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PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE

SECTION – A: FINANCIAL MANAGEMENT

Question No. 1 is compulsory.
Attempt any four questions out of the remaining five questions.
In case, any candidate answers extra question(s)/ sub-question(s) over and above the
required number, then only the requisite number of questions first answered in the answer
book shall be valued and subsequent extra question(s) answered shall be ignored.
Working notes should form part of the answer
Question 1
(a) Following information and ratios are given for W Limited for the year ended 31st March, 2022:
Equity Share Capital of ` 10 each ` 10 lakhs
Reserves & Surplus to Shareholders’ Fund 0.50
Sales / Shareholders’ Fund 1.50
Current Ratio 2.50
Debtors Turnover Ratio 6.00
Stock Velocity 2 Months
Gross Profit Ratio 20%
Net Working Capital Turnover Ratio 2.50
You are required to calculate:
(i) Shareholders' Fund
(ii) Stock
(iii) Debtors
(iv) Current liabilities
(v) Cash Balance. (5 Marks)
(b) Balance sheet of X Ltd for the year ended 31st March,2022 is given below:
(` in lakhs)
Liabilities Amount Assets Amount
Equity Shares ` 10 each 200 Fixed Assets 500
Retained earnings 200 Raw materials 150
11% Debentures 300 W.I.P 100
Public deposits (Short-Term) 100 Finished goods 50

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2 INTERMEDIATE EXAMINATION: MAY 2022

Trade Creditors 80 Debtors 125

Bills Payable 100 Cash/Bank 55
980 980
Calculate the amount of maximum permissible bank finance under three methods as per
Tandon Committee lending norms.
The total core current assets are assumed to be ` 30 lakhs. (5 Marks)
(c) A company requires 36,000 units of a product per year at cost of ` 100 per unit. Ordering
cost per order is ` 250 and the carrying cost is 4.5% per year of the inventory cost.
Normal lead time is 25 days and safety stock is NIL.
Assume 360 working days in a year.
(i) Calculate the Reorder Inventory Level.
(ii) Calculate the Economic Order Quantity (EOQ).
(iii) If the supplier offers 1% quantity discount for purchase in lots of 9,000 units or
more, should the company accept the proposal? (5 Marks)
(d) P Ltd. is considering a project with the following details:
Initial Project Cost ` 1,00,000
Annual Cash Inflow ( `) 1 2 3 4
30,000 40,000 50,000 60,000
Project Life (Years) 4
Cost of Capital 10%
(i) MEASURE the sensitivity of the project to change in initial project cost and Annual
cash inflows (considering each factor at a time) such that NPV become zero.
(ii) IDENTIFY which of the two factors; the project is most sensitive to affect the
acceptability of the project?
Year 1 2 3 4 5
PVIF0.10, t 0.909 0.826 0.751 0.683 0.621
(5 Marks)
Answer
(a) (i) Calculation of Shareholders’ Fund:
Reserve & Surplus
= 0.5
Shareholders' Funds

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 3

Reserve & Surplus

= 0.5
Equity Share Capital + Reserve & Surplus
Reserve & Surplus
= 0.5
10,00,000 + Reserve & Surplus

Reserve & Surplus = 5,00,000 + 0.5 Reserve & Surplus

0.5 Reserve & Surplus = 5,00,000
Reserve & Surplus = 10,00,000
Shareholders’ funds = 10,00,000 +10,00,000
Shareholders’ funds = ` 20,00,000
(ii) Calculation of Value of Stock:
Sales
= 1.5
Shareholders' Funds
Sales = 1.5 × 20,00,000
Sales = 30,00,000
Gross Profit = 30,00,000 × 20% = 6,00,000
Cost of Goods Sold = 30,00,000 – 6,00,000
= ` 24,00,000
Stock velocity = 2 months
Average Stock
 12 = 2
Cost of Goods Sold
Average Stock
 12 = 2
24,00,000

2
Average Stock = 24,00,000 
12
Average stock = ` 4,00,000
(iii) Calculation of Debtors:
Debtors Turnover Ratio = 6
Sales
 =6
Average Debtor

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4 INTERMEDIATE EXAMINATION: MAY 2022

30,00,000
 =6
Average Debtor

Average Debtors = ` 5,00,000

(iv) Calculation of Current Liabilities:
Net Working Capital Turnover ratio = 2.5
Sales
= 2.5
Current Assets − Current Liabilites
30,00,000
= 2.5
Current Assets − Current Liabilites
Current Assets – Current Liabilities = 12,00,000 ………….. (1)
Current Ratio = 2.5
Current Assets
= 2.5
Current Liabilities
Current Assets = 2.5 Current Liabilities ……………….……..(2)
From (1) & (2),
2.5 Current Liabilities – Current Liabilities = 12,00,000
1.5 Current Liabilities = 12,00,000
Current Liabilities = ` 8,00,000
(v) Calculation of Cash Balance:
Current Assets = 2.5 Current Liabilities
Current Assets = 2.5 (8,00,000) = 20,00,000
(-) Debtors (5,00,000)
(-) Stock (4,00,000)
Cash Balance ` 11,00,000

(b) Current Assets = 150 + 100 + 50 + 125 + 55 = ` 480 Lakhs

Current Liabilities = 100 + 80 + 100 = ` 280 Lakhs
Maximum Permissible Banks Finance under Tandon Committee Norms:

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 5

Method I
Maximum Permissible Bank Finance = 75% of (Current Assets – Current Liabilities)
= 75% of (480 - 280)
= ` 150 Lakhs
Method II
Maximum Permissible Bank Finance = 75% of Current Assets – Current Liabilities
= 75 % of 480 – 280
= ` 80 Lakhs
Method III
Maximum Permissible Bank Finance = 75% of (Current Assets – Core Current
Assets) – Current Liabilities
= 75 % of (480 - 30) – 280
= ` 57.5 Lakhs
(c) Annual Consumption = 36,000 (A)
Ordering Cost = ` 250 per order (O)
4.5
Carrying Cost =  100
100
= ` 4.5 (C)
Lead Time = 25 days
(i) Reorder Level = Lead Time × Daily Consumption
36,000
= 25 
360
= 2,500 units
2AO
(ii) Economic Order Quantity (EOQ) =
C
2  36,000  250
=
4.5
= 2,000 units

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6 INTERMEDIATE EXAMINATION: MAY 2022

(iii) Evaluation of Profitability of Quantity Discount Offer:

(a) When EOQ is ordered
(`)
Purchase Cost (36,000 units  ` 100) 36,00,000
Ordering Cost [(36,000 units/2,000 units)  ` 250] 4,500
Carrying Cost (2,000 units  ½  ` 4.5) 4,500
Total Cost 36,09,000
(b) When Quantity Discount is accepted
(`)
Purchase Cost (36,000 units  ` 99*) 35,64,000
Ordering Cost [(36,000 units/9,000 units)  ` 250] 1,000
Carrying Cost (9,000 units  ½  ` 99 x 4.5%) 20,048
Total Cost 35,85,048
*Unit Cost = `100
Less: Quantity Discount @ 1% = `1
Purchase Cost = ` 99
Advise – The total cost of inventory is lower if Quantity Discount is accepted.
Hence, the company is advised to accept the proposal.
(d) Computation of Net Present Value (NPV):
Year PVF @ 10% Original Cash Flows (`) PV (`) PV (`)
0 1 (1,00,000) (1,00,000)
1 0.909 30,000 27,270
2 0.826 40,000 33,040
3 0.751 50,000 37,550
4 0.683 60,000 40,980 1,38,840
NPV 38,840
Determination of the most Sensitive factor:
(i) Sensitivity Analysis w.r.t. Initial Project cost (such that NPV becomes zero):
NPV of the project would be zero when the initial project cost is increased by
` 38,840.
` 38,840
 Percentage change in Initial project cost =  100 = 38.84%
` 1,00,000

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 7

(ii) Sensitivity Analysis w.r.t. Annual Cash inflows (such that NPV becomes zero):
NPV of the project would be zero when the Annual cash inflows is decreased by
` 38,840.
` 38,840
 Percentage change in the Annual cash inflows =  100 = 27.97%
` 1,38,840
Conclusion: Annual cash inflows factor is the most sensitive as only a change
beyond 27.97% in savings makes the project unacceptable.
Question 2
Details of a company for the year ended 31 st March, 2022 are given below:
Sales ` 86 lakhs
Profit Volume (P/V) Ratio 35%
Fixed Cost excluding interest expenses ` 10 lakhs
10% Debt ` 55 lakhs
Equity Share Capital of ` 10 each ` 75 lakhs
Income Tax Rate 40%
Required:
(i) Determine company's Return on Capital Employed (Pre-tax) and EPS.
(ii) Does the company have a favourable financial leverage?
(iii) Calculate operating and combined leverages of the company.
(iv) Calculate percentage change in EBIT, if sales increases by 10%.
(v) At what level of sales, the Earning before Tax (EBT) of the company will be equal to
zero? (10 Marks)
Answer
Income Statement
Particulars Amount (`)
Sales 86,00,000
Less: Variable cost (65% of 86,00,000) 55,90,000
Contribution (35% of 86,00,000) 30,10,000
Less: Fixed costs 10,00,000
Earnings before interest and tax (EBIT) 20,10,000
Less: Interest on debt (@ 10% on ` 55 lakhs) 5,50,000

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8 INTERMEDIATE EXAMINATION: MAY 2022

Earnings before tax (EBT) 14,60,000

Tax (40%) 5,84,000
PAT 8,76,000
EBIT EBIT
(i) ROCE (Pre-tax) = 100 = 100
Capital employed Equity + Debt

` 20,10,000
×100 = 15.46%
` (75,00,000+55,00,000)
EPS (PAT/No. of equity shares) 1.168 or ` 1.17
(ii) ROCE is 15.46% and Interest on debt is 10%. Hence, it has a favourable financial
leverage.
(iii) Calculation of Operating, Financial and Combined leverages:
Contribution ` 30,10,000
Operating Leverage = = =1.497 (approx.)
EBIT ` 20,10,000
EBIT ` 20,10,000
Financial Leverage = = = 1.377 (approx.)
EBIT ` 14,60,000
Contribution ` 30,10,000
Combined Leverage = = = 2.062 (approx.)
EBT ` 14,60,000

Or, = Operating Leverage × Financial Leverage = 1.497 × 1.377 = 2.06 (approx.)

(iv) Operating leverage is 1.497. So, if sales are increased by 10%.
EBIT will be increased by 1.497 × 10% i.e. 14.97% (approx.)
(v) Since the combined Leverage is 2.062, sales have to drop by 100/2.062 i.e. 48.50% to
bring EBT to Zero.
Accordingly, New Sales = ` 86,00,000 × (1 - 0.4850)
= ` 86,00,000 × 0.515
= ` 44,29,000 (approx.)
Hence, at ` 44,29,000 sales level, EBT of the firm will be equal to Zero.
Question 3
Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while
making computers. The estimated annual saving from introduction of the artificial intelligence
(AI) is as follows:

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 9

• reduction of five employees with annual salaries of ` 3,00,000 each

• reduction of ` 3,00,000 in production delays caused by inventory problem
• reduction in lost sales ` 2,50,000 and
• Gain due to timely billing ` 2,00,000
The purchase price of the system for installation of artificial intelligence is ` 20,00,000 and
installation cost is ` 1,00,000. 80% of the purchase price will be paid in the year of purchase
and remaining will be paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight -line basis.
However, the operation of the new system requires two computer specialists with annual
salaries of ` 5,00,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance and operating cost are payable in advance.
The company's tax rate is 30% and its required rate of return is 15%.
Year 1 2 3 4 5
PVIF 0.10, t 0.909 0.826 0.751 0.683 0.621
PVIF 0.12, t 0.893 0.797 0.712 0.636 0.567
PVIF 0.15, t 0.870 0.756 0.658 0.572 0.497
Evaluate the project by using Net Present Value and Profitability Index. (10 Marks)
Answer
Computation of Annual Cash Flow after Tax
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in Salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Production Delays
Reduction in Lost 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Sales
Gain due to Timely 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Billing
Salary to Computer (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
Specialist

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10 INTERMEDIATE EXAMINATION: MAY 2022

Maintenance and (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)

Operating Cost
(payable in advance)
Depreciation (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
(21 lakhs/5)
Gain Before Tax 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Less: Tax (30%) 1,89,000 1,95,000 2,01,000 2,07,000 2,13,000
Gain After Tax 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
Add: Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Add: Maintenance 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
and Operating Cost
(payable in advance)
Less: Maintenance (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
and Operating Cost
(payable in advance)
Net CFAT (2,00,000) 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

Note: Annual cash flows can also be calculated Considering tax shield on depreciation &
maintenance and operating cost. There will be no change in the final cash flows after tax.
Computation of NPV
Particulars Year Cash Flows (`) PVF PV (`)
Initial Investment (80% of 20 Lacs) 0 16,00,000 1 16,00,000
Installation Expenses 0 1,00,000 1 1,00,000
Instalment of Purchase Price 1 4,00,000 0.870 3,48,000
PV of Outflows (A) 20,48,000
CFAT 0 (2,00,000) 1 (2,00,000)
CFAT 1 8,81,000 0.870 7,66,470
CFAT 2 8,95,000 0.756 6,76,620
CFAT 3 9,09,000 0.658 5,98,122
CFAT 4 9,23,000 0.572 5,27,956
CFAT 5 10,37,000 0.497 5,15,389
PV of Inflows (B) 28,84,557
NPV (B-A) 8,36,557
Profitability Index (B/A) 1.408 or 1.41

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 11

Evaluation: Since the NPV is positive (i.e. ` 8,36,557) and Profitability Index is also greater
than 1 (i.e. 1.41), Alpha Ltd. may introduce artificial intelligence (AI) while making computers.
Question 4
The particulars relating to Raj Ltd. for the year ended 31 st March, 2022 are given as follows:
Output (units at normal capacity) 1,00,000
Selling price per unit ` 40
Variable cost per unit ` 20
Fixed cost ` 10,00,000
The capital structure of the company as on 31st March, 2022 is as follows:
Particulars Amount in `
Equity share capital (1,00,000 shares of ` 10 each) 10,00,000
Reserves and surplus 5,00,000
Current liabilities 5,00,000
Total 20,00,000
Raj Ltd. has decided to undertake an expansion project to use the market potential that will
involve ` 20 lakhs. The company expects an increase in output by 50%. Fixed cost will be
increased by ` 5,00,000 and variable cost per unit will be decreased by 15%. The additional
output can be sold at the existing selling price without any adverse impact on the market.
The following alternative schemes for financing the proposed expansion program are planned:
(Amount in `)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance
Current market price per share is ` 200.
Slab wise interest rate for fund borrowed is as follows:
Fund limit Applicable interest rate
Up-to ` 5,00,000 10%
Over` 5,00,000 and up-to ` 10,00,000 15%
Over ` 10,00,000 20%

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12 INTERMEDIATE EXAMINATION: MAY 2022

Find out which of the above-mentioned alternatives would you recommend for Raj Ltd. with
reference to the EPS, assuming a corporate tax rate is 40%? (10 Marks)
Answer
Alternative 1 = Raising Debt of ` 5 lakh + Equity of ` 15 lakh
Alternative 2 = Raising Debt of ` 10 lakh + Equity of ` 10 lakh
Alternative 3 = Raising Debt of ` 14 lakh + Equity of ` 6 lakh
Calculation of Earnings per share (EPS)
FINANCIAL ALTERNATIVES
Particulars Alternative 1 Alternative 2 Alternative 3
(`) (`) (`)
Expected EBIT [W. N. (a)] 19,50,000 19,50,000 19,50,000
Less: Interest [W. N. (b)] (50,000) (1,25,000) (2,05,000)
Earnings before taxes (EBT) 19,00,000 18,25,000 17,45,000
Less: Taxes @ 40% 7,60,000 7,30,000 6,98,000
Earnings after taxes (EAT) 11,40,000 10,95,000 10,47,000
Number of shares [W. N. (d)] 1,07,500 1,05,000 1,03,000
Earnings per share (EPS) 10.60 10.43 10.17
Conclusion: Alternative 1 (i.e. Raising Debt of ` 5 lakh and Equity of ` 15 lakh) is
recommended which maximises the earnings per share.
Working Notes (W.N.):
(a) Calculation of Earnings before Interest and Tax (EBIT)
Particulars
Output (1,00,000 + 50%) (A) 1,50,000
Selling price per unit ` 40
Less: Variable cost per unit (` 20 – 15%) ` 17
Contribution per unit (B) ` 23
Total contribution (A x B) ` 34,50,000
Less: Fixed Cost (` 10,00,000 + ` 5,00,000) ` 15,00,000
EBIT ` 19,50,000

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 13

(b) Calculation of interest on Debt

Alternative (`) Total (`)
1 (` 5,00,000 x 10%) 50,000
2 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000 1,25,000
3 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000
(` 4,00,000 x 20%) 80,000 2,05,000

(c) Number of equity shares to be issued

` (20,00,000 - 5,00,000) ` 15,00,000
Alternative 1 = = = 7,500 shares
` 200 (Market price of share) ` 200

` (20,00,000 - 10,00,000) ` 10,00,000

Alternative 2 = = = 5,000 shares
` 200 (Market price of share) ` 200

` (20,00,000 - 14,00,000) ` 6,00,000

Alternative 3 = = = 3,000 shares
` 200 (Market price of share) ` 200

(d) Calculation of total equity shares after expansion program

Alternative 1 Alternative 2 Alternative 3
Existing no. of shares 1,00,000 1,00,000 1,00,000
Add: issued under expansion 7,500 5,000 3,000
program
Total no. of equity shares 1,07,500 1,05,000 1,03,000

Question 5
A company issues:
• 15% convertible debentures of ` 100 each at par with a maturity period of 6 years. On
maturity, each debenture will be converted into 2 equity shares of the company. The risk -
free rate of return is 10%, market risk premium is 18% and beta of the company is 1.25.
The company has paid dividend of ` 12.76 per share. Five year ago, it paid dividend of
` 10 per share. Flotation cost is 5% of issue amount.
• 5% preference shares of ` 100 each at premium of 10%. These shares are redeemable
after 10 years at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.

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14 INTERMEDIATE EXAMINATION: MAY 2022

(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate cost of preference shares.
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.03, t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05, t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA 0.03, t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA 0.05, t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIF i, 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIF i, 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIF i, 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

(10 Marks)
Answer
(i) Calculation of Cost of Convertible Debentures:
Given that,
RF = 10%
Rm – Rf = 18%
Β = 1.25
D0 = 12.76
D-5 = 10
Flotation Cost = 5%
Using CAPM,
Ke = Rf + β (Rm – Rf)
= 10%+1.25 (18%)
= 32.50%
Calculation of growth rate in dividend
12.76 = 10 (1+g) 5
1.276 = (1+g)5
(1+5%)5 = 1.276 ………….. from FV Table
g = 5%

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 15

D7 12.76(1.05)7
Price of share after 6 years = =
k e − g 0.325 − 0.05
12.76  1.407
P6 =
0.275
P6 = 65.28
Redemption Value of Debenture (RV) = 65.28 × 2 = 130.56 (RV)
NP = 95
n =6

INT (1-t) +
( RV − NP )
Kd = n  100
( RV − NP )
2

15 (1-0.4) +
(130.56 − 95 )
= 6  100
(130.56 + 95 )
2
9 + 5.93
=  100
112.78
Kd = 13.24%
(ii) Calculation of Cost of Preference Shares:
Net Proceeds = 100 (1.1) - 6% of 100 (1.1)
= 110 - 6.60
= 103.40
Redemption Value = 100
Year Cash Flows (`) PVF @ 3% PV (`) PVF @ 5% PV (`)
0 103.40 1 103.40 1 103.40
1-10 -5 8.530 -42.65 7.722 -38.61
10 -100 0.744 -74.40 0.614 -61.40
-13.65 3.39
5% − 3%
Kp = 3% + 13.65
[3.39 − ( −13.65)]

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16 INTERMEDIATE EXAMINATION: MAY 2022

2%
= 3% +  13.65
17.04
Kp = 4.6021%
Question 6
(a) Identify the limitations of Internal Rate of Return. (4 Marks)
(b) Briefly explain the assumptions of Walter's Model. (4 Marks)
(c) State advantages of "Wealth Maximization" goals in Financial Management (2 Marks)
OR
Distinguish between American Depository Receipts and Global Depository Receipts.
(2 Marks)
Answer
(a) Limitations of Internal Rate of Return (IRR)
➢ The calculation process is tedious if there is more than one cash outflow
interspersed between the cash inflows; there can be multiple IRR, the interpretation
of which is difficult.
➢ The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
➢ It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It ignores a firm’s ability to re-invest in
portfolio of different rates.
➢ If mutually exclusive projects are considered as investment options which have
considerably different cash outlays. A project with a larger fund commitment but
lower IRR contributes more in terms of absolute NPV and increases the
shareholders’ wealth. In such situation decisions based only on IRR criterion
may not be correct.
(b) Assumptions of Walter’s Model
• All investment proposals of the firm are to be financed through retained earnings
only.
• ‘r’ rate of return & ‘Ke’ cost of capital are constant.
• Perfect capital markets: The firm operates in a market in which all investors are
rational and information is freely available to all.
• No taxes or no tax discrimination between dividend income and capital
appreciation (capital gain). It means there is no difference in taxation of dividend

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 17

income or capital gain. This assumption is necessary for the universal applicability
of the theory, since, the tax rates may be different in different countries.
• No floatation or transaction cost: Similarly, these costs may differ country to
country or market to market.
• The firm has perpetual life.
(c) Advantages of “Wealth Maximization” goals in Financial Management
(i) Emphasizes the long-term gains.
(ii) Recognises risk or uncertainty.
(iii) Recognises the timing of returns.
(iv) Considers shareholders’ return.
OR
Distinguish Between American Depository Receipts and Global Depository
Receipts:
American Depository Receipts Global Depository Receipts
Meaning It is a negotiable instrument It is a negotiable instrument
which is issued by US bank, which is issued by the
which represent the nazon-US international depository bank that
Company stock that is being represent the foreign company’s
traded in US stock Exchange stock trading world-wide.
Issued where In the US domestic capital European capital market.
market.
Listed in In the American Stock Exchange In the Non-US Stock Exchange
Relevance Foreign companies are able to Foreign companies can trade in
trade in the US Stock Market. any country’s stock market other
than that of the US.
Alternatively:
American Depository Receipts (ADRs): These are securities offered by non-US
companies who want to list on any of the US exchange. Each ADR represents a
certain number of a company's regular shares. ADRs allow US investors to buy shares of
these companies without the costs of investing directly in a foreign stock exchange.
Global Depository Receipts (GDRs): These are negotiable certificates held in the bank
of one country representing a specific number of shares of a stock traded on the
exchange of another country. These financial instruments are used by companies to
raise capital in either dollars or Euros. These are mainly traded in European countries
and particularly in London.

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18 INTERMEDIATE EXAMINATION: MAY 2022

SECTION – B: ECONOMICS FOR FINANCE

Question No. 7 is compulsory.
Answer any three from the rest.
Question 7
(a) Following information, relating to a particular financial year, are given as under:
` in Crores
Sales 3,500
Intermediate consumption 400
Closing Stock 300
Opening Stock 200
Net indirect tax 600
Mixed income 200
Consumption of fixed capital 400
Compensation of employees 400
Compute:
(i) GVAMP
(ii) NDPMP
(iii) Operating Surplus (3 Marks)
(b) State the features of Foreign Portfolio Investment. (3 Marks)
(c) Comment on the role of Government intervention for equitable distribution. (2 Marks)
(d) Describe the precautionary motive for money. (2 Marks)
Answer
(a) (i) GVAMP = Sales + Change in stock - Intermediate Consumption
= 3,500 + (300 – 200) – 400

= ` 3,200 Crores

(ii) NDPMP = GDPMP – Consumption of Fixed capital

= 3,200 – 400 [here GDPMP = GVAMP]

= ` 2,800 Crores

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 19

(iii) NDPFC = NDPMP – Net Indirect Taxes

= 2800 – 600 = ` 2,200 Crores

NDPFC = Compensation of employees + Operating surplus + Mixed Income

2,200 = 400 + Operating Surplus + 200
Operating Surplus = 2,200 – 600 = ` 1600 Crores
(b) Features of Foreign Portfolio Investment:
• Investment is only in financial assets
• Only short-term interest and generally remain invested for short periods
• Relatively easy to withdraw
• Not accompanied by technology transfer
• No direct impact on employment of labour and wages
• No abiding interest in management and control
• Securities are held purely as a financial investment and no significant degree of
influence on the management of the enterprise
• Speculative in nature.
(c) Role of Government Intervention for Equitable Distribution: A major function of the
present-day governments therefore involves changing the pattern of distribution of
income, wealth, and opportunities from what the market would put forward to a more
socially optimal and egalitarian one. Governments can redistribute either through the
expenditure side or through the revenue side of the budget. On the expenditure side,
governments may provide free or subsidized education, healthcare, housing, food, and
basic goods etc. to deserving people. On the revenue side, redistribution is done through
progressive taxation.
Inequality and the resulting loss of social welfare is sought to be tackled by government
through an appropriately framed tax and transfer policy. This involves progressive
taxation combined with provision of subsidy to low- income households. Proceeds from
progressive taxes may be used to finance public services, especially those such as
public housing, which particularly benefit low-income households. Few examples are
supply of essential food grains at highly subsidized prices to BPL households, free or
subsidised education, healthcare, housing, rations, and basic goods etc. to the deserving
people.
(d) Precautionary Motive for Money: Many unforeseen and unpredictable contingencies
involving money payments occur in our day-to-day life. Individuals as well as businesses
keep a portion of their income to finance such unanticipated expenditures. The amount of
money demanded under the precautionary motive depends on the size of income,

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20 INTERMEDIATE EXAMINATION: MAY 2022

prevailing economic as well as political conditions and personal characteristics of the

individual such as optimism/ pessimism, farsightedness etc. Keynes regarded the
precautionary balances just as balances under transactions motive as income elastic and
by itself not very sensitive to rate of interest.
The sum of the transaction and precautionary demand, and the speculative demand, is
the total demand for money. An increase in income increases the transaction and
precautionary demand for money and a rise in the rate of interest decreases the demand
for speculative demand money.
Question 8
(a) (i) Differentiate between Non-Discretionary and discretionary Fiscal policy. (3 Marks)
(ii) Write a brief note on Countervailing Duties. (2 Marks)
(b) (i) Explain the 'Circular Flow of Income'. (3 Marks)
(ii) What will be the total money credit created by the commercial banking system for
an initial deposit of ` 500 if the required reserve ratio is 0.04, 0.06 and 0.10 percent
respectively. Compute credit multiplier. (2 Marks)
Answer
(a) (i) Distinction between Non-Discretionary and Discretionary Fiscal Policy
S. Non-Discretionary Fiscal Discretionary Fiscal Policy
No. Policy
1 These are called automatic These are deliberate policy action by
Stabilizers. Changes tend to the Government to change the level of
occur automatically without any expenditure and taxes in order to
explicit action by the influence the level of National output
Government. employment and prices.
2 Personal income tax, corporate Specific export subsidies and
income taxes and transfer concessions are examples.
payments by Government
constitute the major examples.
3 Nondiscretionary fiscal policy Discretionary fiscal policy consists of
is that set of policies that are actions taken at the time of a problem
built into the system to stabilize to alter the economy of the moment.
the economy when growth is Thus, the aim can be anti-cyclical
either too fast or too slow. (decrease) or pro cyclical (increase).
4 Non-Discretionary Fiscal Policy Discretionary policy usually implies
ensures self-correcting fiscal implementation lags and is not
response. automatically reversed when economic
conditions change.

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 21

Alternatively:
Discretionary fiscal policy refers to deliberate policy actions on the part of the
government to change the levels of expenditure and taxes to influence the level of
national output, employment, and prices. Non-discretionary fiscal policy or
automatic stabilizers are part of the structure of the economy and are ‘built-in’ fiscal
mechanisms that operate automatically to reduce the expansions and contractions
of the business cycle. Changes in fiscal policy do not always require explicit action
by government. In most economies, changes in the level of taxation and level of
government spending tend to occur automatically. These are dependent on and are
determined by the level of aggregate production and income, such that the
instability caused by business cycle is automatically dampened without any need for
discretionary policy action.
However, automatic stabilizers that depend on the level of economic activity alone
would not be sufficient to correct instabilities. The government needs to resort to
discretionary fiscal policies. Discretionary fiscal policy for stabilization refers to
deliberate policy actions on the part of government to change the levels of
expenditure, taxes to influence the level of national output, employment, and prices.
Governments influence the economy by changing the level and types of taxes, the
extent and composition of spending, and the quantity and form of borrowing.
(ii) Countervailing Duties
Countervailing duties are tariffs that aim to offset the artificially low prices charged
by exporters who enjoy export subsidies and tax concessions offered by the
governments in their home country. If a foreign country does not have a
comparative advantage in a particular good and a government subsidy allows the
foreign firm to be an exporter of the product, then the subsidy generates a distortion
from the free-trade allocation of resources. In such cases, CVD is charged in an
importing country to negate the advantage that exporters get from subsidies to
ensure fair and market-oriented pricing of imported products and thereby protecting
domestic industries and firms.
(b) (i) Circular Flow of Income
Circular flow of income is a process where the national income and expenditure of
an economy flow in a circular manner continuously through time. Savings,
expenditures, exports, and imports are various components of circular flow of
income which are (shown in the figure) in the form of currents and cross currents in
such a manner that national income equals national expenditure.

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22 INTERMEDIATE EXAMINATION: MAY 2022

Circular Flow in Two Sector Economy

The circular broken lines with arrows show factor and product flows and present
‘real flows’ and the continuous line with arrows show ‘money flows’ which are
generated by real flows. These two circular flows - real flows and money flows - are
in opposite directions and the value of real flows equal the money flows because
the factor payments are equal to household incomes. There are no injections into or
leakages from the system. Since the whole of household income is spent on goods
and services produced by firms, household expenditures equal the total receipts of
firms which equal the value of output.
Alternatively:
Circular Flow of Income refers to the continuous circulation of production, income
generation and expenditure involving different sectors of the economy. There are
three different inter linked phases in a circular flow of income namely, production,
distribution and disposition as follows:
(i) In the production phase, firms produce goods and services with the help of
factor services.
(ii) In the income or distribution phase, the flow of factor incomes in the form of
rent, wages, interest and profits from firms to the household occurs.
(iii) In the expenditure or disposition phase, the income received by different
factors of production is spent on consumption of goods and services and
investment goods.

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 23

1
(ii) Credit multiplier =
Required Reserve Ratio
Credit multiplier when RRR is 0.04 = 25
Credit multiplier when RRR is 0.06 = 16.67
Credit multiplier when RRR is 0.10 = 10
Credit Creation = Initial Deposit x Credit Multiplier
1
Credit creation = 500  = 12,500
0.04
1
Credit creation = 500  = 8,333.33
0.06
1
Credit Creation = 500  = 5,000
0.10
Question 9
(a) (i) Explain 'Global Public goods' with examples. (3 Marks)
(ii) What is aggregate Demand Function? (3 Marks)
(b) (i) Calculate the volume of Transaction:
Price = 105
Velocity of money = 4.2
Money supply 4500 billion
What will be the outcome if volume of transaction increases to 240? (3 Marks)
(ii) What do you mean by 'Bound Tariff’? Explain. (2 Marks)
Answer
(a) (i) Global Public Goods
Global public goods are those public goods with benefits/costs that potentially
extend to everyone in the world. These goods have widespread impact on different
countries and regions, population groups and generations throughout the entire
globe.
Examples of Global Public Goods may be:
• Final public goods which are ‘outcomes’ such as ozone layer preservation or
prevention of climate change and bio-diversity.

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24 INTERMEDIATE EXAMINATION: MAY 2022

• Intermediate public goods, which contribute to the provision of final public

goods e.g., international health regulations for communicable diseases
including HIV/AIDS, tuberculosis, malaria and avian influenza.
• International trade, international financial architecture and global knowledge
for development.
The World Bank identifies five areas of global public goods which it seeks to
address: namely, the environmental commons, communicable diseases,
international trade, international financial architecture, and global knowledge for
development. The distinctive characteristic of global public goods is that there is no
mechanism (either market or government) to ensure an efficient outcome.
(ii) Aggregate Demand Function
Aggregate demand (AD) is what economists call total planned expenditure. In a
simple two-sector economy, the ex-ante aggregate demand (AD) for final goods or
aggregate expenditure consists of only two components:
(i) Ex ante aggregate demand for consumer goods (C), and
(ii) Ex ante aggregate demand for investment goods (I).
Thus, AD = C + I (i)
Of the two components, consumption expenditure accounts for the highest
proportion of the GDP. In a simple economy, the variable I is assumed to be
determined exogenously and constant in the short run. Therefore, the short-run
aggregate demand function can be written as:
AD = C + (ii)
Where = constant investment.
From the equation (ii), we can infer that, in the short- run, AD depends largely on
the aggregate consumption expenditure.
(b) (i) Calculation of Volume of Transaction
MV = PT
4500 × 4.2 = 105 × T
T = (4500 x 4.2) / 105 = 180
Now if volume of transaction increase to 240 then-
4500 × v = 105 × 240
105  240
V= = 5.6
4,500

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 25

(ii) Bound Tariff

The bound tariff rate is specific to individual products and represents the maximum
level of import duty that can be levied on a product imported by that member. Under
this, a WTO member binds itself with a legal commitment not to raise tariff rate
above a certain level. By binding a tariff rate, often during negotiations, the
members agree to limit their right to set tariff levels beyond a certain level. A
member is always free to impose a tariff that is lower than the bound level. Once
bound, a tariff rate becomes permanent, and a member can only increase its level
after negotiating with its trading partners and compensating them for possible
losses of trade. A bound tariff ensures transparency and predictability.
Question 10
(a) (i) What are the common objectives of fiscal policy? (3 Marks)
(ii) State the nature of the monetary policy for the following actions taken by the RBI of
the country:
(A) Reduction in the cash reserve ratio.
(B) Selling of securities in the open market.
(C) Increase of repo rate by 50 base point.
(D) Increase in the supply of currency and coins. (2 Marks)
(b) (i) Calculate Multiplier and Marginal Propensity to Consume (MPC) with the help of
following information:
Particulars 2020-21 (` in Crore) 2021-22 (` in Crore)
Investment 1600 2000
National Income 5000 6600

(2 Marks)
(ii) Explain 'Sanitary and Phytosanitary (SPS) Measures’. (2 Marks)
Answer
(a) (i) Common Objectives of Fiscal Policy
Fiscal policy is in the nature of a demand-side policy. An economy which is
producing at full-employment level does not require government action in the form
of fiscal policy.
The most common objectives of fiscal policy are:
▪ achievement and maintenance of full employment,
▪ maintenance of price stability,

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26 INTERMEDIATE EXAMINATION: MAY 2022

▪ acceleration of the rate of economic growth and development, and

▪ equitable distribution of income and wealth.
(ii) Nature of Monetary Policy
Nature of Monetary Policy
A Reduction in cash reserves ratio. Expansionary
B Selling of securities in the open market. Contractionary
C Increase of repo rate by 50 base point. Contractionary
D Increase in the supply of currency and Expansionary
coins.

(b) (i) Calculation of Marginal Propensity to Consume (MPC)

Increase in investment
∆ I = 2,000 – 1,600 = ` 400 Crore

Increase in National Income

= ∆ Y = 6,600 – 5,000
= ` 1,600 Crore
y 1,600
Multiplier k = = =4
I 400
1
We know that k =
1 − MPC
1
4=
1 − MPC

4(1-MPC) = 1
4-4MPC = 1
3 = 4MPC
3
MPC = = 0.75
4

MPC = 0.75

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 27

(ii) Sanitary and Phytosanitary (SPS) Measures

SPS measures are applied to protect human, animal or plant life from risks arising
from additives, pests, contaminants, toxins or disease-causing organisms and to
protect biodiversity.
These include ban or prohibition of import of certain goods, all measures governing
quality and hygienic requirements, production processes, and associated
compliance assessments. For example, prohibition of import of poultry from
countries affected by avian flu, meat and poultry processing standards to reduce
pathogens, residue limits for pesticides in foods etc.
Question 11
(a) (i) The monetary authority of an economy has provided the following data:
Particulars ` in Crore
Notes in Circulation 2,42,09,645
Rupee Coin in Circulation 3,25,572
Small Coins in Circulation 7,434
Post Office Saving Bank Deposits 14,17,868
Cash in Hand with banks 9,75,635
Deposit Money of the Public 1,77,61,992
Demand Deposited with banks 1,73,76,925
Other Deposits with Reserve Bank 3,85,074
Total Post Office Deposits 1,48,966
Time Deposits with Banks 17,86,969
You are required to calculate (i) M1; and (ii) M2. (3 Marks)
(ii) Identify the market outcomes for each of the following situations:
(A) Playing of loud music at night resulting in inability to sleep.
(B) Wearing of mask during covid-19 pandemic. (2 Marks)
(b) (i) Following information, relating to an economy of a country, for the current year are
as under:
Particulars (In Crores ` )
GDP MP 6550
Gross Investment
(Including Business fixed investment, Residential
construction investment, Public & Inventory investment) 1000

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28 INTERMEDIATE EXAMINATION: MAY 2022

Government Purchases of goods and services 1500

Exports 400
Imports 350
GNPMP 6600
Indirect Taxes 200
Depreciation 200
Find out:
(A) Private Final Consumption Expenditure
(B) Net Factor Income from Abroad
(C) NNPFC or National Income (3 Marks)
(ii) Explain briefly two key concepts of 'New Trade Theory' that gives advantages to
countries that import goods to compete with the home country. (2 Marks)
OR

Explain 'Embargos'. (2 Marks)

Answer
(a) (i) Calculation of M1 and M2
M1 = (Notes in Circulation + Rupee coin in circulation + small coins in circulation –
cash in hands with banks) + demand deposit with bank + other deposit with
RBI
= 2,42,09,645 + 3,25,572 +7,434 - 9,75,635 +1,73,76,925+3,85,074
= ` 4,13,29,015 Crores
M2 = M1+ Post Office Savings Bank Deposits
= 4,13,29,015 +14,17,868
= ` 4,27,46,883 Crores
(ii) Situations and Market outcomes:
(A) Playing of loud music at night resulting in inability to sleep
Market Outcome: Negative Consumption externality, over production.
(B) Wearing of mask during COVID-19 pandemic
Market Outcome: Positive consumption externality as it prevents others from
getting infected.

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PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 29

(b) (i) (A) Private Final Consumption Expenditure:

GDPMP = Private Final Consumption expenditure + Government final
consumption expenditure + Gross domestic Capital formation +
Net Export
6,550 = Private Final Consumption expenditure + 1,500+1,000+50
Private Final Consumption expenditure = 6550-2550 = ` 4000 crores
(B) Net Factor Income from Abroad:
= GNPMP – GDPMP
= 6,600 – 6,550
= ` 50 crores
(C) NNPFC or National Income:
= GDPMP – depreciation + NFIA – NIT
= 6,550 – 200+50-200
= ` 6,200 crores
(b) (ii) New Trade Theory (NTT): According to NTT, two key concepts that gives
advantages to countries that import goods to compete with products from the home
country are:
Economies of Scale: As a firm produces more of a product, its cost per unit keeps
going down. So, if the firm serves domestic as well as foreign market instead of just
one, then it can reap the benefit of large scale of production consequently the
profits are likely to be higher.
Network effects: It refer to the way one person’s value for a good or service is
affected by the value of that good or service to others. The value of the product or
service is enhanced as the number of individuals using it increases. This is also
referred to as the ‘bandwagon effect’. Consumers like more choices, but they also
want products and services with high utility, and the network effect increases utility
obtained from these products over others. A good example will be Mobile App such
as What’s App and software like Microsoft Windows.
OR
Embargos:
An embargo is a total ban imposed by government on import or export of some or
all commodities to particular country or regions for a specified or indefinite period.
This may be done due to political reasons or for other reasons such as health,
religious sentiments. This is the most extreme form of trade barrier.

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