CA Inter FM ECO Paper Dec 2021

CA Inter FM ECO Paper Dec 2021 – CA Inter FM ECO Study Material is designed strictly as per the latest syllabus and exam pattern.

CA Inter FM ECO Question Paper Dec 2021 Solution

Question 1.
(a) A factoring firm has offered a to buy it’s accounts receivables. The relevant information is given below.

  1. The current average collection period for the company’s debts is 80 days and 1/2% of debtors default. The factor has agreed to pay over money due, to the company after 60 days, and it will suffer losses of any bad debts also.
  2. Factor will charge commission @2%.
  3. The company spends ₹ 1,00,000 p.a. on administration of debtor. These are avoidable cost.
  4. Annual credit sales are ₹ 90,00,000. Total variable costs is 80% of sales. The company’s cost of borrowings is 15% per annum. Assume 365 days in a year.
    Should the company enter into a factoring agreement? (5 Marks)

Answer:
Statement of Evaluation
CA Inter FM ECO Paper Dec 2021 1
* Presently, the debtors of the company pay after 80 days. However, the factor has agreed to pay after 60 days only. So, the investment in Debtors will be reduced by 20 days.

Conclusion: Yes, company should enter into factoring agreement.

CA Inter FM ECO Paper Dec 2021

(b) Book value of capital structure of B Ltd. is as follows:

Sources Amount
12% 6,000 Debentures @ ₹ 100 each

Retained earnings

4,500 Equity shares @ ₹ 100 each

₹ 6,00,000
₹ 4,50,000
₹ 4,50,000
₹ 15,00,000

Currently the market value of debenture is ₹ 110 per debenture and equity share is ₹ 180 per share. The expected rate of return to equity shareholder is 24% p.a. Company is paying tax @30%.

Calculate WACC on the basis of market value weights. (5 Marks)
Answer:
Statement of WACC (Market Value Weights)

Capital Structure Amount Weight Specific Cost Cost of Capital
12% Debentures 6,60,000 0.449 0.0764 0.0343
Equity Fund including Retained earning 8,10,000 0.551 0.2400 0.1322
Total 14,70,000 1.000 W4CC 0.1665

WACC (K0) = 0.1665 or 16.65%

Working Notes:

(1) Calculation of Market Value:
Market value of debenture = (₹ 6,00,000 ÷ ₹ 100) × ₹ 110
Market value of Equity and Retained earnings:
= (₹ 4,50,000 ÷ ₹ 100) × ₹ 180

(2) Calculation of Kd:
Kd = \(=\frac{\mathrm{I}(1-\mathrm{t})}{\mathrm{NP}}\) × 100 = \(\frac{12 \% \text { of } 100(1-0.3)}{110}\) × 100 = 7.64%

Note: Debentures issued at market price; alternatively students may take different assumption i.e. Debentures issued at par.

Note: Since, Keand Kr are same therefore, we use market value of Equity fund including retained earnings.

(c) X Ltd. is a manufacturing company. Current market price per share is ₹ 2,185. During the F. Y. 2020-21, the company paid ₹ 140 as dividend per share. The company is expected to grow @12% p.a. for next four years, then 5% p.a. for an indefinite period. Expected rate of return of shareholders is 18% p.a.

(i) Find out intrinsic value per share.
(ii) State whether shares are overpriced or underpriced.

Year 1 2 3 4 5
Discounting Factor@18% 0.847 0.718 0.608 0.515 0.436

(5 Marks)
Answer:
(i) Calculation of Intrinsic Value of Share

Year Expected benefits PVF @ 18% DCF
1 140.00+ 12% = ₹ 156.80 0.847 132.81
2 156.80+ 12% = ₹ 175.62 0.718 126.10
3 175.62 + 12% = ₹ 196.69 0.608 119.59
4 196.69+ 12% = ₹ 220.29 0.515 113.45
(5 to ∞) P4 = ₹ 1,779.27 0.515 916.32
Present value of all future benefits or Intrinsic value of Share ₹ 1,408.27

P4 = \(\frac{D_5}{K_e-g}\) = \(\frac{220.29+5 \%}{18 \%-5 \%}\) = ₹ 1,779.27

CA Inter FM ECO Paper Dec 2021

(ii) Intrinsic value of share is ₹ 1,408.27 as compared to latest market price of ₹ 2,185. Market price of a share is overpriced by ₹ 776.73.

(d) A garment trader is preparing cash forecast for first three months of calendar year 2021. His estimated sales for the forecasted periods are as below:

January (₹ ‘000) February (₹ ‘000) March (₹ ‘000)
Total sales 600 600 800
  1. The trader sells directly to public against cash payments and to other entities on credit. Credit sales are expected to be four times the value of direct sales to public. He expects 15% customers to pay in the month in which credit sales are made, 25% to pay in the next month and 58% to pay in the next to next month. The outstanding balance is expected to be written off.
  2. Purchase of goods are made in the month prior to sales and it amounts to 90% of sales and are made on credit. Payments of these occur in the month after the purchase. No inventories of goods held.
  3. Cash balance as on 1st January, 2021 is ₹ 50,000.
  4. Actual sales for the last two months of calendar year 2020 are as below:
November (₹ ‘000) December (₹ ‘000)
Total sales 640 880

You are required to prepare a monthly cash budget for the three months from January to March, 2021. (5 Marks)
Answer:
CA Inter FM ECO Paper Dec 2021 2

Question 2.
Following are the data in respect of ABC Industries for the year ended 31st March, 2021:

Debt to Total assets ratio : 0.40
Long-term debts to equity ratio : 30%
Gross profit margin on sales : 20%
Accounts receivables period : 36 days
Quick ratio : 0.9
Inventory holding period : 55 days
Cost of goods sold : ₹ 64,00,000

Balance Sheet
CA Inter FM ECO Paper Dec 2021 3
Required:
Complete the Balance Sheet of ABC Industries as on 31st March, 2021.
All calculations should be in nearest rupee. Assume 360 days in a year. (10 Marks)
Answer:
Balance Sheet
CA Inter FM ECO Paper Dec 2021 4

Working Notes:

1.
Inventory = COGS × \(\frac{\text { Inventory holding period }}{360}\)
= ₹ 64,00,000 × 55/360 = ₹ 9,77,778

2. Sales = COGS ÷ COGS ratio
= ₹ 64,00,000 ÷ 80% (100 – G.P. ratio) = ₹ 80,00,000

3. Debtors = Sales ×\(\frac{\text { Account receivables period }}{360}\)
= ₹ 80,00,000 × 36/360 = ₹ 8,00,000

4. Debt:
Debt toTotal asset \(=\frac{\text { Debt (Long-term debt }+ \text { Accounts payables) }}{\text { Total Asset }}\) = 40%
Debt = 40% of Total Assets
= ₹ 50,00,000 × 40% = ₹ 20,00,000

Note: In debt we are considering total debt i.e. Long-term debt and Accounts payables.

5. Equity Fund = Equity Share Capital + Reserve and surplus
= Total Liabilities – Debt
= ₹ 50,00,000 – ₹ 20,00,000 = ₹ 30,00,000
Reserve and sur-plus = Equity fund – Equity share capital plus
= ₹ 30,00,000 – ₹ 20,00,000 = ₹ 10,00,000

6. Long-term debt:
Long-term debt to equity \(=\frac{\text { Long-term debt }}{\text { Equity }}\) = 30%
Long-term debt = 30% of Equity
= 30% of ₹ 30,00,000 = ₹ 9,00,000
= ₹ 20,00,000 – ₹ 9,00,000 = ₹ 11,00,000

7. Quick Ratio \(=\frac{\text { Current assets – Inventories }}{\text { Current liabilities }}\) = 0.9
Current assets – ₹ 9,77,778 = 0.9 × ₹ 11,00,000
Current assets = ₹ 9,90,000 + ₹ 9,77,778 = ₹ 19,67,778
Cash = Current Assets – Inventories – Accounts receivables
= ₹ 19,67,778 – ₹ 9,77,778 – ₹ 8,00,000 = ₹ 1,90,000

8. Fixed assets = Total assets – Current assets
= ₹ 50,00,000 – ₹ 19,67,778 = ₹ 30,32,222

CA Inter FM ECO Paper Dec 2021

Question 3.
Earnings before interest and tax of a company are ₹ 4,50,000. Currently the company has 80,000 equity shares of ₹ 10 each, retained earnings of 1 ₹ 12,00,000. It pays annual interest of ₹ 1,20,000 on 12% Debentures. The company proposes to take up an expansion scheme for which it needs additional fund of ₹ 6,00,000.

It is anticipated that after expansion, the company will be able to achieve the same rate of return on investment as at present. It can raise fund either through debts at rate of 12% p.a. or by issuing Equity shares at par. Tax rate is 40%.
Required:

Compute the earning per share if:

(i) The additional funds were raised through debt.
(ii) The additional funds were raised by issue of Equity shares.
Advise whether the company should go for expansion plan and which sources of finance should be preferred. (10 Marks)

Answer:

Statement of EPS
CA Inter FM ECO Paper Dec 2021 5

Advise to the company:

EPS before expansion = \(\frac{(\mathrm{EBIT}-\mathrm{I})(1-\mathrm{T})}{\mathrm{N}}\) = \(\frac{(4,50,000-1,20,000)(1-0.4)}{80,000}\) = ₹ 2.475

Since EPS after expansion under debt plan is higher (₹ 2.61) than Existing EPS (₹ 2.475), company should go for expansion plan and choose debt source of finance.

Working notes:

1. Calculation of capital employed before expansion plan:
Equity share capital (80,000 shares × ₹ 10) : ₹ 8,00,000
Retained earnings : ₹ 12,00,000
Debentures (₹ 1,20,000/12%) : ₹ 10,00,000
Total capital employed : ₹ 30,00,000

2. Return on capital employed (ROCE) or Return on Investment:

ROCE \(\frac{\text { EBIT }}{\text { Capital Employed }}\)

3. Capital employed after expansion = ₹ 36,00,000 (₹ 30,00,000 + ₹ 6,00,000)

Question 4.
Stand Ltd. is contemplating replacement of one of it’s machine which has become outdated and inefficient. It’s financial manager has prepared a report outlining two possible replacement machines. The details of each machine are as follows:

Machine 1 Machine 2
Initial investment ₹ 12,00,000 ₹ 16,00,000
Estimated useful life 3 Years 5 Years
Residual value ₹ 1,20,000 ₹ 1,00,000
Contribution per annum ₹ 11,60,000 ₹ 12,00,000
Fixed maintenance costs per annum ₹ 40,000 ₹ 80,000
Other fixed operating costs per annum ₹ 7,20,000 ₹ 6,10,000

The maintenance costs are payable annually in advance. All other cash flows apart from the initial investment assumed to occur at the end of each year. Depreciation has been calculated by straight line method and has been included in other fixed operating costs. The expected cost of capital for this project is assumed as 12% p.a.

Required:

(i) Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
(ii) Calculate the sensitivity of your recommendation in part (i) to changes in the contribution generated by machine 1.

Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112

(10 Marks)
Answer:
(i) Statement Showing Evaluation of Two Machines
CA Inter FM ECO Paper Dec 2021 6
CA Inter FM ECO Paper Dec 2021 7

Select the Machine 2 having higher annualized equivalent NPV

Working Notes:

1. Depreciation: (Initial investment – Residual value) ÷ Useful life
Machine 1 = (₹ 12,00,000 – ₹ 1,20,000) ÷ 3 years = ₹ 3,60000
Machine 2 = (₹ 16,00,000 – 1,00,000) ÷ 5 years = ₹ 3,00,000

2. Cash fixed operating costs = Fixed operating costs – Depreciation
Machine 1 = ₹ 7,20,000 – ₹ 3,60,000 = ₹ 3,60,000
Machine 2 = ₹ 6,10,000 – ₹ 3,00,000 = ₹ 3,10,000

(ii) calculation of the sensitivity of contribution generated by machine 1:
NPV of the project would be zero when the present value of contribution is decreased by ₹ 6,99,640
∴ Percentage change in the contribution = (₹ 6,99,640 ÷ ₹ 27,86,320) × 100 = 25.11%

CA Inter FM ECO Paper Dec 2021

Question 5.
Information of A Ltd. is given below:

  • Earnings after tax : 5% of sales
  • Income tax rate : 50%
  • Degree of Operating leverage : 4 times
  • 10% Debenture in capital structure : ₹ 3 lakhs
  • Variable costs : ₹ 6 lakhs

Required:

(i) From the given data complete following statement:
CA Inter FM ECO Paper Dec 2021 8
CA Inter FM ECO Paper Dec 2021 9
(ii) Calculate Financial Leverage and Combined Leverage.
(iii) Calculate percentage change in earning per share, if sales increased by 5%. (10 Marks)

Answer:

(i) Statement of EAT
CA Inter FM ECO Paper Dec 2021 10

(ii) Financial Leverage \(=\frac{\text { EBIT }}{\text { EBT }}\) = \(\frac{1,50,000}{1,20,000}\) = 1.25 times
Combined Leverage = OL × FL = 4 × 1.25 = 5 times

(iii) % change in EPS = % change in Sales = 5% × 5 = 25% increased

Working Notes.

(a) Operating Leverage \(=\frac{\text { Contribution }}{\text { EBIT }}\) \(=\frac{\text { Contribution }}{\text { Contribution – Fixed cost }}\) = 4
Contribution = 4 Contribution – 4 Fixed cost
-3 Contribution = -4 Fixed cost
¼ Contribution = Fixed cost
Contribution = Sales – Variable cost = Sales – ₹ 6,00,000
∴ Fixed cost = 3/4 or 75% of contribution = 75% (Sales – ₹ 6,00,000)
= 75% Sales ₹ 4,50,000

(b) EAT = 5% of Sales
EBT = EAT ÷ (1 – t) = 5% Sales ÷ (1 – 0.5)
= 10% Sales

(c) EBT = Sales – Variable cost – Fixed cost — Interest
10% Sales = Sales – ₹ 6,00,000 – (75% Sales – ₹ 4,50,000) – ₹ 30,000
10% Sales = Sales – ₹ 6,00,000 – 75% Sales + ₹ 4,50.000 – ₹ 30,000
10% Sales = 25% Sales – ₹ 1,80,000
15% Sales = ₹ 1,80,000
Sales = ₹ 1,80,000 ÷ 15% = ₹ 12,00,000

(d) EBT = 10% of Sales = 10% of ₹ 12,00,000
= ₹ 1,20,000

(e) EBIT = EBT + Interest = ₹ 1,20,000 + ₹ 30,000
= ₹ 1,50,000

(f) Fixed cost = 75% of Contribution = 75% of ₹ 6,00,000
= ₹ 4,50,000

Question 6.
(a) Write short noies on Bridge Finance and Clean Packing Credit. (4 Marks)
Answer:
Bridge Finance: Bridge finance refers to loans taken by a company normally from commercial banks for a short period because of pending disbursement of loans sanctioned by financial institutions. Though it is of short-term nature but since it is an important step in the facilitation of long-term loan, therefore it is being discussed along with the long term sources of funds. Normally, it takes time for financial institutions to disburse loans to companies.

However, once the loans are approved by the term lending institutions, companies, in order not to lose further time in starting their projects, arrange short term loans from commercial banks. The bridge loans are repaid/adjusted out of the term loans as and when disbursed by the concerned institutions. Bridge loans are normally secured by hypothecating movable assets, personal guarantees and demand promissory notes. Generally, the rate of interest on bridge finance is higher as compared with that on term loans.

(b) Clean packing credit: This is an advance made available to an exporter only on production of a firm export order or a letter of credit without exercising any charge or control over raw material or finished goods. It is a clean type of export advance. Each proposal is weighed according
to particular requirements of the trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (ECGC) cover should be obtained by the bank.

CA Inter FM ECO Paper Dec 2021

Question 6.
(b) Distinguish between Scenario Analysis & Sensitivity Analysis. (4 Marks)
Answer:
Scenario Analysis v. Sensitivity Analysis: Sensitivity analysis and Scenario analysis both help to understand the impact of the change in input variable on the outcome of the project. However, there are certain basic differences between the two.

Sensitivity analysis calculates the impact of the change of a single input variable on the outcome of the project viz., NPV or IRR. The sensitivity analysis thus enables to identify that single critical variable that can impact the outcome in a huge way and the range of outcomes of the project given the change in the input variable.

Scenario analysis, on the other hand, is based on a scenario. The scenario may be recession or a boom wherein depending on the scenario, all input variables change. Scenario Analysis calculates the outcome of the project considering this scenario where the variables have changed simultaneously. Similarly, the outcome of the project would also be considered for the normal and recessionary situation.

The variability in the outcome under the three different scenarios would help the management to assess the risk a project carries. Higher deviation in the outcome can be assessed as higher risk and lower to medium deviation can be assessed accordingly.

Scenario analysis is far more complex than sensitivity analysis because in scenario analysis all inputs are changed simultaneously considering the situation in hand while in sensitivity analysis only one input is changed and others are kept constant.

Question 6.
(c) Explain in brief the phases of the evolution of financial management. (2 Marks)
Or
Adjustment of risk is required in capital budgeting decision, give reasons for it. (2 Marks)
Answer:
Financial management evolved gradually over the past 50 years. The evolution of financial management is divided into three phases. Financial Management evolved as a separate field of study at the beginning of the century. The three stages of its evolution are:

The Traditional Phase: During this phase, financial management was con-sidered necessary only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial decisions in the organisation, the needs of outsiders (investment bankers, people who lend money to the business and other such people) to the business was kept in mind.

The Transitional Phase: During this phase, the day-to-day problems that financial managers faced were given importance. The general problems related to funds analysis, planning and control were given more attention in this phase.

The Modem Phase: Modern phase is still going on. The scope of financial management has greatly increased now. It is important to carry out financial analysis for a company. This analysis helps in decision making. During this phase, many theories have been developed regarding efficient markets, capital budgeting, option pricing, valuation models and also in several other important fields in financial management.

Or

Answer:

Main reasons for considering risk in capital budgeting decisions are as follows:

1. There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk is necessary to help make the decision as to whether the returns out of the project are proportionate with the risks borne and whether it is worth investing in the project over the other investment options available.

2. Risk adjustment is required to know the real value of the Cash Inflows. Higher risk will lead to higher risk premium and also expectation of higher return.

Question 7.
(a) The following information is given:

Particulars Amount in (₹) Crore
Notes in Circulation 25,00,000
Circulation of Rupee Coins 26,000
Circulation of Small Coins 850
Cash on hand with Banks 95,000
Bankers’ Deposits with RBI 4,500
Other Deposits with RBI 180
Total Post office Deposits 12,000
Time Deposits with Banks 15,000

You are required to compute:

(i) Currency with the Public; and
(ii) Reserve Money. (3 Marks)

Answer:

(i) Currency with the Public = Notes in Circulation + Circulation of Rupee Coins + Circulation of Small Coins – Cash on hand with Banks
= 25,00,000 + 26,000+ 850 – 95,000 = 24,31,850

(ii) Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
= 24,31,850 + 4,500 + 180 = 24,36,530

(b) The Nominal GDP and Real GDP of a country in the financial year 2018-19 were ₹ 1,500 Crores and ₹ 1,200 Crores respectively, you are required to calculate:

(i) GDP deflator in the financial year 2018-19 and comment.
(ii) Inflation rate in the financial year 2019-20 assuming GDP deflator rate in this year is 140 as compared to the year 2018-19. (3 Marks)

Answer:

(i) GDP Deflator \(=\frac{\text { Nominal GDP }}{\text { Real GDP }}\) × 100 = \(\frac{1,500}{1,200}\) × 100 = 125

Comment: The price level has increased since GDP deflator is greater than 100 at 125.

(ii) Inflation Rate = \(\frac{140-125}{125}\) × 100 = 12%

(c) Explain the features of Contractionary Fiscal policy. (2 Marks)
Answer:
When aggregate demand rises beyond what the economy can potentially produce by fully employing it’s given resources, it gives rise to inflationary pressures in the economy. The aggregate demand may rise due to large increase in consumption demand by households or investment expenditure by entrepreneurs, or government expenditure. In these circumstances inflationary gap occurs which tends to bring about rise in prices. Under such circumstances, a contractionary fiscal policy will have to be used.

Contractionary fiscal policy ref ers to the deliberate policy of government applied to curtail aggregate demand and consequently the level of economic activity. In other words, it is fiscal policy aimed at eliminating an inflationary gap. This is achieved by adopting policy measures that would result in the aggregate demand curve (AD) shifting to the left so the equilibrium may be established at the full employment level of real GDP.

(d) Describe the types of transactions in the forex-market and also dis-tinguish between forward premium and forward discount. (2 Marks)
Answer:
There are two types of transactions in a forex market:

  1. Current trans-actions which are carried out in the spot market and
  2. Future transactions involving contracts to buy or sell currencies for future delivery which are carried out in forward and futures markets.

A forward premium is said to occur when the forward exchange rate is more than a spot exchange rates. On the contrary, if the forward trade is quoted at a lower rate than the spot rate, then there is a forward discount.

Question 8.
(a) The following information is related to an economy:

Particulars Amount in (₹) Crore
Domestic Sales 3,600
Opening Stock 800
Exports 1,000
Depreciation 300
Closing Stock 200
Net indirect tax 400
Intermediate consumption 600
Net factor income from abroad 10

Calculate the following:

(i) Gross Value of Output (GVOMP)
(ii) Gross Value Added (GVAMP)
(iii) Net Value Added (NVAMP)
(iv) Net Domestic Product (NDPFC)
(v) Net National Product (NNPFC) (5 Marks)

Answer:

(i) GVOMP = Sales (Domestic + Exports) + Change in stock
= 4,600 (3,600 + 1,000) + (200 – 800) = 4,000 Crores
(ii) GVAMP = Value of output — Intermediate consumption
= 4,000- 600 = 3,400 Crores
(iii) NVAMP = GVAMP – Depreciation
= 3,400 – 300 = 3,100 Crores
(iv) NDPFC = NVAMP – Net Indirect Tax
= 3,100 – 400 = 2,700 Crores
(v) NNPFC = NDPFC + NFIA
= 2,700 + 10 = 2,710 Crores

(b) (i) Discuss the role of government Interventions in minimizing the market power. (2 Marks)
Answer:
As we are aware, market power exercised either by sellers or buyers is an important factor that contributes to inefficiency because it results in higher prices than competitive prices. In addition, market power also tends to restrict output and leads to deadweight loss. Because of the social costs imposed by monopoly, governments intervene by establishing rules and regulations de-signed to promote competition and prohibit actions that are likely to restrain competition.

These legislations differ from country to country. For example, in India, we have the Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007) to promote and sustain competition in markets. The Antitrust laws in the US and the Competition Act, 1998 of UK etc. are designed to promote competitive economy by prohibiting actions that are likely to restrain competition.

Such legislations generally aim at prohibiting contracts, combinations and collusions among producers or traders which are in restraint of trade and other anticompetitive actions such as predatory pricing.

(b)(ii) Calculate Narrow Money (M1) from the following information:
CA Inter FM ECO Paper Dec 2021 12
(3 Marks)
Answer:
M1 = Currency with public + Demand Deposits with Banking System + Other Deposits with the RBI
= 2,80,000 + 4,00,000 + 5,80,000 = ₹ 12,60,000 Crores

CA Inter FM ECO Paper Dec 2021

Question 9.
(a) How is nominal exchange rate determined? Explain. (3 Marks)
Answer:
As you already know, the key framework for analysing prices is the operation of forces of supply and demand in markets. Usually, the supply of and demand for foreign exchange in the domestic foreign exchange market determine the external value of the domestic currency, or in other words, a country’s exchange rate.

We shall now look into how the foreign exchange markets work. Similar to any standard market, the exchange market also faces a downward-sloping demand curve and an upward sloping supply curve.

The equilibrium rate of exchange is determined by the interaction of the supply and demand for a particular foreign currency. In figure, the demand curve (D$) and supply curve (S$) of dollars intersect to determine equilibrium exchange rate eeq with Qe as the equilibrium quantity of dollars exchanged.

Determination of Nominal Exchange Rate

CA Inter FM ECO Paper Dec 2021 11

(b) Discuss the salient features of bilateral trade agreements. (2 Marks)
Answer:
Bilateral Agreements are agreements which set rules of trade between two countries, two blocs or a bloc and a country. These may be limited to certain goods and services or certain types of market entry barriers. E.g. EU-South Africa Free Trade Agreement; ASEAN-India Free Trade Area.

(c) Calculate Money Multiplier with the help of following information: (3 Marks)
Answer:
Money Supply ‘M’ = Currency + Deposits
= ₹ 200 billion + ₹ 400 billion = ₹ 600 billion
c = C/D
= ₹ 200 billion/₹ 400 billion
= 0.5 or depositors hold 50% of their money as currency
e = Excess Reserve/Deposits
= ₹ 800 million or ₹ 0.8 billion/₹ 400 billion
= 0.002 or banks hold 0.2% of their deposit as excess reserves
Multiplier ‘m’ = \(\) = \(\frac{1+0.5}{0.1+0.002+0.5}\) = 2.5
Therefore, a 1 unit increase in MB leads to a 2.5 units increase in M.

(d) What do you mean about gross investment of a country? (2 Marks)
Answer:
Gross domestic fixed capital formation (Gross Investment) is that part of country’s total expenditure which is not consumed but added to the nation’s fixed tangible assets and stocks. It consists of the acquisition of fixed assets and the accumulation of stocks. The stock accumulation is in the form of changes in stock of raw materials, fuels, finished goods and semi-finished goods awaiting completion.

Thus, gross investment includes final expenditure on machinery and equipment and own account production of machinery and equipment, expenditure on construction, expenditure on changes in inventories, and expenditure on the acquisition of valuables such as, jewellery and works of art.

Question 10.
(a) (i) How does the fiscal policy redress the inequalities of income and wealth of a country? (3 Marks)
Answer:
Many developed and developing economies are facing the challenge of rising inequality in incomes and opportunities. Fiscal policy is a chief instrument available for governments to influence income distribution and plays a significant role in reducing inequality and achieving equity and social justice. The distribution of income in the society is influenced by fiscal policy both directly and indirectly. While current disposable incomes of individuals and corporates are dependent on direct taxes, the potential for future earnings is indirectly influenced by the nation’s fiscal policy choices.

Government revenues and expenditure have traditionally been regarded as important instruments for carrying out desired redistribution of income. We shall see a few such measures as to how each of these can be manipulated to achieve desired distributional effects.

♦ A progressive direct tax system ensures that those who have greater ability to pay contribute more towards defraying the expenses of government and that the tax burden is distributed fairly among the population.

♦ Indirect taxes can be differential: for example, the commodities which are primarily consumed by the richer income group, such as luxuries, are taxed heavily and the commodities the expenditure on which form a larger proportion of the income of the lower income group, such as necessities, are taxed light.

♦ A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer sections of the society. This is done through spending programmes targeted on welfare measures for the disadvantaged, such as

  1. poverty alleviation programmes,
  2. free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of living of poor,
  3. infrastructure provision on a selective basis,
  4. various social security schemes under which people are entitled to old age pensions, unemployment relief, sickness allowance etc.,
  5. subsidized production of products of mass consumption,
  6. public production and/or grant of subsidies to ensure sufficient supply of essential goods, and
  7. strengthening of human capital for enhancing employability etc.

Choice of a progressive tax system with high marginal taxes may act as a strong deterrent to work, save and invest. Therefore, the tax structure has to be carefully framed to mitigate possible adverse impacts on production and efficiency. Additionally, the redistributive fiscal policy and the extent of spending on redistribution should be consistent with the macroeconomic policy objectives of the nation.

(ii) State the main objectives of World Trade Organisation (WTO). (2 Marks)
Answer:
The WTO has six key objectives:

  1. to set and enforce rules for international trade,
  2. to provide a forum for negotiating and monitoring further trade liber-alization,
  3. to resolve trade disputes,
  4. to increase the transparency of decision-making processes,
  5. to co-operate with other major international economic institutions involved in global economic management, and
  6. to help developing countries benefit fully from the global trading system.

(b) (i) Explain Friedman’s Restatement of Quantity Theory with ref-erence to demand for money? (3 Marks)
Answer:
Milton Friedman (1956) extended Keynes’ speculative money demand within the framework of asset price theory. Friedman treats the demand for money as nothing more than the application of a more general theory of demand for capital assets. Demand for money is affected by the same factors as demand for any other asset, namely

  1. Permanent income.
  2. Relative returns on assets (which incorporate risk).

Friedman maintains that it is permanent income- and not current income as in the Keynesian theory that determines the demand for money. Permanent income which is Friedman’s measure of wealth is the present expected value of all future income. To Friedman, money is a good as any other durable consumption good and its demand is a function of a great number of factors.

Friedman identifies the following four determinants of the demand for money. The nominal demand for money:

  • is a function of total wealth, which is represented by permanent income divided by the discount rate, defined as the average return on the five asset classes in the monetarist theory world, namely money, bonds, equity, physical capital and human capital.
  • is positively related to the price level, P. If the price level rises the demand for money increases and vice versa.
  • rises if the opportunity costs of money holdings (Le. returns on bonds and stock) decline and vice versa.
  • is influenced by inflation, a positive inflation rate reduces the real value of money balances, thereby increasing the opportunity costs of money holdings.

(b) (ii) Discuss the meaning and consequences of negative production externalities. (2 Marks)
Answer:
A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production. As an example, a negative production externality occurs when a factory which produces aluminium discharges untreated waste water into a nearby river and pollutes the water causing health hazards for people who use the water for drinking and bathing. Pollution of river also affects fish output as there will be less catch for fishermen due to loss of fish resources.

The former is a case where a negative production externality is received in consumption and the latter presents a case of a negative production externality received in production. The firm, however, has no incentive to account for the external costs that it imposes on consumers of river water or fishermen when making its production decision. Additionally, there is no market in which these external costs can be reflected in the price of aluminium.

CA Inter FM ECO Paper Dec 2021

Question 11.
(a) How is aggregate consumption function affected, if:

  1. An impending war is expected to result in shortage of goods and an adoption of rationing system,
  2. Increased cost of steel, oil etc. are expected to result in higher prices for consumer goods, or
  3. The leadership assures that economic policy is bringing the recession to an end. (3 Marks)

Answer:

  1. Aggregate Consumption will be increased
  2. Aggregate Consumption will be decreased
  3. Aggregate Consumption will be increased

(b) Discuss the three branch taxonomy of the role of Government in market economy. (3 Marks)
Answer:
Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three-branch taxonomy of the role of government in a market economy. Musgrave believed that, for conceptual purposes, the functions of the government are to be separated into three, namely, resource allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and distribution functions are primarily micro-economic functions, while stabilization is a macroeconomic function.

The allocation function aims to correct the sources of inefficiency in the economic system, while the distribution role ensures that the distribution of wealth and income is fair. Monetary and fiscal policies, the problems of macroeconomic stability, maintenance of high levels of employment and price stability etc. fall under the stabilization function. We shall now discuss in detail this conceptual three-function framework of the responsibilities of the government.

(c) What is the speculative motive for holding cash? (2 Marks)
Answer:
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure.

According to Keynes, people demand to hold money balances to take advan-tage of the future changes in the rate of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory, that the ‘rate of interest’ is really the return on bonds. Keynes assumed that the expected return on money is zero, while the expected returns on bonds are of two types, namely:

  1. The interest payment,
  2. The expected rate of capital gain.

The market value of bonds and the market rate of interest are inversely related. A rise in the market rate of interest leads to a decrease in the market value of the bond, and vice versa.

If wealth-holders consider that the current rate of interest is high compared to the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high current rate of interest, they will convert their cash balances into bonds because:

  1. They can earn high rate of return on bonds,
  2. They expect capital gains resulting from a rise in bond prices consequent upon an expected fall in the market rate of interest in future.

Conversely, if the wealth-holders consider the current interest rate as low, compared to the ‘normal or critical rate of interest’, ie., if they expect the rate of interest to rise in future (fall in bond prices), they would have an incentive to hold their wealth in the form of liquid cash rather than bonds because:

  1. The loss suffered by way of interest income forgone is small,
  2. They can avoid the capital losses that would result from the anticipated increase in interest rates, and
  3. The return on money balances will be greater than the return on alter-native assets,
  4. If the interest rate does increase in future, the bond prices will fall and the idle cash balances held can be used to buy bonds at lower price and can thereby make a capital gain.

(d) Discuss the non-technical measures adopted by the countries with reference to

(i) Trade related investment measures, and
(ii) Price control measures. (2 Marks)

Or
Discuss the salient features of Escalated tariff. (2 Marks)

Answer:

(i) Trade-Related Investmen t Measures: These measures include rules on local content requirements that mandate a specified fraction of a final good should be produced domestically.

a. Requirement to use certain minimum levels of locally made components, (25 per cent of components of automobiles to be sourced domestically),
b. Restricting the level of imported components, and
c. Limiting the purchase or use of imported products to an amount related to the quantity or value of local products that it exports. (A firm may import only up to 75% of its export earnings of the previous year).

(ii) Price Control Measures: Price control measures (including additional taxes and charges) are steps taken to control or influence the prices of imported goods in order to support the domestic price of certain prod-ucts when the import prices of these goods are lower. These are also known as ‘para-tariff’ measures and include measures, other than tariff measures, that increase the cost of imports in a similar manner, i.e. by a fixed percentage or by a fixed amount. Example: A minimum import price established for sulphur.

Or

Answer:
Escalated Tariff: Structure refers to the system wherein the nominal tariff rates on imports of manufactured goods are higher than the nominal tariff rates on intermediate inputs and raw materials, ie. the tariff on a product increases as that product moves through the value-added chain. For example, a four percent tariff on iron ore or iron ingots and twelve percent tariff on steel pipes.

This type of tariff is discriminatory as it protects manufacturing industries in importing countries and dampens the attempts of developing manufacturing industries of exporting countries. This has special relevance to trade between developed countries and developing countries. Developing countries are thus forced to continue to be suppliers of raw materials without much value addition.

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