May 2023 Answer-P1

ICAMB
Question 1:
(a). What is the stepped cost? Illustrate with an example.
Answer:
Step costs are expenses that are constant for a given level of activity but increase or decrease once a
threshold is crossed. Step costs change disproportionately when the production levels of a
manufacturer, or activity levels of any enterprise, increase or decrease.
(b). Write three disadvantages of absorption costing.
Answer
Overemphasis on production volume: Absorption costing allocates fixed overhead costs to products
based on their production volume. This means that products with higher production volumes will
bear a greater portion of the fixed costs, regardless of their actual consumption of resources. As a
result, absorption costing can distort the true cost per unit of production and lead to misleading
profitability figures. It may incentivize companies to focus on high-volume production even if it is not
the most efficient or profitable strategy.

Difficulty in comparing profitability: Absorption costing treats fixed manufacturing costs as a product
costs and includes them in the inventory valuation until the products are sold. This can create
challenges when comparing the profitability of different products, particularly if they have different
levels of inventory. For instance, if one product has a high level of unsold inventory, it may appear
less profitable compared to another product with lower inventory levels, even if both products have
similar profit margins.

Inadequate cost control: Since absorption costing considers fixed overhead costs as a necessary part
of product costs, it may discourage cost reduction efforts. Managers may feel less motivated to
control or reduce fixed costs because they know these costs will be absorbed by the inventory
regardless. This can lead to inefficiencies and hinder cost management initiatives within the
organization. It may be more challenging to identify and address cost drivers and implement cost-
saving measures effectively under absorption costing compared to alternative costing methods, such
as variable costing.
(c). What is the difference between Cost driver and cost pool in ABC costing?
Answer
In Activity-Based Costing (ABC), cost drivers and cost pools are two important concepts used to
allocate indirect costs to products or services. Here's the difference between the two:

Cost Driver: A cost driver is a factor or activity that causes or influences the incurrence of costs in an
organization. It is a measurable attribute that provides a basis for allocating indirect costs to specific
cost objects (such as products, services, or customers). Cost drivers can vary depending on the nature
of the organization and the activities being performed. For example, in a manufacturing company,
cost drivers could include machine hours, labor hours, or the number of setups required. The
selection of appropriate cost drivers is crucial in ABC to ensure accurate cost allocation.

Cost Pool: A cost pool is a grouping or accumulation of costs that are similar in nature or share a
common cost driver. It represents a collection of costs that are attributed to a specific activity or a
set of related activities. Cost pools are typically created based on the similarity of the cost drivers
associated with different cost items. For example, if a company has several activities related to
machine setup, it can create a cost pool for all setup-related costs. The costs within a cost pool are
then allocated to cost objects using the corresponding cost drivers.

In summary, cost drivers are the factors that influence costs, while cost pools are the accumulations
of costs based on common cost drivers. Cost drivers help determine the cause-and-effect relationship
between activities and costs, while cost pools provide a basis for allocating costs to specific cost
objects using the appropriate cost driver.
(d). What is the difference between period Cost and product cost? Give an example.
Answer
Period costs and product costs are two different types of costs incurred by a business. The main
difference between them lies in their timing and association with the production process. Here's an
explanation along with an example:

Product Costs:
Product costs are directly associated with the production of goods or services. These costs are
incurred during the manufacturing or acquisition of products and are later recorded as expenses
when the products are sold. Product costs are further divided into three categories:

a. Direct Materials Cost: This includes the cost of raw materials that are directly used in the
production process. For example, in the manufacturing of a wooden chair, the cost of wood used to
construct the chair is a direct material cost.

b. Direct Labor Cost: This involves the wages or salaries of employees directly involved in the
manufacturing process. In the example of the wooden chair, the wages paid to the carpenter who
assembles the chair would be considered a direct labor cost.

c. Manufacturing Overhead: This includes indirect costs associated with the production process, such
as factory rent, utilities, equipment depreciation, and indirect labor costs. These costs are not easily
traceable to a specific product but are necessary for the overall production. For instance, the
electricity cost for running machinery in the chair manufacturing process would be considered
manufacturing overhead.

Period Costs:
Period costs are not directly related to the production process but are incurred over a specific period,
such as a month or a year. These costs are not tied to the production of goods or services and are
expensed during the period in which they are incurred. Period costs are typically reported as
operating expenses on the income statement. Examples of period costs include:
a. Selling and Marketing Expenses: Costs associated with advertising, sales commissions, marketing
campaigns, and other activities aimed at promoting and selling products.
b. General and Administrative Expenses: Costs associated with running the overall business,
including salaries of executives, rent for administrative offices, office supplies, and legal fees.
c. Research and Development (R&D) Expenses: Costs incurred in developing new products or
improving existing ones.

(e). When profit computation differs between absorption costing & marginal costing?
Answer
Profit computation can differ between absorption costing and marginal costing when there are
differences in the treatment of fixed manufacturing overhead costs.
Absorption Costing:
In absorption costing, all manufacturing costs, including both variable and fixed overhead costs, are
absorbed into the cost of the product. These costs are allocated to units of production based on a
predetermined overhead absorption rate. The profit is then calculated by deducting the total cost of
goods sold (including both variable and fixed manufacturing costs) from the total sales revenue.
Marginal Costing:
In marginal costing, only variable manufacturing costs are considered as product costs. Fixed
manufacturing overhead costs are treated as period costs and are not allocated to units of production.
These costs are expensed in the period incurred. The profit is calculated by deducting the total
variable cost of goods sold from the total sales revenue.
The main difference between absorption costing and marginal costing lies in the treatment of fixed
manufacturing overhead costs. This can result in variations in profit calculations under different
circumstances. Some situations where the profit computation differs between absorption costing and
marginal costing are:
Inventory Fluctuations: If the production level differs from the sales level, absorption costing
includes a portion of fixed overhead costs in ending inventory, while marginal costing does not. This
can lead to different profit figures between the two methods.
Production Volume: When the production volume is stable, absorption costing and marginal costing
will yield the same profit figures. However, if the production volume fluctuates significantly,
absorption costing may show higher profits during periods of high production and lower profits
during periods of low production compared to marginal costing.
Under or Over-absorption of Overhead: If the actual overhead costs incurred differ from the overhead
costs absorbed into the product under absorption costing, there can be over or under-absorption of
overhead. This can impact on the reported profits as absorption costing includes the absorbed
overhead in the product costs.
(f). What is the theory of constraint? Give an example.
Answer
The Theory of Constraints (TOC) is a management philosophy and methodology introduced by
Eliyahu M. Goldratt in his book "The Goal." It provides a systematic approach to identify and manage
constraints or bottlenecks that limit the overall performance of a system, process, or organization.
The theory suggests that by focusing on improving the constraints, the entire system can achieve
higher efficiency and productivity.
The core idea of the Theory of Constraints is that any system, whether it's a manufacturing process,
a supply chain, or even a personal project, has at least one constraint that limits its output.
Constraints can be physical resources, such as machines, labor, or materials, or they can be intangible
factors like policies, regulations, or knowledge gaps.
To explain further, let's consider an example of a manufacturing company. Suppose this company
produces widgets, and the production process involves multiple stages, including designing,
manufacturing, and packaging. However, the packaging department is a constraint, as it is unable to
keep up with the output of the other stages. As a result, the packaging department becomes a
bottleneck, limiting the overall production capacity of the company.

Using the Theory of Constraints, the company would focus on improving the efficiency and capacity
of the packaging department. This might involve streamlining processes, allocating additional
resources, or implementing new technologies to increase throughput. By addressing the constraint,
the company can improve the overall flow of production and increase its output.

It's important to note that the Theory of Constraints encourages a holistic perspective, emphasizing
that improving non-constraints or excess capacity in a system doesn't necessarily lead to significant
overall improvements. Instead, it suggests that efforts should be focused on identifying and elevating
constraints to maximize the system's performance.
(g). What is ZBB? How incremental budgeting differs from Rolling Budgeting.
Answer:
ZBB stands for Zero-Based Budgeting. It is a budgeting technique where all expenses must be justified
for each new budgeting period, regardless of whether they were included or not in the previous
period's budget. Unlike traditional budgeting methods that typically use a baseline or incremental
approach, ZBB requires a thorough review and analysis of all expenses, starting from a "zero base."
In Zero-Based Budgeting, each expense is evaluated based on its necessity and cost-benefit analysis.
Managers are required to build budgets from scratch, providing justifications for each expense item.
This approach aims to eliminate inefficiencies and non-essential expenses, encouraging managers to
prioritize and allocate resources to activities that generate the most value.
On the other hand, incremental budgeting is a budgeting method where the previous budget or actual
results from the previous period serve as a starting point for the new budget. It involves adjusting
and modifications to the previous budget based on changes in circumstances, such as inflation,
growth, or strategic initiatives. Incremental budgeting assumes that the previous period's budget is
a reasonable benchmark, and the focus is primarily on incremental changes or adjustments.
Rolling budgeting, also known as continuous or rolling forecast, is a budgeting approach that extends
the budgeting horizon beyond the fiscal year. Instead of creating an annual budget, rolling budgeting
typically covers a fixed period (e.g., 12 months) but continuously updates and extends it as each
month or quarter passes. This approach allows for regular reevaluation of assumptions, goals, and
financial plans based on the latest information, enabling organizations to be more adaptive and
responsive to changes in the business environment.
(h). What are the relevant costs and sunk costs? Give an example of each.
Answer:
Relevant costs and sunk costs are concepts commonly used in economics and decision-making
analysis.
Relevant costs: Relevant costs are future costs that are incurred as a result of making a particular
decision. These costs are typically incremental or differential costs that would change based on the
decision being made. Relevant costs are important in decision-making because they help determine
whether a course of action is financially viable or beneficial.
Example of relevant costs: Let's consider a manufacturing company that is evaluating whether to
continue producing a particular product or discontinue it. In this case, the relevant costs would
include the variable costs associated with the production of the product, such as direct material and
labor costs, as well as any additional expenses or savings that would arise if the product is
discontinued. The relevant costs would be compared to the revenue generated from selling the
product to determine whether it is financially worthwhile to continue production.
Sunk costs: Sunk costs are past costs that have already been incurred and cannot be recovered,
regardless of the decision made. These costs are irrelevant to future decision-making since they are
unrecoverable and should not be considered when evaluating the financial implications of a decision.
Sunk costs should be disregarded because they cannot be changed by any decision made in the
present or future.

Example of sunk costs: Let's say a business invests a significant amount of money in developing a
new software application. However, during the development process, it becomes clear that the
software will not meet the market demand and will not be profitable. The money already spent on
development is considered a sunk cost because it cannot be recovered, regardless of the decision to
continue or abandon the project. When deciding whether to continue with the development, the
business should focus on the future costs and potential revenue, without considering the sunk costs.
 May 2023 Answer-EF-232
ICAMB
Question 4:
(a). Financial markets provide platforms or mediums through which holders of
surplus funds invest their funds. Those with financial deficits could raise funds or
capital, enabling both parties to achieve their objectives.
Required: Distinguish between the money market and capital market, giving an
example of a financial instrument traded in each type of market.
Answer:
The money market and capital market are two distinct segments of the financial market that serve
different purposes and cater to different types of financial instruments. Here's a distinction between
the two:
Money Market:
The money market refers to the market where short-term debt securities and financial instruments
are traded. It provides a platform for borrowing and lending funds with maturities typically up to one
year. The main participants in the money market are financial institutions, corporations, and
government entities. The money market plays a crucial role in facilitating liquidity management and
short-term financing needs.

Example of a financial instrument traded in the money market: Treasury Bills (T-Bills)
T-Bills are short-term debt securities issued by governments to raise funds for short durations,
typically ranging from a few days to a year. They are considered one of the safest investments and
are issued at a discount to their face value. T-Bills are actively traded in the money market, where
investors purchase them at a discount and earn the face value at maturity.

Capital Market:
The capital market refers to the market where long-term debt and equity securities are traded. It
provides a platform for raising capital for medium to long-term investment purposes. The capital
market facilitates the transfer of funds from investors who have surplus capital to individuals,
companies, and governments in need of long-term financing.

Example of a financial instrument traded in the capital market: Stocks (Equities)

Stocks, also known as equities or shares, represent ownership in a company. They are issued by
companies to raise capital from investors. Investors who purchase stocks become shareholders and
have the potential to benefit from the company's profits and capital appreciation. Stocks are traded
in the capital market through stock exchanges, where buyers and sellers come together to trade
shares of publicly listed companies.
(b). RD Foods Limited is borrowing tk. 500,000 to finance a project involving the
expansion of its existing factory. It has obtained an offer from City Bank. The terms of
the loan facility are as follows:
Annual interest rate: 22%
Duration: 2
Interest method: Compound interest rate with quarterly compounding
Payment plan: Equal installments at the end of each quarter
Required: (i) Compute the quarterly installment
(ii) Prepare loan amortization.
Answer:
To compute the quarterly installment and prepare the loan amortization schedule, we need to use
the formula for calculating the equal installment payment for a loan with compound interest:
Quarterly Installment = (P * r * (1 + r)^n) / ((1 + r)^n - 1)
Where:
P = Principal amount (loan amount)
r = Quarterly interest rate
n = Total number of quarters
Given:
Principal amount (P) = Tk. 500,000
Annual interest rate = 22%
Duration = 2 years
Interest method = Compound interest rate with quarterly compounding
Payment plan = Equal installments at the end of each quarter
(i) Compute the quarterly installment:
First, let's calculate the quarterly interest rate:
Quarterly interest rate = (1 + Annual interest rate)^(1/4) - 1
= (1 + 0.22)^(1/4) - 1
= (1.22)^(1/4) - 1
≈ 0.04944
Now, let's calculate the total number of quarters:
Total number of quarters = Duration in years * 4
=2*4
=8
Using the formula for the quarterly installment:
Quarterly Installment = (500,000 * 0.04944 * (1 + 0.04944)^8) / ((1 + 0.04944)^8 - 1)
≈ 82,763.75 Tk. (rounded to the nearest Tk.)
Therefore, the quarterly installment is approximately Tk. 82,763.75.

(ii) Prepare the loan amortization schedule:

Quarter Beginning Balance Interest Principal Installment Ending Balance
1 500,000.00 12,361.88 70,401.87 82,763.75 429,598.13
2 429,598.13 10,620.73 72,142.02 82,763.75 357,456.11
3 357,456.11 8,808.58 73,953.17 82,763.75 283,502.94
4 283,502.94 6,914.88 75,846.87 82,763.75 207,656.07
5 207,656.07 4,928.44 77,833.31 82,763.75 129,822.76
6 129,822.76 2,837.14 79,924.61 82,763.75 49,898.15
7 49,898.15 933.06 81,828.69 82,763.75 1,069.45
8 1,069.45 24.88 82,737.87 82,763.75 0.00
In each quarter, the interest is calculated based on the beginning balance
(c). Fortune Limited has an issued 12% bond with a par value of tk. 150,000 and a
redemption value tk. 165,000 with interest payable quarterly. The cost of debt on the
bonds is 8% annually and 2% quarterly. The bonds are redeemable on 3
June 2023 and it is now 31 December 2019.
Required: (i) Compute the market value of the bonds.
Answer:
To compute the market value of the bonds, we need to discount the future cash flows (interest
payments and redemption value) at the required rate of return. In this case, the cost of debt is 8%
annually and 2% quarterly.
First, let's calculate the number of quarters from 31 December 2019 to 3 June 2023:
Number of quarters = 3.5 years * 4 quarters per year = 14 quarters

Next, let's calculate the present value of the interest payments:

Interest payment = 12% of the par value = 0.12 * 150,000 = tk. 18,000

Using the formula for the present value of an ordinary annuity, the present value of the interest
payments is:

PV of interest payments = Interest payment * [1 - (1 + r)^(-n)] / r

where r is the quarterly interest rate (2% or 0.02) and n is the number of quarters (14).

PV of interest payments = 18,000 * [1 - (1 + 0.02)^(-14)] / 0.02 ≈ tk. 215,529.78

Next, let's calculate the present value of the redemption value:

Redemption value = tk. 165,000

Using the formula for the present value of a single sum, the present value of the redemption value is:

PV of redemption value = Redemption value / (1 + r)^n

where r is the quarterly interest rate (2% or 0.02) and n is the number of quarters (14).

PV of redemption value = 165,000 / (1 + 0.02)^14 ≈ tk. 131,262.80

Finally, the market value of the bonds is the sum of the present value of the interest payments and
the present value of the redemption value:

Market value of the bonds = PV of interest payments + PV of redemption value

≈ tk. 215,529.78 + tk. 131,262.80
≈ tk. 346,792.58

Therefore, the market value of the bonds is approximately tk. 346,792.58.

Question 5:
(a). If a company’s beta were to double, would its expected return double?
Answer:
No, doubling a company's beta would not necessarily result in its expected return doubling. Beta is
a measure of a stock's sensitivity to market movements, specifically how closely it tends to move in
relation to the overall market. A beta greater than 1 indicates that the stock tends to be more volatile
than the market, while a beta less than 1 suggests the stock is less volatile.

The expected return of a stock is determined by various factors, including its beta, but it is not solely
dependent on beta. Other factors that contribute to the expected return include the risk-free rate of
return, the market risk premium, and the company's specific risk profile.

If a company's beta were to double, it means that the stock would become more volatile and have a
higher sensitivity to market movements. However, the expected return would also depend on
whether the market risk premium and the risk-free rate of return have changed. If these factors
remain the same, the expected return may increase due to the higher beta, but it would not
necessarily double.
Question 6:
(a). What are the trade-offs in the static trade-off theory of capital structure? How is
the firm’s optimal capital structure determined under the assumptions of this theory?
Is it possible to determine the optimal capital structure in the precise term in the real
world? Why or why not? Explain.
Answer:
The static trade-off theory of capital structure suggests that firms have an optimal capital structure
where the benefits of debt, such as tax advantages and lower cost of capital, are balanced against the
costs, such as financial distress and agency costs. However, there are several trade-offs inherent in
this theory:

Tax Advantage vs. Financial Distress Costs: Debt offers tax advantages due to the deductibility of
interest payments, which reduces the firm's tax liability. On the other hand, excessive debt can
increase the risk of financial distress, leading to costs such as bankruptcy expenses, lower credit
ratings, and higher borrowing costs.

Flexibility vs. Agency Costs: Equity provides flexibility for the firm because it does not have fixed
payment obligations. Debt, however, requires regular interest and principal payments. This flexibility
allows equity holders to undertake riskier projects without the pressure of meeting debt obligations.
However, the presence of equity holders introduces agency costs, as managers may take actions that
benefit shareholders at the expense of debt holders.

Cost of Capital vs. Signaling: Debt financing generally has a lower cost of capital compared to equity
financing. However, issuing excessive debt may signal financial distress to investors, leading to a
higher cost of capital. Therefore, firms must find a balance between the cost of capital and the
signaling effect to maintain an optimal capital structure.

Determining the firm's optimal capital structure under the static trade-off theory involves finding the
debt level that maximizes the firm's value. This can be done by comparing the tax benefits of debt
with the costs associated with financial distress and agency issues. The optimal capital structure is
achieved when the marginal benefits of debt are equal to the marginal costs.
However, it is challenging to determine the precise optimal capital structure in the real world due to
several reasons:

Assumptions and Simplifications: The static trade-off theory relies on various assumptions, such as
the ability to accurately estimate costs and benefits, constant tax rates, and fixed business conditions.
These assumptions may not hold true in reality, making it difficult to determine the precise optimal
capital structure.

Changing Business Environment: The financial landscape and business conditions are dynamic and
subject to change. Factors such as interest rates, industry trends, economic conditions, and
regulatory environments can significantly impact a firm's optimal capital structure. Predicting and
incorporating these changes accurately is a complex task.

Firm-Specific Factors: Each firm has its unique characteristics, including industry, size, growth
prospects, profitability, and risk profile. These factors influence the optimal capital structure, and it
may vary from one firm to another. Determining the precise optimal capital structure requires a
detailed analysis of specific firm attributes, which can be challenging and time-consuming.

Market Imperfections and Information Asymmetry: Financial markets are not perfectly efficient, and
there is often imperfect information and asymmetry between market participants. This can lead to
mispricing of securities, distorted market signals, and difficulties in accurately determining the
optimal capital structure.

Considering these factors, it is difficult to determine the precise optimal capital structure in the real
world. Instead, firms typically aim to achieve a target capital structure that reflects a reasonable
balance between debt and equity based on their specific circumstances, risk appetite, and financial
goals. Regular monitoring and adjustments are made as business conditions evolve.
Question 7:
(a). Covid-19 has led to volatility in the international money market. Although
international business has seen some improvement, progress has been very slow. As
a result, the risk of losing part of an investment due to exchange rate and currency
value fluctuations is very high.
Required: Explain how interest rate swaps and currency swaps can be used to mitigate
the effects of market volatility.
Answer:
Interest rate swaps and currency swaps are financial instruments that can be utilized to mitigate the
effects of market volatility, including exchange rate and currency value fluctuations. Here's an
explanation of how each of these swaps can help in managing risk:
Interest Rate Swaps:
Interest rate swaps involve the exchange of interest payments between two parties based on a
notional principal amount. The purpose of an interest rate swap is to manage or hedge interest rate
risk.
In the context of international business and market volatility, interest rate swaps can be used to
mitigate the impact of fluctuating interest rates on investments and loans denominated in different
currencies. Here's how it works:
Let's consider a scenario where a company has taken a loan with a variable interest rate in a foreign
currency. The company is concerned about the potential increase in interest rates and the resulting
impact on their loan repayments. To manage this risk, the company can enter into an interest rate
swap with another party.
In the swap agreement, the company agrees to exchange their variable interest rate payments in the
foreign currency for fixed interest rate payments in their domestic currency with the counterparty.
By doing so, the company locks in a fixed interest rate, reducing the uncertainty caused by fluctuating
interest rates.

Interest rate swaps help mitigate the risk of interest rate fluctuations, allowing businesses to better
plan their cash flows and budget for loan repayments, thereby reducing the impact of market
volatility.

Currency Swaps:
Currency swaps are financial agreements between two parties to exchange a specified amount of one
currency for another at predetermined exchange rates. Currency swaps are commonly used to
manage exchange rate risk in international transactions.
In the context of market volatility, currency swaps can be used to mitigate the impact of fluctuating
exchange rates on investments or cash flows denominated in different currencies. Here's how it
works:
Let's consider a scenario where a company has invested in a foreign market and expects to receive a
future cash flow in a foreign currency. However, the company is concerned about potential
depreciation of the foreign currency, which could reduce the value of their investment.
To manage this risk, the company can enter into a currency swap agreement with another party. In
the swap agreement, the company agrees to exchange the future cash flows denominated in the
foreign currency for equivalent cash flows in their domestic currency at a predetermined exchange
rate.

By entering into the currency swap, the company effectively hedges against the risk of exchange rate
fluctuations. They can secure a fixed exchange rate, protecting the value of their investment and
reducing the potential loss caused by currency volatility.