GM TEST SERIES

CA-Inter New Course

Top 50 Questions

FM AND ECO

Contact No. -9070800090 Email id – Info@gmtestseries.com

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FM AND ECONOMICS FOR FINANCE

Top 50 Questions

Section- A: FM Questions
Q-1:- XYZ Ltd. is presently all equity financed. The directors of the company have been
evaluating investment in a project which will require Rs270 lakhs capital expenditure on new
machinery. They expect the capital investment to provide annual cash flows of Rs42lakhs
indefinitely which is net of all tax adjustments. The discount rate which it applies to such
investment decisions is 14%net.

The directors of the company believe that the current capital structure fails to take advantage
of tax benefits of debt, and propose to finance the new project with undated perpetual debt
secured on the company's assets. The company intends to issue sufficient debt to cover the
cost of capital expenditure and the after tax cost of issue.

The current annual gross rate of interest required by the market on corporate undated debt of
similar risk is 10%. The after tax costs of issue are expected to be Rs10 lakhs. Company's tax
rate is 30%

You are required to calculate:

i) The adjusted present value of the investment,

ii) The adjusted discount rate and
iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate
future investments.
(8 marks)

Q-2:- Day Ltd., a newly formed company has applied to the Private Bank for the first time for
financing it's Working Capital Requirements. The following information are available about the
projections for the current year:

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Estimated Level of Activity Completed Units of Production 31200 plus unit of work in
progress 12000
Raw Material Cost 40 per unit
Direct Wages Cost 15 per unit
Overhead 40 per unit (inclusive of Depreciation Rs10 per unit)
Selling Price 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance Rs2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and
overheads accrue similarly. All sales are on the credit basis. You are required to calculate the
Net Working Capital Requirement on Cash Cost Basis.

(10 marks)

Q-3:- Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018:

Liabilities Amount in Rs
Shareholder's Fund
Equity Share Capital (Rs10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12 Debentures) 50,00,000
Current Liabilities 20,00,000

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Total 1,00,00,000
Assets Amount in Rs
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000

Additional Information:

i) Variable Cost is 60%of Sales.

ii) Fixed Cost p.a. excluding interest Rs 20,00,000.
iii) Total Asset Turnover Ratio is 5 times.
iv) Income Tax Rate 25%

You are required to:

1) Prepare Income Statement

2) Calculate the following and comment:
a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
(10 marks)

Q-4:- The following data relate to two companies belonging to the same risk class:

Particulars A Ltd. B Ltd.

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

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Required:

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

Q-5:- AT Limited is considering three projects A, B and C. The cash flows associated with the
projects are given below.

Cash flows associated with the Three Projects (Rs)

Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000

You are required to

a) Calculate the payback period of each of the three projects.

b) If the cut-off period is two years, then which projects should be accepted?
c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
d) "Payback gives too much weight to cash flows that occur after the cut-off date". True or
false?
e) "If a firm used a single cut-off period for all projects, it is likely to accept too many short
lived projects." True or false?

P.V. Factor @ 10 %

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Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621
(10 marks)

Q-6:- RM Steels Limited requires Rs 10,00,000 for construction of a new plant. It is considering
three financial plans:

i) The company may issue 1,00,000 ordinary shares at Rs10 per share;
ii) The company may issue 50,000 ordinary shares at Rs 10 per share and 5000 debentures of
Rs 100 denominations bearing a 8 per cent rate of interest; and
iii) The company may issue 50,000 ordinary shares at Rs 10 per share and 5,000 preference
shares at Rs 100 per share bearing a 8 per cent rate of dividend.

If RM Steels Limited's earnings before interest and taxes are Rs 20,000; Rs 40,000; Rs 80,000;
Rs 1,20,000 and Rs 2,00,000, you are required to compute the earnings per share under each
of the three financial plans ?

Which alternative would you recommend for RM Steel s and why? Tax rate is 50%

(10 marks)

Q-7:- Slide Ltd. is preparing a cash flow forecast for the three months period from January to
the end of March. The following sales volumes have been forecasted:

Months December January February March April

Sales (units) 1,800 1,875 1,950 2,100 2,250

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Selling price per unit is Rs600. Sales are all on one month credit. Production of goods for sale
takes place one month before sales. Each unit produced requires two units of raw materials
costing Rs150 per unit. No raw material inventory is held. Raw materials purchases are on one
month credit. Variable overheads and wages equal to Rs100 per unit are incurred during
production and paid in the month of production. The opening cash balance on 1st January is
expected to be Rs 35,000. A long term loan of Rs 2,00,000 is expected to be received in the
month of March. A machine costing Rs 3,00,000 will be purchased in March.

a) Prepare a cash budget for the months of January, February and March and calculate the
cash balance at the end of each month in the three months period.
b) Calculate the forecast current ratio at the end of the three months period.
(10 marks)

Q-8:- A Company wants to raise additional financeofRs5 crore in the next year. The company
expects to retain Rs1 crore earning next year. Further details are as follows

i) The amount will be raised by equity and debt in the ratio of 3: 1.

ii) The additional issue of equity shares will result in price per share being fixed at Rs25.
iii) The debt capital raised by way of term loan will cost 10% for the first Rs75 lakh and 12% for
the next Rs50 lakh.
iv) The net expected dividend on equity shares is Rs2.00 per share. The dividend is expected to
grow at the rate of 5%
v) Income tax rate is 25%

You are required:

a) To determine the amount of equity and debt for raising additional finance
b) To determine the post-tax average cost of additional debt

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c) To determine the cost of retained earnings and cost of equity

d) To compute the overall weighted average cost of additional finance after tax.
(10 marks)

Q-9:- Akash Limited provides you the following information:

(Rs)
Profit (EBIT ) 2,80,000
Less: Interest on Debenture @ 10% (40,000)
EBT 2,40,000
Less Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity Shares (Rs10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10

The company has reserves and surplus of Rs 7,00,000 and required Rs4,00,000 further for
modernization. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity)
Ratio higher than 40% will bring the P/E Ratio down to 8 and increase the interest rate on
additional debts to 12%. You are required to ASCERT AIN the probable price of the share.

i) If the additional capital are raised as debt; and

ii) If the amount is raised by issuing equity shares at ruling market price.
(10 marks)

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Q-10:- An enterprise is investing Rs100 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 (RsIn 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.

(5 marks)

Q-11:- Following are cost information of KG Ltd., which has commenced a new project for an
annual production of 24,000 units which is the full capacity:

Costs per unit (Rs)

Materials 80.00
Direct labour and variable expenses 40.00
Fixed manufacturing expenses 12.00
Depreciation 20.00
Fixed administration expenses 8.00
160.00

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The selling price per unit is expected to be Rs192 and the selling expenses Rs10 per unit, 80% of
which is variable.

In the first two years of operations, production and sales are expected to be as follows:

Year Production (No. of units) Sales (No. of units)

1 12,000 10,000
2 18,000 17,000

To assess the working capital requirements, the following additional information is available:

a) Stock of materials 2 months’ average consumption

b) Work-in-process Nil
c) Debtors 2 month’s average sales.
d) Cash balance Rs1,00,000
e) Creditors for supply of materials 1 month’s average purchase during the year
f) Creditors for expenses 1 month’s average of all expenses during the Year

PREPARE, for the two years:

i) A projected statement of Profit/Loss (Ignoring taxation); and

ii) A projected statement of working capital requirements
(10 marks)

Q-12:- The following information is related to YZ Company Ltd. for the year ended 31stMarch,
2020:

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

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12% Bonds of Rs 1,000 each Rs 37 lakhs

Sales Rs 84 lakhs

Fixed cost (excluding interest) Rs 6.96 lakhs

Financial leverage 1.49

Profit-volume Ratio 27.55%

Income Tax Applicable 40%

You are required to CALCULATE:

i) Operating Leverage;
ii) Combined leverage; and
iii) Earnings per share.

Show calculations up-to two decimal points.

(5 marks)

Q-13:- TM Limited, a manufacturer of colour TV sets is considering the liberalization of existing

credit terms to three of their large customers A, B and C. The credit period and likely quantity of
TV sets that will be sold to the customers in addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 10,000 10,000 -
30 10,000 15,000 -
60 10,000 20,000 10,000
90 10,000 25,000 15,000

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The selling price per TV set is Rs 15,000. The expected contribution is 50% of the selling price.
The cost of carrying receivable averages 20% per annum.

You are required to COMPUTE the credit period to be allowed to each customer.

(Assume 360 days in a year for calculation purposes).

(10 marks)

Q-14:- A large profit making company is considering the installation of a machine to process the
waste produced by one of its existing manufacturing process to be converted into a marketable
product. At present, the waste is re moved by a contractor for disposal on payment by the
company of Rs 150 lakh per annum for the next four years. The contract can be terminated
upon installation of the aforesaid machine on payment of a compensation of Rs 90 lakh before
the processing operation starts. This compensation is not allowed as deduction for tax
purposes.

The machine required for carrying out the processing will cost Rs 600 lakh to be financed by a
loan repayable in 4 equal installments commencing from end of the year 1. The interest rate is
14% per annum. At the end of the 4th year, the machine can be sold for Rs 60 lakh and the cost
of dismantling and removal will be Rs 45 lakh.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated
as under:

(Rs In lakh)

Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210

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Factory overheads 165 180 330 435

Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing operations is Rs60
lakh at the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2
and 3 will be Rs 165 lakh and the stocks at the end of year 4 will be nil. The storage of materials
will utilize space which would otherwise have been rented out for Rs 30 lakh per annum.
Labour costs include wages of 40 workers, whose transfer to this process will reduce idle time
payments of Rs 45 lakh in the year - 1 and Rs 30 lakh in the year - 2. Factory overheads include
apportionment of general factory overheads except to the extent of insurance charges of Rs90
lakh per annum payable on this venture. The company’s tax rate is 30%

Present value factors for four years are as under:

Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for processing the waste.
All calculations should form part of the answer.

(10 marks)

Q-15:- Sun Ltd. is considering two financing plans.

Details of which are as under:

i) Fund's requirement –Rs 100 Lakhs

ii) Financial Plan

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Plan Equity Debt

I 100% -
II 25% 75%

iii) Cost of debt –12%p.a.

iv) Tax Rate –30%
v) Equity Share Rs10 each, issued at a premium of Rs15 per share
vi) Expected Earnings before Interest and Taxes (EBIT) Rs40 Lakhs

You are required to compute:

i) EPS in each of the plan

ii) The Financial Break Even Point
iii) Indifference point between Plan Iand II
(5 marks)

Q-16:- The accountant of Moon Ltd. has reported the following data:

Gross profit Rs 60,000

Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days

Assume 360 days in a year

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You are required to complete the following:

Balance Sheet of Moon Ltd

Liabilities Rs Assets Rs
Net Worth Fixed Assets
Current Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets
(5 marks)

Q-17:- What are the sources of short term financial requirement of the company?

(4 marks)

Q-18:- Following information relating to Jee Ltd. are given:

Particulars
Profit after tax Rs10,00,000
Dividend payout ratio 50%
Number o f Equity Shares 50,000
Cost of Equity 10%
Rate o f Return on Investment 12%

i) What would be the market value per share as per Walter's Model?
ii) What is the optimum dividend payout ratio according to Walter's Model and Market value
of equity share at that payout ratio?
(5 marks)

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Q-19:- Explain in brief following Financial Instruments:

i) Euro Bonds
ii) Floating Rate Notes
iii) Euro Commercial paper
iv) Fully Hedged Bond
(4 marks)

Q-20:- What is the process o f Debt Securitization?

(4 marks)

Q-21:- Briefly explain the three finance function decisions.

(3 marks)

Q-22:- Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y. The
particulars are as under:

Project X (Rs) Project Y (Rs)

Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut off rate is 14%. The discount factor at 14% is

Year 1 2 3 4 5 6 7 8 9
Discount 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308

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factor
Advise management about the acceptability o f projects X and Y

(5 marks)

Q-23:- Write short notes on the following:

a) Functions of Finance Manager.

(5 marks)

Q-24:- COMPARE between Financial Lease and Operating Lease

(5 marks)

Q-25:- The following summarizes the percentage changes in operating income, percentage
changes in revenues, and betas for four listed firms.

Firm Change in revenue Change in operating income Beta

A Ltd. 35% 22% 1.00
B Ltd. 24% 35% 1.65
C Ltd. 29% 26% 1.15
D Ltd. 32% 30% 1.20

Required

i) CALCULAT E the degree of operating leverage for each of these firms. Comment also
ii) Use the operating leverage to EXPLAIN why these firms have different beta.
(5 marks)

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Q-26:- Following information has been provided from the books of M/s Laxmi & Co. for the year
ending on 31st March, 2020:

Net Working Capital Rs 4,80,000

Bank overdraft Rs 80,000

Fixed Assets to Proprietary ratio 0.75

Reserves and Surplus Rs 3,20,000

Current ratio 2.5

Liquid ratio (Quick Ratio) 1.5

You are required to PREPARE a summarized Balance Sheet as at 31st March, 2020.

(5 marks)

Q-27:- Door Ltd. is considering an investment of Rs4,00,000. This investment is expected to

generate substantial cash inflows over the next five years. Unfortunately, the annual cash flows
from this investment is uncertain, and the following profitability distribution has been
established.

Annual Cash Flow (Rs) Probability

50,000 0.3
1,00,000 0.3
1,50,000 0.4

At the end of its 5 years life, the investment is expected to have a residual value of Rs 40,000.

The cost of capital is 5%

i) Calculate NPV under the three different scenarios

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ii) Calculate Expected Net Present Value.

iii) Advise Door Ltd. on whether the investment is to be undertaken.

Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784
(5 marks)

Q-28:- Following Balance Sheet and Income Statement have been obtained from the books of
accounts of Benaca Pvt. Ltd.

Balance Sheet as on March 31st 2020

Liabilities Amount (Rs) Assets Amount (Rs )

Equity Capital (Rs 10 per share) 80,00,000 Net Fixed Assets 1,00,00,000
10% Debt 60,00,000 Current Assets 90,00,000
Retained Earnings 35,00,000
Current Liabilities 15,00,000
1,90,00,000 1,90,00,000

Income Statement for the year ending March 31st 2020

Particulars Amount (Rs )

Sales 34,00,000
Less: Operating expenses (including Rs 6,00,000depreciation) (12,00,000)
EBIT 22,00,000
Less: Interest (6,00,000)
Earnings before tax 16,00,000

The tax rate applicable to the company is 35 percent.

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i) DETERMINE the degree of operating, financial and combined leverages at the current sales
level, if all operating expenses, other than depreciation, are variable costs.
ii) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease
by 20 percent, COMPUTE the earnings per share at the new sales level?
(10 marks)

Q-29:- The annual report of XYZ Ltd. provides the following information for the Financial Year
2019-20

Particulars Amount (Rs )

Net Profit 50 lakhs
Outstanding 15% preference shares 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividends pay-out is-

i) 25%
ii) 50%;
iii) 100%.

(5 marks)

Q-30:- Sinha Steel Ltd. requires Rs 30,00,000 for a new plant which expects to yield earnings
before interest and taxes of Rs 5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per share. It has three alternatives to finance
the project as follows –

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Alternative Debt Equity Shares

1 Rs 2,50,000 balance
2 Rs 10,00,000 balance
3 Rs 15,00,000 balance

The company's share is currently selling at Rs 200, but is expected to decline to Rs 160 in case
the funds are borrowed in excess of Rs 10,00,000.

Fund Limit Applicable Interest rate

up-to Rs 2,50,000 10%
over Rs 2,50,000 and up-to Rs 10,00,000 15%
over Rs 10,00,000 20%

The tax rate applicable to the company is 50 percent.

ANALYSE which form of financing should the company choose?

(10 marks)

Section- B: ECO Questions

Q-1:- Compute GNP at factor cost and NDP at market price use expenditure method from the
following data:

(Rs in Crores)
Personal Consumption expenditure 2900
Imports 300

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Gross public Investment 500

Consumption of fixed capital 60
Exports 200
Inventory Investment 170
Government purchases of goods & services 1100
Gross Residential construction Investment 450
Net factor Income from abroad (-)30
Gross business fixed Investment 410
Subsidies 80
(5 marks)

Q-2:- What is meant by expansionary fiscal policy? Under what circumstances does government
pursue expansionary policy?

(2 marks)

Q-3: - Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI).

(2 marks)

Q-4:- Explain the role of Monetary Policy Committee (MPC) in India.

(2 marks)

Q-5:- Explain the Concept of Gross National Product at market price (GNP mp)

(2 marks)

Q-6:- Explain with example ho w Ad Valorem Tariff is levied.

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(3 marks)

Q-7:- How do changes in Cash Reserve Ratio (CRR) impact the economy?

(2 marks)

Q-8:-Explain the difference between Liquidity Adjustment Facility (LAP) and Marginal Standing
Facility (MSF).

(3 marks)

Q-9:- Explain the Fisher’s Quantity theory of demand for money?

(5 marks)

Q-10:- Differentiate between ‘taxes on production’ and ‘product taxes’

(3 marks)

Q-11:- How can the government influence the resource allocation in an economy?

(3 marks)

Q-12:- Define custom duties? What are their main goals?

(3 marks)

Q-13:- Explain the classical version of quantity theory of demand for money.

(3 marks)

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Q-14:- How does the monetary policy influence the price level and the national income?

(3 marks)

Q-15:- Answer the following question using Keynesian framework of demand for money.

An investment consultant suggests holding of cash instead of bonds. What could be the reason
to encourage holding of money balances? Explain

(3 marks)

Q-16:- Explain why do governments provide subsidies? Illustrate a few examples of subsidies.

(3 marks)

Q-17:- How is exchange rate determined under floating exchange rate regime?

(2 marks)

Q-18:- How does trade increase economic efficiency?

(3 marks)

Q-19:- Define Reserve Money? Compute the Reserve Money from the following data Published
by RBI.

Components (In billions of Rs ) As on 7thJuly 2018

Currency in circulation 15428.40

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Bankers Deposits with RBI 4596.18

Other Deposits with RBI 183.30
(3 marks)

Q-20:- The tradable emissions permits are claimed to have certain advantages. Explain.

(3 marks)

Suggested Answers/ Hints

Section- A: FM Answers

A-1:-

i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-)Rs270 lakhs + (Rs42 lakhs / 0.14) = (-) Rs270 lakhs + Rs300 lakhs
= Rs30
Issue costs =Rs10 lakhs
Thus, the amount to be raised = Rs270 lakhs + Rs10 lakhs
= Rs280 lakhs
Annual tax relief on interest payment = Rs280 X 0.1 X 0.3
= Rs 8.4 lakhs in perpetuity

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The value of tax relief in perpetuity = Rs8.4 lakhs / 0.1

= Rs84 lakhs
Therefore, APV = Base case PV –Issue Costs + PV of Tax Relief on debt interest
=Rs30 lakhs –Rs10 lakhs + 84 lakhs = Rs104 lakhs

ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required allowing an NPV to zero
Let the annual income be x.
(-) Rs280 lakhs X (Annual Income / 0.14) = (-) Rs104 lakhs
Annual Income / 0.14 = (-) Rs104 + Rs280 lakhs
Therefore, Annual income = Rs176 X 0.14 = Rs24.64 lakhs
Adjusted discount rate = (Rs24.64 lakhs / Rs280 lakhs) X 100
= 8.8%
iii) Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new
venture is identical to the one being evaluated here and the project is to be financed by the
same method on the same terms. The effect on the company’s cost of capital of introducing
debt into the capital structure cannot be ignored.
(8 marks)

A-2:- Calculation of Net Working Capital requirement

(Rs) (Rs)

A. Current Assets:

Inventories:
Stock of Raw material 1,44,000
(Refer to Working note (iii)

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Stock of Work in progress 7,50,000

(Refer to Working note (ii)
Stock of Finished goods 20,40,000
(Refer to Working note (iv)

Debtors for Sales 1,02,000

(Refer to Working note (v)

Cash 2,00,000

Gross Working Capital 32,36,000 32,36,000

B. Current Liabilities:

Creditors for Purchases 1,56,000

(Refer to Working note (vi)

Creditors for wages

(Refer to Working note (vii) 23,250

1,79,250 1,79,250

Net Working Capital (A - B) 30,56,750

Working Notes:

(i) Annual cost of production

(Rs)

Raw material requirements

{(31,200 × Rs 40) + (12,000 x Rs 40)} 17,28,000

Direct wages {(31,200 ×Rs 15) +(12,000 X Rs 15 x 0.5)} 5,58,000

Overheads (exclusive of depreciation)

{(31,200 × Rs 30) + (12,000 x Rs 30 x 0.5)} 11,16,000

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Gross Factory Cost 34,02,000

Less: Closing W.I.P [12,000 (Rs 40 + Rs 7.5 + Rs15)] (7,50,000)

Cost of Goods Produced 26,52,000

Less: Closing Stock of Finished Goods (Rs
26,52,000 × 24,000/31,200) (20,40,000)

Total Cash Cost of Sales 6,12,000

(ii) Work in progress stock

(Rs)

Raw material requirements (12,000 units × Rs40) 4,80,000

Direct wages (50% × 12,000 units × Rs 15) 90,000

Overheads (50% × 12,000 units × Rs 30) 1,80,000

7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption. Since, the company is
newly formed; the raw material requirement for production and work in progress will be
issued and consumed during the year. Hence, the raw material consumption for the year (360
days) is as follows.

(Rs)
For Finished goods (31,200 × Rs 40) 12,48,000
For Work in progress (12,000 × Rs 40) 4,80,000
17,28,000

Raw material stock = Rs 17,28,000 /360 days x 30 days = Rs 1,44,000

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(iv) Finished goods stock:

24,000 units @ Rs (40+15+30) per unit = Rs20,40,000

(v) Debtors for sale: Rs 6,12,000 x 60 days/360 days = Rs 1,02,000

(vi) Creditors for raw material Purchases [Working Note (iii)]:

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

Add: Closing stock of raw material Rs1,44,000

Rs 18,72,000

Credit allowed by suppliers = Rs 18,72,000/360 days = Rs 1,56,000

(vii) Creditors for wages:

Outstanding wage payment = Rs 5,58,000 /360 days x 15 days = Rs 23,250

(10 marks)

A-3:- Workings:-

Total Assets= Rs1 crore

Total Asset Turnover Ratio i.e. Total Sales/Total Assets =5

Hence, Total Sales = Rs1 Crore 5 = Rs5 crore

1) Income Statement

(Rs in crore)

Sales 5

Less: Variable cost @ 60% 3

Contribution 2

Less: Fixed cost (other than Interest) 0.2

EBIT(Earnings before interest and tax) 1.8

Less: Interest on debentures (12% 50 lakhs) 0.06

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EBT(Earnings before tax) 1.74

Less: Tax 25% 0.435

EAT (Earning after tax) 1.305

2)
a) Operating Leverage
Operating leverage = Contribution/ EBIT =2/1.8 =1.11
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and
tax (EBIT) to change in sales at a particular level.

b) Financial Leverage
Financial Leverage = EBIT/EBT = 1.8/1.74 =1.03
The financial leverage is very comfortable since the debt service obligation is small vis-à-vis
EBIT

c) Combined Leverage
Combined Leverage = Contribution/EBIT x EBIT/EBT =1.11 x 1.03 =1.15
Or
Contribution/EBT =2/1.74 =1.15
The combined leverage studies the choice of fixed cost in cost structure and choice of debt
in capital structure. It studies how sensitive the change in EPS is vis-à-vis change in sales.
The leveragesoperating, financial and combined are measures of risk.
(10 marks)

A-4:-

a) Assuming no tax as per MM Approach

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Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis

Market Value of ‘B Ltd’ *Unlevered (u)+
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = Rs1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = keas there is no debt) = 0.18
Market Value of ‘A Ltd’ *Levered Firm (I)+
Total Value of Levered Firm (VL) = Vu+ (Debt× Nil) = Rs 1,00,00,000 + (54,00,000 × nil)
= Rs 1,00,00,000
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC)
Particulars A Ltd. B Ltd.
A Net Operating Income (NOI) 18,00,000 18,00,000
B Less: Interest on Debt (I) 6,48,000
C Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke= NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC (ko)]*ko= 0.18 0.18
(ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18

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*Kd = 12% (since there is no tax

WACC = 18%

b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ *Unlevered (u)+
Total Value of unlevered Firm (Vu) = [NOI(1 -t)/ke] = 18,00,000 (1 –0.40)] / 0.18
= Rs60,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = keas there is no debt) = 0.18
Market Value of ‘A Ltd’ *Levered Firm (I)+
Total Value of Levered Firm (VL) = Vu+ (Debt× T ax)
= Rs60,00,000 + (54,00,000 × 0.4)
= Rs81,60,000
Computation of Weighted Average Cost of Capital (WACC) of‘B Ltd’
= 18% (i.e. Ke= Ko)
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC) of a Ltd

Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before T ax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke= NI/S] 0.2504

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Weighted Average Cost of Capital (ko)* 13.23

ko= (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323

*Kd= 12% (1-0.4) = 12% × 0.6 = 7.2%

WACC = 13.23%
(10 marks)

A-5:-

a) Payback Period of Projects

Projects C0(Rs) C1(Rs) C2(Rs) C3(Rs) Payback

A (10,000) 2000 2000 6,000 2,000+2,000+6,000=10,000 i.e 3 years
B (2,000) 0 2000 NA 0+2,000=2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000+2,000+6,000=10,000 i.e 3 years

b) If standard payback period is 2 years, Project B is the only acceptable project.

c) Calculation of NPV

Year PVF @ Project A Project B Project C

10%
Cash PV of cash Cash PV of cash Cash PV of cash
Flows (Rs) flows (Rs) Flows (Rs) flows (Rs) Flows (Rs) flows (Rs)

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0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)

1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806

So, Projects with positive NPV are Project B and Project C

d) False. Payback gives no weight age to cash flows after the cut-off date.
e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future
years’ cash inflows are not considered. Thus, payback is biased towards short-term projects.
(10 marks)

A-6:-

i) Computation of EPS under three-financial plans

Plan I: Equity Financing
(Rs) (Rs) (Rs) (Rs) (Rs)
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
No. of equity shares 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
EPS 0.10 0.20 0.40 0.60 1

Plan II: Debt –Equity Mix

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(Rs) (Rs) (Rs) (Rs) (Rs)

EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 40,000 40,000 40,000 40,000 40,000
EBT (20,000) 0 40,000 80,000 1,60,000
Less: Tax @ 50% 10,000* 0 20,000 40,000 80,000
PAT (10,000) 0 20,000 40,000 80,000
No. of equity shares 50,000 50,000 50,000 50,000 50,000
EPS (Rs 0.20) 0 0.40 0.80 1.60

* The Company can set off losses against the overall business profit or may carry forward it to
next financial years.

Plan III: Preference Shares –Equity Mix

(Rs) (Rs) (Rs) (Rs) (Rs)

EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
Less: Pref. dividend 40,000* 40,000* 40,000 40,000 40,000
PAT after Pref. dividend. (30,000) (20,000) 0 20,000 60,000
No. of equity shares 50,000 50,000 50,000 50,000 50,000
EPS (0.60) (0.40) 0 0.40 1.20

* In case of cumulative preference shares, the company has to pay cumulative dividend to
preference shareholders, when company earns sufficient profits.

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ii) From the above EPS computations tables under the three financial plans we can see that
when EBIT is Rs 80,000 or more, Plan II: Debt-Equity mix is preferable over the Plan I and
Plan III, as rate of EPS is more under this plan. On the other hand an EBIT of less than Rs
80,000, Plan I: Equity Financing has higher EPS than Plan II and Plan III. Plan III Preference
share Equity mix is not acceptable at any level of EBIT, as EPS under this plan is lower.
T he choice of the financing plan will depend on the performance of the company and other
macro economic conditions. If the company is expected to have higher operating profit Plan
II: Debt –Equity Mix is preferable. Moreover, debt financing gives more benefit due to
availability of tax shield.
(10 marks)

A-7:- Working Notes

1) Calculation of Collection from Trade Receivables:

Particulars December January February March

Sales (units) 1,800 1,875 1,950 2,100
Sales (@ Rs600 per unit)/ Trade 10,80,000 11,25,000 11,70,000 12,60,000
Receivables (Debtors)(Rs)
Collection from Trade Receivables 10,80,000 11,25,000 11,70,000
(Debtors) (Rs)

2) Calculation of Payment to Trade Payables

Particulars December January February March
Output(units) 1,875 1,950 2,100 2,250
Raw Material (2 units per output)(units) 3,750 3,900 4,200 4,500
Raw Material (@ Rs150 per unit)/ Trade 5,62,500 5,85,000 6,30,000 6,75,000
Payables (Creditors)(Rs)

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Payment to Trade Payables (Creditors)(Rs) 5,62,500 5,85,000 6,30,000

3) Calculation of Variable Overheads and Wages:

Particulars January February March

Output (units) 1,950 2,100 2,250
Payment in the same month @ Rs100 per unit(Rs) 1,95,000 2,10,000 2,25,000

a) Preparation of Cash Budget

Particulars January February March

Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade Receivables (Debtors) 10,80,000 11,25,000 11,70,000
Receipt of Long-Term Loan 2,00,000
Total (A) 11,15,000 14,82,500 20,57,500
Payments:
Trade Payables (Creditors)for Materials 5,62,500 5,85,000 6,30,000
Variable Overheads and Wages 1,95,000 2,10,000 2,25,000
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,000
Closing Balance (A –B) 3,57,500 6,87,500 9,02,500

b) Calculation of Current Ratio

Particulars March (Rs)

Output Inventory (i.e. units produced in March)
[(2,250 units x 2 units of raw material per unit of output x Rs150 per unit of 9,00,000
raw material) + 2,250 units x Rs100 for variable overheads and wages]

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Trade Receivables (Debtors) 12,60,000

Cash Balance 9,02,500
Current Assets 30,62,500
Trade Payables (Creditors) 6,75,000
Current Liabilities 6,75,000
Current Ratio (Current Assets / Current Liabilities) 4.537approx.
(10 marks)

A-8:-

a) Determination of the amount of equity and debt for raising additional finance:
Pattern of raising additional finance
Equity 3/4 of Rs5 Crore = Rs3.75 Crore
Debt 1/4 of Rs5 Crore = Rs1.25 Crore

The capital structure after raising additional finance:

Particulars (Rs In crore)

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

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

Kd= I (1 –t)

Where,

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I = Interest Rate

t = Corporate tax-rates

On Rs 75,00,000=10% (1–0.25)=7.5% or 0.075

On Rs 50,00,000=12% (1 –0.25)=9% or 0.09

Average Cost of Debt

= (Rs 75,00,000 x 0.075) + ( Rs 50,00,000x 0.09) /1,25,00,000 100

= Rs 5,62,500 + Rs 4,50,000 /1,25,00,000 x 100 =8.10%

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

Where,
Ke= Cost of equity
D1= DO (1+ g)
D0= Dividend paid (i.e = Rs 2)
g = Growth rate
P0= Current market price per share

Cost of retained earnings equals to cost of Equity i.e. 13.4%

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

Particular (Rs) Weights Cost of funds Weighted Cost

(%)
Equity (including retained earnings) 3,75,00,000 3/4 13.4% 10.05

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Debt 1,25,00,000 1/4 8.1% 2.025

WACC 5,00,00,000 12.075
(10 marks)

A-9:- Ascertainment of probable price of shares of Akash limited

Particulars Plan-I Plan-II

If Rs4,00,000 is If Rs4,00,000 is raised by
raised as debt (Rs) issuing equity shares(Rs)
Earnings Before Interest and Tax (EBIT )
{20% of new capital i.e. 20% of (Rs14,00,000 + 3,60,000 3,60,000
Rs4,00,000)}(Refer working note1)
Less: Interest on old debentures (40,000) (40,000)
(10% of Rs4,00,000)
Less: Interest on new debt (48,000) -
(12% of Rs4,00,000)
Earnings Before Tax (EBT) 2,72,000 3,20,000
Less: T ax @ 50% (1,36,000) (1,60,000)
Earnings for equity shareholders (EAT ) 1,36,000 1,60,000
No. of Equity Shares(refer working note 2) 30,000 40,000
Earnings per Share (EPS) Rs4.53 Rs4.00
Price/ Earnings (P/E) Ratio(note 3) 8 10
Probable Price Per Share(PE Ratio × EPS) Rs36.24 Rs40

Working Notes:

1. Calculation of existing Return of Capital Employed (ROCE):

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(Rs)
Equity Share capital (30,000 shares × Rs10) 3,00,000
10% Debentures (Rs 40,000 x 100/10) 4,00,000
Reserves and Surplus 7,00,000
Total Capital Employed 14,00,000
Earnings before interest and tax (EBIT ) (given) 2,80,000
ROCE = Rs 2,80,000/ Rs 14,00,000 x 100 20%

2. Number of Equity Shares to be issued in Plan-II:

= Rs 4,00,000 /Rs 40 =10,000 shares
Thus, after the issue total number of shares = 30,000+ 10,000 = 40,000 shares
3. Debt/Equity Ratio if Rs 4,00,000 is raised as debt:
= Rs 8,00,000 /Rs 18,00,000 x 100 =44.44%

As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in Plan-I

(10 marks)

A-10:- The Present Value of the Cash Flows for all the years by discounting the cash flow at 7%
is calculated as below:

Year Cash flows Rs In Discounting Factor@7% Present value of Cash Flows Rs

lakhs In Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment (100.00)
Net Present Value (NPV) 144.34

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Now when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %.
So the risk adjusted discount rate is 7 % + 7 % =14%.

Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:

Year Cash flows Rs Discounting Factor@14% Present Value of Cash Flows Rs

in Lakhs in lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.592 33.74
Total of present value of Cash flow 199.79
Initial investment (100.00)
Net present value (NPV) 99.79
(5 marks)

A-11:-

i) Projected Statement of Profit / Loss(Ignoring Taxation)

Year 1 Year 2
Production (Units) 12,000 18,000
Sales (Units) 10,000 17,000

(Rs) (Rs)
Sales revenue (A) 19,20,000 32,64,000
(Sales unit × Rs192)
Cost of production:

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Materials cost 9,60,000 14,40,000

(Units produced × Rs80)
Direct labour and variable expenses 4,80,000 7,20,000
(Units produced × Rs40)
Fixed manufacturing expenses 2,88,000 2,88,000
(Production Capacity: 24,000 units × Rs12)
Depreciation 4,80,000 4,80,000
(Production Capacity : 24,000 units × Rs20)
Fixed administration expenses 1,92,000 1,92,000
(Production Capacity : 24,000 units × Rs8)
Total Costs of Production 24,00,000 31,20,000
Add: Opening stock of finished goods - 4,00,000
(Year 1 : Nil; Year 2 : 2,000 units)
Cost of Goods available for sale 24,00,000 35,20,000
(Year 1: 12,000 units; Year 2: 20,000 units)
Less: Closing stock of finished goods at average cost (4,00,000) (5,28,000)
(year 1: 2000 units, year 2 : 3000 units)
(Cost of Production × Closing stock/ units produced)
Cost of Goods Sold 20,00,000 29,92,000
Add: Selling expenses –Variable (Sales unit × Rs8) 80,000 1,36,000
Add: Selling expenses -Fixed (24,000 units × Rs2) 48,000 48,000
Cost of Sales : (B) 21,28,000 31,76,000
Profit (+) / Loss (-): (A -B) (-) 2,08,000 (+) 88,000

Working Notes:

1. Calculation of creditors for supply of materials:

Year 1 (Rs) Year 2 (Rs)

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Materials consumed during the year 9,60,000 14,40,000

Add: Closing stock (2 month’s average consumption) 1,60,000 2,40,000
11,20,000 16,80,000
Less: Opening Stock --- 1,60,000
Purchases during the year 11,20,000 15,20,000
Average purchases per month (Creditors) 93,333 1,26,667

2. Creditors for expenses:

Year 1 (Rs) Year 2 (Rs)

Direct labour and variable expenses 4,80,000 7,20,000
Fixed manufacturing expenses 2,88,000 2,88,000
Fixed administration expenses 1,92,000 1,92,000
Selling expenses (variable + fixed) 1,28,000 1,84,000
Total 10,88,000 13,84,000
Average per month 90,667 1,15,333

ii) Projected Statement of Working Capital requirements

Year 1 (Rs) Year 2 (Rs)

Current Assets:
Inventories
- Stock of materials 1,60,000 2,40,000
(2 month’s average consumption)
- Finished goods 4,00,000 5,28,000
Debtors (2 month’s average sales) (including profit) 3,20,000 5,44,000
Cash 1,00,000 1,00,000
Total Current Assets/ Gross working capital (A) 9,80,000 14,12,000
Current Liabilities

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Creditors for supply of materials 93,333 1,26,667

(Refer to working note 1)
Creditors for expenses 90,667 1,15,333
(Refer to working note 2)
Total Current Liabilities: (B) 1,84,000
2,42,000
Estimated Working Capital Requirements: (A-B) 7,96,000 11,70,000
(10 marks)

A-12:- Computation of Profits after Tax (PAT)

Particulars Amount (Rs)

Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12% Rs37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)
EBT (Earnings before tax) 10,86,040*
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624

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Accordingly, other fixed interest

= Rs 16,18,200 -Rs 10,86,040 -Rs 4,44,000 = Rs88,160

(iii) Earnings per share (EPS):

(5 marks)

A-13:- In case of customer A, there is no increase in sales even if the credit is given. Hence
comparative statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period (days) 0 30 60 90 0 30 60 90

2. Sales Units 10,000 15,000 20,000 25,000 - - 10,000 15,000

Rs in lakh Rsin lakh

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3. Sales Value 1,500 2,250 3,000 3,750 - - 1,500 2,250

4. Contribution at 50% (A) 750 1,125 1,500 1,875 - - 750 1,125

5. Receivables:-
Credit Period × Sales 360 - 187.5 500 937.5 - - 250 562.5

6. Debtors at cost - 93.75 250 468.75 - - 125 281.25

7. Cost of carrying debtors - 18.75 50 93.75 - - 25 56.25

at 20% (B)

8. Excess of contributions 750 1,106.25 1,406.25 1,781.25 - - 725 1,068.75

over cost of carrying debtors
(A – B)

The excess of contribution over cost of carrying Debtors is highest in case of credit period of
90 days in respect of both the customers B and C. Hence, credit period of 90 days should be
allowed to B and C.

(10 marks)

A-14:-

Statement of Operating Profit from processing of waste (Rs in lakh)

Year 1 2 3 4

Sales :(A) 966 966 1,254 1,254

Material consumption 90 120 255 255

Wages 180 195 255 300

Other expenses 120 135 162 210

Factory overheads (insurance only) 90 90 90 90

Loss of rent on storage space (opportunity cost) 30 30 30 30

Interest @14% 84 63 42 21

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Depreciation (as per income tax rules) 150 114 84 63

Total cost: (B) 744 747 918 969

Profit (C)=(A)-(B) 222 219 336 285

Tax (30%) 66.6 65.7 100.8 85.5

Profit after Tax (PAT) 155.4 153.3 235.2 199.5

Statement of Incremental Cash Flows (Rs in lakh)

Year 0 1 2 3 4

Material stock (60) (105) - - 165

Compensation for contract (90) - - - -

Contract payment saved - 150 150 150 150

Tax on contract payment - (45) (45) (45) (45)

Incremental profit - 222 219 336 285

Depreciation added back - 150 114 84 63

Tax on profits - (66.6) (65.7) (100.8) (85.5)

Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) Total - - - - 15
incremental cash flows Present value factor
Present value of cash flows

(150) 155.4 222.3 274.2 397.5

1.00 0.877 0.769 0.674 0.592

(150) 136.28 170.95 184.81 235.32

Net present value 577.36

Advice: Since the net present value of cash flows is Rs 577.36 lakh which is positive the
management should install the machine for processing the waste.

Notes:

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(i) Material stock increases are taken in cash flows.

(ii) Idle time wages have also been considered.

(iii) Apportioned factory overheads are not relevant only insurance charges of this project
are relevant.

(iv) Interest calculated at 14% based on 4 equal installments of loan repayment.

(v) Sale of machinery- Net income after deducting removal expenses taken. Tax on Capital
gains ignored.

(vi) Saving in contract payment and income tax thereon considered in the cash flows.

(10 marks)

A-15:-

(i) Computation of Earnings Per Share (EPS)

Plans I (Rs) II (Rs)

Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of Rs75 lakh) --- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ Rs10+Rs15) 4,00,000 1,00,000
E.P.S (Rs) 7.00 21.70

(ii) Computation of Financial Break-even Points

Plan ‘I’ = 0 –Under this plan there is no interest payment, hence the financial break-even
point will be zero.

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Plan ‘II’ = Rs9,00,000 -Under this plan there is an interest payment of Rs9,00,000, hence
the financial break -even point will be Rs9 lakhs
(iii) Computation of Indifference Point between Plan I and Plan II:
Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be
calculated by applying the following formula:

Or, 2.8 EBIT –25,20,000 = 0.7EBIT

Or, 2.1EBIT = 25,20,000
EBIT =12,00,000

(5 marks)

A-16:- Preparation of Balance Sheet

Working Notes:

Sales = Gross Profit / Gross Profit Margin

= 60,000 / 0.2 = Rs 3,00,000

Total Assets = Sales / Total Asset Turnover

= 3,00,000 / 0.3 = Rs 10,00,000

Net Worth = 0.9 X Total Assets

= 0.9 X Rs 10,00,000 = Rs9,00,000

Current Liability = Total Assets –Net Worth

= Rs10,00,000 –Rs9,00,000

= Rs1,00,000

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Current Assets = 1.5 x Current Liability

= 1.5 x Rs 1,00,000 = Rs1,50,000

Stock = Current Assets –Liquid Assets

= Current Assets –(Liquid Assets / Current Liabilities =1)

= 1,50,000 –(LA / 1,00,000 = 1) = Rs50,000

Debtors = Average Collection Period X Credit Sales / 360

= 60 x 0.8 x 3,00,000 / 360 = Rs40,000

Cash = Current Assets –Debtors –Stock

= Rs1,50,000 –Rs40,000–Rs50,000

=Rs 60,000

Fixed Assets = Total Assets –Current Assets

= Rs10,00,000 –Rs1,50,000

= Rs8,50,000

Balance Sheet

Liabilities Rs Assets Rs
Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities 1,00,000 Stock 50,000
Debtors 40,000
Cash 60,000
Total liabilities 10,00,000 Total Assets 10,00,000
(5 marks)

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A-17:- There are various sources available to meet short-term needs of finance. The different
sources are discussed below:

i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale.
The usual duration of such credit is 15 to 90 days. It generates automatically in the course of
business and is common to almost all business operations. Itcan be in the form of an 'open
account' or 'bills payable'.
ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a
company has to pay for the services which it has already received like wages, taxes, interest
and dividends.
iii) Advances from Customers: Manufacturers and contractors engaged in producing or
constructing costly goods involving considerable length of manufacturing or construction
time usually demand advance money from their customers at the time of accepting their
orders for executing their contracts or supplying the goods. This is a cost free source of
finance and really useful.
iv) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued
in the form of a promissory note.
v) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills,
commonly referred to as T-Bills are issued by Government of India to meet short term
borrowing requirements with maturities ranging between 14 to 364 days.
vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate
with a fixed maturity date of not less than 15 days up to a maximum of one year
vii) Bank Advances: Banks receive deposits from public for different periods at varying rates of
interest. These funds are invested and lent in such a manner that when required, they may
be called back.
(4 marks)

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A-18:-

i) Walter’s model is given by –

Where,
P = Market price per share
E = Earnings per share = Rs10,00,000 ÷ 50,000 = Rs20
D = Dividend per share = 50% of 20 = Rs10
r = Return earned on investment = 12%
Ke= Cost of equity capital = 10%

ii) According to Walter’s model when the return on investment is more than the cost of equity
capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the
optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of zero, the market
value of the company’s share will be:-

(5 marks)

A-19:-

i) Euro bonds: Euro bonds are debt instruments which are not denominated in the currency of
the country in which they are issued. E.g. a Yen note floated in Germany.
ii) Floating Rate Notes: Floating Rate Notes: are issued up to seven years maturity. Interest
rates are adjusted to reflect the prevailing exchange rates. They provide cheaper money
than foreign loans.

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iii) Euro Commercial Paper (ECP): ECPs are short term money market instruments. They are for
maturities less than one year. They are usually designated in US Dollars.
iv) Fully Hedged Bond: In foreign bonds, the risk of currency fluctuations exists. Fully hedged
bonds eliminate the risk by selling in forward markets the entire stream of principal and
interest payments.
(4 marks)

A-20:- Process of Debt Securitization

i) The origination function–A borrower seeks a loan from a finance company, bank, HDFC.
The credit worthiness of borrower is evaluated and contract is entered into with
repayment schedule structured over the life of the loan.
ii) The pooling function–Similar loans on receivables are clubbed together to create an
underlying pool of assets. The pool is transferred in favour of Special purpose Vehicle
(SPV), which acts as a trustee for investors.
iii) The securitization function–SPV will structure and issue securities on the basis of asset
pool. The securities carry a coupon and expected maturity which can be asset based/
mortgage based. These are generally sold to investors through merchant bankers.
Investors are –pension funds, mutual funds, insurance funds. The process of
securitization is generally without recourse i.e. investors bear the credit risk and issuer is
under an obligation to pay to investors only if the cash flows are received by him from
the collateral. The benefits to the originator are that assets are shifted off the balance
sheet, thus giving the originator recourse to off-balance sheet funding.
(4 marks)

A-21:- The finance functions are divided into long term and short term functions/decisions:

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Long term Finance Function Decisions

i) Investment decisions (I): These decisions relate to the selection of assets in which funds will
be invested by a firm. Funds procured from different sources have to be invested in various
kinds of assets. Long term funds are used in a project for various fixed assets and also for
current assets.
ii) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet
financial objectives and seeing that fixed and working capital are effectively managed. The
financial manager needs to possess a good knowledge of the sources of available funds and
their respective costs and needs to ensure that the company has a sound capital structure,
i.e. a proper balance between equity capital and debt.
iii) Dividend decisions (D): These decisions relate to the determination as to how much and
how frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders. The owner of any profit-making organization looks for reward for his
investment in two ways, the growth of the capital invested and the cash paid out as income;
for a sole trader this income would be termed as drawings and for a limited liability
company the term is dividends.

Short-term Finance Decisions/Function

Working capital Management (WCM): Generally short term decision is reduced to

management of current asset and current liability (i.e., working capital Management).

(3 marks)

A-22:- The possible outcomes of Project x and Project y are as follows

Estimates Project X Project Y

Estimated PVF @ PV of NPV(Rs) Estimated PVF @ PV of NPV(Rs)
Annual 14% for 8 Cash Annual 14% for 8 Cash
Cash years flow(Rs) Cash years flow(Rs)
inflows(Rs) inflows(Rs)
Pessimistic 26,000 4.639 1,20,614 614 12,000 4.639 55,668 (-64,332)

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Most likely 28,000 4.639 1,29,892 9,892 28,000 4.639 1,29,892 9,892
Optimistic 36,000 4.639 2,41,228 47,004 52,000 4.639 2,41,228 1,21,228

In pessimistic situation project X will be better as it gives low but positive NPV whereas Project
Y yields highly negative NPV under this situation. In most likely situation both the project will
give same result. However, in optimistic situation Project Y will be better as it will gives very
high NPV. So, project X is a risk less project as it gives positive NPV in the entire situation
whereas Y is a risky project as it will result into negative NPV in pessimistic situation and highly
positive NPV in optimistic situation. So acceptability of project will largely depend on the risk
taking capacity (Risk seeking/ Risk aversion) of the management.

(5 marks)

A-23:- Functions of Finance Manager

The Finance Manager’s main objective is to manage funds in such a way so as to ensure their
optimum utilization and their procurement in a manner that the risk, cost and control
considerations are properly balanced in a given situation. To achieve these objectives the
Finance Manager performs the following functions:

i) Estimating the requirement of Funds: Both for long-term purposes i.e. Investment in fixed
assets and for short-term i.e. for working capital. Forecasting the requirements of funds
involves the use of techniques of budgetary control and long-range planning.
ii) Decision regarding Capital Structure: Once the requirement of funds has been estimated, a
decision regarding various sources from which these funds would be raised has to be taken.
A proper balance has to be made between the loan funds and own funds. He has to ensure
that he raises sufficient long term funds to finance fixed assets and other long term
investments and to provide for the needs of working capital
iii) Investment Decision: The investment of funds, in a project has to be made after careful
assessment of various projects through capital budgeting. Assets management policies are

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to be laid down regarding various items of current assets. For e.g. receivable in coordination
with sales manager, inventory in coordination with production manager.
iv) Dividend decision: The finance manager is concerned with the decision as to how much to
retain and what portion to pay as dividend depending on the company’s policy. Trend of
earnings, trend of share market prices, requirement of funds for future growth, cash flow
situation etc., are to be considered
v) Evaluating financial performance: A finance manager has to constantly review the financial
performance of the various units of organisation generally in terms of ROI Such a review
helps the management in seeing how the funds have been utilized in various divisions and
what can be done to improve it.
vi) Financial negotiation: The finance manager plays a very important role in carrying out
negotiations with the financial institutions, banks and public depositors for raising of funds
on favorable terms
vii) Cash management: The finance manager lays down the cash management and cash
disbursement policies with a view to supply adequate funds to all units of organisation and
to ensure that there is no excessive cash.
viii) Keeping touch with stock exchange: Finance manager is required to analyse major
trends in stock market and their impact on the price of the company share.

(5 marks)

A-24:-

Finance Lease Operating Lease

The risk and reward incident to ownership are The lessee is only provided the use of the
passed on to the lessee. The lessor only asset for a certain time. Risk incident to
remains the legal owner of the asset. ownership belong wholly to the lessor.
The lessee bears the risk of obsolescence. The lessor bears the risk of obsolescence.

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The lessor is interested in his rentals and not in
the asset. He must get his principal back along
with interest. Therefore, the lease is non-
cancellable by either party.
The lessor enters into the transaction only as
financier. He does not bear the cost of repairs,
maintenance or operations.
The lease is usually full payout, that is, the
single lease repays the cost of the asset
together with the interest
As the lessor does not have difficulty in
leasing the same asset to other willing lessor,
the lease is kept cancelable by the lessor.
Usually, the lessor bears cost of repairs,
maintenance or operations.
The lease is usually non-payout, since the
lessor expects to lease the same asset over
and over again to several users.
(5 marks)

A-25:-

i) Degree of operating leverage = % Change in Operating income/ % Change in Revenues

A Ltd. =0.22 / 0.35=0.63
B Ltd. =0.35 / 0.24=1.46
C Ltd. =0.26 / 0.29=0.90
D Ltd. =0.30 / 0.32=0.94
It is level specific.
ii) High operating leverage leads to high beta. So when operating leverage is lowest i.e. 0.63,
Beta is minimum (1) and when operating leverage is maximum i.e. 1.46, beta is highest i.e.
1.65
(5 marks)

A-26:- Working notes:

i) Current Assets and Current Liabilities computation:

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Current assets/ Current liabilities =2.5/1

Or Current assets = 2.5 Current liabilities
Now, Working capital = Current assets  Current liabilities
Or Rs 4,80,000 = 2.5 Current liability  Current liability
Or 1.5 Current liability = Rs 4,80,000
 Current Liabilities = Rs 3,20,000
So, Current Assets = Rs 3,20,000  2.5 = Rs 8,00,000

ii) Computation of stock

Liquid ratio = Liquid assets/ Current liabilities
Or 1.5 = current assets – Inventories /Rs 3,20,000
Or 1.5 Rs 3, 20,000 = Rs 8,00,000  Inventories
Or Inventories = Rs 8,00,000 –Rs 4, 80,000
Or Stock = Rs 3,20,000

iii) Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors
Fixed Asset to Proprietary ratio = Fixed assets/ Proprietary fund =0.75
 Fixed Assets = 0.75 Proprietary fund (PF)[FA+NWC = PF]
or NWC = PF- FA [(i.e. .75 PF)]
and Net Working Capital (NWC) = 0.25 Proprietary fund
Or Rs 4,80,000/0.25 = Proprietary fund
Or Proprietary fund = Rs 19,20,000
and Fixed Assets = 0.75 proprietary fund
= 0.75 Rs 19,20,000 = Rs 14,40,000
Capital = Proprietary fund  Reserves & Surplus
= Rs 19,20,000 Rs 3,20,000 = Rs 16,00,000
Sundry Creditors = (Current liabilities  Bank overdraft)
= (Rs 3,20,000 Rs 80,000) = Rs 2,40,000

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Balance Sheet as at 31st March, 2020

Liabilities Rs Assets Rs
Capital 16,00,000 Fixed Assets 14,40,000
Reserves & Surplus 3,20,000 Stock 3,20,000
Bank overdraft 80,000 Other Current Assets 4,80,000
Sundry creditors 2,40,000
22,40,000 22,40,000
(5 marks)

A-27:-

(i) Calculation of NPV under three different scenarios

(Amount in Rs )

Particulars 1st Scenario 2nd Scenario 3rd Scenario

Annual Cash Flow 50,000 1,00,000 1,50,000
PV of cash inflows 2,16,500 4,33,000 6,49,500
(Annual Cash Flow× 4.33*)
PV of Residual Value 31,360 31,360 31,360
(Rs 40,000 × 0.784)
Total PV of Cash Inflow 2,47,860 4,64,360 6,80,860
Initial investment 4,00,000 4,00,000 4,00,000
NPV (1,52,140) 64,360 2,80,860

* .952 + .907 + .864 + .823 + .784 = 4.33

(ii) Calculation of Expected Net present Value under three different scenarios

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Particulars 1st Scenario 2nd Scenario 3rd Scenario Total (Rs )

Annual Cash Flow Rs 50,000 Rs 1,00,000 Rs 1,50,000
Probability 0.3 0.3 0.4
Expected Value Rs 15,000 Rs 30,000 Rs 60,000 1,05,000
PV of Expected value (1,05,000× 4.33) 4,54,650
PV of Residual Value (40,000 × 0.784) 31,360
Total PV of Cash Inflow 4,86,010
Initial investment 4,00,000
Expected Net Present Value 86,010

(iii) Since the expected net present value of the Investment is positive, the Investment
should be undertaken.
(5 marks)

A-28:-

(i) Degree of operating, financial and combined leverages at the current sales level-

(ii) Earnings per share at the new sales level

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Particulars Increase by 20% Decrease by 20%

Sales level 40,80,000 27,20,000
Less: Variable expenses 7,20,000 4,80,000
Less: Fixed cost 6,00,000 6,00,000
Earnings before interest and taxes 27,60,000 16,40,000
Less: Interest 6,00,000 6,00,000
Earnings before taxes 21,60,000 10,40,000
Less: Taxes @35% 7,56,000 3,64,000
Earnings after taxes (EAT) 14,04,000 6,76,000
Number of equity shares 8,00,000 8,00,000
EPS 1.76 0.85

Working Notes:

Variable Costs = Rs 6,00,000 (total cost - depreciation)

Variable Costs at:

(i) Sales level, Rs 40,80,000 = Rs 7,20,000 (increase by 20%)

(ii) Sales level, Rs 27,20,000 = Rs 4,80,000 (decrease by 20%)

(10 marks)

A-29:- Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in Rs
Net Profit 50 lakhs
Less: Preference dividend 15 lakhs
Earnings for equity shareholders 35 lakhs
Therefore, earning per share 35 lakhs/5lakhs= Rs 7.00

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Price per share according to Gordon’s Model is calculated as follows:

i) When dividend pay-out is 25%

(5 marks)

A-30:-

Alternative I = Raising Debt of Rs 2.5 lakh + Equity of Rs 27.5 lakh.

Alternative II = Raising Debt of Rs 10 lakh + Equity of Rs 20 lakh

Alternative III = Raising Debt of Rs 15 lakh + Equity of Rs 15 lakh.

Calculation of Earnings per share (EPS):

Particulars FINANCIAL ALTERNATIVES

Alternative I Alternative II Alternative III
Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (working note i) (25,000) (1,37,500) (2,37,500)
Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)

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Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250

Number of shares (working note ii) 13,750 10,000 9,375
Earnings per share (EPS) 17.27 18.125 14.00

Financing Alternative II (i.e. raising debt of Rs 10 lakh and issue of equity share capital of Rs 20
lakh) is the option which maximizes the earnings per share.

Working Notes:

i) Calculation of interest on Debt

Alternative I (2,50,000 ×10%) 25,000

Alternative II (2,50,000 ×10%) 25,000
(7,50,000 ×15%) 1,12,500 1,37,500
(2,50,000 ×10%) 25,000
(7,50,000 ×15%) 1,12,500
(5,00,000 ×20%) 1,00,000 2,37,500

ii) Number of equity shares to be issued

Alternative I = Rs 27,50,000/ Rs 200 (Market Price of share)
= 13,750 shares
Alternative II = Rs 20,00,000/ Rs 200
= 10,000 shares
Alternative III = Rs 15,00,000/ Rs 160

= 9, 375 shares

(10 marks)

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Section- B: ECO Answers

A-1:-

GDPMP= Personal consumption expenditure + Government purchase of goods and services +

gross public investment + inventory investment +gross residential construction investment +
Gross business fixed investment + [export –import]

= 2900 + 1100 + 500 + 170+450 + 410 + (200-300)

= Rs 5430 Crores

GNPFC= GDPMP+ Net Factor Income from Abroad -Net Indirect Taxes

= Rs 5430 + (-30) +80 = 5480 Crores

NDPMP= GDPMP-Consumption of fixed capital = 5430-60 = 5370 Crores

(5 marks)

A-2:- An expansionary fiscal policy is designed to stimulate the economy during the
Contractionary phase of a business cycle or when there is an anticipation of a business cycle
contraction. T his is accomplished by increasing aggregate expenditure and aggregate demand
through an increase in all types of government spending and / or a decrease in taxes.

The objectives of expansionary fiscal policy are reduction in cyclical unemployment, increase in
consumer demand and prevention of recession and possible depression. In other words, it aims
to close a ‘recessionary gap’ or a Contractionary gap wherein the aggregate demand is not
sufficient to create conditions of full employment. This is accomplished by increasing aggregate
expenditure and aggregate demand through an increase in all types of government spending
and / or a decrease in taxes. Government uses subsidies, transfer payments, welfare
programmes, corporate and personal income tax cuts and increased spending on public works

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such as on infrastructure development to put more money into consumers' hands to give them
more purchasing power.

(2 marks)

A-3:- Foreign direct investment takes place when the resident of one country (i.e. home
country) acquires ownership of an asset in another country (i.e. the host country) and such
movement of capital involves ownership, control as well as management of the asset in the
host country. Foreign portfolio investment is the flow of what economists call ‘financial capital’
rather than ‘real capital’ and does not involve ownership or control on the part of the investor.

Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)

Foreign direct investment (FDI) Foreign portfolio investment (FPI)

Investment involves creation of physical assets Investment is only in financial assets
Has a long term interest and therefore remain
invested for long
Relatively difficult to withdraw
Not inclined to be speculative
Often accompanied by technology transfer
Direct impact on employment of labour and
wages
Enduring interest in management and control
Securities are held with significant degree of
influence by the investor on the management
of the enterprise
Only short term interest and generally remain
invested for short periods
Relatively easy to withdraw
Speculative in nature
Not accompanied by technology transfer
No direct impact on employment of labour
and wages
No abiding interest in management and
control
Securities are held purely as a financial
investment and no significant degree of
influence on the management of the
enterprise
(2 marks)

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A-4:- Monetary Policy Committee (MPC) constituted by the Central Government is an

empowered six-member committee with RBI Governor as the chairperson. Under the Monetary
Policy Framework Agreement, the RBI will be responsible for price stability and for containing
inflation targets at 4% (with a standard deviation of 2%) in the medium term. T he committee is
answerable to the Government of India if the inflation exceeds the range prescribed for three
consecutive months. MPC has complete control over monetary policy decisions to ensure
economic growth and price stability. T he MPC decides the changes to be made to the policy
rate (repo rate) so as to contain inflation within the target level specified to it by the central
government. Fixing of the benchmark policy interest rate (repo rate) is made in a more
consultative and participative manner and on the basis of majority vote by this panel of experts.
This has added lot of value and transparency to monetary policy decisions.

(2 marks)

A-5:- Gross National Product (GNP) is a measure of the market value of all final economic goods
and services, gross of depreciation, produced within the domestic territory of a country by
normal residents during an accounting year plus net factor incomes from abroad. Thus, GNP
includes earnings of Indian corporations overseas and Indian residents working overseas.

GNPMP= GDPMP+ Net Factor Income from Abroad

Net factor income from abroad is the difference between the income received from abroad for
rendering factor services by the normal residents of the country to the rest of the world and
income paid for the factor services rendered by non-residents in the domestic territory of a
country.

(2 marks)

A-6:- An ad valorem tariff is a duty or other charges levied on an import item on the basis of its
value and not on the basis of its quantity, size, weight, or any other factor.

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It is levied as a constant percentage of the monetary value of one unit of the imported good.
For example, a 20% ad valorem tariff on a computer generates Rs 2,000/ government revenue
from tariff on each imported computer priced at Rs 10,000/ in the world market. If the price of
computer rises to Rs 20,000, then it generates a tariff of Rs 4,000/

(3 marks)

A-7:- Impact of changes in Cash Reserve Ratio (CRR):

Change in Cash Reserve Ratio is one of the important quantitative tools aiding in liquidity
management. Higher the CRR with the central bank, lower will be the liquidity in the system
and vice versa. In order to control credit expansion during periods of inflation, the central bank
increases the CRR. With higher CRR, banks have to keep more reserves and the banks’ lendable
resources get depleted leading to decrease in the volume of bank lending and contraction in
credit and money supply in the economy.

During deflation, the central bank reduces the CRR in order to enable the banks to expand
credit and increase the supply of money available in the economy. With more credit available in
the market, economic activities get accelerated bringing the economy back to stability and
economic growth.

(2 marks)

A-8:- Difference between Liquidity Adjustment Facility (LAF) and Marginal Standing Facility
(MSF).

Liquidity Adjustment Facility (LAF) which was introduced by RBI in June, 2000, is a facility
extended to the scheduled commercial banks and primary dealers to avail of liquidity in case of
requirement on an overnight basis against the collateral of government securities including
state government securities. Its objective is to assist banks to adjust their day to day

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mismatches in liquidity. Currently, the RBI provides financial accommodation to the commercial
banks through repos / reverse repos under LAF.

Marginal Standing Facility (MSF) which was introduced by RBI in its monetary policy statements
2011 -12, refers to the facility under which scheduled commercial banks can borrow additional
amount of overnight money from the central bank over and above what is available to them
through the LAF window by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a
limit at a penal rate of interest. This provides a safety valve against unexpected liquidity shocks
to the banking system. The MSF would be the last resort for banks once they exhaust all
borrowing options including the liquidity adjustment facility.

(3 marks)

A-9:- According to Fisher, quantity theory of money demonstrate that there is strong
relationship between money and price level and the quantity of money is the main determinant
of the price level or the value of money. In other words, changes in the general level of
commodity prices or changes in the value or purchasing power of money are determined first
and foremost by changes in the quantity of money in circulation.

Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally

stated as follows:

MV=PT

Where, M=the total amount of money in circulation (on an average) in an economy, V =

transactions velocity of circulation i.e. the average number of times across all transactions a
unit of money(say Rupee) is spent in purchasing goods and services, P = average price level (P=
MV/T), T = the total number of transactions

Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and
their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of
exchange becomes:

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MV + M'V' = PT

Where M'= the total quantity of credit money, V' = velocity of circulation of credit money. The
total supply of money in the community consists of the quantity of actual money (M) and its
velocity of circulation (V) Velocity of money in circulation (V) and the velocity of credit money
(V') remain constant. T is a function of national income.

Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly
put, the total volume of transactions (T) multiplied by the price level (P) represents the demand
for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any
given period, the total value of transactions made is equal to PT and the value of money flow is
equal to MV+ M'V'.

Fisher did not specifically mention anything about the demand for money; but the same is
embedded in his theory as dependent on the total value of transactions undertaken in the
economy. Thus, there is an aggregate demand for money for transactions purpose and more
the number of transactions people want, greater will be the demand for money. The total
volume of transactions multiplied by the price level (PT) represents the demand for money.

(5 marks)

A-10:-

Product taxes like excise duties, customs, sales tax, service tax etc., are levied by the
government on goods and services and are generally related to the quantum of production.

Taxes on production, such as, factory license fee, taxes to be paid to the local authorities,
pollution tax etc., on the other hand, are unrelated to the quantum of production.

(3 marks)

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A-11:- A variety of allocation instruments are available by which governments can influence
resource allocation in the economy. They are

i) Government may directly produce the economic good (for example, electricity and public
transportation services)
ii) government may influence private allocation through incentives and disincentives (for
example, tax concessions and subsidies may be given for the production of goods that
promote social welfare and higher taxes may be imposed on goods such as cigarettes and
alcohol)
iii) 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).
iv) Governments’ regulatory activities such as licensing, controls, minimum wages, and
directives on location of industry influence resource allocation.
v) government sets legal and administrative frameworks, and
vi) Any of a mixture of intermediate techniques may be adopted by governments.
(3 marks)

A-12:- Customs duties are basically taxes or duties imposed on goods and services which are
imported or exported. It is defined as a financial charge in the form of a tax, imposed at the
border on goods going from one customs territory to another. T hey are the most visible and
universally used trade measures that determine market access for goods. Import duties being
pervasive than export duties, custom duties are often identified with import duties. Custom
duties are aimed at altering the relative prices of goods and services imported, so as to contract
the domestic demand and thus regulate the volume of their imports. Custom duties leave the
world market price of the goods unaffected; while raising their prices in the domestic market.
The main goals of custom duties are to raise revenue for the government, and more
importantly to protect the domestic import-competing industries.

(3 marks)

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A-13:- According to Fisher, quantity theory of money demonstrate that there is strong
relationship between money and price level and the quantity of money is the main determinant
of the price level or the value of money. In other words, changes in the general level of
commodity prices or changes in the value or purchasing power of money are determined first
and foremost by changes in the quantity of money in circulation. Fisher’s version, also termed
as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:

MV = PT

Where, M= the total amount of money in circulation (on an average) in an economy V =

transactions velocity of circulation i.e. the average number of times across all transactions a
unit of money(say Rupee) is spent in purchasing goods and services P = average price level (P=
MV/T ) T = the total number of transactions.

Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and
their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of
exchange becomes:

MV + M'V' = PT

Where M’ = the total quantity of credit money V' = velocity of circulation of credit money T he
total supply of money in the community consists of the quantity of actual money (M) and its
velocity of circulation (V). Velocity of money in circulation (V) and the velocity of credit money
(V') remain constant. T is a function of national income.

Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly
put, the total volume of transactions (T) multiplied by the price level (P) represents the demand
for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any
given period, the total value of transactions made is equal to PT and the value of money flow is
equal to MV+ M'V'.

Fisher did not specifically mention anything about the demand for money; but the same is
embedded in his theory as dependent on the total value of transactions undertaken in the

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economy. Thus, there is an aggregate demand for money for transactions purpose and more
the number of transactions people want, greater will be the demand for money. The total
volume of transactions multiplied by the price level (PT) represents the demand for money.

(3 marks)

A-14:- The process or channels through which the change of monetary aggregates affects the
level of product and prices is known as ‘monetary transmission mechanism’. There are mainly
four different mechanisms through which monetary policy influences the price level and the
national income. These are: (a) the interest rate channel, (b) the exchange rate channel, (c) the
quantum channel (e.g., relating to money supply and credit), and (d) the asset price channel i.e.
via equity and real estate prices.

Under the interest rate channel, changes in monetary policy are eventually reflected in the real
long-term interest rates which influence aggregate demand by altering business investment and
durable consumption decisions. This, in turn, gets reflected in aggregate output and prices.

The exchange rate channel works through expenditure switching between domestic and foreign
goods. Appreciation of the domestic currency makes domestically produced goods more
expensive compared to foreign‐produced goods. This causes net exports to fall;
correspondingly domestic output and employment also fall

The Quantum channel operates by altering access of firms and households to bank credit. Most
businesses and people mostly depend on bank for borrowing money. “An open market
operation” that leads first to a contraction in the supply of bank reserves and then to a
contraction in bank credit requires banks to cut back on their lending. This, in turn makes the
firms that are especially dependent on banks loans to cut back on their investment spending.
Thus, there is decline in the aggregate output and employment following a monetary
contraction.

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The asset price channel suggests that asset prices respond to monetary policy changes and
consequently affect output, employment and inflation.

(3 marks)

A-15:- The market value of bonds and the market rate of interest are inversely related. The
investment consultant considers the current interest rate as low, compared to the ‘normal or
critical rate of interest’, i.e., he expects the rate of interest to rise in future (fall in bond prices),
and therefore it is advantageous to hold wealth in the form of liquid cash rather than bonds
because:

i) When interest is low, the loss suffered by way of interest income forgone is small,
ii) one can avoid the capital losses that would result from the anticipated increase in interest
rates, and
iii) the return on money balances will be greater than the return on alternative assets
iv) If the interest rate does increase in future, the bond prices will fall and the idle cash
balances held can be used to buy bonds at lower price and can thereby make a capital-gain.
(3 marks)

A-16:- Subsidy is market-based policy and involves the government paying part of the cost to
the firms in order to promote the production of goods having positive externalities. Or in other
words, a subsidy on a good which has substantial positive externalities would reduce its cost
and consequently price, shift the supply curve to the right and increase its output. A higher
output that would equate marginal social benefit and marginal social cost is socially optimal.
There are many forms of subsidies given out by the government. Two of the most common
types of individual subsidies are welfare payments and unemployment benefits. The objective
of these types of subsidies is to help people who are temporarily suffering economically. Other

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subsidies, such as subsidized interest rates on student loans, are given to encourage people to
further their education.

(3 marks)

A-17:- Under floating exchange rate regime the equilibrium value of the exchange rate of a
country’s currency is market determined i.e the demand for and supply of currency relative to
other currencies determines the exchange rate.

(2 marks)

A-18:- Economic efficiency increases due to quantitative and qualitative benefits of extended
division of labour, economies of large scale production, betterment of manufacturing
capabilities, increased competitiveness and profitability by adoption of cost reducing
technology and business practices and decrease in the likelihood of domestic monopolies.
Efficient deployment of productive resources natural, human, industrial and financial resources
ensures productivity gains.

(3 marks)

A-19:-

Reserve Money = Currency in circulation + Bankers’ deposits with the RBI

+ Other deposits with the RBI

=15428.40 + 4596.18+ 183.30

= 20207.88

(3 marks)

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A-20:- Tradable emissions permits are marketable licenses to emit limited quantities of
pollutants and can be bought and sold by polluters. Under this method, each firm has permits
specifying the number of units of emissions that the firm is allowed to generate. A firm that
generates emissions above what is allowed by the permit is penalize d 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
ca se. The high polluters have to buy more permits, which increases their costs, and makes
them less competitive and less profitable. The low polluters receive extra revenue from selling
their surplus permits, which makes them more competitive and more profitable. Therefore,
firms will have an incentive not to pollute. India is experimenting with tradable emissions
permits in the form of Perform, Achieve & Trade (PAT) scheme and carbon tax in the form of a
cess on coal. The advantages claimed for tradable permits are that the system allows flexibility
and reward efficiency and it is administratively cheap and simple to implement and ensures
that pollution is minimized in the most cost-effective way. It also provides strong incentives for
innovation and consumers may benefit if the extra profits made by low pollution firms are
passed on to them in the form of lower prices.

The main argument in opposition to the employment of tradable emission permits is that they
do not in reality stop firms from polluting the environment; they only provide an incentive to
them to do so. Moreover, if firms have monopoly power of some degree along with a relatively
inelastic demand for its product, the extra cost incurred for procuring additional permits so as
to further pollute the atmosphere, could easily be compensated by charging higher prices to
consumers.

(3 marks)

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