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Determination of National Income – CA Inter Economics Study Material is designed strictly as per the latest syllabus and exam pattern.

Determination of National Income – CA Inter Economics Study Material

Theory Questions

Question 1.
Explain the leakages and injections in the circular flow of Income. (2 Marks May 2018)
Answer:
Leakages: Outflow or withdrawal of income from the circular flow is known as leakages like: savings, taxes and import etc. Leakages are money leaving the circular flow and therefore, not available for spending on currently produced goods and services. Leakages reduce the flow of income.

Injections: Addition of money in the circular flow is known as injections like: investment, government spending and export etc. It is a non-consumption expenditure. It is an expenditure on goods and services produced within the domestic territory but not used by the domestic household for consumption purposes. Injections are exogenous additions to the circular flow and add to the total volume of the basic circular flow.

In the two-sector model with households and firms, household saving is the only leakage and investment is the only injection. In the three-sector model which includes the government, saving and taxes are the two leakages and investment and government purchases are the two injections. In the four-sector model which includes foreign sector also, saving, taxes, and imports are the three leakages; investment, government purchases, and exports are the three injections.

The state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports

Question 2.
Explain the Concept of Gross National Product at market price (GNPMp). (2 Marks Nov. 2018)
Answer:
Gross National Product (GNP): Gross National product is a measure of the market value of all final economic goods and services, gross of depreciation, produced within the domestic territory of a country by normal residents during an accounting year plus net factor incomes from abroad. Thus, GNP includes earnings of Indian corporations overseas and Indian residents working overseas.
GNP_MP = GDP_MP + Net Factor Income from Abroad

Net factor income from abroad is the difference between the income received from abroad for rendering factor services by the normal residents of the country to the rest of the world and income paid for the factor services rendered by non-residents in the domestic territory of a country.

Question 3.
Distinguish between Personal Income and Disposable Personal Income. (3 Marks Nov. 2018)
Answer:
Personal Income:
Personal Income refers to the income received by the household sector including Non-Profit organisations serving households. Thus, while national income is a measure of income earned and 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. Examples of this include transfer payments such as social security benefits, unemployment compensation, welfare payments etc. Individuals also contribute income which they do not actually receive; for example, undistributed corporate profits and the contribution of employers to social security. Personal income forms the basis for consumption expenditures and is derived from national income as follows:
PI = NI + income received but not earned – income earned but not received
PI = NI – Undistributed profits – Net interest payments made by households – Corporate Tax + Transfer Payments to the households from firms and Government

Disposable Personal Income (DI):
It 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 – Non tax payments

Question 4.
What are the conceptual difficulties in the measurement of national income? (2 Marks May 2019)
Answer:
Conceptual difficulties in the measurement of national income are:
(a) Lack of an agreed definition of national income,
(b) Accurate distinction between final goods and intermediate goods,
(c) Issue of transfer payments,
(d) Services of durable goods,
(e) Difficulty of incorporating distribution of income,
(f) Valuation of a new good at constant prices, and
(g) Valuation of government services rendered without remuneration.

Question 5.
Explain the consumption function using a suitable table and diagram. (3 Marks Nov. 2019)
Answer:
Consumption function shows the functional relationship between aggregate consumption expenditure and aggregate disposable income, expressed as:
C = f(Y)
In case of low income, consumption expenditures of households will exceed their disposable income and households dis-save i.e. they either borrow money or draw from their past savings to purchase consumption goods. If the disposable income increases, consumers will increase their planned expenditures and current consumption expenditures rise, but only by less than the increase in income. This can be illustrated with the following table and diagram: The positive relationship between consumption spending and disposable income is described by the consumption function.

The specific form of consumption income relationship termed the consumption function, proposed by Keynes is as follows:
C = a+bY
Where C = aggregate consumption expenditure; Y = total disposable income; a is a constant term which denotes the (positive) value of consumption at zero level of disposable income; and the parameter b, the slope of the function, (∆ C/ ∆ Y) is the marginal propensity to consume (MPC) i.e the increase in consumption per unit increase in disposable income.

Question 6.
Explain the circular flow of income in an economy. (3 Marks Nov. 2019)
Answer:
Circular flow of income refers to the continuous circulation of production, income generation and expenditure involving different sectors of the economy. There are three different interlinked phases in a circular flow of income, viz: production, distribution and disposition as can be seen from the following figure.

Circular Flow of Income

1. In the production phase, firms produce goods and services with the help of factor services.
2. 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.
3. 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.

It is clear from the above figure that income is first generated in production unit, then it is distributed to households in the form of wages, rent, interest and profit. This increases the demand for goods and services and as a result there is increase in consumption expenditure. This leads to further production of goods and services and thus make the circular flow complete. These processes of production, distribution and disposition keep going on simultaneously.

Question 7.
Clarify the concept of ‘Average Propensity to Save’ with the help of formula and example. (2 Marks Nov. 2020)
Answer:
Average propensity to save: Average Propensity to Save (APS) is the ratio of total saving to total income or we can say, it is that part of total income which is saved.
APS = Total Saving/Total Income = S/Y
For example, if saving is ₹ 200 at national income of ₹ 1,000, then:
APS = S/Y = 20/100 = 0.20, i.e. 20%
The estimation of APS is illustrated with the help of the following table:

Question 8.
Which method is used in India for measurement of National Income? Also, state the method which is considered the most suitable for measurement of National Income of the developed economies. (2 Marks Nov. 2020)
Answer:
The method is used in India for measurement of National Income: In India, the Central Statistics Office under the Ministry of Statistics and Programme Implementation is responsible for macro-economic data gathering and statistical record keeping. Since reliable statistical data are not available, it is not possible to estimate India’s national income wholly by one method.

Therefore, a combination of output method and income method is used. The value added method is used largely in the commodity producing sectors like agriculture and manufacturing. 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 also.

The method which is considered suitable for measurement of National Income of developed economies: Income method may be most suitable for developed economies where data in respect of factor income are readily available. 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.

Practical Problems

Question 1.
Calculate Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MP$) from the following data: (2 Marks May 2018)
Income – Consumption – Level
8,000 – 6,000 – Initial Level
12,000 – 9,000 – Changed Level
Answer:
(a) MPC(b) = ∆C/∆Y
= (9,000 – 6,000) ÷ (12,000 – 8,000) = 0.75

(b) MPS = 1 – b = 1 – 0.75 = 0.25

Question 2.
Suppose in an economy: (5 Marks May 2018)
Consumption Function = 150 + 0.75 Y_d
Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) Exports (X) = 40
Imports (M) = 15 + 0.1Y
Where, Y and Y_d are National Income and Personal Disposable Income respectively. All figures are in rupees.
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level
Answer:
(a) The equilibrium level of National Income:
Y = C + I + G + (X – M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 ÷ 0.5
= 800

(b) Consumption at equilibrium level:
C = 150 + 0.75Y_d
Y_d = Y – Tax + Transfer Payments,
= Y – (20 + 0.2Y) + 40
= = 0.8Y + 20,
C = 150 + 0.75Y_d
= 150 + 0.75 (0.8Y + 20) (where Y_d = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800
= 645

(c) Net Exports at equilibrium level:
X – M = 35 – (15 + 0.1Y)
= 35 – (15 + 0.1 × 800)
= – 60
There is adverse balance of trade

Question 3.
From, the following data, compute the Gross National Product at Market Price using Value Added method: (3 Marks May 2018)
(₹ in Crores)
Value of output in secondary sector – 1,000
Intermediate consumption in primary sector – 300
Value of output in tertiary sector – 3,000
Intermediate consumption in secondary sector – 400
Net factor income from abroad – 100
Value of output in primary sector – 800
Intermediate consumption in tertiary sector – 900
Answer:
Value Added Method:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 800 – 300 + 1,000 – 400 + 3,000 – 900
= 3,200 Crores
GNP_MP = GDP_MP + NFIA = 3,200 – 100 = 3,100 Crores

Question 4.
In a two sector economy, the business sector produces 7,500 units at an average price of ₹ 7. (5 Marks Nov. 2018)
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 75 per cent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
Answer:
(a) The money value of output == 7,500 × 7 = ₹ 52,500

(b) In a two sector economy, households receive an amount equal to the money
value of output. Therefore, the money income of households is the same as the money value of output i.e 152,500.

(c) Total spending by households = ₹ 52,500 × 0.75 = ₹ 39,375

(d) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 39,3 75.

(e) The business sector makes payments of ₹ 52,500 to produce output, whereas the households purchase only output worth ₹ 3 9,3 75 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 13,125. They should be expected to decrease output.

Question 5.
Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the following data: (2 Marks Nov. 2018)
Income – 4,000
Consumption – ₹ 3,000
Answer:
APC = C/Y = 3,000/4,000 = 0.75
APS = S/Y = 1,000/4,000 = 0.25

Question 6.
Given:
Consumption function C = 300 + 0.75Y
Investment = ₹ 800
Net Imports = ₹ 100
Calculate equilibrium level of output. (3 Marks May 2019)
Answer:
Y = C + I + G + (X – M)
Y = (300 + 0.75Y) + 800 + 0 + (-100)
Y = 300 + 0.75Y + 800 – 100
0.25Y = 1,000
Y = ₹ 4,000

Question 7.
Compute GNP at factor cost and NDP at market price using expenditure method from the following data: (5 Marks May 2019)

Answer:
GDP_MP = Personal consumption expenditure + Government purchase of goods and services + gross public investment + inventory investment + gross residential construction investment + Gross business fixed investment + [export – import]
= 2,900 + 1,100 + 500 + 170 + 450 + 410 + (200 – 300) = ₹ 5,430 Crores
GNP_FC = GDP_MP + Net Factor Income from Abroad – Net Indirect Taxes
= 5,430 + (-30) + 80 = ₹ 5,480 Crores
NDP_MP = GDP_MP – Consumption of fixed capital
= 5430 – 60 = 5,370 Crores

Question 8.
When investment in an economy increases from ₹ 10,000 crores to ₹ 14,000 crores and as a result of this national income rises from ₹ 80,000 crores to ₹ 92,000 crores, compute investment multiplier. (2 Marks May 2019)
Answer:
Investment Multiplier K = ∆Y/∆I = 12,000/4,000 = 3

Question 9.
Compute the amount of subsidies from the following data: (3 Marks Nov. 2019)
GDP at market price (₹ in crores) – 7,79,567
Indirect taxes (₹ in crores) – 4,54,367
GDP at factor cost (₹ in crores) – 3,60,815
Answer:
GDP_MP = GDP_FC + Indirect taxes – Subsidies
₹ 7,79,567 crores = ₹ 3,60,815 crores + ₹ 4,54,367 crores – Subsidies
Subsidies = ₹ 35,615 crores

Question 10.
Compute NNP at factor cost or national income from the following data using income method: (3 Marks Nov. 2019)

Answer:
GDP_MP = Employee compensation (wages) + rent + interest + profits + mixed income + depreciation+net indirect taxes (Indirect taxes – subsidies)
= 3,000 + 1,020 + 2,010 + 980 + 1,050 + 428 + (480 – 630) = ₹ 8,338 crores
NNP_FC = GDP_MP – Net indirect taxes – Depreciation + NFIA
= 8,338 + 150 – 428 + 370 = ₹ 8,430 crores

Question 11.
Compute the amount of depreciation from the following data: (3 Marks Nov. 2020)

Answer:
GDP_MP = NNP_FC – NFIA + NIT + Depreciation
8,76,532 = 8,46,576 – (-232) + (564 – 30) + Depreciation
8,76,532 = 8,46,576 + 232 + 534 + Depreciation
Depreciation = 29,190 Crores

Question 12.
You are given the following information of an economy:
Consumption Function: C = 200 + 060 Yd
Government Spending’ G = 150
Investment Spending I = 240
Tar Tx = 10 + 0.20Y
TransferPayrnent: Tr = 50
Exports: X = 30 + 0.2Y
Imports M = 400
Where Y and Yd are National Income and Personal Disposable Income respectIvely.

Find:
(i) The equilibrium level of National Income.
(ii) Net Exports at equilibrium level.
(iii) Consumption at equilibrium level. (5 Marks Nov. 2020)
Answer:
(i) The equilibrium level of national income:
Y = C + I + G +(X – M)
= 200 + 0.60 (40 + 0.8Y) + 240 + 150 + (30 + 0.2 Y – 400)
= 200 + 24 +.48 Y + 240 + 150 + 30 + 0.2 Y – 400
= 244 + 0.68Y
Y = 244 ÷ 0.32 . = 762.5
Yd = Y + Tr – Tax
= Y + 50 – 10 – 0.2Y
Yd = 40+0.8 Y

(ii) Net exports ai equilibrium leveL
Net X – M = 30 + 0.2Y – 400
Exports
= 30 + 0.2 (762.5) – 400 = -217.5
There is adverse balance of trade

(iii) Consumption at equilibrium level:
C = 200 + 0.60 (40 + 0.8Y)
= 200 + 24 + 0.60 (40 + 0.8 × 762.5)
= 200 + 24 + 366 = 590

Question 13.
Given the following equations:
C = 200 + 0.8Y
I = 1,200
Calculate equilibrium level of National Income and the Consumption Expenditure at equilibrium level of National Income. (3 Marks Jan. 2021)
Answer:
Y = C + I = 200 + 0.8Y + 1,200 = 1,400 + 0.8Y
Y = 1,400 ÷ 0.2 = 7,000
C = 200+ 0.8Y = 200 + 0.8 × 7,000 = 5,800

Question 14.
Calculate GNP at market price from the following data using Value Added Method. (5 Marks Jan. 2021)

Answer:
GVA_MP = Value of Output – Intermediate Consumption
= 1,500 + 2,700 + 2,100 – 750 – 1,200 – 900 = 3,450 Crores
GNP_MP = GVA_MP + Net factor Income from Abroad
= 3,450 + (-) 60 = 3,390 Crores

Question 15.
Compute GDP at market price and Mixed Income of Self-Employed from the data given below: (3 Marks Jan. 2021)

Answer:
GDP_MP = NDP_FC + Depreciation + Net Indirect Taxes
= 1,450+ 26+ (57- 18) = 1,515Crores
NDP_FC = Compensation of employees + Operating Surplus + Mixed Income of Self Employed
1,450 = 810 + 453 + Mixed Income of Self Employed
187 Crores = Mixed Income of Self Employed

Question 16.
Due to Recession in an economy, Government expenditure increases by ₹ 6 billion. If Marginal Propensity to Consume (MPC or b) in the economy is 0.8, compute the increase in GDP. (2 Murks Jan. 2021)
Answer:
Government Spending Multiplier = 1 ÷ (1 – b) = 1 ÷ (1 – 0.8) = 5
Increase in GDP = Increase in Government Expenditure × Multiplier
= 6 billion × 5 = 30 billion

Important Questions

Question 1.
The nominal and real GOP respectively of a country In a particular year are ₹ 3,000 Crores and ₹ 4,700 Crores respectively. Calculate GOP deflator and comment on the level of prices of the year In comparison with the base year.
Answer:
Nominal GDP = ₹ 3000 Crores
Real GDP = ₹ 4,700 Crores
GDP Deflator = \(\frac{\text { Nominal GDP }}{\text { Real GDP }}\) × 100
= \(\frac{3,000}{4,700}\) × 100
= 63.83
The price level has fallen since GDP deflator is less than loo at 63.83.

Question 2.
In a two sector economy, the business sector produces 7,000 units at an average price of ₹ 5.
(a) What is the money value of output?
(b) What is the money income of households?
(c) If households spend 80 percent of their income, what is the total consumer expenditure?
(d) What is the total money revenues received by the business sector?
(e) What should happen to the level of output?
Answer:
(a) The money value of output equals total output times the average price per unit. The money value of output is: = 7,000 × 5 = ₹ 35,000

(b) In a two sector economy, households receive an amount equal to the money value of output. Therefore, the money income of households is the same as the money value of output i.e. 135,000.

(c) Total spending by households: =₹ 35,000 × 0.8 = ₹ 28,000

(d) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 28,000.

(e) The business sector makes payments of ₹ 35,000 to produce output, whereas the households purchase only output worth₹ 28,000 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 7,000. They should be expected to decrease output.

Question 3.
Assume that an economy’s consumption function is specified by the equation C = 500 + 0.80Y.
(a) What will be the consumption when disposable income (Y) is ₹ 4,000, ₹ 5,000, and ₹ 6,000?
(b) Find saving when disposable income is ₹ 4,000, ₹ 5,000, and ₹ 6,000.
(c) What amount of consumption for consumption function C is autonomous?
(d) What amount is induced when disposable income is ₹ 4,000, ₹ 5,000, ₹ 6,000?
Answer:
(a) Consumption for each level of disposable income is found by substituting the specified disposable income level into the consumption equation.
When Y = ₹ 4,000
C = ₹ 500 + 0.80 (₹ 4,000) = ₹ 500 + ₹ 3,200 = ₹ 3,700
When Y = ₹ 5,000
C = ₹ 500 + 0.80 (₹5,000) = ₹ 500 + ₹ 4,000 = ₹ 4,500
When Y = ₹ 6,000
C = ₹ 500 + 0.80 (₹ 6,000) = ₹ 500 + ₹ 4,800 = ₹ 5,300

(b) Saving is the difference between disposable income and consumption:
S = Y – C
= 4,000 – 3,700 = ₹ 300 (when Y is ₹ 4,000)
= 5,000 – 4,500 = ₹ 500 (when Y is ₹ 5,000)
= 6,000 – 5,300 = ₹ 700 (when Y is ₹ 6,000)

(c) Autonomous consumption is the amount consumed when disposable income is zero; autonomous consumption is ₹ 500, i.e. the consumption expenditure when the disposable income is 0. Since autonomous consumption is unrelated to income, autonomous consumption is ₹ 500 for all levels of income.

(d) Induced consumption is the amount of consumption that depends upon the level of income. Consumption is ₹ 3,700 when disposable income is ₹ 4,000. Since ₹ 500 is autonomous (i.e. consumed regardless of the income level), ₹ 3,200 out of the ₹ 3,700 level of consumption is induced by disposable income. Similarly, Induced consumption is ₹ 4,000 when disposable income is ₹ 5,000, and ₹ 4,800 when disposable income is ₹ 6,000.

Question 4.
Compute the amount of subsidies from the following data:
GDP at market price (₹ in crores) – 7,79,567
Indirect taxes (₹ in crores) – 4,54,367
GDP at factor cost (₹ in crores) – 3,60,815
Answer:
GDP_MP = GDP_FC + Indirect taxes – Subsidies
₹ 7,79,567 crores = ₹ 3,60,815 crores + ₹ 4,54,367 crores – Subsidies
Subsidies = ₹ 35,615 crores

Question 5.
Calculate the aggregate value of depreciation when the GDP at market price of a country in a particular year was ₹ 1,100 Crores. Net Factor Income from Abroad was ₹ 100 Crores, The value of Indirect taxes – Subsidies was ₹ 150 Crores and National Income was ₹ 850 Crores,
Answer:
NNP_FC = GDP_MP – NIT + NFIA – Depreciation
850 = 1,100 – 150 + 100 – Depreciation
Depreciation = 1,050 – 850 = 200 Crores

Question 6.
Calculate ‘Sales’ from the following data:

Answer:
NVA_FC = Sales + Change in stocks – Intermediate consumption – depreciation – NIT
2,000 = Sales + (600 – 100) – 3,000 – 700 – (-200)
Sales = 2,000 – 500 + 3,000 + 700 – 200 = 5,000 Lakhs

Question 7.
Compute GNP at factor cost and NDP at market price using expenditure method from the following data:

Answer:
GDP_MP = Personal consumption expenditure + Government purchase of goods and services + gross public investment + inventory investment + gross residential construction investment + Gross business fixed investment + [export-import]
= 2,900 + 1,100 + 500 + 170 + 450 + 410 + (200 – 300)
= ₹ 5,430 Crores
GNP_FC = GDP_MP + Net Factor Income from Abroad – Net Indirect Taxes
= 5,430 + (-30) + 80
= ₹ 5,480Crores
NDP_MP = GDP_MP – Consumption of fixed capital
= 5430 – 60
= ₹ 5,370 Crores

Question 8.
From the following data, calculate NNP_FC, NNP_MP, GNP_MP and GDP_MP.

Answer:
GDP_MP = Compensation of employees + mixed income of self-employed + operating surplus + depreciation + net indirect taxes
GDP_MP = 1,000 + 1,100 + 2,000 + 400+ 450 = 4,950 Crores
GNP_MP = GDP_MP + NFIA
= 4,950 + (50) = 4,900 Crores
NNP_MP = GNP_MP – Depreciation
= 4,900 – 400 = 4,500 Crores
NNP_FC = NNP_MP – Net indirect tax
= 4,500 – 450 = 4,050 Crores

Question 9.
From the following data, estimate National Income and Personal Income

Answer:
National = Net national product at market price – Indirect taxes + Subsidies Income
= 1,891 – 175 + 30 = 1,746 Crores
Personal Income = National income – Income from property and entrepreneurship accruing to government administrative departments – Saving of non-departmental enterprises + National debt interest + Current transfers from government + Current transfers from rest of the world – Saving of private corporate sector – Corporate profit tax
= 1,746 – 45 – 10 + 15 + 35 + 20 – 25 – 25
= 1,711 Crores

Question 10.
On basis of following information, calculate NNP at market price and Disposable personal income

Answer:
NNP_MP = NDP_FC + NFIA + NIT
= 14,900 + 80 + 335 – 262 = 15,053 Crores
Disposable personal income (DI):
DI = PI – Personal income tax
= NI + Income received but not earned – Income earned but not received – Personal Income Tax
= (14,900 + 80) + (170 + 60 + 30) – (150 + 222 + 105) – 100
= 14,663 Crores

Question 11.
Calculate National Income by Value Added Method with the help of following data:

Answer:
GVA_MP = Value of output- Intermediate consumption
= Sales + Change in stock – Intermediate consumption
= 700 + (400 – 500) – 350 = 250 Crores
NVA_FC = GVA_MP – Depreciation + NFIA – Net Indirect Tax
NI = 250 – 150 + 30 – (110 – 50) = 70 Crores

Question 12.
Calculate the Operating Surplus with the help of following data:

Answer:
GVA_MP = Value Output – Intermediate consumption
= (Sales + Change in stock) – Intermediate consumption
= 4,000 – 600 = 3,400 Crores
NDP_MP = GDP_MP – Consumption of Fixed capital
= 3,400 – 200 = 3,200 Crores
NDP_FC = NDP_MP – NIT
= 3,200 – 500 = 2,700 Crores
NDP_FC Compensation of employees + Operating surplus + Mixed income
2,700 = 800 + Operating Surplus + 400
Operating surplus = 1,500 Crores

Question 13.
Calculate national Income by value added method

Answer:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 2,000 – 200 + 2,800 – 800 + 1,600- 600 = 4,800 Crores
NNP_FC = GDP_MP + NFIA – NIT – Depreciation
= 4,800 + (-30) – 300 – 470 = 4,000 Crores

Question 14.
Calculate NNPFC by expenditure method with the help of following information:

Answer:
GDP_MP = Government final consumption expenditure (Public final consumption expenditure) + Private final consumption expenditure + Gross domestic capital formation (Gross domestic fixed capital formation + Change stock + Net acquisition of valuables) + Net export
= 5 + 10 + [350 + 30 + 10] + (- 20) = 385 Crores
NNP_FC = GDP_MP – Depreciation + Net factor income from abroad (Income from abroad – Income paid to abroad) – Net Indirect tax (Indirect tax – subsidies)
= 385 – 30 + [0 – 20] – [0 – 100] = 435 Crores

Question 15.
Given the following data, determine the National Income of a country using expenditure method and income method;
₹ in Crores
Private Final Consumption Expenditure – 1,000
Government Final Consumption Expenditure – 550
Compensation of Employees – 600
Net Exports – 15
Net Indirect Taxes – 60
Net Domestic Fixed Investment – 385
Consumption of Fixed Capital Formation – 65
Net Factor Income from Abroad – 10
Interest – 310
Rent – 200
Mixed Income of Self-Employed – 350
Profit – 400
Answer:
Expenditure Method:
NNP_FC = Private Final Consumption Expenditure + Net Domestic Fixed Investment + Government final consumption expenditure+Net Exports + Net factor income from abroad – Indirect Taxes
= 1,000 + 385 + 550 -15 – 10 – 60 = 1,850 Crores

Income Method:
NNP_FC = Employee compensation + Profits + Rent + Interest + Mixed income + NFIA
= 600 + 400 + 200 + 310 + 350-10 = 1,850 Crores

Question 16.
Suppose in an economy: C = 100 + b (Y – 50 – tY); I = 50; G = 50; X = 10; M = 5 + 0.1Y; MPC (b) = 0.8; Proportional income tax rate (t) = 0.25
(a) Find the equilibrium national income, foreign trade multiplier, equilibrium value of imports.
(b) If equilibrium national income falls short of full employment income by ₹ 50, how much government should increase its expenditure to attain full – employment?
Answer:
(a) Y = C + I + G + (X – M)
= 100 + b (Y – 50 – tY) + 50 + 50 + (10 – 5 – 0.1Y)
= 100 + 0.8 (Y – 50 – 0.25Y) + 105 – 0.1Y
= 100 + 0.8Y – 40 – 0.2Y + 105 – 0.1Y
= 165 + 0.5Y
Y = 165 ÷ 0.5 = 330
Foreign trade multiplier = \(\frac{1}{1-b(1-t)+m}\) = \(\frac{1}{1-0.8(1-0.25)+0.1}\) = 2
Equilibrium value of imports can be obtained by substituting the equilibrium income in the import function. Thus,
M = 5 + 0.1Y = 5 + 0.1 × 330 = 38

(b) Required increase in government expenditure to attain ₹ 50 increase in income can be obtained as under:
∆Y = Foreign trade multiplier × ∆G
= \(\frac{1}{1-b(1-t)+m}\) × ∆G
50 = 2 × ∆G
∆G = 50 ÷ 2 =25

Question 17.
Suppose the consumption function is C = 50 + 0.8Yd, I = 180 crores, G = 190 crores, T = 0.20Y
(a) Find the equilibrium level of income.
(b) Find the revenue from taxes at equilibrium. Is the government budget balanced?
(c) Find the equilibrium level of income when investment increases by 120 crores.
Answer:
(a) Y = C + I + G + (X – M)
= 50 + 0.8(Y – 0.2Y) + 180 + 190
= 420 + 0.8Y – 0.16Y
Y = 420 ÷ 0.36 = 1,166.66 Crores

(b) T = 0.2Y
= 0.2 × 1,166.66 = 233.332 Crores
G i.e. 190 < T i.e. 233.332, thus, budget is not in balance. There exists a budget Surplus.

(c) Change in Y = Change in I/(1 – b + bt)
= 120/(1 – 0.8 + 0.16)
= 120/.36 = 333.33 Crores
So new Y equilibrium
Y new = 1,166.66 + 333.33 = 1,499.99 Crores

CA Inter Costing Question Paper May 2022 – CA Inter Costing Study Material is designed strictly as per the latest syllabus and exam pattern.

CA Inter May 2022 Costing Question Paper Solution

Question 1.
Answer the following :
(a) A Limited a toy company purchases its requirement of raw material from S Limited at ₹ 120 per kg. The company incurs a handling cost of ₹ 400 plus freight of ₹ 350 per order. The incremental carrying cost of inventory of raw material is ₹ 0.25 per kg. per month. In addition the cost of working capital finance on the investment in inventory of raw material is ₹ 15 per kg. per annum. The annual production of the toys is 60,000 units and 5 units of toys are obtained from one kg. of raw material.
Required:
(i) Calculate the Economic Order Quantity (EOQ) of raw materials.
(ii) Advise, how frequently company should order to minimize its procurement cost. Assume 360 days in a year.
(iii) Calculate the total ordering cost and total inventory carrying cost per annum as per EOQ.
(b) PQR Limited has replaced 72 workers during the quarter ended 31st March 2022. The labour rates for the quarter are as follows :

You are required to ascertain:
(i) Average number of workers on roll (for the quarter),
(ii) Number of workers left and discharged during the quarter,
(iii) Number of workers recruited and joined during the quarter,
(iv) Equivalent employee turnover rates for the year.

(c) Top-tech a manufacturing company is presently evaluating two possible machines for the manufacture of superior Pen-drives. The following information is available :

(i) Recommend which machine should be chosen?
(ii) Would you change your answer, if you were informed that in near future demand will be unlimited and the capacities of the two machines are as follows?
Machine A – 12,00,000 units
Machine B – 12,00,000 units Why?
(d) Coal is transported from two mines X & Y and unloaded at plots in a railway station. X is at distance of 15 kms and Y is at a distance of 20 kms from the rail head plots. A fleet of lorries having carrying capacity of 4 tonnes is used to transport coal from the mines. Records reveal that average speed of the lorries is 40 kms per hour when running and regularly take 15 minutes to unload at the rail head.
At Mine X average loading time is 30 minutes per load, while at mine Y average loading time is 25 minutes per load.
Additional Information:
Drivers’ wages, depreciation, insurance and taxes, etc. 12 per hour Operated Fuel, oil tyres, repairs and maintenance, etc. ₹ 1.60 per km.
You are required to prepare a statement showing the cost per tonne kilometre of carrying coal from each mine ‘X’ and ‘Y’. (Marks 4 × 5 = 20)
Answer:
Answer the following:
(a) Ordering Cost (O) = 400 + 350 = ₹ 750
Price per kg. = ₹ 120
Carrying cost (C) = 0.25 × 12 + 15 = ₹ 18
Annual requirement (A) = \(\frac{60,000}{5}\) = 12,000
(i) EOQ = \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\)
= \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\)
= 1000 units

(ii) Frequency = 360 × \(\frac{\mathrm{EOQ}}{\mathrm{A}}\)
= 360 × \(\frac{1000}{12000}\)
= 30 days
∴ Company should order every 30 days to minimize its procure¬ment cost.

(iii) Total Ordering Cost = \(\frac{\mathrm{A}}{\mathrm{EOQ}}\) × O
= \(\frac{12000}{1000}\) × 750 = ₹ 9000

Total Inventory Carrying Cost = \(\frac{\mathrm{EOQ}}{\mathrm{A}}\) × C
= \(\frac{1000}{2}\) × 18 = ₹ 9000

(b) (i) Employee Turnover rate using Replacement Method
= \(\frac{\text { No. of Replacements }}{\text { Average No. of workers on roll }}\) × 100
\(\frac{8}{100}=\frac{72}{\text { Average No. of workers on roll }}\)
Average No. of workers on roll = 900

(ii) Employee turnover Rate (Separation Method)
= \(\frac{\text { No. of Separations(S) }}{\text { Average No. of workers on roll }}\) × 100
\(\frac{5}{100}=\frac{S}{900}\)
or S = 45
Hence, No. of workers left and discharged comes to 45.

(iii) Employee Turnover Rate (Flux Method)
= \(\frac{\text { No. of Separations }(\mathrm{S})+\text { No. of Accession(A) }}{\text { Average No. of workers on roll }}\)
\(\frac{16}{100}=\frac{45+A}{900}\)
A = 99
No. of workers joined and recruited is 99

(iv) Calculation of equivalent employee turnover ratio:

(c) (i) Statement of profit from Machine A and Machine B

As the profit in Machine B is higher, Machine B should be selected.

(ii) Now, if the capacity for both the machine are similar, the profit under both the machine will be as under:

Therefore, as the profit under Machine A is higher, machine A will be recommended.
The profit under machine A is higher because the contribution per unit under machine A is greater as compared to machine B and the higher fixed cost in Machine A is offset by the higher contribution per unit in machine A.

(d) Calculate of cost per tonne km

Working Notes:
1.

2.

Question 2.
(a) In a manufacturing company, the overhead is recovered as follows:
Factory Overheads: a fixed percentage basis on direct wages and Administrative overheads: a fixed percentage basis on factory cost.
The company has furnished the following data relating to two jobs undertaken by it in a period.

You are required to :
(i) Compute the percentage recovery rates of factory overheads and administrative overheads.
(ii) Calculate the amount of factory overheads, administrative overheads and profit for each of the two jobs.
(iii) Using the above recovery rates, determine the selling price to be quoted for Job 3. Additional data pertaining to Job 3 is as follows : (10 Marks)

(b) Paramount Constructions Limited is engaged in construction and erection of bridges under long term contracts. It has entered into a big contract at an agreed price of ₹ 250 Lakhs subject to an escalation clause for material and labour as spelt out in the contract and corresponding actual are as follows :

Required:
(i) Prepare a statement showing admissible additional claim of material and labour due to escalation clause.
(ii) Determine the final price payable after admissible escalation claim. (5 Marks)
(c) Distinguish between Job costing and Process Costing. (Any five points of differences) (5 Marks)
Answer:
(a)
(i) Let the factory overhead recovery rate as percentage of direct wages be ‘F’ and Administrative overhead recovery rate as percentage of factory cost be ‘A’
Factory cost of jobs:
Direct materials + Direct wages + Factory overhead
For Job 101 = ₹ 1,08,000 + ₹ 84,000 + ₹ 84,000 F
For Job 102 = ₹ 75,000 + ₹ 60,000 + ₹ 60,000F
Total Cost of Jobs: Factory cost + Administrative overhead
For Job 1 = (₹ 1,92,000 + ₹ 84,000F) + (₹ 1,92,000 + ₹ 84,000F) A
= ₹ 2,97,600 [WN-1]
For Job-2 = (₹ 1,35,000 + ₹ 60,000F) + (₹ 1,35,000 + ₹ 60,000F) A
= ₹ 2,10,000 [WN-2]

The value of F & A can be found using following equations
1.92.0 + 84,000F + 1,92,000A + 84,000AF = 2,97,600 …eqn (i)
1.35.0 + 60,000F + l,35,OOOA + 60,000AF = 2,10,000 …eqn (ii)

Multiplying Equation (i) by 5 and Equation (ii) by 7

15.000A = 3,000
A = 0.2
Now put the value of ‘A’ in equation (z) to find the value of ‘F’
1,92,0 + 84000F + 1,92,000(0.2)+ 16,800F = 2,97,600
F = 0.6667
On solving the above relations: F = 0.6667 and A = 0.20
Hence, percentage recovery rates of:
Factory overheads = 66.67% of wages and Administrative overheads = 20% of factory cost.

Working note:

(ii) Statement of jobs, showing amount of factory overheads, administrative overheads and profit:

(iii) Selling price of Job 3

(b) Statement Showing Final Claim

Final Claim = (A) + (B) = 5,25,000 + 8,80,000 = ₹ 14,05,000

Statement Showing Final Price Payable

(c)

Question 3.
(a) SR Ltd. is a manufacturer of Garments. For the first three months of financial year 2022-23 commencing on 1st April 2022, production will he constrained by direct labour. It is estimated that only 12,000 hours of direct labour hours w ill be available in each month.
For market reasons, production of either of the two garments must be at least 25% of the production of the other. Estimated cost and revenue per garment are as follows :

From the month of July, 2022 direct labour will no longer be a constraint. The company expects to be able to sell 15,000 shirts and 20,000 shorts in July 2022. There wrill be no opening stock at the beginning of July 2022.
Sales volumes are expected to grow at 10% per month cumulatively thereafter throughout the year. Following additional information is available:

• The company intends to carry stock of finished garments sufficient to meet 40% of the next month’s sale from July 2022 onwards.
• The estimated selling price will be same as above.

Required:
I. Calculate the number of shirts and shorts to be produced per month in the first quarter of financial year 2022-23 to maximize company’s profit.
II. Prepare the following budgets on a monthly basis for July, August and September 2022:
(i) Sales budget showing sales units and sales revenue for each product.
(ii) Production budget (in units) for each product. (10 Marks)
(b) The following data are available from the books and records of A Ltd. for the month of April 2022 :

Stock of finished goods as on 1st April 2022 was 200 units having a total cost of ₹ 28,000. The entire opening stock of finished goods has been sold during the month. Production during the month of April, 2022 was 3,000 units. Closing stock of finished goods as on 30th April, 2022 was 400 units.
You are required to :
I. Prepare a Cost Sheet for the above period showing the:
(i) Cost of Raw Material consumed
(ii) Prime Cost
(iii) Factory Cost
(iv) Cost of Production
(v) Cost of goods sold
(vi) Cost of Sales
II. Calculate selling price per unit, if sale is made at a profit of 20% on sales. (10 Marks)
Answer:
(a)

Given That Production of one garment must be 25% of the production of other
So, let the No. of units production of shorts be x
the production of shirts will be 0.25x.
→ The labour hours of shorts + labour hours of shirts must be 12,000
Now, 0.5 hours (x) + 1 hour (0.25x) = 12,000 hours
0.5x + 0.25x = 12,000
0.75x = 12,000
x = 16,000
∴ Production of Shorts will be 16,000 units and Production of Shirts will be 4,000 units.
The Profit for the first quarter will be:
16,000 units × ₹ 22 + 4,000 units × ₹ 18
= ₹ 4,24,000

(II)
(i) Sales Budget

(ii) Production Budget (Shirts)

Production Budget (Shorts)

(I) Cost Sheet: (Amount in ₹)

(II) Total no. of Units sold
= Opening + Production – Closing
= 200 + 3000 – 400
= 2800 Units

Total Selling Price

Question 4.
(a) STG Limited is a manufacturer of Chemical ‘GK’ which is required for industrial use. The complete production operation requires two processes.
The raw material first passes through Process I, where Chemical ‘G’ is produced. Following data is furnished for the month April 2022 ;

You are further provided that:

Normal process loss may be estimated to be 10% of material input. It has no realizable value. Any loss over and above normal loss is considered to be 100% complete in material and processing.
The Company transfers 60,000 kgs. of output (Chemical G) from Process I to Process II for producing Chemical ‘GK’ Further materials are added in Process II which yield 1.20 kg. of Chemical ‘GK’ for every kg. of Chemical ‘G’ introduced. The chemicals transferred to Process II for further processing are then sold as Chemical ‘GK’ for ₹ 10 per kg. Any quantity of output completed in Process I, are sold as Chemical ‘G’ @ ₹ 9 per kg.
The monthly costs incurred in Process II (other than the cost of Chemical ‘G’ are :
Input 60,000 kg. of Chemical ‘G’
Materials Cost ₹ 5,000
Processing Costs ₹ 50,000
You are required:
(i) Prepare Statement of Equivalent production and determine the cost per kg. of Chemical ‘G’ in Process I using the weighted average cost method.
(ii) Prepare a statement showing cost of Chemical ‘G’ transferred to Pro-cess II, cost of abnormal loss and cost of closing work-in-progress.
(iii) STG is considering the option to sell 60,000 kg. of Chemical ‘G’ of Process I without processing it further in Process-II. Will it be beneficial for the company over the current pattern of processing 60,000 kg. in process II ?
(Note : You are not required to prepare Process Accounts) (10 Marks)

(b) UV Limited started a manufacturing unit from 1st October, 2021. It produces designer lamps and sells its lamps at ₹ 450 per unit.
During the quarter ending on 31st December, 2021, it produced and sold
12,0 units and suffered a loss of ₹ 35 per unit.
During the quarter ending on 31st March, 2022, it produced and sold 30,000 units and earned a profit of ₹ 40 per unit.
You are required to calculate :
(i) Total fixed cost incurred by UV Ltd. per quarter.
(ii) Break Even sales value (in rupees)
(iii) Calculate Profit, if the sale volume reaches 50,000 units in the next quarter (i.e., quarter ending on 30th June, 2022). (5Marks)

(c) Journalize the following transactions assuming the cost and financial accounts are integrated: (5 Marks)

Answer:
(a)
(i) Statement of equivalent production

(ii) Calculation of cost per unit
Material Cost = 1 04 000 “ = ₹ 3.5/kg.
2,53,100 + 14,750 ‘
Conversion Cost = Q7 = ₹ 2.75/kg.
Cost of chemical & transferred to process II
Material cost = ₹ 3.5/kg × 60,000 kg = 2,10,000
Conversion cost = ₹ 2.75/kg × 60,000 kg = 1,65,000
= 3,75,000

Cost of abnormal loss
Material cost = ₹ 3.5/kg × 4,500 kg
Conversion cost = ₹ 2.75/kg × 4,500 kg
Cost of Closing W-I-P
Material cost = ₹ 3.5/kg × 16,500 kg
Conversion cost = ₹ 2.75/kg × 9,900 kg

(iii) If chemical G is further processed in process II Total Sales value 7,20,000
(60,000 kg × 1.2 × ₹ 10/kg)

If chemical G is not further processed

Therefore, further processing of Chemical G will give incremental revenue of ₹ 45,000 ie. (2,10,000 – 1,65,000).

(b) Contribution p.u. = \(\frac{\text { Change in Contribution }}{\text { Change in No. of Units }}\)
Change in Contribution = (12,000 × ₹ 35) + (30,000 × ₹ 40)
= ₹ 16,20,000
Change in No. of Units = 30,000 – 12,000
= 18,000 Units
Contribution p.u. = \(\frac{₹ 16,20,000}{18,000 \text { units }}\)
= ₹ 90 p.u.
∴ P/V Ratio = \(=\frac{₹ 90}{₹ 450}\) × 100 = 20%

(i) Fixed Cost = Total Contribution + Loss
= (12,000 × ₹ 90) + (12,000 × ₹ 35)
= ₹ 10,80,000 + ₹ 4,20,000
= ₹ 15,00,000

(ii) Break Even Sales Value (in ?)
= \(\frac{\text { Fixed Cost }}{P / V \text { Ratio }}\)
= \(\frac{15,00,000}{20 \%}\)
= ₹ 75,00,000

(iii) Total Profit = Total Contribution – Fixed Cost
= (50,000 × ₹ 90) – ₹ 15,00,000
= ₹ 45,00,000 – ₹ 15,00,000
= ₹ 30,00,000

(c)
Journal Entries

Question 5.
(a) StaT Limited manufacture three products using the same production methods. A conventional product costing system is being used currently. Details of the three products for a typical period are :

Direct Labour costs ₹ 20 per hour and production overheads are absorbed on a machine hour basis. The overhead absorption rate for the period is ₹ 30 per machine hour.
Management is considering using Activity Based Costing system to ascertain the cost of the products. Further analysis shows that the total production overheads can be divided as follows :

The following activity volumes are associated with the product line for the period as a whole. Total activities for the period :

Required:
(i) Calculate the cost per unit for each product using the conventional method.
(ii) Calculate the cost per unit for each product using activity based costing method. (10 Marks)
(b) A manufacturing department of a company has employed 120 workers. The standard output of product “NPX” is 20 units per hour and the standard wage rate is ₹ 25 per labour hour.
In a 48 hours week, the department produced 1,000 units of ‘NPX’ despite 5% of the time paid being lost due to an abnormal reason. The hourly wages actually paid were ₹ 25.70 per hour.
Calculate:
(i) Labour Cost Variance
(ii) Labour Rate Variance
(iii) Labour Efficiency Variance
(iv) Labour Idle time Variance (5 Marks)
(c) RST Limited produces three joint products X, Y and Z. The products are processed further. Pre-separation costs are apportioned on the basis of weight of output of each joint product. The following data are provided for the month of April, 2022.
Cost incurred up to separation point: ₹ 10,000

You are required to :
(i) Prepare a statement showing profit or loss made by each product after further processing using the presently adopted method of apportionment of pre-separation cost.
(ii) Advise the management whether, on purely financial consideration, the three products are to be processed further or not.
Answer:
(a)
(i) Statement Showing Cost (Conventional Method)

Total Overhead = Σ Overhead Cost per unit × No. of Units
= (7,500 × ₹ 60) + (12,500 × ₹ 45) + (25,000 × ₹ 75)
= 28,87,500

Cost driver Rates

(ii) Calculate the cost per unit for each product using activity based costing method.

(b) Standard output per hour = 20 units
Standard rate (SR) = ₹ 25/Hr
Actual output = ₹ 1,000 units
Actual Hrs. (AH) = 48 Hrs – idle time (48 × 5%)
= 45.60 Hr

Standard has required for actual output (SH) = \(\frac{1,000 \text { units }}{20 \text { units } / \mathrm{hr}}\) = 50 hrs
Actual Rate (AR) = ₹ 25.70 Hr.
Idle time = ₹ 48 Hrs × 5% = 2.4 Hrs.
(i) Labour Cost Variance = SH × SR – AH × AR
= 50 × ₹ 25/Hr – 48 Hr × ₹ 25.70/Hr
= ₹ 16.40 (F).

(ii) Labour Rate Variance = AH (SR – AR)
= 48 Hrs (25 – 25.70) 1 Hr .
= ₹ 33.60 (A).

(iii) Labour Efficiency Variance = SR (SH – AH)
= 25 (50 – 45.60)
= 110(F)

(iv) Labour IDLE TIME variance = Idle time × Std. Rate (SR)
= 2.4 Hrs × 25 = 60 (A).

(c)
(i) Statement showing profit and loss of each product if products are processed further:

(ii) Statement showing profit/loss if products are not processed further

Therefore,

As clearly visible that further processing of Products X & Z to be incremental benefit, so it should be processed further.
However, Product Y should not be processed further as it leads to loss, so it should be sold at separation point.

Question 6.
Answer any four of the following :
(a) Briefly explain the essential features of a good Cost Accounting System.

(b) Write down the treatment of following items associated with purchase of materials.
(i) Cash discount
(ii) IGST
(iii) Demurrage
(iv) Shortage
(v) Basic Custom Duty

(c) Explain the treatment of Overtime Premium in following situations:
(i) SV & Co. wants to grab some special orders, and overtime is required to meet the same.
(ii) Dept. X has to work overtime to make up a shortfall in produc¬tion due to some fault of management in dept. Y.
(iii) S Ltd. has to work overtime regularly throughout the year as a policy due to the workers’ shortage.
(iv) Due to flood in Odisha, RS Ltd. has to work overtime to com¬plete the job.
(v) A customer requested the company MN Ltd. to expedite the job because of his urgency of work.

(d) Discuss briefly some of the criticism which may be levelled against the Standard Costing System.

(e) Identify the methods of costing from the following statements:
(i) Costs are directly charged to a group of products.
(ii) Nature of the product is complex and method cannot be ascertained.
(iii) Cost is ascertained for a single product.
(iv) All costs are directly charged to a specific job.
(v) Costs are charged to operations and averaged over units pro-
Answer:
(a) The essential features, which a good cost accounting system should possess, are as follows:

• Informative and simple: Cost accounting system should be tailor-made, practical, simple and capable of meeting the requirements of a business concern. The system of costing should not sacrifice the utility by introducing inaccurate and unnecessary details.
• Accurate and authentic: The data to be used by the cost accounting system should be accurate and authenticated; otherwise it may distort the output of the system and a wrong decision may be taken.
• Uniformity and consistency: There should be uniformity and consistency in classification, treatment and reporting of cost data and related information. This is required for benchmarking and comparability of the results of the system for both horizontal and vertical analysis.
• Integrated and inclusive: The cost accounting system should be integrated with other systems like financial accounting, taxation, statistics and operational r esearch etc. to have a complete overview and clarity in results.
• Flexible and adaptive: The cost accounting system should be flexible enough to make necessary amendment and modifications in the system to incorporate changes in technological, reporting, regulatory and cither requirements.
• Trust on the system: Management should have trust on the system and its output. For this, an active role of management is required for the development of such a system that reflects a strong conviction in using information for decision making.

(b) (i) Cash discount will be treated as an income and will be credited to P/I. A/c
(ii) Amount of IGST will have no effect on the value of purchase. It shall be excluded from the value of Materials, if already included.
(iii) Demurrage
(iv) The value of shortage will be excluded from the value of materials and be charged to P/L A/c
(v) Basic Custom Duty will be added to the purchase amount.

(c)
(i) Overtime premium will be including in the cost of order
(it) Since the overtime was required due to the fault of management in Department Y, such overtime premium will be charged to overheads of Department Y.
(iii) Overtime premium will be added to the cost of contract
(iv) Overtime premium will be charged to costing P/L A/c
(v) Overtime premium will be including in the cost of order

(d) The following are some of the criticism which may be levelled against the standard costing system. The arguments have been suitably answered as stated against each by advocates of the standard costing and hence they do not invalidate the usefulness of the system to business enterprises.

• Variation in price: One of the chief problems faced in the operation of the standard costing system is the precise estimation of likely prices or rate to be paid. The variability of prices is so great that even actual prices are not necessarily adequately representative of cost. But the use of sophisticated forecasting techniques should be able to cover the price fluctuation to some extent. Besides this, the system provides for isolating uncontrollable variances arising from variations to be dealt with separately.
• Varying levels of output: If the standard level of output set for pre-determination of standard costs is not achieved, the standard costs are said to be not realised. However, the statement that the capacity utilisation cannot be precisely estimated for absorption of overheads may be true only in some industries of jobbing type. In vast majority of industries, use of forecasting techniques, market research, etc., help to estimate the output with reasonable accuracy and thus the variation is unlikely to be very large. Prime cost will not be affected by such variation and, moreover, variance analysis helps to measure the effects of idle time.
• Changing standard of technology: In case of industries that have frequent technological changes affecting the conditions of pro¬duction, standard costing may not be suitable. This criticism does not affect the system of standard costing. Cost reduction and cost control is a cardinal feature of standard costing because standards once set do not always remain stable. They have to be revised.
• Attitude of technical people: Technical people are accustomed to think of standards as physical standards and, therefore, they will be misled by standard costs. Since technical people can be educated to adopt themselves to the system through orientation courses, it is not an insurmountable difficulty.
• Mix of products: Standard costing presupposes a pre-determined combination of products both in variety and quantity. The mix¬ture of materials used to manufacture the products may vary in the long run but since standard costs are set normally for a short period, such changes can be taken care of by revision of standards.
• Level of Performance: Standards may be either too strict or too liberal because they may be based on (a) theoretical maximum efficiency, (b) attainable good performance or (c) average past performance. To overcome this difficulty, the management should give thought to the selection of a suitable type of standard. The type of standard most effective in the control of costs is one which represents an attainable level of good performance.
• Standard costs cannot possibly reflect the true value in exchange:
  If previous historical costs are amended roughly to arrive at estimates for ad /zocpurposes, they are not standard costs in the strict sense of the term and hence they cannot also reflect true value in exchange. In arriving at standard costs, however, the economic and technical factors, internal and external, are brought together and analysed to arrive at quantities and prices which reflect opti¬mum operations. The resulting costs, therefore, become realistic measures of the sacrifices involved.
• Fixation of standards may be costly: It may require high order of skill and competency. Small concerns, therefore, feel difficulty in the operation of such system.

(e) (i) Batch Costing
(ii) Standard Costing
(iii) Unit Costing
(iv) Job Costing
(v) Process Costing

Determination of National Income Notes – CA Inter Economics Notes is designed strictly as per the latest syllabus and exam pattern.

Determination of National Income Notes – CA Inter ECO Notes

1. Meaning of National Income:

• National Income Accounting, pioneered by the Nobel prize-winning economists Simon Kuznets and Richard Stone, is one such measure.
• National Income is defined as the net value of all economic goods and services produced within the domestic territory of a country in an ac-counting year plus the net factor income from abroad.

2. Usefulness and Significance of National Income Estimates:

• Framework for analyzing and evaluating the short-run performance of an economy
• Pattern of demand for goods and services
• Economic welfare
• Quantitative basis for assessing and choosing economic policies
• Throw light on income distribution
• Assist in determining eligibility for loans etc.
• A guide to make policies for growth and inflation
• Forecasting about the future development trends of the economy

3. Different Concepts of National Income:
Market Price = Factor Cost + Net Indirect Taxes = Factor Cost + Indirect Taxes – Subsidies
Factor Cost = Market Price – Net Indirect Taxes = Market Price – Indirect Taxes + Subsidies
Net Indirect Taxes = Indirect Taxes – Subsidies
Gross = Net + Depreciation
Net = Gross – Depreciation
GDP_MP = Value of Output in the Domestic Territory – Value of Intermediate Consumption
Or
GDP_MP = Σ Value Added

• The basis of distinction between ‘gross’and ‘net’is depreciation or con-sumption of fixed capital.
• If NFIA is positive, then National Income will be greater than domestic factor incomes.

4. Few Important Points While Learning About National Income:

• The value of only final goods and services or only the value added is considered.
• ‘Value Added’ means the difference between value of output and pur-chase of intermediate goods.
• Consumption of fixed assets is ignored.
• Production of agriculture, forestry and fishing which are used for own consumption of producers is also included.
• Economic activities, include all human activities which create goods and services that are exchanged in a market and valued at market price.
• Non-economic activities are not considered e.g. hobbies, housekeeping and child-rearing services of home makers and services of family members that are done out of love and affection.
• National income is a ‘flow’ measure of output per time period (like 1 year).
• The net change in inventories may be positive or negative.

5. Nominal GDP VS Real GDP (GDP at Current and Constant Prices):

• GDP in terms of current market prices, termed ‘nominal GDP’ or ‘GDP at current prices’,
• ‘Real GDP’ or ‘GDP at constant prices’ which is the value of domestic product in terms of constant prices

6. Per Capita Income:
GDP_FC per capita = GDP_FC ÷ Population

7. Personal Income (PI):

PI = NI + Income received but not earned – Income earned but not received

PI = NI – Undistributed profits – Net interest payments made by households – Corporate Tax + Transfer Payments to the households from firms and Government

PI = Factor income from net domestic product accruing to the private sector + Net factor income from abroad + National debt interest + Current transfers from government + Other net transfers from the rest of the world – Undistributed profits – Corporate Tax

8. Disposable Personal Income (DI):
DI = PI – Personal Income Taxes – Non-tax payments
Two more concepts need to be understood, namely:

(a) Net National Disposable Income (NNDI)

NNDI = Net National Income + Other net current transfers from the rest of the world (Receipts less payments)
= NNI + Net taxes on income and wealth receivable from abroad + Net social contributions and benefits receivable from abroad.

(b) Gross National Disposable Income (GNDI)

GNDI = NNDI + CFC (Consumption of fixed capital)
= GNI + Other net current transfers from the rest of the world (Receipts less payments) (Other Current Transfers refer to current transfers other than the primary incomes)

9. Categories of Domestic Income:

• Income from domestic product accruing to the public sector which includes income from property and entrepreneurship accruing to gov-ernment administrative departments and savings of non-departmental enterprises.
• Income from domestic product accruing to private sector = NDPFC – Income from property and entrepreneurship accruing to government administrative departments – Savings of non-departmental enterprises.

10. Private Income:
Private Income = Factor income from net domestic product accruing to the private sector + Net factor income from abroad + National debt interest + Current transfers from government + Other net transfers from the rest of the world.

Private Income = Personal Income + Undistributed Profit + Corporate tax

11. There are many reasons to dispute the validity of GDP as a perfect measure of well being:

• Income distributions and, therefore, GDP per capita is a completely inadequate measure of welfare.
• Quality improvements in systems and processes are ignored.
• Productions hidden from government authorities.
• Non-market production and Non-economic contributors to well-being.
• The disutility of loss of leisure time.
• Economic ‘bads’.
• The volunteer work and services rendered without remuneration.
• Many things such as, leisure time, fairness, gender equality, security of community feeling etc.
• Both positive and negative externalities.
• The distinction between production that makes us better off and pro-duction that only prevents us from becoming worse off.

12. The Circular Flow of Income:

13. Value Added Method or Product Method or Industrial Origin Method or Net Output Method:

Step 1: All the producing enterprises are broadly classified into three main sectors namely:

(a) Primary sector,
(b) Secondary sector, and
(c) Tertiary sector or service sector

Step 2: Estimating the gross value added (GVA_MP) by each producing enterprise:
GDP/GVA_MP = Value of output – Intermediate consumption
= (Sales + change in stock) – Intermediate consumption

Step 3: Estimation of National income for each individual unit and then Na-tional Income:
NDP/NVA_MP = (GVA_MP) – Depreciation
NDP/NVA_FC = NVA_MP – Net Indirect taxes
NI/NNP_FC = NVA_FC + NFIA

14. Income Method or Factor Payment Method or Distributed Share Method:
National income is calculated by summation of factor incomes paid out by all production units within the domestic territory of a country as wages and salaries, rent, interest, and profit. By definition, it includes factor payments to both residents and non- residents.

NDP_FC = Sum of factor incomes paid out by all production units within the domestic territory of a country
NNP_FC/NI = Compensation of employees + Operating Surplus (rent + interest + profit) + Mixed Income of Self- employed + NFIA

15. Expenditure Method:
Under this method, National income is calculated by summation of following items:

1. Final Consumption Expenditure:
(a) Private Final Consumption Expenditure (PFCE)
(b) Government Final Consumption Expenditure
2. Gross Domestic Capital formation
3. Net Exports

GDP_MP = Final consumption expenditure + Gross domestic capital formation + Net Expon
GNP_MP = GDP_MP + NFIA
GNP_FC = GNPMP – Net indirect taxes
NNP_FC or NI = GNP_FC – Depreciation

16. National Income as per Keynes:
A comprehensive theory of National Income was first put forward by the British economist John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest and Money’ published in 1936.

The Keynesian theory of income determination is presented in three models:

• The two-sector model consisting of the household and the business sectors,
• The three-sector model consisting of household, business and government sectors, and
• The four-sector model consisting of household, business, government and foreign sectors.

17. The Simple Two Sector Economy Model Assumes:

• Only two sectors in the economy viz., households and firms,
• Only consumption and investment outlays,
• Households own all factors of production,
• They sell their factor services to earn factor incomes,
• They do not save,
• No corporations, corporate savings or retained earnings,
• Y = Y_d
• No government, no taxes, no government expenditure or transfer payments,
• The economy is a closed economy, i.e., foreign trade does not exist.
  Factor Payments = Household Income = Household Expenditure = Total Receipts of Firms = Value of Output

18. The Aggregate Demand Function (AD): Two-Sector Model:

Aggregate demand (AD) or aggregate expenditure consists of only two components:

(i) Aggregate demand for consumer goods (C), and
(ii) Aggregate demand for investment goods (I)
AD = C + I (constant investment)

19. The Consumption Function (C):
C = f(Y)
According to Keynes:
C = a + bY
C = Aggregate consumption expenditure;
Y = Total disposable income;
a = Consumption at zero level of disposable income;
b = The slope of the function, (ΔC/ΔY)

20. Marginal Propensity to Consume (MPC) ‘b’: MPC(b) = ΔC /ΔY

21. Average Propensity to Consume (APC): APC = C/Y
22. The Saving Function (S): S = f(Y)
S = Y – C

23. The Marginal Propensity to Save (MPS): MPS(1 – b) = ΔS/ΔY

• MPC is always less than unity, but greater than zero, i.e., 0 < b < 1
• MPC + MPS = 1

24. Average Propensity to Save (APS): APS = S/Y

25. Relationship Between Income and Consumption:

26. The Consumption and Saving Function:
Since C+ S = Y, the national income equilibrium can be written as:
Y = C + I
CPS = C + I, or S = I

27. Determination of Equilibrium Income: Three Sector Model:
Y = C + I + G

28. Determination of Equilibrium Income: Four Sector Model:
Y = C + I + G + (X – M)

29. Effects on Income when Imports are Greater than Exports: National income will decrease.

30. The Investment Multiplier (k)

In two sector model:
k = ΔY/ΔI or ΔY = k × Δl
ΔY/ΔI = 1/1-MPC = 1/MPS

In three sector model;
k = \(\frac{1}{1-b(1-t)}\)

In four sector model:
k = \(\frac{1}{1-b(1-t)+m}\)

Scope and Objectives of Financial Management – CA Inter FM Notes is designed strictly as per the latest syllabus and exam pattern.

Scope and Objectives of Financial Management – CA Inter FM Notes

1. Financial Management:
Financial management refers to that managerial activity which is concerned with the arrangement of funds from various sources with consideration of cost, control and risk involved with such sources and application of these funds in an effective manner to maximize shareholders earning and wealth (EPS and MPS).

FINANCIAL MANAGEMENT

2. Sources of Funds

• Equity Share Capital
• Retained Earnings
• Preference Share Capital
• Debentures
• Funding from banks
• International Funding

3. Application of Funds:

• Investment in Fixed Assets
• Investment in Working Capital

4. Evolution of Financial Management: Evolution of financial management took 50 years and can be divided into three stages:

• The Traditional Phase: In traditional phase, financial management was relevant only for big decisions like: takeovers, mergers, expansion, liq-uidation, etc.
• The Transitional Phase: In transitional phase, importance of day to day financial decisions increased, small decisions also got more attention. Like: funds analysis, planning and control etc.
• The Modern Phase: It is current phase today and is still going on. In today’s world importance and scope of financial management greatly increased due to globalization, heavy foreign exchange transfers, capital market transactions etc. Many new theories have been developed regarding efficient markets, capital budgeting, option pricing, valuation models and also in several other important fields in financial management.

5. Finance Functions or Finance Decisions: we can classify finance decisions into two categories:

• Long term finance decisions: It can be further divided into three categories:
• Investment decisions (I): Selection of assets and investment of long term funds into these assets.
• Financing decisions (F): Selection of optimum capital structure on the basis of cost of fund, risk associated with these funds and control.
• Dividend decisions (D): Decisions related to distribution of profit as dividend.
• Short term finance decisions: Decisions related to management of cur-rent assets and current liabilities. It is also known as Working Capital Management (WCM).

6. Importance of Financial Management due to following tasks:

• Look after not to over-invest in fixed assets,
• Maintain balancing of cash outflow with cash inflows,
• Maintaining sufficient level of short term working capital,
• Preparation of growing sales budget,
• Set correct pricing for products or services to increase gross profit,
• Look after and control general and administrative expenses, and
• Focusing on tax planning to minimize the taxes.

7. Scope of Financial Management:

• Determination of size of the enterprise and determination of rate of growth,
• Determining the composition of assets of the enterprise,
• Determining the mix of enterprise’s financing,
• Analysis, planning and control of financial affairs of the enterprise.

8. Objectives of Financial Management: Main two objectives of financial management are profit maximization and wealth maximization.

9. Role of Finance Executive:

• Financial analysis and planning,
• Investment decisions,
• Financing and capital structure decisions,
• Management of financial resources (such as working capital),
• Risk management.

10. Financial Distress and Insolvency: When a company cannot pay its day to day expenses and financial expenses like: salaries, rent, interest on debt etc. smoothly, then this situation is known as financial distress. Continuation of financial distress create insolvency situation in long term.

11. Agency Problem and Agency Cost: When management is focusing their salaries, perks etc. instead of maximization of shareholders wealth and profit then this situation is known as agency problem. Agency cost is the additional cost borne by the shareholders to monitor the manager and control their behaviour so as to maximise shareholders wealth.

CA Inter FM ECO Paper May 2022 – CA Inter FM ECO Study Material is designed strictly as per the latest syllabus and exam pattern.

CA Inter FM ECO Question Paper May 2022 Solution

Question 1.
(a) Following are the information and ratios are given for W limited for the year ended 31st March, 2022:
Equity Share Capital of 10 each : ₹ 10 Lakhs
Reserves & Surplus to Shareholder& Fund : 0.50
Sales / Shareholders’ Fund : 1.50
Current Ratio : 2.50
Debtors Turnover Ratio : 6.00
Stock Velocity : 2 Months
Gross Profit Ratio : 20%
Net Working Capital Turnover Ratio : 2.50

You are required to calculate:
(1) Shareholders’ Fund
(2) Stock
(3) Debtors
(4) Current Liabilities
(5) Cash Balance (5 Marks)
Answer:
(1) Shareholders’ Fund = Equity Share Capital + Reserve and Surplus
= ₹ 10 Lakhs + 0.50 Shareholders’ Fund
0.50 Shareholders’Fund = ₹ 10 Lakhs
Shareholders’ Fund = ₹ 10 Lakhs ÷ 0.50 = ₹ 20,00,000
\(\frac{\text { Reserve and Surplus }}{\text { Shareholders’ Fund }} \) = 0.50 or Reserve & Surplus = 0.50 Shareholders’ Fund

(2) Stock = COGS × Stock Velocity /12
= ₹ 24,00,000 × 2 /12 = ₹ 4,00,000
\(\frac{\text { Sales }}{\text { Shareholders Fund }}\) = 1.50 or Sales = 1.50 Shareholders’ Fund
Sales = 1.50 × ₹ 20,00,000 = ₹ 30,00,000
COGS = Sales – Gross Profit
= ₹ 30,00,000 – 20% = ₹ 24,00,000

(3) Debtors = Annual Credit Sales -P Debtors Turnover Ratio
= ₹ 30,00,000 ÷ 6 = ₹ 5,00,000

(4) Current Liabilities
Current Ratio = CA ÷ CL = 2.50
Current Assets = 2.50 CL
\(\frac{\text { Sales }}{\text { Net Working Capital }}\) = 2.50
Net Working Capital = Sales ÷ 2.50 = ₹ 30,00,000 ÷ 2.50 = ₹ 12,00,000
CA – CL = ₹ 12,00,000
2.5 CL – CL = ₹ 12,00,000
Current Liabilities = ₹ 12,00,000 ÷ 1.5 = ₹ 8,00,000

(5) Cash Balance = Current Asset – Debtors – Stock
= ₹ 20,00,000 – ₹ 5,00,000 – ₹ 4,00,000
= ₹ 11,00,000
Current Asset = 2.5 CL
= 2.5 × 8,00,000 = ₹ 20,00,000

(b) Balance sheet of X Ltd. for the year ended 31st March, 2022 is given below: (₹ in lakhs)

Calculate the amount of maximum permissible bank finance under three methods as per Tandon Committee lending norms.
Total core current assets are assumed to be ₹ 30 Lakhs. (5 Marks)
Answer:
Calculation of MPBF:
Method 1 = 75% (CA – CL) = 15% (480 – 280) = ₹ 150 Lakhs
Method 2 = (75% CA) – CL = (75% 480) – 280 = ₹ 80 lakhs

Method 3 = (75% CA other than core CA) – CL
= 75% (480 -30) – 280 = ₹ 57.50 Lakhs
Current Assets = Raw Materials + WIP + Finished Goods + Debtors + Cash and Bank
= 150 + 100 + 50 + 125 + 55 = ₹ 480Lakhs
Current Liabilities = Public deposit (Short.term) + Trade Creditors + Bills Payable
= 100 + 80 + 100 = ₹ 280 Lakhs

(c) A company requires 36,000 units of a product per year at a cost of ₹ 100 per unit. Ordering cost per order is ₹ 250 and the carrying cost is 4.5% per year of the inventory cost. Normal lead time is 25 days and safety stock is Nil. Assume 360 working days in a year.
(а) Calculate the Reorder Inventory Level.
(b) Calculate the Economic Order Quantity (EOQ).
(c) If the Supplier offers 1% quantity discount for purchase in lots of 9,000 units or more, should the company accept the proposal? (5 Marks)
Answer:
(a) Reorder Inventory Level = (Average Consumption × Average Lead Time) + Safety Stock
= [(36,000 ÷ 360) × 25 days] + Nil
= 2,500 units

(b) EOQ = \(\sqrt{\frac{2 \mathrm{AO}}{\mathrm{C}}}\) = \(\sqrt{\frac{2 \times 36,000 \times 250}{100 \times 4.5 \%}}\) = 2,000 units

(c) Statement of Evaluation of 1% Discount Offer

Advise: Company should accept 1% discount offer (Net saving by acceptance is ₹ 23,952).

(d) P Ltd. is considering a project with the following details: (5 Marks)

(a) MEASURE the sensitivity of the project to change in Initial Project Cost and Annual Cash Inflows (considering each factor at a time) such that NPV become zero.
(b) IDENTIFY which of the two factors; the project is most sensitive to affect the acceptability of the project?

Answer:
Current Net Present value (NPV)

(a) Measurement of Sensitivity:
(i) Sensitivity Analysis w.r.t. Initial Project Cost:
NPV of the project would be zero when the cost of the project is increased by ₹ 38,840
∴ Percentage change in the cost = (38,840 ÷ 1,00,000) × 100 = 38.84%

(ii) Sensitivity Analysis w.r.t. Annual Cash Flows:
NPV of the project would be zero when the PV of annual cash inflows is decreased by ₹ 3 8,840
∴ Percentage change in the annual cash inflows = (38,840 ÷ 1,38,840) × 100 = 27.97%

(b) The Annual cash inflows is the most sensitive as only a change beyond 27.97% in savings makes the project unacceptable.

Question 2.
Details of a company for the year ended 31st March, 2022 are given below: (10 Marks)
Sales : ₹ 86,00,000
Profit Volume (P/V) Ratio : 35%
Fixed Cost excluding interest expenses : ₹ 10,00,000
10% Debt : ₹ 55,00,000
Equity Share Capital of ₹ 10 each : ₹ 75,00,000
Income Tax Rate : 40%

Required:
(1) Determine company’s Return on Capital Employed (Pre-tax) and EPS.
(2) Does the company have a favourable financial leverage?
(3) Calculate operating and combined leverage of the company.
(4) Calculate percentage change in EBIT, if sales increases by 10%.
(5) At what level of sales, the Earning Before Tax (EBT) of the company will be equal to zero?
Answer:

(2) ROCE is 15.46% and Interest on debt is 10%, hence, it has a favourable financial leverage.

(3) Calculation of Operating and Combined leverages:
Operating Leverage = \(\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{30,10,000}{20,10,000}\) = 1.497
Combined Leverage = \(\frac{\text { Contribution }}{\text { EBT }}\) = \(\frac{30,10,000}{14,60,000}\) = 2.062

(4) Operating leverage is 1.497. So if sales is increased by 10% then EBIT will be increased by 1.497 × 10 i.e. 14.97% (approx.)

(5) EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 65% sales – 10,00,000 – 5,50,000
35% of sales = 15,50,000
Sales = ₹ 44,28,571

Question 3.
Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making computers. The estimated annual saving from introduction of the Artificial Intelligence (AI) is as follows: (10 Marks)

• Reduction of five employees with annual salaries of ₹ 3,00,000 each.
• Reduction of ₹ 3,00,000 in production delays caused by inventory problem;
• Reduction in lost sales ₹ 2,50,000; and
• Gain due to timely billing ₹ 2,00,000

The purchase price of the system for installation of artificial intelligence is ₹ 20,00,000 and installation cost is ₹ 1,00,000. 80% of the purchase price will be paid in the year of purchase and remaining will be paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight-line basis.
However, the operation of the new system requires two computer specialists with annual salaries of ₹ 5,00,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in ₹)

Maintenance and Operating Cost are payable in advance.
The company’s tax rate is 30% and its required rate of return is 15%.

Evaluate the project by using Net Present Value and Profitability Index.
Answer:
(1) Net Present value (NPV)

Advice: Accept the proposal having positive NPV.

(2) Profitability Index = PV of Inflows ÷ PV of Outflows
= 27,80,391 ÷ 18,40,000 = 1.51
Advice: Accept the proposal having PI higher than 1.

Working Note:
Statement of CFAT

Question 4.
The particulars relating to Raj Ltd. for the year ended 31st March, 2022 are given as follows:

The capital structure of the company as on 31st March, 2022 is as follows:

Raj Ltd. has decided to undertake an expansion project to use the market potential that will involve ₹ 20,00,000. The company expects an increase in output by 50%. Fixed cost will be increased by ₹ 5,00,000 and variable cost per unit will be increased by 15%. The additional output can be sold at the existing selling price without any adverse impact on the market.
The following alternative schemes for financing the proposed expansion program are planned:

Slab wise interest rate for fund borrowed is as given follows:

Current market price per share is 200.
Find out which of the abovementioned alternatives would you recommend for raj Ltd. with reference to the EPS, assuming a corporate tax rate is 40%? (10 Marks)
Answer:
Statement of EPS

Decision: The earning per share is higher in alternative I ie. if the company finance the project by raising debt of ₹ 5,00,000 & issue equity shares of ₹ 15,00,000. Therefore, the company should choose this alternative to finance the project.

Question 5.
A company issues:
15% convertible debentures of ₹ 100 each at par with a maturity period of 6 years. On maturity, each debenture will be converted into 2 equity shares of the company. The risk-free rate of return is 10%, market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of ₹ 12.76 per share. Five year ago, it paid dividend of ₹ 10 per share. Flotation cost is 5% of issue amount.

5% preference shares of ₹ 100 each at premium of 10%. These shares are redeemable after 10 years at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.
(a) Calculate the cost of convertible debentures using the approximation method.
(b) Use YTM method to calculate cost of preference shares. (10 Marks)

Answer:
(a) Calculation of cost of Convertible Debentures using Approximation method:

= 13.24%
Working Notes:
Determination of Redemption value:
Higher of
(i) The cash value of debentures = ₹ 100
(ii) Value of equity shares = 2 shares × ₹ 48.72 (1 + 0.05)⁶ = ₹ 130.58
₹ 130 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Calculation of Value of Share today:
P₀ = \(\frac{D_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{12.76(1+0.05)}{32.50 \%-5 \%}\) = ₹ 48.72
K_e = R_f + β (R_m – R_f) = 10% + 1.25 × 18% = 32.50%
g = \(\sqrt[5]{\frac{12.76}{10.00}}\) = 5% or
g = 12.76 ÷ 10.00 = 1.276 (5% for 5 year; given in interest rate table)

(b) Calculation of Cost of Preference shares using YTM method:
Calculation of NPV at two discount rates:

IRR/K_d = LR + \(\frac{\mathrm{NPV}_L}{\mathrm{NPV}_L-\mathrm{NPV}_H}\) × (H – L) = 3% + \(\frac{13.65}{13.65-(-3.39)}\) × (5% – 3%)
= 4.60%
Working Note:
Net Proceeds = Issue Price – Flotation Cost
= (100 + 10% Premium) – 6% = ₹ 103.40

Question 6.
(a) Identify the limitations of Internal Rate of Return. (4 Marks)
Answer:
Followings are the limitations of IRR:
(a) The calculation process is tedious if there is more than one cash outflow interspersed between the cash inflows; there can be multiple IRR, the interpretation of which is difficult.

(b) The IRR approach creates a peculiar situation if we compare two projects with different inflow/outflow patterns.

(c) It is assumed that under this method all the future cash inflows of a proposal are reinvested at a rate equal to the IRR. It ignores a firm’s ability to reinvest in portfolio of different rates.

(d) If mutually exclusive projects are considered as investment options which have considerably different cash outlays. A project with a larger fund commitment but lower IRR contributes more in terms of absolute NPV and increases the shareholders’ wealth. In such situation decisions based only on IRR criterion may not be correct.

(b) Briefly explain the assumptions of the Walter’s Model. (4 Marks)
Answer:
Followings are the assumptions of Walter’s Model:
(a) All investment proposals of the firm are to be financed through retained earnings only.

(b) ‘ r’ rate of return & ‘Ke’ cost of capital are constant.

(c) Perfect capital markets: The firm operates in a market in which all investors are rational and information is freely available to all.

(d) No taxes or no tax discrimination between dividend income and capital appreciation (capital gain). It means there is no difference in taxation of dividend income or capital gain. This assumption is necessary for the universal applicability of the theory, since, the tax rates may be different in different countries.

(e No flotation or transaction cost: Similarly, these costs may differ country to country or market to market.
(f) The firm has perpetual life

(c) State advantages of “Wealth Maximization” goals in Financial Management (2 Marks)
OR
Distinguish between American Depository Receipts and Global Depository Receipts. (2 Marks)
Answer:
Followings are the advantages of ‘Wealth Maximization’:
(a) Emphasizes the long-term gains
(b) Recognises risk or uncertainty
(c) Recognises the timing of returns id) Considers shareholders’ return.
Or
Answer:
American Depository Receipts (ADRs): These are securities offered by non-US companies who want to list on any of the US exchange. Each ADR represents a certain number of a company’s regular shares. ADRs allow US investors to buy shares of these companies without the costs of investing directly in a foreign stock, exchange.

The Indian companies have preferred the GDRs to ADRs because the US market exposes them to a higher level of responsibility than a European listing in the areas of disclosure, costs, liabilities and timing. The regulations are somewhat more stringent and onerous, even for companies already listed and held by retail investors in their home country. The most onerous aspect of a US listing for the companies is to provide full, half yearly and quarterly accounts in accordance with, or at least reconciled with US GAAPs.

Global Depository Receipts (GDRs): These are negotiable certificates held in the bank of one country representing a specific number of shares of a stock traded on the exchange of another country. These financial instruments are used by companies to raise capital in either dollars or Euros. These are mainly traded in European countries and particularly in London.

Question 7.
(a) Following information, relating to a particular financial year, are given as under: (3 Marks)

Compute:
(a) GVA_MP
(b) NDP_MP
(c) Operating Surplus
Answer:
(a) GVA_MP = Value of output- Intermediate consumption
= Sales + Change in stock – Intermediate consumption
= 3,500 + (300 – 200) – 400 = 3,200 Crores

(b) NDP_MP = GVA_MP – Consumption of Fixed Capital
= 3,200 – 400 = 2,800 Crores

(c) NDP_FC 2,200 = Compensation of Employees + Operating Surplus + Mixed Income 400 + Operating Surplus + 200
Operating Surplus = 1,600 Crores
NDP_FC = NDP_MP – Net Indirect Tax
= 2,800 – 600 = 2,200 Crores

(b) State the features of Foreign Portfolio Investment. (3 Marks)
Answer:
Foreign Portfolio Investment (FPI) is not concerned with either manufacture of goods or with provision of services. Such investors also do not have any intention of exercising voting power or controlling or managing the affairs of the company in whose securities they invest.

The singular intention of a foreign portfolio investor is to earn a remunerative return through investment in foreign securities and is primarily concerned about the safety of their capital, the likelihood of appreciation in its value, and the return generated. Logically, portfolio capital moves to a recipient country which has revealed its potential for higher returns and profitability.

Following international standards, portfolio investments are characterised by lower stake in companies with their total stake in a firm at below 10 per cent. It is also noteworthy that unlike the FDIs, these investments are typically of short term nature, and therefore, are not intended to enhance the productive capacity of an economy by the creation of capital assets.

Portfolio investors will evaluate, on a separate basis, the prospects of each independent unit in which they might invest and may often shift their capital with changes in these prospects. Therefore, portfolio investments are, to a large extent, expected to be speculative. Once investor confidence is shaken, such capital has a tendency to speedily shift from one country to another, occasionally creating financial crisis for the host country.

(c) Comment on the role of Government intervention for equitable distribution. (2 Marks)
Answer:
One of the most important activities of the government is to redistribute incomes so that there is equity and fairness in the society. Equity can be brought about by redistribution of endowments with which the economic agents enter the market.

Some common policy interventions include: progressive income tax, targeted budgetary allocations, unemployment compensation, transfer payments, subsidies, social security schemes, job reservations, land reforms, gender sensitive budgeting etc. Government also intervenes to combat black economy and market distortions associated with a parallel black economy. Government intervention in a market that reduces efficiency while increasing equity is often justified because equity is greatly appreciated by society.

(d) Describe the precautionary motive for money. (2 Marks)
Answer:
Many unforeseen and unpredictable contingencies involving money payments occur in our day to day life. Individuals as well as businesses keep a portion of their income to finance such unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of income, prevailing economic as well as political conditions and personal characteristics of the individual such as optimism/pessimism, farsightedness etc. Keynes regarded the precautionary balances just as balances under transactions motive as income elastic and by itself not very sensitive to rate of interest.

Question 8.
(a)(i) Differentiate between Non-Discretionary and Discretionary Fiscal Policy. (3 Marks)
Ans.
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. Changes in fiscal policy do not always require explicit action by government. 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. Any government programme that automatically tends to reduce fluctuations in GDP is called an automatic stabilizer.

However, automatic stabilizers that depend on the level of economic activity alone would not be sufficient to correct instabilities. The government needs to resort to discretionary fiscal policies. Discretionary fiscal policy for stabilization refers to deliberate policy actions on the part of government to change the levels of expenditure, taxes to influence the level of national output, employ-ment and prices. Governments influence the economy by changing the level and types of taxes, the extent and composition of spending, and the quantity and form of borrowing.

(a) (ii) Write a brief note on Countervailing Duties. (2 Marks)
Answer:
Countervailing duties are tariffs that aim to offset the artificially low prices charged by exporters who enjoy export subsidies and tax concessions offered by the governments in their home country. If a foreign country does not have a comparative advantage in a particular good and a government subsidy allows the foreign firm to be an exporter of the product, then the subsidy generates a distortion from the free-trade allocation of resources.

In such cases, CVD is charged in an importing country to negate the advantage that exporters get from subsidies to ensure fair and market oriented pricing of imported products and thereby protecting domestic industries and firms. For example, in 2016, in order to protect its domestic industry, India imposed 12.5% countervailing duty on Gold jewellery imports from ASEAN.

(b )(i) Explain the ‘Circular Flow of Income’. (3 Marks)
Answer:
Circular flow of income refers to the continuous circulation of production, income generation and expenditure involving different sectors of the economy. There are three different interlinked phases in a circular flow of income,
namely: production, distribution and disposition as can be seen from the following figure.

Circular Flow of Income

1. In the production phase, firms produce goods and services with the help of factor services.
2. 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.
3. 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.

These 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. The details in respect of what is measured and what data are required for all three methods mentioned above are given in the following table.

(b) (ii) What will be the total money credit created by the commercial banking system for an initial deposit of ₹ 500 if the required reserve ratio is 0.04, 0.06 and 0.10 per cent respectively. Compute credit multiplier. (2 Marks)
Answer:
(a) Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\)
Required Reserved Ratio
For RRR 0.04 Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\) = 1/0.04 = 25
For RRR 0.06 Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\) = 1/0.06 = 16.67
For RRR 0.10 Credit Multiplier = \(\frac{1}{\text { Required Reserved Ratio }}\) = 1/0.10 = 10

(b) Credit Creation = Initial deposits × Credit Multiplier
For RRR 0.04
Credit Creation = 500 × 25 — 12,500
For RRR 0.06
Credit Creation = 500 × 16.67 = 8,333
For RRR 0.10
Credit Creation = 500 × 10 = 5,000

Question 9.
(a) (i) Explain ‘Global Public goods’ with examples. (3 Marks)
Answer:
There are several public goods benefits of which accrue to everyone in the world. These goods have widespread impact on different countries and regions, population groups and generations. These are goods whose impacts are indivisibly spread throughout the entire globe.

The WHO delineates two categories of global public goods namely, final public goods which are ‘outcomes’, (e.g. the eradication of polio) and intermediate public goods, which contribute to the provision of final public goods, (e.g. International Health Regulations aimed at stopping the cross-border movement of communicable diseases and thus reducing cross-border health risks).

Similarly, the World Bank identifies five areas of global public goods which it seeks to address: namely, the environmental commons (including the prevention of climate change and biodiversity), communicable diseases (including HIV /AIDS, tuberculosis, malaria and avian influenza), international trade, international financial architecture, and global knowledge for development. The distinctive characteristic of global public goods is that there is no mechanism (either market or government) to ensure an efficient outcome.

(a) (ii) What is Aggregate Demand Function? (2 Marks)
Answer:
In a simple two-sector economy Aggregate Demand (AD) or aggregate expenditure consists of only two components:
(i) Aggregate demand for consumer goods (C), and
(ii) Aggregate demand for investment goods (I)
AD = C + I
Of the two components, consumption expenditure accounts for the highest proportion of the GDP. In a simple economy, the variable I is assumed to be determined exogenously and constant in the short run. Therefore, the short- run aggregate demand function can be written as:
AD = C + I (constant investment)
We can infer that, in the short run, AD depends largely on the aggregate consumption expenditure.

(b) (i) Calculate the volume of Transaction:
Price = 105
Velocity of money = 4.2
Money supply = 4500 billion
What will be the outcome if volume of transaction increases to 240? (3 Marks)
Answer:
MV = PT,
(a) 4500 × 4.2 = 105 × T
T = 180
MV = PT,

(b) M × 4.2 = 105 × 240
M = 6,000 billion

(b) (ii) What do you mean by ‘Bound Tariff’? Explain.
Answer:
A bound tariff is a tariff which a WTO member binds itself with a legal commitment not to raise it above a certain level. By binding a tariff, often during negotiations, the members agree to limit their right to set tariff levels beyond a certain level. The bound rates are specific to individual products and represent the maximum level of import duty that can be levied on a product imported by that member.

A member is always free to impose a tariff that is lower than the bound level. Once bound, a tariff rate becomes permanent and a member can only increase its level after negotiating with its trading partners and compensating them for possible losses of trade. A bound tariff ensures transparency and predictability.

Question 10.
(a) (i) What are the common objectives of fiscal policy? (3 Marks)
Answer:
Most common objectives of fiscal policy are:
(a) Achievement and maintenance of full employment,
(b) Maintenance of price stability,
(c) Acceleration of the rate of economic development, and
(d) Equitable distribution of income and wealth.

(a) (ii) State the nature of the monetary policy for the following actions taken by the RBI of the country: (2 Marks)
(A) Reduction in the cash reserve ratio.
(B) Selling of securities in the open market.
(C) Increase of repo rate by 50 base point.
(D) Increase in the supply of currency and coins.
Answer:

(b) (i) Calculate, Multiplier and Marginal Propensity of Consume (MPC) with the help of following information: (3 Marks)

Answer:
Investment multiplier (k) = ∆Y/∆I = 1600/400 = 4
∆Y/∆I = \(\frac{1}{1-\mathrm{MPC}}\) = 4
4 – 4MPC = 1
MPC = 0.75

(b) (ii) Explain ‘Sanitary and Phytosanitary (SPS) Measures’. (2 Marks)
Answer:
SPS measures are applied to protect human, animal or plant life from risks arising from additives, pests, contaminants, toxins or disease-causing organisms and to protect biodiversity. These include ban or prohibition of import of certain goods, all measures governing quality and hygienic requirements, production processes, and associated compliance assessments. For example; prohibition of import of poultry from countries affected by avian flu, meat and poultry processing standards to reduce pathogens, residue limits for pesticides in foods etc.

Question 11.
(a) (i) The monetary authority of an economy has provided the following data: (3 Marks)

You are required to calculate (i) M1; and (ii) M2.
Answer:
M1 = (Notes in Circulation + Circulation of Rupee Coin + Circulation of Small Coins – Cash on Hand with Banks) + Deposit Money of the Public
= (2,42,09,645 + 3,25,572 + 7,434 – 9,75,635) + 1,77,61,992
= 4,13,29,008 Crores

M2 = M1+ Post Office Saving Bank Deposits
= 4,13,29,008 + 1,48,966
= 4,14,77,974 Crores

(a) (ii) Identify the market outcomes for each of the following situations: (2 Marks)
(A) Playing of loud music at night in inability to sleep.
(B) Wearing of mask during Covid-19 pandemic.
Answer:

(b) (i) Following information, relating to an economy of a country, for the current year are as under: (3 Marks)

Find out:
(A) Private Final Consumption Expenditure
(B) Net Factor Income from Abroad
(C) NNP_FC or National Income
Answer:
(A) GDP_MP = C + I + G + X – M
6,550 = C + 1000 + 1,500 + 400 – 350
C = 4,000 Crores

(B) GNP_MP = GDP_MP + NFIA
6,600 = 6,550 + NFIA
NFIA = 50 Crores

(C) NNP_FC (NI) = GNP_MP – Depreciation
= 6,600 – 200
= 6,400 Crores

(b) (ii) Explain briefly two key concepts of ‘New Trade Theory’ that gives advantages to countries that import goods to compete with the home country. (2 Marks)
Or
Explain ‘Embargos; (2 Marks)
Answer:
According to NTT, two key concepts give advantages to countries that import goods to compete with products from the home country:
(a) Economies of Scale: As a firm produces more of a product its cost per unit keeps going down. So if the firm serves domestic as well as foreign market instead of just one, it can reap the benefit of large scale of production consequently the profits are likely to be higher.

(b) Network effects are the way one person’s value of a good or service is affected by the value of that good or service to others. The value of the product or service is enhanced as the number of individuals using it increases. This is also referred to as the ‘bandwagon effect’. Consumers like more choices, but they also want products and services with high utility, and the network effect offers increased utility from these products over others. A good example will be Mobile App such as Whats App and software like Microsoft Windows.

Or

An embargo is a total ban imposed by government on import or export of some or all commodities to particular country or regions for a specified or indefinite period. This may be done due to political reasons or for other reasons such as health, religious sentiments. This is the most extreme form of trade barrier.

CA Inter FM ECO Question Paper 1 – CA Inter FM ECO Study Material is designed strictly as per the latest syllabus and exam pattern.

FM ECO CA Inter Question Paper 1

Time Allowed – 3 Hours
Maximum Marks – 100

Section A – Financial Management

Question 1.
Answer the followings:

(a) The Sale revenue of TM excellence Ltd. @ ₹ 20 per unit of output is ₹ 20 lakhs and Contribution is ₹ 10 lakhs. At the present level of output the DOL of the company is 2.5. The company does not have any Preference , Shares. The number of Equity Shares are 1 lakh. Applicable corporate income tax rate is 50% and the rate of interest on Debt Capital is 16% p.a.
What is the EPS (At sales revenue of ₹ 20 lakhs) and amount of Debt Capital of the company if a 25% decline in Sales will wipe out EPS.
Answer:
(A) Earnings Per Share = \(\frac{(\text { EBIT }-\mathrm{I})(1-\mathrm{t})}{\text { Equity shares }}\)
= \(\frac{(4,00,000-1,50,000)(1-0.50)}{1,00,000}\) = ₹ 1.25
(B) Amount of DEBT = Interest ÷ Rate of interest
= 1,50,000 ÷ 16% = ₹ 9,37,500

Working Note:
(1) Calculation of Fixed Cost:
DOL = \(\frac{\text { Contribution }}{\text { EBIT }}\) = \(\frac{10,00,000}{\text { EBIT }}\) = 2.5 times
EBIT = 10,00,000 ÷ 2.5 = ₹ 4,00,000
Fixed Cost = Contribution – EBIT
= 10,00,000 – 4,00,000 = ₹ 6,00,000

(2) Calculation of Degree of Combined Leverage:
Question says that 25% change in sales will wipe out EPS. Here wipe out means it will reduce EPS by 100%.
DCL = \(\frac{\% \text { Change in EPS }}{\% \text { Change in Sales }}=\frac{100 \%}{25 \%}\) = 4 times

(3) Calculation of EBT and Interest:
DCL = \(\frac{\text { Contribution }}{\text { EBT }}=\frac{10,00,000}{\text { EBT }}\) = 4 times
EBT = 10,00,000 ÷ 4 = ₹ 2,50,000
Interest = EBIT – EBT = 4,00,000 – 2,50,000
= ₹ 1,50,000

(b) The following figures are collected from the annual report of XYZ Ltd.:

What should be the approximate dividend payout ratio so as to keep the share price at ₹ 42 by using Walter model?
Answer:

Divided Payout ratio:
= \(\frac{\text { DPS }}{\text { EPS }}\) × 100 = \(\frac{3.12}{6}\) × 100 = 52%

(c) Alpha Ltd. requires funds amounting to ₹ 80,00,000 for its new project. To raise the funds, the company has following two alternatives:

(1) To issue Equity Shares of ₹ 100 each (at par) amounting to ₹ 60,00,000 and borrow the balance amount at the interest of 12% p.a.; or
(2) To issue Equity Shares of ₹ 100 each (at par) and 12% Debentures in equal proportion.
Find out the point of in difference between two modes of financing and state which option will be beneficial in different situations assuming tax rate 30%.
Answer:
Calculation of Indifference two modes of financing:
\(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_1}\) = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}_2}\)
\(\frac{(\text { EBIT }-12 \% \text { of } 20 \text { lakhs) }(1-0.30)}{60,000}\) = \(\frac{(\text { EBIT }-12 \% \text { of } 20 \text { lakhs) }(1-0.30)}{40,000}\)
EBIT = ₹ 9,60,000
Course of action:
(a) If expected EBIT is less than ₹ 9,60,000 : Alternate 1
(b) if expected EBIT is equal to ₹ 9,60,000 : Alternate 1 or 2
(c) If expected EBIT is more than ₹ 9,60,000: Alternate 2

(d) From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
Working capital: ₹ 2,40,000
Bank overdraft : ₹ 40,000
Fixed assets to proprietary ratio : 0.75
Reserves and Surplus : ₹ 1,60,000
Current ratio : 2.5
Liquid ratio : 1.5
Answer:
Balance Sheet As at 31.03.2002

Working Notes:
1. Current assets and Current liabilities computation:
\(\frac{\mathrm{CA}}{\mathrm{CL}}\) = 2.5
CA = 2.5 CL
Working capital = CA – CL
2,40,000 = 2.5 CL – CL
CL = 1,60,000
CA = 1,60,000 × 2.5 = ₹ 4,00,000

2. Computation of stock:
Liquid ratio = \(\frac{\text { Liquid Assets }}{\text { Current Liabilities }}\)
1.5 = \(\frac{\text { Current Assets-Stock }}{1,60,000}\)
1.5 × 1,60,000 = 4,00,000 – Stock
Stock = 1,60,000

3. Computation of Proprietary fund. Fixed assets, Capital and Sundry Creditor
\(\frac{\text { Fixed Assets }}{\text { Proprietary Fund }}\) = 0.75
Fixed assets = 0.75 Proprietary fund
Net working capital = 0.25 Proprietary fund
2,40,000 = Proprietary fund
Proprietary fund = \(\frac{2,40,000}{0.25}\) = 9,60,000
Fixed assets = 0.75 Proprietary fund
= 0.75 × 9,60,000 = 7,20,000
Share Capital = Proprietary fund – R & S
= 9,60,000 – 1,60,000 = 8,00,000
Sundry creditors = CL – Bank overdraft
= 1,60,000 – 40,000 = 1,20,000

Question 2.
A company has to make a choice two machines ‘X’ and ‘Y’. The two machines have identical capacity, do exactly the same job, but designed differently.

Machine X costs ₹ 5,50,000 and will last for three years. It costs ₹ 1,25,000 per year to run. Machine Y is an economic model costing ₹ 4,00,000 will last for two years. It costs ₹ 1,50,000 per year to run.

The cash flows of machine ‘X’ and ‘Y’ are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore taxes. The present value factors at 12% are:

Which machine would you recommend the company to buy? (10 Marks)
Answer:
Statement Showing Evaluation of Two Machines

Select the Machine X having lower equivalent annualized outflow.

Question 3.
The R & G Company has following capital structure at 31st March, 2004, which is considered to be optimum:
13% debenture : ₹ 3,60,000
11% preference share capital : ₹ 1,20,000
Equity share capital (2,00,000 shares) : ₹ 19,20,000
The company’s share has a current market price of ₹ 27.75 per share. The expected dividend per share in next year is 50 per cent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

The company can issue 14 per cent new debenture. The company’s debenture is currently selling at ₹ 98. The new preference issue can be sold at a net price of ₹ 9.80, paying a dividend of ₹ 1.20 per share. The company’s marginal tax rate is 50%.

(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity, assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that retained earning available for next year’s investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part (iii)] if the company can sell new ordinary shares to net ₹ 20 per share? The cost of debt and of preference capital is constant. (10 Marks)
Answer:
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis

(i) (a) After tax cost of new debt
K_d = \(\frac{I(1-t)}{N P}\) × 100 = \(\frac{14(1-.50)}{98}\) × 100 = 7.143%
After tax cost of new preference shares
K_p = \(\frac{\mathrm{PD}}{\mathrm{NP}}\) × 100 = \(\frac{1.20}{9.80}\) × 100 = 12.25%

(b) Cost of new equity (comes from retained earnings)
K_e = \(\frac{\mathrm{D}_1}{\mathrm{P}_0 \text { (old) }}\) + g = \(\frac{1.3865}{27.75}\) + 0.12 = 17%

(ii) MCC (K₀) = K_dW_d + K_pW_p + K_eW_e
= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%

(iii) The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital
Therefore, investment before new issue = \(\frac{2,77,300}{80 \%}\) = ₹ 3,46,625
Retained earnings = ₹ 1.3865 × 2,00,000
= ₹ 2,77,300

(iv) MCC (K₀)
= K_dW_d + K_pW_p + K_eW_e
= 7.14396 × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than ₹ 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
K_e = \(\frac{D_1}{P_0(\text { new })}\) + g = \(\frac{1.3865}{20}\) + 0.12 = 18.93%

Question 4.
Q Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of production.
Its annual figures are as under:
Sales (at 2 months’ credit) : ₹ 24,00,000
Materials consumed (suppliers credit 2 months) : ₹ 6,00,000
Wages paid (monthly at the beginning of the subsequent month) : ₹ 4,80,000
Manufacturing expenses (cash expenses are paid one month in arrear) : ₹ 6,00,000
Administration expenses (cash expenses are paid one month in arrear) : ₹ 1,50,000
Sales promotion expenses (paid quarterly in advance) : ₹ 75,000
The company keeps one month stock each of raw materials and finished goods. A minimum cash balance of ₹ 80,000 is always kept. The company wants to adopt a 10% safety margin in the maintenance of working capital. The company has no work-in-progress.

Find out the requirements of working capital of the company on cash cost basis. (10 Marks)
Answer:
Statement of Working Capital Requirement (Cash Cost Basis)

Working Notes:
Projected Income Statement

Question 5.
RST Ltd. is expecting an EBIT of ₹4,00,000 for F.Y. 2015-16. Presently the company is financed by equity share capital ₹ 20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50% of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12% and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different options and also state which is the best option. (10 Marks)
Answer:
Statement of Value of Firm and Cost of Capital

Decision: Company should opt for 30% debt finance having higher Value of firm and lower K₀.

Question 6.
(a) Briefly explain the three finance function decisions. (3 Marks)
Answer:
The finance functions are divided into long term and short term functions/ decisions:
Long term Finance Function Decisions
(i) Investment decisions (I):
These decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for various fixed assets and also for current assets.

(ii) Financing decisions (F):
These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the sources of available funds and their respective costs and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity capital and debt.

(iii) Dividend decisions (D):
These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any profit-making organization looks for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.

Short-term Finance Decisions/Function
Working capital Management (WCM): Generally short term decision is reduced to management of current asset and current liability (ie., working capital Management).

(b) Explain the steps while using the equivalent annualized criterion. (3 Marks)
Answer:
Equivalent Annualized Criterion: This method involves the following steps:

1. Compute NPV using the WACC or discounting rate.
2. Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period of each project.’
3. Divide NPV computed under step (i) by PVAF as computed under step (ii) and compare the values.

(c) Explain the significance of Cost of Capital. (4 Marks)
OR
Briefly describe any four sources of short-term finance.
Answer:
ignificance of the Cost of Capital: The cost of capital is important to arrive at correct amount and helps the management or an investor to take an appropriate decision. The correct cost of capital helps in the following decision making:

(i) Evaluation of investment options:
The estimated benefits (future cash flows) from available investment opportunities (business or project) are converted into the present value of benefits by discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment option may have different cost of capital hence it is very important to use the cost of capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two options (projects).

(ii) Performance Appraisal:
Cost of capital is used to appraise the performance of a particulars project or business. The performance of a project or business in compared against the cost of capital which is known here as cut-off rate or hurdle rate.

(iii) Designing of optimum credit policy:
While appraising the credit period to be allowed to the customers, the cost of allowing credit period is compared against the benefit/profit earned by providing credit to customer of segment of customers. Here cost of capital is used to arrive at the present value of cost and benefits received.

OR

Sources of Short Term Finance: There are various sources available to meet short-term needs of finance. The different sources are discussed below-

(i) Trade Credit:
It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common to almost all business operations. It can be in the form of an ‘open account’ or ‘bills payable’.

(ii) Accrued Expenses and Deferred Income:
Accrued expenses represent liabilities which a company has to pay for the services which it has already received like wages, taxes, interest and dividends. Such expenses arise out of the day-to-day activities of the company and hence represent a spontaneous source of finance.

Deferred Income:
These are the amounts received by a company in lieu of goods and services to be provided in the future. Since these receipts increases a company’s liquidity, they are also considered to be an important sources of short-term finance.

(iii) Advances from Customers:
Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing or construction time usually demand advance money from their customers at the time of accepting their orders for executing their contracts or supplying the goods. This is a cost free source of finance and really useful.

(iv) Commercial Paper:
A Commercial Paper is an unsecured money market instrument issued in the form of a promissory note. The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.

(v) Treasury Bills:
Treasury bills are a class of Central Government Securities. Treasury bills, commonly referred to as T-Bills are issued by Government of India to meet short term borrowing requirements with maturities ranging between 14 to 364 days.

(vi) Certificates of Deposit (CD):
A certificate of deposit (CD) is basically a savings certificate with a fixed maturity date of not less than 15 days up to a maximum of one year.

(vii) Bank Advances:
Banks receive deposits from public for different periods at varying rates of interest. These funds are invested and lent in such a manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met and a reasonable profit is made. A bank’s lending policy is not merely profit motivated but has to also keep in mind the socio-economic development of the country. Some of the facilities provided by banks are Short Term Loans, Overdraft, Cash Credits, Advances against goods, Bills Purchased/Discounted.

(viii) Financing of Export Trade by Banks:
Exports play an important role in accelerating the economic growth of developing countries like India. Of the several factors influencing export growth, credit is a very important factor which enables exporters in efficiently executing their export orders. The commercial banks provide short-term export finance mainly by way of pre and post-shipment credit. Export finance is granted in Rupees as well as in foreign currency.

(ix) Inter Corporate Deposits:
The companies can borrow funds for a short period say 6 months from other companies which have surplus liquidity. The rate of interest on inter corporate deposits varies depending upon the amount involved and time period.

(x) Certificate of Deposit (CD):
The certificate of deposit is a document of title similar to a time deposit receipt issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encash the deposit before maturity period and the investor is assured of liquidity because he can sell the CD in secondary market.

(xi) Public Deposits:
Public deposits are very important source of short-term and medium term finances particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid up capital and reserves, from the public and shareholders.

These deposits may be accepted for a period of six months to three years. Public deposits are unsecured loans; they should not be used for acquiring fixed assets since they are to be repaid within a period of 3 years. These are mainly used to finance working capital requirements.
Note: Student may write any six.

Section B – Economics For Finance

Question 7.
(a) Calculate Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) from the following data: (2 Marks)

Answer:
(a) MPC (b) = ∆C/∆Y
= (9,000 – 6,000) ÷ (12,000 – 8,000) = 0.75
(b) MPS = 1 – b = 1 – 0.75 = 0.25

(b) Why is there a need for the government to resort to resource allocation? (3 Marks)
Answer:
Market failures provide the rationale for government’s allocative function. Market failures are situations in which a particular market, left to itself, is inefficient and leads to misallocation of society’s scarce resources. In the absence of appropriate government intervention in resource allocation, the resources are likely to be misallocated with too much production of certain goods or too little production of certain other goods. The allocation responsibility of the governments involves suitable corrective action when private markets fail to provide the right and desirable combination of goods and services to ensure optimal outcomes in terms of social welfare.

(c) Suppose in an economy:
Consumption Function = 150 + 0.75Y_d
Investment spending = 100
Government spending = 115
Tax (Tx) = 20 + 0.20Y
Transfer Payments (Tr) = 40
Exports (X) = 35
Imports (M) = 15 + 0.1Y
Where, Y and Y_d are National Income and Personal Disposable Income respectively. All figures are in rupees.

Find:
(a) The equilibrium level of National Income,
(b) Consumption at equilibrium level,
(c) Net Exports at equilibrium level (5 Marks)
Answer:
(a) The equilibrium level of National Income:
Y =C + I + G + (X – M)
= 165 + 0.6Y + 100 + 115 + [35 – (15 + 0.1Y)]
= 400 + 0.5Y
= 400 4- 0.5 = 800

(b) Consumption at equilibrium level:
C = 150 + 0.75Y_d
Y_d = Y – Tax + Transfer Payments,
= Y – (20 + 0.2Y) + 40 = 0.8Y + 20,
and C = 150 + 0.75Y_d
= 150 + 0.75 (0.8Y + 20) (where Y_d = 0.8Y + 20)
= 150 + (0.75 × 0.8Y) + (0.75 × 20)
C = 165 + 0.6Y
C = 165 + 0.6 × 800 = 645

(c) Net Exports at equilibrium level:
X – M = 35 – (15 + 0.1Y)
= 35 – (15 + 0.1 × 800) = – 60
There is adverse balance of trade

Question 8.
(a) Explain the leakages and Injections in the circular flow of Income. (2 Marks)
Answer:
Leakages:
A leakage is an outflow or withdrawal of income from the circular flow. Leakages are money leaving the circular flow and therefore, not available for spending on currently produced goods and services. Leakages reduce the flow of income.

Injections:
An injection is a non-consumption expenditure. It is an expenditure on goods and services produced within the domestic territory but not used by the domestic household for consumption purposes. Injections are exogenous additions to the circular flow and add to the total volume of the basic circular flow.

In the two-sector model with households and firms, household saving is the only leakage and investment is the only injection. In the three-sector model which includes the government, saving and taxes are the two leakages and investment and government purchases are the two injections. In the four-sector model which includes foreign sector also, saving, taxes, and imports are the three leakages; investment, government purchases, and exports are the three injections.

The state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy.
Savings + Taxes + Imports = Investment + Government Spending + Exports

(b) Define ‘Market power’. What Is Its disadvantage? (2 Marks)
Answer:
Market power is the ability of a price making firm to profitably raise the market price of a good or service over its marginal cost and thus earn supernormal profits or positive economic profits. Market power is an important cause of market failure. Market failure occurs when the free market outcomes do not maximize net benefits of an economic activity and therefore there is deadweight losses and inefficient allocation of resources.

Excess market power causes a single producer or a small number of producers to strategically reduce their supply and charge higher prices compared to competitive market. Market power can cause markets to be inefficient because it keeps price and output away from the equilibrium of supply and demand. Market power thus results in suboptimal outcomes such as deadweight loss, underproduction of goods and services, higher prices and loss of consumer surplus.

(c) The RBI published the following data as on 31st March, 2018. You are required to compute M4: (3 Marks)
(₹ in crores)
Currency with the public : ₹ 1,12,206.6
Demand Deposits with Banks : ₹ 1,93,300.4
Net Time Deposits with Banks : ₹ 2,67,310.2
Other Deposits of RBI : ₹ 614.8
Post Office Savings Deposits : ₹ 277.5
Post Office National Savings Certificates (NSCs) : ₹ 110.5
Answer:
M4 = Currency and coins with the people + demand deposits with the banks (Current and Saving accounts) + other deposits with the RBI + Net time deposits with the banking system + Total deposits with the Post Office Savings (excluding National Savings Certificate

(d) Explain the role of Monetary Policy Committee (MPC) In India. (3 Marks)
Answer:
Monetary Policy Committee (MPC) constituted by the Central Government is an empowered six-member committee with RBI Governor as the chairperson. Under the Monetary Policy Framework Agreement, the RBI will be responsible for price stability and for containing inflation targets at 496 (with a standard deviation of 296) in the medium term.

The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months. MPC has complete control over monetary policy decisions to ensure economic growth and price stability. The MPC decides the changes to be made to the policy rate (repo rate) so as to contain inflation within the target level specified to it by the central government.

Fixing of the benchmark policy interest rate (repo rate) is made in a more consultative and participative manner and on the basis of majority vote by this panel of experts. This has added lot of value and transparency to monetary policy decisions.

Question 9.
(a) From, the following data, compute the Gross National Product at Market Price using Value Added method: (3 Marks)

Answer:
Value Added Method:
GDP_MP = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector)
= 800 – 300 + 1,000 – 400 + 3,000 – 900 = 3,200 Crores
GNP_MP = GDP_MP + NFIA
= 3,200 – 100 = 3,100 Crores

(b) Describe the limitations of fiscal policy. (3 Marks)
Answer:
The following are the significant limitations in respect of choice and implementation of fiscal policy: ‘
1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is the different types of lags involved in fiscal policy action. There are significant lags such as recognition lag, decision lag, implementation lag and impact lag.

2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an expansionary policy is initiated when the economy is already on a path of recovery and vice versa.

3. There are difficulties in instantaneously changing governments’ spending and taxiftion policies.

4. It is practically difficult to reduce government spending on various items such as defence and social security as well as on huge capital projects which are already midway.

5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.

6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and also promptly determining the accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal policy such that a policy designed to achieve one goal may adversely affect another. For example, an expansionary fiscal policy may worsen inflation in an economy.

8. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example, increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security benefits may adversely affect incentives to work and save.

9. Deficit financing increases the purchasing power people. The production of goods and services, especially in under developed countries may not catch up simultaneously to meet the increased demand. This will result in prices spiraling beyond control.

10. Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid. If the economy lags behind in productive utilization of borrowed money, sufficient surpluses will not be generated for servicing debts. External debt burden has been a constant problem for India and many developing countries.
11. An increase in the size of government spending during recessions will ‘crowd out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long run economic growth.

12. If governments compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may not be realized.
Note: Student may write any six.

(c) Explain the Monetary Policy Framework Agreement. (2 Marks)
Answer:
The Reserve Bank of India (RBI) Act, 1934 was amended in 2016, for giving a statutory backing to the Monetary Policy Framework Agreement. It is an agreement reached between the Government of India and the RBI on the maximum tolerable inflation rate that the RBI should target to achieve price stability.

The amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation targeting framework’ by abandoning the ‘multiple indicator’ approach. The inflation target is to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly –

• The Central Government has notified 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5,2016 to March 31, 2021 with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.
• The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and the forecasts of inflation for the coming period of six to eighteen months.

(d) Explain ‘depreciation’ and ‘appreciation’ of home currency under floating exchange rate. (2 Marks)
Answer:
Under a floating rate system, home currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies i.e. there is an increase in the home currency price of the foreign currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹ 70 and ₹ 72 in June, then the Indian Rupee has depreciated in its value with respect to the US dollar and the value of US dollar has appreciated in terms of the Indian Rupee.

On the contrary, home currency appreciates when its value increases with respect to the value of another currency or a basket of other currencies i.e. there is a decrease in the home currency price of foreign currency. For example, if the Rupee dollar exchange rate in the month of January is $1 = ₹72 and ₹70 in June, then the Indian Rupee has appreciated in its value with respect to the US dollar and the value of US dollar has depreciated in terms of the Indian Rupee.

Question 10.
(a) What is meant by quasi public goods? (2 Marks)
Answer:
A quasi public good or near public good has many but not all the characteristics of a public good. These are goods which have an element of non-excludability and non rivalry.
Quasi public goods are:
(i) Not completely non rival. For example, public roads wi-fi networks and public parks do not get congested so as to reduce the space available for others when extra consumers use them only up to an optimal point. When more people use it beyond that, the amount others can benefit from these is reduced to some extent, because there will be increased congestion.

(ii) It is easy to keep people away from quasi public goods by charging a price or fee. For example, it is possible to exclude some users by building toll booths to charge for road usage on congested routes. Other examples are education, and health services. It is easy to keep people away from them by charging a price or fee.

However, it is undesirable to keep people away from such goods because the society would be better off if more people consume them. This particular characteristic namely, the combination of virtually infinite benefits and the ability to charge a price results in some quasi-public goods being sold through markets and others being provided by government.

(b) What is meant by expansionary fiscal policy? Under what circumstances does government pursue expansionary policy? (3 Marks)
Answer:
An expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction. This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes.

The objectives of expansionary fiscal policy are reduction in cyclical unemployment, increase in consumer demand and prevention of recession and possible depression. In other words, it aims to close a ‘recessionary gap’ or a contractionary gap wherein the aggregate demand is not sufficient to create conditions of full employment.

This is accomplished by increasing aggregate expenditure and aggregate demand through an increase in all types of government spending and/or a decrease in taxes. Government uses subsidies, transfer payments, welfare programmes, corporate and personal income tax cuts and increased spending on public works such as on infrastructure development to put more money into consumers’ hands to give them more purchasing power.

(c) Mention the general characteristics of Money. (2 Marks)
Answer:
There are some general characteristics that money should possess in order to make it serve its functions as money. Money should be:

• Generally acceptable
• Durable or long-lasting
• Effortlessly recognizable
• Difficult to counterfeit i.e. not easily reproducible by people
• Relatively scarce, but has elasticity of supply
• Portable or easily transported
• Possessing uniformity; and
• Divisible into smaller parts in usable quantities or fractions without losing value.

(d) Explain the classical theory of Comparative Advantage as given by David Ricardo. (3 Marks)
Answer:
The law of comparative advantage states that even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of both commodities, there is still scope for mutually beneficial trade.

The first nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage). Labour differs in its productivity internationally and different goods have different labour requirements, so comparative labour productivity advantage was Ricardo’s predictor of trade.

The theory can be explained with a simple example Output per Hour of Labour

Country B has absolute disadvantage in the production of both wheat and cloth. However, since B’s labour is only half as productive in cloth but six times less productive in wheat compared to country A, country B has a comparative advantage in cloth. On the other hand, country A has an absolute advantage in both wheat and cloth with respect to the country B, but since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), country A has a comparative advantage in wheat.

According to the law of comparative advantage, both nations can gain if country A specialises in the production of wheat and exports some of it in exchange for country B’s cloth. Simultaneously, country B should specialise in the production of cloth and export some of it in exchange for country A’s wheat.

If country A could exchange 6W for 6C with country B, then, country A would gain 2C (or save one-half bour of labour time) since the country A could only exchange 6W for 4C domestically. The 6W that the country B receives from the country A would require six hours of labour time to produce in country B. With trade, country B can instead use these six hours to produce 12C and give up only 6C for 6W from the country A. Thus, the country B would gain 6C or save three hours of labour time and country A would gain 2C. However, the gains of both countries are not equal.

Question 11.
(a) Explain the different mechanism of monetary policy which influences the price level and national income. (3 Marks)
Answer:
The process or channels through which the evolution of monetary aggregates affects the level of product and prices is known as ‘monetary transmission mechanism’. There are mainly four different mechanisms, namely, the interest rate channel, the exchange rate channel, the quantum channel, and the asset price channel.

The interest rate channel: A contractionary monetary policy-induced increase in interest rates increases the cost of capital and the real cost of borrowing for firms and households with the result that they cut back on their investment expenditures and durable goods consumption expenditures respectively.

A decline in aggregate demand results in a fall in aggregate output and employment. Conversely, an expansionary monetary policy induced decrease in interest rates will have the opposite effect through decreases in cost of capital for firms and cost of borrowing for households.

The exchange rate channel: The exchange rate channel works through expenditure switching between domestic and foreign goods. Appreciation of the domestic currency makes domestically produced goods more expensive compared to foreign-produced goods. This causes net exports to fall; correspondingly domestic output and employment also fall.

The quantum channel: (e.g., relating to money supply and credit) Two distinct credit channels: the bank lending channel and the balance sheet channel- also allow the effects of monetary policy actions to propagate through the real economy. Credit channel operates by altering access of firms and households to bank credit.

A direct effect of monetary policy on the firm’s balance sheet comes about when an increase in interest rates works to increase the payments that the firm must make to service its floating rate debts. An indirect effect sets in, when the same increase in interest rates works to reduce the capitalized value of the firm’s long-lived assets.

The asset price channel: Asset prices respond to monetary policy changes and consequently impact output, employment and inflation. A policy-induced increase in the short-term nominal interest rates makes debt instruments more attractive than equities in the eyes of investors leading to a fall in equity prices, erosion in household financial wealth, fall in consumption, output, and employment.

(b) How does international trade Increase economic efficiency? Explain. (3 Marks)
Answer:
International trade is a powerful stimulus to economic efficiency and contributes to economic growth and rising incomes.
(i) The wider market made possible owing to trade induces companies to reap the quantitative and qualitative benefits of extended division of labour. As a result, they would enlarge their manufacturing capabilities and benefit from economies of large scale production.

(ii) The gains from international trade are reinforced by the increased competition that domestic producers are confronted with on account of internationalization of production and marketing requiring businesses to invariably compete against global businesses. Competition from foreign goods compels manufacturers, especially in developing countries, to enhance competitiveness and profitability by adoption of cost reducing technology and business practices. Efficient deployment of productive resources to their best uses is a direct economic advantage of foreign trade. Greater efficiency in the use of natural, human, industrial and financial resources ensures productivity gains.

Since international trade also tends to decrease the likelihood of domestic monopolies, it is always beneficial to the community.

(iii) Trade provides access to new markets and new materials and enables sourcing of inputs and components internationally at competitive prices. Also, international trade enables consumers to have access to wider variety of goods and services that would not otherwise be available. It also enables nations to acquire foreign exchange reserves necessary for imports which are crucial for sustaining their economies.

(iv) International trade enhances the extent of market and augments the scope for Mechanization and specialisation.

(v) Exports stimulate economic growth by creating jobs, reducing poverty and augmenting factor incomes and in so doing raising standards of livelihood and overall demand for goods and services.

(vi) Employment generating investments, including foreign direct investment, inevitably follow trade.

(vii) Opening up of new markets results in broadening of productive base and facilitates export diversification.

(viii) Trade also contributes to human resource development, facilitates fundamental and applied research and exchange of know-how and best practices between trade partners

(ix) Trade strengthens bonds between nations by bringing citizens of different countries together in mutually beneficial exchanges and thus promotes harmony and cooperation among nations.
Note: Student may write any six.

(c) What is meant by ‘Mixed tariffs’? (2 Marks)
Answer:
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. For example, duty on cotton: 5 per cent ad valorem or ₹ 3,000 per tonne, whichever is higher.

(d) Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). (2 Marks)
Answer:
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)

Scope and Objectives of Financial Management – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

Scope and Objectives of Financial Management – CA Inter FM Study Material

Theory Questions

Question 1.
Elucidate the responsibilities of Chief Financial Officer. (4 Marks Nov. 2011)
Answer:
One of the key person of an organisation is chief financial officer, he plays vital role in management, and his main responsibilities are:

1. Financial analysis and planning: CFO estimates requirement of amount of funds to be invested in the business, size of business firm and growth of organisation.
2. Investment decisions: CFO decides which asset should be purchased and which should not be.
3. Financial and capital structure decisions: CFO arranges funds from various sources with consideration of cost, risk and control.
4. CFO manages short term financial resources like: short term loan, over-draft, creditors etc.
5. Risk Management: It is the responsibility of CFO that business assets should be risk free.

Question 2.
“The profit maximization is not an operationally feasible criterion.” Comment on it. (4 Marks May 2012)
Answer:
“The profit maximisation is not an operationally feasible criterion.” A company cannot follow profit maximisation as its sole objective. Profit maximisation is a short term objective. When a company focus on profit maximisation it starts to ignore maximizing the owner’s economic welfare. It cannot work towards economic efficiency and might be unethical.

Following are the limitations of profit maximisation approach:

1. Profit is vague term: What is the meaning of profit? Is it short term profit or long term profit? Is it PAT or PBT? Term profit is not clear so company goal to maximise profit is also vague.
2. Timing of Return is ignored: Profit maximisation criteria ignores concept of time value of money. If we receives any amount today then it differs from amount receivable at future date.
3. It avoids the risk factor: If any organisation wants to earn higher profit then it has to accept higher degree of risk and in case of adverse situation stakeholders will suffer higher losses even in worst situation bankruptcy.
4. It’s as an objective is not ethical In today’s world corporate social responsibility is very famous term which means apart from government of any country, corporates are also responsible for welfare of country’s people. When company wants to maximize its profit, company don’t take any step toward CSR even most of the time company take unethical steps.

Question 3.
Discuss the conflicts in profit verses wealth maximization principle of the firm or Distinguish between Profit maximisation and Wealth maximisation objective of the firm. (4 Marks Nov. 2012, May 2015, May 2017)
Answer:
The main two objectives of any business firm are:
A. The maximisation of firm’s profit.
B. The maximisation of firm’s wealth.

Since every business firm is established to earn profit, therefore profit maximization is as an implied objective of a business firm. To maximise profit, management may take decision which are unethical and risky. Many times results of management decisions leads to financial distress and in worst situation bankruptcy and fails to provide higher profit and growth.

Market price of share indicates value or wealth of a firm. Market price of share of any company is based on various factor like: timely payment of dividend, product or service quality, goodwill of company, CRS activities, research and development steps taken by company, present and future expected income and growth of company, timing of earning and risk associated with business etc.

The value maximisation objective of a firm is superior to its profit maximisation objective due to following reasons.

1. Business firm considers all future cash flows, dividends, earning per share, risk of a decision etc. for wealth maximisation whereas business firm does not consider the effect of EPS, dividend paid or any other returns to shareholders or the wealth of the shareholder under profit maximisation objective.

2. To maximise the shareholders wealth firm may pay regular dividends whereas a firm with the objective of profit maximisation may prefer to retain earning instead of dividend payment.

3. Shareholders of any company always prefer increase in value of shares over increase in EPS.

4. Market price of share is based on expectations of shareholders, timing of return, goodwill of company, CSR activities, product and service quality, risk associated with projects, debt equity ratio, timely distribution of income and timing of return etc.

5. The main objective of any firm is wealth maximisation and profit is a part of the wealth maximisation strategy.

Question 4.
Discuss emerging issues affecting the future role of Chief Financial Officer (CFO) or List the emerging issues (any four) affecting the future role of CFO. (4 Marks May 2014, Nov. 2016)
Answer:
Future role of Chief Financial Officer (CFO) is affected by the following major emerging issues:

1. Regulation: CFOs have to look after personally in day by day increasing regulatory requirements.
2. Globalisation: Globalisation creates new financial challenges in front of CFOs. Now CFOs has to develop a finance function to perform effectively on the global stage.
3. Technology.-Nowadays technology is evolving very fast, and CFOs require to reconfigure finance processes and drive business insight through large data and analytics.
4. Risk: Changing nature of the risks, requiring more efficient risk man-agement approaches. CFOs have a role to play in ensuring safeguard of assets.
5. Transformation: CFOs have to transform their finance functions to provide a better service to the business without additional cost.
6. Stakeholder Management: CFOs become the representative of business firm and responsible to handle stakeholder management and maintain principle agent relationship.
7. Strategy: CFOs play a greater role in strategy validation and execution, because of increasing environment complexity and quick changing behaviour.
8. Reporting: CFOs are responsible to fulfil increasing reporting require-ments.
9. Talent and Capability: A person with talent, capability and good behaviour can execute the top finance role.

Question 5.
Briefly explain the three finance function decisions. (4 Marks Nov. 2017, 3 Marks Nov. 2019)
Answer:
Following are the three long term financial function decisions in financial management:
1. Investment decisions (I):
It is related to selection of assets in which long term funds will be employed. Finance manager arranged funds from various sources with consideration of cost, risk and control and invest these funds in various types of business assets. Long term funds are used to purchase fixed assets and also a portion of fixed asset is used to finance permanent current assets. Finance manager use capital bud-geting techniques to evaluate long term investment proposals.

2. Financing decisions (F):
Finance manager arranges funds from various sources with consideration of cost, risk and control. Finance manager chooses capital structure for business firm and try to maintain optimum capital structure. Neither these funds should be over nor less, estimation of requirements of funds and accordingly fulfilment of such requirement covered under financing decisions. Funds are arranged to finance fixed assets and working capital. Financing decisions also require a good knowledge of evaluation of risk associated with finance like: excessive debt may lead situation of financial distress and at worst level bankruptcy.

3. Dividend decisions (D):
Company has two options related to profit available for equity shareholders, first is to distribute profit and second is to retain such profit and reinvest it in business. Dividend decisions are related to balancing between profit distribution and retention of earnings. It is advised to retain profit in business when business is growing i.e. internal rate of return is higher than cost of capital. On the other hand is company retain entire profit then in equity investor may disappoint and market value of shares will decrease. Finance manager has to maintain balancing between distribution of profit and retention of profit to maximise shareholders wealth.

Question 6.
What are the roles of Finance Executive in Modern World? (2 Marks May 2018, 4 Marks Nov. 2020)
Answer:
In today’s world apart from accounting, financial reporting and risk management, the role of chief financial officer is much broader. Finance officer is the face of corporate brand and strategic business partner of the firm. In modern world CEO plays a vital role in budgeting, forecasting, managing merger & acquisitions, profitability analysis, pricing analysis, decisions about outsourcing, overseeing the IT function, overseeing the HR function, strategic planning, regulatory compliance and risk management etc.

Question 7.
What are the two main aspects of the Finance Function? (2 Marks May 2018)
Answer:
Two main aspects of Finance function are:
1. Procurement of Funds:
Finance manager arranges funds from various sources with consideration of cost, risk and control. Finance manager chooses capital structure for business firm and try to maintain optimum capital structure. Neither these funds should be over nor less, estimation of requirements of funds and accordingly fulfilment of such requirement covered under financing decisions.

Funds are arranged to finance fixed assets and working capital. Financing decisions also require a good knowledge of evaluation of risk associated with finance like: excessive debt may lead situation of financial distress and at worst level bankruptcy.

2. Effective Utilization of Funds:
It is related to selection of assets in which long term funds will be employed. Finance manager arranged funds from various sources with consideration of cost, risk and control and invest these funds in various types of business assets. Long term funds are used to purchase fixed assets and also a portion of fixed asset is used to finance permanent current assets.

Finance manager use capital budgeting techniques to evaluate long term investment proposals. The Finance Manager has to keep in mind that funds are not kept idle or there is no improper use of funds. The funds are to be invested in a efficient way such that they generate returns higher than the cost of capital to the firm.

Question 8.
Write two main objectives of financial management. (2 Marks Nov. 2018)
Answer:
Two main objectives of financial management are:
1. Profit Maximisation:
Since every business firm is established to earn profit, therefore profit maximization is as an implied objective of a business firm. To maximise profit, management may take decision which are unethical and risky. Many times results of management decisions leads to financial distress and in worst situation bankruptcy and fails to provide higher profit and growth. Profit maximisation is secondary goal of the company and it helps in wealth maximisation.

2. Wealth or Value Maximisation:
Market price of share indicates value or wealth of a firm. Market price of share of any company is based on various factor like: timely payment of dividend, product or service quality, goodwill of company, CRS activities, research and development steps taken by company, present and future expected income and growth of company, timing of earning and risk associated with business etc. it is the primary goal of the firm.

Question 9.
State four tasks involved to demonstrate the importance of good Financial Management. (4 Marks Jan. 2021)
Answer:
Following are the main task involved to demonstrate the importance of good financial management is to:

1. Look after not to over-invest in fixed assets,
2. Maintain balancing of cash outflow with cash inflows,
3. Maintaining sufficient level of short term working capital,
4. Preparation of growing sales budget,
5. Set correct pricing for products or services to increase gross profit,
6. Look after and control general and administrative expenses, and
7. Focusing on tax planning to minimize the taxes.