CA Inter Taxation

Sub-part (a): Degree of Operating Leverage

Given: Break-even point = 20,000 units; Selling price = ₹14; Variable cost = ₹9 per unit.

Contribution per unit = ₹14 − ₹9 = ₹5

Fixed Cost = BEP × Contribution per unit = 20,000 × ₹5 = ₹1,00,000

Degree of Operating Leverage (DOL) = Total Contribution / EBIT (Profit before interest and tax)

At 25,000 units: Total Contribution = 25,000 × ₹5 = ₹1,25,000; EBIT = ₹1,25,000 − ₹1,00,000 = ₹25,000. DOL = 1,25,000 / 25,000 = 5

At 30,000 units: Total Contribution = 30,000 × ₹5 = ₹1,50,000; EBIT = ₹1,50,000 − ₹1,00,000 = ₹50,000. DOL = 1,50,000 / 50,000 = 3

A DOL of 5 at 25,000 units means a 1% change in sales will cause a 5% change in operating profit. Higher sales volume reduces operating risk, as evidenced by DOL falling from 5 to 3.

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Sub-part (b): Labour Turnover

Given: Replacement method rate = 8%; Number replaced = 36; Flux method rate = 14%; Separation method rate = 6%.

Step 1 – Average number of workers (using Replacement method):
Replacement Rate = (Workers Replaced / Average Workers) × 100
8 = (36 / Average Workers) × 100 → Average Workers = 450

Step 2 – Workers left and discharged (using Separation method):
Separation Rate = (Separations / Average Workers) × 100
6 = (Separations / 450) × 100 → (ii) Workers left and discharged = 27

Step 3 – Workers recruited and joined (using Flux method):
Flux Rate = (Separations + New Accessions) / Average Workers × 100
14 = (27 + New Joinings) / 450 × 100
27 + New Joinings = 63 → (i) Workers recruited and joined = 36

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Sub-part (c): Compound Interest

Principal (P) = ₹2,40,000; Rate = 10% p.a.; Time = 3 years. Formula: A = P(1 + r/n)^(nt)

(i) Annual compounding: A = 2,40,000 × (1.10)³ = 2,40,000 × 1.331 = ₹3,19,440

(ii) Semi-annual compounding: Rate per period = 5%; Periods = 6. A = 2,40,000 × (1.05)⁶ = 2,40,000 × 1.340096 = ₹3,21,623 (approx.)

Semi-annual compounding yields ₹2,183 more than annual compounding due to more frequent interest application.

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Sub-part (d): Economic Order Quantity for Material 'X'

Annual demand of material X = 8,000 units/quarter × 4 × 3 kg = 96,000 kgs; Ordering cost (Co) = ₹1,000; Carrying cost (Cc) = 15% × ₹20 = ₹3 per kg per annum.

(i) EOQ = √(2 × 96,000 × 1,000 / 3) = √(6,40,00,000) = 8,000 kgs

(ii) Evaluation of 2% discount with 4 quarterly instalments:

Current Total Cost (at EOQ): Purchase cost = 96,000 × ₹20 = ₹19,20,000; Orders = 96,000/8,000 = 12; Ordering cost = 12 × ₹1,000 = ₹12,000; Carrying cost = (8,000/2) × ₹3 = ₹12,000. Total = ₹19,44,000

With Discount (order qty = 24,000 kgs, 4 orders): New price = ₹20 × 0.98 = ₹19.60; Carrying cost/kg = 15% × ₹19.60 = ₹2.94; Purchase cost = 96,000 × ₹19.60 = ₹18,81,600; Ordering cost = 4 × ₹1,000 = ₹4,000; Carrying cost = (24,000/2) × ₹2.94 = ₹35,280. Total = ₹19,20,880

Saving = ₹19,44,000 − ₹19,20,880 = ₹23,120

Conclusion: The company should accept the supplier's offer as it results in a net saving of ₹23,120 per annum.

Answer to Question 7 (Any Four)

(a) Conflicts in Profit vs. Wealth Maximisation Principle

The profit maximisation principle aims at maximising the accounting profits of the firm in the short run, while the wealth maximisation principle (also called value maximisation or shareholders' wealth maximisation) aims at maximising the market value of equity shares (i.e., Net Present Value of future cash flows).

The key conflicts between the two are:

1. Short-term vs. Long-term perspective: Profit maximisation focuses on current-period profits and may sacrifice long-term growth. Wealth maximisation takes a long-term view, accepting short-term profit reduction for sustainable value creation.

2. Time Value of Money: Profit maximisation ignores the time value of money — a ₹1 profit today and ₹1 profit five years later are treated equally. Wealth maximisation explicitly discounts future cash flows, recognising that money has time value.

3. Risk Consideration: Profit maximisation ignores risk associated with earnings. A high-risk project generating high profits may be preferred under profit maximisation, whereas wealth maximisation penalises higher risk through a higher discount rate, thus giving a lower NPV.

4. Ambiguity of 'Profit': Profit can be measured in multiple ways (gross profit, net profit, EPS, EBIT, etc.), making profit maximisation an ambiguous goal. Wealth maximisation is unambiguous — it refers to the market price of equity shares.

5. Dividend and Retention Policy: Profit maximisation may encourage distributing all profits as dividends, whereas wealth maximisation considers reinvestment of retained earnings to generate future growth, enhancing shareholder value.

Conclusion: Wealth maximisation is considered a superior and operationally sound objective of financial management as it resolves the conflicts by incorporating risk, time value, and the long-term perspective.

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(b) Considerations for Preparing a Capital Expenditure Budget

A Capital Expenditure (Capex) Budget is a plan outlining proposed investments in fixed or long-term assets. The following considerations govern its preparation:

1. Long-term Planning: Capital investments are made over long horizons. The firm must align capex with its strategic and long-term business plan.

2. Demand Forecasting: Anticipated increase in demand for products/services drives the need for additional capacity, machinery, or infrastructure.

3. Availability of Funds: The firm must assess whether sufficient internal funds (retained earnings, depreciation reserves) or external funds (loans, equity) are available to finance the proposed expenditure.

4. Profitability of Projects: Each proposed project must be evaluated using capital budgeting techniques such as NPV, IRR, Payback Period, or Profitability Index to ensure economic viability.

5. Urgency and Priority: Some expenditures may be mandatory (legal compliance, safety requirements, replacement of worn-out assets) and take priority over discretionary expansion projects.

6. Economic Conditions: General economic environment, interest rate trends, inflation, and industry outlook influence the timing and scale of capital expenditure.

7. Technological Considerations: Technological obsolescence risk must be evaluated — investing in technology that may soon become outdated should be carefully weighed.

8. Government Policies: Tax incentives (e.g., accelerated depreciation under the Income Tax Act 1961), subsidies, or sector-specific policies may influence capital investment decisions.

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(c) Business Risk vs. Financial Risk

Business Risk refers to the risk inherent in a firm's operations — the uncertainty in earnings before interest and taxes (EBIT) arising from the nature of the business, market conditions, competition, and operating cost structure. It is measured by the Operating Leverage (DOL).

Financial Risk refers to the additional risk borne by equity shareholders due to the use of debt (fixed interest-bearing securities) in the capital structure. It represents the variability in EPS (Earnings Per Share) caused by the presence of fixed financial charges. It is measured by the Financial Leverage (DFL).

Combined effect of business and financial risk is captured by Combined Leverage (DCL) = DOL × DFL, which measures the total risk borne by equity shareholders.

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(d) Forms of Bank Credit

Banks extend credit to businesses in the following principal forms:

1. Overdraft: A facility allowing the borrower to withdraw amounts exceeding the credit balance in their current account, up to a sanctioned limit. Interest is charged only on the amount actually overdrawn.

2. Cash Credit: The most common form of working capital finance in India. A borrower can withdraw funds up to a sanctioned limit against security of current assets (stock, debtors). Interest is charged on the outstanding balance.

3. Loans: A lump-sum amount sanctioned for a specific purpose (term loans for capital assets, demand loans for short-term needs). The entire amount is credited to the borrower's account and repaid in instalments or at maturity.

4. Discounting of Bills of Exchange: The bank purchases trade bills (before maturity) at a discount and pays the net proceeds to the seller. On maturity, the bank collects the full amount from the buyer.

5. Letter of Credit (LC): The bank guarantees payment to the supplier on behalf of the buyer, provided the documents comply with LC terms. It facilitates trade credit, especially in international trade.

6. Bank Guarantee: The bank acts as a surety for the borrower's obligations to a third party. It is a contingent liability for the bank and a source of non-fund-based credit for the business.

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(e) Borrowing is Cheaper than Equity Financing

Financing a business through debt (borrowings) is considered cheaper than equity for the following reasons:

1. Tax Deductibility of Interest (Tax Shield): Interest paid on debt is a tax-deductible expense under Section 36(1)(iii) of the Income Tax Act 1961, thereby reducing taxable income. Dividends paid on equity are an appropriation of profit — not tax-deductible. This gives debt a built-in cost advantage known as the tax shield.

Effective cost of debt = Kd = I(1 – t) / P, where t is the tax rate. For example, at a 30% tax rate, a 10% loan effectively costs only 7%.

2. Fixed Return Obligation: Equity shareholders expect returns commensurate with the higher risk they bear (residual claimants). The required rate of return on equity (Ke) is always higher than the pre-tax cost of debt (Kd), because equity carries no repayment guarantee.

3. No Sharing of Ownership or Control: Borrowing does not dilute ownership. Existing shareholders retain all residual profits. If the firm earns a return higher than the cost of debt, the surplus benefits equity shareholders — this is the concept of financial leverage or trading on equity.

4. Priority in Repayment: Lenders have a priority claim on assets, reducing their risk compared to equity holders, which is why they accept a lower return.

Important Caveat: Excessive borrowing increases financial risk (interest burden, bankruptcy risk), which may eventually raise the cost of equity and overall cost of capital. Therefore, an optimal capital structure balances debt and equity to minimise the Weighted Average Cost of Capital (WACC).