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 INDEX
TOPIC
Section-A: Financial Management Page No.
Chapter 1: Scope and Objectives of Financial 3
Management
Chapter 2: Types of Financing 16
Chapter 3: Financial Analysis and Planning - Ratio 24
Analysis
Chapter 4: Cost of Capital 66
Chapter 5: Financing Decisions - Capital Structure 96
Chapter 6: Financing Decisions - Leverages 137
Chapter 7: Investment Decisions 170
Chapter 8: Risk Analysis in Capital Budgeting 233
Chapter 9: Dividend Decisions 263
Chapter 10: Management of Working Capital 296

TOPIC
Section-B: Economics for Finance Page No.
Chapter 1: Determination of National Income 378
Chapter 2: Public Finance 443
Chapter 3: Money Market 506
Chapter 4: International Trade 562
2
PAST PAPERS, RTPs, MTPs 641
 Section-A Financial Management

CHAPTER-1 SCOPE AND OBJECTIVES OF

FINANCIAL MANAGEMENT
ILLUSTRATION 1
Profit maximization does not consider risk or uncertainty, whereas wealth maximization considers both risk
and uncertainty. Suppose there are two products, X and Y, and their projected earnings over the next 5
years are as shown below:

Year Product X (₹) Product Y (₹)

1. 10,000 11,000
2. 10,000 11,000
3. 10,000 11,000
4. 10,000 11,000
5. 10,000 11,000
50,000 55,000

A profit maximization approach would favour product Y over product X. However, if product Y is more risky
than product X, then the decision is not as straightforward as the figures seem to indicate. It is important to
realize that a trade-off exists between risk and return. Stockholders expect greater returns from investments
of higher risk and vice-versa. To choose product Y, stockholders would demand a sufficiently large return to
compensate for the comparatively greater level of risk.

3
MCQs based Questions

1. Focus of financial management is mainly concerned with the decision related to:

(a) Financing

(b) Investing

(c) Dividend

(d) All of above.

ANSWER 1-D

2. The main objective of financial management is to:

(a) Secure profitability

(b) Maximise shareholder wealth

(c) Enhancing the cost of debt

(d) None of above.

ANSWER 2-B

3. The shareholder value maximisation model holds that the primary goal of the firm is to maximise its:

(a) Accounting profit

(b) Liquidity 4

(c) Market value

(d) Working capital.

ANSWER 3-C
4. Wealth maximisation approach is based on the concept of:

(a) Cost benefit analysis

(b) Cash flow approach

(c) Time value of money

(d) All of the above.

ANSWER 4-D

5. Management of all matters related to an organisation’s finances is called:

(a) Cash inflows and outflows

(b) Allocation of resources

(c) Financial management

(d) Finance.
ANSWER 5-C

6. Which of the following is not an element of financial management?

(a) Allocation of resources

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(b) Financial Planning

(c) Financial Decision-making

(d) Financial control.

ANSWER 6-D
7. The most important goal of financial management is:

(a) Profit maximisation

(b) Matching income and expenditure

(c) Using business assets effectively

(d) Wealth maximisation.

ANSWER 7-D

8. To achieve wealth maximization, the finance manager has to take careful decision in respect of:

(a) Investment

(b) Financing

(c) Dividend

(d) All the above.

ANSWER 8-D

9. Early in the history of finance, an important issue was:

(a) Liquidity

(b) Technology

(c) Capital structure

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(d) Financing options.
ANSWER 9-A
10. Which of the following are microeconomic variables that help define and explain the discipline of
finance?

(a) Risk and return

(b) Capital structure

(c) Inflation

(d) All of the above.

ANSWER 10-D

11. Financial Management is mainly concerned with the-

(a) Acquiring and developing assets to forfeit its overall benefit.

(b) Acquiring, financing and managing assets to accomplish the overall goal of a business enterprise.

(c) Efficient management of the business.

(d) Sole objective of profit maximization.

ANSWER 11-B

12. Which of the following need not be followed by the finance manager for measuring and maximising
shareholders' wealth?

(a) Accounting profit analysis.

(b) Cash Flow approach.

(c) Cost benefit analysis. 7

(d) Application of time value of money.

ANSWER 12-A
Theoretical Questions

1. POINT OUT the difference between Financial Management & Financial Accounting?

ANSWER 1

Financial Management and Accounting The relationship between financial management and accounting are
closely related to the extent that accounting is an important input in financial decision making. In other words,
accounting is a necessary input into the financial management function. Financial accounting generates
information relating to operations of the organisation. The outcome of accounting is the financial statements
such as balance sheet, income statement, and the statement of changes in financial position. The information
contained in these statements and reports helps the financial managers in gauging the past performance and
future directions of the organisation. Though financial management and accounting are closely related, still
they differ in the treatment of funds and also with regards to decision making. Some of the differences are:-

Treatment of Funds
In accounting, the measurement of funds is based on the accrual principle i.e. revenue is recognised at the
point of sale and not when collected and expenses are recognised when they are incurred rather than when
actually paid. The accrual based accounting data do not reflect fully the financial conditions of the
organisation. An organisation which has earned profit (sales less expenses) may said to be profitable in the
accounting sense but it may not be able to meet its current obligations due to shortage of liquidity as a result
of say, uncollectible receivables. Such an organisation will not survive regardless of its levels of profits.
Whereas, the treatment of funds in financial management is based on cash flows. The revenues are
recognised only when cash is actually received (i.e. cash inflow) and expenses are recognised on actual
payment (i.e. cash outflow). This is so because the finance manager is concerned with maintaining solvency of
the organisation by providing the cash flows necessary to satisfy its obligations and acquiring and financing the
assets needed to achieve the goals of the organisation. Thus, cash flow based returns help financial managers
to avoid insolvency and achieve desired financial goals.

Decision – making
The purpose of accounting is to collect and present financial data of the past, present and future operations of
the organization. The financial manager uses these data for financial decision making. It is not that the

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financial managers cannot collect data or accountants cannot make decisions, but the chief focus of an
accountant is to collect data and present the data while the financial manager’s primary responsibility relates
to financial planning, controlling and decision making. Thus, in a way it can be stated that financial
management begins where accounting ends.
2. “Financial management is concerned with acquisition & financing of short term & long-term credit”.
ELABORATE.

ANSWER 2

For the purpose of starting any new business/venture, an entrepreneur goes through the following stages of
decision making:-

While deciding how much to take from each source, the entrepreneur would keep in mind the cost of capital
for each source (Interest/Dividend etc.). As an entrepreneur he would like to keep the cost of capital low.
Thus, financial management is concerned with efficient acquisition (financing) and allocation (investment in
assets, working capital etc.) of funds with an objective to make profit (dividend) for owners. In other words,
focus of financial management is to address three major financial decision areas namely, investment,
financing and dividend decisions.

Any business enterprise requiring money and the 3 key questions being enquired into
1. Where to get the money from? (Financing Decision)

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2. Where to invest the money? (Investment Decision)
3. How much to distribute amongst shareholders to keep them satisfied? (Dividend Decision)

3. DISCUSS the two main aspects of the finance function?

ANSWER 3

The finance functions are divided into long term and short term functions/decisions
Long term Finance Function Decisions.

(a) Investment decisions

(I): These decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured
from different sources have to be invested in various kinds of assets. Long term funds are used in a project for
various fixed assets and also for current assets. The investment of funds in a project has to be made after
careful assessment of the various projects through capital budgeting. A part of long term funds is also to be
kept for financing the working capital requirements. Asset management policies are to be laid down regarding
various items of current assets. The inventory policy would be determined by the production manager and the
finance manager keeping in view the requirement of production and the future price estimates of raw
materials and the availability of funds.

(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial
objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to
possess a good knowledge of the sources of available funds and their respective costs and needs to ensure
that the company has a sound capital structure, i.e. a proper balance between equity capital and debt. Such
managers also need to have a very clear understanding as to the difference between profit and cash flow,
bearing in mind that profit is of little avail unless the organisation is adequately supported by cash to pay for
assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation
of risk, e.g. excessive debt carried high risk for an organization’s equity because of the priority rights of the
lenders. A major area for risk-related decisions is in overseas trading, where an organisation is vulnerable to
currency fluctuations, and the manager must be well aware of the various protective procedures such as
hedging (it is a strategy designed to minimize, reduce or cancel out the risk in another investment) available to
him. For example, someone who has a shop, takes care of the risk of the goods being destroyed by fire by
hedging it via a fire insurance contract.

(c) Dividend decisions(D): These decisions relate to the determination as to how much and how frequently
cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of
any profit-making organization looks for reward for his investment in two ways, the growth of the capital
invested and the cash paid out as income; for a sole trader this income would be termed as drawings and for a
limited liability company the term is dividends.
The dividend decision thus has two elements – the amount to be paid out and the amount to be retained to

10
support the growth of the organisation, the latter being also a financing decision; the level and regular growth
of dividends represent a significant factor in determining a profit-making company’s market value, i.e. the
value placed on its shares by the stock market.
All three types of decisions are interrelated, the first two pertaining to any kind of organisation while the third
relates only to profit-making organisations, thus it can be seen that financial management is of vital
importance at every level of business activity, from a sole trader to the largest multinational corporation.
Short- term Finance Decisions/Function.
Working capital Management (WCM): Generally short term decision are reduced to management of current
asset and current liability (i.e., working capital Management)

4. DISCUSS three main considerations in procuring funds?

ANSWER 4

Since funds can be obtained from different sources therefore their procurement is always considered as a
complex problem by business concerns.

In a global competitive scenario it is not enough to depend on the available ways of raising finance but
resource mobilization has to be undertaken through innovative ways on financial products which may meet
the needs of investors. We are constantly seeing new and creative sources of funds which are helping the
modern businesses to grow faster. For example trading in Carbon Credits is turning out to be another source
of funding.

Funds procured from different sources have different characteristics in terms of risk, cost and control. The cost
of funds should be at the minimum level for that a proper balancing of risk and control factors must be carried
out. Another key consideration in choosing the source of new business finance is to strike a balance between
equity and debt to ensure the funding structure suits the business. Let us discuss some of the sources of
funds:

(a) Equity: The funds raised by the issue of equity shares are the best from the risk point of view for the firm,
since there is no question of repayment of equity capital except when the firm is under liquidation. From the
cost point of view, however, equity capital is usually the most expensive source of funds. This is because the
dividend expectations of shareholders are normally higher than prevalent interest rate and also because
dividends are an appropriation of profit, not allowed as an exp
ense under the Income Tax Act. Also the issue of new shares to public may dilute the control of the existing
shareholders.

11
(b) Debentures: Debentures as a source of funds are comparatively cheaper than the shares because of their
tax advantage. The interest the company pays on a debenture is free of tax, unlike a dividend payment which
is made from the taxed profits. However, even when times are hard, interest on debenture loans must be paid
whereas dividends need not be. However, debentures entail a high degree of risk since they have to be repaid
as per the terms of agreement. Also, the interest payment has to be made whether or not the company makes
profits.
 (c) Funding from Banks: Commercial Banks play an important role in funding of the business enterprises.
Apart from supporting businesses in their routine activities (deposits, payments etc.) they play an important
role in meeting the long term and short term needs of a business enterprise. Different lending services
provided by Commercial Banks are depicted as follows:-

(d) International Funding: Funding today is not limited to domestic market. With liberalization and
globalization a business enterprise has options to raise capital from International markets also. Foreign Direct
Investment (FDI) and Foreign Institutional Investors (FII) are two major routes for raising funds from foreign
sources besides ADR’s (American depository receipts) and GDR’s (Global depository receipts). Obviously, the
mechanism of procurement of funds has to be modified in the light of the requirements of foreign investors.

5. EXPLAIN “Wealth maximisation” and “Profit maximisation” objectives of financial management.

ANSWER 5

Profit Maximisation It has traditionally been argued that the primary objective of a company is to earn profit;
hence the objective of financial management is also profit maximisation. This implies that the finance manager
has to make his decisions in a manner so that the profits of the concern are maximised. Each alternative,
therefore, is to be seen as to whether or not it gives maximum profit. However, profit maximisation cannot be
the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number
of problems can arise. Some of these have been discussed below: (i) The term profit is vague. It does not
clarify what exactly it means. It conveys a different meaning to different people. For example, profit may be
in short term or long term period; it may be total profit or rate of profit etc. (ii) Profit maximisation has to be
attempted with a realisation of risks involved. There is a direct relationship between risk and profit. Many
risky propositions yield high profit. Higher the risk, higher is the possibility of profits. If profit maximisation is
the only goal, then risk factor is altogether ignored. This implies that finance manager will accept highly risky
proposals also, if they give high profits. In practice, however, risk is very important consideration and has to be
balanced with the profit objective. (iii) Profit maximisation as an objective does not take into account the
time pattern of returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if the

12
returns of proposal A begin to flow say 10 years later, proposal B may be preferred which may have lower
overall profit but the returns flow is more early and quick.

(iv) Profit maximisation as an objective is too narrow. It fails to take into account the social considerations as
also the obligations to various interests of workers, consumers, society, as well as ethical trade practices. If
these factors are ignored, a company cannot survive for long. Profit maximization at the cost of social and
moral obligations is a short sighted policy.
Wealth / Value Maximisation

Finance manager should emphasis on Cash flow for investment or financing decisions not on Accounting
profit. The shareholder value maximization model holds that the primary goal of the firm is to maximize its
market value and implies that business decisions should seek to increase the net present value of the
economic profits of the firm. So for measuring and maximising shareholders wealth finance manager should
follow:
♦ Cash Flow approach not Accounting Profit
♦ Cost benefit analysis
♦ Application of time value of money.

How do we measure the value/wealth of a firm?

According to Van Horne, “Value of a firm is represented by the market price of the company's common stock.
The market price of a firm's stock represents the focal judgment of all market participants as to what the value
of the particular firm is. It takes into account present and prospective future earnings per share, the timing
and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market
price of the stock. The market price serves as a performance index or report card of the firm's progress. It
indicates how well management is doing on behalf of stockholders.”

6. DISCUSS the role of a chief financial officer.

ANSWER 6

His responsibilities include:

13
(a) Financial analysis and planning: Determining the proper amount of funds to employ in the firm, i.e.
designating the size of the firm and its rate of growth.

(b) Investment decisions: The efficient allocation of funds to specific assets.

(c) Financing and capital structure decisions: Raising funds on favourable terms as possible i.e. determining
the composition of liabilities.

(d) Management of financial resources (such as working capital).

(e) Risk management: Protecting assets.

What a CFO used to do? What a CFO now does?

Budgeting Budgeting
Forecasting Forecasting
Accounting Managing M&As
Treasury (cash management) Profitability analysis (for example, by
customer or product)
Preparing internal financial reports for Pricing analysis
management.
Preparing quarterly, annual filings for Decisions about outsourcing
investors.
Tax filing Overseeing the IT function.
Tracking accounts payable and accounts Overseeing the HR function.
receivable.
Travel and entertainment expense Strategic planning (sometimes overseeing
management. this function).
Regulatory compliance.
Risk management.

7. In recent years, there have been a number of environmental, pollution and other regulations imposed on
businesses. In view of these changes, is maximisation of shareholder wealth still a realistic objective?
EXPLAIN.

ANSWER 7

Every entity associated with the company will evaluate the performance of the management from the
fulfilment of its own objective. The survival of the management will be threatened if the objective of any of
the entities remains unfulfilled.

The wealth maximization objective is generally in accord with the interests of the various groups such as
owners, employees, creditors and society, and thus, it may be consistent with the management objective of

14
survival.

Owing to limitation (timing, social consideration etc.) in profit maximization, in today’s real world situations
which is uncertain and multi-period in nature, wealth maximization is a better objective. Where the time
period is short and degree of uncertainty is not great, wealth maximization and profit maximization amount to
essentially the same. The table below highlights some of the advantages and disadvantages of both profit
maximization and wealth maximization goals:-
Example: Profit maximization can be achieved in the short term at the expense of the long term goal, that is,
wealth maximization. For example, a costly investment may experience losses in the short term but yield
substantial profits in the long term. Also, a firm that wants to show a short term profit may, for example,
postpone major repairs or replacement, although such postponement is likely to hurt its long term
profitability.
Following illustration can be taken to understand why wealth maximization is a preferred objective than profit
maximization.

15
 CHAPTER-2 TYPES OF FINANCING

MCQs based Questions

1. Equity shares:

(a) Have an unlimited life, and voting rights and receive dividends

(b) Have a limited life, with no voting rights but receive dividends

(c) Have a limited life, and voting rights and receive dividends

(d) Have an unlimited life, and voting rights but receive no dividends

ANSWER 1-A

2. External sources of finance do not include:

(a) Debentures

(b) Retained earnings

(c) Overdrafts

(d) Leasing

ANSWER 2-B

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3. Internal sources of finance do not include:

(a) Better management of working capital

(b) Ordinary shares

(c) Retained earnings

(d) Reserve and Surplus

ANSWER 3-B

4 In preference shares:

(a) Dividends are not available

(b) Limited voting rights are available

(c) Are not part of a company’s share capital

(d) Interest can be received

ANSWER 4-B

5 A debenture:

(a) Is a long-term loan

(b) Does not require security

(c) Is a short-term loan

(d) Receives dividend payments

17
ANSWER 5-A

6. Debt capital refers to:

(a) Money raised through the sale of shares.

(b) Funds raised by borrowing that must be repaid.

(c) Factoring accounts receivable.

(d) Inventory loans.

ANSWER 6-B

7 The most popular source of short-term funding is:

(a) Factoring.

(b) Trade credit.

(c) Family and friends.

(d) Commercial banks.

ANSWER 7-B

8 Marketable securities are primarily-

(a) short-term debt instruments.

(b) short-term equity securities.

(c) long-term debt instruments.

(d) long-term equity securities.

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ANSWER 8-A

9. Which of the following marketable securities is the obligation of a commercial bank?

(a) Commercial paper

(b) Negotiable certificate of deposit

(c) Repurchase agreement

(d) T-bills

ANSWER 9-B

10. Reserves & Surplus are which form of financing?

(a) Security Financing

(b) Internal Financing

(c) Loans Financing

(d) International Financing

ANSWER 10-B

11. With reference to ₹IFC Masala Bonds’, which of the statements given below is/are correct?
1. The International Finance Corporation, which offered these bonds, is an arm of the World Bank.
2. They are rupee-denominated bonds and are a source of debt financing for the public and private sector.

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

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ANSWER 11-C
12. External Commercial Borrowings can be accessed through ..............

(a) only automatic route

(b) only approval route

(c) both automatic and approval route

(d) neither automatic nor approval route

ANSWER 12-C

Theoretical based Questions

1. DESCRIBE the different types of Packing Credit.

ANSWER 1

Types of Packing Credit

(a) Clean packing credit: This is an advance made available to an exporter only on production of a firm export
order or a letter of credit without exercising any charge or control over raw material or finished goods. It is a
clean type of export advance. Each proposal is weighed according to particular requirements of the trade and
credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee
Corporation (ECGC) cover should be obtained by the bank.

(b) Packing credit against hypothecation of goods: Export finance is made available on certain terms and
conditions where the exporter has pledge able interest and the goods are hypothecated to the bank as

20
security with stipulated margin. At the time of utilising the advance, the exporter is required to submit, along
with the firm export order or letter of credit relative stock statements and thereafter continue submitting
them every fortnight and/or whenever there is any movement in stocks.

(c) Packing credit against pledge of goods: Export finance is made available on certain terms and conditions
where the exportable finished goods are pledged to the banks with approved clearing agents who will ship the
same from time to time as required by the exporter. The possession of the goods so pledged lies with the bank
and is kept under its lock and key.
(d) E.C.G.C. guarantee: Any loan given to an exporter for the manufacture, processing, purchasing, or packing
of goods meant for export against a firm order qualifies for the packing credit guarantee issued by Export
Credit Guarantee Corporation.

(e) Forward exchange contract: Another requirement of packing credit facility is that if the export bill is to be
drawn in a foreign currency, the exporter should enter into a forward exchange contact with the bank, thereby
avoiding risk involved in a possible change in the rate of exchange.

2. DISCUSS the advantages of raising funds by issue of equity shares.

ANSWER 2

Advantages of raising funds by issue of equity shares are:

(i) It is a permanent source of finance. Since such shares are not redeemable, the company has no liability for
cash outflows associated with its redemption. In other words, once the company has issued equity shares,
they are tradable i.e. they can be purchased and sold. So, a company is in no way responsible for any cash
outflows of investors by which they become the shareholders of the company by purchasing the shares of
existing shareholders.

(ii) Equity capital increases the company’s financial base and thus helps to further the borrowing powers of the
company. In other words, by issuing equity shares, a company manage to raise some money for its capital
expenditures and this helps it to raise more funds with the help of debt. This is because; debt will enable the
company to increase its earnings per share and consequently, its share prices.

(iii) A company is not obliged legally to pay dividends. Hence in times of uncertainties or when the company is
not performing well, dividend payments can be reduced or even suspended.

(iv) A company can make further increase its share capital by initiating a right issue.

3. EXPLAIN in brief the features of Commercial Paper. 21

ANSWER 3

Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a
view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors. Subsequently, in addition to the Corporate, Primary Dealers and
All India Financial Institutions have also been allowed to issue Commercial Papers. Commercial papers are
issued in denominations of ₹ 5 lakhs or multiples thereof and the interest rate is generally linked to the yield
on the one-year government bond.

All eligible issuers are required to get the credit rating from Credit Rating Information Services of India Ltd,
(CRISIL), or the Investment Information and Credit Rating Agency of India Ltd (ICRA) or the Credit Analysis and
Research Ltd (CARE) or the FITCH Ratings India Pvt. Ltd or any such other credit rating agency as is specified by
the Reserve Bank of India.

4. DISCUSS the features of Secured Premium Notes (SPNs).

ANSWER 4

Secured Premium Notes: Secured Premium Notes is issued along with a detachable warrant and is
redeemable after a notified period of say 4 to 7 years. The conversion of detachable warrant into equity
shares will have to be done within time period notified by the company.

5. DISCUSS ADRs and GDRs

ANSWER 5

(a) American Depository Receipts (ADRs): These are securities offered by non-US companies who want to list
on any of the US exchange. Each ADR represents a certain number of a company's regular shares. ADRs allow
US investors to buy shares of these companies without the costs of investing directly in a foreign stock
exchange. ADRs are issued by an approved New York bank or trust company against the deposit of the original
shares. These are deposited in a custodial account in the US. Such receipts have to be issued in accordance
with the provisions stipulated by the regulator Securities Exchange Commission (SEC) of USA.

22
ADRs can be traded either by trading existing ADRs or purchasing the shares in the issuer's home market and
having new ADRs created, based upon availability and market conditions. When trading in existing ADRs, the
trade is executed on the secondary market on the New York Stock Exchange (NYSE) through Depository Trust
Company (DTC) without involvement from foreign brokers or custodians. The process of buying new, issued
ADRs goes through US brokers, Helsinki Exchanges and DTC as well as Deutsche Bank. When transactions are
made, the ADRs change hands, not the certificates. This eliminates the actual transfer of stock certificates
between the US and foreign countries.
In a bid to bypass the stringent disclosure norms mandated by the SEC for equity shares, the Indian companies
have however, chosen the indirect route to tap the vast American financial market through private debt
placement of GDRs listed in London and Luxembourg Stock Exchanges.
The Indian companies have preferred the GDRs to ADRs because the US market exposes them to a higher level
of responsibility than a European listing in the areas of disclosure, costs, liabilities and timing. The SECs
regulations set up to protect the retail investor base are somewhat more stringent and onerous, even for
companies already listed and held by retail investors in their home country. The most onerous aspect of a US
listing for the companies is to provide full, half yearly and quarterly accounts in accordance with, or at least
reconciled with US GAAPs.

(b) Global Depository Receipts (GDRs): These are negotiable certificates held in the bank of one country
representing a specific number of shares of a stock traded on the exchange of another country. These
financial instruments are used by companies to raise capital in either dollars or Euros. These are mainly traded
in European countries and particularly in London.
ADRs/GDRs and the Indian Scenario: Indian companies are shedding their reluctance to tap the US markets.
Infosys Technologies was the first Indian company to be listed on Nasdaq in 1999. However, the first Indian
firm to issue sponsored GDR or ADR was Reliance industries Limited. Beside these two companies there are
several other Indian firms which are also listed in the overseas bourses. These are Wipro, MTNL, State Bank of
India, Tata Motors, Dr. Reddy's Lab, Ranbaxy, Larsen & Toubro, ITC, ICICI Bank, Hindalco, HDFC Bank and Bajaj
Auto.

6. DISTINGUISH between Preference Shares and Debentures

ANSWER 6

Difference between Preference Shares and Debentures:

Basis of difference Preference shares Debentures

Ownership Preference Share Capital is a special Debenture is a type of loan
kind of share which can be raised from the
public
Payment of Dividend/Interest The preference shareholders enjoy It carries fixed percentage of

23
priority both as regard to the payment interest.
of a fixed amount of dividend and also
towards repayment of capital in case
of winding up of a company
Nature Preference shares are a hybrid form of Debentures are instrument
financing with some characteristic of for raising long term capital
equity shares and some attributes of with a fixed period of
Debt Capital. maturity.
 CHAPTER-3 FINANCIAL PLANNING AND
PLANNING- RATIO ANALYSIS
ILLUSTRATION 1
In a meeting held at Solan towards the end of 2019, the Directors of M/s HPCL Ltd. have taken a decision to
diversify. At present HPCL Ltd. sells all finished goods from its own warehouse. The company issued
debentures on 01.01.2020 and purchased fixed assets on the same day. The purchase prices have remained
stable during the concerned period. Following information is provided to you:

INCOME STATEMENTS

24
BALANCE SHEET

You are required to CALCULATE the following ratios for the years 2019 and 2020.

(i) Gross Profit Ratio

(ii) Operating Expenses to Sales Ratio.

(iii) Operating Profit Ratio

(iv) Capital Turnover Ratio

(v) Stock Turnover Ratio

25
(vi) Net Profit to Net Worth Ratio, and

(vii) Receivables Collection Period.

Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons
for change in the ratios for 2 years. Assume opening stock of ₹ 40,000 for the year 2020. Ignore Taxation.
SOLUTION

Computation of Ratios
Ratio 2019 (₹) 2020 (₹)
1. Gross profit ratio (Gross profit/sales) = 64000 X 100 /3,00,000 = 76000 X 100 / 3,74,000
=21.3% =20.3%

2. Operating expense to sales ratio = 49,000×100 /3,00,000 = 57000 X 100 / 3,74,000

(Operating exp/ Total sales) =16.3% =15.2%

3. Operating profit ratio (Operating = 15000 X 100 / 3,00,000 = 19000 X 100 / 3,74,000
profit / Total sales) =5% =5.08%

4. Capital turnover ratio (Sales / capital = 31,00,000 / 3,00,000 = 3 = 374000 / 147000 =

employed) 2.541

5.Stock turnover ratio (COGS / Average = 236000 /50,000 = 298000 / 77,000

stock) = 4.72 =3.87

6. Net Profit to Networth (Net profit / = 15000 X 100 /1,00,000 = 19000X 100 / 17,000
Networth) =15% =16.24%

7.Receivables collection period = 500000/ 739.73 = 82000/936.99

(Average receivables / Average daily =67.6 days =87.5 days
credit sales) (Refer to working note)
Working note: = 2,70,000 / 365 = 3,42,000 / 365
Average daily sales = Credit sales / 365 = 739.73 = 936.99

Analysis: The decline in the Gross profit ratio could be either due to a reduction in the selling price or increase
in the direct expenses (since the purchase price has remained the same). In this case, cost of goods sold have
increased more than proportion of increment in sales & hence impacting gross profit ratio.
Similarly, there is a decline in the ratio of operating expenses to sales. Further analysis reveals although that in

26
comparison to increase in sales, there has a lesser proportionate increase in operating expenses. As a result,
even the operating profit ratio has remained the same in spite of a decline in the Gross profit margin ratio.

The company has not been able to deploy its capital efficiently. This is indicated by a decline in the Capital
turnover from 3 to 2.5 times. In case the capital turnover would have remained at 3 the company would have
increased sales and profits by ₹ 67,000 and ₹ 3,350 respectively.
The decline in stock turnover ratio implies that the company has increased its investment in stock. Return on
Net worth has declined indicating that the additional capital employed has failed to increase the volume of
sales proportionately. The increase in the Average collection period indicates that the company has become
liberal in extending credit on sales. However, there is a corresponding increase in the current assets due to
such a policy.

ILLUSTRATION 2
Following is the abridged Balance Sheet of Alpha Ltd. :-

With the help of the additional information furnished below, you are required to PREPARE Trading and
Profit & Loss Account and a Balance Sheet as at 31st March, 2020:

(i) The company went in for reorganisation of capital structure, with share capital remaining the same as
follows:

Share capital 50%

Other Shareholders’ funds 15%
5% Debentures 10%

27
Payables 25%

Debentures were issued on 1st April, interest being paid annually on 31st March.

(ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought and a further
₹ 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8 : 5.

(iv) Quick assets ratio was 1 : 1.

(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of 2 months. There
were no cash sales.

(vi) Return on net worth was 10%.

(vii) Gross profit was at the rate of 15% of selling price.

(viii) Stock turnover was eight times for the year.

Ignore Taxation.

SOLUTION

Particulars % (₹ )
Share capital (given to be same) 50% 1,00,000
Other shareholders funds 15% 30,000
5% Debentures 10% 20,000
Payables 25% 50,000
Total (1,00,000 / 50%) 100% 2,00,000

Land and Buildings

Total liabilities = Total Assets

₹ 2,00,000 = Total Assets

Fixed Assets = 60% of total fixed assets and current assets

= ₹ 2,00,000 × 60/100 = ₹ 1,20,000

28
Calculation of additions to Plant & Machinery

₹
Total fixed assets 1,20,000
Less: Land & Buildings 80,000
Plant and Machinery (after providing depreciation) 40,000
Less: Existing Plant & Machinery (after extra depreciation of ₹ 5,000) 30,000
i.e. 50,000 – 20,000
Addition to the Plant & Machinery 10,000
Current assets = Total assets – Fixed assets
= ₹ 2,00,000 – ₹ 1,20,000 = ₹ 80,000

Calculation of stock

Quick ratio: = (Current assets –stock) / Current liabilities = 1

= (80,000 – stock) / 50000 = 1

₹ 50,000 = ₹ 80,000 – Stock

Stock = ₹ 80,000 - ₹ 50,000

= ₹ 30,000

Receivables = 4/5th of quick assets

= (₹ 80,000 – 30,000)× 4/5
= ₹ 40,000

Receivables turnover ratio

= Receivables×12 Months / Credit Sales = 2 months

= 40,000×12 / Credit Sales = 2 months

2credit sales = 4,80,000

Credit sales = 4,80,000/2

= ₹ 2,40,000 = Total Sales (As there were no cash sales)

Gross profit (15% of sales)

₹ 2,40,000 × 15/100 = ₹ 36,000

29
Return on net worth (net profit)

Net worth = ₹ 1,00,000 + ₹ 30,000

= ₹ 1,30,000

Net profit = ₹ 1,30,000 × 10/100 = ₹ 13,000

Debenture interest = ₹ 20,000 × 5/100 = ₹ 1,000

Projected profit and loss account for the year ended 31-3-2020

To cost of goods sold 2,04,000 By sales 2,40,000

To gross profit 36,000 ________
2,40,000 2,40,000
To debenture interest 1,000 By gross profit 36,000
To administration and other 22,000
expenses (bal fig)
To net profit 13,000 ______
36,000 36,000

Projected Balance Sheet as at 31st March, 2020

Liabilities ₹ Assets ₹
Share capital 1,00,000 Fixed assets
Profit and loss A/c 30,000 Land & buildings 80,000
(17,000+13,000) Plant & 60,000
machinery
5% Debentures 20,000 Less: 20,000 40,000
Depreciation
Current liabilities Current assets
Stock 30,000
Trade creditors 50,000 Receivables 40,000
_ Bank 10,000 80,000
2,00,000 2,00,000

ILLUSTRATION 3 (PAST EXAM NOV 2020)

X Co. has made plans for the next year.
It is estimated that the company will employ total assets of ₹ 8,00,000;
50 per cent of the assets being financed by borrowed capital at an interest cost of 8 per cent per year.
The direct costs for the year are estimated at ₹4,80,000
and all other operating expenses are estimated at ₹ 80,000.

30
the goods will be sold to customers at 150 per cent of the direct costs.
Tax rate is assumed to be 50 per cent.
You are required to CALCULATE: (i) net profit margin; (ii) return on assets; (iii) asset turnover and (iv) return
on owners’ equity.

SOLUTION
The net profit is calculated as follows:

Particulars ₹ ₹
Sales (150% of ₹ 4,80,000) 7,20,000
 Direct costs 4,80,000
Gross profit 2,40,000

Operating expenses 80,000

Interest changes (8% of ₹ 4,00,000) 32,000 1,12,000
Profit before taxes 1,28,000
Taxes (@ 50%) 64,000
Net profit after taxes 64,000

ILLUSTRATION 4
ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statements over the last 3 years
are as follows:

31
Particular 2018 2019 2020
₹ ₹ ₹
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
₹ ₹ ₹
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
 Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000

Common stock 1,00,000 1,00,000 1,00,000

Retained earnings 5,00,000 5,50,000 5,50,000
14,30,000 15,60,000 16,95,000

₹ ₹ ₹
Sales 40,00,000 43,00,000 38,00,000
Cost of goods 32,00,000 36,00,000 33,00,000
sold
Net profit 3,00,000 2,00,000 1,00,000

ANALYSE the company’s financial condition and performance over the last 3 years. Are there any problems?

SOLUTION

Ratios 2018 2019 2020

Current ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18 22 27
Inventory turnover NA* 8.2 6.1
Total debt to net worth 1.38 1.40 1.61
Long-term debt to total capitalization 0.33 0.32 0.32
Gross profit margin 0.200 0.163 0.132
Net profit margin 0.075 0.047 0.026
Asset turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06

32
Analysis: The company’s profitability has declined steadily over the period. As only ₹ 50,000 is added to
retained earnings, the company must be paying substantial dividends. Receivables are growing slower,
although the average collection period is still very reasonable relative to the terms given. Inventory turnover is
slowing as well, indicating a relative buildup in inventories. The increase in receivables and inventories,
coupled with the fact that net worth has increased very little, has resulted in the total debt-to-worth ratio
increasing to what would have to be regarded on an absolute basis as a high level.
The current and acid-test ratios have fluctuated, but the current ratio is not particularly inspiring. The lack of
deterioration in these ratios is clouded by the relative build up in both receivables and inventories, evidencing
deterioration in the liquidity of these two assets. Both the gross profit and net profit margins have declined
substantially. The relationship between the two suggests that the company has reduced relative expenses in
2019 in particular. The build-up in inventories and receivables has resulted in a decline in the asset turnover
ratio, and this, coupled with the decline in profitability, has resulted in a sharp decrease in the return on assets
ratio.

ILLUSTRATION 5

Following information are available for Navya Ltd. along with various ratio relevant to the particulars
industry it belongs to. APPRAISE your comments on strength and weakness of Navya Ltd. comparing its
ratios with the given industry norms.

Navya Ltd.
BALANCE SHEET AS AT 31.3.2020

Liabilities Amount (₹) Assets Amount (₹)

Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,0000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current 4,40,000 -
Liabilities
Total 77,00,000 Total 77,00,000

STATEMENT OF PROFITABILITY
FOR THE YEAR ENDING 31.3.2020

Particulars Amount (₹) Amount (₹)

Sales 1,10,00,000
Less: Cost of goods sold: - -
Material 41,80,000 -
Wages 26,40,000 -
Factory Overhead 12,98,000 81,18,000

33
Gross Profit - 28,82,000
Less: Selling and Distribution Cost 11,00,000 -
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes - 5,54,000
Less: Interest Charges - 92,000
Earning before Tax - 4,62,000
Less: Taxes & 50% - 2,31,000
Net Profit (PAT) 2,31,000
 INDUSTRY NORMS

Ratios Norm
Current Ratio 2.5
Receivables Turnover Ratio 8.0
Inventory Turnover Ratio (based on Sales) 9.0
Total Assets Turnover Ratio 2.0
Net Profit Ratio 3.5%
Return on Total Assets 7.0%
Return on Net worth (Based on Net 10.5%
profit)
Total Debt/Total Assets 60.0%

SOLUTION

34

Comments:
1. The position of Navya Ltd. is better than the industry norm with respect to Current Ratios and the Sales to
Debtors Ratio.
2. However, the position of sales to stock and sales to total assets is poor comparing to industry norm.
3. The firm also has its net profit ratios, net profit to total assets and net profit to total worth ratio much lower
than the industry norm.

4. Total debt to total assets ratio suggest that, the firm is geared at lower level and debt are used to Asset.

ILLUSTRATION 6
From the following ratios and information given below, PREPARE Trading Account, Profit and Loss Account
and Balance Sheet of Aebece Company:
Fixed Assets ₹ 40,00,000
Closing Stock ₹ 4,00,000
Stock turnover ratio 10
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Fixed assets to capital 5/4
Fixed assets/Total current 5/7
assets

SOLUTION
Workings:

35
Trading Account

Profit and Loss Account

Balance Sheet

36
MCQs based Questions

1. Ratio of Net sales to Net working capital is a:

(a) Profitability ratio

(b) Liquidity ratio

(c) Current ratio

(d) Working capital turnover ratio

ANSWER 1-D

2. Long-term solvency is indicated by:

(a) Debt/ equity ratio

(b) Current Ratio

(c) Operating ratio

(d) Net profit ratio

ANSWER 2-A

3. Ratio of net profit before interest and tax to sales is:

37
(a) Gross profit ratio

(b) Net profit ratio

(c) Operating profit ratio

(d) Interest coverage ratio.

ANSWER 3-C
4. Observing changes in the financial variables across the years is:

(a) Vertical analysis

(b) Horizontal Analysis

(c) Peer-firm Analysis

(d) Industry Analysis.

ANSWER 4-B

5. The Receivable-Turnover ratio helps management to:

(a) Managing resources

(b) Managing inventory

(c) Managing customer relationship

(d) Managing working capital

ANSWER 5-D

6. Which of the following is a liquidity ratio?

38
(a) Equity ratio.

(b) Proprietary ratio.

(c) Net Working Capital ratio.

(d) Capital Gearing ratio.

ANSWER 6-C
7. Which of the following is not a part of Quick Assets?

(a) Disposable investments.

(b) Receivables.

(c) Cash and Cash equivalents.

(d) Prepaid expenses.

ANSWER 7-D

8. Capital Gearing ratio is the fraction of -

(a) Preference Share Capital and Debentures to Equity Share Capital and Reserve & Surplus

(b) Equity Share Capital and Reserve & Surplus to Preference Share Capital and Debentures.

(c) Equity Share Capital to Total Assets.

(d) Total Assets to Equity Share Capital.

ANSWER 8-A

9. From the following information, calculate P/E ratio:

Equity share capital of ₹ 10 each ₹ 8,00,000

39
9% Preference share capital of ₹ 10 each ₹ 3,00,000
Profit (after 35% tax) ₹ 2,67,000
Depreciation ₹ 67,000
Market price of equity share ₹ 48

(a) 15 times

(b) 16 times

(c) 17 times
(d) 18 times
ANSWER 9-B

10. Equity multiplier allows the investor to see-

(a) What portion of interest on debt can be covered from earnings available to equity shareholders?

(b) How many times preference share interest be paid from earnings available to equity shareholders?

(c) What portion of return on equity is the result of debt?

(d) How many times equity is multiplied to get the value of debt?
ANSWER 10-C

11. A company has average accounts receivable of ₹ 10,00,000 and annual credit sales of ₹ 60,00,000. Its
average collection period would be-

(a) 60.83 days

(b) 6.00 days

(c) 1.67 days

(d) 0.67 days

ANSWER 11-A

12. A company has net profit margin of 5%, total assets of ₹ 90,00,000 and return on assets of 9%. Its total

40
asset turnover ratio would be-

(a) 1.6

(b) 1.7

(c) 1.8

(d) 1.9
ANSWER 12-C
13. What does Q ratio measures?

(a) Relationship between market value and book value per equity share.

(b) Proportion of profit available per equity share.

(c) Overall earnings on average total assets.

(d) Market value of equity as well as debt in comparison to all assets at their replacement cost.

ANSWER 13-D

14. Calculate operating expenses from the information given below:

Sales ₹ 75,00,000
Rate of income tax 50%
Net profit to sales 5%
Cost of goods sold ₹ 32,90,000
Interest on debentures ₹ 60,000

(a) ₹ 41,00,000

(b) ₹ 8,10,000

(c) ₹ 34,00,000

(d) ₹ 33,90,000

ANSWER 14-C

41
15. Which of the following is not a profitability ratio?

(a) P/E ratio

(b) Return on capital employed (ROCE)

(c) Q Ratio
(d) Preference Dividend Coverage Ratio
ANSWER 15-D

Theoretical Questions

1. DISCUSS any three ratios computed for investment analysis.

ANSWER 1

(a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds
invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into
the business has been worthwhile. It compares earnings/ returns/ profit with the investment in the company.
The ROI is calculated as follows:

So, ROI = Profitability Ratio × Investment Turnover Ratio.

ROI can be improved either by improving Profitability Ratio or Investment Turnover Ratio or by both.

The concept of investment varies and accordingly there are three broad categories of ROI i.e.
(i) Return on Assets (ROA),
(ii) Return on Capital Employed (ROCE) and

42
(iii) Return on Equity (ROE).

We should keep in mind that investment may be Total Assets or Net Assets. Further, funds employed in net
assets are also known as capital employed which is nothing but Net worth plus Debt, where Net worth is
equity shareholders’ fund. Similarly, the concept of returns/ earnings/ profits may vary as per the requirement
and availability of information.

(i) Return on Assets (ROA): The profitability ratio is measured in terms of relationship between net profits and
assets employed to earn that profit. This ratio measures the profitability of the firm in terms of assets
employed in the firm. Based on various concepts of net profit (return) and assets the ROA may be measured as
follows:
Here net profit is exclusive of interest. As Assets are also financed by lenders, hence ROA can be calculated as:

(ii) Return on Capital Employed (ROCE): It is another variation of ROI.

The ROCE is calculated as follows:

43
Where,

Capital Employed = Total Assets – Current Liabilities

Or
= Fixed Assets + Working Capital
Or
= Equity + Long Term Debt

ROCE should always be higher than the rate at which the company borrows.
Intangible assets (assets which have no physical existence like goodwill, patents and trade-marks) should be
included in the capital employed. But no fictitious asset (such as deferred expenses) should be included within
capital employed. If information is available, then average capital employed shall be taken.

(iii) Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested in the firm.
This ratio reveals how profitably of the owners’ funds have been utilised by the firm. It also measures the
percentage return generated to equity shareholders. This ratio is computed as:

ROE = (Net Profit after taxes − Preference dividend (if any)) / (Net Worth/ Equity Shareholders′ Funds) × 100

Return on equity is one of the most important indicators of a firm’s profitability and potential growth.
Companies that boast a high return on equity with little or no debt are able to grow without large capital
expenditures, allowing the owners of the business to withdraw cash and reinvest it elsewhere. Many investors
fail to realize, however, that two companies can have the same return on equity, yet one can be a much better
business.

2. DISCUSS the financial ratios for evaluating company performance on operating efficiency and liquidity
position aspects.

ANSWER 2

The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect
the final results of business operations. They are some of the most closely watched and widely quoted ratios.
Management attempts to maximize these ratios to maximize the firm’s value.
The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or
sales or owner’s interest etc. Therefore, the profitability ratios are broadly classified in four categories:

(i) Profitability Ratios related to Sales

(ii) Profitability Ratios related to overall Return on Investment

(iii) Profitability Ratios required for Analysis from Owner’s Point of View 44

(iv) Profitability Ratios related to Market/ Valuation/ Investors.

Profitability Ratios are as follows:

1. Profitability Ratios based on Sales

(a) Gross Profit Ratio

(b) Net Profit Ratio

(c) Operating Profit Ratio

(d) Expenses Ratio

2. Profitability Ratios related to Overall Return on Assets/ Investments

(a) Return on Investments (ROI)

(i) Return on Assets (ROA)

(ii) Return of Capital Employed (ROCE)

(iii) Return on Equity (ROE)

3. Profitability Ratios required for Analysis from Owner’s Point of View

(a) Earnings per Share (EPS)

(b) Dividend per Share (DPS)

(c) Dividend Pay-out Ratio (DP)

4. Profitability Ratios related to Market/ Valuation/ Investors

45
(a) Price Earnings (P/E) Ratio

(b) Dividend and Earning Yield

(c) Market Value/ Book Value per Share (MVBV)

(d) Q Ratio

3. DISCUSS Stock Turnover ratio and Gearing ratio?

ANSWER 3

Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship
between the cost of goods sold during the year and average inventory held during the year. It measures the
efficiency with which a firm utilizes or manages its inventory. It is calculated as follows:

In the case of inventory of raw material, the inventory turnover ratio is calculated using the following formula :

Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to
show the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders i.e.
equity funds or net worth. Again, higher ratio may indicate more risk.

4. DISCUSS the composition of Return on Equity (ROE) using the DuPont model.

ANSWER 4

Return on Equity using the Du Pont Model: 46

A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system
of financial analysis in 1919. That system is used around the world today and serves as the basis of
components that make up return on equity.
There are various components in the calculation of return on equity using the traditional DuPont model- the
net profit margin, asset turnover, and the equity multiplier.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit
margin, asset turnover, and equity multiplier.)

Return on Equity = (Profitability/ Net profit margin) x (Investment Turnover/ Asset Turnover / Capital
Turnover) x Equity Multiplier

5. EXPLAIN briefly the limitations of Financial ratios.

ANSWER 5

The limitations of financial ratios are listed below:

(i) Diversified product lines: Many businesses operate a large number of divisions in quite different industries.
In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

(ii) Financial data are badly distorted by inflation: Historical cost values may be substantially different from
true values. Such distortions of financial data are also carried in the financial ratios.

(iii) Seasonal factors :It may also influence financial data. Example: A company deals in cotton garments. It
keeps a high inventory during October - January every year. For the rest of the year its inventory level
becomes just 1/4th of the seasonal inventory level. So, the liquidity ratios and inventory ratios will produce
biased picture. Year end picture may not be the average picture of the business. Sometimes it is suggested to
take monthly average inventory data instead of year end data to eliminate seasonal factors. But for external
users it is difficult to get monthly inventory figures. (Even in some cases monthly inventory figures may not be
available).

(iv) To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.):
The business may make some year-end adjustments. Such window dressing can change the character of
financial ratios which would be different had there been no such change.

(v) Differences in accounting policies and accounting period: It can make the accounting data of two firms
non-comparable as also the accounting ratios.

(vi) No standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are 47
compared with the industry average. But if a firm desires to be above the average, then industry average
becomes a low standard. On the other hand, for a below average firm, industry averages become too high a
standard to achieve.

(vii) Difficulty to generalise whether a particular ratio is good or bad: For example, a low current ratio may be
said ‘bad’ from the point of view of low liquidity, but a high current ratio may not be ‘good’ as this may result
from inefficient working capital management.
(viii) Financial ratios are inter-related, not independent: Viewed in isolation one ratio may highlight
efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among
the ratios can be taken care of through multivariate analysis (analyzing the relationship between several
variables simultaneously).

6. DISCUSS DuPont Model.

ANSWER
A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of
financial analysis in 1919. That system is used around the world today and serves as the basis of components that make
up return on equity.
There are various components in the calculation of return on equity using the traditional DuPont model- the net profit
margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's
return on equity can be discovered and compared to its competitors.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin,
asset turnover, and equity multiplier.)

Return on Equity = (Profitability/ Net profit margin) x (Investment Turnover/ Asset Turnover / Capital Turnover) x Equity
Multiplier

Practical Problems

1. The total sales (all credit) of a firm are ₹ 6,40,000. It has a gross profit margin of 15 per cent and a current
ratio of 2.5. The firm’s current liabilities are ₹ 96,000; inventories ₹ 48,000 and cash ₹ 16,000.

(a) DETERMINE the average inventory to be carried by the firm, if an inventory turnover of 5 times is
expected? (Assume a 360 day year).

(b) DETERMINE the average collection period if the opening balance of debtors is intended to be of ₹
80,000? (Assume a 360 day year).

48
ANSWER 1

(a) Inventory turnover = Cost of goods sold / Average inventory

Since gross profit margin is 15 per cent, the cost of goods sold should be 85 per cent of the sales.

Cost of goods sold = 0.85 × ₹ 6,40,000 = ₹ 5,44,000.

Thus, 5,44,000 / Average inventory =₹ 5

Average inventory = 5,44,000 / ₹ 5 = ₹1,08,800

(b) Average collection period = Average Receivables×360days / Credit Sales
Average Receivables =(Opening Receivables + Closing Receivables) / 2
Closing balance of receivables is found as follows:

Current assets (2.5 of current liabilities) 2,40,000

Less: Inventories 48,000
Cash 16,000 64,000
Receivables ∴ 1,76,000

Average Receivables = ( 1,76,000 + 80,000)/ 2

₹ 2,56,000 ÷2 = ₹ 1,28,000

Average collection period = 1,28,000 × 360 / 640000 = 72 days

2. The capital structure of Beta Limited is as follows:

Equity share capital of ₹ 10 each 8,00,000

9% preference share capital of ₹ 10 each 3,00,000

Additional information: Profit (after tax at 35 per cent), ₹ 2,70,000; Depreciation, ₹ 60,000; Equity dividend
paid, 20 per cent; Market price of equity shares, ₹ 40.

You are required to COMPUTE the following, showing the necessary workings:

(a) Dividend yield on the equity shares

49
(b) Cover for the preference and equity dividends

(c) Earnings per shares

(d) Price-earnings ratio.

ANSWER 2
3. The following accounting information and financial ratios of PQR Ltd. relate to the year ended 31st
March, 2020

I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage

50
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit

II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13 : 11
Current ratio 2:1
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
If value of Fixed Assets as on 31st March, 2019 amounted to ₹ 26 lakhs, PREPARE a summarised Profit and
Loss Account of the company for the year ended 31st March, 2020 and also the Balance Sheet as on 31st
March, 2020.
ANSWER 3

(iii) Calculation of Raw Material Consumption and Direct Wages

Sales 78,00,000
Less: Gross Profit 11,70,000
Works Cost 66,30,000

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Raw Material Consumption (20% of Works Cost) ₹ 13,26,000
Direct Wages (10% of Works Cost) ₹ 6,63,000

(iv) Calculation of Stock of Raw Materials (= 3 months usage)

= 13,26,000 ×3 / 12 = 3,31,500
(ix) Calculation of Cash Balance

Current assets 22,00,000

Less: Receivables 12,82,192
Raw materials stock 3,31,500
Finished goods stock 3,97,800 20,11,492
Cash balance 1,88,508

(x) Calculation of Net worth

52
Fixed Assets 26,00,000
Current Assets 22,00,000
Total Assets 48,00,000
Less: Long term Loan 22,00,000
Current Liabilities 11,00,000 33,00,000
Net worth 15,00,000
 Profit and Loss Account of PQR Ltd.
for the year ended 31st March, 2020

Particulars ₹ Particulars ₹
To Direct Materials 13,26,000 By Sales 78,00,000
Direct Wages 6,63,000
To Works (Overhead) Balancing 46,41,000
figure
To Gross Profit c/d (15% of 11,70,000 _
Sales)
78,00,000 78,00,000
To Selling and Distribution 5,46,000 By Gross Profit 11,70,000
Expenses (Balancing figure) b/d
To Net Profit (8% of Sales) 6,24,000 _
11,70,000 11,70,000
Balance Sheet of PQR Ltd.
as at 31st March, 2020

Liabilities ₹ Assets ₹
Share Capital 3,00,000 Fixed Assets 26,00,000

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Reserves and 12,00,000 Current Assets:
Surplus
Long term loans 22,00,000 Stock of Raw 3,31,500
Material
Current liabilities 11,00,000 Stock of Finished 3,97,800
Goods
Receivables 12,82,192
Cash 1,88,508
48,00,000 48,00,000
4. Ganpati Limited has furnished the following ratios and information relating to the year ended 31st March,
2020.

Sales ₹ 60,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 7:3
Current ratio 2
Net profit to sales 6.25%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ₹ 18,00,000
Interest on debentures ₹ 60,000
Receivables ₹ 2,00,000
Payables ₹ 2,00,000

You are required to:

(a) CALCULATE the operating expenses for the year ended 31st March, 2020.

(b) PREPARE a balance sheet as on 31st March in the following format:

Balance Sheet as on 31st March, 2020

Liabilities ₹ Assets ₹
Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash

54
ANSWER 4

(a) Calculation of Operating Expenses for the year ended 31st March, 2020.

Net Profit [@ 6.25% of Sales] 3,75,000

Add: Income Tax (@ 50%) 3,75,000
Profit Before Tax (PBT) 7,50,000
Add: Debenture Interest 60,000
 Profit before interest and tax (PBIT) 8,10,000
Sales 60,00,000
Less: Cost of goods sold 18,00,000
PBIT 8,10,000 26,10,000
Operating Expenses 33,90,000

(b) Balance Sheet as on 31st March, 2020

Liabilities ₹ Assets ₹
Share Capital 10,50,000 Fixed Assets 17,00,000
Reserve and Surplus 4,50,000 Current Assets:
15% Debentures 4,00,000 Stock 1,50,000
Payables 2,00,000 Receivables 2,00,000
- - Cash 50,000
21,00,000 21,00,000

Working Notes:
(i) Share Capital and Reserves
The return on net worth is 25%. Therefore, the profit after tax of ₹ 3,75,000 should be equivalent to 25% of
the net worth.

55
(iv) Fixed Assets

Liabilities ₹
Share capital 10,50,000
Reserves 4,50,000
Debentures 4,00,000
Payables 2,00,000
21,00,000
Less: Current Assets 4,00,000
Fixed Assets 17,00,000

(v) Composition of Current Assets

Inventory Turnover = 12

Cost of goods sold / Closing stock = 12

Closing stock = 18,00,00012₹ = Closing stock ₹ 1,50,000

Composition ₹
Stock 1,50,000
Receivables 2,00,000
Cash (balancing figure) 50,000
Total Current Assets 4,00,000

5. Using the following information, PREPARE the balance sheet:

Long-term debt to net worth 0.5 to 1

56
Total asset turnover 2.5 ×
Average collection period* 18 days
Inventory turnover 9×
Gross profit margin 10%
Acid-test ratio 1 to 1
∗Assume a 360-day year and all sales on credit.

₹ ₹
Cash ___________ Notes and payables 1,00,000
 Accounts receivable ____________ Long-term debt ____________
Inventory ____________ Common stock 1,00,000
Plant and equipment ____________ Retained earnings 1,00,000
Total assets ____________ Total liabilities and ____________
equity

ANSWER 5

Long-term debt / Net worth = 0.5 = Long-term debt / 2,00,000

Balance Sheet

Cash 50,000 Notes and 1,00,000

57
payables
Accounts 50,000 Long-term debt 1,00,000
receivable
Inventory 1,00,000 Common stock 1,00,000
Plant and 2,00,000 Retained 1,00,000
equipment earnings
Total assets 4,00,000 Total liabilities 4,00,000
and equity
6. Following information has been provided from the books of Laxmi Pvt. Ltd. for the year ending on 31st
March, 2020:

Net Working Capital ₹ 4,80,000

Bank overdraft ₹ 80,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ₹ 3,20,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5

You are required to PREPARE a summarised Balance Sheet as at 31st March, 2020 assuming that there is no
long term debt.
ANSWER 6

Working notes:

(i) Current Assets and Current Liabilities computation:

58
(ii) Computation of stock
(iii) Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors

Or Net Working Capital (NWC)= 0.25 Proprietary fund

Or ₹ 4,80,000/0.25 = Proprietary fund

Or Proprietary fund = ₹ 19,20,000 and Fixed Assets = 0.75 proprietary fund

= 0.75 × ₹ 19,20,000 = ₹ 14,40,000

Capital = Proprietary fund − Reserves & Surplus

= ₹ 19,20,000 − ₹ 3,20,000 =₹ 16,00,000

Sundry Creditors = (Current liabilities − Bank overdraft)

= (₹ 3,20,000 − ₹ 80,000) =₹ 2,40,000

Balance Sheet as at 31st March, 2020

59
G6 ₹ Assets ₹
Capital 16,00,000 Fixed Assets 14,40,000
Reserves & 3,20,000 Stock 3,20,000
Surplus
Bank overdraft 80,000 Other Current 4,80,000
Assets
Sundry creditors 2,40,000
22,40,000 22,40,000
7. Manan Pvt. Ltd. gives you the following information relating to the year ending 31st March, 2020:

(1) Current Ratio 2.5 : 1

(2) Debt-Equity Ratio 1 : 1.5

(3) Return on Total Assets (After Tax) 15%

(4) Total Assets Turnover Ratio 2

(5) Gross Profit Ratio 20%

(6) Stock Turnover Ratio 7

(7) Net Working Capital ₹ 13,50,000

(8) Fixed Assets ₹ 30,00,000

(9) 1,80,000 Equity Shares of ₹ 10 each

(10) 60,000, 9% Preference Shares of ₹ 10 each

(11) Opening Stock ₹ 11,40,000

You are required to CALCULATE:

(a) Quick Ratio

(b) Fixed Assets Turnover Ratio

(c) Proprietary Ratio 60

(d) Earnings per Share

ANSWER 7
Workings Notes:

61
8. Gig Ltd. has furnished the following information relating to the year ended 31st March, 2020 and 31st
March, 2021: (₹)

• Net profit ratio: 8%

• Gross profit ratio: 20%
• Long-term loan has been used to finance 40% of the fixed assets.
• Stock turnover with respect to cost of goods sold is 4.
• Debtors represent 90 days sales.

62
• The company holds cash equivalent to 1½ months cost of goods sold.
• Ignore taxation and assume 360 days in a year.
You are required to PREPARE Balance Sheet as on 31st March, 2021 in the following format:

Liabilities (₹) Assets (₹)

Share Capital - Fixed Assets -
Reserve and Surplus - Sundry Debtors -
Long-term loan - Closing Stock -
Sundry Creditors - Cash in hand -
ANSWER
(i) Change in Reserve & Surplus = ₹ 25,00,000 – ₹ 20,00,000 = ₹ 5,00,000
So, Net profit = ₹ 5,00,000
Net Profit Ratio = 8%

(ii) Cost of Goods sold

= Sales – Gross profit Margin
= ₹ 62,50,000 – 20% of ₹ 62,50,000
= ₹ 50,00,000

Balance Sheet as on 31st March 2021

63

9. Following information relates to Temer Ltd.:

Debtors Velocity 3 months

Creditors Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables ₹ 25,000
Bills Payables ₹ 10,000
Gross Profit ₹ 4,00,000
Fixed Assets turnover Ratio 4

Closing stock of the period is ₹ 10,000 above the opening stock.

DETERMINE:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Sundry Creditors
(iv) Closing Stock
(v) Fixed Assets

ANSWER

(i) Determination of Sales and Cost of goods sold:

(ii) Determination of Sundry Debtors:

Debtors’ velocity is 3 months or Debtors’ collection period is 3 months

Or, Sundry Debtors + Bills receivable = ₹ 4,00,000 64

Sundry Debtors = ₹ 4,00,000 – ₹ 25,000 = ₹ 3,75,000
(iii) Determination of Sundry Creditors:
Creditors’ velocity of 2 months or credit payment period is 2 months.
So, Sundry Creditors + Bills Payable = ₹ 2,01,667
Or, Sundry Creditors + ₹ 10,000 = ₹ 2,01,667

Or, Sundry Creditors = ₹ 2,01,667 – ₹ 10,000 = ₹ 1,91,667

(iv) Determination of Closing Stock

Or, Opening Stock = ₹ 7,95,000

So, Closing Stock = ₹ 7,95,000 + ₹ 10,000 = ₹ 8,05,000
(v) Determination of Fixed Assets

Or, Fixed Asset = ₹ 3,00,000

Workings:
*Calculation of Credit purchases:

65
Cost of goods sold = Opening stock + Purchases – Closing stock
₹ 12,00,000 = ₹ 7,95,000 + Purchases – ₹ 8,05,000
₹ 12,00,000 + ₹ 10,000 = Purchases
₹ 12,10,000 = Purchases (credit)
Assumption:
(i) All sales are credit sales
(ii) All purchases are credit purchase
(iii) Stock Turnover Ratio and Fixed Asset Turnover Ratio may be calculated either on Sales or on Cost of Goods Sold.
 CHAPTER-4 COST OF CAPITAL
ILLUSTRATION 1
Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ₹ 103, at ₹ 3 premium to their
par value of ₹ 100. The current market price of these debentures is ₹ 94. If the company pays corporate tax
at a rate of 35 per cent CALCULATE its current cost of debenture capital?

SOLUTION

Cost of irredeemable debenture:

ILLUSTRATION 2
A company issued 10,000, 10% debentures of ₹ 100 each at a premium of 10% on 1.4.2017 to be matured on
1.4.2022. The debentures will be redeemed on maturity. COMPUTE the cost of debentures assuming 35% as
tax rate.
SOLUTION

66

ILLUSTRATION 3
A company issued 10,000, 10% debentures of ₹ 100 each at par on 1.4.2012 to be matured on 1.4.2022. The
company wants to know the cost of its existing debt on 1.4.2017 when the market price of the debentures is
₹ 80. COMPUTE the cost of existing debentures assuming 35% tax rate.

SOLUTION

ILLUSTRATION 4
Institutional Development Bank (IDB) issued Zero interest deep discount bonds of face value of ₹ 1,00,000
each issued at ₹ 2,500 & repayable after 25 years. COMPUTE the cost of debt if there is no corporate tax.

SOLUTION

Here,

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Redemption Value (RV)= ₹1,00,000
Net Proceeds (NP) = ₹ 2,500
Interest = 0
Life of bond = 25 years

There is huge difference between RV and NP therefore in place of approximation method we should use trial
& error method.

FV = PV x (1+r)n
1,00,000 = 2,500 x (1+r)25
40 = (1+r)25

Trial 1: r = 15%, (1.15)25 = 32.919

Trial 2: r = 16%, (1.16)25 = 40.874

Here:
L = 15%, H = 16%
NPVL = 32.919-40 = -7.081
NPVH = 40.874-40 = +0.874

ILLUSTRATION 5
RBML is proposing to sell a 5-year bond of ₹ 5,000 at 8 per cent rate of interest per annum. The bond
amount will be amortised equally over its life. CALCULATE the bond’s present value for an investor if he
expects a minimum rate of return of 6 per cent?

SOLUTION

The amount of interest will go on declining as the outstanding amount of bond will be reducing due to
amortisation. The amount of interest for five years will be:

First year: ₹5,000 × 0.08 = ₹ 400;

Second year: (₹5,000 – ₹1,000) × 0.08 = ₹ 320;
Third year: (₹4,000 – ₹1,000) × 0.08 = ₹ 240;
Fourth year: (₹3,000 – ₹1,000) × 0.08 = ₹ 160; and
Fifth year: (₹2,000 – ₹1,000) × 0.08 = ₹ 80.

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The outstanding amount of bond will be zero at the end of fifth year.

Since RBML will have to return ₹1,000 every year, the outflows every year will consist of interest payment and
repayment of principal:

First year: ₹1,000 + ₹ 400 = ₹1,400;

Second year: ₹1,000 + ₹ 320 = ₹1,320;
Third year: ₹1,000 + ₹ 240 = ₹1,240;

Fourth year: ₹1,000 + ₹ 160 = ₹1,160; and

Fifth year: ₹1,000 + ₹80 = ₹ 1,080.

The above cash flows of all five years will be discounted with the cost of capital. Here the expected rate i.e. 6%
will be used.

Value of the bond is calculated as follows:

ILLUSTRATION 6
XYZ & Co. issues 2,000 10% preference shares of ₹ 100 each at ₹ 95 each. CALCULATE the cost of preference
shares.
SOLUTION

ILLUSTRATION 7
If R Energy is issuing preferred stock at ₹100 per share, with a stated dividend of ₹12, and a floatation cost
of 3% then, CALCULATE the cost of preference share?

69
SOLUTION
ILLUSTRATION 8
XYZ Ltd. issues 2,000 10% preference shares of ₹ 100 each at ₹ 95 each. The company proposes to redeem
the preference shares at the end of 10th year from the date of issue. CALCULATE the cost of preference
share?
SOLUTION

ILLUSTRATION 9
A company has paid dividend of ₹ 1 per share (of face value of ₹ 10 each) last year and it is expected to grow
@ 10% next year. CALCULATE the cost of equity if the market price of share is ₹ 55.
SOLUTION

ILLUSTRATION 10
Mr. Mehra had purchased a share of Alpha Limited for ₹ 1,000. He received dividend for a period of five
years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for ₹ 1,128.
You are required to COMPUTE the cost of equity as per realised yield approach.

SOLUTION

70
We know that as per the realised yield approach, cost of equity is equal to the realised rate of return.
Therefore, it is important to compute the internal rate of return by trial and error method. This realised rate of
return is the discount rate which equates the present value of the dividends received in the past five years
plus the present value of sale price of ₹ 1,128 to the purchase price of ₹1,000. The discount rate which
equalises these two is 12 percent approximately. Let us look at the table given for a better understanding:

Year Dividend (₹) Sale Discount Present

Proceeds (₹) Factor @ Value (₹)
 12%
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1000.076

We find that the purchase price of Alpha limited’s share was ₹ 1,000 and the present value of the past five
years of dividends plus the present value of the sale price at the discount rate of 12 per cent is ₹1,000.076.
Therefore, the realised rate of return may be taken as 12 percent. This 12 percent is the cost of equity.

ILLUSTRATION 11

CALCULATE the cost of equity from the following data using realized yield approach:

Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60

SOLUTION

In this question we will first calculate yield for last 4 years and then calculate it geometric mean as follows:

71
Note: to calculate power ¼ simply press square root switch, two times on your calculator.

ILLUSTRATION 12
CALCULATE the cost of equity capital of H Ltd., whose risk-free rate of return equals 10%. The firm’s beta
equals 1.75 and the return on the market portfolio equals to 15%.

SOLUTION

Ke = Rf + ß (Rm − Rf)

Ke = 0.10 + 1.75 (0.15 − 0.10)

= 0.10 + 1.75 (0.05) = 0.1875 or 18.75%

ILLUSTRATION 13
Face value of equity shares of a company is ₹ 10, while current market price is ₹ 200 per share. Company is
going to start a new project, and is planning to finance it partially by new issue and partially by retained
earnings. You are required to CALCULATE cost of equity shares as well as cost of retained earnings if issue
price will be ₹ 190 per share and floatation cost will be₹ 5 per share. Dividend at the end of first year is
expected to be ₹ 10 and growth rate will be 5%.

SOLUTION

72
ILLUSTRATION 14

ABC Company provides the following details: D0 = ₹ 4.19 P0 = ₹ 50 g = 5% CALCULATE the cost of retained
earnings.

SOLUTION

ILLUSTRATION 15
ABC Company provides the following details: Rf = 7% ß = 1.20 Rm - Rf = 6% CALCULATE the cost of retained
earnings based on CAPM method.

SOLUTION

Kr = Rf + ß (Rm – Rf) = 7% + 1.20 (6%) = 7% + 7.20 Kr = 14.2%

ILLUSTRATION 16
Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000 equity shares
of ₹10 each and retained earnings of ₹15,00,000. Market price per equity share is ₹50. Calculate WACC using
market value weights if there are no other sources of finance.

SOLUTION 73

Book value of paid up equity capital = ₹ 5,00,000

Book value of retained earnings = ₹ 15,00,000
Ratio Paid up equity capital & retained earnings = 500000:1500000 = 1:3

Market value of paid equity capital & retained earnings = ₹ 50,000 x ₹ 50 = ₹ 25,00,000
Market value of paid up equity capital = ₹ 25,00,000 x ¼ = ₹ 6,25,000
Market value of retained earnings = ₹ 25,00,000 x ¾ = ₹18,75,000

Calculation of WACC using market value weights

Source of capital Market Value Weights Cost of capital WACC (Ko)

(₹) (a) (b) (c) = (a)×(b)
Equity shares 6,25,000 0.25 0.1041 0.0260
Retained earnings 18,75,000 0.75 0.1000 0.0750
25,00,000 1.000 0.1010

WACC (Ko) = 0.1010 or 10.10%

ILLUSTRATION 17
CALCULATE the WACC using the following data by using:

(a) Book value weights

(b) Market value weights

The capital structure of the company is as under:

Debentures (₹ 100 per debenture) 5,00,000

Preference shares (₹ 100 per share) 5,00,000
Equity shares (₹ 10 per share) 10,00,000
20,00,000

The market prices of these securities are:

Debentures ₹ 105 per debenture
Preference shares ₹ 110 per preference share
Equity shares ₹ 24 each.

74
Additional information:

(1) ₹ 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10-year maturity.

(2) ₹ 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year maturity.

(3) Equity shares has ₹ 4 floatation cost and market price ₹ 24 per share.

The next year expected dividend is ₹ 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.

SOLUTION

(ii) Cost of Debt (Kd)

Current market price (P0) – floatation cost = I(1-t)×PVAF(r,10) + RV×PVIF(r,10)
₹105 – 4% of ₹105 = ₹10(1-0.3)× PVAF (r,10) + ₹100×PVIF (r,10)
Calculation of NPV at discount rate of 5% and 7%

Year Cash Discount Present Discount Present

flows (₹) factor @ Value factor @ Value
5% 7% (₹)
0 100.8 1.000 (100.8) 1.000 (100.8)
1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83

Calculation of IRR

Cost of Debt (Kd) = 6.89%

(iii) Cost of Preference shares (Kp)

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Current market price (P0) – floatation cost = PD×PVAF(r,10) + RV×PVIF(r,10)
₹110 – 2% of ₹110 = ₹5×PVAF (r,10) + ₹100×PVIF (r,10)

Calculation of NPV at discount rate of 3% and 5%

 Year Cash flows Discount Present Discount Present
(₹) factor @ Value factor @ Value (₹)
3% 5%
0 107.8 1.000 (107.8) 1.000 (107.8)
1 to 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79

Calculation of IRR

Cost of Preference Shares (Kp) = 4.08%

(a) Calculation of WACC using book value weights

Source of capital Book Value Weights After tax WACC (Ko)

cost of
capital
(₹) (a) (b) (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.0689 0.01723
5% Preference shares 5,00,000 0.25 0.0408 0.0102
Equity shares 10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743

WACC (Ko) = 0.07743 or 7.74%

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(b) Calculation of WACC using market value weights

WACC (Ko) = 0.0859 or 8.59%

ILLUSTRATION 18
ABC Ltd. has the following capital structure, EXAMINE which is considered to be optimum as on 31st March,
2018.

14% Debentures 30,000

11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000

The company share has a market price of ₹ 23.60. Next year dividend per share is 50% of year 2017 EPS. The
following is the trend of EPS for the preceding 10 years which is expected to continue in future.

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Year EPS (₹) Year EPS (₹)
2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is ₹ 96.

Preference shares ₹ 9.20 (with annual dividend of ₹ 1.1 per share) were also issued. The company is in 50%
tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)

(B) CALCULATE marginal cost of capital when no new shares are issued.

(C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year’s investment is 50 percent of 2017.

(D) COMPUTE marginal cost of capital when the fund exceeds the amount calculated in (C), assuming new
equity is issued at ₹ 20 per share?

SOLUTION

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(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

(C) The company can spend the following amount without increasing marginal cost of capital and without
selling the new shares:

Retained earnings = (0.50) (2.36 × 10,000) = ₹ 11,800

The ordinary equity (Retained earnings in this case) is 80% of total capital
11,800 = 80% of Total Capital

(D) If the company spends in excess of ₹ 14,750 it will have to issue new shares.

The marginal cost of capital will be:

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.0833 0.0125
Preference 0.05 0.1200 0.0060
Shares

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Equity Shares 0.80 0.1590 0.1272
(New)
0.1457
MCQs based Questions

1. Which of the following is not an assumption of the capital asset pricing model (CAPM)?

(a) The capital Market is efficient

(b) Investors lend or borrow at a risk-free rate of return

(c) Investors do not have the same expectations about the risk and return

(d) Investor’s decisions are based on a single-time period

ANSWER 1-C

2. Given: risk-free rate of return = 5 % market return = 10%, cost of equity = 15% value of beta (β) is:

(a) 1.9

(b) 1.8

(c) 2.0

(d) 2.2
ANSWER 2-C

3. Which of the following sources of funds is related to Implicit Cost of Capital?

(a) Equity Share Capital,

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(b) Preference Share Capital,

(c) Debentures,

(d) Retained earnings.

ANSWER 3-D
4. Which of the following cost of capital require to adjust tax?

(a) Cost of Equity Shares,

(b) Cost of Preference Shares,

(c) Cost of Debentures,

(d) Cost of Retained Earnings.

ANSWER 4-C

5. Marginal Cost of capital is the cost of:

(a) Additional Revenue,

(b) Additional Funds,

(c) Additional Interests,

(d) None of the above.

ANSWER 5-B

6. In order to calculate Weighted Average Cost of Capital, weights may be based on:

(a) Market Values,

(b) Target Values

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(c) Book Values,

(d) Anyone.
ANSWER 6-D
7. Firm’s Cost of Capital is the average cost of :

(a) All sources of finance,

(b) All Borrowings,

(c) All share capital,

(d) All Bonds & Debentures.

ANSWER 7- A

8. A company has a financial structure where equity is 70% of its total debt plus equity. Its cost of equity is
10% and gross loan interest is 5%. Corporation tax is paid at 30%. What is the company’s weighted average
cost of capital (WACC)?

(a) 7.55%

(b) 7.80%

(c) 8.70%

(d) 8.05%

ANSWER 8-D

9. The cost of equity capital is all of the following except:

(a) The minimum rate that a firm should earn on the equity-financed part of an investment.

(b) A return on the equity-financed portion of an investment that, at worst, leaves the market price of the 82
stock
unchanged.

(c) By far the most difficult component cost to estimate.

(d) Generally lower than the before-tax cost of debt.

ANSWER 9-D
10. What is the overall (weighted average) cost of capital when the firm has Rs 20 crore in long-term debt, 4
crore in preferred stock, and Rs 16 crore in equity shares. The before-tax cost for debt, preferred stock, and
equity capital are 8%, 9%, and 15%, respectively. Assume a 50% tax rate.

(a) 7.60%

(b) 6.90%

(c) 7.30%

(d) 8.9%

ANSWER 10-D

Theoretical based Questions

1. DISCUSS the meaning of weighted average cost of capital? ILLUSTRATE with an example.
ANSWER 1

To balance financial risk, control over the company and cost of capital, a company usually does not procure
entire fund from a single source, rather it makes a mix of various sources of finance. Hence cost of total capital
will be equal to weighted average of cost of individual sources of finance. WACC is also known as the overall
cost of capital of having capitals from the different sources as explained above. WACC of a company depends
on the capital structure of a company. It weighs the cost of capital of a particular source of capital with its
proportion to the total capital. Thus, weighted average cost of capital is the weighted average after tax costs
of the individual components of firm’s capital structure. That is, the after-tax cost of each debt and equity is
calculated separately and added together to a single overall cost of capital

Example:
Calculation of WACC

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Capital Component Cost of capital % of total capital Total
structure
Retained Earnings 10% (Kr) 25% (Wr) 2.50% (Kr × Wr)
Equity Share Capital 11% (Ke) 10% (We) 1.10%(Ke× We)
Preference Share Capital 9% (Kp) 15% (Wp) 1.35%(Kp× Wp)
Long term debts 6% (Kd) 50% (Wd) 3.00%(Kd× Wd)
Total (WACC) 7.95%
2. DISCUSS the dividend-price approach, and earnings price approach to estimate cost of equity capital.

ANSWER 2

Dividend Price Approach

This is also known as Dividend Valuation Model. This model makes an assumption that the dividend per share
is expected to remain constant forever. Here, cost of equity capital is computed by dividing the expected
dividend by market price per share as follows:

Cost of Equity (Ke) = D/P0

Where,

Ke= Cost of equity

D = Expected dividend (also written as D1)

P0 = Market price of equity (ex- dividend)

3. What is the DIFFERENCE between Book Value and Market Value?

ANSWER 3

There is a choice weights between the book value (BV) and market value (MV).

Book Value (BV): Book value weights is operationally easy and convenient. While using BV, reserves such as
share premium and retained profits are included in the BV of equity, in addition to the nominal value of share
capital. Here the value of equity will generally not reflect historic asset values, as well as the future prospects
of an organisation.

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Market Value (MV): Market value weight is more correct and represent a firm’s capital structure. It is
preferable to use MV weights for the equity. While using MV, reserves such as share premium and retained
profits are ignored as they are in effect incorporated into the value of equity. It represents existing conditions
and also take into consideration the impacts of changing market conditions and the current prices of various
security. Similarly, in case of debt MV is better to be used rather than the BV of the debt, though the
difference may not be very significant.
There is no separate market value for retained earnings. Market value of equity shares represents both paid
up equity capital and retained earnings. But cost of equity is not same as cost of retained earnings. Hence to
give market value weights, market value of equity shares should be apportioned in the ratio of book value of
paid up equity capital and book value of retained earnings.
4. DISCUSS Marginal Cost of Capital?

ANSWER 4

The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the
capital is raised in substantial amount in practice, marginal cost is referred to as the cost incurred in raising
new funds. Marginal cost of capital is derived, when the average cost of capital is calculated using the
marginal weights. The marginal weights represent the proportion of funds the firm intends to employ. Thus,
the problem of choosing between the book value weights and the market value weights does not arise in the
case of marginal cost of capital computation. To calculate the marginal cost of capital, the intended financing
proportion should be applied as weights to marginal component costs. The marginal cost of capital should,
therefore, be calculated in the composite sense. When a firm raises funds in proportional manner and the
component’s cost remains unchanged, The marginal cost of capital may be defined as the cost of raising an
additional rupee of capital. Since the capital is raised in substantial amount in practice, marginal cost is
referred to as the cost incurred in raising new funds. Marginal cost of capital is derived, when the average cost
of capital is calculated using the marginal weights. The marginal weights represent the proportion of funds
the firm intends to employ. Thus, the problem of choosing between the book value weights and the market
value weights does not arise in the case of marginal cost of capital computation. To calculate the marginal
cost of capital, the intended financing proportion should be applied as weights to marginal component costs.
The marginal cost of capital should, therefore, be calculated in the composite sense. When a firm raises funds
in proportional manner and the component’s cost remains unchanged,

5. EXPLAIN YTM approach of calculating Cost of Debt.

ANSWER 5

Cost of Debt using Present value method [Yield to maturity (YTM) approach)]
The cost of redeemable debt (Kd) is also calculated by discounting the relevant cash flows using Internal rate

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of return (IRR). (The concept of IRR is discussed in the Chapter- Investment Decisions). Here YTM is the annual
return of an investment from the current date till maturity date. So, YTM is the internal rate of return at which
current price of a debt equals to the present value of all cash-flows.
The relevant cash flows are as follows:

Year Cash flows

0 Net proceeds in case of new issue/ Current market price in case of existing debt (NP or P0)
1 to n Interest net of tax [I(1-t)]
n Redemption value (RV)
Steps to calculate relevant cash flows:

Step-1: Identify the cash flows

Step-2: Calculate NPVs of cash flows as identified above using two discount rates (guessing).

Step-3: Calculate IRR

Example - 2: A company issued 10,000, 10% debentures of ₹ 100 each on 1.4.2013 to be matured on 1.4.2018.
The company wants to know the current cost of its existing debt and the market price of the debentures is ₹
80. Compute the cost of existing debentures assuming 35% tax rate.

6. DISCUSS the meaning of Amortisation of Bond?

ANSWER 6

Amortisation of Bond
A bond may be amortised every year i.e. principal is repaid every year rather than at maturity. In such a
situation, the principal will go down with annual payments and interest will be computed on the outstanding
amount. The cash flows of the bonds will be uneven.

The formula for determining the value of a bond or debenture that is amortised every year is as follows:

Practical Problems

1. Gamma Limited has in issue 5,00,000 ₹ 1 ordinary shares whose current ex-dividend market price is ₹ 1.50

86
per share. The company has just paid a dividend of 27 paise per share, and dividends are expected to
continue at this level for some time. If the company has no debt capital, COMPUTE the weighted average
cost of capital?

ANSWER 1

Market value of equity, E = 5,00,000 shares ×₹1.50 = ₹7,50,000

Market value of debt, D = Nil
2. The following details are provided by the GPS Limited:

Equity Share Capital 65,00,000

12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000

The cost of equity capital for the company is 16.30% and income tax rate for the company is 30%. You are
required to CALCULATE the Weighted Average Cost of Capital (WACC) of the company.

ANSWER 2

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount (₹) Weight Cost of Capital after tax WACC

Equity Capital 65,00,000 0.619 0.163 0.1009

12% Preference Capital 12,00,000 0.114 0.120 0.0137
15% Redeemable Debentures 20,00,000 0.190 0.105* 0.020
10% Convertible Debentures 8,00,000 0.076 0.07** 0.0053
Total 1,05,00,000 1.0000 0.1399

Cost of Debentures (after tax) = 15 (1 – 0.30) = 10.5% = 0.105

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** Cost of Debentures (after tax) = 10 (1 – 0.30) = 7% = 0.07
Weighted Average Cost of Capital = 0.1399 = 13.99%

(Note: In the above solution, the Cost of Debentures has been computed in the above manner without
considering the impact of special features i.e. redeemability and convertibility in absence of requisite
information.)
3. ABC Company’s equity share is quoted in the market at ₹s25 per share currently. The company pays a
dividend of ₹ 2 per share and the investor’s market expects a growth rate of 6% per year.

You are required to:

(i) CALCULATE the company’s cost of equity capital.

(ii) If the company issues 10% debentures of face value of ₹s100 each and realises ₹ 96 per debenture while
the debentures are redeemable after 12 years at a premium of 12%, CALCULATE cost of debenture Using
YTM?
Assume Tax Rate to be 50%.

ANSWER 3

Year Cash flows

0 Current market price (P0) = ₹ 96
1 to 12 Interest net of tax [I(1-t)] = 10% of ₹ 100 (1 – 0.5) = ₹ 5
12 Redemption value (RV) = ₹ 100 (1.12) = ₹ 112

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Calculation of Net Present Values (NPV) at two discount rates

Year Cash flows Discount factor @ Present Value Discount factor @ Present Value
5%(L) 10% (H)
0 (96) 1.000 (96.00) 1.000 (96.00)
1 to 12 5 8.863 44.32 6.814 34.07
12 112 0.557 62.38 0.319 35.73
NPV +10.7 -26.2
Calculation of IRR

4. Masco Limited wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans. It has ₹
2,10,000 in the form of retained earnings available for investment purposes. Further details are as
following:

(1) Debt / equity mix 3:7

(2) Cost of debt
Upto₹ 1,80,000 10% (before tax)
Beyond ₹ 1,80,000 16% (before tax)
(3) Earnings per share ₹4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate in dividend 10%
(6) Current market price per share ₹ 44
(7) Tax rate 50%

You are required:

(a) To DETERMINE the pattern for raising the additional finance.
(b) To DETERMINE the post-tax average cost of additional debt.
(c) To DETERMINE the cost of retained earnings and cost of equity, and

(d) COMPUTE the overall weighted average after tax cost of additional finance.
ANSWER 4

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(a) Pattern of raising additional finance

Equity 70% of ₹ 10,00,000 = ₹ 7,00,000

Debt 30% of ₹ 10,00,000 = ₹ 3,00,000

The capital structure after raising additional finance:

Equity Capital (7,00,000–2,10,000) 4,90,000

Retained earnings 2,10,000
 Debt (Interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (3,00,000–1,80,000) 1,20,000
Total Funds 10,00,000

(b) Determination of post-tax average cost of additional debt

Kd = I (1 – t)

Where,
I = Interest Rate
t = Corporate tax-rate
On ₹ 1,80,000 = 10% (1 – 0.5) = 5% or 0.05
On ₹ 1,20,000 = 16% (1 – 0.5) = 8% or 0.08

Average Cost of Debt

(c) Determination of cost of retained earnings and cost of equity applying Dividend growth model:

Where,
Ke = Cost of equity
D1 = D0(1+ g)
D0 = Dividend paid (i.e., 50% of EPS = 50% × ₹ 4 = ₹ 2)
g = Growth rate =10%
P0 = Current market price per share = ₹44

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(d) Computation of overall weighted average after tax cost of additional finance

Particular (₹) Weights Cost of funds Weighted Cost (%)

Equity (including 7,00,000 0.70 15% 10.5
retained earnings)
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36
5. DETERMINE the cost of capital of Best Luck Limited using the book value (BV) and market value (MV)
weights from the following information:

Sources Book Value Market Value

Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 —
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000

Additional information:

I. Equity: Equity shares are quoted at ₹130 per share and a new issue priced at ₹125 per share will be fully
subscribed; flotation costs will be ₹ 5 per share.

II. Dividend: During the previous 5 years, dividends have steadily increased from ₹ 10.60 to ₹ 14.19 per
share. Dividend at the end of the current year is expected to be ₹ 15 per share.

III. Preference shares: 15% Preference shares with face value of ₹ 100 would realise ₹105 per share.

IV. Debentures : The company proposes to issue 11-year 15% debentures but the yield on debentures of

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similar maturity and risk class is 16% ; flotation cost is 2%.

V. Tax : Corporate tax rate is 35%. Ignore dividend tax. Floatation cost would be calculated on face value.

ANSWER 5
*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures
at discount.

Market price of debentures (approximation method)

= ₹ 15 ÷ 0.16 = ₹ 93.75

Sale proceeds from debentures = ₹93.75 – ₹ 2 (i.e., floatation cost) = ₹91.75

Market value (P0) of debentures can also be found out using the present value
method:

92
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%,
11 years)
P0 = ₹15 × 5.029 + ₹100 × 0.195
P0 = ₹75.435 + ₹19.5 = ₹ 94.935
Net Proceeds = ₹94.935 – 2% of ₹100 = ₹ 92.935
Accordingly, the cost of debt can be calculated
Cost of capital (amount in lakh of rupees)
[BV weights and MV weights]

Source of Weights Specific Total cost

capital BV MV Cost (K) (BV × K) (MV × K)

Equity Shares 120 160* 0.1850 22.2 29.6

Retained 30 40* 0.1800 5.4 7.2
Earnings
Preference 36 33.75 0.1429 5.14 4.82
Shares
Debentures 9 10.4 0.1095 0.986 1.139
Total 195 244.15 33.73 42.76

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings

Weighted Average Cost of Capital (WACC):

Using Book Value = ₹ 33.73 / ₹195 = 0.1729 or 17.29%

Using Market Value = ₹ 42.76 / ₹244.15 = 0.1751 or 17.51%

6. Kalyanam Ltd. has an operating profit of ₹ 34,50,000 and has employed Debt which gives total Interest
Charge of ₹ 7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8% respectively.
The firm has a new proposal before it, which requires funds of ₹ 75 Lakhs and is expected to bring an
additional profit of ₹ 14,25,000. To finance the proposal, the firm is expecting to issue an additional debt at

93
8% and will not be issuing any new equity shares in the market. Assume no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:
(i) Before the new Proposal
(ii) After the new Proposal.

ANSWER
Workings:

(c) New Cost of equity (Ke) after proposal

(i) Calculation of Weighted Average Cost of Capital (WACC) before the new proposal

94

(ii) Calculation of Weighted Average Cost of Capital (WACC) after the new proposal
95
 CHAPTER-5 FINANCING DECISIONS-
CAPITAL STRUCTURE
ILLUSTRATION 1

Rupa Ltd.’s EBIT is ₹ 5,00,000. The company has 10%,₹ 20 lakh debentures. The equity capitalization rate i.e.
Ke is 16%.

You are required to CALCULATE:

(i) Market value of equity and value of firm

(ii) Overall cost of capital.

SOLUTION

(i) Statement showing value of firm

EBIT 5,00,000
Less: Interest on debentures (10% of ₹ 20,00,000) (2,00,000)
Earnings available for equity holders i.e. Net Income (NI) 3,00,000
Equity capitalization rate (Ke) 16%
Market value of equity (S) = NI / Ke = (300000 / 16.00 x 100) 18,75,000
Market value of debt (D) 20,00,000
Total value of firm V = S + D 38,75,000

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(ii) Over cost of capital = EBIT / Value of firm = 5,00,000 / 38,75,000 = 12.90%

ILLUSTRATION 2

Indra Ltd. has EBIT of ₹ 1,00,000. The company makes use of debt and equity capital. The firm has 10%
debentures of ₹ 5,00,000 and the firm’s equity capitalization rate is 15%.
You are required to COMPUTE:

(i) Current value of the firm

(ii) Overall cost of capital.

SOLUTION

(i) Calculation of total value of the firm

EBIT 1,00,000
Less: Interest (@10% on ₹ 5,00,000) 50,000
Earnings available for equity holders 50,000
Equity capitalization rate i.e. Ke 15%

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ILLUSTRATION 3
DETERMINE the optimal capital structure of a company from the following information:

Options Cost of Debt (Kd) Cost of Equity (Ke) Percentage of

in % in % Debt on total
value (Debt
+Equity)
1 11 13.0 0.0
2 11 13.0 0.1
3 11.6 14.0 0.2
 4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6

SOLUTION
Note that the ratio given in this question is not debt to equity ratio. Rather it is the debt to value ratio.
Therefore, if the ratio is 0.6, it means that capital employed comprises 60% debt and 40% equity.

In this question total of weight is equal to 1 in all cases, hence we need not to divide by it.

1) K0 = 11% x 0 + 13% x 1 = 13%

2) K0 = 11% x 0.1 + 13% x 0.9 = 12.8%

3) K0 = 11.6% x 0.2 + 14% x 0.8 = 13.52%

4) K0 = 12% x 0.3 + 15% x 0.7 = 14.1%

5) K0 = 13% x 0.4 + 16% x 0.6 = 14.8%

6) K0 = 15% x 0.5 + 18% x 0.5 = 16.5%

7) K0 = 18% x 0.6 + 20% x 0.4 = 18.8%

Decision: 2nd option is the best because it has lowest WACC.

ILLUSTRATION 4

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Amita Ltd’s operating income (EBIT) is ₹ 5,00,000. The firm’s cost of debt is 10% and currently the firm
employs ₹ 15,00,000 of debt. The overall cost of capital of the firm is 15%.

You are required to CALCULATE:

(i) Total value of the firm.

(ii) Cost of equity.

SOLUTION

(i) Statement showing value of the firm

Net operating income/EBIT 5,00,000

Less: Interest on debentures (10% of ₹ 15,00,000) (1,50,000)
Earnings available for equity holders 3,50,000
Total cost of capital (K0) (given) 15%
Value of the firm V = EBIT / K0 = 500000/ 0.15 33,33,333

(ii) Calculation of cost of equity

Market value of debt (D) 15,00,000

Market value of equity (s) S = V − D = ₹ 18,33,333
33,33,333 – ₹15,00,000

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ILLUSTRATION 5

Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent debt
and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are
in market-value terms). The borrowing rate for both companies is 8 per cent in a no-tax world, and capital
markets are assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., DETERMINE your return if the company has net
operating income of ₹3,60,000 and the overall capitalisation rate of the company, K0 is 18 per cent?

(ii) CALCULATE the implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) DETERMINE the implied required equity
return of Beta Ltd.? (ii) ANALYSE why does it differ from that of Alpha Ltd.?

SOLUTION

(i) Return on Shares on Alpha Ltd.

Value of the company 20,00,000

Market value of debt (50%) 10,00,000
Market value of shares (50%) 10,00,000
Net operating income 3,60,000
Interest on debt (8% × ₹10,00,000) 80,000
Earnings available to shareholders 2,80,000
Return on 2% shares (2% × ₹ 2,80,000) 5,600

(ii) Implied required rate of return on equity = 2,80,000 / 10,00,000 = 28% 100
(b) (i) Calculation of Implied rate of return

Total value of company 20,00,000

Market value of debt (20% × ₹20,00,000) 4,00,000
Market value of equity (80% × 16,00,000
₹20,00,000)
Net operating income 3,60,000
Interest on debt (8%× ₹4,00,000) 32,000
Earnings available to shareholders 3,28,000

Implied required rate of return on equity = 3,28,000 / 16,00,000 = 20.5%

(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity
capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income approach,
the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of
“cheaper” debt funds.

ILLUSTRATION 6:

When value of levered firm is more than the value of unlevered firm
There are two company N Ltd. and M Ltd., having same earnings before interest and taxes i.e. EBIT of ₹
20,000. M Ltd. is a levered company having a debt of ₹1,00,000 @ 7% rate of interest. The cost of equity of
N Ltd. is 10% and of M Ltd. is 11.50%.
COMPUTE how arbitrage process will be carried on?

101
SOLUTION

Company
M Ltd. N Ltd.
EBIT (NOI) ₹ 20,000 ₹ 20,000
Debt (D) ₹ 1,00,000 ---
Ke 11.50% 10%
Kd 7% ---
Arbitrage Process:
If you have 10% shares of M Ltd., your value of investment in equity shares is 10% of ₹1,13,043 i.e. ₹
11,304.30 and return will be 10% of (₹20,000 – ₹7,000) = ₹ 1,300.

Alternate Strategy will be:

Sell your 10% share of levered firm for ₹ 11,304.30 and borrow 10% of levered firms debt i.e. 10% of ₹
1,00,000 and invest the money i.e. 10% in unlevered firms stock:
Total resources /Money we have = ₹11,304.30 + ₹10,000 = ₹21,304.3 and you invest 10% of ₹2,00,000 = ₹
20,000
Surplus cash available with you is = ₹21,304.3 – ₹20,000 = ₹ 1,304.3
Your return = 10% EBIT of unlevered firm – Interest to be paid on borrowed funds
i.e. = 10% of ₹ 20,000 – 7% of ₹ 10,000 = ₹2,000 – ₹700 = ₹ 1,300
i.e. your return is same i.e. ₹ 1,300 which you are getting from N Ltd. before investing in M Ltd. but still you
have ₹ 1,304.3 excess money available with you. Hence, you are better off by doing arbitrage.
In the above example you have not invested entire amount received from “sale of shares of levered company
plus amount borrowed”. You maintained same level of earning and reduced investment. Alternatively, you
could have invested entire amount in unlevered company. In that case your annual earnings would have
increased. An example for the same is as follows:

ILLUSTRATION 7

102
Following data is available in respect of two companies having same business risk:
Capital employed = ₹ 2,00,000 ,EBIT = ₹ 30,000
Ke = 12.5%

Sources Levered Company (₹) Unlevered Company(₹)

Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Investor is holding 15% shares in levered company. CALCULATE increase in annual earnings of investor if he
switches his holding from Levered to Unlevered company.

SOLUTION

1. Valuation of firms

Particulars Levered Firm (₹) Unlevered Firm (₹)

EBIT 30,000 30,000
Less: interest 10,000 Nil
Earnings available to Equity Shareholder/Ke 20,000 30,000
12.5% 12.5%
Value of Equity 1,60,000 2,40,000
Debt 1,00,000 Nil
Value of Firm 2,60,000 2,40,000

Value of Levered company is more than that of unlevered company. Therefore investor will sell his shares in
levered company and buy shares in unlevered company. To maintain the level of risk he will borrow
proportionate amount and invest that amount also in shares of unlevered company.

2. Investment & Borrowings

Sell shares in Levered company (1,60,000x15%) 24,000
Borrow money (1,00,000 x15%) 15,000
Buy shares in Unlevered company 39,000

3. Change in Return
Income from shares in Unlevered company
(39,000 x 12.5%) 4,875
Less: interest on loan (15,000 x 10%) 1,500

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Net Income from unlevered firm 3,375
Income from Levered firm (24000 x 12.5%) 3,000
Incremental Income due to arbitrage 375

ILLUSTRATION 8: When value of unlevered firm is more than the value of levered firm
There are two companies U Ltd. and L Ltd., having same NOI of ₹20,000 except that L Ltd. is a levered
company having a debt of ₹1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18%
respectively.
COMPUTE how arbitrage process will work.

SOLUTION

Particulars Company
U Ltd. L Ltd.
NOI ₹ 20,000 ₹ 20,000
Debt capital − ₹ 1,00,000
Kd − 7%
Ke 10% 18%
Value of equity capital ₹ 2,00,000 ₹ 72,222
(s) =(EBIT- Interest) / ke (20000 / 0.10) ( 20000- 7000) / 0.18

Total value of the firm ₹ 2,00,000 ₹ 1,72,222

V=S+D (₹ 72,222 + ₹1,00,000)

Assume you have 10% shares of unlevered firm i.e. investment of 10% of ₹ 2,00,000 = ₹ 20,000 and Return @
10% on ₹ 20,000. Investment will be 10% of earnings available for equity i.e. 10% × 20,000 = ₹ 2,000.

ILLUSTRATION 9
Following data is available in respect of two companies having same business risk:
Capital employed = ₹ 2,00,000, EBIT = ₹ 30,000

Sources Levered Company (₹) Unlevered Company (₹)

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Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Ke 20 % 12.5%

Investor is holding 15% shares in Unlevered company. CALCULATE increase in annual earnings of investor if
he switches his holding from Unlevered to Levered Company.
SOLUTION

1. Valuation of firms

Particulars Levered Firm (₹) Unlevered Firm(₹)

EBIT 30,000 30,000
Less: interest 10,000 Nil
Earnings available to Equity Shareholder/Ke 20,000 30,000
20% 12.5%
Value of Equity 1,00,000 2,40,000
Debt 1,00,000 Nil
Value of Firm 2,00,000 2,40,000

Value of Unlevered company is more than that of Levered company therefore investor will sell his shares in
unlevered company and buy shares in levered company. Market value of Debt and Equity of Levered company
are in the ratio of ₹ 1,00,000 : ₹1,00,000, i.e., 1:1. To maintain the level of risk he will lend proportionate
amount (50%) and invest balance amount (50%) in shares of Levered company.

2. Investment & Borrowings ₹

Sell shares in Unlevered company (240000x15%) 36,000
Lend money (36000 x50%) 18,000
Buy shares in Levered company (36000 x50%) 18,000
Total 36,000

3. Change in Return

105
Income from shares in Levered company ₹
(18000 x 20%) 3,600
Interest on money lent (18000 x 10%) 1,800
Total Income after switch over 5,400
Income from Unlevered firm (36000 x 12.5%) 4,500
Incremental Income due to arbitrage 900
ILLUSTRATION 10

Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of ₹ 10 per
share. The firm wants to raise ₹ 250,000 to finance its investments and is considering three alternative
methods of financing – (i) to issue 25,000 ordinary shares at ₹ 10 each, (ii) to borrow₹ 2,50,000 at 8 per cent
rate of interest, (iii) to issue 2,500 preference shares of ₹ 100 each at an 8 per cent rate of dividend. If the
firm’s earnings before interest and taxes after additional investment are ₹ 3,12,500 and the tax rate is 50
per cent, FIND the effect on the earnings per share under the three financing alternatives.

SOLUTION

EPS under alternative financing plans:

Particulars Equity Financing (₹) Debt Financing(₹) Preference Financing

(₹)
EBIT 3,12,500 3,12,500 3,12,500
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary 1,56,250 1,46,250 136,250
shareholders
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though the rate of preference 106
dividend is equal to the rate of interest, EPS is high in case of debt financing because interest charges are tax
deductible while preference dividends are not. With increasing levels of EBIT, EPS will increase at a faster rate
with a high degree of leverage.
We know that market price per share is equal to earning per share multiplied by price earning (PE) ratio. If PE
ratio is same for all three plans then the plan which has highest EPS will also have highest MPS and it will be
selected. On the other hand if PE ratio for equity plan is 10 times, for debt plan it is 8 times and for preference
plan it is 7 times then:
EPS 1.25 1.46 1.36
PE ratio x10 x8 x7
MPS 12.50 11.68 9.52

Now despite lower EPS, equity plan will be selected because it has highest MPS.
However, if a company is not able to earn a rate of return on its assets higher than the interest rate (or the
preference dividend rate), debt (or preference financing) will have an adverse impact on EPS.

Suppose the firm in illustration above has an EBIT of ₹75,000/-, then EPS under different methods will be as
follows:
EPS under alternative financing methods: Unfavourable EBIT:

Particulars Equity Financing Debt Financing(₹) Preference Financing

(₹) (₹)
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000
Less: Taxes 37,500 27,500 37,500
PAT 37,500 27,500 37,500
Less: Preference dividend 0 0 20,000
Earning available to ordinary 37,500 27,500 17,500
shareholders
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 0.30 0.275 0.175

It is obvious that under unfavourable conditions, i.e. when the rate of return on the total assets is less than the
cost of debt, the earnings per share will fall with the degree of leverage.

ILLUSTRATION 11

107
Best of Luck Ltd., a profit making company, has a paid-up capital of ₹ 100 lakhs consisting of 10 lakhs
ordinary shares of ₹ 10 each. Currently, it is earning an annual pre-tax profit of ₹ 60 lakhs. The company's
shares are listed and are quoted in the range of ₹ 50 to ₹ 80. The management wants to diversify production
and has approved a project which will cost ₹ 50 lakhs and which is expected to yield a pre-tax income of ₹
40 lakhs per annum. To raise this additional capital, the following options are under consideration of the
management:

(a) To issue equity share capital for the entire additional amount. It is expected that the new shares (face
value of ₹ 10) can be sold at a premium of ₹ 15.

(b) To issue 16% non-convertible debentures of ₹ 100 each for the entire amount.
(c) To issue equity capital for ₹ 25 lakhs (face value of ₹ 10) and 16% non-convertible debentures for the
balance amount. In this case, the company can issue shares at a premium of ₹ 40 each.

CALCULATE the additional capital that can be raised, keeping in mind that the management wants to
maximise the earnings per share to maintain its goodwill. The company is paying income tax at 50%.

SOLUTION
Calculation of Earnings per share under the three options:

108
Advise: Option II i.e. issue of 16% Debentures is most suitable to maximize the earnings per share.

ILLUSTRATION 12
Shahji Steels Limited requires ₹ 25,00,000 for a new plant. This plant is expected to yield earnings before
interest and taxes of ₹ 5,00,000. While deciding about the financial plan, the company considers the
objective of maximizing earnings per share. It has three alternatives to finance the project - by raising debt
of ₹ 2,50,000 or ₹ 10,00,000or ₹ 15,00,000 and the balance, in each case, by issuing equity shares. The
company's share is currently selling at ₹ 150, but is expected to decline to ₹ 125 in case the funds are
borrowed in excess of ₹ 10,00,000. The funds can be borrowed at the rate of 10 percent upto ₹ 2,50,000, at
15 percent over ₹ 2,50,000 and upto ₹ 10,00,000 and at 20 percent over ₹ 10,00,000. The tax rate applicable
to the company is 50 percent. ANALYSE which form of financing should the company choose?

SOLUTION

109
Plan I = Raising Debt of ₹ 2.5 lakh + Equity of ₹ 22.5 lakh.
Plan II = Raising Debt of ₹ 10 lakh + Equity of ₹ 15 lakh.
Plan III = Raising Debt of ₹ 15 lakh + Equity of ₹ 10 lakh

Calculation of Earnings per share (EPS):

 Particulars FINANCIAL PLANS
Plan I Plan II Plan III
₹ ₹ ₹
Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (a) (25,000) (1,37,500) (2,37,500)
Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)
Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250
Number of shares (b) 15,000 10,000 8,000
Earnings per share (EPS) 15.83 18.13 16.41

Financing Plan II (i.e. Raising debt of ₹10 lakh and issue of equity share capital of ₹15 lakh) is the option which
maximises the earnings per share.

Working Notes:
(a) Calculation of interest on Debt.

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ILLUSTRATION 13
The following data are presented in respect of Quality Automation Ltd.:

Amount (₹)
Profit before interest and tax 52,00,000
Less : Interest on debentures @ 12% 12,00,000
Profit before tax 40,00,000
Less : Income tax @ 50% 20,00,000
Profit After tax 20,00,000
No. of equity shares (of ₹ 10 each) 8,00,000
EPS 2.5
P/E Ratio 10
Market price per share 25

The company is planning to start a new project requiring a total capital outlay of ₹ 40,00,000. You are
informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio
to 8 and rises the interest rate on additional amount borrowed at 14%. FIND OUT the probable price of
share if:
(i) the additional funds are raised as a loan.

(ii) the amount is raised by issuing equity shares.

(Note: Retained earnings of the company is ₹ 1.2 crore)

SOLUTION

In this question EBIT after proposed extension is not given. Therefore, we can assume that existing return on
capital employed will be maintained.

Working notes:

111

2. Proposed EBIT = Proposed Capital Employed x Return on capital employed

= (3,00,00,000 + 40,00,000) x 17.33% = ₹ 58,92,200
(if you take return on capital employed in full digits then accurate EBIT will be 58,93,333)
3. Debt Equity ratio=Debt / Debt Equity

Option1: Loan option

Debt = 1,00,00,000 + 40,00,000 = ₹1,40,00,000

Equity = ₹ 2,00,00,000 Debt Equity ratio=1.4 cr.1.4 cr.+2 cr.=41.18%

Debt equity ratio has crossed the limit of 35% hence PE ratio in this case will be 8 times and additional
borrowing will be at the rate of 14%

Option2: Equity option

Debt = 1,00,00,000
Equity = 2,00,00,000 + 40,00,000 = ₹2,40,00,000 Debt Equtiy ratio= (1 cr.) / (1 cr.+2.4 cr).=29.41%

Debt equity ratio has not crossed the limit of 35% hence PE ratio in this case will remain at 10 times.

4. Number of equity shares to be issued in case of equity option@ ₹25 per share = ₹40,00,000 / ₹25 = 1,60,000

Calculation of EPS and MPS Financial Options

under two financial options Option I Option II
Particulars 14% additional loan of 8,00,000equity share @ ₹10 i.e
40,00,000(₹) 1,60,000 equity shares @25(₹)
Profit before interest and Tax 58,92,200 58,92,200
(PBIT))
Less: Interest on old 12,00,000 12,00,000
debentures @12%
Less: Interest on additional 560000 Nil
loan(new) @ 14% on
₹ 40,00,00
Profit before tax 4132200 4692000
Less: Tax @50% 2066100 2346100

112
Earnings for equity 2066100 2346100
shareholders
(EAT/Profit after tax)
Number of Equity 800000 960000
Shares
Earnings per Share 2.58 2.44
(EPS)
Price/ Earnings ratio 8 10
Probable per share (MPS) 20.66 24.44
Decision: Though loan option has higher EPS but equity option has higher MPS therefore company should
raise additional fund through equity option.

ILLUSTRATION 14
Blue Ltd., an all equity financed company is considering the repurchase of ₹ 275 lakhs equity shares and to
replace it with 15% debentures of the same amount. Current market value of the company is ₹ 1,750 lakhs
with its cost of capital of 20%. The company's Earnings before Interest and Taxes (EBIT) are expected to
remain constant in future years. The company also has a policy of distributing its entire earnings as
dividend.
Assuming the corporate tax rate as 30%, you are required to CALCULATE the impact on the following on
account of the change in the capital structure as per Modigliani and Miller (MM) Approach:
(i) Market value of the company
(ii) Overall Cost of capital
(iii) Cost of equity

ANSWER
Workings:

Income Statement

113

(i) Market value of the company

Market value of levered firm = Value of unlevered firm + Tax Advantage
= ₹ 1,750 lakhs + (₹ 275 lakhs x 0.3)
= ₹ 1,832.5 lakhs

Change in market value of the company = ₹ 1,832.5 lakhs – ₹ 1,750 lakhs

= ₹ 82.50 lakhs
The impact is that the market value of the company has increased by ₹ 82.50 lakhs due to replacement of equity with
debt.
(ii) Overall Cost of Capital
Market Value of Equity = Market value of levered firm - Equity repurchased
= ₹ 1,832.50 lakhs – ₹ 275 lakhs = ₹ 1,557.50 lakhs
Cost of Equity (Ke) = (Net Income to equity holders / Market value of equity) × 100
= (₹ 321.12 lakhs / ₹ 1,557.50 lakhs) × 100 = 20.62%
Cost of debt (Kd) = I (1 - t) = 15 (1 - 0.3) = 10.50%

Components Amount (₹ In Cost of Capital Weight WACC (Ko) %

lakhs) %
Equity 1,557.50 20.62 0.85 17.53
Debt 275.00 10.50 0.15 1.58
1832.50 1 19.11
The impact is that the Overall Cost of Capital or Ko has fallen by 0.89% (20% - 19.11%) due to the benefit of tax relief on
debt interest payment.
(iii) Cost of Equity
The impact is that cost of equity has risen by 0.62% (20.62% - 20%) due to the presence of financial risk i.e. introduction
of debt in capital structure.
Note: Cost of Capital and Cost of equity can also be calculated with the help of following formulas, though there will be
no change in the final answers.
Cost of Capital (Ko) = Keu [1 – (t x L)]
Where,

114
MCQs based Questions

1. The assumptions of M-M hypothesis of capital structure do not include the following-

(a) Capital markets are imperfect

(b) Investors have homogeneous expectations

(c) All firms can be classified into homogeneous risk classes

(d) The dividend-payout ratio is cent percent, and there is no corporate tax
ANSWER 1-A

2. Which of the following is irrelevant for optimal capital structure?

(a) Flexibility,

115
(b) Solvency,

(c) Liquidity,

(d) Control.
ANSWER 2-B
3. Financial Structure refer to

(a) All Financial resources,

(b) Short-term funds,

(c) Long-term funds

(d) None of these.

ANSWER 3-A

4. An EBIT-EPS indifference analysis chart is used for-

(a) Evaluating the effects of business risk on EPS

(b) Examining EPS results for alternative financial plans at varying EBIT levels

(c) Determining the impact of a change in sales on EBIT

(d) Showing the changes in EPS quality over time

ANSWER 4-B

5. The term "capital structure" means-

(a) Long-term debt, preferred stock, and equity shares.

(b) Current assets and current liabilities.

116
(c) Net working capital

(d) Shareholders' equity.

ANSWER 5-A

6. The cost of monitoring management is considered to be a (an):

(a) Bankruptcy cost.

(b) Transaction cost.

(c) Agency cost.

(d) Institutional cost.

ANSWER 6-C

7. The traditional approach towards the valuation of a firm assumes:

(a) That the overall capitalization rate changes in financial leverage.

(b) That there is an optimum capital structure.

(c) That total risk is not changed with the changes in the capital structure.

(d) That markets are perfect.

ANSWER 7-B

8. Market values are often used in computing the weighted average cost of capital because-

(a) This is the simplest way to do the calculation.

117
(b) This is consistent with the goal of maximizing shareholder value.

(c) This is required by SEBI.

(d) This is a very common mistake.

ANSWER 8-B
9. A firm's optimal capital structure:

(a) Is the debt-equity ratio that results in the minimum possible weighted average cost of capital.

(b) 40 percent debt and 60 percent equity.

(c) When the debt-equity ratio is .50.

(d) When Cost of equity is minimum

ANSWER 9-A

10. Capital structure of a firm influences the-

(a) Risk.

(b) Return

(c) Both Risk and Return.

(d) Return but not Risk

ANSWER 10-C

11. Consider the below mentioned statements:

1. A company is considered to be over-capitalised when its actual capitalisation is lower than the proper
capitalisation as warranted by the earning capacity.

118
2. Both over-capitalisation and under-capitalisation are detrimental to the interests of the society.
State True or False:

(a) 1-True, 2-True

(b) 1-False, 2-True

(c) 1-False, 2-False

(d) 1-True, 2-False

ANSWER 11-B

12. A critical assumption of the net operating income (NOI) approach to valuation is:

(a) that debt and equity levels remain unchanged.

(b) that dividends increase at a constant rate.

(c) that ko remains constant regardless of changes in leverage.

(d) that interest expense and taxes are included in the calculation.
ANSWER 12-C

13. Which of the following steps may be adopted to avoid the negative consequences of over-capitalisation?

(a) The shares of the company should be split up. This will reduce dividend per share, though EPS shall
remain
unchanged.

(b) Issue of Bonus Shares.

(c) Revising upward the par value of shares in exchange of the existing shares held by them.

(d) Reduction in claims of debenture-holders and creditors.

ANSWER 13-D

Theoretical based Questions 119

1. DESCRIBE Capital Structure.

ANSWER 1

Capital structure is the combination of capitals from different sources of finance. The capital of a company
consists of equity share holders’ fund, preference share capital and long term external debts. The source and
quantum of capital is decided keeping in mind following factors:
1. Control: capital structure should be designed in such a manner that existing shareholders continue to hold
majority stake.

2. Risk: capital structure should be designed in such a manner that financial risk of the company does not
increases beyond tolerable limit.

3. Cost: overall cost of capital remains minimum.

Practically, it is difficult to achieve all of the above three goals together, hence, a finance manager has to make
a balance among these three objectives.
However, the objective of a company is to maximise the value of the company and it is prime objective while
deciding the optimal capital structure. Capital Structure decision refers to deciding the forms of financing
(which sources to be tapped); their actual requirements (amount to be funded) and their relative proportions
(mix) in total capitalisation.

Capital structure decision will decide weight of debt and equity and ultimately overall cost of capital as well as
Value of the firm. So capital structure is relevant in maximizing value of the firm and minimizing overall cost of
capital.
Whenever funds are to be raised to finance investments, capital structure decision is involved. A demand for
raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of
financing

2. EXPLAIN in brief the assumptions of Modigliani-Miller theory.

ANSWER 2

This approach describes, in a perfect capital market where there is no transaction cost and no taxes, the value
and cost of capital of a company remain unchanged irrespective of change in the capital structure. The
approach is based on further additional assumptions like:
♦ Capital markets are perfect. All information is freely available and there are no transaction costs.

120
♦ All investors are rational.
♦ Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
♦ Non-existence of corporate taxes.

3. DESCRIBE Net Operating Income (NOI) theory of capital structure? EXPLAIN the assumptions of Net
Operating Income approach theory of capital structure.
ANSWER 3

NOI means earnings before interest and tax (EBIT). According to this approach, capital structure decisions of
the firm are irrelevant.

Any change in the leverage will not lead to any change in the total value of the firm and the market price of
shares, as the overall cost of capital is independent of the degree of leverage. As a result, the division between
debt and equity is irrelevant.

As per this approach, an increase in the use of debt which is apparently cheaper is offset by an increase in the
equity capitalisation rate. This happens because equity investors seek higher compensation as they are
opposed to greater risk due to the existence of fixed return securities in the capital structure.

The above diagram shows that Ko (Overall capitalisation rate) and (debt – capitalisation rate) are constant and
Ke (Cost of equity) increases with leverage.

4. EXPLAIN the principles of “Trading on equity”.

ANSWER 4

Financial leverage or Trading on Equity: The use of long-term fixed interest bearing debt and preference share
capital along with equity share capital is called financial leverage or trading on equity. The use of long-term
debt increases the earnings per share if the firm yields a return higher than the cost of debt. The earnings per

121
share also increase with the use of preference share capital but due to the fact that interest is allowed to be
deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate
adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm.
Therefore, it needs caution to plan the capital structure of a firm.

5. DISCUSS the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital
structure of a company.
ANSWER 5

Relationship between EBIT - EPS-MPS The basic objective of financial management is to design an appropriate
capital structure which can provide the highest wealth, i.e., highest MPS, which in turn depends on EPS.
Given a level of EBIT, EPS will be different under different financing mix depending upon the extent of debt
financing. The effect of leverage on the EPS emerges because of the existence of fixed financial charge i.e.,
interest on debt, financial fixed dividend on preference share capital. The effect of fixed financial charge on
the EPS depends upon the relationship between the rate of return on assets and the rate of fixed charge. If the
rate of return on assets is higher than the cost of financing, then the increasing use of fixed charge financing
(i.e., debt and preference share capital) will result in increase in the EPS. This situation is also known as
favourable financial leverage or Trading on Equity. On the other hand, if the rate of return on assets is less
than the cost of financing, then the effect may be negative and, therefore, the increasing use of debt and
preference share capital may reduce the EPS of the firm.
The fixed financial charge financing may further be analyzed with reference to the choice between the debt
financing and the issue of preference shares. Theoretically, the choice is tilted in favour of debt financing for
two reasons: (i) the explicit cost of debt financing i.e., the rate of interest payable on debt instruments or
loans is generally lower than the rate of fixed dividend payable on preference shares, and (ii) interest on debt
financing is tax-deductible and therefore the real cost (after-tax) is lower than the cost of preference share
capital.

Thus, the analysis of the different types of capital structure and the effect of leverage on the expected EPS and
eventually MPS will provide a useful guide to selection of a particular level of debt financing. The EBIT-EPS
analysis is of significant importance and if undertaken properly, can be an effective tool in the hands of a
financial manager to get an insight into the planning and designing of the capital structure of the firm.

6. DISCUSS financial break-even and EBIT-EPS indifference analysis.

ANSWER 6

122
Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e.
interest and preference dividends. It denotes the level of EBIT for which the company’s EPS equals zero.

If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the expected level of
EBIT is more than the breakeven point, then more fixed costs financing instruments can be taken in the capital
structure, otherwise, equity would be preferred.
EBIT-EPS breakeven analysis is used for determining the appropriate amount of debt a company might carry.
Another method of considering the impact of various financing alternatives on earnings per share is to prepare
the EBIT chart or the range of Earnings Chart. This chart shows the likely EPS at various probable EBIT levels.
Thus, under one particular alternative, EPS may be ₹ 2 at a given EBIT level. However, the EPS may go down if
another alternative of financing is chosen even though the EBIT remains at the same level. At a given EBIT,
earnings per share under various alternatives of financing may be plotted. A straight line representing the EPS
at various levels of EBIT under the alternative may be drawn. Wherever this line intersects, it is known as
break-even point. This point is a useful guide in formulating the capital structure. This is known as EPS
equivalency point or indifference point since this shows that, between the two given alternatives of financing
(i.e., regardless of leverage in the financial plans), EPS would be the same at the given level of EBIT.
The equivalency or indifference point can also be calculated algebraically in the following manner:

123

Where,

EBIT = Indifference point

E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2

I1 = Interest charges in Alternative 1

I2 = Interest charges in Alternative 2
T = Tax-rate

Just keep in mind that if amount of equity share capital is same under two financial plans then one of the
following two situations will arise:

1. No indifference point: if after tax cost of the source other than equity shares is not same under both plans
then there will be no indifference point between the two. Because one plan will be better than other at all
levels of EBIT. For example if two plans have equity shares of ₹ 1,00,000 each. Plan 1 has 10% debentures of ₹
50,000 while plan 2 has 8% Term loan of ₹ 50,000. Then plan 2 will be better than plan 1 at any level of EBIT
and there will be no indifference point

2. Many indifference points: if after tax cost of the source other than equity shares is same under both plans
then each EBIT will be an indifference point.

Practical Problems

1. Aaina Ltd. is considering a new project which requires a capital investment of ₹ 9 crores. Interest on term
loan is 12% and Corporate Tax rate is 30%. CALCULATE the point of indifference for the project considering
the Debt Equity ratio insisted by the financing agencies being 2 : 1.

ANSWER 1

The capital investment can be financed in two ways i.e.

(i) By issuing equity shares only worth ₹ 9 crore or
(ii) By raising capital through taking a term loan of ₹ 6 crores and ₹ 3 crores through issuing equity shares (as
the company has to comply with the 2 : 1 Debt Equity ratio insisted by financing agencies).

In first option interest will be Zero and in second option the interest will be ₹ 72,00,000
Point of Indifference between the above two alternatives =

124

Or, 0.7 EBIT = 2.1 EBIT – ₹ 1,51,20,000

EBIT = ₹ 1,08,00,000
EBIT at point of Indifference will be ₹ 1.08 crore.
(The face value of the equity shares is assumed as ₹ 10 per share. However, indifference point will be same
irrespective of face value per share).

2. Xylo Ltd. is considering two alternative financing plans as follows:

Particulars Plan – A (₹) Plan – B (₹)

Equity shares of ₹ 10 8,00,000 8,00,000
each
Preference Shares of ₹ - 4,00,000
100 each
12% Debentures 4,00,000 -
12,00,000 12,00,000

The indifference point between the plans is ₹ 4,80,000. Corporate tax rate is 30%. CALCULATE the rate of
dividend on preference shares.

ANSWER 2
Computation of Rate of Preference Dividend

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3. Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives in
financing the project cost.

Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each

Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)

The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%. CALCULATE the
indifference point between the two alternative methods of financing.

ANSWER 3

Calculation of Indifference point between the two alternatives of financing.

Alternative-I By issue of 6,00,000 equity shares of ₹10 each amounting to ₹ 60 lakhs. No financial charges are
involved.

Alternative-II By raising the funds in the following way:

Debt = ₹40 lakhs

Equity = ₹20 lakhs (2,00,000 equity shares of ₹10 each)

Interest payable on debt = 4000000 X 18 / 100 = 720000

The difference point between the two alternatives is calculated by:

Where,

EBIT = Earnings before interest and taxes

I1 = Interest charges in Alternative-I
I2 = Interest charges in Alternative-II

T = Tax rate
E1 = Equity shares in Alternative-I

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E2 = Equity shares in Alternative-II

Putting the values, the break-even point would be as follows:

Therefore, at EBIT of ₹10,80,000 earnings per share for the two alternatives is equal.

4. Ganapati Limited is considering three financing plans. The key information is as follows:

(a) Total investment to be raised ₹ 2,00,000

(b) Plans of Financing Proportion:

Plans Equity Debt Preference

Shares
A 100% - -
B 50% 50% -
C 50% - 50%

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(c) Cost of debt 8%
Cost of preference shares 8%

(d) Tax rate 50%

(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.

(f) Expected EBIT is ₹ 80,000.

You are required to DETERMINE for each plan: -

(i) Earnings per share (EPS)

(ii) The financial break-even point.

(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.

ANSWER 4

(i) Computation of Earnings per share (EPS)

(ii)
Plans A B C
Earnings before 80,000 80,000 80,000
interest and tax
(EBIT)
Less: Interest --- (8,000) ---
charges (8% × ₹1 lakh)

Earnings before 80,000 72,000 80,000

tax (EBT)
Less: Tax (@ 50%) (40,000) (36,000) (40,000)
Earnings after tax 40,000 36,000 40,000
(EAT)
Less: Preference --- --- (8,000)
Dividend (8% × ₹1 lakh)
Earnings available 40,000 36,000 32,000
for Equity
shareholders (A)
No. of Equity 10,000 5,000 5,000
shares (B) (₹2 lakh ÷ ₹20) (₹1 lakh ÷ ₹20) (₹1 lakh ÷ ₹20)
EPS ₹ [(A) ÷ (B)] 4 7.20 6.40

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(ii) Calculation of Financial Break-even point
Financial break-even point is the earnings which are equal to the fixed finance charges and preference
dividend.

Plan A : Under this plan there is no interest or preference dividend payment hence, the Financial Break-even
point will be zero.
Plan B : Under this plan there is an interest payment of ₹8,000 and no preference dividend, hence, the
Financial Break-even point will be ₹8,000 (Interest charges).

Plan C : Under this plan there is no interest payment but an after tax preference dividend of ₹8,000 is paid.
Hence, the Financial Break- even point will be before tax earnings of ₹16,000 (i.e. ₹8,000 ÷ 0.5 = ₹16,000.)

(iii) Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by applying the following formula

Where,

EBIT = Earnings before interest and tax.

I1 = Fixed charges (interest or pref. dividend) under Alternative
I2 = Fixed charges (interest or pref. dividend) under Alternative

T = Tax rate

E1 = No. of equity shares in Alternative 1

E2 = No. of equity shares in Alternative 2

Now, we can calculate indifference point between different plans of financing.

129
There is no indifference point between the financial plans B and C. It can be seen that Financial Plan B
dominates Plan C. Since, the financial break-even point of the former is only ₹8,000 but in case of latter it is
₹16,000. Further EPS of plant B is the highest.

5. Yoyo Limited presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It 130
wishes to finance a ₹ 40,00,000 expansion programme and is considering three alternatives: additional debt
at 12 per cent interest, preference shares with an 11 per cent dividend, and the issue of equity shares at ₹16
per share. The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax bracket.

(a) If earnings before interest and taxes are presently ₹15,00,000, DETERMINE earnings per share for the
three alternatives, assuming no immediate increase in profitability?
(b) ANALYSE which alternative do you prefer? COMPUTE how much would EBIT need to increase before the
next alternative would be best?

ANSWER 5

(a)
Particulars Alternatives
Alternative Alternative Alternative
–I : Take -II: Issue -III: Issue
additional 11% fur-ther
Debt Preference Equity
Shares Shares
EBIT 15,00,000 15,00,000 15,00,000
Interest on Debts:
- on existing debt @10% (3,60,000) (3,60,000) (3,60,000)
- on new debt @ 12% (4,80,000) --- ---
Profit before taxes 6,60,000 11,40,000 11,40,000
Taxes @ 40% (2,64,000) (4,56,000) (4,56,000)
Profit after taxes 3,96,000 6,84,000 6,84,000
Preference shares dividend --- (4,40,000) ---
Earnings available to equity Shareholders 3,96,000 2,44,000 6,84,000
Number of shares 8,00,000 8,00,000 10,50,000
Earnings per share 0.495 0.305 0.651

(b) For the present EBIT level, equity shares are clearly preferable. EBIT would need to increase by ₹2,376
−₹1,500 = ₹876 before an indifference point with debt is reached. One would want to be comfortably above
this indifference point before a strong case for debt should be made. The lower the probability that actual
EBIT will fall below the indifference point, the stronger the case that can be made for debt, all other things
remain the same.

6. Alpha Limited requires funds amounting to ₹ 80 lakh for its new project. To raise the funds, the company 131
has following two alternatives:

(i) To issue Equity Shares of ₹100 each (at par) amounting to ₹60 lakh and borrow the balance amount at the
interest of 12% p.a.; or

(ii) To issue Equity Shares of ₹100 each (at par) and 12% Debentures in equal proportion.

The Income-tax rate is 30%.

IDENTIFY the point of indifference between the available two modes of financing and state which option
will be beneficial in different situations.

ANSWER 6

(i) Amount = ₹80,00,000

Plan I = Equity of ₹60,00,000 + Debt of ₹20,00,000

Plan II = Equity of ₹40,00,000 + 12% Debentures of ₹40,00,000

Plan I: Interest Payable on Loan

= 12% × ₹20,00,000 = ₹2,40,000

Plan II: Interest Payable on Debentures

= 12% × ₹40,00,000 = ₹4,80,000

Computation of Point of Indifference

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(ii) Earnings per share (EPS) under Two Situations for both the Plans

Situation A (EBIT is assumed to be ₹9,50,000)

Particulars Plan I Plan II
EBIT 9,50,000 9,50,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,10,000 4,70,000
Less: Taxes @ 30% (2,13,000) (1,41,000)
 EAT 4,97,000 3,29,000
No. of Equity Shares 60,000 40,000
EPS 8.28 8.23

Comment: In Situation A, when expected EBIT is less than the EBIT at indifference point then, Plan I is more
viable as it has higher EPS. The advantage of EPS would be available from the use of equity capital and not
debt capital.

Situation A (EBIT is assumed to be ₹9,50,000)

Particulars Plan I Plan II
EBIT 9,70,000 9,70,000
Less: Interest @ 12% (2,40,000) (4,80,000)
EBT 7,30,000 4,90,000
Less: Taxes @ 30% (2,19,000) (1,47,000)
EAT 5,11,000 3,43,000
No. of Equity Shares 60,000 40,000
EPS 8.52 8.58

Comment: In Situation B, when expected EBIT is more than the EBIT at indifference point then, Plan II is more
viable as it has higher EPS. The use of fixed-cost source of funds would be beneficial from the EPS viewpoint. In
this case, financial leverage would be favourable.

(Note: The problem can also be worked out assuming any other figure of EBIT which is more than 9,60,000
and any other figure less than 9,60,000. Alternatively, the answer may also be based on the factors/governing
the capital structure like the cost, risk, control, etc. Principles).

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7. One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10
per cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except that
its capital structure is all-equity, and its cost of equity is 16 per cent. According to Modigliani and Miller, if
we ignored taxation and tax relief on debt capital, COMPUTE the cost of equity of Sanghmani Limited?

A NSWER 7
Here we are assuming that MM Approach 1958: Without tax, where capital structure has no relevance with
the value of company and accordingly overall cost of capital of both levered as well as unlevered company is
same. Therefore, the two companies should have similar WACCs. Because Samsui Limited is all-equity
financed, its WACC is the same as its cost of equity finance, i.e. 16 per cent. It follows that Sanghmani Limited
should have WACC equal to 16 per cent also.
Therefore, Cost of equity in Sanghmani Ltd. (levered company) will be calculated as follows:

8. The following data relates to two companies belonging to the same risk class:

Particulars A Ltd. B Ltd.

Expected Net Operating Income ₹ 18,00,000 ₹ 18,00,000
12% Debt ₹ 54,00,000 -
Equity Capitalization Rate – 18

REQUIRED:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach.

ANSWER

(a) Assuming no tax as per MM Approach.

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]

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Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = ₹ 1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18

Market Value of ‘A Ltd’ [Levered Firm (I)]

Total Value of Levered Firm (VL) = Vu + (Debt× Nil)
= ₹ 1,00,00,000 + (54,00,000 × nil)
= ₹1,00,00,000
Computation of Equity Capitalization Rate and Weighted Average Cost of Capital (WACC)
 Particulars A Ltd. B Ltd.
A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC (ko)]*ko = (ke×S/V) + (kd×D/V) 0.18 0.18
Computation of WACC A Ltd

*Kd = 12% (since there is no tax)

WACC = 18%

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= ₹60,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)

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= ₹ 60,00,000 + (54,00,000 × 0.4)
= ₹ 81,60,000
Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’
= 18% (i.e. Ke = Ko)
Computation of Equity Capitalization Rate and Weighted Average Cost of Capital (WACC) of A Ltd

Particulars A Ltd. (₹)

Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)
*Computation of WACC A Ltd

*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%

WACC = 13.23%

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 CHAPTER-6 FINANCIAL DECISIONS-LEVERAGES
ILLUSTRATION 1
A Company produces and sells 10,000 shirts. The selling price per shirt is ₹ 500. Variable cost is ₹ 200 per
shirt and fixed operating cost is ₹ 25,00,000.
(a) CALCULATE operating leverage.
(b) If sales are up by 10%, then COMPUTE the impact on EBIT?

SOLUTION

(a) Statement of Profitability

Sales Revenue (10,000 × 500) 50,00,000

Less: Variable Cost (10,000 × 200) 20,00,000
Contribution 30,00,000
Less: Fixed Cost 25,00,000
EBIT 5,00,000

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ILLUSTRATION 2
CALCULATE the operating leverage for each of the four firms A, B, C and D from the following price and cost
data:

Firms
A (₹) B (₹) C (₹) D (₹)
Sale price per unit 20 32 50 70

Variable cost per unit 6 16 20 50

Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage
result? Explain. Assume number of units sold is 5,000.

SOLUTION

The operating leverage exists only when there are fixed costs. In the case of firm D, there is no magnified
effect on the EBIT due to change in sales. A 20 per cent increase in sales has resulted in a 20 per cent increase
in EBIT. In the case of other firms, operating leverage exists. It is maximum in firm A, followed by firm C and

138
minimum in firm B. The interception of DOL of 7 is that1 per cent change in sales results in 7 per cent change
in EBIT level in the direction of the change of sales level of firm A.
ILLUSTRATION 3

A firm’s details are as under:

Sales (@100 per unit) ₹ 24,00,000
Variable Cost 50%
Fixed Cost ₹ 10,00,000
It has borrowed ₹ 10,00,000 @ 10% p.a. and its equity share capital is ₹ 10,00,000 (₹ 100 each).

Consider tax @ 50 %.

CALCULATE:
(a) Operating Leverage

(b) Financial Leverage

(c) Combined Leverage

(d) Return on Investment

(e) If the sales increases by ₹ 6,00,000; what will the new EBIT?

SOLUTION

Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
EAT 50,000
No. of equity shares 10,000

139
EPS 5
ILLUSTRATION 4
The following information is related to Yizi Company Ltd. for the year ended 31st March, 2021:

Equity share capital (of ₹ 10 each) ₹ 50 lakhs

12% Bonds of ₹ 1,000 each ₹ 37 lakhs
Sales ₹ 84 lakhs
Fixed cost (excluding interest) ₹ 6.96 lakhs
Financial leverage 1.49
Profit-volume Ratio 27.55%

140
Income Tax Applicable 40%

You are required to CALCULATE:

(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations up-to two decimal points.
SOLUTION
Computation of Profits after Tax (PAT)

Particulars Amount (₹)

Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12% × ₹37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)*
EBT (Earnings before tax) 10,86,040
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624

(i) Operating Leverage:

(ii) Combined Leverage:

141

(iii) Earnings per share (EPS):

ILLUSTRATION 5
Following are the selected financial information of A Ltd. and B Ltd. for the year ended March 31st, 2021:

You are required to FIND out:

(i) EBIT
(ii) Sales
(iii) Fixed Cost
(iv) Identify the company which is better placed with reasons based on leverages.

SOLUTION

Company A

142

Company B
Income Statements of Company A and Company B

143

Comment based on Leverage

Comment based on leverage – Company B is better than company A of the following reasons:
• Capacity of Company B to meet interest liability is better than that of companies A (from EBIT/Interest ratio)
 Company B has the least financial risk as the total risk (business and financial) of company B is lower (combined
leverage of Company A – 15 and Company B- 4)

MCQs based Questions

1. Given

Operating fixed ₹ 20,000

costs
Sales ₹ 1,00,000
P/ V ratio 40%

The operating leverage is:

(a) 2.00

(b) 2.50

(c) 2.67

(d) 2.47

ANSWER 1-A

2. If EBIT is ₹ 15,00,000, interest is ₹ 2,50,000, corporate tax is 40%, degree of financial leverage is;

(a) 1:11

(b) 1.20

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(c) 1.31

(d) 1.41

ANSWER 2-B

3. If DOL is 1.24 and DFL is 1.99, DCL would be:

(a) 2.14
(b) 2.18

(c) 2.31

(d) 2.47

ANSWER 3-D

4. Operating Leverage is calculated as:

(a) Contribution ÷ EBIT

(b) EBIT ÷ PBT

(c) EBIT ÷ Interest

(d) EBIT ÷ Tax

ANSWER 4-A

5. Financial Leverage is calculated as:

(a) EBIT ÷ Contribution

(b) EBIT ÷ PBT

(c) EBIT ÷ Sales

(d) EBIT ÷ Variables Cost

145
ANSWER 5-B

6. Which of the following is correct?

(a) CL = OL + FL

(b) CL = OL – FL
(c) OL = OL× FL

(d) OL = OL ÷ FL

ANSWER 6-C

7. Which of the following indicates business risk?

(a) Operating leverage

(b) Financial leverage

(c) Combined leverage

(d) Total leverage

ANSWER 7-A

8. Degree of combined leverage is the fraction of:

(a) Percentage change in EBIT on Percentage change in Sales.

(b) Percentage change in EPS on Percentage change in Sales.

(c) Percentage change in Sales on Percentage change in EPS.

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(d) Percentage change in EPS on Percentage change in EBIT.

ANSWER 8-B

9. From the following information, calculate combined leverage:

Sales Rs. 20,00,000

Variable Cost 40%
Fixed Cost Rs. 10,00,000
Borrowings Rs. 10,00,000 @ 8% p.a.
(a) 10 times

(b) 6 times

(c) 1.667 times

(d) 0.10 times

ANSWER 9-A

10. Operating leverage is a function of which of the following factors?

(a) Amount of variable cost.

(b) Variable contribution margin.

(c) Volume of purchases.

(d) Amount of semi-variable cost.

ANSWER 10-B

11. Financial leverage may be defined as:

(a) Use of funds with a product cost in order to increase earnings per share.

(b) Use of funds with a contribution cost in order to increase earnings before interest and taxes.

(c) Use of funds with a fixed cost in order to increase earnings per share.

147
(d) Use of funds with a fixed cost in order to increase earnings before interest and taxes.

ANSWER 11-C

12. If Margin of Safety is 0.25 and there is 8% increase in output, then EBIT will be:

(a) Decrease by 2%
(b) Increase by 32%

(c) Increase by 2%

(d) Decrease by 32%

ANSWER 12-B

13. If degree of financial leverage is 3 and there is 15% increase in Earning per share (EPS), then EBIT will be:

(a) Decrease by 15%

(b) Increase by 45%

(c) Decrease by 45%

(d) Increase by 5%

ANSWER 13-D

14. When EBIT is much higher than Financial break-even point, then degree of financial leverage will be
slightly:

(a) Less than 1

(b) Equals to 1

(c) More than 1

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(d) Equals to 0

ANSWER 14-C

15. Firm with high operating leverage will have:

(a) Higher breakeven point

(b) Lower business risk

(c) Higher margin of safety

(d) All of above

ANSWER 15-A

16. When sales is at breakeven point, the degree of operating leverage will be:

(a) Zero

(b) Infinite

(c) One

(d) None of above

ANSWER 16-B

17. If degree of combined leverage is 3 and margin of safety is 0.50, then degree of financial leverage is:

(a) 6.00

(b) 3.00

(c) 0.50

(d) 1.50

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ANSWER 17-D

Theoretical based Questions

1. DIFFERENTIATE between Business risk and Financial risk.

ANSWER 1
 BASIS FOR
BUSINESS RISK FINANCIAL RISK
COMPARISON

Meaning The risk of insufficient profit, to meet out the Financial Risk is the risk arising
expenses is known as Business Risk. due to the use of debt financing
in the capital structure.

Evaluation Variability is EBIT Leverage Multiplier and Debt to

asset ratio.

Connected with Economic environment Use of debt capital

Minimization The risk cannot be minimized. If the firm does not use debt
funds, there will be no risk.

Types Compliance risk, operational risk, reputation Credit risk, Market risk, Liquidity
risk, financial risk, strategic risk etc. risk, exchange rate risk, etc.

Disclosed by Difference in net operating income and net cash Difference in the return of
flows. equity shareholders.

2. Explain the concept of “Double edged sword” in Financial leverage analysis?

ANSWER 2

Financial Leverage as a ‘Double edged Sword’

On one hand when cost of ‘fixed cost fund’ is less than the return on investment financial leverage will help to

150
increase return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts etc.
However, when cost of debt will be more than the return it will affect return of equity and EPS unfavourably
and as a result firm can be under financial distress. This is why financial leverage is known as “double edged
sword”.

Effect on EPS and ROE:

When, ROI > Interest – Favourable – Advantage
When, ROI < Interest – Unfavourable – Disadvantage
When, ROI = Interest – Neutral – Neither advantage nor disadvantage.
Note: DFL can never be between zero and one. It can be zero or less or it can be one or more.
*Financial BEP is the level of EBIT at which earning per share is zero. If a company has not issued preference
shares then Financial BEP is simply equal to amount of Interest.
When EBIT is much higher than Financial BEP, DFL will be slightly more than one. With decrease in EBIT, DFL
will increase. At Financial BEP, DFL will be infinite. When
EBIT is slightly less than Financial BEP, DFL will be negative infinite. With further reduction in EBIT, DFL will
move towards zero. At zero EBIT, DFL will also be zero.

3. “Operating risk is associated with cost structure, whereas financial risk is associated with capital structure
of a business concern.” Critically EXAMINE this statement.

ANSWER

Operating Leverage (OL) means tendency of operating income (EBIT) to change disproportionately with change in sale
volume. This disproportionate change is caused by operating fixed cost, which does not change with change in sales
volume. In other words, Operating Leverage maybe defined as the employment of an asset with a fixed cost so that
enough revenue can be generated to cover all the fixed and variable costs. The use of assets for which a company pays a
fixed cost is called operating leverage. Operating leverage is a function of three factors: (i) Amount of fixed cost, (ii)
Variable contribution margin, and (iii) Volume of sales.

Practical Problems

1. From the following information extracted from the books of accounts of Imax Ltd., CALCULATE
percentage change in earnings per share, if sales increase by 10% and Fixed Operating cost is ₹ 1,57,500:

Particulars Amount in ₹
EBIT (Earnings before 31,50,000
Interest and Tax)
Earnings before Tax (EBT) 14,00,000

151
ANSWER 1
2. Consider the following information for Mega Ltd.:

Production level 2,500 units

Contribution per unit ₹ 150
Operating leverage 6
Combined leverage 24
Tax rate 30%

Required:
COMPUTE its earnings after tax.

ANSWER 2

152
Computation of Earnings after tax

Contribution = ₹ 150 × 2,500 = ₹ 3,75,000

Operating Leverage (OL) × Financial Leverage (FL) = Combined Leverage (CL) 6 × Financial Leverage = 24 ∴
Financial Leverage = 4
Since tax rate = 30%
Earnings after Tax (EAT) = EBT (1 − 0.30) [ 30% is tax rate]=₹ 15,625 (0.70)
∴ Earnings after Tax (EAT) = ₹ 10,938

3. From the following information, prepare Income Statement of Company A & B:

Particulars Company A Company B

Margin of safety 0.20 0.25
Interest ₹ 3000 ₹ 2000
Profit volume ratio 25% 33.33%
Financial Leverage 4 3
Tax rate 45% 45%

ANSWER 3

Income Statement (Amount in ₹)

153

Working Notes:

(i) Company A
Financial Leverage = EBIT/(EBIT- Interest)
4/1 = EBIT/(EBIT- ₹ 3,000)
4EBIT – ₹ 12,000= EBIT
3EBIT = ₹ 12,000
EBIT = ₹ 4,000

Company B

Financial Leverage = EBIT/(EBIT - Interest)

3/1 = EBIT/ (EBIT – ₹ 2,000)
3EBIT – ₹ 6000= EBIT
2EBIT = ₹ 6,000
EBIT = ₹ 3,000

(ii) Company A

Operating Leverage = 1/Margin of Safety

= 1/0.20 = 5
Operating Leverage = Contribution/EBIT
5 = Contribution/₹ 4,000
Contribution = ₹ 20,000

Company B

Operating Leverage = 1/Margin of Safety

= 1/0.25 = 4
Operating Leverage = Contribution/EBIT
4 = Contribution/₹ 3,000
Contribution = ₹ 12,000

154
(iii) Company A
Profit Volume Ratio = 25%(Given)
Profit Volume Ratio = Contribution/Sales * 100
25% = ₹ 20,000/Sales
Sales = ₹ 20,000/25%
Sales = ₹ 80,000

Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ₹ 12,000/33.33%
Sales = ₹ 36,000
4. The capital structure of PS Ltd. for the year ended 31st March, 2020 consisted as follows:

Particulars Amount in ₹
Equity share capital (face value ₹ 100 10,00,000
each)
10% debentures (₹ 100 each) 10,00,000

During the year 2019-20, sales decreased to 1,00,000 units as compared to 1,20,000 units in the previous
year. However, the selling price stood at ₹ 12 per unit and variable cost at ₹ 8 per unit for both the years.
The fixed expenses were at ₹ 2,00,000 p.a. and the income tax rate is 30%.

You are required to CALCULATE the following:

(i) The degree of financial leverage at 1,20,000 units and 1,00,000 units.

(ii) The degree of operating leverage at 1,20,000 units and 1,00,000 units.

(iii) The percentage change in EPS.

ANSWER 4

155
5. The Sale revenue of TM excellence Ltd. @ ₹ 20 Per unit of output is ₹ 20 lakhs and Contribution is ₹ 10
lakhs. At the present level of output the DOL of the company is 2.5. The company does not have any
Preference Shares. The number of Equity Shares are 1 lakh. Applicable corporate Income Tax rate is 50% and

156
the rate of interest on Debt Capital is 16% p.a. What is the EPS (At sales revenue of ₹ 20 lakhs) and amount
of Debt Capital of the company if a 25% decline in Sales will wipe out EPS.

ANSWER 5
6. Betatronics Ltd. has the following balance sheet and income statement information:

157
Balance Sheet as on March 31st 2020

Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 8,00,000 Net fixed assets 10,00,000
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000
Income Statement for the year ending March 31st 2020

Particulars ₹
Sales 3,40,000
Operating expenses (including ₹ 60,000 1,20,000
depreciation)
EBIT 2,20,000
Less: Interest 60,000
Earnings before tax 1,60,000
Less: Taxes 56,000
Net Earnings (EAT) 1,04,000

(a) DETERMINE the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs.

(b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20
percent, COMPUTE the earnings per share at the new sales level?

ANSWER 6

(a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages (DCL).

158

(b) Earnings per share at the new sales level

Working Notes:
(i) Variable Costs = ₹ 60,000 (total cost − depreciation)
(ii) Variable Costs at:
(a) Sales level, ₹ 4,08,000 = ₹ 72,000 (increase by 20%)
(b) Sales level, ₹ 2,72,000 = ₹ 48,000 (decrease by 20%)

7. A company had the following Balance Sheet as on 31stMarch, 2020:

Liabilities (₹in crores) Assets (₹in crores)

Equity Share 5
Capital (50 lakhs
shares of ₹ 10
each)

159
Reserves and 1 Fixed Assets 12.5
Surplus (Net)
15% Debentures 10 Current Assets 7.5
Current 4
Liabilities
20 20
The additional information given is as under:

Fixed cost per annum (excluding interest) ₹ 4 crores

Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:

CALCULATE the following and comment:

(i) Earnings Per Share

(ii) Operating Leverage

(iii) Financial Leverage

(iv) Combined Leverage

ANSWER 7

Total Assets = ₹ 20 crores

Total Asset Turnover Ratio = 2.5

Hence, Total Sales = 20 × 2.5 = ₹ 50 crores

Computation of Profit after Tax (PAT)

160
(i) Earnings per Share
EPS =8.40 crores / Number of Equity Shares = 8.40 crores / 50,00,000 = ₹ 16.80
It indicates the amount the company earns per share. Investors use this as a guide while valuing the share and
making investment decisions. It is also a indicator used in comparing firms within an industry or industry
segment.

(ii) Operating Leverage

Operating Leverage = Contribution / EBIT = 17.50 /13.50 = 1.296

It indicates the choice of technology and fixed cost in cost structure. It is level specific. When firm operates
beyond operating break-even level, then operating leverage is low. It indicates sensitivity of earnings before
interest and tax (EBIT) to change in sales at a particular level.

(iii) Financial Leverage

Financial Leverage = EBIT / PBT = 13.50 / 12.00 = 1.125

The financial leverage is very comfortable since the debt service obligation is small vis-à-vis EBIT.

(iv) Combined Leverage

Combined Leverage = (Contribution X EBIT) / (EBIT× PBT)
Or,
= Operating Leverage × Financial Leverage
= 1.296 × 1.125 = 1.458

The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure.
It studies how sensitive the change in EPS is vis-à-vis change in sales. The leverages operating, financial and

161
combined are used as measurement of risk.
8. CALCULATE the operating leverage, financial leverage and combined leverage from the following data
under Situation I and II and Financial Plan A and B:

Installed Capacity 4,000 units

Actual Production and Sales 75% of the Capacity
Selling Price ₹ 30 Per Unit
Variable Cost ₹ 15 Per Unit

Fixed Cost:

Under Situation I ₹ 15,000

Under Situation-II ₹20,000

Capital Structure:

Financial Plan
Particulars A₹ B₹
Equity 10,00,000 15000
10% debentures (₹ 100 each) 10,00,000 5000
20,000 20,000
ANSWER 8

162
(ii) Financial Leverages

(iii) Combined Leverages

163
9. The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given:

Output 1,00,000 units at normal capacity

Selling price per unit ₹ 40
Variable cost per unit ₹ 20
Fixed cost ₹ 10,00,000

The capital structure of the company as on 31st March, 2021 is as follows:

Particulars ₹
Equity share capital (1,00,000 10,00,000
shares of ₹ 10 each)
Reserves and surplus 5,00,000
7% debentures 10,00,000
Current liabilities 5,00,000
Total 30,00,000

Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve ₹ 10
lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by ₹ 5,00,000 and
variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling
price without any adverse impact on the market.
The following alternative schemes for financing the proposed expansion programme are planned:
(i) Entirely by equity shares of ₹ 10 each at par.
(ii) ₹ 5 lakh by issue of equity shares of ₹ 10 each and the balance by issue of 6% debentures of ₹ 100 each at
par.
(iii) Entirely by 6% debentures of ₹ 100 each at par.
FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference
to the risk and return involved, assuming a corporate tax of 40%.

164
ANSWER

Statement showing Profitability of Alternative Schemes for Financing

(₹ in ‘00,000)
165
From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial Leverage
differs. Alternative (iii) uses the maximum amount of debt and result into the highest degree of financial leverage,
followed by alternative (ii). Accordingly, risk of the company will be maximum in these options. Corresponding to this
scheme, however, maximum EPS (i.e., ₹ 10.02 per share) will be also in option (iii).
So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In case of opting for
less risk, alternative (ii) is the next best option with a reduced EPS of ₹ 6.80 per share. In case of alternative (i), EPS is
even lower than the existing option, hence not recommended.

10. The following details of a company for the year ended 31st March, 2021 are given below:

166

CALCULATE:
(i) Financial Leverage
(ii) P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets
turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?

ANSWER

(i) Financial leverage

Combined Leverage = Operating Leverage (OL) × Financial Leverage (FL)
2.5 = 2 × FL
Or, FL = 1.25
Financial Leverage = 1.25
(ii) P/V Ratio and Earning per share (EPS)

167
(iii) Assets turnover

(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.5, sales have to be dropped by 100/2.5 = 40%.
Hence new sales will be ₹ 50,00,000 × (100 – 40) % = ₹ 30,00,000.
Therefore, at ₹ 30,00,000 level of sales, the Earnings before Tax (EBT) of the company will be zero.
Alternatively

[Note: The question can also be solved by first calculating EBIT with the help of Financial Leverage. Accordingly answer
to the requirement (ii) and (iv) will also vary]

11. You are given the following information of 5 firms of the same industry:

168

You are required to CALCULATE for all firms:

(i) Degree of operating leverage and
(ii) Degree of combined leverage.

ANSWER

Calculation of Degree of Operating leverage and Degree of Combined leverage

169
 CHAPTER-7 INVESTMENT DECISIONS

ILLUSTRATION 1
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of ₹ 1,00,000; expected
economic life of 4 years and change in earnings before taxes and depreciation of ₹ 45,000 in year 1, ₹ 30,000
in year 2, ₹ 25,000 in year 3 and ₹ 35,000 in year 4. Assume straight-line depreciation and a 20% tax rate.
You are required to COMPUTE relevant cash flows.

SOLUTION

Years
1 2 3 4
Earnings before 45,000 30,000 25,000 35,000
tax and
depreciation
Less: (25,000) (25,000) (25,000) (25,000)
Depreciation
Earnings before 20,000 5,000 0 10,000
tax
Less: Tax @20% (4,000) (1,000) 0 (2,000)
16000 4000 0 8000
Add: 25,000 25,000 25,000 25,000
Depreciation
Net Cash flow 41,000 29,000 25,000 33,000

Working Note:
Depreciation = ₹ 1,00,000 ÷ 4 = ₹ 25,000

170
ILLUSTRATION 2
A project requiring an investment of ₹ 10,00,000 and it yields profit after tax and depreciation which is as
follows:

Years Profit after tax and depreciation

(₹)
1 50,000
2 75,000
3 1,25,000
4 130000
5 80000
6 460000

Suppose further that at the end of the 5th year, the plant and machinery of the project can be sold for ₹
80,000. DETERMINE Average Rate of Return.

SOLUTION

In this case the rate of return can be calculated as follows:

(Total Profit÷No. of years) / (Average investment/Initial Investment) ×100

(a) If Initial Investment is considered then,

This rate is compared with the rate expected on other projects, had the same funds been invested
alternatively in those projects. Sometimes, the management compares this rate with the minimum rate
(called-cut off rate). For example, management may decide that they will not undertake any project which has
an average annual yield after tax less than 20%. Any capital expenditure proposal which has an average annual
yield of less than 20% will be automatically rejected.

(b) If Average investment is considered, then,

171

Where, Average Investment= ½ (Initial investment – Salvage value) + Salvage value

= ½ (10,00,000 – 80,000) + 80,000

= 4,60,000 + 80,000 = 5,40,000

ILLUSTRATION 3
COMPUTE the net present value for a project with a net investment of ₹ 1,00,000 and net cash flows for
year one is ₹ 55,000; for year two is ₹ 80,000 and for year three is ₹ 15,000. Further, the company’s cost of
capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

SOLUTION

Year Net Cash Flows PVIF @ 10% Discounted Cash

(₹) Flows (₹)
0 (1,00,000) 1.000 (1,00,000)
1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
NPV 27340

Recommendation: Since the net present value of the project is positive, the company should accept the
project.

ILLUSTRATION 4
ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the purchase of
equipment; the company uses the net present value technique to evaluate projects. The capital budget is
limited to ₹ 500,000 which ABC Ltd believes is the maximum capital it can raise. The initial investment and
projected net cash flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You are
required to COMPUTE the NPV of the different projects.

(Amount in ₹ )

Project A Project B Project C Project D

Initial 200,000 190,000 250,000 210,000
Investment

172
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000
SOLUTION

Calculation of net present value:

Period PV factor Project A Project B Project C Project D

(₹) (₹) (₹) (₹)
0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
NPV -19750 25635 27050 -3750

ILLUSTRATION 5
Suppose we have three projects involving discounted cash outflow of ₹ 5,50,000, ₹ 75,000 and ₹ 1,00,20,000
respectively. Suppose further that the sum of discounted cash inflows for these projects are ₹ 6,50,000, ₹
95,000 and ₹ 1,00,30,000 respectively. CALCULATE the desirability factors for the three projects.

SOLUTION

The desirability factors for the three projects would be as follows:

173
It would be seen that in absolute terms project 3 gives the highest cash inflows yet its desirability factor is low.

This is because the outflow is also very high. The Desirability/ Profitability Index factor helps us in ranking
various projects.

Since PI is an extension of NPV it has same advantages and limitation.

ILLUSTRATION 6
A Ltd. is evaluating a project involving an outlay of ₹ 10,00,000 resulting in an annual cash inflow of ₹
2,50,000 for 6 years. Assuming salvage value of the project is zero; DETERMINE the IRR of the project.

SOLUTION

First of all, we shall find an approximation of the payback period:

(₹) 10,00,000 / (₹) 2,50,000=4

Now we shall search this figure in the PVAF table corresponding to 6-year row.
The value 4 lies between values 4.111 and 3.998 correspondingly discounting rates are 12% and 13%
respectively.

NPV @ 12%

NPV12%= (10,00,000) + 4.111 × 2,50,000 = 27,750

NPV13%= (10,00,000) + 3.998 × 2,50,000 = -500
The internal rate of return is, thus, more than 12% but less than 13%. The exact rate can be obtained by
interpolation:

Scenario 2: When the cash inflows are not uniform over the life of the investment, the determination of the 174
discount rate can involve trial and error and interpolation between discounting rates as mentioned above.
However, IRR can also be found out by using following procedure:
Step 1: Discount the cash flow at any random rate say 10%, 15% or 20% randomly.
Step 2: If resultant NPV is negative then discount cash flows again by lower discounting rate to make NPV
positive. Conversely, if resultant NPV is positive then again discount cash flows by higher discounting rate to
make NPV negative.
Step 3: Use following Interpolation Formula:
Where
LR = Lower Rate
HR = Higher Rate

ILLUSTRATION 7
CALCULATE the internal rate of return of an investment of ₹ 1,36,000 which yields the following cash inflows

Year Cash Inflows (in ₹ )

1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

SOLUTION
Let us discount cash flows by 10%.

Year Cash Inflows (₹) Discounting factor Present Value (₹)

at 10%
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420

175
Total Pressnt Value 131810

The internal rate of return is, thus, more than 10% but less than 12%. The exact rate can be obtained by
interpolation:
IRR = 10.704%

ILLUSTRATION 8

A company proposes to install machine involving a capital cost of ₹ 3,60,000. The life of the machine is 5
years and its salvage value at the end of the life is nil. The machine will produce the net operating income
after depreciation of ₹ 68,000 per annum. The company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:

Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to COMPUTE the internal rate of return of the proposal.

SOLUTION

Computation of Cash inflow per annum (₹)

Net operating income per annum 68,000

Less: Tax @ 45% (30,600)
Profit after tax 37,400
Add: Depreciation (₹ 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400

The IRR of the investment can be found as follows:

NPV = −₹ 3,60,000 + ₹ 1,09,400 (PVAF5, r) = 0

or PVAF5,r (Cumulative factor) = ₹3,60,000 / 109400 = 3.29 176

Computation of Internal Rate of Return

Discounting Rate 15% 16%

Cumulative factor 3.35 3.27
PV of Inflows 3,66,490 3,57,738
(₹ 1,09,400×3.35) (₹ 1,09,400×3.27)
 Initial outlay (₹) 3,60,000 3,60,000
NPV (₹) 6,490 (2,262)

ILLUSTRATION 9
An investment of ₹ 1,36,000 yields the following cash inflows (profits before depreciation but after tax).
DETERMINE MIRR considering 8% as cost of capital.

Year ₹
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

SOLUTION

Year 0 – Cash-outflow ₹ 1,36,000

The MIRR is calculated on the basis of investing the inflows at the cost of capital. The table below shows the
value of the inflows if they are immediately reinvested at 8%.

Year Cash flow @ 8% ₹

reinvestment
rate factor
1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388

177
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587

* Investment of ₹ 1 at the end of the year 1 is reinvested for 4 years (at the end of 5 years) shall become
1(1.08)4= 1.3605. Similarly, reinvestment rate factor for remaining years shall be calculated. Please note
investment at the end of 5th year shall be reinvested for zero year hence reinvestment rate factor shall be
1.00.
The total cash outflow in year 0 (₹ 1,36,000) is compared with the possible inflow at year 5 and the resulting
figure of = 136000 / 213587 = 0.6367 is the discount factor in year 5. By looking at the year 5 row in the
present value tables, you will see that this gives a return of 9%. This means that the ₹ 2,13,587 received in
year 5 is 2,13,587 equivalent to ₹ 1,36,000 in year 0 if the discount rate is 9%. Alternatively, we can compute
MIRR as follows

ILLUSTRATION 10
Suppose there are two Project A and Project B are under consideration. The cash flows associated with
these projects are as follows:

Year Project A Project B

0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000

Assuming Cost of Capital equal to 10%, IDENTIFY which project should be accepted as per NPV Method and
IRR Method.

SOLUTION

Net Present Value (NPV) of Projects:

178
Year Cash Cash Present PV of PV of
Inflows Inflows Value Project A Project B
Project A Project B Factor @ (₹) (₹)
(₹) (₹) 10%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.909 45,450 1,27,260
2 60,000 1,90,000 0.826 49,560 1,56,940
3 40,000 1,00,000 0.751 30,040 75,100
 25040 59300

Internal Rate of Returns (IRR) of projects:

Since by discounting cash flows at 10% we are getting values very far from zero. Therefore, let us discount
cash flows using 20% discounting rate.

Year Cash Cash Present PV of PV of

Inflows Inflows Value Project A Project B
Project A Project B Factor @ (₹) (₹)
(₹) (₹) 20%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.833 41,650 1,16,620
2 60,000 1,90,000 0.694 41,640 1,31,860
3 40,000 1,00,000 0.579 23,160 57,900
6450 6380

Since by discounting cash flows at 20% we are getting values far from zero. Therefore, let us discount cash
flows using 25% discounting rate.

Year Cash Cash Present PV of PV of

Inflows Inflows Value Project A Project B
Project A Project B Factor @ (₹) (₹)
(₹) (₹) 25%
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600
3 40,000 1,00,000 0.512 20,480 51,200
-1120 -15200

179
The internal rate of return is, thus, more than 20% but less than 25%. The exact rate can be obtained by
interpolation:
Overall Position

Project A Project B
NPV @ 10% 25,050 59,300
IRR 24.26% 21.48%

Thus there is contradiction in ranking by two methods.

Scenario 2 – Time Disparity in Cash Flows

It might be possible that overall cash flows may be more or less same in the projects but there may be
disparity in their flows i.e. larger part of cash inflows may be occurred in the beginning or end of the project.
In such situation there may be difference in the ranking of projects as per two methods.

ILLUSTRATION 11
Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash flows associated with
these projects are as follows:

Year Project X (₹) Project Y (₹)

0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000

Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted as per NPV Method and IRR
Method.

180
SOLUTION
Net Present Value of Projects

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project X (₹) Project Y (₹) Factor @ 10% Project X (₹) Project Y (₹)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.909 1,81,800 45,450
2 1,00,000 1,00,000 0.826 82,600 82,600
3 50,000 3,00,000 0.751 37,550 2,25,300
51950 53350

Internal Rate of Returns of projects

Since by discounting cash flows at 10% we are getting values far from zero. Therefore, let us discount cash
flows using 20% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project X (₹) Project Y (₹) Factor @ 20% Project X (₹) Project Y (₹)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.833 1,66,600 41,650
2 1,00,000 1,00,000 0.694 69,400 69,400
3 50,000 3,00,000 0.579 28,950 1,73,700
14950 -15250

Since by discounting cash flows at 20% we are getting value of Project X is positive and value of Project Y is
negative. Therefore, let us discount cash flows of Project X using 25% discounting rate and Project Y using
discount rate of 1

Year Cash Inflows Present Value PV of Cash Inflows Present Value PV of

Project X (₹) Factor @ 25% Project X (₹) Project Y (₹) Factor @ 15% Project Y (₹)
0 (2,50,000) 1.000 (2,50,000) (3,00,000) 1.000 (3,00,000)
1 2,00,000 0.800 1,60,000 50,000 0.870 43,500
2 1,00,000 0.640 64,000 1,00,000 0.756 75,600
3 50,000 0.512 25,600 3,00,000 0.658 1,97,400
-400 16500

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The internal rate can be obtained by interpolation:
Overall Position

Project A Project B
NPV @ 10% 51,950 53,350
IRR 24.87% 17.60%

Thus there is contradiction in ranking by two methods.

Scenario 3 – Disparity in life of Proposals (Unequal Lives)
Conflict in ranking may also arise if we are comparing two projects (especially mutually exclusive) having
unequal lives

ILLUSTRATION 12
Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash flows associated with
these projects are as follows:

Year Project A (₹) Project B (₹)

0 (5,00,000) (5,00,000)

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1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000

Assuming Cost of Capital equal to 12%, ANALYSE which project should be accepted as per NPV Method and
IRR Method?
SOLUTION
Net Present Value of Projects
Year Cash Inflows Cash Inflows Present Value PV of PV of
Project A (₹) Project B (₹) Factor @ 12% Project A (₹) Project B (₹)
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.893 6,69,750 1,78,600
2 0 2,00,000 0.797 0 1,59,400
3 0 7,00,000 0.712 0 4,98,400
169750 336400

Internal Rate of Returns of projects

Let us discount cash flows using 50% discounting rate.

Year Cash Inflows Cash Inflows Present Value PV of PV of

Project A (₹) Project B (₹) Factor @ 50% Project A (₹) Project B (₹)
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.667 5,00,250 1,33,400
2 0 2,00,000 0.444 0 88,800
3 0 7,00,000 0.296 0 2,07,200
250 -70600

Since, IRR of project A shall be 50% as NPV is very small. Further, by discounting cash flows at 50% we are
getting NPV of Project B negative, let us discount cash flows of Project B using 15% discounting rate.

Year Cash Inflows Present Value PV of

Project B (₹) Factor @ 15% Project B (₹)

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0 (5,00,000) 1.000 (5,00,000)
1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200
3 7,00,000 0.658 4,60,600
285800

The internal rate can be obtained by interpolation:

Overall Position

Project A Project B
NPV @ 12% (₹) 1,69,750 (₹) 3,36,400
IRR 50.00% 43.07%

Thus there is contradiction in ranking by two methods.

ILLUSTRATION 13

Shiva Limited is planning its capital investment programme for next year. It has five projects all of which
give a positive NPV at the company cut-off rate of 15 percent, the investment outflows and present values
being as follows:

The company is limited to a capital spending of ₹ 1,20,000. You are required to ILLUSTRATE the returns from
a package of projects within the capital spending limit. The projects are independent of each other and are

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divisible (i.e., part-project is possible).

SOLUTION
Computation of NPVs per ₹ 1 of Investment and Ranking of the Projects

Project Investment NPV @ 15% NPV per ₹ 1 Ranking

₹ '000 ₹ '000 invested
 A (50) 15.4 0.31 5
B (40) 18.7 0.47 2
C (25) 10.1 0.40 3
D (30) 11.2 0.37 4
E (35) 19.3 0.55 1

Building up of a Programme of Projects based on their Rankings

Project Investment NPV @ 15%

₹ '000 ₹ '000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5
(2/3 of project total)
20 55.6

Thus Project A should be rejected and only two-third of Project D be undertaken. If the projects are not
divisible then other combinations can be examined as:

Project Investment NPV @ 15%

₹ '000 ₹ '000
E+B+C 100 48.1
E+B+D 105 49.2

In this case E + B + D would be preferable as it provides a higher NPV despite D ranking lower than C.

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ILLUSTRATION 14
R plc is considering modernizing its production facilities and it has two proposals under consideration. The
expected cash flows associated with these projects and their NPV as per discounting rate of 12% and IRR is
as follows:

Year Cash Flow

Project A (₹) Project B (₹)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
 4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%

IDENTIFY which project should R plc accept?

SOLUTION

Although from NPV point of view Project A appears to be better but from IRR point of view Project B appears
to be better. Since, both projects have unequal lives, selection on the basis of these two methods shall not be
proper. In such situation we shall use any of the following method:

(i) Replacement Chain (Common Life) Method: Since the life of the Project A is 6 years and Project B is 3 years
to equalize lives we can have second opportunity of investing in project B after one time investing. The
position of cash flows in such situation shall be as follows:

186
NPV of extended life of 6 years of Project B shall be ₹ 8,82,403 and IRR of 25.20%. Accordingly, with extended
life NPV of Project B it appears to be more attractive.

(ii) Equivalent Annualized Criterion: The method discussed above has one drawback when we have to
compare two projects one has a life of 3 years and other has 5 years. In such case the above method shall
require analysis of a period of 15 years i.e. common multiple of these two values. The simple solution to this
problem is use of Equivalent Annualised Criterion involving following steps:

(a) Compute NPV using the WACC or discounting rate.

(b) Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period of each
project.

(c) Divide NPV computed under step (a) by PVAF as computed under step (b) and compare the values.
Accordingly, for proposal under consideration:

Project A (₹) Project B (₹)

NPV @ 12% ₹ 6,49,094 ₹ 5,15,488
PVAF @12% 4.112 2.402
Equivalent ₹ 1,57,854 ₹ 2,14,608
Annualized
Criterion

Thus, Project B should be selected.

ILLUSTRATION 15
Alpha Company is considering the following investment projects:

Cash Flows (₹)

Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

(a) ANALYSE and rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii) IRR

187
and (iv) NPV, assuming discount rates of 10 and 30 per cent.

(b) Assuming the projects are independent, which one should be accepted? If the projects are mutually
exclusive, IDENTIFY which project is the best?

SOLUTION

(a) (i) Payback Period

Project A : (₹)10,000/(₹)10,000 = 1 year
Project B: (₹)10,000/(₹)7,500 = 1 1/3 years.

Project D: 1 year.

(ii) ARR (Figures in (₹))

Note: This net cash proceed includes recovery of investment also. Therefore, net cash earnings are found by
deducting initial investment

(iii) IRR

Project A: The net cash proceeds in year 1 are just equal to investment. Therefore, r =
0%.
Project B: This project produces an annuity of ₹ 7,500 for two years. Therefore, the

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required PVAF is: 10,000/7,500 = 1.33.
This factor is found under 32% column. Therefore, r = 32%
Project C: Since cash flows are uneven, the trial and error method will be followed.
Using 20% rate of discount the NPV is + ₹ 1,389. At 30% rate of discount,
the NPV is -₹ 633. The true rate of return should be less than 30%. At 27%
rate of discount it is found that the NPV is -₹ 86 and at 26% +₹ 105. Through
interpolation, we find r = 26.5%
Project D: In this case also by using the trial and error method, it is found that at 37.6%
rate of discount NPV becomes almost zero.
Therefore, r = 37.6%.
(iv) NPV

Project A:
at 10% -10,000+10,000×0.909 = -910
at 30% -10,000+10,000×0.769 = -2,310
Project B:
at 10% -10,000+7,500(0.909+0.826) = +3,013
at 30% -10,000+7,500(0.769+0.592)= +208
Project C:
at 10% -10,000+2,000×0.909+4,000×0.826+12,000×0.751= +4,134
at 30% -10,000+2,000×0.769+4,000×0.592+12,000×0.455 =-633
Project D:
at 10% -10,000+10,000×0.909+3,000×(0.826+0.751) =+ 3,821
at 30% -10,000+10,000×0.769+3,000×(0.592+0.455) = + 831

The projects are ranked as follows according to the various methods:

Ranks
Projects PBP ARR IRR NPV NPV
(10%) (30%)
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3

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D 1 3 1 2 1

(b) Payback and ARR are theoretically unsound method for choosing between the investment projects.
Between the two time-adjusted (DCF) investment criteria, NPV and IRR, NPV gives consistent results. If the
projects are independent (and there is no capital rationing), either IRR or NPV can be used since the same set
of projects will be accepted by any of the methods. In the present case, except Project A all the three projects
should be accepted if the discount rate is 10%. Only Projects B and D should be undertaken if the discount rate
is 30%.
If it is assumed that the projects are mutually exclusive, then under the assumption of 30% discount rate, the
choice is between B and D (A and C are unprofitable). Both criteria IRR and NPV give the same results – D is
the best. Under the assumption of 10% discount rate, ranking according to IRR and NPV conflict (except for
Project A). If the IRR rule is followed, Project D should be accepted. But the NPV rule tells that Project C is the
best. The NPV rule generally gives consistent results in conformity with the wealth maximization principle.
Therefore, Project C should be accepted following the NPV rule.

ILLUSTRATION 16
The expected cash flows of three projects are given below. The cost of capital is 10 per cent.

(a) CALCULATE the payback period, net present value, internal rate of return and accounting rate of return
of each project.

(b) IDENTIFY the rankings of the projects by each of the four methods.
(figures in ‘000)

Period Project A (₹) Project B (₹) Project C (₹)

0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000

4 900 1,000 1,000

5 900 1100
6 900 1200

7 900 1300

8 900 1400

9 900 1500

10 900 1600 190

SOLUTION

(a) Payback Period Method:

A = 5 + (500/900) = 5.56 years
B = 5 + (500/1,200) = 5.42 years
C = 2 + (1,000/2,000) = 2.5 years
Net Present Value Method:
NPVA = (− 5,000) + (900×6.145) = (5,000) + 5,530.5 = ₹ 530.5
NPVB is calculated as follows:

Year Cash flow (₹) 10% discount Present value

factor (₹)
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 800 0.826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591

NPVC is calculated as follows:

Year Cash flow (₹) 10% discount factor Present value (₹)
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655

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Internal Rate of Return
Project A
NPV at 12% = (5,000) + 900×5.650
= (5,000) + 5085= 85
NPV at 13% = (5,000) + 900×5.426
= (5,000) + 4,883.40= -116.60
IRRA = 12.42%.

Project B
IRRB

Year Cash flow 10% Present 16% Present

(₹) discount value discount value (₹)
factor (₹) factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.862 603
2 800 0.826 661 0.743 595
3 900 0.751 676 0.641 577
4 1,000 0.683 683 0.552 552
5 1,100 0.621 683 0.476 524
6 1,200 0.564 677 0.410 493
7 1,300 0.513 667 0.354 460
8 1,400 0.467 654 0.305 427
9 1,500 0.424 636 0.263 394
10 1,600 0.386 618 0.227 363
1591 -12

Accounting Rate of Return:

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(b) Summary of Results

Project A B C
Payback 5.5 5.4 2.5
(years)
NPV (₹) 530.50 1,591 655
IRR (%) 12.42 15.94 16.52
ARR (%) 16 26 20

Comparison of Rankings

Method Payback NPV IRR ARR

1 C B C B
2 B C B C
3 A A A A

ILLUSTRATION 17
X Limited is considering purchasing of new plant worth ₹ 80,00,000. The expected net cash flows after taxes
and before depreciation are as follows:
Year Net Cash Flows

193
(₹)
1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000

The rate of cost of capital is 10%.

You are required to CALCULATE:
(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor
The following present value table is given for you:

Year Present value of ₹ 1 at Present value of ₹ 1 at

10% discount rate 15% discount rate
1 0.909 0.87
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247

SOLUTION
(i) Calculation of Pay-back Period

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(ii) Calculation of Net Present Value (NPV) @10% discount rate:
Net Present Value (NPV) = Cash Outflow – Present Value of Cash Inflows
= ₹ 80,00,000 – ₹ 97,92,200 = 17,92,200
(iii) Calculation of Profitability Index @ 10% discount rate:

(iv) Calculation of Internal Rate of Return:

Net present value @ 10% interest rate factor has already been calculated in (ii) above, we will calculate Net present
value @15% rate factor.

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Net Present Value at 15% = ₹ 78,84,000 – ₹ 80,00,000 = ₹ -1,16,000
As the net present value @ 15% discount rate is negative, hence internal rate of return falls in between 10% and 15%.
The correct internal rate of return can be calculated as follows:

196
ILLUSTRATION 11

HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of ₹ 2,40,000 on 31st
March 2021. The machine has begun causing problems with breakdowns and it cannot fetch more than ₹
30,000 if sold in the market at present. It will have no realizable value after 10 years. The company has been
offered ₹ 1,00,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of ₹ 4,50,000. The expected life of new machine is 10 years with salvage value of ₹
35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down value
method depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:

From the above information, ANALYSE whether the old machine should be replaced or not if required rate
of return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

SOLUTION

2. Calculation of Profit before tax as per books

Particulars Old machine New machine Difference
(₹) (₹) (₹)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500
Profit before tax and depreciation (PBTD) 3,48,750 4,28,750 80,000

Calculation of Incremental NPV 197

Year PVF PBTD Dep. @ 7.5% PBT Tax @ 30% Cash Inflows PV of Cash
@ 10% (₹) (₹) (₹) (₹) (₹) Inflows
(₹)
(1) (2) (3) (4) (5) = (4) x 0.30 (6) = (4) – (5) + (7) = (6) x (1)
(3)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38
2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21
6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73
7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44

Add: PV of Salvage value of new machine (₹ 35,000 × 0.386) 13,510.00

Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44

Analysis: Since the Incremental NPV is positive, the old machine should be replaced.
ILLUSTRATION 19
XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment in a
project which will require ₹ 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of ₹ 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take advantage of tax
benefits of debt and propose to finance the new project with undated perpetual debt secured on the
company's assets. The company intends to issue sufficient debt to cover the cost of capital expenditure and
the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated debt of similar risk is
10%. The after tax costs of issue are expected to be ₹ 10 lakhs. Company's tax rate is 30%.

You are REQUIRED to:

(i) Calculate the adjusted present value of the investment,

(ii) Calculate the adjusted discount rate and

(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future

198
investments.

SOLUTION

(i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs
= ₹ 30
Issue costs = ₹ 10 lakhs
Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs
= ₹ 280 lakhs
Annual tax relief on interest payment = ₹ 280 X 0.1 X 0.3
= ₹ 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1
= ₹ 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs = ₹ 104 lakhs
(ii) Calculation of Adjusted Discount Rate (ADR)
Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) ₹280 lakhs X (Annual Income / 0.14) = (-) ₹104 lakhs
Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs
Therefore, Annual income = ₹ 176 X 0.14 = ₹ 24.64 lakhs
Adjusted discount rate = (₹ 24.64 lakhs / ₹280 lakhs) X 100
= 8.8%
(iii) Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new venture is identical to the one
being evaluated here and the project is to be financed by the same method on the same terms. The effect on the
company’s cost of capital of introducing debt into the capital structure cannot be ignored.

MCQs based Questions

1. A capital budgeting technique which does not require the computation of cost of capital for decision
making purposes is,

(a) Net Present Value method

(b) Internal Rate of Return method

(c) Modified Internal Rate of Return method

(d) Pay back

ANSWER 1-D

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2. If two alternative proposals are such that the acceptance of one shall exclude the possibility of the
acceptance of another then such decision making will lead to,

(a) Mutually exclusive decisions

(b) Accept reject decisions

(c) Contingent decisions

(d) None of the above

ANSWER 2-A

3. In case a company considers a discounting factor higher than the cost of capital for arriving at present
values, the present values of cash inflows will be

(a) Less than those computed on the basis of cost of capital

(b) More than those computed on the basis of cost of capital

(c) Equal to those computed on the basis of the cost of capital

(d) None of the above

ANSWER 3-A

4. If the cut off rate of a project is greater than IRR, we may

(a) Accept the proposal

(b) Reject the proposal

(c) Be neutral about it

(d) Wait for the IRR to increase and match the cut off rate.

ANSWER 4-B

5. While evaluating capital investment proposals, time value of money is used in which of the following

200
techniques,

(a) Payback method

(b) Accounting rate of return

(c) Net present value

(d) None of the above

ANSWER 5-C

6. IRR would favour project proposals which have,

(a) Heavy cash inflows in the early stages of the project.

(b) Evenly distributed cash inflows throughout the project.

(c) Heavy cash inflows at the later stages of the project

(d) None of the above.

ANSWER 6-A

7. The re- investment assumption in the case of the IRR technique assumes that,

(a) Cash flows can be re- invested at the projects IRR

(b) Cash flows can be re- invested at the weighted cost of capital

(c) Cash flows can be re- invested at the marginal cost of capital

(d) None of the above

ANSWER 7-A

8. Multiple IRRs are obtained when,

(a) Cash flows in the early stages of the project exceed cash flows during the later stages.

(b) Cash flows reverse their signs during the project 201

(c) Cash flows are uneven

(d) None of the above.

ANSWER 8-B
9. Depreciation is included as a cost in which of the following techniques,

(a) Accounting rate of return

(b) Net present value

(c) Internal rate of return

(d) None of the above

ANSWER 9-A

10. Management is considering a ₹ 1,00,000 investment in a project with a 5 year life and no residual value.
If the total income from the project is expected to be ₹ 60,000 and recognition is given to the effect of
straight line depreciation on the investment, the average rate of return is :

(a) 12%

(b) 24%

(c) 60%

(d) 75%

ANSWER 10-B

202
11. Assume cash outflow equals ₹ 1,20,000 followed by cash inflows of ₹ 25,000 per year for 8 years and a
cost of capital of 11%. What is the Net present value?

(a) (₹ 38,214)

(b) ₹ 9,653

(c) ₹ 8,653

(d) ₹ 38,214
ANSWER 11-C

12. What is the Internal rate of return for a project having cash flows of ₹ 40,000 per year for 10 years and a
cost of ₹ 2,26,009?

(a) 8%

(b) 9%

(c) 10%

(d) 12%

ANSWER 12-D

13. While evaluating investments, the release of working capital at the end of the projects life should be
considered as,

(a) Cash in flow

(b) Cash out flow

(c) Having no effect upon the capital budgeting decision

(d) None of the above.

ANSWER 13-A

14. Capital rationing refers to a situation where,

(a) Funds are restricted and the management has to choose from amongst available alternative

203
investments.

(b) Funds are unlimited and the management has to decide how to allocate them to suitable projects.

(c) Very few feasible investment proposals are available with the management.

(d) None of the above.

ANSWER 14-A
15. Capital budgeting is done for

(a) Evaluating short term investment decisions.

(b) Evaluating medium term investment decisions.

(c) Evaluating long term investment decisions.

(d) None of the above.

ANSWER 15-C

Theoretical Questions

1. DISCUSS the various technique of capital budgeting.

ANSWER 1

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

These techniques of capital Budgeting does not discount the future cash flows. There are two such techniques
namely Payback Period and Accounting Rate of Return

Payback Period Time required to recover the initial cash-outflow is called pay-back period. The payback
period of an investment is the length of time required for the cumulative total net cash flows from the
investment to equal the total initial cash outlays. At that point in time, the investor has recovered the money

204
invested in the project.

Accounting (Book) Rate of Return (ARR) or Average Rate of Return (ARR)

The accounting rate of return of an investment measures the average annual net income of the project
(incremental income) as a percentage of the investment.
Accounting rate of return = Average annual net income / Investment

2. DISCUSS NPV. How it is calculated?

ANSWER 2

The net present value technique is a discounted cash flow method that considers the time value of money in
evaluating capital investments. An investment has cash flows throughout its life, and it is assumed that an
amount of cash flow in the early years of an investment is worth more than an amount of cash flow in a later
year.
The net present value method uses a specified discount rate to bring all subsequent cash inflows after the
initial investment to their present values (the time of the initial investment is year 0).
The net present value of a project is the amount, in current value of amount, the investment earns after
paying cost of capital in each period.

Steps to calculating Net Present Value (NPV):

The steps to calculating net present value are: -
1. Determine the net cash inflow in each year of the investment

2. Select the desired rate of return or discounting rate or Weighted Average Cost of Capital.

3. Find the discount factor for each year based on the desired rate of return selected.

4. Determine the present values of the net cash flows by multiplying the cash flows by respective discount
factors of respective period called Present Value (PV) of Cash flows

5. Total the amounts of all PVs of Cash Flows

Decision Rule:
If NPV ≥ 0 Accept the Proposal
If NPV ≤ 0 Reject the Proposal

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV
should be selected

3. DISCUSS in detail the ‘Capital Budgeting Process.

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ANSWER 3

The extent to which the capital budgeting process needs to be formalised and systematic procedures
established depends on the size of the organisation; number of projects to be considered; direct financial
benefit of each project considered by itself; the composition of the firm's existing assets and management's
desire to change that composition; timing of expenditures associated with the projects that are finally
accepted.

(i) Planning: The capital budgeting process begins with the identification of potential investment
opportunities. The opportunity then enters the planning phase when the potential effect on the firm's
fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined.
Opportunities having little merit are rejected and promising opportunities are advanced in the form of a
proposal to enter the evaluation phase.

(ii) Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows.
Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to
the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique
selected should be the one that enables the manager to make the best decision in the light of prevailing
circumstances.

(iii) Selection: Considering the returns and risks associated with the individual projects as well as the cost of
capital to the organisation, the organisation will choose among projects so as to maximise shareholders’
wealth.

(iv) Implementation: When the final selection is made, the firm must acquire the necessary funds, purchase
the assets, and begin the implementation of the project.

(v) Control: The progress of the project is monitored with the aid of feedback reports. These reports will
include capital expenditure progress reports, performance reports comparing actual performance against
plans set and post completion audits.

(vi) Review: When a project terminates, or even before, the organisation should review the entire project to
explain its success or failure. This phase may have implication for firms planning and evaluation procedures.
Further, the review may produce ideas for new proposals to be undertaken in the future.

4. CLASSIFY various types of Capital Investment decisions known to you.

ANSWER 4

There are many ways to classify the capital budgeting decision. Generally capital investment decisions are
classified in two ways. One way is to classify them on the basis of firm’s existence. Another way is to classify

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them on the basis of decision situation.

On the basis of firm’s existence The capital budgeting decisions are taken by both newly incorporated firms as
well as by existing firms. The new firms may require decision making in respect of selection of a plant to be
installed. The existing firm may require taking decisions to meet the requirement of new environment or to
face the challenges of competition.
These decisions may be classified as follows:

(i) Replacement and Modernisation decisions: The replacement and modernisation decisions aim at to
improve operating efficiency and to reduce cost. Generally, all types of plant and machinery require
replacement either because of the economic life of the plant or machinery is over or because it has become
technologically outdated. The former decision is known as replacement decisions and latter is known as
modernisation decisions. Both replacement and modernisation decisions are called cost reduction decisions.

(ii) Expansion decisions: Existing successful firms may experience growth in demand of their product line. If
such firms experience shortage or delay in the delivery of their products due to inadequate production
facilities, they may consider proposal to add capacity to existing product line.

(iii) Diversification decisions: These decisions require evaluation of proposals to diversify into new product
lines, new markets etc. for reducing the risk of failure by dealing in different products or by operating in
several markets.
Both expansion and diversification decisions are called revenue expansion decisions.

On the basis of decision situation

The capital budgeting decisions on the basis of decision situation are classified as follows:

(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more alternative
proposals are such that the acceptance of one proposal will exclude the acceptance of the other alternative
proposals. For instance, a firm may be considering proposal to install a semi-automatic or highly automatic
machine. If the firm installs a semi-automatic machine it excludes the acceptance of proposal to install highly
automatic machine.

(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do not
compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the
required investment. All those proposals which give a higher return than certain desired rate of return are
accepted and the rest are rejected.

(iii) Contingent decisions: The contingent decisions are dependable proposals. The investment in one proposal
requires investment in one or more other proposals. For example, if a company accepts a proposal to set up a
factory in remote area it may have to invest in infrastructure also e.g. building of roads, houses for employees
etc.

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5. DESCRIBE the advantage and disadvantage of profitability of index.

ANSWER 5

Advantages of PI

The method also uses the concept of time value of money.

 In the PI method, since the present value of cash inflows is divided by the present value of cash outflow, it is
a relative measure of a project’s profitability.

Limitations of PI

Profitability index fails as a guide in resolving capital rationing where projects are indivisible.

Once a single large project with high NPV is selected, possibility of accepting several small projects which
together may have higher NPV than the single project is excluded.
Also situations may arise where a project with a lower profitability index selected may generate cash flows
in such a way that another project can be taken up one or two years later, the total NPV in such case being
more than the one with a project with highest Profitability Index.

The Profitability Index approach thus cannot be used indiscriminately but all other type of alternatives of
projects will have to be worked out.

6. DESCRIBE MIRR.

ANSWER 6

As mentioned earlier, there are several limitations attached with the concept of the conventional Internal Rate
of Return (IRR). The MIRR addresses some of these deficiencies e.g., it eliminates multiple IRR rates; it
addresses the reinvestment rate issue and produces results which are consistent with the Net Present Value
method. This method is also called Terminal Value method.
Under this method, all cash flows, apart from the initial investment, are brought to the terminal value using an
appropriate discount rate (usually the Cost of Capital). This results in a single stream of cash inflow in the
terminal year. The MIRR is obtained by assuming a single outflow in the zeroth year and the terminal cash
inflow as mentioned above. The discount rate which equates the present value of the terminal cash inflow
to the zeroth year outflow is called the MIRR. The decision criterion of MIRR is same as IRR i.e. you accept an
investment if MIRR is larger than required rate of return and reject if it is lower than the required rate of

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return.

Practical Problems

1. Following data has been available for a capital project:

Annual cash inflows ₹ 1,00,000

Useful life 4 years
Salvage value 0
Internal rate of return 12%
Profitability index 1.064

You are required to CALCULATE the following for this project:

(i) Cost of project

(ii) Cost of capital

(iii) Net present value

(iv) Payback period

PV factors at different rates are given below:

Discount 12% 11% 10% 9%

factor
1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708

ANSWER 1

(i) Cost of the Project

At 12% internal rate of return (IRR), the sum of total cash inflows = cost of the project i.e initial cash outlay
Annual cash inflows = ₹ 1,00,000
Useful life = 4 years

Considering the discount factor table @ 12%, cumulative present value of cash inflows for 4 years is 3.038

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(0.893 + 0.797 + 0.712 + 0.636)

Hence, Total Cash inflows for 4 years for the Project is

₹ 1,00,000 × 3.038 = ₹ 3,03,800
Hence, Cost of the Project = ₹ 3,03,800
From the discount factor table, at discount rate of 9%, the cumulative discount factor for 4 years is 3.239
(0.917 + 0.842 + 0.772 + 0.708)
Hence, Cost of Capital = 9% (approx.)

(iii) Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project

= ₹ 3,23,243.20 – ₹ 3,03,800 = ₹ 19,443.20
Net Present Value = ₹ 19,443.20

2. Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A and B
are available at the same cost of ₹ 5 lakhs each. Salvage value of the old machine is ₹ 1 lakh. The utilities of

210
the existing machine can be used if the company purchases A. Additional cost of utilities to be purchased in
that case are ₹ 1 lakh. If the company purchases B then all the existing utilities will have to be replaced with
new utilities costing ₹ 2 lakhs. The salvage value of the old utilities will be ₹ 0.20 lakhs. The earnings after
taxation are expected to be:

(cash in-flows of)

Year A B P.V. Factor
₹ ₹ @ 15%
1 1,00,000 2,00,000 0.870
 2 1,50,000 2,10,000 0.756
3 1,80,000 1,80,000 0.658
4 2,00,000 1,70,000 0.572
5 1,70,000 40,000 0.497
Salvage Value at 50000 60000
the end of Year 5

The targeted return on capital is 15%. You are required to (i) COMPUTE, for the two machines separately,
net present value, discounted payback period and desirability factor and (ii) STATE which of the machines is
to be selected?

ANSWER 2

Working:

Calculation of Cash-outflow at year zero

Particulars A (₹) B (₹)

Cost of Machine 5,00,000 5,00,000
Cost of Utilities 1,00,000 2,00,000
Salvage value of Old Machine (1,00,000) (1,00,000)
Salvage of value Old Utilities – (20,000)
Total Expenditure (Net) 5,00,000 5,80,000

(i) (a) Calculation of NPV

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Machine A Machine B

Year NPV Cash Discoun Cash Discoun

Factor inflows ted inflows ted
@ 15% value of value of
inflows inflows
0 1.000 (5,00,00 (5,00,00 (5,80,00 (5,80,00
0) 0) 0) 0)
1 0.870 1,00,000 87,000 2,00,000 1,74,000
2 0.756 1,50,000 1,13,400 2,10,000 1,58,760

3 0.658 1,80,000 1,18,440 1,80,000 1,18,440

4 0.572 2,00,000 1,14,400 1,70,000 97,240

5 0.497 1,70,000 84,490 40,000 19,880

Salvage 0.497 50,000 24,850 60,000 29,820

Net Present Value 5,42,580 5,98,140

42,580 18,140

Since the Net present Value of both the machines is positive both are acceptable.

(b) Discounted Pay-back Period (Amount in ₹)

Machine A Machine B

Year Discounted Cumulative Discounted Cumulative

Cash Discounted Cash Discounted
inflows value of inflows value of
inflows inflows
1 87,000 87,000 1,74,000 1,74,000

2 1,13,400 2,00,400 1,58,760 3,32,760

3 1,18,440 3,18,840 1,18,440 4,51,200

4 1,14,400 4,33,240 97,240 5,48,440

5 1,09,340* 5,42,580 49,700* 5,98,140

* Includes salvage value 212

(ii) Since the absolute surplus in the case of A is more than B and also the desirability factor, it is better to
choose A. The discounted payback period in both the cases is almost same, also the net present value is
positive in both the cases but the desirability factor (profitability index) is higher in the case of Machine A, it is
therefore better to choose Machine A.

3. Hindlever Company is considering a new product line to supplement its range of products. It is
anticipated that the new product line will involve cash investments of ₹ 7,00,000 at time 0 and ₹ 10,00,000
in year 1. After-tax cash inflows of ₹ 2,50,000 are expected in year 2, ₹ 3,00,000 in year 3, ₹ 3,50,000 in year
4 and ₹ 4,00,000 each year thereafter through year 10. Although the product line might be viable after year
10, the company prefers to be conservative and end all calculations at that time.

(a) If the required rate of return is 15 per cent, COMPUTE net present value of the project? Is it acceptable?

(b) ANALYSE What would be the case if the required rate of return were 10 per cent?

(c) CALCULATE its internal rate of return?

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(d) COMPUTE the project’s payback period?
ANSWER 3

(a) Computation of NPV at 15% discount rate

Year Cash flow Discount Factor Present value

(15%)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5−10 4,00,000 2.163 8,65,200
NPV -118200

As the net present value is negative, the project is unacceptable.

(b) Computation of NPV if discount rate would be 10% discount rate

Year Cash flow Discount Factor Present value

(15%)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5−10 4,00,000 2.974 11,89,600
NPV 251450

Since NPV = ₹ 2,51,450 is positive, hence the project would be acceptable.

(c) Calculation of IRR:

214
(d) Computation of Pay-back period of the project:
Payback Period = 6 years:
−₹ 7,00,000−₹ 10,00,000 + ₹ 2,50,000 + ₹ 3,00,000 + ₹ 3,50,000 + ₹ 4,00,000 + ₹ 4,00,000 = 0

4. Elite Cooker Company is evaluating three investment situations: (1) produce a new line of aluminium
skillets, (2) expand its existing cooker line to include several new sizes, and (3) develop a new, higher-
quality line of cookers. If only the project in question is undertaken, the expected present values and the
amounts of investment required are:

Project Investment required Present value of

Future Cash-Flows
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and present
values will simply be the sum of the parts. With projects 1 and 3, economies are possible in investment
because one of the machines acquired can be used in both production processes. The total investment
required for projects 1 and 3 combined is ₹ 4,40,000. If projects 2 and 3 are undertaken, there are
economies to be achieved in marketing and producing the products but not in investment. The expected
present value of future cash flows for projects 2 and 3 is ₹ 6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a ₹ 1,25,000 extension on the plant will be
necessary, as space is not available for all three projects. CALCULATE NPV of the projects and STATE which
project or projects should be chosen?

ANSWER 4

Project Investment Present value of Net Present

Required Future Cash Flows value
1 2,00,000 2,90,000 90,000

2 1,15,000 1,85,000 70,000

3 2,70,000 4,00,000 1,30,000

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1 and 2 3,15,000 4,75,000 1,60,000

1 and 3 4,40,000 6,90,000 2,50,000

2 and 3 3,85,000 6,20,000 2,35,000

1, 2 and 3 6,80,000* 9,10,000 2,30,000

(Refer Working note)

Working Note:
(i) Total Investment required if all the three projects are undertaken simultaneously:
Project 1& 3 4,40,000
Project 2 1,15,000
Plant extension cost 1,25,000
Total 6,80,000

(ii) Total of Present value of Cash flows if all the three projects are undertaken simultaneously:

Project 2& 3 6,20,000

Project 1 2,90,000
Total 9,10,000

Projects 1 and 3 should be chosen, as they provide the highest net present value.

5. Cello Limited is considering buying a new machine which would have a useful economic life of five years,
a cost of ₹ 1,25,000 and a scrap value of ₹ 30,000, with 80 per cent of the cost being payable at the start of
the project and 20 per cent at the end of the first year. The machine would produce 50,000 units per annum
of a new product with an estimated selling price of ₹ 3 per unit. Direct costs would be ₹ 1.75 per unit and
annual fixed costs, including depreciation calculated on a straight- line basis, would be ₹ 40,000 per annum.

In the first year and the second year, special sales promotion expenditure, not included in the above costs,
would be incurred, amounting to ₹ 10,000 and ₹ 15,000 respectively.
CALCULATE NPV of the project for investment appraisal, assuming the company’s cost of capital is 10
percent.

216
ANSWER 5

Calculation of Net Cash flows

Contribution = (3.00 – 1.75)×50,000 = ₹ 62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ₹ 21,000

Year Capital (₹) Contribution (₹) Fixed costs (₹) Adverts (₹) Net cash
flow (₹)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500

Calculation of Net Present Value

Year Net cash 10% Present

flow (₹) discount value (₹)
factor
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
NPV 31,712

The net present value of the project is ₹ 31,712.

6. Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a choice between the two
identical machines, in terms of Capacity, ‘X’ and ‘Y’. Despite being designed differently, both machines do
the same job. Further, details regarding both the machines are given below:

Particulars Machine ‘X’ Machine ‘Y’

Purchase Cost of the 15,00,000 10,00,000
Machine (₹)
Life (years) 3 2

217
Running cost per year 4,00,000 6,00,000
(₹)

The opportunity cost of capital is 9%.

You are required to:
IDENTIFY the machine the company should buy?
The present value (PV) factors at 9% are:

Year t1 t2 t3
PVIF0.09.t 0.917 0.842 0.772
ANSWER 6

Statement Showing the Evaluation of Two Machines

Particulars Machine ‘X’ Machine ‘Y’

(i) Purchase Cost ₹ 15,00,000 ₹ 10,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year ₹ 4,00,000 ₹ 6,00,000
(iv) PVIFA 0.09, 3 2.531
PVIFA 0.09, 2 1.759
(v) PV of Running Cost of Machine ₹ 10,12,400 ₹ 10,55,400
{(iii)×(iv)}
(vi) Cash outflows of Machine {(i) + (v)} ₹ 25,12,400 ₹ 20,55,400
(vii) Equivalent PV of Annual Cash ₹ 9,92,651 ₹ 11,68,505
outflow (vi/iv)

Recommendation: Ae Bee Cee Ltd. should buy Machine ‘X’ since equivalent annual cash outflow is less than
that of Machine ‘Y’.

7. Alley Pvt. Ltd. is planning to invest in a machinery that would cost ₹ 1,00,000 at the beginning of year 1.
Net cash inflows from operations have been estimated at ₹ 36,000 per annum for 3 years. The company has
two options for smooth functioning of the machinery- one is service, and another is replacement of parts. If
the company opts to service a part of the machinery at the end of year 1 at ₹ 20,000, in such a case, the
scrap value at the end of year 3 will be ₹ 25,000. However, if the company decides not to service the part,
then it will have to be replaced at the end of year 2 at ₹ 30,800. And in this case, the machinery will work for
the 4th year also and get operational cash inflow of ₹ 36,000 for the 4th year. It will have to be scrapped at
the end of year 4 at ₹ 18,000.

Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase of this machinery based on
the net present value of its cash flows?
If the supplier gives a discount of ₹ 10,000 for purchase, what would be your decision?

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Note:
The PV factors at 10% are:

Year 0 1 2 3 4 5 6
PV 1 0.909 0.826 0.751 0.683 0.620 0.564
Factor 1 4 3 0 9 5

ANSWER 7
Option I: Purchase Machinery and Service Part at the end of Year 1.
Net Present value of cash flow @ 10% per annum discount rate.

= − 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (20,000 × 0.9091) + (25,000 × 0.7513)

= − 1,00,000 + (36,000 × 2.4868) – 18,182 + 18,782.5
= − 1,00,000 + 89,524.8 – 18,182 + 18,782.5
NPV = − 9,874.7

Since, Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ₹ 10,000 then,
NPV (in ₹ ) = + 10,000 – 9,874.7 = + 125.3
In this case, Net Present Value is positive but very small; therefore, this option may not be advisable.

Option II: Purchase Machinery and Replace Part at the end of Year 2.

= − 1,00,000+ 36,000 (0.9091 + 0.8264 + 0.7513) – (30,800 × 0.8264) + (54,000 × 0.6830)

= − 1,00,000 + 36,000 (2.4868) – 25,453.12 + 36,882

= − 1,00,000 + 89,524.8 – 25,453.12 + 36,882

NPV = + 953.68

Net Present Value is positive, but very low as compared to the investment.

219
If the Supplier gives a discount of ₹ 10,000, then

NPV (in ₹ ) = 10,000 + 953.68 = 10,953.68

Decision: Option II is worth investing as the net present value is positive and higher as compared to Option I.

8. NavJeevani hospital is considering to purchase a machine for medical projectional radiography which is
priced at ₹ 2,00,000. The projected life of the machine is 8 years and has an expected salvage value of ₹
18,000 at the end of 8th year. The annual operating cost of the machine is ₹ 22,500. It is expected to
generate revenues of ₹ 1,20,000 per year for eight years. Presently, the hospital is outsourcing the
radiography work to its neighbour Test Center and is earning commission income of ₹ 36,000 per annum,
net of taxes.

Required:

ANALYSE whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:

(i) Net Present Value method

(ii) Profitability Index method.

Consider tax @30%. PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

ANSWER 8

Determination of Cash inflows ₹

Sales Revenue 1,20,000
Less: Operating Cost 22,500
97,500
Less: Depreciation (₹ 2,00,000 – ₹ 18,000)/8 22,750
Net Income 74,750
Tax @ 30% 22,425
Earnings after Tax (EAT) 52,325
Add: Depreciation 22,750
Cash inflow after tax per annum 75,075

220
Less: Loss of Commission Income 36,000
Net Cash inflow after tax per annum 39,075
In 8th Year :
New Cash inflow after tax 39,075
Add: Salvage Value of Machine 18,000
Net Cash inflow in year 8 57,075
(i) Calculation of Net Present Value (NPV)

Year CFAT (₹) PV Factor Present Value

@10% of Cash inflows
(₹)
1 to 7 39,075 4.867 1,90,178.03
8 57,075 0.467 26,654.03
2,16,832.06
Less: Cash 2,00,000.00
Outflows
NPV 16,832.06

Advise: Since the net present value (NPV) is positive and profitability index is also greater than 1, the hospital
may purchase the machine

9. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. Initial equipment cost will be
₹ 3.5 crores. Additional equipment costing ₹ 25,00,000 will be purchased at the end of the third year from
the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but
additional equipment can be sold for ₹ 2,50,000. A working capital of ₹ 40,00,000 will be needed and it will
be released at the end of eighth year. The project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4−5 6−8

Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ₹ 240 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed 221
cash operating costs will amount ₹ 36,00,000 per year. The loss of any year will be set off from the profits of
subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent to be an
appropriate after tax cost of capital for this project. The company follows straight line method of
depreciation.

Required:

CALCULATE the net present value of the project and advise the management to take appropriate decision.
Note:
The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

ANSWER 9

Workings:
(a) Calculation of annual cash flows (₹ in lakh)

Year Sales VC FC Dep. Profit Tax PAT Dep. Cash inflow

1 172.80 103.68 36 43.75 (10.63) − − 43.75 33.12
2 259.20 155.52 36 43.75 23.93 3.99* 19.94 43.75 63.69
3 624.00 374.40 36 43.75 169.85 50.955 118.895 43.75 162.645
4−5 648.00 388.80 36 48.25 174.95 52.485 122.465 48.25 170.715
6−8 432.00 259.20 36 48.25 88.55 26.565 61.985 48.25 110.235

(b) Calculation of Depreciation:

(c) *Calculation of tax in 2nd Year:

222
₹ in
lakh
Profit for the year 23.93
Less: Set off of unabsorbed depreciation in 1st year (10.63)
Taxable profit 13.30
Tax @30% 3.99
(d) Calculation of Initial cash outflow

₹ in
lakh
Cost of New Equipment 350
Add: Working Capital 40
Outflow 390

Calculation of NPV (₹in lakh)

Year Cash flows PV factor @12% PV of cash-flows Remark

0 (390) 1.000 (390.00) Initial equipment cost
1 33.12 0.893 29.57
2 63.69 0.797 50.76
3 162.645 0.712 115.80
3 (25.00) 0.712 (17.80) Additional equipment cost
4 170.715 0.636 108.57
5 170.715 0.567 96.79
6 110.235 0.507 55.89
7 110.235 0.452 49.83
8 110.235 0.404 44.53
8 40.00 0.404 16.16 Release of working capital
Net Present Value 160.10

Advise: Since the project has a positive NPV, therefore, it should be accepted.

10. A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product. At

223
present, the waste is removed by a contractor for disposal on payment by the company of ₹ 150 lakh per
annum for the next four years. The contract can be terminated upon installation of the aforesaid machine
on payment of a compensation of ₹ 90 lakh before the processing operation starts. This compensation is not
allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ₹ 600 lakh to be financed by a loan repayable
in 4 equal instalments commencing from end of the year- 1. The interest rate is 14% per annum. At the end
of the 4th year, the machine can be sold for ₹ 60 lakh and the cost of dismantling and removal will be ₹ 45
lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:

(₹ In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material 90 120 255 255
consumption
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory 165 180 330 435
overheads
Depreciation (as 150 114 84 63
per income tax
rules)

Initial stock of materials required before commencement of the processing operations is ₹ 60 lakh at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be ₹ 165 lakh
and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for ₹ 30 lakh per annum. Labour costs include wages of 40 workers, whose
transfer to this process will reduce idle time payments of ₹ 45 lakh in the year- 1 and ₹ 30 lakh in the year-
2. Factory overheads include apportionment of general factory overheads except to the extent of insurance
charges of ₹ 90 lakh per annum payable on this venture. The company’s tax rate is 30%.
Present value factors for four years are as under:

Year 1 2 3 4
PV factors 0.877 0.769 0.674 0.592
@14%

ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.

224
ANSWER 10

Statement of Operating Profit from processing of waste

(₹ in lakh)

Year 1 2 3 4
Sales :(A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space (opportunity cost) 30 30 30 30
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5

Statement of Incremental Cash Flows (₹ in lakh)

Year 0 1 2 3 4
Material stock (60) (105) - - 165
Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285
Depreciation added back - 150 114 84 63
Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) - - - - 15
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
NPV 577.36

Advice: Since the net present value of cash flows is ₹ 577.36 lakh which is positive the management should
install the machine for processing the waste.

Notes:

225
1. Material stock increases are taken in cash flows.
2. Idle time wages have also been considered
3. Apportioned factory overheads are not relevant only insurance charges of this project are relevant.

4. Interest calculated at 14% based on 4 equal instalments of loan repayment.

5. Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.

6. Saving in contract payment and income tax thereon considered in the cash flows.
11. Xavly Ltd. has a machine which has been in operation for 3 years. The machine has a remaining
estimated useful life of 5 years with no salvage value in the end. Its current market value is ₹ 2,00,000. The
company is considering a proposal to purchase a new model of machine to replace the existing machine.
The relevant information is as follows:

Existing Machine New Machine

Cost of machine ₹ 3,30,000 ₹ 10,00,000
Estimated life 8 years 5 years
Salvage value Nil ₹ 40,000
Annual output 30,000 units 75,000 units
Selling price per unit ₹ 15 ₹ 15
Annual operating hours 3,000 3,000
Material cost per unit ₹4 ₹4
Labour cost per hour ₹ 40 ₹ 70
Indirect cash cost per annum ₹ 50,000 ₹ 65,000

The company uses written down value of depreciation @ 20% and it has several other machines in the block
of assets. The Income tax rate is 30 per cent and Xavly Ltd. does not make any investment, if it yields less
than 12 per cent.
ADVISE Xavly Ltd. whether the existing machine should be replaced or not.
PV factors @12%:

Year 1 2 3 4 5
PVF 0.893 0.797 0.712 0.636 0.567

ANSWER

(i) Calculation of Net Initial Cash Outflows:

226

(ii) Calculation of Base for depreciation

 227
(iii) Calculation of annual Profit Before Tax and depreciation
 228

(iv) Calculation of Incremental Net Present Value:

Advice: Since the incremental NPV is positive, existing machine should be replaced.

12. A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A
& Co. currently pays no taxes. The replacement machine costs ₹ 90,000 now and requires maintenance of ₹
10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of ₹
20,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and
its salvage value falls each year as follows:

Year Maintenance (₹) Salvage (₹)

Present 0 40,000
1 10,000 25,000
2 20,000 15,000

229
3 30,000 10,000
4 40,000 0

The opportunity cost of capital for A & Co. is 15%.

REQUIRED:
When should the company replace the machine?
(Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% : 4.4873; present
value of Re. 1 to be received after 8 years at interest rate of 15% : 0.3269).
ANSWER
A & Co.
Equivalent cost of (EAC) of new machine

PV of cost of replacing the old machine in each of 4 years with new machine

230
Advice: The company should replace the old machine immediately because the PV of cost of replacing the old machine
with new machine is least.

13. A chemical company is presently paying an outside firm ₹ 1 per gallon to dispose off the waste resulting
from its manufacturing operations. At normal operating capacity, the waste is about 50,000 gallons per
year.
After spending ₹ 60,000 on research, the company discovered that the waste could be sold for ₹ 10 per
gallon if it was processed further. Additional processing would, however, require an investment of ₹
6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.
Except for the costs incurred in advertising ₹ 20,000 per year, no change in the present selling and
administrative expenses is expected, if the new product is sold. The details of additional processing costs
are as follows:
Variable : ₹ 5 per gallon of waste put into process.
Fixed : (Excluding Depreciation) ₹ 30,000 per year.
There will be no losses in processing, and it is assumed that the total waste processed in a given year will be
sold in the same year. Estimates indicate that 50,000 gallons of the product could be sold each year.
The management when confronted with the choice of disposing off the waste or processing it further and
selling it, seeks your ADVICE. Which alternative would you recommend? Assume that the firm's cost of
capital is 15% and it pays on an average 50% Tax on its income.
You should consider Present value of Annuity of ₹ 1 per year @ 15% p.a. for 10 years as 5.019.

ANSWER

Evaluation of Alternatives:
Savings in disposing off the waste

Particulars (₹)
Outflow (50,000 × ₹ 1) 50,000
Less: tax savings @ 50% 25,000
Net Outflow per year 25,000

231
Calculation of Annual Cash inflows in Processing of waste Material
Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in
disposal cost
= ₹ 1,30,000 + ₹ 25,000 = ₹ 1,55,000

Calculation of Net Present Value

232
Recommendation: Processing of waste is a better option as it gives a positive Net Present Value.
Note- Research cost of ₹ 60,000 is not relevant for decision making as it is sunk cost.
 CHAPTER-8 RISK ANALYSIS IN CAPITAL BUDGETING

ILLUSTRATION 1
Possible net cash flows of Projects A and B at the end of first year and their probabilities are given as below.
Discount rate is 10 per cent. For both the project initial investment is ₹ 10,000. From the following
information, CALCULATE the expected net present value for each project. State which project is preferable?

Possible Event Project A Project B

Cash Flow (₹) Probability Cash Flow (₹) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8 ,000 0.10

SOLUTION

Calculation of Expected Value for Project A and Project B

Possible Project A Project B

Event
Cash Flow Probability Expected Cash Flow Probability Expected
(₹) Value (₹) Value
(₹) (₹)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800

233
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

The net present value for Project A is (0.909 × ₹ 12,000 – ₹ 10,000) = ₹ 908
The net present value for Project B is (0.909 × ₹ 16,000 – ₹10,000) = ₹ 4,544.
ILLUSTRATION 2
Probabilities for net cash flows for 3 years of a project are as follows:

Year 1 Year 2 Year 3

Cash Flow (₹) Probability Cash Flow (₹) Probability Cash Flow (₹) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
2,000 0.1 2,000 0.2 2,000 0.3

CALCULATE the expected net cash flows. Also calculate net present value of the project using expected cash
flows using 10 per cent discount rate. Initial Investment is ₹ 10,000.
SOLUTION

Year 1 Year 2 Year 3

Cash Probab Expecte Cash Probab Expected Cash Flow Probability Expect
Flow (₹) ility d Value Flow (₹) ility Value (₹) ed
(₹) (₹) Value
(₹)
2,000 0.1 2000 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1600
6,000 0.3 1800 6,000 0.4 2400 6,000 0.2 1200
8,000 0.4 3200 8,000 0.1 800 8,000 0.1 800
6000 4800 4200

The present value of the expected value of cash flow at 10 per cent discount rate has been determined as
follows:

234

= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751)

= 12,573
Expected Net Present value = Present Value of cash flow - Initial Investment
= ₹ 12,573 – ₹10,000 = ₹2,573.
ILLUSTRATION 3
CALCULATE Variance and Standard Deviation on the basis of following information:

Possible Event Project A Project B

Cash Flow (₹) Probability Cash Flow (₹) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8 ,000 0.10

SOLUTION
Calculation of Expected Value for Project A and Project B

Possible Project A Project B

Event
Cash Flow Probability Expected Cash Flow Probability Expected
(₹) Value (₹) Value
(₹) (₹)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

Project A
Variance (σ2) = (8,000 – 12,000)2 × (0.1) + (10,000 -12,000)2 × (0.2) + (12,000 – 12000)2 × (0.4) + (14,000 –
12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

235
ILLUSTRATION 4
CALCULATE Coefficient of Variation based on the following information:

Possible Event Project A Project B

Cash Flow (₹) Probability Cash Flow (₹) Probability
A 10000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10

SOLUTION
Calculation of Expected Value for Project A and Project B

Possible Project A Project B

Event
Cash Flow Probability Expected Cash Flow Probability Expected
(₹) Value (₹) Value
(₹) (₹)
A 10,000 0.10 1,000 26,000 0.10 2,600
B 12,000 0.20 2,400 22,000 0.15 3,300
C 14,000 0.40 5,600 18,000 0.50 9,000
D 16,000 0.20 3,200 14,000 0.15 2,100
E 18,000 0.10 1,800 10,000 0.10 1,000
ENCF 14,000 18,000

Project A
Variance (σ2) = (10,000 – 14,000)2 × (0.1) + (12,000 -14,000)2 × (0.2) + (14,000 – 14000)2 × (0.4) + (16,000 –
14,000)2 × (0.2) + (18000 – 14,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

236

Project B: Variance(σ2) = (26,000 – 18,000)2 × (0.1) + (22,000 – 18,000)2 × (0.15) + (18,000 – 18,000)2 × (0.5) +
(14,000 – 18,000)2 × (0.15) + (10,000 – 18,000)2 × (0.1) = 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 =
1,76,00,000
In project A risk per rupee of cash flow is Rs. 0.15while in project B it is Rs. 0.23. Therefore Project A is better
than Project B.

ILLUSTRATION 5
An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected
by the Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated
over the life of the project.

Year Cash flows (₹ in lakhs)

1 25
2 60
3 75
4 80
5 65

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate.
SOLUTION
The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as below:

Year Cash flows Discounting Factor @7% Present value of Cash

₹ in lakhs Flows ₹ In Lakhs
1 25 0.935 23.38

237
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34
Now when the risk-free rate is 7% and the risk premium expected by the Management is 7%. So the risk
adjusted discount rate is 7% + 7% =14%.

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:

Year Cash flows Discounting Present Value of

₹ in Lakhs Factor@14% Cash Flows ₹ in
lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.79
Less: Initial investment 100.00
Net Present Value (NPV) 99.79

ILLUSTRATION 6
If Investment proposal is ₹45,00,000 and risk free rate is 5%, CALCULATE net present value under certainty
equivalent technique.

Year Expected cash flow (₹) Certainty Equivalent coefficient

1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

SOLUTION

238
ILLUSTRATION 7
X Ltd is considering its New Product ‘with the following details

Sr. No. Particulars Figures

1 Initial capital cost ₹ 400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit ₹ 100
4 Variable cost per unit ₹ 50
5 Fixed costs per year ₹ 50 Cr
6 Discount Rate 6%

Required:
1. CALCULATE the NPV of the project.
2. COMPUTE the impact on the project’s NPV of a 2.5 per cent adverse variance in each variable. Which
variable is having maximum effect .Consider Life of the project as 3 years.

SOLUTION
1. Calculation of Net Cash Inflow per year:

Particulars Amount (₹)

A Selling Price Per Unit (A) 100
B Variable Cost Per Unit (B) 50
C Contribution Per Unit (C = A-B) 50
D Number of Units Sold Per Year 5 Cr.
E Total Contribution (E = C × D) ₹ 250 Cr.
F Fixed Cost Per Year ₹ 50 Cr.
G Net Cash Inflow Per Year (G = E - F) ₹ 200 Cr.

Calculation of Net Present Value (NPV) of the Project:

Year Year Cash Flow Discounting @ Present Value

(₹ in Cr.) 6% (PV)

239
(₹ in Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value (188.60 + 178 + 168) - 400= 134.60

Here NPV represent the most likely outcomes and not the actual outcomes. The actual outcome can be lower
or higher than the expected outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable

Changes in Base Initial Cash Selling Price Variable Cost Fixed Cost Units
variable Flow per Unit Per Unit Per Unit sold per
increased to Reduced to ₹ increased to increased to year
₹ 410 crore 97.5 ₹ 51.25 ₹ 51.25 reduced
to 4.875
crore

Particulars Amount (₹) Amount (₹) Amount (₹) Amount (₹) Amount (₹) Amount
(₹)

A Selling Price 100 100 97.5 100 100 100

Per Unit (A)
B Variable Cost 50 50 50 51.25 50 50
Per Unit (B)
C Contribution 50 50 47.5 48.75 50 50
Per Unit (C =
A-B)
D Number of 5 5 5 5 5 4.875
Units Sold Per
Year (in
Crores)
E Total 250 250 237.5 243.75 250 243.75
Contribution
(E = C × D )
F Fixed Cost 50 50 50 50 51.25 50
Per Year (in
Crores)
G Net Cash 200 200 187.5 193.75 198.75 193.75
Inflow Per
Year ( G = E -
F)
H (G × 2.673) 534.60 534.60 501.19 517.89 531.26 517.89

I Initial Cash 400 410 400 400 400 400 240

Flow
J NPV 134.60 124.60 101.19 117.89 131.26 117.89

K Percentage -7.43% -24.82% -12.41% -2.48% -12.41%

Change in
NPV
The above table shows that by varying one variable at a time by 2.5% while keeping the others constant, the
impact in percentage terms on the NPV of the project can be calculated. Thus, it can be seen that the change
in selling price has the maximum effect on the NPV by 24.82 %.

ILLUSTRATION 8
XYZ Ltd. is considering a project “A” with an initial outlay of ₹ 14,00,000 and the possible three cash inflow
attached with the project as follows:
(₹ 000)

Particular Year 1 Year 2 Year 3

Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900

Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most
likely result but uncertain about the third year’s cash flow, ANALYSE what will be the NPV expecting worst
scenario in the third year.

SOLUTION

The possible outcomes will be as follows:

Now suppose that CEO of XYZ Ltd. is bit confident about the estimates in the first two years, but not sure 241
about the third year’s high cash inflow. He is interested in knowing what will happen to traditional NPV if 3rd
year turn out the bad contrary to his optimism.
The NPV in such case will be as follows:
ILLUSTRATION 9
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ₹ 36,000 and project B ₹
30,000. You have been given below the net present value probability distribution for each project.

Project A Project B
NPV estimates Probability NPV estimates Probability
(₹) (₹)
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1

(i) COMPUTE the expected net present values of projects A and B.

(ii) COMPUTE the risk attached to each project i.e. standard deviation of each probability distribution.

(iii) COMPUTE the profitability index of each project.

(iv) IDENTIFY which project do you recommend? State with reasons.

SOLUTION

(i) Statement showing computation of expected net present value of Projects A and B:

Project A Project B
NPV Probabilit Expected NPV Probabilit Expected
Estimate y Value (₹) Estimate y Value (₹)

242
(₹) (₹)
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9000 EV = 9000
(ii) Computation of Standard deviation of each project
Project A

P X (X – EV) P (X- EV)²

0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 - 3,000 27,00,000
0.2 3,000 - 6,000 72,00,000
Variance = 1,98,00,000

Project B

P X (X – EV) P (X- EV)²

0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000
0.4 6,000 3,000 36,00,000
0.1 3,000 6,000 36,00,000
Variance =
1,44,00,000

(iii) Computation of profitability of each project

Profitability index = Discount cash inflow / Initial outlay

243
(iv) In the selection of one of the two projects A and B, Project B is preferable because the possible profit
which may occur is subject to less variation (or dispersion). Much higher risk is lying with project A.
ILLUSTRATION 10
From the following details relating to a project, analyse the sensitivity of the project to changes in initial
project cost, annual cash inflow and cost of capital:

Initial Project Cost (₹) 1,20,000

Annual Cash Inflow (₹) 45,000
Project Life (Years) 4
Cost of Capital 10%

IDENTIFY which of the three factors, the project is most sensitive if the variable is adversely affected by
10%? (Use annuity factors: for 10% 3.169 and 11% ... 3.103).

SOLUTION

Calculation of NPV through Sensitivity Analysis

PV of cash inflows (₹ 45,000 × 3.169 ) 1,42,605

Initial Project Cost 1,20,000
NPV 22,605

Situation NPV Changes in NPV

Base (present) ₹ 22,605
If initial project cost is (₹1,42,605 - ₹1,32,000) = (₹ 22,605 – ₹ 10,605)/
varied adversely by 10% ₹10,605 ₹ 22,605 = (53.08%)
If annual cash inflow is [₹40,500 (revised cash (₹ 22,605 – ₹ 8,345) /
varied adversely by 10% flow) × 3.169) – (₹ ₹ 22,605=63.08%
1,20,000)] = ₹ 8,345
If cost of capital is varied (₹ 45,000 × 3.103) – (₹22,605 – ₹19,635) / ₹

244
adversely by 10% i.e. it ₹ 1,20,000 = ₹19,635 22,605 = 13.14%
becomes 11%
Conclusion: Project is most sensitive to ‘annual cash inflow’
ILLUSTRATION 11
PNR Ltd. is considering a project with the following Cash flows:

Years Cost of Plant (₹) Running Cost (₹) Savings (₹)

0 1200000
1 4,00,00,000 12,00,00,000
2 5,00,00,000 14,00,00,000
3 6,00,00,000 11,00,00,000

The cost of capital is 12%. Measure the sensitivity of the project to changes in the levels of plant cost,
running cost and savings (considering each factor at a time) such that the NPV becomes zero. The P.V.
factors at 12% are as under:

Year 0 1 2 3
PV factor 1 0.892 0.797 0.711
@12%

DETERMINE the factor which is the most sensitive to affect the acceptability of the project?

SOLUTION
Present value (PV) of Cash Flows

Year 0 1 2 3 Total
Cost of Plant (12,00,00,000)
Running cost 0 (4,00,00,000) (5,00,00,000) (6,00,00,000)
Savings 0 12,00,00,000 14,00,00,000 11,00,00,000
Net cash inflow (12,00,00,000) 8,00,00,000 9,00,00,000 5,00,00,000
PV factor 1 0.892 0.797 0.711
NPV (12,00,00,000) 7,13,60,000 7,17,30,000 3,55,50,000 5,86,40,000

245
Determination of the most Sensitive factor:

(i) Sensitivity Analysis w.r.t. Plant cost:

NPV of the project would be zero when the cost of the plant is increased by ₹5,86,40,000
ILLUSTRATION 12
DETERMINE the risk adjusted net present value of the following projects:

246
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:

Coefficient of Variation Risk-Adjusted discount rate P.V. Factor 1 to 5 years at risk adjusted
discount rate
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
SOLUTION
Statement showing the determination of the risk adjusted net present value

MCQs based Questions

1. Risk arises from various sources such as:

(a) Market Risk

(b) Competition Risk

(c) International Risk

(d) All of the above

ANSWER 1-D

2. Expected cash flows are calculated as:

247
(a) Sum of likely cash flow of the project

(b) Sum of likely cash flow of project multiplied by probability of cash flow

(c) Sum of likely cash flow of project divided by probability of cash flow

(d) None of the above

ANSWER 2-B
3. Variance Measures:

(a) How far each number in the set is from the mean

(b) The mean of a given data set

(c) Return on Investment

(d) level of risk borne for every percent of expected return

ANSWER 3-A

4. Certainty Equivalent:

(a) Is a guaranteed return from an Investment after adjusting for risk

(b) Is the return that is expected over the lifetime of a project

(c) Is equivalent to Net Present Value

(d) Is an important component in Decision Tree Analysis

ANSWER 4-D

5. The firm expects an NPV of Rs 10,000 if the economy is exceptionally strong (30% probability), an NPV of
Rs 4,000 if the economy is normal (40% probability), and an NPV of Rs 2,000 if the economy is exceptionally

248
weak (30% probability). Expected Net present value is _________

(a) ₹ 5,200

(b) ₹ 6,000

(c) ₹ 5,000

(d) ₹ 6,200

ANSWER 5-D
6. Risk Premium:

(a) is the extra rate of return expected by the Investors as a reward for bearing extra risk

(b) is equivalent to the rate of Government Securities

(c) is the return provided to equity shareholders

(d) is over and above expected rate of return

ANSWER 6-B

7. Calculation of Coefficient of Variance depends on:

(a) Standard Deviation

(b) Expected Return

(c) Expected cash flow

(d) All of the above

ANSWER 7-B

8. Scenario Analysis is considered under scenarios such as:

249
(a) Worst Case Scenario

(b) Base Case Scenario

(c) Best Case Scenario

(d) All of the above

ANSWER 8-D
9. Sensitivity analysis is useful in decision making because:

(a) It shows the probabilities associated with each outcome

(b) It tells the user how much critical each input is for the Output value

(c) It allows to calculate the probable results under different scenarios

(d) The results of Sensitivity Analysis are reliable

ANSWER 9-B

10. When the risk is high, the certainty equivalent coefficient is:

(a) Higher

(b) Lower

(c ) No impact

(d) None of the above

ANSWER 10-B

Theoretical Questions

250
1. EXPLAIN Certainty Equivalent.

ANSWER 1

Certainty Equivalent (CE) Method for Risk Analysis

Certainty equivalent method –Definition: As per CIMA terminology, “An approach to dealing with risk in a
capital budgeting context. It involves expressing risky future cash flows in terms of the certain cashflow which
would be considered, by the decision maker, as their equivalent, that is the decision maker would be
indifferent between the risky amount and the (lower) riskless amount considered to be its equivalent.”
The certainty equivalent is a guaranteed return that the management would accept rather than accepting a
higher but uncertain return. This approach allows the decision maker to incorporate his or her utility function
into the analysis. In this approach a set of risk less cash flow is generated in place of the original cash flows.

2. STATE Risk Adjusted Discount rate.

ANSWER 2

Risk Adjusted Discount Rate The use of risk adjusted discount rate (RADR) is based on the concept that
investors demands higher returns from the risky projects. The required rate of return on any investment
should include compensation for delaying consumption plus compensation for inflation equal to risk free rate
of return, plus compensation for any kind of risk taken. If the risk associated with any investment project is
higher than risk involved in a similar kind of project, discount rate is adjusted upward in order to compensate
this additional risk borne.

Where, NCFt = Net cash flow

K = Risk adjusted discount rate.
I = Initial Investment

A risk adjusted discount rate is a sum of risk free rate and risk premium. The Risk Premium depends on the
perception of risk by the investor of a particular investment and risk aversion of the Investor.
So Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g., Government securities yield a
return of 6 % and bear no risk. In such case, 6 % is the risk-free rate.
Risk Premium: It is the rate of return over and above the risk-free rate, expected by the Investors as a reward
for bearing extra risk. For high risk project, the risk premium will be high and for low risk projects, the risk
premium would be lower.

3. EXPLAIN Scenario Analysis.

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ANSWER 3

Scenario Analysis
Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations.
Therefore, we need to extend sensitivity analysis to deal with the probability distributions of the inputs. In
addition, it would be useful to vary more than one variable at a time so we could see the combined effects of
changes in the variables. Scenario analysis provides answer to these situations of extensions. This analysis
brings in the probabilities of changes in key variables and also allows us to change more than one variable at a
time.
This analysis begins with base case or most likely set of values for the input variables. Then, go for worst case
scenario (low unit sales, low sale price, high variable cost and so on) and best case scenario. Alternatively
scenarios analysis is possible where some factors are changed positively and some factors are changed
negatively.
So, in a nutshell Scenario analysis examine the risk of investment, to analyse the impact of alternative
combinations of variables, on the project’s NPV (or IRR).

4. EXPLAIN the different scenarios under which Scenario Analysis is considered.

ANSWER 4

Scenario Analysis
Although sensitivity analysis is probably the most widely used risk analysis technique, it does have limitations.
Therefore, we need to extend sensitivity analysis to deal with the probability distributions of the inputs. In
addition, it would be useful to vary more than one variable at a time so we could see the combined effects of
changes in the variables. Scenario analysis provides answer to these situations of extensions. This analysis
brings in the probabilities of changes in key variables and also allows us to change more than one variable at a
time.
This analysis begins with base case or most likely set of values for the input variables. Then, go for worst case
scenario (low unit sales, low sale price, high variable cost and so on) and best case scenario. Alternatively
scenarios analysis is possible where some factors are changed positively and some factors are changed
negatively.
So, in a nutshell Scenario analysis examine the risk of investment, to analyse the impact of alternative
combinations of variables, on the project’s NPV (or IRR).

5. STATE the two approaches to Sensitivity Analysis.

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ANWER 5

Steps involved in Sensitivity Analysis

Sensitivity Analysis is conducted by following the steps as below:
1. Finding variables, which have an influence on the NPV (or IRR) of the project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.
6. EXPLAIN what is Sensitivity Analysis used for.

ANSWER 6

Sensitivity analysis put in simple terms is a modeling technique which is used in Capital Budgeting decisions
which is used to study the impact of changes in the variables on the outcome of the project. In a project,
several variables like weighted average cost of capital, consumer demand, price of the product, cost
price per unit etc. operate simultaneously. The changes in these variables impact the outcome of the project.
It therefore becomes very difficult to assess change in which variable impacts the project outcome in a
significant way. In Sensitivity Analysis, the project outcome is studied after taking into change in only one
variable. The more sensitive is the NPV, the more critical is that variable. So, Sensitivity analysis is a way of
finding impact in the project’s NPV (or IRR) for a
given change in one of the variables.

7. DISTINGUISH between Scenario Analysis & Sensitivity Analysis.

ANSWER 7

Scenario Analysis Vs Sensitivity Analysis

Sensitivity analysis and Scenario analysis both help to understand the impact of the change in input variable
on the outcome of the project. However, there are certain basic differences between the two.
Sensitivity analysis calculates the impact of the change of a single input variable on the outcome of the project
viz., NPV or IRR. The sensitivity analysis thus enables to identify that single critical variable that can impact the
outcome in a huge way and the range of outcomes of the project given the change in the input variable.
Scenario analysis, on the other hand, is based on a scenario. The scenario may be recession or a boom
wherein depending on the scenario, all input variables change. Scenario Analysis calculates the outcome of the
project considering this scenario where the variables have changed simultaneously. Similarly, the outcome of
the project would also be considered for the normal and recessionary situation. The variability in the outcome
under the three different scenarios would help the management to assess the risk a project carries. Higher
deviation in the outcome can be assessed as higher risk and lower to medium deviation can be assessed
accordingly.
Scenario analysis is far more complex than sensitivity analysis because in scenario analysis all inputs are

253
changed simultaneously considering the situation in hand while in sensitivity analysis only one input is
changed and others are kept constant.

Practical Problems

1. Gauav Ltd. is using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected Cash flow (₹) Certainty-equivalent
quotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3

Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project should
be accepted?
ANSWER 1

Determination of Net Present Value (NPV)

Year Expected Cash Certainty- Adjusted Cash PV factor (at Total PV (₹)
flow (₹) equivalent flow (Cash 0.06)
(CE) flow × CE) (₹)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 – 4,00,000) 2,58,776
As the Net Present Value is positive the project should be accepted.

254
2. Following information have been retrieved from the finance department of Corp Finance Ltd. relating to
Projects X, Y and Z:

Particulars X Y Z
Net cash outlays 42,00,000 24,00,000 20,00,000
(₹)
Project life 5 years 5 years 5 years
Annual Cash 14,00,000 8,40,000 6,00,000
inflow (₹)
Coefficient of 2.0 0.8 1.6
variation
You are required to DETERMINE the risk adjusted net present value of the projects considering that the
Company selects risk-adjusted rate of discount on the basis of the coefficient of variation:

Coefficient of Variation Risk-Adjusted Rate of P.V. Factor 1 to 5 years

Return at risk adjusted rate of
discount
0.0 8% 3.992
0.4 10% 3.790
0.8 12% 3.604
1.2 14% 3.433
1.6 16% 3.274
2.0 20% 2.990
More than 2.0 22% 2.863

ANSWER 2

Statement showing the determination of the risk adjusted net present value

Projects Net cash Coefficient Risk Annual PV factor 1- Discounted Net present
outlays of variation adjusted cash inflow 5 years cash inflow value
discount
rate
(₹) (₹) (₹) (₹)

(i) (ii) (iii) (iv) (v) (vi) (vii) = (v) × (viii) = (vii) −
(vi) (ii)

X 42,00,000 2.0 20% 14,00,000 2.990 41,86,000 -14,000

Y 24,00,000 0.8 12% 8,40,000 3.604 30,27,360 6,27,360

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Z 20,00,000 1.6 16% 6,00,000 3.274 19,64,400 -35,600

3. The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals, Projects
M and N, which require cash outlays of ₹ 8,50,000 and ₹ 8,25,000 respectively. The certainty-equivalent
(C.E) approach is used in incorporating risk in capital budgeting decisions. The current yield on government
bonds is 6% and this is used as the risk free rate. The expected net cash flows and their certainty equivalents
are as follows:
Project M Project N
Year-end Cash Flow (₹) C.E. Cash Flow (₹) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7

Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and 0.840
respectively.
Required:

(i) ANALYSE which project should be accepted?

(ii) If risk adjusted discount rate method is used, IDENTIFY which project would be appraised with a higher
rate and why?
ANSWER 3

(i) Statement Showing the Net Present Value of Project M

Year end Cash C.E. Adjusted Present Total

Flow (₹) (b) Cash flow value Present
(a) (₹) factor at value (₹)
(c) = (a) × 6%(d) (e) = (c)
(b) ×(d)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
860980
Less: Initial Investment 850000
Net Present Value 10980

Statement Showing the Net Present Value of Project N

Year end Cash C.E. Adjusted Present Total

256
Flow (₹) (b) Cash value Present
(a) flow (₹) factor value (₹)
(c) = (a) × (d) (e) = (c) ×
(b) (d)
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 4,50,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
860980
Less: Initial Investment 850000
Net Present Value 10980
Decision : Since the net present value of Project N is higher, so the project N should be accepted.
(ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4). This means Project
M is riskier than Project N as "higher the riskiness of a cash flow, the lower will be the CE factor". If risk
adjusted discount rate (RADR) method is used, Project M would be analysed with a higher rate.

4. DETERMINE the risk adjusted net present value of the following projects:

X Y Z
Net cash outlays (₹) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (₹) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:

Coefficient of Risk-Adjusted Rate of P.V. Factor 1 to 5 years

Variation Return At risk adjusted rate of
discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

ANSWER 4

Statement showing the determination of the risk adjusted net present value

257
Projects Net cash Coefficient Risk Annual PV factor 1- Discounted Net present
outlays of variation adjusted cash inflow 5 years cash inflow value
discount
rate
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180

Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186

Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

5. A&R Ltd. has under its consideration a project with an initial investment of ₹ 90,00,000. Three probable
cash inflow scenarios with their probabilities of occurrence have been estimated as below:

Annual cash 20,00,000 30,00,000 40,00,000

inflow (₹)
Probability 0.2 0.7 0.1

The project life is 5 years and the desired rate of return is 18%. The estimated terminal values for the
project assets under the three probability alternatives, respectively, are ₹ 0, ₹ 20,00,000 and ₹ 30,00,000.

You are required to:

(i) CALCULATE the probable NPV;

(ii) CALCULATE the worst-case NPV and the best-case NPV; and

(iii) STATE the probability occurrence of the worst case, if the cash flows are perfectly positively correlated
over time.

ANSWER 5

(i) Calculation of Net Present Value (NPV)

Prob. = 0.2 Prob. = 0.7 Prob. = 0.1

Ye Cash Probable Cash Probable Cash Probable Total PVF@1 PV of
ar Flow Cash Flow Cash Flow Cash Cash 8% Total
Flow Flow Flow Flow cash flow

0 -9000000 1.000 -9000000 258

1 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.847 24,56,300
2 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.718 20,82,200
3 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.608 17,63,200
4 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.515 14,93,500
5 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.437 12,67,300
5 0 0 20,00,000 14,00,000 30,00,000 3,00,000 17,00,000 0.437 7,42,900
NPV 805400
(ii) Worst and Best case is the case where expected annual cash inflows are minimum and maximum
respectively.
Calculation of Worst Case and Best Case NPV:

Year PVF@18% Worst case Best case

Cash Flow PV of Cash Flow Cash Flow PV of Cash
Flow
0 1.000 (90,00,000) (90,00,000) (90,00,000) (90,00,000)
1 0.847 20,00,000 16,94,000 40,00,000 33,88,000
2 0.718 20,00,000 14,36,000 40,00,000 28,72,000
3 0.608 20,00,000 12,16,000 40,00,000 24,32,000
4 0.515 20,00,000 10,30,000 40,00,000 20,60,000
5 0.437 20,00,000 8,74,000 40,00,000 17,48,000
5 0.437 0 0 30,00,000 13,11,000
NPV -2750000 4811000

Worst case NPV = ₹ (27,50,000)

Best Case NPV = ₹ 48,11,000

(iii) The cash flows are perfectly positively correlated over time means cash flow in first year will be cash flows
in subsequent years. The cash flow of ₹20,00,000 is the worst case cash flow and its probability is 20%, thus,
possibility of worst case is 20% or 0.2.

5. SG Ltd. is considering a project “Z” with an initial outlay of ₹ 7,50,000 and life of 5 years. The estimates of
project are as follows:

259

Depreciation included in Fixed cost is ₹ 35,000 and corporate tax is 25%.

Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst, base and best case
scenario.
PV factor for 5 years at 15% are as follows:
Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497

ANSWER

(i) Calculation of Yearly Cash Inflow

In worst case: High costs and Low price (Selling price) and volume(Sales units) are taken.
In best case: Low costs and High price(Selling price) and volume(Sales units) are taken.

(ii) Calculation of NPV in different scenarios

260

(iii)
6. New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available in respect of
these projects:
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free interest rate
is 10%.
REQUIRED:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?

ANSWER

(i) The risk free rate of interest and risk factor for each of the projects are given. The risk adjusted discount rate (RADR)
for different projects can be found on the basis of CAPM as follows:
Required Rate of Return = IRf + (ke-IRF ) Risk Factor
For P-I : RADR = 0.10 + (0.15 – 0.10 ) 1.80 = 19%
For P-II : RADR = 0.10 + (0.15 – 0.10 ) 1.00 = 15 %
For P-III : RADR = 0.10 + (0.15 – 0.10) 0.60 = 13 %
(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows:
Project P-I

261
Project P-III has highest NPV. So, it should be accepted by the firm.

262
 CHAPTER-9 DIVIDEND DECISIONS

ILLUSTRATION 1
AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has
outstanding 10,000 shares selling at ₹ 100 each. The firm is contemplating the declaration of a dividend of ₹
5/ share at the end of the current financial year. It expects to have a net income of ₹ 1,00,000 and has a
proposal for making new investments of ₹ 2,00,000. CALCULATE the value of the firms when dividends (i)
are not paid (ii) are paid

SOLUTION

CASE 1: Value of the firm when dividends are not paid.

Step 2: Calculation of funds required for investment

Earning ₹ 1,00,000
Dividend distributed Nil
Fund available for investment ₹ 1,00,000

263
Total Investment ₹ 2,00,000
Balance Funds required ₹ 2,00,000 - ₹1,00,000 =
₹1,00,000

Step 3:No. of shares required to be issued for balance fund

Step 4:Calculation of value of firm

CASE 2: Value of the firm when dividends are paid.

Step 1:Calculate price at the end of the period

Step 2: Calculation of funds required for investment

Earning ₹ 1,00,000
Dividend distributed ₹ 50,000

264
Fund available for ₹ 50,000
investment
Total Investment ₹ 2,00,000
Balance Funds ₹ 2,00,000 - ₹ 50,000 = ₹1,50,000
required

Step 3: No. of shares required to be issued for balance fund

Step 4: Calculation of value of firm

Thus, it can be seen from the example that the value of the firm remains the same in either case.

ILLUSTRATION 2
XYZ Ltd. earns ₹ 10/ share. Capitalization rate and return on investment are 10% and 12% respectively.
DETERMINE the optimum dividend payout ratio and the price of the share at the payout.

SOLUTION
Since r > Ke , the optimum dividend pay-out ratio would ‘Zero’ (i.e. D = 0),
Accordingly, value of a share:

265

The optimality of the above payout ratio can be proved by using 25%, 50%, 75% and 100% as pay- out ratio:
At 25% pay-out ratio
ILLUSTRATION 3
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference ₹ 100 lakhs
shares
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

COMPUTE the approximate dividend pay-out ratio so as to keep the share price at ₹ 42 by using Walter’s

266
model?
SOLUTION

₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = ₹ 6.00
Let, the dividend per share be D to get share price of ₹42

ILLUSTRATION 4
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference ₹ 100 lakhs
shares
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.

SOLUTION 267

₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = ₹ 6.00
Price per share according to Gordon’s Model is calculated as follows:

ILLUSTRATION 5
X Ltd. is a no growth company, pays a dividend of ₹ 5 per share. If the cost of capital is 10%, COMPUTE the
current market price of the share?

SOLUTION

268
ILLUSTRATION 6
XYZ is a company having share capital of ₹10 lakhs of ₹10 each. It distributed current dividend of 20% per
annum. Annual growth rate in dividend expected is 2%. The expected rate of return on its equity capital is
15%. CALCULATE price of share applying Gordon’s growth Model.

SOLUTION
ILLUSTRATION 7
A firm had paid dividend at ₹2 per share last year. The estimated growth of the dividends from the company
is estimated to be 5% p.a. DETERMINE the estimated market price of the equity share if the estimated
growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also FIND OUT the present market price of the
share, given that the required rate of return of the equity investors is 15%.

SOLUTION

In the present situation, the current MPS is as follows:

269
ILLUSTRATION 8
The earnings per share of a company is ₹ 30 and dividend payout ratio is 60%. Multiplier is 2.
DETERMINE the price per share as per Graham & Dodd model.

SOLUTION

ILLUSTRATION 9
The following information regarding the equity shares of M Ltd. is given below:

Market price ₹ 58.33

Dividend per ₹5
share
Multiplier 7

According to the Graham & Dodd approach to the dividend policy, COMPUTE the EPS.

SOLUTION

270
ILLUSTRATION 10
Given the last year’s dividend is ₹ 9.80, speed of adjustment = 45%, target payout ratio 60% and EPS for
current year ₹ 20. COMPUTE current year’s dividend using Linter’s model.

SOLUTION

D₁ = Dₒ + [(EPS ×Target payout) - Dₒ] × Af

D₁ = 9.80 + [(20 × 60%) – 9.80] × 0.45

D₁ = 9.80 + 0.99 = ₹10.79

ILLUSTRATION 11

RST Ltd. has a capital of ₹ 10,00,000 in equity shares of ₹ 100 each. The shares are currently quoted at par.
The company proposes to declare a dividend of ₹ 10 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is 12%. COMPUTE market price of the
share at the end of the year, if

(i) dividend is not declared ?

(ii) dividend is declared ?

(iii) assuming that the company pays the dividend and has net profits of ₹5,00,000 and makes new
investments of ₹10,00,000 during the period, how many new shares must be issued? Use the MM model.

SOLUTION
Given,

Cost of Equity (Ke) 12%

271
Number of shares in the beginning 10,000
(n)
Current Market Price (P0) ₹100
Net Profit (E) ₹ 5,00,000
Expected Dividend ₹10 per share
Investment (I) ₹10,00,000
Computation of market price per share, when:
(i) No dividend is declared:

(iii) Calculation of funds required for investment

Earning 5,00,000
Dividend distributed 1,00,000
Fund available for investment 4,00,000
Total Investment 10,00,000
Balance Funds required 10,00,000 - 4,00,000 = ₹6,00,000

ILLUSTRATION 12

272
The following information pertains to M/s XY Ltd.

Earnings of the Company ₹ 5,00,000

Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on 15%
investment

CALCULATE:
(i) What would be the market value per share as per Walter’s model?

(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of
Company’s share at that payout ratio?

SOLUTION

273
ILLUSTRATION 13

Taking an example of three different firms i.e. growth, normal and declining, CALCULATE the share price
using Gordon’s model:
Factors Growth Firm Normal Firm Declining Firm
r > Ke r = Ke r < Ke
r (rate of return on retained 15% 10% 8%
earnings)
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) ₹ 10 ₹ 10 ₹ 10
b (Retained Earnings) 0.6 0.6 0.6
1- b (Dividend Payout) 0.4 0.4 0.4
SOLUTION

If the retention ratio (b) is changed from 0.6 to 0.4, the new share price will be as follows:

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From the above analysis it can be concluded that.

When r > k, the market value increases with retention ratio.

When r < k, the market value of share stands to decrease.

When r = k, the market value is not affected by dividend policy.

The conclusion of the Gordon’s model is similar to that of Walter’s model.

ILLUSTRATION 14

The following information is given below in case of Aditya Ltd.:

Earnings per share - ₹ 60
Capitalisation rate -15%
Return on investment- 25% per cent
Dividend payout ratio- 30%
(i) COMPUTE price per share using Walter’s Model
(Ii) WHAT would be optimum dividend payout ratio per share under Gordon’s Model.

SOLUTION
(i) As per Walter’s Model, Price per share is computed by using the following formula:

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(iv) As per Gordon’s model, when r > Ke, optimum dividend payout ratio is ‘Zero’.
MCQs based Questions

1 Which one of the following is the assumption of Gordon’s Model:

(a) Ke > g

(b) Retention ratio, (b), once decide upon, is constant

(c) Firm is an all equity firm

(d) All of the above

ANSWER 1-D

2 What should be the optimum Dividend pay-out ratio, when r = 15% & Ke = 12%:

(a) 100%

(b) 50%

(c) Zero

(d) None of the above.

ANSWER 2-C

3 Which of the following is the irrelevance theory?

(a) Walter model

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(b) Gordon model

(c) M.M. hypothesis

(d) Linter’s model

ANSWER 3-C
4 If the company’s D/P ratio is 60% & ROI is 16%, what should be the growth rate:

(a) 5%

(b) 7%

(c) 6.4%

(d) 9.6%

ANSWER 4-C

5 If the shareholders prefer regular income, how does this affect the dividend decision:

(a) It will lead to payment of dividend

(b) It is the indicator to retain more earnings

(c) It has no impact on dividend decision

(d) Can’t say

ANSWER 5-A

6 Mature companies having few investment opportunities will show high payout ratios, this statement is:

(a) False

(b) True

(c) Partial true

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(d) None of these

ANSWER 6-B
7 Which of the following is the limitation of Linter’s model:

(a) This model does not offer a market price for the shares

(b) The adjustment factor is an arbitrary number and not based on any scientific criterion or methods

(c) Both (a) & b)

(d) None of the above.

ANSWER 7-C

8. What are the different options other than cash used for distributing profits to shareholders?

(a) Bonus shares

(b) Stock split

(c) Both (a) and (b)

(d) None of the above

ANSWER 8-C

9. Which of the following statement is correct with respect to Gordon’s model?

(a) When IRR is greater than cost of capital, the price per share increases and dividend pay-out decreases.

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(b) When IRR is greater than cost of capital, the price per share decreases and dividend pay-out increases.

(c) When IRR is equal to cost of capital, the price per share increases and dividend pay-out decreases.

(d) When IRR is lower than cost of capital, the price per share increases and dividend pay-out decreases.

ANSWER 9-A
10. Compute EPS according to Graham & Dodd approach from the given information:

Market price ₹ 56
Dividend pay-out ratio 60%
Multiplier 2

(a) ₹ 30

(b) ₹ 56

(c) ₹ 28

(d) ₹ 84

ANSWER 10-A

11. Which among the following is not an assumption of Walter’s Model?

(a) Rate of return and cost of capital are constant

(b) Information is freely available to all

(c) There is discrimination in taxes

(d) The firm has perpetual life

ANSWER 11-C

Theoretical based Questions

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1. STATE dividend decision? Briefly EXPLAIN the factors which govern this decision.
ANSWER 1

Dividend is that part of profit after tax which is distributed to the shareholders of the company. Furthermore,
the profit earned by a company after paying taxes can be used for:

i. Distribution of dividend or
ii. Can be retained as surplus for future growth
Dividend policy of a firm is governed by:

(i) Long Term Financing Decision: As we know that one of the financing option is ‘Equity’. Equity can be raised
externally through issue of equity shares or can be generated internally through retained earnings. But
retained earnings are preferable because they do not involve floatation costs. But whether to retain or
distribute the profits forms the basis of this decision. Further, payment of cash dividend reduces the amount
of funds required to finance profitable investment opportunities thereby restricting its financing options. In
this backdrop, the decision is based on the following:

1. Whether the organization has opportunities in hand to invest the amount of profits, if retained?

2. Whether the return on such investment (ROI) will be higher than the expectations of shareholders i.e. Ke?

(ii) Wealth Maximization Decision: Under this head, we are facing the problem of amount of dividend to be
distributed i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS).

1. Because of market imperfections and uncertainty, shareholders give higher value to near dividends than
future dividends and capital gains. Payment of dividends influences the market price of the share. Higher
dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between
these two approaches.

2. When the firm increases retained earnings, shareholders' dividends decrease and consequently market
price is affected. Use of retained earnings to finance profitable investments increases future earnings per
share. This is because, shareholders expect that profitable investments made by the company may lead to
higher return for them in future.

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On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of
funds and thereby decrease the future earnings per share. Thus, management should develop a dividend
policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve
the objective of wealth maximization for shareholders. Such a policy will be influenced by investment
opportunities available to the firm and value of dividends as against capital gains to shareholders.
2. EXPLAIN the advantages and disadvantages of the stock dividend.

ANSWER 2

Advantages of Stock Dividend There are many advantages both to the shareholders and to the company.
Some of the important ones are listed as under:

(1) To Share Holders: (a) Tax benefit –At present there is no tax on dividend received from a domestic
company. (b) Policy of paying fixed dividend per share and its continuation even after declaration of stock
dividend will increase total cash dividend of the shareholders in future.

(2) To Company: (a) Conservation of cash for meeting profitable investment opportunities. (b) Suitable in case
of cash deficiency and restrictions imposed by lenders to pay cash dividend.

Limitations of Stock Dividend Limitations of stock dividend to shareholders and to company are as follows:

1. To Shareholders: Stock dividend does not affect the wealth of shareholders and therefore it has no value
for them. This is because the declaration of stock dividend is a method of capitalising the past earnings of the
shareholders and is a formal way of recognising earnings which the shareholders already own. It merely
divides the company's ownership into a large number of share certificates. James Porterfield regards stock
dividends as a division of corporate pie into a larger number of pieces. Stock dividend does not give any extra
or special benefit to the shareholder. His proportionate ownership in the company does not change at all.
Stock dividend creates a favourable psychological impact on the shareholders and is greeted by them on the
ground that it gives an indication of the company's growth.

2. To Company: Stock dividends are more costly to administer than cash dividends. It is disadvantageous if

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periodic small stock dividends are declared by the company as earnings. Also, companies have to pay tax on
their distribution.

3. DISCUSS the practical considerations in dividend policy.

ANSWER 3

The formulation of dividend policy depends upon answers to the following questions:
• whether there should be a stable pattern of dividends over the years or
• whether the company should treat each dividend decision completely independent. The practical
considerations in dividend policy of a company are briefly discussed below:

(a) Financial Needs of a Company: Retained earnings can be a source of finance for creating profitable
investment opportunities. As we discussed earlier, when internal rate of return of a company is greater than
return required by shareholders, it would be advantageous for the shareholders to re-invest their earnings.
Risk and financial obligations increase if a company raises capital through issue of new shares where floatation
costs are involved.

(b) Constraints on Paying Dividends

(i) Legal: Please see point no. (9) under the heading, “Determinants of Dividend Decisions”.

(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay dividends depends on cash and
liquidity position of the firm. A mature company does not have much investment opportunities, nor its funds
tied up in permanent working capital and, therefore has a sound cash position. A growth oriented company in
spite of having good profits need funds to expand its operations and permanent working capital and therefore
it is less likely to declare dividends.

(iii) Access to the Capital Market: By paying large dividends, cash position is affected. So, if new shares have to
be issued to raise funds for financing investment programmes and if the existing shareholders cannot buy
additional shares, their control is diluted. In such a situation, payment of dividends may be withheld and
earnings are utilised for financing firm’s investment opportunities.

(iv) Investment Opportunities: If investment opportunities are inadequate, it is better to pay dividends and
raise external funds whenever necessary for such opportunities.

(c) Desire of Shareholders: The desire of shareholders (whether they prefer regular income by way of dividend
or maximize their wealth by way of gaining on sale of the shares) is also an important point to be considered
by the companies. The small shareholders are concerned with regular dividend income, hence, some select
group of companies paying regular and liberal dividend.

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As compared to those shareholders who prefer regular dividend as source of income, there are shareholders
who prefer to gain on sale of shares at times when shares command higher price in the market. However,
capital gain on sale of shares attracts tax on such gain and rates vary on the basis of holding period.

The dividend policy, thus pursued by the company should strike a balance on the desires of the shareholders.
Also, the dividend policy once established should be continued as long as possible without interfering with the
needs of the company to create a positive clientele effect.

(d) Stability of Dividends: Stability in dividend can be maintained by fixing the amount or rate of dividend
irrespective of the earnings of the company
4. LIST out the assumptions of irrelevance theory.

ANSWER 4

Assumptions of M.M Hypothesis

MM hypothesis is based on the following assumptions:

• Perfect capital markets: The firm operates in a market in which all investors are rational and information is
freely available to all.

• No taxes or no tax discrimination between dividend income and capital appreciation (capital gain). It means
there is no difference in taxation of dividend income or capital gain. This assumption is necessary for the
universal applicability of the theory, since, the tax rates may be different in different countries.

• Fixed investment policy: It is necessary to assume that all investment should be financed through equity
only, since implication after using debt as a source of finance may be difficult to understand. Further, the
impact will be different in different cases.

• No floatation or transaction cost: Similarly, these costs may differ from country to country or market to
market.

• Risk of uncertainty does not exist. Investors are able to forecast future prices and dividend with certainty
and one discount rate is appropriate for all securities and all time periods.

5. EXPLAIN the parameters Linter’s model of dividend policy. Also explain the reasons of its criticism.

ANSWER 5

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Linter’s model has two parameters:
i. The target payout ratio,
ii. The spread at which current dividends adjust to the target.
John Linter based his model on a series of interviews which he conducted with corporate managers in the mid
1950’s.While developing the model, he considers the following assumptions:

1. Firm have a long term dividend payout ratio. They maintain a fixed dividend payout over a long term.
Mature companies with stable earnings may have high payouts and growth companies usually have low
payouts.
2. Managers are more concerned with changes in dividends than the absolute amounts of dividends. A
manager may easily decide to pay a dividend of ₹ 2 per share if last year too it was ₹ 2 but paying ₹ 3 dividend
if last year dividend was ₹2 is an important financial management decision.

3. Dividend changes follow changes in long run sustainable earnings.

4. Managers are reluctant to affect dividend changes that may have to be reversed.
Under Linter’s model, the current year’s dividend is dependent on current year’s earnings and last year’s
dividend.

D₁ = Dₒ + [(EPS ×Target payout) - Dₒ] × Af

Where D₁ = Dividend in year 1

Dₒ = Dividend in year 0 (last year dividend)
EPS = Earnings per share
Af = Adjustment factor or Speed of adjustment

6. State the meaning of stock split. Explain its advantages and disadvantages.

ANSWER 6

Meaning of Stock Split:

Stock split means splitting one share into many, say, one share of ₹ 500 in to 5 shares of ₹100. Stock splits is a
tool used by the companies to regulate the prices of shares i.e. if a share price increases beyond a limit, it may
become less tradable, for e.g. suppose a company’s share price increases from ₹50 to ₹1000 over the
years, it is possible that it might goes out of range of many investors.

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Advantages of Stock Splits Various advantages of Stock Splits are as follows:

1. It makes the share affordable to small investors.

2. Number of shares may increase the number of shareholders; hence the potential of investment may
increase.

Limitations of Stock Splits

Various limitations of Stock Splits are as follows:

1. Additional expenditure need to be incurred on the process of stock split.

2. Low share price may attract speculators or short term investors, which are generally not preferred by any
company.

Practical Problems

1. The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend policy
with a multiplier of 9, COMPUTE P/E ratio.

ANSWER 1

The P/E ratio i.e. price earnings ratio can be computed with the help of the following formula:

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2. M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares and
the current market price is ₹ 100. It expects a net profit of ₹ 2,50,000 for the year and the Board is
considering dividend of ₹ 5 per share.

M Ltd. requires to raise ₹ 5,00,000 for an approved investment expenditure. ILLUSTRATE, how the MM
approach affects the value of M Ltd. if dividends are paid or not paid.

ANSWER 2

Given,

Cost of Equity (Ke) 10%

Number of shares in the beginning (n) 25,000
Current Market Price (P0) ₹100
Net Profit (E) ₹2,50,000

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Expected Dividend ₹5 per share
Investment (I) ₹5,00,000
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3. The following information is supplied to you:

Total Earnings 2,00,000

No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.

(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.

ANSWER 3

(i) The EPS of the firm is ₹ 10 (i.e., ₹ 2,00,000/ 20,000). r = 2,00,000/ (20,000 shares × ₹100) = 10%. The P/E
Ratio is given at 12.5 and the cost of capital, Ke, may be taken at the inverse of P/E ratio. Therefore, Ke is 8
(i.e., 1/12.5). The firm is distributing total dividends of ₹ 1,50,000 among 20,000 shares, giving a dividend per
share of ₹ 7.50. the value of the share as per Walter’s model may be found as follows:

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total earnings of ₹ 2,00,000. since, the rate of
return of the firm, r, is 10% and it is more than the Ke of 8%, therefore, by distributing 75% of earnings, the
firm is not following an optimal dividend policy. The optimal dividend policy for the firm would be to pay zero
dividend and in such a situation, the market price would be

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So, theoretically the market price of the share can be increased by adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the
Ke would be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect on the value of the share.
(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5 and in such a
situation ke> r and the market price, as per Walter’s model would be:

4. With the help of following figures CALCULATE the market price of a share of a company by using:

(i) Walter’s formula

(ii) Dividend growth model (Gordon’s formula)

Earnings per share (EPS) ₹ 10

Dividend per share (DPS) ₹6
Cost of capital (Ke) 20%
Internal rate of return on investment 25%
Retention Ratio 40%
ANSWER 4

Market price per share by

(i) Walter’s model:

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(ii) Gordon’s model (Dividend Growth model): When the growth is incorporated in earnings and dividend, the
present value of market price per share (Po) is determined as follows
Gordon’s theory:
5. The annual report of XYZ Ltd. provides the following information for the Financial Year 2020-21:

Particulars Amount (₹)

Net Profit 50 lakhs
Outstanding 15% preference shares 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

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CALCULATE price per share using Gordon’s Model when dividend pay-out is-

(i) 25%;

(ii) 50%;

(iii) 100%.
ANSWER 5

Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in ₹
Net Profit 50 lakhs
Less: Preference dividend 15 lakhs
Earnings for equity shareholders 35 lakhs
Therefore, earning per share 35 lakhs/5 lakhs = ₹ 7.00

Price per share according to Gordon’s Model is calculated as follows:

6. A&R Ltd. is a large-cap multinational company listed in BSE in India with a face value of ₹ 100 per share.
The company is expected to grow @ 15% p.a. for next four years then 5% for an indefinite period. The
shareholders expect 20% return on their share investments. Company paid ₹ 120 as dividend per share for

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the FY 2020-21. The shares of the company traded at an average price of ₹ 3,122/- on last day. FIND out the
intrinsic value of per share and state whether shares are overpriced or underpriced.

ANSWER 6

As per Dividend discount model, the price of share is calculated as follows:

Where,
P = Price per share
Ke = Required rate of return on equity
g = Growth rate

Intrinsic value of share is ₹ 2,557.5/- as compared to latest market price of ₹ 3,122/-. Market price of a share is
overpriced by ₹ 564.5/-.

7. In May, 2020 shares of RT Ltd. was sold for ₹ 1,460 per share. A long term earnings growth rate of 7.5% is
anticipated. RT Ltd. is expected to pay dividend of ₹ 20 per share.

(i) CALCULATE rate of return an investor can expect to earn assuming that dividends are expected to grow
along with earnings at 7.5% per year in perpetuity?

(ii) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of earnings. In
this case, STATE whether, there would be any change in growth rate and cost of Equity?

ANSWER 7

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(i) According to Dividend Discount Model approach the firm’s expected or required return on equity is
computed as follows:
(ii) With rate of return on retained earnings (r) 10% and retention ratio (b) 60%, new growth rate will be as
follows:
g = br i.e.
= 0.10 × 0.60 = 0.06

Accordingly, dividend will also get changed and to calculate this, first we shall calculate previous retention
ratio (b1) and then EPS assuming that rate of return on retained earnings (r) is same.
With previous Growth Rate of 7.5% and r =10%, the retention ratio comes out to be:

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8. Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2021. The existing market price
per share is ₹ 150. Expected dividend is ₹ 8 per share. The rate of capitalization appropriate to the risk class to which the
company belongs is 10%.
(i) CALCULATE the market price per share when expected dividends are: (a) declared, and (b) not declared, based on the
Miller – Modigliani approach.
(ii) CALCULATE number of shares to be issued by the company at the end of the accounting year on the
assumption that the net income for the year is ₹ 3 crore, investment budget is ₹ 6 crores, when (a) Dividends are
declared, and (b) Dividends are not declared.
(iii) PROOF that the market value of the shares at the end of the accounting year will remain unchanged irrespective of
whether (a) Dividends are declared, or (ii) Dividends are not declared.

ANSWER

(i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

Where,
Existing market price (Po) = ₹ 150
Expected dividend per share (D1) = ₹ 8
Capitalization rate (ke) = 0.10
Market price at year end (P1) = to be determined
(a) If expected dividends are declared, then

(b) If expected dividends are not declared, then

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(ii) Calculation of number of shares to be issued

(iii) Calculation of market value of the shares

Hence, it is proved that the total market value of shares remains unchanged irrespective of whether dividends are 295
declared, or not declared.
 CHAPTER-10 MANAGEMENT OF WORKING
CAPITAL

ILLUSTRATION 1
A firm has the following data for the year ending 31st March, 2020:

Sales (1,00,000 @ ₹ 20) 20,00,000

Earnings before Interest and 2,00,000
Taxes
Fixed Assets 5,00,000

The three possible current assets holdings of the firm are ₹ 5,00,000, ₹ 4,00,000 and ₹ 3,00,000. It is
assumed that fixed assets level is constant and profits do not vary with current assets levels. ANALYSE the
effect of the three alternative current assets policies.

SOULTUION

Effect of Alternative Working Capital Policies

Working Capital Policy Conservative Moderate Aggressive

(₹) (₹) (₹)
Sales 20,00,000 20,00,000 20,00,000

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The aforesaid calculation shows that the conservative policy provides greater liquidity (solvency) to the firm,
but lower return on total assets. On the other hand, the aggressive policy gives higher return, but low liquidity
and thus is very risky. The moderate policy generates return higher than Conservative policy but lower than
aggressive policy. This is less risky than aggressive policy but riskier than conservative policy.

In determining the optimum level of current assets, the firm should balance the profitability – solvency tangle
by minimizing total costs – Cost of liquidity and cost of illiquidity.

ILLUSTRATION 2

From the following information of XYZ Ltd., you are required to CALCULATE:

(a) Net operating cycle period.

(b) Number of operating cycles in a year.

(i) Raw material inventory consumed during the 6,00,000

year
(ii) Average stock of raw material 50,000
(iii) Work-in-progress inventory 5,00,000
(iv) Average work-in-progress inventory 30,000
(v) Cost of goods sold during the year 8,00,000
(vi) Average finished goods stock held 40,000
(vii) Average collection period from debtors 45 days
(viii) Average credit period availed 30 days

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(ix) No. of days in a year 360 days

SOLUTION
(a) Calculation of Net Operating Cycle period of XYZ Ltd.
ILLUSTRATION 3
On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working capital that
will be required during the year. From the following information PREPARE the working capital requirements
forecast.
Production during the previous year was 60,000 units. It is planned that this level of activity would be
maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and Overheads

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20%.
Raw materials are expected to remain in store for an average of 2 months before issue to production.
Each unit is expected to be in process for one month, the raw materials being fed into the pipeline
immediately and the labour and overhead costs accruing evenly during the month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3 months.
Credit allowed by creditors is 2 months from the date of delivery of raw material.
Credit allowed to debtors is 3 months from the date of dispatch.
Selling price is ₹ 5 per unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month.
The company normally keeps cash in hand to the extent of ₹ 20,000.
SOLUTION

Working Notes:

1. Raw material inventory: The cost of materials for the whole year is 60% of the Sales value.

Hence it is 60,000 units × ₹ 5 × 60/100 .The monthly consumption of raw material would be ₹ 15,000. Raw
material requirements would be for two months; hence raw materials in stock would be ₹ 30,000. ₹
60=1,80,000100

2. Work-in-process: (Students may give special attention to this point). It is stated that each unit of production
is expected to be in process for one month).

299

3. Finished goods inventory: (3 month’s cost of production)

 300
Here it has been assumed that inventory level is uniform throughout the year, therefore opening inventory
equals closing inventory.
Statement of Working Capital Required:

ILLUSTRATION 4

The following annual figures relate to XYZ Co.,

Sales (at two months’ credit) 36,00,000

Materials consumed (suppliers extend two months’ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses (expenses are paid one month in 9,60,000
arrear)
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000

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The company sells its products on gross profit of 25%. Depreciation is considered as a part of the cost of
production. It keeps one month’s stock each of raw materials and finished goods, and a cash balance of ₹
1,00,000.

Assuming a 20% safety margin, COMPUTE the working capital requirements of the company on cash cost
basis.

Ignore work-in-process.

SOLUTION
Statement of Working Capital requirements (cash cost basis)

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Working Notes:

i) Computation of Annual Cash Cost of Production (₹)

Material consumed 9,00,000
Wages 7,20,000
Manufacturing expenses 9,60,000
Total cash cost of production 25,80,000
(ii) Computation of Annual Cash Cost of Sales: (₹)
Cash cost of production as in (i) above 25,80,000
Administrative Expenses 2,40,000
Sales promotion expenses 1,20,000
Total cash cost of sales 29,40,000

ILLUSTRATION 5
Samreen Enterprises has been operating its manufacturing facilities till 31.3.2020 on a single shift working
with the following cost structure:

Per unit (₹)

Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% 5.00
fixed)

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Profit 2.00
Selling Price 18.00

As at 31.3.2020 the company held:

Stock of raw materials (at cost) 36,000

Work-in-progress (valued at prime 22,000
cost)
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift. It is
expected that a 10% discount will be available from suppliers of raw materials in view of increased volume
of business. Selling price will remain the same. The credit period allowed to customers will remain
unaltered. Credit availed of from suppliers will continue to remain at the present level i.e., 2 months. Lag in
payment of wages and expenses will continue to remain half a month.

You are required to PREPARE the additional working capital requirements, if the policy to increase output is
implemented.

SOLUTION

This question can be solved using two approaches:

(i) To assess the impact of double shift for long term as a matter of production policy.

(ii) To assess the impact of double shift to mitigate the immediate demand for next year only.

The first approach is more appropriate and fulfilling the requirement of the question.

(i) Assessment of impact of double shift for long term as a matter of production policy:

Comparative Statement of Working Capital Requirement

Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800

Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: (A) 226000 344000
Current Liabilities

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Creditors for Materials 4,000 6.00 24,000 8,000 5.40 43,200
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current Liabilities: 34,000 57,200
(B)
Working Capital: (A) – (B) 1,92,00 286800
0
Additional Working Capital requirement = ₹ 2,86,800 – ₹ 1,92,000 = ₹ 94,800

Workings:

(1) Statement of cost at single shift and double shift working

Raw materials 6.00 1,44,000 5.40 2,59,200

Wages - Variable 3.00 72,000 3.00 1,44,000
Fixed 2.00 48,000 1.00 48,000
Overheads - Variable 1.00 24,000 1.00 48,000
Fixed 4.00 96,000 2.00 96,000
Total cost 16.00 3,84,000 12.40 5,95,200
Profit 2.00 48,000 5.60 2,68,800
18.00 432000 18.00 8,64,000

305
(ii) Assessment of the impact of double shift to mitigate the immediate demand for next year only & not as
part of policy implementation.
In this approach, working capital shall be computed as if we are calculating the same for the next / second
year with double production. Whereas, in the first approach to implement double-shift as part of policy
implementation, we calculated comparative analysis of working capital requirement for single & double shift
within the same year.
Working
(6) Calculation of no. of units to be sold:

No. of units to be Produced 48,000

Add: Opening stock of finished goods 4,500
Less: Closing stock of finished goods (9,000)
No. of units to be Sold 43,500

(7) Calculation of Material to be consumed and materials to be purchased in units:

No. of units Produced 48,000

Add: Closing stock of WIP 2,000
Less: Opening stock of finished goods (2,000)
Raw Materials to be consumed in units 48,000
Add: Closing stock of Raw material 12,000
Less: Opening stock of Raw material (6,000)
Raw Materials to be purchased (in units) 54,000

(8) Credit allowed by suppliers:

Comparative Statement of Working Capital Requirement

Single Shift (Current Year – 24,000 units) Double Shift (Next Year – 48,000 units)

306
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in- 2,000 11.00 22,000 2,000 9.40 18,800
Progress
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current 2,26,000 3,44,000
Assets: (A)
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 9,000 5.40 48,600
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current 34000 62600
Liabilities (B)

Working Capital: (A) – 192000 281400

(B)

Additional Working Capital requirement = ₹ 2,81,400 – ₹ 1,92,000 = ₹ 89,400

Notes:

(i) The quantity of material in process will not change due to double shift working since work started in the
first shift will be completed in the second shift.

(ii) It is given in the question that the WIP is valued at prime cost hence, it is assumed that the WIP is 100%
complete in respect of material and labour.

(iii) In absence of any information on proportion of credit sales to total sales, debtors quantity has been
doubled for double shift. Hence, the units have been taken as 12,000 only.

(iv) It is assumed that all purchases are on credit.

(v) The valuation of work-in-progress based on prime cost (i.e. material & labor) as per the policy of the
company is as under

Single shift (₹) Double shift (₹)

Materials 6.00 5.40
Wages – Variable 3.00 3.00

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Fixed 2.00 1.00
11.00 9.40

ILLUSTRATION 6
PREPARE monthly cash budget for six months beginning from April 2020 on the basis of the following
information:-
(i) Estimated monthly sales are as follows:-
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

(ii) Wages and salaries are estimated to be payable as follows:-

April 9,000 July 10,000

May 8,000 August 9,000
June 10,000 September 9,000

(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
after sale and the balance in two months after sale. There are no bad debt losses.

(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the sales.

(v) The firm has 10% debentures of ₹ 1,20,000. Interest on these has to be paid quarterly in January, April
and so on.

(vi) The firm is to make an advance payment of tax of ₹ 5,000 in July, 2020.

(vii) The firm had a cash balance of ₹ 20,000 on April 1, 2020, which is the minimum desired level of cash
balance.
Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation of
temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).

308
SOLUTION

Workings:
Collection from debtors:

February March April May June July August September

Total sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
sales (80%
of total
sales)
Collections:
One 72,000 84,000 48,000 36,000 48,000 60,000 48,000
month
Two 24,000 28,000 16,000 12,000 16,000 20,000
months
Total 1,08,000 76,000 52,000 60,000 76,000 68,000
collections

Monthly Cash Budget for Six months, April to September, 2020

(Amount in ₹)

Receipts: April May June July August Sept

Opening balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collection from debtors 1,08,000 76,000 52,000 60,000 76,000 68,000
Total cash available (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,00
0
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages & salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 --- --- 3,000 --- ---
Tax payment --- --- --- 5,000 --- ---
Total payments (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum cash balance desired 20,000 20,000 20,000 20,000 20,000 20,000
Total cash needed (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,00
0
Surplus - deficit (A-C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investment/financing Temporary (64,000) (16,000) ---- (35,000) -----
Investments
Liquidation of temporary investments ---- ---- 22,000 2,000 ---- 9,000
or temporary borrowings
Total effect of (64,000) (16,000) 22,000 2,000 (35,000) 9,000

309
investment/financing (D)
Closing cash balance (A+D-B) 20,000 20,000 20,000 20,000 20,000 20,000
ILLUSTRATION 7

From the following information relating to a departmental store, you are required to PREPARE for the three
months ending 31st March, 2020:-

(a) Month-wise cash budget on receipts and payments basis; and

(b) Statement of Sources and uses of funds for the three months period.

It is anticipated that the working capital & other account balances at 1st January, 2020 will be as follows:-

310
Budgeted balances at the end of each months: ₹ in ‘000’s
31st Jan. 29th Feb. 31st March
Short term investments 700 --- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485 -- --
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550

Depreciation amount to ₹ 60,000 is included in the budgeted expenditure for each month.

SOLUTION

Workings: ₹ in ‘000’
1. Payments to creditors: Jan. 2020 Feb. 2020 March, 2020
Cost of Sales 1,635 1,405 1,330
Add Closing Stocks 1,200 1,100 1,000
2,835 2,505 2,330
Less: Opening Stocks 1,300 1,200 1,100
2. Purchases 1,535 1,305 1,230
Add: Trade Creditors, Opening balance 2,110 2,000 1,950
3,645 3,305 3,180
Less: Trade Creditors, closing balance 2,000 1,950 1,900
Payment 1,645 1,355 1,280
4670 4400 4200
Less: Debtors, closing balance 2,600 2,500 2,350
Receipt 2,070 1,900 1,850

311
CASH BUDGET

(a) 3 months ending 31st March, 2020 (₹ in 000)

January, 2020 February, 2020 March, 2020
Opening cash balances 545 315 65
Add: Receipts:
From Debtors 2,070 1,900 1,850
Sale of Investments --- 700 ----
Sale of Plant --- --- 50
Total (A) 2,615 2,915 1,965
Deduct: Payments
Creditors 1,645 1,355 1,280
Expenses 255 210 195
Capital Expenditure --- 800 ---
Payment of dividend --- 485 ---
Purchase of investments 400 --- 200
Total payments (B) 2,300 2,850 1,675
Closing cash balance (A-B) 315 65 290

(b) Statement of Sources and uses of Funds for the three month period ending 31st March, 2020

Sources: ₹ ’000 ₹ ’000

Funds from operation:
Net profit (150+125+115) 390
Add: Depreciation (60×3) 180 570
Sale of plant 50
620
Decrease in Working Capital 665
(Refer Statement of changes in

312
working capital)
Total 1,285
Uses:
Purchase of plant 800
Payment by dividends 485
Total 1,285
Statement of Changes in Working Capital

January,20 March,20 Increase Decrease

₹’ 000 ₹’ 000 ₹’ 000 ₹’ 000
Current Assets
Cash in hand and at Bank 545 290 255
Short term Investments 300 200 100
Debtors 2,570 2,350 220
Stock 1,300 1,000 300
4,715 3,840
Current Liabilities
Trade Creditors 2,110 1,900 210 ---
Other Creditors 200 200 --- ---
Tax Due 320 320 --- ---
2,630 2,420
Working Capital 2,085 1,420
Decrease 665 665
2,085 2,085 875 875

ILLUSTRATION 8
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account

Year 1 Year 2 Year 1 Year 2

₹ ₹ ₹ ₹
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,00
0
To Raw materials 3,00,00,000 4,00,00,000 By Closing 1,00,00,000 1,50,00,000
stock
To Stores 1,00,00,000 1,20,00,000 By Misc. 10,00,000 10,00,000
Income

313
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
To Other Expenses 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000 - -
To Net Profit 1,30,00,000 1,80,00,000
9,10,00,000 11,60,00,00 9,10,00,000 11,60,00,00
0 0

Sales are expected to be ₹ 12,00,00,000 in year 3.

As a result, other expenses will increase by ₹ 50,00,000 besides other charges. Only raw materials are in
stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same
amount as between year 1 and 2. You may assume that no dividend is being paid. The Company can use
75% of the cash generated to service a loan. COMPUTE how much cash from operations will be available in
year 3 for the purpose? Ignore income tax.

SOLUTION

Projected Profit and Loss Account for the year 3

Year 2 Year 3 Year 2 Year 3

Actual Projected Actual Projected
(₹ in lakhs) (₹ in lakhs) (₹ in lakhs) (₹ in lakhs)
To Materials consumed 350 420 By Sales 1,000 1,200
To Stores 120 144 By Misc. Income 10 10
To Mfg. Expenses 160 192
To Other expenses 100 150
To Depreciation 100 100
To Net profit 180 204
1,010 1,210 1,010 1,210

Cash Flow:

in lakhs)
Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock 50
Net cash inflow 254

314
Available for servicing the loan: 75% of ₹ 2,54,00,000 or ₹ 1,90,50,000

Working Notes:

(i) Material consumed in year 2: 35% of sales.

Likely consumption in year 3: 1200 X 35 / 100 or 420 lakhs

(ii) Stores are 12% of sales, as in year 2.

(iii) Manufacturing expenses are 16% of sales.

Note: The above also shows how a projected profit and loss account is prepared.

ILLUSTRATION 9
Prachi Ltd is a manufacturing company producing and selling a range of cleaning products to wholesale
customers. It has three suppliers and two customers. Prachi Ltd relies on its cleared funds forecast to
manage its cash.
You are an accounting technician for the company and have been asked to prepare a cleared funds forecast
for the period Friday 7 August to Tuesday 11 August 2020 inclusive. You have been provided with the
following information:

(1) Receipts from customers

Credit terms Payment method 7 Aug 2020 sales 7 Jul 2020

sales
W Ltd 1 calendar month BACS ₹ 150,000 ₹ 130,000
X Ltd None Cheque ₹ 180,000 ₹ 160,000

(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.

(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale is made and will
clear on the third day following this (excluding day of payment).

(2) Payments to suppliers

Supplier name Credit terms Payment 7 Aug 2020 7 Jul 2020 7 Jun 2020
method purchases purchases purchases
A Ltd 1 calendar Standing order ₹ 65,000 ₹ 55,000 ₹ 45,000
month
B Ltd 2 calendar Cheque ₹ 85,000 ₹ 80,000 ₹ 75,000

315
months
C Ltd None Cheque ₹ 95,000 ₹ 90,000 ₹ 85,000

(a) Prachi Ltd has set up a standing order for ₹ 45,000 a month to pay for supplies from A Ltd. This will leave
Prachi’s bank account on 7 August. Every few months, an adjustment is made to reflect the actual cost of
supplies purchased (you do NOT need to make this adjustment).

(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August. The amounts will leave its bank
account on the second day following this (excluding the day of posting).
(3) Wages and salaries

July 2020 August 2020

Weekly wages ₹ 12,000 ₹ 13,000
Monthly salaries ₹ 56,000 ₹ 59,000

(a) Factory workers are paid cash wages (weekly). They will be paid one week’s wages, on 11 August, for the
last week’s work done in July (i.e. they work a week in hand).

(b) All the office workers are paid salaries (monthly) by BACS. Salaries for July will be paid on 7 August.

(4) Other miscellaneous payments

(a) Every Friday morning, the petty cashier withdraws ₹ 200 from the company bank account for the petty
cash. The money leaves Prachi’s bank account straight away.

(b) The room cleaner is paid ₹ 30 from petty cash every Sunday morning.

(c) Office stationery will be ordered by telephone on Saturday 8 August to the value of ₹ 300. This is paid for
by company debit card. Such payments are generally seen to leave the company account on the next
working day.

(d) Five new softwares will be ordered over the Internet on 10 August at a total cost of ₹ 6,500. A cheque
will be
sent out on the same day. The amount will leave Prachi Ltd’s bank account on the second day following this
(excluding the day of posting).

316
(5) Other information
The balance on Prachi’s bank account will be ₹ 200,000 on 7 August 2020. This represents both the book
balance and the cleared funds.

PREPARE a cleared funds forecast for the period Friday 7th August to Tuesday 11th August 2020 inclusive
using the information provided. Show clearly the uncleared funds float each day.

SOLUTION
Cleared Funds Forecast

317
ILLUSTRATION 10

A firm maintains a separate account for cash disbursement. Total disbursement are ₹ 1,05,000 per month or
₹ 12,60,000 per year. Administrative and transaction cost of transferring cash to disbursement account is ₹
20 per transfer. Marketable securities yield is 8% per annum.
DETERMINE the optimum cash balance according to William J. Baumol model.
SOLUTION

The limitation of the Baumol’s model is that it does not allow the cash flows to fluctuate. Firms in practice do
not use their cash balance uniformly nor are they able to predict daily cash inflows and outflows. The Miller-
Orr (MO) model, as discussed below, overcomes this shortcoming and allows for daily cash flow variation.

ILLUSTRATION 11

The following information is available in respect of Sai trading company: (i) On an average, debtors are
collected after 45 days; inventories have an average holding period of 75 days and creditor’s payment
period on an average is 30 days. (ii) The firm spends a total of ₹ 120 lakhs annually at a constant rate. (iii) It
can earn 10 per cent on investments. From the above information, you are required to CALCULATE:

(a) The cash cycle and cash turnover,

(b) Minimum amounts of cash to be maintained to meet payments as they become due,

(c) Savings by reducing the average inventory holding period by 30 days.

SOLUTION

(a) Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months)

Cash turnover = 12 months (360 days)/3 months (90 days) = 4.

(b) Minimum operating cash = Total operating annual outlay/cash turnover, that is, ₹ 120 lakhs/4 = ₹ 30 lakhs.

318
(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months).
Cash turnover = 12 months (360 days)/2 months (60 days) = 6.
Minimum operating cash = ₹ 120 lakhs/6 = ₹ 20 lakhs.
Reduction in investments = ₹ 30 lakhs – ₹ 20 lakhs = ₹ 10 lakhs.
Savings = 0.10 × ₹ 10 lakhs = ₹ 1 lakh.
ILLUSTRATION 12

A company’s requirements for ten days are 6,300 units. The ordering cost per order is ₹ 10 and the carrying
cost per unit is ₹ 0.26. You are required to CALCULATE the economic order quantity.

SOLUTION

The economic order quantity is:

ILLUSTRATION 13

Marvel Limited uses a large quantity of salt in its production process. Annual consumption is 60,000 tonnes
over a 50-week working year. It costs ₹ 100 to initiate and process an order and delivery follow two weeks
later. Storage costs for the salt are estimated at ₹ 0.10 per tonne per annum. The current practice is to order
twice a year when the stock falls to 10,000 tonnes. IDENTIFY an appropriate ordering policy for Marvel
Limited, and contrast it with the cost of the current policy.

SOLUTION

The recommended policy should be based on the EOQ model.

F = ₹ 100 per order

S = 60,000 tonnes per year

H = ₹ 0.10 per tonne per year 319

To compare the optimum policy with the current policy, the average level of stock under the current policy
must be found. An order is placed when stock falls to 10,000 tonnes, but the lead time is two weeks. The stock
used in that time is (60,000×2)/50 = 2,400 tonnes. Before delivery, inventory has fallen to (10,000 – 2,400) =
7,600 tonnes. Orders are made twice per year, and so the order size = 60,000/2 = 30,000 tonnes. The order
will increase stock level to 30,000 + 7,600 = 37,600 tonnes. Hence the average stock level = 7,600 + (30,000/2)
= 22,600 tonnes. Total costs of current policy = (0.1×22,600) + (100×2) = ₹ 2,460 per year.

Advise: The recommended policy should be adopted as the costs are less than the current policy (by ₹ 1,365
per year).

ILLUSTRATION 14

Pureair Company is a distributor of air filters to retail stores. It buys its filters from several manufacturers.
Filters are ordered in lot sizes of 1,000 and each order costs ₹ 40 to place. Demand from retail stores is
20,000 filters per month, and carrying cost is ₹ 0.10 a filter per month.

(a) COMPUTE the optimal order quantity with respect to so many lot sizes?

(b) CALCULATE the optimal order quantity if the carrying cost were ₹ 0.05 a filter per month?

320
(c) COMPUTE the optimal order quantity if ordering costs were ₹ 10?

SOLUTION
ILLUSTRATION 15
A trader whose current sales are in the region of ₹ 6 lakhs per annum and an average collection period of 30
days wants to pursue a more liberal policy to improve sales. A study made by a management consultant
reveals the following information:-

Credit Policy Increase in Increase in sales Present default anticipated

collection period
A 10 days ₹ 30,000 1.5%
B 20 days ₹ 48,000 2%
C 30 days ₹ 75,000 3%
D 45 days ₹ 90,000 4%

The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable costs per unit are ₹ 2. The
current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.
ANALYSE which of the above policies would you recommend for adoption?

321
SOLUTION

A. Statement showing the Evaluation of Debtors Policies (Total Approach)

Particulars Present Policy 30 Proposed Policy Proposed Policy Proposed Policy Proposed
days A 40 days B 50 days C 60 days Policy D 75
days
₹ ₹ ₹ ₹ ₹

A. Expected
Profit:
(a) Credit 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
Sales
(b) Total
Cost other
than Bad
Debts
(i) Variable 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
Costs
[Sales × 2/
3]
(ii)Fixed 50,000 50,000 50,000 50,000 50,000
Costs
4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
(c) Bad 6,000 9,450 12,960 20,250 27,600
Debts
(d) Expected 1,44,000 1,50,550 1,53,040 1,54,750 1,52,400
Profit [(a) –
(b) – (c)]
B. 7,500 10,444 13,389 16,667 21,250
Opportunity
Cost of
Investments

322
in
Receivables
C. Net 1,36,500 1,40,106 1,39,651 1,38,083 1,31,150
Benefits (A
– B)

Recommendation: The Proposed Policy A (i.e. increase in collection period by 10 days or total 40 days) should
be adopted since the net benefits under this policy are higher as compared to other policies.
Working Notes:

(i) Calculation of Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of Units sold
= [₹ 2.25 - ₹ 2.00] × (₹ 6,00,000/3)
= ₹ 0.25 × 2,00,000 = ₹ 50,000

(ii) Calculation of Opportunity Cost of Average Investments

B. Another method of solving the problem is Incremental Approach. Here we assume that sales are all credit
sales

Particulars Present Policy 30 days Proposed Proposed Proposed Proposed

Policy A 40 Policy B 50 Policy C 60 Policy D

323
days days days 75 days
₹ ₹ ₹ ₹ ₹
A. Incremental Expected
Profit:
(a) Incremental Credit --- 30,000 48,000 75,000 90,000
Sales
(b) Incremental Costs
(i) Variable Costs --- 20,000 32,000 50,000 60,000
(ii)Fixed Costs --- - - - -
(c) Incremental Bad --- 3,450 6,960 14,250 21,600
Debt Losses
(d) Incremental 6,550 9,040 10,750 8,400
Expected Profit (a – b –
c)]
B. Required Return on
Incremental Investments:
(a) Cost of Credit Sales 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
(b) Collection period 30 40 50 60 75
(c) Investment in 37,500 52,222 66,944 83,333 1,06,250
Receivable (a × b/360)
(d) Incremental --- 14,722 29,444 45,833 68,750
Investment in
Receivables

(e) Required Rate of 20 20 20 20

Return (in %)
(f) Required Return --- 2,944 5,889 9,167 13,750
on Incremental
Investments (d× e)
C. Net Benefits (A – B) --- 3,606 3,151 1,583 - 5,350

Recommendation: The Proposed Policy A should be adopted since the net benefits under this policy are
higher than those under other policies.

324
C. Another method of solving the problem is by computing the Expected Rate of Return.

Recommendation: The Proposed Policy A should be adopted since the Expected Rate of Return (44.49%) is
more than the Required Rate of Return (20%) and is highest among the given policies compared.

ILLUSTRATION 16
XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two
proposed policies. Currently, the firm has annual credit sales of ₹ 50 lakhs and accounts receivable turnover
ratio of 4 times a year. The current level of loss due to bad debts is ₹ 1,50,000. The firm is required to give a
return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the
selling price. Given the following information, IDENTIFY which is the better option?

Present Policy Policy

Policy Option I Option II
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover 4 times 3 times 2.4 times
ratio

325
Bad debt losses 1,50,000 3,00,000 4,50,000

SOLUTION
Statement showing the Evaluation of Debtors Policies

Particulars Present Policy Proposed Proposed

Policy I Policy II
₹ ₹
A Expected Profit:
(a) Credit Sales 50,00,000 60,00,000 67,50,000
(b) Total Cost other than Bad
Debts:
(i) Variable Costs 35,00,000 42,00,000 47,25,000
(c) Bad Debts 1,50,000 3,00,000 4,50,000
(d) Expected Profit [(a) – (b) – 13,50,000 15,00,000 15,75,000
(c)]
B Opportunity Cost of 2,18,750 3,50,000 4,92,188
Investments in Receivables
C Net Benefits (A – B) 11,31,250 11,50,000 10,82,812

Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy are higher
as compared to other policies.

326
ILLUSTRATION 17
A company is presently having credit sales of ₹ 12 lakh. The existing credit terms are 1/10, net 45 days and
average collection period is 30 days. The current bad debts loss is 1.5%. In order to accelerate the collection
process further as also to increase sales, the company is contemplating liberalization of its existing credit
terms to 2/10, net 45 days. It is expected that sales are likely to increase by 1/3 of existing sales, bad debts
increase to 2% of sales and average collection period to decline to 20 days. The contribution to sales ratio of
the company is 22% and opportunity cost of investment in receivables is 15 percent (pre-tax). 50 per cent
and 80 percent of customers in terms of sales revenue are expected to avail cash discount under existing
and liberalization scheme respectively. The tax rate is 30%.
ADVISE, should the company change its credit terms? (Assume 360 days in a year).
SOLUTION
Working Notes:
(i) Calculation of Cash Discount
Cash Discount = Total credit sales × % of customers who take up discount × Rate

(ii) Opportunity Cost of Investment in Receivables

Present Policy = 9,36,000 × (30/360) × (70% of 15)/100 = 78,000 × 10.5/100 = ₹ 8,190
Proposed Policy = 12,48,000 × (20/360) × 10.50/100 = ₹ 7,280
Statement showing Evaluation of Credit Policies

Particulars Present Policy Proposed Policy

Credit Sales 12,00,000 16,00,000
Variable Cost @ 78%* of sales 9,36,000 12,48,000
Bad Debts @ 1.5% and 2% 18,000 32,000

*Only relevant or variable costs are considered for calculating the opportunity costs on the funds blocked in receivables.
Since 22% is contribution, hence the relevant costs are taken to be 78% of the respective sales. Advise: Proposed policy
should be adopted since the net benefit is increased by (₹ 1,98,800 − 1,59,810) ₹ 38,990.

327
ILLUSTRATION 17

A Factoring firm has credit sales of ₹ 360 lakhs and its average collection period is 30 days. The financial
controller estimates, bad debt losses are around 2% of credit sales. The firm spends ₹ 1,40,000 annually on
debtors administration. This cost comprises of telephonic and fax bills along with salaries of staff members.
These are the avoidable costs. A Factoring firm has offered to buy the firm’s receivables. The factor will
charge 1% commission and will pay an advance against receivables on an interest @15% p.a. after
withholding 10% as reserve. ANALYSE what should the firm do?
Assume 360 days in a year.
SOLUTION

Working notes:

Evaluation of Factoring Proposal

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ILLUSTRATION 18
Mosaic Limited has current sales of ₹ 15 lakhs per year. Cost of sales is 75 per cent of sales and bad debts
are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent fixed costs,
while the company’s required rate of return is 12 per cent. Mosaic Limited currently allows customers 30
days’ credit, but is considering increasing this to 60 days’ credit in order to increase sales.
It has been estimated that this change in policy will increase sales by 15 per cent, while bad debts will
increase from one per cent to four per cent. It is not expected that the policy change will result in an
increase in fixed costs and creditors and stock will be unchanged.
Should Mosaic Limited introduce the proposed policy? ANALYSE (Assume a 360 days year)

SOLUTION

New level of sales will be 15,00,000 × 1.15 = ₹ 17,25,000

Variable costs are 80% × 75% = 60% of sales
Contribution from sales is therefore 40% of sales
Fixed Cost are 20% × 75% = 15% of sales

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* Fixed Cost is taken at existing level in case of proposed investment as well

Advise: Mosaic Limited should introduce the proposed policy.
ILLUSTRATION 19
Suppose ABC Ltd. has been offered credit terms from its major supplier of 2/10, net 45. Hence the company
has the choice of paying ₹ 10 per ₹ 100 or to invest ₹ 98 for an additional 35 days and eventually pay the
supplier ₹ 100 per ₹ 100. The decision as to whether the discount should be accepted depends on the
opportunity cost of investing ₹ 98 for 35 days. ANALYSE what should the company do?

SOLUTION

If the company does not avail the cash discount and pays the amount after 45 days, the implied cost of
interest per annum would be approximately:

Now let us assume that ABC Ltd. can invest the additional cash and can obtain an annual return of 25% and if
the amount of invoice is ₹ 10,000. The alternatives are as follows:

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Advise: Thus, it is better for the company to refuse the discount, as return on cash retained is more than the
saving on account of discount.

ILLUSTRATION 20
The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s records
by the owner, Mr. Gautam, revealed that payments are usually made 15 days after purchases are made.
When asked why the firm did not take advantage of its discounts, the accountant, Mr. Rohit, replied that it
cost only 2 per cent for these funds, whereas a bank loan would cost the company 12 per cent.
(a) ANALYSE what mistake is Rohit making?

(b) If the firm could not borrow from the bank and was forced to resort to the use of trade credit funds,
what suggestion might be made to Rohit that would reduce the annual interest cost? IDENTIFY.

SOLUTION

(a) Rohit’s argument of comparing 2% discount with 12% bank loan rate is not rational as 2% discount can be
earned by making payment 5 days in advance i.e. within 10 days rather 15 days as payments are made
presently. Whereas 12% bank loan rate is for a year.
Assume that the purchase value is ₹100, the discount can be earned by making payment within 10 days is ₹2,
therefore, net payment would be ₹98 only. Annualized benefit

This means cost of not taking cash discount is 149%.

(b) If the bank loan facility could not be available, then in this case the company should resort to utilise
maximum credit period as possible.
Therefore, payment should be made in 30 days to reduce the interest cost.

Example - 1: From the following data, calculate the maximum permissible bank finance under the three
methods suggested by the Tandon Committee:

Liabilities ₹ in lakhs
Creditors 120
Other current liabilities 40
Bank borrowing 250
Total 410
Current Assets ₹ in lakhs
Raw material 180

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Work-in-progress 60
Finished goods 100
Receivables 150
Other current assets 20
Total current assets 510
The total Core Current Assets (CCA)
are ₹ 200 lakhs

Solution
The maximum permissible bank finance for the firm, under three methods may be ascertained as follows:

Method I: = 0.75 (CA – CL)

= 0.75 (510 – 160)
= ₹ 262.50 lakhs

Method II: = 0.75 CA – CL

= 0.75 × 510 – 160
= ₹ 222.50 lakhs

Method III: = 0.75 (CA – CCA) – CL

= 0.75 (510 – 200) – 160
= ₹ 72.50 lakhs

So, it may be noted that the MPBF decreases gradually from the first method to second method and then to
third method. As the firm, has already availed the bank loan of 250 lakhs, it can still avail a loan of ₹ 12.50
lakhs as per the first method. However, as per the second and third method, it is not eligible for additional
financing as maximum financing allowed is for ₹ 222.50 lakhs and ₹ 72.50 lakhs only whereas its present bank
borrowings are already ₹ 250 lakhs.

MCQs based Questions

1. The credit terms may be expressed as “3/15 net 60”. This means that a 3% discount will be granted if the
customer pays within 15 days, if he does not avail the offer he must make payment within 60 days.

(a) I agree with the statement

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(b) I do not agree with the statement

(c) I cannot say.

ANSWER 1-A
2. The term ‘net 50’ implies that the customer will make payment:

(a) Exactly on 50th day

(b) Before 50th day

(c) Not later than 50th day

(d) None of the above.

ANSWER 2-C

3. Trade credit is a source of :

(a) Long-term finance

(b) Medium term finance

(c) Spontaneous source of finance

(d) None of the above.

ANSWER 3-C

4. The term float is used in:

(a) Inventory Management

(b) Receivable Management

(c) Cash Management 333

(d) Marketable securities.

ANSWER 4-C
5. William J Baumol’s model of Cash Management determines optimum cash level where the carrying cost
and transaction cost are:

(a) Maximum

(b) Minimum

(c) Medium

(d) None of the above.

ANSWER 5-B

6. In Miller – ORR Model of Cash Management:

(a) The lower, upper limit, and return point of Cash Balances are set out

(b) Only upper limit and return point are decided

(c) Only lower limit and return point are decided

(d) None of the above are decided.

ANSWER 6-A

7. Working Capital is defined as:

(a) Excess of current assets over current liabilities

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(b) Excess of current liabilities over current assets

(c) Excess of Fixed Assets over long-term liabilities

(d) None of the above.

ANSWER 7-A
8. Working Capital is also known as “Circulating Capital, fluctuating Capital and revolving capital”. The
aforesaid statement is;

(a) Correct

(b) Incorrect

(c) Cannot say.

ANSWER 8-A

9. The basic objectives of Working Capital Management are:

(a) Optimum utilization of resources for profitability

(b) To meet day-to-day current obligations

(c) Ensuring marginal return on current assets is always more than cost of capital

(d) Select any one of the above statements.

ANSWER 9-B

10. The term Gross Working Capital is known as:

(a) The investment in current liabilities

(b) The investment in long-term liability

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(c) The investment in current assets

(d) None of the above.

ANSWER 10-C
11. The term net working capital refers to the difference between the current assets minus current
liabilities.

(a) The statement is correct

(b) The statement is incorrect

(c) I cannot say.

ANSWER 11-A

12. The term “Core current assets’ was coined by:

(a) Chore Committee

(b) Tandon Committee

(c) Jilani Committee

(d) None of the above.

ANSWER 12-B

13. The concept operating cycle refers to the average time which elapses between the acquisition of raw
materials and the final cash realization. This statement is:

(a) Correct

(b) Incorrect 336

(c) Partially True

(d) I cannot say.

ANSWER 13-A
14. As a matter of self-imposed financial discipline can there be a situation of zero working capital now-a-
days in some of the professionally managed organizations.

(a) Yes

(b) No

(c) Impossible

(d) Cannot say.

ANSWER 14-A

15. Over trading arises when a business expands beyond the level of funds available. The statement is:

(a) Incorrect

(b) Correct

(c) Partially correct

(d) I cannot say.

ANSWER 15-B

16. A Conservative Working Capital strategy calls for high levels of current assets in relation to sales.

(a) I agree

(b) Do not agree

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(c) I cannot say.

ANSWER 16-A
17. The term Working Capital leverage refer to the impact of level of working capital on company’s
profitability. This measures the responsiveness of ROCE for changes in current assets.

(a) I agree

(b) Do not agree

(c) The statement is partially true.

ANSWER 17-A

18. The term spontaneous source of finance refers to the finance which naturally arise in the course of
business operations. The statement is:

(a) Correct

(b) Incorrect

(c) Partially Correct

(d) I cannot say.

ANSWER 18-A

19. Under hedging approach to financing of working capital requirements of a firm, each asset in the
balance sheet assets side would be offset with a financing instrument of the same approximate maturity.
This statement is:

(a) Incorrect

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(b) Correct

(c) Partially correct

(d) I cannot say.

ANSWER 19-B
20. Trade credit is a:

(a) Negotiated source of finance

(b) Hybrid source of finance

(c) Spontaneous source of finance

(d) None of the above.

ANSWER 20-C

21. Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial
institution.
The statement is:

(a) Correct

(b) Incorrect

(c) Partially correct

(d) I cannot say.

ANSWER 21-A

22. A factoring arrangement can be both with recourse as well as without recourse:

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(a) True

(b) False

(c) Partially correct

(d) Cannot say.

ANSWER 22-A
23. The Bank financing of working capital will generally be in the following form. Cash Credit, Overdraft, bills
discounting, bills acceptance, line of credit; Letter of credit and bank guarantee.

(a) I agree

(b) I do not agree

(c) I cannot say.

ANSWER 23-A

24. When the items of inventory are classified according to value of usage, the technique is known as:

(a) XYZ Analysis

(b) ABC Analysis

(c) DEF Analysis

(d) None of the above.

ANSWER 24-B

25. When a firm advises its customers to mail their payments to special Post Office collection centers, the
system is known as.

(a) Concentration banking

(b) Lock Box system

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(c) Playing the float

(d) None of the above.

ANSWER 25-B
Theoretical Questions

1. DISCUSS the factors to be taken into consideration while determining the requirement of working capital.

ANSWER 1
Working capital management is concerned with:

(a) Maintaining adequate working capital (managing the level of individual current assets and the current
liabilities) and

(b) Financing of the working capital.

For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its
business.
And once the requirement has been computed he needs to ensure that it is financed properly. This whole
exercise is known as Working Capital Management. Sound financial and statistical techniques, supported by
judgment should be used to predict the quantum of working capital required at different times. Some of the
factors which need to be considered while planning for working capital requirement are

1. Cash – Identify the cash balance which allows for the business to meet day-to-day expenses, but reduces
cash holding costs (example - loss of interest on long term investment had the surplus cash invested therein).

2. Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials and hence increases cash flow. The techniques like Just in Time (JIT) and
Economic order quantity (EOQ) are used for this.

3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence
Return on Capital (or vice versa). The tools like Early Payment Discounts and allowances are used for this.

4. Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier. However,
depending on the cash conversion cycle, it may be necessary to utilize a bank loan (or overdraft), or to

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“convert debtors to cash” through “factoring” in order to finance working capital requirements.

5. Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore, need for
working capital is very less. On the other hand, there would be a higher inventory in case of a pharmacy or a
bookstore.

6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working
capital requirement would be less as investment in finished goods inventory would be very less with
continuous sales.
7. Technology and Manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in
that case a business may follow a policy for steady production throughout the whole year or rather may
choose a policy of production only during the demand season.

8. Operating Efficiency – A company can reduce the working capital requirement by eliminating waste,
improving coordination, process improvements etc.

9. Price Level Changes & Exchange Rate Fluctuations – For e.g. rising prices necessitate the use of more
funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are
required. Therefore, the effect of rising prices is that a higher amount of working capital is required. Another
example would be unfavorable exchange rate movement in case of imported raw materials would warrant
additional cost of same.

2. DISCUSS the liquidity vs. profitability issue in management of working capital.

ANSWER 2

The trade-off between the components of working capital can be summarised as follows:

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3. DISCUSS the estimation of working capital need based on operating cycle process.

ANSWER 3

Operating cycle is one of the most reliable methods of Computation of Working Capital. However, other
methods like ratio of sales and ratio of fixed investment may also be used to determine the Working Capital
requirements. These methods are briefly explained as follows:
(i) Current Assets Holding Period: To estimate working capital needs based on the average holding period of
current assets and relating them to costs based on the company’s experience in the previous year. This
method is essentially based on the Operating Cycle Concept.

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(ii) Ratio of Sales: To estimate working capital needs as a ratio of sales on the assumption that current assets
change with changes in sales.

iii) Ratio of Fixed Investments: To estimate Working Capital requirements as a percentage of fixed
investments. A number of factors will, however, be impacting the choice of method of estimating Working
Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and variability in sales
price would generally be considered. The production cycle and credit and collection policies of the firm will
have an impact on Working Capital requirements. Therefore, they should be given due weightage in projecting
Working Capital requirements.
4. EXPLAIN briefly the functions of Treasury Department.
ANSWER 4

1. Cash Management: It involves efficient cash collection process and managing payment of cash both inside
the organisation and to third parties.
There may be complete centralization within a group treasury or the treasury may simply advise subsidiaries
and divisions on policy matter viz., collection/payment periods, discounts, etc.
Treasury will also manage surplus funds in an investment portfolio. Investment policy will consider future
needs for liquid funds and acceptable levels of risk as determined by company policy.
2. Currency Management: The treasury department manages the foreign currency risk exposure of the
company. In a large multinational company (MNC) the first step will usually be to set off intra-group
indebtedness. The use of matching receipts and payments in the same currency will save transaction costs and
also will save the organization from any unfavorable exchange movements. Accordingly, Treasury might advise
on the currency to be used when invoicing overseas sales.
The treasury will manage any net exchange exposures in accordance with company policy. If risks are to be
minimized then forward contracts can be used either to buy or sell currency forward.
3. Fund Management: Treasury department is responsible for planning and sourcing the company’s short,
medium and long-term cash needs. They also facilitate temporary investment of surplus funds by mapping the
time gap between funds inflow and outflow. Treasury department will also participate in the decision on
capital structure and forecast future interest and foreign currency rates.
4. Banking: It is important that a company maintains a good relationship with its bankers. Treasury
department carry out negotiations with bankers with respect to interest rates, foreign exchange rates etc. and
act as the initial point of contact with them. Short-term finance can come in the form of bank loans or through
the sale of commercial paper in the money market.
5. Corporate Finance: Treasury department is involved with both acquisition and divestment activities within
the group. In addition, it will often have responsibility for investor relations. The latter activity has assumed
increased importance in markets where share-price performance is regarded as crucial and may affect the
company’s ability to undertake acquisition activity or, if the price falls drastically, render it vulnerable to a
hostile bid.

5. STATE the advantage of Electronic Cash Management System.

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ANSWER 5

Electronic-scientific cash management results in:

Significant saving in time.

Increase in Interest earned & Decrease in interest expense.
Reduces paper work & hence manpower

Greater accounting accuracy as it allows easy detection of book-keeping errors.

More control over time and funds.
 Supports electronic payments.

Faster transfer of funds from one location to another, where required.

Speedy conversion of various instruments into cash.

Making available funds wherever required, whenever required.

Reduction in the amount of ‘idle float’ to the maximum possible extent.

Ensures no idle funds are placed at any place in the organization.

It makes inter-bank balancing of funds much easier.

It is a true form of centralized ‘Cash Management’.

Produces faster electronic reconciliation.
Reduces the number of cheques issued.

6. EXPLAIN with example the formula used for determining optimum cash balance according to Baumol’s
cash management model.

ANSWER 6

According to this model, optimum cash level is that level of cash where the carrying costs and transactions
costs are the minimum.
The carrying costs refer to the cost of holding cash, namely, the opportunity cost or interest foregone on
marketable securities. The transaction costs refer to the cost involved in getting the marketable securities
converted into cash. This happens when the firm falls short of cash and has to sell the securities resulting in
clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point where these two costs are minimum. The
formula for determining optimum cash balance is:

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Where, C = Optimum cash balance
U = Annual (or monthly) cash disbursement
P = Fixed cost per transaction.
S = Opportunity cost of one rupee p.a. (or p.m.)
This can be explained with the following diagram:
The model is based on the following assumptions:
(i) Cash needs of the firm are known with certainty.
(ii) The cash is used uniformly over a period of time and it is also known with certainty.
(iii) The holding cost is known and it is constant.
(iv) The transaction cost also remains constant

7. DISCUSS Miller-Orr Cash Management model.

ANSWER 7

Miller-Orr Cash Management Model (1966)

According to this model the net cash flow is completely stochastic.
When changes in cash balance occur randomly the application of control theory serves a useful purpose. The
Miller-Orr model is one of such control limit models.

This model is designed to determine the time and size of transfers between an investment account and cash
account. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as
the return point; and zero as the lower limit.

When the cash balance reaches the upper limit, the transfer of cash equal to h – z is invested in marketable
securities account.
When it touches the lower limit, a transfer from marketable securities account to cash account is made.

During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low limits no transactions
between cash and marketable securities account is made. The high and low limits of cash balance are set up

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on the basis of fixed cost associated with the securities transactions, the opportunity cost of holding cash and
the degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest
possible total costs.
8. EXPLAIN briefly the accounts receivable systems.
ANSWER 8

Following are the major determinants for significant innovations in accounts receivable management and
process efficiency.

1. Re-engineering Receivable Process: In some of the organizations real cost reductions and performance
improvements have been achieved by re-engineering in accounts receivable process. Re-engineering is a
fundamental re-think and re-design of business processes by incorporating modern business approaches. The
nature of accounts receivables is such that decisions made elsewhere in the organization are likely to affect
the level of resources that are expended on the management of accounts receivables.

2. Evaluation of Risk: Risk evaluation is a major component in the establishment of an effective control
mechanism. Once risks have been properly assessed controls can be introduced to either contain the risk to an
acceptable level or to eliminate them entirely. This also provides an opportunity for removing inefficient
practices. This involves a re-think of processes and questioning the way that tasks are performed. This also
opens the way for efficiency and effectiveness benefits in the management of accounts receivables.

3. Use of Latest Technology: Technological developments now-a-days provides an opportunity for

improvement in accounts receivables process. The major innovations available are the integration of systems
used in the management of accounts receivables, the automation and the use of e-commerce.

4. Receivable Collection Practices: The aim of debtors’ collection should be to reduce, monitor and control the
accounts receivable at the same time maintain customer goodwill. The fundamental rule of sound receivable
management should be to reduce the time lag between the sale and collection. Any delays that lengthen this
span causes receivables to unnecessary build up and increase the risk of bad debts. This is equally true for the
delays caused by billing and collection procedures as it is for delays caused by the customer.

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9. DESCRIBE Factoring.
ANSWER 9

Factoring: Factoring is a relatively new concept in financing of accounts receivables. This refers to outright sale
of accounts receivables to a factor or a financial agency. A factor is a firm that acquires the receivables of
other firms. The factoring lays down the conditions of the sale in a factoring agreement. The factoring agency
bears the risk of collection and services the accounts for a fee.

Factoring arrangement can be either on a recourse basis or on a non-recourse basis:

 - Recourse: In case factor is unable to collect the amount from receivables then, factor can turn back the
same to the organization for resolution (which generally is by replacing those receivables with new
receivables)

- Non-Recourse: The factor bears the ultimate risk of loss in case of default and hence in such cases they
charge higher commission.
There are a number of financial institutions providing factoring services in India. Some commercial banks and
other financial agencies provide this service. The biggest advantages of factoring are the immediate
conversion of receivables into cash and predicted pattern of cash flows. Financing receivables with the help of
factoring can help a company having liquidity without creating a net liability on its financial condition and
hence no impact on debt equity ratio. Besides, factoring is a flexible financial tool providing timely funds,
efficient record keepings and effective management of the collection process. This is not considered as a loan.
There is no debt repayment and hence no compromise to balance sheet, no long-term agreements or delays
associated with other methods of raising capital. Factoring allows the firm to use cash for the growth needs of
business.

10. DESCRIBE the various forms of bank credit in financing the working capital of a business organization.

ANSWER 10

The bank credit will generally be in the following forms:

Cash Credit: This facility will be given by the banker to the customers by giving certain amount of credit
facility on continuous basis. The borrower will not be allowed to exceed the limits sanctioned by the bank.

Bank Overdraft: It is a short-term borrowing facility made available to the companies in case of urgent need
of funds. The banks will impose limits on the amount they can lend. When the borrowed funds are no longer
required they can quickly and easily be repaid. The banks issue overdrafts with a right to call them in at short
notice.

Bills Discounting: The Company which sells goods on credit will normally draw a bill on the buyer who will
accept it and sends it to the seller of goods. The seller, in turn discounts the bill with his banker. The banker
will generally earmark the discounting bill limit.

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Bills Acceptance: To obtain finance under this type of arrangement a company draws a bill of exchange on
bank. The bank accepts the bill thereby promising to pay out the amount of the bill at some specified future
date.
Line of Credit: Line of Credit is a commitment by a bank to lend a certain amount of funds on demand
specifying the maximum amount.

Letter of Credit: It is an arrangement by which the issuing bank on the instructions of a customer or on its
own behalf undertakes to pay or accept or negotiate or authorizes another bank to do so against stipulated
documents subject to compliance with specified terms and conditions.
 Bank Guarantees: Bank guarantee is one of the facilities that the commercial banks extend on behalf of
their clients in favour of third parties who will be the beneficiaries of the guarantees.

Practical Problems

1. Following information is forecasted by R Limited for the year ending 31st March, 2020:

Balance as at 31st Balance as at 31st March,

March, 2020 2019
(₹ in lakh) (₹ in lakh)
Raw Material 65 45
Work-in-progress 51 35
Finished goods 70 60
Receivables 135 112
Payables 71 68
Annual purchases of raw material (all 400
credit)
Annual cost of production 450
Annual cost of goods sold 525
Annual operating cost 325
Annual sales (all credit) 585

You may take one year as equal to 365 days.

You are required to CALCULATE:

(i) Net operating cycle period.

(ii) Number of operating cycles in the year.

(iii) Amount of working capital requirement.

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ANSWER 1
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2. The following figures and ratios are related to a company:

(i) Sales for the year (all credit) ₹ 90,00,000

(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5

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(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1

You are required to PREPARE:

(a) Balance Sheet of the company on the basis of above details.

(b) The statement showing working capital requirement, if the company wants to make a provision for
contingencies @15 percent of net working capital.

ANSWER 2

Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)
= ₹ 90,00,000 – ₹ 31,50,000
= ₹ 58,50,000

(ii) Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 58,50,000/6 = ₹ 9,75,000

(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover

= ₹ 58,50,000/1.5
= ₹ 39,00,000

(iv) Current Assets :

Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
Current Assets = Amount of Inventories (Stock) × 2.5/1
= ₹ 9,75,000 × 2.5/1 = ₹ 24,37,500

Or

Current Ratio / Quick Ratio = Current Assets / Quick Assets

2.5 / 1.5 = Current Assets / (Current Assets – Inventory)

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2.5/1.5 Current Assets – 2.5/1.5 x ₹ 9,75,000 = Current Assets

Hence, Current Assets = ₹ 24,37,500

(v) Liquid Assets (Receivables and Cash)

= Current Assets – Inventories (Stock)
= ₹ 24,37,500 – ₹ 9,75,000
= ₹14,62,500
(vi) Receivables (Debtors) = Sales × Debtors Collection period /12
= ₹ 90,00,000 × 1/12
= ₹ 7,50,000

(vii) Cash = Liquid Assets – Receivables (Debtors)

= ₹14,62,500 – ₹ 7,50,000 = ₹ 7,12,500

(viii) Net worth = Fixed Assets /1.3

= ₹ 39,00,000/1.3 = ₹ 30,00,000

(ix) Reserves and Surplus

Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
Reserves and Surplus = ₹ 30,00,000 × 1/1.5
= ₹ 20,00,000

(x) Share Capital = Net worth – Reserves and Surplus

= ₹ 30,00,000 – ₹ 20,00,000
= ₹ 10,00,000

(xi) Current Liabilities = Current Assets/ Current Ratio

= ₹ 24,37,500/2.5 = ₹ 9,75,000

(xii) Long-term Debts

Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ₹30,00,000 × 0.7875 = ₹23,62,500

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3. PQ Ltd., a company newly commencing business in 2020 has the following projected Profit and Loss
Account:

Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less: Stock of Finished goods 17,000
(10% of goods produced not yet sold)
1,53,000

The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the
year’s production (in terms of physical units) will be in process on the average requiring full materials but
only 40% of the other expenses. The company believes in keeping materials equal to two months’
consumption in stock.

All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months credit.
Sales will be 20% for cash and the rest at two months’ credit. 70% of the Income tax will be paid in advance
in quarterly instalments. The company wishes to keep ₹ 8,000 in cash. 10% has to be added to the estimated
figure for unforeseen contingencies.

PREPARE an estimate of working capital.

Note: All workings should form part of the answer.

ANSWER 3

Statement showing the requirements of Working Capital

Particulars (₹) (₹)

354
A. Current Assets:
Inventory:
Stock of Raw material (₹ 96,600 × 2/12) 16,100
Stock of Work-in-progress (As per Working Note) 16,350
Stock of Finished goods (₹ 1,46,500 × 10/100) 14,650
Receivables (Debtors) (₹1,27,080 × 2/12) 21,180
Cash in Hand 8,000
Prepaid Expenses:
Wages & Mfg. Expenses (₹ 66,250 × 1/12) 5,521
Administrative expenses (₹ 14,000 × 1/12) 1,167
Selling & Distribution Expenses (₹13,000 × 1/12) 1,083
Advance taxes paid {(70% of ₹10,000)× 3/12} 1,750

Working Notes:
(i) Calculation of Stock of Work-in-progress

Particulars (₹)
Raw Material (₹ 84,000 × 15%) 12,600
Wages & Mfg. Expenses (₹ 62,500 × 15% × 40%) 3,750
Total 16,350

(ii) Calculation of Stock of Finished Goods and Cost of Sales

Particulars (₹)
Direct material Cost [₹ 84,000 + ₹ 12,600] 96,600
Wages & Mfg. Expenses [₹62,500 + ₹ 3,750] 66,250
Depreciation 0
Gross Factory Cost 1,62,850
Less: Closing W.I.P (16,350)
Cost of goods produced 1,46,500
Add: Administrative Expenses 14,000
1,60,500
Less: Closing stock (14,650)
Cost of Goods Sold 1,45,850
Add: Selling and Distribution Expenses 13,000
Total Cash Cost of Sales 1,58,850
Debtors (80% of cash cost of sales) 1,27,080

(iii) Calculation of Credit Purchase

Particulars (₹)

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Raw material consumed 96,600
Add: Closing Stock 16,100
Less: Opening Stock -
Purchases 1,12,700
4. M.A. Limited is commencing a new project for manufacture of a plastic component. The following cost
information has been ascertained for annual production of 12,000 units which is the full capacity:

Costs per unit (₹)

Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00

The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per unit, 80% of which is
variable.
In the first two years of operations, production and sales are expected to be as follows:

Year Production (No. of units) Sales (No. of units)

1 6,000 5,000
2 9,000 8,500

To assess the working capital requirements, the following additional information is available:

(a) Stock of materials 2.25 months’ average

consumption
(b) Work-in-process Nil
(c) Debtors 1 month’s average sales.
(d) Cash balance ₹ 10,000
(e) Creditors for supply of 1 month’s average
materials purchase during the
year.
(f) Creditors for expenses 1 month’s average of all
expenses during the
year.

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PREPARE, for the two years:

(i) A projected statement of Profit/Loss (Ignoring taxation); and

(ii) A projected statement of working capital requirements.

ANSWER 4

(i) M.A. Limited

Projected Statement of Profit / Loss
(Ignoring Taxation)

Year 1 Year 2
Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
(₹) (₹)
Sales revenue (A) 4,80,000 8,16,000
(Sales unit × ₹ 96)
Cost of production:
Materials cost 2,40,000 3,60,000
(Units produced × ₹ 40)
Direct labour and variable expenses 1,20,000 1,80,000
(Units produced × ₹ 20)
Fixed manufacturing expenses 72,000 72,000
(Production Capacity: 12,000 units × ₹ 6)
Depreciation 1,20,000 1,20,000
(Production Capacity : 12,000 units × ₹ 10)
Fixed administration expenses 48,000 48,000
(Production Capacity : 12,000 units × ₹ 4)
Total Costs of Production 6,00,000 7,80,000
Add: Opening stock of finished goods --- 1,00,000
(Year 1 : Nil; Year 2 : 1,000 units)
Cost of Goods available for sale 6,00,000 8,80,000
(Year 1: 6,000 units; Year 2: 10,000 units)
Less: Closing stock of finished goods at average cost (year 1: 1000 (1,00,000) (1,32,000)
units, year 2 : 1500 units)
(Cost of Production × Closing stock/ units produced)
Cost of Goods Sold 5,00,000 7,48,000
Add: Selling expenses – Variable (Sales unit × ₹ 4) 20,000 34,000
Add: Selling expenses -Fixed (12,000 units × ₹1) 12,000 12,000
Cost of Sales : (B) 5,32,000 7,94,000
Profit (+) / Loss (-): (A - B) (-) 52,000 (+) 22,000

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Working Notes:

1. Calculation of creditors for supply of materials:

Year 1 (₹) Year 2 (₹)

Materials consumed during the year 2,40,000 3,60,000
Add: Closing stock (2.25 month’s average consumption) 45,000 67,500
2,85,000 4,27,500
Less: Opening Stock --- 45,000
Purchases during the year 2,85,000 3,82,500
Average purchases per month (Creditors) 23,750 31,875

2. Creditors for expenses:

Year 1 (₹) Year 2 (₹)

Direct labour and variable expenses 1,20,000 1,80,000
Fixed manufacturing expenses 72,000 72,000
Fixed administration expenses 48,000 48,000
Selling expenses (variable + fixed) 32,000 46,000
Total (including 2,72,000 3,46,000
Average per month 22,667 28,833

(ii) Projected Statement of Working Capital requirements

Year 1 (₹) Year 2 (₹)

Current Assets:
Inventories:
- Stock of materials 45,000 67,500
(2.25 month’s average consumption)
- Finished goods 1,00,000 1,32,000
Debtors (1 month’s average sales) (including profit) 40,000 68,000

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Cash 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,95,000 2,77,500
Current Liabilities:
Creditors for supply of materials 23,750 31,875
(Refer to working note 1)
Creditors for expenses 22,667 28,833
(Refer to working note 2)
Total Current Liabilities: (B) 46,417 60,708
Estimated Working Capital Requirements: (A-B) 1,48,583 2,16,792
Projected Statement of Working Capital Requirement (Cash Cost Basis)

Year 1 (₹) Year 2 (₹)

(A) Current Assets

Inventories:

- Stock of Raw Material 45,000 67,500

(6,000 units X ₹ 40 X 2.25/12)
(9,000 units X ₹ 40 X 2.25 /12)
- Finished Goods (Refer working note 3) 80,000 1,11,000
Receivables (Debtors) (Refer working note 4) 36,000 56,250
Minimum Cash balance 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,71,000 2,44,750
(B) Current Liabilities
Creditors for raw material (Refer working note 1) 23,750 31,875
Creditors for Expenses (Refer working note 2) 22,667 28,833
Total Current Liabilities 46,417 60,708
Net Working Capital (A – B) 1,24,583 1,84,042

Working Note:
3. Cash Cost of Production:

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4. Receivables (Debtors)

Year 1 (₹) Year 2 (₹)

Cash Cost of Goods Sold 4,00,000 6,29,000
Add : Variable Expenses @ ₹ 4 20,000 34,000
Add : Total Fixed Selling expenses (12,000 units × ₹1) 12,000 12,000
Cash Cost of Debtors 4,32,000 6,75,000
Average Debtors 36,000 56,250

5. Aneja Limited, a newly formed company, has applied to a commercial bank for the first time for financing
its working capital requirements. The following information is available about the projections for the
current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-progress.
Based on the above activity, estimated cost per unit is:

Raw material ₹ 80 per unit

Direct wages ₹ 30 per unit
Overheads (exclusive of ₹ 60 per unit
depreciation)
Total cost ₹ 170 per unit
Selling price ₹ 200 per unit

Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion stage in
respect of conversion cost) (materials issued at the start of the processing).

Finished goods in stock 8,000 units

Credit allowed by suppliers Average 4 weeks
Credit allowed to Average 8 weeks

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debtors/receivables
Lag in payment of wages Average 1.5 weeks

Cash at banks (for smooth operation) is expected to be ₹ 25,000.

Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads
accrue similarly. All sales are on credit basis only.

You are required to CALCULATE the net working capital required.

ANSWER 5

Calculation of Net Working Capital requirement:

(₹) (₹)
A. Current Assets:
Inventories:
- Raw material stock 6,64,615
(Refer to Working note 3)
- Work in progress stock 5,00,000
(Refer to Working note 2)
- Finished goods stock 13,60,000
(Refer to Working note 4)
Receivables (Debtors) 25,10,769
(Refer to Working note 5)
Cash and Bank balance 25,000
Gross Working Capital 50,60,384 50,60,384
B. Current Liabilities:
Creditors for raw materials 7,15,740
(Refer to Working note 6)
Creditors for wages 91,731
(Refer to Working note 7)
8,07,471 8,07,471
Net Working Capital (A - B) 42,52,913

Working Notes:
1. Annual cost of production

(₹)
Raw material requirements {(1,04,000 units × ₹ 80)+ ₹3,20,000} 86,40,000

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Direct wages {(1,04,000 units × ₹ 30) + ₹60,000} 31,80,000
Overheads (exclusive of depreciation) {(1,04,000 × ₹ 60)+ ₹1,20,000} 63,60,000
Gross Factory Cost 1,81,80,000
Less: Closing W.I.P (5,00,000)
Cost of Goods Produced 1,76,80,000
Less: Closing Stock of Finished Goods (₹1,76,80,000 × 8,000/1,04,000) (13,60,000)
Total Cash Cost of Sales 1,63,20,000
2. Work in progress stock

Raw material requirements (4,000 units × ₹ 80) 3,20,000

Direct wages (50% × 4,000 units × ₹ 30) 60,000
Overheads (50% × 4,000 units × ₹ 60) 1,20,000
5,00,000

3. Raw material stock

It is given that raw material in stock is average 4 weeks consumption. Since, the company is newly formed, the
raw material requirement for production and work in progress will be issued and consumed during the year.
Hence, the raw material consumption for the year (52 weeks) is as follows:

For Finished goods (1,04,000 × ₹ 80) 83,20,000

For Work in progress (4,000 × ₹ 80) 3,20,000
86,40,000

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6. The following information relates to Zeta Limited, a publishing company:

The selling price of a book is ₹ 15, and sales are made on credit through a book club and invoiced on the last
day of the month.

Variable costs of production per book are materials (₹ 5), labour (₹ 4), and overhead (₹ 2)
The sales manager has forecasted the following volumes:

Month No. of Books

November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August 2,300

Customers are expected to pay as follows:

One month after the sale 40%

Two months after the sale 60%

The company produces the books two months before they are sold and the creditors for materials are paid
two months after production.

Variable overheads are paid in the month following production and are expected to increase by 25% in
April; 75% of wages are paid in the month of production and 25% in the following month. A wage increase
of 12.5% will take place on 1st March.

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The company is going through a restructuring and will sell one of its freehold properties in May for ₹25,000,
but it is also planning to buy a new printing press in May for ₹10,000. Depreciation is currently ₹1,000 per
month, and will rise to ₹1,500 after the purchase of the new machine.
The company’s corporation tax (of ₹10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2019, of ₹ 1,500.

You are required to PREPARE a cash budget for the six months from January to June, 2020.
ANSWER 6

Workings:
1. Sale receipts

Month Nov Dec Jan Feb Mar Apr May Jun

Forecast sales (S) 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
S×15 15,000 15,000 15,000 18,750 22,500 30,000 28,500 33,000
Debtors pay:
1 month 40% 6,000 6,000 6,000 7,500 9,000 12,000 11,400
2 month 60% - 9,000 9,000 9,000 11,250 13,500 18,000
- - 15,000 15,000 16,500 20,250 25,500 29,400

2. Payment for materials – books produced two months before sale

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
Materials (Q×5) 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
Paid (2 months - - 5,000 6,250 7,500 10,000 9,500 11,000
after)

3. Variable overheads

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹
Var. overhead (Q×2) 2,000 2,500 3,000 4,000 3,800
Var. overhead (Q×2.50) 5,500 5,500 5,750

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Paid one month later 2,000 2,500 3,000 4,000 3,800 5,500 5,500

4. Wages payments

Month Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹
Wages (Q × 4) 5,000 6,000 8,000
Wages (Q × 4.50) 8,550 9,900 9,900 10,35
 0
75% this month 3,750 4,500 6,000 6,412 7,425 7,425 7,762
25% this month 1,250 1,500 2,000 2,137 2,475 2,475
5,750 7,500 8,412 9,562 9,900 10,23
7

Cash budget – six months ended June

Jan Feb Mar Apr May Jun

Receipts: ₹ ₹ ₹ ₹ ₹ ₹
Sales receipts 15,000 15,000 16,500 20,250 25,500 29,400
Freehold property - - - - 25,000 -
15,000 15,000 16,500 20,250 50,500 29,400
Payments:
Materials 5,000 6,250 7,500 10,000 9,500 11,000
Var. overheads 2,500 3,000 4,000 3,800 5,500 5,500
Wages 5,750 7,500 8,412 9,562 9,900 10,237
Printing press - - - - 10,000 -
Corporation tax - - 10,000 - - -
13,250 16,750 29,912 23,362 34,900 26,737
Net cash flow 1,750 (1,750) (13,412) (3,112) 15,600 2,663
Balance b/f 1,500 3,250 1,500 (11,912) (15,024) 576
Cumulative cash flow 3,250 1,500 (11,912) (15,024) 576 3,239

7. From the information and the assumption that the cash balance in hand on 1st January 2020 is ₹ 72,500,
PREPARE a cash budget.

Assume that 50 per cent of total sales are cash sales. Assets are to be acquired in the months of February
and April. Therefore, provisions should be made for the payment of ₹ 8,000 and ₹ 25,000 for the same. An
application has been made to the bank for the grant of a loan of ₹ 30,000 and it is hoped that the loan

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amount will be received in the month of May.
It is anticipated that a dividend of ₹ 35,000 will be paid in June. Debtors are allowed one month’s credit.
Creditors for materials purchased and overheads grant one month’s credit. Sales commission at 3 per cent
on sales is paid to the salesman each month.

Month Sales Materials Salaries & Production Office and

(₹) Purchases Wages Overheads Selling
(₹) (₹) (₹) Overheads
(₹)
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500

ANSWER 7

Cash Budget

Receipts Jan ₹ Feb ₹ Mar ₹ Apr ₹ May ₹ June ₹ Total ₹

Cash sales 36,000 48,500 43,000 44,300 51,250 54,350 2,77,40
0
Collections from debtors - 36,000 48,500 43,000 44,300 51,250 2,23,05
0
Bank loan - - - - 30,000 - 30,000
Total 36,000 84,500 91,500 87,300 1,25,550 1,05,600 5,30,45
0
Payments
Materials - 25,000 31,000 25,500 30,600 37,000 1,49,10
0
Salaries and wages 10,000 12,100 10,600 25,000 22,000 23,000 1,02,70
0
Production overheads - 6,000 6,300 6,000 6,500 8,000 32,800
Office & selling overheads - 5,500 6,700 7,500 8,900 11,000 39,600
Sales commission 2,160 2,910 2,580 2,658 3,075 3,261 16,644
Capital expenditure - 8,000 - 25,000 - - 33,000
Dividend - - - - - 35,000 35,000
Total 12,160 59,510 57,180 91,658 71,075 1,17,261 4,08,84
4
Net cash flow 23,840 24,990 34,320 (4,358) 54,475 (11,661) 1,21,60
6
Balance, beginning of 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,10

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month 6
Balance, end of month 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106 3,15,71
2
8. Consider the balance sheet of Maya Limited as on 31 December,2019. The company has received a large
order and anticipates the need to go to its bank to increase its borrowings. As a result, it has to forecast its
cash requirements for January, February and March, 2020. Typically, the company collects 20 per cent of its
sales in the month of sale, 70 per cent in the subsequent month, and 10 per cent in the second month after
the sale. All sales are credit sales.

Equity & Amount Assets Amount

liabilities (₹ in ‘000) (₹ in ‘000)
Equity shares 100 Net fixed assets 1,836
capital
Retained 1,439 Inventories 545
earnings
Long-term 450 Accounts 530
borrowings receivables
Accounts 360 Cash and bank 50
payables
Loan from banks 400

Other liabilities 212

2961 2961

Purchases of raw materials are made in the month prior to the sale and amounts to 60 per cent of sales.
Payments for these purchases occur in the month after the purchase. Labour costs, including overtime, are
expected to be ₹ 1,50,000 in January, ₹ 2,00,000 in February, and ₹ 1,60,000 in March. Selling,
administrative, taxes, and other cash expenses are expected to be ₹ 1,00,000 per month for January through
March. Actual sales in November and December and projected sales for January through April are as follows
(in thousands):

Month ₹ Month ₹ Month ₹

November 500 January 600 March 650

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December 600 February 1,000 April 750

On the basis of this information:

(a) PREPARE a cash budget for the months of January, February, and March.

(b) DETERMINE the amount of additional bank borrowings necessary to maintain a cash balance of ₹ 50,000
at all times.

(c) PREPARE a pro forma balance sheet for March 31.

ANSWER 8

(a) Cash Budget (in thousands)

Nov. Dec. Jan. Feb. Mar. Apr.

₹ ₹ ₹ ₹ ₹ ₹
Sales 500 600 600 1,000 650 750
Collections, current month’s sales 120 200 130
Collections, previous month’s sales 420 420 700
Collections, previous 2 month’s sales 50 60 60
Total cash receipts 590 680 890
Purchases 360 600 390 450
Payment for purchases 360 600 390
Labour costs 150 200 160
Other expenses 100 100 100
Total cash disbursements 610 900 650
Receipts less disbursements (20) (220) 240

(b)

Jan. Feb. Mar.

₹ ₹ ₹
Additional borrowings 20 220 (240)
Cumulative borrowings (Opening balance of 400) 420 640 400

The amount of financing peaks in February owing to the need to pay for purchases made the previous month
and higher labour costs. In March, substantial collections are made on the prior month’s billings, causing large
net cash inflow sufficient to pay off the additional borrowings.

(c) Pro forma Balance Sheet, 31st March, 2020

Equity & liabilities Amount Assets Amount

(₹ in ‘000) (₹ in ‘000)

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Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,529 Inventories 635
Long-term 450 Accounts 620
borrowings receivables
Accounts payables 450 Cash and bank 50
Loan from banks 400

Other liabilities 212

3141 3141
Accounts receivable = Sales in March × 0.8 + Sales in February × 0.1
Inventories = ₹545 + Total purchases from January to March − Total sales from January to March × 0.6

Accounts payable = Purchases in March

Retained earnings = ₹ 1,439 + Sales – Payment for purchases – Labour costs and – Other expenses, all for
January to March

9. PQR Ltd. having an annual sales of ₹ 30 lakhs, is re-considering its present collection policy. At present,
the average collection period is 50 days and the bad debt losses are 5% of sales. The company is incurring an
expenditure of ₹ 30,000 on account of collection of receivables. Cost of funds is 10 percent.

The alternative policies are as under:

Alternative I Alternative II
Average Collection Period 40 days 30 days
Bad Debt Losses 4% of sales 3% of sales
Collection Expenses ₹ 60,000 ₹ 95,000

DETERMINE the alternatives on the basis of incremental approach and state which alternative is more
beneficial.

ANSWER 9

Evaluation of Alternative Collection Programmes

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Conclusion: From the analysis it is apparent that Alternative I has a benefit of ₹ 8,333 and Alternative II has a
benefit of ₹ 11,667 over present level. Alternative II has a benefit of ₹ 3,334 more than Alternative I. Hence
Alternative II is more viable.

(Note: In absence of Cost of Sales, sales has been taken for purpose of calculating investment in receivables. 1

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year = 360 days.)

10. As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell
goods to a group of new customers with 10% risk of non-payment. This group would require one and a half
months credit and is likely to increase sales by ₹ 1,00,000 p.a. Production and Selling expenses amount to
80% of sales and the income-tax rate is 50%. The company’s minimum required rate of return (after tax) is
25%.
Should the sales manager’s proposal be accepted? ANALYSE
Also COMPUTE the degree of risk of non-payment that the company should be willing to assume if the
required rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.
ANSWER 10

Statement showing the Evaluation of Proposal

Particulars ₹
A. Expected Profit:
Net Sales 1,00,000
Less: Production and Selling Expenses @ 80% (80,000)
Profit before providing for Bad Debts 20,000
Less: Bad Debts @10% (10,000)
Profit before Tax 10,000
Less: Tax @ 50% (5,000)
Profit after Tax 5,000
B. Opportunity Cost of Investment in Receivables (2,500)
C. Net Benefits (A – B) 2,500

Advise: The sales manager’s proposal should be accepted.

Working Note: Calculation of Opportunity Cost of Funds

Statement showing the Acceptable Degree of Risk of Non-payment

Particulars Required Rate of Return

30% 40% 60%

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Sales 1,00,000 1,00,000 1,00,000
Less: Production and Sales Expenses 80,000 80,000 80,000
Profit before providing for Bad Debts 20,000 20,000 20,000
Less: Bad Debts (assume X) X X X
Profit before tax 20,000 – X 20,000 – X 20,000 – X
Less: Tax @ 50% (20,000 – X) 0.5 (20,000 – X) 0.5 (20,000 – X) 0.5
Profit after Tax 10,000 –0.5X 10,000 –0.5X 10,000 –0.5X
Required Return (given) 30% of 10,000* 40% of 10,000* 60% of 10,000*
= 3000 = 4000 = 6000
Computation of the value and percentage of X in each case is as follows:

Case I 10,000 – 0.5x = 3,000

0.5x = 7,000
X = 7,000/0.5 = ₹ 14,000

Bad Debts as % of sales = ₹ 14,000/₹1,00,000 × 100 = 14%

Case II 10,000 – 0.5x = 4,000

0.5x = 6,000
X = 6,000/0.5 = ₹ 12,000

Bad Debts as % of sales = ₹ 12,000/₹1,00,000 × 100 = 12%

Case III 10,000 – 0.5x = 6,000

0.5x = 4,000
X = 4,000/0.5 = ₹ 8,000
Bad Debts as % of sales = ₹ 8,000/₹1,00,000 × 100 = 8%

Thus, it is found that the Acceptable Degree of risk of non-payment is 14%, 12% and 8% if required rate of
return (after tax) is 30%, 40% and 60% respectively.

11. Slow Payers are regular customers of Goods Dealers Ltd. and have approached the sellers for extension

372
of credit facility for enabling them to purchase goods. On an analysis of past performance and on the basis
of information supplied, the following pattern of payment schedule emerges in regard to Slow Payers:

Pattern of Payment Schedule

At the end of 30 days
At the end of 60 days
At the end of 90 days
At the end of 100 days
Non-recovery
15% of the bill
34% of the bill.
30% of the bill.
20% of the bill.
1% of the bill.
Slow Payers want to enter into a firm commitment for purchase of goods of ₹ 15 lakhs in 2020, deliveries to
be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is ₹ 150 on which a profit of ₹ 5 per unit is expected to be made. It is anticipated by Goods
Dealers Ltd., that taking up of this contract would mean an extra recurring expenditure of ₹ 5,000 per
annum. If the opportunity cost of funds in the hands of Goods Dealers is 24% per annum, would you as the
finance manager of the seller recommend the grant of credit to Slow Payers? ANALYSE. Workings should
form part of your answer. Assume year of 365 days.

ANSWER 11

Statement showing the Evaluation of Debtors Policies

Particulars Proposed Policy ₹

A. Expected Profit:
(a) Credit Sales 15,00,000
(b) Total Cost
(i) Variable Costs 14,50,000
(ii) Recurring Costs 5,000
14,55,000
(c) Bad Debts 15,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of 68,787
Investments in Receivables
C. Net Benefits (A – B) (38,787)

Recommendation: The Proposed Policy should not be adopted since the net benefits under this policy are
negative

Working Note: Calculation of Opportunity Cost of Average Investments

373
Particulars 15% 34% 30% 20% Total
A. Total Cost 218250 494700 436500 291000 1440450
B. Collection period 30/365 60/365 90/365 100/365
C. Required Rate of Return 24% 24% 24% 24%
D. Opportunity Cost (A × B × C) 4,305 19,517 25,831 19,134 68,787
12. The management of Trux Company Ltd. is planning to expand its business and consults you to prepare
an estimated working capital statement. The records of the company reveals the following annual
information:

Rate of gross profit is 20%. Ignore work-in-progress and depreciation.

The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping ₹
2,50,000 available to it including the overdraft limit of ₹ 75,000 not yet utilized by the company.
The management is also of the opinion to make 10% margin for contingencies on computed figure.
You are required to PREPARE the estimated working capital statement for the next year.

ANSWER
Preparation of Statement of Working Capital Requirement for Trux Company Ltd.

374
375
Working Notes:
1. Calculation of Cost of Goods Sold and Cost of Sales

376

2. Calculation of gross profit on Export Sales

Let domestic selling price is ₹ 100. Gross profit is ₹ 20, and then cost per unit is ₹ 80
Export price is 10% less than the domestic price i.e. ₹ 100–(1-0.1)= ₹ 90
Now, gross profit will be = ₹ 90 - ₹ 80 = ₹ 10
3. Apportionment of Selling expenses between Domestic and Exports sales:
Apportionment on the basis of sales value:

4. Assumptions
(i) It is assumed that administrative expenses is related to production activities.
(ii) Value of opening and closing stocks are equal.

377

SECTION B- ECONOMICS FOR FINANCE

 CHAPTER 1- DETERMINATION OF
NATIONAL INCOME
Illustration 1

Find out GDP deflator? Interpret it

Solution

Notice that we use 2014 (base year) prices to compute real GDP of subsequent years. Real GDP has risen over
the years from 500 billion in 2014 to 1240 billion in 2019. This indicates that the increase is attributable to an
increase in quantities produced because the prices are held constant at base year. A deflator above 100
is an indication of price levels being higher as compared to the base year. From years 2015 through 2019, we
find that price levels are higher than that of the base year, the highest being in the year 2016.If the GDP
deflator is greater than 100, then nominal GDP is greater than real GDP. If the GDP deflator next year is less
than the GDP deflator this year, then the price level has fallen; if it is greater, price levels have increased.

Illustration 2

378
The nominal and real GDP respectively of a country in a particular year are ₹ 3000 Crores and ₹ 4700 Crores
respectively. Calculate GDP deflator and comment on the level of prices of the year in comparison with the
base year.

Solution

Nominal GDP = ₹ 3000 Crores

Real GDP = ₹ 4700 Crores
GDP Deflator = Nominal GDP/ Real GDP × 100
= 100 X 3000 / 4700 = 63.83

The price level has fallen since GDP deflator is less than 100 at 63.83.

Illustration 3

Find nominal GDP if real GDP = 450 and price index = 120

Solution

Illustration 4

Suppose nominal GDP of a country in year 2010 is given at ₹ 600 Crores and price index is given as base year
2010 is 100. Now let the nominal GDP increases to ₹ 1200 Crores in year 2018 and price index rises to 110,
find out real GDP?

Solution

379

Illustration 5

From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
 Items ₹ in Crores
Operating surplus 2000
Mixed income of self-employed 1100
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed capital 400
Net factor income from abroad -50
Compensation of employees 1000

Solution
GDPMP = Compensation of employees + mixed income of self-employed + operating surplus + depreciation +
net indirect taxes

(Note: operating surplus = rent+ profit + interest)

=1000 + 1100 + 2000 + 400 + 450 =4950

GNPMP = GDPMP + NFIA = 4950 + (-50) = 4900

NNPMP = GNPMP consumption of fixed capital = 4900 – 400 = 4500
NNPFC or NI = NNPMP – NIT =4500 – 450 = = 4050 Crores

Illustration 6

From the following data, estimate National Income and Personal Income.

Items ₹ . in Crores
Net national product at market price 1,891
Income from property and entrepreneurship accruing
to government administrative departments 45

380
Indirect taxes 175
Subsidies 30
Saving of non-departmental enterprises 10
Interest on National debt 15

Current transfers from government 35

Current transfers from rest of the world 20
Saving of private corporate sector 25
Corporate profit tax 25
Solution

National Income = Net national product at market price – Indirect taxes + Subsidies
= 1,891 – 175 + 30 = 1746crores

Personal Income = National income – Income from property and entrepreneurship accruing to government
administrative departments – Saving of non-departmental enterprises + National debt interest + Current
transfers from government + Current transfers from rest of the world – Saving of private corporate sector –
Corporate profit tax

= 1746 – 45 –10+ 15 + 35 + 20 – 25 – 25

= 1711 Crores

Illustration 7
Calculate the aggregate value of depreciation when the GDP at market price of a country in a particular year
was ₹ 1,100 Crores. Net Factor Income from Abroad was ₹ 100 Crores. The value of Indirect taxes – Subsidies
was ₹ 150 Crores and National Income was ₹ 850 Crores.

Solution

Given
GDPMP = 1100 Crores, NFIA = 100 Crores, NIT =150 Crores, NNPFC = 850 Crores
∴ GDPFC = GDPMP- NIT = 1100 – 150 = 950
GNPFC = GDPFC+ NFIA = 950 + 100 = 1050
NNPFC = GNPFC- Depreciation
850 = 1050- Depreciation
Depreciation = 1050 – 850 = 200 Crores.

381

Illustration 8
On basis of following information, calculate NNP at market price and Disposable personal income
Solution

NNP at Market price = NNP at factor cost +indirect tax-subsidies

Where NNP at factor cost = NDPFC + NFIA

= 14900 + 80=14980

Therefore, NNP MP = Therefore, NNP MP = 14980 + 335 – 262 = 15053

Disposable personal income (DI) = PI- Personal income tax

PI = NI + income received but not earned – income earned but not received
= 14980+ 170+60 +30 -150 -222- 105 = 14763

Therefore, DI= 14763- 100 = 14663 Crores 382

Illustration 9
Calculate National Income by Value Added Method with the help of following data-
Solution

NVA(FC) = GDP (MP) –Depreciation +NFIA- Net Indirect Tax

Where GVA(MP) = Value of output- intermediate consumption

Value of Output = Sales+ change in stock

= 700+ (400-500)=600
GVA(MP) = 600 – 350= 250

Therefore NI = 250-150 +30-(110-50)

= 70 Crores

383

Illustration 10
Calculate the Operating Surplus with the help of following data-

Solution

GVAMP = Gross Value OutputMP – Intermediate consumption

= (Sales + change in stock) – Intermediate consumption
= 4000-600 = 3400

GDPMP = GVAMP = 3400 Crores

NDPMP = GDPMP – consumption of fixed capital

= 3400 – 200
= 3200 Crores

NDP FC = NDPMP – NIT

= 3200 – 500 = 2700 Crores

NDPFC = Compensation of employees + Operating surplus + Mixed income

2700 = 800 + Operating Surplus + 400

384
Operating surplus = 1500 Crores

Illustration 11
Calculate national income by value added method.

Solution

GDPMP= (Value of output in primary sector - intermediate consumption of primary sector) + (value of output
in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector
- intermediate consumption of tertiary sector)

Value of output in primary sector = 2000

- Intermediate consumption of primary sector = 200

+ Value of output in secondary sector = 2800

- Intermediate consumption in secondary sector = 800

+ Value of output in tertiary sector = 1600

- Intermediate consumption of tertiary sector = 600

385
GDP MP = ₹ 4800 Crores

NNPFC = GDPMP + NFIA -NIT-Depreciation

NNPFC =National income= 4800+(-30)-300-470= 4000 Crores

Illustration 12
Calculate Net Value Added by Factor Cost from the following data

Solution

GVA MP = Sales+ change in stock - Intermediate consumption

= 450+ (30-40) -200
= 240Crores

NVAMP = GVAMP – Depreciation

NVAMP = 240-30 = 210 Crores

NVAFC = NVAMP – (indirect tax - subsidies)

= 210 – (45 -15) = 180Crores

Illustration 13

386
Calculate NI with the help of Expenditure method and income method with the help of following data:

Items ₹ in Crores
Compensation of employees 1,200
Net factor income from Abroad 20
Net indirect taxes 120
Profit 800
Private final consumption expenditure 2,000
Net domestic capital formation 770
Consumption of fixed capital 130
Rent 400
Interest 620
Mixed income of self-employed 700
Net export 30
Govt. final consumption expenditure 1100
Operating surplus 1820
Employer’s contribution to social security scheme 300

Solution

By Expenditure method

GDPMP = Private final consumption expenditure + Government final

consumption expenditure + Gross domestic capital formation
(Net domestic capital formation+ depreciation) + Net export
= 2000 + 1100 + (770+ 130) + 30= 4030Crores

NNPFC or NI = GDPMP- depreciation + NFIA – NIT

= 4030 – 130 + 20 – 120= 3800 Crores

By Income method

NNPFC or NI = compensation of employees+ operating surplus+ Mixed income

of self-employed + NFIA
= 1200+ 1820+ 700+ 20= 3740Crores

Illustration 14

From the following data calculate

387
(a) Gross Domestic Product at Factor Cost, and

(b) Gross Domestic Product at Market price

Solution

(a) GDP at factor cost = NDP at factor cost + Depreciation

= Compensation of employees+ Rent+ Interest+
Profit +Mixed income+ (Gross domestic capital
formation - Net domestic capital formation)
= ₹ 3,000 + ₹ 800 + ₹ 900 + ₹ 1,300 + (₹ 900 - ₹ 800)
= ₹ 6100 Crores

(b) Gross Domestic Product at Market Price

= GDP at factor cost + Net Indirect taxes =₹ 6100 + ₹ 300
= 6400 Crores

Illustration 15
Calculate NNPFC by expenditure method with the help of following information-

388
Solution

Calculation of national income by expenditure method:

GDPMP = Government final consumption expenditure (Public final consumption expenditure) + Private final
consumption expenditure + Gross domestic capital formation (Gross domestic fixed capital formation +
change stock + Net acquisition of valuables) + Net export (Note: As net import is20,
hence, net export is -20)

= 5 +10 + [350 + 30 +10 ]+(- 20) = 5+10+390-20 = 385 Crores

NNPFC = GDPMP – Depreciation + Net factor income from abroad (Income from abroad – Income paid to
abroad) – Net Indirect tax (Indirect tax – subsidies)

= 385 – 30 + [0 – 20] – [0-100] = 385 – 30 – 20 + 100 = 435 Crores

I Multiple Choice Type Questions

1. The concept of ‘resident unit’ involved in the definition of GDP denotes

(a) A business enterprise which belongs to a citizen of India with production units solely situated in India

(b) The unit having predominant economic interest in the economic territory of the country for one year or

389
more irrespective of the nationality or legal status

(c) A citizen household which had been living in India during the accounting year and one whose economic
interests are solely in India

(d) Households and business enterprises composed of citizens of India alone living in India during the
accounting year

ANSWER 1-B
2. Read the following statements and answer the following question.
I. Intermediate consumption consists of the value of the goods and services consumed as inputs by a
process of production,

II. Intermediate consumption excludes fixed assets whose consumption is recorded as consumption of fixed
capital.

(a) Only I is true

(b) Both I and II are true

(c) Only II is true

(d) Neither I nor II is true

ANSWER 2-B

3. Gross Domestic Product (GDP) of any nation

(a) excludes capital consumption and intermediate consumption

(b) is inclusive of capital consumption or depreciation

(c) is inclusive of indirect taxes but excludes subsidies

(d) None of the above

ANSWER 3-B

4. Read the following statements 390

I ‘Value added’ refers to the difference between value of output and purchase of intermediate goods.
II. ‘Value added’ represents the contribution of labour and capital to the production process.

(a) Statements I and II are incorrect

(b) Statements I and II are correct

(c) Statement I is correct and II is incorrect

(d) Statement II is correct and I is incorrect

ANSWER 4-B

5.. Non-economic activities are

(a) those activities whose value is excluded from national income calculation as it will involve double
counting

(b) those which produce goods and services, but since these are not exchanged in a market transaction they
do not command any market value

(c) those which do not involve production of goods and services as they are meant to provide hobbies and
leisure time activities

(d) those which result in production for self consumption and therefore not included in national income
calculation

ANSWER 5-B

6. Which of the following does not enter into the calculation of national income?

(a) Exchange of previously produced goods

(b) Exchange of second hand goods

(c) Exchange of stocks and bonds

(d) All the above

391
ANSWER 6-D
7. Which of the following enters into the calculation of national income?

(a) The value of the services that accompany the sale

(b) Additions to inventory stocks of final goods and materials

(c) Stocks and bonds sold during eth current year

(d) (a) and (b) above

ANSWER 7-D

8. Gross National Product at market prices GNP MP is

(a) GDP MP + Net Factor Income from Abroad

(b) GDP MP - Net Factor Income from Abroad

(c) GDP MP - Depreciation

(d) GDP MP + Net Indirect Taxes

ANSWER 8-A

9. Choose the correct statement

(a) GNP includes earnings of Indian corporations overseas and Indian residents working overseas; but GDP
does not include these

(b) NNPFC = National Income = FID (factor income earned in domestic territory) – NFIA.

(c) Capital goods and inventory investment are excluded from computation of GDP 392

(d) NDP MP = GDP MP + Depreciation

ANSWER 9-A
10. The basis of distinction between market price and factor cost is

(a) net factor income from abroad

(b) net indirect taxes (i.e., Indirect taxes - Subsidies)

(c) net indirect taxes (i.e., Indirect taxes + Subsidies)

(d) depreciation ( consumption of fixed capital)

ANSWER 10-B

11. If net factor income from abroad is positive, then

(a) national income will be greater than domestic factor incomes.

(b) national income will be less than domestic factor incomes.

(c) net exports will be negative

(d) domestic factor incomes will be greater than national income

ANSWER 11-A

12. The GDP per capita is

(a) a measure of a country's economic output per person

(b) actual current income receipts of persons

(c) national income divided by population 393

(d) (a)and (c) above

ANSWER 12-D
13. Which of the following is an example of transfer payment?

(a) Old age pensions and family pensions

(b) Scholarships given to deserving diligent students.

(c) Compensation given for loss of property due to floods

(d) All the above

ANSWER 13-D

14. Mixed income of the self -employed means

(a) net profits received by self -employed people

(b) outside wages received by self- employed people

(c) combined factor payments which are not distinguishable,

(d) wages due to non- economic activities

ANSWER 14-C

15. Which of the following is added to national income while calculating personal income?

(a) Transfer payments to individuals

(b) Undistributed profits of corporate

(c) Transfer payments made to foreigners 394

(d) Mixed income of self employed

ANSWER 15-A
II Short Answer Type Questions

1. Define national income.

ANSWER 1

National Income is defined as the net value of all economic goods and services produced within the domestic
territory of a country in an accounting year plus the net factor income from abroad. According to the Central
Statistical Organisation (CSO) ‘National income is the sum total of factor incomes generated by the
normal residents of a country in the form of wages, rent, interest and profit in an accounting year’.

2. What function does the System of National accounts (SNA) serve?

ANSWER 2

The basic concepts and definitions of the terms used in national accounts largely follow those given in the UN
System of National Accounts (SNA) developed by United Nations to provide a comprehensive, conceptual and
accounting framework for compiling and reporting macroeconomic statistics for analysing
and evaluating the performance of an economy. Each of these concepts has a specific meaning, use and
method of measurement.

National income accounts have three sides: a product side, an expenditure side and an income side. The
product side measures production based on concept of value added. The expenditure side looks at the final
sales of goods and services, whereas the income side measures the distribution of the proceeds from sales to
different factors of production. Accordingly, national income is a measure of the total flow of ‘earnings of the
factor-owners’ which they receive through the production of goods and services. Thus, national income is the
sum total of all the incomes accruing over a specified period to the residents of a country and consists of
wages, salaries, profits, rent and interest.

3. Define GDP MP.

ANSWER 3 395

Gross domestic product (GDP) is a measure of the market value of all final economic goods and services, gross
of depreciation, produced within the domestic territory of a country during a given time period. It is the sum
total of ‘value added’ by all producing units in the domestic territory and includes value added by current
production by foreign residents or foreign-owned firms. The term ‘gross’ implies that GDP is measured ‘gross’
of depreciation.’ Domestic’ refers to ‘the geographic confines’ of a country. For example, if a Chinese citizen
works temporarily in India, her production is part of the Indian GDP. If an Indian citizen owns a factory in
another country, for e.g. Germany, the production at her factory is not part of India’s GDP.
4. What do you understand by ‘value added’?

ANSWER 4

Product Method or Value Added Method is also called Industrial Origin Method or Net Output Method.
National income by value added method is the sum total of net value added at factor cost across all producing
units of the economy. The value added method measures the contribution of each producing enterprise in
the domestic territory of the country in an accounting year and entails consolidation of production of each
industry less intermediate purchases from all other industries.

5. Distinguish between Intermediate goods and final goods.

ANSWER 5
Intermediate goods used to produce other goods rather than being sold to final purchasers are not counted as
it would involve double counting whereas final goods are those that meant for final consumption

6. Distinguish between non-economic activities and economic activities.

ANSWER 6
Economic activities, as distinguished from non-economic activities, include all human activities which create
goods and services that are exchanged in a market and valued at market price. Non-economic activities are
those which produce goods and services, but since these are not exchanged in a market transaction they do
not command any market value; for e.g. hobbies, housekeeping and child rearing services of home makers and
services of family members that are done out of love and affection.

7. Distinguish between nominal GDP and real GDP.

ANSWER 7

396
When GDP is estimated on the basis of current year’s market prices, it is called ‘nominal GDP’ or ‘GDP at
current prices’. For example, GDP of year 2020-21 may be measured using prices of 2020-21. Nominal GDP
changes from year to year for two reasons. First, the amount of goods and services produced changes, and
second, market prices change. Changes in GDP due to changes in prices fail to correctly explain the
performance of the economy in producing goods and services.

Therefore, for making comparisons of GDP at different points of time, we need to compute real GDP. Real GDP
is calculated in such a way that the goods and services produced in a particular year are evaluated at some
constant set of prices or constant prices. In other words, it is calculated using the prices of a selected
‘base year’.
8. What is the difference between ‘national’ and ‘domestic’?
ANSWER 8

The term ‘national’ refers to normal residents of a country who may be within or outside the domestic
territory of a country and is a broader concept compared to the term ‘domestic’ which refers to the domestic
territory of the country.

9. What do you understand by ‘factor cost’?

ANSWER 9

Factor Cost = Market Price - Net Indirect Taxes = Market Price – Indirect Taxes + Subsidies

10. Differentiate between ‘taxes on production’ and ‘product taxes’.

ANSWER 10
Product taxes are related to the quantum of production and are levied by the government on goods and
services (These taxes are known as indirect taxes).
Taxes on production are taxes which are not related to quantum of production like factory, license fee,
pollution tax etc.,

11. Define ‘mixed income of self- employed’

ANSWER 11
Mixed income includes all those incomes which are difficult to separate eg. labour income from capital income
because people provide both labour and capital services.

397
12. Define Per Capita Income.

ANSWER 12
The GDP per capita is a measure of a country's economic output per person. It is obtained by dividing the
country’s gross domestic product, adjusted byinflation, by the total population
13. How does Personal Income differ from Disposable Personal Income?

ANSWER 13
Personal income is a measure of the actual current income receipt of persons from all sources. Disposable
personal income is what is available for their consumption or savings and is derived from personal income by
subtracting the direct taxes paid by individuals and other compulsory payments made to the government.

14. Define ‘Private income’ as used in India.

Private income is a measure of the income (both factor income and transfer income) which accrues to private
sector from all sources within and outside the country.

Private Income = Factor income from net domestic product accruing to the private sector + Net factor income
from abroad + National debt interest + Current transfers from government + Other net transfers from the rest
of the world.

15. Illustrate the circular flow of income.

ANSWER 15

Circular flow of income refers to the continuous circulation of production, income generation and expenditure
involving different sectors of the economy. There are three different interlinked phases in a circular flow of
income, namely: production, distribution and disposition as can be seen from the following figure.

398
16. How do you arrive at ‘gross value added’

ANSWER 16
Gross value added (GVA MP) = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption

17. What is meant by intermediate consumption?

ANSWER 17
Intermediate consumption consists of the value of the goods and services consumed as inputs by a process of
production, excluding fixed assets whose consumption is recorded as consumption of fixed capital; the goods
or services may be either transformed or used up by the production process.

18. Define ‘Net Factor Income from Abroad’

ANSWER 18
NFIA is the difference between the aggregate amount that a country's citizens and companies earn abroad,
and the aggregate amount that foreign citizens and overseas companies earn in that country.

NFIA =Net compensation of employees + Net income from property and entrepreneurship + Net retained
earnings

If Net Factor Income from Abroad is positive, then GNPMP would be greater than GDPMP..

399
19. What is meant by the term ‘net exports’?

ANSWER 19

Net exports are the difference between exports and imports of a country during the accounting year. It can be
positive or negative.
III Long Answer Type Questions

1. Define national income and explain the usefulness of national income estimates.

ANSWER 1

National Income is defined as the net value of all economic goods and services produced within the domestic
territory of a country in an accounting year plus the net factor income from abroad. According to the Central
Statistical Organisation (CSO) ‘National income is the sum total of factor incomes generated by the
normal residents of a country in the form of wages, rent, interest and profit in an accounting year’.

USEFULNESS AND SIGNIFICANCE OF NATIONAL INCOME ESTIMATES

National income accounts are fundamental aggregate statistics in macroeconomic analysis and are extremely
useful, especially for the emerging and transition economies

1. National income accounts provide a comprehensive, conceptual and accounting framework for analyzing
and evaluating the short-run performance of an economy. The level of national income indicates the level
of economic activity and economic development as well as aggregate demand for goods and services of a
country.

2. The distribution pattern of national income determines the pattern of demand for goods and services and
enables businesses to forecast the future demand for their products.

3. Economic welfare depends to a considerable extent on the magnitude and distribution of national income,
size of per capita income and the growth of these over time.

4. The estimates of national income show the composition and structure of national income in terms of
different sectors of the economy, the periodical variations in them and the broad sectoral shifts in an
economy over time. It is also possible to make temporal and spatial comparisons of the trend and speed of
economic progress and development. Using this information, the government can fix various sector-specific
development targets for different sectors of the economy and formulate suitable development plans and
policies to increase growth rates.

5. National income statistics also provide a quantitative basis for macroeconomic modelling and analysis, for 400
assessing and choosing economic policies and for objective statement as well as evaluation of
governments’ economic policies. These figures often influence popular and political judgments about the
relative success of economic programmes.

6. National income estimates throw light on income distribution and the possible inequality in the distribution
among different categories of income earners. It is also possible to make comparisons of structural statistics,
such as ratios of investment, taxes, or government expenditures to GDP.
7. International comparisons in respect of incomes and living standards assist in determining eligibility for
loans, and/or other funds or conditions under which such loans, and/ or funds are made available. The
national income data are also useful to determine the share of nation’s contributions to various international
bodies.

8. Combined with financial and monetary data, national income data provides a guide to make policies for
growth and inflation.

9. National income or a relevant component of it is an indispensable variable considered in economic

forecasting and to make projections about the future development trends of the economy.

2. Describe the generally used concepts of national income.

ANSWER 2

Gross Domestic Product (GDP MP)

Gross domestic product (GDP) is a measure of the market value of all final economic goods and services, gross
of depreciation, produced within the domestic territory of a country during a given time period. It is the sum
total of ‘value added’ by all producing units in the domestic territory and includes value added by current
production by foreign residents or foreign-owned firms. The term ‘gross’ implies that GDP is measured ‘gross’
of depreciation.’ Domestic’ refers to ‘the geographic confines’ of a country. If an Indian citizen owns a factory
in another country, for e.g. Germany, the production at her factory is not part of India’s GDP.

Gross National Product (GNP) is a measure of the market value of all final economic goods and services, gross
of depreciation, produced within the domestic territory of a country by normal residents during an accounting
year including net factor incomes from abroad. It is the total income earned by a nation’s permanent residents
(called nationals). It differs from GDP by including income that our citizens earn abroad and excluding income
that foreigners earn here. In the example given in 1.3.1 above, the Chinese citizen’s production is part of the

401
Indian GDP, but it is not part of Indian GNP. (It is part of China’s GNP).
3. What are the different methods of calculation of national income?
ANSWER 3

There are three methods of measuring national income. They are: Value Added Method (alternatively known
as Product Method); Income Method; and Expenditure Method

Value Added Method or Product Method

Step1. Identifying the producing enterprises and classifying them into different
sectors according to the nature of their activities

Step 2. Estimating the gross value added (GVAMP) by each producing enterprise
(This is the same as GDPMP)
Gross value added (GVA MP) = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate
consumption

Step 3.Estimation of National income

For each individual unit, Net value added is found out.
Σ (GVA MP) – Depreciation = Net value added (NVA MP)

Net value added (NVA MP) – Net Indirect taxes = Net Domestic Product (NVA FC)
Net Domestic Product (NVA FC) + (NFIA) = National Income (NNP FC)

Income Method

NDP FC = Sum of factor incomes paid out by all production units within the

402
domestic territory of a country
NNP FC or National Income= Compensation of employees
+ Operating Surplus (rent + interest+ profit)
+ Mixed Income of Self- employed
+ Net Factor Income from Abroad

Expenditure Method
In the expenditure approach, also called Income Disposal Approach, national income is the aggregate final
expenditure in an economy during an accounting year.
GDPMP = Σ Final Expenditure
4. Explain the term Gross Domestic Product (GDP). How is it estimated?
ANSWER 4

Gross domestic product (GDP) is a measure of the market value of all final economic goods and services, gross
of depreciation, produced within the domestic territory of a country during a given time period. It is the sum
total of ‘value added’ by all producing units in the domestic territory and includes value
added by current production by foreign residents or foreign-owned firms. The term ‘gross’ implies that GDP is
measured ‘gross’ of depreciation.’ Domestic’ refers to ‘the geographic confines’ of a country. For example, if a
Chinese citizen works temporarily in India, her production is part of the Indian GDP. If an Indian
citizen owns a factory in another country, for e.g. Germany, the production at her
factory is not part of India’s GDP.

However, GDP excludes transfer payments, Gross domestic product (GDP) is a measure of the market value of
all final economic goods and services, gross of depreciation, produced within the domestic territory of a
country during a given time period. It is the sum total of ‘value added’ by all producing units in the domestic
territory and includes value added by current production by foreign residents or foreign-owned firms. The
term ‘gross’ implies that GDP is measured ‘gross’ of depreciation.’ Domestic’ refers to ‘the geographic
confines’ of a country. For example, if a Chinese citizen works temporarily in India, her production is part of
the Indian GDP. If an Indian citizen owns a factory in another country, for e.g. Germany, the production at her
factory is not part of India’s GDP. However, GDP excludes transfer payments, production process. For
example, the value of flour used in making bread would not be counted as it will be included while bread is
counted. This is because flour is an intermediate good in bread making process. Similarly, if
we include the value of an automobile in GDP, we should not be including the value of the tyres separately.

(iii) Gross Domestic Product (GDP) is a measure of production activity. GDP covers all production activities
recognized by SNA called the ‘production boundary’. The production boundary covers production of almost all
goods and services classified in the National Industrial Classification (NIC).

Production of agriculture, forestry and fishing which are used for own consumption of producers is also
included in the production boundary. Thus, Gross Domestic Product (GDP) of any nation represents the sum

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total of gross value added (GVA) (i.e, without discounting for capital consumption or depreciation) in all the
sectors of that economy during the said year.

(iv) Economic activities, as distinguished from non-economic activities, include all human activities which
create goods and services that are exchanged in a market and valued at market price. Non-economic activities
are those which produce goods and services, but since these are not exchanged in a market transaction they
do not command any market value; for e.g. hobbies, housekeeping and child rearing services of home makers
and services of family members that are done out of love and affection.
(v) National income is a ‘flow’ measure of output per time period—for example, per year—and includes only
those goods and services produced in the current period i.e. produced during the time interval under
consideration.

The value of market transactions such as exchange of goods which already exist or are previously produced,
do not enter into the calculation of national income. Therefore, the value of assets such as stocks and bonds
which are exchanged during the pertinent period are not included in national income as these do not directly
involve current production of goods and services. However, the value of services that accompany the sale and
purchase (e.g. fees paid to real estate agents and lawyers) represent current production and, therefore, is
included in national income.

(vi) An important point to remember is that two types of goods used in the production process are counted in
GDP namely, capital goods (business plant and equipment purchases) and inventory investment—the net
change in inventories of final goods awaiting sale or of materials used in the production which may be positive
or negative. Inventories are treated as capital. Additions to inventory stocks of final goods and materials
belong to GDP because they are currently produced output.

5. Distinguish between GDP current and constant prices. What purpose does real GDP serve?

ANSWER 5
When GDP is estimated on the basis of current year’s market prices, it is called ‘nominal GDP’ or ‘GDP at
current prices’. For example, GDP of year 2020-21 may be measured using prices of 2020-21. Nominal GDP
changes from year to year for two reasons. First, the amount of goods and services produced changes, and
second, market prices change. Changes in GDP due to changes in prices fail to correctly explain the
performance of the economy in producing goods and services.

Therefore, for making comparisons of GDP at different points of time, we need to compute real GDP. Real GDP
is calculated in such a way that the goods and services produced in a particular year are evaluated at some
constant set of prices or constant prices. In other words, it is calculated using the prices of a selected
‘base year’.

404
For example, if 2011-12 is selected as the base year, then real GDP for 2020-21 will be calculated by taking the
quantities of all goods and services produced in 2020-21 and multiplying them by their 2011-12 prices. Thus,
real GDP or GDP at constant prices refers to the total money value of the final goods and services produced
within the domestic territory of a country during an accounting year, estimated using base year prices. Real
GDP is an inflation adjusted measure and is not affected by changes in prices; it changes only when there is
change in the amount of output produced in the economy. Real GDP is a better measure of economic well
being as it shows the true picture of the change in production of an economy.

The calculation of real GDP gives us a useful measure of inflation known as GDP deflator. The GDP deflator is
the ratio of nominal GDP in a given year to real GDP of that year.
6. How is national income calculated under ‘Income Method’?

ANSWER 6
Production is carried out by the combined effort of all factors of production. The factors are paid factor
incomes for the services rendered. In other words, whatever is produced by a producing unit is distributed
among the factors of production for their services.

Under Factor Income Method, also called Factor Payment Method or Distributed Share Method, national
income is calculated by summation of factor incomes paid out by all production units within the domestic
territory of a country as wages and salaries, rent, interest, and profit. By definition, it includes factor payments
to both residents and non- residents.

Thus,

NDP FC = Sum of factor incomes paid out by all production units within the domestic territory of a country

NNP FC or National Income= Compensation of employees

+ Operating Surplus (rent + interest+ profit)
+ Mixed Income of Self- employed
+ Net Factor Income from Abroad

7. Explain ‘Expenditure Method’ for calculation of national income?

ANSWER 7
In the expenditure approach, also called Income Disposal Approach, national income is the aggregate final
expenditure in an economy during an accounting year.

GDPMP = Σ Final Expenditure

In this approach to measuring GDP which considers the demand side of the products, we add up the value of 405
the goods and services purchased by each typeof final user mentioned below.
1. Final Consumption Expenditure
(a) Private Final Consumption Expenditure (PFCE)

To measure this, the volume of final sales of goods and services to consumer households and non-profit
institutions serving households acquired for consumption (not for use in production) are multiplied by
market prices and then summation is done. It also includes the value of primary products which are produced
for own consumption by the households, payments for domestic services which one household renders
to another, the net expenditure on foreign financial assets or net foreign investment. Land and residential
buildings purchased or constructed by households are not part of PFCE. They are included in gross capital
formation. Thus, only expenditure on final goods and services produced in the period for which national
income is to be measured and net foreign investment are included in the expenditure method of calculating
national
income.

(b) Government Final Consumption Expenditure

Since the collective services provided by the governments such as defence, education, healthcare etc. are not
sold in the market, the only way they can be valued in money terms is by adding up the money spent by the
government in the production of these services. This total expenditure is treated as consumption
expenditure of the government. Government expenditure on pensions, scholarships, unemployment
allowance etc. should be excluded because these are transfer payments.

8. Explain with illustrations the limitations of national income computation?

ANSWER 8
There are innumerable limitations and challenges in the computation of national income. The task is more
complex in underdeveloped and developing countries.

Following are the general dilemmas in measurement of national income.

There are many conceptual difficulties related to measurement which are difficult
to resolve, such as:

(a) lack of an agreed definition of national income, 406

(b) accurate distinction between final goods and intermediate goods,

(c) issue of transfer payments,

(d) services of durable goods,

(e) difficulty of incorporating distribution of income,

(f) valuation of a new good at constant prices, and

(g) valuation of government services

Other challenges relate to:

(a) Inadequacy of data and lack of reliability of available data,

(b) presence of non-monetised sector,

(c) production for self-consumption,

(d) absence of recording of incomes due to illiteracy and ignorance,

(e) lack of proper occupational classification, and

(f) accurate estimation of consumption of fixed capital

9. Distinguish between Personal Income and Disposable personal income.

ANSWER 9

While national income is income earned by factors of production, Personal Income is the income received by
the household sector including Non-Profit Institutions Serving Households. Thus, national income is a measure
of income earned and personal income is a measure of actual current income receipts of persons from all
sources which may or may not be earned from productive activities during a given period of time. In other
words, it is the income ‘actually paid out’ to the household sector, but not necessarily earned. Examples of this
include transfer payments such as social security benefits, unemployment compensation, welfare payments
etc. Individuals also contribute income which they do not actually receive; for example, undistributed

407
corporate profits and the contribution of employers to social security. Personal income excludes retained
earnings, indirect business taxes, corporate income taxes and contributions towards social security.
Households receive interest payments from the firms and governments; they also make interest payments to
firms and governments. As such, the net interest paid by households to firms and government is also
deducted from national income. Personal income forms the basis for consumption expenditures and is derived
from national income as follows:

PI = NI + income received but not earned – income earned but not received.
PI = NI - Undistributed profits – Net interest payments made by households – Corporate Tax +Transfer
Payments to the households from firms and government.

An important point to remember is that national income is not the sum of personal incomes because personal
income includes transfer payments (eg. pension) which are excluded from national income. Further, not all
national income accrues to individuals as their personal income.

Disposable Personal Income (DI)

Disposable personal income is a measure of amount of money in the hands of the individuals that is available
for their consumption or savings. Disposable personal income is derived from personal income by subtracting
the direct taxes paid by individuals and other compulsory payments made to the government.

DI = PI - Personal Income Taxes – Non tax payments

Apart from the above aggregates, a few other aggregates are reported in India.

These reflect the amount of goods and services the domestic economy has at its disposal. Two more concepts
need to be understood, namely:

1. Net National Disposable Income

Net National Disposable Income (NNDI) = Net National Income + other net current transfers from the rest of
the world (Receipts less payments)

Net National Disposable Income (NNDI) = NNI + net taxes on income and wealth receivable from abroad + net
social contributions and benefits receivable from abroad.

2. Gross National Disposable Income (GNDI)

= NNDI + CFC = GNI + other net current transfers from the rest of the world (Receipts less payments)
(Other Current Transfers refer to current transfers other than the primary incomes)

10. How real GDP is better measure of economic well-being? Explain. 408

ANSWER 10
For making comparisons of GDP at different points of time, we need to compute real GDP. Real GDP is
calculated in such a way that the goods and services produced in a particular year are evaluated at some
constant set of prices or constant prices. In other words, it is calculated using the prices of a selected
‘base year’. For example, if 2011-12 is selected as the base year, then real GDP for 2020-21 will be calculated
by taking the quantities of all goods and services produced in 2020-21 and multiplying them by their 2011-12
prices. Thus, real GDP or GDP at constant prices refers to the total money value of the final goods
and services produced within the domestic territory of a country during an accounting year, estimated using
base year prices. Real GDP is an inflation adjusted measure and is not affected by changes in prices; it changes
only when there is change in the amount of output produced in the economy. Real GDP is a
better measure of economic well being as it shows the true picture of the change in production of an
economy.

IV Application Oriented Questions

1. Compute National income

Consumption 750
Investment 250
Government Purchases 100
Exports 100
Imports 200

ANSWER 1

Expenditure Method: National income equals domestic spending

Y = C + I + G + (X – M)
(C + I + G = 1100) plus exports (X = 100) less imports (M = 200). Y =1000

2. Calculate Gross Domestic Product at market Prices (GDPMP) and derive national income from the
following data (in Crores of ₹)

Inventory Investment 100 409

Exports 200
Indirect taxes 100
Net factor income from abroad - 50
Personal consumption expenditure 3500
Gross residential construction investment 300
Depreciation 50
 Imports 100
Government purchases of goods and services 1000
Gross public investment 200
Gross business fixed investment 300

ANSWER 2

Expenditure Method
GDPMP = Personal consumption expenditure + Gross Investment (Gross business fixed investment + inventory
investment) + Gross residential construction investment + Gross public investment + Government
purchases of goods and services + Net Exports (Exports-imports)
GNPMP = GDPMP +Net factor income from abroad GNPMP - Indirect Taxes = GNP FC
GNP FC – Depreciation = NNP FC (National Income)

GDP Mp=
Personal consumption expenditure = 3500
+ Gross Investment = 900
which include(Gross Business fixed = 300
investment
Gross residential construction investment = 300
Gross public investment = 200
Inventory investment = 100)

+ Government purchases of goods arid = 1000

services
+ Net exports which include: = 100
(Exports = 200
Imports = 100)

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GDP Mp= = 5500 Crores

+Net Factor Income From Abroad = -50

GNP MP = = 5450 Crores

-Indirect Taxes = 100

GNP FC = 5350 Crores
- Depreciation = 50
NNP FC (National Income) = 5300 Crores
3. Find GDPMP and GNPMP from the following data (in Crores of ₹ ) using income method. Show that it is the
same as that obtained by expenditure method.

Personal Consumption 7,314

Depreciation 800
Wages 6,508
Indirect Business Taxes 1,000
Interest 1,060
Domestic Investment 1,442
Government Expenditures 2,196
Rental Income 34
Corporate Profits 682
Exports 1,346
Net Factor Income from Abroad 40
Mixed Income 806
Imports 1,408

ANSWER 3

GDPMP = (Value of output in primary sector - intermediate consumption of primary sector) + (value of output
in secondary sector - intermediate consumption of secondary sector) + (value of output in tertiary sector -
intermediate consumption of tertiary sector)

Value of output in primary sector = 500

-Intermediate consumption of primary sector = 250
+ Value of output in secondary sector = 900
-Intermediate consumption in secondary sector = 400
+ Value of output in tertiary sector = 700

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-Intermediate consumption of tertiary sector = 300

GDP MP = ₹ 1150 Crores

GNPMP = GDPMP + NFIA

GNPMP = 1150 – 20 = ₹ 1130 Crores

4 . From, the following data calculate the Gross National Product at Market Price using Value Added method

(₹ in Crores)
Value of output in primary sector 500
Net factor income from abroad -20
Value of output in tertiary sector 700
Intermediate consumption in secondary sector 400
Value of output in secondary sector 900
Government Transfer Payments 600
Intermediate consumption in tertiary sector 300
Intermediate consumption in primary sector 250

ANSWER 4

GDPMP = (Value of output in primary sector - intermediate consumption of primary sector) + (value of output
in secondary sector - intermediate consumption of secondary sector) + (value of output in tertiary sector -
intermediate consumption of tertiary sector)
Value of output in primary sector = 500
-Intermediate consumption of primary sector = 250
+ Value of output in secondary sector = 900
-Intermediate consumption in secondary sector = 400
+ Value of output in tertiary sector = 700
-Intermediate consumption of tertiary sector = 300
GDP MP = ₹ 1150 Crores
GNPMP = GDPMP + NFIA
GNPMP = 1150 – 20 = ₹ 1130 Crores

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5. Calculate ‘Sales’ from the following data :

Particulars ₹ in Lakhs
Subsidies 200
Opening stock 100
Closing stock 600
Intermediate consumption 3,000
Consumption of fixed capital 700
Profit 750
Net value added at factor cost 2,000

ANSWER 5

Net Value Added at factor cost = Sales + change in stocks - intermediate consumption- depreciation – NIT
2000 = Sales + 500 – 3000 – 700 –(-200)
Sales= 2000- 500 +3000 + 700 – 200= 5000 lakhs

6. Given the following data, determine the National Income of a country using expenditure method and
income method:

Particulars ₹in Crores

Private Final Consumption Expenditure 1000
Government Final Consumption Expenditure 550
Compensation of Employees 600

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Net Exports -15
Net Indirect Taxes 60
Net Domestic Fixed Investment 385
Consumption of Fixed Capital Formation 65
Net Factor Income from Abroad -10
Interest 310
Rent 200
 Mixed Income of Self-Employed 350
Profit 400

ANSWER 6

Expenditure Method formula:

NDPMP = Private Final Consumption Expenditure + Net Domestic Fixed Investment

+ Government final consumption expenditure + Net Exports (Exports-imports)

NNPMP = NDPMP + Net factor income from abroad NNPMP – Indirect Taxes = NNP FC = National Income Income
Method Formula:

NDPFC = Employee compensation + profits + rent + interest + mixed income

NNPFC = NDPFC + NFIA = National Income

Particulars ₹ in crores
Expenditure Method
Private Final Consumption Expenditure 1000
+Government Final Consumption Expenditure +550
+Net Domestic fixed Investment +385
+Net Exports +(-15)
NDP@MP =1920
+Net Factor Income from Abroad +(-10)
NNP@MP =1910
-Net Indirect Taxes -60

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NNP@FC = 1850
Consumption of Fixed Capital 65
Income Method
Compensation of Employees 600
Interest +310
Rent +200
Mixed Income of Self-Employed +350
 Profit +400
NDP@FC =1860
+Net Factor Income from Abroad +(-10)
NNP@FC = 1850

UNIT-II THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME

Illustration 1

What will be the value of average propensity to save when -

(i) C = 200 at Y = 1,000

(ii) S = 450 at Y = 1,200

Solution

Illustration 2
Calculate marginal propensity to consume and marginal propensity to save from the following data about
an economy which is in equilibrium:

National income = 2500, Autonomous consumption expenditure = 300,

Investment expenditure = 100

Solution

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Y=C+I
By putting the value we get, 2500 = C + 100
C = 2500 -100 = 2400
C = C̅+ bY
2400 = 300 + 2500 b
2400-300= 2500b
b = 0.84; MPS= 1- MPC = 1- 0.84 = 0.16
Illustration 3
An economy is in equilibrium. Calculate national income from the following-
Autonomous consumption = 100; Marginal propensity to save= 0.2; Investment expenditure= 200

Solution
Y= C + I
Y= C̅ + MPC (Y) + I where MPC = 1-MPS
Y = 100 + 0.8Y + 200= 300 + 0.8Y
Y- 0.8Y = 300
0.2Y=300,
Y= 1500

Illustration 4
Suppose the consumption of an economy is given by C = 20+ 0.6 Y and investment
I= 10+ 0.2 Y. What will be the equilibrium level of National Income?

Solution
Y= C + I= 20+ 0.6 Y + 10+ 0.2 Y
Y = 30+ 0.8 Y
Y- 0.8 Y = 30
Y= 150

Illustration 5
Suppose the consumption function C= 7+ 0.5Y, Investment is ₹ 100, Find out equilibrium level of Income,
consumption and saving?

Solution
Equilibrium Condition–
Y= C +I, Given C= 7+0.5Y and I= 100
Therefore Y= 7+0.5Y+ 100

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Y- 0.5Y= 107

Y=107/0.5 = 214

Y= C+I
214= C+100

C=114
S= Y- C =100
Illustration 6
If the consumption function is C= 250 + 0.80 Y and I = 300. Find out equilibrium level of Y, C and S?
Solution

S=Y- C
S=2750 – 2450= 300.

Illustration 7
If saving function S = -10 + 0.2Y and autonomous investment I = 50 Crores. Find out the equilibrium level of
income, consumption and if investment increases permanently by ₹ 5 Crores, what will be the new level of
income and consumption?

Solution
S= I
-10 + 0.2Y = 50
0.2Y = 50+ 10

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Y = 300 Crores
C= Y- S

Where S= -10 + 0.2 (300) = 50

C= 300-50 = 250 Crores

With the increase in investment by ₹ 5 Crores, the new investment will become equal to ₹ 55 Crores.
S= I
-10 + 0.2Y = 55
Y= 325 Crores
C= 270 Crores
Illustration 8
Given the empirical consumption function C= 100+0.75Y and I = 1000, calculate equilibrium level of national
income. What would be the consumption expenditure at equilibrium level national income?

Solution
C= 100+0.75Y and I = 1000,
Y=C+I in equilibrium

Illustration 9
In an economy investment expenditure is increased by ₹ 400 Crores and marginal propensity to consume is
0.8. Calculate the total increase in income and saving.

Solution

MPC = 0.8; ΔI = 400 Crores

Multiplier (K)= 1 /1- MPC = 1 /1- 0.8 =1/ 0.2= 5
MPS= 1 - MPC = 1 – 0.8 = 0.2
Increase in income (ΔY) = K ×ΔI = 5 × 400=2,000 Crores
Increase in saving= ΔY × MPS = 2,000 × 0.2 = 400Crores

Illustration 10
An increase in investment by 400 Crores leads to increase in national income by 1,600 Crores. Calculate

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marginal propensity to consume.

Solution

Increase in investment (ΔI) = 400 Crores

Increase in national income (Δ Y) = 1,600 Crores
Multiplier (K) =ΔY/ΔI = K= 1,600/ 400 = 4
We know, K= 1 /1 –MPC
4= 1 /1 -MPC
MPC= 0.75
Illustration 11
In an economy, investment is increased by Rs 600 Crores. If the marginal propensity to consume is 0.6,
calculate the total increase in income and consumption expenditure.

Solution
MPC = 0.6; ΔI = ₹ 600 Crores
Multiplier (K) = 1/ 1- MPC = 1/ 1 – 0.6 = 1/ 0.4 =25.
Increase in income (ΔY) = K × ΔI = 2.5 × Rs 600 Crores= Rs1,500 Crores
Increase in consumption (ΔC) =ΔY × MPC = Rs1, 500Crores × 0.6 = ₹ 900 Crores.

Illustration 12
Suppose in a country investment increases by ₹ 100 Crores and consumption is given by C = 10 + 0.6Y (where
C = consumption and Y = income). How much increases will there take place in income?
Solution

Substituting the value of k and ΔI value in ΔY= kΔI

ΔY= 2.5 × 100= ₹ 250Crores

Thus, increase in investment by Rs 100 Crores will cause equilibrium income to rise
by ₹ 250 Crores.

Illustration 13
Suppose we have the following data about a simple economy:

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C = 10 + 0.75Yd, I = 50, G = T = 20where C is consumption, I is investment, Yd is disposable income, G is
government expenditure and T is tax.

(a) Find out the equilibrium level of national income.

(b) What is the size of the multiplier?

Solution
(a) Since G = T, budget of the government is balanced

Substituting the values of C, I and G in Y we have

Y=C+I+G
Y = a + bYd + I + G
Y= 10 + 0.75 (Y – 20) + 50 + 20

Y= 10 + 0.75 Y- 15 + 50 + 20
or, Y – 0.75 Y = 65
or, Y (1 – 0.75) = 65

or, 0.25 Y = 65
or, Y = 65 /.25 = 260

The equilibrium value of Y = 260

(b) The value of the multiplier is = 1/ (1 – MPC) = 1/ (1 – b) = 1/ (1 – 0.75) = 1/0.25 = 4

Illustration 14
Suppose the structural model of an economy is given –
C = 100+ 0.75 Yd; I = 200, G = T = 100; TR= 50, find the equilibrium level of income?

Solution
Y= C+ I+ G
Y = 100+ 0.75 Yd + 200 + 100
Y= 100 + 0.75(Y– 100 + 50) + 200 + 100
Y = 100 + 0.75Y -75 + 37.5 +200 +100
Y = 1450

420
Illustration 15
For a closed economy, the following data is given –
Consumption C = 75 + 0.5 (Y-T); Investment I = 80; Total tax T = 25 + 0.1Y;
Government expenditure G = 100.
(a) Find out equilibrium income?
(b) What is the value of multiplier?

Solution
a) Y = C+ I+G
Y= 75+ 0.5(Y- 25- 0.1Y) + 80+ 100

Illustration 16
Suppose C= 100 + 0.80 (Y- T + TR); I = 200; T= 25+0.1Y; TR= 50; G = 100
Find out equilibrium level of Income?

Solution
Y=C+I+G
Y= 100 + 0.80 (Y- T + TR) + I+ G
Y=100 +0.80(Y – 25 - 0.1Y + 50) + 200 + 100
Y – 0.80 Y +0.08 Y = 420
Y(1-0.8+0.08) =420
Y= 1500

421
Illustration 17
The consumption function is C = 40 + 0.8Yd,T= 0.1Y, I = 60 Crores G = 40 Crores,
X = 58 and M = 0.05 Y. Find out equilibrium level of income, Net Export, net export if export were to
increase by 6.25.

Solution

C= 40+ 0.8Yd
C= 40 + 0.8 (Y- 0.1Y)
Y= C + I+ G + (X – M)Y= 40+0.8(Y-0.1Y)+60+40+(58-0.05Y)
Y= 40+0.8(0.9Y)+60+40+58-0.05Y

Y-0.72Y+0.05Y =198
Y(1-0.72+0.05) =198
Y(0.33) =198
Y= 198/0.33 = 600 Crores

Net Export= X-M = 58 – 0.05Y

58 – 0.05 (600) =58- 30= 28

If exports increase by 6.25, then exports = 64.25

Then, Y = 40+ 0.8 (Y- 0.1Y) + 60 + 40 + (64.25- 0.05Y)

Y(1-0.72+0.05) = 204.5
Y(0.33) = 204.5
Y=204.5/0.33 = 619.697

Then import = .05 × 619.697= 30.98

Net Export= 64.25- 30.98= 33.27 Crores
Thus, there is surplus in balance of trade as Net Exports are positive.

Illustration 18
An economy is characterised by the following equation-

Consumption C = 60+0.9Yd
Investment I = 10
Government expenditure G = 10
Tax T = 0

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Exports X = 20
Imports M = 10 +0.05 Y
What is the equilibrium income?
Calculate trade balance and foreign trade multiplier.

Solution
Y = C + I+ G + (X – M)
= 60+0.9(Y – 0) + 10 +10 + (20- 10 -0.05Y)
= 60+ 0.9 Y +30 -0.05 Y
Y= 600
Trade Balance = X – M = 20-10-0.05(600)=- 20

Thus, trade balance in deficit.

Multiple Choice Questions

1. In the Keynesian model, equilibrium aggregate output is determined by

(a) aggregate demand

(b) consumption function

(c) the national demand for labor

(d) the price level

ANSWER 1-A

2. Keynes believed that an economy may attain equilibrium level of output

(a) only at the full-employment level of output

(b) below the full-employment level of output

(c) only if prices were inflexible

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(d) a) and c) above

ANSWER 2-B

3. According to Keynes, consumption expenditure is determined by

(a) the level of interest rates

(b) extent of government taxes and subsidies

(c) disposable income

(d) autonomous investment expenditure

ANSWER 3-C

4. The marginal propensity to consume (MPC) can be defined as

(a) a change in spending due to a change in income

(b) a change in income that is saved after consumption

(c) part of income that is spent on consumption.

(d) part of income that is not saved.

ANSWER 4-A

5. If the consumption function is expressed as C = a + bY then b represents

(a) autonomous consumer expenditure when income is zero

(b) the marginal propensity to consume.

(c) the expenditure multiplier when consumption is increased

(d) part of disposable income

ANSWER 5-B

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6. If the consumption function is expressed as C = a + bY then a represents

(a) autonomous consumer expenditure.

(b) the marginal propensity to consume.

(c) the consumption income relationship

(d) Non- linear consumption function

ANSWER 6-A

7. If the consumption function is C = 20 + 0.5Yd, then an increase in disposable income by ₹ 100 will result in
an increase in consumer expenditure by ₹-----------

(a) 25

(b) 70

(c) 50

(d) 100

ANSWER 7-C

8. If the autonomous consumption equals ₹ 2,000 and the marginal propensity to consume equals 0.8. If
disposable income equals ₹ 10,000, then total consumption will be ₹ ---------

(a) 8,000

(b) 6,000

(c) 10,000

(d) None of the above

ANSWER 8-C

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9. In the Keynesian cross diagram, the point at which the aggregate demand function crosses the 45-degree
line indicates the

(a) level of full employment income.

(b) less than full employment level of income.

(c) equilibrium level of income which may or may not be full employment level of income
(d) autonomous level of income which may not be full employment level of income

ANSWER 9-C

10. In a closed economy, aggregate demand is the sum of

(a) consumer expenditure, demand for exports and government spending.

(b) consumer expenditure, planned investment spending and government spending.

(c) consumer expenditure, actual investment spending, government spending and net exports.

(d) consumer expenditure, planned investment spending, government spending, and net exports.

ANSWER 10-B

11. Under equation C= a+by, b=0.8, what is the value of 2 sector expenditure multiplier?
(a) 4

(b) 2

(c) 5

(d) 1

ANSWER 11-C

Short Answer Type Questions

426
1. Define equilibrium output?

ANSWER 1

‘Equilibrium’ (defined as a state in which there is no tendency to change; or a

position of rest). Equilibrium output occur when the desired amount of output demanded by all the agents in
the economy exactly equals the amount produced in a given time period.
2. What are the components of aggregate expenditure in two sector economy?

ANSWER 2

Only two components namely: aggregate demand for consumer goods ( C), and aggregate demand for
investment goods (I)

3. Define consumption function?

ANSWER 3

Functional relationship between aggregate consumption expenditure and aggregate disposable income,
expressed as C = f (Y) ;shows the level of consumption (C) corresponding to each level of disposable income (Y)

4. Explain the concept of marginal propensity to consume?

ANSWER 4

The consumption function is based on the assumption that there is a constant relationship between
consumption and income, as denoted by constant b which is marginal propensity to consume. The concept of
MPC describes the relationship between change in consumption (ΔC) and the change in income (ΔY). The
value of the increment to consumer expenditure per unit of increment to income is termed the Marginal
Propensity to Consume (MPC).

5. Define average propensity to consume?

427
ANSWER 5

Just as marginal propensity to consume, the average propensity to consume is a ratio of consumption defi ning
income consumption relationship. The ratio of totalconsumption to total income is known as the average
propensity to consume (APC).

6. Distinguish between saving function and marginal propensity to save.

ANSWER 6
The Saving Function
Saving is also a function of disposable income. The saving function shows the function shows the functional
relationship between national income (= disposable income in two sector model) and saving.

The Marginal Propensity to Save (MPS)

The slope of the saving function is the marginal propensity to save. If one-unit increase in disposable income
leads to an increase of ‘b’ units in consumption, the remainder (1 - b) is the increase in saving. This increment
to saving per unit increase in disposable income (1 - b) is called the marginal propensity to save
(MPS). In other words, the marginal propensity to save is the increase in saving per unit increase in disposable
income.

7. What is meant by autonomous expenditure?

ANSWER 7

Expenditures that do not vary with the level of income. They are determined by factors other than income
such as business expectations and economic policy

8. What would happen if aggregate expenditures were to exceed the economy’s production capacity?
ANSWER 8
Aggregate expenditures in excess of output lead to a higher price level once the economy reaches full
employment. Nominal output will increase, but it merely reflects higher prices, rather than additional real
output

9. Outline the relationship between marginal propensity to consume and multiplier.

ANSWER 9

The marginal propensity to consume is the determinant of the value of the multiplier. The higher the (MPC)
the greater is the value of the multiplier.

428

10. What is the effect of income leakages on multiplier?

ANSWER 10

The more powerful the leakages are, the smaller will be the value of multiplier.
11. List out the components of aggregate demand in a three-sector economy?
ANSWER 11

Three components namely, household consumption(C), desired business investment demand (I) and the
government sector’s demand for goods and services (G).

12. What role does government play in a three-sector economy?

ANSWER 12

Imposes taxes on households and business sector, effects transfer payments to household sector and subsidy
payments to the business sector, purchases goods and services and borrows from financial markets

13. Define net exports?

ANSWER 13

The foreign sector's contribution to aggregate expenditures; derived by subtracting imports from exports i.e.
net exports

14. How do imports affect investment multiplier?

ANSWER 14

The greater the value of propensity to import m, the lower will be the autonomous expenditure multiplier.

15. Differentiate excess demand and deficient demand.

429
ANSWER 15

If the aggregate demand is for an amount of output greater than the full\ employment level of output, then
we say there is excess demand. Excess demand gives rise to ‘inflationary gap’. On the other hand, If the
aggregate demand is for an amount of output less than the full employment level of output, then we say there
is deficient demand. Deficient demand gives rise to a ‘deflationary gap’ or ‘recessionary gap’. Recessionary gap
also known as ‘contractionary gap’.
III Long Answer Type Questions
1. Explain Keynesian concept of equilibrium aggregate income? Illustrate your answer with appropriate
diagrams.
ANSWER 1

Keynes’ theory of determination of equilibrium real GDP, employment and prices focuses on the relationship
between aggregate income and aggregate expenditure. There is a difference between equilibrium income (the
level toward which the economy gravitates in the short run) and potential income (the level of
income that the economy is technically capable of producing, without generating accelerating
inflation).Keynes argued that markets would not automatically lead to full-employment equilibrium and the
resulting natural level of real GDP. The economy could settle in equilibrium at any level of unemployment.
Keynesians believe that prices and wages are not so flexible; they are sticky, especially downward. The
stickiness of prices and wages in the downward direction prevents the economy's resources from being fully
employed and thereby prevents the economy from returning to the natural level of real GDP. Therefore,
output will remain at less than the full employment level as long as there is insufficient spending in the
economy. This was precisely what was happening during the great depression.

The Keynesian theory of income determination is presented in three models:

(i) The two-sector model consisting of the household and the business sectors,

(ii) The three-sector model consisting of household, business and government sectors, and

(iii) The four-sector model consisting of household, business, government and foreign sectors

430
2. Describe the circular flow in a simple two-sector model?
ANSWER 2

The circular flow of income is a process where the national income and expenditure of an economy flow in a
circular manner continuously through time. Savings, expenditures, exports and imports are various
components of circular flow of income which are shown in the figure in the form of currents and cross
currents in such a manner that national income equals national expenditure.

Initially, we consider a hypothetical simple two-sector economy. Even though an economy of this kind does
not exist in reality, it provides a simple and convenient basis for understanding the Keynesian theory of
income determination. The simple two sector economy model assumes that there are only two sectors in the
economy viz., households and firms, with only consumption and investment outlays. Households own all
factors of production and they sell their factor services to earn factor incomes which are entirely spent to
consume all final goods and services produced by business firms. The business firms are assumed
to hire factors of production from the households; they produce and sell goods and services to the households
and they do not save. There are no corporations, corporate savings or retained earnings. The total income
produced, Y, accrues to the households and equals their disposable personal income Yd i.e., Y = Yd.

All prices (including factor prices), supply of capital and technology remain constant. The government sector
does not exist and therefore, there are no taxes, government expenditure or transfer payments. The economy
is a closed economy, i.e., foreign trade does not exist; there are no exports and imports and external
inflows and outflows. All investment outlay is autonomous (not determined either by the level of income or
the rate of interest); all investment is net and, therefore, national income equals the net national product.

431

3. Explain the concept of investment multiplier? Give suitable examples?

ANSWER 3
Multiplier refers to the phenomenon whereby a change in an injection of
expenditure will lead to a proportionately larger change (or multiple changes) in the equilibrium level of
national income. The investment multiplier explains how many times the equilibrium aggregate income
increases as a result of an increase in autonomous investment. When the level of investment increases by an
amount
say ΔI, the equilibrium level of income will increase by some multiple amounts, Δ Y. The ratio of ΔY to ΔI is
called the investment multiplier, k.

The size of the multiplier effect is given by Δ Y = k ΔI.

For example, if a change in investment of ₹ 2000 million causes a change in national income of ₹ 6000 million,
then the multiplier is 6000/2000 =3. Thus multiplier indicates the change in equilibrium national income for
each rupee change in the desired autonomous investment. The value 3 in the above example tells us that for
every ₹ 1 increase in desired autonomous investment expenditure, there will be ₹ 3 increase in equilibrium
national income. Multiplier, therefore, expresses the relationship between an initial increment in autonomous
investment and the resulting increase in equilibrium aggregate income. Since the increase in national income
(ΔY) is the result of increase in investment (ΔI), the multiplier is called ‘investment multiplier.’

The process behind the multiplier can be compared to the ‘ripple effect’ of water.

Let us assume that the initial disturbance comes from a change in autonomous investment (ΔI) of 500 units.
The economy being in equilibrium, an upward shift in aggregate demand leads to an increase in national
income which in a two sector economy will be, by definition, distributed as factor incomes. There will be an
equal increase in disposable income. Firms experience increased demand and as a response, their output
increases. Assuming that MPC is 0.80, consumption expenditure increases by 400, resulting in increase in
production. The process does not stop here; it will generate a second-round of increase in income. The
process further continues as an autonomous rise in investment leads to induced increases in consumer
demand as income increases.

4. Describe the components of aggregate expenditure in two sector economy models.

ANSWER 4

TWO SECTOR MODEL 432

Equilibrium with Unemployment or Inflation

(i) Deflationary Gap

If the aggregate demand is for an amount of output less than the full employment level of output, then we say
there is deficient demand. Deficient demand gives rise to a ‘deflationary gap’ or ‘recessionary gap’.
Recessionary gap also known as ‘contractionary gap’ arises in the Keynesian model of the macro economy
when the equilibrium level of aggregate production achieved in the short-run falls short of what could be
produced at full employment. Recessionary gap occurs when the economy is in a business-cycle contraction or
recession.

Deflationary gap is thus a measure of the extent of deficiency of aggregate demand and it causes the
economy’s income, output and employment to decline, thus pushing the economy to under- employment
equilibrium. The macroequilibrium occurs at a level of GDP less than potential GDP; thus, there is cyclical
unemployment i.e. rate of unemployment is higher than the natural rate. (Demand deficient unemployment is
the same as cyclical unemployment)

(ii) Inflationary Gap

If the aggregate demand is for an amount of output greater than the full employment level of output, then we
say there is excess demand. Excess demand gives rise to ‘inflationary gap’ which is the amount by which actual
aggregate demand exceeds the level of aggregate demand required to establish the full
employment equilibrium. This is the sort of gap that tends to occur during a business-cycle expansion and sets
in motion forces that will cause demand pull inflation.

5. Explain national income determination in a two sector economy?

ANSWER 5

The nature of shift in aggregate demand curve and its effect on equilibrium level of national income.

• Given the intercept, a steeper aggregate demand function—as would be implied by a higher marginal
propensity to consume—implies a higher level of equilibrium income.

• For a given marginal propensity to consume, a higher level of autonomous spending implies a higher
equilibrium level of income.

Therefore, it may be inferred that a change in aggregate spending will shift the equilibrium from one point to
another and a shift in the equilibrium will change the level of national income. An increase in aggregate
spending makes the aggregate demand schedule shift upward. As a result, the equilibrium point
would shift upward along the AS schedule causing an increase in the national income. Likewise, a fall in the

433
aggregate spending causes a fall in the national income. This relationship between the aggregate spending and
the national income is simple and straightforward.

The proposition put forth above tells us only the direction of change in the national income resulting from the
change in the aggregate demand. It does not quantify the relationship between the two variables, i.e.; it does
not tell us the magnitude of change in national income due to a given change in aggregate
spending.
6. Distinguish between national income determination in three and four sector economy models?

ANSWER 6

Income Determination – THREE SECTOR MODEL

(i) Income Determination with Lump Sum Tax

We assume that the government imposes lump sum tax, i.e. taxes that do not depend on income, has a
balanced budget (G=T) and also that there are no transfer payments. The consumption function is defined as –

C = a + b Yd

Where Yd = Y –T (disposable income), T = lump sum tax

Y= a + b (Y - T) + I + G

The four sector model includes all four macroeconomic sectors, the household sector, the business sector, the
government sector, and the foreign sector. The foreign sector includes households, businesses, and
governments that reside in other countries. The following flowchart shows the circular flow in a four sector
economy.

In the four sector model, there are three additional flows namely: exports, imports and net capital inflow
which is the difference between capital outflow and capital inflow. The C+I+G+(X-M) line indicates the
aggregate demand or the total planned expenditures of consumers, investors, governments and foreigners
(net
exports) at each income level.

434
In equilibrium, we have
Y = C + I + G + (X-M)

The domestic economy trades goods with the foreign sector through exports and imports. Exports are the
injections in the national income, while imports act as leakages or outflows of national income. Exports
represent foreign demand for domestic output and therefore, are part of aggregate demand. Since imports
are
not demands for domestic goods, we must subtract them from aggregate demand. The demand for imports
has an autonomous component and is assumed to depend on income. Imports depend upon marginal
propensity to import which is the increase in import demand per unit increase in GDP. The demand for
exports depends on foreign income and is therefore exogenously determined and are autonomous. Imports
are subtracted from exports to derive net exports, which is the foreign sector's contribution to aggregate
expenditures.

Since import has an autonomous component (M̅ ) and is assumed to depend on income(Y) and marginal
propensity to import (m), the import function is expressed as M= M̅ + mY. Marginal propensity to import m = Δ
M/Δ Y is assumed to be constant.

7. Define multiplier. Explain the functioning of multiplier?

ANSWER 7

Multiplier refers to the phenomenon whereby a change in an injection of

expenditure will lead to a proportionately larger change (or multiple changes) in the equilibrium level of
national income. The investment multiplier explains how many times the equilibrium aggregate income
increases as a result of an increase in autonomous investment. When the level of investment increases by an
amount say ΔI, the equilibrium level of income will increase by some multiple amounts, Δ Y. The ratio of ΔY to
ΔI is called the investment multiplier, k.

The size of the multiplier effect is given by Δ Y = k ΔI.

For example, if a change in investment of ₹ 2000 million causes a change in national income of ₹ 6000 million,
then the multiplier is 6000/2000 =3. Thus multiplier indicates the change in equilibrium national income for
each rupee change in the desired autonomous investment. The value 3 in the above example
tells us that for every ₹ 1 increase in desired autonomous investment expenditure, there will be ₹ 3 increase in
equilibrium national income. Multiplier, therefore, expresses the relationship between an initial increment in
autonomous investment and the resulting increase in equilibrium aggregate income. Since the
increase in national income (ΔY) is the result of increase in investment (ΔI), the multiplier is called ‘investment
multiplier.’ The process behind the multiplier can be compared to the ‘ripple effect’ of water.

Let us assume that the initial disturbance comes from a change in autonomous investment (ΔI) of 500 units.
The economy being in equilibrium, an upward shift in aggregate demand leads to an increase in national
income which in a two sector economy will be, by definition, distributed as factor incomes. There will be an

435
equal increase in disposable income. Firms experience increased demand and as a response, their output
increases. Assuming that MPC is 0.80, consumption expenditure increases by 400, resulting in increase in
production. The process does not stop here; it will generate a second-round of increase in income. The
process further continues as an autonomous rise in investment leads to induced increases in consumer
demand as income increases.
8. Elucidate the relationship between consumption function and saving function?
ANSWER 8

The Saving Function

Saving is also a function of disposable income. The saving function shows the function shows the functional
relationship between national income (= disposable income in two sector model) and saving.
S = f(Y)

The Consumption Function

Consumption function expresses the functional relationship between aggregate consumption expenditure and
aggregate disposable income, expressed as:

C = f (Y)

When income is low, consumption expenditures of households will exceed their disposable income and
households dissave i.e. they either borrow money or draw from their past savings to purchase consumption
goods. If the disposable income increases, consumers will increase their planned expenditures and current
consumption expenditures rise, but only by less than the increase in income.

The specific form of consumption–income relationship termed the consumption function, proposed by Keynes
is as follows:

C = a + By

where C = aggregate consumption expenditure; Y= total disposable income; a is a constant term which
denotes the (positive) value of consumption at zero level of disposable income; and the parameter b, the
slope of the function, (ΔC /ΔY) is the marginal propensity to consume (MPC) i.e. the increase in consumption
per
unit increase in disposable income.

9. How do imports and exports with the rest of the world affect the level of income and output? 436

ANSWER 9

The domestic economy trades goods with the foreign sector through exports and imports. Exports are the
injections in the national income, while imports act as leakages or outflows of national income. Exports
represent foreign demand for domestic output and therefore, are part of aggregate demand. Since imports
are not demands for domestic goods, we must subtract them from aggregate demand. The demand for
imports has an autonomous component and is assumed to depend on income. Imports depend upon marginal
propensity to import which is the increase in import demand per unit increase in GDP. The demand for
exports depends on foreign income and is therefore exogenously determined and are autonomous. Imports
are subtracted from exports to derive net exports, which is the foreign sector's contribution to aggregate
expenditures. Since import has an autonomous component (M̅ ) and is assumed to depend on income(Y) and
marginal propensity to import (m), the import function is expressed as

M= M̅ + mY. Marginal propensity to import m = Δ M/Δ Y is assumed to be constant.

As noted above, the equilibrium level of national income is determined at the level at which the aggregate
demand is equal to aggregate supply. The equilibrium condition is expressed as follows-

Y = C + I+ G + (X – M)

Where C = a + b(Y-T)

M= M̅ + mY

10. Define Inflationary gap and how it arises in an economy?

ANSWER 10

Inflationary Gap
If the aggregate demand is for an amount of output greater than the full employment level of output, then we
say there is excess demand. Excess demand gives rise to ‘inflationary gap’ which is the amount by which actual
aggregate demand exceeds the level of aggregate demand required to establish the full
employment equilibrium. This is the sort of gap that tends to occur during a business-cycle expansion and sets
in motion forces that will cause demand pull inflation.

The real output will be constant, but the rise in the price level will cause an increase in the nominal output

437
until the new equilibrium is reached at point E. Point E is an equilibrium point because the aggregate demand
ME is equal to output OM. At the new equilibrium, real output, real income and employment will be the same;
nominal output and income has increased due to inflation.

In the Keynesian model, neither wages nor interest rates will decline in the face of abnormally high
unemployment and excess capacity. Therefore, output will remain at less than the full employment rate as
long as there is insufficient spending in the economy. Keynes argued that this was precisely what was
happening during the Great Depression.
IV Application Oriented Question

1. In a two sector economy, the business sector produces 7000 units at an average price of ₹ 5.

(a) What is the money value of output?

(b) What is the money income of households?

(c) If households spend 80 percent of their income, what is the total consumer expenditure?

(d) What are the total money revenues received by the business sector?

(e) What should happen to the level of output?

ANSWER 1

(a) The money value of output equals total output times the average price per unit. The money value of
output is (7,000 x 5) = ₹ 35,000.

(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore,
the money income of households is the same as the money value of output i.e₹ 35,000.

(c) Total spending by households (₹ 35,000 x 0.8) i.e. ₹ 28,000.

(d) The total money revenues received by the business sector is equal to aggregate spending by households
i.e. ₹ 28, 000.

(e) The business sector makes payments of ₹ 35000 to produce output, whereas the households purchase only
output worth ₹ 28,000 of what is produced. Therefore, the business sector has unsold inventories valued at ₹
7000. They should be expected to decrease output.

2. Assume that an economy’s consumption function is specified by the equation C = 500 + 0.80Y. 438

(a) What will be the consumption when disposable income (Y) is ₹ 4,000, ₹ 5,000, and ₹ 6,000?

(b) Find saving when disposable income is ₹ 4,000, ₹ 5,000, and ₹ 6,000.
(c) What amount of consumption for consumption function C is autonomous?
(d) What amount is induced when disposable income is₹ 4,000?₹ 5,000?₹ 6,000?

ANSWER 2
(a) Consumption for each level of disposable income is found by substituting the specified disposable income
level into the consumption equation.
Thus, for Y = ₹ 4,000, C = ₹ 500 + 0.80(₹ 4,000) = ₹ 500 + ₹ 3,200 = ₹ 3,700.
Likewise C is ₹ 4,500 when Y = ₹ 5,000, and ₹ 5,300 when Y = ₹ 6,000.

(b) Saving is the difference between disposable income and consumption.

It is the difference between the consumption line and the 45 line at each level of disposable income

Using the calculation from part a) above, we find that saving is ₹ 300 when Y is ₹ 4,000; ₹ 500 when Y is ₹
5,000 and ₹ 700 when Y is ₹ 6,000.

(c) Autonomous consumption is the amount consumed when disposable income is zero; autonomous
consumption is ₹ 500, i.e the consumption expenditure when the consumption line C intersects the vertical
axis and disposable income is 0. Since autonomous consumption is unrelated to income, autonomous
consumption is ₹ 500 for all levels of income.

(d) Induced consumption is the amount of consumption that depends upon the level of income. Consumption
is ₹ 3,700 when disposable income is ₹ 4,000. Since ₹ 500 is autonomous (i.e consumed regardless
of the income level), ₹ 3,200 out of the ₹ 3,700 level of consumption is induced by disposable income.
Similarly, Induced consumption is ₹ 4,000 when disposable income is ₹ 5,000, and ₹ 4,800 when disposable
income is ₹ 6,000.

3. Find the value of the multiplier when

(a) MPC is 0.2
(b) MPC is 0.5
(c) MPC is 0.8

ANSWER 3

The value of the multiplier (k) is found by relating the change in output (ΔY) 439
to the initial change in aggregate spending. The value of the multiplier is
directly related to the level of MPC, i.e., the greater the MPC, the larger the
value of the multiplier. The value of the multiplier is found from the
equation k = 1/ (1 − MPC).
(a) Thus, when MPC is 0.2, the multiplier is 1.25
(b) When MPC is 0.5, the multiplier is 2
(c) When MPC = 0.80, the multiplier is 5
4. For the linear consumption function is C = 700 + 0.8Y; I is ₹ 1200 and Net exports X-M = 100. Find
equilibrium output?

ANSWER 4
The equilibrium level of output can be found by equating output and aggregate spending i.e. by solving Y = C +
I + X-M for Y
Y = C + I + X- M
Y = 700 + 0.8Y + 1200 + 100
Y − 0.8Y = 700 + 1200 + 100
0.2Y = 2000
Y =2000/.2 = 10,000

5. Suppose in an economy
C = 100 + b(Y – 50 –t Y) ; I = 50; G = 50 ;X = 10; M = 5 + 0.1Y; MPC (b) =
0.8; Proportional income tax rate (t) = 0.25
(a) Find the equilibrium national income, foreign trade multiplier, equilibrium value of imports.
(b) If equilibrium national income falls short of full employment income by ₹ 50, how much government
should increase its expenditure to attain full – employment?

ANSWER 5

(a) Y = C + I + G+X- M
Y= 100 + b (Y – 50 –t Y) +50+50 +10-5-0.1Y
Y= 100+ 0.8 (Y-50-0.25Y) +105 -0.1Y
Y= 100+0.8Y-40-0.2Y +105-0.1Y
Y= 165 +0.8Y-0.2Y-0.1Y
Y=165+ 0.5Y
Y-0.5Y=165
Y=165/0.5
Y= 330

440
OR
6. Suppose the consumption function is C=50+0.8Yd, I=180 crores, G=190, crores, T=0.20Y
(a) Find the equilibrium level of income.
(b) Find the revenue from taxes at equilibrium. Is the government budget balanced?
(c) Find the equilibrium level of income when investment increases by 120 crores.

ANSWER 6

(a) Y= 50+0.8(Y-.20Y) +180+190,

Ye= 420/.36= 1166.66 Crores

(b) T=0.2 (1166.66) = 233.332 Crores

G=190< T= 233.332, thus, budget is not in balance. There exists a budget Surplus

441
(c) Change in Y= Change in I/ (1-b+bt) = 120/ (1-.8+.16) = 120/.36= 333.33Crores, So new Y equilibrium:
Y new= 1166.66+333.33 = 1499.99 Crores

7. Given the following equations:

C=50+0.6Yd, I= 160, T =30, G =28, X-M = 20 -0.05 Y
(a) Find the equilibrium level of income.
(b) Find the net exports at equilibrium.
(c) Find the income and net exports when investment increases to 195.
ANSWER 7
(a) Y = AE
Y= C + I + G + (X – M)
Y= 50+0.6(Y-T) + I + G + (X – M)
240+.55Y=Y
Ye= 533.33 Crores

(b) X-M=20- .05(533.33) = -6.66 Crores

(c) Change in I= 35
Change in Y= 35/(1-b+m) =35/ (1-.6+.05) = 77.77 Crores
Thus, Ye= 533.33+77.77 =611.1 Crores
X-M @ Ye= 611.1= 20-.05(611.1) =10.555 Crores

7. Given the following equations:

C=50+0.6Yd, I= 160, T =30, G =28, X-M = 20 -0.05 Y
(a) Find the equilibrium level of income.
(b) Find the net exports at equilibrium.
(c) Find the income and net exports when investment increases to 195.

ANSWER

(a) Y = AE
Y= C + I + G + (X – M)
Y= 50+0.6(Y-T) + I + G + (X – M)
240+.55Y=Y
Ye= 533.33 Crores

(b) X-M=20- .05(533.33) = -6.66 Crores

(c) Change in I= 35
Change in Y= 35/(1-b+m) =35/ (1-.6+.05) = 77.77 Crores
Thus, Ye= 533.33+77.77 =611.1 Crores
X-M @ Ye= 611.1= 20-.05(611.1) =10.555 Crores

442
 CHAPTER-2 PUBLIC FINANCE
Multiple Choice Type Questions

1. Macroeconomic stabilization may be achieved through

(a) Free market economy

(b) Fiscal policy

(c) Monetary policy

(d) (b) and (c) above

ANSWER 1-D

2. Which of the following policies of the government fulfils the redistribution function

(a) Parking the army on the northern borders of the country

(b) Supply of medicines at subsidized prices to the poor people

(c ) Controlling the supply of money through monetary policy

(d) None of the above

443
ANSWER 2-B
3. Choose the correct statement

(a) Fiscal policy involves the use of changes in taxation and government spending; while monetary policy
involves the use of price and profit controls.

(b) Fiscal policy involves the use of price and profit controls; while monetary policy involves the use of
taxation and government spending.

(c) Fiscal policy involves the use of changes in taxation and government spending; while monetary policy
involves the use of changes in the supply of money and interest rates.

(d) Fiscal policy involves the use of changes in the supply of money and interest rates; while monetary policy
involves the use of changes in taxation and government spending.
ANSWER 3-C

4. The justification for government intervention is best described by

(a) The need to prevent recession and inflation in the economy

(b) The need to modify the outcomes of private market actions

(c) The need to bring in justice in distribution of income and wealth

(d) All the above

ANSWER 4-D

5. When the government decides to produce fertilizers and supply them to the agriculturists, it aims

444
(a) to achieve equity and fairness to the agriculturists

(b) to influence the way resources are allocated in the economy

(c) to ensure higher profits to agriculturists

(d) to make greater profits for the public sector

ANSWER 5-B
6.. Read the following statements:

1. The market-generated allocation of resources is usually imperfect and leads to inefficient allocation of
resources in the economy

2. Market failures can at all times be corrected through government intervention

3. Public goods will not be produced in sufficient quantities in a market economy

Of the three statements above:

(a) 1 ,2 and 3 are correct

(b) 1 and 3 are correct

(c) 2 and 3 are correct

(d) 3 alone is correct

ANSWER 6-B

7. The allocation and distribution functions are primarily:

(a) Micro-economic functions

(b) Macro-economic functions

(c) both micro as well as macro-economic functions

(d) aimed at bringing in price stability and economic growth

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ANSWER 7-A

II. Short Answer Type Questions

1. Describe why governments should perform the allocation function in an economy.

ANSWER 1
Government intervention in resource allocation is necessary and justified to ensure social welfare through
optimal allocation of resources. Government should perform the allocation function in an economy because it
is the responsibility of the governments to initiate suitable corrective action when private markets fail to
provide the right and desirable combination of goods and services. .Government intervention in resource
allocation is also warranted in the case of goods which we cannot produce on our own, or buy at a price from
the market and in the case of merit goods and goods which involve externalities

2. How does monopoly power affect efficiency of markets?

ANSWER 2

The presence of monopoly power affects the efficiency of markets in different degrees leading to under-
production and higher prices than would exist under conditions of competition. These distort the choices
available to consumers and reduce their welfare.

3. Explain how government can get domestic producers to produce more pulses.
ANSWER 3

Government may influence private allocation through incentives and disincentives. Pulses being a major
source of protein and nutritional security for people, government should ensure that sufficient quantities are
produced. This may be done through a structured policy of tax concessions, subsidies, guaranteed minimum
support prices and assured government procurement. Government also needs to incur expenditure to provide
accessible physical and technological infrastructure to boost production

4. Enumerate the circumstances which necessitate redistribution by government.

ANSWER 4

Governments redistribution function arises when it is necessary to change the pattern of distribution of
income, wealth and opportunities from what the market would put forward to a more socially optimal and

446
egalitarian
one. The redistribution function aims to achieve an equitable distribution of societal output among
households, advance the well-being of those members of the society who suffer from deprivations of different
types,
provide equality in income, wealth and opportunities, offer security to people who have hardships, and to
ensure that everyone enjoys a minimal standard of living.
5. Illustrate with an example the redistribution effect of a tax and transfer policy.

ANSWER 5

Inequality and the resulting loss of social welfare is sought to be tackled by government through an
appropriately framed tax and transfer policy. This involves progressive taxation combined with provision of
subsidy to low income households. Proceeds from progressive taxes may be used to finance public services,
especially those such as public housing, which particularly benefit low income households. Few examples are:
supply of essential food grains at highly subsidized prices to BPL households, free or subsidised education,
healthcare, housing, rations and basic goods etc to the deserving people

6. What is the objective of government subsidy?

ANSWER 6
Subsidy is a form of market intervention by government. It involves the government directly paying part of
cost to the producers (or consumers) in order to promote the production (consumption) of goods and
services. The
aim of subsidy is to intervene with market equilibrium to reduce the costs and thereby the market price of
goods and services and encourage increased production and consumption. Major subsidies in India are
fertiliser subsidy, food subsidy, interest subsidy, etc.

7. Why do private producers hesitate to produce public parks, bridges and highways?

ANSWER 7
While private goods will be sufficiently provided by the market, public goods will not be produced in sufficient
quantities by the market. The private producers hesitate to produce public parks, bridges and highways

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because these are public goods. Markets typically fail to provide such collective goods which are, by their very
nature, non-excludable and consumed in common by all the people who are most likely to free – ride
8. What reason would you assign for employment reservations to socially backward communities?

ANSWER 8
Employment reservation to socially backward communities is a government intervention policy for
redistribution and to ensure equity, social justice and fairness to the people who are underprivileged. Left to
the competitive
market, these communities are unlikely to get their fair share as they are less entitled to compete with others
and secure employment.

9. What would be the objective of a government when it declares special schemes for backward regions?

ANSWER 9
Declaration of special schemes for backward region is a type of government intervention in the market for
socio-economic reasons. The objective of such a measure is to ensure equity by changing the pattern of
distribution of income, wealth and opportunities from what the market would put forward to a more socially
optimal and egalitarian one.

10. What should be the public revenue and expenditure policy of the government during recession?

ANSWER 10
During recession, the government increases its expenditure or cuts down taxes or adopts a combination of
both so that aggregate demand is boosted up with more money put into the hands of the people.

11. Describe the rationale for the stabilization function of government policy.

448
ANSWER 11
The rationale for the stabilization function of the government is derived from the Keynesian proposition that a
market economy does not automatically generate full employment and price stability and therefore the
governments should pursue deliberate stabilization policies. The market system has inherent tendencies to
create business cycles. The market mechanism is limited in its capacity to prevent or to resolve the disruptions
caused by the fluctuations in economic activity
III. Long Answer Type Questions

1. Explain the role of government in a market economy.

ANSWER 1

A market economy is subject to serious malfunctioning in several basic respects.

There is also the problem of nonexistence of markets in a variety of situations. While private goods will be
sufficiently provided by the market, public goods will not be produced in sufficient quantities by the market.
Why do markets fail to give the right answers to the questions as to how the resources can be efficiently
utilised and what goods should be produced and in what quantities?

In other words, why do markets generate misallocation of resources?

Efficient allocation of available resources in an economy takes place only when free and competitive market
structure exists and economic agents make rational choices and decisions. Such efficient allocation of
resources is assumed to take place only in perfectly competitive markets. In reality, markets are never
perfectly
competitive. Market failures which hold back the efficient allocation of resources occur mainly due to the
following reasons:

• Imperfect competition and presence of monopoly power in different degrees leading to under-production
and higher prices than would exist under conditions of competition. These distort the choices available to
consumers and reduce their welfare.

• Markets typically fail to provide collective goods which are, by their very nature, consumed in common by all
people.

• Markets fail to provide the right quantity of merit goods.

• Common property resources are overused and exhausted in individual pursuit of self-interest.

449
• Externalities which arise when the production and consumption of a good or service affect people and they
cannot influence through markets the decision about how much of the good or service should be produced
e.g.
pollution.
2. Illustrate four cases which provide justification for government intervention in markets.
ANSWER 2

A few examples of the redistribution function (or market intervention for socioeconomic reasons) performed
by governments are:

• taxation policies of the government whereby progressive taxation of the rich is combined with provision of
subsidy to the poor households

• proceeds from progressive taxes used for financing public services, especially those that benefit low-income
households (for example, supply of essential food grains at highly subsidized prices to BPL households)

• employment reservations and preferences to protect certain segments of the population,

• unemployment benefits and transfer payments to provide support to the underprivileged, dependent, and
physically handicapped,

• families below the poverty line are provided with monetary aid and aid in kind

• regulation of manufacture and sale of certain products to ensure health and well-being of consumers, and

• special schemes for backward regions and for the vulnerable sections of the
population

3. Describe the various interventional measures adopted by the government.

ANSWER 3

Government’s stabilization intervention may be through monetary policy as well as fiscal policy. Monetary
policy works through controlling the size of money supply and interest rate in the economy which in turn
would affect consumption, investment and prices. Fiscal policy for stabilization purposes attempts to direct
the actions of individuals and organizations by means of its expenditure and taxation decisions. On the

450
expenditure side, Government can choose to spend in such a way that it stimulates other economic activities.
For example, government expenditure on building infrastructure may initiate a series of productive
activities. Production decisions, investments, savings etc can be influenced by its tax policies
4. What are the different instruments available to the government to improve allocation efficiency in an
economy?

ANSWER 4
A variety of allocation instruments are available by which governments can influence resource allocation in
the economy. For example,

• government may directly produce an economic good (for example, electricity and public transportation
services)

• government may influence private allocation through incentives and disincentives (for example, tax
concessions and subsidies may be given for the production of goods that promote social welfare and higher
taxes may be imposed on goods such as cigarettes and alcohol)

• government may influence allocation through its competition policies, merger policies etc. which affect the
structure of industry and commerce (for example, the Competition Act in India promotes competition and
prevents anti-competitive activities)

• governments’ regulatory activities such as licensing, controls, minimum wages, and directives on location of
industry influence resource allocation.

• government sets legal and administrative frameworks, and

• any mixture of intermediate methods may be adopted by governments

5. Explain how economic stability can be achieved through fiscal policy.

451
ANSWER 5

The stabilization function is concerned with the performance of the aggregate

economy in terms of:
• labour employment and capital utilization,

• overall output and income,

• general price levels,

• balance of international payments, and

• the rate of economic growth.
Government’s fiscal policy has two major components which are important in stabilizing the economy:

1. an overall effect generated by the balance between the resources the government puts into the economy
through expenditures and the resources it takes out through taxation, charges, borrowing etc.

2. a microeconomic effect generated by the specific policies it adopts.

IV. Application Oriented Questions

1. Elucidate the nature of economic function performed by the government in the following cases:-
(a) The government initiates a massive programme for eradication of mosquito-borne diseases in coastal
areas.

(b) The government fixes the prices of 377 essential medicines listed in the National List of Essential
Medicine, 2015.

ANSWER 1

(a) (i) Public good – Merit good- Positive externalities – Inefficient market outcomes - Possible market failure –
scope for market intervention to improve social welfare - Adam Smith’s proposition of resource allocation role
of government i.e establishment and maintenance of highly beneficial public institutions and public works
which the market may fail to produce on account of lack of sufficient profits.

Define the resource allocation role of government’s policy - the potential for the government to improve
economic performance through its expenditure to provide an optimum mix of various social
goods.

(ii) Nature and characteristics of the programme of government action – Policy of Expenditure - Purpose-
Welfare outcomes of programmes for eradication of mosquito-borne diseases – Possibility of government
failure.

(iii) Substantiate with examples from recent policy propositions of government.

(b) (i) The distributive function of budget related to the basic question of for whom should an economy 452
produce goods and services.

Left to the market, only private benefits and private costs would be reflected in the price paid by consumers.
This means, through the market mechanism, people would consume inadequate quantities compared to what
is socially desirable. Outcome:

social welfare will not be maximized. Therefore – Government Intervention in the case of Merit Goods eg.
Healthcare - government deems that its consumption should be encouraged - Price intervention- setting price
ceilings - to influence the outcomes of a market on grounds of fairness and equity – price floor for ensuring
minimum price and price ceiling for making a resource or commodity available to all at reasonable prices -
May illustrate with diagram.

(ii) Nature and characteristics of the programme of government action - Purpose- Welfare outcomes of the
policy – Negative outcomes - Possible disincentives to producers- diversion of resources away from regulated
products- black marketing- etc.

2. The government decides to levy up to ₹ Rs 20,500/ per flight from private airlines on major routes in
order to fund an ambitious regional connectivity scheme which seeks to connect small cities by air and to
make flying more affordable for the masses. Critically examine the implications of this policy on the airlines
market
ANSWER 2

Theory of Government intervention for redistribution to ensure fairness and equity (As discussed in the above
two questions)

(i) Price intervention - a market-based policy - contributing airlines may experience cost escalation – possible
fare hikes – changes in equilibrium quantities – disincentives to fly aircrafts in taxed routes -
possible exit from market by low profit margin airlines- Regional connectivity and other welfare outcomes as
subsidies to producers would lower their cost of production increase output- substantial
positive externalities.

(ii) Another possibility: government intervention in the economy to correct a market failure creates
inefficiency and leads to a misallocation of scarce resources - social welfare will not be maximized –
uncertainty as to the need for merit goods – disincentives to existing players - cannot be sure that the
government interventions would be effective – possibility of government failure

UNIT II: MARKET FAILURE

I Multiple Choice Type Question 453

1. ‘Market failure’ occurs

(a) when public goods are not sufficiently provided by public sector

(b) the market fails to allocate resources efficiently and therefore market outcomes become inefficient

(c) people are not willing to pay and want to free ride
(d) (a) and (b) above

ANSWER 1-B

2. Markets fail because

(a) externalities are not accounted for in pricing and quantity decisions of firms

(b) most often the prerequisites of competition are unlikely to be present in an economy

(c) prices fail to reflect the true costs and benefits to the society

(d) all the above

ANSWER 2-D

3. Market power
(a) makes price equal marginal cost and produce a positive external benefit on others

(b) can cause markets to be inefficient because it keeps price and output away from equilibrium of supply
and demand

(c) makes the firms price makers and restrict output so as to make allocation inefficient

(d) (b) and(c) above

ANSWER 3-D

4. Markets do not exist

(a) for pure public goods

(b) for goods which have positive externalities 454

(c) for goods which have negative externalities

(d) none of the above

ANSWER 4-A
5. The unique feature of an externality is that it is

(a) initiated and experienced, not through the operation of the price system but affects an external agent

(b) initiated and experienced, not through the operation of the price system, but outside the market

(c) initiated and experienced by the same entity, but causes decrease in social welfare

(d) causes decreases in social welfare through the system of prices prevailing in the market

ANSWER 5-B

6. If a textile mill produces large amounts of negative externality, then which one of the following is
possible?

(a) The output of textile is too little when compared to the socially optimal quantity

(b) The output of textile is too large when compared to the socially optimal quantity

(c) The output of textile is not socially optimal as it is likely to be a regulated one

(d) Any of the above

ANSWER 6-B

7. All but one of the following statements is incorrect. Identify the correct statement.
(a) When there is a negative externality, the social marginal cost will exceed private marginal cost

(b) When there is a positive externality the social marginal cost will exceed private marginal cost 455

(c) Common property resources are non-rival and non-excludable public goods so that the problem of
sustainability becomes grave

(d) Goods that are rival in consumption and are non-excludable are known as private goods

ANSWER 7-A
8. In case of a positive externality

(a) the social marginal cost will exceed private marginal cost

(b) the social marginal cost will be equal to private marginal cost

(c) the social marginal cost will be less than private marginal cost

(d) the social marginal cost has no relation to private marginal cost

ANSWER 8-C

9. Which of the following statement is correct in respect of externalities?

(a) When social marginal costs are equal to private marginal costs, the level of output will be equal to the
socially optimal level

(b) When social marginal costs are less than private marginal costs, the level of output will be lower than
the socially optimal level

(c) When social marginal costs are greater than private marginal costs, the level of output will be higher
than the socially optimal level

(d) All of the above.

ANSWER 9-C

456
10. Match the following

(a) Pure public goods i) Excludable and rival

(b) Club goods ii) Non excludable and rival

(c) Common resources iii) Non excludable and non rival

(d) Private good iv) Non rival and excludable

(a) {a) i)}; {b) ii)}; {c) iv)}; {d) iii)}

(b) {a) ii)}; {b) i)}; {c) iii)}; {d) iv)}

(c) {a) iii)}; {b) i)}; {c)ii)}; {d) iv)}

(d) {a) iii)}; {b) iv)}; {c) ii)}; {d) i)}

ANSWER 10-D

11. Pollution is an instance of market failure

(a) because the equilibrium price is higher than the efficient price

(b) because the equilibrium price is less than the efficient price

(c) because property rights are poorly distributed

(d) because the market does not produce enough of the good

ANSWER 11-B

12. An adequate amount of a pure public good will not be provided by the private market because of

(a) the existence of negative externalities

457
(b) governments would any way produce them

(c) There are restrictions as well as taxes on the private market

(d) The possibility of free riding

ANSWER 12-D
13. The free rider problem arises because of

(a) ability of participants to produce goods at zero marginal cost

(b) marginal benefit cannot be calculated due to externalities present

(c) the good or service is non excludable

(d) general poverty and unemployment of people

ANSWER 13-C

14. Which of the following is an example of an impure public good?

(a) a lighthouse provided by government

(b) a congested highway during peak hours

(c) a polio vaccination program sponsored by the government

(d) national defence and the security offered by it

ANSWER 14-B

15. A situation where a pharmaceutical company has full information regarding the risks of a product, but

458
continues to sell it is a case of

(a) asymmetric information

(b) moral hazard

(c) free riding

(d) (a) and (c) above

ANSWER 15-A

16. If an individual tends to drive his car in a dangerously high speed because he has a comprehensive
insurance cover, it is a case of

(a) free riding

(b) moral hazard

(c) negative externality

(d) efficiency

ANSWER 16-B

17. Read the following statements

I. Common resources are pure public goods which are non rival

II. Since price mechanism does not apply to common resources, producers and consumers do not pay for
these resources

III. Self-interest makes them overuse the common resources and cause their depletion and degradation

IV. The common resources are impure public goods which are excludable but nonrival

(a) Statement I alone is correct

(b) Statements I and IV are correct

(c) Statements II and III are correct

(d) Statements ,II and III are correct 459

ANSWER 17-C
18. Market failure will never occur in a

(a) Socialist economy which is developed

(b) Unplanned economy which is underdeveloped

(c) Capitalist economy which is developed

(d) None of the above

ANSWER 18-D

II Short Answer Type Questions

1. Explain the term market failure.

ANSWER 1

Market failure is a situation in which the free market fails to allocate resources efficiently in the sense that
there is either overproduction or underproduction of particular goods and services leading to less than
optimal market outcomes

2. Explain, with the aid of examples, the main characteristics of private goods.

ANSWER 2

Private goods like car , food are ‘rivalrous’ ‘and excludable’ and less likely to have the free rider problem which
means that simultaneous consumption of these goods by more than one person is impossible and it is possible
to exclude or prevent consumers who have not paid for them from consuming them or having access to them.

460
Additional resource costs are involved for providing to another consumer.

3. Identify a pure public good using the criteria for identification

ANSWER 3

The criteria for identifying the nature of the good, whether private or public are rivalry and excludability in
consumption. Pure public goods are perfectly non-rival in consumption and are non–excludable. Knowledge is
a pure public good: once something is known, that knowledge can be used by anyone, and its use by any one
person does not preclude its use by others.

4. Explain the free rider problem. Give examples

ANSWER 4

The incentive to let other people pay for a good or service, the benefits of which are enjoyed by an individual
is known as the free rider problem. In other words, free riding is ‘benefiting from the actions of others without
paying’. Example is national defence. The government provides defence for all its citizens regardless of much
they contribute in taxes. Another example is Wikipedia- few people contribute (financially or otherwise), but
everyone gets to use it.

5. Public goods do not use up extra resources as additional people consume them. Why?
ANSWER 5

Public goods do not use up extra resources as additional people consume them. In other words, once a public
good like a light house is provided, it is commonly consumed and the additional resource cost of another
person consuming the goods is ‘zero’.

6. Why do economists use the word external to describe third-party effects that are harmful or beneficial?

ANSWER 6
Economists use the word ‘external’ to describe third-party effects that are harmful or beneficial because
sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part
of the market price. Such costs or benefits which are not accounted for by the market price are called
externalities because they are “external” to the market. Or in other words, externality is costs or benefits that

461
result from an activity or transaction and affects a third party who did not choose to incur the cost or
benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.

7. Explain why environmental pollution is regarded as a source of market failure.

ANSWER 7

Environmental pollution is regarded as a source of market failure because third parties experience negative
effects from this activity in which they did not choose to be involved. The social cost exceeds private cost and
if producers do not take into account the externalities, there will be overproduction and market failure

8. Define externalities. Why are they considered as a source of market failure?

ANSWER 8

Externality refers to costs or benefits that result from an activity or transaction and affects a third party who
did not choose to incur the cost or benefit. They are considered as a source of market failure because prices
fail to reflect the true costs and benefits to the society and externalities are not accounted for in pricing and
quantity decisions of the firms.

9. Distinguish between positive and negative externalities.

ANSWER 9

Externalities can be positive or negative. Positive externalities occur when the action of one party confers
benefits on another party. For example, providing good public education mainly benefits the students, but the
benefits of this public good will spill over to the whole society. On the other hand, negative externalities occur
when the action of one party imposes costs on another party. For example, even though cigarette smoking is
primarily harmful to a smoker; it also causes a negative health impact on people around the smoker

10. Appraise the role of incomplete information in generating market failure.

462
ANSWER 10

Incomplete information is manifest in asymmetric information which occurs when there is an imbalance in
information between the buyer and the seller i.e. when the buyer knows more than the seller or the seller
knows more than the buyer. This can distort choices. Asymmetric information generates adverse selection and
moral hazard. Adverse selection is a situation in which asymmetric information about quality eliminates high-
quality goods from a market.
Economic agents end up either selecting a sub-standard product or leaving the market altogether. It can also
lead to missing markets. Moral hazard arises whenever there is an externality (i.e., whenever an economic
agent can shift some of its costs to others). It occurs when one party to an agreement knows that he need not
bear the consequences of his bad behaviour or poor decision making and that the consequence, if any,
would be borne by the other party. In the insurance market, moral hazard refers to a situation that increases
the probability of occurrence of a loss or a larger than normal loss because of a change in the insurance policy
holders’ behaviour after the issuance of policy

11. What do you understand by externalities in consumption?

ANSWER 11

Externality in consumption occurs when consuming a good cause either a positive or negative externality to a
third party. Positive consumption externality initiated in consumption confers external benefits on others.
Negative consumption externalities initiated in consumption produce external costs on others.

12. What criteria are used to distinguish between pure and impure public goods?

ANSWER 12

A pure public good is non-rivalrous and non-excludable whereas impure public goods are partially rivalrous or
congestible. Because of the possibility of congestion, the benefit that an individual gets from an impure
public good depends on the number of users.

13. Explain the term quasi public goods.

ANSWER 13

463
Quasi-public goods or services, also called a near public good (for e.g. education, health services) possess
nearly all of the qualities of the private goods and some of the benefits of public good. Markets for the
quasipublic goods are considered to be incomplete markets and their lack of provision by free markets reflects
inefficiency and market failure.
14. How can social costs be differentiated from private cost?

ANSWER 14

Social Cost = Private Cost + External Cost

The presence of externalities creates a divergence between private and social costs of production. When
negative production externalities exist, social costs exceed private cost because the true social cost of
production would be private cost plus the cost of the damage from externalities. If producers do not take into
account the externalities, there will be overproduction and market failure. Applying the same logic, negative
consumption externalities lead to a situation where the social benefit of consumption is less than the private
benefit.

15. What is the consequence of a negative externality on price and output?

ANSWER 15

When there is negative externality, a competitive market will produce too much output relative to the social
optimum. This is a clear case of market failure where prices fail to provide the correct signals.

16. How does the presence of positive externality influence price and output?
ANSWER 16

The presence of positive externalities influence price and output since marginal social benefits is greater than
marginal private benefits and hence equilibrium (where MPC=MPB) is unlikely to be efficient. If a positive
production externality is present, then ceteris paribus, MSC is less than MPC and the market output is less
than optimal. Similarly, when there is a positive consumption externality ceteris paribus, MSB is greater than
MPB and output will be less than optimal.

17. Describe the term ‘Tragedy of Commons’. 464

ANSWER 17

Economists use the term ‘tragedy of the commons’ to describe the problem which occurs when rivalrous but
non-excludable goods are overused to the disadvantage of the entire universe. For example, everyone has
access to a commonly held pasture; there are no rules about sustainable numbers for grazing. The outcome of
the individual rational economic decisions of cattle owners would be market failure, because these actions
result in the degradation, depletion or even destruction of the resource leading to welfare loss for the entire
society.
18. Define common resources. Why are they overused?
ANSWER 18

Common access resources or common pool resources are a special class of impure public goods which are
non-excludable as people cannot be excluded from using them. These are rival in nature and their
consumption lessens the benefits available for others. Since price mechanism does not apply to ‘common
resources’, producers and consumers do not pay for these resources and therefore, they overuse them and
cause their depletion and degradation.

19. Discuss the importance of the distinction between private costs and social costs.

ANSWER 19

Private cost is the cost faced by the producer or consumer directly involved in a transaction. Social costs refer
to the total costs to the society on account of a production or consumption activity and include external costs
as well. The actors in the transaction (consumers or producers) tend to ignore those external costs and these
are not included in firms’ income statements or consumers’ decisions. However, these external costs are real
and important as far as the society is concerned. If producers do not take into account the externalities, there
will be over-production and market failure. Applying the same logic, negative consumption externalities lead
to
a situation where the social benefit of consumption is less than the private benefit. Therefore, it is important
that a distinction be made between private costs and social costs.

20. Describe, using examples, common access resources

ANSWER 20

465
Common access resources or common pool resources are a special class of impure public goods which are
non-excludable as people cannot be excluded from using them. These are rival in nature and their
consumption lessens the benefits available for others. This rival nature of common resources is what
distinguishes them from pure public goods, which exhibit both non-excludability and non-rivalry in
consumption. They are generally available free of charge. Examples of common access resources are fisheries,
common pastures, rivers, sea, backwaters, biodiversity etc.
21. Why are health and education not pure public goods?
ANSWER 21

A pure public good is non-rivalrous and non-excludable in nature. Education and health services are not pure
public goods; rather they are quasi-public goods that possess nearly all of the qualities of the private
goods and some of the benefits of public good. It is clearly possible to exclude people who do not pay from
availing these services

III Long Answer Type Questions

1. Define the concept of market failure. Describe the different sources of market failure.
ANSWER 1

Market failure is a situation in which the free market leads to misallocation of society's scarce resources in the
sense that there is either overproduction or underproduction of particular goods and services leading to a less
than optimal outcome. The reason for market failure lies in the fact that though perfectly competitive markets
work efficiently, most often the prerequisites of competition are unlikely to be present in an economy. Market
failures are situations in which a particular market, left to itself, is inefficient. We shall first try to understand
why markets fail and later, in the subsequent unit, proceed to identify the role of government in dealing with
market failure.

We need to appreciate the fact that there are two aspects of market failures namely, demand-side market
failures and supply side market failures. Demandside market failures are said to occur when the demand
curves do not take into account the full willingness of consumers to pay for a product. For example,
though we experience the benefit, none of us will be willing to pay to view a wayside fountain because we can
view it without paying. Supply-side market failures happen when supply curves do not incorporate the full
cost of producing the product. For example, a thermal power plant that uses coal may not have to include or
pay completely for the costs to the society caused by fumes it discharges into the atmosphere as part of the
cost of producing electricity.

The pertinent question here is why do markets fail? There are four major reasons for market failure. They are:

• Market power, 466

• Externalities,

• Public goods, and

• Incomplete information
2. Explain the different types of externalities. Illustrate how externalities lead to welfare loss of markets.

ANSWER 2

The four possible types of externalities are:

• Negative production externalities

• Positive production externalities

• Negative consumption externalities ,and

• Positive consumption externalities

Negative Production Externalities

A negative externality initiated in production which imposes an external cost on others may be received by
another in consumption or in production. As an example, a negative production externality occurs when a
factory which produces aluminium discharges untreated waste water into a nearby river and pollutes the
water causing health hazards for people who use the water for drinking and bathing. Pollution of river also
affects fish output as there will be less catch for fishermen due to loss of fish resources. The former is a case
where a negative production externality is received in consumption and the latter presents a case
of a negative production externality received in production. The firm, however, has no incentive to account for
the external costs that it imposes on consumers of river water or fishermen when making its production
decision. Additionally, there is no market in which these external costs can be reflected in the price of
aluminium.

Positive Production Externalities

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A positive production externality initiated in production that confers external benefits on others may be
received in production or in consumption. Compared to negative production externalities, positive production
externalities are less common. As an example of positive production externality received in production,
we can cite the case of a firm which offers training to its employees for increasing their skills. The firm
generates positive benefits on other firms when they hire such workers as they change their jobs. Another
example is the case of a beekeeper who locates beehives in an orange growing area enhancing the
chances of greater production of oranges through increased pollination.
 A positive production externality is received in consumption when an individual raises an attractive garden
and the persons walking by enjoy the garden. These external effects were not in fact taken into account when
the production decisions were made.

Negative Consumption Externalities

Negative consumption externalities are extensively experienced by us in our day to day life. Such negative
consumption externalities initiated in consumption which produce external costs on others may be received in
consumption or in production. Examples to cite where they affect consumption of others are smoking
cigarettes in public place causing passive smoking by others, creating litter and diminishing the aesthetic value
of the room and playing the radio loudly obstructing one from enjoying a concert. The act of undisciplined
students
talking and creating disturbance in a class preventing teachers from making effective instruction and the case
of excessive consumption of alcohol causing impairment in efficiency for work and production are instances of
negative consumption externalities affecting production.

Positive Consumption Externalities

A positive consumption externality initiated in consumption that confers external benefits on others may be
received in consumption or in production. For example, if people get immunized against contagious diseases,
they would confer a social benefit to others as well by preventing others from getting infected. Consumption
of the services of a health club by the employees of a firm would result in an external benefit to the firm in the
form of increased efficiency and productivity. When there are externalities and the costs or benefits are
experienced by people outside a transaction, the actors in the transaction (consumers or producers) tend
to ignore those external costs or benefits.

3. Describe why markets have incentives to produce private goods.

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ANSWER 3

• Private goods refer to those goods that yield utility to people. Since they are scarce anyone who wants to
consume them must purchase them.

• Owners of private goods can exercise private property rights and can prevent others from using the good or
consuming their benefits.

• Consumption of private goods is ‘rivalrous’ that is the purchase and consumption of a private good by one
individual prevents another individual from consuming it. In other words, simultaneous consumption of
a rivalrous good by more than one person is impossible.

• Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who have not paid for them
from consuming them or having access to them. In other words, those who want to consume private goods
must buy them at a price from its sellers. Excludability necessitates that consumers of private goods send the
right signals in the market. A buyer of a private good is forced in a transaction to reveal what he or she is
willing to pay for a good or a service.

• Private goods do not have the free-rider problem. This means that private goods will be available to only
those persons who are willing to pay for them.

• Private goods can be parcelled out among different individuals and therefore, it is possible to refer to total
consumption as the sum of each individual’s consumption. Therefore, the market demand curve for a private
good is obtained by horizontal summation of individual demand curves.

• All private goods and services can be rejected by the consumers if their needs, preferences or budgets
change.

• Additional resource costs are involved for producing and supplying additional quantities of private goods.

• Since buyers can be excluded from enjoying the good if they are not willing and able to pay for it, consumers
will get different amounts of goods and services based on their desires and ability and willingness to pay.
Therefore, whenever there is inequality in income distribution in an economy, issues of fairness and justice
tend to arise with respect to private goods.

• Normally, the market will efficiently allocate resources for the production of private goods.

Most of the goods produced and consumed in an economy are private goods. A few examples are: food items,
clothing, movie ticket, television, cars, houses etc.

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5. Distinguish between different types of public goods. How do public goods cause market failure?

ANSWER 5
• Goods in category A are rival in consumption and are excludable. These are also known as pure private
goods.

• Goods in category D which are characterized by both non-excludability and non-rivalry properties are called
pure public goods. A pure public good isnon-rival as well as non-excludable. The benefit that an individual gets
from a pure public good does not depend on the number of users.

The clarity of your radio reception, for example, is generally independent of the number of other listeners.
Knowledge is another non-rivalrous good. Once something has been discovered, one person's use of that
knowledge does not preclude others from applying the same knowledge. But, this is not the case with most
private goods.

• Consumption goods that fall in category B are rival but not excludable.

Let us take another example. Bees from the hives of different bee keepers collect nectar from the nearby
orange garden. The blossom is rival as the nectar collected for one hive is unavailable to another. Even so, it
may be inconceivable to try to deny any particular honey bee access i.e. the situation is non-excludable. The
examples include public parks, public roads in a city etc.

• Goods in category C are non-rival in consumption but are excludable. A toll booth may exclude vehicles
unless payment is made. Yet, if the road is not congested, one car may utilize it with no loss of benefit even

470
though the other cars are also consuming the road service. Similarly, admission to a cinema, swimming pool,
music concert etc. has potential for exclusion, but if there is no congestion, each individual admitted may
consume the services without subtracting from the benefit of others. A good example of this is DTH cable TV
service or Digital goods. The consumption of these is nonrival in nature but exclusion of households who do
not pay is feasible.
6. Explain using diagram and examples, the concepts of negative externalities of production and
consumption, and the welfare loss associated with the production or consumption of a good or service.

ANSWER 6

Negative Production Externalities

A negative externality initiated in production which imposes an external cost on others may be received by
another in consumption or in production. As an example, a negative production externality occurs when a
factory which produces aluminium discharges untreated waste water into a nearby river and pollutes the
water causing health hazards for people who use the water for drinking and bathing. Pollution of river also
affects fish output as there will be less catch for fishermen due to loss of fish resources. The former is a case
where a negative production externality is received in consumption and the latter presents a case
of a negative production externality received in production. The firm, however has no incentive to account for
the external costs that it imposes on consumers of river water or fishermen when making its production
decision. Additionally, there is no market in which these external costs can be reflected in the price of
aluminium

Negative Consumption Externalities

Negative consumption externalities are extensively experienced by us in our day to day life. Such negative
consumption externalities initiated in consumption which produce external costs on others may be received in
consumption or in production. Examples to cite where they affect consumption of others are smoking
cigarettes in public place causing passive smoking by others, creating litter and diminishing the aesthetic value
of the room and playing the radio loudly obstructing one from enjoying a concert. The act of undisciplined
students
talking and creating disturbance in a class preventing teachers from making effective instruction and the case
of excessive consumption of alcohol causing impairment in efficiency for work and production are instances of
negative consumption externalities affecting production.

8. Describe the free rider problem associated with public goods. What would be the outcome of this

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problem? Give examples.

ANSWER 8

A free rider is a person who benefits from something without expending effort or paying for it. In other
words, free riders are those who utilize goods without paying for their use. Example is Wikipedia, a free
encyclopaedia which faces a free rider problem. Hundreds of millions of people use Wikipedia every month
but only a small part of users pay to use it. A large majority of Wikipedia users do not pay to use the site but
are able to benefit from the information provided by the website. The free-rider problem occurs when
everyone enjoys the benefits of a good without paying for it. Since private goods are excludable, free-riding
mostly occurs in the case of public goods. The free-rider problem leads to underprovision of a good or service
and thus causes market failure.

As seen above, public goods provide a very important example of market failure in which the self-interested
behaviour of individuals does not produce efficient results. The absence of excludability in the case of public
goods and the tendency of people to act in their own self-interest will lead to the problem of free-riding. If
individuals cannot be excluded from the benefit of a public good, then they are not likely to express the value
of the benefits which they receive as an offer to pay. In other words, they will not express to buy a particular
quantity at a price.

Briefly put, there is no incentive for people to pay for the good because they can consume it without paying
for it. The problem occurs because of the failure of individuals to reveal their real or true preferences for the
public good through their willingness to pay. On account of the free- rider problem, there is no meaningful
demand curve for public goods.

If individuals make no offer to pay for public goods, there is a market failure in the case of theses goods and
the profit-maximizing firms will not produce them. There is an important implication for the behaviour of free-
riding. If every individual plays the same strategy of free-riding, the strategy will fail because nobody is willing
to pay and therefore, nothing will be provided by the market.

Then, a free ride for any one becomes impossible.

In fact, the public goods are valuable for people. If there is no free-rider problem, people would be willing to
pay for them and they will be produced by the market.

As such, if the free-rider problem cannot be solved, the following two outcomes are possible:

1. No public good will be provided in private markets

2. Private markets will seriously under produce public goods even though these goods provide valuable service
to the society.

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IV Application Oriented Questions

1. Identify the market outcomes for each of the following situations

(a) A few youngsters play loud music at night. Neighbours may not be able to sleep.

(b) Ram buys a large SUV which is very heavy

(c) X smokes in a public place

(d) Rural school students are given vaccination against measles

(e) Traffic congestion making travel very uncomfortable

(f) Piracy of computer programs

(g) Some species of fish are now getting extinct because they have been caught indiscriminately.

(h) The municipality provides sirens four times a day

(i) Burglar alarms are installed by many in your locality

(j) Global warming increases due to emissions of fossil fuels

ANSWER

(a) Negative externality, overproduction

(b) Negative externality, environmental externality, wear and tear of roads, increased fuel consumption,
added insecurity imposed on others

(c) Negative externality, overproduction 473

(d) Public good, positive externality

(e) Negative externality

(f) Unpatented computer programs have characteristics very much like a public good and therefore market
failure.

(g) The problem of the commons –The tragedy of commons

(h) Sirens have all characteristics of public goods. People will free ride – market failure.

(i) Positive externality, free riding.

(j) Negative externality.

UNIT III: GOVERNMENT INTERVENTIONS TO CORRECT MARKET FAILURE

I Multiple Choice Type Questions

1. A thermal power plant uses coal and creates pollution in an otherwise unpolluted area. Which of the
following would ensure that a socially optimal output of electricity is produced?

(a) Where marginal private cost equals marginal private benefit.

(b) Where marginal private cost equals marginal social benefit.

(c) Where marginal social cost equals marginal private benefit.

(d) Where marginal social cost equals marginal social benefit.

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ANSWER 1-D

2. Which of the following statements is true?

I The market-based approaches to control externalities operate through price mechanism
II. When externalities are present, the welfare loss would be eliminated
III. The key is to internalizing an externality is to ensure that those who create the extern

(a) Both II and III

(b) I only

(c) II only

(d) Both I and III

ANSWER 2-D

3. Which of the following statements is false?

(a) Tradable permits provide incentive to innovate

(b) A subsidy on a good which has substantial positive externalities would reduce its cost and consequently
price

(c) Substantial negative externalities are involved in the consumption of merit goods.

(d) Merit goods are likely to be under-produced and under consumed through the market mechanism

ANSWER 3-C

4. A Pigouvian subsidy

(a) cannot be present when externalities are present

(b) is a good solution for negative externality as prices will increase

(c) is not measurable in terms of money and therefore not practical

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(d) may help production to be socially optimal when positive externalities are present

ANSWER 4-B

5. If governments make it compulsory to avail insurance protection, it is because

(a) Insurance companies need to be running profitably

(b) Insurance will generate moral hazard and adverse selection

(c) Insurance is a merit good and government wants people to consume it

(d) None of the above

ANSWER 5-C

6. If merit goods are provided free by the government

(a) The quantity demanded of merit good will be less than supply

(b) The quantity demanded of merit good will be equal to supply

(c) The quantity demanded of merit good is likely to be more than supply

(d) Any of the above can happen

ANSWER 6-C

7. The government should intervene in the marketplace to discourage the production and consumption of --
-------------

(a) Goods which are not necessary

(b) Demerit goods

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(c) Goods having no externalities

(d) Goods which the markets produce less

ANSWER 7-B
8. If government produces and supplies a public good

(a) It may correct market failure as there will be no externalities

(b) It may correct market failure caused by free riding

(c) It may correct market failure because people may free ride

(d) It may correct market failure because people may not free ride

ANSWER 8-C

9. Rules regarding product labelling

(a) Seeks to correct market failure due to externalities

(b) Is a method of solving the problem of public good

(c) May help solve market failure due to information failure

(d) Reduce the problem of monopolies in the product market

ANSWER 9-C

10. Identify the incorrect statement

(a) A minimum support price for agricultural goods is a market intervention method to guarantee steady

477
and assured incomes to farmers.

(b) A price ceiling which is set below the prevailing market clearing price will generate excess demand over
supply.

(c) Excludable public goods can be provided by government and the same can be financed through entry
fees.

(d) The production and consumption of demerit goods are likely to be less than optimal under free markets
ANSWER 10-D

II Short Answer Type Questions

1. How do governments ensure that market power does not create distortions in the market?

ANSWER 1

Market power is an important factor that contributes to inefficiency due to higher prices than competitive
prices. Because of the social costs imposed by monopoly, governments intervene by establishing rules and
regulations designed to promote competition and prohibit actions that are likely to restrain competition.
Policy options also include price regulation in the form of setting maximum prices that firms can charge based
on the firm’s variable costs, past prices, and possible inflation and productivity growth.
These are some methods by which the government ensures that market does not create distortions

2. Describe direct government actions to solve negative externalities.

ANSWER 2

Direct controls prohibit specific activities that explicitly create negative externalities or require that the
negative externality be limited to a certain level, for instance limiting emissions.
Government initiatives towards negative externalities may include

1. Direct controls that openly regulate the actions of those involved in generating negative externalities, and

2. Market-based policies that would provide economic incentives so that the self-interest of the market
participants would achieve the socially optimal solution.

Direct controls prohibit specific activities that explicitly create negative externalities or require that the

478
negative externality be limited to a certain level, for instance limiting emissions. Production, advertising, use
and sale
of many commodities and services may be prohibited. Stringent rules may be established in respect of
advertising, packaging and labeling etc.

Governments may, through legislation, stipulate stringent standards such as environmental standards,
emissions standards non adherence of which will invite monetary penalties or/and criminal liabilities. Another
method is to create negative incentives through charging fees on activities creating negative externalities
Governments may also form special bodies/ boards to specifically address the problem of negative
externality. The market-based approaches (such as environmental taxes and cap-and-trade), operate through
price mechanism to create an incentive for change

3. What are the relative advantages of market based interventions?

ANSWER 3

The market-based approaches–environmental taxes and cap-and-trade – operate through price mechanism to
create an incentive for change. In other words, they rely on economic incentives to accomplish environmental
goals at lesser costs. They make use of market forces to encourage consumers and producers to take negative
externalities into account when planning their consumption and production. In other words, the polluters are
forced to consider pollution as a private cost.

4. Account for the difficulties in determination of level of taxes to solve the problems associated with
market failure?

ANSWER 4
Pollution taxes are difficult to determine and administer due to difficulty to discover the right level of taxation,
problems associated with inelastic nature of demand for the good and the problem of possible capital flight

5. Why do governments provide public goods?

ANSWER 5

Direct provision of a public good by government can help overcome freerider problem which leads to market
failure. The non-rival nature of consumption provides a strong argument for the government rather than
the market to provide and pay for public goods

6. Define demerit good and point out its characteristics 479

ANSWER 6

Demerit goods are goods which impose significant negative externalities on the society as a whole and are
believed to be socially undesirable. The production and consumption of demerit goods are likely to be more
than optimal under free markets. The government should therefore intervene in the marketplace to
discourage their production and consumption.
7. What are the different options for providing merit goods to the public?

ANSWER 7

Merit goods are likely to be under-produced and under consumed so that social welfare will not be
maximized. The possible government responses to under-provision of merit goods are regulation, legislation,
subsidies, direct government provision and a combination of government provision and market provision.

8. What are the consequences if demerit goods are left to free market?
ANSWER 8

If demerits goods are left to the free market then the production and consumption of demerit goods are likely
to be more than optimal under free markets.

9. Explain why governments impose taxes on goods and services?

ANSWER 9

Imposing unusually high taxes on producing or purchasing the goods and services making them very costly and
unaffordable to many.

10. Explain why governments provide subsidies? Illustrate a few examples of subsidies.
ANSWER 10

Subsidy is market-based policy and involves the government paying part of the cost to the firms in order to

480
promote the production of goods having positive externalities. Or in other words ,A subsidy on a good which
has substantial positive externalities would reduce its cost and consequently price, shift the supply curve to
the right and increase its output. A higher output that would equate marginal social benefit and marginal
social cost is socially optimal. There are many forms of subsidies given out by the government. Two of the
most common types of individual subsidies are welfare payments and unemployment benefits. The objective
of these types of subsidies is to help people who are temporarily suffering economically. Other subsidies, such
as subsidized interest rates on student loans, are given to encourage people to further their education.
11. Explain why governments impose price ceilings?

ANSWER 11

When prices of certain essential commodities rise excessively government may resort to controls in the form
of price ceilings (also called maximum price) for making a resource or commodity available to all at reasonable
prices.

12. How do you justify food price controls and rent controls?
ANSWER 12

Food price control is justified as long as farmer gets profits and customer gets food stuff at lesser price
without middle men. Rent control is justified as owner and tenant have correct price according to the locality.
Both these need Governmental control

13. Describe the effects of price ceilings with examples

ANSWER 13

Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the
equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will
result. For example: maximum prices of food grains and essential items are set by government
during times of scarcity. A price ceiling which is set below the prevailing market clearing price will generate
excess demand over supply.

14. Illustrate the impact of a price ceiling on market outcomes.

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ANSWER 14

A price ceiling will only impact the market if the ceiling is set below the free- market equilibrium price. This is
because a price ceiling above the equilibrium price will lead to the product being sold at the equilibrium
price. If the ceiling is less than the economic price, the immediate result will be a supply shortage.
15. Explain why governments impose price floors?
ANSWER 15

Price floor prevent a price from falling below a certain level. Price floors are used by the government to
prevent prices from being too low. The most common price floor is the minimum wage-the minimum price
that can be
paid for labour.

16. Describe the concept of price floors with examples.

ANSWER 16

Price floor is defined as an intervention to raise market prices if the government feels the price is too low. In
this case, since the new price is higher, the producers benefit. For a price floor to be effective, the minimum
price has to be higher than the equilibrium price. For example, many governments intervene by establishing
price floors to ensure that farmers make enough money by guaranteeing a minimum price that their goods
can be sold for. The most common example of a price floor is the minimum wage. This is the minimum price
that employers can pay workers for their labour.

17. Explain the rationale for price support for agricultural products
ANSWER 17

The rationale for price support for agricultural products is to guarantee steady and assured income to farmers.
In case the market price falls below the MSP, then the guaranteed MSP will prevail.

18. Why do governments fix minimum wages?

ANSWER 18

The government fixes minimum wages because minimum wage is the lowest remuneration that employers 482
can legally pay their workers—the price floor below which workers may not sell their labour
III Long Answer Type Questions

1. Do you think government intervention in markets will help enhance social welfare? Substantiate your
arguments
ANSWER 1

Merit goods are rival, excludable, limited in supply, rejectable by those unwilling to pay, and involve positive
marginal cost for supplying to extra users. Merit goods can be provided through the market, but
are likely to be under-produced and under-consumed through the market mechanism so that social welfare
will
not be maximized.

The additional reasons for government provision of merit goods are:

• Information failure is widely prevalent with merit goods and therefore individuals may not act in their best
interest because of imperfect information.

• Equity considerations demand that merit goods such as health and education should be provided free on the
basis of need rather than on the basis of individual’s ability to pay.

• There is a lot of uncertainty as to the need for merit goods E.g. health care.

Due to uncertainty about the nature and timing of healthcare required in future, individuals may be unable to
plan their expenditure and save for their future medical requirements. The market is unlikely to provide the
optimal quantity of health care when consumers actually need it, because they may be short of the necessary
finances to pay the market price. The possible government responses to under-provision of merit goods are
regulation, subsidies, direct government provision and a combination of government provision and market
provision. Regulation determines how a private activity may be conducted.

2. Explain the effectiveness of regulatory mechanisms for mitigating market failure?

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ANSWER 2

It is common that some of the regulatory responses of government to incentive failure tend to create and
protect monopoly positions of firms that have developed unique innovations. For example, patent and
copyright laws grant exclusive rights of products or processes to provide incentives for invention and
innovation. Another example is that of permitted natural monopoly. Natural monopolies can produce the
entire output of the market at a cost that is lower than what it would be if there were several firms. If a firm is
a natural monopoly, it is more efficient to permit it to serve the entire market rather than have several firms
compete each other. Examples of such natural monopoly are electricity, gas and water supplies. The Policy
options for limiting market power in case of natural monopolies include price regulation in the form of setting
maximum prices that firms can charge. In some cases, the government‘s regulatory agency determines an
acceptable price, so as to ensure a competitive or fair rate of return. This practice is called rate-of-return
regulation.

IV Application Oriented Questions

1. The pharmaceutical industry is involved in innovation, development, production, and marketing of

medicines in India. Ensuring the availability of lifesaving drugs at reasonable prices is the duty of the
government. The
National Pharmaceutical Pricing Authority (NPPA) is the watchdog in India, which controls the prices of
drugs. Government has to consider the interest of both the producers and the buyers.

Questions

(i) Elucidate the market outcomes if matters relating to drugs are entirely left to the pharmaceutical
industry.

(ii) Appraise the need for government action in the above case. Do you consider government action
necessary in the case of medicines? Why?

(iii) What are the different policy options available to government to meet its public health objectives?

ANSWER 1

(i) Essential commodity – Left to market there may be inefficiency and possible market power – likely to
charge higher prices than competitive prices- Price controls are put in place by governments to influence the
outcomes of a market- Policy options for limiting market power also include price regulation in the form of

484
setting maximum prices that firms can charge- In some cases, the government‘s regulatory agency determines
an acceptable rate-of return – setting price-caps based on the firm’s variable costs, past prices, and possible
inflation and productivity growth regulation price, so as to ensure a competitive or fair rate of return.
Legislation, regulation in terms of price controls, selection and listing of items to be included in price
control, care to be taken not to damage the incentives of producers.
(ii) Merit good- merit goods are rival, excludable, limited in supply, rejectable by those unwilling to pay, and
involve positive marginal cost for supplying to extra users. Positive externalities- Left to the market, only
private benefits and private costs would be reflected in the price paid by consumers. This means, compared to
what is socially desirable, people would consume inadequate quantities.

(iii) Merit goods can be provided through the market, but are likely to be under produced and under-
consumed through the market mechanism so that social welfare will not be maximized - This is a strong case
for government intervention. Government intervention in the form of direct provision, regulation, licensing
and controls. Illustrate with figure: Market outcome for merit goods

2. The Commission for Agricultural Costs and Prices (CACP) advises the government on minimum support
prices of 23 agricultural commodities which comprise 7 cereals, 5 pulses, 7 oilseeds, and 4 commercial
crops.

(i) What is the underlying principle of minimum support prices? Do you think MSP is a form of market
intervention? Why?

(ii) Why do you consider free markets undesirable for the above mentioned agricultural commodities?

ANSWER 2

(i) Influence the outcomes of a market on grounds of fairness and equity- strong political demand for
government intervention – Price intervention for ensuring stable prices and stable incomes to
producers - market-based incentives to ensure steady output, outcomes of higher than equilibrium price.
Illustrate with figures

(ii) Markets for primary products are subject to extreme as well as unpredictable fluctuations in price –
Income elasticity of demand for primary products is less than one – need to guarantee steady and

485
assured incomes to farmers - Minimum Support Price (MSP) programme as well as procurement by
government agencies at the set support prices - Illustrate with figure : Market outcome of minimum
support price- When price floors are set above market clearing price, suppliers are encouraged to over-supply
and there would be an excess of supply over demand – limitations -possible government failure
3. The draft of New Education Policy, 2016 proposes key changes in government’s policy towards education.
Explain the rationale for government action to streamline the education system in the county.

ANSWER

On the totem pole of the state management hierarchy, education comes relatively low both in status and
recognition. This was part of the administrative ethos bestowed by colonial rulers who had no interest in
imparting education to the bulk of Indians. This neglect should no longer be tolerated. Education must be
given the highest priority. It is the duty of Central and State Governments to provide necessary resources and
create conditions that are favourable for the process of teaching and learning to flourish. Every opportunity
needs to be provided to young persons to get good quality education and acquire skills that lead to
employment and entrepreneurship.

The basic education infrastructure already exists in India. The Indian child is as resourceful and intelligent as
any in the world. New technologies are now available. Governments at the Centre and the States only need to
understand the catalytic role they have to play in fostering an atmosphere that enables students to think, to
learn, and contribute to the country's development. All that is required is a change in the mindset among
stakeholders. Once the importance of ascribing the highest priority to education is recognized, the
corresponding responsiveness and sense of accountability will inexorably emerge.

For two-thirds of mankind’s history, India as one of the oldest and most glorious living civilizations in the world
dominated the world scene in every respect –in philosophy, economics, trade, culture as well as in education.
If India does the things now required to be done, in 15 to20 years Indian Education can be transformed. The
rest of the 21st century could then belong to India

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 UNIT-IV FISCAL POLICY
Multiple Choice Type Questions

1. If Real GDP is continuously declining and the rate of unemployment in the economy is increasing, the
appropriate policy should be to

(a) Increase taxes and decrease government spending

(b) Decrease both taxes and government spending

(c) Decrease taxes and increase government spending

(d) Either ( a) or (c)

ANSWER 1-C

2. Which of the following are likely to occur when an economy is in an expansionary phase of a business
cycle?

A. Rising unemployment rate

B. Falling unemployment rate

C. Rising inflation rate

D. Deflation

E. Falling or stagnant wage for workers

487
F. Increasing tax revenue

G. Falling tax revenue

(a) A, B and F are most likely to occur

(b) B, C and F and are most likely to occur

(c) D, E and F are most likely to occur

(d) A, E and G are most likely to occur

ANSWER 2-B

3. Fiscal policy refers to

(a) use of government spending, taxation and borrowing to influence the level of economic activity

(b) government activities related to use of government spending for supply of essential goods

(c) use of government spending, taxation and borrowing for reducing the fiscal deficits

(d) (a) and (b) above

ANSWER 3-A

4. During recession fiscal policy of the government should be directed towards

(a) Increasing the taxes and reducing the aggregate demand

(b) Decreasing taxes to ensure higher disposable income

(c) Increasing government expenditure and increasing taxes

(d) None of the above

ANSWER 4-B

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5. Automatic stabilizers
(a) work towards stimulating aggregate spending during economic expansion and reducing aggregate
spending during the recessionary phase.

(b) provide proportionally more disposable income available for consumption spending to households
during expansion

(c) work towards stimulating aggregate spending during the recessionary phase and reducing aggregate
spending during economic expansion.

(d) provide proportionally less disposable income available for consumption spending to households during
contraction

ANSWER 5-C

6. Discretionary fiscal policy

(a) refers to the working of built-in stabilizers to change the levels of expenditure and taxes to influence the
level of national output,

employment and prices

(b) refers to how governments may directly as well as indirectly influence the level of taxes to attain export
competitiveness

(c) refers to deliberate policy actions on the part of the government to change the levels of expenditure and
taxes to influence the level of national output, employment and prices

(d) refers to deliberate policy actions on the part of the government to change the composition of taxes to 489
influence compliance

ANSWER 6-C
7. Keynesian economists believe that

(a) fiscal policy can have very powerful effects in altering aggregatedemand, employment and output in an
economy

(b) when the economy is operating at less than full employment levels and when there is a need to offer
stimulus to demand fiscal policy is of great use

(c) Wages are flexible and therefore business fluctuations would be automatically adjusted

(d) (a) and(b) above

ANSWER 7-D

8. Which of the following may ensure a decrease in aggregate demand during inflation

(a) decrease in all types of government spending and/ or an increase in Taxes

(b) increase in government spending and/ or a decrease in taxes

(c) decrease in government spending and/ or an decrease in taxes

(d) All the above

ANSWER 8-A

9. A recession is characterized by

(a) Declining prices and rising employment 490

(b) Declining unemployment and rising prices

(c) Declining real income and rising unemployment

(d) Rising real income and rising prices

ANSWER 9-C
10. Discretionary fiscal policy differs from non-discretionary fiscal policy in which of the following manner?

(a) Discretionary fiscal policy is concerned with government spending and non discretionary fiscal policy
deals with tax policy

(b) Discretionary fiscal policy is concerned with government spending and non discretionary fiscal policy
deals government revenues

(c) Discretionary fiscal policy is concerned with deliberate actions on the part of the government and non-
discretionary fiscal policy works automatically

(d) Discretionary fiscal policy is built into the system and non discretionary fiscal policy is concerned with
deliberate actions on the part of government
ANSWER 10-C

11. Which one of the following is an example of discretionary fiscal policy?

(a) A tax-cut aimed at increasing the disposable income and spending

(b) A reduction in government expenditure to contain inflation

(c) An increase in taxes and decrease in government expenditure to control inflation

(d) All the above

ANSWER 11-D

12. Which of the following would illustrate a recognition lag?

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(a) The time required to identify the appropriate policy

(b) The time required to identify to pass a legislation

(c) The time required to identify the need for a policy change

(d) The time required to establish the outcomes of fiscal policy

ANSWER 12-C
13. Which statement (s) is (are) correct about crowding out?
I. A decline in private spending may be partially or completely offset the expansion of demand resulting
from an increase in government expenditure.

II. Crowding out effect is the negative effect fiscal policy may generate when money from the private sector
is ‘crowded out’ to the public sector.

III When spending by government in an economy increases; government spending would be crowded out.

IV. Private investments, especially the ones which are interest –sensitive, will be reduced if interest rates
rise due to increased spending by government

(a) I and III only

(b) I, II, and III

(c) I, II, and IV

(d) III only

ANSWER 13-C

14. Which of the following policies is likely to shift an economy’s aggregate demand curve to the right?

(a) Increase in government spending

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(b) Decrease in taxes

(c) A tax cut along with increase in public expenditure

(d) All the above

ANSWER 14-D
15. Identify the incorrect statement

(a) A progressive direct tax system ensures economic growth with stability because it distributes the burden
of taxes equally

(b) A carefully planned policy of public expenditure helps in redistributing income from the rich to the
poorer sections of the society.

(c) There are possible conflicts between different objectives of fiscal policy such that a policy designed to
achieve one goal may adversely affect another

(d) An increase in the size of government spending during recessions may possibly ‘crowd-out’ private
spending in an economy.

ANSWER 15-A

II Short Answer Type Questions

1. Define fiscal policy.

ANSWER 1

Use of government spending, taxation and borrowing to influence both the pattern of economic activity and
level of growth of aggregate demand, output and employment.

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2. What are the objectives of fiscal policy?
ANSWER 2

Objectives vary from country to country - achievement and maintenance of full employment, maintenance of
price stability, acceleration of the rate of economic development, and equitable distribution of income and
wealth.
3. Distinguish between discretionary and non-discretionary fiscal policy.

ANSWER 3

Automatic stabilisation occurs through automatic adjustments in government expenditures and taxes (non-
discretionary policy) without any deliberate governmental action - stimulate aggregate spending during the
recessionary phase and reduce aggregate spending during economic expansion

4. Explain how automatic stabilization brings in stability in an economy.

ANSWER 4

Automatic stabilisation occurs through automatic adjustments in government expenditures and taxes (non-
discretionary policy) without any deliberate governmental action - stimulate aggregate spending during the
recessionary phase and reduce aggregate spending during economic expansion

5. How do built-in stabilizers combat demand-pull inflationary pressures?

ANSWER 5

Employment increases, with progressive system of taxes - higher taxes - lower disposable incomes - higher
corporate tax payments- lower surplus - decline in consumption and investments – decline in aggregate
demand.

6. What are the symptoms of the beginning of a recession?

ANSWER 6

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Declining GDP - growing unemployment - declining prices – lower aggregate demand
7. Explain the term ‘recessionary gap’.

ANSWER 7

Also known as a contractionary gap, the difference between the actualaggregate demand and the aggregate
demand which is required to be filled-in to establish the equilibrium at full employment level of income

8. What should be the tax policy during recession and depression?

ANSWER 8

Tax policy to encourage private consumption and investment – general reduction in income taxes -higher
disposable incomes –higher consumption- low corporate taxes –further investment.

9. What is the consequence excessive taxation will have on business?

ANSWER 9

Less potential profits - disincentives- stifles new investments- less growth

10. Distinguish between ‘pump priming’ and the 'compensatory spending'.

ANSWER 10

Pump priming - certain volumes of public spending to revive the economy; compensatory spending is
government spending to compensate for the deficiency in private investmen

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11. Describe the term expansionary fiscal policy.

ANSWER 11

Designed to stimulate the economy – aim to increase aggregate expenditures and aggregate demand- increase
in government spending and / or a decrease in taxes.
12. What is meant by crowding out?
ANSWER 12

Negative effect of fiscal policy when spending by government in an economy replaces private spending -
money from private sector is ‘crowded out’ to the public sector- decline in private spending - fiscal policy
becomes ineffective

13. Explain the use of fiscal policy for economic growth.

ANSWER 13

Expenditure on developmental activities- public goods such as education, research and development etc.-tax
policy that rewards innovation and entrepreneurship

14. What types of fiscal policy measures are useful for redistribution of income in an economy?

ANSWER 14

Progressive direct tax system - differential indirect taxes –use of taxproceeds for social development

15. What are the measures undertaken in a contractionary fiscal policy?

ANSWER 15

Deliberate policy to curtail aggregate demand - eliminate an inflationary gap – reduce the level of economic 496
activity -decrease in government spending -increase in personal income taxes and/or business taxes -a
combination of decrease in government spending and increase in personal income taxes and/or business
taxes.
16. Point out the limitations of fiscal policy.

ANSWER

• Recognition lag: The economy is a complex phenomenon and the state of the macro economic variables is
usually not easily comprehensible. Just as in the case of any other policy, the government must first recognize
the need for a policy change.

• Decision lag: Once the need for intervention is recognized, the government has to evaluate the possible
alternative policies. Delays are likely to occur to decide on the most appropriate policy.

• Implementation lag: even when appropriate policy measures are decided on, there are possible delays in
bringing in legislation and implementing them.

• Impact lag: impact lag occurs when the outcomes of a policy are not visible for some time.

III Long Answer Type Questions

1. Explain the role of fiscal policy in achieving economic stability.

ANSWER 1

Fiscal policy acts as an effective tool for managing aggregate demand in the short-run to help maintain price
stability and employment levels. However, demand-side policies unaccompanied by policies to stimulate
aggregate supply cannot produce long-run economic growth. Fiscal policies such as those involving
infrastructure spending generally have positive supply-side effects. When government supports building a
modern infrastructure, the private sector is provided with the requisite overheads it needs.
Government provision of public goods such as education, research and development etc. provide momentum
for long-run economic growth. A well designed tax policy that rewards innovation and entrepreneurship,

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without
discouraging incentives will promote private businesses who wish to invest and thereby help the economy
grow
2. Define the terms ‘recessionary gap’ and ‘inflationary gap’. What would be the appropriate fiscal policy
measures to eliminate ‘recessionary gap’ and ‘inflationary gap’? Illustrate your answer.

ANSWER 2

A recessionary gap, also known as a contractionary gap, is said to exist if the existing levels of aggregate
production is less than what would be produced with the full employment of resources

Non-discretionary fiscal policy or automatic stabilizers are part of the structure of the economy and are ‘built-
in’ fiscal mechanisms that operate automatically to reduce the expansions and contractions of the business
cycle. Changes in fiscal policy do not always require explicit action by government. In most economies,
changes in the level of taxation and level of government spending tend to occur automatically. These are
dependent on and are determined by the level of aggregate production and income, such that the instability
caused by business cycle is automatically dampened without any need for discretionary policy action.

Any government programme that automatically tends to reduce fluctuations in GDP is called an automatic
stabilizer. Automatic stabilizers have a tendency for increasing GDP when it is falling and reducing GDP when it
is rising. In automatic or non-discretionary fiscal policy, the tax policy and expenditure pattern are so
framed that taxes and government expenditure automatically change with the change in national income. It
involves built-in tax or expenditure mechanism that automatically increases aggregate demand when
recession is there and reduces aggregate demand when there is inflation in the economy. Personal income
taxes,
corporate income taxes and transfer payments (unemployment compensation, welfare benefits) are
prominent automatic stabilizers.

Automatic stabilisation occurs through automatic adjustments in government expenditures and taxes without
any deliberate governmental action. These automatic adjustments work towards stimulating aggregate
spending during the recessionary phase and reducing aggregate spending during economic
expansion. As we know, during recession incomes are reduced; with progressive tax structure, there will be a
decline in the proportion of income that is taxed. This would result in lower tax payments as well as some tax
refunds. Simultaneously, government expenditures increase due to increased transfer payments like

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unemployment benefits. These two together provide proportionately more disposable income available for
consumption spending to households. In the absence of such automatic responses, household spending would
tend to decrease more sharply and the economy would in all probability fall into a deeper recession.

On the contrary, when an economy expands, employment increases, with progressive system of taxes people
have to pay higher taxes as their income rises. This leaves them with lower disposable income and thus causes
a decline in their consumption and therefore aggregate demand. Similarly, corporate profits tend
to be higher during an expansionary phase attracting higher corporate tax payments. With higher income
taxes, firms are left with lower surplus causing a decline in their investments and thus in the aggregate
demand. Again, during expansion unemployment falls, therefore government expenditure by way of
transfer payments falls and with lower government expenditure inflation gets controlled to a certain extent.

Briefly put, during an expansionary phase, all types of incomes rise and the amount of transfer payments
decline resulting in proportionately less disposable income available for consumption expenditure.
The built-in stabilisers automatically remove spending from the economy to reduce demand-pull inflationary
pressures and further expansionary stimulation. In brief, automatic stabilizers work through limiting the
increase in disposable income during an expansionary phase and limiting the decrease in disposable
income during the contraction phase of the business cycle. Since automatic stabilizers affect disposable
personal income directly, and because changes in disposable personal income are closely linked to changes in
consumption, these stabilizers act swiftly to reduce the extent of changes in real GDP.

However, automatic stabilizers that depend on the level of economic activity alone would not be sufficient to
correct instabilities. The government needs to resort to discretionary fiscal policies. Discretionary fiscal policy
for stabilization refers to deliberate policy actions on the part of government to change the levels
of expenditure, taxes to influence the level of national output, employment and prices. Governments
influence the economy by changing the level and types of taxes, the extent and composition of spending, and
the quantity and form of borrowing.

3. Explain the term contractionary fiscal policy. What are limitations in pursuing a contractionary fiscal
policy?

ANSWER 3

When aggregate demand rises beyond what the economy can potentially produce by fully employing it’s given
resources, it gives rise to inflationary pressures in the economy. The aggregate demand may rise due to large
increase in consumption demand by households or investment expenditure by entrepreneurs, or
government expenditure. In these circumstances inflationary gap occurs which tends to bring about rise in

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prices. Under such circumstances, a contractionary fiscal policy will have to be used.

Contractionary fiscal policy refers to the deliberate policy of government applied to curtail aggregate demand
and consequently the level of economic activity. In other words, it is fiscal policy aimed at eliminating an
inflationary gap. This is achieved by adopting policy measures that would result in the aggregate demand
curve (AD) shifting to the left so the equilibrium may be established at the full employment level of real GDP.
This can be achieved either by:
1. Decrease in government spending: With decrease in government spending, the total amount of money
available in the economy is reduced which in turn trim down the aggregate demand.

2. Increase in personal income taxes and/or business taxes: An increase in personal income taxes reduces
disposable incomes leading to fall in consumption spending and aggregate demand. An increase in taxes on
business profits reduces the surpluses available to businesses, and as a result, firms’ investments shrink
causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants
who will respond by holding back fresh investments.

4. Under what circumstances do governments pursue expansionary fiscal policy? What are the instruments
for expansionary fiscal policy?

ANSWER 4
A recession is said to occur when overall economic activity declines, or in other words, when the economy
‘contracts’. A recession sets in with a period of declining real income, as measured by real GDP simultaneously
with a situation of rising unemployment. If an economy experiences a fall in aggregate demand
during a recession, it is said to be in a demand-deficient recession.

Due to decline in real GDP, the aggregate demand falls and therefore, lesser quantity of goods
and services will be produced. To combat such a slump in overall economic activity, the government can resort
to expansionary fiscal policies.

An expansionary fiscal policy is used to address recession and the problem of general unemployment on
account of business cycles. We may technically refer to this as a policy measure to close a ‘recessionary gap’. A
recessionary gap, also known as a contractionary gap, is said to exist if the existing levels of aggregate
production is less than what would be produced with full employment of resources.

It is a measure of output that is lost when actual national income falls short of potential income, and

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represents the difference between the actual aggregate demand and the aggregate demand which is required
to establish the equilibrium at full employment level of income. This gap occurs during the contractionary
phase of business-cycle and results in higher rates of unemployment. In other words, recessionary gap occurs
when the aggregate demand is not sufficient to create conditions of full employment. Now the question is
how do changes in government expenditure (G), and taxes (T) eliminate a recessionary gap?
5 Unemployment and recessionary trends can be solved through the use of fiscal policies. Do you agree?
Justify your answer.

ANSWER 5

A recession is said to occur when overall economic activity declines, or in other words, when the economy
‘contracts’. A recession sets in with a period of declining real income, as measured by real GDP simultaneously
with a situation of rising unemployment. If an economy experiences a fall in aggregate demand
during a recession, it is said to be in a demand-deficient recession. Due to decline in real GDP, the aggregate
demand falls and therefore, lesser quantity of goods and services will be produced. To combat such a slump in
overall economic activity, the government can resort to expansionary fiscal policies.

An expansionary fiscal policy is used to address recession and the problem of general unemployment on
account of business cycles. We may technically refer to this as a policy measure to close a ‘recessionary gap’.
A recessionary gap, also known as a contractionary gap, is said to exist if the exist ng levels of aggregate
production is less than what would be produced with full employment of resources. It is a measure of output
that is lost when actual national income falls short of potential income, and represents the difference between
the actual aggregate demand and the aggregate demand which is required to establish the
equilibrium at full employment level of income. This gap occurs during the contractionary phase of business-
cycle and results in higher rates of unemployment. In other words, recessionary gap occurs when the
aggregate demand is not sufficient to create conditions of full employment. Now the question is how do
changes in government expenditure (G), and taxes (T) eliminate a recessionary gap?

IV Application Oriented Questions

1. The government of Country X, an underdeveloped country, having a severe problem of unemployment of
labour embarks on a massive development programme. It has recognized the imminent need for boosting
up investments to take the country to a higher than average growth trajectory.

The following steps were taken by the government:

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i) Invited tenders for a huge network of highways, solar energy generation, communication systems and
computerized systems

ii) Large number of schools throughout the country

iii) Research grants for universities and private research institutes

iv) Announced a number of free healthcare programmes for all

v) All citizens assured of social security

vi) Increase in payments under existing social security schemes

vii) Tax exemption limit raised for individuals, instituted progressive taxes with high marginal rates -
increased corporate taxes. Very soon prices started spiralling and there was general unrest among
people especially the poor.

i) Analyze each of the above measures from a fiscal policy perspective.

ii) Why did overall prices increase?

iii) What policies do you suggest to solve the problem of price rise?

iv) What are the limitations of such policies?

ANSWER 1

(i) Fiscal policy aimed at economic growth and desired redistribution of income - This is done through
spending programmes targeted on welfare measures for the disadvantaged for e.g. poverty alleviation
programmes, free or subsidized amenities to improve the quality of living of poor, infrastructure provision on
a selective basis,
strengthening of human capital for enhancing employability, Government provision of public goods such as
education, research and development etc. provide momentum for long-run economic growth - A well
designed tax policy that rewards innovation and entrepreneurship, without discouraging incentives will
promote
private businesses who wish to invest and thereby help the economy grow- A progressive direct tax system
ensures that those who have greater ability to pay contribute more towards defraying the expenses
of government and that the tax burden is distributed fairly among the population- carefully planned policy of
public expenditure helps in redistributing income from the rich to the poorer sections of the
society-

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(ii) Conflict with stabilization functions of state policy – Government expenditure injects more money into the
economy and stimulates demand in each case, disposable incomes increase- aggregate demand increases –
illustrate with shift in AD curve- No corresponding increase in output- inflation sets in

(iii) Remedy through fiscal policy- reduce aggregate demand – contractionary fiscal policy–increase aggregate
supply –
(iv) Conflict of objectives -Possible lags - long gestation periods - politically unviable to reduce expenditure-
high taxes lead to disincentives to invest.

2. In the above example, suppose that the increase in government spending has been 5 billion. Assume that
the marginal propensity to consume of people is equal to 0.6.

(i) what will be the government spending multiplier?

(ii) What impact would a 5 billion increase in government expenditure have on equilibrium GDP?

ANSWER 2
(i) The government spending multiplier when the MPC is 0.6, is 1/1-
MPC) = 2.5.
(ii) A 5 billion increase in government expenditure will change the GDP by
5*2.5=12.5 billion if the MPC = 0.6.

3. For an Economy with the following specifications

Consumption, C = 50+0.75 Yd
Investment, I = 100
Government Expenditure, G = 200
Transfer Payments, R= 110
Income Tax = 0.2Y
Calculate the equilibrium of income and the value of expenditure multiplier.

ANSWER 3

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The level of disposable income Yd is given by
Yd = Y-Tax + Transfer Payments, Where, Transfer Payment = 110
= Y -0.2 Y +110 = 0.8Y +110,
and C = 50+0.75 Yd
= 50+0.75(0.8Y +110)(where Yd = 0.8Y +110)
= 50+(0.75×0.8Y) + (0.75X110) =132.50+0.6Y
C = 132.50+0.6 Y
Now Y = C+I+G, Where C = 132.50+0.6Y, I = 100 , G = 200( Given)
Y = (132.50+0.6Y)+100+200
= 432.50+0.6Y

Y-0.6Y= 0.4Y = 432.50

or Y = 432.50/0.4 = 1,081.25 Crores.

ILLUSTRATION 1
Assume that the MPC is equal to 0.6.
(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on equilibrium GDP?
(c) What about a 50 billion decrease in government spending?

SOLUTION

ILLUSTRATION 2

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If country X has a marginal propensity to consume of 0, what is the value of fiscal multiplier?

SOLUTION

Given MPC=0; MPS = (1-0) = 1

The spending multiplier =1. There is no multiplier effect

ILLUSRATION 3
Average per capita income of country Y rose from 42,300 to 50,000 and the corresponding figures for per
capita consumption rose from 35,400 to 42,500. Find the spending multiplier for this economy.

SOLUTION
Spending multiplier = 1/(1-MPC).
MPC = Increase in Consumption/ Increase in Income
= (42,500−35,400)/ (50,000 − 42,300)
= 0 .922
Multiplier = 1/(1-0.922) = 1/(0.078) = 12.83

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 CHAPTER-3 MONEY MARKET
UNIT I- THE CONCEPT OF MONEY DEMAND:IMPORTANT THEORIES

I Multiple Choice Type Questions

1. Choose the incorrect statement

(a) Anything that would act as a medium of exchange is money

(b) Money has generalized purchasing power and is generally acceptable in settlement of all transactions

(c) Money is a totally liquid asset and provides us with means to access goods and services

(d) Currency which represents money does not necessarily have intrinsic value.

ANSWER 1-A

2. Money performs all of the three functions mentioned below, namely

(a) medium of exchange, price control, store of value

(b) unit of account, store of value , provide yields

(c) medium of exchange, unit of account, store of value

(d) medium of exchange, unit of account, income distribution

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ANSWER 2-C

3. Demand for money is

(a) Derived demand

(b) Direct demand

(c) Real income demand

(d) Inverse demand

ANSWER 3-A

4. Higher the ----------------------, higher would be -----------------------of holding cash and lower will be the --------
------------------------

(a) demand for money, opportunity cost, interest rate

(b) price level , opportunity cost, interest rate

(c) real income , opportunity cost, demand for money

(d) interest rate, opportunity cost, demand for money

ANSWER 4-D

5. The quantity theory of money holds that

(a) changes in the general level of commodity prices are caused by changes in the quantity of money

(b) there is strong relationship between money and price level and the quantity of money is the main
determinant of the price

(c) changes in the value of money or purchasing power of money are determined first and foremost by

507
changes in the quantity of money in circulation

(d) All the above

ANSWER 5-D
6. The Cambridge approach to quantity theory is also known as

(a) Cash balance approach

(b) Fisher’s theory of money

(c) Classical approach

(d) Keynesian Approach

ANSWER 6-A

7. Fisher’s approach and the Cambridge approach to demand for money consider

(a) money’s role in acting as a store of value and therefore, demand for money is for storing value
temporarily.

(b) money as a means of exchange and therefore demand for money is termed as for liquidity preference

(c) money as a means of transactions and therefore, demand for money is only transaction demand for
money.

(d) None of the above

ANSWER 7-C

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8. Real money is
(a) nominal money adjusted to the price level

(b) real national income

(c) money demanded at given rate of interest

(d) nominal GNP divided by price level

ANSWER 8-A

9. The precautionary money balances people want to hold

(a) as income elastic and not very sensitive to rate of interest

(b) as income inelastic and very sensitive to rate of interest

(c) are determined primarily by the level of transactions they expect to make in the future.

(d) are determined primarily by the current level of transactions

ANSWER 9-A

10. Speculative demand for money

(a) is not determined by interest rates

(b) is positively related to interest rates

(c) is negatively related to interest rates

(d) is determined by general price level

ANSWER 10-C

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11. According to Keynes, if the current interest rate is high

(a) people will demand more money because the capital gain on bonds would be less than return on money

(b) people will expect the interest rate to rise and bond price to fall in the future.

(c) people will expect the interest rate to fall and bond price to rise in the future.

(d) Either a) or b) will happen

ANSWER 11-C

12. The inventory-theoretic approach to the transactions demand for money

(a) explains the negative relationship between money demand and the interest rate.

(b) explains the positive relationship between money demand and the interest rate.

(c) explains the positive relationship between money demand and general price level

(d) explains the nature of expectations of people with respect to interest rates and bond prices

ANSWER 12-A

13. According to Baumol and Tobin’s approach to demand for money, the optimal average money holding
is:

(a) a positive function of income Y and the price level P

(b) a positive function of transactions costs c,

(c) a negative function of the nominal interest rate i

(d) All the above

ANSWER 13-D

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14. ___________ considered demand for money is as an application of a more general theory of demand for
capital assets

(a) Baumol

(b) James Tobin

(c) J M Keynes
(d) Milton Friedman

ANSWER 14-D

15. The nominal demand for money rises if

(a) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and rE , respectively- decline
and vice versa

(b) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and rE , respectively- rises and
vice versa

(c) the opportunity costs of money holdings – i.e. bonds and stock returns, rB and rE , respectively remain
constant

(d) b) and c) above

ANSWER 15-A

II. Short Answer Type Questions

1. Define money.
ANSWER 1

Assets which are commonly used and accepted as a means of payment or as a medium of exchange or of
transferring purchasing power. Also defined as the set of liquid financial assets, the variation in the stock of
which will have impact on aggregate economic activity

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2. What is meant by the term “legal tender,”
ANSWER 2

They serve by law as means of payment –legally bound to accept insettlement of obligations
3. Write notes on the function of money as a medium of exchange,
ANSWER 3

Money facilitate easy exchanges of goods and services increases the ease of trade and reduces the inefficiency
and transaction costs involved in a barterexchange

4. Outline how money is useful as a ‘common denominator of value’.

ANSWER 4

The monetary unit is the unit of measurement in terms of which the value ofall goods and services is
measured and expressed.

5. Examine the relationship between purchasing power of money and general price level

ANSWER 5
Value of money is linked to its purchasing power. Purchasing power is the inverse of the average or general
level of prices as measured by the consumer price index.

6. Critically examine money’s function as standard of deferred payment

ANSWER 6
Money facilitates recording of deferred promises to pay. Money is the unitin terms of which future payments

512
are contracted or stated

7. List the general characteristics that money should possess?

ANSWER 7

Money should be generally acceptable, durable, difficult to counterfeit, relatively scarce, uniform, easily
transported, divisible without losing value, elastic in supply and effortlessly recognizable
8. Explain the concept of demand for money.
ANSWER 8
The demand for money is a decision about how much of one’s given stock of wealth should be held in the
form of money rather than as other assets such as bonds. Demand for money is actually demand for liquidity
and a
demand to store value.

9. Why do we say that money demand is derived demand?

ANSWER 9
Demand for money is in the nature of derived demand; it is demanded for it purchasing power. Basically
people demand money because they wish to have command over real goods and services with the use of
money

10. Why is it important to study about demand for money?

ANSWER 10

Demand for money has an important role in the determination of interest, prices and income in an economy.

11. Explain how higher the interest rate affect the demand for money.
ANSWER 11
Important determinant of demand for money. Higher the interest rate, higher would be opportunity cost of

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holding cash and lower the demand for Money

12. Describe the main postulates of quantity theory of money

ANSWER 12

The main postulates of the theory are: the proportionality of m and p, theactive or causal role of m, neutrality
of money on real variables, exogenous nature of nominal money supply and the monetary theory of the price
level
13. Describe the Keynesian view of different motives of holding cash

ANSWER 13

According to Keynes, people hold money in cash for three motives: the transactions, precautionary and
speculative motives.

14. Compare transaction demand for money according to Keynes and Baumol& Tobin

ANSWER 14
In contrast to the Keynesian demand for transaction balances which is interest-inelastic, the transaction
demand of Baumol and Tobin is interestelastic.

III. Long answer Type Questions

1. Define money and describe its nature and characteristics

ANSWER 1
Money is at the centre of every economic transaction and plays a significant role in all economies. In simple
terms money refers to assets which are commonly used and accepted as a means of payment or as a medium
of exchange or for transferring purchasing power. For policy purposes, money may be defined as the
set of liquid financial assets, the variation in the stock of which will have impact on aggregate economic
activity. As a statistical concept, money could include certain liquid liabilities of a particular set of financial
intermediaries or other issuers (RBI, 2007).

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Money has generalized purchasing power and is generally acceptable in settlement of all transactions and in
discharge of other kinds of business obligations including future payments. Anything that would act as a
medium of exchange is not necessarily money. For example, a bill of exchange may also be a
medium of exchange, but it is not money since it is not generally accepted as a means of payment. Money is a
totally liquid asset as it can be used directly, instantly, conveniently and without any costs or restrictions to
make payments. At the fundamental level, money provides us with a convenient means to access
goods and services.
Money represents a certain value, but currency which represents money does not necessarily have intrinsic
value. When money takes the form of a commodity with intrinsic value, it is called commodity money. For e.g.
gold, silver or any other such elements may be used as money. As you know, fiat money (also known as
token money) has no intrinsic value, that is, it has no value if it were not used as money. Fiat money is used as
a medium of exchange because the government has, by law, made them “legal tender,” which means, they
serve, by law, as means of payment. In modern days, money is not necessarily a physical item; it may also
constitute electronic records. Money is, in fact, only one among many kinds of financial assets which
households, firms, governments and other economic units hold in their asset portfolios. Unlike other financial
assets, money is an essential element in conducting most of the economic transactions in an economy.

There are some general characteristics that money should possess in order to make it serve its functions as
money. Money should be:

• generally acceptable

• durable or long-lasting

• effortlessly recognizable.

• difficult to counterfeit i.e. not easily reproducible by people

• relatively scarce, but has elasticity of supply

• portable or easily transported

• possessing uniformity; and

• divisible into smaller parts in usable quantities or fractions without losing value

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2. Explain the functions performed by money

ANSWER 2

Money performs many important functions in an economy which not only remove the difficulties of barter but
also support trade and industry. These functions are as follows-

(i) Money is a convenient medium of exchange or it is an instrument that facilitates easy exchange of goods
and services. Money, though not having any inherent power to directly satisfy human wants, by acting as a
medium of exchange, it commands purchasing power and its possession enables us to purchase goods and
services to satisfy our wants. By acting as an intermediary, money increases the ease of trade and reduces the
inefficiency and transaction costs involved in a barter exchange. In a barter economy every transaction has to
involve an exchange of goods (and /or services) on both sides of the transaction. By decomposing the single
barter transaction into two separate transactions of sale and purchase, money eliminates the need for double
coincidence of wants. Money also facilitates separation of transactions both in time and place and this in turn
enables us to economize on time and efforts involved in transactions.

(ii) Money is an explicitly defined unit of value or unit of account. A unit of account is the yardstick people use
to post prices and record debts. All economic values are measured and recorded in terms of money. As a
measure of value, money works as a common denominator, as a unit of account. We know, Rupee is the unit
of account in India in which the entire money is denominated.

(iii) Money serves as a unit or standard of deferred payment i.e money facilitates recording of deferred
promises to pay. Money is the unit in terms of which future payments are contracted or stated. It simplifies
credit transactions. By acting as a standard of deferred payments, money helps in capital formation both by
the government and business enterprises. This function of money enables the growth of financial and capital
markets and helps in the growth of the economy. However, variations in the purchasing power of money due
to inflation or deflation reduce the efficacy of money in this function.

(iv) Like nearly all assets such as stocks, bonds and other forms of wealth, money is a store of value. A store of
value is an item that people can use to transfer purchasing power from the preset to the future. People prefer
to hold it as an asset, that is, as part of their stock of wealth. The splitting of

3. ‘The quantity theory of money is not a theory about money at all, rather it is a theory of the price-level’
Elucidate
ANSWER 3

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Classical Approach: The Quantity Theory of Money (QTM)

The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving Fisher
of Yale University in his book ‘The Purchasing Power of Money’ published in 1911 and later by the neoclassical
economists. Both versions of the QTM demonstrate that there is strong relationship between
money and price level and the quantity of money is the main determinant of the price level or the value of
money. In other words, changes in the general level of commodity prices or changes in the value or purchasing
power of money are determined first and foremost by changes in the quantity of money in circulation
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
MV = PT

Where, M = the total amount of money in circulation (on an average) in an economy

V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of
money(say Rupee) is spent in purchasing goods and services
P = average price level (P= MV/T)
T = the total number of transactions.
(Later economists replaced T by the real output Y).

Subsequently, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their
velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes:

MV + M'V' = PT

Where M' = the total quantity of credit money

V'= velocity of circulation of credit money

The total supply of money in the community consists of the quantity of actual money (M) and its velocity of
circulation (V). Velocity of money in circulation (V) and the velocity of credit money (V') remain constant. T is a
function of national income. Since full employment prevails, the volume of transactions T is fixed in
the short run. Briefly put, the total volume of transactions (T) multiplied by the price level (P) represents the
demand for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any given
period, the total value of transactions made is equal to PT and the value of money flow is equal to MV+
M'V'.

We shall now look into the classical idea of the demand for money. Fisher did not specifically mention
anything about the demand for money; but the same is embedded in his theory as dependent on the total
value of transactions undertaken in the economy. That is people would hold money in a quantity proportional
to total transactions irrespective of interest rate. Thus, there is an aggregate demand for money for
transactions purpose and more the number of transactions people want, greater will be the demand for
money. The total volume of transactions multiplied by the price level (PT) represents the demand for money.

4. Describe the various theories related to demand for money

ANSWER 4 517

1. Classical Approach: The Quantity Theory of Money (QTM)

2. The Cambridge approach

In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard
Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory,
known as cash balance approach. The Cambridge version holds that money increases utility in
the following two ways:
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being
simultaneous ,and

2. being a hedge against uncertainty. While the first above represents transaction motive, just as Fisher
envisaged, the second points to money’s role as a temporary store of wealth. Since sale and
purchase of commodities by individuals do not take place simultaneously, they need a ‘temporary abode’ of
purchasing power as a hedge against uncertainty. As such, demand for money also involves a precautionary
motive in Cambridge approach. Since money gives utility in its store of wealth and precautionary
modes, one can say that money is demanded for itself.

3. The Keynesian Theory of Demand for Money

Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity preference’, a term
that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and
Money’ 1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing
investments. According to Keynes, people hold money (M) in cash for three motives:

(i) Transactions motive ,

(ii) Precautionary motive, and

(iii) Speculative motive.

5. Define ‘real cash balance’. Describe the Inventory Theoretic Approach to demand for money

ANSWER 5

Inventory Approach to Transaction Balances

Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money, known 518
as Inventory Theoretic Approach, in which money or ‘real cash balance’ was essentially viewed as an inventory
held for transaction purposes.
Inventory models assume that there are two media for storing value:

(a) money and

(b) an interest-bearing alternative financial asset.
There is a fixed cost of making transfers between money and the alternative assets e.g. broker charges. While
relatively liquid financial assets other than money (such as, bank deposits) offer a positive return, the above
said transaction cost of going between money and these assets justifies holding money.

Baumol used business inventory approach to analyze the behaviour of individuals. Just as businesses keep
money to facilitate their business transactions, people also hold cash balance which involves an opportunity
cost in terms of lost interest. Therefore, they hold an optimum combination of bonds and cash
balance, i.e., an amount that minimizes the opportunity cost.

Baumol’s propositions in his theory of transaction demand for money hold that receipt of income, say Y takes
place once per unit of time, but expenditure is spread at a constant rate over the entire period of time. Excess
cash over and above what is required for transactions during the period under consideration will be invested
in bonds or put in an interest-bearing account. Money holdings on an average will be lower if people hold
bonds or other interest yielding assets.

Just as businesses would like to hold an optimal inventory to reduce cost, individuals would like to keep
optimal inventory of money and thus ensure minimum cost of money holding. The more cash the individual
holds, the less would be the cost on account of broker’s fee; but then the opportunity cost in
terms of interest forgone would be more. The opposite would be the case if an individual holds less money.
Therefore the individual faces a trade off which he should resolve by choosing the level of optimal money
holding that would minimise the interest income foregone and broker’s fee.

The higher the income, the higher is the average level or inventory of money holdings. The level of inventory
holding also depends upon the carrying cost, which is the interest forgone by holding money and not bonds,
net of the cost to the individual of making a transfer between money and bonds, say for example
brokerage fee. The individual will choose the number of times the transfer between money and bonds takes
place in such a way that the net profits from bond transactions are maximized.

The average transaction balance (money) holding is a function of the number of times the transfer between

519
money and bonds takes place. The more the number of times the bond transaction is made, the lesser will be
the average transaction balance holdings. In other words, the choice of the number of times the bond
transaction is made determines the split of money and bond holdings for a given income.
The inventory-theoretic approach also suggests that the demand for money and bonds depend on the cost of
making a transfer between money and bonds e.g. the brokerage fee. An increase the brokerage fee raises the
marginal cost of bond market transactions and consequently lowers the number of such transactions.
The increase in the brokerage fee raises the transactions demand for money and lowers the average bond
holding over the period. This result follows because an increase in the brokerage fee makes it more costly to
switch funds temporarily into bond holdings. An individual combines his asset portfolio of cash and bond
in such proportions that his overall cost of holding the assets is minimized.
6. Explain why bond prices move inversely to market interest rates

ANSWER 6
Tobin's theory implies that the amount of money held as an asset depends on the level of interest rate. An
increase in the interest rate will improve the terms on which the expected return on the portfolio can be
increased by accepting greater risk. In response to the increase in the interest rate , the individual will increase
the proportion of wealth held in the interest-bearing asset, say bonds, and will decrease the holding of money.

Within Tobin's framework, an increase in the rate of interest can be considered as an increase in the payment
received for undertaking risk. When this payment is increased, the individual investor is willing to put a greater
proportion of the portfolio into the risky asset, (bonds) and thus a smaller proportion into the safe asset,
money. His analysis implies that the demand for money as a store of wealth will decline with an increase in the
interest rate. Tobin's analysis also indicates that uncertainty about future changes in bond prices, and hence
the risk involved in buying bonds, may be a determinant of money demand. Just as Keynes’ theory, Tobin's
theory implies that the demand for money as a store of wealth depends negatively on the interest
rate.

7. To what extent does Friedman's Restatement of the Quantity Theory explain the demand for money?
ANSWER 7

Friedman's Restatement of the Quantity Theory

Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price
theory. Friedman treats the demand for money as nothing more than the application of a more general theory
of demand for capital assets.

Demand for money is affected by the same factors as demand for any other asset, namely

520
1. Permanent income.

2. Relative returns on assets. (which incorporate risk)

Friedman maintains that it is permanent income– and not current income as in the Keynesian theory – that
determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present
expected value of all future income. To Friedman, money is a good as any other durable consumption good
and its demand is a function of a great number of factors. Friedman identifies the following four determinants
of the demand for money.
The nominal demand for money:

• is a function of total wealth, which is represented by permanent income divided by the discount rate,
defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds,
equity,
physical capital and human capital.

• is positively related to the price level, P. If the price level rises the demand for money increases and vice
versa.

• rises if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and vice versa.

• is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby
increasing the opportunity costs of money holdings.

8. ‘Risk-avoiding behaviour of individuals provided the foundation for the liquidity preference and for a
negative relationship between the demand for money and the interest rate’ Elucidate with examples
ANSWER 8

The Demand for Money as Behaviour toward Risk

In his classic article, ‘Liquidity Preference as Behaviour towards Risk’ (1958), Tobin established that the risk-
avoiding behaviour of individuals provided the foundation for the liquidity preference and for a negative
relationship between the demand for money and the interest rate. The risk-aversion theory is based on
the principles of portfolio management. According to Tobin, the optimal portfolio structure is determined by

(i) the risk/reward characteristics of different assets

(ii) the taste of the individual in maximizing his utility consistent with the existing opportunities

521
In his theory which analyzes the individual's portfolio allocation between money and bond holdings, the
demand for money is considered as a store of wealth. Tobin hypothesized that an individual would hold a
portion of his wealth in the form of money in the portfolio because the rate of return on holding money was
more certain than the rate of return on holding interest earning assets and entails no capital gains or losses. It
is riskier to hold alternative assets vis-à-vis holding just money alone, because government bonds and equities
are subject to market price volatility, while money is not. Thus, bonds pay an expected return of r, but as
asset, they are unlike money because they are risky; and their actual return is uncertain. Despite this, the
individual will be willing to face this risk because the expected rate of return from the alternative financial
assets exceeds that of money.
According to Tobin, the rational behaviour of a risk-averse economic agent induces him to hold an optimally
structured wealth portfolio which is comprised of both bonds and money. The overall expected return on the
portfolio would be higher if the portfolio were all bonds, but an investor who is ‘risk-averse’ will be
willing to exercise a trade- off and sacrifice to some extent the higher return for a reduction in risk.

Tobin's theory implies that the amount of money held as an asset depends on the level of interest rate. An
increase in the interest rate will improve the terms on which the expected return on the portfolio can be
increased by accepting greater risk. In response to the increase in the interest rate , the individual will increase
the proportion of wealth held in the interest-bearing asset, say bonds, and will decrease the holding of money.
Within Tobin's framework, an increase in the rate of interest can be considered as an increase in the payment
received for undertaking risk. When this payment is increased, the individual investor is willing to put a greater
proportion of the portfolio into the risky asset, (bonds) and thus a smaller proportion into the safe asset,
money. His analysis implies that the demand for money as a store of wealth will decline with an increase in the
interest rate. Tobin's analysis also indicates that uncertainty about future changes in bond prices, and hence
the risk involved in buying bonds, may be a determinant of money demand. Just as Keynes’ theory, Tobin's
theory implies that the demand for money as a store of wealth depends negatively on the interest
rate.

9. Critically examine the post Keynesian theories of demand for money.

ANSWER 9

POST-KEYNESIAN DEVELOPMENTS IN THE THEORY OF DEMAND FOR MONEY

Most post-Keynesian theories of demand for money emphasize the store-of-value or the asset function of
money

1. Inventory Approach to Transaction Balances

2. Friedman's Restatement of the Quantity Theory

IV. Application Oriented Question

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1. (a) Why should you hold money balances?

(b) Will you choose to hold only interest bearing assets?

(c) What would your choice be if you can pay for nearly all transactions through online transfers?

(d) Do you think money is a unique store of value?

ANSWER 1
(a) Transaction, precautionary and speculative demand – depends on the nature of the holder- institutional
payments mechanisms and the gap between receipt and use of money, amount of income and changes in
incomes, general level of prices, cost of conversion from near money to money etc.

(b) Not always- Partly held in assets- Depends on costs in terms of time and resources to keep moving in and
out of bonds or other assets, the levels of interest payments, expectations about bond prices, future
price levels- concept of speculative demand for money

(c) Depends on financial infrastructure, how costless and immediate are transfers, preferences, attitude
towards risks and the opportunity costs.

(d) Financial assets other than money are also performing the function of store of value. Just as money has,
the financial assets have fixed nominal value over time and represent generalized purchasing power.
Therefore, money is not a unique store of value.

2. (a) Calculate M
Velocity 19
Price 108.5
Volume of transactions 120 billion

(b) What will be the effect on money supply if velocity is 25?

ANSWER 2

(a) MV = PT,
M x 19 = 108.5 x 120; Therefore M 685.26

(b) For V =25, with given p and T, M will be 520.8

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3. (a) Calculate velocity of money

Money Supply 5000 billion
Price 110
Volume of transaction 200

(b) What will be the outcome if volume of transaction increases to225?

ANSWER 3

(a) MV=PT;
5000 x V = 110x200, Therefore V = 4.4

(b) If Volume of transaction 225, then V= 4.95

UNIT-II COCNCEPT OF MONEY SUPPLY

Illustration 1
Calculate Narrow Money (M1) from the following data
Currency with public ₹ 90000 crore
Demand Deposits with Banking System ₹ 200000 crore
Time Deposits with Banking System ₹ 220000 crore
Other Deposits with RBI ₹ 280000 crore
Saving Deposits of Post office saving banks ₹ 60000 crore

Solution
M1 = Currency with public + Demand Deposits with Banking System + Other
Deposits with the RBI
= 90000 crore + 200000 crore + 280000 crore = 57 0000crore

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Illustration 2
Compute credit multiplier if the required reserved ratio is 10% and 12.5% for every ₹ 1, 00,000 deposited in
the banking system. What will be the total credit money created by the banking system in each case?

Solution
Credit Multiplier is the reciprocal of required reserved ratio.
For RRR 0.10 credit creation will be 1, 00,000× 1/0.10 = Rs, 10, 00,000
For RRR 0.125 credit creation will be 1, 00,000× 1/0.125= Rs, 8, 00,000

Illustration 3
Calculate currency with the Public from the following data (₹ Crore)

1.1 Notes in Circulation 2496611

1.2 Circulation of Rupee Coin 25572
1.3 Circulation of Small Coins 743
1.4 Cash on Hand with Banks 98305

Solution
Currency with the Public (1.1 + 1.2 + 1.3 – 1.4) =(2496611+25572+743) – 98305
=2424621

Illustration 4
Calculate M2 from the following data

525
Solution
M2 = M1+ Post Office Saving Bank Deposits
where M1 = (Notes in Circulation + Circulation of Rupee Coin + Circulation of
Small Coins - Cash on Hand with Banks) + Deposit Money of the Public
= (2420964+25572+743+97563- 97563) +1776199 =4125915
M2 = M1+ Post Office Saving Bank Deposits = 4125915 +141786= 4267701

Illustration 5
If the required reserve ratio is 10 percent, currency in circulation is ₹ 400 billion, demand deposits are ₹
1000 billion, and excess reserves total ₹ 1 billion, find the value of money multiplier
Solution
r = 10% = 0.10
Currency = 400 billion
Deposits = 1000 billion
Excess Reserves = 1 billion

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Money Supply is M = Currency + Deposits = 1400 billion
c = C/D =
400 billion/1000 billion = 0. 4 or depositors hold 40 percent of their money as currency
e= 1billion /1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves.
Multiplier
= 1+0.4/ 0.1+0.001+0.4 = 1.5/ 0. 501 =2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.

I. Multiple Choice Type Questions

1. Reserve money is also known as

(a) central bank money

(b) base money

(c) high powered money

(d) all the above

ANSWER 1-D

2. Choose the correct statement from the following

(a) Money is deemed as something held by the public and therefore onlycurrency held by the public is
included in money supply.

(b) Money is deemed as something held by the public and thereforeinter-bank deposits are included in
money supply.

(c) Since inter-bank deposits are not held by the public, therefore interbankdeposits are excluded from the
measure of money supply.

(d) Both (a ) and (c) above.

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ANSWER 2-C

3. Reserve Money is composed of

(a) currency in circulation + demand deposits of banks (Current and Saving accounts) + Other deposits with
the RBI.

(b) currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI.
(c) currency in circulation + demand deposits of banks + Other deposits with the RBI.

(d) currency in circulation + demand and time deposits of banks + Other deposits with the RBI.

ANSWER 3-B

4. M1 is the sum of

(a) currency and coins with the people + demand deposits of banks (Current and Saving accounts) + other
deposits of the RBI.

(b) currency and coins with the people + demand and time deposits of banks (Current and Saving accounts)
+ other deposits of the RBI.

(c) currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI

(d) none of the above

ANSWER 4-A

5. Under the’ minimum reserve system’ the central bank is

(a) empowered to issue currency to any extent by keeping an equivalent reserve of gold and foreign
securities.

(b) empowered to issue currency to any extent by keeping only a certain minimum reserve of gold and
foreign securities.

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(c) empowered to issue currency in proportion to the reserve money by keeping only a minimum reserve of
gold and foreign securities.

(d) empowered to issue currency to any extent by keeping a reserve of gold and foreign securities to the
extent of ₹ 350 crores

ANSWER 5-B
6. The primary source of money supply in all countries is

(a) the Reserve Bank of India

(b) the Central bank of the country

(c) the Bank of England

(d) the Federal Reserve

ANSWER 6-B

7. The supply of money in an economy depends on

(a) the decision of the central bank based on the authority conferred on it.

(b) the decision of the central bank and the supply responses of the commercial banking system.

(c) the decision of the central bank in respect of high powered money.

(d) both a) and c) above.

ANSWER 7-B

8. Banks in the country are required to maintain deposits with the central bank

(a) to provide the necessary reserves for the functioning of the central bank 529

(b) to meet the demand for money by the banking system

(c) to meet the central bank prescribed reserve requirements and to meet settlement obligations.

(d) to meet the money needs for the day to day working of the commercial banks

ANSWER 8-C
9. If the behaviour of the public and the commercial banks is constant, then

(a) the total supply of nominal money in the economy will vary directly with the supply of the nominal high-
powered money issued by the central bank

(b) the total supply of nominal money in the economy will vary directly with the rate of interest and
inversely with reserve money

(c) the total supply of nominal money in the economy will vary inversely with the supply of high powered
money

(d) all the above are possible

ANSWER 9-A

10. Under the fractional reserve system

(a) the money supply is an increasing function of reserve money (or high powered money) and the money
multiplier.

(b) the money supply is an decreasing function of reserve money (or high powered money) and the money
multiplier.

(c) the money supply is an increasing function of reserve money (or high powered money) and a decreasing
function of money multiplier.

(d) none of the above as the determinants of money supply are different

ANSWER 10-A 530

11. The money multiplier and the money supply are

(a) positively related to the excess reserves ratio.

(b) negatively related to the excess reserves ratio.

(c) not related to the excess reserves ratio .

(d) proportional to the excess reserves ratio .

ANSWER 11-B

12. The currency ratio represents

(a) the behaviour of central bank in the issue of currency.

(b) the behaviour of central bank in respect cash reserve ratio.

(c) the behaviour of the public.

(d) the behaviour of commercial banks in the country.

ANSWER 12-C

13. The size of the money multiplier is determined by

(a) the currency ratio (c) of the public,

(b) the required reserve ratio (r) at the central bank, and

(c) the excess reserve ratio (e) of commercial banks.

(d) all the above

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ANSWER 13-D
14. --------------- tells us how much new money will be created by the banking system for a given increase in
the high-powered money.

(a) The currency ratio

(b) The excess reserve ratio (e)

(c) The credit multiplier

(d) The currency ratio (c)

ANSWER 14-C

15. The money multiplier will be large

(a) for higher currency ratio (c),lower required reserve ratio (r) and lower excess reserve ratio (e)

(b) for constant currency ratio (c),higher required reserve ratio (r) and lower excess reserve ratio (e)

(c) for lower currency ratio (c),lower required reserve ratio (r) and lower excess reserve ratio (e)

(d) None of the above

ANSWER 15-C

16. The ratio that relates the change in the money supply to a given change in the monetary base is called
the

532
(a) required reserve ratio.

(b) money multiplier.

(c) deposit ratio.

(d) discount rate.

ANSWER 16-B
17. For a given level of the monetary base, an increase in the required reserve ratio will denote

(a) a decrease in the money supply.

(b) an increase in the money supply.

(c) an increase in demand deposits.

(d) Nothing precise can be said

ANSWER 17-A

18. For a given level of the monetary base, an increase in the currency ratio causes the money multiplier to
_____ and the money supply to _____.

(a) decrease; increase

(b) increase; decrease

(c) decrease; decrease

(d) increase; increase

ANSWER 18-C

19. If commercial banks reduce their holdings of excess reserves

(a) the monetary base increases.

(b) the monetary base falls.

533
(c) the money supply increases.

(d) the money supply falls.

ANSWER 19-C
II. Short Answer Type Questions
(a) Explain the nature of currency issue under minimum reserve system

ANSWER

(a) Under the ‘minimum reserve system’ the central bank is empowered to issue currency to any extent by
keeping only a certain minimum reserve of gold and foreign securities.

(b) Define ‘credit money’.

ANSWER

(b) 'Credit money’ refers to the fraction of money supply created by commercial banks in the process of
borrowing and lending transactions with the public

(c) List the components of M1

ANSWER

(c) M1 is composed of currency and coins with the people, demand deposits of banks (current and saving
accounts) and other deposits of the RBI.

(d) Distinguish between M1 and M2

ANSWER

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(d) M2 includes M1( as above) as well as savings deposits with post office savings banks

(e) What is the rationale behind inclusion of net demand deposits of banks in money supply measurement?
ANSWER

(e) Money is deemed as something held by the ‘public’. Since inter-bank deposits are not held by the public,
they are netted out of the total demand deposits to arrive at net demand deposits.
(f) Define ‘Reserve Money’
ANSWER

(f) Reserve Money is composed of currency in circulation, bankers’ deposits with

(g) Write a note on two major components Reserve money?

ANSWER

(g) the RBI and other deposits with the RBI

(h) Describe the term ‘cash reserve ratio’ (CRR)

ANSWER
(h) Reserve money has two major components – currency in circulation and reserves. Currency in circulation
comprises currency with the public and cash in hand with banks. Reserves are bank deposits with the central
bank.

(i) Write a note on the liquidity aggregates compiled by RBI

ANSWER

(i) Banks in the country are required to maintain deposits with the central bank to meet the central bank
prescribed reserve requirements or cash reserve ratio (CRR) as also to meet settlement obligations. They
represent balances maintained by banks in the current account with the Reserve Bank of India.

535

(j) Define ‘money multiplier’

ANSWER

(j) The liquidity aggregates are: L1 which is composed of NM3, all deposits with the post office savings banks
(excluding National Savings Certificates), L2 which comprises of L1,term deposits with term lending institutions
and refinancing institutions (FIs),term borrowing by FIs and certificates of deposit issued by FIs and L3
consisting of L2 and Public deposits of nonbanking financial companies
(k) What is the nature of relationship between money multiplier and the money supply?
ANSWER

(k) The money supply is defined as M= m X MB where M is the money supply, m is money multiplier and MB is
the monetary base or high powered money. Money multiplier m is defined as a ratio that relates the change in
the money supply to a given change in the monetary base.

(l) What would be the effect on money multiplier if banks hold excess reserves?
ANSWER
(l) The multiplier indicates what multiple of the monetary base is transformed into money supply. The link
from reserve money to money supply is through the money multiplier. The multiplier process operates as long
as banks have Aexcess reserves.

(m) What effect does government expenditure have on money supply?

ANSWER
(m) The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do
not lead to any additional loans, and therefore, these excess reserves do not lead to creation of deposits. In
other words, excess reserves may be considered as an idle component of reserves and therefore has no effect
on money multiplier

(n) What is the value of the money multiplier in a system of 100% reserve banking?

ANSWER
(n) When the Reserve Bank lends to the governments under WMA /OD it results in the generation of excess
reserves (i.e., excess balances of commercial banks with the Reserve Bank). The excess reserves thus created
can potentially lead to an increase in money supply through the money multiplier process.

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(o) Define credit multiplier. How is it calculated?

ANSWER

(o) If banks keep the whole deposits as reserve, deposits simply replace currency as reserves and therefore no
new extra claims will be created and no new money will be created by banks.
The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion multiplier, describes
the amount of additional money created by commercial bank through the process of lending the available
money it has in excess of the central bank's reserve requirements. It is the reciprocal of the required reserve
ratio. If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5

III. Long Answer Type Questions

1. Define money supply. Describe the different components of money supply.

ANSWER 1

The term money supply denotes the total quantity of money available to the people in an economy. The
quantity of money at any point of time is a measurable concept. It is important to note two things about any
measure of money supply:

(i) The supply of money is a stock variable i.e. it refers to the total amount of money at any particular point of
time. It is the change in the stock of money (say, increase or decrease per month or year,), which is a flow.

(ii) The stock of money always refers to the stock of money available to the ‘public’ as a means of payments
and store of value. This is always smaller than the total stock of money that really exists in an economy.

There are two alternate theories in respect of determination of money supply.

According to the first view, money supply is determined exogenously by the central bank. The second view
holds that the money supply is determined endogenously by changes in the economic activities which affect
people’s desire to hold currency relative to deposits, rate of interest, etc. The current practice is
to explain the determinants of money supply based on ‘money multiplier approach’ which focuses on the
relation between the money stock and money supply in terms of the monetary base or high-powered money.

The monetary base is the sum of currency in circulation and bank reserves. This approach holds

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that total supply of nominal money in the economy is determined by the joint behaviour of the central bank,
the commercial banks and the public.

2. Explain the concept of money multiplier and bring out its impact on money supply.
ANSWER 2

Money multiplier m is defined as a ratio that relates the changes in the money supply to a given change in the
monetary base. It is the ratio of the stock of money to the stock of high powered money. It denotes by how
much the money supply will change for a given change in high-powered money. The money multiplier
process explains how an increase in the monetary base causes the money supply to increase by a multiplied
amount. For instance, if there is an injection of Rs.100 Cr through an open market operation by the central
bank of the country and if it leads to an increment of Rs.500 Cr. of final money supply, then the money
multiplier is said to be 5. Hence, the multiplier indicates the change in monetary base which is transformed
into money supply. The multiplier indicates what multiple of the monetary base is transformed into
money supply. In other words, money and high powered money are related by the money multiplier. We
make two simplifying assumptions as follows;

• Banks never hold excess reserves.

• Individuals and non-bank corporations never hold currency.

What determines the size of the money multiplier? The money multiplier is the reciprocal of the reserve ratio.
Deposits, unlike currency held by people, keep only a fraction of the high-powered money in reserves and the
rest is lent out and culminate in money creation. If R is the reserve ratio in a country for all
commercial banks, then each unit of (say Rupee) money reserves generates 1/R money.

3. Explain the factors which determine excess reserves held by banks? How do changes in each such factor
affect the excess reserves, money multiplier, and money supply?

ANSWER 3

The Behaviour of Commercial Banks

By creating credit, the commercial banks determine the total amount of nominal demand deposits. The
behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits
known as the ‘reserve ratio’. If the required reserve ratio on demand deposits increases while all the
other variables remain the same, more reserves would be needed. This implies that banks must contract their
loans, causing a decline in deposits and hence in the money supply. If the required reserve ratio falls, there will
be greater expansions of deposits because the same level of reserves can now support more deposits and the
money supply will increase. To sum up, smaller the reserve ratio larger will be the money multiplier.

In actual practice, however, the commercial banks keep only the required fraction of their total deposits in the 538
form of cash reserves. However, for the commercial banking system as a whole, the actual reserves ratio may
be greater than the required reserve ratio since the banks keep a higher than the statutorily required
percentage of their deposits in the form of cash reserves as a buffer against unexpected events requiring cash.

The excess reserves (ER) which are funds that a bank keeps back beyond what is required by regulation form a
very important determinant of money supply. ‘Excess reserves’ are the difference between total reserves (TR)
and required reserves (RR). Therefore, ER=TR-RR. If total reserves are Rs 800 billion, whereas
the required reserves are Rs 600billion, then the excess reserves are Rs 200 billion.
The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do not
lead to any additional loans, and therefore, these excess reserves do not lead to creation of money. Therefore,
if the central bank injects money into the banking system and these are held as excess reserves by
the banking system, there will be no effect on deposits or currency and hence no effect on money supply.

When the costs of holding excess reserves rise, we should expect the level of excess reserves to fall; when the
benefits of holding excess reserves rise, we would expect the level of excess reserves to rise. Two primary
factors namely market interest rates and expected deposit outflows affect these costs and benefits
and hence in turn affect the excess reserves ratio.

We know that the cost to a bank while holding excess reserves is in terms of its opportunity cost, i.e. the
interest that could have been earned on loans or securities if the bank had chosen to invest in them instead of
excess reserves. If interest rate increases, it means that the opportunity cost of holding excess reserves rises
because the banks have to sacrifice possible higher earnings and hence the desired ratio of excess reserves to
deposits falls. Conversely, a decrease in interest rate will reduce the opportunity cost of excess reserves, and
excess reserves will rise. Therefore, we conclude that the banking system's excess reserves ratio r is negatively
related to the market interest rate.

If banks fear that deposit outflows are likely to increase (that is, if expected deposit outflows increase), they
will want more assurance against this possibility and will increase the excess reserves ratio. Conversely, a
decline in expected deposit outflows will reduce the benefit of holding excess reserves and excess reserves
will fall.
As we know, money is mostly held in the form of deposits with commercial banks.

Therefore, money supply may become subject to ‘shocks’ on account of behaviour of commercial banks which
may present variations overtime either cyclically and more permanently. For instance, in times of financial
crises, banks may be unwilling to lend to the small and medium scale industries who may become credit
constrained facing a higher risk premia on their borrowings. The rising interest rates on bank credit to the
commercial sector reflecting higher risk premia can co-exist with the lowering of policy rates by the central
bank. The lower credit demand can lead to a sharp deceleration in monetary growth at a time when the
central bank pursues an easy monetary policy.

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4. Explain the money multiplier approach to money supply?

ANSWER 4

The money multiplier is a function of:

(a) the currency ratio set by depositors c which depends on the behaviour of the public

(b) excess reserves ratio set by banks e, and

(c) the required reserve ratio set by the central bank r, which depends on prescribed CRR and the balances
necessary to meet settlement obligations.

5. Describe with illustrations how changes in high powered money, required reserves, excess reserves and
currency ratio, influence the money supply in an economy?

ANSWER 5

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963)
considers three factors as immediate determinants of money supply, namely:

(a) the stock of high-powered money (H)

(b) the ratio of reserves to deposits or reserve-ratio r = {Reserves/Deposits R/D} and

(c) the ratio of currency to deposits, or currency-deposit ratio c={C/D}

6. Describe the different determinants of money supply in a country.

ANSWER 6

The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963)
considers three factors as immediate determinants of money supply, namely:

(a) the stock of high-powered money (H)

(b) the ratio of reserves to deposits or reserve-ratio r = {Reserves/Deposits R/D}

and

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(c) the ratio of currency to deposits, or currency-deposit ratio c={C/D}
IV. Application Oriented Question

1. Prepare separate graphs using excel on ‘Money Stock: Components and Sources’ and ‘Reserve Money:
Components and Sources’ for four previous months from the weekly statistical supplements published by
Reserve Bank of India. Identify the trends in each.

ANSWER 1

Refer RBI website, collect the relevant information from the ‘publications (weekly) page.

2. Compute Reserve Money from the following data published by RBI

Components (In billions of ₹) As on 7 July 2017

Currency in Circulation 15428.40
Bankers’ Deposits with RBI 4596.18
’Other’ Deposits with RBI 183.30

ANSWER 2

Reserve Money =Currency in Circulation + Bankers’ Deposits with RBI+’Other’ Deposits with

3. Compute M3 from the following data published by RBI

Components (In billions of ₹) As on 31 March, 2017

Currency with the Public 12637.1
Demand Deposits with Banks 14,106.3
Time Deposits with Banks 101,489.5

541
‘Other’ Deposits with Reserve Bank 210.9

ANSWER 3

RBI15428.40+4596.18+183.30= 20207.88
4. What will be the total credit created by the commercial banking system for an initial deposit of ₹ 1000/
for required reserve ratio 0.02, 0.05 and 0.10 percent respectively? Compute credit multiplier
ANSWER 4

M3 = 128,443.9 Currency with the Public + Demand Deposits with Banks+

Time Deposits with Banks+ ‘Other’ Deposits with Reserve Bank
=12637.1+14,106.3+101,489.5+210.9 = 128,443.8

Credit Multiplier =1/ Required Reserve Ratio

1000 x 1/0.02= 50,000
1000x 1/0.05 – 20,000
1000x1/0.10= 10,000

5. How would each of the following affect money multiplier and money supply?
(i) Commercial banks in India decide to hold more excess reserves

(ii) Fearing shortage of money in ATMs, people decide to hoard money

(iii) Banks open large number ATMs all over the country

(iv) E banking becomes very common and nearly all people use them

(v) During festival season , people decide to use ATMs very often

(vi) If banks decide to keep 100% reserves. What would be the effect on money multiplier and money
supply?

(vii) Suppose banks need to keep no reserves only 0% reserves are there.

ANSWER 5

(i) Excess reserves are those reserves that the commercial banks hold with the central bank in addition to the
mandatory reserve requirements. Excess reserves result in an increase in reserve-deposit ratio of banks; less

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money for lending reduces money multiplier; money supply declines.

(ii) When people hold more money, it increases the currency-deposit ratio; reduces money multiplier; money
supply declines.

(iii) ATMs let people to withdraw cash from the bank as and when needed, reduces cost of conversion of
deposits to cash and makes deposits relatively more convenient. People hold less cash and more deposits,
thus reducing the currency-deposit ratio; increasing the money multiplier causing the money supply to
increase
(iv) See (iii) above

(v) If people, for any reason, are expected to withdraw money from ATMs with more frequency, then banks
will want to keep more reserves. This will raise the reserve ratio, and lower the money multiplier. As a result
money supply will decline

(vi) If banks decides to keep 100% reserves, then the Money multiplier = 1/required reserve ratio = 1/100% =
1. No additional money supply as there is no credit creation

(vii) If the required reserve ratio is 0 %, then money multiplier is infinite and there will be unlimited money
creation. There will be chaos with spiraling prices as money supply is too much and real output cannot
increase.

UNIT III: MONETARY POLICY

I Multiple Choice Type Questions

1. Which of the following is the function of monetary policy?

(a) regulate the exchange rate and keep it stabl

(b) regulate the movement of credit to the corporate sector

(c) regulate the level of production and prices

(d) regulate the availability, cost and use of money and credit

ANSWER 1-D

2. The main objective of monetary policy in India is _______:

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(a) reduce food shortages to achieve stability

(b) economic growth with price stability

(c) overall monetary stability in the banking system

(d) reduction of poverty and unemployment

ANSWER 2-B
3. The monetary transmission mechanism refers to

(a) how money gets circulated in different sectors of the economy post monetary policy

(b) the ratio of nominal interest and real interest rates consequent on a monetary policy

(c) the process or channels through which the evolution of monetary aggregates affects the level of product
and prices

(d) none of the above

ANSWER 3-C

4. A contractionary monetary policy‐induced increase in interest rates

(a) increases the cost of capital and the real cost of borrowing for firms

(b) increases the cost of capital and the real cost of borrowing for firms and households

(c) decreases the cost of capital and the real cost of borrowing for firms

(d) has no interest rate effect on firms and households

ANSWER 4-B

5. During deflation

(a) the RBI reduces the CRR in order to enable the banks to expand credit and increase the supply of money
available in the economy

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(b) the RBI increases the CRR in order to enable the banks to expand credit and increase the supply of
money available in the economy

(c) the RBI reduces the CRR in order to enable the banks to contract credit and increase the supply of money
available in the economy

(d) the RBI reduces the CRR but increase SLR in order to enable the banks to contract credit and increase the
supply of money available in the economy

ANSWER -A
6. Which of the following statements is correct?
(a) The governor of the RBI in consultation with the Ministry of Finance decides the policy rate and
implements the same

(b) While CRR has to be maintained by banks as cash with the RBI, the SLR requires holding of approved
assets by the bank itself

(c) When repo rates increase, it means that banks can now borrow money through open market operations
(OMO)

(d) None of the above

ANSWER 6-B

7. RBI provides financial accommodation to the commercial banks through repos/reverse repos under

(a) Market Stabilisation Scheme (MSS)

(b) The Marginal Standing Facility (MSF)

(c) Liquidity Adjustment Facility (LAF).

(d) Statutory Liquidity Ratio (SLR)

ANSWER 7-C

8. ---------------- is a money market instrument, which enables collateralized short term borrowing and
lending through sale/purchase operations in debt instruments.

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(a) OMO

(b) CRR

(c) SLR

(d) Repo

ANSWER 8-D
9. In India, the term ‘Policy rate’ refers to
(a) The bank rate prescribed by the RBI in its half yearly monetary policy statement

(b) The CRR and SLR prescribed by RBI in its monetary policy statement

(c) the fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity Adjustment
Facility (LAF)

(d) the fixed repo rate quoted for sovereign securities in the overnight segment of Marginal Standing
Facility(MSF)

ANSWER 9-C

10. Reverse repo operation takes place when

(a) RBI borrows money from banks by giving them securities

(b) banks borrow money from RBI by giving them securities

(c) banks borrow money in the overnight segment of the money market

(d) RBI borrows money from the central government

ANSWER 10-A

11. The Monetary Policy Framework Agreement is on

(a) the maximum repo rate that RBI can charge from government

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(b) the maximum tolerable inflation rate that RBI should target to achieve price stability.

(c) the maximum repo rate that RBI can charge from the commercial banks

(d) the maximum reverse repo rate that RBI can charge from the commercial banks

ANSWER 11-B
12. An open market operation is an instrument of monetary policy which involves buying or selling of
________from or to the public and banks

(a) bonds and bills of exchange

(b) debentures and shares

(c) government securities

(d) none of these

ANSWER 12-C

13. Which statement (s) is (are) true about Monetary Policy Committee?

I. The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving a statutory backing to
the Monetary Policy Framework Agreement and for setting up a Monetary Policy Committee

II. The Monetary Policy Committee shall determine the policy rate through debate and majority vote by a
panel of experts required to achieve the inflation target.

III. The Monetary Policy Committee shall determine the policy rate through consensus from the governor of
RBI

IV. The Monetary Policy Committee shall determine the policy rate through debate and majority vote by a
panel of bankers chosen for eth purpose

(a) I only

(b) I and II only

(c) III and IV

(d) III only 547

ANSWER13- B
II Short Answer Type Questions

1. Define monetary policy.

ANSWER 1
Instruments which are at the disposal of the central bank to regulate theavailability, cost and use of money
and credit so as to attain predetermined objectives, mainly growth with stability

2. Describe the objectives of monetary policy?

ANSWER 2
The most commonly pursued objectives of monetary policy: maintenance of price stability (or controlling
inflation) and achievement of economic growth. Context-specific multiple objectives are pursued such as
moderate long term interest rates, exchange rate stability and external balance of payments equilibrium etc

3. What is meant by the term monetary policy framework?

ANSWER 3
The operating framework relates to all aspects of implementation of monetary policy

4. Define ‘monetary transmission mechanism’.

ANSWER 4
Different mechanisms through which monetary policy is able to influence the price level and the national
income

5. Explain the transmission of monetary policy outcomes through interest rate channel?

548
ANSWER 5

A monetary policy‐induced change in interest rates generate corresponding changes in the cost of capital and
the real cost of borrowing for firms and households who respond by changing on their investment and
purchase expenditures respectively affecting aggregate demand and employment
6. Distinguish between the bank lending channel and the balance sheet channel of monetary transmission?

ANSWER 6
Two distinct credit channels- the bank lending channel and the balance sheet channel- operate by altering
access of firms and households to bank credit and by the effect of monetary policy on the firm’s balance sheet
respectively.

7. How do asset prices asset prices respond to monetary policy?

ANSWER 7
Asset prices generate important wealth effects that impact, through spending, output and employment

8. What is meant by the term ‘monetary policy instruments’?

ANSWER 8

Monetary policy instruments are the various tools that a central bank can use to influence money market and
credit conditions and pursue its monetary policy objectives.

9. What is the distinction between direct and indirect instruments of monetary policy?
ANSWER 9

Direct instruments presuppose one-to-one correspondence between the instrument (such as a credit ceiling)
and the policy objective (such as a specific amount of domestic credit outstanding),while indirect instruments
act through the market by adjusting the underlying demand for, and supply of, bank reserves

10. Write notes on Cash Reserve Ratio (CRR) Explain the operation of CRR

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ANSWER 10
Cash Reserve Ratio (CRR)refers to the fraction of the total net demand and time liabilities (NDTL) of a
scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank. Higher
the CRR, lower the credit creation capacity of banks. Reduce CRR during deflation- - banks to expand credit
and increase the supply of money available in the economy- increase the CRR to contain credit expansion
during – inflation
11. Distinguish between CRR and Statutory Liquidity Ratio (SLR)
ANSWER 11

While CRR has to be maintained by banks as cash with the RBI, the SLR requires holding of assets in one of the
above three categories by the bank itself.

12. What are the eligible securities for SLR?

ANSWER 12

Cash, Gold, or investments in un-encumbered Instruments that include: treasury-bills, dated securities, State
Development Loans (SDLs) issued by State Governments under their market borrowings programme and other
instruments as notified by the RBI

13. Explain the functioning of SLR?

ANSWER 13

Changes in SLR chiefly influence the availability of resources in the banking system for lending. A rise in SLR -
during periods of high liquidity - to lock up a rising fraction of a bank’s assets in the form of eligible
instruments - reduces the credit creation capacity of banks. A reduction in SLR during periods of economic
downturn has the opposite effect.

14. What is the role of Liquidity Adjustment Facility (LAF)?

ANSWER 14

The Liquidity Adjustment Facility(LAF) is a facility extended by the Reserve Bank of India to the scheduled

550
commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement (or park
excess funds with the RBI in case of excess liquidity) on an overnight basis against the collateral of government
securities including state government securities
15. Define ‘repo’
ANSWER 15

Repo, is defined as ‘an instrument for borrowing funds by selling securities with an agreement to repurchase
the securities on a mutually agreed future date at an agreed price which includes interest for the funds
borrowed’

16. What is meant by ‘policy rate’?

ANSWER 16

The policy rate is the fixed repo rate quoted for sovereign securities in theovernight segment of Liquidity
Adjustment Facility (LAF).

17. Define ‘Reverse Repo’

ANSWER 17

Reverse Repo" is defined as an instrument for lending funds by purchasing securities with an agreement to
resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds
lent

18. What role does Market Stabilisation Scheme (MSS) play in our economy?

ANSWER 18

Under the Market Stabilisation Scheme (MSS) the Government of India borrows from the RBI (such borrowing
being additional to its normal borrowing requirements) and issues treasury-bills/dated securities that are
utilized for absorbing from the market excess liquidity of a more enduring nature arising from large capital

551
inflows

19. Assess the role of Bank Rate as an instrument of monetary policy

ANSWER 19

The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and, therefore, as and when the
MSF rate changes alongside policy repo rate changes, the bank rate also changes automatically. Now bank rate
is used only for calculating penalty on default in the maintenance of Cash Reserve Ratio (CRR) and the
Statutory Liquidity Ratio (SLR).
20. Open Market Operations

ANSWER 20

Open Market Operations (OMO) is a general term used for market operations conducted by the Reserve Bank
of India by way of sale/ purchase of Government securities to/ from the market with an objective to adjust the
rupee liquidity conditions in the market on a durable basis

21. Outline the role of Monetary Policy Committee (MPC)

ANSWER 21

The Monetary Policy Committee (MPC)consisting of six members shall determine the policy rate to achieve the
inflation target through debate and majority vote by a panel of experts.

III Long Answer Type Questions

1. Explain the objectives of monetary policy in an economy. Assess the instruments and targets of monetary
policy of the Reserve Bank of India.

ANSWER 1

The objectives set for monetary policy are important because they provide explicit guidance to policy makers.
Monetary policy of a country is in fact a reflection of its economic policy and therefore, the objectives of
monetary policy generally coincide with the overall objectives of economic policy.

There are significant differences among different countries in respect of the selection of objectives,
implementation procedures and tools of monetary policy either due to differences in the underlying

552
economies or due to differences in the financial systems and in the infrastructure of financial markets.
Coverage of aspects related to monetary policies of different countries would be beyond the scope of this
unit. Therefore, the following discussions relate to the monetary policy situations in the context of Indian
economy.

In the pre-Keynesian period, monetary policy, with its conventional objective of establishment and
maintenance of stability in prices, was the single well acknowledged instrument of macroeconomic policy. The
Great Depression in 1930s and the associated economic crises marked a turning point resulting in a
major shift in the objective of governments’ economic policy in favour of maintenance of full employment,
more generally described as economic stability.

The most commonly pursued objectives of monetary policy of the central banks across the world are
maintenance of price stability (or controlling inflation) and achievement of high level of economy’s growth and
maintenance of full employment

The Reserve Bank of India Act, 1934,in its preamble sets out the objectives of the Bank as ‘to regulate the
issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its advantage’. It is to be noted that
though price stability as an objective is not explicitly spelt out, the monetary policy in India has evolved
towards maintaining price stability and ensuring adequate flow of credit to the productive sectors of the
economy. Price stability, as we know, is a necessary precondition for sustainable growth. Fundamentally, the
primary
objective of monetary policy has been maintenance of a judicious balance between price stability and
economic growth.

Multiple objectives, all of which are equally desirable, such as rapid economic growth, debt management,
moderate long-term interest rates, exchange rate stability and external balance of payments equilibrium were
incorporated as objectives of monetary policy by policy makers in later years. The need for simultaneous
achievement of several objectives brings in the possibility of conflict among the different monetary policy
objectives. For example, there is often a conflict between the objectives of holding down both inflation and
unemployment; a policy targeted at controlling inflation is very likely to generate unemployment. As such,
based on the set national priorities, the monetary policymakers have to exercise appropriate trade-offs to
balance the conflicting objectives.
Given the development needs of developing countries, the monetary policy of such countries also incorporate
explicit objectives such as:

(i) maintenance of economic growth

(ii) ensuring an adequate flow of credit to the productive sectors,

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(iii) sustaining a moderate structure of interest rates to encourage investments, and

(iv) creation of an efficient market for government securities.

Considerations of financial and exchange rate stability have assumed greater importance in India recently on
account of increasing openness of the economy and the progressive economic and financial sector reforms.
2. Make a critical evaluation of the latest monetary policy statement of the Reserve Bank of India.

ANSWER 2

Analytics of Monetary Policy

As we are aware, just as fiscal policy, monetary policy is intended to influence macro- economic variables such
as aggregate demand, quantity of money and credit , interest rates etc , so as to influence overall economic
performance. The process or channels through which the change of monetary aggregates affects
the level of product and prices is known as ‘monetary transmission mechanism’. It describes how policy-
induced changes in the nominal money stock or in the short-term nominal interest rates impact real variables
such as aggregate output and employment.

Generally central banks use the short-term interest rate as the policy instrument.

Therefore, monetary policy transmission is the process through which a change in the policy rate gets
transmitted primarily to the short-term money market rate and subsequently to the entire range of interest
rates namely, banks’ deposit and lending rates and interest rates in bond markets. These interest rate changes
affect macro economic variables such as consumption, investment and exports which in turn influence
aggregate demand, output and employment.

Although we know that monetary policy does influence output and inflation, we are not certain about how
exactly it does so, because the effects of such policy are visible often after a time lag which is not completely
predictable

There are mainly five different mechanisms through which monetary policy influences the price level and the
national income. These are:

(a) the interest rate channel,

(b) the exchange rate channel,

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(c) the quantum channel (e.g., relating to money supply and credit),

(d) the asset price channel i.e. via equity and real estate prices. and

(e) the expectations channel

We shall have a brief discussion on each of the above transmission mechanisms. According to the traditional
Keynesian interest rate channel, a contractionary monetary policy‐induced increase in interest rates increases
the cost of capital and the real cost of borrowing for firms with the result that they cut back on their
investment expenditures.

Similarly, households facing higher real borrowing costs, cut back on their purchases of homes, automobiles,
and all types of durable goods. A decline in aggregate demand results in a fall in aggregate output and
employment. Conversely, an expansionary monetary policy induced decrease in interest rates will have the
opposite effect through decreases in cost of capital for firms and cost of borrowing for households.

In open economies, additional real effects of a policy‐induced change in the short‐term interest rate come
about through the exchange rate channel. Changes in monetary policy cause differences between domestic
and foreign interest rates leading to capital flows (inflow or outflow) and exchange rate. Typically, the
exchange rate channel works through expenditure switching between domestic and foreign goods.
Appreciation of the domestic currency makes domestically produced goods more expensive compared to
foreign‐produced goods. This causes net exports to fall; correspondingly domestic output and employment
also fall.

Two distinct credit channels- the bank lending channel and the balance sheet channel- also allow the effects of
monetary policy actions to spread through the real economy. Credit channel operates by altering access of
firms and households to bank credit. Most businesses and people mostly depend on bank for borrowing
money. “An open market operation” that leads first to a contraction in the supply of bank reserves and then to
a contraction in bank credit requires banks to cut back on their lending. This, in turn makes the firms that are
especially dependent on banks loans to cut back on their investment spending.

Thus, there is decline in the aggregate output and employment following a monetary contraction.

Now we shall look into how the balance sheet channel works. Logically, as a firm’s cost of credit rises, the
strength of its balance sheet deteriorates. A direct effect of monetary policy on the firm’s balance sheet comes
through an increase in interest rates leading to an increase in the payments that the firm must make to
repay its floating rate debts. An indirect effect occurs when the same increase in interest rates works to
reduce the capitalized value of the firm’s long‐lived assets. Hence, a policy‐induced increase in the short‐term
interest rate not only acts immediately to depress spending through the traditional interest rate channel, it
also acts, possibly with a time-lag, to raise each firm’s cost of capital through the balance sheet channel. These

555
together aggravate the decline in output and employment.

The standard asset price channel suggests that asset prices respond to monetary policy changes and
consequently affect output, employment and inflation. A policy‐induced increase in the short‐term nominal
interest rates makes debt instruments more attractive than equities in the eyes of investors leading to a fall
in equity prices. If stock prices fall after a monetary tightening, it leads to reduction in household financial
wealth, leading to fall in consumption, output, and employment.
Finally, changes in monetary policy may have impact on people’s expectations about inflation and therefore
on aggregate demand. This in turn affects employment and output in the economy.

The manner in which these different channels function in a given economy depends on:

(i) the stage of development of the economy, and

(ii) the underlying financial structure of the economy

3. Explain the operational procedure of the monetary policy in India.

ANSWER 3

Operating Procedures and Instruments

The operating framework relates to all aspects of implementation of monetary policy. It primarily involves
three major aspects, namely,

(i) choosing the operating targets,

(ii) choosing the intermediate targets, and

(iii) choosing the policy instruments.

• The operating targets refer to the financial variables that can be controlled by the central bank to a large
extent through the monetary policy instruments (reserve money and short-term money market interest rates
or weighted average call rate (WACR)).

• The intermediate targets (e.g. monetary aggregates and short-term and longterm interest rates) are
variables which the central bank can hope to influence to a reasonable degree through the operating targets.
The intermediate targets display a predictable and stable relationship with the goal variables
(e.g. stability, growth etc.)

• The monetary policy instruments are the various tools that a central bank can use to influence money 556
market and credit conditions and pursue its monetary policy objectives. The day-to-day implementation of
monetary policy by central banks through various instruments is referred to as ‘operating procedures’. For
example, liquidity management is the operating procedure of the Reserve Bank of India

For implementing monetary policy, a central bank can act directly, using its regulatory powers, or indirectly,
using its influence on money market conditions as the issuer of reserve money (currency in circulation and
deposit balances with the central bank).
4. A central bank is a ‘bankers’ bank.’ Elucidate the statement with illustrations
ANSWER 4

A central bank is a ‘bankers’ bank.’ It provides liquidity to banks when the latter face shortage of liquidity. This
facility is provided by the Central Bank through its discount window. The scheduled commercial banks can
borrow from the discount window against the collateral of securities like commercial bills, government
securities, treasury bills, or other eligible papers. This type of support earlier took the form of refinance of
loans given by commercial banks to various sectors (e.g. exports, agriculture etc). By varying the terms and
conditions of refinance, the RBI could employ the sector-specific refinance facilities as an instrument of credit
policy to encourage /discourage lending to particular sectors. In line with the financial sector reforms, the
system of sector-specific refinance schemes (except export credit refinance scheme) was withdrawn. From
June 2000, the RBI has introduced Liquidity Adjustment Facility (LAF).

The Liquidity Adjustment Facility (LAF) enables the RBI to modulate short-term liquidity under varied financial
market conditions to ensure stable conditions in the overnight (call) money market. It is extended by the
Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of
liquidity in case of requirement (or park excess funds with the RBI in case of excess liquidity) on an overnight
basis against the collateral of government securities including state government securities. The LAF consists of
overnight as well as term repo auctions. The aim of term repo is to help develop the inter-bank term money
market. This move is expected to set market based benchmarks for pricing of loans and deposits, and hence
improve transmission of monetary policy.

The introduction of LAF is an important landmark since it triggered a rapid transformation in the monetary
policy operating environment in India. As a key element in the operating framework of the RBI, its objective is
to assist banks to adjust their day to day mismatches in liquidity. Currently, the RBI provides financial
accommodation to the commercial banks through repos/reverse repos under the Liquidity Adjustment Facility
(LAF).

5. Describe the organisational structure for monetary policy decisions in India , Outline different
components the monetary policy framework for India

ANSWER 5 557

THE ORGANISATIONAL STRUCTURE FOR MONETARY POLICY DECISIONS

The Monetary Policy Framework Agreement

The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving a statutory backing to the
Monetary Policy Framework Agreement (MPFA) and for setting up a Monetary Policy Committee (MPC).
The Monetary Policy

Framework Agreement is an agreement reached between the Government of India and the Reserve Bank of
India (RBI) on the maximum tolerable inflation rate that the RBI should target to achieve price stability. The
amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation
targeting framework’. Announcement of an official target range for inflation is known as inflation
targeting. The Expert Committee under Urijit Patel to revise the monetary policy framework, in its report in
January, 2014 suggested that RBI abandon the ‘multiple indicator’ approach and make inflation targeting the
primary objective of its monetary policy. The inflation target is to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years.

Accordingly,

• The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for the
period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.

• The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of
inflation and the forecasts of inflation for the coming period of six to eighteen months.

• The following factors are notified by the central government as constituting a failure to achieve the inflation
target:

(a) The average inflation is more than the upper tolerance level of the inflation target for any three
consecutive quarters; or

(b) The average inflation is less than the lower tolerance level for any three consecutive quarters.

The choice of CPI was made because it closely reflects cost of living and has larger influence on inflation
expectations compared to other anchors. With this step, India is following countries such as the New Zealand,
the USA, the UK, European Union, and Brazil. In recent times many countries are moving away from
this approach and are targeting nominal GDP growth.

The Monetary Policy Committee (MPC) 558

An important landmark in India’s monetary history is the constitution of an empowered six-member Monetary
Policy Committee (MPC) in September, 2016 consisting of the RBI Governor (Chairperson), the RBI Deputy
Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining
three central government nominees representing the Government of India who are persons of ability, integrity
and standing, having knowledge and experience in the field of Economics or banking or finance or monetary
policy.
The Committee is required to meet at least four times a year and the decisions adopted by the MPC are
published after conclusion of every meeting of the MPC. Based on the review of the macroeconomic and
monetary developments in the economy, the MPC shall determine the policy rate required to achieve the
inflation target. The fixing of the benchmark policy interest rate (repo rate) is made through debate and
majority vote by this panel of experts. With the introduction of the Monetary Policy Committee, the RBI will
follow a
system which is more consultative and participative similar to the one followed by many of the central banks
in the world. The new system is intended to incorporate:

• diversity of views,
• specialized experience,
• independence of opinion,
• representativeness, and
• accountability.

The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy.
The views of key stakeholders in the economy and analytical work of the Reserve Bank contribute to the
process for arriving at the decision on the policy repo rate.

The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through
day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review
the liquidity conditions so as to ensure that the operating target of monetary policy (weighted
average lending rate) is kept close to the policy repo rate.

Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts
from Monetary Economics, Central Banking, Financial Markets and Public Finance advised the RBI on the
standpoint of monetary policy. However, its role was only advisory in nature. With the formation
of MPC, the TAC on Monetary Policy ceased to exist.

7. Critically examine the different instruments of monetary policy.

IV Application Oriented Question

1. What will be the nature of the monetary policy undertaken by RBI in the following? 559

(i) Increases repo rate by 50 basis points

(ii) Reduces the cash reserve ratio

(iii) Increases the supply of currency and coins

(iv) Terminates marginal standing facility

(v) Increases the interest rates chargeable by commercial banks

(vi) Sells securities in the open market

(vii) Initiates reverse repo operation

(viii) Changes in the SLR

ANSWER 1

(i) Contractionary monetary policy

(ii) Expansionary monetary policy

(iii) Expansionary monetary policy

(iv) Contractionary monetary policy

(v) Contractionary monetary policy

(vi) Contractionary monetary policy

(vii) Absorbs the liquidity in the system

(viii) Influence the availability of resources in the banking system for lending

2. Write a brief note about the reasons why the policy rates were changed /not changed in the recent
monetary policy announcement by the RBI

ANSWER 2

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With retail inflation remaining elevated, the Monetary Policy Committee (MPC) of the Reserve Bank of India,
headed by Governor Shaktikanta Das, has decided to keep the policy rates unchanged for the third time in a
row in the bi-monthly monetary policy announced on Friday (December 4).

This effectively means lending rates in the banking system and EMIs on home, auto and personal loans will
remain more or less steady
Why has the policy panel opted for status quo on rates?

The MPC is of the view that inflation is likely to remain elevated, barring transient relief in the winter months
from prices of perishables. This constrains monetary policy at the current juncture from using the space
available to act in support of growth.

“At the same time, the signs of recovery are far from being broad-based and are dependent on sustained
policy support,” the RBI says.

“A small window is available for proactive supply management strategies to break the inflation spiral being
fuelled by supply chain disruptions, excessive margins and indirect taxes. Further efforts are necessary to
mitigate supply-side driven inflation pressures,” MPC said.

Monetary policy will monitor closely all threats to price stability to anchor broader macroeconomic and
financial stability. Accordingly, the MPC in its meeting today decided to maintain the status quo on the policy
rate, the central bank said.

561
 CHAPTER-4 INTERNATIONAL TRADE
UNIT I: THEORIES OF INTERNATIONAL TRADE

I Multiple Choice Type Questions

1 Which of the following does not represent a difference between internal trade and international trade?

(a) transactions in multiple currencies

(b) homogeneity of customers and currencies

(c) differences in legal systems

(d) none of the above

ANSWER 1-B

2. The theory of absolute advantage states that

(a) national wealth and power are best served by increasing exports and decreasing imports

(b) nations can increase their economic well-being by specializing in the production of goods they produce
more efficiently than anyone else.

(c) that the value or price of a commodity depends exclusively on the amount of labour going into its

562
production and therefore factor prices will be the same

(d) differences in absolute advantage explains differences in factor endowments in different countries

ANSWER 2-B
3 Which of the following theories advocates that countries should produce those goods for which it has the
greatest relative advantage?

(a) Modern theory of international trade

(b) The factor endowment theory

(c) The Heckscher-Ohlin Theory

(d) None of the above

ANSWE R 3-D

4. Which of the following holds that a country can increase its wealth by encouraging exports and
discouraging imports

(a) Capitalism

(b) Socialism

(c) Mercantilism

(d) Laissez faire

ANSWE R 4-C

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5. Given the number of labour hours to produce cloth and grain in two countries, which country should
produce grain?
Labour cost (hours) for production of one unit

Country A Country B
Cloth 40 80
Grain 80 40
(a) Country A

(b) Country B

(c) Neither A nor B

(d) Both A and B

ANSWER 5-B

6. According to the theory of comparative advantage

(a) trade is a zero-sum game so that the net change in wealth or benefits among the participants is zero.

(b) trade is not a zero-sum game so that the net change in wealth or benefits among the participants is
positive

(c) nothing definite can be said about the gains from trade

(d) gains from trade depends upon factor endowment and utilization

ANSWER 6-B

7. Given the number of labour hours to produce wheat and rice in two countries and that these countries
specialise and engage in trade at a relative price of 1:1 what will be the gain of country X ?

Labour cost (hours) for production of one unit 564

Wheat Rice
Country X 10 20
Country Y 20 10

(a) 20 labour hours

(b) 10 labour hours

(c) 30 labour hours

(d) Does not gain anything

ANSWE R 7-B

8. Assume India and Bangladesh have the unit labour requirements for producing tables and mats shown in
the table below. It follows that:

Labour cost (hours) for production of one unit

India Bangladesh
Tables 3 8
Mats 2 1

(a) Bangladesh has a comparative advantage in mats

(b) India has a comparative advantage in tables

(c) Bangladesh has an absolute advantage in mats

(d) All the above are true

ANSWER 8-D

9. Comparative advantage refers to

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(a) a country’s ability to produce some good or service at the lowest possible cost compared to other
countries

(b) a country’s ability to produce some good or service at a lower opportunity cost than other countries.

(c) Choosing a productive method which uses minimum of the abundant factor

(d) (a) and (b) above

ANSWER 9-B
10. Ricardo explained the law of comparative advantage on the basis of

(a) opportunity costs

(b) the law of diminishing returns

(c) economies of scale

(d) the labour theory of value

ANSWER 10-D

II Short Answer Type Questions

1. Define international trade?

ANSWER 1

International trade is the exchange of goods and services as well as resources between countries and involves
transactions between residents of different countries

2. What is meant by opportunity cost?

ANSWER 2
The value of the best foregone alternative that is given up when something is chosen. In production, it is the
amount of a second commodity that must be given up to release just enough resources to produce one more
unit of the first commodity

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3. How does trade increase economic efficiency?

ANSWER 3

Economic efficiency increases due to quantitative and qualitative benefits of extended division of labour,
economies of large scale production, betterment of manufacturing capabilities, increased competitiveness and
profitability by adoption of cost reducing technology and business practices and decrease in the likelihood of
domestic monopolies. Efficient deployment of productive resources natural, human, industrial and financial
resources ensures productivity gains
4. What is meant by absolute advantage?
ANSWER 4

The ability of a country to produce a good at a lower cost, in terms of labour, than another country.

5. What is the major idea behind Mercantilist’s view of trade?

ANSWER 5
Encourage exports and prevent imports and accumulate as much precious metals as possible to become
wealthy

6. What is the essence of the theory of absolute advantage?

ANSWER 6
A trade theory which holds that nations can increase their economic wellbeing by specializing in goods that
they can produce more efficiently than anyone else.

7. Mention the core principle of the theory of comparative advantage.

ANSWER 7
A nation should specialize in the production and export of the commodity in which its absolute disadvantage is
smaller (this is the commodity of its comparative advantage) and import the commodity in which it’s absolute
disadvantage is greater (this is the commodity of its comparative disadvantage).

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8. What is meant by ‘factor endowment ‘in the theory of international trade?
ANSWER 8

In a general sense of the term, ‘factor endowment’ which explains comparative advantage in cost of
production, refers to the overall availability of usable resources including both natural and man-made means
of production. Differences between countries are explained exclusively by the differences in factor
endowments of the nations.
9. What is the crux of Heckscher-Ohlin theory of international trade?

ANSWER 9

A country tends to specialize in the export of a commodity whose production requires intensive use of its
abundant resources and imports a commodity whose production requires intensive use of its scarce resources

10. What do you understand by ‘factor-price equalization’ in the context of international trade?

ANSWER 10
International trade equalizes the factor prices between trading nations; implies that the wages and rents will
converge across the countries with free trade, i.e. if the prices of the output of goods are equalised between
countries engaged in free trade, then the price of the input factors will also be equalised between countries.

III Long Answer Type Questions

1. Critically examine the arguments for and against international trade?

ANSWER 1

The arguments in support of international trade.

(i) International trade is a powerful stimulus to economic efficiency and contributes to economic growth and
rising incomes. The wider market made possible owing to trade induces companies to reap the quantitative
and qualitative benefits of extended division of labour. As a result, they would enlarge their manufacturing
capabilities and benefit from economies of large scale production. The gains from international trade are

568
reinforced by the increased competition that domestic producers are confronted with on account of
globalization of production and marketing, requiring businesses to compete against global businesses.
Competition from foreign goods compels manufacturers, especially in developing countries, to enhance
efficiency and profitability by adoption of cost reducing technology and business practices. Efficient
deployment of productive resources to their best use is a direct economic advantage of foreign trade. Greater
efficiency in the use of natural, human, industrial and financial resources ensures productivity gains. Since
international trade also tends to decrease the likelihood of domestic monopolies, it is always beneficial to the
community.
(ii) Trade provides access to new markets and new materials and enables sourcing of inputs and components
internationally at competitive prices. This reflects in innovative products at lower prices and wider choice in
products and services for consumers. Also, international trade enables consumers to have access to wider
variety of goods and services that would not otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for sustaining their economies.

(iii) International trade enhances the extent of market and augments the scope for mechanization and
specialisation. Trade necessitates increased use of automation, supports technological change, stimulates
innovations, and facilitates greater investment in research and development and productivity
improvement in the economy.

(iv) Exports stimulate economic growth by creating jobs, which could potentially reduce poverty, and
augmenting factor incomes and in so doing raising standards of livelihood and overall demand for goods and
services. Trade also provides greater stimulus to innovative services in banking, insurance, logistics,
consultancy services etc.

(v) Employment generating investments, including foreign direct investment, inevitably follow trade. For
emerging economies, improvement in the quality of output of goods and services, superior products, finer
labour and environmental standards etc. enhance the value of their products and enable them to move up the
global value chain.

(vi) Opening up of new markets results in broadening of productive base and facilitates export diversification
so that new production possibilities are opened up. Countries can gainfully dispose off their surplus output
and,
thus, prevent undue fall in domestic prices caused by overproduction. Trade also allows nations to maintain
stability in prices and supply of goods during periods of natural calamities like famine, flood, epidemic etc.

(vii) Trade can also contribute to human resource development, by facilitating fundamental and applied

569
research and exchange of know-how and best practices between trade partners.

(viii) Trade strengthens bonds between nations by bringing citizens of different countries together in mutually
beneficial exchanges and, thus, promotes harmony and cooperation among nations
2. What are the major arguments against liberal trade?
ANSWER 2

The major arguments put forth against trade openness are:

(i) Possible negative labour market outcomes in terms of labour-saving technological change that depress
demand for unskilled workers, loss of labourers’ bargaining power, downward pressure on wages of semi-
skilled and unskilled workers and forced work under unfair circumstances and unhealthy occupational
environments.

(ii) International trade is often not equally beneficial to all nations. Potential unequal market access and
disregard for the principles of fair trading system may even amplify the differences between trading countries,
especially if they differ in their wealth. Economic exploitation is a likely outcome when underprivileged
countries become vulnerable to the growing political power of corporations operating globally. The domestic
entities can be easily outperformed by financially stronger transnational companies.

(iii) International trade is often criticized for its excessive stress on exports and profit-driven exhaustion of
natural resources due to unsustainable production and consumption. Substantial environmental damage and
exhaustion of natural resources in a shorter span of time could have serious negative consequences on the
society at large.

(iv) Probable shift towards a consumer culture and change in patterns of demand in favour of foreign goods,
which are likely to occur in less developed countries, may have an adverse effect on the development of
domestic industries and may even threaten the survival of infant industries. Trade cycles and the associated
economic crises occurring in different countries are also likely to get transmitted rapidly to other countries.

(v) Risky dependence of underdeveloped countries on foreign nations impairs economic autonomy and
endangers their political sovereignty. Such reliance often leads to widespread exploitation and loss of cultural
identity. Substantial dependence may also have severe adverse consequences in times of wars and other

570
political disturbances.

(vi) Welfare of people may often be ignored or jeopardized for the sake of profit. Excessive exports may cause
shortages of many commodities in the exporting countries and lead to high inflation (e.g. onion price rise in
2014; export ban on all non-basmati rice in an attempt to reign in soaring prices and to ensure sufficient
stocks for domestic consumption as global reserve levels hit a 25-year low). Also, import of harmful products
or international trade in hazardous chemicals may cause health hazards and environmental damage in those
countries which do not have sufficient infrastructure or capacity to scrutinize such imports.
(vii) Too much export orientation may distort actual investments away from the genuine investment needs of
a country.

(viii) Instead of cooperation among nations, trade may breed rivalry on account of severe competition

(ix) Finally, there is often lack of transparency and predictability in respect of many aspects related to trade
policies of trading partners. There are also many risks in trade which are associated with changes in
governments’ policies of participating countries, such as imposition of an import ban, high import tariffs or
trade embargoes.

3. Using Ricardian model, explain how two countries can gain from trade? What does the Ricardian model
suggest regarding the effect of trade?

ANSWER 3

David Ricardo developed the classical theory of comparative advantage in his book ‘Principles of Political
Economy and Taxation’ published in 1817. The law of comparative advantage states that even if one nation is
less efficient than (has an absolute disadvantage with respect to) the other nation in the production of all
commodities, there is still scope for mutually beneficial trade. The first nation should specialize in the
production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity
of its comparative advantage) and import the commodity in which its absolute disadvantage is
greater (this is the commodity of its comparative disadvantage). Comparative advantage differences between
nations are explained by exogenous factors which could be due to the differences in national characteristics.
Labour differs in its productivity internationally and different goods have different labour requirements,
therefore comparative labour productivity advantage was Ricardo’s predictor of trade

4. Explain the Heckscher-Ohlin theory of international trade.

ANSWER 4 571

The Heckscher-Ohlin theory of trade, (named after two Swedish economists, Eli Heckscher and his student
Bertil Ohlin), also referred to as Factor-Endowment Theory of Trade or Modern Theory of Trade, is considered
as a very important theory of international trade. In view of the contributions made by P. A.
Samuelson, this theory is also sometimes referred to as Heckscher-Ohlin- Samuelson theorem.
The Heckscher-Ohlin (H-O) model studies the case that two countries have different factor endowments under
identical production function and identical preferences. The difference in factor endowment results in two
countries having different factor prices in the beginning. Consequently, H-O model implies that the
two countries will have different cost functions.

The Heckscher-Ohlin theory of trade states that comparative advantage in cost of production is explained
exclusively by the differences in factor endowments of the nations. In a general sense of the term, ‘factor
endowment’ refers to the overall availability of usable resources including both natural and man-made
means of production. Nevertheless, in the exposition of the modern theory, only the two most important
factors—labour and capital—are taken into account. According to this theory, international trade is but a
special case of inter-regional trade. Different regions have different factor endowments, that is, some regions
have abundance of labour, but scarcity of capital; whereas other regions have abundance of capital, but
scarcity of labour. Different goods have different production functions, that is, factors of production are
combined in different proportions to produce different commodities.

While some goods are produced by employing a relatively larger proportion of labour and relatively small
proportion of capital, other goods are produced by employing a relatively small proportion of labour and
relatively large proportion of capital. Thus, each region is suitable for the production of those goods for whose
production it has relatively abundant supply of the requisite factors. A region is not suitable for production of
those goods for whose production it has relatively scarce or zero supply of essential factors. Hence different
regions have different capacity to produce different commodities. Therefore, difference in factor endowments
is the main cause of international trade as well as inter-regional trade.

IV Application Oriented Questions

1. The price index for exports of Country A in year 2012 (2000 base-year), was 116.1 and the price index for
Country A’s imports was 120.2 (2000 base year)

(i) What do these figures mean?

(ii) Calculate the index of terms of trade for Country A

(iii) How do you interpret the index of terms of trade for Country A? 572

ANSWER 1
(i) The price index for exports of Country A in year 2012 (2000 baseyear), was 116.1 means that compared to
year 2000, its export prices were 16.1 percent above the 2000 base year prices.

(ii) The price index for Country A’s imports was 120.2 in year 2012(2000 base-year), means that compared to
year 2000, its import prices were 20.2 percent above the 2000 base year prices.
(iii) The index of the terms of trade for Country A in 2012 would be calculated as follows:
Terms of Trade = Price index of exports / Price index of its imports x 100 =(116.1/120.2)x100 = 96.6

“Terms of trade” is ratio of the price of a country’s export commodity to the price of its import commodity.
The figure 96.6 means that each unit of country A’s exports in 2012 exchanged for 3.4 percent (3.4 =
100 – 96.6) fewer units of imports than in the base year.

2. The table below shows the number of labour hours required to produce wheat and cloth in two countries
X and Y.
Commodity Country X Country Y
I unit of cloth 4 1.0
I unit of wheat 2 2.5

(i) Compare the productivity of labour in both countries in respect of both commodities

(ii) Which country has absolute advantage in the production of wheat?

(iii) Which country has absolute advantage in the production of cloth?

(iv) If there is trade, which commodity should these countries produce?

(v) What are the opportunity costs of each commodity?

ANSWER 2

(i) Productivity of labour in both countries in respect of both commodities

Productivity of Labour Country X Country Y

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Units of cloth per hour 0.25 1.0
Units of wheat per hour 0.5 0.4

(ii) Country X has absolute advantage in the production of wheat because productivity of wheat is higher in
country X , or conversely, the number of labour hours required to produce wheat in country X is
less compared to country Y

(iii) Country Y has absolute advantage in the production of cloth because productivity of cloth is higher in
country Y , or conversely, the number of labour hours required to produce cloth in country Y is less
compared to country X
(iv) In country X, the opportunity cost is 0.25 units of cloth for 0.5 unit of wheat.

(v) In country Y the opportunity cost is 0.4 units of wheat for 1 unit of Cloth

(3) Countries Rose Land and Daisy land have a total of 4000 hours each of labour available each day to
produce shirts and trousers. Both countries use equal number of hours on each good each day. Rose Land
produces 800 shirts and 500 trousers per day. Daisy land produces 500 shirts and 250
trousers per day.

In the absence of trade:

i. Which country has absolute advantage in producing

a. Shirts
b. Trousers

ii. Which country has comparative advantage in producing

a. Shirts
b. Trousers

ANSWER 3

Goods produced by each country

Country Shirts Trousers

Rose Land 800 500
Daisy Land 500 250

Each country has 4000 hours of labour and uses 2000 hours each for both the goods. Therefore, the number
of hours spent per unit on each good

Country Shirts Trousers

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Rose Land 2.5 4
Daisy Land 4 8

Since Rose Land produces both goods in less time, it has absolute advantage in both shirts and trousers.

Comparative advantage; comparing the opportunity costs of both goods we have

Rose Land

Opportunity cost of Shirts =2.5/4 = 0.625 trousers

If 4 hours are used up in 1 trouser, trousers given up in 2.5 hours are
(1/4)*2.5 = 0.625 trousers.
Similarly, Opportunity cost of Trousers = 4/2. 5 =1.6 shirts

Daisy Land
Opportunity cost of Shirts 4/8 = 0.5 trousers
Opportunity cost of Trousers 8/4 =2 shirts

For producing shirts

Daisy Land has lower opportunity cost for producing shirts (0.5<0.625), therefore Daisy Land has comparative
advantage

For producing Trousers

Rose Land has lower opportunity cost for producing Trousers (1.6<2), therefore Rose Land has comparative
advantage

UNIT II: THE INSTRUMENTS OF TRADE POLICY

I Multiple Choice Type Questions

1. A specific tariff is

(a) a tax on a set of specified imported good

575
(b) an import tax that is common to all goods imported during a given period

(c) a specified fraction of the economic value of an imported good

(d) a tax on imports defined as an amount of currency per unit of the good

ANSWER 1-D
2. A tariff on imports is beneficial to domestic producers of the imported good because
(a) they get a part of the tariff revenue

(b) it raises the price for which they can sell their product in the domestic market

(c) it determines the quantity that can be imported to the country

(d) it reduces their producer surplus, making them more efficient

ANSWER 2-B

3. A tax applied as a percentage of the value of an imported good is known as

(a) preferential tariff

(b) ad valorem tariff

(c) specific tariff

(d) mixed or compound tariff

ANSWER 3-B

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4. Escalated tariff refers to

(a) nominal tariff rates on raw materials which are greater than tariffs on manufactured products

(b) nominal tariff rates on manufactured products which are greater than tariffs on raw materials

(c) a tariff which is escalated to prohibit imports of a particular good to protect domestic industries

(d) none of the above

ANSWER 4-B

5. Voluntary export restraints involve:

(a) an importing country voluntarily restraining the quantity of goods that can be exported into the country
during a specified period of time

(b) domestic firms agreeing to limit the quantity foreign products sold in their domestic markets

(c) an exporting country voluntarily restraining the quantity of goods that can be exported out of a country
during a specified period of time

(d) quantitative restrictions imposed by the importing country's government.

ANSWER 5-C

6. Anti-dumping duties are

(a) additional import duties so as to offset the effects of exporting firm's unfair charging of prices in the
foreign market which are lower than production costs.

(b) additional import duties so as to offset the effects of exporting firm's increased competitiveness due to
subsidies by government

(c) additional import duties so as to offset the effects of exporting firm's unfair charging of lower prices in
the foreign market

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(d) Both (a) and (c) above

ANSWER 6-D
7. A countervailing duty is
(a) a tariff that aim to offset artificially low prices charged by exporters who enjoy export subsidies and tax
concessions in their home country

(b) charged by importing countries to ensure fair and market-oriented pricing of imported products

(c) charged by importing countries to protect domestic industries and firms from unfair price advantage
arising from subsidies

(d) All the above

ANSWER 7-D

8. Which of the following is an outcome of tariff?

(a) create obstacles to trade and increase the volume of imports and exports

(b) domestic consumers enjoy consumer surplus because consumers must now pay only a lower price for
the good

(c) discourage domestic consumers from consuming imported foreign goods and encourage consumption of
domestically produced import substitutes

(d) increase government revenues of the importing country by more than value of the total tariff it charges

ANSWER 8-C

9. SPS measures and TBTs are

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(a) permissible under WTO to protect the interests of countries

(b) may result in loss of competitive advantage of developing countries

(c) increases the costs of compliance to the exporting countries

(d) All the above

ANSWER 9-D
10. Which of the following is not a non-tariff barrier.

(a) Complex documentation requirements

(b) Import quotas on specific goods

(c) Countervailing duties charged by importing country

(d) Pre shipment product inspection and certification requirements

ANSWER 10-C

11. Under tariff rate quota

(a) countries promise to impose tariffs on imports from members other than those who are part of a
preferential trade agreement

(b) a country permits an import of limited quantities at low rates of duty but subjects an excess amount to a
much higher rate

(c) lower tariff is charged from goods imported from a country which is given preferential treatment

(d) none of the above

ANSWER 11-B

12. Non -tariff barriers (NTBs) include all of the following except:

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(a) import quotas

(b) tariffs

(c) export subsidies

(d) technical standards of products

ANSWER 12-B

II Short Answer Type Questions

1. Define trade policy.

ANSWER 1
Trade policy encompasses all instruments that governments may use to promote or restrict imports and
exports

2. What is the purpose of trade policy?

ANSWER 2
The instruments of trade policy are typically used by countries to restrict imports and/ or to encourage exports

3. What are the main types of trade policy instruments?

ANSWER 3
The instruments of trade policy are broadly classified into price- related measures such as tariffs and non-price
measures or non-tariff measures (NTMs).

4. Define ‘tariff’?
ANSWER 4
Tariffs, also known as customs duties, are basically taxes or duties imposed on goods and services which are
imported or exported.

5. Outline the main goals of tariffs?

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ANSWER 5
The main goals of tariffs are to raise revenue for the government and more importantly to protect the
domestic import-competing industries

6. What is meant by ‘specific tariff’?

ANSWER 6
A specific tariff is an import duty that assigns a fixed monetary tax per physical unit of the good imported
7. Explain the term ‘ad valorem tariff’?
ANSWER 7
An ad valorem tariff is levied as a constant percentage of the monetary value of one unit of the imported
good. A 20% ad valorem tariff on imported car

8. What is meant by ‘mixed tariff’?

ANSWER 8
Mixed tariff is a combination of an ad valorem and a specific tariff. That is, the tariff is calculated on the basis
of both the value of the imported goods (an ad valorem duty) and a unit of measure of the imported goods (a
specific duty).

9. Define ‘bound tariff’?

ANSWER 9
The bound tariff rate represents the maximum level of import duty/tariff that can be levied by a WTO member
on a product imported by that member.

10. What is the purpose of binding a tariff?

ANSWER 10
By binding a tariff, often during negotiations, the members agree to limit their right to set tariff levels beyond
a certain level

11. How does ‘escalated tariff structure’ work?

ANSWER 11
Escalated tariff structure refers to the system wherein the nominal tariff rates on imports of manufactured

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goods are higher than the nominal tariff rates on intermediate inputs and raw materials, i.e.the tariff on a
product increases as that product moves through the value-added chain

12. Define ‘dumping’?

ANSWER 12
Dumping occurs when manufacturers sell goods in a foreign country below the sales prices in their domestic
market or below their full average cost of the product. It hurts domestic producers.
13. What is meant by an ‘Anti-dumping’ measure?
ANSWER 13

Anti-dumping measures are additional import duties so as to offset the foreign firm's unfair price advantage

14. Why are countervailing duties imposed?

ANSWER 14

Countervailing duties are tariffs which seek to offset artificially low prices charged by exporters who enjoy
export subsidies and tax concessions offered by the Governments in their home country

15. Describe the term ‘Non-Tariff measure’ (NTM).

ANSWER 15
Non-tariff measures (NTMs) are policy measures, other than ordinary customs tariffs, that can potentially have
an economic effect on international trade in goods, changing quantities traded, or prices or both.

16. What is the purpose of SPS measures?

ANSWER 16
SPS measures are applied to protect human, animal or plant life from risks arising from additives, pests,
contaminants, toxins or disease-causing organisms and to protect biodiversity

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17. What do you understand by the term ‘import quota’?
ANSWER 17
An import quota is a direct restriction which specifies that only a certain physical amount of the good will be
allowed into the country during a given time period, usually one year.

18. Explain the concept of ‘local content requirements’ in the context of trade policy.

ANSWER 18
Local content requirements mandate that a specified fraction of a final good should be produced domestically.

19. What is meant by ‘Voluntary Export Restraints’?

ANSWER 19

Voluntary Export Restraints (VERs) refer to a type of informal quota administered by an exporting country
voluntarily restraining the quantity of goods that can be exported out of a country during a specified period of
time

20. Outline the meaning of ‘Trigger-price mechanism’.

ANSWER 20
Trigger-price mechanisms are quick responses of affected importing countries upon confirmation of trade
distortion to offset the distortion. E.g. Anti-dumping duties

III Long Answer Type Questions

1. Define ‘trade policy’. What are the major objectives of trade policy?

ANSWER 1
Trade policy encompasses all instruments that governments may use to promote or restrict imports and
exports. Trade policy also includes the approach taken by countries in trade negotiations. While participating
in the multilateral trading system and/or while negotiating bilateral trade agreements, countries assume
obligations that shape their national trade policies. The instruments of trade policy that countries typically use
to restrict imports and/ or to encourage exports can be broadly classified into price- related measures such as
tariffs and nonprice measures or non-tariff measures (NTMs).

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2. Describe the ‘trigger price mechanisms’ for protection of domestic industry?

ANSWER 2

Tariffs as Response to Trade Distortions: Sometimes countries engage in 'unfair' foreign-trade practices which
are trade distorting in nature and adverse to the interests of the domestic firms. The affected importing
countries, upon confirmation of the distortion, respond quickly by measures in the form of tariff responses to
offset the distortion. These policies are often referred to as "trigger-price" mechanisms. The following sections
relate to such tariff responses to distortions related to foreign dumping and export subsidies

3. Outline the different non- tariff measures adopted by countries.

ANSWER 3

Non-tariff measures (NTMs) are policy measures, other than ordinary customs tariffs, that can potentially have
an economic effect on international trade in goods, changing quantities traded, or prices or both (UNCTAD,
2010).Non-tariff measures comprise all types of measures which alter the conditions of international trade,
including policies and regulations that restrict trade and those that facilitate it. NTMs consist of mandatory
requirements, rules, or regulations that are legally set by the government of the exporting, importing, or
transit
country.

It should be kept in mind that NTMs are not the same as non-tariff barriers (NTBs). NTMs are sometimes used
as means to circumvent free-trade rules and favour domestic industries at the expense of foreign competition.
In this case they are called non-tariff barriers (NTBs). In other words, non-tariff barriers are discriminatory
non-tariff measures imposed by governments to favour domestic over foreign suppliers. NTBs are thus a
subset of NTMs that have a 'protectionist or discriminatory intent'. Compared to NTBs, non-tariff measures
encompass a
broader set of measures.

According to WTO agreements, the use of NTMs is allowed under certain circumstances. Examples of this
include the Technical Barriers to Trade (TBT) Agreement and the Sanitary and Phytosanitary Measures (SPS)
Agreement, both negotiated during the Uruguay Round. However, NTMs are sometimes used as a
means to circumvent free-trade rules and favour domestic industries at the expense of foreign competition. In
this case they are called non-tariff barriers (NTBs). It is very difficult, and sometimes impossible, to distinguish
legitimate

NTMs from protectionist NTMs, especially because the same measure may be used for several reasons.

Depending on their scope and/or design NTMs are categorized as:

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I. Technical Measures: Technical measures refer to product-specific properties such as characteristics of the
product, technical specifications and production processes. These measures are intended for ensuring product
quality, food safety, environmental protection, national security and protection of animal and plant health.

II. Non-technical Measures: Non-technical measures relate to trade requirements; for example; shipping
requirements, custom formalities, trade rules, taxation policies, etc.

These are further distinguished as:

(a) Hard measures (e.g. Price and quantity control measures),
(b) Threat measures (e.g. Anti-dumping and safeguards) and
(c) Other measures such as trade-related finance and investment measures.

Furthermore, the categorization also distinguishes between:

(i) Import-related measures which relate to measures imposed by the importing country, and
(ii) Export-related measures which relate to measures imposed by the exporting country itself.

4. How do import tariffs influence international trade?

ANSWER 4
A tariff levied on an imported product affects both the exporting country and the importing country.

(i) Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of
international trade. The prospect of market access of the exporting country is worsened when an importing
country imposes a tariff.

(ii) By making imported goods more expensive, tariffs discourage domestic consumers from consuming
imported foreign goods. Domestic consumers suffer a loss in consumer surplus because they must now pay a
higher price for the good and also because compared to free trade quantity, they now
consume lesser quantity of the good.

(iii) Tariffs encourage consumption and production of the domestically produced import substitutes and thus
protect domestic industries.

(iv) Producers in the importing country experience an increase in well-being as a result of imposition of tariff.
The price increase of their product in the domestic market increases producer surplus in the industry. They
can also charge higher prices than would be possible in the case of free trade because foreign competition has
reduced.

(v) The price increase also induces an increase in the output of the existing firms and possibly addition of new
firms due to entry into the industry to take advantage of the new high profits and consequently an increase in
employment in the industry.

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(vi) Tariffs create trade distortions by disregarding comparative advantage and prevent countries from
enjoying gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in
the rest of the world and encourage inefficient production in the home country.

(vii) Tariffs increase government revenues of the importing country by the value of the total tariff it charges
5. Distinguish between anti-dumping duties and countervailing duties. What purpose do they serve?

ANSWER 5

Anti-dumping Duties: An anti-dumping duty is a protectionist tariff that a domestic government imposes on
foreign imports that it believes are priced below fair market value. Dumping occurs when manufacturers sell
goods in a foreign country below the sales prices in their domestic market or below their full average cost of
the product. Dumping may be persistent, seasonal, or cyclical. Dumping may also be resorted to as a
predatory pricing practice to drive out established domestic producers from the market and to establish
monopoly position. Dumping is an international price discrimination favouring buyer of exports, but in fact,
the exporters deliberately forego money in order to harm the domestic producers of the importing country.

Dumping is unfair and constitutes a threat to domestic producers and therefore when dumping is found, anti-
dumping measures may be initiated as a safeguard instrument by imposing additional import duties/tariffs so
as to offset the foreign firm's unfair price advantage. This is justified only if the domestic industry is seriously
injured by import competition, and protection is in the national interest (that is, the associated costs to
consumers would be less than the benefits that would accrue to producers). For example: In January 2017,
India imposed anti-dumping duties on colour-coated or prepainted flat steel products imported into the
country from China and European nations for a period not exceeding six months and for jute and jute products
from Bangladesh and Nepal.

(n) Countervailing Duties: Countervailing duties are tariffs that aim to offset the artificially low prices charged
by exporters who enjoy export subsidies and tax concessions offered by the governments in their home
country. If a foreign country does not have a comparative advantage in a particular good and a government
subsidy allows the foreign firm to be an exporter of the product, then the subsidy generates a distortion from
the free-trade allocation of resources. In such cases, CVD is charged in an importing country to negate the
advantage that exporters get from subsidies to ensure fair and market-oriented pricing of imported products
and thereby protecting domestic industries and firms. For example, in 2016, in order to protect its domestic
industry, India imposed 12.5% countervailing duty on Gold jewellery imports from ASEAN.

6. Describe different technical barriers to trade (TBT) and their effects on trade?

ANSWER 6 586

Technical Barriers To Trade (TBT): Technical Barriers to Trade (TBT) which cover both food and non-food
traded products refer to mandatory ‘Standards and Technical Regulations’ that define the specific
characteristics that a product should have, such as its size, shape, design, labelling / marking / packaging,
functionality or performance and production methods, excluding measures covered by the SPS Agreement.
The specific procedures used to check whether a product is really conforming to these requirements
(conformity assessment procedures e.g. testing, inspection and certification) are also covered in TBT. This
involves compulsory quality, quantity and price control of goods before shipment from the exporting country.
Just as SPS, TBT measures are standards-based measures that countries use to protect their consumers and
preserve natural resources, but these can also be used effectively as obstacles to imports or to discriminate
against imports and protect domestic products. Altering products and production processes to comply
with the diverse requirements in export markets may be either impossible for the exporting country or would
obviously raise costs, hurting the competitiveness of the exporting country. Some examples of TBT are: food
laws, quality standards, industrial standards, organic certification, eco-labelling, and marketing and label
requirements.

7. How do import quotas affect domestic industries and consumers?

ANSWER 7

Import Quotas: An import quota is a direct restriction which specifies that only a certain physical amount of
the good will be allowed into the country during a given time period, usually one year. Import quotas are
typically set below the free trade level of imports and are usually enforced by issuing licenses.

This is referred to as a binding quota; a non-binding quota is a quota that is set at or above the free trade level
of imports, thus having little effect on trade. Import quotas are mainly of two types: absolute quotas and
tariff-rate quotas.

Absolute quotas or quotas of a permanent nature limit the quantity of imports to a specified level during a
specified period of time and the imports can take place any time of the year. No condition is attached to the
country of origin of the product. For example: 1000 tonnes of fish import which can take place any time
during the year from any country. When country allocation is specified, a fixed volume or value of the product
must originate in one or more countries. Example: A quota of 1000 tonnes of fish that can be imported any
time during the year, but where 750 tonnes must originate in country A and 250 tonnes in country B. In
addition, there are seasonal quotas and temporary quotas.

With a quota, the government, of course, receives no revenue. The profits received by the holders of such

587
import licenses are known as ‘quota rents’. While tariffs directly interfere with prices that can be charged for
an imported good in the domestic market, import quota interferes with the market prices indirectly.

Obviously, an import quota always raises the domestic price of the imported good. The license holders are
able to buy imports and resell them at a higher price in the domestic market and they will be able to earn a
‘rent’ on their operations over and above the profit they would have made in a free market.
The welfare effects of quotas are similar to that of tariffs. If a quota is set below free trade level, the amount
of imports will be reduced. A reduction in imports will lower the supply of the good in the domestic market
and raise the domestic price.

Consumers of the product in the importing country will be worse-off because the increase in the domestic
price of both imported goods and the domestic substitutes reduces consumer surplus in the market.
Producers in the importing country are better-off as a result of the quota. The increase in the price of their
product increases producer surplus in the industry. The price increase also induces an increase in output of
existing firms (and perhaps the addition of new firms), an increase in employment, and hence an increase in
profit

8. Explain the concept of ‘Voluntary Export Restraints’. What are the circumstances under which exporters
commit to voluntary export restraints?

ANSWER 8

Voluntary Export Restraints: Voluntary Export Restraints (VERs) refer to a type of informal quota
administered by an exporting country voluntarily restraining the quantity of goods that can be exported out of
that country during a specified period of time. Such restraints originate primarily from political considerations
and are imposed based on negotiations of the importer with the exporter. The inducement for the exporter to
agree to a VER is mostly to appease the importing country and to avoid the effects of possible retaliatory trade
restraints that may be imposed by the importer. VERs may arise when the import competing industries seek
protection from a surge of imports from particular exporting countries. VERs cause, as do tariffs and quotas,
domestic prices to rise and cause loss of domestic consumer surplus.

Over the past few decades, significant transformations are happening in terms of growth as well as trends of
flows and patterns of global trade. The increasing importance of developing countries has been a salient
feature of the shifting global trade patterns. Fundamental changes are taking place in the way countries
associate themselves for international trade and investments. Trading through regional arrangements which
foster closer trade and economic relations is shaping the global trade landscape in an unprecedented way.

588
Alongside, the trading countries also have devised ingenious policies aimed at protecting their
economic interests.
IV Application Oriented Question

1. (i) Which of the three exporters engage in anticompetitive act in the international market while pricing its
export of good X to country D?

(ii) What would be the effect of such pricing on the domestic producers of good X? Advise remedy available
for country D?

ANSWER 1

(i) Dumping by Country B and Country C. B , because it sells at a lower price than that in domestic market;
Country C because it is selling at a price which is less than the average cost of production.

(ii) Adverse effects on domestic industry as they will lose competitiveness in their markets due to unfair
practice of dumping. Country D may prove damage to domestic industries and charge anti-dumping duties
on goods imported from Country B and Country C so as to raise the price and make it at par which similar
goods produced by domestic firms.

2. (i) What do you think the implications on trade will be if India pays an export subsidy of ₹ 400 / on every
pair of cotton trousers exported by it to Germany.
(ii) Suppose Germany charged an equivalent countervailing duty on every pair of cotton trousers imported
from India. Do you think world welfare will be affected?

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ANSWER 2

(i) Unfair and artificially created price advantage to trousers exporters of India – price does not reflect costs-
German trousers industry lose competitiveness and market share as trousers from India are lower priced- Loss
of world welfare. German industry can ask for protection by introducing countervailing duties.

(ii) An equivalent countervailing duty will push the prices of Indian trousers and afford protection to domestic
trousers industry. World welfare will be the same as before India introduced export subsidy.
 UNIT III: TRADE NEGOTIATIONS

I Multiple Choice Type Questions

1. Which of the following culminated in the establishment of the World Trade Organization?

(a) The Doha Round

(b) The Tokyo Round

(c) The Uruguay Round

(d) The Kennedy Round

ANSWER 1-C

2. Choose the correct statement

(a) The GATT was meant to prevent exploitation of poor countries by richer countries

(b) The GATT dealt with trade in goods only, while, the WTO covers services as well as intellectual property.

(c) All members of the World Trade Organization are required to avoid tariffs of all types

(d) All the above

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ANSWER 2-B

3. The ‘National treatment’ principle stands for

(a) the procedures within the WTO for resolving disagreements about trade policy among countries

(b) the principle that imported products are to be treated no worse in the domestic market than the local
ones
(c) exported products are to be treated no worse in the domestic market than the local ones

(d) imported products should have the same tariff, no matter where they are imported from

ANSWER 3-B

4. ‘Bound tariff’ refers to

(a) clubbing of tariffs of different commodities into one common measure

(b) the lower limit of the tariff below which a nation cannot be taxing its imports

(c) the upper limit on the tariff that a country can levy on a particular good, according to its commitments
under the GATT and WTO.

(d) the limit within which the country’s export duty should fall so that there are cheaper exports

ANSWER 4-C

5. The essence of ‘MFN principle’ is

(a) equality of treatment of all member countries of WTO in respect of matters related to trade

(b) favour one, country, you need to favour all in the same manner

(c) every WTO member will treat all its trading partners equally without any prejudice and discrimination

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(d) all the above

ANSWER 5-D

6. The World Trade Organization (WTO)

(a) has now been replaced by the GATT

(b) has an inbuilt mechanism to settle disputes among members

(c) was established to ensure free and fair trade internationally.

(d) (b) and c) above

ANSWER 6-D

7. The Agreement on Agriculture includes explicit and binding commitments made by WTO Member
governments

(a) on increasing agricultural productivity and rural development

(b) market access and agricultural credit support

(c) market access, domestic support and export subsidies

(d) market access, import subsidies and export subsidies

ANSWER 7-C

8. The Agreement on Textiles and Clothing

(a) provides that textile trade should be deregulated gradually and the tariffs should be increased

(b) replaced the Multi-Fiber Arrangement (MFA) which was prevalent since 1974

(c) granted rights of textile exporting countries to increase tariffs to protect their domestic textile industries

(d) stipulated that tariffs in all countries should be the same

ANSWER 8-B 592

9. The Agreement on Trade-Related Aspects of Intellectual Property Rights

(a) stipulates to administer a system of enforcement of intellectual property rights.

(b) provides for most-favoured-nation treatment and national treatment for intellectual properties
(c) mandates to maintain high levels of intellectual property protection by all members

(d) all the above

ANSWER 9-D

10 The most controversial topic in the yet to conclude Doha Agenda is

(a) trade in manufactured goods

(b) trade in intellectual property rights-based goods

(c) trade in agricultural goods

(d) market access to goods from developed countries

ANSWER 10-C

11. The WTO commitments

(a) affect developed countries adversely because they have comparatively less agricultural goods

(b) affect developing countries more because they need to make radical adjustments

(c) affect both developed and developing countries equally

(d) affect none as they increase world trade and ensure prosperity to all

ANSWER 11-B

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II Short Answer Type Questions
1. Define the term Regional Trade Agreements (RTAs). What is its major advantage?

ANSWER 1
Regional Trade Agreements (RTAs) are groupings of countries, which are formed with the objective of
reducing barriers to trade between member countries.; not necessarily belonging to the same geographical
region. They reduce trade barriers on a reciprocal and preferential basis only for the members of the group.

2. What is meant by ‘free trade area’?

ANSWER 2
Free-trade area is a group of countries that eliminate all tariff barriers on trade with each other and retains
independence in determining their tariffs with non-members. Example: NAFTA

3. What is the key feature of Monetary Union?

ANSWER 3
In a Monetary Union, members share a common currency and macroeconomic policies. For example, the euro
zone countries implement and adopt a single currency.

4. What are the peculiarities of the GATT?

ANSWER 4
General Agreement on Tariffs and Trade (GATT) (1948 to 1994) provided the rules for most of world trade; it
was a multilateral instrument governing international trade or a provisional agreement along with the two
fullfledged “Bretton Woods” institutions, the World Bank and the International Monetary Fund

5. What are the major functions of the WTO?

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ANSWER 5

The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly and
predictably. The WTO does its functions by acting as a forum for trade negotiations among member
governments, administering trade agreements, reviewing national trade policies, assisting developing
countries in trade policy issues, through technical assistance and training programmes and cooperating with
other international organizations
6. What do you understand by the term ‘Most-favoured-nation’ (MFN)?
ANSWER 6

Under the WTO agreements, countries cannot normally discriminate betweentheir trading partners. If a
country lowers a trade barrier or opens up a market, it has to do so for the same goods or services from all
other WTO members

7. What is meant by ‘National Treatment Principle’?

ANSWER 7

With respect to internal taxes, internal laws, etc. applied to imports, treatment not less favourable than that
which is accorded to like domestic products, must be accorded to all other members; i.e. a country should not
discriminate between its own and foreign products, services or nationals

8. How does the WTO agreement ensure market access?

ANSWER 8

The WTO aims to increase world trade by enhancing market access by converting all non- tariff barriers into
tariffs which are subject to country specific limits. Further, in major multilateral agreements like the
Agreement
on Agriculture (AOA), specific targets have been specified for ensuring market access.

9. Describe the functioning of the dispute settlement mechanism?

ANSWER 9

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The disputes can be referred to the WTO and can pursue a carefully mapped out, stage-by-stage procedure
that includes the possibility of a judgment by a panel of experts, and the opportunity to appeal the ruling on
legal grounds. The decisions of the dispute settlement body are final and binding
10. What is the major aim of the agreement on the ‘Application of Sanitary and Phytosanitary (SPS)
Measures’?

ANSWER 10

To prevent sanitary and phytosanitary measures from being used for arbitrary or unjustifiable discrimination
or for camouflaged restraint on international trade and to minimize their adverse effects on trade

11. What purpose does the Agreement on Technical Barriers to Trade (TBT) serve?
ANSWER 11
Agreement on Technical Barriers to Trade (TBT)aims to prevent standards and conformity assessment systems
from becoming unnecessary trade barriers by securing their transparency and harmonization with
international standards

12. What does the agreement on Trade-Related Investment Measures (TRIMs) stipulate?

ANSWER 12

Establishes disciplines governing investment measures in relation to crossborder investments by stipulating

that countries receiving foreign investments shall not impose investment measures such as requirements,
conditions and restrictions inconsistent with the provisions of the principle of national treatment and general
elimination of quantitative restrictions

13. What do you understand by agreement on Trade-Related Aspects of Intellectual Property Rights
(TRIPS)?

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ANSWER 13
This agreement stipulates most-favoured-nation treatment and national treatment for intellectual properties.
III Long Answer Type Questions

1. Distinguish between different types of regional trade agreements? How are they different from the WTO
agreements?

ANSWER 1

1. Unilateral trade agreements under which an importing country offers trade incentives in order to
encourage the exporting country, to engage in international economic activities that will improve the
exporting country’s economy. E.g. Generalized System of Preferences.

2. Bilateral Agreements are agreements which set rules of trade between two countries, two blocs or a bloc
and a country. These may be limited to certain goods and services or certain types of market entry barriers.
E.g. EU-South Africa Free Trade Agreement; ASEAN–India Free Trade Area.

3. Regional Preferential Trade Agreements among a group of countries reduce trade barriers on a reciprocal
and preferential basis for only the members of the group. E.g. Global System of Trade Preferences among
Developing Countries (GSTP)

4. Trading Bloc has a group of countries that have a free trade agreement between themselves and may apply
a common external tariff to other countries. Example: Arab League (AL), European Free Trade Association
(EFTA)

5. Free-trade area is a group of countries that eliminate all tariff and quota barriers on trade with the
objective of increasing exchange of goods with each other. The trade among the member states flows tariff
free, but the
member states maintain their own distinct external tariff with respect to imports from the rest of the world. In
other words, the members retain independence in determining their tariffs with non-members. Example:

597
NAFTA.
6. A customs union is a group of countries that eliminate all tariffs on trade among themselves but maintain a
common external tariff on trade with countries outside the union (thus, technically violating MFN).The
common external tariff which distinguishes a customs union from a free trade area implies that, generally, the
same tariff is charged wherever a member imports goods from outside the customs union. The EU is a
Customs Union; its 27 member countries form a single territory for customs purposes. Other examples are
Gulf Cooperation Council (GCC), Southern Common Market (MERCOSUR).

7. Common Market: A Common Market deepens a customs union by providing for the free flow of output and
of factors of production (labour, capital and other productive resources) by reducing or eliminating internal
tariffs on goods and by creating a common set of external tariffs. The member countries attempt to harmonize
some institutional arrangements and commercial and financial laws and regulations among themselves.
There are also common barriers against non-members (e.g., EU, ASEAN)

8. Economic and Monetary Union: For a common market, the free transit of goods and services through the
borders increases the need for foreign exchange operations and results in higher financial and administrative
expenses of firms operating within the region. The next stage in the integration sequence is formation of some
form of monetary union. In an Economic and Monetary Union, the members share a common currency.
Adoption of common currency also makes it necessary to have a strong convergence in macroeconomic
policies. For example, the European Union countries implement and adopt a single currency.

2. Describe the structure and guiding principles of the World Trade Organization.

ANSWER 2

The WTO activities are supported by a Secretariat located in Geneva, headed by a Director General. It has a
three-tier system of decision making. The WTO’s toplevel decision-making body is the Ministerial Conference
which can take decisions on all matters under any of the multilateral trade agreements. The Ministerial
Conference meets at least once every two years. The next level is the General Council which meets several
times a year at the Geneva headquarters. The General Council also meets as the Trade Policy Review Body and
the Dispute Settlement Body. At the next level, the Goods Council, Services Council and Intellectual Property
(TRIPS) Council report to the General Council. These councils are responsible for overseeing the

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implementation of the WTO agreements in their respective areas of specialisation. The WTO Secretariat
maintains working relations with almost 200 international organisations in activities ranging from
statistics, research, standard-setting, and technical assistance and training.

Numerous specialized committees, working groups and working parties deal with the individual agreements
and other areas such as the environment, development, membership applications and regional trade
agreements. The WTO accounting for about 95% of world trade currently has 164 members, of
which 117 are developing countries or separate customs territories. Around 24 others are negotiating
membership. The WTO’s agreements have been ratified in all members’ parliaments.
Following are the major guiding principles:

1. Trade without discrimination: Most-favoured-nation (MFN): Originally formulated as Article 1 of GATT, this
principle states that any advantage, favour, privilege or immunity granted by any contracting party to any
product originating in or destined for any other country shall be extended immediately and unconditionally to
the like product originating in or destined for the territories of all other contracting parties. Under the WTO
agreements, countries cannot normally discriminate between their trading partners. If a country lowers a
trade barrier or opens up a market, it has to do so for the same goods or services from all other WTO
members. Under strict conditions, various permitted exceptions are allowed. For example; countries may
enter into free trade agreements and trading may be done within the group discriminating against goods from
outside; a country can raise barriers against products that are considered to be traded unfairly from specific
countries; or they may give special market access to developing countries.

2. The National Treatment Principle (NTP): The National Treatment Principle is complementary to the MFN
principle. GATT Article III requires that with respect to internal taxes, internal laws, etc. applied to imports,
treatment not less favourable than that which is accorded to like domestic products must be accorded to all
other members. In other words, a country should not discriminate between its own and foreign products,
services or nationals. For instance, once imported apples reach Indian market, they cannot be discriminated
against and should be treated at par in respect of marketing opportunities, product visibility or any other
aspect with locally produced apples.

3. Freer trade: Lowering trade barriers for opening up markets is one of the most obvious means of
encouraging trade. But by the 1980s, the negotiations had expanded to cover non-tariff barriers on goods, and
to the new areas such as services and intellectual property. Since these require adjustments, the WTO
agreements permit countries to bring in changes gradually, through “progressive liberalization”. Developing
countries are generally given longer time to conform to their obligations.

4. Predictability: Investments will be encouraged only if the business environment is stable and predictable.
The foreign companies, investors and governments should be confident that the trade barriers will not be
raised arbitrarily. This is achieved through ‘binding’ tariff rates, discouraging the use of quotas and other

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measures used to set limits on quantities of imports, establishing market-opening commitments and other
measures to ensure transparency. A country can change its bindings, but only after negotiating with its trading
partners, which could mean compensating them for loss of trade.
5. Principle of general prohibition of quantitative restrictions: One reason for this prohibition is that
quantitative restrictions are considered to have a greater protective effect than tariff measures and are more
likely to distort the free flow of trade

6. Greater competitiveness: This is to be achieved by discouraging “unfair” practices such as export subsidies,
dumping etc. The rules try to establish what is fair or unfair, and how governments can take action, especially
by charging additional import duties intended to compensate for injury caused by unfair trade.

7. Tariffs as legitimate measures for the protection of domestic industries:

The imposition of tariffs should be the only method of protection, and tariff rates for individual items should
be gradually reduced through negotiations ‘on a reciprocal and mutually advantageous’ basis. Member
countries bind themselves to maximum rates and the imposition of tariffs beyond such maximum rates (bound
rates) or the unilateral raise in bound rates are banned.

8. Transparency in Decision Making: The WTO insists that any decision by members in the sphere of trade or
in respect of matters affecting trade should be transparent and verifiable. Such changes in matters of trade or
of trade related rules have to be invariably and without delay be notified to all the trading partners. In case of
any opposition to such changes, they should be appropriately addressed and any loss occurring to the affected
members should be suitably compensated for. well as plant health with the stipulation that such measures
should be nondiscriminatory and that members should not employ environmental protection measures as a
means of disguising protectionist policies

9. Progressive Liberalization: Many trade issues of a controversial nature similar to labour standards, non-
agricultural market access, etc. on which there was general disagreement among trading partners were left

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unsettled during the Uruguay Round. These are to be liberalized during consecutive rounds of discussion.

10. Market Access: The WTO aims to increase world trade by enhancing market access by converting all non-
tariff barriers into tariffs which are subject to country specific limits. Further, in major multilateral agreements
like the Agreement on Agriculture (AOA), specific targets have been specified for ensuring market access.
11. Special privileges to less developed countries: With majority of WTO members being developing countries
and countries in transition to market economies, the WTO deliberations favour less developed countries by
giving them greater flexibility, special privileges and permission to phase out the transition period. Also, these
countries are granted transition periods to make adjustments to the not so familiar and intricate WTO
provisions.

12. Protection of Health &Environment: The WTO’s agreements support measures to protect not only the
environment but also human, animal as

13. A transparent, effective and verifiable dispute settlement mechanism: Trade relations frequently involve
conflicting interests. Any dispute arising out of violation of trade rules leading to infringement of rights under
the agreements or misunderstanding arising as regards the interpretation of rules, are to be settled through
consultation. In case of failures, the dispute can be referred to the WTO and can pursue a carefully mapped
out, stageby- stage procedure that includes the possibility of a judgment by a panel of experts, and the
opportunity to appeal the ruling on legal grounds. The decisions of the dispute settlement body are final and
binding.

4. Give an overview of the WTO agreements.

ANSWER 4

The WTO agreements cover goods, services and intellectual property and the permitted exceptions. These
agreements are often called the WTO’s trade rules, and the WTO is often described as “rules-based”, a system
based on rules. (The rules are actually agreements that the governments negotiated). The WTO agreements
are voluminous and multifaceted. The ‘Legal Texts’ consist of a list of about 60 agreements, annexes, decisions
and understandings covering a wide range of activities. (The list of WTO agreements is given at the end of this
unit).

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5. List out the major concerns in respect of functioning of the WTO.

ANSWER 5
Following are the important agreements under WTO. Since a thorough discussion on the features of each
agreement is beyond the scope of this unit, only the major provisions are given below:

1. Agreement on Agriculture aims at strengthening GATT disciplines and improving agricultural trade. It
includes specific and binding commitments made by WTO Member governments in the three areas of market
access, domestic support and export subsidies.
2. Agreement on the Application of Sanitary and Phytosanitary (SPS) Measures establishes multilateral
frameworks for the planning, adoption and implementation of sanitary and phytosanitary measures to
prevent such measures from being used for arbitrary or unjustifiable discrimination or for camouflaged
restraint on international trade and to minimize their adverse effects on trade.

3. Agreement on Textiles and Clothing replaced the Multi-Fibre Arrangement (MFA) which was prevalent since
1974 and entailed import protection policies. ATC provides that textile trade should be deregulated by
gradually integrating it into GATT disciplines over a 10-year transition period.

4. Agreement on Technical Barriers to Trade (TBT) aims to prevent standards and conformity assessment
systems from becoming unnecessary trade barriers by securing their transparency and harmonization with
international standards. Often excessive standards or misuse of standards in respect of manufactured goods,
and safety/environment regulations act as trade barriers.

5. Agreement on Trade-Related Investment Measures (TRIMs) expands disciplines governing investment

measures in relation to cross-border investments. It stipulates that countries receiving foreign investments
shall
not impose investment measures such as requirements, conditions and restrictions inconsistent with the
provisions of the principle of national treatment and general elimination of quantitative restrictions. For
example: measures such as local content requirements and trade balancing requirements should not be
applied on investing corporations.

6. Anti-Dumping Agreement seeks to tighten and codify disciplines for calculating dumping margins and
conducting dumping investigations, etc. in order to prevent anti-dumping measures from being abused or
misused to protect domestic industries.

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7. Customs Valuation Agreement specifies rules for more consistent and reliable customs valuation and aims
to harmonize customs valuation systems on an international basis by eliminating arbitrary valuation systems.

8. Agreement on Pre-shipment Inspection (PSI) intends to secure transparency of pre-shipment inspection

wherein a company designated by the importing country conducts inspection of the quality, volume, price,
tariff
classification, customs valuation, etc. of merchandise in the territory of the exporting country on behalf of the
importing country’s custom office and issues certificates. The agreement also provides for a mechanism for
the
solution of disputes between PSI agencies and exporters.

9. Agreement on Rules of Origin provides for the harmonization of rules of origin for application to all non-
preferential commercial policy instruments. It also provides for dispute settlement procedures and creates the
rules of origin committee.

IV Applications Oriented Question

Case Scenario

India aims to become a global leader in solar energy and for achieving this, the Jawaharlal Nehru National
Solar Mission (JNNSM) was launched in 2010. To persuade and to promote producers to participate in the
national solar programme, the government planned long-term power purchase agreements with
solar power producers, thus effectively guaranteeing the sale of the energy produced as well as the price
that solar power producers would obtain. However, there was a stipulation that the producers should use
domestically sourced inputs, namely solar cells and modules. India lost the case in DSB and WTO has ruled
against the stipulation of local content requirements by government of India.

Answer the following questions

(i) How does the ‘local content requirements’ clause violate the WTO agreements?

ANSWER

(i) Local-sourcing regulation is considered as a protectionist measure inconsistent with India’s international

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obligations under WTO agreement. Discrimination on the basis of the national ‘origin’ of the cells and modules
is a violation of its trade commitment for ‘national treatment obligation’ under WTO. If the objective is cost
reduction and efficiency, then the solar power producers should be free to choose energy-generation
equipment and components on the basis of price and quality, irrespective of whether they are manufactured
locally or not. By mandatorily requiring solar power producers to buy locally, the government has, it is argued,
tried to distort competition. This imposes extra cost, and may possibly be passed on to the final consumers.
Therefore, the interests of the consumers will not be protected.
(ii) Do you think Indian domestic solar power industry will be affected when India scraps the local-sourcing
regulation as per the ruling of WTO?

ANSWER

(ii) The market forces would prevail in respect of solar energy production. The import competing domestic
industry of solar panels and modules may face stiff competition from imported items, especially those from
China. Indian solar industry is in its infancy. Possibility of subsidized imports and dumping from different
countries. India can evoke anti-dumping duties, countervailing duties and safe guards as provided for in WTO
agreements. Need for innovation, cost reduction and quality improvement of Indian solar industry to
compete with global manufacturers. Since clean energy is a merit good, government may produce and supply
it directly - economies of large-scale production can be reaped leading to cost and price reduction

UNIT- IV EXCHANGE RATE AND ITS ECONOMIC EFFECTS

I Multiple Choice Type Questions

1. Based on the supply and demand model of determination of exchange rate, which of the following ought
to cause the domestic currency of Country X to appreciate against dollar?

(a) The US decides not to import from Country X

(b) An increase in remittances from the employees who are employed abroad to their families in the home
country

(c) Increased imports by consumers of Country X

(d) Repayment of foreign debts by Country X

ANSWER 1-B 604

2. All else equal, which of the following is true if consumers of India develop taste for imported
commodities and decide to buy more from the US?

(a) The demand curve for dollars shifts to the right and Indian Rupee appreciates

(b) The supply of US dollars shrinks and, therefore, import prices decrease

(c) The demand curve for dollars shifts to the right and Indian Rupee depreciates

(d) The demand curve for dollars shifts to the left and leads to an increase in exchange rate

ANSWER 2-C

3. ‘The nominal exchange rate is expressed in units of one currency per unit of the other currency. A real
exchange rate adjusts this for changes in price levels’. The statements are

(a) wholly correct

(b) partially correct

(c) wholly incorrect

(d) None of the above

ANSWER 3-A

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4. Match the following by choosing the term which has the same meaning

i) floating exchange rate ii) fixed exchange rate

iii) pegged exchange rate a. depreciation
iv) devaluation b. revaluation
v) appreciation c. flexible exchange rate

(a) (i c ) ; ( ii d) ;( iii b); (iv a))

(b) (i b) ; ( ii a) ;( iii d); (iv c )
(c) (i a ) ; ( ii d ) ;( iii b); (iv c )
(d) (i d) ; ( ii a) ;( iii b); (iv c )

ANSWER 4-D

5. Choose the correct statement

(a) An indirect quote is the number of units of a local currency exchangeable for one unit of a foreign
currency

(b) the fixed exchange rate regime is said to be efficient and highly transparent.

(c) A direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency

(d) Exchange rates are generally fixed by the central bank of the country

ANSWER 5-C

6. Which of the following statements is true?

(a) Home-currency appreciation or foreign-currency depreciation takes place when there is a decrease in the
home currency price of foreign currency

(b) Home-currency depreciation takes place when there is an increase in the home currency price of the
foreign currency

(c) Home-currency depreciation is the same as foreign-currency appreciation and implies that the home
currency has become relatively less valuable.

(d) All the above 606

ANSWER 6-D
7. An increase in the supply of foreign exchange

(a) shifts the supply curve to the right and as a consequence, the exchange rate declines

(b) shifts the supply curve to the right and as a consequence, the exchange rate increases

(c) more units of domestic currency are required to buy a unit of foreign exchange

(d) the domestic currency depreciates and the foreign currency appreciates

ANSWER 7-A

8. Currency devaluation

(a) may increase the price of imported commodities and, therefore, reduce the international
competitiveness of domestic industries

(b) may reduce export prices and increase the international competitiveness of domestic industries

(c) may cause a fall in the volume of exports and promote consumer welfare through increased availability
of goods and services

(d) (a) and (c) above

ANSWER 8-B

9. At any point of time, all markets tend to have the same exchange rate for a given currency due to

607
(a) Hedging

(b) Speculation

(c) Arbitrage

(d) Currency futures

ANSWER 9-C
10. ‘Vehicle Currency’ refers to

(a) a currency that is widely used to denominate international contracts made by parties because it is the
national currency of either of the parties

(b) a currency that is traded internationally and, therefore, is in high demand

(c) a type of currency used in euro area for synchronization of exchange rates

(d) a currency that is widely used to denominate international contracts made by parties even when it is not
the national currency of either of the parties

ANSWER 10-D

II Short Answer Type Questions

1. Define exchange rate?

ANSWER 1
The price of one currency expressed in terms of units of another currency represents the number of units of
one currency that exchanges for a unit of another

2. Distinguish between direct quote and indirect quote?

ANSWER 2

A direct quote (European Currency Quotation) is the number of units of a local currency exchangeable for one
unit of a foreign currency. For example, ₹ 66/US$. An indirect quote (American Currency Quotation)is the
number of units of a foreign currency exchangeable for one unit of local currency; for example: $ 0.0151 per

608
rupee

3. What do you understand by the term ‘cross rate’?

ANSWER 3

The rate between Y and Z which is derived from the given rates of another set of two pairs of currency (say, X
and Y, and, X and Z) is called “cross rate”.
4. What is an ‘exchange rate regime’?

ANSWER 4

An exchange rate regime is the system by which a country manages its currency with respect to foreign
currencies.

5. Which are the major types of exchange rate regimes?

ANSWER 5

There are two major types of exchange rate regimes at the extreme ends; namely floating exchange rate
regime, (also called a flexible exchange rate) and fixed exchange rate regime

6. How is exchange rate determined under floating exchange rate regime?

ANSWER 6

Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is
market determined i.e. the demand for and supply of currency relative to other currencies determines the
exchange rate.

7. Define fixed exchange rate?

ANSWER 7

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A fixed exchange rate, also referred to as pegged exchange rate, is an exchange rate regime under which a
country’s government or central bank announces, or decrees, what its currency will be worth in terms of
either another country’s currency or a basket of currencies or another measure of value, such as gold.
8. What are the major merits of floating exchange rate?

ANSWER 8

A floating exchange rate allows a government to pursue its own independent monetary policy and there is no
need of market intervention or maintenance of reserves

9. Mention the main demerit of floating exchange rate?

ANSWER 9
The volatile exchange rates generate a lot of uncertainties in relation to international transactions

10. Explain the term ‘real exchange rate’?

ANSWER 10
The ‘real exchange rate' incorporates changes in prices and describes ‘how many’ of a good or service in one
country can be traded for ‘one’ of that good or service in a foreign country.
Real exchange rate = Nominal exchange rate X Domestic price Index/ Foreign price Index

11. Define Real Effective Exchange Rate (REER)?

ANSWER 11
Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a measure of the value of a
currency against a weighted average of various foreign currencies) divided by a price deflator or index of costs

610
12. Describe the chief characteristics of foreign exchange market?
ANSWER 12
The wide-reaching collection of markets and institutions that handle the exchange of foreign currencies is
known as the foreign exchange market. Being an over-the-counter market, it is not a physical place; rather, it
is an electronically linked network bringing buyers and sellers together and has only very narrow spreads.
13. What is Arbitrage? What is the outcome of Arbitrage?
ANSWER 13

Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an
asset at different dealing places. On account of arbitrage, regardless of physical location, at any given
moment,
all markets tend to have the same exchange rate for a given currency

14. Mention the types of transactions in the forex market?

ANSWER 14
There are two types of transactions in a forex market; current transactions which are carried out in the spot
market and future transactions involving contracts to buy or sell currencies for future delivery which are
carried out in forward and futures markets.

15. Describe the term currency appreciation?

ANSWER 15

Currency appreciates when its value increases with respect to the value of another currency or a basket of
other currencies. On the contrary, currency depreciates when its value falls with respect to the value of
another
currency or a basket of other currencies

16. What is meant by devaluation? 611

ANSWER 16
Devaluation is a deliberate downward adjustment in the value of a country's currency relative to another
currency or group of currencies or standard
III Long Answer Type Questions

1. Distinguish between fixed exchange rate and floating exchange rate? What are the merits and demerits
of each?
ANSWER 1

An exchange rate regime is the system by which a country manages its currency with respect to foreign
currencies. It refers to the method by which the value of the domestic currency in terms of foreign currencies
is determined. There are two major types of exchange rate regimes at the extreme ends; namely:

(i) floating exchange rate regime (also called a flexible exchange rate), and

(ii) fixed exchange rate regime

Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is
market-determined i.e. the demand for and supply of currency relative to other currencies determine the
exchange rate. There is no predetermined target rate and the exchange rates are likely to change at every
moment in time depending on the changing demand for and supply of currency in the market. There is no
interference on the part of the government or the central bank of the country in the determination of
exchange rate. Any intervention by the central banks in the foreign exchange market (through purchases or
sales of foreign currency in exchange for local currency) is intended for only moderating the rate of change
and preventing undue fluctuations in the exchange rate, rather than for establishing a particular level for it
(for example: India).Nevertheless, in a few countries (for example, New Zealand, Sweden, th United States),
the central banks almost never interfere to administer the exchange rates. Nearly all advanced economies
follow floating exchange rate regimes. Some large emerging market economies also follow the system.

A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate regime under which a
country’s Central Bank and/ or government announces or decrees what its currency will be worth in terms of
either another country’s currency or a basket of currencies or another measure of value, such as gold. For
example: a certain amount of rupees per dollar. (When a government intervenes in the foreign exchange
market so that the exchange rate of its currency is different from what the market forces of demand and

612
supply would have decided, it is said to have established a “peg” for its currency). In order to sustain a fixed
exchange rate, it is not enough that a country pronounces a fixed parity: it must also make concentrated
efforts to defend that parity by being willing to buy (or sell) foreign reserves whenever the market demand for
foreign currency is lesser (or greater) than the supply of foreign currency. In other words, in order to maintain
the exchange rate at the predetermined level, the central bank intervenes in the foreign exchange market.
2. What are the characteristic features of foreign exchange market? Who are the participants in the foreign
exchange market?

ANSWER 2

Foreign exchange brokers participate in the market as intermediaries between different dealers or banks.
Arbitrageurs make profit by discovering price differences between pairs of currencies with different dealers or
banks.

Speculators, who are bulls or bears, are deliberate risk-takers who participate in the market to make gains
which result from unanticipated changes in exchange rates. Other participants in the exchange market are
individuals who form only a very insignificant fraction in terms of volume and value of transactions.

Regardless of physical location, and given that the markets are highly integrated, at any given moment, all
markets tend to have the same exchange rate for a given currency. This phenomenon occurs because of
arbitrage. Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences
of an asset at different dealing locations. There is potential for arbitrage in the forex market if exchange rates
are not consistent between currencies. When price differences occur in different markets, participants
purchase foreign exchange in a low-priced market for resale in a high-priced market and makes profit in this
process. Due to the operation of price mechanism, the price is driven up in the low-priced market and pushed
down in the high-priced market. This activity will continue until the prices in the two markets are equalized, or
until they differ only by the amount of transaction costs involved in the operation. Since forex markets
are efficient, any profit spread on a given currency is quickly arbitraged away.

In the foreign exchange market, there are two types of transactions:

(i) current transactions which are carried out in the spot market and the exchange involves immediate
delivery, and

(ii) future transactions wherein contracts are agreed upon to buy or sell currencies for future delivery which
are carried out in forward and/or futures markets

Exchange rates prevailing for spot trading (for which settlement by and large takes two days) are called spot
exchange rates. The exchange rates quoted in foreign exchange transactions that specify a future date are

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called forward exchange rates. The currency forward contracts are quoted just like spot rate;
however, the actual delivery of currencies takes place at the specified time in future. When a party agrees to
sell euro for dollars on a future date at a forward rate agreed upon, he has ‘sold euros forward’ and ‘bought
dollars forward’. A forward premium is said to occur when the forward exchange rate is more than a
spot exchange rates. On the contrary, if the forward trade is quoted at a lower rate than the spot rate, then
there is a forward discount. Currency futures, though conceptually similar to currency forward and perform
the same function, they are distinct in their nature and details concerning settlement and delivery.
While a foreign exchange transaction can involve any two currencies, most transactions involve exchanges of
foreign currencies for the U.S. dollars even when it is not the national currency of either the importer or the
exporter. On account of its critical role in the forex markets, the dollar is often called a ‘vehicle
currency’.

3. What do you understand by appreciation and depreciation of currency? How do they affect real
economy?

ANSWER 3
DEVALUATION (REVALUATION) VS DEPRECIATION (APPRECIATION)

Devaluation is a deliberate downward adjustment in the value of a country's currency relative to another
country’s currency or group of currencies or standard. It is a monetary policy tool used by countries that have
a fixed exchange rate or nearly fixed exchange rate regime and involves a discrete official reduction in the
otherwise fixed par value of a currency. The monetary authority formally sets a new fixed rate with respect to
a foreign reference currency or currency basket. In contrast, depreciation is a decrease in a currency's value
(relative to other major currency benchmarks) due to market forces of demand and supply under
a floating exchange rate and not due to any government or central bank policy actions.
Revaluation is the opposite of devaluation and the term refers to a discrete official increase of the otherwise
fixed par value of a nation’s currency. Appreciation, on the other hand, is an increase in a currency's value
(relative to other major currencies) due to market forces of demand and supply under a floating exchange rate
and not due to any government or central bank policy interventions.

4. Explain the nature of changes in exchange rates and their impact on real economy?
ANSWER 4

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The developments in the foreign exchange markets affect the domestic economy both directly and indirectly.
The direct impact of fluctuations in rates is initially felt by economic agents who are directly involved in
international trade or international finance. In judging the impacts of exchange rate fluctuations, it becomes,
therefore, necessary to evaluate their effects on trade, investments, consumption output, economic growth
and inflation.

(i) Exchange rates have a very significant role in determining the nature and extent of a country's trade.
Changes in import and export prices will lead to changes in import and export volumes, causing changes in
import spending and export revenue.
(ii) Fluctuations in the exchange rate affect the economy by changing the relative prices of domestically-
produced and foreign-produced goods and services. All else equal (or other things remaining the same), an
appreciation of a country’s currency raises the relative price of its exports and lowers the relative price of its
imports. Conversely, depreciation lowers the relative price of a country’s exports and raises the relative price
of its imports. When a country’s currency depreciates, foreigners find that its exports are cheaper and
domestic residents find that imports from abroad are more expensive. An appreciation has opposite effects i.e
foreigners pay more for the country’s products and domestic consumers pay less for foreign products.
For example; assume that there is devaluation or depreciation of Indian Rupee from $1=₹ 65/ to $1=₹ 70/. A
foreigner who spends ten dollars on buying Indian goods will, post devaluation, get goods worth ₹.700/
instead
of ₹ 650/ prior to depreciation. An importer has to pay for his purchases in foreign currency, and, therefore, a
resident of India, who wants to import goods worth $1 will have to pay ₹ 70/ instead of ₹ 65/ prior to
depreciation. Importers will be affected most as they will have to pay more rupees on importing products. On
the contrary, exporters will be benefitted as goods exported abroad will fetch dollars which can now be
converted to more rupees.

(iii) Exchange rate changes affect economic activity in the domestic economy. A depreciation of domestic
currency primarily increases the price of foreign goods relative to goods produced in the home country and
diverts spending from foreign goods to domestic goods. Increased demand, both for domestic import-
competing goods and for exports, encourages economic activity and creates output expansion. Overall, the
outcome of exchange rate depreciation is an expansionary impact on the economy at an aggregate level. The
positive effect of currency depreciation, however, largely depends on whether the switching of demand has
taken place in the right direction and in the right amount, as well as on the capacity of the home economy to
meet that increased demand by supplying more goods.

(iv) By lowering export prices, currency depreciation increase the international competitiveness of domestic
industries, the volume of exports and promotes trade balance. However, a point to be noted is that the price
changes in exports and imports may counterbalance or offset each other only if trade is in balance and terms
of trade are not changed. In case the country’s imports exceed exports, the net result is a reduction in real
income within the country.

(v) We have seen above that by changing the relative prices, depreciation may increase windfall profits in 615
export and import-competing industries. However, depreciation may also cause contractionary effects. We
shall see how it may happen. In an under developed or semi industrialized country, where -inputs (such as oil)
and components for manufacturing are mostly imported and cannot be domestically produced, increased
import prices will increase firms’ cost of production , push domestic prices up and decrease
real output.
(vi) For an economy where exports are significantly high, a depreciated currency would mean a lot of gain. In
addition, if exports originate from labourintensive industries, increased export prices will have positive effect
on
employment and potentially on wages.

(vii) Depreciation is also likely to add to consumer price inflation in the short run, directly through its effect on
prices of imported consumer goods and also due to increased demand for domestic goods. The impact will be
greater if the composition of domestic consumption baskets consists more of imported goods. Indirectly, cost
push inflation may result through possible escalation in the cost of imported inputs. In such an inflationary
situation, the central bank of the country will have no incentive to cut policy rates as this is likely to increase
the burden of all types of borrowers including businesses.

(viii) When a country’s currency depreciates, production for exports and of import substitutes become more
profitable. Therefore, factors of production will be induced to move into the tradable goods sectors and out of
the nontradable goods sectors. The reverse will be true when the currency appreciates. These types of
resource movements involve economic wastes.

(ix) A depreciation or devaluation is also likely to affect a country’s terms of trade (Terms of trade is the ratio
of the price of a country’s export commodity to the price of its import commodity). Since the prices of both
exports and imports rise in terms of the domestic currency as a result of depreciation or devaluation, the
terms of trade of the nation can rise, fall or remain unchanged, depending on whether price of exports rises by
more
than, less than or same percentage as the price of imports.

(x) The fiscal health of a country whose currency depreciates is likely to be affected with rising export earnings
and import payments and consequent impact on current account balance. A widening current account deficit
is a danger signal as far as growth prospects of the overall economy is concerned. If export earnings rise faster
than the imports spending then current account balance will improve.

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(xi) Companies that have borrowed in foreign exchange through external commercial borrowings (ECBs) but
have been careless and did not sufficiently hedge these loans against foreign exchange risks, would also be
negatively impacted as they would require more domestic currency to repay their loans. A depreciated
domestic currency would also increase their debt burden and lower their profits and impact their balance
sheets adversely. These would signal investors who will be discouraged from investing in such
companies.
(xii) Countries with foreign currency denominated government debts, currency depreciation will increase the
interest burden and cause strain to the exchequer for repaying and servicing foreign debt. Fortunately, India’s
has small proportion of public debt in foreign currency.

(xiii) Exchange rate fluctuations make financial forecasting more difficult for firms and larger amounts will
have to be earmarked for insuring against exchange rate risks through hedging.

(xiv) With growth of investments across international boundaries, exchange rates have assumed special
significance. Investors who have purchased a foreign asset, or the corporation which floats a foreign debt, will
find themselves facing foreign exchange risk. Exchange rate movements have become the single most
important factor affecting the value of investments at international level. They are critical to business
volumes, profit forecasts, investment plans and investment outcomes. Depreciating currency hits investor
sentiments and has radical impact on patterns of international capital flows.

(xv) Foreign investors are likely to be indecisive or highly cautious before investing in a country which has high
exchange rate volatility. Foreign capital inflows are characteristically vulnerable when local currency weakens.
Therefore, foreign portfolio investment flows into debt and equity as well as foreign direct investment flows
are likely to shrink. This shoots up capital account deficits affecting the country’s fiscal health. If investor
sentiments are such that they anticipate further depreciation, there may be large scale withdrawal of portfolio
investments and huge redemptions through global exchange traded funds leading to further depreciation of
domestic currency. This may result in a highly volatile domestic equity market affecting the confidence of
domestic investors. Reduced foreign investments also widen the gap between investments required for
growth and actual investments. Over a period of time, unemployment is likely to mount in the economy. With
increasing dependence on imports, Indian economy has always felt the brunt of higher international prices of
fuel impacting domestic transportation and overall cost of production which often triggered inflation, increase
in oil and fertilizer subsidy bills, costly foreign travel, escalated foreign debt service payments and higher
outstanding external commercial borrowings (or ECB) and government’s foreign debt.

The other impacts of currency depreciation are: 617

(i) Windfall gains for export-oriented sectors (such as IT sector, textile, pharmaceuticals, gems and jewellery in
the case of India) because depreciating currency fetches more domestic currency per unit of foreign
currency.

(ii) Remittances to homeland by non-residents and businesses abroad fetches more in terms of domestic
currency
(iii) Depreciation would enhance government revenues from import related taxes, especially if the country
imports more of essential goods

(iv) Depreciation would result in higher amount of local currency for a given amount of foreign currency
borrowings of government.

(v) Depreciation also can have a positive impact on country’s trade deficit as it makes imports more expensive
for domestic consumers and exports cheaper for foreigners.

(vi) Depreciation also can have a positive impact on controlling spiralling gold imports (mostly wasteful) and
thereby improve trade balance.

An appreciation of currency or a strong currency (or possibly an overvalued currency) makes the domestic
currency more valuable and, therefore, can be exchanged for a larger amount of foreign currency. An
appreciation will have the following consequences on real economy:

(i) An appreciation of currency raises the price of exports and, therefore, the quantity of exports would fall.
Since imports become cheaper, we may expect an increase in the quantity of imports. Combining these two
effects together, the domestic aggregate demand falls and, therefore, economic growth is likely to be
negatively impacted.

(ii) The outcome of appreciation also depends on the stage of the business cycle as well. If appreciation sets in
during the recessionary phase, the result would be a further fall in aggregate demand and higher levels of
unemployment. If the economy is facing a boom, an appreciation of domestic currency would trim down
inflationary pressures and soften the rate of growth of the economy.

(iii) An appreciation may cause reduction in the levels of inflation because imports are cheaper. Lower price of
imported capital goods, components and raw materials lead to decrease in cost of production which reflects
on
decrease in prices. Additionally, decrease in aggregate demand tends to lower demand pull inflation. Living
standards of people are likely to improve due to availability of cheaper consumer goods.

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(iv) With increasing export prices, the competitiveness of domestic industry is adversely affected and
therefore, firms have greater incentives to introduce technological innovations and capital-intensive
production to cut costs to remain competitive.

(v) Increasing imports and declining exports are liable to cause larger deficits and worsen the current account.
However, the impact of appreciation on current account depends upon the elasticity of demand for exports
and imports. Relatively inelastic demand for imports and exports may lead to an improvement in the current
account position. Higher the price elasticity of demand for exports, greater would be the fall in demand and
higher will be the fall in the aggregate value of exports. This will adversely affect the current account balance.

(vi) Loss of competitiveness will be insignificant if currency appreciation is because of strong fundamentals of
the economy.

IV Application Oriented Questions

I. Explain the implications of the following on the demand and supply of foreign exchange and the exchange
rate in spot foreign exchange market.

(i) Merry Land’s exports remained more or less stagnant in the years 2005-06 to 2016-17. However, due to
heavy thrust on industrialization, import of machinery, raw materials and components as well as
associated services of different types increased.

(ii) The investors of Merry Land find investments in financial assets in UK highly attractive and the
government of Merry Land which has a liberal attitude on foreign investments permits such investments.

(iii) Many foreign investors who had previously acquired Roseland ’s financial assets sell them.

(iv) Effect on Country Y if Country X borrows $ 100 billion from country Y

ANSWER I

(i) Higher demand in Merry Land for foreign exchange (say $) to make development imports for
industrialization ; coupled with no proportionate increase in supply on account of meagre inflow of foreign
exchange consequent on stagnant exports for more than a decade, lead to rise in exchange rate and
depreciation in the value of domestic currency.

(ii) Increased demand for foreign exchange in Australia; the domestic currency depreciates. 619

(iii) Increased demand for foreign exchange; Roseland’s domestic currency depreciates

(iv) International capital outflow: demand for foreign currency-outflow of foreign exchange, depreciation of
domestic currency
II. Explain how the exchange rate value of Indian Rupee will be affected in each of the following cases. What
are the possible consequences on exports and imports?

(i) The spot exchange rate changes from ₹ 61/ 1$ to₹ 64/1$

(ii) The spot exchange rate changes from ₹ 66/ 1$ to₹ 63/1$

ANSWER II
(i) The spot exchange rate changes from ₹ 61/ 1$ to ₹ 64/1$. It implies depreciation of Rupee and appreciation
of Dollar. Exports become cheaper and more attractive to foreigners; imports will be discouraged as they
become costlier to import.

(ii) The spot exchange rate changes from ₹ 66/ 1$ to ₹ 63/1$. This means that Rupee has appreciated in value
and dollar has depreciated Exports become costlier and so demand for Indian exports may fall;
imports become cheaper.

III. In 1983 Australia decided to float its dollar. Assuming free trade, explain the effects of each of the
following on the spot exchange rate between AUD and USD.

(i) There is a substantial increase demand in Australia for US exports of services. Since Australia
manufactures were favoured over others, there is a proportionate increase in exports of Australian products
to
the US.

(ii) Investors in Australia perceive that the returns on investments in the US would be much more lucrative
than elsewhere. As a result there is a huge increase in demand for investments in US dollar denominated
financial investments

(iii) Political uncertainties in the US due to presidential elections caused large scale shift of Australian

620
financial investments back in to Australia

(iv) An epidemic in some parts of Australia made the US evoke SPS measures and ban the entry of a number
of food items to the US

ANSWER III
(i) The spot exchange rate between AUD and USD will not be affected as increased demand for foreign
currency in each country will be matched by a proportionate increase in the supply of foreign
exchange.

(ii) Investors in Australia would demand more USD for making dollar denominated financial investments in the
US. Supply of US dollars remaining the same, being in floating rate, AUD will depreciate and
USD will appreciate.

(iii) Large scale shift of Australian financial investments back to home due to political uncertainties in the US
would result in large scale sale of financial assets and capital outflow from the US. This will lead to more
inflow of US dollars to Australia and demand remaining the same, depreciation in the value of USD viz a viz
AUD.

(iv) Ban of exports to the US reduces USD inflows to Australia; Supply of USD decreases and demand for USD
remaining the same, AUD may depreciate

UNIT V: INTERNATIONAL CAPITAL MOVEMENTS

I. Multiple Choice Type Questions

1. Which of the following statements is incorrect?

(a) Direct investments are real investments in factories, assets, land, inventories etc. and involve foreign
ownership of production facilities.

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(b) Foreign portfolio investments involve flow of ‘financial capital’

(c) Foreign direct investment (FDI) is not concerned with either manufacture of goods or with provision of
services.

(d) Portfolio capital moves to a recipient country which has revealed its potential for higher returns and
profitability.
ANSWER 1-C

2. Which of the following is a component of foreign capital?

(a) Direct inter government loans

(b) Loans from international institutions (e.g. World Bank, IMF, ADB)

(c) Soft loans for e.g. from affiliates of World Bank such as IDA

(d) All the above

ANSWER 2-D

3. Which of the following would be an example of foreign direct investment from Country X?
(a) A firm in Country X buys bonds issued by a Chinese computer manufacturer.

(b) A computer firm in Country X enters into a contract with a Malaysian firm for the latter to make and sell
to it processors

(c) Mr. Z a citizen of Country X buys a controlling share in an Italian electronics firm

(d) None of the above

ANSWER 3-C

4 Which of the following types of FDI includes creation of fresh assets and production facilities in the host

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country?

(a) Brownfield investment

(b) Merger and acquisition

(c) Greenfield investment

(d) Strategic alliances

ANSWER 4-C

5. Which is the leading country in respect of inflow of FDI to India?

(a) Mauritius

(b) USA

(c) Japan

(d) USA

ANSWER 5-A

6. An argument in favour of direct foreign investment is that it tends to

(a) promote rural development

(b) increase access to modern technology

(c) protect domestic industries

(d) keep inflation under control

ANSWER 6-B

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7. Which of the following is a reason for foreign direct investment?

(a) secure access to minerals or raw materials

(b) desire to capture of large and rapidly growing emerging markets

(c) desire to influence home country industries

(d) (a) and (b) above

ANSWER 7-D

8. A foreign direct investor

(a) May enter India only through automatic route

(b) May enter India only through government route

(c) May enter India only through equity in domestic enterprises

(d) Any of the above

ANSWER 8-D

9. Foreign investments are prohibited in

(a) Power generation and distribution

(b) Highways and waterways

(c) Chit funds and Nidhi company

(d) Airports and air transport

ANSWER 9-C

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10. Which of the following statement is false in respect of FPI?

(a) portfolio capital in general, moves to investment in financial stocks, bonds and other financial
instruments

(b) is effected largely by individuals and institutions through the mechanism of capital market

(c) is difficult to recover as it involves purely long-term investments and the investors have controlling
interest
(d) investors also do not have any intention of exercising voting power or controlling or managing the affairs
of the company

ANSWER 10-C

II. Short Answer Type Questions

1. What are the different types of foreign capital?

ANSWER 1
Foreign aid or assistance, multilateral aid from international organizations like the World Bank, borrowings of
all types; such as, soft loans, external commercial borrowings, deposits from NRIs, and investments both FPI
and FDI.

2. Define foreign direct investment?

ANSWER 2
All investments involving a long-term relationship and reflecting a lasting interest and control of a resident
entity in one economy in an enterprise resident in an economy other than that of the direct investor and occur
through acquisition of more than 10 percent of the shares of the target asset

3. Enumerate the components of foreign direct investment?

ANSWER 3

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FDI has three components, viz., equity capital, reinvested earnings and other direct capital in the form of intra-
company loans

4. Distinguish between horizontal and vertical foreign direct investment

ANSWER 4
A horizontal direct investment is said to take place when the investor establishes the same type of business
operation in a foreign country as it operates in its home country, whereas a vertical investment is one under
which the investor establishes or acquires a business activity in a foreign country which is different from the
investor’s main business activity, yet in some way supplements its major activity.

5. What is meant by foreign portfolio investment?

ANSWER 5
Foreign portfolio investment is the flow of ‘financial capital’ rather than ‘real capital’ and does not involve
ownership, control, or management on the part of the investor.

6. What are the different routes for securing FDI?

ANSWER 6

The main forms of direct investments are: the opening of overseas companies, including the establishment of
subsidiaries or branches, creation of joint ventures on a contract basis, joint development of natural resources
and purchase or annexation of companies in the country receiving foreign capital.

7. What is meant by automatic route?

ANSWER 7

Direct investments through ‘automatic route’ do not need any prior approval either of the Government or of
the Reserve Bank of India

8. Mention the effects of FDI on host country labour.

ANSWER 8

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Benefits of higher wages, better opportunities for employment and skill enhancement, increased productivity,
adverse effects of displacement due to use of capital intensive methods, crowding in jobs requiring low skills,
perpetuation of low labour standards and differential treatment

9. What are the reasons for the speculative nature of foreign portfolio investments?

ANSWER 9
Typically, of short-term nature with no intention to create capital assets; tendency to often speedily shift the
capital from one country to another with changes in prospects of returns.

10. What impact does FDI have on host country employment?

ANSWER 10

Better opportunities for employment, likely to concentrate in less skill requiring jobs, possible displacement
due to use of capital-intensive methods

11. Outline the effect of FDI on technology of host country?

ANSWER 11
Possible state-of-the-art technology transfer, improvement in host country technology (may be inappropriate
for a labour abundant nation). Often criticized for transferring outdated technology

12. Enumerate the effect of FDI on domestic industries?

ANSWER 12
Unequal competition, gainfully outperforms the host country's domestic firms, tendency to undercut a
competitive local industry, may even drive out domestic firms from the industry, exercise a high degree of
market power and exist as monopolists, high growth of wages in foreign corporations can influence a similar
escalation in the domestic corporations, decreasing competitiveness, detrimental to the long term interests

627
13. Do you think FDI would help prevent formation of monopolies?
ANWER 13
Increased competition decreases market power and the chance of formation of monopolies. However, foreign
firms may also act as monopolists.

14. Do you agree with the argument that FDI is likely to reduce employment?
ANSWER 14
Possible due to capital intensive technology which is inappropriate for a labour abundant country;
displacement of labour if industries fail or are forced to close down

15. What are the implications of FDI on domestic resource use?

ANSWER 15
Better and more efficient utilization of available resources, but resources are likely to be unsustainable and
overexploited causing environmental damage.

16. Why did India discourage FDIs in its early stages?

ANSWER 16
Policy of import substitution, extensive controls, selective policy

III. Long Answer Type Questions

1. What are the different types of foreign capital?

ANSWER 1

Foreign capital may flow into an economy in different ways. Some of the important components of foreign
capital flows are:

1. Foreign aid or assistance which may be:

(a) Bilateral or direct inter government grants.

(b) Multilateral aid from many governments who pool funds with international organizations like the World
Bank.

628
(c) Tied aid with strict mandates regarding the use of money or untied aid where there are no such stipulations

(d) Foreign grants which are voluntary transfer of resources by governments, institutions, agencies or
organizations.
2. Borrowings which may take different forms such as:

(a) Direct inter government loans

(b) Loans from international institutions (e.g. world bank, IMF, ADB)

(c) Soft loans for e.g. from affiliates of World Bank such as IDA

(d) External commercial borrowing, and

(e) Trade credit facilities

3. Deposits from non-resident Indians (NRI)

4. Investments in the form of :

(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and
(ii) Foreign direct investment (FDI) in industrial, commercial and similar other enterprises

2. Define foreign direct investment (FDI). What are the features of FDI?

ANSWER 2
Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is "all investments
involving a long-term relationship and reflecting a lasting interest and control of a resident entity in one
economy in an enterprise resident in an economy other than that of the direct investor”. This typically occurs
through acquisition of more than 10 percent of the shares of the target asset. Direct investment comprises not
only the initial transaction establishing the relationship between the investor and the enterprise, but also all
subsequent transactions between them and among affiliated enterprises, both incorporated and
unincorporated.

Based on the nature of foreign investments, FDI may be categorized as horizontal, vertical or conglomerate. 629

i) A horizontal direct investment is said to take place when the investor establishes the same type of business
operation in a foreign country as it operates in its home country, for example, a cell phone service provider
based in the United States moving to India to provide the same service.

ii) A vertical investment is one under which the investor establishes or acquires a business activity in a foreign
country which is different from the investor’s main business activity yet in some way supplements its major
activity. For example; an automobile manufacturing company may acquire an interest in a foreign company
that supplies parts or raw materials required for the company.

iii) A conglomerate type of foreign direct investment is one where an investor makes a foreign investment in a
business that is unrelated to its existing business in its home country. This is often in the form of a joint
venture with a foreign firm already operating in the industry, as the investor has no previous experience.

3. What are the characteristics of foreign portfolio investments (FPI)?

ANSWER 3

Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than ‘real capital’ and
does not involve ownership or control on the part of the investor. Examples of foreign portfolio investment
are the deposit of funds in an Indian or a British bank by an Italian company, the purchase of a bond (a
certificate of indebtedness) of a Swiss company or the Swiss government by a citizen or company based in
France. Unlike FDI, portfolio capital, in general, moves to investment in financial stocks, bonds and other
financial instruments and is effected largely by individuals and institutions through the mechanism of
capital market. These flows of financial capital have their immediate effects on balance of payments or
exchange rates rather than on production or income generation.

Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or with provision of
services. Such investors also do not have any intention of exercising voting power or controlling or managing
the affairs of the company in whose securities they invest. The sole intention of a foreign portfolio investor is
to earn a remunerative return through investment in foreign securities and is primarily concerned about the
safety of their capital, the likelihood of appreciation in its value, and the return generated. Logically, portfolio
capital moves to a recipient country which has revealed its potential for higher returns
and profitability.

4. Describe the factors influencing foreign direct investments? 630

ANSWER 4

Investments move across borders on account of:

(i) the increasing interdependence of national economies and the consequent trade relations and
international industrial cooperation established among them
(ii) internationalisation of production and investment of transnational corporations in their subsidiaries and
affiliates.

(iii) desire to reap economies of large-scale operation arising from technological growth

(iv) lack of feasibility of licensing agreements with foreign producers in view of the rapid rate of technological
innovations

(v) necessity to retain direct control of production knowledge or managerial skill (usually found in
monopolistic or oligopolistic markets) that could easily and profitably be utilized by corporations

(vi) desire to procure a promising foreign firm to avoid future competition and the possible loss of export
markets

(vii) risk diversification so that recessions or downturns may be experienced with reduced severity

(viii) shared common language or common boundaries and possible saving in time and transport costs because
of geographical proximity

(ix) necessity to retain complete control over its trade patents and to ensure consistent quality and service or
for creating monopolies in a global context

(x) promoting optimal utilization of physical, human, financial and other resources

(xi) desire to capture large and rapidly growing high potential emerging markets with substantially high and
growing population

(xii) ease of penetration into the markets of those countries that have established import restrictions such as
blanket bans, high customs duties or non-tariff barriers which make it difficult for the foreign firm to sell in the
host-country market by ‘getting behind the tariff wall’.

(xiii) lower environmental standards in the host country and the consequent relative savings in costs

(xiv) stable political environment and overall favourable investment climate in the host country

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(xv) higher degree of openness to foreign capital exhibited by the recipient country and the prevalence of
preferential investment systems such as special economic zones to encourage direct foreign investments

(xvi) the strategy to obtain control of strategic raw material or resource so as to ensure their uninterrupted
supply at the lowest possible price; usually a form of vertical integration
(xvii) desire to secure access to minerals or raw material deposits located elsewhere and earn profits through
processing them to finished form (Eg.FDI in petroleum)

(xviii) the existence of low relative wages in the host country because of relative labour abundance coupled
with shortage and high cost of labour in capital exporting countries, especially when the production process is
labour intensive.

(xix) lower level of economic efficiency in host countries and identifiable gaps in development

(xx) tax differentials and tax policies of the host country which support foreign direct investment. However, a
low tax burden cannot compensate for a generally fragile and unattractive FDI environment.

(xxi) inevitability of defensive investments in order to preserve a firm’s competitive position

(xxii) high gross domestic product and high per capita income coupled with their high rate of growth. There
are also other philanthropic objectives such as strengthening of socio-economic infrastructure, alleviation of
poverty and maintenance of ecological balance of the host country, and

(xxiii) prevalence of high standards of social amenities and possibility of good quality of life in the host country

5. What are the benefits of foreign direct investments to the host country?

ANSWER 5

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Following are the benefits ascribed to foreign investments:

1. Entry of foreign enterprises usually fosters competition and generates a

competitive environment in the host country. The domestic enterprises are compelled to compete with the
foreign enterprises operating in the domestic market. This results in positive outcomes in the form of
costreducing and quality-improving innovations, higher efficiency and increasing variety of better products
and services at lower prices ensuring wider choice and welfare for consumers.
2. International capital allows countries to finance more investment than can be supported by domestic
savings. The provision of increased capital to work with labour and other resources available in the host
country can enhance the total output/GDP (as well as output per unit of input) flowing from the factors of
production.

3. From the perspective of emerging and developing countries, FDI can accelerate growth and foster economic
development by providing the much needed capital, technological know-how, management skills, marketing
methods and critical human capital skills in the form of managers and technicians. The spill-over effects of the
new technologies usually spread beyond the foreign corporations. In addition, the new technology can
clearly enhance the recipient country's production possibilities.

4. Competition for FDI among national governments also has helped to promote political and structural
reforms important to attract foreign investors, including legal systems and macroeconomic policies.

5. Since FDI involves setting up of production base (in terms of factories, power plants, etc.), it generates
direct employment in the recipient country. Subsequent FDI as well as domestic investments propelled in the
downstream and upstream projects that come up in multitude of other services, generate multiplier effects on
employment and income/GDP.

6. FDI not only creates direct employment opportunities but also, through backward and forward linkages,
generate indirect employment opportunities. This impact is particularly important if the recipient country is
a developing country with an excess supply of labour caused by population pressure.

7. Foreign direct investments also promote relatively higher wages for skilled jobs. More indirect employment
will be generated to people in the lowerend services sector occupations thereby catering to an extent even to
the less educated and unskilled persons engaged in those units.

8. Foreign corporations provide better access to foreign markets. Unlike portfolio investments, FDI generally 633
entails people-to-people relations and is usually considered as a promoter of bilateral and international
relations. Greater openness to foreign capital leads to higher national dependence on international investors,
making the cost of discords higher.

9. There is also greater possibility for the promotion of ancillary units resulting in job creation and skill
development for workers.
10. Foreign enterprises possessing marketing information with their global network of marketing are in a
unique position to utilize these strengths to promote the exports of developing countries. If the foreign capital
produces goods with export potential, the host country is in a position to secure scarce foreign exchange
needed to import capital equipments or materials to assist the country's development plans or to ease its
external debt servicing.

11. If the host country is in a position to implement effective tax measures, the foreign investment projects
also would act as a source of new tax revenue which can be used for development projects.

12. It is likely that foreign investments enter into industries in which economies of scale can be realized so that
consumer prices may be reduced. Domestic firms might not always be able to generate the necessary capital
to achieve the cost reductions associated with large-scale production.

13. Increased competition resulting from the inflow of foreign direct investments facilitates weakening of the
market power of domestic monopolies resulting in a possible increase in output and fall in prices.

14. Since FDI has a distinct advantage over the external borrowings, it is considered to have a favourable
impact on the host country’s balance of payment position, and

15. Better work culture and higher productivity standards brought in by foreign firms may possibly induce
productivity related awareness and may also contribute to overall human resources development.

6. Critically examine the general arguments put forth against entry of foreign capital.

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ANSWER 6

Following are the general arguments put forth against the entry of foreign capital:

1) FDIs are likely to concentrate on capital-intensive methods of production and service so that they need to
hire only relatively few workers. Such technology is inappropriate for a labour-abundant country as it does not
support generation of jobs which is a crucial requirement to address the two fundamental areas of concern for
the less developed countries namely, poverty and unemployment
2) The inherent tendency of FDI flows to move towards regions or states which are well endowed in terms of
natural resources and availability of infrastructure has the potential to accentuate regional disparity. Foreign
capital is also criticized for accentuating the already existing income inequalities in the host country.

3) In the context of developing countries, it is usually alleged that the inflow of foreign capital may cause the
domestic governments to slow down its efforts to generate more domestic savings, especially when tax
mechanisms are difficult to implement. If the foreign corporations are able to secure incentives in the form of
tax holidays or similar provisions, the host country loses tax revenues.

4) Often, the foreign firms may partly finance their domestic investments by borrowing funds in the host
country's capital market. This action can raise interest rates in the host country and lead to a decline in
domestic investments through ‘crowding-out’ effect. Moreover, suppliers of funds in developing economies
would prefer foreign firms due to perceived lower risks and such shifts of funds may divert capital away from
investments which are crucial for the development needs of the country.

5) The expected benefits from easing of the balance of payments situation might remain unrealised or
narrowed down due to the likely instability in the balance of payments and the exchange rate. Obviously, FDI
brings in more foreign exchange, improves the balance of payments and raises the value of the host country's
currency in the exchange markets. However, when imported inputs need to be obtained or when profits are
repatriated, a strain is placed on the host country's balance of payments and the home currency leading to its
depreciation. Such instabilities jeopardize long-term economic planning. Foreign corporations also have a
tendency to use their usual input suppliers which can lead to increased imports. Also, large scale
repatriation of profits can be stressful on exchange rates and the balance of payments.

6) Jobs that require expertise and entrepreneurial skills for creative decision making may generally be retained
in the home country and therefore the host country is left with routine management jobs that demand only
lower levels of skills and ability. The argument of possible human resource development and acquisition of

635
new innovative skills through FDI may not be realized in reality.

7) High profit orientation of foreign direct investors tend to promote a distorted pattern of production and
investment such that production could get concentrated on items of elite and popular consumption and on
nonessential items.
8) Foreign entities are usually accused of being anti-ethical as they frequently resort to methods like
aggressive advertising and anticompetitive practices which would induce market distortions.

9) A large foreign firm with deep pockets may undercut a competitive local industry because of various
advantages (such as in technology) possessed by it and may even drive out domestic firms from the industry
resulting in serious problems of displacement of labour. The foreign firms may also exercise a high degree of
market power and exist as monopolists with all the accompanying disadvantages of monopoly. The high
growth of wages in foreign corporations can influence a similar escalation in the domestic corporations which
are not able to cover this increase with growth of productivity. The result is decreasing competitiveness of
domestic companies which might prove detrimental to the long-term interests of industrial development of
the host country.

10) FDI usually involves domestic companies ‘off –shoring’, or shifting jobs and operations abroad in pursuit of
lower operating costs and consequent higher profits. This has deleterious effects on employment potential of
home country.

11) The continuance of lower labour or environmental standards in host countries is highly appreciated by the
profit seeking foreign enterprises. This is of great concern because efforts to converge such standards often
fail to receive support from interested parties.

12) At times, there is potential national security considerations involved when foreign firms function in the
territory of the host country, especially when acute hostilities prevail.

13) FDI may have adverse impact on the host country's commodity terms of trade (defined as the price of a

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country's exports divided by the price of its imports). This could occur if the investments go into production of
export oriented goods and the country is a large country in the sale of its exports. Thus, increased exports
drive down the price of exports relative to the price of imports.

14) FDI is also held responsible by many for ruthless exploitation of natural resources and the possible
environmental damage.
15) With substantial FDI in developing countries there is a strong possibility of emergence of a dual economy
with a developed foreign sector and an underdeveloped domestic sector.

16) Perhaps the most disturbing of the various charges levied against foreign direct investment is that a large
foreign investment sector can exert excessive amount of power in a variety of ways so that there is potential
loss of control by host country over domestic policies and therefore the less developed host country’s
sovereignty is put at risk. Mighty multinational firms are often criticized of corruption issues, unduly
influencing policy making and evasion of corporate social responsibility.

7. Write a note on foreign direct investment in India.

ANSWER 7

FOREIGN DIRECT INVESTMENT IN INDIA

FDI is an important monetary source for India's economic development. The import-substitution strategy of
industrialisation followed by India postindependence, stressed on an extremely careful and selective approach
while formulating FDI policy. Extensive controls imposed by the government severely restricted the inflow of
foreign capital to India. The enactment of the Foreign Exchange Regulation Act (FERA), 1973 consolidated the
regulatory framework with stipulations of up to 40 per cent of foreign equity holding in a joint venture.
The Industrial Policy announcements of 1980 and 1982 and the Technology Policy Statement (1983) provided
for a moderately lenient attitude towards foreign investments by endorsement of manufacturing exports as
well as modernization of industries through liberalised imports of capital goods and technology. This was
supplemented by trade liberalisation measures in the form of tariff reduction and shifting of large number of
items from import licensing to Open General Licensing (OGL).
The most important shift in investment policy occurred when India embarked upon economic liberalisation
and reforms programme in 1991 to raise its growth potential and to integrate with the world economy.
Further reforms in subsequent years put in place a series of measures directed towards liberalizing foreign
investments and for ensuring access to foreign technology and funding.

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8. Give an account of overseas direct investments by Indian companies?

ANSWER 8

OVERSEAS DIRECT INVESTMENTBY INDIAN COMPANIES

Integration of the Indian economy with the rest of the world is evident not only in terms of higher level of FDI
inflows but also in terms of increasing level of FDI outflows. The overseas foreign direct investments by the
Indian entrepreneurs are called Out-bound investments. Direct investment outside India means investments,
either under the automatic route or the government approval route, by way of contribution to the capital or
subscription to the memorandum of a foreign entity or by way of purchase of existing shares of a foreign
entity either by market purchase or private placement or through stock exchange, signifying a long-term
interest in the foreign entity (joint venture (JV) / wholly owned subsidiary (WOS).

Indian corporates can also invest overseas other than by way of directinvestments. Listed Indian companies
can invest up to 50% of their net worth as on the date of the last audited Balance Sheet in overseas
companies, listed on a recognized stock exchange, or in the rated debt securities issued by such
companies. Outbound investments from India have undergone substantial changes not only in terms of size
but also in terms of geographical spread and sectoral composition. The total financial commitment (equity
+loan+ guarantee issue) on outward Foreign Direct Investment (OFDI) from India stood at US$
805.86 million in the month of June, 2020. The overseas investments have been primarily driven by resource
seeking, market seeking or technology seeking motives. Many Indian IT firms like Tata Consultancy Services,
Infosys, WIPRO, and Satyam acquired global contracts and established overseas offices in developed
economies to be close to their key clients. Recently, there has been a surge in resource seeking overseas
investments by Indian companies, especially to acquire energy resources in Australia, Indonesia and Africa.
Indian entrepreneurs are also choosing investment destinations in countries such as Mauritius, Singapore,
British Virgin Islands, and the Netherlands on account of higher tax benefits they provide.

17. Which are the sectors in India where FDI is prohibited? Why?

ANSWER 17

In India, foreign investment is prohibited in the following sectors:

(i) Lottery business including Government / private lottery, online lotteries, etc.

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(ii) Gambling and betting including casinos etc.

(iii) Chit funds

(iv) Nidhi company

(v) Trading in Transferable Development Rights (TDRs)

(vi) Real Estate Business or Construction of Farm Houses

(vii) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

(viii) Activities / sectors not open to private sector investment e.g. atomic energy and railway operations
(other than permitted activities).

IV Application Oriented Questions

1. Which of the following is FDI?

(i) Claram Joe, a German investor buys 5000 shares of Ford, a US Automobile company.

(ii) Annette D, the US Company acquires all the equity shares of Emeline & Co in Alice Land which makes
computer components.

(iii) A Bulgarian investor Boryana Gergiev pays cash and buys 0.2 % of all outstanding equity shares of
Mariette company which makes computer peripherals

(iv) Maansi Tech solutions purchase 52% stake in a Sarra, a Jamaican technology firm

(v) Kora extends a loan to Christa Victorine, a power producing firm in which it holds 60 percent of equity

(vi) Augusta Corp lends pounds 10 million to Lee Sud, a Dutch parts making firm in which it holds 79 percent
of equity

ANSWER 1

i. Not FDI because less than 10 percent (which is the globally accepted criterion)

ii. FDI since 100 percent shares are bought

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iii. Not FDI because an insignificant part of the total stake is acquired

iv. FDI because it involves more than 10 percent of the company’s shares.

v. FDI; lending to a company in which Kora has majority stake

vi. FDI refer (e)above

2. a) Labour group in your country oppose the flow of FDI into the country on grounds of perceived
inequities consequent on FDI. What are their arguments?

b) Beth & Sushil are members of the committee for resolution of the issue cited above. What arguments
would they put forth to convincethe labour groups with respect to welfare implications for labour that
may arise from FDI?

ANSWER 2

a) Foreign corporates concentrate on capital-intensive methods of production - so they need to hire only
relatively few workers, technology inappropriate for a labour-abundant country - does not support generation
of jobs or address poverty and unemployment help accentuate the already existing income inequalities- jobs
that
require expertise and entrepreneurial skills for creative decision making may generally be retained in the
home country and therefore the host country is left with routine management jobs that demand only lower
levels of skills and ability. The argument of possible human resource development and acquisition of new
innovative skills through FDI may not be realized in reality- may resort to anti-ethical, and anticompetitive
practices- ‘off –shoring’, or shifting jobs – negative effects on employment potential of home country-
continuance of
lower labour or environmental standards and ruthless labour and natural resources exploitation.

b) FDI will - accelerate growth and foster economic development – bring in technological know-how,
management skills and marketing methods- generate direct employment in the recipient country-
Subsequent FDI as well as domestic investments propelled in the downstream and upstream projects that
come up in multitude of other services generate multiplier effects on employment and income
- generate indirect employment opportunities-- promote relatively higher wages for skilled jobs- more indirect
employment will be generated to persons in the lower-end services sector occupations thereby catering to an
extent even to the less educated and unskilled engaged in those units- Better work culture and higher
productivity standards- induce productivity related awareness and may also contribute to overall human

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resources development
 RTP- NOV 2020
PART A: FINANCIAL MANAGEMENT

QUESTIONS
Ratio Analysis

1. Following information has been provided from the books of M/s Laxmi & Co. for the year ending
on 31st March, 2020:

Net Working Capital ₹ 4,80,000

Bank overdraft ₹ 80,000
Fixed Assets to Proprietary 0.75
ratio
Reserves and Surplus ₹ 3,20,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5

You are required to PREPARE a summarised Balance Sheet as at 31st March, 2020.

ANSWER 1

Working notes: (i) Current Assets and Current Liabilities computation:

Current assets / Current liabilities = 2.5 / 1

Or
Current assets = 2.5 Current liabilities
Now, Working capital = Current assets - Current liabilities

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Or ₹ 4,80,000 = 2.5 Current liability -Current liability
Or 1.5 Current liability = ₹ 4,80,000

Current Liabilities = ₹ 3,20,000

So, Current Assets = ₹ 3,20,000 X 2.5 = ₹ 8,00,000

(ii) Computation of stock

(iii) Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors

Capital = Proprietary fund - Reserves & Surplus

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= ₹ 19,20,000 - ₹ 3,20,000 = ₹ 16,00,000

Sundry Creditors = (Current liabilities -Bank overdraft)

= (₹ 3,20,000 - ₹ 80,000) = ₹ 2,40,000
Balance Sheet as at 31st March, 2020

Cost of Capital
2 CALCULATE the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:

Particulars (₹)
Debentures (₹ 100 per debenture) 5,00,000
Preference shares (₹ 100 per share) 5,00,000
Equity shares (₹ 10 per share) 10,00,000
20,00,000

The market prices of these securities are:

Debentures ₹ 105 per debenture
Preference shares ₹ 110 per preference share
Equity shares ₹ 24 each.
Additional information:

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₹ 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10-year maturity

₹ 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year maturity.

Equity shares has ₹ 4 floatation cost and market price ₹ 24 per share.

The next year expected dividend is ₹ 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.

ANSWER 2

(i) Cost of Equity (Ke)

(ii) Cost of Debt (Kd)

Current market price (P0) – floatation cost = I(1-t) × PVAF(r,10) + RV × PVIF(r,10)

₹ 105 – 4% of ₹ 105 = ₹ 10 (1-0.3) × PVAF (r,10) + ₹ 100 × PVIF (r,10)

Calculation of NPV at discount rate of 5% and 7%

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Calculation of IRR

Cost of Debt (Kd) = 6.89%

(iii) Cost of Preference shares (Kp)

Current market price (P0) – floatation cost = PD × PVAF(r,10) + RV × PVIF(r,10)

₹ 110 – 2% of ₹ 110 = ₹ 5 × PVAF (r,10) + ₹ 100 × PVIF (r,10)

Calculation of NPV at discount rate of 3% and 5%

Calculation of IRR

Cost of Preference Shares (Kp) = 4.08%

(a) Calculation of WACC using book value weights

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WACC (Ko) = 0.07743 or 7.74%

(b) Calculation of WACC using market value weights

WACC (Ko) = 0.0859 or 8.59%

Capital Structure
3 Xylo Ltd. is considering two alternative financing plans as follows:

Particulars Plan – A (₹) Plan – B (₹)

Equity shares of ₹ 10 each 8,00,000 8,00,000
Preference Shares of ₹ 100 each - 4,00,000
12% Debentures 4,00,000 -
12,00,000 12,00,000

The indifference point between the plans is ₹ 4,80,000. Corporate tax rate is 30%. CALCULATE the rate of
dividend on preference shares.

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ANSWER 3

Computation of Rate of Preference Dividend

Leverage

4. The capital structure of PS Ltd. for the year ended 31st March, 2020 consisted as follows

Particulars Amount in ₹
Equity share capital (face value ₹ 100 each) 10,00,000
10% debentures (₹ 100 each) 10,00,000

During the year 2019-20, sales decreased to 1,00,000 units as compared to 1,20,000 units in the
previous year. However, the selling price stood at ₹ 12 per unit and variable cost at
₹ 8 per unit for both the years. The fixed expenses were at ₹ 2,00,000 p.a. and the income

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tax rate is 30%.
You are required to CALCULATE the following:
(a) The degree of financial leverage at 1,20,000 units and 1,00,000 units.
(b) The degree of operating leverage at 1,20,000 units and 1,00,000 units.
(c) The percentage change in EPS.
ANSWER 4

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 Investment Decisions

5. A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product. At
present, the waste is removed by a contractor for disposal on payment by the company of ₹ 150
lakh per annum for the next four years. The contract can be terminated upon installation of the
aforesaid machine on payment of a compensation of ₹ 90 lakh before the processing operation
starts. This compensation isnot allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ₹ 600 lakh to be financed by a
loan repayable in 4 equal instalments commencing from end of the year 1. The interest rate is
14% per annum. At the end of the 4th year, the machine can be sold for ₹ 60 lakh and the cost
of dismantling and removal will be ₹45 lakh.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated
as under: (₹ In lakh)

Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax 150 114 84 63
rules)

Initial stock of materials required before commencement of the processing operations is ₹ 60 lakh at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be ₹ 165 lakh
and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for ₹ 30 lakh per annum. Labour costs include wages of 40 workers, whose
transfer to this process will reduce idle time payments of ₹ 45 lakh in the year - 1 and ₹ 30 lakh in the year -

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2. Factory overheads include apportionment of general factory overheads except to the extent of insurance
charges of ₹ 90 lakh per annum payable on this venture. The company’s tax rate is 30%.

Present value factors for four years are as under:

Year 1 2 3 4
PV factors @14% 0.877 0.769 0.67 0.59
4 2
ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.

ANSWER 5

Statement of Operating Profit from processing of waste (₹ in lakh)

Statement of Incremental Cash Flows (₹ in lakh)

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Advice: Since the net present value of cash flows is ₹ 577.36 lakh which is positive the management should
install the machine for processing the waste.

Notes:
(i) Material stock increases are taken in cash flows.
(ii) Idle time wages have also been considered.
(iii) Apportioned factory overheads are not relevant only insurance charges of this project are relevant.
(iv) Interest calculated at 14% based on 4 equal instalments of loan repayment.
(v) Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital gains ignored.
(vi) Saving in contract payment and income tax thereon considered in the cash flows.

Management of Receivables (Debtors)

6. A company wants to follow a more prudent policy to improve its sales for the region which is ₹ 9
lakhs per annum at present, having an average collection period of 45 days. After certain researches,
the management consultant of the company reveals the following information:

Credit Increase in Increase in Present default

Policy collection sales anticipated
period
W 15 days ₹ 60,000 1.5%
X 30 days ₹ 90,000 2%
Y 45 days ₹ 1,50,000 3%
Z 70 days ₹ 2,10,000 4%

The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable costs per unit are ₹ 2. The
current bad debt loss is 1%. Required return on additional investment is 20%. (Assume 360 days year)

ANALYSE which of the above policies would you recommend for adoption?

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ANSWER 6

A. Statement showing the Evaluation of Debtors Policies (Total Approach)

(Amount in ₹)
Recommendation: The Proposed Policy W (i.e. increase in collection period by 15 days or total 60 days) should
be adopted since the net benefits under this policy are higher as compared to other policies.

Working Notes:

(i) Calculation of Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of Units sold
= [₹ 2.25 - ₹ 2.00] × (₹ 9,00,000/3)
= ₹ 0.25 × 3,00,000 = ₹ 75,000

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B. Another method of solving the problem is Incremental Approach. Here we assume that sales are all credit
sales. (Amount in ₹)

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Recommendation: The Proposed Policy W should be adopted since the net benefits under this policy are
higher than those under other policies.

C. Another method of solving the problem is by computing the

Expected Rate of Return.

Recommendation: The Proposed Policy W should be adopted since the Expected Rate of Return (41.96%) is
more than the Required Rate of Return (20%) and is highest among the given policies compared

Risk Analysis in Capital Budgeting

7. A&R Ltd. is considering one of two mutually exclusive proposals, Projects - X and Y, which require cash
outlays of ₹ 42,50,000 and ₹ 41,25,000 respectively. The certainty-equivalent (C.E) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bonds is 5.5% and
this is used as the risk-free rate. The expected net cash flows and their certainty equivalents are as
follows:

Project Project
X Y
Year- Cash Flow C.E. Cash Flow C.E.
end (₹) (₹)

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1 16,50,000 0.8 16,50,000 0.9
2 15,00,000 0.7 16,50,000 0.8
3 15,00,000 0.5 15,00,000 0.7
4 20,00,000 0.4 10,00,000 0.8
5 21,00,000 0.6 8,00,000 0.9

The Present value (PV) factor @ 5.5% is as follows:

 Year 0 1 2 3 4 5
PV factor 1 0.947 0.898 0.851 0.807 0.765
Required:
DETERMINE the project that should be accepted?

ANSWER 7

Calculation of Net Present Value (NPV) of Project X

Calculation of Net Present Value (NPV) of Project Y

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Project Y has NPV of ₹ 5,56,605/- which is higher than the NPV of Project X. Thus, A&R Ltd. should accept
Project Y.

Dividend Decisions

8. The following information is given for QB Ltd.

Earnings per share ₹ 120

Dividend per share ₹ 36
Cost of capital 15%
Internal Rate of Return on investment 20%

CALCULATE the market price per share using

(a) Gordon’s formula

(b) Walter’s formula

ANSWER 8

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Management of working Capital

9.
The following figures and ratios are related to a company:

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You are required to PREPARE:

(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a provision for
contingencies @ 15 percent of net working capital.
ANSWER 9

Working Notes:

(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)

= ₹ 90,00,000 – ₹ 31,50,000
= ₹ 58,50,000

(ii) Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 58,50,000/6 = ₹ 9,75,000

(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover

= ₹ 58,50,000/1.5
= ₹ 39,00,000

(iv) Current Assets:

Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
Current Assets = Amount of Inventories (Stock) × 2.5/1
= ₹ 9,75,000 × 2.5/1 = ₹ 24,37,500

(v) Liquid Assets (Receivables and Cash)

= Current Assets – Inventories (Stock)
= ₹ 24,37,500 – ₹ 9,75,000
= ₹14,62,500

(vi) Receivables (Debtors) = Sales × Debtors Collection period /12

= ₹ 90,00,000 × 1/12

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= ₹ 7,50,000

(vii) Cash = Liquid Assets – Receivables (Debtors)

= ₹14,62,500 – ₹ 7,50,000 = ₹ 7,12,500

(viii) Net worth = Fixed Assets /1.3

= ₹ 39,00,000/1.3 = ₹ 30,00,000
(ix) Reserves and Surplus
Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
Reserves and Surplus = ₹ 30,00,000 × 1/2.5
= ₹ 12,00,000

(x) Share Capital = Net worth – Reserves and Surplus

= ₹ 30,00,000 – ₹ 12,00,000
= ₹ 18,00,000

(xi) Current Liabilities = Current Assets/ Current Ratio

= ₹ 24,37,500/2.5 = ₹ 9,75,000

(xii) Long-term Debts

Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ₹30,00,000 × 0.7875 = ₹23,62,500

(a) Balance Sheet of the Company

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(b) Statement Showing Working Capital Requirement

Miscellaneous
10. (a) EXPLAIN agency problem and agency cost. How to address the issues of the same.
(b) COMPARE between Financial Lease and Operating Lease.

ANSWER 10

(a)
Though in a sole proprietorship firm, partnership etc., owners participate in management but in corporates,
owners are not active in management so, there is a separation between owner/ shareholders and managers.
In theory managers should act in the best interest of shareholders , however, in reality, managers may try to
maximise their individual goal like salary, perks etc., so there is a principal agent relationship between
managers and owners, which is known as Agency Problem. In a nutshell, Agency Problem is the chances that
managers may place personal goals ahead of the goal of owners. Agency Problem leads to Agency Cost.

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Agency cost is the additional cost borne by the shareholders to monitor the manager and control their
behaviour so as to maximise shareholders wealth. Generally, Agency Costs are of four types
(i) monitoring (ii) bonding (iii) opportunity (iv) structuring

Addressing the agency problem

The agency problem arises if manager’s interests are not aligned to the interests of the debt lender and equity
investors. The agency problem of debt lender would be addressed by imposing negative covenants i.e. the
managers cannot borrow beyond a point. This is one of the most important concepts of modern day finance
and the application of this would be applied in the Credit Risk Management of Bank, Fund Raising, Valuing
distressed companies.
Agency problem between the managers and shareholders can be addressed if the interests of the managers
are aligned to the interests of the shareholders. It is easier said than done.

However, following efforts have been made to address these issues:

Managerial compensation is linked to profit of the company to some extent and also with the long term
objectives of the company.

Employee is also designed to address the issue with the underlying assumption that maximisation of the
stock price is the objective of the investors.
Effecting monitoring can be done.

(b)

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SECTION: B: ECONOMICS FOR FINANCE

QUESTIONS

1. (a) From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.
Items In Cr.
Operating surplus 2000
Mixed income of self-employed 1100
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed capital 400
Net factor income from abroad - 50
Compensation of employees 1000

(b) A sells a used car to B and receives Rs. 60,000. How much of the sale proceeds will be included in
national income calculation?

ANSWER 1

(a) GDPMP = Compensation of employees + mixed income of self-employed + operating surplus + depreciation
+ net indirect taxes
= 1000 crores + 1100 crores + 2000 crores + 400 crores + 450 crores = 4950 crores
GNPMP = GDPMP + NFIA
= 4950 crores + (-50) crores = 4900 crores
NNPMP = GNPMP – consumption of fixed capital
= 4900 crores – 400 crores = 4500 crores
NNPFC or NI = NNPMP- NIT
= 4500 crores – 450 crores= 4050 crores

(b) National income is a flow measure of output per time period—for example, per year—and includes only
those goods and services currently produced i.e. produced during the time interval under consideration. The
value of market transactions such as exchange of goods which already exist or are previously produced, do not

662
enter into the calculation of national income. No part of the used car sales proceeds of Rs 60,000 will be
included in national income calculation because sale of a used car represents transfer of existing asset which
was produced during some earlier year and was accounted in the national income calculation of that year.
2. (a) An economy is characterized by the following equation-
Consumption C = 60+0.9Yd
Investment I = 10
Government expenditure G = 10
Tax T = 0
Exports X = 20
Imports M = 10 +0.05 Y
Find equilibrium income and trade balance.

(b) Explain (with the aid of a diagram) how an increase in the marginal propensity to consume impacts
consumption expenditure.

ANSWER 2

(a) Y = C + I+ G + (X – M)
= 60+0.9(Y – 0) + 10 +10 + (20- 10 -0.05Y)
= 60+ 0.9 Y +30 -0.05 Y
Y = 600
Trade Balance = X – M = - 20
Thus trade balance is in deficit.

(b) An increase in marginal propensity to consume implies that the proportion of income that is spent on
consumption increases with an increase in income. In other words, except for an income level of zero, at each
income level, the level of consumption spending is higher. The vertical intercept is unchanged as autonomous
consumption remains unchanged; but the slope of the consumption curve would be higher and it will spin
upwards. For example, if consumption function 20+ .6Y changes to 20+ .8Y, for an income of 200, consumption
rises from 140 to 180.
(The students need to draw diagram to illustrates the same).

3. (a) According to Richard Musgrave, there are three branch taxonomy of the role of government in a
market economy? Explain them.

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(b) Why do economists use the word external to describe third-party effects that are harmful or beneficial?

ANSWER 3

(a) Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three-branch
taxonomy of the role of government in a market economy namely, resource allocation, income redistribution
and macroeconomic stabilization. The allocation and distribution functions are primarily microeconomic
functions, while stabilization is a macroeconomic function. The allocation function aims to correct the sources
of inefficiency in the economic system while the distribution role ensures that the distribution of wealth and
income is fair. Monetary and fiscal policy, the problems of macroeconomic stability, maintenance of high
levels of employment and price stability etc. fall under the stabilization function.

(b) Economists use the word ‘external’ to describe third-party effects that are harmful or beneficial because
sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part
of the market price. Such costs or benefits which are not accounted for by the market price are called
externalities because they are “external” to the market. Or in other words, externalities are costs or benefits
that result from an activity or transaction and affect a third party who did not choose to incur the cost or
benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.

4. (a) Explain why do governments provide subsidies? Illustrate a few examples of subsidies.

(b) Describe the concept of price floors with examples.

ANSWER 4

(a) Subsidy is market-based policy and involves the government paying part of the cost to the firms in order to
promote the production of goods having positive externalities. Or in other words, a subsidy on a good which
has substantial positive externalities would reduce its cost and consequently price, shift the supply curve to
the right and increase its output. A higher output that would equate marginal social benefit and marginal
social cost is socially optimal. There are many forms of subsidies given out by the government. Two of the
most common types of individual subsidies are welfare payments and unemployment benefits. The objective
of these types of subsidies is to help people who are temporarily suffering economically. Other subsidies, such
as subsidized interest rates on student loans, are given to encourage people to further their education.

(b) Price floor is defined as an intervention to raise market prices if the government feels the price is too low.
In this case, since the new price is higher, the producers benefit. For a price floor to be effective, the minimum
price has to be higher than the equilibrium price. For example, many governments intervene by establishing
price floors to ensure that farmers make enough money by guaranteeing a minimum price at which their
goods can be sold for. The most common example of a price floor is the minimum wage. This is the minimum
price that employers can pay workers for their labour.

5. The tradable emissions permits are claimed to have certain advantages. Explain. 664

ANSWER 5

Tradable emissions permits are marketable licenses to emit limited quantities of pollutants and can be bought
and sold by polluters. Under this method, each firm has permits specifying the number of units of emissions
that the firm is allowed to generate. A firm that generates emissions above what is allowed by the permit is
penalized with substantial monetary sanctions. These permits are transferable, and therefore different
pollution levels are possible across the regulated entities.
Permits are allocated among firms, with the total number of permits so chosen as to achieve the desired
maximum level of emissions. By allocating fewer permits than the free pollution level, the regulatory agency
creates a shortage of permits which then leads to a positive price for permits. This establishes a price for
pollution, just as in the tax case. The high polluters have to buy more permits, which increases their costs, and
makes them less competitive and less profitable. The low polluters receive extra revenue from selling their
surplus permits, which makes them more competitive and more profitable. Therefore, firms will have an
incentive not to pollute. India is experimenting with tradable emissions permits in the form of Perform,

Achieve & Trade (PAT) scheme and carbon tax in the form of a cess on coal. The advantages claimed for
tradable permits are that the system allows flexibility and reward efficiency and it is administratively cheap
and simple to implement and ensures that pollution is minimised in the most cost-effective way. It also
provides strong incentives for innovation and consumers may benefit if the extra profits made by low
pollution firms are passed on to them in the form of lower prices.

The main argument in opposition to the employment of tradable emission permits is that they do not in reality
stop firms from polluting the environment; they only provide an incentive to them to do so. Moreover, if firms
have monopoly power of some degree along with a relatively inelastic demand for its product, the extra cost
incurred for procuring additional permits so as to further pollute the atmosphere, could easily be
compensated by charging higher prices to consumers.

6. Examine the influence of different variables on demand for money according to Inventory Theoretic
Approach?

ANSWER 6

Inventory-theoretical approach assumes that there are two media for storing value: money and an interest-
bearing alternative financial asset. There is a fixed cost of making transfers between money and the
alternative assets e.g. broker charges. While relatively liquid financial assets other than money (such as, bank
deposits) offer a positive return, the above said transaction cost of going between money and these assets
justifies holding money.

Baumol used Business Inventory approach to analyse the behaviour of individuals. Just as businesses keep

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money to facilitate their business transactions, people also hold cash balance which involves an opportunity
cost in terms of lost interest. Therefore, they hold an optimum combination of bonds and cash balance, i.e., an
amount that minimizes the opportunity cost.

Baumol’s propositions in his theory of transaction demand for money hold that receipt of income, say Y takes
place once per unit of time but expenditure is spread at a constant rate over the entire period of time. Excess
cash over and above what is required for transactions during the period under consideration will be invested
in bonds or put in an interest-bearing account. Money holdings on an average will be lower if people hold
bonds or other interest yielding assets.
The higher the income, the higher is the average level or inventory of money holdings. The level of inventory
holding also depends also upon the carrying cost, which is the interest forgone by holding money and not
bonds, net of the cost to the individual of making a transfer between money and bonds, say for example
brokerage fee. The individual will choose the number of times the transfer between money and bonds takes
place in such a way that the net profits from bond transactions are maximized.

The average transaction balance (money) holding is a function of the number of times the transfer between
money and bonds takes place. The more the number of times the bond transaction is made, the lesser will be
the average transaction balance holdings. In other words, the choice of the number of times the bond
transaction is made determines the split of money and bond holdings for a given income.

The inventory-theoretic approach also suggests that the demand for money and bonds depend on the cost of
making a transfer between money and bonds e.g. the brokerage fee. An increase the brokerage fee raises the
marginal cost of bond market transactions and consequently lowers the number of such transactions. The
increase in the brokerage fee raises the transactions demand for money and lowers the average bond holding
over the period. This result follows because an increase in the brokerage fee makes it more costly to switch
funds temporarily into bond holdings. An individual combines his asset portfolio of cash and bond in such
proportions that his cost is minimized.

7. (a) How is the behaviour of central bank in economy reflected? Explain.

(b) Distinguish between M1 and M2. Find out M1 when a country has the following monetary asset
information as of March 2020:

Components ₹ in million
Cash in hands of the public 300
Demand Deposits 400
Savings Type accounts 2000
Money Market Mutual Funds 1000
Traveller’s checks 50
Small Time Deposits 500
Large Time Deposits 450
Other Checkable Deposits 150

ANSWER 7 666

(a) The behaviour of the central bank which controls the issue of currency is reflected in the supply of the
nominal high-powered money. Money stock is determined by the money multiplier and the monetary base is
controlled by the monetary authority. If the behaviour of the public and the commercial banks remains
unchanged over time, the total supply of nominal money in the economy will vary directly with the supply of
the nominal high-powered money issued by the central bank.
(b) M1 is composed of currency and coins with the people, demand deposits of banks (current and saving
accounts) and other deposits with the RBI whereas M2 includes M1 as well as savings deposits with post office
savings banks.
M1= 300 + 400 + 150 + 50 = Rs 900 Millions

8. Describe the different types of agreements that take place during the negotiations of trade?

ANSWER 8

Trade negotiations result in different types of agreements. These agreements are-

Unilateral trade agreements- under which an importing country offers trade incentives in order to encourage
the exporting country to engage in international economic activities. E.g. Generalized System of Preferences.
Bilateral agreements- agreements which set rules of trade between two countries, two blocs or a bloc and a
country. These may be limited to certain goods and services or certain types of market entry barriers. E.g. EU-
South Africa Free Trade Agreement; ASEAN–India Free Trade Area. Regional Preferential Trade Agreements-
agreements that reduce trade barriers on a reciprocal and preferential basis for only the members of the
group. E.g. Global System of Trade Preferences among Developing Countries (GSTP).
Trading bloc- A group of countries that have a free trade agreement between themselves and may apply a
common external tariff to other countries. Example: Arab League (AL), European Free Trade Association
(EFTA).

Free-trade area- is a group of countries that eliminate all tariff barriers on trade with each other and retains
independence in determining their tariffs with non-members. Example: NAFTA.
Customs union -A group of countries that eliminate all tariffs on trade among themselves but maintain a
common external tariff on trade with countries outside the union (thus technically violating MFN). E.g. EC,
MERCOSUR.
Common market- A common market deepens a customs union by providing for the free flow of factors of
production (labor and capital) in addition to the free flow of outputs. The member countries attempt to
harmonize some institutional arrangements and commercial and financial laws and regulations among
themselves. There are also common barriers against non-members (E.g., EU, ASEAN).
In an Economic and Monetary Union- members share a common currency and macroeconomic policies. For
E.g., the European Union countries implement and adopt a single currency.

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9. (a) Into how many parts are FDIs categorized according to the nature of foreign investment? Describe
them.

(b) What does the Agreement on Trade-Related Investment Measures (TRIMs) stipulate?

ANSWER 9
(a) Based on the nature of foreign investments, FDI may be categorized into three parts as horizontal, vertical
or conglomerate.

(i) A horizontal direct investment is said to take place when the investor establishes the same type of business
operation in a foreign country as it operates in its home country, for example, a cell phone service provider
based in the United States moving to India to provide the same service.

(ii) A vertical investment is one under which the investor establishes or acquires a business activity in a foreign
country which is different from the investor’s main business activity yet in some way supplements its major
activity. For example; an automobile manufacturing company may acquire an interest in a foreign company
that supplies parts or raw materials required for the company.

(iii) A conglomerate type of foreign direct investment is one where an investor makes a foreign investment in a
business that is unrelated to its existing business in its home country. This is often in the form of a joint
venture with a foreign firm already operating in the industry as the investor has no previous experience

(b) Agreement on TRIMS establishes discipline governing investment measures in relation to cross-border
investments by stipulating that countries receiving foreign investments shall not impose investment measures
such as requirements, conditions and restrictions inconsistent with the provisions of the principle of national
treatment and general elimination of quantitative restrictions.

10. Countries Rose Land and Daisy land have a total of 4000 hours each of labour available each day to
produce shirts and trousers. Both countries use equal number of hours on each good each day. Rose Land
produces 800 shirts and 500 trousers per day. Daisy land produces 500 shirts and 250 trousers per day.
In the absence of trade:

i. Which country has absolute advantage in producing shirts or trousers?

ii. Which country has comparative advantage in producing shirts or trousers?

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ANSWER 10

Goods produced by each country

Country Shirts Trousers

Rose Land 800 500
Daisy Land 500 250
Each country has 4000 hours of labour and uses 2000 hours each for both the goods. Therefore, the number
of hours spent per unit on each good

Country Shirts Trousers

Rose Land 2.5 4
Daisy Land 4 8

Since Rose Land produces both goods in less time, it has absolute advantage in both shirts and trousers.
Comparative advantage; comparing the opportunity costs of both goods we have

Rose Land
Opportunity cost of Shirts 2.5/4 = 0.625
Opportunity cost of Trousers 4/2. 5 =1.6

Daisy Land
Opportunity cost of Shirts 4/8 = 0.5
Opportunity cost of Trousers 8/4 =2

For producing shirts

Daisy Land has lower opportunity cost for producing shirts, therefore Daisy Land has comparative advantage

For producing Trousers

Rose Land has lower opportunity cost for producing Trousers, therefore Rose Land has comparative
advantage.

669
 RTP- MAY 2020
SECTION A: FINANCIAL MANAGEMENT
QUESTIONS

Ratio Analysis
1. MT Limited has the following Balance Sheet as on March 31, 2019 and March 31, 2020:
Balance Sheet

₹ in lakhs ₹ in lakhs
March 31, 2019 March 31, 2020
Sources of Funds:
Shareholders’ Funds 2,500 2,500
Loan Funds 3,500 3,000
6,000 5,500
Applications of Funds:
Fixed Assets 3,500 3,000
Cash and bank 450 400
Receivables 1,400 1,100
Inventories 2,500 2,000
Other Current Assets 1,500 1,000
Less: Current Liabilities (1,850) (2,000)
6,000 5,500

The Income Statement of the MT Ltd. for the year ended is as follows:

₹ in lakhs ₹ in lakhs
March 31, March
2019 31, 2020

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Sales 22,500 23,800
Less: Cost of Goods sold (20,860) (21,100)
Gross Profit 1,640 2,700
Less: Selling, General and Administrative expenses (1,100) (1,750)
Earnings before Interest and Tax (EBIT) 540 950
Less: Interest Expense (350) (300)
Earnings before Tax (EBT) 190 650
Less: Tax (57) (195)
Profits after Tax (PAT) 133 455
Required:

CALCULATE for the year 2019-20-

(a) Inventory turnover ratio

(b) Financial Leverage

(c) Return on Capital Employed (ROCE)

(d) Return on Equity (ROE)

(e) Average Collection period.

[Take 1 year = 365 days]

ANSWER 1
Ratios for the year 2019-2020

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Cost of Capital

2. PK Ltd. has the following book-value capital structure as on March 31, 2020.

Equity share capital 2,00,00,000

(10,00,000 shares)
11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
36000000

The equity shares of the company are sold for ₹ 200. It is expected that the company will pay next year a
dividend of ₹ 10 per equity share, which is expected to grow by 5% p.a. forever. Assume a 35% corporate
tax rate.
Required:

(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital
structure.

(ii) COMPUTE the new WACC, if the company raises an additional ₹50 lakhs debt by issuing 12% debentures.

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This would result in increasing the expected equity dividend to ₹12.40 and leave the growth rate
unchanged, but the price of equity share will fall to ₹ 160 per share.
ANSWER 2

(i) Computation of Weighted Average Cost of Capital based on existing capital structure

Source of Capital Existing Capital Weights After tax cost WACC (%)
structure (₹) of capital (%)
(a) (b) (a) (b)

Equity share capital (W.N.1) 2,00,00,000 0.555 10.00 5.55

11.5% Preference share 60,00,000 0.167 11.50 1.92
capital
10% Debentures (W.N.2) 1,00,00,000 0.278 6.50 1.81
3,60,00,000 1.000 9.28

Working Notes (W.N.):

(ii) Computation of Weighted Average Cost of Capital based on new capital structure

Source of Capital Existing Capital Weights After tax cost WACC (%)
structure (₹) of capital (%)
(a) (b) (a) (b)

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Equity share capital (W.N. 3) 2,00,00,000 0.488 12.75 6.10

Preference share 60,00,000 0.146 11.50 1.68

10% Debentures (W.N. 2) 1,00,00,000 0.244 6.50 1.59

12% Debentures (W.N.4) 50,00,000 0.122 7.80 0.95

4,10,00,000 1.00 10.32

Working Notes (W.N.):

Capital Structure Decisions

3. CALCULATE the level of earnings before interest and tax (EBIT) at which the EPS indifference point
between the following financing alternatives will occur.

(i) Equity share capital of ₹60,00,000 and 12% debentures of ₹40,00,000.

Or

(ii) Equity share capital of ₹40,00,000, 14% preference share capital of ₹20,00,000 and 12% debentures of
₹40,00,000.
Assume the corporate tax rate is 35% and par value of equity share is ₹100 in each case.

ANSWER 3 674

Computation of level of earnings before interest and tax (EBIT)

In case, alternative (i) is accepted, then the EPS of the firm would be:
Leverage
4. The following information is related to YZ Company Ltd. for the year ended 31st March, 2020:

Equity share capital (of ₹ 10 each) ₹ 50 lakhs

12% Bonds of ₹ 1,000 each ₹ 37 lakhs
Sales ₹ 84 lakhs
Fixed cost (excluding interest) ₹ 6.96 lakhs

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Financial leverage 1.49
Profit-volume Ratio 27.55%
Income Tax Applicable 40%

You are required to CALCULATE:

(i) Operating Leverage;

(ii) Combined leverage; and

(iii) Earnings per share.

Show calculations up-to two decimal points.

ANSWER 4
Computation of Profits after Tax (PAT)
Particulars Amount (₹)
Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12% ₹37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)
EBT (Earnings before tax) 10,86,040*
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624

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Accordingly, other fixed interest

= ₹ 16,18,200 - ₹ 10,86,040 - ₹ 4,44,000 = ₹ 88,160
(iii) Earnings per share (EPS):

Capital Budgeting

5. A company is considering the proposal of taking up a new project which requires an investment of ₹800
lakhs on machinery and other assets. The project is expected to yield the following earnings (before
depreciation and taxes) over the next five years:

Year Earnings (₹ in lakhs)

1 320
2 320
3 360
4 360
5 300

The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on written down
value basis. The scrap value at the end of the five year period may be taken as zero. Income-tax applicable
to the company is 40%.

You are required to CALCULATE the net present value of the project and advise the management to take
appropriate decision. Also CALCULATE the Internal Rate of Return of the Project.

Note: Present values of Re. 1 at different rates of interest are as follows:

Year 10% 12% 14% 16% 20% 677

1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40
ANSWER 5

(i) Calculation of Net Cash Flow

(₹ in lakhs
Year Profit before Depreciation (20% on PBT PAT Net cash flow
dep. and tax WDV)
(1) (2) (3) (4) (5) (3) + (5)
1 320 800 20% = 160 160 96 256
2 320 (800 160) 20% = 128 192 115.20 243.20
3 360 (640 128) 20% = 102.4 257.6 154.56 256.96
4 360 (512 102.4) 20% = 278.08 166.85 248.77
81.92
5 300 (409.6 81.92) = 327.68* 27.68 16.61 311.07
*this is treated as a short term capital loss.

(ii) Calculation of Net Present Value (NPV) (₹ in lakhs)

12% 16% 20%

Year Net Cash Flow D.F P.V D.F P.V D.F P.V
1 256 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.03
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
941.36 850.71 773.16
Less: Initial Investment 800.00 800.00 800.00
NPV 141.36 50.71 -26.84

(iii) Advise: Since Net Present Value of the project at 12% = 141.36 lakhs, therefore the project should be

678
implemented.
(iv) Calculation of Internal Rate of Return (IRR)

Management of Receivables (Debtors)

6. TM Limited, a manufacturer of colour TV sets is considering the liberalization of existing credit terms to
three of their large customers A, B and C. The credit period and likely quantity of TV sets that will be sold to
the customers in addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 10,000 10,000 -
30 10,000 15,000 -
60 10,000 20,000 10,000
90 10,000 25,000 15,000

The selling price per TV set is ₹15,000. The expected contribution is 50% of the selling price. The cost of
carrying receivable averages 20% per annum.
You are required to COMPUTE the credit period to be allowed to each customer.
(Assume 360 days in a year for calculation purposes).

ANSWER 6

679
In case of customer A, there is no increase in sales even if the credit is given. Hence comparative statement for
B & C is given below:
The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90 days in respect
of both the customers B and C. Hence, credit period of 90 days should be allowed to B and C.

Risk Analysis in Capital Budgeting

7. G Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following information
regarding a new project is as follows:

Year Expected Cash flow Certainty-equivalent quotient

0 (8,00,000) 1.0
1 6,40,000 0.8
2 5,60,000 0.7
3 5,20,000 0.6

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4 4,80,000 0.4
5 3,20,000 0.3

Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project should
be accepted?
ANSWER 7

Determination of Net Present Value (NPV)

Year Expected Certainty- Adjusted Cash PV factor Total PV

Cash flow equivalent flow (Cash flow (at 0.06) (₹)
(₹) (CE) × CE) (₹)
0 (8,00,000) 1.0 (8,00,000) 1.000 (8,00,000)
1 6,40,000 0.8 5,12,000 0.943 4,82,816
2 5,60,000 0.7 3,92,000 0.890 3,48,880
3 5,20,000 0.6 3,12,000 0.840 2,62,080
4 4,80,000 0.4 1,92,000 0.792 1,52,064
5 3,20,000 0.3 96,000 0.747 71,712
NPV = (13,17,552 – 8,00,000) 5,17,552

As the Net Present Value is positive the project should be accepted.

Dividend Decisions
8. Following information relating to Jee Ltd. is given:

(i) CALCULATE market value per share as per Walter's Model?

(ii) What is the optimum dividend pay-out ratio according to Walter's Model and Market value of equity

681
share at that pay-out ratio?

ANSWER 8
(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the
price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio
in this case is Nil. So, at a pay-out ratio of zero, the market value of the company’s share will be:

Management of working Capital

9. Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's
Working Capital Requirements. The following information is available about the projections for the current
year:

Estimated Level of Activity Completed Units of Production 31,200

plus unit of work in progress 12,000

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Raw Material Cost ₹ 40 per unit
Direct Wages Cost ₹ 15 per unit
Overhead ₹ 40 per unit (inclusive of Depreciation
₹10 per unit)
Selling Price ₹ 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost
50%
Finished Goods Stock 24,000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ₹ 2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and overheads
accrue similarly. All sales are on the credit basis. You are required to CALCULATE the Net Working Capital
Requirement on Cash Cost Basis.

ANSWER 9

Calculation of Net Working Capital requirement:

Working Notes: 683

(i) Annual cost of production

Raw material requirements 17,28,000

{(31,200 × ₹ 40) + (12,000 x ₹ 40)}
Direct wages {(31,200 ×₹ 15) +(12,000 X ₹ 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation) 11,16,000
{(31,200 × ₹ 30) + (12,000 x ₹ 30 x 0.5)}
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (₹ 40 + ₹ 7.5 + ₹15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods (20,40,000)
(₹ 26,52,000 × 24,000/31,200)
Total Cash Cost of Sales* 6,12,000

[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000 units) x (₹ 40 + ₹ 15 + ₹ 30) = ₹
6,12,000]

(ii) Work in progress stock

Raw material requirements (12,000 units × ₹40) 4,80,000

Direct wages (50% × 12,000 units × ₹ 15) 90,000
Overheads (50% × 12,000 units × ₹ 30) 1,80,000
7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption. Since, the company is newly formed; the
raw material requirement for production and work in progress will be issued and consumed during the year.
Hence, the raw material consumption for the year (360 days) is as follows:

For Finished goods (31,200 × ₹ 40) 12,48,000

For Work in progress (12,000 × ₹ 40) 4,80,000
17,28,000

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Miscellaneous

10. (i) “The profit maximization is not an operationally feasible criterion.” IDENTIFY.

(ii) EXPLAIN the basics of debt securitisation process.

ANSWER 10

(i) The profit maximisation is not an operationally feasible criterion.” This statement is true because profit
maximisation can be a short-term objective for any organisation and cannot be its sole objective. Profit
maximization fails to serve as an operational criterion for maximizing the owner's economic welfare. It fails to
provide an operationally feasible measure for ranking alternative courses of action in terms of their economic
efficiency. It suffers from the following limitations:

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(a) Vague term: The definition of the term profit is ambiguous. Does it mean short term or long term profit?
Does it refer to profit before or after tax? Total profit or profit per share?

(b) Timing of Return: The profit maximization objective does not make distinction between returns received in
different time periods. It gives no consideration to the time value of money, and values benefits received
today and benefits received after a period as the same.
(c) It ignores the risk factor.

(d) The term maximization is also vague.

(ii) Process of Debt Securitisation:

(a) The origination function – A borrower seeks a loan from a finance company or a bank. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the
life of the loan.

(b) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.

(c) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The securities
carry a coupon and expected maturity which can be asset-based/mortgage based. These are generally sold to
investors through merchant bankers. Investors are – pension funds, mutual funds, insurance funds.

The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is under
an obligation to pay to investors only if the cash flows are received by him from the collateral. The benefits to
the originator are that assets are shifted off the balance sheet, thus giving the originator recourse to off-
balance sheet funding.

SECTION: B: ECONOMICS FOR FINANCE

QUESTIONS

1. (a) Calculate the Operating Surplus with the help of following data-

Particulars ₹ (In Crore)

Sales 4,000
Compensation to employees 800

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Intermediate consumption 600
Rent 400
Interest 300
Net indirect taxes 500
Consumption of fixed capital 200
Mixed income 400

(b) Why do pensions and other security payments get excluded while calculating National Income?
ANSWER 1

(a) GVAMP = Gross Value OutputMP – Intermediate consumption

= (Sales + change in stock) – Intermediate consumption
= 4000-600 = 3400 crore

GDPMP = GVAMP = 3400 crore

NDPMP = GDPMP – consumption of fixed capital

= 3400 – 200
= 3200 crore

NDPFC = NDPMP – NIT

= 3200 – 500
= 2700 crore

NDPFC = Compensation of employees + Operating surplus + Mixed income

2700 = 800 + Operating Surplus + 400
Operating surplus = 1500 crore

(b) GDP measures what is produced or created over the current time period and excludes all non-production
transactions. Only incomes earned by owners of primary factors of production for services rendered in
production are included in national income. Transfer payments, both private and government, are made
without goods or services being received in return. These payments do not correspond to return for
contribution to production because they do not directly absorb resources or create output. Therefore, transfer
incomes such as pensions and other social security payments are excluded from national income.

2. (a) Suppose you are given following information-

Consumption function C = 10 + 0.8Yd
Tax T = 50
Investment spending I = 135
Government Spending G = 60
Exports X = 35

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Imports M = 0.05 Y
Where Y and Yd are income and personal disposable income respectively.
Find the equilibrium level of income and net exports.

(b) How are the following transactions treated in national income calculation? What is the rationale in each
case?
i. Electricity sold to a steel plant.
ii. Electric power sold to a consumer household.
iii. A car manufacturer procuring parts and components from the market.
iv. A computer producer buys a robot produced in the same country and uses it in production of computers.

ANSWER 2

(a) Here,
C = 10 + 0.8Yd
= 10+0.8 (Y- 50)
Y = C+ I + G + (X - M)
= 10 + 0.8(Y- 50) + 135 + 60 + (35 – 0.05Y)

Y - 0.8Y + 0.05Y = 10 - 40 + 135 + 60 + 35

0.25Y = 200
Y = 800
Net Exports = (X- M) = 35 - 0.05Y
35 - 0.05 800 = -5
Thus, Trade is in deficit.

(b) i Being an intermediate good, electricity sold to a steel plant will not be included in national income
calculation. The underlying principle is that only finished goods and services which are directly sold to the
consumer for final consumption would be included.

ii. Electric power sold to a consumer household would be included in the calculation of GDP since it is a final
good consumed by the end user.

iii. The value of parts and components procured from the market by a car manufacturer will not be included in
national income calculation because these are intermediate goods used in car production.

iv. The value of the robot bought by a computer producer for use in the production of computers would be
included in national income calculation because the computer producer is the "final consumer" of the robot
and the robot is not resold in the market after value addition.

3. (a) Government’s stabilization intervention may be through monetary policy as well as fiscal policy. How 688

(b) How do government correct market failure resulting from demerits goods?
ANSWER 3

(a) Government’s stabilization intervention may be through monetary policy as well as through fiscal policy.
Monetary policy has a singular objective of controlling the size of money supply and interest rate in the
economy which in turn would affect consumption, investment and prices. On the other hand, Fiscal policy for
stabilization purposes attempts to direct the actions of individuals and organizations by means of its
expenditure and taxation decisions. On the expenditure side, Government can choose to spend in such a way
that it stimulates other economic activities. For example, government expenditure on building infrastructure
may initiate a series of productive activities. Production decisions, investments, savings etc can be influenced
by its tax policies.

(b) Demerit goods are goods which impose significant negative externalities on the society as a whole and are
believed to be socially undesirable. The production and consumption of demerit goods are likely to be more
than optimal under free markets. The government should therefore intervene in the marketplace to
discourage their production and consumption. The Governments correct market failure resulting from demerit
goods in the following way-

• At the extreme, government may enforce complete ban on a demerit good. e.g. Intoxicating drugs. In such
cases, the possession, trading or consumption of the
good is made illegal.

• Through persuasion which is mainly intended to be achieved by negative advertising campaigns which
emphasize the dangers associated with consumption of demerit goods.

• Through legislations that prohibit the advertising or promotion of demerit goods in whatsoever manner.

• Strict regulations of the market for the good may be put in place so as to limit access to the good, especially
by vulnerable groups such as children and adolescents.

• Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of tobacco to be
away from schools, and time restrictions under which sale at particular times during the day is banned.

689
4. (a) Reflect on the externalities presents in each of the following. Also examine their market implications-

i. A decision to stop smoking

ii Switching from conventional farming to organic farming

iii Started to drive a car and increased road congestion

iv Water polluted by industries

v Building Lighthouse

(b) Suppose country X is passing through recession, what type of tax policy should be framed during this
period?

ANSWER 4

(a) (i) A decision to stop smoking – positive consumption externalities – as it causes benefits to other people in
society who have been suffering from passive smoking.

(ii) Switching from conventional farming to organic farming- positive production externalities -as it helps the
environment as there are fewer chemicals in the environment.

(iii) Started to drive a car and increased road congestion– negative consumption externalities – as individual
consume road space they reduce available road space and deny this space to others.

(iv) Water polluted by industries- negative production externalities –as it adds effluent which harms plants,
animals and humans.

(v) Building Lighthouse – free rider problem- as all sailors will benefit from its illumination – even if they don’t
pay towards its upkeep.

(b) During recession the tax policy is framed to encourage private consumption and investment. A general
reduction in income taxes leaves higher disposable incomes with people inducing higher consumption. Low
corporate taxes increase the prospects of profits for business and promote further investment. The extent of
tax reduction required depends on the size of the recessionary gap and the magnitude of the multiplier.

690
5. How does the monetary policy influence the price level and the national income?

ANSWER 5

The process or channels through which the change of monetary aggregates affects the level of product and
prices is known as ‘monetary transmission mechanism’. There are mainly four different mechanisms through
which monetary policy influences the price level and the national income. These are: (a) the interest rate
channel, (b) the exchange rate channel, (c) the quantum channel (e.g., relating to money supply and credit),
and (d) the asset price channel i.e. via equity and real estate prices. Under the interest rate channel, changes
in monetary policy are eventually reflected in the real long-term interest rates which influence aggregate
demand by altering business investment and durable consumption decisions. This, in turn, gets reflected in
aggregate output and prices.

The exchange rate channel works through expenditure switching between domestic and foreign goods.
Appreciation of the domestic currency makes domestically produced goods more expensive compared to
foreign‐produced goods. This causes net exports to fall; correspondingly domestic output and employment
also fall.

The Quantum channel operates by altering access of firms and households to bank credit. Most businesses
and people mostly depend on bank for borrowing money. “An open market operation” that leads first to a
contraction in the supply of bank reserves and then to a contraction in bank credit requires banks to cut back
on their lending. This, in turn makes the firms that are especially dependent on banks loans to cut back on
their investment spending. Thus, there is decline in the aggregate output and employment following a
monetary contraction.

The asset price channel suggests that asset prices respond to monetary policy changes and consequently
affect output, employment and inflation.

6. (a) Answer the following question using Keynesian framework of demand for money.
An investment consultant suggests holding of cash instead of bonds. What could be the reason to encourage
holding of money balances? Explain

(b) Calculate liquidity aggregate L2 when the following information is given-

Particulars ₹ in crore
Term deposits with term lending institutions 750
Term borrowing by refinancing institutions 450
All deposits with post office savings banks 1320
Term deposits with refinancing institutions 590
Certificate of deposits issued by FIs 290
Public deposits of non-banking financial companies 450

691
NM3 2650
National saving certificates 240

ANSWER 6

(a) The market value of bonds and the market rate of interest are inversely related. The investment consultant
considers the current interest rate as low, compared to the ‘normal or critical rate of interest’, i.e., he expects
the rate of interest to rise in future (fall in bond prices), and therefore it is advantageous to hold wealth in the
form of liquid cash rather than bonds because:
(i) when interest is low, the loss suffered by way of interest income forgone is small,

(ii) one can avoid the capital losses that would result from the anticipated increase in interest rates, and

(iii) the return on money balances will be greater than the return on alternative assets

(iv) if the interest rate does increase in future, the bond prices will fall and the idle cash balances held can be
used to buy bonds at lower price and can thereby make a capital-gain.

(b) L2 = L1 + Term deposits with term lending institutions + Term deposits with refinancing institutions + Term
borrowing by refinancing institutions + Certificate of deposits issued by FIs

Where L1 = NM3 + All deposits with post office savings banks

= 2650 + 1320

= 3970 crore

Therefore L2 = 3970 + 750 +590 + 450 + 290 = 6050 crore

7. (a) Explain how a tariff levied on an imported product affects both the country exporting a product and
the country importing that product.

(b) Why GATT lost its relevance by 1980?

ANSWER 7

(a) A tariff levied on an imported product affects both the country exporting a product and the country
importing that product.

692
(i) Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of
international trade. The prospect of market access of the exporting country is worsened when an importing
country imposes a tariff.

(ii) By making imported goods more expensive, tariffs discourage domestic consumers from consuming
imported foreign goods. Domestic consumers suffer a loss in consumer surplus because they must now pay a
higher price for the good and also because compared to free trade quantity, they now consume lesser
quantity of the good.
(iii) Tariffs encourage consumption and production of the domestically produced import substitutes and thus
protect domestic industries.

(iv)Producers in the importing country experience an increase in well-being as a result of imposition of tariff.
The price increase of their product in the domestic market increases producer surplus in the industry. They
can also charge higher prices than would be possible in the case of free trade because foreign competition has
reduced.

(v) The price increase also induces an increase in the output of the existing firms and possibly addition of new
firms due to entry into the industry to take advantage of the new high profits and consequently an increase in
employment in the industry.

(vi)Tariffs create trade distortions by disregarding comparative advantage and prevent countries from enjoying
gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in the rest
of the world and encourage inefficient production in the home country.

(vii) Tariffs increase government revenues of the importing country by the value of the total tariff it charges.

(b) The GATT lost its relevance by 1980s because-

(i) It was obsolete to the fast evolving contemporary complex world trade scenario characterized by emerging
globalization.

(ii) International investments had expanded substantially.

(iii) Intellectual property rights and trade in services were not covered by GATT.

(iv) World merchandise trade increased by leaps and bounds and was beyond its scope.

(v) The ambiguities in the multilateral system could be heavily exploited.

(vi) Efforts at liberalizing agricultural trade were not successful.

(vii) There were inadequacies in institutional structure and dispute settlement system. 693

(viii) It was not a treaty and therefore terms of GATT were binding only insofar as they are not incoherent with
a nation’s domestic rules.
8 Even if one nation is less efficient than the other nation in the production of all commodities, there is still
scope for mutually beneficial trade. Explain in detail.

ANSWER 8

Yes, there is still scope for mutually beneficial trade. The first step is that nation should specialize in the
production and export of the commodity in which its absolute disadvantage is smaller and import the
commodity in which its absolute disadvantage is greater. This can be explained with the help of an example
(Theory of Comparative Advantage).

9. Many apprehensions have been raised in respect of the WTO and its ability to maintain and extend a
system of liberal world trade. Comment.
ANSWER 9

The major issues are:

(i) The progress of multilateral negotiations on trade liberalization is very slow and the requirement of
consensus among all members acts as a constraint and creates rigidity in the system. As a result, countries find
regionalism a plausible alternative.

(ii) The complex network of regional agreements introduces uncertainties and murkiness in the global trade
system.

(iii) While multilateral efforts have effectively reduced tariffs on industrial goods, the achievement in
liberalizing trade in agriculture, textiles, and apparel, and in many other areas of international commerce has
been negligible.

(iv) The latest negotiations, such as the Doha Development Round, have run into problems, and their definitive
success is doubtful.

(v) Most countries, particularly developing countries are dissatisfied with the WTO because, in practice, most 694
of the promises of the Uruguay Round agreement to expand global trade has not materialized.

(vi) The developing countries have raised a number of concerns and a few are presented here:

• The real expansion of trade in the three key areas of agriculture, textiles and services has been dismal.
• Protectionism and lack of willingness among developed countries to provide market access on a multilateral
basis has driven many developing countries to seek regional alternatives.

• The developing countries have raised a number of issues in the Doha Agenda in respect of the difficulties
that they face in implementing the present agreements.

• The North-South divide apparent in the WTO ministerial meets has fuelled the apprehension of developing
countries about the prospect of trade expansion under the WTO regime.

• Developing countries complain that they face exceptionally high tariffs on selected products in many
markets and this obstructs their vital exports.

• Another major issue concerns ‘tariff escalation’ where an importing country protects its processing or
manufacturing industry by setting lower duties on imports of raw materials and components, and higher
duties on finished products.

• There is also possible erosion of preferences i.e. the special tariff concessions granted by developed
countries on imports from certain developing countries have become less meaningful because of the
narrowing of differences between the normal and preferential rates.

• The least-developed countries find themselves disproportionately disadvantaged and vulnerable with regard
to adjustments due to lack of human as well as physical capital, poor infrastructure, inadequate institutions,
political instabilities etc.

10. (a) Explain the principle motivations of a country seeking FDI?

(b) Explain the role of Liquidity Adjustment Facility (LAF).

ANSWER 10 695
(a) Motivations for a country seeking investments occurs when:

I. Producers have saturated sales in their home market

II. Firms want to ensure market growth and to find new buyers and larger markets with sizable population.
III. Technological developments and economies arising from large scale production necessitate greater ability
of the market to support the expected demand on which the investment is based. The minimum size of
market needed to support technological development in certain industries is sometimes larger than the
largest national market.

IV. There are substantial barriers to exporting from the home country

V. Firms identify country-specific consumer preferences and favourable structure of markets elsewhere.

VI. Firms realize that their products are unique or superior and that there is scope for exploiting this
opportunity by extending to other regions.

(b) RBI has introduced Liquidity Adjustment Facility (LAF) in 2000. The Liquidity Adjustment Facility(LAF) is a
facility extended by the Reserve Bank of India to the scheduled commercial banks (excluding RRBs) and
primary dealers to avail of liquidity in case of requirement (or park excess funds with the RBI in case of excess
liquidity) on an overnight basis against the collateral of government securities including state government
securities. The introduction of LAF is an important landmark since it triggered a rapid transformation in the
monetary policy operating environment in India. As a key element in the operating framework of the RBI, its
objective is to assist banks to adjust their day to day mismatches in liquidity. Currently, the RBI provides
financial accommodation to the commercial banks through repos/reverse repos under the Liquidity
Adjustment Facility (LAF).

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 RTP- NOV 2019

SECTION A: FINANCIAL MANAGEMENT

QUESTIONS

Ratio Analysis

1. The following is the Profit and loss account and Balance sheet of KLM LLP.
Trading and Profit & Loss Account

Particulars Amount (₹) Particulars Amount (₹)

To Opening stock 12,46,000 By Sales 1,96,56,000
To Purchases 1,56,20,000 By Closing stock 14,28,000
To Gross profit c/d 42,18,000
2,10,84,000 2,10,84,000
By Gross profit b/d 42,18,000
To Administrative 18,40,000 By Interest on 24,600
expenses investment
To Selling & 7,56,000 By Dividend 22,000
distribution received
expenses
To Interest on loan 2,60,000
To Net profit 14,08,600
42,64,600 42,64,600

697
Balance Sheet as on……….

Capital & Liabilities Amount (₹) Assets Amount (₹)

Capital 20,00,000 Plant & machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General reserve 12,00,000 Furniture 12,00,000
Term loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry Payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash & Bank balance 4,22,000
1,10,00,000 1,10,00,000

You are required to COMPUTE:

(i) Gross profit ratio

(ii) Net profit ratio

(iii) Operating cost ratio

(iv) Operating profit ratio

(v) Inventory turnover ratio

(vi) Current ratio

(vii) Quick ratio

(viii) Interest coverage ratio

(ix) Return on capital employed

(x) Debt to assets ratio. 698

ANSWER 1
699
700
Cost of Capital

2. KM Ltd. has the following capital structure on September 30, 2019:

Sources of capital (₹)

Equity Share Capital (40,00,000 Shares of ₹ 10 each) 4,00,00,000
Reserves & Surplus 4,00,00,000
12% Preference Shares 2,00,00,000
9% Debentures 6,00,00,000
16,00,00,000

The market price of equity share is ₹60. It is expected that the company will pay next year a dividend of ₹6
per share, which will grow at 10% forever. Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.

ANSWER 2

Workings:

Computation of Weighted Average Cost of Capital (WACC using market value weights)

Source of capital Market Value of capital (₹) Weight Cost of capital (%) WACC (%)
9% Debentures 6,00,00,000 0.1875 5.40 1.01
12% Preference Shares 2,00,00,000 0.0625 12.00 0.75
Equity Share Capital 24,00,00,000 0.7500 20.00 15.00
(₹60 × 40,00,000 shares)

701
Total 32,00,00,000 1.00 16.76
Capital Structure

3. The management of RT Ltd. wants to raise its funds from market to meet out the financial demands of its
long-term projects. The company has various combinations of proposals to raise its funds. You are given the
following proposals of the company:

Proposal Equity shares (%) Debts (%) Preference shares (%)

P 100 - -
Q 50 50 -
R 50 - 50

(i) Cost of debt and preference shares is 12% each.

(ii) Tax rate –40%

(iii) Equity shares of the face value of ₹10 each will be issued at a premium of ₹10 per share.

(iv) Total investment to be raised ₹8,00,00,000.

(v) Expected earnings before interest and tax ₹3,60,00,000.

From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:

• Earnings per share

• Financial break-even-point

COMPUTE the EBIT range among the plans for indifference.

702
ANSWER 3

(i) Computation of Earnings per Share (EPS)

Plans P (₹) Q (₹) R (₹)

Earnings before interest & tax (EBIT) 3,60,00,000 3,60,00,000 3,60,00,000
Less: Interest charges -- (48,00,000) --
Earnings before tax (EBT) 3,60,00,000 3,12,00,000 3,60,00,000
Less : Tax @ 40% (1,44,00,000) (1,24,80,000) (1,44,00,000)
Earnings after tax (EAT) 2,16,00,000 1,87,20,000 2,16,00,000
 Less : Preference share dividend -- -- (48,00,000)
Earnings available for equity shareholders 2,16,00,000 1,87,20,000 1,68,00,000
No. of equity shares 40,00,000 20,00,000 20,00,000
E.P.S 5.40 9.36 8.40

(ii) Computation of Financial Break-even Points

Proposal ‘P’ = 0
Proposal ‘Q’ = ₹48,00,000 (Interest charges)
Proposal ‘R’ = Earnings required for payment of preference share dividend
i.e. ₹48,00,000 0.6 = ₹80,00,000

(iii) Computation of Indifference Point between the Proposals

703
Leverage

4. The following summarises the percentage changes in operating income, percentage changes in revenues,
and betas for four listed firms.

Firm Change in Change in Beta

revenue operating
income
A Ltd. 35% 22% 1.00
B Ltd. 24% 35% 1.65
C Ltd. 29% 26% 1.15
D Ltd. 32% 30% 1.20

Required:

(i) CALCULATE the degree of operating leverage for each of these firms. Comment also.

(ii) Use the operating leverage to EXPLAIN why these firms have different beta.

ANSWER 4

704
Capital Budgeting

5. MTR Limited is considering buying a new machine which would have a useful economic life of five years,
at a cost of ₹25,00,000 and a scrap value of ₹3,00,000, with 80 per cent of the cost being payable at the start
of the project and 20 per cent at the end of the first year. The machine would produce 75,000 units per
annum of a new product with an estimated selling price of ₹300 per unit. Direct costs would be ₹285 per
unit and annual fixed costs, including depreciation calculated on a straight- line basis, would be ₹8,40,000
per annum.

In the first year and the second year, special sales promotion expenditure, not included in the above costs,
would be incurred, amounting to ₹1,00,000 and ₹1,50,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the company’s cost of
capital to be 15 percent.

ANSWER 5

Calculation of Net Cash flows

Contribution = (300 – 285) 75,000 = ₹11,25,000
Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = ₹4,00,000

Year Capital (₹) Contribution (₹) Fixed costs (₹) Adverts (₹) Net cash flow (₹)
0 -2000000 -2000000
1 -500000 1125000 -400000 -100000 125000
2 1125000 -400000 -150000 575000
3 1125000 -400000 725000
4 1125000 -400000 725000
5 300000 1125000 -400000 1025000

Calculation of Net Present Value

Year Net cash flow (₹) 12% discount factor Present value (₹)
0 (20,00,000) 1.000 (20,00,000)

705
1 1,25,000 0.892 1,11,500
2 5,75,000 0.797 4,58,275
3 7,25,000 0.711 5,15,475
4 7,25,000 0.635 4,60,375
5 10,25,000 0.567 5,81,175
1,26,800

The net present value of the project is ₹1,26,800

Risk Analysis in Capital Budgeting

6. SL Ltd. has invested ₹1,000 lakhs in a project. The risk-free rate of return is 5%. Risk premium expected by
the Management is 10%. The life of the project is 5 years. Following are the cash flows that are estimated
over the life of the project.

Year Cash flows (₹ in lakhs)

1 125
2 300
3 375
4 400
5 325

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate.

ANSWER 6
The Present Value of the Cash Flows for all the years by discounting the cash flow at 5% is calculated as below
Year Cash flows Discounting Present value of
₹ in lakhs Factor @5% Cash Flows ₹ In
Lakhs
1 125 0.952 119.00
2 300 0.907 272.10
3 375 0.863 323.62
4 400 0.822 328.80
5 325 0.783 254.4
Total of present value of Cash flow 1,297.99
Less: Initial investment 1,000.00
Net Present Value (NPV) 297.99

Now when the risk-free rate is 5% and the risk premium expected by the Management is 10%. So the risk 706
adjusted discount rate is 5% + 10% =15%.

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
 Year Cash flows Discounting Present Value
₹ in Lakhs Factor@15% of Cash Flows
₹in lakhs
1 125 0.869 108.62
2 300 0.756 226.80
3 375 0.657 246.37
4 400 0.571 228.40
5 325 0.497 161.52
Total of present value of Cash flow 971.71
Initial investment 1,000.00
Net present value (NPV) (28.29)

Dividend Decision

7. The following information pertains to SD Ltd.

Earnings of the Company ₹ 50,00,000

Dividend Payout ratio 60%
No. of shares outstanding 10,00,000
Equity capitalization rate 12%
Rate of return on 15%
investment

(i) COMPUTE the market value per share as per Walter’s model?

(ii) COMPUTE the optimum dividend payout ratio according to Walter’s model and the market value of
Company’s share at that payout ratio?

707
ANSWER 7

Management of Working Capital

8. Following are cost information of KG Ltd., which has commenced a new project for an annual production

708
of 24,000 units which is the full capacity

Costs per unit (₹)

Materials 80.00
Direct labour and variable expenses 40.00
Fixed manufacturing expenses 12.00
Depreciation 20.00
Fixed administration expenses 8.00
160.00
The selling price per unit is expected to be ₹192 and the selling expenses ₹10 per unit, 80% of which is
variable.
In the first two years of operations, production and sales are expected to be as follows

Year Production (No. of units) Sales (No. of units)

1 12,000 10,000
2 18,000 17,000
To assess the working capital requirements, the following additional information is available:

(a) Stock of materials 2 months’ average consumption

(b) Work-in-process Nil
(c) Debtors 2 month’s average sales.
(d) Cash balance ₹ 1,00,000
(e) Creditors for supply of materials 1 month’s average purchase during the year.
(f) Creditors for expenses 1 month’s average of all expenses during the year.

PREPARE, for the two years:

(i) A projected statement of Profit/Loss (Ignoring taxation); and
(ii) A projected statement of working capital requirements

ANSWER 8

(i) Projected Statement of Profit / Loss

(Ignoring Taxation)

Year 1 Year 2
Production (Units) 12,000 18,000
Sales (Units) 10,000 17,000

(₹) (₹)
Sales revenue (A) 19,20,000 32,64,000

709
(Sales unit × ₹192)
Cost of production:
Materials cost 9,60,000 14,40,000
(Units produced × ₹80)
Direct labour and variable expenses 4,80,000 7,20,000
(Units produced × ₹40)
Fixed manufacturing expenses 2,88,000 2,88,000
(Production Capacity: 24,000 units × ₹12)
Depreciation 4,80,000 4,80,000
(Production Capacity : 24,000 units × ₹20)
Fixed administration expenses 1,92,000 1,92,000
(Production Capacity : 24,000 units × ₹8)
Total Costs of Production 24,00,000 31,20,000
Add: Opening stock of finished goods --- 4,00,000
(Year 1 : Nil; Year 2 : 2,000 units)
Cost of Goods available for sale 24,00,000 35,20,000
(Year 1: 12,000 units; Year 2: 20,000 units)
Less: Closing stock of finished goods at average cost (4,00,000) (5,28,000)
(year 1: 2000 units, year 2 : 3000 units)
(Cost of Production × Closing stock/ units produced)
Cost of Goods Sold 20,00,000 29,92,000
Add: Selling expenses – Variable (Sales unit × ₹8) 80,000 1,36,000
Add: Selling expenses -Fixed (24,000 units × ₹2) 48,000 48,000
Cost of Sales : (B) 21,28,000 31,76,000
Profit (+) / Loss (-): (A - B) (-) 2,08,000 (+) 88,000

Working Notes:
1. Calculation of creditors for supply of materials:

Year 1 Year 2
Materials consumed during the year 9,60,000 14,40,000
Add: Closing stock (2 month’s average consumption) 1,60,000 2,40,000
11,20,000 11,20,000
Less: Opening Stock --- 1,60,000
Purchases during the year 11,20,000 15,20,000
Average purchases per month (Creditors) 93,333 1,26,667

710
2. Creditors for expenses:

Year 1 Year 2
Direct labour and variable expenses 4,80,000 7,20,000
Fixed manufacturing expenses 2,88,000 2,88,000
Fixed administration expenses 1,92,000 1,92,000
Selling expenses (variable + fixed) 1,28,000 1,84,000
Total 10,88,000 13,84,000
Average per month 90,667 1,15,333
(ii) Projected Statement of Working Capital requirements

Year 1 Year 2
Current Assets:
Inventories:
-Stock of materials 1,60,000 2,40,000
(2 month’s average consumption)
-Finished goods 4,00,000 5,28,000
Debtors (2 month’s average sales) (including profit) 3,20,000 5,44,000
Cash 1,00,000 1,00,000
Total Current Assets/ Gross working capital (A) 9,80,000 14,12,000
Current Liabilities:
Creditors for supply of materials 93,333 1,26,667
(Refer to working note 1)
Creditors for expenses 90,667 1,15,333
(Refer to working note 2)
Total Current Liabilities: (B) 1,84,000 2,42,000
Estimated Working Capital Requirements: (A-B) 7,96,000 11,70,000

Management of Working Capital

9. A regular customer of your company has approached to you for extension of credit facility for purchasing of
goods. On analysis of past performance and on the basis of information supplied, the following pattern of
payment schedule emerges:

Pattern of Payment Schedule

At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.
At the end of 90 days 30% of the bill.
At the end of 100 days 18% of the bill.

711
Non-recovery 2% of the bill

The customer wants to enter into a firm commitment for purchase of goods of ₹30 lakhs in 2019, deliveries to
be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is ₹300 on which a profit of ₹10 per unit is expected to be made. It is anticipated that taking up of
this contract would mean an extra recurring expenditure of ₹10,000 per annum. If the opportunity cost is 18%
per annum, would you as the finance manager of the company RECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.
ANSWER 9

Statement showing the Evaluation of credit Policies

Particulars Proposed Policy ₹

A. Expected Profit:
(a) Credit Sales 30,00,000
(b) Total Cost
(i) Variable Costs 29,00,000
(ii) Recurring Costs 10,000
29,10,000
(c) Bad Debts 60,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investments in 1,00,395
Receivables
C. Net Benefits (A – B) (70,395)

Recommendation: The Proposed Policy should not be adopted since the net benefits under this policy are
negative

Working Note: Calculation of Opportunity Cost of Average Investments

Particulars 20% 30% 30% 18% Total

A. Total Cost 5,82,000 8,73,000 8,73,000 5,23,800 28,51,800
B. Collection period 30/360 60/360 90/360 100/360
C. Required Rate of Return 18% 18% 18% 18%
D. Opportunity Cost (A × B × C) 8,730 26,190 39,285 26,190 1,00,395

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Miscellaneous

10. Write short notes on the following:

(a) STATE the meaning of Payback Reciprocal.

(b) STATE the functions of treasury department.

(c) DESCRIBE the Inter relationship between investment, financing and dividend decisions.

ANSWER 10

a) As the name indicates it is the reciprocal of payback period. A major drawback of the payback period
method of capital budgeting is that it does not indicate any cut off period for the purpose of investment
decision. It is, however, argued that the reciprocal of the payback would be a close approximation of the
Internal Rate of Return (later discussed in detail) if the life of the project is at least twice the payback period
and the project generates equal amount of the annual cash inflows. In practice, the payback reciprocal is a
helpful tool for quick estimation of rate of return of a project provided its life is at least twice the payback
period.

(b) 1. Cash Management: It involves efficient cash collection process and managing payment of cash both
inside the organisation and to third parties.
There may be complete centralization within a group treasury or the treasury may simply advise subsidiaries
and divisions on policy matter viz., collection/payment periods, discounts, etc.
Treasury will also manage surplus funds in an investment portfolio. Investment policy will consider future
needs for liquid funds and acceptable levels of risk as determined by company policy.

2. Currency Management: The treasury department manages the foreign currency risk exposure of the
company. In a large multinational company (MNC) the first step will usually be to set off intra-group
indebtedness. The use of matching receipts and payments in the same currency will save transaction costs.
Treasury might advise on the currency to be used when invoicing overseas sales.
The treasury will manage any net exchange exposures in accordance with company policy. If risks are to be
minimized then forward contracts can be used either to buy or sell currency forward.

3. Fund Management: Treasury department is responsible for planning and sourcing the company’s short,
medium and long-term cash needs. Treasury department will also participate in the decision on capital
structure and forecast future interest and foreign currency rates.

4. Banking: It is important that a company maintains a good relationship with its bankers. Treasury
department carry out negotiations with bankers and act as the initial point of contact with them. Short-term

713
finance can come in the form of bank loans or through the sale of commercial paper in the money market.

5. Corporate Finance: Treasury department is involved with both acquisition and divestment activities within
the group. In addition, it will often have responsibili ty for investor relations. The latter activity has assumed
increased importance in markets where share-price performance is regarded as crucial and may affect the
company’s ability to undertake acquisition activity or, if the price falls drastically, render it vulnerable to a
hostile bid.
(c) Inter-relationship between Investment, Financing and Dividend Decisions: The finance functions are
divided into three major decisions, viz., investment, financing and dividend decisions. It is correct to say that
these decisions are inter-related because the underlying objective of these three decisions is the same, i.e.
maximisation of shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated,
one has to consider the joint impact of these decisions on the market price of the company’s shares and these
decisions should also be solved jointly. The decision to invest in a new project needs the finance for the
investment. The financing decision, in turn, is influenced by and influences dividend decision because retained
earnings used in internal financing deprive shareholders of their dividends. An efficient financial management
can ensure optimal joint decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and to see how
they can help in maximising the shareholders’ wealth i.e. market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be
accepted which is expected to yield at least so much return as is adequate to meet its cost of financing. This
have an influence on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the
total volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. The optimum
financing mix will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by
way of dividends and what portion should be retained in the business. An optimal dividend pay-out ratio
maximises shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are
to be taken jointly keeping in view their joint effect on the shareholders’ wealth

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 RTP- MAY 2019
SECTION A: FINANCIAL MANAGEMENT

QUESTIONS

Ratio Analysis
1. From the following table of financial ratios of R. Textiles Limited, comment on various ratios given at the
end:

Ratios 2017 2018 Average of

Textile Industry
Liquidity Ratios
Current ratio 2.2 2.5 2.5
Quick ratio 1.5 2 1.5
Receivable turnover ratio 6 6 6
Inventory turnover 9 10 6
Receivables collection 87 days 86 days 85 days
period
Operating profitability
Operating income –ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing decisions
Debt ratio 49.00% 48.00% 57%
Return
Return on equity 24% 25% 15%

COMMENT on the following aspect of R. Textiles Limited

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(i) Liquidity

(ii) Operating profits

(iii) Financing

(iv) Return to the shareholders

ANSWER 1

Ratios Comment
Liquidity Current ratio has improved from last year and matching
the industry average.
Quick ratio also improved than last year and above the
industry average. This may happen due to reduction in
receivable collection period and quick inventory turnover.
However, this also indicates idleness of funds.
Overall it is reasonably good. All the liquidity ratios are
either better or same in both the year compare to the
Industry Average.
Operating Profits Operating Income-ROI reduced from last year but
Operating Profit Margin has been maintained. This may
happen due to variability of cost on turnover. However,
both the ratio are still higher than the industry average.
Financing The company has reduced its debt capital by 1% and saved
operating profit for equity shareholders. It also signifies
that dependency on debt compared to other industry
players (57%) is low.
Return to the shareholders R’s ROE is 24 per cent in 2017 and 25 per cent in 2018
compared to an industry average of 15 per cent. The ROE is
stable and improved over the last year.

Cost of Capital

2. As a financial analyst of a large electronics company, you are required to DETERMINE the weighted
average cost of capital of the company using (a) book value weights and (b) market value weights. The
following information is available for your perusal.

716
The Company’s present book value capital structure is:

Debentures (₹100 per debenture) 8,00,000

Preference shares (₹100 per share) 2,00,000
Equity shares (₹10 per share) 10,00,000
20,00,000

All these securities are traded in the capital markets. Recent prices are:
Debentures, ₹110 per debenture, Preference shares, ₹120 per share, and Equity shares, ₹ 22 per share
Anticipated external financing opportunities are:

(i) ₹ 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4 per cent flotation
costs, sale price, ₹ 100

(ii) ₹ 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5 per cent
flotation costs, sale price, ₹100.

(iii) Equity shares: ₹ 2 per share flotation costs, sale price = ₹ 22.
In addition, the dividend expected on the equity share at the end of the year is ₹ 2 per share, the
anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings in
the form of dividends. The corporate tax rate is 35 per cent.

ANSWER 2

Determination of specific costs:

717
I – Interest, t – Tax, RV- Redeemable value, NP- Net proceeds, N- No. of years, PD-Preference dividend,
D1- Expected Dividend, P0- Price of share (net)

Using these specific costs we can calculate WACC on the basis of book value and market value weights as
follows:
(a) Weighted Average Cost of Capital (K0) based on Book value weights

Source of Book Weights Specific WACC (%)

capital value (₹) cost (%)
Debentur 8,00,000 0.40 7.70 3.08
es
Preferenc 2,00,000 0.10 12.82 1.28
es shares
Equity 10,00,000 0.50 17.00 8.50
shares
20,00,000 1.00 12.86

(b) Weighted Average Cost of Capital (K0) based on market value weights:

Source of capital Market value Weights Specific cost (%) WACC (%)
(₹)
Debentures 8,80,000 0.265 7.70 2.04
8,00,000 X 110 / 100
Preferences shares 2,40,000 0.072 12.82 0.92
2,00,000 X 120 / 100
Equity shares 22,00,000 0.663 17.00 11.27
10,00,000 X 22 /10
33,20,000 1.000 14.23

Capital Structure

3. Akash Limited provides you the following information:

718
(₹)
Profit (EBIT) 2,80,000
Less: Interest on Debenture @ 10% (40,000)
EBT 2,40,000
Less Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity Shares (₹ 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10
The company has reserves and surplus of ₹ 7,00,000 and required ₹ 4,00,000 further for modernisation.
Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity) Ratio higher than 40% will bring
the P/E Ratio down to 8 and increase the interest rate on additional debts to 12%. You are required to
ASCERTAIN the probable price of the share.

(i) If the additional capital are raised as debt; and

(ii) If the amount is raised by issuing equity shares at ruling market price.

ANSWER 3

Ascertainment of probable price of shares of Akash limited

Particulars Plan-I Plan-I I

I f ₹ 4,00,000 is raised I f ₹ 4,00,000 is raised by
as debt (₹) issuing equity shares
(₹)
Earnings Before Interest and Tax 3,60,000 3,60,000
(EBIT)
{20% of new capital i.e. 20% of
(₹14,00,000 + ₹4,00,000)}
(Refer working note1)
Less: Interest on old debentures (40,000) (40,000)
(10% of ₹4,00,000)
Less: Interest on new debt (48,000) --
(12% of ₹4,00,000)
Earnings Before Tax (EBT) 2,72,000 3,20,000
Less: Tax @ 50% (1,36,000) (1,60,000)
Earnings for equity shareholders 1,36,000 1,60,000
(EAT)
No. of Equity Shares (refer 30,000 40,000
working note 2)

719
Earnings per Share (EPS) ₹ 4.53 ₹ 4.00
Price/ Earnings (P/E) Ratio (refer 8 10
working note 3)
Probable Price Per Share (PE ₹ 36.24 ₹ 40
Ratio × EPS)
Working Notes:

1. Calculation of existing Return of Capital Employed (ROCE):

Equity Share capital (30,000 3,00,000

shares × ₹10)
10% Debentures 4,00,000
Reserves and Surplus 7,00,000
Total Capital Employed 14,00,000
Earnings before interest and 2,80,000
tax (EBIT) (given)
ROCE = 2,80,000 X100 / 20%
14,00,000

Leverage
4. A Company had the following Balance Sheet as on March 31, 2019:

Equity and Liabilities (₹ in crore) Assets (₹ in crore)

720
Equity Share Capital 100 Fixed 250
(10 crore shares of ₹ 10 Assets
each) (Net)
Reserves and Surplus 20 Current 150
Assets
15% Debentures 200
Current Liabilities 80
400 400
The additional information given is as under:

Fixed Costs per annum (excluding interest) ₹ 80 crores

Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required:

CALCULATE the following and comment:

(i) Earnings per share

(ii) Operating Leverage

(iii) Financial Leverage

(iv) Combined Leverage.

ANSWER 4

Total Assets = ₹ 400 crores

Asset Turnover Ratio = 2.5
Hence, Total Sales = 400 2.5 = ₹ 1,000 crores

Computation of Profits after Tax (PAT)

(₹ in
crore)
Sales 1,000
Less: Variable operating cost (65% of ₹1,000 (650)
crore)
Contribution 350
Less: Fixed cost (other than Interest) (80)

721
EBIT 270
Less: Interest on debentures (15% ₹200 crore) (30)
EBT 240
Less: Tax 40% (96)
EAT (earnings available to equity share holders) 144
It indicates sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.

Capital Budgeting
5. BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives. Following
new X-ray machines are of two different brands with same features are available for the purchase.

Maintenance Cost
Brand Cost of Machine Life of Machine Year 1-5 Year 6-10 Year 11- Rate of

722
15 Depreciation
XYZ ₹6,00,000 15 years ₹ 20,000 ₹ 28,000 ₹ 39,000 4%
ABC ₹4,50,000 10 years ₹ 31,000 ₹ 53,000 -- 6%

Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and
thereafter shall be depreciated at the rate mentioned above.
Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after
use on the following terms and conditions:
• Annual Rent shall be paid in the beginning of each year and for first year it shall be ₹ 1,02,000.

• Annual Rent for the subsequent 4 years shall be ₹ 1,02,500.

• Annual Rent for the final 5 years shall be ₹ 1,09,950.

• The Rent Agreement can be terminated by BT Labs by making a payment of ₹ 1,00,000 as penalty. This
penalty would be reduced by ₹ 10,000 each year of the period of rental agreement.

You are required to:

(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be
continued for a period of 20 years.

(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years?
The cost of capital of BT Labs is 12%.

ANSWER 5

Since the life span of each machine is different and time span exceeds the useful lives of each model, we shall
use Equivalent Annual Cost method to decide which brand should be chosen.

(i) If machine is used for 20 years

Present Value (PV) of cost if machine of Brand XYZ is purchased

Period Cash Outflow (₹) PVF@12% Present Value

0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
6-10 28,000 2.045 57,260
11-15 39,000 1.161 45,279
15 (64,000) 0.183 (11,712)
6,51,786

723
Present Value (PV) of cost if machine of Brand ABC is taken on Rent

Period Cash Outflow (₹) PVF@12% Present Value

0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5-9 1,09,950 2.291 2,51,895
6,65,188

Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the same
should be purchased.

(ii) If machine is used for 5 years

(a) Scrap Value of Machine of Brand XYZ

= ₹ 6,00,000 – ₹ 2,00,000 – ₹ 6,00,000 × 0.04 × 4 = ₹ 3,04,000

(b) Scrap Value of Machine of Brand ABC

= ₹ 4,50,000 – ₹ 1,50,000 – ₹ 4,50,000 × 0.06 × 4 = ₹ 1,92,000

Present Value (PV) of cost if machine of Brand XYZ is purchased

Period Cash Outflow (₹) PVF@12% Present Value

0 6,00,000 1.000 6,00,000

724
1-5 20,000 3.605 72,100
5 (3,04,000) 0.567 (1,72,368)
4,52,891

Present Value (PV) of cost if machine of Brand ABC is taken on Rent

Period Cash Outflow (₹) PVF@12% Present Value
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5 50,000 0.567 28,350
4,41,643
Decision: Since Cash Outflow is least in case of lease of Machine of brand ABC the same should be taken on
rent.

Working Capital Management

6. A company is considering its working capital investment and financial policies for the next year.
Estimated fixed assets and current liabilities for the next year are ₹ 2.60 crores and ₹ 2.34 crores
respectively. Estimated Sales and EBIT depend on current assets investment, particularly inventories and
book-debts. The Financial Controller of the company is examining the following alternative Working Capital
Policies:
(₹ in crore)

Working Investment in Estimated EBIT

Capital Policy Current Sales
Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.0

After evaluating the working capital policy, the Financial Controller has advised the adoption of the
moderate working capital policy. The company is now examining the use of long-term and short-term
borrowings for financing its assets. The company will use ₹ 2.50 crores of the equity funds. The corporate
tax rate is 35%. The company is considering the following debt alternatives.

Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate- 12% 16%
Average

You are required to CALCULATE the following:

(i) Working Capital Investment for each policy: 725

(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio

(ii) Financing for each policy:

(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.
ANSWER 6

(i) Statement showing Working Capital Investment for each policy (₹ in crore)

Working Capital Policy

Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v) = (iii) - (iv) 4.76 4.16 2.86
Total liabilities: (iv) + (v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i) - (iv) 2.16 1.56 0.26
(b) Rate of return: (vii) /(iii) 17.32% 17.69% 19.23%
(c) Current ratio: (i)/ (iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy (₹ in crore)

Financing Policy Conservative Moderate Aggressive

Current Assets (i) 3.90 3.90 3.90
Fixed Assets (ii) 2.60 2.60 2.60
Total Assets (iii) 6.50 6.50 6.50
Current Liabilities (iv) 2.34 2.34 2.34
Short term Debt (v) 0.54 1.00 1.50
Total current liabilities 2.88 3.34 3.84
(vi) = (iv) + (v)

726
Long term Debt (vii) 1.12 0.66 0.16
Equity Capital (viii) 2.50 2.50 2.50
Total liabilities (ix) = (vi)+(vii)+(viii) 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT (x) 1.15 1.15 1.15
Less: Interest on short-term debt 0.06 0.12 0.18
(12% of ₹0.54) (12% of ₹ 1) (12% of ₹ 1.5)
Interest on long term debt 0.18 0.11 0.03
(16% of ₹1.12) (16% of ₹0.66) (16% of ₹0.16)
Earnings before tax (EBT) (xi) 0.91 0.92 0.94
Taxes @ 35% (xii) 0.32 0.32 0.33
Earnings after tax: (xiii) = (xi) – (xii) 0.59 0.60 0.61
(a) Net Working Capital 1.02 0.56 0.06
Position: (i) - [(iv) + (v)]
(b) Rate of return on shareholders 23.6% 24.0% 24.4%
Equity capital : (xiii)/ (viii)
(c) Current Ratio (i) / (vi) 1.35 1.17 1.02

Management of Working Capital

7. A proforma cost sheet of a company provides the following particulars:

Amount per unit (₹)

Raw materials cost 100.00
Direct labour cost 37.50
Overheads cost 75.00
Total cost 212.50
Profit 37.50
Selling Price 250.00

The Company keeps raw material in stock, on an average for one month; work-in-progress, on an average
for one week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag
in payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put together
at ₹37,500.

727
Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000
units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects.

ANSWER 7
Statement showing Estimate of Working Capital Needs

728
Risk Analysis in Capital Budgeting

8. An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that are
estimated over the life of the project.

Year Cash flows (₹In

lakhs)
1 25
2 60
3 75
4 80
5 65

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate.

ANSWER 8

The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as below:

Year Cash flows Discounting Present value

₹ In lakhs Factor @ 7% of Cash Flows ₹
In Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04

729
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment (100.00)
Net Present Value (NPV) 144.34

Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %. So the risk
adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:

Year Cash flows Discounting Present Value

₹ in Lakhs Factor @ 14% of Cash Flows
₹ in lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.79
Initial investment (100.00)
Net present value (NPV) 99.79

Dividend Decision

9. The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹30 lakhs

Outstanding 12% preference shares ₹100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.

ANSWER 9

₹ in lakhs 730
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = ₹ 6.00
Miscellaneous
10. Write short notes on the following:

(a) Functions of Finance Manager.

(b) Inter relationship between investment, financing and dividend decisions.

(c) Debt securitisation

ANSWER 10

(a) Functions of Finance Manager

The Finance Manager’s main objective is to manage funds in such a way so as to ensure their optimum

731
utilisation and their procurement in a manner that the risk, cost and control considerations are properly
balanced in a given situation. To achieve these objectives the Finance Manager performs the following
functions:

(i) Estimating the requirement of Funds: Both for long-term purposes i.e. investment in fixed assets and for
short-term i.e. for working capital. Forecasting the requirements of funds involves the use of techniques of
budgetary control and long-range planning.
(ii) Decision regarding Capital Structure: Once the requirement of funds has been estimated, a decision
regarding various sources from which these funds would be raised has to be taken. A proper balance has to be
made between the loan funds and own funds. He has to ensure that he raises sufficient long term funds to
finance fixed assets and other long term investments and to provide for the needs of working capital.

(iii) Investment Decision: The investment of funds, in a project has to be made after careful assessment of
various projects through capital budgeting. Assets management policies are to be laid down regarding various
items of current assets. For e.g. receivable in coordination with sales manager, inventory in coordination with
production manager.

(iv) Dividend decision: The finance manager is concerned with the decision as to how much to retain and what
portion to pay as dividend depending on the company’s policy. Trend of earnings, trend of share market
prices, requirement of funds for future growth, cash flow situation etc., are to be considered.

(v) Evaluating financial performance: A finance manager has to constantly review the financial performance of
the various units of organisation generally in terms of ROI Such a review helps the management in seeing how
the funds have been utilised in various divisions and what can be done to improve it.

(vi) Financial negotiation: The finance manager plays a very important role in carrying out negotiations with
the financial institutions, banks and public depositors for raising of funds on favourable terms.

(vii) Cash management: The finance manager lays down the cash management and cash disbursement policies
with a view to supply adequate funds to all units of organisation and to ensure that there is no excessive cash.

(viii) Keeping touch with stock exchange: Finance manager is required to analyse major trends in stock market
and their impact on the price of the company share.

732
(b) Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing and dividend
decisions. It is correct to say that these decisions are inter-related because the underlying objective of these
three decisions is the same, i.e. maximisation of shareholders’ wealth. Since investment, financing and
dividend decisions are all interrelated, one has to consider the joint impact of these decisions on the market
price of the company’s shares and these decisions should also be solved jointly. The decision to invest in a new
project needs the finance for the investment. The financing decision, in turn, is influenced by and influences
dividend decision because retained earnings used in internal financing deprive shareholders of their dividends.
An efficient financial management can ensure optimal joint decisions. This is possible by evaluating each
decision in relation to its effect on the shareholders’ wealth.

The above three decisions are briefly examined below in the light of their inter-relationship and to see how
they can help in maximising the shareholders’ wealth i.e. market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be
accepted which is expected to yield at least so much return as is adequate to meet its cost of financing. This
have an influence on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the
total volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. The optimum
financing mix will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by
way of dividends and what portion should be retained in the business. An optimal dividend pay-out ratio
maximises shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are
to be taken jointly keeping in view their joint effect on the shareholders’ wealth.

(c) Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to financial intermediaries
to support the lending volumes. Assets generating steady cash flows are packaged together and against this
asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.

Process of Debt Securitisation

(i) The origination function – A borrower seeks a loan from a finance company, bank. The credit worthiness of
borrower is evaluated and contract is entered into with repayment schedule structured over the life of the
loan.

(ii) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of 733
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.

(iii) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The
securities carry a coupon and expected maturity which can be asset-based/mortgage based. These are
generally sold to investors through merchant bankers. Investors are – pension funds, mutual funds, insurance
funds.
 SECTION : B: ECONOMICS FOR FINANCE

QUESTIONS

1 (a) (i) Differentiate between ‘taxes on production’ and ‘product taxes’

(ii) Distinguish between non-economic activities and economic activities?

(b) Using the information given in the following table calculate,

(i) Value added by firm A and firm B

(ii) Gross Domestic Product at Market Price

(iii) Net Domestic Product at Factor Cost.

Particulars ₹ crore
(i) Sales by firm B to general 300
government
(ii) Sales by firm A 1500
(iii) Sales by firm B to households 1350
(iv) Change in stock of firm A 200
(v) Closing stock of firm B 140
(vi) Opening stock of firm B 130
(vii) Purchases by firm A 270
(viii) Indirect taxes paid by both the 375
firms
(ix) Consumption of fixed capital 720
(x) Sales by firm A to B 300
ANSWER 1

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(a) (i) Product taxes like excise duties, customs, sales tax, service tax etc., are levied by the government on
goods and services and are generally related to the quantum of production.
Taxes on production, such as, factory license fee, taxes to be paid to the local authorities, pollution tax etc.,
on the other hand, are unrelated to the quantum of production.

(ii) Economic activities as distinguished from non-economic activities, include all human activities which
create goods and services that can be valued at market price. Non-economic activities are those which
produce goods and service, but are not exchanged in a market transaction so that do not command any
market value.
(b) (i) Value added by Firm A and Firm B
Gross Value Added (GVAMP) of Firm A = Gross value of output (GVOMP) of Firm A - Intermediate consumption
of firm A

= (Sales by firm A + Change in stock of firm A) - (Purchases by firm A)

= [(ii) + (iv)] – (vii) = (1500 + 200) - 270 = 1430 Crores

Gross Value Added (GVAMP) of Firm B = Gross value of output (GVOMP) of firm B -Intermediate consumption
of firm B

= [Sales by firm B to general government + Sales by firm B to households + (Closing stock of firm B - Opening
stock of firm B)] - Purchases by firm B

= [(300 + 1350) + (140 - 130)] - 300 = 1650 + 10 - 300 = ₹ 1360 Crores

(ii) Gross Domestic product at Market Price:

= Value added by firm A + Value added by firm B = 1430 + 1360 = ₹ 2790 Crores

(iii) Net Domestic Price at Factor Cost:

NDP FC = Gross Domestic product at market price - Consumption of fixed capital – Indirect taxes paid by both
the firms
= 2790 - (ix) - (viii) = 2790 - 720 – (375 -0) = ₹ 1695 Crores

2. (a) Define multiplier. What is the range of values it can take?

(b) How do imports affects investment multiplier?

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(c) An increase of investment by ₹ 600 Crores resulted in an increase in national income by 2400 Crores. Find
MPC and MPS.

ANSWER 2

(a) Multiplier expresses the relationship between an initial increment in investment and the resulting increase
in aggregate income i.e how many times the aggregate income increases as a result of an increase in
investment. The ratio of ΔY to ΔI is called the investment multiplier, k. For example, if a change in investment
of ₹ 2000 million causes a change in national income of ₹ 6000 million, then the multiplier is 6000/2000 = 3.
Thus multiplier indicates the change in national income for each rupee change in the desired investment. The
value 3 in the above example tells us that for every Re. 1 increase in desired investment expenditure, there
will be ₹ 3 increase in equilibrium national income. The ratio of ΔY to ΔI is called the investment multiplier, k.

k = Change in Income / Change in Investment = Δ Y / ΔI

The size of the multiplier effect is given by Δ Y = k ΔI.

The increase in income per rupee increase in investment is:

From the above, we find that the marginal propensity to consume (MPC) is the determinant of the value of the
multiplier and that there exists a direct relationship between MPC and the value of multiplier. Higher the MPC,
more will be the value of the multiplier, and vice-versa. On the contrary, higher the MPS, lower will be the
value of multiplier and vice-versa.

Since, 0<MPC<1; therefore,

if MPC is zero then K = 1 and if MPC = 1, then K=∞

The maximum value of multiplier is infinity when the value of MPC is 1 i.e. the economy decides to consume
the whole of its additional income.

(b) The greater will be propensity to import, the lower will be autonomous expenditure multiplier

(c) The ratio of ΔY to ΔI is called the investment multiplier, k.

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3. (a) Classify each of the following goods based on their characteristics. Mention the rationale.

(i) Open-access Wi-Fi networks

(ii) Roads with toll booths

(iii) Parks

(b) What is the major determinant of the economic functions of a government?

(c) Distinguish between private cost and social cost

(d) Describe the term ‘Tragedy of commons’.

ANSWER 3

(a) All the goods mentioned in the question can be classified as impure public good. There are many hybrid
goods that possess some features of both public and private goods. These goods are called impure public
goods and are partially rivalrous or congestible. Because of the possibility of congestion, the benefit that an
individual gets from an impure public good depends on the number of users. Consumption of these goods by
another person reduces, but does not eliminate, the benefits that other people receive from their
consumption of the same good. Impure public goods also differ from pure public goods in that they are often
excludable.
Since free riding can be eliminated, the impure public good may be provided either by the market or by the
government at a price or fee. If the consumption of a good can be excluded, then the market would provide a
price mechanism for it. The provider of an impure public good may be able to control the degree of congestion
either by regulating the number of people who may use it, or the frequency with which it may be used or
both.

(b) The nature of the economic system determines the size and scope of the economic functions of the
government. In a centrally planned socialistic economy, the state owns all productive resources and makes all
important economic decisions. On the contrary, in a market economy, all important economic decisions are
made by individuals and firms who want to maximise self interest and there is only limited role for the

737
government. In a mixed economic system, both markets and government contribute towards resource
allocation decisions.

(c) Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the
case of a producer, his private cost includes direct cost of labour, materials, energy and other indirect
overheads. These are usually added up to determine market price. The actions of consumers or producers
result in costs or benefits to others and the relevant costs and benefits are not reflected as part of market
prices. In other words, market prices do not incorporate externalities. Social costs refer to the total costs to
the society on account of a production or consumption activity. Social costs are private costs borne by
individuals directly involved in a transaction together with the external costs borne by third parties not directly
involved in the transaction. Social costs represent the true burdens carried by society in monetary and non-
monetary terms.

(d) Common access resources such as oceans tend to be over-consumed in an unregulated market because
they are rivalrous and non-excludable in consumption. ‘Tragedy of the commons’ is a term to describe the
problem which occurs when rivalrous but non-excludable goods are overused by individual users acting
independently and rationally according to their own self-interest. In doing so, they behave contrary to the
common good of all users by depleting a shared common resource to the disadvantage of the entire universe.

4. Explain the concept of adverse selection. What are the possible consequences of adverse selection?

ANSWER 4

Adverse selection is a situation in which asymmetric information about quality eliminates high-quality goods
from a market. It a form of market failure which occurs when buyers have better information than sellers due
to hidden information, and this can distort the usual market process. For example, in the insurance market
adverse selection is the tendency for people with higher risk to obtain insurance coverage to a greater extent
than persons with lesser risk because compared to insurance buyers, insurers know less about the health
conditions of buyers and are therefore unable to differentiate between high-risk and low-risk persons. If the
insurance company charges an average price, and only high-risk consumers buy insurance it will make losses.
It is therefore possible that there will be higher overall premium as firms insure themselves against high-risk
customers buying insurance. Then the low-risk customers may not want to buy insurance because it is quite
expensive. Economic agents end up either selecting a sub-standard product or leaving the market altogether
leading to a condition of ‘missing market’. If the sellers wish to do business profitably, they may have to incur
considerable costs in terms of time and money for identifying the extent of risk for different buyers.

5. (a) Why do you consider national defence as a public good?

(b) Define information failure 738

ANSWER 5

(a) National defence has all characteristics of a public good. It yields utility to people; its consumption is
essentially nonrival, non-excludable and collective in nature and is characterized by indivisibility. National
defence is available for all individuals whether they pay taxes or not and it is impossible to exclude anyone
within the country from consuming and benefiting from it. No direct payment by the consumer is involved in
the case of defence. Once it is provided, the additional resource cost of another person consuming it is zero.
Defence also has the unique feature of public good i.e. it does not conform to the settings of market
exchange. Though defence is extremely valuable for the wellbeing of the society, left to market, it will not be
produced at all or will be under produced.

(b) Perfect information which implies that both buyers and sellers have complete information about anything
that may influence their decision making is an important element of an efficient competitive market.
Information failure occurs when lack of information can result in consumers and producers making decisions
that do not maximize welfare. Information failure is widespread in numerous market exchanges due to
complex nature of goods and services that are transacted, inaccurate and incomplete data, and non-
availability of correct information

6. (a) Explain the function of money as a unit of account?

(b) Examine the different variables on demand for money according to inventory theoretic approach.

ANSWER 6

(a) A unit of account is a common unit for measuring how much something is worth. The monetary unit (for
e.g. Rupee, Dollar) serves as a numeraire or common measure value in terms of which the value of all goods,
services, assets, liabilities, income, expenditure etc are measured and expressed. This helps in measuring and
fixing the exchange values in terms of a common unit and avoids the problem of recording and expressing the
value of each commodity in terms of quantities of other goods. Use of money as a unit of account thus

• reduces the number of exchange ratios between goods and services

• makes it possible to keep business accounts

• allows meaningful interpretation of prices, costs, and profits, and

• facilitates a system of trade through orderly pricing, comparison of value and rational economic choices. 739

(b) Inventory Theoretic Approach (by Baumol and Tobin), assume that there are two media for storing value:
money and an interest-bearing alternative asset. There is a fixed cost of making transfers between money and
the alternative assets e.g. broker charges. While relatively liquid financial assets other than money (such as,
bank deposits) offer a positive return, the above said transaction costs of going between money and these
assets justifies holding money.
Baumol used business inventory approach to analyze the behaviour of individuals. Just as businesses keep
money to facilitate their business transactions, people also hold cash balance which involves an opportunity
cost in terms of lost interest. Therefore, they hold an optimum combination of bonds and cash balance, i.e., an
amount that minimizes the opportunity cost.
Baumol’s propositions in his theory of transaction demand for money hold that receipt of income, say Y takes
place once per unit of time but expenditure is spread at a constant rate over the entire period of time. Excess
cash over and above what is required for transactions during the period under consideration will be invested
in bonds or put in an interest-bearing account. Money holdings on an average will be lower if people hold
bonds or other interest yielding assets.
The higher the income, the higher is the average level or inventory of money holdings. The level of inventory
holding also depends also upon the carrying cost, which is the interest forgone by holding money and not
bonds, net of the cost to the individual of making a transfer between money and bonds, say for example
brokerage fee. The individual will choose the number of times the transfer between money and bonds takes
place in such a way that the net profits from bond transactions are maximized.
The average transaction balance (money) holding is a function of the number of times the transfer between
money and bonds takes place. The more the number of times the bond transaction is made, the lesser will be
the average transaction balance holdings. In other words, the choice of the number of times the bond
transaction is made determines the split of money and bond holdings for a given income.
The inventory-theoretic approach also suggests that the demand for money and bonds depend on the cost of
making a transfer between money and bonds e.g. the brokerage fee. An increase the brokerage fee raises the
marginal cost of bond market transactions and consequently lowers the number of such transactions. The
increase in the brokerage fee raises the transactions demand for money and lowers the average bond holding
over the period. This result follows because an increase in the brokerage fee makes it more costly to switch
funds temporarily into bond holdings. An individual combines his asset portfolio of cash and bond in such
proportions that his cost is minimized

7. (a) Define Reserve Money? Compute the Reserve Money from the following data Published by RBI.

Components (In billions of ₹) As on 7th July

2018
Currency in circulation 15428.40
Bankers Deposits with RBI 4596.18
Other Deposits with RBI 183.30

(b) Which of the functions of money do the following items satisfy? 740

(i) A credit card.

(ii) A token of specified amount of money which can be used for shopping

(c) What role does Market Stabilization Scheme (MSS) play in our economy?
ANSWER 7

(a) Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
=15428.40 + 4596.18 + 183.30
= 20207.88

(b) (i) A credit card is a medium of exchange

(ii) A token of specified amount of money which can be used for shopping satisfies all 3 functions of money,
which are store of value, unit of account, and medium of exchange.

(c) Market Stabilization Scheme for monetary management was introduced in 2004 following a MoU between
the Reserve Bank of India (RBI) and the Government of India (GoI) with the primary aim of aiding the
sterilization operations of the RBI. (Sterilization is the process by which the monetary authority sterilizes the
effects of significant foreign capital inflows on domestic liquidity by off-loading parts of the stock of
government securities held by it). Under this scheme, the Government of India borrows from the RBI (such
borrowing being additional to its normal borrowing requirements) and issues treasury-bills/dated securities
for absorbing excess liquidity from the market arising from large capital inflows.

8. (a) Mention the core principle of comparative advantage

(b) Explain the operational procedure of the monetary policy of India?

ANSWER 8

(a) A nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in
which it’s absolute disadvantage is greater (this is the commodity of its comparative disadvantage).

(b) Operating procedures are the variety of rules, traditions and practices used in the actual implementation
of monetary policy. It encompasses, basically, a set of tactics such as choice of the operating target and policy
instruments, the nature and frequency of use of policy instruments, market interventions, the width of
corridor for market interest rates and the manner of policy signals to effect desired changes in the

741
intermediate target. In other words, the operating procedure in monetary policy refers to its implementation
in very short run, including the day-to-day operations.
9. How do foreign direct investments affect human capital in recipient countries?

ANSWER 9

Since FDI involves setting up of production base (in terms of factories, power plants, etc.) it generates direct
employment in the recipient country. Subsequent FDI as well as domestic investments propelled in the
downstream and upstream projects that come up in multitude of other services generate multiplier effects on
employment and income. FDI not only creates direct employment opportunities but also, through backward
and forward linkages, it is able to generate indirect employment opportunities as well. It is also argued that
more indirect employment will be generated to persons in the lower-end services sector occupations thereby
catering to an extent even to the less educated and unskilled engaged in those units. This impact is particularly
important if the recipient country is a developing country with an excess supply of labour caused by
population pressure.

Foreign direct investments also promote relatively higher wages for skilled jobs. However, jobs that require
expertise and entrepreneurial skills for creative decision making may generally be retained in the home
country and therefore the host country is left with routine management jobs that demand only lower levels of
skills and ability. This may result in ‘crowding in’ of people in jobs requiring low skills, perpetuation of low
labour standards and differential treatment.

FDIs are likely use labor-saving technology and capital-intensive methods in a labour-abundant country and
cause labour displacement. Such technology is inappropriate for a labour-abundant country as it does not
support generation of jobs which is a crucial requirement to address poverty and unemployment which are
the two fundamental areas of concern for the less developed countries. Not only that foreign entities fail to
support employment generation, but they may also drive out domestic firms from the industry resulting in
serious problems of displacement of labour.

10. (a) What is local content requirement? How will it affect trade?

(b) How is exchange rate determined under floating exchange rate regime?

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(c) What is meant by trade distortion?
ANSWER 10
(a) Local content requirements (LCRs) are conditions imposed by a host country government that require
investing firms to purchase and use domestically manufactured goods or domestically supplied services in
order to operate in an economy. The fraction of a final good to be procured locally may be specified either in
value terms (e.g. 25% of the value of a product must be locally produced), by requiring that some minimum
share of the value of a good represent home value added, or in physical units ( eg. 50% of component parts for
a product must be locally produced). From the viewpoint of domestic producers of inputs, local content
requirement provides greater demand which is not necessarily associated to their competitiveness and for
components/ parts manufacturers gives protection in the same way that an import quota would. Local
content requirement benefits producers and not consumers because such requirements may raise the prices.

(b) Under floating exchange rate regime the equilibrium value of the exchange rate of a country’s currency is
market determined i.e. the demand for and supply of currency relative to other currencies determines the
exchange rate.

(c) Trade is distorted if quantities of commodities produced, bought, and sold and their prices are higher or
lower than levels that would usually exist in a competitive market. For example, barriers to imports such as
tariffs, domestic subsidies and quantitative restrictions can make agricultural products more costly in a market
of a country. The higher prices will result in higher production of crop. Then export subsidies are needed to
sell the surplus output in the world markets, where prices are low. Thus, the subsidising countries can be
producing and exporting considerably more than what they normally would.

743
 PAPER-MAY 2018

SECTION – A: FINANCIAL MANAGEMENT

Question 1

(a) Stopgo Ltd, an all equity financed company, is considering the repurchase of ₹ 200 lakhs equity and to
replace it with 15% debentures of the same amount. Current market Value of the company is ₹ 1140 lakhs
and it's cost of capital is 20%. It's Earnings before Interest and Taxes (EBIT) are expected to remain constant
in future. It's entire earnings are distributed as dividend. Applicable tax rate is 30 per cent.
You are required to calculate the impact on the following on account of the change in the capital structure
as per Modigliani and Miller (MM) Hypothesis:

(i) The market value of the company

(ii) It's cost of capital, and

(iii) It’s cost of equity (5 Marks)

(b) The following data have been extracted from the books of LM Ltd:
Sales - ₹100 lakhs
Interest Payable per annum - ₹ 10 lakhs
Operating leverage - 1.2
Combined leverage - 2.16
You are required to calculate:

(i) The financial leverage,

(ii) Fixed cost and 744

(iii) P/V ratio (5 Marks)
(c) The accountant of Moon Ltd. has reported the following data:

Gross profit ₹ 60,000

Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days

Assume 360 days in a year

You are required to complete the following: (5 Marks)

Balance Sheet of Moon Ltd.

Liabilities ₹ Assets ₹
Net Worth Fixed Assets
Current Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets

(d) Sun Ltd. is considering two financing plans.

Details of which are as under:
(i) Fund's requirement – ₹ 100 Lakhs
(ii) Financial Plan

Plan Equity Debt

I 100% -

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II 25% 75%

(iii) Cost of debt – 12% p.a.

(iv) Tax Rate – 30%

(v) Equity Share ₹ 10 each, issued at a premium of ₹ 15 per share

(vi) Expected Earnings before Interest and Taxes (EBIT) ₹ 40 Lakhs

You are required to compute:

(i) EPS in each of the plan

(ii) The Financial Break Even Point

(iii) Indifference point between Plan I and II (5 Marks)

ANSWER 1

All Equity Debt of Equity

(₹ In lakhs) (₹ In lakhs)
EBIT 325.70 325.70
Interest on ₹200 lakhs @ 15% -- 30.00
EBT 325.70 295.70
Tax @ 30 % 97.70 88.70
Income available to equity holders 228 207

(i) Market value of levered firm = Value of unlevered firm + Tax Advantage
= ₹ 1,140 lakhs + (₹200 lakhs x 0.3)

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= ₹ 1,200 lakhs
The impact is that the market value of the company has increased by ₹ 60 lakhs (₹ 1,200 lakhs – ₹ 1,140 lakhs)

Calculation of Cost of Equity

Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %
(ii) Cost of Capital

Components Amount Cost of Capital Weight WACC %

(₹ In lakhs) %
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00

The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax relief on debt interest
payment.

(iii) Cost of Equity is 20.7% [As calculated in point (i)]

The impact is that cost of equity has risen by 0.7% i.e. 20.7% - 20% due to the presence of financial risk.
Further, Cost of Capital and Cost of equity can also be calculated with the help of formulas as below, though
there will be no change in final answers.
Cost of Capital (Ko) = Keu(1-tL)

Where,

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b) (i) Calculation of Financial Leverage:
Combined Leverage (CL) = Operating Leverage (OL) Financial Leverage (FL)
2.16 = 1.2 X FL
FL = 1.8

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= 0.9 X ₹ 10,00,000 = ₹ 9,00,000

Current Liability = Total Assets – Net Worth

= ₹ 10,00,000 – ₹ 9,00,000
= ₹ 1,00,000

Current Assets = 1.5 x Current Liability

= 1.5 x ₹ 1,00,000 = ₹ 1,50,000

Stock = Current Assets – Liquid Assets

= Current Assets – (Liquid Assets / Current Liabilities =1)
= 1,50,000 – (LA / 1,00,000 = 1) = ₹ 50,000

Debtors = Average Collection Period X Credit Sales / 360

= 60 x 0.8 x 3,00,000 / 360 = ₹ 40,000

Cash = Current Assets – Debtors – Stock

= ₹ 1,50,000 – ₹ 40,000 – ₹ 50,000
=₹ 60,000

Fixed Assets = Total Assets – Current Assets

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= ₹ 10,00,000 – ₹ 1,50,000
= ₹ 8,50,000
 Balance Sheet

Liabilities ₹ Assets ₹
Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities 1,00,000 Stock 50,000
Debtors 40,000
Cash 60,000
Total liabilities 10,00,000 Total Assets 10,00,000
(d) (i) Computation of Earnings Per Share (EPS)

Plans I (₹) II (₹)

Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of ₹75 lakh) -- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ ₹10+₹15) 4,00,000 1,00,000
E.P.S (₹) 7.00 21.70

(ii) Computation of Financial Break-even Points

Plan ‘I’ = 0 – Under this plan there is no interest payment, hence the financial break-even point will be zero.
Plan ‘II’ = ₹ 9,00,000 - Under this plan there is an interest payment of ₹9,00,000, hence the financial break -
even point will be ₹9 lakhs

(iii) Computation of Indifference Point between Plan I and Plan II:

Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be calculated by applying the
following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2

750
Question 2

(a) XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment
in a project which will require ₹ 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of ₹ 42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take advantage of tax
benefits of debt, and propose to finance the new project with undated perpetual debt secured on the
company's assets.

The company intends to issue sufficient debt to cover the cost of capital expenditure and the after tax cost
of issue.

The current annual gross rate of interest required by the market on corporate undated debt of similar risk is
10%. The after tax costs of issue are expected to be ₹ 10 lakhs. Company's tax rate is 30%.

You are required to calculate:

(i) The adjusted present value of the investment,

(ii) The adjusted discount rate and

(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments. (8 Marks)

(b) What are Masala Bonds? (2 Marks)

Answer

(a) (i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs

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= ₹ 30

Issue costs = ₹ 10 lakhs

Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs
= ₹ 280 lakhs

Annual tax relief on interest payment = ₹ 280 X 0.1 X 0.3

= ₹ 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1
= ₹ 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs = ₹ 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero

Let the annual income be x.
(-) ₹280 lakhs X (Annual Income / 0.14) = (-) ₹104 lakhs

Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs

Therefore, Annual income = ₹ 176 X 0.14 = ₹ 24.64 lakhs

Adjusted discount rate = (₹ 24.64 lakhs / ₹280 lakhs) X 100

= 8.8%

(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the business risk of the new venture is identical
to the one being evaluated here and the project is to be financed by the same method on the same terms. The
effect on the company’s cost of capital of introducing debt into the capital structure cannot be ignored.

(b) Masala Bond:

Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate
borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated in
Indian Rupees. NTPC raised ₹2,000 crore via masala bonds for its capital expenditure in the year 2016.

Question 3
Maruti Ltd. requires a plant costing ₹ 200 Lakhs for a period of 5 years. The company can use the plant for
the stipulated period through leasing arrangement or the requisite amount can be borrowed to buy the
plant. In case of leasing, the company received a proposal to pay annual lease rent of ₹ 48 Lakhs at the end
of each year for a period of 5 years.

In case of purchase, the company would have a 12%, 5 years loan to be paid in equated annual installment, 752
each installment becoming due in the beginning of each year. It is estimated that plant can be sold for ₹ 40
Lakhs at the end of 5th year. The company uses straight line method of depreciation. Corporate tax rate is
30%. Cost of Capital after tax for the company is 10%.
The PVIF @ 10% and 12% for the five years are given below:

Year 1 2 3 4 5
PVIF @ 10 0.909 0.826 0.751 0.683 0.621
PVIF @ 12 0.893 0.797 0.712 0.636 0.567

You are required to advise whether the plant should be purchased or taken on lease. (10 Marks)

Answer

Purchase Option
Loan installment = ₹ 200 lakhs / (1 + PVIFA 12%, 4)
= ₹ 200 lakhs / (1 + 3.038) = ₹ 49.53 lakhs

Interest payable = (₹ 49.53 X 5) – ₹ 200 lakhs = ₹ 47.65 lakhs

Working note:

Amortisation of Loan Installment

Year Loan Installme Interest (₹ Principal O/S

amount (₹ nt (₹ In In Lakhs) (₹ In Amount
In Lakhs) Lakhs) Lakhs) (₹ In
Lakhs)
0 200 49.53 0.00 49.53 150.47
1 150.47 49.53 18.06 31.47 119.00
2 119.00 49.53 14.28 35.25 83.75
3 83.75 49.53 10.05 39.48 44.27
4 44.27 49.53 *5.26 44.27 -
5 0 0 0 0 0

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Calculation of PV of outflow under Purchase Option (₹ In Lakhs)

1) (2) (3) (4) (5) (6) (7) (8)

End Debt Payment Int. of the o/s Dep. Tax Shield [(3) Net Cash PV factors @ PV
Principal +(4)]x 0.3 outflows (2) – 10%
(5)
0 49.53 0.00 0.00 0.00 49.53 1.000 49.53
1 49.53 18.06 32.00 15.02 34.51 0.909 31.37
2 49.53 14.28 32.00 13.88 35.65 0.826 29.44
3 49.53 10.05 32.00 12.61 36.92 0.751 27.72
4 49.53 *5.26 32.00 11.18 38.35 0.683 26.19
5 49.53 0 32.00 9.60 (9.60) 0.621 (5.96)
47.65 160.00 158.29
Less: PV of Salvage Value (₹40 lakhs x 0.621) = 24.84
Total PV of Outflow 133.45
*Balancing Figure

Leasing Option
PV of Outflows under lease @ 10%= ₹ 48 lakhs x (1-0.30) x 3.790
= ₹ 127.34 lakhs
Decision: The plant should be taken on lease because the PV of outflows is less as compared to purchase
option.

Question 4
A company is evaluating a project that requires initial investment of ₹ 60 lakhs in fixed assets and ₹ 12 lakhs
towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by ₹ 24,00,000 during its life. The
fixed assets would have zero residual value at the end of life of 5 years. The company follows straight line
method of depreciation which is expected for tax purposes also. Inflation is expected to be 6% per year. For

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evaluating similar projects, the company uses discounting rate of 12% in real terms. Company's tax rate is
30%.

Advise whether the company should accept the project, by calculating NPV in real terms (10 Marks)

PVIF (12%, 5 years) PVIFA(12%, 5 years)

Year 1 0.893 Year 1 0.943
Year 2 0.797 Year 2 0.890
Year 3 0.712 Year 3 0.840
Year 4 0.636 Year 4 0.792
Year 5 0.567 Year 5 0.747
Answer

(i) Equipment’s initial cost = ₹ 60,00,000 + ₹ 12,00,000

= ₹ 72,00,000

(ii) Annual straight line depreciation = ₹ 60,00,000/5

= ₹ 12,00,000.

(iii) Net Annual cash flows can be calculated as follows:

= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ₹ 24,00,000 × (1 – 0.3) + (0.3 x ₹ 12,00,000)
= ₹ 16,80,000 + ₹ 3,60,000 = ₹ 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (₹ 20,40,000 × PVIF 12%, 5 years) + (₹ 12,00,000 × 0.567)
= (₹ 20,40,000 × 3.605) + ₹ 6,80,400
= ₹ 73,54,200 + ₹ 6,80,400
= ₹ 80,34,600
So NPV = PV of Inflows – Initial Cost
= ₹ 80,34,600 – ₹ 72,00,000
= ₹ 8,34,600

Advice: Company should accept the project as the NPV is Positive

Question 5
Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's
Working Capital Requirements. The following informations are available about the projections for the
current year

Estimated Level of Activity Completed Units of Production 31200

plus unit of work in progress 12000
Raw Material Cost ₹ 40 per unit
Direct Wages Cost ₹ 15 per unit

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Overhead ₹ 40 per unit (inclusive of Depreciation
₹10 per unit)
Selling Price ₹ 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ₹ 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and overheads
accrue similarly. All sales are on the credit basis. You are required to calculate the Net Working Capital
Requirement on Cash Cost Basis. (10 Marks)

Answer

Calculation of Net Working Capital requirement:

(₹) (₹)
A. Current Assets:
Inventories:
Stock of Raw material 1,44,000
(Refer to Working note (iii)
Stock of Work in progress 7,50,000
(Refer to Working note (ii)
Stock of Finished goods 20,40,000
(Refer to Working note (iv)
Debtors for Sales 1,02,000
(Refer to Working note (v)
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases 1,56,000
(Refer to Working note (vi)
Creditors for wages 23,250
(Refer to Working note (vii)
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750

Working Notes:

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(i) Annual cost of production

Raw material requirements 17,28,000

{(31,200 × ₹ 40) + (12,000 x ₹ 40)}
Direct wages {(31,200 ×₹ 15) +(12,000 X ₹ 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation) 11,16,000
{(31,200 × ₹ 30) + (12,000 x ₹ 30 x 0.5)}
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (₹ 40 + ₹ 7.5 + ₹15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods (20,40,000)
(₹ 26,52,000 × 24,000/31,200)
Total Cash Cost of Sales 6,12,000

(ii) Work in progress stock

Raw material requirements (12,000 units × ₹40) 4,80,000

Direct wages (50% × 12,000 units × ₹ 15) 90,000
Overheads (50% × 12,000 units × ₹ 30) 1,80,000
7,50,000

iii) Raw material stock

It is given that raw material in stock is average 30 days consumption. Since, the company is newly formed; the
raw material requirement for production and work in progress will be issued and consumed during the year.
Hence, the raw material consumption for the year (360 days) is as follows

For Finished goods (31,200 × ₹ 40) 12,48,000

For Work in progress (12,000 × ₹ 40) 4,80,000
17,28,000

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Question 6
Answer all.

(a) What are the sources of short term financial requirement of the company? (4 Marks)

(b) What is certainty Equivalent? (4 Marks)

(c) What are the roles of Finance Executive in Modem World? (2 Marks)

OR

What are the two main aspects of the Finance Function?

Answer

(a) There are various sources available to meet short-term needs of finance. The different sources are
discussed below:

(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual
duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to
almost all business operations. It can be in the form of an 'open account' or 'bills payable'.

(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a company has to
pay for the services which it has already received like wages, taxes, interest and dividends.

(iii) Advances from Customers: Manufacturers and contractors engaged in producing or constructing costly
goods involving considerable length of manufacturing or construction time usually demand advance money
from their customers at the time of accepting their orders for executing their contracts or supplying the goods.
This is a cost free source of finance and really useful.

(iv) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note.

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(v) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills, commonly
referred to as T-Bills are issued by Government of India to meet short term borrowing requirements with
maturities ranging between 14 to 364 days.

(vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate with a fixed
maturity date of not less than 15 days up to a maximum of one year.

(vii) Bank Advances: Banks receive deposits from public for different periods at varying rates of interest. These
funds are invested and lent in such a manner that when required, they may be called back.
(b) Certainty Equivalent (CE)

It is a coefficient used to deal with risk in a capital budgeting context. It expresses risky future cash flows in
terms of the certain cash flows which would be considered by the decision maker, as their equivalent. That is
the decision maker would be indifferent between the risky amount and the (Lower) riskless amount
considered to be its equivalent.
It is a guaranteed return that the management would accept rather than accepting a higher but uncertain
return. Calculation of this equivalent involves the following three steps:

Step 1: Remove risks by substituting equivalent certain cash flows in the place of risky cash flows. This can be
done by multiplying each risky cash flow by the appropriate CE Coefficient.

Step 2: Obtain discounted value of cash flow by applying riskless rate of interest.

Step 3: Apply normal capital budgeting method to calculate NPV by using the firm’s required rate of return.

NCFt = the forecasts of net cash flow without risk-adjustment

α t = the risk-adjustment factor or the certainly equivalent coefficient.
Kf = risk-free rate assumed to be constant for all periods.
Certainty Coefficient lies between 0 and 1.

(c) Role of Finance Executive in modern World

Today, the role of Financial Executive, is no longer confined to accounting, financial reporting and risk
management. Some of the key activities that highlight the changing role of a Finance Executive are as follows:-

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• Budgeting

• Forecasting
• Managing M & As

• Profitability analysis relating to customers or products

• Pricing Analysis
• Decisions about outsourcing
• Overseeing the IT function.

• Overseeing the HR function.

• Strategic planning (sometimes overseeing this function).

• Regulatory compliance.
• Risk management.

Or

(c) Value of a firm will depend on various finance functions/decisions. It can be expressed as:
V = f (I,F,D).
The finance functions are divided into long term and short term functions/decisions

Long term Finance Function Decisions

(a) Investment decisions (I): These decisions relate to the selection of assets in which funds will be invested by
a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds
are used in a project for various fixed assets and also for current assets.

(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial
objectives and seeing that fixed and working capital are effectively managed.

(c) Dividend decisions(D): These decisions relate to the determination as to how much and how frequently
cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any
profit-making organization looks for reward for his investment in two ways, the growth of the capital invested
and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited
liability company the term is dividends.

Short- term Finance Decisions/Function

Working capital Management (WCM): Generally short term decision are reduced to management of current

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asset and current liability (i.e., working capital Management)
SECTION – B: ECONOMICS FOR FINANCE

Question 7
(a) Calculate the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) from the
following data:

Income (Y) Consumption (C) Level

₹ 8,000 ₹ 6,000 Initial level
₹ 12,000 ₹ 9,000 Changed level
(2 Marks)

(b) What would be the impact of each of the following on credit multiplier and money supply?

(i) If Commercial Banks keep 100 percent reserves.

(ii) If Commercial Banks do not keep reserves.

(iii) If Commercial Banks keep excess reserves. (3 Marks)

(c) Explain the role of Government in a market economy as stated by Richard Musgrave. (3 Marks)

(d) List the point of difference between fixed exchange rate and floating exchange rate. (2 Marks)

Answer

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(b) Credit Multiplier = 1 / Required Reserve Ratio

(i) If commercial banks keep 100% reserves, the reserve deposit ratio is one and the value of money multiplier
is one. Deposits simply substitute for the currency that is held by banks as reserves and therefore, no new
money is created by banks.

(ii) If commercial banks do not keep reserves and lends the entire deposits, it is a case of zero required reserve
ratio and credit multiplier will be infinite and therefore money creation will also be infinite.

(iii) Excess reserves are reserves over and above what banks are legally required to hold against deposits. The
additional units of money that goes into ‘excess reserves’ of the commercial banks do not lead to any
additional loans, and therefore, these excess reserves do not lead to creation of money. The i ncrease in
banks’ excess reserves reduces the credit multiplier, causing the money supply to decline.

(c) Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch
taxonomy of the role of government in a market economy. The objective of the economic system and the role
of government is to improve the wellbeing of individuals or households. According to ‘Musgrave Three-
Function Framework', the functions of government are to be separated into three, namely, resource
allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and
distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic function.
The allocation function aims to correct the sources of inefficiency in the economic system while the
distribution role ensures that the distribution of wealth and income is fair. The stabilization branch is to
ensure achievement of macroeconomic stability, maintenance of high levels of employment and price

762
stability.
(d

Fixed Exchange Rate Floating Exchange Rate

A fixed exchange rate, also referred to as pegged
exchange rate, is an exchange rate regime under
which a country’s central bank and/ or government
announces or decrees what its currency will be worth
in terms of either another country’s currency or a
basket of currencies or another measure of value,
such as gold.
Under floating exchange rate regime, the equilibrium
value of the exchange rate of a country’s currency is
market-determined i.e. the demand for and supply of
currency relative to other currencies determine the
exchange rate.

In order to maintain the exchange rate at the
predetermined level, the central bank intervenes in
the foreign exchange market
There is no interference on the part of the
government or the central bank of the country in the
determination of exchange rate. Any interference in
the foreign exchange market on the part of the
government or central bank would be only for
moderating the rate of change

Question 8

(a) (i) Explain the following modified equation of exchange as given by Irving Fisher:
MV +M'V'=PT (3 Marks)

(ii) Describe the meaning and mechanism of 'crowding out' effect of public expenditure. (3 Marks)

(b) (i) Explain the leakages and injections in the circular flow of Income. (2 Marks)
(ii) Describe features of public goods. (2 Marks)

Answer

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(a) (i) Modified Equation of Exchange

MV + M’ V’ = PT
MV + M’ V’ = PT is an extended form of the original equation of exchange which Fisher gave to include
demand deposits (M’) and their velocity (V’) in the total supply of money. The equation can also be rewritten
as P = (MV + M’ V’) / T

From the above equation, it is evident that the price level is determined by the following factors: (i) Quantity
of money in circulation (M), (ii) the velocity of circulation of money (V), (iii) the volume of credit money (M’),
the velocity of circulation of credit money (V’) and the volume of trade (T).
The equation of exchange further shows that the price level (P) is directly related to M, V, M’ and V’. It is,
however, inversely related to T. Velocity of money in circulation (V) and the velocity of credit money (V’)
remain constant. Since full employment prevails and since T is function of national income the volume of
transactions T is fixed in the short run.

The total volume of transactions (T) multiplied by the price level (P) represents the demand for money. The
demand for money (PT) is equal to the supply of money (MV + M'V’). In any given period, the total value of
transactions made is equal to PT and the value of money flow is equal to MV+ M'V'.

(ii) Crowding Out:

Meaning

‘Crowding out’ effect is the negative effect fiscal policy may generate when spending by government in an
economy substitutes private spending. For example, if government provides free computers to students, the
demand from students for computers may not be forthcoming.
Mechanism

The interest rates in an economy increase when:

• Government increases its spending by borrowing from the loanable funds from market and thus the demand
for loans increases.

• Government increases the budget deficit by selling bonds or treasury bills and the amount of money with
the private sector decreases.

Due to high interest, private investments, especially the ones which are interest – sensitive, will be reduced.
Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion
in demand resulting from an increase in government expenditure.

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(b) (i) Leakages: A leakage is an outflow or withdrawal of income from the circular flow. Leakages are money
leaving the circular flow and therefore, not available for spending on currently produced goods and services.
Leakages reduce the flow of income.

Injections: An injection is a non-consumption expenditure. It is an expenditure on goods and services

produced within the domestic territory but not used by the domestic household for consumption purposes.
Injections are exogenous additions to the circular flow and add to the total volume of the basic circular flow.
In the two-sector model with households and firms, household saving is the only leakage and investment is
the only injection. In the three-sector model which includes the government, saving and taxes are the two
leakages and investment and government purchases are the two injections. In the four-sector model which
includes foreign sector also, saving, taxes, and imports are the three leakages; investment, government
purchases, and exports are the three injections.
The state of equilibrium occurs when the total leakages are equal to the total injections that occur in the
economy.

Savings + Taxes + Imports = Investment + Government Spending + Exports

(ii) Features of public goods

• Public goods yield utility and their consumption is essentially collective in nature.

• Public goods are non rival in consumption i.e. consumption of a public good by one individual does not
reduce the quality or quantity available for all other individuals

• Public goods are non-excludable i.e. consumers cannot (at least at less than prohibitive cost) be excluded
from consumption benefits

• Public goods are characterized by indivisibility, each individual may consume all of the good i.e. the total
amount consumed is the same for each individual.

• Once a public good is provided, the additional resource cost of another person consuming the good is zero.
No direct payment by the consumer is involved in the case of pure public goods and these goods are generally
more vulnerable to issues such as externalities, inadequate property rights, and free rider problems

• Competitive private markets will fail to generate economically efficient outputs of public goods. E.g. national
defence.

Question 9

765
(a) (i) Explain why people hold money according to Liquidity Preference Theory. (3 Marks)

(ii) Which types of Government interventions are applied for correcting information failure? (2 Marks)

(b) Suppose in an economy: (5 Marks)

Consumption Function C = 150 + 0.75 Yd

Investment spending I = 100
Government spending G= 115
Tax Tx = 20 + 0.20 Y
Transfer Payments Tr = 40
Exports X = 35
Imports M = 15 + 0.1 Y

Where, Y and Yd are National Income and Personal Disposable Income respectively. All figures are in
rupees.
Find:

(i) The equilibrium level of National Income

(ii) Consumption at equilibrium level

(iii) Net Exports at equilibrium level (5 Marks)

Answer

(a) (i) Reasons for holding money as per Liquidity Preference Theory:
According to Keynes’ Liquidity Preference Theory’, people hold money (M) in cash for three motives:

i. The transactions motive: People hold cash for current transactions for personal and business exchanges i.e.
to bridge the time gap between receipt of income and planned expenditures.

ii. The precautionary motive: People hold cash to make unanticipated expenditures that may occur due to
unforeseen and unpredictable contingencies.
iii. The speculative motive: This motive reflects people’s desire to hold cash in order to be equipped to exploit
any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to
hold money balances to take advantage of the future changes in the rate of interest, which is the same as
future changes in bond prices.

(ii) Government Interventions: For combating the problem of market failure due to information failure the

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following interventions are resorted to:

• Government makes it mandatory to have accurate labelling and content disclosures by producers.

• Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.

• Regulation of advertising and setting of advertising standards to make advertising more responsible,
informative and less persuasive.
A few examples are: SEBI mandates on accurate information disclosure to prospective buyers of new stocks,
mandatory statutory information, licensing of doctors practicing medicine, awareness campaigns and funding
of organisations to influence public, media and government attitudes.

(b) The consumption function is

C = 150 + 0.75Yd
Level of Disposable income Yd is given by
Yd = Y-Tax + Transfer Payments, Where, Transfer Payment = Tr = 40
= Y – (20+ 0.20 Y) + 40 = Y – 20 – 0.20Y +40
= Y – 0.2Y - 20+40

Yd = 20 + 0.8 Y and C = 150+0.75 Yd

C = 150 + .75 (20 +0.8 Y) where Yd = (20+0.8Y)
C = 150 +15+ 0.6Y
C = 165 + 0.6Y

(i) The equilibrium level of national income

Y = C + I + G + (X-M)
Y = 165 + 0.6Y +100+115+ [35 – (15+0.1Y)]
= 165 +0.6 Y +100+115+ [35 -15 – 0.1Y]
= 165+0.6Y +215+ 35 – 15 - 0.1Y
Y = 400+ 0.5Y
Y-0.5Y = 400; 0.5 Y = 400
Y = 400 / 0.5 = 800
The equilibrium level of national income is ₹ 800

(ii) Consumption at equilibrium level of national income of ₹ 800

C = 165 + 0.6Y
C = 165 + 0.6(800)
C = 165+480 = 645
Consumption at equilibrium level = ₹ 645

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(iii) Net Exports at equilibrium level of national income 800
Net exports = Value total exports - Value of total imports
Given, exports X = 35; and imports M = 15+0.1Y
Net exports = [35 - (15+0.1Y)]
= 35 -15 – 0.1Y
= 35 -15 – (0.1X 800) = 35 – 15 – 80 = - 60
Net exports = ₹ (-)60
There is an adverse balance of trade
Question 10
(a) (i) Explain the difference between Liquidity Adjustment Facility (LAP) and Marginal Standing Facility
(MSF). (3 Marks)

(ii) From the following data, compute the Gross National Product at Market Price (GNPMP)
using value added method: (3 Marks)

(₹ In crores)
Value of output in Secondary Sector 1000
Intermediate consumption in Primary Sector 300
Value of output in Tertiary Sector 3000
Intermediate consumption in Secondary Sector 400
Net factor income from abroad (-) 100
Value of output in Primary Sector 800
Intermediate consumption in Tertiary Sector 900

(b) (i) What do you mean by anti-dumping duties? (2 Marks)

(ii) Describe deterrents to Foreign Direct Investment (FDI) in the country. (2 Marks)

Answer

(a) (i) Difference between Liquidity Adjustment Facility (LAF) and Marginal Standing Facility (MSF).
Liquidity Adjustment Facility (LAF) which was introduced by RBI in June, 2000, is a facility extended to the
scheduled commercial banks and primary dealers to avail of liquidity in case of requirement on an overnight
basis against the collateral of government securities including state government securities. Its objective is to
assist banks to adjust their day to day mismatches in liquidity. Currently, the RBI provides financial
accommodation to the commercial banks through repos / reverse repos under LAF.
Marginal Standing Facility (MSF) which was introduced by RBI in its monetary policy statements 2011 -12,
refers to the facility under which scheduled commercial banks can borrow additional amount of overnight
money from the central bank over and above what is available to them through the LAF window by dipping

768
into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety
valve against unexpected liquidity shocks to the banking system. The MSF would be the last resort for banks
once they exhaust all borrowing options including the liquidity adjustment facility.

(ii) Computation of Gross National Product at Market Price (GNPMP)

GNPMP = (Value of output in primary sector – Intermediate consumption of primary sector) + (Value of output
in secondary sector – Intermediate consumption of secondary sector) + (Value of output in tertiary sector –
Intermediate consumption of tertiary sector) + Net Factor Income from Abroad
GNPMP = [(800- 300) + (1000 – 400) + (3000 – 900)] + (-100)

= 500+ 600+ 2100 - 100

= 3200 -100 = ₹ 3100 Crores

(b) (i) Anti –Dumping Duties

An anti-dumping duty is an extra import duty that a domestic government imposes on foreign imports that it
believes are priced below fair market value causing injury to the competing domestic industry. It is a
protectionist tariff equal to the difference between the importing country's FOB price of the goods at the time
of their import and the market value of similar goods in the exporting country. An anti-dumping duty increases
the price of imports and brings it closer to the domestic price and prevents injury to domestic industry due to
unfair competition.

(ii) Deterrents to Foreign Direct Investment (FDI)

(i) Poor macro-economic environment, such as, infrastructure lags, high rates of inflation and continuing
instability, balance of payment deficits, exchange rate volatility, unfavourable tax regime (including double
taxation), small size of market and lack of potential for its growth and poor track-record of investments.

(ii) Unfavourable resource and labour market conditions such as poor natural and human resources, rigidity in
the labour market, low literacy, low labour skills, language barriers and high rates of industrial disputes

(iii) Unfavourable legal and regulatory framework such as absence of well-defined property rights, lack of
security to life and property, stringent regulations, cumbersome legal formalities and delays, bureaucracy and
corruption and political instability.

(iv) Lack of host country trade openness viz. lack of openness, prevalence of non-tariff barriers, lack of a
general spirit of friendliness towards foreign investors, lack of facilities for immigration and employment of
foreign technical and administrative personnel.

Question 11 769
(a) (i) Describe the objectives of World Trade Organization (WTO). (3 Marks)

(ii) Examine why General Agreement in Tariff & Trade (GATT) lost its relevance. (2 Marks)

(b) (i) Explain the objectives of Fiscal Policy. (3 Marks)

(ii) How do import tariffs affect International Trade? (2 Marks)

OR

How do changes in Cash Reserve Ratio (CRR) impact the economy? (2 Marks)

Answer

(a) (i) Objectives of World Trade Organization (WTO):

The WTO aims to facilitate the flow of international trade smoothly, freely, fairly and predictably for the
benefit of all. The chief objectives of WTO are:

• to set and enforce rules for international trade

• to provide a forum for negotiating and monitoring further trade liberalization

• to resolve trade disputes

• to increase the transparency of decision-making processes

• to cooperate with other major international economic institutions involved in global economic management
and

• to help developing countries to get benefit fully from the global trading system

(ii) The GATT lost its relevance by 1980s because:

• It was obsolete to the fast evolving contemporary complex world trade scenario characterized by emerging
globalisation

• International investments had expanded substantially

• Intellectual property rights and trade in services were not covered by GATT 770

• World merchandise trade increased by leaps and bounds and was beyond its scope

• The ambiguities in the multilateral system could be heavily exploited

• Efforts at liberalizing agricultural trade were not successful

• There were inadequacies in institutional structure and dispute settlement system

• It was not a treaty and therefore terms of GATT were binding only insofar as they are not incoherent with a
nation’s domestic rules

(b) (i) Objectives of Fiscal Policy

Fiscal Policy refers to the policy of government related to public revenue and public expenditure. The
objectives of fiscal policy are derived from the aspirations and goals of the society and vary from country to
country. The most common objectives of fiscal policy are:

• Achievement and maintenance of full employment,

• Maintenance of price stability,

• Acceleration of the rate of economic development,

• Equitable distribution of income and wealth,

• Eradication of poverty, and

• Removal of regional imbalances in different parts of the country.

The importance as well as order of priority of these objectives may vary from country to country and from
time to time. For instance, while stability and equality may be the priorities of developed nations, economic
growth, employment and equity may get higher priority in developing countries. Also, these objectives are not
always compatible; for instance the objective of achieving equitable distribution of income may conflict with
the objective of economic growth and efficiency.

(ii) Demerits of Tariffs in International Trade:

Tariffs are the most visible and universally used trade measures that determine market access for goods.
Tariffs are aimed at altering the relative prices of goods and services imported, so as to contract the domestic

771
demand and thus regulate the volume of their imports.

(i) Tariff barriers create obstacles to international trade, decrease the volume of imports and of international
trade.
(ii) The prospect of market access of the exporting country is worsened when an importing country imposes a
tariff.
(iii) By making imported goods more expensive, tariffs discourage domestic consumption of imported foreign
goods and therefore imports are discouraged.
(iv) Tariffs create trade distortions by disregarding comparative advantage and prevent countries from
enjoying gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in
the rest of the world and encourage inefficient production in the home country.

OR

(ii) Impact of changes in Cash Reserve Ratio (CRR):

Change in Cash Reserve Ratio is one of the important quantitative tools aiding in liquidity management. Higher
the CRR with the central bank, lower will be the liquidity in the system and vice versa. In order to control
credit expansion during periods of inflation, the central bank increases the CRR. With higher CRR, banks have
to keep more reserves and the banks’ lendable resources get depleted leading to decrease in the volume of
bank lending and contraction in credit and money supply in the economy.
During deflation, the central bank reduces the CRR in order to enable the banks to expand credit and increase
the supply of money available in the economy. With more credit available in the market, economic activities
get accelerated bringing the economy back to stability and economic growth.

772
 PAPER- NOV 2018
SECTION – A: FINANCIAL MANAGEMENT

Question 1

(a) Y Limited requires ₹ 50,00,000 for a new project. This project is expected to yield earnings before
interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company considers the
objective of maximizing earnings per' share. It has two alternatives to finance the project - by raising debt ₹
5,00,000 or ₹ 20,00,000 and the balance, in each case, by issuing Equity Shares. The company's share is
currently selling at ₹ 300, but is expected to decline to ₹ 250 in case the funds are borrowed in excess of ₹
20,00,000. The funds can be borrowed at the rate of 12 percent upto ₹ 5,00,000 and at 10 percent over ₹
5,00,000. The tax rate applicable to the company is 25 percent.
Which form of financing should the company choose? (5 Marks)

(b) Following information relating to Jee Ltd. are given:

Particulars
Profit after tax ₹ 10,00,000
Dividend payout ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%

(i) What would be the market value per share as per Walter's Model?

(ii) What is the optimum dividend payout ratio according to Walter's Model and Market value of equity
share at that payout ratio? (5 Marks)

(c) The following is the information of XML Ltd. relate to the year ended 31-03-2018 :

Gross Profit 20% of Sales 773

Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months

Non-Current Assets to Sales 1:4

Non-Current Assets to Current Assets 1:2
Current Ratio 2:1
Non-Current Liabilities to Current Liabilities 1 : 1
Share Capital to Reserve and Surplus 4:1

Non-current Assets as on 31st March, 2017 ₹ 50,00,000

Assume that:

(i) No change in Non-Current Assets during the year 2017-18

(ii) No depreciation charged on Non-Current Assets during the year 2017-18.

(iii) Ignoring Tax

You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018

(d) From the following details relating to a project, analyse the sensitivity of the project to changes in the
Initial Project Cost, Annual Cash Inflow and Cost of Capital :

Particulars
Initial Project Cost ₹2,00,00,000
Annual Cash Inflow ₹60,00,000
Project Life 5 years
Cost of Capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10 ?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696. (5 Marks)

Answer

(a) Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.

Plan II = Raising Debt of ₹ 20 lakh + Equity of ₹ 30 lakh.
Calculation of Earnings per share (EPS)

Particulars Financial Plans

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Plan I Plan II
₹ ₹
Expected EBIT 10,00,000 10,00,000
Less: Interest (60,000) (2,10,000)
(Working Note 1)
Earnings before taxes 9,40,000 7,90,000
Less: Taxes @ 25% (2,35,000) (1,97,500)
Earnings after taxes 7,05,000 5,92,500
(EAT)
 Number of shares 15,000 10,000
(Working Note 2)
Earnings per share 47 59.25
(EPS)

Financing Plan II (i.e. Raising debt of ₹ 20 lakh and issue of equity share capital of ₹ 30 lakh) is the option which
maximises the earnings per share.

Working Notes:

1. Calculation of interest on Debt.

Plan I (₹ 5,00,000 X 12%) ₹ 60,000

Plan II (₹ 5,00,000 X 12%) ₹ 60,000 ₹ 2,10,000
(₹ 15,00,000 X 10%) ₹ 1,50,000

2. Number of equity shares to be issued

775
(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the
price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio
in this case is Nil. So, at a payout ratio of zero, the market value of the company’s share will be:-

Calculation of Cost of Goods sold, Net profit, Inventory, Receivables and Cash:

(i) Cost of Goods Sold (COGS):

Cost of Goods Sold = Sales- Gross Profit

776
= ₹ 2,00,00,000 – 20% of ₹ 2,00,00,000
= ₹ 1,60,00,000

(ii) Net Profit = 10% of Sales = 10% of ₹ 2,00,00,000

= ₹ 20,00,000
(d) Calculation of NPV through Sensitivity Analysis 777
PV of cash inflows (₹ 60,00,000 × 3.791) 2,27,46,000
Initial Project Cost 2,00,00,000
NPV 27,46,000
*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000
**Revised Cash Flow = ₹ 60,00,000 x (100 – 10) % = ₹ 54,00,000
Conclusion: Project is most sensitive to ‘annual cash inflow’

Question 2

Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018 :

Liabilities Amount in ₹
Shareholder's Fund
Equity Share Capital (₹ 10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12 Debentures) 50,00,000
Current Liabilities 20,00,000
Total 1,00,00,000
Assets Amount in ₹

778
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000

Additional Information:
(i) Variable Cost is 60% of Sales.

(ii) Fixed Cost p.a. excluding interest ₹ 20,00,000.

(iii) Total Asset Turnover Ratio is 5 times.

(iv) Income Tax Rate 25%

You are required to:

(1) Prepare Income Statement

(2) Calculate the following and comment:

(a) Operating Leverage

(b) Financial Leverage

(c) Combined Leverage (10 Marks)

Answer

Workings:-
Total Assets = ₹ 1 crore
Total Asset Turnover Ratio i.e. = Total Sales / Total Assets = 5
Hence, Total Sales = ₹ 1 Crore 5 = ₹ 5 crore

(1) Income Statement

(₹ in crore)
Sales 5
Less: Variable cost @ 60% 3
Contribution 2
Less: Fixed cost (other than Interest) 0 .2
EBIT (Earnings before interest and tax) 1.8
Less: Interest on debentures (12% 50 lakhs) 0 .06

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EBT (Earning before tax) 1.74
Less: Tax 25% 0.435
EAT (Earning after tax) 1.305
(2)

The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure.
It studies how sensitive the change in EPS is vis-à-vis change in sales.
The leverages operating, financial and combined are measures of risk.

Question 3
PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years. Project
cost will be ₹ 2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of ₹

780
30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the Production and
Sales Volume is expected are as under :

Year Number of Units

1 60,000 units
2. 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units
Other Information:

(i) Selling price per unit ₹ 200

(ii) Variable cost is 40 of sales.

(iii) Fixed cost p.a. ₹ 30,00,000.

(iv) In addition to these advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure (₹) 50,00,000 25,00,000 10,00,000 5,00,000

(v) Income Tax is 25%.

(vi) Straight line method of depreciation is permissible for tax purpose.

(vii) Cost of capital is 10%.

(viii) Assume that loss cannot be carried forward.

Present Value Table

Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Advise about the project acceptability. (10 Marks)

Answer

Computation of initial cash outlay(COF) 781

(₹ in lakhs)
Project Cost 240
Working Capital 30
270
Calculation of Cash Inflows(CIF):

Years 1 2 3-5 6-8

Sales in units 60,000 80,000 1,40,000 1,20,000
₹ ₹ ₹ ₹
Contribution (₹ 200 x 60% x No. of Unit) 72,00,000 96,00,000 1,68,00,000 1,44,00,000
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8) = 30,00,000 30,00,000 30,00,000 30,00,000 30,00,000
Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000

(Note: Since variable cost is 40%, Contribution shall be 60% of sales)

Computation of PV of CIF

Year CIF PV Factor ₹

₹ @ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 Working 89,25,000 0.467 55,68,975
Capital 30,00,000
3,88,82,700
PV of COF 2,70,00,000

782
NPV 1,18,82,700

Recommendation: Accept the project in view of positive NPV.

Question 4

MN Ltd. has a current turnover of ₹ 30,00,000 p.a. Cost of Sale is 80% of turnover and Bad Debts are 2% of
turnover, Cost of Sales includes 70% variable cost and 30% Fixed Cost, while company's required rate of
return is 15%. MN Ltd. currently allows 15 days credit to its customer, but it is considering increase this to
45 days credit in order to increase turnover.
It has been estimated that this change in policy will increase turnover by 20%, while Bad Debts will increase
by 1%. It is not expected that the policy change will result in an increase in fixed cost and creditors and stock
will be unchanged.
Should MN Ltd. introduce the proposed policy? (Assume 360 days year) (10 Marks)

Answer

Statement Showing Evaluation of Credit Policies

Particulars Present Policy Proposed Policy

A. Expected Contribution
(a) Credit Sales 30,00,000 36,00,000
(b) Less: Variable Cost 16,80,000 20,16,000
(c) Contribution 13,20,000 15,84,000
(d) Less: Bad Debts 60,000 1,08,000
(e) Contribution after Bad debt [(c)-(d)] 12,60,000 14,76,000
B. Opportunity Cost of investment in 15,000 54,000
Receivables
C. Net Benefits [A-B] 12,45,000 14,22,000
D. Increase in Benefit 1,77,000

Recommendation: Proposed Policy i.e credit from 15 days to 45 days should be implemented by NM Ltd since
the net benefit under this policy are higher than those under present policy

783
Working Note: (1)

Present Policy Propose Policy

(₹) (₹)
Sales 30,00,000 36,00,000
Cost of Sales (80% of sales) 24,00,000 28,80,000
Variable cost (70% of cost of sales) 16,80,000 20,16,000
2. Opportunity Costs of Average Investments

Question 5
The following data relate to two companies belonging to the same risk class :

Particulars A Ltd. B Ltd.

Expected Net Operating Income ₹ 18,00,000 ₹ 18,00,000
12% Debt ₹ 54,00,000 -
Equity Capitalization Rate - 18

Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming no taxes as per M.M. Approach.

(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach. (10 Marks)

Answer

(a) Assuming no tax as per MM Approach.

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = ₹ 1,00,00,000

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Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Nil) = ₹ 1,00,00,000 + (54,00,000 × nil)
= ₹1,00,00,000

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC)

Particulars A Ltd. B Ltd.

A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC (ko)]* 0.18 0.18
ko = (ke×S/V) + (kd×D/V)
*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18

*Kd = 12% (since there is no tax)

WACC = 18%

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis

Market Value of ‘B Ltd’ [Unlevered(u)]

Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= ₹60,00,000

785
Ke of unlevered Firm (given) = 0.18

Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18

Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= ₹ 60,00,000 + (54,00,000 × 0.4)
= ₹ 81,60,000
Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’
= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC) of a Ltd

Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323

*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%

WACC = 13.23%

786
Question 6
Answer the following:
(a) Explain in brief following Financial Instruments:

(i) Euro Bonds

(ii) Floating Rate Notes

(iii) Euro Commercial paper

(iv) Fully Hedged Bond (1 x 4 = 4 Marks)

(b) Discuss the Advantages of Leasing. (4 Marks)

(c) Write two main objectives of Financial Management.

OR

Write two main reasons for considering risk in Capital Budgeting decisions. (2 Marks)

Answer

(a) (i) Euro bonds: Euro bonds are debt instruments which are not denominated in the currency of the country
in which they are issued. E.g. a Yen note floated in Germany.

(ii) Floating Rate Notes: Floating Rate Notes: are issued up to seven years maturity. Interest rates are adjusted
to reflect the prevailing exchange rates. They provide cheaper money than foreign loans.

(iii) Euro Commercial Paper(ECP): ECPs are short term money market instruments. They are for maturities less
than one year. They are usually designated in US Dollars.

(iv) Fully Hedged Bond: In foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate
the risk by selling in forward markets the entire stream of principal and interest payments.

(b) (i) Lease may low cost alternative: Leasing is alternative to purchasing. As the lessee is to make a series of
payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is based on
a comparison between leasing and buying an asset. Many lessees find lease more attractive because of low
cost.

(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less than that
available for lease payment

787
(iii) Working capital conservation: When a firm buy an equipment by borrowing from a bank (or financial
institution), they never provide 100% financing. But in case of lease one gets normally 100% financing. This
enables conservation of working capital.

(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing debt equity ratio. This
enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt financing
is called debt capacity (also, reserve debt capacity).
(v) Obsolescence and Disposal: After purchase of leased asset there may be technological obsolescence of the
asset. That means a technologically upgraded asset with better capacity may come into existence after
purchase. To retain competitive advantage the lessee as user may have to go for the upgraded asset.

(c) Two Main Objective of Financial Management

Two objectives of financial management are:

(i) Profit Maximisation

It has traditionally been argued that the primary objective of a company is to earn profit; hence the objective
of financial management is also profit maximisation.
Wealth / Value Maximization

Wealth / Value Maximization Model. Shareholders wealth are the result of cost benefit analysis adjusted with
their timing and risk i.e. time value of money. This is the real objective of Financial Management.

So, Wealth = Present Value of benefits – Present Value of Costs

(c) Main reasons for considering risk in capital budgeting decisions:

Main reasons for considering risk in capital budgeting decisions are as follows

1. There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk is
necessary to help make the decision as to whether the returns out of the project are proportionate with the
risks borne and whether it is worth investing in the project over the other investment options available.

2. Risk adjustment is required to know the real value of the Cash Inflows.

788
SECTION – B: ECONOMICS FOR FINANCE

Question 7

(a) How the Government intervenes to ensure stability in price level? (2 Marks)

(b) Explain the Concept of Gross National Product at market price (GNP mp). (2 Marks)

(c) The RBI Published the following data as on 31st March, 2018. You are required to compute M4: (₹ in
crores)
Currency with the public 1,12,206.6
Demand Deposits with Banks 1,93,300.4
Net Time Deposits with Banks 2,67,310.2
Other Deposits of RBI 614.8
Post Office Savings Deposits 277.5
Post Office National Savings Certificates (NSCs) 110.5 (3 Marks)

(d) The table given below shows the number of labour hours required to produce Sugar and Rice in two
countries X and Y:

Commodity Country X Country Y

1 Unit of Sugar 2.0 5.0
1 unit of Rice 4.0 2.5

(i) Compute the Productivity of labour in both countries in respect of both commodities.
(ii) Which country has absolute advantage in production of Sugar?
(iii) Which country has absolute advantage in production of Rice? (3 Marks)

Answer

789
(a) Government intervenes to ensure price stability and thus regulate aggregate demand with two policy
instruments namely, monetary (credit) policy and fiscal (budgetary) policy. Monetary policy attempts to
stabilise aggregate demand in the economy by influencing the availability and cost of money, i.e., the rate of
interest. Fiscal policy, on the other hand, aims at influencing aggregate demand by altering tax, public
expenditure and public debt of the government. When total spending is too low, the government may
increase its spending and/or lower taxes to reduce unemployment and the central bank may lower interest
rates. When total spending is excessive, the government may cut its spending and/or raise taxes to foster
price stability and the central bank may raise interest rates. In addition, the government may initiate
regulatory measures such as price ceiling and price floors.
(b) Gross National Product (GNP) is a measure of the market value of all final economic goods and services,
gross of depreciation, produced within the domestic territory of a country by normal residents during an
accounting year plus net factor incomes from abroad. Thus, GNP includes earnings of Indian corporations
overseas and Indian residents working overseas.
GNPMP = GDPMP + Net Factor Income from Abroad
Net factor income from abroad is the difference between the income received from abroad for rendering
factor services by the normal residents of the country to the rest of the world and income paid for the factor
services rendered by non- residents in the domestic territory of a country.

(c) M4 = Currency and coins with the people + demand deposits with the banks (Current and Saving accounts)
+ other deposits with the RBI + Net time deposits with the banking system + Total deposits with the Post
Office Savings (excluding National Savings Certificates).

Components ₹ in Crores
Currency with the public 1,12,206.6
Demand deposits with banks 1,93,300.4
Other deposits with the RBI 614.8
Net time deposits with the banking system. 2,67,310.2
Post Office Savings deposits 277.5
Total 5,73,709.5

(d) (i) Productivity of labour (output per labour hour = the volume of output produced per unit of labour input)
= output / input of labour hours

Output of commodity Units in Country X Units in Country Y

Sugar 0.5 0.20
Rice 0.25 0.40

(ii) A country has an absolute advantage in producing a good over another country if it requires fewer
resources to produce that good. Since one hour of labour time produces 0.5 units of sugar in country X against

790
0.20 units in country Y, Country X has absolute advantage in production of sugar.

(iii) Since one hour of labour time produces 0.40 units of rice in country Y against 0.25 units in country X,
Country Y has absolute advantage in production of rice.
Question 8

(a) In a two sector model Economy, the business sector produces 7500 units at an average price of ₹ 7.

(i) What is the money value of output?

(ii) What is the money income of Households?

(iii) If households spend 75 of their Income, what is the total consumer expenditure?

(iv) What is the total money revenue received by the business sector?
(v) What should happen to the level of output? (5 Marks)

(b) (i) Define the Contractionary Fiscal Policy. What measures under this policy are to be adopted to
eliminate the inflationary gap? (3 Marks)

(ii) Explain the role of Monetary Policy Committee (MPC) in India. (3 Marks)

Answer

(a) (i) The money value of output equals total output times the average price per unit. The money value of
output is (75000×7) = ₹ 52,500

(ii) In a two sector economy, households receive an amount equal to the money value of output. Therefore,
the money income of households is the same as the money value of output i.e. ₹ 52,500

(iii) Total spending by households (₹ 52,500 × .75) i.e. ₹ 39,375

(iv) The total money revenues received by the business sector is equal to aggregate spending by households
ie. ₹ 39,375

(v) The circular flow will be balanced and therefore in equilibrium when the injections are equal to the 791
leakages. The saving by the household sector would imply leakage or withdrawal of money (equal to saving)
from the circular flow of income. If at any time intended saving is greater than intended investment, (not
given; assumed = zero) this would mean that people are spending lesser volume of money on consumption.
Here, the business sector makes payments of ₹ 52,500 to produce output, whereas the households purchase
only output worth ₹ 39,375 of what is produced. Therefore, the business sector has unsold inventories valued
at ₹ 13,125. Consequently, the firms would decrease their production which would lead to a fall in output and
income of the household.
(b) (i) Contractionary fiscal policy refers to the deliberate policy of government applied to curtail aggregate
demand and consequently the level of economic activity. In other words, it is fiscal policy aimed at eliminating
an inflationary gap.

This can be achieved either by:

1. Decrease in government spending: With decrease in government spending, the total amount of money
available in the economy is reduced which is turns trim down the aggregate demand.

2. Increase in personal income taxes and/or business taxes: An increase in personal income taxes reduces
disposable income leading to fall in consumption spending and aggregate demand. An increase in taxes on
business profits reduces the surpluses available to businesses, and as a result, firms’ investments shrink
causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants
who will respond by holding back fresh investments.

3. A combination of decrease in government spending and increase in personal income taxes and/or business
taxes.

(ii) Monetary Policy Committee (MPC) constituted by the Central Government is an empowered six-member
committee with RBI Governor as the chairperson. Under the Monetary Policy Framework Agreement, the RBI
will be responsible for price stability and for containing inflation targets at 4% (with a standard deviation of
2%) in the medium term. The committee is answerable to the Government of India if the inflation exceeds the
range prescribed for three consecutive months. MPC has complete control over monetary policy decisions to
ensure economic growth and price stability. The MPC decides the changes to be made to the policy rate (repo
rate) so as to contain inflation within the target level specified to it by the central government. Fixing of the
benchmark policy interest rate (repo rate) is made in a more consultative and participative manner and on the
basis of majority vote by this panel of experts. This has added lot of value and transparency to monetary policy
decisions.

Question 9

(a) (i) Explain with example how Ad Valorem Tariff is levied. (3 Marks) 792
(ii) What is allocation function of Fiscal-Policy? (2Marks)

(b) (i) What are the modes of Foreign Direct Investment (FDI)? (3 Marks)
(ii) Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the
following data: (2 Marks)
Income Consumption
₹ 4,000 ₹ 3,000

Answer

(a) (i) An ad valorem tariff is a duty or other charges levied on an import item on the basis of its value and not
on the basis of its quantity, size, weight, or any other factor.
It is levied as a constant percentage of the monetary value of one unit of the imported good. For example, a
20% ad valorem tariff on a computer generates ₹2,000/ government revenue from tariff on each imported
computer priced at ₹10,000/ in the world market. If the price of computer rises to ₹ 20,000, then it generates
a tariff of ₹ 4,000/

(ii) Allocation function of fiscal policy is concerned with the process by which the total resources of the
economy are divided among various uses as well as for provision of an optimum mix of various social goods
(both public goods and merit goods). The allocation function also involves the reallocation of society’s
resources from private use to public use.
The resource allocation role of government’s fiscal policy focuses on the potential for the government to
improve economic performance and welfare through its expenditure and tax policies. It also determines who
and what will be taxed as well as how and on what the government revenue will be spent.

(b) (i) Modes of foreign direct investment (FDI)

Foreign direct investment is defined as the process whereby the resident of one country (i.e. home country)
acquires more than 10 percent ownership of an asset in another country (i.e. the host country) and such
movement of capital involves ownership, control as well as management of the asset in the host country.
Various modes are:
(i) Opening of a subsidiary or associate company in a foreign country,
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions (M&A)
(v) Joint venture with a foreign company.
(vi) Green field investment (establishment of a new overseas affiliate for freshly starting production by a

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parent company).

(b) (ii) The average propensity to consume (APC) is the ratio of consumption expenditures (C) to disposable
income (DI), or APC =C / DI.
The average propensity to save (APS) is the ratio of savings to disposable income or APS =S / DI
APC= 3000/4000= 0.75.
APS= 1000/4000= 0.25.
Question 10
(a) (i) Define the market failure. Why do markets fail? (3 Marks)

(ii) Mention the general characteristics of Money. (2 Marks)

(b) (i) How do Governments correct market failure resulting from demerit Goods? (3 Marks)

(ii) The Nominal Exchange rate of India is ₹ 56/1 $, Price Index in India is 116 and Price Index in USA is 112.
What will be the Real Exchange Rate of India? (2 Marks)

Answer

(a) (i) Market failure is a situation in which the free market with an unrestricted price system determined by
forces of supply and demand leads to misallocation of society’s scarce resources in the sense that there is
either overproduction or underproduction of particular goods and services leading to a less than optimal
outcome. The major reasons for market failure and economic inefficiency include:

(i) Though perfectly competitive markets work efficiently, most often the prerequisites of competition are
unlikely to be present in an economy.

(ii) Market power of firms enables them to act as price makers and keep the level of prices and output that
give them positive economic profits.

(iii) Externalities hinder the ability of market prices to convey accurate information about how much to
produce and how much to buy

(iv) Public goods are not produced at all or produced less than optimal quantities due to its special
characteristics such as indivisibility, non - excludability and non-rivalry.

(v) Free rider problem causing overuse, degradation and depletion of common resources

(vi) Information failure manifest in asymmetric information, adverse selection and moral hazard.

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(ii) There are some general characteristics that money should possess in order to make it serve its functions as
money. Money should be:

• Generally acceptable

• Durable or long-lasting
• Effortlessly recognizable

• Difficult to counterfeit i.e. not easily reproducible by people

• Relatively scarce, but has elasticity of supply

• Portable or easily transported

• Possessing uniformity; and

• Divisible into smaller parts in usable quantities or fractions without losing value.

(b) (i) Demerit goods are deemed socially undesirable and their consumption imposes considerable negative
externalities on the society as a whole. Examples of demerit goods are cigarettes, alcohol etc. Since demerit
goods are clear cases of market failure, the government intervenes in the marketplace to discourage their
production and consumption mainly by the following methods:

(i) At the extreme, the government may enforce complete ban on a demerit good; e.g. intoxicating drugs. In
such cases, the possession, trading or consumption of the good is made illegal.

(ii) Impose unusually high taxes on producing or purchasing the demerit goods making them very costly and
unaffordable to many.

(iii) Through persuasion which is mainly intended to be achieved by negative advertising campaigns which
emphasize the dangers associated with consumption of demerit goods and granting of subsidies for such
advertisements.

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(iv) Through legislations that prohibit the advertising or promotion of demerit goods in whatsoever manner.

(v) Strict regulations of the market for the good may be put in place so as to limit access to the good,
especially by vulnerable groups such as children and adolescents. Restrictions in terms of a minimum age may
be stipulated at which young people are permitted to buy cigarettes and alcohol.

(vi) Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of tobacco to be
away from schools, and time restrictions under which sale at particular times during the day is banned.
(ii) T he ‘real exchange rate' describes ‘how many’ of a good or service in one country can be traded for ‘one’
of that good or service in a foreign country. T hus it incorporates changes in prices

Question 11

(a) (i) Explain the different mechanism of monetary policy which influences the price-level and national
income. (3 Marks)

(ii) Explain the Monetary Policy Framework Agreement. (2 Marks)

(b) (i) Distinguish between Personal Income and Disposable Personal Income. (3 Marks)
(ii) "World Trade Organisation (WTO) has a three-tier system of decision making." Explain. (2 Marks)
OR
Explain the concept of Social Costs.

Answer

(a) (i) The process or channels through which the evolution of monetary aggregates affects the level of
product and prices is known as ‘monetary transmission mechanism’. There are mainly four different
mechanisms, namely, the interest rate channel, the exchange rate channel, the quantum channel, and the
asset price channel.

The interest rate channel: A contractionary monetary policy‐induced increase in interest rates increases the
cost of capital and the real cost of borrowing for firms and households with the result that they cut back on
their investment expenditures and durable goods consumption expenditures respectively. A decline in
aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary
monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of

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capital for firms and cost of borrowing for households.

The exchange rate channel: The exchange rate channel works through expenditure switching between
domestic and foreign goods. Appreciation of the domestic currency makes domestically produced goods more
expensive compared to foreign‐produced goods. This causes net exports to fall; correspondingly domestic
output and employment also fall.
The quantum channel (e.g., relating to money supply and credit) Two distinct credit channels: the bank lending
channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate through
the real economy. Credit channel operates by altering access of firms and households to bank credit.
A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest rates
works to increase the payments that the firm must make to service its floating rate debts. An indirect effect
sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long‐lived
assets.

The asset price channel: Asset prices respond to monetary policy changes and consequently impact output,
employment and inflation. A policy‐induced increase in the short‐term nominal interest rates makes debt
instruments more attractive than equities in the eyes of investors leading to a fall in equity prices, erosion in
household financial wealth, fall in consumption, output, and employment.

• the Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for the
period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.

• The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of
inflation and the forecasts of inflation for the coming period of six to eighteen months.

(ii) The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the
Monetary Policy Framework Agreement. It is an agreement reached between the Government of India and
the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability. The
amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation
targeting framework’ by abandoning the ‘multiple indicator’ approach. The inflation target is to be set by the
Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly,

(b) (i) Personal Income is the income received by the household sector including Non-Profit Institutions
Serving Households. Thus, while national income is a measure of income earned and personal income is a

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measure of actual current income receipts of persons from all sources which may or may not be earned from
productive activities during a given period of time. In other words, it is the income ‘actually paid out’ to the
household sector, but not necessarily earned. Examples of this include transfer payments such as social
security benefits, unemployment compensation, welfare payments etc. Individuals also contribute income
which they do not actually receive; for example, undistributed corporate profits and the contribution of
employers to social security. Personal income forms the basis for consumption expenditures and is derived
from national income as follows:
PI = NI + income received but not earned - income earned but not received.
Disposable Personal Income (DI): Disposable personal income is a measure of amount of the money in the
hands of the individuals that is available for their consumption or savings. Disposable personal income is
derived from personal income by subtracting the direct taxes paid by individuals and other compulsory
payments made to the government.
DI = PI - Personal Income Taxes

(ii) The World Trade Organization has a three- tier system of decision making. The WTO’s top level decision-
making body is the Ministerial Conference which can take decisions on all matters under any of the
multilateral trade agreements. The Ministerial Conference meets at least once every two years. The next level
is the General Council which meets several times a year at the Geneva headquarters. The General Council also
meets as the Trade Policy Review Body and the Dispute Settlement Body. At the next level, the Goods Council,
Services Council and Intellectual Property (TRIPS) Council report to the General Council. These councils are
responsible for overseeing the implementation of the WTO agreements in their respective areas of
specialisation. The three also have subsidiary bodies. Numerous specialized committees, working groups and
working parties deal with the individual agreements.

Or

Social costs refer to the total costs to the society on account of a production or consumption activity. Social
costs are private costs borne by individuals directly involved in a transaction together with the external costs
borne by third parties not directly involved in the transaction. Social costs represent the true burdens carried
by society in monetary and non-monetary terms.

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 PAPER- MAY 2019
SECTION – A: FINANCIAL MANAGEMENT

Working notes should form part of the answer

Question 1

(a) Following figures and ratios are related to a company Q Ltd. :

(i) Sales for the year (all credit) ₹ 30,00,000

(ii) Gross Profit ratio 25 per cent

(iii) Fixed assets turnover (based on cost of goods sold) 1.5

(iv) Stock turnover (based on cost of goods sold) 6

(v) Liquid ratio 1 : 1

(vi) Current ratio 1. 5 : 1

(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to share capital 0.6 : 1

(ix) Capital gearing ratio 0.5

(x) Fixed assets to net worth 1.20 : 1

You are required to calculate :

Closing stock, Fixed Assets, Current Assets, Debtors and Net worth. (5 Marks)

(b) Alpha Ltd. has furnished the following information : -

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Earning Per Share (EPS) ₹4
- Dividend payout ratio 25%
- Market price per share ₹ 50
- Rate of tax 30%
- Growth rate of dividend 10%

(c) Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
The particulars are as under :
 Project X (₹) Project Y (₹)
Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per
annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut off rate is 14%. The discount factor at 14% are :

Year 1 2 3 4 5 6 7 8 9
Discount factor 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308

Advise management about the acceptability of projects X and Y. (5 Marks)

(d) The following information is supplied to you

Total Earning ₹ 40 Lakhs

No. of Equity Shares (of ₹ 100 each) 4,00,000
Dividend Per Share ₹4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%

Calculate the market price of a share of a company by using :

(i) WaIter’s Formula
(ii) Gordon's Formula (5 Marks)

Answer
(a) (i) Calculation of Closing Stock:
Cost of Goods Sold = Sales – Gross Profit (25% of Sales)

800
= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000

Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 22,50,000/6 = ₹ 3,75,000
(ii) Calculation of Fixed Assets:
Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ₹ 22,50,000/1.5
= ₹ 15,00,000

(iii) Calculation of Current Assets:

Current Ratio = 1.5 and Liquid Ratio = 1
Stock = 1.5 – 1 = 0.5
Current Assets = Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5 = ₹ 11,25,000

(iv) Calculation of Debtors:

Debtors = Sales × Debtors Collection period /12
= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000

(v) Calculation of Net Worth:

Net worth = Fixed Assets /1.2
= ₹ 15,00,000/1.2 = ₹ 12,50,000

(b) (i) Cost of Equity Share Capital (Ke)

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(iii) Weighted Average Cost of Capital (WACC)

Source of capital Amount (₹) Weights Cost of Capital (%) WACC (%)
Equity shares 6,00,000 0.60 12.20 7.32
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.82
Alternatively Cost of Equity Share Capital (Ke) can be calculated as

Accordingly
Weighted Average Cost of Capital (WACC)

Source of capital Amount (₹ ) Weights Cost of Capital (%) WACC (%)

Equity shares 6,00,000 0.60 12.00 7.20
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.70

(c) The possible outcomes of Project x and Project y are as follows

In pessimistic situation project X will be better as it gives low but positive NPV whereas Project Y yield highly

802
negative NPV under this situation. In most likely situation both the project will give same result. However, in
optimistic situation Project Y will be better as it will gives very high NPV. So, project X is a risk less project as it
gives positive NPV in all the situation whereas Y is a risky project as it will result into negative NPV in
pessimistic situation and highly positive NPV in optimistic situation. So acceptability of project will largely
depend on the risk taking capacity (Risk seeking/ Risk aversion) of the management.
803
Question 2

RM Steels Limited requires ₹ 10,00,000 for construction of a new plant. It is considering three financial plans

(i) The company may issue 1,00,000 ordinary shares at ₹ 10 per share;

(ii) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5000 debentures of ₹ 100
denominations bearing a 8 per cent rate of interest; and
(iii) The company may issue 50,000 ordinary shares at ₹ 10 per share and 5,000 preference shares at ₹ 100
per share bearing a 8 per cent rate of dividend.

If RM Steels Limited's earnings before interest and taxes are ₹ 20,000; ₹ 40,000; ₹ 80,000; ₹ 1,20,000 and ₹
2,00,000, you are required to compute the earnings per share under each of the three financial plans ?
Which alternative would you recommend for RM Steels and why? Tax rate is 50%. (10 Marks)

Answer

(i) Computation of EPS under three-financial plans

Plan I: Equity Financing

₹ ₹ ₹ ₹ ₹
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
No. of equity shares 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
EPS 0.10 0.20 0.40 0.60 1

Plan II: Debt – Equity Mix

804
₹ ₹ ₹ ₹ ₹
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 40,000 40,000 40,000 40,000 40,000
EBT (20,000) 0 40,000 80,000 1,60,000
Less: Tax @ 50% 10,000* 0 20,000 40,000 80,000
PAT (10,000) 0 20,000 40,000 80,000
No. of equity shares 50,000 50,000 50,000 50,000 50,000
EPS (₹ 0.20) 0 0.40 0.80 1.60
* The Company can set off losses against the overall business profit or may carry forward it to next financial
years.

Plan III: Preference Shares – Equity Mix

₹ ₹ ₹ ₹ ₹
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
Less: Pref. dividend 40,000* 40,000* 40,000 40,000 40,000
PAT after Pref. (30,000) (20,000) 0 20,000 60,000
dividend.
No. of Equity shares 50,000 50,000 50,000 50,000 50,000
EPS (0.60) (0.40) 0 0.40 1.20

* In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits.

(ii) From the above EPS computations tables under the three financial plans we can see that when EBIT is ₹
80,000 or more, Plan II: Debt-Equity mix is preferable over the Plan I and Plan III, as rate of EPS is more under
this plan. On the other hand an EBIT of less than ₹ 80,000, Plan I: Equity Financing has higher EPS than Plan II
and Plan III. Plan III Preference share Equity mix is not acceptable at any level of EBIT, as EPS under this plan is
lower.
The choice of the financing plan will depend on the performance of the company and other macro economic
conditions. If the company is expected to have higher operating profit Plan II: Debt – Equity Mix is preferable.
Moreover, debt financing gives more benefit due to availability of tax shield.

Question 3

805
AT Limited is considering three projects A, B and C. The cash flows associated with the projects are given
below:
Cash flows associated with the Three Projects (₹)

Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
You are required to :

(a) Calculate the payback period of each of the three projects.

(b) If the cut-off period is two years, then which projects should be accepted?

(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.

(d) "Payback gives too much weight to cash flows that occur after the cut-off date". True or false?

(e) "If a firm used a single cut-off period for all projects, it is likely to accept too many short lived projects."
True or false?

P.V. Factor @ 10 % (10 Marks)

Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

Answer
(a) Payback Period of Projects

Projects C0(₹) C1(₹) C2(₹) C3(₹) Payback

A (10,000) 2000 2000 6,000 2,000+2,000+6,000 =10,000 i.e 3 years
B (2,000) 0 2,000 NA 0+2,000 = 2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000+2,000+6,000 = 10,000 i.e 3 years

(b) If standard payback period is 2 years, Project B is the only acceptable project.
(c) Calculation of NPV

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So, Projects with positive NPV are Project B and Project C

(d) False. Payback gives no weightage to cash flows after the cut-off date.

(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash inflows
are not considered. Thus, payback is biased towards short-term projects.

Question 4

The capital structure of the Shiva Ltd. consists of equity share capital of ₹ 20,00,000 (Share of ₹ 100 per
value) and ₹ 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000 units, the
selling price is ₹ 10 per unit; variable costs amount to ₹ 6 per unit and fixed expenses amount to ₹ 4,00,000.
The income tax rate is assumed to be 50%.

(a) You are required to calculate the following:

(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.
(b) Comment on the behaviour of operating and Financial leverages in relation to increase in production
from 2,00,000 units to 2,40,000 units. (10 Marks)

Answer

(a)

Sales in units 2,00,000 2,40,000

(₹) (₹)
Sales Value @ ₹ 10 Per Unit 20,00,000 24,00,000
Variable Cost @ ₹ 6 per unit (12,00,000) (14,40,000)
Contribution 8,00,000 9,60,000

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Fixed expenses (4,00,000) (4,00,000)
EBIT 4,00,000 5,60,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 3,60,000
Tax @ 50% (1,00,000) (1,80,000)
Profit after tax (PAT) 1,00,000 1,80,000
No of Share 20,000 20,000
Earnings per share (EPS) 5 9
 (b) When production is increased from 2,00,000 units to 2,40,000 units both financial leverage and operating
leverages reduced from 2 to 1.56 and 1.71 respectively. Reduction in financial leverage and operating
leverages signifies reduction in business risk and financial risk.

Question 5

Bita Limited manufactures used in the steel industry. The following information regarding the company is
given for your consideration:

(i) Expected level of production 9000 units per annum.

(ii) Raw materials are expected to remain in store for an average of two months before issue to production.
(iii) Work-in-progress (50 percent complete as to conversion cost) will approximate to 1/2 month’s
production.
(iv) Finished goods remain in warehouse on an average for one month.

(v) Credit allowed by suppliers is one month.·

(vi) Two month's credit is normally allowed to debtors.

(vii) A minimum cash balance of ₹ 67,500 is expected to be maintained.

(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.

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(xi) The cost structure for Bita Limited's product is as follows:
₹
Raw Materials 80 per unit
Direct Labour 20 per unit
Overheads (including depreciation ₹ 20) 80 per unit
Total Cost 180 per unit
Profit 20 per unit
Selling Price 200 per unit
You are required to estimate the working capital requirement of Bita limited. (10 Marks)
Answer
Statement showing Estimate of Working Capital Requirement

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Working Notes:
1. If Credit sales is x then cash sales is x-75% of x i.e. x/4.

Or x+0.25x = ₹ 18,00,000
Or x=₹ 14,40,000

Question 6

(a) Explain the steps of Sensi tivi ty Analysis. (4 Marks)

(b) What is the process of Debt Securi tisation ? (4 Marks)

(c) Explain any two steps involved in Decision tree Analysis. (2 Marks)
OR
Give any two limitations of leasing. (2 Marks)

Answer

(a) Steps involved in Sensitivity Analysis 810

Sensitivity Analysis is conducted by following the steps as below:
1.Finding variables, which have an influence on the NPV (or IRR) of the project
2.Establishing mathematical relationship between the variables.
3.Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.
(b) Process of Debt Securitisation

(i) The origination function – A borrower seeks a loan from a finance company, bank, HDFC. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the
life of the loan.

(ii) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.

(iii) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The
securities carry a coupon and expected maturity which can be asset based/ mortgage based. These are
generally sold to investors through merchant bankers. Investors are – pension funds, mutual funds, insurance
funds. The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is
under an obligation to pay to investors only if the cash flows are received by him from the collateral. The
benefits to the originator are that assets are shifted off the balance sheet, thus giving the originator recourse
to off-balance sheet funding.

(c) Steps involved in Decision Tree analysis:

Step 1- Define Investment: Decision three analysis can be applied to a variety of business decision-making
scenarios.

Step 2- Identification of Decision Alternatives: It is very essential to clearly identity decision alternatives. For
example, if a company is planning to introduce a new product, it may be local launch, national launch or
international launch.

Step 3- Drawing a Decision Tree: After identifying decision alternatives, at the relevant data such as the
projected cash flows, probability distribution expected present value etc. should be put in diagrammatic form
called decision tree.

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Step 4- Evaluating the Alternatives: After drawing out the decision the next step is the evaluation of
alternatives.
Or

Limitations of Leasing

(1) The lease rentals become payable soon after the acquisition of assets and no moratorium period is
permissible as in case of term loans from financial institutions. The lease arrangement may, therefore, not be
suitable for setting up of the new projects as it would entail cash outflows even before the project comes into
operation.
(2) The leased assets are purchased by the lessor who is the owner of equipment. The seller’s warranties for
satisfactory operation of the leased assets may sometimes not be available to lessee.

(3) Lessor generally obtains credit facilities from banks etc. to purchase the leased equipment which are
subject to hypothecation charge in favour of the bank. Default in payment by the lessor may sometimes result
in seizure of assets by banks causing loss to the lessee.

(4) Lease financing has a very high cost of interest as compared to interest charged on term loans by financial
institutions/banks.

SECTION – B: ECONOMICS FOR FINANCE

Question 7 (a) Given Consumption function C = 300 + O.75Y;

Investment = ₹ 800; Net Imports = ₹ 100 Calculate equilibrium level of output. (3 Marks)

(b) Explain 'depreciation' and 'appreciation' of home currency under floating exchange rate. (2 Marks)

(c) Compute M1 supply of money from the data given below:

Currency with public 2,13,279.8 Crores

Time deposits with bank 3,45,000.7 Crores
Demand deposits with bank 1,62,374.5 Crores
Post office savings deposit 382.9 Crores
Other deposits of RBI 765.1 Crores (3 Marks)
(d) Define 'Market power'. What is i ts disadvantage? (2 Marks)

Answer

(a) Y = C+I+G+(X-M)
Y = (300+0.75Y) +800+ 0+ (-100)

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Y = 300+0.75Y +800 -100 = 0.25
Y =1000
Y= ₹ 4000

(b) Under a floating rate system, home currency depreciates when its value falls with respect to the value of
another currency or a basket of other currencies i.e there is an increase in the home currency price of the
foreign currency.

For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹ 70 and ₹ 72 in June, then the
Indian Rupee has depreciated in its value with respect to the US dollar and the value of US dollar has
appreciated in terms of the Indian Rupee. On the contrary, home currency appreciates when its value
increases with respect to the value of another currency or a basket of other currencies i.e. there is a decrease
in the home currency price of foreign currency.
For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹ 72 and ₹ 70 in June, then the
Indian Rupee has appreciated in its value with respect to the US dollar and the value of US dollar has
depreciated in terms of the Indian Rupee.

(c) Calculation of M1
M1 = Currency and coins with the people + demand deposits of banks (current and saving accounts) + other
deposits of the RBI.
M1 = 2,13,279.8 + 1,62,374.5 + 765.1
= 3,76,419.4 Crores

(d) Market power is the ability of a price making firm to profitably raise the market price of a good or service
over its marginal cost and thus earn supernormal profits or positive economic profits. Market power is an
important cause of market failure. Market failure occurs when the free market outcomes do not maximize net
benefits of an economic activity and therefore there is deadweight losses and inefficient allocation of
resources. Excess market power causes a single producer or a small number of producers to strategically
reduce their supply and charge higher prices compared to competitive market. Market power can cause
markets to be inefficient because it keeps price and output away from the equilibrium of supply and demand.
Market power thus results in suboptimal outcomes such as deadweight loss, underproduction of goods and
services, higher prices and loss of consumer surplus.

Question 8

(a) Compute GNP at factor cost and NDP at market price using expenditure method from the following data:
(₹ in Crores)

Personal Consumption expenditure 2900

Imports 300

Gross public Investment 500

Consumption of fixed capital 60
Exports 200

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Inventory Investment 170
Government purchases of goods & services 1100
Gross Residential construction Investment 450
Net factor Income from abroad (-)30
Gross business fixed Investment 410
Subsidies 80 (5 Marks)
(b)

(i) Why is there a need for the government to resort to resource allocation ? (3 Marks)

(ii) Why is the central bank referred to as a "banker's bank" ? (2 Marks)

Answer

(a) GDPMP = Personal consumption expenditure + Government purchase of goods and services + gross public
investment + inventory investment +gross residential construction investment + Gross business fixed
investment + [export – import]

= 2900 + 1100 + 500 + 170+450 + 410 + (200-300) = ₹ 5430 Crores

GNPFC = GDPMP + Net Factor Income from Abroad - Net Indirect Taxes = ₹ 5430 + (-30) +80 = 5480 Crores

NDPMP = GDPMP - Consumption of fixed capital = 5430- 60 = 5370 Crores

(b) (i) Market failures provide the rationale for government’s allocative function. Market failures are situations
in which a particular market, left to itself, is inefficient and leads to misallocation of society’s scarce resources.
In the absence of appropriate government intervention in resource allocation, the resources are likely to be
misallocated with too much production of certain goods or too little production of certain other goods. The
allocation responsibility of the governments involves suitable corrective action when private markets fail to
provide the right and desirable combination of goods and services to ensure optimal outcomes in terms of
social welfare.

(ii) A central bank of a country is called a ‘bankers’ bank because it acts as a banker to the community of
commercial banks and provides them with financial services to facilitate their efficient functioning.
• The central bank acts as a custodian of cash reserves of commercial banks in the country.
• The central bank provides efficient means of funds transfer for all banks. All commercial banks maintain
accounts with the central bank and it enables smooth and swift clearing and settlements of inter-bank
transactions and interbank payments.
• The central bank acts as a lender of last resort. It provides liquidity to banks when the latter face shortage of

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liquidity. The scheduled commercial banks can borrow from the discount window against the collateral of
securities like commercial bills, government securities, treasury bills, or other eligible papers.

Question 9
(a) (i) Explain the classical theory of Comparative Advantage as given by David Ricardo. (3 Marks)

(ii) What will be the total credit created by the commercial banking system for an initial deposit of ₹ 3000 at
a Required Reserve Ratio (RRR) of 0.05 and 0.08 respectively? Also compute credit multiplier. (2 Marks)
(b) (i) Describe the limitations of fiscal policy. (3 Marks)

(ii) What are the conceptual difficulties in the measurement of national income? (2 Marks)

Answer
(a)

(i) The law of comparative advantage states that even if one nation is less efficient than (has an absolute
disadvantage with respect to) the other nation in the production of both commodities, there is still scope for
mutually beneficial trade.

The first nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in
which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage). Labour
differs in its productivity internationally and different goods have different labour requirements, so
comparative labor productivity advantage was Ricardo’s predictor of trade.
The theory can be explained with a simple example Output per Hour of Labour

Country B has absolute disadvantage in the production of both wheat and cloth.

However, since B’s labour is only half as productive in cloth but six times less productive in wheat compared to
country A, country B has a comparative advantage in cloth. On the other hand, country A has an absolute
advantage in both wheat and cloth with respect to the country B, but since its absolute advantage is greater in
wheat (6:1) than in cloth (4:2), country A has a comparative advantage in wheat. According to the law of
comparative advantage, both nations can gain if country A specialises in the production of wheat and exports
some of it in exchange for country B’s cloth. Simultaneously, country B should specialise in the production of
cloth and export some of it in exchange for country A’s wheat.

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If country A could exchange 6W for 6C with country B, then, country A would gain 2C (or save one-half hour of
labour time) since the country A could only exchange 6W for 4C domestically. The 6W that the country B
receives from the country A would require six hours of labour time to produce in country B. With trade,
country B can instead use these six hours to produce 12C and give up only 6C for 6W from the country A. Thus,
the country B would gain 6C or save three hours of labour time and country A would gain 2C. However, the
gains of both countries are not equal.
Country A would gain if it could exchange 6W for more than 4C from country B; because 6W for 4 C is what it
can exchange domestically (both require the same one hour labour time). The more C it gets, the greater
would be the gain from trade.

Conversely, in country B, 6W = 12C (in the sense that both require 6 hours to produce). Anything less than 12C
that country B must give up to obtain 6W from country A represents a gain from trade for country B. To
summarize, country A gains to the extent that it can exchange 6W for more than 4C from the country B.
country B gains to the extent that it can give up less than 12C for 6W from the country A. Thus, the range for
mutually advantageous trade is 4C < 6W < 12C.

(ii) The credit multiplier is the reciprocal of the required reserve ratio.

(b) (i) The following are the significant limitations in respect of choice and implementation of fiscal policy.

1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is the different
types of lags involved in fiscal -policy action. There are significant lags such as recognition lag, decision lag,
implementation lag and impact lag

2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an
expansionary policy is initiated when the economy is already on a path of recovery and vice versa.

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3. There are difficulties in instantaneously changing governments’ spending and taxation policies.

4. It is practically difficult to reduce government spending on various items such as defence and social security
as well as on huge capital projects which are already midway.

5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge
projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot
be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.
6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in
and also promptly determining the accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal policy such that a policy designed to
achieve one goal may adversely affect another. For example, an expansionary fiscal policy may worsen
inflation in an economy

8. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example,
increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security
benefits may adversely affect incentives to work and save.

9. Deficit financing increases the purchasing power people. The production of goods and services, especially in
under developed countries may not catch up simultaneously to meet the increased demand. This will result in
prices spiraling beyond control.

10. Increase is government borrowing creates perpetual burden on even future generations as debts have to
be repaid. If the economy lags behind in productive utilization of borrowed money, sufficient surpluses will
not be generated for servicing debts. External debt burden has been a constant problem for India and many
developing countries.

11. An increase in the size of government spending during recessions will ‘crowd
- out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the
recession, and possibly also reduce the economy’s prospects of long-run economic growth. 12. If governments
compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and
firms’ willingness to invest may be reduce
d. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may
not be realized.

(ii) There are many conceptual difficulties related to measurement which are difficult to resolve. A few
examples are:

817
(a) lack of an agreed definition of national income,
(b) accurate distinction between final goods and intermediate goods,
(c) issue of transfer payments,
(d) services of durable goods,
(e) difficulty of incorporating distribution of income
(f) valuation of a new good at constant prices, and
(g) valuation of government services
(h) valuation of services rendered without remuneration
Question 10

(a) (i) How does international trade Increase economic efficiency? Explain.
(ii) What is meant by expansionary fiscal policy? Under what circumstances do government pursue
expansionary policy? (3 Marks)

(b) (i) "Money has four functions: a medium, a measure, a standard and a store." Elucidate. (2 Marks)

(ii) When investment in an economy increases from ₹ 10,000 crores to ₹ 14,000 crores and as a result of this
national income rises from ₹ 80,000 crores to ₹ 92,000 crores, compute investment multiplier. (2 Marks)

Answer

(a) (i) International trade is a powerful stimulus to economic efficiency and contributes to economic growth
and rising incomes.

(i) The wider market made possible owing to trade induces companies to reap the quantitative and qualitative
benefits of extended division of labour. As a result, they would enlarge their manufacturing capabilities and
benefit from economies of large scale production.

(ii) The gains from international trade are reinforced by the increased competition that domestic producers
are confronted with on account of internationalization of production and marketing requiring businesses to
invariably compete
against global businesses. Competition from foreign goods compels manufacturers, especially in developing
countries, to enhance competitiveness and profitability by adoption of cost reducing technology and business
practices. Efficient deployment of productive resources to their best uses is a direct economic advantage of
foreign trade. Greater efficiency in the use of natural, human, industrial and financial resources ensures
productivity gains. Since international trade also tends to decrease the likelihood of domestic monopolies, it is
always beneficial to the community.

(iii) Trade provides access to new markets and new materials and enables sourcing of inputs and components
internationally at competitive prices. Also, international trade enables consumers to have access to wider
variety of goods and services that would not otherwise be available. It also enables nations to acquire foreign
exchange reserves necessary for imports which are crucial for sustaining their economies.

(iv) International trade enhances the extent of market and augments the scope for mechanization and 818
specialisation.

(v) Exports stimulate economic growth by creating jobs, reducing poverty and augmenting factor incomes and
in so doing raising standards of livelihood and overall demand for goods and services.

(vi) Employment generating investments, including foreign direct investment, inevitably follow trade.

(vii) Opening up of new markets results in broadening of productive base and facilitates export diversification.
(viii) Trade also contributes to human resource development, facilitates fundamental and applied research and
exchange of know-how and best practices between trade partners.

(ix) Trade strengthens bonds between nations by bringing citizens of different countries together in mutually
beneficial exchanges and thus promotes harmony and cooperation among nations.

(ii) An expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a
business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by
increasing aggregate expenditure and aggregate demand through an increase in all types of government
spending and / or a decrease in taxes. The objectives of expansionary fiscal policy are reduction in cyclical
unemployment, increase in consumer demand and prevention of recession and possible depression.

In other words, it aims to close a ‘recessionary gap’ or a contractionary gap wherein the aggregate demand is
not sufficient to create conditions of full employment. This is accomplished by increasing aggregate
expenditure and aggregate demand through an increase in all types of government spending and / or a
decrease in taxes. Government uses subsidies, transfer payments, welfare programmes, corporate and
personal income tax cuts and increased spending on public works such as on infrastructure development to
put more money into consumers' hands to give them more purchasing power.

(b) (i) Money performs many important functions in an economy.

(i) Money is a convenient medium of exchange or it is an instrument that facilitates easy exchange of goods
and services. Money, though not having any inherent power to directly satisfy human wants, by acting as a
medium of exchange, it commandspurchasing power and its possession enables us to purchase goods and
services to satisfy our wants. By acting as an intermediary, money increases the ease of trade and reduces the
inefficiency and transaction costs involved in a barter exchange. By decomposing the single barter transaction
into two separate transactions of sale and purchase, money eliminates the need for double coincidence of
wants. Money also facilitates separation of transactions both in time and place and this in turn enables us to
economize on time and efforts involved in transactions.

(ii) Money is a ‘common measure of value’. T he monetary unit is the unit of measurement in terms of which
the value of all goods and services is measured and expressed. It is convenient to trade all commodities in

819
exchange for a single commodity. So also, it is convenient to measure the prices of all commodities in terms of
a single unit, rather than rec ord the relative price of every good in terms of every other good. A common unit
of account facilitates a system of orderly pricing which is crucial for rational economic choices. Goods and
services which are otherwise not comparable are made comparable through expressing the worth of each in
terms of money.

(iii) Money serves as a unit or standard of deferred payment i.e money facilitates recording of deferred
promises to pay. Money is the unit in terms of which future payments are contracted or stated. However,
variations in the purchasing power of money due to inflation or deflation, reduces the efficacy of money in this
function.
(iv) Like nearly all other assets, money is a store of value. People prefer to hold it
as an asset, that is, as part of their stock of wealth. The splitting of purchases and sale into two transactions
involves a separation in both time and space.

This separation is possible because money can be used as a store of value or store of means of payment during
the intervening time. Again, rather than spending one’s money at present, one can store it for use at some
future time. Thus, money functions as a temporary abode of purchasing power in order to efficiently perform
its medium of exchange function. Money also functions as a permanent store of value. Money is the only asset
which has perfect liquidity.

(b) (ii) Investment Multiplier K

= ΔY/ΔI = 12,000/ 4,000 = 3

Question 11 (a) (i) Describe the determinants of demand for money as identified by Milton Friedman in his
re-statement of Quanti ty Theory of demand for money. (3 Marks)

(ii) What is meant by 'Mixed tari ffs'? (2 Marks)

(b) (i) Using suitable diagram, explain, how the nominal exchange rate between two countries is
determined'? (3 Marks)
(ii) What is meant by quasi public goods? (2 Marks)

OR

Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). (2 Marks)

Answer

(a) (i) According to Milton Friedman, Demand for money is affected by the same factors as demand for any
other asset, namely

1. Permanent income.

2. Relative returns on assets. (which incorporate risk) Friedman maintains that it is permanent income – and 820
not current income as in the

Keynesian theory – that determines the demand for money. Permanent income which is Friedman’s measure
of wealth is the present expected value of all future income. To Friedman, money is a good as any other
durable consumption good and its demand is a function of a great number of factors. Friedman identified the
following four determinants of the demand for money. The nominal demand for money:
• is a function of total wealth, which is represented by permanent income divided by the discount rate,
defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds,
equity, physical capital and human capital.

• is positively related to the price level, P. If the price level rises the demand for money increases and vice
versa.

• rises, if the opportunity costs of money holdings (i.e. returns on bonds and stock) decline and vice versa.

• is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby
increasing the opportunity costs of money holdings.

(ii) Mixed tariffs are expressed either on the basis of the value of the imported goods (an ad valorem rate) or
on the basis of a unit of measure of the imported goods (a specific duty) depending on which generates the
most income (or least income at times) for the nation. For example, duty on cotton: 5 per cent ad valorem 0r ₹
3000/ per tonne, whichever is higher.

(b) (i) Under a floating exchange rate system, the supply of and demand for foreign exchange in the domestic
foreign exchange market determine the external value of the domestic currency, or in other words, a
country’s nominal exchange rate. Similar to any standard market, the exchange market also faces a
downward-sloping demand curve and an upward-sloping supply curve.

Determination of Nominal Exchange Rate The equilibrium rate of exchange is determined by the interaction of
the supply and demand for a particular foreign currency. In the figure above, the demand curve (D$) and
supply curve (S$) of dollars intersect to determine equilibrium exchange rate eeq with Qe as the equilibrium
quantity of dollars exchanged.

(ii) A quasi-public good or near-public good has many but not all the characteristics of a public good. These are
goods which have an element of non-excludability and non-rivalry.

Quasi public goods are:

(i) Not completely non rival. For example, public roads wi -fi networks and public parks do not get congested

821
so as to reduce the space available for others when extra consumers use them only up to an optimal point.
When more people use it beyond that, the amount others can benefit from these is reduced to some extent,
because there will be increased congestion.

(ii) It is easy to keep people away from quasi public goods by charging a price or fee. For example, it is possible
to exclude some users by building toll booths to charge for road usage on congested routes. Other examples
are education, and health services. It is easy to keep people away from them by charging a price or fee.
However, it is undesirable to keep people away from such goods because the society would be better off if
more people consume them. This particular characteristic namely, the combination of virtually infinite
benefits and the ability to charge a price results in some quasi-public goods being sold through markets and
others being provided by government.

OR

Foreign direct investment takes place when the resident of one country (i.e. home country) acquires
ownership of an asset in another country (i.e. the host country) and such movement of capital involves
ownership, control as well as management of the asset in the host country. Foreign portfolio investment is the
flow of what economists call ‘financial capital’ rather than ‘real capital’ and does not involve ownership or
control on the part of the investor.

Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)

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 PAPER- NOV 2019
SECTION – A: FINANCIAL MANAGEMENT

Question
(a) Following information has been gathered from the books of Tram Ltd. the equity shares of which is
trading in the stock market at ₹ 14.

Particulars Amount (₹)

Equity Share Capital (face value ₹ 10) 10,00,000
10% Preference Shares 2,00,000
Reserves 8,00,000
10% Debentures 6,00,000
Profit before Interest and Tax for the year 4,00,000
Interest 60,000
Profit after Tax for the year 2,40,000

Calculate the following:

(i) Return on Capital Employed

(ii) Earnings per share

(iii) PE ratio

(b) Door Ltd. is considering an investment of ₹ 4,00,000. This investment is expected to generate substantial
cash inflows over the next five years. Unfortunately, the annual cash flows from this investment is

823
uncertain, and the following profitability distribution has been established.

Annual Cash Flow (₹) Probability

50,000 0.3
1,00,000 0.3
1,50,000 0.4

At the end of its 5 years life, the investment is expected to have a residual value of ₹ 40,000.
The cost of capital is 5%
(i) Calculate NPV under the three different scenarios.
(ii) Calculate Expected Net Present Value.
(iii) Advise Door Ltd. on whether the investment is to be undertaken.

Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784

(c) Following figures and information were extracted from the company A Ltd.

Earnings of the company ₹ 10,00,000

Dividend paid ₹ 6,00,000
No. of shares outstanding 2,00,000
Price Earnings Ratio 10
Rate of return on investment 20%

You are required to calculate:

(i) Current Market price of the share
(ii) Capitalisation rate of its risk class
(iii) What should be the optimum pay-out ratio?
(iv) What should be the market price per share at optimal pay-out ratio? (use Walter’s Model)

(d) A company has ₹ 1,00,000 available for investment and has identified the following four investments in
which to invest.

Project Investment (₹) NPV (₹)

C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000

824
You are required to optimize the returns from a package of projects within the capital spending limit if-
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible. (4 x 5 = 20 Marks)

Answer

(a) (i) Calculation of Return on capital employed (ROCE)

Capital employed = Equity Shareholders’ funds + Debenture + Preference shares
= ₹ (10,00,000 + 8,00,000 + 6,00,000 + 2,00,000)
= ₹ 26,00,000
(b) (i) Calculation of NPV under three different scenarios (Amount in ₹)

Particulars 1st Scenario 2nd Scenario 3rd Scenario

825
Annual Cash Flow 50,000 1,00,000 1,50,000
PV of cash inflows 2,16,500 4,33,000 6,49,500
(Annual Cash Flow ×
4.33*)
PV of Residual Value 31,360 31,360 31,360
(₹ 40,000 × 0.784)
Total PV of Cash 2,47,860 4,64,360 6,80,860
Inflow
Initial investment 4,00,000 4,00,000 4,00,000
NPV (1,52,140) 64,360 2,80,860
* .952 + .907 + .864 + .823 + .784 = 4.33

(ii) Calculation of Expected Net present Value under three different scenarios

(iii) Since the expected net present value of the Investment is positive, the Investment should be undertaken.

(c) (i) Current Market price of shares (applying Walter’s Model)

• The EPS of the firm is ₹ 5 (i.e., Rs 10,00,000 / 2,00,000).

• Rate of return on Investment (r) = 20%.
• The Price Earnings (P/E) Ratio is given as 10, so capitalization rate (Ke), may be taken at the inverse of P/E
Ratio. Therefore, Ke is 10% or .10 (i.e., 1/10).
• The firm is distributing total dividends of ₹ 6,00,000 among 2,00,000 shares, giving a dividend per share of ₹

3. 826
The value of the share as per Walter’s model may be found as follows:

Walter’s model is given by

(ii) Capitalization rate (Ke) of its risk class is 10% or .10 (i.e., 1/10).

(iii) Optimum dividend pay-out ratio

According to Walter’s model when the return on investment is more than the cost of equity capital (10%), the
price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio

827
in this case is nil or 0 (zero).

(iv) Market price per share at optimum dividend pay-out ratio

At a pay-out ratio of zero, the market value of the company’s share will be:
(d) (i) Optimizing returns when projects are independent and divisible.
Computation of NPVs per Re. 1 of Investment and Ranking of the Projects

Project Investment NPV NPV per Re. 1 invested Ranking

(₹) (₹) (₹)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4

Building up of a Package of Projects based on their Rankings

Project Investment NPV

(₹) (₹)
C 40,000 20,000
E 50,000 24,000
D (1/10th of 10,000 3,500
Project)
Total 1,00,000 47,500

The company would be well advised to invest in Projects C, E and D (1/10th) and reject Project F to optimise
return within the amount of ₹ 1,00,000 available for investment.

(ii) Optimizing returns when projects are indivisible.

Package of Project Investment (₹) Total NPV (₹)

C and E 90,000 (40,000 + 44,000 (20,000 +
50,000) 24,000)
C and F 1,00,000 (40,000 + 38,000 (20,000 +
60,000) 18,000)
Only D 1,00,000 35,000

The company would be well advised to invest in Projects C and E to optimise return within the amount of ₹ 828
1,00,000 available for investment.
Question 2
The Balance Sheet of Gitashree Ltd. is given below:

Liabilities (₹ )
Shareholders’ fund
Equity share capital of ₹ 10 each ₹ 1,80,000
Retained earnings ₹ 60,000 2,40,000
Non-current liabilities 10% debt 2,40,000
Current liabilities 1,20,000
6,00,000
Assets
Fixed Assets 4,50,000
Current Assets 1,50,000
6,00,000

The company's total asset turnover ratio is 4. Its fixed operating cost is ₹ 2,00,000 and its variable operating
cost ratio is 60%. The income tax rate is 30%.

Calculate:
(i) (a) Degree of Operating leverage.
(b) Degree of Financial leverage.
(c) Degree of Combined leverage.

(ii) Find out EBIT if EPS is (a) ₹ 1 (b) ₹ 2 and (c) ₹ 0. (10 Marks)

Answer

Working Notes:

829
Computation of Profits after Tax (PAT)

Particulars (₹)
Sales 24,00,000
Less: Variable operating cost @ 60% 14,40,000
Contribution 9,60,000
Less: Fixed operating cost (other than 2,00,000
Interest)
EBIT (Earning before interest and tax) 7,60,000
Less: Interest on debt (10% 2,40,000) 24,000
EBT (Earning before tax) 7,36,000
Less: Tax 30% 2,20,800
EAT (Earning after tax) 5,15,200

830
Alternatively, if EPS is 0 (zero), EBIT will be equal to interest on debt i.e. ₹ 24,000.

Question 3
Slide Ltd. is preparing a cash flow forecast for the three months period from January to the end of March.
The following sales volumes have been forecasted:

Months December January February March April

Sales (units) 1,800 1,875 1,950 2,100 2,250

Selling price per unit is ₹ 600. Sales are all on one month credit. Production of goods for sale takes place one
month before sales. Each unit produced requires two units of raw materials costing ₹ 150 per unit. No raw
material inventory is held. Raw materials purchases are on one month credit. Variable overheads and wages
equal to ₹ 100 per unit are incurred during production and paid in the month of production. The opening
cash balance on 1st January is expected to be ₹ 35,000. A long term loan of ₹ 2,00,000 is expected to be
received in the month of March. A machine costing ₹ 3,00,000 will be purchased in March.

(a) Prepare a cash budget for the months of January, February and March and calculate the cash balance at
the end of each month in the three months period.

(b) Calculate the forecast current ratio at the end of the three months period. (10 Marks)

Answer

Working Notes: 831

(1) Calculation of Collection from Trade Receivables:

Particulars December January February March

Sales (units) 1,800 1,875 1,950 2,100
Sales (@ ₹ 600 per unit) / Trade Receivables 10,80,000 11,25,000 11,70,000 12,60,00
(Debtors) (₹) 0
Collection from Trade Receivables (Debtors) (₹) 10,80,000 11,25,000 11,70,00
0
(2) Calculation of Payment to Trade Payables

Particulars December January February March

Output (units) 1,875 1,950 2,100 2,250
Raw Material (2 units per output) 3,750 3,900 4,200 4,500
(units)
Raw Material (@ ₹ 150 per unit) / Trade Payables 5,62,500 5,85,000 6,30,000 6,75,000
(Creditors) (₹)
Payment to Trade Payables (Creditors) (₹) 5,62,500 5,85,000 6,30,000

(3) Calculation of Variable Overheads and Wages:

Particulars January February March

Output (units) 1,950 2,100 2,250
Payment in the same month @ ₹ 100 per 1,95,000 2,10,000 2,25,000
unit (₹)

(a) Preparation of Cash Budget

Particulars January (₹) February (₹) March (₹)

Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade Receivables 10,80,000 11,25,000 11,70,000
(Debtors)
Receipt of Long-Term Loan 2,00,000
Total (A) 11,15,000 14,82,500 20,57,500
Payments:
Trade Payables (Creditors) for 5,62,500 5,85,000 6,30,000
Materials
Variable Overheads and Wages 1,95,000 2,10,000 2,25,000

832
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,000
Closing Balance (A – B) 3,57,500 6,87,500 9,02,500
(b) Calculation of Current Ratio

Particulars March (₹)

Output Inventory (i.e. units produced in March) 9,00,000
[(2,250 units x 2 units of raw material per unit of output x
₹ 150 per unit of raw material) + 2,250 units x ₹ 100 for
variable overheads and wages]
or, [6,75,000 + 2,25,000] from Working Notes 2 and 3
Trade Receivables (Debtors) 12,60,000
Cash Balance 9,02,500
Current Assets 30,62,500
Trade Payables (Creditors) 6,75,000
Current Liabilities 6,75,000
Current Ratio (Current Assets / Current Liabilities) 4.537 approx

Question 4
Loft Ltd. is considering an investment in new technology that will reduce operating costs through increasing
efficiency. The new technology will cost ₹ 5,00,000 and have a four year life at the end of which it will have
a residual value of ₹ 50,000.

An annual license fee of ₹ 52,000 is payable to operate the machine. The purchase can be financed by 10%
loan payable in equal installments at the end of each of four years. The depreciation is to be charged as per
reducing balance method. The rate of depreciation is 25% per annum.

Alternatively, Loft Ltd. could lease the new technology. The Company would pay four annual lease rentals of
₹ 1,90,000 per year. The annual lease rentals include the cost of license fee. Tax rate is 30%. Compute the
incremental cash flows under each option. What would be the appropriate rate at which these cash flows
have to be discounted? Discount the incremental cash flows under each option and decide which option is

833
better - buy or lease? (10 Marks)

Year 1 2 3 4
DF @ 7% 0.935 0.873 0.816 0.763
DF @ 10% 0.909 0.826 0.751 0.683
Answer

(1) The buy or lease decision means computation of NPV arising from lease decision i.e. computation of
valuation advantage of lease over buy. If the value is positive then we go for lease, otherwise we buy.

(2) The valuation process involves – a) finding incremental cash flow of lease over buy, and then, b)
discounting the incremental cash flow by net of tax interest rate of equivalent loan (to purchase the asset in
question).

If we go for lease, there would be cash outflow in the form of net of tax lease rent from year 1 to 4. Net of tax
lease rent per annum = ₹ 1,90,000 x (1-.30) = ₹ 1,33,000.
Again, if the equipment had been purchases there would have been tax saving of depreciation = Depreciation
x tax rate. Here, the tax saving or tax shield is available for 4 years. But under lease the benefit accrues to
lessor. For lessee it is a negat ive cash flow as advantage is not available to him under lease arrangement as
lessor is considered the legal owner of the asset for claiming depreciation under Income tax law. The
depreciation schedule and tax shield on depreciation are given in table 1.

Table 1

Year Cost/ Depreciation Closing Tax shield (₹)

opening @ 25% (₹) balance (₹)
balance (₹)
1 5,00,000 1,25,000 3,75,000 37,500
2 3,75,000 93,750 2,81,250 28,125
3 2,81,250 70,312.50 2,10,937.50 21,093.75
4 2,10,937.50 52,734.38 1,58,203.12 15,820.31

(3) Further, if the equipment had been purchased there would have been tax saving of interest on loan =
interest on loan x tax rate. Here, the tax saving or tax shield is available for 4 years. For lessee it is a negative
cash flow as advantage is not available to him under lease arrangement.
The loan amount would have been repayable together with the interest at the rate of 10% in equal installment

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at the end of each year. The PVAF at the rate of 10% for 4 years is 3.169 (.909 + .826 + .751 + .683), the
amount payable would have been-

The interest expense schedule and tax shield on interest expense are given in table 2.
 Table 2

Year Total Interest (₹) Principal Principal amount Tax shield (₹)
Installment (₹) (₹) outstanding (₹)
1 1,57,778 50,000 1,07,778 3,92,222 15,000
2 1,57,778 39,222 1,18,556 2,73,666 11,766.6
3 1,57,778 27,367 1,30,411 1,43,255 8,210.1
4 1,57,778 14,523 1,43,255 ------ 4,356.9
(bal. fig.)

(4) After 4 years the equipment is sold for ₹ 50,000 which is a cash outflow due to lease over buy
Loss on sale = ₹ (1,58,203.12 - 50,000)
= ₹ 1,08,203.12
Tax savings on loss = 30% of ₹ 1,08,203.12 = ₹ 32,460.94
This further tax shield has to be accounted for in the year 4.

(5) If the equipment is taken on lease, the cash outflow on a/c of lease rental, depreciation tax shield is given
in table 3

Table 3

Year Net of tax Depreciati Interest Total (₹)

lease on tax tax shield
rental (₹) shield (₹) (₹) (from
(from Table 2)
Table 1)
1 1,33,000 37,500 15,000 1,85,500
2 1,33,000 28,125 11,766.6 1,72,891.6
3 1,33,000 21,093.75 8,210.1 1,62,303.8
5

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4 1,33,000 15,820.31 4,356.9 1,53,177.2
1
(6) Net of tax interest rate = 0.10X (1-.30) = 0.07

Calculation of NPV for lease over buy option (Amount in ₹)

Year 1 2 3 4
Loan Installment 1,57,778 1,57,778 1,57,778 1,57,778
License Fees (net of Taxes) 36,400 36,400 36,400 36,400
Amount from sale of Machine (50,000)
Tax saving on loss on sale (32,460.94)
Total Tax Shield on Lease Rent, Interest (1,85,500) (1,72,891.60) (1,62,303.85) (1,53,177.21)
and Depreciation
Total Cash flow 8,678.00 21,286.40 31,874.15 (41,460.15)
Discounting Factor @7% 0.935 0.873 0.816 0.763
Discounted Cash Flow 8,113.93 18,583.03 26,009.31 (31,634.09)
NPV [8,113.93 + 18,583.03 + 26,009.31 + (31,634.09)] 21,072.17

Since, NPV or value of the lease is positive, the equipment should be taken on lease.

Question 5
A Company wants to raise additional finance of ₹ 5 crore in the next year. The company expects to retain ₹ 1
crore earning next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3: 1.

(ii) The additional issue of equity shares will result in price per share being fixed at ₹ 25.

(iii) The debt capital raised by way of term loan will cost 10% for the first ₹ 75 lakh and 12% for the next ₹ 50
lakh.

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(iv) The net expected dividend on equity shares is ₹ 2.00 per share. The dividend is expected to grow at the
rate of 5%.

(v) Income tax rate is 25%.

You are required:

(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post-tax average cost of additional debt.

(c) To determine the cost of retained earnings and cost of equity.

(d) To compute the overall weighted average cost of additional finance after tax. (10 Marks)

Answer

(a) Determination of the amount of equity and debt for raising additional finance:

Pattern of raising additional finance Equity 3/4 of ₹ 5 = ₹ 3.75 Crore

Crore
Debt 1/4 of ₹ 5 = ₹ 1.25 Crore
Crore

The capital structure after raising additional finance:

Particulars (₹ In crore)
Shareholders’ Funds
Equity Capital (3.75 – 2.75
1.00)
Retained earnings 1.00
Debt (Interest at 10% p.a.) 0.75
(Interest at 12% p.a.) (1.25-0.75) 0.50
Total Funds 5.00

(b) Determination of post-tax average cost of additional debt

Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate

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On ₹ 75,00,000 = 10% (1 – 0.25) = 7.5% or 0.075
On ₹ 50,00,000 = 12% (1 – 0.25) = 9% or 0.09

Average Cost of Debt

(c) Determination of cost of retained earnings and cost of equity (Applying Dividend growth model):

(d) Computation of overall weighted average after tax cost of additional finance

Particular (₹) Weights Cost of funds Weighted Cost (%)

Equity (including retained 3,75,00,00 3/4 13.4% 10.05
earnings) 0
Debt 1,25,00,00 1/4 8.1% 2.025
0
WACC 5,00,00,00 12.075
0

838
Question 6

(a) Briefly explain the three finance function decisions. (3 Marks)

(b) Explain the steps while using the equivalent annualized criterion. (3 Marks)

(c) Explain the significance of Cost of Capital. (4 Marks)

OR

Briefly describe any four sources of short-term finance. (4 Marks)

Answer

(a) The finance functions are divided into long term and short term functions/ decisions:
Long term Finance Function Decisions

(i) Investment decisions (I): These decisions relate to the selection of assets in which funds will be invested by
a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds
are used in a project for various fixed assets and also for current assets.

(ii) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial
objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to
possess a good knowledge of the sources of available funds and their respective costs and needs to ensure
that the company has a sound capital structure, i.e. a proper balance between equity capital and debt.

(iii) Dividend decisions (D): These decisions relate to the determination as to how much and how frequently
cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any
profit-making organization looks for reward for his investment in two ways, the growth of the capital invested
and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited
liability company the term is dividends.

Short- term Finance Decisions/Function

Working capital Management (WCM): Generally short term decision is reduced to management of current
asset and current liability (i.e., working capital Management).

(b) Equivalent Annualized Criterion: This method involves the following steps-
(i) Compute NPV using the WACC or discounting rate.
(ii) Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period of each
project.

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(iii) Divide NPV computed under step (i) by PVAF as computed under step (ii) and compare the values.

(c) Significance of the Cost of Capital: The cost of capital is important to arrive at correct amount and helps
the management or an investor to take an appropriate decision. The correct cost of capital helps in the
following decision making:

(i) Evaluation of investment options: The estimated benefits (future cashflows) from available investment
opportunities (business or project) are converted into the present value of benefits by discounting them with
the relevant cost of capital. Here it is pertinent to mention that every investment option may have different
cost of capital hence it is very important to use the cost of capital which is relevant to the options available.
Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).

(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars project or
business. The performance of a project or business in compared against the cost of capital which is known
here as cut-off rate or hurdle rate.

(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the customers,
the cost of allowing credit period is compared against the benefit/ profit earned by providing credit to
customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and
benefits received.

OR

Sources of Short Term Finance: There are various sources available to meet short- term needs of finance. The
different sources are discussed below-

(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual
duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to
almost all business operations. It can be in the form of an 'open account' or 'bills payable'.

(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a company has to
pay for the services which it has already received like wages, taxes, interest and dividends. Such expenses
arise out of the day-to-day activities of the company and hence represent a spontaneous source of finance.

Deferred Income: These are the amounts received by a company in lieu of goods and services to be provided
in the future. Since these receipts increases a company’s liquidity, they are also considered to be an important
sources of short-term finance.

(iii) Advances from Customers: Manufacturers and contractors engaged in producing or constructing costly
goods involving considerable length of manufacturing or construction time usually demand advance money
from their customers at the time of accepting their orders for executing their contracts or supplying the goods.
This is a cost free source of finance and really useful.

840
(iv) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a
view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors.

(v) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills, commonly
referred to as T-Bills are issued by Government of India to meet short term borrowing requirements with
maturities ranging between 14 to 364 days.
(vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate with a fixed
maturity date of not less than 15 days up to a maximum of one year.

(vii) Bank Advances: Banks receive deposits from public for different periods at varying rates of interest. These
funds are invested and lent in such a manner that when required, they may be called back. Lending results in
gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met and a
reasonable profit is made. A bank's lending policy is not merely profit motivated but has to also keep in mind
the socio- economic development of the country. Some of the facilities provided by banks are Short Term
Loans, Overdraft, Cash Credits, Advances against goods, Bills Purchased/Discounted.

(viii) Financing of Export Trade by Banks: Exports play an important role in accelerating the economic growth
of developing countries like India. Of the several factors influencing export growth, credit is a very important
factor which enables exporters in efficiently executing their export orders. The commercial banks provide
short-term export finance mainly by way of pre and post-shipment credit. Export finance is granted in Rupees
as well as in foreign currency.

(ix) Inter Corporate Deposits: The companies can borrow funds for a short period say 6 months from other
companies which have surplus liquidity. The rate of interest on inter corporate deposits varies depending
upon the amount involved and time period.

(x) Certificate of Deposit (CD): The certificate of deposit is a document of title similar to a time deposit receipt
issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encash the deposit before maturity period and the
investor is assured of liquidity because he can sell the CD in secondary market.

(xi) Public Deposits: Public deposits are very important source of short-term and medium term finances
particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject
to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid up capital
and reserves, from the public and shareholders. These deposits may be accepted for a period of six months to
three years. Public deposits are unsecured loans; they should not be used for acquiring fixed assets since they
are to be repaid within a period of 3 years. These are mainly used to finance working capital requirements.

841
SECTION – B: ECONOMICS FOR FINANCE

Question 7

(a) Compute the amount of subsidies from the following data:

GDP at market price (₹ in crores) 7,79,567
Indirect Taxes (₹ in crores) 4,54,367
GDP at factor cost (₹ in crores) 3,60,815 (3 Marks)

(b) What do you mean by 'Global Public Goods'? Explain in brief. (2 Marks)

(c) Compute reserve money from the following data published by RBI: (3 Marks)

(₹ in crores)
Net RBI credit to the government 8,51,651
RBI Credit to the commercial sector 2,62,115
RBI' s claim on Banks 4.10,315
Government's Currency liabilities to the public 1,85,060
RBI’s net foreign assets 72,133
RBI’s net non-monetary liabilities 68,032

(d) Explain the term 'Real Exchange Rate'. (2 Marks)

Answer

(a) Gross Domestic Product at Market Price (GDP MP) = Gross Domestic Product at Factor Cost (GDPFC) +
(Indirect Taxes – Subsidies)
Subsidies = GDPFC + Indirect tax - GDPMP ∴

842
= 360815 + 454367 – 779567
= ₹ 35,615 Crores

(b) Global Public Goods are those public goods with benefits /costs that potentially extend to everyone in the
world. These goods have widespread impact on different countries and regions, population groups and
generations throughout the entire globe. Global Public Goods may be:

• final public goods which are ‘outcomes’ such as ozone layer preservation or climate change prevention, or
intermediate public goods, which contribute to the provision of final public goods. e.g. International health
regulations

The distinctive characteristic of global public goods is that there is no mechanism (either market or
government) to ensure an efficient outcome.

The World Bank identifies five areas of global public goods which it seeks to address: namely, the
environmental commons (including the prevention of climate change and biodiversity), communicable
diseases (including HIV/AIDS, tuberculosis, malaria, and avian influenza), international trade, international
financial architecture, and global knowledge for development.

(c) Reserve Money = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on
banks + RBI’s net Foreign assets + Government’s Currency liabilities to the public – RBI’s net non - monetary
Liabilities.
= 851651 + 262115 + 410315 + 72133 + 185060 -68032
= 1713242 crores

(d) The Real Exchange Rate (RER) compares the relative price of the consumption baskets of two countries, i.e.
it describes ‘how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a
foreign country. Unlike nominal exchange rate which assumes constant prices of goods and services, the real
exchange rate incorporates changes in prices. The real exchange rate therefore is the exchange rate times the
relative prices of a market basket of goods in the two countries and is calculated as:
Real exchange rate = Nominal exchange rate X Domestic Price IndexForeign Price Index

Question 8

(a) (i) Describe the problems in administering an efficient pollution tax. (3 Marks)
(ii) Explain the open market operations conducted by RBI. (2 Marks)

(b) (i) Explain the key features of modem theory of international trade. (3 Marks) 843
(ii) Distinguish between 'pump priming' and ‘compensatory spending’ (2 Marks)
Answer

(a) (i) Pollution tax is imposed on the polluting firms in proportion to their pollution output to ensure
internalization of externalities. Following are the problems in administering an efficient pollution tax:

1. Pollution taxes are complex to determine and administer because it is difficult to discover the right level of
taxation that would ensure that the private cost plus taxes will exactly equate with the social cost.

2. If the demand for the good on which pollution tax is imposed is inelastic, the tax may only have an
insignificant effect in reducing demand. The producers will be able to easily shift the tax burden in the form of
higher product prices. This will have an inflationary effect and may reduce consumer welfare.

3. Imposition of pollution tax involves the use of complex and costly administrative procedures for monitoring
the polluters.

4. Pollution tax does not provide any genuine solutions to the problem. It only establishes an incentive system
for use of methods which are less polluting.

5. Pollution taxes also have potential negative consequences on employment and investments because high
pollution taxes in one country may encourage producers to shift their production facilities to those countries
with lower pollution taxes.

(ii) Open Market Operations (OMO) is a general term used for monetary policy involving market operations
conducted by the Reserve Bank of India by way of sale/ purchase of government securities to/ from the
market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.
When the Reserve Bank of India feels that there is excess rupee liquidity in the market, it resorts to sale of
government securities for absorption of the excess liquidity. Similarly, when the liquidity conditions are tight,
the RBI will buy securities from the market, thereby injecting liquidity into the market.

(b) (i) The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of Trade or Modern

844
Theory of Trade, emphasises the role of a country's factor endowments in explaining the basis for its trade.
‘Factor endowment’ refers to the overall availability of usable resources including both natural and man-made
means of production.

If two countries have different factor endowments under identical production function and identical
preferences, then the difference in factor endowment results in two countries having different factor prices
and different cost functions. In this model a country's advantage in production arises solely from its relative
factor abundance. Thus, comparative advantage in cost of production is explained exclusively by the
differences in factor endowments of the nations.
According to this theory, international trade is but a special case of inter-regional trade. Different regions have
different factor endowments, that is, some regions have abundance of labour, but scarcity of capital; whereas
other regions have abundance of capital, but scarcity of labour. Thus, each region is suitable for the
production of those goods for whose production it has relatively plentiful supply of the requisite factors. The
theory states that a country’s exports depend on its resources endowment i.e. whether the country is capital-
abundant or labour-abundant. A country which is capital-abundant will export capital-intensive goods.

Likewise, the country which is labor-abundant will export labour-intensive goods.

The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the export of a
commodity whose production requires intensive use of its abundant resources and imports a commodity
whose production requires intensive use of its scarce resources .
The Factor-Price Equalization Theorem which is a corollary to the Heckscher-Ohlin trade theory states that in
the absence of foreign trade, it is quite likely that factor prices are different in different countries.
International trade equalizes the absolute and relative returns to homogenous factors of production and their
prices. This implies that the wages and rents will converge across the countries with free trade, or in other
words, trade in goods is a perfect substitute for trade in factors. The Heckscher-Ohlin theorem thus postulates
that foreign trade eliminates the factor price differentials.

(ii) A distinction may be made between the two concepts of public spending during depression, namely, the
concept of ‘pump priming’ and the concept of 'compensatory spending'. Pump priming involves a one-shot
injection of government expenditure into a depressed economy with the aim of boosting business confidence
and encouraging larger private investment. It is a temporary fiscal stimulus in order to set off the multiplier
process. The argument is that with a temporary injection of purchasing power into the economy through a rise
in government spending financed by borrowing rather than taxes, it is possible for government to bring about
permanent recovery from a slump. Compensatory spending is said to be resorted to when the government
spending is deliberately carried out with the obvious intention to compensate for the deficiency in private
investment.

Question 9

(a) The price index for exports of Bangladesh in the year 2018-19 (based on 2010-11) was 233.73 and the
price index for imports of it was 220.50 (based on 2010-11)

845
(i) What do these figures mean?

(ii) Calculate the index of terms of trade for Bangladesh.

(iii) How would you interpret the index of terms of trade for Bangladesh? (5 Marks)

(b) (i) Explain the consumption function using a suitable table and diagram. (3 Marks)

(ii) Distinguish between positive and negative externalities. (2 Marks)

Answer

(a) (i) The figures represent foreign trade price indices which are compiled using prices of specified group of
commodities exported from and imported by Bangladesh in the year 2018-19. Both indices have a base year of
2010 -11 (=100) and the price changes are measured in relation to that figure. In the current year, the import
price index of 220.50 indicates that there has been a 120.50 percent increase in price since 2010-11 and
export price index shows that there is 133.73 percent increase in
export prices. These indices track the changes in the price which firms and countries receive / pay for products
they export/ import and can be used for assessing the impact of international trade on the domestic economy.

(ii) Terms of trade for Bangladesh (ToT) is given by

(iii) ‘Terms of trade’ is defined as the ratio between the index of export prices and the index of import prices.
It is the relative price of a country’s exports in terms of its imports and can be interpreted as the amount of
import goods an economy can purchase per unit of export goods. If the export prices increase more than the
import prices, a country has positive terms of trade, because for the same amount of exports, it can purchase
more imports.
In the given problem, with a ToT of 106, a unit of exports by Bangladesh will buy six percent more of imports.
In other words, from the sale of home produced goods at higher export prices and the purchase of foreign
produced goods at lower prices, trade will result in Bangladesh obtaining a greater volume of imported
products for a given volume of the exported product. This indicates increased welfare for Bangladesh.

(b) (i) Consumption function expresses the functional relationship between aggregate consumption

846
expenditure and aggregate disposable income, expressed as:
C = f (Y)

When income is low, consumption expenditures of households will exceed their disposable income and
households dissave i.e. they either borrow money or draw from their past savings to purchase consumption
goods. If the disposable income increases, consumers will increase their planned expenditures and current
consumption expenditures rise, but only by less than the increase in income. This can be illustrated with the
following table and diagram:
Disposable Income (Yd) (₹ Crores) Consumption (C) (₹ Crores)
0 30
100 100
200 170
300 240
400 310
500 380
600 450
700 520

The specific form of consumption function, proposed by Keynes is as follows:

C = a + bY

where C = aggregate consumption expenditure; Y= total disposable income; a is a constant term which
denotes the (positive) value of consumption at zero level of disposable income; and the parameter b, the
slope of the function, (ΔC /ΔY) is the marginal propensity to consume (MPC) i.e the increase in consumption
per unit increase in disposable income.

(ii) An externality is defined as the uncompensated impact of one person’s production and/or consumption

847
actions on the well-being of another who is not involved in the activity and such effects are not reflected
directly in market prices. If the impact on the third parties’ is adverse, it is called a negative externality. If it is
beneficial, it is called a positive externality.
When negative externalities are present, the social cost of production or consumption is greater than the
private cost. The benefit of a negative externality goes to the agent producing it, while the costs are invariably
borne by the society at large.
When a positive externality exists, the benefit to the individual or firm is less than the benefit to the society
i.e. the social value of the good exceeds the private value. In both cases, the outcome is market failure and
inefficient allocation of resources.
Question 10

(a) (i) Explain the circular flow of income in an economy. (3 Marks)

(ii) How does the WTO agreement ensure market access? (2 Marks)

(b) (i) How does a discretionary fiscal policy help in correcting instabilities in the economy? (3 Marks)

(ii) Explain 'Reverse Repo Rate'. (2 Marks)

Answer

(a) (i) Circular flow of income refers to the continuous circulation of production, income generation and
expenditure involving different sectors of the economy. There are three different interlinked phases in a
circular flow of income, namely: production, distribution and disposition as can be seen from the following
figure∗.

848
Circular Flow of Income

(i) In the production phase, firms produce goods and services with the help of factor services.

(ii) In the income or distribution phase, there is a flow of factor incomes in the form of rent, wages, interest
and profits from firms to the households.

(iii) In the expenditure or disposition phase, the income received by different factors of production is spent on
consumption goods and services and investment goods. This expenditure leads to further production of goods
and services and sustains the circular flow.
It is clear from the figure that income is first generated in production unit, then it is distributed to households
in the form of wages, rent, interest and profit. This increases the demand for goods and services and as a
result there is increase in consumption expenditure.

This leads to further production of goods and services and thus make the circular flow complete. These
processes of production, distribution and disposition keep going on simultaneously.

(ii) The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly and
predictably. The WTO agreement aims to increase world trade by enhancing market access by the following:

(i) The agreement specifies the conduct of trade without discrimination. The Most-favoured-nation (MFN)
principle holds that if a country lowers a trade barrier or opens up a market, it has to do so for the same goods
or services from all other WTO members.

(ii) The National Treatment Principle requires that a country should not discriminate between its own and
foreign products, services or nationals. With respect to internal taxes, internal laws, etc. applied to imports,
treatment not less favourable than that which is accorded to like domestic products must be accorded to all
other members.

(iii) The principle of general prohibition of quantitative restrictions

(iv) By converting all non- tariff barriers into tariffs which are subject to country specific limits.

(v) The imposition of tariffs should be only legitimate measures for the protection of domestic industries, and
tariff rates for individual items are being gradually reduced through negotiations ‘on a reciprocal and mutually
advantageous’ basis.

(vi) In major multilateral agreements like the Agreement on Agriculture (AOA), specific targets have been
specified for ensuring market access.

(b) (i) Discretionary fiscal policy for stabilization refers to the deliberate policy actions on the part of a

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government to change the levels of expenditure, taxes and borrowing to influence the level of national
output, employment and prices. Governments aim to correct the instabilities in the economy by changing:

(i) the level and types of taxes,

(ii) the extent and composition of spending, and

(iii) the quantity and form of borrowing.

During inflation, or during the expansionary phase of the business cycle when there is excessive aggregate
spending and excessive level of utilization of resources, contractionary fiscal policy is adopted to close the
inflationary gap. This measure involves:

(i) decrease in government spending,

(ii) increase in personal and business taxes, and introduction of new taxes

(iii) a combination of decrease in government spending and increase in personal income taxes and/or business
taxes

(iv) a smaller government budget deficit or a larger budget surplus

(v) a reduction in transfer payments

(vi) increase in government debt from the domestic economy

During deflation or during a recessionary/contractionary phase of the business cycle, with sluggish economic
activity when the rate of utilization of resources is less, expansionary fiscal policy aims to compensate the
deficiency in effective demand by boosting aggregate demand. The recessionary gap is set right by:

(i) increased government spending,

(ii) decrease in personal and business taxes,

(iii) a combination of increase in government spending and decrease in personal income taxes and/or business
taxes

(iv) a larger government budget deficit or a lower budget surplus

(v) an increase in transfer payments

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(vi) repayment of public debt to people

(b) (ii) ‘Reverse repo operation’ is a monetary policy instrument and in effect it absorbs the liquidity from the
system. This operation takes place when the RBI borrows money from commercial banks by selling them
securities (which RBI permits) with an agreement to repurchase the securities on a mutually agreed future
date at an agreed price which includes interest for the funds borrowed. The interest rate paid by the RBI for
such borrowings is called the "Reverse Repo Rate". Thus, reverse repo rate is the rate of interest paid by the
RBI on its borrowings from commercial banks.
Question 11
(a) (i) Compute NNP at factor cost or national income from the following data using income method:

(3 Marks)

(₹ in crores)
Compensation of employees 3,000
Mixed income of self-employed 1,050
Indirect taxes 480
Subsidies 630
Depreciation 428
Rent 1,020
Interest 2,010
Profit 980
Net factor income from abroad 370

(ii) Compute credit multiplier if the Requited Reserve Ratio is 10% and 12.5% for every ₹ 1,00,000 deposited
in the banking system. What will be the total credit money created by the banking system in each case? (2
Marks)

(b) (i) Explain the neo-classical approach to demand for money. (3 Marks)
(ii) What is 'Recessionary Gap'? (2 Marks)

OR

What is meant by ‘Bound tariff’? (2 Marks)

Answer

(a) (i) NNPFC or NI = Compensation of employees + Operating Surplus (rent + interest+ profit) + Mixed Income

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of Self- employed + Net Factor Income from Abroad
= 3,000+ (1,020+2,010+980) +1,050+370 =₹ 8,430 Crores

(ii) The credit multiplier is the reciprocal of the required reserve ratio.
For RRR = 0.10 i.e. 10% the Credit Multiplier = 1/ 0.10 = 10
For RRR = 0.125 i.e. 12.5% Credit Multiplier = 1/ 0.125 = 8
Credit Creation = Initial Deposit x 1/RRR
For RRR = 0.10, Credit creation will be 1, 00,000 x 1/0.10 = ₹ 10, 00,000

For RRR = 0. 125, Credit creation will be 1, 00,000 x 1/0. 125 = ₹ 8, 00,000

(b) (i) The Neo classical Approach or the cash balance approach put forth by Cambridge economists holds that
money increases utility in the following two ways:

1. for transaction motive, i.e. for enabling the possibility of split-up of sale and purchase to two different
points of time rather than being simultaneous

2. as a temporary store of wealth i.e. for a hedge against uncertainty

Since demand for money also involves a precautionary motive in this approach and money gives utility in its
store of wealth and precautionary modes, money is demanded for itself. How much money will be demanded
depends:

(i) partly on income which points to transactions demand, such that higher the income, the greater the
quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value
to overcome transactions costs, and

(ii) partly on other factors of which important ones are wealth and interest rates.

The Cambridge equation is stated as:

Md = k PY
Where

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Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for
money (M) equals k proportion of the total money income. The neoclassical theory changed the focus of the
quantity theory of money to money demand and hypothesized that demand for money is a function of money
income.
(ii) A recessionary gap, also known as a contractionary gap, is said to exist if the existing levels of aggregate
production is less than what would be produced with full employment of resources. It is a measure of output
that is lost when actual national income falls short of potential income, and represents the difference between
the actual aggregate demand and the aggregate demand which is required to establish the equilibrium at full
employment level of income. This gap occurs during the contractionary phase of business-cycle and results in
higher rates of unemployment. In other words, a recessionary gap occurs when the aggregate demand is not
sufficient to create conditions of full employment.

OR

A bound tariff is a tariff which a WTO member binds itself with a legal commitment not to raise it above a
certain level. By binding a tariff, often during negotiations, the members agree to limit their right to set tariff
levels beyond a certain level. The bound rates are specific to individual products and represent the maximum
level of import duty that can be levied on a product imported by that member. A member is always free to
impose a tariff that is lower than the bound level. Once bound, a tariff rate becomes permanent and a
member can only increase its level after negotiating with its trading partners and compensating them for
possible losses of trade. A bound tariff ensures transparency and predictability in trade.

853
 MTP- NOV 2018
PAPER 8A : FINANICAL MANAGEMENT (60 Marks)

1. Answer the following:

(a) From the following information, PREPARE a summarised Balance Sheet as at 31st March, 20X6:

Working Capital Rs.2,40,000

Bank overdraft Rs.40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus Rs.1,60,000
Current ratio 2.5
Liquid ratio 1.5

(b) An enterprise is investing Rs.100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the management is 7%. The life of the project is 5 years. Following are the cash flows that are
estimated over the life of the project.

Year Cash flows (Rs.)

1 25,00,000
2 60,00,000
3 75,00,000
4 80,00,000
5 65,00,000

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate.

854
(c) M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares
and the current market price is Rs. 100. It expects a net profit of Rs. 2,50,000 for the year and the Board is
considering dividend of Rs. 5 per share.
M Ltd. requires to raise Rs. 5,00,000 for an approved investment expenditure. ANALYSE, how the MM
approach affects the value of M Ltd. if dividends are paid or not paid.

(d) PQR Ltd. has the following capital structure on October 31, 20X8:
 Sources of capital (Rs.)
Equity Share Capital (2,00,000 Shares of Rs. 10 each) 20,00,000
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
9% Debentures 30,00,000
80,00,000

The market price of equity share is Rs. 30. It is expected that the company will pay next year a dividend of
Rs. 3 per share, which will grow at 7% forever. Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.
(4 × 5 = 20 Marks)

ANSWER 1

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Balance Sheet

Liabilities (Rs.) Assets (Rs.)

Equity Capital 8,00,000 Fixed assets 7,20,000
Reserves & Surplus 1,60,000 Stock 1,60,000
Bank overdraft 40,000 Current assets 2,40,000
Sundry payables 1,20,000
11,20,000 11,20,000

(b) The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as

856
below:

Year Cash flows Discounting Present value

Rs. in lakhs factor @ 7% of cash flows
Rs. in lakhs
1 25,00,000 0.935 23,37,500
2 60,00,000 0.873 52,38,000
3 75,00,000 0.816 61,20,000
4 80,00,000 0.763 61,04,000
5 65,00,000 0.713 46,34,500
Total of present value of Cash flow 2,44,34,000
Less: Initial investment 1,00,00,000
Net Present Value (NPV) 1,44,34,000

When the risk-free rate is 7% and the risk premium expected by the management is 7 %. So the risk adjusted
discount rate is 7% + 7% =14%.

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:

Year Cash flows Discounting Present Value of cash

Rs. in lakhs factor @14% flows Rs. in lakhs
1 25,00,000 0.877 21,92,500
2 60,00,000 0.769 46,14,000
3 75,00,000 0.675 50,62,500
4 80,00,000 0.592 47,36,000
5 65,00,000 0.519 33,73,500
Total of present value of Cash flow 1,99,78,500
Initial investment 1,00,00,000
Net present value (NPV) 99,78,500

857
(c) A When dividend is paid

(a) Price per share at the end of year 1

858
Computation of Weighted Average Cost of Capital (WACC using market value weights)

Source of capital Market Value of capital Weight Cost of capital (%) WACC (%)
(Rs.)
9% Debentures 30,00,000 0.30 5.40 1.62
12% Preference Shares 10,00,000 0.10 12.00 1.20
Equity Share Capital 60,00,000 0.60 17.00 10.20
(Rs.30 × 2,00,000 shares)
Total 1,00,00,000 1.00 13.02

2. A newly formed company has applied to the commercial bank for the first time for financing its working
capital requirements. The following information is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of product ion plus 4,000 units of work-in progress.
Based on the above activity, estimated cost per unit is:

Raw material Rs. 80 per unit

Direct wages Rs. 30 per unit
Overheads (exclusive of depreciation) Rs. 60 per unit
Total cost Rs. 170 per unit
Selling price Rs. 200 per unit

Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion stage in
respect of conversion cost) (materials issued at the start of the processing).

859
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1.5 weeks

Cash at banks (for smooth operation) is expected to be Rs.25,000

Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads
accrue similarly. All sales are on credit basis only.
CALCULATE

(i) Net Working Capital required;

(ii) Maximum Permissible Bank finance under first and second methods of financing as per Tandon
Committee Norms. (10 Marks)

ANSWER 2

(i) Estimate of the Requirement of Working Capital

(ii) The maximum permissible bank finance as per Tandon Committee Norms

860
First Method:
75% of the net working capital financed by bank i.e. 75% of Rs.46,95,990
(Refer to (i) above)
= Rs. 35,21,993

Second Method:
(75% of Current Assets) - Current liabilities
= 75% of Rs. 55,03,461 - Rs. 8,07,471
(Refer to (i) above)
= Rs. 41,27,596 – Rs. 8,07,471
= Rs. 33,20,125

Working Notes:

1. Annual cost of production Rs.

Raw material requirements (1,04,000 units X Rs. 80) 83,20,000

Direct wages (1,04,000 units Rs. 30) 31,20,000
Overheads (exclusive of depreciation) (1,04,000 X Rs. 60) 62,40,000
1,76,80,000

2. Work in progress stock Rs.

Raw material requirements (4,000 units X Rs. 80) 3,20,000
Direct wages (50% X 4,000 units Rs. 30) 60,000
Overheads (50% X 4,000 units X Rs.60) 1,20,000
5,00,000

861
862
3. A company has to make a choice between two projects namely A and B. The initial capital outlay of two
Projects are Rs.1,35,00,000 and Rs.2,40,00,000 respectively for A and B. There will be no scrap value at the
end of the life of both the projects. The opportunity cost of capital of the company is 16%. The annual
incomes are as under:

Year Project A Project B Discounting

factor @ 16%
1 -- 60,00,000 0.862
2 30,00,000 84,00,000 0.743
3 1,32,00,000 96,00,000 0.641
4 84,00,000 1,02,00,000 0.552
5 84,00,000 90,00,000 0.476

You are required to CALCULATE for each project:

(i) Discounted payback period

(ii) Profitability index

(iii) Net present value (10 Marks)

ANSWER 3

(1) Computation of Net Present Values of Projects (Amount in Rs. ‘000)

Year Cash flows Discounted Cash flow

Project A (Rs.) Project B (Rs.) Discount factor @ 16 % Project Project B
A (Rs.) (Rs.)
(1) (2) (3) (3) X (1) (3) X (2)

863
0 (13,500) (24,000) 1.000 (13,500) (24,000)
1 -- 6,000 0.862 -- 5,172
2 3,000 8,400 0.743 2,229 6,241.2
3 13,200 9,600 0.641 8,461.2 6,153.6
4 8,400 10,200 0.552 4,636.8 5,630.4
5 8,400 9,000 0.476 3,998.4 4,284
Net present value 5,825.4 3,481.2
(2) Computation of Cumulative Present Values of Projects Cash inflows (Amount in Rs. ‘000)

Year Cash flows Discounted Cash flow

Project A (Rs.) Project B (Rs.) Project Project B
A (Rs.) (Rs.)
1 -- -- 5,172 51,72
2 2,229 22,29 6,241.2 11,413.2
3 8,461.2 10,690.2 6,153.6 17,566.8
4 4,636.8 15,327 5,630.4 23,197.2
5 3,998.4 19,325.4 4,284 27,481.2

(i) Discounted payback period: (Refer to Working note 2)

Cost of Project A = Rs.1,35,00,000

Cost of Project B = Rs.2,40,00,000
Cumulative PV of cash inflows of Project A after 4 years = Rs.1,53,27,000
Cumulative PV of cash inflows of Project B after 5 years = Rs.2,74,81,200
A comparison of projects cost with their cumulative PV clearly shows that the project A’s cost will be
recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted
payback period can be computed as follows:

Project A Project B
Excess PV of cash inflows over the 18,27,000 34,81,200
project cost (Rs.) (Rs.1,53,27,000 - Rs.1,35,00,000) (Rs. 2,74,81,200 - Rs.2,40,00,000)
Computation of period required to 0.39 year 0.81 years
recover excess amount of (Rs. 18,27,000 ÷ Rs.46,36,800) (Rs.34,81,200 ÷ Rs. 42,84,000)
cumulative PV over project cost
(Refer to Working note 2)
Discounted payback period 3.61 year 4.19 years
(4 0.39) years (5 0.81) years

864
4. The Modern Chemicals Ltd. requires Rs.25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of Rs. 5,00,000. While deciding about the financial plan, the company considers
the objective of maximising earnings per share. It has three alternatives to finance the project-by raising
debt of Rs.2,50,000 or Rs.10,00,000 or Rs.15,00,000 and the balance, in each case, by issuing equity shares.
The company’s share is currently selling at Rs. 150, but is expected to decline to Rs.125 in case the funds are
borrowed in excess of Rs.10,00,000. The funds can be borrowed at the rate of 10% upto Rs. 2,50,000, at 15%
over Rs.2,50,000 and upto Rs.10,00,000 and at 20% over Rs.10,00,000. The tax rate applicable to the
company is 50%.
DETERMINE, which form of financing should the company choose? (10 Marks)

ANSWER 4

Calculation of Earnings per share for three alternatives to finance the project

865
The company should raise Rs.10,00,000 from debt and Rs.15,00,000 by issuing equity shares, as it gives
highest EPS.

5. From the following, PREPARE Income Statement of Company A and B. (10 Marks)

Company A B
Financial leverage 3:1 4:1
Interest Rs.20,000 Rs.30,000
Operating leverage 4:1 5:1
Variable Cost as a 66 x 2 / 3 % 75%
Percentage to Sales
Income tax Rate 45% 45%

ANSWER 5

Working Notes:
Company A

866
Income Statement

A (Rs.) B (Rs.)
Sales 3,60,000 8,00,000
Less: Variable Cost 2,40,000 6,00,000
Contribution 1,20,000 2,00,000

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Less: Fixed Cost (bal. Fig) 90,000 1,60,000
EBIT 30,000 40,000
Less: Interest 20,000 30,000
EBT 10,000 10,000
Less: Tax 45% 4,500 4,500
EAT 5,500 5,500
6. (a) STATE Agency Cost. DISCUSS the ways to reduce the effect of it.

(b) EXPLAIN the importance of trade credit and accruals as source of short-term finance. DISCUSS the cost of
these sources?

(c) STATE two advantages of Walter Model of Dividend Decision. (4 + 4 + 2 =10 Marks)

ANSWER 6

(a) Agency Cost: In a sole proprietorship firm, partnership etc., owners participate in management but in
corporate, owners are not active in management so, there is a separation between owner/ shareholders and
managers. In theory managers should act in the best interest of shareholders however in reality, managers
may try to maximise their individual goal like salary, perks etc., so there is a principal-agent relationship
between managers and owners, which is known as Agency Problem. In a nutshell, Agency Problem is the
chances that managers may place personal goals ahead of the goal of owners. Agency Problem leads to
Agency Cost. Agency cost is the additional cost borne by the shareholders to monitor the manager and control
their behaviour so as to maximise shareholders wealth. Generally, Agency Costs are of four types (i)
monitoring (ii) bonding (iii) opportunity (iv) structuring
However, following efforts can be made to address Agency Cost:
Managerial compensation to be linked to profit of the company to some extent with the long term objectives
of the company.
Employees’ Stock option plan (ESOP) is also designed to address the issue with the underlying assumption that
maximisation of the stock price is the objective of the investors.
Effective monitoring through corporate governance can be done.

(b) Trade credit and accruals as source of short-term finance like working capital refers to credit facility given
by suppliers of goods during the normal course of trade. It is a short term source of finance. Micro small and
medium enterprises (MSMEs) in particular are heavily dependent on this source for financing their working
capital needs. The major advantages of trade credit are easy availability, flexibility and informality.
There can be an argument that trade credit is a cost free source of finance. But it is not. It involves implicit

868
cost. The supplier extending trade credit incurs cost in the form of opportunity cost of funds invested in trade
receivables. Generally, the supplier passes on these costs to the buyer by increasing the price of the goods or
alternatively by not extending cash discount facility.

(c) Advantages of Walter Model

1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers internal rate of return,
market capitalisation rate and dividend payout ratio in the determination of market value of shares.
PAPER – 8B: ECONOMICS FOR FINANCE

Working Notes should from part of the respective questions.

7. (a) The equilibrium level of real GDP is Rs 1,000 billion, the full employment level of real GDP is Rs 1,250
billion, and the marginal propensity to consume (MPC) is 0.60. How much government spending (ΔG) would
be needed to raise income to full-employment level? (2 Marks)

(b) Explain how Reserve Bank of India acts as a ‘lender of last resort ‘to commercial banks? Or Explain the
operation of Marginal Standing Facility? (3 Marks)

(c) Classify each of the following goods based on their characteristics. Mention the rationale.
(i) Open-access Wi-Fi networks
(ii) Roads with toll booths
(iii) Parks (3 Marks)

(d) Define Real Effective Exchange Rate (REER)? (2 Marks)

ANSWER 7

(a) k. ΔI =Δ Y; k = 1/0.4
= (1250 -1000) .0.4
= 100 billion

(b) The Marginal Standing Facility (MSF) is the last resort for banks to obtain funds once they exhaust all
borrowing options including the liquidity adjustment facility on which the rates are lower compared to the
MSF. Under this facility, the scheduled commercial banks can borrow additional amount of overnight money
from the central bank over and above what is available to them through the LAF window by dipping into their
Statutory Liquidity Ratio (SLR) portfolio up to a limit ( a fixed per cent of their net demand and time liabilities
deposits (NDTL) liable to change ) at a penal rate of interest. The scheme has been introduced by RBI with the
main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth

869
monetary transmission in the financial system. This provides a safety valve against unexpected liquidity shocks
to the banking system.

(c) All the goods mentioned above can be classified as impure public good. There are many hybrid goods that
possess some features of both public and private goods. These goods are called impure public goods and are
partially rivalrous or congestible. Because of the possibility of congestion, the benefit that an individual gets
from an impure public good depends on the number of users. Consumption of these goods by another person
reduces, but does not eliminate, the benefits that other people receive from their consumption of the same
good. Impure public goods also differ from pure public goods in that they are often excludable.
Since free riding can be eliminated, the impure public good may be provided either by the market or by the
government at a price or fee. If the consumption of a good can be excluded, then the market would provide a
price mechanism for it. The provider of an impure public good may be able to control the degree of congestion
either by regulating the number of people who may use it, or the frequency with which it may be used or
both.

(d) The ‘real exchange rate' incorporates changes in prices and describes ‘how many’ of a good or service in
one country can be traded for ‘one’ of that good or service in a foreign country.

Real exchange rate = Nominal exchange rate X Domestic price Index / Foreign price Index

8. (a) (i) Explain the Cambridge Version of Cash Balance Approach

Md = k P Y (3 Marks)

(ii) Distinguish between ‘pump priming’ and ‘compensatory spending’ (3 Marks)

(b) (i) If an economy has a flat aggregate expenditure function, what would be the nature of the multiplier?
(2 Marks)

(ii) Distinguish between private cost and social cost (2 Marks)

ANSWER 8

(a) (i) In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard
Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory,
known neoclassical theory or cash balance approach. The Cambridge version holds that money increases
utility in the following two ways:

870
1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being
simultaneous, and

2. being a hedge against uncertainty.

While the first above represents transaction motive, just as Fisher envisaged, the second points to money’s
role as a temporary store of wealth. Since sale and purchase of commodities by individuals do not take place
simultaneously, they need a ‘temporary abode’ of purchasing power as a hedge against uncertainty. As such,
demand for money also involves a precautionary motive in Cambridge approach. Since money gives utility in
its store of wealth and precautionary modes, one can say that money is demanded for itself.
Now, the question is how much money will be demanded? The answer is: it depends partly on income and
partly on other factors of which important ones are wealth and interest rates. The former determinant of
demand i.e. income, points to transactions demand such that higher the income, the greater the quantity of
purchases and as a consequence greater will be the need for money as a temporary abode of value to
overcome transactions costs.

The Cambridge equation is stated as:

Md = k PY, Where Md = is the demand for money
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances

The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for
money (M) equals k proportion of the total money income.
Thus we see that the neoclassical theory changed the focus of the quantity theory of money to money
demand and hypothesized that demand for money is a function of money income. Both these versions are
chiefly concerned with money as a means of transactions or exchange, and therefore, they present models of
the transaction demand for money.

(ii) A distinction is made between the two concepts of public spending during depression, namely, the concept
of ‘pump priming’ and the concept of 'compensatory spending'. Pump priming involves a one-shot injection of
government expenditure into a depressed economy with the aim of boosting business confidence and
encouraging larger private investment. It is a temporary fiscal stimulus in order to set off the multiplier
process. The argument is that with a temporary injection of purchasing power into the economy through a rise
in government spending financed by borrowing rather than taxes, it is possible for government to bring about
permanent recovery from a slump. Pump priming was widely used by governments in the post-war era in
order to maintain full employment; however, it became discredited later when it failed to halt rising
unemployment and was held responsible for inflation. Compensatory spending is said to be resorted to when
the government spending is deliberately carried out with the obvious intention to compensate for the
deficiency in private investment.

(b) (i) The marginal propensity to consume (MPC) is the determinant of the value of the multiplier and that

871
there exists a direct relationship between MPC and the value of multiplier. Higher the MPC, more will be the
value of the multiplier and vice-versa. A flat aggregate expenditure function implies lower MPC and higher
MPS for all levels of income. Therefore, the value of multiplier will be small.

(ii) Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the
case of a producer, his private cost includes direct cost of labour, materials, energy and other indirect
overheads. These are usually added up to determine market price. The actions of consumers or producers
result in costs or benefits to others and the relevant costs and benefits are not reflected as part of market
prices. In other words, market prices do not incorporate externalities. Social costs refer to the total costs to
the society on account of a production or consumption activity. Social costs are private costs borne by
individuals directly involved in a transaction together with the external costs borne by third parties not directly
involved in the transaction. Social costs represent the true burdens carried by society in monetary and non-
monetary terms.

9. (a) (i) What is meant by Liquidity Adjustment Facility (LAF)? How does it help commercial banks? (3
Marks)

(ii) Define ‘Moral Hazard’ (2 Marks)

(b) You are given the following data on an economy (Rs. in Cores):

Investment expenditure (I): 250

Government expenditure on goods and services (G): 800
Exports (X): 600

All tax revenues are derived from a uniform rate of income tax of 30% of income.
Consumption expenditure is given by: C = 0.75 Yd; Where: Yd is disposable national income (i.e. income less
taxes) and C is consumption expenditure
Import expenditure is given by: M = 0.15 Y Where: Y is national income and M is import expenditure

(i) Calculate the equilibrium value of National Income.

(ii) Calculate the Current Account Balance at the equilibrium value of National Income.

(ii) Calculate the Fiscal Surplus (+) or Deficit (-) at the equilibrium value of National Income. (5 Marks)

ANSWER 9

(a) (i) The Liquidity Adjustment Facility(LAF) is a facility extended by the Reserve Bank of India to the
scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement

872
(or park excess funds with the RBI in case of excess liquidity) on an overnight basis against the collateral of
government securities including state government securities. The objective is to provide liquidity to
commercial banks to adjust their day to day mismatches in liquidity. Under this facility, financial
accommodation is provided through repos/reverse repos.

(ii) Moral hazard is associated with information failure and refers to a situation that increases the probability
of occurrence of a loss or a larger than normal loss, because of a change in the unobservable or hard to
observe behaviour of one of the parties in the transaction after the transaction has been made. Moral hazard
is opportunism characterized by an informed person’s taking advantage of a less-informed person through an
unobserved action. It arises from lack of information about someone’s future behavior. Moral hazard occurs
due to asymmetric information i.e., an individual knows more about his or her own actions than other people
do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of
the lack of care or effort. For example, in the insurance market, the expected loss from an adverse event
increases as insurance coverage increases.

10. (a) (i) What is meant by ‘monetary policy instruments’ (3 Marks)

(ii) Estimate national Income by (a) Expenditure Method (b) Income Method From Following data (3 Marks)

Rs. in Crores
Private Final Consumption Expenditure 210
Govt. Final Consumption Expenditure 50
Net domestic capital Formation 40
Net Exports (-) 5
Wages and Salaries 170
Employers Contribution 10
Profit 45
Interest 20
Indirect Taxes 30
Subsidies 05
Rent 10
Factor Income from abroad 03
Consumption of Fixed capital 25
Royalty 15

(b) (i) What do you understand by the term ‘Most-Favored-Nation’ (MFN)? (2 Marks)

(ii) What’s meant by free trade area? (2 Marks)

873
ANSWER 10

(a) (i) The monetary policy instruments are the various direct and indirect instruments or tools that a central
bank can use to influence money market and credit conditions and pursue its monetary policy objectives. In
general, the direct instruments comprise of:

(a) the required cash reserve ratios and liquidity reserve ratios prescribed from time to time.
(b) directed credit which takes the form of prescribed targets for allocation of credit to preferred sectors (for
e.g. Credit to priority sectors), and

(c) administered interest rates wherein the deposit and lending rates are prescribed by the central bank.

The indirect instruments mainly consist of:

(a) Repos

(b) Open market operations

(c) Standing facilities, and

(d) Market-based discount window.

(ii) National Income (NNPFC)

Expenditure Method:
= Private Final Consumption Expenditure + Govt. Final Consumption Expenditure + Net domestic capital

Formation + Net Exports = 210+50+40+( -5) = 295

NNP (FC) = NDP MP + Factor Income from abroad – Net Indirect Tax (Indirect Tax – Subsidy)
= 295 + 3 - (30-5)

= 295 + 3 - 25 = 273
= 298 - 25 = 273
NNP FC = 273 Crores

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Income Method: Wages and Salaries+ Employers Contribution+ Profit + Interest + Rent + Royalty
= 170 + 10 + 45 + 20 + 10 + 15 = 270 (NDPFC)
NNPFC = NDPFC + FIFA
270+3 = 273 Crores
(b) (i) When a country enjoys the best trade terms given by its trading partner it is said to enjoy the Most
Favoured Nation (MFN) status. Originally formulated as Article 1 of GATT, this principle of non-discrimination
states that any advantage, favour, privilege or immunity granted by any contracting party to any product
originating in or destined for any other country shall be extended immediately and unconditionally to the like
product originating or destined for the territories of all other contracting parties. Under the WTO agreements,
countries cannot normally discriminate between their trading partners. If a country improves the benefits that
it gives to one trading partner, (such as a lower a trade barrier, or opens up a market), it has to give the same
best treatment to all the other WTO members too in respect of the same goods or services so that they all
remain ‘most-favoured’. As per the WTO agreements, each member treats all the other members equally as
“most-favoured” trading partners.

(ii) Free trade policy is based on the principle of non-interference by government in foreign trade. The
distinction between domestic trade and international trade disappears and goods and services are freely
imported from and exported to the rest of the world. Buyers and sellers from separate economies voluntarily
trade without the domestic government helping or hindering movements of goods and services between
countries by applying tariffs, quotas, subsidies or prohibitions on their goods and services. The theoretical case
for free trade is based on Adam Smith’s argument that the division of labour among countries leads to
specialization, greater efficiency, and higher aggregate production.

11. (a) (i) What is the rationale behind resource seeking foreign direct investments (3 Marks)

(ii) What is meant by ‘safeguard measures’ under WTO? (2 Marks)

(b) (i) What is the major determinant of the economic functions of a government (3 Marks)

(ii) What ‘s Arbitrage? What is the outcome of Arbitrage? (2 Marks)

Or

875
Define Money Multiplier (2 Marks)

ANSWER 11

(a) (i) The foreign-based multinational companies invest abroad to gain access to resources, that are either
unobtainable or available only at a much higher cost in the home country. The firm may find it cheaper to
produce in a foreign facility due to the availability of superior or less costly access to the inputs of production
than at home. The resources generally sought for are:
(i) physical resources such as oil, minerals, raw materials, or agricultural products.
(ii) human resources such as skilled labor and low-cost unskilled labour, organizational skills, management,
consultancy or marketing expertise,
(iii) technological resources such as innovative, and other created assets (e.g., brand names)
(iv) physical infrastructure
(v) financial infrastructure such as safe efficient and integrated financial market, set of market institutions,
networks and financial intermediaries

(ii) A safeguard measures is an action taken to protect a specific domestic industry from an unexpected build-
up of imports. Safeguard measures are initiated by countries to restrict imports of a product temporarily if its
domestic industry is injured or threatened with serious injury caused by a surge in imports.

(b) (i) The nature of the economic system determines the size and scope of the economic functions of the
government. In a centrally planned socialistic economy, the state owns all productive resources and makes all
important economic decisions. On the contrary, in a market economy, all important economic decisions are
made by individuals and firms who want to maximise self-interest and there is only limited role for the
government. In a mixed economic system, both markets and government contribute towards resource
allocation decisions.

(ii) Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an
asset at different dealing places. On account of arbitrage, regardless of physical location, at any given
moment, all markets tend to have the same exchange rate for a given currency

or

(ii) Money Multiplier( 𝑚) = Money Supply / Monetary Base

Money multiplier m is defined as a ratio that relates the change in the money supply to a given change in the

876
monetary base. It denotes by how much the money supply will change for a given change in high-powered
money. The multiplier indicates what multiple of the monetary base is transformed into money supply.
 MTP- MAY 2019
PAPER 8A : FINANICAL MANAGEMENT

1. Answer the following:

(a) The proportion and required return of debt and equity was recorded for a company with its increased
financial leverage as below:

Debt (%) Required Equity (%) Required Weighted

return (Kd) Return (Ke) Average Cost
(%) (%) of Capital
(WACC)
(Ko)(%)
0 5 100 15 15
20 6 80 16 ?
40 7 60 18 ?
60 10 40 23 ?
80 15 20 35 ?

You are required to complete the table and IDENTIFY which capital structure is most beneficial for this
company. (Based on traditional theory, i.e., capital structure is relevant).

(b) Annova Ltd is considering raising of funds of about Rs.250 lakhs by any of two alternative methods, viz.,
14% institutional term loan and 13% non-convertible debentures. The term loan option would attract no
major incidental cost and can be ignored. The debentures would have to be issued at a discount of 2.5% and
would involve cost of issue of 2% on face value.
ADVISE the company as to the better option based on the effective cost of capital in each case. Assume a

877
tax rate of 50%.
(c) Probabilities for net cash flows for 3 years of a project of Ganesh Ltd are as follows:

Year 1 Year 2 Year 3

Cash Flow Probability Cash Flow Probability Cash Flow Probability
(Rs.) (Rs.) (Rs.)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1

CALCULATE the expected net cash flows and the present value of the expected cash flow, using 10 per cent
discount rate. Initial Investment is Rs. 10,000

(d) With the help of the following information ANALYSE and complete the Balance Sheet of Anup Ltd.: (4 × 5
= 20 Marks)

Equity share capital Rs. 1,00,000

The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
Fixed assets to Equity share capital 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times

ANSWER 1

878
(a) Computation of Weighted Average Cost of Capital (WACC) for each level of Debt-equity mix.

Debt Required Equity Required return (Ke) Kd× Proportion of debt + Weighted
(%) return (%) (%) Ke Proportion and Average Cost of
(Kd)(%) equity Capital
(WACC)(Ko)(%)
0 5 100 15 0%(5%)+100%(15%) 15
20 6 80 16 20%(6%)+80%(16%) 14
40 7 60 18 40%(7%)+60%(18%) 13.6
60 10 40 23 60%(10%)+40%(23%) 15.2
80 15 20 35 80%(15%)+20%(35%) 19

The optimum mix is 40% debt and 60% equity, as this will lead to lowest WACC value i.e., 13.6%.

(b) Calculation of Effective Cost of Capital

Particulars Option 1 Option 2

14% 13% Non-convertible
institutional Debentures
Term loan (Rs. in lakhs)
(Rs. in Lakhs)
(A) Effective capital to be raised Face value 250.00 250.00
Less: Discount Nil (6.25)
250.00 243.75
Less: Cost of issue Nil 5.00
Effective amount of capital 250.00 238.75
(B) Annual interest charges on face value of Rs. 250 lakhs 35.0 32.50
Less: Tax benefit on interest @ 50% 17.5 16.25
17.5 16.25
(C) Effective cost of capital after tax B x 100 A 16.25 x100 238.75
= 7.0% = 6.81% (approx)

So, the better option is raising of funds of Rs.250 lakhs by issue of 13% Non-convertible Debenture

(c)

879
Year 1 Year 2 Year 3
Cash Proba Expect Cash Proba Expect Cash Proba Expect
Flow bility ed Flow bility ed Flow bility ed
(Rs.) Value (Rs.) Value (Rs.) Value
(Rs.) (Rs.) (Rs.)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200
The present value of the expected value of cash flow at 10 per cent discount rate has been determined as
follows:

= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751) = 12,573

Expected Net Present value = Present Value of cash flow - Initial Investment
= Rs. 12,573 – Rs.10,000 = Rs.2,573.

(d) MNOP Ltd. Balance Sheet

Working Notes 1. Total debt = 0.60 x Equity share capital = 0.60

Rs. 1,00,000 = Rs. 60,000

Further, Current debt to total debt = 0.40. So, current debt = 0.40 × Rs.60,000 = Rs.24,000,

Long term debt = Rs.60,000 - Rs.24,000= Rs. 36,000

2. Fixed assets = 0.60 × Equity share Capital = 0.60 × Rs. 1,00,000 = Rs. 60,000

3. Total assets to turnover = 2 Times : Inventory turnover = 8 Times

880
Hence, Inventory /Total assets = 2/8=1/4, Total assets = Rs. 1,60,000

Therefore Inventory = Rs. 1,60,000/4 = Rs. 40,000

2. (a) The capital structure of Anshu Ltd. as at 31.3.2019 consisted of ordinary share capital of Rs. 5,00,000
(face value Rs. 100 each) and 10% debentures of Rs. 5,00,000 (Rs. 100 each). In the year ended with March
2019, sales decreased from 60,000 units to 50,000 units. During this year and in the previous year, the
selling price was Rs. 12 per unit; variable cost stood at Rs. 8 per unit and fixed expenses were at Rs. 1,00,000
p.a. The income tax rate was 30%.

You are required to CALCULATE the following:

(i) The percentage of decrease in earnings per share.

(ii) The degree of operating leverage at 60,000 units and 50,000 units.

(iii) The degree of financial leverage at 60,000 units and 50,000 units. (6 Marks)

(b) EXPLAIN the limitations of Leasing? (4 Marks)

ANSWER 2 (a)

881
(b) Limitations are:

1) The lease rentals become payable soon after the acquisition of assets and no moratorium period is
permissible as in case of term loans from financial institutions. The lease arrangement may, therefore, not be
suitable for setting up of the new projects as it would entail cash outflows even before the project comes into
operation.

2) T he leased assets are purchased by the lessor who is the owner of equipment. T he seller’s warranties for
satisfactory operation of the leased assets may sometimes not be available to lessee.

3) Lessor generally obtains credit facilities from banks etc. to purchase the leased equipment which are
subject to hypothecation charge in favour of the bank. Default in payment by the lessor may sometimes result
in seizure of assets by banks causing loss to the lessee.

882
4) Lease financing has a very high cost of interest as compared to interest charged on term loans by financial
institutions/banks.

Despite all these disadvantages, the flexibility and simplicity offered by lease finance is bound to make it
popular. Lease operations will find increasing use in the near future.
3. (a) Navya Ltd has annual credit sales of Rs. 45 lakhs. Credit terms are 30 days, but its management of
receivables has been poor and the average collection period is 50 days, Bad debt is 0.4 per cent of sales. A
factor has offered to take over the task of debt administration and credit checking, at an annual fee of 1 per
cent of credit sales. Navya Ltd. estimates that it would save Rs. 35,000 per year in administration costs as a
result. Due to the efficiency of the factor, the average collection period would reduce to 30 days and bad
debts would be zero. The factor would advance 80 per cent of invoiced debts at an annual interest rate of
11 per cent. Navya Ltd. is currently financing receivables from an overdraft costing 10 per cent per year.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services should be
accepted or rejected. Assume 365 days in a year. (6 Marks)

(b) EXPLAIN the principles of “Trading on equity”. (4 Marks)

ANSWER 3

(a)

Rs.
Present level of receivables is 45 lakh× 50/365 6,16,438
In case of factor, receivables would reduce to 45 lakhs× 30/365 3,69,863
The costs of the existing policy are as follows:
Cost of financing existing receivables: 6,16,438×10% 61,644
Cost of bad debts: 45 lakhs × 0.4% 18,000
Cost of current policy 79,644
The cost under the factor are as follows:
Cost of financing new receivable through factor:
(Rs. 3,69,863 × 0.8 × 0.11) + (Rs. 3,69,863 × 0.2 × 0.10) 39,945
= (32,548 + 7,397)
Factor’s annual fee: 45 Lakhs × 0.01 45,000
Administration costs saved: (35,000)
Net cost under factor: 49,945
From the above analysis it is clear that the factor’s services are cheaper than Existing policy by Rs. 29,699 per
year. Hence, the services of the factor should be accepted. (Rs. 79,644 - Rs.49,945)

883
(b) The term trading on equity means debts are contracted and loans are raised mainly on the basis of equity
capital. T hose who provide debt have a limited share in the firm’s earning and hence want to be protected in
terms of earnings and values represented by equity capital. Since fixed charges do not vary with firm’s
earnings before interest and tax, a magnified effect is produced on earning per share. Whether the leverage is
favourable, in the sense, increase in earnings per share more proportionately to the increased earnings before
interest and tax, depends on the profitability of investment proposal. If the rate of returns on investment
exceeds their explicit cost, financial leverage is said to be positive.
4. (a) Prem Ltd has a maximum of Rs. 8,00,000 available to invest in new projects. Three possibilities have
emerged and the business finance manager has calculated Net present Value (NPVs) for each of the projects
as follows :

Investment Initial cash NPV

outlay Rs.
Rs.
Alfa (α) 5,40,000 1,00,000
Beta(β) 6,00,000 1,50,000
Gama (γ) 2,60,000 58,000

DETERMINE which investment/combination of investments should the company invest in, if we assume that
the projects can be divided? (6 Marks)

(b) Invest Corporation Ltd. adjusts risk through discount rates by adding various risk premiums to the risk
free rate. Depending on the resultant rate, the proposed project is judged to be a low, medium or high risk
project.

Risk level Risk free rate Risk Premium

(%) (%)
Low 8 4
Medium 8 7
High 8 10

DEMONSTRATE the acceptability of the project on the basis of Risk Adjusted rate. (4 Marks)

ANSWER 4

884
(a) Since funds available are restricted, the normal Net Present Value (NPV) rule of accepting investments
decisions with the highest NPVs cannot be adopted straight way. Further, as the projects are divisible, a
Profitability Index (PI) can be utilized to provide the most beneficial combination of investment for Rio Ltd.
Project PV Per Rs. Rank as per PI
Alfa (α) Rs. 6,40,000 / Rs. 5,40,000 = 1.185 III
Beta (β) Rs. 7,50,000 / Rs. 6,00,000 = 1.250 I
Gama (γ) Rs. 3,18,000 / Rs. 2,60,000 = 1.223 II

Therefore Rio Ltd should invest Rs. 6,00,000 into project β (Rank I) earnings Rs. 1,50,000 and Rs.2,00,000 into
project γ (Rank II) earning Rs.44,615 Rs. 2,00,000 / Rs. 2,60,000 × Rs. 58,000
So, total NPV will be Rs.1,94,615 from Rs. 8,00,000 of investment. Rs. 1,50,000 + Rs. 44,615

(b) Calculation of Risk Adjusted rate

Risk level Risk free rate Risk Premium Risk adjusted

(%) (%) rate (%)
Low 8 4 12
Medium 8 7 15
High 8 10 18

The cash flows of the project considered are as following:

Point in time 0 1 2
(yearly
intervals)
Cash flow (Rs. (100) 45 80
in crore)

If the project is judged to be Low risk

885

NPV = 40.18 + 63.78 – 100 = 3.96: Accept

5. The following information is supplied to you:

Rs.
Total Earnings 2,00,000
No. of equity shares (of Rs. 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5

Applying Walter’s Model

(i) DETERMINE whether the company is following an optimal dividend policy.

(ii) IDENTIFY, what should be the P/E ratio at which the dividend policy will have no effect on the value of
the share.

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE. (10 Marks)

886
ANSWER 5

6. (a) DESCRIBE Bridge Finance.

(b) STATE Virtual Banking? DISCUSS its advantages.

(c) EXPLAIN Concentration Banking (4 + 4 + 2 = 10 Marks) 887

ANSWER 6

(a) Bridge finance refers, normally, to loans taken by the business, usually from commercial banks for a short
period, pending disbursement of term loans by financial institutions, normally it takes time for the financial
institution to finalise procedures of creation of security, tie-up participation with other institutions etc. even
though a positive appraisal of the project has been made. However, once the loans are approved in principle,
firms in order not to lose further time in starting their projects arrange for bridge finance. Such temporary
loan is normally repaid out of the proceeds of the principal term loans. It is secured by hypothecation of
moveable assets, personal guarantees and demand promissory notes. Generally rate of interest on bridge
finance is higher as compared with that on term loans.

(b) Virtual Banking and its Advantages

Virtual banking refers to the provision of banking and related services through the use of information
technology without direct recourse to the bank by the customer.

The advantages of virtual banking services are as follows:

➢ Lower cost of handling a transaction.

➢ The increased speed of response to customer requirements.

➢ The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.

Virtual banking allows the possibility of improved and a range of services being made available to the
customer rapidly, accurately and at his convenience.

(c) Concentration Banking: In concentration banking the company establishes a number of strategic collection
centres in different regions instead of a single collection centre at the head office. This system reduces the
period between the time a customer mails in his remittances and the time when they become spendable
funds with the company. Payments received by the different collection centers are deposited with their
respective local banks which in turn transfer all surplus funds to the concentration bank of head office

888
PAPER – 8B: ECONOMICS FOR FINANCE

7. (a) Suppose in an economy:

Consumption Function (C) = 100 + 0.9 Yd, where Yd = Y-T

Autonomous Investment (I) = Rs. 1
00 crores
Government Expenditure G = Rs. 120 crores
Taxes (T) = Rs.50 crores
Exports (X) = Rs.200 crores
Import Function (M) = 100 + 0.15Y

Where Y and Yd National Income and Personal Disposable Income respectively. All the figures are in
Rupees. Find the Equilibrium level of GDP? (3 Marks)

(b) Define permanent income and state its relationship to demand for real money balances? (3 Marks)

(c) Explain why government imposes price ceilings? (2 Marks)

(d) What is meant by trade distortion? (2 Marks)

ANSWER 7

889

(b) According to Milton Friedman, permanent income is a measure of wealth which is the present discounted
value of all expected future incomes. As distinguished from transitory income, it is the normal income or the
income that people expect to persist into the future. The nominal demand for money is a function of total
wealth, which is represented by permanent income divided by the discount rate, defined as the average
return on the five asset classes in the monetarist theory world, namely: money, bonds, equity, physical capital
and human capital.

(c) In order to protect the interest of consumer’s government fixes the maximum price of the commodity. This
maximum price is generally lower than the equilibrium price. This is called control price or ceiling price. This
price is fixed by the government because poor people cannot afford to buy the commodity at equilibrium
price. This situation arises when the production of a commodity is less than its demand. In India government
has a control price or ceiling price of the commodities which it considers essential for the masses. For
examples maximum prices of food grains and essential items like some goods such as wheat, rice, sugar,
kerosene oil etc. are during scarcity.

(d) Trade is distorted if quantities of commodities produced, bought, and sold and their prices are higher or
lower than levels that would usually exist in a competitive market. For example, barriers to imports such as
tariffs, domestic subsidies and quantitative restrictions can make agricultural products more costly in a market
of a country. The higher prices will result in higher production of crop. Then export subsidies are needed to
sell the surplus output in the world markets, where prices are low. Thus, the subsidising countries can be
producing and exporting considerably more than what they normally would.

8. (a) (i) Explain how decline in interest rates influence economic activity by changing the incentives for
households and businesses to save or invest? (3 Marks)
(ii) Define Information Failure (3 Marks)

(b) (i) What is meant by nominal GDP-growth? (2 Marks)

(ii) Define optimal output from the point of view of social welfare? (2 Marks)

ANSWER 8

(a) (i) Lower interest rates increases disposable incomes and influence the spending decisions of households

890
and businesses by reducing the amount of interest they pay on debt. Reductions in interest rates which they
receive on deposits reduce the incentives for households to save and may encourage them to borrow and
spend now rather than later, in particular, on durable goods, such as cars and household appliances, and
housing. Lower interest rates are thus associated with higher household consumption and housing
investment. Similarly, with lower interest rates the cost of borrowing declines, expected returns on
investment projects increase, and these encourage businesses to borrow and increase their spending on
investment (in capital assets like new equipment or buildings). Since households and businesses substitute
between spending now and in the future, overall, lower interest rates should be associated with an increase in
business investmen
(ii) Perfect information which implies that both buyers and sellers have complete information about anything
that may influence their decision making is an important element of an efficient competitive market.
Information failure occurs when lack of information can result in consumers and producers making decisions
that do not maximize welfare. Information failure is widespread in numerous market exchanges due to
complex nature of goods and services that are transacted, inaccurate and incomplete data, and non-
availability of correct information.

(b) (i) Nominal GDP is calculated in terms of current prices. Nominal GDP growth refers to the percentage
change in nominal GDP over a specific period of time. Since the effect of inflation/ deflation is not removed, it
does not present the true picture of growth of the economy.

(ii) Optimal output is the ideal quantity of output that ensures maximum level of social welfare. This will occur
at a level of output where social marginal cost (SMC) = social marginal benefit. (SMB) At this level of output
the society’s resources are utilised in the most efficient way.

9. (a) (i) Explain the effects of monetary policy through balance sheet channel (3 Marks)
(ii) What is the major determinant of the economic functions of a government? (2 Marks)

ANSWER 9

(a) (i) A direct effect of monetary policy on the firm’s balance sheet comes through an increase in interest
rates leading to an increase in the payments that the firm must make to repay its floating rate debts. Logically,
as a firm’s cost of credit rises, the strength of its balance sheet deteriorates. An indirect effect occurs when
the same increase in interest rates works to reduce the capitalized value of the firm’s long‐lived assets.
Reduced net worth of businesses and individuals make it tougher for them to qualify for loans at any interest
rate, thus reducing spending and price pressures. Hence, a policy‐induced increase in the short‐term interest
rate not only acts immediately to depress spending through the traditional interest rate channel, it also acts,
possibly with a time-lag, to raise each firm’s cost of capital through the balance sheet channel. These together
aggravate the decline in output and employment.
Conversely, a reduction in interest rates can increase the borrowing capacity of households and businesses.

891
This is because lower interest rates are associated with higher asset prices. In turn, higher asset prices increase
the equity (or collateral) of existing assets that a bank can lend against. As a result, borrowers with existing
assets may be able to borrow more, which can lead to more spending.

(ii) The nature of the economic system determines the size and scope of the economic functions of the
government. In a centrally planned socialistic economy, the state owns all productive resources and makes all
important economic decisions. On the contrary, in a market economy, all important economic decisions are
made by individuals and firms who want to maximise self interest and there is only limited role for the
government. In a mixed economic system, both markets and government contribute towards resource
allocation decisions.

(b) NDPFC = Compensation of Employees + Operating Surplus + Mixed Income

= (viii) + (ix) + (iv) + (v) + (vi) + (vii) = 489 + 50+ 311 + 892 + 81 + 6 = 1829 Crores
GDPMP = NDPFC + Depreciation + Net Indirect Tax
= NDPFC + (ii) + (i) = 1829 + 42 + 208 = 2079 Crores
NNP Fc= NDPFC + Net Factor Income from Abroad
= NDPFC + (iii) = 2079+ (-40) = 2039 Crores

10. (a) (i) How do foreign direct investments enhance human capital in recipient countries? (3 Marks)
(ii) Distinguish between domestic subsidy and export subsidy? (2 Marks)

(b) (i) What do you understand by the term ‘ final good”? (2 Marks)
(ii) Explain the different types of Externalities? How Externalities lead to welfare loss of markets? (3 Marks)

ANSWER 10

(a) (i) Since FDI involves setting up of production base (in terms of factories, power plants, etc.) it generates
direct employment in the recipient country. Subsequent FDI as well as domestic investments propelled in the
downstream and upstream projects that come up in multitude of other services generate multiplier effects on
employment and income. FDI not only creates direct employment opportunities but also, through backward
and forward linkages, it is able to generate indirect employment opportunities as well.Foreign direct
investments also promote relatively higher wages for skilled jobs. However, jobs that require expertise and
entrepreneurial skills for creative decision making may generally be retained in the home country and
therefore the host country is left with routine management jobs that demand only lower levels of skills and
ability. This may result in ‘crowding in’ of people in jobs requiring low skills, perpetuation of low labour
standards and differential treatment.

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FDIs are likely use labor-saving technology and capital-intensive methods in a labour-abundant country and
cause labour displacement. Such technology is inappropriate for a labour-abundant country as it does not
support generation of jobs which is a crucial requirement to address poverty and unemployment which are
the two fundamental areas of concern for the less developed countries. Not only that foreign entities fail to
support employment generation, but they may also drive out domestic firms from the industry resulting in
serious problems of displacement of labour.
(b) (i) A final good is a good sold to final purchasers and is consumed by the end user in its present state. It
does not require any further processing and therefore will not undergo any further transformation at the
hands of producer. Once a final good has been sold, it passes out of the active economic flow. The value of the
final goods already includes the value of the intermediate goods that have entered into their production as
inputs.

(ii) Externalities, also referred to as 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-
effects', occur when the actions of either consumers or producers result in costs or benefits that do not reflect
as part of the market price. Externalities cause market inefficiencies because they hinder the ability of market
prices to convey accurate information about how much to produce and how much to buy. Since externalities
are not reflected in market prices, they can be a source of economic inefficiency. The four possible types of
externalities are negative externality initiated in production which imposes an external cost on others, positive
production externality, less commonly seen, initiated in production that confers external benefits on others,
negative consumption externalities initiated in consumption which produce external costs on others, positive
consumption externality initiated in consumption that confers external benefits on others. Each of the above
may be received by another in consumption or in production.

11. (a) (i) What is the rationale for government intervention in allocation of resources? (3 Marks)
(ii) Distinguish between ‘non tariff measures’ and ‘non tariff barriers’ (3 Marks)

(b) (i) What do you understand by the term ‘cross rate’? (2 Marks)
(ii) What is the objective of policies requiring foreign entities to procure local contents? (2 Marks)

OR

What is meant by open market operations?

ANSWER 11

(a) (i) The allocation responsibility of the governments involves suitable corrective action when private
markets fail to provide the right and desirable combination of goods and services to ensure social welfare. In

893
the absence of appropriate government intervention, market failures may occur and the resources are likely
to be misallocated by too much production of certain goods or too little production of certain other goods.
Thus, market failures provide the rationale for government’s allocative function.

(ii) Non tariff measures are policy measures other than ordinary customs tariffs that can potentially have an
economic effect on international trade in goods, changing quantities traded, or prices or both (UNCTAD,
2010). For example, the sound use of NTMs like sanitary and phytosanitary measures and licensing could be
legitimately used to ensure consumer health and to protect plant and animal life and environment
NTMs are not the same as non-tariff barriers (NTBs). NTMs are sometimes used as means to circumvent free-
trade rules and favour domestic industries at the expense of foreign competition. In this case they are called
non-tariff barriers (NTBs). NTBs are a subset of NTMs that have a 'protectionist or discriminatory intent' and
implies a negative impact on trade. NTMs only become NTBs when they are more trade restrictive than
necessary. Some examples of NTBs are compulsory standards, often not based on international norms or
genuine science; stringent technical regulations requiring alterations in production processes, testing regimes
which require complex procedures and product approvals requiring inspection of individual premises

(b) (i) The rate between Y and Z which is derived from the given rates of another set of two pairs of currency
(say, X and Y, and, X and Z) is called cross rate.

(ii) Local content policies requiring the purchase or use by a foreign enterprise of domestic products and
employment of the local workforce seek to ensure that the maximum benefits from production activities
accrue to local economic actors. These are essentially aimed at reducing the volume or value of imports or at
restraining the employment of foreign labour.

OR

Open market operations are conducted by the RBI by way of sale or purchase of government securities to
adjust money supply conditions. The central bank sells government securities to suck out liquidity from the
system and buys back government securities to infuse liquidity into the system. When the RBI feels that there
is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity.
Similarly, when the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing
liquidity into the market. These operations are often conducted on a day-to-day basis in a manner that
balances inflation while helping the banks to continue lending.

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 MTP- NOV 2019

PAPER 8A : FINANICAL MANAGEMENT

1. Answer the following:

(a) The following figures are collected from the annual report of XYZ Ltd.:

Net Profit Rs.60 lakhs

Outstanding 10% preference Rs.100 lakhs
shares
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 14%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%;

(ii) 50% and (iii) 100%.

(b) RPS Company presently has Rs. 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It
wishes to finance a Rs. 40,00,000 expansion programme and is considering three alternatives: additional
debt at 12 per cent interest, preferred stock with an 11 per cent dividend, and the sale of common stock at
Rs. 16 per share. The company presently has 8,00,000 shares of common stock outstanding and is in a 40 per
cent tax bracket.

(i) If earnings before interest and taxes are presently Rs. 15,00,000, CALCULATE earnings per share for the
three alternatives, assuming no immediate increase in profitability?

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(ii) CALCULATE indifference point between debt and common stock.

(c) MNP Limited has made plans for the year 2019 -20. It is estimated that the company will employ total
assets of Rs.50,00,000; 30% of assets being financed by debt at an interest cost of 9% p.a. The direct costs
for the year are estimated at Rs. 30,00,000 and all other operating expenses are estimated at Rs. 4,80,000.
The sales revenue are estimated at Rs. 45,00,000. Tax rate is assumed to be 40%. CALCULATE:

(i) Net profit margin (After tax);

(ii) Return on Assets (After tax);

(iii) Asset turnover; and

(iv) Return on Equity.

(d) A Ltd. and B Ltd. are identical in every respect except capital structure. A Ltd. does not employ debts in
its capital structure whereas B Ltd. employs 12% Debentures amounting to Rs.100 lakhs. Assuming that :

(i) All assumptions of M-M model are met;

(ii) Income-tax rate is 30%;

(iii) EBIT is Rs. 25,00,000 and

(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.

CALCULATE the value of both the companies and also find out the Weighted Average Cost of Capital for
both the companies. [4 × 5 = 20 Marks]

ANSWER 1

(a)

Rs. in lakhs
Net Profit 60
Less: Preference dividend 10
Earning for equity 50
shareholders
Therefore earning per share 50/5 = Rs.10.00

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Price per share according to Gordon’s Model is calculated as follows:

(b) (i) (Rs. in thousands)

Debt Preferred Stock Common Stock

Rs. Rs. Rs.
EBIT 1,500 1,500 1,500
Interest on existing debt 360 360 360
Interest on new debt 480 - -
Profit before taxes 660 1,140 1,140
Taxes 264 456 456
Profit after taxes 396 684 684
Preferred stock dividend 440

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Earnings available to 396 244 684
common shareholders
Number of shares 800 800 1,050
Earnings per share .495 .305 .651

(ii) Mathematically, the indifference point between debt and common stock is (Rs in thousands):
(c) The net profit is calculated as follows:

Rs.
Sales Revenue 45,00,000
Less: Direct Costs 30,00,000
Gross Profits 15,00,000
Less: Operating Expense 4,80,000
Earnings before Interest and tax 10,20,000
(EBIT)
Less: Interest on debt (9% × 1,35,000
15,00,000)
Earnings before Tax) (EBT) 8,85,000
Less: Taxes (@ 40%) 3,54,000
Profit after Tax (PAT) 5,31,000

898
 B Ltd. (Rs.)
EBIT 25,00,000
Interest to Debt holders (12,00,000)
EBT 13,00,000
Taxes @ 30% (3,90,000)
Income available to Equity 9,10,000
Shareholders
Total Value of Firm 1,17,50,000
Less: Market Value of Debt (1,00,00,000)
Market Value of Equity 17,50,000
Return on equity (Ke) = 0.52
9,10,000 / 17,50,000

Computation of WACC B. Ltd

Componen Amount Weight Cost of WACC

t of Capital Capital

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Equity 17,50,000 0.149 0.52 0.0775
Debt 1,00,00,000 0.851 0.084* 0.0715
Total 1,17,50,000 0.1490

*Kd= 12% (1- 0.3) = 12% × 0.7 = 8.4%

WACC = 14.90%
2. (a) B LLP. has the following balance sheet and Income statement information:

Balance Sheet as on March 31st 2019

Liabilities (Rs.) Assets (Rs.)

Partners’ Capital 80,00,000 Net Fixed Assets 1,00,00,000
Term Loan 60,00,000 Inventories 45,00,000
Retained 35,00,000 Trade 40,50,000
Earnings Receivables
Trade Payables 15,00,000 Cash & Bank 4,50,000
1,90,00,000 1,90,00,000

Income Statement for the year ending March 31st 2019

Sales 34,00,000
Operating expenses (including Rs. 12,00,000
6,00,000 depreciation)
EBIT 22,00,000
Less: Interest 6,00,000
Earnings before tax 16,00,000
Less: Taxes 5,60,000
Net Earnings (EAT) 10,40,000

COMPUTE the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs. [3 Marks]

(b) H Ltd. is considering a new product line to supplement its range of products. It is anticipated that the
new product line will involve cash investments of Rs.70,00,000 at time 0 and Rs.1,00,00,000 in year 1. After-
tax cash inflows of Rs. 25,00,000 are expected in year 2, Rs.30,00,000 in year 3, Rs.35,00,000 in year 4 and
Rs.40,00,000 each year thereafter through year 10. Although the product line might be viable after year 10,

900
the company prefers to be conservative and end all calculations at that time.

(i) If the required rate of return is 15 per cent, FIND OUT the net present value of the project? Is it
acceptable?

(ii) COMPUTE NPV if the required rate of return were 10 per cent?

(iii) COMPUTE the internal rate of return? [7 Marks]

ANSWER 2

2. (a) Computation of Degree of Operating (DOL), Financial (DFL) and Combined leverages (DCL).

(b) (i)

Year Cash flow Discount Present

Factor (15%) value
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.870 (87,00,000)
2 25,00,000 0.756 18,90,000
3 30,00,000 0.658 19,74,000
4 35,00,000 0.572 20,02,000
5-10 40,00,000 2.163 86,52,000
NPV -1182000

As the net present value is negative, the project is unacceptable.

(ii) Similarly, NPV at 10% discount rate can be computed as follows:

Year Cash flow Discount Present value

Factor (10%)
0 (70,00,000) 1.000 (70,00,000)
1 (1,00,00,000) 0.909 (90,90,000)

901
2 25,00,000 0.826 20,65,000
3 30,00,000 0.751 22,53,000
4 35,00,000 0.683 23,90,500
5-10 40,00,000 2.974 1,18,96,000
NPV 25,14,500

Since NPV = Rs.25,14,500 is positive, hence the project would be acceptable.

3. You are given the following information:

(i) Estimated monthly Sales are as follows:

Rs. Rs.
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

(ii) Wages and Salaries are estimated to be payable as follows:

Rs. Rs.
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses.

(iv) Purchases amount to 80% of sales and are made and paid for in the month preceding the sales.

902
(v) The firm has taken a loan of Rs.1,20,000. Interest @ 10% p.a. has to be paid quarterly in January, April
and so on.
(vi) The firm is to make payment of tax of Rs. 5,000 in July, 2019.
(vii) The firm had a cash balance of Rs. 20,000 on 1St April, 2019 which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).

Required
PREPARE monthly cash budgets for six months beginning from April, 2019 on the basis of the above
information. [10 Marks]

ANSWER 3

Computation – Collections from Debtors

Particulars Feb Mar Apr May Jun Jul Aug Sep
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Total Sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit Sales (80% of total 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
Sales)
Collection (within one month) 72,000 84,000 48,000 36,000 48,000 60,000 48,000
Collection 24,000 28,000 16,000 12,000 16,000 20,000
(within two months)
Total Collections 1,08,00 76,000 52,000 60,000 76,000 68,000
0

Monthly Cash Budget for Six Months: April to September, 2019

Particulars April May June July August Sept.

(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Receipts:
Opening Balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash Sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections from Debtors 1,08,000 76,000 52,000 60,000 76,000 68,000
Total Receipts (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages and Salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on Loan 3,000 ----- ----- 3,000 ----- -----

903
Tax Payment ----- ----- ----- 5,000 ----- -----
Total Payment (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum Cash Balance 20,000 20,000 20,000 20,000 20,000 20,000
Total Cash Required (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus/ (Deficit) (A)-(C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investment/F inancing:
Total effect of (64,000) (16,000) 22,000 2,000 (35,000) 9,000
(Invest)/ Financing (D)
Closing Cash Balance (A) + (D) - 20,000 20,000 20,000 20,000 20,000 20,000
(B)
4. ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March, 2019

(Rs.)
14% Debentures 30,00,000
11% Preference shares 10,00,000
Equity Shares (10,000 1,60,00,000
shares)
2,00,00,000

The company share has a market price of Rs. 236. Next year dividend per share is 50% of year 2019 EPS. The
following is the trend of EPS for the preceding 10 years which is expected to continue in future.

Year EPS (Rs.) Year EPS Rs.)

2010 10.00 2015 16.10
2011 11.00 2016 17.70
2012 12.10 2017 19.50
2013 13.30 2018 21.50
2014 14.60 2019 23.60

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is Rs. 96.

Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) were also issued. The company is in
50% tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)

(B) CALCULATE marginal cost of capital when no new shares are issued.

904
(C) COMPUTE the amount that can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year’s investment are 50 percent of 2019.

(D) COMPUTE marginal cost of capital when the funds exceeds the amount calculated in (C), assuming new
equity is issued at Rs. 200 per share? [10 Marks]
ANSWER 4

(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference 0.05 0.12 0.0060
Share
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

(C) The company can spend the following amount without increasing marginal cost of capital and without

905
selling the new shares:
Retained earnings = (0.50) (236 × 10,000) = Rs. 11,80,000
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,80,000 = 80% of Total Capital
Capital investment before issuing equity = Rs.11,80,000/ 0.80 = Rs.14,75,000
(D) If the company spends in excess of Rs.14,75,000 it will have to issue new shares.
The cost of new issue will be Rs. 11.80 = + 0.10 = 0.159 200
The marginal cost of capital will be:

Type of Proportion Specific Cost Product

Capital
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.0833 0.0125
Preference 0.05 0.1200 0.0060
Shares
Equity Shares 0.80 0.1590 0.1272
(New)
0.1457

5. (a) CALCULATE Variance and Standard Deviation on the basis of following information [8 Marks]

Possible Project A Project B

Event
Cash Flow Probability Cash Flow Probability
(Rs.) (Rs.)
A 80,000 0.10 2,40,000 0.10
B 1,00,000 0.20 2,00,000 0.15
C 1,20,000 0.40 1,60,000 0.50
D 1,40,000 0.20 1,20,000 0.15
E 1,60,000 0.10 80,000 0.10

(b) A firm maintains a separate account for cash disbursement. Total disbursement are Rs.10,50,000 per
month or Rs. 1,26,00,000 per year. Administrative and transaction cost of transferring cash to disbursement
account is Rs.20 per transfer. Marketable securities yield is 8% per annum.

906
COMPUTE the optimum cash balance according to William J. Baumol model. [2 Marks]
ANSWER 5

(a) Calculation of Expected Value for Project A and Project B

Project A Project B
Possible Net Cash Probabili Expecte Cash Probabili Expecte
Event Flow ty d Value Flow ty d Value
(Rs.) (Rs.) (Rs.) (Rs.)
A 80,000 0.10 8,000 2,40,000 0.10 24,000
B 1,00,000 0.20 20,000 2,00,000 0.15 30,000
C 1,20,000 0.40 48,000 1,60,000 0.50 80,000
D 1,40,000 0.20 28,000 1,20,000 0.15 18,000
E 1,60,000 0.10 16,000 80,000 0.10 8,000
ENCF 1,20,000 1,60,000

Project A
Variance (σ2) = (80,000 – 1,20,000)2 × (0.1) + (1,00,000 -1,20,000)2 × (0.2) + (1,20,000 – 1,20,000)2 × (0.4) +
(1,40,000 – 1,20,000)2 × (0.2) + (1,60,000 – 1,20,000)2 × (0.1)

907
6. (a) DISCUSS the Inter relationship between investment, financing and dividend decisions.

(b) What is debt securitisation? EXPLAIN the basics of debt securitisation process.

(c) EXPLAIN the concept of discounted payback period. (4 + 4+ 2 =10 Marks)

ANSWER 6

(a) Inter-relationship between Investment, Financing and Dividend Decisions: The finance functions are
divided into three major decisions, viz., investment, financing and dividend decisions. It is correct to say that
these decisions are inter-related because the underlying objective of these three decisions is the same, i.e.
maximisation of shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated,
one has to consider the joint impact of these decisions on the market price of the company’s shares and these
decisions should also be solved jointly. The decision to invest in a new project needs the finance for the
investment. The financing decision, in turn, is influenced by and influences dividend decision because retained
earnings used in internal financing deprive shareholders of their dividends. An efficient financial management
can ensure optimal joint decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and to see how
they can help in maximising the shareholders’ wealth i.e. market price of the company’s shares.

Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be
accepted which is expected to yield at least so much return as is adequate to meet its cost of financing. This
have an influence on the profitability of the company and ultimately on its wealth.

Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the
total volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. T he

908
optimum financing mix will increase return to equity shareholders and thus maximise their wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by
way of dividends and what portion should be retained in the business. An optimal dividend pay-out ratio
maximises shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are
to be taken jointly keeping in view their joint effect on the shareholders’ wealth .
(b) Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to financial intermediaries
to support the lending volumes. Assets generating steady cash flows are packaged together and against this
asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.

Process of Debt Securitisation

(i) The origination function – A borrower seeks a loan from a finance company, bank, HDFC. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over the
life of the loan.

(ii) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for investors.

(iii) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The
securities carry a coupon and expected maturity which can be asset-based/mortgage based. These are
generally sold to investors through merchant bankers. Investors are – pension funds, mutual funds, insurance
funds.
The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is under
an obligation to pay to investors only if the cash flows are received by him from the collateral. The benefits to
the originator are that assets are shifted off the balance sheet, thus giving the originator recourse to off-
balance sheet funding.

(c) Concept of Discounted Payback Period

Payback period is time taken to recover the original investment from project cash flows. It is also termed as
break even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring
time value of money and profitability. Discounted payback period considers present value of cash flows,
discounted at company’s cost of capital to estimate breakeven period i.e. it is that period in which future
discounted cash flows equal the initial outflow. The shorter the period, better it is. It also ignores post
discounted payback period cash flows.

909
PAPER – 8B: ECONOMICS FOR FINANCE

7. (a) Calculate National Income by Value Added Method with the help of following data- (3
Marks)

(b) Define Social Good? What is the similarity and dissimilarity between Social Goods and Common Pool
Resources? (2 Marks)

(c) Why Marginal Standing Facility (MSF) would be the last resort for banks? (3 Marks)

(d) Assume that 15% specific tariff is levied by the government on every sunglass which is imported into
India, and if 2000 sunglasses are imported and price of each sunglass is Rs.1000/- , then find out the amount
of total
tariff revenue collected by the government? (2 Marks)

ANSWER 7

910
(a) NI = GDP (MP) –Depreciation +NFIA- Net Indirect Tax
Where GDP (MP) = Value of output- intermediate consumption
Value of Output = Sales+ change in stock
= 700+ (400-500)
= 600
GDP (MP) = 600-350 = 250
Therefore NI= 250-150 +30-(110-50)
= 70 Crore
(b) A Social Good is defined as one which all enjoy in common in the sense that each individual’s consumption
of such a good leads to no subtraction from any other individuals consumption of that good. Similarity
between Social Goods and Common Pool Resources is that both are non-excludable whereas dissimilarity is
seen in their nature that is Social Goods are non-rival which means that the use of these goods does not
reduce the availability for others, while Common Pool Resources are rival in nature which means that the use
of these resources reduce the availability for others.

(c) The Marginal Standing Facility (MSF) refers to the facility under which scheduled commercial banks can
borrow additional amount of overnight money from the central bank over and above what is available to them
through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit .The
scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in
the inter-bank market and to enable smooth monetary transmission in the financial system. Banks can borrow
through MSF on all working days except Saturdays, between 7.00 pm and 7.30 pm, in Mumbai. The minimum
amount which can be accessed through MSF is ₹ 1 crore and more will be available in multiples of ₹ 1 crore.
The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity
adjustment facility on which the rates are lower compared to the MSF.

(d) Specific tariff is an import duty which levied as a fixed charge per unit of the good imported.
Therefore amount in total tariff revenue = 2000*15%
= Rs. 300/-
In this case, total Rs. 300/- is collected, whether the price of a sunglass is of Rs. 1000 or Rs. 2000 for different
brand.

8. (a) (i) Suppose M3 = Rs. 450000 Crore

Currency with Public = Rs 3000 Crore

Demand Deposits of Banks = Rs. 100000 Crore
Other deposits with RBI= Rs. 100000 Crore
Saving Deposits with Post Office Saving Banks = Rs. 150000 Crore

911
Total deposits with the Post Office Savings Organization (excluding National Saving Certificate) = Rs. 20000
Crore
National Saving Certificate = Rs. 250 Crore
Calculate Net Time Deposits and M4 wi th the banking system? (3 Marks)

(ii) Compare transaction demand for money according to Keynes and Baumol & Tobin? (2 Marks)

(b) How does trade increase economic efficiency and which view argued that trade is a zero- sum game and
how? (3 Marks)
(c) Is country like India unable to estimate their National Income wholly by one method? Give comments (2
Marks)

ANSWER 8

(a) (i) M3 = M1+ net time deposits with the banking system
M1= Currency notes and coins with the public+ demand deposits of banks+ other deposits with RBI
Therefore, Net time deposits with the banking system = M3 - M1
450000- 3000-100000-100000
= Rs. 247000 Crore
M4 = M3 + total deposits with the post office savings organization (excluding National savings Certificate)
M4 = 450000 + 20000
M4 = 470000 Crore.

(ii) The transaction demand for money according to Keynes is interest-inelastic; whereas Baumol and Tobin
show that money held for transaction purposes is interest elastic.

(b) Economic efficiency increases due to quantitative and qualitative benefits of extended division of labour,
economies of large scale production, betterment of manufacturing capabilities, increased competitiveness and
profitability by adoption of cost reducing technology and business practices and decrease in the likelihood of
domestic monopolies. Efficient deployment of productive resources - natural, human, industrial and financial
resources ensures productivity gains.
Mercantilist argued that trade is a zero sum game. Mercantilism advocated maximizing exports in order to
bring in more precious metals and minimizing imports through the state imposing very high tariffs on foreign
goods. This view argues that trade is a ‘zero-sum game’, with winners who win does so only at the expense of
losers and one country’s gain is equal to another country’s loss, so that the net change in wealth or benefits
among the participants is zero.

(c) Yes, Countries like India are unable to estimate their national income wholly by one method. There are
various sectors in an economy and national income generated by these sectors is estimated by using different
methods. For example, in agricultural sector, net value added is estimated by the production method, in small
scale sector net value added is estimated by the income method and in the construction sector net value

912
added is estimated by the expenditure method.

9. (a) How does the government intervene to minimize market power? (5 Marks)

(b) Define the deposit expansion multiplier? How it is calculated? (3 Marks)

(c) Suppose MPC is 0.8 and it is planned to increase National Income by Rs. 3000 Crore then how much
increase in investment is required to fulfill this target? (2 Marks)
ANSWER 9

(a) Market power is an important factor that contributes to inefficiency because it results in higher prices than
competitive prices. In addition, market power also tends to restrict output and leads to deadweight loss.
Because of the social costs imposed by monopoly, governments intervene by establishing rules and
regulations designed to promote competition and prohibit actions that are likely to restrain competition.
These legislations differ from country to country. For example, in India, we have the Competition Act, 2002(as
amended by the Competition (Amendment) Act, 2007) to promote and sustain competition in markets.

Such legislations generally aim at prohibiting contracts, combinations and collusions among producers or
traders which are in restraint of trade and other anticompetitive actions such as predatory pricing. On the
contrary, some of the regulatory responses of government to incentive failure tend to create and protect
monopoly positions of firms that have developed unique innovations. For example, patent and copyright laws
grant exclusive rights of products or processes to provide incentives for invention and innovation. Policy
options for limiting market power also include price regulation in the form of setting maximum prices that
firms can charge.

Price regulation is most often used for natural monopolies that can produce the entire output of the market at
a cost that is lower than what it would be if there were several firms. If a firm is a natural monopoly, it is more
efficient to permit it serve the entire market rather than have several firms who compete each other.
Examples of such natural monopoly are electricity, gas and water supplies. In some cases, the government‘s
regulatory agency determines an acceptable price, so as to ensure a competitive or fair rate of return. This
practice is called rate-of-return regulation. Another approach to regulation is setting price-caps based on the
firm’s variable costs, past prices, and possible inflation and productivity growth.

(b) The deposit expansion multiplier describes the amount of additional money created by commercial bank
through the process of lending the available money it has in excess of the central bank's reserve requirements.
The deposit expansion multiplier is, thus inextricably tied to the bank's reserve requirement. This measure
tells us how much new money will be created by the banking system for a given increase in the high powered
money. It reflects a bank's ability to increase the money supply. The deposit expansion multiplier is the
reciprocal of the required reserve ratio.

If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5.

The deposit expansion multiplier = 1/ Required Reserve Ratio 913

10. (a) What is meant by foreign exchange market? What are the roles played by the participants in the
foreign exchange market? (5 Marks)

(b) Define ‘Net Factor Income from Abroad’ (3 Marks)

(c) Determine the government spending multiplier when there is an increase of Rs.100 crore in government
spending and MPC is 0.75 ? And also find out the net effect of Rs. 100 crore spending?
(2 Marks)

ANSWER 10

(a) The wide-reaching collection of markets and institutions that handle the exchange of foreign currencies is
known as the foreign exchange market. Being an over-the-counter market, it is not a physical place; rather, it
is an electronically linked network of big banks, dealers and foreign exchange brokers who bring buyers and
sellers together.
The major participants in the exchange market are central banks, commercial banks, governments, foreign
exchanged dealers, multinational corporations that engage in international trade and investments, non-bank

914
financial institutions such as asset management firms, insurance companies, brokers, arbitrageurs and
speculators. The central banks participate in the foreign exchange markets, not to make profit, but essentially
to contain the volatility of exchange rate to avoid sudden and large appreciation or depreciation of domestic
currency and to maintain stability in exchange rate in keeping with the requirements of national economy. If
the domestic currency fluctuates excessively, it causes panic and uncertainty in the business world.
Commercial banks participate in the foreign exchange market either on their own account or for their clients.

When they trade on their own account, banks may operate either as speculators or arbitrageurs/or both. The
bulk of currency transactions occur in the inter-bank market in which the banks trade with each other. Foreign
exchange brokers participate in the market as intermediaries between different dealers or banks.
Arbitrageurs profit by discovering price differences between pairs of currencies with different dealers or
banks. Speculators, who are bulls or bears, are deliberate risk-takers who participate in the market to make
gains which result from unanticipated changes in exchange rates. Other participants in the exchange market
are individuals who form only a very insignificant fraction in terms of volume and value of transactions.

(b) The difference between the aggregate amount that a country's citizens and companies earn abroad, and
the aggregate amount that foreign citizens and overseas companies earn in that country.

11. (a) (i) What are the main advantages of fixed rate regime in an open economy? (3 Marks)

(ii) How the autonomous expenditure multiplier is stated in four sector model? (2 Marks)

(b) (i) What is non- discretionary fiscal policy and how it occurs? (3 Marks)

(ii) Explain the concept of demand for money? (2 Marks)

Or
Define the term Regional Trade Agreement (RTAs)? (2 Marks)

ANSWER 11

(a) (i) In an open economy, the main advantages of a fixed rate regime are, firstly, a fixed exchange rate avoids

915
currency fluctuations and eliminates exchange rate risks and transaction costs that can impede international
flow of trade and investments. A fixed exchange rate can thus greatly enhance international trade and
investment. Secondly, a fixed exchange rate syste m imposes discipline on a country’s monetary authority and
therefore is more likely to generate lower levels of inflation. Thirdly, the government can encourage greater
trade and investment as stability encourages investment. Fourthly, exchange rate peg c an also enhance the
credibility of the country’s monetary policy. And lastly, in the fixed or managed floating (where the market
forces are allowed to determine the exchange rate within a band) exchange rate regimes, the central bank is
required to stand ready to intervene in the foreign exchange market and, also to maintain an adequate
amount of foreign exchange reserves for this purpose.
(ii) The autonomous expenditure multiplier in a four sector model includes the effects of foreign transactions
and is stated as where v is the propensity to import which is greater than zero. The greater the value of v, the
lower will be the autonomous expenditure multiplier. 1 / (1- b + v)

(b) (i) Non-discretionary fiscal policy or automatic stabilizers are part of the structure of the economy and are
‘built-in’ fiscal mechanisms that operate automatically to reduce the expansions and contractions of the
business cycle. It occurs through automatic adjustments in government expenditures and taxes without any
deliberate governmental action i.e. by limiting the increase in disposable income during an expansionary
phase and limiting the decrease in disposable income during the contraction phase of the business cycle.

(ii) T he demand for money is a decision about how much of one’s given stock of wealth should be held in the
form of money rather than as other assets such as bonds. Demand for money is actually demand for liquidity
and a demand to store value.

Or

Regional Trade Agreements (RTAs) are defined as grouping of countries, which are formed under the objective
of reducing barriers to trade between member countries; not necessarily belonging to the same geographical
region.

916
 MTP- MAY 2020
PAPER 8A: FINANICAL MANAGEMENT

1. Answer the following:

(a) The data relating to two companies are as given below:

Company A Company B
Equity Capital Rs.6,00,00,000 Rs.3,50,00,000
15% Debentures Rs.40,00,000 Rs.65,00,000
Output (units) per 6,00,000 1,50,000
annum
Selling price/ unit Rs.60 Rs.500
Fixed Costs per Rs.70,00,000 Rs.1,40,00,000
annum
Variable Cost per Rs.30 Rs.275
unit

You are required to CALCULATE the Operating leverage, Financial leverage and Combined leverage of the
two Companies.

(b) ABC Limited has the following book value capital structure:

Equity Share Capital (1 crore shares Rs.1,000 lakh

@ Rs.10 each)

917
Reserves and Surplus Rs.2,250 lakh
9% Preference Share Capital (5 lakh Rs.500 lakh
shares @ Rs.100 each)
8.5% Debentures (1.5 lakh Rs.1,500 lakh
debentures @ Rs.1,000 each)
12% Term Loans from Financial Rs.500 lakh
Institutions
- The debentures of ABC Limited are redeemable at par after five years and are quoting at Rs.985 per
debenture.
- The current market price per equity share is Rs.60. The prevailing default-risk free interest rate on 10-year
GOI Treasury Bonds is 5.5%. The average market risk premium is 7%. The beta of the company is 1.85
- The preference shares of the company are redeemable at 10% premium after 5 years is currently selling at
Rs.102 per share.
The applicable income tax rate for the company is 35%.

Required:
CALCULATE weighted average cost of capital of the company using market value weights.

(c) A company proposes to install a machine involving a Capital Cost of Rs.72,00,000. The life of the machine
is 5 years and its salvage value at the end of the life is nil. The machine will produce the net operating
income after depreciation of Rs.13,60,000 per annum. The Company’s tax rate is 35%.

The Net Present Value factors for 5 years are as under:

Discounting : 14 15 16 17 18 19
Rate
Cumulative : 3.43 3.35 3.27 3.20 3.13 3.06
factor

You are required to COMPUTE the internal rate of return (IRR) of the proposal.

(d) A&R Ltd. is an all equity financed company with a market value of Rs.25,000 lakh and cost of equity (Ke)
18%. The company wants to buyback equity shares worth Rs.5,000 lakh by issuing and raising 10%
debentures redeemable at 10% premium after 5 years. Rate of tax may be taken as 35%. Applying
Modigliani-Miller (MM) (with taxes), you are required to CALCULATE after restructuring:

(i) Market value of A&R Ltd.

918
(ii) Cost of Equity (Ke)

(iii) Weighted average cost of capital (using market weights). [4 × 5 Marks = 20 Marks]

ANSWER 1

(a) Computation of Operating leverage, Financial leverage and Combined leverage of two companies
 Company A Company B
Output units per annum 6,00,000 1,50,000
(Rs.) (Rs.)
Selling price / unit 60 500
Sales revenue 3,60,00,000 7,50,00,000
(6,00,000 units × (1,50,000 units ×
Rs.60) Rs.500)
Less: Variable costs 1,80,00,000 4,12,50,000
(1,50,000 units ×
(6,00,000 units × Rs.275)
Rs.30)
Contribution (C) 1,80,00,000 3,37,50,000
Less: Fixed costs 70,00,000 1,40,00,000
EBIT (Earnings before Interest 1,10,00,000 1,97,50,000
and tax)
Less: Interest @ 15% on 6,00,000 9,75,000
debentures
PBT 1,04,00,000 1,87,75,000

Operating Leverage = 1.64 1.71

Contribution / EBIT (Rs.1,80,00,000 ÷ (Rs.3,37,50,000 ÷ Rs.
1,10,00,000) 1,97,50,000)
Financial Leverage = 1.06 1.05
PBT/ EBIT (Rs.1,10,00,000 ÷ (Rs.1,97,50,000 ÷ Rs.
Rs.1,04,00,000) 1,87,75,000)
Combined Leverage = 1.74 1.80
DOL × DFL (1.64 × 1.06) (1.71 × 1.05)

919
Calculation of Weighted Average cost of capital Using market value weights

Source of Capital Market value of Weights After tax cost of WACC (%)
capital structure capital (%)
(Rs. in lakh)
Equity share capital 6,000 0.71 18.45 13.09
(1 crore shares × Rs.60 )
9% Preference share 510 0.06 10.00 0.60
capital
(5 lakh shares × Rs.102)
8.5 % Debentures 1,477.5 0.17 5.86 0.99
(1.5 lakh × Rs.985)
12% Term loans 500 0.06 7.80 0.47
8,487.50 1.000 15.15

920
(c)
Computation of cash inflow per Rs.
annum
Net operating income per annum 13,60,000
Less: Tax @ 35% 4,76,000
Profit after tax 8,84,000
Add: Depreciation (Rs.72,00,000 / 5 14,40,000
years)
Cash inflow 23,24,000

921
922
(iii) WACC (on market value weight)

Components of Amount Cost of Capital Weigh WACC

Costs (lakh) (%) t (%)
Equity 21,750 19.19 0.81 15.54
Debt 5,000 8.10 0.19 1.54
26,750 17.08

Workings Note:
1. (Rs. in lakh)

All Equity Debt and

Equity
EBIT (as calculated above) 6,923.07 6,923.07
Interest to debt-holders - 500.00
EBT 6,923.07 6,423.07
Taxes (35%) 2,423.07 2,248.07
Income available to equity shareholders 4,500.00 4,175.00
Income to debt holders plus income 4,500.00 4,675.00
available to shareholders

2. ZX Ltd. has a paid-up share capital of Rs.1,00,00,000, face value of Rs.100 each. The current market price

923
of the shares is Rs.100 each. The Board of Directors of the company has an agenda of meeting to pay a
dividend of 50% to its shareholders. The company expects a net income of Rs.75,00,000 at the end of the
current financial year. Company also plans for a capital expenditure for the next financial year for a cost of
Rs.95,00,000, which can be financed through retained earnings and issue of new equity shares.
Company’s desired rate of investment is 15%.

Required:

Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the company when:
(i) It does not pay dividend and
(ii) It does pay dividend [10 Marks]

ANSWER 2

924
Earnings Rs.75,00,000
Dividend distributed Nil
Fund available for investment Rs.75,00,000
Total Investment Rs.95,00,000
Balance Funds required Rs.20,00,000
5. Calculation of funds required for investment

Earnings Rs.75,00,000
Dividend distributed Rs.50,00,000
Fund available for Rs.25,00,000
investment
Total Investment Rs.95,00,000
Balance Funds required Rs.70,00,000

925

Note- As per MM-hypothesis of dividend irrelevance, value of firm remains same irrespective of dividend paid.
In the solution, there may be variation in value, which is due to rounding off error.
3. A&R Ltd. has undertaken a project which has an initial investment of Rs.2,000 lakhs in plant & machinery
and Rs.800 lakhs for working capital. The plant & machinery would have a salvage value of Rs. 474.61 lakhs
at the end of the fifth year. The plant & machinery would depreciate at the rate of 25% p.a. on WDV
method. The other details of the project for the five year period are as follows:

Sales 10,00,000 units p.a.

Selling price per unit Rs.500
Variable cost 50% of selling price
Fixed overheads (excluding depreciation) Rs.300 lakh p.a.
Corporate tax rate 35%
Rate of interest on bank loan 12%
After tax required rate of return 15%

Required:
(i) CACULATE net present value (NPV) of the project and DETERMINE the viability of the project.

(ii) DETERMINE the sensitivity of project’s NPV under each of the following condition: a. Decrease in selling
price by 10%;
b. Increase in cost of plant & machinery by 10%. [10 Marks]

PV factor Year-1 Year-2 Year-3 Year-4 Year-5

12% 0.892 0.797 0.711 0.635 0.567
15% 0.869 0.756 0.657 0.571 0.497

ANSWER 3

(i) Calculation of Net Present Value (NPV):

Year-1 Year-2 Year-3 Year-4 Year-5

Sales volume (Qty. in lakh) 10 10 10 10 10

926
Contribution per unit (Rs.) 250 250 250 250 250
(Selling price – variable cost)
Total contribution (Rs.in lakh) 2,500 2,500 2,500 2,500 2,500
Less: Fixed overheads (Rs. In lakh) 300 300 300 300 300
PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (Rs. in lakh) (Working 500 375 281.25 210.94 158.20
note-1)
PBT 1,700 1,825 1,918.75 1,989.06 2,041.80
Less: Tax @ 35% 595 638.75 671.56 696.17 714.63
PAT 1,105 1,186.25 1,247.19 1,292.89 1,327.17
Add: Depreciation 500 375 281.25 210.94 158.20
Add: Salvage value of plant & machinery - - - - 474.61
Add: Working capital - - - - 800
Net Cash inflow 1,605 1,561.25 1,528.44 1,503.83 2,759.98
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,394.74 1,180.31 1,004.18 858.68 1,371.71

Net Present Value = P.V of cash inflows – P.V of cash outflows

= Rs. (1,394.74+1,180.31+1,004.18+858.68+1,371.71) – Rs.2,000
= Rs.3,809.62 lakh

The NPV of the project is positive, hence, the project is viable.

Working note-1:

Year-1 Year-2 Year-3 Year-4 Year-5

Opening balance 2,000 1,500 1,125 843.75 632.81
Depreciation 500 375 281.25 210.94 158.20
@25%
Closing WDV 1,500 1,125 843.75 632.81 474.61

(ii) Determination of sensitivity of NPV w.r.t.

a. Decrease in selling price by 10%

Year-1 Year-2 Year-3 Year-4 Year-5

Sales volume (Qty. in lakh) 10 10 10 10 10
New Selling price 450 450 450 450 450
Variable cost 250 250 250 250 250

927
Contribution per unit (Rs.) 200 200 200 200 200
(Selling price – variable cost)
Total contribution (Rs.in lakh) 2,000 2,000 2,000 2,000 2,000
Less: Fixed overheads (Rs. In lakh) 300 300 300 300 300
PBDT 1,700 1,700 1,700 1,700 1,700
Less: Depreciation (Rs. in lakh) (Working note- 500 375 281.25 210.94 158.20
1)
PBT 1,200 1,325 1,418.75 1,489.06 1,541.80
Less: Tax @ 35% 420 463.75 496.56 521.17 539.63
PAT 780 861.25 922.19 967.89 1,002.17
Add: Depreciation 500 375 281.25 210.94 158.20
Add: Salvage value of plant & machinery - - - - 474.61
Add: Working capital - - - - 800
Net Cash inflow 1,280 1,236.25 1,203.44 1,178.83 2,434.98
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,112.32 934.61 790.66 673.11 1,210.18

NPV = (1,112.32+934.61+790.66+673.11+1,210.18) – 2,000

= 4,720.88 – 2,000 = 2,720.88 lakh
10% reduction in selling price reduces the NPV by 28.58% (3,809.62-2,720.88/3809.62)

b. Increase in project cost by 10%

Year-1 Year-2 Year-3 Year-4 Year-5

PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (Rs. in lakh) (Working note- 550 412.5 309.37 232.03 174.03
2)
PBT 1,650 1,787.50 1,890.63 1,967.97 2,025.97
Less: Tax @ 35% 577.50 625.63 661.72 688.79 709.09
PAT 1072.50 1,161.87 1,228.91 1,279.18 1,316.88
Add: Depreciation 550 412.5 309.37 232.03 174.03
Add: Salvage value of plant & machinery - - - - 474.61
Add: Working capital - - - - 800
Net Cash inflow 1,622.50 1,574.37 1,538.28 1,511.21 2,765.52
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,409.95 1,190.22 1,010.65 862.90 1,374.46

928
NPV = (1,409.95+1,190.22+1,011.65+862.90+1,374.46) – 2,200
= 5,849.18 – 2,200 = 3,649.18 lakh
10% increase in project cost reduces the NPV only by 4.21% (3,809.62 - 3,649.18/3809.62)
Working note-2:

Year-1 Year-2 Year-3 Year-4 Year-5

Opening balance 2,200 1,650 1,237. 928.13 696.10
50
Depreciation 550 412.5 309.37 232.03 174.03
@25%
Closing WDV 1,650 1,237. 928.13 696.10 522.07
50

4. The following accounting information and financial ratios of A&R Limited relate to the year ended 31st
March, 2020:

Inventory Turnover Ratio 6 Times

Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%

Total sales Rs.6,00,00,000; cash sales 25% of credit sales; cash purchases Rs.46,00,000; working capital
Rs.56,00,000; closing inventory is Rs.16,00,000 more than opening inventory.

You are required to CALCULATE:

(i) Average Inventory

(ii) Purchases

(iii) Average Debtors

(iv) Average Creditors

929
(v) Average Payment Period

(vi) Average Collection Period

(vii) Current Assets

(viii) Current Liabilities.

Take 365 days a year [10 Marks]

ANSWER 4

(i) Computation of Average Inventory

Gross Profit = 25% of Rs.6,00,00,000 = Rs.1,50,00,000

Cost of goods sold (COGS) = Sales - Gross Profit
= Rs.6,00,00,000 – Rs.1,50,00,000
= Rs.4,50,00,000

Inventory Turnover Ratio = COGS / Average Inventory

6 = Rs.4,50,00,000/ Average Inventory

Average inventory = Rs.75,00,000

(ii) Computation of Purchases

Purchases = COGS + (Closing Stock – Opening Stock)

= Rs.4,50,00,000 + 16,00,000*
Purchases = Rs.4,66,00,000
* Increase in Stock = Closing Stock – Opening Stock = Rs.16,00,000

(iii) Computation of Average Debtors

Let Credit Sales be Rs.100, Cash sales = 25 /100 × 100 = Rs.25

Total Sales = 100 + 25= Rs.125
Total sales is Rs.125 credit sales is Rs.100

If total sales is Rs.6,00,00,000, then credit sales is = Rs. 6,00,00,000 × 100125

Credit Sales = Rs.4,80,00,000
Cash Sales = (Rs.6,00,00,000 – Rs.4,80,00,000) = Rs.1,20,00,000

930
931
5. (a) Cost sheet of A&R Ltd. provides the following particulars:

Amount per unit

(Rs.)
Raw materials cost 200.00
Direct labour cost 75.00
Overheads cost 150.00
Total cost 425.00
Profit 75.00
Selling Price 500.00

The Company keeps raw material in stock, on an average for four weeks; work-in-progress, on an average
for one week; and finished goods in stock, on an average for two weeks.

932
The credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag
in payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put together
at Rs.2,50,000.

Required:

PREPARE a statement showing estimate of Working Capital needed to finance an activity level of 2,60,000
units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects.
(b) The following information is provided by the P Ltd. for the year ending 31st March, 2020.

Raw Material storage period 52 days

Work in progress conversion period 18 days
Finished Goods storage period 20 days
Debt Collection period 75 days
Creditors' payment period 25 days
Annual Operating Cost 45 crore

(Including depreciation of Rs.42,00,000)

(1 year = 360 days)
You are required to CALCULATE Operating Cycle period and Number of Operating Cycles in a year. [8 + 2 =
10 Marks]

ANSWER 5

(a) Statement showing Estimate of Working Capital Needs

933
(b) Calculation of Operating Cycle Period and number of Operating Cycle in a Year

Operating Cycle Period = R + W + F + D – C

= 52 + 18 + 20 + 75 – 25 = 140 days

Number of Operating Cycle in a Year = 360/ Operating Cycle Period

= 360/140 = 2.57 times

6. Answer the followings:

(a) EXPLAIN in brief the Pecking order theory.

(b) EXPLAIN Over-capitalisation. STATE its causes and consequences.

(c) EXPLAIN in short the term Letter of Credit.

OR

"Financing a business through borrowing is cheaper than using equity." Briefly EXPLAIN. [4+4+2 = 10 Marks]

934
ANSWER 6

(a) This theory states that firms prefer to issue debt when they are positive about future earnings. Equity is
issued when they are doubtful and internal finance is insufficient.
The pecking order theory argues that the capital structure decision is affected by manager’s choice of a source
of capital that gives higher priority to sources that reveal the least amount of information.
Pecking order theory suggests that managers may use various sources for raising of fund in the following
order.
1. Managers first choice is to use internal finance

2. In absence of internal finance they can use secured debt, unsecured debt, hybrid debt etc.

3. Managers may issue new equity shares as a last option.

So briefly under this theory rules are

Rule 1: Use internal financing first.

Rule 2: Issue debt next

Rule 3: Issue of new equity shares at last

(b) Over-capitalization and its Causes and Consequences

It is a situation where a firm has more capital than it needs or in other words assets are worth less than its
issued share capital, and earnings are insufficient to pay dividend and interest.

Causes of Over Capitalization

Over-capitalisation arises due to following reasons:

(i) Raising more money through issue of shares or debentures than company can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.
(v) Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest payments.
(ii) Reduction in the market price of shares.
(iii) Resorting to “window dressing”.

935
(iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the
company may go into liquidation.

(c) Letter of Credit: It is an arrangement by which the issuing bank on the instructions of a customer or on its
own behalf undertakes to pay or accept or negotiate or authorizes another bank to do so against stipulated
documents subject to compliance with specified terms and conditions.

Or
“Financing a business through borrowing is cheaper than using equity”
(i) Debt capital is cheaper than equity capital from the point of its cost and interest being deductible for
income tax purpose, whereas no such deduction is allowed for dividends.
(ii) Issue of new equity dilutes existing control pattern while borrowing does not result in dilution of control.
(iii) In a period of rising prices, borrowing is advantageous. The fixed monetary outgo decreases in real terms
as the price level increases.

7. (a) How are the following transactions treated in national income calculation? What is the rationale in
each case?

(i) Electricity sold to a steel plant

(ii) Electric power sold to a consumer household

(iii) A car manufacturer procuring parts and components from the market (3 Marks)

(b) What do you mean by price ceiling? Explain it with the help of examples. (2 Marks)

(c) How the following affect money multiplier and money supply?

(i) Banks open large number ATMs all over the country.

(ii) If banks decide to keep 100% reserves. (3 Marks)

(d) How does trade increase economic efficiency? (2 Marks)

ANSWER 7

(a) (i) Being an intermediate good, electricity sold to a steel plant will not be included in national income
calculation. The underlying principle is that only finished goods and services which are directly sold to the

936
consumer for final consumption would be included. The value of the final output, namely steel, includes the
value of electricity used up in the production process. Counting electricity sold to a steel plant separately will
lead to the error of double counting and exaggerate the value of steel production.

(ii) Electric power sold to a consumer household would be included in the calculation of GDP since it is a final
good consumed by the end user. Electric power sold to a consumer does not require any further processing
and does not undergo any further transformation before use. Once a final good has been sold, it passes out of
the active economic flow.
(iii) The value of parts and components procured from the market by a car manufacturer will not be included
in national income calculation because these are intermediate goods used in car production. Value is added to
the parts and components through the process of production and the same is resold. The value of the final
output, namely car, includes the value of the parts and components. Counting parts and components
separately will lead to the error of double counting and exaggerate the value of car production.

(b) Price ceiling is a government intervention in regulated market economies wherein an upper limit is set on
the price charged for a product or service and the sellers are bound to abide by such limits. The objective is to
influence the outcomes of a market on the grounds of fairness and equity. When prices of certain essential
commodities rise excessively, government may resort to controls in the form of price ceilings (also called
maximum price) for making a resource or commodity available to all at reasonable prices. For example:
maximum prices of food grains and essential items are set by government during times of scarcity. A price
ceiling which is set below the prevailing market clearing price will generate excess demand over supply.

(c) (i) ATMs let people to withdraw cash from the bank as and when needed, reduces cost of conversion of
deposits to cash and makes deposits relatively more convenient. People hold less cash and more deposits,
thus reducing the currency-deposit ratio; increasing the money multiplier causing the money supply to
increase.

(ii) If banks decides to keep 100% reserves, then the Money multiplier = 1/required reserve ratio = 1/100% = 1.
Deposits simply substitute for the currency that is held by banks as reserves and therefore no new money is
created by banks.

(d) Economic efficiency increases due to quantitative and qualitative benefits of extended division of labour,
economies of large scale production, betterment of manufacturing capabilities, increased competitiveness and
profitability by adoption of cost reducing technology and business practices and decrease in the likelihood of
domestic monopolies. Efficient deployment of productive resources -natural, human, industrial and financial
resources ensures productivity gains.

8. (a) Examine the situation if aggregate expenditures exceeds the economy’s production capacity. (2
Marks)

(b) How do the markets fail in an economy? What are the main reasons behind this market failure and 937
economic inefficiency? (3 Marks)

(c) Explain operating procedures in the context of monetary policy of India? (2 Marks)

(d) How does Escalated tariff structure work and discriminated ? (3 Marks)
ANSWER 8

(a) Aggregate expenditure or Aggregate demand is the sum of all Planned expenditures for the entire
economy. When aggregate expenditure exceeds an economy’s production capacity at full employment level,
the resulting strain on resources creates demand - pull inflation or higher price level. Nominal output will
increase, but it merely reflects higher prices, rather than additional real output.

(b) Market fails in an economy when the free market leads to misallocation of society's scarce resources or in
other words, there is either overproduction or underproduction of particular goods and services leading to a
less than optimal outcome.
The four main reasons for market failure are: market power, externalities, public goods, and incomplete
information. Excessive market power causes single producer or small number of producers to produce and sell
less output than would be produced and charge a higher price.
Externalities hinder the ability of market prices to convey accurate information about how much to produce
and how much to buy.
Public goods, due to their special characteristics such as non-excludability and non-rivalry, are not produced at
all or produced less than optimal quantities. These have Free rider problem causing over-use, degradation and
depletion of common resources resulting in market failure.
Information failure manifests in asymmetric information causing adverse selection and moral hazard.

(c) Operating procedures are the variety of rules, traditions and practices used in the actual implementation of
monetary policy. It encompasses, basically, a set of tactics such as choice of the operating target and policy
instruments, the nature and frequency of use of policy instruments, market interventions, the width of
corridor for market interest rates and the manner of policy signals to effect desired changes in the
intermediate targets.

(d) Escalated Tariff structure refers to the system wherein the nominal tariff rates on imports of manufactured
goods are higher than the nominal tariff rates on intermediate inputs and raw materials, i.e the tariff on a
product increases as that product moves through the value-added chain. For example a four percent tariff on
iron ore or iron ingots and twelve percent tariff on steel pipes. This type of tariff is discriminatory as it protects
manufacturing industries in importing countries and dampens the attempts of developing manufacturing
industries of exporting countries. This has special relevance to trade between developed countries and
developing countries. Developing countries are thus forced to continue to be suppliers of raw materials

938
without much value addition
9. (a) Fiscal policy achieve social justice and equity. Comment on this with the help of examples. (5 Marks)
(b) What does the reserve money determine? Compute Reserve Money from the following data- (3 Marks)

Particulars Rs. in Crore

Currency in circulation 14903.90
RBI’s net non-monetary liabilities 4945.80
Banker’s deposits with RBI 5780.60
Other deposits with RBI 317.20
Long term deposits of residents 321.10

ANSWER 9

(a) Fiscal policy is a chief instrument available for governments to influence income distribution and plays a
significant role in reducing inequality and achieving equity and social justice. The distribution of income in the
society is influenced by fiscal policy both directly and indirectly. While current disposable incomes of
individuals and corporates are dependent on direct taxes, the potential for future earnings is indirectly
influenced by the nation’s fiscal policy choices.
Government revenues and expenditure have traditionally been regarded as important instruments for
carrying out desired redistribution of income. Following are few measures to achieve desired distributional
effects.
• A progressive direct tax system ensures that those who have greater ability to pay contribute more towards
defraying the expenses of government and that the tax burden is distributed fairly among the population.
• Indirect taxes can be differential: for example, the commodities which are primarily consumed by the richer
income group, such as luxuries, are taxed heavily and the commodities the expenditure on which form a larger
proportion of the income of the lower income group, such as necessities, are taxed light.
• A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer
sections of the society. This is done through spending programmes targeted on welfare measures for the
disadvantaged, such as

(i) poverty alleviation programmes

(ii) free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of
living of poor

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(iii) infrastructure provision on a selective basis
(iv) various social security schemes under which people are entitled to old-age pensions, unemployment relief,
sickness allowance etc.

(v) subsidized production of products of mass consumption

(vi) public production and/ or grant of subsidies to ensure sufficient supply of essential goods, and
(vii) strengthening of human capital for enhancing employability etc.

Choice of a progressive tax system with high marginal taxes may act as a strong deterrent to work save and
invest. Therefore, the tax structure has to be carefully framed to mitigate possible adverse impacts on
production and efficiency. Additionally, the redistributive fiscal policy and the extent of spending on
redistribution should be consistent with the macroeconomic policy objectives of the nation.

(b) The Reserve money determines the level of liquidity and price level in the economy. It is calculated by the
following formula-
Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
= 14903.90 + 5780.60 + 317.20 = 21001.7 Crore

(c) The principal objective of the WTO is to facilitate the flow of international trade smoothly, freely, fairly and
predictably. The WTO does its functions by acting as a forum for trade negotiations among member
governments, administering trade agreements, reviewing national trade policies, assisting developing
countries in trade policy issues, through technical assistance and training programmes and cooperating with
other international organizations.

10. (a) An increase in investment by Rs. 700 crore leads to increase in national income by Rs 3,500 crore.
Calculate marginal propensity to consume and change in saving. (3 Marks)

(b) What effect does government expenditure have on money supply? (2 Marks)
(c) Define tariff and what are its effects on the importing and exporting countries? (5 Marks)

ANSWER 10

940
(b) Whenever the central and the state governments’ cash balances fall short of the minimum requirement,
they are eligible to avail a facility called Ways and Means Advances (WMA)/overdraft (OD) facility. When the
Reserve Bank lends to the governments under Ways and Means Advances (WMA)/overdraft (OD) , it results in
the generation of excess reserves (i.e., excess balances of commercial banks with the Reserve Bank). The
excess reserves thus created can potentially lead to an increase in money supply through the money multiplier
process.

(c) Tariff is defined as a financial charge in the form of a tax, imposed at the border on goods going from one
customs territory to another. Tariffs are the most visible and universally used trade measures. Tariffs are
aimed at altering the relative prices of goods and services imported, so as to contract the domestic demand
and thus regulate the volume of their imports. Tariffs leave the world market price of the goods unaffected;
while raising their prices in the domestic market. The main goals of tariffs are to raise revenue for the
government, and more importantly to protect the domestic import-competing industries.
A tariff levied on an imported product affects both the country exporting a product and the country importing
that product.

(i) Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of
international trade. The
prospect of market access of the exporting country is worsened when an importing country imposes a tariff.

(ii) By making imported goods more expensive, tariffs discourage domestic consumers from consuming
imported foreign goods. Domestic consumers suffer a loss in consumer surplus because they must now pay a
higher price for the good and also because compared to free trade quantity, they now consume lesser
quantity of the good.

(iii) Tariffs encourage consumption and production of the domestically produced import substitutes and thus
protect domestic industries.

(iv) Producers in the importing country experience an increase in well-being as a result of imposition of tariff.
The price increase of their product in the domestic market increases producer surplus in the industry. They
can also charge higher prices than would be possible in the case of free trade because foreign competition has

941
reduced.

(v) The price increase also induces an increase in the output of the existing firms and possibly addition of new
firms due to entry into the industry to take advantage of the new high profits and consequently an increase in
employment in the industry.

(vi) Tariffs create trade distortions by disregarding comparative advantage and prevent countries from
enjoying gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in
the rest of the world and encourage inefficient production in the home country.
(vii) Tariffs increase government revenues of the importing country by the value of the total tariff it charges.

11. (a) Calculate the GNP at market price using value added method with the help of following data – (5
Marks)

Particulars Rs. in crore

Value of output in primary sector 1000
Net factor income from abroad -20
Value of output in tertiary sector 700
Intermediate consumption in secondary sector 400
Value of output in secondary sector 900
Government transfer payments 600
Intermediate consumption in primary sector 500
Intermediate consumption in tertiary sector 400

(b) What do you mean by common pool resources and why producers and consumers do not pay for these
resources? (3 Marks)

(c) What role does Market Stabilisation Scheme (MSS) play in our economy? (2 Marks)

OR

What is meant by import quotas? (2 Marks)

ANSWER 11

(a) GDPMP = (Value of output in primary sector - intermediate consumption of primary sector) + (value of
output in secondary sector - intermediate consumption of secondary sector) + (value of output in tertiary
sector - intermediate consumption of tertiary sector)
GDPMP = (1000-500) + (900-400) + (700-400)

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= 500+ 500 +300 = Rs.1300 crore
GNPMP = GDPMP + NFIA
= 1300 – 20 = Rs. 1280 crore

(b) Common pool resources are a special class of impure public goods which are non-excludable as people
cannot be excluded from using them. These are rival in nature and their consumption lessens the benefits
available for others. This rival nature of common resources is what distinguishes them from pure public goods,
which exhibit both non-excludability and non-rivalry in consumption. They are generally available free of
charge. Some important natural resources fall into this category.
Since price mechanism does not apply to common resources, producers and consumers do not pay for these
resources and therefore, they overuse them and cause their depletion and degradation.
(c) Under the Market Stabilisation Scheme (MSS) the Government of India borrows from the RBI (such
borrowing being additional to its normal borrowing requirements) and issues treasury-bills/dated securities
that are utilized for absorbing from the market excess liquidity of a more enduring nature arising from large
capital inflows.

OR

An import quota is a direct restriction which specifies that only a certain physical amount of the good will be
allowed into the country during a given time period, usually one year. Import quotas are typically set below
the free trade level of imports and are usually enforced by issuing licenses. This is referred to as a binding
quota.

943
 MTP - NOV 2020
PAPER 8A: FINANICAL MANAGEMENT

1. Answer the following:

(a) ABC Pvt. Ltd. is considering relaxing its present credit policy for accounts receivable and is in the process
of evaluating two proposed policies. Currently, the company has annual credit sales of ₹ 50 lakhs and
accounts receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is ₹ 1,50,000.
The company is required to give a return of 20% on the investment in new accounts receivable. The
company’s variable costs are 70% of the selling price. Given the following information, IDENTIFY which is
the better policy?
(Amount in ₹)

Particulars Present Policy Proposed Policy 1 Proposed Policy 2

Annual credit 50,00,000 60,00,000 67,50,000
sales
Accounts 4 times 3 times 2.4 times
receivable
turnover ratio
Bad debt losses 1,50,000 3,00,000 4,50,000

(b) The annual report of XYZ Ltd. provides the following information for the Financial Year 2019-20:

Particulars Amount (₹)

Net Profit 50 lakhs
Outstanding 15% 100 lakhs

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preference shares
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is-

(i) 25%;

(ii) 50%;
(iii) 100%.

(c) ABC Ltd. is considering a project “X” with an initial outlay of ₹ 16,00,000 and the possible three cash
inflow attached with the project is as follows:
(Amount in ₹ ‘000)

Particular Year 1 Year 2 Year 3

Scenario 1 550 500 800
Scenario 2 650 550 900
Scenario 3 750 600 1000

Assuming the cost of capital as 9%.

(i) DETERMINE NPV in each scenario.

(ii) If ABC Ltd. is certain about the 1st and 2nd year’s results in scenario 2 but uncertain about the third
year’s cash flow,

DETERMINE NPV expecting scenario 1 in the third year.

Year 1 2 3
DF @ 9% 0.917 0.842 0.772

(d) Using the information given below, PREPARE the Balance Sheet of SKY Private Limited:

(i) Current ratio 1.6 :1

(ii) Cash and Bank balance 15% of total current
assets
(iii) Debtors turnover ratio 12 times
(iv) Stock turnover (cost of goods sold) 16 times
ratio

945
(v) Creditors turnover (cost of goods sold) 10 times
ratio
(vi) Gross profit ratio 20%
(vii) Capital gearing ratio 0.6
(viii) Depreciation rate 15% on W.D.V.
(ix) Net fixed Assets 20% of total assets

(Assume all purchase and sales are on credit)

Balance Sheet of SKY Private Limited as at 31.03.2020

(Detailed working notes are not required to be shown) [4 × 5 Marks = 20 Marks]

ANSWER 1

(a) Statement showing the Evaluation of Accounts Receivable Policies

(Amount in ₹)

946

Recommendation: The Proposed Policy 1 should be adopted since the net benefits under this policy are
higher as compared to other policies.
Working Note:

Calculation of Opportunity Cost of Average Investments

Opportunity Cost = Total Cost × Collection period/12 × Rate of Return/100
Present Policy = ₹ 35,00,000 × 3/12 × 20% = ₹ 1,75,000
Proposed Policy 1 = ₹ 42,00,000 × 4/12 × 20% = ₹ 2,80,000
Proposed Policy 2 = ₹ 47,25,000 × 5/12 × 20% = ₹ 3,93,750

(b) Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in ₹
Net Profit 50 lakhs
Less: Preference dividend 15 lakhs
Earnings for equity 35 lakhs
shareholders
Therefore, earning per 35 lakhs/5 lakhs = ₹ 7.00
share

947
(c) (i) The possible outcomes under different scenario will be as follows: (Amount in ₹ ‘000)

(ii) The company is bit confident about the estimates in the first two years, but not sure about the third year’s
cash inflow, the NPV in such case expecting scenario 1 in the third year will be as follows:
= -16,00,000 + (6,50,000 × 0.917 + 5,50,000 × 0.842 + 8,00,000 × 0.772)
= -16,00,000 + (5,96,050 + 4,63,100 + 6,17,600)
= ₹ 76,750

(d) Working Notes

1. Computation of Current Assets and Cash & Bank Balance

Current Ratio = Current Assets (CA) / Current Liabilities (CL) = 1.6

Current Assets = 1.6 Current Liabilities = 1.6 ₹ 68,50,000 = ₹ 1,09,60,000/- ×
So, Cash and Bank Balance=15% of Current Assets = ₹ 16,44,000

2. Computation of Total Assets, Fixed assets and Depreciation

948
Total Assets = Net Fixed assets+ Current Asset
Or, Total Assets = 20% of Total Asset + ₹ 1,09,60,000
Or, Total Assets = ₹ 1,37,00,000
So, Net Fixed assets = 20% of Total Asset = ₹ 27,40,000
Fixed Assets = ₹ 27,40,000 + Rs4,83,529 = ₹ 32,23,529
Or, x = ₹ 6,98,70,000
So, Sales = ₹ 6,98,70,000

Cash of Goods Sold (COGS) = ₹ 5,58,96,000

Stock (COGS/16) = ₹ 34,93,500

949
Debtors (Sales/12) = ₹ 58,22,500
Creditors (COGS/10) = ₹ 55,89,600

4. Calculation of Provision of outstanding Expenses

= ₹ 68,50,000 – ₹ 55,89,600
= ₹ 12,60,400

5. Share Capital + Reserve of surplus + long term debt = Total Asset or total liability – Current liability
Or, Reserve & surplus + long term debt = ₹ 1,37,00,000 – 68,50,000 – 25,00,000
= ₹ 43,50,000
Balance Sheet of SKY Private Limited as at 31.03.2020

Liabilities ₹ Assets ₹
Share Capital 25,00,000 Fixed assets
Reserve & Surplus 17,81,250 Opening WDV
32,23,529
12% Long term debt 25,68,750 Less: Depreciation 27,40,000
4,83,529
Current Liabilities
Creditors 55,89,600 Current Assets
Provisions & outstanding expenses 68,50,000 Stock 34,93,500
12,60,400
Debtors 58,22,500
Cash and bank 1,09,60,000
balance 16,44,000
1,37,00,000 Total 1,37,00,000

950
2. Sinha Steel Ltd. requires ₹ 30,00,000 for a new plant which expects to yield earnings before interest and
taxes of ₹ 5,00,000. While deciding about the financial plan, the company considers the objective of
maximizing earnings per share. It has three alternatives to finance the project as follows -

Alternative Debt Equity Shares

1 ₹ 2,50,000 balance
2 ₹ 10,00,000 balance
3 ₹ 15,00,000 balance
The company's share is currently selling at ₹ 200, but is expected to decline to ₹ 160 in case the funds are
borrowed in excess of ₹ 10,00,000.
Slab wise interest rate for fund borrowed are as follows -

Fund Limit Applicable Interest rate

up-to ₹ 2,50,000 10%
over ₹ 2,50,000 and up-to ₹ 10,00,000 15%
over ₹ 10,00,000 20%

The tax rate applicable to the company is 50 percent.

ANALYSE which form of financing should the company choose? [10 Marks]
ANSWER 2

Alternative I = Raising Debt of ₹ 2.5 lakh + Equity of ₹ 27.5 lakh.

Alternative II = Raising Debt of ₹ 10 lakh + Equity of ₹20 lakh.
Alternative III = Raising Debt of ₹ 15 lakh + Equity of ₹ 15 lakh.
Calculation of Earnings per share (EPS):
(Amount in ₹)

FINANCIAL ALTERNATIVES Alternative I Alternative II Alternative III

Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (working note i) (25,000) (1,37,500) (2,37,500)
Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)
Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250
Number of shares (working note ii) 13,750 10,000 9,375
Earnings per share (EPS) 17.27 18.125 14.00

Financing Alternative II (i.e. Raising debt of ₹10 lakh and issue of equity share capital of ₹ 20 lakh) is the option
which maximises the earnings per share.

951
Working Notes:
(i) Calculation of interest on Debt (Amount in ₹)

Alternative I (2,50,000 × 10%) 25,000

Alternative II (2,50,000 × 10%) 25,000
(7,50,000 × 15%) 1,12,500 1,37,500
Alternative III (2,50,000 × 10%) 25,000
(7,50,000 × 15%) 1,12,500
(5,00,000 × 20%) 1,00,000 2,37,500
(ii) Number of equity shares to be issued
Alternative I = ₹ 27,50,000/ ₹ 200 (Market Price of share)
= 13,750 shares
Alternative II = ₹ 20,00,000/ ₹ 200
= 10,000 shares
Alternative III = ₹ 15,00,000/ ₹ 160
= 9,375 shares

3. P Ltd. has the following capital structure at book-value as on 31st March, 2020:

Particulars (₹)
Equity share capital (10,00,000 shares) 3,00,00,000
11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
4,60,00,000

The equity shares of the company are sold for ₹ 300. It is expected that the company will pay next year a
dividend of ₹ 15 per equity share, which is expected to grow by 5% p.a. forever. Assume a 35% corporate
tax rate.

Required:

(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital
structure.

(ii) COMPUTE the new WACC, if the company raises an additional ₹ 50 lakhs debt by issuing 12%
debentures. This would result in increasing the expected equity dividend to ₹ 20 and leave the growth rate
unchanged, but the price of equity share will fall to ₹ 250 per share. [10 Marks]
ANSWER 3

952
(i) Computation of Weighted Average Cost of Capital based on existing capital structure

Source of Capital Existing Capital Weights (a) After tax cost of WACC (%) (a) × (b)
structure (₹) capital (%) (b)
Equity share capital 3,00,00,000 0.652 10.00 6.52
(W.N.1)
11.5% Preference 60,00,000 0.130 11.50 1.50
share capital
10% Debentures 1,00,00,000 0.218 6.50 1.42
(W.N.2)
Total 4,60,00,000 1.000 9.44
(ii) Computation of Weighted Average Cost of Capital based on new capital structure

Source of Capital New Capital Weights (a) After tax cost of WACC (%) (a) x (b)
structure (₹) capital (%) (b)
Equity share capital 3,00,00,000 0.588 13.00 7.64
(W.N.3)
11.5% Preference 60,00,000 0.118 11.50 1.36
share capital
10% Debentures 1,00,00,000 0.196 6.50 1.27
(W.N.2)
12% Debentures 50,00,000 0.098 7.80 0.76
(W.N.4)
Total 5,10,00,000 1.000 11.03

953
4. A firm can make investment in either of the following two projects. The firm anticipates its cost of capital
to be 10%. The pre-tax cash flows of the projects for five years are as follows:

Year 0 1 2 3 4 5
Project A (₹) (2,00,000) 35,000 80,000 90,000 75,000 20,000
Project 8 (₹) (2,00,000) 2,18,000 10,000 10,000 4,000 3,000

Ignore Taxation.

An amount of ₹ 35,000 will be spent on account of sales promotion in year 3 in case of Project A. This has
not been taken into account in calculation of pre-tax cash flows.

Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62

You are required to calculate for each project:

954
(i) The payback period

(ii) The discounted payback period

(iii) Desirability factor

(iv) Net Present Value [10 Marks]

ANSWER 4

Calculation of Present Value of cash flows

(i) The Payback period of the projects:

Project-A: The cumulative cash inflows up-to year 3 is ₹1,70,000 and remaining amount required to equate
the cash outflow is ₹ 30,000 i.e. (₹ 2,00,000 – ₹ 1,70,000) which will be recovered from year-4 cash inflow.
Hence, Payback period will be calculated as below:

3 years + = 3.4 years Or 3 years 4.8 months Or 3 years 4 months and 24 days 75,000 30,000 ₹₹

Project-B: The cash inflow in year-1 is ₹ 2,18,000 and the amount required to equate the cash outflow is ₹
2,00,000, which can be recovered in a period less than a year. Hence, Payback period will be calculated as
below:

(i) The Payback period of the projects:

Project-A: The cumulative cash inflows up-to year 3 is ₹1,70,000 and remaining amount required to equate

955
the cash outflow is ₹ 30,000 i.e. (₹ 2,00,000 – ₹ 1,70,000) which will be recovered from year-4 cash inflow.
Hence, Payback period will be calculated as below:
3 years + = 3.4 years Or 3 years 4.8 months Or 3 years 4 months and 24 days 75,000 30,000 ₹₹

Project-B: The cash inflow in year-1 is ₹ 2,18,000 and the amount required to equate the cash outflow is ₹
2,00,000, which can be recovered in a period less than a year. Hence, Payback period will be calculated as
below:
(i) The Payback period of the projects:

Project-A: The cumulative cash inflows up-to year 3 is ₹1,70,000 and remaining amount required to equate
the cash outflow is ₹ 30,000 i.e. (₹ 2,00,000 – ₹ 1,70,000) which will be recovered from year-4 cash inflow.
Hence, Payback period will be calculated as below:

Project-B: The cash inflow in year-1 is ₹ 2,18,000 and the amount required to equate the cash outflow is ₹
2,00,000, which can be recovered in a period less than a year. Hence, Payback period will be calculated as
below:

956
5. (a) Following Balance Sheet and Income Statement have been obtained from the books of accounts of
Benaca Pvt. Ltd.

Balance Sheet as on March 31st 2020

Liabilities Amount (₹) Assets Amount (₹)

Equity Capital 80,00,000 Net Fixed Assets 1,00,00,000
(₹10 per share)
10% Debt 60,00,000 Current Assets 90,00,000
Retained 35,00,000
Earnings
Current 15,00,000
Liabilities
1,90,00,000 1,90,00,000

Income Statement for the year ending March 31st 2020

Particulars Amount (₹)

Sales 34,00,000
Less: Operating expenses (including ₹ 6,00,000 depreciation) (12,00,000)
EBIT 22,00,000
Less: Interest (6,00,000)
Earnings before tax 16,00,000

The tax rate applicable to the company is 35 percent.

(i) DETERMINE the degree of operating, financial and combined leverages at the current sales level, if all

957
operating expenses, other than depreciation, are variable costs.

(ii) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20
percent, COMPUTE the earnings per share at the new sales level? [8 Marks]

(b) EXPLAIN certainty equivalents, one of the techniques of risk analysis. [2 Marks]
ANSWER 5

(a) (i) Degree of operating, financial and combined leverages at the current sales level-

(ii) Earnings per share at the new sales level (Amount in ₹)

Particulars Increase by 20% Decrease by 20%

Sales level 40,80,000 27,20,000
Less: Variable expenses 7,20,000 4,80,000
Less: Fixed cost 6,00,000 6,00,000
Earnings before interest and taxes 27,60,000 16,40,000
Less: Interest 6,00,000 6,00,000
Earnings before taxes 21,60,000 10,40,000
Less: Taxes @35% 7,56,000 3,64,000
Earnings after taxes (EAT) 14,04,000 6,76,000
Number of equity shares 8,00,000 8,00,000
EPS 1.76 0.85

Working Notes:
Variable Costs = ₹ 6,00,000 (total cost - depreciation)

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Variable Costs at:
(i) Sales level, ₹ 40,80,000 = ₹ 7,20,000 (increase by 20%)
(ii) Sales level, ₹ 27,20,000 = ₹ 4,80,000 (decrease by 20%)

(b) Certainty Equivalents: As per CIMA terminology, “An approach to dealing with risk in a capital budgeting
context. It involves expressing risky future cash flows in terms of the certain cashflow which would be
considered, by the decision maker, as their equivalent, that is the decision maker would be indifferent
between the risky amount and the (lower) riskless amount considered to be its equivalent.”
The certainty equivalent is a guaranteed return that the management would accept rather than accepting a
higher but uncertain return. This approach allows the decision maker to incorporate his or her utility function
into the analysis. In this approach a set of risk less cash flow is generated in place of the original cash flows.

6. (a) DISCUSS Agency Problem and Agency Cost. [4 Marks]

(b) EXPLAIN in brief the features of Commercial Papers. [4 Marks]

(c) EXPLAIN Billing float and Mail float with reference to management of cash.

Or

STATE any four factors which need to be considered while planning for working capital requirement. [2
Marks]

ANSWER 6

(a) Agency Problem and Agency Cost: Though in a sole proprietorship firm, partnership etc., owners
participate in management but incorporates, owners are not active in management so, there is a separation
between owner/ shareholders and managers. In theory, managers should act in the best interest of
shareholders however in reality, managers may try to maximise their individual goal like salary, perks etc., so
there is a principal agent relationship between managers and owners, which is known as Agency Problem. In a
nutshell, Agency Problem is the chances that managers may place personal goals ahead of the goal of owners.
Agency Problem leads to Agency Cost. Agency cost is the additional cost borne by the shareholders to monitor
the manager and control their behaviour to maximise shareholders wealth. Generally, Agency Costs are of
four types (i) monitoring (ii) bonding (iii) opportunity (iv) structuring.

(b) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a
view to enabling highly rated corporate borrowers to diversify their sources of short- term borrowings and to
provide an additional instrument to investors. Subsequently, in addition to the Corporate, Primary Dealers and

959
All India Financial Institutions have also been allowed to issue Commercial Papers. Commercial papers are
issued in denominations of ₹ 5 lakhs or multiples thereof and the interest rate is generally linked to the yield
on the one-year government bond.
All eligible issuers are required to get the credit rating from Credit Rating Information Services of India Ltd,
(CRISIL), or the Investment Information and Credit Rating Agency of India Ltd (ICRA) or the Credit Analysis and
Research Ltd (CARE) or the FITCH Ratings India Pvt. Ltd or any such other credit rating agency as is specified by
the Reserve Bank of India.
(c) Billing Float: An invoice is the formal document that a seller prepares and sends to the purchaser as the
payment request for goods sold or services provided. The time between the sale and the mailing of the invoice
is the billing float.
Mail Float: This is the time when a cheque is being processed by post office, messenger service or other
means of delivery.
OR
Some of the factors which need to be considered while planning for working capital requirement are-

(i) Cash: Identify the cash balance which allows for the business to meet day- to-day expenses, but reduces
cash holding costs.

(ii) Inventory: Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and Economic
order quantity (EOQ) are used for this.

(iii) Receivables: Identify the appropriate credit policy, i.e., credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence
Return on Capital (or vice versa). The tools like Discounts and allowances are used for this.

(iv) Short-term Financing Options: Inventory is ideally financed by credit granted by the supplier; dependent
on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert
debtors to cash” through “factoring” in order to finance working capital requirements.

(v) Nature of Business: For e.g. in a business of restaurant, most of the sales are in Cash. Therefore, need for
working capital is very less.

(vi) Market and Demand Conditions: For e.g. if an item’s demand far exceeds its production, the working
capital requirement would be less as investment in finished goods inventory would be very less.

(vii) Technology and Manufacturing Policies: For e.g. in some businesses the demand for goods is seasonal, in
that case a business may follow a policy for steady production through out over the whole year or instead may
choose policy of production only during the demand season.

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(viii) Operating Efficiency: A company can reduce the working capital requirement by eliminating waste,
improving coordination etc.

(ix) Price Level Changes: For e.g. rising prices necessitate the use of more funds for maintaining an existing
level of activity. For the same level of current assets, higher cash outlays are required. Therefore, the effect of
rising prices is that a higher amount of working capital is required.
Section B: ECONOMICS FOR FINANCE

7. (a) Assume in an economy, saving function is S = -10 + 0.2Y and autonomous investment is I = 50 crore.
Find out the equilibrium level of income and consumption. If investment increases by ₹ 5 crores, what will
be the new level of income and consumption? (3 Marks)

(b) Are health and education pure public goods? Comment (2 Marks)

(c) Why does measurement of money supply essential from a monetary policy perspective? Explain.
(2 Marks)

(d) Which technical measures are applied to protect human, animal or plant life from risks arising from
additives, pests, contaminants, toxins or disease-causing organisms. Explain with an example. (3 Marks)

ANSWER 7

(a) S= I -10 + 0.2Y = 50

0.2Y = 50+ 10
Y = 300 crore
C= Y- S
Where S= -10 + 0.2 (300) = 50 C= 300-50 = 250 crore

With the increase in investment by ₹ 5 crores, the new investment will become equal to ₹ 55 crores.
S= I -10 + 0.2Y = 55
Y= 325 crores
C= 270 crores

(b) No, A pure public good is non-rivalrous and non-excludable in nature therefore education and health
services are not pure public goods; rather they are quasi -public goods that possess nearly all of the qualities

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of the private goods and some of the benefits of public good. It is clearly possible to exclude people who do
not pay from availing these services

(c) Measurement of money supply is essential from a monetary policy perspective because it enables a
framework to evaluate whether the stock of money in the economy is consistent with the standards for price
stability, to understand the nature of deviations from this standard and to study the causes of money growth.
(d) Sanitary and Phyto -Sanitary (SPS) measures are applied to protect human, animal or plant life from risks
arising from additives, pests, contaminants, toxins or disease-causing organisms and to protect biodiversity.
These include ban or prohibition of import of certain goods, all measures governing quality and hygienic
requirements, production processes, and associated compliance assessments. For example; prohibition of
import of poultry from countries affected by avian flu, meat and poultry processing standards to reduce
pathogens, residue limits for pesticides in foods etc.

8. (a) How do governments ensure that market power does not create distortions in the market?
(3 Marks)

(b) Do you think money is a unique store of value? (2 Marks)

(c) Countries China and India have a total of 6000 hours each of labour available each day to produce shirts
and trousers. Both countries use equal number of hours on each good each day. China produces 1000 shirts
and 300 trousers per day. India produces 300 shirts and 200 trousers per day.
In the absence of trade:

i. Which country has absolute advantage in producing Shirts and Trousers?

ii. Which country has comparative advantage in producing Shirts and Trousers? (5 Marks)

ANSWER 8

(a) Market power is an important factor that contributes to inefficiency due to higher prices than competitive
prices. Because of the social costs imposed by monopoly, governments intervene by establishing rules and
regulations designed to promote competi tion and prohibit actions that are likely to restrain competition.
Policy options also include price regulation in the form of setting maximum prices that firms can charge based
on the firm’s variable costs, past prices, and possible inflation and productivity growth. These are some
methods by which the government ensures that market does not create distortions.

(b) Financial assets other than money are also performing the function of store of value. Just as money has, 962
the financial assets have fixed nominal value over time and represent generalized purchasing power.
Therefore, money is not a unique store of value.

(c) Goods produced by each country

Each country has 6000 hours of labour and uses 3000 hours each for both the goods. Therefore, the number
of hours spent per unit on each good

Since China produces both goods in less time, it has absolute advantage in both shirts and trousers.

Comparative advantage:

Comparing the opportunity costs of both goods we have

China
Opportunity cost of Shirts 3/10 = 0.3
Opportunity cost of Trousers 10/3 =3.33

India
Opportunity cost of Shirts 10/15 = 0.67
Opportunity cost of Trousers 15/10 =1.5

For producing shirts

China has lower opportunity cost for producing shirts, therefore China has comparative advantage

For producing Trousers

India has lower opportunity cost for producing Trousers, therefore India has comparative advantage.

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9. (a) Calculate Gross Domestic Product at market price (GDPMP) and derive National Income from the
following data (in Crores of Rupees) (5 Marks)

Particulars in ₹ Crore
Inventory investment 400
Exports 350
Indirect taxes 150
Net factor income from abroad - 75
Personal consumption expenditure 7500
Gross residential construction investment 700
Depreciation 100
Imports 200
Government purchases of goods and services 1800
Gross public investment 400
Gross business fixed investment 375

b) Define near public goods. Is it desirable to keep people away from such goods? Give comments. (2 Marks)
(c) Write a note on Cash Reserve Ratio (CRR). Explain the operation of CRR. (3 Marks)

ANSWER 9

(a) GDPMP = Personal consumption expenditure + Gross investment (Gross business fixed
investment + inventory investment) + Gross residential construction investment + Gross public investment +
Government purchases of goods and services + Net Exports (exports-imports) GDPMP = 7500 + 775 + 700 +
400 + 1800 + 150
= 11325 crores
NNP FC (National Income) = GNP FC – Depreciation Where GNPFC = GNPMP - Indirect Taxes
And GNPMP = GDPMP + Net factor income from abroad GNPMP = 11325 – 75 = 11250 crores
GNPFC = 11250 – 150 = 11100 crores
NNP FC (National Income) = 11100 – 100 = 11000 crores

(b) Near public good (for e.g. education, health services) possess nearly all of the qualities of the private goods
and some of the benefits of public good. It is easy to keep people away from them by charging a price or fee.
However, it is undesirable to keep people away from such goods because the society would be better off if
more people consume them. This particular characteristic namely, the combination of virtually infinite
benefits and the ability to charge a price results in some near public goods being sold through markets and
others being provided by government. As such, people argue that these should not be left to the market
alone.

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(c) Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time liabilities (NDTL) of a
scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank. Higher
the CRR, lower is the credit creation capacity of banks. Reducing CRR during deflation results in expansion of
credits by banks and increases the supply of money available in the economy. Increasing the CRR during
inflation helps in containing credit expansion.
10. (a) (i) Define common resources. Why are they overused? (2 Marks)

(ii) Explain the free rider problem. Give examples (3 Marks)

(b) Distinguish between Leakages and Injections in the circular flow of income? (2 Marks)

(c) Differentiate Trade- Related Investment Measures (TRIMS) and Trade-Related Aspects of Intellectual
Property Rights (TRIPS). (3 Marks)

ANSWER 10

(a) (i) Common access resources or common pool resources are a special class of impure public goods which
are non-excludable as people cannot be excluded from using them. These are rival in nature and their
consumption lessens the benefits available for others. Since price mechanism does not apply to ‘common
resources’, producers and consumers do not pay for these resources and therefore, they overuse them and
cause their depletion and degradation.

(ii) The incentive to let other people pay for a good or service, the benefits of which are enjoyed by an
individual is known as the free rider problem. In other words, free riding is ‘benefiting from the actions of
others without paying’. Example is national defence. The government provides defence for all its citizens
regardless of much they contribute in tax es. Another example is Wikipedia- few people contribute (financially
or otherwise), but everyone gets to use it.

(b) Leakages are withdrawals from the economy as a result of taxation, spending on imports, and monetary
savings. It reduces the flow of income. On the other hand, Injections are additions and contributions to the
economy through government spending, money from exports, and investments made by firms. Injections
increase the flow of income.

(c) Trade-Related Investment Measures (TRIMs) is an agreement on trade related investment measures which

965
specifies the rule that are applicable to domestic regulation a country applies to foreign investors. The
agreement is applicable to all the members of WTO. It expands disciplines governing investment measures in
relation to cross-border investments by stipulating that countries receiving foreign investments shall not
impose investment measures such as requirements, conditions and restrictions inconsistent with the
provisions of the principle of national treatment and general elimination of quantitative restrictions. On the
other hand, Trade - Related Aspects of Intellectual Property Rights (TRIPS) is an international agreement
among various members of WTO on intellectual property rights. It is one of the most comprehensive
multilateral agreements on intellectual rights. It stipulates most -favoured-nation treatment and national
treatment for intellectual properties, such as copyright, trademarks, geographical indications, industrial
designs, patents, IC layout designs and undisclosed information.
11. (a) Explain the Fisher’s Quantity theory of demand for money? (5 Marks)

(b) (i) How are the following transactions treated in national income calculation? What is the rationale in
each case? (3 Marks)

(1) Expenditure by government on providing free education.

(2) Capital gain on sale of a house.

(3) Mineral wealth of a nation.

(ii) Define Contractionary monetary policy (2 Marks)

OR

Differentiate Crawling Peg and Crawling Bands.

ANSWER 11

(a) According to Fisher, quantity theory of money demonstrate that there is strong relationship between
money and price level and the quantity of money is the main determinant of the price level or the value of
money. In other words, changes in the general level of commodity prices or changes in the value or purchasing
power of money are determined first and foremost by changes in the quantity of money in circulation.

Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:

MV=PT

Where,

M= the total amount of money in circulation (on an average) in an economy,

V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of

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money(say Rupee) is spent in purchasing goods and services,
P = average price level (P= MV/T), T = the total number of transactions

Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their velocity (V’)
in the total supply of money. Thus, the expanded form of the equation of exchange becomes:
MV + M'V' = PT

Where M' = the total quantity of credit money,

V' = velocity of circulation of credit money. The total supply of money in the community consists of the
quantity of actual money (M) and its velocity of circulation (V). Velocity of money in circulation (V) and the
velocity of credit money (V') remain constant. T is a function of national income.

Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly put, the total
volume of transactions (T) multiplied by the price level (P) represents the demand for money. The demand for
money (PT) is equal to the supply of money (MV + M'V)'.

In any given period, the total value of transactions made is equal to PT and the value of money flow is equal to
MV+ M'V'.
Fisher did not specifically mention anything about the demand for money; but the same is embedded in his
theory as dependent on the total value of transactions undertaken in the economy. Thus, there is an
aggregate demand for money for transactions purpose and more the number of transactions people want,
greater will be the demand for money. The total volume of transactions multiplied by the price level (PT)
represents the demand for money.

(b) (i) 1. Expenditure by government on providing free education is included while estimating national income,
as it is part of government final consumption expenditure. Since the service provided by the government are
not sold in the market, the only way they can be valued in money terms is by adding up the money spent by
the government in the production of the service.

2. Capital gain on sale of the house is not be included while estimating national income, as it is already
included in the year when it is built and to avoid double counting which means counting value of the same
commodity more than once.

3. It is a part of national wealth and is not included in national income. However, that part of mineral wealth
which has been extracted during the current year will be included in national income under the product
method.

(ii) Contractionary monetary policy is a policy used by monetary authorities to contract the money supply and
reduce economic activity by raising interest rates to slow the rate of borrowing by companies, individuals and
banks.

OR 967

Currency is adjusted periodically in small amounts at a fixed; pre announced rate in response to changes in
certain quantitative indicators is called Crawling Peg. On the other hand, when currency is maintained within
certain fluctuation margins say (±1-2 %) around a central rate that is adjusted periodically is Crawling Bands.
PAST PAPER- NOV 2020

SECTION – A: FINANCIAL MANAGEMENT

Question 1
(b) CK Ltd. is planning to buy a new machine. Details of which are as follows:

Cost of the Machine at the commencement - ₹ 2,50,000

Economic Life of the Machine - 8 year
Residual Value- Nil
Annual Production Capacity of the Machine - 1,00,000 units
Estimated Selling Price per unit- ₹ 6
Estimated Variable Cost per unit - ₹ 3

Estimated Annual Fixed Cost - ₹ 1,00,000

(Excluding depreciation)
Advertisement Expenses in 1st year in addition of annual fixed cost - ₹ 20,000
Maintenance Expenses in 5th year in addition of annual fixed cost - ₹ 30,000
Cost of Capital 12% Ignore Tax.
Analyse the above mentioned proposal using the Net Present Value Method and advice.

P.V. factor @ 12% are as under:

Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

ANSWER
Calculation of Net Cash flows
Contribution = (₹ 6 – ₹ 3) 1,00,000 units = ₹ 3,00,000
Fixed costs (excluding depreciation) = ₹ 1,00,000

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Calculation of Net Present Value

Year Net cash flow 12% discount Present value

(₹) factor (₹)
0 (2,50,000) 1.000 (2,50,000)
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
7,08,730
Advise: CK Ltd. should buy the new machine, as the net present value of the proposal is positive i.e ₹ 7,08,730.

(c) The following figures are extracted from the annual report of RJ Ltd.:

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Net Profit -₹ 50 Lakhs
Outstanding 13% preference shares -₹ 200 Lakhs
No. of Equity Shares - 6 Lakhs
Return on Investment - 25%
Cost of Capital (Ke) - 15%
You are required to compute the approximate dividend pay-out ratio by keeping the share price at ₹ 40 by
using Walter's Model. (5 Marks)

ANSWER
Particulars ₹ in lakhs
Net Profit 50
Less: Preference dividend (₹ 200,00,000 x 13%) 26
Earning for equity shareholders 24
Therefore, earning per share = ₹ 24 lakh /6 lakh shares = ₹ 4

Let, the dividend per share be D to get share price of ₹ 40

So, the required dividend pay-out ratio will be = 25%

(d) TT Ltd. issued 20,000, 10% convertible debenture of ₹ 100 each with a maturity period of 5 years. At
maturity the debenture holders will have the option to convert debentures into equity shares of the
company in ratio of 1:5 (5 shares for each debenture). The current market price of the equity share is ₹ 20
each and historically the growth rate of the share is 4% per annum. Assuming tax rate is 25%. Compute the
cost of 10% convertible debenture using Approximation Method and Internal Rate of Return Method.
PV Factor are as under:

Year 1 2 3 4 5

970
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497

ANSWER

Determination of Redemption value:

Higher of-
(i) The cash value of debentures = ₹100
(ii) Value of equity shares = 5 shares × ₹ 20 (1+0.04)5
= 5 shares × ₹ 24.333
= ₹121.665 rounded to ₹121.67
₹121.67 will be taken as redemption value as it is higher than the cash option and attractive to the investors.
Calculation of Cost of 10% Convertible debenture
(i) Using Approximation Method:

(ii) Using Internal Rate of Return Method

Question 2 971

PK Ltd., a manufacturing company, provides the following information:

Additional Information:

(a) Receivables are allowed 3 months' credit.

(b) Raw Material Supplier extends 3 months' credit.

(c) Lag in payment of Labour is 1 month.

(d) Manufacturing Overhead are paid one month in arrear.

(e) Administrative & Selling Overhead is paid 1 month advance.

(f) Inventory holding period of Raw Material & Finished Goods are of 3 months.

(g) Work-in-Progress is Nil.

(h) PK Ltd. sells goods at Cost plus 33⅓%.

(i) Cash Balance ₹ 3,00,000.

(j) Safety Margin 10%.

You are required to compute the Working Capital Requirements of PK Ltd. on Cash Cost basis.

(10 Marks)

Answer

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Statement showing the requirements of Working Capital (Cash Cost basis)
Working Notes:
(i)

(A) Computation of Annual Cash Cost of Production (₹)

Raw Material consumed 27,00,000
Wages (Labour paid) 21,60,000
Manufacturing overhead (₹ 32,40,000 - ₹ 3,60,000) 28,80,000
Total cash cost of production 77,40,000

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(B) Computation of Annual Cash Cost of Sales (₹)
Cash cost of production as in (A) above 77,40,000
Administrative & Selling overhead 10,80,000
Total cash cost of sales 88,20,000
*Purchase of Raw material can also be calculated by adjusting Closing Stock and Opening Stock (assumed nil). In that
case Purchase will be Raw material consumed +Closing Stock-Opening Stock i.e ₹27,00,000 + ₹6,75,000 - Nil =
₹33,75,000. Accordingly, Total Working Capital requirements (₹ 43,35,375) can be calculated.

Question 3
J Ltd. is considering three financing plans. The-key information is as follows:
(a) Total investment to be raised ₹ 4,00,000.
(b) Plans showing the Financing Proportion:

Plans Equity Debt Preference Shares

X 100% - -
Y 50% 50% -
Z 50% - 50
(c) Cost of Debt 10%
Cost of preference shares 10%
(d) Tax Rate 50%
(e) Equity shares of the face value of ₹10 each will be issued at a premium of ₹ 10 per share.
(f) Expected EBIT is ₹ 1,00,000.
You are required to compute the following for each plan :
(i) Earnings per share (EPS)
(ii) Financial break even point
(iii) Indifference Point between the plans and indicate if any of the plans dominate.(10 Marks)

Answer

(i) Computation of Earnings per Share (EPS)

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(ii) Computation of Financial Break-even Points

Financial Break-even point = Interest + Preference dividend/(1 - tax rate)
Proposal ‘X’ = 0
Proposal ‘Y’ = ₹ 20,000 (Interest charges)
Proposal ‘Z’ = Earnings required for payment of preference share dividend = ₹ 20,000 ÷ (1- 0.5 Tax Rate) = ₹ 40,000
(iii) Computation of Indifference Point between the plans
Combination of Proposals
(a) Indifference point where EBIT of proposal “X” and proposal ‘Y’ is equal

(b) Indifference point where EBIT of proposal ‘X’ and proposal ‘Z’ is equal:

(c) Indifference point where EBIT of proposal ‘Y’ and proposal ‘Z’ are equal

There is no indifference point between proposal ‘Y’ and proposal ‘Z’

Analysis: It can be seen that financial proposal ‘Y’ dominates proposal ‘Z’, since the financial break-even-point of the
former is only ₹ 20,000 but in case of latter, it is ₹ 40,000. EPS of plan ‘Y’ is also higher.

975
Question 4
A Ltd. is considering two mutually exclusive projects X and Y.
You have been given below the Net Cash flow probability distribution of each project:
(i) Compute the following :
(a) Expected Net Cash Flow of each project.
(b) Variance of each project.
(c) Standard Deviation of each project.
(d) Coefficient of Variation of each project.
(ii) Identify which project do you recommend ? Give reason. (10 Marks)

Answer
(i) (a) Calculation of Expected Net Cash Flow (ENCF) of Project X and Project Y

(b) Variance of Projects

Project X
Variance (σ2) = (50,000 – 61,000)2 × (0.3) + (60,000 -61,000)2 × (0.3) + (70,000 – 61,000)2 × (0.4)
= 3,63,00,000 + 3,00,000 + 3,24,00,000 = 6,90,00,000

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Project Y
Variance(σ2) = (1,30,000 – 1,04,000)2 × (0.2) + (1,10,000 – 1,04,000)2 × (0.3) + (90,000 – 1,04,000)2 × (0.5)
= 13,52,00,000 + 1,08,00,000 + 9,80,00,000 = 24,40,00,000

(c) Standard Deviation of Projects

Project X
Standard Deviation (σ) = √Variance(σ2) = √6,90,00,000 = 8,306.624
Project Y
Standard Deviation (σ) = √Variance(σ2)= √24,40,00,000 = 15,620.499

(d) Coefficient of Variation of Projects

(ii) In project X risk per rupee of cash flow is 0.136 (approx.) while in project Y it is 0.15 (approx.). Therefore, Project X is
better than Project Y.

Question 5
The following data is available for Stone Ltd. :

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Using the concept of leverage, find out
(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%.
Also verify the results in each of the above case. (10 Marks)

Answer
Verification

Particulars Amount (₹)

New EBIT after 10% increase (₹ 1,00,000 + 10%) 1,10,000
Less: Interest 25,000
Earnings before Tax after change (EBT) 85,000

Increase in Earnings before Tax = ₹ 85,000 - ₹ 75,000 = ₹ 10,000

So, if sale is increased by 10% then EBIT will be increased by 3 × 10 = 30%

Verification

Particulars Amount (₹)

New Sales after 10% increase (₹ 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ₹ 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax after change (EBIT) 1,30,000

Increase in Earnings before interest and tax (EBIT) = ₹ 1,30,000 - ₹ 1,00,000 = ₹ 30,000 978

So, if sale is increased by 10% then Taxable Income (EBT) will be increased by 4 × 10 = 40%
Verification

Particulars Amount (₹)

New Sales after 10% increase (₹ 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ₹ 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax (EBIT) 1,30,000
Less: Interest 25,000
Earnings before tax after change (EBT) 1,05,000

Increase in Earnings before tax (EBT) = ₹ 1,05,000 - ₹ 75,000 = ₹ 30,000

So, percentage change in Taxable Income (EBT) = hence verified ₹30,000 x 100 /₹ 75,000 = 40%

Question 6
(a) List out the role of Chief Financial Officer in today's World. (4 Marks)

Answer

Role of Chief Financial Officer (CFO) in Today’s World: Today, the role of chief financial officer, or CFO, is no longer
confined to accounting, financial reporting and risk management. It’s about being a strategic business partner of the
chief executive officer, or CEO. Some of the role of a CFO in today’s world are as follows-
• • Budgeting
• • Forecasting
• • Managing M&As
• • Profitability analysis (for example, by customer or product)
• • Pricing analysis
• • Decisions about outsourcing
• • Overseeing the IT function.

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• • Overseeing the HR function.
• • Strategic planning (sometimes overseeing this function).
• • Regulatory compliance.
• • Risk management

(b) Explain in brief the methods of Venture Capital Financing. (4 Marks)

ANSWER
Methods of Venture Capital Financing: Some common methods of venture capital financing are as follows-
(i) Equity financing: The venture capital undertakings generally require funds for a longer period but may not be able to
provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by
way of equity share capital. The equity contribution of venture capital firm does not exceed 49% of the total equity
capital of venture capital undertakings so that the effective control and ownership remains with the entrepreneur.
(ii) Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales.
No interest is paid on such loans. In India venture capital financiers charge royalty ranging between 2 and 15 per cent;
actual rate depends on other factors of the venture such as gestation period, cash flow patterns, risk and other factors
of the enterprise. Some Venture capital financiers give a choice to the enterprise of paying a high rate of interest (which
could be well above 20 per cent) instead of royalty on sales once it becomes commercially sound.
(iii) Income note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The
entrepreneur has to pay both interest and royalty on sales but at substantially low rates. IDBI’s VCF provides funding
equal to 80 – 87.50% of the projects cost for commercial application of indigenous technology.
(iv) Participating debenture: Such security carries charges in three phases — in the start-up phase no interest is
charged, next stage a low rate of interest is charged up to a particular level of operation, after that, a high rate of
interest is required to be paid.

(c) Distinguish between Unsystematic Risk & Systematic Risk. (2 Marks)

ANSWER
(i) Unsystematic Risk: This is also called company specific risk as the risk is related with the company’s performance. This
type of risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable
risk.
(ii) Systematic Risk: It is the macro-economic or market specific risk under which a company operates. This type of risk
cannot be eliminated by the diversification hence, it is non-diversifiable. The examples are inflation, Government policy,
interest rate etc.
OR
What is Risk Adjusted Discount Rate ? (2 Marks)
Answer

(i) Unsystematic Risk: This is also called company specific risk as the risk is related with the company’s performance. This
type of risk can be reduced or eliminated by diversification of the securities portfolio. This is also known as diversifiable
risk.
(ii) Systematic Risk: It is the macro-economic or market specific risk under which a company operates. This type of risk

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cannot be eliminated by the diversification hence, it is non-diversifiable. The examples are inflation, Government policy,
interest rate etc.
SECTION – B: ECONOMICS FOR FINANCE

Question 7
(a) Compute the amount of depreciation from the following data (₹ in Crores)
GDP at Market Price (GDPMp) 8,76,532
Net factor income from abroad (-) 232
Aggregate amount of Indirect Taxes 564
Subsidies 30
National Income (NNPFc) 8,46,576

ANSWER
The amount of depreciation
GDPMP = NNPFC - NFIA + NIT + Depreciation
8,76,532 = 8,46,576 – (-232) + (564-30) + Depreciation
8,76,532= 8,46,576 +232 +534 +Depreciation
8,76,532 = 8,47,342 + Depreciation
8,76,532 – 8,47,342 = 29,190 = Depreciation
Depreciation = 29,190 Crores.

(b) Discuss the guiding principle of WTO in relation to trade without discrimination. (2 Marks)

ANSWER
The guiding principle of WTO in relation to trade without discrimination
The two principles on non-discrimination namely, Most-favoured-Nation (MFN) and the National Treatment Principle
(NTP) relate to the rules of trade among member - nations. These are designed to secure fair conditions of trade.
(a) Most-favoured-Nation (MFN) principle holds that the member countries cannot normally discriminate among their
trading partners. Each member treats all the other members equally as “most-favoured” trading partners. If a country
grants a special advantage, favour, privilege or immunity to one (such as lowering of customs duty or opening up of
market), it has to unconditionally extend the same treatment to all the other WTO members.
(b) The National Treatment Principle (NTP) mandates that when goods are imported, the imported goods and the
locally produced goods and services should be treated equally in respect of internal taxes and internal laws. A member

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country should not discriminate between its own and foreign products, services or nationals. For instance, once
imported apples reach Indian market, they cannot be discriminated against and should be treated at par in respect of
marketing opportunities, product visibility or any other aspect with locally produced apples.

(c) "Money performs many functions in an economy”. Explain those functions briefly.
(3 Marks)
ANSWER

Functions of Money: Money performs the following important functions in an economy.

1. Money is a convenient medium of exchange or it is an instrument that facilitates easy exchange of goods and
services. By acting as an intermediary, money increases the ease of trade and reduces the inefficiency and transaction
costs involved in a barter exchange.
• • Money also facilitates separation of transactions both in time and place and this in turn enables us to
economize on time and efforts involved in transactions.

2. Money is a unit of account and acts as a yardstick people use to post prices and record debts. All economic values
are measured and recorded in terms of money.
• • Money helps in expressing the value of each good or service in terms of price making it convenient to trade all
commodities in exchange for a single commodity.
• • Money makes it possible to measure the prices of all commodities in terms of a single unit.
• • A common unit of account facilitates a system of orderly pricing which is crucial for rational economic choices.
• • Goods and services which are otherwise not comparable are made comparable through expressing the worth
of each in terms of money.

3. Money serves as a unit or standard of deferred payment i.e. money facilitates recording of deferred promises to
pay.
• • Money is the unit in terms of which future payments are contracted or stated. It simplifies credit transactions.

• By acting as a standard of deferred payments, money helps in capital formation and growth of financial and
capital markets which are essential for the growth of the economy.
4. Money acts as a temporary store of value and enables people to transfer purchasing power from the present to the
future. Money also functions as a permanent store of value. Unlike other assets which have limitations such as storage
costs, lack of liquidity and possibility of depreciation in value, money has perfect liquidity and commands reversibility as
its value in payment equals its value in receipt.

(d) Describe the characteristics of 'Public Goods'.

Answer

• Public goods are products (goods or services) whose consumption is essentially collective in nature. When
consumed by one person, it can be consumed in equal amounts by the rest of the persons in the society.
• • Public goods are non-rival in consumption; consumption of a public good by one individual does not reduce
the quality or quantity available for all other individuals.

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• • Public goods are non-excludable. If the good is provided, consumers cannot (at least at less than prohibitive
cost) be excluded from the benefits of consumption.
• • Public goods are characterized by indivisibility. Each individual may consume all of the good i.e. the total
amount consumed is the same for each individual. For example, a lighthouse
• • Public goods are generally more vulnerable to issues such as externalities, inadequate property rights, and free
rider problems.
• • The property rights of public goods with extensive indivisibility and nonexclusive properties cannot be
determined with certainty.
• • A unique feature of public goods is that they do not conform to the settings of market exchange.
• • As a consequence of their peculiar characteristics, public goods do not provide market incentives. Since
producers cannot charge a positive price for public goods or make profits from them, they are not motivated to produce
a socially-optimal level of output. As such, though public goods are extremely valuable for the well-being of the society,
left to the market, either they will not be produced at all or will be grossly under produced.

Question 8
(a) You are given the following information of an economy:
Consumption Function : C = 200 + 0.60 Yd
Government Spending : G = 150 Investment Spending : I = 240
Tax : Tx = 10+0.20Y
Transfer Payment : Tr =50
Exports : X = 30+0.2Y
Imports : M = 400
Where Y and Yd are National Income and Personal Disposable Income respectively. All figures are in ₹
Find:
(i) The equilibrium level of National Income.
(ii) Net Exports at equilibrium level.
(iii) Consumption at equilibrium level. (5 Marks)

ANSWER
(i) The equilibrium level of national income
Yd = Y + Tr –Tax
= Y + 50 - 10 - 0.2Y
Yd = 40+0.8 Y
Y = C+I+G+(X-M)
Y = 200+ 0.60 (40+0.8Y) +240 +150 + (30 + 0.2 Y - 400)
Y = 200 + 24 +.48 Y +240 +150 + 30 + 0.2 Y – 400
Y = 244 + 0.68 Y
Y- 0.68 Y = 244
0.32 Y = 244
Y = 244 /0.32 = 762.5

(ii) Net exports at equilibrium level

Net Exports = Exports – Imports or (X-M)
= 30 + 0.2 Y- 400
= 30 + 0.2 (762.5) - 400]

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= 30 + 152.5 - 400 = - 217.5
Net Exports = - 217.5 Crores
Imports are greater than exports. Therefore, ‘net exports’ are negative.
(iii) Consumption at equilibrium level
C = 200 + 0.60 (40+0.8 Y)
= 200 + 24 + 0. 48 (762.5)
=200 + 24 + 366 = 590
Consumption at equilibrium level of income = 590 Crores

(b) (i) Discuss the “Fiscal Policy Measures” which are useful for reduction in inequalities of income and
wealth. (3 Marks)
(ii) What is the impact of the following on credit multiplier and money supply, if Commercial Banks keep:
(1) Less Reserve?
(2) Excess Reserve?

ANSWER

(i) The Fiscal Policy Measures which are useful for reduction in inequalities of income and wealth.
Fiscal policy is a powerful instrument available for governments to influence income redistribution and for reducing
inequality of income and wealth to bring about equity and social justice.
Government revenues and expenditure have traditionally been regarded as important instruments for carrying out
desired redistribution of income.
Following are examples of a few such measures:
• • Progressive direct tax system: A progressive system of direct taxes ensures that those who have greater ability
to pay contribute more towards defraying the expenses of government and that the tax burden is distributed fairly
among the population.
• • Indirect taxes which are differential: The indirect taxes may be designed in such a way that the commodities
which are primarily consumed by the richer income groups, such as luxuries, are taxed heavily and the commodities the
expenditure on which form a larger proportion of the income of the lower income group, such as necessities, are taxed
light.
• A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer
sections of the society. This is done
• through spending programmes targeted on welfare measures for the disadvantaged, such as:
• (i) poverty alleviation programmes.
• (ii) free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of
living of the poor.
• (iii) infrastructure provision on a selective basis.
• (iv) various social security schemes under which people are entitled to old-age pensions, unemployment relief,
sickness allowance etc.
• (v) subsidized production of products of mass consumption.
• (vi) public production and/ or grant of subsidies to ensure sufficient supply of essential goods, and
• (vii) strengthening of human capital for enhancing employability etc.

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(ii) (1) The impact on credit multiplier and money supply, if commercial banks keep less reserves: The Credit Multiplier
describes the amount of additional money created by commercial banks through the process of lending the available
money it has in excess of the central bank's reserve requirements. Thus the credit multiplier is inextricably tied to the
bank's reserve requirement.
Credit Multiplier = 1 /Required Reserve Ratio
If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5. If banks need to keep only less reserve, then the credit
multiplier would be high and therefore money supply would be higher. If the reserve ratio is only10%, then the credit
multiplier is 1/0.10 =10.
(2) The impact on credit multiplier and money supply, if commercial banks keep excess reserve
• ‘Excess reserves’ refers to the positive difference between total reserves (TR) and required reserves (RR). The
money that is kept as ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these
excess reserves do not lead to creation of credit. When banks keep excess reserves, the credit multiplier would be low
and it impact on money supply would be less.

Question 9
(a) (i) 'The Heckscher Ohlin theory of Foreign Trade' can be stated in the form of two theorems. Explain
those briefly.
(ii) 'Lemons Problem' is an important source of market failure. How? (2 Marks)

ANSWER

(i) The ‘Heckscher-Ohlin theory of foreign trade ‘can be stated in the form of two theorems namely,
a) Heckscher-Ohlin Trade Theorem and
b) Factor-Price Equalization Theorem.

The Heckscher-Ohlin Trade Theorem establishes that a country’s exports depend on the endowment of resources it has
i.e. whether the country is capital-abundant or labour-abundant. If a country is a capital abundant one, it will produce
and export capital-intensive goods relatively more cheaply than other countries. Likewise, a labour-abundant country
will produce and export labour-intensive goods relatively more cheaply than another country.
Countries tend to specialize in the export of a commodity whose production requires intensive use of its abundant
resources and imports a commodity whose production requires intensive use of its scarce resources. The cause of
difference in the relative prices of goods is the difference the amount of factor endowments, like capital and labour,
between two countries.
The ‘Factor-Price Equalization’ Theorem postulates that if the prices of the output of goods are equalised
between countries engaged in free trade, then the price of the input factors will also be equalised between
countries. In other words, international trade eliminates the factor price differentials and tends to equalize the
absolute and relative returns to homogenous factors of production and their prices. Thus, the wages of homogeneous
labour and returns to homogeneous capital will be the same in all those nations which engage in trading.
(ii) ‘Lemons problem ’an important source of market failure
The ‘lemons problem’ arises due to asymmetric information between the buyers and sellers. The problem exists in
many markets, but it was popularized by the used car market in which cars are classified as good from those defined as
“lemons” (poor quality vehicles).
The owner of a car knows much more about its quality than anyone else. While placing it for sale, he may not disclose all
that he knows about the mechanical defects of the vehicle. Based on the probability that the car on sale is a ‘lemon’, the
buyers’ willingness to pay for any particular car will be based on the ‘average quality’ of used cars. Not knowing the

985
honesty of the seller means, the price offered for the vehicle is likely to be less to account for this risk. If buyers were
aware as to which car is good, they would pay the price they feel reasonable for a good car.
Since the price offered in the used car market is lower than the acceptable one, sellers of good cars will not be inclined
to sell. The market becomes flooded with ‘lemons’ and eventually the market may offer nothing but ‘lemons’. The good
-quality cars disappear because they are kept by their owners or sold only to friends. The result is: the proportion of
good products that is actually offered falls further and there will be market distortion with lower prices and lower
average quality of cars. Low-quality cars can drive high-quality cars out of the market. Eventually, this process may lead
to a complete breakdown of the market.
(b) (i) Compute M3 from the following data :

Component ₹ in Crores
Currency with the public 2,25,432.6
Demand Deposits with Banks 3,40,242.4
Time Deposits with Banks 2,80,736.8
Post office savings Deposits 446.7
(Excluding National Saving Certificates)
Other Deposits with RBI 392.7
(Including Government Deposits)
Post Office National Saving Certificates 83.7
Government Deposits with RBI· 102.5
(ii) Clarify the concept of ‘Average Propensity to Save’ with the help of formula and example.

ANSWER

(i) Computation of M3
M3 = Currency with the public + Demand deposits with the banks + Time deposits with the banks + ‘Other’ deposits with
the RBI
M3 = 2,25,432.6 + 3,40,242.4 + 2,80,736.8 + (392.7 – 102.5) = 8,46,702
M3 = ₹ 8,46,702 Crores
(ii) The concept of Average propensity to save
Average Propensity to Save (APS) is the ratio of total saving to total income. Alternatively, it is that part of total income
which is saved.
APS = Total Saving /Total Income = S /Y

For example, if saving is ₹ 20 Crores at national income of ₹ 100 Crores, then:

APS = S/Y =20/ 100 = 0.20, i.e. 20% of the income is saved. The estimation of APS is illustrated with the help of the
following table:

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Income Saving APS = S/Y APS
(₹ Crores) (₹ Crores)
0 - 40 - -
100 -20 (-20/100) - 0.20
200 0 (0/200) 0
300 20 (20/300) 0.067
400 40 (40/400) 0.10

Question 10
(a) (i) Explain the various types of externalities. (3 Marks)
(ii) Which method is used in India for measurement of National Income? Also, state the method which is
considered the most suitable for measurement of National Income of the developed economies. (2 Marks)

ANSWER
(i) The various types of Externalities
An externality is a cost or benefit of an economic activity experienced by an unrelated third party who did not choose to
incur that cost or benefit. These costs and benefits are not reflected in market prices.
Externalities can be positive or negative. Negative externalities occur when the action of one party imposes costs on
another party. Positive externalities occur when the action of one party confers benefits on another party.
The four possible types of externalities are:
(a) Negative production externalities
(b) Positive production externalities
(c) Negative consumption externalities,
(d) Positive consumption externalities
(a) Negative Production Externalities
A negative production externality initiated in production which imposes an external cost on others may be received by
another in consumption or production. As an example, a negative production externality occurs when a factory
discharges untreated waste water into a nearby river and pollutes the water.
• • This negative externality is said to be received in consumption when it causes health hazards for people who
use the water for drinking and bathing.
• • This negative externality is said to be received in production when pollution in the river affects fish output and
loss of fish resources resulting in less catch for fishermen.

(b) Positive production externalities

A positive production externality initiated in production that confers external benefits on others may be received in
production or in consumption. For example, positive production externality occurs when a firm offers training to its
employees for increasing their skills. Training generates positive benefits on the productive efficiency of other firms
when they hire such workers as they change their jobs.
• • A positive production externality is received in consumption when an individual raises an attractive garden and
the persons walking by enjoy the garden.

(c) Negative consumption externalities

Negative consumption externalities initiated in consumption confer external costs on others that may be
received in production or in consumption. For example, smoking cigarettes by one person in public place
causes passive smoking by others. These external costs affect consumption of others by causing consumption
of poor-quality air or by creating litter and diminishing the aesthetic value of the place. Another example is playing

987
the radio loudly obstructing another person from enjoying a concert.
• • The case of excessive consumption of alcohol causing impairment in efficiency for work and production are
instances of negative consumption externalities affecting production.

(d) Positive consumption externalities

A positive consumption externality occurs when an individual’s consumption increases the well-being of others but the
individual is not compensated by those others. For example, if people get immunized against contagious diseases, they
would confer a social benefit on others as well by preventing others from getting infected.
• • Consumption of the services of a health club by the employees of a firm would result in an external benefit to
the firm in the form of increased efficiency and productivity.
(ii) The method used in India for measurement of National Income
In India, the Central Statistics Office under the Ministry of Statistics and Programme Implementation is responsible for
macro-economic data gathering and statistical record keeping.
Since reliable statistical data are not available, it is not possible to estimate India’s national income wholly by one
method. Therefore, a combination of output method and income method is used. The value-added method is used
largely in the commodity producing sectors like agriculture and manufacturing. Thus, in agricultural sector, net value
added is estimated by the production method, in small scale sector net value added is estimated by the income method
and in the construction sector net value added is estimated by the expenditure method also.
The method which is considered suitable for measurement of National Income of developed economies:
Income method may be most suitable for developed economies where data in respect of factor income are readily
available. With the growing facility in the use of the commodity flow method of estimating expenditures, an increasing
proportion of the national income is being estimated by expenditure method.

(b) (i) Following exchange rate quotations are available for different periods:
(1) The spot exchange rate changes from ₹ 65 per $ to ₹ 68 per $.
(2) The spot exchange rate changes from $ 0.0125 per rupee to $ 0.01625 per rupee.
Answer:
(A) Identify the nature of rate quotations in (1) and (2) above.
(B) Identify the base currency and counter currency in (1) and (2) above.
(C) What are possible consequences on exports and imports of (1) and (2) above.
(3 Marks)
(ii) ''The deposit multiplier and the money multiplier though closely related are not identical". Explain
briefly. (2 Marks)
Answer

(i) (A) The nature of rate quotations in (1) and (2)

In an exchange rate, two currencies are involved. There are two ways to express nominal exchange rate between two
currencies (here US $ and Indian Rupee) namely direct quote and indirect quote.
The nature of rate quotation in [(1) ₹ 65/per $] is direct quote, (also called European Currency Quotation). The
exchange rate is quoted in terms of the number of units of a local currency exchangeable for one unit of a foreign
currency. For example, 65/US$ means that an amount of 65 is needed to buy one US dollar or 65 will be received while
selling one US dollar.
An indirect quote is presented in [(2) $ 0.0125 per Rupee] of the question. In an indirect quote, (also known as American
Currency Quotation), the exchange rate is quoted in terms of the number of units of a foreign currency exchangeable for

988
one unit of local currency; for example: $ 0.0125 per rupee. In an indirect quote, domestic currency is the commodity
which is being bought and sold.
(B) The base currency and counter currency in (1) and (2)
An exchange rate has two currency components; a ‘base currency’ and a ‘counter currency’. The currency in the
numerator always states ‘how much of that currency is required for one unit of the base currency’.
• • In a direct quotation [in (1) ₹ 65/per $], the foreign currency is the base currency and the domestic currency is
the counter currency. So in the given question, US dollar is the base currency and Indian Rupee is the counter currency.
• • In an indirect quotation, [in (2) $ 0.0125 per Rupee], the domestic currency is the base currency and the
foreign currency is the counter currency. So in the given question, Indian Rupee is the base currency and US dollar is the
counter currency.
(C) The possible consequences on exports and imports of (1) and (2)
When the spot exchange rate changes from ₹ 65/per $ to ₹ 68/ per $, it indicates that a person has to exchange a
greater amount of Indian Rupees (68) to get the same 1 unit of US dollar. The rupee has become less valuable with
respect to the U.S. dollar or Indian Rupee has depreciated in its value. Simultaneously, the dollar has appreciated.
Consequence on exports and imports of (1)
Other things remaining the same, when a country’s currency depreciates, foreigners find that its exports are cheaper
and the quantity demanded of its export goods will increase. For example a foreigner who spends ten dollars on buying
Indian goods will, get goods worth ₹ 680 /- instead of ₹ 650/- prior to depreciation.
On the other hand, the domestic residents find that imports from abroad are more expensive. A resident of India, who
wants to import goods worth $1 will have to pay ₹ 68/- instead of ₹ 65/- prior to depreciation. Imports will be
discouraged as importers will have to pay more rupees per dollar for importing products.

In short, depreciation of domestic currency lowers the relative price of a country’s exports and raises the relative price
of its imports.
Consequence on exports and imports of (2)
In this case, Rupee has appreciated and dollar has depreciated. Earlier, $ 1.25 would fetch export goods worth ₹ 100/-
from India; but after the change $16.25 would be necessary to buy the same amount of goods.
Other things remaining the same, when a country’s currency appreciates, it raises the relative price of its exports and
lowers the relative price of its imports. In other words, foreigners find their imports from that country (exports from
India in the above case) costlier. Therefore quantity demanded of export goods would decrease.
On the other hand, the domestic residents find that imports from abroad are cheaper. Therefore, we may expect an
increase in the quantity of imports.
(ii) The Deposit Multiplier and the Money Multiplier
The money multiplier denotes by ‘how much the money supply will change for a given change in high-powered money’.
The deposit multiplier describes the amount of additional money created by commercial bank through the process of
lending the available money it has in excess of the central bank's reserve requirements. Though closely related they are
not identical because:
(a) Generally banks do not lend out all of their available money, but instead maintain reserves at a level above the
minimum required reserve. In other words, banks keep excess reserves.
(b) The public prefers to hold some cash and therefore, some of the increase in loans will not be deposited at the
commercial banks, but will be kept cash. This means, that when new reserves enter the banking system they will not be
multiplied entirely by the deposit multiplier into new demand deposits. Some money will leave the banking system in
the form of cash. Therefore, the money supply will be raised by less than the demand deposits.
If some portion of the increase in high-powered money finds its way into currency, this portion does not undergo
multiple deposit expansion. The size of the money multiplier is reduced when funds are held as cash rather than as
demand deposits.

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Question 11
(a) (i) What is the meant by 'Statutory Liquidity Ratio’? ·In which forms this ratio is maintained? (3 Marks)
(ii) Explain the concept of soft peg and hard peg exchange rate policies. (2 Marks)

ANSWER
(i) The Statutory Liquidity Ratio.
The Statutory Liquidity Ratio (SLR) is the ratio of a bank's liquid assets to its net demand and time liabilities (NDTL). The
SLR is a powerful tool for controlling liquidity in the domestic market by means of manipulating bank credit.
Changes in the SLR chiefly influence the availability of resources in the banking system for lending. A rise in the SLR
which is resorted to during periods of high liquidity, tends to lock up a rising fraction of a bank’s assets in the form of
eligible instruments, and this reduces the credit creation capacity of banks. A reduction in the SLR during periods of
economic downturn has the opposite effect.
As per the Banking Regulations Act 1949, all scheduled commercial banks in India are required to maintain a stipulated
percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL) in one of the following forms:
i (i) Cash
ii (ii) Gold, or
iii (iii) Investments in un-encumbered Instruments that include:
(a) Treasury-bills of the Government of India.
(b) Dated securities including those issued by the Government of India from time to time under the market borrowings
programme and the Market Stabilization Scheme (MSS).
(c) State Development Loans (SDLs) issued by State Governments under their market borrowings programme.
(d) Other instruments as notified by the RBI. These include mainly the securities issued by PSEs.

The SLR requires holding of assets in one of the above three categories by the bank itself.
(ii) The concept of soft peg and hard peg exchange rate policies
A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a
foreign currency or basket of currencies. Pegging a currency stabilizes the exchange rate between countries.
A soft peg refers to an exchange rate policy under which the exchange rate is generally determined by the market, but in
case the exchange rate tends to move speedily in one direction, the central bank will intervene in the market.
With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. Both
soft peg and hard peg policy require that the central bank intervenes in the foreign exchange market.

(b) (i) In which sectors Foreign Investment is prohibited in India? (3 Marks)

(ii) Explain the market outcome of price ceiling through diagram. (2 Marks)

ANSWER
(i) Sectors in which foreign investment is prohibited in India
In India, foreign investment is prohibited in the following sectors:
i (i) Lottery business including Government / private lottery, online lotteries, etc.

ii (ii) Gambling and betting including casinos etc.

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iii (iii) Chit funds

iv (iv) Nidhi company

v (v) Trading in Transferable Development Rights (TDRs)

vi (vi) Real Estate Business or Construction of Farm Houses

vii (vii) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

viii (viii) Activities / sectors not open to private sector investment e.g. atomic energy and railway operations (other
than permitted activities).
Foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management
contract is also prohibited for lottery business and gambling and betting activities.
(ii) The market outcome of price ceiling through diagram
When prices of certain essential commodities rise excessively, government may resort to controls in the form of price
ceilings (also called maximum price) for making a resource or commodity available to all at reasonable prices. For
example: maximum prices of food grains and essential items are set by government during times of scarcity. The market
outcome of price ceiling can be explained with the help of the following diagram.

(i) Sectors in which foreign investment is prohibited in India

In India, foreign investment is prohibited in the following sectors:
ix (i) Lottery business including Government / private lottery, online lotteries, etc.

x (ii) Gambling and betting including casinos etc.

xi (iii) Chit funds

xii (iv) Nidhi company

xiii (v) Trading in Transferable Development Rights (TDRs)

xiv (vi) Real Estate Business or Construction of Farm Houses

xv (vii) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes

xvi (viii) Activities / sectors not open to private sector investment e.g. atomic energy and railway operations (other
than permitted activities).

Foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management
contract is also prohibited for lottery business and gambling and betting activities.
(ii) The market outcome of price ceiling through diagram
When prices of certain essential commodities rise excessively, government may resort to controls in the form of price
ceilings (also called maximum price) for making a resource or commodity available to all at reasonable prices. For
example: maximum prices of food grains and essential items are set by government during times of scarcity. The market
outcome of price ceiling can be explained with the help of the following diagram.

Market Outcome of Price Ceiling

991
The intersection of demand and supply curves set the market price of the commodity in question at ₹ 150. Since the
market determined equilibrium price is considered high considering the welfare of people, the government intervenes in
the market and a price ceiling is set at ₹ 75/ which is below the prevailing market clearing price. At price ₹ 75/, the
quantity demanded is Q2 and the quantity supplied is only Q1. In other words, there is excess demand equal to Q1-Q2.
Thus the market outcome a price ceiling which is below the market-determined price leads to generation of excess
demand over supply.

OR

What is meant by 'Countervailing Duties'?

ANSWER

(ii) Countervailing Duties

Countervailing duties are tariffs imposed by an importing country with the aim of off-setting the artificially low prices
charged by exporters who enjoy export subsidies and tax concessions offered by the governments in their home
country.
If a foreign country does not have a comparative advantage in a particular product and a government subsidy allows the
foreign firm to artificially reduce the export price and be an exporter of the product, then the subsidy generates a
distortion from the free-trade allocation of resources. In such cases, CVD is charged by an importing country to negate

992
such advantage that exporters get from subsidies. This is done to ensure fair and market-oriented pricing of imported
products and thereby protecting domestic industries and firms.
PAST PAPER JAN 2021
SECTION – A: FINANCIAL MANAGEMENT

Question 1
(a) From the following information, complete the Balance Sheet given below:
(i) Equity Share Capital : ₹ 2,00,000
(ii) Total debt to owner's equity : 0.75
(iii) Total Assets turnover : 2 times
(iv) Inventory turnover : 8 times
(v) Fixed Assets to owner's equity : 0.60
(vi) Current debt to total debt : 0.40
Balance Sheet of XYZ Co. as on March 31, 2020

ANSWER

Balance Sheet of XYZ Co. as on March 31, 2020

993
Working Notes
1. Total Debt = 0.75 x Equity Share Capital = 0.75 x ₹ 2,00,000 = ₹ 1,50,000
Further, Current Debt to Total Debt = 0.40.
So, Current Debt = 0.40 x ₹ 1,50,000 = ₹ 60,000
Long term Debt = ₹ 1,50,000 - ₹ 60,000 = ₹ 90,000
2. Fixed Assets = 0.60 x Equity Share Capital = 0.60 x ₹ 2,00,000 = ₹ 1,20,000
3. Total Assets to Turnover = 2 times; Inventory Turnover = 8 times
Hence, Inventory /Total Assets = 2/8 =1/4
Further, Total Assets = ₹ 2,00,000 + ₹ 1,50,000 = ₹ 3,50,000
Therefore, Inventory = ₹ 3,50,000/4 = ₹ 87,500
Cash in Hand = Total Assets – Fixed Assets – Inventory
= ₹ 3,50,000 - ₹ 1,20,000 - ₹ 87,500 = ₹ 1,42,500

(b) The following information is taken from ABC Ltd.

Net Profit for the year ₹ 30,00,000
12% Preference share capital ₹ 1,00,00,000
Equity share capital (Share of ₹ 10 each) ₹ 60,00,000
Internal rate of return on investment 22%
Cost of Equity Capital 18%
Retention Ratio 75%

Calculate the market price of the share using:

(1) Gordon's Model
(2) Walter's Model (5 Marks)

ANSWER
(b) Market price per share by-
(1) Gordon’s Model:

OR

Where,
Po = Present market price per share.
g = Growth rate (br) = 0.75 X 0.22 = 0.165
b = Retention ratio (i.e., % of earnings retained)
r = Internal rate of return (IRR)
D0 = E x (1 – b) = 3 X (1 – 0.75) = 0.75

994
E = Earnings per share
Workings:
1. Calculation of Earnings per share

2. Calculation of Dividend per share

995
(c) A project requires an initial outlay of ₹ 3,00,000.
The company uses certainty equivalent method approach to evaluate the project. The risk
free rate is 7%.
Following information is available:

PV Factor at 7%

ANSWER
Statement Showing the Net Present Value of Project

996
(d) The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
Raw Material Storage period 45 days
Work-in-Progress conversion period 20 days
Finished Goods storage period 25 days
Debt Collection period 30 days
Creditors payment period 60 days
Annual Operating Cost ₹ 25,00,000
(Including Depreciation of ₹ 2,50,000)
Assume 360 days in a year.
You are required to calculate:
(i) Operating Cycle period
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cost basis.

(iv) The company is a market leader in its product and it has no competitor in the market.
Based on a market survey it is planning to discontinue sales on credit and deliver
products based on pre-payments in order to reduce its working capital requirement
substantially. You are required to compute the reduction in working capital
requirement in such a scenario. (5 Marks)

Answer

(i) Calculation of Operating Cycle Period:

Operating Cycle Period = R + W + F + D – C
= 45 + 20 + 25 + 30 – 60 = 60 days
(ii) Number of Operating Cycle in a Year

997

(iv) Reduction in Working Capital

Operating Cycle Period = R + W + F – C
= 45 + 20 + 25 – 60 = 30 days
Reduction in Working Capital = ₹ 3,75,000 – ₹ 1,87,500 = ₹ 1,87,500
Note: If we use Total Cost basis, then amount of Working Capital required will be
₹ 4,16,666.67 (approx.) and Reduction in Working Capital will be ₹ 2,08,333.33 (approx.)

Question 2
The information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as follows:
Equity Share Capital of ₹ 100 each ₹ 50 Lakhs
12% Bonds of ₹ 1000 each ₹ 30 Lakhs
Sales ₹ 84 Lakhs
Fixed Cost (Excluding Interest) ₹ 7.5 Lakhs
Financial Leverage 1.39
Profit-Volume Ratio 25%
Market Price per Equity Share ₹ 200
Income Tax Rate Applicable 30%
You are required to compute the following:
(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning per share
(iv) Earning Yield (10 Marks)

Answer

Workings:

998
3. Income Statement

999
Note: The question has been solved considering Financial Leverage given in the question
as the base for calculating total interest expense including the interest of 12% Bonds of
₹ 30 Lakhs. The question can also be solved in other alternative ways.

Question 3
A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt
and 40 per cent equity, whereas B Ltd. has 20 per cent debt and 80 per cent equity. (All
percentages are in market-value terms.) The borrowing rate for both companies is 8 per cent in
a no-tax world, and capital markets are assumed to be perfect.
(a) (i) If X, owns 3 per cent of the equity shares of A Ltd., determine his return i f the
Company has net operating income of ₹ 4,50,000 and the overall capitalization rate
of the company, (Ko) is 18 per cent.
(ii) Calculate the implied required rate of return on equity of A Ltd.
(b) B Ltd. has the same net operating income as A Ltd.
(i) Calculate the implied required equity return of B Ltd.
(ii) Analyse why does it differ from that of A Ltd.

Answer

(i) Return on Shares of X on A Ltd.

1000

(b) (i) Calculation of Implied rate of return of B Ltd

(ii) Implied required rate of return on equity of B Ltd. is lower than that of A Ltd. because
B Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear
function of the debt-to-equity ratio when we use the net operating income approach,
the decline in required equity return offsets exactly the disadvantage of not employing
so much in the way of “cheaper” debt funds.

Question 4
The Capital structure of PQR Ltd. is as follows:

Additional Information: 1001

(i) ₹ 100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The
market price per debenture is ₹ 110.
(ii) ₹ 100 per preference share redeemable at par has 3% floatation cost & 10 years of
maturity. The market price per preference share is ₹ 108.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 25. The next year
expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of
paying all earnings in the form of dividends.
(iv) Corporate Income Tax rate is 30%.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights.

ANSWER

Workings:

1002
Calculation of WACC using market value weights
WACC (Ko) = 0.129 or 12.9% (approx.)

Question 5
A company wants to buy a machine, and two different models namely A and B are available.
Following further particulars are available:

The company provides depreciation under Straight Line Method. Income tax rate applicable is
30%.
The present value of ₹ 1 at 12% discounting factor and net profit before depreciation and tax
are as under:

1003

Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period
method, NPV method and PI method. (10 Marks)
Answer
Workings:
(i) Calculation of Annual Depreciation

(ii) Calculation of Annual Cash Inflows

1004

(iii) Calculation of PV of Cash Flows

1. NPV (Net Present Value)
Machine – A
NPV = ₹ 8,18,909 - ₹ 8,00,000 = ₹ 18,909

Machine – B
NPV = ₹ 6,17,425 – ₹ 6,00,000 = ₹ 17,425
2. Discounted Payback Period
Machine – A

Machine – B

1005

3. PI (Profitability Index)
Machine – A
Machine – B

Suggestion:

Question 6
(a) State four tasks involved to demonstrate the importance of good Financial Management.
(4 Marks)

ANSWER
The best way to demonstrate the importance of good financial management is to
describe some of the tasks that it involves:
Taking care not to over-invest in fixed assets
Balancing cash-outflow with cash-inflows
Ensuring that there is a sufficient level of short-term working capital
Setting sales revenue targets that will deliver growth
Increasing gross profit by setting the correct pricing for products or services
Controlling the level of general and administrative expenses by finding more cost efficient ways of running the day-to-
day business operations, and
Tax planning that will minimize the taxes a business has to pay.

(b) Explain Electronic Cash Management System. (4 Marks)

1006
ANSWER

Electronic Cash Management System: Most of the cash management systems now-adays are electronically based, since
‘speed’ is the essence of any cash management system. Electronically, transfer of data as well as funds play a key role in
any cash management system. Various elements in the process of cash management are linked through a satellite.
Various places that are interlinked may be the place where the instrument is collected, the place where cash is to be
transferred in company’s account, the place where the payment is to be transferred etc.
(c) Define Internal Rate of Return (IRR)

Internal rate of return: Internal rate of return for an investment proposal is the discount rate that equates the present
value of the expected cash inflows with the initial cash outflow.

OR
Explain in brief the following bonds:
(i) Callable Bonds
(ii) Puttable Bonds

ANSWER

(i) Callable bonds: A callable bond has a call option which gives the issuer the right to redeem the bond before maturity
at a predetermined price known as the call price Generally at a premium).
(ii) Puttable bonds: Puttable bonds give the investor a put option (i.e. the right to sell
the bond) back to the company before maturity.

SECTION – B: ECONOMICS FOR FINANCE

Question 7
(a) Given the following equations:
C = 200 + 0.8Y
I = 1200
Calculate equilibrium level of National Income and the Consumption Expenditure at equilibrium level of
National Income. (3 Marks)

ANSWER
Y=C+I
Y = 200 + 0.8 Y + 1200
Y-0.8Y = 1400
0.2Y = 1400
Y = 1400/0.2 = 7000
C = 200+ 0.8 x 7000 = 5800

1007
(b) Distinguish between 'direct quote' and ‘indirect quote’ with re ference to express nominal
exchange rate between two currencies. (2 Marks)

ANSWER
Exchange rate is the rate at which the currency of one country is exchanged for the currency of another country. There
are two ways to express nominal exchange rate between two currencies namely direct quote and Indirect quote. A
direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency. The
price of 1 dollar may be quoted in terms of how much rupees it takes to buy one dollar.
An indirect quote is the number of units of a foreign currency exchangeable for one unit of local currency. A quotation
in direct form can easily be converted into a quotation in indirect form and vice versa. This is done by taking the
reciprocal of the given rate.
(c) Compute M2 supply of money from the following RBI data: (3 Marks)
(₹ in Crores)

ANSWER

M1 = Currency Notes and Coins with the people + demand deposits with the banking system (currency and saving
deposit accounts) + Other deposits with the RBI
= 435656.6 cr + 274254.9 cr + 1234.2 cr
= 711145.7 cr
M2 = M1 + Saving deposit with Post Office Saving Bank
= 711145.7cr + 647.7cr
= 711793.4 cr

(d) Explain the Transactions Motive for holding cash

ANSWER

The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business
exchange.’ The need for holding money arises between as there is lack of synchronization between receipts and
expenditures. The transaction motive is further classified into income motive and business motive, both of
which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of
income and planned expenditure. The transaction demand for money is a direct proportional and positive function of
the level of Income.

1008
Lr = KY
Where Lr is the transaction demand for money
K is the ratio of earnings which is kept for transaction purposes
Y is the earning.

Question 8
(a) Calculate GNP at market price from the following data using Value Added Method.
(₹ in Crores)
ANSWER

Gross Value Added at Market Price = Value of Output – Intermediate Consumption

= 1500+ 2700 + 2100- 750-1200-900
= 3450 cr
GNP at market Price = Gross Value Added at Market Price + Net factor Income from
Abroad
= 3450 + (-) 60
= 3390 cr

(b) (i) Distinguish between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
(3 Marks)
(ii) What do you mean by "Crowding Out" in relation to fiscal policy?

ANSWER

(i) Cash Reserve Ratio (CRR) refers to the average daily balance that a bank is required to maintain with the Reserve
bank of India as a share of its total net demand and time liabilities (NDTL). This Percentage will be notified from time to
time by Reserve bank of India. The RBI may set the ratio in keeping with the broad objective of maintaining monetary
stability in the economy. This requirement applies uniformly to all the scheduled banks in the country irrespective of its
size or financial position.

1009
Higher the CRR with the RBI, lower will be the liquidity in the system and vice versa. During Slowdown in the economy,
the RBI reduces the CRR in order to enable the banks to expand credit and increase the supply of money available in the
economy.

In order to contain credit expansion during the period of high inflation, the RBI increases the CRR.
As per the Banking Regulations Act 1949, all Schedule commercial banks in India are required to maintain a stipulated
percentage of their total Demand and Time liabilities (DTL)/ Net DTL (NDTL) in one of the following forms
(i) Cash
(ii) Gold
(iii) Investment in un-encumbered instruments that include
(a) Treasury bills of the Government of India
(b) Dated securities including those issued by the Government of India from
time to time under the market borrowings programme and the Market Stabilization Scheme (MSS).
(c) State Development loans (SDLs) issued by State Government under their market borrowings programme.
(d) Other instruments as notified by the RBI. These include mainly the securities issued by PSEs

While CRR has to be maintained by banks as cash with the RBI, the SLR requires holding of assets in one of the above
three categories by the bank itself. The Banks which fail to meet its SLR obligations are liable to be imposed penalty in
the form of penal interest payable to RBI. The SLR is also a powerful tool for controlling liquidity in the domestic market
by means of manipulating bank credit.

(ii) Government Spending would sometimes substitute private spending and when this happens the impact of
government spending on aggregate demand would be smaller than what it should be and therefore fiscal Policy may
become ineffective.

The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources
from the private sector to the public sector where productivity might be lower. An increase in the size of government
spending during recessions will crowd out private spending in an economy and lead to reduction in an economy’s ability
from the recession and possibly also reduce the economy’s prospects of long run economic growth.

Crowding out effect is the negative effect fiscal policy may generate when money from the private sector is crowded out
to the public sector. In other words when spending by government in an economy replaces private spending, the latter is
said to be crowded out.

Question 9
(a) (i) Compute GDP at market price and Mixed Income of Self-Employed from the data
given below :
(₹ in Crores)

1010

(ii) Due to Recession in an economy, Government expenditure increases by ₹ 6 billion.

If Marginal Propensity to Consume (MPC) in the economy is 0.8, compute the
increase in GDP. (2 Marks)

ANSWER
(i) GDP at Factor Cost: NDP at Factor Cost + Depreciation = 1450cr + 26cr = 1476 Cr
GDP at Market Price = GDP at Factor Cost + Net Indirect Taxes
= 1476cr + Indirect Taxes – Subsidies
= 1476cr + 39 cr
= 1515 Cr
NNP at Factor Cost = NDP at Factor cost + Net Factor Income from Abroad
NNP at Factor Cost = Compensation of employees + Operating Surplus + Mixed
Income of Self Employed + Net Factor Income from Abroad
Mixed Income of Self Employed = 1450cr – 1263 cr = 187 cr
(ii) Change in Income ÷ Change in Expenditure = 1- MPC = 1– 0.8 = 0.2
Change in Income × 0.2 = Change in Expenditure = 6 bn
Change in Income = 6 ÷0.2 = 30 bn
Hence the GDP will increase by 30 bn.

(b) (i) Describe the advantages of Floating Exchange Rate.

(ii) Discuss the role of 'Market Stabilization Scheme' in our economy. (2 Marks)

Answer

(i) Under floating exchange rate regime, the equilibrium value of the exchange rate of a country’s currency is market
determined i.e., the demand for and supply of currency relative to other currencies determine the exchange rate. A
floating exchange rate has many advantages:

(a) A floating exchange rate has the greatest advantage of allowing a Central bank and /or government to persue its own
monetary policy.
(b) Floating exchange rate regime allows exchange rate to be used as a policy tool: for example, policy makers can adjust
the nominal exchange rate to influence the competitiveness of the tradable goods sector.

(c) As there is no obligation or necessary to intervene in the currency markets, the Central bank is not required to
maintain a huge foreign exchange reserves. On the contrary a floating rate has greater policy flexibility but less stability.
(ii) Market Stabilization Scheme was introduced in 2004 as an Instrument for monetary
management with the primary aim of aiding the sterilization operations of the RBI.
(Sterilization is the process by which the monetary authority sterilizes the effects of significant foreign capital inflows on
domestic liquidity by off- loading parts of the stock of government securities held by it). Surplus liquidity of a more
enduring nature arising from large capital inflows is absorbed through sale of short, dated government securities and

1011
treasury bills. Under this Scheme, the government of India borrows from the RBI (Such borrowing being additional to its
normal borrowing requirements and issues treasury-bills/dated securities for absorbing excess liquidity from the market
arising from large capital inflows.

Question10
(a) (i) Describe the allocation instruments available to the Government to influence
resource allocation in an economy. 3
(ii) Explain the concept of 'Money Multiplier'. (2 Marks)
ANSWER
(i) The Resource allocation role of the government’s fiscal policy focuses on the potential of the government to improve
economic performance through its expenditure and tax policies. The allocative function in budgeting determines who
and what will be taxed as well as how and on what the government revenue will be spent. The allocative function also
involves the reallocation of society’s resources from private to public use.
A variety of allocation instruments are available by which governments can influence resource allocation in the
economy. For example:

Government may directly produce an economic good.

Government may influence private allocation through incentives and disincentives.
Government may influence allocation through its competitive policies, merger policies etc. which affect the structure
of industry and commerce.

Government’s regulatory activities such as licensing control minimum wages and directives on location of industry
influence resource allocation.

Government sets legal and administrative framework and

Any mixture of intermediate methods may be adopted by the government.

(ii) Money multiplier m is defined as a ratio that relates the changes in the money supply to a given change in the
monetary base. It is the ratio of the stock of money to the stock of high-powered money. It denotes by how much the
money supply will change for a given change in high powered money. It denotes by how much the money supply will
change for a given change in high powered money. The moneymultiplier process explains how an increase in the
monetary base causes, the money supply to increase by a multiplied amount. For example, if there is an
injection of ₹ 100cr through an open market operation by the Central Bank of the country and if it leads to an increment
of ₹ 500 cr of final money supply, then the money multiplier is said to be 5. Hence the multiplier indicates the change in
monetary base which is transformed into money supply. Money Multiplier (m) = Money Supply ÷ Monetary Base

(b) (i) Calculate the Fiscal Deficit and Primary Deficit from the data given below:
(₹ in Crores)

1012

(ii) Describe the purposes of Trade Barriers in international trade. (2 Marks)

Answer

(i) Fiscal Deficit = Total Expenditure on Revenue Account and Capital Account –
Revenue receipts- Non-debt Capital Receipts
= 547.2 – 226.82- 103.00
= 217.8 Cr
Primary Deficit = Fiscal Deficit – Interest Payments
= 217.8cr – 84.00cr
= 133.8 Cr.
(ii) Over the past decades significant transformation are happening in terms of growth as well as trends of flows and
pattern of global trade. The increasing importance of developing countries has been a salient feature of the shifting
global trade patterns. Fundamental changes are taking place in the way countries associate themselves
for International trade and investments. Trading through regional arrangements which foster closer trade and economic
relations is shaping the global trade landscape in an unprecedented way. Trade barriers create obstacles to trade,
reduce the prospect of market access, make imported goods more expensive, increase consumption of domestic goods,
protect domestic industries, and increase government revenue.

Question 11
(a) (i) You are given the following information:

(A) Which of the three exporters are engaged in anticompetitive act in theinternational market while pricing
its export of mobile phones to Dubai?
(B) What would be the effect of such pricing on domestic producers of mobile phones? (3 Marks)
(ii) Explain the significance of public debt as an instrument of fiscal policy. (2 Marks)

ANSWER
(i) China and Japan are engaged in anti-competitive act in the international market while pricing its export of mobile
phones to Dubai. Both China and Japan are selling at a price which is less than price per unit for domestic sales.

The effect of such pricing will be having adverse effect on domestic industry as they will lose competitiveness in their
domestic market due to unfair practice of dumping. Dubai may prove damage to domestic industries and change anti -

1013
dumping duties on goods imported from Japan and China so as to raise the price and making it at par
with similar goods produced by domestic firms.
(ii) If a government has borrowed money over the years to finance its deficits and has not paid it back through
accumulated surpluses then it is said to be in debt. Public debt may be internal or external, when the government
borrows from its own people in the country, it is called internal debt. On the other hand, when the government
borrows from outside sources, the debt is called external debt. Public debt takes two forms namely, market loans and
small savings. A national Policy of Public borrowing and debt repayment is a potent weapon to fight inflation and
deflation.

Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy.
Repayment of debt by government increases the availability of money in the economy and increase aggregate demand.
(b) (i) Describe the benefits and costs of FDI to the host country. (3 Marks)
ANSWER
(i) Benefit of Foreign Direct Investment:
Entry of foreign enterprises fosters competition and generates a competitive environment in the host country.
International capital allows countries to finance more investment than can be supported by domestic savings.
FDI can accelerate growth by providing much needed capital, technological know-how and management skill.
Competition for FDI among national government promotes political and structural reforms.
FDI also help in creating direct employment opportunities.
It also promotes relatively higher wages for skilled jobs.
FDI generally entails people to people relations and is usually considered as a promoter of bilateral and international
relations.
Foreign investment projects also would act as a source of new tax revenue which can be used for development
projects.

Cost of Foreign Direct Investment:

FDI are likely to concentrate on capital intensive methods of production and services so they need to hire few
workers.
FDI flows has tendency to move towards regions which is well endowed in natural resources and infrastructure so
accentuate regional disparity.
If foreign corporations are able to secure incentives in the form of tax holidays or similar provisions, the host country
loses tax revenue.
FDI is also held responsible by many for ruthless exploitation of natural resources and the possible environmental
damage.
With substantial FDI in developing countries there is strong possibility of emergence of a dual economy with a
developed foreign sector and an underdeveloped domestic sector.
Foreign entities are usually accused of being anti-ethical as they frequently resort to methods like aggregate
advertising and anticompetitive practices which would induce market distortions.

(ii) Explain the concept of 'private cost'. (2 Marks)

ANSWER
Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the case of a
producer his private cost includes direct cost of labour, materials, energy, and other indirect overheads.
Social Cost = Private cost + External Cost

1014
OR
What do you mean by 'Reserve Money'?

ANSWER

The Reserve Money, also known as central bank money, base money or high powered money determines the level of
liquidity and the price level in the economy. Reserve Money = Currency in Circulation + Banker’s deposits with the RBI +
other deposits with the RBI.
= Net RBI credit to the government + RBI credit to the commercial sector + RBI’s claim on banks + RBI’s net foreign
exchange assets + Government Currency liabilities to the Public- RBI’s net non-monetary liabilities
PAST PAPER JULY 2021
SECTION – A: FINANCIAL MANAGEMENT

Question 1
(a) Current annual sale of SKD Ltd. is ₹ 360 lakhs. It's directors are of the opinion that company's current
expenditure on receivables management is too high and with a view to reduce the expenditure they are
considering following two new alternate credit policies:
Policy X Policy Y
Average collection period 1.5 months 1 month
% of default 2% 1%
Annual collection expenditure ₹ 12 lakh ₹ 20 lakh
Selling price per unit of product is ₹ 150.
Total cost per unit is ₹ 120.
Current credit terms are 2 months and percentage of default is 3%.
Current annual collection expenditure is ₹ 8 lakh.
Required rate of return on investment of SKD Ltd. is 20%. Determine which credit policy SKD Ltd. should
follow. (5 Marks)
ANSWER

Statement showing the Evaluation of Credit policies (Total Approach)

1015
Recommendation: The Proposed Policy X should be followed since the net benefits under this policy are higher as
compared to other policies.
*Note: It is assumed that all sales are on credit.
Working Note:
Calculation of Opportunity Cost of Average Investments

Alternatively
Statement showing the Evaluation of Credit policies (Incremental Approach)

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Recommendation: The Proposed Policy X should be followed since the net benefits under this policy are higher as
compared to other policies.
*Note: It is assumed that all sales are on credit.
Working Note:
Calculation of Investment in Receivables

(b) The details about two companies R Ltd. and S Ltd. having same operating risk are given below:

Particulars R Ltd. S Ltd.

Profit before interest and tax ₹ 10 lakhs ₹ 10 lakhs
Equity share capital ₹ 10 each ₹ 17 lakhs ₹ 50 lakhs
Long term borrowings @ 10% ₹ 33 lakhs -
Cost of Equity (Ke) 18% 15%
You are required to:
(1) Calculate the value of equity of both the companies on the basis of M.M. Approach without tax.
(2) Calculate the Total Value of both the companies on the basis of M.M. Approach without tax.

ANSWER

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(1) Computation of value of equity on the basis of MM approach without tax

Particulars R Ltd. S Ltd.

(₹ in lakhs) (₹ in lakhs)
Profit before interest and taxes 10 10
Less: Interest on debt (10% × ₹ 33,00,000) 3.3 -
Earnings available to Equity shareholders 6.7 10
Ke 18% 15%
Value of Equity 37.222 66.667
(Earnings available to Equity shareholders/Ke)
(2) Computation of total value on the basis of MM approach without tax

Particulars R Ltd. S Ltd.

(₹ in lakhs) (₹ in lakhs)
Value of Equity (S) (as calculated above) 37.222 66.667
Debt (D) 33 -
Value of Firm (V) = S + D 70.222 66.667

(c) K.P. Ltd. is investing ₹ 50 lakhs in a project. The life of the project is 4 years. Risk free rate of return is 6%
and risk premium is 6%, other information is as under:

Sales of 1st year ₹ 50 lakhs

Sales of 2nd year ₹ 60 lakhs
Sales of 3rd year ₹ 70 lakhs
Sales of 4th year ₹ 80 lakhs
P/V Ratio (same in all the years) 50%
Fixed Cost (Excluding Depreciation) of 1st year ₹ 10 lakhs
Fixed Cost (Excluding Depreciation) of 2nd year ₹ 12 lakhs
Fixed Cost (Excluding Depreciation) of 3rd year ₹ 14 lakhs
Fixed Cost (Excluding Depreciation) of 4th year ₹ 16 lakhs

Ignoring interest and taxes,

You are required to calculate NPV of given project on the basis of Risk Adjusted Discount Rate.
Discount factor @ 6% and 12% are as under:

Year 1 2 3 4
Discount Factor @ 6% 0.943 0.890 0.840 0.792
Discount Factor@ 12% 0.893 0.797 0.712 0.636

ANSWER

Calculation of Cash Flow

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Year Sales P/V ratio (B) Contribution Fixed Cost Cash Flows
(₹ in Lakhs) (A) (₹ in Lakhs) (₹ in Lakhs) (₹ in lakhs)
(C) = (A x B) (D) (E) = (C – D)
1 50 50% 25 10 15
2 60 50% 30 12 18
3 70 50% 35 14 21
4 80 50% 40 16 24

When risk-free rate is 6% and the risk premium expected is 6%, then risk adjusted discount rate would be 6% + 6% =12%.
Calculation of NPV using Risk Adjusted Discount Rate (@ 12%)

Year Cash flows Discounting Factor Present Value of Cash Flows

(₹ in Lakhs) @ 12% (₹ in lakhs)
1 15 0.893 13.395
2 18 0.797 14.346
3 21 0.712 14.952
4 24 0.636 15.264

Total of present value of Cash flow 57.957

Less: Initial Investment 50.000
Net Present value (NPV) 7.957

(d) The following information relates to LMN Ltd.

Earning of the company ₹ 30,00,000

Dividend pay-out ratio 60%
No. of shares outstanding 5,00,000
Rate of return on investment 15%
Equity capitalized rate 13%

Required:
(i) Determine what would be the market value per share as per Walter's model.
(ii) Compute optimum dividend pay-out ratio according to Walter's model and the market value of
company's share at that pay-out ratio.

ANSWER

(i) Calculation of market value per share as per Walter’s model

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Where,
P = Market price per share.
E = Earnings per share = ₹ 30,00,000/5,00,000 = ₹ 6
D = Dividend per share = ₹ 6 x 0.60 = ₹ 3.6
r = Return earned on investment = 15%
Ke = Cost of equity capital = 13%
(ii) According to Walter’s model, when the return on investment (r) is more than the cost of equity capital (Ke), the price
per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in this case is
nil.
So, at a pay-out ratio of zero, the market value of the company’s share will be:

Question 2
Following are the information of TT Ltd.:

Earnings per share ₹ 10

Dividend per share ₹6
Expected growth rate in Dividend 6%
Current market price per share ₹ 120
Tax Rate 30%
Requirement of Additional Finance ₹ 30 lakhs
Debt Equity Ratio (For additional finance) 2:1
Cost of Debt
0-5,00,000 10%
5,00,001 - 10,00,000 9%
Above 10,00,000 8%

Assuming that there is no Reserve and Surplus available in TT Ltd.

You are required to:
(a) Find the pattern of finance for additional requirement
(b) Calculate post tax average cost of additional debt
(c) Calculate cost of equity

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(d) Calculate the overall weighted average after tax cost of additional finance. (10 Marks)

Answer

a) Pattern of raising additional finance

Equity 1/3 of ₹ 30,00,000 = ₹ 10,00,000

Debt 2/3 of ₹ 30,00,000 = ₹ 20,00,000
The capital structure after raising additional finance:

Particulars (₹)
Shareholder’s Funds
Equity Capital 10,00,000
Debt (Interest at 10% p.a.) 5,00,000
(Interest at 9% p.a.) 5,00,000
(Interest at 8% p.a.) (20,00,000–10,00,000) 10,00,000
Total Funds 30,00,000

Alternative Solution

Pattern of raising additional finance

Equity 1/3 of ₹ 30,00,000 = ₹ 10,00,000
Debt 2/3 of ₹ 30,00,000 = ₹ 20,00,000
The capital structure after raising additional finance:

(b) Determination of post-tax average cost of additional debt

Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate

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On First ₹ 5,00,000 = 10% (1 – 0.3) = 7% or 0.07

On Next ₹ 5,00,000 = 9% (1 – 0.3) = 6.3% or 0.063

On Next ₹ 10,00,000 = 8% (1 – 0.3) = 5.6% or 0.056

Average Cost of Debt

Alternative Solution
Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate
Kd = 8% (1 – 0.3) = 5.6%

(c) Determination of cost of equity applying Dividend growth model:

Where,

Ke = Cost of equity

D1 = D0 (1+ g)

D0 = Dividend paid

g = Growth rate = 6%

P0 = Current market price per share = ₹ 120

Alternative Solution

Determination of cost of equity applying Dividend growth model

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Where,
Ke = Cost of equity
D1 = D0 (1+ g)
D0 = Dividend paid
g = Growth rate =6%
P0 = Current market price per share = ₹ 120
(d) Computation of overall weighted average after tax cost of additional finance

(Note: In the above solution different interest rate have been considered for different slab of Debt)

Alternative Solution

Computation of overall weighted average after tax cost of additional finance

(Note: In the above solution single interest rate have been considered for Debt)

Question 3
Masco Limited has furnished the following ratios and information relating to the year ended 31st March
2021:

Sales ₹ 75,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 6:4
Current ratio 2.5
Net profit to sales (After Income Tax) 6.50%

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Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ₹ 22,50,000
Interest on debentures ₹ 75,000
Receivables (includes debtors ₹ 1,25,000) ₹ 2,00,000
Payables ₹ 2,50,000
Bank Overdraft ₹ 1,50,000

You are required to:

(a) Calculate the operating expenses for the year ended 31st March, 2021.
(b) Prepare a balance sheet as on 31st March in the following format:

ANSWER

(a) Calculation of Operating Expenses for the year ended 31st March, 2021

(b) Balance Sheet as on 31st March, 2021

1024
Working Notes:
(i) Calculation of Share Capital and Reserves
The return on net worth is 25%. Therefore, the profit after tax of ₹ 4,87,500 should be equivalent to 25% of the net
worth

The ratio of share capital to reserves is 6:4

Share Capital = 19,50,000 x 6/10 = ₹ 11,70,000
Reserves = 19,50,000 x 4/10 = ₹ 7,80,000
(ii) Calculation of Debentures
Interest on Debentures @ 15% (as given in the balance sheet format) = ₹ 75,000

(iii) Calculation of Current Assets

Current Ratio = 2.5
Payables = ₹ 2,50,000
Bank overdraft = ₹ 1,50,000
Total Current Liabilities = ₹ 2,50,000 + ₹ 1,50,000 = ₹ 4,00,000
Current Assets = 2.5 x Current Liabilities = 2.5 4,00,000 = ₹ 10,00,000
(iv) Calculation of Fixed Assets

Particulars ₹
Share capital 11,70,000
Reserves 7,80,000
Debentures 5,00,000
Payables 2,50,000
Bank Overdraft 1,50,000

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Total Liabilities 28,50,000
Less: Current Assets 10,00,000
Fixed Assets 18,50,000

(v) Calculation of Composition of Current Assets

Particulars ₹
Stock 1,87,500
Receivables 2,00,000
Cash (balancing figure) 6,12,500
Total Current Assets 10,00,000

Question 4
An existing company has a machine which has been in operation for two years, its estimated remaining
useful life is 4 years with no residual value in the end. Its current market value is ₹ 3 lakhs. The management
is considering a proposal to purchase an improved model of a machine gives increase output. The details are
as under:

Particulars Existing Machine New Machine

Purchase Price ₹ 6,00,000 ₹ 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ₹ 10 ₹ 10
Material cost per unit ₹2 ₹2
Output per hour in units 20 40
Labour cost per hour ₹ 20 ₹ 30
Fixed overhead per annum excluding depreciation ₹ 1,00,000 ₹ 60,000
Working Capital ₹ 1,00,000 ₹ 2,00,000

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Income-tax rate 30% 30%
Assuming that - cost of capital is 10% and the company uses written down value of depreciation @ 20% and
it has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method.
The discounting factors table given below:

Discounting Factors Year 1 Year 2 Year 3 Year 4

10% 0.909 0.826 0.751 0.683

ANSWER
(i) Calculation of Net Initial Cash Outflows:

Particulars ₹
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual Profit Before Tax and depreciation

Particulars Existing New Differential

machine Machine
(1) (2) (3) (4) = (3) – (2)
Annual output 36,000 units 72,000 units 36,000 units

(iii) Calculation of Net Present value on replacement of machine

Year PBTD Depreciati PBT Tax PAT Net cash PVF @ 10% PV

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on @ 20% @ 30% flow
WDV
(1) (2) (3) (4 = 2-3) (5) (6 = 4-5) (7 = 6 + 3) (8) (9 = 7 x 8)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.00
0
2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.60
0
3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.88
0
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.23
2
7,88,478.71
2
Add: Release of net working capital at year end 4 (1,00,000 x 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000
NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should be replaced.
Working Notes:
1. Calculation of Annual Output
Annual output = (Annual operating days x Operating hours per day) x output per hour
Existing machine = (300 x 6) x 20 = 1,800 x 20 = 36,000 units
New machine = (300 x 6) x 40 = 1,800 x 40 = 72,000 units

2. Base for incremental depreciation

(Note: The above solution have been done based on incremental approach)
Alternatively, solution can be done based on Total Approach as below:
(i) Calculation of depreciation:

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* As the company has several machines in 20% block, the value of Existing Machine from the block calculated as below
shall be added to the new machine of ₹ 10,00,000:

WDV of existing machine at the beginning of the year ₹ 3,84,000

Less: Sale Value of Machine ₹ 3,00,000
WDV of existing machine in the block ₹ 84,000
Therefore, opening balance for depreciation of block = ₹ 10,00,000 + ₹ 84,000 = ₹ 10,84,000
(ii) Calculation of annual cash inflows from operation:

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(iii) Calculation of Incremental Annual Cash Flow:

Particulars Year 1 (₹) Year 2 (₹) Year 3 (₹) Year 4 (₹)

Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

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Incremental Annual Cash Flow 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00
(B – A)

(iv) Calculation of Net Present Value on replacement of machine:

Year Incremental Annual Cash Discounting factor @ 10% Present Value of

Flow (₹) (A) (B) Incremental Annual Cash
Flow (₹) (A x B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232

Total Incremental Inflows 8,56,778.712

Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should be replaced.

Working Note:
Calculation of Net Initial Cash Outflows:

Particulars ₹
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required (₹ 2,00,000 – ₹ 1,00,000) 1,00,000
Net initial cash outflows 8,00,000

Question 5

A company had the following balance sheet as on 31st March, 2021:

1031
The additional information given is as under:

Fixed cost per annum (excluding interest) ₹ 6 crores

Variable operating cost ratio 60%

Total assets turnover ratio 2.5

Income-tax rate 40%

Calculate the following and comment:

(i) Earnings per share

(ii) Operating Leverage

(iii) Financial Leverage

(iv) Combined Leverage (10 Marks)

Answer

Total Assets = ₹ 30 crores

Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 30 x 2.5 = ₹ 75 crores

Computation of Profit after Tax (PAT)

Particulars (₹ in crores)
Sales 75.00
Less: Variable Operating Cost @ 60% 45.00
Contribution 30.00
Less: Fixed Cost (other than Interest) 6.00
EBIT/PBIT 24.00
Less: Interest on Debentures (15% x 15) 2.25
EBT/PBT 21.75
Less: Tax @ 40% 8.70
EAT/ PAT 13.05

(i) Earnings per Share

It indicates the amount the company earns per share. Investors use this as a guide while valuing the share and making
investment decisions. It is also an indicator used in comparing firms within an industry or industry segment.

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(ii) Operating Leverage

It indicates the choice of technology and fixed cost in cost structure. It is level specific. When firm operates beyond
operating break-even level, then operating leverage is low. It indicates sensitivity of earnings before interest and tax
(EBIT) to change in sales at a particular level.

(iii) Financial Leverage

The financial leverage is very comfortable since the debt service obligation is small vis -à-vis EBIT.

(iv) Combined Leverage

Or,
= Operating Leverage × Financial Leverage
= 1.25 x 1.103 = 1.379
The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital structure. It studies
how sensitive the change in EPS is vis-à-vis change in sales. The leverages operating, financial and combined are used as
measurement of risk.

Question 6
(a) Explain in brief the forms of Post Shipment Finance. (4 Marks)

ANSWER
(a) Post-shipment Finance: It takes the following forms:
(a) Purchase/discounting of documentary export bills: Finance is provided to exporters by purchasing export bills drawn
payable at sight or by discounting usance export bills covering confirmed sales and backed by documents including
documents of the title of goods such as bill of lading, post parcel receipts, or air consignment notes.
(b) E.C.G.C. Guarantee: Post-shipment finance, given to an exporter by a bank through purchase, negotiation or discount
of an export bill against an order, qualifies for post-shipment export credit guarantee. It is necessary, however, that
exporters should obtain a shipment or contracts risk policy of E.C.G.C. Banks insist on the exporters to take a contracts
shipments (comprehensive risks) policy covering both political and commercial risks. The Corporation, on acceptance of
the policy, will fix credit limits for individual exporters and the Corporation’s liability will be limited to the extent of the
limit so fixed for the exporter concerned irrespective of the amount of the policy.

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(c) Advance against export bills sent for collection: Finance is provided by banks to exporters by way of advance against
export bills forwarded through them for collection, taking into account the creditworthiness of the party, nature of
goods exported, usance, standing of drawee, etc.
(d) Advance against duty draw backs, cash subsidy, etc.: To finance export losses sustained by exporters, bank advance
against duty draw-back, cash subsidy, etc., receivable by them against export performance. Such advances are of clean
nature; hence necessary precaution should be exercised.

(b) Describe the salient features of FORFAITING. (4 Marks)

ANSWER
The Salient features of forfaiting are:
• • It motivates exporters to explore new geographies as payment is assured.
• • An overseas buyer (importer) can import goods and services on deferred payment terms.
• • The exporter enjoys reduced transaction costs and complexities of international trade transactions.
• • The exporter gets to compete in the international market and can continue to put his working capital to good
use to scale up operations.
• • While importers avail of forfaiting facility from international financial institutions in order to finance their
imports at competitive rates.

(c) List out the steps to be followed by the manager to measure and maximize the Shareholder's Wealth (2
Marks)
ANSWER
For measuring and maximising shareholders’ wealth, manager should follow:
Cash Flow approach not Accounting Profit
Cost benefit analysis
Application of time value of money.

OR
Explain the limitations of Average Rate of Return. (2 Marks)
Answer

Limitations of Average Rate of Return

➢ The accounting rate of return technique, like the payback period technique, ignores the time value of money and
considers the value of all cash flows to be equal.
➢ The technique uses accounting numbers that are dependent on the organization’s choice of accounting procedures,
and different accounting procedures, e.g., depreciation methods, can lead to substantially different amounts for an
investment’s net income and book values.
➢ The method uses net income rather than cash flows; while net income is a useful measure of profitability, the net
cash flow is a better measure of an investment’s performance.
➢ Furthermore, inclusion of only the book value of the invested asset ignores the fact that a project can require
commitments of working capital and other outlays that are not included in the book value of the project.

SECTION – B: ECONOMICS FOR FINANCE

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Question 7
(a) Explain the measurement of Net Domestic Product at market price. (2 Marks)

ANSWER
Net domestic product at market prices (NDPMP) is a measure of the market value of all final economic goods and
services, produced within the domestic territory of a country by its normal residents and non-residents during an
accounting year less depreciation. The portion of the capital stock used up in the process of production or depreciation
must be subtracted from final sales because depreciation represents capital consumption and therefore accost of
production.
NDPMP = GDPMP – Depreciation
(b) In the context of India, measure money supply (In crores of) (3 Marks)
(M3) as per guidelines published by Reserve Bank of India. ₹
(i) Currency notes and coins with the public 24,637.20
(ii) Demand deposits of Banks 2,01,589.60
(iii) Net time deposits with post office saving accounts 28,116.40
(iv) Other deposits with Reserve Bank 420.10
(v) Saving deposits with post office saving banks 415.25

ANSWER
M3 = M1 + time deposits with banking System
= Currency notes and coins with the people + demand deposits with the banking system (Current and Saving deposit
accounts) + other deposits with the RBI + time deposits with banking System
= 24637.20 + 201589.60 + 28116.40 + 420.10
= ₹ 254763.3 Cr

(c) Justify the role of public debt as an instrument of Fiscal Policy. (2 Marks)
ANSWER
A rational policy of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. Borrowing
from the public through the sale of bonds and securities curtails the aggregate demand in the economy. Repayments of
debt by governments increase the availability of money in the economy and increase aggregate demand.
Public debt may be internal or external; when the government borrows from its own people in the country, it is called
internal debt. On the other hand, when the government borrows from outside sources, the debt is called external debt.
Public debt takes two forms namely, market loans and small savings.

(d) Compare and contrast between devaluation and depreciation in the context of exchange rate. (3 Marks)
Answer

Devaluation is a monetary policy tool used by countries that have a fixed exchange rate or nearly fixed exchange rate
regime and involves a discrete official reduction in the otherwise fixed par value of a currency. The monetary authority
formally sets a new fixed rate with respect to a foreign reference currency or currency basket.
Depreciation lowers the relative price of a country’s exports, raises the relative price of its imports, increases demand
both for domestic import- competing goods and for exports, leads to output expansion, encourages economic activity,
increases the international competitiveness of domestic industries, increases the volume of exports, and improves trade
balance.

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Devaluation is a deliberate downward adjustment in the value of a country's currency relative to another country’s
currency or group of currencies or standard, in contrast depreciation is a decrease in a currency's value (relative to other
major currency benchmarks) due to market forces of demand and supply under a floating exchange rate and not due to
any government or central bank policy actions.

Question 8

(a) Calculate the national income using income and expenditure method from the data given below:
ANSWER

Income Method
NNP FC or National Income = Compensation of employees + Operating Surplus (rent + interest+ profit) + Mixed Income
of Self- employed+ Net Factor Income from Abroad
= 24000 + 10,000 + 28000 + (-300)
= ₹ 61700 Cr
Expenditure Method:
GDP=C+I+G+(X−M)
= personal consumption expenditure (c) + gross business fixed capital + inventory management (I) + govt purchases (G) +
(exports- imports)
GDPMP= 51000+7000+13000+3000+(4800-5600)

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= ₹ 73200cr
GNPmp = 73200+Net factor Income from Abroad
=₹ 73200+(-300) = ₹ 72900cr
NNPmp = ₹72900 – 4000 = ₹ 68900 cr
NNPfc or National Income = ₹ 68900-7200 = ₹ 61700cr

(b) (i) Describe various types of externalities which cause market failure. (3 Marks)

(ii) Mention any four sectors in which foreign direct investment is prohibited. (2 Mark

ANSWER
(i) There are four major reasons for market failure which are: Market power, Externalities, Public goods, and Incomplete
information. Sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as
part of the market price. Such costs or benefits which are not accounted for by the market price are called externalities
because they are “external” to the market.
The four possible types of externalities are:
• • Negative production externalities: A negative externality initiated in production which imposes an external
cost on others may be received by another in consumption or in production. As an example, a negative production
externality occurs when a factory which produces aluminum discharges untreated waste water into a nearby river and
pollutes the water causing health hazards for people who use the water for drinking and bathing. Additionally, there is
no market in which these external costs can be reflected in the price of aluminum.

Positive production externalities: A positive production externality is received in consumption when an individual
raises an attractive garden and the persons walking by enjoy the garden. These external effects were not in fact
considered when the production decisions were made.
• Negative consumption externalities: Negative consumption externalities are extensively experienced by us in our day-
to-day life. Such negative consumption externalities initiated in consumption which produce external costs on others
may be received in consumption or in production
• Positive consumption externalities: A positive consumption externality initiated in consumption that confers external
benefits on others may be received in consumption or in production. For example, if people get immunized against
contagious diseases, they will confer a social benefit to others as well by preventing others from getting infected.

The presence of externalities creates a divergence between private and social costs of production. When negative
production externalities exist, social costs exceed private cost because the true social cost of production would be
private cost plus the cost of the damage from externalities. Negative externalities impose costs on society that extend
beyond the cost of production as originally intended and borne by the producer. If producers do not take into account
the externalities, there will be over- production and market failure.
Externalities cause market inefficiencies because they hinder the ability of market prices to convey accurate information
about how much to produce and how much to consume.

Question 9
(a) (i) Justify the following statements in the light of holding cash balance. (3 Marks)
(1) For investment in interest bearing assets

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(2) In the prevailing scenario, usually all transactions are made through online or E-banking.
(3) Money is a unique store of value
(ii) Briefly describe any two advantages of fixed exchange rate regime in the context of open economy. (2
Marks)

ANSWER
(i) (1) For Investment in interest bearing assets: The speculative motive reflects people’s desire to hold cash in order to
be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people
demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as
future changes in bond prices.
(2) In the prevailing scenario, usually all transactions are made through online or E banking: The transactions motive
for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for
holding money arises because there is lack of synchronization between receipts and expenditures.
(3) Money is a unique store of value: Many unforeseen and unpredictable contingencies involving money payments
occur in our day-to-day life. Individuals as well as businesses keep a portion of their income to finance such
unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of
income, prevailing economic as well as political conditions and personal characteristics of the individual such as
optimism/ pessimism, farsightedness etc.
(ii) A fixed exchange rate, also referred to as pegged exchange rate, is an exchange rate regime under which a country’s
government announces, or decrees, what its currency will be worth in terms of either another country’s currency or a
basket of currencies or another measure of value, such as gold.

A fixed exchange rate avoids currency fluctuations and eliminates exchange rate risks and transaction costs, enhances
international trade and investment, and lowers the levels of inflation. But the central bank has to maintain an adequate
amount of reserves and be always ready to intervene in the foreign exchange market.

(b) (i) Define Common Access Resources. Why they are over-used? Explain. (2 Marks)
(ii) Explain in brief any four effects of Tariffs on importing and exporting countries.
(3 Marks)

ANSWER

(i) Common access resources or common pool resources are a special class of impure public goods which are non-
excludable as people cannot be excluded from using them. These are rival in nature and their consumption lessens the
benefits available for others. They are generally available free of charge. Some important natural resources fall into this
category. Examples of common access resources are fisheries, forests, backwaters, common pastures, rivers, sea,
backwaters biodiversity etc.
Since price mechanism does not apply to common resources, producers and consumers do not pay for these resources
and therefore, they overuse them and cause their depletion and degradation. This creates threat to the sustainability of
these resources and, therefore, the availability of common access resources for future generations.
(ii) Tariffs, also known as customs duties, are basically taxes or duties imposed on goods and services which are
imported or exported. They are the most visible and universally used trade measures that determine market access for
goods. Instead of a single tariff rate, countries have a tariff schedule which specifies the tariff collected on every
particular good and service.
Effect of tariff on importing and exporting countries is as follows:
• • Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of

1038
international trade. The prospect of market access of the exporting country is worsened when an importing country
imposes a tariff.
• • By making imported goods more expensive, tariffs discourage domestic consumers from consuming imported
foreign goods. Domestic consumers suffer a loss in consumer surplus because they must now pay a higher price for the
good and also because compared to free trade quantity, they now consume lesser quantity of the good.
• • Tariffs encourage consumption and production of the domestically produced import substitutes and thus
protect domestic industries.
• • Producers in the importing country experience an increase in well-being as a result of imposition of tariff. The
price increase of their product in the domestic market increases producer surplus in the industry. They can also charge
higher prices than would be possible in the case of free trade because foreign competition has reduced.
• The price increase also induces an increase in the output of the existing firms and possibly addition of new
firms due to entry into the industry to take advantage of the new high profits and consequently an increase in
employment in the industry.
• • Tariffs create trade distortions by disregarding comparative advantage and prevent countries from enjoying
gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in the rest of the
world and encourage inefficient production in the home country.
• • Tariffs increase government revenues of the importing country by the value of the total tariff it charges.

Question 10

(a) (i) Fisher's equation of exchange is: MV =PT. If velocity (V) = 25, Price (P) 110.5 and volume of transaction
(T) = 200 billion. (3 Marks)
Calculate:
(1) Total money supply (m)
(2) Effect on M when velocity (V) increases to 75
(3) Velocity (V) when the volume of transactions increases to 325 billion.
(ii) Briefly explain the advantages of two key concepts of New Trade theories to countries when importing
goods to compete with products from the home country.
(2 Marks)

ANSWER
(i) (1) MV = PT
M× 25 = 110.5 ×200
Therefore,25 M = 22100
Then M = 22100÷25 = 884 bn
Total supply supply (m) = 884bn
(2) M ×75 = 110.5 × 200
M = 110.5 × 200÷ 75 = 294.66bn
Hence supply of money will reduce from 884bn to 294.66bn
(3) MV = PT

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Economies of Scale: As a firm produces more of a product, its cost per unit keeps going down. So, if the firm serves
domestic as well as foreign market instead of just one, then it can reap the benefit of large scale of production
consequently the profits are likely to be higher.
• Network effects refer to the way one person’s value for a good or service is affected by the value of that good or
service to others. The value of the product or service is enhanced as the number of individuals using it increases. A good
example will be Mobile App such as What’s App and software like Microsoft Windows.

884× V= 110.5×325 V = 40.62bn

When Volume of transaction increases to 325bn velocity (v) will be 40.62bn
(ii) New Trade Theory helps in understanding why developed and big countries trade partners are when they are trading
similar goods and services. This is particularly true in key economic sectors such as electronics, IT, food, and automotive.
According to New Trade Theory, two key concepts give advantages to countries that import goods to compete with
products from the home country:

(b) (i) Mention any three key objectives of World Trade Organisation. (3 Marks)
(ii) Describe the differences between Liquidity Adjustment Facility (LAF) and Marginal Standing Facility
(MSF). (2 Marks)
Answer
(i) The WTO does its functions by acting as a forum for trade negotiations among member governments, administering
trade agreements, reviewing national trade policies, cooperating with other international organizations, and assisting
developing countries in trade policy issues through technical assistance and training programmes. The WTO, accounting
for about 95% of world trade, currently has 164 members, of which 117 are developing countries or separate customs
territories.
The WTO has six key objectives:
• • to set and enforce rules for international trade
• • to provide a forum for negotiating and monitoring further trade liberalization
• • to resolve trade disputes
• • to increase the transparency of decision-making processes
• • to cooperate with other major international economic institutions involved in global economic management,
and
• • to help developing countries benefit fully from the global trading system.

(b) (ii) The Liquidity Adjustment Facility (LAF) enables the RBI to modulate short-term liquidity under varied
financial market conditions to ensure stable conditions in the overnight (call) money market. The LAF consists
of overnight as well as term repo auctions. The aim of term repo is to help develop the inter-bank term money
market. Currently, the RBI provides financial accommodation to the commercial banks through repos/reverse
repos under the Liquidity Adjustment Facility (LAF).
The Marginal Standing Facility (MSF) announced by the Reserve Bank of India (RBI) in its Monetary Policy, 2011-12 refers
to the facility under which scheduled commercial banks can borrow additional amount of overnight money from the
central bank over and above what is available to them through the LAF window by dipping into their Statutory Liquidity
Ratio (SLR) portfolio up to a limit ( a fixed per cent of their net demand and time liabilities deposits (NDTL) liable to
change every year ) at a penal rate of interest.
The MSF would be the last resort for banks once they exhaust all borrowing options including the liquidity adjustment
facility on which the rates are lower compared to the MSF.

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Question 11
(a) (i) The equation of 'consumption function' of an economy is as follows: (3 Marks)
C = ₹ 450 + 0. 70 y
You are required to compute the following:
(1) Consumption when disposable income (y) is ₹ 3,500 and ₹ 5,800.
(2) Saving when disposable income (y) is ₹ 3,500 and ₹ 5,500.
(3) Amount induced when disposable income is ₹ 3,200.
(ii) Distinguish between horizontal, vertical and conglomerate type of foreign investments. (2 Marks)
ANSWER
(i) C = 450 + 0.70y
(1) Consumption when disposable income (y) is ₹ 3,500 and ₹ 5800 C = 450 + 0.70 × 3500 = 2900
C = 450 + 0.70 × 5800 = 4510
(2) Saving when disposable income (y) is ₹ 3500 & ₹ 5,500 When y = ₹ 3500, C = ₹2900
S = y-c = 3500-2900= 600
When y = 5500
C = 450 + 0.70 ×5500 = 4300
S = y-c = 5500-4300= 1200
(3) Amount induced when disposable income is ₹ 3200
Y = C+I
C= 450 + 0.70× 3200 = 2690
3200 = 2690 + I
I = 510
(ii) Based on the nature of foreign investments, FDI may be categorized as horizontal, vertical, or conglomerate.
A horizontal direct investment is said to take place when the investor establishes the same type of business operation in
a foreign country as it operates in its home country, for example, a cell phone service provider based in the United
States moving to India to provide the same service.
A vertical investment is one under which the investor establishes or acquires a business activity in a foreign country
which is different from the investor’s main business activity yet in some way supplements its major activity. For
example, an automobile manufacturing company may acquire an interest in a foreign company that supplies parts or
raw materials required for the company.
A conglomerate type of foreign direct investment is one where an investor makes a foreign investment in a business
that is unrelated to its existing business in its home country. This is often in the form of a joint venture with a foreign
firm already operating in the industry, as the investor has no previous experience.

(b) (i) Explain the concept of 'Voluntary Export Restraints'. Under which circumstances exporters commit to
voluntary export restraint? Discuss. (3 Marks)
(ii) Mention any four arguments made in favour of Foreign Direct Investment to developing economy like
India. (2 Marks)

ANSWER
(i) Voluntary Export Restraints (VERs) refer to a type of informal quota administered by an exporting country voluntarily
restraining the quantity of goods that can be exported out of that country during a specified period of time.

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The inducement for the exporter to agree to a VERs is mostly to appease the importing country and to avoid the effects
of possible retaliatory trade restraints that may be imposed by the importer. VERs may arise when the import-
competing industries seek protection from a surge of imports from exporting countries. VERs cause, as do tariffs and
quotas, domestic prices to rise and cause loss of domestic consumer surplus.
(ii) Foreign direct investment (FDI), according to IMF manual on 'Balance of payments' is "all investments involving a
long-term relationship and reflecting a lasting interest and control of a resident entity in one economy in an enterprise
resident in an economy other than that of the direct investor”.

the increasing interdependence of national economies and the consequent trade relations and international industrial
cooperation established among them
• desire to reap economies of large-scale operation arising from technological growth
• shared common language or common boundaries and possible saving in time and transport costs because of
geographical proximity
• promoting optimal utilization of physical, human, financial and other resources
• desire to capture large and rapidly growing high potential emerging markets with substantially high and growing
population
• stable political environment and overall favourable investment climate in the host country
• lower level of economic efficiency in host countries and identifiable gaps in development
• tax differentials and tax policies of the host country which support foreign direct investment. However, a low tax
burden cannot compensate for a generally fragile and unattractive FDI environment.

Arguments in favour of foreign Direct Investment to developing economy like India are as follows:

OR
Explain the concept of Real Exchange Rate. (2 Marks)
ANSWER
The ‘real exchange rate' incorporates changes in prices and describes ‘how many’ of a good or service in one country can
be traded for ‘one’ of that good or service in a foreign country.
For calculating real exchange rate, in the case of trade in a single good, we must first use the nominal exchange rate to
convert the prices into a common currency. The real exchange rate (RER) between two currencies is the product of the
nominal exchange rate and the ratio of prices between the two countries

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RTP- JULY 2021

PART A: FINANCIAL MANAGEMENT QUESTIONS

Ratio Analysis
1. Given below are the estimations for the next year by Niti Ltd.:

The company will issue equity funds of ₹ 5 crores in the next year. It is also considering the debt
alternatives of ₹ 3.32 crores for financing the assets. The company wants to adopt one of the policies given
below: (₹ in crores)

Assuming corporate tax rate at 30%, CALCULATE the following for each of the financing policy:
(i) Return on total assets
(ii) Return on owner's equity
(iii) Net Working capital

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(iv) Current Ratio

Also advise which Financing policy should be adopted if the company wants high returns.

ANSWER

(i) Return on total assets

(ii) Return on owner's equity (Amount in ₹)

(iii) Net Working capital (₹ in crores)

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(iv) Current ratio (₹ in crores)

Advise: It is advisable to adopt aggressive financial policy, if the company wants high return as the return on owner's
equity is maximum in this policy i.e. 26.44%.

Cost of Capital
2. Indel Ltd. has the following capital structure, which is considered to be optimum as on 31st March, 2021:

The company share has a market price of ₹ 47.20. Next year dividend per share is 50% of year 2020 EPS. The
following is the uniform trend of EPS for the preceding 10 years which is expected to continue in future.

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is ₹ 96. Preference shares of ₹ 18.50 (with annual dividend of ₹ 2.22 per share) were also issued.

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The company is in 30% tax bracket.
(A) CALCULATE after tax: (i) Cost of new debt (ii) Cost of new preference shares (iii) New equity share
(assuming new equity from retained earnings)
(B) CALCULATE marginal cost of capital when no new shares are issued.
(C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be
sold, assuming that the retained earnings for next year’s investment is 50 percent of earnings of 2020.
(D) COMPUTE marginal cost of capital when the fund exceeds the amount calculated in (C), assuming new
equity is issued at ₹ 40 per share?

ANSWER
(B) Calculation of marginal cost of capital

(C) The company can spend the following amount without increasing marginal cost of capital and without selling the

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new shares:
Retained earnings = 50% of EPS of 2020 × outstanding equity shares = 50% of ₹ 4.72 × 10,000 shares = ₹ 23,600
The ordinary equity (Retained earnings in this case) is 80% of total capital. S So, ₹ 23,600 = 80% of Total Capital ∴ Capital
investment before issuing equity shares =23,600 / 0.80 = ₹ 29,500
(D) If the company spends in excess of ₹ 29,500, it will have to issue new equity shares at ₹ 40 per share.
Capital Structure
3. Zordon Ltd. has net operating income of ₹ 5,00,000 and total capitalization of ₹ 50,00,000 during the
current year. The company is contemplating to introduce debt financing in capital structure and has various
options for the same. The following information is available at different levels of debt value:

Assuming no tax and that the firm always maintains books at book values, you are REQUIRED to calculate:
(i) Amount of debt to be employed by firm as per traditional approach. (ii) Equity capitalization rate, if MM
approach is followed.

ANSWER
(a) Amount of debt to be employed by firm as per traditional approach Calculation of Equity, Wd and We

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Statement of Weighted Average Cost of Capital (WACC)

So, amount of Debt to be employed = ₹ 15,00,000 as WACC is minimum at this level of debt i.e. 9.8%. (b) As per MM
approach, cost of the capital (Ko) remains constant and cost of equity increases linearly with debt.

Statement of Equity Capitalization rate (ke) under MM approach

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Leverage
4. Following information has been extracted from the accounts of newly incorporated Textyl Pvt. Ltd. for
the Financial Year 2020-21: Sales ₹ 15,00,000 P/V ratio 70% Operating Leverage 1.4 times Financial Leverage
1.25 times
 Using the concept of leverage, find out and verify in each case:
(i) The percentage change in taxable income if sales increase by 15%.
(ii) The percentage change in EBIT if sales decrease by 10%.
(iii) The percentage change in taxable income if EBIT increase by 15%.

ANSWER
Workings:
1. Contribution = Sales x P/V ratio = ₹ 15,00,000 x 70% = ₹ 10,50,000

6. Income Statement

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Or, Combined Leverage = Operating Leverage x Financial Leverage = 1.4 x 1.25 = 1.75 times So, if sales is increased by
15% then taxable income (EBT) will be increased by 1.75 × 15% = 26.25% Verification

Increase in Earnings before tax (EBT) = ₹ 7,57,500 - ₹ 6,00,000 = ₹ 1,57,500

(ii) Degree of Operating Leverage (Given) = 1.4 times So, if sales is decreased by 10% then EBIT will be decreased by 1.4
× 10% = 14%
Verification

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Decrease in Earnings before interest and tax (EBIT) = ₹ 7,50,000 - ₹ 6,45,000 = ₹ 1,05,000

(iii) Degree of Financial Leverage (Given) = 1.25 times So, if EBIT increases by 15% then Taxable Income (EBT) will be
increased by 1.25 × 15% = 18.75%
Verification
Increase in Earnings before Tax = ₹ 7,12,500 - ₹ 6,00,000 = ₹ 1,12,500

Investment Decisions
5. The General Manager of Merry Ltd. is considering the replacement of five-year-old equipment. The
company has to incur excessive maintenance cost of the equipment. The equipment has zero written down
value. It can be modernized at a cost of ₹ 1,40,000 enhancing its economic life to 5 years. The equipment
could be sold for ₹ 30,000 after 5 years. The modernization would help in material handling and in reducing
labour , maintenance & repairs costs. The company has another alternative to buy a new machine at a cost
of ₹ 3,50,000 with an economic life of 5 years and salvage value of ₹ 60,000. The new machine is expected
to be more efficient in reducing costs of material handling, labour , maintenance & repairs, etc.

The annual cost are as follows:

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Assuming tax rate of 50% and required rate of return of 10%, should the company modernize the equipment
or buy a new machine? PV factor at 10% are as follows:

ANSWER
Workings:
Calculation of Depreciation:
(i) Calculation of Incremental annual cash inflows/ savings:

(ii) Calculation of Net Present Value (NPV)

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Advise: The company should modernize its existing equipment and not buy a new machine because NPV is positive in
modernization of equipment

Risk Analysis in Capital Budgeting

6. X Ltd is considering installation of new machine with the following details:

Consider Life of the project as 4 years with no salvage value.

Required:
(i) CALCULATE the expected NPV of the project.
(ii) COMPUTE the impact on the project’s NPV if change in variables is as under and
also compute which variable is having maximum impact on NPV.

PV factor at 12% are as follows:

ANSWER
(i) Calculation of Net Cash Inflow per year:

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Calculation of expected Net Present Value (NPV) of the Project:

(ii) Sensitivity Analysis under variable different value:

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The above table shows that by varying one variable at a time while keeping the others
constant, the impact in percentage terms on the NPV of the project. Thus, it can be seen
that the change in units sold per year has the maximum effect on the NPV by 32.35%.

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Dividend Decision
7. The following information is supplied to you:
Applying Walter’s Model: (i) ANALYSE whether the company is following an optimal dividend policy. (ii)
COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share. (iii) Will your
decision change if the P/E ratio is 8 instead of 12.5? ANALYSE.

ANSWER
(i) The EPS of the firm is ₹ 10 (i.e., ₹ 2,00,000/ 20,000) and r = 2,00,000/ (20,000 shares × ₹100) = 10%. The P/E Ratio is
given at 12.5 and the cost of capital, Ke, may be taken at the inverse of P/E ratio. Therefore, Ke is 8 (i.e., 1/12.5). The firm
is distributing total dividends of ₹ 1,50,000 among 20,000 shares, giving a dividend per share of ₹ 7.50. the value of the
share as per Walter’s model may be found as follows:

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total earnings of ₹ 2,00,000. Since, the rate of return of
the firm, r, is 10% and it is more than the Ke of 8%, therefore, by distributing 75% of earnings, the firm is not following an
optimal dividend policy. The optimal dividend policy for the firm would be to pay zero dividend and in such a situation,
the market price would be-

So, theoretically the market price of the share can be increased by adopting a zero payout. (ii) The P/E ratio at which the
dividend policy will have no effect on the value of the share is such at which the Ke would be equal to the rate of return,
r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy would
have no effect on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5 and in such a situation ke> r
and the market price, as per Walter’s model would be:

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Management of Working Capital

8. MT Ltd. has been operating its manufacturing facilities till 31.3.2021 on a single shift working with the
following cost structure:
As at 31.3.2021 with the sales of ₹ 17,28,000, the company held:

In view of increased market demand, it is proposed to double production by working an extra shift. It is
expected that a 10% discount will be available from suppliers of raw materials in view of increased volume
of business. Selling price will remain the same. The credit period allowed to customers will remain
unaltered. Credit availed from suppliers will continue to remain at the present level i.e. 2 months. Lag in
payment of wages and overheads will continue to remain at one month. You are required to CALCULATE the
additional working capital requirements, if the policy to increase output is implemented, to assess the
impact of double shift for long term as a matter of production policy.

ANSWER
Workings: (1) Statement of cost at single shift and double shift working

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Comparative Statement of Working Capital Requirement

Analysis: Additional Working Capital requirement = ₹ 10,91,200 – ₹ 7,28,000 = ₹3,63,200, if the policy to increase output
is implemented.

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9. While applying for financing of working capital requirements to a commercial bank, TN Industries Ltd.
projected the following information for the next year:
Additional Information:
(a) Raw Materials are purchased from different suppliers leading to different credit period allowed as
follows: X – 2 months; Y– 1 months; Z – ½ month

(b) Production cycle is of ½ month. Production process requires full unit of X and Y in the beginning of the
production. Z is required only to the extent of half unit in the beginning and the remaining half unit is
needed at a uniform rate during the production process.

(c) X is required to be stored for 2 months and other materials for 1 month.

(d) Finished goods are held for 1 month.

(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed by debtors is 2
months.

(f) Average time lag in payment of all overheads is 1 months and ½ months for direct labour.

(g) Minimum cash balance of ₹ 8,00,000 is to be maintained.

CALCULATE the estimated working capital required by the company on cash cost basis if the budgeted level 1059
of activity is 1,50,000 units for the next year. The company also intends to increase the estimated working
capital requirement by 10% to meet the contingencies. (You may assume that production is carried on
evenly throughout the year and direct labour and other overheads accrue similarly.)

ANSWER
Statement showing Working Capital Requirements of TN Industries Ltd. (on cash cost basis)
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Workings: 1.

2. Calculation of cost of WIP

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Miscellaneous
10. (i) "Profit Maximization cannot be the sole objective of a company". COMMENT.
(ii) DISCUSS the advantages and disadvantages of raising funds by issue of preference shares.
ANSWER
(i) Following are the reasons due to which Profit Maximization cannot be the sole objective of a company: (a) The
term profit is vague. It does not clarify what exactly it means. It conveys a different meaning to different people. For
example, profit may be in short term or long-term period; it may be total profit or rate of profit etc. (b) Profit
maximisation has to be attempted with a realisation of risks involved. There is a direct relationship between risk and
profit. Many risky propositions yield high profit. Higher the risk, higher is the possibility of profits. If profit maximisation
is the only goal, then risk factor is altogether ignored. This implies that finance manager will accept highly risky proposals
also, if they give high profits. In practice, however, risk is very important consideration and has to be balanced with the
profit objective. (c) Profit maximisation as an objective does not take into account the time pattern of returns.
Proposal A may give a higher amount of profits as compared to proposal B, yet if the returns of proposal A begin to flow
say 10 years later, proposal B may be preferred which may have lower overall profit but the returns flow is more early
and quick. (d) Profit maximisation as an objective is too narrow. It fails to take into account the social considerations as
also the obligations to various interests of workers, consumers, society, as well as ethical trade practices. If these factors
are ignored, a company cannot survive for long. Profit maximization at the cost of social and moral obligations is a short
sighted policy.

(ii) Advantages and disadvantages of raising funds by issue of preference shares

Advantages
(i) No dilution in EPS on enlarged capital base – On the other hand if equity shares are issued it reduces EPS, thus
affecting the market perception about the company.

(ii) There is also the advantage of leverage as it bears a fixed charge (because companies are required to pay a fixed rate
of dividend in case of issue of preference shares). Non-payment of preference dividends does not force a company into
liquidity.

(iii) There is no risk of takeover as the preference shareholders do not have voting rights except where dividend
payment are in arrears.

(iv) The preference dividends are fixed and pre-decided. Hence preference shareholders cannot participate in surplus
profits as the ordinary shareholders can except in case of participating preference shareholders. (v) Preference capital

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can be redeemed after a specified period.

Disadvantages
(i) One of the major disadvantages of preference shares is that preference dividend is not tax deductible and so does
not provide a tax shield to the company. Hence, preference shares are costlier to the company than debt e.g. debenture.

(ii) Preference dividends are cumulative in nature. This means that if in a particular year preference dividends are not
paid they shall be accumulated and paid later. Also, if these dividends are not paid, no dividend can be paid to ordinary
shareholders. The non-payment of dividend to ordinary shareholders could seriously impair the reputation of the
concerned company.
SECTION: B: ECONOMICS FOR FINANCE
QUESTIONS
1. (a) The nominal and real GDP of a country in a particular year are ₹ 3000 Crores and ₹ 4700 Crores
respectively. Calculate GDP deflator and comment on the level of prices of the year in comparison with the
base year.
(b) Differentiate excess demand and deficient demand.

ANSWER

The price level has fallen since GDP deflator is less than 100 at 63.83

(b) If the aggregate demand for an amount of output is greater than the full employment level of output, then we say
there is excess demand. Excess demand gives rise to ‘inflationary gap’. On the other hand, if the aggregate demand for
an amount of output is less than the full employment level of output, then we say there is deficient demand. Deficient
demand gives rise to a ‘deflationary gap’ or ‘recessionary gap’. Recessionary gap is also known as ‘contractionary gap’

2. Calculate National Income by Expenditure method and Income method with the help of following data:

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ANSWER
By Expenditure method
GDPMP = Private final consumption expenditure + Government final consumption expenditure + Gross domestic capital
formation (Net domestic capital formation + depreciation) + Net export
= 2000 + 1100 + (770+ 130) + 30= 4030 Crores
NNPFC or NI = GDPMP – Depreciation + NFIA – NIT
= 4030 – 130 + 20 – 120= 3800 Crores
By Income method
NNPFC or NI = Compensation of Employees+ Operating Surplus+ Mixed Income of Self-Employed + NFIA
= 1200+ 1820+ 700+ 20= 3740 Crores

3. (a) Illustrate with an example the redistribution effect of a tax and transfer policy.
(b) Discuss the importance of the distinction between private costs and social costs.

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ANSWER
(a) Inequality and the resulting loss of social welfare is sought to be tackled by government through an appropriately
framed tax and transfer policy. This involves progressive taxation combined with provision of subsidy to low-income
households. Proceeds from progressive taxes may be used to finance public services, especially those such as public
housing, which particularly benefit low income households. Few examples are: supply of essential food grains at highly
subsidized prices to BPL households, free or subsidized education, healthcare, housing, rations and basic goods etc. to
the deserving people.
(b) Private cost is the cost faced by the producer or consumer directly involved in a transaction. Social costs refer to the
total costs to the society on account of a production or consumption activity and include external costs as well. The
actors in the transaction (consumers or producers) tend to ignore those external costs and these are not included in
firms’ income statements or consumers’ decisions. However, these external costs are real and important as far as the
society is concerned. If producers do not take into account the externalities, there will be over-production and market
failure. Applying the same logic, negative consumption externalities lead to a situation where the social benefit of
consumption is less than the private benefit. Therefore, it is important that a distinction be made between private costs
and social costs.

4. (a) Describe direct government actions to solve negative externalities.

(b) For an Economy with the following specifications
Consumption, C = 50+0.75 Yd
Investment, I = 100
Government Expenditure, G = 200
Transfer Payments, R= 110
Income Tax = 0.2Y
Calculate the equilibrium of income and the value of expenditure multiplier.

ANSWER
(a) Direct controls prohibit specific activities that explicitly create negative externalities or require that the negative
externality be limited to a certain level, for instance limiting emissions.
Government initiatives towards negative externalities may include
1. Direct controls that openly regulate the actions of those involved in generating negative externalities, and
2. Market-based policies that would provide economic incentives so that the self-interest of the market participants
would achieve the socially optimal solution.
Direct controls prohibit specific activities that explicitly create negative externalities or require that the negative
externality be limited to a certain level, for instance limiting emissions. Production, advertising, use and sale of many
commodities and services may be prohibited. Stringent rules may be established in respect of advertising, packaging and
labelling etc. Governments may, through legislation, stipulate stringent standards such as environmental standards,
emissions standards non adherence of which will invite monetary penalties or/and criminal liabilities. Another method is
to create negative incentives through charging fees on activities creating negative externalities Governments may also
form special bodies/ boards to specifically address the problem of negative externality. The market-based approaches
(such as environmental taxes and cap-and-trade), operate through price mechanism to create an incentive for change.
(b) The level of disposable income Yd is given by
Yd = Y-Tax + Transfer Payments
Where, Transfer Payment = 110
= Y-0.2 Y+110 = 0.8Y +110

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and C = 50+0.75 Yd
= 50+0.75(0.8Y +110) (where Yd = 0.8Y +110)
= 50+ (0.75×0.8Y) + (0.75X110) =132.50+0.6Y
C = 132.50+0.6 Y
Now Y = C+I+G, Where C = 132.50+0.6Y, I = 100, G = 200 (Given)
Y = (132.50+0.6Y) +100+200
= 432.50+0.6Y
Y-0.6Y = 432.50
0.4Y = 432.50

or Y = 432.50/0.4 = 1,081.25 Crores

5. (a) (i) Calculate velocity of money when-
Money Supply = 5000 billion
Price =110
Volume of transaction = 200
(ii) What will be the outcome if volume of transaction increases to 225?
(b) Assess the role of Bank Rate as an instrument of monetary policy.

ANSWER
(a) (i) MV=PT;
5000 x V = 110x200, Therefore V = 4.4
(ii) If Volume of transaction 225, then V= 4.95
(b) The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and, therefore, as and when the MSF
rate changes alongside policy repo rate changes, the bank rate also changes automatically. Now bank rate is used only
for calculating penalty on default in the maintenance of Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR).

6. (a) Explain the concept of Liquidity Trap.

(b) (i) Examine the relationship between purchasing power of money and general price level.
(ii) Why do people demand money for precautionary motive?

ANSWER
(a) Liquidity trap is a situation where the desire to hold bonds is very low and approaches zero, and the demand to hold
money in liquid form as an alternative approaches infinity. People expect a rise in interest rate and the consequent fall
in bond prices and the resulting capital loss. The speculative demand becomes perfectly elastic with respect to interest
rate and the speculative money demand curve becomes parallel to the X axis.
(b) (i) Value of money is linked to its purchasing power. Purchasing power is the inverse of the average or general level
of prices as measured by the consumer price index.
(ii) The amount of money demanded under the precautionary motive is to meet unforeseen and unpredictable

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contingencies involving money payments and depends on the size of the income, prevailing economic as well as political
conditions and personal characteristics of the individual such as optimism/ pessimism, farsightedness etc.

7. How real GDP is a better measure of economic well -being? Explain.

ANSWER
Real GDP is calculated in such a way that the goods and services produced in a particular year are evaluated at some
constant set of prices or constant prices. In other words, it is calculated using the prices of a selected ‘base year’. For
example, if 2011-12 is selected as the base year, then real GDP for 2020-21 will be calculated by taking the quantities of
all goods and services produced in 2020-21 and multiplying them by their 2011-12 prices. Thus, real GDP or GDP at
constant prices refers to the total money value of the final goods and services produced within the domestic territory of
a country during an accounting year, estimated using base year prices. Real GDP is an inflation-adjusted measure and is
not affected by changes in prices; it changes only when there is change in the amount of output produced in the
economy. Therefore, Real GDP is a better measure of economic well-being as it shows the true picture of the change in
production of an economy.
The calculation of real GDP gives us a useful measure of inflation known as GDP deflator. The GDP deflator is the ratio of
nominal GDP in a given year to real GDP of that year.
GDP Deflator = Nominal GDP / Real GDP X100

8. Briefly explain the New Trade Theory and its importance.

ANSWER
New Trade Theory (NTT) is an economic theory that was developed in the 1970s as a way to understand international
trade patterns. NTT helps in understanding why developed and big countries are trade partners when they are trading
similar goods and services. These countries constitute more than 50% of world trade.
This is particularly true in key economic sectors such as electronics, IT, food, and automotive. We have cars made in the
India, yet we purchase many cars made in other countries.
These are usually products that come from large, global industries that directly impact international economies. The
mobile phones that we use are a good example. India produces them and also imports them. NTT argues that, because
of substantial economies of scale and network effects, it pays to export phones to sell in another country. Those
countries with the advantages will dominate the market, and the market takes the form of monopolistic competition.
Monopolistic competition tells us that the firms are producing a similar product that isn 't exactly the same, but awfully
close. According to NTT, two key concepts give advantages to countries that import goods to compete with products
from the home country . These are:
Economies of Scale: As a firm produces more of a product, its cost per unit keeps going down. So if the firm serves
domestic as well as foreign market instead of just one, then it can reap the benefit of large scale of production
consequently the profits are likely to be higher.
Network effects refer to the way one person’s value for a good or service is affected by the value of that good or service
to others. The value of the product or service is enhanced as the number of individuals using it increases. This is also
referred to as the ‘bandwagon effect’. Consumers like more choices, but they also want products and services with high
utility, and the network effect increases utility obtained from these products over others. A good example will be Mobile
App such as what’s App and software like Microsoft Windows.

9. (a) Describe different technical barriers to trade (TBT) and their effects on trade?

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(b) Explain Export Duties.

ANSWER
(a) Technical Barriers to Trade (TBT) which cover both food and non-food traded products refer to mandatory ‘Standards
and Technical Regulations’ that define the specific characteristics that a product should have, such as its size, shape,
design, labelling / marking / packaging, functionality or performance and production methods, excluding measures
covered by the SPS Agreement. The specific procedures used to check whether a product is really conforming to these
requirements (conformity assessment procedures e.g. testing, inspection and certification) are also covered in TBT. This
involves compulsory quality, quantity and price control of goods before shipment from the exporting country.
Just as SPS, TBT measures are standards-based measures that countries use to protect their consumers and preserve
natural resources, but these can also be used effectively as obstacles to imports or to discriminate against imports and
protect domestic products. Altering products and production processes to comply with the diverse requirements in
export markets may be either impossible for the exporting country or would obviously raise costs, hurting the
competitiveness of the exporting country. Some examples of TBT are: food laws, quality standards, industrial standards,
organic certification, eco-labelling, and marketing and label requirements.
(b) An export duty tax is a tax collected on exported goods and may be either specific or ad valorem. The effect of an
export tax is to raise the price of the good and to decrease exports. Since an export tax reduces exports and increases
domestic supply, it also reduces domestic prices and leads to higher domestic consumption.

10. (a) What is Arbitrage? What is the outcome of Arbitrage?

(b) Mention the types of transactions in the forex market?
ANSWER
(a) Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an asset at
different dealing places. On account of arbitrage, regardless of physical location, at any given moment, all markets tend
to have the same exchange rate for a given currency.
(b) There are two types of transactions in a forex market; current transactions which are carried out in the spot market
and future transactions involving contracts to buy or sell currencies for future delivery which are carried out in forward
and futures markets.

RTP- NOV 2021

PART A: FINANCIAL MANAGEMENT
QUESTIONS
Ratio Analysis
1. Following information has been gathered from the books of Cram Ltd. for the year ended 31st March
2021, the equity shares of which is trading in the stock market at ₹ 28:

Particulars Amount (₹)

Equity Share Capital (Face value @ ₹ 20) 20,00,000
10% Preference Share capital 4,00,000
Reserves & Surplus 16,00,000
12.5% Debentures 12,00,000

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Profit before Interest and Tax for the year 8,00,000

CALCULATE the following when company falls within 25% tax bracket:
(i) Return on Capital Employed
(ii) Earnings Per share
(iii) P/E Ratio

ANSWER
(i) Return on Capital Employed (ROCE)

= 15.38% (approx.)

(ii) Earnings Per share (EPS)

(iii) P/E Ratio

Workings:
(a) Income Statement
Particulars Amount (₹)
Profit before Interest and Tax (PBIT) 8,00,000

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Interest on Debentures (12.5% of ₹ 12,00,000) (1,50,000)
Profit before Tax (PBT) 6,50,000
Tax @ 25% (1,62,500)
Profit after Tax (PAT) 4,87,500
Preference Dividend (10% of ₹ 4,00,000) (40,000)
Profit available to Equity shareholders 4,47,500

(b) Calculation of Capital Employed

= Equity Shareholder's Fund + Preference share Capital + Debentures
= (₹ 20,00,000 + ₹ 16,00,000) + ₹ 4,00,000 + ₹ 12,00,000 = ₹ 52,00,000
Cost of Capital
2. Kalyanam Ltd. has an operating profit of ₹ 34,50,000 and has employed Debt which gives total Interest
Charge of ₹ 7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8% respectively.
The firm has a new proposal before it, which requires funds of ₹ 75 Lakhs and is expected to bring an
additional profit of ₹ 14,25,000. To finance the proposal, the firm is expecting to issue an additional debt at
8% and will not be issuing any new equity shares in the market. Assume no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:
(i) Before the new Proposal
(ii) After the new Proposal

ANSWER
Workings:

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(i) Calculation of Weighted Average Cost of Capital (WACC) before the new proposal
Sources Amount (₹) Weight Cost of Capital WACC
Equity 1,68,75,000 0.6429 0.160 0.1029
Debt 93,75,000 0.3571 0.080 0.0286
Total 2,62,50,000 1 0.1315 or 13.15 %

(ii) Calculation of Weighted Average Cost of Capital (WACC) after the new proposal
Sources Amount (₹) Weight Cost of Capital WACC
Equity 1,68,75,000 0.5000 0.209 0.1045
Debt 1,68,75,000 0.5000 0.080 0.0400
Total 3,37,50,000 1 0.1445 or 14.45 %
Capital Structure

3. Blue Ltd., an all equity financed company is considering the repurchase of ₹ 275 lakhs equity shares and
to replace it with 15% debentures of the same amount. Current market value of the company is ₹ 1,750
lakhs with its cost of capital of 20%. The company's Earnings before Interest and Taxes (EBIT) are expected
to remain constant in future years. The company also has a policy of distributing its entire earnings as
dividend.
Assuming the corporate tax rate as 30%, you are required to CALCULATE the impact on the following on
account of the change in the capital structure as per Modigliani and Miller (MM) Approach:
(i) Market value of the company
(ii) Overall Cost of capital
(iii) Cost of equity

ANSWER
3. Workings:

Income Statement

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(i) Market value of the company

Market value of levered firm = Value of unlevered firm + Tax Advantage
= ₹ 1,750 lakhs + (₹ 275 lakhs x 0.3)
= ₹ 1,832.5 lakhs
Change in market value of the company = ₹ 1,832.5 lakhs – ₹ 1,750 lakhs
= ₹ 82.50 lakhs
The impact is that the market value of the company has increased by ₹ 82.50 lakhs due to replacement of equity with
debt.
(ii) Overall Cost of Capital
Market Value of Equity = Market value of levered firm - Equity repurchased
= ₹ 1,832.50 lakhs – ₹ 275 lakhs = ₹ 1,557.50 lakhs
Cost of Equity (Ke) = (Net Income to equity holders / Market value of equity ) 100
= (₹ 321.12 lakhs / ₹ 1,557.50 lakhs ) x 100 = 20.62%
Cost of debt (Kd) = I (1 - t) = 15 (1 - 0.3) = 10.50%

Components Amount Cost of Capital Weight WACC (Ko)

(₹ In lakhs) % %
Equity 1,557.50 20.62 0.85 17.53
Debt 275.00 10.50 0.15 1.58
1832.50 1 19.11

The impact is that the Overall Cost of Capital or Ko has fallen by 0.89% (20% - 19.11%) due to the benefit of tax relief on
debt interest payment.
(iii) Cost of Equity
The impact is that cost of equity has risen by 0.62% (20.62% - 20%) due to the presence of financial risk i.e. introduction
of debt in capital structure.
Note: Cost of Capital and Cost of equity can also be calculated with the help of following formulas, though there will be
no change in the final answers.
Cost of Capital (Ko) = Keu [1 – (t x L)]
Where,
Keu = Cost of equity in an unlevered company
t = Tax rate

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Where,
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
t = Tax rate
Leverage
4. The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given:

Output 1,00,000 units at normal capacity

Selling price per unit ₹ 40
Variable cost per unit ₹ 20
Fixed cost ₹ 10,00,000

The capital structure of the company as on 31st March, 2021 is as follows:

Particulars ₹
Equity share capital (1,00,000 shares of ₹ 10 each) 10,00,000
Reserves and surplus 5,00,000
7% debentures 10,00,000
Current liabilities 5,00,000
Total 30,00,000
Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve ₹ 10
lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by ₹ 5,00,000 and
variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling
price without any adverse impact on the market.
The following alternative schemes for financing the proposed expansion programme are planned:
(i) Entirely by equity shares of ₹ 10 each at par.
(ii) ₹ 5 lakh by issue of equity shares of ₹ 10 each and the balance by issue of 6% debentures of ₹ 100 each at
par.
(iii) Entirely by 6% debentures of ₹ 100 each at par.
FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference
to the risk and return involved, assuming a corporate tax of 40%.

ANSWER - (₹ in ‘00,000)

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 1074

From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial Leverage
differs. Alternative (iii) uses the maximum amount of debt and result into the highest degree of financial leverage,
followed by alternative (ii). Accordingly, risk of the company will be maximum in these options. Corresponding to this
scheme, however, maximum EPS (i.e., ₹ 10.02 per share) will be also in option (iii).
So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In case of opting for
less risk, alternative (ii) is the next best option with a reduced EPS of ₹ 6.80 per share. In case of alternative (i), EPS is
even lower than the existing option, hence not recommended.
Investment Decisions
5. HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of ₹ 2,40,000 on 31st
March 2021. The machine has begun causing problems with breakdowns and it cannot fetch more than ₹
30,000 if sold in the market at present. It will have no realizable value after 10 years. The company has been
offered ₹ 1,00,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of ₹ 4,50,000. The expected life of new machine is 10 years with salvage value of ₹
35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down value
method depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.
Given below are the expected sales and costs from both old and new machine:

Old machine (₹) New machine (₹)

Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075

From the above information, ANALYSE whether the old machine should be replaced or not if required rate
of return is 10%? Ignore capital gain tax.
PV factors @ 10%:

Year 1 2 3 4 5 6 7 8 9 10

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PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

ANSWER
Workings:
1. Calculation of Base for depreciation or Cost of New Machine
Particulars (₹)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000

2. Calculation of Profit before tax as per books

Particulars Old machine New machine Difference
(₹) (₹) (₹)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per books 24,000 41,500 17,500
Profit before tax and depreciation (PBTD) 3,48,750 4,28,750 80,000

Calculation of Incremental NPV

Year PVF PBTD Dep. @ 7.5% PBT Tax @ 30% Cash Inflows PV of Cash
@ 10% (₹) (₹) (₹) (₹) (₹) Inflows
(₹)
1 2 3 4 (5) = (4) x 0.30 (6) = (4) – (5) + (7) = (6) x (1)
(3)
1 0.909 80,000. 26,250.00 53,750 16,125.00 63,875.00 58,062.38
00 .00
2 0.826 80,000. 24,281.25 55,718 16,715.63 63,284.38 52,272.89
00 .75
3 0.751 80,000. 22,460.16 57,539 17,261.95 62,738.05 47,116.27
00 .84
4 0.683 80,000. 20,775.64 59,224 17,767.31 62,232.69 42,504.93
00 .36
5 0.621 80,000. 19,217.47 60,782 18,234.76 61,765.24 38,356.21
00 .53
6 0.564 80,000. 17,776.16 62,223 18,667.15 61,332.85 34,591.73
00 .84
7 0.513 80,000. 16,442.95 63,557 19,067.12 60,932.88 31,258.57
00 .05
8 0.467 80,000. 15,209.73 64,790 19,437.08 60,562.92 28,282.88
00 .27
9 0.424 80,000. 14,069.00 65,931 19,779.30 60,220.70 25,533.58
00 .00
10 0.386 80,000. 13,013.82 66,986 20,095.85 59,904.15 23,123.00
00 .18
3,81,102.44

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Add: PV of Salvage value of new machine (₹ 35,000 X 0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44

Analysis: Since the Incremental NPV is positive, the old machine should be replaced.

Risk Analysis in Capital Budgeting

6. TIP Ltd. is considering two mutually exclusive projects M and N. You have been given below the Net Cash
flow probability distribution of each project:
(i) REQUIRED:
(a) Expected Net Cash Flow of each project.
(b) Variance of each project.
(c) Standard Deviation of each project.
(d) Coefficient of Variation of each project.
(ii) IDENTIFY which project would you recommend? Give reasons.

ANSWER
(i) (a) Expected Net Cash Flow (ENCF) of Projects

(b) Variance of Projects

Project M
= (62,500 – 76,250)2 (0.3) + (75,000 – 76,250)2 (0.3) + (87,500 – 76,250)2 (0.4)
= 5,67,18,750 + 4,68,750 + 5,06,25,000 = 10,78,12,500
Project N
= (1,62,500 – 1,30,000)2 (0.2) + (1,37,500 – 1,30,000)2 (0.3) + (1,12,500 – 1,30,000)2 (0.5)
= 21,12,50,000 + 1,68,75,000 + 15,31,25,000 = 38,12,50,000

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(c) Standard Deviation of Projects
Project M
= √Variance = √10,78,12,500 = 10,383.2798
Project N
= √Variance = √ 38,12,50,000 = 19,525.6242

(d) Coefficient of Variation of Projects

(ii) Coefficient of Variation of Project M is 0.1362 and Project N is 0.1502. So, the risk per rupee of net cash flow is less of
Project M, therefore, Project M is better than Project N.

Dividend Decision
7. Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2021. The existing
market price per share is ₹ 150. Expected dividend is ₹ 8 per share. The rate of capitalization appropriate to
the risk class to which the company belongs is 10%.
(i) CALCULATE the market price per share when expected dividends are: (a) declared, and (b) not declared,
based on the Miller – Modigliani approach.
(ii) CALCULATE number of shares to be issued by the company at the end of the accounting year on the
assumption that the net income for the year is ₹ 3 crore, investment budget is ₹ 6 crores, when (a)
Dividends are declared, and (b) Dividends are not declared.
(iii) PROOF that the market value of the shares at the end of the accounting year will remain unchanged
irrespective of whether (a) Dividends are declared, or (ii) Dividends are not declared.
Management of Receivables (Debtors)

ANSWER

(i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach

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Where,
Existing market price (Po) = ₹ 150
Expected dividend per share (D1) = ₹ 8
Capitalization rate (ke) = 0.10
Market price at year end (P1) = to be determined
(a) If expected dividends are declared, then
(b) If expected dividends are not declared, then

(ii) Calculation of number of shares to be issued

(iii) Calculation of market value of the shares

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Hence, it is proved that the total market value of shares remains unchanged irrespective of whether dividends are
declared, or not declared
8. The Alliance Ltd., a Petrochemical sector company had just invested huge amount in its new expansion
project. Due to huge capital investment, the company is in need of an additional ₹ 1,50,000 in working
capital immediately. The Finance Manger has determined the following three feasible sources of working
capital funds:
(i) Bank loan: The Company's bank will lend ₹ 2,00,000 at 15%. A 10% compensating balance will be
required, which otherwise would not be maintained by the company.
(ii) Trade credit: The company has been offered credit terms from its major supplier of 3/30, net 90 for
purchasing raw materials worth ₹ 1,00,000 per month.
(iii) Factoring: A factoring firm will buy the company’s receivables of ₹ 2,00,000 per month, which have a
collection period of 60 days. The factor will advance up to 75% of the face value of the receivables at 12% on
an annual basis. The factor will also charge commission of 2% on all receivables purchased. It has been
estimated that the factor’s services will save the company a credit department expense and bad debt
expense of ₹ 1,250 and ₹ 1,750 per month respectively.
On the basis of annual percentage cost, ADVISE which alternative should the company select? Assume 360
days year.

ANSWER
(i) Bank loan: Since the compensating balance would not otherwise be maintained, the real annual cost of taking bank
loan would be:
=. 15 × 100 / 90 = 16.67% p.a

(ii) Trade credit: Amount upto ₹ 1,50,000 can be raised within 2 months or 60 days. The real annual cost of trade credit
would be:

(iii) Factoring:
Commission charges per year = 2% (₹ 2,00,000 12) = ₹ 48,000
Total Savings per year = (₹ 1,250 + ₹ 1,750) 12 = ₹ 36,000
Net factoring cost per year = ₹ 48,000 - ₹ 36,000 = ₹ 12,000
Annual Cost of Borrowing ₹ 1,50,000 receivables through factoring would be:

1080

Advise: The company should select alternative of Bank Loan as it has the lowest annual cost i.e. 16.67% p.a

Management of Working Capital

9. The management of Trux Company Ltd. is planning to expand its business and consults you to prepare an
estimated working capital statement. The records of the company reveals the following annual information:
Sales – Domestic at one month’s credit 18,00,000
Export at three month’s credit (sales price 10% below domestic price) 8,10,000
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000
Lag in payment of Administration Expenses – 1 month 1,80,000
Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four installments, of which one falls in the next 1,68,000
financial year

Rate of gross profit is 20%. Ignore work-in-progress and depreciation.

The company keeps one month’s stock of raw materials and finished goods (each) and believes in keeping ₹
2,50,000 available to it including the overdraft limit of ₹ 75,000 not yet utilized by the company.
The management is also of the opinion to make 10% margin for contingencies on computed figure.
You are required to PREPARE the estimated working capital statement for the next year.

ANSWER
Preparation of Statement of Working Capital Requirement for Trux Company Ltd.

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 1082
Working Notes:
1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic (₹) Export (₹) Total (₹)

Domestic Sales 18,00,000 8,10,000 26,10,000
Less: Gross profit @ 20% on domestic sales and 3,60,000 90,000 4,50,000
11.11% on export sales (Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,000
Add: Selling expenses (Working note-3) 77,586 34,914 1,12,500
Cash Cost of Sales 15,17,586 7,54,914 22,72,500
2. Calculation of gross profit on Export Sales
Let domestic selling price is ₹ 100. Gross profit is ₹ 20, and then cost per unit is ₹ 80
Export price is 10% less than the domestic price i.e. ₹ 100 – (1- 0.1) = ₹ 90
Now, gross profit will be = ₹ 90 - ₹ 80 = ₹ 10

3. Apportionment of Selling expenses between Domestic and Exports sales:

Apportionment on the basis of sales value:

4. Assumptions
(i) It is assumed that administrative expenses is related to production activities.
(ii) Value of opening and closing stocks are equal

Miscellaneous
10. (a) DISCUSS the points that demonstrates the Importance of good financial management.

ANSWER
Points that demonstrate the "Importance of good financial management":
▪ Taking care not to over-invest in fixed assets
▪ Balancing cash-outflow with cash-inflows
▪ Ensuring that there is a sufficient level of short-term working capital
▪ Setting sales revenue targets that will deliver growth
▪ Increasing gross profit by setting the correct pricing for products or services
▪ Controlling the level of general and administrative expenses by finding more cost-efficient ways of running the day-to-
day business operations, and

1083
▪ Tax planning that will minimize the taxes a business has to pay.

(b) EXPLAIN some common methods of Venture capital financing.

ANSWER
Some common methods of venture capital financing are as follows:
(i) Equity financing: The venture capital undertakings generally require funds for a longer period but may not
be able to provide returns to the investors dur ing the initial stages. Therefore, the venture capital finance is
generally provided by way of equity share capital. The equity contribution of venture capital firm does not
exceed 49% of the total equity capital of venture capital undertakings so that the effective control and ownership
remains with the entrepreneur.
(ii) Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales.
No interest is paid on such loans. In India venture capital financiers charge royalty ranging between 2 and 15 per cent;
actual rate depends on other factors of the venture such as gestation period, cash flow patterns, risk and other factors
of the enterprise. Some Venture capital financiers give a choice to the enterprise of paying a high rate of interest (which
could be well above 20 per cent) instead of royalty on sales once it becomes commercially sound.
(iii) Income note: It is a hybrid security which combines the features of both conventional loan and conditional loan. The
entrepreneur has to pay both interest and royalty on sales but at substantially low rates. IDBI’s VCF provides funding
equal to 80 – 87.50% of the projects cost for commercial application of indigenous technology.
(iv) Participating debenture: Such security carries charges in three phases — in the start-up phase no interest is
charged, next stage a low rate of interest is charged up to a particular level of operation, after that, a high rate of
interest is required to be paid

SECTION : B: ECONOMICS FOR FINANCE

QUESTIONS
1. (i) How the concept of National Income helps in analyzing an economy’s aggregate behavior?
(ii) From the following data calculate National Income
Personal disposable income
₹ in Crores

1 Personal Income 8000

2 Mixed Income of self employed 2000
3 Compensation of employees 1600
4 Net-factor Income from abroad -200
5 Rent 1500
6 Personal Income Taxes 800
7 Profit 1400
8 Consumption of fixed capital 600
9 Direct taxes paid by households 900
10 Non-Tax Payments 1000
11 Net Indirect taxes 700
12 Net Exports Taxes -180

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13 Interest 1100
(iii) What is the importance of Keynesian theory in determination of national income?

ANSWER
i) The estimates of national income show the composition and structure of national income in terms of different sectors
of the economy, the periodical variations in them and the broad sectoral shifts in an economy over time. It is also
possible to make temporal and spatial comparisons of the trend and speed of economic progress and development.
Using this information, the government can fix various sector-specific development targets for different sectors of the
economy and formulate suitable development plans and policies to increase growth.
National income estimates also throw light on income distribution and the possible inequality in the distribution among
different categories of income earners. It is also possible to make comparisons of structural statistics, such as ratios of
investment, taxes, or government expenditures to GDP.
(ii) National Income or NNPFC = Compensation of employees + Mixed Income of Self-employed + Operating Surplus (Rent
+ Interest + Profit) + Net factor Income from abroad
= 1600 + 2000+ (1500 + 1400+1100) +(-200)
= ₹ 7,400crores
Personal disposable Income = Personal Income – Personal Income Taxes- Non-Tax Payments
= 8000-800-1000
= Rs 6200 crores
(iii) Before the ‘General Theory’ by Keynes, economists could not explain how economic depressions happen, or what to
do about them. Keynes’ theory of determination of equilibrium real GDP, employment and prices focuses on the
relationship between aggregate income and aggregate expenditure. There is a difference between equilibrium income
(the level toward which the economy gravitates in the short run) and potential income (the level of income that the
economy is technically capable of producing, without generating accelerating inflation).
Keynes argued that markets would not automatically lead to full-employment equilibrium and the resulting natural level
of real GDP. The economy could settle in equilibrium at any level of unemployment. The stickiness of prices and wages in
the downward direction prevents the economy's resources from being fully employed and thereby prevents the
economy from returning to the natural level of real GDP. Therefore, output will remain at less than the full employment
level as long as there is insufficient spending in the economy.

2. (i) Calculate from the following data:

(a) Private Income

(b) Personal Income

1 Savings of non-department private enterprises 5000

2 Income from domestic product accruing to private sector 400
3 Saving of private corporate sector 250
4 Current Transfer from government administrative 600
departments
5 Current Transfer from of the world 200
6. Corporative Tax 80
7 Direct personal tax 160
8 Net factor Income from abroad -70

(ii) What is the importance of demand side driven fiscal policy? 1085
(iii) How does money supply impacted inflation in the economy?

ANSWER
(i) Private Income = Factor Income from domestic product accruing to the private sector + Net factor Income from
abroad + Current Transfers from government + Other net transfer from the rest of the world.
= 400+(-70)+ 600 +200
= ₹ 1130 cr
Personal Income = National Income – Undistributed Profits- Net interest payment made by households- Corporate Tax +
Transfer payments to the households from firms and government
= 5000-80
= ₹ 4920 cr
(ii) Fiscal policy is in the nature of a demand-side policy. An economy which is producing at full-employment level does
not require government action in the form of fiscal policy. when an economy expands, employment increases, with
progressive system of taxes people have to pay higher taxes as their income rises. This leaves them with lower
disposable income and thus causes a decline in their consumption and therefore aggregate demand.
Similarly, corporate profits tend to be higher during an expansionary phase attracting higher corporate tax payments.
With higher income taxes, firms are left with lower surplus causing a decline in their investments and thus in the
aggregate demand. Governments may directly as well as indirectly influence the way resources are used in an economy.
Governments influence the economy by changing the level and types of taxes, the extent and composition of spending,
and the quantity and form of borrowing.
(iii) Measurement of money supply is essential from a monetary policy perspective because it enables a framework to
evaluate whether the stock of money in the economy is consistent with the standards for price stability, to understand
the nature of deviations from this standard and to study the causes of money growth. Central banks all over the world
adopt monetary policy to stabilise price level and GDP growth by directly controlling the supply of money. This is
achieved mainly by managing the quantity of monetary base. The success of monetary policy depends to a large extent
on the controllability of the monetary base and the money supply.
If the money supply grows at a faster rate than the economy's ability to produce goods and services, then inflation will
result, therefore the thrust of monetary policy to stabilize price level and GDP growth by controlling the supply of money

3. (i) What are the problems associated with foreign Direct Investment?
(ii) Suppose in an economy

Consumption Function C = 170+0.80 Y

Investment spending I = 200
Government Spending G = 150
Tax Tx = 30+0.30Y
Transfer payments Tr = 60
Exports X = 45
Imports M = 20 + 0.2Y

Calculate:

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1. The equilibrium level of national income
2. Consumption of equilibrium level
3. Net Exports of equilibrium level
(iii) Explain in brief the signification of global public goods?
(iv) What are the market outcome of price ceiling explain with a help of a diagram?

ANSWER
(i) Potential problems of foreign direct investment include use of inappropriate capital- intensive methods in a labour-
abundant country, increase in regional disparity, crowding-out of domestic investments, diversion of capital resulting in
distorted pattern of production and investment, instability in the balance of payments and exchange rate and
indiscriminate repatriation of the profits.
FDIs are also likely to indulge in anti-ethical market distortions, off shoring or shifting of jobs, overexploitation
of natural resources causing environmental damage, exercising monopoly power, decrease in competitiveness of
domestic companies, potentially jeopardizing national security and sovereignty, worsening commodity terms of trade,
and causing emergence of a dual economy.
(ii) C = 170+ 0.80yd
Yd = Y─Tax + Transfer Payment
= Y- (30+0.30Y) + 60 = Y+30-0.30Y = Y (1-0.30) +30
Yd = 0.7Y+30
C = 170+0.80(0.7+30) = 170+ 0.56Y + 24 = 194 +0.56Y
The Equation for Equilibrium
Y = C + I + G + X- M
= 194+0.56Y + 200+150 + 45-(20+0.2Y)
= 194+0.56Y+375-0.2Y= 569+0.36Y
Y – 0.36Y = 569 therefore Y = 569 /0.64 = 889.06
C = 194 + 0.56X889.06= 691.87
Net Export = Value of total export- Value of import
X = 45- (20+0.2Y) = 45-20-0.2Y = 25-0.2(691.87)
= ─ (113.37)
(iii) Global public goods are those public goods with benefits /costs that potentially extend to everyone in the world.
These goods have widespread impact on different countries and regions, population groups and generations throughout
the entire globe. Global Public goods may be:
• final public goods which are ‘outcomes’ such as ozone layer preservation or climate change prevention, or
• intermediate public goods, which contribute to the provision of final public goods. e.g., international health
regulations

The World Bank identifies five areas of global public goods which it seeks to address: namely, the environmental
commons (including the prevention of climate change and biodiversity), communicable diseases (including HIV/AIDS,
tuberculosis, malaria, and avian influenza), international trade, international financial architecture, and global
knowledge for development.
(iv) When prices of certain essential commodities rise excessively, government may resort to controls in the
form of price ceilings (also called maximum price) for making a resource or commodity available to all at
reasonable prices. For example: maximum prices of food grains and essential items are set by government
during times of scarcity. A price ceiling which is set below the prevailing market clearing price will generate excess
demand over supply. As can be seen in the following figure, the price ceiling of ₹ 75/ which is below the market-
determined price of ₹150/leads to generation of excess demand over supply equal to Q1-Q2.
Market Outcome of Price Ceiling

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With the objective of ensuring stability in prices and distribution, governments often intervene in grain markets through
building and maintenance of buffer stocks. It involves purchases from the market during good harvest and releasing
stocks during periods when production is below average.

4. (i) How does Friedman’s Restatement of the Quality theory is different from Keynes speculative demand
for money?
(ii) What is money multiplier approach to supply of money?
(iii) What are the operating procedures and instrument of monetary policy?
(iv) How does non-tariff measures interfere with free trade?

ANSWER

(i) Milton Friedman extended Keynes’ speculative money demand within the framework of asset price theory. Friedman
treats the demand for money as nothing more than the application of a more general theory of demand for capital
assets.
Demand for money is affected by the same factors as demand for any other asset, namely Permanent income &Relative
returns on assets. Friedman maintains that it is permanent income and not current income as in the Keynesian theory

1088
that determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present
expected value of all future income.
(ii) The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, considers
three factors as immediate determinants of money supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposits
(c) currency-deposit ratio
The above determinant represents the behaviour of the central bank, behaviour of the commercial banks and
the behaviour of the general public respectively. The behaviour of the central bank which controls the issue of
currency is reflected in the supply of the nominal high-powered money.
If the required reserve ratio on demand deposits increases while all the other variables remain the same, more reserves
would be needed. This implies that banks must contract their loans, causing a decline in deposits and hence in the
money supply. If the required reserve ratio falls, there will be greater expansions of deposits because the same level of
reserves can now support more deposits and the money supply will increase. The currency-deposit ratio (c) represents
the degree of adoption of banking habits by the people.
(iii) The day-to-day implementation of monetary policy by central banks through various instruments is referred to as
‘operating procedures. For example, liquidity management is the operating procedure of the Reserve Bank of India
The operating framework relates to all aspects of implementation of monetary policy. It primarily involves three major
aspects, namely,
• • choosing the operating targets,
• • choosing the intermediate targets, and
• • choosing the policy instruments.

The operating targets refer to the financial variables that can be controlled by the central bank to a large extent through
the monetary policy instruments the intermediate targets are variables which the central bank can hope to influence to
a reasonable degree through the operating targets.The monetary policy instruments are the various tools that a central
bank can use to influence money market and credit conditions and pursue its monetary policy objectives.
In general, the direct instruments comprise of:
(a) the required cash reserve ratios and liquidity reserve ratios prescribed from time to time.
(b) directed credit which takes the form of prescribed targets for allocation of credit to preferred sectors
(c) administered interest rates wherein the deposit and lending rates are prescribed by the central bank.
The indirect instruments mainly consist of:
(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window.
(iv) The non- tariff measures (NTM) which have come into greater prominence than the conventional tariff barriers,
constitute the hidden or 'invisible' measures that interfere with free trade. Non-tariff measures comprise all types of
measures which alter the conditions of international trade, including policies and regulations that restrict trade and
those that facilitate it. NTMs consist of mandatory requirements, rules, or regulations that are legally set by the
government of the exporting, importing, or transit country. NTMs are sometimes used as means to circumvent free-
trade rules and favour domestic industries at the expense of foreign competition

5. (i) How does arbitrage prevents the risk arising out of the fluctuations in the exchange rate?
(ii) Information failure is also a reason for market failure. With the Intervention of government this failure is
corrected how?
(iii) How deflationary gap arises in an economy?

1089
(iv) What are the major component of Reserve Money?
ANSWER
(i) Arbitrage refers to the practice of making risk-less profits by intelligently exploiting price differences of an asset at
different dealing places. On account of arbitrage, regardless of physical location, at any given moment, all markets tend
to have the same exchange rate for a given currency. When price differences occur in different markets, participants
purchase foreign exchange in a low-priced market for resale in a high-priced market and makes profit in this process.
Due to the operation of price mechanism, the price is driven up in the low-priced market and pushed down in the high-
priced market. This activity will continue until the prices in the two markets are equalized, or until they differ only by the
amount of transaction costs involved in the operation. Since forex markets are efficient, any profit spread on a given
currency is quickly arbitraged away.
(ii) Information failure is widespread in numerous market exchanges. When this happens misallocation of scarce
resources takes place and equilibrium price and quantity is not established through price mechanism. This results in
market failure.
Complete information is an important element of competitive market. Perfect information implies that both buyers and
sellers have complete information about anything that may influence their decision making. However, this assumption is
not fully satisfied in real markets due to the following reasons.
• • Often, the nature of products and services tends to be highly complex
• • In many cases consumers are unable to quickly / cheaply find sufficient information on the best prices as well
as quality for different products
• • People are ignorant or not aware of many matters in the market

(iii) Deflationary gap is thus a measure of the extent of deficiency of aggregate demand, and it causes the economy’s
income, output, and employment to decline, thus pushing the economy to under- employment equilibrium. The macro-
equilibrium occurs at a level of GDP less than potential GDP; thus, there is cyclical unemployment i.e., rate of
unemployment is higher than the natural rate.

C+I
In the figure given above OQ* is the full employment level of output. For the economy to be at full employment
equilibrium, aggregate demand should be Q*F. If the aggregate demand is Q*G, it represents a situation of deficient
demand. The resulting deflationary gap is FG.
(iv) Reserve money, also known as central bank money, base money, or high-powered money, needs a special mention

1090
as it plays a critical role in the determination of the total supply of money. Reserve money determines the level of
liquidity and price level in the economy and, therefore, its management is of crucial importance to stabilize liquidity,
economic growth, and price level in an economy. Reserve money is comprised of the currency held by the public, cash
reserves of banks and other deposits of the RBI.
MTP- JULY 2021
PAPER – 8A: FINANCIAL MANAGEMENT

1. Answer the following:

(a) The following information is given:

Dividend per share (DPS) Rs. 9

Cost of capital (Ke) 19%
Internal rate of return on 24%
investment
Retention Ratio 25%

CALCULATE the market price per share by using:

(i) Walter’s formula
(ii) Gordon’s formula (Dividend Growth model)

ANSWER

Working:
Calculation of Earnings per share (EPS):

1091
Where,
Po = Present market price per share.
g = Growth rate (br) = 0.25 × 0.24 = 0.06
b = Retention ratio
k = Cost of Capital
r = Internal rate of return (IRR)
D0 = Dividend per share
E = Earnings per share

Alternatively,

(b) SN Ltd. has furnished the following ratios and information relating to the year ended 31st March 2021:

Share Capital Rs. 6,25,000

Working Capital Rs. 2,00,000
Gross Margin 25%
Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.7:1
Reserves & Surplus to Bank & Cash 3 times

Further, the assets of the company consist of fixed assets and current assets, while its current liabilities
comprise bank credit and others in the ratio of 3:1. Assume 360 days in a year.
You are required to PREPARE the Balance Sheet as on 31st March 2021.

1092
(Note- Balance sheet may be prepared in traditional T Format.)

ANSWER

Alternatively,
1093
Balance Sheet of SN Ltd. as on 31st March 2021

1094

(c) Following information are related to four firms of the same industry:
Firm Change in Revenue Change in Operating Change in Earning per
Income Share
P 25% 23% 30%
Q 27% 30% 26%
R 24% 36% 20%
S 20% 30% 20%

For all the firms, FIND OUT:

(i) Degree of operating leverage, and
(ii) Degree of combined leverage.

ANSWER
Calculation of Degree of Operating leverage and Degree of Combined leverage

(d) HN Limited is considering total investment of Rs. 20 lakhs. You are required to CALCULATE the level of

1095
earnings before interest and tax (EBIT) at which the EPS indifference point between the following financing
alternatives will occur:
(i) Equity share capital of Rs. 12,00,000 and 14% debentures of Rs. 8,00,000.

Or
(ii) Equity share capital of Rs. 8,00,000, 16% preference share capital of Rs. 4,00,000 and 14% debentures of
Rs. 8,00,000.
Assume the corporate tax rate is 30% and par value of equity share is Rs.10 in each case.

ANSWER
Computation of level of earnings before interest and tax (EBIT)

In order to determine the indifference level of EBIT, the EPS under the two alternative plans should be equated as
follows:

2. CALCULATE the WACC by using Market value weights.

The capital structure of the company is as under:

Debentures (Rs.100 per debenture) 10,00,000

1096
Preference shares (Rs.100 per share) 10,00,000
Equity shares (Rs.10 per share) 20,00,000
40,00,000
The market prices of these securities are:
Debentures Rs. 115 per debenture
Preference shares Rs. 120 per preference share
Equity shares Rs. 265 each.
Additional information:
(1) Rs.100 per debenture redeemable at par, 10% coupon rate, 2% floatation cost, 10-year maturity.
(2) Rs.100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year
maturity.
(3) Equity shares have a floatation cost of Rs. 1 per share.
The next year expected dividend is Rs. 5 with an annual growth of 15%. The firm has the practice of paying
all earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.

ANSWER
(i) Cost of Equity (Ke)

(ii) Cost of Debt (Kd)

Calculation of NPV at discount rate of 5% and 7%

Year Cash flows Discount Present Discount Present

(Rs.) factor @ Value factor @ Value
5% 7% (Rs.)
0 112.7 1.000 (112.7) 1.000 (112.7)
1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +2.75 -12.73

Calculation of IRR

(iii) Cost of Preference shares (Kp)

Calculation of NPV at discount rate of 2% and 5%

1097
Year Cash flows Discount Present Discount Present
(Rs.) factor @ Value factor @ Value
2% 5% (Rs.)
0 117.6 1.000 (117.6) 1.000 (117.6)
1 to 10 5 8.983 44.92 7.722 38.61
10 100 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

Calculation of IRR
Calculation of WACC using market value weights

3. PREPARE monthly cash budget for the first six months of 2021 on the basis of the following information:
(i) Actual and estimated monthly sales are as follows:

Actual (Rs.) Estimated (Rs.)

October 2020 2,00,000 January 2021 60,000
November 2020 2,20,000 February 2021 80,000
December 2020 2,40,000 March 2021 1,00,000
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000

1098
(ii) Operating Expenses (including salary & wages) are estimated to be payable as follows:
Month (Rs.) Month (Rs.)
January 2021 22,000 April 2021 30,000
February 2021 25,000 May 2021 25,000
March 2021 30,000 June 2021 24,000

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales are collected after one month,
30% after two months and 10% after three months.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the sales.
(v) The firm has 12% debentures of Rs.1,00,000. Interest on these has to be paid quarterly in January, April
and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in April.
(vii) The firm had a cash balance of Rs. 40,000 at 31st Dec. 2020, which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each month (interest on these to be
ignored).

ANSWER
Monthly Cash Budget for first six months of 2021
(Amount in Rs.)

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Workings:
1. Collection from debtors: (Amount in Rs.)
2. Payment to Creditors: (Amount in Rs.)

4. (a) N&B Ltd. is considering one of two mutually exclusive proposals, Projects A and B, which require cash
outlays of Rs. 34,00,000 and Rs. 33,00,000 respectively. The certainty-equivalent (C.E) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bonds is 5% and this is
used as the risk free rate. The expected net cash flows and their certainty equivalents are as follows:

1100

PV factor at 5% are as follows:

Year 1 2 3 4 5
PV factor 0.952 0.907 0.864 0.823 0.784

DETERMINE which project should be accepted. (8 Marks)

(b) DISCUSS the advantages of Certainty Equivalent Method. (2 Marks)
ANSWER
(a) Statement Showing the Net Present Value of Project A
Year end Cash Flow (Rs.) C.E. Adjusted Cash Present value Total Present
(a) (b) flow (Rs.) factor at 5% value (Rs.)
(c) = (a) (b) (d) (e) = (c) (d)
1 16,75,000 0.8 13,40,000 0.952 12,75,680
2 15,00,000 0.7 10,50,000 0.907 9,52,350
3 15,00,000 0.5 7,50,000 0.864 6,48,000
4 20,00,000 0.4 8,00,000 0.823 6,58,400
5 21,20,000 0.6 12,72,000 0.784 9,97,248

PV of total Cash Inflows 45,31,678

Less: Initial Investment 34,00,000
Net Present Value 11,31,678

Statement Showing the Net Present Value of Project B

Year end Cash Flow (Rs.) C.E. Adjusted Cash Present value Total Present
(a) (b) flow (Rs.) (c) = factor at 5% (d) value (Rs.) (e) =
(a) (b) (c) (d)
1 16,75,000 0.9 15,07,500 0.952 14,35,140
2 15,00,000 0.8 12,00,000 0.907 10,88,400
3 15,00,000 0.7 10,50,000 0.864 9,07,200
4 10,00,000 0.8 8,00,000 0.823 6,58,400
5 9,00,000 0.9 8,10,000 0.784 6,35,040

PV of total Cash Inflows 47,24,180

Less: Initial Investment 33,00,000
Net Present Value 14,24,180

Project B has NPV of Rs. 14,24,180 which is higher than the NPV of Project A. Thus, N&B Ltd. should accept Project B.

(b) Advantages of Certainty Equivalent Method:

1. The certainty equivalent method is simple and easy to understand and apply.

1101
2. It can easily be calculated for different risk levels applicable to different cash flows. For example, if in a particular year,
a higher risk is associated with the cash flow, it can be easily adjusted and the NPV can be recalculated accordingly.

5. GG Pathology Lab Ltd. is using 2D sonography machine which has reached the end of its useful life. The
lab is intending to upgrade along with the technology by investing in 3D sonography machine as per the
choices preferred by the patients. Following new 3D sonography machine of two different brands with same
features is available in the market:
Residual Value of machines shall be dropped by 10% and 40% of Purchase price for Brand X and Y
respectively in the first year and thereafter shall be depreciated at the rate mentioned above on the original
cost.
Alternatively, the machine of Brand Y can also be taken on rent to be returned back to the owner after use
on the following terms and conditions:
• • Annual Rent shall be paid in the beginning of each year and for first year it shall be Rs. 2,24,000.
Annual Rent for the subsequent 4 years shall be Rs. 2,25,000.
• • Annual Rent for the final 5 years shall be Rs. 2,70,000.
• • The Rent/Agreement can be terminated by GG Labs by making a payment of Rs. 2,20,000 as
penalty. This penalty would be reduced by Rs. 22,000 each year of the period of rental agreement.

You are required to:

i (i) ADVISE which brand of 3D sonography machine should be acquired assuming that the use of
machine shall be continued for a period of 20 years.
ii (ii) STATE which of the option is most economical if machine is likely to be used for a period of 5
years?

The cost of capital of GG Labs is 12%.

The present value factor of Rs. 1 @ 12% for different years is given as under:

Year PVF Year PVF

1 0.893 9 0.361
2 0.797 10 0.322
3 0.712 11 0.287
4 0.636 12 0.257

1102
5 0.567 13 0.229
6 0.507 14 0.205
7 0.452 15 0.183
8 0.404 16 0.163

ANSWER

Since the life span of each machine is different and time span exceeds the useful lives of each modeI, we shall use
Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
(a) Residual value of machine of brand X
= [Rs. 15,00,000 – (1 - 0.10)] - (Rs. 15,00,000 × 0.06 × 14) = Rs. 90,000
(b) Residual value of machine of brand Y
= [Rs. 10,00,000 – (1 - 0.40)] - (Rs. 10,00,000 × 0.06 × 9) = Rs. 60,000
Present Value (PV) of cost if machine of brand X is purchased
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
6-10 70,000 2.046 1,43,220
11-15 98,000 1.161 1,13,778
15 (90,000) 0.183 (16,470)
19,20,778

Present Value (PV) of cost if machine of brand Y is purchased

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
6-10 1,15,000 2.046 2,35,290
10 (60,000) 0.322 (19,320)
14,68,320

Present Value (PV) of cost if machine of brand Y is taken on rent

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)

1103
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5-9 2,70,000 2.291 6,18,570
15,26,120

Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand Y the same should be
purchased.
(ii) If machine is used for 5 years
(a) Scrap value of machine of brand X
= [Rs. 15,00,000 – (1 - 0.10)] - (Rs. 15,00,000 × 0.06 × 4) = Rs. 9,90,000
(b) Scrap value of machine of brand Y
= [Rs. 10,00,000 – (1 - 0.40)] - (Rs. 10,00,000 × 0.06 × 4) = Rs. 3,60,000
Present Value (PV) of cost if machine of brand X is purchased

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)

0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
5 (9,90,000) 0.567 (5,61,330)
11,18,920

Present Value (PV) of cost if machine of brand Y is purchased

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
5 (3,60,000) 0.567 (2,04,120)
10,48,230

Present Value (PV) of cost if machine of brand Y is taken on rent

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5 1,10,000* 0.567 62,370
9,69,920

* [Rs. 2,20,000 - (Rs. 22,000 × 5) = Rs. 1,10,000]

Decision: Since Cash Outflow is least in case of rent of Machine of brand Y the same should be taken on rent.

6. (a) DISCUSS the advantages and disadvantages of Wealth maximization principle. (4 Marks)

ANSWER
Advantages and disadvantages of Wealth maximization principle.
Advantages:
(i) Emphasizes the long term gains

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(ii) Recognises risk or uncertainty
(iii) Recognises the timing of returns
(iv) Considers shareholders’ return.
Disadvantages:
(i) Offers no clear relationship between financial decisions and share price.
(ii) Can lead to management anxiety and frustration.

(b) DISCUSS in brief the characteristics of Debentures. (4 Marks)

ANSWER
Characteristics of Debentures are as follows:
• • Normally, debentures are issued on the basis of a debenture trust deed which lists the terms and conditions
on which the debentures are floated.
• • Debentures are either secured or unsecured.
• • May or may not be listed on the stock exchange.
• • The cost of capital raised through debentures is quite low since the interest payable on debentures can be
charged as an expense before tax.
• • From the investors' point of view, debentures offer a more attractive prospect than the preference shares
since interest on debentures is payable whether or not the company makes profits.
• • Debentures are thus instruments for raising long-term debt capital.
• • The period of maturity normally varies from 3 to 10 years and may also increase for projects having high
gestation period.

(c) DEFINE Security Premium Notes.

Or
DEFINE Masala bond.

ANSWER
Secured Premium Notes: Secured Premium Notes is issued along with a detachable warrant and is redeemable after a
notified period of say 4 to 7 years. The conversion of detachable warrant into equity shares will have to be done within
time period notified by the company.
Or
Masala bond: Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate
borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated in Indian
Rupees. NTPC raised Rs. 2,000 crore via masala bonds for its capital expenditure in the year 2016.

PAPER 8B: ECONOMICS FOR FINANCE

QUESTIONS
7. (a) How is the measurement of National Income done in India? (2 Marks)

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ANSWER

National Accounts Statistics in India are compiled by National Accounts Division in the Central Statistics Office,
Ministry of Statistics and Programme Implementation. The estimates are published both annually and
quarterly. This publication is the key source of macroeconomic data of the country and as per the mandate of
FRBM Act 2003, the Ministry of Finance uses the GDP numbers (at current prices) to determine the fiscal
targets. The Ministry has released the new series of National Accounts by revising the base year from 2004-05
to 2011-12. The revision of National Accounts was done by CSO in January 2015.
(b) What are the important Characteristics of Public Good? Why does market fails to produce public goods?
(3 Marks)

ANSWER

Once the Public good is provided, the additional resource cost of another person consuming the goods is
zero.
Characteristics of Public Goods:
(a) is non -rival in consumption
(b) are non-excludable
(c) are characterised by indivisibility
(d) are generally more vulnerable to issues such as externalities, inadequate property rights and free rider
problems.
Because of the peculiar characteristics of public goods such as indivisibility, non -excludability, competitive
market will fail to generate economically efficient outputs of public goods.

(c) Calculate Personal Income and Personal Disposable Income from the following data (In crores of Rupees)
(5 Marks)

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ANSWER

Personal Income = National Income - Undistributed Profits - Net Interest Payments made by households -
corporate tax + Transfer payments to the households from firms and government
= 2000-175- 35- 20 + 25
= 1795 Crores Personal Disposable Income = Personal Income – Personal Income Taxes – Non-Tax payments =
1795 –50 –40
= 1705 crores

8. (a) Calculate Operating Surplus and Net Value added at Factor Cost from the following data:

ANSWER
GVAmp = Value of Output - Intermediate Consumption
= (Sales + Change in Stocks) – Intermediate Consumption = 4500 + 10 – 200
= 4,310 crores
GVA mp= 4 ,310 cr

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NVAmp = GVAmp -- Depreciation
= 4, 310 – 200
= 4,110 cr
NVA fc = NVA mp – (Indirect Taxes – Subsidies)
= 4,110 – (70- 20)
= 4,060 cr.
NDPfc = NVAfc = Compensation of employees + Operating Surplus + Mixed Income of self employed 4,060 =
600 + Operating Surplus + 700
Operating Surplus = 2760 cr

(b) What do you understand by the term “Tragedy of Common’s “in Public Finance. (2 Marks)
ANSWER
The Problem of the Tragedy of commons was first described by Garrett Hardin. Economists used the term to
describe the problem which occurs when rivalrous and non-excludable goods are overused to the
disadvantage of the entire world. The term “commons “is derived from the traditional English legal term of
“Common land “ where farmers / peasant would graze their livestock, hunt and collect wild plants and other
produce. Everyone has access to a commonly held pasture there and are no rules for sustainable numbers for
grazing. The outcome of the individual rational economic decisions of cattle owners was market failure
because these actions resulted in degradation, depletion or even destruction of the resource leading to
welfare loss for the entire society.

(c) How fiscal Policy can be used as a tool for Reduction in inequalities of Income and Wealth?
(3 Marks)

ANSWER
Government’s fiscal policy has a strong influence on the performance of the macro economy in terms of employment,
price stability, economic growth, and external balances. Proceeds from progressive taxes to be used for financing public
services, especially those that benefit low-income households (for example, supply of essential food grains at highly
subsidized prices to BPL households). The challenge before any government is how to design its budgetary policy so that
the pursuit of one goal does not jeopardize the other.

9. (a) What is the effect of government expenditure on Money Supply? (2 Marks)

ANSWER
Whenever the Central and the State government’s cash balances fall short of the minimum requirement, they
are eligible to avail of a facility called Ways and Means Advances (WMA/Overdraft facility). When the reserve
bank lends to the governments under WMA/OD it results in the generation of excess reserves. The excess
reserves thus created can potentially lead to an increase in money supply through the money multiplier
process

(b) What is credit multiplier and how it is calculated? (3 Marks)

ANSWER
The Credit Multiplier is also referred to as the deposit multiplier or the deposit expansion multiplier, describes
the amount of additional money created by commercial bank through the process of lending the available
money it has in excess of the central bank’s reserve requirements. It is the reciprocal of the required reserve

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ratio.
Credit Multiplier = 1 ÷ by required reserve ratio

(c) In an economy the equations are given as follows:

C = 200 + 0.80 Yd, I = 400, G = 300, T = 100, TR = 50
Find the equilibrium level of Income. (5 Mark)

ANSWER
Yd = Y-T + TR
Yd = Y- 100 +50
Y = C + I +G Y = 200 + 0.80 (Y- 100 +50) + 400 + 300
Y = 200 + 0.80 Y- 0.80 X 50 + 700
Y = 900 + 0.80 Y- 40
Y- 0.80Y = 860
0.20 Y = 860
Y = 860 ÷ 0.20 = 4350

10. (a) What is Factor Price–Equalization Theorem of International Trade? (2 Marks)

(b) The developing countries will have disadvantage if they engage in liberal trade
Explain in detail. (3 Marks)
(c) The Role of bank rate as an instrument of monetary policy? (3 Marks)
(d) What is the difference between Repo and Reverse Repo Rate? (2 Marks)

ANSWER

(a) The factor price equalisation theorem postulates that if the prices of the output of goods are equalized
between countries engaged in free trade, then the price of the input factor will also be equalised between
countries. This implies that the wages and rent will converge across the countries with free trade or in other
words, trade in goods is a perfect substitute for trade in factors.

(b) The developing countries find themselves disproportionately disadvantage and vulnerable with regard to
adjustments due to lack of human as well as physical capital, poor infrastructure, inadequate institutions,
political instabilities etc. Developing countries also complain that they face exceptionally high tariffs on
selected products in many markets and this obstructs their vital exports.

(c) The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and therefore as and when the
MSF rate changes alongside policy repo rate changes automatically. Now bank rate is used only for calculating
penalty on default in the maintenance of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

(d) Repo or repurchase option is a collaterised lending because banks borrow money from RBI to fulfil their
short-term monetary requirements by selling securities to RBI with an explicit agreement to repurchase the
same at predetermined date and at a fixed rate. The rate charged by RBI for this transaction is called the ‘repo
rate’. The Reverse repo is defined as an instrument for lending funds by purchasing securities on a mutually
agreed future date at an agreed price which includes interest for the funds lent.

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11. (a) What is Cambridge – Approach theory of demand for Money? (2 Marks)
(b) Relevance of Monetary Policy Committee and its impact? (3 Marks)
(c) What is the leakages-injections approach in two sector circular flow Model? (3 Marks)
(d) What are the conceptual three functions framework of the responsibilities of Government in Public
Finance?

ANSWER
(a) The Cambridge approach holds that money increases utility in the following two ways:
• enabling the possibility of split-up sale and purchase to two different points of time rather than
being simultaneous and
• being a hedge against uncertainty.
The Cambridge money demand function is stated as:
Md = K PY
Md = is the demand of money balances,
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as Cash Balances.
The term ‘k’ in the above equation is called Cambridge K is a parameter reflecting economic
structure and monetary habits, namely the ratio of desired money balances to total transactions to income
and the ratio of desired money balances to total transactions.

(b) The Monetary Policy Committee was constituted in September 2016. The Committee is required to meet
four times a year and decision taken in the meeting is published after conclusion of the meeting. Based on the
review of the macroeconomic and monetary developments in the economy, the monetary policy will
determine the policy rate required to achieve the inflation target. The fixing of the benchmark policy interest
rate (repo rate) is made through debate and majority vote by the
panel of experts of the committee.

(c) A leakage is referred to as an outflow of income from the circular flow model. Leakages are that part of
income which is not used to purchase goods and services or what households withdraw from the circular flow.
An injection is an inflow of income to the circular flow. Due to injection of income in the circular flow, the
volume of income increases. Investment is an injection in the circular flow. The Circular flow will be balanced
and therefore in equilibrium when the injections are equal to the leakages.

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(d) Richard Musgrave in his classic treatise “The Theory of Public Finance” introduced the three branch
taxonomy of the role of government in a market economy. The functions of the government are to be
separated into three namely: resource allocation, income redistribution and macroeconomic stabilization. The
allocation and redistribution function are primarily microeconomic functions while stabilization is a
macroeconomic function. The allocation function aims to correct the sources of inefficiency in the economic
system while distribution role ensures that the distribution of wealth and income is fair. Monetary and fiscal
Policy, maintenance of high levels of employment and price stability fall under the stabilization function.
MTP- I- NOV 2021
PAPER 8A: FINANCIAL MANAGEMENT

1. Answer the following:

(a) In respect of two companies having same business risk, following information is given:
Capital employed = ₹ 4,00,000; EBIT = ₹ 60,000; Ke = 12%

Sources Levered Company (₹) Unlevered Company (₹)

Debt (@10%) 1,50,000 Nil
Equity 1,50,000 3,00,000

Investor is holding 20% shares in levered company. CALCULATE increase in annual earnings of investor if he
switches his holding from Levered to Unlevered company.

ANSWER

1. Valuation of firms

Particulars Levered Firm (₹) Unlevered Firm (₹)

EBIT 60,000 60,000
Less: interest (1,50,000 x 10%) 15,000 Nil
Earnings available to Equity Shareholder/Ke 45,000 60,000
12% 12%
Value of Equity 3,75,000 5,00,000
Debt 1,50,000 Nil
Value of Firm 5,25,000 5,00,000

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Value of Levered company is more than that of unlevered company. Therefore, investor will sell his shares in levered
company and buy shares in unlevered company. To maintain the level of risk he will borrow proportionate amount and
invest that amount also in shares of unlevered company.
2. Investment & Borrowings

Sell shares in Levered company 75,000

(3,75,000x20%)
Borrow money (1,50,000 x 20%) 30,000
Buy shares in Unlevered company 1,05,000
3. Change in Return

Income from shares in Unlevered company

(1,05,000 x 12%) 12,600
Less: interest on loan (30,000 x 10%) 3,000
Net Income from unlevered firm 9,600
Income from Levered firm (75000 x 12%) 9,000
Incremental Income due to arbitrage 600

(b) The following is the capital structure of Sharda Ltd. as on 31.12.2020:

(₹)
Equity shares: 2,00,000 shares (of ₹ 100 each) 2,00,00,000
9% Preference Shares (of ₹ 100 each) 60,00,000
8% Debentures 90,00,000
3,50,00,000

The market price of the company’s share is ₹ 120 and it is expected that a dividend of ₹ 12 per share would
be declared for the year 2021. The dividend growth rate is 5% and the company is in the 30% tax bracket.
(i) CALCULATE the company’s weighted average cost of capital.
(ii) Further, in order to finance an expansion plan, the company intends to borrow a fund of ₹ 2 crores
bearing 12% rate of interest. In this situation, WHAT will be the company’s revised weighted average cost of
capital? This financing decision is expected to increase dividend from ₹ 12 to ₹ 14 per share. However, the
market price of equity share is expected to decline from ₹ 120 to ₹ 115 per share.
In case of both (i) and (ii) above, use market value weight while calculating weighted average cost of capital.

ANSWER

(i) Computation of the weighted average cost of capital

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(ii) Computation of Revised Weighted Average Cost of Capital

Working Notes:
(1) Cost of Equity Shares
Ke = {Dividend Per Share (D1)/Market Price Share (P0)} + Growth Rate
= 12/120 + 0.05
= 0.15 or 15%
(2) Revised cost of equity shares (Ke)
Revised Ke = 14/115 + 0.05
= 0.1717 or 17.17%

(c) ABC Ltd. has total sales of 10,00,000 all of which are credit sales. It has a gross profit ratio of 25% and a
current ratio of 2. The company’s current liabilities are ₹ 2,00,000. Further, it has inventories of ₹ 80,000,
marketable securities of ₹ 50,000 and cash of ₹ 30,000. From the above information:
(i) CALCULATE the average inventory, if the expected inventory turnover ratio is three times?
(ii) Also CALCULATE the average collection period if the opening balance of debtors is expected to be ₹
1,50,000.
Assume 360 days a year.

ANSWER
(i) Calculation of Average Inventory
Since gross profit is 25% of sales, the cost of goods sold should be 75% of the sales.

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(ii) Calculation of Average Collection Period

Calculation of Closing balance of debtors

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(d) M Ltd. belongs to a risk class for which the capitalization rate is 12%. It has 40,000 outstanding shares
and the current market price is ₹ 200. It expects a net profit of ₹ 5,00,000 for the year and the Board is
considering dividend of ₹ 10 per share.
M Ltd. requires to raise ₹ 10,00,000 for an approved investment expenditure. ILLUSTRATE, how the MM
approach affects the value of M Ltd. if dividends are paid or not paid.
ANSWER
Given,
1115
2. Sophisticated Limited is considering three financing plans. The key information is as follows:
(a) Total investment amount to be raised ₹ 4,00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%

(c) Cost of debt 10%

Cost of preference shares 10%
(d) Tax rate 30%
(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(f) Expected EBIT is ₹ 10,00,000.
You are required to DETERMINE for each plan: -
(i) Earnings per share (EPS)
(ii) The financial break-even point.
(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.
[10 Marks]

ANSWER
(i) Computation of Earnings per share (EPS)
Plans A B C
Earnings before interest and tax 10,00,000 10,00,000 10,00,000
(EBIT)
Less: Interest charges --- (20,000) ---

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(10% × ₹2 lakh)
Earnings before tax (EBT) 10,00,000 9,80,000 10,00,000
Less: Tax (@ 30%) (3,00,000) (2,94,000) (3,00,000)
Earnings after tax (EAT) 7,00,000 6,86,000 7,00,000
Less: Preference Dividend --- --- (20,000)
(10% × ₹2 lakh)
Earnings available for Equity 7,00,000 6,86,000 6,80,000
shareholders (A)
No. of Equity shares (B) 20,000 10,000 10,000
(₹ 4 lakh ÷ ₹ 20) (₹ 2 lakh ÷ ₹ 20) (₹ 2 lakh ÷ ₹ 20)
EPS ₹ [(A) ÷ (B)] 35 68.6 68
(ii) Calculation of Financial Break-even point
Financial break-even point is the earnings which are equal to the fixed finance charges and preference dividend.
Plan A: Under this, plan there is no interest or preference dividend payment . Hence, the Financial Break-even point will
be zero.
Plan B: Under this plan, there is an interest payment of ₹ 20,000 and no preference dividend. Hence, the Financial
Break-even point will be ₹ 20,000 (Interest charges).
Plan C: Under this plan, there is no interest payment but an after tax preference dividend of ₹ 20,000 is paid. Hence, the
Financial Break- even point will be before tax earnings of ₹ 28,571 (i.e. ₹ 20,000 ÷ 0.7)

(iii) Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by applying the following formula.

Where, EBIT = Earnings before interest and tax.

1l = Fixed charges (interest or pref. dividend) under Alternative 1
2l = Fixed charges (interest or pref. dividend) under Alternative 2
T = Tax rate
1E = No. of equity shares in Alternative 1
2E = No. of equity shares in Alternative 2

Now, we can calculate indifference point between different plans of financing.

(a) Indifference point where EBIT of Plan A and Plan B is equal.

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(b) Indifference point where EBIT of Plan A and Plan C is equal

(c) Indifference point where EBIT of Plan B and Plan C are equal
3. Sadbhavna Limited is a manufacturer of computers. It wants to introduce artificial intelligence while
making computers. It estimates that the annual savings from the artificial intelligence (AI) include a
reduction of five employees with annual salaries of ₹ 3,00,000 each, ₹ 3,00,000 from reduction in production
delays caused by inventory problem, reduction in lost sales ₹ 2,50,000 and ₹ 2,00,000 from billing issues.
The purchase price of the system for installation of artificial intelligence is ₹ 20,00,000 with installation cost
of ₹ 1,00,000. The life of the system is 5 years and it will be depreciated on a straight-line basis. The salvage
value is zero which will be its market value after the end of its life of five years.
However, the operation of the new system for AI requires two computer specialists with annual salaries of ₹
5,00,000 per person. Also, the estimated maintenance and operating expenses of 1,50,000 is required.
The company’s tax rate is 30% and its required rate of return is 12%.
From the above information:
i (i) CALCULATE the initial cash outflow and annual operating cash flow over its life of 5 years.
ii (ii) Further, EVALUATE the project by using Payback Period, Net Present Value and Profitability
Index.
iii (iii) You are also REQUIRED to obtain the cash flows and NPV on the assumption that book salvage
value for depreciation purposes is ₹ 2,00,000 even though the machine is having no real worth in terms of
its resale value. Also, the book salvage value of ₹ 2,00,000 is allowed for tax purposes.

Also COMMENT on the acceptability of the project in (ii) and (iii) above. [10 Marks]

ANSWER
(i) Project’s Initial Cash Outlay

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 1119
(ii) Evaluation of the project by using NPV Method

Since NPV is positive, therefore, the project is acceptable.

Evaluation of the project by using Profitability Index Method
Profitability Index = Present Value of Cash Inflows/Present Value of Cash Outflows
= 32,30,080/21,00,000
= 1.538
Since, the profitability index is more than 1, the project is acceptable.
Calculation of the Project’s Payback*

Year Net Cash Flow Cumulative Cash Flow

1 8,96,000 8,96,000
2 8,96,000 17,92,000
3 8,96,000 26,88,000
4 8,96,000 35,84,000
5 8,96,000 44,80,000
Here, the payback period is 2 years plus a fraction of the 3rd year
So, payback period = 2 years + 3,08,000/8,96,000
= 2.34 years
* Payback period may also be solved directly as follows: 21,00,000/8,96,000 = 2.34 years
(iii) Project’s cash flows and NPV assuming that the book salvage for depreciation purpose is ₹ 2,00,000
Depreciation = (₹ 21,00,000 – 2,00,000)/5 = 3,80,000
Cash Inflows for the years 1 to 5 are:

Calculation of NPV
It may be noted that at the end of year 5, the book value of the project would be ₹ 2,00,000 but its realizable value is nil.

1120
So, the capital loss of ₹ 2,00,000 will result in tax savings of ₹ 60,000 (i.e., ₹ 2,00,000 x 30%), as the capital loss is
available for tax purposes in view of the information given. Therefore, at the end of year 5, there would be an additional
inflow of ₹ 60,000. The NPV may now be calculated as follows:
4. The following figures and ratios are related to a company:

(i) Sales for the year (all credit) ₹ 30,00,000

(ii) Gross Profit ratio 25 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1:1
(vi) Current ratio 1.5 : 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to Share capital 0.6 : 1
(ix) Capital gearing ratio 0.5
(x) Fixed assets to net worth 1.20 : 1
You are REQUIRED to prepare:
(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a provision for
contingencies @ 10 percent of net working capital including such provision. [10 Marks]

ANSWER
Working Notes:
i (i) Cost of Goods Sold = Sales – Gross Profit (25% of Sales)

= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000

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i (ii) Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 22,50,000/6 = ₹ 3,75,000
i (iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover

= ₹ 22,50,000/1.5
= ₹ 15,00,000
i (iv) Current Assets:

Current Ratio = 1.5 and Liquid Ratio = 1

Stock = 1.5 – 1 = 0.5
Current Assets = Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5 = ₹ 11,25,000

i (v) Liquid Assets (Debtors and Cash)

= Current Assets – Stock
= ₹ 11,25,000 – ₹ 3,75,000
= ₹ 7,50,000
i (vi) Debtors = Sales × Debtors Collection period /12

= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000
i (vii) Cash = Liquid Assets – Debtors

= ₹ 7,50,000 – ₹ 5,00,000 = ₹ 2,50,000

i (viii) Net worth = Fixed Assets /1.2

= ₹ 15,00,000/1.2 = ₹ 12,50,000
i (ix) Reserves and Surplus

Reserves and Share Capital = 0.6 + 1 = 1.6

Reserves and Surplus = ₹ 12,50,000 × 0.6/1.6
= ₹ 4,68,750
i (x) Share Capital = Net worth – Reserves and Surplus

= ₹ 12,50,000 – ₹ 4,68,750
= ₹ 7,81,250
i (xi) Current Liabilities = Current Assets/Current Ratio

= ₹ 11,25,000/1.5 = ₹ 7,50,000
i (xii) Long-term Debts

Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund

Long-term Debts = ₹ 12,50,000 × 0.5 = ₹ 6,25,000

(a) Preparation of Balance Sheet of a Company

Balance Sheet

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(b) Statement Showing Working Capital Requirement

5. (a) The following details of PQR Limited for the year ended 31st March, 2021 are given below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) ₹ 2.10 lakhs
Sales ₹ 40.00 lakhs
10% Debentures of ₹ 100 each ₹ 25.00 lakhs
Equity Share Capital of ₹ 10 each ₹ 20.00 lakhs
Income tax rate 30 per cent
REQUIRED:
(i) Calculate Financial leverage
(ii) Calculate P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.6, does it have a high or low assets
turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?

1123
In the question, assume that 10% Debentures and Share Capital consists of total liabilities.
[8 Marks]

ANSWER
(i) Financial leverage
Combined Leverage = Operating Leverage x Financial Leverage
So, financial leverage = Combined Leverage/Operating Leverage
= 2.8/1.4 = 2
(ii) P/V Ratio and EPS
1.4 Contribution – 2,94,000 = Contribution
0.4 Contribution = 2,94,000
Contribution = 7,35,000

Earning before tax (EBT) = Contribution – Fixed Cost – Interest

= 7,35,000 – 2,10,000 – 2,50,000
= 2,75,000
Profit after tax = EBT – Tax @ 30%
= 2,75,000 – 82,500
= 1,92,500

(iii) Asset Turnover

Total Assets = Equity Share Capital + Debentures = ₹ 20 lakhs + ₹ 25 lakhs = ₹ 45 lakhs

0.89 < 1.6, means lower than industry turnover.

(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to be dropped by 100/2.8 =

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35.71%. Hence new sales will be
40,00,000 x (100% - 35.71%) = 25,71,600

(b) Write a short note on electronic fund transfer. [2 Marks]

ANSWER
Electronic Fund Transfer: With the developments which took place in the information technology, the present banking
system has switched over to the computerization of banks branches to offer efficient banking services and cash
management services to their customers. The network wil l be linked to the different branches, banks. This helped the
customers in the following ways:
(i) Instant updating of accounts.
(ii) Quick transfer of funds.
(iii) Instant information about foreign exchange rates

6. (a) BRIEFLY explain the three finance function decisions. [4 Marks]

(b) EXPLAIN sensitivity analysis and its various steps. [4 Marks]
(c) WRITE two main objectives of Financial Management.
Or
BRIEFLY describe the financial needs of a business

ANSWER

(a) The three finance function decisions are as follows:

Investment decisions: These decisions relate to the selection of assets in which funds will be invested by a firm. Funds
procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for
various fixed assets and also for current assets. The investment of funds in a project has to be made after careful
assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing
the working capital requirements.
Financing decisions: These decisions relate to acquiring the optimum finance to meet financial objectives and seeing
that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the
sources of available funds and their respective costs and needs to ensure that the company has a sound capital
structure, i.e. a proper balance between equity capital and debt. Such managers also need to have a very clear
understanding as to the difference between profit and cash flow, bearing in mind that profit is of little use unless the
organisation is adequately supported by cash to pay for assets and sustain the working capital cycle.
Dividend decisions: These decisions relate to the determination as to how much and how frequently cash can be paid
out of the profits of an organization as income for its owners/shareholders. The dividend decision thus has two
elements – the amount to be paid out and the amount to be retained to support the growth of the organization, the
latter being also a financing decision. The level and regular growth of dividends represent a significant factor in
determining a profit-making company’s market value, i.e. the value placed on its shares by the stock market.
(b) Sensitivity Analysis and its various steps: Sensitivity analysis put in simple terms is a modeling technique which is
used in Capital Budgeting decisions which is used to study the impact of changes in the variables on the outcome of the
project. In a project, several variables like weighted average cost of capital, consumer demand, price of the produc t,
cost price per unit etc. operate simultaneously.
The changes in these variables impact the outcome of the project. It therefore becomes very difficult to assess change in

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which variable impacts the project outcome in a significant way. In Sensitivity Analysis, the project outcome is studied
after taking into change in only one variable.

The more sensitive is the NPV, the more critical is that variable. So, Sensitivity analysis is a way of finding impact in the
project’s NPV (or IRR) for a given change in one of the variables.
Sensitivity Analysis is conducted by following the steps as below:
(i) Finding variables, which have an influence on the NPV (or IRR) of the project.
(ii) Establishing mathematical relationship between the variables.
(iii) Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.
(c) Two main objectives of Financial Management
Profit Maximisation
It has traditionally been argued that the primary objective of a company is to earn profit; hence the objective of financial
management is also profit maximisation. This implies that the finance manager has to make his decisions in a manner so
that the profits of the concern are maximised. Each alternative, therefore, is to be seen as to whether or not it gives
maximum profit.
Wealth / Value Maximisation
We will first like to define what is Wealth / Value Maximization Model. Shareholders wealth are the result of cost benefit
analysis adjusted with their timing and risk i.e. time value of money.
So, Wealth = Present Value of benefits – Present Value of Costs
It is important that benefits measured by the finance manager are in terms of cash flow. Finance manager should
emphasis on Cash flow for investment or financing decisions not on Accounting profit. The shareholder value
maximization model holds that the primary goal of the firm is to maximize its market value and implies that business
decisions should seek to increase the net present value of the economic profits of the firm.
OR
(c) Financial Needs of a Business: Business enterprises need funds to meet their different types of requirements. All the
financial needs of a business may be grouped into the following three categories-
Long-term financial needs: Such needs generally refer to those requirements of funds which are for a period exceeding
5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long-term financial needs.
Medium- term financial needs: Such requirements refer to those funds which are required for a period exceeding one
year but not exceeding 5 years.
Short- term financial needs: Such type of financial needs arises to finance current assets such as stock, debtors, cash,
etc. Investment in these assets is known as meeting of working capital requirements of the concern for a period not
exceeding one year.

PAPER 8B: ECONOMICS FOR FINANCE

1. (a) How is Personal Income and Disposable Personal Income defined and calculated? (3 Marks)
ANSWER

Personal income is a measure of actual current income receipts of persons from all sources which may or may not be
earned from productive activities during a given period. Personal income excludes retained earnings, indirect business
taxes, corporate income taxes and contributions towards social security.
Personal Income = NI - Undistributed profits – Net interest payments made by households – Corporate Tax +Transfer
Payments to the households from firms and government.
Disposable personal income is a measure of amount of the money in the hands of the individuals that is available for

1126
their consumption or savings. Disposable personal income is derived from personal income by subtracting the direct
taxes paid by individuals and other compulsory payments made to the government
Disposable Income = Personal Income - Personal Income Taxes – Nontax payments

(b) How Fiscal Policy had a strong influence on the performance of macro economy? (2 Marks)

ANSWER
Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic
activity and level of growth of aggregate. demand, output, and employment. It includes any design on the part of the
government to change the price level, composition, or timing of government expenditure or to alter the burden,
structure, or frequency of tax payment. In other words, fiscal policy is designed to influence the pattern and level of
economic activity in a country.

(c) Calculate the Operating Surplus

Particulars ₹ in Crores
Compensation of employees 200
Intermediate Consumption 800
Rent 600
Interest 500
Consumption of fixed capital 300
Net Indirect Taxes 400
Mixed Income 700
Sales 2500

ANSWER
GVAmp = GVAmp – Intermediate Consumption
= (Sales + Change in stock)- Intermediate Consumption
= 2500 – 800
= 1700 cr
GDPmp = GVAmp = 1700cr
NDPmp = GDP mp – Consumption of fixed Capital
= 1700 – 300
= 1400cr
NDPfc = NDPmp- Net Indirect taxes
= 1400- 400
= 1000cr
NDPfc = Compensation of employees + Operating Surplus + Mixed Income
1000 = 200 + operating surplus + 700
Operating Surplus = 100cr

(d) What are the analytics of Monetary Policy? (2 Marks)

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ANSWER
The monetary policy is intended to influence macro- economic variables such as aggregate demand, quantity of money
and credit, interest rates etc., so as to influence overall economic performance. The process or channels through which
the change of monetary aggregates affects the level of product and prices is known as ‘monetary transmission
mechanism’.
Generally central banks use the short-term interest rate as the policy instrument. These interest rate changes affect
macro-economic variables such as consumption, investment, and exports which in turn influence aggregate demand,
output, and employment. Changes in monetary policy may have impact on people’s expectations about inflation and
therefore on aggregate demand. This in turn affects employment and output in the economy

2. (a) What is supra regional sector in an economy? (2 Marks)

ANSWER
In the preparation of State income estimates, certain activities such as railways, communications, banking. and
insurance and central government administration, that cut across state boundaries, and thus their economic
contribution cannot be assigned to any one state directly are known as the ‘supra-regional sectors’ of the economy. The
estimates for these supra regional activities are compiled for the economy as a whole and allocated to the states based
on relevant indicators.

(b) What is the difference between Classical and Keynesian theory of determination
of National Income? (2 Marks)
ANSWER
The classical economists maintained that the economy is self‐regulating and is always capable of automatically achieving
equilibrium at the ‘natural level’ of real GDP or output, which is the level of real GDP that is obtained when the
economy's resources are fully employed. . If an excess in the labour force (unemployment) or products exist, the wage
or price of these will adjust to absorb the excess. According to them, there will be no involuntary unemployment.
Keynesian believe that prices and wages are not so flexible; they are sticky, especially downward. The stickiness of prices
and wages in the downward direction prevents the economy's resources from being fully employed and thereby
prevents the economy from returning to the natural level of real GDP. Therefore, output will remain at less than the full
employment level as long as there is insufficient spending in the economy

(c) How is Cambridge approach different from classical approach in the theory
of demand for money? (3 Marks)

ANSWER

Classical Approach: Changes in the general level of commodity prices or changes in the value or purchasing power of
money are determined first and foremost by changes in the quantity of money in circulation.
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
MV = PT
Where, M = the total amount of money in circulation in an economy
V = transactions velocity of circulation
P = average price level
T = the total number of transactions.
Cambridge Approach
The demand for money was primarily determined by the need to conduct transactions which will have a positive
relationship to the money value of aggregate expenditure. Since the latter is equal to money national income, the
Cambridge money demand function is stated as:

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Md = k PY
Md = is the demand for money balances,
Y = real national income
P = average price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’ is a parameter reflecting economic structure and monetary
habits, namely the ratio of total transactions to income and the ratio of desired money balances to total transactions.
The neoclassical theory changed the focus of the quantity theory of money-to-money demand and hypothesized that
demand for money is a function of only money income.

(d) What are the reason for superiority of Hecksher Ohlin theory of International Trade
over the theory of comparative advantage? (3 Marks)

ANSWER
The law of comparative advantage states that even if one nation is less efficient than the other nation in the production
of all commodities, there is still scope for mutually beneficial trade. The first nation should specialize in the production
and export of the commodity in which its absolute disadvantage is smaller and import the commodity in which its
absolute disadvantage is greater.
Ricardo based his law of comparative advantage on the ‘labour theory of value’, which assumes that the value or price
of a commodity depends exclusively on the amount of labour going into its production. This is quite unrealistic because
labour is not the only factor of production, nor is it used in the same fixed proportion in the production of all
commodities.
The Heckscher-Ohlin theory of trade states that comparative advantage in cost of production is explained exclusively by
the differences in factor endowments of the nations. In a general sense of the term, ‘factor endowment’ refers to the
overall availability of usable resources including both natural and man-made means of production. Nevertheless, in the
exposition of the modern theory, only the two most important factors—labour and capital—are taken into account.
The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the export of a commodity whose
production requires intensive use of its abundant resources and imports a commodity whose production requires
intensive use of its scarce resources.

3. (a) What are the conceptual problem confronted in estimating national income? (3 Marks)

ANSWER
Usually it is difficult to separate labour income from capital income because in many instances people provide both
labour and capital services. Such is the case with self-employed people like lawyers, engineers, traders, proprietors etc.
Other’s problems include:
(a) lack of an agreed definition of national income,
(b) accurate distinction between final goods and intermediate goods,
(c) issue of transfer payments,
(d) services of durable goods,
(e) difficulty of incorporating distribution of income,
(f) valuation of a new good at constant prices, and valuation of government services

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(b) What are the role of subsidy as part of government intervention in public finance? (2 Marks)
ANSWER
Subsidy is a form of market intervention by government. It involves the government directly paying part of cost to the
producers or consumers in order to promote the production (consumption) of goods and services. The aim of subsidy is
to intervene with market equilibrium to reduce the costs and thereby the market price of goods and services and
encourage increased production and consumption. Major subsidies in India are fertiliser subsidy, food subsidy, interest
subsidy, etc.

(c) How does fluctuations in exchange rate impact the domestic economy? (3 Marks)
ANSWER
Exchange rate changes affect economic activity in the domestic economy. A depreciation of domestic currency primarily
increases the price of foreign goods relative to goods produced in the home country and diverts spending from foreign
goods to domestic goods. Increased demand, both for domestic import-competing goods and for exports, encourages
economic activity and creates output expansion. Overall, the outcome of exchange rate depreciation is an expansionary
impact on the economy at an aggregate level. The positive effect of currency depreciation, however, largely depends on
whether the switching of demand has taken place in the right direction and in the right amount, as well as on the
capacity of the home economy to meet that increased demand by supplying more goods.

(d) What lead to emergence of WTO as a forum for Trade negotiation? (2 Marks)

ANSWER
The WTO Agreements as acknowledged in the preamble of the Agreement creating the World Trade Organization,
include raising standards of living, ensuring full employment and a large and steadily growing volume of real income and
effective demand, and expanding the production of and trade in goods and services. The WTO, whose primary purpose
is to open trade for the benefit of all, does its functions by acting as a forum for trade negotiations among member
governments, administering trade agreements, reviewing national trade policies, assisting developing countries in trade
policy issues, through technical assistance and training programmes and cooperating with other international
organizations.

4. (a) Market failure is a situation in which free market leads to misallocation of

society’s scarce resources? Comment (2 Marks)

ANSWER

The reason for market failure lies in the fact that though perfectly competitive markets work efficiently, most often the
prerequisites of competition are unlikely to be present in an economy. Market power can cause markets to be inefficient
because it keeps price higher and output lower than the outcome of equilibrium of supply and demand.
The demand-side market failures are said to occur when demand curves do not consider the full willingness of
consumers to pay for a product. The supply-side market failures happen when supply curves do not incorporate the full
cost of producing the product.

(b) Calculate National Income by Expenditure Method?

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Items ₹ In crore
Private Final Consumption Expenditure 1000
Government Final Consumption Expenditure 800
Net factor Income from abroad 40
Net Indirect Taxes 60
Net Exports -80
Net Domestic Capital Formation 70
National debt Interest 50
Net Current Transfer to abroad 20
ANSWER
GDPmp = Private final Consumption Expenditure + Government final Consumption expenditure + Gross domestic capital
formation + Net Export
= 1800 +70 + (-80)
= 1790 Cr
NDPfc = GDPmp- Consumption of fixed Capital + Net Indirect Taxes
= 1790+60
= 1850 cr
NNPfc = NDPfc + Net factor Income from abroad
= 1850+40
= 1890 cr

(c) What are the different modes of foreign Direct Investment? (3 Marks)
ANSWER
FDI is an important monetary source for India's economic development. The import-substitution strategy of
industrialisation followed by India post-independence era, stressed on an extremely careful and selective approach
while formulating FDI policy. The government’s strategy favouring foreign investments and the prevalent robust
business environment have ensured that foreign capital keeps flowing into the country
Modes of FDI is as follows:
i (i) Opening of a subsidiary or associate company in a foreign country,
ii (ii) Equity injection into an overseas company,
iii (iii) Acquiring a controlling interest in an existing foreign company,
iv (iv) Mergers and acquisitions(M&A)
v (v) Joint venture with a foreign company.
vi (vi) Green field investment (establishment of a new overseas affiliate for freshly starting production by a parent
company).
vii (vii) Brownfield investments (a form of FDI which makes use of the existing infrastructure by merging, acquiring,
or leasing, instead of developing a completely new one. For e.g., in India 100% FDI under automatic route is allowed in
Brownfield Airport projects.

1131
(d) What is open market operations? (2 Marks)
ANSWER

Open Market Operations (OMO) is a general term used for market operations conducted by the Reserve Bank of India by
way of sale/ purchase of Government securities to/ from the market with an objective to adjust the rupee liquidity
conditions in the market on a durable basis. When the RBI feels there is excess liquidity in the market, it resorts to sale
of securities thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the RBI will buy
securities from the market, thereby releasing liquidity into the market.

5. (a) What is the role of fiscal Policy during recession? (3 Marks)

ANSWER
The tools of fiscal policy are taxes, government expenditure, public debt, and the budget. A recession sets in with a
period of declining real income, as measured by real GDP and a situation of rising unemployment.
During recession incomes are reduced leading to lower tax payments. Government expenditures increase due to
increased transfer payments. These together provide proportionally more disposable income available for consumption
spending to households.
The tax policy during recession and depression, is framed to encourage private consumption and investment. A general
reduction in income taxes and low corporate taxes increases aggregate demand and investments respectively.

(b) What are Club goods and how it is defined? (2 Marks)

ANSWER
The Concept of Club goods was first studied by Buchanan. Impure public goods which are replicable and therefore
individuals who are excluded from one facility may get similar services from an equivalent provider. Examples of club
goods are facilities such as swimming pools, fitness centres etc.

(c) What are the impact of liquidity trap on the economy? (3 Marks)
ANSWER
Empirical evidence of liquidity trap is found during the global financial crisis of 2008 in the United States and Europe.
Short-term interest rates moved close to zero. Some economists argued that these developed economies were in a
liquidity trap. Even tripling of the monetary base in the US between 2008 and 2011 failed to produce significant effect
on the domestic prices.
When interest rates fall to very low levels, the expectation is that since the interest rate is very low it cannot go further
lower and that in all possibility it will move upwards. When interest rates rise, the bond prices will fall. To hold bonds at
this low interest rate is to take the almost certain risk of a capital loss. Therefore, the desire to hold bonds is very low
and approaches zero, and the demand to hold money in liquid form as alternative to bond holding approaches infinity.
In other words, investors would maintain cash savings rather than hold bonds. The speculative demand becomes
perfectly elastic with respect to interest rate and the speculative money demand curve becomes parallel to the X axis.
This situation is called a ‘Liquidity trap’.

(d) Why do people hold money balances?

ANSWER
Transaction, precautionary and speculative demand – depends on the nature of the holder- institutional payments

1132
mechanisms and the gap between receipt and use of money, amount of income and changes in incomes, general level of
prices, cost of conversion from near money to money etc.
MTP-II- NOV 2021
PAPER 8A: FINANCIAL MANAGEMENT

1. Answer the following:

(a) XYZ Company’s equity share is quoted in the market at ₹ 25 per share currently. The company pays a
dividend of ₹ 5 per share and the investor’s market expects a growth rate of 5% per year.
You are required to:
(i) CALCULATE the company’s cost of equity capital.
(ii) If the company issues 12% debentures of face value of ₹ 100 each and realises ₹ 95 per debenture while
the debentures are redeemable after 10 years at a premium of 12%, CALCULATE cost of debenture using
YTM?
Assume tax rate to be 30%.

ANSWER

(i) Cost of Equity Capital (Ke):

(ii) Cost of Debenture (Kd):

Using Present Value method (or YTM)
Identification of relevant cash flows

Year Cash flows

0 Current market price (P0) = ₹ 95
1 to 10 Interest net of tax [I(1-t)] = 12% of ₹ 100 (1 – 0.30) = ₹
8.40
10 Redemption value (RV) = ₹ 100 (1.12) = ₹ 112

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Calculation of Net Present Values (NPV) at two discount rates

Year Cash flows Discount factor @ Present Value Discount factor @ Present Value
9% (L) 10% (H)
0 (95) 1.0000 (95.00) 1.0000 (95.00)
1 to 10 8.40 6.4176 53.91 6.1445 51.61
10 112 0.4224 47.31 0.3855 43.18
NPV +6.22 -0.21
Calculation of IRR

Therefore, Kd = 9.97%

(b) ABC Limited is setting up a project with a capital outlay of ₹ 90,00,000. It has two alternatives in
financing the project cost.
Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each
Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 30%. CALCULATE the
indifference point between the two alternative methods of financing.

ANSWER

Calculation of Indifference point between the two alternatives of financing.

Alternative-I By issue of 9,00,000 equity shares of ₹10 each amounting to ₹ 90 lakhs. No financial charges are involved
Debt = ₹ 60 lakhs
Equity = ₹ 30 lakhs (3,00,000 equity shares of ₹ 10 each)

1134
Therefore, at EBIT of ₹ 16,20,000, earnings per share for the two alternatives is equal.

(c) The capital structure of PS Ltd. for the year ended 31st March, 2021 consisted as follows:

Particulars Amount in
₹
Equity share capital (face value ₹ 10,000
10 each)
10% debentures (₹ 100 each) 1,00,000

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During the year 2020-21, sales decreased to 10,000 units as compared to 12,000 units in the previous year.
However, the selling price stood at ₹ 12 per unit and variable cost at ₹ 8 per unit for both the years. The
fixed expenses were at ₹ 20,000 p.a. and the income tax rate is 30%.
You are required to CALCULATE the following:
(i) The degree of financial leverage at 12,000 units and 10,000 units.
(ii) The degree of operating leverage at 12,000 units and 10,000 units.
(iii) The percentage change in EPS due to change in units sold.

ANSWER
Sales in units 12,000 10,000
(₹) (₹)
Sales Value 1,44,000 1,20,000
Variable Cost (96,000) (80,000)
Contribution 48,000 40,000
Fixed expenses (20,000) (20,000)
EBIT 28,000 20,000
Debenture Interest (10,000) (10,000)
EBT 18,000 10,000
Tax @ 30% (5,400) (3,000)
Profit after tax (PAT) 12,600 7,000
(i) Financial Leverage= EBIT / = ₹ 28,000/₹ 18,000 = = ₹ 20,000 /₹ 10,000 =
EBT 1.56 2

(d) The following information is supplied to you:

Particulars ₹
Total Earnings 5,00,000
Equity shares (of ₹ 100 50,00,00
each) 0
Dividend paid 3,75,000
Price/ Earnings ratio 12.5

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Applying Walter’s Model:
(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.

ANSWER
(i) The EPS of the firm is ₹ 10 (i.e. ₹ 5,00,000/ 50,000). r = 5,00,000/ 50,00,000 = 10%. The P/E Ratio is given at 12.5 and
the cost of capital, Ke, may be taken at the inverse of P/E ratio. Therefore, Ke is 8 (i.e., 1/12.5). The firm is distributing
total dividends of ₹ 3,75,000 among 50,000 shares, giving a dividend per share of ₹ 7.50. The value of the share as per
Walter’s model may be found as follows:

The firm has a dividend payout of 75% (i.e., ₹ 3,75,000) out of total earnings of ₹ 5,00,000. Since, the rate of return of
the firm, r, is 10% and it is more than the Ke of 8%, therefore, by distributing 75% of earnings, the firm is not following an
optimal dividend policy. The optimal dividend policy for the firm would be to pay zero dividend and in such a situation,
the market price would be,

So, theoretically, the market price of the share can be increased by adopting a zero payout.
(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which the Ke would
be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10. Therefore, at the P/E ratio
of 10, the dividend policy would have no effect on the value of the share.
(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5 and in such a situation ke>
r and the market price, as per Walter’s model would be:

2. Jensen and spencer pharmaceutical is in the business of manufacturing pharmaceutical drugs including
the newly invented Covid vaccine. Due to increase in demand of Covid vaccines, the production had
increased at all time high level and the company urgently needs a loan to meet the cash and investment
requirements. It had already submitted a detailed loan proposal and project report to Expo-Impo bank,
along with the financial statements of previous three years as follows:

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Statement of Profit and Loss (In ₹ ‘000)
BALANCE SHEET (In ₹ ‘000)

1138
INDUSTRY AVERAGE OF KEY RATIOS

As a loan officer of Expo-Impo Bank, you are REQUIRED to apprise the loan proposal on the basis of
comparison with industry average of key ratios considering closing balance for accounts receivable of ₹
6,00,000 and inventories of ₹ 6,40,000 respectively as on 31st March, 2018. [10 Marks] (In ₹ ‘000)

ANSWER

1139
 1140

Conclusion:
In the last two years, the current ratio and quick ratio are less than the ideal ratio (2:1 and 1:1 respectively)
indicating that the company is not having enough resources to meet its current obligations. Receivables are
growing slower. Inventory turnover is slowing down as well, indicating a relative build-up in inventories or
increased investment in stock. High Long-term debt to total debt ratio and Debt to equity ratio compared to
that of industry average indicates high dependency on long term debt by the company. The net profit ratio is
declining substantially and is much lower than the industry norm. Additionally, though the Return on Total Asset(ROTA)
is near to industry average, it is declining as well. The interest coverage ratio measures how many times a company can
cover its current interest payment with its available earnings. A high interest coverage ratio means that an enterprise
can easily meet its interest obligations, however, it is declining in the case of Jensen & Spencer and is also below the
industry average indicating excessive use of debt or inefficient operations.
On overall comparison of the industry average of key ratios than that of Jensen & Spencer, the company is in
deterioration position. The company’s profitability has declined steadily over the period. However, before jumping to
the conclusion relying only on the key ratios, it is pertinent to keep in mind the industry, the company dealing in with i.e.
manufacturing of pharmaceutical drugs. The pharmaceutical industry is one of the major contributors to the economy
and is expected to grow further. After the covid situation, people are more cautious towards their health and are going
to spend relatively more on health medicines. Thus, while analysing the loan proposal, both the factors, financial and
non-financial, needs to be kept in mind.

3. Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The parts are
constructed in eight locations (including the central headquarter) around the world. The Finance Director,
Ms. Kuthrapali, chooses to implement video conferencing to speed up the budget process and save travel
costs. She finds that, in earlier years, the company sent two officers from each location to the central
headquarter to discuss the budget twice a year. The average travel cost per person, including air fare,
hotels and meals, is ₹ 27,000 per trip. The cost of using video conferencing is ₹ 8,25,000 to set up a system
at each location plus ₹ 300 per hour average cost of telephone time to transmit signals. A total 48 hours of
transmission time will be needed to complete the budget each year. The company depreciates this type of
equipment over five years by using straight line method. An alternative approach is to travel to local rented
video conferencing facilities, which can be rented for ₹ 1,500 per hour plus ₹ 400 per hour averge cost for
telephone charges. You are Senior Officer of Finance Department. You have been asked by Ms. Kuthrapali to
EVALUATE the proposal and SUGGEST if it would be worthwhile for the company to implement video
conferencing. [10 Marks]

ANSWER
Option I : Cost of travel, in case Video Conferencing facility is not provided
Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7×2×2 = 28 Trips
Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips × ₹ 27,000 per trip) = ₹ 7,56,000
Option II : Video Conferencing Facility is provided by Installation of Own Equipment at Different Locations
Cost of Equipment at each location (₹ 8,25,000 × 8 locations) = ₹ 66,00,000
Economic life of Machines (5 years). Annual depreciation (66,00,000/5) = ₹ 13,20,000
Annual transmission cost (48 hrs. transmission × 8 locations × ₹ 300 per hour) = ₹ 1,15,200

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Annual cost of operation (13,20,000 + 1,15,200) = ₹ 14,35,200
Option III : Engaging Video Conferencing Facility on Rental Basis
Rental cost (48 hrs. × 8 location × ₹ 1,500 per hr) = ₹ 5,76,000
Telephone cost (48 hrs.× 8 locations × ₹ 400 per hr.) = ₹ 1,53,600
Total rental cost of equipment (5,76,000 + 1,53,600) = ₹ 7,29,600
Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged on rental basis. Therefore,
Option III is suggested.
4. On 01st April, 2020, the Board of Director of ABC Ltd. wish to know the amount of working capital that
will be required to meet the programme they have planned for the year. From the following information,
PREPARE a working capital requirement forecast and a forecast profit and loss account and balance sheet:
Issued share capital ₹ 6,00,000
10% Debentures ₹ 1,00,000
Fixed Assets ₹ 4,50,000
Production during the previous year was 1,20,000 units; it is planned that this level of activity should be
maintained during the present year.
The expected ratios of cost to selling price are: raw materials 60%, direct wages 10% overheads 20%
Raw materials are expected to remain in store for an average of two months before issue to production.
Each unit of production is expected to be in process for one month. The time lag in wage payment is one
month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately three months.
Credit allowed by creditors is two months from the date of delivery of raw materials. Credit given to debtors
is three months from the date of dispatch.
Selling price is ₹ 5 per unit.
There is a regular production and sales cycle and wages and overheads accrue evenly. [10 Marks]

ANSWER
Forecast Profit and Loss Account for the period 01.04.2020 to 31.03.2021

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Working Capital Requirement Forecast for the year 01.04.2020 to 31.03.2021

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Forecast Balance Sheet as on 31.03.2021

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Notes:
1. Average monthly production: 1,20,000 ÷ 12 = 10,000 units
2. Average cost per month:

Raw Material 10,000 × (₹ 5 × 0.6) = ₹ 30,000

Direct wages 10,000 × (₹ 5 × 0.1) = ₹ 5,000
Overheads 10,000 × (₹ 5 × 0.2) = ₹ 10,000
3. Average profit per month: 10,000 × (₹ 5 × 0.1) = ₹ 5,000
4. Wages and overheads accrue evenly over the period and, hence, are assumed to be completely introduced for half
the processing time.

5. (a) PQR Ltd. has under its consideration a project with an initial investment of ₹ 2,25,00,000. Three
probable cash inflow scenarios with their probabilities of occurrence have been estimated as below:

Annual cash 50,00,000 75,00,000 1,00,00,000

inflow (₹)
Probability 0.2 0.7 0.1

The project life is 5 years and the desired rate of return is 12%. The estimated terminal values for the
project assets under the three probability alternatives are ₹ 0, ₹ 50,00,000 and ₹ 75,00,000 respectively.
You are required to:
(i) CALCULATE the probable NPV;
(ii) CALCULATE the worst-case NPV and the best-case NPV; and
(iii) STATE the probability occurrence of the worst case, if the cash flows are perfectly positively correlated
over time.
ANSWER
(a) (i) Calculation of Net Present Value (NPV)

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(ii) Worst and Best case is the case where expected annual cash inflows are minimum and maximum respectively.
Calculation of Worst Case and Best Case NPV:
Worst case NPV = ₹ (44,76,000)
Best Case NPV = ₹ 1,78,03,500
(iii) The cash flows are perfectly positively correlated over time means cash flow in first year will be cash flows in
subsequent years. The cash flow of ₹ 50,00,000 is the worst case cash flow and its probability is 20%, thus, possibility of
worst case is 20%.

(b) ‘Pecking order theory’ suggests manager to use various sources for raising of fund in certain order. BRIEF
out that order. [2 Marks]
ANSWER
Pecking order theory suggests that managers may use various sources for raising of fund in the following order:
1. Managers first choice is to use internal finance.
2. In absence of internal finance, they can use secured debt, unsecured debt, hybrid debt etc.
3. Managers may issue new equity shares as a last option

6. (a) BRIEF out any four types of Preference shares along with its feature. [4 Marks]
ANSWER
Sl. No. Type of Preference Shares Salient Features
1 Cumulative Arrear Dividend will accumulate.
2 Non-cumulative No right to arrear dividend.
3 Redeemable Redemption should be done.
4 Participating Can participate in the surplus which remains after
payment to equity shareholders.
5 Non- Participating Cannot participate in the surplus after payment of

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fixed rate of Dividend.
6 Convertible Option of converting into equity Shares

(b) EXPLAIN any four types of Packing Credit. [4 Marks]

ANSWER
(i) Clean packing credit: This is an advance made available to an exporter only on production of a firm export order or a
letter of credit without exercising any charge or control over raw material or finished goods. It is a clean type of export
advance. Each proposal is weighed according to particular requirements of the trade and credit worthiness of the
exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (ECGC) cover should be
obtained by the bank.
(ii) Packing credit against hypothecation of goods: Export finance is made available on certain terms and conditions
where the exporter has pledge able interest and the goods are hypothecated to the bank as security with stipulated
margin. At the time of utilising the advance, the exporter is required to submit, along with the firm export order or letter
of credit relative stock statements and thereafter continue submitting them every fortnight and/or whenever there is
any movement in stocks.
(iii) Packing credit against pledge of goods: Export finance is made available on certain terms and conditions where the
exportable finished goods are pledged to the banks with approved clearing agents who will ship the same from time to
time as required by the exporter. The possession of the goods so pledged lies with the bank and is kept under its lock
and key.
(iv) E.C.G.C. guarantee: Any loan given to an exporter for the manufacture, processing, purchasing, or packing of goods
meant for export against a firm order qualifies for the packing credit guarantee issued by Export Credit Guarantee
Corporation.
(v) Forward exchange contract: Another requirement of packing credit facility is that if the export bill is to be drawn in a
foreign currency, the exporter should enter into a forward exchange contact with the bank, thereby avoiding risk
involved in a possible change in the rate of exchange.

(c) EXPLAIN: Callable bonds and Puttable bonds.

ANSWER
(i) Callable bonds: A callable bond has a call option which gives the issuer the right to redeem the bond before maturity
at a predetermined price known as the call price (Generally at a premium).
(ii) Puttable bonds: Puttable bonds give the investor a put option (i.e. the right to sell the bond) back to the company
before maturity.

Or
Briefly DESCRIBE bridge finance.
ANSWER
Bridge Finance: Bridge finance refers to loans taken by a company normally from commercial banks for a short period
because of pending disbursement of loans sanctioned by financial institutions. Though it is of short-term nature but
since it is an important step in the facilitation of long-term loan, therefore it is being discussed along with the long term
sources of funds. Normally, it takes time for financial institutions to disburse loans to companies. However, once the
loans are approved by the term lending institutions, companies, in order not to lose further time in starting their
projects, arrange short term loans from commercial banks. The bridge loans are repaid/ adjusted out of the term loans
as and when disbursed by the concerned institutions. Bridge loans are normally secured by hypothecating movable
assets, personal guarantees and demand promissory notes. Generally, the rate of interest on bridge finance is higher as

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compared with that on term loans

PAPER 8B: ECONOMICS FOR FINANCE

1. (a) What is the distinction between taxes on production and product taxes? (Marks 2)
ANSWER
Production taxes are paid in relation to production and are independent of the volume of actual production. Examples of
production taxes are land revenues, stamps and registration fees and tax on profession, factory license fee, taxes to be
paid to the local authorities, pollution tax etc.
Product taxes are paid on per unit of product. Examples of product taxes are excise duties, sales tax, service tax and
import-export duties.

(b) Describe the relevance of Circular flow of income in the measurement of National Income (Marks 3)
ANSWER
Circular flow of income refers to the continuous circulation of production, income generation and expenditure involving
different sectors of the economy. There are three different interlinked phases in a circular flow of income, namely:
production, distribution, and disposition.
(i) In the production phase, firms produce goods and services with the help of factor services.
(ii) In the income or distribution phase, the flow of factor incomes in the form of rent, wages, interest, and profits from
firms to the households occurs
(iii) In the expenditure or disposition phase, the income received by different factors of production is spent on
consumption goods and services and investment goods. This expenditure leads to further production of goods and
services and sustains the circular flow

(c) What are the factors behind the concept of multiplier? (Marks 3)
ANSWER
The multiplier concept is central to Keynes's theory because it explains how shifts in investment caused by changes in
business expectations set off a process that causes not only investment but also consumption to vary. The multiplier
shows how shocks to one sector are transmitted throughout the economy. Increase in income due to increase in initial
investment, does not go on endlessly. If the increased income goes out of the cycle of consumption expenditure, there is
a leakage from income stream which reduces the effect of multiplier. The more powerful these leakages are the smaller
will be the value of multiplier.

(d) Suppose the Consumption function of the economy is given by: (Marks 2)
C = 40 + 0.8 Y
and Investment Function is given by
I = 30 + 0.4 Y
What will be the equilibrium level of national Income?
ANSWER
Y = C +I
Y = 40 + 0.2Y + 30 + 0.3Y
Y = 70 + 0.5Y

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Y = 70 /0.5
Y = 140

2. (a) What is the role of the government in the management of the fiscal parameters of the economy?
(Marks 3)
ANSWER
The significance of fiscal policy as a strategy for achieving certain socio-economic objectives was not recognized or
widely acknowledged before 1930 due to the faith in the limited role of government advocated by the then prevailing
laissez- faire approach. Governments of all countries pursue innumerable policies to accomplish their economic goals
such as rapid economic growth, equitable distribution of wealth and income, reduction of poverty, price stability,
exchange rate stability, full- employment, balanced regional development etc. Government budget is one among the
most powerful instruments of economic policy.
Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic
activity and level of growth of aggregate demand, output, and employment.

(b) What is the rationale of measuring money supply?. (Marks 2)

ANSWER
The term money supply denotes the total quantity of money available to the people in an economy. The quantity of
money at any point of time is a measurable concept.
Rationale of money supply:
• It facilitates analysis of monetary developments in order to provide deeper understanding of the causes of money
growth.
• It is essential from a monetary policy perspective as it provides a framework to evaluate whether the stock of money
in the economy is consistent with the standards for price stability and to understand the nature of deviations from this
standard. The central banks all over the world adopt monetary policy to stabilise price level and GDP growth by directly
controlling the supply of money. This is achieved mainly by managing the quantity of monetary base. The success of
monetary policy depends to a large extent on the controllability of the monetary base and the money supply.

(c) Calculate GDP and National Income from the Following data: (Marks 5)

Item Rs. In crore

Depreciation 400
Exports 1200
Imports 900
Net Factor income from rest of 600
the world
Change in business inventories 200
Gross private domestic fixed 400
Investment
Indirect Taxes 7000
Subsidies 500
State government consumption 700
and investment expenditure

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Central government consumption 800
and investment expenditure
Private Consumption Expenditure 5000

ANSWER
GDPmp = Private consumption expenditure + Gross Private (both fixed and inventories) + Gross expenditure (Central &
State) + Net Exports
= 5000+ 400 + 200 + 700 + 800 + (1200-900)
= 7400cr
National Income = GDPmp – Net Indirect Taxes
= 7400-6500-600
= 300cr

3. (a) What are the Operating Procedures and Instruments of Monetary Policy? (Marks 3)
ANSWER

The operating framework relates to all aspects of implementation of monetary policy

• The operating targets refer to the financial variables that can be controlled by the central bank to a large extent
through the monetary policy instruments.
• The intermediate targets are variables which the central bank can hope to influence to a reasonable degree through
the operating targets. The intermediate targets display a predictable and stable relationship with the goal variables.
• The monetary policy instruments are the various tools that a central bank can use to influence money market and
credit conditions and pursue its monetary policy objectives. The day-to-day implementation of monetary policy by
central banks through various instruments is referred to as ‘operating procedures.

In general, the direct instruments comprise of:

(a) the required cash reserve ratios and liquidity reserve ratios prescribed from time to time.
(b) directed credit which takes the form of prescribed targets for allocation of credit to preferred sectors
(c) administered interest rates wherein the deposit and lending rates are prescribed by the central bank.
The indirect instruments mainly consist of:
(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window.

(b) What is the Process of determination of Nominal Exchange Rate ? (Marks 2)

ANSWER
As you already know, the key framework for analyzing prices is the operation of forces of supply and demand in
markets. Usually, the supply of and demand for foreign exchange in the domestic foreign exchange market determine
the external value of the domestic currency, or in other words, a country’s exchange rate. Individuals, institutions, and
governments participate in the foreign exchange market for a number of reasons. On the demand side, people desire
foreign currency to: • purchase goods and services from another country • for unilateral transfers such as gifts, awards,
grants, donations or endowment. • to make investment income payments abroad • to purchase financial assets, stocks,
or bonds abroad • to open a foreign bank account • to acquire direct ownership of real capital, and • for speculation and
hedging activities related to risk-taking or risk- avoidance activity

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Determination of Nominal Exchange Rate
The equilibrium rate of exchange is determined by the interaction of the supply and demand for a particular foreign
currency. In figure the demand curve (D$) and supply curve (S$) of dollars intersect to determine equilibrium exchange
rate.

(c) What are the Factors that leads to market Failure? (Marks 3)
ANSWER
There are four major reasons for market failure. They are: • Market power, • Externalities, • Public goods, and •
Incomplete information Market Power: Market power is the ability of a firm to profitably raise the market price of a
good or service over its marginal cost. Externalities: The unique feature of an externality is that it is initiated and
experienced not through the operation of the price system, but outside the market. Since it occurs outside the price
mechanism, it has not been compensated for, or in other words it is uninternalized or the cost of it is not borne by the
parties. Public Goods: A public good is defined as one which all enjoy in common in the sense that everyone’s
consumption of such a good lead to no subtraction from any other individuals’ consumption of that good. Incomplete
information: Information failure is widespread in numerous market exchanges. When this happens misallocation of
scarce resources takes place and equilibrium price, and quantity is not established through price mechanism. This results
in market failure.

(d) What are the advantage of Foreign Portfolio Investment? (Marks 2)

ANSWER
Foreign portfolio investment (FPI) is not concerned with either manufacture of goods or with provision of services. Such

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investors also do not have any intention of exercising voting power or controlling or managing the affairs of the
company in whose securities they invest. The sole intention of a foreign portfolio investor is to earn a remunerative
return through investment in foreign securities and is primarily concerned about the safety of their capital, the
likelihood of appreciation in its value, and the return generated.
• Portfolio capital moves to a recipient country which has revealed its potential for higher returns and profitability.
• Investment is only in financial assets
• Only short-term interest and generally remain invested for short periods
• Relatively easy to withdraw
• Not accompanied by technology transfer
• No direct impact on employment of labour and wages
• No abiding interest in management and control
• Securities are held purely as a financial investment and no significant degree of influence on the management of the
enterprise

4 (a) What is countervailing duty and how does it effect trade policy? (Marks 3)
ANSWER
Countervailing duties are tariffs that aim to offset the artificially low prices charged by exporters who enjoy export
subsidies and tax concessions offered by the governments in their home country. If a foreign country does not have a
comparative advantage in a particular good and a government subsidy allows the foreign firm to be an exporter of the
product, then the subsidy generates a distortion from the free-trade allocation of resources. In such cases, CVD is
charged in an importing country to negate the advantage that exporters get from subsidies to ensure fair and market-
oriented pricing of imported products and thereby protecting domestic industries and firms.

(b) How is economy effected by crowding out effect? (Marks 2)

ANSWER
The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources
from the private sector to the public sector where productivity might be lower. An increase in the size of government
spending during recessions will ‘crowd-out’ private spending in an economy and lead to reduction in an economy’s
ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic
growth. Crowding out effect is the negative effect fiscal policy may generate when money from the private sector is
‘crowded out’ to the public sector.
During deep recessions, crowding-out is less likely to happen as private sector investment is already minimal and
therefore there is only insignificant private spending to crowd out. Moreover, during a recession phase the government
would be able to borrow from the market without increasing interest rates.

(c). Elaborate the reason why tragedy of the commons occurs? (Marks 3)
ANSWER
Economists use the term to describe the problem which occurs when rivalrous but non excludable goods are overused
to the disadvantage of the entire world. The term “commons” is derived from the traditional English legal term of
“common land” where farmers/peasants would graze their livestock, hunt, and collect wild plants and other produce.
Everyone has access to a commonly held pasture; there are no rules about sustainable numbers for grazing. The
outcome of the individual rational economic decisions of cattle owners was market failure because these actions
resulted in degradation, depletion or even destruction of the resource leading to welfare loss for the entire society.

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(d) What is the usefulness of the National Income Account? (Marks 2)
ANSWER
The estimates of national income show the composition and structure of national income in terms of different sectors of
the economy, the periodical variations in them and the broad sectoral shifts in an economy over time. It is also possible
to make temporal and spatial comparisons of the trend and speed of economic progress and development. Using this
information, the government can fix various sector-specific development targets for different sectors of the economy
and formulate suitable development plans and policies to increase growth rates.

5. (a) What is the effect of New Trade Policy on Industries? (Marks 3)

ANSWER
New Trade Policy helps in understanding why developed and big countries trade partners are when they are trading
similar goods and services. These countries constitute more than 50% of world trade. This is particularly true in key
economic sectors such as electronics, IT, food, and automotive. NTT argues that, because of substantial economies of
scale and network effects, it pays to export phones to sell in another country. Those countries with the advantages will
dominate the market, and the market takes the form of monopolistic competition.
According to NTT, two key concepts give advantages to countries that import goods to compete with products from the
home country:
Economies of Scale: As a firm produces more of a product, its cost per unit keeps going down. So, if the firm serves
domestic as well as foreign market instead of just one, then it can reap the benefit of large scale of production
consequently the profits are likely to be higher.
Network effects refer to the way one person’s value for a good or service is affected by the value of that good or service
to others. The value of the product or service is enhanced as the number of individuals using it increases. This is also
referred to as the ‘bandwagon effect’. Consumers like more choices, but they also want products and services with high
utility, and the network effect increases utility obtained from these products over others.

(b) Why is government intervention required in case of demerit good? (Marks 2)

ANSWER
Demerit goods are goods which are believed to be socially undesirable. The consumption of demerit goods imposes
significant negative externalities on the society as a whole and therefore the private costs incurred by individual
consumers are less than the social costs experienced by the society. The production and consumption of demerit goods
are likely to be more than optimal under free markets. The government should therefore intervene in the marketplace
to discourage their production and consumption. Imposing unusually high taxes on producing or purchasing the good
making them very costly and unaffordable to many is perhaps the most commonly used method for reducing the
consumption of a demerit good.

(c) What are the limitation of Fiscal Policy? (Marks 3)

ANSWER

Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an
expansionary policy is initiated when the economy is already on a path of recovery and vice versa. The imitation of fiscal
policy is :-
• There are difficulties in instantaneously changing governments’ spending and taxation policies.
• It is practically difficult to reduce government spending on various items such as defence and social security as well as
on huge capital projects which are already midway.

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• Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as
highways and dams have long gestation period.
• Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and
promptly determining the accurate policy to be undertaken.
• There are possible conflicts between different objectives of fiscal policy such that a policy designed to achieve one goal
may adversely affect another.
• Supply-side economists are of the opinion that certain fiscal measures will cause disincentives
• Deficit financing increases the purchasing power of people.
• Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid.
(d). What are the export related measures as an instrument of Trade Policy? (Marks 2)
ANSWER
Trade Policy encompasses all instruments that government may use to promote or restrict imports and exports.Export
related measures are:1.Ban on export.2.Export Taxes.3.Export Subsidies and incentives.4.Voluntary Export Restraints
Over the past few decades, significant transformations are happening in terms of growth as well as terms of flows and
pattern of global trade. The increasing importance of developing countries has been a salient feature of the shitting
global trade patterns.

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