108 Finance and Finance Reporting (Actuarrial)

Faculty of Actuaries Institute of Actuaries
EXAMINATIONS
13 April 2000 (pm)
Subject 108 Finance and Financial Reporting
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1. Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
2. Mark allocations are shown in brackets.
3. Attempt all 19 questions, beginning your answer to each question on a
separate sheet.
Graph paper is not required for this paper.
AT THE END OF THE EXAMINATION
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available
Actuarial Tables and an electronic calculator.
! Faculty of Actuaries
108A2000 ! Institute of Actuaries
1082
For questions 15 indicate in your answer booklet which one of the answers A, B, C or D
is correct.
1 In certain circumstances the Stock Exchange may grant a quotation for a
company even though the company is not making any new shares or existing
shares available to the market.
This method of obtaining a quotation is known as:
A A placing
B A tender issue
C An introduction
D A prospectus issue [2]
2 The following information relates to the ordinary shares of F plc:
Earnings per share 50p
Dividend cover 2.5 times
Published dividend
yield
3.2%
The price of F plcs ordinary shares implied by the above data is:
A 78p
B 625p
C 1563p
D 3906p [2]
1083 PLEASE TURN OVER
The following information relates to questions 3 and 4.
X Ltds Balance sheet as at 31 December 1999 included the following items:

Total assets less current liabilities 125,000
9% Debentures (repayable 2004) 20,000
105,000
Ordinary shares of 50p each 50,000
10% Preference shares of 1 each 20,000
Reserves 35,000
105,000
3 X Ltds profit before interest and taxation for the year to 31 December 1999
was 40,000.
X Ltds companys Return on Capital employed for the year ended 31
December 1999 is:
A 32%
B 38%
C 44%
D 47% [2]
4 X Ltds interest cover is:
A 6.6 times
B 10.5 times
C 13.9 times
D 22.2 times [2]
1084
5 A companys ordinary shares have a current market price of 2. The company
is making a 2 for 5 rights issue at a price of 1.50.
What is the ex-rights price?
A 1.50
B 1.74
C 1.86
D 2.60 [2]
In questions 610 one or more of the options may be correct. Answer in your booklet by
selecting according to the following code:
A if I and II only are correct
B if II and III only are correct
C if I only is correct
D if III only is correct
6 Which of the following assets are not intangible fixed assets?
I Research costs
II Trade marks
III Development costs [2]
7 Which of the following is true:
I Depreciation adjustments are attempts to reflect the value of fixed
assets in the balance sheet.
II Depreciation is an application of the matching concept.
III Depreciation is a measure of the wearing out or consumption of a
fixed asset over time. [2]
8 Which of the following statements about preference shares is correct?
I Preference shares carry fixed dividend rights.
II Preference dividends can be suspended if the directors decide that the
company cannot afford to pay them.
III Preference shareholders never have any voting rights. [2]
9 An ordinary share may have a high dividend yield because:
I Dividend cover is high.
II It is cheap.
III Dividend growth prospects are poor. [2]
10 Chargeable gains on the disposal of the following assets are not subject to
capital gains tax:
I Any residential properties.
II Private motor cars.
III British government securities. [2]
11 The directors of Sawburn plc have decided to investigate ways in which they
might improve their management of short and medium term finance. The
companys business involves irregular inflows and outflows of cash. The
directors have tended not to rely on bank overdraft in order to deal with cash
shortages, preferring to use short fixed term loans instead. They are now
considering a change to this policy because of the greater flexibility of
overdraft finance. They have decided that this might reduce finance costs
because interest is only paid on overdrafts on the amount by which the account
is actually overdrawn.
Describe the factors that the directors should take into account in making this
change of policy and explain whether overdraft is likely to be the most suitable
form of short term finance in these circumstances. Your answer should make
appropriate references to the alternatives to overdrafts. [8]
12 The directors of a company are planning to undertake a rights issue. Describe
the factors that should be taken into account in deciding whether to have this
issue underwritten. [6]
13 Explain what is meant by the term associate company and explain how
associates are treated on consolidation. [4]
14 Discuss the proposition that ratio analysis is considered to be a useful method
of interpreting financial statements, although it has some limitations. [6]
15 A company intends to acquire a factory and 600,000 of plant and machinery.
Explain the taxation implications of leasing these assets rather than
purchasing them outright. [6]
16 Describe the main features of merchant banks and discuss their influence on
the financial markets. [6]
1086
17 Explain how the Bank of England provides liquidity in the money markets. [4]
18 The following information has been extracted from the accounting records of
Tyler plc:
Trial Balance at 31 March 2000
000
Administration costs 800
Bank overdraft 700
Debtors 1,300
Factory cost 23,300
Factory depreciation 1,800
Factory running costs 1,200
Loan interest 1,680
Long term loans 12,000
Machinery cost 15,000
Machinery depreciation 8,000
Manufacturing wages 1,300
Materials consumed 1,600
Profit and loss account 380
Sales 13,000
Sales salaries 1,600
Share capital 12,000
Stock at 31 March 2000 700
Trade creditors 600
Notes:
(a) The corporation tax charge for the year has been estimated at
1,290,000.
(b) The directors have proposed a dividend of 1,400,000.
(c) At the year end the directors had the factory professionally revalued.
The valuers report estimates the value of the property at 25,000,000.
This value is to be incorporated into the balance sheet.
(d) During the year the company charged depreciation of 460,000 on the
factory and 2,000,000 on the machinery. The company purchased new
machinery at a cost of 2,700,000. There were no other transactions
involving fixed assets. All of these adjustments and transactions have
been incorporated into the above figures.
Prepare Tyler plcs profit and loss account for the year ended 31 March 2000
and the balance sheet as at that date. These should be in a form suitable for
publication. You should provide a note in respect of tangible fixed assets, but
you are not otherwise required to provide notes to the accounts. You should,
however, clearly show your workings. [20]
1087
19 The directors of Holt plc have introduced a formal system of investment
appraisal. Projects must have a positive net present value when discounted at
a cost of capital determined in relation to their systematic risk. The board is
presently considering two unrelated projects. One is for an investment in a
speculative research project. This is fraught with potential problems because
it is dependent on the successful application of a recent theoretical discovery
reported in the physics literature. Even if the technical problems can be
overcome, there is a serious risk that another company will offer the principal
scientists who are the leading specialists in their field more lucrative
contracts. The other project is a rather more predictable expansion of the
production facilities for an existing product line which has a well established
market.
The beta coefficient for the research project is 0.6 while that of the new
production facilities is 1.3. The risk free rate is 3% and the risk premium is
8%.
(a) Calculate the required rate of return for each of the projects. [4]
(b) Explain why it might be possible that an apparently risky project could
have a lower required rate of return than that for a less volatile project.
[6]
(c) Explain whether company directors are likely to accept the logic
underlying the capital asset pricing model (CAPM) in practice when
they are making investment decisions. [5]
(d) Outline alternative ways in which one might estimate the beta
coefficient of a project. [5]
[Total 20]
EXAMINATIONS
April 2000
EXAMINERS REPORT
Faculty of Actuaries
Institute of Actuaries
Subject 108 (Finance and Financial Reporting) April 2000 Examiners Report
Page 2
1 C
2 B
3 -
4 -
5 C
6 C
7 B
8 A
9 B
10 -
There were three small errors in questions in order to ensure no student was
unfairly penalised for this the paper was marked out of 94 and the three questions
were discounted. The remaining questions were answered well.
11 The directors should consider the cost of the different types of finance available to
them. Clearly, it is desirable to use the cheapest source unless it has some other
disadvantage. Different types of finance involve different levels of risk for the
lender and that will tend to result in different rates of interest.
The other major issue is the risks created for the company. A source of finance
might leave the company open to serious penalties if it is forced to default for any
reason. For example, a secured loan will tend to be relatively cheap but might
create serious problems for the company if the lender calls in the security.
Furthermore, the company will have a limited borrowing capacity for any given
type of finance. Exhausting this might restrict its ability to deal with future
problems.
Bank overdrafts do provide a flexible means of dealing with fluctuating
requirements. Most loans commit the company to the payment of interest
throughout the agreed term of the loan. Early repayment might not be permitted
by the agreement or could involve an additional charge. Overdraft facilities can
be agreed with the bank and then used and as and when the company requires.
The company can borrow up to its overdraft limit for as short a period as it
requires the funding. Interest will be charged on a daily basis on the actual
amount outstanding.
The rates of interest charged on overdrafts tend to be quite high and so it might
prove to be an expensive source of finance if the company is likely to be heavily
overdrawn for a large proportion of the time. Term loans might prove cheaper in
this situation because of lower rates, even though there might be short periods of
cash surplus during which the company does not actually require the funding.
One disadvantage of using the overdraft facility is that the banks are likely to
impose a restriction on the maximum amount that they are willing to advance in
this manner. Having the capacity to borrow up to the limit at short notice could
be useful if the company has an unexpected need for cash. If part of the facility
has been used up in the course of normal operations then the company will be
more severely constrained.
Page 3
There may be other sources of finance which would be more suitable for the
companys fluctuating needs. For example, debt factoring makes it possible to
raise cash immediately after a sale has taken place. This has the advantage of
bringing in more cash at busier times when the companys needs might be
greater and could offer many of the benefits of overdraft without using up any of
the actual overdraft facility.
This question was well answered by most candidates
12 The main advantage of underwriting a share issue is that there is no risk of the
company being left with unsold shares. If the rights issue proves unattractive to
shareholders then the company may have insufficient funds to finance the project
for which the shares were being issued. It may prove difficult and expensive to
raise additional long term finance by some other means.
The main disadvantage of underwriting the issue is that the company will have
to incur fees which may prove substantial. While this might be a worthwhile
investment, it is desirable to minimise such costs wherever possible.
The rights issue is likely to prove successful if the new shares are sold at a
reasonable discount. While any discount is likely to make the shares attractive,
the volatility of the stock market and of the company itself should be considered.
If the share price is likely to move rapidly then the rights price could exceed the
market price, thereby making he new shares unattractive.
The extent to which the company can persuade the markets that the new funds
will be invested profitably will also have some bearing on the need for an
underwriter. If the company has a viable project then the share price could rise
in response to that information and that will make the issue even more
attractive. The company should discuss the likely market perception of the
project with independent experts such as the companys merchant bankers.
This question was reasonably well answered by candidates
13 An associate company is one in which the holding company has an interest which
grants it some influence, but not outright control. This is normally implied by an
investment which exceeds 20% of share capital, but is less than 50%.
Associate companies are included in the consolidated profit and loss account by
including the groups share of their profits, regardless of whether those profits
have been distributed by way of dividend. The group share of net assets is
included in the consolidated balance sheet.
The first part of this question was well answered however candidates had little
idea of how the associate should be treated in the consolidation as a result the
marks were low.
Page 4
14 Many figures in the financial statements are difficult to interpret in isolation. For
example, it means very little to know how much profit a business made without
having some corresponding idea of the amount of capital that had to be invested
in order to generate this income.
Ratios provide a basis for comparing related figures and for identifying issues
that ought to be investigated. Management might, for example, monitor liquidity
by calculating the current ratio and would deal with any deviation from the
optimal relationship usually 2:1.
Trends in ratios can be particularly revealing. For example, a decreasing current
ratio is normally a more worrying sign than a ratio which appears to be low in
absolute terms.
Ratios do have a number of drawbacks. For example, they can be distorted by
wilful manipulation of the figures (e.g. window dressing or off-balance sheet
financing). They can also omit crucial information such as contingent liability
information.
This question was well answered
15 If the company purchases the assets then it will receive a writing down
allowance on both the industrial buildings and the plant and machinery. This
means that the tax benefits of the investment will not be received immediately
after the investment takes place. Instead, the company will have to offset the
cost against taxable profit in future years.
If the company borrows in order to finance the acquisition of the assets then it
will be able to claim tax on the interest payments.
Rental payments on property and lease payments on plant and machinery will
attract immediate tax relief, with the taxable profit being reduced by the
amounts of the cash flow in each year.
The companys ability to enjoy the tax relief on writing down allowances is
related to its ability to earn taxable profits. If the company is making a loss for
tax purposes then it will receive no benefit from the additional writing down
allowances. A lessor may be in a better position to take advantage of these reliefs
and this may well be reflected in the rentals.
This question was quite well answered by the majority of candidates.
Page 5
16 Merchant banks specialise in corporate finance. Their role is largely advisory.
Typically, merchant banks will provide advice on the following types of matter:
1. bid or defence strategies in a takeover
2. financial aspects of a merger
3. investment projects
4. raising capital
They also act as intermediaries in the issue of financial instruments:
1. issuing houses in share issues
2. underwriters of new issues
3. Eurobonds
Merchant banks also provide fund management services:
1. management of unit trusts, investment trusts and pension funds
2. organisation of the Eurobond market
Merchant banks are active in the money markets:
1. as guarantors of bills of exchange
2. as holders of Treasury bills and local authority bills
Occasionally, merchant banks provide finance to companies.
Candidates answered the first part of the question well but were unsure of
merchant banks influence on the market.
17 The Bank of England acts in a supporting role for the various institutions that
are active in the short-term money markets, particularly the discount houses.
The discount houses provide short term finance by borrowing cash surpluses that
might be available for as little as a few days and lending for a slightly longer
period. This difference in maturity between their assets and liabilities can leave
them exposed to the risk of being unable to repay their debts.
The risk of default is avoided because the Bank of England will always provide
the discount houses with support whenever they need it. This can take the
following forms:
1. The Bank will always be prepared to purchase Treasury or local authority
bills or bills of exchange from the discount houses in order to help them
through a cash crisis.
2. The Bank will act as a lender of last resort provided the discount houses
deposit bills as security.
3. The discount houses can sell a bill of exchange to the Bank and
simultaneously agree to repurchase it at a later date.
Page 6
This support is available because the discount houses are an important element
of the Banks mechanism for controlling short term interest rates. The discount
houses agree to buy the Treasury bills that the Bank sells at its weekly Treasury
bill auctions.
This question was well answered by most candidates.
Page 7
18 Tyler plc
Profit and loss account
for the year ended 31 March 2000
000 000
Turnover
Cost of sales - 4,100
Gross profit
Distribution costs - 1,600
Administrative expenses - 800
- 2,400
Operating profit
Interest payable - 1,680
Taxation - 1,290
Dividend - 1,400
Retained profit for the year
Retained profit brought forward
Retained profit carried forward 2,510
Tyler plc
Balance sheet as at 31 March 2000
000 000
Tangible fixed assets (note 1) 32,000
Current assets
Stock 700
Trade debtors 1,300
2,000
Creditors: amounts due within one year
Bank overdraft - 700
Trade creditors - 600
Taxation - 1,290
Proposed dividend - 1,400
- 3,990
Net current liabilities - 1,990
30,010
Long term liabilities - 12,000
18,010
Share capital 12,000
Revaluation reserve 3,500
Profit and loss 2,510
18,010
Page 8
Note 1 Tangible fixed assets
Factory
Machinery
Total
000 000 000
Cost at 31 March 1999 23,300 12,300 35,600
Additions - 2,700 2,700
Adjustment on revaluation 1,700 - 1,700
Cost at 31 March 2000 25,000 15,000 40,000
Depreciation at 31 March 1999 1,340 6,000 7,340
Charge for year 460 2,000 2,460
Adjustment on revaluation - 1,800 - - 1,800
Depreciation at 31 March 2000 - 8,000 8,000
Net book value at 31 March 2000 25,000 7,000 32,000
Net book value at 31 March 1999 21,960 6,300 28,260
Cost of sales
Factory running costs 1,200
Manufacturing wages 1,300
Materials consumed 1,600
4,100
This question was badly answered very few candidates produced a note for
fixed assets and the formats were poor. Given that this is not one of the new
topics it was surprising how badly the question was answered.
19 (a) Required rate on the research project = 3+(8*.6) = 7.8%
Required rate on expansion = 3+(8*1.3) = 13.4%
(b) The total risk associated with an investment is not particularly important
in the context of a diversified portfolio. A significant proportion of the risk
in most investments can be diversified away. In other words, factors such
as movements in exchange rates will have an adverse effect on some
investments and a positive effect on others. The effect of investing in a
portfolio is to reduce the overall volatility of the returns.
Risk can be separated into two components: systematic and unsystematic.
Systematic risk is inherent in the political and economic environment and
is common to all companies. For example, a change in energy prices will
affect all companies to some extent. Unsystematic risk is specific to the
company. It encompasses a range of risks specific to the company such as
changes in market demand for its products, stability of industrial
relations, nature and location of its assets, and so on.
Page 9
Systematic risk cannot be diversified away because it arises from factors
which will have an effect on all companies. Thus, an increase in interest
rates or oil prices is likely to have an adverse effect on all companies and
will depress returns from the market as a whole. Unsystematic risk can
be diversified away and, provided the investment is held in a properly
diversified portfolio, it can therefore be ignored.
It is possible that a highly speculative investment will not be affected by
general market conditions to any great extent. That means that it will not
have a high systematic risk. The volatility will, therefore, be due to
unsystematic factors that can be diversified away. That, in turn, suggests
that the investment may require a very low return.
(c) Company directors are in a rather different position from shareholders. A
shareholder can hold a diversified portfolio of investments and can,
therefore, reduce the risks associated with a particular investment. A
director will probably have only one principal employer and will,
therefore, be motivated more by total risk.
This different perspective might be evidenced by a tendency to invest in
relatively safe projects. This is because a disaster might be rather
catastrophic for the board even though it would have relatively little
impact on the shareholders.
Alternatively the board might be inclined to seek diversification for the
company even though the shareholders can diversify for themselves.
Given that diversification will have the effect of distracting management
from the core activities of the business, the overall effect will not be in the
shareholders interests.
(d) One approach is to use the companys own beta coefficient. That is only
relevant, however, if the project is subject to the same risks as the
company as a whole.
Another approach is to use the beta of a company which is engaged in the
same line of business as the project.
A third possibility is to use historical data to estimate the betas of
individual divisions or segments of the main company. These betas can
then be used as a surrogate for the coefficients of individual projects
which fall within their scope.
This question was very badly done by most candidates. Many candidates
correctly calculated the answer to part (a) and then demonstrated little
understanding of the theory required in the rest of the question. This is an
important area of finance and candidates should study the topic more
carefully.
EXAMINATIONS
14 September 2000 (pm)
1. Write your surname in full, the initials of your other names and your
Candidates Number on the front of the answer booklet.
3. Attempt all 18 questions, beginning your answer to each question on a
separate sheet.
Hand in BOTH your answer booklet and this question paper.
In addition to this paper you should have available
Actuarial Tables and an electronic calculator.
108S2000 Institute of Actuaries
1082
For questions 14 indicate in your answer booklet which one of the answers A, B, C or D
is correct.
1 Which of the following statements is incorrect:
A Companies can issue ordinary shares below the par value.
B Ordinary shares normally offer a higher expected return than other
classes of security.
C A companys authorised share capital will be laid down in its
Memorandum of Association.
D An appropriate way of valuing ordinary shares is to find the present value
of the future dividend stream. [2]
2 One of G plc's employees developed a new product. This has just been patented.
The development costs of this product were negligible, but the patent rights are
almost certainly worth many millions of pounds. Which accounting concept
would prevent the company from recognising the value of this patent as a fixed
asset in its balance sheet?
A Going concern
B Materiality
C Money measurement
D Prudence [2]
3 Which of the following is not true for a finance lease?
A The lease agreement has a primary period which covers all or most of the
useful economic life of the asset.
B The lessee is normally responsible for servicing and maintenance of the
asset.
C The lease payments will appear in the profit and loss account as an
expense.
D The lessee records the leased asset as a fixed asset in its balance sheet.
[2]
4 Which of the following best describes the effects of an increase in the risk
characteristics of a project when evaluating its net present value?
A The discount rate increases and the net present value increases.
B The discount rate increases and the net present value decreases.
C The discount rate remains constant, but the net present value decreases.
D The discount rate decreases and the net present value decreases.
[2]
In questions 510 one or more of the options may be correct. Answer in your booklet by
selecting according to the following code:
A if I and II only are correct
B if II and III only are correct
C if I only is correct
D if III only is correct
5 Companies who wish to raise finance by issuing sterling commercial paper have
to meet certain minimum standards. They must:
I be listed on the London Stock Exchange
II have a minimum level of net assets of 50m
III have a minimum level of share capital of 50m [2]
6 When choosing between two mutually exclusive projects, the internal rate of
return can give a misleading decision. Which of the following may be reasons for
this?
I Projects can have more than one rate of return.
II Internal rate of return ignores the rates of return available from other
projects.
III Internal rate of return ignores the cost of capital. [2]
7 An increase in the value of a fixed asset due to revaluation would:
I increase the equity of a company
II make the balance sheet look stronger
III increase the profit of a company [2]
8 Which of the following would you normally expect to find in the external auditors
report to the shareholders:
I a certificate guaranteeing the truth and fairness of the financial
statements
II a statement that the directors were responsible for preparing the financial
statements
III a brief description of the work undertaken by the auditor prior to drafting
the report [2]
1084
9 A company might carry out a rights issue at a deep discount:
I to reduce the share premium account
II to avoid misunderstandings by unsophisticated shareholders
III to avoid having to pay underwriting costs [2]
10 Which of the following statements is true?
I Specific risk can be diversified away on a large, well spread portfolio.
II Systematic risk arises because of the volatility of the market as a whole.
III Diversification across a well diversified internationally-based portfolio will
remove systematic risk entirely. [2]
11 Explain the shareholder value approach to project evaluation. [6]
12 X Plc is planning an expansion and requires 500,000 in order to do so. The
directors are unsure whether to finance this by debt or equity. Discuss the
factors they should take into account including any taxation implications. [8]
13 Describe the accounting standard setting process in the UK and explain why
such a system is necessary. [8]
14 Describe the role life insurance offices play in the investment markets. [6]
15 Explain the taxation treatment of UK company dividends and also how franked
investment income is treated. [6]
16 Companies throughout the world raise finance by issuing Eurobonds. Describe
the main characteristics of Eurobonds and briefly explain their popularity. [6]
17 The profit and loss accounts and balance sheets of two manufacturing companies
are shown below:
T Plc Y Plc
000 000 000 000
Sales 600 700
Cost of sales 240 210
Gross profit 360 490
Selling expenses 54 84
Administrative expenses 60 35
114 119
Net profit 246 371
Taxation 64 100
182 271
Dividend 80 110
102 161
Retained profit b/fwd 106 230
208 391
T Plc Y Plc
000 000 000 000
Fixed assets
Property - 500
Machinery 760 280
760 780
Current assets
Stock 48 26
Debtors 150 105
Bank 2 22
200 153
Current liabilities
Creditors (including Tax) 89 118
Net current assets 111 35
871 815
Share capital 663 424
Profit and loss 208 391
871 815
Compare these two companies in terms of their profitability and solvency.
Explain which company appears to be the better managed in respect of each of
these matters. You should support your answer with ratios. [20]
1086
18 Z plc is a large, long established manufacturing company. The company is
expanding and the directors are keen to identify new ways in which they might
obtain the necessary finance. The finance director has warned that the company
must obtain most of this new funding from the sale of new shares. The company
has borrowed very heavily in the past and the company's existing loan
agreements require it to seek the permission of existing lenders before obtaining
further debt.
Z plc is not quoted on the stock exchange. The family of the companys founders
owns most of the companys share capital. It is unlikely that these investors will
be able to invest the sums required to take advantage of the opportunities that
the directors have identified. It has been suggested that the company might seek
a stock exchange quotation.
(i) Explain the advantages and disadvantages to Z plc of issuing fresh share
capital. [6]
(ii) Explain the advantages and disadvantages of obtaining a stock exchange
quotation. [6]
(iii) Assuming that Z plc obtains a quotation, identify the most appropriate
method by which the company might issue fresh share capital and
describe the steps that are involved. Your answer should explain why you
have chosen this particular method. [8]
[Total 20]
EXAMINATIONS
September 2000
EXAMINERS REPORT
Subject 108 (Finance and Financial Reporting) September 2000 Examiners Report
Page 2
1 A
2 C
3 C
4 B
5 A
6 C
7 A
8 B
9 D
10 A
Comment on Questions 1 to 10
There were no particular problems with the objective test questions, with most candidates
scoring a reasonable mark.
11 The shareholder value approach to project evaluation considers the net present
value of the project from the shareholders perspective.
In theory, investing in a positive NPV project will increase shareholders wealth
by the amount of that NPV. In practice, this change will only occur if the market
is aware of the investment and agrees with managements estimates of the
potential risks and rewards. It may be that the share price will not move in line
with expectations because the market is not convinced that the risk is justified or
even because the directors have withheld important information for the sake of
commercial sensitivity.
The directors would essentially attempt to apply the same valuation models used
by outside analysts and advisers in an attempt to determine how the
information that they intend to publish will impact the share price.
Comment on Question 11
Many candidates had clearly not understood that the shareholder value approach is a
clearly defined technique for project evaluation. A large number of answers were clearly
based on a sensible guess as to what the technique might comprise.
12 The directors should consider the current level of gearing. If the company is
already heavily financed by debt then it will be difficult for the directors to justify
borrowing more.
The use of one form of finance can have implications for the risks, and therefore
costs, associated with the other. Issuing fresh debt will expose the existing
shareholders to a greater risk of losing their investment if the company is forced
to default on its loans. This will mean that the cost of equity might increase.
Issuing fresh equity creates a broader buffer between assets and liabilities for
providing lenders with collateral and that might reduce the cost of debt.
Page 3
Debt finance is usually cheaper than equity and so the company should consider
using it wherever possible. The lower cost is partly because the debt holders are
taking much less of a risk when they purchase debt stock and are, therefore,
willing to accept a lower rate of return.
The cost of debt is further reduced because interest is allowable as an expense for
tax purposes, whereas dividends on shares is not.
It might be difficult to sell 500,000 of share capital without incurring
disproportionate issue costs. Raising debt can be rather more flexible. The
company could, however, get round this by issuing rather more than 500,000
and using the additional sum raised to repay some of its existing debt.
This question was generally answered well.
13 A body called the Financial Reporting Council (FRC) is responsible for the
standard setting process. The FRC concentrates on the management of the
process and delegates the real work of developing standards to the Accounting
Standards Board (ASB). The FRCs contribution to the process is largely
restricted to raising finance for the ASB and appointing its members.
The ASB develops documents called Financial Reporting Standards (FRSs).
FRSs are intended to reduce the number of acceptable treatments for specific
items in the financial statements. One example of this is FRS 2 which deals with
group accounts. This standard defines the relationship between holding
companies and their subsidiaries and establishes a standard approach to their
incorporation into consolidated financial statements.
A typical standard would be set in the following manner:
ASB establishes a working party.
Working party drafts an exposure draft (ED).
ED published and comments invited.
Interested parties may lobby in defence of their interests.
There may be one or more rounds of revision to the ED.
FRS issued.
This process involves considerable openness, but it also creates the risk of the
standards being influenced by the actions of lobbyists.
This system is necessary because there have been many controversies over the
correct preparation of financial statements. These have led to problems with the
credibility of the profession. Standards also reduce processing and interpretation
costs for users because they can become more familiar with the specific
treatments adopted by all companies for particular items.
Page 4
Many candidates appeared to be writing everything that they knew about accounting in
the hope that this related to the question. The most common error was to write a detailed
explanation of the concepts underlying financial accounting, with no reference whatsoever
to the regulatory framework referred to in the question.
14 Life insurance companies are major institutional investors and, collectively, are
amongst the very largest institutions.
The companies collect cash from policy holders and invest this in the long term.
Policy holders will normally be offered the expectation of a future bonus based on
the profits of the company. This has the effect of requiring insurance companies
to seek out investment opportunities which both offer the prospect of maintaining
the real purchasing power of their deposits and also a realistic expectation of
capital growth.
Insurance companies are also subject to a number of regulatory constraints on
the nature of their investments. These are partly attributable to the need to
maintain solvency margins in accordance with DTI regulations.
15 Franked investment income (FII) is the grossed-up value of dividends paid by UK
companies. The cash value of the dividend received is grossed up by the addition
of a tax credit which is currently 10%.
The tax credit is a reflection of the fact that the dividend has been paid out of
profits which have already been subject to corporation tax. Individuals who are
basic rate taxpayers will not normally pay any further tax on their FII. The FII
is added to their taxable income, but the tax credit will cancel the additional tax
that this would involve. Non taxpayers cannot, however, recover the tax credit
which has been notionally withheld by the company. Higher rate taxpayers may
have to pay some additional tax in order to satisfy their obligation to pay tax at
the higher rate.
Companies must also include their FII in their tax computation and will be liable
to tax on it. This income will, however, be taxed at a flat rate of 20% regardless
of the rate of corporation tax to which the company is subject.
Page 5
16 Eurobonds are bonds which are issued outside of the companys domicile. There
is a thriving market in such arrangements. The fact that the stocks are traded
in a country in which the host government has no particular interest can mean
that they are not subject to any legal or tax regulations. This lack of regulation
can reduce issuing costs and the possibility of freedom from taxes can even
reduce the coupon rates of debts. Eurobonds tend to be traded through banks
rather than recognised stock exchanges.
Eurobonds can be issued in almost any currency. They are redeemed at par with
coupon payments throughout the term of the bond. Almost all Eurobonds are
unsecured. Eurobonds are bearer documents.
Most Eurobonds offer a fixed coupon rate, although some offer a variable coupon
rate.
17
T plc Y plc
ROCE 246 28 % 371 46 %
871 815
Gross profit % 360 60 % 490 70 %
600 700
Selling / sales 54 9 % 84 12 %
600 700
Admin / sales 60 10 % 35 5 %
600 700
Current ratio 200 2.2 :1 153 1.3 :1
89 118
Acid test ratio 152 1.7 :1 127 1.1 :1
89 118
Y plc is the more profitable company because it has a higher return on capital
employed. It appears to have achieved a higher return by virtue of three factors:
It can generate a higher gross profit from every of sales. Either it is selling
at a higher margin or it can obtain goods at a lower cost price.
Page 6
Its sales appear to be supported by a higher spend on advertising. This has
enabled it to achieve higher sales despite having higher selling prices.
It manages to spend less on administration.
Y plc also appears to have better managed working capital. At first glance, T plc
has a textbook current ratio of 2:1. The company has a very high acid test
ratio, which appears to be due to very slow turnover of debtors. This means that
the company has a great deal of finance tied up in non-productive assets. These
are not necessarily available to meet short-term commitments.
18 (i) Share capital is the most flexible form of finance. The payment of
dividend is entirely at the discretion of the directors. If the dividends are
withheld for any reason then the shareholders have no direct sanctions
against the company, other than the right to sell their shares on the open
market.
Issuing fresh share capital also makes it easier to raise further finance by
borrowing. This is because lenders are usually keen to see the company
maintain a sensible relationship between debt and equity. If the company
fails then the lenders must be repaid in full before the shareholders
receive anything. If the shareholders have financed a large proportion of
the share capital then this protects the lenders from the loss of their
principal.
Share capital tends to be a rather expensive form of finance. This is
because shareholders bear a much higher risk than lenders. They have to
be rewarded with a substantial return in order to motivate them to accept
this level of risk. In addition, the company does not receive any tax relief
on dividends whereas loan interest is tax deductible.
Issuing additional share capital will also tend to dilute the sense of
ownership and control enjoyed by the present shareholders. They might
be willing to forego the opportunity to expand if doing so would make
them accountable to outside shareholders.
(ii) A stock exchange quotation would provide a ready market for the sale of
shares. This would make it easier for the company to sell fresh shares on
the open market. It would also offer existing and future shareholders a
means of disposing of their shares.
The fact that an investment in the company could be liquidated more
easily would make it a more attractive prospect, thereby reducing the cost
of finance.
Page 7
The availability of a ready market means that market forces will
determine an objective share price. This can be a useful piece of
information for shareholders and directors alike. There can be tax
problems associated with the gift of shares that cannot be easily valued.
Knowing the share price makes it easier to calculate the cost of capital.
The stock exchange imposes strict regulations on the behaviour of quoted
companies. The fact that a company is willing to accept this discipline
provides further confidence for both shareholders and lenders and so
should have the effect of further reducing finance costs.
There are, of course, substantial transaction costs associated with
obtaining a listing. Apart from professional fees and other direct costs, a
great deal of management time will be taken up.
The fact that the companys shareholders can sell their shares easily on
the market might encourage them to take a short-term outlook. This
could make the company vulnerable to take-over bids.
(iii) The company ought to consider an offer for sale. This would involve
selling new shares to the general public at a fixed price which was
determined by the directors. The advantage of this is that it raises
additional capital at the same time as introducing the company to the
stock exchange.
There is relatively little risk of this type of transaction going wrong
because the company would sell the shares via an issuing house. The
issuing house would act as an intermediary between the company and the
public. In the first instance, the issuing house would purchase the shares
from the company and then resell them to the public. This means that
the company knows in advance how much the issue will generate because
the issuing house is responsible for any lack of demand and will be left
holding any unsold shares.
The use of an issuing house also provides the company with a source of
experience and advice in the selection of other professionals and in the
coordination of their various efforts.
Well before the offer for sale, the company will engage an issuing house.
The issuing house will try to generate interest in the launch, e.g. by
publicising positive news that might be picked up by the financial press.
In the weeks before the launch, the issuing house will advise on the price
that should be set. This will normally be a reasonably conservative
figure, if only because a higher issue price would involve a greater risk for
the issuing house and that might result in higher fees and premia.
The company is required to publish a prospectus, which is a formal
document required by the stock exchange. This is a detailed document
containing a wealth of historical and forecast information, both financial
and non-financial. This information will also be supported by a number of
Page 8
assurances from the companys external auditors. The prospectus will
also state the offer price for the shares.
The prospectus will be reproduced in at least one national newspaper and
may be distributed in other ways.
Anyone wishing to purchase shares can do so during the period
immediately after the publication of the prospectus. Hopefully, the offer
price was set at a level that would encourage investment and the issue
will be over-subscribed. This means that the issuing house will have to
decide on the most appropriate basis for the allocation of shares.
Finally, the successful applicants will receive letters of acceptance.
Official trading on the stock exchange can take place on the day after the
acceptance letters are posted.
This question tended to be answered well in some parts, but not others. Parts (i) and (ii)
were generally answered well, although there was very little attempt to relate answers to
the facts of the scenario. Part (iii) tended to generate a checklist of mechanisms for issuing
shares instead of recommending one particular technique, as required by the question.
!"#$%&' )* +#&$",-./ 01/&-&$&. )* +#&$",-./
23+405+60758
5 ArII 200l (m)
8$9:.#& ;<= > !-1"1#. "1? !-1"1#-"% @.A),&-1B
!"#$ &''()$*+ !,-$$ ,(.-/
!"#$%&'$!("# $( $*+ ',"-!-,$+
01 2-"3$ 4(.- /.-5&#$ "5 6.''7 3,$ "5"3"&'/ (6 4(.- (3,$- 5&#$/ &5* 4(.-
8&5*"*&3$9/ :.#;$- (5 3,$ 6-(53 (6 3,$ &5/)$- ;((<'$31
=1 >&-< &''(?&3"(5/ &-$ /,()5 "5 ;-&?<$3/1
@1 A33$#B3 &'' 0C D.$/3"(5/1 E-(# D.$/3"(5 00 (5)&-*/ ;$F"5 $&?, &5/)$- (5 &
/$B&-&3$ /,$$31
./012 1013/ 45 678 /39:4/3; <7/ 8245 1013/=
A! !GH H:I JE !GH HKA>L:A!LJ:
G&5* "5 MJ!G 4(.- &5/)$- ;((<'$3 &5* 3,"/ D.$/3"(5 B&B$-1
L5 &**"3"(5 3( 3,"/ B&B$- 4(. /,(.'* ,&N$ &N&"'&;'$
A?3.&-"&' !&;'$/ &5* &5 $'$?3-(5"? ?&'?.'&3(-1
IncuIfy of AcfunrIos
l08A200l InsfIfufo of AcfunrIos
l08 A200l2
E(- D.$/3"(5/ 0O0P "5*"?&3$ "5 4(.- &5/)$- ;((<'$3 ),"?, (5$ (6 3,$ &5/)$-/ A7 M7 8 (- I
"/ ?(--$?31
; C Ic Is fo mnko n 3 for 5 rIghfs Issuo nf l20. If fho rIco of fho shnros on fho
dny fho nIIofmonf Ioffors woro osfod wns l40, whnf rIco wouId you oxocf for
fho shnros ox-rIghfs whon donIIngs commonco
A l2?.5
I l30
C l32.5
l40 |2]
C A koy dIfforonco bofwoon fho nof rosonf vnIuo fochnIquo nnd fho InfornnI rnfo of
rofurn fochnIquo for cnIfnI budgofIng Is:
A fhnf fho nof rosonf vnIuo Is onsIor fo cnIcuInfo
I fhnf fhoy uso dIfforonf cnsh fIows
C fhnf fhoy hnvo dIfforonf roInvosfmonf rnfo nssumfIons
fhnf fhoy nro roIovnnf fo fho shnrohoIdors |2]
D WhIch of fho foIIowIng wouId 576 bo IncIudod In n fIrm`s cnIfnI sfrucfuro
A rofnInod onrnIngs
I dIvIdonds
C cnIfnI surIus
convorfIbIo dobonfuros |2]
E WhIch of fho foIIowIng Is 576 n curronf nssof
A sfock
I crodIfors
C dobfors
cnsh |2]
F WhIch of fho foIIowIng Is 576 n mofhod of shorf form borrowIng
A commorcInI nor
I bIII of oxchnngo
C fncforIng
IonsIng |2]
l08 A200l3 GH2+82 6I@5 7J2@
K WhIch of fho foIIowIng nro IImIfod comnnIos 576 roquIrod fo roduco ns n
rosuIf of fho ComnnIos Acf
A chnIrmnn`s roorf
I dIrocfors` roorf
C bnInnco shoof
nudIfor`s roorf |2]
L WhIch of fho foIIowIng Is 576 n mofhod of brIngIng n socurIfy fo IIsfIng
A nn offor for snIo
I n scrI Issuo
C nn offor for subscrIfIon
nn InfroducfIon |2]
= A mnnufncfurIng comnny`s cnsh bnInncos hnvo run Iow. WhIch of fho foIIowIng
wouId Incronso cnsh In fho shorf form
A ross dobfors for romfor nymonf
I ny crodIfors moro quIckIy
C oncourngo snIos sfnff fo soII moro
doIny fho ncquIsIfIon of n Ioco of mnnufncfurIng oquImonf |2]
M WhIch of fho foIIowIng sfnfomonfs Is 576 fruo of soIf-ndmInIsforod onsIon
funds
A n fyIcnI fund Invosfs mnInIy In Indox IInkod gIIfs
I mosf oxIsfIng schomos nro dofInod bonofIf schomos
C nII fho schomos nro rosonsIbIo for fhoIr own Invosfmonf sfrnfogy
nImosf nII rIvnfo socfor schomos nro fundod |2]
;< WhIch of fho foIIowIng Is 576 nn InfnngIbIo nssof
A dovoIomonf cosfs
I nfonfs
C Invosfmonfs
goodwIII |2]
;; IxInIn fho dIfforoncos bofwoon nn Invosfmonf frusf nnd n unIf frusf. |8]
;C IxInIn why n comnny wouId sook n Sfock Ixchnngo quofnfIon. |8]
l08 A200l4
;D oscrIbo fho dIfforonf roorfs fho oxfornnI nudIfor cnn gIvo whon If Is ImossIbIo
fo oxross nn unqunIIfIod oInIon. |6]
;E OrdInnry shnros nro fho mosf Imorfnnf form of fInnncInI Insfrumonf usod by !K
comnnIos.
(I) oscrIbo fho mnIn chnrncforIsfIcs of ordInnry shnros. |6]
(II) IxInIn why ordInnry shnros nro moro mnrkofnbIo fhnn Ionn cnIfnI. |2]
|TofnI 8]
;F IxInIn why onsIon funds hnvo socInI roguInfIons govornIng fho form nnd
confonf of fhoIr fInnncInI sfnfomonfs. |4]
;K IxInIn why n comnny mIghf Issuo convorfIbIo socurIfIos Insfond of
sfrnIghfforwnrd dobf or oquIfy. |6]
;L IQ! Ic Is n hnrmncoufIcnI comnny. Tho comnny`s rosonrch donrfmonf hns
IdonfIfIod n comound fhnf cnn curo fho common coId wIfhouf nny sIdo offocfs.
!nforfunnfoIy, fho mnnufncfuro of fhIs comound roquIros fho comnny fo Invosf
honvIIy In n hIgh fochnoIogy fncfory whIch wIII uso n numbor of now fochnIquos,
somo of whIch nro unrovon. Tho comnny wIII nIso nood fo rocruIf nnd rofnIn
fho sorvIcos of n numbor of omInonf scIonfIsfs, onch of whom Is bofh vIfnI fo fho
rojocf nnd wouId bo IrroInconbIo.
IInnncIng fhIs rojocf wIII roquIro fho comnny fo borrow honvIIy. Tho comnny
Is unIIkoIy fo survIvo ns nn Indoondonf onfIfy If If Invosfs In fhIs rojocf nnd If
fnIIs. Tho dIrocfors hnvo boon ndvIsod fhnf fhoro Is nf Ionsf n 50 chnnco of n
cnfnsfrohIc fnIIuro.
Tho rojocf hns n bofn of 0.5. Tho rIsk froo rnfo Is 3 nnd fho oquIfy rIsk
romIum Is 8. Tho rojocf offors nn osfImnfod rofurn of 24.
!IQ!I!I:
(n) CnIcuInfo fho roquIrod rnfo of rofurn for fho rojocf. |2]
(b) IxInIn how InvosfIng In fhIs rojocf wouId nffocf fho wonIfh of IQ! Ic`s
shnrohoIdors. |5]
(c) IxInIn how nn nnronfIy rIsky rojocf cnn hnvo n roInfIvoIy Iow
roquIrod rnfo of rofurn. |?]
(d) IxInIn whofhor you boIIovo fhnf fho dIrocfors of IQ! Ic wIII Invosf In
fho rojocf. |6]
|TofnI 20]
l08 A200l5
;= MO Ic hns n numbor of dIfforonf busInoss Inforosfs. Tho dIrocfors of MO nro
Inforosfod In IdonfIfyIng mnnngors for romofIon fo sonIor osIfIons. As nrf of
fhIs rocoss, fhoy nro comnrIng fho orformnnco of fwo nufonomous dIvIsIons,
bofh of whIch urchnso goods In buIk for rosnIo fo smnII rofnIIors. Inch dIvIsIon
Is rosonsIbIo for n dIfforonf nrf of fho counfry, buf Is ofhorwIso ongngod In fho
snmo IIno of busInoss. Tho dIrocfors hnvo ronrod fho foIIowIng summnry
fInnncInI sfnfomonfs from fho comnny`s bookkooIng rocords:
H&/3$-5
*"N"/"(5
2$/3$-5
*"N"/"(5
Q-(6"3 /3&3$#$53/ R4$&- $5*$* @0 I$?$#;$- =PPPS TPPP TPPP
SnIos 800 l,400
Cosf of snIos 320 490
Cross rofIf 480 9l0
AdvorfIsIng nnd dIsfrIbufIon 80 l96
AdmInIsfrnfIon 64 56
OornfIng rofIf 336 658
Inforosf 24 ll
of rofIf 3l2 64?
M&'&5?$ /,$$3/ R&/ &3 @0 I$?$#;$- =PPPS TPPP TPPP
IIxod nssofs l,000 l,200
Curronf nssofs
Sfock 5l 5?
obfors 80 222
Innk l0 ?
l4l 286
Curronf IInbIIIfIos
CrodIfors 48 53
WorkIng cnIfnI 93 233
!ong form Ionns 200 l00
893 l,333
CnIfnI 893 l,333
(n) Comnro fho orformnnco of fho fwo dIvIsIons In forms of fhoIr
rofIfnbIIIfy, IIquIdIfy nnd mnnngomonf of sfock, dobfors nnd crodIfors.
Your nnswor shouId bo suorfod by roIovnnf rnfIos, nIfhough fhoso
shouId form onIy nrf of your nnnIysIs. |l4]
(b) oscrIbo fho IImIfnfIons of your nnnIysIs In (n), oxInInIng why fho
dIrocfors shouId sook nddIfIonnI InformnfIon boforo mnkIng n fInnI
docIsIon nbouf fho suIfnbIIIfy of oIfhor dIvIsIonnI mnnngomonf fonm for
romofIon. |6]
|TofnI 20]
!"#$%&' )* +#&$",-./ 01/&-&$&. )* +#&$",-./
23+405+60758
ArII 200l
8$9:.#& ;<= > !-1"1#. "1? !-1"1#-"% @.A),&-1B
IXAMII!S` !IIO!T
InsfIfufo of AcfunrIos
Subject 108 (Finance and Financial Reporting) April 2001 Examiners' Report
Page 2
Suggosfod nnswors:
; C
C A
D I
E I
F
G A
H I
= A
I A
;< C
!"#"$%&&' %&& )*&+,-&" ./0,1" 2*"3+,0#3 4"$" %#34"$"5 10$$"1+&' 4,+/ +/" 6%70$,+' 08
1%#5,5%+"3 310$,#9 0:"$ ;<=
;; Invosfmonf frusfs nro comnnIos, mosf of whIch nro IIsfod on fho Sfock
Ixchnngo. Shnros In Invosfmonf frusfs cnn bo urchnsod nnd soId ns for nny
ofhor quofod comnny.
Unit trusts are not companies, but are trusts in the strict legal sense. They cannot,
thereIore, be quoted on the Stock Exchange. Units can only be bought Irom and sold to
the management company which organises the trust.
Invosfmonf frusfs fond fo socInIIso In Invosfmonfs In ofhor comnnIos, nIfhough
somo Invosf In gIIfs, roorfy nnd ovorsons comnnIos.
!nIf frusfs nro fnr moro honvIIy consfrnInod nnd roguInfod In forms of whnf fhoy
cnn Invosf In nnd fhoy fond fo rosfrIcf fhoIr Invosfmonfs fo quofod socurIfIos.
Invosfmonf frusfs cnn borrow In nddIfIon fo rnIsIng funds from Invosfors. !nIf
frusfs musf roIy on fho snIo of unIfs for fInnnco. ThIs monns fhnf Invosfmonf
frusfs cnn offor fhoIr shnrohoIdors fho bonofIfs of gonrIng whorons unIf frusfs
cnnnof.
!nIfs In unIf frusfs nro normnIIy rIcod by fnkIng fho mnrkof vnIuo of fho frusf`s
undorIyIng nssofs nnd dIvIdIng by fho numbor of unIfs. Tho mnnngomonf chnrgos
nIIod for runnIng fho fund nro nId for by nn InIfInI chnrgo IovIod on fho fund
Invosfod. Shnros In Invosfmonf frusfs nro normnIIy worfh Ioss fhnn fho mnrkof
vnIuo of fho nssofs dIvIdod by fho numbor of shnros. Tho mnIn ronson for fhIs Is
Page 3
fhnf fho mnnngors fnko nn nnnunI foo for fhoIr mnnngomonf chnrgo nnd fhIs hns
fho offocf of dorossIng fho vnIuo of fho shnros roInfIvo fo fhoIr undorIyIng nssofs.
>/,3 ?*"3+,0# 4%3 %#34"$"5 :"$' 4"&& 4,+/ 603+ 1%#5,5%+"3 310$,#9 :"$' /,9/
6%$@3
;C A quofnfIon wIII hoI fo rnIso cnIfnI. If fho comnny Is quofod fhon If wIII bo nbIo fo
soII shnros fo n wIdo mnrkof nnd rnIso Inrgo sums chonIy. ThIs Is bocnuso fho
quofnfIon wIII rovIdo n froo socondnry mnrkof In fho comnny`s shnros.
IrovIdors of dobf wIII Iond moro hnIIy fo n quofod comnny ns fhoy know fhnf fho
comnny musf comIy wIfh fho Sfock Ixchnngo roquIromonfs on nn ongoIng bnsIs.
ShnrohoIdors wIII nIso bonofIf from fho fncf fhnf fho shnros wIII hnvo n rondIIy
obsorvnbIo mnrkof rIco whIch mny bo usofuI for fnx urosos nnd nIso for orffoIIo
mnnngomonf. Thoso ndvnnfngos wIII nIso hoI fho comnny fo rnIso funds.
Tho onso wIfh whIch shnros In quofod comnnIos cnn bo frndod monns fhnf
shnrohoIdors hnvo nn onsy oxIf roufo If fhoy ovor docIdo fo soII fhoIr Invosfmonf.
Tho fncf fhnf fhoy cnn do so monns fhnf fhoy wIII fooI fnr moro socuro whon buyIng
shnros.
Tho rondy nvnIInbIIIfy of n mnrkof rIco monns fhnf fho shnros nro fnr moro
nccofnbIo fo omIoyoos If fhoy nro grnnfod ns nrf of n shnro ofIon schomo. If wIII
bo ossIbIo fo nffrIbufo n vnIuo fo fho shnros or ofIons rocoIvod.
Tho fncf fhnf fho shnros nro IIsfod wIII nIso mnko fhom moro rondIIy nvnIInbIo fo
uso ns fho urchnso consIdornfIon In n fnkoovor sIfunfIon. ShnrohoIdors of fho
fnrgof comnny wIII hnvo n fnr cIonror ImrossIon of fho roInfIvo vnIuos of fho
shnros boIng offorod comnrod wIfh fho onos fhnf fhoy nIrondy hoId.
AB1"&&"#+ %#34"$3 C' 6%#' 1%#5,5%+"3= .%#5,5%+"3 4/0 /%5 3+*5,"5 +/" 10$"
$"%5,#9 80*#5 +/,3 ?*"3+,0# 3+$%,9/+80$4%$5!
;D Tho mosf common form of qunIIfIod oInIon Is fho oxcof for form. ThIs Is
nrorInfo whon fho nudIfor hns oncounforod n mnforInI dIsngroomonf ovor fho
fInnncInI sfnfomonfs or hns boon subjocf fo n mnforInI uncorfnInfy bocnuso fho
scoo of fho nudIf work hns boon rosfrIcfod. Tho oxcof for mnkos If cIonr fhnf fho
fInnncInI sfnfomonfs gIvo n fruo nnd fnIr vIow oxcof for fho chnngos fhnf wouId
hnvo boon nocossnry In ordor fo corrocf for fho dIsngroomonf or In rosonso fo fho
rosoIufIon of fho uncorfnInfy.
Thoro nro fwo moro oxfromo forms of qunIIfIod oInIon. Advorso oInIons nro usod
whon fho nudIfor dIsngroos wIfh fho ImrossIon cronfod by fho fInnncInI sfnfomonfs
so vIoIonfIy fhnf s/ho Is of fho oInIon fhnf fho fInnncInI sfnfomonfs do nof gIvo n
fruo nnd fnIr vIow. IscInImors of oInIon nro gIvon whon fho nudIfor Is fncod wIfh
such fundnmonfnI uncorfnInfy fhnf If Is ImossIbIo fo foII whofhor fho fInnncInI
sfnfomonfs gIvo n fruo nnd fnIr vIow. In fhIs Inffor cnso, fho nudIfor rofusos fo
oxross nn oInIon.
In onch of fho cnsos doscrIbod nbovo, fho nudIfor wIII doscrIbo fho robIoms fhnf
hnvo Iod fo fho nood for n qunIIfIod oInIon nnd wIII mnko fhoIr ImIIcnfIons cIonr
Page 4
fo fho rondors. Thon fho roorf wIII cIonrIy sfnfo fho oInIon, mnkIng uso of ono of
fho roscrIbod forms of qunIIfIcnfIon.
>/,3 ?*"3+,0# 4%3 +/" 603+ -00$&' %#34"$"5 ,# +/" -%-"$D 1&"%$&' 603+ 1%#5,5%+"3
/%5 ,9#0$"5 +/,3 ,# +/" 10$" $"%5,#9= E 40*&5 "6-/%3,3 +/%+ %&& +0-,13 ,# +/" 10$"
$"%5,#9 %$" &,@"&' +0 C" "B%6,#"5 %#5 ,+ $"%&&' -%'3 +0 3+*5' %&& +/" %$"%3=
;E OrdInnry shnrohoIdors bonr fho rIsks nnd rownrds of ownorshI. Thoy nro Insf fo
bo ronId In fho ovonf fhnf fho comnny fnIIs. Thoy mny nIso rocoIvo IIffIo or no
dIvIdond nf dIffIcuIf fImos. On fho ofhor hnnd, fhoy wIII nIso bo onfIfIod fo nII of
fho rofIfs nffor fnx nnd nny roforonco dIvIdond. Thoy wIII normnIIy bo fho onIy
onos onfIfIod fo vofo nf gonornI moofIngs.
Ordinary shareholders will normally have a relatively volatile return Irom their
investment, but this will be compensated Ior by the possibility oI unrestricted
opportunity Ior capital growth. II the company is a massive success then the shareholders
may Iind that their stake increases in value beyond all recognition.
OrdInnry shnros nro bnckod by ronI frndIng nssofs. ThIs monns fhnf fhoy offor n
monsuro of rofocfIon ngnInsf InfInfIon. ThIs Is rofIocfod by fho fncf fhnf, on
nvorngo, ordInnry shnros hnvo gIvon n hIghor Iong form rofurn fhnn nny ofhor
Invosfmonf.
OrdInnry shnros nro normnIIy IrrodoomnbIo. Indood, fhoro nro rovIsIons fhnf nro
dosIgnod fo onsuro fhnf shnrohoIdors cnnnof hnvo fhoIr cnIfnI rofurnod.
ShnrohoIdors normnIIy rocoIvo n dIvIdond, nIfhough fho nmounf of fhIs wIII bo nf
fho dIscrofIon of fho dIrocfors. Tho nmounfs wIII bo nffocfod by fho comnny`s
orformnnco nnd nIso by fho bonrd`s dosIro fo rofnIn funds for fufuro oxnnsIon.
OrdInnry shnros fond fo bo mnrkofnbIo bocnuso fhoro Is nn ncfIvo socondnry
mnrkof In fho shnros of quofod comnnIos. ThIs Is nssIsfod by fho fncf fhnf fho
shnros fond fo bo Issuod In Inrgo, homogonous bIocks, mnkIng fho cronfIon of n
mnrkof worfhwhIIo. Ofhor Insfrumonfs nro moro IIkoIy fo bo Issuod In smnIIor,
moro frngmonfod frnnchos nnd so fhoro Is Ioss scoo for offorIng n IIquId
socondnry mnrkof.
F9%,# %#34"$"5 4"&&=
;F IonsIon funds offor n vohIcIo for Invosfmonf, In oxncfIy fho snmo mnnnor ns nny
ofhor form of commorcInI onfIfy. Thoro nro, howovor, sIgnIfIcnnf fonfuros whIch
mnkos fhoIr nccounfIng rIncIIos dIfforonf:
IonsIonors hnvo fnr Ioss scoo for dIvorsIfIcnfIon In fhoIr onsIons fhnn In nny
ofhor fyo of InvosfIng ncfIvIfy. ThIs monns fhnf fhoy hnvo fo bo kof
Informod nbouf fho sfownrdshI of fhoIr fund fo roduco fho rIsk of fhom boIng
Ioff oxosod fo fho Ioss of fhoIr onsIons.
Page 5
IonsIon funds hnvo vory Iong form commIfmonfs fo onsIonors nnd musf
domonsfrnfo fhnf fhoy nro boIng mnnngod for fho Iong form.
Tho Ioss of n onsIon mny bo fnr moro sorIous fhnn fho Ioss of nny ofhor fyo
of Invosfmonf. IonsIonors mny bo fnr moro vuInornbIo bocnuso fhoy nro
unIIkoIy fo hnvo fho cnncIfy fo onrn suffIcIonf Incomo fo mnko u for nny
Ioss.
Thoso fncfors como fogofhor fo cronfo n nood for mombors of n onsIon fund fo
rocoIvo ndoqunfo nccounfIng InformnfIon fo onnbIo fhom fo monsuro fho
sfownrdshI nnd orformnnco of fho fund. Tho rondors mny bo roInfIvoIy
unsohIsfIcnfod nnd roquIro ovon gronfor rofocfIon fhnn fhnf offorod fo fho rondors
of fho fInnncInI sfnfomonfs of IImIfod comnnIos.
)03+ -0,#+3 6"#+,0#"5 C' 1%#5,5%+"3 D /04":"$ &,++&" 6"#+,0# 08 %110*#+,#9
,#80$6%+,0# ,# 603+ %#34"$3=
;G ConvorfIbIos nro nffrncfIvo fo Issuors whon If Is foIf fhnf fho rIco of fho ordInnry
shnros Is nbnormnIIy Iow. ThIs mIghf hnon In fho cnso of n sfnrf-u or n busInoss
whIch Is donIIng wIfh consIdornbIo fomornry uncorfnInfy. IssuIng frosh shnros
undor such cIrcumsfnncos wouId dIIufo fho oquIfy of oxIsfIng shnrohoIdors. Thoro
wIII sfIII bo somo dIIufIon whon fho dobonfuros nro convorfod, buf fhIs wIII
hoofuIIy bo Ioss fhnn wouId nrIso If fho shnros hnd boon Issuod whon fho comnny
wns nf n frnnsIfIonnI sfngo.
Tho comnny hns fo bo ronsonnbIy confIdonf fhnf fho shnro rIco Is onIy
fomornrIIy dorossod, ofhorwIso fho dobonfuro hoIdors wouId nof convorf. In
fhnf cnso fho comnny wouId hnvo fo fInd cnsh In ordor fo moof fho rodomfIon.
ConvorfIbIos nro ossonfInIIy n monns of rnIsIng oquIfy durIng dIffIcuIf orIods. Thoy
cnn bo rofornbIo fo sfrnIghf Ionn sfock bocnuso fhoy nro soIf-IIquIdnfIng nnd cnn bo
Issuod nf n sIIghfIy Iowor couon rnfo. Thoy mIghf nffrncf n nrfIcuInr grou of
Invosfors who nro IookIng for n gunrnnfood shorf form Incomo Ius fho ossIbIIIfy of
n cnIfnI gnIn nf n Infor dnfo.
>/,3 ?*"3+,0# 4%3 -00$&' %#34"$"5D 6%#' 1%#5,5%+"3 5"31$,C"5 10#:"$+,C&"3 C*+
4"$" %+ % &033 +0 3*99"3+ 4/' 106-%#,"3 6,9/+ 4,3/ +0 ,33*" +/"6= E+ 40*&5 C"
C"#"8,1,%& ,8 1%#5,5%+"3 10*&5 %--&' +/" 10$" $"%5,#9 +0 5,88"$"#+ 3,+*%+,0#3 $%+/"$
+/%# 3,6-&' 6"60$,3,#9 8%1+3=
;H (n) Tho roquIrod rnfo of rofurn Is rIsk froo rnfo + (bofn x oquIfy rIsk romIum).
!oquIrod rnfo of rofurn = 3 + (0.5 x 8) = ?.
(b) InvosfIng In fhIs rojocf wouId Incronso fho shnrohoIdors` wonIfh. Tho
roquIrod rnfo of rofurn, fnkIng rIsk Info nccounf, Is onIy ?. Tho rojocf
ncfunIIy offors 24. ThIs monns fhnf fho rojocf hns n osIfIvo nof rosonf
vnIuo (IV) nnd fho vnIuo of fhoIr shnros wIII Incronso by fho IV of fhIs
rojocf.
Tho Incronso wIII, howovor, onIy occur If fho sfock mnrkof hns suffIcIonf
InformnfIon fo form n vIow on Ifs IIkoIy oufcomo. If musf nIso ngroo wIfh
mnnngomonf`s ovnIunfIon of fho rojocf. If shnrohoIdors nro Ioss ofImIsfIc
fhnn fho bonrd fhon fho shnro rIco wIII nof rIso by ns much.
Page 6
(c) Tho rIsks nssocInfo wIfh Invosfmonfs nro sIIf Info fhoso fhnf cnn bo
dIvorsIfIod nwny nnd fhoso fhnf cnnnof. Tho rIsks fhnf cnn bo dIvorsIfIod
nwny cnn bo Ignorod bocnuso nny rnfIonnI Invosfor wIII hoId n brond orffoIIo
of nssofs. Somo of fho Invosfmonfs wIII do bndIy buf fhIs wIII bo comonsnfod
by fho fncf fhnf ofhors wIII do woII. Ovor fho orffoIIo ns n whoIo fho Invosfor
shouId oxocf fo hnvo n rofurn fhnf fonds fownrds fhnf offorod by fho
mnrkof ns n whoIo.
If fho orffoIIo hns boon woII consfrucfod, fho onIy vnrInfIon from mnrkof
rofurns shouId bo bocnuso of nny doIIbornfo sfrucfurIng of fho orffoIIo fo
Ionvo fho shnrohoIdor oxosod fo moro or Ioss of fho rIsks fncod by fho
mnrkof ns n whoIo. Thoso rIsks cnnnof ovor bo dIvorsIfIod nwny bocnuso fhoy
nffocf nII comnnIos fo somo oxfonf or nnofhor. Ior oxnmIo, nn Incronso In
Inforosf rnfos wIII ush down mosf shnro rIcos fo somo oxfonf nnd so nII
Invosfmonfs wIII suffor.
!ookIng nf IQ! Ic`s rojocf from fho shnrohoIdors` orsocfIvo, mnny of fho
rIsks nro vory socIfIc fo fho Invosfmonf. Tho rIsk fhnf fho fochnoIogy wIII
nof work or fhnf fho sfnff wIII Ionvo cnn bo counforod by InvosfIng In n
suffIcIonf srond of ofhor socurIfIos fo cnncoI fho hIghs nnd Iows on fhIs
rojocf wIfh fhoso obfnInod from ofhors. Tho rojocf mIghf nof bo
nrfIcuInrIy sonsIfIvo fo fncfors fhnf nffocf fho mnrkof ns n whoIo nnd so If
nood nof roquIro n hIgh rnfo of rofurn.
(d) In fhoory fho dIrocfors shouId onIy bo concornod wIfh fho shnrohoIdors`
wonIfh. Thnf monns fhnf fhoy shouId Invosf In fhIs rojocf bocnuso If hns n
osIfIvo IV. Tho fncf fhnf If mIghf fhronfon fho comnny`s oxIsfonco wouId
nof mnffor bocnuso fhoIr orffoIIos wIII IncIudo somo comnnIos fhnf wIII fnII
nnd ofhors fhnf wIII fhrIvo.
Tho dIrocfors cnnnof, howovor, dIvorsIfy In quIfo fho snmo mnnnor. Mosf of
fhoIr Incomo wIII como from fhIs ono comnny nnd fhoIr orsonnI
roufnfIons wIII bo nssocInfod wIfh Ifs succoss or fnIIuro. Thoy wIII,
fhoroforo, hnvo n gronf donI fo Ioso If fhoy uf fho shnrohoIdors` Inforosfs
fIrsf. Tho dIrocfors mIghf nIso fooI n mornI rosonsIbIIIfy fownrds fho ofhor
omIoyoos fo onsuro fhnf fho comnny survIvos In ordor fo koo fhom In
omIoymonf.
Tho dIrocfors mIghf nIso bo concornod fhnf mnny Invosfors wIII nof
nrocInfo fho Imorfnnco of InnnIng fhoIr Invosfmonfs on n orffoIIo bnsIs.
Thoy mIghf crIfIcIso fho dIrocfors for fnkIng n rIsk fhnf Is, In fncf, jusfIfIod by
fho rofurns offorod. If fhoy do nof nccof fhnf mnny of fho rIsks nro socIfIc
fo fho rojocf nnd cnn bo dIvorsIfIod nwny fhoy mIghf nccuso fho dIrocfors of
mIsmnnngomonf.
G%$+ % 4%3 4"&& %#34"$"5 D +/" $"6%,#,#9 -%$+3 08 +/" ?*"3+,0# 4"$" -00$&'
%#34"$"5D 603+ 1%#5,5%+"3 /%5 &"%$#"5 8%1+3 C*+ 80*#5 ,+ 5,88,1*&+ +0 %--&'
+/"3" +0 -$%1+,1%& 3,+*%+,0#3=
Page 7
;= (a)
Eastern Western
Return on capital employed 31224
893200
31 64711
1333100
46
ProIit margin 336
800
42 658
1,400
47
Gross proIit 480
800
60 910
1400
65
Advertising " sales 80
800
10 196
1400
14
Administration / sales 64
800
8 56
1400
4
Asset turnover 800
1000
0.8 times 1400
1200
1.2 times
Current ratio 141
48
2.9 times 286
53
5.4 times
Quick ratio 141 51
48
1.9 times 286-57
53
4.3 times
Stock turnover 51 x365
320
58 days 57 x 365
490
42 days
Debtors turnover 80
800
37 days 222
1400
58 days
Creditors turnover 48
320
55 days 53
490
39 days
Wosforn hns n hIghor rofurn on cnIfnI omIoyod. Thnf Is onough In IfsoIf fo
IndIcnfo fhnf If Is fho moro rofIfnbIo of fho fwo comnnIos.
Wosforn nonrs fo hnvo sonf moro on ndvorfIsIng wIfh n vIow fo sookIng n
hIghor soIIIng rIco or unIf. ThIs mny hnvo confrIbufod fo n hIghor ovornII
rofIfnbIIIfy. Tho comnny hns nIso mnnngod fo snvo consIdornbIy on
ndmInIsfrnfIon cosfs, sondIng onIy 4 of furnovor ns oosod fo 8. IInnIIy,
Wosforn hns mnnngod fo obfnIn n hIghor nssof furnovor.
Wosforn hns nIso mnnngod IIquIdIfy moro offocfIvoIy. Tho comnny hns Ionnor
curronf nnd quIck nssof rnfIos. Insforn nonrs fo bo honvIIy ovor Invosfod In
unroducfIvo nssofs.
IInnIIy, Wosforn nIso nonrs fo hnvo n boffor sfrnfogy for fho mnnngomonf of
sfock, dobfors nnd crodIfors. If Is furnIng sfock ovor rnIdIy, fhoroby mnnngIng
cnsh fIows. If hns mnnngod fo offor dobfors n ronsonnbIo orIod of crodIf, ossIbIy
jusfIfyIng Ifs romIum rIcIng oIIcy. If Is nIso nyIng crodIfors wIfhIn n ronIIsfIc
orIod, fhoroby mnInfnInIng Ifs crodIf rnfIng.
(b)
Thoro Is nIwnys n rIsk fhnf nccounfIng fIguros nro nof comnrnbIo. Tho
nccounfIng oIIcIos couId bo dIfforonf or fho comnnIos` nccounfnnfs couId hnvo
mndo dIfforonf osfImnfos nnd nssumfIons.
Wosforn Is nIso 50 Inrgor In forms of furnovor. Thnf mIghf mnko fho comnny
nonr fo bo moro offIcIonf, whon If Is ncfunIIy onjoyIng oconomIos of scnIo. Thoso
oconomIos couId mnsk nn undorIyIng wonknoss In mnnngomonf.
Thoro couId bo ofhor sfrucfurnI ronsons why Wosforn onjoys gronfor succoss. Tho
comnny couId, for oxnmIo, soII fo n dIfforonf, moro rofIfnbIo mnrkof sogmonf.
InrrIors fo onfry mIghf mnko If ImossIbIo for Insforn fo comofo dIrocfIy.
H"&& %#34"$"5 C' 603+ 1%#5,5%+"3=
!"#$%&' )* +#&$",-./ 01/&-&$&. )* +#&$",-./
23+405+60758
ll Sofombor 200l (m)
8$9:.#& ;<= > !-1"1#. "1? !-1"1#-"% @.A),&-1B
!"#$ &''()$*+ !,-$$ ,(.-/
!"#$%&'$!("# $( $*+ ',"-!-,$+
01 2-"3$ 4(.- /.-5&#$ "5 6.''7 3,$ "5"3"&'/ (6 4(.- (3,$- 5&#$/ &5* 4(.-
8&5*"*&3$9/ :.#;$- (5 3,$ 6-(53 (6 3,$ &5/)$- ;((<'$31
=1 >&-< &''(?&3"(5/ &-$ /,()5 "5 ;-&?<$3/1
@1 A33$#B3 &'' 0C D.$/3"(5/1 E-(# D.$/3"(5 00 (5)&-*/ ;$F"5 $&?, &5/)$- (5 &
/$B&-&3$ /,$$31
./012 1013/ 45 678 /39:4/3; <7/ 8245 1013/=
A! !GH H:I JE !GH HKA>L:A!LJ:
G&5* "5 MJ!G 4(.- &5/)$- ;((<'$3 &5* 3,"/ D.$/3"(5 B&B$-1
L5 &**"3"(5 3( 3,"/ B&B$- 4(. /,(.'* ,&N$ &N&"'&;'$
A?3.&-"&' !&;'$/ &5* &5 $'$?3-(5"? ?&'?.'&3(-1
l08S200l (l5.2.0l) InsfIfufo of AcfunrIos
l08 S200l2
E(- D.$/3"(5/ 0O0P "5*"?&3$ "5 4(.- &5/)$- ;((<'$3 ),"?, (5$ (6 3,$ &5/)$-/ A7 M7 8 (- I
"/ ?(--$?31
; WhIch of fho foIIowIng Is subjocf fo fnxnfIon In fho !K
A socInI socurIfy bonofIfs
I wInnIngs from gnmbIIng
C rofIfs from nn ISA
dIvIdonds from n !K comnny |2]
C WhIch of fho foIIowIng sfnfomonfs Is 576 fruo of Invosfmonf frusfs
A nn Invosfmonf frusf Is n comnny
I fhoy rnIso oquIfy nnd dobf cnIfnI
C fhoy novor Invosf In fho shnros of ofhor !K comnnIos
mosf Invosfmonf frusfs nro IIsfod on fho sfock oxchnngo |2]
D Whon n fIrm nnnouncos n fwo-for-ono scrI Issuo Invosfors shouId oxocf fhnf, (In
fho nbsonco of ofhor now InformnfIon):
A onrnIngs or shnro wIII fnII buf fho sfock rIco wIII romnIn fho snmo
I fho sfock rIco wIII fnII buf fho onrnIngs or shnro wIII romnIn fho snmo
C bofh fho onrnIngs or shnro nnd fho sfock rIco wIII romnIn fho snmo
bofh fho onrnIngs or shnro nnd fho sfock rIco wIII fnII |2]
E Tho nomInnI vnIuo of n bond Is rocoIvod by fho bondhoIdor:
A nf fho fImo of urchnso
I nnnunIIy
C whonovor couon nymonfs nro mndo
nf mnfurIfy |2]
F Tho nof rosonf vnIuo mofhod of cnIfnI budgofIng nssumos fhnf cnsh fIows nro
roInvosfod nf:
A fho fIrm`s cosf of cnIfnI
I fho fIrm`s dIvIdond yIoId
C no rnfo fhoy nro nof roInvosfod
fho rnfo of rofurn of fho rojocf |2]
l08 S200l3 GH2+82 6I@5 7J2@
K Tho nybnck mofhod cnn Iond fo fho wrong docIsIon boIng mndo bocnuso:
A If Ignoros Incomo boyond fho nybnck orIod
I fho nybnck orIod Is dIffIcuIf fo cnIcuInfo
C fho rofurns In Infor yonrs nro uncorfnIn
of fho omhnsIs Incod on fho Inforosf fncfor |2]
L WhIch of fho foIIowIng chnngos In workIng cnIfnI wIII rosuIf In nn Imrovomonf
In n comnny`s nof cnsh InfIow from oornfIng ncfIvIfIos
A Incronso In crodIfors
I Incronso In sfock
C Incronso In dobfors
docronso In ofhor curronf IInbIIIfIos |2]
= Tho foIIowIng rnfIos woro cnIcuInfod from fho fInnncInI sfnfomonfs of C Ic, n
mnjor mnnufncfurIng comnny.
Sfock furnovor l2 dnys
obfors furnovor 42 dnys
CrodIfors furnovor 46 dnys
Ior how Iong, on nvorngo, doos C Ic hnvo cnsh fIod u In nny nrfIcuInr Ioco of
sfock
A 8 dnys
I l2 dnys
C 54 dnys
l00 dnys |2]
l08 S200l4
M H Ic`s summnry fInnncInI sfnfomonfs nro ns foIIows:
Q-(6"3 &5* '(// &??(.53
E(- 3,$ 4$&- $5*$* @0 >&-?, =PP0 RPPP
IrofIf boforo fnx nnd Inforosf 2,000
Inforosf (300)
TnxnfIon (500)
l,200
IvIdond (?00)
!ofnInod for yonr 500
InInnco broughf forwnrd 4,?00
InInnco cnrrIod forwnrd 5,200
M&'&5?$ /,$$3
A/ &3 @0 >&-?, =PP0 RPPP
TofnI nssofs Ioss curronf IInbIIIfIos 35,200
!ong form Ionns (3,000)
32,200
Shnro cnIfnI 2?,000
IrofIf nnd Ioss nccounf 5,200
32,200
CnIcuInfo H Ic`s rofurn on cnIfnI omIoyod.
A 3.?
I 4.3
C 5.?
?.4 |2]
;< WhIch of fho foIIowIng sfnfomonfs Is 576 fruo of doubIo fnxnfIon roIIof (T!)
A Tho !K hns n doubIo fnxnfIon ngroomonf wIfh mnny counfrIos.
I Tho mnxImum offsof Is fho rnfo of fnx fhnf wouId hnvo boon nId In fho
!K.
C T! Is nvnIInbIo on rovonuo of n cnIfnI nnfuro.
T! Is onIy nvnIInbIo on Incomo rocoIvod from nbrond. |2]
;; IxInIn why fho nof rosonf vnIuo crIforIon Is suorIor fo ofhor mofhods of
Invosfmonf nrnIsnI. |6]
l08 S200l5 GH2+82 6I@5 7J2@
;C IxInIn fho InfIuonco of n confrnI bnnk (o.g. fho Innk of IngInnd) on fho
govornmonf bond mnrkof. |6]
;D IxInIn how n comnny`s cnIfnI sfrucfuro mIghf InfIuonco Ifs shnro rIco. |6]
;E oscrIbo fho roIo buIIdIng socIofIos Iny In Invosfmonf mnrkofs. |4]
;F Iscuss fho Inforosfs of four usor grous of fInnncInI sfnfomonfs nnd oxInIn why
somo of fho grous` Inforosfs mny confIIcf. |8]
;K IxInIn how n comnny`s !K corornfIon fnx IInbIIIfy Is cnIcuInfod nnd whon If
musf bo nId. |6]
;L oscrIbo fho fncfors fhnf musf bo doformInod whon soIocfIng n comnny`s
dorocInfIon oIIcy. |4]
;= Ic Is In fho rocoss of mnkIng n l for 4 rIghfs Issuo. Tho rIghfs Ioffors hnvo
jusf boon sonf fo shnrohoIdors. Tho comnny curronfIy hns 20m l shnros In
Issuo nnd fho curronf mnrkof rIco Is 4.50 or shnro.
Tho rIghfs Ioffor gIvos shnrohoIdors fho rIghf fo buy fhoIr now shnros for 3.50
onch. Ic Inns fo uso fho cnsh rnIsod fo buIId n mnjor oxfonsIon fo Ifs fncfory,
fhoroby doubIIng roducfIon cnncIfy.
Tho fInnnco dIrocfor hns rocoIvod nn nngry Ioffor from n shnrohoIdor. Tho
shnrohoIdor comInIns fhnf ho cnnnof nfford fo Invosf In now shnros. Ho Is,
fhoroforo, IIkoIy fo suffor n Ioss bocnuso fho fncf fhnf fho mnrkof wIII bo fIoodod
wIfh chon shnros wIII nImosf corfnInIy docronso fho vnIuo of hIs hoIdIng.
!oquIrod:
(n) CnIcuInfo fho vnIuo nf whIch fho shnro rIco Is IIkoIy fo soffIo nffor fho
rIghfs Issuo. |2]
(b) IxInIn whofhor fho shnrohoIdor's comInInf Is jusfIfIod wIfh nrfIcuInr
roforonco fo fho dIfforonco bofwoon fho rIghfs rIco nnd fho curronf
mnrkof rIco. |4]
(c) IxInIn whofhor fho shnro rIco Is IIkoIy fo soffIo nf fho fIguro cnIcuInfod
In (n) nbovo. |4]
(d) Iscuss fho ndvnnfngos nnd dIsndvnnfngos of fInnncIng fho oxfonsIon by
IssuIng Ionn sfock. |5]
(o) Iscuss fho ndvnnfngos nnd dIsndvnnfngos of fInnncIng wIfh n commorcInI
morfgngo. |5]
|TofnI 20]
l08 S200l6
;M Tho foIIowIng InformnfIon hns boon oxfrncfod from fho bookkooIng rocords of Z
Ic:
Z Ic
TrInI InInnco ns nf 30 Juno 200l.
RPPP RPPP
AdmInIsfrnfIvo oxonsos 25
AdvorfIsIng 200
Innk 6
CrodIfors 54
obfors l40
Inforosf l20
!nnd nnd IuIIdIngs cosf 983
!nnd nnd IuIIdIngs dorocInfIon 45
!onn 600
MnnufncfurIng ovorhonds 35
IInnf nnd MnchInory cosf 550
IInnf nnd MnchInory dorocInfIon l50
IrofIf nnd Ioss ns nf l JuIy 2000 l80
Iurchnsos 450
SnIos l,200
Shnro cnIfnI 200
Shnro romIum 300
Sfock ns nf l JuIy 2000 l8
Wngos ndmInIsfrnfIvo sfnff 44
Wngos dIsfrIbufIon sfnff 30
Wngos mnnufncfurIng l40
2,?35 2,?35
ofos:
(I) CIosIng sfock wns counfod nf fho yonr ond nnd wns vnIuod nf l9,000.
(II) orocInfIon Is fo bo chnrgod on fho foIIowIng bnsos:
Incfory 2 of cosf
IInnf nnd MnchInory 25 of roducIng bnInnco
(III) Tho dIrocfors hnvo docIdod fo ny n dIvIdond of 80,000 for fho yonr.
(Iv) Tho corornfIon fnx chnrgo hns boon osfImnfod nf 22,000 for fho yonr.
(n) Ironro Z Ic`s rofIf nnd Ioss nccounf for fho yonr ondod 30 Juno
200l nnd Ifs bnInnco shoof ns nf fhnf dnfo. Thoso shouId bo In n
form suIfnbIo for ubIIcnfIon Insofnr ns fhIs Is ossIbIo from fho
InformnfIon rovIdod. |l5]
(b) Commonf on nny nofnbIo fonfuros of Z Ic`s dIvIdond oIIcy, ns
rovonIod by your nnswor fo (n) nbovo. |5]
|TofnI 20]
!"#$%&' )* +#&$",-./ 01/&-&$&. )* +#&$",-./
23+405+60758
Sofombor 200l
8$9:.#& ;<= > !-1"1#. "1? !-1"1#-"% @.A),&-1B
IXAMII!S` !IIO!T
InsfIfufo of AcfunrIos
Subject 108 (Finance and Financial Reporting) September 2001 Examiners' Report
Page 2
2C"D-1.,E/ F)DD.1&/
G$./&-)1/ ; &) ;<
Thoro woro no nrfIcuInr robIoms wIfh fho objocfIvo fosf quosfIons, wIfh mosf
cnndIdnfos scorIng n ronsonnbIo mnrk.
G$./&-)1 ;;
Tho onIy rocurrIng robIom wIfh fhIs quosfIon wns n sIIghf fnIIuro fo nnswor fho
quosfIon. Mnny cnndIdnfos doscrIbod fho shorfcomIngs of vnrIous mofhods wIfhouf
oxInInIng whofhor fhoy hnd boon donIf wIfh by nof rosonf vnIuo.
G$./&-)1 ;H
ThIs quosfIon wns gonornIIy nnsworod woII.
G$./&-)1 ;I
Mnny cnndIdnfos wrofo vory gonornI ossnys nbouf gonrIng nnd Ifs cnIcuInfIon rnfhor
fhnn dIscussIons of how gonrIng mIghf nffocf shnro rIco.
G$./&-)1 ;J
ThIs quosfIon wns gonornIIy nnsworod woII.
G$./&-)1 ;K
AgnIn, mnrks woro Iosf bocnuso of n fnIIuro fo nnswor fho quosfIon ns sof. Mosf
cnndIdnfos mnnngod fo dIscuss fho InformnfIon noods of vnrIous usors grous, buf mnny
oIfhor Ignorod fho furfhor roquIromonf fo oxInIn how fhoso InformnfIon noods mIghf
confIIcf or dIscussod fho dIfforonf busInoss sfrnfogIos nnd oIIcIos fhnf onch grou mIghf
rofor fo soo fho comnny ndof.
G$./&-)1 ;L
ThIs quosfIon wns nnsworod ronsonnbIy woII, nIfhough n sIgnIfIcnnf mInorIfy of
cnndIdnfos focussod on cnIfnI gnIns nnd IndoxnfIon nIIownnco rnfhor fhnn nddrossIng
fho whoIo quosfIon.
G$./&-)1 ;M
Mosf cnndIdnfos scorod woII on fhIs quosfIon, nIfhough mnny nnswors fondod fo doscrIbo
dorocInfIon nnd IdonfIfIod fho oInfs roquIrod by fho quosfIon nImosf by chnnco.
G$./&-)1 ;=
ThIs quosfIon wns gonornIIy nnsworod woII, nIfhough mnny cnndIdnfos soomod fo bo
unnwnro fhnf shnrohoIdors couId soII fhoIr rIghfs rnfhor fhnn IoffIng fhom Inso
unoxorcIsod. Ofhors nonrod fo oxocf fho shnro rIco fo sfnbIIIso on fho fhoorofIcnI
rIco wIfhouf nny consIdornfIon for fho ossIbIIIfy fhnf mnrkof oxocfnfIons concornIng
fho uso of fho funds rnIsod mIghf hnvo n roIo fo Iny.
Page 3
G$./&-)1 ;N
Mosf cnndIdnfos mnnngod fo roduco ronsonnbIo nccounfIng sfnfomonfs nnd scorod woII.
Mosf cnndIdnfos nIso soffod fhnf fho comnny hnd n roInfIvoIy ofImIsfIc dIvIdond
oIIcy roInfIvo fo Ifs rofIfnbIIIfy.
Page 4
;
H C
I
J
K C
L A
M A
= A
N C
;< C
;; of rosonf vnIuo fnkos nccounf of fho fImo vnIuo of monoy. ThIs gIvos If nn
ImmodInfo ndvnnfngo ovor sovornI ofhor mofhods such ns nybnck nnd
nccounfIng rnfo of rofurn. Thoso do nof fnko Info nccounf fho offocfs of Inforosf
rnfos nnd nIso Ignoro somo cnsh fIows.
of rosonf vnIuo gIvos n dIrocf IInk fo fho offocf of fho rojocf on fho
shnrohoIdors` wonIfh. Ofhor mofhods, such ns I!!, cnn IndIcnfo whofhor n
rojocf wouId Incronso fhoIr wonIfh, buf wouId nof IndIcnfo by how much.
of rosonf vnIuo Is fho onIy crIforIon fhnf roIInbIy rnnks mufunIIy oxcIusIvo
rojocfs.
;H Tho Innk IIconcos gIIf-odgod mnrkof mnkors nnd Imosos corfnIn roquIromonfs
on fhom In rofurn for whIch fhoy rocoIvo corfnIn rIvIIogos.
Mnrkof mnkors cnn buy, soII or borrow gIIfs dIrocf from fho bnnk nnd fhoy gof
fnvournbIo fnx fronfmonf.
Tho bnnk Is rosonsIbIo for kooIng fho mnIn rogIsfor of ownors of gIIfs.
Tho bnnk buys nnd soIIs gIIfs. If usos vnrIous mofhods of soIIIng gIIfs: offors for
subscrIfIon, nucfIons, fondors, fn sfocks nnd fnIofs. Tho bnnk buys gIIfs In
fho mnrkof wooks nnd monfhs boforo mnfurIfy so If doos nof hnvo fo fInd bIIIIons
of ounds on ono dny.
Page 5
Tho bnnk`s ncfIvIfIos hnvo fho offocf of rovIdIng IIquIdIfy fhroughouf fho
mnrkofs nnd fhoroby onnbIo govornmonf fo InfIuonco IIquIdIfy nnd fhoroby shorf
form Inforosf rnfos.
;I CnIfnI sfrucfuro, or gonrIng, cnn nffocf fho rofIfs nvnIInbIo fo fho shnrohoIdors.
obf Is n roInfIvoIy chon sourco of fInnnco. If fho comnny borrows rnfhor fhnn
IssuIng furfhor shnro cnIfnI fhon n Inrgor roorfIon of fho rofurns from fho
rosuIfIng Invosfmonfs wIII bo nvnIInbIo fo fho shnrohoIdors. Tho comnny cnn
nIso cInIm fnx roIIof on fho Inforosf nnd fhnf wIII furfhor docronso fho cosf of
dobf.
obf cnn nIso nffocf fho voInfIIIfy of rofurns fo shnrohoIdors. Inforosf nnd cnIfnI
ronymonfs musf bo nId rognrdIoss of whofhor fho comnny hns hnd n good yonr
or nof. Tho fncf fhnf fhIs fIxod commIfmonf musf bo mof monns fhnf fho
comnny mny hnvo vory IIffIo rofIf Ioff for fho shnrohoIdors In Ionnor yonrs.
ConvorsoIy, fho fIxod rofurn offorod fo fho Iondors wIII monn fhnf nny ufurn In
rovonuos wIII Iond fo nII of fho oxcoss boIng nssod on fo fho shnrohoIdors. ThIs
monns fhnf borrowIng wIII ncconfunfo nny fIucfunfIons In fho oornfIng rofIf.
;J IuIIdIng socIofIos fnko doosIfs nnd Invosf mnInIy In morfgngos for houso
urchnso. Thoy do, howovor, fInd fhomsoIvos wIfh surIus cnsh nnd wIII Invosf
fhIs In shorf dnfod gIIfs nnd IocnI nufhorIfy bonds nnd In ofhor bnnks nnd
buIIdIng socIofIos.
ThIs monns fhnf buIIdIng socIofIos hnvo somo, buf nof much, InfIuonco In fho
mnrkofs for shorf dnfod gIIfs nnd IocnI nufhorIfy bonds.
IuIIdIng socIofIos nIso rnIso funds by IssuIng Iong form dobf cnIfnI. ThIs Is In
fho form of Indox-IInkod bonds nnd so fhoy hnvo consIdornbIo InfIuonco In fhIs
mnrkof.
;K IquIfy Invosfors mnko Invosfmonf docIsIons nnd roquIro InformnfIon nbouf
rofIfs nnd cnsh fIows. AnnIysfs nro consfnnfIy ronrIng nnd udnfIng forocnsfs
of orformnnco. Tho nnnunI roorf rovIdos nn oorfunIfy fo fIno funo fhoso
forocnsfs. IxIsfIng shnrohoIdors nIso roquIro InformnfIon nbouf fho frnnsncfIons
nufhorIsod by fho dIrocfors for sfownrdshI urosos.
!onn crodIfors mnko IondIng docIsIons InvoIvIng fho monsuromonf of fho rIsk of
dofnuIf. A Iondor wnnfs fo know whofhor n busInoss cnn gonornfo suffIcIonf cnsh
fo rony nny Ionn. Tho Iondor wIII nIso wIsh fo onsuro fhnf fho busInoss hns nn
ndoqunfo nssof bnso fo moof Ifs obIIgnfIons In fho ovonf of fnIIuro. To fhIs ond,
Ionn ngroomonfs offon confnIn rosfrIcfIvo covonnnfs whIch nro bnsod on
nccounfIng numbors.
ImIoyoos nro Inforosfod In fho onforrIso`s nbIIIfy fo ny snInrIos nnd nIso fo
offor job socurIfy. AccounfIng InformnfIon Is, howovor, of IImIfod vnIuo for such
docIsIons.
Page 6
IusInoss confncfs nro Inforosfod In confInuIfy of snIos (fo cusfomors) nnd of
mnforInIs nnd sorvIcos (from fho suIIors). ThoIr Inforosf Is, fhoroforo, sImIInr
fo fhnf of fho shnrohoIdors. Thoy mny nIso uso nccounfIng InformnfIon fo fry fo
gnIn somo InsIghf Info fho comnny`s rIcIng nnd frndIng oIIcIos.
Thoso grous hnvo dIfforonf noods nnd If mny bo fhnf boffor sorvIng fho noods of
ono wIII confIIcf wIfh fho ofhors. Ior oxnmIo, Invosfors roquIro fho mosf
ronIIsfIc ImrossIon ossIbIo of fho comnny`s orformnnco. !ondors wIII rofor n
moro consorvnfIvo fronfmonf so fhnf fhoy cnn boffor mnnngo fho rIsk of dofnuIf.
;L ComnnIos nro IInbIo fo corornfIon fnx on fhoIr fnxnbIo rofIfs. TnxnbIo rofIfs
IncIudo Incomo Ioss oxonsos nnd cnIfnI gnIns. Tho fnx yonr runs for l2 monfhs
fo 3lsf Mnrch rognrdIoss of fho comnny`s fInnncInI yonr.
CorornfIon fnx Is nId 9 monfhs nffor fho ond of fho nccounfIng orIod oxcof for
Inrgo comnnIos who ny fnx on n curronf yonr bnsIs by qunrforIy InsfnImonfs.
Tho nccounfIng rofIf Is ndjusfod fo nrrIvo nf fho fnxnbIo rofIf. Tho mnIn
ndjusfmonfs nro: ndd bnck nny busInoss oxonsos shown In fho nccounfs whIch
nro nof nIIownbIo, ndd bnck nny dorocInfIon nnd doducf gross frnnkod
Invosfmonf Incomo nnd subfrncf cnIfnI nIIownncos.
;M Tho dorocInfIon chnrgo Is nffocfod by fho osfImnfod usofuI IIfo of fho nssof,
fnkIng nccounf of fho ossIbIIIfy fhnf If mIghf bo roIncod boforo If ronchos fho
ond of Ifs hysIcnI cnncIfy. If wIII nIso bo nffocfod by fho osfImnfod rosIdunI
vnIuo of fho nssof whon If ronchos fho ond of Ifs usofuI IIfo. Thoso roquIro
subjocfIvo docIsIons, nrfIcuInrIy wIfh rosocf fo usofuI IIfo bocnuso fhIs Is fho
mosf Imorfnnf sIngIo fncfor In doformInIng fho chnrgo In nny ono yonr.
Tho ofhor fncfor fhnf cnn nffocf dorocInfIon Is fho nIIocnfIon of fho Ioss of vnIuo
fo fho dIfforonf nccounfIng orIods. orocInfIon cnn bo wrIffon off In oqunI
InsfnImonfs (sfrnIghf IIno) or on ofhor bnsos (o.g. roducIng bnInnco). Tho choIco
of mofhod cnn nIso hnvo n sIgnIfIcnnf offocf on fho chnrgo In nny ono yonr.
Page 7
;= (n) Ioforo fho rIghfs Issuo, four shnros wouId hnvo boon worfh 4 4.50 =
l8.00. In fhoory, nffor fho Issuo, fhIs wouId Ionvo fIvo shnros worfh
l8.00 + 3.50 = 2l.50.
Thus, fho shnros wouId bo worfh 4.30 onch.
(b) Thoro Is no ronson why fho shnrohoIdor shouId oIfhor hnvo fo buy now
shnros or suffor nny Ioss In wonIfh. Ho musf, howovor, oIfhor fnko u hIs
rIghfs or soII fhom for fhoIr mnrkof vnIuo. IrovIdod ho fnkos ono of fhoso
sfos, fho Issuo shouId hnvo no offocf on hIs wonIfh. Tho Inrgor fho
dIscounf, fho moro vnIunbIo fho rIghfs fo subscrIbo.
If wouId bo worfh oInfIng ouf fhnf fho dIscounf Is nocossnry fo nvoId fho
comnny hnvIng fo ny subsfnnfInI undorwrIfIng foos. If fho rIghfs rIco
wns cIoso fo mnrkof vnIuo fhon fho shnro rIco couId Incronso so fhnf If
wns chonor fo buy shnros on fho oon mnrkof fhnn fo fnko u fho rIghfs.
Tho dIscounf ncfunIIy hoIs fo onsuro fhnf fho Issuo rocoods smoofhIy
nnd wIfhouf unduo oxonso. If Is, fhoroforo, In fho shnrohoIdors`
Inforosfs, whofhor fhoy chooso fo fnko u fhoIr rIghfs or soII fhom.
(c) If Is ImossIbIo fo foII whnf fho shnro rIco wIII ncfunIIy bo nffor fho Issuo.
IvoryfhIng doonds on fho mnrkof`s orcofIon of fho comnny`s fufuro.
If fho mnrkofs nro nwnro of fho dofnIIod uroso of fho Issuo nnd If If Is
confIdonf fhnf mnnngomonf hns n vInbIo rojocf fhon fho shnro rIco couId
bo fnr hIghor fhnn fho fhoorofIcnI ox-rIghfs rIco. If fho mnrkof Is unsuro
nbouf fho comnny s rosocfs fhon fho shnro rIco couId ncfunIIy fnII
much furfhor fhnn our rodIcfIon.
(d) !onn sfock Is n chonor form of fInnnco fhnn oquIfy.
IssuIng Ionn sfock wIII InvoIvo subsfnnfInI cosfs.
Tho frosh Ionn sfock wIII Incronso gonrIng, roducIng fho comnny`s
borrowIng fufuro cnncIfy nnd IncronsIng fho rIsks nssocInfod wIfh
oxIsfIng dobf nnd oquIfy.
Tho Ionn sfock hoIdors wIII rnnk nIongsIdo fho oxIsfIng Iondors for
nymonf nnd mny roquIro n hIghor rnfo of Inforosf fo comonsnfo for fhIs.
If mny bo dIffIcuIf fo orgnnIso nn Issuo quIckIy In ordor fo gof fho
oxfonsIon work undor wny.
(o) Tho morfgngo wIII bo ovon chonor fhnn fho Ionn sfock bocnuso fho Ionn
wIII bo socurod ngnInsf fho now roorfy.
If shouId bo ossIbIo fo orgnnIso fho morfgngo ronsonnbIy quIckIy.
Ivon fhough fho Ionn Is socurod ngnInsf n socIfIc nssof fhnf wIII bo
boughf ouf of fho rocoods of fho Ionn If wIII sfIII roduco fho comnny`s
fufuro borrowIng cnncIfy.
Tho cosfs of nogofInfIng nnd orgnnIsIng fho morfgngo wIII bo Iowor fhnn
for fho Issuo of Ionn sfock.
Page 8
Tho morfgngo hoIdor mIghf InsIsf on rosfrIcfIvo covonnnfs whIch wIII
roduco fho comnny`s froodom fo onfor Info confrncfs In fho fufuro.
;N (n)
! #$%
&'()*+ ,-. /(00 1%%(2-+
)(' +34 54,' 4-.4. 67 82-4 977:
;777 ;777
SnIos l,200.0
Cosf of snIos ?43.?
Cross rofIf 456.3
AdmInIsfrnfIon 69.0
IsfrIbufIon 230.0
299.0
OornfIng rofIf l5?.3
Inforosf l20.0
of rofIf boforo fnxnfIon 3?.3
TnxnfIon 22.0
l5.3
IvIdond 80.0
64.?
InInnco broughf forwnrd l80.0
ll5.3
Page 9
! #$%
<,$,-%4 =344+
,0 ,+ 67 82-4 977:
;777 ;777
IIxod Assofs
l,2l8.3
Curronf Assofs
Sfock l9.0
obfors l40.0
l59.0
Curronf IInbIIIfIos
Innk 6.0
Iroosod dIvIdond 80.0
TnxnfIon 22.0
CrodIfors 54.0
l62.0
of curronf IInbIIIfIos 3.0
l,2l5.3
!onn 600.0
6l5.3
CnIfnI nnd rosorvos
Shnro cnIfnI 200.0
Shnro romIum 300.0
IrofIf nnd Ioss nccounf ll5.3
6l5.3
Page 10
>(+4 ? @*A4. 1004+0
B(0+ 1CC'4C,+4
.4#'4%*,+*(-
>4+ D((E
F,$24
; ; ;
Incfory 983.0 64.? 9l8.3
MnchInory 550.0 250.0 300.0
l,533.0 3l4.? l,2l8.3
WorkIngs
Cosf of snIos
OonIng sfock l8.0
Iurchnsos 450.0
CIosIng sfock l9.0
Incfory don
l9.?
MnchInory don l00.0
MnnufncfurIng ovorhond 35.0
MnnufncfurIng wngos l40.0
?43.?
AdmIn
oxonsos 25.0
AdmIn wngos 44.0
69.0
IsfrIbufIon
AdvorfIsIng 200.0
Wngos 30.0
230.0
(b) Tho comnny`s dIvIdond oxcoods Ifs rofIf for fho yonr. ThIs monns fhnf
fho dIvIdond hns boon fInnncod by drnwIng on rofnInod rofIfs from
rovIous yonrs. Thnf Is orfocfIy IognI, nIfhough If doos fond fo suggosf
fhnf Z Ic Is doformInod fo mnInfnIn Ifs dIvIdonds rognrdIoss of whofhor If
hns hnd n good yonr or nof.
If Is nIso nofIconbIo fhnf fho comnny hns n bnnk ovordrnff nnd hns vory
IIffIo In fho wny of workIng cnIfnI. ThIs monns fhnf fho comnny wIII
hnvo fo borrow, orhns subsfnnfInIIy, In ordor fo moof fho commIfmonf
rorosonfod by fho dIvIdond nymonf.
If mny bo fhnf fho comnny`s shnrohoIdors hnvo uf fho dIrocfors undor
somo rossuro fo mnInfnIn fhoIr dIvIdond. If mny bo fhnf fho dIrocfors do
nof hnvo suffIcIonf confIdonco In fho shnrohoIdors` judgomonf fo rIsk
nyIng n moro ronIIsfIc dIvIdond roInfIvo fo fho rofIf for fho yonr.
!"#$%&' )* +#&$",-./ 01/&-&$&. )* +#&$",-./
23+405+60758
12 April 2002 (pm)
8$9:.#& ;<= > !-1"1#. "1? !-1"1#-"% @.A),&-1B
Time allowed. Three hours
!"#$%&'$!("# $( $*+ ',"-!-,$+
1. Enter all the candidate and examination details as requested on the front of vour answer
booklet.
2. You must not start writing vour answers in the booklet until instructed to do so bv the
supervisor.
4. Attempt all 19 questions. From question 11 onwards begin each answer on a separate
sheet.
./012 1013/ 45 678 /39:4/3; <7/ 8245 1013/=
Hand in BOTH vour answer booklet, with anv additional sheets firmlv attached, and this
question paper.
In addition to this paper vou should have available Actuarial Tables and
vour own electronic calculator.
Faculty oI Actuaries
108A2002 Institute oI Actuaries
108 A20022
For questions 110 indicate in vour answer booklet which one of the answers A, B, C or D is
correct.
; Which oI the Iollowing roles would NOT typically be played by a merchant bank?
A acting as a trustee
B large scale lending to corporate borrowers
C issuing treasury bills
D providing advice on company mergers |2|
C Which oI the Iollowing bodies is primarily responsible Ior issuing accounting
standards in the UK?
A Financial Reporting Council
B Accounting Standards Board
C Accounting Standards Committee
D Urgent Issues Task Force |2|
D Which oI the Iollowing statements is NOT true oI companies issuing commercial
paper?
A They must be listed on the London Stock Exchange.
B They must issue a statement that they comply with the requirements oI the
Stock Exchange.
C They must have a minimum level oI net assets oI 50m.
D They must have the commercial paper endorsed by a merchant bank. |2|
E Which oI the Iollowing best describes the manner in which individuals can claim tax
relieI Ior capital losses?
A Capital losses can be oIIset against capital gains in the same year. Any unused
capital loss may be carried Iorward to oIIset against capital gains in the next
three years.
B Capital losses can be oIIset against capital gains in the same year. Any unused
capital loss may be carried Iorward to oIIset against capital gains in any Iuture
year or years.
C Capital losses can be oIIset against capital gains in the same year. Any unused
capital loss may be oIIset against taxable income in that year.
D Capital losses can be oIIset against capital gains in the same year. Any unused
capital loss may be carried back to reclaim tax paid on capital gains during the
previous three years. |2|
108 A20023 FG2+82 6H@5 7I2@
J Which oI the Iollowing is most likely to be true:
A A company`s cost oI equity will be equal to its weighted average cost oI
capital.
B A company`s cost oI equity will be greater than its weighted average cost oI
capital.
C A company`s cost oI equity will be lower than its weighted average cost oI
capital.
D A company`s cost oI equity will Iluctuate around its weighted average cost oI
capital. |2|
K Which oI the Iollowing types oI company is most likely to employ a high proportion
oI equity Iinancing?
A supermarket
B property company
C IT developer
D bank |2|
L Which oI the Iollowing statements is NOT true oI Iactoring.
A A Iactoring service may be with recourse or without recourse.
B Factoring is the sale oI debts to a Iactor at a discount.
C Factoring companies oIten provide their clients with bookkeeping services to
save them Irom keeping their own records oI debtor balances.
D The Iactor will make payment to the client as soon as the debt is collected.
|2|
= Which oI the Iollowing statements is NOT true?
A Companies can issue ordinary shares below the par value.
B The expected overall Iuture return Ior ordinary shares ought to be higher than
Ior most other classes oI security.
C The Memorandum oI Association will set out the total nominal value oI
authorised share capital.
D An appropriate way oI valuing ordinary shares is to calculate the present value
oI the Iuture dividend stream.
|2|
108 A20024
M In certain circumstances the Stock Exchange may grant a quotation Ior a company
even though the company is not making any new shares or existing shares available to
the market. This method oI obtaining a quotation is known as:
A a placing
B a prospectus issue
C a tender issue
D an introduction |2|
;< Which oI the Iollowing changes in working capital will result in an outIlow oI cash?
A decrease in creditors
B decrease in stock
C decrease in debtors
D increase in other current liabilities |2|
;; One oI R plc`s shareholders has written to the directors to complain that the company
has reduced its dividend payment compared to last year. The shareholder is oI the
opinion that this action has reduced his wealth.
IdentiIy the matters that should be included in the directors` reply to their unhappy
shareholder. |5|
;C Outline the key Ieatures oI the taxation oI a liIe insurance company. |6|
;D Explain how a holding company would construct a set oI consolidated Iinancial
statements. |6|
;E Explain how you would price units in a unit trust, including a consideration oI
whether the Iund is expanding or contracting. |5|
;J Trade credit and debt Iactoring are both used to provide business with short term
Iinance. Outline the main Ieatures oI each, stating the advantages and disadvantages
oI each. |6|
;K Accountants are guided by a series oI accounting concepts when they prepare
Iinancial statements. IdentiIy any three such concepts and explain how each aIIects
the content oI the Iinancial statements. |6|
108 A20025 FG2+82 6H@5 7I2@
;L A company operates several successIul restaurants. It is considering Iranchising its
restaurant concept in a scheme whereby the company and the Iranchisee would invest
equal amounts in setting up each new restaurant. The company would then receive a
percentage oI the turnover Irom each restaurant Ior the liIe oI the agreement.
Outline how simulation might be used to estimate the cash Ilows Irom each proposed
Iranchise site. |6|
;= The directors oI Y plc are concerned that the company has a relatively low return on
capital employed. They have asked you to help them to identiIy the areas where there
is the greatest need Ior improvement. You have asked your assistant to obtain the
Iinancial statements oI Y plc`s most successIul competitor and to compare these with
those oI Y plc. Your assistant has prepared the Iollowing table oI ratios:
Y plc Competitor
(a) Return on capital employed 8 15
(b) Turnover / Fixed assets 4:1 6.5:1
(c) Current ratio 3:1 1.8:1
(d) Gross proIit percentage* 27 34
* Both companies sell very similar product ranges. Their market is very competitive
and their selling prices are almost identical.
(i) Explain why each oI the ratios (b) to (d) above help us to understand why Y
plc`s return on capital employed is relatively poor. |6|
(ii) For each oI the ratios (b) to (d) above, recommend courses oI action to
management which would improve Y plc`s return on capital employed. |9|
(iii) Explain why the limitations oI Iinancial reporting could mean that the
comparison oI Y plc`s perIormance with its competitor might prove
misleading. |5|
|Total 20|
108 A20026
;M W plc was established nine years ago. The company has grown steadily throughout
that period and the directors are beginning to plan the next stage oI expansion. The
company requires to raise a substantial amount oI Iinance in order to grow and the
directors are considering the options that are open to them.
One possibility is to raise Iunds through borrowing. Another would be to raise Iurther
equity, although the directors are oI the opinion that they might have to seek a stock
exchange quotation in order to do so.
(i) Describe the tax implications oI selecting a source oI Iinance Irom the point oI
view oI the company and the provider oI the Iinance. |5|
(ii) Explain why it might not always be appropriate Ior management to choose the
least expensive Iorm oI capital whenever new Iinance is required. |5|
(iii) Explain the advantages and disadvantages oI seeking a stock exchange listing.
|6|
(iv) All oI W plc`s shares are held by the directors, all oI whom are actively
involved in the running oI the company. Describe one advantage and one
disadvantage oI having a 'tight shareholding. |4|
|Total 20|
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Page 2
1 C
2 B
3 D
4 B
5 B
6 C
7 D
8 A
9 D
10 A
Generallv questions 1-10 were well answered, most candidates scored well. There was no
particular question which was badlv done.
11 II the company does not have suIIicient cash to pay a dividend or iI it does not have
suIIicient retained proIits to Iund one then the directors would be both irresponsible
and in breach oI company law iI they were to pay one. Paying a dividend under such
circumstances could also damage the company`s cash Ilows at a sensitive time and
might actually reduce the value oI the shareholder`s investment by Iar more than the
amount oI dividend received.
The directors might also decide to suspend or reduce a dividend in order to provide
Iunds Ior investment. Doing so will oIten avoid the issue costs associated with selling
shares and the transaction costs associated with borrowing. II the markets anticipate
that this expansion will be successIul then the share price will increase by at least the
amount oI the dividend Ioregone. In that case, the shareholder`s wealth will actually
have improved because oI the company`s decision to reduce dividends. II the
shareholder was relying on cash Irom the dividends then he or she could sell some
shares in order to realise part oI the capital gain.
Unexpected variations in dividend policy could worry the market and so it would be
undesirable Ior the directors to have reduced the payments without prior warning.
This question was answered well bv most candidates. It was designed to test knowledge of the
issues associated with the dividend decision. Most candidates demonstrated good
understanding.
Page 3
12 A liIe insurance company`s activities are split into various diIIerent Iunds according
to the type oI policy. The two most important Iunds are:
(1) the pensions business Iund
(2) the liIe business and general annuity business Iund
The two Iunds are taxed in a diIIerent way. Income, capital gains and expenses are
attributed to each class oI business separately. Expenses in one class oI business are
not allowed to oIIset tax in another class.
Pensions business is taxed on a proIits basis. ProIits are calculated as:
Premiums received
investment income
capital gains
- payments made to policyholders
- pension Iund expenses
- increase in reserves needed to meet Iuture payments to policyholders
taxable proIits
The liIe business and general annuity business is taxed on a diIIerent basis:
Investment income
realised capital gains
- liIe business expenses
- general annuity business expenses
- income element oI general annuity payments to policyholders
taxable proIits
This question was well done bv manv candidates, there were however a number of candidates
who scored verv poor marks. Some candidates appeared to be familiar with the material in the
core reading on this topic while others were not.
13 The Iirst step is to identiIy the subsidiary companies. These are essentially the
companies over which the holding company can exercise control.
The holding company should ensure that the accounting policies used throughout the
group are consistent.
Any transactions and balances between group members must be identiIied so that they
can be excluded Irom the consolidation.
The Iigures in the Iinancial statements are combined to give the group totals Ior
turnover, expenses, assets and so on. However, any inter company elements are
excluded Irom the consolidation so that sales would include only sales to third parties
outside oI the group and so on.
Page 4
The process oI cancelling internal balances extends to the holding company`s
investment in the subsidiaries. These will be cancelled against the related obligations
Irom the subsidiaries to the holding company as represented by the equity as at the
date oI acquisition. Any balancing Iigure arising because oI diIIerences between the
cost oI the investment and related equity is called goodwill and is written oII against
retained proIit.
Any equity in subsidiaries held by third parties should be shown on the consolidated
balance sheet as a minority interest.
This question tested awareness of the important accounting topic of preparation of
group financial statements. Most candidates appeared comfortable with this material.
14 The price oI the units is calculated by the managers to be:
Market value oI assets
Number oI units
Unit trust managers must use this Iormula, but they have some discretion over the
calculation oI the 'market value oI assets. They can use the cost oI buying new
assets ('oIIer pricing) or the cost oI destroying units ('bid pricing).
The managers can change Irom oIIer to bid pricing, depending on circumstances.
OIIer pricing is used when the unit trust is expanding and bid pricing is used when it
is contracting.
This question required awareness of the broader issues associated with the valuation of
units. Candidates were generallv well prepared for this.
15 Trade credit is the short term Iinance oIIered by vendors. Much trade is done on the
basis that all goods will be supplied on credit and paid Ior at an agreed time, oIten 30
days aIter receipt. It is necessary to establish a credit Iacility with each vendor,
although this is usually a relatively simple process. The vendor will usually request a
credit reIerence and may carry out background checks with a credit agency.
Trade credit is usually a Iairly Ilexible Iorm oI Iinance, although the cost is not always
immediately obvious. The purchase prices will include an element Ior Iinance. Many
vendors will impose additional interest penalties in case oI overdue amounts and this
may also lead to a report being passed to a credit agency, thereby reducing the
company`s score.
Debt Iactoring is also a source oI short term Iinance. It is essentially a loan secured
on the company`s debtors` balances. Once the company has reached an agreement
with the Iactor, it will send copies oI invoices on despatch oI goods. The Iactor will
then pay an agreed proportion oI the invoice by return. The debtor will normally
make payment to the Iactor and this will lead to the Iactor making a second payment
oI the balance Irom the invoice, less interest.
Page 5
There are two types oI Iactoring. Non-recourse Iactoring is where the supplier takes
over all responsibility Ior credit analysis oI new accounts, payments collection, and
credit losses. Recourse Iactoring only provides early payment oI invoices, with credit
risk remaining with the original supplier.
This question tested the candidates knowledge of different form of medium term
finance. The candidates answered this question verv well, with manv achieving
excellent marks.
16 The cost concept requires that assets appear in the balance sheet at their original
cost, less any depreciation to date. EIIectively, it is assumed that the purchasing
power oI money will remain unchanged. While this is clearly invalid, it simpliIies the
task oI maintaining bookkeeping records. The disadvantage is that accounting
statements Irequently report totals which are made up oI inconsistent units.
The money measurement concept accounting statements restrict themselves to
matters which can be measured objectively in money terms. Again, this simpliIies
accounting enormously. It also means that a balance sheet will rarely give even a
rough approximation oI the value oI the business because it will exclude such items as
the values oI the company`s customer base, its work Iorce and its brand names.
The going concern concept - it is usually assumed that a business will continue
indeIinitely in its present Iorm. This concept acts as a justiIication Ior the limitations
imposed by the cost concept because there is little harm in reporting irrelevant Iigures
Ior value iI the assets concerned are unlikely to be sold in the immediate Iuture.
The business entity concept the aIIairs oI the business are kept separate Irom
those oI the owners. This is perIectly valid in the case oI a limited company, which
has its own legal identity. It would, however, also apply to sole traders and
partnerships where the business does not exist except as part oI the owners` estate.
The realisation concept states that income is recognised as and when it is
'earned. It is not, thereIore, necessary to wait until the customer settles his or her
bill. This avoids the Iluctuations in reported income which might arise iI everything
was accounted Ior on a cash basis. It can also create the impression that the business
is perIorming well when, in Iact, it is in danger oI running out oI cash. A business
which is expanding might report income long beIore the related cash inIlows.
The accruals concept expenses are recognised as and when they are incurred,
regardless oI whether or not the amount has been paid. Again, this avoids the random
allocation oI costs to periods depending on whether the bill happens to have been paid
or not.
Prudence the preparers oI the Iinancial statements should avoid presenting an
unduly optimistic set oI results. Thus, the lowest reasonable Iigure should be stated
Ior proIit or Ior any oI the assets. The highest reasonable Iigure should be stated Ior
any liabilities. This means that there is very little danger oI the Iigures lulling
anybody into a Ialse sense oI security by overstating the company`s strengths.
Page 6
Consistency the Iigures published by the company should be comparable Irom one
year to the next. Accounting policies should not, thereIore, be changed Irom one year
to the next unless there is a very good reason Ior doing so. Any changes should be
highlighted and their impact explained.
Materiality there is little point in providing inIormation which is so detailed as to
be unintelligible. The statements can, thereIore, be made clearer by showing totals
such as 'administrative expenses instead oI listing every item which makes up this
heading. Similarly, there is very little point in making minute adjustments which
have no real eIIect on the picture portrayed by the Iinancial statements. Thus
accountants might report rough approximations Ior certain costs rather than waste
time calculating more precise Iigures.
Candidates were good at identifving the concepts but were weaker when it came to
discussing how the concepts might affect the financial statements. This resulted in
poor marks for this question. This demonstrates the need to think carefullv about
accounting issues - candidates with good understanding of the concepts scored
highlv.
17 The Iirst step would be to develop some model that can be used to estimate turnover
under various conditions. The company could try to identiIy the Iactors that appear to
aIIect the turnover in its existing branches. These could include Iactors such as the
distance to the nearest competitor, the number oI people passing the branch at certain
times oI day, proximity to any major concentrations oI customers (e.g. a major
railway station) and so on. The company could then combine these Iactors in an
attempt to model turnover Ior the existing shops Ior comparison with historical data.
The models could then be applied to potential Iranchise locations. These should be
modelled many times using variations oI the underlying assumptions in order to
establish whether the Iorecasts appear to be robust. This could be done by
determining probability distributions Ior Iactors such as passing trade and the
likelihood oI Iresh competition.
This question was not answered bv a number of candidates, and there were manv weak
answers from the candidates who did attempt the question. The question required some
application of the issues covered in the core reading although this did not require an
inordinate level of understanding. The best wav to tackle such a question would be to imagine
dealing with the problem in the real world.
18 (i) The ratio oI turnover to Iixed assets measures the company`s ability to
generate sales Irom its Iixed asset base. Y plc cannot match the productivity
oI its competitor and is, thereIore, bringing in a smaller return Irom its
investment in Iixed assets.
Capital tied up in current assets generates little or no direct return. Y`s
competitor has less invested in these unproductive assets. This means that Y
has either had to divert capital Irom more productive activities or that the
company has borrowed more in order to Iinance working capital.
Page 7
The gross proIit percentage is a measure oI the company`s ability to generate
proIits Irom any given sale. Given the nature oI the market, Y`s competitor
appears to be selling similar products at similar prices, but generating a higher
proIit on every sale. Even iI the companies were equally eIIicient in their use
oI assets, this would enable the competitor to enjoy a higher ROCE. The Iact
that the competitor also manages to generate more sales Irom every oI its
asset base means that it has a double advantage over Y.
(ii) The company should review its utilisation oI Iixed assets. It may be that there
is scope Ior reorganising the company so that it can improve its output. Given
the 'benchmark provided by the competitor, it looks as iI there is scope Ior
making greater use oI them. The reasons Ior not doing so should be identiIied.
It may be possible to accomplish a great deal Irom a simple reorganisation. Y
may have to make some Iurther investment iI the investigation reveals that
there is a bottleneck which constrains the use oI the existing assets.
Alternatively, the review may indicate that the company has spare capacity, in
which case it should consider either diversiIying into another area in order to
make use oI the slack or it should sell any surplus assets.
Y plc should review its activity ratios: stock, debtor and creditor turnover. II
stocks or debtors are turning over too slowly then the reasons Ior this should
be established. It may be that the company will have to invest in better
systems which enable it to exert a greater control over working capital. It may
be that staII simply need to be better trained or motivated in order to avoid
wasteIul investments in stock or sales ledger accounts. The company might
also be able to pass some oI the burden Ior Iinancing working capital on to
suppliers. II the creditors turnover is too rapid then it may be able to delay
payments, thereby releasing some cash with which to Iinance expansion or to
reduce capital employed. The company should also review its cash balances.
While it is prudent to hold some cash, the company needs to make sure that it
is not tying too much up in low yielding bank accounts.
Given that Y plc`s selling prices cannot be increased without the loss oI sales,
the problem appears to be that it is paying too much Ior its product. This may
be because the company has not been aggressive enough in negotiating with
its suppliers. It may be that there are less expensive suppliers or that the
company could switch to a smaller number oI suppliers so that it can obtain
the beneIit oI bulk discounts. The company may also be incurring
unnecessary overheads (e.g. depreciation on unproductive assets) and these
could be eating into the proIit margins too.
(iii) The Iigures in the Iinancial statements are highly subjective. The statements
produced by the competitor could have been aIIected by greater optimism or
pessimism on the part oI the accountants who prepared them. This attitude
could have been due to a genuine diIIerence oI opinion or it could have been
due to the company being under some pressure to distort its Iigures in one
direction or another.
The Iigures might not be comparable Ior other reasons. For example, the
assets oI both companies could be shown at historical cost. The asset bases oI
Page 8
both businesses might be identical, but the company with the older assets will
have the lower book value because oI the eIIects oI rising prices and
depreciation. This could have the eIIect oI reducing return on capital.
The Iigures could have been aIIected by transactions occurring close to the
year end. For example, the purchase oI new assets just beIore the year end
will increase capital employed, but the company will have had no opportunity
to generate a return Irom this.
This question tested candidates understanding of accounting ratios. Manv
candidates produced good answers demonstrating understanding of the topic.
19 (i) One oI the main choices is between equity and debt. Debt is generally more
tax eIIicient Irom the company`s point oI view because interest is tax
deductible whereas dividends on equity is not.
DiIIerent Iorms oI borrowing will have diIIerent cash Ilows and tax
implications. For example, the purchase oI an asset using borrowed money
will attract tax relieI on the interest and the company will also be able to claim
capital allowances on the price oI the asset itselI. The purchase oI an asset
using a Iinance lease will attract tax relieI on the whole oI the lease payments,
but the borrower will not be able to claim capital allowances.
The company should also consider the tax implications Ior the providers oI
Iinance. Their tax position will aIIect the cost oI capital because they will be
concerned with their returns aIter tax. Shareholders might preIer equity
because they can manage their exposure to tax by selecting the point at which
they realise capital gains. Interest received Irom loans is, however, taxed as it
is received and so there is less scope Ior management oI tax.
(ii) It would be short-sighted to rely exclusively on the cheapest Iorm oI Iinance
Ior every decision. This is partly because issuing Iresh debt can aIIect the
overall risk characteristics oI the company`s existing debt and equity. The risk
oI the company becoming Iorced into deIault increases as gearing rises.
Issuing Iresh debt might undermine conIidence in the company as a whole and
that could lead to a disproportionate increase in the cost oI capital.
The beneIits oI the tax allowances associated with debt are dependent on the
company having suIIicient proIit to oIIset the interest against. The gross cost
oI the debt might become more relevant iI the company issues Iresh debt when
it is breaking even or making a loss.
There can be substantial issue costs Ior some Iorms oI Iinance. The Iixed
costs associated with issuing shares can be so great that the company should
not consider raising Iinance in this way unless an economic amount is being
raised.
Page 9
(iii) The main advantage is that shares will be Iar more attractive to the capital
markets. Anyone buying shares will be able to sell them at any time and at a
readily observable market price.
Existing shareholders will also enjoy the opportunity to sell some oI their
shares and realise some oI the gains earned during their period oI ownership.
They will also beneIit Irom the Iact that they will have a market price which is
acceptable as a valuation basis Ior tax purposes.
The main disadvantage oI a listing is one oI cost. There are substantial
proIessional Iees and other expenses associated with obtaining a listing.
The stock exchange will also impose additional reporting and other regulatory
requirements on the company.
Having a quotation will make it easier Ior outsiders to mount a takeover bid.
This could prove a distraction Ior management, especially when the company
is vulnerable during diIIicult times.
(iv) The Iact that the company is owned and managed by the same individuals
avoids a host oI problems associated with accountability and agency.
Shareholders normally require some assurance that the directors are not
pursuing their own interests.
There is no conIlict between the interests oI the owners and the managers and
so there is less risk oI dysIunctional behaviour on the part oI the directors. For
example, the directors will be under much less pressure to pursue short term
proIits at the expense oI longer term wealth.
The narrow shareholding makes it more diIIicult to raise Iresh equity Irom the
existing shareholders. This will make it more expensive to raise additional
equity whenever the need arises.
The narrow shareholding will also make it more diIIicult to obtain a stock
market quotation because oI the regulations designed to ensure a Iree and open
market.
The candidates answered part 1 verv well as thev could explain the differences
between funding bv debt or equitv.
Most candidates were aware of the advantages and disadvantages of Stock Exchange
listing but were not so good at part 4 which asked about tight and narrow
shareholdings, this required application of the core reading and some candidates
found this difficult. Again thinking of a practical example could be helpful.
EXAMINATIONS
Subject 108 - Finance and Financial Reporting
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./012 1013/ 45 678 /39:4/3; <7/ 8245 1013/=
question paper.
108S2002 Institute oI Actuaries
108 S20022
correct.
The following information relates to questions 1 to 3:
Y plc is a quoted company. The Iollowing inIormation has been extracted Irom the
company`s annual report and other sources:
m
Earnings beIore interest and tax 36
Interest 1.65
Tax 9.9
Book values Market values
m m
Share capital (1 shares, Iully paid) 40 178
Debenture stock 15 19
1 Y plc`s earnings per share Iigure is:
A 0.14
B 0.61
C 0.86
D 0.90 |2|
2 The most relevant measure oI Y plc`s gearing Ior decision making purposes is:
A 7.8
B 9.6
C 27.3
D 32.2 |2|
3 II prevailing interest rates increase, what is likely to happen to the market prices oI
Y plc`s Iinancial instruments?
A Share price Debenture price
B Share price Debenture price
C Share price Debenture price
D Share price Debenture price |2|
4 S plc has 20 million shares in issue, with a current market price oI 5 a share. A
rights issue will allow one share to be purchased Ior every Iive shares currently held
by shareholders Ior 3 each. Which oI the Iollowing is true?
A The number oI shares in issue will Iall to 16 million.
B The Iirm will raise 32 million.
C The share price will Iall to 4.67.
D The total value oI the company will decrease to 88 million. |2|
108 S20023 PLEASE TURN OVER
5 Which oI the Iollowing would NOT aIIect an income tax calculation?
A contributions made to an approved pension scheme
B beneIits in kind
C personal allowance
D income Irom an ISA |2|
6 Why might a scrip issue lead to an overall increase in a company`s market
capitalisation?
A there are more shares in issue
B shareholders can sell their new shares without aIIecting their original holding
C scrip issues are only possible iI the company has been proIitable in past
D scrip issues are oIten interpreted as a sign oI conIidence on the part oI the
directors in the Iuture perIormance oI the company |2|
7 Which oI the Iollowing will calculate a company`s taxable proIit?
A accounting proIit capital allowances depreciation
Iranked investment income
B accounting proIit - capital allowances - depreciation
- Iranked investment income
C accounting proIit - capital allowances depreciation
- Iranked investment income
D accounting proIit capital allowances - depreciation
- Iranked investment income |2|
8 Building societies will normally NOT invest surplus cash in the Iollowing:
A Short dated gilts
B Banks using certiIicates oI deposit
C Ordinary shares
D Local authority bonds |2|
108 S20024
9 Which oI the Iollowing statements about gilt-edged market makers (GEMMs) is NOT
true?
A The Bank oI England licences GEMMs.
B Only the GEMMs can buy, sell or borrow existing gilts directly Irom the Bank
oI England.
C They are given no special tax treatment.
D Only the GEMMs can make a market in gilts. |2|
10 Which oI the Iollowing is NOT a valid reason Ior using simulation in order to
evaluate an investment project?
A the cash Ilows are uncertain
B the required rate oI return might vary during the liIe oI the project
C decision makers are interested in the range oI possible outcomes
D decision makers require an accurate Iorecast |2|
11 Explain how the statement oI net assets Ior a pension Iund diIIers Irom the balance
sheet oI a company reporting under the requirements oI the Companies Act. Outline
reasons Ior these diIIerences. |5|
12 Describe the diIIerences between a bank overdraIt and a bank loan and indicate how
each might be used by a business. |6|
13 A company has been oIIered the Iollowing mutually exclusive investment projects:
Profect 1 Profect 2
Initial investment 400,000 80,000
Payback 6 years 3 years
Internal rate oI return 9 13
Net present value 63,000 10,500
(i) Explain why the three investment criteria payback, internal rate oI return
(IRR) and net present value (NPV) might have given diIIerent rankings Ior
the two projects. |3|
(ii) Explain which oI the two projects is the optimal investment project Ior the
company, based on the inIormation given. |3|
|Total 6|
108 S20025 PLEASE TURN OVER
14 Most businesses oI any size operate as a group oI companies and these are required to
prepare and publish consolidated Iinancial statements.
(i) Explain why consolidated statements are preIerable to having the statements
oI each oI the companies in the group. |4|
(ii) IdentiIy TWO Iigures that you would expect to Iind in a consolidated balance
sheet that would not normally appear in an individual company`s accounts.
Explain what each oI these Iigures reIlects. |6|
|Total 10|
15 Harold and Maude are in the process oI setting up a risk management consultancy.
They have known each other Ior a relatively short time, but have decided to go into
business together. The initial setting up costs will be Iairly substantial: the business
will need to pay a deposit on a leased oIIice and will have to purchase computers and
other oIIice equipment. Maude has agreed that she will Iund most oI these Irom her
savings, with Harold providing roughly 10. Harold and Maude have agreed that
both will work Iull-time in the business and that each will probably contribute equally
to the success and proIitability oI the enterprise.
(i) Explain the relative advantages and disadvantages oI setting up this business
as a partnership and as a limited company. |4|
(ii) Assuming that Harold and Maude decide to incorporate the business as a
limited company, describe the best way to organise their interests in terms oI
Maude`s investment in the initial setting up and the equitable sharing oI proIits
and losses. |4|
|Total 8|
16 Explain the possible uses by a non-Iinancial company oI swaps. |5|
108 S20026
17 The directors oI D plc have decided to review their decision to invest 12 million in
new equipment. They have decided that their initial decision to make this investment
had not been adequately justiIied in terms oI Iormal investment appraisal techniques.
In the past, the directors have appraised all investments by discounting the expected
cash Ilows at 9.5 per annum. This required rate oI return is based on the interest
rate likely to be charged by D plc`s bank on a term loan. They have, however,
recently decided that it would be more appropriate to relate the required rate oI return
to the risk associated with the investment. They have decided to apply the Capital
Asset Pricing Model (CAPM) when appraising investment opportunities.
The directors have decided that the investment in the new equipment constitutes an
expansion oI the company and that it would be appropriate to use the Beta coeIIicient
oI the company as a whole as a surrogate Ior the project Beta. The company`s
stockbrokers have advised them that the company Beta is 0.6. The risk Iree rate is 3
and the risk premium is 8.
(i) Calculate the required rate oI return Ior the investment project using the
Capital Asset Pricing Model (CAPM). |2|
(ii) Explain how a highly risky project, such as investment in a high technology
industry, might have a relatively low required rate oI return in the context oI a
portIolio oI investments. |8|
(iii) Explain how the beta coeIIicient oI a project might be estimated. |5|
(iv) Explain how the share price oI a company quoted on the stock exchange
should move in response to an investment in a project with a positive net
present value. |5|
|Total 20|
108 S20027
18 The Iollowing inIormation has been extracted Irom the bookkeeping records oI B plc:
B plc
Trial Balance as at 31 August 2002.
000 000
Administrative expenses 435
Bank 14
Cost oI goods sold 800
Creditors 110
Debtors 240
Interest 110
Land and Buildings cost 2,300
Land and Buildings depreciation 180
Loan 1,400
Plant and Machinery cost 900
Plant and Machinery depreciation 350
ProIit and loss as at 31 August 2001 180
Sales 2,600
Selling and distribution costs 850
Share capital 500
Share premium 400
Stock as at 31 August 2002 99
5,734 5,734
Notes:
(1) Depreciation is to be charged on the Iollowing bases:
Factory 3 oI cost;
Plant and Machinery 25 oI reducing balance.
All depreciation is to be charged to the cost oI sales.
(2) The directors have decided to pay a dividend oI 150,000 Ior the year.
(3) The corporation tax charge has been estimated at 40,000 Ior the year.
(i) Prepare B plc`s proIit and loss account Ior the year ended 31 August 2002 and
its balance sheet as at that date. These should be in a Iorm suitable Ior
publication insoIar as this is possible Irom the inIormation provided. |14|
(ii) The directors oI B plc are under some pressure to report a higher than normal
proIit Iigure this year. It has been suggested that they might reduce the
depreciation charge by revising their estimate oI the useIul lives oI Iixed
assets.
Explain whether it would be possible to restate proIit by artiIicially depressing
the depreciation charge. |6|
|Total 20|
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Institute oI Actuaries
Page 2
; B
C B
D C
E C
F D
G D
H C
= C
I C
;< D
There were no particular problems with the obfective test questions, with most candidates
scoring a reasonable mark.
;; The statement oI net assets is similar to a balance sheet, but is simpler in that it merely
lists the investments, cash balances, any other assets that the Iund has and any
immediate liabilities that it owes.
The statement oI net assets does not show the long term liability due to the scheme`s
members. This is omitted because it is diIIicult to measure with any certainty and
also because it will not arise until some time in the distant Iuture. Such considerations
have not, however, prevented liabilities Irom being disclosed in the Iinancial
statements oI limited companies.
The special regulations Ior pension Iunds arise because a pension is likely to be a
major component oI any individual`s wealth. Unlike stocks and shares, it is virtually
impossible to diversiIy one`s pension arrangements in order to spread the risk oI bad
luck, Iraud or mismanagement. Whereas a company can aIIord to plan Ior the short to
medium term Iuture, a pension scheme has responsibilities to pensioners which might
not crystallise until they retire in the distant Iuture, when the Iund must be in a
position to meet its commitments in Iull.
This question was designed to test basic understanding of one of the primarv accounting
statements of a pension fund. This question was generallv answered poorlv, with manv
candidates displaving little or no knowledge of the statement of net assets. Others made no
attempt to compare the statement with the balance sheet of a limited companv.
Page 3
;C A bank overdraIt is a loan drawn against a Iacility oIIered by the bank. The bank will
provide the business with the ability to write cheques until the balance reaches a
predetermined maximum. The company may have to pay Ior the overdraIt Iacility
itselI, but will pay interest only on the balance outstanding at any given time. The
overdraIt may remain outstanding Ior many years, but it is always repayable on
demand.
A loan is a predetermined amount that will normally have to be repaid in accordance
with a prearranged schedule. The borrower will pay interest in accordance with the
agreed basis speciIied in the loan agreement, but this will normally be a percentage oI
the capital balance outstanding.
OverdraIts tend to be an expensive source oI Iinance. This means that it will usually
be cheaper to take out a loan iI the company needs cash Ior a speciIic length oI time.
An overdraIt will be cheaper iI the amount required varies throughout the loan period
and will also oIIer Ilexibility iI the company runs short oI cash.
This question was answered well, demonstrating awareness of two of the principal sources of
short-term finance.
;D (i) The methods give diIIerent rankings because each stresses diIIerent criteria.
Payback is concerned only with cash Ilows during the early part oI the project.
Internal rate oI return is concerned only with the interest rate implicit in the
project. Net present value is concerned with the increase or decrease in wealth
resulting Irom the project. A relatively short-term project could, thereIore,
Iavour payback. One with a high yield over a short period or on a small initial
investment could Iavour IRR.
(ii) The company should choose project 1 because it has the higher net present
value. Project 1 will have the greatest positive impact on shareholder wealth.
Project 2 is less attractive in the long term, although it does oIIer the
opportunity oI a higher rate in the short term iI the company is Iaced with
capital rationing.
Manv candidates failed to recognise that the primarv consideration is the impact on the
owners wealth. That means that net present value will normallv provide the correct ranking
of mutuallv exclusive profects. Manv answers consisted of little more than a regurgitation of
the points raised in the core reading with respect to the different investment criteria.
;E (i) Consolidated statements are necessary because the individual company
statements will usually include a mixture oI balances and transactions
involving Iellow group members as well as third parties. This will make it
diIIicult, iI not impossible, to get any real indication oI the overall size oI the
group or the extent oI its operations. Even iI there was no real interaction
within the group, it will be Iar easier and more convenient to work with the
group accounts than to deal with the individual statements and have to work
out group totals.
Page 4
(ii) The B))?J-%% Iigure is the diIIerence between the cost oI the group member
and the underlying reported assets acquired. When the group member is Iirst
acquired the holding company will normally have paid a premium over the
cost oI the assets shown in the subsidiary`s balance sheet in order to acquire
such assets as the company`s reputation and its work Iorce. This balance is
then amortised over the liIe oI the goodwill and so the balance shown in the
consolidated statements is the unamortised balance remaining.
The K-1),-&' -1&.,./& Iigure is the equity in subsidiary companies that is
owned by outside investors. There is no need Ior the holding company to hold
more than a proportion oI the shares in order to have control. Any amount
remaining in the hands oI third parties is a source oI Iinance Ior the group, but
it does not impose the same duties on the holding company as a direct
investment in the holding company`s shares.
This question produced some verv good answers. Candidates tended to be aware of the issues
associated with consolidations, although a minoritv of answers provided verv weak
explanations.
;F (i) II the business is a partnership then both partners will be jointly and severally
liable Ior the debts owed by the business. This means that iI the business Iails
then they will have to make up any shortIall Irom their own pockets. It also
means that iI one partner cannot or will not make settlement then the other will
be liable Ior the unpaid share and will have to make that good as well. This
implies the individuals trust each other, but in this case they have known each
other Ior a short time.
II the business is a limited company then the owners will not be directly liable
Ior its debts. II the business Iails then both will be able to walk away and
leave the unpaid creditors to gather as much as they can Irom any assets
remaining in the company. The company will, however, require more time
and eIIort to administer. II turnover grows they may also be Iorced to have an
audit.
(ii) Maude`s initial Iinance should be treated as a loan, Ior which she should be
paid a realistic rate oI interest. II she receives additional shares then this
might mean that she will enjoy a disproportionate amount oI proIit iI the
company grows and succeeds. It will also mean that she will receive nothing
in recognition oI her advance while proIits are poor. They should split the
equity equally between them.
The owners should agree on salaries to provide them with some cash to
support themselves on a day to day basis. This will ensure that they do not
take excessive amounts.
The remaining proIit will then be available to pay dividends, although this will
require the agreement oI the owners, who should consider the need to leave
adequate Iunds in the business to ensure that it can grow in the Iuture.
Page 5
The first part of this question was answered well, with candidates appreciating the
advantages and disadvantages of the different forms of business. The second part of the
question was intended to test an appreciation of the real issues associated with going into
business. Jerv few candidates produced a realistic basis for sharing profits.
;G A company can use swaps to reduce risk by matching its assets and its liabilities. For
example, a company which has short term liabilities linked to Iloating interest rates,
but long term Iixed rate assets can use interest rate swaps to achieve a more matched
position. Currency swaps would be used by a company with liabilities in one
currency and assets in another.
Companies can also use swaps to reduce the cost oI debt. II one company has a
comparative advantage in borrowing at a Iloating rate, while another company has a
comparative advantage in borrowing at a Iixed rate, they can use an interest rate swap
to reduce the total cost oI Iinancing and both beneIit Irom a lower cost oI debt.
This question was generallv answered well, although a minoritv of candidates appeared to be
confused over the uses of interest rate swaps.
;H (i) Required rate oI return 3|8|.0.6
7.8
(ii) The total risk associated with an investment is not particularly important in the
context oI a diversiIied portIolio. A signiIicant proportion oI the risk in most
investments can be diversiIied away. In other words, Iactors such as
movements in exchange rates will have an adverse eIIect on some investments
and a positive eIIect on others. The eIIect oI investing in a portIolio is to
reduce the overall volatility oI the returns.
Risk can be separated into two components: systematic and unsystematic.
Systematic risk is inherent in the political and economic environment and is
common to all companies. For example, a change in energy prices will aIIect
all companies to some extent. Unsystematic risk is speciIic to the company. It
encompasses a range oI risks speciIic to the company such as changes in
market demand Ior its products, stability oI industrial relations, nature and
location oI its assets, and so on.
Systematic risk cannot be diversiIied away because it arises Irom Iactors
which will have an eIIect on all companies. Thus, an increase in interest rates
or oil prices is likely to have an adverse eIIect on all companies and will
depress returns Irom the market as a whole. Unsystematic risk can be
diversiIied away and, provided the investment is held in a properly diversiIied
portIolio, it can thereIore be ignored.
It is possible that a highly speculative investment will not be aIIected by
general market conditions to any great extent. That means that it will not have
Page 6
a high systematic risk. The volatility will, thereIore, be due to unsystematic
Iactors that can be diversiIied away. That, in turn, suggests that the
investment may require a very low return.
(iii) One approach is to use the company`s own beta coeIIicient. That is only
relevant, however, iI the project is subject to the same risks as the company as
a whole. That would suggest that investments which will amount to expansion
oI the business are subject to the same degree oI systematic risk.
Another approach is to use the beta oI a company which is engaged in the
same line oI business as the project. That would be appropriate Ior
investments which take the company into a new business sector.
A third possibility is to use historical data to estimate the betas oI individual
divisions or segments oI the main company. These betas can then be used as a
surrogate Ior the coeIIicients oI individual projects which Iall within their
scope.
Finally, any oI the above Iigures can be adjusted to allow Ior the eIIects oI
high Iixed costs. These will tend to reduce the variability oI expenses to
changes in market conditions. In poor periods the revenues will be depressed
without a corresponding decrease in expenses. That will increase the exposure
oI the company to changes in economic Iactors and will, thereIore increase
systematic risk.
(iv) In theory, investing in a positive NPV project will increase shareholders`
wealth by the amount oI that NPV. In practice, this change will only occur iI
the market is aware oI the investment and agrees with management`s estimates
oI the potential risks and rewards. It may be that the share price will not move
in line with expectations because the market is not convinced that the risk is
justiIied or even because the directors have withheld important inIormation Ior
the sake oI commercial sensitivity.
II the directors wish to estimate the likely response to an investment then they
should attempt to apply the same valuation models used by outside analysts
and advisers in an attempt to determine how the inIormation that they intend
to publish will impact the share price. This might prove important because the
company might prove vulnerable to a takeover bid iI the market price oI the
shares is depressed by an adverse or lukewarm reaction to the news.
This question was intended to test some of the issues associated with the role of finance
theorv in investment decisions. It was generallv answered well, with most candidates
demonstrating an understanding of both CAPM and NPJ. Part (iii) was, however, answered
badlv bv manv, with few practical suggestions as to how to estimate a profects beta.
;= (i) L A%#
ProIit and Loss Account Ior the year ended 31 August 2002
Page 7
000 000
Sales 2,600.0
Cost oI sales 1,006.5
Gross proIit 1,593.5
Administration 435.0
Distribution 850.0
1,285.0
Operating proIit 308.5
Interest 110.0
Net proIit beIore taxation 198.5
Taxation 40.0
158.5
Dividend 150.0
8.5
Balance brought Iorward 180.0
188.5
B plc Balance Sheet as at 31 August 2002
000 000
Fixed Assets 2,463.5
Current Assets
Stock 99.0
Debtors 240.0
339.0
Current liabilities
Bank 14.0
Proposed dividend 150.0
Taxation 40.0
Creditors 110.0
314.0
Net current assets 25.0
2,488.5
Loan 1,400.0
1,088.5
Share capital 500.0
Share premium 400.0
ProIit and loss account 188.5
1,088.5
Note Fixed Assets
Cost Aggregate
depreciation
Net book
value
000 000 000
Land and buildings 2,300.0 249.0 2,051.0
Machinery 900.0 487.5 412.5
3,200.0 736.5 2,463.5
Page 8
M),N-1B/
Cost of sales
trial balance 800.0
Plant depreciation 137.5
Land and buildings depreciation 69.0
1,006.5
(ii) The depreciation charge should be based on the estimated useIul lives oI the
assets. These should reIlect the underlying nature oI the assets themselves and
should be Iactually correct to the extent that it is possible Ior such an estimate
to be so. II the directors were to distort this inIormation with the intention oI
distorting the annual report then it would amount to deliberately misleading
the shareholders and anyone else reading the Iinancial statements. Apart Irom
being morally wrong, this would be a criminal oIIence. The company`s
auditors might identiIy the distortion and ask Ior an alteration to the
statements. II this was not made then they might Iind it necessary to qualiIy
their audit report.
The directors are also required to disclose their main accounting policies. II
they are seen to be depreciating the company`s assets at a slower rate than the
industry norm then their scheme will simply draw attention to the Iact that
proIit has been overstated.
Part (i) was designed to test the abilitv to prepare a simple set of financial statements. This
produced some verv good answers, with verv few candidates finding anv real difficultv.
Part (ii) drew on the core reading, but also reflected some of the current unease with respect
to the integritv of accounting information (which became even more topical in the period
immediatelv prior to this diet). Manv candidates correctlv explained how an artificial
understatement of depreciation would increase profits, but relativelv few considered the
associated issues of whether accounting regulations would prevent companies from doing so.
Still fewer referred to the moral implications of manipulating profits.
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108A2003 Institute oI Actuaries
108 A20032
correct.
; Which oI the Iollowing best describes a company`s 'authorised capital?
A The amount oI share capital it has issued.
B The amount oI share capital Ior which payment has been received.
C The total amount oI share capital it is allowed to issue.
D The total amount oI loan capital it has issued. |2|
C Which oI the Iollowing is NOT a disadvantage oI using the internal rate oI return
(IRR) method oI capital budgeting?
A Projects can have multiple IRRs.
B IRR ignores the time value oI money.
C IRR does not provide a clear basis Ior deciding about an individual project.
D It is diIIicult to determine an 'average IRR Ior a range oI scenarios. |2|
D Which oI the Iollowing would not normally be included in the calculation oI gearing?
A bank overdraIt
B debentures
C ordinary shares
D preIerence shares |2|
E Laura has just been admitted to a long established business partnership. She has
purchased 20 oI the partnership equity, although she has not paid Ior this yet. She
will be entitled to 15 oI the partnership proIit. II the Iirm incurs any liability, what
proportion oI that liability will be Laura's legal responsibility?
A 0
B 15
C 20
D 100 |2|
108 A20033 FG2+82 6H@5 7I2@
J X plc has issued both ordinary and preIerence shares. The directors have suspended
payment oI the preIerence dividend. Which oI the Iollowing is UNLIKELY to be
true?
A The company will be unable to pay an ordinary dividend.
B The preIerence shareholders will be entitled to vote at the annual general
meeting.
C The market value oI the preIerence shares will decrease.
D The preIerence shareholders will be entitled to sue the company Ior non-
payment oI preIerence dividend. |2|
K Beta plc is a quoted company. Which oI the Iollowing is a speciIic risk that can be
diversiIied away by shareholders?
A Beta plc is highly geared and it is exposed to increases in interest rates.
B Beta plc has a great deal oI Ioreign competition and so changes in exchange
rates can aIIect its competitive position.
C Beta plc`s main product line requires a steady supply oI a rare mineral that is
only Iound in a region that is politically unstable.
D Beta plc produces luxury goods, demand Ior which is highly vulnerable to
changes in the economic climate. |2|
L When a Iirm announces a two-Ior-one stock split (in the absence oI other new
inIormation), investors should expect that:
A earnings per share will Iall but stock price will remain the same
B stock price will Iall but earnings per share will remain the same
C both earnings per share and stock price will remain the same
D both earnings per share and stock price will Iall
|2|
= Bidder plc acquired all oI the shares oI Target Ltd Ior 4.5m. At the date oI
acquisition Target Ltd`s premises had a Iair value oI 1m, although their written down
value according to its balance sheet was 0.6m. Other Iixed assets were worth 0.8m.
Net current assets were worth 0.1m. Long term liabilities were worth 1.3m. The
goodwill on acquisition was:
A 2.6m
B 3.0m
C 3.9m
D 4.3m |2|
108 A20034
M II a company has stock oI 20,000, debtors oI 30,000, bank deposits oI 5,000,
creditors oI 22,000, and an overdraIt oI 11,000, then the quick ratio is:
A 1.1:1
B 1.6:1
C 1.7:1
D 2.5:1 |2|
;< Which oI the Iollowing is NOT true oI investment trusts?
A They are owned by management companies.
B They are companies which may be listed on the stock exchange.
C They raise equity and debt capital.
D They are run by a board oI directors. |2|
;; T plc has never had a Iormal system oI investment appraisal. The directors have
decided that, in Iuture, managers must submit a Iormal proposal in respect oI all
investment projects and each project must have a payback period oI Iive years or less.
Describe the advantages and disadvantages oI this new policy. |6|
;C Outline how the directors oI a company can decide whether the accounting policies
that they wish to adopt in their company`s annual report are acceptable. Your answer
should reIer to both legal and proIessional pronouncements. |8|
;D Explain how the tax liability oI the liIe business and general annuity business oI a liIe
insurance company is determined. |6|
;E The board oI F plc, a major quoted company, intends to raise additional equity. The
directors have been advised to do so by means oI a rights issue. State the advantages
oI a rights issue as a method oI issuing shares and explain the decisions that the
directors have to make in the process oI making this issue. |10|
;J Explain how the main types oI derivative instrument might be used by a multinational
manuIacturing company in the aerospace industry. |10|
108 A20035 FG2+82 6H@5 7I2@
;K R plc is a quoted company. Its directors are reviewing the company`s long term
Iinancial strategy. The company has been criticised Ior being Iinanced largely by
equity. It has no signiIicant long term borrowings. The board has asked Ior some
calculations to enable them to decide whether the company should consider
borrowing in the Iuture. The next phase oI expansion will require the company to
raise 200m and will involve a general expansion oI the existing lines oI business.
The Iollowing inIormation has been obtained:
Current risk Iree rate 4
Equity risk premium 5
Current corporation tax rate 30
Equity capital 1,000m
R plc`s Beta 1.4
Probable gross interest rate on debt 7
(i) Calculate R plc`s expected weighted average cost oI capital (WACC). |3|
(ii) Calculate R plc`s expected WACC AFTER the new Iinance has been raised
assuming that the Iinance is raised by borrowing. |6|
(iii) Explain the relevance oI the WACC Iigure to the decision to use equity or debt
Ior the new Iinance. |6|
(iv) It has been suggested that company directors are oIten motivated by a desire to
act in their own best interests rather than those oI the shareholders. Explain
why directors might be reluctant to use the capital asset pricing model
(CAPM) as a decision making criterion Ior Iinancial planning. |5|
|Total 20|
108 A20036
;L The Iollowing balances have been extracted Irom the books oI JK plc, as at 31 March
2003:
000
Advertising 70
Cash at bank 10
Creditors 45
Debtors 115
Directors` remuneration 75
Interest on long term loans 4
Investment income 18
Investments (short term) 350
Long term loans 200
Ordinary dividend paid 30
Ordinary share capital, issued and Iully paid 700
Plant and machinery cost 210
Plant and machinery depreciation at 31 March 2002 95
Premises cost 950
Premises depreciation at 31 March 2002 20
ProIit and loss at 31 March 2002 236
Purchases 600
Sales 1,760
Share premium account 50
Stock at 31 March 2002 130
Wages and salaries administrative staII 160
Wages and salaries manuIacturing staII 190
Wages and salaries sales staII 80
Additional information.
1. Stock at 31 March 2003 was valued at 185,000.
2. Provision is to be made Ior administrative expenses owing at 31 March 2003
amounting to 12,000.
3. Premises are to be depreciated at the rate oI 2 on cost, and plant and machinery
at 25 reducing balance.
4. Advertising paid in advance at the end oI the year amounted to 9,000.
5. Corporation tax based on the year`s proIit is estimated at 15,000.
6. The company`s ordinary share capital is 700,000 1 ordinary shares, Iully paid.
7. A Iinal ordinary dividend oI 5p per share is proposed.
@.N$-,.?
Prepare JK plc`s proIit and loss account Ior the year to 31 March 2003, and a balance
sheet at that date. These should comply with Companies Act presentation
requirements. |20|
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Institute oI Actuaries
Page 2
5 C
= B
> A
? D
@ D
A C
B D
7 C
C A
56 A
Questions 1-10 were generallv answered well.
11 A Iormal proposal will require explicit consideration oI the cash Ilows associated with
the project. This will make it easier Ior management to decide on the overall impact
on the company`s Iuture perIormance. Payback is also relatively easy to understand
and to implement.
UnIortunately, payback is probably the least relevant investment criteria. It ignores
the time value oI money. It ignores cash Ilows occurring aIter the end oI the payback
period. It will also rank mutually exclusive projects in a manner that might be sub-
optimal Ior the shareholders.
This question was answered well, candidates should however be careful in this tvpe of
question to discuss cash flow rather than profit.
12 Company law lays down a host oI detailed procedures relating to the Iorm and content
oI Iinancial statements. These requirements include some prescriptions concerning
accounting policies , such as a requirement that the current assets other than debtors
should be valued at cost or net realisable value iI lower . The Companies Acts also
prescribe the basic accounting concepts such as accruals, consistency and so on .
The accountancy proIession has published a series oI detailed accounting standards .
These generally Iocus on areas where there have been problems with accounting
policies in the past . For example, there are accounting standards on detailed matters
such as the valuation oI closing stock and the calculation oI depreciation .
Page 3
Both company law and accounting standards require Iinancial statements to give a
'true and Iair view . This provides a Iurther benchmark against which to measure the
acceptability oI accounting policies . Do the Iinancial statements give a true and Iair
view ?
The directors can also consider the consistency oI their policies with those oI other
similar companies . Readers oI Iinancial statements will expect similar businesses to
Iollow broadly similar accounting practices .
Finally the directors can share the burden oI ensuring the validity oI their accounting
policies with the auditors . The auditors will use similar criteria to those oI the
directors, but will provide an independent perspective in doing so.
Candidates should alwavs be careful to answer the question rather than writing
evervthing thev know about the topic. A number of candidates confused accounting
concepts and policies.
13 Insurance companies are taxed on their investment income and realised capital gains .
These will have to be calculated in a manner that is acceptable to the Revenue .
The company can oIIset liIe business expenses and general annuity business expenses
Irom their income. Only permissible expenses can be deducted . For example,
entertaining and depreciation charges must be excluded Irom costs Ior tax purpose .
The income element oI general annuity payments to policyholders may also be deducted.
The net income Iigure is the company`s taxable proIit. This is then multiplied by the
appropriate tax rate , as set by the government, in order to arrive at the Iinal liability.
Generallv this question was well answered.
14 The company is quoted. The stock exchange requires existing shareholders to have
the opportunity to purchase any new issues . Rights issues automatically grant this
opportunity to the shareholders . Rights issues also involve slightly lower issue costs
than other Iorms oI selling new shares . The Iact that the company is Iollowing this
'common approach will also reduce the risk oI unsettling the stock market by trying
something new.
The directors must decide on the most appropriate time Ior the issue . Ideally, it
should be at a time when the markets are likely to be most Iavourably disposed to the
company. For example, iI the annual report will be due in a Iew months and iI it is
likely to impress the markets then it might be better to delay the announcement . II the
next proIit Iigure is likely to be slightly depressed then it might be better to move
sooner .
The directors must also decide the issue price oI the new shares . This must be less
than the current market price, otherwise there ill be no point in exercising the rights .
A large discount should not matter, at least in theory, because the shareholders can
buy these reduced price shares and avoid diluting their equity . Alternatively, a large
discount will increase the value oI the rights themselves iI the shareholders decide to
sell rather than exercise them . Too large a discount could, however, unsettle the
markets .
Page 4
The directors must also decide how much inIormation to release with respect to the
underlying reasons Ior the issue . They are required to make some disclosures in the
rights oIIer document , but they might decide to publish more detail in order to appear
open and transparent and win the trust oI the markets . Too much disclosure could,
however, cost the company competitive advantage because competing businesses
will make a point oI obtaining a copy.
This question was reallv well answered most candidates were well prepared.
15 This company is likely to have large contracts that involve substantial payments at
Iuture dates. The company could use currency Iutures to 'lock in the exchange rate
oI receipts or payments that have been agreed Ior a Iuture date and in a Ioreign
currency . This will protect the company Irom the risk oI liabilities appreciating in
value or assets declining in value beIore they Iall due to be settled.
The company can also sell its own specialised Iutures or options as an incentive to
customers. It is common in this industry Ior airlines to take options on aircraIt. These
give the airline the right, but not the obligation, to purchase by a predetermined date
but at a Iixed price . This means that the airline is protected Irom any price increases .
The company also beneIits because it can retain the cost oI the option, even iI the
customer decides not to buy.
The company is likely to have operations around the world. It might be able to make
use oI currency swaps in order to reduce its total cost oI borrowing. For example, it
might have a comparative advantage in borrowing in the main currency oI it base
country . It might enter into a reciprocal agreement with a borrower in a host country
who has a corresponding comparative advantage . The two parties can exchange a
series oI payments so that each has access to Iinance in their desired country and
currency, but payable on terms that have been negotiated with their counterpart .
The company might also be able to use interest rate swaps in a similar way iI it has a
similar Iorm oI advantage (say in borrowing at a Iixed rate) that can be shared with
another company with a corresponding advantage (say in borrowing at a variable
rate).
This question was poorlv answered with manv candidates giving a general answer on
all tvpes of derivatives. Candidates should alwavs trv to be as specific as possible.
16 (a) WACC cost oI equity
Cost oI equity 4 (1.4 x 5) 11 |2|
(b) Gearing 200:1,000 0.2
Page 5
Geared beta 1.4 x (1(0.2 x (1-0.3)) 1.596 |2|
Cost oI equity 4 (1.596 x 5) 11.98
Net cost oI debt 7 x (1-.3) 4.9
WACC (11.98 x 1,000 / 1,200) (4.9 x 200 / 1,200) 10.8
(c) The company should, ideally, minimise its WACC. In theory, doing so will
maximise the expected cash Ilows that it will generate and so increase its
market capitalisation . II it raises the additional Iinance Irom shares then it will
have 100 equity and so its WACC will be 11 . It would, thereIore, be
slightly cheaper to borrow the 200,000 .
The problem is that this comparison is not quite valid because oI the risks
associated with borrowing . II the company borrows then it will run the risk oI
being unable to make interest payments when they Iall due . Earnings
available to the shareholders will also be more volatile because oI gearing .
This could mean that the shareholders will actually Ieel that the company is a
poorer investment, even though it is beneIiting Irom the cheaper debt Iinance
and its associated tax advantages .
It should also be noted that R plc`s ungeared beta is relatively high at 1.4 .
This means that the company`s shares are already a slightly risky proposition
when taken on their own. Adding the additional risks associated with gearing
might make things even worse .
(d) CAPM assumes that investors have a portIolio oI assets . A company
director`s principal asset will be his or her job . CAPM assumes that any and
all unsystematic risks can be diversiIied away . The directors are, however,
exposed to both systematic and unsystematic risks . Companies sometimes
reduce this problem slightly by rewarding directors with stock options, thereby
providing an incentive to introduce some volatility into the company`s share
price perIormance , but these are unlikely to be a suIIicient incentive to invest
in highly risky investments. The directors might also be concerned that the
shareholders will not view any investments Irom a CAPM perspective. CAPM
is not especially intuitive and so the directors might be concerned that the
merits oI their decisions will not be understood .
This question was verv well answered bv most candidates
Page 6
17
JK plc
Profit and loss account for the year ended 31 March 2003
000 000
Turnover 1,760
Cost of sales (783)
Gross profit 977
Selling and distribution costs (141)
Administrative expenses (397)
(538)
Operating profit 439
nterest paid (4)
nvestment income 18
14
Profit before taxation 453
Taxation (15)
Profit on ordinary activities after taxation 438
Dividends (65)
Retained profit for the year 373
Balance brought forward 236
Retained profits carried forward 609
JK plc
Balance sheet at 31 March 2003
000 000
Fixed assets 997
Current assets
Stock 185
Debtors 115
nvestments 350
Prepaid expense 9
Bank 10
669
Creditors: amounts falling due within one year
Creditors (45)
Accrued charge (12)
Corporation tax (15)
Proposed dividends (35)
(107)
Net current assets 562
1,559
Creditors: amounts falling due after more than one year
Long term loan (200)
1,359
Share capital and reserves
Ordinary share capital 700
Share premium 50
1,359

Page 7
Workings
000
Cost of sales
Opening stock 130
Purchases 600
Closing stock (185)
Depreciation - premises 19
Depreciation - plant and machine 29
Wages and salaries 190
783
Selling and distribution
Advertising 70
Less - prepaid (9)
wages and salaries 80
141
Administrative expenses
Add - accrual 12
Directors' remuneration 75
Wages and salaries 160
397
Dividends
Paid 30
Proposed 35
65
Fixed assets
Cost
Aggregate
depreciation
Net book
value
Premises 950 39 911
Plant and machinery 210 124 86
1,160 163 997
This question was designed to test the candidates abilitv to prepare a profit and loss account
and balance sheet. Most candidates could calculate the correct figures but manv lost marks
for incorrect formats.
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108S2003 Institute oI Actuaries
108 S20032
correct.
; Which oI the Iollowing statements is correct?
A External auditors report to the directors.
B External auditors are required to give a report to the shareholders.
C External auditors correct errors in Iinancial statements.
D External auditors are appointed by the directors. |2|
C Which oI the Iollowing types oI Iinancial instrument is best described as Iollows: a
Iixed return, a Iixed repayment date, it is secured and the return is classiIied as an
expense?
A medium term bank loan
B preIerence share
C ordinary share
D debenture |2|
D JenniIer successIully applied to buy shares that had been oIIered Ior sale by tender.
She tendered to pay 2.40 per share. The maximum tendered by any applicant was
2.50. The average tendered was 2.20. The strike price was 2.30. How much did
JenniIer pay Ior each oI the shares that she received Irom the company?
A 2.20
B 2.30
C 2.40
D 2.50 |2|
E A plc owns shares in three companies, B Ltd (40 shareholding), C Ltd (100
shareholding) and D Ltd (25 shareholding). C Ltd also owns 30 oI the shares oI
D Ltd. A plc has a contractual right to appoint two thirds oI the board oI B Ltd. A
plc has used its voting rights to appoint all oI the directors oI C Ltd. Which
companies are subsidiaries oI A plc?
A C only
B B and C only
C B, C and D
D none oI the above |2|
108 S20033 FG2+82 6H@5 7I2@
J A company`s share capital comprises 40,000 20 pence ordinary shares, which were all
issued at a premium oI 25. The shares are Iully paid up. The market value oI the
shares is currently 50 pence each. The Iigure Ior ordinary share capital appearing in
the company`s balance sheet will be:
A 8,000
B 10,000
C 18,000
D 20,000 |2|
K In times oI rising prices, the historical cost convention has the eIIect oI:
A understating proIits and overstating balance sheet items
B understating proIits and understating balance sheet items
C overstating proIits and overstating balance sheet items
D overstating proIits and understating balance sheet items |2|
L Assume the current corporation tax rate is 30. The directors oI ABC Ltd were
surprised when they received a corporation tax assessment Ior less than 30 oI its
reported proIits. Which oI the Iollowing items may have contributed to ABC Ltd
receiving a tax assessment which was lower than anticipated?
I losses carried Iorward Irom previous years
II capital allowances which are higher than depreciation
III entertaining expenses which are disallowed Ior tax
A I only
B II only
C I and II only
D I and II and III |2|
= Which oI the Iollowing would NOT appear in a cash Ilow statement, in the
'reconciliation oI operating proIit to net cash inIlow Irom operating activities?
A Depreciation
B Wages
C Increase in creditors
D Increase in stocks |2|
108 S20034
M A company is planning to expand and has prepared a set oI discounted cash Ilow
calculations Ior consideration by the board oI directors. Prior to the Iinal decision, the
company`s weighted average cost oI capital has increased. How will this aIIect the
discounted cash Ilow results?
A Net present value will decrease and internal rate oI return will decrease.
B Net present value will decrease and internal rate oI return will increase.
C Net present value will decrease and internal rate oI return will remain the
same.
D Net present value will increase and internal rate oI return will remain the
same.
|2|
;< Which oI the Iollowing institutions do not normally invest in short dated gilts?
A General Insurance Company
B Discount House
C LiIe Insurance Company
D Clearing Banks |2|
;; Your company has traditionally used the net present value criterion Ior analysing
investment opportunities. It has recently been proposed that it should switch to a
shareholder value approach. Discuss the advantages oI doing so. Your answer should
consider the problems that would have to be overcome in order to implement this
approach successIully. |8|
;C Explain how a company`s UK corporation tax liability is calculated and when it must
be paid. |6|
;D One oI your relatives has recently received a substantial sum oI money. He is keen to
invest this Ior long term growth, so that he can provide Ior his retirement. He would
like to invest in the shares oI the quoted company Ior which he has worked Ior the
past twenty years. He already owns some shares in that company and has always
been satisIied with the returns that he has obtained.
Explain why it would be inadvisable Ior your relative to invest this sum in a single
company, even one which he knows well and which has perIormed well in the past.
Your answer should reIer to the principles underlying the capital asset pricing model
(CAPM). |6|
108 S20035 FG2+82 6H@5 7I2@
;E Explain how the Bank oI England traditionally provided liquidity in the money
markets, and how it provides liquidity now. |6|
;J The board oI a major quoted company is considering making a scrip issue. It is
weighing up the costs oI doing so against the expected beneIit in terms oI a possible
short-term boost to the company`s share price.
Describe the costs associated with making a scrip issue and explain how it could
increase the share price. |6|
;K The treasurer oI a major multinational company is preparing a proposal to the board
that the company should issue Eurobonds Ior the Iirst time. The directors are unsure
what is involved and have sought clariIication oI the issues involved.
Explain the advantages and disadvantages oI the use oI Eurobonds to an issuer. |8|
;L Trevor and Simone are directors oI Make Ltd, a wholly owned subsidiary oI a large
group oI companies. Make Ltd manuIactures packaging Ior the other companies in the
group.
The directors oI the group`s holding company have approached Trevor and Simone
and have oIIered to sell them Make Ltd. II Trevor and Simone accept this oIIer, the
group will continue to buy its packaging materials Irom Make Ltd Ior three years,
aIter which time Make Ltd will have to compete Ior this business against other
manuIacturers. Make Ltd will be also be Iree to Iind new customers who are not part
oI the group. II Trevor and Simone do not accept the oIIer then the group will
probably make the workIorce oI Make Ltd redundant and close the company down.
They will then obtain their packaging Irom independent suppliers, probably Irom
overseas.
Trevor and Simone have discussed this proposal. They could each raise 25 oI the
asking price by remortgaging their homes. They could raise the remainder oI the price
by inviting the workIorce oI Make Ltd to buy shares.
In the medium term, Make Ltd will have to invest heavily in new technology in order
to compete Ior new business.
In the short term, Make Ltd will have to rearrange its short term Iinances to reIlect the
Iact that it is no longer part oI the group.
(i) Explain the main issues that Trevor and Simone should consider beIore
committing themselves to acquiring this interest in Make Ltd. |8|
(ii) Describe the main sources oI Iinance that Make Ltd should consider Ior the
acquisition oI new manuIacturing equipment. Assume that this acquisition will
only be made iI the purchase oI the company is completed. |6|
(iii) Describe the main sources oI short term Iinance that will have to be organised
by Make Ltd iI Trevor and Simone complete the purchase. Describe the main
problems that will have to be overcome when obtaining each Iorm oI Iinance.
|6|
|Total 20|
108 S20036
;= PJ plc is a large retailer which sells electrical goods to the public. Every year the
board obtains copies oI the Iinancial statements oI their two main competitors:
Pricecut and Bigstore. The directors oI PJ plc try to obtain insights into their
competitors' business practices so that they can improve their own perIormance.
The summary Iinancial statements oI the three companies are shown below:
F,)*-& "1? %)// "##)$1&/ *), &N. '.", .1?.? D< O$1. C<<D
PJ plc Pricecut Bigstore
000 000 000
Sales 5,000 4,000 11,000
Cost oI goods sold (1,500) (2,000) (2,750)
Advertising (400) (480) (880)
Sales staII (350) (400) (880)
Other expenses (600) (160) (1,430)
Net proIit 2,150 960 5,060
P"%"1#. /N..&/ "/ "& D< O$1. C<<D
PJ plc Pricecut Bigstore
000 000 000
Tangible Iixed assets 5,000 1,300 8,000
Current assets
Stock 123 99 286
Bank 10 3 17
133 102 303
Current liabilities
Creditors (115) (82) (286)
Net current assets 18 20 17
Total assets less current liabilities 5,018 1,320 8,017
Share capital and reserves 5,018 1,320 8,017
(i) Discuss the main diIIerences between PJ plc`s business practices and those oI
Pricecut and Bigstore, using relevant ratios to support your answer. |15|
(ii) Describe the limitations oI the annual report as a basis Ior the comparison oI
companies in the manner suggested by the directors oI PJ plc. |5|
|Total 20|

REPORT OF THE BOARD OF EXAMINERS

September 2003


EXAMINERS REPORT

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EXAMINATIONS

September 2003


EXAMINERS REPORT


Page 3
1 B

2 D

3 B

4 C

5 A

6 D

7 C

8 B

9 C

10 C

In Questions 1-10 there were no particular problems with the objective test questions, with
most candidates scoring a reasonable mark.

11 Shareholder value reflects the impact of any investment decision on the wealth of the
shareholders. This is important because it is generally accepted that the directors are
responsible for maximising the shareholders wealth. The focus is on the needs and
interests of the shareholders, rather than that of the directors or the company itself.
The criterion looks at more than the quantitative analysis of the project itself. Instead,
it takes into account the markets perception of whether the company is improving as
a result of the investment.

The biggest problem to be overcome in applying this approach is in predicting how
the market will perceive a project. If the company enters into a project without
releasing any information then the immediate impact on the market perception could
be zero. News will only start to affect the share price as it unfolds and as the markets
become confident in its authenticity. Thus, the markets might react badly to the
announcement of a new project if they discount some of the claims made by
management as over-confident or self-serving. This could mean rejecting positive
NPV projects because they might harm the companys standing in the eyes of the
investment community. The company will have to decide on the time frame to be
considered. In the longer term, market confidence should be restored as the project
develops and matures and the shareholders can see profits and cash flows coming
from it.


Page 4
The company will also have to decide how much information it is planning to make
available to the markets and when this will be released. Keeping the market abreast of
developments will see the information about new projects incorporated into share
prices sooner, but could also provide competitors with valuable information.

This question was answered quite badly. In many cases this appeared to be due to candidates
either being unaware of the shareholder value approach or providing a prefabricated
answer on the net present value criterion.

12 Corporation tax is charged on the annual accounting profit. This figure is, however,
adjusted to take account of a variety of adjustments. These adjustments include the
replacement of depreciation with capital allowances, the exclusion of disallowed
expenses such as entertaining and the exclusion of franked investment income from
profit.

Some companies are also entitled to exclude profits earned overseas because of
double tax relief provisions. These profits will be taxable in the jurisdiction where
they are earned, but not in the home country.

The tax rate is announced by the government, usually on an annual basis.

Corporation tax is normally paid nine months after the year end. Large companies are,
however, required to pay their tax on a quarterly basis.

This question was answered well, demonstrating awareness of the basic principles of UK
corporation tax.

13 The return on a security is largely related to the risk that is borne by an investor. This
return is determined on the basis that the investor takes all reasonable steps to
minimise those risks. In particular, investors are expected to diversify, so that certain
risks are cancelled out. Companies face both systematic and unsystematic risks .
The latter are specific to the company (e.g. some companies are exposed to a strong
US Dollar and others to a weak Dollar) . Investing in a portfolio combines companies
that thrive in, say, a weak Dollar with those that do better when the Dollar is strong.
This means that movements in the Dollar have very little effect on the portfolio .
Systematic risks cannot be diversified away because they affect all companies . For
example, high interest rates tend to affect all companies .

Investing in a single company will mean that the relative is being rewarded for the
systematic risks associated with the security, but not the unsystematic . That means
that the return will not adequately compensate for the risks undertaken .

Common sense also dictates that the investor runs the risk of losing everything from
investing in a single company if that company fails . The fact that this person also
works for that company could mean the loss of both his job and his savings if the
company collapses .

Page 5
Most candidates provided sensible answers to this question. Better answers highlighted the
practical implications of the CAPM for investors without becoming bogged down in technical
detail.

14 Traditionally, the Bank of England used discount houses as a buffer between itself
and the clearing banks . The discount houses acted as money-market intermediaries,
channelling excess short term cash to institutional borrowers, and borrowing from the
clearing banks on a very short term basis . The traditional money market has been
replaced and widened over the last two decades, since the Bank of England has
allowed other institutions to participate in maintaining the liquidity of the money-
markets .

The Bank of England still acts in a supporting role for the various institutions that are
active in the short-term money markets. Banks and other institutions can lend money
to, or borrow money from, the Bank of England . The Bank is always willing to act as
lender of last resort, otherwise the banks could run short of money and a financial
panic could occur .

If the money markets are short of cash, Treasury bills, local authority bills and bills of
exchange can be sold to the Bank of England in return for cash . Similarly, if there has
been a large cash inflow into the money markets institutions can use up their spare
cash by buying existing bills from the Bank of England .

The Bank of England also provides cash to the market by lending cash against bills
deposited on security , and by purchasing bills with a simultaneous agreement to sell
at a later date (known as repo arrangements) .

The quality of answers to this question varied considerably. Weaker answers were generally
short of detail and gave the impression of a lack of familiarity with the subject matter. While
the examination is designed to avoid testing recall of facts, candidates should attempt to
understand the role and behaviour of institutions and the frameworks in which they operate.
That should develop sufficient familiarity with the basic facts to deal with questions such as
this.

15 The scrip issue does not require many formalities. It does, however, involve some
administrative effort and therefore cost . The company will have to write to
shareholders and inform them that the issue is taking place . This will also have to be
announced publicly to prevent anyone being misled and buying or selling at a time
when the rights to scrip shares are lost . The shareholders themselves will also suffer
an element of irritation because they will have to keep detailed records of the change
in their holdings for tax purposes .

The company will also have to update its share registers and will have to issue the
shares themselves .

It is unlikely that the issue itself will make the company a better investment . It could,
however, be interpreted as a signal of confidence on the part of the directors . For

Page 6
example, scrip issues can reduce the scope for a future rights issue. Carrying on with
the issue might signal that the directors believe that future share price strength will
outweigh these concerns . Scrip issues can also be associated with a slight increase in
future dividends .

This answer was answered well, with candidates demonstrating understanding of both the
mechanics of scrip issues and their role in signalling confidence to the markets.

16 One of the advantages of Eurobonds is that they are issued outside of the tax and legal
framework of the country of the issuing company . It is possible to arrange for loan
capital to be issued without it coming under the legal or tax jurisdiction of any
country . Additionally, Eurobonds can be issued in any currency .

Eurobonds normally have fixed coupon rates, although floating rate bonds can be
issued . Bonds are normally unsecured .

Eurobonds are bearer bonds . The company does not keep a register of owners;
instead holders must claim coupon payments using coupons cut out of the
certificates . A possible disadvantage for the company is that it may have very little
real idea of the identity of the holders of its bonds .

The nature of these instruments means that the company must have a strong
reputation, otherwise the general absence of regulation may mean that the lenders will
be deterred from buying the issue .

Eurobonds cannot be issued for small amounts, but must be issued in large blocks .
Issues are generally for $75m or more .

Answers to this question were very variable, with weaker candidates struggling to
demonstrate any real understanding of the Eurobond markets.

17 (i) Trevor and Simone are effectively faced with two alternatives. If they invest in
this company then they will suffer all of the risks associated with running it .
They may also lose their homes if the business fails or does not provide them
with sufficient return to service the mortgages that they will have to take out .
On the other hand, they will enjoy the benefits if the company grows and
succeeds . If the company is a major success then they will either be able to
share 25% each of the profits or they will be able to sell out at a substantial
capital gain .

If they do not buy this company then it appears that their employers will make
them redundant . This means that, by buying the company, they will suffer the
opportunity cost of the redundancy pay that they would have received if the
company was closed down .

Given the importance of the future prosperity of the company, it is worth
considering the motives of the holding company . It appears committed to
either selling or liquidating its subsidiary . This suggests that it can obtain

Page 7
either better service or keener prices from other suppliers . They may have
decided that it would be cheaper to sell the company as a going concern rather
than incur the redundancy costs associated with closing it down .

(ii) Make Ltd might find it difficult to borrow in order to expand because it is a
small company that does not have the backing of a larger entity . The
shareholders are unlikely to be able to provide much fresh finance or to
guarantee loans for the company because they will be stretched by the cost of
buying out the existing owners .

Leasing would be a suitable means of acquiring specialised plant because it
would provide the lessor with security in the form of legal ownership of the
new assets . Make Ltd could specify the precise items of equipment that they
want and the lessor would then buy these and make them available to the
company . Make Ltd would enjoy all of the benefits associated with outright
ownership for as long as they met the lease payments .

Hire purchase would be a similar form of finance to leasing in the sense that
the asset would provide its own security for the duration of the loan period .

The third possibility would be a term loan to enable the company to buy the
equipment outright . This might require Trevor and Simone to provide
personal guarantees to the lender . Even though the guarantees might not
provide sufficient financial backing to compensate the lender they would, at
least, provide the lender with the reassurance that the directors had an
incentive to see the loan repaid .

(iii) The most important source of short term finance is trade credit . This is
effectively a free source of finance since its cost is built into the cost price
of the goods, but this is unlikely to be discounted for immediate cash
payment . It is also a very flexible source of finance, that expands and
contracts in line with the companys requirements .
The creditors are under no obligation to continue to support Make Ltd after the
change of ownership . They might be concerned that the company no longer
has the strength of a large group behind it . They might also be concerned that
any attempts to expand could create cash flow problems that might threaten
the companys ability to meet its short term debts .

As a matter of priority, Trevor and Simone should meet with their principal
suppliers and attempt to negotiate a continuation of existing credit
arrangements . If they have any immediate plans to expand then they should
discuss their needs with each supplier in turn and attempt to negotiate an
adequate credit facility .

The second important source of short term finance is the companys bank
overdraft facility . This gives the company the right to borrow up to its
overdraft limit as and when required and without seeking specific permission
from the bank . Overdraft rates are relatively high, but the company will only
have to pay interest on the amounts actually borrowed at any given time . This

Page 8
can mean that the overdraft is a relatively cheap means of covering short term
commitments .

Trevor and Simone should seek a meeting with their bank manager to
negotiate an adequate overdraft facility . This might prove difficult because
overdrafts are not normally secured . The bank might be nervous about
supporting this new venture .

This question was intended to test a basic understanding of business risks. Answers tended to
be either very good or very bad. The former achieved success by applying some common
sense to dealing with the business issues described. The latter often appeared to be trying to
list facts from the core reading without any real attempt to relate them to the circumstances
of the case.


Page 9
18 (i) The following ratios are relevant:

Profitability

PJ plc

Pricecut

Bigstore
Return on capital
employed
2,150
5, 018

43% 960
1, 320

73% 5, 060
8, 017

63%
Gross profit percentage 5, 000 1, 500
5, 000
70% 4, 000 2, 000
4, 000

50% 11, 000 2, 750
11, 000

75%
Advertising / sales 400
5, 000

8% 480
4, 000

12% 880
11, 000

8%
Sales compensation /
sales
350
5, 000

7% 400
4, 000

10% 880
11, 000

8%
Fixed asset turnover
(times)
5, 000
5, 000

1.0 4, 000
1, 300

3.1 11, 000
8, 000

1.4

Activity

Stock turnover (days) 123
365
1, 500

30 99
365
2, 000

18 286
365
2, 750

38
Creditors turnover
(days)
115
365
1, 500

28 82
365
2, 000

15 286
365
2, 750

38

Pricecut appears to have a much smaller markup than PJ plc on its selling
prices. Assuming that it is selling the same ranges as PJ plc, this suggests that
it is competing on the basis of price . It also spends a higher proportion of its
turnover on advertising and on rewarding its sales staff . Pricecut appears to
have a more aggressive selling policy, as indicated by the fact that it has a
more rapid stock turnover .

Pricecut also has a greater fixed asset turnover. This suggests that it has
consciously minimised its investments in fixed assets in order to maximise
return on capital employed .

Finally, Pricecut pays its suppliers very quickly, suggesting that it buys a
proportion of its goods for cash or that it is keen to maintain supplier support .

Overall, Pricecut appears to be a low cost, low status supplier, possibly selling
in the cheaper end of the market . This approach generates a higher return on
capital employed than PJ plc and so might be worth considering . It could,
however, be risky to adopt this policy because it would provoke direct price
competition with an established competitor .
Bigstore has a higher margin than PJ plc on its sales . It has managed to
achieve higher sales and so it manages to spend a much greater absolute

Page 10
amount on advertising, even though it does not spend more as a percentage of
turnover . That means that it might be able to afford more effective methods
(e.g. television or large press adverts) .

Bigstore has a slower stock turnover than PJ plc, suggesting that it carries a
wider range of stocks or that it sells more expensive brands or ranges .

Bigstore appears to be a high status, high cost supplier concentrating on the
luxury end of the market . PJ plc might also consider this approach because it
also yields a higher return on capital employed . Doing so would, however,
require a great deal of time to develop a reputation to rival Bigstore and to
grow to the necessary size to make some of these practices viable .

(ii) The financial statements could be based on different accounting policies.
Many of the differences identified in (i) above could be due to the manner in
which the figures have been prepared .

Some companies will disclose as little as possible about their business
strategies in order to avoid giving useful information to competitors .

Comparisons could be misleading because of the effects of inflation or
specific price changes . It may be that Pricecut does not have a smaller store
or less equipment its investment could be just as great in real terms, but the
valuations could be markedly different .

There might not be sufficient detail to make some of the comparisons provided
above. For example, the statements might not disclose the amounts paid to
sales staff .

The working capital sections of the balance sheets could be affected by
window dressing or other factors . For example, one of the companies could
have had a sale just before the year end so that the stock figures were
artificially low .

Part (i) tended to be answered well by candidates who understood the technique of ratio
analysis. Good answers provided a range of relevant ratios and made use of these in
providing a considered analysis of the companies. Weak answers often provided more ratios
than was necessary and failed to draw any form of reasoned conclusions in their analysis.

Part (ii) tended to be answered well, with many candidates demonstrating some
understanding of the problems affecting the preparation of financial statements.

EXAMINATIONS
29 April 2004 (pm)
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.

108 A2004 Institute of Actuaries
108 A2004 2
For questions 1 10 indicate in your answer book which one of the answers A, B, C or D is
correct.
1 Which of the following is not explicitly required by the UK Companies Act?
A Directors report
B Auditor s report
C Chairman s report
D Notes to the accounts
[2]
2 Kate is an employee of an insurance company in the UK.
Kate receives additional benefits such as free medical insurance cover. What effect
will these benefits have on her income tax liability?
A The benefits are not subject to tax because they are not in the form of cash.
B She will be taxed on the benefit at a lower rate than the rate of tax applied to
her salary.
C She will be taxed on the benefit to her of receiving these benefits.
D She will be taxed only on the benefits that are not provided in the normal
course of the company s business.
[2]
3 A company s long term finance comprises: ordinary shares 10m, share premium
8m, preference shares 3m, debentures 6m and long terms loans 5m. What is the
company s gearing ratio?
A 19%
B 34%
C 44%
D 69%
[2]
4 Sam owns 1,000 1.00 ordinary shares in T Ltd. These shares were purchased from
the company for 1.25 each. Sam has paid 0.80 per share to date and the shares are
deemed 0.45 paid up. What would be the maximum that Sam could be made to pay
to T Ltd s creditors if the company fails and leaves unpaid liabilities?
A 550
B 800
C 1,000
D 1,250
[2]
108 A2004 3 PLEASE TURN OVER
5 Frank submitted a tender to buy 2,000 1.00 shares in X plc. He offered 3.00 per
share. Tenders received varied from 1.50 to 3.60. The striking price was set at
2.40. How much will Frank have to pay for his allocation of 2,000 shares?
A 2,000
B 4,800
C 6,000
D 7,200
[2]
6 Grow plc owns sugar cane plantations in the Caribbean. In April 2004 it buys an
option to give it the right to purchase refined sugar at a predetermined price at some
time in the future. Which of the following is the LEAST likely explanation for Grow
plc s purchase?
A Grow plc is concerned that this year s crop will fail.
B Grow plc wishes to hedge against price changes on the commodity markets for
sugar.
C Grow plc s knowledge of the industry leads it to believe that it can make
money from speculating.
D Grow plc is attempting to drive up the cost of refined sugar.
[2]
7 Preference share capital has been more popular in recent years. Which of the
following is the most likely explanation for this?
A Preference dividends are more tax efficient than ordinary dividends.
B Preference shares are always redeemable.
C Preference shares can be structured so as to improve the issuer s gearing ratio.
D Preference shares impose no risks on the ordinary shareholders.
[2]
8 Owner plc owns 60% of the ordinary share capital of M Ltd and classifies M Ltd as a
subsidiary. Owner plc owns 25% of the ordinary share capital of O Ltd and classifies
O Ltd as an associate company. Each of the three companies have tangible fixed
assets worth 1m. What total will appear under tangible fixed assets in the
consolidated financial statements published by the Owner Group?
A 1.6m
B 1.85m
C 2.0m
D 3.0m
[2]
108 A2004 4
9 Which of the following is the best reason for NOT referring to the working capital
section of a company s latest balance sheet when deciding whether that company is a
good risk for purposes of granting trade credit?
A A company s liquidity says nothing about its ability to pay debts.
B It is reckless to base such decisions on information provided by the customer.
C The figure for working capital is likely to be distorted.
D The information will almost certainly be out of date.
[2]
10 Which of the following is true of unit trusts?
A Unit trusts are quoted on the Stock Exchange.
B Unit trusts are not companies.
C Unit trusts are allowed to have gearing.
D Unit trusts have no initial charge.
[2]
11 Compare a finance lease with a medium-term loan as a means of acquiring a fixed
asset. [6]
12 Peter and Susan cannot understand why their business is short of cash as it made
profits of over 100,000 last year. Explain why there can be differences between
profits or losses generated, and cash received.
[8]
13 Q Ltd is a general trading company that is domiciled for tax purposes in the UK. The
directors are considering setting up an overseas subsidiary but are concerned that they
might end up paying tax twice on the subsidiary s profits, once in the host country
and a second time when the profits are remitted back to the UK. Describe the
principles of double taxation relief (DTR) as they would apply to Q Ltd. [6]
14 Terry and Julie have decided to establish their own actuarial consultancy. They have
identified a gap in the consultancy market for their services and are keen to start
trading as a partnership soon. First they have to go through the process of creating
and financing their business.
Identify the financing needs of this business and explain how these might best be met
from the various alternatives available. [10]
15 Describe the operation of self-administered pension funds in the UK and explain how
the factors that govern their operation influence their choice of investment.
[10]
108 A2004 5 PLEASE TURN OVER
16 G plc is a quoted company in the telecommunications industry. The government has
offered a licence for the use of a new broadcast technology that could revolutionise
the sector in which G plc operates. This would initially operate in parallel with
existing communications media, but has the potential to become the standard
technology within the next ten years. The directors believe that they would have to
bid 800m in order to secure this licence in competition with the other companies in
the industry.
G plc s market capitalisation is 4,000m. If it decides to bid for the licence and is
successful then it will have to raise most of the cost through the combination of a
rights issue and a loan from a consortium of commercial banks.
G plc s directors are unsure whether to proceed with the bid. One aspect of their
decision is the question of whether the potential returns from this project are adequate
to compensate for the risks involved. They have obtained the following information:
Current risk free rate 5%
Equity risk premium 7%
G plc s Beta 1.8
(i) Calculate the required rate of return from this investment, using G plc s Beta
coefficient as a proxy for the project Beta. [3]
(ii) Explain why G plc s Beta is likely to be an appropriate approximation for the
project Beta and explain how a more appropriate project Beta might be
determined. [6]
(iii) Explain the limitations of the capital asset pricing model (CAPM) in making a
decision about a project of this size and nature. [6]

(iv) Assuming that the directors of G plc make a successful bid for this project,
explain how the stock market is likely to react to the news and explain how
that reaction might best be managed by the company. [5]
[Total 20]
108 A2004 6
17 The Insurance Group has recently published an annual report. This contains the
following summarised balance sheet:
Insurance Group

Consolidated balance sheet as at 31 March 2004

Assets m

Intangible assets

Goodwill on acquisition of subsidiary 4

Investments 278

Reinsurers share of technical provisions

Claims outstanding 110

Debtors 80

Other assets

Tangible assets 6

Cash at bank and in hand 35

41

Prepayments and accrued income 14

Total assets 527

Liabilities

Capital and reserves

Called up share capital 50

Share premium account 22


Shareholders funds attributable to equity interest 81

Technical provisions

Claims outstanding 386

Creditors 60

Total liabilities 527

108 A2004 7
Required
The following questions have been posted to an internet chat site devoted to the
Insurance Group. Outline your response to each question, taking account of the
specific interests of each person asking a question.
(i) Insurance (Accident) Ltd, a wholly owned subsidiary of the Insurance Group,
owes me substantial compensation which will be paid in six months time.
Insurance (Accident) Ltd has massive liabilities and almost no assets. When I
wrote and asked for some assurance that they were capable of paying my
settlement they sent me the group balance sheet and stated that they were part
of a large and solvent group of companies. Explain whether I should accept
this reassurance . [5]
(ii) I am a shareholder in Insurance (Holdings) plc, the holding company of the
Insurance Group. I have the following questions:
(a) Every year the financial statements show that a proportion of the
goodwill on the acquisition of a subsidiary has been written off. Why
is this adjustment necessary and what does it mean for the value of
my investment? [5]
(b) The notes to the financial statements explain that the company has
estimated the amount payable in respect of claims from policyholders
and also the amount recoverable from reinsurers. Why should the
financial statements contain such estimates when their value must
be the subject of some doubt? [5]
(c) How can I be certain that these financial statements have not been
falsified by dishonest directors? [5]
[Total 20]
END OF PAPER
EXAMINATIONS
April 2004
EXAMINERS REPORT

Subject 108 (Finance and Financial Reporting) April 2004

Examiners Report
Page 2
1 C
2 C
3 C
4 A
5 B
6 B
7 C
8 C
9 D
10 B
All questions in this section were answered well apart from a common error in question 3.
The only potentially correct answer is C because preference shares should be treated as debt
in the gearing ratio. Borderline candidates who missed this point were reviewed and given
some credit for question 3 where this made a difference.
11 Both methods would give the use of the asset for its useful life. Both have the effect
of increasing borrowing in the company s balance sheet. The cost of each is likely to
be of broadly equal size. The concept of borrowing is rather simpler than the concept
of leasing. That can make the bookkeeping arrangements for a loan rather simpler.
Leasing an asset does not lead to transfer of legal ownership. Borrowing offers scope
for negotiating the form of the loan. For example, the borrower might opt for a
variable rate or the right to repay early. Leasing is unlikely to be as flexible.
This question was answered well by most candidates.
12 The calculation of profit involves a number of adjustments that do not involve any
cash flows. Depreciation, gains or losses on disposal of fixed assets, accrued income
and expenses affect profits but not cash flows. Conversely, there are many different
transactions that can affect cash flows without any impact on the profit and loss
account. For example, receipts and payments of loans, acquisitions and disposals of
fixed assets, issue of shares all affect bank but not profit.
In the very long term total profit and net cash flow should be roughly the same . Over
time, the cost of fixed assets and the total depreciation charged will come into line
with one another . That does, however, require a very long term outlook.
If the business is growing then it is possible for increased profits to be associated with
a decline in cash. The growth is often associated with additional investment in stock
and debtors and that can lead to an outflow of cash. Furthermore, the fact that the
company has done well might encourage an excessive dividend payment, more than
the company can afford in cash terms.

Examiners Report
Page 3
An alternative reason for differences may be fraud or error in the business accounting
system.
This question produced some very weak answers. Many candidates were not capable
of explaining the difference between profit and cash flows in the common sense
manner implied by the question.
13 The first issue is whether the country that Q Ltd will be operating in has a DTR treaty
with the UK. Many countries do, but not all .
If a treaty is in place then Q Ltd will be able to offset tax paid overseas against the
liability to UK tax on that income. The maximum offset is the rate of tax that would
have been payable in the UK.
Q Ltd can only claim DTR in respect of income-based tax. No relief is available for
tax of a capital nature .
This question was well answered. Most candidates were aware of the nature of double
taxation relief.
14 The business will require some initial funding in order to provide drawings for the
owners living costs while they become established and also to provide for basic
requirements of office equipment, stationery, etc. . Initially there are three main
sources: owners capital , a bank loan and a bank overdraft .
Owners capital has the advantage of being flexible . It is a matter for Terry and Julie
to decide how much each should contribute. Thereafter they are only accountable to
each other . Arguably, the two of them will have greater confidence in the business
than outside investors and so this might be the easiest way to raise money . This does,
however, leave them exposed to any problems with the business. If it fails then they
will have spent their savings and will have nothing to fall back on .
A bank loan has the advantage of providing an agreed source of finance right from the
beginning of the business . The bank might, however, demand personal guarantees
from Terry and Julie and so the exposure might be almost as great as for personal
investment . The business will also have to generate sufficient cash right from the
start to service the loan and so that will put them under some pressure .
An overdraft is a flexible form of finance, most suited to meeting day to day
requirements . One advantage is that interest is paid only on the amount outstanding .
A major disadvantage is that the bank can demand the repayment of the overdraft at
any time, without any particular reason . An overdraft is also likely to have higher
interest charges than a loan .
Most candidates applied their understanding of the material in the core reading to
this simple scenario.

Examiners Report
Page 4
15 A self-administered pension fund aims to provide pensions for employees when they
retire . Almost all are funded by contributions from both employers and employees
throughout the working lives of members . The funds are normally established by
employers who make contributions of a sum determined by an actuary or as set out in
the fund rules . The employer will also collect contributions as deductions from
employees salaries and will pay those into the fund on the employees behalf .
The trustees of a self-administered pension fund are responsible for its investment
strategy . Trustees must act in accordance with the trust deeds and rules, and in the
best interests of the beneficiaries .
The funds liabilities are long-term, relatively open-ended and are automatically
adjusted for inflation when pensions are linked to final salary . This means that they
need to invest in real assets that are likely to maintain their values in times of rising
values . Historically, most funds invested heavily in equities, but now more funds are
investing in a wider range of activities .
Some assets are in the form of very secure investments such as stocks and bonds in
order to obtain some return from working capital . The long term nature of the
liabilities is likely to mean that any investment in bonds is likely to be an investment
in long dated bonds.
This question tested knowledge of self-administered pension funds. It caused no
particular difficulty for most candidates.
16 (i) Rate = 5% + (1.8 7%) = 17.6%
(ii) This model is only appropriate where the project is subject to the same
systematic risks as the company as a whole . This might be the case here
because the investment is fundamentally in the same industry as G plc . On
the other hand, a new form of telecommunication (e.g. a new form of digital
television or the latest mobile phone) might be regarded as more of a luxury
item . That could make adoption far more dependent on the state of the
economy than the flow of revenue from existing technologies .
The company should consider the fundamental nature of the project in order to
understand its underlying sensitivity to movements in the market . The beta of
existing telecommunications companies is an appropriate starting point. If this
product is a must have then it might not be sensitive to factors such as
interest rates or exchange rates . That would suggest a lower beta . If it is a
luxury then it might be more appropriate to compare it to other forms of
consumer spending such as designer clothing . Risks associated with the
technology itself or the detail of the market can be diversified away and can
be ignored.

Examiners Report
Page 5
(iii) CAPM is ideal if the directors are primarily interested in the needs of the
shareholders. The shareholders can diversify away the unsystematic risks
associated with the large project. There could, however, be a problem if the
project is so large as to affect the company s beta . That might alter the
balance of the shareholders investment portfolios and leave them open to
more risk than they would wish to accept.
CAPM might create a conflict between the interests of the directors and their
shareholders. The shareholders can diversify, but each of the directors is
likely to have only one major appointment and only one reputation. The
directors are more exposed to the total risk of the project and might not pursue
investments that are in the shareholders interests.
(iv) The stock market may view this investment as a risk and the share price might
drop once the company s successful bid is announced. Alternatively the share
price might rise once the successful bid is announced if the market views this
as a good investment. If the market is unsure of whether this is good or bad
news the uncertainty is likely to result in a fall in the share price. That will be
a temporary reaction to the uncertainty created by the project and the price
will stabilise once the market has worked through whether this is a good
investment or not.
The best way to minimise this uncertainty is to keep the markets as fully
informed as possible. That might be difficult given the need for commercial
sensitivity. Ideally, the directors should brief the major investors prior to the
result of the bid being announced. The markets will then factor in an amount
(but not the full announcement of bid result amount) for the possibility that the
company s bid is successful.
The performance in this question was disappointing given results in similar
questions in previous diets. Candidates should ensure that they understand the
logic behind this topic.
17 (i) The compensation is a liability of Insurance (Accident) Ltd. Its holding
company has no specific duty to make good any default by any member
company. There is no legal advantage in being owed money by a company
that happens to be part of a large group. It would be possible to ask for a
formal guarantee from the holding company. That would create a contract that
would be binding in the event of default. There is also the commercial reality
that the holding company would suffer adverse publicity if it permitted a
group member to collapse leaving unpaid creditors. It is very possible that the
group would make good any failure by Insurance (Accident) Ltd as a goodwill
gesture. You should not accept this reassurance without obtaining legal
advice.
(ii) (a) The goodwill on acquisition is very much a technical accounting
adjustment that reflects differences between the amount paid for a
subsidiary and its balance sheet valuation according to accounting

Examiners Report
Page 6
standards. As an asset it has no separate existence outside of the group
accounts and even its initial valuation might not reflect the true value
of the investment in the subsidiary (e.g. it could have been purchased
at a low price because of sound bargaining). The asset cannot remain a
permanent entry in the consolidated financial statements because the
factors that led to its initial recognition will change rapidly, rendering
its value out of date. It is written off in order to eliminate it from the
bookkeeping records, but that does not imply any lack of commitment
to maintaining its value. The alternative to writing it off would be to
revalue each and every group member on an annual basis and restate
goodwill to reflect the underlying worth of the businesses. Such a
treatment would be impractical because of the difficulties of valuing
companies in any kind of objective manner. There is no direct
implication for the value of your investment.
(b) Many of the figures in the financial statements require some estimates
or assumptions in order to determine them. Failure to include such
figures would leave substantial gaps in the accounts. Very few figures,
other than bank or cash, are strictly accurate. Most readers are aware
of this and take it into account when reading the annual report.
In general, the estimates and assumptions are likely to fall within
realistic ranges and so there is little scope for massive manipulation or
error. For example, an insurance company will have substantial
experience of determining the likely outcome of pending claims. Those
involved in the reporting process will take care to ensure that this
expertise and experience is put to good use.
(c) The directors are subject to the provisions of the accounting standards
published by the accountancy profession , the relevant rules and
regulations contained in legislation and possibly other rules such as
those laid down by the stock exchange. The directors are legally
responsible for ensuring compliance with these requirements and
would suffer public criticism if they were later found to have
manipulated them. The financial statements also carry an auditor s
report. The auditor is responsible for expressing an opinion on the
truth and fairness of the accounts and is subject to various professional
and statutory duties to ensure that this responsibility is discharged
correctly.
Performance in this question was notably weak. This was largely due to a
failure to read the question s requirements. The case material provided was
intended to support candidates, but many appeared to have been confused
by it. This was essentially a straightforward question that tested an
understanding of the key accounting statements.
END OF EXAMINERS REPORT
EXAMINATIONS
1. Enter all the candidate and examination details as requested on the front of your answer
booklet.
2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
sheet.
Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.
In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.

108 S2004 Institute of Actuaries
108 S2004 2
For questions 1 10 indicate in your answer book which one of the answers A, B, C or D is
correct.
1 What is the main purpose of charging depreciation in the accounts of a business?
A To ensure that funds are available for the eventual replacement of the asset.
B To reduce the cost of the asset in the balance sheet to its estimated market
value.
C To allocate the cost of the fixed asset over the accounting periods expected to
benefit from its use.
D To show the fixed asset at its true value to the business.
[2]
2 A company has ranked four mutually exclusive projects, each requiring an equal
initial investment, using four different criteria. Each criterion identifies a different
project as best. Which project should the company select?
A The project with the highest internal rate of return.
B The project with the highest net present value.
C The project with the highest surplus over annual capital.
D The project with the shortest payback period.
[2]
3 Z plc has just published its financial statements, which show a gross profit for the
year of 7.5 million. A major error in the stock valuation has just been discovered.
The opening stock is overstated by 0.8 million, and the closing stock has been
understated by 1.2 million. What should be Z plc s correct gross profit for the year?
A 5.5m
B 7.1m
C 7.9m
D 9.5m
[2]
108 S2004 3 PLEASE TURN OVER
4 Rights issues are normally associated with a decrease in the share price immediately
following the issue. Which of the following is the most likely reason for this?
A The market will be uncertain about the merits of the investment that is to be
funded by the issue.
B The new shares are issued at a discount to their current market value.
C The use of a rights issue implies a lack of confidence on the part of
management.
D Rights issues involve substantial professional fees and other expenses.
[2]
5 Which of the following best describes the purpose of an external audit of financial
statements?
A The auditor advises on accounting matters.
B The auditor ensures that the company s financial statements comply with all
relevant legislation.
C The auditor expresses an opinion on corporate governance matters.
D The auditor expresses an opinion on the truth and fairness of the financial
statements.
[2]
6 A company must raise finance in order to acquire a piece of machinery. Which of the
following is likely to be the least appropriate form of finance for this purpose?
A Borrow the cost of the machine from a bank.
B Lease the machine from a finance company.
C Purchase the machine by cheque, increasing the company s overdraft by the
cost of the machine.
D Purchase the machine on hire purchase from the manufacturer.
[2]
108 A2004 4
7 Y plc has a high price earnings ratio. Which of the following best describes the
market s opinion of Y plc?
A High risk and expectations of strong future growth.
B High risk and expectations of weak future growth.
C Low risk and expectations of strong future growth.
D Low risk and expectations of weak future growth.
[2]
8 Which of the following defines a limited company s relationship with the outside
world?
A Annual report and accounts
B Articles of association
C Memorandum of association
D Share certificates
[2]
9 Which of the following organisations is responsible for the issue of Treasury bills?
A Gilt-edged market makers
B The Bank of England
C The Debt Management Office
D The Financial Services Authority
[2]
10 A company owns 30% of the ordinary share capital of another. Which of the
following is most likely to be the correct description of the investment in the first
company s balance sheet?
A An associate company
B A fixed asset investment
C An intangible asset
D A subsidiary company
[2]
11 Explain the role of simulation as an element of appraising an investment project. [6]
12 Explain the role of investment trusts as vehicles for investors. [8]
13 Explain the purpose of consolidated financial statements. [6]
14 V plc is a quoted company. The directors are discussing the final dividend for the
year ended 31 December 2004. The company has recently been forced to make a
series of structural and financial changes. Even though the financial year has not yet
ended, it has become apparent that the company will not be able to pay the same level
of dividend as in previous years.
Explain how the directors should proceed if they decide to reduce the dividend
temporarily and explain the possible implications for the company s share price.
[10]
15 Many equity investment decisions made by individual investors are affected by tax
considerations. Some equities offer greater potential for income while others are
more likely to generate capital growth. Explain how the UK tax system differs
between its treatment of dividend income and capital gains and explain which form of
return is likely to be the more tax efficient for investors. [10]
16 The Marco family own 100% of Marco Trading Ltd, a major company that has been
established for many years. The directors, all members of the family, are considering
floating the company on the London Stock Exchange.
(i) Identify the matters that the directors and shareholders of this company ought
to consider in deciding whether to seek a flotation and explain the importance
of each. [10]
(ii) Assuming that the company does decide to proceed with the flotation, describe
the major decisions that will have to be taken by the directors of the company.
[10]
[Total 20]
108 A2004 6
17 H plc manufactures household appliances. Most of its purchases are of generic parts
and materials that are widely available. H plc has a policy of developing a very close
working relationship with one supplier for each category of material and relying
heavily on that supplier to deliver in quantities and at times that enable H plc to meet
its manufacturing deadlines without carrying a great deal of stock.
H plc is looking for a new supplier of light sheet steel. It has obtained the financial
statements of two possible companies, each of which can supply steel of the necessary
quality for an acceptable price. H plc s chief buyer is comparing the financial
statements of both companies to identify the one which is at least risk of becoming
insolvent. The statements have been summarised below:
Profit and loss accounts

for the year ended 31 August 2004

P Ltd

Q Ltd

000

000

Sales 2,900

1,800

Operating expenses 2,030

1,460

Earnings before interest and tax 870

340

Interest 16

44

Tax 370

280

Ordinary dividend 120

12

Preference dividend 72

Retained for year 292

4

Balance sheets

as at 31 August 2004

P Ltd

Q Ltd

000

000

Tangible fixed assets 3,800

1,210

Current assets

Stock 40

34

Debtors 238

170

Bank 5

7

283

211

Current liabilities

Creditors 190

160

Proposed dividend 96

6

Tax 350

270

636

436

Net current liabilities 353

225

3,447

985

Loans 200

400

3,247

585

Ordinary share capital 1,000

300

Preference share capital 900

Retained profit 1,347

285

3,247

585

P Ltd owns its factory premises. Q Ltd rents a factory unit, paying 200,000 per
annum in rent.
108 A2004 8
Requirements
(i) Calculate the following ratios for each of the above companies:
(a) Gearing
(b) Interest cover
(c) Current ratio (excluding tax from current liabilities)
[6]
(ii) Identify the company which is at greatest risk, referring to the ratios that you
calculated above. You should also refer to any other relevant information
contained in the question. All of Q Ltd s tangible fixed assets are in the form
of plant and equipment. [12]
(iii) Explain why the tax liability was excluded from the current ratio in the above
comparison. [2]
[Total 20]
END OF PAPER
EXAMINATIONS
September 2004
EXAMINERS REPORT

Subject 108 (Finance and Financial Reporting) September 2004

Examiners Report
Page 2
1 C
2 B
3 D
4 B
5 D
6 C
7 C
8 C
9 C
10 A
The objective test questions were generally answered well, with no particular problems
arising.
11 Projects are often too complex or too uncertain to analyse using conventional means.
Cash flows might be subject to a host of different assumptions. Discount rates or beta
coefficients might also be subject to some uncertainty. Simulation provides a means
of sensitivity analysis to enable management to see whether altering key variables is
likely to have a profound effect on the outcome of the project. In an ideal world, the
simulation will indicate that the expected outcome of the project is robust even when
several aspects of the decision vary.
Simulation makes it possible to model the effects of changing estimates and
assumptions. A model can be built that allows for relationships between these (e.g.
links between exchange rates and interest rates). A probability distribution can be
modelled for the remaining independent variables and a series of outcomes can be
generated using a range of inputs possibly biased towards the most likely or the
most pessimistic depending on the nature of the decision and its importance to the
company.
This question was looking for an understanding of the role of simulation. Generally
answers were correct in factual terms, but often failed to make the link to investment.
12 Individual shareholders might not have the necessary wealth to enable them to
diversify their investment portfolios. Investment trusts enable them to make a single
investment in one company and to have that investment spread across a range of
shares. Investment in an investment trust may also entail the purchase of the
underlying assets at a discount to their net asset value. The investment trust managers
will also be expert investors. Investing in an investment trust might be a cheaper
means of obtaining such expertise than would be offered by an investment adviser.
Individual investment trusts have different investment policies, offering a choice
between different profiles of risk and return. Investors should be able to find a fund
that balances their need for stability against their desire for higher gains. Some
investment trusts are geared to providing capital growth, whereas others focus on

Examiners Report
Page 3
income, so investors can choose accordingly depending on their circumstances and
their tax position.
Investors might want to invest in particular niche areas, such as specific industries or
markets. Even larger investors might not have the necessary expertise to invest in,
say, the Japanese market. Some investment trusts specialise in very focussed areas
and so it should be possible to find a trust that can plug a gap in a portfolio.
Investment trusts are not ideal investments for everybody. Some investors will have
both the means and the expertise to manage their own portfolios. Investing through an
investment trust will involve management charges that could be avoided. Some
investors will have very specific needs for flexibility and access to their funds.
Investment trust investments will generally be suitable for those who intend to buy
and hold for a considerable period.
This question was looking for knowledge of the particular institutional issues raised.
Answers were surprisingly weak, with relatively few full answers.
13 Large companies, including quoted companies, are often organised as groups.
Consolidated financial statements reflect the economic reality of the group structure.
Groups have no specific legal identity. Technically, they comprise independent
companies operating under the common control of a holding company. Groups do,
however, have an economic identity. Almost by definition, the directors of the
holding company can control the affairs and manage the assets of each of the group
members. Consolidated financial statements present the economic reality of this
group arrangement by combining the figures of the individual group members in such
a way as to eliminate internal balances and combine the remaining figures as if they
were under one common management.
If there were no consolidated financial statements then investors in holding companies
would have no convenient means of understanding how their investments were being
managed by their directors. The process of consolidation enables shareholders to see
how their investments are being managed in terms of real, economic activities.
This question was looking for an appreciation of the nature of consolidated financial
statements. Answers were generally sound, although many candidates did not attempt
the question.
14 The stock market is likely to interpret any change in the dividend policy as a very
clear message about the directors confidence in the company s future. The decrease
will almost certainly create doubts and uncertainties and the directors should take the
greatest possible care to minimise these. The company should give the markets as
much warning as possible about the decrease. That announcement should be
supported by the clearest possible indication that this is a temporary measure intended
to get the company through a period of change. The directors will have to take care
that this information is distributed in a manner acceptable to the stock exchange
because it is clearly price-sensitive. It would be advisable to brief analysts and other
key investors in greater detail so that they are less likely to undermine public
confidence in the company s recovery.

Examiners Report
Page 4
There is no doubt that the share price will fall as soon as the announcement is made.
This is partly because the markets will regard the reduction in dividend as a more
reliable signal than the directors assurances. Some shareholders will choose to sell
because the suspension of the dividend will affect their personal liquidity. The laws
of supply and demand will push down prices. In the medium to long term the price
will rise again and, hopefully, return to its previous level. The share price will always
be a function of the market s expectation of future earnings and dividends. Once the
markets see that the directors promises about the future are genuine then the
uncertainty that depressed the share price will be eliminated.
This question brings together issues about dividend policy and the behaviour of
capital markets. It tended to polarise candidates, with some very full and thorough
answers and others that were either thin or had missed the point.
15 Investment income from equities normally takes the form of franked investment
income. That is the amount of any net dividend received plus an associated tax credit.
The tax credit is then deducted from the resulting tax liability in order to reflect the
fact that the company has already paid corporation tax on the profits that provided the
means to pay the dividend. Basic rate taxpayers will not pay any additional tax as a
result of the receipt of franked investment income, but higher rate taxpayers will be
required to pay additional tax.
Investors have no discretion about the timing of the receipt of their dividend income
and are taxed in the year in which the income is received.
Capital gains are taxed separately from dividend income. Individuals have a separate
annual allowance for capital gains. The gains themselves are not taxed in the year in
which the gain arises but in the year in which it is recognised. Thus, an investor could
delay the timing of a disposal in order to delay a gain until a more suitable tax period.
The gains themselves are subject to a tapering allowance which counters the effects
of rising prices.
Higher rate taxpayers will often find that capital gains are taxed in a less onerous
manner than income.
This question was generally answered well, with most candidates being aware of the
broad differences in the tax treatments of income and capital gains.
16 (i) The company cannot be listed unless a significant proportion of the shares are
in public hands. This means that the family will have to make significant
sacrifices in terms of control over their business.
Decision making will be far more formal and complex because it is no longer
a matter for family discussion. Outside shareholders will probably want a
significant change in the composition of the board to ensure that the family s
interests do not drive the direction of the company.
There will be substantial costs associated with the flotation and these will
effectively be borne by the family. There are also ongoing reporting costs and
compliance costs associated with listing.

Examiners Report
Page 5
Outside shareholders will not have the same long-term commitment to the
company as members of a family.
The flotation would open up the prospect of significant external equity. That
might make it possible for the company to expand rapidly. However, the
company may also become more open to an unwelcome takeover.
There will be an objective market price for the shares and this will make it far
easier to value any shares that are sold or given to a family member.
Any member of the family who is not happy will be able to leave and liquidate
his/her shareholding.
(ii) The directors will have to decide on the timing of the flotation. Ideally, this
will be at a time when the business is likely to be viewed as successful.
There are different levels of quotation. A quote on the main exchange will be
more expensive, but will carry more prestige. A quote on one of the
alternative markets will be simpler, but might not offer as many advantages.
The directors may wish to consider whether London is the most appropriate
stock exchange for the company, or whether a better alternative would be
found overseas.
The method of introducing the shares will have to be considered. For
example, the company could sell additional shares on the open market (and
dilute existing shareholdings) or it could sell existing shares on behalf of the
family members.
The asking price will have to be decided. Too high a price will make the sale
flop while too low a price will dilute the family s wealth.
The company will have to select professional advisers to manage this process.
Depending on the manner in which the shares are to be made available to the
market, the directors will have to decide on whether to underwrite the
transaction. Doing so will reduce risk, but will also incur substantial fees.
Again, this question was answered well, with most candidates being aware of the
implications of a flotation.
17 (i)
P Ltd Q Ltd
Gearing 900 200
3, 247 200

32% 400
585 400

41%
Interest cover 870
16 72

9.9 times 340
44

7.7 times

Examiners Report
Page 6
Current ratio 283
286

1.0:1 211
166

1.3:1
(ii) Q Ltd appears to be at greater risk in terms of gearing and interest cover. This
means that Q Ltd is more vulnerable to any fluctuation in operating profits. Q
Ltd s fixed outgoings are proportionately higher than P Ltd s. Any decrease in
turnover will put the company at greater risk of failing to meet an interest
payment or loan repayment.
The above comparison actually overstates P Ltd s vulnerability relative to Q
Ltd s. Much of P Ltd s fixed interest capital is in the form of preference
shares. In the event of a downturn in business, it should be possible for P Ltd
to suspend dividend payments to the preference shareholders. It is also
unlikely that the preference shareholders will be entitled to the repayment of
their investment or that they can force P Ltd into liquidation in the event that
any scheduled repayment is delayed.
Q Ltd s gearing is also understated in the sense that the company rents its
premises. The nature of the rental agreement does not appear to require
disclosure as a finance lease, but the need to pay rent on this factory or a
replacement creates a very similar commitment. If Q Ltd s factory rent was
treated as a finance charge then earnings before interest and tax would
increase to 540,000 and interest to 244,000. That would reduce Q Ltd s
interest cover to 2.2 times.
The fact that P Ltd owns property will also make it easier for the company to
secure a loan in order to weather any temporary cash crisis.
P Ltd has a poorer current ratio. That increases the risk of the company
running out of cash in the short term. That is, however, a less serious threat
than that created by Q Ltd s high gearing because P Ltd could borrow more
easily to obtain long term working capital. It would also be relatively easy for
H plc to make a small payment in advance to P Ltd in order to resolve any
short-term difficulties.
(iii) The current ratio measures a company s ability to meet its immediate
liabilities. The tax liability is not an immediate liability because it does not
have to be paid until several months after the year end. There is no need to
worry whether the company has sufficient cash to meet this liability as at the
year end provided it has the capacity to raise funds before the due date.
Answers to this question were disappointing, with too many answers consisting of
little more than a computation of ratios. Also, the question had some quite specific
requirements about the issues that were to be raised in the analysis. Many candidates
wasted time on the provision of ratios that were irrelevant to the question.
END OF EXAMINERS REPORT

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