Cost Management and

Financial Management
Theory Compilation

For CMA Inter

Group 2

Important for upcoming CMA Inter Online Exams

In online mock exams, upto 24 marks theory questions are being asked,
out of which 12 marks may be compulsory.
 

Cost Management

Introduction to Cost and Management Accounting MTP Dec’17

Q.1 Relationship between Management Accounting and Cost Accounting

Answer
Management Accounting is primarily concerned with the requirements of the management.
It involves application of appropriate techniques and concepts, which help management in
establishing a plan for reasonable economic objective. It helps in making rational decisions for
accomplishment of management objectives. Any workable concept or techniques whether it
is drawn from Cost Accounting, Financial Accounting, Economics, Mathematics and statistics,
can be used in Management Accountancy. The data used in Management Accountancy should
satisfy only one broad test. It should serve the purpose that it is intended for. A management
accountant accumulates, summarises and analysis the available data and presents it in relation
to specific problems, decisions and day-to-day task of management. A management accountant
reviews all the decisions and analysis from management’s point of view to determine how
these decisions and analysis contribute to overall organisational objectives. A management
accountant judges the relevance and adequacy of available data from management’s point of
view.
The scope of Management Accounting is broader than the scope of Cost Accountancy.
In Cost Accounting, primary emphasis is on cost and it deals with its collection, analysis,
relevance interpretation and presentation for various problems of management. Management
Accountancy utilizes the principles and practices of Financial Accounting and Cost Accounting
in addition to other management techniques for efficient operations of a company. It widely
uses different techniques from various branches of knowledge like Statistics, Mathematics,
Economics, Laws and Psychology to assist the management in its task of maximising profits or
minimizing losses. The main thrust in Management Accountancy is towards determining policy
and formulating plans to achieve desired objective of management. Management
Accountancy makes corporate planning and strategy effective.

Introduction to Cost and management accounting Jun’18

Q.2 Concept of Management Accounting

Answer
Management Accounting is a new approach to accounting. The term ‘Management Accounting’
is composed of two words-Management and Accounting. It refers to Accounting for the
Management. Management Accounting is a modern tool to management. Management
Accounting provides the techniques for interpretation of accounting data. Here, accounting
should serve the needs of management. Management is concerned with decision-making.
Therefore, the role of Management Accounting is to facilitate the process of decision-making
by the management. Managers in all types of organizations need information about business
activities to plan accurately for the future and make decisions for achieving the goals of the
enterprise. Uncertainty is the characteristic of the decision-making process. Uncertainty cannot
be eliminated altogether, but can be reduced. The function of Management Accounting

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is to reduce this uncertainty and help the management in the decision-making process.
Management Accounting is that field of accounting, which deals with providing information
including financial accounting information to managers for their use in planning, decision-
making, performance evaluation, control management of costs and cost determination for
financial reporting. Management Accounting contains reports prepared to fulfill the needs of
managements.

Introduction to Cost and Management Accounting Dec’19/MTP Jun’17/

MTP Dec’19
Q.3 Significance of Management Accounting.

Answer
The various advantages that accrue out of management accounting are enumerated below:
(1) Delegation of Authority : Now a days the function of management is no longer personal.
Management accounting helps the organization in proper delegation of authority for the
attainment of the vision and mission of the business.
(2) Need of the Management : Management Accounting plays the role in meeting the need
of the management.
(3) Qualitative information : Management Accounting accumulates the qualitative
information so that management would concentrate on the actual issue to deliberate
and attain the specific conclusion even „for the complex problem.
(4) Objective of-the Business : Management Accounting provides measure and reports to
the management thereby facilitating in attainment of the objective of the business.

Marginal Costing MTP Jun’20/Jun’17

Q.4 Differential Cost

A n s w e r
Differential Cost is the change in the costs which results from the adoption of an alternative
course of action. The alternative actions may arise due to change in sales volume, price,
product mix (by increasing, reducing or stopping the production of certain items), or methods
of production, sales, or sales promotion, or they may be due to ‘make or buy’ take or refuse’
decisions. When the change in costs occurs due to change in the activity from one level to
another, differential cost is referred to as incremental cost or detrimental cost.

Marginal Costing Jun’17

Q.5 Angle of Incidence

A n s w e r
Angle of Incidence is an angle formed at the intersection point of total Sales line and total cost
line in a formal break even chart. If the angle is larger, the rate of growth of profit is higher and
if the angle is lower, the rate of growth of profit is lower. So, growth of profit or profitability rate
is depicted by Angle of Incidence.

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Marginal Costing MTP Jun’20/Jun’17

Q.6 Principal Budget Factor

A n s w e r
Budgets cover all the functional areas of the organisation. For the effective implementation
of the budgetary system, all the functional areas are to be considered which are interlinked.
Because of these interlinks, certain factors have the ability to affect all other budgets. Such
factor is known as principle budget factor.
Principal Budget factor is the factor the extent of influence of which must first be assessed in
order to ensure that the functional budgets are reasonably capable of fulfillment. A principal
budget factor may be lack of demand, scarcity of raw material, non-availability of skilled labour,
inadequate working capital etc. If for example, the organisation has the capacity to produce
2500 units per annum. But the production department is able to produce only 1800 units due
to non-availability of raw materials. In this case, non- availability of raw materials is the principal
budget factor (limiting factor). If the sales manager estimates that he can sell only 1500 units
due to lack of demand. Then lack of demand is the principal budget factor. This concept is also
known as key factor, or governing factor. This factor highlights the constraints with in which the
organisation functions.

Marginal Costing MTP Jun’20/Dec’17

Q.7 Break even analysis

Answer
Break Even means the volume of production or sales where there is no profit or loss. In other
words, Break Even Point is the volume of production or sales where total costs are equal to
revenue. It helps in finding out the relationship of costs and revenues to output. In understanding
the breakeven point, cost, volume and profit are always used. The break even analysis is used to
answer many questions of the management in day to day business.

Marginal Costing MTP Jun’20/Dec’17

Q.8 Difference between Absorption costing and Marginal costing

Answer
Absorption Costing Marginal Costing
Both fixed and variable costs are considered Only variable costs are considered for product
for product costing and inventory valuation. costing and inventory valuation.
Fixed costs are charged to the cost of Fixed costs are regarded as period costs. The
production. Each product bears a reasonable profitability of different products is judged by
share of fixed cost and thus the profitability of their P/V ratio.
a product is influenced by the apportionment
of fixed costs

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Cost data are presented in conventional Cost data are presented to highlight the total
pattern. Net Profit of each product is contribution of each product.
determined after ‘subtracting fixed cost along
with their variable cost.
The difference in the magnitude of opening The difference in the magnitude of opening
stock and closing stock affects the unit cost of stock and closing stock does not affect the
production due to the impact of related fixed unit cost of production.
cost.
In case of absorption costing the cost per In case of marginal costing the cost per
unit reduces, as the production increases as unit remains the same, irrespective of the
it is fixed cost which reduces, whereas, the production as it is valued at variable cost.
variable cost remains the same per unit.

Marginal Costing MTP Dec’17/June’19

Q.9 Limitations of Marginal Costing

Answer
1. The separation of costs into fixed and variable presents technical difficulties. Infact, no
variable cost is completely variable nor is a fixed cost completely fixed.
2. It is not correct to eliminate fixed costs from finished stock and work-in-progress.
3. The exclusion of fixed overhead from the inventories affects the P&L A/c and produces an
unrealistic and conservative Balance Sheet, unless adjustments are made in the financial
accounts at the end of the period.
4. In Marginal Costing System, marginal contribution and profits increase or decrease with
changes in sales volume. Where sales are seasonal, profits fluctuate from period to period.
Monthly operating statements under the Marginal Costing System will not, therefore, be
as realistic or useful as in Absorption Costing.
5. Marginal Costing does not give full information. For example, increased production and
sales may be due to extensive use of existing equipments; (by working overtime or in
shifts), or by an expansion of the resources, or by the replacement of labour force by
machines. The Marginal Contribution fails to reveal these.
6. Marginal Costing does not provide any standard for the evaluation of performance. A
system of Budgetary Control and Standard Costing provides more effective control than
that obtained by Marginal Costing.
7. Though for short-term assessment of profitability, marginal costs may be useful, long
term is correctly determined on full costs only.
8. Although marginal costing eliminates the difficulties involved in the apportionment
and under/over absorption of fixed overhead, the problem still remains in so far as the
variable overhead is concerned.
9. With automation and technological developments, the impact of fixed costs on products
is much more than that of variable costs. A system which ignores fixed cots is therefore
less effective because a major portion of costs is not taken care of.

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10. During earlier stages of a period of recession, the low profits or increase in losses in a
magnified way in the marginal cost statements may unduly create panic and compel the
management to take action that may lead to further depression of the market.

Marginal Costing Dec’18

Q.10 Application of Marginal Costing in Decision Making

Answer
Some of the important areas where Marginal Costing techniques are generally applied are as
given below:
(i) Selection of a Profitable Sales Mix or Profitable Product Mix
(ii) Problem of Limiting Factors
(iii) Make or Buy Decisions
(iv) Diversification of Production
(v) Fixation of Selling Price
(vi) Export Market Vs. Home Market
(vii) Alternative Methods of Manufacturing
(viii) Operate or Shut Down Decision
(ix) Maintaining a Desired Level of Profit
(x) Alternative Courses of Action
(xi) Profit Planning

Learning Curve Jun’17

Q.11 Learning Curve

A n s w e r
It is essentially a measure of the experience gained in production of an article by an organization.
As more and more units are reproduced, workers involved in production become more efficient
than before. Each subsequent unit takes fewer man hour to produce. The learning curve
exists during a worker’s start up or familiarization period on a particular job. After the limits of
experimental learning are reached, productivity tends to stabilize and no further improvement
is possible. The learning curve will pass through three different phases. In the first phase, there
will be gradual increase in production rate until the maximum expected rate is reached and
this phase is generally steep. In the second phase, the learning rate will gradually deteriorate
because of the limitations of equipment. In the third phase, the production rate begins to
decrease due to a reduction in customer requirements and increase in costs.
Under the Learning curve model, the cumulative average time per unit produced is assumed
to fall by a constant percentage every time total output of the unit doubles. Learning curve is a
geometrical operation, as the identical operation is increasingly repeated.
Learning curve is essentially a measure if the experience gained in production of an article by
an organization. As more and more units re-produced, workers involved in production become

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more efficient than before. Each subsequent unit takes fewer man-hours or produce. The
Learning curve exists during a worker’s start up or familiarization period on a particular job.
After the limits of experimental learning are reached, productivity tends to stabilize and no
further improvement is possible. The learning curve ratio can be calculated with the help of the
following formula:
Learning curve ratio = Average Cost of First 2 Units / Average Labour Cost of First Units

Learning Curve MTP Dec’17/Dec’19

Q.12 Uses of Learning Curve

Answer
Knowledge of learning curve can be useful both in planning and control. Standard cost for new
operations should be revised frequently to reflect the anticipated learning pattern.
Its main uses are summarized below:
1. Helps to analyze. Cost-Volume-Profit (CVP) relationship during familiarization phase of
product or process.
Learning curve can be used as a tool for forecasting.
2. Helps in developing budgets and profit planning of the project.
3. Helps in development of advantageous pricing policy.
4. It helps design engineers in making decisions based upon expected (predictable from
past experience) rates of improvement.
5. It is very useful to the Government in negotiations about the contracts.
6. It is quite helpful in setting standards in learning phase.

Learning Curve MTP Jun’17/MTP Dec’17/MTP Dec’19

Q.13 Factors affecting Learning Curve

Answer
(i) While pricing for bids, general tendency is to set up a very high initial labour cost so as
to show a high learning curve. This should the learning curve useless and sometimes
misleading.
(ii) The method of production i.e. whether it is labour oriented or machine oriented influences
the slop of the learning.
(iii) When labour turnover rate is high management has to train new workers frequently. In
such situations the company may never reach its maximum efficiency potential. One of the
important requisites of the learning curve concept is that there should be uninterrupted
flow of work. The fewer the interruptions, the grater will be the improvement in efficiency.
(iv) Changes in a product or in the methods of production, designs, machinery, or the tools/
used affect the slope of the learning curve. All these have the effect of starting learning a
fresh because of new conditions If the changes are frequent, there may be no learning at all.

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(v) Also other factors influencing the learning curve are labour strikes, lock outs and shut
downs due to other cause also/affect the learning curve. In each such case there is
interruption in the progress of learning.
As far as possible the effects of above factors should be carefully separated from the data used
to establish the curve. The effects of these factors must also be separated from the actual costs
used to measure the performance. Unless this is done analysis of the projected cost or the
actual cost will not be meaningful.

Budget and Budgetary Control MTP Jun’17/MTP Jun’18/

MTP Dec’19/Dec’17/Dec’19
Q.14 Zero-Base Budgeting (ZBB)

Answer
ZBB was introduced by Peter Pnyrs in 1969 who defined it as “a planning and budgeting process
which requires each manager to justify his entire budget request in detail from scratch (hence
zero base). Each manager states why he should append any money at all. This approach requires
that all activities be identified as decision packages which will be evaluated by systematic
analysis ranked in order of importance”. According to CIMA London, ZBB is defined as “a
method of budgeting whereby all-activities are revalued each time a budget is set”. Discrete
levels activity are valued and combination chosen to match funds available.
Features of ZBB
1. All budget items old or new are considered afresh.
2. Amount spent on each budgets totally justified.
3. Departmental objectives are linked to corporate goals.
4. Cost benefit analysis of each budget is undertaken.
5. Managers at all level participate in ZBB.
Process of ZBB
1. Determination of set of objectives
2. Deciding upon the extent on which the technique is used
3. Determine the areas which require decision making.
4. Developing decision and ranking them in order of performance.
5. Preparation of budget and allocation of resources.

Budget and Budgetary Control MTP Jun’20/Jun’18/Dec’18

Q.15 Performance Budgeting

Answer
Performance Budgeting: is synonymous with Responsibility Accounting, which means that the
responsibility of various levels of management is predetermined in terms of output or result
keeping in view the authority is vested with them.

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Performance budget is a budget that reflects the input of resources and the output of services
for each unit of an organization. This type of budget is commonly used by the government to
show the link between the funds provided to the public and the outcome of these services.
Performance budgeting is a method of budgeting that provides the purpose and objectives
for which funds are needed, costs of programs and related activities proposed to accomplish
those objectives and outputs to be produced or services to be rendered under each program.
Performance budgeting follows the validation that a relaxation of input controls and an increased
flexibility enhances managers’ performance as long as results are measured and managers are
held responsible for their results . The major aim of performance budgeting is to improve the
efficiency of public expenditure, by linking the funding of public sector organizations to the
results they deliver. It adopts organized performance information (indicators, evaluations,
program costings) to make this link. There is a good impact of performance budgeting on
organizations in terms of improved prioritization of expenditure, and in improved service
effectiveness. Performance budgeting is based on a classification of managerial level for the
purpose of establishing a budget for each level. The individual in charge of that level should be
made responsible and held accountable for its performance over a given period of time.

Budget and Budgetary Control MTP Dec’17/Dec’18

Q.16 Difference between Fixed and Flexible Budget (Any four points)

Answer
Fixed Budget Flexible Budget
(i) It does not change with actual volume of It can be recasted on the basis of activity
activity achieved. Thus it is known as rigid level to be achieved. Thus it is not rigid
or inflexible budget
(ii) It operates on one level of activity and It consists of various budgets for different
under one set of conditions levels of activity
(iii) Here all costs like-Fixed, Variable and Here analysis of variance provides useful
Semi-variable are related to only one level Information as each cost is analysed
of activity according to its behaviour
(iv) If the budgeted and actual activity levels Flexible Budgeting at different levels of
differ significantly, then the aspects like activity facilities the ascertainment of cost,
cost ascertainment and price fixation do fixation of selling price and tendering of
not give a correct picture quotations
(v) Comparison of actual performance with It provides a meaningful basis of
budgeted targets will be meaningless comparison of the actual performance
specially when there is a difference with the budgeted targets
between the two activity levels

Budget and Budgetary Control MTP Jun’18/MTP Jun’17

Q.17 Responsibility Accounting

Answer
One of the recent developments in the field of management accounting is the responsibility
accounting, which is helpful in exercising cost control. Responsibility Accounting is a system

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of accounting that recognizes various responsibility centers throughout the organization and
reflects the plans and actions of each of these centers by assigning particular revenues and
costs to the one having the pertinent responsibility. It is also called profitability accounting
and activity accounting. It is a system in which the person holding the supervisory posts as
president, function head, foreman, etc are given a report showing the performance of the
company or department or section as the case may be. The report will show the data relating to
operational results of the area and the items of which he is responsible for control. Responsibility
accounting follows the basic principles of any system of cost control like budgetary control and
standard costing. It differs only in the sense that it lays emphasis on human beings and fixes
responsibilities for individuals. It is based on the belief that control can be exercised by human
beings, so responsibilities should be fixed for individuals.
Principles of responsibility accounting are as follows:
 A target is fixed for each department or responsibility center.
 Actual performance is compared with the target.
 The variances from plan are analysed so as to fix the responsibility.
 Corrective action is taken by higher management and is communicated.

Budget and Budgetary Control MTP Dec’19

Q.18 Master Budget

Answer
The master budget is the aggregation of all lower-level budgets produced by a company’s
various functional areas, and also includes budgeted statements, cash forecast, and a financing
plan. The master budget is typically presented in either a monthly or quarterly format, or usually
covers a company’s entire fiscal year. An explanatory text may be included with the master
budget, which explains the company’s strategic direction, how the master budget will assist
in accomplishing specific goals, and the management actions needed to achieve the budget.
There may also be a discussion of the headcount changes that are required to achieve the
budget.
A master budget is the central planning tool that a management team uses to direct the
activities of a corporation, as well as to judge the performance of its various responsibility
centers. It is customary for the senior management team to review a number of iterations of the
master budget and incorporate modifications until it arrives at a budget that allocates funds to
achieve the desired results. Hopefully, a company uses participative budgeting to arrive at this
final budget, but it may also be imposed on the organization by senior management, with little
input from other employees.

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Transfer Pricing Jun’18

Q.19 Transfer pricing

Answer
A ‘Transfer Price’ is that notional value at which goods and services are transferred between
divisions in a decentralized organization. Transfer Pricing has become necessary in highly
decentralized companies where number of divisions/departments are created as a part and
parcel of the decentralized organization.
Transfer Pricing is one of the tools in the hands of management for measuring the performance
of divisions or departments.
Transfer Prices are normally set for intermediate products, which are goods and services that
are supplied by the selling division to the buying division. In large organization, each division is
treated as a ‘profit center’ as a part and parcel of decentralization. Their profitability is measured
by fixation of ‘transfer price’ for interdivisional transfers. The transfer Price can have a big impact
on the division’s performance and hence a lot of care is to be taken in the fixation of the same.
The transfer Price should motivate the divisional managers to maximize the profitability of
their divisions. It should allow ‘Goal Congruence’, which means that the objectives of divisional
managers match with those of the organization.

Transfer Pricing Jun’19

Q.20 Methods of Transfer Pricing

Answer
There are several methods for fixation of ‘Transfer Price’. Some of them are:
1. Pricing based on Actual Cost/Cost plus basis/Standard Cost/Marginal Cost.
2. Market Price as transfer price. This will act as a good incentive for efficient production
to the selling division and any inefficiency in production and abnormal costs will not be
borne by the buying division.
3. Negotiated Pricing as the transfer price. The transfer prices are fixed through negotiations
between the seller and the buyer division.
4. Pricing based on Opportunity Cost. This method recognizes the minimum price that the
selling division is ready to accept and the maximum price that the buying division is ready
to pay.

Transfer Pricing MTP Jun’17/MTP Dec’17/MTP Dec’19

Q.21 Objectives of Inter company Transfer Pricing

Answer
The following are the main objectives of intercompany transfer pricing scheme:
 To evaluate the current performance and profitability of each individual unit: This
is necessary in order to determine whether a particular unit is competitive and can stand

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on its working. When the goods are transferred from one department to another, the
revenue of one department becomes the cost of another and such inter transfer price
affects the reported profits.
 To improve the profit position: Intercompany transfer price will make the unit
competitive so that it may maximize its profits and contribute to the overall profits of the
organisation.
 To assist in decision making: Correct intercompany transfer price will make the costs
of both the units realistic in order to take decisions relating to such problems as make or
buy, sell or process further, choice between alternative methods of production.
 For accurate estimation of earnings on proposed investment decisions: When
finance is scarce and it is required to determine the allocation of scarce resources between
various divisions of the concern taking into consideration their competing claims, then
this technique is useful.

Transfer Pricing MTP Jun’18/MTP Jun’20

Q.22 Negotiated Pricing

Answer
Under this method, the transfer prices may be fixed through negotiations between the selling
and the buying division. Sometimes it may happen that the concerned product may be available
in the market at a cheaper price than charged by the selling division. In this situation the buying
division may be tempted to purchase the product from outside sellers rather than the selling
division. Alternatively, the selling division may notice that in the outside market, the product
is sold at a higher price but the buying division is not ready to pay the market price. Here, the
selling division may be reluctant to sell the product to the buying division at a price, which is less
than the market price. In all these conflicts, the overall profitability of the firm may be affected
adversely. Therefore, it becomes beneficial for both the divisions to negotiate the prices and
arrive at a price, which is mutually beneficial to both the divisions. Such prices are called as
‘Negotiated Prices’. In order to make these prices effective care should be taken that both, the
buyers and sellers should have access to the available data including about the alternatives
available if any. Similarly, buyers and sellers should be free to deal outside the company, but
care should be taken that the overall interest of the organisation is not affected.
• The main limitation of this method is that lot of time is spent by both the negotiating
parties in fixation of the negotiated prices.
• Negotiating skills are required for the managers for arriving at a mutually acceptable
price, otherwise there is a possibility of conflicts between the divisions.

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Standard Costing MTP Jun’20/Jun’18/Jun’19

Q.23 Difference between Standard Costing and Budgetary Control

Answer
Standard Costing Budgetary Control
i. Standards are based on technical assessments Budgets are based on past actuals
adjusted to future trends
ii. Standards are mainly for production expenses Budgets are compiled for sales,
i.e., elements of cost production, expenses, Profit, capital
expenditure.
iii. Standard cost is projection of cost accounts. Budgets are projects of financial accounts
iv. Standards are minimum targets which are to Budgets are the maximum limits of
be attained expenses above which expenditure
should not be incurred.
v. Standards are pointers to further improvements. Budgets are indices, adherence to which
keeps a business out of problems.
vi. Variances are accounted for in the books. Variance analysis is only a statistical data
vii. Standards are expressed per unit of production Budgets are expressed in totals of
amounts
viii. Detailed analysis is needed in case of variances, No further analysis is required if costs are
whether they are favourable or unfavourable. within the budget.

Standard Costing Dec’18

Q.24 Advantages of Standard Costing

Answer
The advantages of Standard Costing are:
(i) Established yard - sticks against which the efficiency of actual performances is measured
(ii) The Standards provide incentive and motivation to work with greater effort and vigilance
for achieving the standard
(iii) At the very stage of setting the standards, simplification and standardisation of products,
methods and operations are effected and waste of time and materials is eliminated
(iv) Costing Procedures are simplified. There is a reduction in Paper work
(v) Standard Costing is an exercise in planning
(vi) Standard Costing System facilitates delegation of authority and fixation of responsibility
for each department or individual
(vii) Enables Variance Analysis and the Reporting is based on the principles of Management
by Exception
(viii) Optimizes the use of plant capacities, current assets and working capital
(ix) Standard Costing facilitates the integration of accounts

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Uniform Costing and Inter firm comparison Jun’19

Q.25 Inter Firm Comparison

Answer
Inter-Firm Comparison, as the name denotes, means the techniques of evaluating the
performances, efficiencies, deficiencies, costs and profits of similar nature of firms engaged in
the same industry or business. It consists of exchange of information, voluntarily, concerning
production, sales, costs with various types of break-up prices, profits etc., among the firms who
are interested of willing to make the device a success.
The basic purposes of Inter-firm comparison are to find out the weak points in an organization
and to improve the efficiency by taking appropriate measures to wipe out the weakness
gradually over a period of time.
Inter-firm comparison makes the management of the organization aware of the strengths and
weaknesses in relation to other organizations in the same industry. Such comparison helps in
developing cost- consciousness amongst the members of the industry.

Uniform Costing and Inter firm comparison Dec’17/Dec’19

Q.26 Uniform Costing

Answer
Uniform Costing is not a separate method or type of Costing. It is a technique of Costing and can
be applied to any industry. Uniform Costing may be defined as the application and use of the same
costing principles and procedures by different organisations under the same management or
on a common understanding between members of an association. The main feature of uniform
costing is that whatever be the method of costing used, it is applied uniformly in a number
of concerns in the same industry, or even in different but similar industries. This enables cost
and accounting data of the member undertakings to be compiled on a comparable basis so
that useful and crucial decisions can be taken. The principles and methods adopted for the
accumulation, analysis, apportionment and allocation of costs vary so widely from concern to
concern that comparison of costs is rendered difficult and unrealistic. Uniform Costing attempts
to establish uniform methods so that comparison of performances in the various undertakings
can be made to the common advantage of all the constituent units.
The need for application of uniform Costing System exists in a business, irrespective of the
circumstances and conditions prevailing therein. In concerns which are members of a trade
association, the procedure for uniform Costing may be devised and controlled by the association
or by any other central body specially formed for the purpose.

Uniform Costing and Inter firm comparison MTP Jun’17/MTP Jun’18

Q.27 Limitations of Inter-firm Comparison

Answer
The practical difficulties that are likely to arise in the implementation of a scheme of inter firm
comparison are:

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(a) The top management may not be convinced of the utility of inter-firm comparison.
(b) Reluctance to disclose data which a concern considers to be confidential.
(c) A sense of complacence on the part of the management who may be satisfied with the
present level of profits.
(d) Absence of a proper system of Cost Accounting so that the costing figures supplied may
not be relied upon for comparison purposes.
(e) Non-availability of a suitable base for comparison.

Uniform Costing and Inter firm comparison MTP Jun’20

Q.28 Advantage of Uniform Costing

Answer
Main advantages of a uniform Costing System are summarised below:
(i) It provides comparative information to the members of the organisation/association
which may by them to reduce or eliminate the evil effects of competition and unnecessary
expenses arising from competition.
(ii) It enables the industry to submit the statutory bodies reliable and accurate data which
might be required to regulate pricing policy or for other purposes.
(iii) It enables the member concerns to compare their own cost data with that of the others
detect the weakness and to take corrective steps for improvement in efficiency.
(iv) The benefits of research and development can be passed on the smaller members of the
association lead to economy of the industry as a whole.
(v) It provides all valuable features of sound cost accounting such as valued and efficiency of
the workers, machines, methods, etc., current reports of comparing major cost items with
the predetermined standards, etc.
(vi) It serves as a prerequisite to Cost Audit and inter firm comparison

Uniform Costing and Inter firm comparison MTP Dec’19

Q.29 Prerequisites of Uniform Costing System

Answer
a. The member of the trade association or Chamber of Commerce should work with a spirit
of mutual trust and cooperation.
b. Member should exchange their ideas freely, without fearing the leakage of secrecy.
c. The well-organized and large scale sector should be prepared to pass on the technological
development in the process or method of production to the other companies who are
unable to conduct their own research and developmental activities.
d. The companies must furnish full and correct information to the Association so that
efficiency of the member-companies can be compared.
e. The member should not work with a sense of rivalry or jealousy.

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Uniform Costing and Inter firm comparison MTP Dec’19

Q.30 Limitations of Uniform Costing

Answer
a. The various member-units in an industry differ widely with regard to location, age,
condition of plant and degree of mechanism. This difference is sometimes so wide that it
does not permit efficient use of uniform costing system.
b. For smaller units, this system becomes too expensive to operate. The cost incurred in
operation of this system may not commensurate with the benefits derived.
c. Uniform costing system may promote a monopolistic tendency. Thus, it may prove
harmful to the consumers.
d. The standard terminology used in the uniform costing system may not be understood
properly by the member companies. However, this objective can be overcome by
introduction of uniform Costing Manual.

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Financial Management

Introduction to Financial Management Dec’17

Q.1 Sweat Equity Shares

Answer
As per Sec 2(88) of the Companies Act 2013 — Sweat equity shares means such equity shares as
are issued by a company to its directors or employees at a discount or for consideration, oilier
than cash, for providing their knowhow or making available rights in the nature of intellectual
property rights or value additions, by whatever name called.
A company may issue sweat equity shares of a class of shares already issued, if the following
conditions are fulfilled:
(a) the issue is authorised by a special resolution passed by the company;
(b) the resolution specifies the number of shares, the current market price, consideration, if
any, and the class or classes of directors or employees to whom such equity shares are to
be issued;
(c) not less than one year has, at the date of such issue, elapsed since the date on which the
company had commenced business; and
(d) where the equity shares of the company are listed on a recognised stock exchange, the
sweat equity share issued in accordance with the regulations made by the Securities and
Exchange Board in this behalf and if they are not so listed, the sweat equity shares are
issued in accordance with rule 8 of Companies (Share Capital and Debenture) Rules, 2014.

Introduction to Financial Management Dec’17/Dec’18

Q.2 Venture Capital

Answer
Venture Capital is a form of equity financing especially designed for funding high risk and high
reward projects. There is a common perception that Venture Capital is a means of financing high
technology projects. However, Venture Capital is investment of long term financial made in: 1.
Ventures promoted by technically or professionally qualified but unproven entrepreneurs, or
2. Ventures seeking to harness commercially unproven technology, or [Link] risk ventures. The
term ‘Venture Capital’ represents financial investment in a highly risky project with the objective
of earning a high rate of return.
Modes of Finance by Venture Capitalists
1. Equity Most of the venture capital funds provide financial support to entrepreneurs in the
form of equity by financing 49% of the total equity. This is to ensure that the ownership
and overall control remains with the entrepreneur. Since there is a great uncertainty about
the generation of cash inflows in the initial years, equity financing is the safest mode of
financing. A debt instrument on the other hand requires periodical servicing of dept.
2. Conditional Loan From a venture capitalist point of view, equity is an unsecured

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instrument hence a less preferable option than a secured debt instrument. A conditional
loan usually involves either no interest at all or a coupon payment at nominal rate. In
addition, a royalty at agreed rates payable to the lender on the sales turnover. As the units
picks up in sales interest rate are increased and royalty amounts are decreased.
3 Convertible Loans the convertible loan “is subordinate’ to all other loans which may be
converted into equity if interest payments are not made within agreed time limit.

Introduction to Financial Management MTP Dec’18/Jun’19

Q.3 Lease Financing

Answer
Lease Financing is an arrangement that provides a firm with the use and control over assets
without buying and owning the same. It is a form of renting assets. It is a contract between the
owner of asset (lessor) and the user of the asset called the lessee, whereby the lessor gives the
right to use the asset to the lease over an agreed period of time for a consideration called the
lease rental. The contract is regulated by the terms and conditions of the agreement. The lessee
pays the lease rent periodically to the lessor as regular fixed payments over a period of time.
There are two basic kinds of leases. They are:
(i) Operating or Service Lease
(ii) Financial Lease
An Operating Lease is a short term lease with the lease period being less than the useful life
of asset. Such a lease is cancellable at a short notice by the lessee. Such a leasing is common
to the equipments which require expert technical staff for maintenance and are exposed to
technological developments e.g., computers, vehicles, data processing equipments etc.
A Financial Lease ensures the lessor for amortization of the entire cost of investment plus the
expected return on capital outlay during the terms of the lease. Such a lease is usually for a
longer period and non- cancellable. These leases are commonly used for leasing land, building,
machinery, fixed equipments etc.

Introduction to Financial Management Jun’19

Q.4 Objectives, Functions and Powers of the Securities Exchange Board of India (SEBI):

Answer
The overall objective of the SEBI is to protect the interests of the investors in securities and to
promote the development of and to regulate the securities market and for matters connected
therewith or incidental thereto.
To carry out its overall objectives, the SEBI performs the following functions:
 Regulate the business in stock exchanges and other securities markets;
 Registering and regulating the working of stock brokers, share-transfer agents, bankers,
underwriters, portfolio managers, investment advisor and such other intermediaries,
who may be associated with the securities market in any manner;

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 Registering and regulating the working of depositories, custodians of securities, credit

rating schemes, including mutual funds;
 Prohibiting fraudulent and unfair trade practices relating to the securities market. It has
the powers to call for periodical return from any recognized stock exchange.
It performs such functions and exercises such powers, under the Securities Contract (Regulation)
Act, 1956, as may be delegated to it by the Central Government.

Introduction to Financial Management Dec’19

Q.5 Process of Debt Securitization

Answer
Process of debt securitization
• The loans are segregated into relatively homogeneous pools.
• The basis of pool is the type of credit, maturity pattern, interest rate, risk etc.
• The assets pools are then transferred to a trustee.
• The trustee then issues securities which are purchased by investors.
• Such security (asset pool) are sold on the undertaking without recourse to seller. In this way
conversion of debts to securities is known as Debt securitization.

Introduction to Financial Management MTP Dec’19

Q.6 Wealth maximization

Answer
Wealth maximization is a modern approach of the financial management where we consider
the concept of time value of money. According to this criterion, the financial activities of a firm
are conducted in such a way so that the net wealth of the firm is maximum. Wealth Maximization
is considered as the appropriate objective of an enterprise. When the firms maximizes the stock
holders wealth, the individual stockholder can use this wealth to maximize his individual utility.
Wealth Maximization is the single substitute for a stock holders utility.
The wealth maximization criterion is more acceptable in case of taking investment decisions in
financial management because
(1) In wealth maximization criterion, wealth refers to the net present value. So, wealth
maximization refers to the maximization of net present value of a project.
(2) It is considered in wealth maximization criterion as income streams of the entire life of a
project are discounted is such a case.
(3) Under this approach, the aspects of risk and uncertainty are considered. A Stock holders
wealth may be calculated by the following way: Stock holders wealth = No. of shares
owned x Current stock price per share
Higher the stock price per share, the greater will be the stock holders wealth.

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Introduction to Financial Management MTP Dec’19

Q.7 Foreign Currency Convertible Bonds

Answer
The FCCB means bonds issued in accordance with the relevant scheme and subscribed by a
non-resident in foreign currency and convertible into ordinary shares of the issuing company
in any manner, either in whole or in part, on the basis of any equity related warrants attached
to debt instruments. The FCCBs are unsecured; carry a fixed rate of interest and an option for
conversion into a fixed number of equity, shares of the issuer company. Interest and redemption
price (if conversion option is not exercised) is payable in dollars. Interest rates are very low by
Indian domestic standards. FCCBs are denominated in any freely convertible foreign currency.
FCCBs have been popular with issuers. Local debt markets can be restrictive in nature with
comparatively short maturities and high interest rates. On the other hand, straight equity-issue
may cause a dilution in earnings, and certainly a dilution in control, which many shareholders,
especially major family shareholders, would find unacceptable. Thus, the low coupon security
which defers shareholders dilution for several years can be alternative to an issuer. Foreign
investors also prefer FCCBs because of the Dollar denominated servicing, the conversion option
and the arbitrage opportunities presented by conversion of the FCCBs into equity at a discount
on prevailing India market price.

Introduction to Financial Management MTP Dec’19

Q.8 Global Depository Receipt (GDR)

Answer
A GDR is a negotiable instrument, basically a bearer instrument which is traded freely in the
international market either through the stock exchange or over the counter or among Qualified
International Buyers (QIB). It is denominated in US Dollars and represents shares issued in the
local currency.
Characteristics
1. The shares underlying the GDR do not carry voting rights.
2. The instruments are freely traded in the international market.
3. The investors earn fixed income by way of dividend.
4. GDRS can be converted into underlying shares, depository/custodian banks reducing the
issue.

Introduction to Financial Management MTP Dec’19

Q.9 Factoring

Answer
Factoring, as a fund based financial service, provides resources to finance receivables as well as
facilities the collection of receivables. It is another method of raising short-term finance through
account receivable credit offered by commercial banks and factors. A commercial bank may

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provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediate
payment for sales made on credit. A factor is a financial institution which offers services relating
to management and financing of debts arising out of credit sales. Factoring is becoming popular
all over the world on account of various services offered by the institutions engaged in it. Factors
render services varying from bill discounting facilities offered by commercial banks to a total
take-over of administration of credit sales including maintenance of sales ledger, collection of
accounts receivables, credit control and protection from bad debts, provision of finance and
rendering of advisory services to their clients. Factoring, may be on a recourse basis, where the
risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is
borne by the factor.

Introduction to Financial Management MTP Jun’18/MTP Dec’18

Q.10 Issue of Commercial Papers in India

Answer
CP was introduced as a money market instruments in India in January, 1990 with a view to enable
the companies to borrow for short term. Since the CP represents an unsecured borrowing in the
money market, the regulation of CP comes under the purview of the Reserve Bank of India:
(i) CP can be issued in multiples of `5 lakhs.
(ii) CP can be issued for a minimum duration of 15 days and maximum period of 12 months.
(iii) For issuing CP the company’s net worth should be more than `4 crores.
(iv) CP can neither be redeemed before maturity nor can be extended the beyond the
maturity period.
(v) CP issue requires a credit rating of P2 from CRISIL or A2 from ICRA.

Introduction to Financial Management MTP Jun’18

Q.11 Features of Financial lease

Answer
A lease is classified as Financial Lease if it ensures the lessor for amortization of the entire cost of
investment plus the expected return on capital outlay during the terms of the lease. A Financial
Lease is usually characterized by the following features:
(i) The present value of the total lease rentals payable during the period of the lease exceeds
or is equal substantially the whole of the fair value of the leased asset. It implies that
within the lease period, the lessor recovers his investment in the asset along with an
acceptable rate of return.
(ii) As compared to Operating Lease, a Financial Lease is for a longer period of time.
(iii) It is usually non cancellable by the lessee prior to its expiration date.
(iv) The lessee is generally responsible for the maintenance, insurance and services of the
asset. However, the terms of lease agreement, in some cases may require the lessor to
maintain and service the asset. Such an arrangement is called ‘maintenance or gross

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lease’. But usually in an Operating Lease, it is lessee who has to pay for maintenance and
service costs and such a lease is known as ‘net lease’.
(v) A Financial Lease usually provides the lessee an option of renewing the lease for further
period at a normal renewing the lease for further period at a normal rent.

Capital Structure Theories MTP Jun’18/MTP Dec’18

Q.12 Write the basic propositions of the MM Approach.

Answer
M -M Hypothesis can be explained in terms of two propositions of Modigliani and Miller. They
are:
• The overall cost of capital (Ko) and the value of the firm are independent of the capital
structure. The total market value of the firm is given by capitalizing the expected net
operating income by the rate appropriate for that risk class.
• The financial risk increases with more debt content in the capital structure. As a result cost
of equity (Ke) increases in a manner to offset exactly the low – cost advantage of debt.
Hence, overall cost of capital remains the same.

Capital Structure Theories MTP Jun’20/Jun’17

Q.13 Net Income Approach of Capital Structure

Answer
This approach was advocated by David Durand. According to this approach, capital structure
has relevance and a firm can increase the value of the firm and minimise the overall cost of
capital by employing debt capital in its capital structure. Accordingly, greater the debt capital in
the capital structure, lower shall be the overall cost of capital and more shall be the value of the
firm.

Cost of Capital MTP Jun’18/MTP Jun’20/Jun’17

Q.14 Capital Asset Pricing Model
Another technique that can be used to estimate the cost of equity is the capital asset pricing
model approach. The capital asset pricing model explains the behaviour of security prices
and provides a mechanism whereby investors could assess the impact of a proposed security
investment on their overall portfolio risk and return. In other words, CAPM formally describes
the risk required return trade off for securities. The assumptions for CAPM approach are:
(i) The efficiency of the security
(ii) Investor preferences.
The capital asset pricing model describes the relationship between the required rates of return,
or the cost of equity capital and the non-diversifiable or relevant risk of the firm as reflected in
its index of non- diversifiable risk. Symbolically,
Ke = Rf + β (Rm – Rf ) Where,
Ke = Cost of equity capital

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Rf = Risk free rate of return

Rm = Return on market portfolio β = Beta of Security

Cost of Capital MTP Jun’18

Q.15 Importance of Cost of Capital in Financial Management.

Answer
The Cost of Capital is very important in Financial Management and plays a crucial role in the
following areas:
(i) Capital budgeting decisions: The cost of capital is used for discounting cash flows
under Net Present Value method for investment proposals. So, it is very useful in capital
budgeting decisions.
(ii) Capital structure decisions: An optimal capital is that structure at which the value of the
firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.
(iii) Evaluation of final Performance: Cost of capital is used to evaluate the financial
performance of top management. The actual profitably is compared with the actual cost
of capital of funds and if profit is greater than the cost of capital the performance nay be
said to be satisfactory.
(iv) Other financial decisions: Cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making the rights issue, etc.

Cost of Capital MTP Dec’18

Q.16 Criticisms of CAPM

Answer
The criticisms of Capital Assets Pricing Model (CAPM) are enumerated below:
(i) CAPM makes a number of assumptions that weaken its usefulness.
(ii) The assumptions that there are no imperfections in the markets, there are no transaction
costs and the Betas of shares do not change, are not realistic.
(iii) It does not take into account that over a period of time, the market rate of return and the
risk- free return can change.
(iv) CAPM always considers a high level of diversification of portfolios, which may not be
always possible.

Leverage MTP Jun’20/Jun’17

Q.17 Financial Leverage

Answer
The Financial Leverage may be defined as a % increase in EPS associated with a given percentage
increase in the level of EBIT. Financial leverage emerges as a result of fixed financial charge
against the operating profits of the firm. The fixed financial charge appears in case the funds

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requirement of the firm is partly financed by the debt financing. By using this relatively cheaper
source of finance, in the debt financing, the firm is able to magnify the effect of change in EBIT
on the level of EPS. The significance of DFL may be interpreted as follows:
 Other things remaining constant, higher the DFL, higher will be the change in EPS for
same change in EBIT.
 Higher the interest burden, higher is the DFL, which means more a firm borrows more is
its risk.
 Since DFL depends on interest burden, it indicates risk inherent in a particular capital
mix, and hence the name financial leverage.

Leverage MTP Jun’20/Dec’17

Q.18 Combined Leverage

Answer
A combination of the operating and financial leverages is the total or Combination Leverage.
The operating leverage causes a magnified effect of the change in sales level on the EBIT level
and if the financial leverage combined simultaneously, then the change in EBIT will, in turn,
have a magnified effect on the EPS. A firm will have wide fluctuations in the EPS for even a small
change in the sales level. Thus effect of change in sales level on the EPS is known as combined
leverage. Thus Degree of Combined Leverage may be calculated as follows:
DCL=Contribution/Earning after Interest

Leverage Dec’19
Q.19 Significance of Degree of Financial Leverage

Answer
Significance of Degree of Financial Leverage (DFL):
• Higher the DFL more is the risk.
• Higher the interest burden, higher is DFL, which means more a firm borrows more is its risk.
• Since DFL depends on interest burden, it indicates risk inherent in a particular mix and
hence the name financial leverage.
• There is a unique DFL for each amount of EBIT
DFL = Earning before Internet and tax (EBIT) / Earning before tax (EBT)

Leverage MTP Dec’18

Q.20 How does financial leverage increase the potential reward to the shareholders?

Answer
Financial leverage is based on the assumption that firm is to earn more on the assets that
acquired by the use of Funds on which a Fixed Rate of interest/dividend is to be paid. Financial
leverage can be calculated as follows:

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Financial leverage=EBIT/EBT
The Financial leverage increase the reward to the shareholders, as by increasing the debt, the
organization enjoys the tax benefit as the interest on the debt capital is chargeable to the profit,
thus reducing the tax burden. Again the Profit Before Tax (PBT) will be higher with lower or nil
interest on debt, leading to high incidence of Corporation tax. The Balance representing Profit
After Tax (PAT) become proportionately lower when such PAT is related to the higher equity
capital and lower or nil debt capital. As the shareholder’s reward is the PAT earned against
the volume of capital invested, the financial leverage increase the potential reward to the
shareholders. Further, Increase in Equity to finance low risk activities will lead to lower return for
shareholders. Companies having lower risk cash flow can therefore enhance the shareholders
return by increasing the debt instead of Equity. The net operating surplus represents PAT when
related to the lower level of paid up share capital shows a higher reward to the shareholder.

Leverage MTP Jun’18

Q.21 Explain how the combined effects of operating and financial leverages provide the risk
profile of an organization.

Answer
The total risk involved in a firm can be determined by combining the operating and financial
leverages. The Degree of combined leverage is calculated by multiplying the two leverages. As
a rule, a firm having a high operating leverage should have a low financial leverage and vice
versa. If a firm has both the leverages at a high level, it will be a very risky proposition because
the combined effect of the two is a multiple of these two leverages. As such if a firm has a high
operating leverage the financial leverage should be kept low.
Thus it will be necessary to have a proper balance between operating and financial leverage of
keep the risk profile of a firm within a reasonable limit. Such a situation should also maximize
return to shareholders.

Ratio Analysis MTP Jun’20/Jun’17/Jun’19

Q.22 Window Dressing

Answer
The term window dressing means manipulation of accounts in a way so as to conceal vital facts
and present the financial statements in a way to show a better position than what it actually is.
On account of such a situation, presence of a particular ratio may not be a definite indicator of
good or bad management For example a high stock turnover ratio is generally considered to
be an indication of operational efficiency of the business. But this might have been achieved by
unwarranted price reductions or failure to maintain proper stock of goods.

Ratio Analysis Jun’18

Q.23 Debtors Turnover Ratio

Answer
This ratio ‘DTR’ indicates the speed at which the debtors are converted into cash. It is also called
as ‘Receivables Turnover Ratio’. DTR = Credit Sales in a year / Average Account Receivable The

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term, average account receivable includes trade debtors and bills receivable. Average accounts
receivables are computed by taking the average receivables in the beginning and at the end of
the accounting year.
The optimum ratio is dependent on the credit policy of the firm and credit period allowed to the
customers. A lower ratio indicates poor collection from the debtors. The higher the ratio, better
it is. Sometimes, we have to calculate the average collection period of debtors. In such a case,
the formula would be;
Average Collection Period = Days in a year / DTR
Or Average Collection Period = (Debtors × Days in a year) / Credit Sales in a year. i.e., Debtors/
Credit Sales per day.
Significance of DTR:
DTR or Debt Collection Period measures the quality of debtors since it indicates the speed with
which money is collected from the debtor. A shorter collection period implies prompt payment
by debtors. A longer collection period implies too liberal and inefficient credit collection
performance. The credit policy should neither be too liberal nor too restrictive. The former will
result in more blockage of funds and bad debts while the latter will cause lower sales which will
reduce profits.

Ratio Analysis Dec’18

Q.24 Defensive Internal Ratio

Answer
This ratio denotes the liquidity of a firm in relation to its ability to meet projected daily
expenditure from operations. It can be expressed as follows:
Defensive Interval Ratio = Liquid assets(quick assets) / Daily Cash Requirements (Projected)
Daily cash requirements (projected) = Projected cash operating expenditure/Number of days in
a year. The DIR is thought by many people to be a better liquidity measure than the quick and
current ratios. Because these ratios compare assets to liabilities rather than comparing assets
to expenses, the DIR and current/quick ratios would give quite different results if the company
hand allot of expenses, but no debt.

Ratio Analysis MTP Jun’20/Jun’18/Dec’18

Q.25 Advantages of Ratio Analysis

Answer
Ratio Analysis is useful and very relevant in assessing the performance of a firm in respect of the
following purposes:
 Ratio analysis is the process of determining and interpreting numerical relationships
based mainly on the financial statements
 To measure the liquidity position, i.e., whether the firm will be able to meet its current
obligations when they become due or not.

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 To know the solvency position for assessing the long-term financial liability of the firm
 Operating efficiency or turnover of the firm
 To assess the profitability position of the firm, in respect of sales and the investments
 For Inter-firm and Intra-firm comparison, to assess the relative position of the firm vis-a-
vis its competitors.
 For Trend Analysis, for ascertaining whether the financial position of a firm is improving
or deteriorating over the years
 Commercial Bankers and Trade Creditors are most interested in ratios like Current Ratio,
Acid Test Ratio, Turnover of Receivables, Inventory Turnover, Coverage of interest by level
of earnings, etc.

Ratio Analysis MTP Dec’18

Q.26 Standards for Comparison in Ratio Analysis

Answer
For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio
by itself has very little meaning unless it is compared to some appropriate standard. The four
most common standards used in ratio analysis in Financial Management are: absolute, historical,
horizontal and budgeted.
Absolute: Absolute standards are those which become generally recognized as being desirable
regardless of the type of company, the time, stage of business cycle and the objectives of the
analyst.
Historical: Historical (also known as internal) standards involves comparing a company’s own
past performance as a standard for the present or future. But this standard may not provide
a sound basis for judgment as the historical figure may not have represented an acceptable
standard. It is also called as intra firm comparison.
Horizontal: In case of horizontal (external) standards, one company is compared with another
or with the average of other companies of the same nature. It is also called as inter-firm
comparison.
Budgeted: The budgeted standard is arrived at after preparing the budget for a period. Ratio
developed from actual performance are compared to the planned ratios in the budget in order
to examine the degree of accomplishment of the anticipated targets of the firm.

Capital Budgeting MTP Jun’20/Dec’17

Q.27 Internal rate of return.

Answer
IRR method follows discounted cash flow technique which takes into account the time value
of money. The internal rate of return is the interest rate which equates the present value of
expected future cash inflows with the initial capital outlay. In other words, it is the rate at which
NPV is equal zero. Whenever a project report is prepared, IRR is to be worked out in order
to ascertain the viability of the project. This is also an important guiding factor to financial
institutions and investors.

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Computation of IRR
The Internal rate of return is to be determined by trial and error method. The following steps can
be used for its computation, (i) Compute the present value of the cash flows from an investment,
by using arbitrary by selected interest rate, (ii) Then compare the present value so obtained with
capital outlay, (iii) If the present value is higher than the cost, then the present value of inflows
is to be determined by using higher rate, (iv) This procedure is to be continued until the present
value of the inflows from the investment are approximately equal to its outflow, (v) The interest
rate that bring about equality is the internal rate of return.

Capital Budgeting Dec’19

Q.28 Need for Capital Budgeting

Answer
The selection of the next profitable Project of capital investment is the key Function of Financial
Manager. The decisions taken by the management in this area affect the operations of the firm
for many years.
Capital budgeting decisions may be generally needed for the following purposes:
(i) Expansion: Firm requires additional funds to invest in Fixed in Fixed assets when it
intends to expand the production facilities.
(ii) Replacement: The machines and equipments used in production may either wear out or
may be rendered obsolete due to new technology. The firm needs funds for modernization
and renovation.
(iii) Diversification: Diversification in production would require large funds for long term
investment.
(iv) Buy or Leases: This is most important area in financial management whether the firm
acquires the desired equipment and building on lease or buy it.
(v) Research and development: It is quite helpful in setting standards in learning phase.

Cash Flow Statement and Fund Flow Statement MTP Dec’18/Jun’18

Q.29 Differentiate between Fund Flow Statement and Cash Flow Statement.

Answer
The following are the main differences between a Fund Flow Statement and a Cash Flow
Statement:

Sl No. Fund Flow Statement (FFS) Cash Flow Statement (CFS)

(i) FFS reveals the change in Working CFS reveals the changes in Cash Position
Capital between two Balance Sheet between two Balance Sheet dates
dates
(ii) FFS is based on accounting CFS is based on cash basis of accounting

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(iii) In the case of FFS, a schedule of changes No such schedule of changes in Working
in Working Capital is prepared Capital is prepared for a CFS
(iv) FFS is useful in planning Intermediate CFS ,as a tool of financial analysis is more
and Long term financing useful for Short-term analysis and Cash
Planning

Cash Flow Statement & Fund Flow Statement MTP Dec’19/Jun’19

Q.30 Significance of Funds Flow Statement (FFS):

Answer
Funds Flow Statement (FFS) is a widely used tool in the hands of financial executives for
analysing the financial performance of a business concern. The Balance Sheet provides only a
static view of the business. It is a statement of assets and liabilities on a particular date. It does
not show the movement of funds. In business, funds flow from different sources and similarly
funds are invested in various sources of investment. It is a continuous process. The study and
control of this funds flow process is the main objective of Financial Management. There is a need
to prepare a statement to know the changes in assets, liabilities and owners’ equity between
dates of two Balance Sheets. Such a statement is called FFS or ‘Statement of Sources and Uses of
funds’ or ‘Where come and Where gone statement’ .
FFS provides a summary of management decisions on financing activities of the firm and
investment policy. FFS helps the Finance Managers to completely analyse the various financial
operations. It guides the management in formulating the financial policies such as dividend,
reserves etc. FFS serves as a measure of control to the management.
FFS helps in evaluating the firm’s financing. It shows how the funds were obtained from various
sources and used.
FFS acts as a guide for the future .It helps the management in knowing how effectively the
working capital is put to use. It reveals the financial soundness of the business. It helps the
management in framing its investing policy.

Cash Flow Statement & Fund Flow Statement MTP Dec’19/MTP Jun’20
Q.31 Limitation of fund flow statement

Answer
The following are the important limitations of Funds Flow Statement
(i) Funds Flow Statement is not a substitute of Income Statement or a Balance Sheet. It
furnished only some additional information as regards changes in Working Capital.
(ii) This statement lacks originality. It is simply rearrangement of data appearing in account
books.
(iii) It indicates only the past changes. It cannot reveal continuous changes.
(iv) When both the aspects of the transaction are current, they are not considered.

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Dividend Policy MTP Dec’19

Q.32 Assumptions of Walter Model

Answer
Assumptions of Walter Model:
(i) All financing is done through retained earnings; external sources of funds like debt or
new equity capital are not used.
(ii) With additional investment undertaken, the firm’s business risk does not change. It
implies that ‘internal rate of return on investment and the cost of capital are constant.
(iii) There is no change in the key variable namely Earning per share and dividend per share.
The values (D) or Dividend per share and (E) or Earning per share may be changed in
the model to determine results, but, any given value of E and D are assumed to remain
constant in determining a given value.
(iv) The firm has a perpetual (very long) life.’

Working Capital Management Jun’18/Dec’19

Q.33 Determinants of Working Capital

Answer
The size or magnitude and amount of working capital will not be uniform for all organizations
and will differ from one organization to another.
The following are some factors that would determine the size of Working Capital:
 Nature and size of the Business
 Production Policies of the concern
 Process of manufacturing
 Growth and expansion of business
 Fluctuations in the trade cycle
 Dividend Policy
 Operating Efficiency
 Other Factors like Market facilities, tax considerations, Locational Factors, Labour
availability. etc,

Working Capital Management Dec’18

Q.34 Danger of inadequate amount of working capital

Answer
Danger of inadequate amount of working capital:
 Inadequate amount of working capital makes it difficult to implement operating plans
and for achieving the firm’s profit target.
CMA Inter
Cost Management and Financial Management | 29
 

 It stagnates growth. It will become very difficult to the firm to undertake profitable.
ventures due to inadequacy of working capital funds.
 The firm may not be in a position to meet its day-to-day current obligations, leading to
operational inefficiencies
 The ROI falls due to under-utilisation of fixed assets and other capabilities of the business
concern.
 Credit facilities in the market will be lost due to faculty working capital.
 The reputation and goodwill of the firm will also be impaired considerably.

Working Capital Management MTP Dec’18/MTP Dec’19

Q.35 Importance of Cash Management

Answer
(i) Cash Management ensures that the firm has sufficient cash during peak times for purchase
and for other purposes.
(ii) Cash Management help to meet obligatory cash out flows that are all due.
(iii) Cash Management assists in planning capital expenditure projects.
(iv) Cash Management helps to arrange for outside financing at favorable terms and
conditions, if necessary.
(v) Cash Management helps to allow the firm to take advantage of discount, special purchases
and business opportunities.
(vi) Cash Management helps to invest surplus cash for short or long term periods to keep the
idle funds fully employed.

Working Capital Management MTP Jun’18

Q.36 Danger of too high amount of Working Capital

Answer
(i) It results in unnecessary accumulation of inventories and gives chance to inventory
mishandling, wastage, pilferage, theft, etc., and losses increase.
(ii) Excess working capital means idle funds which earns no profits for the business.
(iii) It shows a defective credit policy of the company resulting in higher incidence of bad
debts and adversely affects Profitability.
(iv) It results in overall inefficiency.

30 |CMA Inter
Cost Management and Financial Management