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PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE

Question No. 1 is compulsory.
Attempt any four questions out of the remaining five questions.
In case, any candidate answers extra question(s)/ sub-question(s) over and above the
required number, then only the requisite number of questions first answered in the answer
book shall be valued and subsequent extra question(s) answered shall be ignored.
Working notes should form part of the answer

SECTION – A: FINANCIAL MANAGEMENT

Question 1
(a) Stopgo Ltd, an all equity financed company, is considering the repurchase of ` 200 lakhs
equity and to replace it with 15% debentures of the same amount. Current market Value
of the company is ` 1140 lakhs and it's cost of capital is 20%. It's Earnings before
Interest and Taxes (EBIT) are expected to remain constant in future. It's entire earnings
are distributed as dividend. Applicable tax rate is 30 per cent.
You are required to calculate the impact on the following on account of the change in the
capital structure as per Modigliani and Miller (MM) Hypothesis:
(i) The market value of the company
(ii) It's cost of capital, and
(iii) It’s cost of equity (5 Marks)
(b) The following data have been extracted from the books of LM Ltd:
Sales - `100 lakhs
Interest Payable per annum - ` 10 lakhs
Operating leverage - 1.2
Combined leverage - 2.16
You are required to calculate:
(i) The financial leverage,
(ii) Fixed cost and
(iii) P/V ratio (5 Marks)
(c) The accountant of Moon Ltd. has reported the following data:
Gross profit ` 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1

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2 INTERMEDIATE EXAMINATION: MAY 2018

Net Worth to Total Assets 0.90:1

Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days
Assume 360 days in a year
You are required to complete the following:
Balance Sheet of Moon Ltd.
Liabilities ` Assets `
Net Worth Fixed Assets
Current Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets
(5 Marks)
(d) Sun Ltd. is considering two financing plans.
Details of which are as under:
(i) Fund's requirement – ` 100 Lakhs
(ii) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%
(iii) Cost of debt – 12% p.a.
(iv) Tax Rate – 30%
(v) Equity Share ` 10 each, issued at a premium of ` 15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) ` 40 Lakhs
You are required to compute:
(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iii) Indifference point between Plan I and II (5 Marks)

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 3

Answer
(a) Working Note
Net income (NI) for equity - holders
= Market Value of Equity
Ke
Net income (NI) for equity holders
= ` 1,140 lakhs
0.20
Therefore, Net Income to equity–holders = ` 228 lakhs
EBIT = ` 228 lakhs / 0.7 = ` 325.70 lakhs
All Equity Debt of Equity
(` In lakhs) (` In lakhs)
EBIT 325.70 325.70
Interest on `200 lakhs @ 15% -- 30.00
EBT 325.70 295.70
Tax @ 30 % 97.70 88.70
Income available to equity holders 228 207
(i) Market value of levered firm = Value of unlevered firm + Tax Advantage
= ` 1,140 lakhs + (`200 lakhs x 0.3)
= ` 1,200 lakhs
The impact is that the market value of the company has increased by ` 60 lakhs (`
1,200 lakhs – ` 1,140 lakhs)
Calculation of Cost of Equity
Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %
(ii) Cost of Capital
Components Amount Cost of Capital Weight WACC %
(` In lakhs) %
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00

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4 INTERMEDIATE EXAMINATION: MAY 2018

The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax
relief on debt interest payment.
(iii) Cost of Equity is 20.7% [As calculated in point (i)]
The impact is that cost of equity has risen by 0.7% i.e. 20.7% - 20% due to the
presence of financial risk.
Further, Cost of Capital and Cost of equity can also be calculated with the help of
formulas as below, though there will be no change in final answers.
Cost of Capital (K o) = Keu(1-tL)
Where,
Keu = Cost of equity in an unlevered company
t = Tax rate
Debt
L =
Debt  Equity

 ` 200lakh 
Ko = 0.2 ×  1   0.3 
 ` 1,200lakh 
So, Cost of capital = 0.19 or 19%
Debt (1- t)
Cost of Equity (K e) = Keu + (Keu – Kd)
Equity
Where,
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
t = Tax rate
 ` 200 lakh  0.7 
Ke = 0.20 +  (0.20  0.15)  
 ` 1,000 lakh 

Ke = 0.20 + 0.007 = 0.207 or 20.7%

So, Cost of Equity = 20.70%
(b) (i) Calculation of Financial Leverage:
Combined Leverage (CL) = Operating Leverage (OL)  Financial Leverage (FL)
2.16 = 1.2  FL
FL = 1.8

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 5

(ii) Calculation of Fixed cost:

EBIT
Financial Leverage =
EBT i.e EBIT Interest

EBIT
1.8 =
EBIT -10,00,000

1.8 (EBIT – 10,00,000) = EBIT

1.8 EBIT - 18,00,000 = EBIT

18,00,000
EBIT = = ` 22,50,000
0.8

Contribution
Further, Operating Leverage =
EBIT

Contribution
1.2 =
` 22,50,000

Contribution = ` 27,00,000
Fixed Cost = Contribution – EBIT

= ` 27, 00,000 – ` 22,50,000

Fixed cost = ` 4,50,000

(iii) Calculation of P/V ratio:

Contribution (C) 27,00,000
P/V ratio = × 100 = × 100 = 27%
Sales (S) 100,00,000

(c) Preparation of Balance Sheet

Working Notes:
Sales = Gross Profit / Gross Profit Margin
= 60,000 / 0.2 = ` 3,00,000
Total Assets = Sales / Total Asset Turnover
= 3,00,000 / 0.3 = ` 10,00,000
Net Worth = 0.9 X Total Assets

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6 INTERMEDIATE EXAMINATION: MAY 2018

= 0.9 X ` 10,00,000 = ` 9,00,000

Current Liability = Total Assets – Net Worth
= ` 10,00,000 – ` 9,00,000
= ` 1,00,000
Current Assets = 1.5 x Current Liability
= 1.5 x ` 1,00,000 = ` 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets / Current Liabilities =1)
= 1,50,000 – (LA / 1,00,000 = 1) = ` 50,000
Debtors = Average Collection Period X Credit Sales / 360
= 60 x 0.8 x 3,00,000 / 360 = ` 40,000
Cash = Current Assets – Debtors – Stock
= ` 1,50,000 – ` 40,000 – ` 50,000
=` 60,000
Fixed Assets = Total Assets – Current Assets
= ` 10,00,000 – ` 1,50,000
= ` 8,50,000
Balance Sheet
Liabilities ` Assets `
Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities 1,00,000 Stock 50,000
Debtors 40,000
Cash 60,000
Total liabilities 10,00,000 Total Assets 10,00,000
(d) (i) Computation of Earnings Per Share (EPS)
Plans I (`) II (`)
Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of `75 lakh) -- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 7

No. of equity shares (@ `10+`15) 4,00,000 1,00,000

E.P.S (`) 7.00 21.70

(ii) Computation of Financial Break-even Points

Plan ‘I’ = 0 – Under this plan there is no interest payment, hence the financial break-
even point will be zero.
Plan ‘II’ = ` 9,00,000 - Under this plan there is an interest payment of `9,00,000,
hence the financial break -even point will be `9 lakhs
(iii) Computation of Indifference Point between Plan I and Plan II:
Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be
calculated by applying the following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2
EBIT(1- 0.3) (EBIT - ` 9,00,000)(1- 0.3)
So =
4,00,000shares 1,00,000shares
Or, 2.8 EBIT – 25,20,000 = 0.7EBIT

Or, 2.1EBIT = 25,20,000

EBIT =12,00,000
Question 2
(a) XYZ Ltd. is presently all equity financed. The directors of the company have been
evaluating investment in a project which will require ` 270 lakhs capital expenditure on
new machinery. They expect the capital investment to provide annual cash flows of ` 42
lakhs indefinitely which is net of all tax adjustments. The discount rate which it applies to
such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt, and propose to finance the new project with undated
perpetual debt secured on the company's assets. The company intends to issue sufficient
debt to cover the cost of capital expenditure and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated
debt of similar risk is 10%. The after tax costs of issue are expected to be ` 10 lakhs.
Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and

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8 INTERMEDIATE EXAMINATION: MAY 2018

(iii) Explain the circumstances under which this adjusted discount rate may be used to
evaluate future investments. (8 Marks)
(b) What are Masala Bonds? (2 Marks)
Answer
(a) (i) Calculation of Adjusted Present Value of Investment (APV)
Adjusted PV = Base Case PV + PV of financing decisions associated with the
project
Base Case NPV for the project:
(-) ` 270 lakhs + (` 42 lakhs / 0.14) = (-) ` 270 lakhs + ` 300 lakhs
= ` 30
Issue costs = ` 10 lakhs
Thus, the amount to be raised = ` 270 lakhs + ` 10 lakhs
= ` 280 lakhs
Annual tax relief on interest payment = ` 280 X 0.1 X 0.3
= ` 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ` 8.4 lakhs / 0.1
= ` 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= ` 30 lakhs – ` 10 lakhs + 84 lakhs = ` 104 lakhs
(ii) Calculation of Adjusted Discount Rate (ADR)
Annual Income / Savings required to allow an NPV to zero
Let the annual income be x.
(-) `280 lakhs X (Annual Income / 0.14) = (-) `104 lakhs
Annual Income / 0.14 = (-) ` 104 + ` 280 lakhs
Therefore, Annual income = ` 176 X 0.14 = ` 24.64 lakhs
Adjusted discount rate = (` 24.64 lakhs / `280 lakhs) X 100
= 8.8%
(iii) Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of
the new venture is identical to the one being evaluated here and the project is to be
financed by the same method on the same terms. The effect on the company’s cost
of capital of introducing debt into the capital structure cannot be ignored.

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 9

(b) Masala Bond:

Masala (means spice) bond is an Indian name used for Rupee denominated bond that
Indian corporate borrowers can sell to investors in overseas markets. These bonds are
issued outside India but denominated in Indian Rupees. NTPC raised `2,000 crore via
masala bonds for its capital expenditure in the year 2016.
Question 3
Maruti Ltd. requires a plant costing ` 200 Lakhs for a period of 5 years. The company can use
the plant for the stipulated period through leasing arrangement or the requisite amount can be
borrowed to buy the plant. In case of leasing, the company received a proposal to pay annual
lease rent of ` 48 Lakhs at the end of each year for a period of 5 years.
In case of purchase, the company would have a 12%, 5 years loan to be paid in equated
annual installment, each installment becoming due in the beginning of each year. It is
estimated that plant can be sold for ` 40 Lakhs at the end of 5 th year. The company uses
straight line method of depreciation. Corporate tax rate is 30 %. Cost of Capital after tax for the
company is 10%.
The PVIF @ 10% and 12% for the five years are given below:
Year 1 2 3 4 5
PVIF @ 10 0.909 0.826 0.751 0.683 0.621
PVIF @ 12 0.893 0.797 0.712 0.636 0.567
You are required to advise whether the plant should be purchased or taken on lease.
(10 Marks)
Answer
Purchase Option
Loan installment = ` 200 lakhs / (1 + PVIFA 12%, 4)
= ` 200 lakhs / (1 + 3.038) = ` 49.53 lakhs
Interest payable = (` 49.53 X 5) – ` 200 lakhs = ` 47.65 lakhs
Working note:
Amortisation of Loan Installment
Year Loan amount Installment (` Interest Principal O/S Amount
(` In Lakhs) In Lakhs) (` In Lakhs) (` In Lakhs) (` In Lakhs)
0 200 49.53 0.00 49.53 150.47
1 150.47 49.53 18.06 31.47 119.00
2 119.00 49.53 14.28 35.25 83.75
3 83.75 49.53 10.05 39.48 44.27

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10 INTERMEDIATE EXAMINATION: MAY 2018

4 44.27 49.53 *5.26 44.27 -

5 0 0 0 0 0
Calculation of PV of outflow under Purchase Option
(` In Lakhs)
(1) (2) (3) (4) (5) (6) (7) (8)
End Debt Int. of Dep. Tax Shield Net Cash PV factors PV
Payment the o/s [(3) +(4)]x 0.3 outflows @ 10%
Principal (2) – (5)
0 49.53 0.00 0.00 0.00 49.53 1.000 49.53
1 49.53 18.06 32.00 15.02 34.51 0.909 31.37
2 49.53 14.28 32.00 13.88 35.65 0.826 29.44
3 49.53 10.05 32.00 12.61 36.92 0.751 27.72
4 49.53 *5.26 32.00 11.18 38.35 0.683 26.19
5 49.53 0 32.00 9.60 (9.60) 0.621 (5.96)
47.65 160.00 158.29
Less: PV of Salvage Value (`40 lakhs x 0.621) = 24.84
Total PV of Outflow 133.45
*Balancing Figure
Leasing Option
PV of Outflows under lease @ 10%= ` 48 lakhs x (1-0.30) x 3.790
= ` 127.34 lakhs
Decision: The plant should be taken on lease because the PV of outflows is less as compared
to purchase option.
Question 4
A company is evaluating a project that requires initial investment of ` 60 lakhs in fixed assets and
` 12 lakhs towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by ` 24,00,000
during its life. The fixed assets would have zero residual value at the end of life of 5 years.
The company follows straight line method of depreciation which is expected for tax purposes
also. Inflation is expected to be 6% per year. For evaluating similar projects, the company
uses discounting rate of 12% in real terms. Company's tax rate is 30%.

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 11

Advise whether the company should accept the project, by calculating NPV in real terms.
PVIF (12%, 5 years) PVIF (12%, 5 years)
Year 1 0.893 Year 1 0.943
Year 2 0.797 Year 2 0.890
Year 3 0.712 Year 3 0.840
Year 4 0.636 Year 4 0.792
Year 5 0.567 Year 5 0.747
(10 Marks)
Answer
(i) Equipment’s initial cost = ` 60,00,000 + ` 12,00,000
= ` 72,00,000
(ii) Annual straight line depreciation = ` 60,00,000/5
= ` 12,00,000.
(iii) Net Annual cash flows can be calculated as follows:
= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ` 24,00,000 × (1 – 0.3) + (0.3 x ` 12,00,000)
= ` 16,80,000 + ` 3,60,000 = ` 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (` 20,40,000 × PVIF 12%, 5 years) + (` 12,00,000 × 0.567)
= (` 20,40,000 × 3.605) + ` 6,80,400
= ` 73,54,200 + ` 6,80,400
= ` 80,34,600
So NPV = PV of Inflows – Initial Cost
= ` 80,34,600 – ` 72,00,000
= ` 8,34,600
Advice: Company should accept the project as the NPV is Positive
Question 5
Day Ltd., a newly formed company has applied to the Private Bank for the first time for
financing it's Working Capital Requirements. The following informations are available about
the projections for the current year:

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12 INTERMEDIATE EXAMINATION: MAY 2018

Estimated Level of Activity Completed Units of Production 31200 plus unit of work in
progress 12000
Raw Material Cost ` 40 per unit
Direct Wages Cost ` 15 per unit
Overhead ` 40 per unit (inclusive of Depreciation `10 per unit)
Selling Price ` 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ` 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and
overheads accrue similarly. All sales are on the credit basis. You are required to calculate the
Net Working Capital Requirement on Cash Cost Basis. (10 Marks)
Answer
Calculation of Net Working Capital requirement:
(`) (`)
A. Current Assets:
Inventories:
Stock of Raw material 1,44,000
(Refer to Working note (iii)
Stock of Work in progress 7,50,000
(Refer to Working note (ii)
Stock of Finished goods 20,40,000
(Refer to Working note (iv)
Debtors for Sales 1,02,000
(Refer to Working note (v)
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases 1,56,000

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 13

(Refer to Working note (vi)

Creditors for wages
(Refer to Working note (vii) 23,250
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 x 0.5)} 5,58,000
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 + `15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
(` 26,52,000 × 24,000/31,200) (20,40,000)
Total Cash Cost of Sales 6,12,000

(ii) Work in progress stock

(`)
Raw material requirements (12,000 units × `40) 4,80,000
Direct wages (50% × 12,000 units × ` 15) 90,000
Overheads (50% × 12,000 units × ` 30) 1,80,000
7,50,000
(iii) Raw material stock
It is given that raw material in stock is average 30 days consumption. Since, the
company is newly formed; the raw material requirement for production and work in
progress will be issued and consumed during the year. Hence, the raw material
consumption for the year (360 days) is as follows:

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14 INTERMEDIATE EXAMINATION: MAY 2018

(`)
For Finished goods (31,200 × ` 40) 12,48,000
For Work in progress (12,000 × ` 40) 4,80,000
17,28,000
`17,28,000
Raw material stock = × 30 days = `1,44,000
360days
(iv) Finished goods stock:
24,000 units @ ` (40+15+30) per unit = `20,40,000
60days
(v) Debtors for sale: ` 6,12,000   ` 1,02,000
360days
(vi) Creditors for raw material Purchases [Working Note (iii)]:
Annual Material Consumed (`12,48,000 + `4,80,000) `17,28,000
Add: Closing stock of raw material ` 1,44,000
`18,72,000
`18,72,000
Credit allowed by suppliers = × 30days = ` 1,56,000
360days
(vii) Creditors for wages:
` 5,58,000
Outstanding wage payment = × 15days = ` 23,250
360days
Question 6
Answer all.
(a) What are the sources of short term financial requirement of the company? (4 Marks)
(b) What is certainty Equivalent? (4 Marks)
(c) What are the roles of Finance Executive in Modem World? (2 Marks)
OR
What are the two main aspects of the Finance Function?
Answer
(a) There are various sources available to meet short-term needs of finance. The
different sources are discussed below:
(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident
of sale. The usual duration of such credit is 15 to 90 days. It generates

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 15

automatically in the course of business and is common to almost all business

operations. It can be in the form of an 'open account' or 'bills payable'.
(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities
which a company has to pay for the services which it has already received like
wages, taxes, interest and dividends.
(iii) Advances from Customers: Manufacturers and contractors engaged in producing
or constructing costly goods involving considerable length of manufacturing or
construction time usually demand advance money from their customers at the time
of accepting their orders for executing their contracts or supplying the goods. This is
a cost free source of finance and really useful.
(iv) Commercial Paper: A Commercial Paper is an unsecured money market
instrument issued in the form of a promissory note.
(v) Treasury Bills: Treasury bills are a class of Central Government Securities.
Treasury bills, commonly referred to as T-Bills are issued by Government of India to
meet short term borrowing requirements with maturities ranging between 14 to 364
days.
(vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings
certificate with a fixed maturity date of not less than 15 days up to a maximum of
one year.
(vii) Bank Advances: Banks receive deposits from public for different periods at varying
rates of interest. These funds are invested and lent in such a manner that when
required, they may be called back.
(b) Certainty Equivalent (CE)
It is a coefficient used to deal with risk in a capital budgeting context. It expresses risky
future cash flows in terms of the certain cash flows which would be considered by the
decision maker, as their equivalent. That is the decision maker would be indifferent
between the risky amount and the (Lower) riskless amount considered to be its
equivalent.
It is a guaranteed return that the management would accept rather than accepting a
higher but uncertain return. Calculation of this equivalent involves the following three
steps:
Step 1: Remove risks by substituting equivalent certain cash flows in the place of risky
cash flows. This can be done by multiplying each risky cash flow by the appropriate CE
Coefficient.
Step 2: Obtain discounted value of cash flow by applying riskless rate of interest.
Step 3: Apply normal capital budgeting method to calculate NPV by using the firm’s
required rate of return.

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16 INTERMEDIATE EXAMINATION: MAY 2018

n
 t NCFt
NPV =  -I
1+ k f 
t
t=0

Where,
NCFt = the forecasts of net cash flow without risk-adjustment
α t = the risk-adjustment factor or the certainly equivalent coefficient.
Kf = risk-free rate assumed to be constant for all periods.
Certainty Coefficient lies between 0 and 1.
(c) Role of Finance Executive in modern World
Today, the role of Financial Executive, is no longer confined to accounting, financial
reporting and risk management. Some of the key activities that highlight the changing
role of a Finance Executive are as follows:-
• Budgeting
• Forecasting
• Managing M & As
• Profitability analysis relating to customers or products
• Pricing Analysis
• Decisions about outsourcing
• Overseeing the IT function.
• Overseeing the HR function.
• Strategic planning (sometimes overseeing this function).
• Regulatory compliance.
• Risk management.
Or
(c) Value of a firm will depend on various finance functions/decisions. It can be expressed
as:
V = f (I,F,D).
The finance functions are divided into long term and short term functions/decisions
Long term Finance Function Decisions
(a) Investment decisions (I): These decisions relate to the selection of assets in which
funds will be invested by a firm. Funds procured from different sources have to be
invested in various kinds of assets. Long term funds are used in a project for
various fixed assets and also for current assets.

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 17

(b) Financing decisions (F): These decisions relate to acquiring the optimum finance
to meet financial objectives and seeing that fixed and working capital are effectively
managed.
(c) Dividend decisions(D): These decisions relate to the determination as to how
much and how frequently cash can be paid out of the profits of an organisation as
income for its owners/shareholders. The owner of any profit-making organization
looks for reward for his investment in two ways, the growth of the capital invested
and the cash paid out as income; for a sole trader this income would be termed as
drawings and for a limited liability company the term is dividends.
Short- term Finance Decisions/Function
Working capital Management (WCM): Generally short term decision are reduced to
management of current asset and current liability (i.e., working capital Management)

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18 INTERMEDIATE EXAMINATION: MAY 2018

SECTION – B: ECONOMICS FOR FINANCE

Question No. 7 is compulsory.
Answer any three from the rest.
Question 7
(a) Calculate the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save
(MPS) from the following data:
Income (Y) Consumption (C) Level
` 8,000 ` 6,000 Initial level
` 12,000 ` 9,000 Changed level
(2 Marks)
(b) What would be the impact of each of the following on credit multiplier and money supply?
(i) If Commercial Banks keep 100 percent reserves.
(ii) If Commercial Banks do not keep reserves.
(iii) If Commercial Banks keep excess reserves. (3 Marks)
(c) Explain the role of Government in a market economy as stated by Richard Musgrave.
(3 Marks)
(d) List the point of difference between fixed exchange rate and floating exchange rate.
(2 Marks)
Answer
C
(a) Marginal Propensity to Consume (MPC) =
Y
Where ∆ C is change in consumption and ∆Y is change in income
∆ C = (9,000 – 6,000); ∆Y = (12,000 – 8,000)
C 3000
= = 0.75
Y 4000
S C
Marginal Propensity to Save (MPS) = =1- = 1 – 0.75 = 0.25
Y Y
OR
S = Y-C
S
Marginal Propensity to Save (MPS) =
Y

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 19

(12000  9000)  (8000  6000)

(12,000  8000)
1000
= = 0.25
4000
1
(b) Credit Multiplier =
Required Reserve Ratio
(i) If commercial banks keep 100% reserves, the reserve deposit ratio is one and the
value of money multiplier is one. Deposits simply substitute for the currency that is
held by banks as reserves and therefore, no new money is created by banks.
(ii) If commercial banks do not keep reserves and lends the entire deposits, it is a case
of zero required reserve ratio and credit multiplier will be infinite and therefore
money creation will also be infinite.
(iii) Excess reserves are reserves over and above what banks are legally required to
hold against deposits. The additional units of money that goes into ‘excess
reserves’ of the commercial banks do not lead to any additional loans, and
therefore, these excess reserves do not lead to creation of money. The i ncrease in
banks’ excess reserves reduces the credit multiplier, causing the money supply to
decline.
(c) Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959),
introduced the three branch taxonomy of the role of government in a market economy.
The objective of the economic system and the role of government is to improve the
wellbeing of individuals or households. According to ‘Musgrave Three-Function
Framework', the functions of government are to be separated into three, namely,
resource allocation, (efficiency), income redistribution (fairness) and macroeconomic
stabilization. The allocation and distribution functions are primarily microeconomic
functions, while stabilization is a macroeconomic function. The allocation function aims to
correct the sources of inefficiency in the economic system while the distribution role
ensures that the distribution of wealth and income is fair. The stabilization branch is to
ensure achievement of macroeconomic stability, maintenance of high levels of
employment and price stability.
(d)
Fixed Exchange Rate Floating Exchange Rate
A fixed exchange rate, also Under floating exchange rate regime, the
referred to as pegged exchange equilibrium value of the exchange rate of a
rate, is an exchange rate regime country’s currency is market-determined i.e. the
under which a country’s central demand for and supply of currency relative to
bank and/ or government other currencies determine the exchange rate.
announces or decrees what its

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20 INTERMEDIATE EXAMINATION: MAY 2018

currency will be worth in terms of

either another country’s currency
or a basket of currencies or
another measure of value, such
as gold.
In order to maintain the exchange There is no interference on the part of the
rate at the predetermined level, government or the central bank of the country in
the central bank intervenes in the the determination of exchange rate. Any
foreign exchange market interference in the foreign exchange market on
the part of the government or central bank would
be only for moderating the rate of change
Question 8
(a) (i) Explain the following modified equation of exchange as given by Irving Fisher:
MV +M'V'=PT (3 Marks)
(ii) Describe the meaning and mechanism of 'crowding out' effect of public expenditure.
(3 Marks)
(b) (i) Explain the leakages and injections in the circular flow of Income. (2 Marks)
(ii) Describe features of public goods. (2 Marks)
Answer
(a) (i) Modified Equation of Exchange
MV + M’ V’ = PT
MV + M’ V’ = PT is an extended form of the original equation of exchange which
Fisher gave to include demand deposits (M’) and their velocity (V’) in the total
supply of money. The equation can also be rewritten as P = (MV + M’ V’) / T
From the above equation, it is evident that the price level is determined by the
following factors: (i) Quantity of money in circulation (M), (ii) the velocity of
circulation of money (V), (iii) the volume of credit money (M’), the velocity of
circulation of credit money (V’) and the volume of trade (T).
The equation of exchange further shows that the price level (P) is directly related to
M, V, M’ and V’. It is, however, inversely related to T. Velocity of money in
circulation (V) and the velocity of credit money (V’) remain constant. Since full
employment prevails and since T is function of national income the vol ume of
transactions T is fixed in the short run.
The total volume of transactions (T) multiplied by the price level (P) represents the
demand for money. The demand for money (PT) is equal to the supply of money

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 21

(MV + M'V’). In any given period, the total value of transactions made is equal to PT
and the value of money flow is equal to MV+ M'V'.
(ii) Crowding Out:
Meaning
‘Crowding out’ effect is the negative effect fiscal policy may generate when
spending by government in an economy substitutes private spending. For example,
if government provides free computers to students, the demand from students for
computers may not be forthcoming.
Mechanism
The interest rates in an economy increase when:
• Government increases its spending by borrowing from the loanable funds from
market and thus the demand for loans increases.
• Government increases the budget deficit by selling bonds or treasury bills and the
amount of money with the private sector decreases.
Due to high interest, private investments, especially the ones which are interest –
sensitive, will be reduced. Fiscal policy becomes ineffective as the decline in
private spending partially or completely offset the expansion in demand resulting
from an increase in government expenditure.
(b) (i) Leakages: A leakage is an outflow or withdrawal of income from the circular flow.
Leakages are money leaving the circular flow and therefore, not available for
spending on currently produced goods and services. Leakages reduce the flow of
income.
Injections: An injection is a non-consumption expenditure. It is an expenditure on
goods and services produced within the domestic territory but not used by the
domestic household for consumption purposes. Injections are exogenous additions
to the circular flow and add to the total volume of the basic circular flow.
In the two-sector model with households and firms, household saving is the only
leakage and investment is the only injection. In the three-sector model which
includes the government, saving and taxes are the two leakages and investment
and government purchases are the two injections. In the four-sector model which
includes foreign sector also, saving, taxes, and imports are the three leakages;
investment, government purchases, and exports are the three injections.
The state of equilibrium occurs when the total leakages are equal to the total
injections that occur in the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports

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22 INTERMEDIATE EXAMINATION: MAY 2018

(ii) Features of public goods

• Public goods yield utility and their consumption is essentially collective in nature.
• Public goods are non rival in consumption i.e. consumption of a public good by one
individual does not reduce the quality or quantity available for all other individuals
• Public goods are non-excludable i.e. consumers cannot (at least at less than
prohibitive cost) be excluded from consumption benefits
• Public goods are characterized by indivisibility, each individual may consume all of
the good i.e. the total amount consumed is the same for each individual.
• Once a public good is provided, the additional resource cost of another person
consuming the good is zero. No direct payment by the consumer is involved in the
case of pure public goods and these goods are generally more vulnerable to
issues such as externalities, inadequate property rights, and free rider problems
• Competitive private markets will fail to generate economically efficient outputs of
public goods. E.g. national defence.
Question 9
(a) (i) Explain why people hold money according to Liquidity Preference Theory. (3 Marks)
(ii) Which types of Government interventions are applied for correcting information
failure? (2 Marks)
(b) Suppose in an economy:
Consumption Function C = 150 + 0.75 Yd
Investment spending I = 100
Government spending G= 115
Tax Tx = 20 + 0.20 Y
Transfer Payments Tr = 40
Exports X = 35
Imports M = 15 + 0.1 Y
(5 Marks)
Where, Y and Yd are National Income and Personal Disposable Income respectively. All
figures are in rupees.
Find:
(i) The equilibrium level of National Income
(ii) Consumption at equilibrium level
(iii) Net Exports at equilibrium level (5 Marks)

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 23

Answer
(a) (i) Reasons for holding money as per Liquidity Preference Theory:
According to Keynes’ Liquidity Preference Theory’, people hold money (M) in cash
for three motives:
i. The transactions motive: People hold cash for current transactions for
personal and business exchanges i.e. to bridge the time gap between receipt of
income and planned expenditures.
ii. The precautionary motive: People hold cash to make unanticipated
expenditures that may occur due to unforeseen and unpredictable contingencies.
iii. The speculative motive: This motive reflects people’s desire to hold cash in
order to be equipped to exploit any attractive investment opportunity requiring
cash expenditure. According to Keynes, people demand to hold money balances
to take advantage of the future changes in the rate of interest, which is the same
as future changes in bond prices.
(ii) Government Interventions: For combating the problem of market failure due to
information failure the following interventions are resorted to:
• Government makes it mandatory to have accurate labelling and content
disclosures by producers.
• Public dissemination of information to improve knowledge and subsidizing of
initiatives in that direction.
• Regulation of advertising and setting of advertising standards to make
advertising more responsible, informative and less persuasive.
A few examples are: SEBI mandates on accurate information disclosure to
prospective buyers of new stocks, mandatory statutory information, licensing of
doctors practicing medicine, awareness campaigns and funding of organisations to
influence public, media and government attitudes.
(b) The consumption function is
C = 150 + 0.75Yd
Level of Disposable income Yd is given by
Yd = Y-Tax + Transfer Payments, Where, Transfer Payment = Tr = 40
= Y – (20+ 0.20 Y) + 40 = Y – 20 – 0.20Y +40
= Y – 0.2Y - 20+40

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24 INTERMEDIATE EXAMINATION: MAY 2018

Yd = 20 + 0.8 Y and C = 150+0.75 Yd

C = 150 + .75 (20 +0.8 Y) where Yd = (20+0.8Y)
C = 150 +15+ 0.6Y
C = 165 + 0.6Y
(i) The equilibrium level of national income
Y = C + I + G + (X-M)
Y = 165 + 0.6Y +100+115+ [35 – (15+0.1Y)]
= 165 +0.6 Y +100+115+ [35 -15 – 0.1Y]
= 165+0.6Y +215+ 35 – 15 - 0.1Y
Y = 400+ 0.5Y
Y-0.5Y = 400; 0.5 Y = 400
Y = 400 / 0.5 = 800
The equilibrium level of national income is ` 800
(ii) Consumption at equilibrium level of national income of ` 800
C = 165 + 0.6Y
C = 165 + 0.6(800)
C = 165+480 = 645
Consumption at equilibrium level = ` 645
(iii) Net Exports at equilibrium level of national income 800
Net exports = Value total exports - Value of total imports
Given, exports X = 35; and imports M = 15+0.1Y
Net exports = [35 - (15+0.1Y)]
= 35 -15 – 0.1Y
= 35 -15 – (0.1X 800) = 35 – 15 – 80 = - 60
Net exports = ` (-)60
There is an adverse balance of trade
Question 10
(a) (i) Explain the difference between Liquidity Adjustment Facility (LAP) and Marginal
Standing Facility (MSF). (3 Marks)
(ii) From the following data, compute the Gross National Product at Market Price
(GNPMP) using value added method:

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 25

(` In crores)
Value of output in Secondary Sector 1000
Intermediate consumption in Primary Sector 300
Value of output in Tertiary Sector 3000
Intermediate consumption in Secondary Sector 400
Net factor income from abroad (-) 100
Value of output in Primary Sector 800
Intermediate consumption in Tertiary Sector 900
(3 Marks)
(b) (i) What do you mean by anti-dumping duties? (2 Marks)
(ii) Describe deterrents to Foreign Direct Investment (FDI) in the country. (2 Marks)
Answer
(a) (i) Difference between Liquidity Adjustment Facility (LAF) and Marginal Standing
Facility (MSF).
Liquidity Adjustment Facility (LAF) which was introduced by RBI in June, 2000, is a
facility extended to the scheduled commercial banks and primary dealers to avail of
liquidity in case of requirement on an overnight basis against the collateral of
government securities including state government securities. Its objective is to
assist banks to adjust their day to day mismatches in liquidity. Currently, t he RBI
provides financial accommodation to the commercial banks through repos / reverse
repos under LAF.
Marginal Standing Facility (MSF) which was introduced by RBI in its monetary policy
statements 2011 -12, refers to the facility under which scheduled commercial banks
can borrow additional amount of overnight money from the central bank over and
above what is available to them through the LAF window by dipping into their
Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This
provides a safety valve against unexpected liquidity shocks to the banking system.
The MSF would be the last resort for banks once they exhaust all borrowing options
including the liquidity adjustment facility.
(ii) Computation of Gross National Product at Market Price (GNP MP)
GNPMP = (Value of output in primary sector – Intermediate consumption of primary
sector) + (Value of output in secondary sector – Intermediate consumption of
secondary sector) + (Value of output in tertiary sector – Intermediate consumption
of tertiary sector) + Net Factor Income from Abroad
GNPMP = [(800- 300) + (1000 – 400) + (3000 – 900)] + (-100)

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26 INTERMEDIATE EXAMINATION: MAY 2018

= 500+ 600+ 2100 - 100

= 3200 -100 = ` 3100 Crores
(b) (i) Anti –Dumping Duties
An anti-dumping duty is an extra import duty that a domestic government imposes
on foreign imports that it believes are priced below fair market value causing injury
to the competing domestic industry. It is a protectionist tariff equal to the difference
between the importing country's FOB price of the goods at the time of their import
and the market value of similar goods in the exporting country. An anti-dumping
duty increases the price of imports and brings it closer to the domestic price and
prevents injury to domestic industry due to unfair competition.
(ii) Deterrents to Foreign Direct Investment (FDI)
(i) Poor macro-economic environment, such as, infrastructure lags, high rates of
inflation and continuing instability, balance of payment deficits, exchange rate
volatility, unfavourable tax regime (including double taxation), small size of
market and lack of potential for its growth and poor track-record of
investments.
(ii) Unfavourable resource and labour market conditions such as poor natural and
human resources, rigidity in the labour market, low literacy, low labour skills,
language barriers and high rates of industrial disputes
(iii) Unfavourable legal and regulatory framework such as absence of well -defined
property rights, lack of security to life and property, stringent regulations,
cumbersome legal formalities and delays, bureaucracy and corruption and
political instability.
(iv) Lack of host country trade openness viz. lack of openness, prevalence of non-
tariff barriers, lack of a general spirit of friendliness towards foreign investors,
lack of facilities for immigration and employment of foreign technical and
administrative personnel.
Question 11
(a) (i) Describe the objectives of World Trade Organization (WTO). (3 Marks)
(ii) Examine why General Agreement in Tariff & Trade (GATT) lost its relevance .
(2 Marks)
(b) (i) Explain the objectives of Fiscal Policy. (3 Marks)
(ii) How do import tariffs affect International Trade? (2 Marks)
OR
How do changes in Cash Reserve Ratio (CRR) impact the economy? (2 Marks)

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PAPER 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 27

Answer
(a) (i) Objectives of World Trade Organization (WTO):
The WTO aims to facilitate the flow of international trade smoothly, freely, fairly and
predictably for the benefit of all. The chief objectives of WTO are:
• to set and enforce rules for international trade
• to provide a forum for negotiating and monitoring further trade liberalization
• to resolve trade disputes
• to increase the transparency of decision-making processes
• to cooperate with other major international economic institutions involved in global
economic management and
• to help developing countries to get benefit fully from the global trading system
(ii) The GATT lost its relevance by 1980s because:
• It was obsolete to the fast evolving contemporary complex world trade scenario
characterized by emerging globalisation
• International investments had expanded substantially
• Intellectual property rights and trade in services were not covered by GATT
• World merchandise trade increased by leaps and bounds and was beyond its
scope
• The ambiguities in the multilateral system could be heavily exploited
• Efforts at liberalizing agricultural trade were not successful
• There were inadequacies in institutional structure and dispute settlement
system
• It was not a treaty and therefore terms of GATT were binding only insofar as
they are not incoherent with a nation’s domestic rules
(b) (i) Objectives of Fiscal Policy
Fiscal Policy refers to the policy of government related to public revenue and public
expenditure. The objectives of fiscal policy are derived from the aspirations and
goals of the society and vary from country to country. The most common objectives
of fiscal policy are:
• Achievement and maintenance of full employment,
• Maintenance of price stability,
• Acceleration of the rate of economic development,
• Equitable distribution of income and wealth,

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28 INTERMEDIATE EXAMINATION: MAY 2018

• Eradication of poverty, and

• Removal of regional imbalances in different parts of the country.
The importance as well as order of priority of these objectives may vary from
country to country and from time to time. For instance, while stability and equality
may be the priorities of developed nations, economic growth, employment and
equity may get higher priority in developing countries. Also, these objectives are not
always compatible; for instance the objective of achieving equitable distribution of
income may conflict with the objective of economic growth and efficiency.
(ii) Demerits of Tariffs in International Trade:
Tariffs are the most visible and universally used trade measures that determine
market access for goods. Tariffs are aimed at altering the relative prices of goods
and services imported, so as to contract the domestic demand and thus regulate the
volume of their imports.
(i) Tariff barriers create obstacles to international trade, decrease the volume of
imports and of international trade.
(ii) The prospect of market access of the exporting country is worsened when an
importing country imposes a tariff.
(iii) By making imported goods more expensive, tariffs discourage domestic
consumption of imported foreign goods and therefore imports are discouraged.
(iv) Tariffs create trade distortions by disregarding comparative advantage and
prevent countries from enjoying gains from trade arising from comparative
advantage. Thus, tariffs discourage efficient production in the rest of the world
and encourage inefficient production in the home country.
OR

(ii) Impact of changes in Cash Reserve Ratio (CRR):

Change in Cash Reserve Ratio is one of the important quantitative tools aiding in
liquidity management. Higher the CRR with the central bank, lower will be the
liquidity in the system and vice versa. In order to control credit expansion during
periods of inflation, the central bank increases the CRR. With higher CRR, banks
have to keep more reserves and the banks’ lendable resources get depleted leading
to decrease in the volume of bank lending and contraction in credit and money
supply in the economy.
During deflation, the central bank reduces the CRR in order to enable the banks to
expand credit and increase the supply of money available in the economy. With
more credit available in the market, economic activities get accelerated bringing the
economy back to stability and economic growth.

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