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 are given for a company:
Earnings per share ` 10
P/E ratio 12.5
Rate of return on investment 12%
Market price per share as per Walter’s Model ` 130
You are required to calculate:
(i) Dividend payout ratio.
(ii) Market price of share at optimum dividend payout ratio.
(iii) P/E ratio, at which the dividend policy will have no effect on the price of share.
(iv) Market price of share at this P/E ratio.
(v) Market price of share using Dividend growth model. (5 Marks)
(b) A company has current sale of ` 12 lakhs per year. The profit-volume ratio is 20% and
post-tax cost of investment in receivables is 15%. The current credit terms are 1/10, net
50 days and average collection period is 40 days. 50% of customers in terms of sales
revenue are availing cash discount and bad debt is 2% of sales.
In order to increase sales, the company want to liberalize its existing credit terms to 2/10,
net 35 days. Due to which, expected sales will increase to ` 15 lakhs. Percentage of default
in sales will remain same. Average collection period will decrease by 10 days. 80% of
customers in terms of sales revenue are expected to avail cash discount under this
proposed policy.
Tax rate is 30%.
ADVISE, should the company change its credit terms. (Assume 360 days in a year.)
(5 Marks)

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 2 INTERMEDIATE EXAMINATION: MAY, 2023

(c) A company wants to invest in a project. This requires an initial investment of ` 4,50,000.
Salvage value after estimated useful life of 5 years is ` 50,000. Other details of project are
as follows:
Worst case Most likely Best case
Contribution (`) 3,30,000 5,40,000 6,31,250
Fixed cost (excluding depreciation) ( `) 75,000 1,50,000 2,00,000
Tax rate is 40%. Expected cost of capital of project is 12%. Ignore tax on capital gain.
(i) Calculate NPV in each scenario.
(ii) The company is certain about most likely result in first two years, but uncertain about
remaining period. In such a situation, calculate NPV expecting worst case scenario
during next two years and best case scenario in the remaining period.
Years 1 2 3 4 5
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605
(5 Marks)
(d) Following information is given for X Ltd.:
Total contribution ( `) 4,25,000
Operating leverage 3.125
15% Preference shares ( ` 100 each) 1,000
Number of equity shares 2,500
Tax rate 50%
Calculate EPS of X Ltd., if 40% decrease in sales will result EPS to zero. (5 Marks)
Answer
(a) (i) The EPS of the firm is ` 10, r =12%. The P/E Ratio is given at 12.5 and the cost of
capital (Ke) may be taken as the inverse of P/E ratio. Therefore, K e is 8% (i.e., 1/12.5).
The value of the share is ` 130 which may be equated with Walter Model as follows:
r 12%
D+ (E-D) D+ (10-D)
P = Ke
or P =
8%
Ke 8%
or [D+1.5(10-D)]/0.08=130
or D+15-1.5D=10.4

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 3

or -0.5D=-4.6
So, D = ` 9.2
The firm has a dividend pay-out of 92% (i.e., 9.2/10).
(ii) Since the rate of return of the firm (r) is 12% and it is more than the Ke of 8%,
therefore, by distributing 92% of earnings, the firm is not following an optimal dividend
policy. The optimal dividend policy for the firm would be to pay zero dividend and in
such a situation, the market price would be:
12%
0+ (10-0)
P = 8%
8%
P = ` 187.5
So, theoretically the market price of the share can be increased by adopting a zero
pay-out.
(iii) The P/E ratio at which the dividend policy will have no effect on the value of the share
is such at which the K e would be equal to the rate of return (r) of the firm. The K e
would be 12% (= r) at the P/E ratio of 1/12%=8.33. Therefore, at the P/E ratio of 8.33,
the dividend policy would have no effect on the value of the share.
(iv) If the P/E is 8.33 instead of 12.5, then the K e which is the inverse of P/E ratio, would
be 12% and in such a situation k e= r and the market price, as per Walter’s model
would be:
r 0.12
D+ (E-D) 9.2+ (10-9.2)
P = Ke = 0.12 = ` 83.33
Ke 0.12

(v) Dividend Growth Model applying growth on dividend

Ke = 8%, r = 12%, D 0 = 9.2, b = 0.08
g = b.r
g = 0.08 x 0.12=0.96%
D1 = D0 (1+g) = 9.2 (1+0.0096) = ` 9.2883
D1
P= = 9.2883/(0.08 – 0.0096) = 9.2883/0.0704 = ` 131.936
(Ke − g)

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 4 INTERMEDIATE EXAMINATION: MAY, 2023

Alternative
Alternatively, without applying growth on dividend
E(1 − b) 10(1 − 0.08)
P= = = ` 130.68
Ke − br 0.08 − (0.08  0.12)
(b) (i) Calculation of Cash Discount
Cash Discount = Total credit sales × % of customers who take up discount × Rate
12,00,000×50×0.01
Present Policy = = ` 6,000
100
Proposed Policy = 15,00,000 × 0.80 × 0.02 = ` 24,000
(ii) Opportunity Cost of Investment in Receivables
Collection period Rate of Return
Present Policy: Opportunity Cost = Total Cost × ×
360 100
40 15
= 9,60,000 × × = ` 16,000
360 100
Collection period Rate of Return
Proposed Policy: = Total Cost × ×
360 100
30 15
= 12,00,000 × × = ` 15,000
360 100
Statement showing Evaluation of Credit Policies
Particulars Present Proposed
Policy Policy
Credit Sales 12,00,000 15,00,000
Variable Cost @ 80%* of sales 9,60,000 12,00,000
Bad Debts @ 2% 24,000 30,000
Cash Discount 6,000 24,000
Profit before tax 2,10,000 2,46,000
Tax @ 30% 63,000 73,800
Profit after Tax 1,47,000 1,72,200
Opportunity Cost of Investment in Receivables 16,000 15,000
Net Profit 1,31,000 1,57,200

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 5

*Only relevant or variable costs are considered for calculating the opportunity costs
on the funds blocked in receivables. Since 20% is profit-volume ratio, hence the
relevant costs are taken to be 80% of the respective sales.
Advise: Proposed policy should be adopted since the net benefit is increased by
(` 1,57,200 - ` 1,31,000) = ` 26,200.
Alternative presentation using incremental approach
`
Incremental sales (15,00,000 – 12,00,000) 3,00,000
Less: Incremental variable cost (12,00,000 – 9,60,000) 2,40,000
Less: Incremental Bad debts (30,000 – 24,000) 6,000
Less: Incremental Cash discount (24,000 – 6,000) 18,000
Increase in Profit Before Tax 36,000
Less: Tax @ 30% 10,800
Increase in Profit After Tax 25,200
Add: Savings in opportunity cost (16,000 - 15,000) 1,000
Increase in Net Profit 26,200
Advise: Proposed policy should be adopted since the net benefit is increased by
(` 1,57,200 - ` 1,31,000)
= ` 26,200.
(c) (i) Initial Investment = ` 4,50,000
Salvage Value = ` 50,000
Useful Life = 5 years
Calculation of cash flow in each scenario
Particulars Scenario
Worst case Most Likely Best case
Contribution 3,30,000 5,40,000 6,31,250
Less: Fixed Cost 75,000 1,50,000 2,00,000
Less: Depreciation 80,000 80,000 80,000
Profit before tax 1,75,000 3,10,000 3,51,250
Less: Taxes 70,000 1,24,000 1,40,500

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 6 INTERMEDIATE EXAMINATION: MAY, 2023

Profit after tax 1,05,000 1,86,000 2,10,750

Add: Depreciation 80,000 80,000 80,000
Cash Flow After Tax 1,85,000 2,66,000 2,90,750

The possible outcomes will be as follows:

Year PVF Worst Case Most likely Best case
@ Cash PV Cash PV Cash PV
12% Flow Flow Flow
0 1 (4,50,000) (4,50,000) (4,50,000) (4,50,000) (4,50,000) (4,50,000)
1-5 3.605 1,85,000 6,66,925 2,66,000 9,58,930 2,90,750 10,48,153.75
5 0.567 50,000 28,350 50,000 28,350 50,000 28,350
NPV 2,45,275 5,37,280 6,26,503.75
Alternative presentation
(i) Computation of NPV of different scenarios
Worst case Most-likely case Best case
Years DF
CF DCF CF DCF CF DCF
0 1.000 (450000) (450000) (450000) (450000) (450000) (450000)
1 0.893 185000 165205 266000 237538 290750 259640
2 0.797 185000 147445 266000 212002 290750 231728
3 0.712 185000 131720 266000 189392 290750 207014
4 0.636 185000 117660 266000 169176 290750 184917
5 0.567 185000 104895 266000 150822 290750 164855
5 0.567 50000 28350 50000 28350 50000 28350
NPV 2,45,275 5,37,280 6,26,504

(ii) If the company is certain about the most likely result in first two years but uncertain
about the remaining period, then, NPV expecting worst case scenario during next two
years and best-case scenario in remaining period will be as follows:
`2,66,000 `2,66,000 `1,85,000 `1,85,000 `2,90,750 `50,000
= - 4,50,000+ + + + + +
(1+0.12) (1+0.12)2 (1+0.12)3 (1+0.12)4 (1+0.12)5 (1+0.12)5

= -4,50,000 + (2,66,000 × 0.893) + (2,66,000 × 0.797) + (1,85,000 × 0.712) +

(1,85,000 × 0.636) + (2,90,750 × 0.567) + (50,000 × 0.567)

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 7

= -4,50,000 + 2,37,538 + 2,12,002 + 1,31,720 + 1,17,660 + 1,64,855 + 28,350

= ` 4,42,125
Alternative presentation
(ii) Computation of NPV on the basis of fixed scenarios
Years Scenarios DF CF DCF
(DF*CF)
0 Initial Outflow 1.000 (450000) (450000)
1 Most-likely case 0.893 266000 237538
2 Most-likely case 0.797 266000 212002
3 Worst case 0.712 185000 131720
4 Worst case 0.636 185000 117660
5 Best case 0.567 290750 164855
5 Salvage 0.567 50000 28350
4,42,125
(All figures are in `)
Contribution ` 4,25,000
(d) (i) Operating Leverage (OL) = Or, 3.125 = Or EBIT
EBIT EBIT
= ` 1,36,000
% Change in EPS 100
(ii) Degree of Combined Leverage (CL) = = = 2.5
% Change in Sales 40
(iii) Combined Leverage = OL × FL = 3.125 × FL
So, Financial Leverage = 2.5 /3.125 = 0.8

EBIT 1,36,000
(iv) Financial Leverage = = = 0.8
EBT EBT
1,36,000
So, EBT = = ` 1,70,000
0.80
Calculation of EPS of X Ltd
Particulars (`)
EBT 1,70,000
Less: Tax (50%) 85,000

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 8 INTERMEDIATE EXAMINATION: MAY, 2023

EAT 85,000
Preference Dividend 15,000
Net Earnings for Equity Shareholders 70,000
Number of equity shares 2,500
EPS 28
Question 2
Following information and ratios are given in respect of AQUA Ltd. for the year ended
31st March, 2023:
Current ratio 4.0
Acid test ratio 2.5
Inventory turnover ratio (based on sales) 6
Average collection period (days) 70
Earnings per share ` 3.5
Current liabilities ` 3,10,000
Total assets turnover ratio (based on sales) 0.96
Cash ratio 0.43
Proprietary ratio 0.48
Total equity dividend ` 1,75,000
Equity dividend coverage ratio 1.60
Assume 360 days in a year.
You are required to complete Balance Sheet as on 31 stMarch, 2023.
Balance Sheet as on 31 stMarch, 2023.
Liabilities ` Assets `
Equity share capital ( `10 per share) XXX Fixed assets XXX
Reserves & surplus XXX Inventory XXX
Long-term debt XXX Debtors XXX
Current liabilities 3,10,000 Loans & advances XXX
Cash & bank XXX
Total XXX Total XXX
(10 Marks)

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 9

Answer
(i) Current Ratio = 4
Current Assets
=4
Current Liabilities
Current Assets
 =4
3,10,000

 Current Assets = ` 12,40,000

(ii) Acid Test Ratio = 2.5
Current Assets - Inventory
= 2.5
Current Liabilities
12,40,000 − Inventory
 = 2.5
3,10,000

 12,40,000 – Inventory = ` 7,75,000

Inventory = ` 4,65,000
(iii) Inventory Turnover Ratio (on Sales) = 6
Sales
=6
Inventory
Sales
=6
4,65,000

 Sales = ` 27,90,000
(iv) Debtors Collection Period = 70 days
(Debtors / sales) x 360 = 70
 (Debtors / 27,90,000) x 360 = 70
Debtors = ` 5,42,500
(v) Total Assets Turnover Ratio (on Sales) = 0.96
Sales
 = 0.96
Total Assets
27,90,000
 = 0.96
Total Assets
Total Assets = ` 29,06,250

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 10 INTERMEDIATE EXAMINATION: MAY, 2023

(vi) Fixed Assets (FA) = Total Assets – Current Assets

= 29,06,250 – 12,40,000
Fixed Assets = ` 16,66,250
Cash
(vii) Cash Ratio = = 0.43
Current Liabilities
Cash
 = 0.43
3,10,000

 Cash = ` 1,33,300
Proprietary Fund
(viii) Proprietary Ratio = = 0.48
Total Assets
Proprietary Fund
 = 0.48
29,06,250

 Proprietary Fund = ` 13,95,000

(ix) Equity Dividend Coverage Ratio = 1.6
EPS 3.5
or =
DPS DPS
 DPS = ` 2.1875
Total Dividend
DPS =
Number of Equity Shares

1,75,000
 2.1875 =
Number of Equity Shares
 Number of Equity Shares = 80,000

 Equity Share Capital = 80,000 x 10 = ` 8,00,000

 Reserves &Surplus = 13,95,000 - 8,00,000 = ` 5,95,000
(x) Loans and Advances = Current Assets - (Inventory + Receivables + Cash & Bank)
= ` 12,40,000 - (` 4,65,000 + 5,42,500 + 1,33,300) = ` 99,200

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 11

Balance Sheet as on 31 st March 2023

Liabilities ` Assets `
Equity Share Capital (` 10 per share) 8,00,000 Fixed Assets 16,66,250
Reserves & Surplus 5,95,000 Inventory 4,65,000
Long-term debt *(B/F) 12,01,250 Receivables 5,42,500
Current Liabilities 3,10,000 Loans & Advances 99,200
Cash & Bank 1,33,300
Total 29,06,250 Total 29,06,250
Question 3
The following information pertains to CIZA Ltd.:
`
Capital Structure:
Equity share capital ( ` 10 each) 8,00,000
Retained earnings 20,00,000
9% Preference share capital ( ` 100 each) 12,00,000
12% Long-term loan 10,00,000
Interest coverage ratio 8
Income tax rate 30%
Price – earnings ratio 25
The company is proposed to take up an expansion plan, which requires an additional investment
of ` 34,50,000. Due to this proposed expansion, earnings before interest and taxes of the
company will increase by ` 6,15,000 per annum. The additional fund can be raised in following
manner:
• By issue of equity shares at present market price, or
• By borrowing 16% Long-term loans from bank.
You are informed that Debt-equity ratio (Debt/ Shareholders' fund) in the range of 50% to 80%
will bring down the price-earnings ratio to 22 whereas; Debt-equity ratio over 80% will bring
down the price-earnings ratio to 18.
Required:
Advise which option is most suitable to raise additional capital so that the Market Price per
Share (MPS) is maximized. (10 Marks)

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 12 INTERMEDIATE EXAMINATION: MAY, 2023

Answer
Working notes:
(i) Interest Coverage ratio = 8
EBIT
=8
Interest
EBIT
=8
1,20,000
So, EBIT = ` 9,60,000
(ii) Proposed Earnings Before Interest & Tax = 9,60,000 + 6,15,000 = ` 15,75,000
Option 1: Equity option
Debt = ` 10,00,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000+34,50,000 = ` 74,50,000
10,00,000
Debt Equity ratio(Debt/Shareholders fund) =
74,50,000
= 13.42%
P/E ratio in this case will be 25 times
Option 2: Debt option
Debt = 10,00,000+34,50,000 = ` 44,50,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000 = ` 40,00,000
44,50,000
Debt Equity ratio(Debt/Shareholders fund) = = 111.25%
40,00,000
Debt equity ratio has crossed the limit of 80% hence PE ratio in this case will remain at 18
times.
Number of Equity Shares to be issued = ` 34,50,000/ ` 150 = 23,000
(iii) Calculation of Earnings per Share and Market Price per share
Particulars `
Current Earnings Before Interest & Tax 9,60,000
Less: Interest 1,20,000
Earnings Before Tax 8,40,000
Less: Taxes 2,52,000
Earnings After Tax 5,88,000
Less: Preference Dividend (@9%) 1,08,000

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 13

Net earnings for Equity shareholders 4,80,000

Number of equity shares 80,000
Earnings Per Share 6
Price-earnings ratio 25
Market Price per share 150
Calculation of EPS and MPS under two financial options
Financial Options
Option I Option II
Particulars
Equity Shares 16% Long Term
Issued (`) Debt Raised (`)
Earnings before interest and Tax (EBIT) 15,75,000 15,75,000
Less: Interest on old debentures @ 12% 1,20,000 1,20,000
Less: Interest on additional loan (new) @ 16% NIL 5,52,000
on ` 34,50,000
Earnings before tax 14,55,000 9,03,000
Less: Taxes @ 30% 4,36,500 2,70,900
(EAT/Profit after tax) 10,18,500 6,32,100
Less: Preference Dividend (@9%) 1,08,000 1,08,000
Net Earnings available to Equity 9,10,500 5,24,100
shareholders
Number of Equity Shares 1,03,000 80,000
Earnings per Share (EPS) 8.84 6.55
Price/ Earnings ratio 25 18
Market price per share (MPS) 221 117.9
Advise: Equity option has higher Market Price per Share therefore company should raise
additional fund through equity option.
Question 4
Capital structure of D Ltd. as on 31 stMarch, 2023 is given below:
Particulars `
Equity share capital (` 10 each) 30,00,000
8% Preference share capital ( ` 100 each) 10,00,000
12% Debentures (` 100 each) 10,00,000

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 14 INTERMEDIATE EXAMINATION: MAY, 2023

• Current market price of equity share is ` 80 per share. The company has paid dividend of
` 14.07 per share. Seven years ago, it paid dividend of ` 10 per share. Expected dividend
is ` 16 per share.
• 8% Preference shares are redeemable at 6% premium after five years. Current market
price per preference share is ` 104.
• 12% debentures are redeemable at 20% premium after 10 years. Flotation cost is ` 5 per
debenture.
• The company is in 40% tax bracket.
• In order to finance an expansion plan, the company intends to borrow 15% Long-term loan
of ` 30,00,000 from bank. This financial decision is expected to increase dividend on equity
share from ` 16 per share to ` 18 per share. However, the market price of equity share is
expected to decline from ` 80 to ` 72 per share, because investors' required rate of return
is based on current market conditions.
Required:
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value
weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book
value weights.
Interest Rate 1% 2% 3% 4% 5% 6% 7%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606
(10 Marks)
Answer
(i) (a) Growth rate in Dividends
14.07 = 10 x FVIF (i,7 years)
FVIF (i,7 years) = 1.407
FVIF (5%, 7 years) = 1.407
i = 5%
Growth rate in dividend= 5%
(b) Cost of Equity
D1
Ke = +g
P0

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 15

16
Ke = + 0.05
80
Ke = 25%
(c) Cost of Preference Shares
(RV-NP)
PD+
Kp = n
(RV+NP)
2
(106 104)
8
Kp = 5
(106 104)
2
Kp = 8.4/105
Kp = 8%
(d) Cost of Debt
( RV -NP )
I (1-t ) +
Kd = n
( RV + NP )
2
(120-95)
12(1-0.4)+
Kd = 10
(120+95)
2
Kd = (7.2+2.5)/107.5 = 9.02%
Kd = 9.02%
Calculation of existing Weighted Average Cost of Capital (WACC)
Capital Amount (`) Weights Cost WACC
Equity Share Capital 30,00,000 0.6 25% 15.00%
Preference Share Capital 10,00,000 0.2 8% 1.60%
Debenture 10,00,000 0.2 9.02% 1.80%
50,00,000 1 18.40%

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 16 INTERMEDIATE EXAMINATION: MAY, 2023

Alternative presentation
(i) Computation of existing WACC on book value weights
Source Book value Weight Cost of Product
(1) (`) (2) (3) capital (%) (4) (2) x (4)
Equity share capital 30,00,000 0.60 25 7,50,000
Preference share capital 10,00,000 0.20 8 80,000
Debentures 10,00,000 0.20 9.02 90,200
Total 50,00,000 1.00 9,20,200
WACC = (Product / Total book value) x 100 = (9,20,200 /50,00,000) x 100 = 18.4%
(ii) Cost of Long Term Debt = 15% (1-0.4) = 9%
18
Revised Ke = + 0.05 = 30%
72
Calculation of WACC after expansion taking book value weights
Capital Amount Weights Cost W.C
Equity Share Capital 30,00,000 0.3750 30% 11.25%
Preference Share Capital 10,00,000 0.1250 8% 1.00%
Debenture 10,00,000 0.1250 9.02% 1.13%
Long Term Debt 30,00,000 0.3750 9.00% 3.38%
80,00,000 1.0000 16.76%
Alternative presentation
(i) Computation of WACC on book value weights after expansion
Source Book value Weight Cost of capital Product
(1) (`) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.375 30 9,00,000
Preference share capital 10,00,000 0.125 8 80,000
Debentures 10,00,000 0.125 9.02 90,200
Long term loan 30,00,000 0.375 9 2,70,000
Total 80,00,000 1.00 13,40,200
WACC = (Product / Total book value) x 100 = (13,40,200 / 80,00,000) x 100 = 16.76%

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 17

Question 5
Four years ago, Z Ltd. had purchased a machine of ` 4,80,000 having estimated useful life of
8 years with zero salvage value. Depreciation is charged using SLM method over the useful life.
The company want to replace this machine with a new machine. Details of new machine are as
below:
• Cost of new machine is ` 12,00,000, Vendor of this machine is agreed to take old machine
at a value of ` 2,40,000. Cost of dismantling and removal of old machine will be ` 40,000.
80% of net purchase price will be paid on spot and remaining will be paid at the end of one
year.
• Depreciation will be charged @ 20% p.a. under WDV method.
• Estimated useful life of new machine is four years and it has salvage value of ` 1,00,000
at the end of year four.
• Incremental annual sales revenue is ` 12,25,000.
• Contribution margin is 50%.
• Incremental indirect cost (excluding depreciation) is ` 1,18,750 per year.
• Additional working capital of ` 2,50,000 is required at the beginning of year and ` 3,00,000
at the beginning of year three. Working capital at the end of year four will be nil.
• Tax rate is 30%.
• Ignore tax on capital gain.
Z Ltd. will not make any additional investment, if it yields less than 12%
Advice, whether existing machine should be replaced or not.
Year 1 2 3 4 5
PVIF0.12, t 0.893 0.797 0.712 0.636 0.567
(10 Marks)
Answer
Working Notes:
(i) Calculation of Net Initial Cash Outflow
Particulars `
Cost of New Machine 12,00,000
Less: Sale proceeds of existing machine 2,00,000
Net Purchase Price 10,00,000
Paid in year 0 8,00,000
Paid in year 1 2,00,000

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 18 INTERMEDIATE EXAMINATION: MAY, 2023

(ii) Calculation of Additional Depreciation

1 2 3 4
Year
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine 2,00,000 1,60,000 1,28,000 1,02,400
@ 20%
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400

(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values
(`)
Sales 12,25,000
Contribution 6,12,500
Less: Indirect Cost 1,18,750
Profit before Depreciation and Tax (PBDT) 4,93,750
Calculation of Incremental NPV
Year PVF PBTD Incremental PBT Tax @ Cash Inflows PV of Cash
@ 12% Depreciation 30% (`) Inflows
(`) (`) (`) (`) (`)
(1) (2) (3) (4) (5) = (4) x (6) = (4) – (5) (7) = (6) x (1)
0.30 + (3)
1 0.893 4,93,750 1,40,000 3,53,750 106,125 3,87,625 3,46,149.125
2 0.797 4,93,750 1,00,000 3,93,750 1,18,125 3,75,625 2,99,373.125
3 0.712 4,93,750 68,000 4,25,750 1,27,725 3,66,025 2,60,609.800
4 0.636 4,93,750 42,400 4,51,350 1,35,405 3,58,345 2,27,907.420
* * 11,34,039.470
Add: PV of Salvage (` 1,00,000 x 0.636) 63,600
Less: Initial Cash Outflow - Year 0 8,00,000
Year 1 (` 2,00,000 × 0.893) 1,78,600

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 19

Less: Working Capital - Year 0 2,50,000

Year 2 (` 3,00,000 × 0.797) 2,39,100
Add: Working Capital released - Year 4 (` 5,50,000 × 0.636) 3,49,800
Incremental Net Present Value 79,739.470

Since the incremental NPV is positive, existing machine should be replaced.

Alternative Presentation
Computation of Outflow for new Machine:
`
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000
Computation of additional deprecation
Year 1 2 3 4
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400
Computation of NPV
0 1 2 3 4
Year
` ` ` ` `
1. Increase in sales revenue 12,25,000 12,25,000 12,25,000 12,25,000
2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500
3. Increase in fixed cost 1,18,750 1,18,750 1,18,750 1,18,750
4. Incremental Depreciation 1,40,000 1,00,000 68,000 42,400
5. Net profit before tax 3,53,750 3,93,750 4,25,750 4,51,350
[1-(2+3+4)]

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 20 INTERMEDIATE EXAMINATION: MAY, 2023

6. Net Profit after tax 2,47,625 2,75,625 2,98,025 3,15,945

(5 x 70%)
7. Add: Incremental 1,40,000 1,00,000 68,000 42,400
depreciation
8. Net Annual cash inflows 3,87,625 3,75,625 3,66,025 3,58,345
(6 + 7)
9. Release of salvage value 1,00,000
10. (investment)/disinvestment (2,50,000) (3,00,000) 5,50,000
in working capital
11. Initial cost (8,00,000) (2,00,000)
12. Total net cash flows (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345
13. Discounting Factor 1 0.893 0.797 0.712 0.636
14. Discounted cash flows (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420
(12 x 13)

NPV = (1,67,549 + 60,273 + 2,60,610 + 6,41,307) - 10,50,000 = ` 79,739

Since the NPV is positive, existing machine should be replaced.
Question 6
(a) List out the conditions, framed by SEBI, which a company needs to fulfil in order to issue
of bonus shares. (4 Marks)
(b) “Permanent working capital and fluctuating (temporary) working capital, both are
necessary to facilitate production and sales through the operating cycle.” - Describe.
(4 Marks)
(c) Briefly explain concept of "Trading on Equity" in financial leverage analysis. (2 Marks)
OR
Discuss features of Secured Premium Notes. (2 Marks)
Answer
(a) To issue Bonus shares, a Company needs to fulfill all the conditions given by Securities
Exchange Board of India (SEBI):
(i) As per SEBI, the bonus shares are issued not in lieu of cash dividends.
(ii) A bonus issue should be authorized by Article of Association (AOA) and not to be
declared unless all partly paid-up shares have been converted into fully paid-up
shares.
(iii) The Company should not have defaulted on re-payment of loan, interest, and any
statutory dues.

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 PAPER – 8 : FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 21

(iv) Bonus shares are to be issued only from share premium and free reserves and not
from capital reserve on account of fixed assets revaluation.
(b) Both kinds of working capital i.e. permanent and fluctuating (temporary) are necessary to
facilitate production and sales through the operating cycle:
Permanent working capital refers to the base working capital, which is the minimum level
of investment in the current assets that is carried by the entity at all times to carry its day
to day activities. It generally stays invested in the business unless the operations are
scaled up or down permanently which would also result in increase or decrease in
permanent working capital. It is generally financed by long term sources of finance.
Temporary working capital refers to that part of total working capital, which is required by
an entity in addition to the permanent working capital. It is also called variable or fluctuating
working capital which is used to finance the short-term working capital requirements which
arises due to fluctuation in sales volume. For instance, an organization w ould maintain
increased levels of inventory to meet increased seasonal demand.
(c) Financial Leverage as ‘Trading on Equity’:
Financial leverage indicates the use of funds with fixed cost like long term debts and
preference share capital along with equity share capital which is known as trading on
equity. The basic aim of financial leverage is to increase the earnings available to equity
shareholders using fixed cost fund. A firm is known to have a positive/favourable leverage
when its earnings are more than the cost of debt. If earnings are equal to or less than cost
of debt, it will be a negative/unfavourable leverage. When the quantity of fixed cost fund is
relatively high in comparison to equity capital it is said that the firm is ‘trading on equity”.
OR
Features of Secured Premium Notes:
• SPN instruments are issued with a detachable warrant.
• These instruments are redeemable after a notified period of say 4 to 7 years.
• No interest is paid during the lock in period.
• The conversion of detachable warrant into equity shares will have to be done within
time period notified by the company.

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 22 INTERMEDIATE EXAMINATION: MAY, 2023

SECTION – B: ECONOMICS FOR FINANCE

Question No. 7 is compulsory.
Answer any three from the rest.
Question 7
(a) The following information relating to a particular financial year of a country is given
below:
Particulars Amount (` in crore)
Private final consumption expenditure 1,620
Government final consumption expenditure 750
Net domestic fixed investment 500
Export 400
Import 440
Net Factor Income from Abroad 20
Net Indirect Taxes 100
You are required to compute the National Income of the country by using Expenditure
Method. (3 Marks)
(b) Compute the Reserve Money from the following data relating to 31 st March, 2023:
Particulars (` in crore)
Currency in Circulation 28,637
Bank Deposits with RBI 5,673
Post Office Deposits 400
Other Deposits with RBI 210
(2 Marks)
(c) Explain the differences between Foreign Direct Investment (FDI) and Foreign Portfolio
Investment (FPI). (3 Marks)
(d) Describe the name and salient features of the fiscal policy for combating inflationary
pressures in the economy. (2 Marks)
Answer
(a) Calculation of National Income Using Expenditure Method
NDPMP = Private Final – Consumption expenditure + Net domestic fixed investment
+ Govt Final – consumption expenditure + Net exports (Exports–Imports)
= 1,620 + 500 + 750 + (400 – 440)

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 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 23

= 1,620 + 1,250 – 40
= 1,620 + 1,210
NDPMP = ` 2,830 cr
NNPMP = NDPMP + Net factor Income from abroad
= 2,830 + 20
NNPMP = ` 2,850 cr
NNPFC = National Income = NNPMP – Net Indirect Taxes
= 2,850 – 100
NNPFC = ` 2,750 cr
(b) Reserve Money = Currency in-circulation + Banker’s deposit within the RBI +
Other deposits with RBI
= 28,637 + 5,673 + 210
= ` 34,520 cr
(c) Foreign direct investment is defined as a process whereby 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 ‘financial capital’ with stake in a firm at below
10 percent and does not involve manufacture of goods or provision of services,
ownership management or control of the asset on the part of the investor.

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

Investment involves creation of physical Investment is only in financial assets
assets
Has a long-term interest and therefore Only short-term interest and generally
remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw
Not inclined to be speculative Speculative in nature
Often accompanied by technology Not accompanied by technology transfer
transfer
Direct impact on employment of labour No direct impact on employment of
and wages labour and wages

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 24 INTERMEDIATE EXAMINATION: MAY 2023

Enduring interest in management and No abiding interest in management and

control control
Securities are held with significant degree Securities are held purely as a financial
of influence by the investor on the investment and no significant degree of
management of the enterprise influence on the management of the
enterprise

(d) Name: Contractionary Fiscal Policy

Contractionary fiscal policy refers to the deliberate policy of government applied to curtail
aggregate demand and consequently the level of economic activity. In other words, it is
fiscal policy aimed at eliminating an inflationary gap. This is achieved by adopting policy
measures that would result in the aggregate demand curve (AD) shifting to the left so the
equilibrium may be established at the full employment level of real GDP. This can be
achieved either by:
• Decrease in government spending: With decrease in government spending, the
total amount of money available in the economy is reduced which in turn trim down
the aggregate demand.
• Increase in personal income taxes and/or business taxes: An increase in
personal income taxes reduces disposable incomes leading to fall in consumption
spending and aggregate demand. An increase in taxes on business profits reduces
the surpluses available to businesses, and as a result, firms’ investments shrink
causing aggregate demand to fall. Increased taxes also dampen the prospects of
profits of potential entrants who will respond by holding back fresh investments.
• A combination of decrease in government spending and increase in personal
income taxes and/or business taxes.
Question 8
(a) (i) Following information is related to an economy:
Autonomous consumption ` 1,000 crore
Marginal propensity to consume 0.8
Equilibrium level of income ` 10,000 crore
You are required to calculate the investment expenditure and consumption
expenditure of the economy. (3 Marks)
(ii) Explain the government interventions for combating the market failures due to
information problem. (2 Marks)

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 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 25

(b) (i) Compute M1 and M4 from the following data relating to 31 st March, 2023:
(` in crore)
Notes in circulation 3,01,78,670
Circulation of rupee coins 6,48,902
Demand deposits with banks 1,41,31,650
Time Deposits with Banks 31,24,276
Cash in hand with banks 7,64,130
Other Deposits with RBI 3,98,048
Post Office Savings Deposits 2,02,684
Post Office National Savings Certificates (NSCs) 820

(3 Marks)
(ii) Describe the exchange rate regime that is commonly used by the countries in real
world. (2 Marks)
Answer
(a) (i) Y=C+I
Y = Ca + bY + I
Y – bY = Ca + I
Y (1 – b) = Ca + I
10,000 (1-0.8) = 1000 + I
10,000 x 0.2 = 1000 + I
2000 = 1000 + I
I = ` 1000 cr
Y=C+I
C = Y - I = 10,000 – 1000
= ` 9000 cr
Investment expenditures = ` 1000 cr
Consumption expenditure = ` 9000 cr

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 26 INTERMEDIATE EXAMINATION: MAY 2023

Alternative presentation
Equilibrium level of income (Y) = ` 10,000 crores
Autonomous consumption (a) = ` 1,000 Crores
Marginal Propensity to Consume (MPC) = 0.8
C = a + MPC (Y)
Consumption expenditure (C) = 1000 + 0.8 * 10,000 = 1000 + 8000
C = ` 9,000 crores
Similarly,
Y=C+I
Investment expenditure (I) = Y – C = 10000 – 9000 = ` 1,000 crores
(ii) For combating the problem of market failure due to information problems and
considering the importance of information in making rational choices, the following
interventions are resorted to:
• Government makes it mandatory to have accurate labelling and content
disclosures by producers. eg. Labelling on cigarette packets and nutritional
information in food packages.
• Mandatory disclosure of information for example: SEBI requires that
accurate information be provided to prospective buyers of new stocks.
• 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.
(b) (i) M1 = (Notes in circulation + Circulation of rupee coins - Cash in hand with
banks) + demand deposit with banking system+ other deposits with RBI
= 30178670 + 648902 – 764130 +14131650+ 398048
M1 = ` 4,45,93,140 cr
M3 = M1 + time deposit with the banking system
= 44593140 + 3124276
= ` 4,77,17,416 cr

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 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 27

M4 = M3 + Total deposits within the Post office savings organisation (excluding

National Saving Certificate)
= 47717416+ 202684
M4 = ` 4,79,20,100 cr
(ii) In the real world, there is a spectrum of ‘intermediate exchange rate regimes’
which are either inflexible or have varying degrees of flexibility that lie in
between these two extremes (fixed and flexible). For example, a central bank can
implement soft peg and hard peg policies. A soft peg refers to an exchange
rate policy under which the exchange rate is generally determined by the
market, but in case the exchange rate tends to be move speedily in one direction,
the central bank will intervene in the market. With a hard peg exchange rate policy,
the central bank sets a fixed and unchanging value for the exchange rate. Both
soft peg and hard peg policy require that the central bank intervenes in the foreign
exchange market.
Question 9
(a) (i) Two Countries G and Hare producing Sugar and Steel. The table given below
shows the number of labour hours required to produce Sugar and Steel:
Commodity Country G Country H
One Unit of Sugar 6.0 2.0
One Unit of Steel 2.5 5.0
(A) Compute the Productivity of labour in both countries in respect of both
commodities.
(B) Which country has absolute advantage of production of Steel?
(C) Which country has absolute advantage of production of Sugar? (3 Marks)
(ii) In an economy investment have been increased by ` 5,000 crore.
The Marginal Propensity to Consume (MPC) is 0.82. (2 Marks)
You are required to compute the total increase in income and saving in the
economy.
(b) (i) Discuss the similarities between Fisher's Transaction approach and Cambridge
Cash Balance approach. (3 Marks)
(ii) Explain the following terms:
• Stagflation
• Contagion Effect (2 Marks)

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Answer
(a) (i) (A) Productivity of Labour in both Countries in respect of both commodities
Productivity of Labour Country G Country H
Units of Sugar per hour 0.16 0.5
Unit of Steel per hour 0.4 0.2
(B) Country G has absolute advantage in the production of Steel because
Productivity of Steel is higher in Country G or Conversely the number of labour
hour required to produce Steel in Country G is less compared to Country H.
(C) Country H has absolute advantage in the production of Sugar because
productivity of Sugar is higher in Country H or conversely the number of labour
hours required to Produce sugar in Country H is less compound to Country G.
(ii)  I = 5000
MPC = 0.82
1 1 1
Multiplier K = = = = 5.55
1 − MPC 1 − 0.82 0.18
MPS = 1 – MPC = 1 – 0.82 = 0.18
Increase in Income = Y = K x I
= 5.55 x 5000
= ` 27,750 cr
Increase in Saving = Y x MPS
= 27750 x 0.18
= ` 4995 cr
(b) (i) The Fisher’s version and Cambridge version lead to the same conclusion that
there is a direct and proportional relationship between the quantity of mone y and
the price level and an inverse proportionate relationship between the quantity of
money and the value of money.
The two approaches almost similar equations. Fishers’ equation P = MV/T is a
similar to Robertson’s equation P = M/kY. However, the only difference is between
the two symbols V and k which are reciprocal to each other. The difference in the
two equations can be reconciled by substituting 1/V for K in Robertson’s equation
and 1/k for V in Fisher’s equation.

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 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 29

(ii) Stagflation: A state of affairs in which inflation and unemployment exist side by
side.
Or
The combination of recession or stagnation and increasing prices or inflation.
Contagion Effect: The stabilization issue also becomes more complex due to
‘contagion effect’ whereby the increased international interdependence and financial
integration causes forces of instability to get easily transmitted from one country to
other countries.
Question 10
(a) (i) Following information relating to a developing country is available to you:
Investment (I) ` 140 crore
Government Expenditure (G) ` 90 crore
Export (X) ` 100 crore
Consumption Function (C) = 80 + 0.8 Yd (Disposable Income)
Import (M) = 50 + 0.09Y (Income)
Tax (T) 0.2 Y (Income)

You are required to:

(A) Find out equilibrium level of income (Y).
(B) Calculate foreign trade multiplier.
(C) Calculate net export if investment is increased by ` 30 crore. (3 Marks)
(ii) A customer of a bank deposits ` 50,000 in his bank. The bank is required to keep a
cash reserve of 20 percent to meet the demand for cash by its depositors.
Calculate the amount of bank deposits the banking system as a whole would
generate on the basis of such deposit by the customer. (2 Marks)
(b) (i) Is World Trade Organization (WTO) better than General Agreement on Tariffs and
Trade (GATT)? Explain with reasons. (3 Marks)
(ii) Write down the name of the terms used in the analysis of the effect of externalities
in the following conditions:
(A) The change in the cost to parties other than the producer or buyer of a good or
service due to an additional unit of the good or service.
(B) The change in society's total benefits associated with an additional unit of
good or service.

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 30 INTERMEDIATE EXAMINATION: MAY 2023

(C) The change in the benefit to parties other than the producer or buyer of a good
or service due to an additional unit of the good or service.
(D) The change in society's total cost brought about by an additional unit of a good
or service. (2 Marks)
Answer
(a) (i) (A) C = 80 + 0.8 Yd
= 80 + 0.8 (Y – 0.2Y)
Y = 80 + 0.8 (Y – 0.2Y) + 140 + 90 + 100 – 50 – 0.09Y
= 0.55Y + 360
Or Y = ` 800 crores
1
(B) Foreign trade Multiplier =
1 − 0.8(1 − 0.2) + 0.09

= 1/0.45
Change in I = ` 30
(C) If investment is increased by ` 30 crores:
Y/30 = 1/0.45
Y = 66.67
Y = ` 866.67 Crores
Net export = 100 – 50-(0.09 x 866.67)
= - ` 28 Crores
Alternative
Y = C + I + G + (X – M)
Y = 80 + 0.8 Yd + 140 + 90 (100 – (50 + 0.09Y)
Y = 80 + 0.8 (Y – T) + 140 + 90 (100 – (50 + 0.09 Y)
= 80 + 0.8 (Y – 0.2Y) + 140 + 90 (100 – 50 – 0.09Y)
= 80 + 0.8 (0.8Y) + 140 + 90 (50 – 0.09Y)
= 80 + 0.64 Y + 140 + 4500 – 8.1 Y
Y = 4720 + 0.64Y – 8.1Y

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 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 31

Y (1 – 0.64 + 8.1) = 4720

8.46 Y = 4720
4720
Y= = ` 557.92 cr
8.46
1
Foreign trade Multiplier =
1− b + m
1
=
1 − 0.8 + 0.09
1
= = 3.45
0.29
Change in I = ` 30
30
Change in Y =
1− b + m
30
=
1 − 0.8 + 0.09
30
= = ` 103.45 cr
0.29
Ye = 557.91 + 103.45
= ` 661.36 cr
X - M @ Ye = 661.36 = 100 – (50+0.09×661.36)
= 50 + 0.09 x 661.36
= 50 + 59.53
= ` 109.53 cr
(ii) Required reserve ratio, RR = 20%
Spending multiplier = 1/RR = 1/0.2 i.e. 5
Initial change in volume of deposits, D = ` 50000
New deposits = (1/RR) x D
= 5 x ` 50000
= ` 250000

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 32 INTERMEDIATE EXAMINATION: MAY 2023

Alternative
If the Customer A deposit ` 50000 in his bank (Bank X), this constitutes the bank
current total cash deposits. If the required reserve is 20 percent, the bank would
lend ` 40000 to B. by lending B ` 40000 the bank creates a deposit for ` 40000
that B now use. It is as though B owns ` 40000. This in turn mean that A can claim
against ` 50000 while B will have a claim against ` 40000. The bank has cash of
` 50000 against claim of ` 90000. In short, the bank has created ` 40000 out of
“thin air ‘” Since ` 40000 are not supported by any genuine money. At any time, the
fractional reserve commercial banks have more cash liabilities than cash in their
vaults. Now B buys good worth ` 40000 from c and pays by Cheque. C Places the
cheque in bank Y which bank y will lend to D. The Summation will end with an
amount which is equivalent to 1/20 % of ` 50000 which is equal to ` 250000. In this
example the Initial deposit is capable of multiplying itself 5 times.
In Short, we find that the fact that banks make use of demand deposits for lending it
sets in motion a series of activities leading to expansion of money that is not backed
by proper money.
(b) (i) The multilateral trading system, first under the General Agreement on Tariffs and
Trade (GATT) and later in the World Trade Organisation (WTO), has reduced
unilateral approaches to trade by gradually integrating the majority of the world’s
countries into our rules- based system. But WTO has proved to be better GATT due
to the following reasons.
• WTO dispute resolution is quicker than GATT (disputes have to be solved
within 18 months)
• GATT talked only about Goods, but WTO talks about services and intellectual
property rights, along with Goods.
• The working of WTO is more transparent.
(ii) A. The change in the cost to parties other than the producer or buyer of a good or
service due to an additional unit of the good or service – Marginal External
Cost (MEC)
B. The Change in society’s total benefits associated with an additional unit of
good or service –Marginal Social Benefit (MSB)
C. The change in the benefit to parties other than the producer or buyer of a good
or service due to an additional unit of the good or service – Marginal External
benefit (MEB)
D. The Change in society’s total cost brought about by an additional unit of a
good or service - Marginal Social Cost. (MSC)

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Question 11
(a) (i) Suppose in an economy, government expenditure is increased by ` 10 crore and
taxes increased by ` 5 crore. Spending multiplier of the economy is 5. What impact
would such increase have on GDP? (3 Marks)
(ii) Calculate the arbitrage for £2,00,000 from the following details:
£1 = ` 100
US$ 1 = ` 80
£1 = US $ 1.30 in UK (2 Marks)
(b) (i) Repo injects liquidity into the system whereas the reverse repo absorbs the liquidity
from the system. In the light of this statement briefly state the impact of high repo
and reverse repo rate on a developing economy. (3 Marks)
(ii) What steps are to be taken by the Government as instruments of trade policy in the
following cases?
(A) There is severe shortage of an essential product X in Indian domestic market
due to its less production.
(B) The export of product Y is decreasing. continuously due to cost and
competition in the international market. (2 Marks)
OR
Describe any two reasons for leakages which are responsible for decline in income.
(2 Marks)
Answer
(a) (i) Spending Multiplier = 1/1-b
5 = 1/1-b
5-5b = 1
b = 4/5 = 0.8
MPC = 0.8
Change in GDP = Initial Change in Government Expenditure × Spending Multiplier
= 10 ×5 = ` 50 Cr
Tax Multiplier = -b/1-b
= -0.8/ 1-0.8

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 34 INTERMEDIATE EXAMINATION: MAY 2023

= -0.8/0.2
= -4
Decrease in GDP = Initial Change in Tax × 4
=5×4
= ` 20 crore
Net Result is Output increases by 30 crore.
(ii) (a) (ii) Arbitrage gain can be calculated as follows:
Buy US $ in UK market for £ 2,00,000.
Since £1 = US $ 1.30 for £2,00,000 = 2,00,000 x 1.3 = $2,60,000
So, total US $ in Indian market
US 4 2,60,000 x 80 = ` 2,08,00,000
Purchasing £ in Indian market for ` 2,08,00,000
2,08,00,000/100 = £2,08,000
Hence the arbitrage gain is £8000
(b) (i) The RBI uses the single independent ‘policy rate’ which is the repo rate (in the LAF
window) for balancing liquidity. The policy rate is in fact, the key lending rate of the
central bank in a country. A change in the policy rate gets transmitted through the
money market to the entire the financial system and alters all other short term
interest rates in the economy, thereby influencing aggregate demand – a key
determinant of the level of inflation and economic growth. If the RBI wants to make
it more expensive for banks to borrow money, it increases the repo rate. Similarly, if
it wants to make it cheaper for banks to borrow money, it reduces the repo rate. In
other words, an increase in the repo rate will lead to liquidity tightening and vice -
versa, other things remaining constant. The cost of funds increases from
commercial banks hence loans become more expensive.
It is a monetary policy instrument and in effect it absorbs the liquidity from the
system. This operation takes place when the RBI borrows money from commercial
banks by selling them securities (which RBI permits) with an agreement to
repurchase the securities on a mutually agreed future date at an agreed price which
includes interest for the funds borrowed. The interest rate paid by the RBI for such
borrowings is called the "Reverse Repo Rate". Thus, reverse repo rate is the rate of
interest paid by the RBI on its borrowings from commercial banks. In case of
reverse repo, the money supply in the economy decreases as the commercial banks
parks more funds with the RBI.

© The Institute of Chartered Accountants of India

 PAPER 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 35

(ii) (A) Ban on exports or export restriction:

During the period of shortage of product X the government restricted the
export of product X to make the supply in domestic market. It is export related
measure of trade policy.
During periods of shortages, export of product X may be prohibited to make
them available for domestic consumption. Export restrictions have an important
effect on international markets. By reducing international supply, export
restrictions have been effective in increasing international prices.
(B) Export subsidies and Incentives: To encourage the export of product Y the
government provides subsidy, grant, loans, duty free access etc. It is also and
export related measure.
Or
There are two flows out of the household sector in addition to consumption
expenditure namely, saving flow and the flow of tax payments to the
government. These are leakages. The saving leakage flows into financial
markets, which means that the part of that is saved is held in the form of some
financial asset (currency, bank deposits, bonds, equities, etc.). The tax flow
goes to the government sector. The leakages which occur in household sector
do not necessarily mean that the total demand must fall short of output. There
are additional demands for output on the part of the business sector itself for
investment and from the government sector. In terms of the circular flow, these
are injections. The investment injection is shown as a flow from financial
markets to the business sector. The purchasers of the investment goods,
typically financed by borrowing, are actually the firms in the business sector
themselves. Thus, the amount of investment in terms of money represents an
equivalent flow of funds lent to the business sector.

© The Institute of Chartered Accountants of India