Fm & Eco Marathon Revision By Ca Rahul Garg Sir.pdf

CA RAHUL GARG’s

FM & ECO MARATHON 2019 CA IPC CA INTER RAHUL SHIKHA ACADEMY

Page |1

CHAPTER 1

COST OF CAPITAL

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Exam

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May 2017

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CA IPC CA INTER CONCEPT

FINANCING DECISION & COST OF CAPITAL

CONCEPT

COMPONENTS OF CAPITAL

CONCEPT

COMPONENTS OF COST OF CAPITAL

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Page |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

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CONCEPT

COST OF EQUITY SHARE CAPITAL Dividend Yield Model

Earnings Yield Model

Dividend Growth Model

Earnings Growth Model

Realised Yield Approach

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Page |4

Capital Asset Pricing Model

CONCEPT

COST OF RETAINED EARNINGS In absence of Personal Taxes

In presence of Personal Taxes

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CONCEPT S.No. 1

WEIGHTED AVERAGE COST OF CAPITAL

Source of Finance Equity Share Capital

2

Preference Share Capital

3

Reserves & Surplus

4

Debt

CONCEPT

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Amount

Weight

Cost

W × C

BOOK VALUE WEIGHTS VS. MARKET VALUE WEIGHTS

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CHAPTER 2

LEVERAGE

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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%.

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Page |7

CONCEPT

FINANCING RISK Meaning and Basic Condition

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%.

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CONCEPT

COMBINED RISK Meaning and Basic Condition

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%.

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Page |9

CHAPTER 3

CAPITAL STRUCTURE

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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.

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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

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CHOICE OF PLAN

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P a g e | 11

CHAPTER 4

THEORIES OF CAPITAL STRUCTURE

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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.

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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

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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 Kd (%) Ke (%) capital employed 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

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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.

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P a g e | 15

CHAPTER 5

CAPITAL BUDGETING

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Exam

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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 Accounting Rate of Return Pay Back Period Variants of Pay Back Period

CONCEPT

Modern Techniques Discounted Pay Back Period Net Present Value Profitability Index Internal Rate of Return

ACCOUNTING RATE OF RETURN Meaning

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

Decision Rule

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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

EBDIT ‘

EBDIT

- Depreciation

‘

= EBIT ‘

- Interest

= Balance

- Interest

‘

=

- Tax

=

= EBT ‘

METHOD 2

= Balance

- Tax

‘

+ Tax Saving on Depreciation

= EAT

(Depreciation × Tax Rate)

+ Depreciation

= Cash Flow

= Cash Flow Question

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P a g e | 17

METHOD 1 EBDIT ‘

EBDIT

- Depreciation

‘

= EBIT ‘

METHOD 2 - Interest

= Balance

- Interest

‘

=

- Tax

=

= EBT

= Balance

= EAT

+ Tax Saving on Depreciation (Depreciation × Tax Rate)

+ Depreciation

= Cash Flow

‘

- Tax

‘

= 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.

Year End

If Cash Flows are not equal p.a.

Statement showing computation of Payback period Cash Inflow Cumulative Cash Inflow

Decision Rule

Question

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P a g e | 18

CONCEPT

TIME VALUE OF MONEY

CONCEPT

DISCOUNTED PAY BACK PERIOD Decision Rule

Computation of Discounted Pay back Period

Year End

Statement showing computation of Discounted Payback period 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

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P a g e | 19 Computation of NPV

Year End

Statement showing computation of NPV Particulars Cash Inflow PVF @ __ %

PVCF

Question

CONCEPT

PROFITABILITY INDEX Formula

Decision Rule

CONCEPT

NET PROFITABILITY INDEX Formula

Decision Rule CA Rahul Garg

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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

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SCRAP VALUE

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P a g e | 21

CHAPTER 6

WORKING CAPITAL MANAGEMENT

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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

CONCEPT

Net Working Capital

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 A

Computation

Amount

Current Assets 1

Raw Material Inventory

2

WIP Inventory a Material

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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

D

Safety Margin

E

Total Working Capital

CONCEPT

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(A) - (B) ‘

(C) + (D) ‘

SOME SPECIAL POINTS

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P a g e | 23

CONCEPT

MAXIMUM PERMISSIBLE BANK FINANCE (MPBF) AS PER TANDON COMMITTEE

NORM I

NORM II

Current Assets ‘

Current Assets

- Current Liabilities

‘

= Working Capital ‘

NORM III

- 25 %

‘

= 75% Current Assets

- 25 %

‘

= MPBF

- Current Liabilities

= MPBF

Current Assets - Core Current Assets

= Non Core Current Assets ‘

- 25 %

= 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

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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

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P a g e | 25

CHAPTER 7

DEBTOR’S MANAGEMENT

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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

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)

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Option 2

Option 3

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CONCEPT

COMPUTATION OF OPPORTUNITY COST

CONCEPT

COMPUTATION OF DISCOUNT

CONCEPT

IMPACT OF FIXED COST

CONCEPT

IMPACT OF TAXATION

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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 Administration Cost Collection Cost Bad Debts

Cost Due to Factoring Commission Interest on Advance

Effective Cost or Saving Due to Factoring

Effective Cost or Saving %

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P a g e | 28

CHAPTER 8

CASH MANAGEMENT

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OPTIMUM CASH BALANCE

CONCEPT

AVERAGE CASH BALANCE

CONCEPT

CASH BUDGET

S.No.

Particulars

1

A

Opening Balance

B

Receipts 1

Cash Sales

2

Receipt from Debtors

3

Sale of Asset

4

Tax Refund

2

3

Total (B) C

Payments 1

Cash Purchases

2

Payment to Creditors

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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)

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P a g e | 30

CHAPTER 9

RATIO ANALYSIS

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CONCEPT

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PROFITABILITY RATIOS

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CONCEPT

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ACTIVITY RATIOS

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CONCEPT

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COVERAGE RATIOS

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CONCEPT

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MARKET TEST RATIOS

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CONCEPT

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SOLVENCY/ FINANCIAL RATIOS

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CA Rahul Garg

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P a g e | 36

CHAPTER 10

TIME VALUE OF MONEY

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CA IPC CA INTER CONCEPT

BASIC OF TVM

CONCEPT

SIMPLE INTEREST

CONCEPT

COMPOUND INTEREST

CONCEPT

EFFECTIVE RATE OF INTEREST

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P a g e | 37

CONCEPT

FUTURE VALUE OF ANNUITY

CONCEPT

PRESENT VALUE OF ANNUITY

CONCEPT

PERPETUITY

CONCEPT

SINKING FUND

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P a g e | 38

CHAPTER 11

FUND FLOW STATEMENT

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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

A

Current Assets 1

Debtors

2

Cash

3

Stock

4

Prepaid Expenses

Closing

Increase in WC

Decrease in WC

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

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CONCEPT

ADJUSTED PROFIT & LOSS A/C

Particulars

Amount

Particulars

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

Amount

FUNDS FLOW STATEMENT

Sources

Amount

Applications

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 Redemption of Debentures

Refund of Tax

Amount

Tax Paid Dividend Paid

CONCEPT

TRANSACTIONS AFFECTING FFS

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

Source Any transaction which increases the amount of working capital is a Source. WC increases if the transaction - Increases CA - Decreases CL

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Application Any transaction which decreases the amount of working capital is Application. WC decreases if the transaction - Decreases CA - Increases CL

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P a g e | 40

CHAPTER 12

CASH FLOW STATEMENT

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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 per AS 3, these are Cash in Hand Cash at Bank Marketable Securities Bank Overdraft Cash Credit 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.

AS : 3

Cash Flows

CONCEPT Operating Activity Investing Activity Financing Activity

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DIVISION INTO ACTIVITIES These are the principle revenue producing activities of enterprise and other activities which are not investing or financing. These are acquisition and disposal of long term assets and other investments. These are the activities which result in change in size and composition of owner’s capital and borrowings of enterprise.

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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

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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

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LEDGER ACCOUNTS TO BE PREPARED

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CHAPTER 13

RISK ANALYSIS IN CAPITAL BUDGETING

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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 :

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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.

Path

PVCF (Y 1)

Path

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Computation of NPV PVCF (Y 2) Total PVCI

Computation of Expected NPV NPV Joint Probability

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CHAPTER 14

LEASING

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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 Year End 0 1 – n n

COMPUTATION OF PVCO : BUY (OWN FUNDS) Particulars

Cash Flow

PVF @___%

PVCF

Cost of Asset Tax Saving on Depreciation Scrap Value

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CONCEPT Year End 0

COMPUTATION OF PVCO : BUY (BORROWED FUNDS) Particulars

Cash Flow

1 – n

Down Payment (Cost of Asset – Borrowings) Tax Saving on Depreciation

1 – n

Principal

1 – n

Interest (1 - t)

n

PVF @___%

PVCF

Scrap Value

CONCEPT

DISCOUNT RATE ABSENT

CONCEPT

AMOUNT OF INSTALLMENT NOT GIVEN

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CHAPTER 15

DIVIDEND DECISONS

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GORDON MODEL

CONCEPT

WALTER MODEL

CONCEPT

TRADITIONAL MODEL

CONCEPT

LINTNER MODEL

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CONCEPT

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M-M HYPOTHESIS

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CHAPTER 1

DETERMINATION OF NATIONAL INCOME UNIT – 1 : NATIONAL INCOME ACCOUNTING 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

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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. Gold Medalist

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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

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Components Private Final Consumption Expenditure (PFCE)

Government Final Consumption Expenditure (GFCE) Gross Domestic Capital formation Net Exports Adding above 3, we get GDPMP. GNPMP = GDPMP + NFIA GNPFC = GNPMP – NIT NNPFC = GNPFC – Depreciation

Formula

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

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

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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

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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

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Investment Multiplier

Meaning

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

Relationship There exists a direct relationship between MPC and the value of multiplier. with MPC & 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 viceMPS versa.

Formula

Diagram

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CHAPTER 2

PUBLIC FINANCE UNIT – 1 : FISCAL FUNCTIONS : AN OVERVIEW 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

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.

Allocation Function

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

Government Intervention

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

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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.

Government Intervention

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

UNIT – 2 : MARKET FAILURE 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

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.

Public Goods

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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

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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.

UNIT – 3 : GOVERNMENT INTERVENTIONS TO CORRECT MARKET FAILURE Government Intervention To Minimize Market Power

Competition Based Regulations Price Based Regulations

Government brings rules and regulations designed to promote competition and prohibit actions that are likely to restrain competition.

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

Marketbased 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.

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

Government Intervention To Correct Externalities

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.

Governments can prohibit some type of goods and activities, set standards and Forms of Government issue mandates making others oblige. Intervention The government can provide the merit goods at subsidized prices to increase their CA Rahul Garg

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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.

Complete Ban Forms of Government Persuasion Intervention 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.

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

UNIT – 4 : FISCAL POLICY 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.

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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 Taxes 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.

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.

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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.

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CHAPTER 3

MONEY MARKET

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

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

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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 Concept

It is also termed as cash balance approach.

Equation

Md = k PY

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.

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 Meaning

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

The Transactions

The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’

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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.

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Motive The Precautionary Motive The Speculative Demand for Money

Demand for money arises due to the unforeseen and unpredictable contingencies involving money payments which occur in our day to day life. The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure.

UNIT – 2 : THE CONCEPT OF MONEY SUPPLY 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 Commercial Banking system

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.

Formula

The money supply is defined as :

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 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

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If govt. issues High Powered Money, the money supply will increase largely due to money multiplier approach. 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’. Gold Medalist

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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.

UNIT – 3 : MONETARY POLICY 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.

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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.

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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.

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CHAPTER 4

INTERNATIONAL TRADE UNIT – 1 : THEORIES OF INTERNATIONAL TRADE 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/ Disadvantages/ 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

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Adam Smith supported unrestricted trade and free international competition. According to him, absolute cost advantage is the determinant of mutually beneficial international trade. Gold Medalist

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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.

UNIT – 2 : THE INSTRUMENTS OF TRADE POLICY Trade Policy

Meaning

Trade policy encompasses all instruments that governments may use to promote or restrict imports and exports.

The instruments of trade policy that countries typically use to restrict imports Types of Instruments 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).

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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 mostfavoured nation (MFN) basis.

Prohibitive tariff Antidumping Duties

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

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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.

Countervailing 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.

NonTechnical 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.

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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.

UNIT – 3 : TRADE NEGOTIATIONS 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

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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 Evolvement of WTO

The seeds of the Uruguay Round were sown in November 1982 at a Ministerial Meeting of GATT members in Geneva.

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.

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.

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 CA Rahul Garg

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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

UNIT – 4 : EXCHANGE RATE AND ITS ECONOMIC EFFECTS 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.

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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 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 exchange rate regimes 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

Spot Type of Transactions Forward

Changes In Exchange Rates

Homecurrency 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.

Homecurrency 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.

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

Appreciation

Appreciation is a non-deliberate upward adjustment in the value of a country's currency relative to another currency, group of currencies or standard.

UNIT – 5 : INTERNATIONAL CAPITAL MOVEMENTS 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

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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 CA Rahul Garg

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) Gold Medalist

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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).

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