PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE

PART A: FINANCIAL MANAGEMENT

QUESTIONS

Ratio Analysis
1. From the following information, find out missing figures and REWRITE the balance sheet
of Mukesh Enterprise.
Current Ratio = 2:1
Acid Test ratio = 3:2
Reserves and surplus = 20% of equity share capital
Long term debt = 45% of net worth
Stock turnover velocity = 1.5 months
Receivables turnover velocity = 2 months
You may assume closing Receivables as average Receivables.
Gross profit ratio = 20%
Sales is ` 21,00,000 (25% sales are on cash basis and balance on credit basis)
Closing stock is ` 40,000 more than opening stock.
Accumulated depreciation is 1/6 of original cost of fixed assets.
Balance sheet of the company is as follows:
Liabilities (`) Assets (`)
Equity Share Capital ? Fixed Assets (Cost) ?
Reserves & Surplus ? Less: Accumulated. Depreciation ?
Long Term Loans 6,75,000 Fixed Assets (WDV) ?
Bank Overdraft 60,000 Stock ?
Creditors ? Debtors ?
Cash ?
Total ? Total ?
Cost of Capital
2. Amrit Corporation has the following book value capital structure:
Equity Capital (50 lakh shares of ` 10 each). ` 5,00,00000

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 100 INTERMEDIATE EXAMINATION: MAY, 2023

15% Preference share (50,000 shares ` 100 each) ` 50,00,000

Retained earnings ` 4,00,00,000
Debentures 14% (2,50,000 debentures ` 100 each) ` 2,50,00,000
Term loan 13% ` 4,00,00000

The companies last year earnings per share was ` 5, and it maintains a dividend pay-out
ratio of 60% and returns on equity is 10%. The market price per share is ` 20.8. Preference
share redeemable after 10 years is currently selling for ` 90 per share. Debentures
redeemable after 6 years are currently selling for ` 75 per debenture. The income tax rate
is 40%.
(a) CALCULATE the Weighted Average Cost of Capital (WACC) using market value
proportions.
(b) DETERMINE the Marginal Cost of Capital (MACC) if it needs ` 5,00,00000 next year
assuming the amount will be raised by 60% equity, 20% debt and 20% retained
earnings. Equity issues will fetch a net price of ` 14 and cost of debt will be 13%
before tax up to ` 40,00,000 and beyond ` 40,00,000 it will be 15% before tax.
Capital Structure
3. Current Capital Structure of XYZ Ltd is as follows:
Equity Share Capital of 7 lakh shares of face value ` 20 each
Reserves of ` 10,00,000
9% bonds of ` 3,00,00,000
11% preference capital: 3,00,000 shares of face value ` 50 each
Additional Funds required for XYZ Ltd are ` 5,00,00,000.
XYZ Ltd is evaluating the following alternatives:
I. Proposed alternative I: Raise the funds via 25% equity capital and 75% debt at 10%.
PE ratio in such scenario would be 12.
II. Proposed alternative II: Raise the funds via 50% equity capital and rest from 12%
Preference capital .PE ratio in such scenario would be 11.
Any new equity capital would be issued at a face value of ` 20 each. Any new preferential
capital would be issued at a face value of ` 20 each. Tax rate is 34%
DETERMINE the indifference point under both the alternatives.
Leverages
4. The selected financial data for A, B and C companies for the current year ended 31st March
are as follows:

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 PAPER – 8A: FINANCIAL MANAGEMENT 101

Particulars A B C
Variable Expenses as a % of 60 50 40
sales
Interest ` 1,00,000 ` 4,00,000 ` 6,00,000
Degree of Operating Leverage 4:1 3:1 2.5:1
Degree of Financial Leverage 3:1 5:1 2.5:1
Income Tax Rate 30% 30% 30%
(a) PREPARE income statement for A, B and C companies
(b) COMMENT on the financial position and structure of these companies
Investment Decisions
5. Dharma Ltd, an existing profit-making company, is planning to introduce a new product
with a projected life of 8 years. Initial equipment cost will be ` 240 lakhs and additional
equipment costing ` 26 lakhs will be needed at the beginning of third year. At the end of 8
years, the original equipment will have resale value equivalent to the cost of removal, but
the additional equipment would be sold for ` 2 lakhs. Working Capital of ` 25 lakhs will be
needed at the beginning of the operations. The 100% capacity of the plant is of 4,00,000
units per annum, but the production and sales volume expected are as under:
Year Capacity (%)
1 20
2 30
3-5 75
6-8 50
A sale price of ` 100 per unit with a profit volume ratio (contribution/sales) of 60% is likely
to be obtained. Fixed operating cash cost are likely to be ` 16 lakhs per annum. In addition
to this the advertisement expenditure will have to be incurred as under:
Year 1 2 3-5 6-8
Expenditure (` Lakhs each year) 30 15 10 4

The company is subjected to 50% tax rate and consider 12% to be an appropriate cost of
capital. Straight line method of depreciation is followed by the company. ADVISE the
management on the desirability of the project.
Risk analysis in Capital Budgeting
6. Remi limited is a manufacturer of mobile phones in India. Currently the company is
dependent on the foreign supplier for import of the battery. It is considering investment of
` 55,00,000 in a new machine for manufacturing battery of mobile phones. The expected

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life of machine is 5 years and has no scrap value. It is expected that 3 lakhs units will be
produced and sold each year at a selling price of ` 20 per unit. The estimated variable
costs and annual fixed costs will be` 12 per unit and ` 6,00,000 respectively. Consider
14% to be an appropriate cost of capital. Ignore the taxation and depreciation.
CALCULATE the expected net present value of the project.
You are also REQUIRED to measure the sensitivity of the projects NPV to a 10% decrease
in the project variables sale price per unit and sales volume and 10% increase in Fixed
Cost
Dividend Decisions
7. Rambo Limited Has 1,00,000 equity shares outstanding for the year 2022. The current
market price of the shares is ` 100 each. Company is planning to pay dividend of ` 10 per
share. Required rate of return is 15%. Based on Modigliani-Miller approach, calculate the
market price of the share of the company when the recommended dividend is 1) declared
and 2) not declared.
How many new shares are to be issued by the company at the end of the year on the
assumption that net income for the year is ` 40 Lac and the investment budget is
` 50,00,000 when dividend is declared, or dividend is not declared.
PROOF that the market value of the company at the end of the accounting year will remain
same whether dividends are distributed or not distributed.
Management of Receivables
8. River limited currently uses the credit terms of 1.5/15 net 45 days and average collection
period was 30 days. The company presently having sales of ` 50,00,000 and 30%
customers availing the discount. The chances of default are currently 5%. Variable cost
constitutes 65% and total cost constitute 85% of sales. The company is planning
liberalization of credit terms to 2/20 net 50 days. It is expected that sales are likely to
increase by ` 5,00,000, the default chances are 10% and average collection period will
decline to 25 days. There won't be any change in the fixed cost and 50% customers are
expected to avail the discount. Tax rate is 35%.
EVALUATE this policy in comparison with the current policy and recommend whether the
new policy should be implemented. Assume cost of capital to be 10% (post tax) and 360
days in a year.
Management of Working Capital

9. Kalyan limited has provided you the following information for the year 2021-22:
By working at 60% of its capacity the company was able to generate sales of ` 72,00,000.
Direct labour cost per unit amounted to ` 20 per unit. Direct material cost per unit was 40%
of the selling price per unit. Selling price was 3 times the direct labour cost per unit. Profit
margin was 25% on the total cost.

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For the year 2022-23, the company makes the following estimates:
Production and sales will increase to 90% of its capacity. Raw material per unit price will
remain unchanged. Direct expense per unit will increase by 50%. Direct labour per unit will
increase by 10%. Despite the fluctuations in the cost structure, the company wants to
maintain the same profit margin on sales.
Raw materials will be in stock for one month whereas finished goods will remain in stock
for two months. Production cycle is for 2 months. Credit period allowed by suppliers is 2
months. Sales are made to three zones:
Zone Percentage of sale Mode of Credit
A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash Sales
There are no cash purchases and cash balance will be ` 1,11,000
The company plans to apply for a working capital financing from bank for the year 2022 -
23. ESTIMATE Net Working Capital of the Company receivables to be taken on sales and
also COMPUTE the maximum permissible bank finance for the company using 3 criteria of
Tandon Committee Norms. (Assume stock of finished goods to be a core current asset)
Miscellaneous
10. (a) HIGHLIGHT the similarities and differences between Samurai Bond and Bull Dog
Bond.
(b) EXPLAIN the process of Debt Securitisation.

SUGGESTED ANSWERS

1.

Liabilities (`) Assets (`)

Equity Share Capital 12,50,000 Fixed Assets (cost) 20,58,000
Reserves & Surplus 2,50,000 Less: Acc. Depreciation (3,43,000)
Long Term Loans 6,75,000 Fixed Assets (WDV) 17,15,000
Bank Overdraft 60,000 Stock 2,30,000
Payables 4,00,000 Receivables 2,62,500
Cash 4,27,500
Total 26,35,000 Total 26,35,000

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Working Notes:
(i) Sales ` 21,00,000
Less: Gross Profit (20%) ` 4,20,000
Cost of Goods Sold (COGS) ` 16,80,000
Average Receivables
(ii) Receivables Turnover Velocity =  12
Credit Sales
Average Receivables
2=  12
` 21,00,000  75%
` 21,00,000  75%  2
Average Receivables =
12
Average Receivables = ` 2,62,500
Closing Receivables = ` 2,62,500
Average Stock
(iii) Stock Turnover Velocity =  12
COGS
Average Stock
Or 1.5 =  12
` 16,80,000
` 16,80,000  1.5
Or Average Stock =
12
Or Average Stock = ` 2,10,000
Opening Stock + Closing Stock
=` 2, 10, 000
2
Opening Stock + Closing Stock = ` 4,20,000…………………..(1)
Also, Closing Stock-Opening Stock = ` 40,000………………..(2)
Solving (1) and (2), we get closing stock = ` 2,30,000
Current Assets Stock + Receivables + Cash
(iv) Current Ratio= =
Current Liabilities Bank Overdraft + Creditors
` 2,30,000 + ` 2,62,500 + Cash
Or 2 =
` 60,000 + Creditors
Or ` 1,20,000 + 2 Payables = ` 4,92,500 + Cash
Or 2 Payables – Cash.= ` 3,72,500
Or Cash = 2 Payables – ` 3,72,500…………………………..….(3)

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Current Assests - Stock Debtor + Cash

Acid Test Ratio = =
Current Liabilities Current Liabilities
3 ` 2,62,500 + Cash
Or =
2 60,000 + Creditors
Or ` 1,80,000 + 3 Payables = ` 5,25,000 + 2 Cash

Or 3 Payables – 2 Cash = ` 3,45,000 …………………… (4)

Substitute (3) in (4)

Or 3 Payables – 2(2 Payables – ` 3,72,500) = ` 3,45,000

Or 3 Payables – 4 Payables + ` 7,45,000= ` 3,45,000

(Payables) = ` 3,45,000 - ` 7,45,000

Payables = ` 4,00,000
So, Cash = 2 x ` 4,00,000 – ` 3,72,5000
Cash = ` 4,27,500
(v) Long term Debt = 45% of Net Worth
Or ` 6,75,000 = 45% of Net Worth

Net Worth = ` 15,00,000

(vi) Equity Share Capital (ESC) + Reserves = ` 15,00,000
Or ESC + 0.2ESC = ` 15,00,000
Or 1.2 ESC = ` 15,00,000
Equity Share Capital (ESC) = ` 12,50,000
(vii) Reserves = 0.2 x ` 12,50,000
Reserves = ` 2,50,000
(viii) Total of Liabilities=Total of Assets
Or ` 12,50,000 + ` 2,50,000 + ` 6,75,000 +` 60,000 + ` 4,00,000 + Fixes
Assets(FA) (WDV) + ` 2,30,000 + ` 2,62,000 +` 4,27,500
Or ` 26,35,000 = ` 9,20,000 + FA(WDV)

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FA (WDV) =` 17,15,000
Now FA(Cost) – Depreciation = FA(WDV)
Or FA(Cost) – FA(Cost)/6 = ` 17,15,000
Or 5 FA(Cost)/6 = ` 17,15,000

Or FA(Cost) = ` 17,15,000x 6/5

So, FA(Cost) = ` 20,58,000
Depreciation = ` 20,58,000/6 = ` 3,43,000
2. (a) Calculation of Cost of Equity
(i) D0 = ` 5x 60%
D0 = ` 3
g=bxr
= (1-0.6) x 10% = 4%
D1 = D0 x (1 + g)
= 3 x (1 + 4%)
= 3 x 1.04 = 3.12
D1
Ke= +g
P0
3.12
Ke = + 0.04
20.8
Ke = 19%
(ii) Calculation of Cost of Preference Shares
N =10 years
NP = ` 90
PD = ` 15
RV = ` 100
PD + (RV - NP) / N
Kp = x100
(RV + NP )
15 + (100 - 90) / 10
Kp = x100
(100 + 90 ) / 2

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Kp = 16/95 x 100
Kp= 16.84%
(iii) Calculation of Cost of Debentures
N = 6 years
NP = ` 75
Interest = ` 14
RV = ` 100
T = 40%
int (1 - t) + (RV - NP) / N
Kd = x 100
(RV + NP ) / 2
14 x (1 - 0.4) + (100 - 75) / 6
Kd = x 100
(100 + 75) / 2
8.4 - 4.17
Kd = x 100
87.5
Kd=14.37%
(iv) Cost of Term Loan
Kd = Interest rate (1-t)
Kd = 13% (1-40%)
Kd = 7.8%
Calculation of Weighted Average Cost of Capital (WACC) (using market
weights)
Capital Cost of Market Value Market Product
Capital Value (Cost x
Weights weights)
Equity 19.00% 20.8 x 50,00,000 `10,40,00,000 0.6218 11.81%
Preference Shares 16.84% 90 x 50,000 ` 45,00,000 0.0269 0.45%
Debentures 14.37% 75 x 2,50,000 ` 1,87,50,000 0.1121 1.61%
Term Loan 7.80% ` 4,00,00,000 0.2392 1.87%
Total `16,72,50,000 1 15.74%

WACC= 15.74%

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(b) Calculation of Marginal Cost of Capital (MACC)

The required capital of ` 50,000,000 will be raised as follows:
Equity = 60% of ` 50,000,000 = ` 30,000,000
Deby = 20% of ` 50,000,000 = `10,000,000
Retained Earnings= 20% of ` 50,000,000 = ` 10,000,000
3.12
Marginal Cost of Equity = + 0.04
1.4
= 26.28%
Marginal Cost of Debt
13% of ` 40,00,000 + 15% of ` 60,00,000
Cost of Debt (before tax) =
` 1,00,00,000
` 5,20,000 + ` 9,00,000
= = 14.2%
` 1,00,00,000

Cost of Debt (after tax). = 14.2% (1-t)

= 14.2% (1-0.4)
= 8.52%
Calculation of marginal cost of capital
Capital Cost of Value Weights Product (Cost
Capital x weights)
Equity 26.28% ` 3,00,00,000 0.6 15.77%
Reserves 26.28% ` 1,00,00,000 0.2 5.26%
Debt 8.52% ` 1,00,00,000 0.2 1.70%
Total ` 5,00,00,000 1 22.73%
Marginal Cost of Capital (MACC) = 22.73%
3.

Current Capital Structure

Equity Share Capital ` 20 x 7 lakhs ` 1,40,00,000
Reserves ` 10,00,000
9% Bonds ` 3,00,00,000
11% Preference Share Capital ` 50 x 3 lakhs ` 1,50,00,000
Total Capital Employed ` 6,00,00,000

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Proposed Capital Structure

Capital Working Proposal I Proposal II
Capital to be raised `5,00,00,000 `5,00,00,000
Equity 50000000 x 25% ` 1,25,00,000 -
50000000 x 50% - ` 2,50,00,000
Debt @ 10% 50000000 x 75% ` 3,75,00,000 -
Preference Shares @ 50000000 x 50% - ` 2,50,00,000
12%
Combined Capital Amount Amount
(proposal 1) (proposal 2)
Equity ` 2,65,00,000 ` 3,90,00,000
Reserves ` 10,00,000 ` 10,00,000
9% Bond ` 3,00,00,000 ` 3,00,00,000
10% Debt ` 3,75,00,000 -
11% Preference Shares ` 1,50,00,000 ` 1,50,00,000
12% Preference Shares - ` 2,50,00,000
` 11,00,00,000 ` 11,00,00,000

Interest for Proposal I = ` 3,00,00,000 x 9% + ` 3,75,00,000 x 10%

= ` 27,00,000 + ` 37,50,000
= ` 64,50,000
Preference Dividend for Proposal I = ` 1,50,00,000 x 11% = ` 16,50,000
Interest for Proposal II = ` 3,00,00,000 x 9% = ` 27,00,000
Preference Dividend for Proposal II = ` 1,50,00,000 x 11% + ` 2,50,00,000 x 12%
= ` 16,50,000 + ` 30,00,000 = ` 46,50,000
Let the indifference point be ` X
For Proposal I,

EPS =
( X - ` 64,50,000) x 0.66 - ` 16,50,000 (1)
13,25,000
For Proposal II,

EPS =
(X - ` 27,00,000 ) x 0.66 - ` 46,50,000
(2)
19,50,000
Equating (1) and (2),

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EPS =
( X - ` 64,50,000 ) x 0.66 - ` 16,50,000 = ( X - ` 27,00,000 ) x 0.66 - ` 46,50,000
13,25,000 19,50,000
0.66 X ` 42,57,000 - ` 16,50,000 0.66X - ` 17,82,000 - ` 46,50,000
=
1,325 1,950

0.66X - ` 59,07,000 0.66X - ` 64,32,000

……… =
53 78
51.48X – ` 46,07,46,000 = 37.98X - `34,08,96,000
16.5X = ` 11,98,50,000
Indifference Point = X = ` 72,63,636.36
4. Income Statement of companies A, B and C
Particulars A B C
Sales `15,00,000 `30,00,000 `41,66,667
Less: Variable Expenses `9,00,000 `15,00,000 `16,66,667
Contribution `6,00,000 `15,00,000 `25,00,000
Less: Fixed Cost `4,50,000 `10,00,000 `15,00,000
EBIT `1,50,000 `5,00,000 `10,00,000
Less: Interest `1,00,000 `4,00,000 `6,00,000
PBT `50,000 `1,00,000 `4,00,000
Less: Tax @ 30% `15,000 `30,000 `1,20,000
PAT `35,000 `70,000 `2,80,000
Working Notes:
EBIT
(i) Degree of Financial Leverage =
EBIT - Interest
DFL x (EBIT – Int) = EBIT
DFL x EBIT – Int x DFL= EBIT
DFL x EBIT – EBIT =Int x DFL
EBIT(DFL – 1) = Int x DFL
int x DFL
EBIT =
DFL - 1

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For A,
` 1,00,000 x 3
EBITA =
3-1
EBITA = `150000
For B
` 4,00,000 x 5
EBITB =
5-1
EBITB = `500000
For C
` 6,00,000 x 2.5
EBITc =
2.5 - 1
EBITc =10,00,000
Contribution
(ii) DOL=
EBIT
Contribution = DOL x EBIT
Contribution A = 4 x `1,50,000
Contribution A = `6,00,000
Contribution B = 3 x `5,00,000
Contribution B = `15,00,000
Contribution C = 2.5 x `10,00,000
Contribution C = `25,00,000
(iii) Fixed Cost = Contribution – EBIT
Fixed Cost A= `6,00,000 – `1,50,000 = `4,50,000
Fixed Cost B =`15,00,000 – `5,00,000 = `10,00,000
Fixed Cost C = `25,00,000 – `10,00,000 = `15,00,000
(iv) Contribution= Sales – VC
VC= Sales – Contribution
Sales x VC Ratio= Sales – Contribution
Contribution= Sales – Sales x VC Ratio
Contribution=Sales(1-VCR)

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Contribution
Sales =
1- VCR
Sales A = `6,00,000/(1-0.6) = `15,00,000
Sales B = `15,00,000/(1-0.5) = `30,00,000
Sales C = `25,00,000/(1-0.4) = `41,66,667
Of all the companies, A has the highest degree of Operating Leverage, B has highest
degree of Financial Leverage and C is equally leveraged on both Operating and
Financial fronts. If we consider combined leverage companies will have the leverages
of 12, 15 and 6.25 (by multiplying both operating and financial leverages). This means
A is undertaking a higher degree of operating risk while B is undertaking a higher
degree of financial risk.
5. Calculation of Cash Flow After tax

Year 1 2 3 to 5 6 to 8
A Capacity 20% 30% 75% 50%
B Units 80000 120000 300000 200000
C Contribution p.u. `60 `60 `60 `60
D Contribution `48,00,000 `72,00,000 `1,80,00,000 `1,20,00,000
E Fixed Cash Cost `16,00,000 `16,00,000 `16,00,000 `16,00,000
Depreciation
F Original Equipment `30,00,000 `30,00,000 `30,00,000 `30,00,000
(`240Lakhs/8)
G Additional Equipment -- -- `4,00,000 `4,00,000
(`24Lakhs/6)
H Advertisement `30,00,000 `15,00,000 `10,00,000 `4,00,000
Expenditure
I Profit Before Tax (D- ` (28,00,000) `11,00,000 `1,20,00,000 `66,00,000
E-F-G-H)
J Tax savings/ `14,00,000 ` (5,50,000) ` (60,00,000) ` (33,00,000)
(expenditure)
K Profit After Tax ` (14,00,000) `5,50,000 `60,00,000 `33,00,000
L Add: Depreciation `30,00,000 `30,00,000 `34,00,000 `34,00,000
(F+G)
M Cash Flow After Tax `16,00,000 `35,50,000 `94,00,000 `67,00,000
Calculation of NPV
Year Particulars Cash Flows PV factor PV
0 Initial Investment ` (2,40,00,000) 1.000 ` (2,40,00,000)

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0 Working Capital Introduced ` (25,00,000) 1.000 ` (25,00,000)

1 CFAT `16,00,000 0.893 ` 14,28,800
2 CFAT ` 35,50,000 0.797 ` 28,29,350
2 Additional Equipment ` (26,00,000) 0.797 ` (20,72,200)
3 CFAT ` 94,00,000 0.712 ` 66,92,800
4 CFAT ` 94,00,000 0.636 ` 59,78,400
5 CFAT ` 94,00,000 0.567 ` 53,29,800
6 CFAT ` 67,00,000 0.507 ` 33,96,900
7 CFAT ` 67,00,000 0.452 ` 30,28,400
8 CFAT ` 67,00,000 0.404 ` 27,06,800
8 WC Released ` 25,00,000 0.404 ` 10,10,000
8 Salvage Value ` 2,00,000 0.404 ` 80,800
Net Present Value `39,09,850

Since the NPV is positive, the proposed project should be implemented.

6. Calculation of NPV and sensitivity for different scenarios

Original Sale Price Sales Volume Fixed Cost

Scenario reduced by reduced by increased
10% 10% by 10%
Units 300000 300000 270000 300000
Sale Price p.u. `20 `18 `20 `20
VC p.u. `12 `12 `12 `12
Contribution p.u. `8 `6 `8 `8
Contribution `24,00,000 `18,00,000 `21,60,000 `24,00,000
Less: Fixed Cost `6,00,000 `6,00,000 `6,00,000 `6,60,000
Profit/Cash Flows `18,00,000 `12,00,000 `15,60,000 `17,40,000
PVAF (14%, 5 3.4331 3.4331 3.4331 3.4331
years)
PV of Cash Inflows `61,79,546 `41,19,697 `53,55,606 `59,73,561
Less: Initial ` (55,00,000) ` (55,00,000) ` (55,00,000) ` (55,00,000)
Investment
NPV `6,79,546 ` (13,80,303) ` (1,44,394) `4,73,561
% Change in NPV NA (303.12%) (121.25%) (30.31%)
Sensitivity NA 30.3121 12.1249 3.0312
times times times

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Sales Price is the most sensitive variable of all and needs to be given due attention during
the life of the project.
7. CASE 1: Value of the firm when dividends are not paid.
Step 1: Calculate price at the end of the period
Ke = 15%, P₀ = `100, D₁ = 0
P1 + D1
Pₒ =
1 + Ke
P1 + 0
`100 =
1 + 0.15
P₁ = `115
Step 2: Calculation of funds required for investment
Earning ` 40,00,000
Dividend distributed Nil
Fund available for investment ` 40,00,000
Total Investment ` 50,00,000
Balance Funds required ` 50,00,000 - ` 40,00,000 = ` 10,00,000
Step 3: Calculation of No. of shares required to be issued for balance funds
No. of shares = Funds required/P 1
∆n = `10,00,000/`115
Step 4: Calculation of value of firm
nPₒ = [(n+∆n)P1-I+E]/(1+Ke)
nP₀ = [(100000+1000000/`115) `115 - `5000000 + `4000000]/(1.15)
= `1,00,00,000
CASE 2: Value of the firm when dividends are paid.
Step 1: Calculate price at the end of the period
Ke= 15%, P₀= `100, D₁= `10
P1 + D1
Pₒ =
1+ K e
P1 + 10
`100 =
1 + 0.15
P₁ = `105

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 PAPER – 8A: FINANCIAL MANAGEMENT 115

Step 2: Calculation of funds required for investment

Earning ` 40,00,000
Dividend distributed 10,00,000
Fund available for investment ` 30,00,000
Total Investment ` 50,00,000
Balance Funds required ` 50,00,000 - ` 30,00,000 = ` 20,00,000
Step 3: Calculation of No. of shares required to be issued for balance fund
No. of shares = Funds Required/P1
∆n = `2000000/`105
Step 4: Calculation of value of firm
nPₒ = [(n+∆n)P1 – I+E]/(1+Ke)
nP₀ = [(100000 + 2000000/`105) `105 – `5000000 + `4000000]/(1.15)= `1,00,00,000
Thus, it can be seen from the above calculations that the value of the firm remains
the same in either case.
8. Evaluation of Credit Policies

Particulars 1.5/15 net 45 2/20 net 50

A Sales `50,00,000 `55,00,000
B Variable Cost (65%) `32,50,000 `35,75,000
C Fixed Cost (20% in 1st Case) `10,00,000 `10,00,000
D Bad Debts (5% and 10%) `2,50,000 `5,50,000
E Discounts
(`5000000x30%x1.5%) `22,500 -
(`5500000x50%x2%) - `55,000
F PBT (A-B-C-D-E) `4,77,500 `3,20,000
G Tax @ 35% `1,67,125 `1,12,000
H PAT `3,10,375 `2,08,000
I Opportunity Cost
(`3250000 + `1000000) x 30/360x10% `35,417 -
(`3575000 + `1000000) x 25/360 x 10% - `31,771
J Net Benefit `2,74,958 `1,76,229
The new policy leads to lower net benefit for the company. Hence it should not be
implemented.

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9. Cost Structure
2021-22 2022-23
Particulars Calculations P.U. Amount Calculations P.U. Amount
(p.u. X units) (p.u. X units)
Direct 40% of SP `24 `28,80,000 Same as PY `24 `43,20,000
Material
Direct Given `20 `24,00,000 20*1.1 `22 `39,60,000
labour
Direct bal. fig. `4 `4,80,000 4*1.5 `6 `10,80,000
Expenses
Total Cost SP - Profit `48 `57,60,000 `52 `93,60,000
Profit (SP/125x25) `12 `14,40,000 52*25% `13 `23,40,000
Sales 3 x Direct `60 `72,00,000 `65 `1,17,00,000
Labour p.u.
*units= `72,00,000 / `60 =1,20,000 1,20,000/60 x
90=1,80,000

Operating Cycle

Raw material holding period 1 month

Finished Goods holding period 2 months
WIP conversion period 2 months
Creditor Payment Period 2 months
Receivables Collection Period 2/3 months

Estimation of Working Capital

Particulars Calculation Amount
Current Assets
Stock of Raw Material 43,20,000 x 1/12 `3,60,000
Stock of WIP
RM cost `43,20,000
Labour cost `19,80,000
Direct Exp cost `5,40,000
Total WIP Cost `68,40,000
Stock of WIP 68,40,000 x 2/12 `11,40,000
Stock of Finished Goods 93,60,000 x 2/12 `15,60,000
Receivables (on sales)

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 PAPER – 8A: FINANCIAL MANAGEMENT 117

A 1,17,00,000 x 50% x 2/12 `9,75,000

B 1,17,00,000 x 30% x 3/12 `8,77,500
C NIL -
Cash Balance Given `1,11,000
Total Current Assets ` 50,23,500
Current Liabilities
Payables *`44,40,000 x 2/12 `7,40,000
Net Working Capital ` 42,83,500
Opening RM stock = 28,80,000 x 1/12= `2,40,000
* RM purchased = RM consumed – Opening Stock + Closing Stock
= `43,20,000 – `2,40,000 + `3,60,000
= `44,40,000
Computation of Maximum Permissible Bank Finance
Method Formula Calculation `
I 75% x (Current Assets- 75% x (`50,23,500 - `7,40,000) `32,12,625
Current Liabilities)
II 75% x Current Assets- 75% x `50,23,500 - `7,40,000 `30,27,625
Current Liabilities
III 75% x (Current Assets-Core 75% x (`50,23,500- `15,60,000) - `18,57,625
CA)- Current Liabilities `7,40,000

10. (a)
Samurai Bond • Samurai bonds are denominated in Japanese Yen JPY
• Issued in Tokyo
• Issuer Non- Japanese Company
• Regulations: Japanese
• Purpose: Access of capital available in Japanese
market
• Issue proceeds can be used to fund Japanese
operation
• Issue proceeds can be used to fund a company’s local
opportunities.
• It can also be used to hedge foreign exchange risk
Bulldog Bond • It is denominated in Bulldog Pound Sterling/Great
Britain Pound (GBP)

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 118 INTERMEDIATE EXAMINATION: MAY, 2023

• Issued in London
• Issuer Non- UK Company
• Regulations: Great Britain
• Purpose: Access of capital available in UK market
• Issue proceeds can be used to fund UK operation
• Issue proceeds can be used to fund a company’s local
opportunities
(b) Securitisation is a process in which illiquid assets are pooled into marketable
securities that can be sold to investors. The process leads to the creation of financial
instruments that represent ownership interest in, or are secured by a segregated
income producing asset or pool of assets. These assets are generally secured by
personal or real property such as automobiles, real estate, or equipment loans but in
some cases are unsecured.
Example of Debt Securitisation:
A finance company has given a large number of car loans. It needs more money so
that it is in a position to give more loans. One way to achieve this is to sell all the
existing loans. But, in the absence of a liquid secondary market for individual car
loans, this is not feasible.
However, a practical option is debt securitisation, in which the finance company sells
its existing car loans already given to borrowers to the Special Purpose Vehicle
(SPV). The SPV, in return pays to the company, which in turn continue to lend with
this money. On the other hand, the SPV pools these loans and convert these into
marketable securities. It means that now these converted securities can be issued to
investors.
So, this process of debt securitization helps the finance company to raise funds and
get the loans off its Balance Sheet. These funds also help the company disburse
further loans. Similarly, the process is beneficial to the investors also as it creates a
liquid investment in a diversified pool of car loans, which may be an attractive option
to other fixed income instruments. The whole process is carried out i n such a way
that the original Receivables i.e. the car loan borrowers may not be aware of the
transaction. They might have continued making payments the way they are already
doing. However, these payments shall now be made to the new investors who have
emerged out of this securitization process.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 119

SECTION: B: ECONOMICS FOR FINANCE

QUESTIONS
1. (a) What is the significance of Intermediate Good?
(b) What are the allocation instruments by which government can influence resource
allocation in the economy?
(c) Calculate the Depreciation from the following data?
` in Cr.
GDP at Market Price (GDP MP) 850000
Net Factor Income from abroad -250
Aggregate amount of Indirect taxes 560
Subsidies 50
National Income (NNP FC) 750000
2. (a) Describe the relevance of Circular Flow of Income in the Measurement of National
Income.
(b) What is lemon Problem in Market Failure?
(c) Calculate National Income by Expenditure Method and Income Method with the help
of following data:
Items ` In Crores
Compensation of employees 1000
Net factor income from Abroad 10
Net indirect taxes 150
Profit 900
Private final consumption expenditure 4,000
Net domestic capital formation 550
Consumption of fixed capital 120
Rent 600
Interest 720
Mixed income of self-employed 800
Net export 40
Govt. final consumption expenditure 1000
Operating surplus 160

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 120 INTERMEDIATE EXAMINATION: MAY, 2023

Employer’s contribution to social security scheme 400

3. (a) How Public Debt is used as an Instrument of Fiscal Policy?
(b) What is Compensatory Spending?
(c) What are the Important Feature of Heckscher Ohlin Theory of International Trade?
(d) What is the Rationale of the Stabilization Function of the Government?
4. (a) Do you think if the developing Countries engage in liberal trade will be at
disadvantage?
(b) Explain the difference between the Classical and Keynesian theory of International
Trade?
(c) What is the motive for Speculative demand for money?
(d) What is Market Stabilisation Scheme?
5. (a) What are the effect of Tariff on an Imported Product?
(b) What are the determinant of money supply?
(c) What is CRR and its impact on Money Supply?
(d) Elaborate on the Export Related Measure in International Trade?
OR
What is Open market Operation?

ANSWERS

1. (a) Intermediate goods refer to those goods which are used either for resale or for
further production in the same year. They do not end up in final consumption and
are not capital goods either. The intermediate goods or services may be either
transformed or used up by the production process. They have derived demand.
Intermediate goods are used up in the same year; if they remain for more than one
year, then they are treated as final goods. Intermediate consumption consists of the
value of the goods and services consumed as inputs by a process of production,
excluding fixed assets whose consumption is recorded as consumption of fixed
capital. Intermediate goods used to produce other goods rather than being sold to
final purchasers are not counted as it would involve double counting.
(b) A variety of allocation instruments are available by which governments can
influence resource allocation in the economy. For example,
• government may directly produce an economic good
• government may influence private allocation through incentives and
disincentives

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 121

• government may influence allocation through its competition policies, merger

policies etc. which affect the structure of industry and
• governments’ regulatory activities such as licensing, controls, minimum wages,
and directives on location of industry influence resource allocation.
• government sets legal and administrative frameworks, and
• any mixture of intermediate methods may be adopted by governments
(c) GDPMP = NNPFC - NFIA + NIT +Depreciation
850000 = 750000- (-250) + (560-50) + Depreciation
850000 = 750000 + 250 + 510 + Depreciation
850000 = 750760 + Depreciation
Depreciation = 850000 – 750760
= ` 99240 cr
2. (a) Circular flow of income refers to the continuous circulation of production, income
generation and expenditure involving different sectors of the economy.
(i) In the production phase, firms produce goods and services with the help of
factor services.
(ii) In the income or distribution phase, the flow of factor incomes in the form of
rent, wages, interest and profits from firms to the households occurs
(iii) In the expenditure or disposition phase, the income received by different
factors of production is spent on consumption goods and services and
investment goods. This expenditure leads to further production of goods and
services and sustains the circular flow.
(b) When dealing with problems of asymmetric information, the most frequently cit ed
and studied example in Economics is the one developed by George Akerlof in
relation to the used car market, which distinguishes cars classified as good from
those defined as “lemons” (poor quality vehicles). The owner of a car knows much
more about its quality than anyone else. While placing it for sale, he may not
disclose all that he knows about the mechanical defects of the vehicle. Based on
the probability that the car on sale is a ‘lemon’, the buyers’ willingness to pay for
any particular car will be based on the ‘average quality’ of used cars. Not knowing
the honesty of the seller means, the price offered for the vehicle is likely to be less
than that of a good car, to account for this risk. However, anyone who sells a
‘lemon’ (an unusually poor car) stands to gain.
(c) By Expenditure method
GDPMP = Private final consumption expenditure + Government final

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 122 INTERMEDIATE EXAMINATION: MAY, 2023

consumption expenditure + Gross domestic capital

formation (Net domestic capital formation+ depreciation) +
Net export
= 4000 + 1000 + (550+ 120) + 40= 5710 cr

NNPFC or NI = GDPMP- depreciation + NFIA – NIT

= 5710 – 120 + 10 – 150= 5450 cr

By Income method
NNPFC or NI = Compensation of employees+ Operating Surplus+ Mixed
income of self-employed + NFIA
= 1000+ 160+ 800+ 10= 1970 cr
3. (a) A rational policy of public borrowing and debt repayment is a potent weapon to fight
inflation and deflation. In the case of market loans, the government issues treasury
bills and government securities of varying denominations and duration which are
traded in debt markets. For financing capital projects, long-term capital bonds are
floated and for meeting short-term government expenditure, treasury bills are
issued.
The small savings represent public borrowings, which are not negotiable and are
not bought and sold in the market. In India, various types of schemes are introduced
for mobilising small savings e.g., National Savings Certificates, National
Development Certificates, etc. Borrowing from the public through the sale of bonds
and securities curtails the aggregate demand in the economy. Repayments of debt
by governments increase the availability of money in the economy and increase
aggregate demand.
(b) 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.
(c) The Heckscher-Ohlin theory of trade states that comparative advantage in cost of
production is explained exclusively by the differences in factor endowments of the
nations. In a general sense of the term, ‘factor endowment’ refers to the overall
availability of usable resources including both natural and man-made means of
production. Nevertheless, in the exposition of the modern theory, only the two most
important factors—labour and capital—are taken into account.
The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize
in the export of a commodity whose production requires intensive use of its
abundant resources and imports a commodity whose production requires intensive
use of its scarce resources.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 123

(d) Stabilization function is one of the key functions of fiscal policy and aims at
eliminating macroeconomic fluctuations arising from suboptimal allocation. The
stabilization function is concerned with the performance of the aggregate economy
in terms of labour employment and capital utilization, overall output and income,
general price levels, economic growth, and balance of international payments.
4. (a) International trade is often not equally beneficial to all nations. Potential unequal
market access and disregard for the principles of fair-trading system may even
amplify the differences between trading countries, especially if they differ in their
wealth. Economic exploitation is a likely outcome when underprivileged countries
become vulnerable to the growing political power of corporations operating globally. The
domestic entities can be easily outperformed by financially stronger transnational
companies.
Risky dependence of underdeveloped countries on foreign nations impairs
economic autonomy and endangers their political sovereignty. Such reliance often
leads to widespread exploitation and loss of cultural identity. Substantial
dependence may also have severe adverse consequences in times of wars and
other political disturbances.
(b) The classical economists maintained that the economy is self‐regulating and is always
capable of automatically achieving equilibrium at the ‘natural level’ of real GDP or
output, which is the level of real GDP that is obtained when the economy's
resources are fully employed. While circumstances arise from time to time that
cause the economy to fall below or to exceed the natural level of real GDP, wage
and price flexibility will bring the economy back to the natural level of real GDP. If
an excess in the labour force (unemployment) or products exist, the wage or price of
these will adjust to absorb the excess. According to them, there will be no
involuntary unemployment.
Keynes argued that markets would not automatically lead to full-employment
equilibrium and the resulting natural level of real GDP. The economy could settle in
equilibrium at any level of unemployment. Keynesians believe that prices and
wages are not so flexible; they are sticky, especially downward. The stickiness of
prices and wages in the downward direction prevents the economy's resources from
being fully employed and thereby prevents the economy from returning to the
natural level of real GDP. Therefore, output will remain at less than the full
employment level as long as there is insufficient spending in the economy. This was
precisely what was happening during the great depression.
(c) The speculative motive reflects people’s desire to hold cash in order to be equipped
to exploit any attractive investment opportunity requiring cash expenditure.
According to Keynes, people demand to hold money balances to take advantage of
the future changes in the rate of interest, which is the same as future changes in
bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the

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 124 INTERMEDIATE EXAMINATION: MAY, 2023

return on bonds. Keynes assumed that that the expected return on money is zero,
while the expected returns on bonds are of two types, namely:
(i) the interest payment
(ii) the expected rate of capital gain.
(d) This instrument for monetary management was introduced in 2004 following a MoU
between the Reserve Bank of India (RBI) and the Government of India (GoI) with
the primary aim of aiding the sterilization operations of the RBI. (Sterilization is the
process by which the monetary authority sterilizes the effects of significant. foreign
capital inflows on domestic liquidity by off-loading parts of the stock of government
securities held by it). Surplus liquidity of a more enduring nature arising from large
capital inflows is absorbed through sale of short-dated government securities and
treasury bills. Under this scheme, the Government of India borrows from the RBI
(such borrowing being additional to its normal borrowing requirements) and issues
treasury-bills/dated securities for absorbing excess liquidity from the market arising
from large capital inflows.
5. (a) Tariffs encourage consumption and production of the domestically produced import
substitutes and thus protect domestic industries. By making imported goods more
expensive, tariffs discourage domestic consumers from consuming imported foreign
goods. Domestic consumers suffer a loss in consumer surplus because they must
now pay a higher price for the good and also because compared to free trade
quantity, they now consume lesser quantity of the good.
Tariffs encourage consumption and production of the domestically produced import
substitutes and thus protect domestic industries.
(b) There are two alternate theories in respect of determination of money supply.
According to the first view, money supply is determined exogenously by the central
bank. The second view holds that the money supply is determined endogenously by
changes in the economic activities which affect people’s desire to hold currency
relative to deposits, rate of interest, etc. The current practice is to explain the
determinants of money supply based on ‘money multiplier approach’ which focuses
on the relation between the money stock and money supply in terms of the
monetary base or high-powered money. The monetary base is the sum of currency
in circulation and bank reserves. This approach holds that total supply of nominal
money in the economy is determined by the joint behavior of the central bank, the
commercial banks and the public.
(c) Cash Reserve Ratio (CRR)refers to the fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should maintain
as cash deposit with the Reserve Bank. Higher the CRR, lower the credit creation
capacity of banks. Reduce CRR during deflation- - banks to expand credit and

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increase the supply of money available in the economy- increase the CRR to
contain credit expansion during – inflation.
(d) The Export Related measure in international trade is as under :
Ban on exports: Export-related measures refer to all measures applied by the
government of the exporting country including both technical and non- technical
measures. For example, during periods of shortages, export of agricultural products
such as onion, wheat etc. may be prohibited to make them available for domestic
consumption.
Export Taxes: The effect of an export tax is to raise the price of the good and to
decrease exports. Since an export tax reduces exports and increases domestic
supply, it also reduces domestic prices and leads to higher domestic consumption.
Export Subsidies and Incentives: Tariffs on imports hurt exports and therefore
countries have developed compensatory measures of different types for exporters
like export subsidies, duty drawback, duty-free access to imported intermediates
etc.
Voluntary Export Restraints: Voluntary Export Restraints (VERs) refer to a type of
informal quota administered by an exporting country voluntarily restraining the
quantity of goods that can be exported out of that country during a specified period
of time.
OR
Open Market Operations (OMO) is a general term used for market operations
conducted by the Reserve Bank of India by way of sale/ purchase of Government
securities to/ from the market with an objective to adjust the rupee liquidity
conditions in the market on a durable basis.

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