PAPER – 8: FINANCIAL MANAGEMENT & ECONOMICS FOR FINANCE

PART A: FINANCIAL MANAGEMENT

QUESTIONS

Ratio Analysis
1. Assuming the current ratio of a Company is 2, STATE in each of the following cases
whether the ratio will improve or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonoured
(v) Issue of new shares
Cost of Capital
2. M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company
is presently considering several alternative investment proposals costing less than ` 20
lakhs. The corporation always raises the required funds without disturbing its present debt
equity ratio.
The cost of raising the debt and equity are as under:
Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%
Assuming the tax rate at 50%, CALCULATE:
(i) Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs and
` 14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what
conditions it would be acceptable?
Capital Structure Decisions
3. Rounak Ltd. is an all equity financed company with a market value of ` 25,00,000 and cost
of equity (K e) 21%. The company wants to buyback equity shares worth ` 5,00,000 by
issuing and raising 15% perpetual debt of the same amount. Rate of tax may be taken as
30%. After the capital restructuring and applying MM Model (with taxes), you are required
to COMPUTE:

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 2

(i) Market value of J Ltd.

(ii) Cost of Equity (K e)
(iii) Weighted average cost of capital (using market weights) and comment on i t.
Leverage
4. A firm has sales of ` 75,00,000 variable cost is 56% and fixed cost is` 6,00,000. It has a
debt of ` 45,00,000 at 9% and equity of ` 55,00,000. You are required to INTERPRET:
(i) The firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or
low capital turnover?
(iv) The operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?
Capital Budgeting
5. Shiv Limited is thinking of replacing its existing machine by a new machine which would
cost ` 60 lakhs. The company’s current production is 80,000 units, and is expected to
increase to 1,00,000 units, if the new machine is bought. The selling price of the product
would remain unchanged at ` 200 per unit. The following is the cost of producing one unit
of product using both the existing and new machine:
Unit cost (`)
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.50 2.50
183.25 165.50 (17.75)

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 3

The existing machine has an accounting book value of ` 1,00,000, and it has been fully
depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The
supplier of the new machine has offered to accept the old machine for ` 2,50,000.
However, the market price of old machine today is ` 1,50,000 and it is expected to be
` 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of
` 2,50,000 at the end of its economic life. Assume corporate Income tax rate at 40%, and
depreciation is charged on straight line basis for Income-tax purposes. Further assume
that book profit is treated as ordinary income for tax purpose. The opportunity cost of
capital of the Company is 15%.
Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? ANALYSE.
Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Management of Receivables (Debtors)

6. Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing
credit terms to three of their large customers A, B and C. The credit period and likely
quantity of TV sets that will be sold to the customers in addition to other sales are as
follows:
Quantity sold (No. of TV Sets)
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500

The selling price per TV set is ` 9,000. The expected contribution is 20% of the selling
price. The cost of carrying receivable averages 20% per annum.
You are required:
(a) COMPUTE the credit period to be allowed to each customer.

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 4

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

(b) DEMONSTRATE the other problems the company might face in allowing the credit
period as determined in (a) above?
Financing of Working Capital
7. A company is considering its working capital investment and financial policies for the next
year. Estimated fixed assets and current liabilities for the next year are ` 2.60 crores and
` 2.34 crores respectively. Estimated Sales and EBIT depend on current assets
investment, particularly inventories and book-debts. The financial controller of the
company is examining the following alternative Working Capital Policies:
(` Crores)
Working Capital Policy Investment in Current Estimated Sales EBIT
Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the
adoption of the moderate working capital policy. The company is now examining the use
of long-term and short-term borrowings for financing its assets. The company will use
` 2.50 crores of the equity funds. The corporate tax rate is 35%. The company is
considering the following debt alternatives.
(` Crores)
Financing Policy Short-term Debt Long-term Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%
You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio
(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 5

Risk Analysis in Capital Budgeting

8. Gauav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The
following information regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalent
quotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether
the project should be accepted?
Lease Financing
9. XYZ Ltd. requires an equipment costing `50,00,000; the same will be utilized over a period
of 5 years. It has two financing options in this regard:
(i) Arrangement of a loan of `50,00,000 at an interest rate of 14 percent per annum; the loan
being repayable in 5 equal year end instalments; the equipment can be sold at the end of
fifth year for `5,00,000.
(ii) Leasing the equipment for a period of five years at an early rental of `16,50,000 payable
at the year end.
The rate of depreciation is 15 percent on Written Down Value (WDV) basis, income tax
rate is 35 percent and discount rate is 12 percent.
ADVISE which of the financing options should XYZ Ltd. exercise and why?
Dividend Decisions
10. The earnings per share of a company is ` 10 and the rate of capitalisation applicable to it
is 10 per cent. The company has three options of paying dividend i.e. (i) 50%, (ii) 75% and
(iii) 100%.
CALCULATE the market price of the share as per Walter’s model if it can earn a return of
(a) 15, (b) 10 and (c) 5 per cent on its retained earnings.
Miscellaneous
11. (i) “The profit maximization is not an operationally feasible criterion.” IDENTIFY.
(ii) EXPLAIN the difference between Financial Lease and Operating Lease.

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 6

SUGGESTED HINTS/ANSWERS

Current Assets (CA)

1. Current Ratio = = 2 i.e. 2 : 1
Current Liabilities (CL)

S. Situation Improve/ Reason

No. Decline/ No
Change
(i) Payment of Current Ratio will Let us assume CA is ` 2 lakhs & CL is
Current liability improve ` 1 lakh. If payment of Current Liability
= `10,000 then, CA = 1, 90,000 CL
= 90,000.
1,90,000
Current Ratio =
90,000
= 2.11 : 1. When Current Ratio is 2:1
Payment of Current liability will reduce
the same amount in the numerator and
denominator. Hence, the ratio will
improve.
(ii) Purchase of Current Ratio will Since the cash being a current asset
Fixed Assets by decline converted into fixed asset, current assets
cash reduced, thus current ratio will fall.
(iii) Cash collected Current Ratio will Cash will increase and Debtors will
from Customers not change reduce. Hence No Change in Current
Asset.
(iv) Bills Receivable Current Ratio will Bills Receivable will come down and
dishonoured not change debtors will increase. Hence no change
in Current Assets.
(v) Issue of New Current Ratio will As Cash will increase, Current Assets will
Shares improve increase and current ratio will increase.
2. (i) Statement of Weighted Average Cost of Capital
Project cost Financing Proportion of After tax cost Weighted
capital (1–Tax 50%) average cost (%)
Structure
Upto ` 2 Lakhs Debt 0.4 10% (1 – 0.5) 0.4 × 5 = 2.0
= 5%
Equity 0.6 12% 0.6 × 12 = 7.2
9.2%

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 7

Above ` 2 lakhs Debt 0.4 11% (1 – 0.5) 0.4 × 5.5 = 2.2

& upto to ` 5 Lakhs = 5.5%
Equity 0.6 13% 0.6 × 13 = 7.8
10.0%
Above ` 5 lakhs Debt 0.4 12% (1 – 0.5) 0.4 × 6 = 2.4
& upto ` 10 lakhs = 6%
Equity 0.6 14% 0.6 × 14 = 8.4
10.8%
Above ` 10 lakhs Debt 0.4 13% (1 – 0.5) 0.4 × 6.5 = 2.6
& upto ` 20 lakhs = 6.5%
Equity 0.6 14.5% 0.6 × 14.5 = 8.7
11.3%

Project Fund requirement Cost of capital

X `6.5 lakhs 10.8% (from the above table)
Y `14 lakhs 11.3% (from the above table)
(ii) If a Project is expected to give after tax return of 10%, it would be acceptable
provided its project cost does not exceed ` 5 lakhs or, after tax return should be
more than or at least equal to the weighted average cost of capital.
3. Value of a company (V) = Value of equity (S) + Value of debt (D)
NetIncome(NI)
` 25,00,000 = + ` 5,00,000
Ke

Or, Net Income (NI) = 0.21 (` 25,00,000 – ` 5,00,000)

Market Value of Equity = ` 25,00,000
Ke =21%
Net income (NI) for equity holders
= Market Value of Equity
Ke

Net income (NI) for equity holders

= ` 25,00,000
0.21
Net income for equity holders = ` 5,25,000
EBIT = 5,25,000/0.7 = ` 7,50,000

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 8

All Equity Debt and Equity

` `
EBIT 7,50,000 7,50,000
Interest to debt-holders - (75,000)
EBT 7,50,000 6,75,000
Taxes (30%) (2,25,000) (2,02,500)
Income available to equity shareholders 5,25,000 4,72,500
Income to debt holders plus income available to 5,25,000 5,47,500
shareholders
Present value of tax-shield benefits = ` 5,00,000 × 0.30 = ` 1,50,000
(i) Value of Restructured firm
= ` 25,00,000 + ` 1,50,000 = ` 26,50,000
(ii) Cost of Equity (K e)
Total Value = `26,50,000
Less: Value of Debt = `5,00,000
Value of Equity = `21,50,000
4,72,500
Ke = =0.219 = 21.98%
21,50,000
(iii) WACC (on market value weight)
Cost of Debt (after tax) = 15% (1- 0.3) = 0.15 (0.70) = 0.105 = 10.5%
Components of Costs Amount Cost of Capital Weight WACC
(`) (%) (%)
Equity 21,50,000 21.98 0.81 17.80
Debt 5,00,000 10.50 0.19 2.00
26,50,000 19.80
Comment: At present the company is all equity financed. So, Ke = Ko i.e. 21%. However, after
restructuring, the Ko would be reduced to 19.80% and Ke would increase from 21% to 21.98%.
4. Income Statement
Particulars Amount (`)
Sales 75,00,000
Less: Variable cost (56% of 75,00,000) (42,00,000)
Contribution 33,00,000
Less: Fixed costs (6,00,000)

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 9

Earnings before interest and tax (EBIT) 27,00,000

Less: Interest on debt (@ 9% on ` 45 lakhs) (4,05,000)
Earnings before tax (EBT) 22,95,000
EBIT EBIT
(i) ROI = ×100 = ×100
Capital employed Equity + Debt
27,00,000
= ×100 = 27%
55,00,000 + 45,00,000

(ROI is calculated on Capital Employed)

(ii) ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
Net Sales
(iii) Capital Turnover =
Capital

Net Sales ` 75,00,000

Or = = = 0.75
Capital ` 1,00,00,000

Which is very low as compared to industry average of 3.

(iv) Calculation of Operating, Financial and Combined leverages
Contribution ` 33,00,000
(a) Operating Leverage = = = 1.22 (approx)
EBIT ` 27,00,000

EBIT ` 27,00,000
(b) Financial Leverage = = = 1.18 (approx)
EBT ` 22,95,000
Contribution ` 33,00,000
(c) Combined Leverage = = = 1.44 (approx)
EBT ` 22,95,000

Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44 (approx)

(v) Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased
by 1.22 × 10 i.e. 12.20% (approx)
(vi) Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to
bring EBT to Zero
Accordingly, New Sales = ` 75,00,000 × (1-0.6944)
= ` 75,00,000 × 0.3056
= ` 22,92,000 (approx)
Hence at `22,92,000 sales level EBT of the firm will be equal to Zero.

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 10

(vii) Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by
1.18 × 20 = 23.6% (approx)
5. (i) Net Cash Outlay of New Machine
Purchase Price ` 60,00,000
Less: Exchange value of old machine
[2,50,000 – 0.4(2,50,000 – 0)] 1,50,000
` 58,50,000
Market Value of Old Machine: The old machine could be sold for ` 1,50,000 in the
market. Since the exchange value is more than the market value, this option is not
attractive. This opportunity will be lost whether the old machine is retained or
replaced. Thus, on incremental basis, it has no impact.
Depreciation base: Old machine has been fully depreciated for tax purpose.
Thus, the depreciation base of the new machine will be its original cost i.e.
` 60,00,000.
Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated
overheads are allocated from corporate office therefore they are irrelevant. The
depreciation tax shield may be computed separately. Excluding depreciation and
allocated overheads, unit costs can be calculated. The company will obtain additional
revenue from additional 20,000 units sold.
Thus, after-tax saving, excluding depreciation, tax shield, would be
= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)
= {52,00,000 – 21,60,000} × 0.60
= ` 18,24,000
After adjusting depreciation tax shield and salvage value, net cash flows and net
present value are estimated.
Calculation of Cash flows and Project Profitability
` (‘000)
0 1 2 3 4 5
1 After-tax savings - 1824 1824 1824 1824 1824
2 Depreciation - 1150 1150 1150 1150 1150
(` 60,00,000 – 2,50,000)/5
3 Tax shield on depreciation - 460 460 460 460 460
(Depreciation × Tax rate)

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 11

4 Net cash flows from - 2284 2284 2284 2284 2284

operations (1 + 3)*
5 Initial cost (5850)
6 Net Salvage Value - - - - - 215
(2,50,000 – 35,000)
7 Net Cash Flows (4+5+6) (5850) 2284 2284 2284 2284 2499
8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972
9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50
10 NPV ` 1913.32

* Alternately Net Cash flows from operation can be calculated as follows:

Profit before depreciation and tax = ` 1,00,000 (200 -148) - 80,000 (200 -173)
= ` 52,00,000 – 21,60,000
= ` 30,40,000
So profit after depreciation and tax is ` (30,40,000 -11,50,000) × (1 - .40)
= ` 11,34,000
So profit before depreciation and after tax is :
` 11,34,000 + ` 11,50,000 (Depreciation added back) = ` 22,84,000
(ii)
` (‘000)
0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12

1066 .94
IRR = 20% + 10% × = 28.23%
1296 .82
(iii) Advise: The Company should go ahead with replacement project, since it is positive
NPV decision.

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 12

6. (a) In case of customer A, there is no increase in sales even if the credit is given. Hence
comparative statement for B & C is given below:
Particulars Customer B Customer C
1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
` in lakhs `in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 20% 18 27 36 45 - - 18 27
(A)
5. Receivables:
Credit Period × Sales - 11.25 30 56.25 - - 15 33.75
360
6. Debtors at cost i.e. - 9 24 45 - - 12 27
80% of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20% (B)
8. Excess of 18 25.2 31.2 36 - - 15.6 21.6
contributions over
cost of carrying
debtors (A – B)
The excess of contribution over cost of carrying Debtors is highest in case of credit
period of 90 days in respect of both the customers B and C. Hence, credit period of
90 days should be allowed to B and C.
(b) Problem:
(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C
is taking 1000 TV sets at credit for 60 days. Hence A also may demand credit
for 60 days compulsorily.
(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets
only. In such case B will demand further relaxation in credit period i.e. B may
ask for 120 days credit.
7. (i) Statement showing Working Capital for each policy
(` in crores)
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 13

Total Assets: (iii) 7.10 6.50 5.20

Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i)-(iv) 2.16 1.56 0.26
(b) Rate of return: (vii)/(iii) 17.3% 17.7% 19.2%
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11
(ii) Statement Showing Effect of Alternative Financing Policy
(` in crores)
Financing Policy Conservative Moderate Aggressive
Current Assets: (i) 3.90 3.90 3.90
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 6.50 6.50 6.50
Current Liabilities: (iv) 2.34 2.34 2.34
Short term Debt: (v) 0.54 1.00 1.50
Long term Debt: (vi) 1.12 0.66 0.16
Equity Capital (vii) 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT: (viii) 1.15 1.15 1.15
Less: Interest short-term debt: 0.06 0.12 0.18
(ix) (12% of ` 0.54) (12% of ` 1.00) (12% of ` 1.50)
Long term debt: (x) 0.18 0.11 0.03
(16% of ` 1.12) (16% of ` 0.66) (16% of ` 0.16)
Earning before tax: 0.91 0.92 0.94
(xi) - (ix + x)
Tax @ 35% (0.32) (0.32) (0.33)
Earning after tax: (xii) 0.59 0.60 0.61
(a) Net Working Capital 0.06
Position: (i) - [(iv)+(v)] 1.02 0.56
(b) Rate of return on 23.6% 24% 24.4%
Equity shareholders’
capital : (xii)/(vii)
(c) Current Ratio: 1.35 1.17 1.02
[(i)/(iv)+(v)]

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 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018 14

8. Determination of Net Present Value (NPV)

Year Expected Cash Certainty- Adjusted Cash PV factor Total PV (`)
flow (`) equivalent flow (Cash flow (at 0.06)
(CE) × CE) (`)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 – 4,00,000) 2,58,776
As the Net Present Value is positive the project should be accepted.
9. Option A
The loan amount is repayable together with the interest at the rate of 14% on loan amount
and is repayable in equal instalments at the end of each year. The PVAF at the rate of 14%
for 5 years is 3.432, the amount payable will be
`50,00,000
Annual Payment = = `14,56,876
3.432
Schedule of Debt Repayment
End of year Total Payment Interest Principal Principal amount
(`) (`) (`) outstanding (`)
1 14,56,876 7,00,000 7,56,876 42,43,124
2 14,56,876 5,94,037 8,62,839 33,80,285
3 14,56,876 4,73,240 9,83,636 23,96,649
4 14,56,876 3,35,531 11,21,345 12,75,304
5 14,56,876 1,81,572* 12,75,304 0
*Balancing Figure
Schedule of Cash Outflows: Debt Alternative (Amount in `)
End Debt Interest Depreciat- Total Tax Cash PV Present
of Payment ion Shield Outflows factor Value
year @12%
1 14,56,876 7,00,000 7,50,000 14,50,000 5,07,500 9,49,376 0.893 8,47,793
2 14,56,876 5,94,037 6,37,500 12,31,537 4,31,038 10,25,838 0.797 8,17,593
3 14,56,876 4,73,240 5,41,875 10,15,115 3,55,290 11,01,586 0.712 7,84,329

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 15

4 14,56,876 3,35,531 4,60,594 7,96,125 2,78,644 11,78,232 0.636 7,49,356

5 14,56,876 1,81,572 3,91,505 5,73,077 2,00,577 12,56,299 0.567 7,12,322
39,11,393
Less: PV of Salvage Value (12,57,904)
26,53,489

Total present value of Outflows = ` 26,53,489

Option B
Lease Rent `16,50,000
Tax Shield (5,77,500)
Outflow 10,72,500 × 3.605 = `38,66,363
Since PV of outflows is lower in the Borrowing option, XYZ Ltd. should avail of the loan
and purchase the equipment.
10. Market Price (P) per share as per Walter’s Model is:
r
D (E  D)
P= Ke
Ke
Where,
P = Price of Share
r = Return on investment or rate of earning
Ke = Rate of Capitalisation or Cost of Equity
Calculation of Market Price (P) under the following dividend payout ratio and earning
rates:
(i) (ii) (iii)
Rate of DP ratio 50% DP ratio 75% DP ratio 100%
Earning (r)
 0.15   0.15   0.15 
(a) 15% 5  (10  5) 7.5    (10  7.5) 10    (10  10)
 0.10   0.10   0.10 
0.10 0.10 0.10
12.5 11.25 10
 `125  `112.5  `100
0.10 0.10 0.10

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 0.10   0.10   0.10 

5  (10  5) 7.5    (10  7.5) 10    (10  10)
(b) 10%  0.10   0.10   0.10 
0.10 0.10 0.10
10 10 10
 `100  `100  `100
0.10 0.10 0.10
 0.05   0.05   0.05 
5  (10  5) 7.5    (10  7.5) 10    (10  10)
(c) 5%  0.10   0.10   0.10 
0.10 0.10 0.10
7.5 8.75 10
 `75  `87.5  `100
0.10 0.10 0.10

11. (i) The profit maximisation is not an operationally feasible criterion.” This statement is
true because profit maximisation can be a short-term objective for any organisation
and cannot be its sole objective. Profit maximization fails to serve as an operational
criterion for maximizing the owner's economic welfare. It fails to provide an
operationally feasible measure for ranking alternative courses of action in terms of
their economic efficiency. It suffers from the following limitations:
(i) Vague term: The definition of the term profit is ambiguous. Does it mean short
term or long term profit? Does it refer to profit before or after tax? Total profit or
profit per share?
(ii) Timing of Return: The profit maximization objective does not make distinction
between returns received in different time periods. It gives no consideration to
the time value of money, and values benefits received today and benefits
received after a period as the same.
(iii) It ignores the risk factor.
(iv) The term maximization is also vague.
(ii) Difference between Financial Lease and Operating Lease

Financial Lease Operating Lease

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

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

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SECTION: B: ECONOMICS FOR FINANCE

QUESTIONS
1. (a) How does Personal Income differ from Disposable Personal Income?
(b) Calculate Gross National Disposable income from the following data (in ` Crores)
NDP at factor cost 6000
Net factor income to abroad - 300
Consumption of fixed capital 400
Current transfers from government 200
Net current transfers from rest of the world 500
Indirect taxes 700
Subsidies 600
2 (a) What would happen if aggregate expenditures were to exceed the country’s
economy’s production capacity?
(b) What effects do income leakages have on multiplier?
(c) An Economy is characterised by the following equations:
Consumption (C) = 100+0.9 Yd
Investment (I) = 100
Government Expenditure (G) = 120
Tax (T) = 50
X (Exports) = 200
M (Imports) = 100+ 0.15 Y
(i) What is the equilibrium Income?
(ii) Calculate trade balance.
(iii) What is the value of Foreign Trade Multiplier?
3. (a) What should be the public revenue and expenditure policy during recession?
(b) Explain the different types of externalities? How do externalities lead to welfare loss
of markets?
(c) Describe price ceilings with examples.
4. Fiscal policy plays a significant role in reducing inequality and achieving equity and social
justice. Do you agree? Substantiate your answer with examples.
5. (a) Explain how ‘technical barriers to trade’ (TBT) may operate as a protectionist
measure?

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(b) Distinguish between ‘pump priming’ and ‘compensatory spending’?

6. (a) Critically examine the post Keynesian theories of demand for money?
(b) (i) In Keynesian analysis of speculative demand for money, how will demand for
money be affected if people feel that the level of interest is very high? What is
the rationale behind their choice?
(ii) Do you think money is a unique store of value?
7. (a) Explain how each of the following may affect money multiplier and money supply?
(i) Fearing shortage of money in ATM’s, people decide to hoard money?
(ii) During festival season, people decide to withdraw money through ATMs very
often
(b) Explain the money multiplier approach to money supply.
(c) Explain the function of SLR? What are the eligible securities of SLR?
8. (a) Enumerate the bases of distinction between FDI and FPI
(b) What is meant by ‘monetary policy instruments’?
9. Distinguish between ‘non tariff measures’ and ‘non tariff barriers’
10. (a) How does the WTO address the special needs of developing and the least developed
countries?
(b) What’s meant by free trade area?
(c) What are the objectives of the Agreement on Agriculture (AOA)?
(d) Explain the effect of currency devaluation? Do you think a weak currency is
advantageous to a country?

SUGGESTED ANSWERS/HINTS

1. (a) Personal income is a measure of actual current income receipts of persons from all
sources which may or may not be earned from productive activities during a given
period of time. In other words, it is the income ‘actually paid out’ to the household
sector, but not necessarily earned.
Disposable personal income is a measure of amount of the money in the hands of the
individuals that is available for their consumption or savings. Disposable personal
income is derived from personal income by subtracting the direct taxes paid by
individuals and other compulsory payments made to the government.
DI = PI - Personal Income Taxes

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(b) Gross National Disposable Income (GNDI)= GNP MP + Net current transfer received
from rest of the world. Net current transfer received from rest of the world is the
difference between the current transfer received from rest of the world and current
transfers paid to rest of the world. Current transfers from government are not included
as they are simply transfers within the economy.
Gross National Disposable Income = (National Consumption Expenditure) + (Gross
National Saving)
= (Government final consumption expenditure+ Private final consumption
expenditure) + (Gross National Saving.)
Calculation: -
= NDP at factor cost + Consumption of fixed capital =GDP at factor cost
GDP at factor cost + Net factor income to abroad = GNP at factor cost
GNP at factor cost + (indirect taxes – subsidies) = GNP at market prices
GNP at market prices + Net current transfers from rest of the world
= Gross National Disposable income
= (6000+400) + (- 300) + (700-600) + 500
= 6400 - 300 + 100 + 500 = 6700 Crores
2. (a) Aggregate demand (AD) is the sum of all planned expenditures for the entire
economy. When aggregate expenditures exceed an economy’s production capacity
at full employment level; the resulting strain on resources creates “demand-pull”
inflation or higher price level. Nominal output will increase, but it merely reflects
higher prices, rather than additional real output.
(b) The multiplier is the ratio of the change in real GDP to the initial change in spending.
Causes responsible for the decline in income are called leakages. Income that is not
spent 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.
(c) (i) National Income
Y = C+I+G+(X-M)
= (100+0.9Y d) +100+120+200-(100+0.15Y)
= 100+0.9(Y-T) +100+120+200-100-0.15Y
= 100+0.9(Y-50) +100+120+200-100-0.15Y
Y= 375+0.75Y

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Y-0.75Y= 375
0.25Y= 375
100
Y= 375×  1500.00
25
(ii) Trade balance = X- M
= 200- (100+0.15Y)
Substituting the value of Y We have
Trade Balance = 200-100-225= -125
Trade balance is in deficit of 125.
1
(iii) Value of foreign trade Multiplier =
1 b  m
Where b marginal propensity to consume, and m is marginal propensity to
import. (Here MPC = 0.9 and marginal propensity to Import (m) = 0.15
1 1 1 100
Foreign trade Multiplier =    4
1  0.9  0.15 1.15  0.9 0.25 25
3. (a) Government’s fiscal policy for stabilization purposes attempts to direct the actions of
individuals and organizations by means of its expenditure and taxation decisions.
During recession, an expansionary fiscal policy is resorted to by government through
increased aggregate spending to compensate for the deficiency in effective demand.
Increased government expenditure (for example on building infrastructure) injects
more money into the economy, initiate a series of productive activities, stimulates
overall economic activities, employment and demand.
Production decisions, investments, savings etc can be influenced by government’s
tax policies. During recession, the government’s tax policy is framed to encourage
private consumption and investment. A general reduction in income taxes leaves
higher disposable incomes with people inducing higher consumption. Low corporate
taxes increase the prospects of profits for business and promote further investment.
(b) Externalities, also referred to as 'spillover effects', 'neighbourhood effects' 'third-party
effects' or 'side-effects', occur when the actions of either consumers or producers
result in costs or benefits that do not reflect as part of the market price. Externalities
cause market inefficiencies because they hinder the ability of market prices to convey
accurate information about how much to produce and how much to buy. Since
externalities are not reflected in market prices, they can be a source of economic
inefficiency. Externalities are initiated and experienced, not through the operation of
the price system, but outside the market and therefore are external to the market.
Externalities may be positive or negative or may be unidirectional or reciprocal.

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Negative externalities occur when the action of one party imposes costs on another
party. Positive externalities occur when the action of one party confers benefits on
another party. The four possible types of externalities are
(i) negative externality initiated in production which imposes an external cost on
others,
(ii) positive production externality, less commonly seen, initiated in production that
confers external benefits on others,
(iii) negative consumption externalities initiated in consumption which produce
external costs on others,
(iv) positive consumption externality initiated in consumption that confers external
benefits on others. Each of the above may be received by another in
consumption or in production. The firm or the consumer as the case may be,
however, has no incentive to account for the external costs that it imposes on
consumers.
How negative externalities lead to welfare loss of markets may be explained with
the help of the following diagram

The equilibrium level of output that would be produced by a free market is Q1 at which
marginal private benefit (MPB) is equal to marginal private cost (MPC). Marginal
social cost (MSC) represents the full or true cost to the society of producing another
unit of a good. It includes marginal private cost (MPC) and marginal social cost
(MSC). Assuming that there are no externalities arising from consumption, we can
see that marginal social cost (Q1S) is higher than marginal private cost (Q1E). Social
efficiency occurs at Q2 level of output where marginal social cost is equal to marginal
social benefit. Output Q1 is socially inefficient because at Q1, the marginal social cost

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is greater than the marginal social benefit and represents over production. The
shaded triangle represents the area of dead weight welfare loss. It indicates the area
of overconsumption. Thus, we conclude that when there is negative externality, a
competitive market will produce too much output relative to the social optimum. This
is a clear case of market failure where prices fail to provide the correct signals.
When there is a positive externality, the actual output is lower than the optimal one
at which marginal social (MSC) cost is equal to marginal social benefit (MSB). There
is a welfare loss to the society due to under production and under consumption. This
is a strong case for government intervention in the case of such goods.
(c) Price ceiling is a government intervention in regulated market economies wherein an
upper limit is set on the price charged for a product or service and the sellers are
bound to abide by such limits. The objective is to influence the outcomes of a market
on grounds of fairness and equity. When prices of certain essential commodities rise
excessively, government may resort to controls in the form of price ceilings (also
called maximum price) for making a resource or commodity available to all at
reasonable prices. Rent controls, setting of maximum prices of food grains and
essential items during times of scarcity etc are examples of price ceiling. A price
ceiling which is set below the prevailing market clearing price will generate excess
demand over supply and shortages will result.
4. Many developed and developing economies are facing the challenge of rising inequality in
incomes and opportunities. Fiscal policy is a chief instrument available to governments to
influence income distribution and plays a significant role in reducing inequality and
achieving equity and social justice. The distribution of income in the society is influenced
by fiscal policy both directly and indirectly. While current disposable incomes of individuals
and corporates are dependent on direct taxes, the potential for future earnings is indirectly
influenced by the nation’s fiscal policy choices.
Government revenues and expenditure have traditionally been regarded as important
instruments for carrying out desired redistribution of income. A progressive direct tax
system ensures that those who have greater ability to pay contribute more towards
defraying the expenses of government and that the tax burden is distributed fairly among
the population.
• Indirect taxes can be differential: for example, the commodities which are primarily
consumed by the richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which form a larger proportion of the income of the
lower income group, such as necessities, are taxed light.
• A carefully planned policy of public expenditure helps in redistributing income from
the rich to the poorer sections of the society. This is done through spending
programmes targeted on welfare measures for the disadvantaged, such as
(i) poverty alleviation programmes

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(ii) free or subsidized medical care, education, housing, essential commodities etc.
to improve the quality of living of poor
(iii) infrastructure provision on a selective basis
(iv) various social security schemes under which people are entitled to old -age
pensions, unemployment relief, sickness allowance etc.
(v) subsidized production of products of mass consumption
(vi) public production and/ or grant of subsidies to ensure sufficient supply of
essential goods, and
(vii) strengthening of human capital for enhancing employability etc.
Choice of a progressive tax system with high marginal taxes may act as a strong
deterrent to work save and invest. Therefore, the tax structure has to be carefully
framed to mitigate possible adverse impacts on production and efficiency.
Additionally, the redistributive fiscal policy and the extent of spending on redistribution
should be consistent with the macroeconomic policy objectives of the nation.
5. (a) The non tariff measure ‘technical barriers to trade’ (TBT) which cover both food and
non-food traded products refers to mandatory standards and technical regulatio ns
that define specific characteristics that a product should have, such as its size, shape,
design, labelling/marking/packaging, production methods, functionality or
performance. The specific procedures used to check whether a product is really
conforming to these requirements (conformity assessment procedures e.g. testing,
inspection and certification) are also covered in TBT. This involves compulsory
quality, quantity and price control of goods before shipment from the exporting
country. TBT measures are standards-based measures that countries use to protect
their consumers and preserve natural resources, but these can also be used
effectively as obstacles to imports or to discriminate against imports and protect
domestic products. In actual practice, technical measures create trade barriers for
existing and potential exporters for the following reasons:
(a) Altering products and production processes to comply with the diverse
requirements in export markets may be either impossible for the exporting
country or would obviously raise costs hurting the competitiveness of the
exporting country.
(b) Compliance with technical regulations needs to be established through testing,
certification or inspection by laboratories or certification bodies. These are
usually cumbersome and costly
(c) The exporters also need to incur additional costs for consultation, acquisition of
expertise, training etc.
In effect technical measures, or the ways in which they are applied, discriminate
against foreign producers and turn out to be trade restrictive rather than being

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legitimate implementation of social policy. Some examples of TBT are: food laws,
quality standards, industrial standards, organic certification, eco-labelling, ingredient
standards, shelf-life restrictions, marketing and labelling requirements.
(b) A distinction is made between the two concepts of public spending during depression,
namely, the concept of ‘pump priming’ and the concept of 'compensatory spending'.
Pump priming involves a one-shot injection of government expenditure into a
depressed economy with the aim of boosting business confidence and encouraging
larger private investment. It is a temporary fiscal stimulus in order to set off the
multiplier process. The argument is that with a temporary injection of purchasing
power into the economy through a rise in government spending financed by borrowing
rather than taxes, it is possible for government to bring about permanent recovery
from a slump. Pumppriming was widely used by governments in the post-war era in
order to maintain full employment; however, it became discredited later when it failed
to halt rising unemployment and was held responsible for inflation. Compensatory
spending is said to be resorted to when the government spending is deliberately
carried out with the obvious intention to compensate for the deficiency in private
investment.
6. (a) The post-Keynesian economists developed a number of models to provide alternative
explanations to confirm the formulation relating real money balances with real income
and interest rates. Most post-Keynesian theories of demand for money emphasize
the store-of-value or the asset function of money.
Inventory Approach to Transaction Balances
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction
demand for money, known as Inventory Theoretic Approach, in which money or ‘real
cash balance’ was essentially viewed as an inventory held for transaction purposes.
People hold an optimum combination of bonds and cash balance, i.e., an amount that
minimizes the opportunity cost. The optimal average money holding is: a positive
function of income Y, a positive function of the price level P, a positive function of
transactions costs c, and a negative function of the nominal interest rate i.
Friedman's Restatement of the Quantity Theory
Milton Friedman (1956) extending Keynes’ speculative money demand within the
framework of asset price theory holds that demand for money is affected by the same
factors as demand for any other asset, namely, permanent income and relative
returns on assets. The nominal demand for money is positively related to the price
level, P; rises if bonds and stock returns, rb and re, respectively decline and vice versa;
is influenced by inflation; and is a function of total wealth. The Demand for Money as
Behaviour toward as ‘aversion to risk’ propounded by Tobin states that money is a
safe asset but an investor will be willing to exercise a trade-off and sacrifice to some
extent the higher return from bonds for a reduction in risk.

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The Demand for Money as Behaviour towards Risk

According to Tobin, rational behaviour explained induces individuals to hold an
optimally structured wealth portfolio which is comprised of both bonds and money and
the demand for money as a store of wealth depends negatively on the interest rate.
These theories establish a positive relation of demand for money to real income and
an inverse relation to the rate of return on earning assets, i.e. the interest rate.
(b) (i) If wealth-holders consider that the current rate of interest is high compared to
the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise
in bond prices). At the high current rate of interest, people are discouraged from
holding money and hence they will convert their cash balances into bonds
because there is high opportunity cost of holding cash in terms of interest
forgone; as they can earn high rate of return on bonds. Also, there is less chance
of interest rates to rise further resulting in a fall in prices of bonds and
consequent capital losses. They expect fall in the market rate of interest in future
and capital gains resulting from a rise in bond prices. Anticipating such capital
gains from rising bond prices, people will convert their cash into bonds.
The inference from the above is that the speculative demand for money and
interest are inversely related. At higher rates of interest, the speculative
demand for money would be less. The individual would then hold as little
money as possible, only for covering the transactions and precautionary
motives
The individual's demand for money, as a function of the interest rate, would
then be a step function, depicting a discontinuous portfolio decision as shown
in figure below;
Individual’s Speculative Demand for Money

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When the current rate of interest r n is higher than the critical rate of
interest rc, the entire wealth is held by the individual wealth-holder in the
form of bonds. If the rate of interest falls below the critical rate of interest
rc, the individual will hold his entire wealth in the form of speculative cash
balances.
(ii) The effectiveness of an asset as a store of value depends on the degree and
certainty with which the asset maintains its value over time. Money is undeniably
a good store of value; but it is not unique as a store of value. Financial assets
other than money are also performing the function of store of value just as money
has the financial assets have fixed nominal value over time and represent
generalised purchasing power. Any asset, such as equities, bonds, land,
buildings, precious metals, antiques and works of art can all act as store of
value.
7. (a) (i) The money multiplier is a function of the currency ratio set by depositors c, which
depends on the behaviour of the public in respect of holding money. The public
by their decisions in respect of the size of the nominal currency in hand
(designated as the currency ratio) is in a position to influence the amount of the
nominal demand deposits of the commercial banks. When people decide to
hoard to money fearing shortage of money in ATM’s, there is an increase in c
because depositors are converting some of their demand deposits into currency.
Demand deposits undergo multiple expansions while currency does not. Henc e
when demand deposits are being converted into currency, there is a switch from
a component of the money supply that undergoes multiple expansions to one
that does not. The overall level of multiple expansion declines, and therefore,
money multiplier also falls.
(ii) Demand deposits held by people are highly liquid as they can be easily
withdrawn and converted to cash. If people, for any reason, withdraw money
from ATMs with greater frequency, then banks will have to keep more cash
reserves to meet the obligations. This will raise the reserve ratio, and lower the
money multiplier. As a result money supply will decline.
(b) The money multiplier approach to money supply propounded by Milton Friedman and
Anna Schwartz, (1963) considers three factors as immediate determinants of money
supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of deposit to reserve, e = {ER/D} and
(c) the ratio of deposit to currency, c ={C/D}
These three represent the behaviour of the central bank, behaviour of the commerc ial
banks and the behaviour of the general public respectively.
(a) The Behaviour of the Central Bank: The behaviour of the central bank which

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controls the issue of currency is reflected in the supply of the nominal high-
powered money. Money stock is determined by the money multiplier and the
monetary base is controlled by the monetary authority. Given the behaviour of
the public and the commercial banks, the total supply of nominal money in the
economy will vary directly with the supply of the nominal high-powered money
issued by the central bank.
(b) The Behaviour of Commercial Banks: By creating credit, the commercial banks
determine the total amount of nominal demand deposits. The behaviour of the
commercial banks in the economy is reflected in the ratio of their cash reserves
to deposits known as the ‘reserve ratio’. If the required reserve ratio on demand
deposits increases while all the other variables remain the same, more reserves
would be needed. This implies that banks must contract their loans, causing a
decline in deposits and hence in the money supply. If the required reserve ratio
falls, there will be greater multiple expansions of demand deposits because the
same level of reserves can now support more demand deposits and the money
supply will increase. The additional units of high-powered money that goes into
‘excess reserves’ of the commercial banks do not lead to any additional loans,
and therefore, these excess reserves do not lead to the creation of deposits.
When the required reserve ratio falls, there will be greater multiple expansions
for demand deposits. Excess reserves ratio e is negatively related to the market
interest rate i. If interest rate increases, the opportunity cost of holding excess
reserves rises, and the desired ratio of excess reserves to deposits falls.
(c) The Behaviour of the Public: The public, by their decisions in respect of the
amount of nominal currency in hand (how much money they wish to hold as
cash) is in a position to influence the amount of the nominal demand deposits of
the commercial banks. The behaviour of the public influences bank credit
through the decision on ratio of currency to the money supply designated as the
‘currency ratio’.
The time deposit-demand deposit ratio i.e. how much money is kept as time
deposits compared to demand deposits, also has an important implication for
the money multiplier and hence for the money stock in the economy. An increase
in TD/DD ratio means that greater availability of free reserves and consequent
enlargement of volume of multiple deposit expansion and monetary expansion.
Thus the money multiplier approach, the size of the money multiplier is
determined by the required reserve ratio (r) at the central bank, the excess
reserve ratio (e) of commercial banks and the currency ratio (c) of the public.
The lower these ratios are, the larger the money multiplier is. In other words,
the money supply is determined by high powered money (H) and the money
multiplier (m) and varies directly with changes in the monetary base, and
inversely with the currency and reserve ratios. Although these three variables
do not completely explain changes in the nominal money supply, nevertheless

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they serve as useful devices for analysing such changes. Consequently, these
variables are designated as the ‘proximate determinants’ of the nominal money
supply in the economy.
(c) The Statutory Liquidity ratio (SLR) is an instrument of monetary policy and aims to
control liquidity in the domestic market by means of manipulating bank credit.
Changes in the SLR chiefly influence the availability of resources in the banking
system for lending. A rise in the SLR which is resorted to during periods of high
liquidity, tends to lock up a rising fraction of a bank’s assets in the form of eligible
instruments, and this reduces the credit creation capacity of banks. A reduction in
the SLR during periods of economic downturn has the opposite effect. The SLR
requirement also facilitates a captive market for government securities.
Following are the eligible securities of SLR;
(i) Cash
(ii) Gold valued at a price not exceeding the current market price,
or
(iii) Investments in un-encumbered Instruments that include:
(a) Treasury-bills of the Government of India.
(b) Dated securities including those issued by the Government of India from
time to time under the market borrowings programme and the Market
Stabilization Scheme (MSS).
(c) State Development Loans (SDLs) issued by State Governments under their
market borrowings programme.
(d) Other instruments as notified by the RBI.
8. (a) Foreign direct investment takes place when the resident of one country (i.e. home
country) acquires ownership of an asset in another country (i.e. the host country) and
such movement of capital involves ownership, control as well as management of the
asset in the host country. Foreign portfolio investment is the flow of what economists
call ‘financial capital’ rather than ‘real capital’ and does not involve ownership or
control on the part of the investor.
Foreign direct investment (FDI) VS Foreign portfolio investment (FPI)
Foreign direct investment (FDI) Foreign portfolio investment (FPI)
Investment involves creation of Investment is only in financial assets
physical assets
Has a long term interest and Only short term interest and generally
therefore remain invested for long remain invested for short periods
Relatively difficult to withdraw Relatively easy to withdraw

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 30 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018

Not inclined to be speculative Speculative in nature

Often accompanied by technology Not accompanied by technology transfer
transfer
Direct impact on employment of No direct impact on employment of labour
labour and wages and wages
Enduring interest in management No abiding interest in management and
and control control
Securities are held with significant Securities are held purely as a financial
degree of influence by the investor investment and no significant degree of
on the management of the influence on the management of the
enterprise enterprise
(b) Monetary policy instruments are the various direct and indirect instruments or tools
that a central bank can use to influence money market and credit conditions and
pursue its monetary policy objectives. In general, the direct instruments comprise of:
(a) the required cash reserve ratios and liquidity reserve ratios prescribed from time
to time.
(b) directed credit which takes the form of prescribed targets for allocation of credit
to preferred sectors (for e.g. Credit to priority sectors), and
(c) administered interest rates wherein the deposit and lending rates are prescribed
by the central bank.
The indirect instruments mainly consist of:
(a) Repos
(b) Open market operations
(c) Standing facilities, and
(d) Market-based discount window.
9. Non-tariff measures are policy measures other than ordinary customs tariffs that can
potentially have an economic effect on international trade in goods, changing quantities
traded, or prices or both (UNCTAD, 2010). They form a constellation of different types of
policies which alter the conditions of international trade. They are more difficult to quantify
or compare than tariffs. NTMs can be instituted for a range of public policy reasons and
have been negotiated within the General Agreement on Tariffs and Trade and at the World
Trade Organization NTMs are allowed under the WTO’s regulations and are meant to allow
governments to pursue legitimate policy goals even if this can lead to increased trade
costs. For example, NTMs like sanitary and phytosanitary measures and licensing could
be legitimately used by members to ensure consumer health and to protect plant and
animal life and environment.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 31

Depending on their scope and/or design NTMs are categorized as:

(i) Technical Measures: Technical measures refer to product-specific properties such
as characteristics of the product, technical specifications and production processes.
These measures are intended for ensuring product quality, food safety, environmental
protection, national security and protection of animal and plant health.
(ii) Non-technical Measures: Non-technical measures relate to trade requirements; for
example; shipping requirements, custom formalities, trade rules, taxation policies,
etc.
These are further distinguished as:
a. Hard measures (e.g. Price and quantity control measures),
b. Threat measures (e.g. Anti-dumping and safeguards) and
c. Other measures such as trade-related finance and investment measures.
Furthermore, the categorization also distinguishes between:
(i) Import-related measures which relate to measures imposed by the importing country,
and
(ii) Export-related measures which relate to measures imposed by the exporting country
itself.
NTMs are not the same as non-tariff barriers (NTBs). NTMs are sometimes used as means
to circumvent free-trade rules and favour domestic industries at the expense of foreign
competition. In this case they are called non-tariff barriers (NTBs). NTBs are a subset of
NTMs that have a 'protectionist or discriminatory intent' and implies a negative impact on
trade. NTMs only become NTBs when they are more trade restrictive than necessary.
Some examples of NTBs are compulsory standards, often not based on international norms
or genuine science; stringent technical regulations requiring alterations in production
processes, testing regimes which require complex procedures and product approvals
requiring inspection of individual premises. In addition, to these, there are procedural
obstacles (PO) which are practical problems in administration, transportation, delays in
testing, certification etc. that may make it difficult for businesses to adhere to a given
regulation.
10. (a) The WTO addresses the special needs and problems of developing and the least
developed countries in the following ways.
(i) Special and Differential Treatment (S&DT) for these countries is incorporated in
the WTO laws and rules.
(ii) Developing and the least developed countries are generally given longer
implementation time to conform to their obligations for promotion of freer trade.
(iii) They are also given more flexibility in matter of compliance with the WTO and
special privileges and permission to phase out the transition period.

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 32 INTERMEDIATE (NEW) EXAMINATION: NOVEMBER, 2018

(iv) These countries are granted transition periods to make adjustments to the not
so familiar and intricate WTO provisions
(v) Members may violate the principle of MFN to give special market access to
developing countries.
(b) Free trade policy is based on the principle of non-interference by government in
foreign trade. The distinction between domestic trade and international trade
disappears and goods and services are freely imported from and exported to the rest
of the world. Buyers and sellers from separate economies voluntarily trade without
the domestic government helping or hindering movements of goods and services
between countries by applying tariffs, quotas, subsidies or prohibitions on their goods
and services. The theoretical case for free trade is based on Adam Smith’s argument
that the division of labour among countries leads to specialization, greater efficiency,
and higher aggregate production.
(c) The Agreement on Agriculture (AoA) is an international treaty of the World Trade
Organization negotiated during the Uruguay Round. It contains provisions in three
broad areas of agriculture and trade policy: market access, domestic support and
export subsidies. The Agreement aims to:
(i) establish fair and market oriented agricultural trading system, and
(ii) provide for substantial and progressive reduction in agricultural support and
export subsidies with a view to remove distortion in the world market. These are
to be achieved through enhancement of market access, reduction of domestic
support and elimination of export subsidies.
(d) Devaluation is a deliberate downward adjustment in the value of a country's currency
relative to another currency, group of currencies or standard. It is a policy tool used
by countries that have a fixed exchange rate or nearly fixed exchange rate regime
and involves a discrete official reduction in the otherwise fixed par value of a currency.
The monetary authority formally sets a new fixed rate with respect to a foreign
reference currency or currency basket.
Devaluation is primarily an expenditure switching policy. Ceteris paribus, the
weakening of currency can have positive effects on an economy’s trade balance.
Devaluation increases the price of foreign goods relative to goods produced in the
home country and diverts spending from foreign goods to domestic goods.
Devaluation implies that foreigners pay less for the devalued currency and that the
residents of the devaluing country pay more for foreign currencies. By lowering export
prices, devaluation helps increase the international competitiveness of domestic
industries and increases the volume of exports. Devaluation lowers the relative price
of a country’s exports, raises the relative price of its imports, increases demand both
for domestic import-competing goods and for exports, leads to output expansion,
encourages economic activity, increases the international competitiveness of
domestic industries, increases the volume of exports and promotes trade balance.

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