CA Intermediate

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ is designed strictly as per the latest syllabus and exam pattern.

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 1.
A bill of exchange is payable 180 days after sight. As per the provisions of the Negotiable Instruments Act, 1881, how many days of grace shall be provided in such a case:
(a) 1 day
(b) 2 days
(c) 3 days
(d) 5 days
Answer:
(c) 3 days

Question 2.
Person named in the instrument to whom money is directed to be paid is known as ________.
(a) Drawer
(b) Acceptor
(c) Maker
(d) Payee
Answer:
(d) Payee

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 3.
Parties to a negotiable instrument can be discharged from liability by _________.
(a) Cancellation
(b) Payment
(c) Release
(d) All of the above
Answer:
(d) All of the above

Questions from RTPs, MTPs and Past Exams (Memory Based) of ICAI

Question 4.
While drawing a bill of exchange, a person whose name is given in addition to the drawee who can be resorted in case of need, is called __________. [MTP-March 19]
(a) Acceptor
(b) Acceptor for honour
(c) Drawee in case of need
(d) Drawer
Answer:
(d) Drawer

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 5.
Days of grace provided to the Instruments at maturity as per the provisions of the Negotiable Instruments Act, 1881 are _________. [MTP-March 19]
(a) 1 day
(b) 2 days
(c) 3 days
(d) 5 days
Answer:
(c) 3 days

Question 6.
The date of maturity of a bill payable 100 days after sight and which is presented for sight on 4th May, 2022, as per the provisions of the Negotiable Instruments Act, 1881 will be _________ . [MTP-March 19, Oct 21, March 22]
(a) 13 August, 2022.
(b) 14 August, 2022.
(c) 15 August, 2022.
(d) 16 August, 2022.
Answer:
(b) 14 August, 2022.

Question 7.
A draws a bill on B. B accepts the bill without any consideration. The bill is transferred to C without consideration. C transferred it to D for value. Decide as per the provisions of the Negotiable Instruments Act, 1881. [MTP-March 19]
(a) D can sue only A.
(b) D can sue A or B only.
(c) D can sue any of the parties A, B or C.
(d) D cannot sue any of the parties A, B or C.
Answer:
(c) D can sue any of the parties A, B or C.

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 8.
As per the Negotiable Instruments Act, 1881, when the day on which a promissory note or bill of exchange is at maturity is a public holiday, the instrument shall be deemed to be due on the _________ . [MTP-April 19, May 20]
(a) said public holiday.
(b) 5 days succeeding public holiday.
(c) next succeeding business day.
(d) next preceding business day.
Answer:
(d) next preceding business day.

Question 9.
Validity period for the presentment of cheque in bank is __________. [MTP-April 19, March 21, April 21]
(a) 3 months
(b) 6 months
(c) 1 year
(d) 2 years
Answer:
(a) 3 months

Question 10.
A draws a cheque in favour of M, a minor. M endorses the same in favour of X. The cheque is dishonoured by the bank on grounds of inadequate funds. As per the provisions of Negotiable Instruments Act, 1881: [MTP-April 19]
(a) M is liable to X.
(b) X can proceed against A.
(c) No one is liable in this case.
(d) M can proceed against A.
Answer:
(b) X can proceed against A.

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 11.
M drew a cheque amounting to Rs. 2 lakh payable to N and subsequently delivered to him. After receipt of cheque N endorsed the same to C but kept it in his safe locker. After sometime, N died, and P found the cheque in N’s safe locker. State the nature of the Instrument as amounting to indorsement under the NI Act,1881. [MTP-Oct. 19, May. 20]
(a) Yes its an endorsement, as P becomes the holder of the cheque that he found in the N’s safe locker.
(b) No, its not an endorsement, as P does not become the holder of the cheque.
(c) Yes, its an endorsement, as P was a ultimate custodian of the cheque.
(d) No, its not an endorsement, as N endorsed it to C and not to the P.
Answer:
(b) No, its not an endorsement, as P does not become the holder of the cheque.

Question 12.
Offences committed under the Negotiable Instruments Act can be _________. [MTP-Oct. 19, April 21]
(a) Compoundable
(b) Non-compoundable
(c) Non-compoundable and non-bailable
(d) Bailable
Answer:
(a) Compoundable

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 13.
A draws a bill on B for ₹ 500 payable to the order of A. B accepts the bill, but subsequently dishonours it by non-payment. A sues B on the bill. B proves that it was accepted for value as to ₹ 400, and as an accommodation to the plaintiff as to the residue. Thus, as per the provisions of the Negotiable Instruments Act, 1881, A can only recover the following amount: [RTP-Nov. 19]
(a) ₹ 900
(b) ₹ 500
(c) ₹ 400
(d) ₹ 100
Answer:
(c) ₹ 400

Question 14.
A negotiable instrument drawn in favour of a minor is _________. [MTP-May. 20, March 21, Oct 21, April 22]
(a) void
(b) void but enforceable
(c) valid
(d) none of the above
Answer:
(c) valid

Question 15.
R purchases some goods on credit from S, payable within 3 months. After 2 months, R makes out a blank cheque in favour of S, signs and delivers it to S with a request to fill up the amount due, as R does not know the exact amount payable by him. S fills up fraudulently the amount larger than the amount payable by R and endorses the cheque to C in full payment of S’s own due. R’s cheque is dishonoured. Referring to the provisions of the Negotiable Instruments Act, 1881, C . [RTP-May 20]
(a) Can claim the full amount from R.
(b) Can claim the full amount from S.
(c) Cannot claim the amount either from R or S.
(d) Can claim from S only the exact amount that was due from R to S.
Answer:
(b) Can claim the full amount from S.

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 16.
Mr. Aylam issued a cheque amounting to ₹ 25,000 dated 2nd February, 2022 to Mr. Gandhi which was deposited by Mr. Gandhi on 16th March, 2022 in his bank account. The said cheque got dishonoured on 17th, March 2022 by the bank citing insufficient funds in the account of Mr. Aylam. Then Mr. Gandhi demanded the payment from Mr. Aylam by issuing the notice on 31st March, 2022 which was received by Mr. Aylam on 2nd April, 2022. Assuming that Mr. Aylam failed to make the payment within stipulated time, what is the last date by which Mr. Gandhi should have made a complaint in the court? [MTP-Oct. 20, April 22]
(a) 17th May 2022
(b) 2nd May 2022
(c) 17th April 2022
(d) 30th April 2022
Answer:
(a) 17th May 2022

Question 17.
A negotiable instrument that is payable to order can be transferred by: [MTP-March 21]
(a) Simple delivery
(b) Indorsement and delivery
(c) Indorsement
(d) Registered post
Answer:
(b) Indorsement and delivery

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 18.
Which of the following is not a correct statement with respect to characteristics of a Promissory Note. [MTP-April 21]
(a) An oral promise to pay is sufficient.
(b) It should be in writing.
(c) There must be an express promise to pay.
(d) The promise to pay should be definite and unconditional.
Answer:
(a) An oral promise to pay is sufficient.

Question 19.
A bill of exchange is due on 2nd January, 2022. How many days of grace shall be provided to this bill of exchange due at maturity: [MTP-Nov. 21]
(a) 1 day
(b) 2 days
(c) 3 days
(d) 5 days
Answer:
(c) 3 days

The Negotiable Instruments Act, 1881 – CA Inter Law MCQ

Question 20.
Which of the following is an essential characteristic of a promissory note. [MTP-April 22]
(a) There must be an order to pay certain sum.
(b) It must be payable to bearer.
(c) It must be signed by the Payee.
(d) It must contain an unconditional under¬taking.
Answer:
(d) It must contain an unconditional under¬taking.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material is designed strictly as per the latest syllabus and exam pattern.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Meaning of Negotiable Instruments

Question 1.
What are the essential characteristics of Negotiable Instruments. (Write any five) [MTP-March 22]
Answer:
Essential characteristics of Negotiable Instruments:

  1. It is necessarily in writing.
  2. It should be signed.
  3. It is free transferable from one person to another.
  4. Holders title is free from defects.
  5. It can be transferred any number of times till its satisfaction.
  6. Every negotiable instrument must contain an unconditional promise or order to pay money. The promise or order to pay must consist of money only.
  7. The sum payable, the time of payment, the payee, must be certain.
  8. The instrument should be delivered. Mere drawing of instrument does not create liability.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Promissory Note

Question 2.
Rama executes a promissory note in the following form, ’I promise to pay a sum of ^ 10,000 after three months’. Decide whether the promissory note is a valid promissory note.
Answer:
Promissory Note:

  • Promissory note is an unconditional promise in writing.
  • In the given situation, the amount is certain but the date and name of payee is missing, thus making it a bearer instrument.
  • As per RBI Act, a promissory note cannot be made payable to bearer – whether on demand or after certain days.

Conclusion: Instrument is not valid as per RBI Act, 1934 and cannot be legally enforced.

Question 3.
(i) Are the following instruments signed by Mr. Honest is valid promissory Notes? Give the reasons.
(a) I promise to pay D’s son ₹ 10000 for value received (D has two sons)
(b) I promise to pay ₹ 5000 on demand at my convenience.
(ii) Who is the competent authority to issue a promissory note ‘payable to bearer’?
Your answers shall be in accordance with the provisions of the Negotiable Instruments Act, 1881. [Nov. 20 (3 Marks)]
Answer:
Promissory Note:
(i) As per Sec. 4 of the Negotiable Instruments Act, 1881, a promissory note is an instrument in writing (not being a bank-note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money to or to the order of a certain person, or to the bearer of the instruments. Based on the provisions of Sec. 4, following conclusions may be drawn:

(a) Instrument signed by Mr. Honest is not a valid promissory note as D has two sons and it is not specified in the promissory note that which son of D is the payee.
(b) Instrument signed by Mr. Honest is not a valid promissory note as details of the payee are not mentioned in it and it is not an unconditional undertaking.

(ii) As per Sec. 31 of Reserve Bank of India Act, 1934, a promissory note cannot be made payable to the bearer. Only the Reserve Bank or the Central Government can make or issue a promissory note ’payable to bearer’.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Crossing of Cheques (Secs. 123 to 131)

Question 4.
Mr. Muralidharan drew a cheque payable to Mr. Vyas or order. Mr. Vyas lost the cheque and was not aware of the loss of the cheque. The person who found the cheque forged the signature of Mr. Vyas and indorsed it to Mr. Parshwanath as thoe consideration for goods bought by him from Mr. Parshwanato. Mr. Parshwanato encashed the cheque, on the very same day from thoe drawee bank. Mr. Vyas intimated the drawee bank about thoe theft of the cheque after three days. Examine the liability of the drawee bank. [Nov. 18 (4 Marks), RTP-Nov. 19]
Answer:
Protection of Liability of the Paying Banker:
Sec. 85 of the Negotiable Instruments Act, 1881 provides the following:
(1) Where a cheque payable to order purports to be indorsed by or on behalf of the payee, the drawee is discharged by payment in due course.

(2) Where a cheque is originally expressed to be payable to bearer, the drawee is discharged by payment in due course to the bearer thereof, notwithstanding any indorsement whether in full or in blank appearing thereon, and notwithstanding that any such indorsement purports to restrict or exclude further negotiation.

In the given situation, cheque is drawn payable to “Mr. Vyas or order”. It was lost and Mr. Vyas was not aware of the same. The person found the cheque and forged and indorsed it to Mr. Parshwanath, who encashed the cheque from the drawee bank. After few days, Mr. Vyas intimated about the theft of the cheque, to the drawee bank, by which time, the drawee bank had already made the payment.

Conclusion: Based on the provisions of Sec. 85 as stated above, the drawee banker is discharged when it has made a payment against the cheque payable to order when it is purported to be indorsed by or on behalf of the payee. Even though the signature of Mr. Vyas is forged, the banker is protected and is discharged. The true owner, Mr. Vyas, cannot recover the money from the drawee bank in this situation.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 5.
What is the meaning of Not negotiable crossing as per the Negotiable Instruments Act, 1881? [MTP-March 21]
Answer:
Not negotiable Crossing:
Not negotiable crossing requires writing of words “not negotiable” in addition to the two parallel lines. These words may be written inside or outside these lines.

As per Sec. 130 of the Negotiable Instruments Act, 1881, a person taking a cheque crossed generally or specially, bearing in either case the word “not negotiable” shall not have, and shall not be capable of giving a better title to the cheque than that which the person from whom he took it.

A cheque with such crossing is not negotiable, but continues to be transferable as before. Ordinarily, in a negotiable instrument, if the title of the transferor is defective, the transferee, if he is a holder in due course, will have a good title. When the words “not negotiable” are written, even a holder in due course will get the same title as that of transferor. Thus, if the title of the transferor is defective, the title of transferee will also be so.

Hence, the addition of the words not negotiable does not restrict the further transferability of the cheque, but it entirely takes away the main feature of negotiability, which is that a holder with a defective title can give a good title to the subsequent holder in due course.

Question 6.
As per the Negotiable Instruments Act, 1881, what are the parties who may cross a cheque? [MTP-April 21]
Answer:
Parties who may cross a cheque:
A cheque may be crossed by the following parties:

  1. By Drawer: A drawer may cross it generally or specially.
  2. By Holder: A holder may cross an uncrossed cheque generally or specially. If the cheque is crossed generally, the holder may cross specially. If cheque crossed generally or specially, he may add words “not negotiable”.
  3. By Banker: A banker may cross an uncrossed cheque, or if a cheque is crossed generally he may cross it specially to himself. Where a cheque is crossed specially, the banker to whom it is crossed may again cross it specially to another banker, his agent, for collection.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 7.
A signs his name on a blank cheque with ‘not negotiable crossing which he gives to B with an authority to fill up a sum of 13,008 only. But B fills it for ₹ 5,000. B then endorsed it to C for a consideration of ₹ 5,000 who takes it in good faith. Examine whether C is entitled to recover the full amount of the instrument from B or A as per the provisions of the Negotiable instruments Act, 1881. [July 21 (3 Marks)]
Answer:
Not negotiable Crossing:
As per Sec. 130 of the Negotiable Instruments Act, 1881, a cheque marked “not negotiable” is a transferable instrument. The inclusion of the words ‘not negotiable’ however makes a significant difference in the transferability of the cheques i.e., they cannot be negotiated. The holder of such a cheque cannot acquire title better than that of the transferor.

In the given situation, A gave to B the blank cheque with ‘not negotiable crossing’. B had an authority to fill only a sum of K 3,000 but he filled it up ₹ 5,000. This makes B’s title defective. B then endorsed it to C for consideration of ₹ 5,000.

Conclusion: Based on the above stated facts and provision, C is not entitled to recover the full amount from A or B as C cannot acquire a title better than that of the transferor (B).

Holder and Holder in due Course

Question 8.
Explain the meaning of ‘Holder’ and ‘Holder in due course’ of a negotiable instrument The drawer, ‘D’ is induced by ‘A’ draws a cheque in favour of P, who is an existing person. ‘A’ instead of sending the cheque to ‘P’, forgoes his name and pays the cheque into his own bank. Whether ‘D’ can recover the amount of Hie cheque from ‘A’s banker. Decide.
Answer:
Meaning of ‘Holder’ and the ‘Holder in due course’ of a negotiable instrument: ‘Holder’:
As per Sec. 8 of the Negotiable Instruments Act, 1881, the “holder” of a promissory note, bill of exchange or cheque means any person entitled in his own name to the possession thereof and to receive or recover the amount due thereon from the parties thereto.

As per Sec. 9 of the Negotiable Instruments Act, 1881, ‘Holder in due course’ means:

  1. In the case of an instrument payable to bearer means any person who, for consideration became its possessor before the amount of an instrument payable.
  2. In the case of an instrument payable to order, ‘holder in due course’ means any person who became the payee or indorsee of the instrument before the amount mentioned in it became payable.
  3. He had come to possess the instrument without having sufficient cause to believe that any defect existed in the title of transferor from whom he derived his title.

Given situation is based upon the privileges of a ‘holder in due course’. As per Sec. 42 of the Negotiable Instrument Act, 1881, an acceptor of a bill of exchange drawn in a fictitious name and payable to the drawer’s order is not, by reason that such name is fictitious, relieved from liability to any holder in due cause claiming under an indorsement by the same hand as the drawer’s signature, and purporting to be made by the drawer.

Conclusion: In the given case, P is not a fictitious payee and D, the drawer can recover the amount of the cheque from A’s bankers.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 9.
Discuss with reasons, whether the following persons can be called as a ‘holder’ under the Negotiable Instruments Act, 1881:  [RTP-May 20; MTP-March 22, April 22]

  1. X who obtains a cheque drawn by Y by way of gift
  2. A, the payee of the cheque, who is prohibited by a court order from receiving the amount of the cheque.
  3. M, who finds a cheque payable to bearer, on the road and retains it.
  4. B, the agent of C, is entrusted with an instrument without indorsement by C, who is the payee.
  5. B, who steals a blank cheque of A and forges A’s signature.

Answer:
Person to be called as a holder:
As per Sec. 8 of the Negotiable Instruments Act, 1881 ‘holder’ of a Negotiable Instrument means any person entitled in his own name to the possession of it and to receive or recover the amount due thereon from the parties thereto.

On applying the above provision in the given situations, following conclusions may be drawn:

  1. X can be termed as a holder because he has a right to possession and to receive the amount due in his own name.
  2. A is not a ‘holder’ because to be called as a ‘holder’ he must be entitled not only to the possession of the instrument but also to receive the amount mentioned therein.
  3. M is not a holder of the Instrument though he is in possession of the cheque, so is not entitled to the possession of it in his own name.
  4. B is not a holder. While the agent may receive payment of the amount mentioned in the cheque, yet he cannot be called the holder thereof because he has no right to sue on the instrument in his own name.
  5. B is not a holder because he is in wrongful possession of the instrument

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 10.
Mr. V draws a cheque of Rs. 11,000 and gives to Mr. B by way of gift. State with reason whether:
(i) Mr. B is a holder in due course as per the Negotiable Instrument Act, 1881 ?
(ii) Mr. B is entitled to receive the amount of Rs. 11,000 from the bank? [May 18 (4 Marks), MTP-May 20]
Answer:
Holder in due course:
As per Sec. 9 of the Negotiable Instrument Act, 1881, “Holder in due course” means any person, who for consideration, becomes the possessor of a promissory note, bill of exchange or cheque (if payable to bearer), or the payee or endorsee thereof,(if payable to order), before the amount mentioned in it became payable, and without having sufficient cause to believe that any defect existed in the title of the person from whom he derived his title.

In the instant case, Mr. V draws a cheque of K 11,000 and gives to Mr. B by way of gift.

Conclusion:

  1. Mr. B is holder but not a holder in due course since he did not get the cheque for value and consideration.
  2. Mr. B’s title is good and bona fide. As a holder, he is entitled to receive R 11,000 from the bank on whom the cheque is drawn.

Question 11.
Give-the answer of the following as per the provisions of the Negotiable Instruments Act, 1881: On a Bill of Exchange for ₹ 5 lakh, X’s acceptance to the Bill is forged. ‘A’ takes the Bill from his customer for value and in good faith before the Bill becomes payable. State with reasons whether ’A* can be considered as a ‘Holder in due course’ and whether he (A) can receive the amount of the Bill from ‘X’. [MTP-Oct. 18, Oct. 20]
Answer:
Holder in due course:
As per Sec. 9 of the Negotiable Instruments Act, 1881 ‘holder in due course’ means any person who for consideration becomes the possessor of a promissory note, bill of exchange or cheque if payable to bearer or the payee or endorsee thereof, if payable to order, before the amount in it became payable and without having sufficient cause to believe that any defect existed in the title of the person from whom he derived his title.

As ‘A’ in this case prima facie became a possessor of the bill for value and in good faith before the bill became payable, he can be considered as a holder in due course.

But where a signature on the negotiable instrument is forged, it becomes a nullity. The holder of a forged instrument cannot enforce payment thereon. In the event of the holder being able to obtain payment in spite of forgery, he cannot retain the money. The true owner may sue on tort the person who had received. This principle is universal in character, by reason where of even a holder in due course is not exempt from it.

A holder in due course is protected when there is defect in the title. But he derives no title when there is entire absence of title as in the case of forgery.

Conclusion: ‘A’ cannot receive the amount on the bill.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 12.
Mr. X is tiie payee of an order cheque. Mr. Y steals the cheque and forges Mr. X signature and endorses the cheque in his own favour. Mr. Y then further endorses the cheque to Mr. Z, who takes the cheque in good faith and for valuable consideration. Examine the validity of the cheque as per the provisions of the Negotiable Instruments Act, 1881 and also state whether Mr. Z can claim the privileges of holder-in-due course. [Nov. 19 (3 Marks)]
Answer:
Validity of a forged instrument:

  • Forgery confers no title and a holder acquires no title to a forged instrument. Thus, where a signature on the negotiable instrument is forged, it becomes a nullity. Therefore, cheque further endorsed to Mr. Z, is not valid.
  • Since a forged instrument is a nullity, therefore the property in such instrument remains vested in the person who is the holder at the time when the forged signatures were put on it. Forgery is also not capable of being ratified.
  • In the case of forged endorsement, the person claiming under forged endorsement even if he is purchaser for value and in good faith, cannot acquire the rights of a holder in due course.

Conclusion: Mr. Z, acquires no title on the cheque.

Question 13.
Ram draws a cheque of f 1 lakh. It was a bearer cheque. Ram kept the cheque with himself. After some time, Ram gives this cheque to Shyam as a gift on his birthday. Decide whether Shyam is having a valid title over the cheque and whether Shyam is a holder in due course or not in relation to this cheque as per the Sec. 9 of the Negotiable Instruments Act 1881. [Nov. 20 (3 Marks)]
Answer:
Holder in due course:
As per Sec. 9 of the Negotiable Instruments Act, 1881, “Holder in due course” means any person, who for consideration, became the possessor of a promissory note, bill of exchange or cheque (if payable to bearer), or the payee or endorsee thereof, (if payable to order), before the amount mentioned in it became payable, and without having sufficient cause to believe that any defect existed in the title of the person from whom he derived his title.

In the instant case. Ram draws a cheque for ₹ 1 lakh and hands it over to Shyam by way of gift.

Conclusion: Shyam’s title is good and bona fide. As a holder he is entitled to receive ₹ 1 lakh from the bank on whom the cheque is drawn. However, Shyam is not a holder in due course as he does not get the cheque for value and consideration.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 14.
Give the answer of the following: Amit draws a cheque for f 1000 and hands it over to Beena by way of gift Is Beena a holder in due course? [MTP-April 21]
Answer:
Holder in due course:
As per Sec. 9 of the Negotiable Instruments Act, 1881, the “holder” of a promissory note, bill of exchange or cheque means any person entitled in his own name to the possession thereof, and to receive or recover the amount due thereon from the parties thereto.

As per Sec. 9 of the Negotiable Instruments Act, 1881, “Holder in due course” means any person who for consideration became the possessor of a promissory note, bill of exchange or cheque (if payable to bearer), or the payee or indorsee thereof, (if payable to order), before the amount mentioned in it became payable, and without having sufficient cause to believe that any defect existed in the title of the person from whom he derived his title.

Conclusion: Beena is a holder but not a holder in due course as she does not get the cheque for value and consideration. Her title is good and bona fide. As a holder she is entitled to receive Rs. 1000 from the bank on whom the cheque is drawn.

Question 15.
Referring the previsions of the Negotiable Instruments Act, 1881 give the answer of the following: Ankit draws a cheque for ₹ 32,808 and hands it over to Shreya by way of gift Whether Shreya is a bolder In due course? [Dec. 21 (2 Marks)]
Answer:
Holder in due course:
As per Sec. 9 of the Negotiable Instruments Act, 1881, “Holder in due course” means any person, who for consideration, became the possessor of a promissory note, bill of exchange or cheque (if payable to bearer), or the payee or indorsee thereof, (if payable to order), before the amount mentioned in it became payable, and without having sufficient cause to believe that any defect existed in the title of the person from whom he derived his title.

In the given case, Ankit draws a cheque for ₹ 32,000 and hands it over to Shreya by way of gift.

Conclusion: Shreya is a holder but not a holder in due course as she does not get the cheque for value and consideration. Her title is good and bona fide. As a holder she is entitled to receive ₹ 32,000 from the bank on whom the cheque is drawn.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Classification of Negotiable Instruments

Question 16.
State with reasons whether each of the following instruments is an Inland Instrument or a Foreign Instrument as per The Negotiable Instruments Act, 1881: [Nov. 20 (4 Marks)]

  1. Ram draws a Bill of Exchange in Delhi upon Shyam a resident of Jaipur and accepted to be payable in Thailand after 90 days of acceptance.
  2. Ramesh draws a Bill of Exchange in Mumbai upon Suresh a resident of Australia and accepted to be payable in Chennai after 30 days of sight.
  3. Ajay draws a Bill of Exchange in California upon Vijay a resident of Jodhpur and accepted to be payable in Kanpur after 6 months of acceptance.
  4. Mukesh draws a Bill of Exchange in Lucknow upon Dinesh a resident of China and accepted to be payable in China after 45 days of acceptance.

Answer:
Inland instrument and Foreign instrument:
As per Sec. 11 of the Negotiable Instruments Act, 1881, a promissory note, bill of exchange or cheque drawn or made in India and made payable in, or drawn upon any person resident in India shall be deemed to be ah inland instrument.

As per Sec. 12 of the Negotiable Instruments Act, 1881, any such instrument not so drawn, made or made payable shall be deemed to be foreign instrument.

Conclusion: Based on the provisions of Secs. 11 and 12 as stated above, nature of the Instruments will be as follows:

  1. Bill is drawn in Delhi by Ram upon Shyam, a resident of Jaipur (though accepted to be payable in Thailand after 90 days) is an Inland instrument.
  2. Ramesh draws a bill in Mumbai on Suresh, a resident of Australia and accepted to be payable in Chennai after 30 days of sight, is an Inland instrument.
  3. Ajay draws a bill in California and accepted to be payable in Kanpur, India, drawn upon Vijay, a person resident in India (Jodhpur), therefore the instrument is a Foreign instrument.
  4. As the bill is drawn in India by Mukesh upon Dinesh, the person resident outside India (China) and also payable outside India (China) after 45 days of acceptance, therefore the instrument is a foreign instrument.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 17.
A bill of exchange is drawn by ‘A’ in Berkley where the rate of interest is 15% and accepted by ‘B’ payable in Washington where the rate of interest is 6%. The bill is indorsed in India and is dishonoured. An action on the bill is brought against ‘B’ in India. Advise as per the provisions of the Negotiable Instruments Act. 1881, what rate of interest ‘B’ is liable to pay? [MTP-March 22]
Answer:
Liability of Drawer of Foreign Bill:
As per Sec. 134 of the Negotiable Instruments Act, 1881, in the absence of a contract to the contrary, the liability of the maker or drawer of a foreign promissory note or bill of exchange or cheque is regulated in all essential matters by the law of the place where he made the instrument, and the respective liabilities of the acceptor and indorser by the law of the place where the instrument is made payable.

In the given case, since action on the bill is brought against B in India, he is liable to pay interest at the rate of 6% only.

Maturity of Negotiable Instrument

Question 18.
Bharat executed a promissory note in favour of Bhushan for ₹ 5 crores. The said amount was payable three days after sight. Bhushan, on maturity, presented the promissory note on 1st January, 2021 to Bharat. Bharat made the payments on 4th January, 2021. Bhushan wants to recover interest for one day from Bharat Advise Bharat, in the light of provisions of the Negotiable Instruments Act, 1881, whether he is liable to pay the interest for one day?
Answer:
Claim of Interest:
Sec. 24 of the Negotiable Instruments Act, 1881 states that where a bill or note is payable after date or after sight or after happening of a specified event, the time of payment is determined by excluding the day from which the time begins to run.

In the given case, Bharat will succeed in objecting to Bhushan’s claim. Bharat paid rightly “three days after sight”. Since the bill was presented on 1st January, 2021, Bharat was required to pay only on the 4th January, 2021 and not on 3rd January, 2021 as contended by Bhushan.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 19.
Ascertain the date of maturity of a bill payable hundred days after sight and which is presented for sight on 4th May, 2021.
Answer:
Date of maturity of the bill of exchange:
In the given case, the day of presentment for sight is to be excluded i.e. 4th May, 2021. The period of 100 days ends on 12th August, 2021 (May 27 days + June 30 days + July 31 days + August 12 days). Three days of grace are to be added. It falls due on 15th August, 2021 which happens to be a public holiday. As such it will fall due on 14th August, 2021 i.e. the next preceding business day.

Question 20.
State briefly the rules laid down under the Negotiable Instruments Act for determining the date of maturity of a biii of exchange. [May 18 (5 Marks)]
Answer:
Determining the date of maturity of a bill of exchange:
As per Sec. 22 of Negotiable Instruments Act, 1881, the maturity of a bill, not payable on demand, at sight, or on presentment, is at maturity on the third day after the day on which it is expressed to be payable. Three days are allowed as days of grace. No days of grace are allowed in the case of bill payable on demand, at sight, or presentment.

As per Sec. 23 of Negotiable Instruments Act, 1881, when a bill is made payable at stated number of months after date, the period stated terminates on the day of the month which corresponds with the day on which the instrument is dated.

When it is made payable after a stated number of months after sight the period terminates on the day of the month which corresponds with the day on which it is presented for acceptance or sight or noted for non-acceptance or protested for non-acceptance. When it is payable a stated number of months after a certain event, the period terminates on the day of the month which corresponds with the day on which the event happens.

When a bill is made payable a stated number of months after sight and has been accepted for honour, the period terminates with the day of the month which corresponds with the day on which it was so accepted.

If the month in which the period would terminate has no corresponding day, the period terminates on the last day of such month.

As per Sec. 24 of Negotiable Instruments Act, 1881, in calculating the date, a bill made payable a certain number of days after date or after sight or after a certain event is at maturity, the day of the date, or the day of presentment for acceptance or sight or the day of protest for non-accordance, or the day on which the event happens shall be excluded.

As per Sec. 25 of Negotiable Instruments Act, 1881, when the last day of grace falls on a day which is public holiday, the instrument is due and payable on the next preceding business day.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 21.
Calculate the date of maturity of bill of exchange drawn on 1.6.2021, payable 120 days after considering the relevant provisions of the Negotiable Instruments Act, 1881. [RTP-May 21]
Answer:
Date of maturity of the bill of exchange:
In this case, the day of presentment for sight is to be excluded i.e. 1st June, 2021. The period of 120 days ends on 29th September, 2021 (June 29 days + July 31 days + August 31 Days + September 29 days = 120 days). Three days of grace are to be added. It falls due on 2nd October, 2021, which happens to be a public holiday. As such it will fall due on 1st October, 2021 i.e., the next preceding Business Day.

Negotiation (Transfer) of Negotiable Instruments

Question 22.
Explain the meaning of’Negotiation by delivery’ with the help of an example. Give your answer as per the provisions of the Negotiable Instruments Act, 1881. [MTP-March 19]
Answer:
Negotiation by delivery:

  • As per Sec. 47 of the Negotiable Instruments Act, 1881, subject to the provisions of Sec. 58, a promissory note, bill of exchange or cheque payable to bearer is negotiable by delivery thereof.
  • Exception: A promissory note, bill of exchange or cheque delivered on condition that it is not to take effect except in a certain event is not negotiable (except in the hands of a holder for value without notice of the condition) unless such event happens.
  • Example: A, the holder of a negotiable instrument payable to bearer, delivers it to B’s agent to keep for B. The instrument has been negotiated.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 23.
M drew a cheque amounting to ₹ 2 lakh payable to N and subsequently delivered to him. After receipt of cheque N indorsed the same to C but kept it in his safe locker. After sometime, N died, and P found the cheque in N’s safe locker. Does this amount to Indorsement under the Negotiable Instruments Act, 1881?
Answer:
Negotiation by indorsement:

  • As per Sec. 47 of the Negotiable Instruments Act, 1881, Subject to the provisions of Sec. 58, a promissory note, bill of exchange or cheque payable to order, is negotiable by the holder by indorsement and delivery thereof.
  • In the given case. M drew a cheque amounting to ₹ 2 lakh payable to N and subsequently delivered to him. After receipt of cheque N indorsed the same to C but kept it in his safe locker. After sometime, N died, and P found the cheque in N’s safe locker.

Conclusion: P does not become the holder of the cheque as the negotiation was not completed by delivery of the cheque to him.

Question 24.
Manoj owes money to Umesh. Therefore, he makes a promissory note for the amount in favour of Umesh, for safety of transmission he cuts the note in half and posts one half to Umesh. He then changes his mind and calls upon Umesh to return the half of the note which he had sent Umesh requires Manoj to send the other half of the promissory note. Decide how rights of the parties are to be adjusted in reference to the Negotiable Instruments Act, 1881. [RTP-May 19; MTP- March 19, May 20, March 21]
Answer:
Importance of Delivery in Negotiation:
As per Sec. 46 of the Negotiable Instruments Act, 1881, delivery of an instrument is essential whether the instrument is payable to bearer or order for effecting the negotiation. The delivery must be voluntary and the object of delivery should be to pass the property in the instrument to the person to whom it is delivered.

The delivery can be, actual or constructive. Actual delivery takes place when the instrument changes hand physically. Constructive delivery takes place when the instrument is delivered to the agent, clerk or servant of the indorsee on his behalf or when the indorser, after indorsement, holds the instrument as an agent of the indorsee.

Delivery refers to the whole of the instrument and not merely a part of it. Delivery of half instrument cannot be treated as constructive delivery of the whole.

Conclusion: Claim of Umesh to have the other half of the promissory note sent to him is not maintainable. Manoj is justified in demanding the return of the first half sent by him. He can change his mind and refuse to send the other half of the promissory note.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 25.
‘Anjum’ drew a cheque for ₹ 20,000 payable to ‘Babioo’ and delivered it to him. ‘Babloo’ indorsed the cheque lit favour of‘Rehansh’ but kept it in his table drawer. Subsequently, ‘Babloo’ died, and cheque was found by ‘Rehansh’ in ‘Babloo’s table drawer. ‘Rehansh’ filed die suit for the recovery of cheque. Whether ‘Rehansh’ can recover cheque under the provisions of the Negotiable Instrument Act 1881? [RTP-May 22]
Answer:
Negotiation of Negotiable Instruments:
As per Sec. 48 of the Negotiable Instrument Act 1881, a promissory note, bill of exchange or cheque payable to order, is negotiable by the holder by indorsement and delivery thereof.

The contract on a negotiable instrument until delivery remains incomplete and revocable. The delivery is essential not only at the time of negotiation but also at the time of making or drawing of negotiable instrument. The rights in the instrument are not transferred to the indorsee unless after the indorsement the same has been delivered.

If a person makes the indorsement of instrument but before the same could be delivered to the indorsee the indorser dies, the legal representatives of the deceased person cannot negotiate the same by mere delivery thereof. [Section 57]

Conclusion: In the given case, cheque was indorsed properly but not delivered to indorsee i.e. ‘Rehansh’, Therefore, ‘Rehansh’ is not eligible to claim the payment of cheque.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Indorsement of Instrument (Sec. 15)

Question 26.
‘M’ is the holder of a bill of exchange made payable to the order of ‘F. The bill of exchange contains the following endorsements in blank:
First endorsement ‘N’
Second endorsement ‘O’
Third endorsement ‘P’ and
Fourth endorsement ‘Q’
‘M’ strikes out, without Q’s consent, the endorsements by ‘O’ and ‘P’. Decide, with reasons, whether ‘M’ is entitled to recover anything from ‘Q’ under the provisions of the Negotiable Instruments Act, 1881. [Dec. 21 (3 Marks)]
Answer:
Discharge of indorser’s liability:
As per Sec. 40 of the Negotiable Instruments Act, 1881, where the holder of a negotiable instrument without the consent of the indorser, destroys or impairs the indorser’s remedy against a prior party, the indorser is discharged from liability to the holder to the same extent as if the instrument had been paid at maturity.

In the given case, ‘M1 is the holder of a bill of exchange made payable to the order of ’F’. The bill of exchange contains the following endorsements in blank:
First endorsement ‘N’
Second endorsement ‘O’
Third endorsement ‘P’ and
Fourth endorsement ‘Q’
‘M’ strikes out, without Q’s consent, the endorsements by ‘O’ and ‘P’.

Conclusion: ‘M’ is not entitled to recover anything from ‘Q’.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 27.
A is a payee and bolder of a bill of exchange. He endorses it in blank and delivers it to B. B endorses it in full to C or order. C without endorsement transfers the bill to D, State giving reasons whether D, as bearer of die bill of exchange, is entitled to recover the payment from A or B or C [Dec. 21 (3 Marks)]
Answer:
Conversion of Indorsement in Blank into Indorsement in full:
As per Sec. 49 of the Negotiable Instruments Act, 1881, the holder of a negotiable instrument indorsed in blank may without signing his own name, by writing above the indorser’s signature a direction to pay to any other person as indorsee, convert the indorsement in blank into an indorsement in full; and the holder does not thereby incur the responsibility of an indorser.

As per Sec. 55, if a negotiable instrument, after having been indorsed in bank, is indorsed in full, the amount of it cannot be claimed from the indorser in full, except by the person to whom it has been indorsed in full, or by one who derives title through such person.

Conclusion: D as the bearer is entitled to receive payment or to sue drawer, acceptor, or A who indorsed the bill in blank, but he cannot sue B or C.

Discharge from liability on Notes, Bills and Cheques (Secs. 82 to 90)

Question 28.
C issues a cheque for ₹ 55,00,00 in favour of D. C has sufficient amount in his account with the Bank. The cheque was not presented within reasonable time to die Bank for payment and the Bank, in the meantime, became bankrupt. Decide under the provisions of Negotiable Instruments Act, 1881, whether D can recover the money from C. [RTP-May 21]
Answer:
Discharge by the drawer not duly presenting a cheque for payment:
As per Sec. 84 of the Negotiable Instruments Act, 1881, cheque should be presented to Bank within reasonable time. If cheque is not presented within reasonable time, meanwhile the drawer suffers actual damage, the drawer is discharged to the extent of such actual damage. This would be so if the cheque would have been passed if it was presented within reasonable time.

In determining what is a reasonable time, regard shall be had to (a) the nature of the instrument (b) the usage of trade and of bankers, and (c) facts of the particular case.

The drawer will get discharge, but the holder of the cheque will be treated as creditor of the bank, in place of drawer. He will be entitled to recover the amount from Bank.

Conclusion: In the given case drawer i.e. C has suffered damage as cheque was not presented by D within reasonable time. Hence, C will be discharged but D will be the creditor of bank for the amount of cheque and can recover the amount from the bank.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 29.
Explain the modes of discharge from liability on instruments, as per the provisions of the Negotiable Instruments Act, 1881. [MTP-Aug. 18]
Answer:
Modes of discharge from liability on instruments:
As per Sec. 82 of the Negotiable Instruments Act, 1881, the maker, acceptor or endorser respectively of a negotiable instrument is discharged from liability thereon:
(a) By cancellation: to a holder thereof who cancels such acceptor’s or endorser’s name with intent to discharge him, and to all parties claiming under such holder,

(b) By release: to a holder thereof who otherwise discharges such maker, acceptor or endorser, and to all parties deriving title under such holder after notice of such discharge;

(c) By payment: to all parties thereto, if the instrument is payable to bearer, or has been endorsed in blank, and such maker, acceptor or endorser makes payment in due course of the amount due thereon.

Further, as per Sec. 83 of the Negotiable Instruments Act, 1881, if the holder of a bill of exchange allows the drawee more than 48 hours, exclusive of public holidays, to consider whether he will accept the same, all previous parties not consenting to such allowance are thereby discharged from liability to such holder.

Question 30.
Referring to the provisions of the Negotiable Instruments Act, 1881, examine the validity of then following: A Bill of Exchange originally drawn by R for a sum of ₹ 10,000 but accepted by S only for ₹ 7,000. [fan. 21 (3 Marks}]
Answer:
Discharge by qualified or limited acceptance:
As per Sec. 86 of the Negotiable Instruments Act, 1881, if the holder of a bill of exchange acquiesces in a qualified acceptance, or one limited to part of the sum mentioned in the bill, or which substitutes a different place or time for payment, or which, where the drawees are not partners, is not signed by all the drawees, all previous parties whose consent is not obtained to such acceptance are discharged as against the holder and those claiming under him, unless on notice given by the holder they assent to such acceptance.

Explanation to Sec. 86 states that an acceptance is qualified where it undertakes the payment of part only of the sum ordered to be paid.

Conclusion: Based on the above stated provisions, the bill, which has been drawn by R for ₹ 10,000, has been accepted by S only for ₹ 7,000, is a clear case of qualified acceptance, which may either be rejected by R or he may give assent to the acceptance of ₹ 7,000 only.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 31.
‘A’ draws a cheque for ₹ 5,000 in favour of’B’. ‘A’ had sufficient funds in his bank account to meet it when the cheque ought to be presented in the bank. The bank fails before the cheque is presented. ‘B‘ wants to claim it from ‘A’. Decide, whether ‘A’ is liable as per the Negotiable Instruments Act, 1881. [May 22 (3 Marks)]
Answer:
Discharge by the drawer not duly presenting a cheque for payment:
As per Sec. 84 of the Negotiable Instruments Act, 1881, cheque should be presented to Bank within reasonable time. If cheque is not presented within reasonable time, meanwhile the drawer suffers actual damage, the drawer is discharged to the extent of such actual damage. This would be so if the cheque would have been passed if it was presented within reasonable time.

In determining what is a reasonable time, regard shall be had to (a) the nature of the instrument (b) the usage of trade and of bankers, and (c) facts of the particular case.

The drawer will get discharge, but the holder of the cheque will be treated as creditor of the bank, in place of drawer. He will be entitled to recover the amount from Bank.

Conclusion: In the given case drawer i.e. A has suffered damage as cheque was not presented by B within reasonable time. Hence, A will be discharged but B will be the creditor of bank for the amount of cheque and can recover the amount from the bank.

Material alteration and its effect

Question 32.
State whether the following alterations are material alterations under the Negotiable Instruments Act, 1881?
(i) The holder of the bill inserts the word “or order” in the bill,
(ii) The holder of the bearer cheque converts it into account payee cheque.
Answer:
Material Alteration:

  • An alteration is material which in any way alters the operation of the instrument and affects the liability of parties thereto. Any alteration is material which alters the business effect of the instrument if used for any business purpose.
  • The following materials alterations have been authorised by the Act and do not require any authentication:
    (a) Filling blanks of inchoate instruments (Sec. 20)
    (b) Conversion of a blank indorsement into an indorsement in full (Sec. 49).
  • Alteration as stated in the question are material in nature and permitted under the provisions of the law.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 33.
A Bill of Exchange was made without mentioning any time for payment The holder added the words “on demand ‘ on the face of the instrument Does this amount to any material alteration? Explain. [May 19 (2 Marks)]
Or
State whether the following alteration is material alteration under the provisions of the Negotiable Instruments Act, 1881.
A promissory note was made without mentioning any time for payment The holder added the words “on demand” mi the face of the instrument. [Nov. 19 (4 Marks)]
Or
A promissory note was made without mentioning any time for payment The holder added the words “on demand” on the face of the instrument Does this amount to material alteration? [MTP-April 21]
Answer:
Material Alteration:

  • An alteration is material which in any way alters the operation of the instrument and affects the liability of parties thereto. Any alteration is material which alters the business effect of the instrument if used for any business purpose.
  • In the given case, a promissory note was made without mentioning any time for payment. The holder added the words “on demand” on the face of the instrument.
  • As per the provision of the Negotiable Instruments Act, 1881 this is not a material alteration as a promissory note where no date of payment is specified will be treated as payable on demand. Hence, adding the words “on demand” does not alter the business effect of the instrument.

Question 34.
Referring the provisions of the Negotiable Instruments Act, 1881 give the answer of the following: A promissory note was made without mentioning any time for payment. The holder added the words ‘on demand’ on the face of the instrument Whether this may be treated as material alteration in the instrument? [Dec. 21 (2 Marks)]
Answer:
Material Alteration:
An alteration is material which in any way alters the operation of the instrument and affects the liability of parties thereto. Any alteration is material which alters the business effect of the instrument if used for any business purpose.

In the given case, a promissory note was made without mentioning any time for payment. The holder added the words “on demand” on the face of the instrument.

Conclusion: As per the provision of the Negotiable Instruments Act, 1881 this is not a material alteration as a promissory note where no date of payment is specified will be treated as payable on demand. Hence, adding the words “on demand” does not alter the business effect of the instrument.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 35.
Examine the validity of the following statements with reference to the Negotiable Instruments Act, 1881.
(i) When payment on an Instrument is made in due coarse, both the instrument and the parties to it are discharged.
(ii) Alteration of rate of interest specified in the Promissory Note is not a material alteration.
(iii) Conversion of the blank indorsement into an indorsement in full is not a material alteration and it does not require authentication. [May 22 (3 Marks)]
Answer:
Validity of Statements with reference to the Negotiable Instruments Act, 1881:
(i) Statement is valid. As per Sec. 78, when payment on an instrument is made in due course, both the instrument and the parties to it are discharged subject to the provision of Sec. 82(c). The payment on an instrument may be made by any party to the instrument. It may even be made by a stranger provided it is made on account of the party liable to pay.

(ii) Statement is not valid. Alteration of rate of interest specified in the Promissory Note is considered as a material alteration.

(iii) Statement is partially valid. Conversion of the blank indorsement into an indorsement in full is a material alteration, but it is authorised by the Act and does not require authentication.

Question 36.
Healthcare Services Limited (the Bidder), bids the tender floated by Super Care Hospital (the Tenderer), attaching a cheque dated 01.04.2022 for ₹ 5,00,000 towards earnest money deposit. Since the tender process was extended, the Tenderer returned the cheque expiring on 30.06.2022 to the Bidder for its resubmission after having revalidated by changing the date of the cheque to 01.07.2022. Accordingly, the revalidated cheque was resubmitted by the Bidder to the Tenderer. The cheque presented by the Tenderer to the banker. It was dishonoured by the bank. Examine, whether, the cheque altered with a new date shall be deemed a valid cheque binding the Bidder for payment as per the Negotiable Instruments Act, 1881? [May 22 (5 Marks)]
Answer:
Validity of a Negotiable instruments in case of material alteration:
As per Sec. 87 of the Negotiable Instruments Act, 1881, any material alteration of negotiable instruments renders the same void as against anyone who is a party thereto at the time of making such alteration and does not consent thereto, unless it was made in order to carry out the common intention of the original parties.

However, the party who consents to the alteration as well as the party who makes the alteration are disentitled to complain against such alteration e.g. the drawer of the cheque himself altered the date of the cheque for validating or revalidating the same instrument, he cannot take advantage of it by saying that the cheque becomes void as there was a material alteration thereto. It is always open to a drawer to voluntarily re-validate a negotiable instrument including a cheque.

In the given case, Healthcare Services Limited (the Bidder), bids the tender floated by Super Care Hospital (the Tenderer), attaching a cheque dated 01.04.2022 for ₹ 5,00,000/- towards earnest money deposit. Since the tender process was extended, the Tenderer returned the cheque expiring on 30.06.2022 to the Bidder for its resubmission after having revalidated by changing the date of the cheque to 01.07.2022. Accordingly, the revalidated cheque was resubmitted by the Bidder to the Tenderer. The cheque presented by the Tenderer to the banker. It was dishonoured by the bank.

Conclusion: Cheque altered with a new date shall be deemed a valid cheque binding the Bidder for
payment.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Dishonour of Negotiable instruments

Question 37.
Is notice of dishonour necessary in the following cases:
(1) X, drawer of a Bill informs Y, the holder of the bill that the bill would be dishonoured on the presentment for payment.
(2) X, drawer of a Bill informs Y, the holder of the bill that the bill would be dis honoured on the presentment for payment.
Answer:
Dishonour of Negotiable instruments:
As per Sec. 98 of the Negotiable Instruments Act, 1881, notice of dishonour is not necessary in the following cases:
(a) Notice of dishonour is dispensed with by the party entitled thereto; a waiver of notice may be made at the time of drawing or indorsing the instrument, or before or after the time for giving notice has arrived.
(b) In order to charge the drawer, when he has countermanded payment;
(c) When the party charged could not suffer damages for want of notice;
(d) When the party entitled to notice cannot after due search be found; or the party bound to give notice is, for any other reason, unable without any fault of his own to give it;
(e) To charge the drawers, when the acceptor is also a drawer;
(f) In the case of a promissory note which is not negotiable.
(g) When the party entitled to notice, knowing the facts, promises unconditionally to pay the amount due on the instrument.

Conclusion: Notice of dishonour is not necessary in both the cases.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 38.
What are the circumstances under which a bill of exchange can be dishonoured by non-acceptance? Also, explain die consequences if a cheque gels dishonoured for insufficiency of funds In the account. [Nov. 18 (5 Marks), MTP-May 20]
Or
What are the circumstances under which a bill of exchange can be dishonoured by non-acceptance? Give your answer as per the provisions of the Negotiable Instruments Act, 1881. [MTP-April 19, Oct 19, April 22]
Answer:
Dishonour by Non-acceptance:
As per Sec. 91 of the Negotiable Instruments Act, 1881, a bill of exchange is said to be dishonoured by non-acceptance in any one of the following circumstances:
(a) When a bill is duly presented for acceptance, and the drawee, or one of several drawees not being . partners, refuse acceptance within 48 hours from the time of presentment, the bill is dishonoured.
(b) where presentment is excused and the bill is not accepted.
(c) Where the drawee is incompetent to contract, the bill may be treated as dishonoured.
(d) Where the drawee is a fictitious person.
(e) Where the drawee could not be found even after reasonable search
(f) When a drawee gives a qualified acceptance, the holder may treat the instrument dishonoured.

Dishonour of Cheque for insufficiency, etc. of funds in the account:
As per Sec. 138 of the Negotiable Instruments Act 1881, where any cheque drawn by a person on an account maintained by him with a banker for payment is dishonoured due to insufficiency of funds, he shall be punished with imprisonment for a term which may extend to two years or with fine which may extend to twice the amount of the cheque or with both.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 39.
Examine the billowing cases with respect to their validity. State your answer with Reasons.
(i) A bill of exchange is drawn, mentioning expressly as ‘payable on demand’. The bill will be at maturity for payment on 04.01.2022, if presented on 01.01.2022.
(ii) A holder gives notice of dishonour of a bill to all the parties except the acceptor. The drawer claims that he is discharged from his liability as the holder fails to give notice of dishonour of the bill to all the parties thereto. [July 21 (4 Marks)]
Answer:
(i) The bill of exchange is drawn, mentioning expressly as ‘payable on demand’. The bill will be at maturity for payment on 04-1-2022, if presented on 01-01-2022: This statement is not valid as no days of grace are allowed in the case of bill payable on demand.

(ii) A holder gives notice of dishonour of a bill to all the parties except the acceptor. The drawer claims that he is discharged form his liability as the holder fails to give notice of dishonour of the bill to all the parties thereto:
As per sec. 93 of the Negotiable Instruments Act, 1881, notice of dishonour must be given by the holder to all parties other than the maker or the acceptor or the drawee whom the holder seeks to make liable. Accordingly, notice of dishonour to the acceptor of a bill is not necessary. Therefore, claim of drawer that he is discharged from his liability on account of holder’s failure to give notice to all the parties thereto, is invalid.

Dishonour of Cheques for Insufficiency of Funds in die Accounts (Secs. 138 to 142)

Question 40.
A promoter who has borrowed a loan on behalf of company, who is neither a director nor a person- in-charge, sent a cheque from the companies account to discharge its legal liability. Subsequently, the cheque was dishonoured and the complaint was lodged against him is he liable for an offence under
Answer:
Dishonour of Cheques for Insufficiency of Funds in the Accounts:
As per Sec. 138 of the Negotiable Instruments Act, 1881 where any cheque drawn by a person on an account maintained by him with a banker for payment of any amount of money to another person from/out of that account for discharging any debt or liability, and if it is dishonoured by banker on sufficient grounds, such person shall be deemed to have committed an offence and shall be liable.

Conclusion: Promoter is neither a director nor a person-in-charge of the company and is not connected with the day-to-day affairs of the company and had neither opened nor is operating the bank account of the company. Further, the cheque, which was dishonoured, was also not drawn on an account maintained by him but was drawn on an account maintained by the company. Therefore, he has not committed an offence under Sec. 138

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 41.
Explain the power of court for trial of cases summarily, as per the provisions of the Negotiable instruments Act, 1881. [MTP-Oct. 18]
Answer:
Power of Court to try Cases Summarily:
Sec. 143 of the Negotiable Instruments Act, 1881, deals with the provisions relating to power of Court for trial of cases summarily. Main provisions are:
(1) Trial of Offence: Notwithstanding anything contained in the Code of Criminal Procedure, 1973, all offences under this Chapter shall be tried by a Judicial Magistrate of the first class or by a Metropolitan Magistrate and the provisions of Secs. 262 to 265 (both inclusive) of the said Code shall, as far as may be, apply to such trials:

In case of summary trial: In the case of any conviction in a summary trial under this Sec., it shall be lawful for the Magistrate to pass a sentence of imprisonment for a term not exceeding one year and an amount of fine exceeding ₹ 5,000.

In case where no summary trial can be made: When at the commencement of, or in the course of, a summary trial under this Sec., it appears to the Magistrate that the nature of the case is such that a sentence of imprisonment for a term exceeding one year may have to be passed or that it is, for any other reason, undesirable to try the case summarily, the Magistrate shall after hearing the parties, record an order to that effect and thereafter recall any witness who may have been examined and proceed to hear or rehear the case in the manner provided by the said Code.

(2) Speedy Trial: The trial of a case under this Sec. shall, so far as practicable, consistently with the interests of justice, be continued from day to day until its conclusion, unless the Court finds the adjournment of the trial beyond the following day to be necessary for reasons to be recorded in writing.

(3) Speedy and efficient Disposal: Every trial under this Sec. shall be conducted as expeditiously as possible and an endeavour shall be made to conclude the trial within six months from the date of filing of the complaint.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 42.
Bhoienath drew a cheque in favour of Surendar. After having issued the cheque; Bholenath requested Surendar not to present the cheque for payment and gave a stop payment request to the bank in respect of the cheque issued to Surendar.

Decide, under the provisions of the Negotiable Instruments Act 1881 whether the said acts of Bholenath constitute an offence? [RTP-Nov. 20, May 18 (4 Marks)]
Answer:
Stop payment of Cheques:
Sec. 138 of the Negotiable Instruments Act, 1881, is a penal provision in the sense that once a cheque is drawn on an account maintained by the drawer with his banker for payment of any amount of money to another person out of that account for the discharge in whole or in part of any debt or liability, is informed by the bank unpaid either because of insufficiency of funds to honour the cheques or the amount exceeding the arrangement made with the bank, such a person shall be deemed to have committed an offence.

Once a cheque is issued by the drawer, a presumption under Sec. 139 of the Negotiable Instruments Act, 1881 follows and merely because the drawer issues a notice thereafter to the drawee or to the bank for stoppage of payment, it will not preclude an action under Sec. 138.

Also, Sec. 140 of the Negotiable Instruments Act, 1881, specifies absolute liability of the drawer of the cheque for commission of an offence under the Sec. 138 of the Act. Sec. 140 states that it shall not be a defence in a prosecution for an offence under Sec. 138 that the drawer had no reason to believe when he issued the cheque that the cheque may be dishonoured on presentment for the reasons stated in that Sec..

As per the facts stated in the question, Bholenath (drawer) after having issued the cheque, informs Surendar (drawee) not to present the cheque for payment and as well gave a stop payment request to the bank in respect of the cheque issued to Surendar.

Conclusion: Act of Bholenath, i.e., his request of stop payment constitutes an offence under the provisions of the Negotiable Instruments Act, 1881.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 43.
Mr. Harsha donated ₹ 50,000 to an N60 by cheque for sponsoring the education of one child for one year. Later on he found that the NGO was a fraud and did not engage in philanthropic activities. He gave a “stoppayment” instruction to his bankers and the cheque was not honoured by the bank as per his instruction. The NGO has sent a demand notice and threatened to tile a case against Harsha. Advise Mr. Harsha about the course of action available under the Negotiable Instruments Act, 1881. [July 21 (3 Marks)]
Answer:
Offence u/s 138 as to dishonour of cheque:
Sec. 138 of the Negotiable Instruments Act, 1881 deals with dishonour of cheque which is issued for the discharge, in whole or in part, of any debt or other liability. However, any cheque given as gift or donation, or as a security or in discharge of a mere moral obligation, would be considered outside the purview of section 138.

In the given situation, Mr. Harsha donated ₹ 50,000 to NGO by cheque for sponsoring child education for 1 year. On founding that NGO was fraud, Mr. Harsha instructed bankers for stop payment. In lieu of that, NGO sent a demand notice and threatened to file a case against him. Here the cheque is given as a donation for the sponsoring child education for 1 year and is not legally enforceable debt or other liability on Mr. Harsha.

Conclusion: Mr. Harsha is not liable for the donated amount which is not honoured by the bank to the NGO.

The Negotiable Instruments Act, 1881 – CA Inter Law Study Material

Question 44.
Mr. Mudlt is the employee in Senior Research Analyst Private Limited. He went to a Super Mall, a departmental store, where he purchased some goods for his personal use on credit Mr. Mudit gave a cheque drawn on the Senior Research Analyst Private Limited’s account to Super Mall towards the full payment of the dues. The cheque was dishonoured by the company’s bank. Mr. Mudit was neither a director nor a person in-charge of die company.

Explain under the provisions of the Negotiable Instruments Act, 1881, whether Mr. Mudit has committed an offence under section 138. [MTP-Aprii 22]
Answer:
Offence u/s 138 as to dishonour of cheque:
As per Sec. 138 of the Negotiable Instruments Act, 1881, where any cheque drawn by a person on an account maintained by him with a banker for payment of any amount of money to another person from/out of that account for discharging any debt or liability, and if it is dishonoured by banker on sufficient grounds, such person shall be deemed to have committed an offence and shall be liable.

As per Sec. 141, if the person committing an offence u/s 138 is a company, every person who, at the time the offence was committed was in charge of, and was responsible to the company for the conduct of the business of the company, as well as the company, shall be deemed to be guilty of the offence and shall be liable to be proceeded against and punished accordingly.

In the given situation, Mudit is neither a director nor a person-in-charge of the company and is not connected with the day-to-day affairs of the company and had neither opened nor is operating the bank account of the company. Further, the cheque, which was dishonoured, was also not drawn on an account maintained by him but was drawn on an account maintained by the company.

Conclusion: Mudit has not committed an offence under section 138.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

The Negotiable Instruments Act, 1881 – CA Inter Law Notes is designed strictly as per the latest syllabus and exam pattern.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Negotiable Instrument:

Meaning & Features:
A negotiable instrument means promissory note, bill of exchange and cheque.

It includes other instrument apart from above mentioned instruments, if such instrument has following features:

  • It should be freely transferable either:
    • By delivery; or
    • By endorsement
  • It must be payable either to order or to bearer.
  • It can be transferred any number of times till its payment
  • Transferee who takes the instrument bona fide and for valuable consideration obtains a good title despite any defects in the title of the transferor
  • It is subject to certain presumptions

Presumptions as to Negotiable Instruments – Section 118:
The presumptions as to negotiable instrument shall prevail. Negotiable instrument is subject to following presumptions:

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Consideration:

  • Every instrument was made, accepted and endorsed for consideration.
  • Consideration is not required to be mentioned on instrument.

Date:
It was drawn on the date shown on face of it.

Time of acceptance:
It was accepted within a reasonable time after its date and before maturity.

Time of transfer:
It was transferred before its maturity.

Duly stamped:
A lost promissory note or bill was duly stamped and signed.

Holder in due course:
The holder of a negotiable instrument is a Holder in due course.

Order of instrument:
Endorsement appearing upon negotiable instrument were made in the order in which they appear thereon.

Promissory Note – Section 4

Definition:
A ‘promissory note’ is an instrument in writing containing an unconditional undertaking signed by the maker to pay a certain sum of money only to

  • a certain person; or
  • the order of a certain person

Parties:

  • The person who makes the promissory note is called as maker. His liability is primary and unconditional.
  • The person to whom money is to be paid is called as payee.

Essential Elements:

  • Following are the elements of promissory note:

In writing:

  • It should be in writing (handwritten or printing).
  • An oral promise to pay is not sufficient.

Express promise to pay:

  • It must contain express promise to pay.
  • Mere acknowledgement of indebtedness is not sufficient.

Example:
‘Mr. B I.O.U. ₹ 10,000.’ There is no promise to pay and therefore this is not a valid promissory note.

Definite & unconditional promise:

  • If a promise to pay is dependent upon an event which is certain to happen, although the unconditional time of its happening is uncertain, the promise to pay is unconditional.

Example:
‘I promise to pay Bina ₹ 5,00,000 on D’s death.’ The promise is not conditional, but definite since death of D is certain. Therefore, the promissory note is valid.

Signed by maker:

  • A promissory note must be signed by the maker.
  • The signatures may be made on any part of the instrument.

Promise to pay a certain sum:
It should contain promise to pay certain sum of money. It should contain promise to pay money only and nothing else.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Example:
‘I promise to pay Balwant ₹ 2,500 and all other sums which shall be due to him.’ Since the amount payable is not certain, it is not a valid promissory note.

Example:
‘I promise to pay Balwant ₹ 1200 and to deliver to him my rabbit on 1 st March 2011.’ It is not a valid promissory note since the promisor is required to deliver rabbit, which is not ‘money’.

Payee must be certain: The name of payee must be specified in the promissory note, otherwise it will be invalid.

Stamped:

  • A promissory note must be stamped.
  • Stamp duty is paid as per Stamp Act.

Bills of Exchange – Section 5

Definition:
A ‘bill of exchange’ is an instrument in writing containing an unconditional order signed by the maker directing a certain person to pay a certain sum of money only to :

  • a certain person; or
  • the order of a certain person; or
  • the bearer of the instrument

Example :
‘A’ wrote and signed an instrument ordering ‘B’ to pay ₹ 500 to ‘C’ This is a Bill of Exchange.

Example :
On demand, pay to ‘A’ or order the sum of rupees five hundred for value received.’

Parties:

  • The person who draws or makes the bill is known as drawer. His liability is secondary and conditional.
  • The person on whom the bill is drawn is called as drawee.
  • On acceptance of the bill drawee is called as acceptor. He becomes liable for the payment of the bill and his liability
    is primary and unconditional.
  • The person to whom money is to be paid is known as payee.

Elements:
Characteristics of bill of exchange are almost similar to promissory note. Following are essentials characteristics of a bill of exchange:

  • It must be in writing.
  • It must contain an express order to pay.
  • The order to pay must be definite and unconditional.
  • It must be signed by the drawer.
  • The sum contained in the order must be certain.
  • The order must be to pay money only.
  • Drawer, drawee and payee must be certain. Drawer and payee may be same person.
    It must be stamped.

Cheque – Section 7

Definition:
A cheque is a bill of exchange drawn on a specified banker and it includes ‘the electronic image of truncated cheque’ and ‘a cheque in electronic form’.

Truncated cheque:
A truncated cheque means a cheque which is truncated during the course of a clearing cycle either by the clearing house or bank whether paying or receiving payment immediately on generation of an electronic image for transmission, substituting the further physical movement of cheque in writing.

Cheque in electronic form:
A cheque in electronic form means a cheque which contains the exact mirror image of a paper cheque and is generated, written and signed in a secure system ensuring the minimum safety standards with the use of digital signature (with or without biometric signature) and asymmetric crypto system.

Parties:
The person who draws or makes the cheque is called as drawer. His liability is primary and conditional.
The bank on whom the cheque is drawn is called as drawee. Bank makes the payment of the cheque.
The person to whom money is to be paid is called as payee. The payee may be the drawer himself or a third party.

Elements:
A cheque must contain all the characteristics of a bill of exchange.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Essentials characteristics of a cheque can be summarized as under:

  • It must be in writing.
  • It must contain an express order to pay.
  • The order to pay must be definite and unconditional.
  • It must be signed by the drawer.
  • The sum contained in the order must be certain.
  • The order must be to pay money only.
  • Drawer, drawee and payee must be certain.
  • It is always drawn upon a specified banker.
  • It is always payable on demand.

Important Mote:
A cheque does not require stamping or acceptance.

Distinguish Between Bills Of Exchange And ProMissory Note

Matter Bill of Exchange Promissory Note
Meaning Bill of exchange is an instrument in writing showing the indebtedness of a buyer towards the seller of goods. A promissory note is a written promise made by the debtor to pay a certain sum of money to the creditor at a future specified date.
Defined in Section Section 5 of Negotiable Instrument Act, 1881. Section 4 of Negotiable Instrument Act, 1881.
Parties Three parties, i.e. drawer, drawee and payee. Two parties, ie. drawer and payee.
Liability of Maker Secondary and conditional Primary and absolute
Can maker and payee be the same person? Yes No
Copies Bill can be drawn in copies. Promissory note cannot be drawn in copies.
Dishonour Notice is necessary to be given to all the parties involved Notice is not necessary to be given to the maker.

Distinguish Between Bills of exchange and cheque

Matter Bill of Exchange Cheque
Drawn on Bill of exchange can be drawn on any person. Cheque is always drawn on bank.
Payable on Demand? Bill of exchange need not al­ways be payable on demand. It is always payable on de­mand.
Payable to Bear­er? It cannot be payable to bearer on demand. It can be drawn payable on bearer on demand.
Acceptance It require an acceptance of drawee. It does not require an accep­tance.
Stamp It requires stamp as per Stamp Act. It does not require stamp.
Crossing It cannot be crossed. It can be crossed.
Notice of Dis­honour Notice of dishonour is usually required. Notice of dishonour is not required.
Noting & Pro­testing To establish dishonour, noting and protesting are required. Noting and protesting are not required for a cheque.

Capacity of Parties

Minor:

  • Minor is incompetent to enter into contract. Therefore, he cannot bind himself by becoming party to negotiable instrument.
  • However, minor may draw, endorse, deliver and negotiate a negotiable instrument so as to bind all other parties except himself.

Insolvent:

  • An insolvent is not competent to enter into valid contract.
  • He cannot draw, make, accept or indorse a negotiable instrument.
  • If he endorses an instrument, of which he is payee, to a holder in due course, then holder in due course can recover the amount from all prior parties except insolvent.

Agent:

  • The negotiable instrument can be drawn or accepted by duly authorised agent on behalf of his principal.
  • Authority of an agent to draw, accept or endorse negotiable instrument must be expressed in clear terms.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Partner:

  • In a trading firm, each partner has implied authority to bind the firm and his co-partners by drawing, signing, making, accepting or endorsing negotiable instrument in the name of firm.
  • But the partner of non-trading firm can bind if he is expressly authorised for same.

Holder and Holder in Due Course

Holder – Section 8:
Holder of negotiable instrument means any person:

  • Who is entitled to the possession of it in his name; and
  • Who is entitled to receive the amount due thereon from party who has transferred it
  • The party transferring the negotiable instrument should be legally capable.

Example:
Finder of the lost instrument payable to bearer is not holder.

Holder in Due course – Section 9:
Every holder of negotiable instrument will be treated as ‘holder in due course’, if he has obtained instrument:

  • For consideration before maturity; and
  • In good faith (Le., without sufficient cause to believe that any defect existed in the title of the person from whom he derived his title).

Distinguish between Holder & Holder in Due Course (HDC):

Matter Holder Holder in Due Course (HDC)
Meaning A holder is a person who legally obtains the negotiable instru­ment, with his name entitled on it, to receive the payment from the parties liable. A holder in due course (HDC) is a person who acquires the negotiable instrument bona- fide for some consideration, whose payment is still due.
Consideration Not necessary Necessary
Right to Sue A holder cannot sue all prior parties. A holder in due course can sue all prior parties.
Good Faith

.

Instrument may or may not be obtained in good faith. Instrument must be obtained in good faith.
Privileges Comparatively less More
Maturity A person can become holder, before or after maturity of the negotiable instrument. A person can become holder in due course, only before the maturity of negotiable instrument.

Privileges of holder in due course:
Protection in Case of Incomplete Instrument- Section 20:
A person signing and delivering to another a stamped but otherwise incomplete cannot assert that the instrument has not been filled in accordance with the authority given by him, provided the amount filled in it is covered by the amount of the stamps.

Liability of Prior Parties – Section 36:
Every prior party to instrument (maker, drawer, acceptor and endorser) is liable thereon to holder in due course until the instrument is duly satisfied.

Protection in Case of Fictitious Bill – Section 42:

  • Where bill is drawn by a fictitious person and is payable to his order, the acceptor cannot be relieved from his liability to the holder in due course.
  • Holder in due course has to prove that instrument was endorsed by the same hand as drawer’s signature.

Protection in Case of Instruments Without Consideration – Section 43:
A negotiable instrument made, drawn, endorsed without consideration does not give any right to intermediate parties. However, when it comes in hands of holder in due course, he can recover an amount due on such instrument from prior parties.

Protection in Case of Conditional Delivery – Section 46:
When instrument is negotiated to the holder in due course, the other parties to bill or note cannot escape liability on the ground that delivery of the instrument was conditional or for a special purpose only.

Instrument Purged (cleared) of All Defects – Section 53:
When instrument passes through the hands of holder in due course, it is purged (cleaned) of all defects. Any person acquiring it also becomes holder in due course and takes it free of all defects, except the person who was party to fraud.

Instrument Obtained by Unlawful Means etc. – Section 58:
The argument (plea) that the instrument was obtained by unlawful means or for unlawful consideration cannot be set up against a holder in due course.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Validity of Instrument – Section 120:
Maker of promissory note, drawer of bill payable to order and acceptor of bill for honour cannot deny validity of instrument in suit filed by holder in due course.

Capacity of Payee to Endorse – Section 121:
Maker of promissory note and acceptor of bill payable to order cannot deny capacity of payee on date of note or bill to endorse it, in suit hied by holder in due course.

Classification of Instruments

Bearer Instrument – Section 13:
A negotiable instrument:

  • which is expressed to by payable to bearer; or
  • on which last endorsement is in blank, is bearer instrument

Order Instrument – Section 13:
A negotiable instrument is order instrument when it is payable to:

  • A specified person; or
  • A specified person or his order.

Demand Instrument – Sections 19 & 21:
A negotiable instrument is demand instrument where

  • time for payment is not fixed; or
  • it is expressly payable on demand.
  • Cheque is always payable on demand

Time Instrument:
A negotiable instrument is time instrument in which time for payment is specified.
Time instrument may be payable:

  • On specific day; or
  • After specified period; or
  • Certain period after sight; or
  • On happening of an event which is certain to happen

Inland Instrument – Section 11:
A negotiable instrument is an inland instrument if:

  • It is drawn in India on person resident in India, payable anywhere; or
  • It is drawn in India on person resident outside India, payable in India

Example:
A bill drawn in India, payable in Japan, upon person in India is an inland instrument.

Foreign Instrument – Section 12:

  • A negotiable instrument which is not inland instrument is called foreign instrument.
  • Foreign instrument must be drawn outside India and made payable outside or inside India.

Ambiguous Instrument – Section 17:

  • An instrument which cannot be clearly identified either as a bill or exchange or promissory note is an ambiguous instrument.

Inchoate Instrument – Section 20:
Where one person signs and delivers to another a paper stamped in accordance with the law relating to negotiable instruments then in force in India, and either wholly blank or having written thereon an incomplete negotiable instrument, he thereby gives prima facie authority to the holder thereof to make or complete, as the case may be, upon it a negotiable instrument, for any amount specified therein; and not exceeding the amount covered by the stamp. Such instrument is called as inchoate instrument.

The person so signing shall be liable upon such instrument, in the capacity in which he signed the same, to any holder in due course for such amount; provided that no person other than a holder in due course shall recover from the person delivering the instrument anything in excess of the amount intended by him to be paid there under.

Other Instrument:
Accommodation Bill

  • Accommodation bill means a bill which is drawn, accepted without consideration.
  • The person who becomes the holder of such a bill in good faith and for consideration after maturity, may recover the amount from any party.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Fictitious bill:

A fictitious bill is a bill in which the name of the drawer or the payee or both is fictitious.

Distinguish Between Inland Bill And Foreign Bill

Matter Inland Bill Foreign Bill
Copy It is drawn in single copy. It is drawn in triplicate.
Dishonour In inland bill, dishonour re­quired noting, protest is op­tional. In foreign bill, dishonour re­quires protesting.

Distinguish Between Ambiguous Instrument and Inchoate Instrument

Matter Ambiguous Instrument Inchoate Instrument
Negotiable

 

Ambiguous instrument can be negotiated. Inchoate instrument is not a negotiable instrument. It can be negotiated only after amounts are filled in.
Can Holder Sue? Holder of ambiguous instrument can sue on it after electing to treat it either as promissory note of bills of exchange. Holder of inchoate instrument can sue only after amounts are filled in.

Maturity of Promissory Note or Bill of Exchange – Sections 22 To 25

  • Cheques are always payable on demand but other instruments like bills, notes etc., may be made payable on specified date or after specified time.
  • Maturity of a negotiable instrument means the date on which the negotiable instrument falls due for payment.
  • A negotiable instrument which is payable otherwise than on demand is entitled to 3 days of grace.
Situation Date of maturity
Instrument payable on a spec­ified day Specified day + 3rd day
Instrument payable on a stated number of days after date Date on which instrument is drawn + stated number of days + 3rd day
Instrument payable on stated number of days after sight Date on which instrument is presented for sight + stated number of days + 3rd day
Instrument payable on stated number of days after happening of a certain event Date on which such event happens + stated number of days + 3rd day
Instrument payable on stated number of months after date Corresponding day of the relevant month1 (ie., Date on which negotiable instrument is drawn + stated number of months) + 3rd day
Instrument payable in instal­ment Each instalment is entitled to 3 days of grace.

Negotiation – Section 14

What is Negotiation?
It means transfer of negotiable instrument to any other person so as to constitute that person as holder of such negotiable instrument.

Methods of Negotiation

  • A bearer instrument can be negotiated by delivery.
  • An order instrument can be negotiated by way of endorsement and delivery.
  • Delivery must be voluntary.

(1) The last day of month is taken if in the relevant month, there is no corresponding day.

Example:
A was holder of cheque payable to bearer. He kept cheque in his table drawer. B, stole cheque from A’s table. There is no negotiation of cheque as it has not been delivered voluntary.

Endorsement – Sections 15-16

What is Endorsement?
Endorsement means signing:

  • on the face or back of negotiable instrument; or
  • on a slip of paper annexed to the negotiable instrument, by the holder of negotiable instrument.

Parties to Endorsement:

  • The endorsement shall be valid only if the negotiable instrument is signed by the holder.
  • The person to whom the instrument is endorsed is called the endorsee.

Purpose of Endorsement:

  • Endorsement is made for the purpose of negotiating such negotiable instrument.
  • It transfers the right, title and interest therein to some other person.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Essentials of Valid Endorsement:

  • It must be in writing.
  • It must be signed by holder.

Types of Endorsement:
Blank endorsement or General endorsement

  • Endorser puts signature without specifying name of endorsee.
  • General endorsement convert order instrument into bearer instrument.

Example:
Where bill is payable to ‘mohan or order’, and he writes on its back ‘mohan’, it is an endorsement in black by mohan and property in the bill can pass by mere delivery.

Full endorsement or Special endorsement:

  • Along with signature, endorser write name of endorsee.
  • A blank endorsement can be turned into special one by addition or an order making the bill payable to the transferee.

Example:
A bill made payable to mohan or order, and endorsed ‘pay to the order of sohan’ would be specially endorsed and sohan endorse it further.

Restrictive endorsement:
It restricts the right of further negotiation.

Examples:
‘Pay A only’.
‘Pay A on account of B’

Partial endorsement:
It is endorsement which transfer part of the amount of the instrument.
Partial endorsement is not valid.

Example:
A holds a bill for ₹ 10,000 and endorses it as “pay B or order ₹ 500”. The endorsement is partial and invalid.

Conditional endorsement or qualified endorsement:

  • It includes order to pay with condition.
  • Endorser makes his liability dependent upon happening of some event.

Example:
Holder of bill endorse it: ‘Pay A or order on his marrying B’. In such case, the endorser will not be liable until A marry toB.”

Facultative endorsement:
It is endorsement where endorser waives his right to receive notice of dishonour.

Sans Frais endorsement:
It is endorsement which indicates that no expenses should be incurred on the bill.

Effect of Endorsement – Section 50:
An unconditional endorsement completed by delivery of instrument has following effects:

  • Ownership of instrument is transferred from endorser to endorsee
  • Endorsee gets rights of further negotiation
  • Endorsee gets rights to bring an action for recovery against all parties whose names appear on the instrument.

Negotiation Back – Section 90

Meaning:
Endorser after he has negotiated instrument, again become holder before its maturity, instrument is said to be negotiated back.

Effects:

  • The holder cannot enforce payment against an intermediate party to whom he was previously liable.
  • Holder can sue all prior parties, if he had made san recourse endorsement.

Example:
A, holder of bill endorsed it to B. B endorsed it to C. C to D. D endorsed it again to A. In this case, endorsement by D to A is negotiation back. And B, C, D are not liable to A.

Assignment

Meaning:
It means transfer of one’s right to recover the payment of debt.

Provisions:
Promissory note, bills of exchange and cheques represent debts.

  • They are assignable (transferable) without an endorsement.
  • Assignment takes place by means of written document signed by the person who transfers his right, under the negotiable instrument, to the other.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Distinguish Between Negotiation and Assignment

Matter Negotiation Assignment
Meaning It means transfer of a negotiable instrument to any other person so as to constitute that person the holder of such negotiable instrument. It is transfer of a right to receive the payment of a debt by one person (viz., assignor) to another person (viz., assignee) by way of a written document.
Applicability of Act Negotiable Instrument Act, 1881 applies. Where any right is transferred by way of assignment, the Transfer of Property Act applies.
For what? Negotiation can be made for transferring negotiable instruments only. Assignment can be made of any right.
Method A bearer instrument can be negotiated merely by delivery, and an order instrument can be negotiated by endorsement and delivery. Assignment is valid only if it is made in writing and is signed by the assignor.
Notice Notice of negotiation is not required to be given to any party. Notice of assignment must be given by the assignee to the debtor.
C6nsideration Every negotiable instrument is negotiated for consideration. Assignment can be made without consideration.
Stamp duty It does not require payment of stamp duty. It requires payment of stamp duty.

Liability Of Parties

Liability of Maker and Acceptor – Section 32:

  • The liability of both, the maker of promissory note and the acceptor of bill of exchange is the same.
  • They are primarily liable to pay amount due on the instrument. It means that they are bound to pay the amount on instrument.

Liability of Drawer – Section 30:
On dishonour of bill of exchange by drawee (for non-acceptance or non-payment) or on dishonour of cheque, the drawer becomes liable to compensate holder.

Liability of Drawee – Section 31:

  • The drawer of cheque is always a banker.
  • It is duty of bank to pay the cheque when it has sufficient fund of drawer.
  • When banker refuses to make payment without any sufficient reason, then it must compensate drawer for any loss occurred. Bank is not liable to holder.

In the following situations, banker is justified to dishonour cheque:

  • If cheque is undated
  • If it is stale (Le. presented beyond period of 3 months)
  • If it is inchoate
  • If it is post-dated and presented before date
  • If it is mutilated or torn
  • If banker has received notice of customer’s death, customer’s insolvency or lunacy
  • If bank has received garnishee order (ie. order of court to attach property)
  • If it contains material alteration or irregular signature or irregular endorsement
  • Balance in account is insufficient

Liability on In-strument Made, Drawn without Consideration – Sections 43-44:

As between immediate parties:
If negotiable instrument is drawn without consideration or consideration fails, it creates no obligation of payment.

As between remote parties:

  • Sometime, a person receives a negotiable instrument without any consideration but transfers instrument for holder for some consideration.
  • In such case, holder and every subsequent holder may recover amount due from the transferor for consideration and from any prior party.

Effect of Partial Absence of Failure of Consideration:
Parties standing in immediate relation to each other cannot recover more than actual consideration but this rule is not apply to holder in due course.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Rights and Obligation of Parties to an Instrument Obtained Illegally

Finder of Lost Instrument:

  • When a negotiable instrument is lost, the finder or endorsee from the finder is not entitled to receive amount of it from maker, acceptor, holder or from any party prior to such holder.
  • However, if instrument is lost by one and if it passes by delivery, the third party acquiring it bona fide and for valuable consideration and before maturity is entitled both to retain the instrument against real owner and to compel payment from the prior parties thereon.

Instrument Obtained by Unlawful Means or Unlawful Consideration:
If instrument is obtained from maker, acceptor or holder by way of fraud (unlawful means) or for unlawful consideration, possessor is not entitled to receive amount.

Forged Endorsement:
Person claiming amount under forged endorsement cannot acquire rights of holder in due course even if he is purchaser for value and in good faith.

Crossing of Cheque – Sections 123-131A

What is Crossing of cheque?

  • A cheque is either ‘open’ or ‘crossed’.
  • An open cheque can be presented to the paying banker and it is paid over the counter.
  • A crossed cheque cannot be paid across the counter.
  • Crossing means a direction given by the drawer of the cheque to the drawee bank, not to pay the cheque at the counter of the bank, but to pay it to a person who presents it through a banker.
  • Crossing makes the cheque safe and protect holder.

General Crossing – Section 123:

  • The cheque must contain two parallel transverse lines.
  • The cheque must be paid only to a banker.
  • In the case of general crossing, holder cannot get payment over the counter of bank.

Example:
The Negotiable Instruments Act, 1881 – CA Inter Law Notes 1

Special Crossing Section 124:

  • The cheque must contain the name of a banker.
  • Cheque must be paid only to the banker to whom it is crossed.
  • Special crossing may be made only once.
  • Special crossing cannot be converted into general crossing.
  • The paying banker will pay only to the banker whose name appears across the cheque.

Example:
The Negotiable Instruments Act, 1881 – CA Inter Law Notes 2

Not Negotiable Crossing – Section 130:

  • The cheque must contain the words ‘not negotiable’. Example:
  • The cheque must be crossed generally or specially.
  • The title of the transferee shall not be better than the title of the transferor.
  • Not negotiable crossing does not restrict transferability but restrict negotiability only.

Example:
The Negotiable Instruments Act, 1881 – CA Inter Law Notes 3

Accounting Payee Crossing:

  • The cheque must contain the words ‘A/c Payee’ or ‘A/c payee only’.
  • It is also known as restrictive crossing.
  • The cheque does not remain negotiable anymore.
  • The cheque must be crossed generally or specially.
  • It warns collective banker that the proceeds are to be credited only to the account of the payee.

Example:
The Negotiable Instruments Act, 1881 – CA Inter Law Notes 4

Marked Cheque:

  • Sometime, a cheque is certified or marked by the banker on whom it is drawn as ‘good for payment’.
  • Such certification or marking is not acceptance but it is similar to it.
  • Bankers in India do not mark or certify cheque in this manner. It was held in case of Bank of Baroda vs. Punjab National Bank that bankers in India are not liable even if the cheque is marked ‘good for payment’.

Material Alteration Of Cheque – Sections 87-89

What is Material Alteration?
An alteration is called as material alteration if it alters:

  • the character or operation (ie., the legal effect) of negotiable instrument; or
  • the rights and liabilities of any of the parties to a negotiable instrument.
    • A material alteration renders the instrument void.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Examples of Material Alteration:

  • Alteration of the date of instrument.
  • Alteration of the amount payable.
  • Alteration in the time of payment.
  • Alteration in the place of payment.
  • Alteration in rate of interest.
  • Addition of new party to an instrument.
  • Conversion of blank endorsement into special endorsement.
  • Alteration of clause of instrument containing penal action.

Not Considered as Material Alteration:
However following are not considered as material alteration as it is authorized under act:

  • Filling blanks of an inchoate instrument – Section 20
  • Conversion of a blank endorsement into an endorsement in full – Section 49
  • Crossing of cheques – Section 125
  • Conversion of general crossing into special crossing or not negotiable crossing or A/c Payee Crossing (but not vice-versa).
  • Additional of the words ‘on demand’ to a note in which no time or payment is expressed.
  • Conversion of a bearer instrument into an order instrument by deleting the word ‘Bearer’.
  • Correction of mistake in instrument.
  • An alteration made before the instrument is issued and made with consent of parties.

Effect of Material Alteration – Sections 87-88:

  • The effect of a material alteration of a negotiable instrument is only to discharge those who become parties thereto prior to the alteration; but if an alteration is made in order to carry out the common intention of the original parties, it does not render the instrument void.
  • Any material alteration, if made by an indorsee, discharges his indorser from all liability to him in respect of the consideration thereof.
  • In Hongkong and Shanghai Bank vs. Lee Shi (1928), it has been held that an accidental alteration will not render the instrument void. It is necessary to show that the alteration has been made improperly and intentionally. The effect of making the material alteration without the consent of the party bound is exactly the same as that of cancelling the deed.
  • In short, we can conclude that all the parties to the negotiable instrument not consenting to the material alteration are discharged.

Presentment Of Instrument – Section 76

Meaning:
Presentment means showing the instrument to the drawee or acceptor to make payment as per condition.

When Presentment?

  • Presentment is made during business hours.
  • Fixed period bill or after sight bill is presented on its maturity.

When Presentment is not Necessary?
In the following conditions presentment of instrument is not necessary:

  • It maker or acceptor intentionally prevents it.
  • If it is payable at place of business and it is closed during usual business hours.
  • If it is payable at some other place (other than place of business) and no one attends at such place during usual business hours
  • If maker or drawer is not found after reasonable search
  • If he is ready to pay without presentment
  • On maturity of instrument, without presentment:
    • He makes a part payment
    • He promises to make payment
    • He waives right to take advantage of any default in presentment of instrument
  • If drawer could not suffer damage as against drawer only
  • If the drawer and acceptor are same person

Acceptance Of Bill – Sections 7 & 86

Meaning of Acceptance:
The drawee signs the bill and delivers it to the holder of the bill or gives notice of acceptance to the holder of the bill.

Essentials of Valid Acceptance:

  • It should be in writing and signed by drawee.
  • Writing may be either on the face or back of the bill.
  • Writing the word ‘Acceptance’ is not necessary.
  • After the signature, delivery or intimation to the holder is given that the bill has been accepted.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Effect:
On acceptance of bill drawee becomes the acceptor.

Types of Acceptance:
An acceptance may be either general or qualified.

General Acceptance:

  • A general acceptance is absolute.
  • It is an acceptance of bill without any qualification.

Qualified Acceptance:
Qualified acceptance of bill means acceptance of bill subject with some qualification (e.g., accepting the bill subject to the condition that the payment of bill shall be made only on happening of an event specified therein).

Effect of Qualified Acceptance – Section 86:

  • The holder may object to the qualified acceptance. In such a case, it shall be treated that the bill is dishonoured due to non-acceptance.
  • He may give his consent to the qualified acceptance. In such a case, all the prior parties, not consenting to it, are discharged.
  • Example: accepted payable on giving up bill of landing.

Acceptance For Honour – Sections 108-112

Who is Acceptor for Honour?

  • If bill is dishonoured for non-acceptance, any person can accept for honour.
  • The person who accepts the bill for the honour of any other person is called as an ‘acceptor for honour’.

Liability of Acceptor for Honour

  • He is liable to pay the amount of the bill, if the drawee does not pay on maturity.
  • He is liable only to the parties subsequent to the party for whose honour the bill is accepted.

Rights of Acceptor for Honour:
He is entitled to recover the amount paid by him from the party for whose honour the bill was accepted, and from all the parties prior to such party.

Conditions for Acceptance for Honour:

  • The bill must have been noted or protested for non-acceptance.
  • The acceptance is given:
    • for the honour of any party already liable under the bill
    • by any person who is already not liable under the bill
    • with the consent of the holder of the bill
  • The acceptance must be made in writing on the bill.
  • The bill must have not been overdue.

Payment Of Honour – Sections 113-114

Who is Payer for Honour?
A person who pays a bill for honour of any other person is called as ‘payer for honour’.

Conditions for Payment for Honour:

  • The bill must have been noted or protested for non-payment.
  • Payment for honour is made:
    • for the honour of any party already liable under the bill
    • by any person (whether or not he is already liable under the bill)
    • with the consent of the holder of the bill
  • The payment must be recorded by Notary Public.

Rights of Payer for Honour:

  • The payer for honour is entitled to all the rights of a holder.
  • He can recover all the sums paid by him from the party for whose honour he pays and all the parties prior to such party.

Drawee in Case of Need:

  • The drawee in case of need accept and pay bill without previous protest.
  • If drawee in case of need is named in bill or in any endorsement thereon, the bill is not dishonoured until it has been dishonoured by such drawee.
  • Failure to present bill to drawee in case of need relieve drawer from liability.

Dishonour of Negotiable Instrument

Negotiable instrument may be dishonoured in either of following ways:

  • Due to non-acceptance
  • Due to non-payment

Dishonour for non-acceptance of bill – Section 91:
When it Take Place?
A bill is dishonoured by non-acceptance if it is duly presented for acceptance, but the bill is not accepted.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Cases of Dishonour:
Only bills of exchange can be dishonoured due to its non-acceptance.
Bills of exchange is treated as dishonoured due to its non-acceptance in any of following circumstances:

  • When drawee does not accept bill within 48 hours of presentment or refuse to accept it
  • In case of more than one drawee, who are not partners, makes default in acceptance
  • Where drawee is incompetent to contract
  • Where drawee gives conditional acceptance
  • Where the drawee cannot be found with reasonable search
  • Where the drawee is fictitious person
  • Where the drawee gives a qualified acceptance, and the holder does not give his consent to the qualified acceptance.

Effect:
The holder gets an immediate right to sue all the prior parties, without waiting for the maturity of the bill.

Dishonour for Non-Payment – Section 92:
A negotiable instrument shall be dishonoured by non-payment if default in payment is made by following parties:

Promissory Note:
Maker

Bills of Exchange:
Acceptor
Drawee, where bill does not require acceptance

Cheque:
Drawee

Notice of Dishonour – Sections 93 to 98:

Who may Give Notice:
Holder or any party liable on the negotiable instrument may give notice of dishonour.

Whom Notice is Given?:
It must be given to all the parties to whom the holder seeks to make liable.

Content & Requirements:
Notice must disclose the fact of dishonour of negotiable instrument.

  • Notice may be given orally or in writing.
  • It must be given within reasonable time of dishonour.

Effect:
A party (other than the party primarily liable on the negotiable instrument) to whom notice of dishonour is not given is discharged from liability on the negotiable instrument.

When Notice of Dishonour not Required?
In the following situation, notice of dishonour is not necessary:

  • When notice of dishonour is dispensed with by a party
  • Where the drawer of the cheque has countermanded payment, notice to drawer is not required to be given
  • When the party entitled to notice cannot be found even after due search.
  • Where the party bound to give notice is unable to give notice without any fault of his own
  • When the party charged could not suffer damage for want to notice
  • When the omission to give notice is caused by unavoidable circumstances ie. death
  • Where the acceptor is also drawee e.g. where firm draws on its branch.

Dishonour of Cheque for Insufficient Funds – Section 138

Punishment:
When cheque is dishonoured due to insufficient funds in drawer’s bank account, he is punishable with:

  • Imprisonment for a term upto 2 years; or
  • Fine which may extend to twice the amount of cheque; or
  • Both

Provisions:
Following conditions shall be satisfied to apply section 138:

  • Cheque is presented to bank with in its validity
  • Payee or holder in due course had made demand in writing for payment of amount of cheque to drawer within 30 days from receipt of information from bank
  • Drawer of cheque failed to pay money to payee or holder in due course within 15 days from written demand for
    payment
  • Payee or holder in due course has made complaint in writing within one month of case of action arising under section 138

Modi cements Ltd. vs. Kuchil Kumar Nandi:
In this case the Supreme Court interpreted meaning of word ‘dishonour of cheque’. According to Court, it includes dishonour of cheque due to stop payment instruction given by drawer to bank and also where the drawer asks the holder not to present cheque.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Noting and Protest- Sections 99 To 104

Noting:

Meaning:

  • Recording of fact of dishonour of negotiable instrument upon the instrument or on a paper attached to it, is known as noting.
  • Noting is a minute recorded by notary public on the dishonoured instrument.

Provisions:

  • It is optional.
  • Dishonoured instrument is handed over to notary public who will present it again for acceptance or payment.
  • If drawee or acceptor refuses to accept or pay, notary public records the fact of dishonour.
  • It must be made within reasonable time after dishonour.
  • It must specify date of dishonour, reason for dishonour and notary’s charge.

Protest:

  • On presenting dishonoured instrument to notary public certificate of dishonour is issued. Such certificate is called a protest.
  • Protest is optional.

Merit:
Noting and protest serve as good evidence in the Court that instrument has been dishonoured.

Important Note:

  • Noting or protesting is not compulsory in case of inland bills.
  • Foreign bill must be protested for dishonour, when such protest is required by law of the country where the bill was drawn. – Section 104

Discharge of Negotiable Instrument and Discharge of Parties From Liability

Discharge in relation to negotiable instrument has two meanings:

  • Discharge of negotiable instrument
  • Discharge of one or more parties from their liability on negotiable instrument

Discharge of Instrument:

Meaning:
Instrument is said to be discharged when all the rights of persons involved in it are over.

Methods of Dis-charged:
Negotiable instrument may be discharged in any of the following ways:

By payment in due course:
A payment by party who is primarily liable to pay or by any person who has accepted it for accommodated bill.

Primarily liable party becomes holder:
If party primarily liable on instrument become holder (Negotiation back) of it on or before its maturity in his own right, instrument is discharged.

By cancellation:
When holder of instrument intentionally cancel it, instrument is discharged.

By discharge as simple contract:
A negotiable instrument may also be discharged in the same way as simple contract for payment of money (ie., by novation, alteration, cancellation etc.)

Insolvency:
A negotiable instrument is discharged on insolvency of party who is primarily liable on it.

Discharge of Parties to Instrument:

Meaning:

  • Party to instrument is discharged when his liability on instrument comes to end.
  • It means, when some parties are discharged, other parties are liable and instrument cannot be said to be discharged.

Cases Where Parties are Discharged:

By cancellation:
When the holder of a negotiable instrument deliberately conceals the name of any of the party liable on the instrument to discharge him from liability the party and all subsequently endorsers are discharged from liability.
A cancellation in order to be operative must be:

  • Intentional; and
  • Apparent.

By payment:
When a party liable on the instrument makes the payment in due course at the maturity, all the parties to the instrument stand discharged.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

By allowing more time:
If the holder of a bill of exchange allows the drawee more than 48 hours to accept the bill, all prior parties not consenting to such allowance are thereby discharged from liability of such holder.

Qualified acceptance:
If the holder of a bill consents to qualified acceptance, all prior parties who did not consent are discharged.

Material alteration:
Any material alteration to negotiable instrument renders same void against anyone who is party thereto at the time of alteration and who has not consented.

Negotiation back:
Where party already liable on negotiable instrument becomes a holder of it, such party and all intermediates parties to whom such party was previously liable shall be discharged.

By operation of law:
A party is discharged if he is declared to be an insolvent by competent Court.

Be default of holder:
When an instrument is not presented for holder payment by the holder within reasonable time, all other parties are discharged.
Where on presentation, the instrument is discharged and the holder fails to give notice of dishonour to any party to the instrument other than the party primarily liable, then such party shall be discharged from liability as against the holder.

Practice Questions

Question 1.
Distinguish between ‘Electronic Cheque’ and ‘Truncated Cheque’.
Answer:

Electronic Cheque Truncated Cheque
Paper is not used at any stage in creation of an electronic cheque. A truncated cheque is nothing, but a paper cheque, which is truncated during the clearing cycle.
Digital signatures must be used to create an electronic image of a cheque. Thus, an electronic cheque contains digital signature. The paper cheque, which is after­wards truncated, contains no digital signature. The signatures in ink appear on the truncated cheque.

The original writing of a truncated cheque is on paper, duly signed in ink.

The electronic cheque is in elec­tronic form. Truncated cheque is in paper form.

Electronic Cheque Truncated Cheque
Paper is not used at any stage in creation of an electronic cheque. A truncated cheque is nothing, but a paper cheque, which is truncated during the clearing cycle.
Digital signatures must be used to create an electronic image of a cheque. Thus, an electronic cheque contains digital signature. The paper cheque, which is afterwards truncated, contains no digital signature. The signatures in ink appear on the truncated cheque.
The original writing of a truncated cheque is on paper, duly signed in ink.
The electronic cheque is in electronic form. Truncated cheque is in paper form.

Question 2.
State giving reasons whether the following statements are correct or incorrect: A bill of exchange may not be in writing.
Answer:
Statement is incorrect. Bill of exchange should be in writing.

Past Examination Questions

Question 1.
Explain the meaning of Holder and Holder in due course of a negotiable instrument. The drawer ‘D’ is introduced by A to draw a cheque in favour of P who is an existing person. A instead of sending the cheque to P forgoes his name and pays the cheque into his own bank. Whether D can recover the amount of the cheque from A’s banker. Decide. (CA November 2002)
Answer:
cannot recover amount from A’s banker. Collecting banker is not liable for any loss suffered to real owner due to defective title of holder provided it has acted in good faith and without negligence while collecting amount of crossed cheque as an agent. – Section 131

Question 2.
Referring to the provisions of the Negotiable Instruments Act, 1881 examine the validity of the following Promissory Notes:
I. I owe you a sum of ₹ 1000 A tells B.
II. X promises to pay Y a sum of ₹ 10000 six months after Y’s marriage with Z. (CA November 2002)
Or
What is a promissory note and what are its elements? S writes ‘I promise to pay B a sum of ₹ 500 seven days after my marriage with C’. Is this a promissory note? (CA May 2004)
Answer:
I. It is not promissory note. There is no promise to pay.
II. It is not promissory note. Element of certainty is missing. It is not certain that Y will marry Z.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 3.
When a bill of exchange may be dishonoured by non-acceptance and non-payment under the provisions of Negotiable Instruments Act, 1881. (CA November 2002)
Answer:

Question 4.
Which are the essential elements of a valid acceptance of a bill of ex-change? An acceptor accepts a bill of exchange but writes on it ‘Accepted but payment will be made when goods delivered to me is sold’. Decide the validity. (CA May 2003)
Answer:
In the given case, acceptance of bill is qualified. Acceptance must be general acceptance. In case of qualified acceptance, holder has liberty to refuse. If he refuses to take it, bill is dishonoured by non-acceptance. On the other hand, if he accepts qualified acceptance, then it binds only him and acceptor. It does not bind other parties who have not consented.

Question 5.
What do you mean by an acceptance of a negotiable instrument? Examine validity of the following in the light of the provisions of the Negotiable Instruments Act, 1881:
I. An oral acceptance
II. An acceptance by mere signature without writing the word ‘accepted’. (CA May 2003)
Answer:
I. Acceptance must be written on bill and signed by drawee. Oral acceptance is not valid.
II. The mere signature of the drawee without addition of the words ‘acceptance’ is valid acceptance. As per section 7, acceptance must appear on the bill and must be signed by drawee.

Question 6.
A issues a cheque for ₹ 25000 in favour of B. A has sufficient amount in his account with the bank. The cheque was not presented within reasonable time to the bank for the payment and the bank in the meantime became bankrupt. Decide under the provisions of Negotiable Instruments Act, 1881 whether B can recover the money from A. (CA May 2003)
Or
‘A’ draws a cheque for ₹ 50000. When the cheque ought to be presented to the drawee bank the drawer has sufficient funds to make payment of the cheque. The bank fails before the cheque is presented. The payee demands payment from the drawer. What is the liability of a drawer? (CA May 2005)
Answer:
B cannot recover money from A. The drawer is discharged. He has sufficient balance in his account when the cheque ought to be presented for payment. Holder has defaulted in presenting the cheque for payment within reasonable time.

Question 7.
What do you understand by ‘crossing of cheques’? What is the object of crossing? State the implications of the following crossing?
I. Restrictive crossing
II. Not – negotiable crossing (CA November 2003)
Answer:

Question 8.
Refer paragraph no. 20
What are the difference between negotiability and assignability? (CA November 2003, May 2013)
Or
Answer:

Question 9.
Point out the difference between transfer by negotiation and transfer by assignment under the provisions of the Negotiable Instruments Act, 1881. (CA May 2006)
Or
State the cases in which banker is justified or bound to dishonour cheques. (CA May 2005)
Or
State the grounds on the basis of which a cheque may be dishonoured by a banker, in spite of the fact that there is sufficient amount in the account of the drawer. (CA November 2003)
Or
State the cases in which banker is justified or bound to dishonour cheques. (CA May 2005)
Or
PQR Ltd. receive a cheque for ₹ 50000 from its customer Mr. LML. After a week company came to know that the proceeds were not credited to the account of PQR Limited due to some ‘defects’ as informed by the Banker. What according to you are the possible defects? (CA May 2007)
Or
State in brief the grounds on the basis of which a banker can dishonour / a cheque under the provisions of the Negotiable Instruments Act, 1881. (CA November 2011)
Or
State the circumstances on the basis of which a banker can dishonour a cheque under the provisions of Negotiable Instruments Act, 1881. (CA November 2013)
Answer:

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 10.
Discuss in brief the main amendments incorporated by the Negotiable Instruments (Amendment and miscellaneous) Act, 2002 in sections 138,141 and 142 of the principal act i.e. Negotiable Act, 1881. (CA May 2004)
Or
Define the term cheque as given in the Negotiable Instruments Act, 1881 and amended by the Negotiable Instruments (Amended and Miscellaneous Provisions) Act, 2002. (CA November 2004)
Answer:
Definition of cheque under section 6 was amended. Refer paragraph no. 4 to refer definition of cheque. Other amendments are as follow:

  • Punishment is increased from one to two years. – Section 138
  • Period of notice issued by payee to drawee is increased from 15 days to 30 days.- Section 138
  • Nominee director is exempted from prosecution under section 138. – Section 141
  • Discretion is granted to court to waive period of one month which has been prescribed for taking cognizance of the case under the Act.- Section 142

Question 11.
Describe the circumstances where under notice of dishonour is excused under Negotiable Instruments Act, 1881. (CA May 2004)
Answer:

Question 12.
A induced B by fraud to draw a cheque payable to C or order. A obtained the cheque forged C’s endorsement and collected proceeds to the cheque through his Bankers. B the drawer wants to recover the amount from C’s Bankers. Decide in the light of the provisions of Negotiable Instrument Act, 1881.
I. Whether B the drawer can recover the amount of the cheque from C’s Bankers?
II. Whether C is the Fictitious Payee?
III. Would your answer be the same in case C is a fictitious person? (CA November 2004)
Answer:
I. B the drawer cannot recover amount of cheque from C’s Banker as it is neither collected not paid cheque.
II. No. He exits.
III. If C was a fictitious payee, the answer would have remained same.

Protection is available to collecting banker. It is not liable for any loss caused to the true owner due to the defective title of holder provided it has acted in good faith and without negligence while collecting the amount of the crossed cheque as an agent. – Section 131

Paying banker is not liable even if it is subsequently found that any endorsement on the cheque has been forged provided it has made payment in due course. – Section 85

Question 13.
A draws a bill on B. B accepts the bill without any consideration. The bill is transferred to C without consideration. C transferred it to D for value. Decide.
I. Whether D can sue the prior parties of the bill and
II. Whether the prior parties other than D have any right of action intense?
Give your answer in reference to the provision of Negotiable Instruments Act, 1881. (CA November 2004)
Answer:
I. D being holder for value can recover amount of bill from all prior parties.
II. No party prior to D can recover the amount of bill from prior party as bill creates no obligation of payment between parties. It was drawn, accepted and transferred without consideration.

Question 14.
A cheque payable to bearer is crossed generally and marked ‘not negotiable’. The cheque is lost or stolen and comes into possession of B who takes it in good faith and gives value for it. B deposits the cheque into his own bank and his banker presents it and obtains payment for his customer from the bank upon which it is drawn. The true owner of the cheque claims refund of the amount of the cheque from B. Discuss the liability of the banker collecting the cheque and the banker paying the cheque and B to the true owner of the cheque referring to the provisions of the Negotiable Instruments Act, 1881. (CA May 2005)
Answer:
Liability of collecting banker:
Collecting banker would not be liable in case title is proved to be defective as it had received payment for B (his customer), in good faith and without negligence for its customer. – Section 131

Liability of paying banker:
Paying banker would not be liable to the true owner because it had paid the same in due course. – Section 128

Liability of B:
Cheque was marked ‘not negotiable’ and hence, B did not acquire any title to cheque as against true owner even though he was holder in due course. The addition of the words ‘not negotiable’ entirely takes away the main feature of negotiability, which is, that a holder with a defective title can give a good title to a subsequent holder in due course. Therefore, B is liable to repay the amount of cheque to the true owner. In turn, he can proceed against the person from whom he received the cheque.

Question 15.
In what ways does the Negotiable Instruments Act, 1881 regulate the determination of the Date of Maturity of a bill of exchange. Ascertain the date of maturity of a bill payable 120 days after the date. The bill of exchange was drawn on 1st June 2009. (CA November 2005)
Answer:
to understand maturity of instrument. The day on which bill was drawn is excluded. Period of 120 days ends on 29th September 2009. Three days of grace are added. Bill falls due on 2nd October 2009. 2nd October 2009 is public holiday and hence it fall due on 1st October 2009. (Preceding business day)

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 16.
Examine when the holder of the negotiable instrument shall be considered as a holder in due course under the provisions of the Negotiable Instruments Act, 1881. (CA November 2005)
Answer:

Question 17.
When is an alteration in a negotiable instrument is deemed to be a ‘material alteration’ under the Negotiable Instruments Act, 1881? What are the consequences of material alteration in a negotiable instrument? (CA May 2006)
Answer:

Question 18.
J a shareholder of a company purchased for his personal use certain goods from a mall on credit. He sent a cheque drawn on the Company’s a/c for the mall towards the full payment of the bills. The cheque was dishonoured by the company’s bank. J the shareholder of the company was neither a director nor a person in charge of the company. Examining the provisions of the Negotiable Instruments Act, 1881 state whether J has committed an offence under section 138 of the act and decide whether he (J can be held liable for the payment. For the goods purchased from the mall.) (CA November 2006)
AnswerTheThe facts in question are similar with facts of case of H.N.D. Mulla Feroze vs. C. Y. Somya Julu. In this case, Court has held that J a shareholder is not drawer of cheque which was dishonoured and cheque was also not drawn from his account. It was drawn from company’s account. Therefore, he cannot be said to have committed offence under section 138. He is not liable for cheque but he is liable to pay for goods.

Question 19.
A owes a certain sum of money to B. A does not know the exact amount and hence he makes out a blank cheque in favour of B, signs and delivers it to B with a request to fill up the amount due payable by him. B fills up fraudulently the amount larger than the amount due, payable by A and endorses the cheque to C in full payment of dues of B. Cheque of A is dishonoured. Referring to the provisions of the Negotiable Instruments Act, 1881, discuss the rights of B and C. (CA May 2007)
Answer:
As per section 44, B who is a party in immediate relation with the drawer of the cheque is entitled to recover from A only the exact amount due from A and not amount mentioned in the cheque. However, right of C, who is holder for value, is not adversely affected and he can claim full amount mentioned in cheque from B.

Question 20.
State the circumstance under which the drawer of a cheque will be liable for an offence relating to dishonor of the cheque under the Negotiable Instruments Act, 1881.
Examine whether there is an offence under the Negotiable Instruments Act, 1881 if a drawer of a cheque after having issued the cheque informs the drawee not to present the cheque as well as informs the bank to stop the payment. (CA May 2007)
Or
X draws a cheque in favour of Y. After having issued the cheque he in-forms Y not to present the cheque for payment. He also informs the bank to stop payment. Decide under provisions of the Negotiable Instruments Act, 1881 whether the said acts of X constitute an offence against him? (CAMay 2008, 2017)
Answer:
In the case of Modi cements Ltd. vs. Kuchil Kumar Nandi, Court interpreted meaning of word ‘dishonour of cheque’. According to Court, it includes dishonour of cheque due to stop payment instruction given by drawer to bank and also where the drawer asks the holder not to present cheque. Applying above judgment, drawer has committed an offence under section 138.

Question 21.
Referring to the provisions of the Negotiable Instruments Act, 1881, examine the validity of the following: A cheque marked ‘not negotiable’ not transferable. (CA May 2007)
Or
State whether the following statements are correct or incorrect: A cheque marked ‘Not Negotiable’ is not transferable. (CA May 2011)
Answer:
It is not completely correct statement. As per section 130, cheque with not negotiable crossing is negotiable so long as its title has not become defective.

Question 22.
Referring to the provisions of Negotiable Instruments Act, 1881 examine the validity of a bill of exchange originally drawn by M for a sum of ₹ 10000 but accepted by R only for ? 7000. (CA May 2007)
Answer:
When bill is accepted for part of payment, it is qualified acceptance. A bill with a qualified acceptance does not have any validity.

Question 23.
Explain as to why shall the combination of ‘not negotiable’ with ‘account payee’ crossing be considered as the safest form of crossing a cheque. (CA November 2007)
Answer:

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 24.
What do you understand by material alteration under the Negotiable Instruments Act 1881? State whether the following alterations are material alterations under the Negotiable Instruments Act, 1881?
a. The holder of the bill inserts the word ‘or order’ in the bill
b. The holder of the bearer cheque converts it into account payee cheque
c. A bill payable to X is converted into a bill payable to X and Y. (CA November 2007)
Or
Define the material alteration under Negotiable Instruments Act, 1881 and give examples. (CA May 2013)
Answer:
a. Inserting word ‘or order’ will not affect negotiable instrument.
Instrument remains as order instrument. It is not material alteration.

b. It is material alteration. It restricts the right of the holder to obtain payment of the cheque in cash and to negotiate it. Such material alteration is authorised by act.

c. It is material alteration. Right to receive payment was altered.

Question 25.
What are the essential elements of a promissory note under the Negotiable Instruments Act, 1881? Whether the following notes may be considered as valid promissory notes:
I. I promise to pay ₹ 5000 or 7000 to Mr. Ram
II. I promise to pay to Mohan ₹ 500, if he secures 60% marks in the examination.
III. I promise to pay ₹ 3000 to Ravi after 15 days of the death of A. (CA November 2007)
Answer:
to understand essential elements of promissory note.
I. It is not valid promissory note. Amount is not certain.
II. It is valid promissory note because it is conditional.
III. It is valid promissory note because death of A is certain even if time of death is not certain.

Question 26.
What is meant by maturity of a bill of exchange or promissory note? Calculate the date of maturity of the following bills of exchange explaining the relevant rules relating to determination of the date of maturity x as provided in the Negotiable Instruments Act, 1881 :
I. A bill of exchange Dated 31st August 2013 is made payable three months after date.
II. A bill of exchange drawn on 15th October 2013, is payable twenty days after sight and the bill is presented for acceptance on 31st October 2013. (CA November 2007)
Answer:
to understand theory on maturity of promissory note and bill of exchange.
I. Bill of exchange will mature on 3rd December 2013
II. Bill of exchange will payable on 23rd November 2013

Question 27.
Bharat executed a promissory note in favour of Bhushan for ₹ 5 crores. The said amount was payable three days after sight. Bhushan on maturity presented the promissory note on 1st January 2008 to Bharat. Bharat made the payment on 4th January 2008. Bhushan wants to recover interest for one day from Bharat. Advise Bharat in the light of provisions of the Negotiable Instruments Act, 1881 whether he is liable to pay the interest for one day? (CA May 2008)
Answer:
Bharat is not liable to pay interest. As per section 24, in calculating date, a bill made payable a certain number of days after sight or after certain event, the maturity is calculated by excluding the day on which instrument is drawn or presented for acceptance or sight or day on which the event happens.

Question 28.
‘A’ draws a bill of exchange payable to himself on X who accepts the bill without consideration. Just to accommodate A. ‘A’ transfers the bill to P for good consideration. State the rights of A and P. Would your answer be different if A transferred the bill to P after maturity? (CA may 2008)
Answer:
A cannot sue X as there is no consideration between A and X. Hence, there is no obligation to pay. P can sue A and X as he is holder for consideration. Holder for consideration can sue the transferor for consideration and ever party prior to him. Even if A had transferred the bill after maturity answer would remain same.

Question 29.
What is meant by ‘Presentment’ of a bill exchange under the Negotiable Instruments Act, 1881? When is such a bill of exchange presented for payment? State when is the presentment not necessary. (CA May 2008)
Answer:

Question 30.
Describe in brief the advantages and protections available to a ‘holder in due course’ under the provisions of the Negotiable Instruments Act, 1881. (CA November 2008)
Answer:

Question 31.
Discuss with reasons whether the following persons can be called as a ‘holder’ under the Negotiable Instruments Act, 1881:
I. X who obtains a cheque drawn by Y by way of gift.
II. A, the payee of the cheque who is prohibited by the court order from receiving the amount of the cheque.
III. M, who finds a cheque payable to bearer on the road and retains it
IV. B the agent of C is entrusted with an instrument without endorsement by C who is the payee.
V. B who steals a blank cheque of A and forges A’s signature (CA November 2008)
Or
Discuss with reasons in the following given conditions whether M can be called as a holder under the Negotiable Instruments Act, 1881:
I. M the payee of the cheque who is prohibited by a court order from receiving the amount of the cheque.
II. M the agent of 0 is entrusted with an instrument without endorsement by 0 who is the payee (CA November 2016)
Answer:
Refer paragraph no. 8 to understand as to who is called ‘holder’.
I. X is holder because he has right to possession and to receive amount due in his own name.
II. A is not holder because holder is entitled to possession of instrument and also entitled to receive amount mentioned therein.
TTT M is not holder as he has possession of instrument but he is not entitled to possession of it in his name.
IV. B is not holder. Agent may receive payment of the amount mentioned in the cheque but he cannot be called holder because he has no right to sue on the instrument on his name.
V. B is not holder. He is having wrongful possession of instrument.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 32.
B issued a cheque for ₹ 1,25,000 in favour of S. B had sufficient amount in his account with the bank. The cheque was not presented within reasonable time to the Bank for payment and the Bank in the meantime became insolvent.
Decide under the provisions of the Negotiable Instruments Act, 1881 whether S can recover the money from B. (CA November 2008)
Or
‘A’ issued a cheque for ? 5000 to B. B did not present the cheque for payment within reasonable period. The bank fails. However when the cheque was ought to be presented to the bank, there was sufficient fund to make payment of the cheque. Now B demands payment from A. Decide the liability of A under the Negotiable Instruments Act, 1881. (CA May 2014)
Answer:
The drawer is discharged as he has sufficient balance in his account when the cheque ought to be presented for payment. Holder has made default by not presenting cheque within reasonable time. S cannot recover damage.

Question 33.
X draws a bill on Y but signs it in the fictitious name of Z. The bill is payable to the order of Z. The bill is duly accepted by Y. M obtains the bill from X thus becoming its holder in due course. Can Y avoid payment of the bill? Decide in the light of the provisions of the Negotiable Instruments Act, 1881. (CA November 2008)
Or
Q draw a bill on S but signs it in the fictitious name of R. The bill is payable to the order of R. The bill is duly accepted by S. P obtains the bill from Q thus becoming its holder in due course. Can S avoid payment of the bill? Decide in the light of the provisions of the Negotiable Instruments Act, 1881. (CA May 2017)
Answer:
Y is liable to M for payment of bill. Where bill is signed by drawer in fictitious name, the acceptor cannot allege against a holder in due course that the drawer is fictitious. It can be easily proved that the signatures of the person signing in the capacity of drawer and that of the person signing in capacity of the endorser are in same handwriting.

Question 34.
Mr. ‘Wise’ obtains fraudulently from ‘R’ a cheque crossed ‘Not Negotiable’. He later transfer the cheque to ‘V’ who gets the cheque encashed from ANS Bank Limited which is not the Drawee bank. R on coming to know about the fraudulent act of Mr. Wise sues ANS Bank for the recovery of money. Examine with reference to the relevant provisions of the Negotiable Instrument Act, 1881, whether R will be successful in his claim. Would your answer be still the same in case Mr. wise does not transfer the cheque and gets the cheque encashed from ANS Bank himself? (CA June 2009)
Answer:
Mr. Wise had obtained cheque fraudulently from R. He had no title of it and could not give it to bank any title to cheque or money. Bank would be liable for the amount of the cheque for encashment. – Held in case of Great Western Railway Co. vs. London and Country Banking Co.
Answer will remain same in the second case. R will be successful in his claim against bank.

Question 35.
A issues an open bearer cheque for ? 10000 in favour of B who strikes out the word bearer and put crossing across the cheque. The cheque is thereafter negotiated to C and D. When it is finally presented by D’s banker, it is returned with remarks “Payment countermanded” by drawer. In response to the legal notice from D., A pleads that the cheques was altered after it had been issued and therefore he is not bound to pay the cheques. Referring to the provisions of the Negotiable Instruments Act, 1881 decide, whether A’s argument is valid or not? (CA June 2009)
Answer:
Striking off word ‘bearer’ amount as material alteration but it is authorised under Act. Therefore, cheque is not discharged and remain valid. Cheque is dishonoured not for material alternation but for payment countermanded by drawer. In view of the above circumstances, A is liable for payment. He is also liable for dishonour of cheque as per section 138.

Question 36.
‘N’ is the holder of a bill of exchange made payable to the order of ‘P’ the bill of exchange contains the following Endorsements in blank :
First endorsement ‘P’
Second endorsement ‘0’
Third endorsement ‘R’
Fourth endorsement ‘S’
‘N’ strikes out without S’s consent the endorsement by ‘Q’ and ‘R’
Describe with reasons whether ‘N’ is entitled to recover anything from ‘S’ (CA November 2009)
Answer:
N is not entitled to recover anything from S. When holder cancels the name of any party liable on the negotiable instrument, then such party as well as all parties subsequent to him are discharged. – Section 82 When N strikes the name of Q and R, so S will be discharged.

Question 37.
P draws a bill on Q for ₹ 10000. Q accepts the bill. On maturity the bill was dishonoured by non-payment. P files a suit against Q for payment of ₹ 10000. Q proved that the bill was accepted for value of ? 7000 and as an accommodation to the plaintiff for the balance amount i.e. ₹ 3000. Referring to the provisions of the Negotiable Instruments Act, 1881 decide whether P would succeed in recovering the whole amount of the bill? (CA November 2010)
Answer:
As per section 44 of Negotiable Instruments Act, 1881, when consideration for which a person signed negotiable instrument consisted money, and was originally absent in part or has subsequently failed in part, the sum which a holder standing in immediate relation with such signer is entitled to receive from him is proportionally reduced.

The drawer of bill of exchange stands in immediate relation with the acceptor. On the basis of above provision, P would succeed to recover ₹ 7000 only from Q and not the entire amount (Le. ₹ 10000) of the bill because it was accepted for value as to ₹ 7000 only and on accommodation to P for ₹ 3000.

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 38.
Point out the difference between a Cheque and a Bill of exchange under the Negotiable Instruments Act, 1881. (CA May 2011)
Answer:

Question 39.
Examining the provisions of the Negotiable instruments Act, 1881 distinguish between a ‘Bill of exchange’ and a ‘Promissory note’. (CAMay 2012)
Answer:

Question 40.
A draws and B accepts bill payable to C or order C endorses the bill to D and D to E who is a holder-in-due course. From whom E can recover the amount? Examining the right of Estate the privileges of the holder in due course provided under the Negotiable Instruments Act, 1881. (CA November 2012)
Answer:
Every prior party to negotiable instrument (re. maker, drawer and all intermediate endorsers) continue to remain liable to the holder in due course until the instrument is duly discharge. – Section 36. Applying pro-visions of section 36, E can recover the amount from D, C, B as well as A.

Question 41.
Ram has ₹ 2000 in his bank account and he has no authority to overdraw. He issued a cheque for ₹ 5000 to Gopal which was dishonoured by the bank. Point out whether Gopal must necessarily give notice of dishonor to Ram under the Negotiable Instruments Act, 1881? (CA May 2014)
Answer:
Notice is not necessary for the reason that party charged could not suffer damage for want of notice.

Question 42.
Explain the terms ‘Acceptance for honour’ and ‘Drawee in case of need’ as used in the Negotiable Instruments Act, 1881. (CA November 2014)
Answer:

Question 43.
S by inducing T obtains a bill of exchange from him fraudulently in his (S) favour. Later he enters into a commercial deal and endorses the bill to U towards consideration to him (U) for the deal. U takes the bill as a holder in due course. U subsequently endorses the bill to S for value as consideration to S for some other deal. On maturity the bill is dishonoured. S sues T for the recovery of the money. With reference to the provisions of the Negotiable Instruments Act, 1881, decide whether X will succeed in the case? (CA November 2014)
Or
F by inducing G obtains a bill of exchange from him fraudulently in his (F) favour. Later he enters in to a commercial deal with H and endorses the bill to him (H) towards consideration for the deal. H takes the bill as holder-in-due course. H subsequently endorses the bill to F for value as consideration to F for some other deal. On maturity the bill is dishonoured. F sues G for the recovery of the money. With reference to the provisions of the Negotiable Instruments Act, 1881 explain whether F will succeed in this case. (CA November 2016)
Answer:
Once a negotiable instrument passes through the hands of holder in due course, if gets cleansed of its defect provided the holder was himself not a party to the fraud or illegality which affected the instrument in some / stage of its journey. Thus, any defect in the title of transferor will not affect the right of holders in due course even if he had knowledge of prior defect provided he is himself not party to fraud. – Section 53

Applying above provision, it can be suggested that S who originally in-duced T in obtaining the bill of exchange fraudulently cannot succeed in the case. S himself was party to the fraud.

Question 44.
A, a major and B a minor executed a Promissory Note in favour of C. Examine with reference to the provision of the Negotiable Instruments Act, 1881, the validity of the promissory note and whether is binding on P and 0- (CA May 2015)
Answer:
Promissory note executed by A and B is valid even though a minor is a party to it. B, being a minor is not liable but A, major joint holder is liable.

Question 45.
What is meant by ‘Sans Recours Endorsement’ of a bill of exchange? How does it differ from ‘Sans Frais Endorsement’? (CA May 2015)
Answer:

The Negotiable Instruments Act, 1881 – CA Inter Law Notes

Question 46.
Explain the concept and different forms of Restrictive and Qualified endorsement. (CA November 2015)
Answer:

Question 47.
State whether the following statement is correct or incorrect:
I. A Promissory note drawn jointly by X a minor and Y a major is valid but can be enforced only against Y.
II. A promissory note duly executed in favour of a minor is valid. (CA November 2015)
Answer:
Statement (I) & (II) are correct.

Question 48.
Mr. A is the payee of an order cheque. Mr. B steals the cheque and forges Mr. A signatures and endorses the cheque in his own favour. Mr. B then further endorses the cheque to Mr. C who takes the cheque in good faith and for valuable consideration. Examine the validity of the cheque as per the provisions of the Negotiable Instruments Act, 1881 and also state whether Mr. C can claim the privileges of a holder-in-due course. (CA November 2015)
Answer:
Endorsement is not valid due to forgery. Mr. C cannot claim privileges of holder in due course.

Question 49.
State giving reasons whether the following statements are correct or incorrect: In a promissory note the promise to pay must be conditional. (CA May 2016)
Answer:
Statement is incorrect. Refer section 4 from paragraph no. 2, Promissory note should be in writing and contain unconditional undertaking to pay certain sum of money.

Question 50.
Mr. Bean is a promoter who has taken a loan on behalf of company but he is neither a director nor a person-in-charge of the company. He sent a cheque from the company’s account to discharge its legal liability. Subsequently the cheque was dishonored and a complaint was lodged against him. Can he be held liable for an offence under section 138 of the Negotiable Instruments Act, 1881? (CA May 2016)
Answer:
If cheque is dishonoured for insufficient fund by bank, drawer is liable to be punished under section 138 of Negotiable Instruments Act, 1881. Action under section 138 can be invoked against person who has issued cheque (Le. account holder) or against person authorised to issue cheque on behalf of account holder.
In the given case, Mr. Bean cannot be held liable for offence under section 138 for dishonour of cheque. Cheque was not drawn on account maintained by him. Cheque was drawn from account maintained by the company. Mr. Bean is neither director of company nor person in charge of company. He has issued cheque from company’s account.

Investment Decisions – CA Inter FM Question Bank

Investment Decisions – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Investment Decisions – CA Inter FM Question Bank

Question 1.
Beta Company Limited is considering replacement of its existing machine by a new machine, which ¡s expected to cost ₹ 2,64,000. The new machine will have a life of five years and will yield annual cash revenues of ₹ 5,68,750 and incùr annual cash expenses of ₹ 2,95,750. The estimated salvage value of the new machine is ₹ 18,200. The existing machine has a book value of ₹ 91,000 and can be sold for ₹ 45,500 today.

The existing machine has a remaining useful life of five years. The cash revenues will be ₹ 4,55,000 and associated cash expenses will be ₹ 3,18,500. The existing machine will have a salvage value of ₹ 4,550, at the end of five years. The Beta Company is in 35% tax bracket, and writes off depreciation at 25% on the written-down value method.

The Beta Company has a target debt-to-value ratio of 15%. The Company in the past has raised debt at 11 % and it can raise fresh debt at 10.5%. Beta Company plans to follow dividend discount model to estimate the cost of equity capital. The Company plans to pay a dividend of ₹ 2 per share in the next year. The current market price of Company’s equity share is ₹ 20 per equity share. The dividend per equity share of the Company is expected to grow at 8% p.a.
Required:
(i) Compute the incremental cash flows of the replacement decision.
(ii) Compute the weighted average cost of Capital of the Company.
(iii) Find out the net present value of the replacement decision.
(iv) Estimate the discounted payback period of the replacement decision.
(v) Should the Company replace the existing machine? Advise. (Nov 2003, 5+3+2+1+1 = 12 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 1

Flows of the replacement decision:
(ii) Computation of WACC of the Co.:
Ke = \(\frac{D_1}{P_0}+g\) = \(\frac{₹ 2}{₹ 20}\) + 8 % =18%
Kd = 10.5% (1 – 0.35) = 6.825%
WACC = Kd × \(\frac{D}{D+E}\) + Ke × \(\frac{E}{E+D}\)
= (6.825% × 15%) + (18% × 85%)
= 16.32% or 16.32375%

(iii) Computation of Net Present Value of the replacement decision:
NPV = \(\sum_{t=1}^5 \frac{\text { FCFFt }}{(1+0.1632375)^t}-01 \)
= (2,18,500) + 89,287 + 73,961 + 61,779 + 51,948 + 54,820 = ₹ 1,13,295/-

(iv) Discounted payback period of the replacement decision:
= 2 years + 10 months 22 days approx.

(v) Advise:
The company should replace the existing machine with new machine.

Question 2.
XYZ Ltd. is planning to introduce a new product with a project life of 8 years The project is to be setup in Special Economic Zone (SEZ) and qualifies for one one-time (at starting) tax-free subsidy from the State Government of ₹ 25,00,000 on Capital investment. The initial equipment cost will be ₹ 1.75 crores. Additional equipment cost ₹ 12,50,000 will be purchased at the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for ₹ 1,25,000. A Working Capital of ₹ 20,00,000 will be needed and it will be released at the end of eighth year. The project will be financed with a sufficient amount of Equity Capital. The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ₹ 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed Cash operating costs will amount ₹18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30% tax rate and considers 12 percent to be an appropriate after-tax cost of Capital for this project. The company follows straight line method of depreciation.

Required:
Calculate the net present value of the project and advise the management to take appropriate decision
Note:
The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
8.893 .797 .712 .636 .567 .507 .452 .404

(Nov 2007, 8 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 2
Advise: Since the project has a positive NPV, therefore, it should be accepted.

Investment Decisions - CA Inter FM Question Bank

Question 3.
A company wants to invest in a machinery that would cost ₹ 50,000 at the beginning of year 1. It is estimated that the net cash inflows from operations will be ₹ 18,000 per annum for 3 years if the company opts to service a part of the machine at the end of year 1 at ₹ 10,000 and the scrap value at the end of year 3 will be ₹ 12,500. However, if the company decides not to services the part, ¡t will have to be replaced at the end of year 2 at ₹ 15,400. But in this case, the machine will work for the 4th year also and get operational cash inflow of ₹ 18,000 for the 4th year. It will have to be scrapped at the end of year 4 at ₹ 9,000. Assuming cost of capital at 10% and ignoring taxes, will you recommend the purchase of this machine based on the net present value of Its cash flows?

If the supplier gives a discount of ₹ 5,000 for purchase, what would be your decision? (The present value factors at the end of years 0, 1, 2, 3, 4, 5, and 6 are respectively 1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6209 and 0.5644). (Nov 2008, 7 marks)
Answer:
Option 1: Purchase Machinery and Service Part at the end of Year 1
Net Present value of cash flow @ 10% per annum discount rate.
NPV= \( -50,000+\frac{18,000}{(1.1)}+\frac{18,000}{(1.1)^2}+\frac{18,000}{(1.1)^3}-\frac{10,000}{(1.1)}+\frac{12,500}{(1.1)^3}\)
= – 50,000 + 18,000 (0.9091 + 0.8264 + 0.7513) – (10,000 × 0.9091 + 12,500 × 0.751 3)
= 50,000 + (18,000 x 2.4868) – 9,091 + 9,391
= – 50,000+44,762 – 9,091 + 9,391
NPV=- 4,938
Since, Net Present Value is negative, therefore, this option is not to be considered.

If Supplier gives a discount of ₹ 5,000 then,
NPV=+ 5,000 – 4,938 = + 62
In this case, Net Present Value is positive but very small, therefore, this option may not be advisable.

Option II: Purchase Machinery and Replace Part at the end of Year 2.
NPV = \(-50,000+\frac{18,000}{(1.1)}+\frac{18,000}{(1.1)^2}+\frac{18,000}{(1.1)^3}-\frac{15,400}{(1.1)^2}+\frac{27,000}{(1.1)^4}\)
= – 50,000 + 18,000(0.9091 + 0.8264 + 0.7513) – (15,400 × 0.8264) + (27,000 × 0.6830)
= – 50,000 + 18,000 (2.4868) – (15,400 × 0.8264) + (27,000 × 0.6830)
= – 50,000 + 44,762 – 12,727 +18,441
= – 62,727 + 63,203
= + 476

Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ₹ 5,000 then
NPV = 5,000 + 476 = 5,476
Decision: Option II is worth investing as the net present value is positive and higher as compared to Option I.

Question 4.
PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years. Project cost will be ₹ 2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of ₹ 30,00,000 will be needed. The 100% capacity of the project is ₹ 2,00,000 units p.a. but the Production and Sales Volume is expected are as under:

Year Number of Units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units.

Other Information:
(i) Selling price per unit ₹ 200.
(ii) Variable cost is 40% of sales.
(iii) Fixed cost p.a. ₹ 30,00,000.
(iv) In addition to these advertisement expenditures will have to be incurred as under:

Year 1 2 3-5 6-8
Expenditure (₹) 50,00,000 25,00,000 10,00,000 5,00,000

(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purposes.
(vii) Cost of capital is 10%.
Investment Decisions - CA Inter FM Question Bank 3
Advise about the project acceptability. (Nov 2018, 10 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 4
Advice: Since the project has a positive NPV, therefore it should be accepted.

Question 5.
Door Ltd. is considering an investment of ₹ 4,00,000. This investment is expected to generate substantial cash inflows over the next five years. Unfortunately, the annual cash flows from this investment is uncertain, but the following probability distribution has been established.

Annual Cash Flow (₹) Probability
50,000 0.3
1,00,000 0.3
1,50,000 0.4

At the end of its 5 years life, the investment is expected to have a residual value of 40,000.
The cost of capital is 5%.
(i) Calculate NPV under the three different scenarios.
(ii) Calculate Expected Net Present Value
(iii) Advise Door Ltd. on whether the investment is to be undertaken.

Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784

(Nov 2019, 5 Marks)
Answer:
(i) NPV under the three different scenarios:
(a) When Probability is 0.3
NPV = Annual cash flow (PVAf, 5%,5) + Residual value (Pvif 5%,5) – Initial Investment
= (₹ 50,000 × 4.33) + (₹ 40,000 × 0.784) – 4,00,000
= ₹ 2,16,500 + ₹ 31,360 – ₹ 4,00,000
NPV = – ₹ 1,52,140

(b) When Probability is 0.3
NPV = (₹ 1,00,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 4,33,000 + ₹ 31,360 – ₹ 4,00,000
NPV = ₹ 64,360

(c) When Probability Is 0.4
NPV = (₹ 1,50,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 6,49,500 + ₹ 31,360 – ₹4,00000
NPV = ₹ 2,80,860

(ii) Expected Net Present Value:
Annual Expected cash flows
= (₹ 50,000 × 0.3) + (₹ 1,00,000 × 0.3) + (₹ 1,50,000 × 0.4)
= ₹ 1,05,000
NPV = (₹ 1,05,000 × 4.33) + (₹ 40,000 × 0.784) – ₹ 4,00,000
= ₹ 4,54,650 + ₹ 31,360 – ₹ 4,00,000
NPV = ₹ 86,010

(iii) Since the expected NPV from the investment is positive (₹ 86,010), Door Ltd. should undertake the project.

Question 6.
CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the Machine at the commencement ₹ 2,50,000
Economic Life of the Machine 8-year
Residual Value Nil
Annual Production Capacity of the Machine 1,00,000 units
Estimated Selling Price per unit. ₹ 6
Estimated Variable Cost per unit ₹ 3
Estimated Annual Fixed Cost ₹ 1,00,000
(Excluding depreciation)
Advertisement Expenses in year in addition of annual fixed cost ₹ 20,000
Maintenance Expenses in 5th year in addition of annual fixed cost ₹ 30,000
Cost of Capital 1 2%
Ignore Tax.
Analyse the above-mentioned proposal using the Net Present Value Method and advice.
P.V. factor @ 12% are as under:

Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

(Nov 2020, 5 marks)

Question 7.
Desirability factor. (Nov 2009, 1.5 marks)
Answer:
In certain cases, we have to compare a number of proposals each involving different amount of cash inflows. One of the methods of comparing such proposals is to work out, what is known as the ‘Desirability Factor’ or ‘Profitability Index’. In general terms, a project is acceptable if the Profitability Index is greater than 1. Mathematically, Desirability Factor = \(\frac{\text { Sum of Discounted Cash inflows }}{\text { Initial Cash Outlay or Total Discounted Cash outflows }} \)

Investment Decisions - CA Inter FM Question Bank

Question 8.
Distinguish Between:
Net Present-value and Internal Rate of Return. (May 2002, 2 marks)
OR
Net present value method and internal rate of return method. (Nov 2011, 4 marks)
OR
Net Present Value (NPV) and Internal Rate of Return (IRR) methods for evaluating projects. (2015 Nov, 4 marks)
Answer:
Difference between NPV and IRR

Basis of Difference NPV IRR
1. Nature of Projects accepted Under NPV, projects with positive NPV are accepted. Under IRR, projects whose IRR is more than the cost of project are accepted.
2. Measures NPV measures both quality and scale of investment. IRR measures only quality of investment.
3. Absolute Vs Relative Measure NPV provides an absolute measure in quantitative terms. IRR Provides a relative measure In percentage.
4. ReInvestment Rate Under NPV, cash flows are re-invested at the rate of cost of capital. Under IRR, cash flows are re-invested at the rate of IRR
5. Multiple/Negative Rate NPV cannot yield Multiple or Negative Rate IRR can yield negative or multiple rate under certain circumstances.

Question 9.
A Company proposes to install a machine involving a Capital Cost of ₹ 3,60,000. The life of the machine is 5 years and its salvage value at the end of the life is nil. The machine will produce the net operating income after depreciation of ₹ 68,000 per annum. The Company4s tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting Rate: 14 15 16 17 18
Cumulative factor: 3.43 3.35 3.27 3.20 3.13
You are required to calculate the internal rate of return of the proposal. (Nov 2002, 4 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 5
The IRR of the investment can be found as follows:
NPV =₹ 3,60,000 +₹ 1,09,400 (PVIFA5.r) = O
PVIFA5.r (Cumulative factor) = \(\frac{₹ 3,60,000}{₹ 1,09,400}\) = 3.29
Investment Decisions - CA Inter FM Question Bank 6
IRR = 15+ \(\left(\frac{6,490}{6,490+2,262}\right)\)
= 15 + 0.74 = 15.74%

Question 10.
What is the ‘Internal Rate of Return’? Explain. (Nov 2014, 4 marks)
Answer:
Internal Rate of Return:
It is that rate at which discounted cash inflows are equal to the discounted cash outflows.
It can be stated in the form of a ratio as follows:
\(\frac{\text { Cash inflows }}{\text { Cash Outflows }}\) = 1
This rate is to be found by trial and error method.
This rate is used in the evaluation of investment proposals. In this method, the discount rate is not known but the cash outflows and cash inflows are known. In evaluating investment proposals, internal rate of return is compared with a required rate of return, known as cut-off rate. If it is more than cut-off rate the project is treated as acceptable; otherwise project is rejected.

Question 11.
Define Internal Rate of Return (IRR) (Jan 2021, 4 marks)

Question 12.
Explain the concept of discounted payback period. (May 2009, 3 marks)
Answer:
Concept of Discounted Payback Period
Payback period is time taken to recover the original investment from project cash flows. It is also termed as break-even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of money and profitability.

Discounted payback period considers present value of cash flows, discounted at company’s cost of capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the initial outflow.

The shorter the period, better it is. It also ignores post-discounted payback period cash flows. it takes care of the time value of money.

Investment Decisions - CA Inter FM Question Bank

Question 13.
Explain the concept of Multiple Internal rate of Return (MIRR). (Nov 2008, 3 marks)
Answer:
Concept of MIRR
MIRR is that rate of compounding which makes the initial cash outflow ¡n zeroth year equal to the terminal value of cash inflows. In order to cope up various limitations of the conventional Internal Rate of Return, Modified Internal Rate of Return was developed. Under this method, all cash flows (except initial investment), are brought to the terminal value using an appropriate discount rate (generally the cost of capital). MIRR results in a single stream of cash inflow in the terminal year. It is obtained by assuming a single outflow in the zero the year and the terminal cash inflow. The discount rate which equates the PV of the terminal cash inflow to the zeroth year outflow is known as MIRR.

Some of the advantages of MIRR are

  1. This method makes use of concept of time value of money.
  2. All the Cash flows in the project are considered.

Some of the limitations of MIRR are

  1. The calculation process is tedious.
  2. The IRR approach creates a peculiar situation if we compare two projects with different inflow-outflow patterns.
  3. In case of mutually exclusive projects decisions based only on IRR may not be correct.

Question 14.
Define Modified Internal Rate of Return method. (May 2007, 2 marks)
Answer:
In order to cope up various limitations of the conventional internal Rate of Return, Modified Internal Rate of Return was developed.
Limitations of the conventional IRR are,

  • it eliminates multiple IRR rates.
  • it addresses to reinvestment rate issue and produces results, which are consistent with the Net Present Value (NPV) method.

Under this method, all cash flows (except initial investment), are brought to the terminal value using an appropriate discount rate (generally the cost of capital). MIRR results in a single stream of cash inflow in the terminal year. It is obtained by assuming a single outflow in the zeroth year and the terminal cash inflow. The discount rate which equates the PV of the terminal cash Inflow to the zeroth year outflow is known as MIRR.

Question 15.
The cash flows of projects C and D are reproduced below:
Investment Decisions - CA Inter FM Question Bank 7
(i) Why there is a conflict of rankings?
(ii) Why should you recommend Project C in spite of lower internal rate of return?
Investment Decisions - CA Inter FM Question Bank 8
(May 2003, 4+4 = 8 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 9
The conflict in ranking arises because of skewness in cash flows, In the case of Project C, Cash flows occurs more late in the life but in the case of Project D, cash flows are skewed towards the beginning.

At lower discount rate, Project C’s NPV will be higher than that of Project D’s. As the discount rate increases, Projects C’s NPV will fall at a faster rate, due to the compounding effect.

After break-even discount rate, Project D has higher NPV as well as higher IRF.
(ii) If the opportunity cost of funds is 10%, Project C should be accepted because the firm’s wealth will increase by ₹ 316 (₹ 4.139 – ₹ 3,823):
The following statement of Incremental analysis will prove the above point:
Investment Decisions - CA Inter FM Question Bank 10
Hence, the Project C should be accepted, when the opportunity cost of funds is 10%.

Question 16.
The cash flows of two mutually exclusive Projects are as under:
Investment Decisions - CA Inter FM Question Bank 11
Required:
(i) Estimate the net present value (NPV) of the Project P’ and J’
using 15% as the hurdle rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion. Make a project choice.

The present value interest factor values at different rates of discount are as under:
Investment Decisions - CA Inter FM Question Bank 12
(May 2004, 2+2+ 1 +2 = 7 marks)
Answer:
(i) Estimation of NPV of the Project ‘P’ & J using 15% as the hurdle rate:
NPV of Project ‘P’:
= – 40,000 + \(\frac{13,000}{(1+15)^1}+\frac{8,000}{(1.15)^2}+\frac{14,000}{(1.15)^3}+\frac{12,000}{(1.15)^4}+\frac{11,000}{(1.15)^5}+\frac{15,000}{(1.15)^6}\)
= – 40,000 + 11.304.35 + 6049.15+ 9205.68+6861.45 + 5469.37 + 6485.65
= ₹ 5375.65
= ₹ 5376/-

NPV of Project J:
=-20,000 + \(\frac{7,000}{(1.15)^1}+\frac{13,000}{(1+15)^2}+\frac{12,000}{(1+15)^3} \)
= -20,000 + 6086.96 + 9829.87 + 7890.58
= ₹ 3807.41

(ii) Estimation of IRR of Project ‘P’ & ‘J’: IRR is the rate at which the sum of cash mf lows after discounting equals to the discounted cash outflows. The value of ‘r1 in the case of given projects can be determined by using the following formula:
Co = \(\frac{C F_0}{(1+r)^0}+\frac{C_1}{(1+r)^1}+\ldots \ldots \ldots \ldots \ldots \ldots+\cdots+\frac{C F_n}{(1+r)^n}+\frac{S V+W C}{(1+r)^n}\)
Where, C0 = Cash flows at the time 0
CF1 = Cash inflow at the end of years t.
r = discount rate
n = life of the project
SV & WC = Salvage value & working capital at end of ‘n’ years.

IRR of Project ‘P’:
40,000 = \(\frac{13,000}{(1+r \%)^1}+\frac{8,000}{(1+r \%)^2}+\frac{14,000}{(1+r \%)^3}+\frac{12,000}{(1+r \%)^4}+\frac{11,000}{(1+r \%)^5}+\frac{15,000}{(1+r \%)^6} \)
r = 19.73%

IRR of Project ‘J’:
20000 = \(\frac{7,000}{(1+r \%)^1}+\frac{13,000}{(1+r \%)^2}+\frac{12,000}{(1+r \%)^3} \)
r = 25.20%

(iii) The conflict between NPV & IRR rule in the case of mutually exclusive projects situation arises due to re-investment rate assumptions. NPV rule assumes that intermediate cash flows are reinvested at ‘r’. The assumption of NPV rules is more realistic.

(iv) When there is a conflict in the Project choice by using NPV & IRR criterion, we would prefer to Equal Annualised Criterion’. According to this, the net annual each inflow in the case of Project P & J would be:
= \(\frac{\text { Net Present Value }}{\text { Cumulative P.V. of Re 1 pa@ } 15 \% \text { for } 6 \text { Years }} \)
Project P’ = ₹ 5375.65/3.7845 = ₹ 1,420.44
Project ‘J’ = ₹ 3807.41/2.2832 = ₹ 1,667.58
Since the cash inflow p.a. in case of project ‘J’ is more than that of project ‘P’, so Project ‘J’ is recommended.

Investment Decisions - CA Inter FM Question Bank

Question 17.
MNP Limited is thinking of replacing its existing machine by a new machine, which would cost ₹ 60 lakhs. The company’s current production is 80,000 units, and is expected to Increase to 1,00,000 units, if the new machine ¡s bought. The selling price of the product would remain unchanged at ₹ 200 per unit. The following is the cost of producing one unit of product using both the existing and new machine:
Investment Decisions - CA Inter FM Question Bank 13
The existing machine has an accounting book value of ₹ 1,00,000 and it has been fully depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered to accept the old machine for ₹ 2,50,000. However, the market price of old machine today is ₹ 1,50,000 and it is expected to be ₹ 35,000 after 5 year. The new machine has a life of 5 years and a salvage value of ₹ 2,50,000 at the end of its economic life. Assume corporate Income-tax rate at 40% and depreciation is charged on straight-line basis for Income-tax purposes. Further, assume that book profit is treated as ordinary income for tax purposes. The opportunity cost of capital of the Company is 15%.

Required:
(i) Estimate net present value of the replacement decision.
(ii) Estimate the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? Suggest.
Investment Decisions - CA Inter FM Question Bank 14
(Nov 2005, 8+3+ 1 =12 marks)
Answer:
(i) Net Cash Outlay of New Machine:-
Investment Decisions - CA Inter FM Question Bank 15
Market Value of Old Machine: The old machine could be sold for ₹ 1,50,000 in the market. Since the exchange value Is more than the market value, this option is not attractive. This opportunity will be lost whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.

Depreciation base: Old machine has been fully depreciated for tax purpose. Thus, the depreciation base of the new machine will be its original cost, i.e. ₹ 60,00,000.

Net Cash Flows: Unit cost includes depreciation & allocated overheads. Allocated OHs are allocations from corporate office therefore they are irrelevant. The depreciation tax shield may be computed separately. Excluding depreciation and allocated OHs, unit costs can be calculated. The company will obtain additional revenue from additional 20,000 units sold.

Thus, after-tax saving, excluding depreciation, tax shield, would be,
= (1,00,000 (200 – 148) -80,000 (200 – 173)) × (1 – 0.40)
= (52,00,000 -21,60,000) × 0.60
= 18,24,000.

After adjusting depreciation, tax should and salvage value, net cash flows and net present value is estimated.
Investment Decisions - CA Inter FM Question Bank 16
IRR = 20% + 10% × \(\frac{1066.94}{1296.82}\) = 28.23%

(iii) Advise: The company should go ahead with replacement project since it is positive NPV decision.

Question 18.
Explain the steps while using the equivalent annualized criterion. (Nov 2019, 3 marks)
Answer:
Equivalent Annualised Criterion 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

  • by PVAF as compute under step
  • and compare the values.

Question 19.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects are ₹ 1,35,000 and ₹ 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both the projects. The opportunity Cost of Capital of the company is
16%. The annual incomes are as under:
Investment Decisions - CA Inter FM Question Bank 17
You are required to calculate for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value. (Nov 2002, 6 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 18
(i) Discounted Payback Period (Refer W. N.-2):
Cost of Project A = ₹ 1,35,000
Cost of Project B = ₹ 2,40,000
Cumulative of PV of cash inflows of Project
A after 4 yrs. = ₹ 1,53,270
Cumulative PV of cash ¡nf lows of Project
B after 5 years = ₹ 2,74,812
A comparison of projects cost with this cumulative PV clearly shows that the Project As cost will be recovered in less than 4 years & that of Project B in less than 5 years. The exact duration of discounted payback period can be computed as follows.
Investment Decisions - CA Inter FM Question Bank 19

(ii) Profitability Index (P.I.) = \(\frac{\text { Sum of discount cash Inflow }}{\text { Initial cash outlay }} \)
P.I. (Pr.A)= \(\frac{₹ 1,93,254}{₹ 1,35,000}\) = 1.43
P.I. (Pr. B) = \(\frac{₹ 2,74,812}{₹ 2,40,000} \) = 1.15

(iii) Net Present Value:
Pr. A (W.N.-1) = ₹ 58,254
Pr. B(W.N.-1)= ₹ 34,812

Question 20.
A Company is considering a proposal of installing a drying equipment. The equipment would involve a Cash outlay of ₹ 6,00,000 and net Working Capital of ₹ 80,000. The expected lite of the project is 5 years without any salvage value. Assume that the company is allowed to charge depreciation on straight-line basis for Income-tax purpose. The estimated before-tax
cash inflows are given below:
Investment Decisions - CA Inter FM Question Bank 20
The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity Cost of Capital is 12%, calculate the equipment’s discounted payback period, payback period, net present value and internal rate of return.
Investment Decisions - CA Inter FM Question Bank 21
(May 2006, 10 Marks)
Answer:
Initial outlay = 6,00,000 + 80,000 = 6,80,000
Investment Decisions - CA Inter FM Question Bank 22
Payback period = 3 + \(\frac{80,740}{7,58,260-5,99,260} \)
=3+51 =3.51 year.
Investment Decisions - CA Inter FM Question Bank 23

NPV = 7,09,116 – 6,80,000 = 29,116
IRR = 12% + \(\frac{29,116}{29,116+20,364} \times 3 \%\)
= 12% + \(\frac{29,116}{49,480} \times 3 \%\) =12% + 1.77% = 13.77%

Investment Decisions - CA Inter FM Question Bank

Question 21.
C Ltd. is considering investing in a project. The expected original investment in the project will be ₹ 2,00,000, the life of project will be 5 years with no salvage value. The expected net cash inflows after depreciation but before tax during the life of the project will be as following:

Year 1 2 3 4 5
85,000 100,000 80,000 80,000 40,000

The project will be depreciated at the rate of 20% on original cost. The company is subjected to 30% tax rate.
Required:
(i) Calculate payback period and average rate of return (ARR).
(ii) Calculate net present value and net present value index, It cost of capital is 10%.
(iii) Calculate internal rate of return.
Investment Decisions - CA Inter FM Question Bank 24
(May 2008, 2 + 3 +3 = 8 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 25
Depreciation = 2,00,000 × 20% = 40,000
Payback period = 1+ (2,00000 – 99,500)/1,10,000 =1.91 years
Computation of Average Rate of Return:

Year PBT PAT
(PBT × 0.7)
1 85,000 59,500
2 1,00,000 70,000
3 80,000 56,000
4 80,000 56,000
5 40,000 28,000
Total 2,69,500

Average Annual Profit =2,69,500/5 = 53,900
Average Investment = (2,00,000 +0)/2 = 1,00,000
ARR = \(\frac{\text { Average Annual Profit after tax }}{\text { Average Investment }} \)
ARR = 53,900 ÷ 1,00,000 = 0.539 i.e. 53.9%.
Investment Decisions - CA Inter FM Question Bank 26
NPV is positive hence C Ltd. can accept the proposal.
NPV Index (PI):
NPV = Investment Decisions - CA Inter FM Question Bank 28
NPV Index = \(\frac{1,61,197.50}{2,00,000}\) = 0.81
Investment Decisions - CA Inter FM Question Bank 29
Calculation of IRR through Interpolation method
IRR= LR + \(\frac{N P V_L}{N P V_L-N P V_H} \times \text { (Rate difference) }\)
IRR=37%+ \(\frac{9,949}{9949-(-305)} \times(40 \%-37 \%)\)
= 37% + \(\frac{9,949}{10,254} \times 3 \%\)
= 37% + 2.91%
IRR = 39.91%

Question 22.
The management of P Limited is considering to select a machine out of the two mutually exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate for the company is 30 percent. Details of the machines are as follows:

Machine-I Machine-II
Cost of machine ₹ 10,00,000 ₹ 15,00,000
Expected life 5 years 6 years
Annual income before tax and depreciation ₹ 3,45,000 ₹ 4,55,000

Depreciation is to be charged on a straight-line basis.

You are required to:
(i) Calculate the discounted pay-back period, net present value, and internal rate of return for each machine.
(ii) Advise the management of P Limited as to which machine they should take up.
Investment Decisions - CA Inter FM Question Bank 30
(May 2010, 9 Marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 31

Discounted Payback Period for:
Machine-I
Discounted Payback Period = 4 + \(\frac{(10,00,000-9,15,958)}{1,70,951}\) = 84,042
= 4+0.4916
= 4.49 years or 4 years and 5.9 months

Machine – II
Discounted Payback Period = 5 + \(\frac{(15,00,000-14,18,569)}{1,99,505}\)
= 5 + \(\frac{81,431}{1,99,505}\)
= 5+0.4082
= 5.41 years or 5 years and 4.9 months

Net Present Value for:
Machine – I
NPV = ₹ 10,86,909 – ₹ 10,00,000
=₹ 86,909

Machine – II
NPV = ₹ 16,18,074 – ₹ 15,00,000
= ₹ 1,18,074
Internal Rate of Return (IRR) for:
Machine – I
P.V. Factor = \(\frac{\text { Initial Investment }}{\text { Annual Cash Inflow }}=\frac{10,00,000}{3,01,500}\) = 3.31 67

PV factor falls between 15% and 16%
Present Value of Cash inflow at 15% and 16% will be:
Present Value at 15% = 3.353 × 3,01,500 = 10,10,930
Present Value at 16% = 3.274 × 3,01,500 = 9,87,111
IRR = 15 + \(\frac{10,10,930-10,00,0000}{10,10,930-9,87,111} \times(16-15) \)
= 15+ \(\frac{10,930}{23,819} \times 1\)
= 15.4588% = 15.46%

Machine – II
P.V. Factor = \(\frac{15,00,000}{3,93,500}\) = 3.8119
Present Value of Cash inflow at 14% and 15% will be:
Present Value at 14% = 3.888 x 3,93,500 = 1 529,928
Present Value at 15% = 3.785 x 3,93,500 = 14,89,398

IRR = 14 + \(\frac{15,29,928-15,00,000}{15,29,928-14,89,398} \times(15-14) \)
= 14+ \(\frac{29,928}{40,530} \times 1\)
= 14.7384% = 14.74%

(ii) Advise to the Management
Ranking of Machines in Terms of the Three Methods

Machine – I Machine – II
Discounted Payback Period I II
Net Present Value II I
Internal Rate of Return I II

Advise: Since Machine – I has better ranking than Machine – II, therefore,
Machine: I should be selected.

Question 23.
ANP Ltd. is providing the following information:
Annual cost of saving ₹ 96,000
Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05
Table of discount factors:
Investment Decisions - CA Inter FM Question Bank 32
You are required to calculate:
(i) Cost of the project
(ii) Payback period
(iii) Net present value of cash inflow
(iv) Cost of capital (May 2012, 8 marks)
Answer:
(i) Cost of Project
At internal rate of return (IRR) of 15%, the amount of total cash
inflows = cost of the project i.e. total cash outflow
Annual cost savings = ₹ 96,000
Useful life = 5 years

Considering the discount factor table @ 15%, cumulative present value of cash inflows for 5 years is 3.353
Hence, Total Cash inflows for 5 years for the Project is
96,000 × 3.353 = ₹ 3,21,888
Hence, Cost of the Project = ₹ 3,21,888

(ii) Payback Period
Payback period = \(\frac{\text { Cost of the Project }}{\text { Annual Cost Savings }}=\frac{₹ 3,21,888}{96,000}\)
Payback Period = 3.353 years

(iii) Net Present Value (NPV)
NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ₹ 3,37,982.40 – 3,21,888 = ₹ 16,094.40
Net Present Value = ₹ 16,094.40

(iv) Cost of Capital
Profitability index = \(\frac{\text { SumofDiscountedCashinflows }}{\text { Cost of theProject }} \)
1.05 = \(\frac{\text { SumofDiscountedCashinflows }}{3,21,888} \)
∴ Sum of Discounted Cash inflows = ₹ 3,37,982.40
Since, Annual Cost Saving = ₹ 96,000
Therefore, cumulative discount factor for 5 years
= \(\frac{₹ 3,37,982.40}{96,000} \)
From the discount factor table, at discount rate of 13%, the cumulative discount factor for 5 years is 3.52 Hence, Cost of Capital = 13%

Investment Decisions - CA Inter FM Question Bank

Question 24.
SS Limited is considering the purchase of a new automatic machine which will carry out some operations which are at present performed by manual labour. NM-A1 and NM-A2, two alternative models are available in the market. The following details are collected:
Investment Decisions - CA Inter FM Question Bank 33
Depreciation will be charged on a straight-line method. The corporate tax rate is 30 percent and the expected rate of return may be 12 percent.
You are required to evaluate the alternatives by calculating the:
(i) Pay-back Period
(ii) Accounting (Average) Rate of Return; and
(iii) Profitability Index or P.V. Index (P.V. factor for 1 @ 12% 0.893;
0.797; 0.712; 0.636; 0.567; 0.507) (Nov 2012, 10 marks)
Answer:
Evaluation of Alternatives
Working Notes:
Depreciation on Machine NM-A1 = \(\frac{20,00,000}{5} \) = 4,00,000
Depreciation on Machine NM-A2 = \(\frac{25,00,000}{5}\) = 5,00,000
Investment Decisions - CA Inter FM Question Bank 34
(i) Payback Period
Machine NM-A1 = \(\frac{\text { Total Initial Capital Investment }}{\text { Annual expected after-tax net cashflow }} \)
= \(\frac{20,00,000}{5,71,500} \)
= 3.50 Years

Machine NM- A2 = \(\frac{25,00,000}{6,92,500}\) = 3.61 Years
Decision: Machine NM-A1 is better.

(ii) Accounting (Average) Rate of Return (ARR)
ARR = \(\frac{\text { Average Annual Net Savings }}{\text { Average Investment }} \times 100 \)
Machine NM-A1 = \(\frac{1,71,500}{10,00,000} \times 100\) = 17.1 5%
Machine NM-A2 = \(\frac{1,92,500}{12,50,000} \times 100 \) = 15.4%
Decision: Machine NM-A1 is better.
(Note: ARR may be computed alternatively by taking initial investment ¡n the denominator.)

(iii) Profitability Index or PV Index
Present Value Cash inflow = Annual Cash Inflow × PV factor at 12%
Machine N M-A1 = 571,500 × 3.605 = ₹ 20,60,258
Machine NM-A2 = 6,92,500 × 3.605 = ₹ 24,96,463
PV Index = \(\frac{\text { Present Value of Cashinflow }}{\text { Investment }}\)
Machine NM-A1 = \(\frac{20,60,258}{20,00,000} \) = 1.03
Machine NM-A2 = \(\frac{24,96,463}{25,00,000}\) = 0.9
Decision: Machine NM-A1 is better.

Question 25.
PQR Company Ltd. is considering to select a machine out of two mutually exclusive machines. The company’s cost of capital is 12 percent and corporate tax rate is 30 percent. Other information relating to both machines is as follows:

Machine-I Machine-II
Cost of Machine 15,00,000 20,00,000
Expected Life 5 Yrs. 5 Yrs.
Annual Income
(Before Tax and Depreciation)
₹ 6,25,000 ₹ 8,75,000

Depreciation is to be charged on a straight-line basis:
You are required to calculate:
(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index
Investment Decisions - CA Inter FM Question Bank 35
(May 2013, 9 Marks)
Answer:
Working Notes:
Depreciation on Machine – I = \(\frac{15,00,000}{5} \) = ₹ 3,00,000
Depreciation on Machine – II = \(\frac{20,00,000}{5}\) = 400 000
Investment Decisions - CA Inter FM Question Bank 36

(i) Discounted Payback Period
Machine-I
Discounted Payback period = 3 + \(\frac{(15,00,000-12,67,056}{3,35,490)} \)
= 3 + \(\frac{2,32,944}{3,35,490}\)
= 3+0.6943
= 3.69 years or 3 years 8.28 months

Machine – II
Discounted Payback Period = 3 + \(\frac{(20,00,000-17,59,466)}{4,65,870}\)
= 3+ \(\frac{2,40,534}{4,65,870} \)
= 3+0.5163
= 3.52 years or 3 years 6.24 months

(ii) Net Present Value (NPV)
Machine – I
NPV= 19,01,639 – 15,00,000 = ₹ 4,01,639
Machine-II
NPV = 26,40,664 – 2000,000 = ₹ 6,40,664

(iii) Profitability Index
Machine – I
Profitability Index = \(\frac{19,01,639}{15,00,000}\) = 1.268

Machine – II
Profitability Index = \(\frac{26,40,664}{20,00,000}\) = 1.320

Conclusion:

Method Machine- I Machine -II Rank
Discounted Payback Period 3.69 years 3.52 years II
Net Present Value 4,01,639 6,40,664 II
Profitability Index 1.268 1.320 II

Question 26.
FH Hospital is considering to purchase a CT scan machine. Presently the hospital is outsourcing the CT-Scan Machine and is earning commission of ₹ 15,000 per month (net of tax). The following details are given regarding the machine:

Cost of CT-Scan machine 15,00,000
Operating cost per annum (excluding Depreciation) 2,25,000
Expected revenue per annum 7,90,000
Salvage value of the machine (after 5 years) 3,00,000
Expected life of the machine 5 years

Assuming tax rate @ 30%, whether it would be profitable for the hospital to purchase the machine?
Give your recommendation under:
(i) Net Present Value Method, and
(ii) Profitability Index Method.
PV factors at 12% are given below:

Year 1 2 3 4 5
PV factor 0.893 0.797 0.712 0.636 0.567

(May 2014, 8 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 37
(ii) Calculation of Profitable Index
Profitable Index
= \(\frac{\text { Sum of discounted cash inflows }}{\text { Present value of cash outflows }}=\frac{12,06,537.50}{15,00,000} \)
= 0.804

Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the hospital should not purchase the CT-Scan machine.

Question 27.
Given below are the data on a capital project ‘M’.
Annual cash inflows ₹ 60,000
Useful life 4 years
Internal rate of return 15%
Profitability index 1.064
Salvage value 0
You are required to calculate for this project M:
(I) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value
PV factors at different rates are given below:

Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636

(May 2015, 8 marks)
Answer:
(i) Calculation for Cost of Project:
Cost of project at 15% Internal rate of return, the sum of total cash Inflows = Cost of the Project i.e. initial cash outlay.
Annual cash inflow = ₹ 60,000
Useful life = 4 years
Considering discounting factor @ 15%, cumulative cash inflow for 4 years is 2.855
Hence, total cash flow for 4 years for the project = ₹ 60,000 x 2.855
Cost of Project = ₹ 1,71,300

(ii) Calculation for Payback Period:
Pay-back Period = \(\frac{\text { Cost of Project }}{\text { Annual Cashinflow }}\)
= \(\frac{1,71,300}{60,000}\)
Pay-back Period = 2.855 years.

(iii) Calculation for Cost of Capital:
Profitability Index = \(\frac{\text { SumofDiscountedCashInflow }}{\text { Cost of project }} \)
1064 = \(=\frac{\text { Sumof DiscountedCashInflows }}{1,71,300}\)
Sum of discounted cash inflows = ₹ 1,82,263.20
Hence, Cumulative discount factor for four years
= \(\frac{₹ 1,82,263.20}{60,000}\) = 3.038

From the discount factor table, at discount rate of 12% the cumulative discount factor for 5 years is 3.038
Hence, Cost of Capital is 12%.

(iv) Calculation for Net Present value (NPV):
NPV = Sum of Present values of cash inflows – Cost of Project
= 182263.2- 171300
NPV = ₹ 10963.20

Investment Decisions - CA Inter FM Question Bank

Question 28.
Given below are the data on a capital project ‘C’:
Cost of the project ₹ 2,28,400
Useful life 4 years
Profitability index 1.0417
Internal rate of return 15%
Salvage value 0
You are required to calculate:
(j) Annual cash flow
(ii) Cost of capital
(iii) Net present value(NPV)
(iv) Discounted payback period
Given the following table of discount factors:

Discount Factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636

(May 2016, 8 marks)
Answer:
At IRR NPV is Zero
Cost of Project = Annual cash flow × Commutative factor IRA
2,28,400 = Annual Cash inflow × 2.855

(i) ∴ Annual Cash Inflow = 80,000
(ii) Cost of Capital
Profitabillty Index (PI) = \(\frac{\text { PV of Cash Inflow }}{\text { PV Cash Outflow }} \)
1.0417 = \(\frac{\text { PV of Casl: Inflow }}{2,28,400} \)

∴ PV of Cash Inflow = 2,37,924.28
Annual Cash Inflow × PV factor = PV of Inflow
80,000 × PV Factor = 2,37,924.28
∴ Commutative PV factor = 2.974

(iii) Cost of Capital = 13%
Net Present Value (NPV) = PV of Inflow – Outflow
= 2,37,924.28 – 2,28,400
NPV = 9,524.28
Investment Decisions - CA Inter FM Question Bank 38
Discounted Payback Period =3+ \(\frac{39,520}{49,040}\) = 3.8059 years
Or = 3 years, 9 Months and 21 days.

Question 29.
X Limited is considering to purchase of new plant worth ₹ 80,00,000. The expected net cash flows after taxes and before depreciation are as follows:

Year Net Cash Flows
1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000

The rate of cost of capital is 10%.
‘fou are required to calculate:
(i) Pay-back period
(ii) Net preseñt value at 10% discount factor
(iii) Profitability index at 10% discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor
The following present value table is given for you:
Investment Decisions - CA Inter FM Question Bank 39
(May 2017, 8 marks)
Answer:

Year Cash Flow Cumulative
0 80,00,000
1 14,00,000 14,00,000
2 14,00,000 28,00,000
3 14,00,000 42,00,000
4 14,00,000 56,00,000
5 14,00,000 70,00,000
6 16,00,000 86,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000

(i) Calculation of Pay-back Period.
Cash Outlay of the Project = ₹ 80,00,000
Total Cash mf low for the first five years = ₹ 70,00,000
Balance of cash outlay left to be paid back in the 6th year = ₹ 10,00,000
Cash inflow for 6th year = ₹ 16,00,000
So the payback period is between and 6th years, i.e.,
= 5 Years + \(\frac{₹ 10,00,000}{₹ 16,00,000}\) = 5.625 Years or 5 years 7.5 months
Investment Decisions - CA Inter FM Question Bank 40

(ii) NPV @ 10% = ₹ 17,97,800
(iii) PI @ 10% = \(\frac{\text { PV of CIF }}{P V \text { of } C O F}=\frac{97,97,800}{80,00,000}\) = 1.225
(iv) IRR = 10 + \(\left[\frac{17,97,800}{17,97,800+114,600} \times 5\right]\)
= 10 + \(\left(\frac{17,97,800}{19,12,400} \times 5\right)\)
= 14.70% (Approx.)

Final Answer:

1. Payback Period 5.625 Years
2. NPV 17,97,800
3. PI 1.225
4. IRR 14.70%

Question 30.
Mr. B will require ₹ 30 lakhs after 10 years from now. He wants to ascertain an amount to be invested in a fund which pays interest @ 10% per annum.
Following options are available to him:
(i) to make annual payment into the fund at the end of each year.
(ii) to invest a lumpsum amount in the fund at the end of the year.
(iii) to make annual payment into the fund in the beginning of each year.
Find out the amount to be invested under each of the options given above.
Factors are as under:
FVIF/CVF(10%,10) = 2.594
FVIFA/CVFA(10%,10) = 15.937
PVIF/PVF (10%, 10) = 0.386
PVIFAIPVFA (10%, 10) = 6.145 (Nov 2017, 5 marks)
Answer:
(I) Here,
FVA = 30,00,000
n =10
i =0.10
Since, FVA = R [FVIFA (I, n)]
FVIFA (10%, 10) = 15.937
R = \(\frac{30,00,000}{15.937}\) = 1,88,241.1997

(ii) Fvn = R [1 + i]n
R = \(\frac{F V_n}{(1+i)^n}\)
R =30,00,000 x 0.386= ₹ 11,58,000

(iii) R = \(\frac{30,00,000}{17.5307}\)
= ₹ 1,71,128.3634.

Question 31.
Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
The particulars are as under:

Project X (₹) Project Y (₹)
Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut-off rate is 14%. The discount factor at 14% are:

Year 1 2 3 4 5 6 7 8 9
Discount factor 0.88 0.77 0.68 0.592 0.519 0.456 0.4 0.351 0.308

Advise management about the acceptability of projects X and Y. (May 2019, 5 marks)
Answer:
Calculation of NPV:
Investment Decisions - CA Inter FM Question Bank 41
In pessimistic situation, project X will be better as it gives low but positive NPV whereas Project Y yields highly negative NPV under this situation. In most likely situation both the project will give same result. However, in optimistic situation, Project Y wilt be better as it will gives very high NPV. So, project X is a risk less project as it gives positive NPV in all the situations where as Y is a risky project as it will result into negative NPV in pessimistic situations and highly positive NPV in optimistic situation. So acceptability of project will largely depend on the risk taking capacity (Risk seeking Risk a version) of the management.

Question 32.
AT Limited is considering three projects A, B and C. The cash flows associated with the projects are given below:
Cash flows associated with the Three Projects (₹)

Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000

You are required to:
(a) Calculate the payback period of each of the three projects.
(b) If the cut-out period is two years, then which projects should be accepted?
(c) Projects with positive NPVs If the opportunity cost of capital is 10 percent.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or false?
(e) “If a firm used a single cutoff period for all projects, it is likely to accept too many short-lived projects. True or false?
P.V. Factor @ 10%

Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

(May 2019, 10 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 42
(b) If the standard payback period is 2 years, Project B is the only acceptable project.
Investment Decisions - CA Inter FM Question Bank 43
So, Projects with positive NPV are Project B and Project C
(d) False. Payback gives no weightage to cash flows after the cut-off date.
(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash inflows are not considered. Thus, payback is biased towards short-term projects.

Investment Decisions - CA Inter FM Question Bank

Question 33.
A company has ₹ 1,00,000 available for investment and has identified the following four investments ¡n which to invest.

Project Investment (₹) NPV (₹)
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000

You are required to optimize the returns from a package of projects within the capital spending limit if
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible. (Nov 2019, 5 marks)
Answer:
Investment Decisions - CA Inter FM Question Bank 44

Question 34.
A company wants to buy a machine, and two different models namely A and B are available. Following further particulars are available:

Particulars Machine – A Machine – B
Original Cost (₹) 8,00000 6,00,000
Estimated Life in Years 4 4
Salvage Value (₹ ) 0 0

The company provides depreciation under Straight Line Method. Income tax rate applicable is 30%. The present value of 1 at 12% discounting factor and net profit before depreciation and tax are as under:
Investment Decisions - CA Inter FM Question Bank 45

Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period method, NPV method and Pl method. (Jan 2021,10 marks)

Question 35.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two Projects are ₹ 1,35,000 and ₹ 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both the projects. The opportunity Cost of Capital of the company is 16%. The annual income are as under:
Investment Decisions - CA Inter FM Question Bank 46

Required:
CALCULATE for each project:
(i) Discounted payback period
(ii) Profitability index
(iii) Net present value
DECIDE which of these projects should be accepted? (, 10 Marks)
Answer:
(i) Discounted payback period: (Refer to Working note 2)
Cost of Project A = ₹ 1,35,000
Cost of Project B = ₹ 2,40,000
Cumulative PV of cash inflows of Project A after 4 years = ₹ 1,53,270
Cumulative PV of cash inflows of Project B after 5 years = ₹ 2,74,812
A comparison of projects cost with their cumulative PV clearly shows that the project’s cost will be recovered in less than 4 years and that of project B in less than 5 years. The exact duration of discounted payback period can be computed as follows:
Investment Decisions - CA Inter FM Question Bank 47
(ii) Profitability Index (PI): = \(\frac{\text { Sum of discounted cash inflows }}{\text { Initian cash outlay }} \)
Profitability Index (for Project A) = \(\frac{₹ 1,93,254}{₹ 1,35,000}\) = 1.43
Profitability Index (for Project B) = \(\frac{₹ 2,74,812}{₹ 2,40,000} \) = 1.15

(iii) Net present value (N PV) (for Project A) = ₹ 58,254
Net present value (NPV) (for Project B) =₹ 34,812
(Refer to Working Note 1)
Conclusion: As the NPV, PI of Project A is higher and Discounted Payback is lower, therefore Project a should be accepted.
Investment Decisions - CA Inter FM Question Bank 48

Question 36.
BT Pathology Lab Ltd. is using an X-ray machine which reached at the end of their useful lives. Following new X-ray machines are of two different brands with same features are available for the purchase.
Investment Decisions - CA Inter FM Question Bank 49
Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and thereafter shall be depreciated at the rate mentioned above. Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after use on the following terms and conditions:
Annual Rent shall be paid in the beginning of each year and for first year it shall be ₹ 1,02,000.
Annual Rent for the subsequent 4 years shall be ₹ 1,02,500.
Annual Rent for the final 5 years shall be ₹ 1,09,950.
The Rent Agreement can be terminated by BT Labs by making a payment of ₹ 1,00,000 as penalty. This penalty would be reduced by ₹ 10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years? The cost of capital of BT Labs is 12%.
Answer:
Since the life span of each machine is different and time span exceeds the useful lives of each model, we shall use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine Is used for 20 years Present Value (PV) of cost If machine of Brand XYZ is purchased
Investment Decisions - CA Inter FM Question Bank 50
PVAF for 1-15 years 6.811
Equivalent Annual Cost= \(\frac{₹ 7,62,927}{6.811}\) = ₹ 1,12,014
Present Value (PV) of cost of machine of Brand ABC Is purchased
Investment Decisions - CA Inter FM Question Bank 51
PVAF for 1-10 years 5.65
Equivalent Annual Cost = \(\frac{₹ 6,51,786}{5.65}\) = ₹ 1,15,360

Present Value (PV) of cost if machine of Brand ABC ¡s taken on Rent
Investment Decisions - CA Inter FM Question Bank 52
PVAF for 1- 1o years = 5.65
Equivalent Annual Cost = \(\frac{₹ 6,65,188}{5.65} \) = ₹ 1,17,732
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the same should be purchased.

(ii) If machine Is used for 5 years
(a) Scrap Value of Machine of Brand XYZ
= ₹ 6,00,000 – ₹ 2,00,000 – ₹ 6,00,000 × 0.04 × 4= ₹ 3,04,000
(b) Scrap Value of Machine of Brand ABC
= ₹ 4,50,000 – ₹ 1,50,000 – ₹ 4,50,000 × 0.06 × 4 = ₹ 1,92,000
Investment Decisions - CA Inter FM Question Bank 53
Decision: Since Cash Outflow is least in case of lease of a Machine of brand ABC the same should be taken on rent.

Cost of Capital – CA Inter FM Question Bank

Cost of Capital – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Cost of Capital – CA Inter FM Question Bank

Question 1.
Explain the significance of Cost of Capital. (Nov 2019, 4 marks)
Answer
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:

1. 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).
2. 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.
3. 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 to the present value of cost and benefits received.

Question 2.
A Company issues ₹ 10,00,000 12% debentures of ₹ 100 each. The debentures are redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax bracket.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
(a) Par
(b) 10% Discount
(c) 10% Premium. (5 marks)
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par? (May 2006, 1 mark)
Answer:
(i) Cost of debenture after tax when debenture are issued:
(a) At par :-
Kd = \(\frac{1(1-t)+(R V-N P) / n}{(R V – N P) / 2} \)
= \(\frac{12(.65)+(100-100) / 7}{(100+100) / 2} \)
= 7.81%

(b) At 10% discount:-
= \(\frac{12(.65)+(100-90) / 7}{(100+90) / 2}\)
= 9.71%

(c) At 10% premium:-
= \(\frac{12(.65)+(100-110) / 7}{(100+110) / 2} \)
= 6.07%

(ii) Cost of debenture when brokerage paid @ 2% issued at par:
Kd = \(\frac{12(.65)+(100-98) / 7}{(100+98) / 2} \)
= \(\frac{7.8+29}{99}\)
= 8.17%.

Question 3.
Answer the following:
A company issues 25,000, 14% debentures of ₹ 1,000 each. The debentures are redeemable after the expiry period of 5 years. Tax rate applicable to the company ¡s 35% (including surcharge and education cess). Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost. (Nov 2015, 5 marks)
Answer:
Calculation of Cost of Debt after Tax:
Cost of Debt (Kd)
= \(\frac{\frac{1(1-t)+\left[\frac{R V-N P}{n}\right]}{R V+N P}}{2}\)
Where, I = Interest payment i.e. 14% of ₹ 1,000 = 140
t = Tax rate applicable to the company i.e. 35%
RV = Redeemable value of debentures i.e. ₹ 1,000
NP = Net proceeds per debentures
= ₹ 1,000 × (1 – (0.05 + 0.02))
= ₹ 1,000 × 0.93= 930
n = Redemption period of debentures i.e 5 years

Therefore, Kd = \(=\frac{₹ 140(1-0.35)+\left[\frac{₹ 1,000-₹ 930}{5 \text { year }}\right]}{\left[\frac{₹ 1,000+₹ 930}{2}\right]} \times 100\)
= \(\frac{₹ 91+₹ 14}{₹ 965} \times 100\) = 10.88 %

The Cost of Debt can also be calculated usinç the formula, where first Cost of Debt before tax is calculated and then tax adjustment is made.

Accordingly:
Cost of Debt = \(\frac{1+\left[\frac{R V-N P}{N}\right]}{\left[\frac{R V-N P}{2}\right]} \times(1-t) \times 100 \)
= \(\frac{₹ 140+14}{₹ 965}(1-0.35) \times 100\) = 10.37%.

Cost of Capital - CA Inter FM Question Bank

Question 4.
TT Ltd. issued 20,000, 10% convertible debentures of ₹ 1oo each with a maturity period of 5 years. At maturity, the debenture holders will have the option to convert debentures into equity shares of the company in ratio of 1: 5 (5 shares for each debenture). The current market price of the equity share is ₹ 20 each and historically the growth rate of the share is 4% per annum. Assuming tax rate is 25%. Compute the cost of 10% convertible debenture using Approximation Method and internal Rate of Return Method. PV Factors are as under:
Cost of Capital - CA Inter FM Question Bank 1
(Nov 2020, 5 Marks)

Question 5.
Answer the following:
A company issued 40,000, 12% Redeemable Preference Shares of ₹ 100 each at a premium of ₹ 5 each, redeemable after 10 years at a premium of 10 each.
The floatation cost of each share is 2.
You are required to calculate cost of preference share capital ignoring dividend tax. (May 2013, 5 marks)
Answer:
Computation of Cost of Preference Shares (Kp)
Preference Dividend (PD) = 0.12 × 40,000 × 1oo = 4,80,000
Floatation Cost = 40,000 × 2 = 80,000
Net Proceeds (NP) = 42,00,000 – 80,000 =41 ,20,000
Redemption Value (RV) = 40,000 × 110= 44,00,000
Cost of Redeemable Preference Shares = \(\frac{\frac{P D+(R V-N P) / N}{R V+N P}}{2} \)
Kp = \(\frac{\frac{4,80,000+(44,00,000-41,20,000) / 10}{44,00,000+41,20,000}}{2}\)
= \(\frac{4,80,000+(2,80,000) / 10}{85,20,000 / 2}\)
= \(\frac{4,80,000+28,000}{42,60,000} \) = \(\frac{5,08,000}{42,60,000} \)
= 0.1192
Kp= 11.92%

Alternative Treatment:
Kp may be computed alternatively by taking the RV and NP for one unit of preferred e-shares. Final figure would remain unchanged.

Question 5.
Discuss the dividend-price approach, and earnings-price approach to estimate cost of Equity Capital. (Nov 2006, 2 marks)
Answer:
Dividend price approach: This approach emphasizes on dividend expected by an investor from a particular share to determines its cost. Cost of ordinary share is calculated on the basis of the present values of the expected future stream of dividend; whereas Earning price approach: Under this approach cost of ordinary share capital would be based on expected ratio of earnings of a company. This approach is similar to dividend price approach, only it seeks to nullify the effect of changes in dividend policy.

Question 6.
Distinguish between Unsystematic Risk and systematic Risk. (Nov 2020, 2 marks)

Question 7.
Piyush Loonker and Associates presently pay a dividend of ₹ 1.00 per share and has a share price of ₹ 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm’s expected or required return on equity using a dividend-discount model approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the firm’s expected, or required, return on equity? (May 2001, 8 marks)
Answer:
(i) Firm’s expected or required return on equity (using a dividend discount model approach):
According to dividend discount model approach, the firm’s expected or required return on equity share capital is computed as follows:
ke= \(\frac{D_1}{P_0}+g \)
Where,
ke =Cost of equity share capital
D1 =Expected dividend at the end of year 1
P0 =Current market price of the share
g =Expected growth rate of dividend.

Given,
D1 =D0(1 +g) or ₹ 1(1 +0.12) = 1.12; P0 = ₹ 2 & g=12%
∴ Ke = \(\frac{1.12}{20}\) + 0.12 = 0.176 = 17.6 %

(ii) Firms expected or required return on equity:
(If dividends were expected to grow at a rate ot 20% p.a. for 5 years & 10% p.a. thereafter): Since in this situation if dividends are expected to grow at a supernormal growth rate gs, for n years & thereafter, at a normal, perpetual growth rate of gn beginning in the year n+l then the cost of equity can be determined by using the following formula:
Cost of Capital - CA Inter FM Question Bank 37
Where,
gs =Rate of growth in earlier years
gn =Rate of constant growth in later years
P0 =Discounted value of dividend stream
ke =Firm’s expected required return on equity
gs =20% for 5 years, gn = 10%
Cost of Capital - CA Inter FM Question Bank 2
By trial & error, we are required to find out ke
Now, assume ke = 18%, then we will have:
P0 = 1.20 (0.8475) + ₹ 1.44 (0.7182) + ₹ 1.73 (0.6086) + ₹ 2.07
(0.51589) + ₹ 2.49 (0.43710) + ₹ 2.74 (0.4371) × \(\frac{1}{0.18-0.10}\)
=₹ 1.017+ ₹ 1.034+ ₹ 1.052+ ₹ 1.067+ ₹ 1.09+ ₹ 14.97 = ₹ 20.23
Since The Present Value of dividend stream is more than required it indicates that ke is greater than 18%.

Now, assume ke = 19% we will have:
P0 = ₹ 1.20 (0.8403) + ₹ 1.44 (0.7061) +₹ 1.73 (0.5934) + ₹ 2.07
(0.4986) + ₹ 2.49 (0.4190) + ₹ 2.74 (0.4190) × \(\frac{1}{0.19-0.10}\)
= ₹ 1.008 + ₹ 1.016 + ₹ 1.026 + ₹ 1.032 + ₹ 1.043 + ₹ 12.76 = ₹ 17.89
Since the market price of share (expected value of dividend stream) is ₹ 20. Therefore, the discount rate is closer to 18% than it is to 19%, we can get the exact rate by using the interpolation formula:
Ke = \(\frac{r-\left(P V_s-P V_D\right)}{\Delta P V} \times \Delta r \)

Where,
r =Either of two interest rates
PV =Present value of share
PVD =Present value of dividend stream
Δr =Difference in value of dividend stream
ΔPV = Difference in calculated P.V. of dividend stream
∴ Ke = \(\frac{18 \%-(₹ 20-₹ 20.23)}{₹ 20.23-₹ 1,789} \times 0.01 \)
= \(\frac{18 \%-(₹ 0.23)}{₹ 2.34} \times 0.01 \)
= \(\frac{18 \%+0.23}{2.34} \times 0.01 \)
= 18% + 0.10 = 18.10%
Therefore, the firm’s expected, or required, return on equity is 18.1 0%. At this rate, the present discounted value of dividend stream is equal to the market value of the shares.

Question 8.
D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth rate is likely to be 10% for the third and fourth years. After that, the growth rate is expected to stabilize at 8% per annum. If the last dividend was ₹ 1.50 per share and the investor’s required rate of return is 16%, determine the current value of the equity share of the company.
The P.V. factors at 16%

Year 1 2 3 4
P.V. factor .862 .743 .641 .552

(May 2005, 6 marks)
Answer:
The current value of the equity share of D Ltd. is a sum of the following:
(a) Present value (PV) of dividends payments during 1- 4 years; and
(b) Present value (PV) of expected market price at the end of the fourth year based on a constant growth rate of 8 percent.
Cost of Capital - CA Inter FM Question Bank 3
Present value of the market price (P4) at the end of the 4th year
P4 = D5(Ke – g) = 2.28 (1.08)/(16% – 8%) = ₹ 30.78
PV of ₹ 30.78 = 30.78 × 0.552 = ₹ 16.99
Therefore Value of equity shares ₹ 5.44 +₹ 16.99 = ₹ 22.43

Question 9.
Answer the following:
Z Ltd.’s operating income (before interest and tax) is ₹ 9,00,000. The firm’s cost of debts ¡s lo per cent and currently firm employs ₹ 30,00,000 of debts. K0 is 12 percent.
Required:
Calculate the cost of equity. (Nov 2007, 3 marks)
Answer:
Total Value of firm = \(\frac{₹ 9,00,000}{12}\)
= 75,00,000
Debt capital: 30,00,000
Equity capital 45,00,000
12 = 10 \(\left(\frac{30,00,000}{75,00,000}\right)+K_e\left(\frac{45,00,000}{75,00,000}\right) \)

12 = 10(4)+Ke(6)
12 = 04+Ke. 6
08 = Ke.6
Ke = \(\frac{.08}{.6}]\)
= 0.1333
= 13.33%

Question 10.
Answer the following:
ABC Company’s equity share is quoted in the market at ₹ 25 per share currently. The company pays a divided of ₹ 2 per share and the investor’s market expects a growth rate of 6% per year.
You are required to:
(i) Calculate the company’s cost of equity capital.
(ii) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share.
(iii) If the company issues 10% debentures of face value of ₹ 1oo each and realises ₹ 96 per debenture white the debentures are redeemable after 12 years at a premium of 12%, what will be the cost of debenture? Assume Tax Rate to be 50%. (Nov 2016, 5 marks)
Answer:
(i) Calculation of Cost of Equity Capital:
Ke = \(\frac{\mathrm{D}_1}{\mathrm{P}_0}+g\)
= \(\frac{2 \times 1.06}{25}\) + 0.06
= 0.0848 + 0.06
= 0.1448
= 14.48%.

Cost of Capital - CA Inter FM Question Bank

(ii) Calculation the indicated Market price per share:
Ke = \(\frac{D_1}{P_0}+g\)
∴ 0.14 = \(\frac{2}{x}\) + 0.08
∴ 0.14- 0.08 = \(\frac{2}{x}\)
∴ x(0.06) = 2
∴ x = 33.33
Hence, the market price will be ₹ 33.33.

(iii) Calculation of Cost of Debenture:
Kd = \(\frac{I(1-t)+\left(\frac{R V-N P}{N}\right)}{\frac{R V+N P}{2}}\)
= \(\frac{10(1-0.50)+\left(\frac{112-96}{12}\right)}{\frac{112+96}{2}} \)
= \(\frac{5+1.33}{104} \)
= \(\frac{6.33}{104}\)
= 0.0608
= 6.08%.

Question 11.
Answer the following:
Y Ltd. retains ₹ 7,50,000 out of its current earnings. The expected rate of return to the shareholders If they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders came in 30% tax bracket. Calculate the cost of retained earnings. (Nov 2009, 2 marks)
Answer:
Computation of Cost of Retained Earnings (Kr)
Kr = K (1 -Tp) – Brokerage
Kr = 0.10(1-0.30) 0.03
= 0.04 or 4%
Cost of Retained Earnings = 6.79%

Question 12.
Answer the following:
What do you understand by Weighted Average Cost of Capital? (Nov 2009, 3 marks)
Answer:
Computation of overall cost of capital of a firm involves:
1. Computation of weighted average cost of capital
2. Computation of cost of specific source of finance.

1. Computation of Weighted Average Cost of Capital (WACC): Weighted average cost of capital is the average cost of the costs of various sources of financing. Weighted average cost of capital is also known as composite cost of capital, overall cost of capital or average cost of capital. Once the specific cost of individual sources of finance is determined, we can compute the weighted average cost of capital by putting weights to the specific costs of capital in proportion to the various sources of firm to the total. The weights may be given either by using the book value of the sources or market value of the sources.

WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Preference x Cost of Preference) + (Proportion of Debt x Cost of Debt) For the above formula, we consider some assumptions in order to simplify and make it calculative. These are:
(i) We consider only three types of capital: Equity, non-convertible & non-cancellable preference shares and non-convertible & non-cancellable debts so, we have to ignore other forms of capital. because cost of these forms of capital is very difficult to calculate due to its complexities. Generally, such types of financing covers a minor part only, so it should be excluded as it cannot make any material difference.

(ii) Debts Include: Long-term debts as well as short-term debts (i.e. working capital loan, commercial papers etc.)

(iii) Non-interest: Bearing liabilities such as trade creditors are not included in the calculation of WACC. This is done to ensure the consistency in reality. Such types of securities have costs but such costs are indirectly reflected in the price paid by the co. at the time of getting the goods & services.

Question 13.
XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of ₹ 1o each, fully paid up – at par) ₹ 15 crores
11 % Preference Capital (in shares of ₹ 1oo each, fully paid up – at par) ₹ 1 crore
Retained Earnings ₹ 20 crores
13.5% Debentures (of ₹ 100 each) ₹ 10 crores
15% Term Loans ₹ 12.5 crores.
The next expected dividend on equity shares per share is 3.60; the
dividend per share is expected to grow at the rate of 7%. The market price per share is 40.
Preference stock, redeemabe after ten years, is currently selling at 75 per share.
Debentures, redeemable after six years, are selling at 80 per debenture.
The Income-tax rate for the company is 40%.
(i) Required:
Calculate the weighted average cost of capital using:
(a) book value proportions; and
(b) market value proportions. (Nov 2000, 6 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 4
Note: Since Retained earnings are treated as equity capital for purposes of calculation of the cost of specific sources of finance, the market value of the ordinary shows may be taken to represent the combined market value of equity shares & retained earnings. The separate market values of retained earnings & ordinary shares may also be worked out by allocating to each of these a percentage of total market value equal to their percentage share of the total based on book values.

Question 14.
JKL Ltd. has the following book-value capital structure as on March 31, 2003.
Equity share capital (2,00,000 shares) ₹ 40,00,000
11.5% preference shares 10,00,000
Cost of Capital - CA Inter FM Question Bank 5
The equity share of the company sells for ₹ 20. It is expected that the company will pay next year a dividend of ₹ 2 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate.

Required:
(i) Compute weighted average cost of capital (WACC) of the company based on the existing capital structure.
(ii) Compute the new WACC, if the company raises an additional ₹ 20 lakhs debt by issuing 12% debentures. This would result in increasing the expected equity dividend to ₹ 2.40 and leave the growth rate unchanged, but the price of equity shares will fall to ₹ 16 per share.
(iii) Comment on the use of weights in the computation of weighted average cost of capital. (May 2003, 3+3+2 = 8 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 6
Working Notes:
1. Cost of equity capital:
Ke = \(\frac{\text { Dividend }}{\text { Current W.P. }}\) + g
= \(\frac{2}{20}\) + 5 % = 0.15

2. Cost of preference share capital:
Cost of Capital - CA Inter FM Question Bank 7
= \(\frac{1,15,000}{10,00,000}\) = 0.115

3. Cost of debentures:
\(\frac{1}{\text { Net Proceeds }}\) (Interest Tax) .
= \(\frac{1}{30,00,000}\) (3,00,000 – 1,05,000) = 0.065

4. Weights of equity share capital, preference share capital & debentures in total investment of ₹ 80,00,000:
Weight of equity share capital = \(\frac{\text { Total equity }}{\text { Total Investment }}=\frac{40,00,000}{80,00,000}\) = 0.50
Weight of Preference share capital = \(\frac{\text { Total Preference share }}{\text { Total Investment }} \)
= \(\frac{10,00,000}{80,00,000}\) = 0.15
Weight of debenture = \(\frac{\text { Total debentures }}{\text { Total Investments }}=\frac{30,00,000}{80,00,000}\) = 0.375
Cost of Capital - CA Inter FM Question Bank 8
Working Notes:
1. Weights of equity, preference & debentures in total Investment of ₹ 1,00,00,000:
Weight of equity hare = \(\frac{40,00,000}{1,00,00,000}\) = 0.4
Weight of Preference share = \(\frac{10,00,000}{1,00,00,000}\) = 0.10

Weight of debenture @ 10% = \(\frac{30,00,000}{1,00,00,000}\) = 0.30
Weight of debenture @ 12% = \(\frac{20,00,000}{1,00,00,000} \) = 0.20

2. Cost of equity capital: ‘
ke= +g
= \(\frac{2.40}{16}\) + 5 % = 20%

3. Comment:
On the computation of weighted average cost of capital weights are preferred to Book value. e.g. weights representing the capital structure under a corporate financing situation, its cash flows are preferred to earnings & market. Balance sheet is preferred to book value Balance sheet.

Cost of Capital - CA Inter FM Question Bank

Question 15.
ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, ₹ 10 par) ₹ 1,500 million
Reserves and Surplus ₹ 2,250 million
10.5% Preference Share Capital
(1 million shares, ₹ 100 par) ₹ 1oo million
9.5% Debentures (1.5 million debentures, ₹ 1000 par) ₹ 1,500 million
8.5% Term Loans from Financial Institutions 500 million
The debentures of ABC Limited are redeemable after three years and are quoting at 981.05 per debenture. The applicable income tax rate for the company is 35%.
The current market price per equity share is ₹ 60. The prevailing default risk-free interest rate on 10-year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The beta of the company is 1.1875. The preferred stock of the company is redeemable after 5 years is currently selling at ₹ 98.15 per preference share.

Required:
(i) Calculate weighted average cost of capital of the company using market value weights.
(ii) Define the marginal cost of capital schedule for the firm if it raises ₹ 750 million for a new project. The firm plans to have a target debt-to-value ratio of 20%. The beta of new project is 1.4375. The debt capital will be raised through term loans, It will carry interest rate of 9.5% for the first 100 million and 10% for the next ₹ 50 million. (May 2004, 6 + 3 = 9 marks)
Answer:
Working Notes:
1. Computation of cost of debentures (kd):
981.05 = \(\frac{95}{(1+\mathrm{YTM})^1}+\frac{95}{(1+\mathrm{YTM})^2}+\frac{1,095}{(1+\mathrm{YTM})^3} \) (yield to maturity (ytm)
= 10% appx.)
kd = YTM × (1-Tc)
=10% × (1-0.35)
=6.5%

2. Computation of cost of term loans (kt):
=i × (1 – Te)
= 8.5% (1 – 0.35)
= 5.525%

3. Computation of cost of Preference capital (kp):
98.5 = \(\frac{10.5}{(1+Y T M)^1}+\frac{10.5}{(1+Y T M)^2}+\frac{10.5}{(1+Y T M)^3}+\frac{10.5}{(1+Y T M)^4}+\frac{10.5}{(1+Y T M)^5}\)
YTM= 11%App.
Kp = 11%

4. Computation of cost of equity (ke):
= rf + Avg. market risk premium x I3eta
= 5.5% + 8% × 1.175
= 15%

5. Computation of proportion of equity capital, preference share, debenture & term loans In the market value of capital structure:
Cost of Capital - CA Inter FM Question Bank 9
(i) Weighted Average Cost of capital (WACC):
Using market value weights:
WACC = \(\left(k_d \times \frac{D}{V}\right)+\left(k_T \times \frac{T}{V}\right)+\left(k_p \times \frac{P}{V}\right)+\left(k_\sigma \times \frac{E}{V}\right) \)
= (6.5% × 0.1329)+ (5.25% × 0.04517)+(11% × 0.0089)+ (15% × 0.813)
= 0.008638 + 0.002495 + 0.00097 + 0.121 95 = 13.41%
For the values of kd, kt,kp, & ke & weights refer to W. N. I to 5 respectively.

(ii) Marginal cost of capital (MCC) schedule:
ke (New project) = 5.5% +8% x 1.4375= 17%
kd= 9.5% × (1-0.35) = 6.175%
= 10% × (1-0.35)= 6.5%
MCC = 17% × 0.80 + 6.175% × \(\frac{100}{750} \) +6.5% × \(\frac{50}{750} \)
= 14.86% (appx.)

Question 16.
ABC Ltd. wishes to raise additional finance of ₹ 20 Iakhs for meeting its investment plans. The company has ₹ 4,00,000 in the form of retained earnings available for investment purposes. The following are the further details:
Debt-equity ratio 25: 75.
Cost of debt at the rate of 10 percent (before tax) up to ₹ 2,00,000 and 13% (before tax) beyond that.
Earning per share, ₹ 12.
Dividend payout 50% of earnings.
Expected growth rate in dividends 10%.
Current market price per share, ₹ 60.
Company’s tax rate is 30% and shareholder’s personal tax rate is 20%.

Required:
(i) Calculate the post-tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance. (May 2008, 2+3+3 = 8 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 10
(i) Kd = Total Interest (1 – t) /₹ 5,00,000
= [20,000 + 39,000] (1 -0.3)/5,00,000 or (41,300/5,00,000) × 100
= 8.26 %

(ii) Ke = EPS × payout/mp +g= 12 (50%) /60 × 100+ 10% 10% + 10% = 20%
Kr = Ke (1 -tp) = 20(1 -0.2) = 16%
Cost of Capital - CA Inter FM Question Bank 11
Ko = (3,25,300/20,00,000) × 100 = 16.27%

Question 17.
The capital structure of MNP Ltd. is as under:
Cost of Capital - CA Inter FM Question Bank 12
Additional information:
(i) ₹ 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market price per debenture is ₹ 105.
(ii) ₹ 1oo per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The market price per preference share is ₹ 106.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 24. The next year expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
(vi) Corporate Income- tax rate is 35 %.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights. (May 2009, 9 marks)
Answer:
Calculation of Weighted Average Cost of Capital by using market value weights:
Cost of Capital - CA Inter FM Question Bank 13
WACC using market value weight = 13.02%
Working Notes:
Calculation of cost of Redeemable debenture:
Kd = \(=\frac{\text { Interest }(1-\text { taxrate })+\left[\frac{\text { Redeemablevalue }- \text { Issueprice }}{\text { No. of years }}\right]}{\left[\frac{\text { Redeemablevalue }+ \text { IssuePrice }}{2}\right]} \times 100\)
OR
kd = \(\frac{(1-t)+(R V-N P) / N}{(R V+N P) / 2}\)
kd = \(\frac{9(1-.35)+\left[\frac{100-98}{10}\right]}{\left[\frac{100+98}{2}\right]} \times 100 \)
kd = 6.11 %

Kp = \(\frac{\text { Preference dividend }+\left[\frac{\text { Redeemablevalue }- \text { Issueprice }}{\text { No. of years }}\right]}{\left[\frac{\text { Redeemablevalue }+ \text { IssuePrice }}{2}\right]} \times 100 \)
Or
Kp = \(\frac{P D+(R V-N P) / N}{(R V+N P) 2} \times 100\)
Kp = \(\frac{11+\frac{(100-97)}{10}}{\frac{100+97}{2}} \times 100\)
Kp = 11.47%

Cost of equity:
Ke = \(\frac{D_1}{P_0}+g \)
Ke = \(\frac{2}{(24-4)}\) + 0.05 = 15%
Ke = \(\frac{\text { Expected Dividend }}{\text { Current market price }} \) + Growth rate

Question 18.
Answer the following:
(i) SK Limited has obtained funds from the following sources, the specific cost are also given against them:
Source of funds Amount ₹ Cost of Capital
Equity shares 30,00,000 15 percent
Preference shares 8,00,000 8 percent
Retained earnings 12,00,000 11 percent
Debentures 10,00,000 9 percent (before tax)
You are required to calculate weighted average cost of capital. Assume that Corporate tax rate is 30 percent. (May 2010, 3 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 14
Cost of Debentures (Kd) (after tax) = Kd (before tax) × (1 – T)
=9%(1 – 0.3) = 6.3%
Weighted Average Cost of Capital = 11.81 %

Question 19.
Answer the following:
PQR Ltd. has the following capital structure on October 31, 2010:
Equity Share Capital ₹ 20,00,000
(2,00,000 Shares of ₹ 10 each)
Cost of Capital - CA Inter FM Question Bank 15
The market price of equity share is ₹ 30. It is expected that the company will pay next year a dividend of ₹3 per share, which will grow at 7% forever.
Assume 40% income tax rate.
You are required to compute weighted average cost of capital using market value weights. (Nov 2010, 5 marks)
Answer:
Computation of Weighted Average Cost of Capital (WACC): Existing Capital Structure
Calculation of Cost of Equity
Cost of Equity = \(\frac{D_1}{P_0}\) + g
= \(\frac{₹ 3}{₹ 30} \) + 0.07 = 0.1 + 0.07 = 0.17 = 17%
Cost of Capital - CA Inter FM Question Bank 16
Kd = rd (1-Tc) = 9% × (1 -0.4) = 5.4% or 0.054
Weighted Average Cost of Capital =0.1302 or 13.02%

Question 20.
Answer the following:
Beeta Ltd. has furnished the following information:
Earning per share (EPS) ₹ 4
Dividend payout ratio 25%
Market price per share ₹ 40
Rate of Tax 30%
Growth rate of dividend 8%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% up to ₹ 2 lakhs and 15% beyond that. Compute the after-tax cost of equity and debt and the weighted average cost of capital. (Nov 2011, 5 marks)
Answer:
Cost of Equity Share Capital (Ke)
Ke (after tax) = \(\left(\frac{\mathrm{DPS}}{\mathrm{MPS}} \times 100\right) \) + G
DPS= 25% of ₹ 4 = ₹ 1.00
Ke = (\(\frac{1}{40}\) × 100) +8
Ke = 10.5%

(ii) Cost of Debt (Kd)
Kd = \(\frac{\text { Interest }}{\text { Net Proceeds }} \times 100 \times(1-\mathrm{T}) \)
Cost of Capital - CA Inter FM Question Bank 17
Kd = \(\frac{50,000}{4,00,000}\) × 100 × (1 – 0.3) = 8.75 %
Cost of Capital - CA Inter FM Question Bank 18

Question 21.
The following details are provided by the GPS Limited:
Equity Share Capital ₹ 65,00,000
12% Preference Share Capital ₹ 12,00,000
15% Redeemable Debentures ₹ 20,00,000
10% Convertible Debentures ₹ 8,00,000
The cost of equity capital for the company is 16.30% and the Income Tax rate for the company is 30%. You are required to calculate the Weighted Average Cost of Capital (WACC) of the company. (May 2014, 5 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 19
Weighted Average Cost of Capital = \(\frac{\text { Weighted Cost }}{\text { Total Cost }} \)
= \(\frac{14,69,500}{1,05,00,000} \)
= 0.1399 or
= 13.99%

Working Notes:
1. Calculation of Cost of Preference Shares:
Kp = \(\frac{D_p}{N P}=\frac{1,44,000}{12,00,000}\) 1,44,000 = 0.12 = 12%

2. Calculation of Cost of 15% Redeemable Debentures:
Kd = \(\frac{I(1-t)}{N P}=\frac{3,00,000(1-0.30)}{20,00,000} \) = 0.105 = 10.5%

3. Calculation of Cost of 10% Convertible Debentures:
Kd = \(\frac{I(1-t)}{N P}=\frac{80,000(1-0.30)}{8,00,000}\) = 0.07 = 7%

Cost of Capital - CA Inter FM Question Bank

Question 22.
A Ltd. wishes to raise additional finance of ₹ 30 lakhs for meeting its investment plans. The company has ₹ 6,00,000 in the form of retained earnings available for Investment purposes.
The following are the further details:
Debt-equity ratio – 30:70
Cost of debt at the rate of 11 % (before tax) upto ₹ 3,00,000 and 14% (before tax) beyond that.
Earnings per share – 15.
Dividend payout – 70% of earnings.
Expected growth rate in dividend – 10%.
Current market price per share – ₹ 90.
Company’s tax rate is 30% and shareholder’s Personal tax rate is 20%.
You are required to:
(i) Calculate the post-tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance. (May 2015, 8 marks)
Answer:
Pattern of raising capital = 0.30 x 30,00,000
Debt = 9,00,000
Equity = 21,00,000
Cost of Capital - CA Inter FM Question Bank 20

(i) Kd = \(\frac{\text { Total Interest }(1-t)}{₹ 9,00,000} \times 100\)
\(\frac{₹ 33,000+₹ 84,000(1-0.3)}{₹ 9,00,000} \times 100\)
Or = \(\frac{₹ 81,900}{₹ 9,00,000} \times 100\) = 9.10%
(ii) Ke = \(\left[\frac{(\text { EPS } \times \text { Payout })(1+g)}{M P} \times 100\right] \) + g
= \(\left[\frac{(₹ 15 \times 0.7) \times 1.1}{₹ 90} \times 100\right]\) + 10%
= \(\left[\frac{₹ 11.55}{₹ 90} \times 100\right] \) + 10% = 22.83%
Kr = Ke (1 – tp) = 22.83%(1 -0.2) = 18.26%
Cost of Capital - CA Inter FM Question Bank 21
Ke is calculated based on dividend growth model
Kd = Cost of capital; Ke = Cost of equity; Kr = Cost of retained earnings;
Mp = Market price; g = growth; tp = Shareholder’s personal tax;
K0 = Cost of overall capital

Question 23.
RST Ltd. is expecting an EBIT of ₹ 4 lakhs for F.Y. 2015-16. Presently the company is financed entirely by equity share capital of ₹ 20 lakhs with equity capitalization rate of 16%. The company rs 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. (Nov 2015, 8 marks)
Answer:
Cost of Capital - CA Inter FM Question Bank 22
Working Note:
1. Calculation of Market Value of Equity:
Equity Capital Rate = \(\frac{\text { EBIT }}{\text { Market Value }} \)
16% = \(\frac{4,00,000}{\text { Market Value }} \)
Market Value = 25,00,000

Computation of Value of the Company and Overall Cost of Capital under the two options:

Particulars Option I Option II
Debt 30% 50%
Equity (existing) ₹ 20,00,000 ₹ 20,00,000
Debt ₹ 6,00,000 ₹ 10,00,000
Equity capitalization rate 17% 20%
Interest on Debt 10% 12%
EBIT ₹ 4,00,000 ₹ 4,00,000
Less: Interest on Debt ₹ 60,000 ₹ 1,20,000
Earnings to equity shareholders ₹ 3,40,000 ₹ 2,80,000

Cost of Capital - CA Inter FM Question Bank 23
Since, in Option I value of the Company is more and overall cost of Capital is less compared to Option II, hence Option I is better.

Question 24.
Following is the capital structure of RBT Limited as on 31st March 2016:

Particulars Book Value (₹) Market Value (₹)
Equity Shares of ₹ 10 each 50,00,000 1,05,00,000
Retained earnings 13,00,000
11% Preference shares of ₹ 100 each 7,00,000 9,00,000
14% debentures of ₹ 100 each 30,00,000 36,00,000

Market price of equity shares is ₹ 40 per share and it is expected that a dividend of ₹ 4 per share would be declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate applicable to the company is 40% and shareholder’s personal income tax rate is 20%.
You are required to calculate:
(i) Cost of capital for each source of capital,
(ii) Weighted average cost of capital on the basis of book value weights,
(iii) Weighted average cost of capital on the basis of market value weights. (Nov 2016, 8 marks)
Answer:
(I) Cost of Capital:
(a) Cost of Equity Share Capital (Ke)
Ke = \(\frac{D_0(1+g)}{P_0}+g\)
= \(\frac{4(1+0.08)}{40}\) +0.08
= \(\frac{4.32}{40} \) +0.08
= 0.188 or 18.8%

(b) Cost of Retained earnings (Ks)
Ks = Ke (1 – tp) = 18.8 (1 .0.2) = 15.04%.

(c) Cost of Preference share (Kp)
Kp = 11%

(d) Cost of debentures (Kd)
Kd = r(1 -t)
=14% (1 -0.4)=0.084 = 8.4%

Cost of Capital - CA Inter FM Question Bank 24

Question 25.
Alpha Ltd. has furnished the following information:
Earning Per Share (EPS) ₹ 4
Dividend payout ratio 25%
Market price per share 50
Rate of tax 30%
Growth rate of dividend 10%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of debt (before tax) is 10% up to ₹ 2 lakhs and 15% beyond that. Compute the after-tax cost of equity and debt and also weighted average cost of capital. (May 2019, 5 marks)
Answer:
(i) Cost of Equity Share Capital (Ke):
Ke = \(\frac{D_0(1+g)}{P_0}+g \)
= \(\frac{25 \% \text { of } ₹ 4(1+0.1)}{₹ 50}+0.10\)
= \(\frac{₹ 1.10}{₹ 50}+0.10 \)
Ke = 0.122 i.e. 12.20%

(ii) Cost of debt (kd):
Kd = \(\frac{\text { Interest }}{\text { NetProceeds }} \times 100 \times(1-t) \)
Interest on First ₹ 2,00,000 @ 10% = ₹ 20,000
Interest on next ₹ 2,00,000 @ 15% = ₹ 30,000
Kd = \(\frac{₹ 50,000}{₹ 4,00,000} \times(1-0.3) \)
Kd = 0.0875 i.e. 8.75%
Cost of Capital - CA Inter FM Question Bank 25

Alternate Solution:
(i) Cost of Equity Share Capital (Ke)
Ke = \(\frac{D_0(1+g)}{P_0}+g=\frac{25 \% \text { of } ₹ 4(1+0.10)}{₹ 50}+0.10 \)
= \(\frac{₹ 1.10}{₹ 50}+0.10 \) = 0.122 or 12.2%

(ii) Cost of Debt (Kd)
Kd = \(\frac{\text { Interest }}{\text { Net Proceeds }} \times 100 \times(1-t) \)
Interest on First ₹ 2,00,000 @ 10% = ₹ 20,000
Interest on next ₹ 2,00,000 @ 15% = ₹ 30,000
Kd = \(\frac{50,000}{4,00,000} \) × (1 – 0.3) = 0.0875 or 8.75%
Cost of Capital - CA Inter FM Question Bank 26
Ke = \(\frac{\mathrm{D}}{\mathrm{P}_0} \) + g = \(\frac{25 \% \text { of } ₹ 4}{₹ 50}+0.10 \) = \(\frac{₹ 1.00}{₹ 50}+0.10\) = 0.120 or 12.00%
Accordingly Weighted Average Cost of Capital (WACC)
Cost of Capital - CA Inter FM Question Bank 27

Question 26.
A Company wants to raise additional finance of ₹ 5 crore in the next year.
The company expects to retain ₹ 1 crore earning next year. Further details are as follows:
(i) The amount will be raised by equity and debt in the ratio of 3:1.
(ii) The additional issue of equity shares will result in price per share being fixed at ₹ 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first ₹ 75 lakh and 12% for the next ₹ 50 lakh.
(iv) The net expected dividend on equity shares is ₹ 2.00 per share. The dividend is expected to grow at the rate of 5%.
(v) Income tax rate is 25%.

You are required:
(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax. (Nov 2019, 10 marks)
Answer:
(a) The amount of equity and debt for raising additional Finance:
Equity = ₹ 5Cr. × \(\frac{3}{4} \) = ₹ 3.75Cr.
Debt = ₹ 5 Cr. × \(\frac{1}{4} \) = ₹ 1.25 Cr.
Cost of Capital - CA Inter FM Question Bank 28

(b) Determination of post-tax average cost of additional debt:
Kd = I (1-t)
Where, I = Interest Rate
t = Corporate tax rate
on ₹ 0.75 Cr. = 10% (1- 0.25) = 7.5% or 0.075
on ₹ 0.50 Cr. = 12% (1 – 0.25) = 9% or 0.09

The average cost of debt
= \(\frac{(₹ 0.75 \mathrm{Cr} . \times 0.075)+(0.50 \times 0.09)}{₹ 1.25 \mathrm{Cr} .} \times 100\)
Kd = 8.1%.

(c) Determination of cost of retained earnings and cost of equity applying dividend growth model.
Ke = \(\frac{D_1}{P_0} \) +9
Where, Ke = Cost of equity
D1 = D0 (1+9)
D0 = Dividend paid (i.e. 2)
g = Growth rate
P0 = Current market price per share
Then,
Ke = \(\frac{₹ 2(1.05)}{₹ 25} \) + 005
= 0.084 + 0.05
=0.134
= 13.4%
Cost of Capital - CA Inter FM Question Bank 29

Question 27.
The Capital structure of PQR Ltd. is as follows:

10% Debenture 3,00,000
12% Preference Shares 2,50,000
Equity Share (face value ₹ 10 per share) 5,00,000
10,50,000

Additional Information:
(i) ₹ 1oo per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The market price per debenture is ₹ 110.
(ii) ₹ 100 per preference share redeemable at par has 3% floatation cost & 10 years of maturity. The market price per preference share is ₹ 108.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 25. The next year expected dividend is ₹ 2 per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
(iv) Corporate Income Tax rate is 30%.
Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights. (Jan 2021, 10 marks)

Question 28.
Navya Limited to wishes to raise additional capital of ₹ 10 lakhs for meeting its modernization plan. it has ₹ 3,00,000 in the form of retained earnings available for investments purposes. The following are the further details:
Debt equity mix 40%/60%
Cost of debt (before tax)
Upto ₹1,80,000 10%
Beyond ₹ 1,80,000 16%
Earnings per share ₹ 4
Dividend payout ₹ 2
Expected growth rate in dividend 10%
Current market price per share ₹ 44
Tax rate 50%
Required:
(i) To determine the pattern for raising the additional finance.
(ii) To calculate the post-tax average cost of additional debt.
(iii) To calculate the cost of retained earning and cost of equity, and
(iv) To determine the overall weighted average cost of capital (after tax).
Answer:
(i) Pattern of Raising Additional Finance
Equity = 10,00,000 × 60/100 = ₹ 600000
Debt = 10,00,000 × 40/100 = ₹ 4,00,000
Capital structure after Raising Additional Finance

Sources of fund Amount (₹)
Shareholder’s funds
Equity capital (6,00,000 – 3,00,000) 3,00,000
Retained earnings 3,00,000
Debt at 10% p.a. 1,80,000
Debt at 16% p.a. (4,00,000 – 1,80,000) 2,20,000
Total funds 10,00,000

(ii) Post-tax Average Cost of Additional Debt
Kd = I (1- t), where ‘Kd’ is cost of debt, ‘I’ is interest, and ‘t’ tax rate.
On ₹ 1,80,000 = 10% (1- 0.5) = 5% or 0.05
On ₹ 2,20,000 = 16% (1 – 0.5) =8% or 0.08
Average Cost of Debt (Post tax) i.e.
Kd = \(\frac{(1,80,000 \times 0.05)+(2,20,000 \times 0.08)}{4,00,000} \) = 100 = 6.65%

(iii) Cost of Retained Earnings and Cost of equity Applying Dividend Growth Model
Ke \(\frac{1.3865}{20} \) + g Or \(\frac{D_0(1+g)}{P_0}\) + g
Then, Ke = \(\frac{2 .(1.1)}{44}+0.10=\frac{2.2}{44}+0.010\) = 0.15 or 15 %

(iv) Overall Weighted Average Cost of Capital (WACC) (After Tax)

Particular Amount (₹) Weights Cost of Capital WACC
Equity (including retained earnings) 6,00,000 0.6 15% 9
Debt 4,00,000 0.4 6.65 2.66
Total 10,00,000 1 11.66

Cost of Capital - CA Inter FM Question Bank

Question 29.
As a financial analyst of a large electronics company, you are required to DETERMINE the weighted average cost of capital of the company using (a) book value weights and (b) market value weights. The following information is available for your perusal.
The Company’s present book value capital structure is:
Debentures (₹ 100 per debenture) ₹ 8,00,000
Preference shares (₹ 100 per share) ₹ 2,00,000
Cost of Capital - CA Inter FM Question Bank 30
All these securities are traded in the capital markets. Recent prices are:
Debentures, ₹ 110 per debenture, Preference shares, ₹ 120 per share, and Equity shares, ₹ 22 per share.
Anticipated external financing opportunities are:
(i) ₹ 100 per debenture redeemable at par; 10-year maturity, 11 percent coupon rate, 4 percent flotation costs, sale price, ₹ 100
(ii) ₹ 100 preference share redeemable at par; 10-year maturity, 12 percent dividend rate, 5 percent flotation costs, sale price, ₹ 100.
(iii) Equity shares: 2 per share flotation costs, sale price = ₹ 22.
In addition, the dividend expected on the equity share at the end of the year is ₹ 2 per share, the anticipated growth rate in dividends is 7 percent and the firm has the practice of paying all its earnings in the form of dividends. The corporate tax rate is 35 percent.
Answer:
Cost of Capital - CA Inter FM Question Bank 31
(iii) Cost of Equity shares (Ke) = \(\frac{D_1}{P_0}+G=\frac{₹ 2}{₹ 22-₹ 2}+0.07 \) = 0.07 = 0.17 or 17%
I – Interest, t – Tax, RV- Redeemable value, NP- Net proceeds, N- No. of years, PD- Preference dividend, D1 – Expected Dividend, Po- Price of share (net) Using these specific costs we can calculate WACC on the basis of book value and market value weights as follows:
(a) Weighted Average Cost of Capital (K0) based on Book value weights
Cost of Capital - CA Inter FM Question Bank 32
(b) Weighted Average Cost of Capital (KO) based on market value weights:
Cost of Capital - CA Inter FM Question Bank 33

Question 30.
Define the weighted marginal cost of capital schedule for the company, if it raises ₹ 10 crores next year, given the following information:
(a) The amount will be raised by equity and debt in equal proportions;
(b) the company expects to retain ₹ 1.5 crores earnings next year;
(c) The additional issue of equity shares results in the net price per share being fixed at ₹ 32;
(d) The debt capital raised by way of term loans will cost 15% for the first ₹ 2.5 crores and 16% for the next ₹ 2.5 crores. (Nov 2000, 12 marks)
Answer:
Statement showing weighted marginal cost of capital schedule for the company, if it raises ₹ 10 crores next year given the following Information:
Cost of Capital - CA Inter FM Question Bank 34
Working Notes:
1. Cost of equity capital & retained earnings (ke):
k = \(\frac{\mathrm{D} 1}{\mathrm{P}_0}\) +g
Where;
ke = Cost of equity capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of equity shares
g = Growth rate of dividend
Given,
D1; = ₹ 360
P0 = ₹ 40
g = 7%
∴ ke = \(\frac{₹ 3.60}{₹ 40}+0.07 \) = ke = 16%

2. Cost of Preference capital (Kp):
kp = \(\frac{D+\left(\frac{F-P}{n}\right)}{\left(\frac{F+P}{2}\right)} \)
Where,
D = Preference dividend
F = Faæ value of fernce aves
P = Current market price of Preren shares
n = Redemption Period of Preference shares.

Given, D= 11%, F= ₹100, P= ₹ 75 & n= 10 years.
∴ Kp = \(\frac{11+\left(\frac{100-75}{10}\right)}{\left(\frac{100+75}{2}\right)} \times 100 \) = 15.43%

3. Cost of Debentures (kd):
Kd = \(=\frac{r(1-t)\left(\frac{F-P}{n}\right)}{\left(\frac{F+P}{2}\right)} \)
Where, r = Interest on debentures
t = Tax rate applicable to the co.
F = Face value of debentures
P = Current Market Price of debentures
n = Redemption Period of debentures.
Given,
r= 13.5%,t=40%, F= ₹ 100, P= ₹ 80 & n=6 years.
Kd= \(\frac{13.5(1-0.40)+\left(\frac{100-80}{6}\right)}{\frac{100+80}{2}} \times 100 \)
= 12.70%

4. Cost of term loans (kt):
kt = r(1-t)
Where,
r = Rate of Interest on term loans
t =Tax rate applicable to the co.

Given,
r = 15% & t = 40%
∴ kt =15% (1- 0.40) = 9%

5. Cost of fresh equity share (ke):
Ke = \(\frac{D_1}{P}\) + g
Give
D1 = ₹ 3.60,P= ₹ 32 & g = 7%
∴ ke = \(\frac{3.60}{32}\) + 0.07 = 18.25%

6. Cost of debt (Kd):
kd = r(1-t)
(for first ₹ 2.5 crores)
r= 15% & t = 40%
∴ (for the next ₹ 2.5 crores)
r = 16% & t+ 14%
₹ kd = 16% (1- 0.40) = 9.6%

Question 31.
The R & G Company has following capital structure at 31 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 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected to continue:

Year 1995 1996 1997 1998 1999  2000 2001 2002 2003 2004
EPS (₹) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773

The company can issue 14 percent 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 now ordinary share must be sold? Assuming that retained earnings available for next year’s investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital (cost of funds 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. (May 2005, 2 + 1 + 2 + 2 =7 marks)
Answer:
Assumption: The present capital structure is assumed to be optimum
Existing Capital Structure Analysis

Type of capital Amount (₹) Ratio
13% debentures 3,60,000 0.15
11% Preference 1,20,000 0.05
Equity 19,20,000 0.80
24,00,000 1.00

(i) (a) After tax cost of debt = Kd = \(\frac{14}{98}\) × (1 – 0.5) = 0.071 43
After-tax cost of preference capital (new)
Kp = \(\frac{1.20}{9.80}\) = 0.122449

(b) After-tax cost of retained earnings
= g = 0.05 + 12=0.17 (where g is the growth rate)
= 0.05 + 0.12 = 0.17

(ii)
Cost of Capital - CA Inter FM Question Bank 35

(iii) The company can pay the following amount without increasing its Marginal cost of capital without selling the new shares.
Retained earnings = 1.3865 × 2,00,000 = 2,77,300
The ordinary equity (retained earnings in this case) is 80% of the total capital.
Therefore, investment before issuing equity (\(\frac{2,77,300}{80} \times 100 \)) = ₹ 3,46,625

(iv) It the company pay more than ₹ 3,46,625, it will have to issue new shares. The cost of new issue of ordinary share is:
Ke = \(\frac{1.3865}{20}\) + 0.12 = 0.1893
The marginal cost of capital of ₹ 3,46,625
Cost of Capital - CA Inter FM Question Bank 36

Question 32.
The X Company has following capital structure at 31st March 2015 which is considered to be optimum.
14% Debentures ₹ 3,00,000
11 % Preference Shares ₹ 1,00,000
Equity (100000 shares) ₹ 16.00.000
₹ 20,00,000
The company’s share has a current market price of ₹ 23.60 per share. The expected dividend per share next year is 50% of 2015 EPS. The following are the earning per share figure for the company during preceding ten years. The past trends are expected to continue.
Year EPS (₹) Year EPS (₹)
2006 1.00 2011 1.61
2007 1.10 2012 1.82
2008 1.21 2013 1.95
2009 1.33 2014 2.15
2010 1.46 2015 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of debenture is ₹ 96.
Preference share ₹ 9.20 (with dividend of 1.1 per share) were also issued. The company is in 50% tax bracket.
(i) Calculate after-tax cost of
(a) New debt (b) New Preference share (c) New equity share
(consuming new equity from retained earnings)
(ii) Calculate marginal cost of capital when no new shares was issued.
(iii) How much can be spent for capital investment before new ordinary shares must be sold? Assuming the retained earnings for next year’s investment are 50% of 2015.
(iv) What will be the flarginal cost of capital when the funds exceed the amount calculated in (iii) assuming new equity is Issued at ₹ 20 per share? (May 2016, 8 marks)
Answer:
(i) Calculation of after-tax cost of the followings:
(a) New Debentures (Kd) = \(\frac{I(1-t)}{N P}=\frac{₹ 16(1-0.5)}{₹ 96} \times 100\) = 8.33%
New Preference Shares (Kp) = \(\frac{\text { Preference Dividend }}{\text { Net Proceed }} \)
= \(\frac{₹ 1.10}{₹ 9.20} \times 100 \) = 11.96%

(b) Equity Shares (Consuming New Equity from Retained Earnings) (Ke) .
= \(\frac{\text { Expected dividend }\left(D_1\right)}{\text { Current market price }\left(P_\nu\right)} \) + Growth rate (G)
= \(\frac{50 \% \text { of } ₹ 2.36}{₹ 23.60} \times 100+10 \%=5 \%+10 \%\) = 15%

Growth rate (on the basis of EPS) is calculated as below:
\(\frac{\text { EPSin current year – EPSin previousyear }}{\text { EPSin previous year }} \)
= \(\frac{₹ 2.36-₹ 2.15}{₹ 2.15} \times 100 \) = 10% (Approximate 10% figure ¡s taken because of decimal figures)

[Alternative calculation of Growth rate: Growth rate is calculated on basis average growth of EPS i.e. 10 + 10 + 9.92 + 9.77 + 10.27 + 13.04 + 7.14 + 10.25 + 9.76 = 90.15/9 = 10.01 or 10%.
Or,
The EPS for 2006 is given ₹ 1 and whereas for 2015 is given at ₹ 2.36. This has resulted in increase of ₹ 1.36 over a period of 9 years.
The growth rate can be calculated by using formula:
Et = E0(1 +g)t
2.36 = 1 (1 + g)9 using the CVF table, ₹ 1 becomes ₹ 2.36 at the end of 9th year at the compound interest rate of 10%. Therefore, the growth rate is taken at 10%.]

(ii) Marginal Cost of Capital at Existing Capital Structure:

(iii) Company can spend the following amount without increasing its NCC and without selling the new share
Retained earning = 1.18 × 1,00,000 = 1,18,000
The ordinary equity is 80% of total capital. Thus, investment before issuing equity
\(\frac{1,18,000}{80}\) × 100 = 1,47,500

(iv) If the company spends more than ₹ 1,47,500 as calculated in part (iii) above, it will have to issue new shares at ₹ 20 per share.
The cost of new issue of equity shares will be:
Ke = \(\frac{\text { Expected dividend }\left(\mathrm{D}_1\right)}{\text {Current market price }\left(\mathrm{P}_{\mathrm{N}}\right)}+\text { Growth rate }(\mathrm{g})=\frac{50 \% \text { of } ₹ 2.36}{₹ 20} \times 100 \) + 10%
= 5.9% + 10% = 15.9%.
Cost of Capital - CA Inter FM Question Bank 38

Financial Analysis and Planning Ratio Analysis – CA Inter FM Question Bank

Financial Analysis and Planning Ratio Analysis – CA Inter FM Question Bank is designed strictly as per the latest syllabus and exam pattern.

Financial Analysis and Planning Ratio Analysis – CA Inter FM Question Bank

Question 1.
Answer the following:
What is quick ratio? What does it signify? (Nov 2008, 2 marks)
Answer:
Quick ratio also termed as “acid test ratio” is one of the best measures of liquidity.
It is worked out as follows:
Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Quick liabilities }}\)
In the above formula:
Quick Assets = Current Assets – Inventories
Quick liabilities = Current liabilities – Bank Overdraft – Cash credit
Quick ratio of 1:1 is an ideal ratio significance:
It indicates whether the firm is in a position to pay its current liabilities within a month or immediately.

Question 2.
Assuming the current ratio of a Company is 2, STATE in each of the following cases whether the ratio will improve or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of Property Plant and Equipment by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonored
(v) Issue of new shares
Answer:
Current Ratio = \(\frac{\text { Current Assets }(\mathrm{CA})}{\text { Current Liabilities }(\mathrm{CL})} \) =2 i.e. 2: 1

Situation Improve/Decline/No Change Reason
(i) Payment of Current liability Current Ratio will improve Let us assume CA is ₹ 2 lakhs and current CL ₹ 1 lakh. It payment of Current Liability = ₹ 10,000
then, CA = ₹ 1, 90,000 CL = 90,000.
Current Ratio = \(\frac{1,90,000}{90,000} \) =2.11 :1.
When Current Ratio is 2:1 Payment of Current liability will reduce the same amount in the numerator and denominator. Hence, the ratio will improve.
(ii) Purchase of PPE by cash Current Ratio will decline Since the cash being a current asset converted into Property Plant and Equipment, current assets reduced, thus, current ratio will fall.
(iii) Cash collected from Customers Current Ratio will not change Cash will increase and Debtors will reduce. Hence, change in Current Asset.
(iv) Bills Receivable dishonored Current Ratio will not change Bills Receivable will come down and debtors will increase. Hence, no change in Current Assets.
(v) Issue of New Shares Current Ratio will improve As cash will increase, Current Assets will increase and current ratio will increase.

Question 3.
Answer the following:
Explain the need of debt-service coverage ratio. (May 2007, 2 marks)
OR
Answer the following:
How is Debt service coverage ratio calculated? What is its significance? (May 2009, 2 marks)
Answer:
Debt-Service Coverage Ratio:

  • This ratio is the vital indicator to the lender to assess the extent of ability of the borrower to service the loan in regard to timely payment of interest and repayment of principal amount.
  • It shows whether the business is earning sufficient profits to pay not only the interest charges, but also the instalment due of the principal amount.
  • Debt service coverage ratio of 1: 2 is considered ideal by the financial institutions.
    This ratio will enable the lender to take correct view of the borrower’s repayment capacity.
  • The ratio is calculated as follows:
    = \(\frac{\text { Earning available for debt service }}{\text { Interest on loan + Instalment of the principal amount }}\)
  • Where earning available for debt service = Profit after tax + Depreciation + Interest on Loan.

Question 4.
Answer the following:
Comment on the Debt Service Coverage Ratio. (May 2014, 4 marks)
Answer:
Debt Service Coverage Ratio (DSCR): This ratio indicates the liability of the company to repay the interest and the fixed installments on accounts of the debt fund which is there in the capital structure out of the cash profit earned during the current year.

The higher the ratio the better it is. A ratio of less than one may be taken as a sign of long-term solvency problem as it indicates that the firm does not generate cash internally to repay the debt. High credit rating firms target DSCR to be greater than 2 in its entire loan life. High DSCR facilitates the firm to borrow at the most competitive rates. Lenders are interested in this ratio to judge the firm’s ability to pay off current interest and installments. Debt Service Coverage Ratio = \(\frac{\text { Earning available for Debt Service }}{\text { Interest }+ \text { Installment }}\)

Question 5.
Answer the following:
From the information given below calculate the amount of Property Plant and Equipment and Proprietor’s fund.
Ratio of Property Plant and Equipment to proprietors fund = 0.75
Net working capital = ₹ 6,00,000 (Nov 2009, 2 marks)
Answer:
Calculation of PPE and Proprietors Fund = 0.75
Since Ratio of PPE to Proprietor1s Fund = 0.75 proprietor’s Fund
Therefore, Property Plant and Equipment = 0.25 proprietor’s Fund
Net Working capital 6,00,000 = 0.25 Proprietor’s fund
Therefore, Proprietors fund = \(\frac{₹ 6,00,000}{0.25}\) = ₹ 24,00,000
Proprietor’s Fund = ₹ 24,00,000
Since, PPE = 0.75 Proprietor’s Fund
therefore, PPE = 0.75 × 24,00,000 = ₹ 18,00,000
Property Plant and Equipment = ₹ 18,00,000

Question 6.
Answer the following:
What do you mean by Stock Turnover ratio and Gearing ratio? (Nov 2008, 3 marks)
Answer:
Inventory/Stock turn over ratio
It establishes the relationship between the cost of goods sold during the year and average inventory held during the year.

It is calculated as follows:
Inventory/Stock turnover Ratio = \(\frac{\text { Sales/Turnover }}{\text { Average/inventory }}\)

In above formula:
Average inventory = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
This ratio indicates that how fast inventory is sold.

A high ratio is good from the viewpoint of liquidity and a low ratio would indicate that inventory is not sold and remains in godown for a long time.
Note : Turnover is generally taken as cost of goods sold.

Gearing Ratio:
It is also called as “Capital Gearing Ratio”. It shows the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders funds. This ratio indicate how much of the business is funded by borrowing.
It is calculated as follows:
\(\text { Preference Capital }+\frac{\text { Debentures }+ \text { Longtermloans }}{\text { Equity share capital + Reserves and Surplus – Iosses }} \)
This ratio helps to judge the long-term solvency position of a firm.

Question 7.
Discuss any three ratios computed for investment analysis. (Nov 2004, 3 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 1

Question 8.
Discuss the Financial ratios for evaluating company performance on operating efficiency and liquidity position aspects. (Nov 2006, 4 marks)
Answer:
Financial ratios for evaluating company performance on operating efficiency and liquidity position aspects:
1. Operating efficiency: Financial Ratio Analysis helps to determine degree of efficiency and effective utilisation of assets. We measure operational efficiency of an enterprise with the help of activity ratio. It helps to determine solvency position of an enterprise. Following are examples of activity ratio:

  • Capital turn over ratio = \(\frac{\text { Net Sales }}{\text { Capital employed }} \)
  • Total asset turn over ratio = \(\frac{\text { Net Sales }}{\text { Total Assets }} \)
  • Property Plant and Equipment turnover ratio = \(\frac{\text { Net Sales }}{\text { PPE }} \)

2. Liquidity positions :
Ratio analysis also helps to determine liquidity positions. A firm should be able to meet all its short-turn obligations. It is current asset that yields funds in short period. Current assets should not only yield sufficient funds to meet current liabilities as they fall due but also enable the firm to carry on its day-to-day activity. If above qualities are present in an enterprise are then firm can be said to have good liquidity position. Current ratio, liquid ratio, Debt equity ratios mainly used to judge liquidity position. These ratios are particularly useful in credit analysis by banks and other suppliers of short term loans.

Following are the Liquidity Ratios:
Current Ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }} \)
Quick Ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }} \)
Cash Ratio = \(\frac{\text { Cast and Bank Balance }+ \text { Marketable Securities }}{\text { Current Liabilities }}\)

Question 9.
Diagrammatically present the DU PONT CHART to calculate return on equity. (May 2007, 3 marks)
Answer:
Du-Pont Chart was developed by the USA-based company Du-Point. This chart is a chart of financial ratios, which analyses the Net Profit Margin in terms of asset turnout. This chart shows that the ROI is ascertained as a product of Net profit margin ratio and investment turnover ratio. There are three components in the calculation of return on equity using the traditional Du Pont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

Return of Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier)
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 2

Question 10.
How is return on capital employed calculated? What is its significance? (Nov 2008, 2 marks)
Answer:
Return
Return on capital employed = \(\frac{\text { Return }}{\text { Capital employed }} \times 100 \)
Return = Profit after tax
+Tax
+ Interest
+ Nontrading Expenses
– Non-operating incomes

Capital employed = Equity share capital
+ Preference share capital
+ Reserves & surplus + P & L (Cr. Bal.) + Long term loans
+ Debentures
– Non-trading investment – Fictitious Assets
– P & L (Dr. Bal)

Significance of Return on Capital employed:

  1. Overall profitability of the business is highlighted
  2. Comparison of Return on capital employed with rate of interest debt leads to financial leverage.

Question 11.
Discuss the composition of Return on Equity (ROE) using the DuPont model. (May 2009, 3 marks)
Answer:
Composition of Return on Equity using the DuPont Model:
There are three components in the computation of return on equity using the traditional DuPont model – the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company’s return on equity can be discovered and compared to its competitors.

1. Net Profit Margin The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.
Net profit margin = Net Income ÷ Revenue
Net profit margin is a safety cushion; the lower the margin, lesser the room for error.
2. Asset Turnover The asset turnover ratio is a measures of how effectively a company converts s assets into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover.
3. Equity Multiplier It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt.
The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ EquityComputation of Return of Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
Return on Equity = Net profit margin × Asset turnover × Equity multiplier

Question 12.
Explain the following ratios:
(i) Operating ratio
(ii) Price earning ratio (May 2011, 4 marks)
Answer:
(i) Operating Ratio: A ratio that shows the efficiency of a company’s management by comparing operating expense to net sales is classified as an Operating Ratio.
It Is calculated as follows: \(\frac{\text { Operating expenses }}{\text { Net Sales }} \)

The smaller the ratio, the greater the organization’s ability to generate profit if revenues decrease. when using this ratio, however, investors should be aware that it doesn’t take debt repayment or expansion into account.

(ii) Price Earning Ratio: The price earning ratio indicates the expectation of equity investors about earnings of the firm. It relates earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders’ orientation, corporate image, and degree of liquidity.

It is calculated as:
P.E Ratio = \(\frac{\text { Market price per share }}{\text { Earnings per share }} \)

Question 13.
Answer the following:
MNP Limited has made plans for the next year 2010-11. It is estimated that the company wifl employ total assets of ₹ 25,00,000; 30% of assets being financed by debt at an interest cost of 9% p.a. The direct costs for the year are estimated at ₹ 15,00,000 and all other operating expenses are estimated at ₹ 2,40,000. The sales revenue are estimated at ₹ 22,50,000.
Tax rate is assumed to be 40%.
Required to calculate:
(i) Net profit margin
(ii) Return on Assets
(iii) Asset turnover
(iv) Return on equity (Nov 2010, 5 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 3

Question 14.
From the following information, prepare a summarised Balance Sheet as at 31st March 2002:
Working Capital ₹ 2,40,000
Bank overdraft ₹ 40,000
PPE to Proprietary ratio 0.75
Reserves and Surplus ₹ 1.60,000
Current ratio 2.5
Liquid ratio 1.5
(Nov 2002, 6 Marks)
Answer:
Working Notes:
1. Current assets and Current liabilities computation:
=\( \frac{\text {Current assets }}{\text {Current liabilities}} \)= \(\frac{2.5}{1}\)
or, Current assets = 2.5 Current liabilities.
or, Working capital = Current assets – Current liabilities
or, ₹ 2,40,000 = 2.5 C.L. – I. C. L.
or, 1.5 C. L. = ₹ 2,40,000
∴ Current liability – ₹ 1,60,000
& Current assets = 2.5 x 1,60,000 = ₹ 4,00,000

2. Computation of stock:
Liquid Ratio = \(\frac{\text { Liquid Assets }}{\text { Current Liabilities }} \)
Or 1.5 = \(=\frac{\text { Current assets – stock }}{₹ 1,60,000}\)
1.5 x 1,60,000 = 4,00,000 – Stock
2,40,000 = 4,00,000 – Stock
∴ Stock = 4,00,000 – 2,40,000 = 1,60,000

3. Computation of Proprietary Fund PPE, creditors & capital:
Proprietary fund = \(\frac{\text { PPE }}{\text { Proprietary Fund }}\) = 0.75
PPE = 0.75 Proprietary fund
& Net working capital = 0.25 Proprietary fund
or, 2,40,000/0.25 = Proprietary fund
Proprietary fund = ₹ 9,60,000
PPE = 0.75 Proprietary fund
= 0.75 × 9,60,000
=₹ 7,20,000
Capital = Proprietary fund – Reserve & surplus
= 9,60,000 – 1,60,000
= ₹ 8,00,000
Sundry Creditors = Current Liabilities – Bank overdraft = 1,60,000 – 40,000 = ₹ 1,20,000
Construction of Balance sheet:
(ReferW.N. 1.3)
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 4

Question 15.
With the help of the following information complete the Balance Sheet of MNOP Ltd.
Equity share capital ₹ 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 40
Total debt to owner’s equity 60
Property Plant and Equipment to owner’s equity 60
Total assets turnover 2 Times
Inventory turnover 8 Times
(May 2005, 7 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 5
Working Notes:
1. Property Plant and Equipment = 0.60 × Owners equity = 0.60 × ₹ 1,00,000 = ₹ 60,000
2. Total equity = Total debt + Owners equity = ₹ 60,000 + ₹ 1,00,000 = ₹ 1,60,000
3. Total assets consisting of PPE and current assets must be equal to ₹ 1,60,000 (Assets = Liabilities + Owners equity). Since PPE are ₹ 60,000 hence, current assets should be ₹ 1,00,000.
4. Total debt = 0.60 × Owners equity = 0.60 × ₹ 1,00,000 = ₹ 60,000
5. Total assets tumover= 2 Times: Inventory turnover = 8 Times Therefore,
Inventory! Total assets = 2/8 = 1/4, Total assets = 1,60,000
Therefore, Inventory = 1,60,000/4 = 40,000 Cash = 1,00,000 – 40,000 = 60,000

Question 16.
Using the following data, complete the Balance Sheet given below:
Gross Profits ₹ 54,000
Shareholders Funds ₹ 6,00,000
Gross Profit Margin 20%
Credit sales to Total sales 80%
Total Assets turnover  0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8
Long-term Debt of Equity 40%
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 6
(Nov 2005, 12 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 7
Working Notes:
1. Gross Profit:
GP margin = 20%
GP = ₹ 54,000
∴ Sales = ₹ 2,70,000

2. Credit Sales:
Cr. Sales = 80% of Total Sales
= 2,70,000 × 80%
= ₹ 2,16,000

3. Total Assets:
Total Assets Turnover = \(\frac{\text { Sales }}{\text { Total Assets }}\) = 0.3 times
∴ Total Assets = \(\frac{2,70,000}{0.3}\)
= ₹ 9,00,000

4. Inventory Turnover:
Inventory Turnover = \(\frac{\text { Cash }}{\text { Inventory }} \times 100\)
∴ 4 = \(\frac{2,70,000-54,000}{\text { Inventory }} \)
∴ Inventory = ₹ 54,000

5. Debtors:
Debtors = \(\frac{\text { Credit Sales } \times 20 \text { days }}{360 \text { days }} \)
= \(2,16,000 \times \frac{20}{360} \text { days }\)
= ₹ 12,000

6. Creditors:
Total Assets = 9,00,000
∴ Total of Balance Sheet = 9,00,000
Now, Long Term Debt
∴ \(\frac{\text { Long Term Debt }}{\text { Equity }}\) = 40%

Long term Debt = 40% of equity
= 6,00,000 x 40%
= ₹ 2,40,000

Now Balancing figure of the Liability Side is creditors:
= 9,00,000 – 6,00,000 (Equity) – 2,40,000 (Long Term Debt)
= 60,000
∴ Creditors = ₹ 60,000

7. Current Ratio-Cash:
Current ratio = \(\frac{\text { Current Assets }}{\text { Current Liabilities }} \)
∴ 1.8 = \(\frac{\text { Debtors }+ \text { Inventory }+ \text { Cash }}{\text { Creditors }} \)
∴ 1.8 = \(\frac{12,000+54,000+\text { Cash }}{60,000} \)
∴ 1,08,000 = 66,000+Cash
∴ Cash = 42,000

8. Property Plant and Equipment:
The balancing figure on the Assets Side is Property Plant and Equipment.

9. Sales:
G.P. = COGS
∴ COGS = ₹ 2,70,000 – 54,000 = ₹ 2,16,000

Question 17.
JKL Limited has the following Balance Sheets as on March 31, 2006, and March 31, 2005:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 8
Required:
(i) Calculate for the year 2005-06:
(a) inventory turnover ratio
(b) Financial Leverage
(c) Return on Investment (ROI)
(d) Return on Equity (ROE)
(e) Average Collection period. (May 2006, 10 marks)
(ii) Give a brief comment on the Financial Position of JKL Limited. (May 2006,2 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 9

(ii) Financial position of JKL Limited:
A careful analysis of above balance sheet shows that current ratio of company ¡s 1.5 which ¡s less than current ratio (i.e. 2) and short-term solvency ratio is therefore not satisfactory. At the same time lot of capital is blocked in inventory as compared to previous year. This affects liquidity of the firm, As regards utilisation of Debt Capital, the percentage of debts to total assets is not high, but as compared to equity, debt content is more in capital structure. Company is said to be leveraged with higher proportion of debt in its capital structure. This situation involves considerable risk to shareholders. In capital structuring, the company should ensure that cost of debt remains lower than return on investment.

Question 18.
The Balance Sheet of X Ltd. as on 31st March 2007 is as follows:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 10
The following additional information is available:
(i) The stock turnover ratio based on cost of goods sold would be 6 times.
(ii) The cost of PPE to sales ratio would be 1.4.
(iii) PPE costing ₹ 30,00,000 to be installed on 1st April, 2007, payment would be made on March 31, 2008.
(iv) In March 2008, a dividend of 7 percent on equity capital would be paid.
(v) ₹ 5,50,000, 11% Debentures would be issued on 1st April, 2007.
(vi) ₹ 30,00,000, Equity shares would be issued on 31st March, 2008.
(vii) Creditors would be 25% of materials consumed.
(viii) Debtors would be 10% of sales.
(ix) The cost of goods soId would be 90 percent of sales include material 40 percent and depreciation 5 percent of sales.
(x) The profit is subject to debenture interest and taxation @ 30 percent.
Required:
(i) Prepare the projected Balance Sheet as on 31st March, 2008.
(ii) Prepare projected Cash Flow Statement in accordance with AS -3. (Nov 2007, 10 + 5 = 15 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 12

Question 19.
The following figures and ratios are related to a company:
(i) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 percent
(iii) PPE turnover (basis on cost of goods sold) 1.5
(iv) Stock turnover (basis on cost of goods sold) 6
(v) Liquid ratio 1: 1
(vi) Current ratio 1.5: 1
(vii) Debtors collection period 2 months
(viii) Reserve and surplus to Share capital 0.6: 1
(ix) Capital gearing ratio 0.5
(X) PPE to net worth 1.20:1
You are required to prepare:
(a) Balance Sheet of the company on the basis of above details. (May 2010, 11 marks)
(b) The statement showing Working capital requirement, if the company wants to make a provision for contingencies @ 10 percent of net working capital including such provision. (May 2010, 4 marks)
Answer:
(a) Preparation of Balance Sheet of a Company
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (= 25% of Sales)
= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000

(ii) Closing Stock = Cost of Goods Sold/Stock Turnover
= ₹ 22,50,000/6
= ₹ 3,75,000

(iii) Property Plant and Equipment = Cost of Goods Sold/PPE Turnover
= ₹ 22,50,000/1.5
= ₹ 15,00,000

(iv) Current Assets:
Current Ratio = 1.5 and Liquid Ratio = 1
Stock = 15-1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= 3,75,000 × 1.5/0.5= ₹ 11,25,000

(v) Liquid Assets (Debtors and Cash)
= Current Assets – Stock
= ₹ 11,25,000 – ₹ 3,75,000
= ₹ 7,50,000

(vi) Debtors = Sales x Debtors Collection period/12
= ₹ 30,00,000 × 2/12
= ₹ 5,00,000

(vii) Cash = Liquid Assets – Debtors
= ₹ 7,50,000 – ₹ 5,00,000
= ₹ 2,50,000

(viii) Net worth = PPE/1 .2
= ₹ 15,00,000/1.2 = ₹ 12,50,000

(ix) Reserves and Surplus
Reserves and
Share Capital = 0.6 + 1 = 1.6
Reserves and Surplus = ₹ 12,50,000 × 0.6/1.6
= ₹ 4,68,750

(x) Share Capital = Net worth – Reserves and Surplus
= ₹ 12,50,000 – ₹ 4,68,750
= ₹ 7,81,250

(xi) Current Liabilities = Current Assets/Current Ratio
= ₹ 11,25,000/1.5 = ₹ 7,50,000

(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts /Equity Shareholders’ Fund
Long-term Debts = ₹ 12,50,000 × 0.5
= ₹ 6,25,000
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 13

Question 20.
The financial statements of a company contain the following information for the year ending 31st March 2011 :
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 14
You are required to calculate:
(i) Quick Ratio
(ii) Debt-equity Ratio
(iii) Return on Capital Employed, and
(iv) Average collection period (Assuming 360 days in a year). (Nov 2011, 8 marks)
Answer:
Quick Assets
(i) Quick ratio = \(\frac{\text { Quick Assets }}{\text { Current Liabilities }} \)
Quick Assets = Current Assets – Stock- Prepaid Expenses
= 30,50,000 – 21,60,000 – 10,000
Quick Assets = 8,80,000
Quick Ratio = 8,80.000/10,00,000 = 0.88:1

(ii) Debt-Equity Ratio = \(\frac{\text { Longtermdebt }}{\text { ShareholdersFunds }} \)
= \(\frac{16,00,000}{(20,00,000+8,00,000)}\)
= 0.57:1

(iii) Return on Capital Employed (ROCE)
ROCE = \(\frac{\text { PBIT }}{\text { CapitalEmployed }} \times 100 \)
Capital Employed loo
= \(=\frac{12,00,000}{44,00,000} \times 100 \) = 27.27%

(iv) Average Collection Period
= \(\frac{\text { Sundry Debtors }}{\text { Credit Sales }} \times 360 \)
= \(\frac{4,00,000}{32,00,000} \times 360\)
= 45 Days

Question 21.
The following accounting information and financial ratios of M Limited relate to the year ended 31st March. 2012:
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%
Total sales ₹ 30,00,000: cash sales 25% of credit sales; cash purchases ₹ 2,30,000; working capital ₹ 2,80,000; closing inventory is ₹ 80,000 more than opening inventory.
You are required to calculate:
(i) Average Inventory
(ii) Purchases
(iii) Average Debtors
(iv) Average Creditors
(v) Average Payment Period
(vi) Average Collection Period
(vii) Current Assets
(viii) Current Liabilities (Nov 2012, 8 marks)
Answer:
(i) Computation of Average Inventory
Gross Profit = 25% of 30,00,000
Gross Profit 7,50,000
Cost of goods sold (COGS) = 30,00,000 – 7,50,000
COGS = 22,50,000
Inventory Turnover Ratio = \(\frac{\text { COGS }}{\text { Average Inventory }} \)
6 = \(\frac{22,50,000}{\text { Average Inventory }}\)
Average inventory = 3,75,000

(ii) Computation of Purchases
Purchases = COGS + increase in Stock
= 22,50,000 + 80,000
Purchases = 23,30,000

(iii) Computation of Average Debtors
Let Credit Sales be 100
∴ Cash sales = \(\frac{25}{100} \times 100 \)
∴ Total Sales = 100 + 25 = 125
If Then Total Sales = Credit Sales
125 = 100
30,00,000 = \frac{30,00,000}{125} \times 100 = 24,00,000
Credit Sales = 24,00,000
Cash Sales = 6,00,000
Now Debtors Turnover Ratio = \(\frac{\text { Net Credit Sales }}{\text { Average debtors }}\) = 8
or Debtor Turnover Ratio = \(\frac{24,00,000}{\text { Average debtors }}\) = 8
or Average Debtors = \(\frac{24,00,000}{8}\)
∴ Average Debtors = 3,00,000

(iv) Computation of Average Creditors
Credit Purchases = Purchases – Cash Purchases
= 23,3000 – 2,30000
= 21,00,000

Now Creditors Turnover Ratio = \(\frac{\text { Credit Purchases }}{\text { Average Creditors }} \)
∴ 10 = \(\frac{21,00,000}{\text { Average Creditors }} \)
or Average Creditor = 2,10,000

(v) Computation of Average Payment Period
Average Payment Period = 365/Creditors Turnover Ratio
= \(\frac{365}{10}\)
= 36.5 days
Average payment period = 365 days

(vi) Computation of Average Collection Period
Average collection period = 365/ Debtors Turnover Ratio
= \(\frac{365}{8} \) = 45.625 days
Average collections period = 45.625 days

(vii) Computation of Current Assets
Current Ratio = \(\frac{\text { Current Assets }(C A)}{\text { Current Liabilities }(C L)}\)
or 2.4 = \(\frac{\mathrm{CA}}{\mathrm{CL}} \)
or CL = \(\frac{\mathrm{CA}}{2.4} \)
Working capital = Current Assets – Current liabilities
2,80,000 = \(\quad(\mathrm{CA})-\left(\frac{\mathrm{CA}}{2.4}\right) \)
2,80,000 = \(\frac{1.4 \mathrm{CA}}{2.4}\)
or CA = 4,80,000

(viii) Computation of Current Liabilities
Current liabilities = \(\frac{4,80,000}{2.4}\) = 2,00,000

Question 22.
Answer the following:
The following information relates to Beta Ltd. for the year ended 31st March 2013:
Net Working Capital ₹ 12,00,000
PPE to Proprietor’s Fund Ratio 0.75
Working Capital Turnover Ratio 5 Times
Return on Equity (ROE) 15%
There is no debt capital.
You are required to calculate:
(i) Proprietor’s Fund
(ii) Property Plant and Equipment
(iii) Net Profit Ratio. (May 2013, 5 marks)
Answer:
(i) Calculation of Proprietor’s Fund
Since Ratio of PPE to Proprietor’s Fund = 0.75
Therefore, PPE = 0.75 Proprietor’s Fund
Net Working Capital = 0.25 Proprietor’s Fund
12,00,000 = 0.25 Proprietor’s Fund
Therefore, Proprietors Fund = \(\frac{12,00,000}{0.25} \) = 48,00,000

(ii) Calculation of Property Plant and Equipment
PPE = 0.75 Proprietor’s Fund
= 0.75 × 48,00.000
= 36,00,000

(iii) Calculation of Net Profit Ratio
Net Working Capital = 0.25 × 48,00,000
= 12,00,000

Work no Capital’ Turnover Ratio = \(\frac{\text { Sales }}{\text { WorkingCapital }} \)
Sale = 60,00,000
ROE = \(\frac{\text { PAT }}{\text { Equity }}\)
015 = \(\frac{\text { PAT }}{48,00,000} \)
PAT = 7,20,000
Net Profit Ratio = \(\frac{\text { NetProfit }}{\text { Sales }} \times 100 \)
= \(\frac{7,20,000}{60,00,000} \times 100\)
Net Profit Ratio = 12%

Alternative Treatment:
PPE may be computed alternatively by (Proprietor’s fund × PPE to Proprietor’s Fund Ratio) and Proprietor’s Fund by (PPE + Net Working Capital.)

Question 23.
The assets of SONA Ltd. consist of Property Plant and Equipment and current assets, while its current liabilities comprise bank credit in the ratio of 2:1. You are required to prepare the Balance Sheet of the company as on 31st March 2013 with the help of following information:
Share Capital – ₹ 5,75,000
Working capital (CA-CL) – ₹ 1,50,000
Gross Margin – 25%
Inventory Turnover – 5 times
Average Collection Period – 1.5 months
Current Ratio – 1.5:1
Quick Ratio – 0.8:1
Reserves & Surplus to Bank & Cash – 4 times (Nov 2013, 8 Marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 15
Working Note:
1. Current ratio =\(\frac{\text { CurrentAssets }}{\text { CurrentLiabilities }} \) = 1.5 times.
Current Liabilities
Therefore, Current Asset = 1.5 × Current Liabilities

2. Net working capital = Current Assets – Current Liabilities
= 1.5 × CL – CL = 1,50,000
= 0.5 CL = 1,50,000

CL = \(\frac{1,50,000}{0.5}\) = 300000 .
Bank Credit and creditors divided in 2: 1 ratio, 2,00,000 & 1,00,000.

3. Current Assets = 1.5 × Current Liabilities = 1.5 × 3,00,000 = 4,50,000.

4. Quick ratio = \(\frac{\text { QuickAssets }}{\text { CurrentLiabilities }} \) = 0.8 times
∴ \(\frac{\text { Current Assets-Stock }}{\text { CurrentLiabilities }}=0.8\)
So, \(\frac{4,50,000-\text { Stock }}{3,00,000}=0.8 \)
Stock = 2,10,000

5. Inventory Turnover = \(\frac{\text { COGS }}{\text { Stock }}=\frac{\text { COGS }}{2,10,000}\) = 5 times.
So, COGS = 2,10,000 × 5 = 10,50,000

6. Since the Gross Margin is 25%, COGS constitutes 75% of sales.
So, Sales = \(\frac{10,50,000}{75 \%}\) = 14,00,000.

7. Debtors Sales × \(\frac{1.5}{12}\) = 1,75,000.

8. Cash & 3ank = Total current assets – stock – debtors
= 4,50,000 – 2,10,000 – 1,75,000 = 65,000.

9. \(\frac{\text { Reserves& Surplus }}{\text { Cash&Bank }} \) = 4 times
So, R & S = 65,000 × 4 = 2,60,000.

Question 24.
NOOR Limited provides the following information for the year ending 31st March 2014:
Equity Share Capital ₹ 25,00,000
Closing Stock ₹ 6,00,000
Stock Turnover Ratio 5 times
Gross Profit Ratio 25%
Net Profit / Sale 20%
Net Profit / Capital \(\frac{1}{4}\)
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March 2014. (May 2014, 5 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 16
Working Note:
1. Calculation of Net Profit:
Net profit/capital = 1/4
∴ \(\frac{N P}{25,00,000}=\frac{1}{4}\)
∴ 4 NP = 25,00,000
∴ NP = 6,25,000

2. Calculation of Sales:
Net profit/sales = 20%
∴ Sales =\(\frac{NP}{20 \%}=\frac{6,25,000}{20 \%} \) = ₹ 31,25,000

3. Calculation of GP:
GP Sales x 25% = 31,25,000 x 25% = ₹ 7,81,250

4. Calculation of Opening Stock:
Stock Turnover Ratio = \(\frac{\text { COGS }}{\text { Avg.Stock }} \)
∴ Avg. Stock = \(\frac{23,43,750}{5}\)
∴ Avg. Stock = 4,68,750
∴ \(\frac{\text { Op. Stock }+\mathrm{Cl} \text {. Stock }}{2}\) = 4,68,750
∴ \(\frac{\text { Op. Stock }+6,00,000}{2}\) = 4,68,750
∴ Op. Stock = 9,37,500 – 6,00,000
∴ Op. Stock = 3,37,500

5. Calculation of Purchase:
Purchase = COGS + Closing Stock – Opening Stock
= 23,43,750 + 6,00,000 – 3,37,500
= ₹ 26,06,250

Question 25.
From the following information, prepare Balance Sheet of a firm:
Stock Turnover Ratio (based on cost of goods sold) – 7 times
Rate of Gross Profit to Sales – 25%
Sales to Property Plant and Equipment – 2 times
Average debt collection period – 1.5 months
Current Ratio – 2
Liquidity Ratio – 1.25
Net Working Capital – ₹ 8,00,000
Net Worth to Property Plant and Equipment – 0.9 times
Reserve and Surplus to Capital – 0.25 times
Long Term Debts – Nil
All Sales are on credit basis (Nov 2014, 8 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 17
Note: 1 Net Working Capital
₹ 8,00,000 = Current assets – Current liabilities
₹ 8,00,000 = 2CL – CL
CL = 8,00,000
CA =2CL
= 2 (8,00,000)
CA =16,00,000

Note: 2 Liquid Ratio
125 = \(\frac{\mathrm{CA}-\text { Stock }}{\mathrm{CL}} \)
125 = \(\frac{16,00,000-\text { Stock }}{8,00,000} \)
∴ Stock = 16,00,000 – 10,00,000
∴ Stock=₹ 6,00,000

Note: 3 Stock Turnover ratio
7 times = \(\frac{\text { COGS }}{\text { Avg.Stock }}\)
Absence of information about opening Stock considering closing stock as Avg.
7 = \frac{\text { COGS }}{6,00,000}
COGS = 42,00,000
GP = COGS × 33.33%
= 42,00,000 × 33.3%
GP =14,00,000
Sales COGS + GP
= 42,00,000 + 14,00,000
Sales = ₹ 56,00,000

Note: 4 Sales to Property Plant and Equipment
2 = \(\frac{\text { Sales }}{F A} \)
∴ FA = \(\frac{56,00,000}{2} \)
∴ F.A. = 28,00,000

Note: 5 Net worth
Networth Total Assets – CL
= 28,00,000 + 16,00,000 – 8,00,000
= ₹ 36,00,000

Capital = \(\frac{36,00,000}{1.25} \) = ₹ 28,80,000
R&S = 28,80,000 × 0.25 = ₹ 7,20,000.

Question 26.
SSR Ltd. has furnished the following ratios and information relating to the year ended 31st March, 2015.
Sales ₹60 Lacs
Return on Net worth 25%
Rate of Income tax 50%
Share Capital to Reserves 7: 3
Current Ratio 2
Net-Profit to Sales (after tax) 6.25%
Inventory Turnover 12
(Based on cost of goods sold and closing stock)
Cost of goods sold ₹ 18 Lacs
interest on Debentures (@ 15%) ₹ 60,000
Sundry Debtors ₹ 2 Lacs
Sundry Creditors ₹ 2 Lacs
You are required to:
(i) Calculate the operating expenses for the year ended 31st March, 2015.
(ii) Prepare a Bance Sheet as on 31 March. 2015. (May 2015, 8 marks)
Answer:
Workings:
1. Net Profit = 6.25% of 60,00,000 = ₹ 3,75,000
2. Net worth = ₹ 3,75,000 × \(\frac{100}{25}\) = ₹ 15,00,000
Share Capital = ₹ 15,00,000 × \(\frac{7}{10}\) = ₹ 10,50,000
Reserve = ₹ 15,00,000 × \(\frac{3}{10}\) = ₹ 4,50,000
Debentures = ₹ 60,000 × \(\frac{100}{15}\) = ₹ 4,00,000

3. Sundry Creditors = ₹ 2,00,000
Current Ratio = \(=\frac{\text { Current Assets }}{\text { Current Liabilities }} \) = 2
Current Assets = 2 Current Liabilities
2 × ₹ 2,00,000 (assumed creditors is the only current liabilities) = ₹ 4,00,000

4. Inventory Turnover =\(\frac{\text { Cost of Goods Sold }}{\text { ClosingStock }} \) = 12
Hence, Closing Stock = \(\frac{₹ 18,00,000}{12} \) = 1,50,000
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 18

Question 27.
VRA Limited has provided the following information for the year ending 31st March 2015.
Debt Equity Ratio 2: 1
14% long-term debt ₹ 50,00,000
Gross Profit Ratio 30%
Return on equity 50%
Income Tax Rate 35%
Capital Turnover Ratio 1.2 times
Opening Stock ₹ 4,50,000
Closing Stock 8% of sales
You are required to prepare Trading and Profit and Loss Account for the year ending 31st March, 2015. (Nov 2015, 8 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 19
Working Note:
Debt Equity Ratio = 2:1, \(\frac{\text { Debt }}{\text { Equity }}=\frac{2}{1} \)
Equity = \(\frac{₹ 50,00,000}{2} \) = ₹ 25,00,000

Return on Equity = \(\frac{\text { Net Profit after tax (PAT) }}{\text { Equity }} \) = 50%
25,00,000 × 50% = 12,50,000

Net Profit before tax = ₹ 12,50,000 × \(\frac{100}{65} \) = ₹ 19,23,077
Tax = ₹ 19.23,077 – 12,50,000 = ₹ 6,73,077
Capital Turnover Ratio = \(\frac{\text { Sales }}{\text { Capital }} \) = 1.2
Or, \(\frac{\text { Sales }}{(₹ 25,00,000+₹ 50,00,000)}\) = 1.2
So, Sales = ₹ 75,00,000 x 1.2 = ₹ 90,00,000
Closing Stock = ₹ 90,00,000 x 8% = ₹ 7,20,000
Gross Profit = ₹ 90,00,000 x 30% = ₹ 27,00,000

Question 28.
With the following ratios and further information given below prepare a Trading Account, Profit and Loss Account and Balance Sheet of ABC Company.
Property Plant and Equipment ₹ 40,00,000
Closing stock ₹ 4,00,000
Stock turnover ratio 10
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Property Plant and Equipment to capital 5/4
PPE/Total current assets 5/7 (May 2016, 8 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 20
Working Notes:
(i) \(\frac{\text { Property Plant and Equipment }}{\text { Total Current Asset }}=\frac{5}{7}\)
\(\frac{40,00,000}{\text { Total Current Asset }} \quad=\frac{5}{7}\)
∴ Total Current asset = 56,00,000

(ii) \(\frac{\text { Property Plant and Equipment }}{\text { Capital }}=\frac{5}{4}\)
\(\frac{40,00,000}{\text { Capital }}=\frac{5}{4} \)
∴ Capital = 32,00,000

(iii) \(\frac{\text { Capital }}{\text { Total Liabilities }} \quad=\frac{1}{2} \)
\(\frac{32,00,000}{\text { Total Liabilites }}=\frac{1}{2}\)
∴ Total Liabilites = 64,00,000

(iv) \(\frac{\text { NetProfit }}{\text { Capital }} \quad=\frac{1}{5}\)
\(\frac{\text { Net Profit }}{32,00,000} \quad=\frac{1}{5} \)
∴ Net Profit = 6,40,000

(v) Net Profit Ratio = \(\frac{\text { Net Profit }}{\text { Sales }} \times 100 \)
20 = \(\frac{6,40,000}{\text { Sales }} \times 100\)
∴ Sales = 32,00,000

(vi) Gross Profit Ratio = \(\frac{\text { Gross Profit }}{\text { Sales }} \times 100 \)
25 = \(\frac{\text { GrossProfit }}{32,00,000} \times 100 \)
∴ Gross Profit = 8,00,000

(vii) Cost of Goods Sold = Sales – GP
= 32,00,000 – 8,00,000
= 24,00,000

(viii) Stock T/O Ratio = \(\frac{\text { COGS }}{\text { AverageStock }} \)
10 = \(\frac{24,00,000}{\text { Average Stock }} \)
∴ Average Stock = 2,40,000

(ix) Average Stock = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
2,40,000 = \(\frac{\text { Opening Stock }+4,00,000}{2} \)
∴ Opening Stock = 80,000

(x) Cost of Goods Sold = Opening Stock + Purchase – Closing Stock
24,00,000 = 80,000 + purchase – 4,00,000
∴ Purchase = 27,20,000

Question 29.
The following figures and ratios pertain to ABG Company Limited for the year ending 31st March, 2016:
Annual Sales (credit) ₹ 50,00,000
Gross Profit Ratio 28%
PPE turnover ratio (based on cost of goods sold) 1.5
Stock turnover ratio (based on cost of goods sold) 6
Quick ratio 1: 1
Current ratio 1 .5
The debtor’s collection period is 45 days
Reserves and surplus to Share Capital 0.60: 1
Capital gearing ratio 0.5
Property Plant and Equipment to net worth 1.2: 1
You are required to prepare the Balance Sheet as at 31st’ March 2016 based on the above information. Assume 360 days in a year. (Nov 2016, 8 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 21
Working Notes:
Calculation of Debtors:
Average collection period = 45 days.
∴ Debtors T/O Ratio =\(\frac{360}{45} \) = 8
∴ Debtors = \(\frac{\text { Credit Sales }}{\text { Debtors } \mathrm{T} / \mathrm{O}} \)
= \(\frac{₹ 50,00,000}{8} \) = ₹ 6,25,000

2. Calculation of Property Plant and Equipment:
PPE = \(\frac{\text { COGS }}{\text { PPE }} \)
∴ 1.5 = \(\frac{36,00,000}{F A} \)
∴ FA = ₹ 24,00,000.

3. Calculation of Working Capital:
PPE to Networth = 1.2
∴ \(\frac{\mathrm{PPE}}{\mathrm{NW}} \quad=\frac{1.2}{1}\)
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 22
∴ Working Capital = ₹ 24,00,000 × 0.2
= ₹ 4,80,000.

4. Current Assets: Current Ratio
= 1.5 and Liquid Ratio 1
Stock =1.5-1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= 6,00,000 × 1.5/0.5 = ₹ 18,00,000

5. Current Liabilities
= Current Assets / Current Ratio
= ₹ 18,00,000/1.5 = ₹ 12,00,000

6. Liquid Assets (Debtors and Cash and cash equivalents)
= Current Assets – Stock
= ₹ 18,00,000 – ₹ 6,00,000
= ₹ 12,00,000

7. Reserves and Surplus
Reserves & Surplus and Share Capital = 0.6 + 1 =1.6
Reserves and Surplus = ₹ 20,00,000 × 0.6/1.6 = ₹ 7,50,000
Share Capital = Net worth – Reserves and Surplus
= ₹ 20,00,000 – ₹ 7,50,000
= ₹ 12,50,000

8. Net Worth
= Property Plant and Equipment / 1.2
= ₹ 24,00,000/1.2
= ₹ 20,00,000

9. Cash & Cash equivalents
= Liquid Assets – Debtors
= ₹ 12,00,000- ₹ 6,25,000
= ₹ 5,75,000

10. Long-term Debts
Capital Gearing Ratio = Long-term Debts/ Equity Shareholders’ Fund (New worth)
Or, Long term Debts = ₹ 20,00,000 x 0.5 = ₹ 10,00,000.

Question 30.
Following information relates to a concern:
Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables ₹ 25,000
Bills Payables ₹ 10,000
Gross Profit ₹ 4,00,000
PPE to turnover Ratio 4
Closing stock of the period is ₹ 10,000 above the opening stock.

Find out:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Sundry Creditors
(iv) Closing Stock
(v) Property Plant and Equipment (May 2017, 8 marks)
Answer:
1. Sales and COGS:
GP. Ratio = \(\frac{\text { Gross Profit }}{\text { Sales }} \times 100 \)
25 = \(\frac{4,00,000}{\text { Sales }} \times 100 \)
Sales = \(\frac{4,00,000 \times 100}{25}\)
∴ Sales = 16,00,000
COGS = Sales – Gross Profit
= 16,00,000 – 4,00,000
∴ COGS = 12,00,000

2. Sundry Debtors:
Debtors Velocity = \(\frac{\text { Debtors }}{\text { Sales }} \times 100 \)
3 = \(\frac{\text { Debtors }}{16,00,000} \times 12\)
Debtors = \(\frac{16,00,000 \times 3}{12}\)
∴ Debtors = 4,00,000
Now S. Debtors + OR = 4,00,000
∴ S. Debtors 4,00,000 -25,000 = 3,75,000

3. Sundry Creditors COGS = Opening Stock + Purchase – Closing Stock
12,00,000 = 7,95,000 + Purchase – 8,05,000
∴ Purchase = 12,10,000

Creditors Velocity = \(\frac{\text { Creditors }}{\text { Purchase }} \times 12 \)
2 = \(\frac{\text { Creditors }}{12,10,000} \times 12 \)
Creditors = \(\frac{12,10,000 \times 2}{12} \)
∴ Creditors = 2,01,667
Now S. Creditors + BP = 2,01,667
∴ S. Creditors = 2,01,667 – 10,000 = 1,91,667

4. Closing Stock
Stock Turnover Ratio = \(\frac{\text { COGS }}{\text { AverageStock }} \)
1.5 = \(\frac{12,00,000}{\text { Average Stock }}\)
Average Stock = 8,00,000
Average Stock = \(\frac{\text { Opening Stock }+ \text { Closing Stock }}{2} \)
8,00,000 = \(\frac{\text { Opening Stock }+(\text { Opening Stock }+10,000)}{2} \)
16,00,000 = 2 Opening Stock + 10,000
Opening Stock = 7,95,000
Closing Stock Opening Stock + 10,000
= 7,95,000 + 10,000
∴ Closing Stock = 8,05,000

5. Property Plant and Equipment
PPE TR= \(\frac{\text { COGS }}{\text { Property Plant Equipment }} \)
4 = \(\frac{12,00,000}{\text { PropertyPlant and Equipment }} \)
Property Plant and Equipment = 3,00,000

Question 31.
XY Ltd. provides the following information for the year ending 31st March 2017:
Equity Share Capital ₹ 8,00,000
Closing Stock ₹ 1,50,000
Stock Turnover Ratio 5 times
Gross profit ratio 20%
Net profit/Sales 16%
Net profit/Capital 25%
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March 2017. (Nov 2017, 8 marks)
Answer:
Working Notes:
(1) \(\frac{\text { Net Profit }}{\text { Capital }}=\frac{25}{100}\)
\(\frac{\text { NetProfit }}{8,00,000}=\frac{1}{4} \)
Net profit = \(\frac{8,00,000}{4} \) = 2,00,000

(2) \(\frac{\text { Net Profit }}{\text { Sales }}=16 \%\)
Sales = \(\frac{2,00,000}{16 \%}\) = 12,50,000

(3) Gross Profìt Rates = \(\frac{\text { G.P. }}{\text { Sales }} \times 100\) = 20%
Gross Profit = 12,50,000 x \(\frac{20}{100} \) = 2,50,000

(4) Stock Turnover = \(\frac{\text { COGS }}{\text { Average stock }} \)
5 = \(\frac{12,50,000-2,50,000}{\text { Averagestock }} \)
Average Stock = \(\frac{10,00,000}{5} \) = 2,00,000
Average Stock = \(\frac{\text { Opening }+ \text { Closing stock }}{2} \)
Opening Stock = 2,00,000 × 2 – 1,50,000 = 2,50,000
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 23

Question 32.
The accountant of Moon Ltd. has reported the following data:
Gross Profit ₹ 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days
Assume 360 days in a year
You are required to complete the following:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 24
(May 2018, 5 marks)
Answer:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 25
Working Notes:
Sales = Gross Profit/Gross Profit Margin
= 60000/0.2 = ₹ 3,00,000
Total Assets = Sales/Total Asset Turnover
= 3,00,000/0.3 = ₹ 10,00,000
Net Worth = 0.9× Total Assets
0.9 x 10,00,000 = ₹ 9,00,000

Current Liability = Total Assets – Net Worth
= ₹ 10,00,000 – ₹ 9,00,000
= ₹ 1,00,000

Current Assets = 1.5 × Current Liability
= 1.5 × 1,00,000 = ₹ 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets/Current Liabilities = 1)
= 1,50,000 – (LA/1 ,00,000 = 1) = ₹ 50,000
Debtors = Average Collection Period × Credit Sales/360
= 60 × 0.8 × 3,00,000/360 = ₹ 40,000
Cash = Current Assets – Debtors – Stock
= ₹ 1,50,000 – ₹ 40,000 – ₹ 50,000
= ₹ 60,000
PPE = Total Assets – Current Assets
= ₹ 10,00,000 – ₹ 1,50,000
= 8,50,000

Question 33.
The following is the information of XML Ltd. related to the year ended 31- 03-2018:
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1: 4
Non-Current Assets to Current Assets 1: 2
Current Ratio 2: 1
Non-Current Liabilities to Current Liabilities 1: 1
Share Capital to Reserve and Surplus 4: 1
Non-current Assets as on 31st March, 2017 ₹ 50,00,000

Assume that:
(i) No change in Non-Current Assets during the year 2017 – 18.
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) Ignoring Tax.
You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables, and Cash for the year ended on 31st March, 2018. (Nov 2018, 5 marks)
Answer:
Non Current Assets to Sale = 1 : 4
Non Current Assets = ₹ 50,00,000
Sales = ₹ 50,00,000 × 4
Sales = ₹ 2,00,00,000
Net Profit = 10% of Sales
= 10% of ₹ 2,00,00,000
= ₹ 20,00,000
Cost of goods sold = Sales – GP
= 2.00,00,000 – 20% of 2,00,00,000
= 1,60,00,000

Raw material consumption = 80% of Sales
= 80% of ₹ 2,00,00,000 = ₹ 1,60,00,000
Inventory = ₹ 1,60,00,000 × \(\frac{3}{12}\) = ₹ 40,00,000
Receivables = ₹ 2,00,00,000 × \(\frac{3}{12}\) = ₹ 50,00,000
Cash = Current Asset – Inventory – Receivables
= ₹ 1,00,00,000 – ₹ 40,00,000 – ₹ 50,00,000 = ₹ 10,00,000
Note: It is assumed that all sales are credit sales.

Question 34.
Following figures and ratios are related to a company Q Ltd.:
(I) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 per cent
(iii) PPE turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio
(vi) Current ratio 1.5: 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to share capital 0.6: 1
(ix) Capital gearing ratio 0.5
(x) PPE to net worth 1.20: 1
You are required to calculate:
Closing Stock, PPE, Current Assets, Debtors, and Net worth. (May 2019, 5 marks)
Answer:
(i) Calculation of Closing Stock:
Sales for the year = ₹ 30,00,000
GP Ratio = 25%
Gross Profit = ₹ 7,50,000

Cost of Goods Sold = S – Gross Profit
= ₹ 30,000 – ₹ 7,50,000
Cost of goods Sold = ₹ 22,50,000
Closing stock = \(\frac{\text { COGS }}{\text { Stock Tumover }}\)
= \(\frac{22,50,000}{6}\)
= ₹ 3,75,000

(ii) Calculation of Fixed Asset:
Fixed Asset Turnover Ratio = \(\frac{\text { Cost of Goods Sold }}{\text { FixedAssets }} \)
∴ 1.5 = \(\frac{₹ 22,50,000}{\text { FixedAssets }}\)
Fixed Assets = \(\frac{₹ 22,50,000}{1.5} \) = ₹ 15,00,000

(iii) Calculation of Current Assets:
Current Ratio = 1.5 and Liquid Ratio = 1
Stock =1.5 – 1=0.5
Current Assets = Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5
= ₹ 11,25,000

(iv) Calculation of Debtors:
Debtors = Sales x Debtors Collection period /12
= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000

(v) Calculation of Net Worth:
Net worth = \( \frac{\text { Fixed Assets }}{\text { Net worth }}=\frac{1.20}{1}\)
= \(\frac{₹ 15,00,000}{\text { Net Worth }}=\frac{1.20}{1} \)
Net worth = ₹ 12,50,000

Question 35.
Following information has been gathered from the books of Tram Ltd. the equity share of which is trading in the stock market at ₹ 14.
Particulars Amount (₹)
Equity Share Capital (face value ₹ 10) 10,00,000
10% preference Shares 2,00,000
Reserves 8,00,000
10% Debentures 6,00,000
Profit before Interest and Tax for the year 4,00,000
Interest 60,000
Profit after Tax for the year 2,40,000

Calculate the following:
(i) Return on Capital Employed
(ii) Earnings per share
(iii) PE ratio (Nov 2019, 5 marks)
Answer:
(i) Return on Capital Employed:
ROCE (Pre Tax) = \(\frac{\text { Profits before Interest and Taxes }}{\text { Capital Employed }} \times 100 \)
= \(\frac{₹ 4,00,000}{₹ 10,00,000+₹ 2,00,000+₹ 8,00,000+₹ 6,00,000} \times 100 \)
= \(\frac{₹ 4,00,000}{₹ 26,00,000} \times 100 \)
= 15.38%.
ROCE (POST TAX) = \(\frac{\text { Profit after Tax }}{\text { Capital Employed }} \times 100 \)
= \(\frac{2,40,000}{26,00,000} \times 100\)
= 9.23%

(ii) Earnings per share:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 26

(iii) PE Ratio:
PE Ratio = \(\frac{\text { Market Price }}{\text { Earnings per Share }} \)
= \(\frac{₹ 14}{₹ 2.20}\)
= 6.36 times

Question 36.
The following information relates to RM Co. Ltd.
Total Assets employed ₹ 10,00,000
Direct Cost ₹ 5,50,000
Other Operating Cost ₹ 90,000
Goods are sold to the customers at 150% of direct costs.
50% of the assets being financed by borrowed capital at an interest cost
of 8% per annum.
Tax rate is 30%
You are required to calculate:
(i) Net profit margin
(ii) Return on assets
(iii) Asset turnover
(iv) Return on owners’ equity (Nov 2020, 5 marks)

Question 37.
From the following information, complete the Balance Sheet given below:
(i) Equity Share Capital: ₹ 2,00,000
(ii) Total debt to owner’s equity: 0.75
(iii) Total Assets turnover: 2 times
(iv) Inventory turnover: 8 times
(v) Fixed Assets to owner’s equity: 0.60
(vi) Current debt to total debt: 0.40
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 27
(Jan 2021, 5 marks)

Question 38.
XV Ltd. provides the following information for the year ending 31st March, 2017:
PPE turnover ratio 8 times
Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
G P Ratio 25%
Gross profit during the year amounts to ₹ 8,00,000. There is no long-term loan or overdraft Reserve and surplus amount ₹ 2,00,000. Ending inventory of the year is ₹ 20,000 above the beginning inventory.

Required:
CALCULATE various assets and liabilities and PREPARE a Balance sheet of Tirupati Ltd.
Answer:
Gross Profit
(a) G.P. ratio = \(\frac{\text { GrossProfit }}{\text {Sale}}\)
Sales = \(\frac{\text { GrossProfit }}{25} \times 100=\frac{₹ 8,00,000}{25} \times 100\) = ₹ 32,00,000

b) Cost of Sales = Sales – Gross profit
= ₹ 32,00,000 – ₹ 8,00,000
= ₹ 24,00,000

(c) Receivable turnover Sale = \(\frac{\text { Sale }}{\text { Receivables }} \) = 4
= Receivables = \(\frac{\text { Sale }}{4}=\frac{₹ 32,00,000}{4}\) = ₹ 8,00,000

(d) PPE turnover = \(\frac{\text { Cost of Sales }}{\text { Property Plant and Equipment }}\) =8
PPE = \(\frac{\text { Cost of Sales }}{8}=\frac{₹ 24,00,000}{8} \) = ₹ 3,00,000

(e) Inventory turnover = \(\frac{\text { Cost of Sales }}{\text { AverageStock }} \) = 8

Average Stock = \(\frac{\text { Cost of Sales }}{8}=\frac{₹ 24,00,000}{8} \) = ₹ 3,00,000
Average Stock = \(\frac{\text { OpeningStock }+ \text { ClosingStock }}{2} \)
Average Stock = \(\frac{\text { OpeningStock }+ \text { Opning Stock }+20,000}{2} \)
Average Stock = Opening Stock + ₹ 10,000
Opening Stock = Average Stock – ₹ 10,000
=₹ 30,00,000 – ₹ 10,000
=₹ 2,90,000
Closing Stock = Opening Stock + ₹ 20,000
=₹ 2,90,000 + ₹ 20,000
= ₹ 3,10,000

(f) Payable turnover = \(\frac{\text { Purchases }}{\text { Payables }} \) = 6
Purchases = Cost of Sales + Increase in Stock = ₹ 24,00,000 + ₹ 20,000 = ₹ 24,20,000
Purchase = ₹ 24,20,000
Payables = \(\frac{\text { Purchase }}{6}=\frac{₹ 24,20,000}{6} \) = ₹ 4,03,333

(g) Capital turnover = \(\frac{\text { Cost of Sales }}{\text { Capital Emloyed }} \) =2
Capital Employed = \(\frac{\text { Cost of Sales }}{2}=\frac{₹ 24,00,000}{2}= \) = ₹ 12,00,000

(h) Share Capital = Capital Employed – Reserves & Surplus
=₹ 12,00,000- ₹ 2,00000 =₹ 10,00,000

Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 28
(PPE turnover, inventory turnover capital turnover is calculated on cost of sales)

Question 39.
Answer the following:
Explain the important ratios that would be used in each of the following situations.
(i) A bank is approached by a company for a loan of ₹ 50 lakh for working capital purposes.
(ii) A long-term creditor interested in determining whether his claim is adequately secured.
(iii) A shareholder who is examining his portfolio and who is to decide whether he should hold or sell his holding in the company.
(iv) A finance manager is interested to know the effectiveness with which a firm uses its available resources. (May 2012, 4 marks)
Answer:
important Ratios used in different situations

1. Liquidity Ratios Liquidity short-term solvency ratios would be used by the bank or financial institutions to check the ability of the company to pay its short-term liabilities. A bank may use the Current ratio and Quick ratio to judge the short-term solvency of the firm.
2. Capital Structure/Leverage Ratios Long-term creditors would use the capital structure/leverage ratio to ensure the long-term stability and structure of the firm. A long-term creditor interested in determining whether his claim is adequately secured may use Debt-service coverage and interest coverage ratio.
3. Profitability Ratios Generally, shareholders would use the profitability ratios to measure the profitability or the operational efficiency of the firm to see the final results of business operations. A shareholder may use return on equity, earnings per share, and dividend per share.
4. Activity Ratios The top financial executive would use these ratios to evaluate the efficiency with which the firm manages and utilizes its assets. Some important ratios are (a) Capital turnover ratio (b) Current and PPE turnover ratio (c) Stock, Debtors, and Creditors turnover ratio.

Question 40.
From the following table of financial ratios of R. Textiles Limited, comment on various ratios given at the end:
Financial Analysis and Planning Ratio Analysis - CA Inter FM Question Bank 29
COMMENT on the following aspect of R. Textiles Limited
(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders.
Answer:

Ratios Comment
Liquidity Current ratio has improved from last year and matching the industry average. Quick ratio also improved than last year and above the industry average. This may happen due to reduction in receivable collection period and quick inventory turnover. However, this also indicates idleness of funds. Overall it is reasonably good. All the liquidity ratios are either better or same in both the year compare to the Industry Average.
Operating Profits Operating Income-ROI reduced from last year but Operating Profit Margin has been maintained. This may happen due to variability of cost on turnover. However, both the ratio are still higher than the industry average.
Financing The company has reduced its debt capital by 1% and saved operating profit for equity shareholders. It also signifies that dependency on debt compared to other industry players (57%) is low.
Return to the shareholders R’s ROE is 24 percent in 2017 and 25 percent in 2018 compared to an industry average of 15 percent. The ROE has stable and improved over the last year.

Question 41.
Answer the following:
(i) Explain briefly the limitations of Financial ratios. (Nov 2009, 2 marks)
Answer:
The limitations of financial ratios are as below:

1. Concept of Ideal Ratio The concept of ideal ratio is vague and there is no uniformity as to what an ideal ratio is.
2. Thin line of difference between good and bad ratio The line of difference between good and bad ratios is so thin that they are hardly separable.
3. Financial ratios are not independent The FR’s cannot be considered in isolation. They are inter related but not independent. Thus, decision taken on the basis of one ratio may not be correct.
4. Misleading Various firms may follow different accounting policies. In such cases ratio comparison among companies may be misleading.
5. Impact of Seasonal Factors Seasonal factor brings boom or recession. Ratios may indicate different results during different periods.
6. Impact of Inflation Under the impact of inflation, the ratios might not present a true picture.
7. Product line diversification Due to product line diversification, the overall position of the firm may differ from position of individual product line.

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International Trade – CA Inter Economics Question Bank

International Trade – CA Inter Economics Question Bank is designed strictly as per the latest syllabus and exam pattern.

International Trade – CA Inter Economics Question Bank

Question 1.
How does international trade increase economic efficiency? Explain” (May 2019, 3 marks)
Answer:
(i) International trade is a powerful stimulus to economic efficiency and contributes to economic growth and rising economies.

Economic efficiency increases due to quantitative and qualitative benefits of extended division of labour, economies of large scale production, betterment of manufacturing capabilities, increased competitiveness and profitability by adoption of cost-reducing techrology and business practices and decrease in the like hood of domestic monopolies. Efficient deployment of productive resources natural, human, industrial and financial resources ensures productivity gains.

(ii) The gains from international trade are reinforced by the increased competition that domestic producers are confronted with on account of internationalisation of production and marketing. 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.

Question 2.
Write short note on Dis advantages of International Trade.
Answer:
Disadvantages of International Trade
1. Adverse effect on wages: It is argued by the critics that international trade adversely affect wages, particularly when trade takes place between two countries in one of which wages are very low and in the other very high. For example, it is argued by the Americans that trade with India or China where wages are low will depress the wages of American workers. Frank William Taussig, a well-known American economist, exposed the fallacy of this argument when he stated that, “Perhaps the most familiar and most unfounded of all is the belief that complete freedom of trade would bring about an equalisation of money wages the world over. There is no such tendency to equalisation. The question of wages is at bottom one of productivity. The greater the productivity of industry at large, the higher will be the general level of wages.’

2. Dependence on other nations: It is argued that while international trade brings the blessings of a higher standard of living for a nation, it also implies dependence on foreign markets as sources of supply of raw materials and as outlets for domestic production. According to some people the national interests demand that this dependence should be reduced or entirely eradicated. In modem times, however, when the world has become a united whole, this nationalist argument is retrogressive.

3. Against national defence: It has been argued by some people that a nation which depends on foreign sources of supply lacks defence during war. The harrowing experience of England during the two world wars is cited as proof of this assertion.

4. Economic instability: International trade has been condemned as a source of economic instability. This argument gained currency in the 1939s when the great depression spread from one country to another by disrupting the international flow of goods, services and capital. Today this argument has been reinforced by government policies directed toward achieving full employment and economic growth. International trade has been regarded as positively harmful for a country’s planned economic development. According to nationalists, free trade is an anachronism and does not fit in with the requirements of a planned economy. Here, it may be pointed out that most nations are unable to achieve the objectives of full employment and growth except as members of an international trading system.

5. Lack of protection of domestic industry: Several arguments have been advanced to justify the protection of domestic industry against foreign competition. Though arguments against international trade and specialisation on the basis of national security, economic stability, full employment, planned economic development and protectionism have a powerful emotional appeal for the layman, international trade has a tremendous vitality for growth and the protectionists have not been able to dislodge it from its strong position. The advantages of international specialisation and trade made its alleged disadvantages pale into insignificance.

International Trade - CA Inter Economics Question Bank

Question 3.
The table given below shows the number of labour hours required to produce Sugar and Rice in two countries X and Y:

Commodity Country X Country Y
1 unit of Sugar 2 5
1 unit of Rice 4 2.5

(i) Compute the Productivity of labour in both countries in respect of both commodities.
(ii) Which country has absolute advantage In production of Sugar?
(iii) Which country has absolute advantage in production of Rice? (Nov 2018, 3 marks)
Answer:
(i) Productivity of Labour in both Countries in respect of both Commodities

Productivity of Labour Country X Country Y
Units of Sugar Per hour 0.5 0.2
Units of Rice Per hour 0.25 0.4

(ii) Country X has absolute advantage in the production of Sugar because productivity of Sugar is higher in Country X, or conversely, the number of labour hours required to produce Sugar in Country X is less compared to Country Y

(iii) Country Y has absolute advantage in the production of Rice because productivity of Rice is higher in Country Y, or Conversely, the number of labour hours required to produce Rice in Country Y is less compared to Country X.

Question 4.
Explain the classical theory of Comparative Advantage as given by David Ricardo. (May 2019, 3 marks)
Answer:
David Ricardo developed the Classical Theory of Comparative advantage in his book ‘Principles of Political Economy and Taxation’ published in 1817.

The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817.

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 all 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).

Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity.

Comparative advantage differences between nations are explained by exogenous factors which could be due to the differences in national characteristics. Labour differs in its productivity internationally and different goods have different labour requirements, so comparative labour productivity advantage was Ricardo’s predictor of trade.

Question 5.
Explain the key features of modern theory of international trade. (Nov 2019, 3 marks)
Answer:
The Heckscher-Ohlin theory of trade, also referred to as Factor-Endowment Theory of Trade or Modem Theory of Trade, emphasises the role of a country’s factor endowments in explaining the basis for its trade. ‘Factor endowment’ refers to the overall availability of usable resources including both natural and man-made means of production.

If two countries have different factor endowments under identical production function and identical preferences, then the difference in factor endowment results in two countries having different factor prices and different cost functions. In this model a country’s advantage in production arises solely from its relative factor abundance. Thus, comparative advantage in cost of production is explained exclusively by the differences in factor endowments of the nations.

According to this theory, international trade is but a special case of inter-regional trade. Different regions have different factor endowments, that is, some regions have abundance of labour, but scarcity of capital; whereas other regions have abundance of capital, but scarcity of labour. Thus, each region is suitable for the production of those goods for whose production it has relatively plentiful supply of the requisite factors. The theory states that a country’s exports depend on its resources endowment i.e. whether the country is capital-abundant or labour-abundant. A country which is capital-abundant will export capital-intensive goods.

Likewise, the country which is labour-abundant will export labour-intensive goods. The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the export of a commodity whose production requires intensive use of its abundant resources and imports a commodity whose production requires intensive use of its scarce resources.

The Factor-Price Equalization Theorem which is a corollary to the Heckscher-Ohlin trade theory states that in the absence of foreign trade, it is quite likely that factor prices are different in different countries. international trade equalizes the absolute and relative returns to homogenous factors of production and their prices. This implies that the wages and rents will converge across the countries with free trade, or in other words, trade in goods is a perfect substitute for trade-in factors. The Heckscher-Ohlin theorem thus postulates that foreign trade eliminates the factor price differentials.

Question 6.
‘The Heckscher Ohlin theory of Foreign Trade’ can be stated In the form of two theorems. Explain those briefly. (Nov 2020, 3 marks)

Question 7.
The price index for exports of Bangladesh in the year 2018-19 (based on 2010-11) was 233.73 and the price index for imports of it was 220.50 (based on 2010-11).
(i) What do these figures mean?
(ii) Calculate the index of terms of trade for Bangladesh.
(iii) How would you interpret the index of terms of trade for Bangladesh? (Nov 2019, 5 marks)
Answer:
(i) Price index for exports of Bangladesh in the year 2018-19 (based on 2010-1 1), was 233.73 means that compared to year 2010-11, its export prices were 133.73% above the 2010-11 base year prices. The price index for Bangladesh’s import is 220.50 (based on 2010-11), means that compared to year 2010-11, its import prices were 120.50% above the 2010-11 base year prices.

(ii) The index of the terms of trade for Bangladesh in 2018-19 would be calculated as follows:
Terms of Trade = \(\frac{\text { Price of a country’s exports }}{\text { Price index of its imports }} \times 100\)
= \(\frac{233.73}{220.50} \times 100\)
= 106%

(iii) Terms of trade is ratio of the price of a country’s export commodity to the price of its import commodity. It is the relative price of a country’s exports in terms of its imports and can be interpreted as the amount of import goods an economy can purchase per unit of export goods.

If the export prices increase more than the import prices, a country has positive terms of trade, because for the same amount of exports, it can purchase more imports. The figure 106% means that each unit of Bangladesh’s exports in 2018-19 exchanged for 6% (6 = 106-100) more unit of imports than in the base year.

International Trade - CA Inter Economics Question Bank

Question 8.
Write short note on Mercantilism.
Answer:
Mercantilism
Developed in the sixteen century, mercantilism was one of the earliest efforts to develop an economic theory
This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings.
In it’s simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports.

In other words, if people in other countries buy more from you (exports) than they sell to you (imports), then they have to pay you the difference in gold and silver.

The objective of each country was to have a trade surplus, or a situation where the value of exports are greater than the valve of imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the value or exports.

A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen their nations by building larger armies and national institutions.

By increasing exports and trade, these rules were able to amass more gold and wealth for their countries. One way that many of these new nations promoted exports was to impose restrictions on imports. This strategy is called protectionism and is still used today.

Question 9.
Explain In brief on theory of Absolute Advantage.
Answer:
Theory of Absolute Advantage
In 1776. Adam Smith questioned the leading mercantile theory of the time in The Wealth of Nations Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations.

Adam Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation.

Adam Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. In a hypothetical two-country world, if Country A could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage and could focus on specializing on producing that good.

Similarly, if Country B was better at producing another good, it could focus on specialization as well. By specialization, countries would generate efficiencies, because their labor force would become more skilled by doing the same tasks. Production would also become more efficient because there would be an incentive to create faster and better production methods to increase the specialization.

Question 10.
Elucidate the theory of Comparative Advantage.
Answer: ‘
Theory of Comparative Advantage
The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful absolute advantages. To answer this challenge, David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries.

Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, ¡t can produce that product better and more efficiently than ¡t does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity.

Question 11.
Trade theory emphasises differences in comparative costs to explain trade patterns. What other factors need to be taken into account if actual patterns are to be fully explained? Explain with reference to Adam Smith’s Theory.
Answer:
Adam Smiths Theory
Interregional or international trade takes place when the domestic price ratios are different. In international trade, a country exports that commodity which is cheaper at home than abroad and vice versa. Thus, differences in the relative prices of goods between different countries is the basis of international trade. The cheapness of one commodity and dearness of another relatively at home than abroad may be due to differences either In the supply conditions or in the demand conditions in the two countries. The classical theory of comparative cost advantage ignored the phenomenon of demand reversal because it focused attention only the supply side.

Absolute Cost Advantage:
Adam Smith argued for free trade on the basis of advantages of division of labour. Free trade makes possible a greater degree of specialisation of labour. It augments the gains from territorial division of labour. Each country specialises in the production of those commodities in which it has a comparative advantage over others. According to Adam Smith the principle governing the international exchange of goods is basically the same that underlines the domestic exchange.

Adam Smith developed the theory of international trade on absolute difference in costs. If one country has an absolute cost advantage in the production of one commodity and dis advantage in the production of the other, each country will export that commodity in the production of which it commands an absolute cost advantage and import that commodity in which it has an absolute cost disadvantage. In order to export a commodity Its price in the country should be low relatively to its price in the other country. It is possible only if the country possesses comparative cost advantage in the production of the commodity. For this purpose the country must have an absolute cost advantage.

Question 12.
Write Short Note on Criticisms of Adam Smith’s Theory.
Answer:
Criticism of Adam Smith’s Theory
Adam Smith explained the basis of trade between tropical zone countries and temperate zone countries or between industrial countries and agricultural countries on the principle of comparative cost advantage emerging from absolute difference in costs. However as P.T. Ellsworth and J. Clark Leith, point out it is assumed without argument that international trade required a producer of exports to have an absolute advantage; that is, an exporting country must be able to produce, with a given amount of capital and labour, a large output than any rival.

But what if a country had no line of production in which ¡t was clearly superior? Suppose a relatively backward country whose and industry In the broadest sense (compared with Its more advanced neighbours) were inefficient, capable of production less In all lines of production, not too hypothetical case. Would it be forced to insulate itself against more efficient outside competition or see all its industry and agriculture subjected to ruinous competition? Adam Smith’s analysis was too narrow. It was left to Robert Torrens and David Ricardo to attack the problem and to elaborate Adam Smith’s statement to fit In a more general framework by formulating a more general theory of international trade.

International Trade - CA Inter Economics Question Bank

Question 13.
Explain the Ricardian theory of Comparative Cost.
Answer:
David Ricardo’s Pure Theory
In his magnum opus entitles. The principles of Political Economy and Taxation, first published in 1817, David Ricardo formulated the pure theory of international trade. At the centre of the theory was the so-called principle of comparative advantage”. The idea was that nations would gain by specialising in the production of those goods in which they possess special advantages. David Ricardo said, “It is important to the happiness of mankind that our enjoyments should be increased by the better distribution of labour, by each country producing those commodities for which by its situation, its climate and its other natural or artificial advantages, it is adapted, and by their exchanging them for the commodities of other countries.”

Labour Theory of Value:
The doctrine of comparative cost advantage was developed by David Ricardo out of his celebrated labour theory of value. According to this theory, the value of any commodity is determined by its labour cost of production. To quote Ricardo’s words, “It is the comparative quantity of commodities which labour will produce that determines their present or past relative values.” This theory breaks down as a determinant of value-in-exchange in international trade.

David Ricardo admitted. “The same rule which regulates the value of commodities in one country does not regulate the relative values of the commodities exchanged between two or more countries. The quantity of wine which Portugal shall give in exchange for the cloth of England is not determined by the respective quantities of labour devoted to the production of each, as it would be if both commodities were manufactured in England, or both in Portugal.”

The labour (cost) theory of value, can not explain the exchange values in international trade due to the immobility of labour as factor of production between different countnes which prohibits the application of this theory to trade taking place between countries. Commodities would exchange in the ratio of the quantities of labour embodied in them if labour were perfectly mobile between countries.

Any divergence between their exchange ratio and their cost ratio would be eliminated by the market forces of demand and supply. If the product of an industry can be sold at more than the value of labour it contains, additional labour will be transferred to that industry from other occupations. The supply of the commodity will expand until the price falls to become equal to the value of labour embodied in it. Conversely, if the commodity sells for less than the value of its labour contents, labour will move away from that industry into other lines of production. Thus, the supply of the commodity will decrease and its price wilt rise until the price equals the labour cost of production of the commodity.

The labour cost principle implies that in different branches of production, there is a tendency of wages towards equality within a country so that prices of goods will be equal to the returns to labour in all lines of production and regions within the country. However, this equilibrating mechanism does not operate between two countries due to the assumption of immobility of labour between the countries. Thus trade will emerge if the exchange ratio between the two commodities is different in two countries.

Values of Goods In International Exchange:
David Ricardo explains it by the doctrine of comparative cost advantage. According to this doctrine, a country will specialise in the production of that commodity for which its labour cost is comparatively lowest. The doctrine emphasises the principle that competence should specialise where competence counts most and incompetence must specialise where incompetence counts least. A country would export that commodity in the production of which It has comparative cost advantage or superiority over others and import that commodity in which its cost advantage is least or in which it suffers from comparative cost disadvantage.

Support of Free Trade:
The principle of comparative cost advantage supports free trade. Each country in the long run tends to specialise in the production of and export of those goods In which it enjoys a comparative advantage in terms of real costs. It tends to import those goods in the production of which it has comparative disadvantage in terms of real costs. This specialisation is to the mutual advantage of both the countries participating in trade.

David Racardo’s classic example of two men of differing efficiencies both of whom could make shoes and hats, illustrated the point. Though simple and powerful, Adam Smith’s demonstration of the benefits of free trade was not very deep and subtle. He did not tackle the more difficult case in which one country enjoys absolute advantage over the other country in the production of both the goods. It was David Ricardo who saw the problem and answered in the affirmative. So long as country A is not equally more productive in both the lines of production, both the countries will benefit by trading.

Question 14.
What were the assumptions underlying the Ricardian Theory of Comparative cost.
Answer:
Assumptions of Comparative Cost Advantage Theory:

  1. Labour is the only factor of production. Consequently, the theory is based on the labour (cost) theory of value.
  2. All units of labour are homogeneous.
  3. Labour is perfectly mobile within the country and perfectly immobile between different countries.
  4. Production functions are linearly homogeneous i.e., production of goods obeys the law of constant returns of scale. In other words, the unit cost ratio of the two goods are constant regardless of the scale of production. Thus, the theory abstracts from considering the economies and diseconomies of scale of production.
  5. The theory assumes trade taking place between only two countries and in only two goods produced by single factor of production (labour). In other words, the theory Is a 2 x 2 x I trade model.
  6. Transport costs are absent.
  7. Process of goods are determined by their real (labour) cost of production.
  8. Product and factor markets are perfectly competitive.

Improvement by Others:
The problem of determination of the actual terms of trade was not tackled by David Ricardo. It was left for John Stuart Mill, Alfred Marshall and Francis Ysidro Edgeworth to introduce the demand condition in international trade in order to explain the process of the determination of terms of trade. Thus, Ricardo’s explanation of the comparative cost advantage theory was incomplete as it focused attention only on the supply side and took the demand side for granted.

John Stuart Mill examined the problem of determination of the real terms of trade (exchange ratio) at which the countries exchange commodities. Mill’s doctrine was, The actual exchange ratio at which goods are traded will depend on the strength and elasticity of each country’s demand for the other country’s product or on the reciprocal demand. The exchange ratio will be stable when the value of each country’s exports is just enough to pay for its imports.”

Mill’s analysis of reciprocal demands was further translated into graphical terms by the noted Cambridge Economists Alfred Marshall and Francis Ysidro Edgeworth. They developed and used the technique of otter curves to explain effectively the operation of Mill’s reciprocal demand.

International Trade - CA Inter Economics Question Bank

Question 15.
Examine the Opportunity Cost Doctrine of International Trade as propounded by Haberler
Answer:
Meaning of Opportunity Cost Approach
In offering his opportunity cost doctrine, Haberler emphasised the role of differing factor endowments of the trading countries but assumed for simplicity that the factors available to a country are fixed in supply. These factors can be used in several ways; some of the output of one commodity can be sacrificed to increase the output of another so that each country can exhibit a set of production possibilities. From this, it follows that the cost of production of a commodity is equal to the value of commodities whose production is given up in order to produce it.

This analysis in which the costs of substituting one commodity for another take the place of labour costs is valid, no matter if the factors, leaving the production of one commodity, are all suited to the production of the other commodity. Haberler gave detailed consideration to the degree to which factors of production are specific to one industry and of no use to another.

Even if the factors are specific, Haberler showed that the exchange ratio is given by the ‘marginal rate of substitution’ defined as the number of units of one commodity given up to obtain one extra unit of the other. Thus, Haberler followed the Austrian school that measured costs not by the absolute amount of labour required but by the alternative foregone. To quote Haberler, “The marginal cost of a given quantity ‘x’ of commodity ‘A’ must be regarded as that quantity of commodity ‘B’ which must be foregone in order that ‘x’, instead of (x-1) units of ‘A’ can be produced. The exchange ratio on the market between A and B must equal their costs in this sense of the terms.

Assumptions of the Theory:
Haberler sought to derive a country’s opportunity cost curve under the following assumptions:
1. Perfect competition exists in factor and commodity markets.
2. The price of every product equals its marginal cost of production.
3. The units of any factor of production, have the same price in all employment provided that they are mobile or substitutable for one another.
4. The factors are fully employed, and the uniform price of each factor is equal to its marginal productivity in each use.
International Trade - CA Inter Economics Question Bank 1
A specialises completely in the production of Y and B in that of X. In equilibrium, the slopes of the new price lines A1A1 and B1B1 countries A and B respectively equal. If specialisation is in complete in one country because of the unequal size of the two countries, the equihbrium price line will be tangent to the production indifference curve in the larger (partially specialised) country.

If the production is subject to the law of increasing costs in country A and to that to constant costs in country B, country B will specialise completely if its size is smaller than or equivalent to that of country A. If country B is larger in size, neither of the two countries might specialise completely.

It production is subject to the law of decreasing costs in A and to that of constant costs in B, both the countries will specialise completely if they are not unequal in size. If the size of the two countries is unequal, the smaller will specialise completely and the larger partially.

When the rate at which the costs are decreasing in A, is precisely the same at which the cost are decreasing ¡n B, there will be no differences in comparative costs. The scope for trade will exist only if the demand conditions favour it. If the consumption indifference curves are identical in the two countries, therë will be no difference in comparative costs and hence no scope for trade. If the consumption indifference curves are dissimilar, there will arise scope for profitable trade. The decreasing costs country will specialise more completely than the increasing costs country.

Question 16.
On what assumptions is the Heckscher-Ohlin theory of international trade based? Explain the relative factor abundance and relative factor intensity.
Answer:
Assumptions of Heckscher-Ohlin Theory
The phenomenon of international trade is exceedingly complex, in the real world. It includes under its cover a multi-commodity, a multi-country and a multi-factor world. In order to avoid total confusion, abstraction from such a complex world of reality is needed. No theory of trade worth the name can be a perfect approximation to the real trading world, as every theory abstracts from complexities of real-world trade by making several assumptions. The Heckscher-Ohlin theory of international trade is no exception to this rule. The following are its self imposed assumptions:
1. Trade takes place between only two countries and in only two commodities which are produced by only two factors of production, namely labour and capital. In other words, the Heckscher-Ohlin theory may be described as a two-country, two commodity and two factor trade model i.e., a 2 x 2 x 2 trade model.

2. Production of both the goods involves the use of both factors and is subject to constant returns to scale. In other words, the production functions of both the commodities are linearly homogeneous.

3. The linearly homogeneous production functions are different for the two goods but are identical for each goods in the two countries.

4. There is perfect competition in the goods and factor markets and resources are fully employed.

5. Transport costs, tariff and other artificial barriers to trade are absent.

6. The relative factor endowments are different in the two countries.

7. Consumer tastes are fixed and identical in the two countries.

8. Production functions are such that the relative factor intensities are the same at all factor prices which are same in both the industries, i.e., the labour-intensive goods remain labour-intensive at all the prices of labour. In other words, the theory is based on the assumption of strong factor intensity.

9. Factor supply (endowments) in each country is fixed, unchanging over time, homogeneous and qualitatively identical. In short, the theory abstracts from consideration of the effect on trade of differences in the qualities of factors of production in different regions.

10. International transactions are confined to only commodity trade. In other words, these ignore transactions arising from capital movements, remittances of interest or dividends, and other invisible items in the balance of payments.

11. Factors are mobile within each country but are immobile between the countries. At any rate, it is assumed that the factor mobility within the country is considerably greater than international factor mobility.

12. Technology is fixed and information is costless and ubiquitous.

Question 17.
Criticise the Heckscher-Ohiin theory of international trade. I
Answer:
Criticisms of Heckscher-OhIlfl Theory
1. OversimplifIed explanatioñ of trade: This theory explains trade between only two countries, in two commodities produced by only two inputs. Thus, it is a 2 x 2 x 2 trade model. In practice, however, trade takes place between many countries and in many commodities which are produced by several inputs. Consequently, the theory cannot explain the actual complex trade pattern. It is an oversimplified explanation of trade.

2. Trade between countries of similar endowments: According to this theory, a country will produce and export that commodity in whose production relatively large amount of its abundant factor is used. Thus, trade occurs due to differences in factor proportions between nations. Trade will not occur between regions or countries endowed with similar relative factory endowments. For example, if the ‘two countries are identical in capital and labour abundance they would not trade. This claim is false as a substantial part of world trade takes place between countries with similar factor endowments.

3. Neglect of cost-influencing factors: In fact, international trade takes place due to differences in the relative prices of commodities between different regions which may be due to cost differences. Differences in costs of different products between different regions arise from many factors including transport costs, economies of scale and external economies. Ohiin was mistaken to make the simplifying assumption that regional differences in factor proportions uniquely determined specialisation and trade. His theory is faulty as an explanation of specialisation and trade because it ignores several other factors like transport costs, economies of scale external economies, etc., which account for the differences in costs and consequently in the prices of products between different regions.

4. Neglect of the role of product differentiation: If there is product differentiation, trade may take place even if the two countries are similarly endowed with the productive agents.

5. Prices of commodities are not determined by the lactar costs of Production: H.W.J. Wijanholds criticised the Heckscher-Ohlin theory on the ground that the prices of commodities are not determined by the factor costs of production. He maintained that the relation is quite the reverse. The prices of commodities are determined by their utility to the consumers. The prices of raw materials and labour ultimately depend on the prices of final goods.

6. No mention of by-products: Heckscher-Ohlin theory does not mention anything about the by-products. In influencing the structure and direction of international trade sometimes the by-products are more important than the main final products.

7. Static-equilibrium analysis: This theory rests on the static assumptions of fixed quantities of factors of production, given consumer incomes and tastes, given production functions, etc. The conclusions drawn from the static equilibrium analysis cannot be applied to a dynamic economy characterised by changes in tastes, technical knowledge and relative factor endowments over time. This theory neglects the problems of long-run historical developments and their impact on the nature and pattern of international trade. The assumptions of fixed factor endowments and unchanging technology cannot be defended.

8. Neglect of the influence of technological progress on trade: The assumption of identical production functions in two countries is plausible only in a static world in which the technical conditions of production remain constant. Any production function is available for exploitation by any potential user barring exceptional cases of very few well-guarded industrial secrets and patented production processes which their owners will not license. There are no industrial secrets, in the long run. Even the patents and copyrights expire after a certain time lapse.

International Trade - CA Inter Economics Question Bank

Question 18.
What do you mean by anti-dumping duties? (May 2018, 2 marks)
Answer:
Anti-Dumping Duties:
Dumping occurs when manufacturers sell goods in a foreign country below the sales price in their domestic market or below their full average cost of the product. Dumping is an international price discrimination favouring buyers of exports, but ¡n tact, the exporters deliberately forego money in order to harm the domestic producers of the importing country. This is unfair and constitutes a threat to domestic producers and therefore when dumping is found, anti-dumping measures which are tariffs to offset the effects of dumping may be initiated as a safeguard instrument by imposition of additional import duties so as to offset the foreign firm’s unfair price advantage.

Question 19.
How do import tariffs affect International Trade? (May 2018, 2 marks)
Answer:
Import tariffs affect International Trade in following manner
1. Tariff barriers create obstacles to trade, decrease the volume of imports and exports and therefore of international trade. The prospect of market access of the exporting country is worsened when an importing country imposes a tariff.

2. By making imported goods more expensive tariffs discourage domestic consumers from consuming imported foreign goods. Domestic consumers suffer a loss in consumer surplus because they must how now pay a higher price for the good and also because compared to free trade quantity they now consume lesser quantity of the good.

3. Tariffs encourage consumption and production of the domestically produced import substitutes and thus protest domestic Industries.

4. Producers in the importing country experience an increase in well-being as a result of imposition of tariff. The price increase of their product in the domestic market increases producer surplus in the industry. They can also charge higher prices than would be possible in the case of free trade because foreign competition has reduced.

5. The price increase also induces an increase in the output of the existing firms and possibly addition of new firms due to entry into the industry to take advantage of the new high profits and consequently an increase in employment in the industry.

6. Tariffs create trade distortions by disregarding comparative advantage and prevent countries from enjoying gains from trade arising from comparative advantage. Thus, tariffs discourage efficient production in the rest of the world and encourage inefficient production in the home country.

7. Tariffs increase government revenues of the importing country by the value of the total tariff it charges.

Question 20.
Explain with example how Ad Valorem Tariffes levied. (Nov 2018, 3 marks)
Answer:
An ad valorem tariff is levied as a constant percentage of the monetary value of one unit of the imported good. For example, a 20% ad valorem tariff on any bicycle generates a ₹ 1,000/- payment on each imported bicycle priced at ₹ 5,000/- in the world market and if the price raises to ₹ 10,000, it generates a payment of ₹ 2,000/-. While ad valorem tariff preserves the protective value of tariff on home producers, it gives incentives to deliberately undervalue the good’s price on invoices and bills of loading to reduce the tax burden. Nevertheless, ad valorem tariffs are widely used the world over.

Question 21.
What is meany by 4 Mixed tariffs’? (May 2019, 2 marks)
Answer:
Mixed tariffs:
Mixed tariffs is a combination of an ad valorem and a specific tariff. That is, the tariff is calculated on the basis of both the value of the imported goods (an ad valorem duty) and a unit of measure of the imported goods (a specific duty).

Question 22.
What is meant by ‘Bound tariff’? (Nov 2019, 2 marks)
Answer:
Bound Tariff:
A bound tariff is a tariff through 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 23.
What is meant by ‘Countervailing Duties’? (Nov 2020, 2 marks)

Question 24.
Describe the purposes of Trade Barriers in international trade. (Jan 2021, 2 marks)

Question 25.
You are given the following information:

Good M (Mobile Phones) India (in $) Japan (In $) China (In $)
Average Cost 70.5 69.4 70.9
Price per unit for domestic sales 71.2 71.10 70.9
Price charged in Dubai 71.9 70.6 70.6

(A) Which of the three exporters are engaged in anti-competitive act in the international market while pricing its export of mobile phones to Dubai?
(B) What would be the effect of such pricing on domestic producers of mobile phones? (Jan 2021, 3 marks)

Question 26.
Describe and classify non tariff measures.
Answer:
Non -Tariff Measures:
Non-tariff barriers to trade or “Non-Tariff Measures (NTMs)” are trade barriers that restrict imports or exports of goods or services through mechanisms other than the simple imposition of tariffs. A Non-Tariff Barrier is any obstacle to international trade that is not an import or export duty. They may take the form of import quotas, subsidies, customs delays, technical barriers, or other systems preventing or impeding trade.

According to the World Trade Organisation, non-tariff barriers to trade Include import licensing, rules for valuation of goods at customs, pro-shipment inspections, rules of origin (‘made in’), and trade-prepared investment measures.

classification:
Sanitary and Phytosanitary Measures:

  • Measures that are applied to protect human or animal lite from risks arising from: additives, contaminants, toxins or disease-causing organisms in food.
  • Geographical restrictions on eligibility: Imports of dairy products from countries.

Technical Barriers to Trade:

  • Measures referring to technical regulations, and procedures for assessment of conformity with technical regulations and standards.
  • Labelling requirements: Refrigerators need to carry a label indicating their size, weight and electricity consumption level.

Contingent Trade-protective Measures:
Measures implemented to counteract particular adverse effects of imports in the market of the importing country contingent upon the fulfilment of certain procedural and substantive requirements.

Anti-dumping duty: An anti-dumping duty of between 8.5 per cent and 36 per cent has been imposed on imports of bio-diesel products from country A.

Question 27.
Defi ne Tariff. Why is it imposed?
Answer:
Tariff:
A tariff is a tax imposed by a governing authority on goods or services entering or leaving the country and is typically focused on a specified industry or product. It is meant to atter the balance of trade between the tariff-imposing country and its international trading partners.

For example, when a government imposes an import tariff, it adds to the cost of importing the specified goods or services. The additional marginal cost added by the tariff discourages imports, thus affecting the balance of trade.

Why are tariffs Imposed?
There are various reasons a government may choose to impose a tariff. The most common examples of rationale used to justify tariffs are protection for nascent industries, national defence purposes, supporting domestic employment, combating aggressive trade policies and environmental reasons.

Infant Industries
Tariffs are commonly used to protect an early-stage domestic industry from international competition. The tariff acts as an incubator that, in theory, should allow the domestic industry ample time to develop and grow into a competitive position on an international landscape.

National Defense
If a particular segment of the economy provides critical products with respect to national defence, a government may impose tariffs on international competition to support and secure domestic production in the event of a conflict.

Domestic Employment
It is common for government economic policies to focus on creating an environment where constituents have robust employment opportunities. If a domestic segment or industry is struggling to complete against international competitors, the government may use tariffs to discourage consumption of imports and encourage consumption of domestic goods in hopes of supporting associated job growth. (For related reading, see: Do Cheap Imported Goods Cost Americans Jobs?)

Aggressive Trade Practices
International competitors may employ aggressive trade tactics such as flooding the market in an attempt to gain market share and put domestic producers out of business. Governments may use tariffs to mitigate the effects of foreign entities employing what may be considered unfair tactics.

Environmental Concerns
Governments may use tariffs to diminish consumption of international goods that do not adhere to certain environmental standards.

Question 28.
Distinguish between ‘non-tariff measures’ and ‘non-tariff barriers’.
Answer:
Non-tariff measures are policy measures other than ordinary customs tariffs that can potentially have an economic effect on international trade in goods, changing quantities traded, or prices or both (UNCTAD, 2010). They form a constellation of different types of policies which alter the conditions of international trade. They are more difficult to quantify or compare than tariffs. NTMs can be instituted for a range of public policy reasons and have been negotiated within the General Agreement on Tariffs and Trade and at the World Trade Organization NTMs are allowed under the WTO’s regulations
and are meant to allow governments to pursue legitimate policy goals even if this can lead to increased trade costs. For example, NTMs like sanitary and phytosanitary measures and licensing could be legitimately used by members to ensure consumer health and to protect plant and animal life and environment.

Depending on their scope and design NTMs are categorized as:
(i) Technical Measures: Technical measures refer to product-specific properties such as characteristics of the product, technical specifications and production processes. These measures are intended for ensuring product quality, food safety, environmental protection, national security and protection of animal and plant health.

(ii) Non-technical Measures: Non-technical measures relate to trade requirements; for example; shipping requirements, custom formalities, trade rules, taxation policies, etc.

These are further distinguished as:
a. Hard measures (e.g. Price and quantity control measures),
b. Threat measures (e.g. Anti-dumping and safeguards) and
c. Other measures such as trade-related finance and investment measures. Furthermore, the categorization also distinguishes between:

  • Import-related measures which relate to measures imposed by the importing country, and
  • Export-related measures which relate to measures imposed by the exporting country itself.

NTMs are not the same as non-tariff barriers (NTBs). NTMs are sometimes used as means to circumvent free-trade rules and favour domestic industries at the expense of foreign competition. In this case, they are called non-tariff barriers (NTBs). NTBs are a subset of NTMs that have a ‘protectionist or discriminatory intent’ and implies a negative impact on trade. NTMs only become NTBs when they are more trade-restrictive than necessary. Some examples of NTBs are compulsory standards, often not based on international norms or genuine science; stringent technical regulations requiring alterations in production processes, testing regimes which require complex procedures and product approvals requiring inspection of individual premises.

In addition, to these, there are procedural obstacles (PO) which are practical problems in administration, transportation, delays in testing, certification etc. that may make it difficult for businesses to adhere to a given regulation.

International Trade - CA Inter Economics Question Bank

Question 29.
Describe the objectives of World Trade Organization (WTO). (May 2018, 3 marks)
Answer:
The objectives of World Trade Organization (WTO) include

  1. Raising standards of living,
  2. Ensuring full employment and a large and steadily growing volume of real income and effective demand.
  3. Expanding the production of and trade in goods and services.
  4. The principal objective of the WTO is to facilitate the flow of international trade, smoothly, freely, fairly and predictably.

Question 30.
Examine why General Agreement in Tariff & Trade (GATT) lost its relevance. (May 2018, 2 marks)
Answer:
General Agreement in Tariff and Trade (GATT) lost its relevance because,

  1. It was obsolete to the fast-evolving contemporary complex world trade scenario characterized by emerging globalisation.
  2. International investments had expanded substantially.
  3. Intellectual property rights and trade-in services were not covered by GATT.
  4. World merchandise trade increased by leaps and bounds and was beyond its scope.
  5. The ambiguities in the multilateral system could be heavily exploited.
  6. Efforts at liberalizing agricultural trade were not successful.
  7. There were inadequacies in institutional structure and dispute settlement system.
  8. It was not a treaty and therefore terms of GATT were binding only insofar as they are not incoherent with a nation’s domestic rules.

Question 31.
“World Trade Organisation (WTO) has a three-tier system of decision making.” Explain. (Nov 2018, 2 marks)
Answer:
The WTO has a three-tier system of decision-making as follows:
1. The WTO’s top-level decision-making body is the Ministerial conference which can take decisions on all matters under any of the multilateral trade agreements. The ministerial conference meets at least once every two years.

2. The next levels general council which meets several times a year at the Geneva headquarters. The General Council also meets as the Trade Policy Review Body and the Dispute Settlement Body.

3. At the next level, the Goods Council, Services Council and Intellectual Property (TRIPS) Council report to the General Council.

Question 32.
How does the WTO agreement ensure market access? (Nov 2019, 2 marks)
Answer:
The WTO aims to increase world trade by enhancing market access by converting all non-tariff barriers into tariffs which are subject to country-specific limits. Further, in major multilateral agreements like the Agreement on Agriculture (AOA). Specific targets have been specified for ensuring market access.

Question 33.
Discuss the guiding principle of WTO in relation to trade without discrimination. (Nov 2020, 2 marks)

Question 34.
Define ‘dumping’?
Answer:
Dumping
Dumping occurs when manufacturers sell goods in a foreign country below the sales prices in their domestic market or below their full average cost of the product. Dumping maybe persistent, seasonal, or cyclical. Dumping may also be resorted to as a predatory pricing practice to drive out established domestic producers troth the market and to establish monopoly position.

Dumping is international price discrimination favouring buyers of exports, but in fact, the exporters deliberately forego money in order to harm the domestic producers of the importing country and to gain market share. This is an unfair trade practice and constitutes a threat to domestic producers.

Question 35.
How does the WTO address the special needs of developing and the least developed countries?
Answer:
The WTO addresses the special needs and problems of developing and the least developed countries in the following ways.

  1. Special and Differential Treatment (S&DT) for these countries is incorporated in the WTO laws and rules.
  2. Developing and the least developed countries are generally given longer implementation time to conform to their obligations for promotion of freer trade.
  3. They are also given more flexibility in matters of compliance with the WTO and special privileges and permission to phase out the transition period.
  4. These countries are granted transition periods to make adjustments to the not-so-familiar and intricate WTO provisions
  5. Members may violate the principle of MEN to give special market access to developing countries.

Question 36.
What’s meant by free trade area?
Answer:
Free Trade Area
Free trade policy is based on the principle of non-interference by government in foreign trade. The distinction between domestic trade and international trade disappears and goods and services are freely imported from and exported to the rest of the world. Buyers and sellers from separate economies voluntarily trade without the domestic government helping or hindering movements of goods and services between countries by applying tariffs, quotas, subsidies or prohibitions on their goods and services.

The theoretical case for free trade is based on Adam Smith’s argument that the division of labour among countries leads to specialization, greater efficiency, and higher aggregate production.

Question 37.
What are the objectives of the Agreement on Agriculture (AOA)?
Answer:
Objectives of the AOA
The Agreement on Agriculture (AoA) is an international treaty of the World Trade Organization negotiated during the Uruguay Round. It contains provisions in three broad areas of agriculture and trade policy: market access, domestic support and export subsidies.

The Agreement aims to:
1. establish fair and market-oriented agricultural trading system, and
2. provide for substantial and progressive reduction in agricultural support and export subsidies with a view to removing distortion in the world market. These are to be achieved through enhancement of market access, reduction of domestic support and elimination of export subsidies.

Question 38.
List the point of difference between fixed exchange rate and floating exchange rate. (May 2018, 2 marks)
Answer:
Difference between Fixed and Floating Exchange Rates Is Concerned.
1. The exchaige rate which the government sets and maintains at the same level is called fixed exchange rate. The exchange rate that variates with the variation in market forces is called floating exchange rate.

2. The fixed exchange rate is determined by government or the central bank of the country. On the other hand, the floating exchange rate is fixed by demand and supply forces.

3. In fixed exchange rate regime, a reduction in the par value of the currency is termed as devaluation and a rise as the revaluation. On the other hand, in the flexible exchange rate system, the decrease in currency price is regarded as depreciation and increase as appreciation.

4. Speculation is common in the floating exchange rate. Conversely, in the case of fixed exchange rate speculation takes place when there is a rumour about change in government policy.

5. In fixed exchange rate, the self-adjusting mechanism operates through variations in the supply of money, domestic interest rate and price. As opposed to the floating exchange rate that operates to remove external instability by the change in forex rate.

Question 39.
Explain ‘depreciation’ and ‘appreciation’ of home currency under floating exchange rate. (May 2019, 2 marks)
Answer:
Under flexible exchange system, the exchange value of currency frequently appreciates or depreciates depending upon the change in the demand for and supply of currency.

Depreciation of a currency is tall in value of domestic currency in terms of foreign currency. Thus, currency depreciation takes place when there is an increase in the domestic currency price of the foreign currency. For instance, if the value of rupee in terms of US dollar fails, say from ₹ 50 to ₹ 51 to a dollar, it will be a case of depreciation of Indian rupee because more rupees are required now to buy one US dollar. In short, higher exchange rate like $1 = ₹ 51 instead of ₹ 50 means depreciation of Indian currency.

Appreciation vs. Depreciation of currency
Appreciation of a currency is the increase in its value in terms of another foreign currency. Thus, currency appreciation takes place when there is a decrease in the domestic currency price of foreign currency. For Instance, if the value of a rupee in terms of US dollar increases, say from ₹ 50 to ₹ 49 to a dollar, it will be called appreciation of Indian currency (i.e., rupee) because less rupees are required to buy one US dollar. This shows strengthening of the Indian rupee. By contrast when Indian rupee in dollar terms appreciates, the dollar would depreciate. In short lower exchange rate like $1 = ₹ 49
instead of ₹ 50 means appreciation of Indian currency.

Question 40.
Using suitable diagram, explain, how the nominal exchange rate between two countries is determined? (May 2019, 3 marks)
Answer:
Determination of Exchange Rate
Flexible Exchange Rate is determined by market forces of Demand for and Supply of Foreign Currency change in flexible exchange rate occur on account of change in market demand and supply.

Demand for Foreign Exchange –
Demand for foreign exchange arises mainly due to import of goods, investing in foreign countries and giving loans to other nations. Demand for foreign exchange signifies the functional relationship between exchange rate and demanded quantity of foreign exchange. There is an inverse relationship between price of foreign exchange (i.e., rate of exchange) and demand for foreign exchange, e.g., more foreign exchange is demanded at lower exchange rate and Wee-versa. That is why demand curve for foreign exchange slopes downward from left to right.
International Trade - CA Inter Economics Question Bank 3
Supply of Foreign Exchange
Supply of foreign exchange represents the functional relationship between foreign exchange rate and supply of foreign exchange. There is a direct positive relationship between foreign exchange rate and supply of foreign exchange, e.g., with rise of foreign exchange rate, supply of foreign exchange increases and vice-versa.
International Trade - CA Inter Economics Question Bank 4


Equilibrium exchange rate is determined at the point where demand and supply curves of foreign exchange (DO and SS respectively) cut each other. In Figure, equilibrium exchange rate is determined at the point E, where both demand and supply of foreign exchange are equal to OQ. Thus, OR is the equilibrium market rate of exchange where the demand for and supply of foreign exchange are equal.

International Trade - CA Inter Economics Question Bank

Question 41.
Explain the term ‘real exchange rate’. (Nov 2019, 2 marks)
Answer:
The ‘real exchange rate’ incorporates changes in prices and describes how many’ of a good or service in one country can be traded for ‘one’ of that good or service in a foreign country.
Real exchange rate = Nominal exchange rate × \(\frac{\text { Domestic Price Index }}{\text { Foreign Price index }}\)

Question 42.
Explain the concept of soft peg and hard peg exchange rate policies. (Nov 2020, 2 marks)

Question 43.
Distinguish between ‘direct quote’ and ‘indirect quote’ with reference to express nominal exchange rate between two currencies. (Jan 2021, 2 marks)

Question 44.
Describe the advantages of Floating Exchange Rate. (Jan 2021, 3 marks)

Question 45.
The Nominal Exchange rate of India is ₹ 56/1 $, Price Index in India is 116 and Price Index in USA is 112. What will be the Real Exchange Rate of India? (Nov 2018, 2 marks)
Answer:
Real Exchange Rate = Nominal exchange rate × \(\frac{\text { Domestic Price Index }}{\text { Foreign Price index }}\)
= ₹ 56 × \(\frac{116}{112}\)
Real Exchange Rate = ₹ 58

Question 46.
Following exchange rate quotations are available for different periods:
(1) The spot exchange rate changes from ₹ 65 por $ to ₹ 68 per $.
(2) The spot exchange rate changes from $ 0.0125 per rupee to $0.01 625 per rupee.
Please Answer the following –
(A) Identify the nature of rate quotations in (1) and (2) above.
(B) Identify the base currency and counter currency in (1) and (2) above.
(C) What are possible consequences on exports and imports of (1) and (2) above. (Nov 2020, 3 marks)

Question 47.
Explain the nature of changes in exchange rates and their impact on real economy
Answer:
Changes In exchange rate takes place in form of:

  1. Appreciation of Domestic Currency
  2. Depreciation of Domestic Currency

Appreciation of Domestic Currency
When the value of domestic currency increases in terms of foreign currency, it is appreciation of domestic currency.

In other words, when there is decrease in the exchange rate of foreign currency (say dollar) in terms of domestic currency (say rupee), it is appreciation of domestic currency (say rupee).

Effects of Appreciation of Domestic Currency
In the situation of appreciation of domestic currency, the imports for domestic country become cheaper, hence, it may lead to increase in imports. On the other hand, exports from domestic country become dearer for foreign country, hence, it may lead to decrease in exports. As a result, it may create the situation of trade deficit in the domestic country.

Depreciation of Domestic Currency
When the value of domestic currency decreases in terms of foreign currency, it is depreciation of domestic currency.

In other words, when there ¡s an increase in the exchange rate of foreign currency (say dollar) in terms of domestic currency (say rupee), it is depreciation of domestic currency (say rupee).

Effects of Depreciation of Domestic Currency
In the situation of depreciation of domestic currency, the imports for domestic country become dearer, hence, it may lead to decrease in imports. On the other hand, exports from domestic country become cheaper for foreign country, hence, it may lead to increase In exports. As a result, it may create the situation of trade surplus in the domestic country.

Question 48.
Explain the effect of currency devaluation? Do you think a weak currency is advantageous to a country?
Answer:
Devaluation is a deliberate downward adjustment in the value of a country’s currency relative to another currency, group of currencies or standard, It is a policy tool used by countries that have a fixed exchange rate or nearly fixed exchange rate regime and involves a discrete official reduction in the otherwise fixed par value of a currency. The ‘monetary authority formally sets a new fixed rate with respect to a foreign reference currency or currency basket.

Devaluation is primarily an expenditure-switching policy. Ceteris paribus, the weakening of currency can have positive effects on an economy’s trade balance. Devaluation increases the price of foreign goods relative to goods produced in the home country and diverts spending from foreign goods to domestic goods. Devaluation implies that foreigners pay less for the devalued currency and that the residents of the devaluing country pay more for foreign currencies. By lowering export prices, devaluation helps increase the international competitiveness of domestic industries and increases the volume of exports.

Devaluation lowers the relative price of a country’s exports, raises the relative price of its imports, increases demand both for domestic import-competing goods and for exports, leads to output expansion, encourages economic activity, increases the international competitiveness of domestic industries, increases the volume of exports and promotes trade balance.

Question 49.
Write short note on Alternative Systems of Exchange Rate.
Answer:
Alternative Systems of Exchange Rate
1. Wider Bands
Wider Bands is a system that allows wider adjustment in the fixed exchange rate system. It allows adjustment upto 10 per cent around the ‘parity’ between any two currencies in the international money market.

Example: If one US dollar is fixed as equal to fifty Indian rupees, 10 per cent revision (upward or downward) is to be allowed in this exchange rate of 1: 50. Exchange rate may be revised as
1 :50 + 10% = 1 :55
Or
1: 50- 10% = 1:45
This is to help the member countries to correct their B0P (balance of payments) status. In the event of deficit BoP, India, for example, may depreciate its currency (upto 10 per cent). So that, purchasing power of other currencies in India increases by 10 percent (from 50 to 55 rupees a dollar). This is expected to increase demand for India’s products. Export earnings are expected to rise. Accordingly, BoP status is expected to improve.

2. Crawling Peg
Crawling Peg allows ‘small’ but regular adjustments in the exchange rate for different currencies. Not more than (±) 1 per cent adjustment is allowed at a time. Indeed it is a small adjustment. But it can crawl: it can be repeated at regular intervals.

Question 50.
Write short note on Effective Exchange Rate.
Answer:
Effective Exchange Rate
Effective Exchange Rate (EER) is a measure of strength of one currency in relation to other currencies in the international money market. EER in India would mean how strong is Indian rupee (on an average) in relation to currencies of our trading partners in the international market.
EER is of two types:

  • NEER (Nominal Effective Exchange Rate), and
  • REER (Real Effective Exchange Rate).

1. Nominal Effective Exchange Rate (NEER): It is that type of EER which does not account for changes in the price level while measuring average strength of one currency in relation to the others. It is estimated as under:
NEER = \(\sum_{i=1}^n\left(R^i \text { index }\right)\left(W_i\right) \)
Here,
NEER = Nominal effective exchange rate.
Σ = Sum total of all values.
i = Ah trading partner (say for India).
R’ = Exchange rate with the Ah partner. It refers to ₹‘:
£ for India-UK and ₹ : $ for India-USA.
R’ index = Index of exchange rate with Ah partner with reference to exchange rate ¡n the base year.
Wi = Rate of trade volume with Ah trading partner to India’s total trade.
n = Number of trading partners.

2. Real Effective Exchange Rate (REER): It is that type of Effective Exchange Rate which accounts for changes in the price level across different countries of the world. It is based on constant prices or real
exchange ra1e and is estimated as under:
PEER = \(\sum_{i=1}^n\left(R E R^i \text { index }\right)\left(W_i\right)\)
Note the difference between NEER and REER:
In NEER we have R index.
In REER we have RER index.
R index refers to index of ‘simple’ exchange rate between (say)
India and its the trading partner.
RER index refers to index of ‘real’ exchange rate between India and its the trading partner.

Real Exchange Rate (RER): It accounts for the change in price level in different countries, It is an exchange rate that is based upon constant prices.

International Trade - CA Inter Economics Question Bank

Question 51.
Write short note on Purchasing Power Parity.
Answer:
Purchasing Power Parity (PPP):
One of the measure of spot rate of exchange is Purchasing Power Parity (PPP). Purchasing power parity refers to the ratio of purchasing power of the currencies of trading partners. It simply implies the ratio of price levels in different countries. Thus, exchange rate between the two countries is simply equal to the ratio of the price levels in the two countries. Symbolically,
R = \(\frac{P_A}{P_B}\)
Here, R = Rate of exchange.
PA = Price level in country ‘A’.
PB = Price level in country ‘B’.
For example, if the price level of one kilogram apples in India is 50 rupees and in USA is 1 dollar then the purchasing power of 50 rupees is equal to the purchasing power of 1 dollar. The exchange rate will be: ₹ 50=$ 1
Some economists believe that exchange rate between two countries in the long run tends to be equal to PPP between the countries.

Absolute Purchasing Power Parity and Relative Purchasing Power Parity
Absolute purchasing power parity simply refers to the ratio between the price levels in the two countries. It does not account for the rate of inflation in the countries. Relative purchasing power parity, on the other hand, is that ratio between the price levels of the two countries which accounts for the difference in the rate of inflation in the two countries.

Question 52.
Write short note on merits and demerits of Flexible Exchange Rate.
Answer:
Merits of Flexible Exchange System:
1. Simple system: It is a simple system in its operation where exchange rate is determined at a point where the demand and supply forces of exchange rate become equal. Hence, it does not need any outside intervention.

2. Continuous adjustments: There is always a possibility of adjustment in flexible exchange rate and hence, adverse effects of long-term disequilibrium can be avoided.

3. Improvement In BOP: Adjustments in balance of payments in flexible exchange rate are smoother as compared with the fixed exchange rate adjustments.

4. Optimum use of resources: Flexible exchange rate ensures optimum use of resources which consequently increases the level of efficiency in the economy.

Demerits of Flexible Exchange Rate:
The main demerits of flexible exchange rate are as follows:
1. Bad effects of less elasticity: Less elasticity in exchange rate makes foreign exchange market unstable and consequently BOP situation becomes worse as a result of depreciation in scarce money.

2. Uncertainty: A flexible exchange rate generates uncertainty and frequent changes in exchange rate discourages international trade and capital movements.

3. Instability in International trade: Instability in international money market generates instability In international trade. Consequently, formulation of long-run policies related to import and export becomes difficult.

International Trade - CA Inter Economics Question Bank

Question 53.
Write short note on arguments against and in favour of Fixed Exchange Rate.
Answer:
Arguments against Fixed Exchange Rate
1. Ignores national interest: Fixed exchange rate ignores national interests for gaining international benefits because national elements like national income, price level and other national interests are placed at secondary level for maintaining fixed exchange rate with other countries.

2. Controls in various sectors: For maintaining fixed exchange rate various types of controls have to be applied on industrial sector, banking section and foreign trade. These controls lead to corruption and immoral activities in the economy.

Arguments In favour of Fixed Exchange Rate
1. Increase In international trade: When all the nations adopt fixed exchange rate, international trade increased because this type of exchange rate contains an element of certainty.

2. Incentives to foreign capital: This exchange rate ensures a regular flow of long-term foreign capital as there is no fear of currency appreciation or depreciation.

3. Acceleration in capital formation: Fixed exchange rate ensures internal price stability which promotes capital formation.

4. Economic Planning Possible: In fixed exchange rate expenditures on public projects do not variate which makes economic planning possible and easy.

5. Helps in maintaining favourable BOP: Fixed exchange rates attract foreign capital which ensures more industriation, employment generation and more production. All these results in favourable balance of payments.

Question 54.
Differentiate between Spot Market and Forward Market in foreign exchange.
Answer:
Foreign exchange markets are sometimes classified in two categories spot market and forward market on the basis of the period of transaction carried out.

It is explained below:
Spot Market
Spot market for foreign exchange is that market which handles only spot transactions or current transactions. Such market does not deal with future transactions and it contains the nature of daily market. It is also called ‘Effective Exchange Rate’.

In terms of ‘period of transactions’, spot market is of ‘daily nature It does not trade in future deliveries. The rate of exchange which is determined in the spot market is known as spot rate of exchange. The spot rate of exchange or current rate of exchange is that rate which happens to prevail at the time when transactions are incurred.

Forward Market
Forward market for foreign exchange is that market which handles such transactions of foreign exchange as are meant future delivery. Such transactions are signed today but are to materialise (or are to be honoured) on some future date.

In this market, foreign exchange is made available in future. So forward exchange rate is that one at which transactions are made on some future date.

It only caters to forward transactions; ¡t does not deal with spot transactions in foreign exchange.
It defines (or determines) forward exchange rate-the exchange rate at which forward transactions are to be honoured.

Question 55.
What is the difference between Appreciation of Currency and Revaluation of Currency?
Answer:
Appreciation vs. Revaluation
When a country raises the value of its currency in terms of foreign currency under a fixed rate regime, it is called revaluation. The effect of revaluation is the same as that of appreciation. Although both appreciation and revaluation convey the same thing, i.e., a rise in the value of domestic currency in terms of foreign currency but they take place in different regimes. Revaluation takes place by government order in Fixed Exchange Rate regime whereas appreciation occurs in Flexible Exchange Rate regime in a free exchange market depending upon forces of demand and supply of currency.

Question 56.
What is the difference between Depreciation of Currency and Devaluation of Currency?
Answer:
Depreciation vs. Devaluation
Devaluation means decrease in price of domestic currency with respect to gold or any other currency by the government. When a country brings down the value of its currency in terms of foreign currency by a government order, it is called devaluation. The effect of depreciation is the same as that of devaluation. Although both depreciation and devaluation mean the same thing, i.e., a tall in the value of domestic currency in terms of foreign currency yet the notable difference between the two is that devaluation takes place in Fixed Exchange Rate regime whereas depreciation occurs in Flexible Exchange Rate regime in a free exchange market.

Question 57.
Give the difference between Nominal Exchange Rate and Real Exchange Rate.
Answer:
Nominal Exchange Rate: Ills price of foreign currency in terms of domestic currency. When cost (price) of purchasing one unit of foreign currency (say, dollar) is quoted in terms of domestic currency (say, rupees), it is called nominal exchange rate because exchange rate es quoted ¡n money terms i.e. so many rupees per dollar. For instance, if 1 American dollar can be obtained (exchanged) for 50 Indian rupees i.e. if it cost rupees 50 to buy 1 dollar, it will be called nominal exchange rate. Generally exchange rate is expressed in the form of nominal exchange rate, i.e. so many units of home currency are to be paid to get one unit of foreign currency.

Real Exchange Rate: It is relative price of foreign goods in terms of domestic goods. When õost of purchasing one unit of domestic currency (say, rupees) is quoted in terms of foreign currency (say, dollar), it is called real exchange rate. For instance in the above case it costs 2 cents (1 dollar = 100 cents) to buy 1 rupee. People who plan to visit America need to know how expensive American goods are relative to goods at home. Real exchange rate is equal to Nominal exchange rate multiplied, by foreign price level and divided by domestic price level.

Symbolically:
Real exchange rate = \(\frac{\text { Nominal exchange rate } \times \text { Foreign price level }}{\text { Domestic price level }} \)

Question 58.
How is Foreign Exchange Rate determined under Flexible Exchange Rate System.
Answer:
Foreign Exchange Rate refers to the system of exchange rate in which the value of a currency is allowed to adjust freely or to float as determined by demand for and supply of exchange. Thus, flexible rate is free to fluctuate according to the changes in the demand and supply of foreign currency.

Hence, R = f(D,S).
i.e. Exchange rate is a function of demand and supply.
(where R = Exchange Rate, D = Demand for various currencies in the international market and S = Supply of various currencies in international market).

The exchange rate, at which demand for foreign exchange becomes equal to supply of foreign exchange is called Par Exchange of Rate’. It is also termed as ‘Normal Rate of Exchange’ or ‘Equilibrium Rate of Exchange’.

Determination of Exchange Rate
Flexible Exchange Rate is determined by market forces of Demand for and Supply of Foreign Currency change in flexible exchange rate occur on account of change in market demand and supply.

Demand for Foreign Exchange
Demand for foreign exchange arises mainly due to import of goods, investing in foreign countries and giving loans to other nations. Demand for foreign exchange signifies the functional relationship between exchange rate and demanded quantity of foreign exchange. There is an inverse relationship between price of foreign exchange (i.e., rate of exchange) and demand for foreign exchange, e.g., more foreign exchange ¡s demanded at lower exchange rate and vice-versa. That is why demand curve for foreign exchange slopes downward from left to right.

Foreign exchange is demanded for the following reasons:
1. Import of goods and services from foreign countries: When Indian people import goods and services from foreign countries, there ¡s a need to pay for the imports in foreign currencies. It creates demand for foreign exchange.

2. Purchase of assets in foreign countries: If Indians want to purchase assets such as land, buildings, factories, shares, bonds, debentures, etc. in foreign countries, it creates demand for foreign exchange.

3. Sending gifts abroad: If anybody wants to send gifts abroad, it also requires foreign exchange.

4. Speculation on the value of foreign currencies also creates demand for foreign exchange.

5. Other payments Involved In International transactions like expenditure on embassies and other organisations, foreign travelling, remittances to their families by foreigners working in India, expenditure by Indian students studying in foreign countries, etc.

The demand for foreign exchange rises or falls with the fall or rise in foreign exchange rate. Thus, there is inverse relationship between foreign exchange rate and demand for foreign exchange. Here, the demand curve for foreign exchange is a downward-sloping curve from left to the right.
International Trade - CA Inter Economics Question Bank 6
Figure shows that at exchange rate OR, OQ dollar is demanded. When dollar’s price (i.e., exchange rate) increases to OR2, demand for dollar comes down to OQ2. Similarly, when price of dollar falls to OR1, the demand of dollar increases to 00f. Hence, the inverse relationship between exchange rate and demand for foreign exchange is established which makes the foreign exchange demand curve sloping downward from left to right.

Supply of Foreign Exchange
Supply of foreign exchange represents the functional relationship between foreign exchange rate and supply of foreign exchange. There is a direct positive relationship between foreign exchange rate and supply of foreign exchange, e.g., with rise of foreign exchange rate, supply of foreign exchange increases and vice-versa.

The supply of foreign exchange comes from:

  1. Export of goods and services to foreign countries;
  2. Investment by foreign countries in the domestic country or purchase of assets by foreigners;
  3. Receiving gifts from the rest of the world;
  4. Inward movement of foreign currencies due to currency dealers and speculators;
  5. Other receipts involved in international transactions.

The supply of foreign exchange rises or falls with the rise or fall in foreign exchange rate. Thus, there is direct relationship between foreign exchange rate and supply for foreign exchange. Hence, the supply curve for foreign exchange is an upward-sloping curve.
International Trade - CA Inter Economics Question Bank 7
The supply curve SS indicates that at higher exchange rates larger amount of foreign exchange are offered for sale. For example, when rate of exchange goes up from OR to OR2, supply of foreign exchange increases from OQ to OQ2 and on the other hand, when exchange rate comes down to OR1, supply of foreign exchange also declines to OQ1.

The positive slope of supply curve shows that when exchange rate of dollar in terms of rupees rises (which also means that exchange rate of rupee in terms of dollar’s falls), the Indian exporters will increase the supply of dollars and vice-versa.
International Trade - CA Inter Economics Question Bank 8
Equilibrium exchange rate is determined at the point where demand and supply curves of foreign exchange (DO and SS respectively) cut each other. In Figure, equilibrium exchange rate is determined at the point E, where both demand and supply of foreign exchange are equal to QQ. Thus, OR is the equilibrium market rate of exchange where the demand for and supply of foreign exchange are equal.

International Trade - CA Inter Economics Question Bank

Question 59.
What are the functions of a Foreign Exchange Market? How does it operates?
Answer:
Foreign Exchange Market refers to the market of trading for different currencies of the world. It is an Institutional arrangement for buying and selling of foreign currencies. Exporters sell foreign currencies while importers buy them.

Participants of Foreign Exchange Market

  • Commercial Banks
  • Foreign Exchange Brokers
  • Authorised dealers
  • Monetary authorities

Functions of Foreign Exchange Market
Foreign exchange market performs the following functions:
1. Transfer Function: It implies transfer of purchasing power in terms of foreign exchange across different countries of the world.

2. Credit Function: It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world.

3. Hedging Function: It implies protection against the risk related to variations in foreign exchange rate. Demand for and supply of foreign exchange is committed at some commonly agree rate of exchange even when the commitments are to be honoured on some future date.

Operation of Foreign Exchange Market
Foreign exchange market consists of two types of foreign exchange-Spot Exchange Rate and Forward Exchange Rate. On the basis of it, foreign exchange market may be classified into two:

  1. Spot Market, and
  2. Forward Market.

Spot Market
Spot market for foreign exchange is that market which handles only spot transactions or current transactions. Such market does not deal with future transactions and ¡t contains the nature of daily market. It is also called ‘Effective Exchange Rate

In terms of ‘period of transactions’, spot market is of ‘daily nature It does not trade in future deliveries. The rate of exchange which Is determined in the spot market is known as spot rate of exchange. The spot rate of exchange or current rate of exchange is that rate which happens to prevail at the time when transactions are incurred.

Forward Market
Forward market for foreign exchange is that market which handles such transactions of foreign exchange as are meant future delivery. Such transactions are signed today but are to materialise (or are to be honoured) on some future date. In this market, foreign exchange is made available in future. So forward exchange rate is that one at Which transactions are made on some future date. It only caters to forward transactions; it does not deal with spot transactions in foreign exchange.
It defines (or determines) forward exchange rate-the exchange rate at which forward transactions are to be honoured.

Question 60.
Explain briefly the effects of change in demand and suppty on Exchange Rate.
Answer:
Effects of Change in Demand and Supply on Exchange Rate Exchange rate is determined by demand and supply forces of foreign exchange. Hence, change in demand and supply conditions bring change in exchange rate. When the demand for foreign exchange increases, demand curve shifts upward and consequently exchange rate rises.
International Trade - CA Inter Economics Question Bank 9
Similarly, when the supply of foreign exchange increases, supply curve shifts to the right and consequently exchange rate falls.
International Trade - CA Inter Economics Question Bank 10
Causes of Changes in Exchange Rates
1. Change In trade: The demand and supply of foreign exchange is influenced by changes in exports and imports. If exports exceed imports, demand for domestic currency increases so that rate of exchange moves in its favour. But, if imports exceed exports, the demand for foreign exchange increases and the rate of exchange will move against the country.

2. Capital movements: Short-term or long-term capital movements also influence the exchange rate. For example, if there is a capital flow from USA for investment in India, the demand for Indian Currency will increase in the foreign exchange market. As a result, the rate of exchange of Indian rupee in terms of US dollar will rise.

3. Sale and purchase of securities: The stock exchange transactions, i.e., the sale and purchase of foreign securities, debentures, shares, etc., influence the demand for foreign exchange, and thereby, the exchange rate.

4. Bank rate: The bank rate also influences the exchange rate. if bank rate is raised, more funds will flow into the country from abroad to earn high interest rate. As a result supply of foreign currency increases and the rate of exchange moves against the foreign exchange. Converse will be the case if the bank rate falls.

5. Speculative activities: Speculation in the foreign exchange market also influences the exchange rate. If the speculators expect a fall in the value of foreign currency, they will sell that currency. As a result, rate of exchange will move against foreign currency and in favour of home currency.

6. Political conditions: If there is political stability, strong and efficient administration foreign investment increases in the country. The demand for domestic currency will increase and the exchange rate will move in favour of the country.

7. Changes in income and exchange rate: Changes in Income also affect exchange rate. When there is increase in income, consumer spending increases. It encourages the increase in spending on imported goods also. As a result of it, demand tor foreign exchange increases.

Consequently, domestic currency depreciates. Similarly, if there is increase in income in the rest of the world, the domestic exports will rise. Consequently, the supply of foreign exchange increases and the domestic currency may appreciate. On the whole, It the aggregate demand of the domestic country grows faster than the rest of the world, its currency depreciates.

8. Determination of exchange rate In the long run: Changes In Purchasing Power of Money: According to the Purchasing Power Parity (PPP) Theory, in the long run, the rate of exchange between two currencies is determined by their respective purchasing powers. In simple words, the theory states that the purchasing power of one currency is equal to that of another currency and the rate of exchange reflects the equality of respective purchasing powers of the two currencies.

Question 61.
Describe deterrents to Foreign Direct Investment (FDI) in the country. (May 2018, 2 marks)
OR
What are the modes of Foreign Direct Investment (FDI)? (Nov 2018, 3 marks)
Answer:
Modes of Foreign Direct Investment: (FOI)
Foreign direct investments can be made In a variety of ways, such as:

  • Opening of a subsidiary or associate company in a foreign country;
  • Equity injection into an overseas company,
  • Acquiring a controlling interest in an existing foreign company
  • Mergers and Acquisitions (M&A)
  • Joint Venture with a foreign company
  • Greenfield investment (establishment of a new. overseas affiliate for freshly starting production by a parent company).

Question 62.
Distinguish between Foreign Direct Investment (FDI) and Foreign Portfolio investment (FPI). (May 2019, 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 öt the asset in the host country. Foreign portfolio investment is the flow of what economists call ‘financial capital’ rather than ‘real capital’ and does not involve ownership or control on the part of the investor.

Foreign Direct Investment (FDI) VS Foreign Portfolio Investment (FPI):

Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI)
Investment involves creation of physical assets. Investment is only in financial assets.
Has a long-term interest and therefore remain invested for long. Only short-term interest and generally remain invested for short periods.
Relatively difficult to withdraw not inclined to be speculative. Relatively easy to withdraw.
Not inclined to be speculative. Speculative in nature.
Often accompanied by technology transfer. Not accompanied by technology transfer.
Direct impact on employment of labour and wages. No direct impact on employment of labour and wages.
Enduring interest in management and control. No abiding interest in management and control.
Securities are held with significant degree of influence by the investor on the management of the enterprise. Securities are held purely as a financial investment and no significant degree of influence on the management of the enterprise.

Question 63.
In which sectors Foreign Investment is Prohibited in India? (Nov 2020, 3 marks)

Question 64.
Describe the benefits and costs of FDI to the host country. (Jan 2021, 3 marks)

Question 65.
Define FDI. Mention two arguments in favour of FDI to developing economies like India.
Answer:
Foreign direct investment is defined as a process whereby 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.

Direct investments are real investments in factories, assets, land, inventories etc. and have three components, viz., equity capital, reinvested earnings and other direct capital in the form of intra-company loans. Foreign direct investment also includes all subsequent investment transactions between the investor and the enterprise and among affiliated enterprises, both incorporated and unincorporated.

FDI involves long-term relationships and reflects a lasting interest and control. According to the IMF and OECD definitions, the acquisition of at least ten percent of the ordinary shares or voting power in a public or private enterprise by non-resident investors makes it eligible to be categorized as FDI.

FDI may be categorized as horizontal, vertical, conglomerate and two-way direct foreign investments
which are reciprocal investments.

Arguments In favour of FOI Investment
Following are the benefits described to Foreign Investments:
1. Entry of foreign enterprises usually fosters competition and generates a competitive environment in the host country. The domestic enterprises are compelled to compete with the foreign enterprises operating in the domestic market. This results in positive outcomes in the form of cost-reducing and quality-improving innovations, higher efficiency and increasing variety of better products and services at lower prices ensuring wider choice and welfare for consumers.

2. International capital allows countries to finance more investment than can be supported by domestic savings resulting in higher productivity and enhanced output. From the perspective of emerging and developing countries, FDI can accelerate growth and foster economic development by providing the much-needed capital, technological know-how, management skills and marketing methods and critical human capital skills in the form of managers and technicians. The spin-over effects as the new technologies usually spread beyond the foreign corporations. In addition, the new technology can clearly enhance the recipient country’s production possibilities.

International Trade - CA Inter Economics Question Bank

Question 66.
Write short note on types of Foreign Capital.
Answer:
Meaning of Capital Movements
international exchange transactions are not only confined to goods and services but include international movement of capital funds too. International capital movements, should not be identified with the payments for imports. Cash flows internationally as a factor of production for the sake of suitable investments and as aids to the under-developed nations. Indeed, international investment plays a significant role in the economic development of countries.

Types of Foreign Capital:
1. ForeIgn investment

  • FDI
  • FPI

2. ForeIgn Deposits
From NRI

3. Foreign Aids

  • Direct Government Aid
  • Aid from World Bank
  • Grants in form of voluntary transfer of resources
  • 4. Foreign Borrowings

Loan from Government

  • Loan from financial institutions
  • Soft Loans
  • ECB
  • Trade Credit

Money Market – CA Inter Economics Question Bank

Money Market – CA Inter Economics Question Bank is designed strictly as per the latest syllabus and exam pattern.

Money Market – CA Inter Economics Question Bank

Question 1.
Define Money
Answer:
Functional Definition of Money
According to Crowther
Money can be defined as anything that is generally acceptable as a means of exchange (i.e. as a means of setting debts) and that at the same time acts as a measure and as a store of value.

Legal Recognition Definition of Money
According to Knapp: Anything which is declared as money by the state, that becomes money.

General AcceptabilIty Definition:
According to Kent: Money is anything which is commonly used and generally accepted as a medium of exchange or as a standard of value.

Question 2.
Mention the general characteristics of Money. (Nov 2018, 2 marks)
Answer:
Following are some general characteristics that money should possess are:

  • 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.

Question 3.
“Money has four functions: a medium, a measure, a standard, and a store.” Elucidate. (May 2019, 3 marks)
Answer:
Primary Functions of Money
Money performs two primary functions, as under:
1. Medium of Exchange:
Money acts as a medium for the sale and purchase of goods and services. In the absence of money, goods were exchanged for goods. This required double coincidence of wants. Implying that exchange was difficult, and therefore limited. Introduction of money has separated the acts of sale and purchase double coincidence of wants is no longer a limitation.

2. Measure of Value or Unit of Value:
Money serves as a measure of value. in other words, it serves as a unit of account. Unit of account means that the value of each good or service is measured in the monetary unit. Measurement of value was very difficult in the barter system: one good was valued in terms of the other. There was no common unit of value. introduction of money has removed this difficulty.

Now, each good is valued in terms of money. It is because of the existence of money as a common unit of value that we are now able to construct consumer price index and wholesale price index. Consumer price index reflects cost of living of the people. Wholesale price index shows the rate of inflation in the country.

Secondary or Subsidiary Functions
Following three functions are secondary or subsidiary functions of money:
1. Standard of Deferred Payments:
Deferred payments refer to those payments which are made sometimes in the future. Money has made deferred payments much easier than before. When we borrow money from somebody, we have to return both the principal as well as Interest amount, sometime in the future. Money is a convenient mode of these payments. It is difficult to make such payments in terms of goods and services. Imagine that you have taken a loan from somebody in terms of wheat. How difficult it is to return this loan in terms of wheat of the same quality?

2. Store of Value: Store of value implies store of wealth. Storing wealth has become considerably easy with the introduction of money. Wealth can be stored just in terms of paper titles like FOR (Fixed Deposit Receipt). It was not convenient to store value in the barter system of exchange. Because goods tend to wear out or perish.

3. Transfer of Value: Money serves as a convenient mode of transfer of value (wealth). Wealth can be conveniently transferred (or can be transferred) to any part of the world, It is the transfer of value, which has led to the emergence of MNCs (Multinational Corporations). Accordingly, the concept of global economy has come into existence.

Money Market - CA Inter Economics Question Bank

Question 4.
“Money performs many functions n an economy.” Explain those functions briefly. (Nov 2020, 3 marks)

Question 5.
Do you think money is a unique store of value?
Answer:
The effectiveness of an asset as a store of value depends on the degree and certainty with which the asset maintains its value over time. Money is undeniably a good store of value; but it is not unique as a store of value.

Financial assets other than money are also performing the function of store of value just as money has the financial assets have fixed nominal value over time and represent generalised purchasing power. Any asset, such as equities, bonds, land, buildings, precious metals, antiques and works of art can all act as store of value.

Question 6.
Explain the concept of demand for money. What are the approaches to demand for money.
Answer: .
Demand for money can be defined as the quantity of money demanded for different purposes by the people at any particular time and in any particular economy.

Approaches to Demand for Money
1. Classical Approach

  • Fisher’s Approach
  • Cambridge Approach

2. Modern Approach

  • Keynesian Approach
  • Post Keynesian Approach.

Question 7.
Explain the following modified equation of exchange as given by Irving Fisher:
MV + M’V’ = PT (May 2018, 3 marks)
Answer:
Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:
MV= PT

Where M = the total amount of money in circulation can an average) in an economy.
V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of money (say Rupee) is spent in purchasing goods and services
P = average price level CP = MV/T)
T = the total number of transactions.
Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes.
(MV + M’V’=PT)
Where, M’ = the total quantity of credit money
V’ = velocity of circulation of credit money.

The equation broadly indicates that the price level (P) is directly related to total quantity of money (original money and bank money) multiplied by its velocity. It, is, however, inversely related to T. He has established in his equation the basic proposition that the price level and the value of money is a function of money supply provided other things remain constant. These other things are M’V, V, and T and if they remain constant, price level will change directly and proportionately with the change in money supply. Price level affects the value of money inversely and thus change In money supply
influences the value of money inversely.

Question 8.
Explain why people hold money according to Liquidity Preference Theory. (May 2018, 3 marks)
Answer:
According to Liquidity Preference Theory as given by Keynes people hold money in cash for three motives:
1. The Transactions Motive
The transactions motive for holding cash relates to the need for cash for current transactions for personal and business exchange. The need for holding money arises because there is lack of synchronization between receipts and expenditures

2. The Precautionary Motive
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.

3. The speculative Demand for Money:
The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure.

According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices.

Money Market - CA Inter Economics Question Bank

Question 9.
Explain the transaction motive for holding cash. (Jan 2021, 2 marks)

Question 10
Explain the neo-classical approach to demand for money. (Nov 2019, 3 marks)
Answer:
The Neoclassical Approach or the cash balance approach put forth by Cambridge economists holds that money increases utility in the following two ways:
1. for transaction motive, i.e. for enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous.

2. as a temporary store of wealth i.e. for a hedge against uncertainty. Demand for money involves a precautionary motive in Cambridge approach.

Since money gives utility in its store of wealth and precautionary modes, one can say that money is demanded for itself. Now question is how much money will be demanded. The answer is it depends partly on income and partly on other factors of which important ones are wealth and interest rates. The former determinant of demand i.e. income point to transactions demand such that higher the income, the greater the quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value to overcome transactions costs.

The Cambridge equation is stated as:
Md=KPY
Where,
Md = is the demand for money
Y = real national income
P = Average price level of currently produced goods and services
PY = Nominal income
K = Proportion of nominal income (PY) that people want to hold as cash balances.

The term ‘K’ in the above equation is called ‘Cambridge K’. The equation above explains that the demand for money (M) equals K proportion of the total money income.

Thus the neoclassical theory changed the focus of the quantity theory of money to money demand and hypothesized that demand for money is a function of only money income. This version is concerned with money as a means for transactions or exchange and therefore, they represent models of the transaction demand for money.

Question 11.
Explain how speculative motive for holding cash is related to market interest rate.
Answer:
According to Keynes’ theory of Liquidity Preference, speculative motive for holding cash is related to market Interest. 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, Investors have a relatively fixed conception of the ‘normal’ or ‘critical’ interest rate and compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.

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’, i.e., 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 alternative assets.
  4. If the interest rate does increase in future, the bond prices will fail and the idle cash balances held can be used to buy bonds at lower prices and can thereby make a capital gain.

Summing up, so long as the current rate of interest is higher than the critical rate of interest, a typical wealth-holder would hold in his asset portfolio only government bonds while if the current rate of interest is lower than the critical rate of interest, his asset portfolio would consist wholly of cash. When the current rate of interest is equal to the critical rate of interest, a wealth-holder is indifferent to holding either cash or bonds. The inference from the above is that the speculative demand for money and interest are inversely related.

Question 12.
Compare and contrast Fisher’s Version with the Cambridge version of the Quantity Theory of Money.
Answer:
Fisher’s Version Vs Cambridge’s Version of Quantity Theory of Money:
Similarities between the two Approaches

  1. Both the theories lead to the same conclusion that it is the quantity of money that determines the value of money and the price level.
  2. MV + M’V’ in Fisher’s equation, M in Robertson’s as well as Pigou’s equations and in Keynes equation refer to the same things i.e. the total quantity of money.

The points are worth nothing here:
(i) In Fisher’s equation credit money has been represented separately by M’ but in Cambridge equations, credit money has not been separately shown because the total quantity of money implies credit money also in this dynamic world of today.

(ii) In Fisher’s equation velocity of Legal tender money and credit money have been represented separately by V and V’ whereas in Cambridge equations, there is no mention velocity of circulation of money.

3. The cash balance equation of Robertson, namely, P = \(\frac{M}{K T}\) and Fisher’s equation namely P = \(\frac{M V}{T} \) resembles with one another. The symbols used in the two equations are almost the same. The only difference relates to V and K. But even V and K are reciprocal to each other. In Fisher’s equation V = \(\frac{P T}{M}\) which in Robertson’s equation K = \(\frac{\mathrm{M}}{\mathrm{PT}} \) Thus, K is reciprocal of V. In other words K = \(\frac{1}{V}\) or V = \(\frac{1}{\mathrm{~K}} \) There is no fundamental difference in the two equations. Rather they represent different aspects of the same phenomenon.

4. Fisher’s equation and Cambridge’s equations, according to Robertson, are not basically different from each other. Rather they explain the same thing with two different angles. Fisher’s equation stresses money as a flow while Cambridge’s version emphasises money as stock.

Dissimilarities Between the Two Approaches
The two approaches differ from each other on the following grounds:
1. The two versions make use of different concepts of demand for money. In transactional approach, the demand for money is to exchange goods and services and thus it stresses medium of exchange function of money. Whereas, in cash balance approach, the demand for money is to store and thus here it emphasises the ‘store of value’ function of money.

2. The two approaches have different nations of money. In Fisher’s approach, emphasis is laid on velocity of circulation of money (V) while the cash balance approach, the stress is on the idle cash balance that is a fractional part of the national income (K). It should be noted that V is exactly opposite of K.

3. Fisher’s equation explain the value of money over a period of time while the Cambridge equations explain the value of money at a point of time. When we consider a period of time, velocity becomes important because money during that period is expected to perform a variety of functions. At a given point of point money simply represents some goods and services. Here K plays an important role. it is for this reason that V is emphasised in Fisher’s equation and K in Cambridge equation.

4. Symbol P in two types of equations is not identical In meaning. P in Fisher’s equation represents general price level whereas P in the Cambridge equations refers to only the prices of consumption goods.

Money Market - CA Inter Economics Question Bank

Question 13.
Out of fisher’s verison and cambridge version of the quantity theory of money, which one do you consider superior and why?
Answer:
Cambridge Version i.e. Cash Balance approach Is Superior
The study of the two version of the Quantity Theory of money-cash transaction and cash balance – their similarities and dissimilarities, establishes the superiority of the Cambridge version i.e. cash balance approach.

The points in support are:
1. Fisher’s version is mechanical whereas Cambridge version is realistic. Fisher’s version is mechanical in the sense that it treats price level as the exclusive function of the quantity of money in circulation. It accords no place to human motives. The Cambridge version, on the other hand, make consideration of human motives by emphasising K in determining the price level. The size of K is more or less determined by human motives i.e., store of money.

2. Fisher’s version considers only the quantity of money (i.e, supply of money) as the sole determinant of the value of money. Whereas the Cambridge equations considers, on the other hand, both the demand and supply aspects of money in determining the value of money. The Cambridge version is thus more comprehensive than Fisher’s version. Fisher’s version, thus, may be considered as incomplete.

3. The Cambridge version is wider and more comprehensive from another point of view also. Fisher’s version does not consider the income level as a determinant of price level. The price level, according to this version, is determined by the quantity of supply (supply of money) and the total number of transactions whereas in Cambridge version, price level is influenced by the income level and the changes in it.

4. Fisher’s equation explains that price level changes only when there is a change in the supply (total quantity) of money in circulation. But the Cambridge version explains that price level may change even without any change ¡n the quantity of money, if K undergoes a change. If people prefer holding more cash balances (if K changes), the price level will also undergo a change without any change in the quantity of money. Thus, K is more important determinant than M.

5. The Cambridge version stresses subjective factors as the main determinants of the demand for money. Fisher’s approach, takes into account only objective factors while discussing the demand for money. On the above ground, the Cambridge version enjoys a superiority over Fisher’s approach to the Quantity Theory of Money.

Question 14.
What are the assumptions of Fisher’s Quantity Theory of Money.
Answer:
The Quantity Theory of money was first expounded by an Italian economist Mr. Davanzatti but the theory was popularised by the American economist, Irving Fisher who gave ¡t a quantitative form and explained by an equation known as Equation of Exchange.

Assumptions of Fisher’s Equation
The Fisher’s equation of exchange is based on the following assumptions:
1. Price level (or P) is a passive factor.
P in the equation (Price level) is inactive or passive in the equation. P ¡s affected by other factors in the equation Le. T,M, M’ V or V’ but it does not influence other factors in any way. P is thus a resultant and not a cause.

2. T and V are constant.
The theory assumes that T in the short period remains constant because T depends upon the volume of production and the production and its techniques do not change in the short period. Similarly. V depends upon the size of population, state of economic development, money habits of the people, which remain unaffected during the short period. Hence, T and V have been assumed constant in the theory.

3. T and V are Independent Factors.
Fisher assumes that total volume of trade (T) and velocity of money (V) are independent variables in the equation and are not affected by the change in any other factor. The volume of trade however, is determined by certain outside factors. V (velocity of circulation of money) is also independent and was not affected by change in M or P. V. is also affected by money other external factors.

4. The Ratio of Credit Money to Legal Tender Money Remains Constant.
The theory assumes that the ratio of credit money to legal tender money also remains constant. If it is not constant, the quantitative relation between money and prices as visualized in the theory does not hold good.

Thus, four variables in the equation of exchange i.e., M’ V, V’, and T are assumed to be constant during the short period. P is a passive factor, therefore, the change in the quantity of money (M) directly affects the price level (P).

Money Market - CA Inter Economics Question Bank

Question 15.
Briefly explain the Quantity Theory of Money.
Answer:
The Quantity Theory of Money – The Transaction Approach As we know, the value of money implies what a unit of money can buy in terms of commodities and services. The price of commodities or the general price level does not remain constant hence the value of money also fluctuates. The two have inverse relationship. If general price level increases, the value of money decreases or the value of money increases with the decrease in general price level.

The quantity theory of money indicates that the value of money In a given period depends upon the quantity of money in circulation in the economy. The quantity of money supply determines the general price level and the value of money. Any change in the money supply will change the general price level directly and the value of money inversely in the same proportion. For example, if the quantity of money in circulation is doubled other things being equal, the general price level will be doubled and the value of money is halved. Similarly, if the quantity of money is halved, the price level will be halved and the value of money will be doubled. Prof. F.W.

Taussig has stated the tendency of this theory thus:
“Double the quantity of money, and other things being equal, prices will be twice as high as before; and the value of money as one-half. Halve the quantity of money, and other things being equal, prices will be one half of what they were before, and the value of money double.” In the words of J.S. Mill, “The value of money, other things being the same, varies inversely as its quantity; increase of quantity lowers the value and every diminution raising it in a ratio exactly equivalent.”

Equation of Exchange
The transaction version of the quantity theory of money was presented by Irving Fisher in the form of an equation known as equation of exchange as given below:
MV = PT
Where M Quantity of money in circulation.
V = Velocity of circulation of money. It denotes average number of times a unit of money changes hands.
P = Price level
T = Total volume of transactions of goods and services during a given period of time.

The above equation has two sides i.e. MV an PT. MV represents total supply of money in the economy. M represents the total money supply in circulation but a unit of money does not purchase goods and services. In a given period of time, only once. It changes hands by a number of times. Hence, total money supply is represented by the quantity of money multiplied by its velocity which is represented by MV in the equation. PT, on the other side of the equation represents total demand for money or the money value of all the goods and services brought during a given period of time. Hence, total volume of transactions (T) multiplied by the price level (P) denotes the total demand of money. Thus, MV = PT or total supply of money (MV) is equal to total demand of money to purchase the total transactions at a given price (PT). The equation is referred to as the cash transaction equation. It could also be expressed as follows:
P = \(\frac{M V}{T}\)

Thus, price level is determined by the total quantity of money divided by the total transactions. Thus, the total quantity of money determines the price level provided P and T are constant. The above equation was criticised by some of the monetary experts on the ground that the theory ignores completely the credit money and its velocity both of which are important in the modern-day economy.

Irving Fisher, later extended his original equation, considering the credit money and its velocity represented by M’ and V’ respectively and put the extended equation as follows:
MV+ M’V’ = PT
or P = \(\frac{M V+M V’}{T} \)

The equation broadly indicates that the price level (P) is directly related to total quantity of money (original money and bank money) multiplied by its velocity. It, is, however, inversely related to T. He has established in his equation the basic proposition that the price level and the value of money is a function of money supply provided other things remain constant. These other things are M’V, V and T and it they remain constant, price level will change directly and proportionately with the change in money supply. Price level affects the value of money inversely and thus change in money supply influences the value of money inversely.

Question 16.
Give the critical Appraisal of Quantity Theory of Money.
Answer:
Critical Appraisal of the Quantity Theory:
The transaction approach of the quantity theory of money (or Fisher’s equation of exchange) has been subjected to the following criticism.
1. The theory Is based upon unreal assumptions. According to Fisher. P is a passive factor, T is independent, M’ V and V’ are constant in the short period. He covered up all these assumptions under ‘other things remaining the same’. But according to critics, these other things do not remain constant in the actual working of the economy hence they are unrealistic and misleading.

For example:

  • the velocity of circulation of money automatically changes with the change in the quantity of legal tender money.
  • there is no well-defined relationship between legal tender money (M) and bank money (M’).
  • any change in legal tender money will also influence the velocity of credit money (V’).
  • the assumption that T is an independent factor and does not change with the change in M.

Which is not correct because T cannot remain constant consequent upon the change in M. If M increases, P will also increase, resulting in higher profits which naturally affect the production. Impliedly, P cannot be assumed as a passive factor. It certainly influence T.

(v) Price level is not an outcome of changes in money supply, P also effectively influence the money supply. Thus, P also determines M and M determines P. Both are inter-related. Thus, according to critics, the assumption are not real because other things do not remain constant.

2. A Long-Term Analysis of Money. The theory offers a long-term analysis of value of money and therefore, ignores the changes in short period. However, there are certain violent and far-reaching changes in the short run in the value of money which the theory ignores.

3. How money supply influences the price level is not Explained. The theory simply presents that the quantity of money affects the price level but it does not explain the process how it is possible. MV = PT is simply a mathematical equation and explains only that total supply of money is equal to total transaction value. It throws no light on cause and effect relationship of money and price.

4. No Direct and Proportional Relationship between Quantity of Money and the Price Level. The theory states that every change in the money supply brings proportional and direct change in the price level. But in actual life, no such relationship exists because there are other external factors which disturb this relationship.

5. Assumption of Full Employment is Wrong. Keynes has raised an objection against, the theory that the assumption of full employment is a rare phenomenon in a economy and the theory is not real. The relationship between M and P does not hold good if we assume unemployment in the economy.

6. The Theory is not Comprehensive. According to Keynes, total legal tender money and credit money do not constitute the total supply of money, because whole of it is not used for the purchase of commodities and services. A part of the total legal tender money is hoarded by the people which is not used for the exchange of goods and services. So, the hoarded money should not be considered.

7. Money Supply is not the only factor influencing price level. The change in price level is not influenced merely by the change in money supply. There are other factors such as change in national income, national expenditure, savings, and investments. According to Prof. Crowther ‘the value of money, in fact, is a consequence of the total of incomes rather than of the quantity of money. It Is the causes of fluctuations in the total of incomes of which we must go in search.’

8. The Theory Neglects Velocity of Commodities. The theory considers velocity of money but ignores velocity of circulation of commodities which is a serious drawback of the theory.

Money Market - CA Inter Economics Question Bank

Question 17.
Examine the Cash Balance Approach to the Quantity Theory of Money.
Answer:
According to Cash Balance Approach, the value of money is determined on the basis of its demand and the its supply. When the demand for money is equal to its supply, the value of money, like other things is settled. The changes in the value of money are thus caused by changes either in its demand or in its supply or in both. In this way the approach is based on the general theory of value and is applicable to the problem of money. The approach considers the demand for and supply of money at a particular point of time, rather than over a period of time enunciated by the transaction approach.

According to Cash Balance Approach, the supply of money is its stock at a particular time not its flow over a period of time and comprises alt the cash and bank deposits subject to withdrawals by cheques. Demand for money, according to this approach, has been interpreted in a different manner.

According to Fisher the demand for money is not for its own sake. It is made only to purchase the commodities and services. In other words, money is demanded because, it serves as a medium of exchange. But this theory emphasises that the demand for money is made for meeting their day-to-day requirements by individuals, firms and governments. Thus, the demand for money refers to that quantity of money which the individuals, commercial firms and the government hold to meet its day-to-day requirements. Thus the supply of money set against the community’s aggregate demand (or cash
balances) determines the level of prices or the value of money in the economy. If demand is constant, only change in the supply of money will directly affect the price level and inversely the money value.

On the other hand, if supply is constant, the price level will change inversely and money value directly with any change in the demand for money. An increase in the demand for money (for store purposes) will lower down the demand for goods and services because people can now have a larger cash balance only by cutting their expenditure on goods and services. Consequently the price level will fall and the money value will go up. Converse will be the case with the fall in demand for money.

Question 18.
Elucidate the equations of Cash Balance Approach.
Some Equations of Cash Balance Approach
We shall now examine some of the equations of cash balance approach.
Marshall’s Equation:
Marshall’s cash balance equation is
M=KY.
where M represents total supply of money.
K is that portion of income which we want to hold in the form of money.
Y is the aggregate real national income
K, in other words, is the reciprocal of velocity.
Since the total money income Y equals the total real output (O) time the price level (P), the abovQ equation can be presented as:
M = KPO
or P = \(\frac{\mathrm{M}}{\mathrm{KO}} \)

This approach emphasises that a shift in the magnitude of K significantly influence the price level even though the supply of money (M) remains constant. Thus, it is K and not M that influences the money value.

Pigou’s Equation:
Prof. Pigou has developed the equation as:
P = \(\frac{K R}{M}\)
where P represents the value of money, K stand for the proportion of total real income to be held in cash, R represents total real income and M is total quantity of money. The equation later enlarged considering the fact that all people do not hold cash strictly in the form of legal tender money. Some of them have cash in the form of bank deposits also. The enlarged equation is:
P = \(\frac{\mathrm{KR}}{\mathrm{M}} \) [c + h(1-c)]
M = \(\frac{\mathrm{KR}}{\mathrm{P}} \) [c+h(1- c)]
Where c represents cash in legal tender money, h represents the proportion of cash reserves to deposits held by the bank. (1- c) stands for the proportion of legal tender money which is kept in the form of bank deposits. For explaining the changes in the value of money, Pigou emphasised on K rather than on M.

Keynes Equation
J.M. Keynes, a noted Cambridge economist has presented his own equation known as ‘The Real Balance Quantity equation.’ His equation is:
n=PK
or P = \(\frac{n}{K}\)
where, n = total supply of money in circulation.
P = Prices of consumption goods.
K = Total quantity of consumption units which the people went to hold in cash. Keynes refers to K as the real balance.

Keynes further enlarged his equation taking bank deposits into account. The enlarged equation is: .
n = P (K + rK)
or P = \(\frac{n}{K+r K} \)
where, r =proportion of bank reserves to their deposits
K’ =number of consumption units which the public keeps in the form of bank deposits. Other symbols carry the same meaning as given above.

Assuming K; K’ and constant nand P have direct and proportional relations. The proportion between K and K’ is determined by the banking arrangements of the public and their absolute value is determined by the habits of the people The value of r is determined by the practice of banks to hold cash reserves. So long as these values remain constant n and P have direct relation.

Question 19.
What were the criticisms against the Cash Balance Approach to Quantity Theory of Money.
Answer:
Criticism of the Cash Balance Approach
The Cambridge version of the quantity theory of money or the cash-balance approach has the following shortcomings:
1. The theory assumes that the elasticity of demand for money is unity which is not possible in the dynamic society of today.

2. The cash-balance approach does not consider all the determents of the demand for money. For example, it ignores the speculative motive of holding money which causes a violent change in the demand for money.

3. The serious defect in the Cambridge equations is that they seek to explain the value of money in terms of consumption goods only. It is wrong and illogical. The equations completely ignores the reference of capital goods.

4. According to theory, the real income only determines the value of k (i.e. cash to be held by people). Whereas there are other determinants of k in the real life than real income, such as, the price level, monetary and business habits and political conditions of the country etc.

5. According to the Approach, cash holdings by the people (K) determines the purchasing power of money or the price level. It is also not correct. Critics pointed out that K not only influences P but is also influenced by it. At a time of rising prices, K falls because the people want to buy today rather than wait for tomorrow. The K (cash holding) would rise in case of a fall in prices. Thus, K is also influenced by the change in the price level (P).

6. It is difficult to visualise in terms of cash balance approach the extent to which prices and output will change, consequent upon a given change in the supply of money. The theory thus lack quantitative exactness.

7. The Cambridge equations also assume K and T as constant. It is thus, open, to the same criticism as the Fisher’s equation.

8. The cash-balance approach ignores those bank deposits which come into existence consequent upon the lending operations of the banks. Thus, the approach considers only primay and not the derivative bank deposits. Derivative bank deposits are not the less important than the primary deposits.

Question 20.
Write short note on how Interest rate affect the transaction demand for money.
Answer:
Interest Rate and Transaction Demand of Money
Keynes has assumed rate of interest ineffective to transaction demand for money as a determinant of transaction demand for money. But he has also pointed that Demand of money is the function of interest rate. Even then, he and his followers have not emphasized much on this i.e. interest rate as a determinant of transaction demand for money and they have ignored this factor.

Some of the post-Keynesian economists like J. Baumol and J. Tobin etc. have assumed interest rate as a very important determinant of ‘Transaction Demand for Money’.

They said this also that there is no linear and proportionate relationship between transaction demand for money and income rather as a result of change in income, change in transaction demand for money is proportionately small.

According to these economists, transaction demand for money is the function of both income and rate of interest i.e. Lt = f (Y, r)

Question 21.
Question Short Notes on liquidity Trap
Answer:
Liquidity Trap:
Liquidity Trap is a situation in which speculative demand for money becomes perfectly elastic. it is a situation of absolute liquidity preference. This term was coined by Prof. J. M. Keynes. A liquidity trap appears at a very low rate of interest in which people prefer to hold cash rather than invest in bonds. The fear of loss due to minimum rate of interest may induce the public to refrain fram further secunty purchases; the alternative is simply to hold the additional cash as an idle asset.
Money Market - CA Inter Economics Question Bank 1

Question 22.
Write short note on superiority of the saving-investment theory of money over Quantity Theory of Money.
Answer:
The saving-investment theory or income theory is superior to the traditional theory of the value of money. Following are the points, explaining merits of the theory over the Quantity Theory of Money.

1. The Saving-Investment theory has a good combination of the two theories i.e., the general theory of value (the theory of individual price) and the theory of money (the theory of general prices). It, therefore, presents a more comprehensive view of the price fluctuations than the classical theory of the value of money (i.e. the quantity theory of money).

2. The older quantity theory of money established that any change in the quantity (or supply) of money will affect the price level directly and proportionately if other things remaining constant. Thus, it presents a very simple explanation to money-price relationship. The saving-investment theory is rather complicated as it describes a series of event that lead to the changes in price level.

Changes in the supply of money lead to changes in the rates of interest, bringing about a change in the relationship between saving and investment. This change in relationship, in their turn, influences the level of income, employment, and output which ultimately brings about a change in price level. If investment exceeds saving, prices will rise or if saving exceeds investment, the price will fall. This establishes a better relationship between money and prices.

3. The Saving-Investment theory, provides a tool for analysing the cyclical fluctuation ¡n prices, employment and output. According to this theory, business cycle is nothing but an altering expansion and contraction of national income. It is, therefore, a distinct improvement over the quantity theory of money.

4. The quantity theory of money has assumed the situation of full employment which is not a realistic assumption because the situation of full employment does not exist in any economy. The Saving-Investment theory, on the other hand, does not assume full employment as the basis of theory.

5. The quantity theory of money does not explain why the velocity of money changes or the factors that change the velocity of money. The Saving Investment theory, on the other hand, throws light on changes in the velocity of circulation of money from time to time. Thus, the theory is better than the quantity theory of money.

Money Market - CA Inter Economics Question Bank

Question 23.
In Keynesian analysis of speculative demand for money, how will demand for money be affected it people feel that the level of interest is very high? What is the rationale behind their choice?
Answer:
If wealth-holders consider that the current rate of interest is high compared to the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high current rate of interest, people are discouraged from holding money and hence they will convert their cash balances into bonds because there is high opportunity cost ot holding cash in terms of interest forgone; as they can earn high rate of return on bonds.

Also, there is less chance of interest rates to rise further resulting in a fall in prices of bonds and consequent capital losses. They expect fall in the market rate of interest in future and capital gains resulting from a rise in bond prices.

Anticipating such capital gains from rising bond prices, people will convert their cash into bonds. The inference from the above is that the speculative demand for money and interest are inversely related. At higher rates of interest, the speculative demand for money would be less. The individual would then hold as little money as possible, only for covering the transactions and precautionary motives.

The individual’s demand fpr money, as a function of the interest rate, would then be a step function, depicting a discontinuous portfoio decision as shown in figure below;
Money Market - CA Inter Economics Question Bank 2
When the current rate of interest in is higher than the critical rate of interest rc, the entire wealth is held by the individual wealth-holder in the form of bonds. If the rate of interest falls below the critical rate of interest rc, the individual will hold his entire wealth in the form of speculative cash balances.

Question 24.
Describe the determinants of demand for money as identified by Milton Friedman in his re-statement of Quantity Theory of demand for money. (May 2019, 3 marks)
Answer:
Modern Quantity Theory of Money by Milton Friedman
According to Milton Friedman, Quantity Theory of Money is mainly ‘Theory of Demand of Money’ and there are four elements or factors which determine the Demand of Money of the society as following:

1. General Price level According to Milton Friedman, General Price Level and Demand of Money change directly and proportionately. Other things remaining the same. Demand of Money will increase exactly by 10% as a result of 10% increase in the price level i.e. Demand of Money is unitary elastic.
2. Change in Quantity of Goods and Services or Real Income Milton Friedman told that Change in Real Income and Quantity of goods and services affect Demand of Money. Change in Real Income and Change in Demand of Money are directly related, though not proportionately. As a result of increase in Real Income or quantity of goods and services, Demand of Money will increase certainly but not proportionately. Here, Demand of Money will not be unitary elastic. Often ¡t is more than unitary elastic.
3. Change In Rate of Interest So far as there is question of interest, if money is held in the form of cash, it will not earn any interest i.e. income. If it is advanced as loan or it is deposited into Bank, it will earn some income as interest. Therefore, interest is the cost of holding cash. Increase in rate of interest increases the cost of holding money in the form of cash. At high rate of interest people would like to hold lesser amount of cash and demand of money will be reduced. Likewise, at low rate of interest, cost of holding money would be reduced and demand of money will be increased. There is inverse relationship between Rate of Interest and Demand of Money. There is no question of proportionate change.
4. Change in Rate of Increase in General Price Level Rate of increase in general price level also affects demand of money. If price level is increasing at a high rate, cost of or loss on holding cash will be increased due to rapid reduction in the purchasing power of money. Therefore, people would likes or prefer to hold lesser amount of money as cash whereby reduction in demand of money will be seen. Contrary to it. If rate of increase in price level is very slow, the cost of holding cash or loss due to reduction in purchasing power would be lesser. Therefore, people would like to hold more cash than before whereby increase in demand of money will be seen.

Question 25.
Describe the treatment of transaction demand for money as per Baumol and Tobin’s model.
Answer:
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money was essentially viewed as an inventory held for transaction purposes.

Inventory models assume that there are two media for storing value: money and an interest-bearing alternative asset. Baurriol’s propositions in his theory of transaction demand for money hold that receipt of income, say Y takes place once per unit of time but expenditure is spread at a constant rate over the entire period of time.

There is an opportunity cost of holding money: the interest forgone on an interest-bearing asset such as a bond. In order to maximize interest earnings, a person would like to hold as much of his wealth as possible in the form of bonds, while still being able to finance the flow of monetary expenditures. If there is no cost to doing so, he would keep all of his wealth in the form of “bond and hold zero money balances.

However, making these transfers generally incurs some kind of cost, either explicitly through a transaction fee or implicitly through the time and inconvenience of making the transfer. The level of inventory holding depends upon the carrying cost, which is the interest forgone by holding money and not bonds, net of the cost to the individual of making a transfer between money and bonds, say for example brokerage fee. 1f an individual, say X, decided to invest in bonds. If r is the return on bond holding; c is the cost of each transaction in the bond market; (i.e. for converting it to Hquid cash) and n is the number of bond transactions, then the net profit for the individual would be R- (n c) where R is the interest earning on the average bond holding which is equal to r times average bond holdings and nc the transaction costs which equal the cost of each transaction multiplied by the number of bond transactions.

Therefore, for a given income, the choice of the split of total money into money and bond holdings is determined by the choice of n. The individual will choose n in such a way that the net profits from bond transactions are maximized. The Baumol-Tobin model derives the optimal frequency of bond-money transactions that minimizes the sum of the two components of cost: the forgone interest cost (which rises as average money balances increase) and the transaction cost (which falls as fewer transactions are made or more money is held).

The individual will apply the marginalist principle and will increase the number of transactions in the bond market until the point at which the marginal interest earnings from one additional transaction just equals the constant margin cost, which will be equal to the brokerage fee etc. Beyond this point, the marginal gain in interest earned from increasing the number of bond market transactions is not sufficient to cover the brokerage cost of the transaction. To surmise, the choice of n determines the spilt of money and bond holdings for a given income.

The optimal average money holding is:

  • a positive function of income Y,
  • a positive function of the price level P,
  • a positive function of transactions costs c, and
  • a negative function of the nominal interest rate i.

Question 26.
Analyse the drawbacks of Friedman’s Quantity theory of money.
Answer:
Friedman’s Approach of Modern Quantity Theory of Money has been mainly criticised on the basis of the following:
1. Rate of Interest: Rate of interest has not been attributed so much importance as it should have been attributed. Rate of Interest plays very important role in influencing or affecting the demand of cash balance. Undoubtedly, cost of holding cash balance is increased due to increase in rate of interest and demand of money is reduced. And contrary to it, increase in fixed deposits of Bank is started, because people like to take advantage of the increased rate of interest. In the last decades of the twentieth-century an extraordinary increase in these deposits was recorded due to the increase in rate of interest on fixed deposits.

2. Supply of Money: It was assumed by Milton Friedman that supp’y of money in society is not affected by change in income and price level. Conversely, supply of money determines price level and income of the society. Experiences prove that supply of money is not an independent variable and this is always affected by the change in price level and income.

Question 27.
Critically examine the post-Keynesian theories of demand for money?
Answer:
Post Keynesian Theories of Demand for Money
The post-Keynesian economists developed a number of models to provide alternative explanations to confirm the formulation relating real money balances with real income and interest rates. Most post-Keynesian theories of demand for money emphasize the store-of-value or the asset function of money.

Inventory Approach to Transaction Balances
Baumol (1952) and Tobin (1956) developed a deterministic theory of transaction demand for money, known as Inventory Theoretic Approach, in which money or ‘real cash balance’ was essentially viewed as an inventory held for transaction purposes. People hold an optimum combination of bonds and cash balance, i.e., an amount that minimizes the opportunity cost. The optimal average money holding is: a positive function of income Y, a positive function of the price level P, a positive function of transactions costs c, and a negative function of the nominal interest rate i.

Friedman’s Restatement of the Quantity Theory
Milton Friedman (1956) extending Keynes’ speculative money demand within the framework of asset price theory holds that demand for money is affected by the same factors as demand for any other asset, namely, permanent income and relative returns on assets. The nominal demand for money is positively related to the price level, P; rises if bonds and stock returns, rb and re, respectively decline and vice versa; is influenced by inflation; and is a function of total wealth. The Demand for Money as Behaviour toward as ‘aversion to risk’ propounded by Tobin states that money is a safe asset but an investor will be willing to exercise a trade-off and sacrifice to some extent the higher return from bonds for a reduction in risk.

The Demand for Money as Behaviour towards Risk
According to Tobin, rational behaviour explained induces individuals to hold an optimally structured wealth portfolio which is comprised of both bonds and money and the demand for money as a store of wealth depends negatively on the interest rate. These theories establish a positive relation of demand for money to real income and an inverse relation to the rate of return on earning assets, i.e. the interest rate.

Question 28.
Write short note on Rationale of Measuring Money Supply.
Answer:
Rationale of Measuring Money Supply
Supply of money is a stock concept. It refers to total stock of money (of all types) held by the people of a country at a point of time.
It is important to note that the supply of money does not include:

  1. stock of money held by the government, and
  2. stock of money held by the banking system of a country. Because, government and the banking system of a country are suppliers of money, and the stock of money held by the suppliers of money is never treated as a part of the supply of money in the country.

Rationale:

  1.  Measurement of money supply helps in analysis of monetary developments in order to provide a deeper understanding of the causes of money growth.
  2. It also facilitates in evaluating whether the stock of money in the economy is consistent with the standards and to understand the nature of deviations from this standard.
  3. The success of monetary policy depends on the contra/ability of money supply hence, the requirement of measurement of money supply.
  4. The Central Banks measure money supply to stabilise price and GDP growth.

Question 29.
What do you mean by ‘Reserve Money’? (Jan 2021, 2 marks)

Question 30.
The RBI Published the following data as on 31st March, 2018. You are required to compute M4:

(₹ 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

(Nov 2018, 3 marks)
Answer:
Calculation of M4 : (₹ in crores)
M4 = M3 + total deposits with the post office savings organisation
(excluding National Saving Certificates).
= ₹ 5,73,432 + ₹ 277.5
M4</sub = ₹ 5,73,709.5

Working Note:
1. Calculation of M1 : (₹ In crores)
M1 = Currency notes and coins with the people + demand deposits of banks (Current and Saving deposit accounts) + other deposits of the RBI.
= ₹ 1,12,06.6 + ₹ 1,93,300.4 + ₹ 614.8
= ₹ 3,06,121.8

2. CalculatIon of M3 (₹ in crores)
M3 = M1 + Net time deposits with the banking system
= ₹ 3,06,121.8 + ₹ 2,67,31 0.2
= ₹ 5,73,432

Money Market - CA Inter Economics Question Bank

Question 31.
Compute M1 supply of money from the data given below:

Currency with public 2,13,279.8 Crores
Time deposits with bank 3,45,000.7 Crores
Demand deposits with bank 1,62,374.5 Crores
Post office savings deposit 382.9 Crores
Other deposits of RBI 765.1 Crores

(May 2019, 3 marks)
Answer:
Calculation of M1, Supply of Money
M1 = Currency flotes and coins with the people + demand deposits of banks (current and saving deposit accounts) + other deposits with the RBI
= ₹ 213279.8 Cr. + ₹ 162374.5 + ₹ 765.1 Cr.
M1 = ₹ 376419.4Cr.

Question 32.
Compute reserve money from the following data published by RBI:

(₹ In crores)
Net RBI credit to the government 8,51,651
RBI Credit to the commercial sector 2,62,115
RBI’s claim on Banks 4,10,315
Government’s Currency liabilities to the public 1,85,060
RBI’s net foreign assets 72,133
RBI’s net non-monetary liabilities 68,032

(Nov 2019, 3 marks)
Answer:
Reserve Money = Net RBI credit to the Government + RBI credit to the Commercial sector + RBI’s Claims on banks + RBI’s net Foreign Assets + Government’s Currency liabilities to the public – RBI’s net non-monetary liabilities.
= ₹ 8,51,651 Cr. + ₹ 2,62.115 Cr. + ₹ 4,10,315 Cr. + ₹ 72,133 Cr. + ₹ 1,85,060 Cr. – ₹ 68,032Cr.
Reserve Money = ₹ 17,13,242 Cr.

Question 33.
Compute M3 from the following data:

Component ₹ In Crores
Currency with the public 2,25,432.6
Demand Deposits with Banks 3,40,242.4
Time Deposits with Banks 2,80,736.8
Post Office Savings Deposits (Excluding National Saving Certificates) 446.7
Other Deposits with RBI (Including Government Deposits) 392.7
Post Office National Saving Certificates 83.7
Government Deposits with RBI 102.5

(Nov 2020, 3 marks)

Question 34.
Compute M2 supply of money from the following RBI data:

(₹ In Crores)
Currency with public 435656.6
‘Other’ deposits with RBI 1234. 2
Saving deposits with post office saving banks 647.7
Net time deposits with the banking system 514834.3
Demand deposits with banks 274254.9

(Jan 2021, 3 marks)

Question 35.
Write short note on Measures of Money Supply.
Answer:
Measures of Money Supply
M1 Measurement
According to M1, measurement, money supply includes the following components:
M1 = C + DD + OD
Where,
C = Currency held by the public. It includes coins as well as paper notes.
DD = Demand deposits of the people with the commercial banks. These are chequeable deposits which can be withdrawn or transferred on demand.
OD = Other deposits which include:

  • Demand deposits with RBI of public financial institutions like NABARD (National Bank for Agriculture and Rural Development).
  • Demand deposits with RBI of foreign central banks and of the foreign governments.
  • Demand deposits of international financial institutions like IMF and World Bank.

Specifically, OD does not include:
(j) deposits of the government of the country with RBI.
(ii) deposits of the country’s banking system with RBI.

M2 Measurement
M2 is a broader concept of money supply compared to M1. Besides all the
components of M1 it also includes savings of the people with the post offices.
Thus.
M2 = M1 + Deposits with Post Office Savings Bank Account

M3 Measurement
M3 is also a broader concept of money supply compared to M1. Besides all
the components of M1 it also includes (net) time deposits (or fixed deposits/terms deposits) of the people with the commercial banks. Thus,
M3 = M1 + Net Time Deposits with the Commercial Banks

M4 Measurement
M4 concept of money supply is still broader, it is broader than even M3.
Besides all the components of M3, it also includes total deposits with the post offices (other than in the form of National Saving Certificate).
M4 = M3 + Total Deposits with post office (Other than NSC)

Question 36.
Write short note on the omponents of New Monetary Aggregates and Liquidity Aggregates.
Answer:
Monetary Aggregates:
Reserve Money = Currency in circulation + Bankers’ deposits with the RBI + Other deposits with the RBI
= Net RBI credit to the Government + RBI credit to the Commercial sector + RBl’s Claims on banks + RBl’s net Foreign assets + Government’s Currency liabilities to the public – RBI’s net non – monetary Liabilities
NM1 = NM1 Currency with the public + Demand deposits with the banking system + ‘Others deposits with the RBI.
NM2 = NM2 + Short-term time deposits of residents (including and up to contractual maturity of one year.)
NM3 = NM3 + Long-term time deposits of residents + Call/Term funding from financial institutions.

Liquidity Aggregates:
L1 = NM3 + All deposits with the post office savings banks (excluding
National Savings Certificates).
L2 = L1 + Term deposits with term lending institutions and refinancing
institutions (Fls) + Term borrowing by Fls + Certificates of deposit issued by FIs.
L3 = L2 + Public deposits of non-banking financial companies.

Question 37.
Explain the concept of ‘Money Multiplier’. (Jan 2021, 2 marks)

Question 38.
Describe the different determinations of money supply in a country.
Answer:
The money supply is defined as .
M=mXMB
Where M is the money supply, m is money multiplier an MB is the monetary base or high powered money. Money Multiplier m is defined as a ratio that relates the change in the money supply to a given change in the monetary base. It denotes by how much the money supply will change for given change in high-powered money. The multiplier indicates what multiple of the monetary base is transformed into money supply.

Money Multiplier m = \(\frac{\text { Money Supply }}{\text { Monetary Base }} \)
There are two alternate theories in respect of determination of money supply.
1. Money supply is determined exogenously by the central bank
2. Money supply is determined endogenously by changes in the economic activities which affect people’s desire to hold currency relative to deposits, rate of interest, etc. The current practice is to explain the determinants of money supply based on ‘money multiplier approach’ which focuses on the relation between the money stock and money supply in terms of the monetary base or high-powered money. This approach holds that total supply of nominal money in the economy is determined by the joint behavior of the central bank, the commercial banks and the public.

Money Market - CA Inter Economics Question Bank

Question 39.
Explain the money multiplier approach to money supply.
Answer:
Money Multiplier Approach to Money Supply:
The money multiplier approach to money supply propounded by Milton Friedman and Anna Schwartz, (1963) considers three factors s immediate determinants of money supply, namely:
1. The stock of high-powered money (H)
2. The ratio of deposit to reserve, e = {ER/D} and
3. The ratio of deposit to currency, c = {C/D}
These three represent the behaviour of the central bank, behaviour of the commercial banks and the behaviour of the general public respectively.

The Behaviour of the Central Bank:
The behaviour of the central bank which controls the issue of currency is reflected in the supply of the nominal high-powered money. Money stock is determined by the money multiplier and the monetary base is controlled by the monetary authority. Given the behaviour of the public and the commercial banks, the total supply of nominal money in the economy will vary directly with the supply of the nominal high-powered money issued by the central bank.

The Behaviour of Commercial Banks:
By creating credit, the commercial banks determine the total amount of nominal demand deposits. The behaviour of the commercial banks in the economy is reflected in the ratio of their cash reserves to deposits known as the ‘reserve ratio’. If the required reserve ratio on demand deposits increases while all the other variables remain the same, more reserves would be needed.

This implies that banks must contract their loans, causing a decline in deposits and hence in the money supply. If the required reserve ratio falls, there will be greater multiple expansions of demand deposits because the same level of reserves can now support more demand deposits and the money supply will increase. The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to the creation of deposits.

When the required reserve ratio falls, there will be greater multiple expansions for demand deposits. Excess reserves ratio e is negatively related to the market interest rate i. If interest rate increases, the opportunity cost of holding excess reserves rises, and the desired ratio’of excess reserves to deposits falls.

The Behaviour of the Public:
The public, by their decisions in respect of the amount of nominal currency in hand (how much money they wish to hold s cash) is in a position to influence the amount of the nominal demand deposits of the commercial banks. The behaviour of the public influences bank credit through the decision on ratio of currency to the money supply designated as the ‘currency ratio’.

The time deposit-demand deposit ratio i.e. how much money is kept as time deposits compared to demand deposits, also has an important implication for the money multiplier and hence for the money stock in the economy. An increase in TD/DD ratio means that greater availability of free reserves and consequent enlargement of volume of multiple deposit expansion and monetary expansion.

Thus, the money multiplier approach, the size of the money multiplier is determined by the required reserve ratio (r) at the central bank, the excess reserve ratio (e) of commercial banks and the currency ratio (c) of the public.

The lower these ratios are, the larger the money multiplier is. In other words, the money supply is determined by high powered money (H) and the money multiplier (m) and varies directly with changes in the monetary base, and inversely with the currency and reserve ratios. Although these three variables do not completely explain changes in the nominal money supply, never the less they serve as useful devices for analysing such changes. Consequently, these variables are designated as the ‘proximate determinants’ of the nominal money supply in the economy.

Question 40.
What would be the impact of each of the following on credit multiplier and money supply?
(i) If Commercial Banks keep 100 percent reserves.
(ii) If Commercial Banks do not keep reserves.
(iii) If Commercial Banks keep excess reserves. (May 2018, 3 marks)
Answer:
(i) If Commercial Banks decides to keep 100% reserves, then the Money multiplier 1/ required reservo ratio = 1/100% = 1. No additional money supply as there is no credit creation.

(ii) If Commercial Banks do not keep reserves, then money multiplier is infinite and there will be unlimited money creation. There will be chaos with spiraling prices as money supply is too much arid real output cannot increase.

(iii) Excess reserves are those reserves that the commercial banks hold with the central bank in addition to the mandatory reserve requirements. Excess reserves result in an increase in reserve deposit ratio of banks; less money for lending reduces money multiplier; money supply declines.

Question 41.
What is the in pact of the following on credit multiplier and money supply, if Commercia Banks keep:
(1) Less Reserve?
(2) Excess Reserve? (Nov 2020, 2 marks)

Question 42.
Explain how each of the following may affect money multiplier and money supply?
(i) Fearing shortage of money in ATM’s, people decide to hoard money?
(ii) During festival season, people decide to withdraw money through ATMs very often
Answer:
(i) The public by their decisions in respect of the size of the nominal currency in hand (designated as the currency ratio) is in a position to influence the amount of the nominal demand deposits of the commercial banks. When people decide to hoard to money fearing shortage of money in ATM’s, there is an increase in currency in hand because depositors are converting some of their demand deposits into currency. Demand deposits undergo multiple expansions while currency does not. Hence, when demand deposits are being converted into currency, there ¡s a switch from a component of the money supply that undergoes multiple expansions to one that does not. The overall level of multiple expansion declines, and therefore, money multiplier also falls.

(ii) Demand deposits held by poople are highly liquid as they can be easily withdrawn and converted to cash. If people, for any reason, withdraw money from ATMs with greater frequency, then banks will have to keep more cash reserves to meet the obligations. This will raise the reserve ratio, and tower the money multiplier. As a result money supply will decline.

Money Market - CA Inter Economics Question Bank

Question 43.
“The deposit multiplier and the money multiplier though closely related are not identical”. Explain briefly. (Nov 2020, 2 marks)

Question 44.
What will be the total credit created by the commercial banking system for an initial deposit of ₹ 3000 at a Required Reserve Ratio (ARR) of 0.05 and 0.08 respectively? Also compute credit multiplier. (May 2019, 3 marks)
Answer:
The credit multiplier is the reciprocal of the required reserve ratio.
Credit Multiplier = \(\frac{1}{\text { Required Reserve Ratio }} \)
For RRR = 0.05 Credit Multiplier = 1/0.05 =20
For RRR = 0.08 Credit Multiplier = 1/0.08 = 12.5
Credit Creation = Initial Deposit x 1/RRR
For RRR = 0.05, Credit creation will be 3,000 x 1/0.05 = 60,000/
For RRR = 0.08, Credit creation will be 3,000 x 1/0.08 = 37,500/

Question 45.
Compute credit multiplier if the Required Reserve Ratio is 10% and 12.5% for every ₹ 1,00,000 deposited in the banking system. What will be the total credit money created by the banking system in each case? (Nov 2019, 2 marks)
Answer:
Credit Multiplier = 1/ Required Reserve Ratio
(a) 10% 1,00,000 × 1/0.10 = ₹ 10,00,000
(b) 12.5% ₹ 1,00,000 × 1/0.125 = ₹ 8,00,000.

Question 46.
Write short note on Monetary Policy.
Answer:
Monetary Policy
Concept:
Policy related with the control on supply of money in circulation and quantity or volume of credit with the object of achieving the goal of planned economic development of any nation is called Monetary Policy.

Definitions
“Monetary Policy includes all those monetary decisions and methods which aim to affect monetary system. – Paul Einzing
“Monetary Policy is the name given to the principle whereby the Government and the Central Bank of a country fulfill the general objectives of the country’s economic policy. – Prof. D. Hazra

Broadly speaking, monetary policy refers to the policy of the central bank which it pursues with a view to administer and control the country’s money supply including the currency and demand deposits and managing the foreign exchange rates. The central bank coordinates the money supply, credit supply, government expenditure, and the rates of interest through its monetary policy in such a way so that the monetary system may be benefitted to the maximum extent. Through its monetary policy, the central bank try to achieve the national objectives.

Question 47.
Briefly explain the features of Monetary Policy.
Answer:
1. It is a part of Economic Policy
The object of the economic policy is to enhance the prosperity and income of the nation. Various plans are designed for it. Monetary policy helps in controlling, the supply of money and volume of credit. It also helps in achieving the rate if economic development as predetermined. Hence, Monetary P’Tìcy is considered as an important part of the economic policy.

2. Control On Supply of Money
Merely Monetary Policy can determine the supply of money of any nation. Government has to maintain the supply of money according to the size of the population and plans of the economic development. Government attempts to establish control over the supply of money in circulation in accordance with the Monetary Policy of the country by direct control or control by other methods through Central Bank like change in bank rates open market operations, deficit budget and surplus budget etc. in accordance with the Monetary Policy of the country.

3. Control On Volume of Credit
Credit Creation and control on the volume of the credit is a part of the Monetary Policy, Modern Banks mainly Commercial Banks play very important role in creating credit as well as increasing credit volume Monetary Policy plays important role in determining the liquidity ratio of the banks also. Volume of credit can be controlled by increasing or decreasing the liquidity ratio also.

4. Determining the Direction of Economic Development
Inflation and deflation, both are quite capable of turning or changing the economic development of any country in the adverse direction. Hence, inflation and deflation must be controlled promptly and strictly. Equilibrium between demand and supply can be maintained by adopting appropriate Monetary Policy. Neither inflation is suitable for any economy nor deflation. Maintaining equilibrium between supply and demand of money in circulation is in the interest of the whole nation as well as in the nation’s economic development.

5. Controlling the Speed of Economic Development
For the economic development of any country more capital, high rate of capital formation and high rate of credit creation is necessary, and for this purpose determination and adoption of an appropriate Monetary Policy is necessary.

Question 48.
Explain the difference between Liquidity Adjustment Facility (LAF) and Marginal Standing Facility (MSF). (May 2018, 3 marks)
Answer:
Difference between LAF and MSF

LAF MSF
1. Minimum bidding amount is ₹ 5 cr. Minimum bidding amount is ₹ 1 Cr.
2. All clients of RBI are eligible to bid Only scheduled commercial banks can bid
3. Bank cannot sell government security to RBI that is part of bank’s SLR quota Bank can sell the government security from its SLR quota to RBI
4. LAF lending rate is always Repo rate MSP lending rate is always repo rate + 3%

Question 49.
How do changes in Cash Reserve Ratio (CRR) impact the economy? (May 2018, 2 marks)
Answer:
Higher the CRR withjhe RBI, lower will be the liquidity in the system and vise-versa. During the slowdown in the economy, the RBI reduces the CRR in order to enable the banks to expand credit and increases the supply of money available in the economy. In order to contain credit expansion during period ‘of high inflation, the RBI increases the CRR.

Question 50.
(i) Explain the different mechanism of monetary policy which influences the price – level and national income. (Nov 2018, 3 marks)
(ii) Explain the Monetary Policy Framework Agreement. (Nov 2018, 2 marks)
Answer:
(i) There are mainly four different mechanisms through monetary policy influences the price level and national income.
These are:

  • the interest rate channel,
  • the exchange rate channel,
  • the quantum channel (e.g., relating to money supply and (credit), and
  • the asset price channel ie. via equity and real estate prices.

(ii) The Monetary Policy Framework Agreement:
The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016 for giving a statutory backing to the Monetary Policy Framework Agreement and for setting up a Monetary Policy Committee (MPG). The Monetary Policy Framework Agreement is an agreement reached between the Government of India and the Reserve Bank of India (RBI) on the maximum tolerable inflation rate that the RBI should target to achieve price stability.

Money Market - CA Inter Economics Question Bank

Question 51.
Why is the central bank reffered to as a “banker’s bank”? (May 2019, 2 marks)
Answer:
A cental bank is a ‘banker’s bank’. It provides liquidity to banks when the latter face shortages of liquidity. This facility is provided by the Central bank through its discount window. The scheduled commercial banks can borrow from the discount window against the collateral of securities like commercial bills, government securities, treasury bills, or other eligible papers. This type of support earlier took.

The form of refinancing of loans given by commercial banks to various sectors (e.g. Exports, agriculture etc.). By varying the terms and conditions of refinance, the RBI could employ the sector-specific refinance facilities as an instrument of credit policy to encourage/discourage lending to particular sectors. In line with the financial sector reforms, the system of sector-specific refinance schemes (except export credit refinance scheme) was withdrawn. From June, 2,000, the RBI has introduced Liquidity Adjustment Facility (LAF).

The Liquidity Adjustment Facility (LAF) is a facility extended by the Reserve bank of India to the scheduled commercial banks (excluding RRBs) and primary dealers to avail of liquidity in case of requirement (or park excess funds with the RBI in case of excess liquidity) on an overnight basis against the collateral of government securities including state government securities.

Question 52.
Explain the open market operations conducted by RBI. (Nov 2019,2 marks)
Answer:
Open Market Operations
1. Open Market Operations (OMO) refers to market operations conducted by the Reserve Bank of India by way of sale/purchase of Government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

2. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity.

3. When the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquity into the market.

Question 53.
Explain ‘Reverse Repo Rate’. (Nov 2019, 2 marks)
Answer:
Reverse Repo Rate
‘Reverse Repo’ is defined as an instrument for lending funds by purchasing securities with as agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.  Reverse repo operation takes place when RBI borrows money from banks by giving them securities. The Securities transacted here can be either government securities or corporate securities or any other securities which the RBI permits for transaction. The interest rate paid by RBI for such transactions is called the ‘reverse repo rate’. Reverse Repo Rate of October 2020 4%.

Question 54.
What is the meant by ‘Statutory Liquidity Ratio’? In which forms this ratio is maintained? (Nov 2020, 3 marks)

Question 55.
Distinguish between Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). (Jan 2021, 3 marks)

Question 56.
Examine what would be the effect on money multiplier if bank loads excess reserves?
Answer:
The money multiplier approach to money supply considers the ratio of deposit to reserve, e = {ER/D) which represent the behaviour of commercial banks as one of the determinants of money supply. The commercial banks are required to keep only a part or fraction of their total deposits in the form of cash reserves. For the commercial banking system as a whole, the actual reserves ratio may be greater than the required reserve ratio since the banks keep with them a higher than the statutorily required percentage of their deposits in the form of cash reserves.

The additional units of high-powered money that goes into ‘excess reserves’ of the commercial banks do not lead to any additional loans, and therefore, these excess reserves do not lead to creation of money. Therefore, if the central bank injects money into the banking system and these are held as excess reserves by the banking system, there will be no effect on deposits or currency and hence no effect on money multiplier and therefore on money supply.

Question 57.
Write a note on CRR. Explain the operation of CRR
Answer:
Cash Reserve Ratio:
Cash Reserve Ratio (CRR) refers to the fraction of the total net demand and time liabilities (NDTL) of a scheduled commercial bank in India which it should maintain as cash deposit with the Reserve Bank. The RBI may set the ratio in keeping with the broad objective of maintaining monetary stability in the economy. The credit creation capacity of commercial banks is inversely related the cash reserve ratio. Higher the CRR, lower will be the credit creation and vice versa.

CRR has, in recent years, assumed significance as one of the important quantitative tools aiding ¡n liquidity management. Higher the CRR with the RBI, lower will be the liquidity in the system and vice versa. During deflation, the RBI reduces the CRR in order to enable the banks to expand credit and increase the supply of money available in the economy. In order to contain credit expansion during periods of inflation, the RBI increases the CRR.

Question 58.
What rate does Market Stabilisation scheme play in our economy?
Answer:
Market Stabilisation scheme (MSS), introduced in April 2004, is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy. Under the Market Stabilisation Scheme (MSS) the Government of India borrows from the RBI (such borrowing being additional to its normal borrowing requirements) and issues treasury bills/dated securities that are utilized for absorbing from the market excess liquidity of a more enduring nature arising from large capital inflows.

The bills/bonds issued under MSS would have all the attributes of the existing treasury bills and dated securities. The bills and securities will be issued by way of auctions to be conducted by the Reserve Bank. These bonds are issued by RBI on the behalf of Government in order to mop out excess liquidity from the market (Banks) and not for raising capital for government.

Question 59.
Briefly explain the instruments of Monetary Policy.
Answer:
The Instruments of monetary policy are
1. DIrect instruments

  • Cash Reserve Ratio
  • Statutory Liquidity Ratio
  • Directed credit
  • Administrated Interest Rate

2. Indirect Instruments

  • Repo
  • Open Market operations
  • Standing Facilities
  • Market-Based Discount window

Cash Reserve Ratio

  • It is the fraction of total net demand and time liabilities (NDLT) of a scheduled bank which it should maintain as cash deposit with RBI.
  • Higher the CRR lower will be the liquidity in the system and vice versa.

Statutory Liquidity Ratio

  • It is the fraction of total demand and time liabilities (DTL)/ Net DTL (NDTL) of a scheduled bank which it should maintain (ie hold as assets) by the bank itself.
  • A rise in SLR reduces the credit creation capacity of banks and vice versa.

Liquidity Adjustment Facility (LAF)
LAF is a facility extended by RBI to the scheduled commercial banks excluding RRB’s and primary dealers to avait of liquidity in case of requirement on an overnight basis against collateral of Government. securities.

Repurchase Option
Repurchase options or in short ‘Repo’, is defined as an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.

It money market instrument, which enables collateralised short-term borrowing and lending through sale/purchase operations in debt instruments.

Higher the Repo Rate, lower the credit creation capacity of commercial banks and vice versa. Repo Rate of October 2020 4%.

The policy Rate

  • The fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity Adjustment Facility (LAF) is considered as the policy rate.
  • The RBI uses the single independent ‘policy rate’ which is the repo rate (in the LAF window) for balancing liquidity.

Reverse Repo Rate
‘Reverse Repo’ is defined as an instrument for lending funds by purchasing securities with as agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.

Reverse repo operation takes place when RBI borrows money from banks by giving them securities.
The Securities transacted here can be either government securities or corporate securities or any other securities which the RBI permits for transaction.

The interest rate paid by RBI for such transactions is called the ‘reverse repo rate’. Reverse Repo Rate of October 2020 4%.

Market Stabilisation scheme
1. Under MSS scheme, the Government of India borrows from the RBI (such borrowing being additional to its normal borrowing requirements) and issues treasury-billy/date securities for absorbing excess liquidity from the market arising from large capital inflows.

2. This instrument for monetary management was introduced in 2004 following a MoU between the Reserve Bank of India (RBI) and the Government of India (Gol) with the primary aim of aiding the sterilization operations of the RBI.

3. Sterilization is the process by which the monetary authority sterilizes the effects of significant foreign capital inflows on domestic liquidity by off loading parts of the stock of government securities held by it.

Bank Rate
Under section 49 of the Reserve Bank of India Act, 1934,
1. The Bank Rate has been defined as ‘the standard rate at which the Reserve Bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the Act.’

2. The bank rate has been aligned to the Marginal Standing Facility (MSF) rate and, therefore, as and when the MSF rate changes alongside policy repo rate changes, the bank rate also changes automatically.

Open Market Operations
1. Open Market Operations (OMO) refers to market operations conducted by the Reserve Bank of India by way of sale/purchase of Government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

2. When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the rupee liquidity.

3. When the liquidity conditions are tight, the RBI will buy securities from the market, thereby releasing liquidity into the market.

Money Market - CA Inter Economics Question Bank

Question 60.
Explain the function of SLR? What are the eligible securities of SLR?
Answer:
Statutory Liquidity Ratio
The Statutory Liquidity ratio (SLR) is an instrument of monetary policy and aims to control liquidity in the domestic market by means of manipulating bank credit. Changes in the SLR chiefly influence the availability of resources in the banking system for lending. A rise in the SLR which is resorted to during periods of high liquidity, tends to lock up a rising traction of a bank’s assets in the form of eligible instruments, and this reduces the credit creation capacity of banks. A reduction in the SLR during periods of economic downturn has the opposite effect. The SLR requirement also facilitates a captive market for government securities.

Following are the eligible securities of SLR:
1. Cash
2. Gold valued at a price not exceeding the current market price,
or
3. Investments in unencumbered Instruments that include:

  • Treasury bills of the Government of India.
  • Dated securities including those issued by the Government of India from time to time under the market borrowings programme and the Market Stabilization Scheme (MSS).
  • State Development Loans (SDLs) issued by State Governments under their market borrowings programme.
  • Other instruments as notified by the RBI.

Question 61.
Explain the role of Monetary Policy Committee (MPC) in India. (Nov 2018, 2 marks)
Answer:
The Monetary Policy Committee (MPC) consisting of six members shall determine the policy rate to achieve the inflation target through debate and majority vote by a panel of experts.

Question 62.
Write short note on:
Formulation and application of Monetary Policy in India.
Answer:
Formulation and Application of Monetary Policy
Formulation and application of a balanced monetary policy is necessary for the rapid and balanced economic development of the economy. Economic development of the nation is indispensable. It’s work-plan is performed with the help of the Planning Commission. Government, Economic Advisory Committee, Economists and Central Bank etc. Central Bank of the country plays a very important role in the formulation and application of the Monetary Policy, It takes necessary steps from time to time for decreasing or increasing the supply of money in circulation. Central Bank of the country is the Banker of the Banks. Therefore, activities of the bank is controlled and regulated by the Central Bank and all the institutions engaged in banking- business are bound to act in accordance with the rules, regulation, order and advices of the Central Bank.

The Monetary Policy in India Is conducted through:

  1. The Monetary Policy Framework Agreement.
  2. The Monetary Policy Committee.

Question 63.
Elucidate the Monetary Policy framework agreement as a component of organisational structure for monetary Policy in India.
Answer:
The Monetary Policy Framework Agreement:

  1. The amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation targeting framework.’
  2. The Monetary Policy Framework Agreement ¡s an agreement reached between the Government of India and the Reserve Bank of India (RBI) on the maximum tolerable inflation rate that the RBI should target to achieve price stability.
  3. Announcement of an official target range for inflation ¡s known as inflation targeting.
  4. 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 eight months.

Question 64.
Write a note on the Monetary Policy Committee (MPG)
Answer:
The Monetary Policy Committee (MPC)
It is an empowered six-member Monetary Policy Committee (MPC) constituted in September 1 2016.
Member:

  • The RBI Governor (Chairperson,)
  • The RBI Deputy Governor in charge of monetary policy,
  • one official nominated by the RBI Board and the remaining,
  • Three central government nominees representing the Government of India who are persons of ability, integrity and standing, having knowledge and experience in the field of Economics or banking or finance or monetary policy.

Purpose:

  • The MPG shall determine the policy rate required to achieve the inflation target. Accordingly fixing of the benchmark policy interest rate (repo rate) is made through debate and majority vote by this panel of experts.
  • With the introduction of the Monetary Policy Committee, the RBI will follow a system which is more consultative and participative similar to the one followed by many of the central bank in the world.

The new system is intended to incorporate

  • diversity of views,
  • specialized experience,
  • independence of opinion,
  • representativeness, and
  • accountability.

Monetary Policy Department
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. The views of key stakeholders in the economy and analytical work of the Reserve Bank contribute to the process for arrng at the decision on the policy repo rate.

Financial Market Operation Department
The financial Markets Operations Department (FMOD) operationalizes the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of monetary policy (weighted average lending rate) is kept close to the policy repo rate.

Determination of National Income – CA Inter Economics Question Bank

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

Financing of Working Capital – CA Inter Economics Question Bank

Question 1.
What is National Income? How is it defined?
Answer:
Meaning of National Income:
The gross money value of final goods and domestic territory of the country is called gross domestic product or income. If depreciation is subtracted from gross domestic income, we get net domestic income. Besides, domestic income there is net factor income earned from abroad. If net factor income earned from abroad is added to domestic income, we get national income.

National income may be defined as follows:
National income is the net money value of all final goods and services that are produced in a country in a year plus net factor income received from abroad. This national income is also distributed as factor income (wages, salary, rent, interest, profit, etc.) among the factors of production. Therefore, national income may also be estimated by adding up all the factors of income. Factors of production spend their factor incomes on final goods and services. In this way, national income can also be obtained by adding up all the final expenditures.

Therefore, in short, national income is either the net value of all final goods and services.
Or the sum total of all factor incomes.
Or the sum total of final expenditures.
Thus, there are 3 ways of expressing National Income
1. NI = ΣPG
Where ΣPG = sum total of market value of the final goods and services produced.

2. NI = ΣFY
Where ΣFY = sum total of factor income.

3. NI = C+1
Where C + 1 = sum total of expenditure on the final goods and services produced.

Question 2.
Write a short note on:
National Income as an indicator of economic welfare.
Answer:
National Income as an Indicator of Economic Welfare The increase in National Income does not necessarily mean an increase in welfare of the people.

The reasons are as follows:
1. Unequal distribution of Gross National Product (GNP): Although there may be rise in GNP but if the distribution is not equal or even, this rise in GNP will not help in raising welfare of people.

2. Composition of growth: If the composition of growth consist of defence equipment and socially under arable product like smack, brown sugar etc. it will not help in raising the welfare of the people.

3. Growth rate of population: If the rate of growth of population is more than the rate of growth of GNP then the growth of GNP will not rise the welfare of the people.

4. Inflation: If the GNP rises due to rise in general price level without any increase in actual production of goods and services, it will not raise the welfare of the people.

5. Industrialisation: If National Income of a country rises due to fast industrialisation, the welfare of the common people falls as industrialisation gives rise to pollution, the greatest every of welfare.

Question 3.
Explain the Concept of Gross National Product at market price (GNPMP). (Nov 2018, 2 marks)
Answer:
Gross National Product (GNP) 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 including net factor incomes from abroad. Gross National Product (GNP) is evaluated at market prices and therefore ills in fact Gross National Product at market prices (GNPMP).
GNPMP = GDPMP + Net factor income from Abroad.

NFIA is the difference between factor income Earned by our residents from the rest of the world and factor income earned by our residents within our country.
Thus, NFIA = Factor Income earned by our resident from abroad – Factor income earned by non-residents within our country.

Question 4.
Distinguish between Personal Income and Disposable Personal Income. (Nov 2018, 3 marks)
Answer:
Difference between Personal Income and Personal Disposable Income

Personal Income Disposable Income
1. Personal income is a measure of actual current income receipts of persons from all sources which may or may not be earned from productive activities during a given period of time. In other words, it is the income actually paid out to the household sector but not necessarily earned. Disposable personal income is a measure of amount of the money in the hands of the individuals that is available for their consumption or savings. Disposable personal income is derived from personal income by subtracting the direct taxes paid by individuals and other compulsory payments made to the government.
DI = Pl – Personal Income Taxes
2. It is a broader concept as it Includes direct taxes and fines and fees of Govt administration. It is a narrow concept and does not include both direct taxes and miscellaneous Govt. receipts.
3. Whole of this income cannot be disposed of upon consumption and savings. It can be disposed of upon consumption expenditure and savings.
4. It includes direct taxes, income tax, wealth tax, etc. It does not include such taxes.

Question 5.
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. (Nov 2020, 2 marks)

Determination of National Income - CA Inter Economics Question Bank

Question 6.
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 (Nov 2019, 3 marks)
Answer:
Gross Domestic Product at Factor cost (GDP)
= Gross Domestic Product at Market Price (GDPMP) – Indirect Taxes + Subsidies.
₹ 3,60,815 Cr. = ₹ 7,79,567 Cr. – ₹ 454,367 + subsidies
₹ 3,60,815 Cr. = ₹ 3,25200 Cr. + subsidies
∴ Subsidies = ₹ 35,615 Cr.

Question 7.
Compute the amount of depreciation from the following data:
(₹ In Crores)
GDP at Market Price (GDPMP) 8,76,532
Net factor income from abroad (-) 232
Aggregate amount of Indirect Taxes 564
Subsidies 30
National Income (NNPFC) 8,46,576 (Nov 2020, 3 marks)

Question 8.
Compute GOP at market price and Mixed Income of Self-Employed from the data given below:

(₹ In Crores)
Compensation of Employees 810
Depreciation 26
Rent, Interest, and Profit 453
NDP at factor cost 1450
Subsidies 18
Net factor Income from Abroad (-) 17
Indirect taxes 57

(Jan 2021, 3 Marks)

Question 9.
You are given the following data on an economy in millions:
Consumer Expenditure (inclusive of indirect taxes) 110 m
Investment 20 m
Government Expenditure (inclusive of transfer payments) 70 m
Export 20m
Imports 50m
Net Property Income from abroad 10 m
Transfer payments 20 m
indirect taxes 30m
Population 0.5 m
(i) Calculate the Gross Domestic Product at market prices.
(ii) Calculate the Gross National Income at market prices.
(iii) Calculate the Gross Domestic Product at factor cost.
(iv) Calculate the per capita Gross National Income at factor cost.
Answer:
(i) GDPMP = C+I+G+(X-Z) = 110+20 + (70-20) + (20-50) = 150 million

(ii) GNPMP = GDP at market prices + net property income from abroad = 150 + 10 = 160 million

(iii) GDPat factor cost = GDP market prices – indirect taxes = 150 – 30 = 120 million
(iv) Per Capita Income = \(\frac{\text { GNP at Factor Cost }}{\text { Population }}\) = (160 m-30 m)/0.5 million = 130/0.5=260

Question 10.
Write short flotes on the following: a
1. Private Income
2. Personal Income
3. Personal Disposable Income
Answer:
1. Private Income
Private Income relates to income and other payments relating to private sector. It includes at payments, which are earned by private sector within the country and abroad, plus all current transfer payments.

Private Income can be obtained from the National Income as well as from the Domestic Income.
Private Income = NI – Income from domestic product accruing to Government sector + current transfer payments also

Private Income = NDPFC accruing to Private sector + NFIA + Interest on national debt + current transfer from government + current transfer from rest of the world.

2. Personal Income
Personal income is the total of all current income received by households from all sources. All income which accrues to the factors i.e. earned by the factors are not received by them (corporate saying, corporate tax) and on the other hand, there are certain payments which they receive but are not earned by them (pension, interest on national debt, etc). Therefore personal income is the total of all such payments and income received whether or not they have earned, it. Thus, Personal Income = Private income – Corporate Tax – Undistributed profit corporate saving.

3. Personal Disposable Income (PDI)
PDI is that part of personal income, which the individual can spend the way they like. It is the income remaining with individual after deduction of all taxes levied against their income and property by the Government.
Thus, PDI = Personal Income Direct Personal taxes – Miscellaneous fees and fines paid by the householders to the Government.

Determination of National Income - CA Inter Economics Question Bank

Question 11.
Differentiate between:
National Income at Current Price and National Income at Constant Price.
Answer:
Difference Between NI at Current Price and NI at Constant Price

Basis of Difference NI at Current Price NI at Constant Price
1. Meaning When goods and services produced by normal residents within and outside the country in a year is valued at current year’s price is called NI at current prices. When goods and services produced by normal residents within and outside the country in a year is valued at constant price i.e. base year’s price is NI at constant price.
2. Formula Y = Q x P
Where:
Y = NI at current price
Q = quantity of goods and services produced during an accounting year
P = Prices of goods and services prevailing during the current accounting year.
Y1 = Q x P1
Where:
Y1 = NI at constant price
Q = Quantity of goods and services produced during an accounting year.
P1 = Prices of goods and services prevailing during the base year.
3. Also known as Nominal National Income. Real National income.

Question 12.
What is the difference between Real GOP and Nominal GOP?
Answer:
Difference between Real GDP and Nominal GDP

Basis of Difference Real GDP Nominal GDP
1. Meaning Goods and services produced by all producing units within the domestic territory of a country during an accounting year valued at current year’s price. Goods and services produced by all producing units within the domestic territory of a country during an accounting year valued at base years’s price or constant price.
2. Influenced by Influenced by change in physical output and not by change in price. Influenced by change in both physical output an price level.
3. As an Indicator of economic development It is considered as a true indicator of economic development. It is not a true indicator of economic development.

Question 13.
How do you differentiate between:
Private Income and Personal Income
Answer:
Difference between Private income and Personal Income

Basis Private Income Personal Income
1. Meaning It is the total income of both private enterprises and households. It is the actual income received by households and individuals.
2. Broad Vs Narrow It is a broader concept than personal income because it includes corporate tax and corporate savings. it is a narrow concept than private income as it does not include corporate tax and corporate savings.
3. Comprises of Private Income = Domestic Income accrued to Private Sector + NFIA + All Transfer Payments +
Interest on National Debts.
Personal Income = Private Income – Corporate Tax – Corporate Savings.

Question 14.
What are the related concepts or aggregates of National Income?
Answer:
The related concepts or Aggregates of National Income are as follows:
1. Gross Domestic Product at Market price (GDPMP)
GDPMP is the market value of the final goods and services produced during a year within the domestic territory of a country.
Note: Gross indicates that the value of domestic product is inclusive of depreciation, i.e. consumption of fixed capital. Within the domestic territory means within the boundaries of the country including the production by domestic companies and by foreign companies as well.

2. Gross National Product at Market price (GDPMP)
When net factor income from abroad (NFIA) is added to GDPMP we get GNPMP
Thus GNPMP = NFIA + GDPMP
NFIA is the difference between factor income Earned by our residents from the rest of the world and factor income earned by our residents within our country.
Thus, NFIA = Factor Income earned by our resident from abroad – Factor income earned by non-residents within our country.

3. Net National Product at Market price (NNPMP)
When Depreciation is subtracted from GNPMP, we get NNPMP
Thus, NNPMP = GNPMP – Depreciation.
In other words, NNPMP – is the market value of final goods and services produced within the domestic territory of a country along with net factor income from abroad during a year.

What is depreciation?
Depreciation, also called consumption of fixed capital refers to the loss of value of fixed asset on account of:

  • Normal wear and tear
  • Normal obsolescence
  • Accidental damage of machinery.

4. Net Domestic Product at Market Price (NNPMP)
When Depreciation is subtracted from GNPMP we get NNPMP
Thus, NNPMP = GNPMP – Depreciation
In other words, NNPMP is the market value of final goods and services produced within the domestic territory of a country during a year, exclusive of depreciation.

5. Gross Domestic Product at Factor Cost GDPFC
GDPFC is the sum total of factor incomes (Rent + Interest + Wages + Profit) generated within the domestic territory of a country along with consumption of fixed capital i.e. depreciation. during a year.

6. Gross National Product at Factor cost GNPFC
When net factor income from abroad (NFIA) is added to GDPFC we get GNPFC
Thus, GNPFC = GDPFC + NFIA

7. Net Domestic Product at Factor Cost NDPFC
When depreciation is subtracted from GDPFC we get NDPFC
Thus, NDPFC = GDPFC – Depreciation.
In other words, NDPFC is the value of final goods and services produced within the domestic territory of a country at factor cost, exclusive of depreciation. It is the sum total of factor incomes generated within the domestic territory and is also known as Domestic income.

8. Net National Product at Factor cost NNPFC
When NFIA is added to NDPFC we get NNPFC
Thus, NNPFC = NDPFC + NFIA.
In other words, NNPFC is the sum total of factor incomes generated within the domestic territory of a country, along with net factor income from abroad during a year. It is this NNPFC which is known as National Income.

9. National Disposable Income (NDI)
NDI is the income from all sources (earned income as well as transfer payments from abroad) available to residents of a country for consumption expenditure or for saving during a year.
Thus, NDI = National Income + Net Indirect taxes + Net current transfer from the rest of the world.
In other words, NDI refers to the net income at market price available to a country for disposal.

10. Factor Income from Net Domestic Product Accruing to Private sector.
Factor income from NDP accruing to private sector is the income earned by the private sector. It is that part of NDPFC which accrues to the private sector and excludes:

  • Property and entrepreneurial income of the departmental and
  • Saving of the non-departmental enterprises of the Government.

Thus Factor income from Net Domestic product Accruing to Private sector = NDPFC – Income from Property and entrepreneurship accruing to Government department enterprises-saving of non-departmental enterprises.

Question 15.
Private Income
Answer:
Private Income
Private Income relates to income and other payment relating to private sector. It includes at payments, which are earned by private sector within the country and abroad, plus all current transfer payments.

Private Income can be obtained from the National Income as well as from the Domestic Income.
Private Income = NI – Income from domestic product accruing to Government sector + current transfer payments also

Private Income = NDPFC accruing to Private sector + NFIA + Interest on national debt + current transfer from government + current transfer from rest of the world.

Question 16.
Personal Income
Answer:
Personal Income
Personal income is the total of all current income received by households from all sources. All income which accrue to the factors i.e. earned by the factors are not received by them (corporate saying, corporate tax) and on the other hand, there are certain payments which they receive but are not earned by them (pension, interest on national debt, etc). Therefore personal income is the total of all such payments and income received whether or not they have earned, it.
Thus, Personal Income = Private income – Corporate Tax – Undistributed profit corporate saving.

Question 17.
Personal Disposable Income (PDI)
Answer:
Personal Disposable Income (PDI):
PDI is that part of personal income, which the individual can spend the way they like. It is the income remaining with individual after deduction of all taxes levied against their income and property by the Government.
Thus, PDI = Personal Income – Direct Personal taxes – Miscellaneous fees and tines paid by the householders to the Government.

Question 18.
Why ‘Indirect Taxes’ are deducted and ‘Subsidy’ is added in NDP, for calculating NDPFC?
Answer:
Deduction of Indirect Taxes:
In the calculation of Net Domestic Product, the value goods and services at market prices are taken into consideration which includes indirect taxes. Hence, the entire market price is not received by factors of production. So indirect taxes are deducted from market price for calculating the value of factor cost.

Addition of Subsidy:
Generally, government provides subsidy (i.e., economic assistance) to the producer or distributor, so that the commodity may be sold at lower prices. In this case, market price becomes lower to what factors of production actually get. Hence, for calculating the actual factor income, subsidy amount is added in market price.

Question 19.
From the following data, calculate the GDP, GNP, NDP and NNP at both factor cost and market prices.

(₹ Lakhs)
Gross investment 120
Net exports 15
Net indirect taxes 5
Depreciation 20
Net factor income from abroad 10
Personal consumption expenditure 450
Government purchases of goods and services 150

Answer:
Determination of National Income - CA Inter ECO Question Bank 1

Question 20.
Given:

₹ (Lakhs)
NDPFC 10,000
Net factor Income from Abroad 200
Depreciation 300
Net Indirect Taxes 250

Calculate:
(a) NNPFC
(b) GNPFC
(c) GNPMP
(d) NNPMP
(e) NDPMP
(f) GDPMP
(g) GDPFC.
Answer:
(a) NNPFC = NDP + Net Factor Income from Abroad
=10,000+200
= ₹ 10,200 Lakhs

(b) GNPFG = NNPFC + Depreciation
= 10,200 + 300
= ₹ 10,500 crores.

(c) GNPMP = GNPMP+ Net indirect taxes
=10,500+250
= ₹ 10,750 Lakhs

(d) NNPMP = GNPMP – DepreciatIon
= 10,750 – 300
= ₹ 10,450 crores.

(e) NDPMP = NNPMP – Net Factor Income from Abroad
= 10,450 – 200
= ₹ 10,250 Lakhs

(f) GDPMP = NDPMP + Depreciation
= 10,250 + 300
= ₹ 10,550 Lakhs

(g) GDPFC = NDPFC + Depreciation
= 10,000 + 300
= ₹ 10,300 Lakhs

Question 21.

Calculate the aggregate value of depreciation.
Answer:
GNPMP = GDPMP + Net Factor Income from Abroad = 1100+ 100= 1200
GNPFC = GNPMP – Net Indirect Taxes = 1200- 150= 1050
Deprecation = GNPFC – NNPFC
= 1050 – 850
= ₹ 200 Lakhs.

Question 22.
From the following data, calculate Personal Income (Pl) and Personal Disposable Income (PDI):

(₹ Lakhs)
NDPFC 10,000
Net Factor Income from Abroad 500
Undistributed Profit 1,500

Answer:
PI = NDPFC + NFIA – Undistributed Profit – Corporate Tax – (Interest paid by households – Interest received by households) + Transfer Income
= 10,000+ 500 – 1,500 – 800 – (1,600 – 1,800) + 400
= 10,000+ 500 – 200+ 400 – (1,500) + 800)
= ₹ 8,800 Lakhs

PDI = Personal Income – Personal Tax
= 8,800 – 600
= ₹ 8,200 Lakhs.

Question 23.
From the following data, estimate:
(a) GDPMP
(b) Private Income and
(c) Personal Income

₹ (Lakhs)
GNPFC 14,500
Depreciation 1,300
Net Factor Income from Abroad (-) 350
income from the property to government administrative department 1,500
National Debt Interest 400
Current transfers from ROW 250
Corporate Tax 280
Savings of private corporate sector 700
Indirect Taxes 800
Subsidies 250

Answer:
(a) GDPMP
= GNPFC – Net Factor income from abroad + Indirect Tax – Subsidies
= 14,500-(-350)+800-250 = ₹ 15,400 Lakhs

(b) Private Income
= GNPFC – Depreciation – Income from property to government administrative department + Current transfers from ROW + National Debt Interest
= 14,500 – 1,300 – 1500 + 250 + 400
= ₹ 12,350 Lakhs

(c) Personal Income
= Private Incbnie – Corporation Tax – Saving of private corporate sector
= 12,350 – 280 – 700
= ₹ 11,370 Lakhs.

Determination of National Income - CA Inter Economics Question Bank

Question 24.
Given:

₹ (Lakhs)
GDPFC 4,000
Depreciation 100
Net Indirect Taxes 300
NNPMP 4,500

Calculate the Net Factor Income from Abroad
Answer:
NDPFC = GDPFC Depreciation
= 4,000 – 100
= 3,900

NDPMP = NDPFC + Net lndrect Taxes
= 3,900+300
= 4,200

NFIA = NNPMP – NDPMP
= 4500 – 4200
= ₹ 300 Lakhs

Question 25.
Given:
GNPMP 7,000
Net Factor Income from Abroad 200
Depreciation 150
NDPFC 6,200
Calculate the Net Indirect Tax.
Answer:
GDPMP = GNPMP – Net Factor Income from Abroad
= 7,000 – 200
= ₹ 6,800 Lakhs

NDPMP = GDPMP – Depreciation
= 6,800 – 150
= ₹ 6,650 Lakhs

NIT = NDPMP – NDPFC
= 6,650 – 6,200
= ₹ 460 Lakhs.

Question 26.
Calculate Gross National Disposable income from the following data:

₹ (Lakhs)
National income (or NNPFC) 2,000
Net Current Transfers from Rest of the World 200
Depreciation 100
Net Factor Income from Abroad (-) 50
Net Indirect Taxes 250

Answer:
GNDI = NI + Net current transfers of the rest of the world + Depreciation + Net Indirect Taxes
= 2,000+200+100+250
= ₹ 2,550 Lakhs.

Question 27.
From the following data calculate Income accruing to the private sector from domestic product:

₹ (Lakhs)
NNPMP 15000
Net Factor Income from Abroad 250
Indirect Tax 200
Subsidies 150
Income accruing to the public sector from domestic product 300

Answer:
NDPFC = NNPMP – Net Factor Income from Abroad – Indirect Tax +
Subsidies
= 15000 – 250 – 200 + 150
= ₹ 14,700 crores.
Income accruing to the private sector from domestic product = NDPFC – Income accruing to the public sector.
∴ Income accruing to the private sector from domestic product =14,700 – 300 = ₹ 14,400 Lakhs.

Question 28.
From the following data calculate Personal Income:

₹ (Lakhs)
Private Income 12,000
Saving of Private Corporate Sector (or undistributed corporate profits) 200
Corporate Tax 70

Answer:
Personal Income
= Private Income – Saving of Private Corporate Sector – Corporate Tax
= 12,000 – 200 – 70
= ₹ 11,730 Lakhs.

Question 29.
Explain the circular flow of income in an economy. (Nov 2019, 3 marks)
Answer:
Production is the result of collective efforts of various factors of production. Factors engaged in production process get their award – land, labour, capital, and entrepreneurship get rent, wage, interest, and profit respectively.

Commercial firms make use of these factors for producing goods and services. These factors of production are not only suppliers of factors to the producer, but they are consumers also. These factors earn their income on consumption. Commercial firms sell their product, earn income, and again spend on completing production activity. Thus, flow of income circulates.

Production gives birth to Income, income to consumption, consumption to expenditure, and again expenditure to income and production. Thus, circular flow of income-earning economic activities takes places in the economy.
Determination of National Income - CA Inter ECO Question Bank 2
Hence, the circular flow of income refers to flow of money income or the flow of goods and services across different sectors of the economy in a circular form. It is a continuous flow of production income and expenditure.

Definition:
According to Lipsey, “The circular flow of income is the flow of payment and receipts between domestic firms and domestic households.”

Determination of National Income - CA Inter Economics Question Bank

Question 30.
What are the Principles of Circular Flow of Income? Explain.
Answer:
Principles or Reasons of Circular Flow of Income:
Circular flow of income depends on two principles (or reasons):
1. In the process of exchange, seller of the producer gets that money which is spent by buyer or consumer, i.e., income earned by the producer equals the income spent by the consumer.
2. Goods and services flow from sellers to buyers in one direction but the money payment for these goods and services flow in opposite direction i.e., it flows from buyers to sellers.
Determination of National Income - CA Inter ECO Question Bank 3

Question 31.
State the relationship between leakages and injections in various economies
Answer:
Relationship between Leakage and Injection:
For the equiftbrium in economy, leakages should be equal to injections.
Or Injections = Leakages
Various sources of Injections and Leakages:
Two Sector Economy:
Leakages = Savings (S)
Injections = Investment (I)

Three Sector Economy:
Leakages = Savings + Tax = S + T
Injections = Investment + Government Expenditure = I + G

Four Sector Economy:
Leakages = Savings + Tax + Import = S + T + M
Injections = lnvestment+Govemment Expenditure + Export = I + G + X

Question 32.
Elucidate the importance of Circular Income Flows.
Answer:
Importance of Circular Income Flows:
In economic analysis circular income flow has a vital role to play. Salient points showing the importance of circular flow of income are as follows:

  1. It helps in estimation of national income.
  2. It gives the knowledge of working of the economy.
  3. Equality between savings and investment becomes an important basis for monetary policy in the economy.
  4. Its study also helps in fiscal policy from the economic point of view.
  5. Its study helps in analysing the reasons of imbalance in the economy and making solutions to them.
  6. Keynesian Theory of Income and Employment takes important note of elements associated with flow of money.
  7. It also helps in studying the effects on imports and exports in the economy.
  8. This circular flow explains that Production = Income = Expenditure
    This identity becomes basis for the methods of calculating national income.

Question 33.
From the following data, compute the Gro€s National Product at Market Price (GNPMP) using value-added method.

(₹ 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

(May 2018, 3 marks)
Answer:

(₹ In cr.)
Value of output in primary sector 800
– Intermediate consumption of primary sector (300)
+ Value of output in secondary sector 1,000
– Intermediate consumption of secondary sector (400)
+ Value of output in tertiary sector 3,000
– Intermediate consumption of tertiary sector (900)
GDPMP 3,200 Cr.

GDPMP + NFIA = GNPMP
∴ GNPMP = 32,000 + (-100) = 3100
Ans: GNPMP = ₹ 3,100 Cr.

Question 34.
Calculate GNP at market price from the following data using Value Added Method.

(₹ in Crores)
Government Transfer Payments 1800
Value of Output in Primary Sector 1500
Value of Output in Secondary Sector 2700
Value of Output in Tertiary Sector 2100
Net factor income from Abroad (-) 60
Intermediate Consumption in Primary Sector 750
Intermediate Consumption in Secondary Sector 1200
Intermediate Consumption in Tertiary Sector 900

(Jan 2021, 5 marks)

Question 35.
Write short note on:
Precautions to be taken while measuring National income by Product Method.
Answer:
Precautions to be taken while measuring National Income by Product Method:

  1. The value of only final goods and services should be included to avoid double counting.
  2. Sale and purchase of 2 hand goods should not be counted.
  3. Services of housewife should not be counted.
  4. Production for self-consumption should also be included
  5. Inputed rental value of the self-occupied house should be included.

Determination of National Income - CA Inter Economics Question Bank

Question 36.
How is NI measured by Value Added Method? Explain.
Answer:
Product Method or Value added method is that method which measures the national income by estimating the contribution of each producing enterprise to production in the domestic territory of the country in an accounting year.

The steps involved are:
1st Step:
First of ah the various producing enterprise in a country are classified into primary sector, secondary sector and tertiary sector.

2nd Step:
Estimating net value added.
Net value added = Value of output – [Value of non-factor inputs (also called intermediate consumption) + depreciation + net indirect tax]
Value of Output = Sales + Change in stock
Change in stock = Closing Stock – Opening stock

3rd Step:
The NVA of all the sectors of a country is added to obtain NDP at factor cost.

4th Step:
Estimating NFIA and adding the same to NDP to obtain net national product or National Income.
Thus, ΣNVA (of all the sectors) = NDPFC
NDPFC + NFIA = NNPFC
NNPFC = NI.

Question 37.
Calculate value added by Firm X and Firm Y from the following data:

₹ (Lakhs)
Sales by Firm X 200
Sales by Firm Y 1000
Purchases by households from Firm Y 600
Exports by Firm Y 100
Change in stock of Firm X 40
Change in stock of Firm Y 20
Imports by Firm X 140
Sales by Firm Z to Firm Y 500
Purchases by Firm Y From X 400

Answer:
Determination of National Income - CA Inter ECO Question Bank 4

Question 38.
Calculate the net value added at factor cost a producing unit from the following data:

₹ (Lakhs)
Total Sales 4,000
Closing stock 700
Opening stock 500
Indirect Taxes 200
Subsidies 150
Depreciation 300
Purchase of raw materials from other firms 1,000

Answer:
Value of output
= Total sales + Change in stock
(Clo. stock – Op. stock)
= 4,000+(700-500)
= ₹ 4,200Lakhs.

GVAMP
= Value of output – Purchase of material from other firms
= ₹ 4,200 – 1,000 = 3,200 Lakhs.
Net Value Added at factor cost
= GVAMP – Depreciation – (Indirect taxes – Subsidies)
= ₹ 3,200 – 300 -(200 – 150)
= ₹ 2,850 Lakhs.

Question 39.
Given:
Value of gross output at market prices ₹ 10,000
Intermediate consumption ₹ 3,000
Net Indirect taxes ₹ 700
Consumption of fixed capital ₹ 140
Calculate:
(a) Gross Value Added at market price.
(b) Gross Value Added at factor price.
(c) Net value added at factor cost.
Answer:
(a) Gross Value Added at market price.
= Value of Gross OutputMP – Intermediate consumption
= ₹ 10,000 – ₹ 3,000 = ₹ 7,000

(b) Gross Value Added at factor cost
= GVAMP – Net Indirect Taxes
= ₹ 7,000 – 700 = ₹ 6,300

(c) Net Value Added at factor cost
= GVAFC – Consumption of fixed capital
= ₹ 6,300 – 140 = ₹ 6,160

Question 40.
From the following data, find out.
Value of output at market prices;
Gross value added at market prices;
Net value added at market prices;
Net value added at factor cost.

₹ (Lakhs)
Opening stock 400
Closing stock 200
Purchase of raw material 300
Sales 1600
Consumption of fixed capital 200
Indirect taxes 150
Subsidies 50

Answer:
(a) Value of output at market prices
= Sales + Closing stock – Opening stock
= (1,600+200 – 400)
= ₹ 1,400 Lakhs

(b) Gross value added at market prices
= Value of output – Purchase of raw materials
= (1,400-300)
= ₹ 1,100 Lakhs

(c) Net value added at market prices
= Gross value added – Consumption of fixed capital
= (1,100-200)
= ₹ 900 Lakhs

(d) Net value added at factor cost
= NVA at market prices – Indirect taxes + Subsidies
= (900-150+50)
= ₹ 800 Lakhs.

Determination of National Income - CA Inter Economics Question Bank

Question 41.
Using the information given in the following table calculate,
(i) Value added by firm A and firm B
(ii) Gross Domestic Product at Market Price
(iii) Net Domestic Product at Factor Cost.

Particulars ₹ crore
(i) Sales by firm B to general government 300
(ii) Sales by firm A 1500
(iii) Sales by firm B to households 1350
(iv) Change in stock of firm A 200
(v) Closing stock of firm B 140
(vi) Opening stock of firm B 130
(vii) Purchases by firm A 270
(viii) Indirect taxes paid by both the firms 375
(ix) Consumption of fixed capital 720
(x) Sales by firm A to B 300

Answer:
(i) Value added by Firm A and Firm B
Gross Value Added (GVAMP) of Firm A
= Gross value of output (GVOMP) of Firm A :
Intermediate consumption of firm A
= (Sales by firm A + Change in stock of firm A) – (Purchases by firm A)
= ((ii) + (iv)] – (vii) = (1500+ 200) -270 = 1430 Crores

Gross Value Added (GVAMP) of Firm B = Gross value of output
(GVOMP) of firm B -Intermediate consumption of firm B
= [Sales by firm B to general government + Sales by firm B to households + (Closing stock of firm B – Opening stock of firm B)] – Purchases by firm B
= [(300+1350)+(140-130)]-300
= 1650+10-300 = ₹ 1360 Crores

(ii) Gross Domestic Product at Market Price:
= Value added by firm A + Value added by firm B
= 1430 + 1360 = ₹ 2790 Crores

(iii) Net Domestic Price at Factor Cost:
NDPFC = Gross Domestic Product at market price – Consumption of fixed capital – Indirect taxes paid by both the firms
= 2790 – (ix) – (viii) = 2790 -720 – (375 -0) = ₹ 1695 Crores

Question 42.
Compute NNP at factor cost or national income from the following data using income method:

(₹ In crores)
Compensation of employees 3,000
Mixed-income of self-employed 1,050
Indirect taxes 480
Subsidies 630
Depreciation 428
Rent 1,020
Interest 2,010
Profit 980
Net factor income from abroad 370

(Nov 2019, 3 marks)
Answer:
(i) NNP et factor cost or National lnocme =
Compensation of employees + operating Surplus (rent + interest + profit) + Mixed Income of Self – employed + Net factor Income from Abroad.
= 3000 Cr. + (₹ 1020 Cr. + 2010 Cr. + 980 Cr.)+ 1050 Cr. + 370 Cr. = ₹ 8430Cr.

Question 43.
Discuss the Income Method of measuring National Income.
Answer:
Income Method of Measuring National Income:
Income method is that method which measures NI from the payment point of view where payment is made in form of wages, rent, interest and profit to the primary factors of production i.e. labour, land, capital, and enterprise respectively for their productive seces in an accounting year.

The steps involved are:
1st Step:
First of all the various producing enterprises in a country are classified into
(a) Primary sector
(b) Secondary sector
(c) Tertiary sector.

2nd Step:
All the factor payments are classified as follows:
(i) Income from work – wages and salary
(ii) Income from property – Rent and Interest
(iii) Income from profit – Dividend, Undistributed Profit and Corporate taxes
(iv) Mixed Income – income of self-emploÿed like doctor, advocate etc.

3rd Step:
Domestic factor Income is estimated by adding all the factor payments of all the enterprises of all the sector.

4th Step:
Net Income earned from abroad is estimated and added to domestic Income to arrive at national product, which ¡s the national Income.
Thus,
Wage
+ Salary
+ Profit
+ Rent
+ Interest
+ Mixed Income
= NDPFC = Domestic Income + NFIA
= NNPFC = National Income.

Question 44.
Write short note on:
Precautions to be taken while measuring National income by income Method
Answer:
Precautions to be taken while measuring National Income by Income Method
1. Windfall gains like income from lottery are not included.
2. Wealth tax capital gain tax are not to be included.
3. Production br self-consumption should also be included.
4. imputed rental value of self-occupied house should also be included.
5. Sale and purchase of 2nd hand goods should not be counted.
6. Income of gamblers, smugglers, thieves etc. should not be included.
7. Financial transaction such as sale of shares is not included.

Question 45.
State the various components of:
Domestic Income
Answer:
Components of Domestic Income
1. CompensatIon of employees
(i) Wages and salaries
(ii) Employer’s contribution to social security schemes.

2. Operating surplus
(i) Rent
(ii) interest
(iii) Profit

3. Mixed Income for self-employed persons.

Determination of National Income - CA Inter Economics Question Bank

Question 46.
Suppose in an economy:
Consumption Function : C = 150+0.75 d
Investment spending: I = 100
Government spending: G = 115
Tax : Tx = 20 + 0.20Y
Transfer Payments: Tr =40
Exports: X=35
Imports : M=15 + 0.1 Y
Where, Y and Yd are National Income and Personal Disposable Income respectively. All figures are in rupees.

Find:
The equilibrium level of National Income
Consumption at equilibrium level
Net Exports at equilibrium level (May 2018, 5 marks)
OR
You are given the following information of an economy:
Consumption Function : C = 200 + 0.60 Yd
Government Spending: G = 150
Investment Spending: I = 240
Tax: Tx=10 + 0.20 Y
Transfer Payment: Tr =50
Exports: X=30 + 0.2Y
Imports: M= 400
Where Y and Yd are National Income and Personal Disposable Income respectively. All figures are in ₹.
Find:
(i) The equilibrium level of National Income.
(ii) Net Exports at equilibrium level.
(iii) Consumption at equilibrium level. (Nov 2020, 5 marks)
Answer:
The consumption function is
C = 150 + 0.75Yd
Level of Disposable income Yd is given by
Yd = V-Tax + TransforPayments, Where, Transfer Payment = Tr =40
=Y-(20 + 0.20Y) + 40 = Y-20-0.20Y+40
=Y- 0.2Y – 20 + 40

Yd = 20 + 0.8V and C = 150 + 0.75 Yd
C = 150+ 75 (20 +0.8 Y) where Yd = (20+0.8V)
C= 150 +1 5+ 0.6Y
C = 165 + 0.6Y

(i) The equilibrium level of national Income
Y =C+I+G+(X-M)
Y =165 + 0.6Y + 100 + 115 + [35- (15+0.1Y)]
= 165+0.6Y +100+115+ [35 -15-0.1Y)
= 165+0.6Y +215+35-15-0.1V
Y =400+0.5V
Y-0.5Y = 400; 0.5 Y = 400
Y =400/0.5
= 800
The equilibrium level of national income is ₹ 800

(ii) Consumption at equilibrium level of national income of ₹ 800
C=165+0.6Y
C = 165 + 0.6(800)
C=165+480=645
Consumption at equilibrium level = ₹ 645

(iii) Net Exports at equilibrium level of national Income 800
Net exports = Value total exports – Value of total imports
Given, exports X = 35; and imports M = 15+0.1V
Net exports = [35- (1 5+0.1 Y)I
=35 -15-0.1V
= 35-15 – (0.1 X 800) = 35-15-80 = -60
Net exports = ₹ (-)60
There is an adverse balance of trade

Question 47.
Compute GNP at factor cost and NDP at market price using expenditure method from the following data:

(₹ In Crores)
Personal Consumption expenditure 2900
Imports 300
Gross public Investment 500
Consumption of fixed capital 60
Exports 200
inventory Investment 170
Government purchases of goods & services 1100
Gross Residential construction Investment 450
Net factor Income from abroad (-) 30
Gross business fixed Investment 410
Subsidies 80

(May 2019, 5 marks)
Answer:
GDPMP = Personal consumption expenditure + Gross Investment (Gross fixed investment + inventory investment) + Gross residential construction investment + Gross Public investment + Government purchases of goods and services + Net Exports (Exports – Imports)
GNPMP = GDPMP + Net factor income from abroad
GNPFC = GNPMP – Indirect Taxes

So, GDPMP Is:

₹ In cr.
Personal consumption expenditure 2900
Gross business fixed Investment 410
Inventory Investment 170
Gross Residential construction investment 450
Gross public investment 500
Government purchases of goods & services 1100
Net Exports (Exports – Imports) (₹ 200 – ₹ 300) -100
GDPMP 5430

GNPMP = 5,430 Cr. + (-30 Cr.) = ₹ 5,400 Cr.
Here, there is no indirect taxes, so GNPMP = GNPFC
So, GNPFC = ₹ 5,400 Cr.
NDPMP = GDPMP – Consumption of fixed capital
= ₹ 5,430 Cr. – ₹ 60 Cr.
NDPMP = ₹ 5,370 Cr.

Question 48.
How is National Income measured by Expenditure Method?
Answer:
Expenditure Method of Measuring National Income:
Expenditure method is the method, which measures the final expenditure on GDP at market price during an accounting year.
The steps involved are:
1st Step:
The private final consumption expenditure is estimated.
This expenditure is the expenditure by consumer households and non profit making institutions on:
(a) Durable consumer goods-fan, TV etc.
(b) Single-use consumer goods-milk, fruit
(c) Services such as education, medical facilities etc.

2nd Step:
The Government’s final consumption expenditure is estimated. This is the expenditure incurred by Govt. for the general well being of the citizen’s like education, health and medical care, electricity and water supply etc.

3rd Step:
The gross domestic capital formation is estimated. Gross domestic capital formation is the sum of change in stock and gross fixed domestic capital formation.

4th Step:
The net export of goods and services is estimated. Net export is the difference between export and import of a country.

5th Step:
All the items from 1st to 4th step is added. The sum Is the expenditure on domestic product. It is also known as NDP at market price.

6th Step:
The NFIA is estimated and added to the NDPMP to get NNPMP Which is the National income at Market price. To obtain NI at factor cost, net indirect taxes have to be subtracted.

Determination of National Income - CA Inter Economics Question Bank

Question 49.
Write short note on:
Precautions to be taken while measuring National Income by Expenditure Method.
Answer:
Precautions to be taken while measuring National Income by Expenditures Method: ,

  1. Expenditure on 2’ hand good should not be included.
  2. Expenditure on financial transaction like purchase of shares should not be included.
  3. Government expenditure on transfer payments should not be included.
  4. To avoid double counting only expenditures on final goods and services is to be included.

Question 50.
State the various components of:
Final Expenditure
Answer:
Components of Final Expenditure
1. Final consumption expenditure

  • Private final consumption expenditure.
  • Government final consumption expenditure.

2. Gross Domestic Capital Formation

  • Gross domestic fixed capital formation.
  • Change in stock

3. Net export (X – M)

  • Export (X)
  • Import (M)

Question 51.
What are the conceptual difficulties in the measurement of national income? (May 2019, 2 marks)
Answer:
The conceptual difficulties in the measurement of national income are as follows:

  1. Lack of an agreed definition of national income
  2. Accurate distinction between final goods and intermediate goods
  3. Issue of transfer payments
  4. Services of durable goods
  5. Difficulty of incorporating distribution of income
  6. Valuation of a new good at constant prices, and
  7. Valuation of government services.

Question 52.
Write short note on: .
Problems in estimation of National Income.
Answer:
Problems In Estimation of National Income:

  1. Presence of non-monetized sector: Sometimes, a part of production escapes valuation (due to self-consumption) Thus, NI is underestimated is that extent.
  2. Ignorance of Indian producer: Many a time the producers are ignorant about the exact value and quantity of their produce.
  3. Lack of differentiation of economic functions: When a person is engaged in many occupation simultaneously it is difficult to make proper valuation of his total economic efforts.
  4. Non-availability of reliable data: There is lack of adequate data and reliability in it is ¿0w. The estimates of costs are generally absent in primary and subsidiary occupation.
  5. Avoidance of financial burden: To avoid the tax liability, people do not furnish exact data about their income and expenditure.

Question 53.
Explain briefly the Two Sector Model of Circular Flow of Income.
Answer:
Two-Sector Model of Circular Flow of income:
The structure of macro economy is given by circular flows of income and output. In a two-sector model of circular flow of Income, there are only two sectors.

  • Household sector.
  • Producer sector (Firms)

A two-sector model of circular flow of income thus deals with circular flow (Money flow as well as real flow) between these two sectors.

Assumptions:
1. The economy consists of two sectors:
(a) Household Sector:
This sector providas its services to producer sector and consumes the goods and services finally produced by producer sector

(b) Producer Sector:
It produces final goods and services and makes use of the services of various factors like land, labour, capital, etc.

2. Economic policies are not influenced by the government.
3. Economy is ‘closed economy’, i.e., producer sector makes neither exports nor imports and household sector is fully dependent on domestic production.
4. Household sector spends Its entire income and saves nothing.

Explanation:
Under these presumptions, the firm sector hires factor services from households, who are owners of factors of production (land, labour, capital, and enterprise), for producing goods and services and pays them remuneration (or compensation) In the form of money for rendering the productive services.

For the factors of production, these are factor incomes known as rent, wages, interest and profit WhiCh have been generated in the production process.

Thus, money income flows from firm sector to the households. With this money the households purchase from the firms, manufactured goods and service to satisfy their wants with the result, the same money flows back from households to the firm sector. Thus, entire income of economy comes back to firms In the form of sales revenue. Clearly one man’s (or sectors) expenditure Is other man’s (or sector’s) Income.

Structure of Two Sector Model:
Determination of National Income - CA Inter ECO Question Bank 5

Question 54.
Explain briefly the Two Sector Model of Circular Flow with Saving Investment within a Capital Market or Financial Systems.
Answer:
Two-Sector Model with Saving-Investment within a Capital Market or Financial Systems:
In real life both household sector, (i.e., family) and producer sector (i.e., firm) save a part of their income. This saying is withdrawn from money flow and consequently, money flow squeezes. This is called leakage.

Thus, saving is a leakage from money flow which becomes available in capital market for loaning purposes. This becomes an injection in the circular how. Commercial firms borrow from capital market for investment. Investment has the opposite effect than that of saving. If the saving made by households returns back to money circulation through investment of commercial firms, money circulation remains stable. Hence, in a two sector model, the equlhbdum condition or the stability condition is:
Savings = Investment
S = I
Factor Payments (Money Flow)
Capital market consisting of financial institutions plays an important role. Financial institutions are primary intermediaries between savers and investors or lenders and borrowers.
Determination of National Income - CA Inter ECO Question Bank 6

Question 55.
Write short note on:
The Various Sectors of Two Sector Economy.
Answer:
Household Sector:

  1. Household sector is the owner of factors of production.
  2. This sector receives income in the form of wages, rent, interest, and profits. They also get certain transfer payments from the government.
  3. This sector spends money on the purchase of goods and services produced by the producing sector (or business sector) and also pays taxes to the government.
  4. This sector saves a part of its income which goes to the financial market.

Producing Sector (Firm):

  1. Producing sector (firms) produces goods and services which are consumed by the households and government. The firms in turn receive revenue from the sale of their goods and services. This sector also earns export income.
  2. This sector hires factor services and makes them payments. It also makes payment to other countries for goods/services imported.
  3. This sector also has to pay taxes to the government on sale and production of their goods. Certain firms receive subsidies from the government.
  4. This sector also saves a part of its income.

Determination of National Income - CA Inter Economics Question Bank

Question 56.
Distinguish between:
Real Flows and Money Flows in a Two Sector Economy.
Answer:
Real Flows:
Real flows refer to flows of goods and services. These are called real flows because they consist of actual goods and services. In the context of national accounting, real flow implies flow of factor services from household sector to the firm (or producing) sector and the corresponding flow of goods and services from firm sector to the household sector. Thus, flows of goods and services between firm sector and household sector are real flows. Such flows are continuous and thereis no beginning or end point in these flows.
Determination of National Income - CA Inter ECO Question Bank 7

Money Flows:
These refer to flows of money in the form of factor payments and consumption expenditure. The monetary flows occur because it is through money that varibus transactions are conducted bringing flows of money from one sector to another.
Determination of National Income - CA Inter ECO Question Bank 8

When factor incomes (rent, wages, interest, and profit) flow from firm sector to the households as reward for their factor services, these are called monetary flows. Similarly, when households spend their incomes on, purchase of goods and services produced by the firm sector, money flows back to the firm sector, household expenditure. These also indicates monetary flows. In short, flows of money between firm sector and household sector are monetary flows.

Question 57.
Explain the consumption function using a suitable table and diagram. (Nov 2019, 3 marks)
Answer:
Propensity to Consume or Consumption Function
Meaning:
The relationship between consumption and income is called consumption function (or propensity to consume). In other words, propensity to consume means proportion of income spent on consumption. Consumption being a part of income directly depends upon income itself. Thus consumption (C) is a function (f) of income (Y).
Symbolically C = f(Y).
Consumption may be divided in two parts:
(i) First part relates to consumption when income is zero, i.e., when minimum level of consumption has to be maintained for survival. This is called autonomous consumption (denoted by C).

(ii) Second part of consumption is when income increases, consumption also increases but by a lesser amount i.e. additional consumption (ΔC) is less than additional income (ΔY) or ΔC/ΔY is less than 1 . This may be represented, by b (i.e., marginal propensity to consume). Thus, Consumption function (linear consumption function) may be represented In the following equation.
C= C+bY
Here C is consumption, C is autonomous consumption, b is marginal propensity to consume or MPC and Y is level of income.
Determination of National Income - CA Inter ECO Question Bank 9

Comments:
1. Consumption can never be zero even if income is zero because survival needs some minimum consumption (called Autonomous Consumption). That is why consumption curve starts from positive point C on Y-axis. In Fig. OC is the minimum level of consumption.

2. Slope of consumption curve is constant making it a straight line because for convenience’s sake we have assumed marginal propensity to consume to be constant. (e.g., MPC, i.e., ΔC/ΔY is 0.8 throughout in the schedule).

3. Point B is the breakeven point indicating consumption = Income – Before it consumption > income showing dissaving but after point B consumption

4. 45° dotted line Y = C + S is the line of equality where each point indicates consumption is equal to income.

Question 58.
Clarify the concept of ‘Average Propensity to Save’ with the help of formula and example. (Nov 2020, 2 marks)

Question 59.
Calculate the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) from the following data:
Income (Y) Consumption (C) Level
₹ 8,000 ₹ 6,000 Initial level
₹ 12,000 ₹ 9,000 Changed level
(May 2018, 2 marks)
Answer:
(i) Change in consumption (ΔC) = 9,000 – 6,000 = ₹ 3,000
Change ¡n Income (ΔY) = 12,000 – 8,000 = ₹ 4,000
Marginal Propensity to Consume (MPC) = \(\frac{\Delta c}{\Delta y} \)
= \(\frac{3,000}{4,000} \)
= 0.75

(ii) MPC+MPS=1
0.75 + MPS = 1
MPS = 0.25
Marginal Propensity to Save (MPS) = 0.25

Question 60.
Calculate the Average Propensity to Consume (APC) and Average Propensity to Save (APS) from the following data:
income Consumption
₹ 4,000 ₹ 3,000
(Nov 2018, 2 marks)
Answer:
(ii) Average Propensity to Consume (APC):
APC = \(\frac{\text { Total Consumption }}{\text { Total Income }}=\frac{C}{\mathrm{Y}} \)
= \(\frac{₹ 3,000}{₹ 4,000} \)
APC = 0.75

Average Propensity to Save (APS):
APS = \(\frac{\text { Total Saving }}{\text { Total Income }}=\frac{S}{Y}\)
= \(\frac{₹ 1,000}{₹ 4,000} \)
APS = 0.25

Question 61.
Can value of APC be greater than one? Comment.
Answer:
Average propensity to consume (APC):
The ratio of total consumption expenditure to total Income is called APC. It is the percentage (or ratio) of income which s spent on consumption. It is worked out by dividing total consumption expenditure (C) with total income (Y).
Symbolically:
APC = C/V
For instance, if the aggregate income of an economy is Z 5,000 crores and aggregate consumption is Z’ 4,500 crores, then:
APC= \(\frac{C}{Y}=\frac{4,500}{5,000}\)= 0.90 or 90%
It indicates that 90% of income is spent by way of consumption expenditure. But if aggregate income is very low, say Z 1,000 crores, and aggregate
consumption is ₹ 1200 crores, the APC = 1,200/1,000 = 1.2.
Thus, the value of APC may be greater than 1 when at very low level of income, consumption exceeds Income to meet the very basic necessities. Then saving becomes negative.

Determination of National Income - CA Inter Economics Question Bank

Question 62.
Income and Consumption expenditure are directly related to each other. Do you agree. Give reasons in support of your answer.
Answer:
Relationship between income and consumption expenditure:
1. According to Keynes, as income increases, consumption expenditure also increases but by less than the increase In income. In other words, when income increases, consumption expenditure does not increase at the same rate as income. This is called Keynesian psychological law of consumption.

There is tendency of people not to spend on consumption the whole of incremental income. i.e., additional consumption is less than additional income. In other words, MPG is less than 1 (MPC < 1).

For example,
If income increases by ₹ 100; the tendency is to spend a part, say ₹ 75, on consumption and save the remaining part (i.e., ₹ 25). This is known as induced consumption.

It should be kept in mind that when income is zero, consumption is positive (+) because a person has to spend a minimum amount to keep his body and soul together. This is called autonomous consumption.

2. When income is very low, consumption expenditure is higher than income:
Its reason is that some minimum level of consumption has to be maintained irrespective of low level of income. In such a situation, value of APC (i.e., C/Y) becomes higher than 1.

Question 63.
What is meant by propensity to save (or saving function)? Explain saving function and State relationship between income and saving.
Answer:
Saving Function:
A person spends a part of his income on consumption and saves the rest. Keynes called the proportion which is consumed as ‘Propensity to consume’ and proportion which is saved as ‘Propensity to save’. Meaning of ‘Saving’ Function: The functional relationship between saving and income is called saving function (or propensity to save). In other words, it is proportion of income Which is saved. Thus, saving (S) is a function (f) of income (Y).

Algebraically:
S = f(Y)
It shows direct relation between saving and level of income. In other words as the level of income increases, saving also increases. Thus, saving function is corollary or reciprocal of consumption function.
Determination of National Income - CA Inter ECO Question Bank 10
The table shows that in the beginning saving ¡s negative since consumption is never zero. But as income increase, consumption increases less than proportionally. Consequently saving becomes positive and increases at a faster rate than the increase in income.
Determination of National Income - CA Inter ECO Question Bank 11

The above Fig. reflects saving function which relates the level of saving to the level of income. A diagrammatic representation of the relationship between income and saving gives the saving curve. Line SS represents saving function. The saving function line SS crosses the income line at point B which is called breakeven point because at this point savings are zero (or consumption is equal to income). To the left of breakeven point, savings are negative indicating consumption being more than income whereas to the right of breakeven point, savings are positive indicating consumption expenditure being less than income. The shaded area reflects dissavings which is equal to equal to the area of autonomous consumption shown as – C in the fig.

Relationship between income end Saving:
1. As income increases, saving also increases but the rate of increase in saving is more than the rate of increase in income after a particular level of income. This means that as income increases, the proportion of income saved increases (and the proportion of income consumed decreases).

2. At lower level of incomes, savings is negative. In the stages when there is no income or very low level of income, consumption expenditure is more than income leading to negative saving (i.e., dissaving). For instance, if income is, say ₹ 5,000, and consumption expenditure is, say ₹ 6,000, then saving will ₹ 1,000 (=5,000-6,000), i.e., there is dissaving.
Here average propensity to save is negative. APS = – 1,000/5,000 =-0.2.

Question 64.
What is Excess Demand? How does it give rise to an Inflationary gap.
Answer:
Meaning of Excess Demand:
When in an economy, aggregate demand is for a level of output that is more than the full employment level of output, the demand is said to be an excess demand and the gap is called inflationary gap. In other words, excess demand refers to the excess of aggregate demand over the available output at full employment. The gap is called inflationary because it causes inflation (continuous rise in prices) in the economy. According to Keynes, equilibrium level of income, output and employment is determined solely by level of aggregate demand during short period.

Inflationary Gap.
When aggregate demand is more than level of output at full employment’ then the excess or gap is called inflationary gap. Alternatively, it is the amount by which actual aggregate demand exceeds the level of aggregate demand required to establish full-employment equilibrium. This inflationary gap is a measure of amount of the excess of aggregate demand. It indicates that the buyers intend to buy more than the maximum physical output the producers can produce by employing all the available resources. In such a situation an increase in demand means only an increase in money expenditure without any corresponding increase in output and employment because all the resources have already been fully employed. A simple example will further clarify it.
Determination of National Income - CA Inter ECO Question Bank 12
Here, point E lying on 45° line is the full employment equilibrium point. This is an ideal situation because aggregate demand represented by EM is equal to full employment level of output (aggregate supply) represented by OM. Suppose the actual aggregate demand is for a level of output BM which is greater than full employment level of output EM (OM). Thus, the difference between the two is EB (BM – EM) which is measure of Inflationary gap or excess demand.

In short inflationary gap is the amount by which aggregate demand exceeds the aggregate demand required to establish the full employment equilibrium. Impact of Excess Demand. Since there is already full capacity production, excess demand does not cause any rise in output and employment but it leads to rise in prices. In such a situation when resources have been fully employed, increase in demand implies pressure on existing supplies of goods causing rise in prices and a situation of inflation. Clearly, this is demand-pull inflation, i.e., demand-induced increase in price level. A persisting rise in general level of prices after full employment is called inflation.

Inflation creates inequalities of distribution of wealth, loss to creditors and salaried people, social unrest and revolt, loss of faith in government and morality. Remember, in such a situation real income (i.e., in ternis of physical output) cannot rise but money income (i.e., in terms of money value of physical output) will rise.

Question 65.
As people become more thrifty, they end up saving less or same as before. Explain Paradox of Thrift in light of the above statement.
Answer:
Paradox of Thrift:
Since start of human civilization it was considered a virtue to keep consumption level at the minimum but the lasting effects and chain reactions of keeping consumption in check were not realised. People were taught that thrift or savings are good because a penny saved today will bring increased income. In this connection, Keynes pointed out paradox of thrift’ and showed that as people become more thrifty, they end up saving less or same as before. According to Keynes if all the people of an economy increased the proportion of income which is saved (Le., MPS), the value of savings in the economy will not increase, rather it will decline or remain unchanged. Let us understand this statement with the help of the diagram given below.
Determination of National Income - CA Inter ECO Question Bank 13
In Figure initial saving curve is SS and investment curve is I. Economy attains equilibrium (saving = investment) at E and equilibrium level of income is OY. Now suppose the society decides to become thrifty and increases saving by, say, AE. As a result saving curve shifts upward to S1S1 intersecting investment curve II at E1. Unplanned inventories will increase and firms will cut down production and employment and move to new equilibrium E1.

The Figure shows that in the end, planned saving has fallen from AY to E1Y1. At the new equilibrium point E1, the investment level and saving remain same ie., E1Y1 but level of income has fallen from OY to OY1. This decline in the equilibrium level of income shows the paradox of thrift as the reverse process of the multiplier has worked on reducing consumption expenditure. In fact, increased saving is virtually a withdrawal from circular flow of income.

Determination of National Income - CA Inter Economics Question Bank

Question 66.
What Is Keynes’ Psychological Law of Consumption?
Answer:
Keynes Psychological Law of Consumption:
Keynes’ Psychological Law of Consumption states that consumption is a direct function of disposable income. According to this law, “Society has a tendency to increase its consumption spending whenever income increases but not in that proportion in which income increases.”

The law has three basic propositions:

  1. When income increases, consumption also increases but by somewhat smaller amount.
  2. Net increase in income will be divided between consumption and savings in some ratio.
  3. It is unlikely that an increase in income would lead to either fall in consumption or decline in savings.

Question 67.
Define saving function. If consumption function is C = C + bY, find out the corresponding saving function.
Answer:
Saving function is a functional relationship between savings and income. i.e. it shows that the level of savings depends upon the level of income. it is expressed as:
S = f (Y)
S = savings
f = function
Y = income

Derivation of saving function:
C= C+bY
S = Y-C
S = Y(C+bY)
= Y-C-bY
= -C + Y- bY
S = -C + Y (1-b)

Question 68.
Given that consumption function C = 100 + 075V, find out:
1. Corresponding saving function
2. Level of income at which savings will be zero.
3. If the level of income ¡s ₹ 800, find out the value of consumption and savings.
Answer:
1. C = 100 + 0.75Y ………………………. (i)
C = C+ bY …………………………. (ii)
From (i) and (ii)
C = 1oo
b = 0.75
S =-C + Y (1 – b)
S=- 100 + Y(1 – 0.75)
= – 100 + 0.25V

2. lf s=0
Then 0 =- 100+0.25V
\(\frac{100}{0.25} \) = Y
When income will be ₹ 400, savings will be zero.

3. WhenY=800
C = C + bY

Question 69.
Write short note on the concept of Aggregate Demand.
Answer:
Aggregate Demand:
Aggregate 1emand broadly refers to the total demand for goods and services in the economy. Since it is measured by total expenditure of the community on goods and services, therefore, aggregate demand is also defined as “the total amount of money which all sections (households, firms, government) are ready to spend on purchase of goods and services produced in an economy during a given period.” Alternatively AD is the total expenditure which the community intends to incur on
purchase of goods and services. Thus, aggregate demand is synonyms with aggregate expenditure in the economy.

If the total intended (i.e., ex-ante) expenditure on buying all the output is larger than before, this shows a higher aggregate demand. On the contrary, if the community decides to spend less on the available output, it shows a fall in the aggregate demand.

In simple words, Aggregate Demand is the total expenditure on consumption and investment. Determination of output and employment in Keynesian framework depends mainly on level of aggregate demand.

Aggregate Demand Function: Two Sector Model
AD = C + I
Aggregate Demand Function: Three Sector Model
AD = C + I + G
Aggregate Demand Function: Four Sector Model
AD = C + I + G + (X-M)
Where,
C = Private (household) consumption demand
I = Private investment demand
G = Government demand for goods and services
(X-M) = Net export demand.

Question 70.
Define consumption function? Examine what would happen if aggregate expenditure were to exceed the economy’s production capacity.
Answer:
Consumption Function:
Consumption function is the functional relationship between aggregate consumption expenditure and aggregate disposable income, expressed as C = f (Y); shows the level of consumption (C) corresponding to each level of disposable income (Y)

Aggregate expenditures in excess of output lead to a higher price level once the economy reaches full employment. Nominal output will increase, but it merely reflects higher prices, rather than additional real output.

Question 71.
In a two-sector model Economy, the business sector produces 7500 units at an average price of 7.
(i) What is the money value of output?
(ii) What is the money income of Households?
(iii) If households spend 75% of their income, what is the total consumer expenditure?
(iv) What ¡s the total money revenue received by the business sector?
(v) What should happen to the level of output? (Nov 2018, 5 marks)
Answer: .
(i) The money value of output equals total output times the average price per unit. The money value of output is (7,500 × ₹ 7) = ₹ 52,500
(ii) 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. ₹ 52,500.
(iii) Total spending by households (₹ 52,500 x 0.75) i.e. ₹ 39,375.
(iv) The total money revenues received by the business sector is equal to aggregate spending by households i.e. ₹ 39,375.
(v) The business sector makes payments of ₹ 52,500 to produce output, whereas the households purchase only worth ₹ 39,375 of what is produced. Therefore, the business sector has unsold inventories valued at ₹ 13125. They should be expected to decrease output.

Determination of National Income - CA Inter Economics Question Bank

Question 72.
Given the following equations:
C = 200 + 0.8V
I = 1200
Calculate equilibrium level of National Income and the Consumption Expenditure at equilibrium level of National Income. (Jan 2021, 3 marks)

Question 73.
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. (May 2019, 2 marks)
Answer:
Investment Multiplies (K) = \(\frac{\Delta y}{\Delta l}\)
Increase In investment = (₹ 14,000 – ₹ 10,000) Cr.
\(\Delta\) I = ₹ 4,000 Cr.
Increase in national income (ΔY) = ₹ (92000-80,000) Cr.
\(\Delta Y \) = ₹ 12,000 Cr.

Investment Multiplier (k) = \(\frac{\Delta y}{\Delta l} \)
∴ K = \(\frac{₹ 12,000 \mathrm{Cr}}{₹ 4,000 \mathrm{Cr}}\)
Investment Multiplier (K) = 3

Question 74.
Due to Recession in an economy, Government expenditure increased by 6 billion. If Marginal Propensity to Consume (MPG) in the economy is 0.8, compute the increase in GDP. (Jan 2021, 2 marks)

Question 75.
What is the concept of Investment Multiplier
Answer:
Investment Multiplier:
The concept of ‘Investment Multipliers is an important contribution of Prof. J.M. Keynes. Keynes believed that an initial increment in investment increases the final income by many times. Multiplier expresses the relationship between an initial increment in investment and the resulting increase in aggregate income.

In practice, it is observed that when investment is increased by a certain amount, then the change in income is not restricted to the extent of the initial investment, but it changes several times the change in investment. In other words, change in income is a multiple of the change in investment. Multiplier explains how many times he income increases as a result of an increase in the investment. Multiplier (k) is the ratio of increase in national income (\(\Delta Y \)) due to an increase in investment (\(\Delta l \)).
K = \(\frac{\Delta Y}{\Delta l} \)

Suppose an additional investment (\(\Delta l \)) of ₹ 4,000 crores in an economy generates an additional income (\frac{\Delta Y}{\Delta l}) of ₹ 16,000 crores. The value of multiplier (K), in this case will be:
k = \(\frac{16,000}{4,000}\) = 4

Question 76.
Explain the relationship between Multiplier and MPG.
Answer:
Multiplier and MPC
There exists a direct relationship between MPG and the value of multiplier. Higher the MPC, more will be the value of multiplier, and vice-versa. The concept of multiplier is based on the fact that one person’s expenditure is another person’s income. When investment is increased, it also increases the income of the people. People spend a part of this increased income on consumption. However, the amount of increased income spent on consumption depends on the value of MPG.

In case of higher MPC, people will spend a large proportion of their increased income on consumption. In such case, value of multiplier will be more.

In case of law MPG, people will spend lesser proportion of their increased income consumption. In such case, value of multiplier will be comparatively less. Thus, the value of multiplier depends upon the MPC.

Question 77.
What is the maximum and minimum value of multiplier.
Answer:
Maximum Value of Multiplier
The maximum value of multiplier is infinity when the value of MPG is 1.
MPG = 1 indicates that the economy decides to consume the whole of its additional income. Here, not even a bit of the additional income is saved. It will lead to a continuous increase in the consumption expenditure and value of multiplier will be infinity.

Proof:
We know;k = \(\frac{1}{1-\mathrm{MPC}}\)
When MPC = 1, then:
k = \(\frac{1}{1-1}=\frac{1}{0} \) = ∞ (as any number, when dividend by 0, gives infinity)

Minimum Value of Multiplier
The minimum value of multiplier is one when the value of MPC is zero. MPC = 0 indicates that the economy decides to save the whole of its additional income and nothing is spent as consumption expenditure. So, there will be no further increase in income. As a result, the total increase in income (\(\Delta Y \)) will be equal to the increase in investment (\(\Delta l \)), i.e., \(\Delta Y \) = \(\Delta l \). Here, the value of multiplier is equal to 1.
Prof: We know; k = \(\frac{1}{1-M P C} \)
When MPC =0, then:
k = \(\frac{1}{1-0}=\frac{1}{1} \) = 1

Question 78.
Explain the Three Sector Model of Circular Flow of Income.
Answer:
Three-Sector Model of Circular Flow of Income:
The structure of Macro Economy is given by circular flows of income and output. A three-sector model of circular flow of income is characterized by the presence of three sectors namely

  • Household sector
  • Producer sector (Firms)
  • Government

Question 79.
Explain the Leakages and Injections in circular flow of Income. (May 2018, 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 terntory 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, savings, 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.

Determination of National Income - CA Inter Economics Question Bank

Question 80.
Given Consumption function C = 300 + 0.75V;
Investment = ₹ 800; Net Imports = ₹ 100
Calculate the equilibrium level of output. (May 2019, 3 marks)
Answer:
The equilibrium level of output can be found by equating output and aggregate spending
Y=C+ I+G+(X-M)
Y=300 + 0.75Y + 800 – 100
V=1,000 + 0.75Y
0.25 Y = 1,000
Y = 4,000

Question 81.
For an Economy with the following specifications
Consumption; C = 50+0.75 Yd
Investment, I = 100
Government Expenditure, G 200
Transfer Payments, R = 110
Income Tax= 0.2 Y
(i) Find out the equilibrium of income and the value of expenditure multiplier.
(ii) If autonomous taxes worth ₹ 25 Crores are added. Find out equilibrium level of Income.
(iii) If the economy is opened up with exports X =25 and imports M = 5 + 0.25V Calculate the new level of Income and Balance of Trade (Assume that there are no autonomous Taxes.)
Answer:
(i) Level of Disposable income Yd is given by
Yd = Y – Tax + transfer Payments, Where, Transfer Payment = 110
=Y- 0.2Y+ 110 =0.8Y+ 110,
and C =50 + 0.75 Yd
= 50 + 0.75 (0.8V + 110) (where Yd = 0.8Y + 110)
= 50 + (0.75 x 0.8Y) + (0.75 x 110) = 132.50 + 0.6Y
C = 132.50 + 0.6Y

Now Y = C + I + G, Where C =132.50 + 0.6Y, =100, G = 200 (Given)
Y= (132.50 + 0.6V) + 100 + 200
=432.50+0.6Y
Y- 0.6Y =0.4Y =432.50
or Y= 432.50/0.4 = ₹ 1,081.25 Crores
Expenditure Multiplier = \(\frac{1}{1-b}=\frac{1}{1-0.6}\) = 2.5 (Multiplier In closed
economy = \(\frac{1}{1-b}\))
Here b = MPC = \(\frac{\Delta C{\Delta Y} \)

(ii) If autonomous taxes worth of ₹ 25 Crores added, this will reduce disposable income by ₹ 25 crores
Level of Disposable income d is given by
Yd = Y – Tax + Transfer payments
Thus Yd = Y – 0.2Y + (110-25) = 0.8Y + 85 (Income Tax Given = 0.2Y, Transfer Payments = 110)
C =50 + 0.75 (0.8Y + 85) (Given C =50+ 0.75Yd)
C =50 + (0.75 × 0.8Y) + (0.75 × 85)
= 50 + 0.6Y + 63.75 = 113.75 + 0.6Y
Y=C+l+G
= (113.75 + 0.6V) + 100 + 200 =413.75+ Q.6Y (C = 113.75 + 0.6Y, I =100,G=200)
Y- 0.6Y = 413.75
0.4Y = 413.75
y = \(\frac{413.75}{0.4} \) = ₹ 1034.375 Crores.

(iii) Y = C + I + G + (X – M), Where Consumption, (C) = 132.50 + 0.6Y,
Investment (I) = 100, Government Expenditure (G) = 200 Since X = 25, M = 5 + 0.25Y
Y = (132.50 + 0.6Y) + 100 + 200 + {25 -(5 + 0.25Y)} (Given X = 25 crores and M = (5 + 0.25Y)
Y = (132.50 + 0.6V) + 100 + 200 + (25-5 -0.25V)
= (1 -0.6 + 0.25) Y = 452.50
y = \(\frac{452.50}{0.65}\) = ₹ 696.15 Crores
Imports = 5 + 0.25Y = 5 + (0.25 × 696.15) = ₹ 179.04 Crores
Balance of trade = Exports – Imports
Balance of Trade =25 – M =25 – 179.04 = – ₹ 154.04 crores.
Thus, there is adverse balance in Trade of ₹ 154.04 crores

Question 82.
Explain the Four Sector Model of Circular flow of Income.
Answer:
Four-Sector Model of Circular Flow of Income:
A four-sector model of circular how of income deals with circular how ¡e., money flow as well as reat flow amongst the following four sectors.

  1. Household sector
  2. Producer sector
  3. Government sector
  4. External sector.

four-sector model of Flow of income represents open economy which includes ‘foreign sector or rest of the world’. In modem times, economy adopts the shape of open economy which indudes exports and imports of goods and services. When an economy pays for imports, outflow of money takes place from that country to rest of the world and on the contrary when a country receives payment for the exports, inflow of money takes place to that country from rest of the world.

In open economy income flow includes the following five sectors:

  • Household Sector,
  • Business Firm,
  • Government Sector,
  • Rest of the World Sector,
  • Capital Market.

With inclusion of rest of the world sector, import (M) and export (X) also affect the circular flow of income. Imports signify leakages from circular flow while exports indicate injection of Income in circular flow.

Condition of Equilibrium:
Four sector economy in its circular flow of income possesses the following equilibrium condition:
Y= C + I + G + (X-M)
Where, Y = Production or Income
C = Consumption Expenditure
I = Investment Expenditure
G = Government Expenditure
(X – M) = Net Export
(X stands for export and M for import)
Determination of National Income - CA Inter ECO Question Bank 14

Question 83.
Write short note on:
Marginal Efficiency of Capital.
Answer:
Marginal Efficiency of Capital:
The expected profitability from addition investment is the called Marginal Efficiency of Capital. In other words, Marginal efficiency of capital is the expected rate of return of an additional unit of capital investment over its cost.

Formula:
MEC = \(\frac{\text { Expected Income }(M}{\text { Cost of Supply Price }(\mathrm{P})} \times 100\)

Components of MEC:
Determination of National Income - CA Inter ECO Question Bank 15
Prospective Yield:
The prospective yield of an asset is the aggregate net return expected from it during its whole life. The term ‘Net Return’ is calculated by deducting’ present cost of the asset from total yields. Prospective yield can be expressed as follows:
PY = Q1 + Q2 + Q3 + …………….. +Qn
Where P represents prospective yield and Q1 + Q2 + Q3 + …………….. +Qn represents net annual returns.

Supply Price:
The expenditure made on capital goods at the time of initial investment is known as supply price. For example, investment made on purchase of new machinery is supply price or cost of investment. It is also known as ‘replacement cost’.

Estimation of Marginal Efficiency of Capital:
Having known the values of prospective yield and supply price, marginal efficiency of capital can be estimated as the rate of discount that equates these two values. Thus,
SP = \(\frac{P_{y_1}}{(1+m)}+\frac{P_{y_2}}{(1+m)^2}+\frac{P_{y_3}}{(1+m)^3}+\ldots \cdots \cdot \frac{P_{y_n}}{(1+m)^n}\)
Here, SP = Supply Price; Py = Prospective Yield; m = Marginal Efficiency of Capital.

Determination of National Income - CA Inter Economics Question Bank

Question 84.
Write short note on:
Relationship between Marginal Efficiency of Capital and Rate of Interest.
Answer:
Marginal Efficiency of Capital (MEC) is the expected rate of return of an additional unit of capital investment over and above its cost. According to Keynes, interest is the reward for parting with liquidity for a specified period. Money supply being constant in short period, rate of interest is basically dependent on liquidity preference. Higher the liquidity preference level, more will be the rate of interest.

Relationship between MEC and Rate of Interest:
The decisions of investors are influenced by both (MEC) and rate of interest(r). As long as the MEC is greater than the rate of interest, the investors will be induced to increase investment till the point where MEC becomes equal to rate of interest, i.e., when MEC is equal to rate of interest, the effect on investment will be passive. If MEC ¡s greater than rate of interest, the investor will increase the investment and on the other hand, if MEC is less than rate of interest, investment will be reduced.

Thus,
1. If MEC=r
Passive effect on investment (i.e., investment will neither increase nor decrease).
2. If MEC > r
Favorable effect on investment (i.e., investment will be increased).
3. If MEC < r
Adverse effect on investment (i.e. investment will be reduced.)