PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE

PART A: FINANCIAL MANAGEMENT

QUESTIONS
Ratio Analysis
1. FM Ltd. is in a competitive market where every company offers credit. To maintain the
competition, FM Ltd. sold all its goods on credit and simultaneously received the goods on
credit. The company provides the following information relating to current financial year:
Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio (on Cost of Goods Sold) 1.5
Fixed Assets turnover Ratio (on Cost of Goods Sold) 4
Gross Profit Ratio 25%
Bills Receivables ` 75,000
Bills Payables ` 30,000
Gross Profit ` 12,00,000
FM Ltd. has the tendency of maintaining extra stock of ` 30,000 at the end of the period
than that at the beginning.
DETERMINE:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Closing Stock
(iv) Sundry Creditors
(v) Fixed Assets
Cost of Capital
2. The information relating to book value (BV) and market value (MV) weights of Ex Limited
is given below:
Sources Book Value (`) Market Value (`)
Equity shares 2,40,00,000 4,00,00,000
Retained earnings 60,00,000 -
Preference shares 72,00,000 67,50,000
Debentures 18,00,000 20,80,000

© The Institute of Chartered Accountants of India

 2 INTERMEDIATE EXAMINATION: MAY, 2022

Additional information:
I. Equity shares are quoted at ` 130 per share and a new issue priced at ` 125 per
share will be fully subscribed; flotation costs will be ` 5 per share on face value.
II. During the previous 5 years, dividends have steadily increased from ` 10 to ` 16.105
per share. Dividend at the end of the current year is expected to be ` 17.716 per
share.
III. 15% Preference shares with face value of ` 100 would realise ` 105 per share.
IV. The company proposes to issue 11-year 15% debentures but the yield on debentures
of similar maturity and risk class is 16%; flotation cost is 2% on face value.
V. Corporate tax rate is 30%.
You are required to DETERMINE the weighted average cost of capital of Ex Limited using
both the weights.
Capital Structure
3. The following data relates to two companies belonging to the same risk class:
Particulars Bee Ltd. Cee Ltd.
12% Debt ` 27,00,000 -
Equity Capitalization Rate - 18
Expected Net Operating Income ` 9,00,000 ` 9,00,000
You are required to:
(a) DETERMINE the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming no taxes as per M.M. Approach.
(b) DETERMINE the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming 40% taxes as per M.M. Approach.
Leverage
4. Company P and Q are having same earnings before tax. However, the margin of safety of
Company P is 0.20 and, for Company Q, is 1.25 times than that of Company P. The interest
expense of Company P is ` 1,50,000 and, for Company Q, is 1/3 rd less than that of
Company P. Further, the financial leverage of Company P is 4 and, for Company Q, is 75%
of Company P.
Other information is given as below:
Particulars Company P Company Q
Profit volume ratio 25% 33.33%
Tax rate 45% 45%
You are required to PREPARE Income Statement for both the companies.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 3

Investment Decisions
5. ABC & Co. is considering whether to replace an existing machine or to spend money on
revamping it. ABC & Co. currently pays no taxes. The replacement machine costs
` 18,00,000 now and requires maintenance of ` 2,00,000 at the end of every year for eight
years. At the end of eight years, it would have a salvage value of ` 4,00,000 and would be
sold. The existing machine requires increasing amounts of maintenance each year and its
salvage value fall each year as follows:
Year Maintenance (`) Salvage (`)
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0
The opportunity cost of capital for ABC & Co. is 15%.
REQUIRED:
When should the company replace the machine?
The following present value table is given for you:

Present value of ` 1 at
Year
15% discount rate
1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
6 0.4323
7 0.3759
8 0.3269
Risk Analysis in Capital Budgeting
6. ASG Ltd. is considering a project “Z” with an initial outlay of ` 15,00,000 and life of 5 years.
The estimates of project are as follows:
Lower Estimates Base Upper Estimates
Sales (units) 9,000 10,000 11,000
(`) (`) (`)
Selling Price p.u. 175 200 225

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 4 INTERMEDIATE EXAMINATION: MAY, 2022

Variable cost p.u. 100 125 150

Fixed Cost 1,00,000 1,50,000 2,00,000
Depreciation included in Fixed cost is ` 70,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst, base
and best case scenario.
PV factor for 5 years at 15% are as follows:
Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497

Dividend Decision
7. The following figures have been collected from the annual report of ABC Ltd. for the current
financial year:
Net Profit ` 75 lakhs
Outstanding 12% preference shares ` 250 lakhs
No. of equity shares 7.50 lakhs
Return on Investment 20%
Cost of capital i.e. (K e) 16%
(a) COMPUTE the approximate dividend pay-out ratio so as to keep the share price at
` 42 by using Walter’s model?
(b) DETERMINE the optimum dividend pay-out ratio and the price of the share at such
pay-out.
(c) PROVE that the dividend pay-out ratio as determined above in (b) is optimum by using
random pay-out ratio.
Management of Cash
8. You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
(`) (`) (`) (`)
To Opening stock 32,00,000 40,00,000 By Sales 3,20,00,000 4,00,00,000
To Raw materials 1,20,00,000 1,60,00,000 By Closing stock 40,00,000 60,00,000
To Stores 38,40,000 48,00,000 By Misc. Income 4,00,000 4,00,000
To Manufacturing 51,20,000 64,00,000
Expenses

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 5

To Other Expenses 40,00,000 40,00,000

To Depreciation 40,00,000 40,00,000
To Net Profit 42,40,000 72,00,000 - -
3,64,00,000 4,64,00,000 3,64,00,000 4,64,00,000

Sales are expected to be ` 4,80,00,000 in year 3.

As a result, other expenses will increase by ` 20,00,000 besides other charges. Only raw
materials are in stock. Assume sales and purchases are in cash terms and the closing
stock is expected to go up by the same amount as between year 1 and 2. You may assume
that no dividend is being paid. The Company can use 75% of the cash generated to service
a loan. COMPUTE how much cash from operations will be available in year 3 for the
purpose? Ignore income tax.
Management of Working Capital
9. PQR Ltd., a company newly commencing business in the year 2021-22, provides the
following projected Profit and Loss Account:
(`) (`)
Sales 5,04,000
Cost of goods sold 3,67,200
Gross Profit 1,36,800
Administrative Expenses 33,600
Selling Expenses 31,200 64,800
Profit before tax 72,000
Provision for taxation 24,000
Profit after tax 48,000
The cost of goods sold has been arrived at as under:
Materials used 2,01,600
Wages and manufacturing Expenses 1,50,000
Depreciation 56,400
4,08,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 40,800
3,67,200
The figure given above relate only to finished goods and not to work-in-progress. Goods
equal to 15% of the year’s production (in terms of physical units) will be in process on the

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 6 INTERMEDIATE EXAMINATION: MAY, 2022

average requiring full materials but only 40% of the other expenses. The company believes
in keeping materials equal to two months’ consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will extend 1 -1/2
months credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of th e
Income tax will be paid in advance in quarterly instalments. The company wishes to keep
` 19,200 in cash. 10% must be added to the estimated figure for unforeseen contingencies.
PREPARE an estimate of working capital.
Miscellaneous
10. (a) ‘Profit maximisation is not the sole objective of a company. It is at best a limited
objective. If profit is given undue importance, a number of problems can arise.’
DISCUSS four of such problems.
(b) DISCUSS Agency problem and its cost. HOW it arises and HOW it can be addressed?

SUGGESTED ANSWERS/HINTS

1. (i) Determination of Sales and Cost of goods sold:

Gross Profit
Gross Profit Ratio = × 100
Sales
25 ` 12,00,000
Or, =
100 Sales
12,00,00,000
Or, Sales = = ` 48,00,000
25
Cost of Goods Sold = Sales – Gross Profit
= ` 48,00,000 - ` 12,00,000 = ` 36,00,000
(ii) Determination of Sundry Debtors:
Debtors’ velocity is 3 months or Debtors’ collection period is 3 months,
12months
So, Debtors’ turnover ratio = =4
3months
Credit Sales
Debtors’ turnover ratio =
Average Accounts Receivable
` 48,00,000
= Bills Receivable + Sundry Debtors = 4

Or, Sundry Debtors + Bills receivable = ` 12,00,000

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 7

Sundry Debtors = ` 12,00,000 – ` 75,000 = ` 11,25,000

(iii) Determination of Closing Stock
Cost of Goods Sold ` 36,00,000
Stock Turnover Ratio = = =1.5
Average Stock Average Stock

So, Average Stock = ` 24,00,000

Opening Stock + Closing Stock
Now Average Stock =
2
Opening Stock + (Opening Stock + ` 30,000)
Or = ` 24,00,000
2
Or 2 Opening Stock + ` 30,000= `48,00,000
Or 2 Opening Stock = `47,70,000
Or, Opening Stock = ` 23,85,000
So, Closing Stock = ` 23,85,000 + ` 30,000 = ` 24,15,000
(iv) Determination of Sundry Creditors:
Creditors’ velocity of 2 months or credit payment period is 2 months.
12 months
So, Creditors’ turnover ratio = =6
2 months
Credit Purchases *
Creditors turnover ratio =
Average AccountsPayables
` 36,30,000
= =6
Sundry Creditors + Bills Payables
So, Sundry Creditors + Bills Payable = ` 6,05,000
Or, Sundry Creditors + ` 30,000 = ` 6,05,000
Or, Sundry Creditors = ` 5,75,000
(v) Determination of Fixed Assets
Cost of GoodsSold
Fixed Assets Turnover Ratio = =4
Fixed Assets
` 36,00,000
Or, =4
Fixed Assets
Or, Fixed Asset = ` 9,00,000

© The Institute of Chartered Accountants of India

 8 INTERMEDIATE EXAMINATION: MAY, 2022

Workings:
*Calculation of Credit purchases:
Cost of goods sold = Opening stock + Purchases – Closing stock
` 36,00,000 = ` 23,85,000 + Purchases – ` 24,15,000
Purchases (credit) = ` 36,30,000
Calculation of credit purchase also can be done as below:
Or Credit Purchases =Cost of goods sold +Difference in Opening Stock
Or Credit Purchases =36,00,000 +30,000=` 36,30,000
D1 ` 17.716
2. (i) Cost of Equity (K e) = +g = + 0.10*
P0 -F ` 125 - ` 5
Ke = 0.2476
*Calculation of g:
` 10 (1+g) 5 = ` 16.105
16.105
Or, (1+g)5 = = 1.6105
10
Table (FVIF) suggests that ` 1 compounds to ` 1.6105 in 5 years at the compound
rate of 10 percent. Therefore, g is 10 per cent.
D1 ` 17.716
(ii) Cost of Retained Earnings (K r) = +g = + 0.10 = 0.2363
P0 ` 130

PD ` 15
(iii) Cost of Preference Shares (K p) = = = 0.1429
P 0 ` 105
 RV -NP 
I(1- t)+  
(iv) Cost of Debentures (K d) =  n 
RV +NP
2
` 100 - ` 91.75*
` 15 (1-0.30) + ( )
11 years
= ` 100 + ` 91.75*
2
` 15 × 0.70 + ` 0.75 ` 11.25
= = = 0.1173
` 95.875 ` 95.875
*Since yield on similar type of debentures is 16 per cent, the company would be
required to offer debentures at discount.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 9

Market price of debentures (approximation method)

= ` 15 ÷ 0.16 = ` 93.75
Sale proceeds from debentures = ` 93.75 – ` 2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the present value
method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%,
11 years)
P0 = ` 15 × 5.0287 + ` 100 × 0.1954
P0 = ` 75.4305 + ` 19.54 = ` 94.9705
Net Proceeds = ` 94.9705 – 2% of ` 100 = ` 92.9705
Accordingly, the cost of debt can be calculated

Total Cost of capital [BV weights and MV weights]

(Amount in (`) lakh)

Weights Specific Total cost

Source of capital Cost (K)
BV MV (BV × K) (MV × K)
Equity Shares 240 320** 0.2476 59.4240 79.2320
Retained Earnings 60 80** 0.2363 14.1780 18.9040
Preference Shares 72 67.50 0.1429 10.2888 9.6458
Debentures 18 20.80 0.1173 2.1114 2.4398
Total 390 488.30 86.0022 110.2216

**Market Value of equity has been apportioned in the ratio of Book Value of equity
and retained earnings i.e., 240:60 or 4:1.
Weighted Average Cost of Capital (WACC):
` 86.0022
Using Book Value = = 0.2205 or 22.05%
` 390
` 110.2216
Using Market Value = = 0.2257 or 22.57%
` 488.30

© The Institute of Chartered Accountants of India

 10 INTERMEDIATE EXAMINATION: MAY, 2022

3. (a) Assuming no tax as per MM Approach.

Calculation of Value of Firms ‘Bee Ltd.’ and ‘Cee Ltd’ according to MM
Hypothesis
Market Value of ‘Cee Ltd’ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/k e] = 9,00,000/0.18 = ` 50,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = k e as there is no debt) = 0.18
Market Value of ‘Bee Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (V L) = Vu + (Debt× Nil)
= ` 50,00,000 + (27,00,000 × nil)
= ` 50,00,000
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC)
Particulars Bee Ltd.
Net Operating Income (NOI) 9,00,000
Less: Interest on Debt (I) 3,24,000
Earnings of Equity Shareholders (NI) 5,76,000
Overall Capitalization Rate (k o) 0.18
Total Value of Firm (V = NOI/k o) 50,00,000
Less: Market Value of Debt 27,00,000
Market Value of Equity (S) 23,00,000
Equity Capitalization Rate [k e = NI /S] 0.2504
Weighted Average Cost of Capital (k o)* 0.18
ko = (ke×S/V) + (k d×D/V)
*Computation of WACC Bee Ltd
Component of Capital Amount Weight Cost of Capital WACC
Equity 23,00,000 0.46 0.2504 0.1152
Debt 27,00,000 0.54 0.12* 0.0648
Total 50,00,000 0.18
*Kd = 12% (since there is no tax)
WACC = 18%

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 11

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘Bee Ltd.’ and ‘Cee Ltd’ according to MM
Hypothesis
Market Value of ‘Cee Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (V u) = [NOI (1 - t)/ke] = 9,00,000 (1 – 0.40)] / 0.18
= ` 30,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = k e as there is no debt) = 0.18
Market Value of ‘Bee Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (V L) = Vu + (Debt× Tax)
= ` 30,00,000 + (27,00,000 × 0.4)
= ` 40,80,000
Computation of Weighted Average Cost of Capital (WACC) of ‘Cee Ltd.’
= 18% (i.e. K e = Ko)
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC) of Bee Ltd
Particulars Bee Ltd. (`)
Net Operating Income (NOI) 9,00,000
Less: Interest on Debt (I) 3,24,000
Earnings Before Tax (EBT) 5,76,000
Less: Tax @ 40% 2,30,400
Earnings for equity shareholders (NI) 3,45,600
Total Value of Firm (V) as calculated above 40,80,000
Less: Market Value of Debt 27,00,000
Market Value of Equity (S) 13,80,000
Equity Capitalization Rate [k e = NI/S] 0.2504
Weighted Average Cost of Capital (k o)* 13.23
ko = (ke×S/V) + (k d×D/V)
*Computation of WACC Bee Ltd.
Component of Capital Amount Weight Cost of Capital WACC
Equity 13,80,000 0.338 0.2504 0.0846

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 12 INTERMEDIATE EXAMINATION: MAY, 2022

Debt 27,00,000 0.662 0.072* 0.0477

Total 40,80,000 0.1323
*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%
WACC = 13.23%
4. Income Statement
Particulars Company P (`) Company Q (`)
Sales 40,00,000 18,00,000
Less: Variable Cost 30,00,000 12,00,000
Contribution 10,00,000 6,00,000
Less: Fixed Cost 8,00,000 4,50,000
EBIT 2,00,000 1,50,000
Less: Interest 1,50,000 1,00,000
EBT 50,000 50,000
Tax (45%) 22,500 22,500
EAT 27,500 27,500
Workings:
(i) Margin of Safety
For Company P = 0.20
For Company Q = 0.20 x 1.25 = 0.25
(ii) Interest Expenses
For Company P = ` 1,50,000
For Company Q = ` 1,50,000 (1-1/3) = ` 1,00,000
(iii) Financial Leverage
For Company P = 4
For Company Q = 4 x 75% = 3
(iv) EBIT
For Company A
Financial Leverage = EBIT/(EBIT- Interest)
4 = EBIT/(EBIT- ` 1,50,000)
4EBIT – ` 6,00,000 = EBIT
3EBIT = ` 6,00,000

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 13

EBIT = ` 2,00,000
For Company B
Financial Leverage = EBIT/(EBIT - Interest)
3 = EBIT/(EBIT – ` 1,00,000)
3EBIT – ` 3,00,000 = EBIT
2EBIT = ` 3,00,000
EBIT = ` 1,50,000
(v) Contribution
For Company A
Operating Leverage = 1/Margin of Safety
= 1/0.20 = 5
Operating Leverage = Contribution/EBIT
5 = Contribution/` 2,00,000
Contribution = ` 10,00,000
For Company B
Operating Leverage = 1/Margin of Safety
= 1/0.25 = 4
Operating Leverage = Contribution/EBIT
4 = Contribution/` 1,50,000
Contribution = ` 6,00,000
(vi) Sales
For Company A
Profit Volume Ratio = 25%
Profit Volume Ratio = Contribution/Sales  100
25% = ` 10,00,000/Sales
Sales = ` 10,00,000/25%
Sales = ` 40,00,000
For Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ` 6,00,000/33.33%
Sales = ` 18,00,000

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 14 INTERMEDIATE EXAMINATION: MAY, 2022

5. ABC & Co.

Equivalent Annual Cost (EAC) of new machine
(`)
(i) Cost of new machine now 18,00,000
Add: PV of annual repairs @ ` 2,00,000 per annum for 8 years
(` 2,00,000  4.4873) 8,97,460
26,97,460
Less: PV of salvage value at the end of 8 years
(` 4,00,0000.3269) 1,30,760
25,66,700
Equivalent annual cost (EAC) (` 25,66,700/4.4873) 5,71,992
PV of cost of replacing the old machine in each of 4 years
with new machine
Scenario Year Cash Flow PV @ 15% PV
(`) (`)
Replace Immediately 0 (5,71,992) 1.00 (5,71,992)
0 8,00,000 1.00 8,00,000
2,28,008
Replace in one year 1 (5,71,992) 0.8696 (4,97,404)
1 (2,00,000) 0.8696 (1,73,920)
1 5,00,000 0.8696 4,34,800
(2,36,524)
Replace in two years 1 (2,00,000) 0.8696 (1,73,920)
2 (5,71,992) 0.7561 (4,32,483)
2 (4,00,000) 0.7561 (3,02,440)
2 3,00,000 0.7561 2,26,830
(6,82,013)
Replace in three years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (5,71,992) 0.6575 (3,76,085)
3 (6,00,000) 0.6575 (3,94,500)
3 2,00,000 0.6575 1,31,500
(11,15,445)

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 15

Replace in four years 1 (2,00,000) 0.8696 (1,73,920)

2 (4,00,000) 0.7561 (3,02,440)
3 (6,00,000) 0.6575 (3,94,500)
4 (5,71,992) 0.5718 (3,27,065)
4 (8,00,000) 0.5718 (4,57,440)
(16,55,365)
Advice: The company should replace the old machine immediately because the PV of cost
of replacing the old machine with new machine is least.
6. (i) Calculation of Yearly Cash Inflow
In worst case: High costs and Low price (Selling price) and volume (Sales units) are
taken.
In best case: Low costs and High price (Selling price) and volume (Sales units) are
taken.
Worst Case Base Best Case
Sales (units) (A) 9,000 10,000 11,000
(`) (`) (`)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 2,25,000 7,50,000 13,75,000
Less: Fixed Cost 2,00,000 1,50,000 1,00,000
EBT 25,000 6,00,000 12,75,000
Less: Tax @ 25% 62,50 1,50,000 3,18,750
EAT 18,750 4,50,000 9,56,250
Add: Depreciation 70,000 70,000 70,000
Cash Inflow 88,750 5,20,000 10,26,250
(ii) Calculation of NPV in different scenarios
Worst Case Base Best Case
Initial outlay (A) (`) 15,00,000 15,00,000 15,00,000
Cash Inflow (c) (`) 88,750 5,20,000 10,26,250
Cumulative PVF @ 15% for 3.353 3.353 3.353
5 years (d)

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 16 INTERMEDIATE EXAMINATION: MAY, 2022

PV of Cash Inflow (B = c x 2,97,578.75 17,43,560.00 34,41,016.25

d) (`)
NPV (B - A) (`) (12,02,421.25) 2,43,560.00 19,41,016.25
7. (a)
` in lakhs
Net Profit 75
Less: Preference dividend 30
Earning for equity shareholders 45
Earning per share = 45/7.5 = ` 6.00

Let, the dividend per share be D to get share price of ` 42

r
D+ (E -D)
P = Ke
Ke

0.20
D+ (6 - D)
` 42 = 0.16
0.16
0.16D + 1.2 - 0.20D
6.72 =
0.16
0.04D = 1.2 – 1.0752
D = 3.12
DPS 3.12
D/P ratio = ×100 = ×100 = 52%
EPS 6
So, the required dividend payout ratio will be = 52%
(b) Since r > K e, the optimum dividend pay-out ratio would ‘Zero’ (i.e. D = 0),
Accordingly, value of a share:
r
D+ (E - D)
P = Ke
Ke

0 + 0.20
0.16
(6-0)
P = = ` 46.875
0.16

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 17

(c) The optimality of the above pay-out ratio can be proved by using 25%, 50%, 75% and
100% as pay- out ratio:
At 25% pay-out ratio
1.5 + 0.20
0.16
(6-1.5)
P = 0.16
= ` 44.531

At 50% pay-out ratio

3 + 0.20
0.16
(6-3)
P = 0.16
= ` 42.188

At 75% pay-out ratio

0.20
4.5 + 0.16 (6-4.5)
P = 0.16
= ` 39.844

At 100% pay-out ratio

6 + 0.20
0.16
(6-6)
P = 0.16
= ` 37.50

From the above it can be seen that price of share is maximum when dividend pay -out
ratio is ‘zero’ as determined in (b) above.
8. Projected Profit and Loss Account for the year 3
Particulars Year 2 Year 3 Particulars Year 2 Year 3
Actual Projected Actual Projected
(` in (` in (` in (` in
lakhs) lakhs) lakhs) lakhs)
To Materials consumed 140.00 168.00 By Sales 400.00 480.00
To Stores 48.00 57.60 By Misc. Income 4.00 4.00
To Mfg. Expenses 64.00 76.80
To Other expenses 40.00 60.00
To Depreciation 40.00 40.00
To Net profit 72.00 81.60
404.00 484.00 484.00 484.00

Cash Flow:
Particulars (` in lakhs)
Profit 81.60
Add: Depreciation 40.00
121.60

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 18 INTERMEDIATE EXAMINATION: MAY, 2022

Less: Cash required for increase in stock 20.00

Net cash inflow 101.60
Available for servicing the loan: 75% of ` 1,01,60,000 or ` 76,20,000
Working Notes:
(i) Material consumed in year 1 = (32 + 120 – 40)/320 = 35%
Material consumed in year 2 = (40 + 160 – 60)/400 = 35%
35
Likely consumption in year 3 = 480 × 100 = ` 168 (lakhs)
(ii) Stores are 12% of sales & Manufacturing expenses are 16% of sales for both the
years.
9. Statement showing the requirements of Working Capital
Particulars (`) (`)
A. Current Assets:
Inventory:
Stock of Raw material (` 2,31,840 × 2/12) 38,640
Stock of Work-in-progress (As per Working Note) 39,240
Stock of Finished goods (` 3,51,600 × 10/100) 35,160
Receivables (Debtors) (`3,04,992 × 2/12) 50,832
Cash in Hand 19,200
Prepaid Expenses:
Wages & Mfg. Expenses (` 1,59,000 × 1/12) 13,250
Administrative expenses (` 33,600 × 1/12) 2,800
Selling & Distribution Expenses (` 31,200 × 1/12) 2,600
Advance taxes paid {(70% of ` 24,000) × 3/12} 4,200
Gross Working Capital 2,05,922 2,05,922
B. Current Liabilities:
Payables for Raw materials (` 2,70,480 × 1.5/12) 33,810
Provision for Taxation (Net of Advance Tax) (` 24,000 × 7,200
30/100)
Total Current Liabilities 41,010 41,010
C. Excess of CA over CL 1,64,912
Add: 10% for unforeseen contingencies 16,491
Net Working Capital requirements 1,81,403

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 19

Working Notes:
(i) Calculation of Stock of Work-in-progress
Particulars (`)
Raw Material (` 2,01,600 × 15%) 30,240
Wages & Mfg. Expenses (` 1,50,000 × 15% × 40%) 9,000
Total 39,240

(ii) Calculation of Stock of Finished Goods and Cost of Sales

Particulars (`)
Direct material Cost [` 2,01,600 + ` 30,240] 2,31,840
Wages & Mfg. Expenses [` 1,50,000 + ` 9,000] 1,59,000
Depreciation 0
Gross Factory Cost 3,90,840
Less: Closing W.I.P. (39,240)
Cost of goods produced 3,51,600
Add: Administrative Expenses 33,600
3,85,200
Less: Closing stock (35,160)
Cost of Goods Sold 3,50,040
Add: Selling and Distribution Expenses 31,200
Total Cash Cost of Sales 3,81,240
Debtors (80% of cash cost of sales) 3,04,992
(iii) Calculation of Credit Purchase
Particulars (`)
Raw material consumed 2,31,840
Add: Closing Stock 38,640
Less: Opening Stock -
Purchases 2,70,480

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 20 INTERMEDIATE EXAMINATION: MAY, 2022

10. (a) Profit maximisation cannot be the sole objective of a company. It is at best a
limited objective. If profit is given undue importance, a number of problems can arise.
Some of these have been discussed below:
(i) The term profit is vague. It does not clarify what exactly it means. It conveys
a different meaning to different people. For example, profit may be in short term
or long term period; it may be total profit or rate of profit etc.
(ii) Profit maximisation has to be attempted with a realisation of risks
involved. There is a direct relationship between risk and profit. Many risky
propositions yield high profit. Higher the risk, higher is the possibility of pro fits.
If profit maximisation is the only goal, then risk factor is altogether ignored. This
implies that finance manager will accept highly risky proposals also, if they give
high profits. In practice, however, risk is very important consideration and has
to be balanced with the profit objective.
(iii) Profit maximisation as an objective does not take into account the time
pattern of returns. Proposal A may give a higher amount of profits as compared
to proposal B, yet if the returns of proposal A begin to flow say 10 years later,
proposal B may be preferred which may have lower overall profit but the returns
flow is more early and quick.
(iv) Profit maximisation as an objective is too narrow. It fails to take into account
the social considerations as also the obligations to various interests of workers,
consumers, society, as well as ethical trade practices. If these factors are
ignored, a company cannot survive for long. Profit maximization at the cost of
social and moral obligations is a short sighted policy.
(b) Agency Problem: Though in a sole proprietorship firm, partnership etc., owners
participate in management but in corporates, owners are not active in management
so, there is a separation between owner/ shareholders and managers. In theory
managers should act in the best interest of shareholders however in reality, managers
may try to maximise their individual goal like salary, perks etc., so there is a principal
agent relationship between managers and owners, which is known as Agency
Problem. In a nutshell, Agency Problem is the chances that managers may place
personal goals ahead of the goal of owners.
Agency Problem leads to Agency Cost. Agency cost is the additional cost borne by
the shareholders to monitor the manager and control their behaviour so as to
maximise shareholders wealth. Generally, Agency Costs are of four types (i)
monitoring (ii) bonding (iii) opportunity (iv) structuring.
The agency problem arises if manager’s interests are not aligned to the
interests of the debt lender and equity investors. The agency problem of debt
lender would be addressed by imposing negative covenants i.e. the managers cannot
borrow beyond a point. This is one of the most important concepts of modern-day

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 21

finance and the application of this would be applied in the Credit Risk Management
of Bank, Fund Raising, Valuing distressed companies.
Agency problem between the managers and shareholders can be addressed if the
interests of the managers are aligned to the interests of the shareholders. It is easier
said than done.
However, following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and
also with the long-term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption
that maximisation of the stock price is the objective of the investors.
 Effecting monitoring can be done.

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 22 INTERMEDIATE EXAMINATION: MAY, 2022

SECTION: B: ECONOMICS FOR FINANCE

QUESTIONS
1. (a) What are the data requirement and outcome of different method of National Income
Calculation?
(b) Can the GDP of a country be taken as an Index of welfare of people in the country?
(c) Calculate National Income with the help of Expenditure Method and Income Method:
Item In Crores
Compensation of employees 1600
Profit 700
Net factor Income from above abroad 40
Indirect Taxes 200
Subsidies 80
Private Final Consumption Expenditure 1800
Net domestic capital formation 900
Depreciation 150
Interest 600
Rent 400
Mixed Income of self employed 800
Export 50
Import 30
Government Final consumption expenditure 1100
Employees contribution to social security scheme 400

2. (a) How is multiplier useful in of functioning of Keynesian theory of determination of

National Income?
(b) Do you agree with the statement “An important element of Keynesian models is that
they relate to short period equilibrium and contain no dynamic elements?”
(c) An Economy is characterized by the following equations:
C = 40+0.6Yd
F = 20
G = 40
TY = 2

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 23

X = 30
M = 25+0.02Y
(a) What is the equilibrium income.
(b) Calculate trade balance and foreign trade multiplier.
3. (a) What are the various instruments by which governments can influence resource
allocation in the economy?
(b) What are the intervention by government for correcting information failure?
(c) What is the distinction between discretionary and non-discretionary fiscal policy?
(d) What is the interrelationship between monetary policy and Money Supply?
4. (a) How is credit multiplier determined?
(b) What is Compound tariff and how it is different from Mixed Tariff?
(c) What is Voluntary Expert Restraints?
(d) Explain the situation “where a pharmaceutical Company has full information
regarding the risks of a product, but it continues to sell”?
5. (a) What are the major concern in functioning of WTO?
(b) How does income leakages effect the multiplier?
(c) Which is the most appropriate method for calculation of National Income in
developed countries?
(d) What is the significance of Liquidity Preference of behavior towards risk?

SUGGESTED ANSWERS

1. (a) The processes of production, distribution and disposition keep going on

simultaneously and enable us to look at national income from three different angles
namely: as a flow of production or value added, as a flow of income and as a flow of
expenditure. Each of these different ways of looking at national income suggests a
different method of calculation and requires a different set of data.
Product Method
Data required: The sum of net values added by all the producing enterprises of the
country.
What is measured: Contribution of production units.

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 24 INTERMEDIATE EXAMINATION: MAY, 2022

Income Method
Data required: Total factor incomes generated in the production of goods and
services
What is measured: Relative contribution of factor owners.
Expenditure method
Data required: Sum of expenditures of the three spending units in the economy,
namely, government, consumer households, and producing enterprises.
What is measured: Flow of consumption and investment expenditures
(b) There are many reasons to dispute the validity of GDP as a perfect measure of well-
being. In fact, GDP measures our ability to obtain many requirements to make our
life better; yet leave out many important aspects which ensure good quality of life
for all. GDP measures exclude the following which are critical for the ov erall
wellbeing of citizens.
• Countries may have significantly different income distributions and,
consequently, different levels of overall well-being for the same level of per
capita income.
• Quality improvements in systems and processes due to technological as well
as managerial innovations which reflect true growth in output from year to
year.
• Productions hidden from government authorities, either because those
engaged in it are evading taxes or because it is illegal.
• Nonmarket production (with a few exceptions) and non-economic contributors
to well-being for example: health of a country’s citizens, education levels,
political participation, or other social and political factors that may significantly
affect well-being levels.
• The disutility of loss of leisure time. We know that other things remaining the
same, a country’s GDP rises if the total hours of work increase.
• The volunteer work and services rendered without remuneration undertaken in
the economy, even though such work can contribute to social well-being as
much as paid work.
• Many things that contribute to our economic welfare such as, leisure time,
fairness, gender equality, security of community feeling etc.,
• Both positive and negative externalities which are external effects that do not
form part of market transactions.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 25

(c) Income Method

NNPFC or NI = Compensation of Employees + Operating Surplus + Mixed
Income of self employed + Net factor Income from abroad.
= 1600 + (Rent + Interest + Profit) + Mixed Income of self-
employed + Net factor Income from Abroad.
= 1600 + (400+600+700) +800+40
= 1600+1700+840
= 4140 Cr.
GDPMP = Private final consumption expenditure + Government final
Consumption expenditure + Gross domestic Capital formation
(Net domestic Capital formation + depreciation) + Net export
= 1800+1100 (900 + 150) + (50 – 30)
= 2900 + 1050+20
= 3970 Cr.
NNPFC or NI = GDPMP – depreciation + Net factor income from abroad – Net
Indirect taxes
= 3970 – 150 + 40 – 120
= 3740 Cr.
2. (a) The multiplier concept is central to Keynes's theory because it explains how shifts in
investment caused by changes in business expectations set off a process that
causes not only investment but also consumption to vary. The multiplier shows how
shocks to one sector are transmitted throughout the economy.
The MPC, on which the multiplier effect of increase in income depends, is hi gh in
underdeveloped countries, but ironically the value of multiplier is low. Due to
structural inadequacies, increase in consumption expenditure is not generally
accompanied by increase in production. Example, increased demand for industrial
goods consequent on increased income does not lead to increase in their real
output, rather prices tend to rise.
(b) An important element of Keynesian models is that they relate to short-period
equilibrium and contain no dynamic elements. There is nothing like Keynesian
macro-economic dynamics. When a shock occurs, for example when there is a
change in autonomous investment due to change in some variable, one equilibrium
position can be compared with another as a matter of comparative statics. There is
no link between one period and the next and no provision is made for an analysis of
processes through time.

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 26 INTERMEDIATE EXAMINATION: MAY, 2022

(c) Y = C + I + G + (X – M)
= 40+0.6Yd + 20+ 40 + (30 – 25 + 0.02Y)
= 40+0.6 (Y – T) +20+40+30 – 25 – 0.02Y
= 40+0.6 (Y – 2) + 65 – 0.02Y
= 40+0.6Y – 1.2 + 65 = 0.02Y
Y = 103.8 + 0.58Y
Y – 0.58Y = 103.8
0.42Y = 103.8
103.8
Y = = 247.142
0.42
Trade Balance = (X – M)
= 30 – 25 + 0.02 (247.142)
= 5+ 4.94
= 9.94 Cr.
1
Foreign Trade multiplier =
1- b + m
1
=
1- 0.6 + 0.02
1
=
0.42
= 2.38
3. (a) The allocation responsibility of the governments involves suitable corrective action
when private market fail to provide the right and desirable combination of goods and
services. 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.
• Government may influence allocation through its competition policies, merger
policies etc. which affect the structure of industry and commerce.
• Governments’ regulatory activities such as licensing, controls, minimum
wages, and directives on location of industry influence resource allocation.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 27

• Government sets legal and administrative frameworks, and

• Any mixture of intermediate methods may be adopted by governments.
(b) For combating the problem of market failure due to information problems and
considering the importance of information in making rational choices, the following
interventions are resorted to:
• Government makes it mandatory to have accurate labelling and content
disclosures by producers. Eg. Labelling of nutritional information in food
packages.
• Mandatory disclosure of information for example: SEBI requires that accurate
information be provided to prospective buyers of new stocks.
• Public dissemination of information to improve knowledge and subsidizing of
initiatives in that direction.
• Regulation of advertising and setting of advertising standards to make
advertising more responsible, informative, and less persuasive.
(c) Discretionary fiscal policy refers to deliberate policy actions on the part of the
government to change the levels of expenditure and taxes to influence the level of
national output, employment, and prices. Non-discretionary fiscal policy or
automatic stabilizers are part of the structure of the economy and are ‘built -in’ fiscal
mechanisms that operate automatically to reduce the expansions and contractions
of the business cycle.
In most economies, changes in the level of taxation and level of government
spending tend to occur automatically. These are dependent on and are determined
by the level of aggregate production and income, such that the instability caused by
business cycle is automatically dampened without any need for discretionary policy
action.
(d) If the central bank of a country wants to stimulate economic activity it does so by
infusing liquidity into the system. Let us take the example of open market operations
(OMO) by central banks. Purchase of government securities injects high powered
money (monetary base) into the system. Assuming that banks do not hold excess
reserves and people do not hold more currency than before, and also that there is
demand for loans from businesses, the credit creation process by the banking
system in the country will create money to the tune of
∆Money Supply = 1 /R X ∆Reserves
The effect of an open market sale is very similar to that of open market purchase,
but in the opposite direction. In other words, an open market purchase by central
bank will reduce the reserves and thereby reduce the money supply.

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 28 INTERMEDIATE EXAMINATION: MAY, 2022

4. (a) The Credit Multiplier also referred to as the deposit multiplier or the deposit
expansion multiplier, describes the amount of additional money created by
commercial bank through the process of lending the available money it has in
excess of the central bank's reserve requirements. The deposit multiplier is, thus
inextricably tied to the bank's reserve requirement. This measure tells us how much
new money will be created by the banking system for a given increase in the high -
powered money. It reflects a bank's ability to increase the money supply.
The existence of the credit multiplier is the outcome of fractional reserve banking. It
explains how increase in money supply is caused by the commercial bank’s use of
depositors funds to lend money.
Credit Multiplier = 1/ Required Reserve Ratio
(b) Tariffs are aimed at altering the relative prices of goods and services imported, so
as to contract the domestic demand and thus regulate the volume of their imports.
Tariffs leave the world market price of the goods unaffected; while raising their
prices in the domestic market. The main goals of tariffs are to raise revenue for the
government, and more importantly to protect the domestic import-competing
industries. The distinction between Compound tariff and Mixed tariff is as follows:
Compound Tariff or a Compound Duty is a combination of an ad valorem and a
specific tariff. i.e., the tariff is calculated on the basis of both the value of the
imported goods (an ad valorem duty) and a unit of measure of the imported goods
(a specific duty). It is generally calculated by adding up a specific duty to an ad
valorem duty.
Mixed Tariffs: Mixed tariffs are expressed either on the basis of the value of the
imported goods (an ad valorem rate) or on the basis of a unit of measure of the
imported goods (a specific duty) depending on which generates the most income (or
least income at times) for the nation.
(c) 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. Such restraints
originate primarily from political considerations and are imposed based on
negotiations of the importer with the exporter.
The inducement for the exporter to agree to a VER is mostly to appease the
importing country and to avoid the effects of possible retaliatory trade restraints that
may be imposed by the importer. VERs may arise when the import- competing
industries seek protection from a surge of imports from particular exporting
countries. VERs cause, as do tariffs and quotas, domestic prices to rise and cause
loss of domestic consumer surplus.

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 PAPER – 8: FINANCIAL MANAGEMENT AND ECONOMICS FOR FINANCE 29

(d) This is a case of Asymmetric Information. Asymmetric information occurs when

there is an imbalance in information between buyer and seller i.e. when the buyer
knows more than the seller or the seller knows more than the buyer. This can distort
choices. With asymmetric information, low-quality goods can drive high-quality
goods out of the market. These are situations in which one party to a transaction
knows a material fact that the other party does not. This phenomenon, which is
sometimes referred to as the ‘lemons problem’, is an important source of market
failure. These are situations in which one party to a transaction knows a material
fact that the other party does not. This phenomenon, which is sometimes referred to
as the ‘lemons problem’, is an important source of market failure.
5. (a) In recent years, apprehensions have been raised in respect of the WTO and its
ability to maintain and extend a system of liberal world trade. The major issues are:
• The progress of multilateral negotiations on trade liberalization is very slow
and the requirement of consensus among all members acts as a constraint and
creates rigidity in the system. As a result, countries find regionalism as a
plausible alternative.
• The complex network of regional agreements introduces uncertainties and
murkiness in the global trade system.
• While multilateral efforts have effectively reduced tariffs on industrial goods,
the achievement in liberalizing trade in agriculture, textiles, and apparel, and in
many other areas of international commerce has been negligible.
• The negotiations, such as the Doha Development Round, have run into
problems, and their definitive success is doubtful.
• Specific to the developing countries, namely, protectionism and lack of
willingness among developed countries to provide market access, difficulties
that they face in implementing the present agreements, apparent north -south
divide, exceptionally high tariffs, tariff escalation, erosion of preferences and
difficulties with regards to adjustments.
(b) The multiplier concept is central to Keynes's theory because it explains how shifts in
investment caused by changes in business expectations set off a process that
causes not only investment but also consumption to vary. The multiplier shows how
shocks to one sector are transmitted throughout the economy.
Increase in income due to increase in initial investment, does not go on end lessly.
The process of income propagation slows down and ultimately comes to a halt.
Causes responsible for the decline in income are called leakages. Income that is not
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

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 30 INTERMEDIATE EXAMINATION: MAY, 2022

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) Ideally, all the three methods of national income computation should arrive at the
same figure. Moreover, different ways of measuring total output give us different
insights into the structure of our economy.
Income method may be most suitable for developed economies where people
properly file their income tax returns. With the growing facility in the use of the
commodity flow method of estimating expenditures, an increasing proportion of the
national income is being estimated by expenditure method. As a matter of fact,
countries like India are unable to estimate their national income wholly by one
method. Thus, in agricultural sector, net value added is estimated by the production
method, in small scale sector net value added is estimated by the income method
and in the construction sector net value added is estimated by the expenditure
method.
(d) In his classic article, ‘Liquidity Preference as Behavior towards Risk’ (1958), Tobin
established that the risk-avoiding behavior of individuals provided the foundation for
the liquidity preference and for a negative relationship between the demand for
money and the interest rate. The risk-aversion theory is based on the principles of
portfolio management.
In his theory which analyzes the individual's portfolio allocation between money and
bond holdings, the demand for money is considered as a store of wealth. Tobin
hypothesized that an individual would hold a portion of his wealth in the form of
money in the portfolio because the rate of return on holding money was more
certain than the rate of return on holding interest earning assets and entails no
capital gains or losses. It is riskier to hold alternative assets vis-à-vis holding just
money alone, because government bonds and equities are subject to market price
volatility, while money is not. Thus, bonds pay an expected return of r, but as asset,
they are unlike money because they are risky; and their actual return is uncertain.
Despite this, the individual will be willing to face this risk because the expected rate
of return from the alternative financial assets exceeds that of money.

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