decision Making 31,995 90,000 x ,005 90,000 x = 10.19% Do not accept project B as the average cost of finance is greater than the projected IRR x (1 -.12) = 12.24% Equity: D 0 (1 + g) K re = + g P0 K re = = 18.55% Debt: net price = x (1 -.10) = = 120 x PV Annuity Factor x% for 10 yrs + 1,000 x PV single sum x% for 10 yrs = 17% (by trial and error) K d =.17 x (1 -.48) = 8.84% Preference Shares: K p = x (1 -.07) = 9.35% Weighted Average Cost of Capital: WACC = (.43 x 18.55) + (.07 x 9.35) + (.50 x 8.84) = 13.05% RE = 3,500,000 x (1 -.7) = 1,050,000 D/E = 1.27 D/D+E = 1.27/2.27 = 56%, +

23 , - Suggested Solutions to Selected Questions 505 E/D+E = = 44% 1,050,000 = $2,386, Chapter b Yes NPV = - 21, , , , = (-21,250) + 5, , , , ,780 = + 2,787 So, with positive NPV, asset should be purchased. + 6, , AROR = (total after-tax accounting profits over investment life)/n (initial outlay + expected salvage value)/2 = [($2,800 x 0.52) x 5] / 5 ($10,000 + $2,500)/2 = 1,456 6,250 = % 18.20b NPV(a) = , , , = +1,560 NPV (B) = -10, ,000 x Annuity Factor 15% for 60 yrs = -10, ,000 x = + 3,330.20

24 Financial Management and Decision Making 18.24a The relevant cashflows are: Initial outlay = -$6,000 Annual pre-tax cashflows: Tax effect (30%) payment to advertising agency -$2000 (yrs 1-2) +$600 (yrs 2-4) increased contribution(3000 x + $1.50) = +$4500 (yrs 1-2) -$1350 (yrs 2-4) (2000 x + $1.50) = +$3000 (yrs 4-5) -$900 (yrs 5-6) Time-line ($): Year Initial outlay Annual cashflows Tax effects TOTALS x discount rate (14%) Discounted cashflow (a) (i) Payback period = 3 years (ii) Discounted payback period = 3.96 years (iii) NPV = +$734 (iv) PI = ($6734 ) $6000) = 1.12 Chapter After-tax earnings available to the firm are $1.2 m x 0.5 = $ 600,000 Therefore, after tax earnings per share are $600,000 / 100,000= $6 per share Dividend payout ratio =dividend per share earnings per share = $1.50 $6.00 = 25%, +

25 , The investment required for project "X"= $ 200,000 Financed according to the firm's preferred D/E ratio: 65% debt $130,000 35% equity $ 70,000 $200,000 Suggested Solutions to Selected Questions 507 Hence from the year's earnings of $100,000, the amount paid out to shareholders as dividends (under the "Residual Dividend Theory") would be: retained earnings $100,000 less equity financing of project "X" $ 70,000 Amount paid as dividends $ 30, ,000 $3.30 = $3,300 value After split, you have (1,000 x 3) = 3,000 shares market price = $3.30 x 0.40 = $1.32 Value = 3,000 x $1.32 = $3,960 Gain: $3,960 - $3,300 = $660 or 20% gain Chapter c x = DFL = 4.0/1.6 = c and d (c) DCL = x = (d) To breakeven at EBIT, sales of $5,500 are needed, from FC 1 - V/S 2,000 = $5,

Sree Lalitha Academy s Key for CA IPC Costing & FM- Nov 2013

Sree Lalitha Academy s Key for CA IPC Costing & FM- Nov 2013 1. a. Question No.1 is compulsory Answer any 5 questions from the remaining 6 questions (Key Covers only Problems does not include theory) i. Annual Demand 60,000 Units Cost Rs. 10 Per unit Cost of Placing