FM - Eco

Inter CA
Financial Management
& Economics
Dear Student,
Welcome to the World of Knowledge - J.K. Shah Classes !
I have the pleasure of presenting this study material to you. It contains good
number of good problems, selected so carefully from wide-ranging sources. It
covers the problems which will bring in to focus all important concepts that you
need to study in order to fortify yourself for your examination. The subject will
be taught by eminent professors who are highly experienced and well-versed
with the job.
The coaching is very exhaustive and wholly concept based. The conceptual
explanations are entirely supported by good problems that cover the past and
the problems which peep into the future. Also, the coaching is very systematic,
well - planned and absolutely time bound. For a change, say good - bye to
mechanical learning. I am sure you will feel that the study is a pleasurable job
and not a painful exercise.
Each Topic of Financial Management is divided in to three parts :

(A) Theory Section : This section covers theory related to the topic.
(B) Classwork Section : This section covers good number of quality problems which
will be solved in the classroom.
(C) Homework Section : This section covers good number of problems. Students are
strongly advised to solve these problems.
Each Topic of Economics for Finance is Divided into 2 Parts:

A. Classwork Section : This section includes coverage of all conceptual questions as
well as numerical questions.
B. Additional Questions: This section emphasizes on extra questions which will
help in deeper understanding of the topics already covered in classwork section.
This section is to be done after completing syllabus.
I wish you a very happy study time.
BEST OF LUCK !
Prof. J.K. Shah.

Chartered Accountant
INTER ca Financial Management
INDEX
Financial Managemnt
Ch. NAME OF THE CHAPTER PAGE NO

No.
1 SCOPE AND OBJECTIVE OF FINANCIAL MANAGEMENT ICAI STUDY
MATERIAL
2 TYPES OF FINANCING ICAI STUDY
MATERIAL
3 FINANCIAL ANALYSIS AND PLANNING – RATIO ANALYSIS 01-26
4 FINANCING DECISIONS – LEVERAGES 27-38
5 FINANCING DECISIONS – CAPITAL STRUCTURE 39-48
6 COST OF CAPITAL 49-72
7 INVESTMENT DECISIONS – CAPITAL BUDGETING 73-90
8 RISK ANALYSIS IN CAPITAL BUDGETING 91-104
9 DIVIDEND DECISIONS 105-119
10 MANAGEMENT OF WORKING CAPITAL
UNIT I: ESTIMATION OF WORKING CAPITAL 120-140
UNIT II: RECEIVABLES MANAGEMENT 141-152
UNIT III: CASH AND TREASURY MANAGEMENT 153-164
UNIT IV: INVENTORY MANAGEMENT COSTING
PAPER
UNIT V: PAYABLES MANAGEMENT ICAI STUDY
MATERIAL
UNIT VI: FINANCING OF WORKING CAPITAL ICAI STUDY
MATERIAL
TABLE 165-168
LAST MINUTE REVISION 169-188
INDEX
Economics
Ch. NAME OF THE CHAPTER PAGE NO

No.
1 DETERMINATION OF NATIONAL INCOME 189-222
2 PUBLIC FINANCE 223-253
3 MONEY MARKET 254-278
4 INTERNATIONAL TRADE 279-321
5 NATIONAL INCOME NUMERICAL SUMS 322-329
6 NATIONAL INCOME NUMERICAL SUMS SOLUTIONS 330-346

Chapter 1
SCOPE AND OBJECTIVE OF
FINANCIAL MANAGEMENT
Refer
ICAI STUDY MATERIAL
Chapter 2
TYPES OF FINANCING
Refer
ICAI STUDY MATERIAL
FINANCIAL ANALYSIS AND PLANNING

– RATIO ANALYSIS
THEORY SECTION
Meaning and Objective

Ratio is relationship between two variables to arrive at a meaningful result. Absolute
figures do not communicate any meaningful result and hence the need for ratios. Ratios
also help in comparing the performance of the company with that of its competitors as
well as with the company's own performance of last year.
Scope
In this chapter we will learn to:
(a) Calculate ratios from the given financial statements.
(b) Prepare Financial Statements from the given ratios.
(c) Calculate ratios and interpretation of the results.
Types of Ratios
All the ratios which we will learn under this chapter can broadly be classified into 3 types.
- Balance Sheet Ratios (numerator and denominator comes from Balance Sheet)
- Profit and Loss Ratios (numerator and denominator comes from P & L)
- Mixed Ratios (Numerator from P&L and denominator from Balance Sheet)
(A) BALANCE SHEET RATIOS

Balance Sheet Ratios are also known as Solvency ratios, as they test the solvency
(ability to pay) position of the company. These ratios are calculated in pure numbers
(2, 1.5, 3, etc.). The lenders and the creditors of the company generally use these
ratios.
We need to learn the following set of ratios under the head Balance Sheet Ratios
- Current Ratio
- Quick Ratio
- Super Quick Ratio
1
- Stock to Working Capital Ratio

- Debt Equity Ratio
- Capital Gearing Ratio
- Proprietary Ratio
• Current Ratio
This Ratio indicates the ability of the company to pay its current liabilities with the help
of current assets. The standard Ratio is considered to be 2:1, which indicates that against
every 1 rupee of current liability the company is having 2 rupees of current assets to
pay its current liabilities as at the balance sheet date. It is a test of short term solvency
position. A very low ratio indicates unsatisfactory liquidity position & a very high ratio
shows inefficient utilization of funds.
• Quick Ratio
Quick Ratio indicates the ability of the company to pay the quick liabilities or immediate
liabilities with the help of Quick Assets. Quick Assets are those current assets which are
immediately convertible into cash without any loss of time or value. The standard ratio is
1:1, which indicates that against every 1 rupee of current liability the company is having
1 rupee of quick asset to repay its current liability. It is a measure of immediate solvency
position. Quick ratio is also known as Acid test ratio, Liquid Ratio or 1:1 Ratio.
Note: Many times Bank overdraft is deducted from current liabilities to arrive at quick
liabilities.
• Super Quick Ratio
This ratio is also known as Absolute Liquidity Ratio, Cash Ratio, Cash Reservoir Ratio.
This ratio indicates that against 1 rupee of current liability how cash and near cash is
available with the company to pay the current liability.
2
• Stock to Working Capital Ratio
This ratio indicates the extent to which the working capital of the company is blocked in
the form of stock. Lower the ratio, higher is the liquidity with the company.
• Debt Equity Ratio

It indicates the proportion of funds belonging to the outsiders to that of the shareholders.
The standard ratio of 2 : 1 which indicates that against 1 rupee of shareholders fund
raised the company has raised 2 rupees from outsiders. Debt Equity ratio is a measure of
financial risk. Higher the Debt Equity ratio higher is the financial risk. Debt equity ratio is
also known as Financial Leverage or Banker’s Ratio.
Debt = Total Long Term Loans.
Equity = Equity Share capital + Preference Share Capital + Reserves and Surplus
• Capital Gearing Ratio
Equity Shareholders funds = Equity share Capital + Reserves and Surplus

This ratio is an extended version of Debt Equity Ratio. It indicates proportion of funds
entitled for fixed commitment (in the form of interest or dividend) to that of funds not
entitled for fixed commitment.
In absence of Preference Share capital, Capital Gearing Ratio = Debt Equity Ratio. The
word gearing indicates risk. High gearing indicate high risk and vice versa.
3
• Proprietary Ratio
This ratio indicates the extent to which the total assets of the company are financed
by the shareholders. Higher the ratio better is the long term stability. Total Assets =
Fixed Assets + Long term Investment + Current Assets.
(B) MIXED RATIOS

In mixed ratio numerator comes from P&L and denominator from Balance Sheet.
Since the P&L figures are generally for the whole year and the Balance Sheet as at
a particular date, there exists a timing difference between the numerator and the
denominator and hence, to eliminate the timing difference we take average of the
Balance Sheet figure. Average = (opening balance + closing balance)/2. In absence
of information about the opening balances, closing balance sheet figures are to be
considered.
• Turnover Ratios
• Turnover Ratios are also known as Activity Ratios, Performance Ratios or
Velocity Ratios. These ratios are always computed in times and hence are also
known as Times Ratios (e.g. 4 times, 10 times, etc.)
• We have to learn the following ratios under this head
• Capital Employed Turnover.
• Fixed Asset Turnover.
• Working Capital Turnover.
• Stock Turnover.
• Accounts Receivable (or Debtors) Turnover.
• Accounts Payable (or Creditors) Turnover.
4
Capital Employed
Turnover- Sales /
Capital Employed
Fixed Asset Working Capital

Turnover- Sales / Turnover- Sales /
Assets Working Capital
Current Assets Current Liabilities
A/c’s Receivable A/c’s Payable Turnover

Stock Turnover Ratio Turnover =Cr. Cash Bank =Cr. Purchase/Average
=COGS/Average Stock Sales/Average Creditors - Average
Debtor+Average B/R B/P
Capital Employed turnover ratio

This Ratio indicates how efficiently the money invested in the business is used during the
year to generate sales.
Fixed Assets Turnover Ratio

This ratio indicates how efficiently the fixed assets were used during the year for generating
sales.
Working Capital Turnover Ratio

This Ratio indicates how well the money invested in working capital was used during the
year for generating sales.
Stock Turnover Ratio

This ratio indicates how many times the stock was turned over i.e. how many times
the stock that was purchased was sold during the year. Higher the ratio efficient is the
inventory management. This ratio is useful for calculating the average holding period of
stock
5
A/c’s Receivable Turnover (or Debtors Turnover)

This ratio indicates how many times the debtors were turned over i.e. how many times
cash was collected from customers for the goods sold during the year. Higher the ratio
efficient is the receivables management. This ratio is useful for calculating the average
collection period.
A/c’s Payable Turnover (or Creditors Turnover)

This ratio indicates how many times the creditors were turned over i.e. how many times
cash was paid to the suppliers for the goods that were purchased. This ratio is useful for
calculating the average payment period.
PROFITABILITY RATIOS IN RELATION TO INVESTMENT

Other set of ratios in mixed ratios is profitability ratios in relation to investment
Return on Capital Employed (ROCE) / Return on Investment (ROI)
This ratio is an indicator of the earning power of the business. It indicates how much
returns has the business earned during the year in % terms on the money employed in
the business.
Capital Employed = Shareholders Funds + Loan Funds
Return on Shareholders’ Funds
This ratio indicates how much returns the company has earned for shareholders during
the year have earned on their funds in % terms
6
Return on Equity (Equity share-holders Funds)
This ratio indicates how much returns the company has earned for equity shareholders
during the year on their investments in % terms.
Return on Equity Share Capital
This ratio indicates how much returns the company has earned for equity shareholders
during the year on the share capital in % terms. Equity share capital is also known as
ordinary capital/common stock.
(C) PROFIT AND LOSS RATIOS

These ratios are also known as profitability ratios in relation to sales.
In this segment we have to learn the following ratios
• Gross Profit Ratio
• Operating Profit Ratio
• Operating Ratio
• Administrative Expenses Ratio
• Selling Expenses Ratio
• Net Profit Ratio
Gross Profit Ratio
This ratio indicates the trading profitability. Higher the gross margin the better it is.
Operating Profit Ratio
This ratio indicates the operating profitability. Higher the operating margins better it is.
7
Operating Ratio
= 1 – operating profit ratio
OR
Administrative Expenses Ratio
This ratio indicates that to generate sales how much admin expenses have been incurred
in % terms.
Selling Expenses Ratio
This ratio indicates that to generate sales how much selling expenses have been incurred
in % terms.
Net Profit Ratio
SOME OTHER IMPORTANT RATIOS
Earnings per Share (EPS)
Dividend per Share (DPS)
Dividend Payout (DP) Ratio
8
Retention Ratio
Book (Balance Sheet) Value per share (BVPS)
Price Earnings Ratio (PE Ratio)

PE Ratio is popularly known as PE multiple. This ratio indicates how many times an
investor is willing to pay to earn 1 rupee of EPS. PE ratio is one factor that determines
the MPS.
MPS = PE x EPS.
Earnings Price Ratio / Earnings Yield Ratio
Yield is defined as the rate of return on the amount invested. The above ratio is a
return on investment ratio. It indicates how much returns an investor has earned on
his investment in percentage terms.
Dividend Price Ratio / Dividend Yield Ratio

It indicates how much returns in the form of Dividend an investor has earned on his
investment in percentage terms.
Interest Coverage Ratio (IC Ratio)

9
This ratio is also called the times interest earned ratio and it measures the ability
of the firm to pay the fixed interest liability. It may be noted that EBIT is operating
profits of the firm, therefore, the IC ratio measures as to how many times the interest
liability of the firm is covered with the operating profits of the firm.
Preference Dividend Coverage Ratio

This ratio attempts to measure the ability of the firm to pay fixed preference dividend
and tells us how secure the preference dividend is in relation to the earning power of
the company.
Debt Service Coverage Ratio

This ratio calculates the company’s ability to repay loan instalment + payment of
interest. Higher the ratio better it is.
DU PONT ANALYSIS FOR EVALUATING ROE
= NP Ratio x Asset Turnover Ratio x Equity Multiplier
10
XYZ LTD
BALANCE SHEETAS AT 31ST MARCH...
PARTICULARS RS RS
SOURCES OF FUNDS
A) SHAREHOLDERS FUNDS
Share Capital xx
Reserves and Surplus xx
Less: Miscellaneous Expenditure not w/off ( xx ) xx
B) BORROWED FUNDS
Secured Loans xx
Unsecured Loans xx xx
TOTAL SOURCES OF FUNDS/CAPITAL EMPLOYED xxxx
APPLICATIONS OF FUNDS
C) FIXED ASSETS
Gross Block xx
Less: Provision for Depreciation (xx)
Net Block/ WDV xx
D) LONG TERM INVESTMENTS xx
E) WORKING CAPITAL xx
Current Assets xx xx
Less: Current Liabilities (xx)
TOTAL APPLICATION OF FUNDS xxxx
11
PROFIT AND LOSS STATEMENT FOR THE YEAR END 31ST MARCH...
PARTICULARS RS RS
Sales xx
Less: Cost of Goods Sold (COGS) (xx)
Gross Profit xx
Operating Expenses
Administrative Expenses xx
Selling Expenses xx
Depreciation xx xx
Operating Profits xx
Less: Non Operating Expenses (xx)
Add: Non Operating Incomes xx
Earnings before Interest and Tax (EBIT) xx
Less: Interest (xx)
Earnings before Tax (EBT) xx
Less: Tax (xx)
Earnings after Tax (EAT) xx
Less: Preference Dividend (including DDT) (xx)
Earnings for Equity Shareholders xx
Less: Equity Dividend (xx)
Retained Earnings xx
Important Points to remember

- Shareholder’s funds are also known as Owner’s Funds, Proprietors Funds, Net
Worth or Equity
- Borrowed Funds are also known as Debt or Loan Funds
- Capital Employed is Debt + Equity
- Shareholder’s Funds = Share Capital + Reserves and Surplus – Miscellaneous
Expenditures not w/off
- Fundamental Balance Sheet Equation
Shareholder’s Funds + Borrowed Funds = Fixed Assets + LT Investments +Working
Capital
12
CLASSWORK SECTION
Question 1
The following is the Balance Sheet of Z Ltd. on 31st March, 2020 and other information
from which you are required to calculate the following ratios:
(a)
Current Ratio.
(b) Liquid Ratio.
(c) Stock Working Capital Ratio.
(d) Capital Gearing Ratio.
(e) Stock Turnover Ratio.
(f) Debtors Turnover Ratio and Collection Period.
Stock on 1.4.2019 was ` 1,20,000. Sales (all credit) were ` 20,00,000. Gross Profit on
sales was 25%. Debtors on 1.4.2019 were ` 40,000.
Balance Sheet on 31.3.2020
Liabilities ` Assets `
12% Preference Capital 3,00,000 Fixed Assets 7,80,000
Equity Share Capital 6,40,000 Short Term Investments 2,00,000
Capital Reserve 60,000 Stock 3,80,000
General Reserve 2,00,000 Debtors 3,60,000
Profit & Loss A/c 20,000 Prepaid Expenses 60,000
14% Debentures 1,60,000
Creditors 3,20,000
Bank Overdraft 80,000
17,80,000 17,80,000
Question 2
The Following information relates to X. Ltd for the year end March 31st 2020.
Net Working Capital ` 12,00,000/-
Fixed Assets to Proprietors Funds 0.75
Working Capital Turnover 5 Times
Return on Equity (ROE) 15%
You are required to calculate:
(a) Proprietors Funds
(b) Fixed Assets
(c) Net Profit Ratio
13
Question 3
Following is the abridged Balance Sheet of Alpha Ltd.:
Liabilities ` Assets ` `
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivable 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000
With the help of the additional information furnished below, you are required to prepare
Trading and Profit & Loss Account and a Balance Sheet as at 31st March, 2020:
(i) The company went in for reorganisation of capital structure, with share capital
remaining the same as follows:
Share Capital 50%
Other Shareholder’s funds 15%
5% Debentures 10%
Payables 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been
bought and a further ` 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8: 5.
(iv) Quick assets ratio was 1: 1.
(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period
of 2 months. There were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
Ignore Taxation.
14
Question 4
X Co. has made plans for the next year. It is estimated that the company will employ
total assets of ` 8, 00,000; 50 per cent of the assets being financed by borrowed capital
at an interest cost of 8 per cent per year. The direct costs for the year are estimated at
` 4, 80,000 and all other operating expenses are estimated at ` 80,000. The goods will
be sold to customers at 150 per cent of the direct costs. Tax rate is assumed to be 50 per
cent.
You are required to calculate: (i) net profit margin; (ii) return on assets; (iii) asset turnover
and (iv) return on owners’ equity.
Question 5
The following accounting information and financial ratios of PQR Ltd. relate to the year
ended 31st December, 2020
I Accounting Information:
Gross Profit 15% of Sales
Net Profit 8% of sales
Raw materials consumed 20% of works cost
Direct Wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13:11
Current ratio 2:1
Long – term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
If value of fixed assets as on 31st December, 2020 amounted to ` 26 lakhs, prepare a
summarised Profit and Loss Account of the company for the year ended 31st December,
2020 and also the Balance Sheet as on 31st December, 2020.
15
Question 6
Ganpati Limited has furnished the following ratios and information relating to the year
ended 31st March, 2020.
Sales ` 60,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 7:3
Current ratio 2
Net profit to sales 6.25%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ` 18,00,000
Interest on debentures ` 60,000
Receivables ` 2,00,000
Payable ` 2,00,000
You are required to:
(a) Calculate the operating expenses for the year ended 31st March, 2020.
(b) Prepare a balance sheet as on 31st March in the following format.
Balance Sheet as on 31st March, 2020

Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash
Question 7
From the following information, prepare a summarised Balance Sheet as at 31st March,
2020:
Net Working Capital ` 2, 40,000
Bank overdraft ` 40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ` 1, 60,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5
16
Question 8
With the help of the following information complete the Balance Sheet of MNOP Ltd.:
Equity share capital ` 1, 00,000
The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
Fixed assets to Equity share capital 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times
Question 9
In a meeting held at Solan towards the end of 2019, the Directors of M/s HPCL Ltd. have
taken a decision to diversify. At present HPCL Ltd. sells all finished goods from its own
warehouse. The company issued debentures on 01.01.2020 and purchased fixed assets
on the same day. The purchase prices have remained stable during the concerned period.
Following information is provided to you:
Income Statements
Particulars 2019 (`) 2020 (`)
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 49,000 14,000
Interest 2,000 59,000
Net Profit 15,000 17,000
Balance Sheet
Assets & Liabilities 31-12-2019 31-12-2020
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
17
Total Current Assets (CA) 1,20,000 1,83,000

Payables 50,000 76,000
Totals Current Liabilities (CL) 50,000 76,000
Working Capital (CA – CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures - 30,000
1,00,000 1,47,000
You are required to calculate the following ratios for the years 2019 - 2020.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio
(vi) Net Profit to Net Worth Ratio, and
(vii) Receivables Collection Period.
Ratio relating to capital employed should be based on the capital at the end of the year.
Give the reasons for change in the ratios for 2 years. Assume opening stock of ` 40,000
for the year 2019. Ignore Taxation.
Question 10
The capital structure of Beta Limited is as follows:
Equity share capital of ` 10 each 8,00,000
9% preference share capital of ` 10 each 3,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent), ` 2, 70,000; Depreciation,
` 60,000; Equity dividend paid, 20 per cent; Market price of equity shares, ` 40.
You are required to compute the following, showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Price-earnings ratio.
18
TO BE DISCUSSED ONLY IN CLASSROOM

Question 1
MN Limited gives you the following information related for the year ending 31st March,
2020:
(1) Current Ratio 2.5: 1
(2) Debt-Equity Ratio 1: 1.5
(3) Return on Total Assets (After Tax) 15%
(4) Total Assets Turnover Ratio 2
(5) Gross Profit Ratio 20%
(6) Stock Turnover Ratio 7
(7) Current Market Price per Equity Share ` 16
(8) Net Working Capital ` 4, 50,000
(9) Fixed Assets ` 10, 00,000
(10) 60,000 Equity Shares of ` 10 each
(11) 20,000, 9% Preference Shares of `10 each
(12) Opening Stock ` 3, 80,000
(i) Quick Ratio
(ii) Fixed Assets Turnover Ratio
(iii) Proprietary Ratio
(iv) Earnings per Share
(v) Price-Earning Ratio.
Question 2
The assets of SONA Ltd. consist of fixed assets and current assets, while its current
liabilities comprise bank credit in the ratio of 2: 1. You are required to prepare the Balance
Sheet of the company as on 31st March 2020 with the help of following information:
Share Capital ` 5, 75,000
Working Capital (CA-CL) ` 1, 50,000
Gross Margin 25%
Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.8: 1
Reserves & Surplus to Bank & Cash 4 times
Assume 360 days in a year
19
Question 3
JKL Limited has the following Balance Sheets as on March 31, 2019 and March 31, 2020:
Balance Sheet
Assets & Liabilities (`) In Lakhs
March 31, 2020 March 31, 2019
Sources of Funds:
Shareholders Funds 2,377 1,472
Loan funds 3,570 3,083
5,947 4,555
Applications of Funds:
Fixed Assets 3,466 2,900
Cash and bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407
Other 1,567 1,404
Current Assets (3,937) (3,794)
Less: Current Liabilities 5,947 4,555
The Income Statement of the JKL Ltd. for the year ended is as follows:
(`) In Lakhs
March 31, 2020 March 31, 2019
Sales 22,165 13,882
Less: Cost of Goods sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative 1,135 752
expenses
Earnings before Interest and Tax (EBIT) 170 586
Interest Expense 113 105
Profits before Tax 57 481
Tax 23 192
Profits after Tax (PAT) 34 289
Required:
(i) Calculate for the year 2019 – 2020:
(a) Inventory turnover ratio
20
(b) Financial Leverage

(c) Return on Capital Employed (ROCE)
(d) Return on Equity (ROE)
(e) Average Collection period.
(ii) Give a brief comment on the Financial Position of JKL Limited.
21
HOMEWORK SECTION
Question 1
Using the following information, complete the Balance Sheet given below:
(i) Total debt to net worth 1: 2
(ii) Total assets turnover 2
(iii) Gross profit on sales 30%
(iv) Average collection period (Assume 360 days in a year) 40 days
(v) Inventory turnover ratio based on cost of goods sold and year- 3
end inventory
(vi) Acid test ratio 0.75
Balance Sheet as on March 31, 2020

Equity Shares Capital 4,00,000 Plant and Machinery and -
Reserves and Surplus 6,00,000 other Fixed Assets
Total Debt: Current Assets:
Current liabilities - Inventory -
Debtors -
- Cash -
- -
Question 2
Using the following data, complete the Balance Sheet given below:
Gross Profit ` 54,000
Shareholders’ Funds ` 6, 00,000
Gross Profit margin 20%
Credit sales to Total sales 80%
Total Assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8
Long-term Debt to Equity 40%
22
Balance Sheet
Creditors ………….. Cash …………..
Long-term debt ………….. Debtors …………..
Shareholders’ funds ………….. Inventory …………..
Fixed assets …………..
Question 3
The following accounting information and financial ratios of M Limited relate to the year
ended 31st March, 2020:
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%
Total sales ` 30, 00,000; cash sales 25% of credit sales; cash purchases ` 2,30,000;
Working capital ` 2, 80,000; closing inventory is ` 80,000 more than opening inventory.
(i) Average Inventory
(ii) Purchases
(iii) Average Debtors
(iv) Average Creditors
(v) Average Payment Period
(vi) Average Collection Period
(vii) Current Assets
(viii) Current Liabilities.
Question 4
The total sales (all credit) of a firm are ` 6, 40,000. It has a gross profit margin of 15
per cent and a current ratio of 2.5. The firm’s current liabilities are ` 96,000; inventories
` 48,000 and cash ` 16,000. (a) Determine the average inventory to be carried by the firm,
if an inventory turnover of 5 times is expected? (Assume a 360 day year). (b) Determine
the average collection period if the opening balance of debtors is intended to be of
` 80,000? (Assume a 360 day year).
23
Question 5
Using the following information, complete this balance sheet:
Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 x
Average collection period* 18 days
Inventory turnover 9x
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.

` `
Cash - Notes and payables 1,00,000
Account - Long – term debt -
Inventory - Common stock 1,00,000
Plant and equipment - Retained earnings 1,00,000
Total assets - Total liabilities and equity -
24
Notes
25
Notes
26
FINANCING DECISIONS –
LEVERAGES
THEORY SECTION
Meaning and Scope

The term leverage, in general, refers to the relationship between two interrelated variables
of which one variable is dependent on the other.
Formula for calculating Leverage
In this chapter we have to learn and calculate 3 leverages :

1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
Operating Leverage
Income Statement for calculating Operating Leverage
Sales xx............. (independent)
Less: Variable Cost xx
Contribution xx
Less: Operating Fixed Cost xx
EBIT xx............. (dependent)
OR
Operating Leverage is a measure of operating risk. Operating risk comes into existence
due to presence of operating fixed cost (e g: Fixed salaries, rent, etc.) Operating Leverage
27
indicates the tendency of the EBIT to change disproportionately due to change in sales.
Operating Leverage of 1 indicates no operating risk. The higher the operating leverage
higher is the operating risk.
Financial Leverage
Income statement for financial leverage
EBIT xx .........(independent)
Less: Interest xx
EBT xx
Less: Tax xx
EAT xx
Less: Preference dividend (1+DDT) (xx)
Earnings for equity shareholders xx...............(dependent)
:- No of equity shares xx
EPS xx..............(dependent)
OR
Financial Leverage is a measure of financial risk and financial risk comes into existence
due to presence of fixed finance cost (e.g. interest, preference dividend). It indicates the
tendency of the EPS / Earnings for equity shareholders to change disproportionately due
to change in EBIT. FL of 1 indicates no financial risk. The higher the financial leverage
higher is the financial risk.
Combined Leverage
OR
28
OR
Combined Leverage = Operating Leverage x Financial Leverage
It is a measure of total risk.
29
CLASSWORK SECTION
Question 1
The data relating to two companies are as given below:
A Ltd. B Ltd.
Equity Capital ` 6,00,000 ` 3,50,000
12% Debentures ` 4,00,000 ` 6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit ` 30 ` 250
Fixed Costs per annum ` 7,00,000 ` 14,00,000
Variable Cost per unit ` 10 ` 75
You are required to calculate the Operating leverage, Financial leverage and Combined
leverage of two Companies.
Question 2
X Limited has estimated that for a new product its break-even point is 20,000 units if
the item is sold for ` 14 per unit and variable cost ` 9 per unit. Calculate the degree of
operating leverage for sales volume 25,000 units and 30,000 units.
Question 3
A company had the following Balance Sheet as on 31st March, 2020:
Liabilities (` in Assets (` in
crores) crores)
Equity Share Capital (50 lakhs 5 Fixed Assets (Net) 12.5
shares of ` 10 each) Current Assets 7.5
Reserves and Surplus 1
15% Debentures 10
Current Liabilities 4
20 20
The additional information given is as under:

Fixed cost per annum (excluding interest) ` 4 crores
Variable operating cost ratio 65%
Total asset turnover ratio 2.5
Income Tax rate 30%
30
Required:
Calculate the following:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
Question 4
The following details of RST Limited for the year ended 31st March, 2020 are given below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) ` 2,04 lakhs
Sales ` 30,00 lakhs
12% Debentures of ` 100 each ` 21,25 lakhs
Equity Share Capital of ` 10 each ` 17,00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial leverage
(ii) Calculate P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a
high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to
zero?
Question 5
A firm has sales of ` 75, 00,000 variable cost is 56% and fixed cost is ` 6, 00,000. It has
a debt of ` 45, 00,000 at 9% and equity of ` 55, 00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or
low capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?
31
Question 6
The operating income of a textile firm amounts to ` 1,86,000. It pays 50% tax on its
income. Its capital structure consists of the following:
14% Debentures ` 5,00,000
15% Preference Shares ` 1,00,000
Equity Shares (` 100 each) ` 4,00,000
(i) Determine the firm’s EPS
(ii) Determine the percentage change in EPS associated with 30% change (both increase
and decrease) in EBIT.
(iii) Determine the degree of financial leverage at the current level of EBIT.
(iv) What additional data do you need to compute operating as well as combined
leverage?
Question 7
The Capital structure of RST Ltd. is as follows:
(`)
Equity Share of ` 10 each 8,00,000
10% Preference Share of ` 100 each 5,00,000
12% Debentures of ` 100 each 7,00,000
20,00,000
Additional Information:
• Profit after tax (Tax Rate 30%) are ` 2, 80,000
• Operating Expenses (including Depreciation ` 96,800) are 1.5 times of EBIT
• Equity Dividend paid is 15%
• Market price of Equity Share is ` 23
Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(iv) The Net Fund Flow
Question 8
The net sales of A Ltd. is ` 30 crores. Earnings before interest and tax of the company as
a percentage of net sales is 12%. The capital employed comprises ` 10 crores of equity, `
32
2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of ` 6 crores.
Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments due to
the presence of Preference Share Capital and Borrowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that combined leverage is
3.
33
Question 1
The following information related to XL Company Ltd. for the year ended 31st March,
2020 are available to you:
Equity share capital of ` 10 each ` 25 lakh
11% Bonds of ` 1000 each ` 18.5 lakh
Sales ` 42 lakh
Fixed cost (Excluding Interest) ` 3.48 lakh
Financial leverage 1.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%
(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning per Share.
Question 2
Calculate the operating leverage, financial leverage and combined leverage from the
following data under Situation I and II and Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price ` 30 Per Unit
Variable Cost ` 15 Per Unit
Fixed Cost:
Under Situation I ` 15,000
Under Situation-II ` 20,000
Capital Structure:
Financial Plan
A (`) B (`)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
34
HOMEWORK SECTION
Question 1
Annual sales of a company is ` 60, 00,000. Sales to variable cost ratio is 150 per cent
and Fixed cost other than interest is ` 5, 00,000 per annum. Company has 11 per cent
debentures of ` 30, 00,000.
You are required to calculate the operating, Financial and combined leverage of the
company.
Question 2
From the following financial data of Company A and Company B: Prepare their Income
Statements.
Company A (`) Company B (`)
Variable Cost 56,000 60% of Sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000
Question 3
Calculate the operating leverage, financial leverage and combined leverage for the
following firms and interpret the results:
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed Cost (`) 5,00,000 2,50,000 10,00,000
Unit Variable Cost (`) 5 2 7.50
Unit Selling Price (`) 7.50 7 10.0
Interest Expense (`) 75,000 25,000 - 7,50,000
Question 4
The capital structure of ABC Ltd. as at 31.3.20 consisted of ordinary share capital of ` 5,
00,000 (face value ` 100 each) and 10% debentures of ` 5, 00,000 (` 100 each). In the
year ended with March 15, sales decreased from 60,000 units to 50,000 units. During this
year and in the previous year, the selling price was ` 12 per unit; variable cost stood at
35
` 8 per unit and fixed expenses were at ` 1, 00,000 p.a. The income tax rate was 30%.
You are required to calculate the following:
(i) The percentage of decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units.
Question 5
A firm has Sales of ` 40 lakhs; Variable cost of ` 25 lakhs; Fixed cost of ` 6 lakhs; 10%
debt of ` 30 lakhs; and Equity Capital of ` 45 lakhs.
Required:
Calculate operating and financial leverage.
Question 6
From the following details of X Ltd., prepare the Income Statement for the year ended
31st December, 2020:
Financial Leverage 2
Interest ` 2,000
Operating Leverage 3
Variable cost as a percentage of sales 75%
Income tax rate 30%
36
Notes
37
Notes
38
FINANCING DECISIONS – CAPITAL

STRUCTURE
THEORY SECTION

The Dictionary meaning of the word Capital is “money required to start or run the business”
and Structure means “arrangement”. The objective of this chapter is to give the answer
to the following question:
“How to arrange the money required to start or run the business?”
We should arrange capital or money in such a manner that the wealth of the shareholders
increases and wealth of the shareholders increases when the MPS of the shares increases.
Other things being constant MPS will increase when the EPS increases. In short, raise
money in such a manner which helps us to maximises the EPS.
Scope
In this chapter we will learn:
1. How to select the Financial Plan.
2. Calculation of Indifference Level and its importance.
3. Calculation of Financial Break-even Level and its importance.
Indifference Level
Indifference level or indifference point is that level of EBIT where equity shareholders are
indifferent between two plans i.e. at indifference level of EBIT, the EPS of two financial
plans is the same.
At Indifference Level,
EPS (plan 1) = EPS (plan 2)
Financial Break Even Point / Financial Break Even Level (F-BEP)

F-BEP is that level of EBIT, where the equity shareholders break even i.e. they are neither
at profit nor at loss. It is that level of EBIT, where EPS of a particular plan is zero. F-BEP
is that minimum level of EBIT which a plan should generate else the equity shareholders
39
will be at a loss. F-BEP is a measure of Financial Risk. Higher the financial Break even,
higher is the financial risk. F-BEP of 0 indicates no financial risk.
Importance of Indifference level and F-BEP

Indifference level along with F-BEP helps in selection of a particular plan. If the expected
EBIT is more than the Indifference Level, select that plan which has higher F-BEP as EPS
will be more. If the expected EBIT is less than indifference level, then select that plan
which has lower F-BEP as EPS will be more. If expected EBIT is equal to indifference level
then go for any plan.

40
CLASSWORK SECTION
Question 1
The Adarsh Ltd. is considering methods to finance its investment proposal. It is estimated
that initially ` 4,00,000 will be needed. Two alternative methods of raising funds are
available to the firm: (a) Issue of 15% Loan amounting to ` 2,00,000 and issue of 2,000
equity shares of ` 100 each; and (b) Issue of 4,000 equity shares of ` 100 each. The
appropriate tax rate is 35 per cent.
(i) Assuming operating profits (EBIT) of: (a) ` 70,000, and (b) ` 80,000, which financing
proposal would you recommend and why?
(ii) Compute the indifference point of the two financial plans & also verify the same.
(iii) Calculate FBEP.
Question 2
Best of Luck Ltd., a profit making company, has a paid-up capital of ` 100 lakhs consisting
of 10 lakhs ordinary shares of ` 10 each. Currently, it is earning an annual pre-tax profit
of ` 60 lakhs. The company’s shares are listed and are quoted in the range of ` 50 to `
80. The management wants to diversify production and has approved a project which
will cost ` 50 lakhs and which is expected to yield a pre-tax income of ` 40 lakhs per
annum. To raise this additional capital, the following options are under consideration of
the management:
(a) To issue equity share capital for the entire additional amount. It is expected that the
new shares (face value of ` 10) can be sold at a premium of ` 15.
(b) To issue 16% non-convertible debentures of `100 each for the entire amount.
(c) To issue equity capital for ` 25 lakhs (face value of ` 10) and 16% non-convertible
debentures for the balance amount. In this case, the company can issue shares at a
premium of ` 40 each.
You are required to advise the management as to how the additional capital can be
raised, keeping in mind that the management wants to maximise the earnings per share
to maintain its goodwill. The company is paying income tax at 50%.
Question 3
Shahji Steels Limited requires ` 25, 00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of ` 5, 00,000. While deciding about the financial
plan, the company considers the objective of maximizing earnings per share. It has three
alternatives to finance the project - by raising debt of ` 2, 50,000 or ` 10, 00,000 or `15,
41
00,000 and the balance, in each case, by issuing equity shares. The company’s share
is currently selling at ` 150, but is expected to decline to ` 125 in case the funds are
borrowed in excess of ` 10, 00,000. The funds can be borrowed at the rate of 10 percent
upto ` 2, 50,000, at 15 percent over ` 2, 50,000 and upto ` 10, 00,000 and at 20 percent
over ` 10, 00,000. The tax rate applicable to the company is 50 percent. Which form of
financing should the company choose?
Question 4
Ganesha Limited is setting up a project with a capital outlay of ` 60, 00,000. It has two
alternatives in financing the project cost.
Alternative-I: 100% equity finance by issuing equity shares of ` 10 each
Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ` 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
Calculate the indifference point between the two alternative methods of financing.
Question 5
Ganapati Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ` 2, 00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%
(c) Cost of debt 8%
Cost of preference shares 8%
(d) Tax rate 50%
(e) Equity shares of the face value of ` 10 each will be issued at a premium of ` 10 per
share.
(f) Expected EBIT is ` 80,000.
You are required to determine for each plan: -
(i) Earnings per share (EPS)
(ii) The financial break-even point.
(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans
for indifference.
42
Question 6
(a) The existing capital structure of XYZ Ltd. is as under :
Equity Shares of ` 100 each ` 40,00,000
Retained Earnings ` 10,00,000
9% Preference Shares ` 25,00,000
7% Debentures ` 25,00,000
The existing rate of return on the company's capital is 12% and the income-tax rate
is 50%.
The company requires a sum of ` 25,00,000 to finance its expansion programme for
which it is considering the following alternatives :
(i) Issue of 20,000 equity shares at a premium of ` 25 per share.
(ii) Issue of 10% preference shares.
(iii) Issue of 8% debentures.
It is estimated that the Price Earning ratios in the cases of equity, preference
and debenture financing would be 20, 17 and 16 respectively.
Which of the above alternatives would you consider to be the best?
(b) Give reasons for your choice in (a) above.
Question 7
The following figures are made available to you :
Net profit for the year/EBIT 18,00,000

Interest on secured debentures at 15% p.a. 1,12,500
(debentures were issued 3 months after the commencement of the year) 16,87,500
Income - tax at 35%

Number of equity shares (` 10 each) 1,00,000
Market quotation of equity share 109.70
The company has accumulated revenue reserves of ` 12,00,000. The company is examining
a project calling for an investment obligation of ` 10,00,000 ; this investment is expected
to earn the same rate of return as funds already employed.
You are informed that a debt equity ratio (Debt divided by debt plus equity) higher
than 60% will cause the price earning ratio to come down by 25%. The interest rate on
additional borrowals will cost company 300 basis points more than on their current
borrowal on secured debentures.
43
You are required to advise the company on the probable price of the equity share, if:
(a) the additional investment were to be raised way of loans ; or
(b) the additional investment were to be raised by way of equity.
Question 8
Alpha Company is contemplating conversion of 500 14% convertible bonds of ` 1,000
each. Market price of the bond is ` 1,080. Bond indenture provides that one bond will be
exchanged for 10 shares. Price earning ratio before redemption is 20 : 1 and anticipated
price - earning ratio after redemption is 25 : 1. Number of shares outstanding prior to
redemption are 10,000. EBIT amounts to ` 2,00,000. The company is in the 35% tax
bracket. Should the company convert bonds into shares? Give reasons.
44
Question 1
Delta Ltd. currently has an equity share capital of ` 10, 00,000 consisting of ` 1, 00,000
Equity share of ` 10 each. The company is going through a major expansion plan requiring
to raise funds to the tune of ` 6, 00,000. To finance the expansion the management has
following plans:
Plan-I : Issue 60,000 Equity shares of ` 10 each.
Plan-II : Issue 40,000 Equity shares of ` 10 each and the balance through long-
term borrowing at 12% interest p.a.
Plan-III: Issue 30,000 Equity shares of ` 10 each and 3,000, 9% Debentures of `
100 each.
Plan-IV : Issue 30,000 Equity shares of ` 10 each and the balance through 6%
preference shares.
The EBIT of the company is expected to be ` 4, 00,000 p.a. assume corporate tax rate of
40%.
Required:
(i) Calculate EPS in each of the above plans.
(ii) Ascertain financial leverage in each plan.
Question 2
Z Limited is considering the installation of a new project costing ` 80, 00,000. Expected
annual sales revenue from the project is ` 90, 00,000 and its variable costs are 60 percent
of sales. Expected annual fixed cost other than interest is ` 10, 00,000. Corporate tax rate
is 30 percent. The company wants to arrange the funds through issuing 4, 00,000 equity
shares of ` 10 each and 12 percent debentures of ` 40, 00,000.
(i) Calculate the operating, financial and combined leverages and Earnings per Share
(EPS).
(ii) Determine the likely level of EBIT, if EPS is ` 4, or ` 2, or Zero.
45
HOMEWORK SECTION
Question 1
A promoter is considering methods to finance establishment of a company. Initially,
` 2,00,000 will be needed. The promoter is considering two proposals for the purpose:
(a) issue of 15% Debentures of ` 1,00,000, and issue of 1,000 equity shares of ` 100
each; and
(b) issue of 2,000 equity shares of ` 100 each. The tax rate is 35 per cent.
(i) (a) Compute the indifference point of the above proposed financial plans.
(b) Show that the indifference point computed in (a) above is correct.
(ii) Initially, the company is expected to operate at a level of 1,00,000 units (selling
price ` 2 per unit; variable cost, Re.1 per unit, and fixed operating costs, ` 50,000).
Calculate the Estimated EPS. Which Plan should be selected.
(iii) Assuming everything to be the same as given in situation (ii) except that sales rises
by 20 per cent from 1,00,000 units to 1,20,000 units.
Calculate the EPS without making income statement for the selected plan.
Question 2
A new project is under consideration in Zip Ltd., which requires a capital investment of
` 4.50 crores. Interest on term loan is 12% and Corporate Tax rate is 50%. If the Debt
Equity ratio insisted by the financing agencies is 2: 1, calculate the point of indifference
for the project.
Question 3
X Ltd. is considering the following two alternative financing plans:
Plan – I (`) Plan – II (`)
Equity shares of ` 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 -
Preference Shares of ` 100 each - 2,00,000
6,00,000 6,00,000
The indifference point between the plans is ` 2, 40,000. Corporate tax rate is 30%.
Calculate the rate of dividend on preference shares.
46
Notes
47
Notes
48
COST OF CAPITAL
THEORY SECTION

The minimum required rate of return expected by the investors on their investment is the
cost of capital. Cost of capital acts as a cut-off rate in selection of long term investment
proposals. It is also useful in capital structure decisions. Cost of capital is also known
as cut-off rate, overall cost of capital, weighted average cost of capital, hurdle rate,
composite cost of capital, WACC, K0, etc.
Scope
In this chapter we will learn
(1) Calculation of Specific cost of Capital
(2) Calculation of Overall cost of Capital
(3) Capital structure theories
* Specific cost of capital
(a) Cost of Debt (Kd)
(i) Cost of irredeemable / perpetual debt
(ii) Cost of Redeemable Debt

Where, RV is the redemption value and NP is the Net Proceeds.
(b) Cost of Preference Shares (Kp)

(i) Cost of irredeemable / perpetual preference shares
49
(ii) Cost of Redeemable Preference shares
Where, RV is the redemption value and NP is the Net Proceeds, DDT is dividend distribution
Tax.
(c) Cost of Equity (Ke)

(i) Dividend Yield Approach / Dividend Price Approach

DPS is Expected Dividends per share
MPS is the Market price per share
This approach takes into account the fact that investor is prepared to pay a particular
market price taking into account the expected dividend e.g. if the expected dividends
are ` 5 and the prevailing market price is ` 20, then the cost of equity works out to 25%.
Under this approach it is presumed that the investors only expects dividends while
making the investments i.e. the investors does not aspire for capital appreciation.
Secondly, this approach is based on the profits which are expected to be distributed
among the shareholders rather than what is available for the investors.

(ii) Earnings Yield Approach/ Earnings Price Approach
EPS is Expected Earnings per share

MPS is the Market price per share
This approach removes the defect of the earlier approach i.e. the cost is calculated
with reference to the amount available for Equity shareholders rather than amounts
distributed. However, even this approach ignores he growth factor.
(iii) Dividend Yield Approach + Growth Model / Gordon’s Formula / Dividend Discount
Model / Constant Growth Model
50
Where, D1 is the expected dividend at the end of year 1

P0 is the market price of the share now
G is the growth in dividends
While dividend price approach assumes constant amount of dividend per share year
after year. This method assumes dividend per share to change year after year at
constant rate. This method is based on the assumption that equity shareholders are
not just satisfied with present rate of dividend but they expect an increase in it every
year at a constant rate.
This formula is also used to calculate the Fair Value / Equilibrium Price / Justifiable
Price / Intrinsic Value / Theoretical Price of the share
Assumptions
• Ke is assumed to be constant
• Growth in dividend is constant
• Ke > g
(iv) Earnings Yield Approach + Growth Model
Where, E1 is the expected dividend at the end of year 1

P0 is the market price of the share now
G is the growth in earnings

(v) Realised Yield Approach
According to this approach, the cost of equity capital should bedetermined on
the basis of return actually realised by the investors in a company on their equity
shares. Thus, according to this approach the past records in a given period regarding
dividends and the actual capital apprecation in the value of the equity shares held
by the shareholders should be taken to compute the cost of equity capital.
This approach gives fairly good results in case of companies with stable dividends
and growth records. In case of such companies, it can be assumed with reasonable
degree of certainty that the past behaviour will be repeated in the future also.

51
(vi) Capital Asset Pricing Model (CAPM)

Any rate of return including cost of equity capital is affected by the risk. If an
investment is more risky, the investor will demand higher compensation in the
form of higher expected returns. The equity shareholders receive dividends after
interest has been paid to the debt holders and preference dividend to the preference
shareholders. This means their return will be volatile with reference to the change
in the company’s performance. The cost of equity capital will be higher than that of
other sources to reflect this risk.
CAPM classifies the total risk associated with a security / asset into two classes i.e.
(i) the diversifiable risk or unsystematic risk and,
(ii) non-diversifiable risk or systematic risk. The diversifiable risk refers to the risk
which can be eliminated by more and more diversification. On the other hand,
non-diversifiable risk is that which affects all the firms at a particular point of
time and hence cannot be eliminated e.g. risk of political uncertainties, risk of
government policies, etc.
An investor can eliminate the diversifiable risk by diversification into more and more
securities; however, the non diversifiable risk is the point where investor’s attention
is required. This non-diversifiable risk of a security is measured in relation to the
market portfolio and is denoted by beta coefficient, ß. In order to estimate the
required rate of return of the equity investors, the risk associated with the shares as
represented by ß needs to be estimated.
As per CAPM,
Ke = Irf + (Rm – Irf) ß

Where, Irf is the return from risk free securities
Rm = Return from the market portfolio
ß = beta factor
(Rm - Irf) = Market risk premium
ß is a measure of the systematic risk of a security.
ß is an Index of how sensitive the returns of a security are to the market returns. ß
is a measure of how responsive the price of a share is to the market movement. If ß
= 1, it means the security exactly copies the market movement i.e. has same risk as
the market. If ß = 2 it means the share is twice as risky as market. If ß = 0.5, it means
that security is only half as risky as market i.e. only half of the market movement is
reflected in the price of the share.
52
(d) Cost of retained Earnings (Kr)

Generally, companies do not distribute the entire profits by way of dividends
among the shareholders. A part of such profits is retained for future expansion and
development. Hence, the equity shareholders block their money with the company
in two ways (i) directly by subscribing to the shares and (ii) amount retained by the
company. Apparently, retained earnings may appear to carry no cost since they
represent funds which have not been raised from outside, but that is not the case. If
earnings are not retained they will be distributed in the form of dividends and hence
cost of retained earnings must therefore be viewed as the opportunity cost of the
forgone dividends to the equity shareholders. Cost of retained earnings is equal to
the income what a shareholder could have earned otherwise by investing the same
in an alternative investment, if the company would have distributed the earnings by
way of dividends instead of retaining it in the business. Therefore every shareholder
expects from the company that much of income on the retained earnings for which
he is deprived of the income arising on its alternative investment.Since it is very
difficult to ascertain the opportunity cost forgone, in absence of information, it is
assumed that the equity shareholders expected the same rate of return which they
expect on their equity share capital. Hence, if no information is given Kr = Ke.
Note: While computing Kr floatation costs are to be ignored.
* Weighted Average Cost of Capital

Sources Amount Weights Cost in % W*C
Debt xxx xx xxx xx
Preference Share Capital xxx xx xxx xx
Equity Share Capital xxx xx xxx xx
Retained Earnings xxx xx xxx xx
WACC xxx
Types of Weights to ascertain WACC

1. Book Value / Balance Sheet Value weights
In this case, to calculate the WACC Book Values or Balance Sheet Values of each
source of finance are considered for ascertaining weights.
2. Market Value weights

In this case, for calculating WACC, Market value of each source of Finance is considered
for ascertaining weights. Between Market values and Book values preference is
53
to be given to Market Value as investors invest always at Market Values and not
Book Values. While calculating WACC as per Market Value weights ignore Retained
Earnings as the market value of Equity Share Capital includes the Value of Retained
earnings.
3. Marginal Value Weights

Whenever we have to calculate WACC for any specific or additional project, Marginal
Value Weights are considered. In this case, the proportion of additional funds raised
is considered as weights to calculate WACC.
* Capital Structure Theories

General assumptions of Capital structure theories
The relationship between the leverage, cost of capital and the value of the firm has
been analysed and examined in different ways. However, the following assumptions
have been made to understand this relationship.
(1) There are only two sources of funds i.e.equity and debt, which is having fixed
interest. (No preference share capital)
(2) The total assets of the firm are given and there would be no change in the
investing decision of the firm (Total assets of the firm remain the same)
(3) The firm has a policy of distributing the entire profits among the shareholders.
(100% Payout Ratio)
(4) The operating profits of the firm are given and are expected to remain
constant. (EBIT to remain constant)
(5) The Operating or the business risk of the firm is given and assumed to be
constant. (Operating Leverage to remain same)
(6) There are no corporate or Personal taxes
(7) Kd is less than Ko
Net Income Approach

This theory was suggested by David Durand. The NI approach to the relationship between
Debt-Equity Mix, cost of Capital and Value of the firm is the simplest in approach and
explanation. This theory states that there is a relationship between the capital structure
and the Ko of the firm. If there will be change in the capital structure, WACC will definitely
change.
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Apart from the general assumptions the following additional assumptions are made by
this theory
• Both Kd and Ke are assumed to remain same irrespective of the debt equity mix i.e.
change in the capital structure doesn’t affect the risk perception of the investors.
The NI approach start with the argument that change in the financial mix of the firm
will lead to change in the WACC and hence it will affect the Overall Value of the firm.
As Kd is less than Ke, the increased use of cheaper debt in the overall capital structure
will result in magnified returns available to the shareholders. The increased returns to
the shareholders will increase the total value of the equity and thus increases the total
value of the firm. NI approach suggest that higher the degree of leverage, better it is, as
the value of the firm would be higher. In other words, a firm can increase its value just by
increasing the debt proportion in the capital structure.
Net Operating Income Approach

The NOI approach is opposite to the NI approach. This is also known as Independent
Hypothesis. According to the NOI approach, the market value of the firm depends upon
the net operating profit or EBIT and the overall cost of Capital, WACC. The financing mix
or the capital structure is irrelevant and does not affect the value of the firm. The NOI
approach has made the following assumptions
• The cost of the Debt, Kd, is taken to be constant
• The use of more and more debt in the capital structure increases the risk perception
of the shareholders and thus their expectation in the form returns also increases.
The increase in Ke is such as to completely offset the benefits of employing the
cheaper debt.
As the debt proportion or the financial leverage increases, the risk of the equity
shareholders also increases and thus Ke also increases. However, the increase in Ke, is
such that the overall all value of the firm remains the same. It may be noted that for
55
an all equity firm the Ke is just equal to Ko. As the debt proportion increases, Ke also
increases. However, the Ko remains constant because increase in Ke is just sufficient to
offset the benefits of cheaper debt financing. Under the NOI approach Ko is constant and
therefore there is no optimal Capital structure, rather every capital structure is as good
as any other and every capital structure is optimum.
Traditional Approach
Traditional Approach is a practical viewpoint. The NI and the NOI approach hold extreme
views on the relationship between the Debt Equity Mix, cost of capital and Value of the
Firm. In practical situation, both these approaches seem to be unrealistic.
As per Traditional Approach the firm should make a judicious use of both the debt and the
equity to achieve a capital structure which may be called the optimal capital structure. At
this capital structure, the overall cost of capital, WACC, of the firm will be minimum and
the value of the firm will be maximum.
The traditional view states that the value of the firm increases with increase in the Debt
Equity mix but up to a certain limit only. Beyond this limit, the increase in the financial
leverage will increase its WACC also, and the value of the firm will decrease.
When (cheaper) debt is introduced in the capital structure and the financial leverage
increases, the Ke remains the same as the equity investors expect a minimum leverage in
every firm. The Ke, doesn’t increases even with the increase in the debt proportion. The
argument for Ke, remaining unchanged may be that up to a particular degree of leverage,
the interest charge may not be large enough to pose a real threat to the dividend payable
to the shareholders. This constant Kd and Ke will make the Ko fall. Thus, it shows that the
benefits of cheaper debts are available to the firm. This position doesn’t continue when
leverage in future increases.
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The increase in leverage beyond the limit increases the risk perception of the equity
investors also and as a result the Ke, starts increasing. However, the benefits of use of
Debt in the capital structure will be so large, that even after off- setting the effects of
increased Ke, the Ko may still go down or may become constant for some degree of FL.
If the firm increases the FL further then the risk perception of the Debt investor will also
increase. The already rising Ke and now increase in the Kd will result into increase of
Ko. Therefore, the use of leverage beyond a point will have the effect of increase in the
overall cost of Capital of the firm resulting into decrease in the value of the firm.
Modigliani Miller Approach

MM have favoured the NOI approach i.e. the Value of the firm remains the same, irrespective
of the Capital structure. There is nothing known as Optimum Capital Structure and for
any Debt equity Mix the Ko remains the same and hence the value of the firm remains
the same. This point they have proved with the help of a behavioural process known as
arbitrage process.
MM model argues that, if two firms are alike in all aspect expect in their capital structure
and Market Value, then the investors will develop a tendency to sell the shares of the
overvalued firm (creating a selling pressure) and to buy the shares of the undervalued
firm (creating buying pressure). This, buying and selling will continue till the two firms
have same market value.
So as per MM, when two companies are identical, there exist a value known as equilibrium
value and Ko known as equilibrium Ko.
Therefore, as per MM, if there are no taxes
Value of Levered Co. = Value of Unlevered Co.
MM model, if there are corporate taxes
Value of Levered Co. = Value of Unlevered Co. + Debt x tax rate.
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The MM model works under the following set of assumptions

(1) There are 2 sources of finance – Debt and Equity.
(2) No corporate and personal taxes (later on this assumption was relaxed).
(3) Investors have all the full knowledge of the over valuation and under valuation of
the firm.
(4) The Loan is available to the investors at the same rate of interest at which it is
available to the company.
(5) Investors are rational wanting to earn arbitrage profits.
(6) There are no frictions in trading i.e. no transaction costs.
58
CLASSWORK SECTION
Question 1
(a) A company issues ` 10,00,000 16% Debentures of ` 100 each. The company is in 35%
tax bracket. You are required to calculate the cost of debt after tax, if debentures are
issued at (i) Par, (ii) 10% discount and (iii) 10% premium.
(b) If brokerage is paid at 2% what will be the cost of the debentures if the issue is at
premium of 10%.
Question 2
The share of ABC Ltd. is presently traded at ` 50 and the company is expected to pay
dividends of ` 4 per share with a growth rate expected at 8% p.a. It plans to raise fresh
equity share capital. The merchant banker has suggested that an under pricing of the Re.
1 is necessary in pricing the new issue besides involving a cost of 50 paise per share on
misc. expenses. Find out the cost of existing shares as well as the new equity given that
the dividend rate and growth rate are not expected to change.
Question 3
Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ` 103, at
` 3 premium to their par value of ` 100. The current market price of these debentures is
` 94. If the company pays corporate tax at a rate of 35 per cent what is its current cost
of debenture capital?
Question 4
XYZ Ltd. issues 2,000 10% preference shares of ` 100 each at ` 95 each. The company
proposes to redeem the preference shares at the end of 10th year from the date of issue.
Calculate the cost of preference share?
Question 5
The latest Balance Sheet of D Ltd. is given below : (` '000)
Ordinary shares (50000 shares) 500
Share Premium 100
Retained Profits 600
1,200
8% Preference Shares 400
13% Perpetual debt (Face value ` 100 each) 600
2,200
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The ordinary shares are currently priced at ` 39 ex-dividend each and ` 25 preference
share is priced at ` 18 cum - dividend. The debentures are selling at 110 per cent ex-
interest and tax is paid by D Ltd. at 40 per cent. D Ltd.'s cost of equity has been estimated
at 19 per cent.
Calculated the weighted average cost of capital, (based on market value) of D Ltd.
Question 6
A company has paid dividend of ` 1 per share (of face value of ` 10 each) last year and
it is expected to grow @ 10% next year. Calculate the cost of equity if the market price of
share is ` 55.
Question 7
Masco Limited wishes to raise additional finance of ` 10 lakhs for meeting its investment
plans. It has ` 2,10,000 in the form of retained earnings available for investment purposes.
Further details are as following:
(1) Debt / equity mix 30%/70%
(2) Cost of debt
Upto ` 1,80,000 10% (before tax)
Beyond ` 1,80,000 16% (before tax)
(3) Earnings per share `4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate in dividend 10%
(6) Current market price per share ` 44
(7) Tax rate 50%
You are required:
(a) To determine the pattern for raising the additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity, and
(d) Compute the overall weighted average after tax cost of additional finance.
Question 8
Calculate the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:

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(`)
Debentures (` 100 per debenture) 5,00,000
Preference shares (`100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000
The market prices of these securities are:
Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.
Additional information:
(1) ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs,
10 year maturity.
(2)
`100 per preference share redeemable at par, 5% coupon rate, 2% floatation
cost and 10 year maturity.
(3) Equity shares has ` 4 floatation cost and market price ` 24 per share.
The next year expected dividend is ` 1 with annual growth of 5%. The firm has
practice of paying all earnings in the form of dividend.
Corporate tax rate is 50%.
Question 9
ABC Ltd. has the following capital structure which is considered to be optimum as on 31st
March, 2017.
(`)
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ` 23.60. Next year dividend per share is 50%
of year 2017 EPS. The following is the trend of EPS for the preceding 10 years which is
expected to continue in future.
Year EPS (`) Year EPS (`)
2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
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The company issued new debentures carrying 16% rate of interest and the current market
price of debenture is ` 96.
Preference share ` 9.20 (with annual dividend of ` 1.1 per share) were also issued. The
company is in 50% tax bracket.
(A) Calculate after tax:
(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)
(B) Calculate marginal cost of capital when no new shares are issued.
(C) How much can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year’s investment are 50 percent of
2017.
(D) What will the marginal cost of capital when the funds exceeds the amount calculated
in (C), assuming new equity is issued at ` 20 per share?
Question 10
X Ltd has shares of ` 10/-each and the current market price of the share is ` 24. The
dividend paid by the company in the past four years have been Re. 1, Re.1.1, Re.1.21 and
Re. 1.331. Calculate Ke.
Question 11
The details of the dividend paid by X ltd on existing equity shares of ` 10/- each for the
past five years are as follows :
Year DPS
1 1
2 1.06
3 1.1025
4 1.16
5 1.23
The current market price of the share is ` 40/-. The company is planning to issue new
shares of ` 10/- each with floatation cost of ` 5/- per share. Calculate Ke of the existing
equity shares and that of the new shares.
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Question 12
Equity shareholders funds is ` 1,00,000/-, ROE is 20%, Dividend payout ratio is 40%.
Calculate growth rate. Assume ROE and payout ratio to remain the same. Ignore DDT.
Question 13
The Fincon Ltd. is planning an equity issue in the current year. It has an expected Earning
per share (EPS) of ` 25 and proposes to pay a dividend of ` 15 per share at the current
year-end. With a P/E ratio of 8, it wants to offer the issue at market price. The flotation
cost is expected to be 10 per cent of the issue price.
Determine the required rate of return for equity shares (cost of equity) before issue and
after the issue.
Question 14
From the following capital structure of XYZ Ltd., determine appropriate weighted
average cost of capital.
(`)
Equity shares (1,00,000) 38,00,000
Preference shares 8,00,000
Debentures 50,00,000
Bank loan (long term) 18,00,000
Bank loan (short term) 14,00,000
Trade creditors 6,00,000
(i) Equity shares include the existing 60,000 shares having current market value of `
40 per share and the balance is net proceeds from the new current year (issue price
of the share, ` 40; flotation cost per share, ` 5). The projected EPS and DPS for the
current year are ` 8 and ` 5 respectively.
(ii) Dividend indicated on preference shares is 16 per cent.
(iii) Pre-tax cost of debentures - 15.5 per cent.
(iv) Interest on bank loan 15 per cent (long term) and 14 per cent (short - term).
(v) Corporate tax : 35 per cent.
(vi) Market value of preference shares is ` 8,50,000 & of debentures is ` 50,00,000.
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Question 15
The beta coefficient of Target Ltd., is 1.4. The company has been maintaining 8 per cent
rate of growth in dividends and earnings. The last dividend paid was ` 4 per share. The
return on government securities is 10 per cent while the return on market portfolio is 15
per cent. The current market price of one share of Target Ltd., is ` 36.
(a) What will be the equilibrium price per share of Target Ltd.?
(b) Would you advise purchasing the share?
Question 16
Y Ltd. retains ` 7,50,000 out of its current earnings. The expected rate of return to the
shareholders, if they had invested the funds elsewhere is 10%. The brokerage is 3% and
the shareholders come in 30% tax bracket. Calculate the cost of retained earnings.
Question 17
ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, ` 10 par) ` 1,500 million
Reserves and Surplus ` 2,250 million
10.5% Preference Share Capital (1 million shares, ` 100 par) ` 100 million
9.5% Debentures (1.5 million debentures, ` 1,000 par) ` 1,500 million
8.5% Term Loans from Financial Institutions ` 500 million
The debentures of ABC Limited are redeemable after three years and are quoting at `
981.05 per debenture. The applicable income tax rate for the company is 35%.
The current market price per equity share is ` 60. The prevailing default-risk free interest
rate on 10- year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The
beta of the company is 1.1875.
The preferred stock of the company is redeemable after 5 years is currently selling at `
98.15 per preference share.
Required:
(i) Calculate weighted average cost of capital of the company using market value
weights.
(ii) Define the marginal cost of capital schedule for the firm if it raises ` 750 million for
a new project. The firm plans to have a debt of 20% of the newly raised capital. The
beta of new project is 1.4375. The debt capital will be raised through term loans, it
will carry interest rate of 9.5% for the first ` 100 million and 10% for the next ` 50
million.
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Question 18
ABC, Ltd., is expecting an annual Earnings before the payment of Interest and Tax of `
2 lacs. The company in its capital structure has ` 8 lacs in 10% debentures. The cost of
equity or capitalisation rate is 12.5%. You are required to calculate the value of firm
according to NI Approach. Also compute the overall cost of capital.
Question 19
ABC Ltd., is expecting an Earning before interest & tax of ` 4,00,000 and belongs to risk
class of 10%. You are required to find out the value of firm & cost of equity capital if it
employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of
` 20,00,000.
Use NOI approach.
Question 20
Abhishek Ltd. with EBIT of ` 3,00,000 is evaluating a number of possible capital structures,
given below. Which of the capital structure will you recommend, and why? Ignore
tax
Capital Structure Debt ( ` ) kd% ke%
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
Question 21
The following are the costs and values for the firms A and B according to the traditional
approach:
Firm A Firm B
Total value of firm, V 50,000 60,000
Market value of debt, D 0 30,000
Market value of equity, E 50,000 30,000
Expected net operating income 5,000 5,000
- Cost of debt 0 1,800
Net income 5,000 3,200
Cost of equity, ke 10.00% 10.67%
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Compute the equilibrium value for Firm A and B in accordance with the M - M approach.
Assume that (i) taxes do not exist and (ii) the equilibrium value of k0 is 9.09%.
Question 22
There are two firms P and Q which are identical except P does not use any debt in its
capital structure while Q has ` 8,00,000, 9% debentures in its capital structure. Both the
firms have earning before interest and tax of ` 2,60,000 p.a. and the capitalisation rate
is 10%. Assuming the corporate tax of 30%, calculate the value of these firms according
to MM Hypothesis.
Question 23
RES Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost
of equity, ke = 21%. The company wants to buyback equity shares worth ` 5,00,000 by
issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken
as 30%. After the capital restructuring and applying MM Model (with taxes), you are
required to calculate :
(i) Market value of RES Ltd.
(ii) Cost of Equity ke
(iii) Weighted average cost of capital and comment on it.
Question 24
There are two company N Ltd. and M Ltd., having same earnings before interest and
taxes i.e. EBIT of ` 20,000. M Ltd. is a levered company having a debt of ` 1,00,000 @ 7%
rate of interest. The cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%. Find out how
arbitrage process will be carried on?
Question 25
There are two companies U Ltd. and L Ltd., having same NOI of ` 20,000 except that L
Ltd. is a levered company having a debt of `1,00,000 @ 7% and cost of equity of U Ltd.&
L Ltd. are 10% and 18% respectively.
Show how arbitrage process will work.
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Question 1
The following details are provided by the GPS Limited :
(`)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000
The cost of equity capital for the company is 16.30% and Income Tax rate for the company
is 30%.
You are required to calculate the Weighted Average Cost of Capital (WACC) of the company.
Question 2
From the following capital structure of a company, calculate the overall cost of capital,
using (a) book value weights, and (b) market value weights
Sources Book Value Market Value
Equity Share capital (`10 shares) 45,000 90,000
Retained Earnings 15,000 ----
Preference share capital 10,000 15,000
Debentures 30,000 35,000
The after tax cost of different sources of finance is as follows:
Equity share capital – 14%
Preference share capital – 10%
Debentures – 5%
Question 3
The Servex Company has the following capital structure on 30th June.
(`)
Ordinary Shares (2,00,000 shares) 40,00,000
10% Preference Shares 10,00,000
80,00,000
The share of the company sells for ` 20. It is expected that company will pay next year
a dividend of ` 2 per share, which will grow at 7 per cent forever. Assume a 50 per cent
tax rate.
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You are required to :

(a) Compute a weighted average cost of capital based on the existing capital structure.
(b) Compute the new weighted average cost of capital if the company raises an
additional ` 20 lakh debt by issuing 15 per cent Debentures. This would result in
increasing the expected dividend to ` 3 and leave the growth rate unchanged, but
the price of share will fall to ` 15 per share.
(c) Compute the cost of capital if in (b) above, growth rate increases to 10 percent.
Use book value weights.
Question 4
XYZ Ltd., is expecting an EBIT of ` 3,00,000. The company presently raised its entire fund
requirement of ` 20 lakhs by issue of equity at a capitalisation rate of 16%. The firm is
now contemplating to redeem a part of capital by introducing debt financing. The firm
has two options-to raise debt to the extent of 30% or 50% of total funds. It is expected
that for debt financing upto 30% the rate of interest will be 10% and equity capitalisation
rate is expected to increases to 17%. However, if firm opts for 50% debt then interest rate
will be 12% and equity capitalisation rate will be 20%. You are required to compute value
of firm and its overall cost of capital under different options. Use traditional approach.
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HOMEWORK SECTION
Question 1
PQR Ltd. has the following capital structure on October 31, 2015:
Sources of capital (`)
Equity Share Capital (2,00,000 Shares of ` 10 each) 20,00,000
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
80,00,000
The market price of equity share is ` 30. It is expected that the company will pay next
year a dividend of ` 3 per share, which will grow at 7% forever. Assume 40% income tax
rate.
You are required to compute weighted average cost of capital using market value weights.
Question 2
A company issued 40,000, 12% Redeemable Preference Share of `100 each at a premium
of ` 5 each, redeemable after 10 years at a premium of ` 10 each. The floatation cost of
each share is ` 2.
You are required to calculate cost of preference share capital ignoring dividend tax.
Question 3
You are required to determine the weighted average cost of capital of a firm using (i)
book-value weights and (ii) market value weights. The following information is available
for your perusal:
Present book value of the firm’s capital structure is:
Sources of capital (`)
Debentures of ` 100 each 8,00,000
Preference shares of ` 100 each 2,00,000
Equity shares of ` 10 each 10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures @ ` 110, Preference shares @ ` 120 and Equity shares @ ` 22.
Anticipated external financing opportunities are as follows:
(i) ` 100 per debenture redeemable at par : 20 years maturity 8% coupon rate, 4%
69
floatation costs, sale price ` 100.

(ii) ` 100 preference share redeemable at par : 15 years maturity, 10% dividend rate,
5% floatation costs, sale price ` 100.
(iii) Equity shares : ` 2 per share floatation costs, sale price ` 22.
In addition, the dividend expected on the equity share at the end of the year is ` 2 per
share; the anticipated growth rate in dividends is 5% and the firm has the practice of
paying all its earnings in the form of dividend. The corporate tax rate is 50%.
Question 4
ABC Ltd. wishes to raise additional finance of ` 20 lakhs for meeting its investments plan.
The company has ` 4,00,000 in the form of retained earnings available for investment
purposes.
The following are the further details:
- Debt equity ratio 25 : 75.
- Cost of debt at the rate of 10% (before tax) upto ` 2,00,000 and 13% (before tax)
beyond that.
- Earnings per share ` 12.
- Dividend payout 50% of earnings.
- Expected growth rate in dividend 10%.
- Current market price per share, ` 60.
- Company’s tax rate is 30% and shareholder’s personal tax rate is 20%.
Required:
(i) Calculate the post tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance.
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Notes
71
Notes
72
INVESTMENT DECISIONS – CAPITAL

BUDGETING
THEORY SECTION

Decisions relating to long term assets / capital assets / fixed assets / long term projects
are known as Capital Budgeting decisions. For e.g. setting up a new branch, purchase
of machinery, manufacturing a new product, etc. The unique part of these decisions is
that the outflows associated with the project are immediate and the inflows are spread
over a number of years. Most of the capital budgeting decisions are irreversible decisions
involving huge cash outflows. Once taken, the firm may not be able to revert back unless
it is ready to absorb heavy losses. Therefore, the capital budgeting decisions should be
taken only after considering and evaluating each and every minute detail of the project
else the financial consequences will have far reaching effects.
This chapter revolves around two things, comparing the cash outflows to that of the cash
inflows. Cash outflows will always be given in the question for that matter even cash
inflows will be given, if not then the same can be calculated as follows:
Sales xx
Less: Variable Cost xx
Fixed Cost xx
Cash flow before tax (CFBT / NPBDT) xx
Less: Depreciation XX
Net Profit before tax (NPBT) xx
Less: Tax xx
Net Profit after tax (NPAT) xx
Add: Depreciation xx
Cash Flows after tax (CFAT / CI) xx
Scope
This chapter will teach us various methods for evaluating long term proposal.
Methods for evaluation
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(a) Pay Back Period Approach (PBP)

(b) Net Present Value (NPV)
(c) Profitability Index (PI)
(d) Internal Rate of Return (IRR)
(e) Discounted Payback period (Discounted PBP)
(f) Average / Accounting Rate of Return (ARR)
(g) Modified IRR
Pay back period

The length of time taken to recover the original investment is the pay back period. For e.g.
if the project requires a cash outflow of `10 Lacs which gets recovered say within 4 years
then the payback period is 4 years.
Decision Rule:
Select that project whose payback period is less.
Limitations:
(a) It ignores Time Value of Money
(b) Post Payback period cash inflows are completely ignored i.e. all cash inflows are not
considered.
Net Present Value

This method takes into consideration all the cash inflows related to the project and also
incorporates the concept of time value of money.
NPV = PVCI – PVCO
In this method, all the related cash flows associated with the project are discounted and
are bought to its present value by using a discounting factor rate which is the cost of
capital or minimum required rate for the company.
Decision Rule:
(a) If there is only one project and it is to be decided whether it should be selected or
not then the criterion is very simple. Accept the project if it has a positive NPV, Reject
if the NPV is negative and if NPV is zero then we are indifferent.
(b) If the management has to select between two mutually exclusive projects, then the
project with highest NPV is to be selected.
74
Profitability Index or Desirability Factor or cost benefit ratio

PI = PVCI (at coc)
PVCO
It is an extended version of NPV. It indicates that against every 1 rupee of outflow how
much cash inflow the project generates in present value terms. PI technique is useful in
capital rationing situation (money is in short supply).
Decision Rule:
(a) If PI > 1, select the project.
(b) If P < 1, reject the project.
(c) If PI = 1 , indifferent.
Internal Rate of Return

IRR is the rate which the project is expected to earn for the Co. Mathematically IRR is the
discount rate which will equate the present value of the cash inflows with the present
value of cash outflows, i.e. at IRR, PVCI – PVCO = 0.
Decision Rule:
(a) If IRR > Cost of Capital, accept the project.
(b) If IRR < Cost of Capital, reject the project.
(c) If IRR = Cost of Capital, indifferent.
Discounted Payback Period

Payback period has 2 limitations; time value of money is ignored and post pay back
profitability is ignored. Discounted Payback period is an attempt to remove one such
limitation. When time value is introduced to the payback period, it is known as Discounted
Payback period.
Average Rate of Return / Accounting Rate of Return
OR
75
It shows book profitability of the project. It indicaes Average NPAT earned by the project
during its life time.
Limitations
(a) Ignores time value of money.
(b) Based on accounting profit and not on cash profit.
MODIFIED IRR
MIRR is superior to the regular IRR, MIRR assumes that project cash flows are reinvested
at a certain re-investment rate, whereas the regular IRR assumes that project cash flows
are reinvested at the project's own IRR. Since reinvestment at cost of capital is more
realistic than reinvestment at IRR, MIRR reflects better the true profit-ability of a project.
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CLASSWORK SECTION
Question 1
A project requiring an investment of ` 10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (`)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project
can be sold for ` 80,000. Determine Average Rate of Return.
Question 2
ABC Ltd is a small company that is currently analyzing capital expenditure proposals
for the purchase of equipment; the company uses the net present value technique to
evaluate projects. The capital budget is limited to ` 500,000 which ABC Ltd believes is
the maximum capital it can raise. The initial investment and projected net cash flows for
each project are shown below. The cost of capital of ABC Ltd is 12%. You are required to
compute the NPV of the different projects.
Project A Project B
Initial Investment 200,000 1,90,000
Project Cash Inflows
Year 1 50,000 40,000
2 50,000 50,000
3 50,000 70,000
4 50,000 75,000
5 50,000 75,000
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Question 3
Calculate the internal rate of return of an investment of ` 1,36,000 which yields the
following cash inflows:
Years Cash inflows in (`)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Question 4
A company proposes to install a machine involving a Capital Cost of ` 3,60,000. The life
of the machine is 5 years and its salvage value at the end of the life is nil. The machine
will produce the net operating income after depreciation of ` 68,000 per annum. The
Company’s tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting Rate : 14 15 16 17 18
Cumulative factor: 3.43 3.35 3.27 3.20 3.13
You are required to calculate the internal rate of return of the proposal.
Question 5
Shiva Limited is planning its capital investment programme for next year. It has five
projects all of which give a positive NPV at the company cut-off rate of 15 percent, the
investment outflows and present values being as follows:
Project Investment NPV@15%
`’000 `’000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of ` 1, 20,000.
You are required to optimise the returns from a package of projects within the capital
spending limit. The projects are independent of each other and are divisible (i.e., part-
project is possible).
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Question 6
An investment of ` 1,36,000 yields the following cash inflows (profits before depreciation
but after tax). Determine MIRR considering 8% as cost of capital.
Years Profit after tax and depreciation (`)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000
Question 7
A Company is considering a proposal of installing a drying equipment. The equipment
would involve a Cash outlay of ` 6,00,000 and net Working Capital of `
80,000. The expected life of the project is 5 years without any salvage value. Assume
that the company is allowed to charge depreciation on straight-line basis for Income-tax
purpose. The estimated before-tax cash inflows are given below:
Year Before tax cash inflows (in ‘000)

1 2 3 4 5
240 275 210 180 160
The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity
Cost of Capital is 12%, calculate the equipment’s discounted payback period, payback
period, net present value and internal rate of return.
The PV factors at 12%, 14% and 15% are:
Year 1 2 3 4 5
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194
PV factor at 15% 0.8696 0.75610 0.6575 0.5718 0.4972
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Question 8
The Management of a Company has two alternative proposals under consideration.
Project A requires a capital outlay of `12,00,000 and project ‘B” requires ` 18,00,000.
Both are estimated to provide a cash flow for five years:
Project A ` 4,00,000 per year and Project B ` 5,80,000 per year. The cost of capital is 10%.
Show which of the two projects is preferable from the view point of (i) Net present value
method,
(ii) Present value index method (PI method), (iii) Internal rate of return method.
The present values of Re. 1 of 10%, 18% and 20% to be received annually for 5 years
being 3.791, 3.127 and 2.991 respectively.
Question 9
A company is considering the proposal of taking up a new project which requires an
investment of ` 400 lakhs on machinery and other assets. The project is expected to yield
the following earnings (before depreciation and taxes) over the next five years:
Year Earnings (` in lakhs)
1 160
2 160
3 180
4 180
5 150
The cost of raising the additional capital is 12% and assets have to be depreciated at
20% on ‘Written Down Value’ basis. The scrap value at the end of the five years’ period
may be taken as zero. Income-tax applicable to the company is 50%.
You are required to calculate the net present value of the project and advise the
management to take appropriate decision.
Note: Present values of Re. 1 at different rates of interest are as follows:
Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48
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Question 10
A hospital is considering to purchase a diagnostic machine costing ` 80,000. The projected
life of the machine is 8 years and has an expected salvage value of ` 6,000 at the end of
8 years.
The annual operating cost of the machine is ` 7,500. It is expected to generate revenues
of `40,000 per year for eight years. Presently, the hospital is outsourcing the diagnostic
work and is earning commission income of ` 12,000 per annum; net of taxes.
Required:
Whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:
(i) Net Present Value method
(ii) Profitability Index method.
PV factors at 10% are given below:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Question 11
The management of P Limited is considering selecting a machine out of two mutually
exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate
for the company is 30 percent. Details of the machines are as follows:
Machine – I Machine – II
Cost of Machine `10,00,000 `15,00,000
Expected life 5 years 6 years
Annual income before tax and depreciation `3,45,000 `4,55,000
Depreciation is to be charged on straight line basis.
(i) Calculate the discounted pay-back period, net present value and internal rate of
return for each machine.
(ii) Advise the management of P Limited as to which machine they should take up.
The present value factors of Re. 1 are as follows:
Year 1 2 3 4 5 6
At 12% .893 .797 .712 .636 .567 .507
At 13% .885 .783 .693 .613 .543 .480
At 14% .877 .769 .675 .592 .519 .456
At 15% .870 .756 .658 .572 .497 .432
At 16% .862 .743 .641 .552 .476 .410
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Question 12
Given below are the data on a capital project 'M'.
Annual savings in cost ` 60,000
Useful life 4 years
Internal rate of return 15%
Profitability index 1.064
Salvage value 0
You are required to calculate for this project M :
(i) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value
PV factors at different rates are given below:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636
Question 13
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project
is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax
free subsidy from the State Government of ` 25,00,000 on capital investment. Initial
equipment cost will be ` 1.75 crores. Additional equipment costing ` 12,50,000 will be
purchased at the end of the third year from the cash inflow of this year. At the end of 8
years, the original equipment will have no resale value, but additional equipment can
be sold for ` 1,25,000. A working capital of ` 20,00,000 will be needed and it will be
released at the end of eighth year. The project will be financed with sufficient amount of
equity capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2.70,000 1,80,000
A sales price of ` 120 per unit is expected and variable expenses will amount to 60% of
sales revenue. Fixed cash operating costs will amount ` 18,00,000 per year. The loss of
any year will be set off from the profits of subsequent two years. The company is subject
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to 30 per cent tax rate and considers 12 per cent to be an appropriate after tax cost of
capital for this project.
The company follows straight line method of depreciation.
Required:
Calculate the net present value of the project and advise the management to take
appropriate decision.
Note:
The PV factors at 12% are
Year 1 2 3 4 5 6 7 8
Units .893 .797 .712 .636 .567 .507 .452 .404
Question 14
Company X is forced to choose between two machines A and B. The two machines are
designed differently, but have identical capacity and do exactly the same job. Machine
A costs ` 1,50,000 and will last for 3 years. It costs ` 40,000 per year to run. Machine B
is an ‘economy’ model costing only ` 1,00,000, but will last only for 2 years, and costs
` 60,000 per year to run. Ignore tax. Opportunity cost of capital is 10 per cent. Which
machine company X should buy?
Question 15
WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated
useful life is 8 years with no salvage value in the end. Its current market value is `
2,00,000. The company is considering a proposal to purchase a new model of machine to
replace the existing machine. The relevant information is as follows:
Existing Machine New Machine

Cost of machine ` 3,30,000 ` 10,00,000
Estimated life 11 years 8 years
Salvage value Nil ` 40,000
Annual output ` 30,000 unit ` 75,000 units
Selling price per unit `15 `15
Annual operating hours ` 3,000 ` 3,000
Material cost per unit `4 `4
Labour cost per hour `40 ` 70
Indirect cash cost per annum ` 50,000 ` 65,000
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The company follow the straight line method of depreciation. The corporate tax rate is
30 per cent and WX Ltd. does not make any investment, if it yields less than 12 per cent.
Present value of annuity of Re. 1 at 12% rate of discount for 8 years is 4.968. Present
value of ` 1 at 12% rate of discount, received at the end of 8th year is 0.404.
Advise WX Ltd. whether the existing machine should be replaced or not.
Question 16
A Ltd. is considering the purchase of a machine which will perform some operations
which are at present performed by workers. Machines X and Y are alternative models. The
following details are available:
Machine X Machine Y
(`) (`)
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 year 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material, p.a. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages pa 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the
alternatives according to:
(i) Average rate of return method, and
(ii) Present value index method assuming cost of capital being 10%.
(The present value of ` 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)
Question 17
A company wants to invest in a machinery that would cost ` 50,000 at the beginning
of year 1. It is estimated that the net cash inflows from operations will be ` 18,000 per
annum for 3 years, if the company opts to service a part of the machine at the end of
year 1 at ` 10,000. In such a case, the scrap value at the end of year 3 will be ` 12,500.
However, if the company decides not to service the part, then it will have to be replaced
at the end of year 2 at ` 15,400. But in this case, the machine will work for the 4th year
also and get operational cash inflow of ` 18,000 for the 4th year. It will have to be
scrapped at the end of year 4 at ` 9,000. Assuming cost of capital at 10% and ignoring
taxes, will you recommend the purchase of this machine based on the net present value
of its cash flows?
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If the supplier gives a discount of ` 5,000 for purchase, what would be your decision? (The
present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091,
0.8264, 0.7513, 0.6830, 0.6209 and 0.5644).
Question 18
R plc is considering to modernize its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as
per discounting rate of 12% and IRR is as follows:
Year Cash Flow
Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000
5 11,00,000
6 10,00,000
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%
Which project should R plc accept?
Question 19
Lockwood Limited wants to replace its old machine with a new automatic machine.
Two models A and B are available at the same cost of ` 5 lakhs each. Salvage value
of the old machine is ` 1 lakh. The utilities of the existing machine can be used if the
company purchases A. Additional cost of utilities to be purchased in that case are ` 1
lakh. If the company purchases B then all the existing utilities will have to be replaced
with new utilities costing ` 2 lakhs. The salvage value of the old utilities will be ` 0.20
lakhs. The earnings after taxation are expected to be :
Year A (cash in-flows of)
A` B` P.V. Factor @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
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Salvage value at the end of year 5 for machine A is ` 50,000 and for Machine B is ` 60,000.
The targeted return on capital is 15%. You are required to (i) Compute, for the two machines
separately, net present value, discounted payback period and desirability factor and (ii)
Advice which of the machines is to be selected?
Question 20
Elite Cooker Company is evaluating three investment situations: (1) produce a new line
of aluminium skillets, (2) expand its existing cooker line to include several new sizes,
and (3) develop a new, higher-quality line of cookers. If only the project in question is
undertaken, the expected present values and the amounts of investment required are:
Project Investment required Present value of Future Cash-Flows
` `
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the investments
required and present values will simply be the sum of the parts. With projects 1 and 3,
economies are possible in investment because one of the machines acquired can be used
in both production processes. The total investment required for projects 1 and 3 combined
is ` 4,40,000. If projects 2 and 3 are undertaken, there are economies to be achieved in
marketing and producing the products but not in investment. The expected present value
of future cash flows for projects 2 and 3 is `6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a `1,25,000 extension on
the plant will be necessary, as space is not available for all three projects. Which project
or projects should be chosen?
Question 21
A Ltd. is an all equity financial company. The current market price of share is ` 180. It
has just paid a dividend of ` 15 per share and expected future growth in dividend is 12%.
Currently, it is evaluating a proposal requiring funds of ` 20 lakhs, with annual inflows of
` 10 lakhs for 3 years.
Find out the Net Present Value of the proposal, if
(i) It is financed from retained earnings ; and
(ii) It is financed by issuing fresh equity at market price with a floatation cost of 5% of
issue price.
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Question 1
The cash flows of projects C and D are reproduced below:
Project Cash Flow NPV at IRR
C0 C1 C2 C3 10%
C - ` 10,000 + 2,000 + 4,000 + 12,000 + ` 4,139 26.5%
D - ` 10,000 + 10,000 + 3,000 + 3,000 + ` 3,823 37.6%
(i) Why there is a conflict of rankings?

(ii) Why should you recommend project C in spite of lower internal rate of return?

Time Period
1 2 3
PVIF0.10, t 0.9090 0.8264 0.7513
PVIF0.14, t 0.8772 0.7695 0.6750
PVIF0.15, t 0.8696 0.7561 0.6575
PVIF0.30, t 0.7692 0.5917 0.4552
PVIF0.40, t 0.7143 0.5102 0.3644
Question 2
The cash flows of two mutually exclusive Projects are as under:
t0 t1 t2 t3 t4 t5 t6
Project ‘P’ (`) (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
Project ‘J’ (`) (20,000) 7,000 13,000 12,000 - - -
Required:
(i) Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the hurdle
rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion.
Make a project choice.
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The present value interest factor values at different rates of discount are as under:
Rate of discount t0 t1 t2 t3 t4 t5 t6
0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704
0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499
Question 3
PR Engineering Ltd. is considering the purchase of a new machine which will carry out some
operations which are at present performed by manual labour. The following information
related to the two alternative models – ‘MX’ and ‘MY’ are available:
Machine ‘MX’ Machine ‘MY’
Cost of Machine ` 8,00,000 ` 10,20,000
Expected Life 6 years 6 years
Scrap Value ` 20,000 ` 30,000
Estimated net income before depreciation and tax:

Year ` `
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000
Corporate tax rate for this company is 30 percent and company’s required rate of return
on investment proposals is 10 percent. Depreciation will be charged on straight line basis.
(i) Calculate the pay-back period of each proposal.
(ii) Calculate the net present value of each proposal, if the P.V. factor at 10% is – 0.909,
0.826, 0.751, 0.683, 0.621 and 0.564.
(iii) Which proposal you would recommend and why?
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Notes
89
Notes
90
RISK ANALYSIS IN CAPITAL

BUDGETING
THEORY SECTION
Question 1
Difference between Risk and Uncertainty.
Answer
Risk is the variability in terms of actual returns comparing with the estimated returns.
Most common techniques of risk measurement are Standard Deviation and Coefficient of
variations. There is a thin difference between risk and uncertainty. In case of risk probability
distribution of cash flow is known. When no information is known to formulate probability
distribution of cash flows, the situation is referred as uncertainty. However these two
terms are used interchangeably.
Question 2
Explain different sources of Risk.
Answer
Risk arises from different sources, depending on the type of investment being considered,
as well as the circumstances and the industry in which the organisation is operating.
Some of the sources of risk are as follows
1. Project-specific risk- Risks which are related to a particular project and affects the
project’s cash flows, it includes completion of the project in scheduled time, error of
estimation in resources and allocation, estimation of cash flows etc.
2. Company specific risk- Risk which arise due to company specific factors like
downgrading of credit rating, changes in key managerial persons, cases for violation
of Intellectual Property Rights (IPR) and other laws and regulations, dispute with
workers etc.
3. Industry-specific risk- These are the risks which effects the whole industry in which
the company operates. The risks include regulatory restrictions on industry, changes
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in technologies etc. For example, regulatory restriction imposed on leather and

breweries industries.
4. Market risk – The risk which arise due to market related conditions like entry of
substitute, changes in demand conditions, availability and access to resources etc.
For example, a thermal power project gets affected if the coal mines are unable to
supply coal requirements of a thermal power company etc.
5. Competition risk- These are risks related with competition in the market in which
a company operates. These risks are risk of entry of rival, product dynamism and
change in taste and preference of consumers etc.
6. Risk due to Economic conditions – These are the risks which are related with macro-
economic conditions like changes in monetary policies by central banks, changes
in fiscal policies like introduction of new taxes and cess, inflation, changes in GDP,
changes in savings and net disposable income etc.
7. International risk – These are risk which are related with conditions which are caused
by global economic conditions like restriction on free trade, restrictions on market
access, recessions, bilateral agreements, political and geographical conditions etc.
For example, restriction on outsourcing of jobs to overseas markets.
Question 3
Write a Note on techniques of Risk Analysis in Capital Budgeting.
Answer
Techniques of risk analysis in capital budgeting can be classified as below:
A. Statistical Techniques
• Probability
• Variance or Standard Deviation
• Coefficient of Variation
B. Conventional techniques
• Risk-adjusted discount rate
• Certainty equivalents
C. Others techniques
• Sensitivity analysis
• Scenario analysis
• Simulation
• Decision tree
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Question 4
Write a Note on Statistical techniques.
Answer
(1) Probability
Meaning: Probability is a measure about the chances that an event will occur. When
an event is certain to occur, probability will be 1 and when there is no chance of
happening an event probability will be 0.
(2) Variance
Meaning: Variance is a measurement of the degree of dispersion between numbers in
a data set from its average. In very simple words, variance is the measurement of
difference between the average of the data set.
(3) Standard deviation
Standard Deviation is a degree of variation of individual items of a set of data from
its average. The square root of variance is called Standard Deviation. For Capital
Budgeting decisions, Standard Deviation is used to calculate the risk associated with
the estimated cash flows from the project.
(4) The Coefficient of Variation
The standard deviation is a useful measure of calculating the risk associated with the
estimated cash inflows from an Investment. However in Capital Budgeting decisions,
the management in several times faced with choosing between many investments
avenues. Under such situations, it becomes difficult for the management to compare
the risk associated with different projects using Standard Deviation as each project
has different estimated cash flow values. In such cases, the Coefficient of Variation
become useful.
The Coefficient of Variation calculates the risk borne for every percent of expected
return.
Question 5
What is Risk Adjusted Discount Rate?
Answer
Risk Adjusted Discount Rate
The use of risk adjusted discount rate is based on the concept that investors demands
higher returns from the risky projects.
A risk adjusted discount rate is a sum of risk free rate and risk premium. The Risk Premium
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depends on the perception of risk by the investor of a particular investment and risk
aversion of the Investor.
So Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate : It is the rate of return on Investments that bear no risk. For e.g., Government
securities yield a return of 6 % and bear no risk. In such case, 6 % is the risk-free rate.
Risk Premium : It is the rate of return over and above the risk-free rate, expected by the
Investors as a reward for bearing extra risk. For high risk project, the risk premium will be
high and for low risk projects, the risk premium would be lower.
Advantages of Risk-adjusted discount rate
(1) It is easy to understand.
(2) It incorporates risk premium in the discounting factor.
Limitations of Risk-adjusted discount rate
(1) Difficulty in finding risk premium and risk-adjusted discount rate.
(2) Assumption that investors are risk averse is always not true.
Question 7
Explain certainty equivalent.
Answer
The certainty equivalent is a guaranteed return that the management would accept
rather than accepting a higher but uncertain return. This approach allows the decision
maker to incorporate his or her utility function into the analysis. In this approach a set of
risk less cash flow is generated in place of the original cash flows.
Steps in the Certainty Equivalent (CE) approach
Step 1 : Remove risk by substituting equivalent certain cash flows from risky cash flows.
This can be done by multiplying each risky cash flow by the appropriate a value (CE
coefficient)
Step 2 : Discounted value of cash flow is obtained by applying risk less rate of interest.
Step 3 : After that normal capital budgeting method is applied except in case of IRR
method, where IRR is compared with risk free rate of interest rather than the firm’s
required rate of return.
Advantages of Certainty Equivalent Method
(1) The certainty equivalent method is simple and easy to understand and apply.
(2) It can easily be calculated for different risk levels applicable to different cash
flows.
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Disadvantages of Certainty Equivalent Method

1. There is no Statistical or Mathematical model available to estimate certainty
Equivalent.
2. Certainty Equivalent are subjective and vary as per each individual’s estimate.
3. Certainty equivalents are decided by the management based on their perception
of risk.
Question 7
Explain Sensitivity Analysis.
Answer
Sensitivity Analysis
Sensitivity analysis put in simple terms is a modeling technique which is used in Capital
Budgeting decisions which is used to study the impact of changes in the variables on
the outcome of the project. In a Project, several variables like Weighted average cost
of capital, consumer demand, price of the product, cost price per unit etc. operate
simultaneously. The changes in these variables impact the outcome of the project. It
therefore becomes very difficult to assess change in which variable impacts the project
outcome in a significant way. In Sensitivity Analysis, the project outcome is studied after
taking into change in only one variable. The more sensitive is the NPV, the more critical
is that variable. So, Sensitivity analysis is a way of finding impact in the project’s NPV (or
IRR) for a given change in one of the variables.
Advantages of Sensitivity Analysis :
(1) Critical Issues : This analysis identifies critical factors that impinge on a project’s
success or failure.
(2) Simplicity : This analysis is quite simple.
Disadvantage of Sensitivity Analysis :
(1) Assumption of Independence: This analysis assumes that all variables are independent
i.e. they are not related to each other, which is unlikely in real life.
(2) Ignore probability: This analysis does not look to the probability of changes in the
variables.
(3) Not so reliable: This analysis provides information on the basis of which decisions can
be made but does not point directly to the correct decision.
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Question 8
Difference between Scenerio Analysis and Sensitivity Analysis.
Answer
Sensitivity analysis and Scenario analysis both help to understand the impact of the
change in input variable on the outcome of the project. However, there are certain basic
differences between the two.
Sensitivity analysis calculates the impact of the change of a single input variable on the
outcome of the project viz., NPV or IRR. The sensitivity analysis thus enables to identify
that single critical variable that can impact the outcome in a huge way and the range of
outcomes of the project given the change in the input variable.
Scenario analysis, on the other hand, is based on a scenario. The scenario may be recession
or a boom wherein depending on the scenario, all input variables change. Scenario
Analysis calculates the outcome of the project considering this scenario where the
variables have changed simultaneously. Similarly, the outcome of the project would also
be considered for the normal and recessionary situation. The variability in the outcome
under the three different scenarios would help the management to assess the risk a
project carries. Higher deviation in the outcome can be assessed as higher risk and lower
to medium deviation can be assessed accordingly.
Scenario analysis is far more complex than sensitivity analysis because in scenario
analysis all inputs are changed simultaneously considering the situation in hand while in
sensitivity analysis only one input is changed and others are kept constant.
96
CLASSWORK SECTION
Question 1
An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.
Year Cash flows (` in lakhs)
1 25
2 60
3 75
4 80
5 65
Calculate Net Present Value of the project based on Risk free rate and also on the basis
of Risks adjusted discount rate.
Question 2
Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of
variation:
Coefficient of Variation Risk-Adjusted Rate P.V. Factor 1 to 5 years
of Return At risk adjusted rate of
discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
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Question 3
The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive
proposals, Projects M and N, which require cash outlays of ` 8, 50,000 and ` 8, 25,000
respectively. The certainty-equivalent (C.E) approach is used in incorporating risk in capital
budgeting decisions. The current yield on government bonds is 6% and this is used as the
risk free rate. The expected net cash flows and their certainty equivalents are as follows:
Project M Project N
Year – end Cash Flow C.E. Cash Flow C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of ` 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943,
0.890 and 0.840 respectively.
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be appraised with
a higher rate and why?
Question 4
X Ltd is considering its New Product ‘with the following details:
Sr. No. Particulars Figures
1 Initial capital cost ` 400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit ` 100
4 Variable cost per unit ` 50
5 Fixed costs per year ` 50 Cr
6 Discount Rate 6%
1. Calculate the NPV of the project.
2. Find the impact on the project’s NPV of a 2.5 per cent adverse variance in each
variable. Which variable is having maximum effect.
Assume life of project to be 3 years.
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Question 5
From the following details relating to a project, analyse the sensitivity of the project to
changes in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 1,20,000
Annual Cash Inflow (`) 45,000
Project Life (Years) 4
Cost of Capital 10%
To which of the three factors, the project is most sensitive if the variable is adversely
affected by 10%? (Use annuity factors: for 10% 3.169 and 11% ...3.103).
Question 6
XYZ Ltd. is considering a project “A” with an initial outlay of ` 14, 00,000 and the possible
three cash inflow attached with the project as follows:
(` 000)
Particular Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain
about the most likely result but uncertain about the third year’s cash flow, what will be
the NPV expecting worst scenario in the third year.
Question 7
Possible net cash flows of Projects A and B and their probabilities are given as below.
Discount rate is 10 per cent for both the project initially investment is ` 10,000. Calculate
the expected net present value for each project. Which project is preferable?
Project A Project B
Possible Event Cash Flow (`) Probability Cash Flow (`) Probability
A 8,000 0.10 4,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
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Question 8
Probabilities for net cash flows for 3 years a project are as follows:
Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
(`) (`) (`)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net cash flows. Also calculate the present value of the expected
cash flow, using 10 per cent discount rate. Initial Investment is ` 10,000.
Question 9
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ` 36,000
and project B ` 30,000. You have been given below the net present value probability
distribution for each project.
Project A Project B
NPV estimates Probability NPV estimates Probability
(`) (`)
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
(i) Compute the expected net present values of projects A and B.
(ii) Compute the risk attached to each project i.e. standard deviation of each probability
distribution.
(iii) Compute the profitability index of each project.
(iv) Which project do you recommend? State with reasons.
100
Question 10
Cyber Company is considering two mutually exclusive projects. Investment outlay of both
the projects is ` 5, 00,000 and each is expected to have a life of 5 years. Under three
possible situations their annual cash flows and probabilities are as under:
Cash Flow (`)
Situation Probabilities Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 per cent, which project should be accepted? Explain with workings.
Question 11
XY Ltd. has under its consideration a project with an initial investment of ` 1, 00,000.
Three probable cash inflow scenarios with their probabilities of occurrence have been
estimated as below:
Annual cash inflow (`) 20,000 30,000 40,000
Probability 0.1 0.7 0.2
The project life is 5 years and the desired rate of return is 20%. The estimated terminal
values for the project assets under the three probability alternatives, respectively, are `
0, 20,000 and 30,000.
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly
positively correlated over time.
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Question 1
New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available
in respect of these projects:
P-I P-II P-III
Cost ` 15,00,000 ` 11,00,000 ` 19,00,000
Inflows – Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The
risk free interest rate is 10%.
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?
HOMEWORK SECTION
Question 1
If Investment Proposal is ` 45, 00,000 and risk free rate is 5%, calculate Net present value
under certainty equivalent technique.
Year Expected cash flow (`) Certainty Equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
102
Notes
103
Notes
104
DIVIDEND DECISIONS
THEORY SECTION
Question 1
Meaning of Dividend and significance of Dividend Policy.
Answer
Meaning of Dividend: Dividend is that part of profit after tax which is distributed to the
shareholders of the company. In other words, the profit earned by a company after paying
taxes can be used for:
i. Distribution of dividend or
ii. Can be retained as surplus for future growth
Significance of Dividend Policy : Dividend policy of the firm is governed by:
(i) Long Term Financing Decision
Whether to retain or distribute the profits forms the basis of this decision. Since
payment of cash dividend reduces the amount of funds necessary to finance
profitable investment opportunities thereby restricting it to find other avenues
of finance.
Under this purview, the decision is based on the following:
1. Whether the organization has opportunities in hand to invest the amount
of profits, if retained?
2. Whether the return on such investment (ROI) will be higher than the
expectations of shareholders i.e. Ke.
(ii) Wealth Maximization Decision
Under this head, we are facing the problem of amount of dividend to be
distributed i.e. the Dividend Payout ratio (D/P) in relation to Market price of the
shares (MPS).
1. Because of market imperfections and uncertainty, shareholders give higher
value to near dividends than future dividends and capital gains. Payment
of dividends influences the market price of the share. Higher dividends
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increase value of shares and low dividends decrease it. A proper balance
has to be struck between the two approaches.
2. When the firm increases retained earnings, shareholders’ dividends
decrease and consequently market price is affected. Use of retained
earnings to finance profitable investments increases future earnings per
share.
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.
Question 2
Write a note on Forms of Dividend.
Answer
Generally, the dividend can take any of the following forms (depending upon some factors
will be discussed later):
1. Cash dividend: It is the most common form of dividend. Cash here means cash, cheque,
warrant, demand draft, pay order or directly through Electronic Clearing Service
(ECS) but not in kind
2. Stock dividend (Bonus Shares): It is distribution of shares in lieu of cash dividend
to existing shareholders. When the company issues further shares to its existing
shareholders without consideration it is called bonus shares.
Advantages of Stock Dividend
There are many advantages both to the shareholders and to the company. Some of
the important ones are listed as under:
(1) To Share Holders: (a) Tax benefit –At present there is no tax on dividend received.
(b) Policy of paying fixed dividend per share and its continuation even after
declaration of stock dividend will increase total cash dividend of the shareholders
in future.
(2) To Company: (a) Conservation of cash for meeting profitable investment
opportunities. (b) Cash deficiency and restrictions imposed by lenders to pay
cash dividend.
Limitations of Stock Dividend
1. To Shareholders: Stock dividend does not affect the wealth of shareholders and
therefore it has no value for them.
2. To Company: Stock dividends are more costly to administer than cash dividend.
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It is disadvantageous if periodic small stock dividends are declared by the

company as earnings. Also, companies have to pay tax on distribution.
Question 3
What are determinants of Dividend Decisions.
Answer
The dividend policy is affected by the following factors:
1. Availability of funds: If the business is in requirement of funds, then retained earnings
could be a good source. Since it saves the floatation cost and further the control will
not be diluted as in case of further issue of share capital.
2. Cost of capital: If the financing requirements can be financed through debt (relatively
cheaper source of finance), then it should be preferred to distribute more dividend
but if the financing is to be done through fresh issue of equity shares, it is better to
use retained earnings as much as possible.
3. Capital structure: An optimum Debt equity ratio should also be under consideration
for the dividend decision.
4. Stock price: Stock price here means market price of the shares. Generally, higher
dividends increase value of shares and low dividends decrease it.
5. Investment opportunities in hand: The dividend decision is also affected, if there are
investment opportunities in hand, the company may prefer to retain more from the
earnings
6. Internal rate of return: If the internal rate of return is more than the cost of retained
earnings, it’s better to distribute the earnings as much as possible.
7. Trend of industry: Few industries have been seen by investors for regular income,
hence in such cases, the firm will have to pay dividend for survival.
8. Expectation of shareholders: The shareholders can be categorised in two categories: (i)
those who invests for regular income, & (ii) those who invests for growth. Generally,
the investor prefers current dividend more than the future growth.
Question 4
What are Practical considerations in Dividend Policy?
Anwer
The formulation of dividend policy depends upon answers to the questions:
• whether there should be a stable pattern of dividends over the years or
• whether the company should treat each dividend decision completely independent.
107
The practical considerations in dividend policy of a company are briefly discussed

below:
(a) Financial Needs of The Company: Retained earnings can be a source of finance
for creating profitable investment opportunities. When internal rate of return
of a company is greater than return required by shareholders, it would be
advantageous for the shareholders to re-invest their earnings.
(b) Constraints on Paying Dividends
(i) Legal:
(ii)
Liquidity:
(iii) Access to the Capital Market:
(iv) Investment Opportunities:
(c) Desire of Shareholders: The desire of shareholders (whether they prefer regular
income by way of dividend or maximize their wealth by way of gaining on sale
of the shares).
(d) Stability of Dividends: Regular payment of dividend annually even if the amount
of dividend may fluctuate year to year may not be, related with earnings.
(i) Constant Dividend per Share:
(ii) Constant Percentage of Net Earnings:
(iii) Small Constant Dividend per Share plus Extra Dividend:
Question 5
Write a note on MM Hypothesis.
Answer
Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961.
MM approach is in support of the irrelevance of dividends i.e. firm’s dividend policy has
no effect on its value of assets.
Assumptions of M.M Hypothesis
MM hypothesis is based on the following assumptions:
• Perfect capital markets: The firm operates in a market in which all investors are
rational and information is freely available to all.
• No taxes : This assumption is necessary for the universal applicability of the theory,
since, the tax rates or provisions to tax income may be different in different countries.
• Fixed investment policy: It is necessary to assume that all investment should be financed
through equity only, since, implication after using debt as a source of finance may be
difficult to understand. Further, the impact will be different in different cases.
108
• No floatation or transaction cost: Similarly, these costs may differ country to country
or market to market.
• Risk of uncertainty does not exist. Investors are able to forecast future prices and
dividend with certainty and one discount rate is appropriate for all securities and all
time periods.
According to MM hypothesis
• Market value of equity shares of its firm depends solely on its earning power and is
not influence by the manner in which its earnings are split between dividends and
retained earnings.
• Market value of equity shares is not affected by dividend size.
Advantages of MM Hypothesis
Various advantages of MM Hypothesis are as follows
1. This model is logically consistent.
2. It provides a satisfactory framework on dividend policy with the the concept of
Arbitrage process.
Limitations of MM Hypothesis
Various Limitations of MM Hypothesis are as follows
1. Validity of various assumptions is questionable.
2. This model may not be valid under uncertainty.
Question 6
What are Assumptions of Walter Model?
Answer
Assumptions of Walter Model
Walter approach is based on the following assumptions:
• All investments proposals of the firm are to be financed through retained earnings
only
• ‘r’ rate of return & ‘Ke’ cost of capital are constant
• Perfect capital markets: The firm operates in a market in which all investors are
rational and information is freely available to all.
• No taxes or no tax discrimination between dividend income and capital appreciation
(capital gain): This assumption is necessary for the universal applicability of the
theory, since, the tax rates or provisions to tax income may be different in different
countries.
• No floatation or transaction cost: Similarly, these costs may differ country to country
109
or market to market.
• The firm has perpetual life
Question 7
What are Advantages and Limitations of Walter Model?
Answer
Advantages of Walter Model
1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers
internal rate of return, market capitalisation rate and dividend payout ratio in the
determination of market value of shares.
Limitations of Walter Model
1. The formula does not consider all the factors affecting dividend policy and share
prices. Moreover, determination of market capitalisation rate is difficult.
2. Further, the formula ignores such factors as taxation, various legal and contractual
obligations, management policy and attitude towards dividend policy and so on.
Question 8
What are Assumptions of Gordon Model?
Answer
Assumptions of Gordon Model
This model is based on the following assumptions:
• Firm is an all equity firm i.e. no debt
• IRR will remain constant, because change of IRR will change the growth rate and
consequently the value will be affected. Hence this assumption is necessary.
• Ke will remains constant, because change in discount rate will affect the present value.
• Retention ratio (b), once decide upon, is constant i.e. constant dividend payout ratio
will be followed.
• Growth rate (g= br) is also constant, since retention ratio and IRR will remain
unchanged and growth, which is the function of these two variable will remain
unaffected.
• Ke> g, this assumption is necessary.
• All investment proposals of the firm are to be financed through retained earnings
only
110
Question 9
What are Advantages and Limitations of Gordon Model?
Answer
Advantages of Gordon Model
1. The dividend discount model is a useful heuristic model that relates the present
stock price to the present value of its future cash flows .
2. This Model is easy to understand.
Limitations of Gordon Model
1. The dividend discount model, depends on projections about company growth rate
and future capitalization rates of the remaining cash flows, which may be difficult
to calculate accurately.
2. The true intrinsic value of a stock is unknowable,
Question 10
Write a Note on Traditional Model / Graham & Dodd Model.
Answer
According to the traditional position expounded by Graham & Dodd, the stock market
places considerably more weight on dividends than on retained earnings. Their view is
expressed quantitatively in the following valuation model:
P = m (D + E/3)
Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
m = a multiplier
Example
The earnings per share of a company is Rs. 30 and dividend payout ratio is 60%. Multiplier
is 2.
Solution
P = 2 (18 + 30/3) = Rs. 56
Question 11
Write a Note on Linters Model
111
Ans. Linter model has two parameters:

i. The target payout ratio,
ii. The spread at which current dividends adjust to the target.
John Linter based his model on a series of interviews which he conducted with corporate
managers in the mid 1950’s.While developing the model, he considers the following
assumptions:
1. Firm have a long term dividend payout ratio. They maintain a fixed dividend payout
over a long term.
2. Managers are more concerned with changes in dividends than the absolute amounts
of dividends.
3. Dividend changes follow changes in long run sustainable earnings.
4. Managers are reluctant to affect dividend changes that may have to be reversed.
Under Linter’s model, the current year’s dividend is dependent on current year’s earnings
and last year’s dividend.
Question 12
Write a Note on Stock Split
Answer
Meaning of Stock Splits
I. Stock split means splitting one share into many, say, one share of Rs.500 in to 5
shares of Rs.100. Stock splits is a tool used by the companies to regulate the prices
of shares i.e. if a share price increases beyond a limit, it may become less tradable,
for e.g. suppose a company’s share price increases from Rs.50 to Rs.1000 over the
years, it is possible that it might goes out of range of many investors.
II. Advantages of Stock Splits
Various advantages of Stock Splits are as follows:
1. It makes the share affordable to small investors.
2. Number of shares may increase the number of shareholders; hence the potential
of investment may increase.
III. Limitations of Stock Splits
Various limitations of Stock Splits are as follows:
1. Additional expenditure need to be incurred on the process of stock split.
2. Low share price may attract speculators or short term investors, which are
generally not preferred by any company.
112
CLASSWORK SECTION
Question 1
The earnings per share of a company are ` 8 and the rate of capitalisation applicable
to the company is 10%. The company has before it an option of adopting a payout ratio
of 25% or 50% or 75%. Using Walter's formula of dividend payout compute the market
value of the company's share if the productivity of retained earnings is (i) 15% (ii) 10%,
and (iii) 5%.
What inference can be drawn from the above exercise?
Question 2
The following figures are collected from the annual report of XYZ Ltd.:
`
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of Capital 16%
What should be the approximate dividend pay-out ratio so as to keep the share price at
` 42 by using Walter model?
Question 3
The following information pertains to M/s XY Ltd.
Earnings of the Company ` 5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%
(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the
market value of Company’s share at that payout ratio?
113
Question 4
The following information is supplied to you:
`
Total Earnings 2,00,000
No. of equity shares (of ` 100 each) 20,000
Dividend paid 1,50,000
Price / Earnings ratio 12.5
Applying Walter’s Model
(i) Ascertain whether the company is following an optimal dividend policy.
(ii) Find out what should be the P/E ratio at which the dividend policy will have no effect
on the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
Question 5
A firm paid dividend at ` 2 per share last year. The estimated growth of the dividends
from the company is estimated to be 5% p.a. Determine the estimated market price of the
equity share if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%.
Also find out the present market price of the share, given that the required rate of return
of the equity investors is 15.5%.
Question 6
XYZ is company having share capital of ` 10 lakhs of ` 10 each. It distributed current
dividend of 20% per annum. Annual growth rate in dividend expected is 2%. The expected
rate of return on its equity capital is 15%.
Calculate the market price of share
Question 7
With the help of following figures calculate the market price of a share of a company by
using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)
Earning per share (EPS) ` 10
Dividend per share (DPS) `4
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 60%
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Question 8
RST Ltd. has a capital of ` 10, 00,000 in equity shares of ` 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of ` 10 per share
at the end of the current financial year. The capitalization rate for the risk class of which
the company belongs is 12%. What will be the market price of the share at the end of
the year, if
(i) A dividend is not declared?
(ii) A dividend is declared?
(iii) Assuming that the company pays the dividend and has net profits of ` 5, 00,000 and
makes new investments of ` 10, 00,000 during the period, how many new shares
must be issued? Use the MM model.
Question 9
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is ` 100. It expects a net profit of ` 2,
50,000 for the year and the Board is considering dividend of ` 5 per share.
M Ltd. requires to raise ` 5, 00,000 for an approved investment expenditure. Show, how
the MM approach affects the value of M Ltd. if dividends are paid or not paid.
Question 10
The following information regarding the equity shares of M ltd. is given:
Market Price ` 58.33
Dividend per share `5
Multiplier 7
According to the Graham & Dodd approach to the dividend policy, compute the EPS.
Question 11
The dividend payout ratio of H ltd. is 40%. If the company follows traditional approach
to dividend policy with a multiplier of 9, what will be the P/E ratio?
Question 12
Given the last year’s dividend is ` 9.80, speed of adjustment = 45%, target payout ratio
60% and EPS for current year ` 20. Calculate current year’s dividend.

115
HOMEWORK SECTION
Question 1
Goldi locks Ltd. was started a year back with equity capital of ` 40 lakhs. The other
details are as under:
Earnings of the company ` 4,00,000
Price Earnings ratio 12.5
Dividend paid ` 3,20,000
Number of Shares 40,000
Find the current market price of the share. Use Walter's Model.
Find whether the company's D/ P ratio is optimal, use Walter's formula.
Question 2
The following information pertains to M/s XY Ltd.
Earnings of the Company ` 5, 00,000
Dividend Payout ratio 60%
No. of shares outstanding 1, 00,000
Equity capitalization rate 12%
Rate of return on investment 15%
(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the
market value of Company’s share at that payout ratio?
Question 3
X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year. The current
market price per share is ` 120. The Board of Directors of the company is contemplating
` 6.4 per share as dividend. The rate of capitalisation, appropriate to the risk-class to
which the company belongs, is 9.6%:
(i) Based on M-M Approach, calculate the market price of the share of the company,
when the dividend is – (a) declared; and (b) not declared.
(ii) How many new shares are to be issued by the company, if the company desires to
fund an investment budget of ` 3.20 crores by the end of the year assuming net
income for the year will be ` 1.60 crores?
116
Question 4
ABC Ltd. has 50,000 outstanding shares. The current market price per share is ` 100 each.
It hopes to make a net income of ` 5, 00,000 at the end of current year. The Company’s
Board is considering a dividend of ` 5 per share at the end of current financial year.
The company needs to raise ` 10, 00,000 for an approved investment expenditure. The
company belongs to a risk class for which the capitalization rate is 10%. Show, how the
M-M approach affects the value of firm if the dividends are paid or not paid.
117
Notes
118
Notes
119
UNIT 1: ESTIMATION OF WORKING

CAPITAL
THEORY SECTION

Capital is nothing but money required to start or run the business. How much to raise money
depends on, how much we are planning to invest. Invest where? Invest in Fixed Assets and
Working Capital. Fixed Assets cannot work on its own until and unless adequate level of
working capital is maintained. This extra capital that we need for smooth working of our
fixed assets is known as working capital.
Objective
This chapter will give us the answer to the following question,
“How much money should we raise to meet our working capital requirement”?
The level of working capital depends on the level of Current Assets and the level of
Current Liabilities. The level of Current assets in turn depends upon the level of Stock
(Stock of Raw Material, WIP, Finished Goods), Debtors and Cash Bank, whereas the level
of Current liabilities is dependent on the level of Creditors and Outstanding expenses. So
if we can fairly estimate the level of these individual components of current assets and
the current liabilities we can very well estimate our Working Capital Requirement.
Scope
In this chapter we will learn
(a) How to estimate our working capital requirement
(b) Working Capital Operating Cycle
(c) How to finance the Working Capital requirement
* How to estimate our working Capital requirement
There are two approaches for estimating our working capital requirement
(1) Total Basis: Under this approach all the expenses and profit margins are considered
for estimating our working capital needs.
120
(2) Cash Cost Basis: Under this approach only cash expenses are considered for estimating
our working capital needs
Rates of Valuation of various items –

Component Total Approach Cash Cost Approach
Raw Materials Purchase Price net of discounts Purchase Price net of discounts
W o r k - i n - Raw Materials+50% of [Direct Raw Materials + 50% of [Direct Labour
Progress Labour +Direct Expenses +All + Direct Expenses + Production OH
Production OH] excluding Depreciation]
Finished Goods Cost of Production Cost of Production Less Depreciation
Sundry Debtors Selling Price Selling Price Less Profit Margin Less
Depreciation
Sundry Creditors Purchase Price net of discounts Purchase Price net of discounts
Note: For WIP valuation, it is assumed that materials are fully issued and conversion (i.e.
Labour and Production OH) is half - complete.
* Working Capital Operating Cycle

The process of conversion of cash back into cash is known as Working Capital
Operating Cycle i.e. the process of cash which is used for purchasing Raw materials to
again get converted back into cash as realisation from Debtors is known as Working
Capital Operating Cycle and the time taken for this conversion of cash back into cash
is known as duration of Operating Cycle.
CASH CYCLE OF MANUFACTURING FIRM CASH CYCLE OF TRADING FIRM
Cash
Cash
Debtors
Raw Materials Debtors
Finished Goods
Work-in-Progress Finished Goods
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Duration of the Working Capital Operating Cycle is calculated in the following manner
Raw material holding period xx
WIP conversion period xx
Finished Goods Holding period xx
Debtors Collection Period xx
Gross Duration xx
Less: Creditors Payment period xx
Net Duration xx
* Financing of Working Capital

Working Capital can be classified based on (a) Concept or (b) Time Factor, as under -
122
There are two views as to the amount of Permanent Working Capital –
PERMANENT WORKING CAPITAL
123
Approaches to Finance the working Capital
Hedging Approach
Hedging approach is also known as matching approach. It is based upon concept of
bifurcation of total working capital needs into permanent and temporary working capital.
Under this approach, the permanent working capital needs are financed by long term
sources and the temporary working capital requirement from short term sources.
Conservative Approach
As the name suggests, under this approach finance manager doesn’t undertake risk. As
a result, all the working capital needs are financed by long term source and the use of
short term sources may be restricted to unexpected and emergency situations only.
Aggressive Approach
A working capital policy is also called as aggressive policy if the firm decides to finance a
part of the permanent working capital by short term sources. So, the short term financing
under aggressive policy is more than hedging approach.
124
CLASSWORK SECTION
Question 1
Cost sheet of the company provides the following data:
Particulars Cost p.u.
Raw Material 50
Direct Labour 20
Overheads (including Depreciation ` 10) 40
Total Cost 110
Profit 20
Selling Price 130
- Raw materials remain in stores for one month
- Credit allowed by suppliers is one month
- Credit allowed to Debtors is 2 months
- Time lag in payment of wages is 10 days
- Time lag in payment of expenses is 30 days
- 25% of the sales are on cash basis
- Cash balance is expected to be ` 1,00,000.
- Finished goods remain in warehouse for 2 month.
You are required to estimate the working capital required to finance a level of activity of
50000 units p.a. Assume that all the business activities are carried out evenly throughout
the year. Assume 360 days for calculation purpose.
Question 2
The following annual figures relate to XYZ Co.
`
Sales (at two months' credit) 36,00,000
Materials consumed (Suppliers extend two months' credit) 9,00,000
Wages (paid monthly in arrears) 7,20,000
Manufacturing expenses outstanding at the end of the year
(Cash expenses are paid one month in arrears) 80,000
Total administrative expenses, paid as above 2,40,000
Total Sales promotion expenses, paid quarterly in advance 1,20,000
The company sells its products on gross profit of 25% counting depreciation as part of
the cost of production. It keeps one month's stock each of raw materials and finished
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goods, and a cash balance of ` 1,00,000.

Assuming a 20% safety margin, work out the working capital requirements of the company
on cash cost basis. Ignore work-in-process.
Question 3
The following information has been extracted from the records of a Company:
Product Cost Sheet `/unit
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
• The materials are in process on an average for 4 weeks. The degree of completion is 50%.
• Finished goods stock on an average is for one month.
• Time lag in payment of wages and overheads is 1½ weeks.
• Time lag in receipt of proceeds from debtors is 2 months.
• Credit allowed by suppliers is one month.
• 20% of the output is sold against cash.
• The company expects to keep a Cash balance of ` 1, 00,000.
• Take 52 weeks per annum.
• Raw material holding period on an average is one month
The Company is poised for a manufacture of 1, 44,000 units in the year.

You are required to prepare a statement showing the Working Capital requirements of the
Company.
Question 4
Bhargava Ltd. furnishes you with the following details with the request to calculate the
estimated working capital requirements on total basis for the year 2011-12.
(1) Credit: Two months credit to domestic customers and three months to overseas
buyers. Suppliers to give one months credit.
(2) Time Lag: One month in respect of all the expenses except sales promotion expenses
which are payable in advance on quarterly basis.
(3) Projected figures for the year 2011-12:
126
`
Domestic Sales 1,80,000
Export Sales 36,000
Wages 42,000
Manufacturing Expenses 57,000
Administrative Expenses 60,000
Sales Promotion Expenses 30,000
(4) Inventories to be maintained as follows:

Raw materials: One month for domestic and two months for export supplies
Finishes Goods : One month for domestic and three months for export supplies.
(5) Gross profit is to be maintained at 25% on sales, while overseas buyers are to be
allowed a special 10% discount.
(6) Special Packing Credit Limits are available on 90 % of export stocks of raw materials
debtors.
(7) An additional cash balance is to be maintained as safety margin which is equivalent
to 10% of total working capital.
Question 5
MA LIMITED is commencing a new project for manufacture of a plastic component. The
following cost information has been ascertained for annual production of 12,000 units
which is the full capacity :
Cost per unit `

Materials 40
Direct Labour and variable expenses 20
Fixed Manufacturing expenses 6
Depreciation 10
Fixed Administration expenses 4
` 80
The selling price per unit is expected to be ` 96 and the selling expenses ` 5 per unit, 80%
of which is variable.
In the first two years of operations, production and sales are expected to be as follows:
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Year Production no. of units Sales no. of units

1 6,000 5,000
2 9,000 8,500
To assess the working capital requirements, the following additional informations is

available:
a) Stock of materials 2.25 months' average consumption
b) Work in process Nil
c) Debtors 1 month's average sales
d) Cash balance ` 10,000
e) Creditors for supply of materials : 1 month's average purchases during the
year
f) Creditors for expenses: 1 month's average of all expenses during
the year
Prepare, for the two years,

(i) A projected statement of Profit / Loss (ignoring taxation); and
(ii) A projected statement of working capital requirements on total basis.
Question 6
A newly formed company has applied to the Commercial Bank for the first time for
financing its working capital requirements. The following information is available about
the projections for the current year:
Per unit
Elements of cost: (`)
Raw material 40
Direct labour 15
Overhead 30
Total cost 85
Profit 15
Sales 100
Other information:
Raw material in stock: average 4 weeks consumption, Work – in progress (completion
stage, 50 per cent), Finished goods in stock: on an average, one month.
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Credit allowed by suppliers is one month.

Credit allowed to debtors is two months.
Average time lag in payment of wages is 1½ weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at ` 50,000.
All Sales are on credit basis only.
Required:
Prepare statement showing estimate of working capital needed to finance an activity level
of 96,000 complete units of production and 8000 units of WIP. Assume that production is
carried on evenly throughout the year, and wages and overhead accrue similarly. For the
calculation purpose 4 weeks may be taken as equivalent to a month and 52 weeks in a
year.
Question 7
Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a
single shift working with the following cost structure:
Per unit (`)

Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016 – 2017 - ` 4, 32,000.
As at 31.3.2017 the company held:

(`)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1, 08,000
In view of increased market demand, it is proposed to double production by working an

extra shift. It is expected that a 10% discount will be available from suppliers of raw
materials in view of increased volume of business. Selling price will remain the same. The
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credit period allowed to customers will remain unaltered. Credit availed of from suppliers
will continue to remain at the present level i.e., 2 months. Lag in payment of wages and
expenses will continue to remain half a month.
You are required to assess the additional working capital requirements, if the policy to
increase output is implemented.
Question 8
Following information is forecasted by the CS Limited for the year ending 31st March,
2020:
Balance as at Balance as at
1st April, 2019 ` 31st March, 2020 `
Raw Material 45,000 65,000
Work-in-progress 35,000 51,000
Finished goods 60,000 70,000
Debtors 1 ,12,000 1,35,000
Creditors 50,000 70,000
Annual purchases of raw material (all 4,00,000
credit)
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit 11,00,000
You may take one year as equal to 365 days.

Calculate the Net operating cycle period.
Question 9
The following information is provided by the DPS Limited for the year ending 31st March,
2020.
Raw material storage period 55 days
Work-in-progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditors’ payment period 60 days
Annual Operating cost ` 21, 00,000
(Including depreciation of ` 2, 10,000)
[1 year = 360 days]
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(i) Operating Cycle period.
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cash cost basis.
(iv) The company is a market leader in its product, there is virtually no competitor in the
market. Based on a market research it is planning to discontinue sales on credit and
deliver products based on pre-payments. Thereby, it can reduce its working capital
requirement substantially.
What would be the reduction in working capital requirement due to such decision?
Question 10
An engineering company is considering its working capital investment for the year 2019-
20. The estimated fixed assets and current liabilities for the next year are ` 6.63 crore
and ` 5.967 crores respectively. The sales and earnings before interest and taxes (EBIT)
depend on investment in its current assets - particularly inventory and receivables. The
company is examining the following alternative working capital policies:
Working Capital Investment in Current Estimated Sales EBIT

Policy Assets (` Crores) (` Crores) (` Crores)
Conservative 11.475 31.365 3.1365
Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55
You are required to calculate the following for each policy:

(i) Rate of return on total assets.
(ii) Net working capital position.
(iii) Current assets to fixed assets ratio.
(iv) Discuss the risk-return trade off of each working capital policy.
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Question 1
On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of
working capital that will be required during the year. From the following information
prepare the working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of
activity would be maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10%
and Overheads 20%.
Raw materials are expected to remain in store for an average of 2 months before issue
to production.
Each unit is expected to be in process for one month, the raw materials being fed into
the pipeline immediately and the labour and overhead costs accruing evenly during the
month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately
3 months.
Credit allowed by creditors is 2 months from the date of delivery of raw material.
Credit allowed to debtors is 3 months from the date of dispatch.
Selling price is ` 5 per unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month.
The company normally keeps cash in hand to the extent of ` 20,000.
Question 2
The management of MNP Company Ltd. is planning to expand its business and consults
you to prepare an estimated working capital statement. The records of the company
reveal the following annual information:
`
Sales –Domestic at one month’s credit 24,00,000
Export at three month’s credit (sales price 10% below domestic price) 10,80,000
Materials used (suppliers extend two months credit) 9,00,000
Lag in payment of wages – ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four instalments of which one falls in the next 2,25,000
financial year
132
Rate of gross profit is 20%.

Ignore work-in-progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and
believes in keeping ` 2,50,000 available to it including the overdraft limit of ` 75,000 not
yet utilized by the company.
The management is also of the opinion to make 12% margin for contingencies on computed
figure.
You are required to prepare the estimated working capital statement for the next year.
Question 3
Aneja Limited, a newly formed company, has applied to the commercial bank for the first
time for financing its working capital requirements. The following information is available
about the projections for the current year :
Estimated level of activity : 1,04,000 completed units of production plus 4,000 units of
work-in-progress. Based on the above activity, estimated cost per unit is :
Raw Material ` 80 per unit

Direct Wages ` 30 per unit
Overheads ` 60 per unit
Total Cost ` 170 per unit
Selling Price ` 200 per unit
Raw materials in stock : Average 4 weeks consumption, work-in-progress (assume 50%
completion stage in respect of conversion cost) (materials issued at the start of the
processing).
Finished goods in stock 8,000 units

Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors / receivables Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at banks (for smooth operation) is expected to be ` 25,000.

Assume that production is carried on evenly throughout the year (52 weeks) and wages
and overheads accrue similarly. All sales are on credit basis only.
You are required to calculate the net working capital required.
133
HOMEWORK SECTION
Question 1
The following annual figures relate to XYZ Co.,
(`)
Sales (at two months’ credit) 36,00,000
Materials consumed (suppliers extend two months’ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses (expenses are paid one month is 9,60,000
arrear)
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000
The company sells its products on gross profit of 25%. Depreciation is considered as a
part of the cost of production. It keeps one month’s stock each of raw materials and
finished goods, and a cash balance of ` 1,00,000.
Assuming a 20% safety margin, work out the working capital requirements of the company
on cash cost basis. Ignore work-in-process.
Question 2
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011
is given below:
Particulars Amount (`) Particulars (`) Amount (`)
To Opening Stock: By Sales (Credit) 20,00,000
Raw Materials 1,80,000 By Closing
Stock:
Work –in –Progress 60,000 Raw Materials 2,00,000
Finished Goods 2,60,000 5,00,000 Work – in – 1,00,000
To Purchases (credit) 11,00,000 progress 3,00,000 6,00,000
To Wages 3,00,000 Finished Goods
To Production 2,00,000
Expenses
To Gross Profit c/d 5,00,000 _______
26,00,000 26,00,000
To Administration 1,75,000 By Gross Profit 5,00,000
Expenses b/s
To Selling Expenses 75,000
To Net Profit 2,50,000 ________
5,00,000 5,00,000
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The opening and closing balances of debtors were ` 1, 50,000 and ` 2, 00,000 respectively
whereas opening and closing creditors were ` 2, 00,000 and ` 2, 40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.
Question 3
A proforma cost sheet of a Company provides the following data:
(`)
Raw material cost per unit 117
Direct Labour cost per unit 49
Factory overheads cost per unit 98
(includes depreciation of 18 per unit at budgeted level of activity)
Total cost per unit 264
Profit 36
Selling price per unit 300
Following additional information is available:

Average raw material in stock : 4 weeks
Average work-in-process stock : 2 weeks
(% completion with respect to Materials : 80%
Labour and Overheads : 60%)
Finished goods in stock : 3 weeks
Credit period allowed to debtors : 6 weeks
Credit period availed from suppliers : 8 weeks
Time lag in payment of wages : 1 week
Time lag in payment of overheads : 2 weeks
The company sells one-fifth of the output against cash and maintains cash balance of `
2, 50,000.
Required:
Prepare a statement showing estimate of working capital needed to finance a budgeted
activity level of 78,000 units of production. You may assume that production is carried on
evenly throughout the year and wages and overheads accrue similarly.
Question 4
STN Ltd. is a readymade garment manufacturing company. Its production cycle indicates
135
that materials are introduced in the beginning of the production phase; wages and
overhead accrue evenly throughout the period of cycle. The following figures for the 12
months ending 31st December 2011 are given.
Production of shirts 54,000 units
Selling price per unit ` 200
Duration of the production cycle 1 month
Raw material inventory held 2 month’s consumption
Finished goods stock held for 1 month
Credit allowed to debtors is 1.5 months and credit allowed by creditors is 1 month.
Wages are paid in the next month following the month of accrual.
In the work-in-progress 50% of wages and overheads are supposed to be conversion
costs.
The ratios of cost to sales price are-raw materials 60% direct wages 10% and overheads
20%. Cash is to be held to the extent of 40% of current liabilities and safety margin of
15% will be maintained.
Calculate amount of working capital required for the company on a cash cost basis.
Question 5
A firm has the following data for the year ending 31st March, 2017:
(`)
Sales (1,00,000 @ ` 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are ` 5, 00,000, ` 4, 00,000 and
` 3, 00,000. It is assumed that fixed assets level is constant and profits do not vary with
current assets levels. Show, the effect of the three alternative current assets policies by
calculating return on total assets and current assets to fixed assets ratio.
Question 6
MN Ltd. is commencing a new project for manufacture of electric toys. The following cost
information has been ascertained for annual production of 60,000 units at full capacity:
Amount per unit `

Raw materials 20
Direct labour 15
Manufacturing overheads:
136
`
Variable 15
Fixed 10 25
Selling and Distribution overheads:
Variable 3
Fixed 1 4
Total cost 64
Profit 16
Selling price 80
In the first year of operations expected production and sales are 40,000 units and
35,000 units respectively. To assess the need of working capital, the following additional
information is available:
(i) Stock of Raw materials........................................3 months consumption.
(ii) Credit allowable for debtors................................1½ months.
(iii) Credit allowable by creditors...............................4 months.
(iv) Lag in payment of wages.....................................1 month.
(v) Lag in payment of overheads...............................½ month.
(vi) Cash in hand and Bank is expected to be ` 60,000.
(vii) Provision for contingencies is required @ 10% of working capital requirement
including that provision.
You are required to prepare a projected statement of working capital requirement for the
First year of operations. Debtors are taken at cost.
Question 7
Q Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation
as part of cost of production. Its annual figures are as under:
(`)
Sales (At 2 months’ credit) 24,00,000
Materials consumed (Suppliers credit 2 months) 6,00,000
Wages paid (Monthly at the beginning of the subsequent month) 4,80,000
Manufacturing expenses (Cash expenses are paid – one month in arrear) 6,00,000
Administration expenses (Cash expenses are paid – one month in arrear) 1,50,000
Sales promotion expenses (Paid quarterly in advance) 75,000
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The company keeps one month stock each of raw materials and finished goods. A
minimum cash balance of ` 80,000 is always kept. The company wants to adopt a 10%
safety margin in the maintenance of working capital.
The company has no work in progress
Find out the requirements of working capital of the company on cash cost basis.
138
Notes
139
Notes
140
UNIT II: RECEIVABLES

MANAGEMENT
THEORY SECTION
Meaning
Sales department would like to grant more & more credit in an effort to increase the
sales. It is the finance manager who has to decide whether the credit period should be
extended. A credit policy decision is a "trade - off" between profit on additional sales &
cost of carrying debtors. Cost of carrying debtors (COCD) means minimum return required
on investment in debtors. A credit policy decision may be general or customer specific.
Scope
The three basic aspects of management of Sundry Debtors will be studied in this Chapter.
1. Credit Policy : decisions on credit period to be allowed, early payment discount
rates, etc.
2. Credit Analysis : decisions on whether credit can be extended to a particular customer.
3. Factoring : decision on whether services of factor should be taken or not.
Statement showing evaluation of Credit Policy

Existing Credit Proposed Options
Policy
I II
Sales x x x
(-) Variable Cost x x x
Contribution x x x
(-) Fixed Cost x x x
(-) Administrative Cost x x x
(-) Bad Debts x x x
(-) Collection Expenditure x x x
(-) Discount Allowed x x x
(-) COCD x x x
Net Benefit
141
CLASSWORK SECTION
Question 1
A company currently has an annual turnover of ` 10 lakhs and an average collection
period of 45 days. The company wants to experiment with a more liberal credit policy
on the ground that increase in collection period will generate additional sales. From the
following information, kindly indicate which of the policies you would like the company
to adopt:
Credit Policy Increase in collection Increase in Sales Percentage of default

period (`)
1 15 days 50,000 2%
2 30 days 80,000 3%
3 40 days 1,00,000 4%
4 60 days 1,25,000 6%
The selling price of the product is ` 5, average costs per unit at current level is ` 4 and the
variable costs per unit is ` 3.
The current bad debt loss is 1% and the required rate of return on investment is 20%. A
year can be taken to comprise of 360 days.
Question 2
PTX Limited is considering a change in its present credit policy. Currently it is evaluating
two policies. The company is required to give a return of 20% on the investment in
new accounts receivables. The company's variable costs are 70% of the selling price.
Information regarding present and proposed policies is as follows:
Present Policy Policy Option 1 Policy Option 2

Annual Credit Sales (`) 30,00,000 42,00,000 45,00,000
Debtors turnover ratio 4 times 3 times 2.4 times
Loss due to bad debts 3% of sales 5% of sales 6% of sales
Note: Return on investment in new accounts receivable is based on cost of investment in

debtors.
Which option would you recommend?
142
Question 3
A Company has sales of ` 25, 00,000. Average collection period is 50 days, bad debt
losses are 5% of sales and collection expenses are ` 25,000. The cost of funds is 15%. The
Company has two alternative Collection Programmes:
Programme I Programme II
Average Collection Period reduced to 40 days 30 days
Bad debt losses reduced to 4% of sales 3% of sales
Collection Expenses ` 50,000 ` 80,000
Evaluate which Programme is viable.
Question 4
A firm has a current sale of ` 50,00,000. The firm has unutilised capacity. In order to
boost its sales, it is considering the relaxation in its credit policy. The proposed terms of
credit will be 60 days credit against the present policy of 45 days. As a result, the bad
debts will increase from 1.5% to 2% of sales. The firm’s sales are expected to increase by
10%. The variable operating costs are 72% of the sales. The Firm’s corporate tax rate is
35%, and it requires an after-tax return of 15% on its investment. Should the firm change
its credit period?
Question 5
A new customer with 10% risk of non-payment desires to establish business connections
with you. He would require 1.5 month of credit and is likely to increase your sales by `
1, 20,000 p.a. Cost of sales amounted to 85% of sales. The tax rate is 30%. Should you
accept the offer if the required rate of return is 40% (after tax)?
Question 6
A group of customers want to enter into a contract with you to buy goods worth ` 20
lakhs during 2019-2020 the deliveries to be made in four equal instalments quarterly.
The price of the commodity is ` 20 per unit on which you expect a profit of ` 10. The
acceptance of this proposal would mean an additional recurring expenditure of ` 10,000
p.a. on your part.
The ageing schedule of accounts receivables in respect of this group of customers in the
past was as follows:
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Period Percentage of bills for which payment is received

At the end of 30 days 15%
Assuming an opportunity cost of 20% of the funds locked up in accounts receivables, will
be desirable to accept this proposal?
Question 7
A company is presently having credit sales of ` 12 lakh. The existing credit terms are
1/10, net 45 days and average collection period is 30 days. The current bad debts loss is
1.5%. In order to accelerate the collection process further as also to increase sales, the
company is contemplating liberalization of its existing credit terms to 2/10, net 45 days.
It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase
to 2% of sales and average collection period to decline to 20 days. The contribution to
sales ratio of the company is 22% and opportunity cost of investment in receivables is 15
percent (pre-tax). 50 per cent and 80 percent of customers in terms of sales revenue are
expected to avail cash discount under existing and liberalization scheme respectively. The
tax rate is 30%.
Should the company change its credit terms? (Assume 360 days in a year).
Question 8
A company is considering using a factor; the following information is relevant
(a) The current average collection period for the company’s debt is 80 days and 0.5% of
the debtors default. The factor has agreed to pay within 60 days and will suffer the loss
of any bad debts.
(b) The annual charges for the factoring is 2% which is payable annually at the end of
the year. Administrative cost savings will amount to ` 1, 00,000/- p.a.
(c) Annual Sales all are on credit are ` 1, 00, 00,000/-. Variable cost is 80% of sales.
The company’s cost of capital is 15% p.a.
Should the company enter into factoring agreement?
Question 9
A firm has credit sales of ` 360 lakhs and its average collection period is 30 days.
The financial controller estimates, bad debt losses are around 2% of credit sales. The
144
firm spends ` 1, 40,000 annually on debtors administration. This cost comprises of

telephonic and fax bills along with salaries of staff members. These are the avoidable
costs. A Factoring firm has offered to buy the firm’s receivables. The factor will charge 1%
commission and will pay an advance against receivables on an interest @15% p.a.
after withholding 10% as reserve. What should the firm do?
Assume 360 days in a year.
Question 10
A Ltd. has total sales of ` 3.2 crores and its average collection period is 90 days. The past
experience indicates that bad-debt losses are 1.5% on sales. The expenditure incurred
by the firm in administering its receivable collection efforts are ` 5, 00,000. A factor is
prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10%
as reserve. Calculate the effective cost of factoring to the Firm.
Question 11
The turnover of PQR Ltd. is ` 120 lakhs of which 75 per cent is on credit. The variable cost
ratio is 80 per cent. The credit terms are 2/10, net 30. On the current level of sales, the
bad debts are 1 per cent. The company spends ` 1, 20,000 per annum on administering
its credit sales. The cost includes salaries of staff who handle credit checking, collection
etc. These are avoidable costs. The past experience indicates that 60 per cent of the
customers avail of the cash discount, the remaining customers pay on an average 60 days
after the date of sale.
The Book debts (receivable) of the company are presently being financed in the ratio of
1 : 1 by a mix of bank borrowings and owned funds which cost per annum 15 per cent
and 14 per cent respectively.
A factoring firm has offered to buy the firm’s receivables. The main elements of such deal
structured by the factor are:
(i) Factor reserve, 12 per cent
(ii) Guaranteed payment, 25 days
(iii) Interest charges, 15 per cent, and
(iv) Commission 4 per cent of the value of receivables.
Assume 360 days in a year.
What advice would you give to PQR Ltd. - whether to continue with the in house
management of receivables or accept the factoring firm’s offer?
145

Question 1
As a part of the strategy to increase sales and profits, the sales manager of a company
proposes to sell goods to new customers with 10% risk of non-payment. This group
would require one and a half months credit and is likely to increase sales by ` 1, 00,000
p.a. Production and selling expenses amount to 80% of sales and the income-tax rate
is 50%. The company's minimum required rate of return (after tax) is 25%. Should the
sales manager proposal be accepted. Also find the degree of risk of non-payment that
the company should be willing to assume if the required rate of return (after tax) were (i)
30% (ii) 40% and (iii) 60%.
Question 2
JKL Ltd. is considering the revision of its credit policy with a view to increasing its sales
and profit. Currently all its sales are on credit and the customers are given one month’s
time to settle the dues. It has a contribution of 40% on sales and it can raise additional
funds at a cost of 20% per annum. The marketing manager of the company has given the
following options along with estimates for considerations:
Particulars Current I II III

Position Option Option Option
Sales (` in lakhs) 200 210 220 250
Credit period (in months) 1 1½ 2 3
Bad debts (% of sales) 2 2½ 3 5
Cost of Credit administration (` in lakhs) 1.20 1.30 1.50 3.00
You are required to advise the company for the best option
Question 3
A bank is analysing the receivables of Jackson Company in order to identify acceptable
collateral for a short-term loan. The company’s credit policy is 2/10 net 30. The bank
lends 80 percent on accounts where customers are not currently overdue and where
the average payment period does not exceed 10 days past the net period. A schedule
of Jackson’s receivables has been prepared. How much will the bank lend on pledge of
receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
146
Accounts Amount Days Outstanding in Average Payment

` days Period historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48
1,08,800
Question 4
Mosaic Limited has current sales of ` 15 lakhs per year. Cost of sales is 75 per cent
of sales and bad debts are one per cent of sales. Cost of sales comprises 80 per cent
variable costs and 20 per cent fixed costs, while the company’s required rate of return is
12 per cent. Mosaic Limited currently allows customers 30 days’ credit, but is considering
increasing this to 60 days’ credit in order to increase sales.
It has been estimated that this change in policy will increase sales by 15 per cent, while
bad debts will increase from one per cent to four per cent. It is not expected that the
policy change will result in an increase in fixed costs and creditors and stock will be
unchanged.
Should Mosaic Limited introduce the proposed policy? (Assume a 360 days year)
147
HOMEWORK SECTION
Question 1
A company has prepared the following projections for a year:
Sales 21,000 units
Selling Price per unit ` 40
Variable Costs per unit ` 25
Total Costs per unit ` 35
Credit period allowed One month
The Company proposes to increase the credit period allowed to its customers from one
month to two months. It is envisaged that the change in the policy as above will increase
the sales by 8%. The company desires a return of 25% on its investment.
You are required to examine and advise whether the proposed Credit Policy should be
Simplemented or not.
Question 2
A firm is considering offering 30-day credit to its customers. The firm likes to charge
them an annualized rate of 24%. The firm wants to structure the credit in terms of a cash
discount for immediate payment. How much would the discount rate have to be?
Question 3
A firm has a total sales of ` 12, 00,000 and its average collection period is 90 days.
The past experience indicates that bad debt losses are 1.5% on sales. The expenditure
incurred by the firm in administering receivable collection efforts are ` 50,000. A factor
is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay
advance on receivables to the firm at an interest rate of 16% p.a. after withholding 10%
as reserve. Calculate effective cost of factoring to the firm. Assume 360 days in a year.
Question 4
A company currently has an annual turnover of ` 50 lakhs and an average collection
period of 30 days. The company wants to experiment with a more liberal credit policy on
the ground that increase in collection period will generate additional sales.
From the following information, kindly indicate which policy the company should adopt:
148
Credit policy Average collection period Annual sales (` lakhs)

A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Costs: Variable cost: 80% of sales
Fixed cost: ` 6 lakhs per annum
Required (pre-tax) return on investment: 20%
A year may be taken to comprise of 360 days.
Question 5
A trader whose current sales are in the region of ` 6 lakhs per annum and an average
collection period of 30 days wants to pursue a more liberal policy to improve sales. A
study made by a management consultant reveals the following information:-
Credit Policy Increase in collection Increase in sales Present default

period anticipated
A 10 days ` 30,000 1.5%
B 20 days ` 48,000 2%
C 30 days ` 75,000 3%
D 45 days ` 90,000 4%
The selling price per unit is ` 3. Average cost per unit is ` 2.25 and variable costs per
unit are ` 2. The current bad debt loss is 1%. Required return on additional investment is
20%. Assume a 360 days year.
Which of the above policies would you recommend for adoption?
Question 6
Metalica Toys manufacturers dye cast metallic cars for kids. Its present sale is ` 60 lakhs
per annum with 20 days credit period. The company is contemplating an increase in the
credit period with a view to increasing sales. Present variable costs are 70% of sales
and the total fixed costs ` 8 lakhs per annum. The company expects pre-tax return on
investment @ 25%.
149
Some other details are given as under:

Proposed Credit Policy Average Collection Period Expected Annual Sales
(days) (` Lakhs)
I 30 65
II 40 70
III 50 74
IV 60 75
You are required to advise the company on the policy to be adopted. Assume 360-days a
year. Calculations should be made upto two digits after decimal.
Question 7
ABC Ltd. is considering relaxing its credit policy, for which the management has evaluated
two policies. From the following information kindly indicate which of the credit policy you
would like the company to adopt.
(i) Annual credit sales at present ` 87.5 lakhs
(ii) Proposed Credit Sales
Policy I – ` 105 lakhs and Policy II – ` 118 lakhs
(iii) Accounts receivable turnover and Bad debts

Existing I II
7 times 5.25 times 4.2 times
` 2.63 lakhs 5.25 lakhs ` 7.88 lakhs
(iv) ABC is required to give a return over 30% on the investment in the accounts
receivables.
(v) Variable cost ratio is 70%.
150
Notes
151
Notes
152
UNIT III: CASH AND TREASURY

MANAGEMENT
THEORY SECTION
Meaning
Cash Budgets are a tool for forecasting short - term cash requirements of an enterprise.
They provide a blueprint of the cash inflows and outflows that are expected to occur in
the immediate future period. They assist the management in determining the surplus or
shortage of funds and to take suitable action. The Cash Budget can be prepared for short
period or for long period.
Monthly Cash Budget
Particulars April May June
Opening Balance
Add : Receipts
Cash sales
Collection from debtors
Raising of loans
Issue of share capital or debentures
Sale of FA / Investments
Income from Investments, etc.
(A)
Less : Payments
Payment to suppliers
Payment of operating expenses
Purchase of FA / Investments
Redemption of shares / debentures
Repayment of loans
Interest Payment, etc.
(B)
Balance (A - B)
Borrowings
Repayment of borrowings
Investment of surplus cash
Balance c/f to Next month
153
CLASSWORK SECTION
Question 1
From the following information relating to a departmental store for the three months
period ending 31st March, 2020, you are required to prepare the following :
Monthly cash budget on receipts and payments basis
It is anticipated that the working capital items on 31st December, 2019 will be as follows:
` 000's
Cash in hand and at bank 545
Short-term investments 300
Debtors 2,570
Stock 1,300
Trade Creditors 2,110
Other Creditors 200
Dividends Due 485
Tax Due 320
BUDGETED PROFIT STATEMENT

Particulars ` 000's
Jan. Feb. March
Sales 2,100 1,800 1,700
Cost of Sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, selling and distribution 315 270 255
expenses and interest
Net Profit prior to tax 150 125 115
BUDGETED BALANCES AT THE END OF EACH MONTH

` 000's
31 Jan.
st
28th Feb. 31st March
Short-term investments 700 ---- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade Creditors 2,000 1,950 1,900
Other Creditors 200 200 200
Dividends Due 485 ---- ----
Tax Due 320 320 320
154
Depreciation amounting to ` 60,000 is included in the budgeted expenditure for each

month.
Capital expenditure amounting to ` 8,00,000 is expected to be incurred during February
2020 and proceeds from the sale of plant and equipment of ` 50,000 is expected in
March, 2020.
Question 2
Ram, Arun & Kalish, Chartered Accountants are partners of the Firm Ranka Associates
specialising in the areas of internal and corporate audit, taxation and project consultancy.
The revenue of the firm is steadily increasing over the years. For the year they decided
to operate a budgetary control system to monitor the profitability as well as cash
movements. To start with the following forecast of profits was prepared for the first six
months :
RANKA ASSOCIATES (` IN '000)
PROJECTED PROFIT FORECASTS FOR THE SIX MONTHS ENDING 30.9.2020
Particulars April May June July Aug. Sept.

Incomes Internal / Corporate 60 60 60 60 60 60
Audit
Taxation 30 45 40 50 40 60
Project Consultancy 30 50 30 40 60 40
Total A 120 155 130 150 160 160
Expenses
Depreciation 10 10 10 10 10 10
Rent 5 5 5 5 5 5
Stipend 15 15 15 15 15 15
Telephone 5 7 8 9 13 15
Office Expenses & Salaries 35 45 50 35 40 42
Training 5 6 4 10 12 13
Travel & Conveyance 10 12 13 14 15 15
Partners & Assistants' Salaries 20 30 35 35 40 40
Total B 105 130 140 133 150 155
Profit (A – B) 15 25 (10) 17 10 5
The following additional information is significant :

(a) Rent is payable in advance on the last day of the previous quarter.
(b) Stipend will be paid in the same month.
155
(c) Telephone will be paid every two months in arrears. (i.e. April and May will be paid
in June)
(d) Office expenses and Salaries will be paid in the following month.
(e) Travel & Training will be paid in the same month.
(f) Partners and assistants salaries will be paid in the following month.
(g) The firm is planning to invest a sum of ` 50,000 in July for acquiring a computer.
(h) The firm expects to pay a self-assessment tax of ` 5,000 and advance tax of `15,000
in August.
(i) The firm is planning to open a branch and spend a sum of ` 20,000 in September in
this regard.
(j) Collection of Fees : Internal / Corporate Audit fees will be collected in the following
month. Taxation : 50% in the same month and 50% in the following month.
Consultancy charge is normally received after 2 months.
(k) The firm's Cash Balance as on July 1st was ` 25,000.
You are required to :
(i) Prepare a Cash Budget for each of the three months - July, August and
September.
(ii) Suggest two improvements that could smoothen the cash position as on 30th
September.
Question 3
A manufacturing company has prepared a budget for the year ended 31.12.2020. Using
the relevant data given below, prepare a cash budget for each of the months of February,
March and April 2020.
Estimated Variable Cost Per Unit `

Direct Materials 3
Direct Wages 4
Production Overheads 2
Total 9
Fixed Overheads are estimated at ` 48,000 per annum. These are expected to be incurred
in equal amounts each month during the budget period. Estimated sales at `11 per unit
for the first 5 months are given below :
156
Month Unit
January 6,200
February 6,800
March 5,400
April 6,000
May 6,000
10% of the sales will be made on cash. Balance will be made on one month's credit. The
following further information are available :
1. Finished goods stock : 75% of each month's invoiced sales units to be produced in the
month of sale and 25% of each month's invoiced sales units to be produced in the
previous month.
2. Stock of direct materials : 50% of direct materials required for each month's production
to be purchased in the previous month.
3. Terms of Payments : (a) Direct materials : To be paid for in the month following the
month of purchase ; (b) Direct Wages : 50% in the month used and the balance in
the following month ; and (c) Expenses : 1 month's lag.
4. Estimated cash balance as on 1.2.2020 ` 5,000.
Question 4
A firm maintains a separate account for cash disbursement. Total disbursements are
` 1,05,000 per month or ` 12, 60,000 per year. Administrative and transaction cost of
transferring cash to disbursement account is ` 20 per transfer. Marketable securities yield
is 8% per annum.
Determine the optimum cash balance according to William J. Baumol model.
157

Question 1
From the following information relating to a departmental store, you are required to
prepare for the three months ending 31st March, 2017:-
(a) Month-wise cash budget on receipts and payments basis; and
(b) Statement of Sources and uses of funds for the three months period.
It is anticipated that the working capital at 1st January, 2017 will be as follows:-
` in ‘000’s
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
Budgeted Profit Statement ` in ‘000’s
January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, Selling and Distribution 315 270 255
Expenses
Net Profit before tax 150 125 115
Budgeted balances at the end of each ` in ‘000’s
months
31st Jan. 28th Feb. 31st March.
Short term investments 700 --- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485 --- ---
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550
158
Depreciation amount to ` 60,000 is included in the budgeted expenditure for each month.
Question 2
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
` ` ` `
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
To Other Expenses 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000

9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000
Sales are expected to be ` 12, 00,00,000 in year 3.

As a result, other expenses will increase by ` 50, 00,000 besides other charges. Only raw
materials are in stock. Assume sales and purchases are in cash terms and the closing
stock is expected to go up by the same amount as between year 1 and 2. You may assume
that no dividend is being paid. The Company can use 75% of the cash generated to service
a loan. How much cash from operations will be available in year 3 for the purpose?
Ignore income tax.
159
HOMEWORK SECTION
Question 1
Prachi Ltd is a manufacturing company producing and selling a range of cleaning products
to wholesale customers. It has three suppliers and two customers. Prachi Ltd relies on its
cleared funds forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare
a cleared funds forecast for the period Monday 7 January to Friday 11 January 20X7
inclusive. You have been provided with the following information:
(1) Receipts from customers
Customer Credit Payment 7 Jan 2017 7 Dec 2016

name terms method sales sales
W Ltd 1 Calendar month BACS ` 150,000 ` 130,000

X Ltd None Cheque ` 180,000 ` 160,000
(a) Receipt of money by BACS (Bankers’ Automated Clearing Services) is

instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as
the sale is made and will clear on the third day following this (excluding day of
payment).
(2) Payments to suppliers
Supplier name Credit terms Payment 7 Jan 2017 7 Dec 2016 7 Nov 2016
method purchases purchases purchases
A Ltd 1 calendar Standing 65,000 55,000 45,000
months order
B Ltd 2 calendar Cheque 85,000 80,000 75,000
months
C Ltd None Cheque 95,000 90,000 85,000
(a) Prachi Ltd has set up a standing order for ` 45,000 a month to pay for supplies
from A Ltd. This will leave Prachi’s bank account on 7 January. Every few months,
an adjustment is made to reflect the actual cost of supplies purchased (you do
NOT need to make this adjustment).
(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 January.
160
The amounts will leave its bank account on the second day following this
(excluding the day of posting).
(3) Wages and salaries
December 20X6 January 20X7
Weekly wages ` 12,000 ` 13,000
Monthly salaries ` 56,000 ` 59,000
(a) Factory workers are paid cash wages (weekly). They will be paid one week’s
wages, on 11 January, for the last week’s work done in December (i.e. they
work a week in hand).
(b) All the office workers are paid salaries (monthly) by BACS. Salaries for December
will be paid on 7 January.
(4) Other miscellaneous payments

(a) Every Monday morning, the petty cashier withdraws ` 200 from the company
bank account for the petty cash. The money leaves Prachi’s bank account
straight away.
(b) The room cleaner is paid ` 30 from petty cash every Wednesday morning.
(c) Office stationery will be ordered by telephone on Tuesday 8 January to the
value of ` 300. This is paid for by company debit card. Such payments are
generally seen to leave the company account on the next working day.
(d) Five new softwares will be ordered over the Internet on 10 January at a total
cost of ` 6,500. A cheque will be sent out on the same day. The amount will
leave Prachi Ltd’s bank account on the second day following this (excluding the
day of posting).
(5) Other information

The balance on Prachi’s bank account will be ` 200,000 on 7 January 20X7. This
represents both the book balance and the cleared funds.
Required:
Prepare a cleared funds forecast for the period Monday 7 January to Friday 7
January 20X7 inclusive using the information provided. Show clearly the uncleared
funds float each day.
Question 2
Prepare monthly cash budget for six months beginning from April 2017 on the basis
of the following information:-
161
(i) Estimated monthly sales are as follows:-

(`) (`)
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and salaries are estimated to be payable as follows:-

(`) (`)
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected
within one month and the balance in two months. There are no bad debt losses.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month
preceding the sales.
(v) The firm has 10% debentures of ` 1, 20,000. Interest on these has to be paid quarterly
in January, April and so on.
(vi) The firm is to make an advance payment of tax of ` 5,000 in July, 2017.
(vii) The firm had a cash balance of ` 20,000 on April 1, 2017, which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level is made
up by temporary investments/liquidation of temporary investments or temporary
borrowings at the end of each month (interest on these to be ignored).
162
Notes
163
Notes
164
TABLES
PRESENT VALUE FACTOR OF A FUTURE AMOUNT OF RE. 1 i.e., PVF(r%, n)
165
166
PRESENT VALUE FACTOR OF AN ANNUITY FACTOR OF RE. 1 i.e., PVAF(r%, n)
167
168
LAST MINUTE REVISION
1. ACCOUNTING RATIOS
1) CURRENT ASSETS
a) Those assets which are converted into cash within a period of one year
b) List of Current Assets
Particulars Rs.
Cash and Bank XXX
Bills Receivables and Debtors XXX
Short Term Investment XXX
Marketable Securities XXX
Short Term Loans and Advances XXX
QUICK ASSETS XXX
Stock XXX
Prepaid Expenses XXX
CURRENT ASSETS XXX
2) CURRENT LIABILITIES
a) Those Liabilities which are settled or paid within one year
b) List of Current Liabilities
Particulars Rs.
Creditors XXX
Bills Payables XXX
Outstanding Expenses XXX
Short Term Loans XXX
Provision for Tax XXX
QUICK LIABILITIES XXX
Bank Overdraft XXX
CURRENT LIABILITIES XXX
CURRENT ASSETS XXX
169
3) WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES

4) Average would generally mean (Opening + Closing )/2
5) ANALYSIS OF LIABILITY SIDE
Particulars Rs.
SHAREHOLDERS FUNDS/NET WORTH/EQUITY/OWNERS FUNDS/
PROPRIETORS FUNDS
Equity Share Capital XXX
Add: Reserves and Surplus XXX
Less: Miscellaneous Expenses not w/off (XX)
EQUITY SHAREHOLDERS FUNDS XXX
Add: Preference Share Capital XXX
(A) XXX
BORROWED FUNDS/LOAN FUNDS/DEBT
Secured Loans XXX
Unsecured Loans XXX
(B) XXX
CAPITAL EMPLOYED/TOTAL SOURCES OF FUNDS (A+B) XXXX
6) ANALYSIS OF ASSET SIDE

FIXED ASSETS
Gross Block XXX
Less: Provision for Depreciation (XXX)
Net Block/ WDV XXX
LONG TERM INVESTMENTS XXX
CURRENT ASSETS XXX
TOTAL ASSETS XXX
LESS: CURRENT LIABILITIES (XX)
CAPITAL EMPLOYED XXX
LESS: DEBT (XX)
SHAREHOLDERS FUNDS XXX
170
7) ANALSIS OF PROFIT AND LOSS STATEMENT

Particulars Rs.
Sales XXX
Less: COGS XXX
GROSS PROFIT XXX
Less: Operating Expenses XXX
OPERATING PROFITS XXX
Add: Non Operating Incomes XXX
Less: Non Operating Expenses XXX
PROFIT BEFORE INTEREST AND TAXES (PBIT/EBIT) XXX
Less: Interest XXX
PROFIT BEFORE TAX (PBT/EBT) XXX
Less : Tax XXX
PROFIT AFTER TAX (PAT/EAT) XXX
Less: Preference Dividend (PD) XXX
EARNINGS FOR EQUITY SHAREHOLDERS XXX
Equity Dividend XXX
RETAINED EARNINGS XXX
8) COGS
a) Sales – Gross Profit
b) Opening Stock of FG + Purchases of FG + Direct Expenses – Closing Stock of FG
c) RM Consumed + Direct Wages + Manufacturing Overheads + Opening Stock of
FG – Closing Stock of FG
d) RM Consumed = Opening Stock of RM + Purchases of RM – Closing stock of RM
9) IMPORTANT FORMULAS
NAME OF THE RATIO FORMULA
CURRENT RATIO (Current Assets)
=
(Current Liabilities)
QUICK RATIO Quick Assets

=
Quick Liabilities
SUPER QUICK RATIO Cash & Bank+Marketable Securites

=
Current Liabilities
171
DEBT RATIO Debt

=
Capital Employed
DEBT – EQUITY RATIO Debt

=
Equity
CAPITAL GEARING RATIO Debt+Preference Share Capital

=
Equity Shareholders Funds
PROPRIETARY RATIO Proprietors Funds

=
Total Assets
CAPITAL EMPLOYED TURNOVER Sales

=
Capital Employed
FIXED ASSETS TURNOVER Sales

=
Fixed Assets
WORKING CAPITAL TURNOVER Sales

=
Working Capital
STOCK TURNOVER COGS

=
Average Stock
DEBTORS TURNOVER Credit Sales

=
Average Debtors
CREDITORS TURNOVER Credit Purchases

=
Average Creditors
RETURN ON CAPITAL EMPLOYED EBIT

= x100
(ROCE/ROI) Capital Employed
Or
EBIT (1-tax rate)
= x100
Capital Employed
RETURN ON EQUITY (ROE) Earnings after tax

= x100
Equity
GROSS PROFIT RATIO Gross Profit

= x100
Sales
OPERATING PROFIT RATIO Operating Profit

= x100
Sales
172
ADMINISTRATIVE EXPENSE RATIO Admin Expenses

= x100
Total Assets
SELLING EXPENSES RATIO Selling expenses

= x100
Sales
NET PROFIT RATIO NPAT

= x100
Sales
EARNINGS PER SHARE (EPS) Earnings for Equity shareholders

=
no. of equity shares
DIVIDEND PER SHARE (DPS) Equity Dividend

=
no. of equity shares
RETENTION RATIO EPS-DPS

= x100
EPS
BOOK VALUE PER SHARE/BALANCE Equity Shareholders Funds

=
SHEET VALUE PER SHARE (BVPS) no. of equity shares
PRICE EARNINGS RATIO (PE) MPS

=
EPS
EARNINGS PRICE RATIO/ EARNINGS EPS

= x100
YIELD RATIO MPS
DIVIDEND PRICE RATIO/ DIVIDEND DPS

= x100
YIELD RATIO MPS
INTEREST COVERAGE RATIO EAT

=
Preference Dividend
DEBT SERVICE COVERAGE RATIO EAT+Depreciation+Amortisation+Interest

=
Annual Installment of Loan+ Interest
173
2. LEVERAGES
1) INCOME STATEMENT FOR CALCULATION OF LEVERAGES
Particulars Rs.
Sales XXX
Less: Variable Cost XXX
CONTRIBUTION XXX
Less: Operating Fixed Cost XXX
PROFIT BEFORE INTEREST AND TAXES (PBIT/EBIT) XXX
Less: Interest XXX
Less : Tax XXX
Less: Preference Dividend (PD) XXX
EARNINGS FOR EQUITY SHAREHOLDERS XXX
No of Equity shares XXX
EPS XXX
NAME OF THE RATIO Formula

OPERATING LEVERAGE (OL/DOL) Contribution
=
EBIT
or
% change in EBIT
=
% change in Sales
174
FINANCIAL LEVERAGE (FL/DFL) EBIT

=
PD(incl.DDT)
EBT- (1-tax rate)
Or
% change in EBIT
=
% change in Sales
COMBINED LEVERAGE (CL/DCL) Contribution

=
PD(incl.DDT)
EBT- (1-tax rate)
Or
= OL X FL
PROFIT VOLUME RATIO Contribution
= x100
Sales
175
3. CAPITAL STRUCTURE
1) INCOME STATEMENT FOR SELECTION OF PLANS
Particulars Plan I Plan II

Sales XXX XXX
Less: Variable Cost XXX XXX
CONTRIBUTION XXX XXX
Less: Operating Fixed Cost XXX XXX
PROFIT BEFORE INTEREST AND TAXES (PBIT/EBIT) XXX XXX
Less: Interest XXX XXX
PROFIT BEFORE TAX (PBT/EBT) XXX XXX
Less : Tax XXX XXX
PROFIT AFTER TAX (PAT/EAT) XXX XXX
Less: Preference Dividend (PD) XXX XXX
EARNINGS FOR EQUITY SHAREHOLDERS XXX XXX
No of Equity shares XXX XXX
EPS XXX XXX
CONCLUSION: SELECT PLAN WHICH MAXIMISES THE EPS
NAME OF THE RATIO FORMULA

INDIFFERENCE LEVEL (EBIT-Interest)(1-t)-PD (EBIT-Interest)(1-t)-PD
=
No of Equity shares of Plan 1 No of Equity shares of Plan 2
Here the unknown variable is EBIT, once found the

same will be known as indifference level of EBIT
FINANCIAL BREAK EVEN PD
F-BEP=Interest+
POINT (F-BEP) (1-t)
176
4. COST OF CAPITAL
1) STATEMENT TO CALCULATE WACC
CALCULATION OF WACC
SOURCES AMOUNTS W COST IN % W X COST=
WACC
EQUITY SHARE CAPITAL XXX XX Ke XXX
RETAINED EARNINGS XXX XX Kr XXX
PREFERENCE SHARE CAPITAL XXX XX Kp XXX
DEBENTURES/LOANS XXX XX Kd XXX
2) CALCULATION OF SPECIFIC COST OF CAPITAL

Name of the Ratio Formula
COST OF DEBT – IRREDEEMABLE Interest (1-t)
Kd =
Net Proceeds
COST OF DEBT – REDEEMABLE Interest (1-t)+

RV-NP
n
Kd =
RV+NP
2
Where, NP is net proceeds at the time of issue which

is issue price – floatation cost
COST OF PREFERENCE SHARES PD
Kp =
– IRREDEEMABLE Net Proceeds
COST OF PREFERENCE SHARES – PD+

RV-NP
n
REDEEMABLE Kp =
RV+NP
2
Where, PD = preference dividend

COST OF EQUITY SHARES
DIVIDEND YIELD APPROACH DPS D
Ke = =
MPS P0
Where D is expected DPS and P0 is price of the share

today
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DIVIDEND YIELD APPROACH + D1

Ke = +g
GROWTH MODEL P0
Where , D1 is expected dividend at the end of year 1

and g = growth rate in dividend which is assumed to
be constant
EARNINGS YIELD APPROACH EPS E
Ke = +
MPS P0
Where D is expected DPS and P0 is price of the share

today
EARNINGS YIELD APPROACH + E1
Ke = +g
GROWTH MODEL P0
Where , D1 is expected dividend at the end of year 1

and g = growth rate in dividend which is assumed to
be constant
CAPITAL ASSET PRICING MODEL Ke = Rf + (Rm – Rf)β
(CAPM) Rf = Returns from risk free securities
Rm = Expected returns from the market
(Rm-Rf) is market risk premium
β is a measure of systematic risk of a security in
relation to market risk
REALISED YIELD APPROACH (P1-P0)+D1
Ke =
P0
COST OF RETAINED EARNINGS IS THE OPPORTUNITY COST FORGONE BY THE EXISINTING
EQUITY SHAREHOLDERS AND IN ABSENCE OF INFORMATION IT IS BE ASSUMED THAT Kr
= Ke
TYPES OF WEIGHTS
BOOK VALUE WEIGHTS MARKET VALUE WEIGHTS MARGINAL VALUE WEIGHTS
Whenever we take book Whenever we take market When we have to calculate
values of each source of values of each source of WACC for new project or
finance to calculate WACC, finance to calculate WACC, additional funds we follow
the weights calculated are the weights arrived are marginal value weights
called Book Value weights called Market Value Weights
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3) CAPITAL STRUCTURE THEORIES

INCOME STATEMENT FOR CAPITAL STRUCTURE THEORIES
EBIT Xxx
Less: Interest Xxx
EBT/EAT/EARNINGS FOR EQUITY SHAREHOLDERS/DIVIDEND Xxx
FORMULAS FOR CAPITAL STRUCTURE THEORIES

VALUE OF DEBT (D) Interest
D=
Kd
VALUE OF EQUITY ( E) Dividend
E=
Ke
VALUE OF THE FIRM (V) V = E +D
OR
EBIT
V=
Ko
(IF THERE ARE NO TAXES)

OR
EBIT(1-t)
V=
Ko
(IF THERE ARE TAXES)
VALUE OF THE FIRMS AS PER MM APPROACH VALUE OF UNLEVERED CO.

EBIT(1-t)
V=
Ko=Ke
VALUE OF LEVERED CO.
= VALUE OF UNLEVERED CO. + DEBT X TAX
RATE
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5. CAPITAL BUDGETING
1) ESTIMATED INCOME STATEMENT FOR CALCULATION OF CASH FLOWS
Particulars Rs
Sales XXX
Less: Variable Cost XXX
Less: Operating Fixed Cost XXX
PROFIT BEFORE DEPRECIATION AND TAXES/ CASH FLOWS BEFORE TAX XXX
(CFBT)
Less: Depreciation XXX
Less : Tax XXX
Add: Depreciation XXX
CASH FLOWS AFTER TAX (CFAT) / FVCI XXX
2) TECHNIQUES FOR EVALUATING LONG TERM PROJECTS

1) PAY BACK PERIOD
IF CASH INFLOWS ARE EVEN (ANNUITY) IF CASH INFLOWS ARE UNEVEN
(ORIGINAL INVESTMENT) YEAR FVCI CUMMULATIVE

PBP=
ANNUITY 1 XXX XXX
2 XXX XXX
3 XXX XXX
4 XXX XXX
2) NET PRESENT VALUE NPV = PVCI –PVCO

(Discounting is always to be done using
Ko)
3) PROFITABILITY INDEX/PRESENT PVCI

PI =
VALUE INDEX/BENEFIT COST RATIO/ PVCO
DESIREABILITY FACTOR (PI)
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4) INTERNAL RATE OF RETURN (IRR) It is the discounting rate where PVCI =

PVCO
5) DISCOUNTED PAY BACK PERIOD YEAR PVCI CUMMULATIVE
1 XXX XXX
2 XXX XXX
3 XXX XXX
4 XXX XXX
6) AVERAGE RATE OF RETURN/ Average NPAT

ARR = x100
ACCOUNTING RATE OF RETURN Original Investment
or
Average NPAT
ARR = x100
Average Investment
Average Investment = (Cost + Scrap)/2
DECISION CRITERIA OF CAPITAL BUDGETING TECHNIQUES

METHOD FOR INDEPENDENT PROJECT FOR MUTUALLY EXCLUSIVE PROJECT
PBP (1) When PBP is < Target PBP : Accept Project with least Payback period
(2) When PBP is > Target PBP : Reject should be selected
ARR (1) When ARR is less than Target Rate Project with highest possible ARR
of Return : Accept
(2) When ARR is greater than Target
Rate of Return : Reject
NPV (1) If NPV is Positive : Accept Select the Project which gives highest
(2) If NPV is Negative : Reject possible NPV
IRR (1) If IRR > Ko : Accept Select the Project which gives highest
(2) If IRR < Ko : Reject possible IRR
PI (1) If PI > 1 : Accept Select the Project which gives highest
(2) If PI < 1 : Reject possible PI
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6. WORKING CAPITAL
ESTIMATION
1. CALCULATION OF OPERATING CYCLE PERIOD
Particulars Period
Stock holding period of RM XXX
Stock conversion period of WIP XXX
Stock holding period of FG XXX
Debt collection period XXX
Gross Duration XXX
Creditors payment period (XXX)
Net Duration XXX
Stock holding period of RM

Average Stock of RM
= x 365 or 52 or 12
RM Consumed
Stock conversion period of WIP

Average Stock of WIP
= x 365 or 52 or 12
COP
Stock holding period of FG

Average Stock of FG
= x 365 or 52 or 12
COGS
Debt collection period

Average Debtors
= x 365 or 52 or 12
Credit Sales
Creditors payment period

Average Creditors
= x 365 or 52 or 12
Credit Purchases
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2) PROFORMA OF STATEMENT TO DETERMINE WORKING CAPITAL REQUIREMENT

Particulars Amount
CURRENT ASSETS
Stock of Raw Material XXX
Stock of WIP XXX
Stock of FG XXX
Debtors XXX
Cash/Bank XXX
Other Current Assets XXX
(A) XXX
CURRENT LIABILITIES XXX
Creditors XXX
Other Current Liabilities XXX
Provision for Tax XXX
Outstanding Expenses XXX
Bank O/D XXX
(B) XXX
WORKING CAPITAL (A-B) XXX
Add : Margin of Safety XXX
TOTAL WORKING CAPITAL XXX
3) INCOME STATEMENT FOR ESTIMATING WORKING CAPITAL REQUIREMENT

Particulars Amount
Raw Material Consumed XXX
Direct Wages XXX
Manufacturing Expense/ Factory OH XXX
Depreciation ( do not consider if WC is on Cash Cost basis) XXX
Cost of production(COP/COGS/COS) XXX
Admin Expenses XXX
Selling Expenses XXX
Total Cost XXX
Add : Profit XXX
Sales XXX
INCOME STATEMENT SHOULD BE RESTRICTED ONLY TILL TOTAL COST IF ESTIMATION
IS TO BE DONE ON CASH COST BASIS.
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7. RECEIVEABLES
MANAGEMENT
1) Income Statement to determine the best credit policy
Particulars Existing Proposed

Credit Policy Credit Policy
Credit Sales p.a xxx xxx
Less : Variable Cost xxx xxx
CONTRIBUTION xxx xxx
Less : Bad Debts xxx xxx
Less : Administrative Cost xxx xxx
Less : Discount xxx xxx
NPBT xxx xxx
Less : Tax xxx xxx
NPAT (A) xxx xxx
Investment in Debtors (Variable cost * credit xxx xxx

period/12 or 365 or 52)
Interest Lost/ Cost of Carrying Debtors (B) xxx xxx
(A) - (B) xxx Xxx
CONCLUSION: IF PROFIT INCREASES THEN IT WILL BE ADVISABLE TO GO FOR
PROPOSED CREDIT POLICY OR ELSE NOT.
2) Evaluation of Factoring Proposal

Particulars Rs.
ANNUAL SAVINGS (BENEFITS) ON TAKING FACTORING SERVICES
- Savings in Administrative Cost XXX
- Savings in Loss due to Bad debts XXX
- Interest saved due to reduction in Average Collection Period XXX
{Annual Credit Sales x Rate of Interest x (Present Collection Period
- Guaranteed Payment period by Factor)/360}
(A) XXX
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ANNUAL COST OF FACTORING TO THE FIRM

- Annual Factoring Commission XXX
- Interest charged by Factor on Advance XXX
{(Annual credit sales - Factor Reserve - Factoring Commission) x
Guaranteed period/360} x Interest rate charged by Factor
(B) XXX
NET ANNUAL BENEFITS/ANNUAL COST TO THE FIRM (A)-(B) XXXX
Effective Cost of Factoring in % = Net Annual Cost of Factoring / XX%

Amount available for Advance x 100
8. CASH BUDGET

A) Calculation of Optimum Cash Balance as per William J Baumal Model
Optimum Cash Balance =
Where
A = Annual Cash Requirement
T = Transfer Cost per Transfer
O = Opportunity Cost in % term per annum.
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9. RISK ANALYSIS IN
CAPITAL BUDGETING
1) RISK ADJUSTED DISCOUNT RATE

Calculation of RANPV
Year FVCI DF @ RADR PVCI
1 XXX XXXX XXX
2 XXX XXXX XXX
3 XXX XXXX XXX
4 XXX XXXX XXX
Total PVCI XXXX
Less: PVCO XXXX
RANPV XXXX
2) CERTAINITY EQUIVALENT
Year Uncertain CE Factor Certain DF @ Risk PVCI
Cash Flows Cash Flows Free Rate
1 XXX XXX XXX XXX XXX
Total PVCI XXXX
Less: PVCO XXXX
NPV XXXX
3) PROBABILTY DISTRIBUTION APPROACH

CALCULATION OF EXPECTED NPV
Step :1 Calculation of Expected Cash Inflows
Year 1 Year 2 Year 3
Estimated Probability Expected Estimated Probability Expected Estimated Probability Expected
Cash Cash Cash Cash Cash Cash
Inflows Inflows Inflows Inflows Inflows Inflows

XXX XXX XXX XXX XXX XXX XXX XXX XXX
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Step : 2 Calculation of Expected NPV

Year Expected Cash DF @ PVCI
Inflows
1 XXX XXXX XXX
2 XXX XXXX XXX
3 XXX XXXX XXX
Total PVCI XXXX
Less: PVCO XXXX
Expected NPV XXXX
ALTERNATIVE TO CALCULATE EXPECTED NPV AND STANDARD DEVIATION OF NPV

Calculation of Expected NPV Calculation of Standard Deviation of NPV
Estimated Probabilty Expected (Est. NPV - Exp. P ∑ P(Est. NPV
NPV NPV NPV) - Exp. NPV)
XXX XXX XXX XXX XXX XXX
Expected NPV XXX Variance XXX
Standard Deviation
variance
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10. DIVIDEND POLICY
NAME OF THE RATIO Formula

WALTER’S FORMULA D+(E-D)r/Ke
Po =
Ke
Where,
Po = Expected MPS
D = Expected DPS
E= Expected EPS
R= Return on Equity/Productivity of Retained Earnings
Ke= Desired rate of return by Equity shareholders/
Cost of Equity/Capitalisation Rate
GORDON’S FORMULA D1
Po =
Ke-g
Where,
D1 =Expected Dividend of Year 1 and G= growth rate
in Dividend
G= retention ratio (b) x return on Equity (r )
D1 = Do(1+g) or D1 = E1 x Dividend Payout ratio
GRAHAM AND DODD MODEL/ E
Po=m x D+ ( )
TRADITION APPROACH 3
Where, M is the multiplier

MM APPROACH P1+D1
Po =
1+Ke
LINTNER’S MODEL Current year DPS = Last year DPS +{ (Current EPS*
Target Payout Ratio)-Last DPS}* Adjustment Factor
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inter ca - economics
DETERMINATION OF NATIONAL INCOME
UNIT 1: NATIONAL INCOME ACCOUNTING
Question 1
Precautions while calculating National Income?
1) National Income is a money value of all final Goods and services produced in
domestic territory during the FY plus net income from abroad.
2) All earned income will be part of National Income and all unearned Income like gift,
grants, charity, donation, pension to be excluded from National Income.
3) Anything produced for self-consumption will be added in National Income.
4) Any kind of financial Investment where Investment is done in shares, bonds, FD,
debentures etc not to be included.
5) Value of only Final product should be taken. Raw material, intermediate goods,
semi-finished goods, which should be excluded from National Income.
6) Any kind of second hand product or transaction where goods are produced in the
previous year should be excluded from the National Income. However, commission
or brokerage earned over it should be included in NI calculation.
7) Income earned by foreign companies in India value of goods produced will be added,
profit earned will be excluded.
8) Any windfall Gain or Losses should be excluded from the calculation of National
Income.
9) Any kind of Illegal income where money is earned through Smuggling, Hawala
money will be excluded from National Income.
10) Rent, wages, Interest, Profit, Dividend, Mixed Income to be added in National Income.
11) All export and receipts are added and all the imports and payment are deducted.
12) Depreciation to be deducted and Indirect tax to be deducted. , Subsidies Added
Question 2
Define national income and explain the usefulness of national estimate:
National Income is defined as the net value of all economic goods and services produced
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within the domestic territory of a country in an accounting year plus the net factor
income from abroad. According to the Central Statistical Organisation (CSO) ‘ National
income is the sum total of factor incomes generated by the normal residents of a
country in the form of wages, rent, interest and profit in an accounting year’.
Following are the Usefulness of estimating National Income:
 National income estimates provide a comprehensive, conceptual and accounting
framework for analyzing and evaluating the short-run performance of an
economy.
 The distribution pattern of national income determines the pattern of demand
for goods and services and enables businesses to forecast the future demand
for their products.
 Economic welfare depends to a considerable degree on the magnitude and
distribution of national income, size of per capita income and the growth of
these over time.
 It shows the composition and structure of national income in terms of different
sectors of the economy, the periodical variation in them and the broad sectoral
shift in an economy over time. Using these information, the governments can
fix various sector- specific development target for different sectors of the
economy and formulate suitable development plans and policies to increase
growth rates.
 National income statistics also helps in assessing and selecting economic
policies and for objective statement as well as evaluation of governments’
economic policies.
 The national income data are also useful to determine the share of nation’s
contributions to various international bodies.(which helps to determine Income,
Standard of living and eligibility for loans)
 Combined with financial and monetary data, national income data provide a
guide to make policies for growth and inflation.
 National Income estimates helps in economic forecasting and to make
projections about the future development trends of the economy.
Question 3
Describe the generally used concept of National Income.
Answer
The basic concept and definitions of the terms used in national accounts largely follow
those given in the UN System of National Account (SNA) developed by United Nations
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to provide a comprehensive conceptual and accounting framework for compiling and

reporting macroeconomic statistic for analyzing and evaluating the performance of an
economy. Each of these concepts has a specific meaning, use and method of measurement.
Following are the generally used concepts of National Income:

Gross Domestic Product (GDP mp): Gross domestic product (GDP) is a measure of the market
value of all final economic goods and services, gross of depreciation, produced within
the domestic territory of a country during a given time period. It is the sum total of
‘value added’ by all producing units in the domestic territory and includes value added by
current production by foreign residents or foreign-owned firms. The term ‘gross’ implies
that GDP is measured ‘gross’ of depreciation. ‘Domestic’ means domestic territory or
resident production units.
Gross Domestic Product at Factor Cost (GDP fc): GDP at factor cost is called so because it
represents the total cost of factors viz. labour, capital and entrepreneurship.
Gross National Product (GNP): It is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country by normal residents during an accounting year including net factor incomes from
abroad.
Net Domestic Product at market prices (NDP mp): It is a measure of the market value of all
final economic goods and services, produced within the domestic territory of a country by
its normal resident and non-residents during an accounting year less depreciation.
Net National Product at Market Prices (NNP mp): is a measure of the market value of all
final economic goods and services, produced by normal residents within the domestic
territory of a country including Net Factor Income from Abroad during an accounting year
excluding depreciation.
GDP mp = Value of Output in the Domestic Territory – Value of Intermediate Consumption

GDP mp = Σ Value Added
GNP mp = GDP mp + Net Factor Income from Abroad
GDP mp = GNP mp - Net Factor Income from Abroad
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National = Domestic + Net Factor Income from Abroad
NDP mp = GDP mp - Depreciation

NDP mp = NNP mp - Net Factor Income from Abroad
Gross = Net + Depreciation or Net = Gross - Depreciation
NNP mp = GNP mp - Depreciation

NNP mp = NDP mp + Net Factor Income from Abroad
NNP mp = GDP mp + Net Factor Income from Aboard - Depreciation
Market Price = Factor Cost + Net Indirect Taxes

= Factor Cost + Indirect Taxes - Subsidies
Factor Cost = Market Price - Net Indirect taxes

= Market Price - Indirect Taxes + Subsidies
Gross Domestic Product at Factor Cost ( GDP fc)

= GDP mp - Indirect Taxes + Subsidies
= Compensation of employees
+ Operating Surplus (rent + interest + profit )
+ Mixed Income of Self - employed
+ Depreciation
NDP fc = NDP mp - Net Indirect Taxes

= Compensation of employees
= Operating Surplus (rent + interest = profit )
= Mixed Income of Self - employed
Question 4
Explain the term Gross Domestic Product (GDP). How is it estimated?
Gross domestic product (GDP) is a measure of the market value of all final economic
goods and services, gross of depreciation, produced within the domestic territory of a
country during a given time period. It is the sum total of ‘value added’ by all producing
units in the domestic territory and includes value added by current production by foreign
residents or foreign-owned firms. The term ‘gross’ means implies that GDP is measured
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‘gross’ of depreciation. ‘Domestic’ means domestic territory or resident production units.

However, GDP excludes transfer payment, financial transaction and non – reported output
generated through illegal transaction such as narcotics and gambling (these are known
as ‘bads’ as opposed to goods which GDP accounts for).
Gross Domestic Product (GDP) is in fact Gross Domestic Product at market prices (GDP mp)
because the value of goods and services is determined by the common measuring unit
of money or it is evaluated at market prices. Money enables us to measure and find the
aggregate of different types of products expressed in different units of measurement by
converting them in terms of Rupees.
GDP can be estimated either at market price (MP) or at Factor Cost (FC). At Market Price
GDP includes all the indirect taxes while it excludes the subsidies given by the government.
While on the other hand GDP at Factor Cost includes all the cost incurred in the production
of goods. In other words GDP at factor cost does not include indirect taxes.
When the GDP is estimated at current price. It exhibits Nominal GDP, whereas Real GDP is
when the estimation is made at constant prices. Both Nominal and real GDP are considered
as a financial metric for evaluating country’s economic growth and development.
Nominal GDP is GDP evaluated at current market prices. Therefore, nominal GDP will
include all of the changes in market prices that have occurred during the current year due
to inflation or deflation.
Real GDP is GDP evaluated at the market prices of some base year. For example, if 1990
were chosen as the base year, then real GDP for 1995 is calculated by taking the quantities
of all goods and services purchased in 1995 and multiplying them by their 1990 prices.
Currently Base year is 2011-12
Question 5
Distinguish between GDP current and constant prices. What purpose does real GDP serve?
Answer
Gross domestic product (GDP) at current prices is GDP at prices of the current reporting
period. It is the market value of goods and services produced in a country during a year.
It is known as nominal GDP. GDP at current prices includes the effect of inflation. On the
other hand GDP at constant prices also known as Real gross domestic product (GDP) is
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measure that reflect the value of all goods and services produced by an economy in a
given year, expressed in base-year prices.
GDP, which is essentially a quantity measure, is sensitive to changes in the average price
level. The same physical output will correspond to a different GDP level if the average
level of market prices changes. That is, if prices rise. GDP measured at market prices will
also rise without any real increase in physical output. This is misleading because it does
not reflect the changes in the actual volume of output. To correct this i.e. to eliminate the
effect of prices, in addition to computing GDP in terms of current market prices, termed
‘nominal GDP’ or ‘GDP at current price’, the national income accountants also calculate
‘real GDP’ or ‘GDP at constant prices’ which is the value of domestic product in terms of
constant prices of a chosen base year.
Question 6
What is the difference between the concepts ‘market price’ and ‘factor cost in national income
accounting?
Answer
Factor cost is called so because it represents the total cost of factor viz. labor, capital and
entrepreneurship.
In addition to factor cost, the market value of the goods and services will include indirect
taxes which are:
 Product taxes like excise duties, customs, sales tax, service tax etc; levied by the
government on goods and services, and
 Taxes on production, such as factory license fee taxes to be paid to the local authorities,
pollution tax etc. which are unrelated to the quantum of production.
Government gives subsidy to many goods and services. The market price will be lower by
the amount of subsidies on products and production which the government pays to the
producer. Hence, the market value of final expenditure would exceed the total obtained
at factor cost by the amount of product and production taxes reduced by the similar kinds
of subsidies.
For example if the factor cost of a unit of goods X is Rs. 50/, indirect taxes amount to
Rs.15/per unit and the government gives a subsidy of Rs. 10/per unit, then market price
will be Rs.55/- Thus, we find that the basic of distinction between market price and
factor cost is net indirect taxes (i.e. Indirect taxes – Subsidies).
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Market Price = Factor Cost + Net Indirect Taxes

= Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price – Net Indirect Taxes
= Market Prices – Indirect Taxes + Subsidies
Question 7
Explain Value Added Method as applied in national Income accounting?
1) Product method/ Output method/Inventory method/ Industry origin method/Value added
method/ Final goods method.
This method of measuring national income is also known as Industry origin method.
This method approaches NI from output side.
According to this method, economy is divided into different sectors, such as
Agriculture, Mining, Manufacturing, Transport.
The output or product method is calculated either by valuing all final goods and
services produced during the year or by adding all the values at each stage of
production till it becomes the Final product.
Final goods are those goods which are ready for final consumption According to
Approach value of all ‘Final goods and services produced in primary, secondary and
territory are Included and values of all Intermediate transactions are Ignored.
In order to Avoid Double Counting, Value Added method is used.
The difference between Value of material output & input at each stage of production
is called as “Value Added.
GVA mp = Value of output – Intermediate Consumption
GVA mp = Sales + change in stock (closing – opening) - Intermediate Consumption
Gross Value Added
= GVA
+ Primary sector
+ Secondary sector
+ Territory Sector
GDP mp
(+) NFIA
GNP mp
(-) Dep
NNP mp
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(-) IT+S
NNP FC = National Income
Example: Bread.
Stage Value of Output Value of Input Value Added
Farmer 7.00 0.00 7.00
Flour mill 10.00 7.00 3.00
Bakery 13.00 10.00 3.00
Retailer 14.00 13.00 1.00
14.00
Per capita Income

The GDP per capita is a measure of a country’s economic output per person. It is obtained
by dividing the country’s gross domestic product, adjusted by inflation, by the total
population. It serves as an indicator of the standard of living of a country.
National income
pci =
Total Population
Explain Personal Income

While national income is income earned by factors of production, Personal Income is
the income received by the household sector including Non-Profit Institutions Serving
Households. Thus, national income is a measure of income earned and personal income
is a measure of actual current income receipt of persons from all sources which may
not be earned from productive activities during a given period of time. In other words,
it is the income ‘actually paid out’ to the household sector, but not necessarily earned.
Examples of this include transfer payment such as social security benefits, unemployment
compensation, welfare payment etc. Individuals also contribute income which they do
not actually receive; for example, undistributed corporate profits and the contribution of
employers to social security. Personal income forms the basis for consumption expenditures
and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received
An important point to remember is that national income is not the sum of personal
incomes because personal income includes transfer payments (e.g. Pension) which are
196
excluded from national income. Also not all national income accrues to individuals as
their personal income.
Personal Income
National Income
NFIA Less:
+ 1. Undistributed Corporate
Rent Profit
+ 2. Corporate Tax
Interest 3. Social Security
+ Contribution
Wages Add: Transfer Payment
+
Profit
+
Dividend
Explain Disposable Personal Income (PDI)

Disposable personal income is a amount of the money in the hands of the individual that
is available for their consumption or savings. Disposable personal income is derived from
personal income by subtracting the direct taxes paid by individual and other compulsory
payment made to the government.
DI = PI - Personal Incomes Taxes
Question 8
How is national income calculated under ‘Income method’?
Production is carried out by the combined effort of all factors of production. The factors
are paid factor incomes for the services rendered. In other words, whatever is produced
by a producing unit is distributed among the factors of production for their services.
Under Factor Income Method, also called Payment Method or Distributed Share Method,
national income is calculated by summation of factor incomes paid out by all production
units within the domestic territory of a country as wages and salaries, rent, interest, and
profit by definition, it includes factor payment to both residents and non-residents.
Thus,
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NDP FC = Sum of factor incomes paid out by all production units within the domestic
territory of a country
NNP FC or National Income = Compensation of employees + Operating Surplus (rent +
interest + profit) + Mixed Income of self-employed + Net Factor income from Abroad
Only incomes earned by owners of primary factors of production are included in national
incomes. Transfer incomes are excluded from national income. Thus, while wages of
labourers will be included, pensions of retried workers will be excluded from national
income. Labour income includes, apart from wages and salaries, bonus, commission,
employers’ contribution to provident fund and compensations in kind. Non-labour
income includes dividends, undistributed profits of corporations before taxes, interest,
rent, royalties and profit of unincorporated enterprises and of government enterprises.
Question 9
Explain ‘Expenditure Method’ for calculation of national income?
In the expenditure approach, also called Income Disposal Approach, national income is the
aggregate final expenditure in an economy during an accounting year. In the expenditure
approach to measuring GDP, we add up the value of the goods and services purchased by
each type of final user mentioned below:
1. Final Consumption Expenditure:
(a) Private Final Consumption Expenditure (PFCE)
To measure this, the volume of final sales and services to consumer households
and nonprofit institutions serving households acquired for consumption (not
for use in production) are multiplied by market prices and then summation
is done. It also includes the value of primary product which are produced for
own consumption by the households, payment for domestic services which
one household renders to another, the net expenditure on financial assets or
foreign investment. Land and residential buildings purchased or constructed by
household are not part of PFCE. They are included in gross capital formation.
Thus, only expenditure on final goods and services produced in the period for
which national income is to be measured and net foreign investment are include
in the expenditure method of calculating national income.
(b) Government Final Consumption Expenditure
Since the collective services provided by the governments such as defence,
education, healthcare etc. are not sold in the market, the only way they can be
valued in money terms is by adding up the money spent by the government in the
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production of these services. This total expenditure is treated as consumption

expenditure of the government. Government expenditure on pensions,
scholarships, unemployment allowance etc. should be excluded because these
are transfer payments.
2. Gross Domestic Capital formation

Gross domestic fixed capital formation includes final expenditure on machinery and
equipment and own account production of machinery and equipments, expenditure
on construction, expenditure on changes in inventories, and expenditure on the
acquisition of valuables such as, jewelry and works of arts.
3. Net Exports
Net exports are the difference between exports and imports of a country during the
accounting year. It can be positive or negative.
To arrive at national income or NNP FC using expenditure method we first find the
sum of final consumption expenditure, gross domestic capital formation and net
exports. The resulting figure is gross domestic product at market price (GDP MP). To
this, we add the net factor income from abroad and obtain Gross National Product
at market price (GDP MP). Subtracting indirect taxes from GNP MP, we get Gross
National Product at Factor cost (GNP FC). National income or NNP FC is obtained
by subtracting depreciation from Gross national product at factor cost (GNP FC).
Question 10
Explain GDP and Welfare?
Answer
(a) Income distributions and, therefore, GDP per capita is a completely inadequate
measure of welfare. Countries may have significantly different income distributions
and, consequently, different levels of overall well-being for the same level of per
capita income.
(b) Quality improvement in systems and processes due to technological as well as
managerial innovations which reflect true growth in output from year to year.
(c) Productions hidden from government authorities, either because those engaged in it
are evading taxes or because it is illegal (drugs, gambling etc.).
(d) Non-market production (with a few exception) and Non-economic contributors to
well-being for example: health of a country’s citizens, education levels, political
participation, or other social and political factors that may significantly affect well-
199
being levels.
(e) The dis-utility of loss of leisure time. We known that, other things remaining the
same a country’s GDP rises if the total hours of work increase.
(f) Economic ‘bads’ for example: crime, pollution, traffic congestion etc. which makes us
worse off.
(g) The volunteer work and services rendered without remuneration undertaken in the
economy, even though such work can contribute to social well-being as much as
paid work.
(h) Many things that contribute to our economic welfare such as, leisure time, fairness,
gender equality, security of community feeling etc..,
(i) The distinction between production that makes us better off and production that
only prevents us from becoming worse off, e.g. defense expenditure such as on police
protection. Increased expenditure on police due to increase in crimes may increase
GDP but these expenses only prevent us from becoming worse off.
Question 11
Explain limitation of national income?
There are innumerable limitations and challenges in the computation of national income.
The task is more complex in underdeveloped and developing countries. Following are
the general dilemmas in measurement of national income. GDP measures ignore the
following:
Conceptual difficulties:
a) Lack of an agreed definition of national income,
b) Accurate distinction between final goods and intermediate goods,
c) Issue of transfer payments,
d) Services of durable goods,
e) Valuation of government service
f) Valuation of a new product at constant price
Other challenges relate to:
a) Inadequacy of data and lack of reliability of available data,
b) Presence of non-monetized sector,
c) Absence of recording of income due to illiteracy and ignorance,
d) Lack of proper occupational classification, and
e) Accurate estimation of consumption of fixed capital.
f) Production for self consumption
200
Question 12
Constant Prices vs. Current Prices
At Constant Prices At Current Prices
1. Measurement of Value of Output at Measurement of Value of Output at the
the Price level of a selected “Base Price level of the “Current Year”
Year”
2. National Income is affect only by National Income is affected by changes
changes in Output levels. in Price levels and Output levels.
3. National Income changes only when National Income changes even if
production/physical output changes. price change, without any change in
production/physical output.
4. This is also called Real Value of This also called Nominal Value of
National Income, e.g. GDP at Constant National Income, e.g. GDP at Current
Price = Real GDP. Prices = Nominal GDP.
Private Income
Private income is a measure of the income (both factor income & transfer income) which
accrues to private sector from all sources within & outside the country.
Private Income
=
Factor Income from Net domestic product
+
Net factor income from abroad
+
National debt interest
+
Current transfer from Govt.
+
Other Net transfer from the Rest of the world.
GDP deflator
• It is a measure of general price inflation.
• It taken into consideration both Nominal GDP as well as Real GDP.
• The word deflator indicates to ‘deflate’ or take inflation out of GDP.
• It is a Price index used to convert Nominal GDP into real GDP.
• The deflator measures the changes in Price that has occurred between base year
201
and Current year
GDP deflator = x 100
Example 2.
Real GDP ` 4700
Nominal GDP ` 3000
Calculate GDP deflator
GDP deflator = x 100

(Price has fallen)
Example 3.
2010 2018
Nominal GDP ` 600 1200
Price index 100 110
Year GDP deflator

2018 100
2019 113.63
2020 130.25

Example 4.
202
Example 5.

= 14.62%
Question 13
Comparison:
Market Prices Factor Cost
(a) Market Prices refer to the Final Money Net Value Added by each Entry gets
Value of goods & service, i.e. Net Value distributed as Income to the Owners
Added in the course of production of of Factors of Production, i.e. as rent,
goods & services. Wages, Interest and Profits for the
Owner of Land, Labour, Capital and
Entrepreneurship respectively. This
total is called Factor Cost.
(b) Measurement at Market Prices Measurement at Factor Cost constitute
constitute external sale price angle. internal value addition angle.
(c) Value at Market Prices = Value at Factor Cost =
Value at Factor Cost Value at Market Prices
Add: Indirect Taxes Less: Indirect Taxes
Less: Subsidies Add: Subsidies
Question 14
Net Domestic Product (NDP) & Net National Product (NNP) at Mkt Prices.
Based on the concept of “Domestic” and “National” measurements, as well as the concept of
“Gross” and “Net” measurements given above, the following concepts of measurement arise –
GDP at Factor Cost GNP at Factor Cost
1. Meaning GDPfc is the Total of Income GNPfc is the Total of Income
of Factor of Production, i.e. of Factors of Production, i.e.
Land, Labour, Capital and Land, Labour, Capital and
Entrepreneurship. entrepreneurship, adjusted for
Net Factor Income from abroad.
2. Formula GDPfc = GDPmp (-) Net Indirect GNPfc = GNP (-) Net Indirect Taxes
(a) Mp vs FC Route Taxes
203
(b) Total Factor Compensation of Employees Compensation of Employees

Cost Route + Operating Surplus + Operating Surplus
+ Mixed Income of Self- Employed + Mixed Income of Self – Employed
+ Depreciation + Depreciation
+ Net Factor Incomes from Abroad
Note:
Net Indirect Taxes = Indirect Taxes (-) Subsidies.
Operating Surplus = Rent + Interest + Profits.
Question 15
Net Domestic Product (NDP) & Net National Product (NNP) at Factor Cost.
Based on the concept of “Domestic” and “National” measurements as well as the concept
of “Market Prices” and “Factor Cost” given above, the following concepts of measurement
arise –
NDP at Factor Cost NNP at Factor Cost
1. Meaning NDPfc is the Total of Incomes NNPfc is Total of Incomes of
of Factor of Production, i.e. Factor of Production, i.e. Land,
Land, Labour, Capital and Capital and Entrepreneurship,
Entrepreneurship, net of net of Depreciation, adjusted for
Depreciation. Net Factor Incomes of Abroad.
2. Concept NDPfc is the Total Domestic Factor NNPfc is the Total Factor Incomes
Income, net of Depreciation. accruing to normal resident of a
country during a period.
3. Formula NDPfc = GDPfc (-) Depreciation NNPfc = GNPfc (-) Depreciation
(a) Gross vs
Net Route
(b) MP vs FC NDPfc = NDPmp (-) Net Income NNP fc = NNPmp (-) Net Indirect
Net Route Taxes Taxes
(c) T o t a l Compensation of Employees Compensation of Employees
Factor Cost + Operating Surplus + Operating Surplus
Route + Mixed Income of Self- Employed +Mixed Income of Self – Employed
- Depreciation
+ Net Factor Incomes from Abroad
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Question 16
Comparison:
National Income Personal Income
(a) Income “earned by Factor of Production Current Income “received” by Persons
from all sources.
(b) It is measure of Income earned from It is measured of actual current
productive activities. Income receipts, from both productive
and non-productive activities.
(c) It forms the basis of Overall Income in It forms the basis for Consumption
the economy. Expenditure.
Note:
Personal Income is generally less than the National Income, unless Transfer Payment are very
high.
Intermediate goods and final goods:
 Those goods which have crossed boundary line of production and ready for use by
end user is known as final goods. Final goods are o1 two types.
1. Consumer final goods (all the goods purchase by households)
2. Producers final goods (capital goods): Agoods purchased by firm is capital

goods if fulfilled all the following conditions -
i) Durable.
ii) Not for resale,
iii) Not use as raw material,
v) Comparatively costly.
(If any of the above condition not fulfil then it will know as intermediate goods,
which is described Below)
 Those goods which are within the boundary line of production and which are
not ready for use by final user are known as intermediate goods,
Student mu st note that only final goods are included in national income not
intermediate otherwise it leads to problem of double counting (which will be discuss
later in this chapter)
So it is impo rtant to identify which good is intermediate and which good is final,
205
List showing some examples of intermediate and final goods:

ITEMS GOODS REASON
Machine purchased by dealer Intermediate Dealer purchased machines
of machine for the purpose of resale
A car purchased by household Final consumer Household is the final user
of the car,
Furniture purchased by a Final consumer School will finally use
school furniture as capital assets.
Chalks, duster etc. Purchased Intermediate These goods will be
by school consumed for the creation
of educational service
during a year.
Computers installed in a Final producer School will finally use
school computers as capital
assets.
Mobile sets purchased by Intermediate Dealer purchased mobile
mobile dealer sets (or the purpose of
resale.
Maintenance of office building Intermediate Items purchased for
maintenance will be used
up during the period of one
year.
Improvement of a machine in Final producer It will increase the value
factory of assets or it will leads to
creation of assets.
Electricity consumed by firms Intermediate It will be used for production
of goods and services in
short period of time.
Purchase of rice by grocery Intermediate Grocery shop is purchasing
shop rice to resale.
Cloth used for making a sofa- Intermediate As it used as raw material
set by the carpenter in manufacturing of sofa
set.
GST book purchased by tax Final producer GST book is an asset for tax
consultant consultant.
Book purchased by a student Final Consumer Student is a household.
206
Factor income and trust transfer income

Basis Factor income Transfer
Meaning It refer to income received It is the income received without
by factors of production for rendering any service or selling
Rendenng factor service or any product.
selling a product
Inclusion It is Included in the calculation It is included in calculation of
of national income as well as only disposable income
disposable income.
Example Rent, wages, interest and profit Old age pension, scholarship,
charity, grants, retirement
207
UNIT 2: THE KEYNESIAN THEORY OF DETERMINATION

OF NATIONAL INCOME
1. Circular Flow of National Income Two Sector Model

Factor Services
Goods & Services

1. Households are the owners of factor of production and consumers of goods
and services.
2. Business sector produces goods & services and sells them to household sector.
3. Household sector is the owner of Land, Labour and Capital.
4. Household sector receives Income by selling those services to business sector.
5. Business sector consist of producer who produces goods and services and sells
them to household sector. Thus, one man’s Income is another man’s expenditure.
The above diagram Indicates money flows from household towards banking
system which leads to borrowing by business which finally leads to Investment
in the economy. Suppose planned saving exceeds planned Investment Income,
Output and employment will fall and flow of money will decline. Now if
planned Investment exceeds planned savings income, output & employment
will Increase so saving are considered as leakage and Investment are considered
as Injection.
The outer circle at the diagram shows Real flow (i.e.) the flow at factor service
from household to business and flow of goods from business, to household.
The inner circle shows money flow, (i.e.) flow of factor payments from business
to household & consumption expenditure from household to business.
208
Conclusion:
In the circular flow of income production generates factor income which is converted
in to expenditure, this flow of income is a continuous activity due to never ending
human wants.
Equilibrium level of national income two sector model
Explanation of diagram
1. Income is measured on the X – axis while
aggregate demand is measured on the Y –
Axis.
2. The C + I line is obtained through addition
of consumption function (C) and
investment function (I) at each level of
income.
3. The C + I curve shows that aggregate
demand rises with the rise in level of
income.
4. Only at point E*, aggregate demand =
output. Hence, point E* shows equilibrium level of income at OYo.

1. At OYo, planned spending of households exactly equal to actual production of
business sector ie AD=AS.
2. At any income level below OYo, aggregate demand > Aggregate supply (C + l
Iine is above 450 line). Alternatively, at income levels above OYo, AS > AD ie C+S
>C + I
3. In both the above cases, market mechanism will drive the income back to OYo
through changes in the level of investment, employment and output.
4. Panel B of dig shows saving and investment function. Saving schedule (S) slopes
upward to indicate that savings rise with increase in income
5. At point E*, investment also equals savings as shown by intersection of saving
and investment schedule.
6. At any income level above OYo savings > planned investment while at income
levels below OY0, planned investment > savings.
7. Hence, only OYo indicates the equilibrium level where S = I (Leakages are equal to
injections)
209
2. Short note on Consumption Function

Agg. Income Agg. Consumption Savings
Y C S=Y–C
0 500 - 500 Dis Saving
1000 1200 - 200 Dis Saving
2000 2000 000
3000 2600 + 400 Savings
4000 3300 + 700 Savings
15000 4000 + 1000 Savings

Lord J.M.Keynes explains the relationship between consumption and income in terms
of psychological law of consumption in his book General theory of employment
income (i.e.) money 1936.
According to this law, as aggregate income increases total consumption in the
economy also increases but in lesser proportion than increase in income. This is
because as income increases individual wants are satisfied to larger and larger
extent. So when income increases further people do not consume entire income,
they will save a part of it. Here, there is balance to be gap between income and
consumption.

According Keynes with increase in income both consumption and saving increase.
However
1. Consumption Increases at diminishing rate.
2. Saving Increases at increasing rate.
210
In the above Horizontal axis represents Aggregate Income and vertical axis represent
consumption expenditure.
OA on vertical axis shows Autonomous consumption at zero level of income. Thus
consumption curve starts at moves to B and further C. (i.e.) C = a + by.
Point B denotes break-even point at this point c = y
The ∆OAB Indicates Dis savings, however after point B. saving are positive and saving
increase with Increasing Income.
3. Saving Function.
S = Y – C / S = F(Y)
Table same as consumptions function

Savings is the income left after consumption. Savings function is the counter part of
consumption function, i.e. s = y – c
In the above diagram the gap between income and consumption measures the
saving. This gap after point B goes on increasing with rising income. This indicates
211
that savings rises with rising income ‘S’ curve represents saving function. The savings
function derives from consumption function. If we draw ┴ from breakeven point, B to
C. and after joining the point If we further extend the line we derive ‘S’ curve that is
nothing but saving curve.
4. APC, MPC, APS, MPS

Average propensity to consume, Marginal propensity to consume, Avg propensity to
save, marginal propensity to Savings.
1) APC = Consumption C
Total Income Y
2) MPC = Change in consumption ∆C

Change in Income ∆Y
3) APS = Savings S
Total Income Y
4) MPS = Change in savings ∆S

Change in income ∆Y
MPS = I – MPC (1 = income)

Or
= I–b (Induced consumption)

Income Consumption Apc Mpc Mps
0 500 - - -
1000 1250 1.25 0.75 0.25
2000 2000 1 0.75 0.25
3000 2150 092 0.75 0.25
6000 5000 0.83 0.75 0.25
10,000 8000 0.8 0.75 0.25
APC+ APS = 1
C+S =Y
Dividing both sides by Y.
C+S+ Y
212
Y + Y +Y
↓ ↓ ↓
APC + APS = 1
Prove:
MPC + MPC = 1
∆C + ∆S = ∆Y
Dividing both sides by ∆Y
∆C + ∆S + ∆Y
∆Y ∆Y ∆Y
↓ ↓ ↓
MPC + MPS + 1
Marginal Propensity to Consume (MPC)

The consumption function is based on the assumption that there is a constant
relationship between consumption and income, as denoted by constant b which
is marginal propensity to consume. The concept of MPC describes the relationship
between change in consumption (∆C) and the change in income (∆Y). The value of the
increment to consumer expenditure per unit of increment to income is termed the
Marginal Propensity to Consume (MPC).
Although the MPC is not necessarily constant for all changes in income (in fact, the
Total Consumption cc
APC = =
Total Income YY
The Marginal Propensity to Save (MPS)

The slope of the saving function is the marginal propensity to save. If a one-unit
increase in disposable income leads to an increase of b units in consumption, the
remainder (1 - b) is the increase in saving. This increment to saving per unit increase
in disposable income (1 - b) is called the marginal propensity to save (MPS). In other
words, the marginal propensity to save is the increase in saving per unit increase in
disposable income.
∆S
MPS = 1-b
∆Y
Average Propensity to Save (APS)

The ratio of total saving to total income is called average propensity to save (APS).
Alternatively, it is that part of total income which is saved.
213
Total Saving S
APS = =
Total Income Y
5. Explain Circular Flow of National Income [ 3 sector]

From the above circular chart we can find that government sector Adds following things,
1. Taxes on household & business sector to find government purchase.
2. Transfer payment to household sector & subsidy payment to business sector.
3. Government purchases goods & services from business sector & factor of
production from household sector.
4. Government borrowings in banking system to finance the deficit, when tax is
fall short of government purchase.
Equililibirium Level of Income:[ Three sectors]

Explanation of diagram:
1. The X – axis represents income while the Y – axis represents Aggregate Exp
2. Investment and government expenditures are exogenously determined. Thus, in
Panel B, I and G are shown as horizontal lines. Their level does not depend on
income
3. Since I and G are determined outside the model, C + I + G schedule lies above C by
constant amount at all level of income.
4. S + T curve denoted the total
leakages from household sector.
214
It is positive since savings vary

positively with income. Level of
Taxes are decided by Govt
5. Equilibrium is determined at point
E1 where C + I + G schedule intersects
450 line. This gives equilibrium level
of income at OY1 where Aggregate
demand = Income.
6. At E1, S + T = I + G which can be
seen in Panel B.
7. At any level of income below OY1,
aggregate demand > income and
I +G > S + T. Conversely, at any level of
income above OY1, S+T > I +G
8. In both the above cases, demand and
Supply will drive the income back to OY1, through changes in the level of investment,
employment and output.
Circular Flow of National Income. [4 Sector]
215
Introduction:
The circular flow model in four sector economy provides the Realistic picture of
circular flow of national income. Four sector model studies the circular flow in open
economy which consist of household, business sector, government sector & Foreign
sector.
Foreign sector has Important role in the economy when domestic business firm
exports goods & services to the foreign market Injection are made to circular flow. On
the other ha¬¬nd, domestic household, firms or government Import something from
foreign market Leakages occurs in circular model. From the view point of circular
flow of Income, each sector has dual role to play in the economy while a sector
receives certain payment from other sectors it pays back to those sector as well,
circular flow income in different sectors is explained as follows (2 sector explanation
to be taken from previous question except conclusion).
Government Sectors.
Receipts:
The major source of income for government sector includes taxes paid by household
and business sector besides these it also receives Interest and dividend for the
investment made.

Payments:
Government sector makes payment to different sectors in the form of transfer
payments, subsidies and grants etc. It pays to business sector in return for goods
purchased, makes transfer payment like pension fund, scholarship to the household
etc.
Government receipts > government expenditure the surplus go to financial market /
banking sector. In case of deficit government borrows from capital market / banking
to maintain balance in the economy.
Foreign Market:
Receipts:
Foreign sector receives income from business sector in return for goods & services
imported by business sector. Income could also be earned through unilateral receipts.
E.g. Gifts, grants, donation, charity.
216
Payments:
Foreign sector needs to make payment to business sector from where Imports have
been made. If export > import the economy has surplus balance of payment. Incase
import > export the economy faces deficit balance between exports and imports.
Explanation of diagram: 4 sector model
1. The X – axis represents income while the

Y – axis represent C + I + G + (X – M).
2. The investment, government
expenditure and the net exports are
exogenously determined. Hence, in Panel
B, I + G + X is shown as horizontal line.
3. Equilibrium level of income is determined
at point E* where C + I + G + (X – M)
curve intersects the 450 line. At this
level of national income leakages
from the circular flow (S + T +M)
are equal to injection (I + G + X).
4. As exports are income and imports are leakages, increase in the level of exports
increases the level of national income, while increase in the level of imports, and
reduces the national income.
5. Explain in Detail Investment Multiplier or Income Multiplier

The relationship between increase in investment and increase in income explained in
terms of multiplier. The multiplier is important concept of Macroeconomics developed
by J.M. Keynes in General theory 1936.
“Multiplier” introduction by R.F. Kahn in 1931. According to him, it was Employment
Multiplier.
Keynes redesigned and redefined it in terms of income. Hence the multiplier shows
the effect increase in investment on income. So Keynes multiplier is known as Income
or Investment Multiplier.

Definition:
“Investment multiplier is the ratio of final changes in income to initial change in
Investment”.
217
Arithmetically it is defined as
∆Y
K=
∆I
I
K=
I – MPC
Thus, if investment increases by 100cr, Income rises by 400cr. Then the multiplier is
4 (i.e.) K = 4times. Hence the multiplier is the number by which change in Investment
must be multiplied in order to determine resulting change in total income. The
multiplier is determined by tape, higher the MPC, higher the MPC, higher will be the
multiplier and vice versa.
Assumptions:
1. MPC should be constant.
2. Economy should be closed Economy.
3. One man’s expenditure another man’s Income.
Working of Multiplies:
Suppose Government Invested 100cr. In Expansion of Factory.
↓
Income of the Employees 100cr.
↓
MPC taken as constant 75%
100 x 75 = 75cr.→ [spend on Goods & Services]

100
↓
Income of producer 75cr.
↓
[MPC constant] = 75x 75 = 56.25cr...........
100
Stages ∆I ∆Y ∆C ( 75% MPC ) ∆S ( 25% MPS )

1 100 100 75 25
2 75 56.25 18.75
3 56.25 42.18 14.06
4 42.18 31.64 10.55
Total 100 400 300 100
∆Y = ∆C + ∆S
218
1 1
K= = = 4 times
MPC 25 %

∆Y ∆Y
K= ' 4= ∆Y = 400
∆I 100
YY1, > AE.
The ‘C’ curve is consumption curve, it is drawn on Assumption that Mpc is constant
at all level of Income. When we super Impose a Fixed Amount of Investment on the
consumption curve C, we get total expenditure curve C + I , which Interested 45 line
at point E. and original equilibrium level at Income is Y.
When Investment rises total expenditure curve shifts upwards to C + I + I,.
The Increase in Investment ∆I is equal to vertical distance between two expenditure
curve i.e. AE.
The new expenditure curve C + I + I, intersects 45º line at E, which gives new
equilibrium level of Income Y1, which is Larger than original income Y.
So, from the above diagram we conclude, Increase in Income ∆Y is multiple of Increase
IN Investment ∆I (i.e.) YY1, > AE.
219
Leakages in the working of multiplier:

1. Paying off debts.
2. Holding of Idle cash balance.
3. Imports
4. Taxation
5. Increase in price level. ( Inflation ) → Higher the price lower the demand.
6. Purchase of old shares & securities.
Q) Explain four sector equilibrium Level of National Income

When Import >Exports.
Effects on Income When Imports are Greater than Exports
When the foreign sector is included in the model (assuming M > X), the aggregate demand
schedule C+I+G shifts downward with equilibrium point shifting from F to E. The inclusion
of foreign sector (with M > X) causes a reduction in national income from Y0 to Y1.
Nevertheless, when X > M, the aggregate demand schedule C+I+G shifts upward causing
an increase in national income. Learners may infer diagrammatic expressions for possible
changes in equilibrium income for X>M and X =M
A change in autonomous expenditures— for example, a change in investment spending,—

will have a direct effect on income and an induced effect on consumption with a further
effect on income. The higher the value of v, larger the proportion of this induced effect on
demand for foreign, not domestic, consumer goods. Consequently, the induced effect on
demand for domestic goods and, hence on domestic income will be smaller. The increase
220
in imports per unit of income constitutes an additional leakage from the circular flow of
(domestic) income at each round of the multiplier process and reduces the value of the
autonomous expenditure multiplier.
An increase in demand for exports of a country is an increase in aggregate demand for

domestically produced output and will increase equilibrium income just as an increase in
government spending or an autonomous increase in investment. In summary, an increase
in the demand for a country’s exports has an expansionary effect on equilibrium income,
whereas an autonomous increase in imports has a contractionary effect on equilibrium
income. However, this should not be interpreted to mean that exports are good and
imports harmful in their economic effects.
INFLATIONARY GAP
 If the aggregate demand for an output is greater than full employment level of
output, then it leads to excess demand.
 Excess demand gives rise to inflationary situation or inflationary gap.
 This situation of occurs during expansion phase of business cycle which leads to
demand pull inflation.
 Inflationary gap which is the amount by which aggregate demand exceeds the level
of aggregate demand required to establish full employment equilibrium.
Excess Demand – Inflationary Gap
221
DEFLATIONARY GAP
 If the aggregate demand for an output is less than the full employment level of
output then it is called deficient demand.
 Deficient demand gives rise to deflationary gap or recessionary gap.
 It happens when equilibrium level of aggregate production is less than full
employment.
 Deflationary gap is thus a measure of extent of deficiency of aggregate demand
and it leads to decline in income output & employment thus pushing economy into
unemployment
Deficient Demand – Deflationary Gap
222
PUBLIC FINANCE
UNIT 1 - FISCAL FUNCTIONS: AN OVERVIEW
Question 1
Explain the role of government in a market economy.
Answer
The modern society, in general, offers three alternate economic systems through which
the decision of resource reallocation may be made namely, the market, the government
and a mixed system where both market and governments simultaneously determine
resource allocation.
Adam Smith is often described as a bold advocate of free markets and minimal
governmental activity. However, smith saw an important resource allocation role for
government when he underlined the role of government in national defense, maintenance
of justice and the rule of law, establishment and maintenance of highly beneficial public
institutions and public works which the market may fail to produce on account of lack
of sufficient profits. Since the 1930s, more specifically as a consequence of the great
depression, the state’s role in the economy has been distinctly gaining in importance
and therefore, the traditional function of the state have been supplemented with what is
referred to as economic function (also called fiscal or public finance function).
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance ‘(1959), introduced the
three branch taxonomy of the role of government are to be separated into three, namely,
resource allocation, (efficiency), income redistribution (fairness) and macroeconomic
stabilization.
The allocation and distribution functions are primarily microeconomic functions, while
stabilization is a macroeconomic function. The allocation function aims to correct the
sources of inefficiency in the economic system while the distribution role ensures that the
distribution of wealth and income is fair.
Monetary and fiscal policy, the problems of macroeconomic stability, maintenance of
high levels of employment and price stability etc. fall under the stabilization function.
223
Question 2
Describe the various interventional measures adopted by the government.
Answer
Following are the fundamental reason which justifies Government’s intervention in
markets:
1. Allocation function: A market economy is subject to serious malfunctioning in several
basic respects. There is also the problem of nonexistence of market in a variety of
situations. While private goods will be sufficiently provided by the market, public
goods will not be produced in sufficient quantities by the market. Efficient allocation
of resources is assumed to take place only in perfectly competitive markets. In
reality, markets are never perfectly competitive. Market failures which hold back the
efficient allocation of resources.
In the absence of appropriate government intervention, market failures may occur
and the resources are likely to be misallocated by too much production of certain
goods or too little production of certain other goods. The allocation responsibility
of the governments involves suitable corrective action when private markets fail to
provide the right and combination of goods and services. Briefly put, market failures
provide the rationale for government’s allocation function.
2. Redistribution Function: The outcomes of this growth have not spread evenly across
the households. The distribution responsibility of the government arises from the
fact that, left to the market, the distribution of income and wealth among individual
in the society is likely to be skewed and therefore the government has to intervene
to ensure a more desirable and just distribution.
The redistribution function of the government aims at:
 redistribution of income to achieve an equitable distribution of societal output
among household
 advancing the well-being of those members of the society who suffer from
deprivations of different types
 providing equality in income, wealth and opportunities
 providing security for people who have hardships, and
 ensuring that everyone enjoys a minimal standard of living
3. Stabilization Function: Market economy does not automatically generate full

employment and price stability and therefore the government should pursue
deliberate stabilization policies. Business cycles are natural phenomena in any
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economy and they tend to occur periodically. In the absence of appropriate corrective
intervention by the government, the instabilities that occur in the economy in the form
of recessions, inflation etc. may be prolonged for longer periods causing enormous
hardship to people especially the poorer sections of society. It is also possible that a
situation of stagflation (a state of affair in which inflation and unemployment exist
side by side) may set in and make the problem more severe. The stabilization function
is one of the key function of fiscal policy and aims at eliminating macroeconomic
fluctuation arising from suboptimal allocation.
The stabilization function is concerned with the performance of the aggregate
economy in terms of:
 labour employment and capital utilization,
 overall output and income,
 general price levels,
 balance of international payments and
 The rate of economic growth.
Question 3
Explain how economic stability can be achieved through fiscal policy.
Answer
Government’s stabilization intervention may be through monetary policy as well as fiscal
policy. Monetary policy has a singular objective of controlling the size of money supply
and interest rate in the economy which in turn would affect consumption, investment and
prices.
Fiscal policy for stabilization purposes attempts to direct the actions of individuals and
organizations by means of its expenditure and taxation decisions. On the expenditure
side. Government can choose to spend in such a way that it stimulates other economic
activities. For example, government expenditure on building infrastructure may initiate
a series of productive activities. Production decisions, investment, saving etc. can be
influenced by its tax policies.
During recession, the government increases its expenditure or cut down taxes or adopts a
combination of both so that aggregate demand is boosted up with more money put into
hands of the people. On the other hand, to control high inflation the government cuts
down its expenditure or raises taxes.
In other words, expansionary fiscal policy is adopted to alleviate recession and
contractionary fiscal policy is resorted to for controlling high inflation.
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Question 4
What are the different instruments available to the government to improve allocation efficiency
in an economy?
Answer
A variety of allocation instruments are available by which government can influence
resource allocation in the economy. For example,
 government may directly produce the economic good (for example, electricity and
public transportation services)
 government may influence private allocation through incentive and disincentive (for
example, tax concessions and subsidies may be given for the production of goods
that promote social welfare and higher taxes may be imposed on goods such as
cigarettes and alcohol)
 government may influence allocation through its competition policies, merger
policies etc. which will affect the structure of industry and commerce (for example,
the Competition Act in India promotes competition and prevents anti-competitive
activities).
 governments’ regulatory activities such as licensing, control, minimum wages, and
directives on location of industry influence resource allocation
 government sets legal and administrative frameworks, and
 any of a mixture of intermediate techniques may be adopted by governments.
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UNIT 2 - MARKET FAILURE
Question 1
Define the concept of market failure. Describe the different sources/reasons of market failure.
Answer
Market failure is a situation in which the free market leads to misallocation of society’s
scare resources in the sense that there is either overproduction or underproduction of
particular goods and services leading to a less than optimal outcome. The reason for
market failure lies in the fact though perfectly competitive markets failures are situations
in which a particular market, left to itself, is inefficient.
There are two aspects of market failures namely, demand-side market failures and supply
side market failures. Demand-side market failures are said to occur when the demand
curves do not take into account the full willingness of consumers to pay for a product.
Supply-side market failures happen when supply curves do not incorporate the full cost
of producing the product.
Following are the four major reasons for market failure:

1. Market Power: Market power or monopoly power is the ability of a firm to profitably
raise the market price of a good or service over its marginal cost. Firms that have
market power are price market and therefore, can charge a price that gives them
positive economic profits.
Market power can cause market to be inefficient because it keeps price higher and
output lower than the outcome of equilibrium of supply and demand. In the extreme
case, there is the problem of non-existence of markets or missing markets resulting
in failure to produce various goods and services, despite the fact that such product
and services are wanted by people. For example, the markets for pure public goods
do not exist.
2. Externalities: Sometimes, the actions of either consumers or producers result

in costs or benefits that do not reflect as part of the market price. Such costs or
benefits which are not accounted for by the market price are called externalities
because they are “external” to the market. In other words, there is an externality
when a consumption or production activity which has an indirect effect on other’s
consumption or production activities and such effects are not reflected directly in
market prices.
The unique feature of an externality is that it is initiated and experienced not through
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the operation of the price system, but outside the market. Since it occur outside the
price mechanism, it has not been compensated for or in word it is un-internalized or
the cost (benefit) of it is not borne (paid) by the parties.
3. Public Goods: Public goods provide a very important example of market failure, in
which the self-interested behaviour of individual does not produce efficient results.
Consumers can take advantage of public goods without contributing sufficiently to
their production. The absence of excludability in the case of public goods and the
tendency of people to act in their own self-interest will lead to the problem of free
riding. If individuals cannot be excluded from the benefit of a public goods, then they
are not likely to express the value of the benefits which they receive as an offer to pay.
If every individual plays the same strategy of free riding, the strategy will fail because
nobody is willing to pay and therefore, nothing will be provided by the market.
4. Incomplete Information: Information failure is widespread in numerous market

exchanges. When this happens misallocation of scarce resources takes place and
equilibrium price and quantity is not established through price mechanism. This
results in market failure. Asymmetric information occurs when there is an imbalance
in information between buyer and seller i.e. when the buyer knows more than the
seller or the seller knows more than the buyer. This can distort choices.
Adverse selection is a situation in which asymmetric information about quality elimates
high-quality goods from a market. Good quality products disappear because they
are kept by their owners and sold only to their friends and relatives, eventually
market may offer nothing but lemons
Moral hazard is opportunism characterized by an informed person’s taking advantage
of a less-informed person through an unobserved action. It arises from lack of
information about someone’s future behaviour. Moral hazard occurs when an
individual knows more about his or her own actions than other people do. This leads
to a distortion of incentives to take care or to exert effort when someone else bears
the costs of the lack of care or effort.
Question 2
Explain the different types of externalities? Illustrate how externalities lead to welfare loss of
markets.
Answer
Anything that one individual does, may have, at the margin, some effect on others.
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Sometimes, the actions of either consumers or producers result in cost or benefits that do
not reflect as part of the market price. Such costs or benefits which are not accounted for
by the market price are called externalities because they are “external” to the market. In
words, there is an externality when a consumption or production activity has an indirect
effect on other’s consumption or production activities and such effects are not reflected
directly in market prices.
The unique feature of an externality is that it is initiated and experienced not through the
operation of the price system, but outside the market. Externalities are also referred to as
‘spill over effects’, ‘neighbourhood effects’ ‘third-party effects’ or ‘side-effects’.
Externalities can be positive or negative. Negative externalities occur when the action of
one party imposes costs on another party. The four possible types of externalities are:
1. Negative production externalities: A negative externality initiated in production which
imposes an external cost on others may be received by another in consumption
or in production. As an example, a negative production externality occurs when a
factory which produces aluminium discharges untreated waste water into a nearby
river and pollutes the water causing health hazards for people who use the water
for drinking and bathing. Pollution of river also affect fish output as there will be
less catch for fishermen due to loss of fish resources. The former is a case where a
negative production externality is received in consumption and the latter presents a
case of a negative production externality received in production.
2. Positive production externalities: A positive production externality initiated in
production that confers external benefits on other may be received in production or
in consumption.an example of positive production externality received in production;
we can see the case of a firm which offers training to its employees for increasing
their skills. The firm generates positive benefits on other firm when they hire such
workers as they change their jobs..
3. Negative consumption externalities: Negative consumption externalities are extensively
experienced by us in our day to day life. Such negative consumption externalities
initiated in consumption which produce external costs on others may be received in
consumption or in production. Smoking cigarettes in public place causing passive
smoking by others, creating litter and diminishing the aesthetic value of the room
and playing the radio loudly obstructing one from enjoying a concert are some are
instances of negative consumption externalities.
The act of undisciplined students talking and creating disturbance in a class preventing
teachers from making effective instruction and the case of excessive consumption of
alcohol causing reduction in efficiency for work and production are instances of
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negative consumption externalities affecting production.

4. Positive consumption externalities: A positive consumption externalities initiated in
consumption that confers external benefit on others may be received in consumption
or in production. For example, if people get immunized against contagious diseases,
they would confer a social benefit to others as well by preventing others from getting
infected. Consumption of the services of a health club by the employees of a firm
would result in an external benefit to the firm in the form of increased efficiency and
productivity.
Question 3
Describe why markets have incentives to produce private goods?
Answer
A private good is a product that must be purchased to be consumed, and its consumption
by one individual prevents another individual from consuming it. Economist refer goods as
rivalrous and excludable. A good is considered to be a private good if there is competition
between individual to obtain the good and if consuming the good prevent someone else
from consuming it.
A private good is the opposite of a public good. Example of private goods include food,
airplane rides and cell phones. Private goods are less likely to experience the free rider
problem because a private good has to be purchased; it is not readily available for free.
Following are the incentives that accrue to the market in the production of Private Goods:
 Owner of private goods can exercise private property right and can prevent others
from using the good or consuming their benefits.
 Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who
have not paid for them from consuming them or having access to them. A buyer of a
private good is forced in a transaction to reveal what he or she is willing to pay for
a good or a service.
 Private goods do not have the rider problem. This means that the private goods will
be available to only those persons who are willing to pay for it.
 Normally, the market will efficiently allocate resources for the production of private
goods.
 The producer and seller will be able to generate more revenue thereby increasing
their profit if they are able to increase the market demand for their products.
 Market equilibrium can be achieved in the production of private goods wherein the
supply will always try to match the quantity demanded.
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Question 4
Why do markets fail to produce public goods? Illustrate your answer.
Answer
A public good is a product that one individual can consume without reducing its availability
to another individual, and from which no one is excluded. Economist refers to public goods
as “non-rivalrous” and “non-excludable.” National defence, sewage system, public parks
and other basic societal goods can all be considered public goods.
A public good is an item consumed by society as a whole and not necessarily by an
individual consumer. Public goods are financed by tax revenues. All public goods must
be consumed without reducing the availability of the good to others, and cannot be
withheld from people who do directly pay for them.
While public goods are important for a functioning society, there is an issue that arises
when these goods are provided, called the free-rider problem. For example, if a person
does not pay his taxes, he still benefits from the government’s provision of national
defence by free riding on the tax payments of his fellow citizens.
Public goods provide a very important example of market failure, in which the self-
interested behaviour of individual does not produce efficient results. Consumers can take
advantage of public goods without contributing sufficiently to their production.
Question 5
Distinguish between different types of public goods. How do public goods cause market failure?
Answer
A public good is a product that one individual can consume without reducing its availability
to another individual, and from which no one is excluded. Economists refer to public
goods as “non-rivalrous” and “non-excludable” National defence, sewer systems, public
parks and other basic societal goods can all be considered public goods.
A public good is an item consumed by society as a whole and not necessarily by an
individual consumer. Public goods are financed by tax revenues.
Public Goods can be classified into the following categories:

1. Pure Public Goods: In economics, a pure public good is a good that is both non-
excludable and non-rivalrous in that individual cannot be effectively excluded from
use and where use by one individual does not reduce availability to others. The
concept of pure public good is often criticized by many who point out that such
goods are not in fact observable in the real world. They argue that goods which
perfectly satisfy non rivalrous and non-excludability are not easy to come across.
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For example, if the government provides law and order or medical care, the use of
law courts or medical care by some individuals subtracts the consumption of others
if they need to wait. As another example, we may take defence. If armies are mostly
deployed in the northern borders, it may not result in the same amount of protection
to people in the south.
2. Impure Public Goods: There are many hybrid goods that possess some features of both
public and private goods. These goods are called impure goods and are partially
rivalrous or congestible. Because of the possibility of congestion, the benefit that
an individual gets from an impure public good depends on the number of users.
Consumption of these goods by another person reduces, but does not eliminate, the
benefits that other people receive from their consumption of the same good. For
example, open access Wi-Fi networks become crowded when more people access
it. Impure public goods also differ from pure public goods in that they are often
excludable.
An example of an impure public good would be cable television. It is non-rivalrous
because the use of cable television by other individual will into way reduce your
enjoyment of it. The good is excludable since the cable TV service provider can refuse
connection if you do not pay for set top box and recharge it regularly.
3. Quasi-Public Goods (Mixed Goods): Quasi Public Goods focuses on the mix services
that arise from the provision of the good. For example, if one gets sterilized against
measles, it confers not only a private benefit to the individual, but also an external
benefit because it reduces the chances getting infected of other person who are in
contact with him. You can observe here that the external effect associated with the
consumption of a private good may have the characteristic of a public good.
The quasi-public goods or services, also called a near public (for e.g. education,
health services) possess nearly all the qualities of the private goods and some of the
benefits of public good. It is easy to keep people away from them by charging a price
or fee. However, it is undesirable to keep people away from such goods because the
society would be better off if more people consume them.
4. Common Access Resources: Common access resources or common pool resources are
a special class of impure public good which are non-excludable as people cannot be
excluded from using them. These are rival in nature and their consumption lessens
the benefits available for others. This rival nature of common resources is what
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distinguishes them from pure public goods, which exhibit both non-excludability
and non-rivalry in consumption.
Since price mechanism does not apply to common resources, producers and consumer
do not pay for these resources and therefore, they overuse them and cause their
depletion and degradation. This creates threat to the sustainability of these resources
and, therefore, the availability of common access resources for future generations.
Economist use them ‘tragedy of the commons’ to describe the problem which occurs
when rivalrous but non-excludable goods are overuse, to the disadvantage of the
entire world. Example of common access resources are fishers, common pastures,
rivers, sea, backwaters biodiversity etc.
5. Global Public Goods: There are several public goods benefits of which accrue to
everyone in the world. These goods have widespread impact on different countries
and regions, population groups and generations. These are goods whose impacts
are indivisibly spread throughout the entire globe.
The WHO explains two categories of global public goods namely, final public goods
which are ‘outcomes’, (e.g. the eradication of polio) and intermediate public goods,
which contribute to the provision of final public goods. (e.g. International Health
Regulations aimed at stopping the cross-border movement of communicable
diseases and thus reducing cross-border health risks). Similarly, the World Bank
identifies five areas of global public goods which it seeks to address: namely,
the environmental commons (including the prevention of climate changes and
biodiversity), communicable diseases (including HIV/AIDS, tuberculosis, malaria,
and avian influenza), international trade, international financial architecture, and
global knowledge for development. The distinctive characteristic of global public
goods is that there is no mechanism (either market or government) to ensure an
efficient outcome.
Question 6
Explain using diagram and examples, the concepts of negative externalities of production and
consumption, and the welfare loss associated with the production or consumption of a good or
service.
Answer
Negative consumption externalities are extensively experienced by us in our day to day life.
Such negative consumption externalities initiated in consumption which produce external
costs on others may be received in consumption or in production. Smoking cigarettes
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in public place causing passive smoking by others, creating litter and diminishing the
aesthetic value of the room and playing the radio loudly obstructing one from enjoying
a concert are some are instance of negative consumption externalities. The act of
undisciplined students talking and creating disturbance in a class preventing teacher from
making effective instruction and the case of excessive consumption of alcohol causing
impairment in efficiency for work and production are instance of negative consumption
externalities affecting production.
Negative externalities cause inefficiency and market failure. If we take the case of a
producer, his private cost includes direct cost of labour, material, energy and other indirect
overhead. Firms do not have to pay for the damage resulting from the pollution which
they generate. As a result, each firm’s private cost would be the direct cost of production
only which does not incorporate externalities.
Social Cost = Private Cost + External Cost
Externalities cause market inefficiencies because they hinder the ability of market prices
to convey accurate information about how much to produce and how much to consume.
Diagram showing Negative Externalities and Loss of Social welfare
The equilibrium level of output that would be produced by a free market is Q1 at which
marginal private benefit (MPB) is equal to marginal private cost (MPC). Assuming that
there are no externalities arising from consumption, we can see that marginal social cost
(Q1S) is higher than marginal private cost (Q1E). Social efficiency occurs at Q2 level of
output where MSC is equal to MSB.
Output Q1 is socially inefficient because at Q1, the MSC is greater than the MSB and
represents over production. The shaded triangle represents the area of dead weight
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welfare loss. It indicates the area of overconsumption. Thus, we conclude that when
there is negative externality, a competitive market failure where prices fall to provide the
correct signals.
Question 7
Describe the Free rider problem associated with public goods.
Answer
The incentive to let other people pay for a good or service, the benefit of which are
enjoyed by an individual is known as the free rider problem. In other words, free riding
is ‘benefiting from the actions of others without paying’. A free rider is a consumer or
producer who does not pay for a nonexclusive good in the expectation that others will
pay.
Public goods provide a very important example of market failure, in which the self-
interested behaviour of individual does not produce efficient results. Consumers can take
advantage of public goods without contributing sufficiently to their production.
The absence of excludability in the case of public goods and the tendency of people to
act in their own self-interest will lead to the problem of free riding. If individual cannot
be excluded from the benefit of a public good, then they are not likely to express the
value of the benefit which they received as an offer to pay. In other words, they will
not express to buy a particular quantity at a price. Briefly put, there is no incentive for
people to pay for the good because they can consume it without paying for it. There is an
important implication for this behaviour. If every individual plays the same strategy of
free riding, the strategy will fail because nobody is willing to pay ad therefore, nothing
will be provided by the market. Then, a free ride for any one becomes impossible.
On account of the free problem, there is no meaningful demand curve for public goods.
If individual make no offer to pay for public goods, then the profit maximizing firms will
not produce them.
In fact, the public goods are valuable for people. If there is no free rider problem, people
would be willing to pay for them and they will be produced by the market. As such, if the
free-rider problem cannot be solved, the following two outcomes are possible:
1. No public good will be provided in private markets
2. Private markets will seriously under produce public goods even though these goods
provide valuable service to the society.
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UNIT 3 – GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE
Question 1
Explain the intervention strategies of government to bring about efficient market outcomes or
to control Market power.
Answer
Freely functioning market produce externalities because producers and consumers need
to consider only their private costs and benefit and not the costs imposed on or benefits
accrued to others. Governments have numerous methods to reduce the effects of negative
externalities and to promote positive externalities. Government regulation can deal with
the inefficient that arise from negative externalities.
Market power tends to restrict output and leads to deadweight loss. Because of the
social costs imposed by monopoly, governments intervene by establishing rules and
regulation designed to promote competition and prohibit actions that are likely to restrain
competition. These legislation differ from country to country. For example, in India, we
have the Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007)
to promote and sustain competition in markets.
Such legislations generally aim at prohibiting contracts, combinations and collusions
among producers or traders which are in restraint of trade and other anticompetitive
actions such as predatory pricing.
On the contrary, some of the regulatory responses of government to incentive failure tend
to create and protect monopoly position of firms that have developed unique innovations.
For example, patent and copyright laws grant exclusive rights of products or processes to
provide incentive for invention and innovation.
Policy options for limiting market power also include price regulation in the form of
setting maximum price that firms can charge.
Other measures include:
• Market liberalization by introducing competition in previously monopolistic sectors
such as energy, telecommunication etc.
• Controls on merger and acquisitions if there is possible market domination
• Price capping and price regulation based on the firm’s marginal costs, average costs,
past prices, or possible inflation and productivity growth
• Profit or rate of return regulation
• Performance targets and performance standards
• Patronage to consumer associations
• Tough investigation into cartelization and fair practices such as collusion and
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predatory pricing
• Restrictions on monopsony power of firms
• Reduction in import control and
• Nationalization
Explain government intervention in case of Negative Production Externality (Pollution)

Government may pass laws to alleviate the effect of negative externalities. Government
stipulated environment standards are rules that protect the environment by specifying
actions by producers and consumers. For example, India has enacted the Environment
(Protection) Act, 1986. The government may, through legislation, fix emission standard
which is legal limit on how much pollutant a firm can emit. The set standard ensures
that the firm produces efficiently. If the firm exceeds the limit, it can invite monetary
penalties or/and criminal liabilities. The firms have pollution-abatement mechanism to
ensure adherence to the emission standards. This means additional expenditure to the
firm leading to rise in the firm’s average cost. New firms will find it profitable to enter
the industry only if the price of the product is greater than the average cost of production
plus abatement expenditure.
Cost/benefit Marginal social cost Marginal private cost plus tax

C Marginal Private cost
B A1
P1
P
A
Marginal Social Benefit
Q1 Q Quantity
Due to negative production externalities, marginal social cost is greater than marginal
private cost. The free market outcome would be to produce a socially non-optimal output
level ‘Q’ at the level of equality between marginal private cost and marginal private
benefit. (Since externalities are not taken into account, marginal private benefit would
be contemplated as marginal social benefit). When externalities are present, the welfare
loss to the society or dead weight loss would be the shaded area ‘ABC’. The tax imposed
by government (equivalent to the vertical distance AA1) would shift the cost curve up by
the amount of tax, price will rise to ‘P1’ and a new equilibrium is established at point ‘B’,
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where the marginal social cost is equal to marginal social benefit. Output level ’Q1’ is
socially optimal and eliminates the whole of welfare loss on account of.
What are the problems in administering an efficient pollution tax?
Answer
1) Pollution taxes are difficult to determine and administer ,because it is difficult to
Discover right level of taxation
2) The method of taxing polluters involves use of complex and costly administrative
procedures
3) This method does not provide any genuine solution to the problem
4) In case of inelastic products producer can easily shift the tax burden on consumers
5) Pollution taxes also have negative impact on employment and investment, as
produces may get discouraged and may shift production units to other countries .
Explain Cap and trade (Market based approach)

The second approach to establishing prices is tradable emissions permits (also known as
cap-and-trade). These are marketable licenses to emit limited quantities of pollutants
and can be bought and sold by polluters. Under this method, each firm has permits
specifying the number of units of emissions that the firm is allowed to generate. A firm that
generates emissions above what is allowed by the permit is penalized with substantial
monetary sanctions. These permits are transferable, and therefore different pollution
levels are possible across the regulated entities. Permits are allocated among firms,
with the total number of permits so chosen as to achieve the desired maximum level
of emissions. By allocating fewer permits than the free pollution level, the regulatory
agency creates a shortage of permits which then leads to a positive price for permits.
This establishes a price for pollution, just as in the tax case. The high polluters have to
buy more permits, which increases their costs, and makes them less competitive and less
profitable.
Advantages:
(1) The system allows flexibility and reward efficiency
(2) It is administratively cheap and simple to implement and ensures that pollution is
minimised in the most cost-effective way
(3) It also provides strong incentives for innovation.
(4) Consumers may benefit if the extra profits made by low pollution firms are passed
on to them in the form of lower prices.
Disadvantages:
(1) They do not in reality stop firms from polluting the environment;
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(2) They only provide an incentive to them to do so.

(3) Price level increase of inelastic goods.
Question 2
Role of Government in case of Positive Externalities.
(Effect of Subsidy on output )
Answer
On the other hand subsidies involve government paying part of the cost to the firms in
order to promote the production of goods having positive externalities. This is in fact a
market-based policy as subsidies to producers would lower their cost of production. A
subsidy on a good which has substantial positive externalities would reduce its cost and
consequently price, shift the supply curve to the right and increase its output. A higher
output that would equate marginal social benefit and marginal social cost is socially
optimal. The effect of a subsidy is shown in the following figure:
Subsidy equal to the benefit of externality (S=E) is granted by government to the producer.
The output level post subsidy is Q* which equates marginal social benefit with marginal
social cost. This is socially optimum level of output.
Question 3
Explain Government intervention in case of Merit goods?
Answer
Merit goods are goods which are deemed to be socially desirable and therefore the
government deems that its consumption should be encouraged. Substantial positive
externalities are involved in the consumption of merit goods. Left to the market, only
private benefit and private costs would be reflected in the price paid by consumers.
This means, compared to what is socially desirable, people would consume inadequate
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quantities. Example of merit goods includes education, health care, welfare service,
housing, fire protection waste management, public libraries, museum and public parks.
Merit goods can be provided through the market, but are likely to be under-produced
and under-consumed through the market mechanism so that social welfare will not be
maximized.
CONSUMPTION OF MERIT GOODS AT ZERO PRICE

When merit goods are directly provided free of cost by government, there will be
substantial demand for the same. As can be seen from the following diagram, when
people are required to pay the free market price, people would consume only OQ quantity
of healthcare. If provided free at zero prices, the demand OD far exceeds supply.
Consumption of Merit Goods at Zero Price

Price s
Free
market
price
D
O Q Quantity of healthcare
Question 4
Explain Government intervention in case of Demerit goods.
(Determining Minimum price of demerit goods)
Answer
The consumption of demerit goods imposed significant negative externalities on the
society as a whole and therefore the private costs incurred by individual consumers are
less than the social costs experienced by the society. The production and consumption
of demerit goods are likely to be more than optimal under free markets. The price that
consumers pay for a packet of cigarettes is market determined and does not account for
the social costs that arise due to externalities. In other words, the marginal social cost
will exceed the market price and overproduction and overconsumption will occur, causing
misallocation of society’s scarce resources. However, it should be kept in mind that all
goods with negative externalities are not essentially demerit goods e.g. Production of
steel causes pollution, but steel is not a
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Minimum price MSC = MPC

P1
P B
MPB
A C
Marginal Social Benefit
Q1 Q Quantity of alcohol
consumed
socially undesirable good. It is found that generally consumers overvalue demerit goods
because of imperfect information and they are not the best judges of welfare with respect
to such goods. The government should therefore intervene in the marketplace to discourage
their production and consumption. Following steps are taken by the government to curb
excess production of demerit goods:
 Government may enforce complete ban on a demerit good. e.g. Intoxicating drugs.
In such cases, the possession, trading or consumption of the good is made illegal.
 Through negative advertising campaigns which emphasize the dangers associated
with consumption of demerit goods.
 Through legislations that prohibit the advertising or promotion of demerit goods in
whatsoever manner.
 Strict regulations of the market for the good may be put in place so as to limit access
to the good, especially by vulnerable groups such as children and adolescents.
 Regulatory controls in the form of spatial restrictions e.g. smoking in public places,
sale of tobacco to be away from schools, and time restrictions under which sale at
particular times during the day is banned.
The government can also impose high taxes on producing or purchasing the good making
them very costly and unaffordable to many is perhaps the most commonly used method
for reducing the consumption of a demerit good.
PRICE INTERVENTION: NON MARKET PRICING

MINIMUM SUPPORT PRICE (MSP) (PRICE FLOOR)
1) Government usually intervenes in many primary markets which are subject to
extreme as well as unpredictable fluctuations in price.
2) For example in India, in the case of many crops the government has initiated the
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Minimum Support Price (MSP) programme as well as procurement by government

agencies at the set support prices
3) The objective is to guarantee fixed and assured incomes to farmers. In case the
market price falls below the MSP, then the guaranteed MSP will prevail.
Market Outcome of Minimum Support Price
Price RS.
S
Price floor
150
75
D
Q
Quantity
Q1 Q2
MAXIMUM PRICE (PRICE CEILING)

1) When prices of certain essential commodities rise excessively, government may resort
to controls in the form of price ceilings (also called maximum price) for making a
resource or commodity available to all at reasonable prices.
2) For example: maximum prices of food grains and essential items are set by
government during times of scarcity. A price ceiling which is set below the prevailing
market clearing price will generate excess demand over supply.
Market Outcome of Price Ceiling
Price RS. S
150
75 Price floor
Quantity
Q1 Q2
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Question 5
Do you think government intervention in market will help enhance social welfare? Substantiate
your argument.
Answer
Yes, government intervention in market will help enhance social welfare.
Government plays a vital role in creating the basic framework within which fair and open
competitive markets can exist. It is indispensable that government establishes the ‘rule
of law’, and in this process, creates and protects property rights, ensures that contracts
are upheld and sets up necessary institution for proper functioning of markets.
Policy options for limiting market power also include price regulation in the form of
setting maximum prices that firms can charge. Price regulation is most often used for
natural monopolies that can produce the entire output of the market at a cost that is
lower than what it would be if there were several firms.
Following measures adopted by the government to achieve desired distributional effects:
 A progressive direct tax system ensures that those who have greater ability to pay
contribute more towards defraying the expenses of government and that the tax
burden is distributed fairly among the population.
 Indirect taxes can be differential: for example, the commodities which are primarily
consumed by richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which form a larger proportion of the income of
the lower income group, such as necessities, are taxed light.
 A carefully planned policy of public expenditure helps in redistributing income
from the rich to the poorer sections of the society. This is done through spending
programmes targeted on welfare measures for the disadvantaged, such as:
 Poverty alleviation programmes
 Free or subsidized medical care, education, housing, essential commodities
etc. to improve the quality of living of poor
 Infrastructure provision on a selective basis
 Various social security schemes under which people are entitled to old-age
pensions, unemployment relief, sickness allowance etc.
 Subsidized production of product of mass consumption
 Public production and/or grant of subsidies to ensure sufficient supply of
essential goods
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UNIT 4 – FISCAL POLICY

Question 1
Define the term ‘recessionary gap’ and ‘inflationary gap’. What would be the appropriate fiscal
policy measures to eliminate recessionary gap’ and ‘inflationary gap’? Illustrate your answer.
Answer
A recessionary gap, is said to exist if the existing level of aggregate production is less than
what would be produced with full employment of resources. It is a measure of output
that is lost when actual national income falls short of potential income, and represents
the difference between the actual aggregate demand and the aggregate demand which
is required to establish the equilibrium at full employment level of income. This gap
occurs during the contractionary phase of business-cycle and results in higher rates of
unemployment. In other words, recessionary gap occurs when the aggregate demand is
not sufficient to create condition of full employment.
The inflationary gap is a situation when the demand for goods and services exceeds
production due to factors such as higher levels of overall employment, increased trade
activities or increased trade activities or increased government expenditure. This can
lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The
inflationary gap is so named because the relative increased in real GDP causes an economy
to increase its consumption, which causes price to rise in the long run.
Due to the higher number of funds available within the economy, consumers are more
inclined to purchase goods and services. As the demand for goods and services increases
but production has yet to compensate for the shift, prices rise in order to restore market
equilibrium.
An expansionary fiscal policy is used to address recessionary gap and the problem of
general unemployment on account of business cycles.
Question 2
List out the factors that limits the effectiveness of fiscal policy? Explain the possible impacts on
private sector? (Limitations)
Answer
Discretionary fiscal policy is the conscious manipulation of government spending and
taxes to influence the economy. However, there are some significant limitation in respect
of choice and implementation of fiscal policy. These limitations are as follows:
1. One of the biggest problems with using discretionary fiscal policy to counteract
fluctuations is the different types of lags involved in fiscal-policy action. There are
significant lags are:
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 Recognition lag: The economy is a complex phenomenon and the state of the
macroeconomic variable is usually not easily comprehensible. Just as in case
of any other policy, the government must first recognize the need for a policy
change.
 Decision lag: Once the need for intervention is recognized, the government has
to evaluate the possible alternative policies. Delays are likely to occur to decide
on the most appropriate policy.
 Implementation lag: even when appropriate policy measures are decided on,
there are possible delays in bringing in legislation and implementing them.
 Impact lag: impact lag occurs when the outcomes of a policy are not visible for
some time.
2. Fiscal policy changes may at time be badly timed due to the various lags so that
it is highly possible that an expansionary policy is initiated when the economy is
already on a path of recovery and vice versa.
3. There are difficulties in instantaneously changing government’ spending and taxation
policies.
4. It is practically difficult to reduce government spending on various items such as
defence and social security as well as on huge capital project which are already
midway.
5. Public works cannot be adjusted easily along with movements of the trade cycle
because many huge projects such as highway and dams have long gestation period.
Besides, some urgent public project cannot be postponed for reasons of expenditure
cut to correct fluctuation caused by business cycles.
6. Due to uncertainties, there are difficulties of forecasting when period of inflation
or deflation may set in and also promptly determining the accurate policy to be
undertaken.
7. There are possible conflicts between different objectives of fiscal policy such that a
policy designed to achieve one goal may adversely affect another. For example, an
expansionary fiscal policy may worsen inflation in an economy.
8. Supply-side economists are of the opinion that certain fiscal measures will cause
disincentives. For example, increase in profits tax may adversely affect the incentives
of firms to invest and an increase in social security benefits may adversely affect
incentives to work and save.
9. Deficit financing increases the purchasing power of people. The production of goods
and services, especially in under developed countries may not catch up simultaneously
to meet the increased demand. This will result in price spiraling beyond control.
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10. Increase is government borrowing creates perpetual burden on even future generations
as debts have to be repaid. If the economy lags behind in productive utilization
of borrowed money, sufficient surpluses will not be generated for servicing debts.
External debt burden has been a constant problem for India and many developing
countries.
Question 3
Explain Crowding out effect.
Answer
Crowding out effect is the negative effect fiscal policy may generate when money from
the private sector is crowded out’ to the public sector. In other words, when spending by
government in an economy replaces private spending the latter is said to be crowded
out. For example, if government provided free computers to students, the demand from
students for computers may not be forthcoming. When government increases it’s spending
by borrowing from the loanable funds from market, the demand for loans increases and
this pushes the interest rates up. Private investments are sensitive to interest rates and
therefore some private investment spending is discouraged.
Similarly, when government increases the budget deficit by selling bonds or treasury bills,
the amount of money with the private sector decreases and consequently interest rates
will be pushed. As a result, private investment, especially the ones which are interest-
sensitive, will be reduced.
Question 4
Explain Government Expenditure as an Instrument of Fiscal Policy
Public expenditures are income generating and include all types of government expenditure
such as capital expenditure on public works, relief expenditures, subsidy payments of various
types, transfer payments and other social security benefits. Government expenditure is
an important instrument of fiscal policy. It includes governments’ expenditure towards
consumption, investment, and transfer payments. Government expenditures include:
1. current expenditures to meet the day to day running of the government,
2. capital expenditures which are in the form of investments made by the government
in capital equipments and infrastructure, and
3. transfer payments i.e. government spending which does not contribute to GDP
because income is only transferred from one group of people to another without
any direct contribution from the receivers.
Government may spend money on performance of its large and ever-growing functions
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and also for deliberately bringing in stabilization. During a recession, it may initiate a fresh
wave of public works, such as construction of roads, irrigation facilities, sanitary works,
ports, electrification of new areas etc. Government expenditure involves employment
of labour as well as purchase of multitude of goods and services. These expenditures
directly generate incomes to labour and suppliers of materials and services. Apart from
the direct effect, there is also indirect effect in the form of working of multiplier. The
incomes generated are spent on purchase of consumer goods. The extent of spending by
people depends on their marginal propensity to consume (MPC)
Question 5
Explain Pump Priming and Compensatory Spending
A distinction is made between the two concepts of public spending during depression,
namely, the concept of ‘pump priming’ and the concept of 'compensatory spending'.
Pump priming involves a one-shot injection of government expenditure into a depressed
economy with the aim of boosting business confidence and encouraging larger private
investment. It is a temporary fiscal stimulus in order to set off the multiplier process. The
argument is that with a temporary injection of purchasing power into the economy through
a rise in government spending financed by borrowing rather than taxes, it is possible
for government to bring about permanent recovery from a slump. Pump priming was
widely used by governments in the post-war era in order to maintain full employment;
however, it became discredited later when it failed to halt rising unemployment and was
held responsible for inflation. Compensatory spending is said to be resorted to when the
government spending is deliberately carried out with the obvious intention to compensate
for the deficiency in private investment.
Question 6
Explain Public Debt as an Instrument of Fiscal Policy
A rational policy of public borrowing and debt repayment is a potent weapon to fight
inflation and deflation. Public debt may be internal or external; when the government
borrows from its own people in the country, it is called internal debt. On the other hand,
when the government borrows from outside sources, the debt is called external debt.
Public debt takes two forms namely, market loans and small savings.
In the case of market loans, the government issues treasury bills and government
securities of varying denominations and duration which are traded in debt markets. For
financing capital projects, long-term capital bonds are floated and for meeting short-
term government expenditure, treasury bills are issued.
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The small savings represent public borrowings, which are not negotiable and are not bought
and sold in the market. In India, various types of schemes are introduced for mobilising
small savings e.g., National Savings Certificates, National Development Certificates, etc.
Borrowing from the public through the sale of bonds and securities curtails the aggregate
demand in the economy. Repayments of debt by governments increase the availability of
money in the economy and increase aggregate demand.
Question 7
Explain Taxes as an Instrument of Fiscal Policy
Taxes form the most important source of revenue for governments. Taxation policies
are effectively used for establishing stability in an economy. Tax as an instrument of
fiscal policy consists of changes in government revenues or in rates of taxes aimed at
encouraging or restricting private expenditures on consumption and investment. Taxes
determine the size of disposable income in the hands of the general public which in
turn determines aggregate demand and possible inflationary and deflationary gaps. The
structure of tax rates is varied in the context of the overall economic conditions prevailing
in an economy. During recession and depression, the tax policy is framed to encourage
private consumption and investment. A general reduction in income taxes leaves higher
disposable incomes with people inducing higher consumption. Low corporate taxes
increase the prospects of profits for business and promote further investment. The extent
of tax reduction and /or increase in government spending required depends on the size of
the recessionary gap and the magnitude of the multiplier.
Question 8
Explain Budget as an Instrument of Fiscal Policy
Government’s budget is widely used as a policy tool to stimulate or contract aggregate
demand as required. The budget is simply a statement of revenues earned from taxes
and other sources and expenditures made by a nation’s government in a year. The net
effect of a budget on aggregate demand depends on the government’s budget balance.
A government’s budget can either be balanced, surplus or deficit. A balanced budget
results when expenditures in a year equal its revenues for that year. Such a budget will
have no net effect on aggregate demand since the leakages from the system in the form
of taxes collected are equal to the injections in the form of expenditures made. A budget
surplus that occurs when the government collects more than what it spends, though
sounds like a highly attractive one, has in fact a negative net effect on aggregate demand
since leakages exceed injections. A budget deficit wherein the government expenditure in
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a year is greater than the tax revenue it collects has a positive net effect on aggregate
demand since total injections exceed leakages from the government sector.
TYPES OF FISCAL POLICY

Expansion fiscal policy:
1. It is adopted during economic recession or depression.
2. Under this policy, the government may lower the tax rates or increase the public
expenditure or do both. These measures are basically intended to simulate the
economy.
3. Through this policy, the government encourages investment, which in turn boosts
output and employment, which further increases aggregate demand, and thereby
economy begins to grow.
4. Expansion fiscal policy will be successful only if there is accommodative monetary
policy.
5. Working of expansionary fiscal policy can be seen the following diagram:

Contractionary fiscal policy:
1. It is adpoted during inflation (where aggregate demand rises beyond what economy
can produce).
2. Under this policy, the government may increases the tax rates or reduce the public
expendutire or do both. These measures are basiclly intended to restrian the level of
economic activity.
3. Through this policy, th governemt discourages investement, which in turn lowers
the output and employment, which further reduces the aggregate demand, hereby,
economy begins to slow down and inflation is controlled.
4. Working of contractionary fiscal policy can be seen in the following diagram:
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5. Inflationary gap refer to the situation whereby scale rise in consumption and
investment enhances aggregate demand beyond what economy can potentially
produce tends to cause extensive price hike. Contractionary fiscal policy aims to
eliminate such inflationary gap.
The Government Spending Multiplier:

Spending multiplier (also known as Keynesian or fiscal policy multiplier) represent the
multiple by which GDP increases or decreases in response to an increase and decrease
in government expenditure and investment, holding the real money supply constant.
Quantitatively, the government spending multiplier is the same as the investment
multiplier. It is the reciprocal of the marginal propensity to save (MPS). Higher the MPS,
lower the multiplier, and lower the MPS, higher the multiplier.

Where,
MPS stand for marginal propensity to save (MPS); and
MPC is marginal propensity to consume
MPS equal 1 – MPS
Numerical Illustration
Q.1] Illustration1.
Assume that the MPC is equal to 0.6.
(a) What is the value of government spending multiplier?
(b) What impact would a 50 billion increase in government spending have on
equilibrium GDP?
(c) What about a 50 billion decrease in government spending?
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Solution:

= 1/(1 – 0.6) = 1/0.4 = 2.5
(b) & (c) Change in GDP = Initial Change in Spending x (1 – MPC)
Q.2] Illustration 2.
If country X has a marginal propensity to consume of 0, what is the value of fiscal
multiplier?
Solution:
Given MPC = 0; MPS = (1-0) = 1
The spending multiplier = 1. There is no multiplier effect
Q.3] Illustration 3.
Average per capita income of country Y rose from 42,300 to 50,000 and the
corresponding figure for per capita consumption rose from 35,400 to 42,500. Find
the spending multiplier of this economy.
Solution:
Spending multiplier = 1/(1-MPC).
MPC = Increase in Consumption / Increase in Income.
= (42,500 – 35,400) / (50,000 – 42,300)
= 0.922
Multiplier = 1/(1 – 0.922) = 1/(0.078) = 12.83
Question 9
Explain the role fiscal policy in achieving economic stability.
Answer
Fiscal policy involves the use of government spending, taxation and borrowing to influence
both the pattern of economic activity and level of growth of aggregate demand, output
and employment. It includes any design on the part of the government to change the price
level, composition or timing of government expenditure or to alter the burden, structure
or frequency of tax payment. In other words, fiscal policy is designed to influence the
pattern and level of economic activity in a country.
The economy does not always work smoothly. There often occurs fluctuation in the level
of economic activity. At time the economy finds itself in the grip of recession when levels
of national income, output and employment are far below their full potential levels.
During recession, there is lot of idle or un-utilized productive capacity, that is, available
machines and factories are not working to their full capacity. As a result, unemployment
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of labour increases along with the existence of excess capital stock.

On the other hand, at time the economy is ‘overheated which means inflation (i.e. rising
price) occurs in the economy. Thus, in a free market economy there is a lot of economy
ic instability. The classical economists believed that an automatic mechanism works
to restore stability in the economy; recession would cure itself and inflation will be
automatically controlled.
Explain Non-discretionary Fiscal policy or Automatic Stabilizer

1) Non-discretionary fiscal policy or Automatic Stabilizer are that part of the structure
of the economy which have built in fiscal mechanism that operates automatically to
reduce expansions and Contractions
2) In Most of the economies changes in the level of taxation and the level of govt
spending tends to occur automatically
3) Any govt programme that automatically tends to reduce fluctuations in GDP is
called as Automatic Stabilizer
4) Automatic Stabilizer have a tendency to increase GDP when it is falling and reduce
GDP when it is rising
5) It involves built in tax and expenditure mechanism that automatically increases
aggregate demand when there is Recession and reduces aggregate demand when
there is Inflation
6) Automatic Stabilizer occurs through automatic adjustments in Public expenditure
and taxes without any govt interference.
FISCAL POLICY FOR REDUCTION OF INEQUALITES:

1. Fiscal policy can play vital role in redistribution of income so as to ensure social
justice.
2. Fiscal policy has direct (through taxes) as well as indirect impact (through other
fiscal policy measures) on income distribution.
3. Government can use following measures to achieve the desired distribution of
income and wealth:
i. Progressive direct tax system: Higher the income, higher the taxes. Ensure that
taxes are based on ability to pay and tax burden is distributed fairly among the
population.
ii. Indirect taxes can be differential: Commodity mainly consumed by rich can be
taxed heavily (E.g. luxury goods) while those consumed by lower income groups
(E.g. necessities) can be taxed light.
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iii. Public expenditure policy: This policy help in redistributing income from the rich
to the poor through spending programmes targeted on welfare measures, such
as :
a. Poverty alleviation programmes.
b. Free or subsidized medical care, education, housing etc.
c. Infrastructure provision on a selective basis.
d. Various social security (old age pension, unemployment benefits etc.)
e. Subsidized production of mass consumption goods.
f. Public production / providing subsidies for supply of essential goods.
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MONEY MARKET
UNIT 1 – THE CONCEPT OF MONEY DEMAND
Question 1
Define money and describe its nature and characteristics.
Answer
Money is all the center of every economic transaction and plays a significant role in all
economies. In simple terms money refers to assets which are commonly used and accepted
as a means of payment or as a medium of exchange or of transferring purchasing power.
For policy purposes, money may be defined as the set of liquid financial assets, the
variation in the stock of which will impact on aggregate economic activity.
Money has generalized purchasing power and is generally acceptable in settlement of
all transactions and in discharge of other kind of business obligations including future
payments.
Anything that would act as a medium of exchange is not necessarily money. For example,
a bill of exchange may also be a medium, but it is not money since it is not generally
accepted as a means of payment. Money is a totally liquid asset as it can be used directly,
instantly, conveniently and without any cost or restriction to make payment.
At the fundamental level, money provides us with a convenient means to access goods
and services. There are some general characteristics that money should possess in order to
make it serve its function as money. Money should be:
 Generally acceptable
 Durable or long lasting
 Effortlessly recognizable
 Difficult to counterfeit i.e. easily reproducible by people
 Relatively scarce, but has elasticity of supply
 Portable or easily transported
 Possessing uniformity, and
 Divisible into smaller parts in usable quantities or fractions without losing value.
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Question 2
Explain the function performed by money.
Answer
The following points highlight some of the important functions of money:
1. Medium of Exchange: Money is a convenient medium of exchange or it is an instrument
that facilitates easy exchange of goods and services. Money, though not having any
inherent power to directly satisfy human wants, by acting as a medium of exchange,
it commands purchasing power and its possession enables us to purchase goods
and services to satisfy our wants.
By acting as an intermediary, money increases the ease of trade and reduces the
inefficiency and transaction costs involved in a barter exchange. By decomposing
the single barter transaction of sales and purchase, money eliminates the need for
double coincidence of wants. Money also facilities separation of transaction both in
time and place and this in turn enables us to economize on time and efforts involved
in transactions.
2. Unit of Account: Money is an explicitly defined unit of value or unit of account. Put
differently, money is a common measure of value’ or ‘common denominator of value’
or money function as a numeracies. We know, Rupee is the unit in India in which the
entire money is denominated.
The monetary unit is the unit of measurement in terms of which the value of all
goods and services is measured and expressed. The value of each good or service is
expressed as price, which is nothing but the number of monetary units for which the
good or service can be exchanged.
It is convenient to trade all commodities in exchange for a single commodity. So
also, it is convenient to measure the price of all commodities in terms of a single
unit, rather than record the relative price of every good in terms of every other good.
3. Standard of deferred payment: Money serves as a unit or standard of deferred payment
i.e. money facilitates recording of deferred promises to pay. Money is the unit in terms
which future payment are contracted or stated. However, variation in the purchasing
power of money due to inflation or deflation, reduce the efficacy of money in this
function.
4. Store Value: Like nearly all other assets, money is a store of value. People prefer
to hold it as an asset, that is, as part of their stock of wealth. This splitting of
purchases and sales in to two transaction involves a separation in the both time and
space. This separation is possible because money can be used as a store of value or
store of means of payment during the intervening time. Again, rather than spending
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one’s money at present, one can store it for use at some future time.
Question 3
‘The quantity theory of money is not theory about money at all, rather it is theory of the price
level’ Elucidate.
Answer
The quantity theory of money, one of the oldest theories in Economics, was first propounded
by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published
in 1911 and later by the neoclassical economist. Both versions of the QTM demonstrate
that there is strong relationship between money and price level and the quantity of
money is the main determinant of the price level or the value of money. In other words,
changes in the general level of commodity prices or changes in the value or purchasing
power of money are determined first and foremost by changes in the quantity of money
in circulation.
Fisher’s version, also termed as ‘equation of exchanges’ or ‘transaction approach’ is
formally stated as follows:
MV = PT
Where, M= the total amount of money in circulation (on an average) in an economy

V= transaction velocity of circulation i.e. the average number of times across all transaction
a unit of money (say Rupee) is spent in purchasing goods and services
P= average price level (P=MV/T)
T= the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposite (M’)
and their velocity (V’) in the total supply of money. Thus, the expanded form of the
equation of exchange becomes:
MV + M’V’ = PT
Where M’ = the total quantity of credit money

V’ = velocity of circulation of credit money.
The total supply of money in the community consists of the quantity of actual money (M)
and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of
credit money (V’) remain constant. T is a function of national income. Since full employment
prevails, the volume of transaction T is fixed in the short run. Briefly out, the total volume
of transaction (T) multiplied by the price level (P) represents the demand for money. The
demand for money (PT) is equal to the supply of money (MV + M’V’)’. In any given period,
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the total value of transaction made is equal to PT and the value of money flow is equal
to MV+M’V’.
Thus from the above discussion it can be clearly concluded that the Quantity Theory of
Money (QTM) states that there is a direct relationship between the quantity of money in
an economy and the level of price of goods and services sold.
Question 4
Explain Neo classical theory of demand of money.
Answer
The Cambridge approach: In the early 1900s, Cambridge Economists Alfred Marshall, A.C.
Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put
forward a fundamentally different approach to quantity theory, known as neoclassical
theory or cash balance approach. The Cambridge version holds that money increases
utility in the following two ways:
a. enabling the possibility of split-up of sale and purchase to two different points of
time rather than being simultaneous, and
b. being a hedge against uncertainty.
While the fist above represents transaction motive, just as Fisher envisaged, the second
points to money’s role as a temporary store of wealth. Since sale and purchase of
commodities by individuals do not take place simultaneously, they need a ‘temporary
adobe’ of purchasing power as a hedge against uncertainty. As such, demand for money
also involves a precautionary motive in Cambridge approach. Since money gives utility in
its store of wealth and precautionary modes, one can say that money is demanded for
itself.
The Cambridge equation is stated as:
Where
Md = is the demand for money
Y = real national income
P = averages price level of currently produced goods and services
PY = nominal income
K = proportion of nominal income (PY) that people want to hold as cash balances
The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains
that the demand for money (M) equals k proportion of the total money income.
Q. Explain Keynesian approach of demand of money or Liquidity theory by Keynes

Keynesian Approach
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↓
Liquidity preference Approach
↓
J.M.Keynes (1936)
↓
General theory of employment Interest money.
[Demand for money both as a medium of exchange & store of value]

Transaction motive
People require money to carry out transaction at all types but most of them receive
income once is a month sometimes once in a week or even daily in case of daily wage
earners.
There is a time gap between two successive Income receipts but not between the expenses
incurred on various transaction. Transaction motive is divided in to two parts,
1) Income motive
2) Business motive
Income motive:
It refers to transaction demand for money by wages and salary earners. They receive their
Income once in a month, in few cases weekly or daily. Money is required for these people
to carry out transaction at all kind they may incur regular payment like Rent, electricity,
grossary bill & other payments. Suppose the time interval between Income receipts is a
month. People required to hold money with them to meet the daily payments. Money
held for this purpose gradually decline over the period.
Business motive:
Business firms required to hold money to meet their day to day transaction. The time
interval of a firm may be a month or two or even longer as there is always a time gap
between production and realization of its value. Meanwhile they are required to keep
money for payment of various bills such as electricity, rent, raw material, wages etc. The
amount of money held for transaction motive depends on three factors.
1. Level of income
2. Time interval
3. Price level
Precautionary motive:
It is necessary to be cautious about future which is uncertain. Uncertainity is an important
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element in Keynesian precautionary motive and additional amount of money over and
above for a known -requirement is held for contingencies, sudden expenditure, illness,
accident or to grab opportunity of advantageous purchase money may also be required
at a time of temporary unemployment.
Business people hold cash with them to meet any unforeseen expenditure or to take
advantage of favourable market condition when price declines.
A firm’s precautionary demand for money is influenced by political uncertainty. When
political conditions are unstable business firms tend to be more cautious and hold larger
amount of cash. The demand for money for transaction & precautionary motive is directly
related to income.
Income Elastic
Demand for money for transaction & precautionary motive
The combined demand for transaction & precautionary motive is expressed as L1 = F(Y)
The demand for money for these motives is not influenced by rate of interest.
Interest inelastic
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Demand for money for transaction & precautionary motive
Demand for money for speculative motive

 Demand for money for speculative motive is related to store of value function of
money.
 Speculative demand is also known as Asset demand for money
 People have the alternative to hold the either cash or financial asset like government
bonds & equities
 Speculative demand also relates to uncertainty
 The cash held under this motive is used to make speculative gain by dealing on
bond whose price fluctuates.
 If bond prices are expected to rise, businessman will buy bonds on other hand is
bond price are expected to fall, businessman will sell bonds to avoid capital losses.
 However Market interest rate is expected to fall, businessman will buy bonds, if
interest rate is expected to rise they will sell bonds. This implies that bond price and
MRI are inversely related to each other
Market rate interest vs BONDS
BONDS MRI ------- FD
↓ 1000/- x 5% 10%
= 50/- 8% ( ROI rises )
7.5%
5.5%
500x10%
=50/-
 Equal amount of return (i.e.) Rs. 50 will be earned by making a financial investment
of just Rs. 500 hence a Rs.1,000 bond value has declined to Rs. 500
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 Keynes assumes that at very high rate interest (low bond price) all other asset
holder will be bulls
 On other hand, at low rate of interest (high bond price) all other asset holder will
be bears
 Speculative demand for money increases as market interest rate fall and vice versa.
Demand for money held under speculative motive is as demand for idle cash balance
L2 = F(r) →Rate of interest
Question 5
List out the factor that determine the demand for money in the Baumol-Tobin analysis of
transactions demand for money? How does a change in each affect the quantity of money
demanded?
Answer
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand
for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’
was essentially viewed as an inventory held for transaction purposes. Inventory models
assume that there are two media for storing value:
1) Money and
2) An interest-bearing alternative financial asset.
There is a fixed cost of making transfers between money and the alternative assets
e.g. broker charges. While relatively liquid financial assets other than money (such
as, bank deposits) offer a positive return, the above said transaction cost of going
between money and these assets justifies holding money.
Baumol used business inventory approach to analyze the behaviour of individual. Just
as businesses keep money to facilitate their business transactions, people also hold
cash balance which involves an opportunity cost in terms of lost interest. Therefore,
they hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost.
Excess cash over and above what is required for transaction during the period under
consideration will be invested in bonds or put in an interest-bearing account. Money
holding on an average will be lower if people hold bonds or other interest yielding
assets.
The higher the income, the higher is the average level or inventory of money holdings.
The level of inventory holding also depends also upon the carrying cost, which is the
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interest forgone by holding money and not bonds, net of the cost to the individual
of making a transfer between money and bonds, say for example brokerage fee.
The inventory-theoretic approach also suggests that the demand for money and
bonds depend on the cost of making a transfer between money and bonds e.g.
the brokerage fee. An increase the brokerage fee raises the marginal cost of bond
market transactions demand for money and lowers the average bond holding over
the period.
Question 6
To what extent does Friedman’s Restatement of the Quantity Theory explain the demand for
money?
Answer
Milton Friedman (1956) extended Keynes’ speculative money demand within the
framework of assets price theory. Friedman treat the demand for money as nothing more
than the application of a more general theory of demand for capital assets.
Demand for money is affected by the same factors as demand for any other assets,
namely
1. Permanent income.
2. Relative return on assets. (Which incorporate risk).
Friedman maintains that it is permanent income and not current income that determines
the demand for money. Permanent income which is Friedman’s measure of wealth is the
present expected value of all future income. To Friedman, money is a good as any other
durable consumption good and its demand is a function of a great number of factors.
Fried identifies the following four determinates of the demand for money.
The nominal demand for money:
 Is a function of total wealth, which is represented by permanent income divided
by the discount rate, defined as the average return on the five asset classes in the
monetarist theory world, namely money, bond, equity, physical capital and human
capital.
 Is positively related to the price level, P. If the price level rises the demand for
money increases and vice versa.
 Raises if the opportunity costs of money holding (i.e. returns on bonds and stock)
decline and vice versa.
 Is influenced by inflation, a positive inflation rate reduces the real value of money
balances, thereby increasing the opportunity coast of money holdings.
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Question 7
‘Risk-avoiding behaviour of individual provided the foundation for the liquidity preference and
for a negative relationship between the demand for money and the interest rate’ Elucidate with
examples.
Answer
‘Liquidity Preference as Behaviour towards Risk’ (1958). Tobin established that the
theory of risk-avoiding behaviour of individuals provided the foundation for the liquidity
preference and for a negative relationship between the demand for money and the
interest rate. The optimal portfolio structure is determined by
1. the risk/reward characteristics of different assets
2. the taste of the individual in maximizing his utility consistent with the existing
opportunities
In his theory which analyzes the individual’s portfolio allocation between money and bond
holdings, the demand for money is considered as a store of wealth. Tobin hypothesized
that an individual would hold a portion of his wealth in the form of money in the portfolio
because the rate of return on holding money was more certain than the rate of return on
holding interest earning assets and entails no capital gains or losses. It is riskier to hold
alternative assets vis-a vis holding interest just money alone because government bonds
and equities are subject to market price volatility, while money is not.
According to Tobin, rational behaviour of a risk-averse individual induces him to hold an
optimally structured wealth portfolio which is comprised of both bond and money. The
overall expected return on the portfolio would be higher if the portfolio were all bonds,
but an investor who is ‘risk-averse’ will be willing to exercise a trade-off and sacrifice to
some extent the higher return for a reduction in risk.
Tobin’s theory implies that the amount of money held as an asset depends on the level
of interest rate. An increase in the interest rate will improve the terms on which the
expected return on the portfolio can be increased by accepting greater risk. In response
to the increase in the interest, the individual will increase the proportion of wealth held
in the interest-bearing asset, say bonds, and will decrease the holding of money. Tobin’s
analysis also indicates that uncertainty about future changes in bond prices, and hence
the risk involved in buying bonds, may be a determinant of money demand. Just as
Keynes’ theory, Tobin’s theory implies that the demand for money as store of wealth
depends negatively on the interest rate.
Q. Short note on Liquidity trap: - (Diagram same as speculative motive)

Definition:-
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Liquidity trap is defined as set of points on liquidity preference schedule when the
percentage change in demand for money in response to % change in rate of interest
is infinite.
The inverse relationship between rate of interest and speculative demand for money
transforms in to a different form of relationship, at a very low rate of interest
speculative demand for money becomes perfectly elastic. Keynes considered 2%
rate of interest as the lowest below which market rate of interest would not decline
at such low rate of interest people prefer cash and not securities or any other
assets as the risk is far greater than interest offered. At point C the L2 curve become
horizontal straight line, and that horizontal part of L2 curve shows liquidity trap.
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UNIT 2 – CONCEPT OF MONEY SUPPLY
From April 1977, following the recommendations of the Second Working Group on Money
Supply (SWG), the RBI has been publishing data on four alternative measures of money
supply denoted by M1, M2, M3 and M4 besides the reserve money. The respective empirical
definitions of these measures are given below:
 The Monetary aggregates are:
 M1 = Currency and coins with the people + demand deposits of banks (Current
and Saving accounts) + other deposits of the RBI;
 M2 = M1 + savings deposits with post office savings banks,
 M3 = M1 + net time deposits of banks and
 M4 = M3 + total deposits with the Post Office Savings Organization (excluding

National Savings Certificates).
Following the recommendations of the Working Group on Money (1998), the RBI has
started publishing a set of four new monetary aggregates on the basis of the balance
sheet of the banking sector in conformity with the norms of progressive liquidity. The new
monetary aggregates are: ( New Monetary aggregates )
NM1 = Currency with the public + Demand deposits with the banking system + ‘Other’
deposits with the RBI.
NM2 = NM1 + time liabilities portion of savings deposit + Certificate of deposit + term
deposits maturing within one year – FCNR ( B ) deposits
NM3 = NM2 + Long-term time deposits of residents + Call/Term funding from financial
institutions
Reserve Money / High Powered Money / Monetary Base
RM = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the
RBI
RM = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s
Claims on banks + RBI’s net Foreign assets + Government’s Currency liabilities to the
public – RBI’s net non - monetary Liabilities
The central bank also measures macroeconomic liquidity by formulating various ‘liquidity’
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aggregates in addition to the monetary aggregates. While the instruments issued by the
banking system are included in ‘money’, instruments, those which are close substitutes of
money but are issued by the Non-banking financial institutions are also included in liquidity
aggregates.
L1= NM3 + All deposits with the post office savings banks (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 FIs.
L3 = L2+ Public deposits of non-banking financial companies
Explain MONEY MULTIPLIER in detail

The money supply is defined as
M = m x MB
Where M is the money supply, m is money multiplier and MB is the monetary base or high
powered money. From the above equation we can derive the money multiplier (m) as
(Money supply )/
Money Multiplier (m)
(Monetary base)
Definition
Money multiplier is defined as a ratio that relates the changes in the money supply to a given
change in the monetary base. It denotes by how much the money supply will change for a given
change in high-powered money. The multiplier indicates what multiple of the monetary base is
transformed into money supply.
If some portion of the increase in high-powered money finds its way into currency, this
portion does not undergo multiple deposit expansion. In other words, as a rule, an
increase in the monetary base that goes into currency is not multiplied, whereas an
increase in monetary base that goes into supporting deposits is multiplied.
The money multiplier approach to money supply propounded by Milton Friedman and Anna
Schwartz, (1963) considers three factors as immediate determinants of money supply,
namely:
(a) the stock of high-powered money (H)
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(b) the ratio of reserves to deposits, e = {ER/D} and

(c) the ratio of currency to deposits , c ={C/D}
a) The Behaviour of the Central Bank

The behaviour of the central bank which controls the issue of currency is reflected in
the supply of the nominal high-powered money. Money stock is determined by the
money multiplier and the monetary base is controlled by the monetary authority.
If the behaviour of the public and the commercial banks remains unchanged over
time, the total supply of nominal money in the economy will vary directly with the
supply of the nominal high-powered money issued by the central bank.
b) The Behaviour of Commercial Banks

By creating credit, the commercial banks determine the total amount of nominal
demand deposits. The behaviour of the commercial banks in the economy is reflected
in the ratio of their cash reserves to deposits known as the ‘reserve ratio’. If the
required reserve ratio on demand deposits increases while all the other variables
remain the same, more reserves would be needed. This implies that banks must
contract their loans, causing a decline in deposits and hence in the money supply. If
the required reserve ratio falls, there will be greater expansions of deposits because
the same level of reserves can now support more deposits and the money supply
will increase.
In actual practice, however, the commercial banks keep only a part or fraction
of their total deposits in the form of cash reserves. However, for the commercial
banking system as a whole, the actual reserves ratio is greater than the required
reserve ratio since the banks keep with them a higher than the statutorily required
percentage of their deposits in the form of cash reserves. The additional units of
high-powered money that goes into ‘excess reserves’ of the commercial banks do
not lead to any additional loans, and therefore, these excess reserves do not lead to
creation of money.
When the costs of holding excess reserves rise, we should expect the level of excess
reserves to fall; when the benefits of holding excess reserves rise, we would expect
the level of excess reserves to rise.
If banks fear that deposit outflows are likely to increase (that is, if expected deposit
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outflows increase), they will want more assurance against this possibility and will
increase the excess reserves ratio. Conversely, a decline in expected deposit outflows
will reduce the benefit of holding excess reserves and excess reserves will fall.
The public, by their decisions in respect of the amount of nominal currency in hand
(how much money they wish to hold as cash) is in a position to influence the amount
of the nominal demand deposits of the commercial banks. The behaviour of the
public influences bank credit through the decision on ratio of currency to the money
supply designated as the ‘currency ratio’.

In other words, you decide to keep more money in your pocket and less money in your
bank. That means you are converting some of your demand deposits into currency.
If many people like you do so, technically we say there is an increase in currency
ratio. As we know, demand deposits undergo multiple expansions while currency in
your hands does not. Hence, when bank deposits are being converted into currency,
banks can create only less credit money. The overall level of multiple expansion
declines, and therefore, money multiplier also falls. Therefore, we conclude that
money multiplier and the money supply are negatively related to the currency ratio
c.

To summarise the money multiplier approach, the size of the money multiplier is
determined by the required reserve ratio (r) at the central bank, the excess reserve
ratio (e) of commercial banks and the currency ratio (c) of the public. The lower these
ratios are, the larger the money multiplier is. In other words, the money supply is
determined by high powered money (H) and the money multiplier (m) and varies
directly with changes in the monetary base, and inversely with the currency and
reserve ratios.
Question 1
Describe the different determinates of money supply in a country.
Answer
There are two alternate theories in respect of determination of money supply. According
to the first view, money supply is determined exogenously by the central bank. The
second view holds that the money supply is determined endogenously by changes in the
economic activities which affect people’s desire to hold currency relative to deposits, rate
of interest, etc.
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The current practice is to explain the determinates of money supply based on ‘money
multiplier approach, which focuses on the relation between the money stock and money
supply in terms of the monetary base or high-powered money. This approach holds that
total supply of nominal money in the economy is determined by the joint behavior of the
central bank, the commercial banks and the public.
Following three factors acts as immediate determinants of money supply, namely:
a) the stock of high-power money (H) which represent the behaviour if the central
bank
b) the ratio of reserves to deposits , e = {ER/D} which represent the behaviour of
Commercial banks
c) the ratio of currency to deposits, c={C/D} which represent the behaviour of General public.
a) The Behaviour of the Central Bank:

The behaviour of the central bank which controls the issue of currency is reflected in
the supply of the nominal high-powered money. Money stock is determined by the
money multiplier and the monetary base is controlled by the monetary authority. If
the behaviour of the public and the commercial bank remains unchanged over time,
the total supply of nominal money in the economy will vary directly with the supply
of the nominal high-powered money issued by the central bank.
b) The Behaviour of Commercial Banks:

By creating credit, the commercial banks determine the total amount of nominal
demand deposits. The behaviour of the commercial banks in the economy is reflected
in the ration of their cash reserve to deposits known as the ‘reserve ratio’.
c) The Behaviour of the Public:

The public, by their decision in respect of the amount of nominal currency in hand
(how much money they wish to hold as cash) is in a position to influence the amount
of the nominal demand deposits of the commercial banks. The behaviour of the
public influence bank credit through the decision on ratio of currency to the money
supply designated as the ‘currency ratio’.
When people decide to keep more money in their pocket and less money in their
bank. That means people are converting some of their demand deposits into
currency then technically we say there is increase in currency ratio. As we know,
demand deposits undergo multiple expansions while currency in people’s hands
does not. Hence, when bank deposits are being converted into currency, bank can
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create only less credit money. The overall level of multiple expansion declines, and
therefore, money multiplier and the money supply are negatively related to the
currency ration c.
Credit Multiplier (Explain)

The Credit Multiplier also referred to as the deposit multiplier or the deposit expansion
multiplier, describes the amount of additional money created by commercial bank
through the process of lending the available money it has in excess of the central bank's
reserve requirements. The deposit multiplier is, thus inextricably tied to the bank's reserve
requirement. This measure tells us how much new money will be created by the banking
system for a given increase in the high- powered money. It reflects a bank's ability to
increase the money supply.
The credit multiplier is the reciprocal of the required reserve ratio. If reserve ratio is 20%,
then credit multiplier = 1/0.20 = 5.
1
Credit Multiplier=
(Required Reserve Ratio)
The existence of the credit multiplier is the outcome of fractional reserve
banking.
The deposit multiplier and the money multiplier though closely related are not identical because:
a) Generally banks do not lend out all of their available money but instead maintain reserves
at a level above the minimum required reserve.
b) All borrowers do not spend every Rupee they have borrowed. They are likely to convert
some portion of it to cash.
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UNIT 3 - MONETARY POLICY
Question 1
Explain the objective of monetary policy in an economy. Assess the instruments and
targets of monetary policy of the Reserve Bank of India.
Answer
Monetary policy encompasses all actions of the central bank which are aimed at directly
controlling the money supply and indirectly at regulating the demand for money. Monetary
policy is in the nature of ‘demand-side’ macroeconomic policy and works by stimulating
or discouraging investment and consumption spending on goods and services.
Following are some of the important objective of the Monetary Policy:
The most commonly pursued objectives of monetary policy of the central banks across
the world are maintenance of price stability (or controlling inflation) and achievement of
high level of economy’s growth and maintenance of full employment.
 To regulate the issue of bank notes and the keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage.
 To promote rapid economic growth, and price stability ( inflation /deflation )
 To maintain a robust debt management,
 To sustain a moderate structure of interest rates to encourage investments,
 To maintain exchange rate stability and external balance of payment equilibrium
 To ensure an adequate flow of credit to the productive sectors
 To create an efficient market for government securities.
Question 2
Explain Operating Procedures & Instruments / target of monetary policy of the Reserve
Bank of India:
Answer
The operating framework relates to all aspects of implementation of monetary policy. It
primarily involves three major aspects, namely,
1. Choosing the operating target,
2. Choosing the intermediate target, and
3. Choosing the policy instruments.
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The operating target refers to the variable (for e.g. inflation) that monetary policy can
influence with its actions. The intermediate target (e.g. economic stability) is a variable
which the central bank can hope to influence to a reasonable degree through the operating
target and which displays a predictable and stable relationship with the goal variables.
The monetary policy instruments are the various tools that a central bank can use to
influence money market and credit conditions and pursue its monetary policy objectives.
The day-to-day implementation of monetary policy by central bank can act directly,
using its regulatory power, or indirectly, using its influence on money market conditions
as the issuer of reserve money (currency in circulation and deposit balances with the
central bank).
In general, the direct instrument comprise of:
(a) The required cash reserve ratio and liquidity reserve ratios prescribed from time to
time.
(b) directed credit which takes the form of prescribed targets for allocation of credit to
preferred sectors (for e.g. Credit to priority sectors), and
(c) Administered interest rates wherein the deposit and lending rates are prescribed by
the central bank.
The indirect instruments mainly consist of:

(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window
The inflation target is to be set by the Government of India, in consultation with the
Reserve Bank, once in every five years. Accordingly,
 The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation
as the target for the period from August 5, 2016 to March 31, 2021 with the upper
tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
 The RBI is mandated to publish a Monetary Policy Report every six months, explaining
the sources of inflation and the forecasts of inflation for the coming period of six to
eighteen months.
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Operating Procedures & Instruments

↓
Quantitative
Measures
Operating Intermediate
Target Target
↓ ↓
Inflation Economic
stability
As per 2021 (June):
Bank rate : 4.25%
CRR : 4%
SLR : 18%
REPO : 4%
Reverse repo : 3.35%
MSF : 4.25%
Instruments:
CRR:
CRR refers to fraction of Total NDTL (Net demand and time liability) of commercial bank
which it should maintain as cash deposits with RBI. CRR is mandatory Reserve for all
commercial bank. Bank have to pay monetary penalty to they don’t maintain CRR. CRR
is applicable only to commercial bank & not applicable to NBFC. RBI may not give any
interest on CRR. Currently CRR is 4%.
Statutory Liquidity Ratio:

SLR is a percentage of NDTL that every commercial bank has to keep with itself either
in cash, gold or government dated securities. Currently SLR is 18%. As per 2021 during
inflation, SLR increases, and during deflation SLR decreases.It is Mandatory to maintain
SLR with RBI, Failure to maintain will attract Monetary penalty , Not applicable to NBFC
Liquidity Adjustment Facilities:

LAF started in year 2000. ( RBI is Bankers Bank), LAF is a window available with central
bank known as discount window which provides financial accommodation to commercial
banks, it helps at the time of Liquidity shortage and control short term Interest rate,
through Repo and. Reverse repo auction
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1. Repo Auction: It is a rate at which commercial bank borrows money from central
bank by keeping some security mortgage which could be repurchased @ later stage.
At present rate is 4%
2. Reverse Repo: It is a percentage that central bank borrows from commercial bank by
keeping security as mortgage currently it is 3.35%
Marginal Standing Facility:

MSF started in the year 2011. MSF refers to the facility under which schedule commercial
bank can borrow additional amount up to 1% of NDTL for overnight purpose (24 hrs). MSF
will be activated when commercial banks have exhausted all borrowings option currently
it is 4.25%, minimum amount 1Cr & in multiples of that.
Market stabilization scheme:

MSS started in the year 2004 it is a program started by RBI & government, to absorb
additional liquidity from the market due to huge foreign inflow of fund and the process
is called as sterilization. later under this scheme Govt borrows money from RBI which
helps to absorb additional liquidity from the system, which controls inflation and brings
Exchange rate Stability
Bank rate:
Bank rate is also known as rediscount rate. It is rate at which central bank rediscount the
bill of commercial bank. Currently bank rate acts as a penalty interest rate. Currently it is
4.25%, it has been dis continued due to introduction of LAF.
Open market operation:

It is a general term used for market operation. It is an deliberate attempt for buying &
selling government bonds in the open market. It will lead to either absorption or injection
of liquidity. During inflation Selling of bonds will take place and during period of low
growth Purchase of bonds will take place .
Question 3
A central bank is a ‘bankers’ bank.’ Elucidate the statement with illustrations.
Answer
A central bank is a ‘bankers’ bank.’ It provides liquidity to bank when the latter face
shortage of liquidity. This facility is provided by the central bank through its discount
window. The scheduled commercial banks can borrow from the discount window against
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the collateral of securities like commercial bills, government securities, treasury bills, or
other eligible papers.
This type of support earlier look the form of refinance of loans given by commercial bank
to various sectors (e.g. Export, agriculture etc.). By varying the terms and conditions
of encourage/discourage lending to particular sectors. In line with the financial sector
reforms, the system of sector-specific refinance schemes (expect export credit refinance
scheme) was withdrawn. From June 2000, the RBI has introduced Liquidity Adjustment
Facility (LAF).
The Liquidity Adjustment Facility (LAF) is a facility extended by the Reserve Bank of
India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail
of liquidity in case of requirement (or park excess funds with the RBI in case of excess
liquidity) on an overnight basis against the collateral of government securities including
state government securities.
Currently, the RBI provides financial accommodation to the commercial banks through
repo/reverse repos under the Liquidity Adjustment facility (LAF).
The Reserve Bank of India, being a bankers’ bank, also acts as a lender of last resort.
The Marginal standing Facility (MSF) announced by the Reserve Bank of India (RBI) in its
Monetary Policy, 2011-12 refers to the facility under which scheduled commercial banks
can borrow additional amount of overnight money from the Liquidity Ratio (SLR) portfolio
up to a limit (a fixed per cent of their net demand and time liabilities deposits (NDTL)
liable to change every year) at a penal rate of interest.
Question 4
Explain Bank lending Channel and balance sheet channel
Two distinct credit channels- the Bank lending channel and the balance sheet channel-
also allow the effects of monetary policy actions to spread through the real economy.
Credit channel operates by altering access of firms and households to bank credit. Most
business and people mostly depend on bank for borrowing money.“An open market
operation” that leads first to a contraction in the supply of bank reserves and then to a
contraction in bank credit requires banks to cut back on their lending. This, in turn makes
the firms that are especially dependent on banks loans to cut back on their investment
spending. Thus, there is decline in the aggregate output and employment following a
monetary contraction.
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Balance sheet channel

Now we shall look into how the balance sheet channel works. Logically, as a firm’s cost
of credit rises, the strength of its balance sheet deteriorates. A direct effect of monetary
policy on the firm’s balance sheet comes through an increase in interest rates leading
to an increase in the payments that the firm must make to repay its floating rate debts.
An indirect effect occurs when the same increase in interest rates works to reduce the
capitalized value of the firm’s long-lived assets. Hence, a policy-induced increase in
the short-term interest rate not only acts immediately to depress spending through the
traditional interest rate channel, it also acts, possibly with a time-lag, to raise each
firm’s cost of capital through the balance sheet channel. These together aggravate the
decline in output and employment.
A policy-induced increase in the short-term nominal interest rates makes debt instruments
more attractive than equities in the eyes of investors leading to a fall in equity prices. If
stock prices fall after a monetary tightening, it leads to reduction in household financial
wealth, leading to fall in consumption, output, and employment.
Question 5
Explain policy rate
In India, the fixed repo rate quoted for sovereign securities in the overnight segment of
Liquidity Adjustment Facility (LAF) is considered as the policy rate. (It may be noted that
India has many other repo rates in operation). The RBI uses the single independent ‘policy
rate’ which is the repo rate (in the LAF window) for balancing liquidity. The policy rate is in
fact, the key lending rate of the central bank in a country. A change in the policy rate gets
transmitted through the money market to the entire the financial system and alters all
other short term interest rates in the economy, thereby influencing aggregate demand – a
key determinant of the level of inflation and economic growth. If the RBI wants to make it
more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants
to make it cheaper for banks to borrow money, it reduces the repo rate.
Short note on Monetary Policy Committee (MPC)

An important landmark in India’s monetary history is the constitution of an empowered
six-member Monetary Policy Committee (MPC) in September, 2016 consisting of the RBI
Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official
nominated by the RBI Board and the remaining three central government nominees
representing the Government of India who are persons of ability, integrity and standing,
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having knowledge and experience in the field of Economics or banking or finance or

monetary policy.
The MPC shall determine the policy rate required to achieve the inflation target. Accordingly,
fixing of the benchmark policy interest rate (repo rate) is made through debate and
majority vote by this panel of experts. With the introduction of the Monetary Policy
Committee, the RBI will follow a system which is more consultative and participative
similar to the one followed by many of the central banks in the world. The new system
is intended to incorporate:
 diversity of views,
 specialized experience,
 independence of opinion ,
 representativeness , and
 accountability.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. The views of key stakeholders in the economy and analytical work
of the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations. The Financial
Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure
that the operating target of monetary policy is kept close to the policy repo rate.
Q. Explain Monetary Policy Frame work agreement or Inflation targeting by RBI

The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving
a statutory backing to the Monetary Policy Framework Agreement and for setting
up a Monetary Policy Committee (MPC). The Monetary Policy Framework Agreement
is an agreement reached between the Government of India and the Reserve Bank
of India (RBI) on the maximum tolerable inflation rate that the RBI should target to
achieve price stability. The amended RBI Act (2016) provides for a statutory basis for
the implementation of the ‘flexible inflation targeting framework’.
Announcement of an official target range for inflation is known as inflation targeting.
The Expert Committee under Urijit Patel to revise the monetary policy framework,
in its report in January, 2014 suggested that RBI abandon the ‘multiple indicator’
approach and make inflation targeting the primary objective of its monetary policy.
The inflation target is to be set by the Government of India, in consultation with the
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Reserve Bank, once in every five years. Accordingly,

 The Central Government has notified 4 per cent Consumer Price Index (CPI)
inflation as the target for the period from August 5, 2016 to March 31, 2021
with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2
per cent.
 The RBI is mandated to publish a Monetary Policy Report every six months,
explaining the sources of inflation and the forecasts of inflation for the coming
period of six to eighteen months.
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INTERNATIONAL TRADE
UNIT 1: THEORIES OF INTERNATIONAL TRADE
Explain in detail Advantages of international trade? (MERITS)

International trade may lead to a lot of advantages for countries as it leads of opening up
of the global economy leading to expansion of the domestic market internationally.
Following are the arguments in the favour of international Trade:
 It is powerful stimulus to economic efficiency and contributes to economic growth and
rising incomes.
 It includes companies to reap the quantitative and qualitative benefits of extended
division of labour.
 Manufacturing capabilities and benefits from economics of large scale production.
 Reduction in domestic price due to increased competition thereby increasing the
living standard of citizens.
 International trade provides access to new market and new material and enables
sourcing of inputs and components internationally at competitive prices.
 Exports stimulate economic growth by creating jobs, which could potentially reduce
poverty.
Explain main arguments against International Trade (DEMERITS)

 Possible negative labour market outcomes in terms of labour- saving technological
change that depress demand for unskilled workers, loss of labourers bargaining
power.
 Economic exploitation is a likely outcome when underprivileged countries become
vulnerable to the growing political power of corporations operating globally.
 Excessive stress on exports and profit-driven exhaustion of natural resources due to
unsustainable production and consumption.
 It may have adverse effect on the development of domestic industries and may even
threaten the survival of infant industries.
 Risky dependence of underdeveloped countries on foreign nation impairs economic
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autonomy and endangers their political sovereignty.

 Instead of cooperation among nation, trade may breed rivalry on account of severe
competition.
Define international trade and describe how it differs from internal trade?
International trade is the exchange of goods and services as well as resources between
countries. It involves transactions between residents of different countries. Whereas
domestic trade or internal trade involves exchange of goods and services within the
domestic territory of a country.
Internationally trade involves transaction in multiple currencies whereas domestic trade
place only using domestic currency.
Compared to internal trade, international trade has greater complexity as it involves
heterogeneity of customers and currencies, differences in legal systems, more elaborate
documentation, diverse restrictions in the form of taxes, regulations, duties, tariffs,
quotas, trade barriers, standards, restraints to movement of specified goods and services
and issues related to shipping and transportation.
For international trade certain general rules of trade are followed by the countries which
are made my international bodies like the WTO. On the other hand in case of internal
trade the laws are sole prerogative of the country.
Explain the Heckscher-Ohlin theory of International trade.

1. This theory was developed by Swedish economists Eli Heckscher and his student
Bertil Ohlin.
2. It is also known as Factor Endowment Theory of Trade or Modern Theory of Trade.
Sometimes it is also referred to as Heckscher-Ohlin-Samuelson theorem
3. Assumptions of H-O theory
I. 2 countries 2 commodities and 2 factors of production (2 x 2 x 2 model).
II. Identical production function.
III. Identical preferences.
IV. Same production technology in both countries.
V. Perfect competition in factor and product markets.
4. This theory suggest that each country has different factor endowments (availability)
and thus have different factor prices.
5. Here, factor endowment means overall availability of usable resources for production.
6. The theory considers two factors, labour and capital. It suggests that difference in
factor endowments is the cause of international trade.
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7. Differences in factor prices (due to differences in factor availability) will result in each
country having different cost function.
8. According to this theory, different goods have different production functions.
9. The theory states that each region is suitable for production of those goods for
whose production it has abundant resources.
10. It states that a country's exports will depend on its resource endowment, i.e. whether
it is capital or labour abundant country. E.g. capital abundant country will have
comparative cost advantage in production of capital-intensive goods and hence, it
will specialize in production and export of capital-intensive products.
11. The H-O theory is a combination of two theorems, namely:
I. Heckscher-Ohlin Trade Theorem
II. Factor Price Equalization Theorem
H-O Theory
Heckscher – Ohlin Factor Price

Trade theorem Equalization Theorem

I. Heckscher-Ohlin Trade Theorem:

It states that, a country tends to specialize in the export of a commodity whose
production requires intensive use of its abundant resources and imports a
commodity whose production requires intensive use of its scarce resources.
II. Factor Price Equalization Theorem:
a. It says that if the prices of output are equalised between trading countries,
then the prices of input factors will also be equalised between these
countries.
b. In simple words, theorem states that international trade tends to equalize
the factor prices between trading nations. E.g. wages of identical labour/
returns to identical capital will be the same in all nations which engage in
trade.
c. The theorem states that trade in goods is perfect substitute for trade in
factors. This theorem is a corollary to H-O theorem.
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d.
Example: Comparing India and US
1. If trade opens up for a labour abundant economy (India), it will
labour the price of labour intensive goods. E.g. Rice. (Price for rice in
India will rise)
2. It will lead to expansion of rice production and thereby, rise in wages
in India.
3. This will attract labour from capital intensive industry like cars.
(Labour from automobile sector will be attracted to rice sector)
4. The expanding rice industry will absorb more labour than what is
released by contraction of automobile industry. Hence, price of labour
increases in the country.
5. As the relative price of labour goes up, the relative price of capital
declines in India.
6. Similarly, when US increases its capital-intensive production, return
on capital will rise in relation to wage rate. (As production of cars
rises, cost of capital will rise in US)
7. This means that specialization leads to change in relative factor
prices. As a result of international trade, factor price will be equalized
in two trading nations.
Explain Theory of Absolute Advantage

1. Concept:
a) Adam Smith propounded the Theory of Absolute Cost Advantage as the basis of
Foreign Trade.
b) Under this theory, an exchange of goods will take place only if each of the two
countries can produce one commodity at an absolutely lower production cost than
the other country.
c) Each Country which has an absolute advantage over another Country in the
production of an item, can trade such item, and hence gain in terms of International
Trade.
d) Absolute Advantage refers to the ability of a Party (an Individual, or Firm, or Country)
to produce more of a good or service than the Competitors, using the same amount
of resources.
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2. Explanation:
Consider two Countries (A and B), and two Products (X and Y). The Countries have different
abilities to produce goods, and accordingly the Production varies as under –
Product X Product Y
Country A 30 units per hour 20 units per hour
Country B 5 units per hour 25 units per hour
 Here, Country A is better equipped to produce Product X (30 units vs 5 units), whereas
Country B is better equipped to produce product Y (25 units vs 20 units).
 Both Countries will gain by trading with one another, by which Country A will
specialize in Product X, and Country B will specialize in Product Y.
 If specialization takes place but there is international trade, residents of Country A
will not have Product Y, and Residents of Country B will not Product X at all. This
situation is avoided by engaging in International Trade.
 Gains may not always be distributed equally between Countries A & B, say if 1 unit
of X is traded for 1 unit of Y.
3. Advantages:
a) Each country which has an absolute advantage over another Country in the production
of an item, can trade such item, and hence gain in terms of International Trade. One
Country’s Gain need not be another Country’s Loss.
b) This Theory recognizes the importance of division of labour, specialization, and
consequent benefits.
c) Global Output is maximized, and all products are available to Consumers of all
Countries.
4. Disadvantages:
a) It is simplistic a Model to consider. It does not recognize many practical barriers to
International trade.
b) Labour is considered as the only Factor Input in the analysis of Absolute Advantage.
c) It does not consider situation where one country has absolute disadvantage over the
first country in both commodities.
It emphasizes only Supply-side conditions, and ignores domestic demand in respective
countries
Distinguish between Comparative cost and Modern theory
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Theory of Comparative Costs Modern Theory

The basis is the difference between Explains the causes of differences in
countries is comparative costs comparative costs as differences in
factor endowments
Based on labour theory of value Based on money cost which is more
realistic.
Considered labour as the sole factor of Widened the scope to include labour
production and presents a one-factor and capital as important factors of
(labour) model production. This is 2-factor model and
cand be extended to more factors.
Treats international trade as quite International trade is only a special case
distinct from domestic trade of inter-regional trade.
Studies only comparative costs of the Considers the relative prices of the
goods concerned factors which influence the comparative
costs of the goods
Attributes the differences in comparative Attributes the differences in comparative

advantage to differences in productive advantage to the differences in factor
efficiency of workers endowments.
Ricardo’s Theory of Comparative Cost Advantage

This theory was developed by David Ricardo and published in his book “Principles of
Political economy & taxation 1917”.
• According to this theory even if one Nation is less efficient than other Nation in the
production of all Commodities there is still scope for mutually beneficial trade.
• In such case first nation should specialized in the production and export of the
commodity in which its absolute disadvantage is smaller and import the commodity
in which its absolute disadvantage is greater.
• This theory also states that if absolute disadvantage that the one Nation has with
respect to other nation is same in both the commodities, there is no possibility of
mutually beneficial trade.
• This theory is based on comparative Labour productivity advantage.

Example of comparative cost theory
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Canada India Cost ratio

Wheat 10 15 10/15 = 0.66
Jute 20 25 20/25 = 0.80
India Canada 1.50 (15/10)

Jute 1.25 (25/20)

A country is going to produced specialized and export those commodities in which it
has greater comparative advantage & the Lower Comparative Disadvantage.
Canada has an advantage to produce both commodities Wheat as well as Jute but
the cost advantage is greater in production of Wheat (0.34) than in Jute (0.20). Hence
Canada should specialized in production of Wheat and exchange it with Indian Jute.
India has relative cost disadvantage in production of both Wheat and Jute. Cost of
Wheat is 1.50 (15//10) and Cost of Jute is 1.25 (25/20)
Disadvantage in production of Jute is Less (0.25) than production of Wheat 0.50

Hence for India also it is beneficial to produce Jute and sell it to Canada & import
wheat in exchange.
Canada has greater comparative advantage in production of Wheat. Hence according

to this theory it will tend to specialized in production of Wheat.
India has less disadvantage in production of Jute hence India will specialized in
production of Jute.
Inshort, Gains from trade.

1. Increase total output
2. Reduction in cost
3. Welfare for both countries
Limitations.
1. Does not consider factor of production other than labour.
2. Focuses only on supply while ignoring demand side .
 New Trade Theory – An Introduction
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• New Trade Theory (NTT) is an economic theory that was developed in the 1970s
as a way to understand international trade patterns. NTT came about to help us
understand why developed and big countries are trade partners when they are
trading similar goods and services. These countries constitute more than 50% of
world trade.
• This is particularly true in key economic sectors such as electronics, IT, food, and
automotive. We have cars made in the India, yet we purchase many cars made in
other countries.
• These are usually products that come from large, global industries that directly
impact international economies. The mobile phones we use are a good example.
India produces them and also imports them. NTT argues that, because of substantial
economies of scale and network effects, it pays to export phones to sell in another
country. Those countries with the advantages will dominate the market, and the
market takes the form of monopolistic competition.
 Economies of Scale: As a firm produces more of a product its cost per unit keeps going
down. So if the firm serves domestic as well as foreign market instead of just one, it
can reap the benefit of large scale of production consequently the profits are likely
to be higher.
 Network effects are the way one person’s value of a good or service is affected by
the value of that good or service to others. The value of the product or service is
enhanced as the number of individuals using it increases. This is also referred to as
the ‘bandwagon effect’. Consumers like more choices, but they also want products
and services with high utility, and the network effect offers increased utility from
these products over others. A good example will be Mobile App such as Whats App
and software like Microsoft Windows.
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UNIT 2 : THE INSTRUMENT OF TRADE POLICY
Define ‘trade policy’. What are the major objectives of trade policy?
Trade policy encompasses all instrument that governments may use to promote or restrict
imports and exports. Trade policy also includes the approach taken by countries in trade
negotiations.
Following are some of the major objectives of Trade Policy:

 To provide a stable and sustainable policy environment for foreign trade in
merchandise and services.
 To link rules, procedures and incentive for exports and imports with other initiative
such as “Make in India”, Digital India and skill India to create an ‘Export Promotion
Mission’ for India.
 To provide a mechanism for regular appraisal in order to rationalize import and
reduce the trade imbalance.
 To allow import of technology and equipment’s which may help in establishing new
industrial enterprises, produce new product and adopt a new process for higher
production levels.
 To accelerate the country’s transition to a globally oriented vibrant economy to
deriving maximum benefits from expanding global market opportunities;
 To provide consumers with good quality product at reasonable prices through
regulated imports of such products.
Explain Effect of Tariffs:

 Tariff barriers create obstacles to trade, decrease the volume of imports and exports
and therefore of international trade.
 Tariffs encourage consumption and production of the domestically produced import
substitutes and thus protect domestic industries.
 Producers in the importing country experience an increase in well – being as
a imposition of tariff. The price increase of their product in the domestic market
increases producer surplus in the industry. The price increase also induces an increase
in the exiting firms and possibly addition of mew firms due to entry into industry to
take advantage of the new high profits and consequently an increase in employment
in the industry.
 Tariffs create trade distortions by disregarding comparative advantage and prevent
countries from enjoying gains from trade arising from comparative advantage.
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 Tariffs increase government revenues of the importing country by the value of the
tariff it charges.
Evaluate the use of tariffs as policy instrument.

A tariff is a tax imposed on the import or export of goods. In general parlance, however,
it refers to “import duties” charged at the time of goods are imported.
Tariff is also a policy tool to protect domestic industries by changing the conditions
under which goods complete in such a way that competitive imports are placed at a
disadvantage. In point of fact, a cursory examination of the tariff rates employed by
different countries does seem to indicate that they reflect, to a considerable extent, the
competitiveness of domestic industries.
Following are example of some tariffs used as an instrument of trade policy (Types of tariffs)
Specific Tariff: A specific tariff is an import duty that assigns a fixed monetary tax per
physical unit of the good imported. It is calculated on the basis of unit measure, such as
weight, volume, etc., of the imported good.
Ad valorem tariff: An ad valorem tariff is levied as a constant percentage of the monetary

value of one unit of the imported good.it is levied on the total value of the commodity
Mixed Tariffs: Mixed tariffs are expressed either on the basis of the value of the imported
goods (an ad valorem rate) or on the basis of a unit of measure of the imported goods (a
specific duty) depending on which generates the most income.
Compound Tariff or a Compound Duty: It is a combination of an ad valorem and a specific

tariff. That is, the tariff is calculated on the basis of both the value of the imported goods
(an ad valorem duty) and a unit of measure of the imported goods (a specific duty).
Technical/Other Tariff: These are calculated on the basis of the specific contents,
components or spare parts of the imported goods i.e. the duties are payable by its
components or related items.
Tariff Rate Quotas: Tariff rate quotas (TRQs) combine two policy instrument: quotas and
tariffs. Imports entering under the specified quota portion are usually subject to a lower
(sometimes Zero), tariff rate. Imports above the quantitative threshold of the quota face
a much higher tariff.
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Most-Favored Nation Tariffs: It’s a tariff without discrimination; MFN tariffs are what
countries promise to impose on other member countries.
Variable Tariff: A duty typically fixed to bring the price of an imported commodity up to
domestic support price for the commodity. (makings foreign goods more expensive, so
that domestic industries are protected .)
Preferential Tariff: A lower tariff is charged from goods imported from a country which
is given preferential treatment. Examples are preferential duties in the EU region under
which a good coming into one EU country from another is charged Zero tariffs. ( eg: other
trading bloc like SAARC , NAFTA etc )
Bound Tariff: A bound tariff is which a WTO member binds itself with a legal commitment
not to raise it above a certain level. The bound rates are specific to individual products
and represent the maximum level of import duty that can be levied on a product imported
by that member. (it helps to bring Transparency among countries)
Escalated tariff: Higher tariff will be charged when countries import Finished goods and
lower tariff will be charged when countries import raw material ,it protects domestic
industries in importing countries
Applied Tariffs: It is charged on imports on a Most Favoured Nation (MFN) basis. A WTO
member can have an applied tariff for product that differ from the bound tariff for that
product as long as the applied level is not higher than the bound level. It’s a tariff that
is actually being Charged .
Prohibitive tariff : It is that were very high tariff is charged so high so that no imports shall enter
the country
 Anti-dumping Duties:
Solution:
An anti-dumping duty is a protectionist tariff that a domestic government imposes on
foreign imports that it believes are priced below fair market value. Dumping is process
where a company exports a product at a price lower than the price normally charges in
its own home market. To protect local business and markets, many countries impose stiff
duties on products they believed are being dumped in their national market.
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Dumping may be persistent, seasonal, or cyclical. Dumping may also be resorted to as a

predatory pricing practice to drive out established domestic producers from the market
and to establish monopoly position. Dumping is an international price discrimination
where the exporters deliberately forego money in order to harm the domestic producers
of the importing country. This is unfair and constitutes a threat to domestic producers.
 Countervailing Duties:
Solution:
It is levied on imported goods to offset subsidies made to producers of these goods in
the exporting country. Countervailing duties (CVD) are meant to level the playing field
between domestic producers of a product and foreign producers of the same product
who can afford to sell it at a lower price because of the subsidy they receive from their
government.
If left unchecked, such subsidized imports can have a severe effect on domestic industry,
forcing factory closures and causing huge job losses. As export subsidies are considered
to be an unfair trade practice, the World Trade Organization (WTO) – which deals with the
global rules of trade between nations – has detailed procedures in place to establish the
circumstance under which countervailing duties can be imposed by an importing nation.
For example, in 2016, in order to protect its domestic industry, India imposed 12.5%
countervailing duty on Gold jewellery imports from ASEAN.
 Outline the different non – tariff measures adopted by countries.

Solution:
Non-tariff measures (NTMs) are policy measures that can be potentially have an economic
effect on international trade in goods, changing quantities traded, or prices or both.
a) Technical Measures:
Sanitary and Phytosanitary (SPS) Measures: SPS measures are applied to product human,
animal or plant life from risks arising from additives, pests, contaminants, toxins or
disease – causing organisms and to protect biodiversity. These include ban or prohibition
of import of certain goods, all measures governing quality and hygienic requirement,
production processes, and associated compliance assessments. For example; prohibition
of import of poultry from countries affected by avian flu, meat and poultry processing
standards to reduce pathogens, residue limits for pesticides in foods etc.
Technical Barriers To Trade (TBT): Technical Barriers to Trade (TBT) which cover both food
and non-food traded products refer to mandatory ‘Standards and Technical Regulation’
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that define the specific characteristic that a product should have, such as its size, shape,
design, labelling / marketing / packaging, functionally or performance and production
methods, excluding measures covered by the SPS Agreement.
b) Non- Technical Measures

 Imported Quotas: An imported quota is a direct restriction which specifies that only
a certain physical amount of the good will be allowed into country during a given
time period, usually one year. Import quotas are typically set below the free trade
level of imports and usually enforced by issuing licenses.
 Price Control Measures: Price control measures (including additional taxes and
charges) are steps taken to control or influence the prices of imported goods in order
to support the domestic price of certain products when the import prices of these
goods are lower.
 Non-automatic Licensing and Prohibition: These measures are normally aimed at

limiting the quantity of goods that can be imported, regardless of whether they
originate from different sources or from one particular supplier.
 Financial Measures: The objective of financial measures is to increase import costs by

regulating the access to and cost of foreign exchange for imports and to define the
terms of payment. It includes measures such as advance payment requirements and
foreign exchange controls denying the use of foreign exchange for certain types of
imports or for goods imported from certain countries.
 Measures Affecting Competition: These measures are aimed at granting exclusive or

special preference or privileges to one or a few limited group of economic operators.
It may include government imposed special channel or enterprises, and compulsory
use of national services.
 Rules of origin : Rules of origin are criteria needed by government of importing country
to determine the national source of a product ,since duties and restrictions in several
cases depend upon source of imports
 Trade-Related Investment Measures: These measures include rules on local content

requirements that mandate a specified fraction of a final good should be produced
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domestically.
 Restriction on Post-sales Services: Producers may be restricted from providing after-

sales services for exported goods in the importing country. Such services may be
reserved to local service companies of the importing country.
 Safeguard Measures are initiated by countries to restrict imports of a product

temporarily if its domestic industry is injured or threatened with serious injury caused
by a surge in imports.
 Embargos: An embargo is a total ban imposes by government on import or export of

some or all commodities to particular country or regions for a specified or indefinite
period.
 Distribution Restrictions: They are the limitations imposed on the distribution of

goods in importing country involving additional license and certification requirement
Basically geographical restrictions
 Explain the concept of ‘Voluntary Export Restraints’

Solution:
Voluntary Export Restraints (VERs) refer to a type of informal quota administered by an
exporting country voluntarily restraining the quantity of goods that can be exported out
of that country during a specified period of time.
Such restrains originate primarily considerations and are imposed based on negotiation
of the importer with the exporter. The inducement for the exporter to agree to a VER is
mostly to appease the importing country and to avoid the effects of possible retaliatory
trade restraints that may be imposed by the importer.
Typically, VERs are a result of requests made by the importing country to provide a measure
of protection for its domestic businesses that produces competing goods. VERs are often
created because the exporting countries would prefer to impose their own restriction
than risk sustaining worse terms from tariffs and/or quotas. Producers in the importing
country experience an increase in well-being, though, as there is decreased competition,
increased in price, profits, and employment. In spite of these benefits to producers.
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UNIT 3 : TRADE NEGOTIATIONS

Question 1
Describe the structure of the World Trade Organization.
Solution:
The World Trade Organization (WTO) is the only global international organization dealing
with the rules of trade between nations. At its heart are the WTO agreements, negotiated
and signed by the bulk of the world’s trading nations and ratified in their parliaments.
The goal is to help producers of goods and services, exporters, and importer conduct
their business. The World Trade Organization - is the international organization whose
primary purpose is to open trade for the benefit of all.
The WTO activities are supported by a Secretariat located in Geneva, headed by a Director
General.
It has a three-tier system of decision making. The WTO’s top level decision-making body
is the Ministerial Conference which can take decision on all matters under any of the
multilateral trade agreements. The Ministerial Conference meets at least once every two
years.
Next level is General council ,they meet frequently at Geneva head office ,and they are
responsible for Trade policy review and act as a dispute settlement body
The next level, Goods Council, services Council and Intellectual Property (TRIPS) Council report
to the General Council. These councils are responsible for overseeing the implementation
of the WTO agreements in their respective areas of specialization.
Right from its inception, the WTO has been driven by a number of fundamental principle
which are the foundations of the multilateral trading system.
Question 2
Demerits of GATT ( Why GATT failed )
Answer
The GATT lost its relevance by 1980s because
 it was obsolete to the fast evolving contemporary complex world trade scenario
characterized by emerging Globalization
 international investments had expanded substantially
 intellectual property rights and trade in services were not covered by GATT
 world merchandise trade increased by leaps and bounds and was beyond its scope
 the ambiguities in the multilateral system could be heavily exploited
 efforts at liberalizing agricultural trade were not successful
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 there were inadequacies in institutional structure and dispute settlement system
Question 3
Write a note in Regional Trade Agreements.
Answer
Regional Trade Agreements (RTAs) are defined as groupings of countries (not necessarily
belonging to the same geographical region), which are formed with the objective of
reducing barriers to trade between member countries.
Trade negotiations result in different types of agreements which are as follows:
1. Unilateral trade agreements under which an importing country offers trade incentives
in order to encourage the exporting country, to engage in international economic
activities that will improve the exporting country’s economy. E.g. Generalized System
of Preferences.
2. Bilateral Agreements are agreements which set rules of trade between two countries,
two blocs or a bloc and a country. These may be limited to certain goods and services
or certain types of market entry barriers. E.g. EU-South Africa Free Trade Agreement;
ASEAN–India Free Trade Area.
3. Regional Preferential Trade Agreements among a group of countries reduce trade
barriers on a reciprocal and preferential basis for only the members of the group.
E.g. Global System of Trade Preferences among Developing Countries (GSTP)
4. Trading Bloc has a group of countries that have a free trade agreement between
themselves and may apply a common external tariff to other countries. Example:
Arab League (AL), European Free Trade Association (EFTA)
5. Free-trade area is a group of countries that eliminate all tariff and quota barriers
on trade with the objective of increasing exchange of goods with each other. The
trade among the member states flows tariff free, but the member states maintain
their own distinct external tariff with respect to imports from the rest of the world.
In other words, the members retain independence in determining their tariffs with
non-members. Example: NAFTA.
6. A customs union is a group of countries that eliminate all tariffs on trade among
themselves but maintain a common external tariff on trade with countries outside
the union (thus, technically violating MFN).The common external tariff which
distinguishes a customs union from a free trade area implies that, generally, the
same tariff is charged wherever a member imports goods from outside the customs
union. The EU is a Customs Union; its 27 member countries form a single territory
for customs purposes. Other examples are Gulf Cooperation Council (GCC), Southern
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Common Market (MERCOSUR).

7. Common Market: A Common Market deepens a customs union by providing for the
free flow of output and of factors of production (labour, capital and other productive
resources) by reducing or eliminating internal tariffs on goods and by creating a
common set of external tariffs. The member countries attempt to harmonize some
institutional arrangements and commercial and financial laws and regulations
among themselves. There are also common barriers against non-members (e.g., EU,
ASEAN)
8. Economic and Monetary Union: For a common market, the free transit of goods and
services through the borders increases the need for foreign exchange operations and
results in higher financial and administrative expenses of firms operating within
the region. The next stage in the integration sequence is formation of some form of
monetary union. In an Economic and Monetary Union, the members share a common
currency. Adoption of common currency also makes it necessary to have a strong
convergence in macroeconomic policies. For example, the European Union countries
implement and adopt a single currency.
Question 4
Write a note on THE GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT).
Answer
The General Agreement on Tariffs and Trade (GATT) provided the rules for much of world
trade for 47 years, from 1948 to 1994; but it was only a multilateral instrument governing
international trade or a provisional agreement along with the two full-fledged “Bretton
Woods” institutions, the World Bank and the International Monetary Fund. Eight rounds of
multilateral negotiations known as “trade rounds” held under the auspices GATT resulted
in substantial international trade liberalization. Though the GATT trade rounds in earlier
years contemplated tariff reduction as their core issue, later on the Kennedy Round in
the mid-sixties, and the Tokyo Round in the 1970s led to massive reductions in bilateral
tariffs, establishment of negotiation rules and procedures on dispute resolution, dumping
and licensing.
A number of codes were ultimately amended in the Uruguay Round and got converted
into multilateral commitments accepted by all WTO members. The eighth, the Uruguay
Round of 1986-94, was the last and most consequential of all rounds and culminated in
the birth of WTO and a new set of agreements.
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Question 5
Objectives of WTO?
Answer
The WTO has six key objectives:
1. to set and enforce rules for international trade,
2. to provide a forum for negotiating and monitoring further trade liberalization,
3. to resolve trade disputes,
4. to increase the transparency of decision-making processes,
5. to cooperate with other major international economic institutions involved in global
economic management, and
6. to help developing countries benefit fully from the global trading system.
The objectives of the WTO Agreements as acknowledged in the preamble of the Agreement
creating the World Trade Organization, include “raising standards of living, ensuring
full employment and a large and steadily growing volume of real income and effective
demand, and expanding the production of and trade in goods and services"
Question 6
Achievements of WTO.
Answer
The WTO has helped transform international economic relations to a great extent over
the past 25 years of its existence.
Since 1995, the dollar value of world trade has increased nearly four-fold, while the real
volume of world trade has expanded by 2.7 times
The average tariffs have almost halved, from 10.5% to 6.4% during this period
The rise of global value chains has been a significant factor in enabling rapid catch-
up growth in developing economies. Also, these have resulted in increased purchasing
power and consumer choice in all countries.
Over the past 25 years, there has been the fastest poverty reduction in history: in 1995,
over one in three people living around the world fell below the World Bank's $1.90
threshold for extreme poverty. Today the extreme poverty rate is less than 10%, the
lowest ever.
Explain the major guiding principles of WTO?

Solution:
Trade without discrimination: Under the agreements, countries cannot normally discriminate
between their trading partners. If a country lowers a trade barrier or opens up a market,
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it has to do so for the same goods or services from all other members.
The National Treatment Principle (NTP): Any country should not discriminate between its
own and foreign products, services or nationals. For instance, once imported apples
reach Indian market, thet cannot be discriminated against and should be treated at par
in respect of marketing opportunities, product visibility or any other aspect with locally
produced apples.
Freer trade: Lowering trade barriers for opening up markets is one of the most obvious
means of encouraging trade as dictated by the WTO. ( Reduction in duties and tarrifs if
not removal)
Predictability: Foreign companies, investors and governments should be confident that

the trade barriers will not be raised arbitrarily. This is achieved through ‘binding’ tariff
rates, discouraging the use of quotas and other measures used to set limits on quantities
of imports, establishing market-opening commitments and other measures to ensure
transparency.
Greater competitiveness: This is to be achieved by discouraging “unfair” practices such as

export subsidies, dumping etc .Instead of Rivalry there should be healthy competition .
Tariffs as legitimate measures for the protection of domestic industries: The imposition of
tariffs should be the only method of protection, and tariff rates for individual items should
be gradually reduced through negotiation ‘on a reciprocal and mutually advantageous’
basis.
Transparency in Decision Making: The WTO insists that any decision by members in the
sphere of trade or in respect of matter affecting trade should be transparent verifiable.
Progressive Liberalization: Many trade issues of a controversial nature similar to labour
standards, non-agricultural market access, etc. be liberalization after discussion.
Special privileges to less developed countries: With majority of WTO members being developing
countries and countries in transition to market economics, the WTO deliberations favour
less developed countries by giving them greater them greater flexibility, special privileges
and permission to phase out the transition period.
Protection of Health & Environment: The WTO’s agreements support measures to protect
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not only the environment but also human, animal as well as plant health.
A transparent, effective and verifiable dispute settlement mechanism: Trade relations

frequently involve conflicting interests. Any dispute arising out of violation of trade rules
leading to infringement of right under the agreement or misunderstanding arising as
regards the interpretation of rules are to be settled through consultation.
Write a note on URUGUAY ROUND.

Answer
The need for a formal international organization which is more powerful and comprehensive
was felt by many countries by late 1980s.Having settled the most ambitious negotiating
agenda that covered virtually every outstanding trade policy issue, the Uruguay Round
brought about the biggest reform of the world’s trading system.
Members established 15 groups to work on limiting restrictions in the areas of tariffs,
non-tariff barriers, tropical products, natural resource products, textiles and clothing,
agriculture, safeguards against sudden ‘surges’ in imports, subsidies, countervailing
duties, trade related intellectual property restrictions, trade related investment
restrictions, services and four other areas dealing with GATT itself, such as, the GATT
system, dispute settlement procedures and implementation of the NTB Codes of the
Tokyo Round, especially on antidumping.
The Round started in Punta del Este in Uruguay in September 1986 and was scheduled to
be completed by December 1990. However, due to many differences and especially due
to heated controversies over agriculture, no consensus was arrived at.
Finally, in December 1993, the Uruguay Round, the eighth and the most ambitious and
largest ever round of multilateral trade negotiations in which 123 countries participated,
was completed after seven years of elaborate negotiations.
The agreement was signed by most countries on April 15, 1994, and took effect on July 1,
1995. It also marked the birth of the World Trade Organization (WTO) which is the single
institutional framework encompassing the GATT, as modified by the Uruguay Round.
Write a note on Doha Round

Answer
The Doha Round, formally the Doha Development Agenda, which is the ninth round since
the Second World War was officially launched at the WTO’s Fourth Ministerial Conference
in Doha, Qatar, in November 2001. The round seeks to accomplish major modifications
of the international trading system through lower trade barriers and revised trade
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rules. The negotiations include 20 areas of trade, including agriculture, services trade,
market access for non-agricultural products(NAMA), trade in services, trade facilitation,
environment, geographical indications and certain intellectual property issues. The most
controversial topic in the Doha Agenda was agriculture trade.
Q. Overview of the WTO agreements?

Answer
The WTO agreements cover goods, services and intellectual property and the permitted
exceptions. These agreements are often called the WTO’s trade rules, and the WTO
is often described as “rules-based”, a system based on rules. (The rules are actually
agreements that the governments negotiated). The WTO agreements are voluminous
and multifaceted. The ‘Legal Texts’ consist of a list of about 60 agreements, annexes,
decisions and understandings covering a wide range of activities.
Following are the important agreements under WTO. Since a thorough discussion on the
features of each agreement is beyond the scope of this unit, only the major provisions
are given below:
Agreement on Agriculture aims at strengthening GATT disciplines and improving
agricultural trade. It includes specific and binding commitments made by WTO Member
governments in the three areas of market access, domestic support and export subsidies.
Agreement on the Application of Sanitary and Phytosanitary (SPS) Measures establishes

multilateral frameworks for the planning, adoption and implementation of sanitary
and phytosanitary measures to prevent such measures from being used for arbitrary or
unjustifiable discrimination or for camouflaged restraint on international trade and to
minimize their adverse effects on trade.
Agreement on Trade-Related Investment Measures (TRIMs) expands disciplines governing

investment measures in relation to cross-border investments.
Anti-Dumping Agreement seeks to tighten and codify disciplines for calculating dumping
margins and conducting dumping investigations, etc.
Agreement on Rules of Origin provides for the harmonization of rules of origin for
application to all non-preferential commercial policy instruments. It also provides for
dispute settlement procedures and creates the rules of origin committee
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Agreement on Subsidies and Countervailing Measures aims to clarify definitions of

subsidies, strengthen disciplines by subsidy type and to strengthen and clarify procedures
for adopting countervailing tariffs
Agreement on Safeguards clarify disciplines for requirements and procedures for imposing
safeguards and related measures which are emergency measures to restrict imports in
the event of a sudden surge in imports
General Agreement on Trade in Services (GATS): This agreement provides the general
obligations regarding trade in services, such as most- favourednation treatment and
transparency.
Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS): This

agreement stipulates most-favoured-nation treatment and national treatment for
intellectual properties, such as copyright, trademarks, geographical indications, industrial
designs, patents, IC layout designs and undisclosed information.
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UNIT 4: EXCHANGE RATE AND ITS ECONOMIC EFFECTS
Describe the functioning of the foreign exchange market?

Solution:
The foreign exchange market is a global decentralized or over-the-counter (OTC) market
for the trading of currencies. This market determined the foreign exchange rate. It includes
all aspects of buying, selling and exchanging currencies at current or determined prices.
In terms of trading volume, it is by far the largest market in the world.
The foreign exchange market works through financial institutions, and operates on several
levels. Behind the scenes, banks turn to a smaller number of financial firms known as
“dealers”, who are involved in large quantities of foreign exchange trading.
Most foreign exchange dealers are banks, sometimes it is also called the “interbank
market”. Trades between foreign exchange dealers can be very large, involving hundreds
of millions of dollars. Five major trading centers in the world New York , London , Tokyo
, Zurich and Frankfurt
Foreign exchange market speculation, based on the differential interest rate between two
currencies.
Explain Participants in the exchange market are:

r The central banks participate in the foreign exchange markets, not to make profit,
but essentially to contain the volatility of exchange rate to avoid sudden and large
appreciation or depreciation of domestic currency and to maintain stability in
exchange rate in keeping with the requirements of national economy If the domestic
currency fluctuates excessively, it causes panic and uncertainty in the business world.
r Commercial banks participate in the foreign exchange market either on their own
account or for their clients. When they trade on their own account, banks may operate
either as speculators or arbitrageurs/or both. The bulk of currency transactions occur
in the interbank mark t in which the banks trade with each other.
r Brokers participate in the market as intermediaries between different dealers or

banks.
r Arbitrageurs for profit by discovering price differences between pairs of currencies

with different dealers or banks.
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r Speculators, who are bulls or bears, are deliberate risk-takers who participate in
the market to make gains which result from unanticipated changes in exchange
rates.
r Multinational corporations that engage in international trade and investments,

nonbank financial institutions such as asset management firms, insurance companies,
r Other participants in the exchange market are individuals who form only a very
insignificant fraction in terms of volume and value of transactions.
r Regardless of physical location, and given that the markets are highly integrated,
at any given moment, all markets tend to have the same exchange rate for a given
currency.
r Above phenomenon occurs because of arbitrage. Arbitrage refers to the practice of

making risk- less profits by intelligently exploiting price differences of an asset at
different dealing locations.
r When price differences occur in different markets, participants purchase foreign

exchange in a low- priced market for resale in a high-priced market and makes
profit in this process.
r Due to the operation of price mechanism, the price is driven up in the low-priced
market and pushed down in the high- priced market. This activity will continue until
the prices in the two markets are equalized, or until they differ only by the amount
of transaction costs involved in the operation.
In the foreign exchange market, there are two types of transactions:
(i) Current transactions which are carried out in the spot market and the exchange
involves immediate delivery, and
(ii) Contracts to buy or sell currencies for future delivery which are carried out in
forward and/or futures markets
What do you understand by appreciation and depreciation of currency? How do they affect real
economy?
Solution:
The terms, currency appreciation’ and currency depreciation’ describe the movement of
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the exchange rate.

Currency appreciation is an increase in the value of one currency in terms of another.
Currencies appreciate against each other for various reasons, including government policy,
interest rates, trade balance and business cycles. Currencies are quoted and traded in
pairs.
Currency depreciation is a fall in the value of a currency in a floating exchange rate system.
Currency depreciation can occur due to any number reasons- economic fundamental,
interest rate differentials, political instability, risk aversion among investors and so on.
Home-currency Appreciation under Floating Exchange Rates
An increase in the supply of foreign shifts the supply curve to the right to ‘S1 $’ and as a
consequence, the exchanges rate declines to ‘e1’. It means, that lesser units of domestic
currency (here Indian Rupees) are required to buy a unit of foreign exchange (dollar), and
that the domestic currency (the Rupees) has appreciated.
Effects of currency appreciation on the economy:

 Exports become more expensive. The price Exports will increase making exports
more expensive. Therefore with a higher price, we would expect to see a fall in the
quantity exports.
 Imports become cheaper: Domestic consumers will find that more goods can be
purchased with the same amount of money. Therefore, with cheaper imports, we
would expect to see an increase in the quantity of imports.
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 Lower (X-M) with lower export demand and greater spending on imports, we would
expect fall in domestic Aggregate Demand (AD), causing lower growth.
 Lower inflation. An appreciation tends to cause lower inflation because import

prices are cheaper. The cost of imported goods and raw materials will fall after an
appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
Home-Currency Depreciation under Floating Exchange Rates

The market reaches equilibrium at point ‘E’ with equilibrium exchange rate ‘eeq’. An
increase in domestic demand for the foreign currency, with supply of dollars remaining
constant, is represented by a rightward shift of the demand curve to ‘D1$”.
The equilibrium exchange rate rises to ‘e1’. It means that more units of domestic currency
(here Indian Rupees) are required to buy a unit of foreign exchange (dollar) and that the
domestic currency (the Rupee) has depreciated.
Effects of currency depreciation on the economy:

 Exports will become cheaper: A depreciation of the domestic currency will make
exports more competitive and appear cheaper to foreigners. This will increase
demand for exports.
 Imports will become more expensive. A depreciation means imports, such as petrol,
food and raw materials will become more expensive. This will reduce demand for
imports.
 Inflation is likely to occur following a depreciation because Imports are more

expensive – causing cost push inflation.
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Q. Explain ‘real exchange rate'

Ans. The ‘real exchange rate' incorporates changes in prices and describes ‘how many’ of
a good or service in one country can be traded for ‘one’ of that good or service in a
foreign country.
Real exchange rate
= Nominal exchange rate
X (Domestic price index)/
(Foreign price index)
 Devaluation is a deliberate downward adjustment in the value of a country's currency

relative to another currency, group of currencies or standard.
 It is a monetary policy tool used by countries that have a fixed exchange rate
or nearly fixed exchange rate regime and involves a discrete official reduction
in the otherwise fixed par value of a currency.
 The monetary authority formally sets a new fixed rate with respect to a foreign
reference currency or currency basket. In contrast, depreciation is a decrease in
a currency's value (relative to other major currency benchmarks) due to market
forces under a floating exchange rate and not due to any government or central
bank policy actions.
 Revaluation is the opposite of devaluation and the term refers to a discrete raising of
the otherwise fixed par value of a nation's currency.
 Appreciation, on the other hand, is an increase in a currency's value (relative
to other major currencies) due to market forces under a floating exchange rate
and not due to any government or central bank policy interventions.
Effect of currency depreciation on the economy:

Solution:
 Depreciation lowers the relative price of a exports and raises the relative price of its
imports. When a country’s currency depreciates, foreigners find that its exports are
cheaper and domestic residents find that imports from abroad are more expensive.
 Importers will be affected most as they will have to pay more rupees on importing
products.
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 A depreciation of domestic currency primarily increases the price of foreign goods

relative to goods produced in the home country and diverts spending from foreign
goods to domestic goods. Increased demand, both for domestic import-competing
goods and for exports encourages economic activity and creates output expansion.
 By lowering exports prices, currency depreciation helps increase the international

competitiveness of domestic industries, increases the volume of exports and
promotes trade balance.
 When a country’s currency depreciates, production for exports and of import

substitutes become more profitable.
 The fiscal health of a country whose currency depreciates is likely to be affected

with rising export earnings and import payments and consequent impact on current
account balance.
 Depreciation is also likely to add to consumer price inflation in the short run, directly
through its effect on prices of imported consumer goods and also due to increased
demand for domestic goods.
 Depreciation may also cause contractionary effects. In an under developed or semi

industrialized country, where- input (such as oil) and components for manufacturing
are mostly imported and cannot be domestically produced, increased import prices
will increase firms’ cost of production, push domestic prices up and decrease real
output.
 A widening current account deficit is a danger signal as far as growth prospects of
the overall economy is concerned. If export earnings rise faster than the imports
spending then current account will improve otherwise not.
 A depreciated domestic currency would also increase debt burden on institutions

and lower their profits and impact their balance sheets adversely.
Effect of Currency Appreciation on the Economy.

Solution:
 Exports become more expensive. The price exports will increase making exports
more expensive. Therefore with higher price, we would expect to see a fall in the
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quantity exports.
 Imports become cheaper: Domestic consumers will find that more goods can be
purchased with the same amount of money. Therefore, with cheaper imports, we
would expect to see an increase in the quantity of imports.
 Lower inflation. An appreciation tends to cause lower inflation beacsuse import

price are cheaper. The cost of imported goods and raw materials will fall after an
appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
 If the economy is facing a boom, an appreciation of domestic currency would trim

inflationary pressures and soften the rate of growth of the economy.
 With increasing export prices, the competitiveness of domestic industry is adversely

affected and, therefore, firms have greater incentives to introduce technological
innovations and capital intensive production to cut costs to remain competitive.
Q. Explain Cross Rates

Ans. There may be two pairs of currencies with one currency being common between
the two pairs. For instance, exchange rates may be given between a pair, X and
Y and another pair, X and Z. The rate between Y and Z is derived from the given
rates of the two pairs (X and Y, and, X and Z) and is called ‘cross rate’. When there
is no difference between the buying and the selling rate, the rate is said to be
‘unique’ or ‘unified’. But, in practice, it is rarely so. . There are generally two rates –
selling rate and buying rate – for any currency when one goes to exchange it in the
market. Selling rate is generally higher than the buying rate for a currency. This is
the commission of the money exchanger (dealer) to run its operations.
Q. Explain in detail Arbitrage

Ans. Arbitrage refers to the practice of making risk-less profits by intelligently exploiting
price differences of an asset at different dealing locations. There is potential for
arbitrage in the forex market if exchange rates are not consistent between currencies.
When price differences occur in different markets, participants purchase foreign
exchange in a low-priced market for resale in a high-priced market and makes
profit in this process. Due to the operation of price mechanism, the price is driven
up in the low- priced market and pushed down in the high-priced market. This
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activity will continue until the prices in the two markets are equalized, or until they
differ only by the amount of transaction costs involved in the operation. Since forex
markets are efficient, any profit spread on a given currency is quickly arbitraged
away.
Q. Explain Terms of Trade

Ans. A depreciation or devaluation is also likely to affect a country’s terms of trade.
(Terms of trade is the ratio of the price of a country’s export commodity to the price
of its import commodity) Since the prices of both exports and imports rise in terms
of the domestic currency as a result of depreciation or devaluation, the terms of
trade of the nation can rise , fall or remain unchanged, depending on whether price
of exports rises by more than , less than or same percentages as price of imports.
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UNIT 5 : INTERNATIONAL CAPITAL MOVEMENTS
 What are the different types of foreign capital?

Solution:
‘Foreign capital” is a comprehensive term which takes into consideration any inflow of
capital into the home country from abroad. Foreign capital may flow into an economy
in different ways. Some of the important components of foreign capital flows are:
1. Foreign aid or assistance which may be:

a) Bilateral or direct inter-government grants
b) Multilateral aid from many governments who pool funds to international
organization like the World Ban
c) Tied aid with strict mandates regarding the use of money or united aid where
there are no such stipulations
d) Foreign grant which are voluntary transfer of resources by governments,
institutions, agencies or organizations
2. Borrowings which may take different forms such as:

a) Direct inter-government loans
b) Loans from international institutions (e.g. world bank, IMF, ADB)
c) Soft loans for e.g. from affiliates of World Bank such as IDA
d) External commercial borrowing, and
e) Trade credit facilities
3. Deposits from non-resident Indians (NRI)

NRI deposits refers to funds deposited by a Non-Resident Indian or NRI with a
financial institution authorized by the Reserve Bank of India to provide such services.
A Non-Resident Indian citizen who primarily resides outside of India.
4. Investment in the form of:

a) Foreign portfolio investment (FDI) in bonds, stocks and securities, and
b) Foreign direct investment (FDI) in industrial, commercial and similar other

enterprises.
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Define foreign direct investment (FDI). What are the features of FDI?
Solution:
Foreign direct investment (FDI) is an investment made by a company or individual in
one country in business interest in another country, in the form of either establishing
business operations or acquiring business assets in the other country, such as ownership
or controlling interest in a foreign company.
FDI has three components, viz., equity capital, reinvested earnings and other direct capital
in the form of intra-company loans between direct investors (parent enterprises) and
affiliate enterprises.
Foreign direct investor may be individuals, incorporated private or public enterprises,
Associated groups of individuals or enterprises, governments or government agencies,
estates, trusts, or other organizations or any combination of the above mentioned entities.
The main forms of direct investments are: the opening of overseas companies, including
the establishment of subsidiaries of branches, creation of joint ventures on a contract
basis, joint development of natural resources and purchase or annexation of companies
in the country receiving foreign capital.
Following are the main features of FDI:

 Investment involves creation of physical assets
 Has a long term interest and therefore remain invested for long
 Relatively difficult to withdraw
 Not speculative in nature
 Often accompanied by transfer of Funds, resources, technology, strategies,
know-how etc.
 Direct impact on employment of labour and wages
 Provides interest in management and control
What are the characteristics of foreign portfolio investment (FPI)?

Solution:
Foreign Portfolio Investment (FPI) also very commonly known as Foreign Institutional
Investment, consists of securities and other financial assets passively held by foreign
investors. It does not provide the investor with direct ownership of financial assets and is
relatively liquid depending on the volatility of the market.
Unlike FDI, portfolio capital, in general, moves to investment in financial stocks, bonds
and other financial instruments and is effected largely by individuals and institutions
through the mechanism of capital market. These flows of financial capital have their
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immediate effect on balance or exchange rates rather than on production or income

generation.
Foreign portfolio investment (FDI) is not concerned with either manufacture of goods
or with provision of services. Such investor also do not have any intention of exercising
voting power or controlling or managing the affairs of the company in whose securities
they invest. The singular intention of a foreign portfolio investor is to earn a remunerative
return through investment in foreign securities and is primarily concerned about the safety
of their capital, the likelihood of appreciation in its value, and the return generated.
Logically, portfolio capital moves to a recipient country which has revealed its reveled its
potential for higher returns and profitability.
Following are the main characteristics of FPI:

 Investment is only in financial assets
 Only short term interest and generally remain invested for short periods.
 Relatively easy to withdraw
 Speculative in nature
 Transfer of Funds only
 No direct impact on employment of labour and wages
 Increase in capital inflow in the country only.
 No abiding interest in management and control
 Securities are held purely as a financial investment and no significant degree of
influence on the management of the enterprise
 Explain the different modes of foreign direct investment (FDI)?

Solution:
Foreign direct investment (FDI) is an investment made by a company or individual in
one country in business interest in the another country, in form of either establishing
business operations or acquiring business assets in the other country, such as ownership
or controlling interest in a foreign company.
Foreign direct investments can be made in a variety of ways (modes), such as:
a) Opening of a subsidiary or associate company in a foreign country,
b) Equity injection into an overseas company,
c) Acquiring a controlling interest in an existing foreign company,
d) Mergers and acquisitions (M&A)
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e) Joint venture with foreign company.

f) Green field investment (establishment of a new overseas affiliates for freshly starting
production by a parent company).
 Distinguish between FDI and FPI

Solution:
Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment involves creation of physical Investment is only in financial assets
assets
Has a long term interest and therefore Only short term interest and generally
remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not speculative in nature Speculative in nature
Often accompanied by transfer of Funds, Transfer of Funds only.
resources, technology, strategies, know-
how etc.
Direct impact on employment of labour No direct impact on employment of
and wages labour and wages
Increase in country’s Gross Domestic Increase in capital inflow in the country
Product (GDP) only
 Which are the sectors in India where FDI is prohibited? Why?

Solution:
In India, foreign investment is prohibited in the following sectors:

a) Lottery business including Government/private lottery, online lotteries, etc.
b) Gambling and betting including casinos etc.
c) Chit funds
d) Nidhi company
e) Trading in Transferable Development Right (TDRs)
f) Real Estate Business or Construction of Farm Houses
g) Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco
substitutes.
Write a note on Exchange rate.

The term ‘Foreign Exchange’ refers to money denominated in a currency other than the
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domestic currency. Similar to any other commodity, foreign exchange has a price. The
exchange rate, also known as a foreign exchange (FX) rate, is the price of one currency
expressed in terms of units of another currency and represents the number of units of one
currency that exchanges for a unit of another.
An exchange rate has two currency components; a ‘base currency’ and a ‘counter currency’.
In a direct quotation, the foreign currency is the base currency and the domestic currency
is the counter currency. In an indirect quotation, the domestic currency is the base currency
and the foreign currency is the counter currency. As the US dollar is the dominant currency
in global foreign exchange markets, the general convention is to apply direct quotes that
have the US dollar as the base currency and other currencies as the counter currency.
Question
THE EXCHANGE RATE REGIMES?
Answer
An exchange rate regime is the system by which a country manages its currency with
respect to foreign currencies. It refers to the method by which the value of the domestic
currency in terms of foreign currencies is determined. There are two major types of
exchange rate regimes at the extreme ends; namely:
(i) floating exchange rate regime (also called a flexible exchange rate), and
(ii) fixed exchange rate regime
A fixed exchange rate, also referred to as pegged exchanged rate, is an exchange rate
regime under which a country’s Central Bank and/ or government announces or decrees
what its currency will be worth in terms of either another country’s currency or a basket
of currencies or another measure of value, such as gold.
Under floating exchange rate regime, the equilibrium value of the exchange rate of a
country’s currency is market-determined i.e. the demand for and supply of currency
relative to other currencies determine the exchange rate.
The following listed are the IMF classifications and definitions of prevalent exchange
rate systems on the distribution of the 189 IMF members based on their exchange rate
regimes.
1. Exchange arrangements with no separate legal tender (13 countries)
E.g. Kosovo –Euro Ecuador, El Salvador - US Dollar
Meaning: Currency of another country circulates as sole legal tender or member
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belongs to a monetary or currency union in which same legal tender is shared by

members of the union.
2. Currency Board Arrangements (11 Countries)
E.g. Hong Kong, Dominica, Grenada etc.- Dollar Bosnia and Herzegovina, Bulgaria-Euro.
Meaning: Monetary regime based on implicit national commitment to exchange
domestic currency for a specified foreign currency at a fixed exchange rate.
3. Other conventional fixed peg arrangement (43 Countries)
E.g. Oman, Qatar, Saudi Arabia, United Arab Emirates etc. to -US Dollar Mali, Niger,
Senegal, Cameroon etc. – Euro,
Meaning: Country pegs its currency (formal or de facto) at a fixed rate to a major
currency or a basket of currencies where exchange rate fluctuates within a narrow
margin or at most ± 1% around central rate.
4. Pegged exchange rates within horizontal bands (1Country)
Eg: Tonga.
Meaning: Value of the currency is maintained within margins of fluctuation around a
formal or de facto fixed peg that are wider than ± 1% around central rate.
5. Crawling Peg (3 countries)
Eg: Honduras, Nicaragua, Botswana.
Meaning: Currency is adjusted periodically in small amounts at a fixed, preannounced
rate in response to changes in certain quantitative indicators.
6. Crawl –like arrangement (15 Countries)
E.g. Iran, Afghanistan, Costa Rica.
Meaning: Currency is maintained within certain fluctuation margins say (±1-2%)
around a central rate that is adjusted periodically.
7. Other Managed Arrangement (13 countries)
E.g. Cambodia, Liberia, Zimbabwe.
Meaning: This category is a residual, and is used when the exchange rate arrangement
does not meet the criteria for any of the other categories. Arrangements characterized
by frequent shifts in policies may fall into this category.
8. Floating (35 Countries)
E.g.India, Philippines, Malaysia.
Meaning: Monetary authority influences the movements of the exchange rate through
intervention in foreign exchange markets without specifying a pre-announced path
for the exchange rate.
9. Free floating (31Countries)
E.g. US, Canada, Japan, New Zealand, UK.
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Meaning: Exchange rate is market determined, with foreign exchange intervention

aimed at moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it.
Question
NOMINAL VERSUS REAL EXCHANGE RATES.
Answer
The nominal exchange rate is the rate at which currency can be exchanged. If the nominal exchange
rate between the dollar and the Rupees is 75, then one dollar will purchase 75 Rupees. Exchange
rates are always represented in terms of the amount of foreign currency that can be purchased for
one unit of domestic currency. Thus, we determine the nominal exchange rate by identifying the
amount of foreign currency that can be purchased for one unit of domestic currency.
The real exchange rate is a bit more complicated than the nominal exchange rate. While
the nominal exchange rate tells how much foreign currency can be exchanged for a unit
of domestic currency, the real exchange rate tells how much the goods and services in
the domestic country can be exchanged for the goods and services in a foreign country.
The real exchange rate is represented by the following equation:
real exchange rate = (nominal exchange rate X domestic price) / (foreign price).
Question
DETERMINATION OF NOMINAL EXCHANGE RATE.
Answer
Individuals, institutions and governments participate in the foreign exchange market for
a number of reasons.
On the demand side & Supply side, foreign currency is influenced due to:
• purchase & Sale goods and services from another country
• for unilateral transfers such as gifts, awards, grants, donations or endowments
• to make or receive investment income payments abroad
• to purchase & sale financial assets, stocks or bonds abroad
• to open a foreign bank account.
• to acquire direct ownership of real capital, and
• for speculation and hedging activities related to risk-taking or risk avoidance activity.
We shall now look into how the foreign exchange markets work. Similar to any
standard market, the exchange market also faces a downward-sloping demand
curve and an upward-sloping supply curve.
315
 Describe Reasons for FDI

Solution:
Economic prosperity and the relative abundance of capital are necessary prerequisites for
export of capital to other countries. Many economies and organizations have accumulation
of huge mass of reserve capital seeking profitable use. The primary aim of economic
agent being maximization of their economic interests, the opportunity to generate profits
available in other countries often entices such entities to make investments in the other
countries.
Following are the main factors influencing foreign direct investments:
 The increasing interdependence of national economies and the consequent trade
relations and international industrial cooperation established among them
 Internationalization of production and investment of transnational corporations in
their subsidiaries and affiliates.
 Desire to reap economies of large-scale operation arising from technological growth
 Lack of feasibility of licensing agreement with foreign producers in view of the rapid
rate of technological innovations
 Necessity to retain direct control of production knowledge or managerial skill (usually
found in monopolistic or oligopolistic markets) that could easily and profitably be
utilized by corporations
 Desire to procure a promising foreign firm to avoid future competition and the
possible loss of export markets.
 Risk diversification so that recessions or downturns may be experienced with reduced
severity
316
 Shared common language or common boundaries and possible saving in time and
transport costs because of geographical proximity
 Necessity to retain complete control over its trade patent and to ensure consistent
quality and service or for creating monopolies in a global context
 Promoting optimal utilization of physical, human, financial and other resources
 Lower environment standards in the host country and the consequent relative saving
in costs
 Stable political environment and overall favourable investment climate in the host
country
 What are the factors in the host country that discourage inflow of foreign investments?
Solution:
Inflow of foreign capital to any country largely happen due to the potential of the host
country to allow the investment grow at a higher rate in the long run due to unutilized
potential in the host country.
But there may be several factors which may discourage the inflow of foreign capital in
the host country.
Following are the main factors that may discourage inflow of foreign capital:
 Host country discouraging inflow of foreign investment are infrastructure lags,
 High rate of inflation,
 Balance of payment deficits,
 Poor literacy and low labour skills,
 Rigidity in the labour market,
 Bureaucracy and corruption,
 Unfavourable tax regime and cumbersome legal formalities and delays,
 Small size of market and lack of potential for its growth,
 Political instability,
 Absence of well-defined property rights,
 Exchange rate volatility,
 Poor track-record of investments,
 Prevalence of non-tariff barriers and stringent regulations,
 Lack of openness,
 Language barriers
317
 Merits of FDI
Solution:
Following are some of the benefits of Foreign Direct Investments in the host country:
 FDI foster competition and generates a competitive environment in the host country.
The domestic enterprises are compelled to compete with the foreign enterprises
operating in the domestic market. This results in positive outcomes in the form of
cost-reducing and quality-improving innovations, higher efficiency.
 FDI can accelerate growth and foster economic development by providing the
much needed capital, technological know-how, management skills and marketing
methods and critical human capital skills in the form of managers and technicians.
 Competition for FDI among national governments also has helped to promote
political reforms important to attract foreign investors, including legal systems and
macroeconomics polices.
 FDI generates direct employment in the host country. Subsequent FDI as well as
domestic investments propelled in the downstream and upstream project that
comes up in multitude of other services generate multiplier effects on employment
and income.
 There is also greater possibility for the promotion of ancillary units resulting in job
creation and skill development for workers.
 Increased competition resulting from the inflow of foreign direct investments facilities
weakening of the market power of domestic monopolies.
 Demerits of FDI
Solution:
Some skeptics argue that foreign entities are highly focused on profits and have eye
on exploiting the natural resources and are almost always not genuinely interested in
the development needs of host countries. Foreign capital is perceived by the critics as
an instrument of imperialism, or as a perpetrator of dependence and inequality both
between nations and within nations.
Following are the general arguments put forth against the entry of foreign capital:
 FDI are likely to concentrate on capital-intensive methods of production and service
318
so that they need to hire only relatively few workers. This may lead to severe
unemployment in a labour abundant economies.
 If the host corporations are able to secure incentives in form of tax holidays or
similar provisions, the host country loses tax revenues.
 When profits are repatriated, a strain is placed on the host country’s balance of
payments and the home currency leading to its depreciation.
 Jobs that require expertise and entrepreneurial skills for creative decision making
may generally be retained in the home country and therefore the host country is left
with routine management jobs that demand only lower levels of skills and ability.
 Foreign entities are usually accused of being anti-ethical as they frequently resort
to methods like aggressive advertising and anticompetitive practices which would
induce market distortions.
 FDI is also held responsible by many for ruthless exploitation of natural resources
and the possible environmental damage.
Fixed Exchange Rate or Pegged exchange rate ?

Solution:
a) Under fixed exchange rate system country’s government and central bank decides
the rate and direction of currencies
b) When exchange rate is generally determined by the market force. (Time being) it is
called Soft peg
c) When central bank sets fixed on unchanging value of exchange it is called hard peg.
d) A fixed exchange rate avoids currency fluctuations and eliminates exchange rate
risks.
e) This system imposes discipline on country’s monetary authorities and therefore
likely to generate lower level inflation
f) Fixed exchange rate system encourages greater trade and investment and also
ensures stabilities
g) Under fixed exchange rate system countries have to maintain adequate amount of
foreign exchange reserves.
319
 Flexible exchange rate system. Or Floating exchange rate ?

Solution:
a) Under this system equilibrium exchange rates of countries’ currencies is market
determined. (i.e.) Demand for and supply of currency relative to other currency
determines the exchange rate.
b) Under this system, there is no intervention of central bank or government
c) Under floating exchange rate system, central bank can pursue its own independent
monetary policies.
d) Under floating exchange rate, countries are not required to maintain huge foreign
exchange reserve
e) The greatest Disadvantage of floating exchange rate, it generates lots of uncertainty
to International transactions.
f) This system has a greater policy flexibility but less stability.
 Difference between Spot Exchange Rate and Forward Exchange Rate:

Solution:
Spot Exchange Rate Forward Exchange Rate
It is an exchange rate which is quote at a It is an rate which is quoted for a
particular time and payable on the spot transaction over the period of time. The
for immediate delivery of foreign current actual transaction would materialized
in future at predetermined rate
In case of spot exchange rate, physical In case of forward rate there is no
delivery of foreign exchange takes place immediate physical delivery as
immediately however in case of whole transaction takes place in future.
sale transaction it may T+ 2days.
Spot exchange rate is a current date It is used for transaction in future. This
which is determined by market force of rate is agreed upon by buyers & sellers
demanding & supply. at predetermined price.
Spot exchange rate doesn’t provide Forward exchange rate is a part of
hedging facility as transaction is done hedging process which helps to minimize
on the spot. foreign exchange fluctuation risk.
THE WTO: A FEW CONCERNS

 The progress of multilateral negotiations on trade liberalization is very slow and
the requirement of consensus among all members acts as a constraint and creates
rigidity in the system.
320
 The complex network of regional agreements introduces uncertainties and murkiness

in the global trade system.
 While multilateral efforts have effectively reduced tariffs on industrial goods, the
achievement in liberalizing trade in agriculture, textiles, and apparel,
 (iv)Doha Development Round, have run into problems, and their definitive success is
doubtful.
 Most countries, particularly developing countries are dissatisfied with the WTO
because, in practice, most of the promises has not materialized.
o The developing countries contend that the real expansion of trade in the three
key areas of agriculture, textiles and services has been dismal.
o The developing countries have raised a number of issues in the Doha Agenda in
respect of the difficulties that they face in implementing the present agreements.
o Developing countries complain that they face exceptionally high tariffs on
selected products in many markets and this obstructs their vital exports.
Examples are tariff peaks on textiles, clothing, and fish and fish products.
o Another major issue concerns ‘tariff escalation’ where an importing country
protects its processing or manufacturing industry by setting lower duties on
imports of raw materials and components, and higher duties on finished
products.
o The least-developed countries find themselves disproportionately
disadvantaged and vulnerable with regard to adjustments due to lack of
human as well as physical capital, poor infrastructure, inadequate institutions,
political instabilities etc.
321
NATIONAL INCOME NUMERICAL SUMS
Q.1 Computation of national Income:

Consumption = 750.00
Investment = 250.00
Gov. Purchase = 100.00
Export = 100.00
Import = 200.00
Q.2 Calculate GDPMP & National Income.

Personal consumption Expenditure 6,500.00
Indirect taxes – subsidies 150.00
State Gov. Consumption & investment exp. 2,000.00
Central Gov. Consumption & investment exp. 500.00
Change in inventory 100.00
Gross private domestic fixed investment 1,200.00
Exports 900.00
Net factor payment to abroad (-) 100.00
Imports 1,200.00
Depreciation 200.00
Q3. Calculate GDPMP & National Income

Inventory Investment 100.00
Indirect taxes 100.00
Export 200.00
Net factor Income from abroad - (50).00
Personal consumption expenditure 3,500.00
Gross residential construction investment 300.00
Depreciation 50.00
Imports 100.00
Stock Gov. purchased goods & services 1,000.00
322
Gross public investment 200.00

Gross business fixed investment 300.00
Q.4 Calculation national Income & personal Disposable Income.

GDPMP 6,000.00
Receipts of factor income from abroad 150.00
Depreciation 800.00
Indirect taxes 700.00
Payment of factory income from abroad 225.00
Corporates profits 1,200.00
Dividend 600.00
Transfer payment 1,300.00
Personal Income Tax 1,500.00
Q.5 Calculate GNPMP by using value method.

Value of output in primary sector 500.00
NFIA (-) 20.00
Value of output in Tertiary 700.00
Value of output in secondary sector . 900.00
Govt. transfer payments 600.00
Intermediate consumption in tertiary 300.00
Intermediate consumption in primary sector 250.00
Intermediate consumption in secondary sector 300.00
Q.6. Illustration: Relationship between National Income Measures.

From the following data, calculate Personal Income and Disposable Income. Rs. Crores
(a) Net Domestic Product at Factor Cost (e) Interest Received by Households
8,000 1,500
(b)Net Factor Income from Abroad (f) Interest Paid by Households
200 1,500
(c) Undisbursed Profit (g) Transfer Income
1,000 300
(d) Corporate Tax 500 (h) Personal Tax
500
323
Q.7 Illustration: Consumption Function

Assume that an Economy’s Consumption Function is specified by the equation C =
6,000 + 0.75Y. Answer the following –
(a) What will be the Consumption when Disposable Income (Y) is Rs. 20,000, Rs.
25,000 and Rs. 30,000?
(b) Find the saving when disposable Income is Rs. 20,000, Rs. 25,000 and Rs. 30,000.
(c) What amount of Consumption for Consumption Function C is autonomous?
(d) What amount is induced when Disposable Income is Rs. 20,000, Rs. 25,000 and Rs.
30,000?
Q8. Illustration: Consumption Function

Consider the following information and frame the Consumption Function. Also
compute Income (Y), when the amount of consumption is Rs. 36,000.
 Autonomous Consumption even at Zero Level of Disposable Income = Rs. 9,000
 Marginal Propensity to save = 0.40
Q9. On the basis of the following data about an economy which consists of only two
Firms, find out:
(a) Value Added by firm A and B and
(b) Gross Value Added or Gross Domestic Product at Factor Cost.
Items (` in Lakh)
(i) Sales by firm A 100
(i) Purchases from firm B by firm A 40
(ii) Purchases from firm A by firm B 60
(iii) Purchases from firm A by firm B 60
(Iv) Sales by firm B 200
(v) Closing stock from A 20
(vi) Closing stock from B 35
(vii) Opening stock of firm A 25
(viii) Opening stock of firm B 45
(ix) Indirect taxes paid by both firms 30
324
Q.10 Calculate:
(a) Gross Value Added at Market Price, and
(b) National Income from the following data.
Items (`in lakhs )
(i) Value of output:
(a) Primary sector 800
(b) Secondary sector 200
(c) Tertiary sector 300
(ii) Value of intermediate inputs purchased by:
(a) Primary sector 400
(b) Secondary sector 100
(c) Tertiary sector 50
(iii) Indirect taxes paid by all sectors 50
(iv) Consumption of fixed capital of all sectors 80
(v) Factor income received by the residents from rest of
the world 10
(vi) Factor income paid to non-residents 20

(vii) Subsidies received by all sectors 20
Q.11.Given the following data and using income method calculate:

(a) Net Domestic Income, (b) Gross Domestic Income,
(c) Net National Income, and (d) Net National Product at market Price.
Items (` in crore)
(i) Indirect taxes 9,000
(ii) Subsidies 1,800
(iii) Depreciation 1,700
(iv) Mixed income of self – employed 28,000
(v) Operating Surplus 10,000
(vi) Net factor income from abroad (-) 300
(vii) Compensation of employees 24,000
325
Q.12. From the following data, calculate the GDP at both (a) market price, and (b)
Factor cost.
Items (` in crore)
(i) Gross Investment 90
(ii) Net exports 10
(iii) Net indirect taxes 5
(iv) Depreciation 15
(v) Net factor income from abroad (-) 5
(vi) Private consumption expenditure 350
(vii) Government purchases of goods and services 100
Q.13.Calculate GDPMP, GDPFC & National Income

Private final consumption expenditure 290.00
Gov. Final consumption expenditure 50.00
Subsidies 20.00
Gross Domestic fixed capital formation 105.00
Indirect Tax 70.00
Consumption of fixed capital 45.00
NFIA (-) 5.00
Net addition to stock 15.00
Net exports -5.00
Q14. Calculate NDPMP & National Income

Subsidies 10.00
Sales 1,000.00
Closing stock 100.00
Indirect tax 50.00
Intermediate consumption 300.00
Opening Stock 200.00
NFIA 10.00
326
Q.15. Illustration – Estimation of National Income by Value Addition

Suppose only the following transactions take place in an economy:
 Industry A imports goods worth Rs. 100. It sells goods worth Rs. 400 to Industry
B, goods worth Rs. 200 to Industry C, and goods worth Rs. 1,000 for Private
Consumption.
 Industry B sells goods worth Rs. 500 to Industry C and goods worth Rs. 800 for
Private Consumption.
 Industry C sell goods worth Rs. 600 to Private Consumption and Export goods
valued at Rs. 500.
 Depreciation Coast during the year is Rs. 100,
 Government realizes Indirect taxes of the valued of Rs. 100. Subsidies paid by
Government is Rs. 50.
Calculate the following with the help of Net Value Added Method: (a) GNP (MP) (b)
GNP (FC) (c) NNP (MP) and (d) NNP (FC)
Q16. Illustration: Relationship between National Income Measures

GDP at Market Prices of a country in a particular year was Rs. 1,100 Crores. Net
Factor Income from Abroad was Rs. 100 Crores. The value of Indirect Taxes –
Subsidies was Rs. 150 Crores. NNPfc `850 Cr. Calculate the aggregate value of
Depreciation.
Q17. An economy has only two firms A and B. on the basis of following information about
these firms, find out:
(a) Value Added by firms A and B, and
(b) Gross Domestic Product at Market Price.
Items (` in Lakh)
(i) Exports by firm A 20
(i) Imports by firm A 50
(ii) Sales to households by firm A 90
(iii) Sales to firm B by firm A 40
(Iv) Sales to firm A by firm B 30
(v) Sales to households by firm B 60
327
Q.18. Calculate Net Domestic Product at Factor Cost from the following data using product
method.
Items Primary Sector Secondary Tertiary

Sector Sector
(i) Sales 100 150 130
(ii) Closing stock 15 20 25
(iii) Intermediate Consumption 15 25 15
(iv) Opening stock 10 10 15
(v) Indirect tax 12 13 17
(vi) Subsidies 7 8 7
(vii) Consumption of fixed capital 10 12 15
(viii) Expenses of electricity and 3 4 3
fuel
Q.19. The Following information is available for an economy. On the basis of this Information
using income method, calculate: (a) Domestic Income, and (b) National income
Items (` in crore)
(i) Wages 10,000
(ii) Rent 5,000
(iii) Interest 400

(iv) Dividend 3,000
(v) Mixed Income 400
(vi) Undistributed profit 200
(vii) Social security contribution 400
(viii) Corporate Profit Tax 400
(ix) Net Factor Income from abroad 1,000
Q20. Find NDPFC from the following
Items (` in crore)
(i) Gross domestic fixed investment 10,000
328
(ii) Inventory investment 5,000

(iii) Depreciation 2,000
(iv) Indirect taxes 1000
(v) Subsidies 2000
(vi) Consumption expenditure 20,000
329
NATIONAL INCOME NUMERICAL SUMS SOLUTIONS
Q.1
Solution:
Consumption = 750.00
+ Investment = 250.00
+ Gov. Purchase = 100.00
+(X - M) 100 - 200 = (100.00)
NNPfc 1,000.00

Q.2
Solution:
Personal consumption Expenditure 6,500.00
State Gov. Consumption & invest. Exp. 2,000.00
Central Gov. Consumption & invest. Exp. 500.00
Gross private domestic fixed investment 1,200.00
(Import- Export ( 1,200.00 – 900.00) 300.00
GDPMP 10,000.00
National Income.
Personal consumption Exp. 6,500.00
Indirect taxes – subsidies (150).00
State Gov. Consumption & investment 2,000.00
Central Gov. Consumption & investment 500.00
Gross private domestic fixed invest. 1,200.00
(Import – Export) (1,200.00 – 900.00) (300).00
Net factor payment to abroad 100.00
Dep. (200).00
9,750.00

330
Q.3
Solution:
Import – Export (100 – 200) 100.00
Personal consumption exp 3,500.00
Gross residential contru. Invest 300.00
Gov. purchased good & services 1,000.00
Gross business fixed invest. 300.00
GDPMP 5,500.00
Import – Export (100 – 200) 100.00
Indirect Taxes (100).00
Net factor Income from abroad (50).00
Personal consumption exp. 3,500.00
Gross residential constr. Invest 300.00
Dep. (50).00
Gov. Purchase goods & serv. 1,000.00
Gross business fixed inv. 300.00
5,300.00
Q.4
Solution:
National Income
GDPMP 6,000.00
Recepits of factor income from abroad 150.00
Dep. (800).00
Indirect taxes (700).00
Payments of factor income from abroad (225).00
National Income 4,425.00
National Income 4,225.00
Retained earnings (1,200.00 – 600.00) (600).00
+ Transfer payment 1,300.00
(-) Personal Income Tax (1,500).00
3,625.00

331
Q.5
Solution:
Value of output in primary sector 500.00
Value of output in secondary sector 700.00
Value of output in tertiary sector 900.00
(A) 2,100.00

Value of intermediate in primary 250.00
Value of intermediate in secondary 300.00
Value of intermediate in tertiary 300.00
(B) 850.00
(A – B) 1,250.00
- NFIA 20.00
1,230.00

Q.6
Solution:
Relationship between NDP at FC, NNP, at FC, Personal Income and Personal Disposable
Income is given in the following Table. Since Interest Received and Paid by Household is
the same, its Net Effect is ignored. Rs. Crores
Net Domestic Product at Factor Cost 8,000
Add: Net Factor Income from Abroad 200
National Income = Net National Product at Factor Cost 8,200
Add: Incomes Received but not “earned”, i.e. Transfer Payments 300
Less: Incomes Earned, but not received, e.g. Contribution to Social 1,000 + 500 =
Insurance, Corporate Income Taxes, Retained Corporate Earning, (1,500)
etc.
Personal Income 7,000
Less: Personal Income Taxes (500)
Personal Disposable Income 6,500
332
Q.7
Solution:
If Disposable Income (Y) is Rs. 20,000 Rs. 25,000 Rs. 30,000
(a) Consumption (C) = 6,000 + (0.75 x 6,000 + (0.75 x 6,000 + (0.75 x
6,000+0.75Y 20,000) 25,000) 30,000)
= Rs. 21,000 = Rs. 24,750 = Rs. 28,500
(b) Saving (S) = Y- C 20,00-21,000= 25,000 – 30,000 –
[Note 1] Dissaving (Rs. 24,750 28,500
1,000) = Rs. 250 = Rs. 1,500
(c) Autonomous Consumption [Note 2] Rs. Rs. 6,000 Rs. 6,000
6,000
(d) Induced Consumption Rs. 15,000 Rs. 18,750 Rs. 22,500
= C-a
Note:
1. Saving is the difference between Disposable Income and Consumption. It is the
difference between the Consumption line and the 45 Degree line at each level of
Disposable Income.
2. For the consumption Function C = a + by, where “a” = a constant which represents
the positive value of Consumption at Zero Level of Disposable Income. Hence, in this
case, a = Rs. 6,000. This is also the point at which the consumption Line intersects
the vertical axis (Y – Axis). This is called Autonomous Consumption, i.e. unconnected
with Income.
3. Induced Consumption is determined by the level of Income, i.e. it is Income-induced
Consumption and is computed as Total Consumption (-) Autonomous Consumption.
Q.18
Solution:
1. Consumption Function (C) = a + by. In case, a = 9,000 (given), b = MPC = 1 – MPS =1
– 0.4 = 0.6 Hence, Consumption Function (C) = 9,000 + 0.6Y
2. If the Consumption is 36,000, then (C) 36,000 = 9,000 + 0.6Y. Solving, we have,
Income (Y) = Rs. 45,000
333
Q.9
Solution:
(a) Value Added by firm A
= Sales by firm A – Purchases from firm B + Change in stock (Closing stock -
Opening stock)
= `100 lakh - `40 lakh + (` 20 lakh - ` 25 lakh)
= `100 lakh - `40 lakh `5 lakh
= `55 lakh
Value Added by firm B
= Sales by firm B – Purchases from firm A + Change in stock (Closing stock –
Opening stock)
= `200 lakh - ` 60 lakh + (`35 lakh - ` 45 lakh)
= `200 lakh - ` 60 lakh - `10 lakh
= `130 lakh
Ans. Value added by firm A = `55 lakh.
Value Added by firm B = `130 lakh.
(b) Gross Value Added or Gross Domestic Product at Factor Cost

= Value added by firm A + Value added by firm B – Indirect taxes
= `55 lakh + `130 lakh - `30 lakh
= `185 lakh - `30 lakh
= `155 lakh
Ans. Gross domestic product at factor cost = `155 lakh.
[ Note: Value by firm A and firm B here implies gross value added at market price.]
Q.10
Solution:
(a) Gross Value added at market Price
= Value of output of different sectors – value of intermediate inputs purchased by
different sectors
= `800 lakh + `200 lakh + `300 lakh - `400 lakh - `100 lakh - `50 lakh
= `750 lakh
Ans. Gross value added at market price = `750 lakh.
(b) National Income

= Gross domestic product at market price – Consumption of fixed capital – Indirect
334
taxes + subsidies + Factor income received by the residents from rest of the
world – Factor income paid to non-residents
= `750 lakh - `80 lakh - `50 lakh + `20 lakh + `10 lakh - `20 lakh
= `630 lakh
Ans. National Income = `630 lakh.
Q.11
Solution:
(a) Net Domestic Income
= Mixed income of self-employed + Operating surplus +
Compensation of employees
= `28,000 crore + `10,000 crore + `24,000 crore
= `62,000 crore
Ans. Net Domestic income = ` 62,000 crore
(b) Gross Domestic income

= Net domestic income + Depreciation
= `62,000 crore + `1,700 crore
= `63,700 crore
Ans. Gross domestic income = `63,700 crore
(c) Net National Income

= Net domestic Income + Net Factor income from abroad
= `62,000 crore + (-) `300 crore
= `62,000 crore - `300 crore
= `61,700 crore
Ans. Net national Income = `61,700 crore.
(d) Net National Product at Market price

= Net National Income + Indirect taxes - Subsidies
= `61,700 crore + `9,000 crore - `1,800 crore
= `68,900 crore
Ans. Net National Product at Market price = `68,900 crore.
335
Q.12
Solution:
(a) GDPMP = Gross investment + Net exports + Private consumption expenditure +
Government purchase of goods and service
= `90 crore + `10 crore + `350 crore + `100 crore
= `550 crore
Ans. GDPMP = `550 crore

(b) GDPFC = GDPMP – Net Indirect taxes

= `550 crore - `5 crore
= `545 crore
Ans. GDPFC = `545 crore
Q.13
Solution:
i) GDPMP
Private final consumption exp. 290.00
Net exports (-) 5.00
455.00

ii) GDPFC
Net exports 5.00
Indirect Tax (70).00
Subsidies 20.00
GDPFC 405.00

ii) National Income:
336

Subsidies 20.00
Indirect Tax (70).00
NFIA (5).00
Net exports (5).00
National Income 355.00
Q.14
Solution:
Sales 1,000.00
Change in stock (200 – 100) (100) .00
Intermediate cons. (300) .00
Consumption of fixed capital (150) .00
NDPMP 450.00
NDP 450.00
Subsidies (10).00
NFIA 10.00
Indirect tax (50).00
420.00
Q.15
Solution:
Particulars Industry A Industry B Industry C
Sale Price of Output 400 + 200 + 500 + 800 600 + 500
1,000 = 1,300 = 1,100
= 1,600
Less: Cost of Intermediate Consumption 100 400 200 + 500 =
700
Value Added by Industry 1,500 900 400
GDP at Market Price = GNP at Market Prices (no Net Factor Income from 2,800
abroad (100)
Less: Indirect Taxes
Add: Subsidies 50
337
Gross National Product at Factor Cost 2,750

Less: Depreciation (100)
Net National Product at Factor Cost 2,650
Less: Subsidies (50)
Add: Indirect Taxes 100
Net National Product at Market Prices 2,700
Q.16
Solution:
1. GNP at Market Prices = GDP at Market Prices + Net Factor Income from Abroad =
1,100 + 100 = 1,200.
2. NNP at Market Prices = NNP at Factor Cost + Net Indirect Taxes = 850 + 150 = 1,000
3. Hence, Depreciation = GNP at Market Prices (-) NNP at Market Prices = 1,200 – 1,000
= Rs. 200 Crores.
Q.17
Solution:
(a) Value Added by firm A

= Sales to households + Sales to firm B + Exports – Imports – Purchase
= `90 lakh + `40 lakh + `20 lakh - `50 lakh - `30 lakh
= `70 lakh
Value added by firm B
= Sales to firm A + sales to households – Purchases from firm A
= `30 lakh + `60 lakh - `40 lakh
= `50 lakh
Ans. Value added by firm A = `70 lakh.
Value added by firm B = `50 lakh.
(b) Gross Domestic product at Market Price

= Value added by firm A + Value added by firm B
= `70 lakh + `50 lakh
= `120 lakh
Ans. Gross domestic product at market price = `120 lakh.
[Note: Sum total of value added by firm A and firm B implies gross value added
because, there are only two firms in the economy.]
338
Q.18
Solution:
Gross Domestic Product at Market Price
= Sales + Closing stock – Opening stock – Intermediate consumption
= (100 + 150 + 130) + (15 + 20 + 25) – (10 + 10 + 15 ) – (15 + 25 + 15)
= 380 + 60 – 35 – 55
= 350
Net Domestic Product at Factor Cost
= Gross domestic Product at market price – Consumption of fixed capital – Indirect
tax + Subsidies
= 350 – (10 + 12 + 15) – (12 + 13 + 17) + (7 + 8 + 7)
= 350 – 37 – 42 + 22
= 293
Ans. Net domestic product at factor cost = 393.
Q.19
Solution:
(a) Domestic Income
= Wages + Rent + Interest + Dividend + Mixed income + Undistributed Profit +
Social security contribution + Corporate profit tax
= `10,000 crore + `5,000 crore + ` 400 crore + `3,000 crore + `400 crore + `200
crore + `400 crore + `400 crore = `19,800 crore
Ans. Domestic Income = `19,800 crore.
(b) National Income

= Domestic Income + Net Factor Income from abroad
= `19,800 crore + `1,000 crore
= `20,800 crore
Ans. National income = `20,800 crore
Q.20
Solution:
GDPMP
= Gross domestic fixed investment + Inventory investment + Consumption
expenditure
= `10,000 crore + `5,000 crore + `20,000 crore
339
= `35,000 crore
NDPFC
= GDPMP – Depreciation - Indirect taxes + Subsidies
= ` 35,000 crore - `2,000 crore - `1,000 crore + `2,000 crore
= ` 34,000 crore
Ans. NDPFC = `34,000 crore
340
Extra sum Chapter 1 & 3

Illustration 1
If the required reserve ratio is 10 percent, currency in circulation is ` 400 billion, demand
deposits are ` 1,000 billion, and excess reserves total ` 1 billion, find the value of money
multiplier.
Solution
r = 10% = 0.10
Currency = 400 billion
Deposits = 1000 billion
Excess Reserves = 1 billion
Money Supply is M = Currency + Deposits = 1400 billion
c = C/D =
400 billion/1000 billion =0.4 or depositors hold 40 percent of their money as currency
e = 1 billion/1000 billion = 0.001 or banks hold 0.1% of their deposits as excess reserves
Multiplier
= 1 + 0.4/0.1 + 0.001 + 0.4 = 1.5/0.501 = 2.79
Therefore, a 1 unit increase in MB leads to a 2.79 units increase in M.
Illustration 2
An economy is in equilibrium. Calculate national income from the following –
Autonomous consumption = 100; Marginal propensity to save = 0.2; Investment
expenditure = 200
Solution
Y=C+1
Y = C + MPC (Y) + 1 where MPC = 1 – MPS
Y = 100 + 0.8Y + 200 = 300 + 0.8Y
Y – 0.8YY = 300
0.2YY = 300
Y = 1500
Illustration 3
Calculate marginal propensity to consume and marginal propensity to save from the
following data about an economy which is in equilibrium.
National income = 25000, Autonomous consumption expenditure = 300, Investment
expenditure = 100
341
Solution
Y=C+1
By putting the value we get, 2500 = C + 100
C = 2500 – 100 = 2400
C = C + bY
2400 = 300 + 2500 b
2400 – 300 = 2500b
b = 0.84; MPS = 1 – MPC = 1 – 0.84 = 0.16
Illustration 4
An economy is characterised by the following equation –
Consumption C = 60 + 0.9Yd
Investment 1 = 10
Government expenditure G = 10
Tax T = 0
Exports X = 20
Imports M = 10 + 0.05Y
What is the equilibrium income?
Calculate trade balance and foreign trade multiplier.
Solution
Y = C + I + G + (X – M)
= 60 + 0.9(Y – 0) + 10 + 10 + (20 – 10 – 0.05Y)
= 60 + 0.9Y + 30 – 0.05Y
Y = 600
Trade Balance = X – M = 20 – 10 – 0.05(600) = - 20
Thus, trade balance in deficit.
Foreign trade multiplier = = 6.66
Illustration 5
Suppose the consumption function C = 7 + 0.5Y, Investment is ` 100. Find out equilibrium
level of Income, consumption and saving?
Solution
Equilibrium Condition –
342
Y = C + I, Given C = 7 + 0.5Y and I = 100

Therefore, Y = 7 + 0.5Y + 100
Y – 0.5Y = 107
Y= = 214
Y=C+I
214 = C + 100
C = 114
S = Y – C = 100
Illustration 6
Suppose the structural model of an economy is given –
C = 100 + 0.75 Yd; I = 200, G = T = 100; TR = 50, find the equilibrium level of income.
Solution
Y=C+I+G
Y = 100 + 0.75 Yd + 200 + 100
Y = 100 + 0.75(Y – 100 + 50) + 200 + 100
Y = 100 + 0.75Y – 75 + 37.5 + 200 + 100
Y = 1450
Or use Y = (a – bT + bTR + I + G) to calculate income.
Illustration 7
Suppose we have the following data about a simple economy:
C = 10 + 0.75Yd, I = 50, G = T – 20 where C is consumption, I is investment, Yd is disposable
income, G is government expenditure and T is tax.
(a) Find out the equilibrium level of national income.
(b) What is the size of the multiplier?
Solution
(a) Since G = T, budget for the government is balanced
Substituting the values of C, I and G in Y we have
Y=C+I+G
Y = a + bYd + I + G
Y = 10 + 0.75 (Y – 20) + 50 + 20
Y = 10 + 0.75 Y – 15 + 50 + 20
or, Y – 0.75 Y = 65
343
or, Y (1 – 0.75) = 65
or, 0.25 Y = 65
or, Y = 65/2.5 = 260
The equilibrium value of Y = 260
(b) The value of the multiplier is = 1/(1 – MPC) = 1/(1 – b) = 1/(1 – 0.75) = 1/0.25 = 4
Illustration 8
If saving function S = - 10 + 0.2Y and autonomous investment I = 50 Crores. Find out the
equilibrium level of income e, consumption and if investment increases permanently by
`5 Crores, what will be the new level of income and consumption?
Solution
S=I
- 10 + 0.2Y = 50
0.2Y = 50 + 10
Y = 300 Crores
C=Y–S
Where, S = 10 + 0.2 (300) = 50
C = 300 – 50 = 250 Crores
With the increase in investment by ` 5 Crores, the new investment will become equal to
` 55 Crores.
S=I
- 10 + 0.2Y = 55
Y = 325 Crores
C = 270 Crores
Illustration 9
The consumption function is C = 40 + 0.8Yd, T = 0.1Y, I = 60 Crores, G = 40 Crores,
X = 58 and M = 0.05Y. Find out equilibrium level of income, Net Export, net export if
export were to increase by 6.25.
Solution
C = 40 + 0.8Yd
C = 40 + 0.8(Y – 0.1Y)
Y = C + I + G + (X – M)Y = 40 + 0.8(Y – 0.1Y) + 60 + 40 + (58 – 0.05Y)
Y = 40 + 0.8(0.9Y) + 60 + 40 + 58 – 0.05Y
344
Y – 0.72Y + 0.05Y = 198

Y(1 – 0.72 + 0.05) = 198
Y(0.33) = 198
Y = 198/0.33 = 600 Crores
Net Export = X – M = 58 – 0.05Y
58 – 0.05 (600) = 58 – 30 = 28
If exports increase by 6.25, then exports = 64.25
Then Y = 40 + 0.8(Y – 0.1Y) + 60 + 40 + (64.25 – 0.05Y)
Y(1 – 0.72 + 0.05) = 204.5
Y(0.33) = 204.5
Y = 204.5/0.33 = 619.697
Then import = .05 ` 619.697 = 30.98
Net Export = 64.25 – 30.98 = 33.27 Crores
Thus, there is surplus in balance of trade as Net Exports are positive.
Illustration 10
Suppose the consumption of an economy is given by C = 20 + 0.6Y and investment
I = 10 + 0.2YY. What will be the equilibrium level of National Income?
Solution
Y = C + I = 20 + 0.6YY + 10 + 0.2Y
Y = 30 + 0.8Y
Y = 0.8Y = 30
Y = 150
Illustration 11
In an economy, investment is increases by `600 Crores. If the marginal propensity to
consume is 0.6, calculate the total increase in income and consumption expenditure.
Solution
MPC = 0.6, ∆I = ` 600 Crores
Multiplier (K) = 1/1 – MPC = 1/1 – 0.6 = 1/0.4 = 25.
Increase in income (∆Y) = K ` ∆I = 2.5 x ` 600 Crores = ` 1,500 Crores
Increase in consumption (∆C) = ∆Y x MPC = ` 1, 500 Crores x 0.6 = ` 900 Crores.
345
Illustration 12
Suppose in a country investment increases by ` 100 Crores and consumption is given by C
= 10 + 0.6Y (where C = consumption and Y = income). How much increases will there take
place in income?
Solution
Multiplier = k = = 2.5
Substituting the value of k and ∆I value in ∆Y = k∆I
∆Y = 2.5 x 100 = ` 250 crores
Thus, increase in investment by ` 100 Crores will cause equilibrium income to rise by `250
Crores.
Illustration 13
If the consumption function is C = 250 + 0.80Y and I = 300. Find out equilibrium level of
Y, C and S?
Solution
C = 250 + 0.8(2750) C = 2450

S = Y – C where C = a + bY
S = Y – (a + bY)
S = - a + (1 – b) Y
= - 250 + (1 – 0.80) 2750 = 300
Or directly,
S=Y–C
S = 2750 – 2450 = 300
346

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Inter CA

Welcome to the World of Knowledge - J.K. Shah Classes !

Each Topic of Financial Management is divided in to three parts :

Each Topic of Economics for Finance is Divided into 2 Parts:

I wish you a very happy study time.

Prof. J.K. Shah.

Ch. NAME OF THE CHAPTER PAGE NO

Ch. NAME OF THE CHAPTER PAGE NO

1 DETERMINATION OF NATIONAL INCOME 189-222

2 PUBLIC FINANCE 223-253

3 MONEY MARKET 254-278

4 INTERNATIONAL TRADE 279-321

5 NATIONAL INCOME NUMERICAL SUMS 322-329

6 NATIONAL INCOME NUMERICAL SUMS SOLUTIONS 330-346

FINANCIAL ANALYSIS AND PLANNING

Meaning and Objective

(A) BALANCE SHEET RATIOS

- Stock to Working Capital Ratio

• Super Quick Ratio

• Stock to Working Capital Ratio

• Debt Equity Ratio

• Capital Gearing Ratio

Equity Shareholders funds = Equity share Capital + Reserves and Surplus

(B) MIXED RATIOS

Fixed Asset Working Capital

Current Assets Current Liabilities

A/c’s Receivable A/c’s Payable Turnover

Capital Employed turnover ratio

Fixed Assets Turnover Ratio

Working Capital Turnover Ratio

Stock Turnover Ratio

A/c’s Receivable Turnover (or Debtors Turnover)

A/c’s Payable Turnover (or Creditors Turnover)

PROFITABILITY RATIOS IN RELATION TO INVESTMENT

Return on Capital Employed (ROCE) / Return on Investment (ROI)

Return on Shareholders’ Funds

Return on Equity (Equity share-holders Funds)

Return on Equity Share Capital

(C) PROFIT AND LOSS RATIOS

Gross Profit Ratio

Operating Profit Ratio

Administrative Expenses Ratio

Selling Expenses Ratio

Net Profit Ratio

SOME OTHER IMPORTANT RATIOS

Earnings per Share (EPS)

Dividend per Share (DPS)

Dividend Payout (DP) Ratio

Book (Balance Sheet) Value per share (BVPS)

Price Earnings Ratio (PE Ratio)

Earnings Price Ratio / Earnings Yield Ratio

Dividend Price Ratio / Dividend Yield Ratio

Interest Coverage Ratio (IC Ratio)

Preference Dividend Coverage Ratio

Debt Service Coverage Ratio

DU PONT ANALYSIS FOR EVALUATING ROE

= NP Ratio x Asset Turnover Ratio x Equity Multiplier

D) LONG TERM INVESTMENTS xx

Important Points to remember

Balance Sheet as on 31st March, 2020

Total Current Assets (CA) 1,20,000 1,83,000

TO BE DISCUSSED ONLY IN CLASSROOM

(b) Financial Leverage