FM & ECO MARATHON 2019 CA IPC CA INTER · Consider the following information for Omega Ltd: EBIT (Earnings before Interest and Tax) Rs. 15,750 Lakh Earnings before Tax (EBT) Rs. 7,000

CA RAHUL GARG’s

FM & ECO

MARATHON

2019

CA IPC

CA INTER

RAHUL SHIKHA ACADEMY

P a g e | 1

CA Rahul Garg Gold Medalist All India Rankholder in CA, CS, CMA (incl Rank 1)

Best COST FM ECO Lectures Regular & Fast Track, available at www.carahulgarg.com, (R.S.A.)

More you know about the past, better prepared you are for the future…

Exam Nov 2016 May 2017 Nov 2017 May 2018 Nov 2018

CA IPC

CA INTER

CONCEPT FINANCING DECISION & COST OF CAPITAL

CONCEPT COMPONENTS OF CAPITAL

CONCEPT COMPONENTS OF COST OF CAPITAL

CHAPTER 1 COST OF CAPITAL

http://www.carahulgarg.com/


P a g e | 2



CONCEPT COST OF DEBT

Cost of Irredeemable Debt

Cost of Redeemable Debt

CONCEPT COST OF PREFERENCE SHARE CAPITAL

Cost of Irredeemable Preference Share

Cost of Redeemable Preference Share


P a g e | 3



CONCEPT COST OF EQUITY SHARE CAPITAL

Dividend Yield Model

Earnings Yield Model

Dividend Growth Model

Earnings Growth Model

Realised Yield Approach


P a g e | 4



Capital Asset Pricing Model

CONCEPT COST OF RETAINED EARNINGS

In absence of Personal Taxes

In presence of Personal Taxes


P a g e | 5



CONCEPT WEIGHTED AVERAGE COST OF CAPITAL

S.No. Source of Finance Amount Weight Cost W × C

1 Equity Share Capital

2 Preference Share Capital

3 Reserves & Surplus

4 Debt

CONCEPT BOOK VALUE WEIGHTS VS. MARKET VALUE WEIGHTS


P a g e | 6





CA IPC

CA INTER

CONCEPT OPERATING RISK

Meaning and Basic Condition

It is measured by Degree of Operating Leverage (DOL).

Higher the DOL, higher is the operating risk.

Condition to apply DOL is the existence of Fixed Operating Cost.

Formula

Interpretation

DOL measures the effect of change in Sales on EBIT.

1% change in sales shall cause >1% change in EBIT.

Question

Consider the following information for RSA Ltd:

Contribution 1,40,000

Fixed Cost 1,00,000

EBIT 40,000

Calculate percentage change in EBIT, if sales increase by 10%.

CHAPTER 2 LEVERAGE


P a g e | 7



CONCEPT FINANCING RISK


It is measured by Degree of Financial Leverage (DFL).

Higher the DFL, higher is the financing risk.

Condition to apply DFL is the existence of Fixed Financing Cost.

Formula

Interpretation

DFL measures the effect of change in EBIT on EPS.

1% change in EBIT shall cause >1% change in EPS.

Question

Consider the following information for RSA Ltd:

EBIT (Earnings before Interest and Tax) 40,000

Interest 5,000

EBT 35,000

Calculate percentage change in earnings per share, if EBIT increase by 6%.


P a g e | 8



CONCEPT COMBINED RISK


It takes into account operating as well as financing risk.

It is measured by Degree of Combined Leverage (DCL).

Higher the DCL, higher is the combined risk.

Condition to apply DCL is the existence of Fixed Cost.

Formula

Interpretation

DCL measures the effect of change in sales on EPS.

1% change in sales shall cause >1% change in EPS.

Question

Consider the following information for Omega Ltd:

EBIT (Earnings before Interest and Tax) Rs. 15,750 Lakh

Earnings before Tax (EBT) Rs. 7,000 Lakh

Fixed Operating costs Rs. 1,575 Lakh

Calculate percentage change in earnings per share, if sales increase by 5%.


P a g e | 9





CA IPC

CA INTER

CONCEPT CHOOSING OPTIMUM CAPITAL STRUCTURE

Particulars Option 1 Option 2 Option 3

EBIT

‘- Interest

= EBT

‘- Tax

= EAT

‘- Preference Dividend

= Earnings for Equity

Shareholders

No. of Equity Shares

= EPS

× P/E Ratio

= MPS

That option shall be chosen which provides maximum MPS.

CHAPTER 3 CAPITAL STRUCTURE


P a g e | 10



CONCEPT FINDING OLD RATE OF RETURN

CONCEPT FINDING NEW RATE OF RETURN

CONCEPT FINDING NEW EBIT

CONCEPT INDIFFERENCE POINT

It is that level of EBIT, at which the firm has 2 such financial plans, which result in

same level of EPS.

CONCEPT CHOICE OF PLAN


P a g e | 11





CA IPC

CA INTER

CONCEPT IMPORTANT FORMULAS

CONCEPT NET INCOME THEORY

Diagram

Question

Expected EBIT is Rs. 2 lacs. The company has Rs. 8 lacs in 10% debentures. The cost of equity or

capitalisation rate is 12.5%. Calculate the value of firm and the overall cost of capital.

CHAPTER 4 THEORIES OF CAPITAL STRUCTURE


P a g e | 12



CONCEPT NET OPERATING INCOME THEORY

Diagram

Question

EBIT is Rs. 9,00,000. The firm’s cost of debt is 10 % and currently firm employs Rs. 30,00,000 of

debt. The overall cost of capital of firm is 12 %. Calculate cost of equity.

CONCEPT TRADITIONAL APPROACH

Diagram


P a g e | 13



Question

In considering the most desirable capital structure of a company, the following estimates of the cost

of debt and equity capital (after tax) have been made at various levels of debt-equity mix :

Debt as a percentage of total

capital employed

Kd (%) Ke (%)

0 5 12

10 5 12

20 5 12.5

30 5.5 13

40 6 14

50 6.5 16

60 7 20

Determine the optimal debt-equity mix for the company by calculating composite cost of capital.

CONCEPT M-M THEORY

Formula


P a g e | 14



Question

'A' Ltd. and 'B' Ltd. are identical in every respect except capital structure. 'A' Ltd. does not employ

debts in its capital structure whereas 'B' Ltd. employs 12% Debentures amounting to Rs. 10 lakhs.

Assuming that :

a. All assumptions of M-M model are met;

b. Income-tax rate is 30%;

c. EBIT is Rs. 2,50,000 and

d. The Equity capitalization rate of ‘A' Ltd. is 20%.

Calculate the value of both the companies.


P a g e | 15





CA IPC

CA INTER

CONCEPT IMPORTANCE OF CAPITAL BUDGETING DECISION

Huge sum of money

Long term implication

Irreversible in short run

CONCEPT CAPITAL BUDGETING TECHNIQUES

Traditional Techniques Modern Techniques Accounting Rate of Return Discounted Pay Back Period

Pay Back Period Net Present Value

Variants of Pay Back Period Profitability Index

Internal Rate of Return

CONCEPT ACCOUNTING RATE OF RETURN

Meaning

It is the rate of return generated by the project during its life.

Formula

Decision Rule

CHAPTER 5 CAPITAL BUDGETING


P a g e | 16



Computation of PAT

Particulars Year 1 Year 2 Year n

Sales

‘- Variable Cost

= Contribution

‘- Fixed Cost

= EBIT

‘- Interest

= EBT

‘- Tax

= EAT

CONCEPT COMPUTATION OF CASH FLOWS

METHOD 1 METHOD 2

EBDIT EBDIT

‘- Depreciation ‘- Interest

= EBIT = Balance

‘- Interest ‘- Tax

=

= EBT =

= Balance

‘- Tax ‘+ Tax Saving on Depreciation

= EAT (Depreciation × Tax Rate)

+ Depreciation = Cash Flow

= Cash Flow

Question


P a g e | 17



METHOD 1 METHOD 2

EBDIT EBDIT

‘- Depreciation ‘- Interest

= EBIT = Balance

‘- Interest ‘- Tax

=

= EBT =

= Balance

‘- Tax ‘+ Tax Saving on

Depreciation

= EAT (Depreciation × Tax Rate)

+ Depreciation = Cash Flow

= Cash Flow

CONCEPT PAY BACK PERIOD

Meaning

It is the period within which cost of the project will be recovered.

Formula

If Cash Flows are equal p.a. If Cash Flows are not equal p.a.

Statement showing computation of Payback period

Year End Cash Inflow Cumulative Cash Inflow

Decision Rule

Question


P a g e | 18



CONCEPT TIME VALUE OF MONEY

CONCEPT DISCOUNTED PAY BACK PERIOD

Decision Rule

Computation of Discounted Pay back Period

Statement showing computation of Discounted Payback period

Year End Cash Inflow PVF @ __ % PVCF Cumulative PVCF

CONCEPT NET PRESENT VALUE

Meaning

It denotes the net value of cash flows from the project, either positive or negative.

Formula

Total PVCI – Total PVCO

Decision Rule


P a g e | 19



Computation of NPV

Statement showing computation of NPV

Year End Particulars Cash Inflow PVF @ __ % PVCF

Question

CONCEPT PROFITABILITY INDEX

Formula

Decision Rule

CONCEPT NET PROFITABILITY INDEX

Formula

Decision Rule


P a g e | 20



CONCEPT INTERNAL RATE OF RETURN

Meaning

It is the actual rate of return being generated by the project.

Formula

It is such rate at which Total PVCI = Total PVCO i.e. NPV is 0.

Methodology

Find out 1 Positive NPV.

Find out 1 Negative NPV.

The maximum difference between the 2 rates should be maximum 4 - 5%.

Apply this formula after that :

Decision Rule

CONCEPT PROJECTS HAVING UNEQUAL LIFE

CONCEPT WORKING CAPITAL

Release of Working Capital

Recovery of Working Capital

CONCEPT SCRAP VALUE


P a g e | 21





CA IPC

CA INTER

CONCEPT BASICS OF WORKING CAPITAL

Meaning

It refers to the funds required for day to day business operations.

Types of Working Capital

Gross Working Capital Net Working Capital

CONCEPT ESTIMATION OF WORKING CAPITAL

To have the better management of working capital, its estimation in advance is essential and

important.

Estimated Current Assets

‘- Estimated Current Liabilities

= Estimated Working Capital

Statement Showing Estimation of Working Capital

S.No. Particulars Computation Amount

A Current Assets

1 Raw Material

Inventory

2 WIP Inventory

a Material

CHAPTER 6 WORKING CAPITAL MANAGEMENT


P a g e | 22



b Labour

c Overheads

3 FG Inventory

4 Debtors

5 Prepaid Expenses

6 Cash

Total (A)

B Current Liabilities

1 Raw Material

Creditors

2 Outstanding

Expenses

Total (B)

C Working Capital (A) ‘- (B)

D Safety Margin

E Total Working

Capital

(C) ‘+ (D)

CONCEPT SOME SPECIAL POINTS


P a g e | 23



CONCEPT MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)

AS PER TANDON COMMITTEE

NORM I NORM II NORM III

Current Assets Current Assets Current Assets

‘- Current Liabilities ‘- 25 % ‘- Core Current Assets

= Working Capital = 75% Current Assets = Non Core Current Assets

‘- 25 % ‘- Current Liabilities ‘- 25 %

= MPBF = MPBF = 75% Non Core Current

Assets

‘- Current Liabilities

= MPBF

CONCEPT EFFECT OF DOUBLE SHIFT ON WORKING CAPITAL

Impact on Total Units

Impact on WIP Units

Impact on Variable Expenses

Impact on Fixed Overheads


P a g e | 24



CONCEPT OPERATING CYCLE PERIOD

Computation of Operating Cycle Period

Particulars Days

Raw Material Holding Period

+ WIP Conversion Period

+ FG Holding Period

+ Average Collection Period

‘- Average Payment Period

Computation of No. of Operating Cycles in a Year

Computation of Amount of Working Capital Required


P a g e | 25





CA IPC

CA INTER

CONCEPT BASICS OF DEBTOR MANAGEMENT

We are concerned with evaluating the impact of change in credit period.

CONCEPT COMPUTATION OF INCREMENTAL GAIN

Statement Showing Incremental Gain or Loss

S.No. Particulars Current

Policy

Option 2 Option 3

1 Sales

2 Contribution

3 Incremental Contribution

4 Bad Debts

5 Incremental Bad Debts

6 Administration Cost

7 Incremental Administration Cost

8 Collection Cost

9 Incremental Collection Cost

10 Discount

11 Incremental Discount

12 Opportunity Cost

13 Incremental Opportunity Cost

14 Net Incremental Gain

(3 – 5 – 7 – 9 – 11 - 13)

CHAPTER 7 DEBTOR’S MANAGEMENT


P a g e | 26



CONCEPT COMPUTATION OF OPPORTUNITY COST

CONCEPT COMPUTATION OF DISCOUNT

CONCEPT IMPACT OF FIXED COST

CONCEPT IMPACT OF TAXATION


P a g e | 27



CONCEPT FACTORING

Computation of Net Amount Given by Factor in Advance

Particulars Computation Amount

Average Debtors

‘- Commission

‘- Reserve

= Eligible Advance

‘- Interest on Advance

= Net Amount given by Factor

Annual Analysis of Factoring

Savings Due to Factoring Cost Due to Factoring Administration Cost Commission

Collection Cost Interest on Advance

Bad Debts

Effective Cost or Saving Due to Factoring

Effective Cost or Saving %


P a g e | 28





CA IPC

CA INTER

CONCEPT OPTIMUM CASH BALANCE

CONCEPT AVERAGE CASH BALANCE

CONCEPT CASH BUDGET

S.No. Particulars 1 2 3

A Opening Balance

B Receipts

1 Cash Sales

2 Receipt from Debtors

3 Sale of Asset

4 Tax Refund

Total (B)

C Payments

1 Cash Purchases

2 Payment to Creditors

CHAPTER 8 CASH MANAGEMENT


P a g e | 29



3 Payment for Wages

4 Payment for Overheadds

5 Payment for Tax

6 Purchase of Asset

7 Dividend Paid

Total (C)

D Balance (A + B - C)

E Investment

F Sale of Investment

G Borrowings

H Closing Balance (D – E + F + G)


P a g e | 30





CA IPC

CA INTER

CONCEPT PROFITABILITY RATIOS

CHAPTER 9 RATIO ANALYSIS


P a g e | 31



CONCEPT ACTIVITY RATIOS


P a g e | 32



CONCEPT COVERAGE RATIOS


P a g e | 33



CONCEPT MARKET TEST RATIOS


P a g e | 34



CONCEPT SOLVENCY/ FINANCIAL RATIOS


P a g e | 35




P a g e | 36





CA IPC

CA INTER

CONCEPT BASIC OF TVM

CONCEPT SIMPLE INTEREST

CONCEPT COMPOUND INTEREST

CONCEPT EFFECTIVE RATE OF INTEREST

CHAPTER 10 TIME VALUE OF MONEY


P a g e | 37



CONCEPT FUTURE VALUE OF ANNUITY

CONCEPT PRESENT VALUE OF ANNUITY

CONCEPT PERPETUITY

CONCEPT SINKING FUND


P a g e | 38





CA IPC

CA INTER

CONCEPT MEANING

It’s a statement of change in assets and liabilities of an enterprise.

It is prepared to indicate how the financial position has changed over a period.

CONCEPT SCHEDULE OF CHANGE IN WORKING CAPITAL

S.No. Particulars Opening Closing Increase in

WC

Decrease

in WC

A Current Assets

1 Debtors

2 Cash

3 Stock

4 Prepaid Expenses

Total (A)

B Current Liabilities

1 Creditors

2 Bills Payable

3 Outstanding Expenses

Total (B)

C Working Capital (A) – (B)

D Increase/ Decrease in WC

CHAPTER 11 FUND FLOW STATEMENT


P a g e | 39



CONCEPT ADJUSTED PROFIT & LOSS A/C

Particulars Amount Particulars Amount

To Non Cash Expenses By Balance b/d

To Non Operating Expenses By Non Cash Income

To Funds Lost in Operations By Non Operating Income

To Balance c/d By Funds From Operations

CONCEPT FUNDS FLOW STATEMENT

Sources Amount Applications Amount

Decrease in WC Increase in WC

Funds From Operations Funds Lost in Operations

Sale of Assets Purchase of Assets

Issue of Share Capital Redemption of Preference

Share Capital

Refund of Tax Redemption of Debentures

Tax Paid

Dividend Paid

CONCEPT TRANSACTIONS AFFECTING FFS

We are concerned with those transactions from where the flow of working capital arises.

Source Application Any transaction which increases the

amount of working capital is a Source.

Any transaction which decreases the

amount of working capital is Application.

WC increases if the transaction

- Increases CA

- Decreases CL

WC decreases if the transaction

- Decreases CA

- Increases CL


P a g e | 40





CA IPC

CA INTER

CONCEPT BASICS

Meaning of CFS It’s a statement of change in cash and cash equivalents of an enterprise.

Cash It comprises Cash in Hand and Demand Deposits with the bank.

Cash Equivalents These are short term highly liquid investments which are readily

convertible into known amounts of cash and which are subject to

insignificant risk of change in value.

Any investment will qualify as cash equivalent only if it has short

maturity of 3 months or less from the date of acquisition.

AS : 3 As per AS 3, these are

Cash in Hand

Cash at Bank

Marketable Securities

Bank Overdraft

Cash Credit

Cash Flows These are inflows and outflows of cash & cash equivalents.

Cash flow arises when the net effect of transaction is to either

increase or decrease the amount of cash and cash equivalents.

CONCEPT DIVISION INTO ACTIVITIES

Operating

Activity

These are the principle revenue producing activities of enterprise

and other activities which are not investing or financing.

Investing

Activity

These are acquisition and disposal of long term assets and other

investments.

Financing

Activity

These are the activities which result in change in size and

composition of owner’s capital and borrowings of enterprise.

CHAPTER 12 CASH FLOW STATEMENT


P a g e | 41



CONCEPT CASH FLOW STATEMENT (INDIRECT METHOD)

S.No. Particulars Amount

A Cash Flow from Operating Activity

Surplus during the year

+ Non cash expenses

+ Non operating expenses

‘- Non cash income

‘- Non operating income

= Cash from Operations (Before Working Capital Changes)

+ Decrease in Current Assets

‘- Increase in Current Assets

‘- Decrease in Current Liabilities

+ Increase in Current Liabilities

= Cash from Operations (Before Tax)

‘- Tax Paid

+/- Extraordinary items

Total (A)

B Cash Flow from Investing Activity

+ Sale of Fixed Assets/ Investment

‘- Purchase of Fixed Assets/ Investment

+ Interest/ Dividend Received

Total (B)

C Cash Flow from Financing Activity

+ Issue of Share Capital/ Debenture

‘- Redemption of Share Capital/ Debenture

‘- Interest/ Dividend Paid

Total (C)

D Net Cash and Cash Equivalents Generated during the year

E Opening balance of Cash and Cash Equivalents

F Closing balance of Cash and Cash Equivalents


P a g e | 42



CONCEPT CASH FLOW STATEMENT (DIRECT METHOD)

S.No. Particulars Amount

A Cash Flow from Operating Activity

Cash Sales

+ Payment received from Debtors

‘- Cash Purchases

‘- Payment made to creditors

‘- Payment made for operating expenses

= Cash Generated from Operations

‘- Tax Paid

+/- Extraordinary items

Total (A)

CONCEPT LEDGER ACCOUNTS TO BE PREPARED


P a g e | 43





CA IPC

CA INTER

CONCEPT STATISTICAL TECHNIQUE

CONCEPT RISK ADJUSTED DISCOUNT RATE

CONCEPT CERTAINTY EQUIVALENT APPROACH

CONCEPT SENSITIVITY ANALYSIS

To find the impact of change in a variable on the outcome of project i.e. NPV.

More sensitive is the NPV, more critical is the variable.

Find Percentage change in NPV :

CHAPTER 13 RISK ANALYSIS IN CAPITAL BUDGETING


P a g e | 44



CONCEPT SCENARIO ANALYSIS

CONCEPT SIMULATION

Determining the range of Random Numbers : For each variable, find the cumulative probability on the

base of probability given and specify the range of random numbers.

Fit the random numbers given in question for each trial run for each variable.

Find NPV for each run.

CONCEPT DECISION TREE

It’s a graphical presentation of relationship between future decisions and their consequences.

Computation of NPV

Path PVCF (Y 1) PVCF (Y 2) Total PVCI PVCO NPV

Computation of Expected NPV

Path NPV Joint Probability Expected NPV


P a g e | 45





CA IPC

CA INTER

CONCEPT TYPE OF DECISIONS

CONCEPT COMPUTATION OF NET ADVANTAGE OF LEASING

CONCEPT COMPUTATION OF PVCO : LEASE

Lease Rent (1 - t) Annuity Factor (r %, n years)

CONCEPT COMPUTATION OF PVCO : BUY (OWN FUNDS)

Year End Particulars Cash Flow PVF @___% PVCF

0 Cost of Asset

1 – n Tax Saving on Depreciation

n Scrap Value

CHAPTER 14 LEASING


P a g e | 46



CONCEPT COMPUTATION OF PVCO : BUY (BORROWED FUNDS)

Year End Particulars Cash Flow PVF @___% PVCF

0 Down Payment

(Cost of Asset – Borrowings)

1 – n Tax Saving on Depreciation

1 – n Principal

1 – n Interest (1 - t)

n Scrap Value

CONCEPT DISCOUNT RATE ABSENT

CONCEPT AMOUNT OF INSTALLMENT NOT GIVEN


P a g e | 47





CA IPC

CA INTER

CONCEPT GORDON MODEL

CONCEPT WALTER MODEL

CONCEPT TRADITIONAL MODEL

CONCEPT LINTNER MODEL

CHAPTER 15 DIVIDEND DECISONS


P a g e | 48



CONCEPT M-M HYPOTHESIS


P a g e | 49



National Income

Meaning National Income is the money value of all the final goods and services produced by

an economy in a specific period of time.

Since in an economy, different types of goods and services are produced, it is not

possible to physically add them. Therefore, all these goods and services are

measured in terms of money and added together to find the value of national

income or national output.

Uses Analyzing and evaluating the short-run performance

Enables businesses to forecast the future demand

Evaluation of governments’ economic policies

International comparisons in respect of incomes and living standards

Governments can fix various sector-specific development targets for different

sectors of the economy

Key points

Only Economic Activities

Final goods

Productive Activities

Excludes transfer payments

Some Important Concepts

Gross vs. Net

The difference between Gross and Net Product is due to Depreciation.

Gross is inclusive of depreciation whereas Net is not.

Domestic vs. National

The difference between ‘national’ and ‘domestic’ is due to net factor income from

abroad (NFIA).

National is inclusive of NFIA whereas Domestic is not.

Market Price vs. Factor Cost

The difference between Market Price and Factor Cost is due to Net Indirect

Taxes.

Market Price is inclusive of Net Indirect Taxes whereas Factor Cost is not.

Net Indirect Taxes means Indirect Taxes less Subsidies.

Aggregates Related to National Income

GDPMP It stands for Gross Domestic Product at Market Prices.

It 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 during a given

time period.

‘Gross’ implies that GDP is measured including depreciation.

‘Domestic’ means domestic territory.

‘Market Price’ means including Net Indirect Taxes.

CHAPTER 1 DETERMINATION OF NATIONAL INCOME

UNIT – 1 : NATIONAL INCOME ACCOUNTING


P a g e | 50



NDPFC It stands for Net Domestic Product at Factor Cost.

It is defined as the total factor incomes earned by the factors of production.

In other words, it is sum of domestic factor incomes or domestic income net of

depreciation.

‘Net’ implies that NDP is measured excluding depreciation.

‘Domestic’ means domestic territory.

‘Factor Cost’ means excluding Net Indirect Taxes.

NNPFC / National Income

It stands for Net National Product at Factor Cost.

National Income is defined as the factor income accruing to the normal residents

of the country during a year.

In other words, national income is the value of factor income generated within the

country plus factor income from abroad in an accounting year.

Value Added Method Or Product Method Or Industrial Origin Method Or Net Output Method

Focus The value added method measures the contribution of each producing enterprise

in the domestic territory of the country in an accounting year and entails

consolidation of production of each industry less intermediate purchases from all

other industries.

Steps Identifying the producing enterprises and classifying them into different

sectors according to the nature of their activities i.e. Primary, Secondary &

Tertiary Sector.

Estimating the gross value added (GVAMP) by each producing enterprise

Gross value added (GVAMP)

= Value of output – Intermediate consumption

Estimation of National income

Σ (GVAMP) – Depreciation = Net value added (NVAMP)

Net value added (NVAMP) – Net Indirect taxes = Net Domestic Product

(NVAFC)

Net Domestic Product (NVAFC) + (NFIA) = National Income (NNPFC)

Income Method Or Factor Payment Method Or Distributed Share Method

Focus National income is calculated by summation of factor incomes paid out by all

production units within the domestic territory of a country as wages and

salaries, rent, interest, and profit.

Formula NNPFC or National Income = Compensation of employees

+ Operating Surplus (rent + interest+ profit)

+ Mixed Income of Self-employed

+ Net Factor Income from Abroad

Expenditure Method Or Income Disposal Approach

Focus National income is the aggregate final expenditure in an economy during an

accounting year.


P a g e | 51



Components Private Final Consumption Expenditure (PFCE)

Government Final Consumption Expenditure (GFCE)

Gross Domestic Capital formation

Net Exports

Formula Adding above 3, we get GDPMP.

GNPMP = GDPMP + NFIA

GNPFC = GNPMP – NIT

NNPFC = GNPFC – Depreciation

Limitations Of National Income Computation

Ignores quality improvements

Production hidden from government (drugs etc.)

Non economic contributors (education level etc.)

Ignores volunteer work (w/o remuneration)

Accurate distinction between final goods and intermediate goods

Issue of transfer payments

Absence of recording of incomes due to illiteracy and ignorance

Lack of reliability of available data

Aggregate Demand

Meaning Aggregate demand broadly refers to the total demand for final goods and services

in the economy.

Components Aggregate demand for consumer goods (C), and

Aggregate demand for investment goods (I)

Diagram

Aggregate Supply

Meaning Aggregate supply refers to the total output of goods and services produced for

sale by all the entrepreneurs in an economy.

UNIT – 2 : THE KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME


P a g e | 52



Components A major portion of income is spent on consumption of goods and services and the

balance is saved.

Thus, national income (Y) or aggregate supply (AS) is sum of

❖ consumption expenditure (C) and

❖ savings (S)

Diagram

Consumption Function

Meaning Consumption function shows the mathematical relation between income and

consumption i.e. how much of income is spent on consumption goods. Consumption is

related to income.

Features At zero or very low level of income, consumption expenditure is higher than income

because minimum consumption is necessary for survival, and

As income increases, consumption expenditure also increases but increase in

consumption is less than the increase in income.

Marginal Propensity To Consume (Mpc)

Meaning MPC is ratio of change in consumption (C) due to change in income (Y).

It is the ratio of additional consumption (C) to additional income (Y).

Insights MPC falls with increase in income.

As a person becomes richer, he tends to consume a smaller portion of increase in

income.

Formula

Average Propensity To Consume (Apc)

Meaning APC is the ratio of total consumption expenditure to total income.

It is the percentage (or ratio) of income which is spent on consumption.

Formula


P a g e | 53



Savings Function

Meaning Saving function shows the mathematical relation between income and saving i.e.

how much of income is saved.

Features At zero or very low level of income, Savings can be negative and

As income increases, savings also increases but increase in savings is more than the

increase in income.

Marginal Propensity To Save (Mps)

Meaning MPS is ratio of change in savings (S) due to change in income (Y).

It is the ratio of additional savings (S) to additional income (Y).

Formula

Average Propensity To Save (Aps)

Meaning APS is the ratio of total savings to total income.

It is the percentage (or ratio) of income which is saved.

Formula

Two-Sector Model Of National Income Determination


P a g e | 54



Investment Multiplier

Meaning Investment Multiplier (K), is the ratio of increase in national income (Y) due to an

increase in investment (l).

Relationship with MPC & MPS

There exists a direct relationship between MPC and the value of multiplier.

Higher the MPC, more will be the value of the multiplier, and vice-versa.

On the contrary, higher the MPS, lower will be the value of multiplier and vice-

versa.

Formula

Diagram


P a g e | 55



Economic System

Basic Economic Problem

Due to qualitative as well as quantitative constraints, the resources available to

any society cannot produce all economic goods and services that its members

desire to have.

Types of Economic System

Market

Government

Mixed System

Allocation Function

Meaning Resource allocation refers to the way in which the available factors of production

are allocated among the various uses to which they might be put.

Importance Optimal or efficient allocation of scarce resources is one of the most important

function of an economic system so that the available resources are put to their

best use and no wastages are there.

Private vs. Govt. Sector Allocation

Private sector resource allocation is characterized by market supply and demand

forces and producer profit motives.

Govt. sector resource allocation is accomplished through the revenue and

expenditure activities of governmental budgeting.

Market Failure

While private goods will be sufficiently provided by the market, public goods will

not be produced in sufficient quantities by the market.

Market failure occurs when the free market leads to misallocation of resources

i.e. the resources are not allocated efficiently.

Government Intervention

Market failures provide the rationale for government’s allocative function.

Government may directly produce the economic good.

Government may influence allocation through its competition policies, merger

policies etc. which will affect the structure of industry and commerce.

Redistribution Function

Meaning It is concerned with the adjustment of the distribution of income and wealth so

as to ensure distributive justice namely, equity and fairness.


If left to the market, the distribution of income and wealth among individuals in

the society is likely to be skewed and therefore the government has to

intervene to ensure a more desirable and just distribution.

Instruments Provision of subsidy to the poor households.

Proceeds from progressive taxes used for financing public services

CHAPTER 2 PUBLIC FINANCE

UNIT – 1 : FISCAL FUNCTIONS : AN OVERVIEW


P a g e | 56



Employment reservations

Special schemes for backward regions

Stabilisation Function

Meaning It aims at eliminating macroeconomic fluctuations arising from suboptimal

allocation.


In the absence of appropriate corrective intervention by the government, the

instabilities that occur in the economy in the form of recessions, inflation etc.

may be prolonged for longer periods causing enormous hardships to people

especially the poorer sections of society.

Instruments Expansionary fiscal policy

Contractionary fiscal policy

Market Power

Meaning Market power can cause markets to be inefficient because it keeps price higher

and output lower than the outcome of equilibrium of supply and demand which

causes market failure.

Externalities

Meaning When the actions of either consumers or producers result in costs or benefits

that do not reflect as part of the market price, such costs or benefits which are

not accounted for by the market price are called externalities.

Insights These can be negative or positive.

These may be unidirectional or reciprocal.

These can be initiated in production or consumption.

Private vs. Social Cost

Private cost is the cost faced by the producer or consumer directly involved in a

transaction.

Social costs refer to the total costs to the society on account of a production or

consumption activity.

Social Cost = Private Cost + External Cost

Public Goods

Meaning A public good (also referred to as collective consumption good or social good) is

defined as one which all enjoy in common in the sense that each individual’s

consumption of such a good leads to no subtraction from any other individuals’

consumption of that good.

Features of Public

Public goods yield utility to people and are products (goods or services) whose

consumption is essentially collective in nature.

UNIT – 2 : MARKET FAILURE


P a g e | 57



Goods No direct payment by the consumer is involved in the case of pure public goods.

Public good is non-rival in consumption.

Public goods are non-excludable.

Public goods are generally more vulnerable to issues such as externalities and free

rider problem.

Features of Private Goods

Consumption of private goods is ‘rivalrous’.

Private goods are ‘excludable’.

Consumers will get different amounts of goods and services based on their desires

and ability and willingness to pay.

There is no market failure as the market will efficiently allocate resources for the

production of private goods.

Impure Public Goods

These are hybrid goods that possess some features of both public and private

goods. Such goods are called impure public goods and are partially rivalrous or

congestible.

For Example, Open access Wi-Fi networks become crowded when more people

access it.

Quasi Public Goods (Mixed Goods)

These are the goods which possess nearly all of the qualities of the private goods

and some of the benefits of public good.

These are also called near public goods.

It is easy to keep people away from them by charging a price or fee.

However, it is undesirable to keep people away from such goods because the

society would be better off if more people consume them like education.

Common Access Resources

Common access resources or common pool resources are a special class of impure

public goods which are non-excludable as people cannot be excluded from using

them.

These are rival in nature and their consumption lessens the benefits available for

others.

These are generally available free of charge.

Free Rider Problem

Free riding is ‘benefiting from the actions of others without paying’. A free rider

is consumer or producer who does not pay for a nonexclusive good in the

expectation that others will pay.

There is no incentive for people to pay for the public good because they can

consume it without paying for it.

Incomplete Information

Impact Due to information failure, misallocation of scarce resources takes place and

equilibrium price and quantity is not established through price mechanism, which

results in market failure.

Types Asymmetric Information - Asymmetric information occurs when there is an

imbalance in information between buyer and seller.

Adverse Selection - Adverse selection is a situation in which asymmetric


P a g e | 58



information about quality eliminates high-quality goods from a market.

Moral Hazard - Moral hazard is opportunism characterized by an informed person’s

taking advantage of a less-informed person through an unobserved action.

Government Intervention To Minimize Market Power

Competition Based Regulations

Government brings rules and regulations designed to promote competition and

prohibit actions that are likely to restrain competition.

Price Based Regulations

Such legislations generally aim at setting maximum prices that firms can charge.

Government Intervention To Correct Externalities

Direct Controls

Prohibition on Production, use and sale of many commodities.

Stringent rules in place in respect of tobacco advertising etc.

Laws & rules to regulate the actions by producers and consumers.

Fixing emissions standard

Installation of pollution-abatement mechanisms

To charge an emissions fee

Market-based policies/ Indirect Controls

Pollution Tax

As the name says, these are the taxes imposed on pollution.

The size of the tax depends on the amount of pollution a firm produces.

Tax increases the private cost of production or consumption, and decreases the

quantity demanded and therefore the output of the good which creates negative

externality.

The proceeds from the tax can be specifically earmarked for projects that

protect or enhance environment.

Tradable Emissions Permits/ Cap-and-Trade

These are marketable licenses to emit limited quantities of pollutants and can be

bought and sold by polluters.

The high polluters have to buy more permits, which increases their costs, and

makes them less competitive and less profitable.

The low polluters receive extra revenue from selling their surplus permits, which

makes them more competitive and more profitable.

Government Intervention In The Case Of Merit Goods

Meaning of Merit Goods

Merit goods are goods which are deemed to be socially desirable and substantial

positive externalities are involved in the consumption of merit goods. Like

Education, health care etc.

Forms of Government Intervention

Governments can prohibit some type of goods and activities, set standards and

issue mandates making others oblige.

The government can provide the merit goods at subsidized prices to increase their

UNIT – 3 : GOVERNMENT INTERVENTIONS TO CORRECT MARKET FAILURE


P a g e | 59



consumption.

When governments provide merit goods, it may give rise to large economies of

scale.

Government can provide such goods free of cost.

Government Intervention In The Case Of Demerit Goods

Meaning Demerit goods are goods which are believed to be socially undesirable and imposes

significant negative externalities on the society as a whole. Ex - Alcohol.

Forms of Government Intervention

Complete Ban

Persuasion

Strict Regulations

High Taxes

Government Intervention In The Case Of Public Goods

Pure Public Goods

It covers goods where entry fees cannot be charged. In such cases, direct

provision by governments through the use of general government tax revenues is

the only option.

Excludable public goods

It covers goods where the government can charge certain fees. Government can

itself provide such goods or services and charge the entry fees. Government can

grant licenses to private firms to provide such goods or services. The goods are

provided to the public on payment of an entry fee.

Price Intervention

Meaning Under this, Government puts Price Controls in place to influence the outcomes of a

market on grounds of fairness and equity.

Types Price floor

Price Ceiling

Government Intervention For Correcting Information Failure

Ways Disclosure

Public Dis-semination by Govt.

Subsidies for dis-semination

Advertisement Standards

Basics

Meaning Fiscal policy involves the use of government spending, taxation and borrowing to

influence both the pattern of economic activity and level of growth of aggregate

demand, output and employment.

Features Fiscal policy is designed to influence the pattern and level of economic activity in a

country. Fiscal policy is in the nature of a demand-side policy.

UNIT – 4 : FISCAL POLICY


P a g e | 60



Automatic Stabilizers/ Non-Discretionary Fiscal Policy

Meaning These are ‘built-in’ fiscal mechanisms that operate automatically to reduce the

expansions and contractions of the business cycle.

Example Income Tax

Recession Phase

The automatic adjustments work towards stimulating aggregate spending during

the recessionary phase.

More disposable income is available for consumption with the households.

Expansion Phase

The automatic adjustments work towards reducing aggregate spending during this

phase.

Less disposable income is available for consumption with the households.

Discretionary Fiscal Policy

Meaning It refers to deliberate policy actions on the part of government to change the

levels of expenditure and taxes to influence the level of national output,

employment and prices.

Government Expenditure as an Instrument of Fiscal Policy

It includes governments’ expenditure towards consumption, investment, and

transfer payments. It is an important instrument of fiscal policy.

Government expenditure increases during recession phase.

Government expenditure decreases during exapnsion phase.

Taxes as an Instrument of Fiscal Policy

Tax as an instrument of fiscal policy consists of changes in government revenues

or in rates of taxes aimed at encouraging or restricting private expenditures on

consumption and investment.

During recession, the tax policy is framed to encourage private consumption and

investment and taxes are reduced.

During inflation, new taxes are levied and the rates of existing taxes are raised to

reduce disposable incomes and to wipe off the surplus purchasing power.

Public Debt as an Instrument of Fiscal Policy

It involves public borrowing and debt repayment.

During Recession, Government reduces its borrowings and repays the existing debt

which increases the availability of money in the economy and increases aggregate

demand.

During Expansion, Government increases its borrowings which decreases aggregate

demand.

Budget as an Instrument of Fiscal Policy

The budget is simply a statement of revenues earned from taxes and other

sources and expenditures made by a nation’s

government in a year.

It can be Balanced, Surplus or Deficit.


P a g e | 61



Money

Meaning Money refers to assets which are commonly used and accepted as a means of

payment or as a medium of exchange or of transferring purchasing power.

Money has generalized purchasing power and is generally acceptable in settlement

of all transactions and in discharge of other kinds of business obligations

including future payments.

Features Totally liquid asset.

Can be used directly, instantly, conveniently and without any costs or restrictions

to make payments.

Convenient means to access goods and services.

Represents a certain value

Can also constitute electronic records.

Functions of money

Convenient medium of exchange

Eliminates Double coincidence of wants

Separation of Time & Place

Common measure of value

Perfect Liquidity

Reversibility

Demand for Money

Need The demand for money is in the nature of derived demand; it is demanded for its

purchasing power.

Basically, people demand money because they wish to have command over real

goods and services with the use of money.

Variables affecting demand for money

Income - Higher the income of individuals, higher the expenditure and richer

people hold more money to finance their expenditure.

General level of prices - Higher the prices, higher should be the holding of

money.

Rate of interest - higher the interest rate, higher would be opportunity cost of

holding cash and lower the demand for money.

Degree of Financial Innovation - Innovations such as internet banking, application

based transfers and automatic teller machines reduce the need for holding liquid

money.

Classical Approach: The Quantity Theory Of Money (Qtm)

Alternative Names

It is also termed as ‘equation of exchange’ or ‘transaction approach’.

Concept There is an aggregate demand for money for transactions purpose and more the

number of transactions people want, greater will be the demand for money.

CHAPTER 3 MONEY MARKET

UNIT – 1 : THE CONCEPT OF MONEY DEMAND: IMPORTANT THEORIES


P a g e | 62



The total volume of transactions multiplied by the price level (PT) represents the

demand for money.

Basic Equation

MV = PT

M= the total amount of money in circulation (on 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 (P=MV/T)

T = the total number of transactions

Fisher extended the equation of exchange to include demand (bank) deposits (M’)

and their velocity (V’) in the total supply of money.

MV + M'V' = PT

M' = the total quantity of credit money

V' = velocity of circulation of credit money

The Neo Classical Approach: The Cambridge Approach

Alternative Name

It is also termed as cash balance approach.

Concept The Cambridge version holds that money increases utility in the following two

ways :

❖ enabling the possibility of split-up of sale and purchase to two different

points of time rather than being simultaneous, and

❖ being a hedge against uncertainty.

While the first above represents transaction motive, just as Fisher envisaged,

the second points to money’s role as a temporary store of wealth.

Equation Md = k PY

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 Keynesian Theory Of Demand For Money

Alternative Name

Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’.

Meaning Liquidity preference denotes people’s desire to hold money rather than

securities or long-term interest-bearing investments.

According to Keynes, people hold money (M) in cash for three motives:

❖ Transactions motive,

❖ Precautionary motive, and

❖ Speculative motive.

The Transactions

The transactions motive for holding cash relates to ‘the need for cash for

current transactions for personal and business exchange.’


P a g e | 63



Motive

The Precautionary Motive

Demand for money arises due to the unforeseen and unpredictable

contingencies involving money payments which occur in our day to day life.

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.

Estimating Money Supply

Meaning The term money supply denotes the total quantity of money available to the people

in an economy.

Stock The supply of money is a stock variable i.e. it refers to the total amount of

money at any particular point of time.

Inclusions and exclusions

It includes amount with public but not with producers of money.

Sources of Money Supply

Decision of Central Bank

The central banks of all countries are empowered to issue currency and,

therefore, the central bank is the primary source of money supply in all countries.

Commercial Banking system

The total supply of money in the economy is also determined by the extent of

credit created by the commercial banks in the country.

Money Multiplier Approach To Supply Of Money

Formula The money supply is defined as :

M = m X MB

Where M is the money supply, m is money multiplier and MB is the monetary

base or high powered money.

Mechanism If some portion of the increase in high-powered money finds its way into currency,

this portion does not undergo multiple deposit expansion. In other words, as a rule,

an increase in the monetary base that goes into currency is not multiplied, whereas

an increase in monetary base that goes into supporting deposits is multiplied.

Determinants of money supply

Behaviour of Central Bank

If govt. issues High Powered Money, the money supply will increase largely due to

money multiplier approach.

Behaviour of

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’.

UNIT – 2 : THE CONCEPT OF MONEY SUPPLY


P a g e | 64



Commercial Banks

If this ratio increases, 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 this ratio falls, there will be greater expansions of deposits because the same

level of reserves can now support more deposits and the money supply will increase.

Behaviour of Public

The behaviour of public influences bank credit through the decision on ratio of

currency to the money supply designated as the ‘currency ratio’.

Higher is this ratio, means higher is currency holding and less amount being

deposited in banks. Thus, less is the credit creation.

Lower is this ratio, means lower is currency holding and more amount being

deposited in banks. Thus, higher is the credit creation.

Basics

Meaning Monetary policy is essentially a programme of action undertaken by the monetary

authorities, normally the central bank, to control and regulate the demand for and

supply of money with the public and the flow of credit with a view to achieving

predetermined macroeconomic goals.

Nature Monetary policy is in the nature of ‘demand-side’ macroeconomic policy and works

by stimulating or discouraging investment and consumption spending on goods and

services.

Objectives

Price stability

Establishment and maintenance of stability in prices has been the most

conventional objective which focuses towards controlling inflation.

Economic Stability

This objective aims to achieve high level of economy’s growth and maintenance of

full employment.

Cash Reserve Ratio (CRR)

Meaning 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.

Extent The RBI may set the ratio in keeping with the broad objective of maintaining

monetary stability in the economy.

Applicability This requirement applies uniformly to all scheduled banks in the country

irrespective of its size or financial position.

Statutory Liquidity Ratio (SLR)

UNIT – 3 : MONETARY POLICY


P a g e | 65



Meaning Statutory Liquidity Ratio (SLR) refers to the fraction of the total Demand and

Time Liabilities (DTL)/ Net DTL (NDTL) of a scheduled commercial bank in India,

which it should maintain in one of the following forms:

❖ Cash

❖ Gold, or

❖ Investments in un-encumbered instruments

Importance The SLR is also a powerful tool for controlling 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.

Liquidity Adjustment Facility (LAF)

Meaning 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.

Objective Its objective is to assist banks to adjust their day to day mismatches in liquidity.

REPO

Meaning Repo is a collaterised lending under which, other banks borrow money from RBI by

giving securities.

The rate charged by RBI for this transaction is called the ‘repo rate’.

Impact It injects liquidity into the system.

If the RBI wants to make it more expensive for banks to borrow money, it

increases the repo rate.

Reverse Repo

Meaning Reverse repo operation takes place when RBI borrows money from banks by giving

them securities.

The rate paid by RBI for this transaction is called the ‘repo rate’.

Impact Reverse Repo operations absorbs liquidity from the system.

Marginal Standing Facility

Meaning It refers to the facility under which scheduled commercial banks can borrow

additional amount of overnight money from the central bank over and above what

is available to them through the LAF window.

Last Resort MSF would be the last resort for banks once they exhaust all borrowing options

including the liquidity adjustment facility on which the rates are lower compared

to the MSF.


P a g e | 66



Open Market Operartions

Meaning Open Market Operations (OMO) is a general term used for market operations

conducted by the Reserve Bank of India by way of sale/ purchase of Government

securities to/ from the market.

Impact When the RBI feels there is excess liquidity in the market, it resorts to sale of

securities thereby sucking out the rupee liquidity.


P a g e | 67



International Trade

Meaning International trade is the exchange of goods and services as well as resources

between countries.

It involves transactions between residents of different countries.

Currency Domestic trade or internal trade involves exchange of goods and services within

the domestic territory of a country using domestic currency, whereas

international trade involves transactions in multiple currencies.

Advantages/ Arguments in favour

Increased Efficiency

Efficient deployment of productive resources

Economies of scale

Division of labour

Enhanced competition

End of Domestic Monopoly

Foreign exchange reserves

Economic Welfare

Growth of service sector

Human Resource development

Criticism/ Dis-advantages/ Arguments against

Loss for labour

Economic exploitation

Transmission of trade cycles

Danger to political sovereignty

Import of harmful products

Lack of transparency

The Mercantilists’ View Of International Trade

Concept It was based on the premise that national wealth and power are best served by

increasing exports and collecting precious metals in return.

Mercantilists also believed that the more gold and silver a country accumulates,

the richer it becomes.

Exports vs. Imports

Mercantilism advocated maximizing exports in order to bring in more “specie”

(precious metals) and minimizing imports through the state imposing very high

tariffs on foreign goods.

The Theory Of Absolute Advantage

Concept Adam Smith supported unrestricted trade and free international competition.

According to him, absolute cost advantage is the determinant of mutually

beneficial international trade.

CHAPTER 4 INTERNATIONAL TRADE

UNIT – 1 : THEORIES OF INTERNATIONAL TRADE


P a g e | 68



Operation The absolute cost advantage theory points out that a country will specialize in

the production and export of a commodity in which it has an absolute cost

advantage.

In other words, exchange of goods between two countries will take place only if

each of the two countries can produce one commodity at an absolutely lower

production cost than the other country. As a result, each nation has an absolute

advantage in the production of one good.

The Theory Of Comparative Advantage

Concept 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.

Operation 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).

The Heckscher-Ohlin Theory Of Trade

Alternative Name

It is also referred to as Factor-Endowment Theory of Trade or Modern Theory

of Trade.

In view of the contributions made by P. A. Samuelson, this theory is also

sometimes referred to as Heckscher-Ohlin-Samuelson theorem.

Basis of theory

The Heckscher-Ohlin (H-O) model studies the case that two countries have

different factor endowments which results in two countries having different

factor prices in the beginning. Thus, the two countries will have different cost

functions.

The Heckscher-Ohlin theory of trade states that comparative advantage in cost

of production is explained exclusively by the differences in factor endowments of

the nations. In a general sense of the term, ‘factor endowment’ refers to the

overall availability of usable resources including both natural and man-made means

of production.

Nevertheless, in the exposition of the modern theory, only the two most

important factors, labour and capital are taken into account.

Trade Policy

Meaning Trade policy encompasses all instruments that governments may use to promote

or restrict imports and exports.

Types of Instruments

The instruments of trade policy that countries typically use to restrict imports

and/ or to encourage exports can be broadly classified into

❖ price-related measures such as tariffs and

❖ non-price measures or non-tariff measures (NTMs).

UNIT – 2 : THE INSTRUMENTS OF TRADE POLICY


P a g e | 69



Tariffs

Meaning Tariffs, also known as customs duties, are basically taxes or duties imposed on

goods and services which are imported or exported.

It is defined as a financial charge in the form of a tax, imposed at the border on

goods going from one customs territory to another.

Specific Tariff

A specific tariff is an import duty that assigns a fixed monetary tax per physical

unit of the good imported.

It is calculated on the basis of a unit of measure, such as weight, volume, etc., of

the imported good.

Ad valorem tariff

An ad valorem tariff is levied as a constant percentage of the monetary value of

one unit of the imported good.

Mixed Tariffs

Mixed tariffs are expressed either on the basis of value of imported goods (an

ad valorem rate) or on the basis of a unit of measure of imported goods (a

specific duty) depending on which generates the most income for the nation.

Compound Tariff or a Compound Duty

It 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).

It is generally calculated by adding up a specific duty to an ad valorem duty.

Technical/ Other Tariff

These are calculated on the basis of the specific contents of the imported goods

i.e. the duties are payable by its components or related items.

Tariff Rate Quotas

Tariff rate quotas (TRQs) combine two policy instruments, quotas and tariffs.

Imports entering under the specified quota portion are usually subject to a lower

(sometimes zero) tariff rate.

Preferential Tariff

A lower tariff is charged from goods imported from a country which is given

preferential treatment.

Bound Tariff A bound tariff is a tariff which a WTO member binds itself with a legal

commitment not to raise it above 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.

Applied Tariffs

An 'applied tariff' is the duty that is actually charged on imports on a most-

favoured nation (MFN) basis.

Prohibitive tariff

A prohibitive tariff is one that is set so high that no imports will enter.

Anti-dumping Duties

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.


P a g e | 70



Anti-dumping duties which are tariffs to offset the effects of dumping which

may be initiated as a safeguard instrument by imposition of additional import

duties so as to offset the foreign firm's unfair price advantage.

Counter-vailing Duties

Countervailing duties are tariffs that aim to offset the artificially low prices

charged by exporters who enjoy export subsidies and tax concessions offered by

the governments in their home country.

Non Tariff Measures

Meaning Non-tariff measures (NTMs) 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.

Technical Measures

Sanitary and Phytosanitary (SPS) Measures

SPS measures are applied to protect human, animal or plant life from risks arising

from additives, pests, contaminants, toxins or disease-causing organisms and to

protect biodiversity.

Technical Barriers To Trade (TBT)

Technical Barriers to Trade (TBT) refer to mandatory ‘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, excluding measures covered by the SPS

Agreement.

Non-Technical Measures

Import Quotas

An import quota is a direct restriction which specifies that only a certain physical

amount of the good will be allowed into the country during a given time period,

usually one year.

Non-automatic Licensing and Prohibitions

These measures are normally aimed at limiting the quantity of goods that can be

imported, regardless of whether they originate from different sources or from

one particular supplier.

Financial Measures

The objective of financial measures is to increase import

costs by regulating the access to and cost of foreign exchange for imports and to

define the terms of payment.

Trade-Related Investment Measures

These measures include rules on local content requirements that mandate a

specified fraction of a final good should be produced domestically.

Restriction on Post-sales Services

Producers may be restricted from providing after- sales services for imported

goods in the importing country.


P a g e | 71



Rules of origin

Rules of origin are the criteria needed by governments of importing countries to

determine the national source of a product.

Embargos

An embargo is a total ban imposed by government on import or export of some or

all commodities to particular country or regions for a specified or indefinite

period. This may be done due to political reasons or for other reasons such as

health, religious sentiments. This is the most extreme form of trade barrier.

Basics

Meaning International trade negotiations are complex interactive processes engaged in by

countries having competing objectives.

Complex Nature

Trade negotiations are not just face to face discussions; rather they are

multilevel or network games and involve intricate and time consuming processes.

Regional Trade Agreements (Rtas)

Meaning Regional Trade Agreements (RTAs) are defined as groupings of countries, (not

necessarily belonging to the same geographical region) which are formed with the

objective of reducing barriers to trade between member countries.

Types Regional Preferential Trade Agreements

Trading Bloc

Free-trade area

Customs Union

Common Market

Economic and Monetary Union

The General Agreement On Tariffs And Trade (Gatt)

Background In an effort to give an early boost to trade liberalization after the Second

World War, tariff negotiations were opened among the 23 founding GATT

"contracting parties" in 1946.

Evolvement of GATT

The tariff concessions and rules together became known as the General

Agreement on Tariffs and Trade and entered into force in January 1948.

Loss of Relevance

The GATT lost its relevance by 1980s because

❖ it was obsolete to the fast evolving contemporary complex world trade

scenario characterized by emerging globalisation

❖ international investments had expanded substantially

❖ intellectual property rights and trade in services were not covered by

GATT

UNIT – 3 : TRADE NEGOTIATIONS


P a g e | 72



❖ world merchandise trade increased by leaps and bounds and was beyond

its scope

❖ the ambiguities in the multilateral system could be heavily exploited

❖ efforts at liberalizing agricultural trade were not successful

❖ there were inadequacies in institutional structure and dispute settlement

system

WTO

Beginning of Uruguay Round

The seeds of the Uruguay Round were sown in November 1982 at a Ministerial

Meeting of GATT members in Geneva.

Evolvement of WTO

The agreement was signed by most countries on April 15, 1994, and took effect

on July 1, 1995.

It also marked the birth of the World Trade Organization (WTO) which

is a single institutional framework encompassing the GATT, as modified by the

Uruguay Round.

Objective of WTO

The principal objective of the WTO is to facilitate the flow of international

trade smoothly, freely, fairly and predictably.

Guiding Principles of World Trade Organization (WTO)

Trade without discrimination/ Most-favoured nation (MFN)

Under the WTO agreements, countries cannot normally discriminate between

their trading partners.

If a country lowers a trade barrier or opens up a market, it has to do so for the

same goods or services from all other WTO members.

National Treatment Principle (NTP)

A country should not discriminate between its own and foreign products, services

or nationals.

Freer trade

Lowering trade barriers is one of the most obvious means of encouraging trade.

The barriers concerned include customs duties (or tariffs) and measures such as

import bans or quotas that restrict quantities selectively.

Predictability

Investments will be encouraged only if the business environment is stable and

predictable.

The foreign companies, investors and governments should be confident that the

trade barriers will not be raised arbitrarily.

Greater competitiveness

This is to be achieved by discouraging “unfair” practices such as export

subsidies, dumping etc.

Special privileges to less developed countries

With majority of WTO members being developing countries, the WTO


P a g e | 73



deliberations favour less developed countries by giving them greater flexibility,

special privileges etc.

Also, these countries are granted transition periods to make adjustments to the

not so familiar and intricate WTO provisions.

A transparent, effective and verifiable dispute settlement mechanism

Trade relations frequently involve conflicting interests.

Any dispute arising out of violation of trade rules is to be settled through

consultation.

In case of failures, the dispute can be referred to the WTO and can pursue a

carefully mapped out, stage-by-stage procedure that includes the possibility of a

judgment by a panel of experts, and the opportunity to appeal the ruling on legal

grounds.

The decisions of the dispute settlement body are final and binding.

Concerns Slow Process

Rigidity

Uncertainty

Sector biasness

Concerns of Developing countries

Exchange Rate

Meaning The exchange rate, also known as a foreign exchange (FX) rate, is the price of

one currency expressed in terms of units of another currency and represents

the number of units of one currency that exchanges for a unit of another.

Concept Exchange rate is the rate at which the currency of one country exchanges for

the currency of another country.

It is the minimum number of units of one country’s currency required to

purchase one unit of the other country’s currency.

Direct quote A direct quote is the number of units of a local currency exchangeable for one

unit of a foreign currency.

For example, Rs. 66/US$ means that an amount of Rs. 66 is needed to buy one

US dollar or Rs. 66 will be received while selling one US dollar.

Indirect quote

An indirect quote is the number of units of a foreign currency exchangeable for

one unit of local currency. For example: $ 0.0151 per rupee.

Buying Rate It is the price at which the dealer buys the currency.

It is also called bid rate.

Selling Rate It is the price at which the dealer sells the currency.

It is also called ask rate or offer rate.

UNIT – 4 : EXCHANGE RATE AND ITS ECONOMIC EFFECTS


P a g e | 74



Exchange Rate Regime

Floating exchange rate regime

Under floating exchange rate regime, the equilibrium value of the exchange rate

of a country’s currency is market-determined i.e. the demand for and supply of

currency relative to other currencies determine the exchange rate.

Fixed exchange rate regime

A fixed exchange rate, also referred to as pegged exchanged rate, is an

exchange rate regime under which a country’s Central Bank and/ or government

announces or decrees what its currency will be worth in terms of either another

country’s currency or a basket of currencies or another measure of value, such

as gold.

Intermediate exchange rate regimes

It refers to an exchange rate policy under which the exchange rate is generally

determined by the market, but in case the exchange rate tend to be move

speedily in one direction, the central bank will intervene in the market.

The Foreign Exchange Market

Meaning The wide-reaching collection of markets and institutions that handle the

exchange of foreign currencies is known as the foreign exchange market.

Features Operates worldwide.

The largest market in the world in terms of cash value traded.

Over-the-counter market, no physical place.

No central trading location and no set hours of trading.

Enormous volume of foreign exchange trading worldwide.

Major participants

Central bank

Commercial banks

Foreign exchange brokers

Arbitrageurs

Speculators

Type of Transactions

Spot

Forward

Changes In Exchange Rates

Home-currency depreciation

Under a floating rate system, if for any reason, the demand curve for foreign

currency shifts to the right representing increased demand for foreign

currency, and supply curve remains unchanged, then the exchange value of

foreign currency rises and the domestic currency depreciates in value.

The home currency thus becomes relatively less valuable.

Home-currency appreciation

Under a floating rate system, if for any reason, the supply curve for foreign

currency shifts to the right representing increased supply for foreign currency,

and demand curve remains unchanged, then the exchange value of foreign

currency falls and the domestic currency appreciates in value.

The home currency thus becomes relatively more valuable.


P a g e | 75



Devaluation (Revaluation) Vs Depreciation (Appreciation)

Devaluation Devaluation is a deliberate downward adjustment in the value of a country's

currency relative to another currency, group of currencies or standard.

Depreciation Depreciation is a non-deliberate downward adjustment in the value of a

country's currency relative to another currency, group of currencies or

standard.

Revaluation Revaluation is a deliberate upward adjustment in the value of a country's


Appreciation Appreciation is a non-deliberate upward adjustment in the value of a country's


Foreign Direct Investment (FDI)

Meaning Foreign direct investment is 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.

Extent of 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 investor makes it eligible to be categorized as foreign direct

investment (FDI).

Main forms of FDI

Opening of a subsidiary or associate company in a foreign country.

Acquiring a controlling interest in an existing foreign company.

Mergers and acquisitions(M&A).

Joint venture with a foreign company.

Joint development of natural resources.

Types of FDI on the basis of nature

Horizontal Direct Investment

Vertical investment

Conglomerate Investment

Foreign Portfolio Investment (FPI)

Meaning Foreign portfolio investment is a process whereby the resident of one country

(i.e. home country) acquires ownership of a financial asset in another country (i.e.

the host country).

Modes It moves to investment in financial stocks, bonds and other financial instruments

and is effected largely by individuals and institutions through the mechanism of

UNIT – 5 : INTERNATIONAL CAPITAL MOVEMENTS


P a g e | 76



capital market.

Foreign portfolio investment (FPI) is not concerned with either manufacture of

goods or with provision of services.

Intention of investor

The singular intention of a foreign portfolio investor is to earn a remunerative

return through investment in foreign securities and is primarily concerned about

the safety of their capital, the likelihood of appreciation in its value, and the

return generated.

Nature of FPI

These investments are typically of short term nature.

Benefits & Limitations Of Foreign Direct Investment

Benefits Increased competition

Increase in Investment

Acceleration of growth

Political Reforms

Generation of Direct employment

Generation of Indirect employment

Higher wages

International relations

Promotion of ancillary units

Increase in Exports

Tax Revenue

Reduced Cost

Weakens monopoly

Favorable impact on BOP

Problems Capital Intensive Techniques

Regional Disparity

Loss of Tax Revenue

Less investment for development needs

Stress on Balance of Payments

No development of human resource

Focus on elite goods/ services

Unethical Practices

Labour related issues

Lower standards

Security considerations

Environmental damage

Dual economy

Foreign Direct Investment In India (Fdi)

Initiatives taken by Government to promote FDI

Automatic approval of FDI

Simplification of procedures

Setting up of Foreign Investment Promotion Board

100% FDI in multitude of sectors

Enactment of Foreign Exchange Management Act (FEMA)


P a g e | 77



Passing of the SEZ Act in 2005

Encouragement to foreign technology collaboration agreements

Routes for FDI

Automatic Route

Approval Route

Instruments An Indian Company can receive foreign investment by issue of ‘FDI compliant

instruments’ namely :

❖ equity shares,

❖ fully and mandatorily convertible preference shares and debentures,

❖ partly paid equity shares and warrants.

Prohibition of FDI

In India, foreign investment is prohibited in the following sectors:

❖ Lottery business including Government/ private lottery, online lotteries,

etc.

❖ Gambling and betting including casinos etc.

❖ Chit funds

❖ Nidhi company

❖ Trading in Transferable Development Rights (TDRs)

❖ Real Estate Business or Construction of Farm Houses

❖ Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or

of tobacco substitutes

❖ Activities/ sectors not open to private sector investment e.g. atomic

energy and railway operations (other than permitted activities).


Documents

FM & ECO MARATHON 2019 CA IPC CA INTER · Consider the following information for Omega Ltd: EBIT (Earnings before Interest and Tax) Rs. 15,750 Lakh Earnings before Tax (EBT) Rs. 7,000