Summy of FM

Referencer for Quick
Revision
Intermediate Course Paper-8:
Financial Management and
Economics for Finance
A compendium of subject-wise capsules published in the
monthly journal “The Chartered Accountant Student”
Board of Studies
(Academic)
ICAI
INDEX
Edition of
Paper Page
Subject Students’ Topics
No. No.
Journal
Scope and Objectives of
1-3 December 2017
Financial Management
3-4 December 2017 Types of Financing
Financial Analysis and
4-7 December 2017
Planning – Ratio Analysis
7-9 December 2017 Cost of Capital
Financing Decisions –
10-11 December 2017
Financial Capital Structure
8A
Management 12-13 December 2017
Financing Decisions –
Leverages
13-15 December 2017 Investment Decisions
Risk Analysis in Capital
16-20 August 2020
Budgeting
20-25 August 2020 Dividend Decisions
Management of Working
26-29 December 2017
Capital
Determination of National
30-33 December 2021
Income
Economics 33-36 December 2021 Public Finance
8B
for Finance 37-41
December 2021,
Money Market
January 2021
42-48 April 2018 International Trade
FINANCIAL MANAGEMENT
Financial Management-A Capsule for Quick Revision
To sustain and grow their financial standing, organisations across the world essentially require managers who are competent in various
domains of finance. One of the fundamental domains of finance, financial management deals with the functions relating to how much
and which assets are to be acquired, how to raise capital to acquire the assets and what is to be done to maximize the shareholder’s wealth.
Financial management comprises the processes of planning and controlling subsystems of funds.
A study in financial management will help the students to understand the functions of financial managers, providing with an overview
of broad issues and problems that financial managers face in various commercial domains of our economy. This subject introduce various
concepts and theories relating to finance, which are fundamental to the methodologies and proficiencies offered as aids to understand,
identify and solve the problems of financial managers. Study of financial management will help the Chartered Accountancy students
to develop an acumen, so as to grow competencies in financing decision, investment decision, dividend decision and working capital
management. Keeping in view the importance of the Subject, Board of Studies (BoS) has decided to bring a capsule on Financial Management.
In the beginning of each topic, a chapter overview has been provided to present a holistic viewpoint on the topic’s coverage. This capsule,
though, facilitates the students in undergoing quick revision, under no circumstances; such revisions can substitute the detailed study of
the material provided by the BoS.
SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Chapter Overview Short- term Finance
Working capital Management (WCM)
Decisions/Function
Scope of Financial Management:

Scope and Objectives of Role and functions of Chief
Finance Officer (CFO) Determination of size of the enterprise and
Financial Management
determination of rate of growth.
Relations of Financial
Profit Maximisation vis-a
Management with other
vis Wealth Maximisation
disciplines of accounting Determining the composition of assets of the enterprise.
Meaning of Financial Management Determining the mix of enterprise’s financing i.e., consideration
of level of debt to equity, etc. and short term functions/decisions
Financial management comprises the forecasting, planning,
organizing, directing, co-ordinating and controlling of all activities
relating to acquisition and application of the financial resources of an
undertaking in keeping with its financial objective. Analysis, planning and control of financial
affairs of the enterprise.
Two Basic Aspects of Financial Management

Procurement of Funds:
There are two basic aspects of financial management viz.,
procurement of funds and an effective use of these funds to achieve Since funds can be obtained from different sources, therefore their
business objectives. procurement is always considered as a complex problem by business
concerns. Some of the sources for funds for a business enterprise are:
Procurement of funds
Debentures and Bonds
Aspects of Financial Management
Utilization of Funds
Owner’s Funds Hire Purchases & Leasing

Finance functions/ finance decision
Value of a firm will depend on various finance functions/decisions.
It can be expressed as Commercial Banks Angel Financing
(Short, Medium & Long)
V = f (I,F,D).
Venture Capital
The finance functions are divided into long term and short term
functions/decisions
Effective Utilisation of Funds:
Investment
Decisions (I) The Finance Manager has to point out situations where the funds are
being kept idle or where proper use of funds is not being made. All
the funds are procured at a certain cost and after entailing a certain
amount of risk.
Long term
Finance
Function Utilization for Fixed
Decisions Assets
Dividend Financing
Utilization for Working
Decisions(D) Decisions (F) Capital
The Chartered Accountant Student December 2017 07

1
Evolution of Financial Management Conflict between Profit versus Value maxi-

The evolution of financial management is divided into three phases.
misation Principle:
Financial Management evolved as a separate field of study at the
beginning of the century. The three stages of its evolution are As a normal tendency, the management may pursue its own personal
goals (profit maximization). But in an organization where there is
a significant outside participation (shareholding, lenders etc.), the
Stages of Evolution of Financial Management management may not be able to exclusively pursue its personal goals
due to the constant supervision of the various stakeholders of the
company-employees, creditors, customers, government, etc.
Traditional Phase Transitional Phase Modern Phase
The below table highlights some of the advantages and disadvantages
of both profit maximisation and wealth maximization goals
Objectives of Financial Management
Goal Objective Advantages Disadvantages
Profit Large (i) Easy to (i) Emphasizes
Profit Maximization amount of calculate the short
Maximisation Wealth / Value profits profits term gains
maximisation (ii) Easy to (ii) Ignores risk
determine or
the link uncertainty
between (iii)Ignores the
financial timing of
decisions and returns
How do we measure the value/wealth of a profits. (iv) Requires
immediate
firm? resources.
Shareholders Highest (i) Emphasizes (i) Offers
Stockholders hire managers to run their firms for them...... Wealth market the long term no clear
Maximisation value of gains relationship
shares (ii) Recognises between
Managers set aside their interest and maximise stock prices... risk or financial
uncertainty decisions and
(iii) Recognises share price.
the timing of (ii) Can lead to
Stockholders wealth is maximised... returns management
(iv) Considers anxiety and
shareholders’ frustration.
Firm value is maximised.... return.
Societal wealth is maximised... Role of Finance executive in today’s World

vis-a-vis in the past
Today, the role of chief financial officer, or CFO, is no longer confined
Value of a firm (V) = Number of Shares (N) × Market price of to accounting, financial reporting and risk management. Some of
shares (MP) the key differences that highlight the changing role of a CFO are as
Or follows
V = Value of equity (Ve) + Value of debt (Vd)
What a CFO used to do? What a CFO now does?
Budgeting Budgeting
Three Important Decisions for Achievement
Forecasting Forecasting
of Wealth Maximisation
Accounting Managing M & As
Treasury (cash management) Profitability analysis (for example,
Investment by customer or product)
Decisions Preparing internal financial Pricing analysis
reports for management.
Financing Preparing quarterly, annual Decisions about outsourcing
Decisions filings for investors.
Tax filing Overseeing the IT function.
Tracking accounts payable and Overseeing the HR function.
accounts receivable.
Dividend Travel and entertainment Strategic planning (sometimes
Decisions expense management. overseeing this function).
Regulatory compliance.
Risk management.
08 December 2017 The Chartered Accountant Student
2
Relationship of financial management with Decision – Chief focus of an accountant is to
related disciplines: making collect data and present the data.
The financial manager’s primary
Financial management is not a totally independent area. It draws responsibility relates to financial
heavily on related disciplines and areas of study namely economics, planning, controlling and decision
accounting, production, marketing and quantitative methods. Even making.
though these disciplines are inter-related, there are key differences
among them.
Financial Management and Other Related
Financial Treatment In accounting, the measurement Disciplines:
Management of Funds of funds is based on the accrual
and principle. Financial management also draws on other related disciplines such
Accounting: as marketing, production and quantitative methods apart from
accounting. For instance, financial managers should consider the
The treatment of funds in financial impact of new product development and promotion plans made in
management is based on cash the marketing area since their plans will require capital outlays and
flows. have an impact on the projected cash flows.
TYPES OF FINANCING
Chapter Overview Sources of Finance
Sources of Finance Long-term
Equity Preference Loans 1. Share capital or Equity shares

Share Share Retained Debentures/ from
Earnings Bonds Others 2. Preference shares
Capital Capital Financial
Institution 3. Retained earnings
4. Debentures/Bonds of different types
5. Loans from financial institutions
Classification of Financial Sources 6. Loans from State Financial Corporations
7. Loans from commercial banks
There are mainly two ways of classifying various financial sources
(i) Based on basic Sources (ii) Based on Maturity of repayment period 8. Venture capital funding
9. Asset securitisation
10. International financing like Euro-issues, Foreign currency loans
Sources of Finance based on Basic Sources Medium-term
Based on basic sources of finance, types of financing 1. Preference shares

can be classified as 2. Debentures/Bonds
3. Public deposits/fixed deposits for duration of three years
4. Medium term loans from Commercial banks, Financial Institutions,
State Financial Corporations
5. Lease financing/Hire-Purchase financing
Sources of Finance 6. External commercial borrowings
7. Euro-issues
8. Foreign Currency bonds
Short-term
Internal Sources External Sources
1. Trade credit
2. Accrued expenses and deferred income
3. Short term loans like Working Capital Loans from Commercial banks
4. Fixed deposits for a period of 1 year or less
5. Advances received from customers
Mainly retained Debt or Borrowed Share Capital 6. Various short-term provisions
earnings Capital
Owner’s Capital or Equity Capital:

Loan from A public limited company may raise funds from promoters or from the
Others Financial Debentures Preference Equity
Shares investing public by way of owner’s capital or equity capital by issuing
Institutions Shares ordinary equity shares.
Preference Share Capital:

Sources of Finance based on Maturity of Payment
These are a special kind of shares; the holders of such shares enjoy
Sources of finance based on maturity of payment can be classified as priority, both as regards to the payment of a fixed amount of dividend
and also towards repayment of capital on winding up of the company

3
Debt Securitisation:
Securitization 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 Bank
interest in, or are secured by a segregated income producing asset or Trade Credit
Advances
pool of assets.
Lease Financing: Accrued

Certificates of Expenses &
Leasing is a general contract between the owner and user of the asset Deposit Deferred
over a specified period of time. The asset is purchased initially by Income
the lessor (leasing company) and thereafter leased to the user (lessee
company) which pays a specified rent at periodical intervals.
Advances
Treasury
from
Bills
Short term Sources of Finance: Customers
There are various sources available to meet short- term needs of Commercial
finance. The different sources are as shown alongside Paper
FINANCIAL ANALYSIS AND PLANNING - RATIO ANALYSIS

Chapter Overview
Liquidity Ratios*/
RATIO ANALYSIS Short-term Solvency
Ratios
Capital Structure
Application of Ratio Leverage Ratios/ Ratios
Types of Ratio Analysis in dicision Long term Solvency
making Ratios
Coverage Ratios
Types of Ratios
* Liquidity Ratio/Short term Activity Ratios/

Solvency Ratio Efficiency Ratios/
Relation of financial Performance Ratios/
* Leverages Ratio/Long Turnover Ratios* Related to Sales
term Solvency Ratios manegment with other
*Activity Ratio/Efficiency disciplines of accounting.
Related to overall
Ratios/Performance Return on Investment
*Profitability Ratios (Assets/ Capital
Profitability Ratios Employed/ Equity)
Required for analysis

from Owner’s point
Ratio and its Types: of view
Related to Market/
Valuation/ Investors
Ratio analysis is a comparison of different numbers from the
balance sheet, income statement, and cash flow statement against
the figures of previous years, other companies, the industry, or
even the economy in general for the purpose of financial analysis.
Summary of Ratios:
Types of the Ratios is as given slongside:
Summary of the ratios has been tabulated as under
Ratio Formulae Comments

Liquidity Ratio
Current Ratio Current Assets A simple measure that estimates whether the business can pay
Current Liabilities short term debts. Ideal ratio is 2 : 1.
Quick Ratio Quick Assets It measures the ability to meet current debt immediately. Ideal
Current Liabilities ratio is 1 : 1.
Cash Ratio (Cash and Bank Balances + It measures absolute liquidity of the business.
Marketable Securities )
Current Liabilities
4
Basic Defense Interval Ratio ( Cash and Bank Balances + It measures the ability of the business to meet regular cash
Marketable Securities) expenditures.
Operating Expenses – No. of days

Net Working Capital Ratio Current Assets – Current Liabilities It is a measure of cash flow to determine the ability of business to
survive financial crisis.
Capital Structure Ratio
Equity Ratio Shareholders’ Equity It indicates owner’s fund in companies to total fund invested.
Capital Employed
Debt Ratio Total Outside Liablilities It is an indicator of use of outside funds.
Total Debt + Net Worth

Debt to equity Ratio Total Outside Liabilities It indicates the composition of capital structure in terms of debt
and equity.
Shareholders’ Equity
Debt to Total assets Ratio Total Outside Liabilities It measures how much of total assets is financed by the debt.
Total Assets
Capital Gearing Ratio ( Preference Share Capital + It shows the proportion of fixed interest bearing capital to equity
Debentures shareholders’ fund. It also signifies the advantage of financial
+ Other Borrowed Funds) leverage to the equity shareholder.
( Equity Share Capital +

Reserves & Surplus – Losses)
Proprietary Ratio Prorietary Fund It measures the proportion of total assets financed by
Total Assets shareholders.
Coverage Ratios
Debt Service Coverage Ratio Earnings available for debt service It measures the ability to meet the commitment of various debt
(DSCR) services like interest, installment etc. Ideal ratio is 2.
Interest + Instalments
Interest Coverage Ratio EBIT It measures the ability of the business to meet interest. Ideal ratio
Interest is > 1.
Preference Dividend Coverage Net Profit/Earning after taxes (EAT) It measures the ability to pay the preference shareholders’
Ratio Preference dividend liability dividend. Ideal ratio is > 1.
Fixed Charges Coverage Ratio EBIT + Depreciation This ratio shows how many times the cash flow before interest
Interest + Re-payment of loan and taxes covers all fixed financing charges. The ideal ratio is > 1.
1 – tax rate
Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
Total Asset Turnover Ratio Sales/COGS A measure of total asset utilisation. It helps to answer the question -
What sales are being generated by each rupee’s
Average Total Assets
worth of assets invested in the business?
Fixed Assets Turnover Ratio Sales/COGS This ratio is about fixed asset capacity. A reducing sales or profit
Fixed Assets being generated from each rupee invested in fixed assets may
indicate overcapacity or poorer-performing equipment.
Capital Turnover Ratio Sales/COGS This indicates the firm’s ability to generate sales per rupee of long
Net Assets term investment.
Working Capital Turnover Sales/COGS It measures the efficiency of the firm to use working capital.
Ratio Working Capital
Inventory Turnover Ratio COGS/Sales It measures the efficiency of the firm to manage its inventory.
Average Inventory
Debtors Turnover Ratio Credit Sales It measures the efficiency at which firm is managing its
Average Accounts Receivable receivables.

5
Receivables (Debtors’) Velocity Average Accounts Receivable It measures the velocity of collection of receivables.
Average Daily Credit Sales
Payables Turnover Ratio Annual Net Credit Purchases It measures the velocity of payables payment.
Average Accounts Payables
Profitability Ratios based on Sales
Gross Profit Ratio Gross Profit This ratio tells us something about the business’s ability
x 100
Sales consistently to control its production costs or to manage the
margins it makes on products it buys and sells.
Net Profit Ratio Net Profit It measures the relationship between net profit and sales of the
x 100
Sales business.
Operating Profit Ratio Operating Profit It measures operating performance of business.

x 100
Sales
Expenses Ratio
Cost of Goods Sold (COGS) COGS
x 100
Ratio Sales
Operating Expenses Ratio Administrative exp. +

Selling & Distribution OH
x 100 It measures portion of a particular expenses in comparison to
Sales sales.
Operating Ratio COGS + Operating Expenses x 100
Sales
Financial Expenses Ratio Financial Expenses x 100

Sales
Profitability Ratios related to Overall Return on Assets/ Investments
Return on Investment (ROI) Return/ Profit / Earnings x 100 It measures overall return of the business on investment/ equity
Investments funds/ capital employed/ assets.
Return on Assets (ROA) Net Profit after taxes x 100 It measures net profit per rupee of average total assets/ average
Average Total Assets tangible assets/ average fixed assets.
Return on Capital Employed EBIT It measures overall earnings (either pre-tax or post tax) on total
x 100
ROCE (Pre-tax) Capital Employed capital employed.
Users and Objective of Financial Analysis : A Bird’s Eye view

Financial Statement analysis is useful to various shareholders to obtain the derived information about the firm
S.No. Users Objectives Ratios used in general

1. Shareholders Being owners of the organisation they are interested • Mainly Profitability Ratio [In particular
to know about profitability and growth of the Earning per share (EPS), Dividend per
organization share (DPS), Price Earnings (P/E), Dividend
Payout ratio (DP)]
2. Investors They are interested to know overall financial health of • Profitability Ratios
the organisation particularly future perspective of the • Capital structure Ratios
organisations. • Solvency Ratios
• Turnover Ratios
3. Lenders They will keep an eye on the safety perspective of their • Coverage Ratios
money lended to the organisation • Solvency Ratios
• Turnover Ratios
• Profitability Ratios
6
4. Creditors They are interested to know liability position of the • Liquidity Ratios
organisation particularly in short term. Creditors • Short term solvency Ratios/ Liquidity
would like to know whether the organisation will be Ratios
able to pay the amount on due date.
5. Employees They will be interested to know the overall financial • Liquidity Ratios
wealth of the organisation and compare it with • Long terms solvency Ratios
competitor company. • Profitability Ratios
• Return of investment
6. Regulator / Government They will analyse the financial statements to determine Profitability Ratios
taxations and other details payable to the government.
7. Managers:-
(a) Production Managers They are interested to know various data regarding • Input output Ratio
input output, production quantities etc. • Raw material consumption.
(b) Sales Managers Data related to quantities of sales for various years, • Turnover ratios (basically receivable
other associated figures and produced future sales turnover ratio)
figure will be an area of interest for them • Expenses Ratios
(c) Financial Manager They are interested to know various ratios for their • Profitability Ratios (particularly related to
future predictions of financial requirement. Return on investment)
• Turnover ratios
• Capital Structure Ratios
Chief Executive/ General They will try to find the entire perspective of the • All Ratios
Manager company, starting from Sales, Finance, Inventory,
Human resources, Production etc.
8. Different Industry
(a) Telecom • Ratio related to ‘call’
• Revenue and expenses per customer
(b) Bank • Loan to deposit Ratios
Finance Manager /Analyst will calculate ratios of their • Operating expenses and income ratios
(c) Hotel company and compare it with Industry norms. • Room occupancy ratio
• Bed occupancy Ratios
(d) Transport • Passenger -kilometre
• Operating cost - per passenger kilometre.
COST OF CAPITAL
Chapter Overview Sources of Capital:
Cost of Capital Equity shares
Preference shares
Cost of Cost of Combination Sources of Capital may

Cost of Preference Cost of Retained of Cost and include Debentures/
Debt Share Equity Earning Weight of each Bond/ other debt
source of instruments
Capital
Loan from financial
Weighted institutions
Average Cost
of Capital
(WACC)
Determination of the Cost of Capital:
Cost of capital is the return expected by the providers of capital Explicit/ Implicit: The cost of capital can either be explicit
(i.e. shareholders, lenders and the debt-holders) to the business as or implicit. The cash outflow of an entity towards the
a compensation for their contribution to the total capital. It is also utilization of capital which is clear and obvious is termed
known as Discount rate, Minimum rate of return etc. It can also as explicit cost of capital. On the other hand, Implicit
be stated as the opportunity cost of an investment, i.e. the rate of cost is the cost which is actually not a cash outflow but it
return that a company would otherwise be able to earn at the same is an opportunity loss of foregoing a better investment
risk level as the investment that has been selected. opportunity by choosing an alternative option.

7
Cost of Preference Share Capital:
The preference share capital is paid dividend at a specified rate
Cost of Equity on face value of preference shares. Payment of dividend to the
preference shareholders are not mandatory but are given priority
over the equity shareholder. The payment of dividend to the
preference shareholders are not charged as expenses but treated as
appropriation of after tax profit. Hence, dividend paid to preference
shareholders does not reduce the tax liability to the company.
Cost of Retained Weighted Average Cost of Cost of Redeemable

Earnings Cost of Capital Pref. Share Capital Preference Share Capital
(WACC) Cost of Preference
Share Capital
Cost of Irredeemable
Preference Share Capital
Cost of Irredeemable Preference Shares:

Cost of Long
term Debt. PD
(Kp) =
P0
Where,
PD = Annual preference dividend
P0 = Net proceeds in issue of preference shares
Cost of Long term Debt:

Cost of Redeemable Preference Shares
Cost of Irredeemable PD+(RV+NP)/n
(Kp) =
Debt RV+NP
Cost of long term Where, 2
Debt PD = Annual preference dividend
Cost of Redeemable RV = Redemption value of preference shares
Debt NP = Net proceeds on issue of preference shares
n = Life of preference shares
Cost of Irredeemable Debentures: Cost of debentures not redeemable Cost of Equity Share Capital:
during the life time of the company
Cost of equity capital is the rate of return which equates the present
I
Kd = (1-t) value of expected dividends with the market share price. Different
NP
methods are employed to compute the cost of equity share capital
Where,
which are as
Kd = Cost of debt after tax
I = Annual interest payment
Dividend Price
NP = Net proceeds of debentures or current market price Approach
t = Tax rate
Earning/ Price
Approach
Cost of Redeemable Debentures: If the debentures are redeemable Cost of Equity Share
after the expiry of a fixed period, the cost of debentures would be: Capital Realized Yield
Approach
Kd = ( RV-NP)
I(1-t)+
n Capital Asset Pricing
Model (CAPM)
( RV+NP)
2
Dividend Price Approach with Constant
Where,
I = Interest payment
Dividend
NP = Net proceeds from debentures in
D
case of new issue of debt or Current Ke =
P
market price in case of existing debt. Where, 0
RV = Redemption value of debentures Ke = Cost of equity
t = Tax rate applicable to the company D = Expected dividend
n = Life of debentures P0 = Market price of equity (ex- dividend)
8
Dividend Price Approach with Constant Realized Yield Approach:
Growth
According to this approach, the average rate of return realized in
D1 +g the past few years is historically regarded as ‘expected return’ in
Ke =
Po the future. It computes cost of equity based on the past records of
Where, dividends actually realised by the equity shareholders.
D1 = [D0 (1+ g)] i.e. next expected dividend
P0 = Current Market price per share
g = Constant Growth Rate of Dividend Capital Asset Pricing Model Approach
(CAPM):
Earning/ Price Approach with constant
Earning: Ke = Rf + ß (Rm − Rf)
Where,
Ke = Cost of equity capital
Ke = E
P Rf = Risk free rate of return
Where, ß = Beta coefficient
E = Current earnings per share Rm = Rate of return on market portfolio
P = Market share price (Rm – Rf) = Market premium
Earnings/ Price Approach with Growth in Cost of Retained Earnings

Earnings:
Like another source of fund, retained earnings involve cost. It is the
Ke = E +g opportunity cost of dividends foregone by shareholders.
P
Where,
E = Current earnings per share In absence of any information on personal tax (tp):
P = Market price per share Cost of Retained Earnings (KS) = Cost of Equity Shares (Ke)
g = Annual growth rate of earnings. If there is any information on personal tax (tp): KS = Ke -tp
Cash
Investment Investment
opportunity Shareholders opportunities
(real asset) Firm
(financial assets)
Invest Alternative pay Shareholders

dividend to invest for
shareholders themselves
Weighted Average Cost Of Capital (WACC): Marginal Cost of Capital:

It is the cost of raising an additional rupee of capital. Since the
It is an average rate of return expected by all contributors of
capital is raised in substantial amount in practice, marginal cost is
capital taking the weight of each element of capital to total
referred to as the cost incurred in raising new funds.
capital
To calculate the marginal cost of capital, the intended financing

WACC (Ko) = (% Debt × Kd) + (% Preff. Capital × Kp) + proportion should be applied as weights to marginal component
(% Equity Capital × Ke) costs. The marginal cost of capital should, therefore, be calculated
in the composite sense. The marginal weights represent the
proportion of funds the firm intends to employ.

9
FINANCING DECISIONS-CAPITAL STRUCTURE
Chapter Overview Net Income (NI) Approach:
According to this approach, capital structure decision is relevant to the value of the firm.
Capital Structure
Decision An increase in financial leverage will lead to decline in the weighted average cost of capital
(WACC), while the value of the firm as well as market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall cost of capital
and a consequent decline in the value as well as market price of equity shares
Capital Structure Theories
Capital Structure
• Net Income (NI) Approach Decision
The value of the firm on the basis of Net Income Approach can be ascertained as follows:
• Traditional Approach
• Net Operating Income (NOI) Approach
• Modigliani- Miller (MM) Approach V = Market Value of Equity + Market Value of Debt
• Trade-off Theory EBIT- EPS Analysis
• Pecking Order Theory EBIT
Overall cost of capital =
Value of the Form
Capital Structure decision refers to deciding the forms of financing (which sources to be
tapped); their actual requirements (amount to be funded) and their relative proportions Traditional Approach:
(mix) in total capitalisation.
This approach favours that as a result of financial leverage up to some point, cost of capital
Replacement comes down and value of firm increases. However, beyond that point, reverse trends
Capital Budgeting Decision Modernisation emerge. The principle implication of this approach is that the cost of capital is dependent
Expansion on the capital structure and there is an optimal capital structure which minimises cost
Diversification of capital.
Internal funds
Need to Raise Funds
Debt Net Operating Income Approach (NOI):
External equity
Any change in the leverage will not lead to any change in the total value of the firm and
Capital Structure Decision the market price of shares, as the overall cost of capital is independent of the degree of
leverage. As a result, the division between debt and equity is irrelevant.
As per this approach, an increase in the use of debt which is apparently cheaper is offset
by an increase in the equity capitalisation rate. This happens because equity investors
Existing Capital Desired Debt seek higher compensation as they are opposed to greater risk due to the existence of fixed
Payout Policy
Structure Equity Mix return securities in the capital structure.
V= NOI
KO
Where,
Effect of Return Effect of Risk
V = Value of the firm
NOI = Net operating Income
Ko = Cost of Capital
Effect of Cost of
Capital Modigliani-Miller Approach (MM):
Optimum Cpital
Structure The NOI approach is definitional or conceptual and lacks behavioral significance. It
does not provide operational justification for irrelevance of capital structure. However,
Modigliani-Miller approach provides behavioral justification for constant overall cost
Value of the Firm of capital and therefore, total value of the firm. This approach indicates that the capital
structure is irrelevant because of the arbitrage process which will correct any imbalance
i.e. expectations will chane and a stage will be reached where arbitrage is not possible.
Capital Structure Theories:

The following approaches explain the relationship between cost of capital, capital Modigliani-Miller (MM)
Approach
structure and value of the firm
Net Income (NI)

Approach
MM Approach MM Approach-
Capital Structure -1958: without
Relevance Theory 1963: with tax
tax
Traditional
Approach
Capital Structure
Theories
Net Operating The Trade-off Theory:
Income (NOI)
Approach
Capital Structure The trade-off theory of capital structure refers to the idea that a company chooses
Irrelevance Theory how much debt finance and how much equity finance to use by balancing the costs
Modigliani and and benefits.
Miller (MM)
Approach
10
EBIT-EPS Analysis:
Maximum
Value of firm The basic objective of financial management is to design an
appropriate capital structure which can provide the highest
earnings per share (EPS) over the company’s expected range of
earnings before interest and taxes (EBIT).
Costs of EPS measures a company’s performance for the shareholders.

finanacial The level of EBIT varies from year to year and represents the
distress success of a company’s operations.
PV of interest
tax shield However, The EPS criterion ignores the risk dimension as well
as it is more of a performance measure.
Value of (EBIT-I1) (1-t) (EBIT-I2) (1-t)

=
unlevered
E1 E2
Firm
Where,
EBIT = Indifference point

Optimal Debt E1 = Number of equity shares in Alternative 1
Level E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
Debt 12 = Interest charges in Alternative 2
level T = Tax-rate
Alternative 1 = All equity finance
Alternative 2 = Debt-equity finance
Pecking order theory:
This theory is based on Asymmetric information, which

• It is a situation where a firm has
refers to a situation in which different parties have different
more capital than it needs or in
information.
Over- Capitalisation other words assets are worth less
than its issued share capital, and
earnings are insufficient to pay
dividend and interest.
• Debt
• Equity
• It is just reverse of over-

Trade- off capitalisation. It is a state, when
Under Capitalisation its actual capitalisation is lower
Theory
than its proper capitalisation as
warranted by its earning capacity.
Pecking Order Theory
• Internal Financing
• Debt
• Equity

11
FINANCING DECISIONS- LEVERAGES
Chapter Overview Chart Showing Operating Leverage,
Financial Leverage and Combined Leverage
Business and Financial
Risk
Profitability Statement
Analysis of Leverage Sales xxx
Types of Leverage Less: Variable Cost (xxx)
(i) Operating Leverage
(ii) Financial Leverages Contribution xxx Operating
(iii) Combined Leverages Leverage
Less: Fixed Cost (xxx)
Operating Profit/ EBIT xxx Combined
In financial analysis, leverage represents the influence of one Leverage
Financial
financial variable over some other related financial variable. These Less: Interest (xxx) Leverage
financial variables may be costs, output, sales revenue, Earnings
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Earnings Before Tax xxx
(EBT)
Less: Tax (xxx)
Business Risk and Financial Risk:
Profit After Tax (PAT) xxx
Risk facing the common shareholders is of two types, namely Less: Pref. Dividend (if (xxx)
business risk and financial risk. Therefore, the risk faced by any)
common shareholders is a function of these two risks, i.e.
(Business Risk, Financial Risk). Net Earnings available xxx
to equity shareholders/
PAT
No. Equity shares (N)
Earnings per Share (EPS)
Business Risk Financial Risk = (PAT ÷ N)
•
It refers to the risk • It refers to the additional
associated with the firm’s risk placed on the firm’s Operating Leverage:
operations. It is the shareholders as a result of
uncertainty about the debt use i.e. the additional
future operating income risk a shareholder bears Operating leverage (OL) maybe defined as the employment of an
(EBIT), i.e. how well can when a company uses asset with a fixed cost in the hope that sufficient revenue will be
the operating incomes be debt in addition to equity generated to cover all the fixed and variable costs.
predicted? financing.
Contribution
Operating leverage =
EBIT
Types of Leverage:
% change in EBIT
There are three commonly used measures of leverage in financial Degree of Operating Leverage (DOL) =
% change in Sales
analysis. These are
Positive and Negative Operating Leverage:
Combined Operating Leverage

Leverage and EBIT
Negative Infinite/ Undefined Positive

Financial
Leverage
Operating at Operating at a
Lower than Operating at break- Higher Level than
break-even point even point break-even point
Operating
Leverage
EBIT= -Ve EBIT = 0 EBIT = +Ve
12
Financial Leverage: Combined Leverage:
Financial leverage (FL) maybe defined as ‘the use of funds with a • It maybe defined as the potential use of fixed
fixed cost in order to increase earnings per share.’ In other words, Combined costs, both operating and financial, which
it is the use of company funds on which it pays a limited return. leverage magnifies the effect of sales volume change
on the earning per share of the firm.
EBIT
Financial leverage = Degree of Combined Leverage = DOL X DFL
EBT
% change in EPS % change in EPS

Degree of Financial Leverage (DFL) = Degree of Combined Leverage (DCL) =
% change in EBIT % change in Sales
Positive and Negative Financial Leverage:
Financial Leverage
Financial Leverage as Financial Leverage as a

‘Trading on Equity’ ‘Double edged Sword’
Positive Infinite/ Undefined Negative • Financial leverage indicates • On one hand when cost of
the use of funds with fixed ‘fixed cost fund’ is less than
cost like long term debts the return on investment
and preference share capital financial leverage will help
EBIT level is more Operating at EBIT level is less along with equity share to increase return on equity
than Fixed Financial Financial break than Fixed capital which is known as and EPS. However, when
Charge even point Financial Charge trading on equity. When cost of debt is more than
the quantity of fixed cost the return it will affect
fund is relatively high return of equity and EPS
EPS: will change in comparison to equity unfavourably. This is why
in the same No Profit no Loss EPS : Negative capital, it is said that the financial leverage is known
direction as EBIT firm is ‘’trading on equity”. as “double edged sword”.
INVESTMENT DECISIONS
Chapter Overview:
Investment Decisions
• Identification of investment projects that are
strategic to business overall objectives;
Types of Investment Capital Budgeting Techniques: Capital • Estimating and evaluating post-tax
Decisions • Pay-back period Budgeting incremental cash flows for each of the
• Accounting Rare of Return (ARR) involves investment proposals; and
Basic Principles for • Net Present Value (NPV) • Selection of an investment proposal that
measuring Project maximizes the return to the investors
• Profitability Index (NI)
Cash Flows
• Internal Rate of Return (IRR)
Capital Budgeting in • Modified Internal Rate of Return
special cases (MIRR)
• Discounted Pay-back period
Capital Budgeting Process:
Planning Evaluation Selection Implementation Control Review

13
Chapter Overview 6. Less: Fixed Cost
(a) Fixed Cash Cost xxx
Generally, capital investment decisions are classified in two (b) Depreciation xxx
ways. One way is to classify them on the basis of firm’s existence.
Another way is to classify them on the basis of decision situation. 7. Earning Before Tax [6 - 7] xxx
8. Less: Tax xxx
9. Earning After Tax [7-8] xxx
Replacement and
Types of Capital Investment Decisions
Modernisation decisions 10. Add: Depreciation xxx
On the basis 11. Cash Inflow After Tax (CFAT) [9 +10] xxx
of firm’s existence Expansion decisions
Diversification decisions
Capital Budgeting Techniques:
In order to maximise the return to the shareholders of a company,

Mutualy exclusive decisions it is important that the best or most profitable investment
projects are selected as the results for making a bad long-term
investment decision can be both financially and strategically
On the basis of devastating, particular care needs to be taken with investment
decision situation Accept-Reject decisions
project selection and evaluation.
Contingent decisions
There are a number of techniques available for appraisal of
investment proposals and can be classified as presented below:
Estimation of Project Cash Flows

Capital Budgeting analysis considers only incremental cash flows Payback Period
from an investment likely to result due to acceptance of any
project. Therefore, one of the most important tasks in capital
budgeting is estimating future cash flows for a project. Traditional or
Non Discounting Accounting Rate of
Return (ARR)
Calculating Cash Flows
Net Present Value
Particulars No Depreciation is Depreciation is (NPV)
Charged Charged Capital
Budgeting
(RCrore) (RCrore) Techniques Profitability
Total Sales *** *** Index (PI)
Less: Cost of Goods *** *** Time adjusted or

Sold Discounted Cash Internal Rate of
Flows Return (IRR)
*** ***
Less: Depreciation - *** Modified Internal
Rate of Return
Profit before tax *** *** (MIRR)
Tax @ 30% *** *** Discounted
Profit after Tax *** *** Payback Period
Add: Depreciation* - ***

Cash Flow *** ***
Payback Period:
* Being non-cash expenditure, depreciation has been added back
while calculating the cash flow. The payback period of an investment is the length of time required
for the cumulative total net cash flows from the investment to
Statement showing the calculation of Cash equal the total initial cash outlay.
Inflow after Tax (CFAT):
Total initial capital investment
Sl. no. (R) Payback period =
Annual expected after-tax net cash flow
1 Total Sales Units xxx
2 Selling Price per unit xxx Accounting (Book) Rate of Return (ARR):
3. Total Sales [1 × 2] xxx
4. Less: Variable Cost xxx The accounting rate of return of an investment measures the
average annual net income of the project (incremental income) as
5. Contribution [3 - 4] xxx a percentage of the investment.
14
Average annual net income Sum of discounted cash in flows

Accounting rate of return = x 100 Profitability Index (PI) =
Investment Initial cash outlay or Total discounted
cash outflow (as the case maybe)
Net Present Value Technique (NPV):
The net present value technique is a discounted cash flow method Decision Rule:
that considers the time value of money in evaluating capital
investments.
If PI ≥ 1 Accept the Proposal
If PI ≤ 1 Reject the Proposal
n Ct
NPV = ∑ -I In case of mutually exclusive projects; project with higher PI should
(1+ k) t
t =1
be selected.
Where,
C = Cash flow of various years

K = discount rate
N = Life of the project
Internal Rate of Return Method (IRR):
I = Investment
Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected net cash flows
with the initial cash outflow.
Profitability Index /Desirability Factor/
Present Value Index Method (PI): NPV at LR
LR + x (HR-LR)
NPV at LR- NPV at HR
In comparing alternative proposal of comparing, we have to
compare a number of proposals each involving different amounts Where,
of cash inflows. One of the methods of comparing such proposals LR = Lower Rate
is to work out what is known as the ‘Desirability factor’, or
‘Profitability index’ or ‘Present Value Index Method’. HR = Higher Rate
Summary of Decision criteria of Capital

Budgeting techniques:
Techniques For Independent Project For Mutually Exclusive Projects
Non- Pay Back (i) When Payback period ≤ Maximum Project with least Payback period should be
Discounted Acceptable Payback period: Accepted selected
(ii) When Payback period ≥ Maximum

Acceptable Payback period: Rejected
Accounting (i) When ARR ≥ Minimum Acceptable Rate Project with the maximum ARR should be
Rate of of Return: Accepted selected.
Return (ARR) (ii) When ARR ≤ Minimum Acceptable Rate
of Return: Rejected
Discounted Net Present (i) When NPV > 0: Accepted Project with the highest positive NPV should
Value (NPV) (ii) When NPV < 0: Rejected be selected
Profitability (i) When PI > 1: Accepted When Net Present Value is same, project with
Index(PI) (ii) When PI < 1: Rejected Highest PI should be selected
Internal Rate (i) When IRR > K: Accepted Project with the maximum IRR should be
of Return (ii) When IRR < K: Rejected selected
(IRR)

15
CA INTERMEDIATE (NEW) - PAPER 8A – FINANCIAL MANAGEMENT
This edition of capsule of Financial Management introduces the students at Intermediate level to two interesting chapters,
namely ‘Risk Analysis in Capital Budgeting’ and ‘Dividend Decision’, which are added in this subject under new scheme of
syllabus. The level of skills expected at the intermediate level requires understanding the various decisions undertaken to
manage finance i.e. Procurement, investment and distribution of dividend to equity shareholders.
When a proposal for capital investment is forwarded to the management, management relies on the estimated cash flows to
undertake investment decisions. The premises of capital investment decisions rest on the ‘degree of accuracy in estimating
cashflows’ and ‘selection of cut-off ’ rate against which estimated return from the proposal is evaluated. Finance Managers
applies various techniques of risk measurement and factors risk elements while making estimation of cashflows under
risk and uncertainty. The subscribers of equity shares finance the capital investment proposal bearing highest risks in
comparison with other finance providers. Being the highest risk taker equity shareholders expect a ‘return commensurate
with the magnitude of risk borne by them. Managers of finance are required to discover a trade-off point where shareholders’
expectation of return meets with appropriateness of risk adjusted return. ‘Dividend decisions’ covers the various approaches
or models which are widely used and accepted in finance world.
RISK ANALYSIS IN CAPITAL BUDGETING

Points of Discussion Techniques of Risk Analysis
Risk and Uncertainty in capital budgeting Probability
Statistical Variance or Standard

Sources of risks Deviation
Techniques
Coefficient of
Consideration of risks and uncertainities in capital Variation
budgeting
Techniques
of Risk Risk-adjusted
Analysis Conventional discount rate
Techniques used for Analysis of Risks techniques
in Capital
Budgeting Certainty equivalents
Advantages and Limitations of Risk Analysis

Techniques Sensitivity analysis
Others
techniques
Scenario analysis
Risk & Uncertainty and its Measurement

Statistical
• PROBABILITY
Technique:
• Risk is the variability of possible
outcomes from the expected one.
• Uncertainty is a situation when
probability of cash flows are unknown Probability is a measure about the chances
RISK • Risk is measured by the Variance that an event will occur.
or Standard Deviation (SD). SD is a
commonly used tool which measures the
dispersion of possible outcomes around Event certain to occur
the mean. • Probability = 1
No Chance of happening an event

Sources of Risk • Probability = 0
Expected cash flows are assigned a probability factor (Pi)

Project- Company- Industry- and net cash flows are calculated.
Market risk
specific risk specific risk specific risk n
E (R)/ENCF = ∑i=1NCFi×Pi
Where,
Risk due to
E (R)/ENCF = Expected Cash flows
Competition International Pi = Probability of Cash flow
Economic
risk risk
conditions NCFi = Cash flows
The Chartered Accountant Student August 2020 17

16
Example:
The investment
Expectation Cash Flows (R) Probability Expected cash flow (2×3) It enables to For selection
with lower ratio
calculate the between two
(2) (3) (R) of standard
risk borne for projects, a project
deviation
Best guess 3,00,000 0.3 3,00,000×0.3 = 90,000 every unit of which has a
to expected return,
estimated return lower Coefficient
High guess 2,00,000 0.6 2,00,000×0.6 =1,20,000 provides a better
from a particular of Variation is
risk – return trade
Low guess 1,20,000 0.1 1,20,000×0.1 =12,000 investment. selected.
off.
Expected Net cash flow (ENCF) 2,22,000
Statistical Conventional
• VARIANCE
Technique: Technique: • RISK ADJUSTED DISCOUNT RATE (RADR)
It measures the degree of dispersion between numbers A risk adjusted discount rate is a sum of risk
in a data set from its average. free rate and risk premium.
Variance is calculated as below:
+
Risks
Risk free Risk
=
n 2
σ 2 = ∑ (NCFJ − ENCF ) Pj adjusted

j =1 rate premium
discount rate
Where, σ2 = variance in net cash flow;
P = probability and ENCF = expected net cash flow.
The rate of return on Investments that

Risk free bear no risk. For e.g., Government
Variance measures the uncertainty of a value from its average. rate securities yield a return of 6 % and
Thus, variance helps an organization to understand the level of bear no risk. In such case, 6 % is the
risk it might face on investing in a project. risk-free rate.
A variance value of ZERO would indicate that the cash flows that
would be generated over the life of the project would be same.
The rate of return over and above the
risk-free rate, expected by the Investors
Risk as a reward for bearing extra risk.
A LARGE variance indicates that there will be a large variability
Premium For high risk project, the risk premium
between the cash flows of the different years.
will be high and for low risk projects,
the risk premium would be lower.
A SMALL variance would indicate that the cash flows would be
somewhat stable throughout the life of the project.
The required rate of return includes compensation for delay in

consumption plus compensation for inflation equal to risk free
rate of return, plus compensation for any kind of risk taken.
Statistical
• THE COEFFICIENT OF VARIATION
Technique:
If the risk is higher than risk involved in a similar kind of project,
discount rate is adjusted upward in order to compensate this
The Coefficient of Variation calculates the risk borne additional risk borne.
for every percent of expected return.
It is calculated as below:
It is calculated as below:
n
NCF
NPV = ∑ -I
(1+k )
t
Standard Deviation t=0
Coefficient of variation = Expected Return / Expected Cash Flow
Where, NCFt = Net cash flow; K = Risk adjusted discount
rate; I = Initial Investment
18 August 2020 The Chartered Accountant Student
17
Advantages And Limitations Of Risk- Certainty Equivalent Coefficients transform

Adjusted Discount Rate expected values of uncertain flows into their
Certainty Equivalents.
• It is easy to understand.
ADVANTAGES • It incorporates risk premium in the
of RADR Calculation is made as below:
discounting factor.
n αt x NCFt
NPV = ∑t=1 -I
(1+k)t
Where,
• Difficulty in finding risk premium and NCFt = the forecasts of net cash flow for year ‘t’ without
risk-adjusted discount rate. risk-adjustment
LIMITATIONS
of RADR
• Though NPV can be calculated but it αt = the risk-adjustment factor or the certainly
is not possible to calculate Standard equivalent coefficient.
Deviation of a given project. Kf = risk-free rate assumed to be constant for all
periods.
I = amount of initial Investment.
Conventional
• CERTAINTY EQUIVALENT (CE)
Technique:
Certainty In industrial
Equivalent situation,
The value of Coefficient 1 cash flows
To deal with risks in a capital budgeting, risky future cash Certainty indicates that are generally
flows are expressed in terms of the certain cashflows as Equivalent the cash flow uncertain and
their equivalent. Decision maker would be indifferent Coefficient lies is certain or managements
between the risky amount and the (lower) riskless amount between 0 & 1. managements are usually risk
considered to be its equivalent. are risk neutral. averse.
STEPS in the Certainty Equivalent (CE)

Method
Advantages and Disadvantages of CE
• Remove risks by substituting equivalent certain Method
cash flows from risky cash flows
Step-1 • Multiply each risky cash flow by the appropriate
αt value (CE coefficient)
• Simple and easy to understand and apply.

ADVANTAGES • It can easily be calculated for different
of CE Method risk levels applicable to different cash
• Discounted value of cash flow is obtained by flows.
Step-2 applying risk less rate of interest
• Capital budgeting methods are applied except

in case of IRR method
Step-3 • IRR is compared with risk free rate of interest • CEs are subjective and vary as per each
rather than the firm’s required rate of return individual’s estimate.
• CEs are decided by the management
DISADVANTAGES based on their perception of risk.
of CE Method
However, the risk perception of the
shareholders who are the money
CE Coefficient (αt) is calculated as below:
lenders for the project is ignored.
Certain cash flow

CE Coefficient (αt) = Risky or expected cash flow t

18
Risk-Adjusted Discount Rate Vs. Certainty- Steps involved in Sensitivity Analysis
Equivalent:
Finding variables, which have an influence on
the NPV (or IRR) of the project
Step-1
2. Each year's 3. Despite its
Certainty soundness, it is
Equivalent not preferable
Coefficient is like Risk Adjusted Establishing mathematical relationship between
based on level of Discount Rate the variables.
risk impacting its Method. Step-2
cash flow.
1. Certainty Analysis the effect of the change in each of the

4. It is difficult variables on the NPV (or IRR) of the project.
Equivalent to specify
Method is Risk-adjusted Step-3
Discount a series of
superior to Risk Certainty
Adjusted Discount Rate
Vs. Equivalent
Rate Method as it Coefficients
does not assume Certainty-
Equivalent but simple to
that risk increases
with time at
adjust discount Advantages and Disadvantages of Sensitivity
constant rate.
rates. Analysis
• Critical Issues: This analysis identifies

ADVANTAGES critical factors that impinge on a project’s
Other of Sensitivity
Analysis success or failure.
• SENSITIVITY ANALYSIS
Technique: • Simplicity: It is a simple technique.
A modeling technique used in Capital • Assumption of Independence: This

Sensitivity Budgeting decisions to study the analysis assumes that all variables are
Analysis impact of changes in the variables on independent i.e. they are not related to
DISADVANTAGES
the outcome of the project. of Sensitivity each other, which is unlikely in real life.
Analysis • Ignore probability: This analysis does
not look to the probability of changes in
the variables.
As per CIMA terminology,” A modeling and risk

assessment procedure in which changes are made to
significant variables in order to determine the effect Other
of these changes on the planned outcome. Particular Technique: • SCENARIO ANALYSIS
attention is thereafter paid to variables identifies as being
of special significance”
This analysis brings in the

Scenario probabilities of changes in key
Analysis variables and also allows us to change
more than one variable at a time.
In Sensitivity It is a way of
Analysis, the finding impact
The more
project outcome in the project’s Although sensitivity analysis is probably the most widely
sensitive is the
is studied after NPV (or IRR) for used risk analysis technique, it does have limitations.
NPV, the more
taking into a given change Therefore, we need to extend sensitivity analysis to deal
critical is the
change in only in one of the with the probability distributions of the inputs.
variable.
one variable. variables.
In addition, it would be useful to vary more than one
variable at a time so we could see the combined effects of
changes in the variables.
Scenario analysis provides answer to these situations of
extensions.
19
Examining Risk of Investment through Scenario Analysis
In a nutshell Scenario
Then, go for worst Alternatively scenarios
Scenario analysis analysis examine the
case scenario (low unit analysis is possible
begins with base case risk of investment, to
sales, low sale price, where some factors
or most likely set of analyse the impact of
high variable cost and are changed positively
values for the input alternative combinations
so on) and best case and some factors are
variables. of variables, on the
scenario. changed negatively.
project’s NPV (or IRR).
Sensitivity Analysis Vs. Scenario Analysis
SENSITIVITY analysis calculates the impact of the change of a single

input variable on the outcome of the project viz., NPV or IRR. The
sensitivity analysis thus enables to identify that single critical variable
that can impact the outcome in a huge way and the range of outcomes
of the project given the change in the input variable.
Sensitivity Analysis
Vs
Scenario Analysis
SCENARIO analysis, on the other hand, is based on a scenario. The
scenario may be recession or a boom wherein depending on the
scenario, all input variables change. Scenario Analysis calculates the
outcome of the project considering this scenario where the variables
have changed simultaneously.
DIVIDEND DECISIONS
Points of Discussion Significance of Dividend policy
Meaning of Dividend and its significance Long Term Financing Decision:
Whether to retain or
Forms of Dividend distribute the profit forms
Equity can be raised
externally through issue the basis of the Dividend
of equity shares or can decision. Since payment of
be generated internally cash dividend reduces the
Determinants of Dividend Decisions through retained earnings. amount of funds necessary
But retained earnings are to finance profitable
preferable because they do investment opportunities
not involve floatation costs. thereby restricting it to find
Theories of Dividend other avenues of finance.
Meaning, Advantages and Limitations of Stock split

The decision is based on the
following
Meaning of Dividend and its Significance
Dividend is the part of profit after tax which is distributed to
the shareholders of the company.
Whether the Whether the return on

Distributed Dividend organization has such investment (ROI)
Profit after opportunities in hand will be higher than
tax to invest the amount of the expectations of
Retained profits, if retained? shareholders i.e. Ke?
Retained
Earnings

20
Wealth Maximization Decision: Advantages and Limitations of Stock

Dividend
Because of market imperfections and uncertainty,
shareholders give higher value to near dividends • Policy of paying fixed dividend per share and
than future dividends and capital gains. its continuation increases total cash dividend
of the shareholders in future
ADVANTAGES • Conservation of cash for meeting profitable
Payment of dividends influences the market price of OF STOCK investment opportunities.
the share. Higher dividends increase value of shares DIVIDEND • Cash deficiency and restrictions imposed by
and low dividends decrease it.
lenders to pay cash dividend
When the firm increases retained earnings,

shareholders' dividends decrease and consequently
market price is affected. • Stock dividend does not affect the wealth of
shareholders and therefore it has no value for
LIMITATIONS them
OF STOCK • Stock dividends are more costly to administer
Use of retained earnings to finance profitable DIVIDEND than cash dividend
investments increases future earnings per share.
On the other hand, increase in dividends may cause the

firm to forego investment opportunities for lack of funds
and thereby decrease the future earnings per share. Determinants of Dividend Decisions
Availability of funds
Thus, management should develop a dividend policy
which divides net earnings into dividends and
retained earnings in an optimum way so as to achieve Cost of capital
the objective of wealth maximization for shareholders.
Capital structure
Stock price
Such policy will be influenced by investment
opportunities available to the firm and value of
dividends as against capital gains to shareholders. Investment opportunities in hand
Factors affecting
Dividend
Decision Internal rate of return
Forms of Dividend
Trend of industry
Forms of Expectation of shareholders

dividend
Legal constraints
Taxation
Cash Stock dividend
dividend (Bonus Shares) Practical Considerations in Dividend Policy
A discussion on internal financing ultimately turns to

When the company practical considerations which determine the dividend
policy of a company.
issues further
Cash here means shares to its existing
cash, cheque, warrant, shareholders without
demand draft, pay consideration, it is called The formulation of dividend policy depends upon
order or directly bonus shares. Such answers to the questions:
through Electronic shares are distributed
Clearing Service (ECS) proportionately thereby Whether there should be a Whether the company should
but not in kind. retaining proportionate stable pattern of dividends treat each dividend decision
ownership of the over the years. completely independent.
company.
21
Theories of Dividend
Theories of Dividend
Irrelevance
Theory Relevance Theory
Other Models
(Dividend is (Dividend is relevant)
ireevelant)
M.M. Walter's Gordon's Dividend Discount Graham & Dodd's Linter's

Approach Model Model Model (DDM) Model Model
Dividend's
• MODIGLIANI and
Advantages and Limitations of MM
Irrelevance MILLER (M.M) HYPOTHESIS Hypothesis
Theory
• This model is logically consistent.

• It provides a satisfactory framework on
According to MM hypothesis, market value of equity shares ADVANTAGES dividend policy with the the concept of
of MM Arbitrage process.
depends solely on its earning power and is not influence by the Hypothesis
manner in which its earnings are split between dividends and
retained earnings.
• Validity of various assumptions is
Market value of equity shares is not affected by dividend size. questionable.
LIMITATIONS • This model may not be valid under
of MM uncertainty.
Hypothesis
Assumptions of MM Hypothesis:
No taxes No Risk of Dividend's

Perfect Fixed
or no tax floatation or uncertainty relevance • WALTER'S MODEL
capital investment
discrimi- transaction does not Theory
markets policy
nation cost exist
As per Walter's Model, in the long run, share prices reflect

Price of shares is calculated as below:
only the present value of expected dividends. Retentions
P1 +D1 influence stock prices only through their effect on further
P₀ = 1+K e dividends.
Where,
P₀ = Price in the beginning of the period.
P₁ = Price at the end of the period. As per Walter's Model, two factors which influence the
D₁ = Dividend at the end of the period. market price of a share are (i) Dividend per share and
Ke = Cost of equity/ rate of capitalization/ discount rate. (ii) Relationship between IRR and Ke.
As per MM hypothesis, the value of firm will remain

unchanged due to dividend decision. The relationship between dividend and share price based on
Walter’s formula is shown below:
This can be computed with the help of the following
r
formula: D+ (E - D)
(n + ∆n) P₁ - I + E Market Price (P) = Ke
Vf or nP₀ = Ke
(1 + Ke )
Where, Where,
Vf = Value of firm in the beginning of the period P = Market Price of the share.
n = number of shares in the beginning of the period E = Earnings per share.
∆n = number of shares issued to raise the funds required D = Dividend per share.
I = Amount required for investment Ke = Cost of equity/ rate of capitalization/ discount rate.
E = total earnings during the period r = Internal rate of return/ return on investment

22
Assumptions of Walter's Model
All investment No taxes

‘r’ rate of No
proposals or no tax The
return & Perfect floatation
are financed discrimination firm has
‘Ke’ cost of capital or
through between perpetual
capital are markets. transaction
retained dividend and life.
constant. cost.
earnings only. capital gain.
Conclusion of Walter’s Model

• The formula does not consider all the factors
Company Condition Correlation between O p t i m u m affecting dividend policy and share prices.
of r vs Ke Size of Dividend dividend payout • Determination of market capitalisation rate is
and Market Price of ratio LIMITATIONS difficult.
share of Walter’s • The formula ignores such factors as taxation,
Model various legal and contractual obligations,
Growth r > Ke Negative Zero
management policy and attitude towards
Constant r = Ke No correlation Every payout dividend policy and so on
ratio is optimum
Decline r < Ke Positive 100%
Dividend's
• Company is able to invest/utilize the relevance • GORDON'S MODEL
Growth fund in a better manner. Shareholders Theory
Company: can accept low dividend because their
value of share would be higher.
According to Gordon’s model, when IRR is greater than

cost of capital, the price per share increases and dividend
pay-out decreases. On the other hand when IRR is lower
• Company is not in a position to cover than the cost of capital, the price per share decreases and
Decline the cost of capital; shareholders dividend pay-out increases.
would prefer a higher dividend to
Company: utilize their funds in more profitable
opportunities.
The following formula is used by Gordon to find out price
per share:
Advantages and Limitations of Walter’s
Model P0 =
E1(1-b)
Ke -br
• Simple to understand and easy to compute. Where,
• It can envisage different possible market P₀ = Price per share
prices in different situations and considers
internal rate of return, market capitalisation E1 = Earnings per share
ADVANTAGES
of Walter’s rate and dividend payout ratio in the b = Retention ratio; (1 - b = Payout ratio)
Model determination of market value of shares. Ke = Cost of capital
r = IRR and br = Growth rate (g)
Assumptions of Gordon's Model
Investment
Retention proposals
Firm is an Growth
IRR will Ke will ratio (b), are financed
all equity rate (g =
remain remains once decide Ke > g through
firm i.e. no br) is also
constant. constant. upon, is retained
debt. constant.
constant. earnings
only.
23
Conclusion of Gordon’s Model
Company Condition of Optimum dividend payout Other • DIVIDEND DISCOUNT MODEL

ratio Models (DDM)
r vs Ke
Growth r > Ke Zero
Constant r = Ke There is no optimum ratio
It is a financial model that values shares at the discounted
Declining r < Ke 100% value of the future dividend payments. Under this model,
the price of a share will be traded is calculated by the PV
of all expected future dividend payment discounted by
The "Bird-in-Hand" Theory an appropriate risk- adjusted rate. The dividend discount
model price is the intrinsic value of the stock.
Myron Gordon revised his dividend model and considered the risk
and uncertainty in his model.
Intrinsic value Sum of PV of future cash flows

Bird-in-hand theory of
Gordon has two arguments
Intrinsic value Sum of PV of PV of Stock Sale

Dividends Price
Investors put a
Investors are premium on certain
D1 D2 Dn RVn
risk averse return and discount on Stock Intrinsic Value = + +.....+ +
(1+Ke)1 (1+Ke)2 (1+Ke)n (1+Ke)n
uncertain return
Gordon argues that what is available at present is preferable to what

may be available in the future. As investors are rational, they want Dividend Discount Model (Possible
to avoid risk and uncertainty. They would prefer to pay a higher situation)
price for shares on which current dividends are paid. Conversely,
they would discount the value of shares of a firm which postpones
dividends. The discount rate would vary with the retention rate.
Dividend Discount
Model
Relationship between Dividend and Share (Possible situation)
Price on the basis of Gordon's formula
 D0 (1+g) 
Market price per share(P0) =  
 Ke - g 
Where, Constant Variable
Zero Growth
Growth Growth
P₀ = Market price per share (ex-dividend)
D₀ = Current year dividend
g = Constant annual growth rate of dividends
Ke = Cost of equity capital (expected rate of return).
Zero growth rates: It assumes all dividend paid by a stock
remains same.
Advantages and Limitations of Gordon’s
Model
In this case the stock price would be equal to:
• A useful heuristic model that relates the
present stock price to the present value of its Annual dividend
Stock's intrinsic Value =
ADVANTAGES future cash flows. Requied rate of return
of Gordon’s • Easy to understand.
Model
D
i.e. P₀ =
Ke
• Model depends on projections about company
growth rate and future capitalization rates Where,
of the remaining cash flows, which may be D = Annual dividend
LIMITATIONS difficult to calculate accurately. Ke = Cost of capital
of Gordon’s • The true intrinsic value of a stock is difficult
Model P₀ = Current Market price of share
to determine realistically.

24
Constant Growth Rate (Gordon’s Growth Model): It assumes

Other
constant growth of dividend. • LINTER's MODEL
Models
The relationship between dividend and share price on the

basis of Gordon’s formula is:
Under Linter’s model, the current year’s dividend is dependent
D0 (1+ g) on current year’s earnings and last year’s dividend.
Market price per share (P) =
Ke - g
Where, Parameters
P = Market price per share (ex-dividend)
D₀ = current year dividend The target The spread at which current
g = growth rate of dividends payout ratio dividends adjust to the target
Ke = cost of equity capital/ expected rate of return
The formula is given below:
Notes:
g = b × r D1 = D₀ + [(EPS ×Target payout) - D₀] × Af
b = proportion of retained earnings or (1- dividend Where,
payout ratio) D1 = Dividend in year 1
D₀ = Dividend in year 0 (last year dividend)
Variable growth rate: Variable-growth rate models
EPS = Earnings per share
(multi-stage growth models) can take many forms, even Af = Adjustment factor or Speed of adjustment
assuming the growth rate is different for every year.
The following are the assumptions of Linter’s Model:
However, the most common form is one that assumes 3 different

rates of growth: an initial high rate of growth, a transition to More concern Dividend Managers are
slower growth, and lastly, a sustainable, steady rate of growth. Firm have on changes in changes follow reluctant to
a long term dividends than changes in affect dividend
dividend the absolute long run changes that
payout ratio. amounts of sustainable may have to
Basically, the constant-growth rate model is extended, with each dividends. earnings. be reversed.
phase of growth calculated using the constant-growth method,
but using 3 different growth rates of the 3 phases.
Criticism of Linter’s Model

The present values of each stage are added together CRITICISM of
to derive the intrinsic value of the stock. Linter’s Model
Adjustment factor is an arbitrary

Sometimes, even the capitalization rate, or the required rate of Does not offer a market number and not based on any
return, may be varied if changes in the rate are projected. price for the shares scientific criterion or method
Stock Splits
Other
Models • GRAHAM & DODD's MODEL Splitting one share into many,
Stock Splits say, one share of R500 in to
5 shares of R100
The stock market places considerably more weight on Advantages and Limitations of Stock Splits
dividends than on retained earnings.
• Makes the share affordable to small investors.
• Number of shares may increase the number
The formula is given below: ADVANTAGES of shareholders.
of Stock Splits
 E
P = mD + 
 3
• Additional expenditure need to be incurred
Where, on the process of stock split.
• Low share price may attract speculators or
P = Market price per share
LIMITATIONS short term investors, which are generally not
D = Dividend per share of Stock Splits preferred by any company.
E = Earnings per share
m = a multiplier
25
MANAGEMENT OF WORKING CAPITAL
Chapter Overview Receivables Higher Credit Evaluate Cash sales
period attract the credit provide
customers policy; use liquidity but
and increase the services fails to boost
Management of revenue of debt sales and
Working Capital management revenue
(factoring)
agencies.
Cash (Treasury) Pre- Reduces Cost-benefit Improves or
Determinants of Management: payment of uncertainty analysis maintains
Working Capital expenses and profitable required liquidity.
• Functions of Treasury
Department in inflationary
environment.
• Treasury Management
Estimation of Working • Cash Management Cash and Payables are Cash budgets Cash can be
Capital Models Cash honoured and other cash invested in
equivalents in time, management some other
improves the techniques can investment
goodwill and be used avenues
Working Capital helpful in
Cycles getting future
discounts.
Payables Capital can Evaluate the Payables are
Inventory and be used in credit policy honoured in
Management Expenses some other and related time, improves
investment cost. the goodwill
Receivable Management: avenues and helpful in
Payables Management • Factors determining getting future
Credit Policy discounts.
• Financing of Receivables
• Monitoring of Rece
Investment and Financing
Financing of Working
Capital
Working Capital: In accounting term working capital is the Investment in working

difference between the current assets and current liabilities. capital is concerned with
the level of investment in Financing decision
the current assets. concerned with the
Working Capital = Current Assets – Current Liabilities arrangement of funds to
finance the working capital.
Scope of Working Capital Management

Approaches of Working Capital investment
Scope of Working Capital Management
Aggressive Moderate Conservative

Liquidity and Investment and
Profitability Financing
•Here investment in working capital is kept at

Aggressive minimal investment in current assets which means
Liquidity vs Profitability: The trade-off between the the entity does hold lower level of inventory, follow
components of working capital can be summarised as follows: strict credit policy, keeps less cash balance etc.
Component Advantages Trade-off Advantages •In this approach of organisation use to invest
of Working of higher side (between of lower side high capital in current assets. Organisations use to
Conservative keep inventory level higher, follows liberal credit
Capital (Profitability) Profitability (Liquidity)
and Liquidity) policies, and cash balance as high as to meet any
current liabilities immediately.
Inventory Fewer Use Lower
stock- outs techniques inventory
increase the like EOQ, JIT requires less •This approach is in between the above two
profitability. etc. to carry capital but approaches. Under this approach a balance
optimum level endangered Moderate
between the risk and return is maintained to gain
of inventory. stock-out and more by using the funds in very efficient manner.
loss of goodwill.
26
The various components of Operating Cycle
may be calculated as shown below:
(1) Raw Material Avereage stock of Raw material

=
A Storage Period Average Cost of Raw material
Level of current assets
Consumption per day

Conservative policy
(2) Work-in-Progress Avg Work-in-progress inventory
B holding period =
Average Cost of Production per day
Average policy
(3) Finished Average stock of finished goods
=
c Goods storage Average Cost of Goods Sold per
period day
Aggressive policy
(4) Receivables Average Receivables
(Debtors) =
collection period Average Credit Sales per day
Fixed asset level
Output (5) Credit period Average Payables
allowed by suppliers =
(Creditors) Average Credit Purchases
per day
Operating/ Working Capital Cycle: Working Capital cycle
indicates the length of time between a company’s paying for
materials, entering into stock and receiving the cash from sales
of finished goods. Estimation of Amount of Different Components
of Current Assets and Current Liabilities
Working Capital Cycle (i) Raw Materials Inventory:
Estimated Production (units)

× Estimated Cost per unit × Average
12 months / 365 days * raw material storage period
Cash
(ii) Work-in-Progress Inventory:

× Estimated WIP cost per unit ×
12 months / 365 days * Average W-I-P holding period
Receivables Raw Material Labour
Overhead (iii) Finished Goods:
× Estimated Cost of production per
12 months / 365 days * unit × Average storage period
(iv) Receivables (Debtors):
Estimated Credit Sales unit

×Cost of sales (excluding depreciation)
12 months / 365 days * per unit × Average collection period
Stock WIP
(v) Cash and Cash equivalents: Minimum desired Cash and Bank
balance to be maintained
(vi) Trade Payables (Creditors):

In the form of an equation, the operating cycle process can be
expressed as follows:
Estimated credit purchase × Credit period allowed by suppliers
12 months / 365 days *
Operating Cycle = R + W + F + D – C (vii) Direct Wages:

Estimated labour hours x wages
Where, rate per hour
×Average time lag in
12 months / 365 days * payment of wages
R = Raw material storage period
(viii) Overheads (other than depreciation and amortization):
W = Work-in-progress holding period
F = Finished goods storage period Estimated Overheads ×Average time lag in payment of
D = Receivables (Debtors) collection period. 12 months / 360 days * overheads
C = Credit period allowed by suppliers (Creditors).
*Number of days in a year may be taken as 365 or 360 days.

27
Estimation of Working Capital Requirements (e) Expected Net .…….. ……….. ……… ……….
Profit before Tax
(a-b-c-d)
Amount Amount Amount
(f ) Less: Tax ……... ……….. ………. ………
I. Current Assets:
(g) Expected ..……. ……… ……… ………
Inventories: Profit after Tax
- Raw Materials --- B. Opportunity ..…… ……… ………. ………
Cost of
- Work-in-process --- Investments
- Finished goods --- --- in Receivables
locked up in
Receivables: Collection
Period
- Trade debtors ---
Net Benefits ……… ……… ……… ……….
- Bills --- --- (A – B)
Minimum Cash Balance ---
Gross Working Capital --- --- Statement showing the Evaluation of Credit Policies (based on
Incremental Approach)
II. Current Liabilities:
Trade Payables ---
Particulars Present Proposed Proposed Proposed
Bills Payables --- Policy Policy I Policy II Policy III
days days days days
Wages Payables ---
Payables for overheads --- --- RS RS RS RS
III. Excess of Current Assets --- A. Incremental
over Current Liabilities Expected Profit:
[I – II]
IV. Add: Safety Margin --- Credit Sales ………. …………. ……….. ……….
V. Net Working Capital [III --- (a) Incremental ………. …………. ……….. ……….
+ IV] Credit Sales
(b) Less:
MANAGEMENT OF RECEIVABLES Incremental
Costs of Credit
Sales
Approaches of Evaluation of Credit Policies
(i) Variable Costs ………. …………. ……….. ……….
There are basically two methods of evaluating the credit policies to be (ii) Fixed Costs ………. …………. ……….. ……….
adopted by a Company – Total Approach and Incremental Approach.
The formats for the two approaches are given as under: (c) Incremental ………. …………. ……….. ……….
Statement showing the Evaluation of Credit Policies (based on Bad Debt Losses
Total Approach)
(d) Incremental ………. …………. ……….. ……….
Cash Discount
Particulars Present Proposed Proposed Proposed
Policy Policy I Policy II Policy III (e) Incremental ………. …………. ……….. ……….
Expected Profit
RS RS RS RS (a-b-c-d)
(f) Less: Tax ………. …………. ……….. ……….

A. Expected
Profit:
(g) Incremental ………. …………. ……….. ……….
(a) Credit Sales ………. …………. ……….. ………. Expected Profit
after Tax
(b) Total Cost
other than Bad ………. …………. ……….. ……….
Debts and Cash
Discount B. Required
Return on
(i) Variable Costs ………. …………. ……….. ………. Incremental
Investments:
(ii) Fixed Costs ………. …………. ……….. ……….
(a) Cost of ………. …………. ……….. ……….
……… ………. ………. ……..
Credit Sales
(c) Bad Debts ………. …………. ……….. ……….
(b) Collection ………. …………. ……….. ……….
(d) Cash discount Period (in days)
28
Financing of Receivables
(c) Investment in ………. …………. ……….. ……….
Receivable (a x
b/365 or 360) (i) Pledging: This refers to the use of a firm’s receivable to secure a
short term loan.
(d) Incremental ………. …………. ……….. ……….
Investment in (ii) Factoring: This refers to outright sale of accounts receivables to a
Receivables factor or a financial agency.
(e) Required Rate of ………. …………. ……….. ………. Factor

Return (in %) Customers send The factor pays
payment to the an agreed-upon
(f) Required Return ………. …………. ……….. ……….
factor percentage of the
on Incremental
Investments accounts receivable
(d x e) to the firm.
Incremental Net ………. …………. ……….. ………. Customer Firm

Benefits (A – B)
Goods
The basic format of evaluating factoring proposal is given as under:

Statement showing the Evaluation of Factoring Proposal
Particulars rs
A. Annual Savings (Benefit) on taking Factoring Service
Cost of Credit Administration saved ………...
Bad Debts avoided …………
Interest saved due to reduction in Average collection period (Wherever applicable) …………
[Cost of Annual Credit Sales × Rate of Interest × (Present Collection Period – New Collection Period)/360* days]
Total ………..
B. Annual Cost of Factoring to the Firm:
Factoring Commission [Annual credit Sales × % of Commission (or calculated annually)] ………..
Interest Charged by Factor on advance (or calculated annually ) ………...
[Amount available for advance or (Annual Credit Sales – Factoring Commission – Factoring Reserve)] ×
[ Collection Period (days)

x Rate of Interest]
360 *
Total ………..
C. Net Annual Benefits/Cost of Factoring to the Firm: ………..
Rate of Effective Cost of Factoring to the Firm
Net Annual cost of Factoring
= x 100 or
Amount available for advance
Net annual Cost of Factoring

x 100
Advances to be paid
Advances to be paid = (Amount available for advance – Interest deducted by factor)

29
ECONOMICS FOR FINANCE
CA INTERMEDIATE - PAPER 8B - ECONOMICS FOR FINANCE
At the Intermediate level , students are expected to not only acquire professional knowledge but also the ability to apply
such knowledge in problem solving. In this capsule for students, an attempt has been made to capture the significance
and importance of the subject of Economics for Finance with the intention to assist in revision of concepts discussed in
the study material.
National Income
National Income Importance
Net Value of all economic goods and services produced within • For analyzing and evaluating the performance of an economy,
the domestic territory of a country in an accounting year plus • Knowing the composition and structure of the national income,
net factor income abroad. • Income distribution, economic forecasting and for choosing
economic policies and evaluating them.
Determination of National Income
National Income Accounting
Different concepts Measurement of National Limitations and Challenges of

of National Income Income in India National Income Computation
Gross National Net National Grorss Domestic Net Domestic Per Capita Personal Disposable
Product Product Product Product Income Income Income
GNP at NNP at GDP at NDP at

Market Prices Market Prices Market Prices Market Prices
GNP at NNP at GDP at NDP at

Factor Cost factor Cost Factor Cost Factor Cost
GNP MP NDP MP NNP MP Market Price

= GDP MP + Net Factor = GDPMP - Depreciation =GNPMP - Depreciation = Factor Cost + Net Indirect
Income from Abroad = NNPMP - Net Factor Income =NNPMp = NDPMP + Ner Factor Taxes= Factor Cost + Indirect
from Abroad Income from abroad Taxes – Subsidies
=NNPMP = GDPMP + Net
Factor Income from Abroad -
Depreciation
Net Domestic Product at Factor Private Income = Factor income

Cost (NDPFC) is defined as the from net domestic product
Factor Cost = Market Price - Gross Domestic Product at total factor incomes earned by accruing to the private sector +
Net Indirect Taxes = Market Factor Cost (GDPFC) the factors of production. Net factor income from abroad +
Price - Indirect Taxes + = GDPMP – Indirect Taxes + = NDPFC = NDPMP - Net National debt interest + Current
Subsidies Subsidies Indirect Taxes transfers from government +
Other net transfers from the rest
of the world.
Personal income is a measure

of the actual current income
receipt of persons from all Disposable Personal Income
sources. (DI) that is available for their
PI = NI + income received but consumption or savings DI = PI
not earned - income earned but - Personal Income Taxes
not received.

30
Product Method or Value Added Method is also called Industrial Origin
Value added Method or Method or Net Output Method and entails the consolidation of the
Production Method production of each industry less intermediate purchases from all other
Measurement of National Income
industries.
Under income method, national income is calculated by summation

Income method of factor incomes paid out by all production units within the domestic
territory of a country as wages and salaries, rent, interest, and profit.
Transfer incomes are excluded.
Under the expenditure approach, also called Income Disposal Approach,

Expenditure method national income is the aggregate final expenditure in an economy during
an accounting year composed of final consumption expenditure, gross
domestic capital formation and net exports.
1 2 3
• Gross value added • NNP FC or • GDPMP
(GVA MP) = National Income= =Private final
Production Method
Income Method
Expenditure Method
Value of output Compensation consumption
– Intermediate of employees+ expenditure+
consumption= Operating Surplus Governmentfinal
(Sales + change (rent + interest+ • consumption
in stock) – profit)+ Mixed expenditure +
Intermediate Income of Self- Gross domestic
consumption employed+ Net capital formation
Factor Income (Net domestic
from Abroad capital formation+
depreciation) +
Net export
The Keynesian theory of Determination of Circular Flow in a Two Sector Economy

National Income Wages, Rent, Interest, Profit
Factor Payments
The Keynesian theory (Y)
Determination of of Determination of Factor inputs
National Income National Income
Households Firms
Two -Sector Three Sector Four Sector The
Model Model Model Investment
Multiplier Goods and
Services (O)
Consumption
Expenditure (C)
• The classical economists maintained that the economy is self-
regulating and is always capable of automatically achieving
equilibrium at the ‘natural level’ of real GDP or output, which
is the level of real GDP that is obtained when the economy's • In the two-sector economy aggregate demand (AD) or aggregate
resources are fully employed. While circumstances arise from expenditure consists of only two components: aggregate demand
time to time that cause the economy to fall below or to exceed for consumer goods and aggregate demand for investment goods,
the natural level of real GDP, wage and price flexibility will bring I being determined exogenously and constant in the short run.
the economy back to the natural level of real GDP. • Consumption function expresses the functional relationship
• Keynes argued that markets would not automatically lead to between aggregate consumption expenditure and aggregate
full-employment equilibrium and the resulting natural level of disposable income, expressed as C = f (Y). The specific form
real GDP. The economy could settle in equilibrium at any level of consumption function, proposed by Keynes C = a + bY
unemployment. Keynesians believe that prices and wages are not • The value of the increment to consumer expenditure per unit of
so flexible; they are sticky, especially downward. increment to income (b) is termed the Marginal Propensity to
Consume (MPC).
31
Inflationary Gap
Determination of Equilibrium Income: Two Excess demand gives rise to ‘inflationary gap’ which is the amount
Sector Model by which actual aggregate demand exceeds the level of aggregate
demand required to establish the full employment equilibrium.
(A)
Y
Aggegate
C+S Demand
Aggregate Demand
C+I<C+S E (C+I)0
B Inflationary Gap
C+I G (C+I)1
C+I=C+S
E C
C+I>C+S
A }
F
> 45°
O Y1 Y0 Y2 X
(B)
Saving / Investment
S
45°
S=I O
Q* M Output, Income
I I
E
O Y1 Y0 Y2 X
CIRCULAR FLOW IN THREE SECTOR MODEL
Income, Output
Y1 Goods and Services Goods and Services
Expenditures on Product ConsumptionExpenditures

Domestic Products Market
Investment Expenditure
Deflationary Gap Govt. Purchases
Deflationary gap is thus a measure of the extent of deficiency of
aggregate demand, and it causes the economy’s income, output, Subsidies Transfer
Payments
and employment to decline, thus pushing the economy to under- Business Government Taxes
Household
Taxes
employment equilibrium.
Government
Borrowings
Aggegate
Demand (C+I)0 Financial
F (C+I)1 Investment
Market
Savings
} (C+I)0
Factor Payments Personal Income
G Factor
Factor Services Market Factor Services
E Deflationary
Gap
• Aggregate demand in the three-sector model of closed economy

(neglecting foreign trade) consists of three components namely,
household consumption(C), desired business investment
demand(I) and the government sector’s demand for goods and
45° services(G).
O • The government sector imposes taxes on households and
M Q* Output, Income
business sector, effects transfer payments to household sector
and subsidy payments to the business sector, purchases goods
and services and borrows from financial markets.
• In equilibrium, it is also true that the (S + T) schedule intersects
the (I + G) horizontal Schedule.

32
Determination of Equilibrium Income: Three • The four-sector model includes all four macroeconomic sectors,
Sector Model the household sector, the business sector, the government sector,
and the foreign sector and in equilibrium, we have Y = C + I + G
+ (X-M)
C,I,G • The domestic economy trades goods with the foreign sector
(A)
(Y=C+S+T) through exports and imports.
C+I+G • Imports are subtracted from exports to derive net exports, which
E1
Aggregate Expenditure
is the foreign sector's contribution to aggregate expenditures.

C+I If net exports are positive (X > M), there is net injection and
E national income increases. Conversely, if X<M, there is net
C withdrawal and national income decreases
G
I Determination of Equilibrium In-

come: Four Sector Model
Y C+S+T
45° (A)
O C+I+G+(X-M)
S,I,G Y Y1 Income (Output)
Aggegate Expenditure
E
(B)
Injections/leakages
S+T
E1
I+G 45°
G E
I O Y Income (Output)
(B) S+T+M
I,G,X,S,T,M
O Y Y1 +
Income (Output)
Injections/leakages
I+G+X
Circular Flow in a Four Sector

C
Y
Economy Income (Output)
Net Capital Inflow Rest of the

World
Exports
Public Finance
Imports
Expenditure on Consumption
Domestic Products Product Expenditure
Govt. Purchases Public Finance
Market
Investment Expenditure
Fiscal Functions:
Subsidies Transfer
Payments An Overview
Business Government Taxes Households
Taxes
Government
Borrowings
Allocation Redistribution Stablization
Financial Function Function Function
Investment Market Savings
Factor Payments Personal Income

Factor
Market
• Since the 1930s, the traditional functions of
the state have been supplemented with the
economic functions (also called the fiscal
functions or the public finance function)
Public • Richard Musgrave (1959) introduced the three
Finance branch taxonomy of the role of government in
a market economy namely, resource allocation,
income redistribution and macroeconomic
stabilization
33
• Government intervention to direct the • Negative production externalities

functioning of the economy is based on the
Government belief that the objective of the economic system
Types of • Positive Production externalities
Intervention and the role of government is to improve the
Externalities • Negative consumption externalitied
• Positive consumption externalities
wellbeing of individuals and households.
• The allocation responsibility of the • Externalities cause market inefficiencies

governments involves appropriate corrective
Allocation action when private markets fail to provide the
because they hinder the ability of market
Function prices to convey accurate information
right and desirable combination of goods and Causes of
about how much to produce and how
services Externalities
much to buy. Since externalities are not
reflected in market prices, they can be a
source of economic inefficiency
• Market failures, which hold back the efficient
allocation of resources, occur mainly due to
imperfect competition, presence of monopoly
Market power, collectively consumed public goods, • Public goods do not conform to the
Failures externalities, factor immobility, imperfect settings of market exchange and left to
Public
information, and inequalities in the distribution the market, they will not be produced
Goods
of income and wealth. at all or will be underproduced. This is
because the price becomes zero.
• The distribution function aims at redistribution

of income so as to ensure equity and fairness • Private goods are ‘rivalrous’ ‘and
Distribution to promote the wellbeing of all sections of Private
excludable’ and less likely to have the
Function people and is achieved through taxation Good
free rider problem. Additional resource
public expenditure, regulation and preferential costs are involved for providing to
treatment of target populations. another individual.
• The stabilization function is concerned with • The quasi-public goods or services,

the performance of the aggregate economy also called a near public good (for e.g.
Quasi Public
Stabilization in terms of labour employment and capital
Goods
education, health services) possess nearly
Function utilization, overall output and income, general all of the qualities of the private goods
price levels, economic growth and balance of and some of the benefits of public good.
international payments.
• Complete information is an essential

Public Finance element of competitive market. But it is
Asymmetric
not fully satisfied in real world markets
information
for goods or services due to highly
complex nature of products
Market Failure
Minimise Market
Market Public Incomplete Power
Power Externalities Information
Goods
Correct
Externalities
Public Finance
Government
Unit-II Market Failure intervention to Mertit and
correct Market Demerit Goods
Failure
Externalities, also referred to as 'spillover
effects', 'neighbourhood effects' 'third-party Correctiong
effects' or 'side-effects', occur when the Information Filure
Externalities actions of either consumers or producers
result in costs or benefits that do not reflect Equitable
as part of the market therefore are external Distribution
to the market.

34
Market Outcomes of Pollution Tax
As Supplier Public
• Pollution taxes are difficult to determine and administer due
Goods/ Information
to difficulty to discover the right level of taxation, problems
associated with inelastic nature of demand for the good and the
Government Intervention
Direct As buyer / problem of possible capital flight

Procurement • Direct provision of a public good by government can help
overcome free- rider problem which leads to market failure. The
non-rival nature of consumption provides a strong argument for
Taxes /Subsidies the government rather than the market to provide and pay for
to alter costs public goods
Indirect
Cost/ Marginal private cost
Regulation/ benefit plus taxes
influence Marginal social cost
C Marginal private cost
Common Access Resources A1
B
Common access resources or common pool resources are a special P1
class of impure public goods which are non-excludable as people P A
cannot be excluded from using them. These are rival in nature
and their consumption lessens the benefits available for others.
Examples of common access resources are fisheries, forests, Marginal Social Benefit
backwater etc
Tragedy of the Commons Q1 Q Quantity

'The Tragedy of the Commons' (1968). Economists use the term to
describe the problem which occurs when rivalrous but non excludable Effect of Subsidy on Output
goods are overused to the disadvantage of the entire world.
• Subsidy is market-based policy and involves the government
paying part of the cost to the firms in order to promote the
Global Public Goods
production of goods having positive externalities.
Global public goods are those public goods with benefits /costs • Two of the most common types of individual subsidies are
that potentially extend to everyone in the world. These goods have welfare payments and unemployment benefits.
widespread impact on different countries and regions, population
groups and generations throughout the entire globe.
P
S=MPC=MSC
The Free Rider Problem
A free rider is a person who benefits from something without S=E
expending effort or paying for it. In other words, free riders are
those who utilize goods without paying for their use. Example is
Wikipedia
Incomplete Information
Complete information is an important element of competitive
market. Perfect information implies that both buyers and sellers MSB
have complete information about anything that may influence
their decision making Q Q *
Quantity
Asymmetric Information
Market Outcome for Merit Goods
Asymmetric information occurs when there is an imbalance in
• Left to the market, merit goods are likely to be under-produced
information between the buyer and the seller i.e., when the buyer
and under- consumed so that social welfare will not be maximized.
knows more than the seller, or the seller knows more than the
buyer. This can distort choices. • When governments provide merit goods, it may give rise to
large economies of scale and productive efficiency and there will
be substantial demand for the same.
Adverse Selection
Cost/
Adverse selection generally refers to any situation in which one party benefit
to a contract or negotiation, such as a seller, possesses information Marginal Private cost
relevant to the contract or negotiation that the corresponding
party, such as a buyer, does not have; this asymmetric information B Marginal social cost
leads the party lacking relevant knowledge to make suboptimal A Welfare loss
decisions and suffer adverse effects. P from
underproduction/
C underprovision
Moral hazard
MPB=MSB
Moral hazard is opportunism characterized by an informed
person’s taking advantage of a less-informed person through an
unobserved action Q Q* Quantity
35
Market Outcome of Minimum Support Price
• Fiscal policy involves the use of government spending, taxation
Government usually intervenes in many primary markets which are and borrowing to influence both the pattern of economic activity
subject to extreme as well as unpredictable fluctuations in price. For and level of growth of aggregate demand, output, and employment.
example, in India, in the case of many crops the government has • The significance of fiscal policy as a strategy for achieving
initiated the Minimum Support Price (MSP) programme as well as certain socio-economic objectives was not recognized or widely
procurement by government agencies at the set support prices. acknowledged before 1930 due to the faith in the limited role
of government advocated by the then prevailing laissez- faire
Price S approach.
Rs.
• Fiscal policy is in the nature of a demand-side policy.
150 Price floor
75
Expansionary Fiscal policy for
Combating Recession
D
Q Quantity
Q1 Q2 An expansionary
fiscal policy is used
to address recession and
Market Outcome of Price Ceiling the problem of general
unemployment on
Price ceilings prevent a price from rising above a certain level. account of
When a price ceiling is set below the equilibrium price, quantity business cycles.
demanded will exceed quantity supplied, and excess demand or
shortages will result. For example: maximum prices of food grains
and essential items are set by government during times of scarcity. Price LAS SAS1
A price ceiling which is set below the prevailing market clearing Level
price will generate excess demand over supply. SAS2
Price S P2
Rs.
P1
P3 AD2
150
AD1
Price ceiling Y1 Y2 Real GDP (Y)

75
D
Contractionary Fiscal policy for Co-
mabating inflation
Q1 Q2 Quantity
Discretionary fiscal
policy refers to deliberate
Fiscal Policy policy actions on the part of D
the government to change the p
levels of expenditure and taxes t
Public Finance to influence the level
of national output,
employment,
and prices.
Fiscal Policy
Price SAS2
Level
SAS1
Objectives Automatic Instruments Types of
of Fiscal Stabilizers of Fiscal Fiscal P3
Policy Versus Policy Policy
P2
Discretionary AD2
Fiscal Policy P1
AD1
Y Real GDP (Y)

36
Money Market
Money Market 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.
The Concept of
Money Demand
r*
Functions The Demand Theories of Post-Keynesian
of Money for Money Demand for Developments Interest rate
Money in the Theory
of Demand for r1
Liquidity Trap
Money r2 Region
r0
Money has generalized purchasing power and is generally
acceptable in settlement of all transactions and in discharge of
other kinds of business obligations including future payments.
O M1 M2 M3 M4
When money takes the form of a commodity with intrinsic value, it Speculative Demand for Money
is called commodity money. For e.g., gold, silver or any other such
elements may be used as money.
Money Market
Fiat money is used as a medium of exchange because the government
has, by law, made them “legal tender,” which means, they serve, by
law, as means of payment. The concept of
Money Supply
THE DEMAND FOR MONEY
The quantity theory of money, one of the oldest theories in The Sources Measurement Determinants The concept
Economics, was first propounded by Irving Fisher of Yale University of Money of Money of Money of Money
in his book ‘The Purchasing Power of Money’ published in 1911 Supply Supply Supply Multiplier
and later by the neoclassical economists
MV = PT
Where, M = the total amount of money in circulation (on an The term money supply denotes the total quantity of money
average) in an economy available to the people in an economy. The quantity of money at
V = transactions velocity of circulation any point of time is a measurable concept.
P = average price level (P= MV/T)
T = the total number of transactions.
The measures of money supply vary from country to country, from
The Cambridge approach time to time and from purpose to purpose.
In the early 1900s, Cambridge Economists Alfred Marshall, A.C.
Pigou, D.H. Robertson, and John Maynard Keynes (then associated
with Cambridge) put forward a fundamentally different approach DETERMINANTS OF MONEY SUPPLY
to quantity theory, known as cash balance approach.
Md = k PY • The current practice is to explain the determinants of money
Md = is the demand for money balances, Y = real national income supply based on ‘money multiplier approach’ which focuses
P = average price level of currently produced goods and services on the relation between the money stock and money supply in
PY = nominal income terms of the monetary base or high-powered money.
k = proportion of nominal income (PY) that people want to M = m X MB
hold as cash balances Where M is the money supply, m is money multiplier and MB is
the monetary base or high-powered money
• Keynes’ theory of demand for money is known as the ‘liquidity
preference theory’. ‘Liquidity preference’, is a term that was coined The monetary base is the sum of currency in circulation and bank
by John Maynard Keynes in his masterpiece ‘The General Theory reserves
of Employment, Interest and Money’ (1936).
• According to Keynes, people hold money (M) in cash for three M1 = Currency notes and coins with the people + demand
motives: the transactions, precautionary and speculative motives. deposits with the banking system (Current and Saving
• The transaction motive for holding cash is directly related to the deposit accounts) + other deposits with the RBI.
level of income and relates to ‘the need for cash for the current M2 = M1 + savings deposits with post office savings banks.
transactions for personal and business exchange.’ M3 = M1 + net time deposits of banks and
• The amount of money demanded under the precautionary M4 = M3 + total deposits with the Post Office Savings
motive is to meet unforeseen and unpredictable contingencies Organization (excluding National Savings Certificates
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, • The Reserve money, also known as central bank money, base
farsightedness etc. money or high-powered money determines the level of liquidity
• The speculative motive reflects people’s desire to hold cash in order and price level in the economy.
to be equipped to exploit any attractive investment opportunity • The money multiplier is a function of the currency ratio which
requiring cash expenditure. The speculative demand for money depends on the behaviour of the public, excess reserves ratio of the
and interest are inversely related. banks andthe required reserve ratio set by the central bank.
37
People hold money (M) in cash Aggregate Speculative Demand for Money
for three motives
According to Keynes, higher the rate of interest, lower the
speculative demand for money, and lower the rate of interest,
the higher the speculative demand for money.
Transactions Precautionary Speculative
motive motive motive
r*
Transacton Motive
• The transactions motive for holding cash relates to ‘the need Interest Rate
for cash for current transactions for personal and business
exchange.
• Lr = kY, Where, Lr is the transactions demand for money, r1
k is the ratio of earnings which is kept for transactions
purposes and Y is the earnings. r2 Liquidity Trap
• The aggregate transaction demand for money is a function Region
r0
of national income.
Precautionary Motive
• Precautionary motive is to meet unforeseen and un
predictable contingencies involving money payments and
depends on the size of the income, prevailing economic as 0 M1 M2 M3 M4
well as political conditions and personal characteristics of Speculative Demand for Money
the individual such as optimism/ pessimism, farsightedness
etc. Aggregate Speculative Demand for Money
Speculative Motive
• The speculative motive reflects people’s desire to hold cash Post-Keynesian
in order to be equipped to exploit any attractive investment Developments in the Theory
opportunity requiring cash expenditure. of Demand for Money
• The speculative demand for money and interest are
inversely related.
Baumol's Inventory Friedman's Tobin's The
Approach to Restatement of Demand for
Transaction the Quantity Money as Behavior
When the current rate of
Balances Theory toward Risk
interest rn is higher than the
critical rate of interest rc, the
entire wealth is held by the
Individual's individual wealth-holder in the  Baumol (1952) and Tobin (1956) developed a
Speculative deterministic theory of transaction demand for
demand for form of government bonds. If Inventory
Money the rate of interest falls below Approach to ‘real cash balance’, known as Inventory Theoretic
the critical rate of interest rc, Transaction Approach, in which money is essentially viewed
the individual will hold his Balances as an inventory held for transaction purposes.
entire wealth in the form of  People hold an optimum combination of bonds
speculative cash balances. and cash balance, i.e., an amount that minimizes
the opportunity cost.
 The optimal average money holding is: a positive
function of income Y, a positive function of the
m price level P, a positive function of transactions
costs c, and a negative function of the nominal
interest rate i.
Interest Rate
rc
Friedman's Restatement of the Quantity Theory
Milton Friedman (1956) The nominal demand for money

extending Keynes’ speculative is positively related to the price
money demand within the level, P; rises if bonds and stock
framework of asset price theory returns, rb and re, respectively
holds that demand for money decline and vice versa; is
M2 is affected by the same factors influenced by inflation; and is a
Speculative Demand for Money as demand for any other asset, function of total wealth
namely, permanent income and
Individual’s Speculative Demand for Money relative returns on assets.
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New Monetary Aggregates
♦ The Demand for Money as
Behavior toward as ‘aversion to • Reserve Money = Currency in circulation + Bankers’
risk’ propounded by Tobin states deposits with the RBI + Other deposits with the RBI Or
that money is a safe asset but an • Reserve Money = Net RBI credit to the Government + RBI
The investor will be willing to exercise credit to the Commercial sector + RBI’s Claims on banks +
Demand a trade-off and sacrifice to some RBI’s net Foreign assets + Government’s Currency liabilities
for extent the higher return from to the public – RBI’s net non-monetary Liabilities
Money as bonds for a reduction in risk • NM1 = Currency with the public + Demand deposits with
Behavior ♦ According to Tobin, rational
behaviour induces individuals the banking system + ‘Other’ deposits with the RBI.
toward • NM2 = NM1 + Short-term time deposits of residents
Risk to hold an optimally structured
wealth portfolio which is (including and up to contractual maturity of one year).
comprised of both bonds and • NM3 = NM2 + Long-term time deposits of residents + Call/
money and the demand for money Term funding from financial institutions
as a store of wealth depends
negatively on the interest rate.
Liquidity Aggregates
The Concept of • L1 = NM3 + All deposits with the post office savings banks
Money Supply (excluding National Savings Certificates).
• L2 = L1 +Term deposits with term lending institutions and
refinancing institutions (FIs) + Term borrowing by FIs +
Certificates of deposit issued by FI’s.
The Sources Measurement Determinants The Concept • L3 = L2 + Public deposits of non-banking financial
of Money of Money of Money of Money companies
Supply Supply Supply Multiplier
Determinants of Money Supply
Importance of Money Supply The first view , money supply is

determined exogenously by the
central bank.
Monetary Monetary Policy Price Stability
Development perspective & GDP Growth
The second view holds that the money
supply is determined endogenously
by changes in the economic activities
Sources of Money Supply which affect people’s desire to hold
currency relative to deposits, rate of
• The central banks of all countries are empowered to issue interest, etc.
currency and therefore, the central bank is the primary source
of money supply in all countries. In effect, high powered
money is the source of all other forms of money. Money Multiplier Approach to Supply of Money
• The second major source of money supply is the banking
system of the country. The money multiplier approach to money supply propounded
by Milton Friedman and Anna Schwartz, (1963) considers three
factors as immediate determinants of money supply
• the stock of high-powered money (H)
Measurement of Money Supply
• the ratio of deposit to reserve, e = {ER/D} and
• The measures of money supply vary from country to country, • the ratio of deposit to currency, c ={C/D}
from time to time and from purpose to purpose.
• Measurement of money supply is essenetial as it enables a
framework to evaluate whether the stock of money in the Effect of Government Expenditure on Money supply
economy is consistent with the standards for price stability, to
When the Reserve Bank lends to the governments under WMA
understand the nature of deviations from this standard and to
/OD it results in the generation of excess reserves (i.e., excess
study the causes of money growth.
balances of commercial banks with the Reserve Bank).
• In India RBI has been publishing data on four alternative
measures of money supply denoted by M1, M2, M3, M4 besides
the reserve money.
The Credit Multiplier

Monetary Aggregates are The Credit Multiplier also referred to
as the deposit multiplier or the deposit
• M1 = Currency and coins with the people + demand deposits
expansion multiplier, describes the
of banks (Current and Saving accounts) + other deposits of
amount of additional money created by
the RBI
commercial bank through the process
• M2 = M1 + savings deposits with post office savings banks
of lending the available money it has
• M3 = M1 + net time deposits of banks
in excess of the central bank's reserve
• M4 = M3 + total deposits with the Post Office Savings
requirements.
Organization (excluding National Savings Certificates)
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39
Monetary Policy
Monetary Policy
Instruments
The Organisational
The Monetary
Structure for
Policy
Monetary Policy
Framework
Decisions
Direct Indirect
Objectives Analytics of Operative

of Monetary Monetary Procedures &
Policy Policy Instruments Direct Instruments
The Monetary The Monetary

Policy Framework Policy Committee Cash Reserve Ratio and Credit to Administered
Agreement ( MPC) Liquidity Reserve Ratios Priority Sector Interest Rate
prescribed from time
to time
Monetary policy refers to the use of monetary
policy instruments which are at the disposal
Monetary of the central bank to regulate the availability,
cost and use of money and credit to promote Indirect Instruments
Policy
economic growth, price stability, optimum levels
of output and employment, balance of payments
equilibrium, stable currency or any other goal of
government's economic policy. Repos Open Market Standing Market-based
Operations Facilities Discount Window
♦ Price Stability Cash Reserve Ratio

Objectives ♦ Economic Growth
of ♦ Ensuring an adequate flow of credit The Cash Reserve Ratio (CRR) refers to the fraction of the
Monetary total net demand and time liabilities (NDTL) of a scheduled
Policy ♦ Creation of an efficient market for
commercial bank in India which it should maintain as cash
government securities
deposit with the Reserve Bank irrespective of its size or
financial position.
Interest rate
Lower will be
Channel Higher the
liuidity in the
CRR with the
system and
RBI
vice versa
Asset Price Analytics of Exchange rate Statutory Liquidity Ratio

Channel Monetary Channel
Policy • The Statutory Liquidity Ratio (SLR) is what the scheduled
commercial banks in India are required to maintain as
a stipulated percentage of their total Demand and Time
Liabilities (DTL) / Net DTL (NDTL) in Cash, Gold or
approved investments in securities.
• The SLR is also a powerful tool for controlling liquidity in
the domestic market by means of manipulating bank credit.
Quantum Changes in the SLR chiefly influence the availability of
Channel resources in the banking system for lending.
The Liquidity Adjustment (LAF)

Operating Framework
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
Choosing the Choosing the Choosing the policy of excess liquidity) on an overnight basis against the collateral of
operating target intermediate target instruments
(e.g. Inflation) (e.g. Economic Stability) (e.g. Cash Reserve Ratio)
government securities including state government securities.
28 January 2021 The Chartered Accountant Student
40
Repo or repurchase option is a collaterised Monetary Policy Committee
lending because banks borrow money from • The Monetary Policy Committee (MPC) consisting of six
Repo Rate Reserve bank of India to fulfill their short term members shall determine the policy rate to achieve the
monetary requirements by selling securities to inflation target through debate and majority vote by a panel
RBI with an explicit agreement to repurchase the of experts.
same at predetermined date and at a fixed rate. • The Monetary Policy Framework Agreement is an
The rate charged by RBI for this transaction is agreement reached between the Government of India and
called the ‘repo rate’. the Reserve Bank of India (RBI) on the maximum tolerable
inflation rate as 4 per cent Consumer Price Index (CPI)
inflation with a deviation of 2 percent.
Reverse Repo Rate • Choice of a monetary policy action is rather complicated
Reverse Repo is defined as an instrument for lending in view of the surrounding uncertainties and the need
funds by purchasing securities with an agreement to resell the for exercising complex judgment to balance growth and
securities on a mutually agreed future date at an agreed price inflation concerns. Additional complexities arise in the case
which includes interest for the funds lent. of an emerging market like India.
Market Stabilisation Scheme

Marginal Standing Facility( MSF)
The Marginal Standing Facility (MSF) refers to the facility under Under the Market Stabilisation Scheme (MSS) the Government
which scheduled commercial banks can borrow additional of India borrows from the RBI (such borrowing being additional
amount of overnight money from the central bank over and to its normal borrowing requirements) and issues treasury-bills/
above what is available to them through the LAF window by dated securities.
dipping into their Statutory Liquidity Ratio (SLR) portfolio up
to a limit.
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41
CHAPTER-IV INTERNATIONAL TRADE

Unit-I: Theories of International Trade
International trade is the exchange of goods and services as well as resources between countries and involves greater complexity
compared to internal trade
♦ Theories ♦ Innovative products at lower prices

International ♦ Wider choice in products and services for consumers are
♦ Important Theories of International
Trade Trade also claimed as benefits of trade
♦ Enhanced foreign exchange reserves
Arguments in favour of International Trade ♦ Increased scope for mechanization and specialisation,
research and development
♦ Contributes to economic growth and rising incomes ♦ Creation of jobs
♦ Enlarges manufacturing capabilities ♦ Reduction in poverty
♦ Ensures benefits from economies of large scale production ♦ Raising standards of livelihood
♦ Enhances competitiveness and profitability by adoption of ♦ Increase in overall demand for goods and services
cost reducing technology business practices ♦ Prospects of employment generating investments
♦ Deployment of productive resources ♦ Improvement in the quality of output
♦ Domestic monopolies ♦ Labour and environmental standards
♦ Cost- effective sourcing of inputs and components ♦ Broadening of productive base
internationally ♦ Development and strengthening of bonds between nations.
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Arguments against International Trade Unit-II The Instruments of Trade Policy

♦ Negative labour market outcomes Trade policy encompasses all instruments that governments
♦ Economic exploitation may use to promote or restrict imports and exports
♦ Exhaustion of Natural Resources
♦ May result in consumerism
♦ Dependence Tariffs
♦ May result in Inflation
♦ Disregard for welfare of people
♦ Quick transmission of trade cycles The Instruments of
♦ Rivalries and risks in trade associated with changes in Non-Tariff Measures
governments’ policies of participating countries Trade Policy (NTMs)
Export-Related
Important Theories of International Trade Measures
The Mercantilist View of International Trade
♦ Mercantilism advocated maximizing exports in order to Tariff

bring in more precious metals and minimizing imports
through the state imposing very high tariffs on foreign ♦ Tariff, also known as customs duty is defined as a financial
goods. charge in the form of a tax, imposed at the border on goods
going from one customs territory to another. Tariffs are the
most visible and universally used trade measures.
The Theory of Absolute Advantage: Adam Smith
♦ According to Adam Smith’s Absolute Cost Advantage

theory, a country will specialize in the production and Forms of Import Tariffs
export of a commodity in which it has an absolute cost
advantage.
♦ A specific tariff is an import duty that assigns a
The Theory of Comparative Advantage : Ricardo Specific fixed monetary tax per physical unit of the good
Tariff imported whereas an ad valorem tariff is levied as
♦ Ricardo’s theory of comparative advantage states that a a constant percentage of the monetary value of one
nation should specialize in the production and export of the unit of the imported good.
commodity in which its absolute disadvantage is smaller
(this is the commodity of its comparative advantage) and
import the commodity in which its absolute disadvantage
is greater (this is the commodity of its comparative ♦ An ad valorem tariff is levied as a constant
Ad
disadvantage). percentage of the monetary value of one unit of the
volorem
tariff imported good.
The Heckscher-Ohlin Theory of Trade
♦ The Heckscher-Ohlin theory of trade, also referred to as

Factor-Endowment Theory of Trade or Modern Theory ♦ Mixed Tariff
of Trade, states that comparative advantage in cost of ♦ Compound Tariff or a Compound Duty
production is explained exclusively by the differences in ♦ Technical/Other Tariff
factor endowments. ♦ Tariff Rate Quotas
♦ Most-Favored Nation Tariffs
Other ♦ Variable Tariff
Tariff ♦ Preferential Tariff
Factor-Price Equalization Theorem
♦ Bound Tariff
♦ Applied Tariffs
♦ The Factor-Price Equalization Theorem states that
♦ Escalated Tariff
international trade equalizes the factor prices between
♦ Prohibitive Tariff
the trading nations. Therefore, with free trade, wages and
♦ Important subsidies
returns on capital will converge across the countries.
♦ Tariffs asa Response
New Trade Theory

Anti-dumping Duties
♦ New Trade Theory is the latest entrant to explain the
rising proportion of world trade in the developed world ♦ Dumping occurs when manufacturers sell goods in a
and bigger developing economies (such as BRICS) which foreign country below the sales prices in their domestic
trade in similar products. These countries constitute more market or below their full average cost of the product. It
than 50% of world trade. Accoring to this theory, two key hurts domestic producers
concepts ♦ Anti-dumping measures are additional import duties so as
♦ Economies of Scale and Network effects, affects to offset the foreign firm’s unfair price advantage.
international tarde in a major way.
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43
Countervailing Duties
♦ Government Procurement Policies : Govt.
♦ Countervailing duties are tariffs to offset the artificially low may lay down policies w.r.t procurements.
prices charged by exporters who enjoy export subsidies ♦ Trade-Related Investment Measures : May
and tax concessions offered by the governments in their include rules on local content requirements
home country. of production.
Non- ♦ Distribution Restrictions.
Technical ♦ Restriction on Post-sales Services.
Measures ♦ Administrative Procedures.
♦ Rules of Origin : To determine the national
Create source of a product.
obstacles to ♦ Safeguard Measures : Initiated by countries
trade to restrict imports of a product temporarily
Increase Reduce the if its domestic industry is injured.
government prospect ♦ Embargos : Total ban on import or export
revenues of market of some commodition to a particular
access country or region for some or indefinits
period.
Effects of
Tariff
Protect Export Related Measures

Make
domestic imported
goods more ♦ Ban of Export : Exports of certain itmes may be banned
industries
expensive during shortages.
Increase ♦ Export Taxes : An export tax is a tax collected on exported
consumption goods and may be either specific or ad valorem and an
of domestic
goods export subsidy includes financial contribution to domestic
producers in the form of grants, loans, equity infusions also
usually provide etc. or give some form of income or price
support. Both distort trade
Non-Tariff Measures ♦ Export subsidies and Incentives: Given by government to
boost exports
♦ Non-tariff measures (NTMs) are policy measures, other ♦ Voluntary Export-Restraints : Voluntary Export Restraints
than ordinary customs tariffs, that can potentially have an (VERs) refer to a type of informal quota administered by
economic effect on international trade in goods, changing an exporting country voluntarily restraining the quantity
quantities traded or prices or both of goods that can be exported out of a country during a
specified period of time, imposed based on negotiations to
appease the importing country and to avoid the effects of
possible trade restraints
Category of Non-Tariff Measures
Technical Measures
Unit-III Trade Negotiations
♦ Sanitary and Phytosanitary (SPS) measures : applied to International trade negotiations, especially the ones aimed at
protect human, animal or plant life from risks arising form formulation of international trade rules, are complex interactive
addition, pests, contaninants, toxins or disease causing processes engaged in by countries having competing objectives.
organisms.
♦ Technical Barriers to Trade specifying details such as size,
shape, design, labelling/marking etc. Trade
Negotiations
♦ Non-technical measures relate to trade

requirements; for example; shipping RTAs GATT WTO
requirements, custom formalities, trade
rules, taxation policies, etc.
♦ Import Quotas: Restrictions on physical
♦ Unilateral trade agreements
Non- amount of imported goods.
♦ Price Control Measures : Imposing taxes on ♦ Bilateral agreements
Technical Major
Measures charges. ♦ Regional preferential trade agreements
Types of
♦ Non Automatic Licensing and Prohibitions: ♦ Trading bloc
Agreements
limiting or prohibiting certain types of ♦ Free-trade area
in
import.
International ♦ Customs union
♦ Financial Measures : Regulating access to
Trade
and cost of foreign exchange. ♦ Common market and economic and
♦ Measures Affecting Competition : Granting monetary union
exclusive or special preferences to one or a
few limited group of economic operations.
44
GATT Important Agreements under WTO
♦ The General Agreement on Tariffs and Trade (GATT) ♦ Rules of origin

provided the rules for much of world trade for 47 years ♦ Import licensing procedures
from 1948 to 1994. ♦ Subsidies and countervailing measures
♦ Eight multilateral negotiations known as trade rounds held ♦ Safeguards, Trade in Services (GATS)
under the GATT auspices. ♦ Intellectual Property Rights (TRIPS)
♦ The 8th of the Uruguay Round of 1986-94 was last under ♦ Settlement of Disputes (DSU)
GATT and culminated in the birth of WTO. ♦ Trade Policy Review Mechanism (TPRM)
♦ Plurilateral trade agreements on trade in civil aircraft
and government procurement.
WTO The principal objective of the
The eighth of the Uruguay WTO
Round of 1986-94, was the last To facilitate the flow of
and most consequential of all international trade smoothly, ♦ Slow progress of multilateral negotiations
rounds and culminated in the freely, fairly and predictably. ♦ Uncertainties resulting from regional trade
birth of WTO and a new set agreements
of agreements replacing the ♦ Inadequate or negligible trade liberalisation
General Agreement on Tariffs ♦ Those which are specific concerns to the developing
and Trade (GATT). A Few countries
concerns ♦ Protectionism and lack of willingness among
developed countries to provide market access
The WTO does its functions The WTO Activities of WTO
♦ Difficulties that they face in implementing the
by acting as a forum for trade are supported by the
present agreements
negotiations among member Secretariat located in Geneva,
♦ Apparent north-south divide
governments, administering headed by a Director General.
♦ Exceptionally high tariffs
trade agreements, reviewing It has a three-tier system of
♦ Tariff escalation, erosion of preferences and
national trade policies, decision making. The top
difficulties with regard to adjustments.
cooperating with other level decision-making body is
international organizations the Ministerial Conference,
and assisting developing followed by councils namely, The Doha Round, formally the Doha Development Agenda
countries in trade policy issues the General Council and
through technical assistance the Goods Council, Services ♦ The ninth round since the Second World War was officially
and training programmes. Council and Intellectual launched at the WTO’s Fourth Ministerial Conference in
Property (TRIPS) Council. Doha, Qatar, in November 2001.
♦ Sought to accomplish major modifications of the
Members International trading system through lower trade barriers
The WTO currently has 164 members, of which 117 are and revised trade rules
developing countries or separate customs territories ♦ Include 20 areas of trade.
accounting for about 95% of world trade.
The major guiding principles of the WTO Unit-IV Exchange Rate and its Economic Effects
♦ Trade without discrimination, most-favoured-nation Exchange rate is the rate at which the currency of one country
treatment(MFN) exchanges for the currency of another country.
♦ The National Treatment Principle (NTP)
♦ Freer trade
♦ Predictability The Exchange Rate
♦ General prohibition of quantitative restrictions Regimes
♦ Greater competitiveness Exchange
International Rate and its Changes in
♦ Tariffs as legitimate measures for protection
Economic Exchange Rates
♦ Transparency in decision making Trade
Effects
♦ Progressive liberalization Devaluation Vs
♦ Market access Depreciation
♦ A transparent, effective and verifiable dispute settlement
mechanism.
Important Agreements under WTO

Exchange Rate
♦ Agriculture
♦ SPS measures
♦ Textiles and clothing Direct Quote Indirect Quote
♦ Technical barriers to trade (TBT)
♦ Trade-related investment measures (TRIMs)
♦ Anti-dumping
♦ Customs valuation Foreign Currency is the Domestic Currency is
♦ Pre-shipment inspection (PSI) Base Currency the Base Currency (e.g.
(e.g. ` 66/US) $ 0.151 per rupee)

45
Cross rate Usually, the supply of and Changes in exchange rates

demand for foreign exchange ♦ portray depreciation or
♦ The rate between Y and Z which is derived from the given in the domestic foreign appreciation of one currency.
rates of another set of two pairs of currency (say, X and Y, exchange market determine
and, X and Z) is called cross rate. ♦ The terms, `currency
the external value of the appreciation’ and ‘currency
domestic currency, or in other depreciation’ describe the
Exchange Rate Regime words, a country’s exchange movements of the exchange
rate. rate.
♦ An exchange rate regime is the system by which a country
manages its currency in respect to foreign currencies.
Appreciation & Depreciation of Currency
♦ when its value increases with respect to the value of another
Floating Exchange Rate Regime
currency or a basket of other currencies. On the contrary,
currency depreciates when its value falls with respect to the
♦ The equilibrium value of the exchange rate of a country’s
value of another currency or a basket of other currencies.
currency is market determined i.e the demand for and
supply of currency relative to other currencies determines
the exchange rate. Effect of Depreciation Effect of Appreciation
♦ A floating exchange rate allows a government to pursue ♦ Exchange rate ♦ An appreciation of a country’s
its own independent monetary policy and there is no need depreciation lowers currency changes in import and
of market intervention or maintenance of reserves. But,
the relative price of export prices will lead to changes in
volatile exchange rates generate a lot of uncertainties in
a country’s exports, import and export volumes, causing
relation to international transactions.
♦ Examples : Advanced economies like U.S.A, New -Zealand, raises the relative changes in import spending and
Swedon. price of its imports, export revenue
increases demand ♦ adversely affect the competitiveness
both for domestic of domestic industry, cause larger
Fixed Exchange Rate import-competing deficits and worsen the current
goods and for exports, account
♦ Also referred to as pegged exchanged rate, is an exchange leads to output
rate regime under which a country’s government
expansion, encourages Devaluation
announces, or decrees, what its currency will be worth in ♦ is a deliberate downward
economic activity,
terms of either another country’s currency or a basket of adjustment in the value of a
increases the country’s currency relative to
currencies or another measure of value, such as gold.
♦ A central bank may implement soft peg policy under which international another currency, group of
competitiveness of currencies or standard.
the exchange rate is generally determined by the market,
or a hard peg where the central bank sets a fixed and domestic industries,
unchanging value for the exchange rate. increases the
♦ A fixed exchange rate avoids currency fluctuations and volume of exports
eliminates exchange rate risks and transaction costs, and promotes trade
enhances international trade and investment and lowers balance.
the levels of inflation. But, the central bank has to maintain
an adequate amount of reserves and be always ready to Determination of Nominal Exchange Rate
intervene in the foreign exchange market.
♦ Examples : Cuba, Hongkong, Diji bouti.
e
S$
Nominal Vs Real Exchange Rate
♦ Nominal Echange Rate states how much of one currency

Exchange Rate Rs/$
can be traded for a unit of another currency.

♦ Real Exchange Rate : The ‘real exchange rate’ incorporates
changes in prices and describes ‘how many’ of a good or e eq
service in one country can be traded for ‘one’ of that good
or service in a foreign country.
♦ Real exchange rate =
Domestic price Index
Nominal exchange rate X
Foreign price Index
D$
♦ Real Effective Exchange Rate (REER) is the nominal
effective exchange rate (a measure of the value of a currency
against a weighted average of several foreign currencies)
divided by a price deflator or index of costs. Qe $
46
Home-Currency Depreciation under Floating Forward and /or Future Market

Exchange Rates ♦ Contracts buy or sell currencies for furture delivery which are
e carried out in forward and/or future
S$
♦ Current transactions which are carried out in the spot market
and contracts to buy or sell currencies for future delivery
Exchange Rate Rs/$
el El which are carried out in forward and futures markets

e eq E
Unit-V International Capital Movements
D1 $ Foreign capital may flow into an economy in different ways,
such as foreign aid, grants, borrowings, deposits from non
D$ resident Indians, investments in the form of Foreign Portfolio
Investment (FPI) and Foreign Direct Investment (FDI)
Qe Q1 $ (Billions)
International Trade
Home-Currency Appreciation under Floating
Exchange Rates
International Capital
e Movements
S$
S1 $
FDI FPI
Exchange Rate Rs/$
E
e eq Foreign direct investment is defined as a process whereby the
resident of one country (i.e. home country) acquires ownership
of an asset in another country (i.e. the host country) and such
e1 E1 movement of capital involves ownership, control as well as
management of the asset in the host country.
D$ Direct investments are real investments in factories, assets,

land, inventories etc. and have three components, viz., equity
O capital, reinvested earnings and other direct capital in the form
Qe Q1 $ (Billions) of intra-company loans. FDI may be categorized as horizontal,
vertical or conglomerate. Two- way direct foreign investments
reciprocal investments.
Foreign Exchange Market
Foreign portfolio investment is the flow of ‘financial capital’
with stake in a firm at below 10 percent, and does not involve
manufacture of goods or provision of services, ownership
The wide-reaching collection of markets and institutions that
management or control of the asset on the part of the investor.
handle the exchange of foreign currencies is known as the foreign
exchange market.
The main reasons for foreign direct investment are
♦ Profits
Being an over-the-counter market, it is not a physical place;
♦ Higher rate of return
rather, it is an electronically linked network bringing buyers and
♦ Possible economies of large-scale operation
sellers together and has only very narrow spreads. ♦ Risk diversification
♦ Retention of trade patents
♦ Capture of emerging markets
On account of arbitrage, regardless of physical location, at any
♦ Lower host country environmental and labour standards,
given moment, all markets tend to have the same exchange rate ♦ Bypassing of non tariff and tariff barriers
for a given currency. Arbitrage refers to the practice of making ♦ Cost–effective availability of needed inputs and tax and
risk-less profits by intelligently exploiting price differences of an investment incentives.
asset at different dealing places.
Foreign direct investment takes place through
Types of transactions in a forex market ♦ Opening of a subsidiary or associate company

♦ Equity injection
Spot Market ♦ Acquiring a controlling interest
♦ Mergers and acquisitions (M&A)
♦ Current transactions which are carried out in the spot market ♦ Joint venture and green field investment
and exchange involves immediate delivery

47
Benefits of foreign direct investment Benefits of foreign direct investment
♦ Include positive outcomes of competition such as cost- ♦ Exercising monopoly power

reducing and quality-improving innovations ♦ Decrease competitiveness of domestic companies
♦ Higher efficiency ♦ Potentially jeopardize national security and sovereignty
♦ Huge variety of better products and services at lower prices ♦ Worsen commodity terms of trade and cause emergence of a
♦ Welfare for consumers, multiplier effects on employment dual economy
♦ Output and income, relatively higher wages
♦ Better access to foreign markets
FDI in India
♦ Control of domestic monopolies and betterment of
balance of payments position ♦ Mostly a post reform phenomenon is a major source of non-
♦ Potential problems of foreign direct investment debt financial resource for economic development.
♦ Include use of inappropriate capital- intensive methods in ♦ The government has at different stages, liberalized FDI
a labour-abundant country by increasing sectoral caps, bringing in more activities
♦ Increase in regional disparity under automatic route and easing of conditions for foreign
♦ Crowding-out of domestic investments investment.
♦ Diversion of capital resulting in distorted pattern of ♦ Overseas direct investments by Indian companies, made
production and investment possible by progressive relaxation of capital controls and
♦ Instability in the balance of payments and exchange rate simplification of procedures for outbound investments from
and indiscriminate repatriation of the profits. India, have undergone substantial changes in terms of size,
♦ Anti-ethical market distortions geographical spread and sectoral composition. Outward
♦ Off–shoring or shifting of jobs Foreign Direct Investment (OFDI) from India stood at US$
♦ Overexploitation of natural resources causing 1.86 billion in the month of June 2016.
environmental damage
48

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