PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE

PART A: FINANCIAL MANAGEMENT

QUESTIONS
Ratio Analysis
1. From the following table of financial ratios of Prabhu Chemicals Limited, comment on
various ratios given at the end:
Ratios 2021 2022 Average of
Chemical Industry
Liquidity Ratios
Current ratio 2.1 2.3 2.4
Quick ratio 1.4 1.8 1.4
Receivable turnover ratio 8 9 8
Inventory turnover 8 9 5
Receivables collection period 46 days 41 days 46 days
Operating profitability
Operating income –ROI 24% 21% 18%
Operating profit margin 18% 18% 12%
Financing decisions
Debt ratio 45% 44% 60%
Return
Return on equity 26% 28% 18%
COMMENT on the following aspect of Prabhu Chemicals Limited
(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders
Cost of Capital
2. Jason Limited is planning to raise additional finance of ` 20 lakhs for meeting its new
project plans. It has ` 4,20,000 in the form of retained earnings available for investment
purposes. Further details are as following:

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 2 INTERMEDIATE EXAMINATION: NOVEMBER 2023

Debt / Equity Mix 30 / 70

Cost of Debt
Upto ` 3,60,000 8 % (before tax)
Beyond ` 3,60,000 12 % (before tax)
Earnings per share `4
Dividend pay-out 50% of earnings
Current Market Price per share ` 44
Expected Growth rate in Dividend 10 %
Tax 40%
You are required:
(a) To determine the cost of retained earnings and cost of equity.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the pattern for raising the additional finance, and
(d) Compute the overall weighted average after tax cost of additional finance.
Capital Structure
3. Prakash Limited provides you the following information:
(`)
Profit (EBIT) 3,00,000
Less: Interest on Debenture @ 10% (50,000)
EBT 2,50,000
Less Income Tax @ 50% (1,25,000)
1,25,000
No. of Equity Shares (` 10 each) 25,000
Earnings per share (EPS) 5
Price /EPS (PE) Ratio 10
The company has reserves and surplus of ` 7,50,000 and required ` 5,00,000 further for
modernisation. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt +
Equity) Ratio higher than 40% will bring the P/E Ratio down to 8 and increase the interest
rate on additional debts to 12%. You are required to ASCERTAIN the probable price of the
share.
(i) If the additional capital is raised as debt; and
(ii) If the amount is raised by issuing equity shares at ruling market price

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 3

Leverage
4. The capital structure of ABC Ltd. for the year ended 31 st March 2022 consisted as follows:
Particulars Amount in `
Equity share capital (face value ` 100 each) 20,00,000
10% debentures (` 100 each) 20,00,000

During the year 2021-22, sales decreased to 1,00,000 units as compared to 1,20,000 units
in the previous year. However, the selling price stood at ` 15 per unit and variable cost at
` 10 per unit for both the years. The fixed expenses were at ` 2,00,000 p.a. and the income
tax rate is 30%.
You are required to CALCULATE the following:
(a) The degree of financial leverage at 1,20,000 units and 1,00,000 units.
(b) The degree of operating leverage at 1,20,000 units and 1,00,000 units.
(c) The percentage change in EPS.
Investment Decisions
5. PQR Limited is considering buying a new machine which would have a useful economic
life of five years, at a cost of ` 40,00,000 and a scrap value of ` 5,00,000, with 80 per cent
of the cost being payable at the start of the project and 20 per cent at the end of the first
year. The machine would produce 80,000 units per annum of a new product with an
estimated selling price of ` 400 per unit. Direct costs would be ` 375 per unit and annual
fixed costs, including depreciation calculated on a straight- line basis, would be
` 10,40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in
the above costs, would be incurred, amounting to ` 1,25,000 and ` 1,75,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the
company’s cost of capital to be 12 percent.
Management of Receivables (Debtors)
6. A regular customer of your company has approached to you for extension of credit facility
for purchasing of goods. On analysis of past performance and on the basis of information
supplied, the following pattern of payment schedule emerges:
Pattern of Payment Schedule
At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.

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 4 INTERMEDIATE EXAMINATION: NOVEMBER 2023

At the end of 90 days 30% of the bill

At the end of 100 days 18% of the bill
Non-recovery 2% of the bill

The customer wants to enter into a firm commitment for purchase of goods of ` 40 lakhs
in 2022, deliveries to be made in equal quantities on the first day of each quarter in the
calendar year. The price per unit of commodity is ` 400 on which a profit of ` 20 per unit
is expected to be made. It is anticipated that taking up of this contract would mean an extra
recurring expenditure of ` 20,000 per annum. If the opportunity cost is 18% per annum,
would you as the finance manager of the company RECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.
Risk Analysis in Capital Budgeting
7. An enterprise is investing ` 200 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.
Year Cash flows (` In lakhs)
1 50
2 120
3 150
4 160
5 130
CALCULATE Net Present Value of the project based on Risk free rate and also on the
basis of Risks adjusted discount rate.
Dividend Decisions
8. HM Ltd. is listed on Bombay Stock Exchange which is currently been evaluated by Mr. A
on certain parameters.
Mr. A collated following information:
(a) The company generally gives a quarterly interim dividend. ` 2.5 per share is the last
dividend declared.
(b) The company’s sales are growing by 20% on a 5-year Compounded Annual Growth
Rate (CAGR) basis, however the company expects following retention amounts
against probabilities mentioned as contention is dependent upon cash requirements
for the company. Rate of return is 10% generated by the company.

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 5

Situation Prob. Retention Ratio

A 30% 50%
B 40% 60%
C 30% 50%
(c) The current risk-free rate is 3.75% and with a beta of 1.2 company is having a risk
premium of 4.25%.
You are required to help Mr. A in calculating the current market price using Gordon’s
formula.
Management of working Capital
9. Consider the following figures and ratios:
(i) Sales for the year (all credit) ` 1,05,00,000
(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1

You are required to PREPARE:

(a) Balance Sheet as on 31/3/2022 based on above details.
(b) The statement showing working capital requirement if the company wants to make a
provision for contingencies @ 14 percent of net working capital.
Miscellaneous
10. (a) EXPLAIN agency problem and agency cost. How to address the issues of the same.
(b) DESCRIBE the inter relationship between investing, financing, and dividend
decisions.
(c) STATE the meaning of debt securitization.

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 6 INTERMEDIATE EXAMINATION: NOVEMBER 2023

SUGGESTED HINTS/ANSWERS

1.
Ratios Comment
Liquidity Current ratio has improved from last year and matching
the industry average.
Quick ratio also improved than last year and above the
industry average.
The reduced inventory levels (evidenced by higher
inventory turnover ratio) have led to better quick ratio
in FY 2022 compared to FY 2021.
Further the decrease in current liabilities is greater than
the collective decrease in inventory and debtors as the
current ratio have increase from FY2021 to FY 2022.
Operating Profits Operating Income-ROI reduced from last year, but
Operating Profit Margin has been maintained. This may
happen due to decrease in operating cost. However,
both the ratios are still higher than the industry
average.
Financing The company has reduced its debt capital by 1% and
saved earnings for equity shareholders. It also signifies
that dependency on debt compared to other industry
players (60%) is low.
Return to the shareholders Prabhu’s ROE is 26 per cent in 2021 and 28 per cent
in 2022 compared to an industry average of 18 per
cent. The ROE is stable and improved over the last
year.
2. (a) Cost of Equity / Retained Earnings (using dividend growth model)
D1
Ke =
P0
where D1 = Do (1 + g) = 2 (1 + .10) = 2.2
2.2
Ke = + 0.10 = 0.15 or 15 %
44
(b) Cost of Debt (Post Tax)
Kd = I (1-t)
Upto 3,60,000 Kd = .08 (1-0.4) = 0.048

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 7

Beyond 3,60,000 = .12 (1-0.4) = 0.072

Thus, post-tax cost of additional debt = 0.048 x 3,60,000 / 6,00,000 + 0.072 x
2,40,000/ 6,00,000 = 0.0288 + 0.0288 = 0.0576 or 5.76%
(c) Pattern for Raising Additional Finance
Debt = 20,00,000 x 30% = 6,00,000
Equity = 20,00,000 x 70 % = 14,00,000
Out of this total equity amount of ` 14,00,000 -
Equity Shares = 14,00,000 – 4,20,000
= 9,80,000
And Retained Earnings = 4,20,000
(d) Overall Weighted Average after tax cost of additional finance
WACC = Kd x Debt Mix + Ke x Equity Mix = 0.0576 x 30% + 0.15 x 70% = 0.01728 +
0.105 = 0.1223 or 12.23% (approx.)
3. Ascertainment of probable price of shares of Prakash limited
Plan-I Plan-II
If ` 5,00,000 is If ` 5,00,000 is
Particulars raised as debt raised by
issuing equity
shares
(`) (`)
Earnings Before Interest and Tax (EBIT)
{20% of new capital i.e., 20% of (`15,00,000 +
4,00,000 4,00,000
` 5,00,000)}
(Refer working note1)
Less: Interest on old debentures
(50,000) (50,000)
(10% of `5,00,000)
Less: Interest on new debt
(60,000) --
(12% of `5,00,000)
Earnings Before Tax (EBT) 2,90,000 3,50,000
Less: Tax @ 50% (1,45,000) (1,75,000)
Earnings for equity shareholders (EAT) 1,45,000 1,75,000

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 8 INTERMEDIATE EXAMINATION: NOVEMBER 2023

No. of Equity Shares (refer working note 2) 25,000 35,000

Earnings per Share (EPS) ` 5.80 ` 5.00
Price/ Earnings (P/E) Ratio (refer working note
8 10
3)
Probable Price Per Share (PE Ratio × EPS) ` 46.40 ` 50
Working Notes:
1. Calculation of existing Return of Capital Employed (ROCE):
(`)
Equity Share capital (25,000 shares × `10) 2,50,000
 100 
10% Debentures  ` 50,000   5,00,000
 10 
Reserves and Surplus 7,50,000
Total Capital Employed 15,00,000
Earnings before interest and tax (EBIT) (given) 3,00,000
` 3,00,000
ROCE =  100 20%
` 15,00,000

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

` 5,00,000
= = 10,000 Shares
` 50

Thus, after the issue total number of shares = 25,000+ 10,000 = 35,000 shares
3. Debt/Equity Ratio if ` 5,00,000 is raised as debt:
` 10,00,000
=  100 = 50%
` 20,00,000

As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in
Plan-I
4.
Sales in units 1,20,000 1,00,000
(`) (`)
Sales Value 18,00,000 15,00,000
Variable Cost (12,00,000) (10,00,000)
Contribution 6,00,000 5,00,000

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 9

Fixed expenses (2,00,000) (2,00,000)

EBIT 4,00,000 3,00,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 1,00,000
Tax @ 30% (60,000) (30,000)
Profit after tax (PAT) 1,40,000 70,000
EBIT 4,00,000 3,00,000
(i) Financial Leverage= = =2 = =3
EBT 2,00,000 1,00,000
Contribution 6,00,000 5,00,000
(ii) Operating leverage = = 1.50 = = 1.67
EBIT 4,00,000 3,00,000
(iii) Earnings per share (EPS) 1,40,000 70,000
=`7 = ` 3.5
20,000 20,000
Decrease in EPS = ` 7 – ` 3.5 = ` 3.5
% decrease in EPS 3.5
= x 100 = 50%
7
5. Calculation of Net Cash flows
Contribution = (400 – 375)  80,000 = ` 20,00,000
Fixed costs = 10,40,000 – [(40,00,000 – 5,00,000)/5] = ` 3,40,000
Year Capital Contribution Fixed costs Promotion Net cash flow
(`) (`) (`) (`) (`)
0 (32,00,000) (32,00,000)
1 (8,00,000) 20,00,000 (3,40,000) (1,25,000) 7,35,000
2 20,00,000 (3,40,000) (1,75,000) 14,85,000
3 20,00,000 (3,40,000) 16,60,000
4 20,00,000 (3,40,000) 16,60,000
5 5,00,000 20,00,000 (3,40,000) 21,60,000
Calculation of Net Present Value
Year Net cash flow (`) 12% discount factor Present value (`)
0 (32,00,000) 1.000 (32,00,000)
1 7,35,000 0.893 6,56,355
2 14,85,000 0.797 11,83,545

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 10 INTERMEDIATE EXAMINATION: NOVEMBER 2023

3 16,60,000 0.712 11,81,920

4 16,60,000 0.636 10,55,760
5 21,60,000 0.567 12,24,720
21,02,300
The net present value of the project is `21,02,300.
6. Statement showing the Evaluation of credit Policies
Particulars Proposed Policy `
A. Expected Profit:
(a) Credit Sales 40,00,000
(b) Total Cost
(i) Variable Costs (` 380 x 10000 units) 38,00,000
(ii) Recurring Costs 20,000
38,20,000
(c) Bad Debts 80,000
(d) Expected Profit [(a) – (b) – (c)] 1,00,000
B. Opportunity Cost of Investments in Receivables 1,31,790
C. Net Benefits (A – B) (31,790)

Recommendation: The Proposed Policy should not be adopted since the net benefits
under this policy are negative.
Working Note: Calculation of Opportunity Cost of Average Investments
Collection period Rate of Return
Opportunity Cost = Total Cost × x
360 100

Particulars 20% 30% 30% 18% Total

A. Total Cost 7,64,000 11,46,000 11,46,000 6,87,600 37,43,600
B. Collection period 30/360 60/360 90/360 100/360
C. Required Rate of 18% 18% 18% 18%
Return
D. Opportunity Cost 11,460 34,380 51,570 34,380 1,31,790
(A × B × C)

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 11

7. The Present Value of the Cash Flows for all the years by discounting the cash flow at 7%
is calculated as below:
Year Cash flows Discounting Present value of Cash
`In lakhs Factor@7% Flows ` In Lakhs
1 50 0.935 46.75
2 120 0.873 104.76
3 150 0.816 122.40
4 160 0.763 122.08
5 130 0.713 92.69
Total of present value of Cash flow 488.68
Less: Initial investment (200.00)
Net Present Value (NPV) 288.68
Now, the risk-free rate is 7 % and the risk premium expected by the Management is 7 %.
So, the risk adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below:
Year Cash flows Discounting Present Value of Cash Flows
` in Lakhs Factor@14% ` in lakhs
1 50 0.877 43.85
2 120 0.769 92.28
3 150 0.675 101.25
4 160 0.592 94.72
5 130 0.519 67.47
Total of present value of Cash flow 399.57
Initial investment (200.00)
Net present value (NPV) 199.79
8. Market price using Gordon’s formula
D 0 (1 + g )
P0 =
ke − g

D0 = 2.5×4 = 10 per share (annual)

g = br or retention ratio x rate of return
Calculation of expected retention ratio

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 12 INTERMEDIATE EXAMINATION: NOVEMBER 2023

Situation Prob. Retention Ratio Expected Retention Ratio

A 30% 50% 0.15
B 40% 60% 0.24
C 30% 50% 0.15
Total 0.54
g = 0.54 × 0.10= 0.054 or 5.4%
D 0 (1 + g )
P0 =
Ke − g

10 (1 + 0.054 ) 10.54
P0 = = = 305.51
0.0885 − 0.054 0.0345
Ke = Risk free rate + (Beta x Risk Premium)
= 3.75% + (1.2 x 4.25%) = 8.85%
9. Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)
= ` 1,05,00,000 – ` 36,75,000
= ` 68,25,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
` 68,25,000
= ` = ` 11,37,500
6
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
` 68,25, 000
= `
1.5
= ` 45,50,000
(iv) Current Assets:
Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
2.5
Current Assets = Amount of Inventories ( Stock ) x
1

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 13

2.5
= `11,37,500 x = ` 28,43,750
1
(v) Liquid Assets (Receivables and Cash)
= Current Assets – Inventories (Stock)
= ` 28,43,750 – ` 11,37,500
= ` 17,06,250
Debtors Collection period
(vi) Receivables (Debtors) = Sales x
12
1
= `1,05,00,000 ×
12
= ` 8,75,000
(vii) Cash = Liquid Assets – Receivables (Debtors)
= ` 17,06,250 – ` 8,75,000 = ` 8,31,250
Fixed Assets
(viii) Net worth =
1.3
` 45,50, 000
= = ` 35,00,000
1.3
(ix) Reserves and Surplus
Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
1
Reserves and Surplus = ` 35,00,000 x
2.5
= ` 14,00,000
(x) Share Capital = Net worth – Reserves and Surplus
= ` 35,00,000 – ` 14,00,000
= ` 21,00,000
(xi) Current Liabilities = Current Assets/ Current Ratio
` 28, 43, 750
= = ` 11,37,500
2.5

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 14 INTERMEDIATE EXAMINATION: NOVEMBER 2023

(xii) Long-term Debts

Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ` 35,00,000 × 0.7875 = ` 27,56,250
(a) Balance Sheet

Particulars Figures as at Figures as at

31-03-2022 (`) 31-03-2021 (`)
I. EQUITY AND LIABILITIES
Shareholders’ funds
(a) Share capital 21,00,000 -
(b) Reserves and surplus 14,00,000 -
Non-current liabilities
(a) Long-term borrowings 27,56,250 -
Current liabilities 11,37,500 -
TOTAL 73,93,750 -
II. ASSETS
Non-current assets
Fixed assets 45,50,000 -
Current assets
Inventories 11,37,500 -
Trade receivables 8,75,000 -
Cash and cash equivalents 8,31,250 -
TOTAL 73,93,750 -
(b) Statement Showing Working Capital Requirement
Particulars (`) (`)
A. Current Assets
(i) Inventories (Stocks) 11,37,500
(ii) Receivables (Debtors) 8,75,000
(iii) Cash in hand & at bank 8,31,250
Total Current Assets 28,43,750

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 15

B. Current Liabilities:
Total Current Liabilities 11,37,500
Net Working Capital (A – B) 17,06,250
Add: Provision for contingencies
2,38,875
(14% of Net Working Capital)
Working capital requirement 19,45,125

10. (a) Though in a sole proprietorship firm, partnership etc., owners participate in
management but in corporates, owners are not active in management so, there is a
separation between owner/ shareholders and managers. In theory managers should
act in the best interest of shareholders, however, in reality, managers may try to
maximise their individual goal like salary, perks etc., so there is a principal agent
relationship between managers and owners, which is known as Agency
Problem. In a nutshell, Agency Problem means that there is a chance that managers
may place personal goals ahead of the goal of owners. Agency Problem leads to
Agency Cost. Agency cost is the additional cost borne by the shareholders to monitor
the manager and control their behaviour so as to maximise shareholders wealth.
Generally, Agency Costs are of four types (i) monitoring (ii) bonding (iii) opportunity
(iv) structuring.
Addressing the agency problem
The agency problem arises if manager’s interests are not aligned to the interests of
the debt lender and equity investors. The agency problem of debt lender would be
addressed by imposing negative covenants i.e. the managers cannot borrow beyond
a point. This is one of the most important concepts of modern day finance and the
application of this would be applied in the Credit Risk Management of Bank, Fund
Raising, Valuing distressed companies.
Agency problem between the managers and shareholders can be addressed if the
interests of the managers are aligned to the interests of the shareholders. It is easier
said than done.
However, following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and
also with the long term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption
that maximisation of the stock price is the objective of the investors.
 Effecting monitoring can be done.

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 16 INTERMEDIATE EXAMINATION: NOVEMBER 2023

(b) Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment,
financing, and dividend decisions. It is correct to say that these decisions are inter -
related because the underlying objective of these three decisions is the same, i.e.,
maximisation of shareholders’ wealth. Since investment, financing and dividend
decisions are all interrelated, one must consider the joint impact of these decisions
on the market price of the company’s shares and these decisions should also be
solved jointly. The decision to invest in a new project needs the finance for the
investment. The financing decision, in turn, is influenced by and influences dividend
decision because retained earnings used in internal financing deprive shareholders
of their dividends. An efficient financial management can ensure optimal joint
decisions. This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter -
relationship and to see how they can help in maximising the shareholders’ wealth i.e.,
market price of the company’s shares.
Investment decision: The investment of long-term funds is made after a careful
assessment of the various projects through capital budgeting and uncertainty
analysis. However, only that investment proposal is to be accepted which is expected
to yield at least so much return as is adequate to meet its cost of financing. This has
an influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds
involves different issues. The finance manager must maintain a proper balance
between long-term and short-term funds. With the total volume of long-term funds, he
must ensure a proper mix of loan funds and owner’s funds. The optimum f inancing
mix will increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay
or declare dividend. He assists the top management in deciding as to what portion of
the profit should be paid to the shareholders by way of dividends and what portion
should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders’ wealth.
The above discussion makes it clear that investment, financing, and dividend
decisions are interrelated and are to be taken jointly keeping in view their joint effect
on the shareholders’ wealth.

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 PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE 17

(c) Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to

financial intermediaries to support the lending volumes. Assets generating steady
cash flows are packaged together and against this asset pool, market securities can
be issued, e.g., housing finance, auto loans, and credit card receivables.
Process of Debt Securitisation
(i) The origination function – A borrower seeks a loan from a finance company,
bank. The credit worthiness of borrower is evaluated, and contract is entered
into with repayment schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to
create an underlying pool of assets. The pool is transferred in favour of Special
purpose Vehicle (SPV), which acts as a trustee for investors.
(iii) The securitisation function – SPV will structure, and issue securities based on
asset pool. The securities carry a coupon and expected maturity which can be
asset-based/mortgage based. These are generally sold to investors through
merchant bankers. Investors are – pension funds, mutual funds, insurance
funds.

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 18 INTERMEDIATE EXAMINATION: NOVEMBER, 2023

SECTION B: ECONOMICS FOR FINANCE

QUESTIONS
1. (a) Explain the distinction between GDP and GNP in the treatment of international
transaction?
(b) Calculate value of output from the following data:
S. No. Particulars ` In lakhs
1. Net value added at factor cost 900
2. Intermediate consumption 650
3. Excise duty 300
4. Subsidy 60
5. Depreciation 110
(c) Suppose in an economy:
Consumption Function C = 150 + 0.75 Yd
Investment Spending I = 100
Government Spending G = 115
Tax Tx = 20 + 0.20 Y
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 arein rupees.
Find:
(i) The equilibrium level of National Income
(ii) Consumption at equilibrium level
2. (a) According to Keynes what had happened during the great depression?
(b) Describe the rationale behind multiplier? What are the factors that weak ens the
multiplier?
(c) Why should government perform the allocation function is an economy?
(d) Describe how the efficiency of market is affected by monopoly power?
3. (a) What do you understand by the term tragedy of the commons?
(b) What are the limitation of Fiscal Policy?

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 19

(c) What determine the size of the money multiplier?

(d) What is measured by different method of National Income Calculation?
4. (a) What is Circular flow in a simple two sector model?
(b) Differentiate between excess demand and deficient demand?
(c) What is the distinction between bound tariff and applied tariffs?
(d) What is the main advantage of a fixed rate regime?
5. (a) Suppose nominal GNP of a country in the year 2015 is given as £ 700 crore and price
index is given as base year 2015 is 100. Now let the nominal GDP increase to ` 1400
crore in year 2020 and the price index rises to 120, find out real GDP?
(b) What are the major guiding principles of the WTO?
(c) What is the limitation of Ricardian theory of comparative advantage?
(d) What are the explicit objective the monetary policy of developing countries should
incorporate?
OR
What is the marginal standing facility?

ANSWERS

1. (a) The two concepts GDP and GNP differ in their treatment of international transactions.
The term national refers to normal residents of a country who may be within or outside
the domestic territory of a country and is a broader concept compared to the term
domestic. For example, GNP includes earnings of Indian corporation overseas and
Indian resident working overseas but GDP does not include these. In other words,
GDP excludes net factor income from abroad. Conversely GDP includes earnings
from current production in India that accrue to foreign residents and foreign owned
firms GNP excluded those items.
(b) NVA at FC = Value of Output – Intermediate Consumption – Depreciation – (Excise
Duty – Subsidy)
Thus, Value of output = Net value added at factor cost + Intermediate consumption +
Depreciation + (Excise Duty - Subsidy)
= 900 + 650 + 110 + (300-60)
= ₹ 1900 lakhs
(c) The consumption function is C = 150 + 0.75Yd
Level of Disposable Income Yd is given by.

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 20 INTERMEDIATE EXAMINATION: NOVEMBER, 2023

Yd = Y – Tax + Transfer Payments, Where, Transfer Payment = Tr = 40

= Y - (20 + 0.20Y) + 40 = Y – 20 - 0.20Y + 40
= Y - 0.2Y – 20 + 40
Yd = 20+0.8Y and C = 150+0.75Yd
C = 150 + 0.75(20 + 0.8Y) where Yd = (20+0.8Y)C = 150+15+0.6Y
C= 165+0.6Y
(i) The equilibrium level of national incomeY = C + I + G + (X - M)
Y = 165 + 0.6Y + 100 + 115 + [35 - (15 + 0.1Y)]
= 165 + 0.6Y + 100 + 115 + [35 – 15 - 0.1Y]
= 165 + 0.6Y + 215 + 35 – 15 - 0.1YY = 400 + 0.5Y
Y - 0.5Y = 400; 0.5Y = 400 Y
= 400/0.5 = 800
The equilibrium level of national income is ₹800.
(ii) Consumption at equilibrium level of national income of ₹800C = 165 + 0.6Y
C = 165 + 0.6(800)
C = 165 +480 = 645
Consumption at equilibrium level = ₹645
2. (a) In the Keynesian model nether wages nor internal rate will decline in the face of
abnormally high unemployment and excess capacity. Therefore, output will remain
at less than the full employment rate as long as there is insufficient spending in the
economy. Keynes argued that this was precisely what was happening during the
Great Depression.
(b) The multiplier concept is central to keyne’s theory because if explains how shifts in
investment caused by changes in business expectation set off a process that causes
not only investment but also consumption to vary. The multiplier shows how shocks
to one sector are transmitted throughout the economy.
Increase in income due to increase in initial investment does not go on endlessly. The
process of income propagation slows down and ultimately comes to a halt. Causes
responsible for the decline in income are called leakages. Income that is not spend
on currently produced consumption goods and services may be regarded as having
leaked out of income stream. If the increased income goes out of the cycle of
consumption expenditure, there is a leakage from income stream which reduces the
effect of multiplier. The more powerful these leakages are the smaller will be the value
of multiplier.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 21

(c) The resource allocation of government’s fiscal policy focuses on the potential for the
government to improve economic performance through its expenditure and tax
policies. The allocative function in budgeting determines who and what will be taxed
as well as how and on what the government revenue will be spend. It is concerned
with the provision of public goods and the process by which the total resources of the
economy are divided among various uses and an optimum mix of various social goods
(both public goods and merit goods) of the allocation functions also involves the
reallocation of society’s resources from private to public use.
(d) The presence of monopoly power affects the efficiently of markets in different degrees
leading to under production and higher prices than would exist under condition of
competition This distort the choices available to consumers and reduce their welfare.
3. (a) Economists use the term ‘tragedy of the commons’ to describe the problem which
occurs when rivalrous but non excludable goods are overused to the disadvantage of
the entire universe. For example, everyone has access to a commonly held pasture
there are no rules above sustainable, numbers for grazing. The outcome of the
individual rational economic decisions of cattle owners would be market failure
because these actions result in the degradation, depletion or even destruction of the
resources leading to welfare loss for the entire society.
(b) Fiscal Policy suffers from limitations such as limitations in respect of choice of
appropriate policy, recognition lag, decision lag, implementation lag, impact lag,
inappropriate timing, difficulties of forecasting due to uncertainties, possible conflicts
between different objectives, possibility of generating disincentives, practical difficulty
to reduce government expenditure and the possibility of certain fiscal measures
regulating private spending or crowding out private spending.
(c) The money multiplier is the reciprocal of the reserve ratio. Deposits unlike currency
need by people keep only a fraction of the high-powered money in reserves and the
rent is lent out and culminate in money creation. If R is the reserve ratio in a country
of all commercial bank, then each units of (say Rupee) money reserves generate 1/R
money. Therefore, for any value of R the money Multiplier is 1/R. For example, if
R = 10%, the value of money multiplier will be 10. If the reserve ratio is only 5% then
money multiplier is 20. Thus, the higher the reserve ratio, the less of each deposit
bank loan out and the smaller the money multiplier.
(d)
Method What is measured
Product Method Contribution of production units
Income Method Relative contribution of factor owners
Expenditure Method Flow of consumption and investment expenditure

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 22 INTERMEDIATE EXAMINATION: NOVEMBER, 2023

4. (a) The Circular flow of income is a process where the national income and expenditure
of an economy flows 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.
(b) If the aggregate demand is for an amount of output greater than the full employment
level of output then we say there is excess demand. Excess demand gives rise to
‘inflationary gap’. On the other hand, if the aggregate demand is for an amount of
output less than the full employment level of output then we say there is deficient
demand. Deficient demand gives rise to a ‘deflationary gap’ or ‘recessionary gap’.
Recessionary gap also known as contractionary gap.
(c) Bound tariff: Under this a WTO member binds itself with a legal commitment not to
raise tariff rate above a certain level. The bound rates are specific to individual
products and represent the maximum level of import duty that can be levied on a
product imported by that member. A bound tariff ensures transparency and
predictability.
Applied tariff: An applied tariff is the duty that is actually charged on imports on a
Most Favoured Nation (MFN) basis. A WTO member can have an applied tariff for a
product that differ from the bound tariff for the product as long as the applied level is
not higher from the bound level.
(d) In an open economy the main advantage of a fixed rate regime are:
- A fixed exchange rate avoids currency fluctuations and eliminates exchange rate
risks and transaction costs that can impede international flow of trade and
investment.
- A fixed exchange rate greatly enhances international trade and investment.
- A reduction in speculation on exchange rate movements if everyone believes
that exchange rates will not change.
- The government can encourage greater trade and investment as stability
encourages investment.
- Exchange rate, Peg can also enhance for creating of the Country’s Monetary
Policy.
Nominal GDP
5. (a) Real GDP =  100
Price Index
100 3500
= 1400 x =
120 3
= 1166.66 cr.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 23

(b) The major guiding principles of WTO are:

• Trade without discrimination
• Most Favoured Nation treatment (MFN)
• The National treatment principle (NTP)
• Free Trade
• Predictability
• General Prohibition of quantitative restrictions
• Greater competitiveness
• Tariffs as legitimate measures for protection
• Transparency in decision making.
• Progressive liberalization
• Market access and a transparent effective and verifiable dispute settlement
mechanism.
(c) The Ricardian theory of comparative advantage suffers from many limitations. Its
emphasis is on supply conditions and excludes demand patterns. Moreover, the
theory does not examine why countries have different costs. The theory of
comparative advantage also does not answer the important question: Why does a
nation have comparative advantage in the production of a commodity and
comparative disadvantage in the production of another.
(d) The monetary Policy of the developing countries should incorporate explicit objective
such as:
(1) maintenance of economic growth.
(2) ensuring an adequate flow of credit to the productive sector.
(3) Sustaining a moderate structure of interest rate to encourage investment and
(4) creation of an efficient market for government securities.
OR
The Marginal standing facility (MSF) refers to the facility under which scheduled
commercial banks can borrow additional amount of oversight money from the central
bank over and above what is available to them through the LAF window by dipping
into their Statutory Liquidity Ratio (SLR) Portfolio up to a limit.

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