Test Series: April 2021

MOCK TEST PAPER – II

INTERMEDIATE (NEW): GROUP – II
PAPER – 8: FINANCIAL MANAGEMENT& ECONOMICS FOR FINANCE
PAPER 8A: FINANICAL MANAGEMENT
SUGGESTED ANSWERS/HINTS
1. (a) Kee Ltd. (pure Equity) i.e. unlevered company:
EAT = EBT (1 – t)
= EBIT (1 - 0.3) = Rs. 5,00,000 × 0.7 = Rs. 3,50,000
(Here, EBIT = EBT as there is no debt)
EAT
Value of unlevered company Kee Ltd. =
Equity capitalization rate

Rs. 3,50,000
= = Rs. 14,00,000
25%
Lee Ltd. (Equity and Debt) i.e levered company:
Value of levered company = Value of Equity + Value of Debt
= Rs. 14,00,000 + (Rs. 20,00,000 × 0.3)
= Rs. 20,00,000
(b) Workings:
PAT Rs. 3.7 crores
1. Earnings per share (E) = = = Rs. 1.48
No. of shares 2.5 crore shares
PAT Rs. 3.7 crores
2. Return on Investment (r) = x 100 = x 100 = 9.25%
Net worth Rs. (25 + 15) crores
Dividend paid Rs. 3 crores
3. Dividend per share (D) = = = Rs. 1.2
No. of shares 2.5 crore shares
Dividend Rs. 3 crores
Dividend payout ratio = x 100 = x 100 = 81.08%
PAT Rs. 3.7 crores
4. Current Market Price (P o) = P/E Ratio x E = 26.7 x Rs. 1.48 = Rs. 39.52
5. Growth rate (g) =bxr = (1 - 0.8108) x 0.0925 = 1.75%
D(1+g) Rs. 1.2 (1 + 0.0175)
6. Cost of Capital (K e) = +g = + 0.0175= 4.84%
Po Rs. 39.52
(i) The value of the share as per Walter’s model:
r
D+ (E-D) 1.2 + 0.0925 (1.48-1.2)
P= Ke =
0.0484
= Rs. 35.85
Ke 0.0484
The firm has a dividend payout of 81.08% (i.e., Rs. 3 crores) out of Profit after tax of
Rs. 3.7 crores with value of the share at Rs. 35.85. The rate of return on investment (r)
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 is 9.25% and it is more than the K e of 4.84%, therefore, by distributing 81.08% of
earnings, the firm is not following an optimal dividend policy.
(ii) Under Walter’s model, when return on investment is more than cost of capital (r > K e),
the market share price will be maximum if 100% retention policy is followed. So, t he
optimal payout ratio would be to pay zero dividend and in such a situation, the market
price would be:
0.0925
0 + 0.0484 (1.48 - 0)
P= = Rs. 58.44
0.0484
(iii) The P/E ratio at which dividend payout will have no effect on share price is at which the
Ke would be equal to the rate of return (r) of the firm i.e. 9.25%.
D (1+g)
So, Ke = +g
Po
Rs. 1.2 (1 + 0.0175)
0.0925 = + 0.0175
Po
 Po = Rs. 16.28
If Po is Rs. 16.28, then, P/E Ratio will be:
Po Rs. 16.28
= = = 11 times
E Rs. 1.48
Therefore, at the P/E ratio of 11, the dividend payout will have no effect on share price.
(c) Balance Sheet
Liabilities (Rs.) Assets (Rs.)
Current debt 30,000 Cash (balancing figure) 1,20,000
Long term debt 70,000 Inventory 60,000
Total Debt 1,00,000 Total Current Assets 1,80,000
Owner's Equity 2,00,000 Fixed Assets 1,20,000
Total liabilities 3,00,000 Total Assets 3,00,000
Workings:
1. Total debt = 0.50 x Owner's Equity = 0.50 x Rs. 2,00,000 = Rs. 1,00,000
Further, Current debt to Total debt = 0.30
So, Current debt = 0.30 × Rs. 1,00,000 = Rs. 30,000
Long term debt = Rs. 1,00,000 - Rs. 30,000 = Rs. 70,000
2. Fixed assets = 0.60 × Owner's Equity = 0.60 × Rs. 2,00,000 = Rs. 1,20,000
3. Total Liabilities = Total Debt + Owner’s Equity
= Rs. 1,00,000 + Rs. 2,00,000 = Rs. 3,00,000
Total Assets = Total Liabilities = Rs. 3,00,000
Total assets to turnover = 2 Times; Inventory turnover = 10 Times
Hence, Inventory /Total assets = 2/10=1/5,
Therefore Inventory = Rs. 3,00,000/5 = Rs. 60,000

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 (d) (i) According to Dividend Discount Model approach the firm’s expected or required return
on equity is computed as follows:
D1
Ke   g
P0
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.
5.04
Therefore, K e   0.1125 = 13.55%
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(ii) With rate of return on retained earnings (r) of 15% and retention ratio (b) of 60%, new
growth rate will be as follows:
g = br = 0.60 x 0.15 = 0.09 or 9%
Accordingly, dividend will also get changed and to calculate this, first we shall calculate
previous retention ratio (b 1) and then EPS assuming that rate of return on retained
earning (r) is same.
With previous Growth Rate of 11.25% and r =15%, the retention ratio comes out to be:
0.1125 = b1 x 0.15
b1 = 0.75 and payout ratio = 0.25
With 0.25 payout ratio, the EPS will be as follows:
5.04
EPS = = Rs. 20.16
0.25
With new payout ratio of 40% (1 – 0.60) the new dividend will be:
D1 = Rs. 20.16 x 0.40 = Rs. 8.064
Accordingly new Ke will be:
8.064
Ke   0.09 = 12.68%
219
2. (a) (i) Calculation of Yearly Cash Inflow
In worst case: High costs and Low price (Selling price) and volume(Sales units) are taken.
In best case: Low costs and High price(Selling price) and volume(Sales units) are taken.
Worst Case Base Best Case
Sales (units) (A) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500
Less: Tax @ 25% 3,125 75,000 1,59,375
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 EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash Inflow 44,375 2,60,000 5,13,125
(ii) Calculation of NPV in different scenarios
Worst Case Base Best Case
Initial outlay (A) (Rs.) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) (Rs.) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) (Rs.) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (Rs.) (6,01,210.62) 1,21,780 9,70,508.13
(b) Here,
Redemption Value (RV)= Rs.1,50,000
Net Proceeds (NP) = Rs. 3,750
Interest = 0
Life of bond = 25 years
There is huge difference between RV and NP therefore in place of approximation method we
should use trial & error method.
FV = PV x (1 + r) n
1,50,000 = 3,750 x (1 + r) 25
40 = (1 + r) 25
Trial 1: r = 15%, (1.15) 25 = 32.919
Trial 2: r = 16%, (1.16) 25 = 40.874
Here:
L = 15%; H = 16%
NPVL = 32.919 - 40 = - 7.081
NPVH = 40.874 - 40 = + 0.874
NPVL
IRR = L+ (H - L)
NPVL - NPVH
-7.081
= 15% + × (16% - 15%)= 15.89%
-7.081 - (0.874)
3. Statement showing evaluation of Credit Policies
(Amount in lakhs)
Particulars Present Proposed Policy
(Rs.) (Rs.)
Option I Option II
A Expected Profit:
(a) Credit Sales 180 220 280
(b) Total Cost other than Bad Debts:
Variable Costs (60%) 108 132 168

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 (c) Bad Debts 6 18 38
(d) Expected Profit [(a)-(b)-(c)] 66 70 74
B Opportunity Cost of Investment in Debtors (Refer 6.75 10.31 17.5
workings)
C Net Benefits [A - B] 59.25 59.69 56.5
Recommendation: The Proposed Policy I should be adopted since the net benefits under this
policy is higher than those under other policies.
Workings:
Calculation of Opportunity Cost of Investment in Debtors
Collection Period * Rate of Return
Opportunity Cost = Total Cost  
12 100
*Collection period (in months) = 12/Debtors turnover ratio
12/4 25
Present Policy = Rs. 108 × × = Rs. 6.75 lakhs
12 100
12/3.2 25
Proposed Policy I = Rs. 132 × × = Rs. 10.31 lakhs
12 100
12/2.4 25
Proposed Policy II = Rs. 168 × × = Rs. 17.5 lakhs
12 100
4. Calculation of NPV
(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanised System:
Operating Cost 20,00,000

Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000

Saving per annum 26,50,000
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: Depreciation 6,00,000
Cash flow per annum 19,25,000
Cumulative PV Factor for 7 years @ 10% 4.867
Present value of cash flow for 7 years 93,68,975
Less: Cost of the Machine 40,00,000
NPV 53,68,975
The mechanized cleaning system should be purchased since NPV is positive by
Rs. 53,68,975.

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5. (i) Operating Leverage
Situation 1 Situation 2 Situation 3
(Rs.) (Rs.) (Rs.)
Sales (S)
2,400 units @ Rs. 30 per unit 72,000 72,000 72,000
Less: Variable Cost (VC) @ Rs. 20 per unit 48,000 48,000 48,000
Contribution (C) 24,000 24,000 24,000
Less: Fixed Cost (FC) 3,000 6,000 9,000
EBIT 21,000 18,000 15,000
C Rs. 24,000 Rs. 24,000 Rs. 24,000
Operating Leverage =
EBIT Rs. 21,000 Rs. 18,000 Rs. 15,000
= 1.14 = 1.33 = 1.60

Financial Leverage
Financial Plan
A (Rs.) B (Rs.)
Situation 1
EBIT 21,000 21,000
Less: Interest on debt 1,800 900
(Rs. 15,000 x 12%);(Rs. 7,500 x 12%)
EBT 19,200 20,100
EBIT Rs. 21,000 Rs. 21,000
Financial Leverage = = 1.09 = 1.04
EBT Rs. 19,200 Rs. 20,100
Situation 2
EBIT 18,000 18,000
Less: Interest on debt 1,800 900
EBT 16,200 17,100
EBIT Rs. 18,000 Rs. 18,000
Financial Leverage = = 1.11 = 1.05
EBT Rs. 16,200 Rs. 17,100
Situation 3
EBIT 15,000 15,000
Less: Interest on debt 1,800 900
EBT 13,200 14,100
EBIT Rs. 15,000 Rs. 15,000
Financial Leverage = = 1.14 = 1.06
EBT Rs. 13,200 Rs. 14,100

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 (ii) Combined Leverages
CL = OL x FL
Financial Plan
A (Rs.) B (Rs.)
(a) Situation 1 1.14 x 1.09 = 1.24 1.14 x 1.04 = 1.19
(b) Situation 2 1.33 x 1.11 = 1.48 1.33 x 1.05 = 1.40
(c) Situation 3 1.60 x 1.14 = 1.82 1.60 x 1.06 = 1.70
The above calculations suggest that the highest value is in Situation 3 financed by Financial
Plan A and the lowest value is in the Situation 1 financed by Financia l Plan B.
6. (a) A Commercial Paper is an unsecured money market instrument issued in the form of a
promissory note. The Reserve Bank of India introduced the commercial paper scheme in the
year 1989 with a view to enabling highly rated corporate borrowers to diversify their sources
of short-term borrowings and to provide an additional instrument to investors. Subsequently,
in addition to the Corporate, Primary Dealers and All India Financial Institutions have also
been allowed to issue Commercial Papers. Commercial papers are issued in denominations
of Rs. 5 lakhs or multiples thereof and the interest rate is generally linked to the yield on the
one-year government bond.
(b) Agency problem between the managers and shareholders can be addressed if the interests
of the managers are aligned to the interests of the share- holders. It is easier said than done.
However, following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and also with
the long term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption that
maximisation of the stock price is the objective of the investors.
 Effecting monitoring can be done.
(c) Debt Securitisation is a process in which illiquid assets are pooled into marketable securities
that can be sold to investors. The process leads to the creation of financial instruments that
represent ownership interest in, or are secured by a segregated income producing asset or
pool of assets. These assets are generally secured by personal or real property such as
automobiles, real estate, or equipment loans but in some cases are unsecured.
Or
The use of long-term fixed interest-bearing debt and preference share capital along with equity
share capital is called financial leverage or trading on equity. The use of long-term debt
increases the earnings per share if the firm yields a return higher than the cost of debt. The
earnings per share also increase with the use of preference share capital but due to the fact
that interest is allowed to be deducted while computing tax, the leverage impact of debt is
much more. However, leverage can operate adversely also if the rate of interest on long -term
loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan
the capital structure of a firm.

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 PAPER 8B: ECONOMICS FOR FINANCE
ANSWERS / HINTS
7. (a) There are innumerable challenges in the computation of National Income in India. These
challenges are more complex in underdeveloped and developing countries. Some of the
challenges are given below:
(a) Inadequacy of data and lack of reliability of available data.
(b) Presence of non- monetised sector.
(c) Production for self-consumption
(d) Absence of recording of data due to illiteracy and Ignorance.
(e) Lack of Proper occupational classification and
(f) Accurate estimation of consumption of fixed capital.
(b) By Income Method:
NNPFC = National Income = Compensation of Employees + Operating Surplus (rent + interest +
profit) + Mixed Income of self-employed + Net Factor Income from abroad
= 2000 +(400 +300+600) + 1000+ 50
= 4350Cr
By Expenditure Method:
GDPmp = Private Final Consumption Expenditure + Government Final Consumption Expenditure
+ Gross Domestic Capital Formation (Net domestic Capital Formation + Net Export
= 700 + 800 + 500 + 80
= 2080 cr
NNPFC or National Income = GDPmp – depreciation + NFIA – Net Indirect Taxes
= 2080 – 200 + 50- 40
= 1890 Cr

(c) A free rider is a person who benefits from something without expending effort or paying for it. In
other words, free riders are those who utilizes goods without paying for their use. Since private
goods are excludable, free riding mostly occurs in the case of public goods. The free-rider problem
leads to under provisions of a good or service and thus causes market failure. As such if the free -
rider problem cannot be solved, the following two outcomes are possible:
(i) No public good will be provided in private markets.
(ii) Private markets will seriously under produce public goods even though these goods provide
valuable service to the society.
8. (a) Personal Income = National Income – Undistributed Profit- Net interest payments made by
households – Corporate Tax + Transfer payments to the households from
firms and Government
= 5000—200-- 400—600+ 500
= 4300 Cr

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 Personal Disposable Income = Personal Income – Personal Income Taxes – Non-Tax Payments
= 4300 - 1200 – 800
= 2300 cr

(b) Subsidy is a form of market intervention by government. It involves the government directly paying
part of the cost to the producers (consumers) in order to promote the production (consumption) of
goods and services. The aim of subsidy is to intervene with market equilibrium to reduce the costs
and thereby the market prices of goods and services and encourage increased production and
consumption. Major subsidies in India are fertilizer subsidy, food subsidy, interest subsidy etc.
(c) The Speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any
attractive investment opportunity requiring cash expenditure. According to Keynes, people demand
to hold money balances to take advantage of the future changes in the rate of interest, which is
same as future change in bond prices. The market value of bonds and the market rate of interest
are inversely related.
When we go from the Individual speculative demand for money to the aggregate speculative
demand for money, the discontinuity of the Individual wealth- holder’s demand curve for the
speculative cash balances disappears and we obtain a continuous downward sloping demand
function showing the inverse relationship between the current rate of interest and the speculative
demand for money as shown in the figure below:

According to Keynes, the higher the rates of interest, lower the speculative demand for money,
and lower the rate of interest, higher the speculative demand for money.
(d) The government budget is said to be in balance when ∆G = ∆T. The balanced budget multi plier is
always equal to 1. The balanced budget multiplier is obtained by adding up the government
spending multiplier (fiscal multiplier) and the tax multiplier.
Balanced budget multiplier = ∆Y ÷ ∆G + ∆Y ÷ ∆ T
= 1 ÷1-b + -b ÷ 1-b
= 1-b ÷ 1-b = 1
9. (a) Externalities cause market inefficiencies because they hinder the ability of market prices to convey
accurate information about how much to produce and how much to buy. Such externalities are not
reflected in market prices, they can be a source of economic inefficiency. When negative
production externalities exist, social costs exceed private cost. If producers do not take into
account the externalities, there will be over – production and market failure and unwarranted social

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 consequences. The Government can play a role in reducing negative externalities by taxing goods
when their production generates spill over cost. The Government can also intervene in regulating
negative externalities like pollution.
(b) Fiscal Policy can be used as a tool for economic growth and desired distribution of income. This
can be done through spending programmes targeted at disadvantage strata of the society some
examples are like poverty alleviation programme, free or subsidized amenities to improve the
quality of living of poor, strengthening of human capital, education, research, and development
which will provide momentum for long term growth. A progressive tax structure carefully planned
public expenditure policy can help in redistribution of income from rich to the poor s ections of the
population.
(c) Major differences between FDI and Foreign Portfolio Investment are as follows
Foreign Direct Investment Foreign Portfolio Investment
Investment involves creation of physical assets Investment is only in financial assets.
Has a long-term interest and therefore Only short-term interest and generally remain
invested for long invested in short periods.
Relatively difficult to withdraw 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 No direct impact on employment of labour and
wages. wages.
Enduring interest in management and control No abiding interest in management and Control.

(d) New Trade Policy (NTT) is an economic theory and that was developed in the 1970’s as a way to
understand International Trade patterns. NTT helps in understanding why developed and big
countries trade partners are when they are trading similar goods and services. These Countries
constitutes more than 50 % of the world trade. This is particularly true in key economic sectors
such as electronics, IT, food and automotive. Those countries with the advantages will dominate
the market and takes the form of monopolistic competition. According to NTT, two key concepts
give advantage to countries that import goods to compete with products from home country namely
economies of scale and network effects.
10. (a) M1 = Currency notes and coins with the people + demand deposit with banking system (Current
and saving deposits accounts) + other deposits with the RBI
= 5000 + 4000 + 3000
= 12000 cr
M3 = M1 + time deposits with the banking system
= 12000 + 1000
= 13000cr
(b) The Quantity theory of money was propounded by Irving Fisher. According to him there is strong
relationship between money and price level and the quantity of money is the main determinant of
the price level or value of money.
Fisher version also termed as ‘Equation of Exchange ‘is formally stated as follows:
MV = PT

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 M= the total amount of money in circulation
V = transactions velocity of circulation
P = average price level
T = Total number of transactions
Subsequently Fisher extended the equation of exchange to include demand bank deposit (M’) and
Velocity (V’) in the total supply of money.
The Expanded Form of the equation becomes:
MV + M’V’ = PT
Where M’ = the total quantity of credit money
V’ = velocity of circulation of credit money.
(c) Government Spending would sometimes substitute private spending and when this happens the
impact of government spending on aggregate demand would be smaller than what it would be and
therefore fiscal policy may become ineffective. The crowding out view is that a rapid growth of
government spending leads to a transfer of scarce productive resources from the private sector to
the public sector where productivity might be lower. An increase in the size of government
spending during recessions will crowd out private spending in an economy and lead to reduction
in the economy’s ability to self -correct from the recession and possibly also reduces the economy’s
prospects of long run economic growth.
(d) Trade barriers create obstacles to trade, reduces the prospect of market access, make imported
goods more expensive, increase consumption of domestic goods, protect domestic Industries, and
increase government revenues.
Technical barriers to trade are Standards and Technical Regulations that define the specific
characteristics that a product should have such as its size, shape, design,
labelling/marking/packaging functionality or performance and production methods, exclud ing
measures covered by the SPS agreement. The resolution of trade barriers will definitely be helpful
in functioning of trade. There are different forum and trade agreements between countries for the
resolution of the obstacle.
11. (a) Aggregate demand in three sector model of closed economy consists of three components namely,
household consumption (c), desired business investment demand (I) and the government sector’s
demand for goods and services (G). Thus, in equilibrium
Y = C+I + G
Since there is no foreign sector, GDP and national income are equal. As prices are assumed to be
fixed, all variables and all changes are in real terms. The Three -sector Keynesian model is
commonly constructed assuming that government purchases are autonomous. This is not a
realistic assumption, but it will simplify the analysis.
AD = C+I+G
AS = C+S+T
Thus, equilibrium is determined at a point where both aggregate demand and aggregate supply
are equal.
C+I+G = Y = C+S+T

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(b) Free riders are those who utilise goods without paying for their use. Since private goods are
excludable, free riding mostly occurs in the case of public goods. The free rider problem leads to
under provision of a good or services and thus causes market failure. The problem occurs because
of the failure of Individual to reveal their real or true preferences for the public good through their
willingness to pay. Because of the free-rider problem, there is no meaningful demand curve for
public goods. If Individuals make no offer to pay for public goods, there is market failure in the
case of these goods and the profit- maximising firms will not produce them.
(c) Monetary Policy is intended to influence macro-economic variables such as aggregate demand,
quantity of money, interest rate to influence overall economic performance. There are five different
mechanism through which monetary policy influences the price level and the national income:
(a) the interest rate channel
(b) the exchange rate channel
(c) the quantum channel (e.g., relating to money supply and credit)
(d) the asset price channel via equity and real estate prices and
(e) the expectation channel
Changes in monetary policy may have impact on people’s expectations about inflation and
therefore on aggregate demand. This in turn affects employment and output in the economy.
(d) An exchange rate regime is the system by which a country manages its currency with respect to
foreign currencies. There are two major types of exchange rate regimes namely floating exchange
rate regime and fixed exchange rate regime.
A floating exchange rate allows a government to pursue its own independent monetary policy and
there is no need for market intervention or maintenance of reserves. However, volatile exchange
rates generate a lot of uncertainties with regard to international transaction.

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