Engineering Economics and Financial Accounting (EECA)

Unit-1
Framework:

Basic Economics

Definitions of Economics
Nature and Scope of Managerial Economics
Basic Terms and Concepts
Goods
Utility
Wealth
Factors of Production
Land its Peculiarities
Labour
Economies of Large and Small Scale
Consumption
Law of Diminishing Marginal Utility
Demand
Demand Schedule and Demand Curve
Law of Demand
Elasticity of Demand
Types of Elasticity
Factors Determining Elasticity and its Measurement and Significance
Supply
Supply Schedule and Supply Curve
Law of Supply
Elasticity of Supply
Time Element In the Determination Of Value
Perfect Competition
Monopoly
Monopolistic Competition
Wants
Relation Between Economic Decision and Technical Decision
Market Price and Normal Price

Definitions of Economics:

Economics is defined as a body of knowledge or study that discuses how a

society tries to solve the human problems of unlimited wants and scare
resources.
Adam Smith (1723-1790) hailed as the father of economics defines as An
enquiry in to the nature and causes of wealth of nations.
Lionel Robbins (1898-1984) defines as The science which studies human
behavior as a relationship between ends and scare means which have alternative
uses.
Economics is a social science, since it deals with the society as a whole and
human behavior in particular and studies the production, distribution and
consumption of goods and service.
According to Keynes defines as The theory of economic does not furnish a
body of settled conclusions immediately applicable to policy. It is a method
rather than a doctrine, an apparatus of the mind, a technique of thinking, which
helps the processor to draw correct conclusions.
Two basic assumptions are Ceterius Paribus and Rationality. Where ceterius
paribus means With other things being same or all other things being equal.
The term most used in isolating description of particular event from other
potential environmental variables. And rationality means consumers and
producers measure and compare the costs and benefits of a decision before
going ahead. Example: whether eating at home is cheaper than going to
restaurant; whether the owner of the firm also acts as the manager the firm;
whether to train the existing workers or to train new workers for the newly
opened unit of a firm and so on.
Thus rationality involves making a choice that gives the greatest benefit relative
to cost. All of conventional theory rests on the assumptions that consumers and
producers all behave rationally, while firms aim at maximizing profit and
minimizing costs, consumers aim at minimizing utility and maximizing
sacrifice.
Types of Economics:
1. Micro and Macro ( Micro means small and Macro means large economies)
2. Positive and Normative (Factual by nature and while with normative concerned
with questions involving value judgments. It is what ought to be in economic
matters)
3. Short and Long Run (Time not enough for producers and consumers to adjust
completely to new situation.)
4. Partial and general ( Its a planning horizon in which consumers and producers can
adjust to any new situation.
2

 Managerial Economics: Means to an end to managers in any business, in terms of finding

the most efficient way of allocating scare organizational resources and reaching stated
objectives.
Nature and Scope of Economics:
Some six main scope of economics are:
1.
2.
3.
4.
5.
6.
1.

2.

3.

4.

5.

6.

Demand Analysis and Forecasting

Cost Analysis
Production and Supply Analysis
Pricing decisions, Policies and procedures
Profit management
Capital Management

Demand Analysis and Forecasting:

A business firm is an economic organism which transforms productive
resource in to goods that are sold in a market. Demand analysis and therefore is
essential for business planning and occupies a strategic place in managerial
economics. Mainly consist of discovering the forces determining sales and
their measurement.
Cost Analysis:
A study on economic cost combined with the data drawn from the firms
accounting records can yield significant cost estimates that are useful for
management decisions.
Production and supply Analysis:
Production analysis is a narrower scope than cost analysis. Production Analysis
frequently proceeds in physical terms while cost analysis proceeds in monetary
terms. While supply analysis deals with various aspects of supply of a
commodity. Certain important aspects of supply analysis are Supply schedule,
curves, and function, Law of Supply, and its limitations, elasticity of supply
and factors influencing supply.
Pricing Decisions, Policies and Practices:
Very important area of managerial economics. In fact price is the genesis
(Beginning) of the revenue of a firm and as such the success of a business firm
largely depends on the correctness of the price decisions taken by it.
Profit Management:
Business Firms are generally organized for the purpose of making profit and in
the long run, profits provide the chief measure of success. The important aspect
covered under this area is: Nature and Measurement of profit planning like
break even analysis.
3
Capital Management:

The most complex and troublesome for the business manager are likely to be
those relating to the firms capital investments. The main topics dealt with are
Cost of Capital, rate of Return and Selection of projects.

Basic Terms and Concepts:

Marshall Definition: (welfare Definition)
-

Alfred Marshall (1842-1924) was the first economics who saved this
science from ridicule, condemnation (Disapproval) and misunderstanding. He
recognized the weakness of the wealth definition. He corrected the mistakes of
classical writers. He formulated a new definition of economics by shifting the
emphasis (Stress) from wealth to welfare.
According to Marshall, Man is Primary and Wealth is secondary. Wealth is
only a means for an end, the end being welfare of the mankind. So economies
studies man first and then wealth in order to increase his welfare.
Prof. Lionel Robbins defines as Science which studies human behavior as
a relationship between end and scare relationship which have alternative uses.
Based on certain assumption as Man has unlimited wants, means (resources) to
satisfy these wants are scare. Means are not only limited ,but are capable of
alternative uses.

Goods:
-

Goods and services have to be produced with the help of factors of

production. So production is another important branch of economics.
Goods produced by one are exchanged for the goods produced by the other.
So exchange forms another important branch of economics. Goods and
services are produced with efforts.

Utility:
-

According to Stanley Jevons was the first economist who conceived the
concept of Utility. Like other economists, Jevons was also confronted with
the problem of determining the fundamental basis of demand and came to the
conclusion that is the ability of a commodity to satisfy demand that constitutes
the basis for demand.
It is the want satisfying power of a Commodity or a service, which
determines the demand for commodity. Jevons called this as Utility
Two main types of utility are Cardinal and Ordinal utility and Total and
Marginal Utility.
4

Cardinal and Ordinal Utility:

1. There are 2 basic approaches to discus the consumer demand theory.

This one is called classical approach in which utility (satisfaction)
has been made measurable. This is called cardinal utility approach.
2. The second approach dispenses with measurement of utility pr
comparing utility in quantities as this is not a realistic one and takes
up the analysis of the preference of the consumer.
3. The terms Cardinal and Ordinal have been taken from
Mathematics. The numbers 1,2,3,4, etc are cardinal in the sense
that the number 2 is twice the size of number 1 and number 4 is
twice the size of number 2.For example orange may yield to a
consumer utility of 10 units wheres a banana yields 20 units. From
this it is clear that the consumer derives twice as much utility from a
banana from a orange. The units of measurement are made purely
imaginary and the cardinalists termed this imaginary unit of as utils.
4. In contrast, the ordinals are 1st, 2nd, 3rd, 4th, etc. It is not possible from
the ranking, to know the actual size of the related numbers. The 2nd
need not be twice as that of first nor the 4th twice as that of the 2nd.
The Sixe may be of any pattern say 1st, 2nd, 3rd, 4th could be 10, 15,
25, or 10, 30, 45, or 55, 65, 95 etc According to ordinals, utility
being a subjective and mental concept cannot be measured and to
qualify utility is absurd. They contended that the theory of consumer
behavior can be explained or analyzed even without measuring
utility as cardinalists do. Hence cardinal approach come to be known
as Marshalian utility analysis and the ordinal approach is called
Hicksian indifference approach.

Concepts of Total and Marginal Utility:

-

Marginal utility is defined as the change in total utility resulting from one
unit change in the consumption of the goods in question per unit of time. To
put it shortly, total utility is the total satisfaction derived in consuming all the
quantities of a commodity in possession or purchased. Ex: Suppose consumer
purchases a packet of biscuits. Total utility or satisfaction derived refers to the
utilities of all biscuits in the packet. If all biscuits in the packet are alike, the
marginal utility may be represented as follows, assuming there are m units of
biscuits in the packet.
5

Marginal utility = Total Utility of M units of biscuits minus total utility of

(m-1) units of biscuits. Suppose consumer n units of oranges, the marginal
utility are the difference between total utility of n units and (n-1) units. In
general, we can say that marginal utility is the difference between total utilities
of n units of a commodity and (n-1) units or (n+1) units of the commodity.

Marginal utility is the rate of change of total utility caused by a small given
change in the quantity of a commodity.
This can be expressed by using formula mathematically
MUx = Dux
Dqx

Where MUx is the marginal utility of a commodity X. Dux is the

change in the total utility of X, Dqx stands for the change in the total
quantity of X.

Marginal Utility Analysis (Cardinal):

-

The principle behind the law of diminishing marginal utility is that as wet
more of a thing, the intensity of our desire for that thing diminishes or tends to
diminish.

According to this law, as a person purchases more and more units of a

commodity, its marginal utility decreases. Prof. Boulding defines the law if
diminishing marginal utility in the following words: As a consumer increases
the consumption of any one of the commodity keeping constant the
consumption of all other commodities.
Illustration of the Law:
Suppose a man is hungry, a loaf of bread will give him immense pleasure as it
has great utility for him. The second loaf though agreeable to him would not
give him as much as the satisfaction as the first one. This means utility of the
second loaf would be less than first loaf. If he consumes the third loaf, it would
give him some satisfaction or but not extent of the previous loaf. So with the
fourth, fifth, and sixth loves of bread goes on diminishing. This can well
illustrated by using utility table.

Number of Loaves

Marginal Utility

Total Utility

20

20

16

36

12

48

56

60

60

-4

56

From the utility table, it is clear that the total utility (sum of the utilities of
all the units consumed) goes on increasing and after a certain state begins to decline. The
marginal utility (addition made to the total utility) on the other hand goes on diminishing till it
reaches zero and then it becomes negative. So long as the marginal utility is tending towards
zero, the total utility is increasing and it is at the maximum when the marginal utility is zero and
afterwards it declines.
The relationship between total utility and marginal utility can be illustrated
by means of a graph based on the utility table given.
90

90

80

80

40
30

98

40
20

20
10
0
1

The successive units of the commodity consumed are represented in X

axis and utility in units are represented in Y axis. With the help of the
data available in the utility table, the total utility and marginal utility at
various levels of consumption are pointed and then the total utility and
marginal utility curve are drawn. As the figure shows, total utility curve
ascends, reaches the maximum point at the fifth and sixth units of
consumption and then begins to decline. Marginal utility declines and it
comes to zero at the consumption of sixth unit and afterwards it becomes
negative.
Factors of Production:
Land its Peculiarities
Labour
Land its Peculiarities:
Land in economies means all those animate or inanimate which are given by
nature freely and are helpful in production. Thus it includes the soil, the
properties of soil, natural elements like air, rainfall, heat, and sunshine water on
the surface and below the surface of the earth, including various minerals and
numerous gifts of nature which man puts in economic use.
Land may be called Nature minus Man. Hence Marshall defined land as the
material and the forces which Nature gives freely for mans aid in land and
water, in air and light and heat. In economic sense, Land means Natural
Resource.
Labour:
Labour and Organization are animate factors of production. Labour has
been defined as any exertion or mind or body undergone partly or wholly with
a view to some good, other than the pleasure derived directly from the work.
Labour includes all the highest professional skill are as well as unskilled
workers and artisans and of those employed in all fields of activity like
education, science, administration, fine arts etc.

Wealth:
-

Adam Smith defined Economics as science of wealth. Economists define

wealth as one that has Value in use and Value in exchange. Economists
also state that wealth should be scarce. How far is this definition scientific?
Accountancy is another branch of science that deals with forms of wealth.
Hence a consensus is required as to what forms a wealth.

Law of Conservation of Wealth on the lines of Law of Conservation of

Mass and Law of Conservation of Energy.

When wealth changes one/more form/s to one more form/s the value of
transferor form of wealth equals value of transferee form of wealth and it can
be further deduced that wealth can neither be created nor be destroyed but can
be changed from one form to the other.
10

Demand ;
-

Defined as a desire for a commodity backed by willingness and ability to

pay a price. And is always relates to price. The desire for the commodity
should be backed by necessary purchasing power. (Money). 3 types of demand
are Recurring and Replacement demand, Direct and Derived demand,
Complementary and Competing Demand.

Demand Schedule and Demand Curve:

-

1.

Demand schedule is the table for statement showing how much of a

commodity is demanded (Purchased) in a particular market at different prices.
A demand schedule is one of the Alfred Marshalls contributions to the
techniques of price theory.
A demand schedule that states relationship between Price and the quantity
demanded.
Statement showing the quantity demanded of a commodity is called
demand schedule of a commodity.

Table: Demand Schedule for Coffee:

Point on Demand Curve

Price (Per Cup)

Demand (1000 Cups)

15

50

20

40

25

30

30

15

35

10

2. Demand Curve:
The demand curve shows the relationship between price of a good and the
quantity demanded by consumers.

It is the graphical presentation of the demand schedule of any commodity. It

is customary to plot the quantity demanded on the horizontal axis and the price
on the vertical axis.
11
D

Price
10
15
D
15

50

Qty

Shifts in demand Curve:

-

Shift in demand curve due to a change in any of the factors other than price
is a change in demand.
Movement along the same demand curve is known as a contraction or
expansion in quantity demanded, which occurs due to rise or fall in price of the
commodity, where a shift of demand curve due to change in any of the factors
other than the price such as income taste and preference or prices of other
goods is known as change in demand.

Table: Demand Schedule for Coffee with Increased Income:

Point on Demand
Curve

Price (Rs Per Cup)

15

Demand (000 Cups)

Monthly Income
(20,000)
50

Demand (000 Cups)

Monthly Income
(30,000)
60

A
B

20

40

50

25

30

40

30

15

25

35

10

15

The below figure shows the phenomenon assuming that earlier monthly income of
consumers was Rs 20,000 and now increased to Rs 30,000.
12

Price

D2

D1

25
D2

20

30

D1

40

When the consumers income increases from 20,000 to Rs 30,000, it

increases their purchasing power with no change in price. Now at the same price of Rs 25, the
consumer can buy more of coffee just because of increased income. So at the same price,
quantity demanded changes from 40 to 30. This causes the demand curve shift to the right from
DD to D1D. Alternatively, if the income of the consumer falls, at the same price, the demand
falls from 40 to 30 thousand cups. The demand curve for coffee shop shifts from DD to D2D2.
A situation like this happens when the prices of other related goods
change. When the price of the complement rises (Milk), the demand for goods under
consideration falls. so the demand curve shifts to the left.
Law of Demand:
-

The law of demand states that demand for a product is inversely proportional
to its price.

It states Other things remaining constant. When the price of the commodity
rises, the demand for that commodity falls and when price of the commodity
falls, the demand for that commodity rises. In other words Demand for a
product is inversely proportional to its price. The formula is Dx = a-bPx.

Elasticity of Demand:
-

States as direction of change. The relationship between the small changes in

price and consequent changes in amount demanded is known as elasticity of
demand.

States as the rate of change. The elasticity of demand shows the extent of
response in demand to change in price.
13

 Types of Elasticity of Demand:

-

Price Elasticity of Demand

Income Elasticity of Demand

Cross elasticity of Demand

1. Price Elasticity of Demand:

-

Defines elasticity as the ratio of relative change in quantity to a relative change in

price. If E stands for elasticity, then
E = Relative change in quantity
Relative change in price

Price elasticity of demand is the ratio of proportionate change in quantity

demanded of a commodity to a given proportionate change in its price. This means
E = Proportionate change in quantity demanded
Proportionate change in price
E = Change in the quantity demanded
Quantity Demanded

Ep=

q /

q /p
q

Ep =

Price

q
=

/ Change in Price

q /p
P

Where ep stands for price elasticity

Q Stands for quantity
P Sands for Price
Stands for small change.
E or Elasticity of demand in the calculations is also called coefficient of elasticity of demand. If E is
greater than one, the demand is said to be elastic. If E is less than one, the demand is said to be unity.

14
Divided in to five main types:
1. Perfectly or Infinity elasticity Demand
2. Perfectly Inelastic Demand
3.

Relatively Elasticity Demand

4. Relatively Inelasticity Demand

5. Unit elasticity Demand
1. Perfectly or Infinite Elasticity of Demand:
-

This is a condition in which a very small change in price will result in

infinitely large response in the demand. A small rise in price may result in the
contraction of demand even to zero and a small drop in price may result in
extension of demand of unimaginable quantity. Hence the type of elasticity is
called perfectly elastic or infinite demand. Where E =
Y

Price

P D

Quantity

2. Perfectly Inelastic Demand:

-

This is a case in which the response in demand to change in price is almost nil.
Even a large fall in price will not induce the quantity of demand to be more, nor will a
large rise in price prevent the consumers from buying less. The demand is inert
(Static) to the changes in price. In this case E = 0.
D2
Price

D
Qty
15

The demand curve DD2 shows that a fixed quantity will be purchased whatever changes take
place in price. The curve is vertical showing no change in quantity demanded.
3 Relatively elastic Demand:
-

This refers to a condition when a small change in price will lead to very big change
in the quantity demanded. In this case E > 1. Hence it is called elastic demand. And to
be more precise, it is relatively a elastic demand. A small fall in price of luxury or
comfort commodity will expand for that commodity largely. Similarly rise in price
will contract the demand. The figure depicts the relative elastic nature of demand
curve.

P
Price

P1

D2

X
M

M1

The demand curve DD3 is rather flatter where the slope is not steep, but
gentle, showing that the quantities demanded are larger to a change in price. The drop
in the from P to P1 has resulted in extension of demand from M to M1 which is
comparatively larger than the fall in price. Hence the demand is said to be relatively
elastic.
4. Relatively Inelastic Demand:
- This is with reference to situations where a larger change in the quantity demanded. In
this case E < 1. Hence it is called inelastic demand. Many commodities which are necessaries of
life will have inelastic demand as they are essential requirements. In the case of inelastic demand,
the demand curve will be steeper as shown in figure. The demand curve DD4 is steeper showing
that in spite of steep fall in price the quantity demanded has gone up only very little. For a price
change of P1P2 the quantity has changed from X1X2 which is smaller than P1P2.

16

D
P1
Price
P4

X1 X2

Qty

5. Unit Elasticity Demand:

- This is a case in which the change in price will result in exactly equal change in the
quantity demanded. If both are equal then E = 1 and the elasticity is said to be unitary. The figure
indicates the unit elasticity.
D

Price P
P5

D5

B
Qty

Factors Determining Elasticity and its Measurement and Significance:

- Some 8 main factors influencing demand are
1. Nature of Commodity
2. Uses of Commodity
3. Existence of Substitutes
4. Postponement of Demand
5. Amount of Money Spent
6. Habits
7. Range of Prices of Commodity 8. Time Factor in Elasticity
17

1. Nature of Commodity:

2.

The elasticity of demand depends on whether a commodity is necessary of

life such as rice, wheat, salt etc

On the other hand, the demand for comforts and luxurious may not have
inelastic demand. When the prices of these fall, generally, more of the
commodities will be demanded. Hence the elasticity on the basis of nature of
commodity can be studied only on a comparative basis.

Uses of Commodity:
-

If the commodity has only one use, a change in price will not effect the
demand much and so it will have inelastic demand. If the commodity has a
number of uses, change in price will effect the demand for commodity in many
uses.

A rise in price will result in curtailment of purchase and householders will

shift to either firewood or oil. Ex: Coal will have an elastic demand in houses,
but inelastic in railways.

3. Existence of Substitutes:
-

Commodities having substitute will have elastic demand and goods with no
substitute will have inelastic demand. When the prices of the commodity
raises, the people would shift their preference to substitute commodities and
demand and substitute with the hope that the price of substitutes will not rise. A
rise in the price of coffee would make the people demand tea which is a fair
substitute for coffee.

Similarly, if the price of the coffee comes down, people sing other hot
drinks will shift to coffee and the demand for coffee will go up.

4. Postponement of Demand:
-

Another important factor affecting the demand in a bigger way is whether

the demand for a commodity can be postponed or not. Hence demand for rice
and medicines will be inelastic, and the fruit will be elastic, that is more will be
purchased when prices come down.

In case of commodities, which are not necessities, demand can be postponed

and so the demand becomes elastic.
18

5.

6.

Amount of Money Spent:

-

Elasticity of demand on the proportion of commodity also depends on the

proportion of consumers money spent on the commodity. If the consumer
spends only a little amount on the consumption of a particular commodity, the
demand for that will be inelastic.

Extra outlay due to increase in price will be very negligible. So the demand
for it will be inelastic. Increase in price will result in sizeably increasing his
total expenditure.

Habits:
-

If the consumers are addicted to some habits and customs then the demand
for the commodity will be inelastic. For instance people addicted to smoking a
particular brand of cigar will not change the quantity demanded whatever be
the change in price. Generally commodities and drugs which are stimulants
will have inelastic demand.

7. Range of Prices of Commodities:

-

8.

Elasticity of demand for a commodity depends on the range of prices at

which the commodity is sold in the market. For example, the price of the motor
car is in the high range of which only the very rich can buy motor cars. At the
price range of Rs.100, 000 neither a drop in price, say by Rs. 400 to Rs.500 nor
will raise in price by that amount effect the demand for cars. Since the demand
comes from a limited group. At this level the demand will be inelastic.

Time Factor in Elasticity:

-

Time plays a vital role in the elasticity of demand for a commodity. Demand
for a commodity exists for a period of time, say a day, week, month or a year or
several years.

Supply:
-

Prof: Mac Connel defines supply as Supply is the schedule which shows
the various amounts of products which a producer is willing to and able
produce and make available for safe in the market at each specific price in the
set of possible prices during some given period.
Supply depends on scarcity, just as demand depends on usefulness.
19

 Supply Schedule and Supply Curve:

-

Supply of different quantities placed on the market at different prices

mentioned with the help of a schedule called supply schedule. Supply is also
related to time, place and price like demand. The supply schedule represents
the functional relationship between he quantity supplied and the prices.
Table: Supply Schedule
Price in Rs.

Quantity supplied in Units

40

50

60

70

90

2. Supply Curve:
- On the basis of schedule given, we can draw the supply curve taking quantities supplied
on the X axis and price on the Y axis as shown in the figure.
Y

7
6
5
4
3

X
40

50

60

75

20

90

The supply curve SS slopes upwards from left to right showing larger supplies at a higher price.
Determinations of Supply or Assumptions of a Supply Schedule and Curve:
-

The supply schedule and the curve are prepared and drawn on certain assumption.
The factors which are likely to change the supply should be keep constant. The
determination of supply, except the price factor, has been kept constant. When are the
other factors influencing?
1. Number of Firms or Sellers
2. State of Technology
3. Cost of Production
4. Price of Related Goods
5. Price Exepctatition
6.

Natural Factors

7. Labour Trouble
8. Change in Government Policy
1.

Number of Firms or Sellers:

-

2.

State of Technology:
-

3.

Depends on the number of firms or seller producing and selling in the market.
When the sellers are few, the supply will be small. Hence every schedule of supply is
prepared on the assumption that the number of firms producing the particular
commodity, the scale of production etc will push up the supply curve to the right.

It is assumed that the level of technology of production remains constant.

Generally, any improvement in technology will reduce the cost of production and
consequently there will be an increase in supply. Hence the state of technology
constant to keep the supply curves at the same level.

Cost of Production:
-

The cost of production is an important item affecting the supply and so this is
assumed to remain constant. Wages, Rate of Interest, Price of Machinery and
equipment, and Raw materials etcremain unchanged.

21

4.

Price of Related Goods:

-

5.

Assumed that supply of price depends purely on its price and not on the prices on
the other commodity related to it. If prices of the related products fall the firm
producing many goods may increase the supply of a particular product even though its
price has not gone up.

Price Expectations:
-

Assumed that the seller sells commodity or supplies the commodity on the basis of
prevailing prices and he does not expect any change in prices of the commodity.

6. Natural Factors:
-

Assumed that there is no change in demand factors, as the supply is governed by

natural factors like rain, drought, etc

7. Labour Trouble:
-

Assumed that there is no labour trouble and consequent strike or lock out reducing
the quantity of supply , the productive units are supposed to be working smoothly
without any interruption , according to schedule.

8. Change in Government Policy:

-

Any change in government policy will affect the supply. A fresh tax or levy of
exercise duty on a commodity will effect the price of the commodity and as a result
the supply will get affected.

Law of Supply:
The law of supply states that Other things being constant, the price of a
commodity has a direct influence on the quantity supplied. As the price of the
commodity raises, its supply is extended, as the price falls, its supply is
contracted. Large quantities are supplied a higher prices and small quantities
are supplied at lower prices.
Elasticity of Supply:
-

The concept of elasticity of supply, like elasticity of demand relates the

responsiveness of supply to change in price. The supply of a commodity may
be called elastic if a small change in price causes more than proportionate
change in supply. The supply is said to be inelastic. Small changes in price
produces less than proportionate change in supply.
22
Elasticity of Supply:

Es = Proportionate change in quantity supplied

Proportionate change in price
Suppose the price of the commodity X increases from Rs. 2,000 per unit to Rs. 2,100
per unit and consequently the quantity supplied rises from 2,500 units to 3,000 units. The
elasticity of supply will be as follows:
Es = 500/2,500
= 500/2,500 2,000/100 = 4
100/2,000
Elasticity of supply = 4
In terms of symbols
Es =
q/q / p/ p
=
Es =

q/q p/ p
q/ p p/q

q = Small change in quantity supplied

p = Small change in price
p = Original Price
q = Original Quantity

I
A

The supply curve in SS in which two points A and B are taken to find out the supply. A and
Bare supposed to be so close that the same tangent passes through both of them.

23
Inelasticity of Supply:
Es< 1

Y
P

Quantity Supplied
Es =

q/

p / p/q

= MM1/PP1 OP/OM
= BC/CA MB/OM
= NM/MB MB/OM
Es = NM/OM

Time Element In the Determination Of Value:

Marshall Introduced time in value analysis and consequently determines
market in to short period and long period markets. According to him time plays
a major role in deciding the value of the commodity and time does not have the
same meaning as it has in everyday life. Divided in to 4 types Short period,
Very short period, Long period, and Very long period.
Perfect Competition:
Prof. Frank Knight defines as Perfect competition as a condition of market
in which there will be fluidly and mobility of factors of production so that the
number of firms and the size of firms can freely increase or decrease.
According to him perfect competition entails rational conduct on the part
of buyers and sellers, full factors of production and completely static
conditions
Features: 7 Main Features of perfect competition are
1. Large no of Buyers and Sellers 2. Homogeneous Product 3. Free entry
and exit barriers 4. Perfect Knowledge on the part of buyers and Sellers
5. Perfect mobility of Factors of Production 6. Absence of transport Cost
7. Absence of Governmental or Artificial Restriction.
24
Monopoly:

Monopoly means absence of competition. It is an extreme situation in

imperfect competition. It denotes a single seller or producer having the control
over the market.
A monopoly can be defined as the condition of production in which a single
person or a number of people acting in combination have the power to fix the
price of the commodity or the output of the commodity.
Should have some 4 main features: 1. It should have only single control 2.
The commodity produced should not have any close substitutes. If it is so, then
the monopoly power is lost as the people can choose the substitutes commodity
produced.

Kinds of Monopoly: 5 Kinds

1. Private and Public Monopolies
2. Pure Monopoly
3. Simple Monopoly
4. Discriminating Monopoly
5. Monopoly Power
Monopolistic Competition:
-

Monopolistic competition is a term which is used interchangeability with

imperfect competition, as the former describes a condition of imperfection.

Assumptions and Features:

Some 4 main assumptions
Existence of large number of firms
Product Differentiation
Selling Cost
Freedom of entry and Exit of Firms
-

Wants:
-

Human Wants are unlimited, human capacity to satisfy such wants is

limited.
Hence any economic problem consists of making decisions regarding the
ends to be pursued and goods to be used for achievement of such ends.

25
Relation Between Economic Decision and Technical Decision:
Economical Decision:
Economic Decision means financing the project within approved design and
environmental framework.

Has an economic impact on Investment in excess, Opportunity cost of

unused commodity, Cost of power capacity.
Technical Decision:
Done by rural development by increasing the opportunity and improving the
quality.
Project Eligibility
Technical Requirements
Energy Audit
Market Price and Normal Price:
1. Definition:
-

Equilibrium price of a good or service in a perfectly competitive market

(see perfect competition), the price that is equal to the lowest possible average
total cost of production plus normal profit.

Normal price can be lesser, equal or greater than the market price. If most of
the companies in an industry charge market prices for the products or services
then competition is high in that specific industry.

2. Market Price:
-

On the other hand, market price is the price of a product or service which is
in a marketplace and is resulted through market efficiency, equilibrium and
rational expectations.

In economics, market price is the economic price for which a good or

service is offered in the marketplace. It is of interest mainly in the study of
microeconomics. Market value and market price are equal only under
conditions of market efficiency, equilibrium, and rational expectations.
26

Unit-II
Organizing and Financing
Framework:

 Forms of Business
Proprietorship
Partnership
Joint Stock Company
Co-operative Organization
State Enterprise
Mixed Economy
Money and Banking
Banking and Its Kinds
Commercial Banks
Central banking Functions
Control of credit
Monetary Policy
Credit Instruments
Types of Financing
Short Term and Long Term Borrowing
Internal Generation of Funds
External Commercial Borrowings
Assistance from government budgeting support and international finance corporations
Analysis of Financial Statement
Balance Sheet, Profit and Loss Account and Funds Flow Statement
27
Forms of Business:

Depends largely on its organizations and the form of ownership in a

significant aspect of any organization.

Business may be organized in various forms, depending on their size, nature

and need for resources.

Legal framework of a economy also plays a significant role in choice in

form of ownership.

Forms of Ownership

Private Sector

Individual

Joint Sector

Collective

Company

Public Sector

Cooperation

Department

Proprietorship
Partnership

Company

Cooperative

3 classifications:
-

Public Sector
Private Sector
Joint Sector

Proprietorship: (Sole Proprietorship):

-

Sole proprietorship firm is one in which an individual invests own uses own
skills in management and is soley reasonable for the results of operations.

28

Means single owner or proprietary firm as one in which an individual

invests his own capital, uses his own skills, in management and soley
responsible for the results of operations.
Some 5 main advantages:
1. Simple and easy to start or exit
2. Undivided Profits
3. Secrets of trade
4.

Prompt Decision Making

5. Personal Touch to Business

Partnership:
-

In partnership two or more individuals decide to start a common business.

According to partnership act 1932, a partnership is relation between persons

who have agreed to share the profit of a business carried on by all or any of
them acting for all.

In partnership agreement to share losses is not essential.

Characteristics of Partnership:
1. Association of Two or More Persons
2. Agreement to Voluntary form Partnership
3. Business carried out by all or any one acting for all.
4. Partnership Deed
Joint Stock Company:
-

A joint stock company is established under companies act 1956.

Today the joint stock company is called as company.

The owners capital in a joint stock company is invested in the form of

shares; hence the owners are regarded as shareholders and preference
shareholders.

29
-

A joint stock company is a legal entity and has perpetual existence.

The maximum number of shareholders in a private limited company is

limited to 50.

There is no limit on the maximum number of members in a public limited

company; through the minimum number of members is 7.

Liability of a joint stock company is limited.

Co-operative Organization:
-

A co-operative is a non profit, non political, nonreligious, voluntary

organization, formed with an economic objective.

Based on mutual help and self reliance. This can be summed up as Each
for all and all for each

Dealings are confined to members only.

Objective is to encourage mutuality and cooperation.

State Enterprise:
-

A firm founded on the initiative of the state and run by it. The argument for
state enterprises is that there are some activities which would be socially
beneficial, but are not attractive to private entrepreneurs, and others which
would be profitable but involve natural monopolies and are therefore not to be
trusted to private owners. An example of the first category would be factories
to employ the disabled; of the second.

In limited census areas, opportunities exist to combine local tax and

investment incentives with direct assistance and tax credits from the state and
federal governments

In addition to discretionary, transaction-based incentive models that must

be reinvented for a specific project or business, a geographic-based program
can be created by local ordinance to provide incentives for all businesses
within the Zone.

30
-

Enterprise Zone Employment Act: Statute has been in existence since 1997.
Local governments interested in the Act should consult closely with their city
or county attorney and obtain proper legal counsel and advice before enacting a
program.
Property tax exemption

OCGA 36-88-3(1)

Abatement or reduction in occupation taxes, regulatory fees, building

inspection fees, and other fees that would otherwise be imposed on qualifying
business

OCGA 36-88-9(a)

Qualifying business or service enterprise: business enterprise means retail,

manufacturing, warehousing & distribution, processing, telecommunications,
tourism, research & development, new residential construction and
rehabilitation

service enterprise means finance, insurance, real estate activities listed under
SIC 60 67 or entities engaged in day-care

State Enterprise Zones: Property Tax Exemption for Qualifying Enterprises

Not to Exceed

100% for first five years

80% for next two years

60% for year eight

40% for year nine

20% for year ten

School taxes, sales and use taxes, and taxes imposed for G.O. debt are
excluded

Enterprise must maintain a minimum of five jobs

Total exemptions limited to 10% of tax digest

31
Advantages:
1. Coherent and easily understood policy that enhances existing local incentives
2. Limits to applicability and costs
3. Clear and coherent public benefits
4. Local control increases availability to existing businesses & entrepreneurs
5. Conforms to existing local admin structures
6. Easier layering with existing federal and state financial assistance programs
Disadvantages:
1. Some ambiguity within statute
2. Educational curve for communities currently reliant on discretionary, transaction based
incentives to attract development.
Mixed Economy:
-

Capitalism has some merits and defects. Socialism has some merits and
defects. If the merits of two systems are combined by a judicious policy, there
will be greater welfare of the society.
Mixed Economy is a compromise between capitalism and socialism

Features of Mixed Economy:

1. Existence of Private and Public Sector
2. It is a planned economy
3. Features of Capitalism and Socialism
Drawbacks of Mixed Economy:
1. In actual working, instead of getting the merits of the two systems, the economy
may have the defects of the two systems.
2. Since the areas of private and public sectors are defined, there may be gaps where
no one will be working. At the same time the work of private and public sector
will overlap.

32
3. May not remain mixed for long time. Slowly public sector will enlarge and
swallow the private sector. This will ultimately turn in to socialism.

Money and Banking:

-

The money is defined as the price to be paid for the commodity at certain
required price.

Money is a demand because all the commodities which have utility are
available in exchange for money.

Some 3 functions of money are 1. Medium of Exchange 2. Measure of Value

3. Store of value.

A currency is issued by the government is called fiduciary issue.

3 motives are 1. Transaction Motive 2. Precautionary Motive 3. Speculative
Motive.

Banking:
-

Flow of money transaction in to business.

Helps in providing loan to business
Certain types of banks namely ICICI bank, HDFC bank and some other
banks which provide loans to business.

Banking and Its Kinds:

-

Flow of money transaction in to business.

Some 4 main kinds of banks ICICI Bank, Corporation Bank, State Bank of
India, and Central bank.

Commercial Banks:
-

A commercial bank (or business bank) is a type of financial institution and

intermediary. It is a bank that provides transactional, savings, and money
market accounts and that accepts time deposits.[1]

33
-

"Commercial bank" to refer to a bank or a division of a bank primarily

dealing with deposits and loans from corporations or large businesses. In some
other jurisdictions, the strict separation of investment and commercial banking
never applied. Commercial banking may also be seen as distinct from retail
banking, which involves the provision of financial services direct to
consumers. Many banks offer both commercial and retail banking services.

The role of commercial banks:

Commercial banks engage in the following activities:

processing of payments by way of telegraphic transfer, EFTPOS, internet banking, or

other means
issuing bank drafts and bank cheques

accepting money on term deposit

lending money by overdraft, installment loan, or other means

providing documentary and standby letter of credit, guarantees, performance bonds,

securities underwriting commitments and other forms of off balance sheet exposures

safekeeping of documents and other items in safe deposit boxes

sale, distribution or brokerage, with or without advice, of insurance, unit trusts and
similar financial products as a financial supermarket

cash management and treasury services

merchant banking and private equity financing

Traditionally, large commercial banks also underwrite bonds, and make markets in
currency, interest rates, and credit-related securities, but today large commercial banks
usually have an investment bank arm that is involved in the mentioned activities.

Types of loans granted by commercial banks:

1.

Secured loan

2.

Mortgage loan

3.

Unsecured loan

Central banking Functions:

Functions of Reserve Bank of India

The Reserve Bank of India Act of 1934 entrust all the important functions of a central
bank the Reserve Bank of India.

34
1. Bank of Issue
Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all over
the country is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank
has a separate Issue Department which is entrusted with the issue of currency notes. The assets
and liabilities of the Issue Department are kept separate from those of the Banking Department.
Originally, the assets of the Issue Department were to consist of not less than two-fifths of gold
coin, gold bullion or sterling securities provided the amount of gold was not less than Rs. 40
crores in value. The remaining three-fifths of the assets might be held in rupee coins,
Government of India rupee securities, eligible bills of exchange and promissory notes payable in
India. Due to the exigencies of the Second World War and the post-was period, these provisions
were considerably modified. Since 1957, the Reserve Bank of India is required to maintain gold
and foreign exchange reserves of Ra. 200 crores, of which at least Rs. 115 crores should be in
gold. The system as it exists today is known as the minimum reserve system.
2. Banker to Government
The second important function of the Reserve Bank of India is to act as Government banker,
agent and adviser. The Reserve Bank is agent of Central Government and of all State
Governments in India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as deposits free of
interest, to receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India helps the
Government - both the Union and the States to float new loans and to manage public debt. The
Bank makes ways and means advances to the Governments for 90 days. It makes loans and
advances to the States and local authorities. It acts as adviser to the Government on all monetary
and banking matters.
3. Bankers' Bank and Lender of the Last Resort
The Reserve Bank of India acts as the bankers' bank. According to the provisions of the Banking
Companies Act of 1949, every scheduled bank was required to maintain with the Reserve Bank a

cash balance equivalent to 5% of its demand liabilites and 2 per cent of its time liabilities in
India. By an amendment of 1962, the distinction between demand and time liabilities was
abolished and banks have been asked to keep cash reserves equal to 3 per cent of their aggregate
deposit liabilities. The minimum cash requirements can be changed by the Reserve Bank of
India.

35
The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting bills of
exchange. Since commercial banks can always expect the Reserve Bank of India to come to their
help in times of banking crisis the Reserve Bank becomes not only the banker's bank but also the
lender of the last resort.

4. Controller of Credit
The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume
of credit created by banks in India. It can do so through changing the Bank rate or through open
market operations. According to the Banking Regulation Act of 1949, the Reserve Bank of India
can ask any particular bank or the whole banking system not to lend to particular groups or
persons on the basis of certain types of securities. Since 1956, selective controls of credit are
increasingly being used by the Reserve Bank.
The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a licence from the Reserve Bank of India to do banking business
within India, the licence can be cancelled by the Reserve Bank of certain stipulated conditions
are not fulfilled. Every bank will have to get the permission of the Reserve Bank before it can
open a new branch. Each scheduled bank must send a weekly return to the Reserve Bank
showing, in detail, its assets and liabilities. This power of the Bank to call for information is also
intended to give it effective control of the credit system. The Reserve Bank has also the power to
inspect the accounts of any commercial bank.
As supereme banking authority in the country, the Reserve Bank of India, therefore, has the
following powers:
(a) It holds the cash reserves of all the scheduled banks.
(b) It controls the credit operations of banks through quantitative and qualitative controls.
(c) It controls the banking system through the system of licensing, inspection and calling for
information.

(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

36
Custodian of Foreign Reserves
The Reserve Bank of India has the responsibility to maintain the official rate of exchange.
According to the Reserve Bank of India Act of 1934, the Bank was required to buy and sell at
fixed rates any amount of sterling in lots of not less than Rs. 10,000. The rate of exchange fixed
was Re. 1 = sh. 6d. Since 1935 the Bank was able to maintain the exchange rate fixed at lsh.6d.
though there were periods of extreme pressure in favour of or against
the rupee. After India became a member of the International Monetary Fund in 1946, the Reserve
Bank has the responsibility of maintaining fixed exchange rates with all other member countries
of the I.M.F.
Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the
custodian of India's reserve of international currencies. The vast sterling balances were acquired
and managed by the Bank. Further, the RBI has the responsibility of administering the exchange
controls of the country.
Supervisory functions
In addition to its traditional central banking functions, the Reserve bank has certain nonmonetary functions of the nature of supervision of banks and promotion of sound banking in
India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI
wide powers of supervision and control over commercial and co-operative banks, relating to
licensing and establishments, branch expansion, liquidity of their assets, management and
methods of working, amalgamation, reconstruction, and liquidation. The RBI is authorised to
carry out periodical inspections of the banks and to call for returns and necessary information
from them. The nationalisation of 14 major Indian scheduled banks in July 1969 has imposed
new responsibilities on the RBI for directing the growth of banking and credit policies towards
more rapid development of the economy and realisation of certain desired social objectives. The
supervisory functions of the RBI have helped a great deal in improving the standard of banking
in India to develop on sound lines and to improve the methods of their operation.
Promotional functions
With economic growth assuming a new urgency since Independence, the range of the Reserve

Bank's functions has steadily widened. The Bank now performs a varietyof developmental and
promotional functions, which, at one time, were regarded as outside the normal scope of central
banking. The Reserve Bank was asked to promote banking habit, extend banking facilities to
rural and semi-urban areas, and establish and promote new specialised financing agencies.
Accordingly, the Reserve Bank has helped in the setting up of the IFCI and the SFC; it set up the
Deposit Insurance Corporation in 1962, the Unit Trust of India in 1964, the Industrial
Development Bank of India also in 1964, the Agricultural Refinance Corporation of India in
1963 and the Industrial Reconstruction Corporation of India in 1972. These institutions were set
up directly or indirectly by the Reserve Bank to promote saving habit and to mobilise savings,
and to provide industrial finance as well as agricultural finance.
37
As far back as 1935, the Reserve Bank of India set up the Agricultural Credit Department to
provide agricultural credit. But only since 1951 the Bank's role in this field has become
extremely important.
The Bank has developed the co-operative credit movement to encourage saving, to eliminate
moneylenders from the villages and to route its short term credit to agriculture. The RBI has set
up the Agricultural Refinance and Development Corporation to provide long-term finance to
farmers.
38
Monetary Policy:
-

Monetary policy is the process by which the monetary authority of a

country controls the supply of money, often targeting a rate of interest for the
purpose of promoting economic growth and stability.[1] The official goals
usually include relatively stable prices and low unemployment. Monetary
theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary, or a

contractionary, where an expansionary policy increases the total supply of
money in the economy more rapidly than usual, and a contractionary policy
expands the money supply more slowly than usual or even shrinks it.
Expansionary policy is traditionally used to try to combat unemployment in a
recession by lowering interest rates in the hope that easy credit will entice
businesses into expanding. Contractionary policy is intended to slow inflation
in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy is contrasted with fiscal policy, which refers to: taxation,
government spending, and associated borrowing.

Monetary policy is the process by which the government, central bank, or

monetary authority of a country controls (i) the supply of money, (ii)
availability of money, and (iii) cost of money or rate of interest to attain a set of
objectives oriented towards the growth and stability of the economy.[1]
Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an

economy, that is the price at which money can be borrowed, and the total
supply of money. Monetary policy uses a variety of tools to control one or both
of these, to influence outcomes like economic growth, inflation, exchange rates
with other currencies and unemployment. Where currency is under a monopoly
of issuance, or where there is a regulated system of issuing currency through
banks which are tied to a central bank, the monetary authority has the ability to
alter the money supply and thus influence the interest rate (to achieve policy
goals).
39

It is important for policymakers to make credible announcements. If private

agents (consumers and firms) believe that policymakers are committed to
lowering inflation, they will anticipate future prices to be lower than otherwise
(how those expectations are formed is an entirely different matter; compare for
instance rational expectations with adaptive expectations). If an employee
expects prices to be high in the future, he or she will draw up a wage contract
with a high wage to match these prices. Hence, the expectation of lower wages
is reflected in wage-setting behavior between employees and employers (lower
wages since prices are expected to be lower) and since wages are in fact lower
there is no demand pull inflation because employees are receiving a smaller
wage and there is no cost push inflation because employers are paying out less
in wages.

To achieve this low level of inflation, policymakers must have credible

announcements; that is, private agents must believe that these announcements
will reflect actual future policy. If an announcement about low-level inflation
targets is made but not believed by private agents, wage-setting will anticipate
high-level inflation and so wages will be higher and inflation will rise. A high
wage will increase a consumer's demand (demand pull inflation) and a firm's
costs (cost push inflation), so inflation rises. Hence, if a policymaker's
announcements regarding monetary policy are not credible, policy will not
have the desired effect.

 Credit Instruments:
-

A credit instrument is nothing but a payment system established in the

business, recognized by the country's legal and financial institutions. Success
and implementation of said instrument largely depend upon the active support
of the banks. Out of the several existing credit instruments, the personal check
system and the documentary credit systems are widely being utilized. A
promissory note or written evidence of a debtor's obligation is also considered
as the credit instrument.

The personal check system ensures a payment order to be paid by the bank
upon production of the check issued to some organization or individual against
the bank's credit. Maker, drawer, bank, payee, bearer, etc. constituent the
organizing machinery of the check credit instrument which is further classified
as the negotiable instrument (does not mean, it can favor anyone!).
40

Based upon the operating and payment conditions, there exist different kind of
checks, such as the cashier's check (hard to get), certified check, electronic check
(may give easy money), QChex, etc.
-

The documentary credit system employs primarily the Letter of Credit (LC)
and Back-to-Back Letter of Credit as its main constituent parts. These credit
operations require production of some pre-defined documents, such as Way
Bills, Bills of Lading, Certificate of origin, Insurance papers, Customs forms,
etc. for clearing the payment. Purchase and payment services of the domestic
and international businesses use the documentary credit system
indiscriminately.

A credit instrument is a term used in the banking and finance world to

describe any item agreed upon that can be used as currency. Banks issue credit
instruments, in the form of credit cards. Customers, in turn, use these credit
instruments to make purchases 'on credit' and pay the amount 'borrowed' back
to the bank either at the end of the month, quarter, or whatever term has been
agreed upon.

Any item can serve as a credit instrument, so long as both parties (the
borrower and the lender) have agreed on the use of that instrument. The
instrument is basically a promise by the debtor that he/she will pay back the
debtor.

A simpler example of a credit instrument is the cheque. When one person

gives another a cheque, he/she is basically saying that this piece of paper
proves I owe you a certain amount of cash, and if you take it the bank, they
will gladly pay you on my behalf. Even simpler than the cheque is the
promissory note, which is also very similar in nature.

Credit instruments are ever popular due to their convenience by not having
you carry around piles of cash everywhere you go.

A credit instruments is a term used in the banking and finance world to

describe any item agreed that can be used as currency. Banks issue credit
instruments in the form of credit cards. Customers in turn use these credit
instruments to make purchase on credit and pay the amount borrowed back
either at the end of the month quarter or what ever term has agreed, upon.

41
Types of Financing:
-

The three types of financial management decisions are capital budgeting,

capital structure, and working capital.
Overdraft
A popular form of finance because it has the advantages of availability,
convenience and flexibility. However, because interest rates are high, it should
only be used for short-term requirements such as funding working capital. Find
out more about Overdraft.

Bank term loans

These provide fixed-term finance for longer periods. They are often secured by
a charge against company assets and require you to sign legally binding
covenants. Find out more about our Loans and Finance products

Asset-based finance
This describes financing an asset over its estimated life span using the asset as
security for the loan. It can be structured so that the borrower has the sole right
to use the asset and ownership transfers to the borrower at the end of the loan
period. Find out more about our Asset Finance products

Receivables Finance
This form of finance uses outstanding customer invoices as security. Find out
more about Receivables Finance.

Invoice discounting
Similar to Receivables Finance, this is usually only offered to larger companies
with strong credit management systems.

Angel funding
An individual invests in a company in return for shares in the company.

Venture capital
There are organisations that specialise in investing in unquoted companies
which they believe will offer high returns to investors. There is strong
competition for this type of finance and you should only consider it after
assessing all the alternatives.
Personal resources
These include personal savings, money borrowed from family and friends, or
profits generated by the business.
41

Short Term and Long Term Borrowing:

-

Short-term loans can be for periods as short as 90 days. The strength of a

business in terms of their balance sheet, financial statement, credit history and
time in business as well as the relationship with the lending institution all enter
into the loan approval decision process. Loans of less than one year to proven
customers are often approved without collateral and are referred to as
unsecured loans. Loans in the one to three year category most often require
collateral and the assets of a business such equipment, buildings or real estate
can easily provide the necessary collateral, provided that there is sufficient
worth in the assets.

The lending institution will obviously want to assess the value of the
collateral and will monitor the loan to insure that the collateral retains its' worth
over the period of the loan. These types of loans are called secured loans
because the collateral that guarantees repayment could be forfeited if the loan
falls into default. An alternative to an unsecured short-term note would be for a
business to negotiate an approved line of credit that could be used as necessary
throughout a year.

This can be negotiated in advance of any requirement for a short-term loan

and is available should the need arise. Short-term loans are commonly used to
cover cash flow shortfalls or the enable the purchase of additional inventory.

Long-term loans of greater than three years require a more detailed analysis
by the lending institution. As with short-term loans the same criteria of a good
credit history coupled with a successful business balance sheet and financial
statement will make the approval process quicker and easier. A long-term loan
will be a secured loan, and sufficient collateral must exist and will definitely be
the basis for approval. Long-term loans are appropriate for large acquisitions or
purchases of equipment that has an extended life.

Interest on short and long-term loans vary widely. Typically the interest rate
will be 1-3% above the prime lending rate and it is obvious that the shorter the
period of the loan the less the interest expense will be. Additionally the value
of any collateral that might be involved in securing the loan could affect the
interest rate that will be charged. Banks and lending institution develop their
policies based on the risk involved in approving a loan. Loans for short terms
generally have less risk associated with them than longer term loans.

42
Internal Generation of Funds:
-

A quantifiable mathematical rate that portrays how quickly a bank is able to

generate equity capital. The Internal Capital Generation Rate (ICGR) is
calculated by dividing the bank's retained earnings by the average balance of
the combined equity of all stockholders for a given accounting period. The
bank's retained earnings are found by subtracting dividends paid from net
income.

The higher the ICGR, the more able a bank is to produce capital to loan. This
rate improves with a bank's profitability and is also affected by the price of its
stock. A quick way to calculate the ICGR is to take the plowback ratio and
multiply by the ROE. For example, if the plowback ratio is 0.80 and ROE is
17%, the ICGR is 13.6%. Thus, the company grew their capital equity by
13.6%.
External Commercial Borrowings:

External Commercial Borrowings (ECB) refer to commercial loans [in the

form of bank loans, buyers credit, suppliers credit, securitised instruments (e.g.
floating rate notes and fixed rate bonds)] availed from non-resident lenders with
minimum average maturity of 3 years.

Foreign Currency Convertible bonds (FCCBs) mean a bond issued by an

Indian company expressed in foreign currency, and the principal and interest in
respect of which is payable in foreign currency. Further the bonds are required to
be issued in accordance with the scheme viz., Issue of Foreign Currency
convertible bonds and Ordinary Shares (Through Depositary Receipt
Mechanism) Scheme, 1993, and subscribed by a non-resident in foreign
currency and convertible into ordinary shares of the issuing company in any
manner, either in whole, or in part, on the basis of any equity related warrants
attached to debt instruments. The policy for ECB is also applicable to FCCBs.
The issue of FCCBs are also required to adhere to the provisions of Notification
FEMA No. 120/RB-2004 dated July 7, 2004 as amended from time to time.

ECB can be accessed under two routes, viz., (i) Automatic Route outlined in
Paragraph I (A) and (ii) Approval Route outlined in paragraph I (B).

43
-

ECB for investment in real sector industrial sector, especially infrastructure

sector-in India, are under Automatic Route, i.e. do not require RBI/Government
approval. In case of doubt as regards eligibility to access Automatic Route,
applicants may take recourse to the Approval Route.

Assistance from government budgeting support and international finance

corporations:
-

Promotes sustainable private sector investment in developing countries.

IFC is a member of the World Bank Group and is headquartered in
Washington, DC. It shares the primary objective of all World Bank Group
institutions: to improve the quality of the lives of people in its developing
member countries.[1]

Established in 1956, IFC is the largest multilateral source of loan and equity financing for private
sector projects in the developing world. It promotes sustainable private sector development
primarily by:
-

Financing private sector projects and companies located in the developing

world.
Helping private companies in the developing world mobilize financing in
international financial markets.
Providing advice and technical assistance to businesses and governments.

Analysis of Financial Statement:

-

Financial statement analysis is defined as the process of identifying financial

strengths and weaknesses of the firm by properly establishing relationship
between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial
statements, such as comparative statements, schedule of changes in working
capital, common size percentages, funds analysis, trend analysis, and ratios
analysis.

44
-

Financial statements are prepared to meet external reporting obligations and

also for decision making purposes. They play a dominant role in setting the
framework of managerial decisions. But the information provided in the
financial statements is not an end in itself as no meaningful conclusions can be
drawn from these statements alone.

However, the information provided in the financial statements is of immense

use in making decisions through analysis and interpretation of financial
statements.
Balance Sheet, Profit and Loss Account and Funds Flow Statement:

In financial accounting, a balance sheet or statement of financial position is a

summary of the financial balances of a sole proprietorship, a business
partnership or a company. Assets, liabilities and ownership equity are listed as
of a specific date, such as the end of its financial year. A balance sheet is often
described as a "snapshot of a company's financial condition".[1] Of the four basic
financial statements, the balance sheet is the only statement which applies to a
single point in time of a business' calendar year.

A standard company balance sheet has three parts: assets, liabilities and
ownership equity. The main categories of assets are usually listed first, and
typically in order of liquidity.[2] Assets are followed by the liabilities. The
difference between the assets and the liabilities is known as equity or the net
assets or the net worth or capital of the company and according to the accounting
equation, net worth must equal assets minus liabilities.[3]

Profit and Loss Account:

The purpose of the profit and loss account is to:

Show whether a business has made a PROFIT or LOSS over a financial year.
Describe how the profit or loss arose e.g. categorising costs between cost of sales
and operating costs.

A profit and loss account starts with the TRADING ACCOUNT and then takes into account all
the other expenses associated with the business.

45
Funds Flow Statements: (FFS):

It is the statement of changes in financial position prepared to determine only

sources and uses of working capital btn dates of 2 balance sheets.

The fund flow statement reports the flow of funds through the firm during the year. In
order to prepare fund flow statement proper understanding of working capital and sources
and applications is necessary. The fund flow statement is a record, a post-mortem of
where the funds came from and how.

UNIT 3

the

Framework:
1. Types of Costing
2. Traditional Costing Approach
3. Activity Base Costing
4. Fixed Cost
5. Variable Cost
6. Marginal Cost
7. Cost output relationship in short and long run.
8. Pricing practice
9. Full Cost pricing and Marginal Cost Pricing
10. Going Rate pricing
11. Bid Pricing
12. Pricing for a Rate of return
13. Apprising Project Profitability
14. Internal Rate of Return
15. Payback Period
16. Net Present Value
17. Cost Benefit Analysis
18. Feasibility Reports
19. Appraisal process
20. Technical, Economical, and Financial Feasibility

1. Types of Costing:
-

Some 8 types of costing 1. Real cost of Production 2. Opportunity Cost or

Production Cost 3. Past Cost or Future Cost 4. Pocket Cost or Book Cost 5.
Incremental Cost and Sunk Cost 6. Shut Down Cost and Abandonment Cost 7.

Replacement Cost and Historical Cost 8. Private and Social Cost 9. Short run
and Long run cost.
2. Traditional Costing Approach:
-

The traditional method of cost accounting refers to the allocation of

manufacturing overhead costs to the products manufactured. The traditional
method (also known as the conventional method) assigns or allocates the
factorys indirect costs to the items manufactured on the basis of volume such as
the number of units produced, the direct labor hours, or the production machine
hours. We will use machine hours in our discussion.

By using only machine hours to allocate the manufacturing overhead to

products, it is implying that the machine hours are the underlying cause of the
factory overhead. Traditionally, that may have been reasonable or at least
sufficient for the companys external financial statements. However, in recent
decades the manufacturing overhead has been driven or caused by many other
factors. For example, some customers are likely to demand additional
manufacturing operations for their diverse products. Other customers simply
want great quantities of uniform products.

If a manufacturer wants to know the true cost to produce specific products for
specific customers, the traditional method of cost accounting is inadequate.
Activity based costing (ABC) was developed to overcome the shortcomings of
the traditional method. Instead of just one cost driver such as machine hours,
ABC will use many cost drivers to allocate a manufacturers indirect costs.

47
A few of the cost drivers that would be used under ABC include the number of
machine setups, the pounds of material purchased or used, the number of
engineering change orders, the number of machine hours, and so on.
3. Activity Base Costing:
-

Activity-based costing (ABC) is a costing model that identifies activities in an

organization and assigns the cost of each activity resource to all products and
services according to the actual consumption by each: it assigns more indirect
costs (overhead) into direct costs.

In this way, an organization can precisely estimate the cost of individual

products and services so they can identify and eliminate those that are
unprofitable and lower the prices of those that are overpriced.

In a business organization, the ABC methodology assigns an organization's

resource costs through activities to the products and services provided to its
customers. It is generally used as a tool for understanding product and customer
cost and profitability. As such, ABC has predominantly been used to support
strategic decisions such as pricing, outsourcing, identification and measurement
of process improvement initiatives.
4. Fixed Cost:
-

A cost that remains constant, regardless of any change in a company's activity.

A good example is a lease payment. If you are leasing a building at $2,000 per
month, then you will pay that amount each month, no matter how well or how
poorly the business is doing.

Fixed costs are those that do not change with the level of sales. If sales increase
or decrease but nothing else changes then fixed costs remain the same. Common
examples of fixed costs include rents, salaries of permanent employees and
depreciation.

A high level of fixed costs increases operational gearing.

Costs that are not fixed are variable or semi-variable.

48
5. Variable Cost:
-

Variable costs are expenses that change in proportion to the activity of a

business. Variable cost is the sum of marginal costs over all units produced. It
can also be considered normal costs. Fixed costs and variable costs make up the
two components of total cost. Direct Costs, however, are costs that can easily be
associated with a particular cost object. However, not all variable costs are direct
costs. For example, variable manufacturing overhead costs are variable costs that

are indirect costs, not direct costs. Variable costs are sometimes called unit-level
costs as they vary with the number of units produced.
-

A cost of labor, material or overhead that changes according to the change in

the volume of production units. Combined with fixed costs, variable costs make
up the total cost of production. While the total variable cost changes with
increased production, the total fixed costs stays the same
A cost that changes in proportion to a change in a company's activity or
business.
A good example of variable cost is the fuel for an airline.

6. Marginal Cost:
-

In economics and finance, marginal cost is the change in total cost that arises
when the quantity produced changes by one unit. That is, it is the cost of
producing one more unit of a good.[1] If the good being produced is infinitely
divisible, so the size of a "unit" is infinitesimal, then assuming the cost function
is differentiable the marginal cost (MC) function is the first derivative of the
total cost (TC) function with respect to quantity (Q). Note that the marginal cost
will change with volume, as a non-linear and non-proportional cost function
includes:
1. variable terms dependent to volume,
2. constant terms independent to volume and occurring with the respective
lot size,
3. Jump fix cost increase or decrease dependent to steps of volume increase.

In general terms, marginal cost at each level of production includes any additional costs
required to produce the next unit. If producing additional vehicles requires, for example,
building a new factory, the marginal cost of those extra vehicles includes the cost of the
new factory. In practice, the analysis is segregated into short and long-run cases, and over
the longest run, all costs are marginal. At each level of production and time period being
considered, marginal costs include all costs which vary with the level of production, and
other costs are considered fixed costs.

If the cost function is differentiable, the marginal cost is the cost of the next unit
produced referring to the basic volume.
49

If the cost function is not differentiable, the marginal cost can be expressed as follows.

A number of other factors can affect marginal cost and its applicability to real world
problems. Some of these may be considered market failures. These may include
information asymmetries, the presence of negative or positive externalities, transaction
costs, price discrimination and others.

The marginal cost of an additional unit of output is the cost of the additional inputs
needed to produce that output. More formally, the marginal cost is the derivative of total
production costs with respect to the level of output.

Marginal cost and average cost can differ greatly. For example, suppose it costs $1000 to
produce 100 units and $1020 to produce 101 units. The average cost per unit is $10, but
the marginal cost of the 101st unit is $20

The Economic Model applications Perfect Competition and Monopoly emphasize the
roles of average cost and marginal cost curves. The short movie Derive a Supply Curve
(40 seconds) shows an excerpt from the Perfect Competition presentation that derives a
supply curve from profit maximizing behavior and a marginal cost curve.

The marginal cost of production is the increase in total cost as a result of producing one
extra unit. The concept of marginal cost in economics is similar to the accounting concept
of variable cost. It is the variable costs associated with the production of one more unit.

Marginal costs are not constant. For example a factory may be operating at the highest
capacity it can with all workers working normal full time hours, so increasing production
by one more unit would mean paying overtime, so the marginal cost would be higher than
the current variable cost per unit.

Conversely, an input may become cheaper as the quantities purchased rise (e.g. quantity
discounts), so marginal costs may fall as production increases.

The importance of marginal costs varies greatly from industry to industry, and from
product to product. The marginal cost of manufacturing jewellery is likely to be high: the
materials and skilled labour needed are both expensive. On the other hand the marginal
cost of producing software or recorded music is negligible.

The concept of marginal cost is very important in areas of economics such as analysing
optimum levels of production for a firm. Profit maximising output is achieved when
marginal cost equals marginal revenue. Selling prices are either constant (given perfect
competition), or fall (the usual situation where the firm has some level of market
influence). Marginal cost usually initially falls as a result of economies of scale, but
eventually rises as a result of diseconomies of scale, and increasing demand pushing up
prices of inputs.

50
7. Cost output relationship in short and long run:
Short run analysis centres around the assumption of fixed prices. No time for
them to change.
Long Run analysis assumes there are no fixed factors of production. Costs can
be assumed to vary.
-

Short run is effects that last only temporarily,

Long run is effects that last quite a long time.

Some inputs can be varied flexibly in a relatively short period of time. We

conventionally think of labor and raw materials as "variable inputs" in this
sense. Other inputs require a commitment over a longer period of time. Capital
goods are thought of as "fixed inputs" in this sense. A capital good represents a
relatively large expenditure at a particular time, with the expectation that the
investment will be repaid -- and any profit paid -- by producing goods and
services for sale over the useful life of the capital good. In this sense, a capital
investment is a long-term commitment. So capital is thought of as being variable
only in the long run, but fixed in the short run.

In microeconomics, the long run is the conceptual time period in which there
are no fixed factors of production as to changing the output level and entering or
leaving an industry. The long run contrasts with the short run, in which some
factors are variable and others are fixed, constraining entry or exit from an
industry. In macroeconomics, the long run is the period when the general price
level, contractual wage rates, and expectations adjust fully to the state of the
economy, in contrast to the short run when these may not fully adjust.[1]

In the long run, firms change production levels in response to (expected)

economic profits or losses, and the land, labor, capital goods and
entrepreneurship vary to reach associated long-run average cost. In the
simplified case of plant capacity as the only fixed factor, a generic firm can
make these changes in the long run:

1.

enter an industry in response to (expected) profits

2.

leave an industry in response to losses

3.

increase its plant in response to profits

4.

Decrease its plant in response to losses.

All production in real time occurs in the short run. The short run is the conceptual time period in
which at least one factor of production is fixed in amount and others are variable in amount.

Costs that are fixed, say from existing plant size, have no impact on a firm's short-run decisions,
since only variable costs and revenues affect short-run profits. Such fixed costs raise the
associated short-run average cost of an output level over the long-run average cost if the amount
of the fixed factor is better suited for a different output level. In the short run, a firm can raise
output by increasing the amount of the variable factor(s), say labor through overtime.

51
A generic firm already producing in an industry can make three changes in the short run as a
response to reach a posited equilibrium:
-

increase production
decrease production

Shut down.

8. Pricing Practice;
-

Done by 2 ways: 1. Pricing of Multiple Products 2. Pricing of Prosucys

with interrelated demands.

When products are jointly produced in fixedproportions,they should be thought

of as a single production package. There is then no rational way of allocating the
cost of producing the package to the individual products in the package. On the
other hand, the jointly produced products may have independent demands and
marginal revenues. The best level of output of the joint product is then
determined at the point where the vertical summation of the marginal revenues
of the various jointly produced products equals the single marginal cost of
producing the entire product package.

9. Full Cost pricing and Marginal Cost Pricing;

-

Selling price arrived at adding by overheads and profit margin to the direct cost
per unit of a product. In manufactures overheads consumption, less than full
capacity utilization of the plant is factored in to allow for fluctuations in the
output. The profit margin is computed as a fixed percentage of the average total
cost of the product.

Total cost of all recourse used or consumed in production, including direct,

indirect, and investing cost.

The practice of setting a product's price equal to the additional (marginal) cost
of producing one more unit of output. The producer charges an amount equal to
the cost of the additional economic resources. The policy is used to maintain a
low selling price or to keep a business operating during a period of poor sales.
Because fixed costs such as rent and building maintenance must be paid whether

a company produces or not, a firm experiencing temporary difficulties may

decide to remain in production and sell the product at marginal cost, since its
losses will be no greater than if it ceased production.
-

A pricing scheme in which the price received by a firm is set equal to the
marginal cost of production. This is not only the efficient outcome achieved by
competitive markets, it is commonly used for comparison of other regulatory
policies, such as average-cost pricing, that are used for public utilities
(especially those that are natural monopolies).

52

The bad thing about marginal-cost pricing for natural monopolies is that a
normal profit is not guaranteed. The good thing about marginal-cost pricing is
that marginal cost is equal to price, and the public utility is operating according
to the price equals marginal cost (P = MC) rule of efficiency.
10. Going Rate pricing:
-

All firms do have the power to fix a price ,but instead of doing so, in a
competitive market situation firms fix a price which is equal to the average price
charged by all firms in an industry,ie,it collects all the prices firms with same
product and compute the average.

Establishing the price for a product or service based on prevalent market

prices. This is most common with products that do not vary much from one
supplier to another, like steel or fresh meat.

All firms do have the power to fix a price ,but instead of doing so,in a
competitive market situation firms fix a price which is equal to the average price
charged by all firms in an industry, ie, it collects all the prices firms with same
product and compute the average.

11. Bid Pricing:

-

A bid price is the highest price that a buyer (i.e., bidder) is willing to pay for a
good. It is usually referred to simply as the "bid."

In bid and ask, the bid price stands in contrast to the ask price or "offer", and
the difference between the two is called the bid/ask spread.

An unsolicited bid or offer is when a person or company receives a bid even

though they are not looking to sell. A bidding war is said to occur when a large

number of bids are placed in rapid succession by two or more entities, especially
when the price paid is much greater than the ask price, or greater than the first
bid in the case of unsolicited bidding.
-

In the context of stock trading on a stock exchange, the bid price is the highest
price a buyer of a stock is willing to pay for a share of that given stock. The bid
price displayed in most quote services is the highest bid price in the market. The
ask or offer price on the other hand is the lowest price a seller of a particular
stock is willing to sell a share of that given stock. The ask or offer price
displayed is the lowest ask/offer price in the market (Stock market).

53
-

The price a buyer is willing to pay for a security. This is one part of the bid
with the other being the bid size, which details the amount of shares the investor
is willing to purchase at the bid price. The opposite of the bid is the ask price,
which is the price a seller is looking to get for his or her shares.

12. Pricing for a Rate of return:

-

Target rate of return pricing is a pricing method used almost exclusively by

market leaders or monopolists. You start with a rate of return objective, like 5%
of invested capital, or 10% of sales revenue. Then you arrange your price
structure so as to achieve these target rates of return.[1]

For example, assume a firm invests $100 million in order to produce and
market designer snowflakes and they estimate that with demand for designer
snowflakes being what it is, they can sell 2 million flakes per year. Further, from
preliminary production data they know that at that level of output their average
total cost (ATC) is $50 per flake. Total annual costs would be $100 million (2
million units at $50 each). Next, management decides they want a 20% return on
investment (ROI). That works out to be $20 million (20% of a $100 million
investment). Profit margin will need to be $10 dollars per flake ($20 million
return over 2 million units). So the price must be set at $60 per designer flake
($50 costs plus $10 profit margin). Similar calculations will determine price
based on rate of return to sales revenue.

An unusual consequence of this pricing model is that to keep the target rate of
return constant, the firm will have to continuously be changing its price as the
level of demand changes. This can be seen in the diagram below. Based on
market demand expectations, the firm estimates it will be operating at 70%
capacity. Given its production function and cost structure, it knows its average
total costs at that output level will be represented as point A . If its
predetermined rate of return requirement is amount A, B, then it will set its price

at P*. Because profit is equal to (P-ATC)*Q, then their total profit will be
defined by area P*, B, A, P70%.

If demand increases such that the firm is now operating at 90% capacity and
facing a reduced average total cost of C, then margin will increase to C,D and
profit will be P*,D,C,P90%.

If demand were to decrease so the firm was operating at 40% capacity, margins
would be reduced to E,F and the firm would have to increase prices to maintain
their desired margin. This is a questionable decision. It is seldom a good strategy
to increase prices in the face of falling demand. The net result is usually further
reductions in demand. That explains why this strategy is used only by market
leaders and monopolists.
55

13. Apprising Project Profitability:

- Assessment of project in terms of economic, social and financial feasibility.
- A lending financial institutions makes an independent and objective assessment of
various aspects of an investment proposition.
Steps:
1. Economic Aspects

2. Technical Aspects
3. Organization Aspects
4. Financial Aspects
5. Market Aspects

14. Internal Rate of Return;

-

The internal rate of return (IRR) is a rate of return used in capital budgeting to
measure and compare the profitability of investments. It is also called the
discounted cash flow rate of return (DCFROR) or simply the rate of return
(ROR).[1] In the context of savings and loans the IRR is also called the effective
interest rate. The term internal refers to the fact that its calculation does not
incorporate environmental factors (e.g., the interest rate or inflation).

The discount rate often used in capital budgeting that makes the net present
value of all cash flows from a particular project equal to zero. Generally
speaking, the higher a project's internal rate of return, the more desirable it is to
undertake the project. As such, IRR can be used to rank several prospective
projects a firm is considering. Assuming all other factors are equal among the
various projects, the project with the highest IRR would probably be considered
the best and undertaken first.IRR is sometimes referred to as "economic rate of
return (ERR)".

IRRs can also be compared against prevailing rates of return in the securities
market. If a firm can't find any projects with IRRs greater than the returns that
can be generated in the financial markets, it may simply choose to invest its
retained earnings into the market.
56

The rate of return that would make the present value of future cash flows plus
the final market value of an investment or business opportunity equal the correct
market price of the investment and opportunity also called as the dollar weighted
rate of return.

15. Payback Period:

-

Payback period in capital budgeting refers to the period of time required for the
return on an investment to "repay" the sum of the original investment. For
example, a $1000 investment which returned $500 per year would have a two

year payback period. The time value of money is not taken into account.
Payback period intuitively measures how long something takes to "pay for
itself." All else being equal, shorter payback periods are preferable to longer
payback periods. Payback period is widely used because of its ease of use
despite recognized limitations, described below.
-

The term is also widely used in other types of investment areas, often with
respect to energy efficiency technologies, maintenance, upgrades, or other
changes. For example, a compact fluorescent light bulb may be described as
having a payback period of a certain number of years or operating hours,
assuming certain costs. Here, the return to the investment consists of reduced
operating costs. Although primarily a financial term, the concept of a payback
period is occasionally extended to other uses, such as energy payback period
(the period of time over which the energy savings of a project equal the amount
of energy expended since project inception); these other terms may not be
standardized or widely used.

Payback period as a tool of analysis is often used because it is easy to apply

and easy to understand for most individuals, regardless of academic training or
field of endeavour. When used carefully or to compare similar investments, it
can be quite useful. As a stand-alone tool to compare an investment to "doing
nothing," payback period has no explicit criteria for decision-making (except,
perhaps, that the payback period should be less than infinity).

The payback period is considered a method of analysis with serious limitations

and qualifications for its use, because it does not account for the time value of
money, risk, financing or other important considerations, such as the opportunity
cost. Whilst the time value of money can be rectified by applying a weighted
average cost of capital discount, it is generally agreed that this tool for
investment decisions should not be used in isolation. Alternative measures of
"return" preferred by economists are net present value and internal rate of return.
An implicit assumption in the use of payback period is that returns to the
investment continue after the payback period. Payback period does not specify
any required comparison to other investments or even to not making an
investment.

57
-

The length of time required to recover the cost of an investment.

Calculated as:
-

16. Net Present Value :

-

In finance, the net present value (NPV) or net present worth (NPW)[1] of a time
series of cash flows, both incoming and outgoing, is defined as the sum of the
present values (PVs) of the individual cash flows. In the case when all future
cash flows are incoming (such as coupons and principal of a bond) and the only
outflow of cash is the purchase price, the NPV is simply the PV of future cash
flows minus the purchase price (which is its own PV). NPV is a central tool in
discounted cash flow (DCF) analysis, and is a standard method for using the
time value of money to appraise long-term projects. Used for capital budgeting,
and widely throughout economics, finance, and accounting, it measures the
excess or shortfall of cash flows, in present value terms, once financing charges
are met.

The NPV of a sequence of cash flows takes as input the cash flows and a
discount rate or discount curve and outputs a price; the converse process in DCF
analysis - taking a sequence of cash flows and a price as input and inferring as
output a discount rate (the discount rate which would yield the given price as
NPV) - is called the yield, and is more widely used in bond trading.

The difference between the present value of cash inflows and the present value
of cash outflows. NPV is used in capital budgeting to analyze the profitability of
an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
Formula:

In addition to the formula, net present value can often be calculated using tables,
and spreadsheets such as Microsoft Excel.
58
-

NPV compares the value of a dollar today to the value of that same dollar in
the future, taking inflation and returns into account. If the NPV of a prospective
project is positive, it should be accepted. However, if NPV is negative, the
project should probably be rejected because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it

would first estimate the future cash flows that store would generate, and then
discount those cash flows into one lump-sum present value amount, say
$565,000. If the owner of the store was willing to sell his business for less than
$565,000, the purchasing company would likely accept the offer as it presents a
positive NPV investment. Conversely, if the owner would not sell for less than
$565,000, the purchaser would not buy the store, as the investment
would present a negative NPV at that time and would, therefore, reduce the
overall value of the clothing company.

Net Present Value (NPV), defined as the present value of the future net cash
flows from an investment project, is one of the main ways to evaluate an
investment. Net present value is one of the most used techniques and is a
common term in the mind of any experienced business person.

When choosing between competiting investments using the net present value
calculation you should select the one with the highest present value.
If:
NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal.

The Net Present Value Formula for a single investment is: NPV = PV less I
Where:
PV = Present Value
I = Investment
NPV = Net Present Value.

Widely used approach for evaluating an investment project. Under the net
present value method, the present value(PV)of all cash inflows from the project
is compared against the initial investment(I). The Net Present Value (NPV)
which is the difference between the present value and the initial investment (i.e.,
NPV =PV - I), determines whether the project is an acceptable investment. To
compute the present value of cash inflows, a rate called the cost of capital is
used for discounting. Under the method, if the net present value is positive(NPV
> 0 or PV>I), the project should be accepted.

59
17. Cost Benefit Analysis:
-

Cost benefit analysis is a term that refers both to:

Helping to appraise, or assess, the case for a project, programme or policy

proposal;
An approach to making economic decisions of any kind.

Under both definitions the process involves, whether explicitly or implicitly,

weighing the total expected costs against the total expected benefits of one or
more actions in order to choose the best or most profitable option. The formal
process is often referred to as either CBA (Cost-Benefit Analysis) or BCA
(Benefit-Cost Analysis).

Benefits and costs are often expressed in money terms, and are adjusted for the
time value of money, so that all flows of benefits and flows of project costs over
time (which tend to occur at different points in time) are expressed on a common
basis in terms of their present value. Closely related, but slightly different,
formal techniques include cost-effectiveness analysis, economic impact analysis,
fiscal impact analysis and Social Return on Investment (SROI) analysis. The
latter builds upon the logic of cost-benefit analysis, but differs in that it is
explicitly designed to inform the practical decision-making of enterprise
managers and investors focused on optimizing their social and environmental
impacts.

A cost benefit analysis is done to determine how well, or how poorly, a

planned action will turn out. Although a cost benefit analysis can be used for
almost anything, it is most commonly done on financial questions. Since the cost
benefit analysis relies on the addition of positive factors and the subtraction of
negative ones to determine a net result, it is also known as running the numbers.

A cost benefit analysis finds, quantifies, and adds all the positive factors. These
are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the
costs. The difference between the two indicates whether the planned action is
advisable. The real trick to doing a cost benefit analysis well is making sure you
include all the costs and all the benefits and properly quantify them.
Should we hire an additional sales person or assign overtime? Is it a good idea
to purchase the new stamping machine? Will we be better off putting our free
cash flow into securities rather than investing in additional capital equipment?
Each of these questions can be answered by doing a proper cost benefit analysis.

Example Cost Benefit Analysis

As the Production Manager, you are proposing the purchase of a $1 Million

stamping machine to increase output. Before you can present the proposal to the
Vice President, you know you need some facts to support your suggestion, so
you decide to run the numbers and do a cost benefit analysis.

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18. Feasibility Reports:

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This is formal document for management use, briefly enough and sufficiently
non technical to be understandable by high level management. There is no
standard or formal format for the preparation of feasibility report. Analyst
usually decides on a format that suits particular user and system.
The primary objectives of this report is to inform about the following matters.
1: What the proposed system will achieve.
2: Who will be involved in operating the proposed system in the organization.
3: The benefits that system will give.
4: The organizational changes needs for its successful implementation.
5: The estimated cost of the system.

The purpose of a feasibility study is to investigate the task requirements and to

determine whether it's worthwhile/feasible to develop the system.

19. Appraisal Process:

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STABLISHING PERFORMANCE STANDARDS;

The first step in the process of performance appraisal is the setting up of the
standards which will be used to as the base to compare the actual performance of
the employees. This step requires setting the criteria to judge the performance of
the employees as successful or unsuccessful and the degrees of their contribution
to the organizational goals and objectives. The standards set should be clear,
easily understandable and in measurable terms. In case the performance of the
employee cannot be measured, great care should be taken to describe the
standards.

20. Technical, Economical, and Financial Feasibility:

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Sinclair Knight Merz specialises in the conduct of economic and financial

evaluations. Economic evaluations are used to estimate the net benefit of
proposals to the community while financial evaluations are used to measure
viability from the perspective of the proponent only.

Sinclair Knight Merz also specialises in the estimation and incorporation of

non-market costs and benefits where markets do not exist for the goods or
services being evaluated. A series of indicators of economic or financial worth
are then derived, including net present values, benefit-cost ratios, net present
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value/capital cost ratios, internal rates of return, discounted payback periods and
cost-effectiveness ratios, which allow the comparison of alternative proposals
over their economic life.
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The evaluations below indicate the diverse nature of projects and sectors in
which Sinclair Knight Merz has experience.over their economic life.
This aspect involves a detailed assessment of the goods and the services needed
for the project land, building, raw materials, transportation, fuel, power, water,
technology etc.
The lender while advancing loan is quite keen about the financial feasibility of
the whole project. In the case of financial feasibility ask a question Should you
do it? In finding out financial feasibility, the following facts should be taken
into account:
1 Cost of Project.
2 Means of Financing.
3 Costs of Production and Profitability.
4 Cash Flow Estimates.
5) Proforma Balance Sheets.
- Businesses, governmental entities, and other organizations face great
uncertainty and risks when making decisions about major investments in new
manufacturing facilities, new products, new markets, new technologies, new
programs, and when acquiring other companies. Economic feasibility studies
provide the facts and analytical rigor to improve these types of strategic
decisions.
- An analysis of the regulatory and legal environment is another common
section in an economic feasibility study.

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UNIT 4

Break Even Analysis

Framework:
1. Basic Assumptions
2. Break Even Chart
3. Managerial Uses of Break Even Analysis
1. Basic Assumptions:
- Break-even analysis is a technique widely used by production management and
management accountants. Total variable and fixed costs are compared with sales revenue in
order to determine the level of sales volume, sales value or production at which the business
makes neither a profit nor a loss (the "break-even point").
- Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven
analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both
fixed and variable costs). At this breakeven point (BEP), a company will experience no income
or loss. This BEP can be an initial examination that precedes more detailed CVP analyses.
- Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis.
The assumptions underlying CVP analysis are:
1. Prices will remain fixed
2. Variable cost rate will remain fixed
3. Total fixed costs will remain fixed up to maximum manufacturing capacity of the firm
4. Quantity of units produced = quantity of unit sold, so there is no change in inventory.
5. Costs can be classified accurately as either fixed or variable.
6. All units produced are sold
7. Changes in activity are the only factors that affect costs
8. When a company sells more than one type of product, the sales mix (the ratio of each product
to total sales) will remain constant.

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2. Break Even Chart:

LMC explains The Breakeven Chart

A breakeven chart is a strategic tool used to plot the financial revenue of a business unit against
time or sales to determine the point when sales output is equal to revenue generated. This is
recognised as the breakeven point. The information used to determine and analyse the breakeven
point includes fixed, variable and total costs and the associated sales revenues. They are defined
as:

Fixed costs: costs that do not vary in relation to the level of sales output, for
example rent.
Variable costs: costs that vary in proportion to the level of sales output, for
example materials.

Total costs: the sum of all costs, including fixed and variable.

Associated sales revenues: the total revenue made by the company from
sales. It can be derived by multiplying price by output.

The analysis of a breakeven chart considers whether a venture runs at a profit or a loss. Sales
above the breakeven point indicates continued and profitable growth. The principle of breakeven theory is that during the early stages of a business venture, total costs, both fixed and
variable, exceed sales. As output increases, sales begin to rise faster than costs and, eventually,
they become equal (breakeven point). If sales continue to rise and exceed total costs, the business
achieves profitability.

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The tool assumes that all the goods which are produced will be sold and that costs, namely the
price, will remain constant. Likewise, it also relies on the capacity in terms of output to remain
unchanged.
Breakeven charts are universally applied to simply and graphically illustrate and forecast a
company's projected revenue, and to calculate the time for profitability to be reached. It is used
by financial and marketing strategists to predict the effect that changes in price will have on the
percentage change in sales over time. It is also a useful tool to analyse the relationship between
fixed and variable costs and to predict the effect on profitability of changes to those costs.
3. Managerial Uses of Break Even Analysis:
- Identify different techniques singer organization uses to measure managerial and
organizational performance.
- Such analysis allows the firm to determine at what level of operations it will break even
(earn zero profit) and to explore the relationship between volume, costs, and profits.It helps the
management that at current costs of products how many number of units must be sold to atleast
recover the cost of producing the product.
For Example: if you spend $200 on producing a product and selling price is $20 then you must
sale 10 units to atleast recover the cost of product.
It also helps the management to determine how much of units to be sold to get desired profit on
product.For example: if in the above example you want ot earn $20 profit then add it to it's cost
of $200 and it will become $220 now you need to earn profit of this $20 you need to sale 11
items of product.