SERIAL N0 CHAPTER NAME PAGE

NO.
1 Ratio Analysis 3

2 Cost of Capital 29

3 Capital Structure 54

4 Leverage 71

5 Investment Decision 99

6 Risk Analysis in Capital Budgeting 131

7 Dividend Decision 150

8 Management of Receivables 171

9 Miscellaneous 214

10 Determination of National Income 235

11 Public Finance 269

12 Money Market 300

13 International Trade 328

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 Section A- Financial Management Ratio Analysis
Q 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%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold 22,50,000
Interest on debentures 75,000
Receivables (includes debtors r 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:
Liabilities r Assets r
Share Capital Fixed Assets
Reserves and Current
Surplus Assets Stock
15% Receivables
Debentures Cash
Payables
Bank Term Loan (10 Marks)

Answer
(a) Calculation of Operating Expenses for the year ended 31st March, 2021

Particulars (`)
Net Profit [@ 6.5% of Sales] 4,87,500
Add: Income Tax (@ 50%) 4,87,500
Profit Before Tax (PBT) 9,75,000
Add: Debenture Interest 75,000
Profit before interest and tax (PBIT) 10,50,000
Sales 75,00,000
Less: Cost of goods sold
PBIT 33,00,000
Operating Expenses 42,00,000

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 (a) Balance Sheet as on 31st March, 2021

Liabilities ` Assets `
Share Capital 11,70,000 Fixed Assets 18,50,000
Reserve and 7,80,000 Current Assets
Surplus
15% Debentures 5,00,000 Stoc 1,87,500
k
Payables 2,50,000 Receivables 2,00,000
Bank 1,50,000 Cash 6,12,500
Overdraft(
or Bank Term
Loan)
28,50,000 28,50,000
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
Net worth 25 = 4,87,500
100
Net worth =` 4,87,500 100 = ` 19,50,000
25
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
Debentures = 75,000 100 = ` 5,00,000
15
(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

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 Particulars `
Share capital 11,70,000
Reserves 7,80,000
Debentures 5,00,000
Payables 2,50,000
Bank Overdraft 1,50,000
Total Liabilities 28,50,000
Less: Current Assets 10,00,000
Fixed Assets 18,50,000

(v) Calculation of Composition of Current Assets

Inventory Turnover = 12
Cost of goods sold 12
Closing stock
Closing stock = ` 22,50,000 = Closing stock = ` 1,87,500

12

Particulars `
Stock 1,87,500
Receivables 2,00,000
Cash (balancing figure) 6,12,500
Total Current Assets 10,00,000

Q 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:
(RTP NOV21)

Particulars Amount
(`)
Equity Share Capital (Face value @ ` 20) 20,00,00
0
10% Preference Share capital 4,00,000
Reserves & Surplus 16,00,00
0
12.5% Debentures 12,00,00
0
Profit before Interest and Tax for the year 8,00,000
CALCULATE the following when company falls within 25% tax bracket:

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 (i) Return on Capital Employed
(ii) Earnings Per share
(iii P/E Ratio
SOL )
1. (i) Return on Capital Employed
(ROCE)
ROCE (Pre-tax) = Profit before interest and taxes(PBIT) × 100
Capital Employed

= ` 8,00,000 × 100
` 52,00,000
= 15.38% (approx.)

ROCE (Post-tax) = PBIT(1 - t) × 100

Capital Employed

= ` 8,00,000 (1 0.25) × 100

` 52,00,000
= 11.54% (approx.)

(ii) Earnings Per share (EPS)

= Profit available to equity
shareholders Number of equity
sharesoutstanding

= ` 4,47,500

1,00,000 =4.475

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 (iii) P/ERatio

= Market Price per Share(MPS)

Earning per Share(EPS)

= 28
4.475
= 6.26 times (approx.)

Working:
(a) Income Statement

Particulars Amount
(`)
Profit before Interest and Tax (PBIT) 8,00,000
Interest on Debentures (12.5% of ` (1,50,00
12,00,000) 0)
Profit before Tax (PBT) 6,50,000
Tax @ (1,62,50
25% 0)
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
Given below are the estimations for the next year by Niti Ltd.: (RTP MAY 21)

Particulars (` in crores)
Fixed Assets 5.20
Current 4.68
Liabilities
Current Assets 7.80
Sales 23.00
EBIT 2.30
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)

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 Financing Short term debt @ 12% Long term debt @ Total
Policy 16%
Conservative 1.08 2.24 3.32
Moderate 2.00 1.32 3.32
Aggressive 3.00 0.32 3.32
Assuming corporate tax rate at 30%, CALCULATE the following for each of the
financingpolicy:
(i) Return on total assets
(ii) Return on owner's equity
(iii) Net Working capital
(iv) Current Ratio
Also advise which Financing policy should be adopted if the company wants high returns.

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 1. (i) Return on total assets

Return on total assets = EBIT (1 - T)

Total assets (FA CA)

= ` 2.30 crores (1- 0.3)

` 5.20 crores + ` 7.80 crores
= 1.61 crores = 0.1238 or 12.38%

13 crores
(ii) Return on owner's equity
(Amount in `)

Financing policy (`)

Conservativ Moderate Aggressiv
e e
Expected EBIT 2,30,00,000 2,30,00,00 2,30,00,00
0 0
Less: Interest
Short term Debt @ 12% 12,96,000 24,00,000 36,00,000
Long term Debt @ 16% 35,84,000 21,12,000 5,12,000
Earnings before tax (EBT) 1,81,20,000 1,84,88,00 1,88,88,0
0 00
Less: Tax @ 30% 54,36,000 55,46,400 56,66,400
Earnings after Tax 1,26,84,000 1,29,41,60 1,32,21,6
(EAT) 0 00
Owner's Equity 5,00,00,000 5,00,00,00 5,00,00,0
0 00
Return on owner's = = =
equity Net Pr ofit after 1,26,84,000 1,29,41,600
taxes (EAT) Owners' 5,00,00,000 5,00,00,00 1,32,21,6
equity = 0.2537 or 0 00
25.37% = 0.2588 or 5,00,00,0
25.88% 00
= 0.2644
or
26.44%
(iii) Net Working Capital
(` in crores)

Financing policy
Conservativ Moderate Aggressiv

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 e e
Current Liabilities 4.68 4.68 4.68
(Excluding
Short Term Debt)
Short term Debt 1.08 2.00 3.00
Total Current Liabilities 5.76 6.68 7.68
Current Assets 7.80 7.80 7.80

Enkindledmindssgtbkhalsa enkindledmindssgtbkhalsa
 Net Working capital 7.80 - 5.76 7.80 - 6.68 7.80 - 7.68
= Current Assets - = 2.04 = 1.12 = 0.12
Current Liabilities
(iv) Current ratio
(` in crores)

Financing policy
Conservative Moderate Aggressive
Current Ratio = 7.80 = 7.80 = 7.80
= Current Assets 1.35 1.17 1.02
Current =5.76 =6.68 =7.68
Liabilities
Advise: It is advisable to adopt aggressive financial policy, if the company
wants highreturn as the return on owner's equity is maximum in this policy i.e.
26.44%.

Ques: From the following information, complete the Balance Sheet given below:
(Jan 21)

(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
Liabilities Amount(` Assets Amount(`
) )
Equity Shares 2,00,000 Fixed Assets ?
Capital
Long term Debt ? Current
Assets:
Current Debt ? Inventory ?
Cash ?
SOL: Balance Sheet of XYZ Co. as on March 31, 2020

Liabilities Amount (`) Assets Amount (`)

Equity Share 2,00,000 Fixed Assets 1,20,000
Capital
Long-term Debt 90,000 Current Assets:
Current Debt 60,000 Inventory 87,500
Cash (balancing 1,42,500
figure)
3,50,000 3,50,000
1. Total Debt = 0.75 x Equity Share Capital = 0.75 x ` 2,00,000 = ` 1,50,000
2. 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
3. Fixed Assets = 0.60 x Equity Share Capital
= 0.60 x ` 2,00,000 = ` 1,20,000
4. 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
Ques: XYZ Ltd. has Owner's equity of Rs. 2,00,000 and the ratios of the company are as
follows:(MTP 2021)

Current debt to total 0.3

debt
Total debt to Owner's 0.5
equity
Fixed assets to Owner's equity 0.6
Total assets turnover 2 times
Inventory turnover 10 times

COMPLETE the following Balance Sheet from the information given above:
 Liabilities (Rs. Assets (Rs.
) )
Current Debt - Cash -
Long-term Debt - Inventory -
Total Debt - Total Current Assets -
Owner's Equity - Fixed Assets -
 Sol: Balance Sheet

Liabilities (Rs.) Assets (Rs.)

Current debt 30,000 Cash (balancing 1,20,000
figure)
Long term debt 70,000 Inventory 60,000
Total Debt 1,00,000 Total Current Assets 1,80,000
Owner's Equity 2,00,000 Fixed Assets 1,20,000
Total liabilities 3,00,000 Total Assets 3,00,000
Workings:
1. Total debt = 0.50 x Owner's Equity = 0.50 x Rs. 2,00,000
= Rs. 1,00,000 Further, Current debt to Total debt =
0.30
So, Current debt = 0.30 × Rs. 1,00,000 =
Rs. 30,000 Long term debt = Rs. 1,00,000 -
Rs. 30,000 = Rs.
70,000
2. Fixed assets = 0.60 × Owner's Equity = 0.60 × Rs. 2,00,000 = Rs. 1,20,000
3. Total Liabilities = Total Debt + Owner’s Equity
= Rs. 1,00,000 + Rs. 2,00,000 = Rs. 3,00,000
Total Assets = Total Liabilities = Rs. 3,00,000
Total assets to turnover = 2 Times; Inventory turnover
= 10 Times Hence, Inventory /Total assets =
2/10=1/5,
Therefore Inventory = Rs. 3,00,000/5 = Rs. 60,000

Ques: SN Ltd. has furnished the following ratios and information relating
to the year ended 31 st March 2021:
(MT
P 21)

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 & 3 times
Cash
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. (Note- Balance sheet may be prepared in
traditional T Format.)
 Workings:

1. Current Ratio = Current Assets(CA) = 1.5

Current
Liabilities(CL) CA =
1.5 CL
Also, CA - CL = Rs.
2,00,000 1.5 CL- CL
= Rs. 2,00,000
CL = Rs. 2,00,000 0.5= Rs. 4,00,000
CA = 1.5 × Rs. 4,00,000 = Rs. 6,00,000
2. Bank Credit (BC) to Other Current Liabilities (OCL) ratio = 3:1
= Bank Credit (BC) = 3 Other Current Liabilities (OCL)
BC = 3 OCL
Also, BC + OCL = CL
3 OCL + OCL = Rs. 4,00,000
OCL = Rs. 4,00,0004= Rs. 1,00,000
Bank Credit = 3 × Rs. 1,00,000 = Rs. 3,00,000
3. Quick Ratio Current Assets -
Inventories=Current Liabilities 0.7 = Rs.
6,00,000-Inventories=Rs. 4,00,000
Inventories = Rs. 6,00,000 – Rs. 2,80,000 = Rs. 3,20,000
4. Inventory Turnover = 5 times
Inventory Turnover = Cost of goods sold (COGS)

Average
Inventory Average Inventory = Cost of
goods sold (COGS)
Inventory
Turnover COGS = Rs. 3,20,000 ×
5 = Rs. 16,00,000
5. Gross Margin = Sales - COGS × 100 = 25%

Sales
Sales = 16,00,000 = Rs. 21,33,333.33
0.75
6. Average Collection Period (ACP) = 1.5
months = 45 days Debtors Turnover = 360 =
360 = 8 times
ACP = 45

Also, Debtors Turnover = Sales

Average
Debtors Hence, Debtors =
Rs.21,33,333.338= Rs.2,66,667
7. Bank & Cash = CA - (Debtors + Inventory)
= Rs. 6,00,000 – (Rs. 2,66,667 + 3,20,000) = Rs. 13,333
8. Reserves &
Surplus = 3
Bank & Cash
 Reserves & Surplus = 3 × Rs. 13,333 = Rs. 40,000
Balance Sheet of SN Ltd. as on 31st March 2021

Liabilities (Rs.) Assets (Rs.)

Share Capital 6,25,000 Fixed Assets 4,65,000
Reserves & Surplus 40,000 (Balancing
Figure)
Current Liabilities: Current Assets:
Bank Credit 3,00,000 Inventories 3,20,000
Other Current 1,00,000 Debtors 2,66,667
Liabilities
Bank & Cash 13,333
10,65,000 10,65,000

(a) Following information relates to RM Co. Ltd. (NOV 20)

(`)

Total Assets 10,00,000

employed
Direct Cost 5,50,000
Other Operating 90,000
Cost
Goods are sold to the customers at 150% of direct costs.
50% of the assets being financed by borrowed capital at an interest cost of
8% per annum. Tax rate is 30%.

You are required to calculate :

(i) Net profit margin
(ii) Return on Assets
(iii) Asset turnover
(iv) Return on owners' equity

Answer
(a) Computation of net profit:

Particulars (`)
Sales (150% of ` 5,50,000) 8,25,000
Direct Costs 5,50,000
Gross profit 2,75,000
Other Operating Costs 90,000
 Operating profit (EBIT) 1,85,000
Interest changes (8% of ` 40,000
5,00,000)
Profit before taxes (EBT) 1,45,000
Taxes (@ 30%) 43,500
Net profit after taxes (EAT) 1,01,500
 (i) Net profit margin (After tax) = Profit after taxes = 1,01,500 = 12.303%
Sales 8,25,000

Net profit margin (Before tax)= Profit before taxes= 1,45,000 = 17.576%
Sales 8,25,000

ii) Return on assets = (EBIT (1 -T) = 1,85,000(1-0.3) = 12.95%

Total Assets 10,00,000

(iii) Asset turnover = Sales = 8,25,000 = 0.825 times

Assets 10,00,000

(iv) Return on owner's equity= Profit after taxes = 1,01,500 = 20.3%

Owners equity

1. Following information has been provided from the books of M/s Laxmi
& Co. for the year ending on 31st March, 2020: (RTP
NOV 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.
1. Working notes:
(i) Current Assets and Current Liabilities computation:
Cur = 2.5
rent
asse 1
ts
Curr
ent
liabi
lities

Or Current assets = 2.5 Current liabilities

 Now, Working capital = Current assets Current
liabilities 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 2.5 = ` 8,00,000
(ii) Computation of stock
Liquid assets
Liquid ratio =
Current liabilities

Or 1.5 = Current assets - Inventorie s

`3,20,000
Or 1.5 `3, 20,000 = ` 8,00,000 Inventories
 Or Inventories = ` 8,00,000 – ` 4, 80,000
Or Stock = ` 3,20,000
(iii) Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors
Fixed Asset to Proprietary ratio = Fixed = 0.75
assets

Proprietary fund

Fixed Assets = 0.75 Proprietary fund

(PF)[FA+NWC = PF] or NWC = PF- FA [(i.e. .75 PF)]
and 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 = (Current liabilities Bank
Creditors = overdraft) (` 3,20,000
`80,000) =
`2,40,000
Balance Sheet as at 31st March, 2020

Liabilities ` Assets `
Capital 16,00,00 Fixed Assets 14,40,00
0 0
Reserves & 3,20,000 Stock 3,20,000
Surplus
Bank overdraft 80,000 Other Current 4,80,000
Assets
Sundry creditors
2,40,000
22,40,00 22,40,00
0 0
1. MT Limited has the following Balance Sheet as on March 31, 2019 and March 31,
2020:
 Balance Sheet (RTP MAY2020)
` in
lakhs
March 31, March 31, 2020
2019
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
March 31, 2019 March 31, 2020
Sales 22,500 23,800
Less: Cost of Goods sold (20,860) (21,100)
Gross Profit 1,640 2,700
Less: Selling, General and (1,100) (1,750)
Administrative
expenses
Earnings before Interest and Tax 540 950
(EBIT)
Less: Interest Expense (350) (300)
Earnings before Tax (EBT) 190 650
Less: (57) (195)
Tax
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]
Sol: Ratios for the year 2019-2020
Inventory turnover ratio
= COGS = `21,100
`(2,500 + 2,000) = 9.4
Average 2
Inventory

Financial = EBIT
leverage
EBT
 `650
= `950 = 1.46
ROCE

= EBIT (1- t) = 950(1-0.3) = X100 = 11.56%

665

Average Capital Employed6000+5500

5,750

[Here Return on Capital Employed (ROCE) is calculated after Tax]

ROE
= Profits after tax = 455 X 100 =

18.2% Average shareholders' funds

2,500

Average Collection Period

Average Sales per day = `23,800 = `65.20 lakhs
365

Average collection period = Average Receivables= (1,400+1,100)

2
Average sales
per day 65.2

= 1250 = 19.17 days

65.2
(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.
(NOV 19)

Particula Amount
rs (`)
Equity Share Capital (face value ` 10) 10,00,00
0
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
Answer 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 PBIT
Return on capital employed [ROCE-(Pre-tax)] =
x 100
Capital Employed

= `4,00,000 x 100
`
26,00,000
 = 15.38% (approx.) x 100
Return on capital employed [ROCE-(Post-tax)] = Profit
after
Tax
Capi
tal
Employed
= `
2,40,000 x 100

`26,00,00
0

= 9.23% (approx.)
Calculation of Earnings per share
Earnings available to equity shareholders = Earnings per share
No of equity shares

= Profit after tax-

preference
Dividend No of
equity shares

= ` (2,40,000 - 20,000)
`1,00,000
= `2.20
Calculation of PE ratio

PE = Market Price per Share (MPS)

Earning per Shares (EPS)
= `14`
2.20

= 6.364 (approx.)
 Cost of Capital
Q Following are the information of TT Ltd.:
(JUL21)

Particulars
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 30lakhs
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
(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 Z 30,00,000= Z 10,00,000
Debt 2/3 of Z 30,00,000= Z 20,00,000
The capital structure after raising additional finance:
Particulars (Z)
Shareholder's Funds
Equity Capital 10,00,000
Debt (Interest at 10% 5,00,000
p.a.)(Interest at 9% p.a.) 5,00,000
(Interest at 8% p.a.) (20,00,000- 10,00,000
Total Funds 10,00,000) 30,00,000
Determination of post-tax average cost of additional debt
Kd = (1 — t)
 Where,
I = Interest Rate
t = Corporate tax-rate

On First Z 5,00,000 = 10% (1 - 0.3) = 7% or 0.07

On Next Z 5,00,000 = 9% (1 - 0.3) = 6.3% or 0.063
On Next Z 10,00,000 = 8% (1 - 0.3) = 5.6% or 0.056
Average Cost of Debt
_ ( 5,00,000x 0.07)+ ( 5,00,000x 0.063)+( 10,00,000x 0.056) x 100 = 6.125%
20,00,000

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

Ke= D +g
P0

Where,
Ke = Cost of equity
= Do (1+ g)
Do= Dividend paid
g = Growth rate = 6%
Po= Current market price per share = 120
Ke = `6(1+ 0.06) + 0.06 = 6.36 + 0.06 = 11.3%
120 120

(d) Computation of overall weighted average after tax cost of additional finance
Particulars (Z) Weights Cost of funds Weighted Cost
Equit 10,00,000 1/3 11.3% (%)
3.767
y
Debt 20,00,000 2/3 6 .125 % 4.083
30,00,000 7.85
WACC
(Note: In the above solution different interest rate have been considered for different slab of
Debt)
Q 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. (RTP NOV
2021)
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
 1. Workings:
(a) Value of Debt = Interest = 7,50,000 = 93,75,000
Cost of Debt(Kd ) 0.08
(b) Value of equity capital = Operating profit -Interest = 34,50,000-7,50,000 =
1,68,75,000
Cost of equity(Ke ) 0.16

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

= Increased Operating profit -Interest on Increased debt
Equity capital

= (` 34,50,000 + ` 14,25,000) - (` 7,50,000 + ` 6,00,000)

` 1,68,75,000= ` 48,75,000 - `13,50,000 = ` 35,25,000

= 0.209 or 20.9%

` 1,68,75,000 ` 1,68,75,000
(i) Calculation of Weighted Average Cost of Capital (WACC) before the newproposal

Source Amount Weigh Cost WACC

s (`) t of
Capita
l
Equity 1,68,75,00 0.6429 0.160 0.1029
0
Debt 93,75,00 0.3571 0.080 0.0286
0
Total 2,62,50,00 1 0.1315 or 13.15
0 %
(ii) Calculation of Weighted Average Cost of Capital (WACC)
after the new proposal

Sources Amount (`) Weight Cost WACC

o
f Capital
Equity 1,68,75,00 0.5000 0.209 0.1045
0
Debt 1,68,75,00 0.5000 0.080 0.0400
0
Total 3,37,50,00 1 0.1445 or 14.45
0 %
1. Indel Ltd. has the following capital structure, which is considered to be
optimum as on31st March, 2021:
(RTP
MAY21)

Particulars (`)
14% Debentures 60,000
11% Preference shares 20,000
Equity Shares (10,000 3,20,000
shares)
4,00,000
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.

Year EPS (`) Year EPS (`)

201 2.00 201 3.22
1 6
201 2.20 201 3.54
2 7
201 2.42 201 3.90
3 8
201 2.66 201 4.29
4 9
201 2.93 202 4.72
5 0
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. 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.
COMPUTE marginal cost of capital when the fund exceeds the amount
calculated in (C), assuming new equity is issued at ` 40 per share
2. (A) (i) Cost of new debt
Kd = I(1- t)
P0
= 16(1 0.3) = 0.11667
96

(ii) Cost of new

preference shares Kp

= ` 2.22 =

0.12

18.5

(ii) Cost of new equity shares

Ke = D1+g

P0

= ` 2.36 + 0.10
` 47.20
= 0.05 + 0.10 = 0.15
Calculation of g when there is a uniform trend (on the basis of EPS)

= EPS (2012) - EPS (2011) = 2.20

– 2.00 = 0.10 or 10% EPS(2011)

Calculation of D1
(B) Calculation of marginal cost of capital

Type of Capital Proportion Specific Cost Product

(1) (2) (3 (2) × (3) = (4)
)
Debentures 0.15 0.11667 0.0175
Preference 0.05 0.1200 0.0060
Share
Equity Share 0.80 0.1500 0.1200
Marginal cost of capital 0.1435
(C) The company can spend the following amount without increasing
marginal cost of capital and without selling the 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. So, ` 23,600 = 80% of Total
Capital
∴ Capital investment before issuing equity shares = 23,600 = 29,500
0.80

(D) If the company spends in excess of ` 29,500, it will have to issue new equity
shares at ` 40 per share.
D1
= +g = 2.36 0.10 = 0.159
(E) The cost of new issue of equity P0 ` 40

shares will be:Ke The marginal cost of

Type of Capital Proportion Specific Cost Product

capital will be:
(1) (2) (3) (2) × (3) = (4)
Debentures 0.15 0.11667 0.0175
Preference Shares 0.05 0.1200 0.0060
Equity Shares (New) 0.80 0.1590 0.1272
Marginal cost of capital 0.1507
 The Capital structure of PQR Ltd. is as follows: (Jan 21)

`
10% Debenture 3,00,000
12% Preference Shares 2,50,000
Equity Share (face value ` 10 per 5,00,000
share)
10,50,000
Additional Information:
(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.
SOL:
1. CALCULATE the WACC by using Market value weights.The capital structure of the company
is as under:
(MTP 21)

(Rs.)
Debentures (Rs.100 per 10,00,000
debenture)
Preference shares (Rs.100 per 10,00,000
share)
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
shareEquity 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 thepractice 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.
1. (i) Cost of Equity (Ke)
=
D Rs. 5
1 +g + = 0.1689 or 16.89%
= 265-1 0.15
P
0
-
F

(ii) Cost of Debt (Kd)

Calculation of NPV at discount rate of 5% and 7%

Year Cas Discount Presen Discount Present

h factor @ t factor @ 7% Value
flow 5% Valu (Rs.)
 s e
(Rs.
)
0 112.7 1.00 (112.7 1.000 (112.7)
0 )
1 to 7 7.72 54.05 7.024 49.17
10 2
10 100 0.61 61.40 0.508 50.80
4
NPV +2.75 -12.73

Calculation 2.75
of IRR (7% - 5%) = 5.36%
2.7 (7% - 5%) = 15.48
5 5% +
IRR =
5% +

2.75- (-12.73)

Cost of Debt (Kd) = 5.36%

(iii) Cost of Preference shares (Kp)

Calculation of NPV at discount rate of 2% and 5%

Year Cas Discou Presen Discou Present

h nt t nt Value
flow factor Valu factor (Rs.)
s @ 2% e @ 5%
(Rs.
)
0 117. 1.000 (117.6 1.000 (117.6
6 ) )
1 to 5 8.983 44.92 7.722 38.61
10
10 100 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

Calculation of IRR (5%-2%)=

2% + 9.32 (5%-2%)= 3.04%
IRR = 2% + 9. 26.91
32
9.32-(-
17.59)

Cost of Preference Shares (Kp) = 3.04%

Calculation of WACC using market value weights

Source of capital Market Weight After WACC

Value s tax (Ko)
cost
of
capita
l
(Rs.) (a) (b) (c) =
(a)×(b)
10% Debentures (Rs.115× 11,50,000 0.021 0.053 0.00113
10,000) 6
5% Preference shares 12,00,000 0.022 0.030 0.00067
(Rs.120× 4
10,000)
Equity shares (Rs.265 × 5,30,00,00 0.957 0.168 0.16164
2,00,000) 0 9
5,53,50,00 1.000 0.16344
0
WACC (Ko) = 0.16344 or 16.344%
(a) 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: (NOV 20)

Year 1 2 3 4 5
PV Factor @ 0.90 0.82 0.75 0.68 0.62
10% 9 6 1 3 1
PV Factor @ 0.87 0.75 0.65 0.57 0.49
15% 0 6 8 2 7
(a) 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: I(1- t )X (RV -NP) 10(1- 0.25)X (121.67 -100)
n = 5

(RV + NP) (121.67 + 100)

2 2

= 7.5 + 4.334
110.835

= 10.676%
(ii) Using Internal Rate of Return Method

Year Cas Discoun Presen Discoun Present

h t factor @ t t factor @ Value
flow 10% Valu 15% (`)
s e
(`
)
0 100 1.000 (100.00) 1.000 (100.00)
1 to 5 7.5 3.790 28.425 3.353 25.148
5 121.67 0.621 75.557 0.497 60.470
NPV +3.982 -14.382

IRR = L + NPVL (H – L) = 10% + (15% -10%)

3.982
NPVL-NPVH
3.982-(-14.382)

= 0.11084 or 11.084% (approx.)

1. CALCULATE the WACC using the following data by using: (RTP NOV20)
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:

Particulars (`)
Debentures (` 100 per 5,00,000
debenture)
Preference shares (` 100 per 5,00,000
share)
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:
(i) ` 100 per debenture redeemable at par, 10% coupon rate, 4%
floatation costs, 10-year maturity.
(ii) ` 100 per preference share redeemable at par, 5% coupon rate, 2%
floatation cost and 10-year maturity.
(iii) 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.
1. (i) Cost of Equity (Ke)
= `1
D + g + 0.05 = 0.1 or 10%
= `24 -
1 `4

P
0

-
F

(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 Cas Discount Presen Discount Present

h factor @ 5% t factor @ 7% Value
flow Valu (`)
s (`) e
0 100. 1.00 (100.8 1.000 (100.8
8 0 ) )
1 to 10 7 7.72 54.05 7.024 49.17
2
 10 100 0.61 61.40 0.508 50.80
4
NPV +14.6 -0.83
5

Calculation of IRR
14.65
IRR = 5%+ (7%-5%) = 5%+ (7%-5%) = 6.89%
14.6
5 15.48

14.65-(-0.83)

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%
 Year Cash Discount Presen Discount Presen
flows factor @ 3% t factor @ 5% t Value
(`) Valu (`)
e
0 107.8 1.000 (107.8 1.00 (107.8)
) 0
1 to 10 5 8.530 42.65 7.72 38.61
2
10 100 0.744 74.40 0.61 61.40
4
NPV +9.25 -7.79

Calculation of
9.25
(5%-3%) = 3%+ 5%- 3%)
IRR IRR =
= 4.08%
(
3%+ 17.04

9.25

9.25-(-
7.79)

Cost of Preference Shares (Kp) = 4.08%

(a) Calculation of WACC using book value weights

Source Book Weights After tax WACC

of Value cost of (Ko)
capital capital
(`) (a) (b) (c) =
(a)×(b)
10% 5,00,000 0.25 0.068 0.01723
Debentures 9
5% 5,00,000 0.25 0.040 0.0102
Preferenc 8
e
shares
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%
(b) Calculation of WACC using market value weights
 Source of capital Mark Weigh After WAC
et t tax C
Valu s cost (Ko)
e of
capita
l
(` (a) (b) (c)
=
) (a)×(
b)
10% Debentures (` 105× 5,25,00 0.15 0.068 0.0104
5,000) 0 1 9
5% Preference shares 5,50,00 0.15 0.040 0.0064
0 8 8
(` 110× 5,000) 24,00,00 0.69 0.10 0.0691
0 1
Equity shares (` 24× 34,75,00 1.00 0.0859
1,00,000) 0 0

WACC (Ko) = 0.0859 or 8.59%

 1. PK Ltd. has the following book-value capital structure as on March 31, 2020. (RTP
MAY20)

(`)
Equity share capital (10,00,000 2,00,00,000
shares)
11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
3,60,00,000
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. 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.

2. (i) Computation of Weighted Average Cost of Capital based on

existing capital structure

Existin Weights After tax WAC

Source of Capital g cost of C
Capita capital (%
l (%) )
structur (a)
(b)
e (`)
(a) (b)
Equity share capital 2,00,00,00 0.555 10.00 5.5
(W.N.1) 0 5
11.5% Preference share 60,00,000 0.167 11.50 1.9
capital 2
10% Debentures (W.N.2) 1,00,00,00 0.278 6.50 1.8
0 1
3,60,00,00 1.000 9.2
0 8

D
Working Notes (W.N.): iv
id
1. Cost of equity capital: en
Expected d(
 D1)
Ke =

+Growth(g)
Current Market Pr ice per share(P0 )

`10
X0.05
= `200 = 10%

2. Cost of 10% Debentures:

= I (1-t) = `10,00,000(1-
NP 0.35) = 0.065 or 6.5%

`1,00,00,00
0
(ii) Computation of Weighted Average Cost of Capital based on new capitalstructure
 Source of Capital New Weight After WAC
Capital s tax cost C
structure of (%
(`) capital )
(b) (%)
(a) (a)
(b
)
Equity share capital 2,00,00,00 0.488 12.75 6.1
(W.N. 3) 0 0
Preference share 60,00,000 0.146 11.50 1.6
8
10% Debentures (W.N. 1,00,00,00 0.244 6.50 1.59
2) 0 0.122 7.80 0.95
12% Debentures 50,00,00 1.00 10.32
(W.N.4) 0
4,10,00,00
0

Working Notes (W.N.):

1. Cost of equity capital:
Expected
Ke = +Growth(g)
Dividend(D1) Current
Market Pr ice per share(P0 )
= `12.4
+ 0.05 = 0.1275 or
12.75%
`160

2. Cost of 12% Debentures

= `6,00,000(1- 0.35) = 0.078 or 7.8%

`50,00,000
Kd = 2,40,000(1-.035) = 7.88%

20,00,000
Q -A Company wants to raise additional finance of ` 5 crore in the next
year. The companyexpects to retain ` 1 crore earning next year. Further
details are as follows:
(N
ov 19)
(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.
(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.
(e) Determination of the amount of equity and debt for raising additional finance:
Pattern of raising additional finance

Equity 3/4 of ` 5 Crore = ` 3.75 Crore

Debt 1/4 of ` 5 Crore = ` 1.25 Crore
 The capital structure after raising additional finance:

Particulars (` In
crore)
Shareholders’ Funds
Equity Capital (3.75 – 1.00) 2.75
Retained earnings 1.00
Debt (Interest at 10% p.a.) .075
(Interest at 12% p.a.) (1.25- 0.50
0.75) Total Funds 5.00

(a) Determination of post-tax average cost of

additional debt Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate

On ` = 10% (1 – 7.5% or
0.25) = 0.075
75,00,000
On ` = 12% (1 – 9% or 0.09
50,00,000 0.25) =
Average Cost of Debt

= (` 75,00,000 X 0.075) + (` 50,00,000 X0.09) x 100

1,25,00,000

= `5,62,500 + `4,50,000 x
100 = 8.10%
1,25,00,000
(b) Determination of cost of retained earnings and cost of equity (Applying
Dividend growth model):
Ke =
D1
+
g
P0
Where,
Ke = Cost
of equity
D1 = DO
(1+ g)
 D0 = Dividend paid
(i.e = ` 2) g =
Growth rate
P0 = Current market price per share
Rs. 2 (1.05) Rs. 2.1
Then, Ke = + 0.05 = + 0.05 = 0.084 + 0.05 = 0.134 = 13.4%
Rs. 25 Rs. 25
Cost of retained earnings equals to cost of Equity i.e. 13.4%
(c) Computation of overall weighted average after tax cost of additional finance

Particular (`) Weight Cost Weighte

s of d Cost
funds (%)
Equity (including 3,75,00,00 3/4 13.4 10.05
retained 0 %
earnings)
Debt 1,25,00,00 1/4 8.1% 2.025
0
WACC 5,00,00,00 12.07
0 5
 Capital Structure
(a) The details about two companies R Ltd. and S Ltd. having same operating risk are given
below: (JUL 21)
Particulars R Ltd. S Ltd.
Profit before interest 10 lakhs 10 lakhs
and tax Equity share 17 lakhs 50 lakhs
-
capital r 10 each Long 33 lakhs 15%
term borrowings @ 10% 18%
You are required to:
Cost of Equity (Ke)
(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. (5 Marks)
(1) Computation of value of equity on the basis of MM approach without tax
Particulars R S
Ltd. (Z in Ltd. (Z in
Profit before interest and taxes 10 10
lakhs) lakhs)
Less: Interest on debt (10% x Z 3.3 -
Earnings available to Equity shareholders
33,00,000) 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
Value of Equity (S) (as calculated 37.222 lakhs)
66.667
above) Debt (D) 33 -
70.222 66.667
Value of Firm (V) = S + D

QBlue 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: (RTP NOV21)
(i) Market value of the company
(ii) Overall Cost of capital
(iii) Cost of equity
 Market Value of Equity = Net income (NI) for equity holders

Ke

1,750 lakhs = Net income (NI) for

equity
holder
0.20
Net Income to equity holders/EAT = 350 lakhs =
500 lakhs Therefore, EBIT = EAT = 350 lakhs
= 500 lakhs
(1-t) (1-0.3)
Income statement

All Equity &

Equity(` In Debt (`
lakhs) In lakhs)
EBIT (as calculated above) 500 500
Interest on ` 275 lakhs @ 15% - 41.25
EBT - 458.75
Tax @ 30% 500 137.63
Income available to equity 150 321.12
holders 350

(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%
Component Amoun Cost of Capital Weight WACC
s t (` In % (Ko)
lakhs) %
Equity 1,557.50 20.62 0.8 17.5
Debt 275.00 10.50 5 3
0.1 1.5
5 8
1,832.5 1 19.1
0 1
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.
2. 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: (RTP MAY21)

Debt value Interest rate Equity capitalization

(`) (%) rate
(%)
0 - 10.00
5,00,000 6.0 10.50
10,00,00 6.0 11.00
0
15,00,00 6.2 11.30
0
20,00,00 7.0 12.40
0
25,00,00 7.5 13.50
0
30,00,00 8.0 16.00
0
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.
Amount of debt to be employed by firm as per traditional approach
Calculation of Equity, Wd and We

Total Deb Wd Equity value We

Capital t (`) (`)
(`)
(a) (b) (b)/(a) (c) = (a) - (b) (c)/(a
)
50,00,00 0 - 50,00,000 1.0
0
50,00,00 5,00,000 0.1 45,00,000 0.9
0
50,00,00 10,00,000 0.2 40,00,000 0.8
0
50,00,00 15,00,000 0.3 35,00,000 0.7
0
50,00,00 20,00,000 0.4 30,00,000 0.6
0
50,00,00 25,00,000 0.5 25,00,000 0.5
0
50,00,00 30,00,000 0.6 20,00,000 0.4
0

Statement of Weighted Average Cost of Capital (WACC)

Ke We Kd Wd Ke We KdWd Ko
(1) (2) (3) (4) (5) = (1) x (6) = (3) x (7) = (5) +
(2) (4) (6)
0.10 1.0 - - 0.100 - 0.100
0
0.10 0.9 0.06 0.1 0.095 0.006 0.101
5 0
0.11 0.8 0.06 0.2 0.088 0.012 0.100
0 0
0.11 0.7 0.06 0.3 0.079 0.019 0.098
3 2
0.12 0.6 0.07 0.4 0.074 0.028 0.102
 4 0
0.13 0.5 0.07 0.5 0.068 0.038 0.106
5 5
0.16 0.4 0.08 0.6 0.064 0.048 0.112
0 0
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.
Value of firm = Net operating Income

Ke
` 50,00,000 = 5,00,000

Ke

Ke = 5,00,000 = 10%

50,00,000

Statement of Equity Capitalization rate (ke) under MM approach

Deb Equit Debt/Equit Ko Kd Ko - Kd Ke

t y y = Ko
(`) (`) + (Ko
- Kd)
Debt
Equit
y
(1 (2) (3) = (4) (5) (6) = (4) (7) = (4)
+
) (1)/(2)
-(5) (6) x (3)
0 50,00,00 0 0.1 - 0.100 0.100
0 0
 5,00,000 45,00,00 0.11 0.1 0.06 0.040 0.104
0 0 0
10,00,00 40,00,00 0.25 0.1 0.06 0.040 0.110
0 0 0 0
15,00,00 35,00,00 0.43 0.1 0.06 0.038 0.116
0 0 0 2
20,00,00 30,00,00 0.67 0.1 0.07 0.030 0.120
0 0 0 0
25,00,00 25,00,00 1.00 0.1 0.07 0.025 0.125
0 0 0 5
30,00,00 20,00,00 1.50 0.1 0.08 0.020 0.130
0 0 0 0

Q The impact is that cost of equity has risen by 0.62% (20.62% - 20%)
due to thepresence of financial risk i.e. introduction of debt in capital
structure
(JA
N 21)
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 ina 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. Analyse why does it differ from
that of A Ltd.
(a) Value of A Ltd. = NOI = 4,50,000 = 25,00,000
Ke 18%
(i) Return on Shares of X on A Ltd.

Particulars Amount (`)

Value of the company 25,00,000
Market value of debt (60% x ` 15,00,000
25,00,000)
 Market value of shares (40% x ` 10,00,000
25,00,000)
Particulars Amount (`)
Net operating income 4,50,000
Interest on debt (8% × ` 15,00,000) 1,20,000
Earnings available to shareholders 3,30,000
Return on 3% shares (3% × ` 9,900
3,30,000)

(ii) Implied required rate of return on equity of A Ltd. = 3,30,000 = 33%

10,00,000

(a) (i) Calculation of Implied rate of return of B Ltd.

Particulars Amount (`)
Total value of 25,00,000
company
 Market value of debt (20% × ` 25,00,000) 5,00,000
Market value of equity (80% × ` 25,00,000) 20,00,000
Particulars Amount (`)
Net operating income 4,50,000
Interest on debt (8% × ` 5,00,000) 40,000
Earnings available to shareholders 4,10,000

Implied required rate of return on equity = 4,10,000 = 20.5%

` 20,00,000

(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
capitalization 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.
Q Kee Ltd. and Lee Ltd. are identical in every respect except for capital
structure. Kee Ltd. does not employ debt in its capital structure, whereas Lee
Ltd. employs 12% debentures amounting to Rs. 20 lakhs. Assuming that:
(MTP 21)
• All assumptions of MM model are met;
• The income tax rate is 30%;
• EBIT is Rs. 5,00,000 and
(c) Kee Ltd. (pure Equity) i.e.
unlevered
company:EAT =
EBT (1 – t)
= EBIT (1 - 0.3) = Rs. 5,00,000 × 0.7 = Rs. 3,50,000
(Here, EBIT = EBT as there is no debt)
EAT
Value of unlevered company Kee
Ltd. =

= Equity capitalization rate

Rs. 3,50,000
= Rs. 14,00,000
25%
Lee Ltd. (Equity and Debt) i.e levered company:
 Value of levered company = Value of Equity + Value of Debt
= Rs. 14,00,000 + (Rs. 20,00,000 × 0.3)
= Rs. 20,00,000

Q The equity capitalization rate of Kee Ltd. is 25%. CALCULATE the average
value of both the Companies
Q J Ltd. is considering three financing plans. The-key information is as follows: (NOV 20)
2
(a) Total investment to be raised ` 4,00,000.
(b) Plans showing the Financing Proportion:

Plans Equit Debt Preference

y Shares
X 100% - -
Y 50% 50% -
Z 50% - 50%

(c) Cost of Debt 10%

Cost of preference 10%
shares
(d) Tax Rate 50%
(e) Equity shares of the face of `10 each will be issued at a premium of ` 10
value 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
Indifference Point between the plans and indicate if any of the plans dominate.

(i) Computation of Earnings per Share (EPS)

Plans X (`) Y (`) Z (`)

Earnings before interest & tax (EBIT) 1,00,000 1,00,000 1,00,00
0
Less: Interest charges (10% of ` -- (20,000) --
2,00,000)
Earnings before tax (EBT) 1,00,000 80,000 1,00,00
0
Less: Tax @ 50% (50,000) (40,000) (50,000
)
Earnings after tax (EAT) 50,000 40,000 50,000
Less: Preference share dividend (10% -- -- (20,000
of )
`2,00,000)
Earnings available for equity 50,000 40,000 30,000
shareholders (A)
 No. of equity shares (B) 20,000 10,000 10,000
Plan X = ` 4,00,000/ `
20 Plan Y = ` 2,00,000 /
` 20
Plan Z = ` 2,00,000 / ` 20
E.P.S (A B) 2.5 4 3
(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 Tax3Rate) = ` 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
(EBIT)(1-
0.5) (EBIT- `
=20,000)(1-0.5)
20,000 shares

10,000 shares
0.5 EBIT = EBIT –
`20,000 EBIT
=`
40,000
(b) Indifference point where EBIT of proposal ‘X’ and proposal ‘Z’ is equal:
(EBIT)(1-
0.5) EBIT(1-0.5) - `
20,000shares
= 20,000

10,000 shares
0.5 EBIT = EBIT-
` 40,000 0.5 EBIT
=`
40,000
`40,000
EBIT = = ` 80,000
0.5
(c) Indifference point where EBIT of proposal ‘Y’ and
proposal ‘Z’ are equal (EBIT- ` 20,000)(1-0.5)
= EBIT(1-0.5) - ` 20,000
10,000 shares 10,000 shares
0.5 EBIT – ` 10,000 = 0.5 EBIT – ` 20,000
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.
1. Xylo Ltd. is considering two alternative financing plans as follows: (RTP NOV20)

Particulars Plan – A (`) Plan – B (`)

Equity shares of ` 10 each 8,00,000 8,00,000
Preference Shares of ` 100 - 4,00,000
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

1. Computation of Rate of Preference

Dividend (`4,80,000- `48,000) x (1- 0.30)
=
4 80,00,000 shares
(EBIT - Interest) (1 - t) = No. of Equity Shares (N1 )
`3,02,400
 =
80,00,000
shares (EBIT (1 - t) - Preference
Dividend No. of Equity
Shares (N2 )
`4,80,000(1- 0.30)- Preference Div idend
80,00,000 shares
`3,36,000 - Preference Div
idend 80,00,000
shares
` 3,02,400 = ` 3,36,000 – Preference Dividend
Preference Dividend = ` 3,36,000 – ` 3,02,400 = ` 33,600
Rate of Dividend = Preference
Dividend
Preference
share capital
= 33,600
X100 = 8.4%
4,00,000
1. CALCULATE the level of earnings before interest and tax (EBIT)
at which the EPS indifference point between the following financing
alternatives will occur. (RTP
MAY 20)
(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.
2. Computation of level of earnings before interest and tax (EBIT)
In case, alternative (i) is accepted, then the EPS of the firm would be

EPSAlternative1 = (EBIT - Interest) (1- tax rate)

No.of equity shares

= (EBIT - 0.12X`40,00,000) (1- 0.35)

60,000 shares
In case, alternative (ii) is accepted, then the EPS of the firm would be:

EPS Alternative 2 = (EBIT - 0.12X`40,00,000) (1- 0.35) -(0.14X`20,00,000)

40,000shares
In order to determine the indifference level of EBIT, the EPS under the
two alternative plans should be equated as follows:
(EBIT - 0.12 X `40,00,000) (1- 0.35) = (EBIT-0.12X`40,00,000)(1-0.35)- (0.14
X`20,00,000)
60,000 shares
5 0.65 EBIT - `3,12,000
Or
40,000shares 3
 2
0.65 EBIT=-
`5,92,000

Or 1.30 EBIT - `6,24,000 = 1.95 EBIT - `17,76,000

Or (1.95 - 1.30) EBIT = `17,76,000 - `6,24,000 =

Or EBIT = `11,52,000
`11,52,000
0.65
Or EBIT = `17,72,30
8
6
 LEVERAGE
Q - A company had the following balance sheet as on 31st March, 2021: (JUL 21)

Liabilities ` in Crores Assets ` in

Crores
Equity Share Capital (75 lakhs 7.50 Building 12.50
Shares of
` 10 each)
Reserves and Surplus 1.50 Machinery 6.25
15% Debentures 15.00 Current Assets
Current Liabilities 6.00 Stock 3.00
Debtors 3.25
Bank Balance 5.00
30.00 30.00

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 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%  15) 2.25
EBT/PBT 21.75
Less: Tax @ 40% 8.70
EAT/ PAT 13.05
 (i)Earnings per Share
EPS = PAT 13.05 = 17.40
Number of Equity Shares= 0.75

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.
Operating Leverage
(ii)

Operating Leverage = Contribution = 30 = 1.25

EBIT 24
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.
Financial Leverage
(iii)
EBIT = 24 = 1.25
Financial Leverage =
PBT 21.75
The financial leverage is very comfortable since the debt service obligation is small vis -à- vis
EBIT.
Combined Leverage
(iv)
Contribution = 30 = 1.379
(v) Combined Leverage =
PBT 21.75

Or,
= Operating Leverage × Financial Leverage
= 1.25 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.

1. The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is
given:
(RTP NOV 21)

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%.

1. Statement showing Profitability of Alternative Schemes for Financing

(` in ‘00,000)

Particulars Existin Alternative Schemes

g (i) (ii) (iii)
Equity Share capital (existing) 10 10 10 10
New issues - 10 5 -
10 20 15 10
7% debentures 10 10 10 10
6% debentures - - 5 10
20 30 30 30
Debenture interest (7%) 70.7 0.7 0.7 0.7
Debenture interest (6%) - - 0.3 0.6
0.7 0.7 1.0 1.3
Output (units in lakh) 1 1.5 1.5 1.5
Contribution per. unit (`) 20 22 22 22
(Selling price - Variable
Cost)
Contribution (` lakh) 20 33 33 33
Less: Fixed cost 10 15 15 15
EBIT 10 18 18 18
Less: Interest (as
calculated above) 0.7 0.7 1.0 1.3
EBT 9.3 17.3 17 16.7
Less: Tax (40%) 3.72 6.92 6.8 6.68
EAT 5.58 10.38 10.2 10.02
0
Operating Leverage
(Contribution /EBIT) 2.00 1.83 1.83 1.83
Financial Leverage 1.08 1.04 1.06 1.08
(EBIT/EBT)
Combined Leverage 2.15 1.91 1.94 1.98
(Contribution/EBT)
EPS (EAT/No. of shares) (`) 5.58 5.19 6.80 10.02
Risk - Lowes Lower than Highes
t option (3) t
Return - Lowes Lower than Highes
t option (3) t
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.
Following information has been extracted from the accounts of newly
incorporated TextylPvt. Ltd. for the Financial Year 2020-21:
(RTP
MAY21)
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:
(iii) The percentage change in taxable income if sales increase by 15%.
(iv) The percentage change in EBIT if sales decrease by 10%.
(v) The percentage change in taxable income if EBIT increase by 15%.
Workings:
(1) Contribution = Sales x P/V ratio
8
= ` 15,00,000 x 70% = ` 10,50,000
(2) Operating Leverage = Contribution
Earnings before interest and tax (EBI)
Or, 1.4 =

10,
50,
000
EBI
T
EBIT = ` 7,50,000
(3) Financial leverage = EBIT
EBT
Or, 1.25 = 7,50,000

EBT
EBT = ` 6,00,000
(4) Fixed Cost = Contribution – EBIT
= ` 10,50,000 – ` 7,50,000 = ` 3,00,000
(5) Interest = EBIT – EBT
= ` 7,50,000 – ` 6,00,000 = ` 1,50,000
(6) Income Statement

Particulars Amount (`)

Sales 15,00,000
Less: Variable cost (30% of ` 4,50,000
15,00,000)
Contribution (70% of ` 15,00,000) 10,50,000
Less: Fixed costs 3,00,000
Earnings before interest and tax 7,50,000
(EBIT)
Less: Interest 1,50,000
Earnings before tax (EBT) 6,00,000

Combined Leverage = Contribution = ` 10,50,000 = 1.75 times

EBT 6,00,000
So, if sales is increased by 15% then taxable income (EBT) will be increased by
1.75
× 15% = 26.25%
Verification

Particulars Amount
(`)
New Sales after 15% increase (` 15,00,000 + 17,25,000
15% of
` 15,00,000)
Less: Variable cost (30% of ` 17,25,000) 5,17,500
Contribution (70% of ` 17,25,000) 12,07,500
Less: Fixed costs 3,00,000
Earnings before interest and tax (EBIT) 9,07,500
Less: Int9erest 1,50,000
Earnings before tax after change (EBT) 7,57,500
Increase in Earnings before tax (EBT) = ` 7,57,500 - ` 6,00,000 = ` 1,57,500
 So, percentage change in Taxable Income (EBT) = 1,57,500 x 100 =
26.25% hence verified.
(i) 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

Particulars Amoun
t
(`)
New Sales after 10% decrease (` 15,00,000 - 13,50,000
10% of
` 15,00,000)
Less: Variable cost (30% of ` 13,50,000) 4,05,000
Contribution (70% of ` 13,50,000) 9,45,000
Less: Fixed costs 3,00,000
Earnings before interest and tax after change (EBIT) 6,45,000
Decrease in Earnings before interest and tax (EBIT) = ` 7,50,000 - `
6,45,000 =
` 1,05,000

So, percentage change in EBIT = 1,05,000 100 = 14%, hence verified.

7,50,000
(ii) 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

Particulars Amount
(`)
New EBIT after 15% increase (` 7,50,000 + 15% of ` 8,62,500
7,50,000)
Less: Interest 1,50,000
Earnings before Tax after change (EBT) 7,12,500

Increase in Earnings before Tax = ` 7,12,500 - ` 6,00,000 = ` 1,12,500

So, percentage change in Taxable Income (EBT) = 1,12,500 x 100 = 18.75%,

6,00,000
hence verified
Q The information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as
follows:
(JAN 21)

Equity Share Capital of ` 100 each ` 50

Lakhs
12% Bonds of ` 1000 each ` 30
Lakhs
Sales 10
` 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
Workings:
Contribution
1. Profit Volume Ratio = x 100
Sales
So, 25 = Contributionx 100
` 84,00,000
` 84,00,000 x 25
Contribution = = ` 21,00,000
100

2. Financial leverage = EBIT

EBT
Or, 1.39 = ` 13,50,000 (as calculated

abovEBT EBT = ` 9,71,223

3. Income Statement

Particulars (`)
Sales 84,00,000
Less: Variable Cost (Sales - (63,00,00
Contribution) 0)
Contribution 21,00,000
Less: Fixed Cost (7,50,000)
EBIT 13,50,000
Less: Interest (EBIT - EBT) (3,78,777)
EBT 9,71,223
Less: Tax @ 30% (2,91,367)
Profit after Tax (PAT) 6,79,856
(i) Operating Leverage = Contribution
11
Earnings before interest and tax (EBI

=` 21,00,000= 1.556 (approx.)

 `
13,50,00
0
(ii) Combined Leverage = Operating Leverage x Financial Leverage
Or, = 1.556 x 1.39 = 2.163 (approx.)
Contribution = ` 21,00,000 = 2.162 (approx.)

EBT ` 9,71,223
(iii) Earnings per Share (EPS)

EPS = PAT = 6,79,85 =

6 13.597
No. of 50,00
shares 0

(iv) Earning Yield = EPS x 100

Market Price
= ` 13.597 x 100 = 6.80% (approx.)
200
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.
Q Following data of MT Ltd. under Situations 1, 2 and 3 and Financial Plan A and B
is given:
(MTP 21)

Installed Capacity (units) 3,600

Actual Production and Sales 2,400
(units)
Selling price per unit (Rs.) 30
Variable cost per unit (Rs.) 20
Fixed Costs (Rs.): Situation 1 3,000
Situation 2 6,000
Situation 3 9,000
Capital Structure :

Particulars Financial Plan

A B
 Equit Rs. 15,000 Rs. 22,500
y Rs. 15,000 Rs. 7,500
Deb 12% 12%
t
Cost of Debt

Required:
(i) CALCULATE the operating leverage and financial leverage.
(ii)FIND out the combinations of operating and financial leverage which
give the highest value andthe least value.
Operating Leverage
12

Situation 1 Situation 2 Situation

3
(Rs.) (Rs.) (Rs.)
 Sales (S)
2,400 units @ Rs. 30 per unit 72,000 72,000 72,000
Less: Variable Cost (VC) @ Rs. 20 48,000 48,000 48,000
per unit
Contribution (C) 24,000 24,000 24,000
Less: Fixed Cost (FC) 3,000 6,000 9,000
EBIT 21,000 18,000 15,000
Operating Leverage = C
Rs. Rs. Rs.
EB 24,000 24,000 24,000
IT
Rs. Rs. Rs.
21,000 18,000 15,000
= = =
1.14 1.33 1.60
Financial Leverage

Financial
A Plan B
Situation 1 (Rs.) (Rs.)
EBIT 21,00 21,000
Less: Interest on debt 0
1,800 900
(Rs. 15,000 x 12%);(Rs. 7,500 x
EBT
12%) 19,20 20,100
Financial Leverage = EBIT 21,00 0 21,000
=
EBT 0 = 1.0 1.04
9 20,100
Situation 2
EBIT 19,2018,00 18,000
0 0
Less: Interest on debt 1,800 900
EBT 16,20 17,100
Financial Leverage = EBIT 18,00 = 0 18,000 = 1.11
EBT 0
16,200 1.1 17,100
Situation 3
EBIT 15,00 15,000
Less: Interest on debt 0
1,800 900
EBT 13,20 14,100
Financial Leverage = EBIT 15,000 0 15,000
14,100
= 1.06
EBT = 1.14
13,200
Combined Leverages
CL = OL x FL

Financial
Plan
 A (Rs.) B (Rs.)
(a) Situation 1 113.14 x 1.09 = 1.14 x 1.04 =
1.24 1.19
(b) Situation 2 1.33 x 1.11 = 1.33 x 1.05 =
1.48 1.40
(c) Situation 3 1.60 x 1.14 = 1.60 x 1.06 =
1.82 1.70
 The above calculations suggest that the highest value is in Situation 3
financed by Financial Plan A and the lowest value is in the Situation 1
financed by Financial Plan B.
Following information are related to four firms of the same industry: (MTP 21)
Firm Change Change in Change in
i Operating Earning per
n Revenue 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
2. Calculation of Degree of Operating leverage and Degree of Combined
leverage

Fir Degree of Operating Leverage Degree of Combined Leverage

m (DOL) (DCL)

= % change in Operating = % change in EPS

% change in Revenue
Income
% change in Revenue
23% = 0.92 30% = 1.2
P 25% 25%
30% = 1.11 26% = 0.96
Q 27% 27%
36% = 1.50 20% = 0.83
R 24% 24%
30% = 1.50 20% = 1.00
S 20% 20%

The following data is available for Stone Ltd. : (NOV 20)

Sales 5,00,000
(-) Variable cost @ 2,00,000
40%
Contribution 3,00,000
(-) Fixed cost 2,00,000
 EBIT 1,00,000
(-) Interest 25,000
Profit before tax 75,000
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 incom1e4 if sales
increases by 10%. Also verify the results in each of the above
case.

(i) Degree of Financial Leverage = EBIT = 1,00,000 = 1.333t

imes
 EBT 75,000
So, If EBIT increases by 10% then Taxable Income (EBT) will be increased by 1.333
× 10
= 13.33% (approx.)
Verification

Particulars Amount (`)

New EBIT after 10% increase (` 1,00,000 1,10,000
+ 10%)
Less: Interest 25,000
Earnings before Tax after change (EBT) 85,000
Increase in Earnings before Tax = ` 85,000 - ` 75,000 = ` 10,000
` 10,000
So, percentage change in Taxable Income (EBT) = 100 = 13.333%, hence verified
75,000
Contribution ` 3,00,000
Degree of Operating Leverage = = = 3 times
EBIT 1,00,000
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 + 5,50,000
10%)
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 1,30,000
(EBIT)
Increase in Earnings before interest and tax (EBIT) = ` 1,30,000 - ` 1,00,000 = `
30,000

So, percentage change in EBIT =` 30,000 x100 = 30%, hence verified.

1,00,000
` 3,00,000
Degree of Combined Leverage = Contribution = = 4 times
EBT 75,000
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 5,50,000
+ 10%)
Less: Variable cost (40% of ` 5,50,000) 2,20,000
Contribution
15 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
30,000
So, percentage change in Taxable Income (EBT) = x100 = 40%, hence verified
` 75,000

1. The capital structure of PS Ltd. for the year ended 31st March, 2020 consisted as
follows:
(RTP NOV 20)

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:
(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.

Sales in units 1,20,000 1,00,000

(`) (`)
Sales Value 14,40,000 12,00,000
Variable Cost (9,60,000) (8,00,000)
Contribution 4,80,000 4,00,000
Fixed expenses (2,00,000) (2,00,000)
EBIT 2,80,000 2,00,000
Debenture Interest (1,00,000) (1,00,000)
 EBT 1,80,000 1,00,000
Tax @ 30% (54,000) (30,000)
Profit after tax (PAT) 1,26,000 70,000

EBIT
16 `2,80,00 `2,00,00
(i) Financial Leverage= =0 = =0 =
EBT 1.56 2
`1,80,00 `1,00,00
0 0
 (ii) Operating leverage = `4,80,000 = `4,00,00
Contribution 1.71 =0 =
EBIT `2,80,000 `2,00,00 2
0
(iii) Earnings per share (EPS) `1,26,000 = 1 2 70,000 = 7
.6
`10,000 `10,000
Decrease in EPS = `12.6 – `7 = `5.6
5.6 = x 100 = 44.44%
% decrease in EPS
12.6
1. The following information is related to YZ Company Ltd. for the year
ended 31st March, 2020:
(RTP MAY 20)

Equity share capital (of `10 `50 lakhs

each)
12% Bonds of `1,000 each `37 lakhs
Sales `84 lakhs
Fixed cost (excluding `6.96 lakhs
interest)
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

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
17 tax) 6,51,624

(i) Operating Leverage:

 = Contribution = 23,14,200 = 1.43
EBIT 16,18,200
(i) Combined Leverage:
= Operating Leverage × Financial Leverage
= 1.43 1.49 = 2.13
Or,
Combined Leverage = C o n t r i b u t i o n X E B I T

EBIT EBT
Combined Leverage = C o n t r i b u t i o n = 2 3 , 1 4 , 2 0 0 = 2.13

EBT 10,86,040
Financial Leverage = EBIT = 16,18,200 = 1.49

EBT EBT
So, EBT =`16,18, 200 =
`10,86,040
1.49
Accordingly, other fixed interest
= ` 16,18,200 - ` 10,86,040 - ` 4,44,000 = ` 88,160
(i) Earnings per share (EPS):
PAT = 6,51,624 = 1.30

No. of shares outstanding 5,00,000 equity shares

The Balance Sheet of Gitashree Ltd. is given below: (NOV 19)

Liabilities (` )
Shareholders’ fund
Equity share capital of ` 10 ` 1,80,000
each
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 18 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.
Find out EBIT if EPS is (a) ` 1 (b) ` 2 and (c) ` 0.
Working Notes:
Total Assets = ` 6,00,000
Total Asset Turnover Ratio i.e. = Total Sales = 4
Total Assets
Hence, Total Sales =
`6,00,000 4=
`24,00,000 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 Interest) 2,00,000
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

(i) (a) Degree of Operating Leverage

Degree of Operating leverage = Contribution = `9,60,000 = 1.263 (approx.)
MT 7,60,000

(b) Degree of Financial Leverage

Degree of Financial Leverage = EBIT = `9,60,000 = 1.033 (approx.)
EBT 7,60,000
(c) Degree of Combined Leverage
Degree of Combined Leverage = Degree of Operating Leverage x Degree of
Financial Leverage
= 1.263 x 1.033 = 1.304 (approx.)
(ii) (a) If EPS is Re. 1
EPS = (EBIT -
Interest)(1-
tax)19 No
of equity
shares

Or, 1 (EBIT- `24,000) (1-0.30)

 18,000
Or, EBIT = 49,714 (approx.)
(b) If EPS is ` 2
2 = (EBIT- `24,000) (1-0.30)
18,000
Or, EBIT = ` 75,429 (approx.)

(c) If EPS 0 = (EBIT- `24,000) (1-0.30)

is ` 0 18,000
Or, EBIT = ` 24,000

Alternatively, if EPS is 0 (zero), EBIT will be equal to interest on debt i.e. ` 24,000

20
 Investment Decisions
Q- 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: (JUL21)
Particulars Existing New Machine
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 ` 1,00,000 ` 60,000
depreciation
Working Capital ` 1,00,000 ` 2,00,000
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 Year 4
3
10% 0.909 0.826 0.751 0.683
(10 Marks)
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 3,00,000
machine
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 72,000 36,000 units
units units
Rs Rs Rs
(A) Sales revenue @ ` 10 per 3,60,000 7,20,000 3,60,000
unit
(B) Cost of Operation
Material @ ` 2 per unit 72,000 1,44,000 72,000
Labour
Old = 1,800 ` 20 36,000
New = 1,800 ` 30 54,000 18,000
Fixed overhead excluding 1,00,000 60,000 (40,000)
depreciation
Total Cost (B) 2,08,000 2,58,000 50,000
Profit Before Tax and 1,52,000 4,62,000 3,10,000
depreciation (PBTD) (A – B)
(i) Calculation of Net Present value on replacement of machine

Depreci
ati on Tax Net PVF
Yea PBT @ 20% PBT PAT P
r D WDV @ cash @ V
30% flow 10
%
(1) (2) (3) (4 = 2- (5) (6 = 4- (7 = 6 (8) (9 = 7 x
3) 5) + 3) 8)
1 3,10,0 1,40,00 1,70,00 51,0 1,19,00 2,59,0 0.90 2,35,431.0
00 0 0 00 0 00 9 00
 2 3,10,0 1,12,00 1,98,00 59,4 1,38,60 2,50,6 0.82 2,06,995.6
00 0 0 00 0 00 6 00
3 3,10,0 89,600 2,20,40 66,1 1,54,28 2,43,8 0.75 1,83,153.8
00 0 20 0 80 1 80
4 3,10,0 71,680 2,38,32 71,4 1,66,82 2,38,5 0.68 1,62,898.2
00 0 96 4 04 3 32
7,88,478.7
12
Add: Release of net working capital at year end 4 (1,00,000 x 68,300.000
0.683)
Less: Initial Cash Outflow 8,00,000.0
00
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

1. Base for incremental depreciation

Particulars `
WDV of Existing Machine
Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000

Depreciation base of New Machine

Purchase price of new machine 10,00,000
Add: WDV of existing machine 3,84,000
Less: Sales value of existing machine 3,00,000
Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000
(Note: The above solution have been done based on incremental approach)

1. 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 bookvalue 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 valueof `
35,000. (RTP
NOV 21)
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%:

Yea 1 2 3 4 5 6 7 8 9 10
r
PVF 0.9 0.82 0.75 0.68 0.62 0.56 0.51 0.46 0.42 0.38
0 6 1 3 1 4 3 7 4 6
9

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

Particulars Old New Difference

machi machi (`)
ne (`) ne (`)
PBT as per books 3,24,75 3,87,25 62,500
0 0
Add: Depreciation as 24,000 41,500 17,500
per books
Profit before tax 3,48,75 4,28,75 80,000
and depreciation 0 0
(PBTD)
Calculation of Incremental NPV

Yea PVF PBTD Dep. @ PBT Tax @ Cas PV of

r @ (`) 7.5% (`) 30% h Cash
10% (`) (`) Inflo Inflows
ws (`)
(`)
(1) (2) (3) (4) (5) = (4) (6) = (4) (7) = (6)
x – x
0.30 (1)
(5)
+ (3)
1 0.90 80,000. 26,250. 53,750. 16,125.0 63,875.0 58,062.3
0 0 0 0 0 8
9 0 0 0
2 0.82 80,000. 24,281. 55,718. 16,715.6 63,284.3 52,272.8
0 2 7 3 8 9
6 0 5 5
3 0.75 80,000. 22,460. 57,539. 17,261.9 62,738.0 47,116.2
0 1 8 5 5 7
1 0 6 4
4 0.68 80,000. 20,775. 59,224. 17,767.3 62,232.6 42,504.9
0 6 3 1 9 3
3 0 4 6
5 0.62 80,000. 19,217. 60,782. 18,234.7 61,765.2 38,356.2
0 4 5 6 4 1
1 0 7 3
6 0.56 80,000. 17,776. 62,223. 18,667.1 61,332.8 34,591.7
0 1 8 5 5 3
4 0 6 4
7 0.51 80,000. 16,442. 63,557. 19,067.1 60,932.8 31,258.5
0 9 0 2 8 7
3 0 5 5
8 0.46 80,000. 15,209. 64,790. 19,437.0 60,562.9 28,282.8
0 7 2 8 2 8
7 0 3 7
9 0.42 80,000. 14,069. 65,931. 19,779.3 60,220.7 25,533.5
0 0 0 0 0 8
4 0 0 0
10 0.38 80,000. 13,013. 66,986. 20,095.8 59,904.1 23,123.0
0 8 1 5 5 0
6 0 2 8
3,81,102.4
4
Add: PV of Salvage value of new machine (` 35,000 0.386) 13,510.0
0
Total PV of incremental cash inflows 3,94,612.4
4
Less: Cost of new machine 3,50,000.0
0
Incremental Net Present Value 44,612.4
4
Analysis: Since the Incremental NPV is positive, the old machine should be replaced.
22

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.
(RTP MAY21)

The annual cost are as follows:

Existing Modernizatio New

Equipment n Machine
(`) (`) (`)
Wages & 45,000 35,500 15,000
Salaries
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
1,20,000 70,500 39,500
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:

7B Year 1 2 3 4 5
PV factor 0.909 0.826 0.75 0.683 0.621
1
(i) Calculation of Incremental annual cash inflows/ savings:

Particular Existing Modernizatio New

s Equipme n Machine
nt Amoun Saving Amoun Saving
t s t s
(`) (`) (`) (`) (`)
(1 (2 (3)=(1)- (4) (5)=(1)-
) ) (2) (4)
Wages & Salaries 45,000 35,500 9,500 15,000 30,000
Supervision 20,000 10,000 10,000 7,000 13,000
Maintenance 25,000 5,000 20,000 2,500 22,500
Power 30,000 20,000 10,000 15,000 15,000
Total 1,20,000 70,500 49,500 39,500 80,500
 Less: 22,000 58,000
Depreciati
on
(Refer Workings)
Total Savings 27,500 22,500
Less: Tax @ 50% 13,750 11,250
After Tax Savings 13,750 11,250
Add: 22,000 58,000
Depreciation
Incremental 35,75 69,25
Annual
0 0
Cash Inflows

(i) Calculation of Net Present Value (NPV)

Particulars Yea Modernization New Machine

r (`) (`)
Initial Cash outflow 0 1,40,000.00 3,50,000.00
(A)
Incremental Cash 1-5 1,35,492.50 2,62,457.50
Inflows
(` 35,750 x 3.790) (` 69,250 x 3.790)
Salvage value 5 18,630.00 37,260.00
(` 30,000 x 0.621) (` 60,000 x 0.621)
PV of Cash inflows 1,54,122.50 2,99,717.50
(B)
Net Present Value (B - 14,122.50 (50,282.50)
A)
Advise: The company should modernize its existing equipment and not buy a
new machine because NPV is positive in modernization of equipment

Q A company wants to buy a machine, and two different models namely A and
B are available. Following further particulars are available: (JAN
21)

Particulars Machine- Machine-B

A
Original Cost (`) 8,00,00 6,00,000
0
 Estimated Life in 4 4
years
Salvage Value (`) 0 0
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:

Yea Net Profit Before Depreciation and PV

r tax Factor
Machine- Machine-
A B
` `
1. 2,30,000 1,75,00 0.89
0 3
2. 2,40,000 2,60,00 0.79
0 7
3. 2,20,000 3,20,00 0.71
0 2
4. 5,60,000 1,50,00 0.63
0 6

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.
 Workings:
(i) Calculation of Annual Depreciation

` 8,00,000
Depreciation on Machine – A = = 2,00,000
4

` 6,00,000
Depreciation on Machine – B = = ` 1,50,000

4
(i) Calculation of Annual Cash Inflows

Particulars Machine-A
(`)
1 2 3 4
Net Profit before Depreciation 2,30,00 2,40,00 2,20,00 5,60,00
and Tax 0 0 0 0
Less: Depreciation 2,00,00 2,00,00 2,00,00 2,00,00
0 0 0 0
Profit before Tax 30,000 40,000 20,000 3,60,00
0
Less: Tax @ 30% 9,000 12,000 6,000 1,08,00
0
Profit after Tax 21,000 28,000 14,000 2,52,00
0
Add: Depreciation 2,00,00 2,00,00 2,00,00 2,00,00
0 0 0 0
Annual Cash Inflows 2,21,00 2,28,00 2,14,00 4,52,00
0 0 0 0

Particulars Machine-B
(`)
1 2 3 4
Net Profit before Depreciation 1,75,00 2,60,00 3,20,00 1,50,00
and Tax 0 0 0 0
Less: Depreciation 1,50,00 1,50,00 1,50,00 1,50,00
0 0 0 0
Profit before Tax 25,000 1,10,00 1,70,00 0
0 0
Less: Tax @ 30% 7,500 33,000 51,000 0
Profit after Tax 17,500 77,000 1,19,00 0
 0
Add: Depreciation 1,50,00 1,50,00 1,50,00 1,50,00
0 0 0 0
Annual Cash Inflows 1,67,50 2,27,00 2,69,00 1,50,00
0 0 0 0
(ii) Calculation of PV of Cash Flows
Machine – Machine - B
A
Yea PV of Re Cas P Cumulativ Cash PV Cumulativ
r 1@ h flow V e flow (`) e
12% (`) (`) PV (`) (`) PV (`)
1 0.89 2,21,00 1,97,35 1,97,35 1,67,50 1,49,57 1,49,578
3 0 3 3 0 8
2 0.79 2,28,00 1,81,71 3,79,06 2,27,00 1,80,91 3,30,497
7 0 6 9 0 9
3 0.71 2,14,00 1,52,36 5,31,43 2,69,00 1,91,52 5,22,025
2 0 8 7 0 8
4 0.63 4,52,00 2,87,47 8,18,90 1,50,00 95,400 6,17,425
6 0 2 9 0
1. NPV (Net Present
Value) Machine
–A
25
NPV = ` 8,18,909 - ` 8,00,000 = ` 18,909
Machine – B
 NPV = ` 6,17,425 – ` 6,00,000 = ` 17,425
1. Discounted Payback
Period Machine –
A
Discounted Payback Period = 3 +` 8,00,000 - ` 5,31,437

2,87,472
= 3 + 0.934
= 3.934 years or 3 years 11.21 months
Machine – B
Discounted Payback Period = 3 +` 6,00,000 - ` 5,22,025

` 95,400

= 3 + 0.817
= 3.817 years or 3 years 9.80 months
2. PI (Profitability
Index)
Machine – A
Profitability Index = 8,18,909 = 1.024
8,00,000
Machine – B
Profitability Index = ` 6,17,425 = 1.029
` 6,00,000
Suggestion:
Method Machine - Machine - Suggested
A B Machine
Net Present Value ` 18,909 ` 17,425 Machine A
Discounted Payback 3.934 3.817 Machine B
Period years years
Profitability Index 1.024 1.029 Machine B

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:
(MTP 21)
 Bran Cost Life Maintenance Cost (Rs.) SLM
d of of Depreciation
machin machin rate
e e
(Rs.) (Rs.) Year 1-5 Year 6- Year 11- (%)
10 15
X 15,00,000 15 50,000 70,000 98,000 6
Y 10,00,000 10 70,000 1,15,00 - 6
0
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 also26be 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) 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) 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 0.36
1
2 0.797 10 0.32
2
3 0.712 11 0.28
7
4 0.636 12 0.25
7

5 0.567 13 0.22
9
6 0.507 14 0.20
5
7 0.452 15 0.18
3
8 0.404 16 0.16
3

27
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

Perio Cash Outflow PVF @ PV (Rs.)

d (Rs.) 12%
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

PVAF for 1-15 years = 6.812

Equivalent Annual Cost = 19,20,778 = 2,81,969.76

6.812
Present Value (PV) of cost if machine of brand Y is purchased

Perio Cash Outflow PVF @ PV (Rs.)

d (Rs.) 12%
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
PVAF for 1-10 years = 5.651
Equivalent Annual Cost = 14,68,320 = Rs. 2,59,833.66
5.651
Present Value (PV) of cost if machine of brand Y is taken on rent

28
Perio Cash Outflow PVF @ PV (Rs.)
d (Rs.) 12%
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

29
 PVAF for 1-10 years = 5.651
Equivalent Annual Cost = Rs.15,26,120 = Rs. 2,70,061.94
5.651
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

Perio Cash Outflow PVF @ PV (Rs.)

d (Rs.) 12%
0 15,00,000 1.000 15,00,00
0
1-5 50,000 3.605 1,80,250
5 (9,90,000) 0.567 (5,61,33
0)
11,18,92
0
Present Value (PV) of cost if machine of brand Y is purchased

Perio Cash Outflow PVF @ PV (Rs.)

d (Rs.) 12%
0 10,00,000 1.000 10,00,00
0
1-5 70,000 3.605 2,52,350
5 (3,60,000) 0.567 (2,04,12
0)
10,48,23
0
Present Value (PV) of cost if machine of brand Y is taken on rent

Perio Cash Outflow PVF @ PV (Rs.)

d (Rs.) 12%
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 betaken on rent.
City Clap Ltd. is in the business of providing housekeeping services. There is a
proposal before the company to purchase a mechanized cleaning system for a
sum of Rs. 40 lakhs. The present system of the company is to use manual
labour for the cleaning job. You are provided with the following
information: (MTP 21)
Proposed Mechanized System:
Cost of the machine Rs. 40 lakhs
Life of the machine 7 years
Depreciation (on straight line basis) 15%
Operating cost of mechanized system Rs.
20 lakhs per annumPresent system (Manual):
Manual labour 350 persons
Cost of manual labour Rs. 15,000 per
person per annumThe company has an after-tax cost of fund
at 10% per annum.
The applicable tax rate is 50%.
PV factor for 7 years at 10% are as follows:

Year 1 2 3 4 5 6 7
s
P.V. 0.90 0.82 0.75 0.683 0.62 0.56 0.51
factor 9 6 1 1 4 3

You are required to DETERMINE whether it is advisable to purchase the

mechanized cleaning system.Give your recommendations with workings
Calculation of NPV

(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanised System:
Operating Cost 20,00,000
Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000
Saving per 26,50,000
annum
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: 6,00,000
Depreciation
Cash flow per annum 19,25,000
Cumulative PV Factor for 7 years @ 10% 4.867
Present value of cash flow for 7 years 93,68,975
Less: Cost of the Machine 40,00,000
NPV 53,68,975
The mechanized cleaning system should be purchased since NPV
is positive byRs. 53,68,975.

CK Ltd. is planning to buy a new machine. Details of which are as follows:

(NOV 20)
 Cost of the Machine at the ` 2,50,000
commencement
Economic Life of the Machine 8 year
Residual Value Nil
Annual Production Capacity of the 1,00,000
Machine 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 0.89 0.797 0.712 0.636 0.567 0.50 0.452 0.404
Factor 3 7
(a) Calculation of Net Cash flows
Contribution = (` 6 – ` 3) x 1,00,000 units = ` 3,00,000
Fixed costs (excluding depreciation) = ` 1,00,000

Yea Capit Contributio Fixed Advertisemen Net cash

r al n costs t/ flow (`)
(`) (`) (`) Maintenan
ce expenses
(`)
0 (2,50,00 (2,50,00
0) 0)
1 3,00,000 (1,00,000) (20,00 1,80,00
0) 0
2 3,00,000 (1,00,000) 2,00,00
0
3 3,00,000 (1,00,000) 2,00,00
0
4 3,00,000 (1,00,000) 2,00,00
0
5 3,00,000 (1,00,000) (30,000) 1,70,00
0
6 3,00,000 (1,00,000) 2,00,00
0
7 3,00,000 (1,00,000) 2,00,00
0
8 3,00,000 (1,00,000) 2,00,00
 0
Calculation of Net Present Value

Year Net cash flow (`) 12% discount factor Present value (`)
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.

2. 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 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: (RTP
NOV20)
(` 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
willreduce 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 0.59
@14% 2
ADVISE the management on the desirability of installing the machine for
processing the waste. All calculations should form part of the answer.
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 30 30 30 30
(opportunity cost)
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. 153. 235.2 199.5
4 3
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 - - - - 15
(net)
Total incremental cash (150) 155.4 222.3 274.2 397.5
flows
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.2 170.9 184.8 235.3
8 5 1 2
Net present value 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:
(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.
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:
(RTP MAY20)

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:

Yea 10 12% 14% 16 20

r % % %
1 0.9 0.89 0.88 0.8 0.8
1 6 3
2 0.8 0.80 0.77 0.7 0.6
3 4 9
3 0.7 0.71 0.67 0.6 0.5
5 4 8
4 0.6 0.64 0.59 0.5 0.4
8 5 8
5 0.6 0.57 0.52 0.4 0.4
2 8 0

Calculation of Net Cash Flow

(` in lakhs)
Yea Profit Depreciation (20% PBT PAT Net
r before onWDV) cash
flow
dep.an
d
tax
(1) (2) (3) (4) (5) (3) + (5)
1 320 800 x 20% = 160 160 96 256
2 320 (800 - 160)x 20% = 192 115.20 243.20
128
3 360 (640 - 128)x 20% = 257.6 154.56 256.96
102.4
4 360 (512 - 102.4)x 20% = 278.0 166.85 248.77
81.92 8
5 300 (409.6 - 81.92) = -27.68 -16.61 311.07
327.68*
*this is treated as a short term capital loss.
 (ii) Calculation of Net Present Value (NPV)
(` in lakhs)

Yea Net 12 16 20
Cash % % %
r Flow D.F P.V D.F P.V D.F P.V
1 256 0.89 227.84 0.86 220.1 0.83 212.4
6 8
2 243.2 0.80 194.56 0.74 179.9 0.69 167.8
0 7 1
3 256.9 0.71 182.44 0.64 164.4 0.58 149.0
6 5 3
4 248.7 0.64 159.21 0.55 136.8 0.48 119.4
7 2 1
5 311.0 0.57 177.31 0.48 149.3 0.40 124.4
7
1 3
941.36 850.7 773.1
1 6
Less: Initial 800.00 800.0 800.0
Investment 0 0
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 implemented.

(iv) Calculation of Internal Rate of Return (IRR)

IRR =16% + 50.71x 4

50.71-(-26.84)

=16% +2.03 = 16% + 2.62% = 18.62%

77.55.

A company has ` 1,00,000 available for investment and has identified

the following four investments in which to invest. (NOV 19)

Projec Investment NPV (`)

t (`)
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
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.

(a) Optimizing returns when projects are independent and divisible.
Computation of NPVs per Re. 1 of Investment and Ranking of
the Projects
Projec Investmen NP NPV per Re. Rankin
t t V 1 invested g
(`)
(`) (`)
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

Projec Investment NP
t (`) V
(`)
C 40,000 20,000
E 50,000 24,000
D 10,000 3,500
(1/10th
of
Project
)
Total 1,00,00 47,500
0
The company would be well advised to invest in Projects C, E and D (1/10
th) andreject Project F to optimise return within the amount of `
1,00,000 available for investment.
(ii) Optimizing returns when projects are indivisible.

Package of Investment Total NPV(`)

Project (`)
C and E 90,000 44,000
(40,000 + (20,000
50,000) +
24,000)
C and F 1,00,000 38,000
(40,000 + (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 `1,00,000 available for investment.
 Risk Analysis in Capital Budgeting

(c) K.P. Ltd. is investing X50 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:
(JUL21)

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 16 lakhs
year

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 @ 0.943 0.890 0.840 0.792
6%
Discount Factor@ 0.893 0.797 0.712 0.636
12%
(5 Marks)
Calculation of Cash Flow
Year Sales P/V Contribution Fixed Cost Cash Flows
(' in Lakhs) ratio (' in Lakhs) (Z in Lakhs) (' in lakhs)
(A) (B) (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
(Z in Lakhs) @ 12% Flows
1 15 0.893 13.395
(Z in lakhs)
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

Q 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: (RTP NOV
21)

Project- Project-
M N
Net Cash Flow Probabilit Net Cash Flow (`) Probability
(`) y
62,500 0.30 1,62,500 0.2
75,000 0.30 1,37,500 0
87,500 0.40 1,12,500 0.3
0
0.5
0

(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.
1. (a) Expected Net Cash Flow (ENCF) of Projects
 Project Project
M N
Net Probabilit Expected Net Probabilit Expecte
Cash y Net Cash Cash y d Net
Flow Flow (`) Flow Cash
(`) (`) Flow
(`)
62,500 0.3 18,750 1,62,50 0.2 32,500
0
75,000 0.3 22,500 1,37,50 0.3 41,250
0
87,500 0.4 35,000 1,12,50 0.5 56,250
0
ENCF 76,250 1,30,000
(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
(c) Standard Deviation of
ProjectsProject 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

Projec Coefficient of
t variation
( Standard
Deviation
Expected )Net Cash
Flow
M 10,383.2798 = 0.1362 or 13.62%
76,250
N 19,525.6242 = 0.1502 or 15.02%
1,30,000

(iii) 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.
(iv) X Ltd is considering installation of new machine with the following details:

Sr. No. Particulars Figures

1 Initial Investment ` 1400 Crore
2 Annual unit sales 100 Crore
3 Selling price per ` 40
unit
4 Variable cost per ` 20
unit
5 Annual Fixed ` 500 Crore
costs
6 Depreciation ` 200 Crore
7 Discount Rate 12%
8 Tax rate 30%
Consider Life of the project as 4 years with no salvage value. Required:
(a) CALCULATE the expected NPV of the project.
(b) COMPUTE the impact on the project’s NPV if change in
variables is as under andalso compute which variable is
having maximum impact on NPV.

Sr. No. Variable Figures

1 Unit sold per year 85 Crore
2 Selling price per ` 39
unit
3 Variable cost per ` 22
unit
4 Annual Fixed ` 575 Crore
 costs
PV factor at 12% are as follows:

7B Year 1 2 3 4
PV 0.893 0.79 0.71 0.63
factor 7 2 6
1. Calculation of Net Cash Inflow per year:

Particulars Amount (`)

A Selling Price Per Unit (A) 40
B Variable Cost Per Unit (B) 20
C Contribution Per Unit (C = A - B) 20
D Number of Units Sold Per Year 100 Crore
E Total Contribution (E = C × D) 2,000 Crore
F Annual Fixed costs 500 Crore
G Depreciation 200 Crore
H Net Profit before taxes (H = E - F 1,300 Crore
- G)
I Tax @ 30% of H 390 Crore
J Net Cash Inflow Per Year (J = H - 1,110 Crore
I + G)
Calculation of expected Net Present Value (NPV) of the Project:

Year Year Cash PVAF @ Present Value (PV)

Flow (` in 12% (` in Crore)
Crore)
0 (1400.0 1.00 (1400.0
1-4 0) 0 0)
1,110.0 3.03 3,372.1
0 8 8
Net Present Value 1,972.1
8

Sensitivity Analysis under variable different value:

Changes in variable Base Units Sellin Variabl Annual

sold per g price e cost Fixed
year is per per costs is
85 unit is unit is ` 575
Crore ` 39 ` 22 Crore
Particulars (`) (`) (`) (`) (`)
A Selling Price Per 40 40 39 40 40
 Unit
B Variable Cost Per 20 20 20 22 20
Unit
C Contribution 20 20 19 18 20
Per
Unit (C
= A - B)
D Number of Units Sold 100 85 100 100 100
Per Year (in
Crores)
E Total Contribution (E 2,000 1,700 1,900 1,800 2,000
= C × D)
F Annual Fixed Cost 500 500 500 500 575
(in Crores)
G Depreciation (in 200 200 200 200 200
Crores)
H Net Profit before 1,300 1,000 1,200 1,100 1,225
taxes (H = E - F
- G)
I Tax @ 30% of H 390 300 360 330 367.50
J Net Cash Inflow Per 1,110 900 1,040 970 1,057.50
Year (J
= H - I + G)
K (J × 3.038) 3,372.1 2,734.20 3,159.5 2,946.8 3,212.69
8 2 6
L Initial Cash Flow 1,400 1,400 1,400 1,400 1,400
M NPV (K - L) 1,972.1 1,334.20 1,759.5 1,546.8 1,812.69
8 2 6
N Change in NPV - (637.98) (212.66 (425.3 (159.50)
) 2)
O Percentage Change in - - - - -
NPV 32.35 10.78 21.57 8.09
% % % %
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%.

Q: A project requires an initial outlay of ` 3,00,000.

The company uses certainty equivalent method approach to evaluate the
project. The riskfree rate is 7%.
Following information is available: (JAN 21)
 Year CFAT CE
(Cash Flow After (Certainty Equivalent
Tax) ` Coefficient)
1. 1,00,000 0.90
2. 1,50,000 0.80
3. 1,15,000 0.60
4. 1,00,000 0.55
5. 50,000 0.50
PV Factor at 7%

Year 1 2 3 4 5
PV 0.935 0.87 0.816 0.763 0.71
Factor 3 3
Evaluate the above. Is investment in the project beneficial?

(a) Statement Showing the Net Present Value of Project

Year CFAT C.E Adjusted Present Total

end (`) . Cash value Present
flow (`) factor @ value
(a) (b) (c) = (a) (b) 7% (d) (`)
(e) = (c)
(d
)
1 1,00,00 0.90 90,000 0.935 84,150
0
2 1,50,00 0.80 1,20,000 0.873 1,04,760
0
3 1,15,00 0.60 69,000 0.816 56,304
0
4 1,00,00 0.55 55,000 0.763 41,965
0
5 50,000 0.50 25,000 0.713 17,825
PV of Cash Inflow 3,05,004
Less: Initial (3,00,000)
Investment 5,004
Net Present
Value
Since the NPV of the project is positive, it is beneficial to invest in the project.
Q: SG Ltd. is considering a project “Z” with an initial outlay of Rs.
7,50,000 and life of 5 years. Theestimates of project are as follows:
(M
TP 21)
 Lower Base Upper
Estimates Estimates
Sales (units) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price 175 200 225
p.u.
Variable cost 100 125 150
p.u.
Fixed Cost 50,000 75,00 1,00,000
0
Depreciation included in Fixed cost is Rs. 35,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst,
base and bestcase scenario.
PV factor for 5 years at 15% are as follows:

Year 1 2 3 4 5
s
P.V. factor 0.87 0.75 0.65 0.57 0.49
0 6 8 2 7
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.
Worst Case Base Best Case
Sales (units) (A) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500
Less: Tax @ 25% 3,125 75,000 1,59,375
EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash 44,375 2,60,000 5,13,125
Inflow
Calculation of NPV in different scenarios

Worst Case Base Best Case

Initial outlay (A) (Rs.) 7,50,000 7,50,000 7,50,000
 Cash Inflow (c) (Rs.) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) 1,48,789.3 8,71,780 17,20,508.1
(Rs.) 8 3
NPV (B - A) (Rs.) (6,01,210.62 1,21,780 9,70,508.1
) 3

(b) Here,
Redemption Value (RV)=
Rs.1,50,000 Net Proceeds
(NP) = Rs. 3,750
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
1,50,000 = 3,750 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 IRR =
NPVL
L+
(H - L)
NPVL - NPVH
-7.081 × (16% - 15%)= 15.89%
= 15% +
-7.081 - (0.874)
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: (MTP
21)

Year-end Project A Project B

Cash Flow (Rs.) C.E. Cash Flow (Rs.) C.E.
1 16,75,000 0.8 16,75,000 0.9
2 15,00,000 0.7 15,00,000 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 21,20,000 0.6 9,00,000 0.9

PV factor at 5% are as follows:

Year 1 2 3 4 5
 PV 0.95 0.907 0.86 0.823 0.78
factor 2 4 4
a) DETERMINE which project should be accepted.
b) DISCUSS the advantages of Certainty Equivalent Method.
1. Statement Showing the Net Present Value of Project A

Year end Cash Flow C.E Adjusted Cash Present Total

(Rs.) . flow (Rs.) value Present
(a) (c) = (a) (b) factor at value
(b) 5% (d) (Rs.)
(e) = (c)
(d
)
1 16,75,00 0.8 13,40,000 0.952 12,75,680
0
2 15,00,00 0.7 10,50,000 0.907 9,52,350
0
3 15,00,00 0.5 7,50,000 0.864 6,48,000
0
4 20,00,00 0.4 8,00,000 0.823 6,58,400
0
5 21,20,00 0.6 12,72,000 0.784 9,97,248
0
PV of total Cash 45,31,678
Inflows
Less: Initial 34,00,000
Investment
Net Present Value 11,31,678
Statement Showing the Net Present Value of Project B

Year end Cash Flow C.E Adjusted Present Total

(Rs.) . Cash value Present
(a) flow factor at value
(b) (Rs.) 5% (d) (Rs.)
(c) = (a) (b) (e) = (c)
(d
)
1 16,75,00 0. 15,07,500 0.952 14,35,14
0 9 0
2 15,00,00 0. 12,00,000 0.907 10,88,40
0 8 0
3 15,00,00 0. 10,50,000 0.864 9,07,200
0 7
4 10,00,00 0. 8,00,000 0.823 6,58,400
0 8
5 9,00,000 0. 8,10,000 0.784 6,35,040
 9
PV of total Cash 47,24,18
Inflows 0
Less: Initial 33,00,00
Investment 0
Net Present Value 14,24,18
0
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.
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

Q: A Ltd. is considering two mutually exclusive projects X and Y. (NOV 20)

You have been given below the Net Cash flow probability distribution of each project:

Project- Project-
X Y
Net Cash Flow Probabili Net Cash Flow Probabili
(`) ty (`) ty
50,00 0.3 1,30,00 0.20
0 0 0 0.30
60,00 0.3 1,10,00 0.50
0 0 0
70,00 0.4 90,000
0 0
(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.
(ii0 Identify which project do you recommend ? Give reason.
(i) Calculation of Expected Net Cash Flow (ENCF) of Project X and Project Y

Project Project
X Y
Net Probabilit Expected Net Probabilit Expecte
Cash y Net Cash Cash y d Net
Flow Flow (`) Flo Cash
(`) w Flow
(`) (`)
50,000 0.30 15,000 1,30,00 0.20 26,000
0
60,000 0.30 18,000 1,10,00 0.30 33,000
0
70,000 0.40 28,000 90,000 0.50 45,000
ENCF 61,000 1,04,000
(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
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(σ 2) =
√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

Project Coefficient of Risk Expected Net

s variation Cash
( Standard Flow
Deviation
)Expected Net Cash
Flow
8,306.24
X = 0.136 or Less Less
13.60%
61,000
15,620.499
Y =0.150or15.0 Mor More
0% e
1,04,000
(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.

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: (RTP
NOV20)

Project Project
X Y
Year-end Cash Flow C.E. Cash Flow C.E.
(`) (`)
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 1 0.947 0.898 0.851 0.807 0.765
factor
Required: DETERMINE the project that should be accepted?
 Calculation of Net Present Value (NPV) of Project X

Year Cash C.E Adjusted Present Total

end Flow (`) . Cash value factor Present
(a) (b) flow (`) at 5.5% (d) value
(c) = (a) (b) (`)
(e) = (c)
(d
)
1 16,50,00 0.8 13,20,000 0.94 12,50,040
0 7
2 15,00,00 0.7 10,50,000 0.89 9,42,900
0 8
3 15,00,00 0.5 7,50,000 0.85 6,38,250
0 1
4 20,00,00 0.4 8,00,000 0.80 6,45,600
0 7
5 21,00,00 0.6 12,60,000 0.76 9,63,900
0 5
PV of total cash inflows 44,40,690
Less: Initial Investment (42,50,00
0)
Net Present Value 1,90,690
Calculation of Net Present Value (NPV) of Project Y

Year Cash C.E Adjusted Present Total

end Flow (`) . Cash value factor Present
(a) (b) flow (`) at 5.5% value
(c) = (a) (b) (d) (`)
(e) = (c)
(d
)
1 16,50,00 0.9 14,85,000 0.94 14,06,295
0 7
2 16,50,00 0.8 13,20,000 0.89 11,85,360
0 8
3 15,00,00 0.7 10,50,000 0.85 8,93,550
0 1
4 10,00,00 0.8 8,00,000 0.80 6,45,600
0 7
5 8,00,00 0.9 7,20,000 0.76 5,50,800
0 5
 PV of total cash inflows 46,81,605
Less: Initial Investment (41,25,00
0)
Net Present Value 5,56,605
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.
Q: G Ltd. using certainty-equivalent approach in the evaluation of risky
proposals. The following information regarding a new project is as
follows: (RTP
MAY20)
Year Expected Cash Certainty-equivalent
flow 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
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?
Determination of Net Present Value (NPV)
Yea Expecte Certaint Adjusted PV Total
r d Cash y- Cash flow factor PV
(`)
flow (`) equivale (Cash flow × (at
nt (CE) CE) (`) 0.06)
0 (8,00,000) 1.0 (8,00,000) 1.00 (8,00,00
0 0)
1 6,40,000 0.8 5,12,000 0.94 4,82,81
3 6
2 5,60,000 0.7 3,92,000 0.89 3,48,88
0 0
3 5,20,000 0.6 3,12,000 0.84 2,62,08
0 0
4 4,80,000 0.4 1,92,000 0.79 1,52,06
2 4
5 3,20,000 0.3 96,000 0.74 71,712
7
NPV = (13,17,552 – 8,00,000) 5,17,55
2
As the Net Present Value is positive the project should be accepted.
 Dividend Decision
Q The following information relates to LMN Ltd. ( JUL21)
Earning of the company X30,00,000
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.
(5 marks)
(d) Calculation of market value per share as per Walter's model
r
D+ (E - D)
P= Ke
Ke
Where,
P = Market price per share.
E= Earnings per share = Z 30,00,000/5,00,000 = Z 6
D= Dividend per share = Z 6 x 0.60 = Z 3.6
r = Return earned on investment = 15%
Ke= Cost of equity capital = 13%
3.6 + 0.15 (6 3.6)

P= 0.13 = 49
0.13
(i) 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:
0+0.15 (6 0)
P= 0.13 = - 53.254
0.13
Q: 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%.
 (RTP NOV21)
(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.
1. Calculation of market price per share
According to Miller – Modigliani (MM) Approach:

Po =

P
1

D
1

K
e
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
` 150 = P1 + `8
1+ 0.10
P1 = ` 157
(b) If expected dividends are not declared, then

` 150 =P1 + 0
1+ 0.10
P1 = ` 165
(ii) Calculation of number of shares to be issued

(a) (b)
Dividends Dividends are
are not Declared
declared (` lakh)
(` lakh)
Net income 300 300
Total dividends (80) -
Retained earnings 220 300
Investment budget 600 600
Amount to be raised by new 380 300
issues
Relevant market price (` per 157 165
share)
No. of new shares to be issued 2.42 1.82
(in lakh)
(` 380 ÷ 157; ` 300 ÷ 165)
(iii) Calculation of market value of the shares

(a) (b)
Dividends Dividends are
are declared not
Declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (`) 157 165
Total market value of shares at 12.42 × 157 11.82 × 165
the end of the year (` in lakh) = 1,950 = 1,950
(approx.) (approx.)
Hence, it is proved that the total market value of shares remains
unchanged irrespective of whether dividends are declared, or not
declared.
Q: The following information is supplied to you: (RTP MAY21)

(`)
Total Earnings 2,00,000
No. of equity shares (of ` 100 20,000
 each)
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
SOL:
(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 opti mal 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-
0.1
0+ (10 - 0)
0.08 = 156.25

0.08
So, theoretically the market price of the share can be increased by ad opting 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 k e> r and the market price, as per Walter’s
model would be:

Q: The following information is taken from ABC Ltd. (JAN 21)

 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 22%
investment
Cost of Equity Capital 18%
Retention Ratio 75%

Calculate
the
market
price of
the share
using:
(1) Gordo
n's
Model
 (2) Walter's Model

(a) Market price per share by-

(1) Gordon’s Model:
D (1+g)
Present market price per share (Po)* = o
Ke -g
OR

Present market price per share (Po) = D1

Ke -g
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
E = Earnings per share

Po = 0.75 (1- 0.165) = 0.874 = ` 58.27 approx.

0.18 - 0.165 0.015
(1) Walter’s Model:
D+ r (E-D)
Ke
P=
Ke

0.75 + 0.22 (3 - 0.75)

= 0.18 = ` 19.44
0.18
Workings:
1. Calculation of Earnings per share

Particulars Amount (`)

 Net Profit for the year 30,00,000
Less: Preference dividend (12% of ` (12,00,000)
1,00,00,000)
Earnings for equity shareholders 18,00,000
No. of equity shares (` 60,00,000/`10) 6,00,000
Therefore, Earnings per share `
18,00,000/6,00,000
Earning for equity shareholders = ` 3.00
( )
No. of equity shares

2. Calculation of Dividend per share

Particula
rs
Earnings per share `3
Retention Ratio (b) 75%
Dividend pay-out ratio (1-b) 25%
Dividend per share ` 3 x 0.25 = `
(Earnings per share x Dividend pay- 0.75
out ratio)
(a) The following data is available in respect of N Ltd. for the year ended 31st March,
2021:
(MTP 21)

Rs. (in Crore)

Share capital (@ Rs. 10 per 25.00
share)
Reserves 15.00
Profit after tax (PAT) 3.70
Dividends paid 3.00
P/E ratio 26.70
Using Walter’s Model:
(i) COMMENT on the firm’s dividend policy;
(ii) DETERMINE the optimum payout ratio and
(iii) DETERMINE the P/E ratio at which dividend payout will have no effect on share
price.
Workings:
1. Earnings per share (E) = P
 AT Rs. 3.7
= = Rs. 1.48
crores
No. of shares 2.5 crore shares
2. Return on Investment (r) = PAT x 100 = Rs. 3.7 crores x
100= 9.25%
Net worth Rs. (25 + 15) crores

3. Dividend per share (D) = Dividend paid = Rs. 3 crores = Rs.1.2

No. of shares Rs3.7 crores
4. Current Market Price (P o) = P/E Ratio x E = 26.7 x Rs.

1.48 = Rs.39.52 5. Growth rate (g) =bxr=

(1 - 0.8108) x 0.0925 = 1.75%

6. Cost of Capital (Ke) = D(1+g) + g = Rs. 1.2 (1 + 0.0175) + 0.0175= 4.84%

Po Rs. 39.52
 (i) The value of the share as per Walter’s model:

The firm has a dividend payout of 81.08% (i.e., Rs. 3 crores) out of Profit after tax
ofRs.
3.7 crores with value of the share at Rs. 35.85. The rate of return on investment (r)
is 9.25% and it is more than the K e of 4.84%, therefore, by distributing
81.08% of earnings, the firm is not following an optimal dividend
policy.
(ii) Under Walter’s model, when return on investment is more than cost of
capital (r > Ke), the market share price will be maximum if 100%
retention policy is followed. So, the optimal payout ratio would be to pay
zero dividend and in such a situation, the market price would be:

(iii) The P/E ratio at which dividend payout will have no effect on share
price is at which the Ke would be equal to the rate of return (r) of
the firm i.e. 9.25%.
D (1+g) + g
So, Ke =
Po
0.0925 = Rs. 1.2 (1 + 0.0175)
+ 0.0175
Po
Po = Rs. 16.28
If Po is Rs. 16.28, then, P/E Ratio will be
Rs. 16.28 =
= Po =
11 times E Rs. 1.48
Therefore, at the P/E ratio of 11, the dividend payout will have no effect on share price.
Q: Answer the following: (MTP 21)
(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)

Working:
Calculation of Earnings per share (EPS):

EPS DPS
Dividend

Payout Ratio EPS=

Rs.9 =

Rs.12

1-0.25
Market price per share by
(i) Walter’s model:

(ii) Gordon’s model (Dividend Growth model):

P = Do (1+g)
K
e
-
g
W
h
e
r
e,
Po = Present market price per share.
 g = Growth rate (br) = 0.25 × 0.24 = 0.06b =
Retention ratio k = Cost of Capital
r = Internal rate of return (IRR)D0 =
Dividend per share E = Earnings per
share

Rs. 9(1+0.06) = 954 = rs.73.38

0.19-0.06 0.13

The following figures are extracted from the annual report of RJ Ltd.:
(NOV20)

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

Particulars ` in lakhs
Net Profit 50
Less: Preference dividend (` 200,00,000 26
x 13%)
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

0.15D + 1 - 0.25D
6 =
0.15
0.1D =
1–
0.9 D
=
`1
D/P ratio = DPS X100 = 1
X100 = 25% EPS 4
So, the required dividend pay-out ratio will be = 25%

1. The following information is given for QB Ltd.

(RTP NOV20)
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
SOL:
a) As per Gordon’s Model, Price per share is computed using the formula:

P0 = E1(1-b)
 Ke – br
Where,
P0 = Price per share
E1 = Earnings per share
b = Retention ratio; (1 - b = Pay-out ratio)
Ke = Cost of
capitalr = IRR br
= Growth rate (g)
Applying the above formula, price per share

P0 = 120(1- 0.7) = 36 = 3,600

0.15- 0.70X0.2 0.01

b) As per Walter’s Model, Price per share is computed using the formula:
𝐃+ 𝐫 (𝐄−𝐃)
Price (𝐏) = 𝐊𝐞
𝐊𝐞
Where,
P = Market Price of
the share. E =
Earnings per
share. D =
Dividend per
share.
Ke = Cost of equity/ rate of capitalization/
discount rate. r = Internal rate of return/
return on investment
Applying the above formula, price per share
36+0.20(1
20−36) P = 0.15
0.15
P = 36+112 = ` 986.67
 0.15

Following figures and information were extracted from the company A Ltd. (NOV 19)

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)
(a) 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.

(b) The value of the share as per Walter’s model may be found as
follows:Walter’s model is given by-
𝐃+ 𝐫 (𝐄−𝐃)
Price (𝐏) = 𝐊𝐞
𝐊𝐞

Where,
P = Market price
per share. E =
Earnings per share
= ` 5 D = Dividend
per share = ` 3
R = Return earned on
investment = 20 % Ke = Cost
of equity capital = 10% or .10

P =3+ 0.20 (5- 3)

10 = 70

0.10
Current Market Price of shares can also be calculated as follows

Price Earnings (P/E) Ratio = Market Price of Share

Earnings per Shares

Or, 10 = Market Price of Share

`10,00,000 / 2,00,000
 Or, 10 = Market Price of Share
`5
(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 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:

0+ 0.20 (5- 0) =100

P = 0.10

0.10
9

Management of Receivables (Debtors)

(a) Current annual sale of SKD Ltd. is 7 360 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:
(JUL 21)

Policy X Policy
Y
Average collection period 1.5 months 1
month
% of default 2% f%
Annual collection 7 12 lakh 720
expenditure lakh
Se/ling price per unit of product is 7150. Total cost per unit is 7 120.
Current credit terms are 2 months and percentage of default iS 3%.
Current annual collection expenditure is 78 lakh. Required rate of return on investment of
SKD Ltd. is 20%. Determine which credit policy SKD Ltd. should follow. (5 Marks)
Ans Statement showing the Evaluation of Credit policies (Incremental Approach)
Particulars Present Proposed Propos
Policy Policy X ed
(2 (1.5 Policy
Months) Months) Y (1
Month)
T in T in T in
lakhs lakhs lakhs
(a) Credit Sales* 360 360 360
(b) Cost of sales (360/150 x 120) 288 288 288
(c) Receivables (Refer Working 48 36 24
Note)
(d) Reduction in from 12 24
receivables present policy
(A Savings in Opportunity 2.4 4.8
) Cost of Investment in
Receivables (@ 20%)
(e) Bad Debts 10. 7. 3.
(36 8 (36 2 (36 x 6
0 x 0 x 0 0.01
0.03) 0.02) )
 (B Reduction in bad debts fro 3.6 7.2
) present policy m
(f) Collection expenditure 8 12 20
(C Increase in Collection 4 12
) expenditure from Present
policy
(D Net Benefits (A +B-C) 2 0
)
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.

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: (RTP
NOV21)
(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.
(i) Bank loan: Since the compensating balance would not otherwise be
maintained, the real annual cost of taking bank loan would be:
= 15 × 100 = 16.67%
p.a.
90

(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:
 = 3 X 360 x = 18.56% p.a.
97 60
(iii) Factoring:
Commission charges per year = 2% (2,00,000 12) = ` 48,000
Total Savings per year = (`1,250 + 1,750) 12 = ` 36,000Net
factoring cost per year = ` 48,000 - ` 36,000 = ` 12,000
Annual Cost of Borrowing ` 1,50,000 receivables through factoring would be:

= 12% x 1,50,000 + 12,000 x100

1,50,000

=18,000 + 12,000 x100

1,50,000
= 20% p.a.
 Advise: The company should select alternative of Bank Loan as it has the lowest
annualcost i.e. 16.67% p.a.

Q: WQ Limited is considering relaxing its present credit policy and is in the

process of evaluating two proposed polices. Currently, the firm has annual credit
sales of Rs. 180 lakh and Debtors turnover ratio of 4 times a year. The current level
of loss due to bad debts is Rs. 6 lakh. The firm is required to give a return of 25% on
the investment in new accounts receivables. The company’s variable costs are 60% of
the selling price. Given the following information, DETERMINE which is a better
Policy?
(Amount in lakhs)

Presen Proposed Policy

t Option Option
Polic I II
y
Annual credit sales 180 220 280
(Rs.)
Debtors turnover 4 3.2 2.4
ratio
Bad debt losses (Rs.) 6 18 38

Statement showing evaluation of Credit Policies

(Amount in lakhs)

Particulars Presen Proposed Policy

t (Rs.)
(Rs. Option I Option II
)
A Expected
Profit:
(a) Credit Sales 180 220 280
(b) Total Cost other than Bad Debts:
Variable Costs (60%) 108 132 168
(c) Bad Debts 6 18 38
(d) Expected Profit [(a)-(b)-(c)] 66 70 74
B Opportunity Cost of Investment in 6.75 10.31 17.5
Debtors (Refer
workings)
C Net Benefits [A - B] 59.25 59.69 56.5
Recommendation: The Proposed Policy I should be adopted since the net
benefits under thispolicy is higher than those under other policies.
Workings:
Calculation of Opportunity Cost of Investment in Debtors

Opportunity Cost = Total Cost CollectionPeriod Rate of Return

12 100
Collection period (in months) = 12/Debtors turnover ratio
Present Policy = Rs.108 x 12/4 x 25 =
Rs.6.75 lakhs 12
100
Proposed Policy I = Rs.132 x 12/3.2 x 25 =
Rs.10.31 lakhs 12
100
Proposed Policy II = Rs.168 x 12/2.4 x 25 = Rs17.5 lakhs

12 100
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:
(RTP NOV20)

Credi Increase in Increase in Present default

t collection period sales anticipated
Polic
y
W 15 ` 60,000 1.5
days %
X 30 ` 90,000 2%
days
Y 45 ` 1,50,000 3%
days
Z 70 ` 2,10,000 4%
days
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?
A. Statement showing the Evaluation of Debtors Policies (Total Approach)
(Amount in `)

Particulars Prese Propose Propose Propose Propose

nt d Policy d Policy d Policy d
Policy W 60 Y 90 Policy
45 days X 75 days Z 115
 days days days

I Expected Profit:
. (a) Credit Sales 9,00,00 9,60,00 9,90,00 10,50,00 11,10,00
0 0 0 0 0
(b) Total Cost
other than
6,00,00 6,40,00 6,60,00 7,00,00 7,40,00
Bad Debts
0 0 0 0 0
(i) Variable
Costs 75,000 75,000 75,000 75,000 75,000
[Sales × 2/ 6,75,00 7,15,00 7,35,00 7,75,00 8,15,00
0 0 0 0 0
3]
9,000 14,400 19,800 31,500 44,400
(ii) Fixed Costs
2,16,00 2,30,60 2,35,20 2,43,50 2,50,60
0 0 0 0 0
(c) Bad Debts
(d) Expected
Profit [(a)
– (b) – (c)]

II. Opportunity Cost 16,87 23,833 30,625 38,750 52,069

of Investments 5
i
n Receivables
III Net Benefits (I – 1,99,12 2,06,76 2,04,57 2,04,75 1,98,53
. II) 5 7 5 0 1
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
(ii) Calculation of Opportunity Cost of Average Investments

Opportunity Cost = Total Cost × Collection period × Rate of Return

360 100
Present Policy = 6,75,000 × 4 5 x 20 = 16,875

360 100
Policy W = 7,15,000 × 6 0x 2 0 = 2 3 , 8 3 3

360 100
Policy X = 7,35,000 x 75 x 20 = 30,625

360 100
Policy Y = 7,75,000 x 90 X 20 = 38,750

360 100
Policy Z = 8,15,000 x 115 X 20 = 52,069

360 100
B. Another method of solving the problem is Incremental Approach.
Here we assume that sales are all credit sales.
(Amount in `)

Particulars Prese Propose Propose Propose Propose

nt d d d Policy d
Policy Policy Policy Y 90 Policy
45 W 60 X 75 days Z 115
days days days days
I. Incremental
Expecte
d Profit: 0 60,000 90,000 1,50,000 2,10,00
(a) Incremental 0
Credit
Sales 6,00,00 40,000 60,000 1,00,000 1,40,00
0 0
(b) Incremental Costs
75,000 - - - -
(i) Variable Costs 9,000 5,400 10,80 22,500 35,40
(ii) Fixed Costs 0 0
14,60 19,20 27,500 34,60
II. 0 0 0
6,75,00 7,15,0 7,35,0 7,75,00 8,15,0
0 00 00 0 00
45 6 75 90 115
0
84,375 1,19,1 1,53,1 1,93,75 2,60,3
67 25 0 47
- 34,79 68,75 1,09,37 1,75,9
2 0 5 72
2 20 20 2
Net Benefits (I-II) 0 0
- 6,958 13,75 21,875 35,19
0 4
III 7,642 5,450 5,625 (594)
. -

Recommendation: The Proposed Policy W should be adopted since

the net benefits under this policy are higher than those under
 other policies.
Q: 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:
(RTP MAY20)
Quantity sold (No. of TV Sets)

Credit Period A B C
(Days)
0 10,000 10,000 -
30 10,000 15,000 -
60 10,000 20,000 10,00
0
90 10,000 25,000 15,00
0
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).

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:

Particul Customer Customer C

ars B
1. Credit period 0 30 60 90 0 3 60 90
(days) 0
2. Sales Units 10,00 15,00 20,00 25,000 - - 10,00 15,00
0 0 0 0 0
` in lakh `in
lakh
3. Sales Value 1,50 2,250 3,000 3,750 - - 1,500 2,250
0
4. Contribution at 750 1,125 1,500 1,875 - - 750 1,125
50% (A)
5. Receivables:-
- 187.5 500 937.5 - - 250 562.5
Credit Period ×
 Sales
360
6. Debtors at 93.75 250 468.75 - - 125 281.2
cost - 5
7. Cost of carrying - 18.75 50 93.75 - - 25 56.25
debtors at 20% (B)
8. Excess of 750 1,106. 1,406.2 1,781. - - 725 1,068.
contributions over 25 5 25 75
cost of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case
of credit periodof 90 days in respect of both the customers B and C.
Hence, credit period of 90 days should be allowed to B and C.

Management of Working Capital

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:
(RTP
NOV21)
(`)

Sales – Domestic at one month’s credit 18,00,00

0
Export at three month’s credit (sales price 10% below domestic 8,10,000
price)
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 1,68,000
the next 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.
Working Notes:
1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic (`) Export (`)Total

(`)
Domestic Sales 18,00,000 8,10,000 26,10,00
0
Less: Gross profit @ 20% 3,60,000 90,000 4,50,00
on domestic sales and 0
11.11% on export sales
(Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,00
0
Add: Selling expenses 77,586 34,914 1,12,50
(Working note-3) 0
Cash Cost of Sales 15,17,586 7,54,914 22,72,50
0
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
10
So, Gross profit ratio at export price will be = 100 = 11.11%
90
3. Apportionment of Selling expenses between Domestic and Exports sales:
Apportionment on the basis of sales value:

Domestic Sales = `1,12,500 x 18,00,000 = 77,586

26,10,000

Export Sales = 1,12,500 x 8,10,000 = 34,916

26,10,000
4. Assumptions
(i) It is assumed that administrative expenses is related to production activities.
(ii) Value of opening and closing stocks are equal.

MT Ltd. has been operating its manufacturing facilities till

31.3.2021 on a single shift working with the following cost
structure: (RTP
MAY21)

Per unit (`)

Cost of Materials 24
Wages (out of which 60% 20
variable)
Overheads (out of which 20% 20
variable)
64
Profit 8
Selling Price 72
As at 31.3.2021 with the sales of ` 17,28,000, the company held:

(`)
Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime 88,000
cost)
Finished goods (valued at total 2,88,000
cost)
Sundry debtors 4,32,000
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 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.
Workings:
(1) Statement of cost at single shift and double shift working

24,000 units 48,000 Units

Per Total Per Tota
unit (`) unit l
(`) (`) (`)
Raw materials 24 5,76,000 21.6 10,36,00
0
Wages
:
Variable 12 2,88,000 12 5,76,000
Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,00 49.6 23,80,80
0 0
Profit 8 1,92,000 22.4 10,75,20
0
Sales 72 17,28,00 72 34,56,00
0 0

(2) Sales in units 2020-21 = Sales = 17,28,000 = 24,000 units

Unit selling price 72 units
(3) Stock of Raw Materials in units on 31.3.2021

= Value of stock = ` 1,44,000 = 6,000 units

Cost per unit 24

(4) Stock of work-in-progress in units
on 31.3.2021 Value of work-in-
progress = 88,000 = 2,000 units
Prime cost per unit (24+20)
(5) Stock of finished goods in units 2020-21
= Value of stock = 2,88,000 =
4,500 units Total cost per unit
64
Comparative Statement of Working Capital Requirement

Single Shift (24,000 Double Shift (48,000

units) units)
Unit Rat Amoun Units Rat Amoun
s e t e t
(`) (`) (`) (`)
Current Assets
Inventories:
Raw Materials 6,00 24 1,44,00 12,00 21.6 2,59,20
0 0 0 0
Work-in-Progress 2,00 44 88,000 2,000 37.6 75,200
0
Finished Goods 4,50 64 2,88,00 9,000 49.6 4,46,40
0 0 0
Sundry Debtors 6,00 64 3,84,00 12,00 49.6 5,95,20
0 0 0 0
Total Current Assets 9,04,00 13,76,00
(A) 0 0
Current Liabilities
Creditors for 4,00 24 96,00 8,000 21.6 1,72,80
Materials 0 0 0
Creditors for Wages 2,00 20 40,000 4,00 16 64,000
0 0
Creditors for 2,00 20 40,000 4,00 12 48,000
Overheads 0 0
Total Current 1,76,00 2,84,80
Liabilities (B) 0 0
Working Capital (A) – 7,28,00 10,91,20
(B) 0 0

Analysis: Additional Working Capital requirement = ` 10,91,200 – `

7,28,000 = `3,63,200, if the policy to increase output is
implemented.
While applying for financing of working capital requirements to a
commercial bank, TN Industries Ltd. projected the following
information for the next year: (RTP MAY21)

Cost Element Per unit Per unit (`)

(`)
Raw materials
X 30
Y 7
Z 6 43
 Direct Labour 25
Manufacturing and administration overheads 20
(excluding depreciation)
Depreciation 10
Selling 15
overheads
113
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 of activity is 1,50,000 units for the
next year. The company also intendsto 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.)
Statement showing Working Capital Requirements of TN
Industries Ltd. (on cash cost basis
 Workings:
1.

(i) Computation of Cash Cost of Production Per unit (`)

Raw Material consumed 43
Direct Labour 25
Manufacturing and administration 20
overheads
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit (`)
Cash cost of production as in (i) 88
above
Selling overheads 15
Cash cost of sales 103

2. Calculation of cost of WIP

Particulars Per unit (`)

Raw material (added at the beginning):
X 30
Y 7
Z (` 6 x 50%) 3
Cost during the year:
Z {(` 6 x 50%) x 50%} 1.5
Direct Labour (` 25 x 50%) 12.5
Manufacturing and administration overheads (` 10
20 x 50%)
64
 (a) The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
(JAN 21)

Raw Material Storage period 45 days

Work-in-Progress conversion 20 days
period
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.
Amount of working capital required for the company on a cost basis
(a) 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
= 360 = 360 = 6
Operating cycle period 60
(iii) Amount of Working Capital Required
Annual operating cost =` 25,00,000 -
` 2,50,000 Number of operating cycle
6
` 22,50,000 = ` 3,75,000
6
(iv) Reduction in Working Capital
Operating Cycle Period =R+W+F–C
= 45 + 20 + 25 – 60 = 30 days
Amount of Working Capital Required =22,50,000 x 30 = 1,87,500
360
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.)
 Q: WQ Limited is considering relaxing its present credit policy and is in the process of
evaluating two proposed polices. Currently, the firm has annual credit sales of Rs. 180
lakh and Debtors turnover ratio of 4 times a year. The current level of loss due to bad
debts is Rs. 6 lakh. The firm is required to give a return of 25% on the investment in
new accounts receivables. The company’s variable costs are 60% of the selling price.
Given the following information, DETERMINE which is a better Policy?
(MTP
(Amount in lakhs) 21)

Presen Proposed Policy

t Option Option
Polic I II
y
Annual credit sales 180 220 280
(Rs.)
Debtors turnover 4 3.2 2.4
ratio
Bad debt losses (Rs.) 6 18 38
Statement showing evaluation of Credit Policies (Amount in lakhs)

Particulars Presen Proposed Policy

t (Rs.)
(Rs. Option I Option II
)
A Expected
Profit:
(a) Credit Sales 180 220 280
(b) Total Cost other than Bad Debts:
Variable Costs (60%) 108 132 168
(c) Bad Debts 6 18 38
(d) Expected Profit [(a)-(b)-(c)] 66 70 74
B Opportunity Cost of Investment in 6.75 10.31 17.5
Debtors (Refer
workings)
C Net Benefits [A - B] 59.25 59.69 56.5
Recommendation: The Proposed Policy I should be adopted since the net
benefits under thispolicy is higher than those under other
policies.Workings:
Calculation of Opportunity Cost of Investment in Debtors
Opportunity Cost = Total Cost CollectionPeriod Rate of Return
12 100
Collection period (in months) = 12/Debtors turnover ratio
Present Policy = Rs. 108 x 12/4 × 2 5 = Rs. 6.75 lakhs
12 100
Proposed Policy I = Rs. 132 ×12/3..2× 2 5 = Rs. 10.31 lakhs

12 100
Proposed Policy II = Rs. 168 x 12/2.4 x 25 = Rs.17.5 lakhs

12 100
 PREPARE monthly cash budget for the first six months of 2021 on
the basis of the followinginformation: (MTP 21)
(i) Actual and estimated monthly sales are as follows:

Actual (Rs.) Estimated (Rs.)

October 2020 2,00,000 January 60,000
2021
November 2,20,000 February 80,000
2020 2021
December 2,40,000 March 2021 1,00,000
2020
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000
(ii) Operating Expenses (including salary & wages) are estimated to be payable as
follows:

Month (Rs.) Month (Rs.)

January 2021 22,000 April 30,000
2021
February 2021 25,000 May 25,000
2021
March 2021 30,000 June 24,000
2021
(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the
credit sales are collected afterone 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 inJanuary, April and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in April.
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).
 Monthly Cash Budget for first six months of 2021 (Amount in Rs.)

Particulars Jan. Feb. Mar. April May June

Opening balance 40,000 40,000 40,000 40,000 40,000 40,000
Receipts:
Cash sales 15,000 20,000 25,000 30,000 20,000 15,000
Collection from 1,72,500 97,500 67,500 67,500 82,500 70,500
debtors
Total cash 2,27,500 1,57,50 1,32,50 1,37,500 1,42,50 1,25,5
available (A) 0 0 0 00
Payments:
Purchases 64,000 80,000 96,000 64,000 48,000 96,000
Operating 22,000 25,000 30,000 30,000 25,000 24,000
Expenses
Interest on 3,000 - - 3,000 - -
debentures
Tax payment - - - 5,000 - -
Total payments (B) 89,000 1,05,00 1,26,00 1,02,000 73,000 1,20,0
0 0 00
Minimum cash balance 40,000 40,000 40,000 40,000 40,000 40,000
desired
Total cash needed 1,29,000 1,45,00 1,66,00 1,42,000 1,13,00 1,60,0
(C) 0 0 0 00
Surplus/(deficit) (A 98,500 12,500 (33,50 (4,500) 29,500 (34,50
- C) 0) 0)
Investment/financi
ng (98,50 (12,50 - - (29,50 -
Temporary 0) 0) 0)
Investments
Liquidation of 33,500 4,500
temporary - 34,500
investments or
temporary
borrowings
Total effect of 4,500 (29,50 34,500
investment/financing(D (98,500) (12,500 33,500 0)
) )
Closing cash balance
(A + D - B) 40,000 40,000 40,000 40,000 40,000 40,000
Workings:
1. Collection from debtors: (Amount in Rs.)
 Year Year
2020 2021
Oct. Nov. Dec. Jan. Feb. Mar. April Ma June
y
Total sales 2,00,0 2,20,0 2,40,0 60,0 80,0 1,00,0 1,20,0 80,0 60,00
00 00 00 00 00 00 00 00 0
Credit sales
(75% of
1,50,0 1,65,0 1,80,0 45,0 60,0 75,00 90,000 60,0 45,00
total 00 00 00 00 00 0 00 0
sales)
Collections
90,00
: 0
One month 99,000 1,08, 27,0 36,00 45,000 54,0 36,00
00 00 0 00 0
0
Two 45,000 49,5 54,0 13,50 18,000 22,5 27,00
months 00 00 0 00 0
Three 15,0 16,5 18,00 4,500 6,00 7,500
months 00 00 0 0
Total
collections 1,72, 97,5 67,50 67,500 82,5 70,50
50 00 0 00 0
0
 2. Payment to Creditors: (Amount in Rs.)

Year
2021
Jan Feb Mar Apr May Jun Jul
Total sales 60,00 80,00 1,00,0 1,20,0 80,00 60,00 1,20,0
0 0 00 00 0 0 00
Purchases 96,00
(80% of total 48,00 64,00 80,00 96,00 64,00 48,00 0
sales) 0 0 0 0 0 0
Payment:
64,00 80,00 96,000 64,00 48,00 96,0
0 0 0 0 00

PK Ltd., a manufacturing company, provides the following information: (NOV 20)

(`)
Sales 1,08,00,00
0
Raw Material Consumed 27,00,000
Labour Paid 21,60,000
Manufacturing Overhead (Including Depreciation for the year 32,40,000
` 3,60,000)
Administrative & Selling Overhead 10,80,000
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.
Statement showing the requirements of Working Capital (Cash Cost basis)

Particulars (` (`)
)
A. Current Assets:
Inventory:
Stock of Raw material (` 27,00,000 × 3/12) 6,75,000
Stock of Finished goods (` 77,40,000 × 19,35,00
3/12) 0
Receivables (` 88,20,000 × 3/12) 22,05,00
0
Administrative and Selling Overhead (` 10,80,000 × 90,000
1/12)
Cash in Hand 3,00,000
Gross Working Capital 52,05,00 52,05,0
00
0
B. Current Liabilities:
Payables for Raw materials* (` 27,00,000 6,75,000
× 3/12)
Outstanding Expenses:
Wages Expenses (` 21,60,000 × 1/12) 1,80,000
Manufacturing Overhead (` 28,80,000 × 1/12) 2,40,000
Total Current Liabilities 10,95,00 10,95,0
00
0
Net Working Capital (A-B) 41,10,0
00
Add: Safety margin @ 10% 4,11,00
0
Total Working Capital requirements 45,21,0
00
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
(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.
 The following figures and ratios are related to a company: (RTP NOV20)

(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 1.5
sold)
(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.

Statement showing the Evaluation of Debtors Policies (Total Approach) (Amount in `)

Particulars Prese Propose Propose Propose Propose

nt d Policy d Policy d Policy d
Policy W 60 Y 90 Policy
45 days X 75 days Z 115
days days days
I Expected Profit:
. (a) Credit Sales 9,00,00 9,60,00 9,90,00 10,50,00 11,10,00
0 0 0 0 0
(b) Total Cost
other than
6,00,00 6,40,00 6,60,00 7,00,00 7,40,00
Bad Debts
0 0 0 0 0
(i) Variable
Costs 75,000 75,000 75,000 75,000 75,000
[Sales × 2/ 6,75,00 7,15,00 7,35,00 7,75,00 8,15,00
0 0 0 0 0
3]
9,000 14,400 19,800 31,500 44,400
(ii) Fixed Costs
2,16,00 2,30,60 2,35,20 2,43,50 2,50,60
0 0 0 0 0
(c) Bad Debts
II. (d) Expected 16,87 23,833 30,625 38,750 52,069
Profit [(a) 5
III. – (b) – (c)] 1,99,12 2,06,76 2,04,57 2,04,75 1,98,53
5 7 5 0 1
 Net benefits (I-II)

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
(ii) Calculation of Opportunity Cost of Average Investments

Opportunity Cost = 6,75,000 × 45 x 20 = 16,875

360 100
Policy W = 7,15,000 x 60 x 20 = 23,833

360 100
Policy X = 7,35,000 x 75 x 20 = 30,625

360 100
Policy Y = 7,75,000 x 90 x 20 = 38,750

360 100
Policy Z = 8,15,000 x 115 x 20 = 52,069

360 100
B. Another method of solving the problem is Incremental Approach.
Here we assume that sales are all credit sales.
(Amou
nt in `)

Particulars Prese Propose Propose Propose Propose

nt d d d Policy d
Policy Policy Policy Y 90 Policy
45 W 60 X 75 days Z 115
days days days days
I. Incremental
Expecte
d Profit: 0 60,000 90,000 1,50,000 2,10,00
(a) Incremental 0
Credit
Sales 6,00,00 40,000 60,000 1,00,000 1,40,00
0 0
(b) Incremental Costs
75,000 - - - -
(i) Variable Costs 9,000 5,400 10,80 22,500 35,40
(ii) Fixed Costs 0 0
14,60 19,20 27,500 34,60
II. 0 0 0
6,75,00 7,15,0 7,35,0 7,75,00 8,15,0
 0 00 00 0 00
45 6 75 90 115
0
84,375 1,19,1 1,53,1 1,93,75 2,60,3
67 25 0 47
- 34,79 68,75 1,09,37 1,75,9
2 0 5 72
2 20 20 2
0 0
Net Benefits(I-II) - 6,958 13,75 21,875 35,19
0 4
III - 7,642 5,450 5,625 (594)
.

Recommendation: The Proposed Policy W should be adopted since the

net benefits under this policy are higher than those under other policies.
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: (RTP MAY20)

Estimated Level of Completed Units of Production 31,200 plus unit

Activity of work in progress 12,000
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 30 days
supplier
Credit Allowed to 60 days
Purchasers
Direct Wages (Lag in 15 days
payment) Expected ` 2,00,000
Cash Balance
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.
Calculation of Net Working Capital requirement:

(`) (`)
A. Current Assets:
Inventories:
Stock of Raw material (Refer to Working note 1,44,000
(iii)
Stock of Work in progress (Refer to Working 7,50,000
note (ii)
Stock of Finished goods (Refer to Working 20,40,000
note (iv)
Debtors for Sales(Refer to Working note (v) 1,02,000
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases (Refer to Working 1,56,000
 note (vi)
Creditors for wages (Refer to Working note 23,250
(vii)
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
 Working Notes:
(i) Annual cost of production

(`)
Raw material requirements
{(31,200 × ` 40) + (12,000 x ` 40)} 17,28,000
Direct wages {(31,200 ×` 15) +(12,000 X ` 15 5,58,000
x 0.5)}
Overheads (exclusive of depreciation)
{(31,200 × ` 30) + (12,000 x ` 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (` 40 + ` 7.5 + (7,50,000)
`15)]
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished
Goods (` 26,52,000 × (20,40,000
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 4,80,000
× `40)
Direct wages (50% × 12,000 units × ` 90,000
15)
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 × ` 12,48,000
40)
For Work in progress (12,000 × 4,80,000
` 40)
17,28,000

Raw material stock = `17,28,000 × 30 days = `1,44,000

 360days

(iv) Finished goods stock:

24,000 units @ ` (40+15+30) per unit = `20,40,000
(v) Debtors for sale: `6,12,000 60days 1,02,000
360days
 (vi) Creditors for raw material Purchases [Working Note (iii)]:

Annual Material Consumed (`12,48,000 + `4,80,000) `17,28,00

0
Add: Closing stock of raw material [(`17,28,000 x 30 days) / ` 1,44,000
360 days]
`18,72,00
0

Credit allowed by suppliers = `18,72,000 × 30days= 1,56,000

360 days
(vii) Creditors for
wages:
Outstanding wage payment = [(31,200 units x ` 15) + (12,000 units
x ` 15 x .50)] x 15 days / 360 days
= `5,58,000 ×15days = ` 23,250
360 days

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: (NOV 19)

Months Decembe Januar Februar March April

r y y
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 onone 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.
Calculate the forecast current ratio at the end of the three months period.
Working Notes:
(1) Calculation of Collection from Trade Receivables:
 Particulars Decembe January Februar Marc
r y h
Sales (units) 1,800 1,875 1,950 2,100
Sales (@ ` 600 per unit) / 10,80,00 11,25,00 11,70,00 12,60,00
Trade Receivables 0 0 0 0
(Debtors) (`)
Collection from 10,80,00 11,25,00 11,70,00
Trade 0 0 0
Receivables (Debtors) (`)
(2) Calculation of Payment to Trade Payables:

Particulars Decembe Januar Februar March

r y y
Output (units) 1,875 1,950 2,100 2,250
Raw Material (2 units per 3,750 3,900 4,200 4,500
output) (units)
Raw Material (@ ` 150 per unit) / 5,62,500 5,85,00 6,30,00 6,75,00
Trade Payables (Creditors) (`) 0 0 0
Payment to Trade 5,62,50 5,85,00 6,30,00
Payables 0 0 0
(Creditors) (`)
(3) Calculation of Variable Overheads and Wages:

Particulars Januar Februar March

y y
Output (units) 1,950 2,100 2,250
Payment in the same month @ ` 100 per 1,95,00 2,10,00 2,25,00
unit(`) 0 0 0
(a) Preparation of Cash Budget

Particula January February March

rs (`) (`) (`)
Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade 10,80,00 11,25,00 11,70,00
Receivables (Debtors) 0 0 0
Receipt of Long-Term Loan 2,00,000
Total (A) 11,15,00 14,82,50 20,57,50
0 0 0
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
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,00
0
Closing Balance (A – B) 3,57,500 6,87,500 9,02,500
(a) Calculation of Current Ratio

Particulars March (`)

Output Inventory (i.e. units produced in March)
[(2,250 units x 2 units of raw material per unit of 9,00,000
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.
 Miscellaneous
Question
(a) Explain in brief the forms of Post Shipment Finance. (4 Marks)
(b) Describe the salient features of FORFAITING. (4 Marks)
(c) List out the steps to be followed by the manager to measure and maximize the
Shareholder's Wealth (2 Marks)
OR
Explain the limitations of Average Rate of Return. (2 Marks)
Answer
(a) Post-shipment Finance: It takes the following forms:
• 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.
• 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.
• 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.
• 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) 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) 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

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.

(RTP NOV 21)

1. (a) DISCUSS the points that demonstrates the Importance of
good financial management.
(b) EXPLAIN some common methods of Venture capital financing.

(a) 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
 ▪ Tax planning that will minimize the taxes a business has to pay.
(b) 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.
 2. (i) Profit Maximization cannot be the sole objective of a company". COMMENT.
(MAY 21)
(ii) DISCUSS the advantages and disadvantages of raising funds by issue of preference
shares.

(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-
© The Institute of Chartered Accountants of India
 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 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

© The Institute of Chartered Accountants of India

 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.
(JAN 21)
(a) State four tasks involved to demonstrate the importance of good Financial
Management.
(b) Explain Electronic Cash Management System.
(c) Define Internal Rate of Return (IRR)
OR
Explain in brief the following bonds:
(i) Callable Bonds
(ii) Puttable Bonds
(a) 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) Electronic Cash Management System: Most of the cash management
systems now-a- days 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) 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
(i) Callable bonds: A callable bond has a call option which gives the
issuer the right to redeem the bond before maturity at a
© The Institute of Chartered Accountants of India
 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.

(MTP 21)

© The Institute of Chartered Accountants of India

 1. (a) EXPLAIN in brief the features of Commercial
Paper.
(b) DESCRIBE how agency problem can be addressed.
(c) DEFINE Debt Securitisation.
Or
EXPLAIN the principles of “Trading on equity
1. 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 Rs. 5 lakhs or multiples thereof and the interest rate is
generally linked to the yield on the one-year government bond.
(b) Agency problem between the managers and shareholders can be addressed
if the interests of the managers are aligned to the interests of the
share- holders. 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 thatmaximisation of the stock price is the
objective of the investors.
• Effecting monitoring can be done.
(c) Debt Securitisation is a process in which illiquid assets are pooled into
marketable securities that can be sold to investors. The process leads to
the creation of financial instruments that represent ownership interest in,
or are secured by a segregated income producing asset or pool of assets.
These assets are generally secured by personal or real property such as
automobiles, real estate, or equipment loans but in some cases are
unsecured.
Or
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
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
© The Institute of Chartered Accountants of India
 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.
(MTP 21)
1. DISCUSS the advantages and disadvantages of Wealth maximization principle.
(b) DISCUSS in brief the characteristics of Debentures.
(c) DEFINE Security Premium Notes.
O
r DEFINE Masala
bond.

1. (a) Advantages and disadvantages of Wealth maximization principle.

© The Institute of Chartered Accountants of India

 Advantages:
(i) Emphasizes the long term gains
(ii) Recognises risk or uncertainty
(iii) Recognises the timing of returns
Considers shareholders’ return.
(iv)
Disadvantages:
(i) Offers no clear relationship between financial decisions and share price.
(ii) Can lead to management anxiety and frustration.
(b) Characteristics of Debentures are as follows:
• Normally, debentures are issued on the basis of a debenture trust
deed which lists the termsand 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) 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.
(NOV 20)
(a) List out the role of Chief Financial Officer in today's World.
(b) Explain in brief the methods of Venture Capital Financing.
(c) Distinguish between Unsystematic Risk & Systematic Risk.
OR
What is Risk Adjusted Discount Rate ?
© The Institute of Chartered Accountants of India
 (a) 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)

© The Institute of Chartered Accountants of India

 • Pricing analysis
• Decisions about outsourcing
• Overseeing the IT function.
• Overseeing the HR function.
• Strategic planning (sometimes overseeing this function).
• Regulatory compliance.
• Risk management

(b) 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 choiceto 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) (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
© The Institute of Chartered Accountants of India
 eliminated by the diversificationhence, it is non-diversifiable. The
examples are inflation, Government policy, interest rate etc.
OR
Risk Adjusted Discount Rate: 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.

(RTP NOV 20)

© The Institute of Chartered Accountants of India

 1. (a) EXPLAIN agency problem and agency cost. How to address the issues of the
same.
(b) COMPARE between Financial Lease and Operating Lease.
5. ) 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. 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.
Finance Lease Operating Lease
© The Institute of Chartered Accountants of India
 1. The risk and reward The lessee is only provided the
incident to ownership are use of the asset for a certain
passed on to the lessee. The time. Risk incident to
lessor only remains the legal ownership belong wholly
owner of the asset. to the lessor.
2. The bear the risk of The lessor the ris of
lesse s bears k
e obsolescenc
obsolescenc e.
e.
3. The lessor is interested in his As the lessor does not have
rentals and not in the asset. He difficulty in leasing the same
must get his principal back asset to other willing lessor,
along with interest. Therefore, the lease is kept cancelable
the lease is non-cancellable by by the lessor.
either party.
4. The lessor enters into the Usually, the lessor bears
transaction only as financier. He cost of repairs,
does not bear the cost of maintenance or
repairs, maintenance or operations.
operations.
5. The lease is usually full payout, that The lease is usually non-
is, the single lease repays the payout, since the lessor
cost of the asset together with expects to lease the same
the interest. asset over and over again
to several users.
(RTP MAY20)
1. (i) “The profit maximization is not an operationally feasible criterion.” IDENTIFY.
(ii) EXPLAIN the basics of debt securitisation process.
(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:
(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
© The Institute of Chartered Accountants of India
 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.
(NOV 19)
(a) Briefly explain the three finance function decisions.
(b) Explain the steps while using the equivalent annualized criterion.
(c) Explain the significance of Cost of Capital.
OR
Briefly describe any four sources of short-term finance.

© The Institute of Chartered Accountants of India

 (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 thesources 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 investedand 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.
(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. Hereit is
pertinent to mention that every investment option may have different
© The Institute of Chartered Accountants of India
 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-

© The Institute of Chartered Accountants of India

 (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.
(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 varyingrates 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
© The Institute of Chartered Accountants of India
 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 sellthe CD

© The Institute of Chartered Accountants of India

 in secondary market.
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

© The Institute of Chartered Accountants of India

 SECTION : B: ECONOMICS FOR FINANCE

Determination of National Income

(a) Explain the measurement of Net Domestic Product at market price. (2 Marks) (JUL 21)
Ans (a) 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) 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
(a) Calculate the national income using income and expenditure method from the data given below:
Items: ` in crores

(i) Government purchase of goods and 7,000

services
(ii) Indirect tax 9,000
(iii) Subsidies 1,800
(iv) Gross business fixed capital 13,000
(v) Inventory Investment 3,000
(vi) Consumption of fixed capital 4,000
(vii) Personal consumption expenditure 51,000
(viii) Export of goods and services 4,800
(ix) Net factor income from aboard (-) 300
(x) Imports of goods and services 5,600
(xi) Mixed income of self employed 28,000
(xii) Rent, interest and profits 10,000
(xiii) Compensation of employees 24,000 (3 + 2 = 5
Marks)

(a) 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
© The Institute of Chartered Accountants of India
 = 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)
= `73200cr
GNPmp = 73200+Net factor Income from Abroad
=`73200+(-300) = ` 72900cr
NNPmp = `72900 – 4000 = ` 68900 cr
NNPfc or National Income = ` 68900-7200 = `61700cr

(RTP NOV21)
1. (i) How the concept of National Income helps in analyzing an
economy’s aggregate behavior? From the
following data
calculate National IncomePersonal 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
13 Interest 1100
(ii) What is the importance of Keynesian theory in determination of national
income?
1. 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
© The Institute of Chartered Accountants of India
 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 crore

© The Institute of Chartered Accountants of India

 (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 thereis insufficient
spending in the economy.
2. 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 400
sector
3 Saving of private corporate sector 250
4 Current Transfer from government 600
administrative departments
5 Current Transfer from of the world 200
6. Corporative Tax 80
2. (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
(II) Personal Income = National Income – Undistributed Profits-
Net interest payment made by households- Corporate Tax +
Transfer payments to the households from firms and
government
© The Institute of Chartered Accountants of India
 = 5000-80
= ` 4920 cr
3. 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

© The Institute of Chartered Accountants of India

 Calculate:
• The equilibrium level of national income
• Consumption of equilibrium level
• Net Exports of
equilibrium level C =
170+ 0.80yd

3. Yd = Y─Tax + Transfer Payment

= Y- (30+0.30Y) + 60 = Y+30-0.30Y = Y (1-
0.30) +30Yd = 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)

(RTP MAY21)
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.

1. (a) Nominal = ` 3000 Crores

GDP
Real GDP = ` 4700 Crores
Nominal
GDP Deflator =
GDP
× 100
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 Real GDP
3000
×100 = 63.83
4700
The price level has fallen since GDP deflator is less than 100 at 63.83.

© The Institute of Chartered Accountants of India

 2. Calculate National Income by 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 300
scheme
2 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. For an Economy with the following
specifications Consumption, C =
50+0.75 Yd
Investment, I = 100
Government Expenditure, G = 200
Transfer Payments, R=
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 110 Income Tax =
0.2Y

Calculate the equilibrium of income and the value of expenditure multiplier

© The Institute of Chartered Accountants of India

 3 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 = 432.50
0.4Y = 432.50
4. How real GDP is a better measure of economic well-being? Explain
4 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 2011-12is 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 changein
the amount of output produced in the economy. Therefore, Real GDP
is a bettermeasure of economic well-being as it shows the true picture of
the change in productionof 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.

Nominal GDP
GDP Deflator = X100
Real GDP
(JAN 21)
1. Given the following equations:C =
200 + 0.8Y I = 1200
© The Institute of Chartered Accountants of India
 Calculate equilibrium level of National Income and the Consumption Expenditure at
equilibrium level of National Income
1 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

© The Institute of Chartered Accountants of India

 2. Calculate GNP at market price from the following data using Value Added Method.
(` in Crores)

Government Transfer Payments 1800

Value of output in Primary Sector 1500
Value of output in Secondary Sector 2700
Value of output in Tertiary Sector 2100
Net factor income from Abroad (-) 60
Intermediate Consumption in Primary 750
Sector
Intermediate Consumption in Secondary 1200
Sector
Intermediate Consumption in Tertiary 900
Sector
2 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
3. (i) Compute GDP at market price and Mixed Income of Self-Employed
from the datagiven below :
(` in Crores)

Compensation of Employees 810

Depreciation 26
Rent, Interest and Profit 453
NDP at factor cost 1450
Subsidies 18
Net factor Income from (-) 17
Abroad
Indirect taxes. 57
(iii) 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.

GDP at Factor Cost: NDP at Factor Cost + Depreciation = = 1476

1450cr + 26cr Cr
GDP at Market Price = GDP at Factor Cost + Net Indirect
Taxes

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 = 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

© The Institute of Chartered Accountants of India

 Change in Income = 6 ÷0.2 = 30 bn
Hence the GDP will increase by 30 bn.

(MTP 21)
1. How is the measurement of National Income done in India?
1 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 dataof 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
2. Calculate Personal Income and Personal Disposable Income from the
following data (In crores of Rupees) (5 Marks)
Particular Rs. In crores
(i) National Income 2000
(ii) Undistributed Profits 175
(iii) Net Interest Payment made by households 35
(iv) Corporate Tax 20
(v) Transfer payment to the households from firms 25
And government
(vi) Personal Income Tax 50
(vii) Non-Tax Payments 40

2 Personal Income = National Income - Undistributed Profits - Net

Interest Payments made byhouseholds - 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

© The Institute of Chartered Accountants of India

3. Calculate Operating Surplus and Net Value added at Factor Cost from the following data:
Particulars Rs in Crore

(i) Compensation of Employee 600

(ii) Intermediate Consumption 200
(iii) Sales 4500
(iv) Depreciation 200
(v) Rent 300
(vi) Interest 500
(vii) Mixed Income of Self Employed 700
(viii) Purchase of materials 90
(ix) Opening Stock 50
(x) Closing Stock 60

(xi) Excise Tax 70

(xii) Subsidies 20

3 GVAmp = Value of Output - Intermediate Consumption

= (Sales + Change in Stocks) – Intermediate Consumption
= 4500 + 10 – 200
= 4,310 crores
GVA mp= 4 ,310 cr
NVAmp = GVAmp -- Depreciation
= 4, 310 – 200
= 4,110 cr
NVA fc = NVA mp – (Indirect Taxes – Subsidies)
= 4,110 – (70- 20)
4,060 cr.

4. What is the leakages-injections approach in two sector circular flow Model?

4. 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
injectionsare equal to the leakages.
© The Institute of Chartered Accountants of India
4. 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.
(b) Yd = Y-T +
TR Yd = Y-
100 +50Y = 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-
40Y- 0.80Y =
860
0.20 Y = 860
Y = 860 ÷ 0.20 = 4350
(MTP 21)

1. (a) What are the Challenges in Computation of National Income in India?

(2 Marks)
(b) Calculate National Income by Expenditure Method and Income Method with the
help of the following data:
Items Rs. In Crores
(i) Compensation of Employees 2000
(ii) Mixed Income of Self Employed 1000
(iii) Net Factor Income of Abroad 50
(iv) GST 100
(v) Subsidies 60
(vi) Private Final Consumption Expenditure 700
(vii) Government Final Consumption Expenditure 800
(viii) Export 200
(ix) Import 120
(x) Net Domestic Capital Formation 500
(xi) Profit 400
(xii) Interest 300
(xiii) Rent 600
(xiv) Depreciation 200
1 There are innumerable challenges in the computation of National Income
in India. These challenges are more complex in underdeveloped and developing
countries. Some of the challenges are given below:
© The Institute of Chartered Accountants of India
 (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 data due to illiteracy and Ignorance.

© The Institute of Chartered Accountants of India

 (e) Lack of Proper occupational classification and
(f) Accurate estimation of consumption of fixed capital.
(b) By Income Method:
NNPFC = National Income = Compensation of Employees + Operating Surplus (rent
+ interest
+ profit) + Mixed Income of self-employed + Net Factor Income from abroad
= 2000 +(400 +300+600) + 1000+ 50
= 4350Cr
By Expenditure Method:
GDPmp = Private Final Consumption Expenditure + Government Final Consumption Expenditure
+ Gross Domestic Capital Formation (Net domestic Capital Formation + Net Export
= 700 + 800 + 500 + 80
= 2080 cr
NNPFC or National Income = GDPmp – depreciation + NFIA – Net Indirect Taxes
= 2080 – 200 + 50- 40= 1890 Cr
2. Calculate Personal Disposable Income from the following data:
Items Rs. In
crores
(i) NNPfc 5000
(ii) Undistributed Profit 200
(iii) Net interest payments made by households 400
(iv) Corporate Tax 600
(i) Transfer Payments to the households from firms and government 500
(ii) Personal Income Taxes 1200
(iii) Non tax payment 800
2 Personal Income = National Income – Undistributed Profit- Net
interest payments made by
households – Corporate Tax + Transfer payments to the households
from firms and Government
= 5000—200-- 400—600+ 500
= 4300 Cr
3. Explain the three Sector Model of determination of National Income?
1. Aggregate demand in three sector model of closed economy consists of three components
namely, household consumption (c), desired business investment demand (I) and the
government sector’s demand for goods and services (G). Thus, in equilibrium
Y = C+I + G
Since there is no foreign sector, GDP and national income are equal. As prices are assumed to be
fixed, all variables and all changes are in real terms. The Three -sector Keynesian model is
© The Institute of Chartered Accountants of India
commonly constructed assuming that government purchases are autonomous. This is not a
realistic assumption, but it will simplify the analysis.
AD C+I+GAS = C+S+T
Thus, equilibrium is determined at a point where both aggregate demand and aggregate
supply are equal.
C+I+G = Y = C+S+T

© The Institute of Chartered Accountants of India

(NOV 20)
1. Compute the amount of depreciation from the
following data
(` in Crores)

GDP at Market Price 8,76,532

(GDPMp)
Net factor income from abroad (-) 232
Aggregate amount of Indirect 564
Taxes
Subsidies 30
National Income (NNPFc) 8,46,576
1 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.

2. You are given the following information of an

: C = 200 + 0.60 Yd
economy: Consumption Function
: G = 150
Government Spending
: I = 240
Investment Spending : Tx = 10+0.20Y

Tax : Tr =50
: X = 30+0.2Y
Transfer
: M = 400
Payment
Exports
Imports
Where Y and Yd are National Income and Personal Disposable Income
respectively. All figures are in `
Find:
Consumption at equilibrium level.

© The Institute of Chartered Accountants of India

 2 The equilibrium level of national income
(i) The equilibrium level of National
Yd = Y + Tr –Tax Income.
= Y + 50 - 10 - 0.2YYd = (ii) Net Exports at equilibrium level.
40+0.8 Y
Y = C+I+G+(X-M)

© The Institute of Chartered Accountants of India

 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]
= 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

3. Clarify the concept of ‘Average Propensity to Save’ with the help of

formula and example

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 = S

Total Income 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
APSis illustrated with the help of the following table:

Incom Savin APS = APS

e (` g (` S/Y
Crores) Crores)
© The Institute of Chartered Accountants of India
 0 - 40 - -
10 -20 (- -
0 20/100) 0.20
20 0 (0/200) 0
0
30 20 (20/300 0.06
0 ) 7
40 40 (40/400 0.10
0 )

4. Which method is used in India for measurement of National Income? Also, state the method

© The Institute of Chartered Accountants of India

 which is considered the most suitable for measurement of National Incomeof the
developed economies.

4 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 statisticalrecord keeping.
Since reliable statistical data are not available, it is not possible to estimate Indi
a’snational 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 Incomeof
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.

(RTP NOV20)
1. (a) From the following data, calculate NNPFC, NNPMP, GNPMP and GDPMP.

Items In
Cr.
Operating surplus
200
0
Mixed income of self- 1100
employed
Rent 550
Profit 800
Net indirect tax 450
Consumption of fixed 400
capital
Net factor income from -50
abroad
Compensation of 1000
employees
(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?

© The Institute of Chartered Accountants of India

 1 (a) GDPMP = Compensation of employees + mixed income of self-employed +
operatingsurplus + depreciation + net indirect taxes
= 1000 crores + 1100 crores + 2000 crores + 400 crores + 450 crores = 4950
crores GNPMP = GDPMP + NFIA
= 4950 crores + (-50) crores = 4900 croresNNPMP = GNPMP –
consumption of fixed capital
= 4900 crores – 400 crores = 4500 croresNNPFC or
NI = NNPMP- NIT
= 4500 crores – 450 crores= 4050 crores

© The Institute of Chartered Accountants of India

(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 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 = 10Tax 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
toconsume impacts consumption expenditure

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).

(RTP MAY20)

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 1. (a) Calculate the Operating Surplus with the help of following data-

Particulars ` (In Crore)

Sales 4,000
Compensation to 800
employees
Intermediate 600
consumption
Rent 400
Interest 300
Net indirect taxes 500
Consumption of fixed 200
capital
Mixed income 400
(b) Why do pensions and other security payments get excluded while
calculating National Income?

1. 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.
© The Institute of Chartered Accountants of India
 2. 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.

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.

© The Institute of Chartered Accountants of India

 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. 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
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
3 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.

© The Institute of Chartered Accountants of India

 (NOV 19)
1. 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

(a) Gross Domestic Product at Market Price (GDP MP) = Gross Domestic Product at Factor Cost
(GDPFC)
+ (Indirect Taxes – Subsidies)
Subsidies = GDPFC + Indirect tax - GDPMP
= 360815 + 454367 – 779567
= ` 35,615 Crores

2. Explain the consumption function using a suitable table and diagram.

(a) 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. Thiscan be illustrated with the following table
and diagram:

Disposable Income (Yd) (` Consumption (C) (` Crores)

Crores)
0 30
100 10
0
200 17
0
300 24
0
400 31
0
500 38
0
600 65 45
 0
700 52
0
The specific form of consumption function, proposed by Keynes is as follows:
C = a + bY

66
 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, (∆C /∆Y) is the marginal propensity to
consume (MPC) i.e the increase in consumption per unit increase in disposable income.
3. Explain the circular flow of income in an economy
(a) 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 .

Circular Flow of Income

(i) In the production phase, firms produce goods and services with the help
offactor services.
(ii) In the income or distribution phase, there is a flow of factor incomes in theform 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
67
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

68
4. Compute NNP at factor cost or national income from the following data
using income method:

(` 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
4. NNPFC or NI = Compensation of employees + Operating Surplus (rent +
interest+profit) + Mixed Income of Self- employed + Net Factor Income from Abroad
= 3,000+ (1,020+2,010+980) +1,050+370 =` 8,430 Crores

69
 Public Finance
Q Justify the role of public debt as an instrument of Fiscal Policy. (2 Marks) (JUL21)
(a) 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.
(b) 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.
Q Describe various types of externalities which cause market failure. (3 Marks)
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 inproduction
• 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

70
 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.

Q Define Common Access Resources. Why they are over-used? Explain. (2 Marks)
(a) 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.
(RTP NOV 21)
1. What is the importance of demand side driven fiscal policy?
1 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.
2. Explain in brief the signification of global public goods?
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

71
• 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.

3. Information
failure is also a reason for market failure. With the Intervention
of government this failure is corrected how?
3. 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

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 4. What are the market outcome of price ceiling explain with a help of a 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. 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

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.
5. How deflationary gap arises in an economy?
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- equilibriumoccurs 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.

73
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

74
 (RTP MAY21)
1. Differentiate excess demand and deficient demand.
1 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. (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
2. (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.
3. Describe direct government actions to solve negative externalities.
3. Direct controls prohibit specific activities that explicitly create negative
externalitiesor 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
75 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.

76
 (JAN 21)
1. What do you mean by "Crowding Out" in relation to fiscal policy?
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.
2. Discuss the role of 'Market Stabilization Scheme' in our economy.
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
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
3. (a) Describe the allocation instruments available to the Government to
influenceresource allocation in an economy.
(b) Calculate the Fiscal Deficit and Primary Deficit from the data given below: (` in Crores)

Total Expenditure on Revenue Account and Capital 547.6

Account Revenue Receipts 2
Non-debt Capital Receipts 226.8
2
103.0
0
Interest Payments 84.0
0
77
(a) 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 whoand 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
caninfluence 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,
mergerpolicies etc. which affect the structure of industry and commerce.
• Government’s regulatory activities such as licensing control minimum wagesand

78
 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
(b) 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.
4. Explain the significance of public debt as an instrument of fiscal policy.
4 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

5. Explain the concept of 'private cost'.

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

(MTP 21)
1. How does Free Rider Problems causes market failure?
1 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 utilizes goods without paying for their use. Since private
goods are excludable, free riding mostly occurs in the case of public goods. The free-rider
problem leads to under provisions of a good or service and thus causes market failure. As
such if the free - rider problem cannot be solved, the following two outcomes are possible:
(i) No public good will be provided in private markets.
(ii) Private markets will seriously under produce public goods even though these goods
provide valuable service to the society.
79
 2. How does government subsidies help in balancing the role as allocative function?
2. Subsidy is a form of market intervention by government. It involves the government directly
paying part of the cost to the producers (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 prices of goods and services and
encourage increased production and

80
consumption. Major subsidies in India are fertilizer subsidy, food subsidy, interest subsidy etc.
3. Define Balanced budget and the process for calculating the same?
3 The government budget is said to be in balance when ∆G = ∆T. The balanced budget multiplier is
always equal to 1. The balanced budget multiplier is obtained by adding up the government
spending multiplier (fiscal multiplier) and the tax multiplier.
Balanced budget multiplier = ∆Y ÷ ∆G + ∆Y ÷ ∆ T
= 1 ÷1-b + -b ÷ 1-b
= 1-b ÷ 1-b = 1
4.(a) How does Government Intervention helps in correcting externalities?
(b) Fiscal Policy can be used as a tool for redistribution and economic growth: Comment.
4. (a) 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. Such
externalities are not reflected in market prices, they can be a source of economic inefficiency.
When negative production externalities exist, social costs exceed private cost. If producers
do not take into account the externalities, there will be over – production and market failure
and unwarranted social

81
 consequences. The Government can play a role in reducing negative externalities
by taxing goodswhen their production generates spill over cost. The Government
can also intervene in regulating negative externalities like pollution.
(b) Fiscal Policy can be used as a tool for economic growth and desired distribution of
income. This can be done through spending programmes targeted at disadvantage
strata of the society some examples are like poverty alleviation programme, free or
subsidized amenities to improve the quality of living of poor, strengthening of human
capital, education, research, and development which will provide momentum for
long term growth. A progressive tax structure carefully planned public expenditure
policy can help in redistribution of income from rich to the poor s ections of the
population.
5. What is crowding out effect and how did it impact fiscal Policy?
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 would 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 the economy’s ability to self -
correct from the recession and possibly also reduces the economy’s prospects of
long run economic growth
6. Why is the role of government important in solving the free rider problem?
6. Free riders are those who utilise goods without paying for their use. Since private
goods are excludable, free riding mostly occurs in the case of public goods. The free
rider problem leads to under provision of a good or services and thus causes market
failure. The problem occurs because of the failure of Individual to reveal their real or
true preferences for the public good through their willingness to pay. Because 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 market failure in the
case of these goods and the profit- maximising firms will not produce them.

(MTP 21)
1. What are the important Characteristics of Public Good? Why does market
fails to produce publicgoods.
1 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

82
 (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.
2. How fiscal Policy can be used as a tool for Reduction in inequalities of Income
and Wealth?
2 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

83
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
3. What are the conceptual three functions framework of the responsibilities of
Government in Public Finance?
3 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.

(NOV 20)
1. Describe the characteristics of 'Public Goods'.
1. Characteristics of Public Goods
• 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.
• 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-

84
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.
2. Discuss the “Fiscal Policy Measures” which are useful for reduction in
inequalities of income and wealth.
2. The Fiscal Policy Measures which are useful for reduction in inequalities
ofincome 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.

85
 Government revenues and expenditure have traditionally been regarded
asimportant 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.
3. 'Lemons Problem' is an important source of market failure. How?
3. ‘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 honesty of the seller means,

86
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 f urther
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

87
 breakdown of the market.
4. Explain the various types of externalities.
4. 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
occurwhen 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

88
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
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.

89
 (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.

5. Explain the market outcome of price ceiling through diagram.

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.

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 priceleads to generation of excess demand over supply.

(RTP NOV20)
90
1. (a) According to Richard Musgrave, there are three branch taxonomy of the
role of government in a market economy? Explain them.
(b) Why do economists use the word external to describe third-party effects that
are harmful or beneficial?
1 (a) Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),

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 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 resu lt 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.
2. (a) Explain why do governments provide subsidies? Illustrate a few
examples of subsidies.
(b) Describe the concept of price floors with examples.
2. (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.
3. The tradable emissions permits are claimed to have certain advantages. Explain.
3 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.
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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, withthe 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

93
 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 compensatedby charging higher prices to consumers.

(RTP MAY20)
1. (a)Government’s stabilization intervention may be through monetary policy
as well asfiscal policy. How ?
(b) How do government correct market failure resulting from demerits goods?
2. Government’s stabilization intervention may be through monetary policy as well as
through fiscal policy. Monetary policy has a singular objective of controlling the
sizeof 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.

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 • 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.

2. 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

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 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?
2. (a) 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.

(NOV 19)
1. What do you mean by 'Global Public Goods'? Explain in brief.
(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.

96
2 (a) Describe the problems in administering an efficient pollution tax.
(b) Distinguish between 'pump priming' and ‘compensatory spending’
2 ( a ) 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

97
 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.
(b) 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.
3. Distinguish between positive and negative externalities.
3 An externality is defined as the uncompensated impact of one person’s production
and/or consumption 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 onthe 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.

3. How does a discretionary fiscal policy help in correcting instabilities

in the economy?

98
(b) ) Discretionary fiscal policy for stabilization refers to the deliberate policy
actions onthe part of a government to change the levels of expenditure, taxes
and borrowingto 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:

99
 (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
(vi) repayment of public debt to people
4. What is '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 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 thecontractionary phase of business-cycle and results in
higher rates of unemployment.In other words, a recessionary gap occurs when
the aggregate demand is notsufficient to create conditions of full
employment.

100
 Money Market
(a) (i) Justify the following statements in the light of holding cash balance. (3 Marks) (JUL 21)
(1) For investment in interest bearing assets
(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)
(b) 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.

(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
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

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(a) 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.
(a) (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
884× V= 110.5×325 V = 40.62bn
When Volume of transaction increases to 325bn velocity (v) will be 40.62bn

Q Describe the differences between Liquidity Adjustment Facility (LAF) and Marginal Standing
Facility(MSF). (2 Marks)
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.

(RTP NOV21)
102
 1. How does money supply impacted inflation in the economy?
1 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.

2. (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?
2. 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 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

103
 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 toa 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.

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 3. What are the major component of Reserve Money?
3 Reserve money, also known as central bank money, base money, or high-
powered money, needs a special mention 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.

(RTP MAY21)
1. (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.
1 (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).

2. (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?
2 (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.
105
(ii) The amount of money demanded under the precautionary motive is to
meet unforeseen and unpredictable 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.

106
(JAN 21)
1. (a) Compute M2 supply of money from the following RBI data: (` in Crores)

Currency with public 435656.6

'Other' deposits with RBI 1234.2
Saving deposits with post office saving 647.7
banks
Net time deposits with the banking 514834.3
system
Demand deposits with banks. 274254.9
(b) Explain the Transactions Motive for holding cash.
(a) 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
(b) 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.
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.

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2. Distinguish between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
2. 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
totime 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.
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.
3.Explain the concept of 'Money Multiplier'.
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 money- multiplier process explains how an increase in the
monetary base causes, the money supply to increase by a multiplied amount.

108
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
4.What do you mean by 'Reserve Money'?
4. 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

109
 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
(MTP 21)
1. What is Speculative demand for Money. Explain with the help of a diagram?
1. 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 same as future change in bond prices. The market value of bonds and the market rate
of interest are inversely related.

When we go from the Individual speculative demand for money to the aggregate speculative
demand for money, the discontinuity of the Individual wealth- holder’s demand curve for the
speculative cash balances disappears and we obtain a continuous downward sloping demand
function showing the inverse relationship between the current rate of interest and the speculative
demand for money as shown in the figure below:
According to Keynes, the higher the rates of interest, lower the speculative demand for money,
and lower the rate of interest, higher the speculative demand for money.

2. (a) Calculate M3 from the Following data?

Items Rs in
crores
Currency Notes and Coins with the people 5000
Demand Deposit with the banking system 4000
Other Deposits with the RBI 3000
Time Deposit with banking system 1000
Saving Deposit with Post office 500
(b) Why is The Quantity Theory of Money Important?

110
2. (a) M = Currency notes and coins with the people + demand deposit with
1 banking system
(Current and saving deposits accounts) + other deposits with the RBI
= 5000 + 4000 + 3000
= 12000 cr
M3 = M1 + time deposits with the banking system

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 = 12000 + 1000
= 13000cr
(b) The Quantity theory of money was propounded by Irving Fisher. According to him
there is strong relationship between money and price level and the quantity of money
is the main determinant of the price level or value of money.
Fisher version also termed as ‘Equation of Exchange ‘is formally stated as

follows: MV = PT
M= the total amount of money in circulationV =
transactions velocity of circulation P
= average price level
T = Total number of transactions
Subsequently Fisher extended the equation of exchange to include demand bank deposit (M’) and
Velocity (V’) in the total supply of money.
The Expanded Form of the equation becomes:
MV + M’V’ = PT
Where M’ = the total quantity of credit money V’ =velocity of circulation of
credit money.

3. What are the mechanism through which monetary policy work?

3 Monetary Policy is intended to influence macro-economic variables such as
aggregate demand, quantity of money, interest rate to influence overall economic
performance. There are five different mechanism through which monetary policy
influences the price level and the national income:
(a) the interest rate channel
(b) the exchange rate channel
(c) the quantum channel (e.g., relating to money supply and credit)
(d) the asset price channel via equity and real estate prices and
(e) the expectation channel
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.

(MTP 21)
1. (a) What is the effect of government expenditure on Money Supply?
(b) What is credit multiplier and how it is calculated?

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1. (a) 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.
(c) 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

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 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. Credit Multiplier = 1 ÷ by required reserve ratio

2. (a) The Role of bank rate as an instrument of monetary policy?

(b) What is the difference between Repo and Reverse Repo Rate?
2. (a) 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).
(b) 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.

3. (a)What is Cambridge – Approach theory of demand for Money?

(b) Relevance of Monetary Policy Committee and its impact?
3. (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 thanbeing 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 servicesPY = 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
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 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

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 made through debate and majority vote by the panel of experts of the
committee.
(NOV 20)
1. "Money performs many functions in an economy”. Explain those functions briefly.
1 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.
2. What is the impact of the following on credit multiplier and money supply,
ifCommercial Banks keep:
(1) Less Reserve?
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(2) Excess Reserve?
2. (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

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 If reserve ratio is 20%, then credit multiplier = 1/0.20 = 5. If banks need
tokeep 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.
3. 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 83.7
Certificates
Government Deposits with RBI· 102.5

3. 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
4. ''The deposit multiplier and the money multiplier though closely related are
not identical". Explain briefly.
4. 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

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 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.

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 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.
5. What is the meant by 'Statutory Liquidity Ratio’? ·In which forms this ratio ismaintained?
5. 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) Cash
(ii) Gold, or
(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.

(RTP NOV20)
1. Examine the influence of different variables on demand for money according to
Inventory Theoretic Approach?
1. (a)
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.

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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 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

121
 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 brokeragefee 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.

2. (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 300
public
Demand Deposits 400
Savings Type accounts 2000
Money Market Mutual 1000
Funds
Traveller’s checks 50

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Small Time Deposits 500
Large Time Deposits 450
Other Checkable 150
Deposits

2. (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.

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 (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
(RTP MAY20)
1. Howdoes the monetary policy influence the price level and the national income?
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
businessinvestment 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

2. (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

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 Certificate of deposits issued by FIs 290
Public deposits of non-banking financial 450
companies
NM3 2650
National saving certificates 240
2. (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

125
 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
3. Explain the role of Liquidity Adjustment Facility (LAF).
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).
(NOV 19)
1. Compute reserve money from the following data published by RBI:

(` 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
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

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 liabilities to the public – RBI’s net non - monetary Liabilities.
= 851651 + 262115 + 410315 + 72133 + 185060 -68032
= 1713242 crores
2. Explain the open market operations conducted by RBI.
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
adjustthe rupee liquidity conditions in the market on a durable basis.

127
 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
3. Explain 'Reverse Repo Rate'.
3. 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
paidby the RBI for such borrowings is called the "Reverse Repo Rate". Thus,
reverserepo rate is the rate of interest paid by the RBI on its borrowings from
commercial banks.
4. 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 moneycreated
by the banking system in each case?
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

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 International Trade
Q Compare and contrast between devaluation and depreciation in the context of exchange rate. (JUL
21)
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.
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.
(ii) Explain in brief any four effects of Tariffs on importing and exporting countries.
(3 Marks)
Answer
(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 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
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 possibly addition of new firms due to entry into the industry to take advantage of
thenew 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.

Q 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)
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:
• 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.
Q Mention any four sectors in which foreign direct investment is prohibited. (2 Marks)
(b) Apart from being a critical driver of economic growth, foreign direct investment (FDI) is a
major source of non-debt financial resource for the economic development of India.
Currently, an Indian company may receive foreign direct investment either through
‘automatic route’ without any prior approval either of the Government or the Reserve Bank
of India or through ‘government route’ with prior approval of the Government. The sectors in
which foreign direct investment is prohibited are as follows:
(i) Lottery business including Government / private lottery, online lotteries, etc.
(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 Farmhouses
(vii) Manufacturing of cigars, cheroots, cigarillos, and cigarettes, of tobacco or of tobacco

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 substitutes
(viii) Activities / sectors not open to private sector investment e.g., atomic energy and railway
operations (other than permitted activities).

Q Mention any three key objectives of World Trade Organisation. (3 Marks)

(a) 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 monitoringfurther 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
Q Distinguish between horizontal, vertical and conglomerate type of foreign
investments. (2 Marks)
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.

(a) Explain the concept of 'Voluntary Export Restraints'. Under which circumstances
exporters commit to voluntary export restraint? Discuss. (3 Marks)

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 (ii) Mention any four arguments made in favour of Foreign Direct Investment to
developing economy like India. (2 Marks)
OR
Explain the concept of Real Exchange Rate. (2 Marks)
(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.
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”.
Arguments in favour of foreign Direct Investment to developing economy like India are as
follows:
• 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.
OR
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

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 exchange rate and the ratio of prices between the two countries
Real exchange rate = Nominal exchange rate x Domestic price
Foreign price Index

(RTP NOV21)
1. What are the problems associated with foreign Direct Investment?
1. 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.

2. How does non-tariff measures interfere with free trade?

2. 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.

3. How does arbitrage prevents the risk arising out of the fluctuations in the exchangerate?
3. 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 ina 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.

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(RTP MAY21)
1. Briefly explain the New Trade Theory and its importance.
1 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

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 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
anothercountry. 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.

2. (a) Describe different technical barriers to trade (TBT) and their effects on trade?
(b) Explain Export Duties.
2(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

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 specificor 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.

3. (a) What is Arbitrage? What is the outcome of Arbitrage?

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 (b) Mention the types of transactions in the forex market?
3. (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 buyor sell currencies for future delivery which are carried out in
forward and futures markets.
(JAN 21)
1. Describe the advantages of Floating Exchange Rate.
1 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 bankand
/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.
2. Describe the purposes of Trade Barriers in international trade.
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.
3. (a) You are given the following information:

Good M Indi Japa Chin

(Mobile Phones) a (in n (in a (in
$) $) $)
Average Cost 70.5 69.4 70.9
Price per unit for domestic 71.2 71.10 70.9
sales
Price charged in Dubai 71.9 70.6 70.6

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(a) Which of the three exporters are engaged in anticompetitive act in
the international 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?

(b) Describe the benefits and costs of FDI to the host country.

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 3. (a) (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-
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) 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.

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• 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.

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(MTP21)
1. (a) What are the major differences between Foreign Direct Investment and
Foreign PortfolioInvestment?
(b) How is New Trade Policy (NTT) beneficial for development of Foreign Trade?
(a) Major differences between FDI and Foreign Portfolio Investment are as follows

Foreign Direct Investment Foreign Portfolio Investment

Investment involves creation of physical Investment is only in financial assets.
assets
Has a long-term interest and therefore Only short-term interest and generally
invested for long remain invested in short
periods.
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology transfer.
transfer
Direct impact on employment of labour No direct impact on employment of labour
and wages. and wages.
Enduring interest in management and No abiding interest in management and
control Control.
(b) New Trade Policy (NTT) is an economic theory and that was developed in the 1970’s as
a way to understand International Trade patterns. NTT helps in understanding why
developed and big countries trade partners are when they are trading similar goods
and services. These Countries constitutes more than 50 % of the world trade. This
is particularly true in key economic sectors such as electronics, IT, food and
automotive. Those countries with the advantages will dominate the market and
takes the form of monopolistic competition. According to NTT, two key concepts give
advantage to countries that import goods to compete with products from home country
namely economies of scale and network effects.

2. What are the important barriers in International Trade ? How does its
resolution help indevelopment of international Trade?
2 Trade barriers create obstacles to trade, reduces the prospect of market access,
make imported goods more expensive, increase consumption of domestic goods, protect
domestic Industries, and increase government revenues.
Technical barriers to trade are 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
resolution of trade barriers will definitely be helpfulin functioning of trade. There
are different forum and trade agreements between countries for the resolution of the

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 obstacle.

3. Under Floating Rate Regime how exchange rate is determined?

3 An exchange rate regime is the system by which a country manages its currency
with respect to foreign currencies. There are two major types of exchange rate
regimes namely floating exchange rate regime and fixed exchange rate regime.
A floating exchange rate allows a government to pursue its own independent monetary
policy and there is no need for market intervention or maintenance of reserves.
However, volatile exchange rates generate a lot of uncertainties with regard to
international transaction.

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 (MTP 21)
1. (a) What is Factor Price–Equalization Theorem of International Trade?
(b) The developing countries will have disadvantage if they engage in liberal trade
Explain in detail.
1. (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.

(NOV 20)
1. Discuss the guiding principle of WTO in relation to trade without discrimination
(a) 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.
(b) 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.
(c) 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 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.
2.'The Heckscher Ohlin theory of Foreign Trade' can be stated in the form of two
theorems. Explain those briefly.
2. The ‘Heckscher-Ohlin theory of foreign trade ‘can be stated in the form
of twotheorems namely,

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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.

144
 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 ofthe 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 willbe the same in all those nations which engage in
trading.
3. 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.
What are possible consequences on exports and imports of (1) and (2)
above.
3. 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 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)

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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.

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(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.
4. Explain the concept of soft peg and hard peg exchange rate policies.
4. (i) 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

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 unchanging value for the exchange rate. Both soft peg and hard peg policy
require that the central bank intervenes in the foreign exchange market.

5. (i) In which sectors Foreign Investment is prohibited in India?

(ii) What is meant by 'Countervailing Duties'?
(i) Sectors in which foreign investment is prohibited in India
In India, foreign investment is prohibited in the following sectors:
(iv) Lottery business including Government / private lottery, online lotteries, etc.

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 (v) Gambling and betting including casinos etc.
(vi) Chit funds
(vii) Nidhi company
(viii) Trading in Transferable Development Rights (TDRs)
(ix) Real Estate Business or Construction of Farm Houses
(x) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco
or of tobacco substitutes
(xi) 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) 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 such advantage that
exporters get from subsidies. Thisis done to ensure fair and market-oriented
pricing of imported products and thereby protecting domestic industries and
firms.

(RTP NOV20)
1. Describe the different types of agreements that take place during the negotiations of trade?
1. 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

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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:

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 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.

2.(a) Into how many parts are FDIs categorized according to the
nature of foreigninvestment? Describe them.
(b) What does the Agreement on Trade-Related Investment Measures (TRIMs) stipulate?
2. (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.

3. Countries Rose Land and Daisy land have a total of 4000 hours each of labour

151
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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4. Goods produced by each country

Country Shirt Trouser

s s
Rose 800 500
Land
Daisy 500 250
Land
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 Trouser

s
Rose 2.5 4
Land
Daisy 4 8
Land
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.

(RTP MAY20)
1. (a) Explain how a tariff levied on an imported product affects both the
country exportinga product and the country importing that product.
(b) Why GATT lost its relevance by 1980?
1. (a) A tariff levied on an imported product affects both the country exporting a

153
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 pricesthan 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

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 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.
(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.

2. 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.
2. 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).
3. Many apprehensions have been raised in respect of the WTO and its
ability to maintainand extend a system of liberal world trade. Comment.
3. 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,

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 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 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

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 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.
4. Explain the principle motivations of a country seeking FDI?
4. 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.

(NOV 19)
1. Explain the term 'Real Exchange Rate'.
1. 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:

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 Real exchange rate = Nominal exchange rate X Domestic Price Index
Foreign Price Index
2. Explain the keyfeatures of modem theory of international trade.
2. The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment
Theory of Trade or Modern 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.

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 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 ofthe 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.
3. 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)
(i) What do these figures mean?
(ii) Calculate the index of terms of trade for Bangladesh.
How would you interpret the index of terms of trade for Bangladesh?

3 (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

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 they export/ import and can be used for assessing the impact of international
trade on the domestic economy.
Terms of trade for Bangladesh (ToT) is given by

Terms of Trade= Price index of Bangladesh export 100

Price index of Bangladesh import
233.73
100 = 106
220.50
(ii) ‘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

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 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 forBangladesh.
4. How does the WTO agreement ensure market access?
4. 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.
5. What is meant by ‘Bound tariff’?
A bound tariff is a tariff which a WTO member binds itself with a legal commitmentnot 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.

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