CT2 PXS 07

CT2 P XS 07
Series X Solutions
ActEd Study Materials: 2007 Examinations

Subject CT2
Contents
Series X Solutions
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CT2: Assignment X1 Solutions
Page 1
Assignment X1 Solutions
Answers to multiple-choice questions
The following table gives a summary of the answers to the multiple-choice questions.
The answers are repeated below with explanations.
1
10
Solution X1.1
Answer = B
A and C are basic principles of taxation. D is a description of corporation tax. The
marginal rate of tax is the proportion of an additional of income that is taken in tax.
This can increase with income, eg income tax in the UK. However, some taxes are
unrelated to income, eg a poll tax. In this case, a 1 increase in income does not cause
any increase in tax and therefore the marginal rate of tax is zero.
[2]
Solution X1.2
Answer = B
Only a public limited company must have an issued share capital of at least 50,000. [2]
Solution X1.3
Answer = C
The effective conversion price is the price per share that you (effectively) pay by buying
the convertible and then converting it.
[2]
Page 2
Solution X1.4
Answer = B
Marketability and credit risk are the key differences between government bonds and
loan stock which are of concern to investors. (The accrued interest basis of taxation
applies to corporate loan stocks as well as to gilts.)
[2]
Solution X1.5
Answer = B
This is the definition of a floating-rate note.
[2]
Solution X1.6
Answer = D
The question says that the security for the loan can be changed by the borrower. This
refers to a floating charge, rather than a fixed charge.
[2]
Solution X1.7
Answer = C
Principal-agent problems arise when there is a conflict of interest between the principal,
eg the shareholder and the agent, eg the manager. These conflicts can be reduced by
incentives to encourage the managers to work in the interest of the shareholders, eg by
executive share options, and by having written agreements setting out the roles and
responsibilities of all the stakeholders. Performance-related pay would be a greater
incentive for workers and managers to strive to increase profits than payment by the hour.
[2]
Page 3
Solution X1.8
Answer = B
The buyer of an option does not have an obligation and therefore cannot have a liability
at expiry. In both other cases the investor may have an obligation to settle. The writer
of a call may find that he has sold someone the right to buy stock from him at a price
below the current market price. In the case of the owner of a futures contract, he may
have bought the obligation to buy a bond at a price that is now above the current market
price.
[2]
Solution X1.9
Answer = C
The financial manager aims to maximise shareholder wealth (or the share price) by
investing in projects that display a positive net present value when discounted at the
(opportunity) cost of capital. We do not discount at the cost of borrowing, but at the
rate that shareholders and debtholders could have received on equivalent alternative
investments.
[2]
Solution X1.10
Answer = D
The theoretical share price after the scrip issue is:
(4 3) + (1 0)
5
4
(3) = 2.40
5
A scrip issue brings no new capital into the business, thus the total share capital and
reserves must remain at 150,000. However, the share capital will increase and the
reserves will fall. The share capital was originally 100,000 (400,000 shares @ 25p)
and is now 125,000 (500,000 shares @ 25p); and the reserves were 50,000 and are
now 25,000.
[2]
Page 4
Solution X1.11
(i)
Main stakeholders
The main stakeholders in an organisation are:
workers
managers
shareholders
lenders
customers
suppliers
pensioners
community, eg residents
government (local and national).
(ii)
Reasons for coincidence and conflict of objectives
[ mark each to a maximum of 2]
Coincidence
Shareholders aim to maximise their wealth and would therefore like to see a rising share
price. Managers might pursue policies that the market believes will achieve this aim for example, the introduction of efficiency measures and new purchasing strategies to
reduce costs, the development of new products to meet new demands of consumers, the
implementation of new marketing campaigns to increase sales revenues, the pursuit of
active involvement in mergers and take-overs.
[1]
In small companies where the owners are also the managers, there is no potential for
conflict between owners and managers. However, in large companies, the managers are
often simply employees of the company. In this case, their main interests might be their
salaries and their job security. If these are linked with the interests of the shareholders,
by, for example, performance-related pay or share options, then the managers are more
likely to pursue policies in the interests of the shareholders.
[1]
Such policies could be welcomed by many other stakeholders. For example, consumers
would welcome new and improved products; workers and suppliers would welcome
expansion in that it safeguards jobs and orders respectively; workers and the community
would welcome the introduction of cleaner technology; and the community would
welcome the additional prosperity to local businesses that any expansion would bring.
[1]
Page 5
Conflict
Managers are sometimes reluctant to pursue risky (but possibly very profitable) policies
because the rewards of success are less than the penalties of failure. Sometimes
therefore, managers aim for a quiet life and a satisfactory level of profit.
[1]
Policies designed to increase shareholder wealth might not find favour with other
stakeholders in the business. For example:
workers might be concerned that jobs might be lost or that working conditions
and practices might deteriorate
suppliers might be concerned that valuable contracts might be lost
consumers might be concerned that cost-cutting might result in quality-cutting,

that they are being misled by aggressive marketing campaigns and that the
companys concern with profit might result in higher prices
the local community and government might be concerned about the effect of the
companys policies on the environment, eg traffic noise and congestion, various
forms of pollution, additional building requirements
debtholders might be concerned if the company takes more risks in its

investments.
[Maximum 4]
Page 6
Solution X1.12
Advantages
The major advantage of the limited company is that its limited liability status makes it
much easier for the organisation to raise money from investors. People may be
reluctant to become involved as a part owner of a partnership since they risk their entire
personal wealth. With limited liability people are likely to be much more willing to
provide capital.
[1]
This is particularly important for business ventures involving a risk of incurring
substantial debts (such as insurance companies), and businesses which require large
amounts of capital (such as large industrial firms).
[1]
Limited liability allows large numbers of people to invest small amounts of money with
relatively minimal checking of the companys prospects. Investors can have
shareholdings in a wide range of companies thus spreading their risk.
[1]
The board of directors can choose to hire professional managers to run the company.
This use of specialists should increase efficiency.
[1]
The separation of owners and managers allows ownership to change without affecting
management.
[1]
Disadvantages
The main disadvantage of limited companies is for the creditors of the company
following a winding-up. Once the companys assets have been exhausted, the trade
creditors have no way of ensuring payment.
[1]
Ownership of the business is often divorced from day to day control, which may
encourage an inefficient corporate attitude to develop. The managers of a company may
have aims that are not in the best interests of the shareholders. This is an example of the
agency problem.
[1]
Similarly, limited liability allows people to invest in shares without taking an active
interest in the long-term needs of the company, because they are more interested in
short-term dividend prospects.
[1]
Information asymmetries often exist between various classes of stakeholder (managers,
workers, shareholders, debtholders etc), ie the different stakeholders have access to
different information. This makes any agency problem more difficult to resolve. It also
reinforces the need for proper accounting standards to be observed.
[1]
[Maximum 8]
Page 7
Solution X1.13
Double taxation relief is intended to reduce the extent to which individuals and
companies that are subject to UK income and corporation tax are taxed twice on the
same income.
[1]
Double taxation relief is available on income only, not capital gains.
[1]
Tax paid overseas on overseas income can be offset against the liability to UK tax on
that income.
[1]
The maximum offset is the rate of tax that would have been paid in the UK on the
grossed-up income.
[1]
For example, if a UK company has to pay 30% corporation tax and has paid 20% tax on
its profit made in India then it will have to pay the additional 10% in the UK. If it has
paid 40% tax on its profit in Norway, it pays no more tax in the UK. It cannot reclaim the
additional tax paid in Norway.
[1]
[Maximum 4]
Solution X1.14
Both recourse and non-recourse factoring are methods of obtaining cash from a factor
for items that have been sold to customers but for which payment has not been received.
[1]
If recourse factoring is used, the supplier obtains a loan from the factor secured against
the invoices. Recourse factoring is also known as invoice discounting. When the
customers pay the supplier, the supplier repays the factor. If non-recourse factoring is
used, the supplier sells on its trade debts to a factor and receives cash. The factor
receives payment directly from the customers.
[1]
In the case of recourse factoring, the supplier retains responsibility for collecting the
debt and therefore bears the credit risk. In the case of non-recourse factoring, the factor
takes over all responsibility for credit analysis of new accounts, payment collection and
credit losses.
[1]
If recourse factoring is used, the supplier retains contact with the customers. If nonrecourse factoring is used, the supplier has no contact with the customers.
[1]
Non-recourse factoring is more expensive than recourse factoring, because the factor
has more responsibility and also bears the credit risk.
[1]
[Total 5]
Page 8
Solution X1.15
A company which has tendered for a project will have used certain currency rates in its
calculations. If the currency rates move after the business has been won, then the
company may find that it is committed to a project which is no longer profitable at the
price tendered.
[1]
The company will have to borrow in the overseas currency in order to finance the
project. It may use derivatives to ensure that the cost of buying the currency is fixed at
todays levels. This can be done in two ways:
1.
Buy sufficient currency futures contracts to hedge the exposure. If the overseas
currency rises relative to the domestic currency, the extra costs of buying the
currency to finance the project will be offset by the profit on the futures
contracts. The futures contracts would be sold prior to exercise, realising the
profit.
[1]
2.
Buy the currency today at the current exchange rates for delivery at the time the
currency will be required. This would be in the form of forward contracts under
which both parties would exchange the amounts of currency on the expiry date.
[1]
The above strategies hedge the company against losses from currency fluctuations as
well as profits. For example, if the overseas currency falls relative to the domestic
currency, the company will make a loss on the futures contract but it will be cheaper to
finance the project.
[1]
Such strategies can only be carried out if the amounts of currency required can be
accurately estimated in advance. This is not always the case, and approximations must
be used.
[1]
The use of futures contracts allows the company to reduce the amount of the hedge in
the light of revised forecasts. By reducing the amount of the outstanding contracts, the
company can reduce the amount of the hedge. In contrast, forward contracts will be
delivered. The company will have to open new forward contracts, selling the overseas
currency, if the amount of the hedge is to be reduced.
[1]
[Maximum 5]
Page 9
Solution X1.16
Comment
Note that the answer asks for the attractions to the issuer. Features which are
attractive to the lender would only be given limited credit, and only if it was made clear
that making an issue attractive to lenders could reduce the issuers interest cost.
(i)
Debentures
Attributes
They are fixed-interest securities, with coupons normally payable half-yearly.
They have a fixed term (except for undated stocks and some with sinking funds).
Secured, sometimes with a fixed charge (a mortgage debenture), sometimes

floating. A fixed charge means that the company cant sell the underlying asset.
A floating charge gives the company more freedom.
Debentures rank above unsecured creditors in the event of a winding-up.
They are negotiable (ie they can be sold to a third party).
They have a trust deed setting out the rights of the issuer and lender.
Attractive to issuer
if credit rating low, with lenders reassured by the security
because security given to lender reduces the interest to be paid
if issuer thinks interest rates are low
because interest payments are allowable against tax.

Page 10
(ii)
Ordinary Shares
Attributes
They give ownership of the company and voting rights.
They pay dividends which are declared out of residual profit by the directors.
Dividends count as franked investment income.
Running yield likely to be low, but capital value should grow.
Income and share price likely to be volatile due to their residual nature.
Shareholders can vote for lower (but not higher) dividends than the directors
propose.
Indefinite term (although some ordinary shares can be redeemed).
Not secured. On winding up they get what is left after everyone else has been
paid off.
They are negotiable.
Issues in larger companies are very marketable.
if stock market rating high, so that a lot of finance can be raised from a share
issue
because a dividend is paid at the discretion of the directors and therefore

ordinary shares are less risky than any other form of finance
if the project needs a lot of further investment, which can come from retaining
profits rather than distributing them in the form of dividends
if project is risky, and issuers dont want to be committed to interest payments.

(iii)
Page 11
Cumulative preference shares
Attributes
They have a fixed coupon, normally payable half-yearly, which counts as

franked investment income.
Preference dividends must be paid before ordinary shares can receive dividends.
Cumulative preference shares must, in addition, have all outstanding dividend
arrears paid in full before ordinary dividends can be paid.
They are sometimes indefinite (usual), sometimes redeemable (more recent

issues).
Not secured. On winding up they usually rank above ordinary shareholders,

behind unsecured creditors.
No legal redress if no dividend is paid, although preference shareholders often

then gain a vote. Unpaid dividends are carried forward (without interest).
if project is fairly risky, and the company does not want to be committed to
interest payments
if investors are all corporation tax payers (so they do not demand a higher gross
yield)
if the company does not want any change to the control of the company (since
they are non-voting shares).
Page 12
(iv)
Convertible loan stock
Attributes
They have a fixed term as a loan stock. During all or some of the term, the stock
can be converted on pre-agreed terms to ordinary shares. If it is not converted,
the nominal value is repaid at the end of the term.
Fixed interest, normally payable half-yearly.
Usually unsecured, so on winding-up they rank above shareholders (prior to

conversion), with other unsecured creditors.
because interest payments prior to conversion are allowable against tax
lower coupon than ordinary loan stock because the stock has the potential to turn
into ordinary shares and is therefore attractive to investors
to finance projects with a long lead time to profitability
if the equity shares are undervalued at present
because if all options to convert are exercised, the loan stock will not have to be
redeemed
if its shares have a low running yield and it wants to take over a firm whose
shareholders are used to a higher level of income
to delay dilution of voting rights in a take-over.

Page 13
Solution X1.17
(i)
Seeking a listing
Reasons for seeking a listing
to raise capital for the company
to make it easier to raise additional equity finance, particularly where the

company hopes to expand
to make it easier to raise short- and long-term debt finance, because lenders feel
safer and happier about lending money to a listed company (since it has to meet
the Stock Exchanges initial and on-going requirements)
to give existing shareholders an exit route, eg venture capitalists who supported

the company in its early years and wish to realise their investment
to enable the companys shares to be more accurately and easily valued by

supply and demand in the market
to enable shareholders to use the companys listed shares as backing for their
own borrowing and thus increase the attraction of holding the shares
to enable the xyz company to offer listed shares to shareholders in another

company which the xyz company wants to take over
to make employee share participation and/or director share option schemes more
attractive
to take advantage of temporarily high share prices
to increase the number of shareholders who own shares in the company to

improve marketability of the shares
to increase the status of the company
to increase public awareness of the company to increase sales.
Disadvantages of obtaining a listing (for existing shareholders)
Any cost that the company incurs in obtaining a listing (both initial cost and ongoing cost associated with meeting the continuing obligations) is likely to reduce
the returns to its shareholders.
As 25% of the shares must be in public hands, the existing shareholders may see
their control over the company reduced.
A listing will make an unwelcome take-over harder to avoid.
The above two points are particularly relevant when the company is family
owned.
Page 14
(ii)
Relative attraction of various issuing methods
In the following answers, + is an advantage and is a disadvantage

Offer for sale (at a fixed price)
[]
most common type of method for large issues
[]
fixed price so amount raised is known in advance
[]
the issuing house advises the company about the timing and the pricing of the
issue and oversees the whole issue, co-ordinating the work of other professional
advisers
[]
the issuing house underwrites the issue thus ensuring that the whole issue will be
sold
[]
is likely to attract a wide range of shareholders
will have to pay the issuing house a fee (or allow it a margin on the selling price)
in respect of its administration role and underwriting
[]
[]
Offer for sale by tender
[]
may raise more money than an offer for sale
[]
may reduce underwriting costs
[]
the method is likely to discourage some types of shareholder and therefore lead
to a narrower distribution of the shares
[]
amount to be raised is uncertain
[]
more complex to administer than an offer for sale (so higher fee)
[]
[]
Offer for subscription
cheaper than the other methods of issue because the company issues the shares
directly to the public without the help of an issuing house (although it may hire
an issuing house as an adviser)
[]
company has responsibility for the issue
[]
company may not raise the required money (since not underwritten)
[]
hardly ever used to issue share capital
[]
Page 15
Placings
[]
most common type of method for small issues
[]
fixed price so amount to be raised is known
[]
simple and fairly cheap method of issue since the issuing house approaches only
institutional investors and so keeps administrative and marketing costs low []
no public applications are invited so the shares could end up being owned by a
small number of shareholders and thus be less marketable.
[]
[Maximum 9]
All study material produced by ActEd is copyright and is

sold for the exclusive use of the purchaser. The copyright
is owned by Institute and Faculty Education Limited, a
subsidiary of the Faculty and Institute of Actuaries.
You must take care of your study material to ensure that it

is not used or copied by anybody else.

addition, we may seek to take disciplinary action through
the profession or through your employer.
These conditions remain in force after you have finished

using the course.
Page 1
1
10
Solution X2.1
Answer = B
Preference dividends come after tax, but before ordinary dividends.
Some companies choose to pay the previous years dividends for ordinary shareholders
out of this years profit. These dividends would have been unapproved by shareholders
when the previous years accounts were drawn up and would have been included as a
note to the accounts. This method of dealing with unapproved dividends conflicts with
the accruals principle. An alternative method is to pay the previous years dividends out
of retained earnings.
[2]
Solution X2.2
Answer = C
As depreciation is calculated using the reducing balance method, we need to find r,
where:
r = 1 (5,000 / 70,000) 0.1 = 23.195%
After one year, the value of machinery shown under non-current assets will be:
= 70,000 (1 0.23195) = 53,763
[2]
Page 2
Solution X2.3
Answer = C
Receipt of unfranked investment income is not a reason it is franked investment
income that is usually taxed at a lower rate.
Overseas income will be taxed in this country if the rate of tax paid overseas is less than
30%. Double tax agreements will not reduce the rate of tax below 30%: they only stop
the total tax charge exceeding 30%.
Capital allowances serve to reduce taxable profits to reflect the usage of non-current
assets. If the rate is greater than the rate at which the company is depreciating the asset
then the taxable profits will be less than the published profits. Hence the tax charge will
be lower than expected.
[2]
Solution X2.4
Answer = D
Before the issues the company had 1m shares and was worth 5m in the market.
Following the issues the company has 2.2m (21 + 0.2) shares and was worth:
5.4m (5 + 0.22).
Therefore each share is now worth 2.45 (5.4 2.2).
Alternatively, you could find the new price as a weighted average of the share price after
the scrip issue and the rights price:
(10 2.50) + (1 2)
= 2.45
11
[2]
Solution X2.5
Answer = A
A cashflow statement is not actually required by the Companies Act, though it is regarded
as good practice to produce one.
[2]
Page 3
Solution X2.6
Answer = C
Financial Reporting Standard 18 (FRS 18) sets out the principles to be followed in
selecting accounting policies. Companies must present a true and fair view of their
financial position. The going concern concept and the accruals concept are regarded as
the most important principles. Prudence should be applied only in conditions of
uncertainty.
[2]
Solution X2.7
Answer = A
An increase in trade payables, eg credit offered by trade suppliers, improves the
companys cash position.
[2]
Solution X2.8
Answer = C
Trade payables are a liability of the business. The business owes trade suppliers money
for supplies received.
[2]
Solution X2.9
Answer = B
Dividends are a payment out of earnings and reduce the amount retained in the business.
Equity includes share capital and reserves. Reserves include share premium, revaluation
reserves and retained earnings.
[2]
Solution X2.10
Answer = C
Debit items include cost items from the income statement and assets from the balance
sheet. Credit items include revenue from the income statement and capital and liabilities
from the balance sheet. Cash is an asset and therefore a debit item. A long-term loan is a
liability and therefore a credit item.
[2]
Page 4
Solution X2.11
Any eight of the following will be acceptable.
The going concern concept
It is usually assumed that a business will continue in its present form for the foreseeable
future.
[]
Assets would be valued very differently if the company were to be wound up because
their net realisable value, ie the value they would fetch if the company were about to be
wound up, could be very low.
[1]
The accruals concept
Expenses are recognised as and when they are incurred, regardless of when the amount
is paid.
[]
For example, the rent on a factory is incurred during the accounting year and is recorded
as a cost for that accounting year even if the rent is actually paid in the preceding or the
succeeding accounting year.
[1]
The realisation concept
Income is recognised as and when it is earned, regardless of when it is received.
[]
It is not, therefore, necessary to wait until the customer settles his or her bill. This
avoids the fluctuations in reported income, which might arise if everything was
accounted for on a cash basis. It can also create the impression that the business is
performing well when, in fact, it is in danger of running out of cash. A business that is
expanding might report income long before the related cash inflows are received.
[1]
Matching
Income and expenses which relate to each other should be matched together and dealt
with in the same income statement.
[]
This, together with the realisation and accruals principles, determines the way in which
the income statement is completed. The expenses that are incurred in generating the
revenue that is earned are matched against each other. For example, the cost of the
goods actually sold (materials, wages, depreciation) is matched against the revenue
from those sales.
[1]
Page 5
Prudence
Those preparing the financial statements should avoid presenting an unduly optimistic
set of results.
[]
Thus, the lowest reasonable figure should be stated for profit or for any of the assets.
The highest reasonable figure should be stated for any liabilities and costs. This means
that there is very little danger of the figures lulling anybody into a false sense of
security by overstating the companys strengths. This should only be used where there
is some uncertainty.
[1]
Consistency
Accounting policies should not be changed from one year to the next unless there is a
very good reason for doing so.
[]
The figures published by the company should be comparable from one year to the next
so therefore any changes should be highlighted and their impact explained, often by reworking accounts from previous years using the new policies.
[1]
The cost concept
Assets appear in the balance sheet at their original cost, less any depreciation to date.
[]
Effectively, it is assumed that the purchasing power of money will remain unchanged.
This has the advantage of objectivity but the disadvantage of giving unrealistic values
and totals made up of inconsistent units because of the effect of inflation. Departures
[1]
from this concept are sometimes made, eg land might be periodically revalued.
The money measurement concept
Accounting statements restrict themselves to matters that can be measured objectively

in money terms.
[]
This has the advantage of objectivity and simplicity but it also means that a balance
sheet will rarely give even a rough approximation of the value of the business because it
will exclude such items as the values of the companys customer base, its workforce and
its brand names.
[1]
Page 6
The business entity concept
The affairs of the business are kept separate from those of the owners.
[]
In the case of a limited company, which has its own legal identity, the distinction
between the affairs of the individual and of the company are reasonably clear-cut.
However, in the case of a sole trader or a partnership, where the business does not have
its own legal identity, owners must be particularly mindful of this concept.
[1]
The dual aspect concept
The dual aspect concept recognises that every transaction or adjustment will affect two
figures.
[]
For example, the purchase of inventories for cash will increase the asset of inventories
and reduce the asset of cash. This concept forms the basis for the double entry
bookkeeping system. The system ensures that all movements have to balance and it
allows errors to be traced quickly.
[1]
Materiality
Information should be provided if it is important to the readers understanding of the

companys position.
[]
There is little point in providing information which is so detailed as to be unintelligible.
The statements can, therefore, be made clearer by showing totals such as
administrative expenses instead of listing every item which makes this heading up.
Similarly, there is very little point in making minute adjustments which have no real
effect on the picture portrayed by the financial statements. Thus, accountants might
report rough approximations for certain costs rather than waste time calculating more
precise figures.
[1]
[Maximum 12]
Page 7
Solution X2.12
(i)
Definition and purpose of depreciation
Depreciation is a measure of the wearing out or using up or other reduction in the useful
life of a non-current asset.
[1]
This can occur because of the passage of time (eg a lease), because of usage (eg a
machine) or because of changes in technology or market conditions (eg computers). []
Depreciation is charged to the companys income statement each year to write off the
amount paid for the asset over the useful life of the asset.
[1]
It is an application of the matching principle in that it is an attempt to match the revenue
earned in an accounting period to the costs incurred (in this case, from the use of a noncurrent asset) in earning that revenue.
[]
It is not an attempt to reflect the value of the non-current assets in the balance sheet. []
[Maximum 3]
(ii)
Depreciation methods
The two methods described here are the straight line method and the reducing balance
method.
As an example, let us assume a vehicle is purchased at a cost of 20,000, and will have
a residual value of 2,000 after ten years.
Using the straight line method, the annual depreciation charge is the same amount each
year.
[]
The annual figure for depreciation is found as follows:
Depreciation =
Cost - Estimated residual value

Estimated useful life
Using the example:

Depreciation =
20, 000 - 2, 000

= 1,800
10
[1]
Using the reducing balance method, a constant percentage of the outstanding value is
charged for depreciation each year.
[]
Page 8
The percentage, r , is determined as follows:

r = 1- n
Estimated residual value

Cost
Using the example:

r = 1 - 10
2, 000
= 20.57%
20, 000
So r is 20.57% and the depreciation charged in the first year will be 4,113.
[2]
[Total 4]
Solution X2.13
Equity investors
Equity investors will be mainly interested in the risk involved in buying a share and the
expected return from the share.
They will require information about the companys profitability and efficiency. They
will want information on its present profitability, the trends in its profitability and the
volatility of the companys profitability.
[1]
They will also want to know about the companys dividend policy: does the company
tend to reward investors by dividends or by capital gain?
[1]
They will also be interested in the proportion of funds obtained from long-term debt
finance. If the company were to be wound up, loan stockholders would receive
payment prior to the shareholders.
[1]
[Maximum 2]
Loan creditors
Loan creditors require information to assist in assessing the risk of default.
They will therefore be interested in the companys cashflow and its profitability to
judge how capable the company is of meeting its interest payments.
[1]
Page 9
They will also be concerned with the assets available for sale in the event of the
company being wound up. Debenture holders will be interested in the assets that their
loan is secured against. Unsecured loan stock holders, who will receive payment only
after debenture holders, will be concerned with the total amount of assets compared
with the total amount of loan stock and any prior ranking debt.
[1]
Employees
Employees will be interested in the continuation of the company and its ability to pay
salaries and offer job security.
[1]
Business customers (eg customers or suppliers)
Business contacts will be interested in the ability of the company to meet future sales
and in the level of future orders for materials and services. They might use accounting
information to gain some insight into the companys pricing and trading policies.
[1]
[Total 6]
Solution X2.14
(i)
The main purpose of the auditors report
The main purpose of the auditors report is to add credibility to the financial statements.
Since the objectives of the various stakeholders in a business often conflict, there is
likely to be a degree of mistrust between them. This mistrust might extend to the
information given by the companys management. The auditors report therefore serves
to reassure shareholders and other stakeholders (though the auditors report is addressed
specifically to the shareholders).
[1]
(ii)
The two aspects about which the auditors express an opinion
The auditors must comment on whether, in their opinion:

1.
the financial statements and the part of the Directors Remuneration Report to be
audited have been properly prepared in accordance with the Companies Act
1985 and Article 4 of the IAS Regulation, and
2.
the financial statements give a true and fair view of the state of the financial
position of the company.
[1]
Page 10
(iii)
The variations to the standard wording of the auditors report
1.
Emphasis of matter paragraphs

If there is a significant uncertainty which has been disclosed in the accounts, the
auditor should point this out. However, if the financial statements give a true
and fair view, then the auditor would issue an unqualified opinion.
[1]
2.
Qualified opinion
This may be issued where there is a limitation on the information which the
auditor has obtained, or the auditor disagrees with the treatment of a matter, but
the auditor is still able to express an opinion of the financial statements.
[1]
3.
Disclaimer of opinion
This is issued if the auditor cannot obtain sufficient information to express an
opinion.
[1]
4.
Adverse opinion
This is issued where the auditor believes that the financial statements do not give
a true and fair view and the effect is so material that a qualified opinion is not
adequate to disclose the misleading or incomplete nature of the financial
statements.
[1]
[Total 4]
Solution X2.15
Comment
For this and the next accounts question, start with the total mark, deduct 2 marks for
the first mistake and 1 mark for each subsequent mistake, down to a minimum of 0.
Where possible follow through mistakes to see whether or not the correct principles are
being used, and only deduct further marks for further mistakes.
Page 11
Income statement for the year ending 30 June 2006

000s
Revenue
000s
1,200.00
Cost of sales
Cost of stock used1
449.00
Wages - manufacturing
140.00
Depreciation2
119.66
(708.66)
Gross profit
491.34
Administrative expenses3
(104.00)
Distribution costs4
(230.00)
Operating profit
Interest on loan stock
Net profit before tax
Tax
157.34
(120.00)
37.34
(22.00)
Profit for the year attributable to equity holders5
15.34
Notes
1.
Opening stock + Purchases - Closing stock = 18 + 450 - 19 = 449
2.
Depreciation
Land and buildings = 2% of 983 = 19.66
Plant and machinery = 25% of 400 = 100
3.
Administrative expenses
Administrative overheads = 25
Wages - administrative staff = 44
Directors remuneration = 35
4.
Distribution costs
Advertising = 200
Wages - distribution staff = 30
5.
The directors propose a dividend of 80,000 for the year ended June 2006.
[7]
Page 12
Balance Sheet as at 30 June 2006

ASSETS
Non-current assets
Land and buildings1
Plant & machinery2
Current assets
Inventories
Trade receivables
Total assets
918.34
300.00
1,218.34
19.00
140.00
159.00
1,377.34
EQUITY AND LIABILITIES
Equity
Ordinary share capital
Share premium account
Retained earnings3
Total equity
Non-current liabilities
Loan stock
Current liabilities
Bank overdraft
Trade payables
Tax
Total liabilities
Total equity and liabilities
200.00
300.00
195.34
695.34
600.00
6.00
54.00
22.00
82.00
682.00
1,377.34
Notes
1.
Land and buildings = 983 - 45 - 19.66 = 918.34
2.
Plant and machinery = 550 - 150 - 100 = 300
3.
Retained earnings = 180 + 15.34 = 195.34
[8]
[Total 15]
Page 13
Solution X2.16
(i)
Purpose of a cashflow statement
A cashflow statement supplements the information contained in the balance sheet and
the income statement.
[]
Whereas the balance sheet shows the amount of cash at the start and end of each year,
the cashflow statement shows the sources and uses of the cash generated by the
company during the year. This is useful when assessing whether a company can
continue in its present shape.
[1]
The income statement registers revenues and expenses before any cash is received or
paid, ie it is constructed using the realisation and accruals concepts. This can give a
very misleading description of a companys financial health. A company can be
profitable but insufficiently liquid. Profitable companies can collapse if they run out of
cash.
[1]
The income statement is not affected by some transactions such as acquisitions and
disposals of non-current assets and changes in loan and equity finance. However, these
transactions can have a major effect on the companys cash balances.
[1]
The reported earnings of a company can be manipulated by altering the accounting
treatment of particular items and transactions. The cashflow statement is an objective
statement and is not subject to such manipulation.
[1]
[Maximum 4]
Page 14
(ii)
Cashflow analysis
The cashflow statement for the year 2005

(000s)
Cashflows from operating activities
Cash generated from operations1
471
Interest paid
(500)
Tax paid2
(70)
Net cash used in operating activities
(99)
Cashflows from investing activities
Purchase of non-current assets3
(2,450)
Net cash used in investing activities
(2,450)
Cashflows from financing activities
Proceeds from borrowings4
2,600
Dividends paid
(10)
Net cash generated from financing activities
2,590
Net increase in cash, cash equivalents and bank overdrafts

Cash, cash equivalents and bank overdrafts at beginning of the year
Cash, cash equivalents and bank overdrafts at end of the year
41
13
54
Notes
1.
Net profit + depreciation + increase in trade payables increase in trade

receivables increase in inventories
(800 + 200 + (120 350) (240 51) (360 250) )
2.
Tax payable at start of year + tax in respect of 2005 tax payable at the end of
the year (10 + 90 30)
3.
No assets were sold during the year. If none had been purchased the non-current
assets at the end of the year would have been equal to the value at the start of the
year less any depreciation charged during the year ie 9.05 million. The fact
that they total 11.5 million means that 2.45 million of non-current assets have
been purchased.
4.
Long-term debt has risen by 2.6 million.
5.
Calculated as tax (note 2), ie (20 + 50 - 60).

[7 marks for cashflow statement and notes]
Page 15
Comments
Initially the company does look to be in a healthy cash position, as evidenced by

the fact that the cash balance has increased slightly.
[]
The company has saved cash by not paying dividends that have been declared
and by paying less tax than it has incurred.
[]
The company can only finance its growth through increased borrowing. In fact,
at the current level of activities it cannot even finance the current debt interest
burden.
[1]
The company now has a lot of debt finance relative to equity finance (ie it is
highly geared) which may lead to more expensive borrowing in the future or
force the company to reduce gearing by having a rights issue. Borrowing can be
risky because if the source of the borrowing dries up, this could lead to the
winding up of the company by the loan stockholders.
[1]
The companys cashflow from operating activities could be drastically improved

if the company were to contain the increase in trade receivables (ie get its
customers to pay up!) and reverse the fall in trade payables (ie dont pay its own
bills with such timeliness!) and run the business on lower levels of inventories.
[1]
[Maximum 3 for comments]
Markers, give credit for appropriate analysis
[Total 10]
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These conditions remain in force after you have finished

using the course.
Page 1
1
10
Solution X3.1
Answer = B
Goodwill is only shown in the consolidated accounts of a holding company with a
subsidiary.
[2]
Solution X3.2
Answer = A
Acid test and quick ratio are names for the same thing. The current ratio is slightly
different (ie current assets current liabilities).
[2]
Solution X3.3
Answer = B
Net profit before tax and interest is: 85 + 6 + 10. Therefore income cover on the ULS
is 101 16.
[2]
Page 2
Solution X3.4
Answer = A
2 or 2 for asset cover (but the exact level will depend upon the quality of assets) and
between 3 and 4 for income cover (again, depending on the stability of profits) are
normal rules of thumb.
[2]
Solution X3.5
Answer = A
Value of Z purchased = 0.75 (500,000 0.25 + 450,000) = 431,250
Value of Qs offer = 0.75
500, 000
( 4 0.50) + 2 + 0.12 = 515, 000
3
Amount shown as goodwill in consolidated balance sheet

= 515,000 431,250 = 83,750
[2]
Solution X3.6
Answer = D
20% and 50% are the important figures. Over 50% is a subsidiary, under 20% an
investment.
[2]
Solution X3.7
Answer = C
Intangible assets, eg patents, can be sold, and they do depreciate. Goodwill can be
created on the consolidated balance sheet when a holding company buys a subsidiary.
[2]
Page 3
Solution X3.8
Answer = D
The return on capital employed has fallen from 32% to 24%. Remember that:
Return on capital employed = Profit margin Asset utilisation ratio
where:
return on capital employed =
profit margin =
asset utilisation ratio =
net profit before tax and interest

long - term debt + equity

sales revenue
sales revenue
long - term debt + equity
Although the profit margin has risen from 10% to 12%, the asset utilisation ratio has
fallen from 3.2 to 2. This means that Frendo plc is generating more profit per of sales
revenue but is generating less sales revenue per of assets. The total capital employed
has doubled, profit has increased by 50% and sales revenue has increased by only 25%.
[2]
Solution X3.9
Answer = B
The shareholders equity ratio is the proportion of long-term capital that is provided by
equity. Equity includes share capital and reserves. Long-term capital includes equity
and long-term debt finance.
[2]
Page 4
Solution X3.10
Answer = D
The average length of time taken for customers to settle their bills is measured by:
debtors turnover ratio =
trade receivables
365
credit sales
which is equal to:

30,000
50,000
365 = 55 days in 2005 and
365 = 73 days in 2006 .
200,000
250,000
[2]
Solution X3.11
(i)(a) Goodwill on consolidation represents the amount paid by the holding company
for a subsidiary company in excess of the nominal value of the shares and all
reserves.
[1]
For example, if Company H purchases 80% of the shares of Company S for
500,000, when 80% of the book value of the company (the nominal value of
the shares plus reserves) is 400,000, then H would show a Goodwill item of
100,000 in its consolidated balance sheet.
[1]
(i)(b) Company S is said to be a subsidiary company of Company H when Company H
has a controlling interest in Company S. Company H might own the majority of
the shares of Company S or be able to control the board of directors of
Company S in some other way.
[1]
For example, Company H might hold 60% of the voting shares. Alternatively,
Company H might only have 45% of the shares but have the right to elect twothirds of the Board of Directors.
[1]
Page 5
(i)(c) Company A is an associate of Company H if Company H has a significant

influence (but not a controlling interest) in Company A.
[1]
For example, Company H would have a significant influence if it held between
20% and 50% of the voting rights in Company A. Alternatively, Company H
might have only 18% of the voting shares but it might hold one of the three seats
on the Board of Directors.
[1]
(i)(d) Minority shareholders are the other shareholders in a company of which a
holding company holds more than 50% of the shares.
[1]
For example, if Company H holds 80% of the shares in Company S, the holders
of the remaining 20% are known as the minority shareholders.
[1]
[Total 8]
(ii)
Consolidated accounts
If Company H is a holding company and has total ownership of its subsidiary

Company S, then Company H will have shares in the subsidiary company as part of its
non-current assets and the shares of Company S will be all owned by the holding
company. When preparing consolidated accounts for the group, internal relationships
like this are cancelled out to avoid double counting, and the other items of the balance
sheet are simply added together.
[2]
If Company H paid more than the book value for the shares of Company S, then, when
consolidated, the difference (goodwill) would be recorded as an intangible non-current
asset of the group.
[1]
If Company H does not own all of the shares in Company S, then the rest of the
shareholding is termed the minority interest. On consolidation, when the internal
relationships are cancelled out, the minority interest must appear separately in the equity
section of the balance sheet, after the capital and reserves attributable to equity holders.
[1]
If Company A is an associate company of Company H, it is not appropriate to include
the value of Company As assets in the consolidated accounts. Nor is it appropriate to
simply include Company Hs holding of Company As shares as an investment.
Instead, Company Hs share of Company As income and its assets and liabilities are
included as single line entries in the consolidated income statement and balance sheet.
[2]
[Total 6]
Page 6
Solution X3.12
Earnings before interest and tax (EBIT) is often used to analyse a companys
profitability. For example, it is used to calculate the profit margin and the return on
capital employed. This figure is before tax and interest and is therefore not affected by
the governments tax policy or the companys financing decision.
[1]
However, the figure is affected by the amounts charged for depreciation and
amortisation. These amounts can be determined in many different ways. It is this
subjectivity that makes some analysts feel that it would be better to use the figure for
earnings before interest, taxation, depreciation and amortisation (EBITDA).
[1]
[Total 2]
Solution X3.13
The price earnings (PE) ratio divides the market price of a companys ordinary share by
the earnings per share.
[]
The market price of the share encapsulates everything the market knows about the
company. Earnings are the net profit available to ordinary shareholders, ie after tax and
preference dividends.
[1]
Earnings are important since they are either paid out as dividends or retained to increase
the value of the company and to increase future dividends.
[]
Relating the market price to the earnings gives an insight into the markets view of the
companys performance. Ignoring discounting, it shows the number of years it would
take for the share price to be paid for by the current level of earnings.
[]
A high PE ratio suggests that the market considers the company to be an attractive
investment. This may be because:
the earnings are expected to grow rapidly
the share is low risk.
Alternatively the share could be overvalued.
[1]
[]
The PE ratio is often used since it is easy to calculate, widely available and relatively
easy to understand.
[]
The dividend yield divides the dividend by the share price. Usually, the dividend yield
is quoted gross (ie including the tax credit on dividends).
[]
Page 7
Dividends are important since these are what a shareholder receives as income.
[]
The dividend yield shows the income (dividend) the investor can expect from his/her
investment (the share price).
[]
A high dividend yield can mean that:
the share is undervalued
the dividend is expected to fall
the share is a high risk investment.

[1]
[Maximum of 4 for PE ratio alone; maximum of 6 in total]
Solution X3.14
(i)
Complications of insurance company accounts
The preparation of insurance company accounts is complicated by two special features:
The underlying contracts (liabilities) fall due outside the accounting period and
are uncertain in timing and size.
Premature transfer of profit to shareholders may endanger the financial

stability of the company and the ability to meet future liabilities.
[2]
Estimates have to be made of the future liabilities, either on a statistical basis, based on
past experience, or by expert judgement.
[]
These estimates are frequently reviewed and updated in the light of claims experience.
[]
Premiums already received in respect of such liabilities need to be identified and held
until such time as the liabilities have expired.
[]
Insurance companies are likely to adopt a prudent approach to the estimation of their
liabilities, and since these reserves are entered as a cost in the income statement, their
profit is likely to be understated.
[]
This conflicts with the basic principle that the accounts should give a true and fair view
of the state of the company.
[]
Page 8
There is an additional problem caused by the long-term nature of the business. New
business initially causes a financial strain due to the costs of setting up the contracts and
establishing adequate initial reserves. However, over time, the product is designed to
make a profit for the business. The question arises as to when (and how) this profit
should be reported.
[1]
The tax system might cause a further problem if particular classes of business are taxed
in different ways. The company might have to set up separate sub-funds for tax
purposes.
[]
[Maximum 5]
(ii)(a) The revenue accounts
There are separate revenue (or technical) accounts for general insurance and long-term
insurance businesses. Each revenue account takes the following form:
Earned premiums (net of reinsurance)
+
Investment income
Realised capital gains
Claims incurred (net of reinsurance)
Net operating expenses incurred
Balance on revenue account
where the investment income and realised capital gains are those earned on the
investments held to cover the insurance liabilities.
[ mark deducted for an omission or incorrect entry; maximum 3]
Page 9
(ii)(b) The non-technical income statement

The balances on the revenue accounts are transferred to the non-technical income
statement:
Balance on general insurance revenue account
+
Balance on long-term insurance revenue account
Investment income
Realised and unrealised gains (losses) on investments
Profit (or loss) from other ordinary activities before tax
Tax on profit (or loss) from all activities
Profit or loss for the financial year
where investment income and capital gains are those earned on investments relating to
shareholders funds / free reserves.
[ mark deducted for an omission or incorrect entry; maximum 3]
(ii)(c) The balance sheet
The main assets of the insurance company are the investments held to cover the
shareholders fund and the insurance liabilities, some of which will be in cash.
[]
The company will also have non-current assets of land, buildings and equipment, and
also current assets of trade receivables and prepayments.
[]
Since the insurance company reduces its exposure to the liabilities of the company by
reinsurance, then the reinsurers share of the technical provisions is counted as an asset.
[]
The main liabilities of the insurance company are the future payments they are likely to
have to make for long-term insurance business and general insurance business.
[]
The company will also have current liabilities eg trade payables, overdraft, tax
provision.
[]
The shareholders funds or free reserves is the capital and reserves provided by the
shareholders.
[]
The shareholders fund is equal to the total assets less the total liabilities.
[]
[Maximum 3]
Page 10
Solution X3.15
(i)
Investment ratios and analysis
Ratio
Earnings per ordinary share (see note 1)
earnings available for ordinary shareholders
=
number of ordinary shares
Price earnings ratio
=
market price
earnings per share
Net dividend yield (see note 2)

net dividend per share
=
market price
Dividend cover
earnings per share
=
dividend per share
Return on capital employed (see note 3)
net profit before tax
=
share capital and reserves
Return on capital employed (alternative)
=
share capital and reserves + long - term debt
Net asset value
ordinary shareholders' equity intangibles
=
number of ordinary shares
Asset gearing (see note 4)
debt
equity
Asset gearing (alternative)
debt
=
debt + equity
=
Company A
300, 000
4, 000, 000
= 7.5p
180
7.5
= 24
Company B
200, 000
6, 000, 000
= 3.3p
95
3.3
= 28.8
5
180
= 2.8%
2.5
95
= 2.6%
7.5
5
= 1.5
3.3
2.5
1.32
420, 000
2,500, 000
= 16.8%
495,000
4,000,000
=12.4%
1,500, 000
4, 000, 000
= 37.5p
1,500,000
2,500,000
= 60%
1.5
1.5 + 2.5
320, 000
3, 000, 000
= 10.7%
350,000
3,500,000
=10%
2,500,000
6,000,000
= 41.7p
500,000
3,000,000
= 16.7%
0.5
2.5 + 1
= 37.5%
= 14.3%
Page 11
Notes
1.
The earnings for ordinary shareholders of Company A has been calculated as

360,000 less the amount payable to preference shareholders of 60,000.
2.
The net dividend per share for Company A has been calculated as:
net dividend
200,000
=
=5p
number of shares 4,000,000
3.
We have included the preference shares in this definition. It would have been
acceptable to define a ratio only for the ordinary shares of:
=
4.
net profit before tax preference payment

ordinary share capital and reserves
To be consistent with the definitions used in ROCE, preference shares are

included as part of equity. It would have been acceptable to treat preference
shares as debt if they had been treated as debt in the calculation of ROCE.
[Maximum 6]
Comments
Company A has a lower price earnings ratio than Company B. This means that the
investor will pay more for each of earnings for Company B. Company A therefore
seems a cheaper share. What is the significance of this? It could imply any of the
following:
Company A has poorer growth prospects than Company B
Company As shares are more risky than Company Bs shares
Company As earnings are unusually high or Company Bs earnings are

unusually low
Company A is undervalued or Company B is overvalued.
[2]
Company A has a slightly higher dividend yield, ie the income return is a higher
proportion of the market price of the share. This supports the view that Company A
looks slightly cheaper.
[]
Company A has a higher dividend cover (and thus a lower payout ratio) than
Company B. Thus Company A is retaining more of its profits within the company and
distributing less to its shareholders than Company B. This might indicate higher future
earnings growth.
[1]
Page 12
Company A is achieving a higher dividend yield on a lower payout ratio, ie Company A

is not achieving a higher dividend yield by simply paying a higher proportion of its
earnings as dividend.
[]
Company A has a higher return on capital than Company B. Company A is using its
assets more effectively to generate profits.
[]
Company A has a lower net asset value per ordinary share (NAV) than Company B.
This is particularly noticeable if we look at the ratio of net asset value and market price
per share. Thus if the company were wound up (at the present time), a shareholder in
Company B may receive more than a shareholder in Company A. This might also mean
Company B might be a take-over candidate (although unlikely whilst NAV remains
below the market price).
[1]
Company A has a higher gearing ratio than Company B (and considerably above the
debt
basis). The additional funds
recommended maximum of 0.4 using the =
debt + equity
made available by debt finance would give Company A greater potential for growth but
the higher gearing also makes it more vulnerable to the downturn in the business cycle
and reduces the funds available to shareholders if the company were to be wound up.
[1]
Conclusion
Thus Company A is a highly geared company that gives greater priority to growth and
earns a higher return on capital. It has a lower payout ratio yet has a higher dividend
yield this is in addition to the prospect of a greater capital gain. Company B appears
to be a slower growing company, which takes fewer risks but offers stability and better
asset backing. Company A might be chosen if the investor seeks growth and can handle
the risk. Company A also looks cheaper (probably because of the high risk), whereas
Company B might be preferable for an investor requiring security.
[2]
[Maximum 6 for comments]
[Total 12]
(ii)
Page 13
Problems in making comparisons
Comparing accounts and accounting ratios for different companies can be fraught with
problems.
Firstly, there is a great deal of subjectivity in the accounts. The two companies might
have used very different accounting policies on, for example, depreciation or the
treatment of intangibles, so the accounting data is not strictly comparable. Even though
the companies might follow accounting standards, the interpretation can be different and
so any comparison will be tenuous. There are differences in interpretation between the
US and European accounting bodies.
[1]
The different methods of treating an item in the accounts can be very important,
depending on the nature of the business. For example, intangibles may be significant
for an advertising company, and therefore the policy chosen will dramatically affect its
profitability.
[1]
One or both of the firms might have engaged in creative accounting, ie the deliberate
use of particular accounting policies in order to show particular results.
[]
The use of ratios to make comparisons can divert attention from the wider view of the
company. In this case, we have very little information to go on and should not place too
much emphasis on the ratio analysis.
[]
Companies operating in different sectors would be expected to have different capital
structures and different accounting ratios. For example, an advertising agency is likely
to be more lowly geared than a car manufacturer.
[1]
Companies in different sectors are exposed to different conditions. For example, a car
manufacturer is likely to be more exposed to recession at home and abroad than a food
manufacturer.
[1]
The figures reported in the accounts are out of date by the time they are published. In
addition, some of the data might suffer from window-dressing. For example, a sale
might have been brought forward in order to enhance the profit figure for the year. [1]
Care must be taken in using the figures as a basis for predictions since the accounts do
not give any indication of the companys future plans. A full reading of the annual
report might give the user some indication.
[1]
[Maximum 4]
Page 14
(iii)
Additional information required
The following information will be useful:
Other accounting information. For example, information on sales revenue

would enable us to consider the profit margin and the asset utilisation ratio,
which would give us further insights into the profitability and efficiency of the
businesses.
[1]
The industries that the companies are involved in. Are they in the same
industry? What are the characteristics of these industries? What is the
competition? What factors determine demand for their product? What are their
costs? Are there any special conditions that have affected/are likely to affect the
performance of the companies?
[1]
Background information on the companies.

What is the quality of
management/staff/product in each company? Have there been any changes in
the management/ style/ priorities?
[]
Historical background of the two companies. How has each company performed
over time? To what extent is the information given typical of each company? []
Prospects for the two companies. What are their business plans? Which
company could achieve better results in the commercial, economic, political and
technological climate ahead?
[1]
Preference of the investor. Does your friend, the investor, want a regular
dividend or a capital gain? What is his/her attitude to risk?
[1]
[Maximum 4]
Markers, reward reasonable suggestions.
Page 15
Solution X3.16
(i)
Balance sheet
Balance sheet as at 31 December 2006

000
ASSETS
Non-current assets
Current assets
Inventories
Trade receivables
Cash
000
3,000
1,400 (1,300 + 100)

600 (700 100)
1,552 See over page
3,552
Total assets
6,552
EQUITY AND LIABILITIES

Equity
Ordinary shares of 10p
Reserves
1,100
2,476
Total equity
Non-current liabilities
12% Loan Stock 2015
Current liabilities
Taxation
Trade payables
Dividends
Total liabilities
Total equity and liabilities
(3,000 500 + 500)
(1,800 + 676)
3,576
400
712
1,500
364
2,576
(400 200 + 512)

(1,200 + 300)
(300300+364)
2,976
6,552
Page 16
Cash balance is found by:

Cash b/f
+ 200
Sales plus decrease in trade receivables
+ (4,000 + 100)
less direct expenses (excluding depreciation)
(2,500 500)
less increase in trade payables

less interest, tax and dividends paid
300
(48 + 200 + 300)
less expenditure on non-current assets
500
1,552
[Deduct 2 marks for the first mistake and 1 mark for subsequent mistakes, maximum 8]
(ii)
Comments on XYZs liquidity, efficiency and profitability
Liquidity
quick ratio
= (cash + trade receivables) current liabilities

= (1,552 + 600) (2,576)
= 2,152 2,576
= 0.84
current ratio
[1]
= current assets current liabilities

= 3,552 2,576
= 1.38
[1]
The quick ratio is a stringent liquidity ratio. A ratio of 1 means that the companys
trade receivables and cash are sufficient to cover its short-term liabilities. A ratio of
much less than 1 would be worrying.
[]
A figure of 0.84 is just about acceptable. The company can probably meet its liabilities
as they fall due. It would be useful to look at trends in this ratio, and to compare it with
other companies in the same industry.
[]
The current ratio is a less stringent test of liquidity. A ratio of 1 means that the
companys inventories, trade receivables and cash are sufficient to cover its short-term
liabilities. A figure of more than 1 would be expected, and preferably greater than 1.5
(although this varies between industries).
[]
A figure of 1.38 suggests that the company has just about enough liquid assets to cover
its short-term liabilities.
[]
Page 17
Efficiency
stock turnover ratio
= (average inventories sales revenue) 365

= (1,350 4,000) 365
= 123 days
debtors turnover ratio
[1]
= (trade receivables credit sales ) 365

= (600 ( 4,000 ) ) 365
= 109 days
creditors turnover ratio
[1]
= (trade payables purchases) 365

= 1,500 1,300 365
= 421 days
[1]
The stock turnover ratio shows how long inventories are held for on average. The
company should minimise inventories to maximise efficiency.
[]
The figure of 123 days can only be interpreted if we know what the figure is for similar
companies. However, holding inventories for four months seems quite long, and may
suggest inefficiency.
[]
The debtors turnover ratio is most useful as a tool to compare the performance from
one year to the next. On its own it shows the number of days credit extended to the
average debtor.
[]
109 days is quite high the company should consider reducing the amount of credit
extended to customers.
[]
The creditors turnover ratio shows the number of days credit it receives from its
suppliers.
[]
421 days seems very high. This will help the companys cashflow and, in particular,
helps cover the credit given to its customers, but such late payment of bills might annoy
suppliers.
[]
Page 18
Profitability
return on capital employed
= net profit before tax and interest (debt+equity)

= 1,600 3,976
= 40.2%
profit margin
[1]
= net profit before tax and interest sales revenue

= 1,600 4,000
= 40%
asset utilisation ratio
[1]
= sales revenue (debt + equity)

= 4,000 3,976
= 1.006
[1]
The return on capital employed shows how productive the capital has been in
generating profits.
[]
40.2% is a high figure and shows that a very good return is being earned on the assets
under management.
[]
The profit margin indicates the mark-up achieved on sales. The company will aim for a
high mark-up but has to consider the effect of a high mark-up on the volume of sales.[]
40% seems quite high for a manufacturing company and may indicate:
an efficient company
a company selling up-market products
supernormal profits.
[]
The asset utilisation ratio shows the sales that are generated from the companys assets.
[]
The ratio of 1.006 is relatively low, though it depends on the nature of the business.
The companys sales could be suffering from its high profit margin. Perhaps the
company is using its assets inefficiently. Better management might allow it to produce
just as much output with fewer assets.
[]
[Total 16]
Page 1
1
10
Solution X4.1
Answer = C
The return on the share would be described by the following formula:
ri = r f + i (rm r f )
= 5% + 1.5 ( 3% 5% )
= 2%
[2]
Solution X4.2
Answer = C
In a tax-free world, the following formula links the returns:
rA =
D
E
rD +
rE
D+E
D+ E
12% = (0.25 8%) + (0.75 rE )

Thus:
rE = 13.33%
[2]
Page 2
Solution X4.3
Answer = A
rE = r f + E rm r f
13.33 = 6 + E (12 6 )
Thus:
E =
7.33
= 1.22
6
[2]
Solution X4.4
Answer = D
Weighted average cost of capital
= (% debt) (cost of debt) + (% equity) (cost of equity)
= (0.25 8%) + (0.75 13.33%) = 12%
[2]
Solution X4.5
Answer = A
If interest rates rise, the company will pay higher borrowing costs. It will recoup this
extra financing cost through the profit on its future contracts. Answer B is the reverse
and increases the risk. The long bond future would expose the company to long-term
interest rates, which have little to do with the risk profile of the project in question. [2]
Solution X4.6
Answer = D
[2]
Solution X4.7
Answer = C
Only the effects of regional price variation can be diversified away by investing in a
large portfolio of risky assets and projects.
[2]
Page 3
Solution X4.8
Answer = C
The following diagram compares the net present value of the projects as the discount
rate varies.
NPV
100
50
Project B
10
-50
15
Discount rate
Project A
Project A is more profitable than Project B at a discount rate of 5%, but not at all
discount rates.
The internal rate of return is the discount rate at which the net present value is zero.
The internal rate of return for Project A is 10% and the internal rate of return of Project
B is at least 15%.
The net present value of Project A at a discount rate of 15% is negative. Thus it will not
earn a 15% return.
Project B is less sensitive to a change in the discount rate as the diagram shows.
[2]
Page 4
Solution X4.9
Answer = B
An increase in gearing increases the risk of default and thus the companys credit rating
will fall. It will have to pay more for its debt finance.
[2]
Solution X4.10
Answer = C
Systematic risk is allowed for by using an appropriate discount rate. Specific risk is
allowed for in the other ways.
[2]
Solution X4.11
In order to reduce the volatility of profits, the management could do any of the
following:
Reduce the gearing of the company by issuing more equity shares.
Negotiate contracts with suppliers which involve the suppliers taking some of
the risks, and consequently some of the volatility of profits.
[1]
Take out insurance against certain risks.
Organise export guarantees to protect against the default of trading partners in

foreign countries.
[1]
Currency hedging techniques can reduce the effect of currency volatility on

translated profits. This could involve options on currencies, or selling an
appropriate amount of the foreign currency forward to hedge the value of the
profits in the domestic currency.
[1]
Organise its debt so that payments of interest and repayments of capital are in
the same currencies as its earnings, eg by using Eurobonds.
[1]
[Maximum 4]
[1]
[]
Page 5
Solution X4.12
(i)
The theoretical ex-rights price
The theoretical price is given by the formula

(2 2.5 + 1 2.23)
(2 + 1)
= $ 2.41 per share
(ii)
[1]
The nil-paid rights
The value of the nil-paid rights = $2.41 $2.23 = $0.18 per share
(iii)
[1]
Mr Grumpys payment
Additional funds = 20,000 $2.23 = $22,300
[1]
(iv)
Options open to Mr Grumpy
1.
Do nothing. In this case his nil-paid rights worth $0.18 10,000 = $1,800 (at
the current market price of the companys shares) would be sold in the market
on his behalf and the proceeds given to him.
[]
His holding of 20,000 shares would then be worth 20,000 2.41 = $48,200 []
His holding has fallen from 50,000 / 250m = 0.02% of the company to a holding
of 48,200 / 361.5m = 0.0133 % of the company.
[]
Sell the nil-paid rights in the market himself. Were Mr Grumpy to do this, the
results would be very much as above except for the fact that he would incur
dealing costs, but perhaps obtain a better price if his timing was better.
[]
He could sell sufficient shares to raise the cash to pay the premium on the nilpaid shares. He requires 10,000 2.23 or $22,300 to take up his rights. If he
were to sell 9,253 shares at the current market price of 2.41 he would raise this
amount.
He would then own (20,000 9,253 + 10,000) or 20,747 shares.
This result can also be achieved if the investor sells 9253 nil-paid rights, raising
$1,665 which would allow him to pay the premium on the remaining 747 nilpaid shares.
[1]
Page 6
These shares would have a value of 20,747 2.41 = $50,000 which is the
original value of his shareholding.
[]
His holding in the company would represent
50,000 / 361.5m = 0.0138 % of the company.
[]
[Total 4]
Solution X4.13
(i)
Why does more debt increase earnings
This is likely to be the case because debt is a tax-efficient manner of raising finance.
The debt interest payments are deducted from profits before the calculation of the tax
charge. As such it serves to reduce the tax charge. If debt interest is compared to equity
income, it can be seen that the government is effectively paying the amount of the tax
charge to the investor on behalf of the company.
[1]
(ii)
Disadvantages of increasing debt
The disadvantages of such a move would be the increase in volatility of reported

earnings for the equity shareholders.
[1]
The knock-on effect of any increased volatility of earnings would be to cause the equity
shareholders to demand a higher return for holding the shares.
[1]
In addition there will be a higher risk of default on interest and on capital for the
outstanding debt, and it should not be assumed that the new debt can be issued on
similar terms to the existing debt.
[1]
Indeed it might well be that the increased earnings per share prospects are only
sufficient to compensate equity shareholders for this increase in uncertainty, and that the
share price does not benefit from such a move.
[1]
Other points to be brought into consideration are:
Covenants in the trust deed for the existing debt may preclude a further increase
in gearing at least on a similar ranking to the existing debt.
[]
If the companys credit rating falls, it may affect almost all of the companys
long-term and short-term borrowings.
[]
[Maximum 4]
(iii)
Page 7
Effects on the share price
The share price might increase or decrease.

It could increase because the equity holders appreciate the enhanced prospects for EPS
growth and are not concerned by the additional volatility of earnings.
[1]
The share price could decrease because the shareholders are more concerned by the
additional volatility and risk of default than the possible increase in EPS. The required
return to hold the shares therefore rises sufficiently so as to more than offset the
increased earning prospects for the newly structured company. Therefore the price falls.
[1]
[Total 2]
Solution X4.14
(i)
The expected return on equity
The graph of the expected return on equity ( re ) is as follows (return on assets ( ra ) and
cost of debt ( rd ) are also shown):
re
12%
6%
ra
rd
Debt/equity
[1]
(ii)(a) Weaknesses in a tax-free world

Even in an untaxed world, the cost of borrowing would rise as the amount of debt
outstanding increases. In other words, the cost of borrowing would rise as the risk of
default increases and the companys credit rating decreases. In these circumstances, the
expected return on equity will rise to a certain point, then begin to tail off as the higher
cost of borrowing bites.
[1]
Page 8
(ii)(b) Weaknesses in a taxed world

In a taxed world, the tax benefit of borrowing would also play a part.
The line re would rise more steeply initially reflecting firstly the benefit to equity
holders of the extra gearing and secondly the effect of the reduction in the relative tax
burden. The former is the effect of the difference between the return on assets and the
cost of debt, which increases the expected return for equity shareholders, and the latter
revolves around the fact that as gearing rises, the tax as a proportion of operating profits
falls.
[2]
Solution X4.15
(i)
Additional information required
Background information explaining the reasons for the companys hard times.
Is it a temporary problem caused by particular business or market conditions, or
is it a long-term structural problem with the company, perhaps reflecting a longterm alteration to business conditions and customer habits?
What is the restructuring package and over what timeframe is it likely to cure the
problems?
What is the likelihood that the restructuring package will not solve the problem?
What is the companys cash situation? Can it continue to finance a dividend

over the restructuring period?
What are the shareholders preferences and expectations? Are they accustomed
to the current level of dividend, and will they be disappointed if the dividend is
stopped for a while during the restructuring? What is the companys stated
dividend policy?
What are other companies in the market and in the sector doing? Have they all
been affected by the same factors that have damaged the companys profits, or
are the difficulties specific to this particular company?
Is the company likely to be the victim of a take-over if shareholders are

disappointed in the companys payout over the next two or so years?
Page 9
Following the restructuring, by how much is the companys level of profitability

likely to rise? Is it the case that the profitability and earnings creation is likely to
return to former levels, or were former levels higher than can ever be expected in
the future?
[ mark for each relevant point, maximum 4]
(ii)
Strategies that could be considered
No dividend over the period of the restructuring. This might be appropriate if

the problems are at the core of the business, and there is no guarantee that
former levels can be attained again in the future.
[1]
Continue paying the dividend at the former level in the anticipation that profits
will recover to this level again. If the management is confident that the current
problems are short-lived and not core to the business, then this could be the
optimal choice.
[1]
Pay a scrip dividend rather than a cash dividend. If cashflow is a problem, but
the level of dividend can be justified at its former level, then this would be a
solution.
[1]
Pay a dividend (or scrip dividend) at a lower level. The new level will reflect
the managements expectations of long-term future profitability, and will be
justifiable using the best estimates of future cash generation and earnings
generation. As detailed above, this strategy would be suitable if the company is
confident that profit levels will return to the level estimated, but that the
company has cashflow problems in the short term.
[1]
[Maximum 3]
Page 10
Solution X4.16
The policy favours small projects quite considerably. To demonstrate 15% IRR
on a large project might prove impossible, and the company might end up
turning down large projects that might have given superior returns for less risk.
[1]
The policy may favour one department above another, depending on

structure and size of the typical projects undertaken. This can cause
business area to grow at the expense of another and can cause political
internal frictions.
The policy may encourage managers to split large projects artificially into many
smaller projects.
[1]
The high rate of return demanded for larger projects will encourage high-risk
projects. Perhaps this is the managements aim, but it should not be by accident.
[1]
The low rate of return for smaller projects might allow the company to spend a
great deal of money on unprofitable projects unless it has other methods to limit
its finite resources.
[1]
[Maximum 3]
the
one
and
[1]
Solution X4.17
(i)(a) Annual capital charge
This is very similar to the accounting depreciation charge calculated on a straight line
basis. The table below gives the net cashflows after the annual capital charge:
Time in years
Cashflow in $ millions
Initial investment
charge
Annual capital charge
(6)
1
(2)
4
(2)
3
(2)
(1)
This shows the effect on the income statement of the investment after depreciation. It is
appropriate for investments such as this that involve the purchase of machinery. The
machinery is likely to be depreciated over a three-year period, and the annual capital
charge method shows directly the effect on the reported profitability.
[1]
Page 11
(i)(b) Payback period

This is defined as the point in time at which the positive cashflows equal the negative
flows over the life of the project. For the above project this will be at the end of year 3.
[1]
(i)(c) Nominal return over 3 years
Nominal return is calculated as the ratio of the amount of positive cashflows to the
negative cashflows over the specified period.
For this project it equals 8/6 = 1.33
The fact that this is greater than 1 is a positive sign for the project. However the method
ignores the time value of money.
[1]
[Total 3]
(ii)
Probability trees
Probability trees are of use in situations where decisions have to made at various points
in time as a project is progressed. Each of these decisions may constrain the project
manager in terms of the option he or she may take in future.
[1]
They are of particular use when the probabilities of certain events can be refined and
clarified with the passage of time. Decisions can be made in the future with the benefit
of knowledge of prevailing market conditions.
[1]
A tree of decisions can be drawn up reflecting all the possible future scenarios, and the
various decisions that have to be made in the future.
[]
The likelihood and probabilities of future events, and the resulting cashflows can be
estimated and assigned to each scenario.
[]
It is then possible to work backwards to establish the most beneficial decision at the
current time, and the likely value of the project.
[]
[Maximum 3]
Page 12
Solution X4.18
Despite the fact that the available data may be woolly and inaccurate, an NPV and
IRR analysis should be attempted. Any limitations of these analyses should be clearly
stated on the report.
[1]
If the future net cashflow data is very uncertain, a payback period and a discounted
payback period analysis might be a useful tool for explanation at the meeting.
[1]
A very useful analysis would be a shareholder value analysis. The aspects of the
company that appeal to the shareholders would be analysed in detail, including the
gearing, the growth prospects, the security aspects, the management control, and the
structure.
[]
An analysis would also be performed of the shareholders risk appetite, and their
reasons for investing in the company.
[]
The company could then be modelled after the European expansion, whether that
involves take-overs in various strategic countries or simply setting up offices in the
region.
[]
The time period until the expansion would enhance earnings per share should be
estimated. If there is a long lead-time to profitability, then the effect on the earnings per
share should be estimated over the short term and a decision made regarding how well
the shareholders would react to this period of poor performance.
[]
By modelling the companys post-expansion financial position in one, two, and perhaps
three years time, it should be possible to work out whether the aspects of the company
that appeal to shareholders have been enhanced or diluted. This will help the decisionmaking process.
[]
A strategic fit analysis should be performed. This would involve analysing the world
market and the measures being taken by the companys main competitors. If a presence
in Europe is deemed to be strategically important but it does not satisfy the necessary
financial criteria, then the strategic appeal of the move might be the ultimate
justification for the project.
[1]
Page 13
It would be possible to weigh up the qualitative benefits of the project relative to other
possible expansion projects. This means creating a list of qualitative benefits achieved
by the company, such as:
improved shareholder perception (max 5 points)
improved brand recognition (max 3 points)
employee career progression (max 2 points)
diversification of business sector (max 4 points)
long-term flexibility of business direction (max 4 points).
Each of these could be given a total maximum number of points as shown above, and
the various projects scored against the maximum available for each category. The final
qualitative score would allow the various projects to be compared.
[1]
Opportunity costs analysis would also be useful. If the company would otherwise place
the money on deposit, then the project should be compared against this rate. If there is
an alternative project, then the project should be compared against the rate of return that
would be earned on the alternative project.
[1]
[Maximum 5]
Markers, give points for any relevant analysis that is properly described and adds value
to the decision-making process.
Solution X4.19
(i)(a) Meaning of specific and systematic risks
Specific risks are the risks that are specific to that particular project. If an investor were
to build up a portfolio of such projects, these risks would be diversified away and the
overall portfolio of projects would not be exposed to any specific risks from any one
project.
[1]
Systematic risks are the risks that cannot be diversified away. They are the risks of
being exposed to the market in general. Some industries are simply more geared to the
performance of the economy in general (so-called cyclical industries) and therefore
are exposed to more systematic risk.
[1]
Page 14
(i)(b) Meaning of beta

The beta of a project is a measure of the systematic risk of the project relative to a
diversified portfolio of all risky assets (ie the market). The market would have a beta
of 1.
[1]
Beta is given by the following formula:
beta =
covariance(ri , rm )
variance(rm )
where:
ri are the returns expected from the project
rm are the returns expected from the market
[1]
(ii)(a) Required rate of return on project

The required return on a project is found from the following formula:
E p = r f + p rm r f
In this case, the required return is:

= 4% + 0.6(6%)
[2]
= 7.6%
(ii)(b) Explanation for low rate of return on a risky project

The beta of the project measures the systematic risk only, ie the extent to which the
project is exposed to market risk. In this case, this risk is relatively low.
[1]
The specific risk is not measured by the beta of the project. In this case, this risk seems
very high. The company will have to take other steps to assess the specific risk,
eg RAMP, risk matrix, scenario testing.
[1]
Page 15
Solution X4.20
(i)
Risk matrix
A risk matrix is a matrix that shows the different causes of risk as column headings and
the list of all specific risks that might befall the project at the different stages of the
project as row headings (or vice versa if matrix is transposed).
[1]
The causes of risk can be classified under many subheadings, but there will often be
seven main classes of risk, namely:
Political
Natural
Crime
Financial
Business
Economic
Project.
[Maximum 2, deduction for each missing category]
Within each of these categories there may be many sub-categories. For example,
economic risk causes might be further classified into currency fluctuation, short interest
[]
rate movements, etc.
The specific risks will be listed, usually in chronological order, as they are expected to
endanger the project.
[]
Typically, the risks might be labelled in the following main categories:
promotion of concept
design
contract negotiations
project approval
raising of capital
construction
operation and maintenance
receiving revenues
decommissioning.
[ mark for each up to a maximum of 2]
And again, within each of these categories there might be many sub-categories. For
example, within the heading construction there may be a number of specific risks
listed such as higher raw material costs, difficult excavation.
[]
[Maximum 5 for description]
Page 16
Uses of the risk matrix
The matrix allows the risk analyst to ensure that he or she has systematically and
comprehensively considered every risk that might affect the project and that nothing has
been overlooked.
[]
It also allows the analyst or risk manager to keep track of the risks in chronological
order as the project proceeds, and allows the project manager to make sure he or she is
considering all the relevant risks at each stage in the project.
[]
It allows the analyst to identify correlations between risks many of the specific risks
listed may be highly correlated to a specific cause of risk. This may mean that these
risks need further detailed analysis because of their interdependency and potentially
larger combined impact.
[1]
[Total 7]
(ii)
Examples of matrix entries for the Abingdon Four Pillows
Specific risks
Stage of project
Example of risk
Investment planning
Poor market conditions lead to more

expensive borrowing than predicted.
Asset creation
Poor weather conditions lead to delays in

construction of the hotel.
Operation
Less demand for rooms than estimated at

the appraisal stage.
Causes of risk
Cause
Example of risk
Natural
Soft soil conditions this could mean

that the foundations need to be
strengthened.
Economic
Lower economic growth this may lead

to lower occupancy rates.
Political
Local authority interference this may

lead to increased safety standards.
[ for each, maximum 3]
Page 17
Solution X4.21
(i)
WACC
The market capitalisation of the loan stock or the equity shares is the value of all the
issued bonds or equity share, valuing each at its market price. It would be defined as:
number of shares (or bonds) issued market price per share (or bond)
[1]
The weighted average cost of capital (WACC) is:

=
Debt
Equity
(net cost of debt ) +
(cost of equity)
Debt + Equity
Debt + Equity
[]
The required return on the debt is the average GRY ie 10%

The net cost of debt = (gross cost of debt) (1 t ) = 7% where t is the corporation tax
rate.
[1]
The cost of equity = risk-free return + beta equity risk premium
= 6% + 1.5 8%
= 18%
[1]
Therefore the WACC:

=
200m 7% + 800m 18%

=15.8%
1, 000m
[]
We have used the market capitalisation of the capital as weightings.

[Total 4]
Page 18
(ii)
Determining the systematic risk of a project
The systematic risk of a project is measured by the project beta.

If the project is similar to the projects usually undertaken by the company, then the
company beta can be used as a surrogate for the project beta. Hence the project can be
assessed at the companys usual weighted average cost of capital.
[1]
If the company invests in a wide variety of projects through its different divisions,
perhaps it has already estimated the project betas for each division, and thus an
appropriate beta can be found for a particular project.
[1]
Difficulties arise if the project is very different from the projects usually undertaken.
There are two main options in these circumstances.
It might be possible to find a company which invests only in this sort of project. The
beta of the equity shares of that company would give a starting point from which to
estimate the beta of the project. The beta of the shares could be measured by
monitoring the return on the shares over 52 weeks (say) and monitoring the return on
the market over the same 52 periods. Then it would be possible to calculate the
covariance and the variances required to apply the following formula:
bi =
Covariance between stock i's return and the market return

Variance of the market return
[1]
Following this step, it would be necessary to adjust the measured beta for the effect of
gearing.
[]
If the company cannot find a company beta to use as a proxy for its project beta, it could
estimate the project beta by creating a stochastic model of the project. Using this model
it could estimate the correlation between the prospective project returns and the market
returns and the standard deviation of the project and market returns. Hence, the project
beta could be calculated using the formula shown above.
[1]
Alternatively, using the projections from the model, the company could plot the
projected returns to the project against the risk premium in the market as a whole on a
scatter diagram, find the line of best fit and then use the following formula:
rp = r f + p rm r f
to find b p as the gradient.
)
[1]
[Maximum 4]
(iii)
Page 19
Relationship between WACC and 14%
If the WACC is used as a hurdle rate of return, then the project would probably not take
place. The projects internal rate of return has been estimated at 14% and the hurdle
rate is 15.8%. The project return is clearly beneath the WACC and as such would not
seem to be appealing. If the WACC were used as the discount rate, the project would
have a negative NPV.
[1]
However, we must ask whether or not the WACC is an appropriate hurdle rate for this
particular project. The project should be appraised using the rate of return appropriate
to the systematic risk of the project, not the WACC (which will equate to the average
systematic risk of all the companys projects). For example, if the beta of the project
were estimated to be 0.5, then the project would be required to make a return:
= risk-free return + p equity risk premium
= 6% + 0.5 (8%) = 10%
Using 10% as the hurdle rate, this project would certainly be worthwhile.
[1]
If we assume that the internal rate of return estimated for the project fully reflects the
risks involved, the beta would be estimated from the following:
14% = risk-free return + equity risk premium
14% = 6% + 8%
Therefore beta = 1. The project has a normal level of systematic risk and less than the
companys assets as a whole.
[1]
[Total 3]
(iv)
Worthwhile or not
It is true that the cost of borrowing would be below the return earned on the project.
However by borrowing debt, the company would be increasing the systematic risk of
the remaining equity capital.
[1]
This can be demonstrated by the formula:
geared beta = ungeared beta (1 +
debt
(1 t ) )
equity
The greater the gearing, the higher the beta of the equity shares.
[1]
[1]
Page 20
Therefore, although the borrowing is cheaper for this particular project, the cost of
capital (WACC) for the whole company might have increased overall. This would
make all the existing projects less profitable and the result may be negative overall for
the company.
[1]
[Total 4]
(v)
Which WACC?
It is true that new capital will alter the existing cost of capital. However this should not
prevent WACC being used.
[1]
How to proceed
It may be possible to calculate the optimum cost of capital using the best possible
split between debt and equity. This should be the case regardless of exactly how the
project in question is to be financed.
[1]
Projects could be assessed against this rate, and any departure from this capital structure
would be treated as a loss due to inefficient management of capital rather than altering
the expected profitability of any project. In other words, the decision to finance the
project in a manner that is inconsistent with the companys minimum WACC is
independent of the choice of WACC used to discount the cashflows from the project
and should not therefore influence that choice.
[2]
Alternatively, and this solution would be preferred by modernists, each project should
be assessed using the ungeared cost of equity. The value of the tax shield would then be
apportioned between the various projects that the company is undertaking in some
appropriate manner.
[1]
By tax shield we mean the tax saved by having loan capital in the company. This
would be calculated as:
Loan capital gross cost of debt corporation tax rate
and would be shared out between the projects in a manner to be determined by

management.
[1]
[Maximum 4]

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CT2: Assignment X1 Solutions

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CT2: Assignment X1 Solutions

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CT2: Assignment X1 Solutions

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CT2: Assignment X1 Solutions

The main stakeholders in an organisation are:

government (local and national).

Reasons for coincidence and conflict of objectives

[ mark each to a maximum of 2]

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suppliers might be concerned that valuable contracts might be lost

consumers might be concerned that cost-cutting might result in quality-cutting,

debtholders might be concerned if the company takes more risks in its

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IFE: 2007 Examinations

CT2: Assignment X1 Solutions

IFE: 2007 Examinations

The Actuarial Education Company

CT2: Assignment X1 Solutions

The Actuarial Education Company

IFE: 2007 Examinations

CT2: Assignment X1 Solutions

IFE: 2007 Examinations

The Actuarial Education Company

CT2: Assignment X1 Solutions

They are fixed-interest securities, with coupons normally payable half-yearly.

Secured, sometimes with a fixed charge (a mortgage debenture), sometimes

Debentures rank above unsecured creditors in the event of a winding-up.

They are negotiable (ie they can be sold to a third party).

if credit rating low, with lenders reassured by the security

because security given to lender reduces the interest to be paid

if issuer thinks interest rates are low

because interest payments are allowable against tax.

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CT2: Assignment X1 Solutions

They give ownership of the company and voting rights.

Dividends count as franked investment income.

Running yield likely to be low, but capital value should grow.

Indefinite term (although some ordinary shares can be redeemed).

They are negotiable.

Issues in larger companies are very marketable.

because a dividend is paid at the discretion of the directors and therefore

if project is risky, and issuers dont want to be committed to interest payments.

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