Suggested Answers UPSC Civil Services Exam mains 2017

Exam 2017: Paper -I

1(a)

Topic : Accountancy

Marks: 10

Provisions of Indian accounting standards regarding Foreign Exchange transactions:

Indian Standard 21 The effects of changes in foreign exchange rate deals with provisions regarding foreign exchange transactions.
An entity may carry on foreign activities in two ways. It may have transactions in foreign currencies or it may have foreign operations. In addition, an entity may present its financial statements in a foreign currency.
The objective of the Standard is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.
Para 23 deals with reporting requirements at the end of subsequent reporting period and at the end of each reporting period:

foreign currency monetary items shall be translated using the closing rate;
non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction; and
non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was measured.

The carrying amount of an item is determined in conjunction with other relevant Standards. For example, property, plant and equipment may be measured in terms of fair value or historical cost in accordance with Ind AS 16, Property, Plant and Equipment. Whether the carrying amount is determined on the basis of historical cost or on the basis of fair value, if the amount is determined in a foreign currency it is then translated into the functional currency in accordance with this Standard.
Recognition of exchange difference:

Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognised in profit or loss in the period in which they arise, except as described in paragraph 32. (Para 28)
When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss shall be recognised in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss. (Para 30)
Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation shall be recognised in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate. In the financial statements that include the foreign operation and the reporting entity (eg consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment.

1(b)

Topic : Accountancy

Marks: 10

The key differences between internal reconstruction and external reconstruction are mentioned below –

Internal reconstruction needs a lot of time and statutory requirements to occur because in internal reconstruction the company has to take the permission of every stakeholder and also of the court. On the other hand, external reconstruction can be done immediately without any need of permission from the court.
Both of these reconstructions ensure the change in financial structure. But since internal reconstruction doesn’t liquidate, things become difficult.
In the case of internal reconstruction, the losses of the company can be set off against the future profit of the company. In the case, external reconstruction the losses of an old company can’t be set off against the profit of the new company.
Internal reconstruction is done when there is a chance for the existing company to bounce back. External reconstruction is done to start the whole thing afresh.
Losses against profits: In Internal reconstruction past losses can be set off against future profits., but in ER Since a new company is established losses of old company can’t be set off against profits of new company

1(c)

Topic : Costing
Marks: 10

A responsibility center is a part of a company for which a manager has authority and responsibility. The company's detailed organization chart is a logical source for determining responsibility centers. The most common responsibility centers are the departments within a company.
When the manager of a responsibility center can control only costs, the responsibility center is referred to as a cost center. If a manager can control both costs and revenues, the responsibility center is known as a profit center. If a manager has authority and responsibility for costs, revenues, and investments the responsibility center is referred to as an investment center.
Types of Responsibility Centres:Responsibility centres can be classified by the scope of responsibility assigned and decision-making authority given to individual managers. The following are the four common types of responsibility centres:

Cost Centre: A cost or expense centre is a segment of an organisation in which the managers are held responsible for the cost incurred in that segment but not for revenues. Responsibility in a cost centre is restricted to cost. For planning purposes, the budget estimates are cost estimates; for control purposes, performance evaluation is guided by a cost variance equal to the difference between the actual and budgeted costs for a given period. Cost centre managers have control over some or all of the costs in their segment of business, but not over revenues. Cost centres are widely used forms of responsibility centres.
Revenue Centre: A revenue centre is a segment of the organisation which is primarily responsible for generating sales revenue. A revenue centre manager does not possess control over cost, investment in assets, but usually has control over some of the expense of the marketing department. The performance of a revenue centre is evaluated by comparing the actual revenue with budgeted revenue, and actual marketing expenses with budgeted marketing expenses. The Marketing Manager of a product line, or an individual sales representative are examples of revenue centres.
Profit Centre: A profit centre is a segment of an organisation whose manager is responsible for both revenues and costs. In a profit centre, the manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits) for the department or division. The main purpose of a profit centre is to earn profit. Profit centre managers aim at both the production and marketing of a product. The performance of the profit centre is evaluated in terms of whether the centre has achieved its budgeted profit. A division of the company which produces and markets the products may be called a profit centre. Such a divisional manager determines the selling price, marketing programmes and production policies.
Investment Centre: An investment centre is responsible for both profits and investments. The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s assets. He also formulates the credit policy which has a direct influence on debt collection, and the inventory policy which determines the investment in inventory.

1(d)

Topic : Taxation

Marks: 10

Service tax was a tax levied by Central Government of India on services provided or agreed to be provided excluding services covered under negative list and considering the Place of Provision of Services Rules, 2012 and collected as per Point of Taxation Rules, 2011 from the person liable to pay service tax.
Person liable to pay service tax is governed by Service Tax Rules, 1994 he may be service provider or service receiver or any other person made so liable. It is an indirect tax wherein the service provider collects the tax on services from service receiver and pays the same to government of India.
Few services are presently exempt in public interest via Mega Exemption Notification 25/2012-ST as amended up to date and few services are charged service tax at abated rate as per Notification No. 26/2012-ST as amended up to date.

1(e)

Topic : Auditing

Marks: 10

Verification of advances is an important function of an auditor of a Bank

In Bank Audit, we as Auditor carry lot of responsibilities as banking sector directly deal in commodity called “Money” that too mainly Public funds by way of deposits and secondly we have limited time to complete the bank – branch audit.
Reason of concern is banking sector is fraud prone and it again increases our responsibilities in carrying out bank – branch audit. There have been many scams in banking sector. As per PTI report on 25th February 2010, Frauds have cost banks Rs. 5,517 Crores in last four fiscals. The highest loss was in fiscal 2008-09 of Rs.1883 Crores. As we read in media, in February 2010, one of the bank was imposed with penalty of Rs.25 Lakhs for violating (RBI) directives on acquisition of immovable property, deletion of records in IT system, non-adherence to KYC and anti- money laundering norms, irregularities in the conduct of certain corporate group etc. In 2009, we read instance of cash transactions of Rs.640 crores between November 2006 to December 2008 in one bank account and in one such similar case transfer of funds overseas amounting to $110 millions.
The first step towards audit of advances is to verify the Procedural and Documentation compliance with respect to the sanction and disbursement of the advances. RBI guidelines, Bank’s advance manual, internal circulars, latest RBI inspection report, concurrent audit reports and the Banks inspection reports should also be referred for the same. The following points need to be covered:

Whether the sanction has been made as per the Bank’s norms and policies?
Whether the credit appraisal report contains adequate information with regard to the means, standing, business integrity, experience and capabilities of the borrower?
Has the advances been sanctioned by designated authorities with proper sanctioning powers?
Have all the documents been executed with respect to the sanction?
Whether certificate of registration of charges is available with the bank?
Have the securities been executed with respect to the sanction?
Whether all the terms and conditions of the sanctions have been complied with before the loan is disbursed?
Whether Processing Fees, Advocate Fees etc has been recovered or not?
Whether Pre and Post Disbursement inspection has been done by the competent Authority or not?
whether the unit has adequately arranged for insurance of stocks, and the bank clause is incorporated in the policy.
Whether the materials lying with third party are also adequately insured with requisite Bank clause
No-lien letters are obtained in case of such inventories lying with third parties
Whether the bank has a policy of obtaining independent Stock audit report from firm of CAs in those cases where advances exceed Rs 5 crore . in such cases the branch auditor should refer to the adverse comments , if any, in stock audit reports for taking a view on the advances
Whether the book debts charged to bank are arising out of genuine trade transactions, are less than XX days old, for calculating the D.P.

2(b)

Topic : Costing

Marks: 15

Differential analysis is useful in this decision making because a company’s income statement does not automatically associate costs with certain products, segments, or customers.
Differential costing is a technique where mainly differential costs are considered relevant. Differential cost is the difference in total costs between two acceptable alternative courses of action.
The alternative actions may arise due to change in sales volume, price, product mix, or such actions as make or buy or continue or stop production, etc
The key emphasis in differential costing is on change in total costs associated with alternative decisions.
When the change in costs occurs due to change in the activity from one level to another, it may result in incremental cost [i.e., increase in costs] or decremental cost [i.e., decrease in costs]. Differential costing is a broader term that includes both incremental costing and decremental costing.
The differential cost analysis is a useful tool for the management to know the results of any proposed changes in the level or nature of activity. Under this method, the differential costs are ascertained for each proposal and compared with the expected changes in revenue associated with each proposal.
When there is net excess revenue, the proposal will be accepted; otherwise it will be rejected. The determination of differential cost is simple. It represents the difference in the relevant costs for the alternative proposal under consideration.
When two levels of activities are being considered, the differential cost is obtained by deducting the cost at one level from another level.
In the above analysis, it is ascertained that the fixed overheads and a portion of semi-variable overheads remain constant for both the alternatives. Hence, they will be considered irrelevant for decision-making, as they are not affected by increase in sales volume. However, if some additional fixed costs are incurred for increased sales volume that will be considered for computation.
Thus, companies must reclassify costs as those that the action would change and those that it would not change.

2(c)

Topic : Taxation

Marks: 15

The residential status under Income Tax plays a vital role for considering taxation of certain incomes. It has no nexus with citizenship of India.
The residential status of a taxpayer is determined on the basis of tenure of his stay in India during the Financial Year.
There are 3 types of Residential status for an Individual as explained below.

Resident:- Person shall be treated as ‘Resident’, if he satisfies any of the following basic conditions:- Basic conditions-

1) If a person is in India for at least 182 days during the Financial Year OR
2) If a person is in India for at least 60 days during the Financial Year and for at least 365 days during the last 4 Financial Years.

Resident Individuals are further sub-divided into following 2 categories :

a) Ordinary Resident:- Person shall be treated as ‘Ordinary Resident’, if he satisfies both the additional conditions.

Additional conditions-

1) If a person is resident of India for any 2 out of last 10 Financial Years AND
2) If a person is in India for at least 730 days during the last 7 Financial Years.

b) Not Ordinary Resident:- If any of the additional conditions specified above are not satisfied then that person is treated as ‘Not Ordinary Resident’ for that Financial Year.

B] Non-Resident:- If none of the basic conditions are satisfied then person is treated as ‘Non-Resident’ for that Financial Year.

Taxability of Income in India as per Residential Status-

1. Income accrue or arise outside India and received outside India

a) Foreign Business income where business is controlled from India

Taxable (Ordinary Resident)
Taxable (Not Ordinary Resident)
Not taxable (Non Resident)

b) Foreign Professional Income where Profession is set up in India

Taxable (Ordinary Resident)
Taxable (Not Ordinary Resident)
Not taxable (Non Resident)

c) Any Other Foreign income

Taxable (Ordinary Resident)
Not Taxable (Not Ordinary Resident)
Not taxable (Non Resident)

3(b)

Topic : Accounting

Marks: 15

IndAS 16 "Property, plant and equipment" deals with provisions on accounting of depreciation.
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately.
An entity allocates the amount initially recognised in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. For example, it may be appropriate to depreciate separately the airframe and engines of an aircraft, whether owned or subject to a finance lease.
Similarly, if an entity acquires property, plant and equipment subject to an operating lease in which it is the lessor, it may be appropriate to depreciate separately amounts reflected in the cost of that item that are attributable to favourable or unfavourable lease terms relative to market terms.
The future economic benefits embodied in an asset are consumed by an entity principally through its use. However, other factors, such as technical or commercial obsolescence and wear and tear while an asset remains idle, often result in the diminution of the economic benefits that might have been obtained from the asset. Consequently, all the following factors are considered in determining the useful life of an asset:

(a) expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output.
(b) expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle.
(c) technical or commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset. Expected future reductions in the selling price of an item that was produced using an asset could indicate the expectation of technical or commercial obsolescence of the asset, which, in turn, might reflect a reduction of the future economic benefits embodied in the asset.
(d) legal or similar limits on the use of the asset, such as the expiry dates of related leases.

The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. The depreciation method applied to an asset shall be reviewed at least at each financial year-end and, if there has been a significant change in the expected pattern of consumption of the future economic benefits embodied in the asset, the method shall be changed to reflect the changed pattern. Such a change shall be accounted for as a change in an accounting estimate in accordance with Ind AS 8.

4(a)

Topic : Auditing

Marks: 15

Information and factors to be inquired during investigation on behalf of bank

Collection of information: Investigator is required to collect the information with respect to

Purpose for which the loan is required
Manner in which the borrower proposed to invest the amuont of the loan
Schedule of repayment of loan submitted by the borrower, particularly, the assumptions made therein as regards amounts of profits that will be earned in cash and the amount of cash that would be available for the repayment of loan to confirm that they are reasonable and valid in the circumstances of the case.
Financial standing and reputation for business integrity enjoyed by the director and officers of the company
History of growth and development of the company and its performance during the past five year.

Examination of Financial statements

Preparation of condensed income statement
Computation of relevant ratios
Break up of annual sale
Schedule of assets and liabilities: Schedule of asset is to be prepared to ensure their existence, ownership and proper valuation and to examine whether assets have been adequately insured, schedule of liabilities will assist in determining present and future obligations and ensure completeness of recording.

4(b)

Topic : Costing

Marks: 15

Normal Wastage: Normal wastage being a normal feature and arising in a process or operation usually through standard set for the normal percentage of visible and invisible wastes that may be anticipated to arise in various manufacturing processes or operations. Therefore, normal wastage should be regarded as part of the production cost. The good units in the process should absorb the cost of waste.

Treatment of Normal Loss in Process Accounts

For example, if in business of timber on the basis of their weight. It is sure that after cutting of tree, weight of wood will decrease. So, this loss is normal loss. In process account’s credit side, we just show the normal loss’s units. Now, our total produced units will decrease. This will decrease our cost of production in any process. For example: If total cost of process A is Rs. 10,000. When we produce 100 units in A process, we have checked that due to natural reasons, we have just 90 units. Now, in A Process Account, we will show 100 units in debit side and 10 units of normal loss in credit side without writing its amount. Due to this our total cost of Rs. 10,000 will of 90 units. It means, cost per unit has increased from Rs. 100 per unit to Rs. 111 per unit

Abnormal Wastage: It is in excess of the standard percentage of wastage set up to account for the normal wastage. The cost of abnormal waste should be excluded from the total cost and charged to Costing Profit and Loss Account. If any value is realized from the waste, the Process Account concerned may be credited.

Treatment of Abnormal Loss in Process Accounts

All those losses which happen due to abnormal reasons are called abnormal losses. Following are its main example.

1. If you use bad quality raw material in the production, there is big risk of wastage in production. So, use of bad quality raw material is the reason of abnormal loss.
2. Careless is also reason of abnormal loss. For example, due to the careless of worker, 5 units waste the products during production. So, loss of 5 units is the abnormal loss.
3. All those losses which are not normal will be the abnormal loss. For treating the abnormal loss in the process account, we need to calculate the value of abnormal loss.

a) When there is not any normal loss: Abnormal loss = Normal cost at normal production / normal output X units of abnormal loss
b) When there is normal loss

Abnormal loss = {Normal cost at normal production / (Total output – normal loss units)} X Units of abnormal loss. Example : In process A 100 units of raw materials were introduced at a cost of Rs. 1000. The other expenditure incurred by the process was Rs. 602 of the units introduced 10% are normally lost in the course of manufacture and they possess a scrap value of Rs. 3 each. The output of process A was only 75 units. Prepare process A account.

Abnormal effectiveness or Abnormal Gain: More output over the expected or normal output realized is called an abnormal gain. Abnormal gain arises because of an abnormal effective in the use of raw material or efficiency in performance so it is known as abnormal effective. Abnormal gain reduces the normal loss quantity so it comes in the form of profit to the industry. The value of an abnormal gain is assessed on the basis of production cost.

Method of determining the value of abnormal gain: Value of abnormal gain = (Normal cost of normal output/Normal output) Abnormal gain qty.

5(a)

Topic : Financial Management

Marks: 10

Pursuing a profit maximization strategy comes with the obvious risk that the company may be so entrenched in the singular strategy meant to maximize its profits that it loses everything if the market takes a sudden turn.
Expectation and Goodwill: We need to consider consequences of profit maximization.

If a company pursues a profit maximization strategy, it creates an environment where price is a premium and cutting costs is a primary goal.
This, in turn, creates a perception of the company that could lead to a loss of goodwill with customers and suppliers; for instance, a company may win subsequent contracts with a client by bidding the first job low.
It also creates an expectation of shareholders to see immediate gains, rather than realizing profits over time.

Some degree of profit maximization is always present.

The goal of a company is to create profits. It has to profit from its business to stay in business.
Moreover, investors and financiers in the company may require a certain level of profits to secure funds for expansion.

A company has to perform well for its shareholders; they expect a return on their investments. As such, maximizing that profit is always a consideration to some extent.

5(b)

Topic : Financial Management

Marks: 10

Definition of 'Risk Return Trade Off'

Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.

However, if he invests in equities, he faces the risk of losing a major part of his capital along with a chance to get a much higher return than compared to a saving deposit in a bank.

Risk and return are opposing concepts in the financial world, and the tradeoff between them could be thought of as the “ability-to-sleep-at-night test.” Depending upon factors like your age, income, and investment goals, you may be willing to take significant financial risks in your investments, or you may prefer to keep things much safer. It’s crucial that an investor decide how much risk to take on while still remaining comfortable with his or her investments.

Generally speaking, at low levels of risk, potential returns tend to be low as well. High levels of risk are typically associated with high potential returns. A risky investment means that you’re more likely to lose everything; but, on the other hand, the amount you could bring in is higher. The tradeoff between risk and return, then, is the balance between the lowest possible risk and the highest possible return. We can see a visual representation of this association in the chart below, in which a higher standard deviation means a higher level of risk, as well as a higher potential return.

It’s crucial to keep in mind that higher risk does NOT equal greater return. The risk/return tradeoff only indicates that higher risk levels are associated with the possibility of higher returns, but nothing is guaranteed. At the same time, higher risk also means higher potential losses on an investment.

On the safe side of the spectrum, the risk-free rate of return is represented by the return on U.S. Government Securities, as their chance of default is essentially zero. Thus, if the risk-free rate is 6% at any given time, for instance, this means that investors can earn 6% per year on their assets, essentially without risking anything.

One of the biggest decisions for any investor is selecting the appropriate level of risk. Risk tolerance differs depending on an individual investor’s current circumstances and future goals, and other factors as well.

For investors, the basic definition of “risk” is the chance that an investment’s actual return will be different from what was expected. One can measure risk in statistics by standard deviation. Because of risk, you have the possibility of losing a portion (or even all) of a potential investment. “Return,” on the other hand, is the gains or losses one brings in as a result of an investment.

Example, Rohan faces a risk return trade off while making his decision to invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh (currently the Deposit Insurance and Credit Guarantee Corporation in India provides insurance up to Rs 1 lakh).

5(c)

Topic : Financial Management

Marks: 10

A financial market brings buyers and sellers together to trade in financial assets such as stocks, bonds, commodities, derivatives and currencies. The purpose of a financial market is to set prices for global trade, raise capital, and transfer liquidity and risk. Although there are many components to a financial market, two of the most commonly used are money markets and capital markets.
Money markets are used by government and corporate entities as a means for borrowing and lending in the short term, usually for assets being held for up to a year. Conversely, capital markets are more frequently used for long-term assets, which are those with maturities of greater than one year.
Capital markets include the equity (stock) market and debt (bond) market. Together, money markets and capital markets comprise a large portion of the financial market and are often used together to manage liquidity and risks for companies, governments and individuals.

Capital Markets

Capital markets are perhaps the most widely followed markets. Both the stock and bond markets are closely followed, and their daily movements are analyzed as proxies for the general economic condition of the world markets. As a result, the institutions operating in capital markets – stock exchanges, commercial banks and all types of corporations, including non-bank institutions such as insurance companies and mortgage banks – are carefully scrutinized.
The institutions operating in the capital markets access them to raise capital for long-term purposes, such as for a merger or acquisition, to expand a line of business or enter into a new business, or for other capital projects. Entities that are raising money for these long-term purposes come to one or more capital markets. In the bond market, companies may issue debt in the form of corporate bonds, while both local and federal governments may issue debt in the form of government bonds.
Similarly, companies may decide to raise money by issuing equity on the stock market. Government entities are typically not publicly held and, therefore, do not usually issue equity. Companies and government entities that issue equity or debt are considered the sellers in these markets. (See also: What Are the Differences Between Debt and Equity Markets?)
The buyers (or the investors) buy the stocks or bonds of the sellers and trade them. If the seller (or issuer) is placing the securities on the market for the first time, then the market is known as the primary market.
Conversely, if the securities have already been issued and are now being traded among buyers, this is done on the secondary market. Sellers make money off the sale in the primary market, not in the secondary market, although they do have a stake in the outcome (pricing) of their securities in the secondary market.
The buyers of securities in the capital market tend to use funds that are targeted for longer-term investment. Capital markets are risky markets and are not usually used to invest short-term funds. Many investors access the capital markets to save for retirement or education, as long as the investors have lengthy time horizons. (For related reading, see Types of Financial Markets and Their Roles.)

Money Market

The money market is often accessed alongside the capital markets. While investors are willing to take on more risk and have patience to invest in capital markets, money markets are a good place to "park" funds that are needed in a shorter time period – usually one year or less. The financial instruments used in capital markets include stocks and bonds, but the instruments used in the money markets include deposits, collateral loans, acceptances and bills of exchange. Institutions operating in money markets are central banks, commercial banks and acceptance houses, among others.
Money markets provide a variety of functions for either individual, corporate or government entities. Liquidity is often the main purpose for accessing money markets. When short-term debt is issued, it's often for the purpose of covering operating expenses or working capital for a company or government and not for capital improvements or large-scale projects. Companies may want to invest funds overnight and look to the money market to accomplish this, or they may need to cover payroll and look to the money market to help.
The money market plays a key role assuring companies and governments maintain the appropriate level of liquidity on a daily basis, without falling short and needing a more expensive loan or without holding excess funds and missing the opportunity of gaining interest on funds. (See also: Money Market Instruments.)
Investors, on the other hand, use money markets to invest funds in a safe manner. Unlike capital markets, money markets are considered low risk; risk-averse investors are willing to access them with the anticipation that liquidity is readily available. Those individuals living on a fixed income often use money markets because of the safety associated with these types of investments.

5(d)

Topic : Financial Management

Marks: 10

Methods used in determining exchange ratio in Merger

A. Net Asset Value (NAV) approach is the most popular and easy approaches of valuation. There are two methods within the NAV approach.

i) NAV at Book Values: This approach involves determining value of the company on the basis of value of the assets and liabilities as disclosed in its Balance Sheet. This is a conservative approach of valuation and is treated as the minimum value for any transaction.

ii) NAV at Market Values: Most companies have investments in marketable securities, inventory or fixed assets and the value of such assets is substantially higher than their Book Values. Book value therefore does not provide the correct estimate of the NAV. In this method, the market value of these assets is substituted for determining the NAV.

B. The Income Approach is based on the future earnings that are available for distribution to the equity holders. The Income based approaches are explained in detail

i) Profit Earning Capacity Value (PECV): It is one of the traditional methods of business valuation whereby maintainable future profits after tax, which are ascertained on the basis of past earnings, are discounted using a suitable discounting factor and capitalized on the basis of a standard Price Earnings Ratio.

ii) Discounted Cash Flow (DCF) Method

C. The Market Price Method evaluates the share price on the basis of weighted average rate of the transactions entered on the stock exchanges. This rate is considered as indicative of the value perception for the shares by investors operating under free market conditions. This method may not be of use in case of shares of a Company which are not listed or not frequently traded on the stock exchanges.

D. The Liquidation method of valuation relates to the special condition when a company has to liquidate part or all of its assets and claims. Under a situation of business failure or intense pressure from creditors, the management will find that the liquidation value is considerably lower than the potential market value. As a consequence, liquidation value is normally applicable only for the limited purpose intended. In case of going concerns, this method is not considered.

5(e)

Topic : Financial Management

Marks: 10

Walter’s model:

Professor James E. Walter argues that the choice of dividend policies almost always affects the value of the enterprise.
His model shows clearly the importance of the relationship between the firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

The firm finances all investment through retained earnings; that is debt or new equity is not issued;
The firm’s internal rate of return (r), and its cost of capital (k) are constant;
All earnings are either distributed as dividend or reinvested internally immediately.
Beginning earnings and dividends never change. The values of the earnings pershare (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value.
The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:

= D/K + (r(E-D)/K)/k

The above equation clearly reveals that the market price per share is the sum of the present value of two sources of income:

i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K]/K

We are assuming that all equity earnings are paid as dividend
So PV of the firm = Earnings / K, simply substituting dividend with earnings and cost of equity K with r the rate of return.
Earnings are having two components one part is paid as dividend and second part is retained, so Earnings = Dividend + Retained earnings
Retained earnings are invested hence generates a return, let’s suppose it as “r”, so returns on retained earnings will be r x retained earnings.
As this return is perpetual, the present value of the return on retained earnings will be
Retained earnings x r / K, which is rate we use to discount cash flows.
So substituting the same will give
PV of the firm = (Dividend + r x retained earnings / K) / K, as retained earnings is nothing but Total earnings - Total dividend paid, the above equation is written as
PV of the firm = (Dividend + r x (Total earnings - Total dividend paid / K) / K
Market price of a share = Dividend per share + return on firm investments x (earnings per share – dividend per share) / cost of equity) / Cost of equity.

6(b)

Topic : Financial Management

Marks: 15

SEBI is regulator to control Indian capital market. Since its establishment in 1992, it is doing hard work for protecting the interests of Indian investors. SEBI gets education from past cheating with naive investors of India. Now, SEBI is more strict with those who commit frauds in capital market.

The role of security exchange board of India (SEBI) in regulating Indian capital market is very important because government of India can only open or take decision to open new stock exchange in India after getting advice from SEBI.

Role of SEBI in regulating Indian Capital Market more deeply with following points:

Power to make rules for controlling stock exchange : SEBI has power to make new rules for controlling stock exchange in India. For example, SEBI fixed the time of trading 9 AM and 5 PM in stock market.
To provide license to dealers and brokers : SEBI has power to provide license to dealers and brokers of capital market. If SEBI sees that any financial product is of capital nature, then SEBI can also control to that product and its dealers. One of main example is ULIPs case. SEBI said, " It is just like mutual funds and all banks and financial and insurance companies who want to issue it, must take permission from SEBI."
To Stop fraud in Capital Market : SEBI has many powers for stopping fraud in capital market. It can ban on the trading of those brokers who are involved in fraudulent and unfair trade practices relating to stock market. It can impose the penalties on capital market intermediaries if they involve in insider trading.
To Control the Merge, Acquisition and Takeover the companies :Many big companies in India want to create monopoly in capital market. So, these companies buy all other companies or deal of merging. SEBI sees whether this merge or acquisition is for development of business or to harm capital market.
To audit the performance of stock market : SEBI uses his powers to audit the performance of different Indian stock exchange for bringing transparency in the working of stock exchanges.
To make new rules on carry - forward transactions : Share trading transactions carry forward can not exceed 25% of broker's total transactions. 90 day limit for carry forward.
To create relationship with ICAI : ICAI is the authority for making new auditors of companies. SEBI creates good relationship with ICAI for bringing more transparency in the auditing work of company accounts because audited financial statements are mirror to see the real face of company and after this investors can decide to invest or not to invest. Moreover, investors of India can easily trust on audited financial reports. After Satyam Scam, SEBI is investigating with ICAI, whether CAs are doing their duty by ethical way or not.
Introduction of derivative contracts on Volatility Index : For reducing the risk of investors, SEBI has now been decided to permit Stock Exchanges to introduce derivative contracts on Volatility Index.
To Require report of Portfolio Management Activities : SEBI has also power to require report of portfolio management to check the capital market performance. Recently, SEBI sent the letter to all Registered Portfolio Managers of India for demanding report.
To educate the investors : Time to time, SEBI arranges scheduled workshops to educate the investors. On 22 may 2010 SEBI imposed workshop. If you are investor, you can get education through SEBI leaders by getting update information on this page.

6(c)

Topic : Financial Management

Marks: 15

Meaning of Capital Rationing:

Capital rationing is a situation where a constraint or budget ceiling is placed on the total size of capital expenditures during a particular period. Often firms draw up their capital budget under the assumption that the availability of financial resources is limited.
Capital rationing refers to the selection of the investment proposals in a situation of constraint on availability of capital funds, to maximize the wealth of the company by selecting those projects which will maximize overall NPV of the concern.

Factors Leading to Capital Rationing:

Two different types of capital rationing situation can be identified, distinguished by the source of the capital expenditure constraint.

External Factors:

Capital rationing may arise due to external factors like imperfections of capital market or deficiencies in market information which might have for the availability of capital.
Generally, either the capital market itself or the Government will not supply unlimited amounts of investment capital to a company, even though the company has identified investment opportunities which would be able to produce the required return. Because of these imperfections the firm may not get necessary amount of capital funds to carry out all the profitable projects.

Internal Factors:

Capital rationing is also caused by internal factors which are as follows:

Reluctance to take resort to financing by external equities in order to avoid assumption of further risk.
Reluctance to broaden the equity share base for fear of losing control.
Reluctance to accept some viable projects because of its inability to manage the firm in the scale of operation resulting from inclusion of all the viable projects.

Situations of Capital Rationing:

Capital rationing decisions can be studied under the following situations:

Situation I – Projects are Divisible and Constraint is a Single Period One. The following are the steps to be adopted for solving the problem under this situation:

(a) Calculate the profitability index of each project.
(b) Rank the projects on the basis of the profitability index calculated in (a) above.
(c) Choose the optimal combination of the projects.

Situation II: Projects are Divisible and Constraint is Multi-period one:

Under this situation, the problem of capital rationing can be solved with the help of linear programming. It is a mathematical programming approach.

7(b)

Topic : Financial Management
Marks: 15

Technique # 1. Ratio Analysis for Control of Receivables:

The analysis of receivables can be done with the help of ratios given below for efficient management of debtors balances:

(a) Debtors Turnover Ratio

(b) Average Credit Period (in days)

(d) Debtors to Total Assets Debtors

(e) Bad Debts to Sales

(f) Bad Debts to Debtors:

The above formulae can be used to analyze the efficiency in management of receivables and to analyze the trend over a period of time.
Ageing Schedule: The ageing schedule of debtors is prepared basing on the collection pattern. The total debtors balances are classified according to their age i.e. the outstanding period for which the amount is uncollected. The ageing schedule provides useful information for assessing the company’s liquidity position, efficiency of credit control department, efficiency in collection of receivables, comparison with previous ageing schedules etc.
The age analysis of debtors may be used to help decide what action to take about older debts. For better control on collection of receivables, ageing schedule is prepared and analyzed for identifying the overdue amounts. Ageing schedule of receivables is prepared according their period of outstanding, for example, less than 30 days, 31-45 days, 46 – 60 days, 61-75 days, 76-90 days, above 90 days etc.
The ageing schedule of debtors can be prepared manually or by computer. Preparation of the schedule requires to go back to the date on which invoice is raised. The schedule is used for identifying the quality accounts, overdue accounts and trouble some accounts. The age schedule can also incorporate the details of individual accounts, region wise accounts, industry sector wise accounts etc.

Technique # 2. ABC Analysis of Receivables:

The ABC analysis technique mainly framed for effective control of inventory. The application of the same technique to manage the debtors balances will also give good results for the firm with huge number of accounts.

Technique # 3. Discriminate Analysis and Credit Scoring:

Discriminate Analysis: It is an important tool used for discriminating between good and bad accounts taking into account the readily available information from financial data relating to size of firm, acid test ratio, creditors payment period etc.

Credit Scoring: It is a technique used in discriminating between good and bad accounts based on past repayment and default experience relating a particular customer. The credit scoring is given for each such customer and credit facility is extend if he exceeds the cut-off score.

Technique # 4. Credit Utilization Report:

The total limit of credit offered to each customer and the extent to which it is utilized will be reviewed on periodical basis to observe the extent to which total limits being utilized. All this information is presented in a report form called ‘credit utilization report’.

Technique # 5. Cost-Benefit Analysis of Collection Expenses:

A firm has to incur some routine costs like sending reminders, telephone expenses, expenses incurred for personal visits to customers’ places, commission and fees payable to collection agencies, legal expenses etc. Economic of Collection Expenses and Bad-Debt Losses: When the firm incurs more costs on collection of debts, there is likely to be less amount of debts turn into bad debts and vice versa. If the firm goes on increasing the cost of collection of debts, after- some point, there would not be further decrease of bad debts. The point is called ‘saturation point’ as shown in figure 16.1, if the firm incurs collection expenses beyond this point, cannot benefit the firm in reducing its bad-debt losses.

Technique # 6. Measuring Day’s Sales in Terms of Debtors:

The total debtor represented by day’s sales is calculated in the following three ways:
Debtors Turnover Method: The days sales in debtors ratio represents the length of the credit period taken by customers.
Count Back Method: This method is based on the assumption that the debtors balance relating to the most current period sales.
Partial Month Period: This method analyses each months sales and the unpaid portion. These are aggregated together to get days sales of debtors.

7(c)

Topic : Financial Management
Marks: 15

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days.
Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.

The issuing firm should have a tangible net worth of not less than Rs.4 crore as per the latest balance sheet.
The firm should have working capital limit of not less than Rs.4 crore.
The current ratio should be minimum 1.33 as per the latest balance sheet.
The firm should have minimum P2/A2 rating from CRISIL/ICRA/CARE or any other credit Rating Agency for the purpose. The rating should not be more than two months old from the date of issue of the Commercial Paper.
The borrowing account of the firm is classified as standard assets by financing banking company / companies.

Conditions for issuing Commercial Papers in India

No Commercial Paper can be issued for a period less than 15 days from the date of its issue. There is no grace period for payment of Commercial Papers. The RBI has increased the maturity period of the Commercial Papers from a maximum of 6 months to a maximum of less than 1 year period from the date of its issue.
There is, however, reluctance on the part of investors, especially banks to invest in less than 1 year Commercial Paper because of the absence of a secondary market. Commercial Paper may be issued to any person including individuals, banks and other corporate bodies registered/incorporated in India and unincorporated bodies. It cannot, however, be issued to NRI’s.
A firm issuing Commercial Paper may request the banker to provide standby facility for an amount not exceeding the amount of issue for meeting the liability of Commercial Paper on maturity. The financing banker shall correspondingly reduce the working capital limits of every firm issuing the Commercial Paper.

Norms for Issuing Commercial Papers in India

As per the guidelines issued by RBI, a firm will issue Commercial Papers through same bank/consortium of banks from whom it has a line of credit. In other words, instead of making loans and advances, the bank will deal in the issue.
Another underlying issue is the time dimension. The firms applying for issue of Commercial Paper to RBI have to obtain credit rating, which should not be more than two months old. This implies that firm intending to issue Commercial Paper has to obtain a fresh rating if time lapses.
Besides, once the RBI approves a firm’s application, it has to make arrangement within 15 days for placing the CP privately.

8(b)

Topic : Financial Management
Marks: 15

An optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one that offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility; however, it is rarely the optimal structure since a company's risk generally increases as debt increases.
According to E. Solomon, the same is defined as ‘that capital structure or combination of debt and equity that leads to the maximum value of the firm’. Thus, we cannot ignore the importance of capital structure of a firm as we believe that there is a clear relationship between the value of the firm and the capital structure although some others do not accept it.

Considerations:

In order to ascertain the amount of optimum capital structure, the following considerations will assist a finance manager:

(a) Advantage of Corporate Taxes:

A finance manager may take the opportunity of utilising the financial leverage through corporate taxes. We know that debt financing is less costly than equity financing due to the allowances prescribed by the corporate tax authorities.

Since the equity financing involves higher cost, the same can be avoided for raising finance. The ultimate benefit will be enjoyed by the equity shareholders, i.e. Trading on Equity.

(b) Advantage of Financial Leverage:

If the return on investment is comparatively higher than fixed cost of funds, a finance manager may go for raising fund although there is a fixed cost of finance, as the equity shareholders will, ultimately, be benefited.

If the proportion of debt capital is more than owned capital the same will invite risk; as a result the prices of share in the open market will go down due to high risky proposition of capital structure. In other words, highly geared capital structure is always risky.

Thus, a finance manager must not go for raising further finance through borrowings under such circumstances. That is, whether a firm should prefer debt-financing or equity financing, the decision depends on the optimum capital structure of a firm.

(d) Advantages of Debt-Equity Mix:

A finance manager may take the advantage of debt-equity mix in the composition of capital structure in order to ascertain the optimum capital structure of a firm. Once the optimum capital structure is attained, a finance manager is free from financial hazards. Thus, the ultimate goal of a finance manager is to see that the proper utilisation of debt-equity mix has been attained.

8(c)

Topic : Financial Management
Marks: 15

(i) Debt equity ratio

Debt-to-equity ratio measure of a company's ability to repay its obligations. When examining

the health of a company, it is critical to pay attention to the debt/equity ratio. If the ratio is

increasing, the company is being financed by creditors rather than from its own financial sources

which may be a dangerous trend. Lenders and investors usually prefer low debt-to-equity ratios

because their interests are better protected in the event of a business decline.

A high debt/equity ratio generally means that a company has been aggressive in financing its

growth with debt. This can result in volatile earnings as a result of the additional interest

expense.

If a lot of debt is used to finance increased operations, the company could potentially generate

more earnings than it would have without this outside financing. If this were to increase

earnings by a greater amount than the debt cost (interest), then the shareholders benefit as

more earnings are being spread among the same amount of shareholders. However, the cost of

this debt financing may outweigh the return that the company generates on the debt through

(ii) Acid test ratio

Acid Test or Liquid Ratio or quick ratio, is a more rigorous test of liquidity than the current ratio. The term ‘liquidity’ refers to the ability of a firm to pay its short-term obligations as and when they become due. The two determinants of current ratio, as a measure of liquidity, are current assets and current liabilities.

Current assets include inventories and prepaid expenses which are not easily convertible into cash within a short period. Quick ratio may be defined as the relationship between quick/liquid assets and current or liquid liabilities. An asset is said to be liquid if it can be converted into cash within a short period without loss of value.

The quick ratio is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio.

(iii) Inventory turnover Ratio

As a general rule, the higher the inventory turnover ratio, the more efficient and profitable the firm. A high ratio means that the firm is holding a low level of average inventory in relation to sales. Holding inventory means money tied up in stock. This money is either borrowed and carries an interest charge, or is money that could have earned interest in a bank. Furthermore, items in inventory carry storage cost, and carry the risk of getting spoiled, breaking, being stolen, or simply going out of style.

(iv) Operating profit ratio

A company with higher operating margin ratio is financially sound. It can easily pay its fixed costs and interest on the debt.

A company with good operating ratio can successfully survive during the economic crisis.

Only a company with higher operating margin ratio can successfully compete with the competitors by lowering the price of products to such level that competitors will not be able to survive.

(v) Current ratio

Current Ratio = Current Assets / Current Liabilities

The higher the current ratio, the more capable the company is of paying its obligations, as it has a larger proportion of asset value relative to the value of its liabilities. However, a high ratio (over 3) does not necessarily indicate that a company is in a state of financial well-being either. Depending on how the company’s assets are allocated, a high current ratio may suggest that that company is not using its current assets efficiently, is not securing financing well, or is not managing its working capital well. To better assess whether or not these issues are present, a liquidity ratio more specific than the current ratio is needed

We can determine the short term liquidity of a business concern using the Current ratio. An increase in the current ratio represents improvement in the liquidity position of a business concern and wise versa. As a banker’s rule of thumb, the standard for current ratio is 2:1.

(Solutions of practical questions will be updated by 20th June 2018)

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