Sumant S.

Chartered Accountant & Tutor for 3 years

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Economics

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Question:

What is the law of demand in economics? Discuss the applicability of the law of demand for Giffen goods?

Sumant S.

Answer:

The law of demand states that all other factors being equal to the price of good or service increases, consumer demand for the good or service will decrease and vice versa. Though this law has very wide applicability, there are some exceptions to this general rule. Giffen goods are one such exception. Giffen goods are those goods for which a higher price causes higher demand. For example. suppose the price of bread and meat increases in an economy. Now, if the income of relatively poorer sections of the population does not increase, they may end up buying more of bread than meat, thus, substituting bread for meat. Hence, though the price of bread has risen, its demand has also risen. This is the classic example of Giffen goods. Thus, for Giffen goods, income effect dominates the substitution effect.

Corporate Finance

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Question:

ABC Corp. issues a bond of face value 100 at 94 itself. The coupon rate is 15% and duration is 7 years. Find the cost of debt (bond) to the company before and after taxes. Assume corporate tax rate as 30%.

Sumant S.

Answer:

The present value of Cash Inflows from debt would be equal to Present Value of Cash Outflows. From the given information: Present Value of Cash Inflow = 94 (i.e. proceeds from issue of bond) Present Value of Cash Outflow = Present Values of all the coupon payments and the redeemable price at the end of year 7. i.e. 15 /(1 + k)^1 + 15 /(1 + k)^2 +...............................+ 15 /(1 + k)^7 + 100 /(1 + k)^7 = 94 where k is equal to the cost of debt. However, since solving the above would involve tedious calculations, a shortcut formula has been devised for finding the cost of debt i.e. k (cost of debt) = Coupon interest payment + (Redeemable Price - Issue Price)/ Life of Debt ________________________________________________________ (Redeemable Price + Issue Price) / 2 Putting the values in above equation, we get: k = 15 + (100 - 94)/7 ___________ (100 + 94)/2 = 16.4% Cost of debt before tax = 16.4% Cost of debt after tax = Cost of debt before tax ( 1 - tax rate) = 16.4 (1 - 0.30) = 11.48%

Accounting

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Question:

ABC Corporation purchases a machinery worth $ 200,000. It is to be depreciated. Life of the machine is 3 years. Estimated scrap value after 3 years is $12,800. The company follows written down value method of depreciation. Find the rate at which company should depreciate the machinery.

Sumant S.

Answer:

Let us assume that rate of depreciation is x % p.a. In Written Down Value method, Closing Book Value of Asset at the end of each year can be computed as Opening Book Value ( 1 - Depreciation Rate) In this case, Closing Book Value at end of Year 1 would be 200,000 (1 - x) which would become Opening Book Value for Year 2. Further, Closing Book Value at the end of Year 2 would be 200,000 (1 - x)(1 - x) Similarly, for Year 3 closing Book Value would be 200,000 (1 - x)(1 - x)(1 - x), which should be equal to 12,800 as provided in the question. Thus, we can frame the equation as: 200,000 (1 - x)(1 - x)(1 - x) = 12,800 Solving for x, we get x = 60% In examination problems, we need not go through this entire cycle and we can simply use the formula: Depreciation Rate under WDV method = 1 - (Salvage Value/Original Cost)^1/n i.e. Rate = 1 - (12800/200000)^(1/3) = 60%

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