May 2006 Examinations

Managerial Level

Paper P8 - Financial Analysis

Question Paper

Examiners Brief Guide to the Paper

16

Examiners Answers

17

The answers published here have been written by the Examiner and should provide a helpful
guide for both tutors and students.
Published separately on the CIMA website (www.cimaglobal.com/students) from the end of
September 2006 will be a Post Examination Guide for this paper, which will provide much
valuable and complementary material including indicative mark information.

2006 The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
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Managerial Level Paper

P8 Financial Analysis
23 May 2006 Tuesday Afternoon Session
Instructions to candidates
You are allowed three hours to answer this question paper.
You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, make
annotations on the question paper. However, you will not be allowed, under
any circumstances, to open the answer book and start writing or use your
calculator during this reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is, all parts and/or subquestions). The question requirements for questions in Sections B and C are
highlighted in a dotted box.
Answer the ONE compulsory question in Section A. This is contains eight
objective test questions on pages 2 to 4.
Answer ALL THREE questions in Section B on pages 6 to 8.
Answer TWO of the three questions in Section C on pages 10 to 15.
Maths Tables and Formulae are provided on pages 17 to 19. These are
detachable for ease of reference.
Write your full examination number, paper number and the examination
subject title in the spaces provided on the front of the examination answer
book. Also write your contact ID and name in the space provided in the right
hand margin and seal to close.
Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.

P8 Financial Analysis

Financial Management Pillar

The Chartered Institute of Management Accountants 2006

P8

May 2006

SECTION A 20 MARKS
[indicative time for answering this Section is 36 minutes]
ANSWER ALL EIGHT SUB-QUESTIONS

Instructions for answering Section A:

The answers to the eight sub-questions in Section A should ALL be written in your
answer book.
Your answers should be clearly numbered with the sub-question number and then
ruled off, so that the markers know which sub-question you are answering. For
multiple choice questions, you need only write the sub-question number and
the letter of the answer option you have chosen. You do not need to start a new
page for each sub-question.
For sub-questions 1.1 and 1.6, you should show your workings as marks are
available for method for these sub-questions.

Question One
1.1

On 30 September 2005, GHI purchased 80% of the ordinary share capital of JKL for
$145 million. The book value of JKLs net assets at the date of acquisition was
$135 million. A valuation exercise showed that the fair value of JKLs property, plant and
equipment at that date was $100,000 greater than book value, and JKL immediately
incorporated this revaluation into its own books. JKLs financial statements at
30 September 2005 contained notes referring to a contingent liability (with a fair value of
$200,000).
GHI acquired JKL with the intention of restructuring the latters production facilities. The
estimated costs of the restructuring plan totalled $115,000.

Calculate goodwill on acquisition, and identify any of the above items that should be excluded
from the calculation in accordance with IFRS 3 Business Combinations.
(3 marks)

May 2006

P8

1.2

DA controls another entity, CB, owning 60% of its ordinary share capital. At the groups
year end, 31 December 2005, CB included $6,000 in its receivables in respect of goods
supplied to DA. However, the payables of DA included only $4,000 in respect of amounts
due to CB. The difference arose because, on 31 December 2005, DA sent a cheque for
$2,000, which was not received by CB until 3 January 2006.

Which ONE of the following sets of consolidation adjustments to current assets and current
liabilities is correct?
A

Deduct $6,000 from both consolidated receivables and consolidated payables.

Deduct $3,600 from both consolidated receivables and consolidated payables.

Deduct $6,000 from consolidated receivables and $4,000 from consolidated payables,
and include cash in transit of $2,000.

Deduct $6,000 from consolidated receivables and $4,000 from consolidated payables,
and include inventory in transit of $2,000.
(2 marks)

1.3

PQR holds several investments in subsidiaries. In December 2005, it acquired 100% of

the ordinary share capital of STU. PQR intends to exclude STU from consolidation in its
group financial statements for the year ended 28 February 2006, on the grounds that it
does not intend to retain the investment in the longer term.

Explain, with reference to the relevant International Financial Reporting Standard, the conditions
relating to exclusion of this type of investment from consolidation.
(2 marks)
1.4

BLX holds several investments in subsidiaries. One of these, CMY, is located overseas.
CMY prepares its financial statements in its local currency, the crown.
Several years ago, when the exchange rate was 5 crowns = 1$, CMY purchased land at a
cost of 170,000 crowns. On 1 June 2005, when the exchange rate was 65 crowns = $1
the land was revalued at a fair value of 600,000 crowns. The exchange rate at the
groups year end, 31 December 2005, was 7 crowns = $1.

In accordance with the requirements of IAS 21 The Effects of Changes in Foreign Exchange
Rates, at what value in $ should the land be recognised in BLXs group financial statements at
31 December 2005?
A

$85,714

$90,440

$100,154

$120,000
(2 marks)

P8

May 2006

1.5

During its financial year ended 31 March 2006, CDO acquired 100% of the issued share
capital of DEP for 750,000. The purchase was partially financed by a loan for 600,000.
The loan is designated by CDO as a hedging instrument. CDOs functional currency is
the $.

Explain the accounting treatment required for gains and losses on the investment and its
hedging instrument.
(2 marks)
1.6

On 1 January 2006, EFG issued 10,000 5% convertible bonds at their par value of $50
each. The bonds will be redeemed on 1 January 2011. Each bond is convertible at the
option of the holder at any time during the five year period. Interest on the bond will be
paid annually in arrears.
The prevailing market interest rate for similar debt without conversion options at the date
of issue was 6%.

At what value should the equity element of the hybrid financial instrument be recognised in the
financial statements of EFG at the date of issue?
(4 marks)
1.7

In the context of IAS 19 Accounting for Employee Benefits, explain how an experience
gain or loss arises.
(3 marks)

1.8

During its financial year ended 31 January 2006, TSQ issued share options to several of
its senior employees. The options vest immediately upon issue.

Which ONE of the following describes the accounting entry that is required to recognise the
options?
A

DR The statement of changes in equity:

CR liabilities

DR The statement of changes in equity:

CR equity

DR The income statement:

CR liabilities

DR The income statement:

CR equity
(2 marks)
(Total for Section A = 20 marks)

End of Section A

May 2006

P8

SECTION B 30 MARKS
[indicative time for answering this Section is 54 minutes]
ANSWER ALL THREE QUESTIONS

Question Two
You are the assistant to the Finance Director of MNO, a medium-sized listed entity that complies
with International Accounting Standards. One of MNOs directors has proposed the publication
of an Operating and Financial Review (OFR) as part of the annual financial statements. Most of
the directors know very little about the OFR, and the Finance Director has asked you to produce
a short briefing paper on the topic for their benefit.

Required:
Write the briefing paper, which should discuss the following issues:
Any relevant regulatory requirements for an OFR;
The purpose and, in outline, the typical content of an OFR;
The advantages and drawbacks of publishing an OFR from the entitys point of view.
(Total for Question Two = 10 marks)

P8

May 2006

Question Three
The income statements of ST and two entities in which it holds investments are shown below for
the year ended 31 January 2006:

Revenue
Cost of sales
Gross profit
Operating expenses
Profit from operations
Finance cost
Interest income
Profit before tax
Income tax expense
Profit for the period

ST
$000

UV
$000

WX
$000

1,800
(1,200)
600
(450)
150
(16)
6
140
(45)
95

1,400
(850)
550
(375)
175
(12)
163
(53)
110

600
(450)
150
(74)
76
76
(26)
50

Note 1 investments by ST
Several years ago ST acquired 70% of the issued ordinary share capital of UV. On 1 February
2005, ST acquired 50% of the issued share capital of WX, an entity set up under a contractual
arrangement as a joint venture between ST and one of its suppliers. The directors of ST have
decided to adopt a policy of proportionate consolidation wherever appropriate and permitted by
International Financial Reporting Standards.
Note 2 UVs borrowings
During the financial year ended 31 January 2006, UV paid the full amount of interest due on its
6% debenture loan of $200,000. ST invested $100,000 in the debenture when it was issued
three years ago.
Note 3 Intra-group trading
During the year, WX sold goods to ST for $20,000. Half of the goods remained in STs
inventories at 31 January 2006. WXs gross profit margin on the sale was 20%.

Required:
Prepare the consolidated income statement of the ST group for the year ended
31 January 2006.
(Total for Question Three = 10 marks)

May 2006

P8

Question Four
LMN trades in motor vehicles, which are manufactured and supplied by their manufacturer, IJK.
Trading between the two entities is subject to a contractual agreement, the principal terms of
which are as follows:

LMN is entitled to hold on its premises at any one time up to 80 vehicles supplied by IJK.
LMN is free to specify the ranges and models of vehicle supplied to it. IJK retains legal
title to the vehicles until such time as they are sold to a third party by LMN.

While the vehicles remain on its premises, LMN is required to insure them against loss or
damage.

The price at which vehicles are supplied is determined at the time of delivery; it is not
subject to any subsequent alteration.

When LMN sells a vehicle to a third party, it is required to inform IJK within three working
days. IJK submits an invoice to LMN at the originally agreed price; the invoice is payable
by LMN within 30 days.

LMN is entitled to use any of the vehicles supplied to it for demonstration purposes and
road testing. However, if more than a specified number of kilometres are driven in a
vehicle, LMN is required to pay IJK a rental charge.

LMN has the right to return any vehicle to IJK at any time without incurring a penalty,
except for any rental charge incurred in respect of excess kilometres driven.

Required:
Discuss the economic substance of the contractual arrangement between the two entities
in respect of the recognition of inventory and of sales. Refer, where appropriate, to
IAS 18 Revenue.
(Total for Question Four = 10 marks)

(Total for Section B = 30 marks)

End of Section B

P8

May 2006

SECTION C 50 MARKS
[indicative time for answering this Section is 90 minutes]
ANSWER TWO QUESTIONS OUT OF THREE

Question Five
You advise a private investor who holds a portfolio of investments in smaller listed companies.
Recently, she has received the annual report of the BZJ Group for the financial year ended
31 December 2005. In accordance with her usual practice, the investor has read the chairmans
statement, but has not looked in detail at the figures. Relevant extracts from the chairmans
statement are as follows:

Following the replacement of many of the directors, which took place in early March 2005,
your new board has worked to expand the groups manufacturing facilities and to replace
non-current assets that have reached the end of their useful lives. A new line of storage
solutions was designed during the second quarter and was put into production at the
beginning of September. Sales efforts have been concentrated on increasing our market share
in respect of storage products, and in leading the expansion into Middle Eastern markets.
The growth in the business has been financed by a combination of loan capital and the issue
of additional shares. The issue of 300,000 new $1 shares was fully taken up on 1 November
2005, reflecting, we believe, market confidence in the groups new management. Dividends
have been reduced in 2005 in order to increase profit retention to fund the further growth
planned for 2006. The directors believe that the implementation of their medium- to longterm strategies will result in increased returns to investors within the next two to three years.
The groups principal activity is the manufacture and sale of domestic and office furniture.
Approximately 40% of the product range is bought in from manufacturers in other countries.
Extracts from the annual report of the BZJ Group are as follows:
BZJ Group: Consolidated income statement for the year ended 31 December 2005

Revenue
Cost of sales
Gross profit
Operating expenses
Profit from operations
Interest payable
Profit before tax
Income tax expense
Profit for the period

2005
$000
120,366
(103,024)
17,342
(11,965)
5,377
(1,469)
3,908
(1,125)
2,783

2004
$000
121,351
(102,286)
19,065
(12,448)
6,617
(906)
5,711
(1,594)
4,117

2,460
323
2,783

3,676
441
4,117

Attributable to:
Equity holders of the parent
Minority interest

May 2006

P8

BZJ Group: Summarised consolidated statement of changes in equity for the year ended
31 December 2005 (attributable to equity holders of the parent)
Accum.
Share
Share
Reval.
Total
Total
profit
capital
premium
reserve
2005
2004
$000
$000
$000
$000
$000
$000
Opening balance
18,823
2,800
3,000
24,623
21,311
Surplus on revaluation of properties
2,000
2,000
Profit for the period
2,460
2,460
3,676
Issue of share capital
300
1,200
1,500
Dividends paid 31/12
(155)
(155)
(364)
3,100
4,200
2,000 30,428
24,623
Closing balance
21,128
BZJ Group: Consolidated balance sheet at 31 December 2005
2005
$000
$000
Non-current assets:
Property, plant and equipment
40,643
Goodwill
1,928
Trademarks and patents
1,004
43,575
Current assets:
Inventories
37,108
Trade receivables
14,922
Cash
52,030
95,605
Equity:
Share capital ($1 shares)
Share premium
Revaluation reserve
Accumulated profits

3,100
4,200
2,000
21,128

2004
$000

$000

21,322
1,928
1,070
24,320
27,260
17,521
170
44,951
69,271
2,800
3,000
18,823

Minority interest

30,428
2,270

24,623
1,947

Non-current liabilities
Interest bearing borrowings

26,700

16,700

Current liabilities:
Trade and other payables
Income tax
Short-term borrowings

31,420
1,125
3,662

24,407
1,594
36,207
95,605

26,001
69,271

Required:
(a)

(b)

Calculate the earnings per share figure for the BZJ Group for the years ended
31 December 2005 and 2004, assuming that there was no change in the number of ordinary
shares in issue during 2004.
(3 marks)
Produce a report for the investor that
(i) analyses and interprets the financial statements of the BZJ Group, commenting upon the
groups performance and position; and
(17 marks)
(ii) discusses the extent to which the chairmans comments about the potential for improved
future performance are supported by the financial statement information for the year
ended 31 December 2005.
(5 marks)
(Total for Question Five = 25 marks)

P8

10

May 2006

Question Six
The balance sheets of AZ and two entities in which it holds substantial investments at
31 March 2006 are shown below:
AZ
BY
CX
$000
$000
$000
$000
$000
$000
Non-current assets:
Property, plant and
equipment
Investments

10,750

5,830

7,650

18 400

Current assets:
Inventories
Trade receivables
Cash

2,030
2,380
1,380

Equity:
Called up share capital
($1 shares)
Preferred share capital
Reserves
Current liabilities:
Trade payables
Income tax
Suspense account

3,300
5,830

1,210
1,300
50

3,300
1,180
1,320
140

5,790
24,190

2,560
8,390

2,640
5,940

8,000
10,750
18,750

2,300
1,000
3,370
6,670

2,600
2,140
4,740

3,770
420
1,250

1,550
170
5,440
24,190

1,080
120
1,720
8,390

1,200
5,940

NOTES:
Note 1 Investments by AZ in BY
Several years ago AZ purchased 80% of BYs ordinary share capital for $3,660,000 when the
reserves of BY were $1,950,000. In accordance with the groups policy goodwill was recorded
at cost, and there has been no subsequent impairment.
At the same time as the purchase of the ordinary share capital, AZ purchased 40% of BYs
preferred share capital at par. The remainder of the preferred shares are held by several private
investors.
Note 2 Investment by AZ in CX
Several years ago AZ purchased 60% of CXs ordinary share capital for $2,730,000 when the
reserves of CX were $1,300,000. Goodwill was recorded at cost and there has been no
subsequent impairment.
On 1 October 2005, AZ disposed of 520,000 ordinary shares in CX, thus losing control of CXs
operations. However, AZ retains a significant influence over the entitys operations and policies.
The proceeds of disposal, $1,250,000, were debited to cash and credited to a suspense
account. No other accounting entries have been made in respect of the disposal. An
investment gains tax of 30% of the profit on disposal will become payable by AZ within the
twelve months following the balance sheet date of 31 March 2006, and this liability should be
accrued.
CXs reserves at 1 April 2005 were $1,970,000. The entitys profits accrued evenly throughout
the year.

May 2006

11

P8

Note 3 Additional information

No fair value adjustments were required in respect of assets or liabilities upon either of the
acquisitions of ordinary shares. The called up share capital of both BY and CX has remained
the same since the acquisitions were made.
Note 4 Intra-group trading
During the year ended 31 March 2006, BY started production of a special line of goods for
supply to AZ. BY charges a mark-up of 20% on the cost of such goods sold to AZ. At 31 March
2006, AZs inventories included goods at a cost of $180,000 that had been supplied by BY.

Required:
(a)

Calculate the profit or loss on disposal after tax of the investment in CX that will be
disclosed in
(i)

AZs own financial statements;

(ii)

the AZ groups consolidated financial statements.

(6 marks)

(b)

Calculate the consolidated reserves of the AZ group at 31 March 2006.

(5 marks)

(c)

Prepare the consolidated balance sheet of the AZ group at 31 March 2006.

(14 marks)

Full workings should be shown.

(Total for Question Six = 25 marks)

P8

12

May 2006

Question Seven
You are the assistant to the Chief Financial Officer (CFO) of ABC, a light engineering business
based in Bolandia. ABC, a listed entity, has expanded over the last few years with the
successful introduction of innovative new products. In order to further expand its product range
and to increase market share, it has taken over several small, unlisted, entities within its own
country.
ABCs directors have recently decided to expand its markets by taking over entities based in
neighbouring countries. As the first step in the appraisal of available investment opportunities
the CFO has asked you to prepare a brief report on the position and performance of three
possible takeover targets: entity W based in Winlandia, entity Y based in Yolandia and entity Z
based in Zeelandia. These three countries share a common currency with Bolandia, and all
three target entities identify their principal activity as being the provision of light engineering
products and services. The report is to comprise a one page summary of key data and a brief
written report providing an initial assessment of the targets. The format of the summary is to be
based upon the one generally used by ABC for its first-stage assessment of takeover targets,
but with the addition of
(i)

price/earnings ratio information (because all three target entities are listed in their own
countries); and

(ii)

some relevant country-specific information.

You have produced the one-page summary of key data, given below, together with comparative
information for ABC itself, based on its financial statements for the year ended 31 March 2006.
ABC
Bolandia
31 March
2006

W
Winlandia
31 January
2006

Y
Yolandia
30 June
2005

Z
Zeelandia
30 June
2005

IFRS

IFRS

Yolandian
GAAP

IFRS

Revenue
Gross profit margin
Operating profit margin
Return on total capital
employed

$2634m
197%
92%

$282m
168%
63%

$247m
173%
47%

$263m
214%
83%

113%

71%

66%

123%

Equity
Long-term borrowings
Average interest rate
applicable to long-term
borrowings by listed
entities
Income tax rate
Inventories turnover
Receivables turnover
Payables turnover
Current ratio

$1978m
$104m

$136m
$62m

$147m
$13m

$167m
$06m

75%
30%
47 days
44 days
46 days
14 : 1

6%
28%
68 days
42 days
50 days
07 : 1

8%
31%
52 days
46 days
59 days
11 : 1

10%
38%
60 days
47 days
73 days
09 : 1

186

126

183

152

Country of operation
Date of most recent
annual report
Financial statements
prepared in compliance
with:

P/E ratio

May 2006

13

P8

ABC has a cash surplus and would seek to purchase outright between 90% and 100% of the
share capital of one of the three entities. The directors of ABC do not intend to increase the
gearing of the group above its existing level. Upon acquisition they would, as far as possible,
retain the acquired entitys management and its existing product range. However, they would
also seek to extend market share by introducing ABCs own products.

Required:
Prepare a report to accompany the summary of key data. The report should:

(a)

analyse the key data, comparing and contrasting the potential takeover targets with
each other and with ABC itself.
(13 marks)

(b)

discuss the extent to which the entities can be validly compared with each other,
identifying the limitations of inter-firm and international comparisons.
(12 marks)
(Total for Question Seven = 25 marks)

End of Question Paper

Maths Tables and Formulae are on pages 14 to 16

P8

14

May 2006

MATHS TABLES AND FORMULAE

Present value table
Present value of $1, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt.
Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

1%
0.990
0.980
0.971
0.961
0.951
0.942
0.933
0.923
0.914
0.905
0.896
0.887
0.879
0.870
0.861
0.853
0.844
0.836
0.828
0.820

2%
0.980
0.961
0.942
0.924
0.906
0.888
0.871
0.853
0.837
0.820
0.804
0.788
0.773
0.758
0.743
0.728
0.714
0.700
0.686
0.673

3%
0.971
0.943
0.915
0.888
0.863
0.837
0.813
0.789
0.766
0.744
0.722
0.701
0.681
0.661
0.642
0.623
0.605
0.587
0.570
0.554

4%
0.962
0.925
0.889
0.855
0.822
0.790
0.760
0.731
0.703
0.676
0.650
0.625
0.601
0.577
0.555
0.534
0.513
0.494
0.475
0.456

Interest rates (r)

5%
6%
0.952
0.943
0.907
0.890
0.864
0.840
0.823
0.792
0.784
0.747
0.746
0705
0.711
0.665
0.677
0.627
0.645
0.592
0.614
0.558
0.585
0.527
0.557
0.497
0.530
0.469
0.505
0.442
0.481
0.417
0.458
0.394
0.436
0.371
0.416
0.350
0.396
0.331
0.377
0.312

7%
0.935
0.873
0.816
0.763
0.713
0.666
0.623
0.582
0.544
0.508
0.475
0.444
0.415
0.388
0.362
0.339
0.317
0.296
0.277
0.258

8%
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215

9%
0.917
0.842
0.772
0.708
0.650
0.596
0.547
0.502
0.460
0.422
0.388
0.356
0.326
0.299
0.275
0.252
0.231
0.212
0.194
0.178

10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
0.467
0.424
0.386
0.350
0.319
0.290
0.263
0.239
0.218
0.198
0.180
0.164
0.149

Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

11%
0.901
0.812
0.731
0.659
0.593
0.535
0.482
0.434
0.391
0.352
0.317
0.286
0.258
0.232
0.209
0.188
0.170
0.153
0.138
0.124

12%
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322
0.287
0.257
0.229
0.205
0.183
0.163
0.146
0.130
0.116
0.104

13%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
0.376
0.333
0.295
0.261
0.231
0.204
0.181
0.160
0.141
0.125
0.111
0.098
0.087

14%
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270
0.237
0.208
0.182
0.160
0.140
0.123
0.108
0.095
0.083
0.073

Interest rates (r)

15%
16%
0.870
0.862
0.756
0.743
0.658
0.641
0.572
0.552
0.497
0.476
0.432
0.410
0.376
0.354
0.327
0.305
0.284
0.263
0.247
0.227
0.215
0.195
0.187
0.168
0.163
0.145
0.141
0.125
0.123
0.108
0.107
0.093
0.093
0.080
0.081
0.069
0.070
0.060
0.061
0.051

17%
0.855
0.731
0.624
0.534
0.456
0.390
0.333
0.285
0.243
0.208
0.178
0.152
0.130
0.111
0.095
0.081
0.069
0.059
0.051
0.043

18%
0.847
0.718
0.609
0.516
0.437
0.370
0.314
0.266
0.225
0.191
0.162
0.137
0.116
0.099
0.084
0.071
0.060
0.051
0.043
0.037

19%
0.840
0.706
0.593
0.499
0.419
0.352
0.296
0.249
0.209
0.176
0.148
0.124
0.104
0.088
0.079
0.062
0.052
0.044
0.037
0.031

20%
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
0.135
0.112
0.093
0.078
0.065
0.054
0.045
0.038
0.031
0.026

May 2006

15

P8

Cumulative present value of $1 per annum,

Receivable or Payable at the end of each year for n years
Periods
(n)
1
2
3
4
5

1 (1+ r ) n
r

1%
0.990
1.970
2.941
3.902
4.853

2%
0.980
1.942
2.884
3.808
4.713

3%
0.971
1.913
2.829
3.717
4.580

4%
0.962
1.886
2.775
3.630
4.452

Interest rates (r)

5%
6%
0.952
0.943
1.859
1.833
2.723
2.673
3.546
3.465
4.329
4.212

7%
0.935
1.808
2.624
3.387
4.100

8%
0.926
1.783
2.577
3.312
3.993

9%
0.917
1.759
2.531
3.240
3.890

10%
0.909
1.736
2.487
3.170
3.791

6
7
8
9
10

5.795
6.728
7.652
8.566
9.471

5.601
6.472
7.325
8.162
8.983

5.417
6.230
7.020
7.786
8.530

5.242
6.002
6.733
7.435
8.111

5.076
5.786
6.463
7.108
7.722

4.917
5.582
6.210
6.802
7.360

4.767
5.389
5.971
6.515
7.024

4.623
5.206
5.747
6.247
6.710

4.486
5.033
5.535
5.995
6.418

4.355
4.868
5.335
5.759
6.145

11
12
13
14
15

10.368
11.255
12.134
13.004
13.865

9.787
10.575
11.348
12.106
12.849

9.253
9.954
10.635
11.296
11.938

8.760
9.385
9.986
10.563
11.118

8.306
8.863
9.394
9.899
10.380

7.887
8.384
8.853
9.295
9.712

7.499
7.943
8.358
8.745
9.108

7.139
7.536
7.904
8.244
8.559

6.805
7.161
7.487
7.786
8.061

6.495
6.814
7.103
7.367
7.606

16
17
18
19
20

14.718
15.562
16.398
17.226
18.046

13.578
14.292
14.992
15.679
16.351

12.561
13.166
13.754
14.324
14.878

11.652
12.166
12.659
13.134
13.590

10.838
11.274
11.690
12.085
12.462

10.106
10.477
10.828
11.158
11.470

9.447
9.763
10.059
10.336
10.594

8.851
9.122
9.372
9.604
9.818

8.313
8.544
8.756
8.950
9.129

7.824
8.022
8.201
8.365
8.514

11%
0.901
1.713
2.444
3.102
3.696

12%
0.893
1.690
2.402
3.037
3.605

13%
0.885
1.668
2.361
2.974
3.517

14%
0.877
1.647
2.322
2.914
3.433

Interest rates (r)

15%
16%
0.870
0.862
1.626
1.605
2.283
2.246
2.855
2.798
3.352
3.274

17%
0.855
1.585
2.210
2.743
3.199

18%
0.847
1.566
2.174
2.690
3.127

19%
0.840
1.547
2.140
2.639
3.058

20%
0.833
1.528
2.106
2.589
2.991

6
7
8
9
10

4.231
4.712
5.146
5.537
5.889

4.111
4.564
4.968
5.328
5.650

3.998
4.423
4.799
5.132
5.426

3.889
4.288
4.639
4.946
5.216

3.784
4.160
4.487
4.772
5.019

3.685
4.039
4.344
4.607
4.833

3.589
3.922
4.207
4.451
4.659

3.498
3.812
4.078
4.303
4.494

3.410
3.706
3.954
4.163
4.339

3.326
3.605
3.837
4.031
4.192

11
12
13
14
15

6.207
6.492
6.750
6.982
7.191

5.938
6.194
6.424
6.628
6.811

5.687
5.918
6.122
6.302
6.462

5.453
5.660
5.842
6.002
6.142

5.234
5.421
5.583
5.724
5.847

5.029
5.197
5.342
5.468
5.575

4.836
4.988
5.118
5.229
5.324

4.656
7.793
4.910
5.008
5.092

4.486
4.611
4.715
4.802
4.876

4.327
4.439
4.533
4.611
4.675

16
17
18
19
20

7.379
7.549
7.702
7.839
7.963

6.974
7.120
7.250
7.366
7.469

6.604
6.729
6.840
6.938
7.025

6.265
6.373
6.467
6.550
6.623

5.954
6.047
6.128
6.198
6.259

5.668
5.749
5.818
5.877
5.929

5.405
5.475
5.534
5.584
5.628

5.162
5.222
5.273
5.316
5.353

4.938
4.990
5.033
5.070
5.101

4.730
4.775
4.812
4.843
4.870

Periods
(n)
1
2
3
4
5

P8

16

May 2006

FORMULAE
Annuity
Present value of an annuity of $1 per annum receivable or payable for n years, commencing in
one year, discounted at r% per annum:
PV =

1
1
1

r
[1 + r ]n

Perpetuity
Present value of $1 per annum receivable or payable in perpetuity, commencing in one year,
discounted at r% per annum:
PV =

1
r

Growing Perpetuity
Present value of $1 per annum, receivable or payable, commencing in one year, growing in
perpetuity at a constant rate of g% per annum, discounted at r% per annum:
PV =

May 2006

1
r g

17

P8

The Examiner for Financial Analysis offers to future candidates and to tutors
using this booklet for study purposes, the following background and guidance on
the questions included in this examination paper.
Section A Question One Compulsory
1.1

Short question that required explanation and application of the concepts of fair value at
the point of acquisition and impairment of goodwill. This tested learning outcome A (iv).

1.2

OTQ that required the selection of the correct consolidation adjustments to current assets
and current liabilities. This tested learning outcome A (iii).

1.3

Short question that required explanation of the rules for the exclusion of investments in
subsidiaries from consolidation according to IFRS 5 Non-Current Assets held for Sale and
Discontinued Operations. This tested learning outcome A (ii).

1.4

OTQ that required the translation of land held by an overseas subsidiary in an entitys
group financial statements. This tested learning outcome A (x).

1.5

Short question that required calculation of the correct treatment for gains and losses on a
financial investment and its hedging instrument. This tested learning outcome A (xi).

1.6

Short question that required discussion of the valuation of the equity element of a hybrid
financial instrument in the issuers financial statements. This tested learning outcome B
(iv).

1.7

Short question that required discussion of how an experience gain or loss arises
according to IAS 19 Accounting for Employee Benefits. This tested learning outcome B
(vi).

1.8

OTQ that required the selection of the correct accounting entry for share options to an
entitys senior employees. This also tested learning outcome B (iv).

Section B Question Two Compulsory

Question Two required candidates to write a briefing paper for the directors of an entity
discussing the regulatory requirements and content of an Operating and Financial Review and
an explanation of both the advantages and drawbacks of such a review. are to be discussedThis
question tested learning outcome D (i).
Question Three required candidates to prepare a consolidated income statement of a group as
detailed in the scenario. This question tested learning outcome A (vi).
Question Four required candidates to discuss the principle of substance over form applied to a
contractual arrangement between two entities as detailed in the scenario, with specific reference
to IAS 18 Revenue. This question tested learning outcome B (iii).

Section C Answer two from three questions

Question Five required candidates to calculate the earnings per share figure for a group as
detailed in the scenario. It also required candidates to produce a report for an investor analysing
and interpreting the given financial statements, discussing whether or not these supported
comments made by the entitys chairman about potential improvements in future performance.
This question tested learning outcomes C (i) and (ii).
Question Six required candidates to calculate the profit or loss on disposal after tax of an
investment in a subsidiary for disclosure in an entitys financial statements as detailed in the
scenario. Candidates were also required to calculate the consolidated reserves and prepare a
consolidated balance sheet. This question tested learning outcomes A (iii) and (v).
Question Seven required candidates to prepare a report analysing a summary of key data as
detailed in the scenario. Specifically, candidates were required to compare and contrast the
potential takeover targets and to discuss the validity of such comparisons identifying their
limitations. This question tested learning outcomes C (iii), (iv) and (v).

P8

18

May 2006

Managerial Level Paper

P8 Financial Analysis
Examiners Answers
SECTION A

Answer to Question One

1.1

Goodwill on acquisition
$

Investment in JKL
Acquired:
Net assets at book value
Revaluation
Contingent liability

$
1,450,000

1,350,000
100,000
(200,000)
1,250,000

80% of fair value of net assets

Goodwill on acquisition

1,000,000
450,000

According to IFRS 3, restructuring provisions can be taken into account only if the acquiree has
an existing liability for restructuring recognised in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets. This condition is not met in this case.

1.2

The correct answer is C

1.3

According to IFRS 5 Non-Current Assets held for Sale and Discontinued Operations, a
subsidiary that has been acquired and is held exclusively with a view to its subsequent
disposal, does not require consolidation. However, the investment can be regarded as
held for sale only if its disposal is intended to take place within 12 months of the balance
sheet date. In the case of PQRs investment in STU, the disposal would have to take
place before 28 February 2007.

May 2006

19

P8

1.4

600,000/7 = $85,714 (that is translate both cost and revaluation at the closing rate)
The correct answer is A

1.5

Accounting for hedging relationships is regulated by IAS 39 Financial Instruments:

Recognition and Measurement. Gains and losses on designated hedging instruments
and the items they hedge are permitted to be set off against each other. In CDOs case,
any gain or loss on the unhedged element of the investment is recognised in profit or loss.

1.6

Bond principal: 10,000 x $50 = $500,000. Annual interest payment = $500,000 x 5% =

$25,000.
Present value of principal: $500,000/(106)5 (factor from table = 0747) 373,500
Present value of interest: $25,000 x cumulative discount factor
(from tables = 4212)
105,300
478,800
Balancing figure = equity element
21,200
Principal
500,000
The equity element should be held at a value of $21,200.

1.7

An actuary identifies the actuarial value of the pension plans assets and liabilities. Where
the value of assets exceeds liabilities, a gain arises, and a loss is created by the opposite
effect. Part of the gain or loss may arise because the actual out-turn of events has not
coincided with the actuarial assumptions that were made previously. This element of the
difference between plan assets and liabilities is known as the experience gain or loss.

1.8

The correct answer is D

P8

20

May 2006

SECTION B

Answer to Question Two

Briefing paper to the directors of MNO
The Operating and Financial Review
Many international entities are choosing to expand the scope of their reporting in the form of an
Operating and Financial Review (OFR). There is no formal regulatory requirement to publish
such a review, although IAS 1 Presentation of Financial Statements encourages entities to
present a financial review by management that would ideally cover some of the areas that are
commonly covered by the OFR. Any such publication, however, would constitute a set of
voluntary disclosures.
The principal source of guidance on the purpose and content of an OFR is the UK Accounting
Standards Board (ASB) Reporting sStatement ofn Best Practice which was issued in January
2006. However, this the topic. A statement has ono international application, except as a
source of general guidance. In October 2005, the IASB isisued a discussion paper on
Management Commentary. The topic is on the IASBs research agenda, but does not, at the
moment, constitute an active project, and so it may be some time before an exposure draft is
issued.
form of disclosure was first issued in 1993, and was revised in 2003. More recently, the UK
government has proposed that publication of an OFR should be mandatory for UK listed entities.
However, this proposal and the exposure draft issued by the ASB in 2004 has no international
application, except as a source of general guidance. The IASB has set up a working group to
undertake a project on Management Commentary, but as yet no exposure draft has been
published on the topic.
The purpose of an OFR is to assist users, principally investors, in making a forward-looking
assessment of the performance of the business by setting out managements analysis and
discussion of the principal factors underlying the entitys performance and financial position.
Typically, an OFR would comprise some or all of the following:

Description of the business and its objectives;

Managements strategy for achieving the objectives;

Review of operations;

Commentary on the strengths and resources of the business;

Commentary about such issues as human capital, research and development activities,
development of new products and services;

Financial review with discussion of treasury management, cash inflows and outflows and
current liquidity levels.

The publication of such a statement would have the following advantages for MNO:

It could be helpful in promoting the entity as progressive and as eager to communicate as

fully as possible with investors;

It could be a genuinely helpful medium of communicating the entitys plans and

managements outlook on the future;

May 2006

21

P8

If the IASB were to introduce a compulsory requirement for management commentary by

listed entities, MNO would already have established the necessary reporting systems and
practices..

However, there could be some drawbacks:

If an OFR is to be genuinely helpful to investors, it will require a considerable input of

senior management time. This could be costly, and it may be that the benefits of
publishing an OFR would not outweigh the costs;

There is a risk in publishing this type of statement that investors will read it in preference
to the financial statements, and that they may therefore fail to readmiss important
information.

Answer to Question Three

ST Group: consolidated income statement for the year ended 31 January 2006
$000
Revenue (1,800 + 1,400 + [{600 - 20}/2]
Cost of sales (1,200 - [20/2] + 850 + [450/2] + 1 [W1])
Gross profit
Operating expenses (450 + 375 + [74/2])
Profit from operations
Finance cost (16 + [12 - 6])
Profit before tax
Income tax expense (45 + 53 + [26/2])
Profit for the period

3,490
(2,266)
1,224
(862)
362
(22)
340
(111)
229
$000

Attributable to:
Equity holders of the parent
Minority interest (110 [profit of UV for the period] x 30%)

196
33
229

(W1) Provision for unrealised profit

$10,000 x 20% = $2,000.
50% of this is treated as realised, and the remainder ($1,000) as unrealised.

P8

22

May 2006

Answer to Question Four

(a)
The economic substance of the arrangement between the two entities is determined by
analysing the risks and benefits of the transaction. The entity that receives the benefits and
bears the risks of ownership should recognise the vehicles as inventory. LMN, the motor vehicle
dealer, appears to derive the following benefits:

It is free to determine the nature of the inventorystock it holds, in terms of ranges and
models;.

It is protected against price increases between the date of delivery to it and the date of
sale because the price is determined at the point of delivery;.

It has access to the inventory for demonstration purposes.

LMN incurs the following costs and risks:

IJK retains legal title to the goods, so in the case of dispute IJK would probably be entitled
to recover its legal property;.

LMN is required to bear the cost of insuring the vehicles against loss or damage;.

Although LMN obtains the benefit of using vehicles for demonstration purposes a rental
charge may become payable;.

If price reductions occur between the date of delivery and the date of sale, LMN will lose
out because it will be required to pay the higher price specified upon delivery.

The analysis of the risks and benefits of the transaction does not produce a clear decision as to
the economic substance of the arrangement between the two parties. IJK bears the substantial
risk of incurring costs related to slow-moving or obsolete vehicles because LMN can return any
vehicle to it, without incurring a penalty. This point alone is highly significant and may be
sufficient to ensure that IJK, the manufacturer, should continue to recognise the vehicles in its
own inventory. A further relevant point is that IJK is not paid until the point of sale to a third
party, and thus it bears the significant financial risk involved in financing the inventory.

(b)
In respect of the sale of goods, IAS 18 Revenue requires that a sale should be recognised when
the selling entity transfers to the buyer the significant risks and rewards of ownership of the
goods. As noted in part (a) above, significant risks and some of the rewards of ownership
remain with the manufacturer, IJK, until such time as the goods are sold by the dealer to a third
party. Therefore, revenue should be recognised by IJK only when a sale to a third party takes
place.

May 2006

23

P8

SECTION C

Answer to Question Five

(a)
Earnings per share for the year ended 31 December 2004:
$3,676,000
= 1313c per share$3,676,000 = 1313 per share
2,800,000

Earnings per share for the year ended 31 December 2005:

$2,460,000
= 863c per share
2,850,000

(W1) Weighted average number of shares in issue

10

/12 x 2,800,000
/12 x 3,100,000

2,333,333
516,667
2,850,000

(b)
Report
To:

Investor

From:

Adviser

The financial statements of the BZJ Group for the year ended 31 December 2005
Financial performance
The performance of the group has declined sharply. Revenue has fallen by 08% between 2004
and 2005. Gross, operating and pre-tax profit margins are all substantially lower in 2005 than in
the previous year: gross profit has fallen from 157% to 144%; operating profit has fallen from
55% to 45%; pre-tax profit margin has fallen from 47% to 32%. The fall in revenue is
particularly striking, given the large amount of investment in non-current assets that has taken
place. Margins may have been adversely affected by additional depreciation charges arising
because of the increase in non-current assets. It is also possible that the expansion into new
markets and the new storage products will result in permanently lower margins. Return on
equity (ROE) and return on on total capital employed (ROTCE) have both dropped by significant
margins: ROE has fallen from 215% to 120%, and ROTCE has fallen from 153% to 8951%.
Investors will be disappointed with the significant drop in the amount of dividend received. The
dividend payout ratio is also substantially lower.
The amount of interest payable has increased by over $500,000 during the year, because of the
large increase in borrowings intended, according to the chairmans statement, to fund business
growth. Interest cover has halved, but the groups current levels of earnings cover the charge
37 times, which provides a reasonable margin of safety. However, it is worth noting that the
average interest charge (taking interest payable as a percentage of long- and short-term
borrowings) is less than 5% in 2005. This may suggest that borrowings have reached their
current level quite recently, and that the interest charge in the 2006 financial statements will be
significantly higher.

P8

24

May 2006

The analysis of financial performance suggests that, with falling margins and rising interest,
potential returns from the business are likely to be more volatile in future.
Financial position
A very large increase in non-current assets has taken place. The increase of nearly $20 million
appears to be mostly accounted for by purchases of new assets, although a revaluation of
$2 million has taken place during the financial year. The investment in non-current assets has
been financed in part by an increase in long-term borrowings of $10 million, and also by an
issue of share capital at a premium which raised $15 million in funds. Current liabilities have
increased by around $7 million and the business has moved from a position of holding cash at
the end of 2004 to quite substantial short-term borrowings at the end of 2005.
Inventories have increased by almost $10 million, and the turnover period is much greater at
1315 days than at the end of 2004. It could be that the business is building up stocks of its new
products; alternatively, it is possible that the new ranges have not sold as well as expected, in
which case the build-up of inventories is a worrying sign. Receivables turnover has improved;
this is the only element of working capital management that shows any sign of improvement.
The current ratio is probably adequate at its present level, but it, too, shows a significant decline
over from the previous year.
Even before the current years expansion programme, gearing was at a high level. It has
increased still further to the point where borrowings represent over 80% of equity. The business
has no cash at the year end, and it may find that it becomes difficult and expensive to obtain
further loan capital. There is an urgent need to improve working capital management and,
especially, to start turning over inventories.
Chairmans comments
The chairman refers to growth in the business. However, closer examination of the financial
statements shows that the growth is all in balance sheet items, especially inventories, trade and
other payables and non-current assets. The increased investment in fixed and working capital
has not, by the 2005 year end, started to yield any benefits in terms of improved performance;
the non-current asset turnover ratio has declined sharply from 499 in 2004 to 2 76 in 2005. All
the performance indicators derived from the income statement are in decline. It is possible that
the expansion into new markets and products had not begun to yield benefits by the end of
2005, but investors and other stakeholders will expect the promised improvements to start to
pay off in 2006.
The chairman also refers to the successful issue of further ordinary shares only two months
before the year end. This is, indeed, reassuring, as it suggests that investors are prepared to
accept the high level of gearing, and that they are prepared to place confidence in the directors
strategies.
In summary, the business is in no immediate danger of failing, but the position could become
critical if managements current expansionary policies do not succeed.

May 2006

25

P8

APPENDIX
2005

2004

Gross profit
margin

17,342
x 100 = 14 4% 17,342 x100 = 14.4%
120,366
120,366

19,065
x 100 = 15 7% 19,065 x 100 =
121,351
15.7%
121,351

Operating
profit
margin

5,377
x 100 = 4 5% 5,377 x 100 = 4.5%
120,366
120,366

6,617
x 100 = 5 5% 6,617 x 100 =
121,351
5.5%
121,351

Pre-tax
profit
margin

3,908
x 100 = 3 2% 3,908 x 100 = 3.2%
120,366
120,366

5,711
x 100 = 4 7% 5,711 x 100 =
121,351
4.7%
121,351

Interest
cover

5,377
= 3 7 5,377
1,469
1,469 = 3.7

6,617
= 7 3 6,617
906
906 = 7.3

Debt/equity

26,700 x 100
= 81 7% 26,700 x 100 =
(30,428 + 2,270)
81.7%
(30,428 + 2,270)

16,700 x 100
= 62 9% 16,700 x 100
(24,623 + 1,947)
= 62.9%
(24,623 + 1,947)

Return on
equity

3,908 x 100
= 12 0% 3,908 x 100 = 12.0%
(30,428 + 2,270)
(30,428 + 2,270)

5,711 x 100
= 21 5% 5,711 x 100 =
(24,623 + 1,947)
21.5%
(24,623 + 1,947)

Return on
total capital
employed

5,377 x 100
= 8 5% 5,377
(30,428 + 2,270 + 26,700 + 3,662)
x 100 = 9.1%
(30,428 + 2,270 + 26,700)

6,617 x 100
= 15 3% 6,617
(24,623 + 1,947 + 16,700)
x 100 = 15.3%
(24,623 + 1,947 + 16,700)

Non-current
asset
turnover

120,366
= 2 76 120,366 = 2.76
43,575
43,575

121,351
= 4 99 121,351 = 4.99
24,320
24,320

Inventory
turnover

37,108 x 365
= 131 5 days 37,108 x 365 =
103,024
131.5 days
103,024

27,260 x 365
= 97 3 days 27,260 x 365
102,286
= 97.3 days
102,286

Receivables
turnover

14,922 x 365
= 45 2 days 14,922 x 365 = 45.2
120,366
days
120,366

17,521 x 365
= 52 7 days 17,521 x 365 =
121,351
52.7 days
121,351

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May 2006

Dividend
per share

155
= 5c/ 155 = 5
3,100
3,100

364
= 13c/ 364 = 13
2,800
2,800

Dividend
payout rate

155
x 100 = 6 3% 5 x 100 = 5.8%
2,460
86.3

364
x 100 = 9 9% 13 x 100 = 9.9%
3,676
131

Liquidity:
current ratio

52,030
= 1 44 : 1 52,030 = 1.44:1
36,207
36,207

44,951
= 1 73 : 1 44,951 = 1.73:1
26,001
26,001

May 2006

27

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Answer to Question Six

(a)
AZ originally acquired 60% of 2,600,000 shares: 1,560,000. On 1 October 2005, it disposed of
520,000 shares that is one third of its holding. After the disposal, AZ retained ownership of
40% of the ordinary share capital of CX.
(i)

Profit or loss on disposal in AZs own financial statements:

Proceeds of sale
Cost: 1/3 x $2,730,000
Profit before tax
Tax charge: $340,000 x 30%
Profit after tax

(ii)

$000
1,250
(910)
340
(102)
238

Profit on disposal in the AZ groups consolidated financial statements

Workings

(W1) Goodwill on the acquisition of CX

$000
2,730
(2,340)
390

Cost of investment
Less: Acquired (2,600 + 1,300 = 3,900 x 60%)
Goodwill on acquisition
(W2) CXs net assets at the date of disposal

$000
1,970
85
2,055

Reserves on 1 April 2005

x profit for the year (2,140 - 1,970)/2

Proceeds of sale
Less: share of net assets relating to the disposal
20% x (2,055 [W2] + 2,600)
Less: unimpaired goodwill relating to the disposal
(390 [W1] x 1/3)
Consolidated profit on disposal before tax
Tax charge (as in part (i))
Consolidated profit on disposal after tax

$000
1,250

(931)
(130)
189
(102)
87

(b)
(W1) Provision for unrealised profit
Cost structure: cost + (20% x cost) =
Unrealised profit = 20/120 x 180 =
Of this, 20% is attributable to the minority:
The remainder reduces consolidated reserves:

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selling price
$30,000
$6,000
$24,000

28

May 2006

Consolidated reserves

Reserves of AZ
Post-acquisition reserves of BY:
($3,370 - 1,950) x 80%
Profit on disposal (see part (a)(i))
Post-acquisition reserves in associate entity CX
($2,140 - 1,300) x 40%
Provision for unrealised profit (W1)

$000
10,750

1,136
238
336
(24)
12,436

(c)
AZ: Consolidated balance sheet at 31 March 2006
$000
Non-current assets:
Property, plant and equipment [10,750 + 5,830]
Goodwill (W1)
Investment in associate (W2)
Other investments (W3)

$000

16,580
260
2,156
860
19,856

Current assets:
Inventories [2,030 + 1,210 - 30 PURP]
Trade receivables [2,380 + 1,300]
Cash [1,380 + 50]

3,210
3,680
1,430
8,320
28,176

Equity:
Share capital
Consolidated reserves (part (b))

8,000
12,436
20,436
1,728

Minority interest (W4)

Current liabilities:
Trade payables (3,770 + 1,550)
Income tax (420 + 170 + 102 [part a)i)]

5,320
692
6,012
28,176

Workings

(W1) Goodwill on the acquisition of BY

$000
3,660
(3,400)
260

Cost of investment
Less: acquired (1,950 + 2,300) x 80%
Goodwill on acquisition
(W2) Investment in associate CX
Investment at cost (2,730 x 2/3)
Share of post-acquisition profits ([2,140 - 1,300] x 40%)

May 2006

29

$000
1,820
336
2,156

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(W3) Investments
As stated in AZs balance sheet
Less: investment at cost in BYs ordinary shares
Less: investment at cost in BYs preferred shares
Less: investment at cost in CXs ordinary shares
Balance = other investments

$000
7,650
(3,660)
(400)
(2,730)
860

(W4) Minority interest

In BYs preferred shares
In BYs other net assets (2,300 + 3,370) x 20%
Provision for unrealised profit (part b))

$000
600
1,134
(6)
1,728

Answer to Question Seven

Report

Takeover targets: W, Y and Z

(a)
The three potential targets are similar in size, each producing revenue at the level of
approximately 10% of ABCs revenue. In respect of performance, Z appears superior to the
others: its gross profit margin and operating profit margins are significantly higher than those of
W and Y. Ys operating profit margin is disappointing at 47%; however, there may be scope to
improve control over its operating expenses. Zs return on capital employed is also impressive,
at almost double that of entity Y, and it is better than that of ABC itself. However, it is relevant to
note that the income tax rate in Zeelandia is significantly higher than that of the other countries,
and this effect offsets some of its advantages.
The level of gearing in ABC itself is negligible with debt constituting only around 5% of equity.
Gearing is also at a low level in Y and Z, but entity W is relatively more highly geared (debt
constitutes 456% of equity). However, after takeover ABCs management would be able to
control the level of gearing and to repay any long-term debt if it was felt necessary to do so. The
economic environments in which the entities operate are, apparently, rather different from each
other. As well as the differences in income tax rates already noted, interest rates vary from 6%
in Winlandia to 10% in Zeelandia.
Working capital management varies between the entities. For ABC, the turnover in days for
inventories, receivables and payables all lie in the mid-40s. Receivables turnover across the
four entities is broadly similar, but there are some significant differences in respect of inventories
and payables. Entity W appears to hold inventories for much longer than the other entities, and
there may be problems with slow-moving or obsolete items. Payables turnover, on the other
hand, is relatively fast in entity W, but at 73 days entity Z takes a long time to meet its payables
obligations. This may be as a result of poor management, or deliberate policy. ABC has a
relatively comfortable current ratio of 14 : 1, but the comparable ratio in all three target entities
is less impressive.
The P/E ratios of the three targets and of ABC itself lie within a fairly narrow band. Ws P/E is
the lowest at 126; this could indicate that the share is relatively undervalued, that the most
recent earnings figure was better than expected and the share price has not yet been adjusted
upwards to reflect this, or that the investment is perceived as relatively risky in the market.

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May 2006

On the basis of the preliminary analysis, entity Z appears superior to the others in several
aspects of performance. However, a great deal of further analysis will be required before
reaching a conclusion, and, as noted below, there are many limitations in the analysis.

(b)
There are several general limitations to any inter-firm comparisons. These limitations become
even more important where international comparisons are made. The limitations include the
following:
Accounting standards Standards and policies: in this case, entity Y prepares its financial
statements in accordance with Yolandian GAAP. This may be very different from the
International Standards that the other entities comply with. Even where the same or similar
standards are adopted there is often scope for considerable variation in the choice of policies.
For example, an entity can choose between valuing property, plant and equipment at
depreciated cost, or at valuation. The policy selected by management may have a significant
effect on the financial statements and upon accounting ratios such as return on capital
employed.
Accounting reference date: there is a gap of 9 nine months between the accounting reference
date of entities Y and Z on the one hand, and the accounting reference date of ABC on the other
hand. A great deal of change can take place in a period of several months, both within the
economy as a whole and in the activities of a single entity. The figures of Y and Z are, relatively
speaking, out of date, and the comparison may be at least partially invalidated because of this
effect.
Size of entities: the three target entities are of similar size, and so comparison between them is
likely to have some validity. However, ABC is approximately ten times the size of each of the
targets. Its expenses, for example, may be subject to economies of scale.
Differences between activities: all of the four entities being compared have the same principal
activity. However, it is rarely, if ever, the case that entities are engaged in precisely the same
sphere of activity, and there may be relatively minor supplementary activities that distort their
performance. For example, one entity may derive part of its income through the hire or leasing
of equipment. It is important to examine the details of entities activities carefully in order to be
sure that they areit is comparable with those of each other entities.
Single period comparisons: there is always a risk that the results of a single period are not
representative of the underlying trends within the business. Therefore, it is better, wherever
possible, to examine the performance and position at several different dates.
Special problems of international comparison: where entities in different countries are being
compared, it is even more important to be cautious about the value of the comparisons and
conclusions drawn. National economies often experience cycles of economic growth and
decline. These cyclical differences may have a significant effect upon the performance of
entities. The entities in this case are, apparently, subject to different tax regimes. Such
differences may very well be important factors in making decisions about investment. The size
and nature of the stock markets may well differ considerably between different regimes. In a
small, illiquid market, for example, share prices may be generally lower, reflecting the lack of
liquidity in the investment. Lower prices would, of course, affect the important P/E ratio, which is
regarded as important.

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