Ignou Mba Ms - 04 Solved Assignments July 2011-Restricted

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IGNOU MBA MS - 04 Solved Assignments July 2011

Course Code
MS - 04
Course Title
Accounting and Finance for Managers
Assignment Code
MS-04/SEM - I /2011
Coverage
All Blocks
Note: Answer all the questions and send them to the Coordinator of the Study Centre you are
attached with.
1. Discuss and explain the relevance of the following accounting concepts

a) Business entity
b) Money measurement
c) Continuity
d) Cost
e) Accrual
f) Conservatism
g) Materiality
h) Consistency
i) Periodicity
Solution: FUNDAMENTAL CONCEPTS OF ACCOUNTING
Accounting is the language of business and it is used to communicate financial information. In
order for that information to make sense, accounting is based on 12 fundamental concepts.
These fundamental concepts then form the basis for all of the Generally Accepted Accounting
Principles (GAAP). By using these concepts as the foundation, readers of financial statements
and other accounting information do not need to make assumptions about what the numbers
mean.
For instance, the difference between reading that a truck has a value of $9000 on the balance
sheet and understanding what that $9000 represents is huge. Can you turn around and sell the
truck for $9000? If you had to buy the truck today, would you pay $9000? Or, perhaps the
original purchase price of the truck was $9000. All of these assumptions lead to very different
evaluations of the worth of that asset and how it contributes to the companys financial situation.
For this reason it is imperative to know and understand the eleven key concepts.
a)Business equitity:
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When starting or expanding a business, many owners wonder if they should form a business entity and, if so, which one they should
use. There is a wide variety of information and "pitches" being made on the Internet regarding the benefits of certain entities versus
others. When you cut through the flak, however, the primary reason for forming a business entity is to create protection from
personal liability arising from your business activities.
It is well established that up to eighty percent of businesses will fail in their first two years. Many of these businesses, and probably
yours, carry a high level of personal risk for their owners. If you are not using the correct entity for your particular business, you are
going to be personally liable if the business fails. Do you want to expose your home, car and other assets? How about the assets
owned by your spouse or their paycheck from a regular job? Selecting the correct entity for your business prevents such nightmares
from occurring. More importantly, you can sleep at night knowing that the worst thing that can happen is losing your investment in
the business, not your home.
Business Structures
There are a number of business structure options that exist in the modern corporate world. Following is a short explanation of the
most common business structures.
Corporations
Corporations come in two basic forms, a "C" corporation and an "S" corporation. There are a variety of differences, but the central
one is a tax issue. Briefly put, "C" corporations are taxed on their revenues and you are then taxed separately on any money you
take out of the corporation. An "S" corporation "passes through" all taxes to the shareholders with the information being reported on
your personal tax returns.
Regardless of the tax classification, a corporation is considered an independent entity from a legal standpoint. This independent
status acts as a shield between the activities of the business and your personal assets. As a practical example, Kmart recently filed
bankruptcy. The individual shareholders were not required to file bankruptcy and lost nothing more than their investment in the stock
of the company. Forming and using a corporation for your business activities will have the same effect, to wit, your personal assets
will not be wiped out if the business fails.
Limited Liability Company
A limited liability company, or "LLC" as it is better known, was a very popular entity choice in the early 1990s. LLCs are similar to
corporations, but can be taxed as a partnership. In California, the LLC can have either one owner or two. Regardless of the number,
these owners carry the legal title of "member." The LLC provides a shield for your personal assets just like a corporation.
Partnerships
In my opinion, it is better to have died a small child then be in a partnership. Unfortunately, many business owners form partnerships
and don't even know it. This occurs when they go into business with another person. If no business entity is formed, the law
considers the business to be a partnership and treats it accordingly.
Partnerships are dangerous for one primary reason: a partnership does not provide any protection from liability and, in many ways,
invites personal liability. Under well-established law, most partnerships are classified as "general". This simply means that all the
partners are contributing to the administration and running of the partnership business. This classification can have grisly results.
In a general partnership, each partner is jointly liable for the debts of any other partner arising from the business. For instance, you
and your partner go to a business dinner with a client. Your partner has a drink and then a few more. They then get into an accident
on the way home. Each of the partners is liable for the damages claimed by the injured people. That means YOU! Even if you were
not in the car, did not rent the car, never saw the car and don't drink!
Partnerships are a recipe for disaster. Stay away from them whenever possible.
Limited Partnerships
Limited Partnerships ["LP"] are perhaps the most misunderstood business entity. A limited partnership is similar to a general
partnership, but allows a number of the partners to limit their liability by being limited partners. It is critical to note that these limited
partners are restricted to simply making a capital [cash, content, equipment] contribution to the partnership. They cannot be involved
in actively running the business. If they are, they lose any protection from partnership debts. Many limited partnerships end
disastrously. If you are married to the idea of pursuing a limited partnership, you must do so in combination with corporations. That
particular strategy is well beyond the scope of this article, but feels free to contact me if you wish to pursue a limited partnership.
Business owners should protect themselves by forming entities for their business activities. The real issue is identifying the structure
that is best for your particular situation.
B) Money Measurement
MONEY MEASUREMENT CONCEPT
Only financial transactions are recorded
Non-financial data are ignored
Qualitative information are ignored
Money measure at the time of transaction, no allowance for changing price level
This concept ignores important economic information
By now, knowing this concept, you should realize that the financial statements will not generate
qualitative, economic and non financial information. At times, this limitation might pose a disadvantage to
the users of the financial statement like the investors, funds managers, suppliers and others.
Illustration No.1:
Say if you are an investor who is interested in purchasing over a company who own a factory. In the
companys financial statement, do you think you are able to see such statistics like consumer price index,
number of loyal customers, industrial output, the factorys productivity ratio, factory staff turnover rate,
number of shift, wastage % , and so on ?
The answer will be no as this concept deals with resources and obligations that can be measured and
quantified into financial terms!
Relevance of
Monetary
measurement
Accountants do not account for items unless they can be quantified in monetary terms. Items
that are not accounted for (unless someone is prepared to pay something for them) include
things like workforce skill, morale, market leadership, brand recognition, quality of
management etc.
C) Countinuity
The COUNTINUITY influences the economic value of assets and in many cases, the values or maturity of
liabilities, especially when the extinction of BODY has determined period, intended or expected.
The observance of the principle of COUNTINUITY is essential to the correct application of the principle of
JURISDICTION the effect of linking directly to quantify the components property & training of the outcome
and to be as important to assess the ability of future generation of result.
These rules, concepts or principles aimed at a uniform accounting treatment & serve as a guide for the
audit to examine the quality of accounting reports. The basic structure of accounting acknowledge the
need to priories these concepts called them of these postulates: Aliceerces, or Pillers basis of accounting
Therefore, the authorities considered a continuing enterprise, operating in continuity.

Based on continuity, the company has major investment, build building, technology purchases, contracts
etc. funding.
The continuity as a basic principle of accounting, contributing remarkably to the monetary valuation of the
assets of the company and consequently thereby generating all other principles of Opportunity,
Registration of the Original value, Update of monetary, Jurisdiction and the of prudence, that they are
intrinsically linked to the entity and its continuity or if it should detect the impossibility of continuing the
venture, the discontinuity through data revealing, evidence, such as in losses, court settlement so.
D) Cost concept :
According to the cost concept of accounting, business transactions should be recorded at cost. The term
cost
means
the
sacrifice
that
one
makes
for
purchase
of
any
goods
or
services.
In addition, it states that cost should the basis of future transactions. It may be noted that depreciation too
is provided on permanent assets on the basis of the cost. Thus the profit/loss made on the sale of the
asset will be calculated on the basis of cost.
E) Accrual
The most commonly used accounting method, which reports income when earned and
expenses when incurred, as opposed to cash basis accounting, which reports income when
received and expenses when paid. Under the accrual method, companies do have some
discretion as to when income and expenses are recognized, but there are rules governing the
recognition. In addition, companies are required to make prudent estimates against revenues
that are recorded but may not be received, called a bad debt expense.
F) Conservatism
With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or
transfer of legal ownership - rather than just when cash actually changes hands. For example, a company that makes
a sale to a customer can recognise that sale when the transaction is legal - at the point of contract. The actual
payment due from the customer may not arise until several weeks (or months) later - if the customer has been
granted some credit terms
g) Materiality:
An important convention. As we can see from the application of accounting standards and accounting policies, the
preparation of accounts involves a high degree of judgement. Where decisions are required about the
appropriateness of a particular accounting judgement, the "materiality" convention suggests that this should only be
an issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is an
important issue for auditors of financial accounts.
h) Consistency:
Transactions and valuation methods are treated the same way from year to year, or period to period. Users of
accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where
accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
J) PERIODICITY
THE PERIODICITY ASSUMPTION: Business activity is fluid. Revenue and expense generating
activities are in constant motion. Just because it is time to turn a page on a calendar does not mean that
all business activity ceases. But, for purposes of measuring performance, it is necessary to "draw a line
in the sand of time." A periodicity assumption is made that business activity can be divided into
measurement intervals, such as months, quarters, and years.
ACCOUNTING IMPLICATIONS: Accounting must divide the continuous business process, and produce
periodic reports. An annual reporting period may follow the calendar year by running from January 1
through December 31. Annual periods are usually further divided into quarterly periods containing activity
for three months.
In the alternative, a fiscal year may be adopted, running from any point of beginning to one year later.
Fiscal years often attempt to follow natural business year cycles, such as in the retail business where a
fiscal year may end on January 31 (allowing all of the Christmas rush, and corresponding returns, to cycle
through). Note in the following illustration that the "2008 Fiscal Year" is so named because it ends in
2008:
You should also consider that internal reports may be

prepared on even more frequent monthly intervals. As a
general rule, the more narrowly defined a reporting period,
the more challenging it becomes to capture and measure
business activity. This results because continuous
business activity must be divided and apportioned among
periods; the more periods, the more likely that "ongoing"
transactions must be allocated to more than one reporting
period. Once a measurement period is adopted, the
accountant's task is to apply the various rules and
procedures of generally accepted accounting principles
(GAAP) to assign revenues and expenses to the reporting
period. This process is called "accrual basis" accounting -accrue means to come about as a natural growth or increase -- thus, accrual basis accounting is
reflective of measuring revenues as earned and expenses as incurred.
The importance of correctly assigning revenues and expenses to time periods is pivotal in the
determination of income. It probably goes without saying that reported income is of great concern to
investors and creditors, and its proper determination is crucial. These measurement issues can become
highly complex. For example, if a software company sells a product for $25,000 (in year 20X1), and
agrees to provide updates at no cost to the customer for 20X2 and 20X3, then how much revenue is
"earned" in 20X1, 20X2, and 20X3? Such questions are vexing, and they make accounting far more
challenging than most realize. At this point, suffice it to say that we would need more information about
the software company to answer their specific question. But, there are several basic rules about revenue
and expense recognition that you should understand, and they will be introduced in the following sections.
Before moving away from the periodicity assumption, and its accounting implications, there is one
important factor for you to note. If accounting did not require periodic measurement, and instead, took
the view that we could report only at the end of a process, measurement would be easy. For example, if
the software company were to report income for the three-year period 20X1 through 20X3, then revenue
of $25,000 would be easy to measure. It is the periodicity assumption that muddies the water. Why not
just wait? Two reasons: first, you might wait a long time for activities to close and become measurable
with certainty, and second, investors cannot wait long periods of time before learning how a business is
doing. Timeliness of data is critical to its relevance for decision making. Therefore, procedures and
assumptions are needed to produce timely data, and that is why the periodicity assumption is put in play.
==================================================================
==============================================================
2. From the Profit and Loss Account of X Limited given below, find out the amount of
funds from operations.
To Salaries
To Printing and
Stationery
To Advertisement
To Depreciation on
Assets
To Discount on Issue of
Shares
To Commission
To Good will written of
To Loss on Sale of
Investment
To Establishment
Expenses
To Provision for Taxation
To Net Profit
To General Reserve
To Proposed Dividend
To Balance c/d
Profit and Loss Account of X Ltd.

For the year ending 31st December, 2010
Rs.
15,000
By Gross Profit b/d
2,000
By Profit on Sales of
8,000
Fixed
15,000
Assets
4,000
By Dividend received
20,000
10,000
3,000
12,000
4,500
15,000
80,000
2,41,500
4,00,000
15,000
75,000
1,96,500
2,86,500
4,00,000
By Balance b/d
By Net Profit for the
year
By Tax Refunds
Solution: - Funds from operation By Direct Method:

Debits
Rs.
3,70.000
Credits
25,000
2,41,500
20,000
2,86,500
To Salaries
To Printing and
Stationery
To Commission
To Establishment
Expenses
To Advertisement
To Funds from
Operation
Rs.
15,000
2,000
By Gross Profit b/d

By Dividend received
Rs.
3,70.000
10,000
3,000
15,000
8,000
3,37,000
3,80,000
3,80,000
2nd method--Funds from operation By using Adjusted Profit & Loss Account method:
Debit
To Depreciation on
Assets
To Discount on Issue of
Shares
To Good will written of
To Loss on Sale of
Investment

Credit
Rs.
15,000
By Funds from
Operations ( Balancing
4,000
figure)
12,000
By Profit on Sales of
Fixed Assets
Rs.
3,70.000
20,000
4,500
To Provision for Taxation
80,000
To Net Profit
2,41,500
3,57,000
________
3,57,000
================================================================
================================================================
3.
What is CVP analysis? Does it differ from break-even analysis?
Solution:
CPV analysis is a system used for checking how changes in the volume of production affect the
costs and thus the profits. It is an expanded form of break-even analysis, which simply identifies the breakeven
point. CVP analysis is somewhat simplified and relies on some assumptions that do not hold in reality, meaning
it is best used for simple "big picture" analysis rather than detailed examination.
Breakeven analysis takes account of the fact that production incurs both fixed and variable costs. Fixed costs
include machinery, factory real estate and, to some extent, marketing. Variable costs include labor and raw
materials; more of these resources are used as more products are made. The break-even point is calculated as
the fixed costs divided by the contribution per unit. The contribution per unit is the price the company sells the
product at, minus the specific variable costs associated with producing that individual unit.
CVP analysis takes its name from cost, volume and profit. The associated analysis plots two lines on a graph
with a horizontal axis that shows the total number of units produced. The two lines represent the total revenue
and the total cost for that number of units. In virtually every case, the revenue line will start out higher than the
cost line, but go up at a steeper angle and eventually narrow the gap before overtaking the cost line and then
widening its lead. This represents increasing sales lowering losses, hitting the breakeven point and then
producing increasing profits.
There are several significant limitations to these figures which result from simplified assumptions in the
process. One obvious one is that it assumes that every unit produced will automatically be sold. This is often
not the case in reality, and the more units that are produced, the greater the risk of being left with unsold stock.
Another problem with CVP analysis is that in reality there is some crossover between fixed and variable costs.
For example, the fixed cost of machinery will increase once it is running at full capacity and production is then
increased. Meanwhile variable costs don't always vary perfectly in line with the volume of production. A
business may be able to increase production without increasing labor costs to the same extent if it is able to
pick up some slack in the staff's workload.
CVP analysis also has the limitation that it fails to account for all the ways figures may vary. The sales price is
treated as a constant, but in the real world, increased sales may entail some buyers getting a bulk discount.
Similarly, the variable cost per unit may not be consistent, for example, if materials can be bought in large
quantities at a lower price.
Difference between CVP Analysis and Break Even Point

I will utilize this fictional company as an example in each of the post below. My fictional company, Henrys Miracle Stomach
Elixer Co, produces and sells stomach elixir next to the Saint Henry River in Escuintla, Guatemala, a very popular tourist
attraction. The bottles are sold to tourists at a stand adjacent to said river at a price of $7 (American dollars). This water is
rumored to cure travelers diarrhea, but only if it is blessed by the local priest, Enrique, who has signed an exclusive contract
with this company. Henry, the companys owner, produces a weekly balance sheet and income statement at the end of each
week. We will utilize the first week of June of 2009 which starts on a Monday.
On the last Friday in May Henry, the companys owner, produces a balance sheet and income statement from the week
before. From this exercise Henry records some facts and numbers that will be useful for the next week;
o
o
o
o
o
o
o
Variable Costs
Decorative Bottles used to store 8 fl ounces of Henrys Miracle Stomach Elixir at a cost of $1 each
Decorative String used to decorate the bottles at a cost of .05 each.
Decorative sticky labels that are put on the bottle at a cost of .05 each
Fine print legal disclaimer stickers bought from Henrys brother, Heinz, the town lawyer at a cost of .75 each.
Bottles of American bottled water at a cost of .50 each purchased from the town import export expert, Harry.
Tablets of Loperamide (Imodium) to be dissolved in water at .25 each. Purchased from the town doctor, Enrico.
Fixed Costs
$10 a week. Rent for souvenir stand spot in between the public water fountain and the very
popular Taco Grande stand.
Raw Materials Beginning Inventory and Cost
1000 decorative bottles
1000 decorative strings
1000 decorative sticky labels
1000 fine print legal disclaimer stickers
1000 bottles of American bottled water
There is never work in process inventory.
Henry buys new raw materials on the 15th of each month
Direct Labor Costs

o
Henrietta, Henrys wife, assembles the bottles at .25 cents per bottle.
Enrique, Henrys son and also the town priest gets paid .25 cents per
Indirect Labor Costs
blessing of one bottle.
Harriet , Henrys daughter gets paid 10.00 a week salary to clean

up the assembly work space
Finished Goods Inventory
100 bottles at a cost of $2.60 (direct materials and direct

labor) each.
The companys salesman Heinrick gets paid a

commission of .25 a bottle and no salary.
It was midnight on Friday and Henry could not sleep. After reviewing his favorite blogs he stumbled upon a site that covered
variable vs. fixed costs, cost-volume profit (CVP) relationships and break even analysis. These concepts interested Henry
because he was never sure what his profit would be until the end of the week.
Being the curious businessman he is, Henry
decided to see how all of this relates to his Miracle Stomach Elixir business. Henry was familiar with the concept of variable
vs. fixed costs. His weekly summary always broke down costs by variable vs. fixed. Variable costs are costs that vary, in
total, in proportion to the changes in levels of activity. All of Henrys direct materials and direct labor costs were variable
costs. Fixed costs are costs that remain constant in total within the relevant range. Henrys weekly rent and daughters
salary were fixed expenses. In order to get started in applying CVP Henry had to first create a Contribution Margin Income
Statement. The Contribution Margin Income Statement tells managers what their contribution margin is. The contribution
margin is the difference between total sales and total variable expenses. This amount is used to cover fixed expenses and
what is left over is net operating income. Once you have the contribution margin you are able to calculate your breakeven
point. The breakeven point is the point at which profit is equal to 0. It is the point where the contribution margin covers your
fixed expenses. Below is Henrys Contribution Margin Income statement:
Contribution Margin Income Statement (1

Week)
TOTAL
Sales (200 bottles at $7 per unit)
PER UNIT
1,400.00
7.00
705.00
3.53
695.00
3.48
Salary)
(20.00)
Net Operating Income
675.00
Goods Available For Sale
1,055.00
(less)Ending Inventory
(390.00)
Variable Cost of Goods Sold
665.00
(10.00)
50.00
Adjust Cost of Goods Sold (minus Harriets fixed

salary)
Variable Selling and Admin Expenses (Heinricks
Commission)
Contribution Margin
Fixed Expenses (Rent and Harriets
From here Henry can determine his breakeven point by using the following formula;
(Break Even Point in Units = Fixed expenses/Contribution margin)
(Breakeven point in Units sold=20/3.48=5.7 units (6 Units)
Henry must sell six units a week in order to break even. In order to determine Henrys breakeven point in total sales dollars
Henry must first calculate the companys contribution margin ratio using the following formula;
(CM Ratio=Contribution margin/ total sales)
(CM Ratio = 695/1400=49.6%).
Henry can utilize the CM ratio to calculate the breakeven point in sales dollars by using the following formula;
(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)
(Breakeven point in sales dollars=20/49.6%=$40.32)
Henry must make 40.32 a week in order to break even.
At this point Henry can also play what if games like how many units he has to sell to profit $1000 a week or what would
happen if he wanted to rent an elixir bottle dispenser, at $25 a week, to be placed across town next Montezumas Revenge
Chili dogs.
In order to figure out how many units he has to sell in order to attain $1000 a week Henry must use the following formula;
(Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution margin) (Unit Sales to attain
target profit = (20+1000/3.48) =294 units
Henry must sell 294 units in order to make $1000 a week.
In order to calculate the Dollar sales to attain target profit Henry should use the following formula;
(Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)
(Dollar Sales to attain target profit = (20+1000/46.9%)=$2174.84
If Henry were to rent the elixir bottle dispenser at $25 a week he would need to increase the fixed expenses variables in the
calculations above by $25.
(Break Even Point in Units with elixir dispensing machine = Fixed expenses/Contribution margin)
(Breakeven point in Units sold with elixir dispensing machine =45/3.48=12.93 units (13 Units)
(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)

(Breakeven point in sales dollars=45/49.6%=$90.73)
(Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution margin) (Unit Sales to
attain target profit = (45+1000/3.48) =301 units
(Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)
(Dollar Sales to attain target profit = (45+1000/46.9%)=$2228.15
Henrys current weekly unit sales were 200 units. Henry predicts that the elixir dispensing machine would be able to sell at
least 120 more units. This would have him selling 320 units a week which would earn him $66.12 (3.48 * 19) more than the
target $1000 dollars a week. Henry decided to rent the elixir machine.
The above examples demonstrate the power of CVP analysis. Utilizing CVP analysis Henry was able to take make informed
decisions for his business.
================================================================
================================================================
4. S Limited is considering for purchase of a machine. There are two possible
machines which will produce the additional output. Details of these machines are as
follows:
Capital Cost
Sales at standard
Machine x
Rs.
60,000
1,00,000
Machine Y
Rs.
60,000
80,000
Price
Costs:
Labour
Materials
Factory Overheads
Administration Cost
Selling Costs
Expected life in years
10,000
8,000
12,000
4,000
2,000
2
6,000
10,000
10,000
2,000
2,000
3
Other Information:
(a) The costs shown above relate to annual expenditure resulting from each
machine. Sales
are expected to continue at the rates shown for each year for the full life of each
machine;
(b) Tax to be paid may be assumed at 50% of net earnings;
(c) Interest on capital is to be ignored;
(d) The appropriate rate of interest for converting to present value may be taken at
10%.
On the basis of the facts given above, show the most profitable investment by the
following methods.
(i)
(ii)
(iii)
Pay-back Period,
Return on Investment; and
Net Present Value on Investment.
Solution: Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able
to decide whether an investment is worth undertaking and be able to choose intelligently between two or
more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed.
This procedure is called capital budgeting.
A. THE PROCESS OF PROJECT EVALUATION
(Suggestions by R. Bruner)
1.
2.
3.
4.
Carefully estimate expected future cash flows.

Select a discount rate consistent with the risk of those future cash flows.
Compute a base-case NPV.
Identify risks and uncertainties. Run a sensitivity analysis.
Identify key value drivers.
Identify break-even assumptions.
Estimate scenario values.
Bound the range of value.
5. Identify qualitative issues.:Flexibility,Quality,Know-how & Learning

6. Decide
II. Basic Steps of Capital Budgeting
1. Estimate the cash flows
2. Assess the riskiness of the cash flows.
3. Determine the appropriate discount rate.
4. Find the PV of the expected cash flows.
5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy
Definitions: Independent versus mutually exclusive projects.
Normal versus nonnormal projects.
Basic Data
Expected Net Cash Flow

Project L
Year
0
($100)
Project S
($100)
10
70
60
50
80
20
III. Evaluation Techniques

A. Payback period
B. Net present value (NPV)
C. Internal rate of return (IRR)
D. Modified internal rate of return (MIRR)
E. Profitability index
A. PAYBACK PERIOD
Payback period = Expected number of years required to recover a projects cost.
Project L
Expected Net Cash Flow
Project L
Year
0
Project S
($100)
($100)
10
(90)
60
(30)
80
50
PaybackL = 2 + $30/$80 years
= 2.4 years.
PaybackS = 1.6 years.

Weaknesses of Payback:
1.Ignores the time value of money. This weakness is eliminated with the discounted payback method.
2. Ignores cash flows occurring after the payback period.
B. NET PRESENT VALUE
CFt
n
NPV
t 0 (1 k) t
Project L:
0
100.00
10
60
80
9.09
49.59
60.11
NPVL = $ 18.79
NPVS = $19.98
If the projects are independent, accept both.
If the projects are mutually exclusive, accept Project S since NPVS > NPVL.
Note: NPV declines as k increases, and NPV rises as k decreases.
C. INTERNAL RATE OF RETURN
IRR :
Project L: 0
100.00
10
8.47 18.1%
43.02
48.57
CFt
n
$0 NPV .
t
t 0 1 IRR
2
60
3
80
18.1%
18.1%
$ 0.06 $0
IRRL = 18.1%
IRRS = 23.6%
If the projects are independent, accept both because IRR > k.
If the projects are mutually exclusive, accept Project S since IRR S > IRRL.
Note: IRR is independent of the cost of capital.
1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, in practice, the IRR method is more popular than the NPV
approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the
time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it
does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of
money.
The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the
cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should
immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that
a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy
indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply
speaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for
reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.
Another problem with the IRR method is that it may give different rates of return. Suppose there are
two discount rates (two IRRs) that make the present value equal to the initial investment. In this case,
which rate should be used for comparison with the cutoff rate? The purpose of this question is not to
resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method,
despite its popularity in the business world, entails more problems than a practitioner may think.
2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS:
When comparing two projects, the use of the NPV and the IRR methods may give different results. A
project selected according to the NPV may be rejected if the IRR method is used.
Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500.
Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of
$100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trial
and error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is
around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR
of Project Y. But what happens to your decision if the NPV method is used? The answer is that the
decision will change depending on the discount rate you use. For instance, at a 5% discount rate, Project
Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher
NPV.
The purpose of this numerical example is to illustrate an important distinction: The use of the IRR
always leads to the selection of the same project, whereas project selection using the NPV method
depends on the discount rate chosen.
PROJECT SIZE AND LIFE

There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the project
being studied are the most common ones. A 10-year project with an initial investment of $100,000 can
hardly be compared with a small 3-year project costing $10,000. Actually, the large project could be
thought of as ten small projects. So if you insist on using the IRR and the NPV methods to compare a
big, long-term project with a small, short-term project, dont be surprised if you get different selection
results. (See the equivalent annual annuity discussed later for a good way to compare projects with
unequal lives.)
DIFFERENT CASH FLOWS
Furthermore, even two projects of the same length may have different patterns of cash flow. The cash
flow of one project may continuously increase over time, while the cash flows of the other project may
increase, decrease, stop, or become negative. These two projects have completely different forms of
cash flow, and if the discount rate is changed when using the NPV approach, the result will probably be
different orders of ranking. For example, at 10% the NPV of Project A may be higher than that of Project
B. As soon as you change the discount rate to 15%, Project B may be more attractive.
WHEN ARE THE NPV AND IRR RELIABLE?

Generally speaking, you can use and rely on both the NPV and the IRR if two conditions are met.
First, if projects are compared using the NPV, a discount rate that fairly reflects the risk of each
project should be chosen. There is no problem if two projects are discounted at two different rates
because one project is riskier than the other. Remember that the result of the NPV is as reliable as
the discount rate that is chosen. If the discount rate is unrealistic, the decision to accept or reject the
project is baseless and unreliable. Second, if the IRR method is used, the project must not be
accepted only because its IRR is very high. Management must ask whether such an impressive IRR
is possible to maintain. In other words, management should look into past records, and existing and
future business, to see whether an opportunity to reinvest cash flows at such a high IRR really exists.
If the firm is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the project
must be reevaluated by the NPV method, using a more realistic discount rate.
D. Modified IRR (MIRR)
The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses of
the IRR. The MIRR correctly assumes reinvestment at the projects cost of capital and avoids the
problem of multiple IRRs. However, please note that the MIRR is not used as widely as the IRR in
practice.
There are 3 basic steps of the MIRR:
(1) Estimate all cash flows as in IRR.
(2) Calculate the future value of all cash inflows at the last year of the projects life.
(3) Determine the discount rate that causes the future value of all cash inflows determined in step 2,
to be equal to the firms investment at time zero. This discount rate is know as the MIRR.
Project L:
10%
10
60
66.00
80.00
-100.00
MIRR = 16.5%
100.00
12.10
$158.10 = TV of inflows
$ 0.00 = NPV
PV outflows
= $100
TV inflows
= $158.10.
PVcosts =
TV
1 MIRR n
MIRRs =16.9%
MIRR is better than IRR because

1.
MIRR correctly assumes reinvestment at projects cost of capital.
2.
MIRR avoids the problem of multiple IRRs.
IV.
PROJECT DECISION ANALYSIS
B. MAKING GO/NO-GO PROJECT DECISION(Suggestions by R. Bruner)
Virtually all general managers face capital-budgeting decisions in the course of their careers.
The most common of these is the simple yes versus no choice about a capital investment.
The following are some general guidelines to orient the decision maker in these situations.
1. Focus on cash flows, not profits. One wants to get as close as possible to the economic
reality of the project. Accounting profits contain many kinds of economic fiction. Flows of
cash, on the other hand, are economic facts.
2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge
whether the firm will be better off or worse off if it undertakes the project. Thus one wants to
focus on the changes in cash flows effected by the project. The analysis may require some
careful thought: a project decision identified as a simple go/no-go question may hide a
subtle substitution or choice among alternatives. For instance, a proposal to invest in an
automated machine should trigger many questions: Will the machine expand capacity (and
thus permit us to exploit demand beyond our current limits)? Will the machine reduce costs
(at the current level of demand) and thus permit us to operate more efficiently than before
we had the machine? Will the machine create other benefits (e.g., higher quality, more
operational flexibility)? The key economic question asked of project proposals should be,
How will things change (i.e., be better or worse) if we undertake the project?
3. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use
NPV as the technique to summarize the quantitative attractiveness of the project. Quite
simply, NPV can be interpreted as the amount by which the market value of the firms equity
will change as a result of undertaking the project.
4. Account for risk. Not all projects present the same level or risk. One wants to be
compensated with a higher return for taking more risk. The way to control for variations in
risk from project to project is to use a discount rate to value a flow of cash that is consistent
with the risk of that flow.
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5. What is working capital? Explain the importance of working capital management and
discuss about the determinants of working capital requirement.
Solution:
Working capital is a measurement of an entitys current assets, after subtracting its liabilities.
Sometimes referred to as operating capital, it is a valuation of the amount of liquidity a business or organization
has for the running and building of the business. Generally speaking, companies with higher amounts of
working capital are better positioned for success. They have the liquid assets needed to expand their business
operations as desired.
Sometimes, a company will have a large amount of assets, but have very little with which to build the business
and improve processes. Even a profitable company may have this problem. This can occur when a company
has assets that are not easy to convert into cash.
Working capital can be expressed as a positive or negative number. When a company has more debts than
current assets, it has negative working capital. When current assets outweigh debts, a company has positive
working capital.
Changes in working capital will impact a business cash flow. When working capital increases, the effect on
cash flow is negative. This is often caused by the liquidation of inventory or the drawing of money from
accounts that are due to be paid by the business. On the other hand, a decrease in working capital translates
into less money to settle short-term debts.
Working capital is among the many important things that contribute to the success of a business. Without it, a
business may cease to function properly or at all. Not only does a lack of working capital render a company
unable to build and grow, but it may also leave a company with too little cash to pay its short-term obligations.
Simply put, a company with a very low amount of working capital may be at risk of running out of money.
When a company has too little working capital, it can face financial difficulties and may even be forced toward
bankruptcy. This is true of both very small companies and billion-dollar organizations. A company with this
problem may pay creditors late or even skip payments. It may borrow money in an attempt to remain afloat. If
late payments have affected the companys credit rating, it may have difficulty obtaining a loan at an affordable
interest rate.
In some types of businesses, it isnt as much of a problem to have a lower amount of working capital.
Companies that are operated on as cash basis, have fast inventory turnovers, and can generate cash quickly
dont necessarily need as much working capital. For example, a grocery store might meet these requirements
and do well with less working capital.
Accounting Formula to Determine a Business Working Capital:
Current Assets - Current Liabilities = Working Capital
Working capital can be reflected as a positive or negative number depending on how much debt the business is carrying.
Where Does Working Capital Come From:
From an accounting standpoint, working capital comes from:
Net income;
Long-term loans (non-current liabilities);
Sale of capital (non-current) assets; and
Funds contributed by the owners and investors (stockholders).
Working Capital is Required to Start and Grow a Business
When you first start a business you need start-up working capital since the business is not yet making money to sustain itself. The
number one reason most businesses fail during their first two years of operation is due to a lack of working capital.
Having ample working capital not only helps you to meet your obligations, it is vital to growing your business.
Working capital is the money you need to cover business expenses, meet short-term obligations, and to grow your business. Startup capital is the money you need to start a business until it generates enough revenue to pay for itself. Start-up and working capital
can come from loans, grants, investors and partners, but many business women use their personal financial resources to fund their
businesses.
Importance of working capital
The term working capital refers to the amount of capital which is readily available to a company.
That is, working capital is the difference between resources in cash or readily convertible into
cash (Current Assets) and organisational commitments for which cash will soon be required
(Current Liabilities).
Current Assets are resources which are in cash or will soon be converted into cash in "the
ordinary course of business".
Current Liabilities are commitments which will soon require cash settlement in "the ordinary
course of business".
Thus:
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
In a company's balance sheet components of working capital are reported under the following
headings:
Current Assets:
Liquid Assets (cash and bank deposits)
Inventory
Debtors and Receivables
Current Liabilities:
Bank Overdraft
Creditors and Payables
Other Short Term Liabilities
The Importance of Good Working Capital Management:
From a company's point of view, excess working capital means operating inefficiencies. Money
that is tied up in inventory or money that customers still owe to the company cannot be used to
pay off any of the company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will show up as an increase in the working capital. This can be seen
by comparing the working capital from one period to another; slow collection may signal an
underlying problem in the company's operations.
Approaches to Working Capital Management
The objective of working capital management is to maintain the optimum balance of each of the
working capital components. This includes making sure that funds are held as cash in bank
deposits for as long as and in the largest amounts possible, thereby maximising the interest
earned. However, such cash may more appropriately be "invested" in other assets or in
reducing other liabilities.
Working capital management takes place on two levels:
* Ratio analysis can be used to monitor overall trends in working capital and to identify areas
requiring closer management

* The individual components of working capital can be effectively managed by using various
techniques and strategies
When considering these techniques and strategies, companies need to recognise that each
department has a unique mix of working capital components. The emphasis that needs to be
placed on each component varies according to department. For example, some departments
have significant inventory levels; others have little if any inventory.
Furthermore, working capital management is not an end in itself. It is an integral part of the
department's overall management. The needs of efficient working capital management must be
considered in relation to other aspects of the department's financial and non-financial
performance.
In working capital, the main types of cash inflow and outflow in a typical business:
Outflows
Inflows
Purchasing finished goods for re-sale
Cash sales to customers
Purchasing raw materials and other

components needed for the manufacturing
of the final product
Receipts from customers who were allowed

to buy on credit (trade debtors)
Paying salaries and wages and other

operating expenses
Interest on bank and other balances
Purchasing fixed assets
Proceeds from sale of fixed assets
Paying the interest on, or repayment of

loans
Investment by shareholders
Paying taxes
Cash flow can be described as a cycle:
The business uses cash to acquire resources (assets such as stocks)

The resources are put to work and goods and services produced. These are then sold to customers
Some customers pay in cash (great), but others ask for time to pay. Eventually they pay and these funds are used
to settle any liabilities of the business (e.g. pay suppliers)
And so the cycle repeats
ully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not
sarily, and if management dont carefully monitor cash flow and take corrective action when necessary, a business
may find itself sinking into trouble.
The cash needed to make the cycle above work effectively is known as working capital.
Working capital is the cash needed to pay for the day to day operations of the business.
In other words, working capital is needed by the business to:
Pay suppliers and other creditors

Pay employees
Pay for stocks
Allow for customers who are allowed to buy now, but pay later (so-called trade debtors)
s crucially important, therefore, is that a business actively manages working capital. It is the timing of cash flows
ch can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not
necessarily mean that there is cash coming into and out of the business.
There are many advantages to a business that actively manages its cash flow:
It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact
It can plan ahead with more confidence. Management are in better control of the business and can make informed
decisions for future development and expansion
It can reduce its dependence on the bank and save interest charges
It can identify surpluses which can be invested to earn interest
Determinants of Working Capital

The level of working capital is influenced by many factors. They are:
1.Nature of Business :This is one of the main factors. Usually in trading businesses the working capital
needs are higher as most of their investment is concentrated in stock or inventory. Manufacturing
businesses also need a good amount of working capital to meet their production requirements. Whereas,
those companies that sell services and not goods, on a cash basis require least working capital because
there is no requirement on their part to maintain heavy inventories.
2. Size of Business :Size of business is another influencing factor. As size increases, the working capital
requirement is also more and vice versa.
1. Credit Terms / Credit Policy :Credit terms greatly influence working capital needs. If terms are:
i.
ii.
iii.
iv.
buy on credit and sell by cash, working capital is lower

buy on credit and sell on credit, working capital is medium
buy on cash and sell on cash, working capital is medium
buy on cash and sell on credit, working capital is higher.
Prevailing trade practices and changing economic condition do generally exert greater influence
on the credit policy of concern.
e.
A liberal credit policy if adopted more trade debtors would result and when the same is
tightened, size of debtors gets slim.
f. Credit periods also influence the size and composition of working capital. When longer
credit period is allowed to debtors as against the one extended to the firm by its creditors,
more working capital is needed and vice versa.
g. Collection policy is another influencing factor. A stringent collection policy might not
only deter away some credit customers, but also force the existing customers to be
prompt in settling dues resulting in lower level of working capital. The opposite holds well
with a liberal collection policy.
h. Collection procedure also influences the working capital needs. A decentralized
collection of dues from customers and centralized payments to suppliers shall reduce the
size of working capital. Centralized collections and centralized payments would lead to
moderate level of working capital. But with centralized collections and decentralized
payments, the working capital need would be the highest.
2. Seasonality
Seasonality of Production :Agriculture and food processing and preservation industries have a
seasonal production. During seasons, when production activities are in their peak, working capital need is
high.
a)Seasonality in supply of raw materials :This also affects the size of working capital. Industries that
use raw materials which are available during seasons only, have to buy and stock those raw materials.
They cannot afford to buy these items in a phased way, since either supplies would get reduced or prices
would be higher. Also, from the point of view of quality of raw materials, it pays to buy in bulk during the
seasons. Hence the high level of working capital needed when season exists for raw materials.
b)Seasonality of demand for finished goods :In case of products like umbrella, rain-coats and other
seasonal items, the demand is high during peak seasons. But the production of these items has to be
continuous throughout the year to meet the high demand during peak seasons. Thus, working capital
requirement would be higher.
3.Trade Cycle :Trade cycle refers to the periodic turns in business opportunities from extremely peak
levels, via a slackening to extremely tough levels and from there, via a recovery phase to peak levels,
thus completing a business cycle. There are 4 phases of trade cycle.
.
Boom Period more business, more production, more working capital.

a. Depression period less business, less production, less working capital.
b. Recession period slackening business, stock pile-up, more working capital.
c. Recovery period recouping business, stock speedily converts to sales, less working
capital.
4)Inflation: Under inflationary conditions generally working capital increases, since with rising prices
demand reduces resulting in stock pile-up and consequent increase in working capital.
5)Production cycle :The time lapse between feeding of raw material into the machine and obtaining the
finished goods out from the machine is what is described as the length of manufacturing process. It is
otherwise known as conversion time. Longer this time period, higher is the volume and value of work-inprogress and hence higher the requirement of working capital and vice versa.
6)System of Production process :If capital intensive, high-technology automated system is adopted for
production, more investment in fixed assets and less investment in current assets are involved. Also, the
conversion time is likely to be lower, resulting in further drop in the level of working capital. On the other
hand, if labor intensive technology is adopted, less investment in fixed assets and more investment in
current assets which would lead to higher requirement of working capital.
7)Growth and expansion plans :Growth and expansion industries need more working capital than those
that are static.
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IGNOU MBA MS - 04 Solved Assignments July 2011

Accounting and Finance for Managers

1. Discuss and explain the relevance of the following accounting concepts

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MONEY MEASUREMENT CONCEPT

Only financial transactions are recorded

Non-financial data are ignored

Qualitative information are ignored

This concept ignores important economic information

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Therefore, the authorities considered a continuing enterprise, operating in continuity.

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You should also consider that internal reports may be

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Profit and Loss Account of X Ltd.

Solution: - Funds from operation By Direct Method:

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By Gross Profit b/d

Profit and Loss Account of X Ltd.

To Provision for Taxation

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What is CVP analysis? Does it differ from break-even analysis?

Difference between CVP Analysis and Break Even Point

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Raw Materials Beginning Inventory and Cost

1000 decorative bottles

1000 decorative strings

1000 decorative sticky labels

1000 fine print legal disclaimer stickers

1000 bottles of American bottled water

There is never work in process inventory.

Henry buys new raw materials on the 15th of each month

Direct Labor Costs

Indirect Labor Costs

blessing of one bottle.

Harriet , Henrys daughter gets paid 10.00 a week salary to clean

Finished Goods Inventory

100 bottles at a cost of $2.60 (direct materials and direct

The companys salesman Heinrick gets paid a

Being the curious businessman he is, Henry

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Contribution Margin Income Statement (1

Sales (200 bottles at $7 per unit)

Net Operating Income

Goods Available For Sale

Variable Cost of Goods Sold

Adjust Cost of Goods Sold (minus Harriets fixed

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(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)

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Carefully estimate expected future cash flows.

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5. Identify qualitative issues.:Flexibility,Quality,Know-how & Learning

Expected Net Cash Flow

III. Evaluation Techniques

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PaybackL = 2 + $30/$80 years

PaybackS = 1.6 years.

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1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV