FM Eco Test Book

Financial Management
&
Economics for Finance
“TEST BOOK”
By
CA NAMIT ARORA SIR

“WORK HARD IN SMART WAY”
ALL THE BEST

CA. NAMIT ARORA
INDEX
S. NO. TEST PAGE NO.
1 TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES 3–4
2 TEST 2 – MANAGAEMENT OF CASH AND MANAGEMENT OF RECEIVABLES 5-6
3 TEST 3 – MANAGMEMENT OF WORKING CAPITAL 7–8
4 TEST 4 – CAPITAL BUDGETING 9 – 10
5 TEST 5 – RISK ANALYSIS WITH CAPITAL BUDGETING AND COST OF CAPITAL 11 – 12
6 TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS 13 – 14
7 TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 15
8 TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 16
9 SAMPLE PAPER 1 17 – 22
10 SAMPLE PAPER 2 23 - 28
SOLUTION
11 SOLUTION TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES 29 – 32
12 SOLUTION TEST 2 – MANAGAEMENT OF CASH AND MANAGEMENT OF 33 – 34
RECEIVABLES
13 SOLUTION TEST 3 – MANAGMEMENT OF WORKING CAPITAL 35 – 36
14 SOLUTION TEST 4 – CAPITAL BUDGETING 37 – 39
15 SOLUTION TEST 5 – RISK ANALYSIS WITH CAPITAL BUDGETING AND COST 40 - 41
OF CAPITAL
16 SOLUTION TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO 42 – 44
ANALYSIS
17 SOLUTION TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 45 – 46
18 SOLUTION TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 47 – 48
19 SOLUTION SAMPLE PAPER 1 49 – 62
20 SOLUTION SAMPLE PAPER 2 63 – 73

TEST 1 – EBIT & EPS ANALYSIS AND LEVERAGES 3
TEST 1 – EBIT & EPS ANALYSIS AND LEVERAGES
Time: 70 Minutes Marks: 40
PART A: EBIT & EPS ANALYSIS
Question 1
RM Steels Limited requires `10,00,000 for the construction of new plant. It is considering three financial
plans:
(1) The Company may issue 1,00,000 ordinary shares at `10 per share.
(2) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 debentures of `100
denomination bearing 8% rate of interest.
(3) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 preference shares at `100
per share bearing a 8% rate of dividend.
If RM Steels Limited’s earnings before interest and taxes are `20,000, `40,000, `80,000, `1,20,000 and
`2,00,000.
You are required to compute the earning per share under each of the three plans? Which
alternative would you recommend for RM Steels and why? Tax rate is 50%.
(10 Marks)
Question 2
The management of Z Company Ltd. wants to raise its funds from market to meet out the financial demands
of its long-term projects. The company has various combinations of proposals to raise its funds. You are
given the following proposals of the company:
(i) Proposals Equity Shares (%) Debts (%) Preference shares (%)
P 100 - -
Q 50 50 -
R 50 - 50
(ii) Cost of debt and preference shares is 10% each.

(iii) Tax rate 50%.
(iv) Equity shares of the face value of `10 each will be issued at a premium of `10 per share.
(v) Total investment to be raised `40,00,000.
(vi) Expected earnings before interest and tax `18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:
(1) Earnings per share

(2) Financial break-even-point
(3) Compute the EBIT range among the plans for indifference. Also indicate if any of the plans dominate.
(10 Marks)
TEST 1 – EBIT & EPS ANALYSIS AND LEVERAGES 4
PART B: LEVERAGES
Question 3
A company had the following Balance Sheet as on 31st March, 2014: [in crores]
Liabilities ` Assets `
Equity Share Capital 5.00 Fixed Assets (Net) 12.50
(50 lakh shares of `10 each) Current Assets 7.50
Reserve and Surplus 1.00
15% Debentures 10.00
Current Liabilities 4.00
20.00 20.00
The additional information given is as under:
Fixed cost per annum (excluding interest) 4 crores

Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:
(i) Earnings Per Share

(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
(10 Marks)
Question 4
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?
(10 Marks)
TEST 2 – MANAGEMENT OF CASH AND MANAGEMENT OF REEIVABLES 5
TEST 2 – MANAGEMENT OF CASH AND MANAGEMENT OF REEIVABLES
PART A: MANAGEMENT OF CASH
Question 1
Prepare monthly cash budget for six months beginning from April 2020 on the basis of the following
information:
(a) 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
(b) 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
(c) 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 debts losses.
(d) Purchase amount to 80% of sales and are made and paid for in the month preceding the sales.
(e) The firm has 10% debenture of `1,20,000. Interest on these has to be paid quarterly in January, April
and so on.
(f) The firm is to make an advance payment of tax of `5,000 in July 2020.
(g) The firm had a cash balance of `20,000 on April 1, 2020, which is the minimum desired level of cash
balance. Any cash surplus or deficit above or below this level is made up by temporary investment or
liquidation of temporary investment or temporary borrowing at the end of each month (interest on
these to be ignored).
(10 Marks)
Question 2
Following information relates to ABC company for the year 2016:
(a) Projected sales (` in lakhs)

August September October November December
35 40 40 45 46
(b) Gross profit margin will be 20% on sale.

(c) 10% of projected sale will be cash sale. Out of credit sale of each month, 50% will be collected in the
next month and the balance will be collected during the second month following the month of sale.
(d) Creditors will be paid in the first month following credit purchase. There will be credit purchase only.
TEST 2 – MANAGEMENT OF CASH AND MANAGEMENT OF REEIVABLES 6
(e) Wages and salaries will be paid on the first day of the next month. The amount will be `3 lakhs each
month.
(f) Interim dividend of `2 lakhs will be paid in December 2016.
(g) Machinery costing `10 lakhs will be purchased in September 2016. Repayment by instalment of
`50,000 p.m. will start from October 2016.
(h) Administrative expenses of `1,00,000 per month will be paid in the month of their incurrence.
(i) Assume no minimum cash balance is required. Opening cash balance as on 01.10.2016 is estimated at
`10 lakhs.
You are required to prepare the monthly cash budget for the 3 month period (October 2016 to
December 2016).
(10 Marks)
PART B: MANAGEMENT OF RECEIVABLES
Question 3
A company is considering to engage a factor. The following information is available:
 The current average collection period for the company's debtors is 90 days and ½% of debtors default.
The factor has agreed to pay money due after 60 days, and will take the responsibility of any loss on
account of bad debts.
 The annual charge for the factoring is 2% of turnover. Administration cost saving is likely to be `1,00,000
per annum.
 Annual credit sales are `1,20,00,000. Variable costs is 80% of sales price. The company's cost of
borrowings is 15% per annum. Assume 360 days in a year.
Should the company enter into a factoring agreement?

(10 Marks)
Question 4
The present credit terms of P Company are 1/10 net 30. Its annual sales is `80 lakhs, its average collection
period is 20 days. Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost
of capital is 10 per cent. The proportion of sales on which customers currently take discount is 0.5.
P Company is considering relaxing its discount terms to 2/10 net 30. Such relaxation is expected to
increase sales by `5 lakhs, reduce the average collection period to 14 days and increase the proportion of
discount sales to 0.8.
What will be the effect of relaxing the discount policy on company's profit? Take year as 360
days.
(10 Marks)
TEST 3 – MANAGEMENT OF WORKING CAPITAL 7
TEST 3 – MANAGEMENT OF WORKING CAPITAL
Question 1
From the following information of XYZ Ltd., you are required to calculate:
(a) Net operating cycle period.

(b) Number of operating cycles in a year.
Raw material inventory consumed during the year `6,00,000

Average stock of raw material `50,000
Annual cost of production `5,00,000
Average work-in-progress inventory `30,000
Annual cost of goods sold `8,00,000
Average finished goods stock held `40,000
Average collection period from debtors 45 days
Average credit period availed 30 days
No. of days in a year 360 days
(10 Marks)
Question 2
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 is 2,08,000 completed units of production plus 8,000 units of work-in-
progress.
Based on the above activity, estimated cost per unit is:
Raw material `16

Direct wages `6
Overheads (exclusive of depreciation) `12
Total cost `34
Selling price `40
Raw materials in stock: average 4 weeks consumption, work-in-progress (assume 50% completion
stage in respect of conversion cost and materials issued at the start of the processing).
Finished goods in stock 16,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 weeks
Lag in payment of wages Average 1.5 weeks
TEST 3 – MANAGEMENT OF WORKING CAPITAL 8
Lag in payment of overheads Average 4 weeks
Cash at banks (for smooth operation) `50,000
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 estimate net working capital.

(10 Marks)
Question 3
PQ Limited wants to expand its business and has applied for a loan from a commercial bank for its growing
financial requirements.
The records of the company reveals that the company sells goods in the domestic market at a gross
profit of 25% not counting depreciation as part of the cost of goods sold.
The following additional information is also available for you:
Sales:
Home at one month’s credit `1,20,00,000
Export at three month’s credit `54,00,000
(Sales price 10% below Home price)
Material used (suppliers extend two months’ credit) `45,00,000
Wages paid ½ month in arrear `36,00,000
Manufacturing expenses (cash) paid (1 month in arrear) `54,00,000
Administrative expenses paid 1 month in arrear `12,00,000
Income tax payable in four installments (of which one falls in the next financial year)`15,00,000
The company keeps one month’s stock of raw materials and finished goods (each) and believes in
keeping `10,00,000 available to it including the overdraft limit of `5,00,000 not yet utilized by the company.
Assume a 15% margin for contingencies.
You are required to ascertain the requirement of the working capital of the company.
(10 Marks)
TEST 4 - CAPITAL BUDGETING 9
TEST 4 - CAPITAL BUDGETING
Question 1
XYZ Ltd is planning to introduce a new product with a projected life of 8 years. The project to be set up in a
backward region, qualifies for a one time (as its starting) tax free subsidy from the government of
`20,00,000 equipment cost will be `140 lakhs and additional equipment costing `10,00,000 will be needed
at the beginning of the third year. At the end of 8 years the original equipment will have no resale value but
the supplementary equipment can be sold for `1,00,000. A working capital of `15,00,000 will be needed. The
sales volume over the eight years period has been forecasted as follows:
Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of `100 per unit is expected and variable expenses will amount to 40% of sales revenue.
Fixed cash operating costs will amount to `16,00,000 per year. In addition an extensive advertising
campaign will be implemented requiring annual outlays as follows:
Year (` in lakhs)
1 30
2 15
3-5 10
6-8 4
The company is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of
capital for this project. The company follows the straight line method of depreciation.
Should the project be accepted?

(10 Marks)
Question 2
APZ limited is considering selecting a machine between two machines ‘A’ and ‘B’. The two machines have
identical capacity, do exactly the same job, but designed differently.
Machine A costs `8,00,000, having useful life of three years. It costs `1,30,000 per year to run.
Machine B is an economic model costing `6,00,000, having useful life of two years. It costs `2,50,000 per year
to run.
The cash flows of machine ‘A’ and ‘B’ are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore taxes. The opportunity cost of capital is 10%.
TEST 4 - CAPITAL BUDGETING 10
The present value factors at 10% are:
Years t1 t2 t3
PVIF0.10t 0.9091 0.8264 0.7513
PVIFA0.10.2 = 1.7355
PVIFA0.10.3 = 2.4868
Which machine would you recommend the company to buy?

(10 Marks)
Question 3
Total fund available is `3,00,000. Determine the optimal combination of projects assuming that the projects
are (a) Divisible or (b) Indivisible.
Project Name Initial Investment NPV

P `1,00,000 `20,000
Q `3,00,000 `35,000
R `50,000 `16,000
S `2,00,000 `25,000
T `1,00,000 `30,000
(10 Marks)
Question 4
Given below are the data on a capital project ‘M’:
Annual cash inflow `60,000

Useful life 4 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.064
Table of discount factor:
Years
Discount Factor
1 2 3 4
15% 0.870 0.756 0.658 0.572
14% 0.877 0.769 0.675 0.592
13% 0.886 0.783 0.693 0.614
12% 0.893 0.797 0.712 0.636
You are required to calculate:

(i) Cost of the project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value of cash inflow
(10 Marks)
TEST 5 – RISK ANALYSIS IN CAPITAL BUDGETING & COST OF CAPITAL 11
TEST 5 – RISK ANALYSIS IN CAPITAL BUDGETING & COST OF CAPITAL
PART A: RISK ANALYSIS IN CAPITAL BUDGETING
Question 1
Gaurav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected cash flow (`) Certainty Equivalent coefficient

0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of return on the government securities is 6%. Determine whether the project
should be accepted.
(5 Marks)
Question 2
From the following details relating to a project, analyze the sensitivity of the project to changes in
initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 2,00,00,000

Annual Cash Inflow (`) 60,00,000
Project Life (Years) 5
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% 3.791 and 11% 3.696).
(5 Marks)
PART B: COST OF CAPITAL
Question 3
The R & G Company has following capital structure at 31st March, 2004, which is considered to be
optimum:
TEST 5 – RISK ANALYSIS IN CAPITAL BUDGETING & COST OF CAPITAL 12
13% debenture `3,60,000
11% preference share capital `1,20,000
Equity share capital (2,00,000 shares) `19,20,000
The company's share has a current market price of `27.75 per share. The expected dividend per
share in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are
expected to continue:
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS (`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14 percent new debenture. The company's debenture is currently selling at
`98. The new preference issue can be sold at a net price of `9.80, paying a dividend of `1.20 per share. The
company's marginal tax rate is 50%.
(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary
equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming
that retained earning available for next year's investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part
(iii)] if the company can sell new ordinary shares to net `20 per share? The cost of debt and of
preference capital is constant.
(10 Marks)
Question 4
ABC Ltd. wishes to raise additional finance of `20 lakhs for meeting its investment purpose. 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:
Upto `2,00,000 : 10% (before tax) and
Beyond `2,00,000 : 13% (before tax)
Earning per share : `12 per share
Dividend payout : 50% of earnings
Expected growth rate : 10%
Current market price : `60 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 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.
(10 Marks)
TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS 13
TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS

PART A: CAPITAL STRUCTURE
Question 1
‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘A’ Ltd. does not use any debt in its
capital structure whereas ‘B’ Ltd. employs 12% debentures amounting to `10,00,000. Assumung that:
(i) All assumptions of MM model are met;

(ii) Income tax rate is 30%;
(iii) EBIT is `2,50,000 and
(iv) The equity capitalization rate of ‘A’ Ltd. is 20%.
Calculate the value of both the companies and also find out Weighted Average Cost of Capital for
both the companies.
(5 Marks)
PART B: DIVIDEND DECISIONS
Question 2
Following figures and information were extracted from the company A Ltd.
Earnings of the company `10,00,000

Dividend paid `6,00,000
No. of shares outstanding 2,00,000
Price earnings ratio 10
Rate of return on investment 20%
(1) Current market price of the share.

(2) Capitalization rate of its risk class.
(3) What should be the optimum payout ratio?
(4) What should be the market price per share at optimal payout ratio? (use Walter’s model)
(5 Marks)
Question 3
AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has outstanding
10,000 shares selling at `100 each. The firm is contemplating the declaration of a dividend of `5 per share at
the end of the current financial year. It expects to have a net income of `1,00,000 and has a proposal for making
new investments of `2,00,000.
TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS 14
Required:
1. Calculate value of firm when dividends are not paid.

2. Calculate value of firm when dividends are paid.
(10 Marks)
PART C: RATIO ANALYSIS
Question 4
The following figures and ratios pertains to ABG Company Limited for the year ending 31st March, 2016:
Annual sales (credit) `50,00,000

Gross Profit ratio 28%
Fixed assets turnover ratio (based on COGS) 1.5
Stock turnover ratio (based on COGS) 6
Quick ratio 1:1
Current ratio 1.5
Debtors collection period 45 days
Reserve and surplus to Share capital 0.60 : 1
Capital gearing ratio 0.5
Fixed assets to net worth 1.2 : 1
You are required to prepare the Balance Sheet as at 31st March, 2016 based on the above information.
Assume 360 days in a year.
(10 Marks)
TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 15
TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE

PART A: NATIONAL INCOME
Question 1
Suppose in an economy:
Consumption Function = 150 + 0.75Yd

Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) = 40
Exports (X) = 35
Imports (M) = 15 + 0.1Y
Where, Y and Yd are National Income and Personal Disposable Income respectively. All figures are in rupees.
Find:
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level
(5 Marks)
Question 2
In a two sector economy, the business sector produces 7,500 units at an average price of `7.
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 75 percent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
(5 Marks)
PART B: PUBLIC FINANCE
Question 3
Explain the role of Government in a market economy as stated by Richard Musgrave.
(3 Marks)
Question 4
Describe the meaning and mechanism of 'crowding out' effect of public expenditure.
(3 Marks)
Question 5
Explain the objectives of Fiscal Policy.
(4 Marks)
TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 16
TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE

PART A: MONEY MARKET
Question 1
Explain the different mechanism of monetary policy which influences the price level and national income.
(3 Marks)
Question 2
Explain the Monetary Policy Framework Agreement.
(2 Marks)
Question 3
Compute M1 supply of money from the data given below:
Currency with public `2,13,279.8 Crores
Time deposits with bank `3,45,000.7 Crores
Demand deposits with bank `1,62,374.5 Crores
Post office savings deposit `382.9 Crores
Other deposits of RBI `765.1 Crores
(3 Marks)
Question 4
Why is the central bank referred to as a "banker's bank"?
(2 Marks)
PART B: INTERNATIONAL TRADE
Question 5
The table given below shows the number of labour hours required to produce Sugar and Rice in two countries
X and Y:
Commodity Country X Country Y
1 Unit of Sugar 2.0 5.0
1 unit of Rice 4.0 2.5
(a) Compute the Productivity of labour in both countries in respect of both commodities.
(b) Which country has absolute advantage in production of Sugar?
(c) Which country has absolute advantage in production of Rice?
(3 Marks)
Question 6
Explain with example how Ad Valorem Tariff is levied.
(3 Marks)
Question 7
What are the modes of Foreign Direct Investment (FDI)?
(4 Marks)
SAMPLE PAPER 1 17
Roll No……………..
Total No. of Questions – 11 Total No. of Printed Pages – 8
Time Allowed – 3 Hours Maximum Marks - 100
SAMPLE PAPER 1
CA Intermediate (New Syllabus)

Paper – 8: Financial Management and Economics for Finance
SECTION A – Financial Management
Question No. 1 is compulsory.

Answer any four questions out of the remaining five questions.
Working notes should form part of the answer.
(4 × 5 = 20 Marks)
1. Answer the followings:
(a) The Sale revenue of TM excellence Ltd. @ `20 per unit of output is `20 lakhs and Contribution is `10
lakhs. At the present level of output the DOL of the company is 2.5. The company does not have any
Preference Shares. The number of Equity Shares are 1 lakh. Applicable corporate income tax rate is
50% and the rate of interest on Debt Capital is 16% p.a.
What is the EPS (At sales revenue of ` 20 lakhs) and amount of Debt Capital of the company
if a 25% decline in Sales will wipe out EPS.
(b) 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 i.e. (K e ) 16%
What should be the approximate dividend payout ratio so as to keep the share price at `42
by using Walter model?
(c) Alpha Ltd. requires funds amounting to `80,00,000 for its new project. To raise the funds, the
company has following two alternatives:
(1) To issue Equity Shares of `100 each (at par) amounting to `60,00,000 and borrow the balance
amount at the interest of 12% p.a.; or
(2) To issue Equity Shares of `100 each (at par) and 12% Debentures in equal proportion.
Find out the point of indifference between two modes of financing and state which option will
be beneficial in different situations assuming tax rate 30%.
(d) From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
SAMPLE PAPER 1 18
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 1.5
2. A company has to make a choice two machines ‘X’ and ‘Y’. The two machines have identical capacity,
do exactly the same job, but designed differently.
Machine X costs `5,50,000 and will last for three years. It costs `1,25,000 per year to run.
Machine Y is an economic model costing `4,00,000 will last for two years. It costs `1,50,000 per year
to run.
The cash flows of machine ‘X’ and ‘Y’ are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Ignore taxes. The present value factors at 12% are:
Years t1 t2 t3
PVIF0.12t 0.8929 0.7972 0.7118
PVIFA0.12.2 = 1.6901
PVIFA0.12.3 = 2.4019
Which machine would you recommend the company to buy?

(10 Marks)
3. The R & G Company has following capital structure at 31st March, 2004, which is considered to be
optimum:
13% debenture `3,60,000

11% preference share capital `1,20,000
Equity share capital (2,00,000 shares) `19,20,000
The company's share has a current market price of `27.75 per share. The expected dividend
per share in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past
trends are expected to continue:
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS (`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14 percent new debenture. The company's debenture is currently
selling at `98. The new preference issue can be sold at a net price of `9.80, paying a dividend of `1.20
per share. The company's marginal tax rate is 50%.
(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary
equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold?
Assuming that retained earning available for next year's investment are 50% of 2004
earnings.
SAMPLE PAPER 1 19
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated
in part (iii)] if the company can sell new ordinary shares to net `20 per share? The cost of
debt and of preference capital is constant.
(10 Marks)
4. 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
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.
(10 Marks)
5. RST Ltd. is expecting an EBIT of `4,00,000 for F.Y. 2015-16. Presently the company is financed by
equity share capital `20,00,000 with equity capitalization rate of 16%. The company is contemplating
to redeem part of the capital by introducing debt financing. The company has two options to raise
debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%,
the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company
opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%.
You are required to compute value of the company; its overall cost of capital under different
options and also state which is the best option.
(10 Marks)
6. (a) Briefly explain the three finance function decisions. (3 Marks)
(b) Explain the steps while using the equivalent annualized criterion. (3 Marks)
(c) Explain the significance of Cost of Capital. (4 Marks)
OR
Briefly describe any four sources of short-term finance. (4 Marks)

SAMPLE PAPER 1 20
SECTION B – Economics for Finance

Answer any three questions from the rest.
Question 7 (1)
Calculate Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) from the
following data:
Income Consumption Level

8,000 6,000 Initial Level
12,000 9,000 Changed Level
(2 Marks)
Question 7 (2)
Why is there a need for the government to resort to resource allocation?

(3 Marks)
Question 7 (3)
Suppose in an economy:
Consumption Function = 150 + 0.75Yd
Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) = 40
Exports (X) = 35
Imports (M) = 15 + 0.1Y
Where, Y and Yd are National Income and Personal Disposable Income respectively. All figures are in
rupees.
Find:
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level
(5 Marks)
Question 8 (1)
Explain the leakages and injections in the circular flow of Income.
(2 Marks)
Question 8 (2)
Define 'Market power'. What is its disadvantage?
(2 Marks)
SAMPLE PAPER 1 21
Question 8 (3)
The RBI published the following data as on 31st March, 2018. You are required to compute M4:
(` in crores)
Currency with the public 1,12,206.6
Demand Deposits with Banks 1,93,300.4
Net Time Deposits with Banks 2,67,310.2
Other Deposits of RBI 614.8
Post Office Savings Deposits 277.5
Post Office National Savings Certificates (NSCs) 110.5
(3 Marks)
Question 8 (4)
Explain the role of Monetary Policy Committee (MPC) in India.
(3 Marks)
Question 9 (1)
From, the following data, compute the Gross National Product at Market Price using Value Added
method:
(` in Crores)
Value of output in secondary sector 1,000
Intermediate consumption in primary sector 300
Value of output in tertiary sector 3,000
Intermediate consumption in secondary sector 400
Net factor income from abroad - 100
Value of output in primary sector 800
Intermediate consumption in tertiary sector 900
(3 Marks)
Question 9 (2)
Describe the limitations of fiscal policy.
(3 Marks)
Question 9 (3)
Explain the Monetary Policy Framework Agreement.
(2 Marks)
Question 9 (4)
Explain 'depreciation' and 'appreciation' of home currency under floating exchange rate.
(2 Marks)
Question 10 (1)
What is meant by quasi public goods?
(2 Marks)
Question 10 (2)
What is meant by expansionary fiscal policy? Under what circumstances do government pursue
expansionary policy?
SAMPLE PAPER 1 22
(3 Marks)
Question 10 (3)
Mention the general characteristics of Money.
(2 Marks)
Question 10 (4)
Explain the classical theory of Comparative Advantage as given by David Ricardo.
(3 Marks)
Question 11 (1)
Explain the different mechanism of monetary policy which influences the price level and national
income.
(3 Marks)
Question 11 (2)
How does international trade Increase economic efficiency? Explain.
(3 Marks)
Question 11 (3)
What is meant by 'Mixed tarifs'?
(2 Marks)
Question 11 (4)
Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI).
(2 Marks)
SAMPLE PAPER 2 23
Roll No……………..
Total No. of Questions – 11 Total No. of Printed Pages – 8
Time Allowed – 3 Hours Maximum Marks - 100
SAMPLE PAPER 2
CA Intermediate (New Syllabus)

Paper – 8: Financial Management and Economics for Finance
SECTION A – Financial Management

Answer any four questions out of the remaining five questions.
(4 × 5 = 20 Marks)
1. Answer the followings:
(a) Following information relating to Jee Ltd. are given:
Profit after tax : `10,00,000

Dividend payout ratio : 50%
Number of Equity shares : 50,000
Cost of equity : 10%
Rate of return on investment : 12%
(1) What would be the market value per share as per as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of
equity share at that payout ratio?
(b) Tarus Ltd. has an estimated cash payments of `8,00,000 for a one month period and the payments
are expected to steady over the period. The fixed cost per transaction is `250 and the interest rate on
marketable securities is 12% p.a.
Calculate the optimal transaction size, average cash and number of transactions during one
month.
(c) 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 amount (Debt).
Rate of tax may be taken as 30%. After the capital restructuring and applying MM model with
taxes.

(a) Market value of RES Ltd.
(b) Cost of Equity Ke.
(c) Weighted average cost of capital and comment on it.
(d) Door ltd. is considering an investment of `4,00,000 this investments expected to generate substantial
SAMPLE PAPER 2 24
cash inflows over the next five years. Unfortunately the annual cash flows from this investment is
uncertain, but the following probability distribution has been established:
Annual Cash Flow (`) 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 `40,000. The cost
of capital is 5%.
(1) Calculate NPV under the three different scenarios.

(2) Calculate expected net present value
(3) 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
2. SRS Ltd has furnished the following ratios and information relating to the year ended 31st
March,2015.
Sales `60,00,000
Return on Net Worth 25%
Rate of Income Tax 50%
Share Capital to Reserve 7: 3
Current Ratio 2
Net Profit to Sales (after tax) 6.25%
Inventory Turnover 12
(Based on cost of goods sold and closing stock)
Cost of Goods Sold `18,00,000
Interest on Debenture @ 15% `60,000
Sundry Debtors `2,00,000
Sundry Creditors `2,00,000
You are required to:

(i) Calculate the operating expenses for the year ended 31st March,2015.
(ii) Prepare Balance Sheet as on 31st March,2015.
(10 Marks)
3. ANP Ltd. Is providing the following information:
Annual cost of saving `96,000

Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05
Table of discount factor:

SAMPLE PAPER 2 25
Discount Years
Factor 1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52

(a) Cost of the project
(b) Payback period
(c) Net present value of cash inflow
(d) Cost of capital
(10 Marks)
4. The management of Royal industries has called for a statement showing the working capital needs to
finance a level of 1,80,000 units of output for the year. The cost structure for the company's product
for the above mentioned activity level is detailed below:
Cost per Unit (`)
Raw materials 20
Direct labour 5
Overheads (including depreciation of `5 per unit) 15
Total cost 40
Profit 10
Selling price 50
Additional Information:
(a) Minimum desired cash balance is `20,000.
(b) Raw materials are held in stock on an average for 2 months.
(c) Work-in-progress (assume 50% completion stage) will approximate to half month's
production.
(d) Finished goods remain in warehouse on an average for a month.
(e) Suppliers of materials extend a month's credit and debtors are provided two month's credit.
(f) Cash sales are 25% of total sales.
(g) There is a time lag in payment of wages of a month and half a month in case of overheads.
From the above data, you are required to:

(1) Prepare a statement showing working capital needs; and
(2) Determine the maximum working capital finance available under the first two methods
suggested by Tandon Committee.
(10 Marks)
5. A company had the following Balance Sheet as on 31st March, 2014: [in crores]
Equity Share Capital 5.00 Fixed Assets (Net) 12.50
(50 lakh shares of `10 each) Current Assets 7.50
Reserve and Surplus 1.00
15% Debentures 10.00
Current Liabilities 4.00
20.00 20.00
SAMPLE PAPER 2 26
The additional information given is as under:
Fixed cost per annum (excluding interest) 4 crores
Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
(10 Marks)
6. Answer the following:

(a) Explain in brief following Financial Instruments:
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial paper
(iv) Fully Hedged Bond
(1 x 4 = 4 Marks)
(b) Discuss the Advantages of Leasing.

(4 Marks)
(c) Write two main objectives of Financial Management.

(2 Marks)
SAMPLE PAPER 2 27
SECTION B – Economics for Finance

Answer any three questions from the rest.
Question 7 (1)
"World Trade Organisation (WTO) has a three-tier system of decision making." Explain.
(2 Marks)
Question 7 (2)
In a two sector economy, the business sector produces 7,500 units at an average price of `7.
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 75 percent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
(5 Marks)
Question 7 (3)
Explain the objectives of Fiscal Policy. (3 Marks)
Question 8 (1)
Which types of Government interventions are applied for correcting information failure?
(2 Marks)
Question 8 (2)
Compute M1 supply of money from the data given below:
Currency with public `2,13,279.8 Crores

Time deposits with bank `3,45,000.7 Crores
Demand deposits with bank `1,62,374.5 Crores
Post office savings deposit `382.9 Crores
Other deposits of RBI `765.1 Crores
(3 Marks)
Question 8 (3)
Describe the determinants of demand for money as identified by Milton Friedman in his restatement
of Quantity Theory of demand for money.
(3 Marks)
Question 8 (4)
The Nominal Exchange rate of India is `56/1$, Price Index in India is 116 and Price Index in USA is
112. What will be the Real Exchange Rate of India?
(2 Marks)
Question 9 (1)
The table given below shows the number of labour hours required to produce Sugar and Rice in two
SAMPLE PAPER 2 28
countries X and Y:
Commodity Country X Country Y
1 Unit of Sugar 2.0 5.0
1 unit of Rice 4.0 2.5
(a) Compute the Productivity of labour in both countries in respect of both commodities.
(b) Which country has absolute advantage in production of Sugar?
(c) Which country has absolute advantage in production of Rice?
(3 Marks)
Question 9 (2)
Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the
following data:
Income Consumption
`4,000 `3,000 (2 Marks)
Question 9 (3)
Explain with example how Ad Valorem Tariff is levied. (3 Marks)
Question 9 (4)
Describe features of public goods. (2 Marks)
Question 10 (1)
Distinguish between Personal Income and Disposable Personal Income. (3 Marks)
Question 10 (2)
Explain the role of Government in a market economy as stated by Richard Musgrave. (3 Marks)
Question 10 (3)
Why is the central bank referred to as a "banker's bank"? (2 Marks)
Question 10 (4)
"World Trade Organisation (WTO) has a three-tier system of decision making." Explain.
(2 Marks)
Question 11 (1)
Describe the meaning and mechanism of 'crowding out' effect of public expenditure. (3 Marks)
Question 11 (2)
"Money has four functions: a medium, a measure, a standard and a store." Elucidate. (2 Marks)
Question 11 (3)
What will be the total credit created by the commercial banking system for an initial deposit of `3,000
at a Required Reserve Ratio (RRR) of 0.05 and 0.08 respectively? Also compute credit multiplier.
(2 Marks)
Question 11 (4)
What are the modes of Foreign Direct Investment (FDI)? (3 Marks)
SOLUTION TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES 29
SOLUTION TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES
Solution 1
1. Statement showing EPS with respect to various plans & different EBIT:
a. Equity Financing
Particulars ` ` ` ` `
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)
EAT 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 `1.00
b. Debt - Equity Mix

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)
EAT (10,000) 0 20,000 40,000 80,000
÷ No. of Equity Shares ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000
EPS (`0.20) `0.00 `0.40 `0.80 `1.60
c. Preference Share - Equity Mix

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)
EAT 10,000 20,000 40,000 60,000 1,00,000
Less: Preferential Dividend (40,000) (40,000) (40,000) (40,000) (40,000)
EAT 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) `0.00 `0.40 `1.20
2. Recommendation:
(a) If expected EBIT is less than `80,000 : Equity Finance (Alternative 1)
(b) If expected EBIT is equal to `80,000 : Equity or Debt - Equity Mix (Alternative 1 or 2)
(c) If expected EBIT is more than `80,000 : Debt – Equity Mix (Alternative 2)
Solution 2
(i) Statement of EPS
Alternatives
Particulars
P Q R
Earnings before interest and tax 18,00,000 18,00,000 18,00,000
Less: Interest @ 10% on `20,00,000 - 2,00,000 -
EBT 18,00,000 16,00,000 18,00,000
Less: Tax @ 50% 9,00,000 8,00,000 9,00,000
EAT 9,00,000 8,00,000 9,00,000
Less: Preference Dividend - - 2,00,000
Earning Available for Equity Shareholders 9,00,000 8,00,000 7,00,000
÷ No. of Equity shares (Issue price `20) 2,00,000 1,00,000 1,00,000
EPS `4.50 `8.00 `7.00
Recommendation: Company should select debt option having highest EPS among different plans.
(ii) Financial Break Even Point (EBIT equals to fixed financial cost):
Proposal P Financial B.E.P. = No Fixed Financial Cost = Zero
Proposal Q Financial B.E.P. = Interest on Debt = 2,00,000
Pr eference Dividend
Proposal R Financial B.E.P. = Gross Preference Dividend =
(1  t )
2,00,000
= = 4,00,000
1  0.50
(iii) Indifference Point:
Between Proposal P & Q:
EBIT  I 1  T =
EBIT  I 1  T
N1 N2
EBIT  Nil  1  0.50 =
EBIT  2,00,000 1  0.50
2,00,000 1,00,000
EBIT = `4,00,000
Between Proposal P & R:

EBIT  I 1  T =
EBIT  I 1  T PD
N1 N3
EBIT  Nil  1  0.50 =
EBIT  Nil  1  0.40 2,00,000
2,00,000 1,00,000
EBIT = `8,00,000
Between Proposal Q & R:

If No. of equity shares between two plans are same then, indifference point can’t be calculate due to
difference in fixed financial cost in Proposal Q and R. Proposal Q having lower financial fixed cost is always
better than Proposal R having higher financial fixed cost.
Alternatively:
EBIT  I 1  T =
EBIT  I 1  T  PD
N2 N3
EBIT  2,00,000 1  0.50 =
EBIT  Nil  1  0.40  2,00,000
1,00,000 1,00,000
0.5 EBIT – 1,00,000 ≠ 0.5 EBIT – 2,00,000
There is no indifference point between proposal ‘Q’ and proposal ‘R’
Analysis: It can be seen that financial proposal ‘Q’ dominates proposal ‘R’, since the financial break-even-
point of the former is only `2,00,000 but in case of latter, it is `4,00,000.
Solution 3
(i) Calculation of EPS:
EAT 840 Lakhs
EPS = = = `16.80
No. of Shares 50 Lakhs
(ii) Calculation of OL:

Contribution 17.50 Crores
OL = = = 1.296 times
EBIT 13.50 Crores
(iii) Calculation of FL:

EBIT 13.50 Crores
FL = = = 1.125 times
EBT 12.00 Crores
(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times
Working Notes:
Income Statement
Particulars ` (in crores)
Sales (2.5 times of 20 crores) 50.00
Less: Variable Cost @ 65% of 50 crores 32.50
Contribution 17.50
Less: Fixed Cost 4.00
EBIT 13.50
Less: Interest @ 15% of 10 crores 1.50
EBT 12.00
Less: Tax @ 30% 3.60
EAT 8.40
Solution 4
Income Statement
Particulars `
Sales 75,00,000
Less: Variable cost @ of 56% of sales 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest @ 9% of 45,00,000 4,05,000
EBT 22,95,000
EBIT 27,00,000
(i) ROI = ×100 = ×100 = 27%
Capital Employed 45,00,000  55,00,000
(ii) ROI is 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
Net Sales 75,00,000

(iii) Capital Turnover = = = 0.75
Capital 1,00,00,000
Firm has very low capital turnover as compared to industry average of 3.
(iv) Calculation of Operating, Financial and Combined leverages:
Operating Leverage = = = 1.222
EBIT 27,00,000
EBIT 27,00,000
Financial Leverage = = = 1.176
EBT 22,95,000
Combined Leverage = OL × FL = 1.222 × 1.176 = 1.437
(v) Operating leverage is 1.22. So if sales is increased by 10% then EBIT will be increased by 1.222 × 10
i.e. 12.22% (approx)
(vi) EBT = Sales – Variable cost – Fixed cost – Interest

Nil = Sales – 56% sales – 6,00,000 – 4,05,000
44% of sales = 10,05,000
Sales = 22,84,091
Hence at `22,84,091 sales level EBT of the firm will be equal to Zero.
(vii) Financial leverage is 1.176. So, if EBIT increases by 20% then EBT will increase by 1.18 × 20% =
23.52% (approx).
SOLUTION TEST 2 - MANAGEMENT OF CASH AND MANAGEMENT OF CASH 33
SOLUTION TEST 2 - MANAGEMENT OF CASH AND MANAGEMENT OF CASH
Solution 1
Monthly Cash Budget for Six Months, April to September 2020
Particulars April May June July August Sept
Opening balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collection from debtors 1,08,000 76,000 52,000 60,000 76,000 68,000
Cash available (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000

Payment for purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages and salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 - - 3,000 - -
Tax payment - - - 5,000 - -
Total payments (B) 60,000 72,000 90,000 82,000 57,000 89,000
Balance (A - B) 84,000 36,000 (2,000) 18,000 55,000 11,000
Less: Temporary Invest (64,000) (16,000) - - (35,000) -
Add: Liquidation of - - 22,000 2,000 - 9,000
Invest or borrowings
Closing balance 20,000 20,000 20,000 20,000 20,000 20,000
WN: Collection from debtors:

(` in Thousands)
Particulars Feb March April May June July August Sept
Sales 120 140 80 60 80 100 80 60
Credit sales 96 112 64 48 64 80 64 48
(80% of total sales)
Collections:
75% in one month 72 84 48 36 48 60 48
25% in two months N. A. 24 28 16 12 16 20
Total collection N. A. 108 76 52 60 76 68
Solution 2
Cash Budget
(From Oct 2016 to December 2016)
Particulars October November December
Opening Balance 10,00,000 14,25,000 21,25,000
Cash Sales @ 10% of Sales 4,00,000 4,50,000 4,60,000
Debtors Collection:
50% of Credit Sales 1 Month 18,00,000 18,00,000 20,25,000
50% of Credit Sales 2 Month 15,75,000 18,00,000 18,00,000
Total A 47,75,000 54,75,000 64,10,000
Payments to creditors (1 Month Credit) 29,00,000 29,00,000 33,00,000
Purchase = Sales – GP - Wages (40L – 20% - 3L) (40L – 20% - 3L) (45L – 20% - 3L)
Wages & Salaries 3,00,000 3,00,000 3,00,000
Admin Expenses 1,00,000 1,00,000 1,00,000
Interim dividend - - 2,00,000
Machine installments 50,000 50,000 50,000
Total B 33,50,000 33,50,000 39,50,000
SOLUTION TEST 2 - MANAGEMENT OF CASH AND MANAGEMENT OF CASH 34
Closing Balance (A - B) 14,25,000 21,25,000 24,60,000
Solution 3
Statement of Evaluation
Particulars `
(A) Savings:
Saving in administration cost 1,00,000
Saving in bad debts (0.5% of 1,20,00,000) 60,000
*Saving in cost of debtors (1,20,00,000 × 80% × 90 – 60/360 × 15%) 1,20,000
Total (A) 2,80,000
(B) Cost:
Annual charges (2% of 1,20,00,000) 2,40,000
Total (B) 2,40,000
Net Benefit (A -B) 40,000
*Presently, the debtors of the company pay after 90 days. However, the factor has agreed to pay after 60 days
only. So, the investment in Debtors will be reduced by 30 days.
Conclusion: Yes, company should enter into factoring agreement.
Solution 4
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 80,00,000 85,00,000
Less: Variable cost @ 85% 68,00,000 72,25,000
Less: Fixed Cost (10% of 80,00,000) 8,00,000 8,00,000
Profit before cost of credit 4,00,000 4,75,000
Less: Cash discount 40,000 1,36,000
Expected Profit 3,60,000 3,39,000
Less: Cost of investment in debtors 42,222 31,208
Net benefit 3,17,778 3,07,792
Effect: Income will be decreased by `9,986.
Working Notes:
(1) Calculation of cost of investment in debtors:
Existing = (68,00,000 + 8,00,000) × 10% × 20/360 = 42,222

Proposed = (72,25,000 + 8,00,000) × 10% × 14/360 = 31,208
(2) Calculation of cash discount:
Existing = 80,00,000 × 0.50 × 1% = 40,000

Proposed = 85,00,000 × 0.80 × 2% = 1,36,000
SOLUTION TEST 3 - MANAGEMENT OF WORKING CAPITAL 35
SOLUTION TEST 3 - MANAGEMENT OF WORKING CAPITAL
Solution 1
(a) Operating cycle = R+W+F+D–C = 30 + 22 + 18 + 45 – 30 = 85 Days
Calculations:
Average stock of raw materials
Raw materials storage period (R) =
Average cos t of raw materials consumption per day
50,000
= = 30 days
6,00,000  360
Average stock of WIP
WIP holding period =
Average cos t of production per day
30,000
= = 22 days
5,00,000  360
Average stock of FG
Finished Goods storage period =
Average cos t of goods sold per day
40,000
= = 18 days
8,00,000  360
(b) Number of operating cycles in the year:

360 360
= = 4.24 times
Operating cycle period 85
Solution 2
Statement of Working Capital Requirement
Particulars `
(1) Current Assets:
Raw materials (34,56,000 × 4/52) 2,65,846
Work in progress 2,00,000
Finished goods 5,44,000
Debtors (65,28,000 × 8/52) 10,04,308
Cash 50,000
Total (1) 20,64,154
(2) Current Liabilities:
Creditors (34,56,000 + 2,65,846) × 4/52 2,86,296
Outstanding labour (12,72,000 × 1.5/52) 36,692
Outstanding overheads (25,44,000 × 4/52) 1,95,692
Total (2) 5,18,680
Working Capital (1 - 2) 15,45,474
Working Notes: Projected Income Statement

Particulars `
Raw materials (2,16,000 × 16) 34,56,000
Direct labour (2,08,000 + ½ × 8,000) × 6 12,72,000
Overheads (2,08,000 + ½ × 8,000) × 12 25,44,000
Cost Upto Factory 72,72,000
Less: Closing WIP 8,000 units × (16 + 3 + 6) (2,00,000)
Cost of Production (2,08,000 units) 70,72,000
SOLUTION TEST 3 - MANAGEMENT OF WORKING CAPITAL 36
Less: Closing FG 16,000 units × 34 (5,44,000)
Cost of Goods Sold (1,92,000 units) 65,28,000
Profit 11,52,000
Sales (1,92,000 × 40) 76,80,000
Solution 3
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (45,00,000 × 1/12) 3,75,000
Finished Goods (1,35,00,000 × 1/12) 11,25,000
Debtors:
Home (98,00,000 × 1/12) 8,16,667
Export (49,00,000 × 3/12) 12,25,000
Cash (10,00,000 – 5,00,000) 5,00,000
Total (A) 40,41,667
(B) Current Liabilities:
Creditors (45,00,000 × 2/12) 7,50,000
Outstanding labour (36,00,000 × ½) 1,50,000
Outstanding Manufacturing Expenses (54,00,000 × 1/12) 4,50,000
Outstanding Administrative Expenses (12,00,000 × 1/12) 1,00,000
Income Tax (15,00,000 × 1/4) 3,75,000
Total (B) 18,25,000
Working Capital Before Provision (A - B) 22,16,667
Add: Contingency Margin @ 15% of 22,16,667 3,32,500
Working Capital 25,49,167
Working Notes:
1. Calculation of Cash cost of Debtors:
Export sales (10% below home sales price) = 54,00,000
Export sales equivalent to home sales = 54,00,000 × 100 = 60,00,000
90
Total equivalent home sales = 1,20,00,000 + 60,00,000 = 1,80,00,000
Apportionment of cash cost of COGS and administrative expenses in proportion of equivalent home sales
between Home and Foreign Sales:
Home sales = 1,47,00,000 × 1,20,00,000 = 98,00,000
1,80,00,000
Foreign sales = 1,47,00,000 × 60,00,000 = 49,00,000

1,80,00,000
2. Projected Income Statement

Particulars `
Raw Materials 45,00,000
Wages 36,00,000
Manufacturing Expenses (in cash) 54,00,000
Cash Cost of Goods Sold 1,35,00,000
Administration Expenses 12,00,000
Cash Cost of sales 1,47,00,000
SOLUTION TEST 4 - CAPITAL BUDGETING 37
SOLUTION TEST 4 - CAPITAL BUDGETING
Solution 1
Net Present Value
Year Particulars ` DF @ 12% PV
0 Initial outflows (1,35,00,000) 1.000 (1,35,00,000)
(140 – 20 + 15) Lakhs
1 CFAT 2,00,000 0.893 1,78,600
2 CFAT less Additional Equipment 24,50,000 0.797 19,52,650
(34,50,000 – 10,00,000)
3-5 CFAT 85,25,000 1.915 1,63,25,375
6–8 CFAT 58,25,000 1.363 79,39,475
8 Working Capital and Salvage 16,00,000 0.404 6,46,400
(15,00,000 + 1,00,000)
NPV 1,35,42,500
Company should accept the proposal having positive NPV of the project.
Working Notes:
1. Statement of CFAT
Particulars 1 2 3–5 6–8
Units sold 80,000 1,20,000 3,00,000 2,00,000
Sales @ `100 p.u. 80,00,000 1,20,00,000 3,00,00,000 2,00,00,000
Less: VC @ 40% 32,00,000 48,00,000 1,20,00,000 80,00,000
Contribution 48,00,000 72,00,000 1,80,00,000 1,20,00,000
Less: Advertisement expenses (30,00,000) (15,00,000) (10,00,000) (4,00,000)
Less: Cash fixed cost (16,00,000) (16,00,000) (16,00,000) (16,00,000)
Less: Depreciation (15,00,000) (15,00,000) (16,50,000) (16,50,000)
PBT (13,00,000) 26,00,000 1,37,50,000 83,50,000
Less: Tax @ 50% - (6,50,000) (68,75,000) (41,75,000)
PAT (13,00,000) 19,50,000 68,75,000 41,75,000
Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
CFAT 2,00,000 34,50,000 85,25,000 58,25,000
2. Depreciation:
Original Cost  Subsidy  Salvage 1,20,00,000
Main equipment (t0 - t8) = =
Life of Equipment 8 Years
= 15,00,000
Original Cost  Salvage 9,00,000

Additional equipment (t3 - t8) = =
Life of Equipment 6 Years
= 1,50,000
3. Tax for year 2 = 50% of (26,00,000 – 13,00,000) = 6,50,000
Note: As per section 32 of Income Tax Act “Depreciation is not allowed on subsidized part of asset”
Solution 2
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B’
Initial outflow/ Purchase cost of machines 8,00,000 6,00,000
Annual running cost 1,30,000 2,50,000
Life of machines 3 years 2 years
PV of annual running cost 3,23,284 4,33,875
(Annual running cost × PVIFA) (1,30,000 × 2.4868) (2,50,000 × 1.7355)
Present value of total outflow 11,23,284 10,33,875
(Initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.4868 ÷ 1.7355
Equivalent Annual outflow 4,51,699 5,95,722
Select the Machine A having lower equivalent annualized outflow.
Solution 3
(a) Statement of Rank and Selection of Projects
(Divisible Situation)
Projects PI (1+ NPV/Investment) Rank Project Cost Project (%) Investment
P 1 + 20,000/1,00,000 = 1.20 3 `1,00,000 100% `1,00,000
Q 1 + 35,000/3,00,000 = 1.11 5 `3,00,000 - -
R 1 + 16,000/50,000 = 1.32 1 `50,000 100% `50,000
S 1 + 25,000/2,00,000 = 1.13 4 `2,00,000 25% `50,000 (b.f.)
T 1 + 30,000/1,00,000 = 1.30 2 `1,00,000 100% `1,00,000
Total Investment `3,00,000
Optimum investment: 100% of P, R, T and ¼ of S.
(b) Statement of Rank and Selection of Projects

(Indivisible Situation)
Possible Combinations Combined Investment Combined NPV
P+R+T `2,50,000 `66,000
P+S `3,00,000 `45,000
Q `3,00,000 `35,000
R+S `2,50,000 `41,000
S+T `3,00,000 `55,000
Invest in combination of P, R and T having highest combined NPV and invest remaining `50,000
elsewhere.
Solution 4
(i) Cost of the project:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR for 4 years
= `60,000 × 2.855
Cost of project = `1,71,300

(ii) Payback Period:
Initial Outflow 1,71,000
Payback period = =
Equal Annual Cash Inflows 60,000
= 2.855 years
(iii) Cost of Capital:

Pr esent Value of Inflows 1,82,263.20
Cum DF @ cost of capital for 4 years = =
Annual Inflows 60,000
= 3.038
From the discount factor table, at discount rate of 12%, the cumulative discount factor for four years is
3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Cost of capital = 12%
(iv) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.064 =
1,71,300
PV of Inflows = 1,71,300 × 1.064 = `1,82,263.2
NPV = PV of inflows – PV of outflows

= `1,82,263.20 – `1,71,300 = `10,963.20
SOLUTION TEST 5 - RISK ANALYSIS IN CAPITAL BUDGETING AND COST OF CAPITAL 40
SOLUTION TEST 5 - RISK ANALYSIS IN CAPITAL BUDGETING AND COST OF CAPITAL
Solution 1
Statement Showing the Net Present Value of Project
Cash Flow (`) C.E. Adjusted Cash flow (`) PVF at 6% PV (`)
Year
(a) (b) (c) = (a) × (b) (d) (e) = (c) ×(d)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
Net Present Value 2,58,776
Yes accept the proposal having positive NPV.
Solution 2
Calculation of NPV through Sensitivity Analysis:
NPV (Base) = 60,00,000 × 3.791 – 2,00,00,000 = 27,46,000
Situation NPV Changes in NPV

Base(present) ` 27,46,000 -
If initial project cost is (`2,27,46,000 - `2,20,00,000 ) (`27,46,000 – `7,46,000)/ `27,46,000
varied adversely by 10% = `7,46,000 = 72.83%
If annual cash flow is (`54,00,000 × 3.791) – `2,00,00,000 (`27,46,000 – `4,71,400)/ `27,46,000
varied adversely by 10% = `4,71,400 = 82.83%
If cost of capital is varied (`60,00,000 × 3.696) – `2,00,00,000 (`27,46,000-`21,76,000)/ `27,46,000
adversely by 10% i.e. 11% = `21,76,000 = 20.76%
Conclusion: Project is most sensitive to ‘annual cash inflow’.
Solution 3
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

Name of source Amount (`) Proportion
13% debentures 3,60,000 0.15
11% Preference 1,20,000 0.05
Equity share capital 19,20,000 0.80
Total 24,00,000 1.00
(i) (a) After tax cost of new debt

I(1  t ) 14(1  .50)
Kd = × 100 = × 100 = 7.143%
NP 98
After tax cost of new preference shares

PD 1.20
Kp = × 100 = × 100 = 12.25%
NP 9.80
SOLUTION TEST 5 - RISK ANALYSIS IN CAPITAL BUDGETING AND COST OF CAPITAL 41
(b) Cost of new equity (comes from retained earnings)
D1 1.3865
Ke = +g = + 0.12 = 17%
P0 (old) 27.75
(ii) MCC (Ko) = KdWd + KpWp + KeWe

= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%
(iii) The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital

2,77,300
Therefore, investment before new issue = = `3,46,625
80%
Retained earnings = `1.3865 × 2,00,000 = `2,77,300
(iv) MCC (Ko)

= KdWd + KpWp + KeWe
= 7.143% × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than `3,46,625, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.3865
Ke = +g = + 0.12 = 18.93%
P0 (new ) 20
Solution 4
Total capital required is `20 lakhs. With a debt-equity ratio of 1:3. It means `5 lakhs is to be raised through
debt and `15 lakhs through equity. Out of `15 lakhs, `4 lakhs are available in the form of retained earnings
hence `11 lakhs will have to raise by issuing equity shares.
(i) Post tax average cost of additional debt:
Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 13% (1 – 0.30) = 9.10%
Average Kd = Kd1Wd1 + Kd2Wd2 = 7% × 2 + 9.10% × 3 = 8.26%
5 5
(ii) Cost of retained earning & cost of equity:
D1 6  10%
Ke = +g = + 0.10 = 21%
P0 60
Kr = Ke (1-PT) = 21% (1 - .20) = 16.80%
D0 = `12 × 50% = `6
(iii) Overall cost of additional finance:
Ko = KeWe + KrWr + KdWd

= 21% × 11 + 16.80% × 4 + 8.26% × 5 = 16.98%
20 20 20
Assumption: DPS is treated at Do.

SOLUTION TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS 42
SOLUTION TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS
Solution 1
Calculation of value of ‘A’ Ltd and ‘B’ Ltd:
Value of ‘A’ Ltd. (Unlevered) = EBIT (1  t )

Ke
2,50,000 (1  .30)
= = 8,75,000
.20
Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd + Debt × Tax
= 8,75,000 + 10,00,000 × 30% = 11,75,000
Calculation of WACC of ‘A’ Ltd and ‘B’ Ltd:
K0 of ‘A’ Ltd. = Ke of ‘A’ Ltd

= 20% [In case of All equity company Ko = Ke ]
EBIT (1  t ) 2,50,000 (1  .30)

K0 of ‘B’ Ltd. = × 100 = × 100
V 11,75,000
= 14.89%
Solution 2
(1) Current market price of share:
Current Market Price of Share = EPS × PE Ratio

10,00,000
= × 10 = `50
2,00,000
(2) Capitalization rate of its risk class:
Capitalization rate (Ke) = 1/PE

= 1/10 = 0.10 or 10%
(3) Optimum payout:
r > Ke, Therefore dividend payout should be Nil.
(4) Market Price of Share (P) as per Walter’s Formula as per optimal payout ratio:
r 0.20
D + (E−D) × 0+(5−0) ×
Ke 0.10
P (Market price of share) = =
Ke 0.10
= `100
Solution 3
1. Value of the firm when dividends are not paid:
Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = 0
P1 +D1
Pₒ = 1+Ke
P1 +0
`100 = 1+0.10
or P1 = `110
Step 2: No. of shares required to be issued:
Funds requied−(E−D) 2,00,000−(1,00,000−0)

No. of shares ∆n = =
Price at end(P₁) 110
= 909.09 shares
Step 3: Calculation of value of firm:
(n+ Δn)P1 − I+E

nPo =
1+Ke
(10,000+909.09)110−2,00,000+1,00,000
nPo = = `10,00,000
(1+.10)
2. Value of the firm when dividends are paid:
Step 1: Calculate price at the end of the period:
Ke = 10%, P₀ = `100, D₁ = `5
P1 +D1
Pₒ = 1+Ke
P1 +5
`100 = 1+0.10
or P1 = `105
Step 2: No. of shares required to be issued:
𝐹𝑢𝑛𝑑𝑠 𝑟𝑒𝑞𝑢𝑖𝑒𝑑−(𝐸−𝐷) 2,00,000−(1,00,000−50,000)

No. of shares ∆n = =
𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑒𝑛𝑑(𝑃₁) 105
= 1,428.57 shares
Step 3: Calculation of value of firm:
(𝑛+ 𝛥𝑛)𝑃1 − 𝐼+𝐸

nPo =
1+𝐾𝑒
(10,000+1,428.57)105−2,00,000+1,00,000
nPo = = `10,00,000
(1+.10)
Thus, it can be seen that the value of the firm remains the same in either case.
Solution 4
Balance Sheet
Equity Share Capital 12,50,000 Fixed Assets 24,00,000
Reserve and Surplus 7,50,000 Current Assets:
Long Term Debts 10,00,000 Stock 6,00,000
Current Liabilities 12,00,000 Debtors 6,25,000
Cash & Cash Eq. (b.f.) 5,75,000 18,00,000
42,00,000 42,00,000
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (28% of Sales)

= `50,00,000 – `14,00,000 = `36,00,000
(ii) Closing Stock = Cost of Goods Sold/Stock Turnover

= `36,00,000/6 = `6,00,000
(iii) Fixed Assets = Cost of Goods Sold/Fixed Assets Turnover

= `36,00,000/1.5 = `24,00,000
(iv) Current Assets and Current Liabilities
Stock = (CR - LR) × CL

6,00,000 = (1.5 – 1) CL OR CL = `12,00,000
Current Assets = 12,00,000 × 1.5 = `18,00,000
(v) Debtors = Sales × Debtors Collection Period(days) /360 days

= `50,00,000 × 45/360 = `6,25,000
(vi) Net worth = Fixed Assets / 1.2

= `24,00,000/1.2 = `20,00,000
(vii) Reserves and Surplus and Share Capital
Reserves & Surplus and Share Capital = 0.6 + 1 = 1.6

Reserves and Surplus = `20,00,000 × 0.6/1.6 = `7,50,000
Share Capital = Net worth – Reserves and Surplus

= `20,00,000 – `7,50,000 = `12,50,000
(viii) Long- term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund (Net worth)
Long-term Debts = `20,00,000 × 0.5 = `10,00,000
SOLUTION TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 45
SOLUTION TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE
Solution 1
(a) The equilibrium level of National Income:
Y = C + I + G + (X - M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 ÷ 0.5 = 800
(b) Consumption at equilibrium level:
C = 150 + 0.75Yd
Yd = Y - Tax + Transfer Payments,

= Y – (20 + 0.2Y) + 40 = 0.8Y + 20,
and C = 150 + 0.75Yd

= 150 + 0.75 (0.8Y + 20) (where Yd = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800 = 645
(c) Net Exports at equilibrium level:
X–M = 35 - (15 + 0.1Y)

= 35 – (15 + 0.1 × 800) = - 60
There is adverse balance of trade
Solution 2
(a) The money value of output equals total output times the average price per unit. The money value of
output is: = 7,500 × 7 = `52,500
(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore,
the money income of households is the same as the money value of output i.e `52,500.
(c) Total spending by households: = `52,500 × 0.75 = `39,375
(d) The total money revenues received by the business sector is equal to aggregate spending by
households ie. `39,375.
(e) The business sector makes payments of `52,500 to produce output, whereas the households purchase
only output worth `39,375 of what is produced. Therefore, the business sector has unsold inventories
valued at `13,125. They should be expected to decrease output.
Solution 3
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch
taxonomy of the role of government in a market economy. The objective of the economic system and the role
SOLUTION TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 46
of government is to improve the wellbeing of individuals or households. According to ‘Musgrave Three-
Function Framework’, the functions of government are to be separated into three, namely, resource allocation,
(efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and distribution
functions are primarily microeconomic functions, while stabilization is a macroeconomic function. The
allocation function aims to correct the sources of inefficiency in the economic system while the distribution
role ensures that the distribution of wealth and income is fair. The stabilization branch is to ensure
achievement of macroeconomic stability, maintenance of high levels of employment and price stability.
Solution 4
Crowding Out Meaning: ‘Crowding out’ effect is the negative effect fiscal policy may generate when spending
by government in an economy substitutes private spending. For example, if government provides free
computers to students, the demand from students for computers may not be forthcoming.
Crowding Out Mechanism:

The interest rates in an economy increase when:
 Government increases its spending by borrowing from the loanable funds from market and thus the
demand for loans increases.
 Government increases the budget deficit by selling bonds or treasury bills and the amount of money with
the private sector decreases.
Due to high interest, private investments, especially the ones which are interest – sensitive, will be reduced.
Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion
in demand resulting from an increase in government expenditure.
Solution 5
Objectives of Fiscal Policy:
Fiscal Policy refers to the policy of government related to public revenue and public expenditure. The
objectives of fiscal policy are derived from the aspirations and goals of the society and vary from country to
country. The most common objectives of fiscal policy are:
 Achievement and maintenance of full employment,

 Maintenance of price stability,
 Acceleration of the rate of economic development,
 Equitable distribution of income and wealth,
 Eradication of poverty, and
 Removal of regional imbalances in different parts of the country.
The importance as well as order of priority of these objectives may vary from country to country and from
time to time. For instance, while stability and equality may be the priorities of developed nations, economic
growth, employment and equity may get higher priority in developing countries. Also, these objectives are not
always compatible; for instance the objective of achieving equitable distribution of income may conflict with
the objective of economic growth and efficiency.
SOLUTION TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 47
SOLUTION TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE
Solution 1
The process or channels through which the evolution of monetary aggregates affects the level of product and
prices is known as ‘monetary transmission mechanism’. There are mainly four different mechanisms, namely,
the interest rate channel, the exchange rate channel, the quantum channel, and the asset price channel.
The interest rate channel: A contractionary monetary policy‐induced increase in interest rates increases the
cost of capital and the real cost of borrowing for firms and households with the result that they cut back on
their investment expenditures and durable goods consumption expenditures respectively. A decline in
aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary
monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of
capital for firms and cost of borrowing for households.
The exchange rate channel: 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: (e.g., relating to money supply and credit) Two distinct credit channels: the bank
lending channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate
through the real economy. Credit channel operates by altering access of firms and households to bank credit.
A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest
rates works to increase the payments that the firm must make to service its floating rate debts. An indirect
effect sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long‐
lived assets.
The asset price channel: Asset prices respond to monetary policy changes and consequently impact output,
employment and inflation. 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, erosion in
household financial wealth, fall in consumption, output, and employment.
Solution 2
The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the
Monetary Policy Framework Agreement. It is an agreement reached between the Government of India and the
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’ by abandoning the ‘multiple indicator’ approach. 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.
Solution 3
Calculation of M1:
M1 = Currency and coins with the people + demand deposits of banks (current and
SOLUTION TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 48
saving accounts) + other deposits of the RBI.
= `2,13,279.8 + `1,62,374.5 + `765.1 = `3,76,419.4 Crores
Solution 4
A central bank of a country is called a ‘bankers’ bank because it acts as a banker to the community of
commercial banks and provides them with financial services to facilitate their efficient functioning.
 The central bank acts as a custodian of cash reserves of commercial banks in the country.
 The central bank provides efficient means of funds transfer for all banks. All commercial banks maintain
accounts with the central bank and it enables smooth and swift clearing and settlements of inter-bank
transactions and interbank payments.
 The central bank acts as a lender of last resort. It provides liquidity to banks when the latter face shortage
of liquidity. The scheduled commercial banks can borrow from the discount window against the collateral
of securities like commercial bills, government securities, treasury bills, or other eligible papers.
Solution 5
(a) Productivity of labour (output per labour hour = the volume of output produced per unit of labour
input) = output / input of labour hours
Output of commodity Units in Country X Units in Country Y

Sugar 0.5 0.20
Rice 0.25 0.40
(b) A country has an absolute advantage in producing a good over another country if it requires fewer
resources to produce that good. Since one hour of labour time produces 0.5 units of sugar in country X
against 0.20 units in country Y, Country X has absolute advantage in production of sugar.
(c) Since one hour of labour time produces 0.40 units of rice in country Y against 0.25 units in country X,
Country Y has absolute advantage in production of rice.
Solution 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.
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 `2,000 government revenue from tariff on each
imported computer priced at `10,000 in the world market. If the price of computer rises to ` 20,000, then it
generates a tariff of ` 4,000.
Solution 7
Foreign direct investment is defined as the process whereby the resident of one country (i.e. home country)
acquires more than 10 percent 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.
Various modes are:
(i) Opening of a subsidiary or associate company in a foreign country,
(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions (M&A),
(v) Joint venture with a foreign company,
(vi) Green field investment (establishment of a new overseas affiliate for freshly starting production by a
parent company).
SOLUTION SAMPLE PAPER 1 49
SOLUTION SAMPLE PAPER 1
Solution 1 (a)
(EBIT I) (1 t ) (4,00,000 − 1,50,000) (1 −0.50)
(A) Earnings Per Share = =
Equity shares 1,00,000
= `1.25
(B) Amount of DEBT = Interest ÷ Rate of interest

= 1,50,000 ÷ 16% = `9,37,500
Working Note:
(1) Calculation of Fixed Cost:
DOL = = = 2.5 times
EBIT EBIT
EBIT = 10,00,000 ÷ 2.5 = `4,00,000
Fixed Cost = Contribution – EBIT = 10,00,000 – 4,00,000 = `6,00,000
(2) Calculation of Degree of Combined Leverage:
Question says that 25% change in sales will wipe out EPS. Here wipe out means it will reduce EPS by
100%.
% Change in EPS 100%
DCL = = = 4 times
% Change in Sales 25%
(3) Calculation of EBT and Interest:
DCL = = = 4 times
EBT EBT
EBT = 10,00,000 ÷ 4 = `2,50,000
Interest = EBIT – EBT = 4,00,000 – 2,50,000 = `1,50,000
Solution 1 (b)
PAT−Preference Dividend 30,00,000−12% of 1,00,00,000
EPS = No of Equity Shares
= 3,00,000
= `6
r 0.20
D + (E−D) × D+(6−D) ×
Ke
P = Ke
= 0.16
0.16
= 42
0.16D+1.2−0.20D
6.72 = 0.16
1.0752 = 1.2 – 0.04D or D = 3.12
Dividend Payout ratio:

DPS 3.12
= EPS
× 100 = 6
× 100 = 52%
Solution 1 (c)
Calculation of Indifference two modes of financing:
EBIT  I 1  T =
EBIT  I 1  T
N1 N2
EBIT  12% of 20 lakhs 1  0.30 = EBIT  12% of 40 lakhs 1  0.30
60,000 40,000
EBIT = `9,60,000
Course of action:
(a) If expected EBIT is less than `9,60,000 : Alternate 1
(b) If expected EBIT is equal to `9,60,000 : Alternate 1 or 2
(c) If expected EBIT is more than `9,60,000 : Alternate 2
Solution 1 (d)
Balance Sheet
As at 31.03.2002
Share Capital 8,00,000 Fixed Assets 7,20,000
Reserves and Surplus 1,60,000 Stock 1,60,000
Bank Overdraft 40,000 Other Current Assets 2,40,000
Other Current Liabilities 1,20,000
11,20,000 11,20,000
Working Notes:
1. Current assets and Current liabilities computation:
CA = 2.5
CL
CA = 2.5 CL
Working capital = CA – CL
2,40,000 = 2.5 CL – CL
CL = 1,60,000
CA = 1,60,000 × 2.5 = 4,00,000
2. Computation of stock:
Liquid Assets
Liquid ratio =
Current Liabilities
Current Assets - Stock
1.5 =
1,60,000
1.5 × 1,60,000 = 4,00,000 – Stock
Stock = 1,60,000
3. Computation of Proprietary fund, Fixed assets, Capital and Sundry Creditor

Fixed Assets
= 0.75
Proprietary Fund
Fixed assets = 0.75 Proprietary fund

Net working capital = 0.25 Proprietary fund
2,40,000 = Proprietary fund
2,40,000
Proprietary fund = = 9,60,000
0.25
Fixed assets = 0.75 Proprietary fund

= 0.75 × 9,60,000 = 7,20,000
Share Capital = Proprietary fund – R & S

= 9,60,000 - 1,60,000 = 8,00,000
Sundry creditors = CL - Bank overdraft

= 1,60,000 - 40,000 = 1,20,000
Solution 2
Statement Showing Evaluation of Two Machines
Particulars Machine ‘X’ Machine ‘Y’
Initial outflow/ Purchase cost of machines 5,50,000 4,00,000
Annual running cost 1,25,000 1,50,000
Life of machines 3 years 2 years
PV of annual running cost 3,00,238 2,53,515
(Annual running cost × PVIFA) (1,25,000 × 2.4019) (1,50,000 × 1.6901)
Present value of total outflow 8,50,238 6,53,515
÷ PVIFA ÷ 2.4019 ÷ 1.6901
Equivalent Annual outflow 3,53,986 3,86,672
Select the Machine X having lower equivalent annualized outflow.
Solution 3
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

Name of source Amount (`) Proportion
13% debentures 3,60,000 0.15
11% Preference 1,20,000 0.05
Equity share capital 19,20,000 0.80
Total 24,00,000 1.00
(i) (a) After tax cost of new debt
I(1  t ) 14(1  .50)

Kd = × 100 = × 100 = 7.143%
NP 98
After tax cost of new preference shares
PD 1.20
Kp = × 100 = × 100 = 12.25%
NP 9.80
(b) Cost of new equity (comes from retained earnings)
D1 1.3865
Ke = +g = + 0.12 = 17%
P0 (old) 27.75
(ii) MCC (Ko) = KdWd + KpWp + KeWe

= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%
(iii) The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital

2,77,300
Therefore, investment before new issue = = `3,46,625
80%
Retained earnings = `1.3865 × 2,00,000
= `2,77,300
(iv) MCC (Ko)

= KdWd + KpWp + KeWe
= 7.143% × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than `3,46,625, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.3865
Ke = +g = + 0.12 = 18.93%
P0 (new ) 20
Solution 4
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(1) Current Assets:
Raw Materials (6,00,000 × 1/12) 50,000
Finished Goods (16,80,000 × 1/12) 1,40,000
Debtors (19,05,000 × 2/12) 3,17,500
Cash 80,000
Prepaid Sales Promotion Expenses (75,000 × 1/4) 18,750
Total (1) 6,06,250
(2) Current Liabilities:
Creditors (6,00,000 × 2/12) 1,00,000
Outstanding labour (4,80,000 × 1/12) 40,000
Outstanding Manufacturing Expenses (6,00,000 × 1/12) 50,000
Outstanding Administrative Expenses (1,50,000 × 1/12) 12,500
Total (2) 2,02,500
Working Capital Before Provision (1 - 2) 4,03,750
Add : Safety Margin @ 10% of 4,03,750 40,375
Working Capital 4,44,125
Working Notes:
Projected Income Statement
Particulars `
Raw Materials 6,00,000

Wages 4,80,000
Manufacturing Expenses (in cash) 6,00,000
Cash Cost of Goods Sold 16,80,000
Administration Expenses (in cash) 1,50,000
Sales Promotion Expenses (in cash) 75,000
Cash Cost of Sales 19,05,000
Solution 5
Statement of Value of Firm and Cost of Capital
Particulars All equity 30% Debt 50% Debt
Earnings before interest and tax 4,00,000 4,00,000 4,00,000
Less: Interest @ 10% of `6,00,000 or - 60,000 -
@ 12% of `10,00,000 - - 1,20,000
Earning available for Equity 4,00,000 3,40,000 2,80,000
÷ Ke 16% 17% 20%
Value of Equity (E) [PBT ÷ Ke] 25,00,000 20,00,000 14,00,000
Value of Debt (D) - 6,00,000 10,00,000
Value of Firm (V) 25,00,000 26,00,000 24,00,000
Ko (EBIT ÷ V) 16% 15.38% 16.67%
Decision: Company should opt for 30% debt finance having higher Value of firm and lower Ko.
Solution 6 (a)
The finance functions are divided into long term and short term functions/ decisions:
Long term Finance Function Decisions

(i) Investment decisions (I): These decisions relate to the selection of assets in which funds will be invested by
a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds
are used in a project for various fixed assets and also for current assets.
(ii) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial
objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to
possess a good knowledge of 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).
Solution 6 (b)
Equivalent Annualized Criterion: This method involves the following steps:
(i) Compute NPV using the WACC or discounting rate.
(ii) Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period of each
project.
(iii) Divide NPV computed under step (i) by PVAF as computed under step (ii) and compare the values.
Solution 6 (c)
Significance of the Cost of Capital: The cost of capital is important to arrive at correct amount and helps the
management or an investor to take an appropriate decision. The correct cost of capital helps in the following
decision making:
(i) Evaluation of investment options: The estimated benefits (future cash flows) from available investment
opportunities (business or project) are converted into the present value of benefits by discounting them with
the relevant cost of capital. Here it is pertinent to mention that every investment option may have different
cost of capital hence it is very important to use the cost of capital which is relevant to the options available.
Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars project or
business. The performance of a project or business in compared against the cost of capital which is known here
as cut-off rate or hurdle rate.
(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the customers, the
cost of allowing credit period is compared against the benefit/ profit earned by providing credit to customer
of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.
OR
Sources of Short Term Finance: There are various sources available to meet short- term needs of finance. The
different sources are discussed below-
(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual
duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to
almost all business operations. It can be in the form of an 'open account' or 'bills payable'.
(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a company has to
pay for the services which it has already received like wages, taxes, interest and dividends. Such expenses arise
out of the day-to-day activities of the company and hence represent a spontaneous source of finance.
Deferred Income: These are the amounts received by a company in lieu of goods and services to be provided
in the future. Since these receipts increases a company’s liquidity, they are also considered to be an important
sources of short-term finance.
(iii) Advances from Customers: Manufacturers and contractors engaged in producing or constructing costly
goods involving considerable length of manufacturing or construction time usually demand advance money
from their customers at the time of accepting their orders for executing their contracts or supplying the goods.
This is a cost free source of finance and really useful.
(iv) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a
view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to
provide an additional instrument to investors.
(v) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills, commonly
referred to as T-Bills are issued by Government of India to meet short term borrowing requirements with
maturities ranging between 14 to 364 days.
(vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate with a fixed
maturity date of not less than 15 days up to a maximum of one year.
(vii) Bank Advances: Banks receive deposits from public for different periods at varying rates of interest. These
funds are invested and lent in such a manner that when required, they may be called back. Lending results in
gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met and a
reasonable profit is made. A bank's lending policy is not merely profit motivated but has to also keep in mind
the socio- economic development of the country. Some of the facilities provided by banks are Short Term Loans,
Overdraft, Cash Credits, Advances against goods, Bills Purchased/Discounted.
(viii) Financing of Export Trade by Banks: Exports play an important role in accelerating the economic growth
of developing countries like India. Of the several factors influencing export growth, credit is a very important
factor which enables exporters in efficiently executing their export orders. The commercial banks provide
short-term export finance mainly by way of pre and post-shipment credit. Export finance is granted in Rupees
as well as in foreign currency.
(ix) Inter Corporate Deposits: The companies can borrow funds for a short period say 6 months from other
companies which have surplus liquidity. The rate of interest on inter corporate deposits varies depending upon
the amount involved and time period.
(x) Certificate of Deposit (CD): The certificate of deposit is a document of title similar to a time deposit receipt
issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encash the deposit before maturity period and the
investor is assured of liquidity because he can sell the CD in secondary market.
(xi) Public Deposits: Public deposits are very important source of short-term and medium term finances
particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject
to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid up capital
and reserves, from the public and shareholders. These deposits may be accepted for a period of six months to
three years. Public deposits are unsecured loans; they should not be used for acquiring fixed assets since they
are to be repaid within a period of 3 years. These are mainly used to finance working capital requirements.
Note: Student may write any six.
Solution 7 (1)
(a) MPC (b) = △C/△Y
= (9,000 – 6,000) ÷ (12,000 – 8,000) = 0.75
(b) MPS = 1–b = 1 – 0.75 = 0.25
Solution 7 (2)
Market failures provide the rationale for government’s allocative function. Market failures are situations in
which a particular market, left to itself, is inefficient and leads to misallocation of society’s scarce resources. In
the absence of appropriate government intervention in resource allocation, the resources are likely to be
misallocated with 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 desirable combination of goods and services to ensure optimal outcomes in terms of
social welfare.
Solution 7 (3)
(a) The equilibrium level of National Income:
Y = C + I + G + (X - M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 ÷ 0.5 = 800
(b) Consumption at equilibrium level:

C = 150 + 0.75Yd
Yd = Y - Tax + Transfer Payments,

= Y – (20 + 0.2Y) + 40 = 0.8Y + 20,
and C = 150 + 0.75Yd

= 150 + 0.75 (0.8Y + 20) (where Yd = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800 = 645
(c) Net Exports at equilibrium level:
X–M = 35 - (15 + 0.1Y)

= 35 – (15 + 0.1 × 800) = - 60
There is adverse balance of trade
Solution 8 (1)
Leakages: A leakage is an outflow or withdrawal of income from the circular flow. Leakages are money leaving
the circular flow and therefore, not available for spending on currently produced goods and services. Leakages
reduce the flow of income.
Injections: An injection is a non-consumption expenditure. It is an expenditure on goods and services produced

within the domestic territory but not used by the domestic household for consumption purposes. Injections
are exogenous additions to the circular flow and add to the total volume of the basic circular flow.
In the two-sector model with households and firms, household saving is the only leakage and
investment is the only injection. In the three-sector model which includes the government, saving and taxes
are the two leakages and investment and government purchases are the two injections. In the four-sector
model which includes foreign sector also, saving, taxes, and imports are the three leakages; investment,
government purchases, and exports are the three injections.
The state of equilibrium occurs when the total leakages are equal to the total injections that occur in
the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports
Solution 8 (2)
Market power is the ability of a price making firm to profitably raise the market price of a good or service over
its marginal cost and thus earn supernormal profits or positive economic profits. Market power is an important
cause of market failure. Market failure occurs when the free market outcomes do not maximize net benefits of
an economic activity and therefore there is deadweight losses and inefficient allocation of resources. Excess
market power causes a single producer or a small number of producers to strategically reduce their supply
and charge higher prices compared to competitive market. Market power can cause markets to be inefficient
because it keeps price and output away from the equilibrium of supply and demand. Market power thus results
in suboptimal outcomes such as deadweight loss, underproduction of goods and services, higher prices and
loss of consumer surplus.
Solution 8 (3)
M4 = Currency and coins with the people + demand deposits with the banks (Current and
Saving accounts) + other deposits with the RBI + Net time deposits with the banking system +
Total deposits with the Post Office Savings (excluding National Savings Certificates).
Components ` in Crores
Currency with the public 1,12,206.6
Demand deposits with banks 1,93,300.4
Other deposits with the RBI 2,67,310.2
Net time deposits with the banking system 614.8
Post office saving deposits 277.5
Total 5,73,709.5
Solution 8 (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. The 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. The 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.
Solution 9 (1)
Value Added Method:
GDPMP = (Value of output in primary sector - intermediate consumption of primary sector) +

(value of output in secondary sector – intermediate consumption of secondary
sector) + (value of output in tertiary sector – intermediate consumption of tertiary
sector)
= 800 – 300 + 1,000 – 400 + 3,000 – 900 = 3,200 Crores
GNPMP = GDPMP + NFIA
= 3,200 - 100 = 3,100 Crores
Solution 9 (2)
The following are the significant limitations in respect of choice and implementation of fiscal policy:
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 such as recognition lag,
decision lag, implementation lag and impact lag
2. Fiscal policy changes may at times 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 governments’ 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 projects which are already midway.
5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge
projects such as highways and dams have long gestation period. Besides, some urgent public projects
cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.
6. Due to uncertainties, there are difficulties of forecasting when a 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 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 prices spiraling beyond control.
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.
11. An increase in the size of government spending during recessions will ‘crowd out’ private spending in an
economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly
also reduce the economy’s prospects of long run economic growth.
12. If governments compete with the private sector to borrow money for spending, it is likely that interest
rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to
borrow and spend and the desired increase in aggregate demand may not be realized.
Solution 9 (3)
The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the Monetary
Policy Framework Agreement. It is an agreement reached between the Government of India and the 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’ by
abandoning the ‘multiple indicator’ approach. 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.
Solution 9 (4)
Under a floating rate system, home currency depreciates when its value falls with respect to the value of
another currency or a basket of other currencies i.e. there is an increase in the home currency price of the
foreign currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = `70 and `72
in June, then the Indian Rupee has depreciated in its value with respect to the US dollar and the value of US
dollar has appreciated in terms of the Indian Rupee.
On the contrary, home currency appreciates when its value increases with respect to the value of
another currency or a basket of other currencies i.e. there is a decrease in the home currency price of foreign
currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = `72 and `70 in June,
then the Indian Rupee has appreciated in its value with respect to the US dollar and the value of US dollar has
depreciated in terms of the Indian Rupee.
Solution 10 (1)
A quasi public good or near public good has many but not all the characteristics of a public good. These are
goods which have an element of non-excludability and non rivalry.
Quasi public goods are:

(i) Not completely non rival. For example, public roads wi-fi networks and public parks do not get congested
so as to reduce the space available for others when extra consumers use them only up to an optimal point.
When more people use it beyond that, the amount others can benefit from these is reduced to some
extent, because there will be increased congestion.
(ii) It is easy to keep people away from quasi public goods by charging a price or fee. For example, it is
possible to exclude some users by building toll booths to charge for road usage on congested routes.
Other examples are education, and health services. 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. This particular characteristic namely, the combination of
virtually infinite benefits and the ability to charge a price results in some quasi-public goods being sold
through markets and others being provided by government.
Solution 10 (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. 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.
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 such as on infrastructure development to put more money into consumers' hands to give them more
purchasing power.
Solution 10 (3)
There are some general characteristics that money should possess in order to make it serve its functions as
money. Money should be:
 Generally acceptable
 Durable or long-lasting
 Effortlessly recognizable
 Difficult to counterfeit i.e. not 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.
Solution 10 (4)
The law of comparative advantage states that even if one nation is less efficient than (has an absolute
disadvantage with respect to) the other nation in the production of both commodities, there is still scope for
mutually beneficial trade. The first nation should specialize in the production and export of the commodity in
which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import
the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative
disadvantage). Labour differs in its productivity internationally and different goods have different labour
requirements, so comparative labor productivity advantage was Ricardo’s predictor of trade.
The theory can be explained with a simple example Output per Hour of Labour
Commodity Country A Country B

Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 2
Country B has absolute disadvantage in the production of both wheat and cloth. However, since B’s labour is
only half as productive in cloth but six times less productive in wheat compared to country A, country B has a
comparative advantage in cloth. On the other hand, country A has an absolute advantage in both wheat and
cloth with respect to the country B, but since its absolute advantage is greater in wheat (6:1) than in cloth (4:2),
country A has a comparative advantage in wheat.
According to the law of comparative advantage, both nations can gain if country A specialises in the production
of wheat and exports some of it in exchange for country B’s cloth. Simultaneously, country B should specialise
in the production of cloth and export some of it in exchange for country A’s wheat.
If country A could exchange 6W for 6C with country B, then, country A would gain 2C (or save one-half hour of
labour time) since the country A could only exchange 6W for 4C domestically. The 6W that the country B
receives from the country A would require six hours of labour time to produce in country B. With trade, country
B can instead use these six hours to produce 12C and give up only 6C for 6W from the country A. Thus, the
country B would gain 6C or save three hours of labour time and country A would gain 2C. However, the gains
of both countries are not equal.
Solution 11 (1)
The process or channels through which the evolution of monetary aggregates affects the level of product and
prices is known as ‘monetary transmission mechanism’. There are mainly four different mechanisms, namely,
the interest rate channel, the exchange rate channel, the quantum channel, and the asset price channel.
The interest rate channel: A contractionary monetary policy‐induced increase in interest rates increases the
cost of capital and the real cost of borrowing for firms and households with the result that they cut back on
their investment expenditures and durable goods consumption expenditures respectively. A decline in
aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary monetary
policy induced decrease in interest rates will have the opposite effect through decreases in cost of capital for
firms and cost of borrowing for households.
The exchange rate channel: 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: (e.g., relating to money supply and credit) Two distinct credit channels: the bank
lending channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate
through the real economy. Credit channel operates by altering access of firms and households to bank credit.
A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest
rates works to increase the payments that the firm must make to service its floating rate debts. An indirect
effect sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long‐
lived assets.
The asset price channel: Asset prices respond to monetary policy changes and consequently impact output,
employment and inflation. 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, erosion in
household financial wealth, fall in consumption, output, and employment.
Solution 11 (2)
International trade is a powerful stimulus to economic efficiency and contributes to economic growth and
rising incomes.
(i) The wider market made possible owing to trade induces companies to reap the quantitative and
qualitative benefits of extended division of labour. As a result, they would enlarge their manufacturing
capabilities and benefit from economies of large scale production.
(ii) The gains from international trade are reinforced by the increased competition that domestic
producers are confronted with on account of internationalization of production and marketing
requiring businesses to invariably compete against global businesses. Competition from foreign goods
compels manufacturers, especially in developing countries, to enhance competitiveness and
profitability by adoption of cost reducing technology and business practices. Efficient deployment of
productive resources to their best uses is a direct economic advantage of foreign trade. Greater
efficiency in the use of natural, human, industrial and financial resources ensures productivity gains.
Since international trade also tends to decrease the likelihood of domestic monopolies, it is always
beneficial to the community.
(iii) Trade provides access to new markets and new materials and enables sourcing of inputs and
components internationally at competitive prices. Also, international trade enables consumers to have
access to wider variety of goods and services that would not otherwise be available. It also enables
nations to acquire foreign exchange reserves necessary for imports which are crucial for sustaining
their economies
(iv) International trade enhances the extent of market and augments the scope for Mechanization and
specialisation.
(v) Exports stimulate economic growth by creating jobs, reducing poverty and augmenting factor incomes
and in so doing raising standards of livelihood and overall demand for goods and services.
(vi) Employment generating investments, including foreign direct investment, inevitably follow trade.
(vii) Opening up of new markets results in broadening of productive base and facilitates export
diversification.
(viii) Trade also contributes to human resource development, facilitates fundamental and applied research
and exchange of know-how and best practices between trade partners
(ix) Trade strengthens bonds between nations by bringing citizens of different countries together in
mutually beneficial exchanges and thus promotes harmony and cooperation among nations.
Solution 11 (3)
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 (or least income at times) for the nation. For example, duty on cotton: 5 per cent ad valorem or `3,000
per tonne, whichever is higher.
Solution 11 (4)
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 Only short term interest and generally remain
invested for long invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology transfer Not accompanied by technology transfer
Direct impact on employment of labour and wages No direct impact on employment of labour and
wages
Enduring interest in management and control No abiding interest in management and control
Securities are held with significant degree of Securities are held purely as a financial investment
influence by the investor on the management of the and no significant degree of influence on the
enterprise management of the enterprise
SOLUTION SAMPLE PAPER 2
Solution 1 (a)
(1) Market value (P) per share as per Walter’s Model:
r 0.12
D + (E−D) × 10+(20−10) ×
Ke
P (Market value of share) = Ke
= 0.10
0.10
= `220.00
E (EPS) = `10,00,000 (PAT) ÷ 50,000 shares = `20
Solution 1 (b)
2 × 8,00,000 × 12 × 250
Optimal transaction size = = `2,00,000
0.12
Number of transactions p.m. = Monthly cash requirement ÷ Transaction size

= `8,00,000 ÷ `2,00,000 = 4 transactions
Solution 1 (c)
(a) Market Value (MV) of RES Ltd:
MV before restructuring (VUL) = 25,00,000
MV after restructuring (VL) = VUL + Debt × Tax

= 25,00,000 + 5,00,000 × 30% = 26,50,000
(b) Cost of Equity:

D(1  t )
Ke = Ko + (Ko – Kd) ×
E
5,00,000(1  .30)
= .21 + (.21 - .15) × = 21.97%
21,50,000
Here,
Kd = before tax cost of debt
Ko = Ko of unlevered firm
Ko of unlevered firm = Ke of unlevered firm = 21%
E = Value of Equity
E = Value of firm – Value of Debt
= 26,50,000 – 5,00,000 = 21,50,000
(c) Weighted average cost of capital:
WACC = KeWe + KdWd

21,50,000 5,00,000
= 21.97% × + 10.50% × = 19.806%
26,50,000 26,50,000
Here,
Kd = I (1-t) = 15% (1- .30) = 10.50%
Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure
the firm.
Solution 1 (d)
(1) NPV under different scenarios:
NPV = PV of inflow – Initial Investment
Situation 1 = 50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = (1,52,140)
Situation 2 = 1,00,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 64,360
Situation 3 = 1,50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 2,80,860
(2) Expected NPV:
Expected NPV = PV of expected inflow – Initial Investment

= 1,05,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 86,010
Expected Inflow = 50,000 × 0.3 + 1,00,000 × 0.3 + 1,50,000 × 0.4 = 1,05,000
(3) Advise: Door Ltd. should accept the proposal having positive expected NPV.
Solution 2
(i) Operating Expenses = Gross Profit - EBIT
= `42,00,000 – `8,10,000 = `33,90,000
Working: Calculation of EBIT

Particulars `
Net Profit After Tax (EAT) 6.25% of `60,00,000 3,75,000
Add: Tax @ 50% (3,75,000 × 0.50/1-0.50) 3,75,000
Net Profit Before Tax (EBT) 7,50,000
Add: Interest 60,000
Earning Before Interest and Tax (EBIT) 8,10,000
(ii) Balance Sheet

(As on 31.03.2015)
Share Capital 10,50,000 Fixed Assets (b.f.) 17,00,000
Reserves 4,50,000 Current Assets:
Debentures 4,00,000 Bank & Cash 50,000
Sundry Creditors 2,00,000 Inventory 1,50,000
Debtors 2,00,000
21,00,000 21,00,000
Working Notes:
PAT
(a) Return on Net Worth = × 100 = 25%
Net Worth
3,75,000
Net Worth = = 15,00,000
25%
Net Worth = Share Capital + Reserve = 15,00,000
Share Capital to Reserve = 7:3
Share Capital = 15,00,000 × 7/10 = 10,50,000

Reserve = 15,00,000 × 3/10 = 4,50,000
Interest 60,000
(b) Debentures = =
Rate of Interest 15%
= 4,00,000
COGS
(c) Inventory Turnover =
Closin g Stock
COGS 18,00,000
Closing Stock = =
Inventory Turnover 12
= 1,50,000
CA
(d) Current Ratio = = 2 times
CL
Debtors + Closin g Stock + Cash
2 times =
Creditors
2,00,000+1,50,000+ Cash
2 =
2,00,000
Cash and Bank = 4,00,000 – 3,50,000 = 50,000
Solution 3
(a) Cost of the project:
At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount
factor @ IRR for 5 years
= `96,000 × 3.353
Cost of project = `3,21,888
(b) Payback Period:

Initial Outflow
Payback period =
Equal Annual Cash Inflows/ Saving
3,21,888
= = 3.353 years
96,000
(c) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.05 =
3,21,888
PV of Inflows = 3,21,888 × 1.05 = `3,37,982.4
NPV = PV of inflows – PV of outflows

= `3,37,982.40 – `3,21,888
= `16,094.40
(d) Cost of Capital:

Pr esent Value of Inflows
Cum DF @ cost of capital for 5 years =
Annual Inflows
3,37,982.40
= = 3.52065
96,000
Cost of capital = 13% (Given in table)
Solution 4
(1) Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw materials (36,00,000 × 2/12) 6,00,000
Work in progress (72,00,000 × 50% × .5/12) 1,50,000
Finished goods (72,00,000 × 1/12) 6,00,000
Debtors (72,00,000 × 75% × 2/12) 9,00,000
Cash 20,000
Total (A) 22,70,000
(B) Current Liabilities:
Creditors (36,00,000 × 1/12) 3,00,000
Outstanding labour (9,00,000 × 1/12) 75,000
Outstanding overhead (18,00,000 × .5/12) 75,000
Total (B) 4,50,000
Working Capital (A - B) 18,20,000
(2) Calculation of Maximum Permissible Bank Finance under the suggestion of Tandon Committee:
Method 1 = 75% (CA - CL) = 75% of 18,20,000 = `13,65,000

Method 2 = (75% CA) – CL = (75% 22,70,000) – 4,50,000 = `12,52,500
Working Notes:
Projected Income Statement
Particulars `
Raw materials (1,80,000 × 20) 36,00,000
Direct Labour (1,80,000 × 5) 9,00,000
Overheads including depreciation (1,80,000 × 15) 27,00,000
Total cost 72,00,000
Profit 18,00,000
Sales (1,80,000 × 50) 90,00,000
Solution 5
(i) Calculation of EPS:
EAT 840 Lakhs
EPS = = = `16.80
No. of Shares 50 Lakhs
(ii) Calculation of OL:

Contribution 17.50 Crores
OL = = = 1.296 times
EBIT 13.50 Crores
(iii) Calculation of FL:

EBIT 13.50 Crores
FL = = = 1.125 times
EBT 12.00 Crores
(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times
Working Notes:
Income Statement
Particulars ` (in crores)
Sales (2.5 times of 20 crores) 50.00
Less: Variable Cost @ 65% of 50 crores 32.50
Contribution 17.50
Less: Fixed Cost 4.00
EBIT 13.50
Less: Interest @ 15% of 10 crores 1.50
EBT 12.00
Less: Tax @ 30% 3.60
EAT 8.40
Solution 6 (a)
(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.
(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.
Solution 6 (b)
(i) Lease may low cost alternative: Leasing is alternative to purchasing. As the lessee is to make a series of
payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is based
on a comparison between leasing and buying an asset. Many lessees find lease more attractive because of
low cost.
(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less than
that available for lease payment
(iii) Working capital conservation: When a firm buy an equipment by borrowing from a bank (or financial
institution), they never provide 100% financing. But in case of lease one gets normally 100% financing.
This enables conservation of working capital.
(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing debt equity ratio. This
enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt
financing is called debt capacity (also, reserve debt capacity).
(v) Obsolescence and Disposal: After purchase of leased asset there may be technological obsolescence of
the asset. That means a technologically upgraded asset with better capacity may come into existence
after purchase. To retain competitive advantage the lessee as user may have to go for the upgraded asset.
Solution 6 (c)
Two Main Objective of Financial Management are:
(i) Profit Maximisation: It has traditionally been argued that the primary objective of a company is to earn
profit; hence the objective of financial management is also profit maximisation.
(ii) Wealth / Value Maximization: Shareholders wealth are the result of cost benefit analysis adjusted with
their timing and risk i.e. time value of money. This is the real objective of Financial Management. So, Wealth =
Present Value of benefits – Present Value of Costs.
Solution 7 (1)
The World Trade Organization has a three-tier system of decision making. The WTO’s top level decision-
making body is the Ministerial Conference which can take decisions on all matters under any of the
multilateral trade agreements. The Ministerial Conference meets at least once every two years. The next level
is the General Council which meets several times a year at the Geneva headquarters. The General Council also
meets as the Trade Policy Review Body and the Dispute Settlement Body. At the next level, the 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
specialisation. The three also have subsidiary bodies. Numerous specialized committees, working groups and
working parties deal with the individual agreements.
Solution 7 (2)
(a) The money value of output equals total output times the average price per unit. The money value of
output is: = 7,500 × 7 = `52,500
(b) In a two sector economy, households receive an amount equal to the money value of output.
Therefore, the money income of households is the same as the money value of output i.e `52,500.
(c) Total spending by households = `52,500 × 0.75 = `39,375
(d) The total money revenues received by the business sector is equal to aggregate spending by
households ie. `39,375.
(e) The business sector makes payments of `52,500 to produce output, whereas the households
purchase only output worth `39,375 of what is produced. Therefore, the business sector has unsold
inventories valued at `13,125. They should be expected to decrease output.
Solution 7 (3)
Objectives of Fiscal Policy: Fiscal Policy refers to the policy of government related to public revenue and public
expenditure. The objectives of fiscal policy are derived from the aspirations and goals of the society and vary
from country to country. The most common objectives of fiscal policy are:
 Achievement and maintenance of full employment,

 Maintenance of price stability,
 Acceleration of the rate of economic development,
 Equitable distribution of income and wealth,
 Eradication of poverty, and
 Removal of regional imbalances in different parts of the country.
The importance as well as order of priority of these objectives may vary from country to country and
from time to time. For instance, while stability and equality may be the priorities of developed nations,
economic growth, employment and equity may get higher priority in developing countries. Also, these
objectives are not always compatible; for instance the objective of achieving equitable distribution of income
may conflict with the objective of economic growth and efficiency.
Solution 8 (1)
Government Interventions: For combating the problem of market failure due to information failure the
following interventions are resorted to:
 Government makes it mandatory to have accurate labelling and content disclosures by producers.
 Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.
 Regulation of advertising and setting of advertising standards to make advertising more responsible,
informative and less persuasive.
A few examples are: SEBI mandates on accurate information disclosure to prospective buyers of new
stocks, mandatory statutory information, licensing of doctors practicing medicine, awareness campaigns and
funding of organisations to influence public, media and government attitudes.
Solution 8 (2)
M1 = Currency and coins with the people + demand deposits of banks (current and saving
accounts) + other deposits of the RBI.
= `2,13,279.8 + `1,62,374.5 + `765.1 = `3,76,419.4 Crores
Solution 8 (3)
According to Milton Friedman, Demand for money is affected by the same factors as demand for any other
asset, namely:
1. Permanent income.
2. Relative returns on assets (which incorporate risk).
Friedman maintains that it is permanent income – and not current income as in the Keynesian theory – that
determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present
expected value of all future income. To Friedman, money is a good as any other durable consumption good
and its demand is a function of a great number of factors. Friedman identified the following four determinants
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,
bonds, 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.
 rises, if the opportunity costs of money holdings (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 costs of money holdings.
Solution 8 (4)
The ‘real exchange rate' 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. Thus it incorporates changes in prices
Real Exchange rate = Nominal exchange rate* (Domestic price index/Foreign price index)
116
= 56 × 112 = 58
Solution 9 (1)
(a) Productivity of labour (output per labour hour = the volume of output produced per unit of labour
input) = output / input of labour hours
Output of commodity Units in Country X Units in Country Y

Sugar 0.5 0.20
Rice 0.25 0.40
(b) A country has an absolute advantage in producing a good over another country if it requires fewer
resources to produce that good. Since one hour of labour time produces 0.5 units of sugar in country
X against 0.20 units in country Y, Country X has absolute advantage in production of sugar.
(c) Since one hour of labour time produces 0.40 units of rice in country Y against 0.25 units in country X,
Country Y has absolute advantage in production of rice.
Solution 9 (2)
The average propensity to consume (APC) is the ratio of consumption expenditures (C) to disposable income
(DI):
APC = C / DI = 3,000/4,000 = 0.75
The average propensity to save (APS) is the ratio of savings to disposable income:
APS = S / DI = 1,000/4,000 = 0.25
Solution 9 (3)
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.
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 `2,000 government revenue from tariff on each
imported computer priced at `10,000 in the world market. If the price of computer rises to ` 20,000, then it
generates a tariff of ` 4,000.
Solution 9 (4)
Features of public goods:
1. Public goods yield utility and their consumption is essentially collective in nature.
2. Public goods are non rival in consumption i.e. consumption of a public good by one individual does not
reduce the quality or quantity available for all other individuals
3. Public goods are non-excludable i.e. consumers cannot (at least at less than prohibitive cost) be excluded
from consumption benefits
4. Public goods are characterized by indivisibility, each individual may consume all of the good i.e. the total
amount consumed is the same for each individual.
5. Once a public good is provided, the additional resource cost of another person consuming the good is
zero. No direct payment by the consumer is involved in the case of pure public goods and these goods
are generally more vulnerable to issues such as externalities, inadequate property rights, and free rider
problems
6. Competitive private markets will fail to generate economically efficient outputs of public goods. E.g.
national defence.
Solution 10 (1)
Personal Income: Personal Income is the income received by the household sector including Non-Profit
Institutions Serving Households. Thus, while national income is a measure of income earned and personal
income is a measure of actual current income receipts of persons from all sources which may or 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 payments such as
social security benefits, unemployment compensation, welfare payments 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
Disposable Personal Income (DI): Disposable personal income is a measure of amount of the money in the
hands of the individuals that is available for their consumption or savings. Disposable personal income is
derived from personal income by subtracting the direct taxes paid by individuals and other compulsory
payments made to the government.
DI = PI - Personal Income Taxes
Solution 10 (2)
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch
taxonomy of the role of government in a market economy. The objective of the economic system and the role
of government is to improve the wellbeing of individuals or households. According to ‘Musgrave Three-
Function Framework’, the functions of government are to be separated into three, namely, resource allocation,
(efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and
distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic
function. The allocation function aims to correct the sources of inefficiency in the economic system while the
distribution role ensures that the distribution of wealth and income is fair. The stabilization branch is to
ensure achievement of macroeconomic stability, maintenance of high levels of employment and price stability.
Solution 10 (3)
A central bank of a country is called a ‘bankers’ bank because it acts as a banker to the community of
commercial banks and provides them with financial services to facilitate their efficient functioning.
 The central bank acts as a custodian of cash reserves of commercial banks in the country.
 The central bank provides efficient means of funds transfer for all banks. All commercial banks maintain
accounts with the central bank and it enables smooth and swift clearing and settlements of inter-bank
transactions and interbank payments.
 The central bank acts as a lender of last resort. It provides liquidity to banks when the latter face shortage
of liquidity. The scheduled commercial banks can borrow from the discount window against the
collateral of securities like commercial bills, government securities, treasury bills, or other eligible
papers.
Solution 10 (4)
The World Trade Organization has a three-tier system of decision making. The WTO’s top level decision-
making body is the Ministerial Conference which can take decisions on all matters under any of the
multilateral trade agreements. The Ministerial Conference meets at least once every two years. The next level
is the General Council which meets several times a year at the Geneva headquarters. The General Council also
meets as the Trade Policy Review Body and the Dispute Settlement Body. At the next level, the 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
specialisation. The three also have subsidiary bodies. Numerous specialized committees, working groups and
working parties deal with the individual agreements.
Solution 11 (1)
Crowding Out Meaning: ‘Crowding out’ effect is the negative effect fiscal policy may generate when spending
by government in an economy substitutes private spending. For example, if government provides free
computers to students, the demand from students for computers may not be forthcoming.
Crowding Out Mechanism:
The interest rates in an economy increase when:

 Government increases its spending by borrowing from the loanable funds from market and thus the
demand for loans increases.
 Government increases the budget deficit by selling bonds or treasury bills and the amount of money with
the private sector decreases.
Due to high interest, private investments, especially the ones which are interest – sensitive, will be reduced.
Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the
expansion in demand resulting from an increase in government expenditure.
Solution 11 (2)
Money performs many important functions in an economy:
1. Money is a convenient medium of exchange or it is an instrument that facilitates easy exchange of goods
and services. 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 into two separate transactions of sale and purchase, money eliminates the need for
double coincidence of wants. Money also facilitates separation of transactions both in time and place and
this in turn enables us to economize on time and efforts involved in transactions.
2. Money is a ‘common measure of value’. The monetary unit is the unit of measurement in terms of which
the value of all goods and services is measured and expressed. It is convenient to trade all commodities
in exchange for a single commodity. So also, it is convenient to measure the prices of all commodities in
terms of a single unit, rather than rec ord the relative price of every good in terms of every other good. A
common unit of account facilitates a system of orderly pricing which is crucial for rational economic
choices. Goods and services which are otherwise not comparable are made comparable through
expressing the worth of each in terms of money.
3. Money serves as a unit or standard of deferred payment i.e money facilitates recording of deferred
promises to pay. Money is the unit in terms of which future payments are contracted or stated. However,
variations in the purchasing power of money due to inflation or deflation, reduces the efficacy of money
in this function.
4. 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. The splitting of purchases and sale into two transactions involves a separation
in 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 one’s money at present,
one can store it for use at some future time. Thus, money functions as a temporary abode of purchasing
power in order to efficiently perform its medium of exchange function. Money also functions as a
permanent store of value. Money is the only asset which has perfect liquidity.
Solution 11 (3)
Credit Multiplier = 1/Required Reserve Ratio
For RRR 0.05 Credit Multiplier = 1/ 0.05 = 20

For RRR 0.08 Credit Multiplier = 1/ 0.08 = 12.5
Credit Creation = Initial Deposit × Credit Multiplier
For RRR 0.05 Credit creation = `3,000 × 20 = `60,000

For RRR 0.08 Credit creation = `3,000 × 12.5 = `37,500
Solution 11 (4)
Foreign direct investment is defined as the process whereby the resident of one country (i.e. home country)
acquires more than 10 percent 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.
Various modes are:
(i) Opening of a subsidiary or associate company in a foreign country,

(ii) Equity injection into an overseas company,
(iii) Acquiring a controlling interest in an existing foreign company,
(iv) Mergers and acquisitions (M&A),
(v) Joint venture with a foreign company,
(vi) Green field investment (establishment of a new overseas affiliate for freshly starting production by a
parent company).

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Financial Management

CA NAMIT ARORA SIR

ALL THE BEST

1 TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES 3–4

2 TEST 2 – MANAGAEMENT OF CASH AND MANAGEMENT OF RECEIVABLES 5-6

3 TEST 3 – MANAGMEMENT OF WORKING CAPITAL 7–8

4 TEST 4 – CAPITAL BUDGETING 9 – 10

5 TEST 5 – RISK ANALYSIS WITH CAPITAL BUDGETING AND COST OF CAPITAL 11 – 12

6 TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO ANALYSIS 13 – 14

7 TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 15

8 TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 16

11 SOLUTION TEST 1 - EBIT & EPS ANALYSIS AND LEVERAGES 29 – 32

12 SOLUTION TEST 2 – MANAGAEMENT OF CASH AND MANAGEMENT OF 33 – 34

13 SOLUTION TEST 3 – MANAGMEMENT OF WORKING CAPITAL 35 – 36

14 SOLUTION TEST 4 – CAPITAL BUDGETING 37 – 39

15 SOLUTION TEST 5 – RISK ANALYSIS WITH CAPITAL BUDGETING AND COST 40 - 41

16 SOLUTION TEST 6 - CAPITAL STRUCTURE, DIVIDEND DECISIONS AND RATIO 42 – 44

17 SOLUTION TEST 7 - NATIONAL INCOME AND PUBLIC FINANCE 45 – 46

18 SOLUTION TEST 8 - MONEY MARKET AND INTERNATIONAL TRADE 47 – 48

19 SOLUTION SAMPLE PAPER 1 49 – 62

20 SOLUTION SAMPLE PAPER 2 63 – 73

PART A: EBIT & EPS ANALYSIS

(ii) Cost of debt and preference shares is 10% each.

(1) Earnings per share

The additional information given is as under:

Fixed cost per annum (excluding interest) 4 crores

(i) Earnings Per Share

(i) What is the firm’s ROI?

PART A: MANAGEMENT OF CASH

(a) Estimated monthly sales are as follows:

January `1,00,000 June `80,000

(b) Wages and salaries are estimated to be payable as follows:

April `9,000 July `10,000

Following information relates to ABC company for the year 2016:

(a) Projected sales (` in lakhs)

(b) Gross profit margin will be 20% on sale.

PART B: MANAGEMENT OF RECEIVABLES

A company is considering to engage a factor. The following information is available:

Should the company enter into a factoring agreement?

Time: 50 Minutes Marks: 30

(a) Net operating cycle period.

Raw material inventory consumed during the year `6,00,000

Based on the above activity, estimated cost per unit is:

Raw material `16

You are required to estimate net working capital.

The following additional information is also available for you:

Time: 70 Minutes Marks: 40

Should the project be accepted?

Which machine would you recommend the company to buy?

Project Name Initial Investment NPV

Given below are the data on a capital project ‘M’:

Annual cash inflow `60,000

You are required to calculate:

TEST 5 – RISK ANALYSIS IN CAPITAL BUDGETING & COST OF CAPITAL

Time: 50 Minutes Marks: 30

PART A: RISK ANALYSIS IN CAPITAL BUDGETING

Year Expected cash flow (`) Certainty Equivalent coefficient

Initial Project Cost (`) 2,00,00,000

PART B: COST OF CAPITAL