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Xaviers Institute of Business Management Studies

 

                                                                                                                                                                                                                                                                                    Marks 100

 

FINANCIAL MANAGEMENT

 

 

Note: Attempt any five questions. All questions carry equal marks.

 

Question.1. (A) Explain the Business Entity concept, Accrual concept and Consistency concept of Accounting.

 

Answer: 1. Business Entity Concept

The Business Entity Concept is a fundamental principle in accounting that treats the business as a separate and distinct entity from its owners or stakeholders. This means that the financial transactions of the business are recorded and reported separately from the personal transactions of its owners, managers, or shareholders.

 

 

 

 

(b) What do you understand by capitalization of earnings? How is the value of a firm ascertained with the help of its earnings? Explain with an example.

 

Answer: Capitalization of Earnings:

 

The capitalization of earnings is a method used to estimate the value of a business or firm based on its future earning potential. Essentially, it involves converting the expected future earnings of a business into a present value. This method assumes that the earnings generated by the firm will continue in the future at a relatively stable rate, and those earnings are capitalized (or multiplied by a capitalization rate) to determine the firm's value.

 

 

 

 

 

Question.2. The following is the Trial Balance of Mr. Keshav Kant on 31st March 2006.

 

 

	Rs.	Rs.
	Dr.	Cr.
Capital	-	8,00,000
Drawings	60,000	-
Opening Stock	75,000	-
Purchases	15,95,000	-
Freight on Purchases	25,000	-
Wages (11 months upto 28-2-2006)	66,000	-
Sales	-	23,10,000
Salaries	1,40,000	-
Postage & Telephones	12,000	-
Printing and Stationery	18,000	-
Miscellaneous expenses	30,000	-
Creditors	-	3,00,000
Investments	1,00,000	-
Discount received	-	15,000
Debtors	2,50,000	-
Bad Debts	15,000	-
Provision for Bad Debts	-	8,000
Building	3,00,000	-
Machinery	5,00,000	-
Furniture	40,000	-
Commission on Sales	45,000	-
Interest on Investments	-	12,000
Insurance (year upto 31 .7 .2006)	24,000	-
Bank Balance	1,50,000	-
	34,45,000	34,45,000

 

Adjustments:

(i) Closing Stock Rs. 2, 25,000.

(ii) Machinery worth Rs. 45,000 purchased on 1.10.2005 was shown as purchases. Freight paid on the machinery was Rs. 5,000 which is included in the Freight on Purchases.

(iii) Commission is payable at 2% on Sales.

(iv) Investments were sold at 10% profit but the entire sale proceeds have been taken as Sales.

(v) Write off Bad Debts Rs. 10,000 and create .a Provision for Doubtful Debts at 5% of Debtors.

(vi) Depreciate Building by 2% p.a. and Machinery and Furniture @ 10% p.a

Prepare Trading and Profit and Loss A/c for the Year ending 31st March 2006 and a Balance Sheet as on that date

 

 

 

 

Question.3. Distinguish between Operating Leverage and Financial Leverage. What will be the effect of small change in Sales on Net Income, Return on Equity and Earnings Per Share if both these leverages are considerable? Explain.

 

Answer: Distinction Between Operating Leverage and Financial Leverage

 

1. Operating Leverage:

Operating leverage refers to the degree to which a company's operating income (EBIT) is sensitive to changes in sales. It is a measure of how fixed costs in the company’s cost structure (such as rent, salaries, and other overheads) affect profitability. A company with high operating leverage has a higher proportion of fixed costs in its total cost structure.

 

• Key Features of Operating Leverage:
• Fixed Costs: The greater the proportion of fixed costs, the higher the operating leverage.
• Effect on Profitability: As sales increase, operating income (EBIT) will increase at an accelerated rate due to
•  

 

 

 

Question.4. (a) What is Production Budget ? What factors are taken into consideration while preparing a Production Budget? Why are separate budgets prepared For each of the elements of production costs? Explain.

 

Answer: What is a Production Budget?

 

A Production Budget is a financial plan that outlines the quantity of goods a company plans to manufacture during a specific period (e.g., monthly, quarterly, or annually). It is a key component of the overall budgeting process in manufacturing companies and helps determine the number of units that need to be produced to meet sales forecasts, inventory requirements, and other operational goals.

The Production Budget is primarily based on two factors:

1. Sales Forecasts: The expected
2.  
3.  

 

 

(b) What is a Rolling Budget? Why is it prepared? Explain the procedure of its preparation.

 

Answer: What is a Rolling Budget?

A Rolling Budget (also known as a Continuous Budget or Rolling Forecast) is a type of financial budget that is continuously updated throughout the year. Instead of being prepared for a fixed period (e.g., annually), a rolling budget involves periodic revisions to ensure it always covers a set period (usually 12 months, or a quarter) into the future.

For example, if a company has a rolling budget for 12 months, at the end of each month, the company will prepare the

 

 

 

 

Question.5. An Engineering Company has received an export order for its sole product that would require the use of half of the factory's total capacity, which is estimated at 4 lakh units per annum. The condition of the export order is that it has to be accepted in full: acceptance of a part is not allowed

The factory is currently operating at 60% level to meet the demand of its domestic customers. As against the current price of Rs. 6 per unit, the export offer is Rs. 4.70 per unit, which is less than the total cost of current production. The cost break-down is given below:

Direct material: Rs. 2.50 per unit

Direct labour: 1.00 per unit

Variable expenses: 0.50 per unit

Fixed overhead: 1.00 per unit

Total: 5.00 per unit

 

The company has the following options:

 

(a) Accept the export order and cut back domestic sales as necessary

 

(b) Remove the capacity constraint by installing balancing equipment and also by working overtime to meet both domestic and export demand. This will increase fixed overheads by Rs. 15,000 annually and additional cost for overtime work will amount to Rs. 40,000 for the year.

 

(c) Appoint a sub-contractor to manufacture the additional requirement and meet the domestic and export requirements in full by supplying raw materials, paying a conversion charge @ Rs. 2 per unit and appointing a supervisor at a salary of Rs. 3,000 per month for checking the quality of the product and controlling operations at the manufacturing unit

 

(d) Refuse the order.

You are required to prepare a statement of costs and profits under each of the options and give your recommendation to the company giving the reasons for the same.

 

 

 

Question.6. Aditya Company's equity shares are being traded in the market at Rs. 54 per share with a price-earning ratio of 9. The company's payout is 72%. It has 1,00,000 equity shares of Rs. 10 each and no preference shares. Book value per share is Rs. 42.

You are required to calculate:

(i) Earnings per Share

(ii) Net Income

(iii) Dividend Yield, and

(iv) Return on Equity

 

Answer:

• Market Price per Share = Rs. 54
• Price-Earnings (P/E) Ratio = 9
• Payout Ratio = 72%
• Number of Equity Shares = 1,00,000 shares
• Face Value per Share = Rs. 10
• Book Value per Share = Rs. 42
• No Preference Shares are issued.

(i) Earnings per Share (EPS):

The Price-Earnings (P/E) Ratio is related to the Earnings per Share (EPS) by the following formula:

We can rearrange this formula to solve for EPS:

Substitute the given values:

 

So, the Earnings per Share (EPS) = Rs. 6.

 

 

 

 

 

 

 

Question.7. Comment on the following statements:

(a) The greater the variability of cash flows, the higher should be the minimum cash balance.

(b) As there is no explicit cost of retained earnings, these funds are free of cost.

(c) Dividend, Investment and Financing decisions are inter-dependent.

(d) Profitability Index is more relevant in the evaluation and ranking of projects than Internal Rate of Return.

 

Answer: (a) The greater the variability of cash flows, the higher should be the minimum cash balance.

 

Comment: This statement is correct. The variability of cash flows refers to how much cash inflows and outflows fluctuate over time. If cash flows are more uncertain or volatile (i.e., if the business experiences high seasonality, irregular sales, or unpredictable customer payments), it is prudent for the company to maintain a higher minimum cash balance to ensure it can cover its operational expenses during periods

 

 

(b) As there is no explicit cost of retained earnings, these funds are free of cost.

 

Comment: This statement is incorrect or, at best, misleading. While it's true that retained earnings do not involve an explicit cash outflow like interest payments on debt or dividend payouts on equity, they do have an implicit cost known as the opportunity cost of equity capital.

The cost of retained earnings is the rate of return that shareholders expect from their investments in the company. If the company

 

 

 

(c) Dividend, Investment and Financing decisions are inter-dependent.

 

Comment: This statement is correct. The dividend decision, investment decision, and financing decision are all interdependent and form the three core components of a company's financial management strategy.

• Investment Decisions: These are decisions related to the allocation of capital to various projects or investments (e.g., whether to expand, buy new assets, or enter new markets). These decisions typically require funds to finance the investments.
• Financing Decisions: These decisions involve determining how to raise the necessary capital to fund investments, either through equity (e.g., issuing new shares), debt (e.g., issuing bonds or taking

 

 

(d) Profitability Index is more relevant in the evaluation and ranking of projects than Internal Rate of Return.

 

Comment: This statement is partially correct, but it depends on the specific context of the project evaluation. Both the Profitability Index (PI) and the Internal Rate of Return (IRR) are used in evaluating projects, but each has its strengths and weaknesses, and their relevance depends on the situation.

(b) Incorrect — Retained earnings are not "free"; they have an implicit opportunity cost known as the cost of equity.

• (c) Correct — Dividend, investment, and financing decisions are interdependent and should be considered together.
• (d) Partially correct — Profitability Index is useful when capital is constrained, but IRR has its own merits in evaluating projects, especially when resources are not a limiting factor.

 

 

 

 

Question.8. Write short notes on the following:

(a) Performance Budget

(b) Amortization of Intangible Assets

(c) Accounting Standards

(d) Funds from Business Operations

Answer:

 

 

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