Test Series: October, 2019

MOCK TEST PAPER 1

INTERMEDIATE (IPC): GROUP – I
PAPER – 3: COST ACCOUNTING AND FINANCIAL MANAGEMENT
SUGGESTED ANSWERS/HINTS
1. (a) (i) Contribution per unit = Selling price – Variable cost
= Rs.100 – Rs.60
= Rs.40
Rs.24,00,000
Break-even Point =
Rs.40
= 60,000 units
Actual Sales – Break - even Sales
Percentage Margin of Safety =
Actual Sales

Actual Sales – 60,000 units

Or, 60% =
Actual Sales

 Actual Sales = 1,50,000 units

(Rs.)
Sales Value (1,50,000 units × Rs.100) 1,50,00,000
Less: Variable Cost (1,50,000 units ×Rs.60) 90,00,000
Contribution 60,00,000
Less: Fixed Cost 24,00,000
Profit 36,00,000
Less: Income Tax @ 40% 14,40,000
Net Return 21,60,000
 Rs.21,60,000 
Rate of Net Return on Sales = 14.40%  ×100 
 Rs.1,50,00,000 

(ii) Products
X (Rs.) Y (Rs.)
Selling Price per unit 100 150
Variable Cost per unit 60 100
Contribution per unit 40 50
Composite contribution will be as follows:
 40   50 
Contribution per unit =  5   3
 8   8 
= 25 + 18.75 = Rs.43.75
 Rs.28,00,000 
Break-even Sale = 64,000 units  
 Rs.43.75 

© The Institute of Chartered Accountants of India

 Break-even Sales Mix:
X (64,000 units × 5/8) = 40,000 units
Y (64,000 units × 3/8) = 24,000 units
(b) Workings:
Annual production of Product X = Annual demand – Opening stock
= 5,00,000 – 12,000 = 4,88,000 units
Annual requirement for raw materials = Annual production × Material per unit – Opening stock of material
Material A = 4,88,000 × 4 units – 24,000 units = 19,28,000 units
Material B = 4,88,000 × 16 units – 52,000 units = 77,56,000 units
(i) Computation of EOQ when purchase order for the both materials is placed separately
2 × Annual Requirement for material × Ordering cost
EOQ =
Carrying cost per unit per annum

2  19,28,000units  Rs.15,000 38,56,000 Rs.15,000

Material A = =
13% of Rs.150 Rs.19.5

= 54,462 units
2  77,56,000units  Rs.15,000 1,55,12,000 Rs.15,000
Material B = =
13%of Rs.200 Rs.26
= 94,600 units
(ii) Computation of EOQ when purchase order for the both materials is not placed separately
2  (19,28,000  77,56,000)units  Rs.15,000
Material A & B =
13%of Rs.190 *

1,93,68,000  Rs.15,000
= = 1,08,452 units
Rs.24.7
1,08,452  19,28,000
Material A = = 21,592 units
96,84,000
1,08,452  77,56,000
Material A = = 86,860 units
96,84,000
(Rs.150 19,28,000)  (Rs.200  77,56,000)
* = Rs.190
(19,28,000  77,56,000)
(c) Future Value = Rs.50,00,000
Interest (i) = 10% p.a.
Period (n) = 10 years
(i) To make annual payment into the fund at the end of each year:
 (1  i)n  1 
Future Value = Annual Payment × (FVIFA n, i ) or Annual Payment ×  
 i 
Rs.50,00,000 = A (FVIFA )
10% , 10

© The Institute of Chartered Accountants of India

 Rs.50,00,000
Or, A = = Rs.3,13,735
15.937
(ii) To invest a lumpsum amount in the fund at the end of the year:
Future Value = Amount × (FVIF 10% , 10) or Amount × (1+ 0.1)10
Rs.50,00,000
Or, A = = Rs.19,27,525
2.594
(iii) To make annual payment into the fund at the beginning of each year:
Future Value = Annual Payment × (FVIFA n, i) × (1+i)
Rs.50,00,000 = A (FVIFA 10% , 10) × (1+ 0.1)
Rs.50,00,000 Rs.50,00,000
Or, A = = = Rs.2,85,209 (approx.)
15.937  1.1 17.531
(d) Statement of Cash Flows for the year ended 31 st March 2019
(Rs.)
Cash flow from Operating Activities
Net profit before taxation 20,78,000
Add: Depreciation charged to P & L account 8,00,000
Less: Profit on Sale of Plant & Machinery (2,20,000)
Operating profit before working capital changes 26,58,000
Add: Decrease in Stock 6,80,000
Add: Increase in Creditors 20,000
Less: Increase in Debtors (2,40,000)
Less: Decrease in Current Liabilities (1,50,000) 3,10,000
Cash generated from Operating activities 29,68,000
Less: Income tax 7,28,000
Net Cash from Operating activities 22,40,000
2. (a) (i) Production Budget of ‘X’ for the Second Quarter
Particulars Bags (Nos.)
Budgeted Sales 50,000
Add: Desired Closing stock 11,000
Total Requirements 61,000
Less: Opening stock 15,000
Required Production 46,000
(ii) Raw–Materials Purchase Budget in Quantity as well as in Rs. for 46,000 Bags of ‘X’
Particulars ‘Y’ ‘Z’ Empty Bags
Kgs. Kgs. Nos.
Production Requirements 2.5 7.5 1.0
Per bag of ‘X’

© The Institute of Chartered Accountants of India

 Requirement for Production 1,15,000 3,45,000 46,000
(46,000 × 2.5) (46,000 × 7.5) (46,000 × 1)
Add: Desired Closing Stock 26,000 47,000 28,000
Total Requirements 1,41,000 3,92,000 74,000
Less: Opening Stock 32,000 57,000 37,000
Quantity to be purchased 1,09,000 3,35,000 37,000
Cost per Kg./Bag Rs.120 Rs.20 Rs.80
Cost of Purchase (Rs.) 1,30,80,000 67,00,000 29,60,000
(iii) Computation of Budgeted Variable Cost of Production of 1 Bag of ‘X’
Particulars (Rs.)
Raw – Material
Y 2.5 Kg @120 300.00
Z 7.5 Kg. @20 150.00
Empty Bag 80.00
Direct Labour (Rs.50× 9 minutes / 60 minutes) 7.50
Variable Manufacturing Overheads 45.00
Variable Cost of Production per bag 582.50
(b) Computation – Collections from Debtors
Particulars Feb Mar Apr May Jun Jul Aug Sep
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Total Sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit Sales (80%
of total Sales) 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
Collection (within one month) 72,000 84,000 48,000 36,000 48,000 60,000 48,000
Collection (within two months) 24,000 28,000 16,000 12,000 16,000 20,000
Total Collections 1,08,000 76,000 52,000 60,000 76,000 68,000
Monthly Cash Budget for Six Months: April to September, 2019
Particulars April May June July August Sept.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Receipts:
Opening Balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash Sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections from Debtors 1,08,000 76,000 52,000 60,000 76,000 68,000
Total Receipts (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages and Salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on Loan 3,000 ----- ----- 3,000 ----- -----

© The Institute of Chartered Accountants of India

 Tax Payment ----- ----- ----- 5,000 ----- -----
Total Payment (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum Cash Balance 20,000 20,000 20,000 20,000 20,000 20,000
Total Cash Required (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus/ (Deficit) (A)-(C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investment/Financing:
Total effect of (Invest)/
Financing (D) (64,000) (16,000) 22,000 2,000 (35,000) 9,000
Closing Cash Balance 20,000 20,000 20,000 20,000 20,000 20,000
(A) + (D) - (B)

3. (a) (i) Table of Primary Distribution of Overheads

Particulars Basis of Total Production Service
Apportionment Amount Department Departments
Fabrication Assembly Stores Maintenance
Overheads
Allocation 27,28,000 15,52,000 7,44,000 2,36,000 1,96,000
Allocated
Direct Costs Actual 86,36,000 71,88,000 14,48,000 --- ---
Other Overheads:
Factory rent Floor Area 15,28,000 9,16,800 3,82,000 95,500 1,33,700
(48:20:5:7)
Factory building Floor Area 1,72,000 1,03,200 43,000 10,750 15,050
insurance (48:20:5:7)
Plant & Machinery Value of Plant & 1,96,000 1,22,038 55,472 5,547 12,943
insurance Machinery
(66:30:3:7)
Plant & Machinery Value of Plant & 2,65,000 1,65,000 75,000 7,500 17,500
Depreciation Machinery
(66:30:3:7)
Canteen Subsidy No. of employees 4,48,000 2,15,040 1,43,360 68,096 21,504
(60:40:19:6)
1,39,73,000 1,02,62,078 28,90,832 4,23,393 3,96,697

Re-distribution of Service Departments’ Expenses:

Particulars Basis of Production Service
Apportionment Department Departments
Fabrication Assembly Stores Maintenance
Overheads as per As per Primary 1,02,62,078 28,90,832 4,23,393 3,96,697
Primary distribution distribution
Maintenance Maintenance Hours 2,01,955 1,65,891 28,851 (3,96,697)
Department Cost (28:23:4:-)
1,04,64,033 30,56,723 4,52,244 ---
Stores Department No. of Stores 3,25,616 1,26,628 (4,52,244)
Requisition
(18:7:-:-)
1,07,89,649 31,83,351 --- ---

© The Institute of Chartered Accountants of India

 (ii) Overhead Recovery Rate
Department Apportioned Basis of Overhead Overhead Recovery Rate
Overhead (Rs.) Recovery Rate (Rs.)
(I) (II) [(I) ÷ (II)]
Fabrication 1,07,89,649 30,00,000 Machine Hours 3.60 per Machine Hour
Assembly 31,83,351 26,00,000 Labour Hours 1.22 per Labour Hour
(b) (i)
Year Cash flow Discount Factor Present value
(15%)
(Rs.) (Rs.)
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.870 (87,00,000)
2 25,00,000 0.756 18,90,000
3 30,00,000 0.658 19,74,000
4 35,00,000 0.572 20,02,000
510 40,00,000 2.163 86,52,000
Net Present Value (11,82,000)
As the net present value is negative, the project is unacceptable.
(ii) Similarly, NPV at 10% discount rate can be computed as follows:
Year Cash flow Discount Factor Present value
(10%)
(Rs.) (Rs.)
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.909 (90,90,000)
2 25,00,000 0.826 20,65,000
3 30,00,000 0.751 22,53,000
4 35,00,000 0.683 23,90,500
510 40,00,000 2.974 1,18,96,000
Net Present Value 25,14,500
Since NPV = Rs.25,14,500 is positive, hence the project would be acceptable.
NP Vat LR
(iii) IRR = LR + ×(HR - LR)
NP Vat LR-NPV at HR
Rs.25,14,500
= 10% +  (15%  10%)
Rs.25,14,500  ( )11,82,000
= 10% + 3.4012 or 13.40%
(iv) Payback Period = 6 years:
Rs.70,00,000Rs.1,00,00,000 + Rs.25,00,000 + Rs.30,00,000 + Rs.35,00,000 +
Rs.40,00,000 + Rs.40,00,000 = 0

© The Institute of Chartered Accountants of India

4. (a) COMPUTATION OF VARIANCES
(i) Overhead Cost Variance = Absorbed Overheads – Actual Overheads
= (Rs.87,200 + Rs.44,800) – (Rs.1,21,520 + Rs.55,680)
= Rs. 45,200 (A)
(ii) Fixed Overhead Cost = Absorbed Fixed Overheads – Actual Fixed Overheads
Variance = Rs. 87,200 – Rs.1,21,520
= Rs.34,320 (A)
(iii) Variable Overhead Cost = Standard Variable Overheads for Production – Actual
Variance Variable Overheads
= Rs. 44,800 – Rs. 55,680
= Rs. 10,880 (A)
(iv) Fixed Overhead Volume = Absorbed Fixed Overheads – Budgeted Fixed
Variance Overheads
= Rs. 87,200 – Rs.1,09,000
= Rs. 21,800 (A)
(v) Fixed Overhead Expenditure = Budgeted Fixed Overheads – Actual Fixed Overheads
Variance
= Rs.10.90 × 10,000 units – Rs.1,21,520
= Rs.12,520 (A)
WORKING NOTE
Budgeted Fixed Overheads Rs.12,00,000 Rs. 10
Fixed Overheads per Unit = =
Budgeted Output 1,20,000units
Fixed Overheads element in Semi-Variable Overheads i.e. 60% of Rs.1,80,000 Rs. 1,08,000
Budgeted Fixed Overheads Rs.1,08,000
Fixed Overheads per Unit = =
Budgeted Output 1,20,000units Rs. 0.90
Standard Rate of Absorption of Fixed Overheads per unit (Rs.10 + Rs.0.90) Rs.10.90
Fixed Overheads Absorbed on 8,000 units @ Rs10.90 Rs. 87,200
Budgeted Variable Overheads Rs. 6,00,000
Add : Variable element in Semi-Variable Overheads 40% of Rs.1,80,000 Rs.72,000
Total Budgeted Variable Overheads Rs.6,72,000
Budgeted Variable Overheads Rs.6,72,000 Rs.5.60
Standard Variable Cost per unit = =
Budgeted Output 1,20,000units

Standard Variable Overheads for 8,000 units @ Rs.5.60 Rs.44,800

Budgeted Annual Fixed Overheads (Rs.12,00,000 + 60% of Rs.1,80,000) Rs.13,08,000
Actual Fixed Overheads (Rs.1,10,000 + 60% of Rs.19,200) Rs.1,21,520
Actual Variable Overheads (Rs.48,000 + 40% of Rs.19,200) Rs. 55,680

© The Institute of Chartered Accountants of India

 (b) (A) (i) Cost of new debt
I(1  t)
Kd =
P0
16 (1  0.5)
=  0.0833
96
(ii) Cost of new preference shares
PD 1.1
Kp =   0.12
P0 9.2
(iii) Cost of new equity shares
D1
Ke = g
P0
11.80
  0.10  0.05 + 0.10 = 0.15
236
Calculation of D1
D1 = 50% of 2019 EPS = 50% of 23.60 = Rs. 11.80
(B) Calculation of marginal cost of capital
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385
(C) The company can spend the following amount without increasing marginal cost of capital and
without selling the new shares:
Retained earnings = (0.50) (236 × 10,000) = Rs. 11,80,000
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,80,000 = 80% of Total Capital
Rs.11,80,000
Capital investment before issuing equity = = Rs.14,75,000
0.80
(D) If the company spends in excess of Rs.14,75,000 it will have to issue new shares.
Rs. 11.80
The cost of new issue will be = + 0.10 = 0.159
200
The marginal cost of capital will be:
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.0833 0.0125
Preference Shares 0.05 0.1200 0.0060
Equity Shares (New) 0.80 0.1590 0.1272
0.1457

© The Institute of Chartered Accountants of India

5. (a) The essential features, which a good cost accounting system should possess, are as follows:
(i) Informative and simple: Cost accounting system should be tailor-made, practical, simple
and capable of meeting the requirements of a business concern. The system of costing should
not sacrifice the utility by introducing meticulous and unnecessary details.
(ii) Accurate and authentic: The data to be used by the cost accounting system should be
accurate and authenticated; otherwise it may distort the output of the system and a wrong
decision may be taken.
(iii) Uniformity and consistency: There should be uniformity and consistency in classification,
treatment and reporting of cost data and related information. This is required for
benchmarking and comparability of the results of the system for both horizontal and vertical
analysis.
(iv) Integrated and inclusive: The cost accounting system should be integrated with other
systems like financial accounting, taxation, statistics and operational research etc. to have a
complete overview and clarity in results.
(v) Flexible and adaptive: The cost accounting system should be flexible enough to make
necessary amendments and modification in the system to incorporate changes in
technological, reporting, regulatory and other requirements.
(vi) Trust on the system: Management should have trust on the system and its output. For this,
an active role of management is required for the development of such a system that reflects
a strong conviction in using information for decision making.
(b)
Cost Control Cost Reduction
1. Cost control aims at maintaining the 1. Cost reduction is concerned with
costs in accordance with the reducing costs. It challenges all
established standards. standards and endeavours to better them
continuously.
2. Cost control seeks to attain lowest 2. Cost reduction recognises no condition as
possible cost under existing conditions. permanent, since a change will result in
lower cost.
3. In case of cost control, emphasis is on 3. In case of cost reduction, it is on present
past and present. and future.
4. Cost control is a preventive function. 4. Cost reduction is a corrective function. It
operates even when an efficient cost
control system exists.
5. Cost control ends when targets are 5. Cost reduction has no visible end.
achieved.
(c) Inter-relationship between Investment, Financing and Dividend Decisions: The finance
functions are divided into three major decisions, viz., investment, financing and dividend decisions.
It is correct to say that these decisions are inter-related because the underlying objective of these
three decisions is the same, i.e. maximisation of shareholders’ wealth. Since investment, financing
and dividend decisions are all interrelated, one has to consider the joint impact of these decisions
on the market price of the company’s shares and these decisions should also be solved jointly. The
decision to invest in a new project needs the finance for the investment. The financing decision, in
turn, is influenced by and influences dividend decision because retained earnings used in internal
financing deprive shareholders of their dividends. An efficient financial management can ensure
optimal joint decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
9

© The Institute of Chartered Accountants of India

 The above three decisions are briefly examined below in the light of their inter-relationship and to
see how they can help in maximising the shareholders’ wealth i.e. market price of the company’s
shares.
Investment decision: The investment of long term funds is made after a careful assessment of
the various projects through capital budgeting and uncertainty analysis. However, only that
investment proposal is to be accepted which is expected to yield at least so much return as is
adequate to meet its cost of financing. This have an influence on the profitability of the company
and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves
different issues. The finance manager has to maintain a proper balance between long -term and
short-term funds. With the total volume of long-term funds, he has to ensure a proper mix of loan
funds and owner’s funds. The optimum financing mix will increase return to equity shareholders
and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare
dividend. He assists the top management in deciding as to what portion of the profit should be paid
to the shareholders by way of dividends and what portion should be retained in the business. An
optimal dividend pay-out ratio maximises shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are
interrelated and are to be taken jointly keeping in view their joint effect on the shareholders’ wealth
(d) Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to financial
intermediaries to support the lending volumes. Assets generating steady cash flows are packaged
together and against this asset pool, market securities can be issued, e.g. housing finance, auto
loans, and credit card receivables.
Process of Debt Securitisation
(i) The origination function – A borrower seeks a loan from a finance company, bank, HDFC. The
credit worthiness of borrower is evaluated and contract is entered into with repayment
schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favour of Special purpose Vehicle (SPV),
which acts as a trustee for investors.
(iii) The securitisation function – SPV will structure and issue securities on the basis of asset pool.
The securities carry a coupon and expected maturity which can be asset-based/mortgage
based. These are generally sold to investors through merchant bankers. Investors are –
pension funds, mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors bear the credit risk
and issuer is under an obligation to pay to investors only if the cash flows are received by him
from the collateral. The benefits to the originator are that assets are shifted off the balance
sheet, thus giving the originator recourse to off-balance sheet funding.
6. (a) (i) Statement of profitability of an Oil Mill (after carrying out further processing) for the
quarter ending 31st March 2019.
Products Sales Value Share of Additional Total cost after Profit (loss)
after further Joint cost processing processing
processing cost
A 25,87,500 14,80,000 6,45,000 21,25,000 4,62,500
B 2,25,000 2,96,000 1,35,000 4,31,000 (2,06,000)
C 90,000 74,000  74,000 16,000

10

© The Institute of Chartered Accountants of India

 D 6,75,000 3,70,000 22,500 3,92,500 2,82,500
35,77,500 22,20,000 8,02,500 30,22,500 5,55,000
(ii) Statement of profitability at the split off point
Products Selling Output in Sales value at Share of joint Profit at split off
price of units split off point cost point
split off
A 225.00 8,000 18,00,000 14,80,000 3,20,000
B 90.00 4,000 3,60,000 2,96,000 64,000
C 45.00 2,000 90,000 74,000 16,000
D 112.50 4,000 4,50,000 3,70,000 80,000
27,00,000 22,20,000 4,80,000
Note: Share of Joint Cost has been arrived at by considering the sales value at split off point.
(b) (i) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages
(DCL).
Rs. 34,00,000 - Rs. 6,00,000
DOL = = 1.27
Rs. 22,00,000
Rs.22,00,000
DFL = = 1.38
Rs. 16,00,000
DCL = DOLDFL = 1.271.38 = 1.75
(ii) Earnings after taxes at the new sales level
Increase by 20% Decrease by 20%
(Rs.) (Rs.)
Sales level 40,80,000 27,20,000
Less: Variable expenses 7,20,000 4,80,000
Less: Fixed cost 6,00,000 6,00,000
Earnings before interest and taxes 27,60,000 16,40,000
Less: Interest 6,00,000 6,00,000
Earnings before taxes 21,60,000 10,40,000
Less: Taxes 7,56,000 3,64,000
Earnings after taxes (EAT) 14,04,000 6,76,000
Working Notes:
(i) Variable Costs = Rs. 6,00,000 (total cost  depreciation)
(ii) Variable Costs at:
(a) Sales level, Rs. 40,80,000 = Rs. 7,20,000 (increase by 20%)
(b) Sales level, Rs. 27,20,000 = Rs. 4,80,000 (decrease by 20%)
7. (a) (i) Controllable Costs: - Cost that can be controlled, typically by a cost, profit or investment
centre manager is called controllable cost. Controllable costs incurred in a particular responsi-
bility centre can be influenced by the action of the executive heading that responsibility centre.
For example, direct costs comprising direct labour, direct material, direct expenses and some
of the overheads are generally controllable by the shop level management.
11

© The Institute of Chartered Accountants of India

 (ii) Uncontrollable Costs - Costs which cannot be influenced by the action of a specified
member of an undertaking are known as uncontrollable costs. For example, expenditure
incurred by, say, the tool room is controllable by the foreman in-charge of that section but the
share of the tool-room expenditure which is apportioned to a machine shop is not to be
controlled by the machine shop foreman.
(b)
Sr. Job Costing Batch Costing
No
1 Method of costing used for non- standard and non- Homogeneous products produced in
repetitive products produced as per customer a continuous production flow in lots.
specifications and against specific orders.
2 Cost determined for each Job Cost determined in aggregate for the
entire Batch and then arrived at on
per unit basis.
3 Jobs are different from each other and Products produced in a batch are
independent of each other. Each Job is unique. homogeneous and lack of
individuality
(c) Factoring: It is a new financial service that is presently being developed in India. Factoring involves
provision of specialised services relating to credit investigation, sales ledger management,
purchase and collection of debts, credit protection as well as provision of finance against
receivables and risk bearing. In factoring, accounts receivables are generally sold to a financial
institution (a subsidiary of commercial bank-called “Factor”), who charges commission and bears
the credit risks associated with the accounts receivables purchased by it.
Its operation is very simple. Clients enter into an agreement with the “factor” working out a factoring
arrangement according to his requirements. The factor then takes the responsibility of monitoring,
follow-up, collection and risk-taking and provision of advance. The factor generally fixes up a limit
customer-wise for the client (seller).
Factoring offers the following advantages which makes it quite attractive to many firms :
(1) The firm can convert accounts receivables into cash without bothering about repayment.
(2) Factoring ensures a definite pattern of cash inflows.
(3) Continuous factoring virtually eliminates the need for the credit department. That is why
receivables financing through factoring is gaining popularly as useful source of financing
short-term funds requirements of business enterprises because of the inherent advantage of
flexibility it affords to the borrowing firm. The seller firm may continue to finance its receivables
on a more or less automatic basis. If sales expand or contract it can vary the financing
proportionally.
(4) Unlike an unsecured loan, compensating balances are not required in this case. Another
advantage consists of relieving the borrowing firm of substantially credit and collection costs
and to a degree from a considerable part of cash management.
However, factoring as a means of financing is comparatively costly source of financing since
its cost of financing is higher than the normal lending rates.
(d) Financial Break-even and EBIT-EPS Indifference Analysis
Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial
charges i.e. interest and preference dividend. It denotes the level of EBIT for which firm’s EPS
equals zero. If the EBIT is less than the financial breakeven point, then the EPS will be negative

12

© The Institute of Chartered Accountants of India

 but if the expected level of EBIT is more than the breakeven point, then more fixed costs financing
instruments can be taken in the capital structure, otherwise, equity would be preferred.
EBIT -EPS analysis is a vital tool for designing the optimal capital structure of a firm. The objective
of this analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen.
(EBIT  I1 )(1  T) (EBIT  I2 )(1  T )

E1 E2

Where,
EBIT = Indifference point
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
12 = Interest charges in Alternative 2
T = Tax-rate
(e) (i) Present Value: “Present Value” is the current value of a “Future Amount”. It can also be
defined as the amount to be invested today (Present Value) at a given rate over specified
period to equal the “Future Amount”.
Perpetuity: Perpetuity is an annuity in which the periodic payments or receipts begin on a
fixed date and continue indefinitely or perpetually. Fixed coupon payments on perma nently
invested (irredeemable) sums of money are prime examples of perpetuities.
(ii) Equivalent Units: Equivalent units or equivalent production units, means converting the
incomplete production units into their equivalent completed units. Under each process, an
estimate is made of the percentage completion of work-in-process with regard to different
elements of costs, viz., material, labour and overheads. It is important that the estimate of
percentage of completion should be as accurate as possible. The formula for computing
equivalent completed units is:
 Actualnumber of unitsin   Percentage of 
Equivalent completed units =   
 theprocessof manufacture   Work completed 
For instance, if 25% of work has been done on the average of units still under process, then
200 such units will be equal to 50 completed units and the cost of work-in-process will be
equal to the cost of 50 finished units.

13

© The Institute of Chartered Accountants of India