Test 4: answer key

Question 1 · 2 marks · Management of Working Capital · medium

Scenario. Aryan Auto Components Ltd. uses a 360-day year for working-capital analysis. For the year, raw material consumed was ₹72,00,000 and average raw material inventory was ₹6,00,000. Cost of production was ₹1,08,00,000 and average work-in-progress was ₹9,00,000. Cost of goods sold was ₹1,44,00,000 and average finished-goods inventory was ₹18,00,000. Average trade receivables were ₹15,00,000 against annual credit sales of ₹1,80,00,000. Annual total purchases were ₹90,00,000, of which credit purchases were ₹60,00,000; average trade payables were ₹7,50,000. Assume the stated annual figures are representative of the year.

Using the operating-cycle data of Aryan Auto Components Ltd., what are the raw material storage period and the work-in-progress holding period, respectively?

1. 30 days and 36 days
2. 36 days and 30 days
3. 30 days and 30 days (correct answer)
4. 45 days and 30 days

Answer: C — 30 days and 30 days

Working. Step 1 - Raw material daily consumption = ₹72,00,000 ÷ 360 = ₹20,000. Step 2 - Raw material storage days = ₹6,00,000 ÷ ₹20,000 = 30 days. Step 3 - Daily cost of production = ₹1,08,00,000 ÷ 360 = ₹30,000. Step 4 - WIP holding days = ₹9,00,000 ÷ ₹30,000 = 30 days.

Explanation. Option (c) is correct. Raw material storage period is average raw material inventory divided by average daily raw material consumption; WIP holding period is average WIP divided by average daily cost of production. Raw material days are ₹6,00,000 ÷ (₹72,00,000 ÷ 360) = 30 days. WIP days are ₹9,00,000 ÷ (₹1,08,00,000 ÷ 360) = 30 days. Option (b) is wrong because 36 days would require daily consumption of ₹16,666.67, equivalent to annual consumption of ₹60,00,000; the stated annual consumption is ₹72,00,000. Option (a) is wrong because the stated WIP and production cost produce 30 days, not 36 days. Option (d) is wrong because it assigns the 45-day finished-goods holding period to raw materials; the raw-material figures produce 30 days.

Where it goes wrong. Do not use cost of production as the denominator for raw material storage or raw material consumption as the denominator for WIP. Match each average inventory balance with its own annual cost base and use 360 days consistently.

Authority. Chapter 9: Management of Working Capital - Unit I, Section 6.1: Working Capital Based on Operating Cycle

Question 2 · 2 marks · Management of Working Capital · medium

What are the finished-goods storage period and the debtors’ collection period of Aryan Auto Components Ltd., respectively?

1. 45 days and 30 days (correct answer)
2. 30 days and 45 days
3. 45 days and 36 days
4. 60 days and 30 days

Answer: A — 45 days and 30 days

Working. Step 1 - Daily cost of goods sold = ₹1,44,00,000 ÷ 360 = ₹40,000. Step 2 - Finished-goods days = ₹18,00,000 ÷ ₹40,000 = 45 days. Step 3 - Daily credit sales = ₹1,80,00,000 ÷ 360 = ₹50,000. Step 4 - Debtors’ collection days = ₹15,00,000 ÷ ₹50,000 = 30 days.

Explanation. Option (a) is correct. Finished-goods storage period is average finished-goods inventory divided by average daily cost of goods sold: ₹18,00,000 ÷ (₹1,44,00,000 ÷ 360) = 45 days. Debtors’ collection period is average receivables divided by average daily credit sales: ₹15,00,000 ÷ (₹1,80,00,000 ÷ 360) = 30 days. Option (b) reverses the two calculated periods. Option (c) correctly states 45 finished-goods days but incorrectly calculates receivables at 36 days; the credit-sales daily rate is ₹50,000 and ₹15,00,000 represents 30 days. Option (d) overstates the finished-goods period; the average stock of ₹18,00,000 divided by the stated daily cost of goods sold of ₹40,000 gives 45 days, not 60.

Where it goes wrong. Use cost of goods sold for finished-goods holding days and credit sales for receivables collection days. Do not use total sales if only credit sales are relevant, and do not interchange the inventory and receivables denominators.

Authority. Chapter 9: Management of Working Capital - Unit I, Section 6.1: Working Capital Based on Operating Cycle

Question 3 · 2 marks · Management of Working Capital · hard

Taking the credit purchases figure rather than total purchases, what are the creditors’ deferral period and the net operating cycle of Aryan Auto Components Ltd., respectively?

1. 45 days and 180 days
2. 45 days and 90 days (correct answer)
3. 30 days and 105 days
4. 45 days and 135 days

Answer: B — 45 days and 90 days

Working. Step 1 - Daily credit purchases = ₹60,00,000 ÷ 360 = ₹16,666.67. Step 2 - Creditors’ deferral days = ₹7,50,000 ÷ ₹16,666.67 = 45 days. Step 3 - Gross operating period = R + W + F + D = 30 + 30 + 45 + 30 = 135 days. Step 4 - Net operating cycle = 135 − 45 = 90 days.

Explanation. Option (b) is correct. Creditors’ deferral period is average trade payables divided by average daily credit purchases: ₹7,50,000 ÷ (₹60,00,000 ÷ 360) = 45 days. Net operating cycle is R + W + F + D − C = 30 + 30 + 45 + 30 − 45 = 90 days. Option (a) uses the correct 45-day credit period but adds it instead of deducting it, producing 180 days. Option (c) uses total purchases of ₹90,00,000 rather than credit purchases of ₹60,00,000, producing an incorrect 30-day creditors’ period and a 105-day cycle. Option (d) identifies the creditors’ period correctly but reports the gross cycle of 135 days without deducting the 45 days of supplier credit.

Where it goes wrong. The operating-cycle equation deducts the supplier credit period. Also, the denominator for creditors’ deferral is credit purchases, not total purchases where a separate credit-purchases figure is given.

Authority. Chapter 9: Management of Working Capital - Unit I, Section 6.1: Working Capital Based on Operating Cycle

Question 4 · 2 marks · Management of Working Capital · hard

Scenario. Apex Distributorship has predictable and uniform cash requirements. Its annual cash outflow is ₹90,00,000, the fixed transaction cost each time marketable securities are converted into cash is ₹200, and the annual opportunity cost of holding cash is 12 percent. Apply William J. Baumol’s cash-management model and use the annual figures consistently.

According to William J. Baumol’s model, what is Apex Distributorship’s optimum cash balance (economic order quantity of cash), approximately?

1. ₹1,22,474
2. ₹17,321
3. ₹2,44,949
4. ₹1,73,205 (correct answer)

Answer: D — ₹1,73,205

Working. Step 1 - U = ₹90,00,000; P = ₹200; S = 12/100 = 0.12. Step 2 - C = √(2 × U × P ÷ S). Step 3 - C = √(2 × ₹90,00,000 × ₹200 ÷ 0.12) = √₹30,00,00,00,000. Step 4 - C ≈ ₹1,73,205.

Explanation. Option (d) is correct. Baumol’s optimum cash balance is C = √(2UP/S), where U is annual cash disbursement, P is fixed transaction cost and S is the annual opportunity cost per rupee. Substituting U = ₹90,00,000, P = ₹200 and S = 0.12 gives C = √(₹30,00,00,00,000) = approximately ₹1,73,205. Option (a) omits the factor 2 in the numerator and obtains approximately ₹1,22,474. Option (b) enters 12 instead of 0.12 as the opportunity-cost rate, understating the result by a factor of ten. Option (c) effectively doubles the required numerator by applying the factor 2 twice, overstating the optimum balance by √2.

Where it goes wrong. Convert 12 percent to 0.12 before substitution. Keep annual cash disbursement, annual transaction cost and annual opportunity-cost rate on a consistent time basis, and do not omit or duplicate the factor 2.

Authority. Chapter 9: Management of Working Capital - Unit II, Section 11.1: William J. Baumol’s Economic Order Quantity Model

Question 5 · 2 marks · Management of Working Capital · medium

At the optimum cash balance calculated under Baumol’s model, what is Apex Distributorship’s annual holding cost?

1. ₹10,392 (correct answer)
2. ₹20,785
3. ₹5,196
4. ₹17,321

Answer: A — ₹10,392

Working. Step 1 - Optimum cash balance C ≈ ₹1,73,205. Step 2 - Average cash balance = C/2 = ₹1,73,205 ÷ 2 = ₹86,602.50. Step 3 - Annual holding cost = average cash balance × opportunity cost rate = ₹86,602.50 × 12% = ₹10,392.30, approximately ₹10,392.

Explanation. Option (a) is correct. The average cash balance under the model is C/2. Annual holding cost is therefore (₹1,73,205 ÷ 2) × 12 percent, approximately ₹10,392. Option (b) applies 12 percent to the entire optimum transfer amount rather than to the average cash balance, doubling the holding cost. Option (c) halves the average-balance base a second time, using C/4 instead of C/2. Option (d) applies a 20 percent opportunity-cost rate instead of the stated 12 percent.

Where it goes wrong. The optimum cash balance is the transfer amount, not the average cash balance held throughout the period. The average balance is one-half of the optimum transfer amount under the Baumol assumptions.

Authority. Chapter 9: Management of Working Capital - Unit II, Section 11.1: William J. Baumol’s Economic Order Quantity Model

Question 6 · 2 marks · Management of Working Capital · hard

At the optimum cash balance, what is Apex Distributorship’s approximate total annual relevant cash-management cost, comprising holding cost and transaction cost?

1. ₹10,392
2. ₹15,589
3. ₹20,785 (correct answer)
4. ₹31,177

Answer: C — ₹20,785

Working. Step 1 - Holding cost = (C/2) × S = ₹86,602.50 × 0.12 = ₹10,392.30. Step 2 - Number of transfers = U/C = ₹90,00,000 ÷ ₹1,73,205 ≈ 51.96. Step 3 - Transaction cost = (U/C) × P = 51.96 × ₹200 ≈ ₹10,392.30. Step 4 - Total annual relevant cost = ₹10,392.30 + ₹10,392.30 = ₹20,784.60, approximately ₹20,785.

Explanation. Option (c) is correct. Annual holding cost is approximately ₹10,392. At the optimum balance, annual transaction cost is also approximately ₹10,392, so the total relevant cost is approximately ₹20,785 after rounding. Option (a) includes only one of the two cost components. Option (b) adds only half of the transaction cost to the holding cost, although the full number of annual transfers must be charged. Option (d) adds the holding cost to an amount that already includes holding cost, thereby counting holding cost twice.

Where it goes wrong. Do not report only the holding cost as the total cost. At the optimum Baumol balance, transaction cost and holding cost are equal; total relevant cost is their sum.

Authority. Chapter 9: Management of Working Capital - Unit II, Section 11.1: William J. Baumol’s Economic Order Quantity Model

Question 7 · 2 marks · Scope and Objectives of Financial Management · medium

Scenario. At Clarity Ltd., senior managers receive incentives based mainly on current-year accounting profit. The chief executive rejects a long-term project with positive net present value because depreciation would reduce current reported profit, while approving company-funded personal perquisites. The board is reviewing the objective of financial management and the finance manager’s principal decision responsibilities.

Which statement most appropriately analyses the chief executive’s conduct and the objective that should guide Clarity Ltd.’s financial decisions?

1. There is no agency problem because managers are formally appointed; current-year accounting profit is the complete measure of shareholder value.
2. The agency problem refers only to transaction costs of raising finance; the project should be rejected whenever it reduces reported profit in the first year.
3. The chief executive’s conduct is only a dividend decision; wealth maximisation requires maximising accounting profit without regard to the timing of returns.
4. Using company resources for personal perquisites illustrates an agency problem; shareholder wealth maximisation instead evaluates cash flows, their timing and risk. (correct answer)

Answer: D — Using company resources for personal perquisites illustrates an agency problem; shareholder wealth maximisation instead evaluates cash flows, their timing and risk.

Working. Step 1 - Identify the separation: shareholders own the company, while managers make operating and financial decisions. Step 2 - Compare interests: personal perquisites and incentives tied only to current reported profit may conflict with shareholder interests. Step 3 - Classify the conflict as an agency problem. Step 4 - Apply the wealth criterion: assess present value of cash benefits less costs, taking account of timing and risk.

Explanation. Option (d) is correct. Where managers place personal interests such as perquisites ahead of shareholders’ interests, an agency problem arises. Wealth maximisation focuses on shareholder value and evaluates benefits and costs through cash flows, cost-benefit analysis, time value of money and risk. Option (a) is wrong because formal appointment does not remove the separation between ownership and management, and reported profit alone does not capture risk and timing. Option (b) is wrong because agency problem is not limited to transaction costs; it concerns divergence between managers’ and owners’ interests, and first-year accounting profit is not the sole decision criterion. Option (c) is wrong because the facts concern managerial self-interest and investment evaluation, not merely dividend distribution; wealth maximisation does consider the timing and risk of returns.

Where it goes wrong. Do not equate profit maximisation with shareholder wealth maximisation. Accounting profit may ignore cash-flow timing and risk, while agency problems arise when managers’ personal objectives diverge from the owners’ interests.

Authority. Chapter 1: Scope and Objectives of Financial Management - Sections 7.1: Profit Maximisation; 7.2: Wealth Maximisation/Value Creation; Section 12: Agency Problem and Agency Cost

Question 8 · 1 marks · Scope and Objectives of Financial Management · medium

Which set correctly represents the three principal financial decision areas of a finance manager?

1. Investment, production and human-resource decisions
2. Investment, financing and dividend decisions (correct answer)
3. Investment, statutory audit and taxation decisions
4. Financing, marketing and dividend decisions

Answer: B — Investment, financing and dividend decisions

Working. Step 1 - Identify the use of funds: investment decision. Step 2 - Identify the source and mix of funds: financing decision. Step 3 - Identify distribution of earnings to shareholders: dividend decision. Step 4 - The complete set is investment, financing and dividend.

Explanation. Option (b) is correct. Financial management centres on deciding where to invest funds, how to procure or finance those funds, and how much of the earnings to distribute to shareholders. Option (a) includes production and human-resource decisions, which are not the three principal financial decision areas identified in the chapter. Option (d) substitutes marketing for investment. Option (c) substitutes statutory audit and taxation for financing and dividend decisions.

Where it goes wrong. Remember the three finance decisions as investment, financing and dividend. Do not substitute related business functions such as production, marketing, audit or taxation.

Authority. Chapter 1: Scope and Objectives of Financial Management - Section 1: Introduction (Investment, Financing and Dividend Decisions)