Chapter 3 : Economic Analysis of Investment Alternatives

Q. 1. Name the Different Methods of Capital Budgeting.

Ans. There are several methods by which the profitability of an investment can be measured. They can be classified as 1. Non-discounted cash flow methods. 2. Discounted cash flow methods. Non-discounted cash flow methods are following (i) Average rate of return (ARR) or accounting rate of return. (ii) Average additional return on investment. (iii) Payback method. Discounted cash flow methods are following (i) Net present value method. (ii) Internal rate of return method.

(iii) Profitability index.

Q. 2. Describe Average Rate of Return (ARR).

Ans. The average rate of return or the accounting rate of return represents the ratio of the average annual net income to the ratio of the average net income to the average or original investment over the life of the project expressed as a percentage This is not based upon cash flow but upon the estimated accounting income It can be calculated by using the following formula :

Merits of Average Rate of Return: 1. It is simple and easy to understand and makes use of readily available accounting information. 2. It takes into account the total earnings from the project during its entire economic life. 3. It gives due weight to the profitability of the project.

4. It gives reliable results when it is intended to measure the current performance of a firm. Demerits of Average Rate of Return: 1. It ignores time value of the money which is very crucial in business decisions, it gives equal weight to current and distinct decisions. 2. It is based upon accounting income rather than cash flows. 3. it doesnt take into consideration the impact of various factors on the overall profits of the firms. 4. It does not determine the fair rate of return on investments. Average Additional Return on Investment This method expresses the ratio of the average additional profits after taxes to the average investment in the projects. Average rate of additional profit is calculated as follows:

where, (i) The average annual profits represents the difference between the average annual profits

resulting from the sale of output produced by the new machine and those produced by the old machine which is proposed to be replaced. (ii) The average investment is taken as half of the depreciable cost of the proposed plant plus residual value, if any.

Q. 3. Describe Net Present Value Method.

Ans. Net Present Value Method : The net present value method, also known as excess present value or net gain method, in a discounted cash flow technique in which all cash inflows are discounted to their present value using the required rate of return and from the summation the initial cost of the project is substracted. If the net present value of the expected cash inflows is positive, i.e. it exceeds the initial cost of the project, the project should be accepted, if negative it should be rejected. Mathematically the method can be expressed as follows :

Where, r represents values of the net cash inflows C, C2, ,,, C represents stream of net cash inflows after tax but before depreciation r is the required rate of return 1,2, n are number of years. Merits of Net Present Value Method 1. It recognises the time value of money. 2. It considers all cash flows over the entire life of the project. 3. It aims at maximizing the welfare of the owners of the organization. Demerits 1. It is difficult to use. 2. It assumes that discount rate which is usually the firms cost of capital is known. 3. It may not give satisfactory answer when projects involving different amount of investment are compared.

Q. 4. Describe Internal Rate of Return.

Ans. This method is popularly known as time adjusted rate of return or discounted rate of return. The internal rate of return is discount or interest rate that equates the present value of expected future receipts to the initial cost of investment. This set the maximum rate of interest which could be paid for the capital employed over the life of an investment without any loss on the project. The internal rate of return can be symbolically expressed as follows :

Where, A1, A2, A represent expected future receipts at lime 1, 2 and so on. r is internal rate of return which has to be interpolated A0 is initial outlay at time 0. According to IRR method, a project is accepted if its internal rate of return is higher than or equal to

the minimum required rate of return (i.e. r k) and the project is rejected if r > k.

Q. 5. Explain the Merits of Internal Rate of Return Method.

Ans. 1. Like the NPV method, it considers the time value of money. 2. It considers cash flow over the entire life. 3. it has psychological appeal to the users. Demerits : 1. It is difficult to understand and use in practice. 2. It may yield results inconsistent with NPV method if the projects differ in their expected lives or cash outlays. 3. It may not give unique answers in all situations.

Q. 6. What is Profitability Index?

Ans. Profitability Index: The profitability index, also known as benefit. Cost ratio of a capital expenditure is the present value of expected net cash over the initial cost. The index expresses the percentage relationship between cash inflows and the amount of the investment is shown below:

The higher the profitability index, the more desirable is the investment. The project is accepted when B/C ratio is greater than one and rejected when it is less than one. For any project having no alternative projects, the net present value method and profitability index give the same accept reject signals. But, if we have to select an investment opportunity from competing proposals, the net present value method should be preferred because it gives us the expected contribution of the project in absolute terms. In such cases, the profitability index is not recommended because it expresses only relative profitability,

Q. 7. Define Present Worth Method.

Ans. Present Worth Method on The prsent worth of Investment Alternative j can be represented as:

The present worth method is the most popular measure of merit available. When it is used in next chapters to compare alternatives, the one having the greatest present worth is the alternative recommended.

Q. 8. Describe Payback Method.

Ans. Also known pay offpay out recoupment period method, this method gives the number of years in which the total investment in a particular pays back itself. This is based on the assumption

that every capital expenditure pays itself back over a number of years. Investment generates income and when the total earnings (or net cash inflows) from such investment equals the total outlay (cash out flows), that period is the pay back period of the capital investment. An investment project is accepted if it pays back within a specified or predetermined period of time. While there is comparison between two or more projects, the one with the shortest pay back will be acceptable because of smallest risk of obsolescence and greater liquidity. The pay back period is calculated by dividing the cost of fixed as set or the value which is sought to be recovered by the relevant annual cash inflows by saving or additional earnings after tax but before depreciation per year. The formula is

This formula is applicable if the savings or net cash inflow occurs at an even rate. But if the annual cash inflows are uneven, then the calculation of pay back takes a cumulative form. Suppose the cost of the investment i.e. Rs. 50,000 and the annual savings in cost of additional earnings are Rs. 10,000 in the first year Rs. 14,000 in second

year. Rs. 16,000 in the third year and Rs. 20,000 in the fourth year so on. In the first three years Rs. 40,000 (Rs. 10,000 + Rs. 16,000) of the original investment will be recovered and the balance of the investment Rs. 10,000 (Rs. 50,000 Rs. 40,000) will be recovered in the first half of the fourth year. Thus pay backperiod in this case will be 3.5 years. Merits of Payback Period: 1. It is easy to understand, compute and communicate to others. 2. It gives importance to the speedy recovery of the initial investment in capital assets. 3. It is an adequate measure for firms with very profitable internal investment opportunities, whose source of funds and limited by internal low availability and external high costs. Demerits: 1. It treats each asset individually in isolation with the others which is improper. 2. This method is delicate and rigid. A slight change in the division of labour will affect the earnings and consequently decisions.

3. It overplays the importance of liquidity as a goal of capital expenditure decisions. 4. It restricts capital wastage and economic life by restricting considerations on the project gross earnings. 5. It ignores the earnings beyond the pay back period while in many cases are substantial.

Q. 9. What are the Different Methods of Measuring Investment Worth Decisions.

Ans. 1. Present worth method (PW). 2. Annual worth method (AW). 3. Future worth method (FW). 4. Interest rate of return method (IRR). 5. External rate of return method (ERR). 6. Saving / investment ratio method (SIR). 7. Payback period method (PBP). 8. Capitalized worth method (CW).

Each of the above measures of merit of measures of effectiveness has been used numerous times in evaluating real-worth investments. They may be described briefly as follows 1. Present worth method coverts all cash flows to a single sum equivalent at time zero using i = MARR. 2. Annual worth method converts all cash flows to an equivalent uniform annual series of cash flows over the planning horizon using i = MARR. 3. Future worth method converts all cash flows to a single sum equivalent at the end of the planning horizon using i MARR. 4. Interest rate of return method determine the interest rate that yield a future worth (or present worth of annual worth) of zero, implicitly assuming reinvestment of recovered funds at the IRR. 5. External rate of return method determines the interest rate that yield a future worth of zero, explicitly assuming reinvestment of recovered funds at the MARR.

6. Savings / investment ratio method determines the ratio, of the present worth of savings to the present worth of the investment. 7. Payback period method determines how long at a zero interest rate it will take to recover the initial investment. 8. Capitalized worth method determines the single sum at time zero that is equivalent at i = MARR to a cash flow pattern that continues indefinitely. With the exception of the payback period and capitalized worth method all of the measures listed are equivalent method of measuring investment worth, Hence, applying each of the first six measure of merit to the same investment alternative will yield the same recommendation. Since the present worth, annual worth, future worth, interest rate of return, external rate of return, and savings / investment ratio method are equivalent, why more than one of the method exist ? The primary reason for having different, but equivalent measures of effectiveness for economic alternatives appears to be the difference in preferences among managers. Some individuals (and firms) prefer to express the net economic worth of an investment alternative as a single sum amount; hence, either the present worth method or the future worth method is used. Other

individuals prefer to see the net economic worth spread out uniformly over the planning horizon, so the annual worth method is used by them. Yet another group of individuals wishes to express the net economic worth as a rate of percentage; consequently, one of the rate-of- return methods would be preferred. Finally, some individuals prefer to see the net economic worth expressed as a percentage of the investment required; the savings/ investment ratio is one method of providing such information. Since many organizations have established procedures for performing economic analyses, it seems worthwhile to consider in this chapter and more popular measures of merit that are used. Among those listed, it appears that the present worth, rate-of-return, and payback period method sare currently the most popular However, the worth method U.S. Postal Service and a number of governmental agencies have adopted some version of the savings / investment (or benefit / cost) ratio method for purposes of comparing investment alternatives; hence it is popular in some sectors.

Q. 10. Explain the Relationship of Economy Studies and Accounting.

Ans. Engineering economy studies are made for the purpose of determining whether capital should be invested in a project or whether it should be utilized in a different manner than it presently is being used. Economy studies always deal, at least for one of the alternatives being considered with something that currently is not being done. Economy studies thus provide information upon which investment and managerial decisions about future operations can be based. Thus the engineering economic analyst be termed an alternatives fortune-teller. After a decision to invest capital in a project has been made and capital has been invested, those who supply and manage the capital want to know the financial results. Therefore, procedures are established so that financial events relating to the investment can be recorded and summarized and financial productivity determined . At the same time, though the use of proper financial information, controls can be established and utilized to aid in guiding the venture toward the desired financial goals. General accounting arid cost accounting are the procedures that provide

these necessary services in a business organization. Accounting studies thus are concerned with past a and current financial-events. Thus the accountant might be termed a financial historian. The accountant is some what like a data recorder in a scientific experiment. Such a recorder reads the pertinent gauges and meters and records all the essential data during t course of an experiment. Form these it is possible to determine the result of the experiment and to prepare a report. Similarly, the accountant records all significant financial events connected with an investment, and from these data he or she can determine what the results have been and can prepare financial reports. Just as an engineering can, by taking cognizance of what is happening during the course of an experiment and making suitable corrections, gain more information and better, results from the experiment, managers must also relay on accounting reports to make corrective decisions in order to improve the current and future financial performance of the business. Accounting is generally a source,of much of the past financial data that are needed in making estimates of future fiTiancial conditions. Accounting is also a prime source of data for postmortem, or after-the-face, analysis that might be

made regarding, how well an investment project has turned out compared to the results that were predicted in the economy study. A proper understanding of the origins and meaning of accounting data is needed in order to properly use or not use that data in making projections into the future and in comparing actual versus predicted results.

Q. 11. What is the Criteria of Project Evaluation ?

Ans. 1. Carefully estimate expected future cash flows. 2. Select a discount rate consistent with the risk of those future cash flows. 3. Compute a base-case NPV. 4. 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. Final Decision.

Q. 12 What is Modified IRR (MIRM)?

Ans. 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 three basic steps of the MIRR:

(1) Estimate all cash flows 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.

Q. 13. NPV as IRR Methods.

Ans. Key differences between the most popular methods, the NPV ( NeT Present Value) method and IRR (Internal Rate of Return) method, include : NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV method is preferred over other methods since it calculates additional wealth and the IRR method does not;

 The IRR method can be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later outflow, such as may be required in the case of land reclamation by a mining firm); However, the IRR method does not have one significant advantage managers tend to better understand the concept of returns stated in percentage and find it easy to compare to the required cost of capital; and finally, While both the NPV method and the IRR method are both DCE models and can even reach similar conclusions about a single project, the use of the IRR method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a large project that will generate more cash. Applying NPV using different discount rates will result in, different recommendations. The IRR method always gives the same recommendation.

Q. 14. When are the NPV and IRR Reliable?

Ans. Generally speaking, you can use and relay on the both the NPV and 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 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 the IRR is very high. Management must ask whether such an impressive IRR is possible to maintain. In other words, management should look past records, and existing and future business, to see whether an opportunit9 to reinvest cash flow 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.

Q. 15. Define Marginal Utility.

Ans. It is defined as the change in the total utility resulting form a one unit change in the consumption of commodity per unit of time. When man is purchasing a commodity, he is consciously or weighting in his mind the price he has to pay and the utility of each unit he buys. He will continue purchasing till the marginal utility equals the price. Here is a fundamental proposition of the theory of customer demand. A consumer will exchange money for units of any commodity A. Up to the point where the last (marginal) unit of A which he buys has for him a marginal significance in terms of money just equal to its money price.

Q. 16. What is Time Value of Money?

Ans. The idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is

worth more the sooner it is received. Also referred to as present discounted value. Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future. For example, assuming a 5% interest rate, $ 100 invested today will be worth $ 105 in one year ($ 100 multiplied by 1.05). Conversely, $ 100 received one year from now is only worth $ 95.24 today ($ 100 divided by 1.05), assuming a 5% interest rate.

Q. 17. What are the Problems with using Internal Rate of Return (IRR).

Ans. As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide, whether a single project is worth investing in. NPV vs discount rate comparison for two mutually exclusive projects. Project A has a higher NPV (for certain discount rates), even though its IRR (= x-

axis intercept) is lower than for project B (click to enlarge). In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholderss wealth) and should thus be accepted over the second project (assuming no capital constraints). IRR makes no assumptions about the reinvestment of the positive cash flow from a project. As a result, IRR should not be used to compare projects of different duration and with a different overall pattern of cash flows. Modified internal Rate of Return (MIRR) provides a better indication of a projects efficiency in contributing to the firms discounted cash flow. In the case of positive cash flows followed by negative ones (+ + -) the IRR is a rate for lending / owing money, so the lowest IRR is best. This applies for example when a customer makes a deposit before a specific machine is built. In a series of cash flows like ( 10, 21, 11), one initially invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so how a low rate of return is best. In this case, it is not even clear

whether a high or a low IRR is better. There may even be multiple IRRs for a single project, like the example 0% as well as 10%. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project. In general, the IRR can be calculated by solving a polynomial equation Sturns Theorem can be used to determine if that equation has a unique solution. In general, the IRR equation cannot be solved analytically but only interactively. A potential shortcoming of the IRR method is that it does not take into account that the intermediate positive cash flows possibly come at inconvenient moments. Their reinvestment may have a lower yield. In that case it may be more realistic to compute the IRR of the project including the reinvestments until e.g. the end date of the project. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the projects cost of capital. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV. Apparently, managers find it easier to compute investment of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the more accurate

reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations.

Q. 18. Net Present Value NPV.

Ans. The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. Formula :

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive It should be accepted However if NP is negative the product

should probably be rejected because ash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lumpsum present value amount say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000 the purchaser would not buy the store, as the investment would present a negative NP\ at the time and would, therefore, reduce the overall value of the clothing company

Q.19. Describe Management Buy-out.

Ans. Essentially, a management buy-out (MBO) is the purchase of a business by its existing management, usually in cooperation with outside financiers. Buy-outs vary in size, scope and complexity but the key feature is that the managers acquire an equity interest in their

business. Sometimes a controlling stake, for a relatively modest personal investment. The existing owners normally sell most or usually all of their investment to the managers and their coinvestors. Often the group of managers involved establish a new holding company, which then effectively purchases the shares of the target company. The typical steps in a management buy-out process are : Agreement in the management team as to who will become the managing director. Appointment of financial consultants; Assessment of suitability of the buy-out; Approval to purchase the MBO; Evaluation of the sellers asking price. Formulation of business plan (s). Selection of equity advisors and obtaining written offers; Selection of legal consultants; Selection of lead investor; Negotiation of best equity deal;

Negotiation of purchase of the business; Selection of auditors. Implementation of a due diligence test; Obtaining finance and other equity investment.

Q. 20. What are the Sources and Uses of Cash?

Ans. The major sources of cash are 45 under: Cash from Operation Issue of Equity Share Capital foi cash Issue of Preference Share Capital for cash Raising long term loans for cash Sale of Investments Sale of Fixed Assets Premium on Issue of Shares / Debentures etc. The major uses of cash are as under: Redemption of Preference Share Capital for cash

Redemption of Debentures / Repayment of Longterm Loans Purchase of Investment. Purchase of Fixed Assets Premium on Redemption of Preference Share / Debentures Dividend Paid Taxes Paid etc.

Q. 21. Differentiate between a Cash Flow Statement and a Funds Flow Statement.

Ans. Difference between Funds Flow Statement and Cash Flow Statement:

Q. 22. What do you mean by Cash Flow Statement?

Ans. A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current

liabilities are taken into consideration. But in a cash flow statement only those sources of funds are taken which provide cash and only the uses of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored. A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash.

Q. 23. What are the Objectives of Cash Flow Statement?

Ans. A Cash Flow Statement provides very useful help to financial management of a business enterprise. It summarises the sources from where the cash may be obtained and the specific uses to which the cash may be applied during a particular period of time.

A Cash Flow Statement has the following uses Helpful in short-term financial planning. Cash Flow Statement provides useful information to a business enterprise to make decision for its shortterm financial planning. Helpful in preparing Cash Budget. A Cash Budget is an estimate of cash receipts and disbursement for a future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A comparison of cash budget and cash flow statement reveals the extent to which the sources of the business were generated and used as per the plans of the business. Helps to understand liquidity. Liquidity means ability of a business enterprise to pay off its liabilities when due. Cash Flow Statement helps to know about the sources where from the cash will be available to pay off the liabilities. Prediction of sickness. With the help of preparing cash from operation a business enterprise may come to know about cash losses in operation. It helps to predict this type of sickness. Dividend decisions Dividend is paid within 42 days, when company declares it. Cash Flow Statement helps the management to know about the sources of cash to pay off dividend.

Q. 24. What is meant by Accounting Ratios ? How are they useful?

Ans. A relationship between various accounting figures, which are connected with each other, expressed in mathematical terms, is called accounting ratios. According to Kennedy and Macmillan, The relationship of one item to another expressed in simple mathematical form is known as ratio. Robert Anthony defines a ratio as, simply one number expressed in terms of another. Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. For example, profit shown by two business concern is Rs. 50,000 and Rs. 1,00,000. It is difficult to say which business concern is more efficient unless figures of capital investment or sales are also available.

Analysis and interpretation of various accounting ratio gives a better understanding of the financial condition and performance of a business cocern.

Q. 25. What do you mean by Ratio Analysis ? What are the advantages of such analysis ? Also point out the limitations of Ratio Analysis.

Ans. Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures. According to Myers, Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements. Advantages and Uses of Ratio Analysis: There are various groups of people who are interested in analysis of financial position of a

company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner: 1. To workout the profitability. According ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way, profitability ratios show the actual performance of the business.

2. To workout the solvency. With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business. In this case the business has to make it possible to repay its loans. 3. Helpful in analysis of financial statement. Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.

4. Helpful in comparative analysis of the performance. With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them. 5. To simplify the accounting information. Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. 6. To workout the operating efficiency. Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources. 7. To workout short-term financial position. Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it. 8. Helpful for forecasting purposes. Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years ratios, estimates for future can be made. In this way these ratios provide the basis

for preparing budgets and also determine future line of action. Limitations of Ratio Analysis In spite of many advantages, there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statements. The following are the main limitations of accounting ratios: 1. Limited Comparability. Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm. Some firms may value the closing stock on LIFO basis while some other firms may value of FIFO basis. Similarly there may be difference in providing depreciation of fixed assets or certain of provision for doubtful debts etc. 2. False Results. Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct. 3. Effect of Price Level Changes. Price level changes often make the comparison of figures

difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison. 4. Qualitative factors are ignored. Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis. 5. Effect of window-dressing. In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way. 6. Costly Technique. Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it. 7. Misleading Results. In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is

Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different. 8. Absence of standard university accepted terminology. There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.

Q. 26. Classify the Various Profitability Ratios. Also explain the Meaning, Method of calculation and objective of these ratios.

Ans. Classification of various profitability ratios: (a) Gross Profit Ratio (b) Net Profit Ratio (c) Operating Net Profit Ratio (d) Operating Ratio (e) Return on Investment or Return on Capital Employed (f) Return on Equity

(g) Earning Per Share Meaning, Objective and Method of Calculation

1.

Gross Profit Ratio. Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner:

Objective and Significance. Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must he investigated. This investigation will be helpful to know about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, had sales policies and other such reasons.

However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.
1.

Net Profit Ratio. Net Profit Ratio shows the relationship between Net Profile of the concern and its Net Sales. Net Profit Ratio can be calculated in the following manner:

Where Net Profit Gross Profit Selling and Distribution Expenses Office and Administration Expenses Financial Expenses - Non Operating Expenses + Non Operating Incomes. And Net Sales = Total Sales Sales Return Objective and Significance. In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the cocern. While comparing the ratio to previous years. Ratios, the increment shows the efficiency of the concern. (c) Operating Profit Ratio. Operating Profit means profit earned by the concern from its business operation and not from the other sources. While

calculating the net profit of the concern all incomes either they are not part of the business operation like rent from tenants, interest on investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations. Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner :

Where Operating Profit = Gross Profit + Operating Expenses Or Operating Profit = Net Profit + Non-Operating Expenses Non Operating Income And Net Sales = Total Sales Sales Return Objective and Significance. Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.

(d) Operating Ratio. Operating Ratio indicates the operating cost to the net sales of the business. Operating cost means cost of goods sold plus Operating Expenses.

where Operating Cost Cost of goods sold + Operating Expenses Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses Closing Stock Operating Expenses Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance, Objective and Significance. Operating Ratio is calculated in order to calculate the operating efficiency of the cocnern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit. (e) Return on Investment or Return on Capital Employed. This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.

Where Capital Employed Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans Fictious Assets Or Capital Employed = Fixed Assets + Current Assets . Current Liabilities Objective and Significance. Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is. (f) Return on Equity. Return on equity is also known as return on shareholders investment. The ratio establishes relationship between profit

available to equity shareholders with equity shareholders funds.

Where Equity Shareholders Fudns = Equity Share Captial + Reserves and Surplus Fictions Assets. Objective and Significance. Return on Equity judges the profitability from the paint of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The Investors favour the company with higher ROE. (g) Earning Per Share. Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.

Objective and Significance. Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.

Q. 27. A used car dealer tells you that if you put $1.500 down on a particular car your payments will be $190.93 per month for 4 years at a nominal interest rate of 18%.Assuming monthly compounding, what is the present prince you are paying for the car?

Solution : A = 190.93 per period; i = 18/12 0.15, n 4 x 12 = 48 P = 1,500 + 190.93 (P/A i% 48) = $8.000.

Q. 28. A Homeowner has just bought a house with a 20 years, 9%, $ 70,000 mortgage on which he is paying $629.81 per month. (a) If He sells the house after ten years, how much must he give the bank to completely pay off the mortgae at the time of the 120th payment? (b) How much of the first $379.33 payment on the loan is interest?

Solution: (a) P = 629.81 + 679.81 (P/A%, 120) = $49.718.46 (b) $70,000 x 0.0075 = $525

Q. 29. Assume you borrowed $50,000 at an interest rate of 1 percent per month, to be repaid in uniform monthly payments for 30 years. In the 163rd payment, how much of it would be interest, and how much of it would be principal?

Solution. In general, the interest paid on a loan at time it is determined by multiplying the effective interest rate times the outstanding principal just after the preceding payment at time t-1. To find the interest paid at time t = 163. (call it 1163) first find the outstanding principal at time t = 162 (call it P162). This can be done by computing the future worth at time t = 162 of the amount borrowed minus the future worth of 162 payments. Alternatively, compute the present worth, at time 162 of the 198 payments remaining. The uniform payments are 50,000 (A/P, 1%, 360) = $514.31. Thus P162 = 50,000 (F/P. .01, 162) 514.31 (F/A, 1%, 162) = 514.31 (P/A. 1% 198) = $44,259.78 The interest is 1163 = 0.01(44,259.78) = $442.59 and the principal in the payment is $ 514.31 442.59 = $71.72.

Q. 30. A person borrows $5,000 at an interest rate of 18%, compounded monthly.

Monthly payments of $180.76 are agreed upon. (a) What is the length of the loan? (Hint: It is an integral number of years.) (b) What is the total amount that would be required at the end of the sixth month to payoff the entire loan balance ?

Solution:

Q. 31. What is the relationship between a future value and a present value?

Ans. A future value equals a present value plus the interest that can be earned by having ownership of the money; it is the amount that the present value will grow to over some stated period

of time. Conversely, a present value equals the future value minus the interest that comes from ownership of the money; it is todays value of a future amount to be received at some specified time in the future.

Q. 32. York company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5M00 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year.

Required : Which machine should be purchased according to payback method ?

According to payback calculations, York company should purchase machine B, since it has a shorter payback period than machine A.

Q. 33. An engineer is considering buying a life insurance policy for his family, lie currently owes about $77,500 in different loans, and would like his family to have an annual available income of $35,000 indefinitely (that is, the annual interest should amount to $35,000 so that the original capital does not decrease). (a) He feels he can safely assume that the family will be able to get a 4% interest rate on that capital. How much life insurance should be buy? (b) If he now assumes that family can get a 7% interest rate, calculate again how much life insurance should he buy.

Solution. (a) If they get 4% interest rate :

Q. 34. The winner of a sweepstrakes prize is given the choice of one million dollars or the guaranteed amount of $80,000 a year for 20 years. if the value of money is taken at a 5% interest rate which choice is better for the winner ?

Solution. Alternative 1: P = $1,000,000 Alternative 2 P = 80,000 KP/A, 5%, 20) 81 K (7.469) $ 996.960 Choose alternative I : take $1,000,000 now

Q. 35. Your company has been presented with an opportunity to invest in a project. The facts on the project are presented below :

Q. 36. A person is planning a new business. The initial outlay and cash flow pattern for the new business are as listed below. The expected life of the business is five years. Find the rate of return for the new business.

Solution. Initial investment = Rs. 1,00,000

Annual equal revenue = Rs. 30,000 Life = 5 years The cash flow diagram for this situation is illustrated in Fig. below

Therefore, the rate of return for the new business is 15.252%.

Q. 37. A company is trying to diversify its business in a new product line. The life of the project is 10 years with no salvage value at the end of its life. The initial outlay of the project is Rs. 20,00,000. The annual net profit is Rs. 3,50,000. Find the rate of return for the new business.

Solution. Life of the product line (n) 10 years Initial outlay Rs. 20,00,000 Annual net profit = Rs. 3,50,000 Scrap value after 10 years=0 The cash flow diagram for this situation is shown in Fig. 7.4.

Therefore, the rate of return of the new product line is 11.74%.

Q. 38. A company is planning to expand its present business activity, It has two alternatives for the expansion programme and the corresponding cash flows are tabulated below. Each alternative has a life of five years and a negligible salvage value. The minimum attractive rate of return for the company is 12%. Suggest the best alternative to the company.

Solution: Alternative 1 Initial outlay = Rs. 5,00,000 Annual revenue = Rs. 1,70,000 Life of alternative 1 = 5 years The cash flow diagram for alternative 1 is illustrated in Fig. 7.9.

Alternative 2

Initial outlay= Rs. 8,00,000 Annual revenue = Rs. 2,70,000 Life = 2 years The cash flow diagram for alternative 2 is depicted in Fig. below.

Since the rate of return of alternative 1 is greater than that of the alternative 2. Select alternative 1.

Q. 39. For the cash flow diagram shown in Fig. 3.1., compute the Rate of Return. The amount are in rupees.

Solution. For the positive cash flows of the problem, At = Rs. 150, G = Rs. 150 The annual equivalent of the positive cash flows of the uniform gradient series is given by

The formula for the present worth of the whole diagram

Therefore, the rate of return for the cash flow diagram is :

Q. 40. What is the TRR if the following Cash Flow Stream?

Ans. CF= Cash Flow r = Internal rate of return

After calculation the IRR is 1.3.

Q. 41. A company is considering a capital investment for which the initial outlay is $20,000. Net annual cash inflows (before taxes) are predicted to be $4,000 for 10 years. Straight-line depreciation is to be used, with an estimated salvage value of zero. Ignoring income taxes. Compute the items listed below. 1. Payback period 2. Accounting rate of return (ARR) 3. Net present value (NPV), assuming a cost of capital (before tax) of 12 percent 4. Internal rate of return (IRR).

Solution.

Q. 42. Consider an investment which has the following cash flows:

1. Compute the following: (a) Payback period

(b) Net present value (NPV) at 14 percent cost of capital (c) Internal rate of return (IRR) 2. Based on (b) and (c) in part 1, make a decision.

Solution : 1. (a) Payback period:

Now we are sure that the true IRR is somewhere between 14 percent and 30 percent.

Using interpolation:

Q. 43. Data realting to three investments are given below:

Rank the projects according to their attractiveness using the following: (a) Payback period. (b) IRR (c) NPV at 14 percent cost of capital

Solution: (a) Payback period:

(b) IRR ranking:

(c) NPV at 14% :

Q. 44. XYZ Corporation is considering five different investment opportunities. The companys cost of capital is 12 percent. Data on these opportunities under consideration are given below:

1. Rank these fives projects in descending order of preference, according to NPV IRR Profitability index 2. Which ranking would you prefer? 3. Based on your answer in part 2, which projects would you select if $55,000 is the limit to be spent?

Solution:

2. The profitability index approach is generally considered the most dependable method of ranking projects competing for limiting funds. It is an index of relative attractiveness, measured in terms of how much you get out for each dollar invested. 3. Based on the answer in part 2. project (a) and (b) should be selected, where combined NPV would

be $7,255 ($2,930 + 54,325) with the limited budget of $.55000.

Q. 45. After-tax cash flows for two mutually exclusive projects (with economic lives of four years each) are:

The companys cost of capital s 10 percent. Compute the. following: 1. The internal rate of return for each project. 2 1 hi net present value for each project 3. Which project should be selected ? Why?

Solution.
1.

Project X:

Project Y:

1.

ProjectX:

Q. 1. Describe Replacement Analysis.

Ans. Replacement analysis is one of the most important and most common types of Iternative comparisons encountered in practice. In replacement analysis, one of the feasible alternatives involves maintaining the status quo; the analysis, one of the feasible alternatives involves maintaining status quo; the remaining alternatives provide replacement options that are available. In some organizations, replacement analysis are performed routinely in an effort to ensure that the best equipment and facilities are in use, compared to their possible successors. The reasons for considering replacement are numerous. Firstly, the current asset (defender) may have number of deficiencies including high set-up cost; excessive maintenance, declining production efficiency energy consumption, and physical impairment. For example, when you are confronted with a car that is expensive to operate and maintain, or one soon to need a major overhaul, you being to consider replacing the car. Secondly, potential replacement assets (challengers) may take advantage of new technology and be easily set up, maintained at low cost, high in output, energy efficient and

possessing increased capabilities, perhaps at a vastly reduced cost. For example, some new generation computer-controlled manufacturing equipment has rendered many old machines economically obsolete. Also, we can relate to the phenomenal accomplishments with which calculators and personal computers have resulted in increased capabilities, vastly lower prices, and economic obsolescence for equipment only a few years old. Finally, the environment affects replacement decisions. Consumer demand preferences change, and present equipment may be unable to adapt to the new designs dictated by consumers. Demand levels may also cause equipment capacity to be relatively high or low, resulting in inefficiency or inability to perform. Rental firms specializing in equipment, automobiles, furniture, and so forth, may affect ownership decisions by offering lease options. Also, outside contractors may be able to perform some tasks cheaper and better than in house facilities. All of the above considerations and more may affect the decision to keep or replace an asset. Two approaches are commonly used in replacement analysis. One is the cash flow approach in which actual cash flows associated with keeping, purchasing, or leasing an - asset are

used directly. The other is the outsider viewpoint approach in which the cash flow profiles by an objective outsider are used. Which approach is used in a replacement analysis is strictly a matter of preference. Both are-mathematically equivalent and yield consistent decisions.

Q. 2. What is the need of replacement studies?

Ans. (i) Physical Impairment : The existing equipment is completely or partially worn out and will no longer function satisfactorily without expensive repairs. (ii) Inadequacy : The equipment does not have sufficient capacity to meet the present demands. (iii) Obsolescence : Lessening in the demand for the services rendered by the equipment or by the availability of more efficient tool or un-economic maintenance are the few reasons.

(iv) Rental Possibilities : It is possible to rent identical or comparable equipment thus freeing capital for them and more profitable use. (v) Rapid Technological Changes : Recognition and handling of replacement problems have paid off quite well in many companies. Some of the advantages are: (a) Maintenance costs would be reduced. (b) Production costs would be reduced and would keep the company competitive. (c) Losses, scraps, rework would be reduced. (d) Modernization would be introduced which will help to take-off productivity and returns, (e) Delays off down-time costs would be reduced. (f) Enthusiam and morale of workers would be increased resulting into increased human efficiency, better human relations. It is clear from these points that replacement should be based on economy, since it is an economic venture which must yield considerable profits. Replacement also add modernization which is essential for growth. Some other reasons which have already been discussed above may include

inadequacy, excessive maintenance, decline of efficiency, obsolescence etc. There are three basic ingredients to the successful handling of replacement problems. (i)There must be clearly stated policies to guide the persons handling the replacement problems. (ii)The replacement problems must be recongnised in the organisation structure by specific assignment of responsibility. (iii)A systematic procedure must be established and used in solving specific problems.

Q. 3. What is MAPI formula?

Ans. MAPI formula for replacement were developed by the Machinery and Allied Products Institute of Washington D.C. to enlightended thinking on the subject of equipment replacement. These formulae were developed in Dynamic Equipment Policy by eorge Terborgh, Director of Research of MAPI.

MAPI formulae are used to determine whether equipment should be replaced based on capital costs, interest, operating costs, and costs associated with physical impairment and onsolescence. Terborgh introduced some new terms such as: Defender present asset whose replacement is under consideration. Challenger asset under consideration as a replacement for another asset, usually the present defender.

Q. 4. Write a short note on replacement policies.

Ans. There are general guidelines carry out actual replacement studies, Such policies should cover the followmg points : (i) The general outlook on operational effectiveness of the existing assets These will of course vary but depend on the effectiveness and competitiveness of our production machinery and the policy must give enough opportunity to keep

close to machinery developments, so that the replacements may be profitable. (ii) The policy may include the aspect of finance condition and the interest rates. (iii) The policy should also cover the aspect of regular checks on the possibility of replacing each asset. (iv) The policy should also identify the types of persons who can carry out such studies in the organisation. Good replacement tsudies from team work. The persons may be drawn from maintenance deptt industrial engg. deptt., production deptt. accounting deptt. etc. There would not be any basic change between the studies carried out in small scale industry or medium industry.

Q. 5. Write a short note on economic life of an asset.

Ans. The economic life is the number of years of use that minimizes an assets equivalent annual cost. Theoretically, at the end of an assets

economic life, it is replaced with another asset having the same cost data as the initial asset. This replacement is repeated over and over again. In this way, the costs over period of time are minimized. Also, in comparing assets on the basis of costs, the used in the comparison should be based on each assets respective economic life. The economic life occurs, with yearly increasing operation and maintenance costs, because the total equivalent annual cost consists of an increasing and a decreasing cost component. That is, the equivalent annual amounts of the yearly operations and maintenance costs increase as the years of use increase. At the same, the equivalent annual cost of the capital recovery and return decreases as the number of years of use increases. The economic life can determined using either a conventional or revenue requirement approach.

Q. 6. What is the use of accounting data in economic ? Explain.

Ans. Since accounting data are the basis for many engineering economy studies, caution should be exercised in their use. An understanding of the

relevance of accounting data is essential for us proper utilization. Two examples of the pertinence of cost accounting data are presented in the action. Cost data must be applicable. It is common to that a reduction in labour costs will result in a proportionate decrease in overhead costs, particularly if overhead is allocated on a labour cost basis. In one instance a company was manufacturing an oil field specialty. An analysis revealed per item costs as follows: Direct labour $ 4.18 Direct material. 1.84 Factory overhead $4.18* 2.30.9.62 Factor cost per item $15.63 The factory cost of $15.36 was slightly less than the price of the item in question. The first suggestion was to cease making the article. But after further analysis it became clear that the overhead of $9 61 would not be incurred if the item was discontinued. The overhead rate used was based on heavy equipment required for most of the work in the department and on early earnings of workmen who averaged $585 per hour. For the job in position only a light drill press and

hand tools were used Little work reduction in cost would have resulted from not using them in the manufacture the articles.

Q 7 What is pattern of maintenance costs in Replacement analysis ?

Ans. The maintenance cost means scattered maintenance cost i.e. it may vary in any Way. Therefore, it is very difficult to have any definite relationship between maintenance cost and capital cost. Sometimes, the maintenance costs are approximately constant in succeeding year, so constant maintenance cost will never justify replacement. However, if no interest or salvage value is involved, then an equation for average cost of a year of service can be written as:

where: CA = average annual cost of capital recovery and maintenance P = initial cost of asset

mc = constant yearly maintenance cost n = number of years of life Obviously, CA will never reach to minimum unless interest and salvage values are involved. Constantly increasing maintenance cost means there is a rising trend in maintenance cost so there will be a minimum average total cost at some point in the life of the asset it interest is assumed to be zero the average annual cost for an asset with increasing maintenance cost may be expressed as :

C = average annual cost P = initial cost of asset Q = annual constant portion of operating cost of asset (maintenance cost is a part of operating cost) m = amount by which maintenance costs increase each year n = life of the asset in year To get minimum annual cost, differentiate C with respect to n and equate it to zero,

Q. 8. Describe various theories of profit.

Ans: Various theories of profit have been put forth by different economists to explain the profits. The important among these are : (1) Risks and Uncertainty theory (2) Dynamic Approach to the Profit Theory (3) Residual Or Rent theory of Profits. 1. Risk and Uncertainty Theory. This theory was introduced by Howley and according to him net profit is the residual income of the owner after making payments for all factors or production and is the reward for the risk taken by him. It concludes that profits are due to the risk taken by the owner. The owner has to bear the risk of losing capital, there are certain risks which can not be issued. They are known as uninsurable risks. We

cannot predict when fashion will change or when new invention will come or when will war outbreak etc. There are unforeseeable changes and hence in value risks which cannot be insured payments made for these uninsurable risks are called profits. 2. Dynamic Theory of Profits. Mr. J.B. Clark introduced this theory. According to Clark, the pure profit in a dynamic society is the residual income of the owner after making all payments including rent, wages interest and salary of management. Such pure profit in the form of residual earning result only in a dynamic society where the changes in population, changes in the stock of capital, changes in tastes of fashions, changes in production techniques and changes in management principles, occur dynamically. In a static society since there are no such changes, no pure profit may result. Thus pure profit is a sign of progress. Thus to increase profit an owner may produce a new commodity, popularise it and earn large profit and soon competition sets in the profit decline. Thus in maintaining pure profits high continuous progress is essential. 3. Rent Theory of Profit. This theory was introduced by Walker, who considered profit as a

form of rent. He says that owner earns profit in the same way as land earns rent. Marshall has criticized theory for the following reasons : (a) Whereas rent on land is in the form of surplus earnings, profit is not. (b) Land may produce zero or positive, zero or negative rent whereas net profit may be positive, zero or negative.

Q. 9. Write a short note on Annuity.

Ans. Annuity : An annuity is a series of equal payments occurring at equal periods of time. It may also be said as Equal payment or uniform payment series. In certain business dealings, equal payments are made at the end of equal periods of time and all such accumulated payments are allowed to earn compound interest. Periods of time may be of any length say a year and a month etc. But periods should be of equal length. Interest is expressed in yearly terms but the actual interest is paid at the end of each equal period. Hire

purchase payments, instalment buying, L.I.C. premium payments etc. are done by this method. Features. These have the following common features: (i) These involve series of payments. (ii) All payments are of equal amount. (iii) Payments occur at equal time intervals. (iv) All payments are made at the end of periods. (v) Compound interest is earned on all accumulated payments.

Q. 10. What are the advantages of cash flow analysis?

Ans. Advantages of cash flow analysis. 1. It is useful in evaluating current cash position and financial policies, from this, the management will know how much cash is needed, how much can be generated internally and how much it should arrange from outside. Thus, it is especially useful in preparing cash budgets.

2. The comparison of original forecast with actual result may highlight trends of movement that might otherwise go undetected. 3. As it gives the amount of cash inflows of operation the management may consider the possibility of retiring long-term loans, replacement of plant facilities etc. 4. It enables to answer the queri6s relating to a situation when the business has made a profit and yet runs out of money or when it has suffered a loss and still has plenty of money at bank. Though the cash flow statement cannot replace the usual financial statements, it serves as a very useful supplementary statement. It provides a barometer for measuring any change in the speed with which cash is flowing through the different parts of the business and its impact on the profitability of the business.

Q. 11. Describe Economic evaluation criterion of the project.

Ans. No project can be taken granted economical viable project, unless it is not evaluated under the constraints. Sometimes a project becomes nonviable since it could not take-off on due-date. Change in starting date may change all the previous cost estimates and implementation schedule of the project Therefore, for declaring a project economically viable, the following three sets of information must be examined: (i) Computed estimates of the net capital outlay required for the proposed project and the future estimate of cash-flows as anticipated. (ii) Availabilty of accurate cost estimates to the proposed project from the proper sources. (iii) A correct planning and time-schedule for the execution of the proposed project so that longterm economic benefits to the promoters are maximised. On the basis of above set of information, a methodology has got to be developed for evaluating the profitability of the new investment. For this, a suitable criterion is to be found out on the basis of two basic principles : (i) If other things being equal, bigger benefits are always preferable than smaller ones.

(ii) If other things being equal, early benefits are better than later benefits. Methods to Assess Economic Viability of Proposed Project : (i) Non-discounted cash flow method - pay back period. (ii) Discounted cash flow methods: (a) Net present value (NPV). (b) Benefits-cost ratio (BCR). (c) Interval rate of Return (IRR). Details of these methods can be taken from any book on Economics or Financial-management. Satisfies and computer techniques which permit the quantitative handling of economic problems, the role of engineers in decision making has increased very much. We therefore, conclude that Engineering Economics deals with cost and other data pertaining to the functions carried out by engineers in engineering process. The study of engineering process takes birth when a want is felt and includes the following steps: 1. An analysis of the want. . 2. Providing suitable solution ant its valuation.

3. Launching of the project and making of arrangement for finance. 4 Organization of project 5 Designing of the project and construction of the plant 6 Supervision and operation of production 7. Distribution of the product. From this point of view, management may be considered as the art and science of directing and coordinating efficiently all the above functions.

Q. 12. Describe the significance of Economics to Engineer.

Ans. Engineering and Technology are closely connected with economic science. In economics, we study the way in which we make optimum use of scarce resources. An engineers and an architects problem is also very much the same. An engineer (or an architect) tries to construct or manufacture goods of a maximum utility with a given cost or a desired product at minimum cost.

At various places in the engineering process the engineer is called upon to take decisions. These decisions have to be made on the basis of economic feasibility. At each point he is faced with the question of cost. The law of equi-marginal utility can help an engineer to substitute one factor of production for another in such a way that he incures minimum cost in production. Besides, a problem is mostly such that it may be solved in more than one way with different results. One result may be superior to another in quality and technical excellence or may be more economical to obtain. The engineer has to choose the best way. Thus, engineering problems2 are nothing but choice involving problems; and choice- making is entirely an economic problem. Sometimes engineers and architects have to work as a factory manager or as an executive engineer, in which capacity they have a deep interest in the problem of labour and personnel management. They, must then be fully aware about the labour laws. A knowledge of accounting and costing : auditing, depreciation; management, and the market condition is also very useful. Needless to say, one must also have an insight into

(i) social and psychological problem, pertaining to the production and (ii) the factory management of the personnel. Management Science is assuming more and importance for engineers and architects. At present our country faces an acute food problem which is threatening a major castastroph in the future. As a matter of fact, the condition of agriculture is unsatisfactory. The problem is serious mainly due to fact that science and technology have not come to the rescue of agriculture. Agriculture is completely at the mercy of Nature. The fate of agriculture and hence, of the country can be changed if irrigation engineers give us a network of small and medium irrigation works all over the country. It has been observed that after the completion of many big irrigation and power projects, the farmer is not getting water and power either because it is too costly or because there are no distributaries. All these are problems which only the engineers can solve. Mechanical Engineers can also be useful in devising cheap and simple mechanical devices or appliances which our farmers can handle easily. In USA each farmer has a small workshop to repair his tools and implements : he also has adequate knowledge. Such a provision will be useful to our country. Electrical and Chemical Engineers can help

agriculture by providing adequate and cheap electrically and fertilizer. Thus agricultural engineering can help in increasing productivity by inventing better methods of production, better tools and equipments, insecticides and pesticides. Engineers can play an important role in searching substitutes for making the country self-sufficient in the matter of power, steel and fertilizers. This will save much foreign exchange which we pay to foreign countries.

Q 13 What do you understand by economic life of a project ? Also discuss challenger and defender.

Ans. Economic life can be less than absolute physical life for reasons of technological obsolesence, physical deterioration, or product life cycle. Terbordg dramatically described the replacement problem as a battle between the current machine, which he called the defender, and a new and

better machine which he called the challenger. In his analysis economic lives of both the challenger and defender are estimated and then the time adjusted costs of the challenger are compared to the time adjusted costs of defender. If the time adjusted costs of the challenger is lower than the time adjusted cost of the defender, replacement is indicated. The problem however, is that the economic life of the challenger is difficult to estimate. The optimal length of time a investment is maintained, its economic life, depends upon not only the newest products available today, but those available tomorrow and so on into the future. If the economic life of an investment is unknown, how then can its cost be calculated ? While this issue of economic life was raised with production machinery in mind it is very relevant, at least as a starting point, for information systems investment. In an environment with no technological progress, one in which the hardware, and software available next year are no better than those of this year, economic life ii simply that life when the sum of the discounted capital and operating costs are at a minimum, the average capital costs of an is investment falls the longer the system is in

operation. The only incentive to replace is that some operating costs, such its program maintenance or software support may increase over time and that these costs may be reduced through replacement. To make the economic life problem more manageable. Terborg made the assumption that, present challenger will accumulate operating inferiority at a constant rate over its life. This suggests that the pace of information technology is constant, which we know is not true. From this assumption, it is possible to determine the economic life of an investment. The Uniform Annual Equivalent, UAE, is the uniform amount whose value is equal to the time adjusted costs, both investment outlays and obsolescence, incurred every year over the life of an investment,

Q. 14. Useful Applications of Life-Cycle Cost Analysis.

Ans. Life-Cycle Cost Analysis (LCCA) has applications for many areas of interest to

State and local transportation agencies. Common applications of LCCA include the following : Designing, selecting and documenting the most affordable means of accomplishing a specified project or objective For instance, if a bridge must be replaced, LCCA can be used to select the replacement option that would cost the least over the expected life of the bridge. Evaluating payment preservation strategies-the costs of each strategy can be evaluated relative to the expected effects it will have on delaying the costs of expensive rehabilitations or reconstructions. Among other requirements, the VE- team must consider the lowest life-cycle cost means of accomplishing a project. Project planning and implementation, especially the use and timing of work zones. LCCA allows the analyst to balance higher agency and/or contractor costs associated with off-peak work hours against reduced traveler delay costs associated with fewer work zones during peak periods.

Q. 15. Discounted Cash Flow Method.

Ans: A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as :

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money youd receive from an investment and to adjust for the time value of money. DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom garbage in, garbage out. Small changes in inputs can result in large changes in the value of a

company. Instead of frying to project the cash flows to infinity, a terminal value approach is often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

Q. 16. Demerits of Limitations of Discounted Cash Flow Method.

Ans. (1) It involves a good amount of calculations hence it is difficult and complicated. But the supporters of this method rebute the argument and assert that difficulty of the method is unfamiliarity rather than its complexity. (2) It does not correspond to accounting concept for recording costs and revenues with the consequence that special analysis is necessary for the study of capital investment. (3) The selection of cash inflows is based on sales forecastes which is in itself an indeterminable element.

(4) The economic life of an investment is very difficult to forecast exactly. (5) The method considers discount on expected rate of return but the determine action of rate of return is in itself a problem. Despite the above defects, the method provides an opportunity for making valid comparisons between long-term competitive capital projects.

Q. 1. Define break-even point.

Ans. When the total costs incurred and the total value of sales made are equal, the organisation attains a stage of no loss and no profit i.e., the sale proceeds are just enough to cover the total costs (both the fixed costs and variable costs). This position is called the break-even point. If sales go up beyond the break-even point, organisation makes a profit; if they come down, a loss is incurred. Thus, sales at break-even point is the minimum amount of sales that must be effect in order to avoid any loss. This figure is very useful for accountants in studying the profit factors. In this context acknowledge of the marginal costing method is essential for the study of break - even analysis. It may be said that break even analysis is simply an extension of the principles of marginal costing.

Q. 2. Describe the significance of, break-even chart.

Ans. Graphically, break-even point is represented in a break-even chart. A break-even chart or profit graph shows the extent of profit or loss at different levels of sales. It is a graphic analysis of the relationship between costs, volumes of activity and profits. Break- even chart is an excellent tool for management planning and control. It can be used to determine the break-even volume, optimum level of output, profit for a given level of output and the effect of change in sales on costs and prices. A typical break-even chart prepared on the basis of above of illustration is given below

In this chart quantity of output is shown on the. Xaxis. The fixed cost line is horizontal to the X-axis indicating that fixed costs remain unchanged up to

12,000 units of output. The variable cost line is superimposed on the fixed cost line to show total costs. The point at which the total revenue line intersects the total cost line is the break-even point. At the point the quantity produced and sold is 5,000 units or the sales revenue and costs are Rs. 2,00,000. The excess of actual sales volume over the break-even sales value is called the margin of safety. Greater the safety margin higher would be the profits. A firm should have a reasonable margin of safety as resistance power-avoid losses. If the safety margin is low a firm runs the risk of incurring losses during the period of reduced business activity. The margin of safety may be low either because the actual sales are low or the fixed costs are very high. Break-even analysis is a simple and inexpensive technique, It can be used for several purposes especially in industries which are not subject to frequent changes in technology, product-mix and factor prices. It presents a microscopic picture of the profit structure of a firm. It highlights the areas of economics strengths and weaknesses and reveals the profit vulnerability of the firm to changes in business conditions. However, breakdown analysis is based on several assumptions which are not true in practice. The

selling price, rate of increase in variable cost are assumed to be constant. It is assumed that there will be no changes in input prices, product mix, labour efficiency and technology. Production and sales volumes are assumed to be equal, ie., there is no change in inventory level. Selling costs are ignored. Break-even analysis is a static picture as it assumes constant relationship of output to costs and revenue. Break-even analysis is based on accounting data which may suffer from several limitations like neglect of imputed costs, arbitrary depreciation estimates, inappropriate allocation of overheads, etc.

Q, 3. Describe, Managerial Uses of Break-even Analysis.

Ans. Managerial Uses of Break-even Analysis. Despite its limitations, break-even analysis has been found useful in several types of managerial decisions. Some of the important managerial applications of break-even analysis are given below:

1. Capacity Planning. Sometimes, management is faced with the problem of deciding whether to expand plant capacity to meet increased demand for the product. The break- even analysis helps in understanding the impact of increase in output on the firms fixed costs and profits. Example. ABC company is examining a proposal to expand its plant capacity which is expected to increase its annual sales from Rs. 40 lakhs to Rs. 60 lakh. The expansion will involve an increase in fixed cost from Rs. 15 lakhs to Rs. 20 lakhs. The variable cost is likely to remain unchanged at 50% of the sales revenue. Should the company go in for expansion? Solution.

As the increase in sales (Rs. 20 lakhs) is greater than the increase in break-even point the company should go in, for expansion. 2. Choice of Technique. Break-even analysis is a useful guide in the selection of most economical production process or equipment. It gives a comparative view of costs of using alternative

techniques at different levels of output. Generally, simple and traditional process/equipments are more economical at low levels of output because they require minimum costs. But at very high levels to output, highly sophisticated and expensive process/equipments might be more profitable. 3. Product-mix Decision. A multi-product firm has to decide the relative proportion of different products in the total output. The objective here is to find out the best combination (mix) of products that can maximise profits. Beak-even analysis is helpful in determining the most profitable productmix. Example. Shilpa Toys Factory has a capacity to provide 3,999 hours per week. The plant can produce two types of toys x and y. Annual costs are Rs. 12,000. The maximum possible sales are estimated to be 4,000 toys of x types and 3,000 y type. Following additional information is available.

Find out the product-mix that will maximise the net profits of the factory.

4. Plant Shutdown Decision. During recession and such other periods when the demand falls considerably, a firm is faced with the problem of deciding whether to close down the plant temporarily or to continue production and sales at prices that do not .cover total costs. Break-even analysis facilitates such a decision by differentiating sunk costs from out of pocket costs. Sunk costs are the fixed costs already incurred and which will be there even it the plant is shut down temporarily. Out of pocket costs are the expenses which need not be incurred if the production is stopped. Example. A toys factory is facing recession. Its sunk costs are Rs. 50 lakhs per annum while the out of pocket costs are Rs. 80 per unit. The factory has a capacity to produce 24,000 units per years. Due to recession the maximum expected sales for six months are 6,000 units at a selling price of Rs 100 per unit. The recession is expected to last 6 months. Should the factory be shut down for this period? Solution. If the factory is shut down the total loss will be Rs. 2.5 lakhs (half of annual sunk costs). But if the factory operates :

The factory should not be shut down. 5. Drop or add a product. In the course of product planning the management has to decide whether to add a product to the existing product line. Similarly, management may feel that an existing product has outlived its utility and should be deleted from the product line. Break-even analysis is useful in such decisions as it indicates the impact of such decisions on the costs and revenues of the firm. 6. Make or Buy Decisions. Management of a firm has often to take a decision whether to buy a component or to manufacture it. For example, an automobile manufacturer can make spark plugs or buy them from the market Break-even analysis can enable the manufacturer to take a decision of this type. Example. An automobile manufacturer buys a certain components at Rs. 8 per unit. In case he makes it himself, his fixed and variable Costs would be Rs. 18,000 and Rs. 5 per unit, respectively. Should the manufacturer make or buy the component?

Solution.

So it would be profitable for the manufacturer to make the component if he needs more than 6,000 units per year. Make or buy decisions, however, should be taken after considering the following points: (a) Is the supply from the market certain and timely? (b) Is the required quality available? (c) Does the supplier try to take any monopoly advantage? In addition to the above uses, break-even analysis can also be used to determine volume required to earn target profits, to find out impact of changes in costs and prices, to determine promotion mix, etc.

Q. 4. Define Margin of safety.

Ans. Excess of actual sales revenue over the break-even sales revenue, expressed usually as a percentage. The greater this margin, the less sensitive the firm to any abrupt fall in revenue. Formula: (Actual sales revenue-Break-even sales revenue) x 100 Actual sales revenue. Margin of safety is a concept used in may areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons ? Probably not. It would be much more prudent to build to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying is at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.

Q. 5. Define Angle of incidence.

Ans. Angle of incidence indicates the rate at which profit is earned in an organisation after crossing the break-even point. In a break even chart, the angle at which the sales line cuts the total cost line

is called the angle of incidence. While the point at which the sales and total cost line cut each other is called the break-even point, the angle at which these lines intersect is called the angle of incidence. Sales after break even point will bring profit; therefore, this angle indicates the profit earning rate of the business. Hence, it is also called profit angle or profit path1n this sense, the concept of angle of incidence is an important tool for management in times of expansion of the market for the product. Every business concern would like to have as large an angle of incidence as possible because a wide angle represents a higher rate of profit earning and a narrow angle implies relatively a low rate of return. The consideration of the angle of incidence arises only after meeting the entire amount of fixed costs; therefore, the nature of the angle depends upon the incidence of variable costs. In other words, a norrow angle indicates that variable costs form relatively a large part of the cost of the product and vice versa.

Q. 6. What is Profit-volume ratio (P.V.R.) ?

Ans. This indicates the relation between the sales value and its corresponding contribution. This explains the rate at which sales are contributing towards the recovery of fixed costs and profit. A high ratio means that break even point is achieved soon after which profit is earned at a higher rate and a low ratio implies the opposite. The following formula calculates this ratio.

From the above discussion, we can understand that the term Profit Volume Ratio is rather misleading, because the term profit where actually means, the contribution of the sales and the term volume actually means sales value and not the sales volume. Therefore, properly speaking it should be called Contribution Sales Ratio (C.S.R.). However, since the term P.V.R. is widely used, we also use the same name in our lessons. Every organisation strives to improve their P.V. ratio ether by reducing the variable cost per unit or by increasing the selling price per unit whichever is possible. A high P.V. ratio earns profits at an accelerated rate and vice versa. The P.V. ratio can be depicted graphically.

Q. 7. How to construct a profit-volume chart?

Ans. (1) Use the horizontal axis for the sales value and the vertical axis for the costs and profit. (2) Measure the sales value (in terms of Rupees) on the horizontal axis by drawing Sales line just in the middle of the chart so as to cut the graph into two areas, the area above the line representing the profit area and the area below the line representing the loss area. (3) Measure the fixed costs on the vertical axis below the sales line (in the loss area) measuring from the zero point (see the chart). (4) Measure title profit on the vertical axis above the sales line (in the profit area). (5) Draw a straight line connecting the points of total fixed costs and the profit volume of the maximum sales.

Q. 8. What are Shortcomings of the Breakeven Analysis?

Ans. (1) The Break-even Point (BEP) is based on some assumptions, such as sales -price, costs, production, sales, etc The technique will be only of financial value unless all these assumptions are well calculated. Besides, the technique is a preliminary and supplementary tool in the whole exercise of ratio analysis. (2) The technique is to provide cost-escalation as built-in safeguard against increase in prices. (3) The proper analysis of various costs into fixed costs and variable costs is very important. This is so because; some of the items will neither fall under fixed costs nor under variable costs. Hence, semi-variable costs may cost its effect on the BEP. BEP may not prove useful to rapidly growing enterprises and to enterprises that frequently change their product mix. (4) It has limited utility in case of multi products. (5) It does not due cognizance of factors like uncertainty and risk involved in estimates for costs, volume and profits. (6) It is not a patent tool for long Range Planning.

Q. 9. Differentiate Risk and uncertainty.

Ans. Risk and uncertainty are two terms basic to any decision making framework. Risk can be defined as imperfect knowledge where the probabilities of the possible outcomes are known, and uncertainty exists when these probabilities are not known. A more common usage of these terms would state uncertainty as imperfect knowledge and risk as uncertain consequences. If a person says I am uncertain about the weather tomorrow, : this would be a value-free statement implying imperfect knowledge about the future. If this same person says, I am planning a picnic for tomorrow and there is a risk of rain, now h or she is indicating preference for an alternative consequence. Taking a risk can now be defined as exposing ones self to a significant chance of injury or loss. Thus risk is variability or randomness that can be quantified. Risk can lead to an unfavourable outcome, but also to a favourable outcome (i.e. there can be a risk of a positive outcome). Risk often stems from a process that is repeated many times. Uncertainty is randomness which cannot be described by a distribution. Uncertainty often

stems from an infrequently occuring, discrete event.

Q. 10. Effect of Risk and uncertainty on lot size.

Ans. Any project related decision or policy is affected by many variables subject to uncertainty. It does not imply, however, that it is practically impossible to assess the reliabilities of finding from cost benefit analysis. In many cases, it might be useful to focus on risks which are well-defined and quantifiable and disregard uncertainties which are very unlikely to materialise. As in mm-max inventory control two points are to be known, i.e. recorder point and the quantity to be ordered. If there is no uncertainty, the graph between the time and the balance on hand shows a pattern as shown in Fig. given below:

Fig. 1.1 Graph between the balance in hand, and time under the condition of certainty. In this case, when the quantity on hand falls to recorder point, an order must be placed for the ordered quantity. Since there is no uncertainty, this ordered quantity will arrive just as the stock at hand falls to minimum. Then with the new arrival the stock position reaches to maximum (i.e. minimum + ordered quantity = maximum). As consumption continues, the stock will again fall towards the recorder point. But under uncertainty, this is not the situation. As if no uncertainty is there, there is no need to maintain the minimum quantity, i.e. safe reserve at all; because the new order would arrive exactly on time, when inventory falls to zero. Now under uncertainty there are two types of uncertainty.

Uncertainty about the rate of consumption of inventory an uncertainty about the amount of time required for delivering the new order. The consumption increases with the demand and shows down in periods of declining in sales. The time required for supplying depends upon the supplier and on the transportation facilities these are subjected to uncertainty. Further if the parts stored are manufactured by the company itself. There is undertinly due to the bottleneck in production, breakdown in machines and so on. This is clear that mm-max inventory control involves uncertainty, and to solve such problem the theory of probability is used. Now the pattern of graph (Fig. 1.1) changes to graph shown in Fig. 1.2.

Fig. 1.2. Graph between the balance in hand and the condition of uncertainty.

The graph shown in Fig. 1.2 shows that inventory will fall below the minimum, even down to the zero, because of rapid consumption or delay in the delivery or ordered quantity. Many times the inventory will reach above the maximum, because the slower consumption after the order was placed, or because of rapid delivery. The consumption required for recorder point and ordered quantity is quite tedious and complicated which requires lengthy statistical procedures and is beyond the scope of this book.

Q. 11. What is life-cycle analysis ?

Ans. Life-cycle analysis Life-cycle cost analysis involves the consideration of all relevant costs of a project, beginning with the planning and design stage, through development and testing, production operation, and maintenance to the final stage sale or disposal. It is widely used under government contracts, such as defense procurement and public works, in order to minimize the total cost of the

project over its useful life In business, life-cycle cost analysis has been costs to justify a projects price vis-a-vis its competitions when all other costs associated with owning the project over its lifetime are taken into consideration. When a consumer is faced with the choice between durable good. Such as automobiles or refrigerators, the economic cost of each alternative can be established, using present worth analysis, by adding to the products price the present value of all other expenses required to operate and maintain that product over its useful life, or by calculating the equivalent annual cost to own, operate, and maintain the product its lifetime.

Q. 12. What is Bill of materials ?

Ans. In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as Bill of Materials. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the

necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department.

Q. 13. What are advantages of ABC analysis ?

Ans. Advantage of ABC Analysis (a) A close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption and due to this the costs associated with inventions may be reduced. (b) The investment in inventory can be regulated in a proper manner and optimum utilisation of the available funds can be assured. (c) A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio. However, it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory items and hence should be handled by only experienced and trained personnel.

Q. 14. Define Inventory.

Ans. The term inventory refers to the stock of raw materials, parts and finished products held by a business firm. It is the aggregate quantity of materials, resources and goods that are idle at a given point of time. In a wider sense. inventory consists of usable but idle resources. The resources may be of any type; for example, men, materials, machines or money. When the resources involved is materials or goods in any stage of completion, inventory is referred to as stock. It may, therefore, be said that inventory comprises 4 Msmen, materials, machines and money. But in a practical sense, inventory consists of the following: (a) raw materials (b) work-in-progress, e.g., semi-finished goods (c) bought out components, (d) finished products, (e) maintenance spare parts, and (f) consumable supplies.

Q. 15. What are the Objectives of Inventory Control?

Ans. The main objectives of controlling inventory are as follows: (i) to minimise capital investment in inventory by eliminating excessive stocks; (ii) to ensure availability of needed inventory for uninterrupted production and for meeting consumer demand; (iii) to provide a scientific basis for planning of inventory needs; (iv) to tiding over the demand fluctuations by maintaining reasonable safety stock; (v)to minimise risk of loss due to obsolescence, deterioration etc, and (vi) to maintain necessary records for protecting against thefts, wastes leakages of inventories and to decide timely replenishment of stocks.

Q. 16. Explain Advantages of Inventory Control

Ans. Scientific inventory control provides the following benefits: 1. It improves the liquidity position of the firm by reducing unnecessary tying up of capital in excess inventories. 2. It ensures smooth production operations by maintaining reasonable stocks of materials. 3. It facilitates regular and timely supply to customers through adequate stocks of finished products. 4. It protects the firm against variations in raw materials delivery time. It facilitate production scheduling, avoids shortage of materials and duplicate ordering. 6. It helps to minimise loss by obsolescence, deterioration, damage etc.

Q. 17. Describe EOQ.

Ans. It indicates that quantity which is fixed in such a way that the total variable cost of managing the inventory can be minimised. Such cost basically consists of two parts. First, Ordering Cost (which in turn consists of the costs associated with the administrative efforts connected with preparation of purchase requisitions, purchase enquiries, comparative statements and handling of more number of bills and receipts) Second, Carying Cost i.e., the cost of carying or holding the inventory (which in turn consists of the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e. interest etc.) There is a reverse relationship between these two types of costs i.e. if the purchase quantity increases, ordering cost may get reduced but the carying cost increases and vice versa. A balance is to be struck between these two factors and it is possible at Economic Order Quantity where the total variable cost of managing the inventory is minimurn. It is possible to fix the Economic Order Quantity with the help of mathematical formula. The following assumptions may be made for this purpose.

Let Q be Economic Order Quantity. A be Annunal Requirement of materials in units. O be cost of placing an order (which is assumed to remain constant irrespective of size of order.) C be cost of carrying one unit per year. Now, if A is the annual requirement and Q is the size of one order, the total number of orders will be A/Q and the total ordering cost will be - A/QxO. Similarly, if the size of one order is, Q and if it is assumed that the inventory is reduced at a constant rate from order quantity to zero when it is repurchased, the average inventory ill be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2XC. Thus, Total Cost = Ordering Cost + Carying Cost

The intention is that the value of Q should be such that the total cost should be minimum. Hence, taking the first derivative of the equation with respect to Q and setting the result to zero,

Where Q = Economic Order Quantity A = Annual requirements O = Ordering Cost C = Unit carrying cost/year.

Q. 18. From the Following data, work out the EOQ of a particular component.

Ans. Annual Demand : 5000 Units Ordering Cost : Rs. 60 per Order Price per Unit Rs 100 Inventory carrying Cost : 15% on average inventory, Solution:

Q. 19. Define: (i) Lead time (ii) Safety Stock.

Ans. Lead time. It refers to the interval between placing on order for a particular item and its actual receipt. Suppose, an order is placed for a particular item on 1st January and the matrialis is received on February. In this case the lead time is one month. Longer is the lead time, higher will be the average level of inventory. Safety stock. It implies the stock of inventory held as a safety measure against fluctuation in demand and lead time. Safety stock is a function of lead time. 11w longer the lead time, the greater the safety stock. Safety stock is also known as buffer stock or minimum stock. Safety stock should be

differentiated from working stock. Safety stock refers to the stock of inventory which is supposed to take care of shortages. On the other hand, working stock refers to the inventory generated by orders.

Q. 20. Consider the following data of a company for the year 1997: Sales = Rs. 1,20,000 Fixed cost = Rs. 25,000 Variable cost = Rs. 45,00Q Find the following: (a) Contribution (c) BE (b) Profit (d) M.S.

Solution. (a) Variable costs Contribution = Sales = Rs. 1,20,000 - Rs. 45,000 = Rs. 75,000

Q. 21. Consider the following data of a company for the year 1998. Sales = Rs. 80,000 Fixed cost = Rs. 15,000 Variable cost = 35,000 Find the following: (a) Contribution (c) BEP (b) Profit (d) M.S.

Solution.

Q. 22. Alpha Associated has the following details: Fixed cost = Rs. 20,00,000 Variable cost per unit = Rs. 100 Selling price per unit=Rs. 200 V Find (a)The break-even sales quantity, (b)The break-even sales (c) If the actual production quantity is 60,000, find (1) contribution; and (ii) margin of safety by all methods.

Solution.

Q. 23. A manufacturing company shows the trading results of records as follows:

(a) P/V ratio (b) Fixed cost (c) Break-even point (sales value) (d)Margin of Satety at a profit of Rs. 3,500. Solution.

Profit is realised only after meeting the fixed costs fully. Therefore, any variation in the profit will be caused only by a variation in contribution. Here, the increase in Net Profit can be taken as the increase in contribution. For an increase of Rs. 8,000 in sale, the contribution is increased by Rs. 2,000.

Q. 24. Describe Minimum cost analysis.

Ans. In evaluating alternative investments it is possible to find the best alternative on the basis of minimum cost rather than maximum benefit. The decision is justifiable, if the benefit of cash alternative is expected to the same. Similarly, when considering the optimum size of a project, such as a piece of machinery or equipment, it is proper to determine its minimum cost over a range of relevant values of the independent variable, i.e. size of capacity, provided that the expected benefit

is the same. In terms of economic theory, the total cost of a project can be said to be a function of the sum of two cost functions, one which increase directly with the independent variable, and the other decreasing as the independent variable increases as follows :

One of the most frequently encountered total cost functions in engineering economy takes the form

where X is an independent variable in is either zero or a fixed cost and b and c are constants. As shown in Fig 1.3, the increasing cost function is assumed to the linear, the decreasing function is non linear, and their sum, which yields the total cost function, is a polynomial the lowest point of the total cost curve is the minimum cost of the project and corresponds to a value of the independent variable that defines the optimum size or capacity of the project. Mathematically, the optimum value of the independent variable, Xo, is obtained h differentiating the total cost function and setting it equal to zero;

The minimum cost in dollars is then found by substitution X0 in the total cost equation. A classic application of this model, first observed by Lord Kelvin, is that the economic size of the conductor occurs when the annual investment cost is equal to the annual cost of lost energy this is known as Kelvins Law.

Q. 25. Explain value analysis.

Ans. Value analysis is a technique of cost reduction. It involves study of cost in relation to product design. Before making or buying a product/material/equipment, a study of its value

(function) is made. The purpose is to reduce the cost of the prescribed function without sacrificing the required standard of performance. First, the required function is determined and then the best way to perform it at a lower cost is found. Value analysis is a systematic application of established techniques to identify the functions of a product or component and to provide the desired functions at the lowest total cost. It is a creative approach to eliminating unnecessary costs which add neither to quality for to the appearance of the product. Value analysis is a study and structured process consisting of (a) functional analysis to define the reason for the existence of a product or its components. (b) creativity analysis for generating new and better alternatives, and (c) measurement for evaluating the value of present and future concepts. Value analysis is closely related to value engineering, though the two are not identical. Value analysis refers to the work done in this regard by purchasing department whereas work which engineers do in this area is called value engineering. Value analysis requires close cooperation between purchase, engineering, production and costing departments and also that of the vendors expertise. It is a team job requiring lot of discussion and deliberations. Any new idea is

fully investigated to analyse its feasibilities. The product is considered from all angles and all possible alternatives are explored. The main questions asked under value analysis include (1) Is the cost vis-a-vis the usefulness of the product reasonable? (2) Can lower cost design work as well? (3) Can another less costly item fil1he need? (4) Will less expensive material do the job? (5) Does the function contribute value? (6) Are the features reasonable? (7) Can scrap be reduced by changing the design or material? (8) Is there an alternative product/process design which is less expensive? Some examples of savings through value analysis are as follows (a) Use of new and cheaper materials in place of traditional materials.

(b) Discarding tailored products where standard components can do the job. (c) Dispensing product features not required by customers, e.g., doing away with headphone in a radio set.

Q. 26. What is ABC analysis?

Ans. The main objective of inventory control is to minimise the carrying costs of inventory. Very often all items of inventory are not equally important. A small number of important items account for the dominant part of total inventory investment while a large number of items constitute so small a value that they have little effect on the results. Therefore, much greater control is required on the first type of items than on the others. The stock of items which are expensive has to be kept at the minimum. Items which are voluminous but relatively inexpensive are kept in large stocks as frequent ordering of such items is costlier. The two types of items are categorised as A and C, the items falling midway between these are put into B category. Maximum attention is focused on items in category

A as they constitute the most important constitute an intermediate position. Items in category C have negligible importance and therefore, minimum attention is paid to them. This selective inventory control is called ABC analysis.

Q. 27. What the required essentials of an effective cost reduction ?

Ans. The foregoing obstacles can be overcome through an effective cost reduction programme. The following points should be incorporated in a sound programme of cost reduction. (1) The co-operation of every employee should be obtained by identifying his self- interest with the companys interests. A deep sense of involvement among employees should be generated and their suggestions should be sought. The role and responsibility of each should be made clear to him. The cooperation of trade unions should also be obtained. (2) Resistance to change should be minimised by disseminating full details about the proposed changes and by convincing the employees that the

changes are ultimately in their own interest. The likely benefits of cost reduction should be explained to inspire confidence among employees. (3) Cost reduction should be a continuing function rather than ad hoc exercise. (4) Efforts should be concentrated in the area where the potential savings are likely to be the maximum. (5) There should be periodic meetings with the employees to review the progress made towards cost reduction. (6) A proper organisational set-up should be created for cost reduction. Cost reduction requires healthy self-criticism and coordination at all levels of management. The organisation would depend upon the size and nature of business. In a large company, a high powered committee consisting of responsible executives from various functional areas may be constituted. The committee fixes priorities, formulates programmes and monitors implementation. In small firms it may not be possible to have full time staff for cost reduction and the responsibility may be given to the cost accountant or to an outside consultant.

(7) Top management must lend full support and assistance to cost reduction. Sustained interest and commitment of management is essential. (8) An efficient system of data collection and reporting should be created. (9) There must be an atmosphere of close cooperation and mutual trust. Well-thought- out procedures should be developed for regular evaluation of the programme. (10) The programme should not be confined to reduction in expenditures and wastes. It must also seek to eliminate uneconomic activities, to improve productivity, etc. A cost reduction programme must keep in view the cost inter-relationship between different products, processes and departments. For example, reduction in labour cost may result in higher machine cost. Cost reduction is not arbitrary cutting, of expenditure and it must be based on careful analysis or study. Cost reduction must contribute to profit improvement. A crash cost reduction programme cannot offer substantial and continuing operating economies in the long run. A well integrated and systematic approach is needed

Q. 28. Differentiate fixed and variable cost.

Ans. Fixed and Variable Costs Fixed costs do not vary in proportion to the quantity of output. General administrative expenses, taxes and insurance, rent building and equipment depreciation, and utilities are examples of cost items that are usually invariant with production volume and hence are termed fixed costs. Such costs may be fixed only over a given range of production; they may then change and be fixed for another range of production. Variable costs vary in proportion to quantity of output. These costs are usually for direct material and direct labor. Many cost items have both fixed and variable components. For example, a plant maintenance department may have a constant number of maintenance personnel at fixed salaries over a wide range of production output. However, the amount of maintenance work done and replacement parts required on equipment may vary in proportion to production to production output.

Q. 29. Explain the concept of ratio-analysis.

Ans. Ratio is a statistical yardstick which provides a measure of relationship between two figures: This relationship may be expressed as a rate (costs per rupees of sales), as a percentage (cost of sales as a percentage of sales) or as a quotient/proportion (sales as number of times the inventory). Ratios are widely used in the analysis of operations as the use of absolute figures might be misleading. Relative figures are better for control purposes. Under ratio analysis, a desirable ratio is determined beforehand. The actual ratio is compared with this predetermined ratio and wherever necessary corrective action is taken. It is possible to compute several types of ratios relating to liquidity, profitability, solvency, etc. But for cost reduction, only operating cost ratios are used. Some of the commonly used ratios for cost comparisons are given below (a) Net profits/Sales (b) Sales/Direct labour (c) Sales/Inventory (d) Sales/Over heads

(e) Sales/ Direct materials (f) Production cost/Cost of sales (g) Selling costs/Cost of sales (h) Administration cost/Cost of sales (i) Material costs/Cost of production (j) Labour costs/Cost of production (k) Overheads/Cost of production. Ratios serve as standards of comparison for evaluation of performance. They can be used for cost reduction in two ways (1) A business may compare its ratios with the ratios of other firms in the industry. Sometimes comparison is made with standard ratios in the industry which are average of the results of all firms in the industry. (2) A firms ratios for the period under scrutiny may be compared with similar ratios of previous periods. Such comparison over time would reveal the areas that need attention.

Q. 30. Define Cost reduction.

Ans. Cost reduction implies deliberate savings in the cost of production and distribution through the elimination of water and in efficiency. It involves reduction in unit costs by improvements in product design an4 related techniques or practises. According to the Institute of Costs and Works Accountants of London cost reduction is the achievement of real and permanent reduction in the unit costs of good manufactured or services rendered without impairing their suitability for the use intended

Q. 31. Differentiate Cost reduction and cost control.

Ans. Both cost reduction and cost control are tools of increasing profitability. But the two differ in terms of their procedures and approach. The differences between them are given below: 1. Nature. Cost reduction is a corrective function and it may operate along with a cost control programme. On .the other hand cost control is

preventive function as costs are optimised before they are incurred. 2. Emphasis. Cost control lays emphasis on present and past behaviour of costs. The stress in cost reduction is on present and future cost. 3. Standards. Cost control involves setting cost standards, analysing variances from the standards and taking corrective actions. Cost reduction is not concerned with standards. It involves obtained potential savings. Cost control attempts to keep actual costs in line with established cost standards. Cost reduction challenges these standards form with. It tries to reduce costs on a continuous basis. In a cost control programme, standards act as targets but cost reduction questions the standard itself. 4. Application. Cost reduction can be applied to each and every area of business. It has universal application and does not depend on standards. But cost control is limited to areas where standards can be set. It has limited application to items for which standards exists. 5. Aim. Cost control seeks to achieve lowest possible cost under given conditions. On the other hand, cost reduction recognises that no condition is permanent. It calls for change in conditions if they result in lower cost.

6. Content. Cost control represents efforts involved in attaining targets or standards. Cost reduction symbolises achievement in reducing cost. 7. Continuity. Cost reduction programme can be finished. Cost control, on the other hand, is an ongoing or never-ending process Cost control, as generally practised, takes the dynamic approach to many of the factors affecting costs which planned cost reduction demands. For example, under cost control, the tendency is to accept standards once they are fixed and leave them unchallenged over a period In cost reduction on the other hand, standards must be constantly challenged for improvement. There is no phase of business which is example from cost reduction Products, processes, procedures and personnel are subject to continuous scrutiny to see where and how they cart be reduced in cost.

Q 32 Name the techniques of cost reduction

Ans. The main techniques used for cast reduction are as follows:

1. Cost Accounting and Analyses 2. Ratio Analysis 3 Break-even Analysis 4. Methods Study 5. Management Audit 6. Value Analysis.

Q. 33. Describe Break-even analysis.

Ans. Break-even analysis or cost volume Profit analysis is the study of interrelationship among a firms sales, costs and operating profit an various levels of output. It reveals the effect of fixed costs, variable costs, prices, sales mix, etc. on the profitability of a firm. In break-even analysis, break-even point and break-even chart are of particular significance. Break-Even Point. Break-even analysis involves the determination of the volume at which the firms costs and revenues will be equal. The break-even point may be defined as that level of sales at which

total revenues and total costs are equal, i.e., the level of operations at which the firm breaks even. It is also known as no-profit-no-loss point. If a firm produces and sells more than the level given by the break-even point, it makes profits. In case it produces and sells less than that suggested by the break-even point, the firm would incur losses. Management can change the break-even point by changing fixed cost, variable cost and selling price. There are two approaches used for representing a break-even point: (a) the algebraic method, and (b) the graphical method. Algebraic Determination of Break-even Point Algebraically, break-even point can be determined either in terms of physical units or in terms of sales value or as a percentage of the total capacity. The former method is convenient for a single product firm while the latter is more suitable for a multi-product firm.

Q. 34. ABC Motors purchase 9,000 motor spare parts for its annual requirements, ordering one-month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15 and the carrying charges are 15% of the average inventory per year. You have been asked to suggest a more economical purchasing policy for the company. What advice would you offer and how much would it save the company per year?

Solution. Present Policy :

Q. 35. You are given the following information about two competing companies during the year 2008.

A friend of yours seeks your advice as to which companys shares he should purchase. Assuming that the capital invested is equal for the two companies, state the advice that you will give.

Ans. The prospects of shareholders in these two companies; must be compared in terms of P.V. ratio. Fixed costs, BEP sales and Margin of Safety as at present. The company which commands more merits that the other must be chosen for investment.

From this table, we ascertain that though theP.V. ratio is higher in the case of company 13, all other factorsnamely I3EP sales, Margin of safety and the incidence of fixed costs are in favour of company A. (Despite higher P.V. ratio company B has to go a long way to reach the BEP and also to suffer from a narrow margin of safety. This is solely because of a huge amount of fixed expences)

Company A is preferable.

Q. 36. XYZ Company Ltd., is manufacturing a uniform product. At present, the company incurs the expenses as follows: Variable cost per unit Rs. 6. Fixed expenses for one year Rs. 35,000 Consider the price range of substitutes and of similar goods, produced by other concerns, the company has fixed the selling price at Rs. 10 per unit. Management considers that Rs 30,000 as profit will be a fair return on investment for the year. Assuming that the fixed costs, remain constant for the next trading period, find out the volume of sales required to earn the desired profit.

Solution:

Q. 37. XYZ Company Ltd., produces a uniform product, X. Out of competition, it is forced to reduce the price of its product. The Company plans to announce a price reduction of 10% to capture more market. The accountnant gives the relative data as follows:

Though, price is reduced the company wants to maintain the present volume of profit through increased sales. Therefore, it wants to know the required volume of sales. Assume that fixed expenses will remain constant at the new level of activity.

Since the price is going to be reduced, we have to find out the P.V. Ratio for the same volume of sales (20,000 units) but at the reduced price rate; then only the require volume of sales can be calculated.

Q. 38. ABC Ltd. Data is given below:

You are required to calculate the Break Even point and Margin of safety and also to provide information to the management regarding the possible effects of the following contingencies (each to be considered separately.) 1. Fixed costs increase by 10% 2. Variable costs decrease by 20% 3. Selling price is increased by 20%. Suitable charts may be presented showing the effect of these change in profit factors Workings:

Note : Since fixed costs have increased by Rs. 6,000 profit will be reduced to some extent: (because other factors are remaining constant). This can be verified as follows: Sales = Rs.2,00,000

Note : Since fixed costs have increased the Breakeven sales will also be increased, in the chart shown below, the total costs line and the sales line intersect at a point indicating break-even sales of Rs. 1,32,000. Thus break-even sales is increased by Rs.12,000 (i.e., to absorb the additional fixed costs of Rs. 6,000. The company has to effect the

sales for Rs. 12,000 more and react the B.E.P.) This can be checked as follows:

i.e., an increase of Rs. 12,000. At the present level of sales, the break-even sales have increased. Therefore, the remaining margin(Margin of Safety) will be decreased i.e.,

These effect can be depicted by the following chart :

(2) Effects of a decrease in variable cost by 20%

When the variable costs decrease, the contribution ratio (P.V. Ratio) increases, there by reducing the break even sales volume and increasing profits and Margin of Safety. That is, the company reaches the break even point sooner than before, and after that stage profit is earned at an accelerated rate in our illustration 20% decrease in variable cost will give following results. (a)Increase in Profits

(b) Decrease in the break-even point Since a reduced variable cost leaves more contribution, fixed costs are absorbed sooner. So the break-even volume is reduced as follows:

(c) Increase m Margin of Safety \At the same volume of sales, fixed costs are recovered sooner. Therefore, Margin of Safety will be increased as follows :

Thus, a decrease in margin cost by 20% results in an additional contribution of Rs. 20,000 with the consequences of: (a) Rs. 20,000 increase in profit (b) Rs. 20,000 increase in Margin of Safety and (c) Rs. 20,000 decrease in B.E.P. Sales These are well depicted in the next given chart:

(3) Effects in increase in the selling price by 20% Other factors remaining constant, the price of the products increased by 20% (i.e. from Rs. 10 to Rs. 12). Therefore, obviously profit will be increased as follows:

These results (a, h, and c) are illustrated in the following chart:

Q. 39. From the given data, Calculate Breakeven point sales.

Q. 40. From the following data, calculate B.E.P. and P.V.R.

Q. 41. From the following, calculate the Cash Break-even Point.

Q. 42. Sales are Rs 150,000 producing a profit of Rs. 4,000 in period 1. Sales are Rs. 1,90,000 producing a profit of Rs. 12,000 in period II. Determine the BEP. Difference in profit = Rs. 8,000 Difference in sales = Rs. 40,000 Since the change in the sale must have led to the change in the profit, P/V ratio: Rs. 8,000 x 100 = 20% Rs. 40,000 At BEP, Profit = Nil

If Rs. 20 is to be reduced from profit, sales must be reduced by Rs. 100. To reduce profit by Rs. 4,000 reduction in sale: (100 x Rs. 4,000/20 = 20,000 B.E.P. = Rs. 1,30,000 (i.e. sales producing profit of Rs. 4,000 less reduction in sales of Rs, 20,000 to wipe out the profit) Alternatively Total contribution on Rs. 1,50,000 @ 20% Rs. 30,000 Profit 4,000 Fixed expenses 26,000 Rs. Rs.

Q. 43. From the following figures ascertain the break-even sales.

Total cost equals sales, hence, there is neither profit nor loss.

Q44. The sales of company are @ Rs. 200 per unit Rs. 20,00,000 Variable cost 12,00,000 Fixed cost 6,00,000 Rs. Rs.

The capacity of the Factory 15,000 units Determine the BEP. How much profit is the company making?

(* Total number of units is 10,000 since sale at Rs. 200 per units is Rs. 20,00,000. Therefore variable cost per unit is Rs. 12,00,000 10,000 = Rs. 120) Profit being earned

At break-even point, the contribution is just equal to fixed costs, any sales above the Bill also provide the profit contribution. But as fixed costs are all met already such contributions become completely profit. The sales above BEP are known as margin of safety 1 he contribution from margin

of safety sales is profit As P/V ratio is (contnbution/ sales) x 100 and as profit is the contribution from these sales above BEP (i.e.), margin of safety, the following formula also is true.

Margin of Safety Thus, in the above illustration margin of safety sales = 2,500 units x Rs. 200 = 5,00,000. Profit = Rs. 2,00,000

Q. 45. From the following information calculate: (1) P.V. ratio even point (iii) Margin of Safety (ii) Break

Total sales Fixed cost Selling price

Rs. 3,60,000 Rs. 1,00,000 Rs. 100/Unit

Variable cost (per unit) = Rs. 50 (iv) if the selling price is reduced to Rs. 90 by how much is the margin of safety reduced ?